Preparer Review. Tax Ease, LLC Paseo Padre Pkwy #624 May, 2011 Fremont, CA Fax:

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1 Preparer Review Tax Ease, LLC Paseo Padre Pkwy #624 May, 2011 Fremont, CA Fax:

2 Introduction Introduction We have designed this course with a heavy emphasis on the forms. An example of most forms the IRS has indicated will be on this exam are included. Although we have included Form 1040EZ and Form 1040A in this syllabus, we determined that using Form 1040 as the guide would be the best way to illustrate the flow of the forms and keep a clear focus on the exam. All the information provided is based on the 2010 tax year. When forms and income items are introduced from the IRS list of included items they will be in Bold, we also have included a separate form and income index for your convenience. Be sure to check out the appendix which is a cross reference from Publications to Forms to the page number in this material. The answers to sample questions are found as the last item in each chapter. Study Hard and Good Luck! About the Writers Sue Tornberg, EA Sue has been part of the tax return industry since the early 1980 s. From 1986 through 1999 she was the Tax Department Manager for Compucraft Data Services, a large computerized processing company. As part of her position Sue conducted workshops and seminars for the many tax professionals. She was also the liaison between the tax department and the programming department. From 2000 through April 2007, Sue was the partner in a smaller computerized processing company in which she began writing and providing CTEC Approved Tax Education. Sue is one of the owners of TaxEase, LLC with a large tax practice specializing in individual and business tax returns. The practice averages over 500 tax returns per year. As a tax professional, Sue understands the need for Enrolled Agents and Tax Preparers to be able to obtain interesting, qualified education at a reasonable cost. TaxEase provides courses that are designed not only to review the important information tax professionals have used for years, but to include and define the new changes each year. Jan Cusumano, CRTP Jan has been in the tax business for nearly thirty years. She started in Compucraft specializing in bookkeeping and payroll taxes. She has been a CTEC registered tax preparer since Jan is one of the owners of TaxEase, where she continues to do payroll tax reports, bookkeeping and individual returns. Jan is instrumental in the research and development of the continuing and qualifying education and maintains the high standards which allow TaxEase to produce quality tax education at a reasonable cost. 2

3 Table of Contents TABLE OF CONTENTS INTRODUCTION... 2 ABOUT THE WRITERS... 2 PART I... 9 CHAPTER 1 - WHICH TO FILE FORM 1040EZ/FORM 1040A/FORM SAMPLE QUESTIONS FOR CHAPTER ONE CHAPTER 1 - ANSWERS TO SAMPLE QUESTIONS CHAPTER 2 - THE BASICS... 9 WHO MUST FILE? FILING REQUIREMENTS FOR DEPENDENTS STANDARD DEDUCTION ACCOUNTING METHOD AND PERIODS CHAPTER 2 SAMPLE QUESTIONS CHAPTER 2 ANSWERS TO SAMPLE QUESTION CHAPTER 3 - FILING STATUS, EXEMPTIONS AND DEPENDENTS FILING STATUS EXEMPTIONS DEPENDENTS WORKSHEET FROM 2010 IRS PUB CHAPTER 3 - SAMPLE QUESTIONS CHAPTER 3 ANSWERS TO SAMPLE QUESTIONS CHAPTER 4 WHERE TO REPORT INCOME FORM W FORM W-2 AND INSTRUCTIONS CHAPTER 4 - SAMPLE QUESTIONS CHAPTER 4 ANSWERS TO SAMPLE QUESTIONS CHAPTER 5 WAGES FORM EMPLOYEE COMPENSATION MISCELLANEOUS COMPENSATION LIFE INSURANCE PROCEEDS FRINGE BENEFITS EMPLOYEE BENEFITS WORKERS COMPENSATION CHAPTER 5 - SAMPLE QUESTIONS CHAPTER 5 ANSWERS TO SAMPLE QUESTIONS CHAPTER 6 INTEREST AND DIVIDENDS

4 4 Table of Contents INTEREST INCOME DIVIDEND INCOME NONTAXABLE DISTRIBUTIONS CHAPTER 6 - SAMPLE QUESTIONS CHAPTER 6 ANSWERS TO SAMPLE QUESTIONS CHAPTER 7 RECOVERIES AND ALIMONY RECEIVED STATE TAX REFUND EXCERPT FROM PUB CHAPTER 7 - SAMPLE QUESTIONS CHAPTER 7 ANSWERS TO SAMPLE QUESTIONS CHAPTER 8 SCHEDULE C-EZ BOX 9. PAYER MADE DIRECT SALES OF $5,000 OR MORE BUSINESS INCOME SCHEDULE C-EZ BUSINESS INCOME SCHEDULE C-EZ SCHEDULE SE CHAPTER 8 - SAMPLE QUESTIONS CHAPTER 8 ANSWERS TO SAMPLE QUESTIONS CHAPTER 9 - CAPITAL ASSETS BASIS OF PROPERTY STOCKS, BONDS AND MUTUAL FUNDS FIRST-IN, FIRST-OUT METHOD OF IDENTIFICATION SPECIFIC IDENTIFICATION METHOD AVERAGE COST BASIS, SINGLE CATEGORY METHOD (MUTUAL FUNDS) AVERAGE COST BASIS, DOUBLE CATEGORY METHOD (MUTUAL FUNDS) SALE OF PROPERTY GAIN AND LOSS CAPITAL GAIN TAX RATES SCHEDULE D TAX WORKSHEET CHAPTER 9 - SAMPLE QUESTIONS CHAPTER 9 - ANSWERS TO SAMPLE QUESTIONS CHAPTER 10 - TYPES OF IRA S AND EMPLOYER SPONSORED PENSION PLANS - DISTRIBUTIONS ROTH IRA DISTRIBUTIONS REPORTING DISTRIBUTIONS PENSION DISTRIBUTIONS DISTRIBUTIONS BEFORE AGE 59 1/ REQUIRED MINIMUM DISTRIBUTION ROLLOVERS OF PENSIONS AND IRA S SIMPLIFIED METHOD WORKSHEET FROM PUB FORM 1099-R ADDITIONAL TAXES ON QUALIFIED PLANS (INCLUDING IRA S) FORM CHAPTER 10 - SAMPLE QUESTIONS CHAPTER 10 -ANSWERS TO SAMPLE QUESTIONS CHAPTER 11 - UNEMPLOYMENT COMPENSATION, SOCIAL SECURITY BENEFITS AND MISCELLANEOUS INCOME

5 Table of Contents UNEMPLOYMENT COMPENSATION SOCIAL SECURITY BENEFITS MISCELLANEOUS INCOME LINE 21 FORM FOREIGN EARNED INCOME EXCLUSION FORM 2555-EZ CANCELLED DEBT FORM 1099-C CANCELLATION OF DEBT DISCOUNTS AND LOAN MODIFICATIONS FORECLOSURES AND REPOSSESSIONS CHAPTER 11 - SAMPLE QUESTIONS CHAPTER 11 ANSWERS TO SAMPLE QUESTIONS CHAPTER 12- ADJUSTMENTS TO INCOME HEALTH SAVINGS ACCOUNT ALIMONY PAID INDIVIDUAL RETIREMENT ARRANGEMENT IRA DEDUCTIONS NONDEDUCTIBLE IRA CONTRIBUTIONS FORM CHAPTER 12 - SAMPLE QUESTIONS CHAPTER 12 ANSWERS TO SAMPLE QUESTIONS CHAPTER 13 ITEMIZED DEDUCTIONS STANDARD DEDUCTION VS. ITEMIZED DEDUCTIONS ITEMIZED DEDUCTIONS MEDICAL AND DENTAL EXPENSES TAXES INTEREST FORM INVESTMENT INTEREST GIFTS TO CHARITY EIGHT TIPS FOR DEDUCTING CHARITABLE CONTRIBUTIONS CASUALTY AND THEFT JOB EXPENSES AND OTHER MISCELLANEOUS DEDUCTIONS FORM EMPLOYEE BUSINESS EXPENSES DEDUCTIONS SUBJECT TO 2% OF ADJUSTED GROSS INCOME DEDUCTIONS NOT SUBJECT TO 2% LIMIT SCHEDULE A, LINE CHAPTER 13 - SAMPLE QUESTIONS CHAPTER 13 - ANSWERS TO SAMPLE QUESTIONS CHAPTER 14 TAXES AND CREDITS TAX CAPITAL GAIN TAX RATES CREDITS ADOPTION BENEFITS CHILD TAX CREDIT (IRC SECTION 24) EDUCATION CREDITS (IRC SECTION 25(A)) RETIREMENT SAVINGS CONTRIBUTION CREDIT (IRC SECTION 25B) MAKING WORK PAY CREDIT CHAPTER 14 SAMPLE QUESTIONS CHAPTER 14 - ANSWERS TO SAMPLE QUESTIONS

6 6 Table of Contents CHAPTER 15 EARNED INCOME CREDIT EARNED INCOME CREDIT CHAPTER 15 - SAMPLE QUESTIONS CHAPTER 15 ANSWERS TO SAMPLE QUESTIONS CHAPTER 16 REFUNDS, AMOUNT DUE & ELECTRONIC FILING REFUND AMOUNT OWED ELECTRONIC FILING FORM ADVANTAGES OF IRS E-FILE FORM FORM CHAPTER 16 SAMPLE QUESTIONS CHAPTER 16 ANSWERS TO SAMPLE QUESTIONS CHAPTER 17 MISCELLANEOUS FORMS FORM INJURED SPOUSE ALLOCATION FORM 9465 INSTALLMENT AGREEMENT FORM W-7- APPLICATION FOR IRS INDIVIDUAL TAXPAYER IDENTIFICATION NUMBER FORM 8821 TAX INFORMATION AUTHORIZATION CHAPTER 17 SAMPLE QUESTIONS CHAPTER 17 ANSWERS TO SAMPLE QUESTIONS PART II CHAPTER 18 SCHEDULE C/FORM 4562 AND BUSINESS INCOME SCHEDULE C ACCOUNTING PERIODS ACCOUNTING METHODS MATERIAL PARTICIPATION COMBINATION METHOD IRS PUBLICATION DEPRECIATION (FORM 4562) SPECIAL DEPRECIATION ALLOWANCE FORM 4562 (SEE BELOW) BUSINESS USE OF HOME FORM SCHEDULE SE EARNINGS FOR CLERGY FORM W FORM EMPLOYEE BUSINESS EXPENSES CHAPTER 18 SAMPLE QUESTIONS CHAPTER 18 ANSWERS TO SAMPLE QUESTIONS CHAPTER 19 - RENTAL REAL ESTATE, K-1 INCOME AND LOSS, PASSIVE ACTIVITIES RENTAL INCOME - PUB RENTAL EXPENSES SCHEDULE E ROYALTY INCOME

7 Table of Contents PASS-THROUGH INCOME FROM PARTNERSHIP, S-CORPORATION, ESTATE OR TRUST K-1 S FORM 1065, K-1, PAGE FORM 1120S, K-1, PAGE FORM 1041, K-1, PAGE CHAPTER 19 - SAMPLE QUESTIONS CHAPTER 19 ANSWERS TO SAMPLE QUESTIONS CHAPTER 20 SCHEDULE F FARM INCOME FARM INVENTORY SCHEDULE F FORM FARM RENTAL INCOME AND EXPENSE DEPRECIATION SCHEDULE J CHAPTER 20 SAMPLE QUESTIONS CHAPTER 20 ANSWERS TO SAMPLE QUESTIONS CHAPTER 21 FORM 1040NR, 1040PR, FORM 2555 AND FORM FORM 1040NR - U.S. NONRESIDENT ALIEN INCOME TAX RETURN FORM 1040NR FORM 1040 SS FORM 1040 SS FORM 2555 FOREIGN INCOME EXCLUSION FORM FOREIGN TAX CREDIT (IRC SECTION 901(A)) CHAPTER 21 SAMPLE QUESTIONS CHAPTER 21 ANSWERS TO SAMPLE QUESTIONS CHAPTER 22 KIDDIE TAX KIDDIE TAX - TAX ON INVESTMENT INCOME OF CERTAIN MINOR CHILDREN FORM CHAPTER 22 SAMPLE QUESTIONS CHAPTER 22 ANSWER TO SAMPLE QUESTIONS CHAPTER 23 GENERAL BUSINESS CREDIT AND ALTERNATIVE MINIMUM TAX FORM ALTERNATIVE MINIMUM TAX FORM GENERAL BUSINESS CREDIT FORM 8801 CREDIT FOR PRIOR YEAR MINIMUM TAX CHAPTER 23 SAMPLE QUESTIONS CHAPTER 23 ANSWERS TO SAMPLE QUESTIONS CHAPTER 24 FORM 4797, 6252, 8824, 4952, FORM 4797 SALE OF BUSINESS PROPERTY GAIN OR LOSS FORM FORM INSTALLMENT SALES FORM 8824 LIKE-KIND EXCHANGE REPORTING THE EXCHANGE

8 Table of Contents FORM 4952 INVESTMENT INTEREST EXPENSE DEDUCTION FORM 6198 AT RISK LIMITATIONS CHAPTER 24 SAMPLE QUESTIONS CHAPTER 24 ANSWERS TO SAMPLE QUESTIONS CHAPTER 25 OTHER ITEMS FORM 8903 DOMESTIC PRODUCTION ACTIVITIES DEDUCTION FORM 8910 ALTERNATIVE MOTOR VEHICLE CREDIT FORM 8919 UNCOLLECTED SOCIAL SECURITY AND MEDICARE TAX ON WAGES

9 Part I 9

10 Form 1040EZ/Form 1040A/Form 1040 Chapter 1 - Which to File Form 1040EZ/Form 1040A/Form 1040 The taxpayer can use Form 1040 EZ if the following is true: The filing status is single or married filing a joint return The taxpayer (and spouse if married filing joint) were under age 65 and not blind at the end of 2010 There are no dependents on the return The taxable income is less than $100,000 The taxpayer did not claim any adjustments to income. The taxpayer did not claim any credit except EIC or recovery rebate credit. The only income is from salaries, wages, tips, taxable scholarship or fellowship grants, unemployment compensation, Alaska Permanent Fund and the taxable interest is not over $1,500 No advanced earned income payments were received, and the taxpayer did not owe Household Employment Taxes The taxpayer did not figure the standard deduction using Schedule L. The taxpayer can use Form 1040A if all five of the following apply: 1. The only income was from the following sources: Wages, salaries, tips Interest and ordinary dividends Capital gain distributions Taxable scholarship and fellowship grants. Pensions, annuities and IRA's. Unemployment compensation. Taxable social security and railroad retirement benefits. Alaska Permanent Fund dividends. 2. The only adjustments to income that can be claimed are: Educator expenses IRA deduction. Student loan interest deduction. Tuition and fees deduction 3. No itemized deductions are taken. 4. The taxable income is less than $100, The only tax credits that can be claimed are: Child tax credit. Additional child tax credit. Education credits. Earned income credit. Credit for child and dependent care expenses. Credit for the elderly or the disabled. Adoption credit. Retirement savings contribution credit. Making work pay credit 10

11 Form 1040EZ/Form 1040A/Form 1040 The following excerpt is from Form 1040A instructions When to Use Form 1040 : Sample Questions for Chapter One 1. All of the following statements are true except; a. A taxpayer can file Form 1040EZ if the taxable income is less than $100,000. b. A taxpayer can file Form 1040EZ if they claim the EIC credit. c. Making Work Pay credit can be claimed only when filing Form d. Taxable scholarships and fellowship grants can be claimed if filing Form 1040A. 2. Which of the following is allowed when filing 1040A? a. The taxpayer is a bona fide resident of Puerto Rico and excludes income from sources in Puerto Rico. b. The taxpayer is a debtor in a bankruptcy filed after October 16, 2005 c. Form W-2, box 12 shows uncollected employee tax (social security and medicare tax on tips or group-term life insurance.) d. Capital gain distributions 3. A taxpayer must file Form 1040 if they have a net disaster loss attributable to federally declared disaster even if they are claiming the standard deduction. a. True b. False 4. A taxpayer may file Form 1040EZ if their taxable interest amount is; a. $2500 b. $1400 c. $1650 d. $

12 12 Form 1040EZ/Form 1040A/Form 1040

13 Form 1040EZ/Form 1040A/Form

14 Form 1040EZ/Form 1040A/Form 1040 Chapter 1 - Answers to Sample Questions 1. C- is not true. The Making Work Pay credit can be claimed on Forms 1040EZ, 1040A or (Form 1040EZ, 1040A and 1040 Instructions) 2. D - Capital gain distributions can be reported on Form 1040A line 10. (Form 1040A Ins., Pg. 11) 3. A -This statement is true. A net disaster loss in 2010 because of a disaster that was declared a federal disaster after 2007 and occurred before 2010 must be reported on Form (Form 1040A Ins., Pg. 12) 4. B The taxable interest reported on Form 1040EZ must be less than $1500. (Form 1040EZ Ins., Pg. 6) 14

15 The Basics Chapter 2 - The Basics Pub.17 Excerpt Who Must File? All US citizens, regardless of where they live, and resident aliens must determine whether they are required to file a tax return. The determination is based on the following three factors: 1. Gross Income 2. Filing Status and 3. Age A return must be filed if any of the following four conditions below apply: 1. The taxpayer owes special taxes, such as: Social Security or Medicare taxes on tips that were not reported to the employer, Alternative Minimum Tax, recapture taxes or tax on a qualified plan including IRA or other tax-favored account. 2. The taxpayer had earnings from self-employment of at least $ Any advanced earned income payments were received. 4. There are wages of $ or more from a church that is exempt from employer social security and Medicare taxes. 9

16 The Basics 2010 Filing Requirements for Dependents Pub 17, Page 8 Standard Deduction The standard deduction is a dollar amount that reduces the amount of income on which the taxpayer is taxed. The standard deduction is allowed only if the taxpayer does not have itemized deductions. In general, the basic standard deduction is an amount relative to each tax year and varies according to the filing status. The standard deduction of an individual who can be claimed as a dependent on another person's tax return is the greater of: An amount specified by law, or The individual's earned income plus a specified amount up to the basic standard deduction for his or her filing status In some cases, the standard deduction can consist of two parts, the basic standard deduction and additional standard deduction amounts, for age, or blindness, or both. The additional amount is an amount specified by law and varies based on the filing status. The additional amount for age will be allowed if the taxpayer is age 65 or older at the end of the tax year. The taxpayer is considered to be 65 on the day before their 65th birthday. The additional amount for blindness will be allowed if the taxpayer is blind on the last day of the tax year. Certain individuals are not entitled to the standard deduction. They are: A married individual filing a separate return whose spouse itemizes deductions, An individual who was a nonresident alien or dual status alien during any part of the year, or An individual who files a return for a period of less than 12 months due to a change in his or her annual accounting cycle 10

17 The Basics Standard Deduction 2010 Age 65 or Older/Blind Single 5,700 1,400 Married Filing Joint or Qualified Widow(er) 11,400 1,100 Head of Household 8,350 1,400 Married Filing Separate 5,700 1,100 Standard Deduction Worksheet (Pub 17, pg 139) When to File? Tax returns for individual taxpayers are due by the 15 th day of the fourth month after the close of the tax year (April 15 th for calendar year taxpayers). If the return is filed after this date it is subject to interest and penalties. If the taxpayer needs an extension of time Form 4868 requesting an automatic 6-month extension must be filed. The due date that falls on a Saturday, Sunday or legal holiday for filing tax forms is delayed until the next business day. Interest Interest will be charged on tax returns not paid by the due date, even if an extension of time is granted. Interest is also charged on penalties imposed for failure to file, negligence, fraud, substantial valuation misstatements, and substantial understatements of tax. Interest is charged on the penalty from the due date of the return (including extensions). 11

18 The Basics The IRS will pay interest on overpayment of tax if the refund is not issued 45 days after the tax return is filed. If the refund is issued within 45 days of the filing date there is no interest. The interest adjusts quarterly. Accepting a check from the IRS does not change the right of the taxpayer to claim an additional refund and interest. A claim for additional refund should be filed on Form 1040X. Amended Returns Errors and omissions on a return can lead to additional refund or additional amount owed. The return should be corrected if: 1. Not all income was reported 2. Deductions and credits were claimed that should not have been claimed. 3. Deductions and credits were not claimed that should have been claimed. 4. The filing status claimed was incorrect. Form 1040X was revamped in January A separate Form 1040X must be filed for every year being changed. Interest and Penalties are not included on Form 1040X, the interest and penalties will be adjusted accordingly. It takes 8 to 10 weeks for an amended return to be processed. (Refer to Form 1040X instructions for further information). Penalties Late Filing: If the return is not filed by the due date (including extensions), the penalty is usually 5% of the amount due for each month or part of the month the return is late, unless there is a reasonable explanation. The explanation must be attached to the return. The penalty can be as much as 25% (more in some cases) of the tax due. If the return is more than 60 days late the minimum penalty will be $100 or the amount of any tax owed whichever is smaller. Late Payment of Tax: If the taxes owed are paid late the penalty is usually 1/2 of 1% of the unpaid amount for each month or part of the month the tax is not paid. This is known as the failure-to pay penalty. The penalty can be as much as 25% of the unpaid amount. It applies to any unpaid amount on the return. This penalty is in addition to interest charges on the late payments. The penalty does not apply during the automatic 6-month extension of time to file. Negligence and disregard: The term negligence includes failure to make a reasonable attempt to comply with the tax law or to exercise ordinary and reasonable care in preparing the tax return and adequate books and records. This accuracy penalty includes any careless, reckless, or intentional disregard. Substantial understatement of income tax: An understatement is considered substantial if it is more than the largest of 10% of the correct tax or $5,000. Negligence, disregard and substantial understatement of income are all considered accuracy related penalties. Accuracy related penalty is equal to 20% of the underpayment. Accounting Method and Periods The accounting method is the way the taxpayer accounts for his/her income and expenses. Most taxpayers use either the cash or accrual method of accounting. The method is chosen the first time a return is filed; approval is needed by the IRS to change the accounting method. 12

19 The Basics If the taxpayer uses the cash method, all items of income are reported in the year they are received or constructively received. Expenses are deducted in the year they are paid. Constructive receipt is when the funds become available to use without restriction whether they are in the physical possession of the taxpayer or not. In general, the cash method cannot be used to account for inventory purchases and sales. However, an exception is allowed for taxpayers with an average annual gross receipt of $1 million or less. If the taxpayer uses the accrual method, the income is generally reported when earned, not received. The expenses are reported when incurred, not paid. Accounts payable and accounts receivable books must be maintained. The accrual method must be used to account for inventory purchases and sales. Hybrid method is a combination of accrual and cash. The most common hybrid uses the accrual method for inventory purchases and sales; and the cash method for non inventory income and operating expenses. Most individual tax returns cover a calendar year the 12 months from January 1 through December 31 st. If the taxpayer does not use a calendar year, the accounting period is a fiscal year. A regular fiscal year is a 12-month period that ends on the last day of any month other than December. A week fiscal year varies from 52 to 53 weeks and always ends on the same day of the week. The accounting period is chosen when the first return is filed; the accounting period cannot be longer than 12 months. For additional information on accounting methods or periods refer to Pub

20 The Basics Chapter 2 Sample Questions 1. Which one of the following is not a determination of whether a person must file a tax return? A. Residency B. Filing status C. Gross Income D. Age 2. The taxpayer may be able to file as a qualifying widow or widower for the two years following the year the spouse died. To do this, the taxpayer must meet all four of the following tests, except? A. The taxpayer is entitled to file a joint return with the spouse for the year he or she died. It does not matter whether the joint return was actually filed, B. The taxpayer did not remarry in the two years following the year the spouse died, C. There is a child, stepchild, or adopted child (a foster child does not meet this requirement) for whom the taxpayer can claim a dependency exemption, D. The child does not have to be a dependent if in the military E. The taxpayer paid more than half the cost of maintaining a household that was the main home for them and that child, for the whole year. 3. You are a dependent who is single, 23 years old, and not blind. You earned $856 of wages and $1,123 of interest income during You must file a tax return A. True B. False 4. Larry, 46, and Donna, 33, are filing a joint return for Neither is blind, and neither can be claimed as a dependent. They decide not to itemize their deductions. Their standard deduction is $11,400 A. True B. False 5. Form 1040 instructions state that gross income means all income that is received in the form of the following, except: A. Money B. Property C. Services that are not tax exempt D. Real estate taxes paid 14

21 The Basics 6. The tax return for a calendar year taxpayer is due on: A. The 15 th day of the 4 th month after the close of the taxable year. B. April 1 st C. August 15 th D. The 15 th day of the 3 rd month after the close of the taxable year. 7. The due date that falls on a Saturday, Sunday or legal holiday for filing tax forms is delayed until the next business day. A. True B. False 8. Form 4868 is used: A. To request an automatic 6-month extension of time to file the tax return. B. To report self-employment tax C. To report miscellaneous income D. To request an automatic 4-month extension of time to pay the tax owed. 9. Which of the following is not an accuracy related penalty? A. Negligence penalty B. Disregard penalty C. Penalty for substantial under reporting of income D. Penalty for late filing of the tax return. 10. The failure-to-pay penalty on the unpaid amount of tax due can be as much as: A. 10% B. 50% C. 25% D. 5% 11. The term for a tax return that is carelessly prepared and without adequate records is considered to be done with: A. Oversight or omission B. Inattention or neglect C. Negligence or disregard D. Indifference or disinterest 12. If the taxpayer uses the cash method of accounting, which of the following statements are correct? A. Income is reported in the year received or constructively received B. Expenses are deducted in the year they are paid C. Income is reported when earned D. Both A and B 15

22 The Basics 13. A regular fiscal year is a 12-month period that ends: A. December 31st B. The first day of any month other than December C. The last day of any month other than December D. Always on November 30 th 16

23 The Basics Chapter 2 Answers to Sample Question 1. A - Residency is not a factor. Filing status, age and gross income are the determining factor of whether a return has to be filed. (Pub 17, Pg 5) 2. C Both A and B are correct. A return must be filed if any of the following four conditions apply: (Pub 17, Pg 7) The taxpayer owes special taxes, such as: Social Security or Medicare taxes on tips that were not reported to the employer, Alternative Minimum Tax, recapture taxes or tax on a qualified plan including IRA or other tax-favored account. The taxpayer had earnings from self-employment of at least $400. Any advanced earned income payments were received. There are wages of $ or more from a church that is exempt from employer social security and Medicare taxes 3. A - The correct answer is True. Single dependents who are not 65 or older, or not blind, must file a tax return if unearned income is more than $950. (Pub 17, Pg 6) 4. A - $11,400 is the amount of standard deduction. Refer to Form 1040 Instructions. (Pub. 17, Pg 138) 5. D - Real estate taxes paid is not correct Refer to Table 1-1 from Pub 17 on page 12 of this text. (Pub. 17, Pg 4) 6. A- Tax returns for individual taxpayers are due by the 15 th day of the fourth month after the close of the tax year (April 15 th for calendar year taxpayers). (Pub 17, Pg 11) 7. A It is true if the due date that falls on a Saturday, Sunday or legal holiday then the filing of the tax form are delayed until the next business day. (Pub 17, Pg 11) 8. A is correct that Form 4868 is used to request a 6-month extension. (Pub 17, Pg 12) 9. D Penalty for late filing of a tax return is not an accuracy related penalty.(pub 17, Pg 18) 10. C A failure-to-pay penalty on the unpaid amount of tax due can be as much as 25%(Pub 17, Pg 18) 11. C Negligence or disregard is the way the IRS terms a carelessly prepared return. (Pub 17, Pg 20) 12. D Income is reported in the year received or constructively received and expenses are deducted in the year they are paid if the taxpayer is a cash basis taxpayer. (Pub 17, Pg 33) 13. C - A calendar year taxpayer s tax year ends December 31, a fiscal year taxpayer s tax year ends the last day of any month except December. (Pub 17, Pg 13) 17

24 Filing Status and Dependents Chapter 3 - Filing Status, Exemptions and Dependents Filing Status Single When to use: The taxpayer is unmarried for the whole year if, on the last day of the tax year, the taxpayer is unmarried or legally separated from their spouse under a divorce or separation maintenance decree. The taxpayer s spouse died a previous tax year and the taxpayer does not have a dependent child The taxpayer does not qualify for head of household filing status Married Filing Jointly Married Filing Separately When to use: The taxpayer is married and living together as husband and wife. The taxpayer is living together in a common law marriage that is recognized in the state where the taxpayer now lives or in the state where the common law marriage began. The taxpayer is married and living apart from their spouse, but not legally separated under a decree of divorce or separate maintenance The taxpayer is separated under an interlocutory (not final) decree of divorce. For purposes of filing a joint return, the taxpayer is not considered divorced. If the taxpayer s spouse died during the year and the taxpayer did not remarry before the end of the tax year. Conditions: Both the taxpayer and the spouse must agree to file a joint return. May file a joint return even if the taxpayer or spouse had no income or deductions Both the taxpayer and the spouse must use the same accounting period, but they may use different accounting methods. Both the taxpayer and the spouse may be held responsible, jointly and individually, for the tax and any interest or penalty due on their joint return even if they divorce in a future tax year. If one spouse is a nonresident alien or dual-status alien who is married to a U.S. citizen or resident alien at the end of the year, the spouses can choose to file a joint return. (See IRS Publication 519) Once the taxpayer and their spouse file a married filing joint tax return they cannot choose to file married filing separate after the due date of the return. Note: If the taxpayer s spouse dies and the taxpayer was to remarry the same tax year, the taxpayer can file a joint return with their new spouse. The taxpayer s deceased spouse s filing status is married filing separately for that year. When to use: Must be married May benefit a married taxpayer who wishes to be responsible only for their own tax May have to use married filing separately if the spouses cannot agree to file a joint return and they live together How to file: Usually the taxpayer would report only their own income, exemptions, credits, and deductions on their individual tax return The taxpayer can claim an exemption for their spouse if the spouse had no gross income and was not the dependent of another person. May use form 1040A or 1040 when using this filing status 18

25 Filing Status and Dependents (Continued) Married Filing Separately Enter the spouse s full name and social security number in the space provided on Form 1040A or 1040 Special rules: The taxpayer s tax rate will usually be higher than it would be on a joint return The exemption amount for figuring the AMT will be half that allowed to a joint return filer Cannot take the credit for child and dependent care expenses in most cases. The amount the taxpayer can exclude from income under an employer s dependent care assistance program is limited to $2,500. Cannot take the earned income credit In most cases the taxpayer cannot take the exclusion or credit for adoption expenses. Cannot take education credits or deduction for student loan interest If the taxpayer lived with the spouse at any time during the year they cannot claim the credit for the elderly or the disabled If the taxpayer lived with the spouse at any time during the year they will have to include in income more (up to 85%) of any social security income or equivalent railroad retirement benefits received The child tax credit and retirement savings contributions credit are reduced at income levels that are half those for a joint return The capital loss deduction limit is $1,500 If the taxpayer s spouse itemizes deductions, the taxpayer cannot claim the standard deduction. The standard deduction is half the amount allowed on a joint return. The first-time homebuyer credit is limited to $4000. If the special rule for longtime residents of the same main home applies, the credit is limited to $3,250. The taxpayer cannot rollover amounts from a traditional IRA to a Roth IRA. Other rules: The taxpayer may not be able to deduct all or part of his or her contributions to a traditional IRA if their spouse was covered by an employee retirement plan at work. The deduction is reduced or eliminated if the taxpayer s income is more than a certain amount. Taxpayer s who actively participate in a passive rental real estate activity that produced a loss cannot claim the special allowance if they lived with their spouse at any time during the year. Married persons filing separate returns that lived apart at all times during the year are each allowed a $12,500 maximum special allowance for losses from passive real estate activities. Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, or Wisconsin is considered community property states. The taxpayer s income may be considered separate or community income for income tax purposes. See IRS Publication 555. Changing a married filing separate return to a married filing joint return: This can be done by filing a 1040X (Amended Return) any time within 3 years from the due date of the separate return or returns. This does not include any extensions. 19

26 Filing Status and Dependents Head of Household When to use: The taxpayer must be unmarried or considered unmarried on the last day of the year, paid more than half the cost of keeping up a home for the tax year, and have a child, stepchild, adopted child, or eligible foster child living with them for more the half the year. All three requirements must apply. However, if the qualifying person is the taxpayer s parent, he or she does not have to live with the taxpayer. The taxpayer must file a separate return. A separate return includes a return filed claiming married filing separately, single, or head of house hold filing status. The taxpayer s spouse did not live in the taxpayer s home during the last 6 months of the tax year. Who is a Qualifying Person? A qualifying child who is single, the taxpayer can claim an exemption for him or her, and lived with the taxpayer more than half the year. However, if the taxpayer cannot claim the exemption only because the noncustodial parent can claim the exemption for the child, the child is usually the qualifying child of the custodial parent for head of household purposes. A qualifying child who is married, lived with the taxpayer more than half the year, and the taxpayer can claim an exemption for him or her. The taxpayer s mother or father who lives or doesn t live with the taxpayer and the taxpayer can claim an exemption for him or her. A qualifying relative (other than the taxpayer s father or mother) who lived with the taxpayer more than half the year. The taxpayer must be able to claim an exemption for him or her. Who is Not a Qualifying Person? A qualifying child who is married and the taxpayer cannot claim an exemption for him or her. The taxpayer s father or mother and the taxpayer cannot claim an exemption for him or her. A qualifying relative (other than the taxpayer s father or mother) who did not live with the taxpayer more than half the year. A person who is not related to the taxpayer in one of the ways listed as Who is a Qualifying Relative? (Below) Who is a Qualifying Child? (All of the following must apply): Must be the taxpayer s son, daughter, stepchild, foster child, brother, sister, half brother, half sister, stepbrother, stepsister, or a descendant of any of them. A legally adopted child is considered your child. The child must be under age 19 at the end of the year and younger then the taxpayer; or under age 24 at the end of the year, a full time student, and younger than the taxpayer; or any age if permanently and totally disabled. The child must have lived with the taxpayer for more than half of the year. The child must not have provided more than half of this or her own support for the year. The child is not filing a joint return for the year (unless that return is filed only as a claim for refund) Who is a Qualifying Relative? (All of the following must apply) Cannot be a qualifying child of the taxpayer or a qualifying child of any other taxpayer. 20

27 Filing Status and Dependents Continued Head of Household Must be the taxpayer s, child, stepchild, foster child, or a descendant of any of them. The taxpayer s brother, sister, half brother, half sister, stepbrother, or stepsister. The taxpayer s father, mother, grandparent, or direct ancestor. The taxpayer s stepfather or stepmother. A brother or sister of the taxpayer s father or mother. The taxpayer s son-in-law, daughter-in-law, father-in-law, motherin-law, brother-in-law, or sister-in-law (any of these relationships that were established by marriage are not ended by death or divorce.) Must have lived in the taxpayer s home for more than half the year The taxpayer must be able to claim an exemption for him or her. Calculation for keeping up a home for the year: Total the amount the taxpayer paid for keeping up a home (see included cost below) Total the total cost of keeping up a home (see included cost below) Subtract the total amount the taxpayer paid from the total cost amount. The answer is amounts others paid. If the total amount the taxpayer paid is more than the amounts others paid, the taxpayer meets the requirement of paying more than half the cost of keeping up the home. What is included in paying more than half of the cost of keeping up a home for the year? The taxpayer can include rent, mortgage interest expense, real estate taxes, insurance on the home, home repairs and maintenance, utilities, other household expenses and food eaten in the home. If the taxpayer used payments they received from TANF or other public assistance programs to pay part of the cost of keeping up their home, the taxpayer cannot count them as money the taxpayer paid. However, the taxpayer must include them in the total cost of keeping up their home to figure if they paid over half the cost. What is not included in paying more than half of the cost of keeping up a home for the year? Clothing, education, medical treatment, vacations, life insurance, or transportation Rental value of a home the taxpayer owns or the value of the taxpayer s services or those of a member of the taxpayer s household. Nonresident alien spouse: The taxpayer is considered unmarried for head of household purposes if their spouse was a nonresident alien at any time during the year and the taxpayer does not choose to treat their nonresident spouse as a resident alien. However, the taxpayer s spouse is not a qualifying person for head of household purposes. The taxpayer must have another qualifying person and meet the other tests to be eligible to file as a head of household. Even if the taxpayer is considered unmarried for head of household purposes because they are married to a nonresident alien, they are still considered married for purposes of the earned income credit. The taxpayer is not entitled to the credit unless they file a joint return with their spouse and meet other qualifications. The taxpayer is considered married if they choose to treat their spouse as a resident alien. 21

28 Filing Status and Dependents Qualifying Widow(er) With Dependent Child When to Use: The taxpayer may be eligible to use qualifying widow(er) with dependent child as their filing status for 2 years following the year their spouse died. Eligibility Rules: The taxpayer was entitled to file a joint return with their spouse for the year their spouse died. It does not matter whether the taxpayer actually filed a joint return. The taxpayer s spouse died in one of the two previous tax years and the taxpayer did not remarry before the end of the current tax year. Example: The taxpayer s spouse died in 2008 or 2009 and they did not remarry before the end of The taxpayer has a child, stepchild or adopted child for who they can claim an exemption. This does not include a foster child. The child lived in their home all year, except for temporary absences. The taxpayer paid more than half the cost of keeping up a home for the year. See head of household above for this calculation. If the taxpayer s child that qualifies them for this filing status dies during the year, the taxpayer may still be eligible to use this filing status. The taxpayer must have provided more than half of the cost of keeping up a home that was the child s main home during the entire part of the year he or she was alive. EXEMPTIONS New for 2010: The taxpayer will no longer lose part of their deduction for personal exemptions, regardless of the amount of their adjusted gross income Personal Exemptions: The taxpayer generally can take one for themselves and, if they are married, one for their spouse. If another taxpayer is entitled to claim this taxpayer as a dependent, they cannot take an exemption for themselves even if the other taxpayer does not actually claim this taxpayer as a dependent. Exemptions for Dependents: The taxpayer generally can take an exemption for each of their dependents. If the taxpayer is entitled to claim an exemption for a dependent, that dependent cannot claim a personal exemption on his or her own tax return. The taxpayer must list the social security number of any dependent for whom they can claim an exemption. The taxpayer can claim an exemption for a qualifying child or qualifying relative only if the dependent taxpayer, joint return, citizen or resident tests are met. The taxpayer must meet all three of the following tests. 22

29 Filing Status and Dependents Dependent Taxpayer Test: If the taxpayer could be claimed as a dependent by another person, the taxpayer cannot claim anyone else as a dependent. Even if the taxpayer has a qualifying child or qualifying relative, the taxpayer cannot claim that person as a dependent. If the taxpayer is filing a joint return and their spouse could be claimed as a dependent by someone else, the taxpayer and their spouse cannot claim any dependents on their join return. Joint Return Test: The taxpayer cannot claim a married person as a dependent if he or she files a joint return. An exception to the joint return test applies if the taxpayer s child and his or her spouse file a joint return merely as a claim for refund and no tax liability would exist for either spouse on separate returns. Citizen or Resident Test: The taxpayer cannot claim a person as a dependent unless that person is a U.S. Citizen, U.S. resident alien, U.S. national, or a resident of Canada or Mexico. An exception for an adopted child if the taxpayer is a U.S. citizen or U.S. national who has legally adopted a child who is not a U.S. citizen, U.S. resident alien, or U.S. national, this test is met if the child lived with the taxpayer as a member of their household all year. This exception also applies if the child was lawfully placed with the taxpayer for legal adoption. If the taxpayer was a U.S. citizen when their child was born, the child may be a U.S. citizen even if the other parent was a nonresident alien and the child was born in a foreign country. A taxpayer cannot claim an exemption for a foreign student placed in their home for a temporary period under a qualified international education exchange program. The foreign student generally is not considered a U.S. resident. U.S. nationals include American Samoans and Northern Mariana Islanders who chose to become U.S. nationals instead of U.S. Citizens. These are individuals who although are not U.S. citizens, they owe his or her allegiance to the United States. Spouses Exemption: The spouse is never considered the taxpayers dependent. On a joint return the taxpayer can claim one exemption for themselves and one for their spouse. If the taxpayer and their spouse file separate returns, the taxpayer can claim an exemption for their spouse only if their spouse had no gross income, is not filing a return, and is not the dependent of another taxpayer. This is true even if the other taxpayer does not actually claim the taxpayer s spouse as their dependent. If the taxpayer s spouse died during the year and the taxpayer and spouse filed a joint return, the taxpayer can generally claim the spouse s exemption the year the spouse died. If the taxpayer s spouse died during the year and the taxpayer and spouse filed separate returns, the taxpayer can claim the spouse s exemption the year the spouse died only if their spouse had no gross income, was not going to file a return, and was not the 23

30 Filing Status and Dependents dependent of another taxpayer. This is true even if the other taxpayer does not actually claim the taxpayer s spouse as their dependent. The taxpayer cannot claim an exemption for their deceased spouse if they remarry during the year. If the taxpayer is a surviving spouse without gross income and they remarry in the year their spouse died, the taxpayer can be claimed as an exemption on both the final separate return of their deceased spouse and the separate return of their of their new spouse for that year. If the taxpayer files a joint return with their new spouse, the taxpayer can be claimed as an exemption only on that return. If the taxpayer obtained a final decree of divorce or separate maintenance by the end of the year, the taxpayer cannot take their former spouse s exemption. This rule applies even if they provided all of their former spouse s support. DEPENDENTS Qualifying Child: There are five tests that must be met for a child to be the taxpayer s qualifying child: Relationship Test Must be the taxpayer s son, daughter, stepchild, foster child, or a descendant of any of them (such as a grandchild), or Must be the taxpayer s brother, sister, half brother, half sister, stepbrother, stepsister, or a descendant of any of them (such as a niece or nephew). A legally adopted child or a child who was lawfully placed with the taxpayer for legal adoption is considered the taxpayer s child. A foster child is an individual who is placed with the taxpayer by an authorized placement agency or by judgment, decree, or other order of any court of competent jurisdiction. Age Test The child must be under age 19 at the end of the year and younger then the taxpayer (or the taxpayer s spouse if filing jointly). Under age 24 at the end of the year, a full time student, and younger than the taxpayer (or the taxpayer s spouse if filing jointly). Permanently and totally disabled at any time during the year, regardless of age. The taxpayer s child is permanently and totally disabled if both of the following applies: (a) He or she cannot engage in any substantial gainful activity because of a physical or mental condition. (b) A doctor determines the condition has lasted or can be expected to last continuously for at least a year or can lead to death. To be the taxpayer s qualifying child, a child who is not permanently and totally disabled must be younger than the taxpayer. However, if you are married filing jointly, the child must be younger than you or your spouse but does not have to be younger than both of you. To qualify as a full time student the taxpayer s child must be, during some part of each of any 5 calendar months of the year: 1. A full-time student at a school that has a regular teaching staff, course of study, and a regularly enrolled student body at the school, or 24

31 Filing Status and Dependents 2. A student taking a full-time, on-farm training course given by a school described in (1), or by a state, county, or local government agency. o The 5 calendar months do not have to be consecutive. o An on-the job training course, correspondence school, or school offering courses only through the internet does not count as a school. o Students who work on co-op jobs in private industry as a part of a school s regular course of classroom and practical training are considered full-time students. Residency Test The child must have lived with the taxpayer for more than half of the year. The exceptions to this are temporary absences due to illness, education, business, vacation, or military service. A child who was born or died during the year is treated as having lived with you all year if your home was the child s home the entire time he or she was alive during the year. The same is true if the child lived with you all year except for any required hospital stay following the birth. The taxpayer cannot claim an exemption for a stillborn child. A child that has been kidnapped is considered to have met the residency test if both of the following statements are true. 1. The child is presumed by law enforcement authorities to have been kidnapped by someone who is not a member of the taxpayer s family or the child s family. 2. In the year the kidnapping occurred, the child lived with the taxpayer for more than half of the part of the year before the date of the kidnapping. The last year this treatment can apply is the earlier of: The year there is a determination that the child is dead, or The year the child would have reached age

32 Filing Status and Dependents In most cases, because of the residency test, a child of divorced or separated parents is the qualifying child of the custodial parent. The child will be treated as the qualifying child of the noncustodial parent if all four of the following statements are true. 1. The parents: Are divorced or legally separated under a decree of divorce or separate maintenance, Are separated under a written separation agreement, or Lived apart at all times during the last 6 months of the year, whether or not they are or were married. 2. The child received over half of his or her support for the year from the parents. 3. The child is in the custody of one or both parents for more than half of the year, and 4. Either of the following statements is true: The custodial parent signs a written declaration that he or she will not claim the child as a dependent for the year, and the noncustodial parent attaches this written declaration to his or her return, or A pre-1985 decree of divorce or separate maintenance or written separation agreement that applies to 2010 states that the noncustodial parent can claim the child as a dependent, the decree or agreement was not changed after 1984 to say the noncustodial parent cannot claim the child as a dependent, and the noncustodial parent provides at least$600 for the child s support during the year. The custodial parent is the parent with whom the child lived for the greater number of nights during the year or remainder of the year if the parents were divorced or separated during the year. The night of December 31 is treated as part of the year in which it begins. Example: December 31, 2010, is treated as part of The other parent is the noncustodial parent. If the child lived with each parent for an equal number of nights during the year, the custodial parent is the parent with the higher adjusted gross income. An emancipated child is treated as not living with either parent. If the child is sleeping overnight at a friend s house or is away at camp, the child is treated as living with the parent that they normally would have lived with during that time. 26

33 Filing Status and Dependents If the divorce decree or separation agreement went into effect after 1984 and before 2009, the noncustodial parent may be able to attach certain pages from the decree or agreement instead of Form The decree or agreement must state all three of the following. 1. The noncustodial parent can claim the child as a dependent without regard to any condition. 2. The custodial parent will not claim the child as a dependent for the year. 3. The years for which the noncustodial parent, rather that the custodial parent, can claim the child as a dependent. Support Test The child must not have provided more than half of his or her own support for the year. Foster care payments and expenses: Payment s the taxpayer receives for the support of a foster child from a child placement agency, state or county are considered support that the agency, state or county paid and are not considered money that the child paid towards their own support. If the taxpayer is in the trade or business of providing foster care, their unreimbursed expenses are not considered support provided by the taxpayer. Scholarships: A scholarship received by a child who is a full-time student is not taken into account in determining whether the child provided more than half of his or her own support. 27

34 Filing Status and Dependents Worksheet from 2010 IRS Pub 17 28

35 Filing Status and Dependents Joint Test The child is not filing a joint return for the year. o An exception to the joint return test applies if your child and his or her spouse file a joint return merely as a claim for refund. Special Rules for Qualifying Child of More than One Person: Sometimes, a child meets the relationship, age, residency, support, and joint return tests to be a qualifying child of more than one person. Should this be the case only one of these people can actually treat the child as a qualifying child and be able to claim (provided the person is eligible for each benefit): The exemption for the child The child tax credit Head of household filing status The credit for child and dependent care expenses The exclusion from income for dependent care benefits The earned income credit The following tie-breaker rules will determine which person can actually treat the child as their qualifying: If only one of the persons is the child s parent, the child is treated as the qualifying child of the parent. If the parents do not file a joint return together but both parents claim the child as a qualifying child, the IRS will treat the child as the qualifying child of the parent with whom the child lived for the longer period of time during the year. If the child lived with each parent for the same amount of time, the IRS will treat the child as the qualifying child of the parent who had the higher adjusted gross income for the year. If no parent can claim the child as a qualifying child, the child is treated as the qualifying child of the person who had the highest AGI for the year. If a parent can claim the child as a qualifying child but no parent does so claim the child, the child is treated as the qualifying child of the person who had the highest AGI for the 29

36 Filing Status and Dependents year, but only if that person s AGI is higher than the highest AGI of any of the child s parents who can claim the child. If the child s parents file a joint return with each other, this rule can be applied by dividing the parents combined AGI equally between the parents. See examples 1 and 6 below; excerpts from IRS Pub. 17. Qualifying Child: There are four tests that must be met for a person to be the taxpayers qualifying relative. Not a qualifying child test: A child is not the taxpayer s qualifying relative if the child is a qualifying child or the qualifying child of any other taxpayer. If a child is not the qualifying child of any other taxpayer, the child may qualify as the taxpayer s qualifying relative if the child s parent is not required to file an income tax return and either: o Does not file an income tax return, or o Files a return only to get a refund of income tax withheld or estimated tax paid. 30

37 Filing Status and Dependents Member of Household or Relationship Test: To meet this test, a person must either: Live with the taxpayer all year as a member of their household, or Be related to the taxpayer in one of the ways listed below. A person related to the taxpayer in any of the following ways does not have to live with the taxpayer all year as a member of their household to meet this test: o The taxpayer s child, stepchild, foster child, or descendant of any of them. o The taxpayer s brother, sister, half brother, half sister, stepbrother, or stepsister. o The taxpayer s father, other, grandparent, or other direct ancestor, but not foster parent. o The taxpayer s stepfather or stepmother. o The son or daughter of the taxpayer s brother or sister. o A brother or sister of the taxpayer s father or mother. o The taxpayer s son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law. Any of these relationships that were established by marriage are not ended by death or divorce. If the taxpayer and their spouse file a joint return, the person can be related to either the taxpayer or their spouse. Also, the person does not need to be related to the spouse who provides support. A person who died during the year, but lived with the taxpayer as a member of their household until death, will meet this test. Gross Income Test: To meet his test, a person s gross income for the year must be less than $3,650 (for 2010). Gross Income Defined: o Income in the form of money, property, and services that is not exempt from tax. o In manufacturing, merchandising, or mining business, gross income is the total net sales minus the cost of goods sold, plus any miscellaneous income from the business. o Gross receipts from rental property are gross income. Do not deduct taxes, repairs, etc., to determine the gross income from rental property. o Gross Income includes taxable unemployment compensation. o Gross Income includes certain scholarship and fellowship grants. Scholarships received by degree candidates that are used for tuition, fees, supplies, books, and equipment required for particular courses may not be included in income. o Tax-exempt income, such as certain social security benefits, is not included in gross income. 31

38 Filing Status and Dependents The income of an individual who is permanently and totally disabled at any time during the year does not include income for services the individual performs at a sheltered workshop. A sheltered workshop is: o A school that provides special instruction or training designed to alleviate the disability of the individual, an o Is operated by certain tax-exempt organizations, or by a state, a U.S. possession, a political subdivision of a state or possession, the United States, or the District of Columbia. Support Test To meet this test, the taxpayer generally must provide more than half of a person s total support during the calendar year. o The taxpayer can determine if they provided more than half of a person s total support by comparing the amount the taxpayer contributed to that person s support with the entire amount of support that person received from all sources. This includes support the person provided from his or her own funds. A person s own funds are not support unless they actually spent for support. o Total support includes amounts spent to provide food, lodging, clothing, education, medical and dental care, recreation, transportation, and similar necessities. The taxpayer cannot include in his or her contribution to their child s support any support that is paid for the child with the child s own wages, even if the taxpayer paid the wages. The year the taxpayer provided the support is the year the taxpayer paid for it, even if the taxpayer did so with borrowed money that he or she repay in a later year. 32

39 Filing Status and Dependents Tax exempt income is included in figuring the person s total support. Tax exempt income includes certain social security benefits, welfare benefits, nontaxable life insurance proceeds, Armed Forces family allotments, nontaxable pensions, and tax exempt interest. Benefits provided by the state to a needy person generally are considered support provided by the state. If the taxpayer makes a lump-sum advance payment to a home for the aged to take care of their relative for life and the payment is based on that person s life expectancy, the amount of support the taxpayer provides each year is the lumpsum payment divided by the relative s life expectancy. If the taxpayer provides a person with lodging, they are considered to provide support equal to the fair rental value of the room, apartment, house, or other shelter in which the person lives. Fair rental includes a reasonable allowance for the use of furniture and appliances, and for heat and other utilities that are provided. The fair rental value is the amount the taxpayer could reasonably expect to receive from a stranger for the same kind of lodging. Do not include in total support: o Federal, state, and local income taxes paid by persons from their own income. o Social security and Medicare taxes paid by persons from their own income. o Life insurance premiums. o Funeral expenses. o Scholarships received by the taxpayer s child if their child is a full-time student. o Survivors and Dependent s Educational Assistance payments used for the support of the child who receives them. 33

40 Filing Status and Dependents Multiple Support Agreement: 34

41 Filing Status and Dependents Chapter 3 - Sample Questions 1. If the taxpayer and spouse were divorced during 2010, and have not remarried. They are considered married for the part of 2010 prior to the divorce, and unmarried for the rest of the year. A. True B. False 2. If the spouse died during the year, and the taxpayer did not remarry, the taxpayer may file a joint return with their deceased spouse. A. True B. False 3. On a joint return both spouses may be held responsible, for the tax and any interest or penalty due. A. Joint only B. Jointly and individually C. Individually only D. As determined by the spouses 4. The taxpayer may be able to file as a qualifying widow or widower for the two years following the year the spouse died. To do this, the taxpayer must meet all four of the following tests, except? A. The taxpayer is entitled to file a joint return with the spouse for the year he or she died. It does not matter whether the joint return was actually filed, B. The taxpayer did not remarry in the two years following the year the spouse died, C. There is a child, stepchild, or adopted child for whom the taxpayer can claim a dependency exemption, D. The child can be the taxpayer s foster child E. The taxpayer paid more than half the cost of maintaining a household that was the main home for them and that child, for the whole year. 5. In respect to Married Filing Separately, which of the following is true if the taxpayer lived with the spouse at any time during the tax year? A. The taxpayer cannot claim the credit for the elderly or the disabled B. The taxpayer will have to include in income more (up to 85%) of any social security income or equivalent railroad retirement benefits received. C. The taxpayer cannot rollover amounts from a traditional IRA to a Roth IRA D. All of the above 35

42 Filing Status and Dependents 6. Which of the following is not a community property state? A. Arizona B. California C. New Mexico D. New York 7. Which of the following are qualifications for the head of household filing status? A. The taxpayer was married or considered unmarried on the last day of the year. B. The home was the main home for the taxpayer and the birth child, stepchild, adopted child, or eligible foster child for more than half the year. C. The taxpayer paid more than half the cost of keeping up a home for the year. D. All of the above 8. If neither parent can claim the child as a qualifying child, the child is treated as the qualifying child of the person who had the highest AGI for the year. A. True B. False 9. Which of the following qualifies as the time to claim head of household filing status that a child must live with a custodial parent? A. More than 5 months B. More than half the year (more than 183 days) C. More than 4 months D. More than 3 months 10. Which of the following is true regarding Form 8332? A. If the exemption is released for more than 1 year, the original release must be attached to the return of the noncustodial parent for the first year. B. Release of Claim of Exemption for Child of Divorced or Separated Parents C. A copy of Form 8332 is attached in subsequent years. D. All of the above 11. Which of the following is not a test for qualifying child A. Residency B. Relationship C. Age D. Gender 12. If the taxpayer can claim an exemption for their dependent son; but the taxpayer does not claim the exemption on their return, the dependent son can claim his personal exemption on his own tax return. A. True B. False 36

43 Filing Status and Dependents 13. The term dependent means: A. Qualifying person B. The spouse. C. Head of Household D. A qualifying child or a qualifying relative 14. Form 2120 is used to identify other eligible persons who paid over of the support of a person claimed as a dependent, and indicates that the taxpayer has a signed agreement from each of the other eligible persons waiving his or her right to claim that person as a dependent. A. 10% B. 20% C. 25% D. 15% 15. The taxpayer cannot claim a person as a dependent unless that person is U.S. citizen, U.S. resident alien, U.S. national, or a resident of Canada or Mexico. A. True B. False 37

44 Filing Status and Dependents Chapter 3 Answers to Sample Questions 1. False The taxpayer is considered unmarried for the whole year if, on the last day of your tax year, if they are unmarried or legally separated from their spouse under a divorce or separate maintenance decree. State law governs whether a couple is married or legally separated under a divorce or separate maintenance decree. (Pub 17, Page 19) 2. True - If the spouse died during the year, the taxpayer is considered married for the whole year for filing status purposes. If the spouse did not remarry before the end of the tax year, they can file a joint return with their deceased spouse. (Pub 17, Page 20) 3. B - On a joint return, both spouses may be held responsible, jointly and individually, for the tax and any interest or penalty due. One spouse may be held responsible for all the tax due even if all the income was earned by the other spouse. (Pub 17, Page 20) 4. D The child or stepchild for whom the taxpayer can claim exemption when using surviving widow(er) filing status cannot be a foster child. (Pub 17, Page 23) 5. D- If the taxpayer is filing Married Filing Separate and lived with their spouse anytime during the year; the taxpayer cannot claim the credit for the elderly or the disabled; the taxpayer will have to include in income more (up to 85%) of any social security income or equivalent railroad retirement benefits received and the taxpayer cannot rollover amounts from a traditional IRA to a Roth IRA. (Pub 17, Page 21) 6. D Community property states are Arizona, California, Idaho, Nevada, New Mexico, Texas, Washington and Wisconsin. (Pub 17, Page 21) 7. D All the answers regarding Head of Household filing status are true. This excerpt is from Pub 17, pg A - If neither parent can claim the child as a qualifying child, the child is treated as a qualifying child; the child is treated as the qualifying child of the person who had the highest AGI for the year is a true statement. (Pub 17, Page 22) 9. B -To claim head of household filing status that a child must live with a custodial parent more than half the year (more than 183 days). (Pub 17, Page 21) 10. All the following are true regarding Form 8332, Release of Claim of Exemption for Child of Divorced or Separated Parents. If the exemption is released for more than 1 year, the original release must be attached to the return of the noncustodial parent for the first year and a copy of Form 8332 is attached in subsequent years. (Pub 17, Page 27) 38

45 Filing Status and Dependents 11. D - Gender is not a test for a qualifying child. Refer to Table 3-1 Pub 17, pg B False - Refer to Pub 17 Pg D - The term dependent means qualifying relative. (Pub 17, Page 23) 14. A - Form 2120 is used to identify other eligible persons who paid over 10% of the support of a person claimed as a dependent, and indicates that the taxpayer has a signed agreement from each of the other eligible persons waiving his or her right to claim that person as a dependent. (Pub 17, Page 34) 15. A - The taxpayer cannot claim a person as a dependent unless that person is U.S. citizen, U.S. resident alien, U.S. national, or a resident of Canada or Mexico. (Pub 17, Page 141) 39

46 Reporting Income/ Withholding/ Estimated Tax Chapter 4 Where to Report Income Form Title What to Report Amounts to Report Due Date to IRS Due Date to Recipient) 1098 Mortgage Interest Statement 1098-C Contributions Statement 1098-E Student Loan Interest Statement Mortgage interest (including points) you received in the course of your trade or business from individuals and reimbursements of overpaid interest. Contributions of motor vehicles, boats and airplanes Student loan interest received in the course of your trade or business. $600 or more February 28 (To Payer/Borrower) January 31 $600 or more February 28 January 31 $600 or more February 28 January T Tuition Payments Statement Qualified tuition and related expenses, reimbursements or refunds, and scholarships or grants (optional). See instructions February 28 January A Acquisition or Abandonment of Secured Property Information about the acquisition or abandonment of property that is security for a debt for which you are lender. All amounts Pub 4681 February 28 (To borrower) January B Proceeds from Broker and Barter Exchange Transactions Sales or redemptions of securities, futures transactions, commodities, and barter exchange transactions. All amounts Pub 525 February 28 January C Cancellation of Debt Cancellation of a debt owed to a financial institution, the Federal government, a credit union, RTC, FDIC, NCUA, a military department, the U.S. Postal Service, the Postal Rate Commission, or any organization having a significant trade or business of lending money. $600 or more Pub 4681 February 28 January DIV Dividends and Distributions Distributions, such as dividends, capital gain distributions, or nontaxable distributions, that were paid on stock, and liquidation distributions. $10 or more, except $600 or more for liquidations February 28 January G Certain Government and Qualified State Tuition Program Payments Unemployment compensation, state and local income tax refunds, agricultural payments, taxable grants, and earnings from a qualified state tuition program (QSTP). QSTP; $10 or more refunds; unemployment; $600 or more for all others February 28 January 31 40

47 Reporting Income/ Withholding/ Estimated Tax Form Title What to Report Amounts to Report Due Date to IRS Due Date to Recipient) 1099-INT Interest Income Interest Income. $10 or more February 28 January LTC Long Term Care and Accelerated Death Benefits Payments under a long term care insurance contract and accelerated death benefits paid under a life insurance contract or by a settlement provider. All amounts Pub 525 February 28 January MISC Miscellaneous Income (Also, use this form to report the occurrence of direct sales of $5000 or more of consumer goods for resale.) Rent or royalty payments; prizes or awards that are not for services, such as winnings on TV or radio shows. Payments to crew-members by owners or operators of fishing boats including payments of proceed from sale of catch. $600 or more, except $10 or more for royalties All amounts February 28 January 31 Payments to a physician, physician's corporation, or other supplier of health or medical services. Issued mainly by medical assistance programs or health and accident insurance plans. $600 or more Payments for services performed for a trade or business by people not treated as its employees. Example: fees to subcontractors or directors, and golden parachute payments. $600 or more Fish purchases paid in cash for resale. $600 or more Substitute dividend and tax-exempt interest payments reportable by brokers $10 or more Crop Insurance proceeds $600 or more Gross Proceeds paid to attorneys All amounts MSA Distributions From an MSA or Medicare+Choice MSA Distributions from a medical savings account (MSA) or Medicare+Choice MSA All amounts February 28 January OID Original Issue Discount Original Issue Discount $10 or more February 28 January 31 41

48 Reporting Income/ Withholding/ Estimated Tax Form Title What to Report Amounts to Report Due Date to IRS Due Date to Recipient) PATR Taxable Distributions Distributions from cooperatives to their patrons. $10 or more February 28 January R Distributions From Pensions, Annuities, Retirement or profit-sharing Plans, IRAs, Insurance Contracts, Etc. Distributions from retirement or profit-sharing plans, any IRA, or insurance contracts, and IRA recharacterizations. $10 or more February 28 January S Proceeds From Real Estate Transactions Gross proceeds from the sale or exchange of real estate Generally, $600 or more February 28 January IRA Contribution Information Contributions (including rollover contributions) to any Individual retirement arrangement (IRA) including SEP, SIMPLE, Roth IRA, and Ed IRA; Roth conversions; IRA recharacterizations; and the fair market value of the account. All amounts May 31 (To Participant) For value of account and for education IRA contributions, January 31; for all other contributions, May MSA MSA or Medicare+Choice MSA Information Contributions to a medical savings account (MSA) and the fair market value of an MSA or Medicare+Choice MSA. All amounts May 31 (To Participant) May 31 W-2G Certain Gambling Winnings Gambling winnings from horse racing, dog racing, jai alai, lotteries, keno, bingo, slot machines, sweepstakes, wagering pools, etc. Generally, $600 or more; $1,200 or more from bingo or slot machines; $1,500 or more from keno February 28 January 31 W-2 Wage and Tax Statement Wages, tips, other compensation; social security, Medicare, withheld income taxes; and advance earned income credit (EIC) payments. Include bonuses, vacation allowances, severance pay, certain moving expense payments, some kinds of travel allowances, and thirdparty payments of sick pay. See separate Instructions To SSA Last day of February January 31 Form W-4 If the taxpayer does not give the employer a completed Form W-4, the employer must withhold at the highest rate, as if the taxpayer was single and claimed no withholding allowances. 42

49 Reporting Income/ Withholding/ Estimated Tax Below are the instructions and a copy of Form W-4. Form W-4 includes four types of information the employer will use to figure withholding: Whether to withhold at a single rate or at the lower married rate. How many withholding allowances the taxpayer claims (each allowance lowers the amount withheld). Whether the taxpayer wants an additional amount withheld Whether the taxpayer is claiming an exemption from withholding. o The taxpayer can claim an exemption from withholding only if both of the following situations apply: For 2010 the taxpayer had a right to a refund of all federal income tax withheld because they had no tax liability. For 2011 the taxpayer expects a refund of all federal income tax withheld because they expect to have no tax liability. o Student s are not automatically exempt o An exemption is only good for one year and a new Form W-4 must be completed by Feb 15 each year to continue the exemption. 43

50 Reporting Income/ Withholding/ Estimated Tax Form W-2 provides information to employees, the Social Security Administration, the IRS, and state and local governments. Employers must file Forms W-2 for wages paid to each employee whom: Income, social security, or Medicare tax was withheld or Income tax would have been withheld if the employee had claimed no more than one withholding allowance or had not claimed exemption from withholding on Form W-4. Employees can submit a new W-4 whenever they wish to change withholding allowances. If events in the coming year will decrease the number of withholding allowances in the next year, the employee must give an employer a new W-4 by December 1. If the events occur in December a new W-4 must be submitted within 10 days. Refer to Pub 17, Chapter 4; Publication 919 How Do I Adjust My Withholding and Pub 505 Tax Withholding and Estimated Tax for additional information. Form W-2 and Instructions 44

51 Reporting Income/ Withholding/ Estimated Tax the amount bet. Form W-2G Gambling Winnings Gambling winnings of more than $5,000 from the following sources are subject to income tax withholding are subject to income tax withholding: Any sweepstakes; wagering pool, including payments made to winners of poker tournaments; or lottery Any other wager, if the proceeds are at least 300 times It does not matter whether the winnings are reported in cash, property or an annuity. Winnings not paid in cash are taken into account at their fair market value. Gambling winnings are reported on Form W-2G. Form W-4P Form W-4V Unemployment Compensation is taxable and tax can be withheld. The taxpayer must fill out Form W-4V for withholding on Unemployment Compensation. The taxpayer can choose to have federal withholding from the following federal payments; 1. Social Security Benefits 2. Tier 1 Railroad Retirement Benefits 3. Commodity Credit Corporation Loans included in gross income 4. Payments under the Agriculture Act of

52 Reporting Income/ Withholding/ Estimated Tax Estimated Tax Estimated tax is the method used to pay tax on income that is not subject to withholding. This includes income from selfemployment, interest, dividends, alimony, rent, gains from the sale of assets, prizes and awards. Estimated tax is used to pay both income tax and selfemployment tax as well as other taxes and amounts reported on the tax return. If not enough tax is paid either through withholding or estimated tax or a combination of both there may be subject to a penalty. Standard due dates for estimated tax payments are Apr. 15, June 15, Sept 15 and Jan 15 of the next year. Use Form 1040-ES, Estimated Tax for Individuals, to figure and pay the estimated tax. For additional information, refer to Publication 505, Tax Withholding and Estimated Tax. 46

53 Reporting Income/ Withholding/ Estimated Tax 47

54 Chapter 4 - Sample Questions Reporting Income/ Withholding/ Estimated Tax 1. Sales or redemptions of securities, future transactions, commodities and barter transactions are reported on which form? A B B T C G D MISC 2. What is the minimum amount of interest that must be earned to issue Form-INT? A. All Amounts B. $600 or more C. $1500 or more D. $10 or more 3. Which of the following forms is the Wage and Tax Statement? A. W-2 B. W-4 C. W-9 D. W-2G 4. Students are always exempt from withholding according to W-4 instructions. A. True B. False 5. The purpose of completing Form W-4 is for. A. The employer to know if the employee is married. B. The employer to know the taxpayer s address. C. The employer to withhold the correct amount of tax from the employee s wages D. None of the above 6. If the taxpayer does not give the employer a completed Form W-4, the employer must withhold at the highest rate, as if the taxpayer was single and claimed no withholding allowances. E. True F. False 7. A new Form W-4 must be completed each year by. A. January 1 B. February 28 C. February 15 D. January 31 48

55 Reporting Income/ Withholding/ Estimated Tax 8. Which publication deals with adjusting tax withholding? A. Pub. 919 B. Pub. 17 C. Pub. 3 D. Pub If the taxpayer chooses to withhold income tax from unemployment compensation, they must fill out which of the following forms A. W-4 B. W-4V C. W-4P D. W-4UC 10. Form W-2 provides information to employees, the Social Security Administration, the IRS, and state and local taxing authority. A. True B. False 11. Dependent care benefits are reported in on the W-2? A. Box 9 B. Box 10 C. Box 18 D. Box 12a 12. A code V in Box 12 of the W-2 indicates for which of the following? A. Deferrals under a Section 409A nonqualified deferred compensation plan B. Nontaxable Sick Pay C. Designated Roth contribution D. Income from the exercise of nonstatutory stock options (included in Box 1 and 3 (up to the social security wage base). 13. The taxpayer must pay estimated tax for 2011if they expect to owe at least $1000 in tax in A. True B. False 14. If events in 2011 will decrease the number of your withholding allowances for 2012, you must give your employer a new Form W-4 by December 1, If the event occurs in December 2011, submit a new Form W-4 within days A. 14 B. 10 C. 30 D

56 Reporting Income/ Withholding/ Estimated Tax Chapter 4 Answers to Sample Questions 1. A - Sales or redemptions of securities, future transactions, commodities and barter transactions are reported on which form 1099-B. (Pub 17, Pg 45) 2. D - The minimum amount of interest that must be earned to issue Form-INT is $10. (Pub 17, Pg 57) 3. A A W-2 is the Wage and Tax Statement. (Pub 17, Pg 36) 4. B False - A student is not always exempt from withholding according to W-4 instructions. (Pub 17, Pg 38) 5. C - The purpose of completing Form W-4 is the employer to withhold the correct amount of tax from the employee s wages. (Pub 17, Pg 39) 6. T - If the taxpayer does not give the employer a completed Form W-4, the employer must withhold at the highest rate, as if the taxpayer was single and claimed no withholding allowances. (Pub 17, Pg 40) 7. A - A new Form W-4 must be completed each year by February 15 (Pub 17, Pg 37) 8. A Publication 919 How Do I Adjust My Tax Withholding (Pub 17, Pg 39) 9. B - If the taxpayer chooses to withhold income tax from unemployment compensation, they must fill out Form W-4V. (Pub 17, Pg 41) 10. A - Form W-2 provides information to employees, the Social Security Administration, the IRS, and state and local taxing authority is a true statement. (Form W-2, Instructions) 11. B - Dependent care benefits are reported in Box 10 on the W-2? (Form W-2, Instructions) 12. A code V in Box 12 of the W-2 indicates income from the exercise of nonstatutory stock options (included in Box 1 and 3 (up to the social security wage base). (Form W-2, Instructions) 13. B -The taxpayer must pay estimated tax for 2011 if they expect to owe at least $1000 in tax in In most cases, the taxpayer must pay estimated tax for 2011 if both of the following apply. They expect to owe at least $1,000 in tax for 2011, after subtracting the withholding and refundable credits. They expect the withholding plus the refundable credits to be less than the smaller of: 90% of the tax to be shown on the 2011 tax return, or 100% of the tax shown on the 2010 tax return (but see Special rules for farmers, fishermen, and higher income taxpayers below). The 2010 tax return must cover all 12 months. (Pub 17, Pg 40) 14. B - If events in 2011 will decrease the number of your withholding allowances for 2012, you must give your employer a new Form W-4 by December 1, If the event occurs in December 2011, submit a new Form W-4 within _10_ days. (Pub 17, Pg 37) 50

57 Wages Chapter 5 Wages Form

58 Wages Employee Compensation Line 7 of Form Wages, Salaries and Tips - (2010, 1040) Wages, salaries and tips reported on Form W-2, Box 1 are reported on Line 7 of Form If a joint return the spouse's income is also included. 52

59 Wages The items below are excerpts from Line 7 of Form

60 Wages Statutory employees Box 13 of Form W-2 should be checked. Statutory employees include full-time life insurance salespeople, certain agent or commission drivers and traveling sales people and certain home workers. The amount reported in Box 1 is not shown on Line 7 of Form 1040 but is entered as income on Schedule C. Statutory employees are not subject to self-employment tax. Miscellaneous Compensation Child-care providers, either in the taxpayer's home, the child's home, or another location, the pay must be included in income. If someone else does not employ the childcare provider, the provider is probably self-employed and must report the income on Schedule C. The same rule applies to babysitting as childcare. Advanced commissions received for services to be performed in the future, a cash taxpayer must report the income in the year received. Back pay awards are reported on a W-2 and entered on Line 7 of Form Bonuses or awards received for outstanding work are included in income and reported on Form 1040, line 7. Prizes such as vacation trips for meeting sales goals or awards in the form of goods or services are taxable at the fair market value. Stock appreciation rights granted by the employer are not included in income until they are exercised (use the right). When the right is used a cash payment equal to the fair market value of the corporation s stock on the date of use minus the fair market value on the date the right was granted is included in income in the year the right is used. Non-statutory stock options to buy or sell stock or other property as payment for services, there will be income either when the option is received or exercised (used to buy or sell other stock or other property). The employer determines which type of option. (Refer to Pub 525). Life Insurance Proceeds Refer to Life Insurance Proceeds in Pub 525 for the taxable portion when the values of the proceeds exceed the value at the date of death or when paid in installments. Fringe Benefits Fringe benefits received in connection with the performance of the services performed are included in income as compensation, usually not in the form of cash. They are not included in income if they are purchased at the fair market value or are specifically excluded by law. The value of accident and health plan benefits are generally not included in income, benefits from the plan may be taxable. Long-term care coverage contributions by the employer are generally not taxable. However, contributions made through a flexible spending or other similar arrangement must be included in income. This amount is usually included in Box 1 of form W-2 as wages. 54

61 Wages Archer MSA contributions made by the employer are not included in income. The total is included in Box 12 of W-2 with a code R. Deminimis benefits or a gift provided by the employer that is a product or service of minimal value is not included in income. However, if the employer gives a gift certificate or similar item that can be easily exchanged for cash the value of the gift should be included in salary or wages, regardless of the amount. No additional cost fringe benefits are those benefits offered to the taxpayer that are of no additional cost to the employer, or a service that is offered for sale to customers in the ordinary course of doing business. These benefits are not taxable. Qualified discounts on the purchase of the employer's goods or services are not taxable if the discount received is not greater than the gross profit percentage of the price the product is offered to the general public. The discount also cannot exceed 20% of the price at which the goods are offered to the public. The discount must be offered to all employees. Working condition fringe benefits are excluded from tax by the employee if it would have been deductible as an employee business expense if the employee had paid the amount out-of pocket. Educational assistance of qualified employer provided educational assistance can be excluded up to $5,250. The exclusion applies to undergraduate and graduate level courses. If the education is not required by the employer or the law, it can be qualifying work-related education only if it maintains or improves skills needed in the taxpayer s present work. Refer to Pub 970 for additional information. Employer-provided vehicles are usually taxable non-cash fringe benefits. The employer must determine the actual value of this fringe benefit to include in income. Clergy and Military A member of the clergy must include in income offerings and fees received for marriages, baptisms, funerals, masses, etc. in addition to the salary unless the offering or fee is to the religious organization. If the clergy donates offerings or fees received by the clergy to the religious institution it is still taxable to the clergy, but the clergy can take a charitable contribution deduction. Special rules apply for housing of the clergy. The rental value of the home or housing allowance is not included in income. The housing allowance is subject to self-employment tax; refer to Schedule SE or Publication 517. A transportation fringe benefit can be excluded from income up to certain limits. A qualified transportation fringe benefit is: Commuter highway vehicle between home and work, or A transit pass, or Qualified parking Cash reimbursement by the employer for these expenses under a bona fide reimbursement arrangement is also excludable. There is a $230 exclusion limit for commuter vehicle and transit pass and a $230 a month exclusion limit for parking, regardless of the value. 55

62 Wages Scholarships or fellowships to someone who is a degree candidate is excluded from income, if the scholarship is used for tuitions, fees, books, supplies or equipment required by the financial institution. Qualified moving expense reimbursements under a qualified plan may be excluded from income if the expenses are a deductible moving expense. If a nonqualified plan, the amount is included in income. (Refer to Form 3903) The cost of group term-life insurance is excludable from income if the coverage is less than $50,000. The cost of the employer provided insurance over $50,000 is included in income. If the taxpayer pays any portion of the premium the taxable portion is reduced dollar for dollar. U.S. citizens working for a foreign government, an international organization, a foreign embassy or any foreign employer the income is included as salary. Social security and Medicare taxes are usually not withheld, but the income is subject to self-employment taxes. Amounts reported on a W-2 for a member of the military are generally taxable as wages except for retirement pay, which is taxed as a pension. Wages earned in a combat zone and other allowances are generally non taxable. Military retirement pay based on age or length of service is generally taxable. Do not include any reduction in retirement or retainer pay to provide a survivor annuity for the spouse or children under the Retired Serviceman s Family Protection Plan or the Survivor Benefit Plan. Do not include in income any veteran's benefits paid under any law, regulation or administrative practice administered by the Department of Veterans Affairs. The following amounts are not taxable: Education, training and subsistence allowances Disability compensation and pension payments for disabilities paid either to veterans or their families Grants for homes designed for wheelchair living Grants for motor vehicles for veterans who lost their sight or use of their limbs Veterans' insurance proceeds and dividends paid either to veterans or their beneficiaries, including the proceeds of a veteran's endowment policy paid before death Interest on insurance dividend left on deposit with the VA VA payments to hospital patients and resident veterans for their services under VA therapeutic or rehabilitative programs are not treated as nontaxable veteran's benefits. Report these payments as income on line 21 of Form

63 Wages Volunteer workers for the Peace Corps receiving living allowances are exempt from tax. Taxable allowances included below are reported as wages: Allowances paid to the spouse or minor children while volunteer leader training in the United States Living allowances designated by the Director of the Peace Corps as basic compensation. These are allowances for personal items such as domestic help, laundry and clothing maintenance, entertainment and recreation, transportation, and other miscellaneous expenses Leave allowances Readjustment allowances or termination payments. These are considered received when credited to the account Employee Benefits Sick pay is a payment to replace regular wages while temporarily absent from work due to sickness or personal injury. To qualify as sick pay, it must be paid under a plan to which the employer is a party. Sick pay is taxable and subject to withholding when paid by the employer. If the sick pay is paid by a third party where the employer is not a party, the sick pay is generally not taxable. Health insurance coverage provided by the employer is usually not included as income. The insurance premiums would not be a Schedule A deduction, unless self-employed health insurance. Disability Insurance Benefits are taxable depending on who paid the premiums. If the employee pays the premium, the premium is not a qualified medical expense and is not deductible. The benefits received are excluded from income. Employer-paid premiums are deductible as employee benefits. The premiums are not included in taxable income of the employee. However, benefits from an employer-paid disability policy are generally taxable to employees to the extent the amounts exceed qualified medical expenses for the current year. Cafeteria Plans (or flexible benefit plan) allows employees to choose between receiving taxable compensation and funding one or more tax-free benefits. The employer for the benefit of the employees must maintain the plan; the plan must be written; the plan must be available to all employees; and the plan must include two or more benefits consisting of cash and qualified benefits. Qualifying benefits include: Group term-life insurance premium costs Disability income and accident insurance costs Health insurance premium costs Dental insurance premium costs Medical costs not covered by insurance Qualified dependent care benefits Qualified transportation costs Contribution to qualified 401(k)-pension plan 57

64 Wages Workers Compensation Amounts received as workers compensation for an occupational sickness or injury are fully exempt from tax, the exemption does not apply to retirement plans based on age, length of service or prior contributions. The following compensation received for injury or sicknesses are not taxable: Compensatory damages received for physical injury or sickness, whether paid in a lump sum or in periodic payments Benefits received under an accident or health insurance policy on which either the taxpayer or the employer paid the premiums that were included in income Compensation received for permanent loss or loss of a part or function of the body, or for permanent disfigurement. This compensation must be based only on the injury and not on the period of absence from work. These benefits are not taxable even if the employer pays for the accident and health plan that provides these benefits Foreign Income Exclusion Qualified individuals may elect to exclude up to $91,500 (2010) of foreign earned income from taxable income, if both spouses work in a foreign country and meet the qualifications for the exclusion, each spouse is allowed the exclusion. The exclusion increases based on cost of living adjustments (COLA). An individual generally qualifies if his/her tax home is in a foreign country and one of the following tests is met: 1. Bona Fide resident test is met when an individual is in a foreign country for an uninterrupted period of time that includes the entire year. 2. The physical presence test is met if an individual is in a foreign country or countries 330 days during a period of 12 consecutive months. Days of travel between countries qualify as full days. Foreign earned income includes: Salaries and wages Allowances for housing and other expenses Business profits, royalties or rents tied to the performance of services Value of fringe benefits An exclusion is also allowed for housing. Foreign taxes paid on excluded income do not qualify for the foreign tax credit (Form 1116). Report the Foreign Earned Income on Form (Refer to Pub 54) 58

65 Wages Chapter 5 - Sample Questions 1. Which of the following are not true about statutory employees? A. Box 13 of the W-2 should be checked. B. Full-time life insurance salespeople can qualify as a statutory employee C. The wages shown in Box 1 of form W-2 is reported as income on Schedule C D. Statutory employee s income is subject to self- employment tax. 2. Fringe benefits received in connection with the performance of the services performed are included in income as compensation, unless purchased at the fair market value or specifically excluded by law. A. True B. False 3. A cash basis taxpayer must report an advanced commission received for services to be performed in the future: A. In the tax year the service is actually performed B. In the tax year the income is received C. The tax year after the advance commission is received D. Never 4. Bonuses or awards received for outstanding work are: A. Reported as an adjustment to income B. Reported on Schedule A as a deduction to income C. Included in income and reported on Form 1040, line 7 D. None of the above 5. Stock appreciation rights granted by the employer are included in income when exercised. A. True B. False 6. Which of the following payments received as a member of the military are not generally taxable? A. Wages except for retirement pay. B. Combat pay. C. Military retirement pay based on age or length of service. D. None of the above 7. An elective deferral, other than a designated Roth contribution is not included in wages subject to income tax at the time contributed. It is also excluded from wages subject to social security and Medicare taxes. A. True B. False 59

66 Wages 8. The taxpayer must report taxable disability payments as wages on line 7 of Form 1040 or 1040A until they reach: A. 55 years of age. B. 65 years of age C. Minimum retirement age. D. As long as they receive the disability pension. 9. Amounts a taxpayer receives as workers' compensation for an occupational sickness or injury are fully exempt from tax if they are paid under a workers' compensation act or a statute in the nature of a workers' compensation act. A. True B. False 10. Sick pay is a payment to replace wages while temporarily absent from work due to sickness. Sick pay is taxable if paid by the employer. A. True B. False 11. The exclusion for commuter vehicle transportation and transit pass fringe benefits cannot be more than $ a month. A. $20 B. $120 C. $230 D. $ Which of the following is incorrect regarding the Foreign Income Exclusion? A. Compute the foreign income exclusion on Form B. Qualified individual may elect to exclude up to $91, of foreign earned income from taxable income. C. Salaries and wages are never included as foreign earned income D. The value of fringe benefits are included in foreign earned income 60

67 Wages Chapter 5 Answers to Sample Questions 1. D A statutory employee s income is subject to self- employment tax. (Pub 17, pg 184) 2. A -Fringe benefits received in connection with the performance of the services performed are included in income as compensation, unless purchased at the fair market value or specifically excluded by law is a true statement. (Pub 17, pg 46) 3. B - A cash basis taxpayer must report an advanced commission received for services to be performed in the future in the tax year the income is received. (Pub 17, pg 45) 4. C - Bonuses or awards received for outstanding work are included in income and reported on Form 1040, line 7. (Pub 17, pg 45) 5. A - Stock appreciation rights granted by the employer are included in income when exercised is a true statement. (Pub 17, pg 49) 6. B - Generally combat pay received as a member of the military is not taxable? (Pub 17, pg 50) 7. B False -An elective deferral, other than a designated Roth contribution (discussed later), is not included in wages subject to income tax at the time contributed. However, it is included in wages subject to social security and Medicare taxes. (Pub 17, pg 49) 8. C - The taxpayer must report taxable disability payments as wages on line 7 of Form 1040 or 1040A until they reach the minimum retirement age. (Pub 17, pg 51) 9. A - Amounts a taxpayer receives as workers' compensation for an occupational sickness or injury are fully exempt from tax if they are paid under a workers' compensation act or a statute in the nature of a workers' compensation act is a true statement. (Pub 17, pg 52) 10. A - Sick pay is a payment to replace wages while temporarily absent from work due to sickness. Sick pay is taxable if paid by the employer. This is a true statement. (Pub 17, pg 46) 11. C - The exclusion for commuter vehicle transportation and transit pass fringe benefits cannot be more than $230 a month. (Pub 17, pg 48) 12. C - Salaries and wages are included as foreign earned income when including the exclusion. (Pub 17, pg 45) 61

68 Interest and Dividends Chapter 6 Interest and Dividends Interest Income 62

69 Interest and Dividends Interest Income Taxable interest includes interest received from bank accounts, certificate of deposits, loans to others and other sources. The following are sources of taxable interest: 1. Dividends that are actually interest must be reported as interest on accounts in: Cooperative banks Credit Unions Domestic building and loan associations Domestic savings and loan associations Federal savings and loan associations Mutual savings banks 2. Money market certificates, savings certificates and other deferred interest accounts. 3. Interest subject to penalty for early withdrawal report the full amount of interest without subtracting the penalty on early withdrawal. The penalty is reported as an adjustment to income. 4. Gifts for opening an account - Gifts or services for deposits less than $5,000 valued at more than $10 or for deposits of $5,000 or more valued at $20 or more must be reported as interest. The value is determined by the financial institution and included on Form 1099-INT. 5. Interest on insurance dividends is taxable in the year the interest is received. 6. Interest on U.S. obligations is taxable for federal income tax purposes. 7. Municipal bonds or interest on obligations used to finance government is not taxable if issued by a state, the District of Columbia, a U.S. possession or any of their subdivisions. 8. Treasury Bills generally have a 4-week, 13-week, or 26-week maturity period. They are issued at a discount in the amount of $1,000 and multiples of $1,000. The difference between the discounted price paid for the bills and the face value received at maturity is interest income. The interest is generally reported at maturity. 9. Money market interest is taxable in the year it is received or credited to the taxpayers account and can be withdrawn without substantial penalty. Interest on the money market account is not taxable if the interest is not credited to the taxpayer's account until maturity and withdrawal or redemption would result in a substantial penalty. 10. OID - When a long-term debt instrument is issued at a price that is lower than its stated redemption value, the difference is called original issue discount (OID). Interest is reported on 1099-OID. Adjustments are sometimes needed for OID interest because the issuing company does not track the activity of the bond. 11. Interest on tax refunds. 12. Interest on installment sale payments is taxable when received. Refer to Pub The interest from a bearer and coupon bond is taxable the year the bonds are due and payable regardless of when they are presented for collection. 14. Interest paid on money borrowed to invest is a separate transaction from the money earned on the investment. The interest paid on the money borrowed is deductible if the taxpayer itemizes. Report investment interest expense on Form Excerpt from Pub 17 63

70 Interest and Dividends Usurious Interest Usurious interest is interest charged at an illegal rate. This is taxable interest unless state law automatically changes it to a payment on the principal Interest on an IRA Interest on a Roth IRS is generally not taxable. Interest on a traditional IRA is tax deferred, and generally not included in income until withdrawals are from the IRA. When to Report Interest Interest is reported depending on the method of accounting. Most individuals use the cash method of accounting. Generally under this method the interest is reported in the year it is actually or constructively received. When interest is credited to an account or made available to the taxpayer it is constructively received. If the taxpayer is using an accrual method of accounting the interest is taxable when it is accrued, whether or not the taxpayer has received it. How Interest is Reported to the Taxpayer? Taxable interest is reported to the taxpayer on Form 1099-INT in Box 1 except for U.S. savings bonds and Treasury obligations, and OID. All taxable interest must be reported whether or not Form 1099 is received. Which Form is used to Report Interest Income? The taxpayer may only use Form 1040EZ if the interest income is less than $1,500. If the taxpayer is filing form 1040 or 1040A, Schedule B (1040) must be completed if any of the following are true: 1. Taxable interest income exceeds $1, The taxpayer is claiming the interest exclusion under the Education Savings Bond Program. 3. Seller-financed mortgage interest and the buyer used the property as a home. 4. The taxpayer received a 1099-INT for savings bond interest (Box 3). 5. The taxpayer received a 1099-INT for tax exempt interest. 6. The taxpayer received as a nominee interest that was reported by someone else. If the taxpayer had interest from or authority over a foreign bank account they must file Form 1040 and use Schedule B to report the interest. Interest is considered nominee interest when the registered owner receives a 1099-INT with interest income in his/her name, but the interest actually belongs to someone else. The full amount of interest must be reported. On a separate line below the total of all interest reported label the nominee interest received as "Nominee Distribution" and subtract it from the total. Note: Form 1099-INT must be issued by the taxpayer (using the name of the taxpayer as the payer) reporting the nominee distribution to the actual owner of the interest. 64

71 Interest and Dividends The Education Savings Bond Program allows interest received on Series EE Bonds issued after 1989 or a Series I Bond to a taxpayer over the age of 24 may exclude the interest income from that bond if during the year the taxpayer paid qualified higher education expenses to an eligible educational institution. Refer to Form 8815 for instructions and limitations. Dividend Income Dividends are distributions of money, stock or other property paid to the taxpayer by a corporation. Dividends may be received by a taxpayer through a partnership, an estate, a trust, or an association that is taxed as a corporation. Excerpt from 2010 Pub 17. Ordinary dividend income that exceeds $1,500 must be reported on Schedule B when filing Form The amount from Schedule B is carried to the 1040, line 9a. The qualified dividends are reported on 9b. Qualified dividends are carried to page 2 of Schedule D, line 23. If the total interest and dividends are less than $1,500, Schedule B is not required. Ordinary dividends reinvested into stock through a dividend reinvestment plan must be reported in income. Regulated investment companies (mutual funds) and real estate investment trusts (REITs) pay capital gain distributions. These capital gain distributions are reported in Box 2a of Form 1099-DIV. If 1099-DIV has only capital gain distributions in Box 2a and 2b the amount can be reported on line 13a and 13b of the 1040 and check the box on the line. Ordinary dividends are the most common type of dividends and are paid out of earnings and profits of a corporation. Ordinary dividends are reported on Form 1099-DIV box 1a. Ordinary dividends that are not qualified are taxed as ordinary income. Qualified Dividends are shown in box 1b of Form 1099-DIV. The dividends must have been paid by a U.S. Corporation or a qualified foreign corporation. The dividends must meet the holding period. 65

72 Interest and Dividends When Schedule D is required in the return the capital gain distributions will net with the other capital gains on the Schedule D. Nontaxable Distributions A nontaxable distribution is a return of capital or a tax-free distribution of shares of stock or stock rights. It is a return of the investment in the stock of the company. Distributions by a corporation of its own stock are commonly known as stock dividends. Stock rights or options are distributions by a corporation of rights to acquire the corporation stock. Generally these nontaxable distributions are not reported on the tax return. Dividends Used to Buy More Stock The corporation in which the taxpayer owns stock may have a dividend reinvestment plan. The dividend reinvestment plan purchases more stock at the fair market value with the dividends. Dividends used in a dividend reinvestment plan must be reported as the fair market value of the additional stock on the dividend payment date. How to Report Dividend Income Dividends are reported to the taxpayer on Form 1099-DIV if you received more than $10 in dividends. Ordinary and qualified dividends are included in adjusted gross income. Taxpayers report dividends on Form 1040 or 1040A. Ordinary dividends are reported on Line 9a and qualified dividends on line 9b. Dividends are reported on Schedule B, Part II if the dividends earned are more than $1500 or if the taxpayer received dividends as a nominee. Expenses related to dividend income may be deducted on Schedule A as a miscellaneous deduction subject to 2% of the adjusted gross income. 66

73 Interest and Dividends Chapter 6 - Sample Questions 1. Which of the following is not taxable interest received? A. Interest on a bank account B. Interest on loans to others C. Capital gain distributions D. Interest from certificate of deposits 2. The taxpayer must complete Schedule B if filing Form 1040 and any of the following apply, except: A. Taxable interest of more than $1500 B. Taxable interest of $500 C. Interest received as a nominee, that belongs to someone else D. The taxpayer is claiming an exclusion under the Education Savings Bond Program 3. Interest on U.S. obligations, such as U.S. Treasury bills, notes, and bonds, issued by any agency or instrumentality of the United States is taxable for federal income tax purposes A. True B. False 4. Taxable interest from U.S. savings bonds are reported to the taxpayer using this form: A. Form 1099-DIV, box 4a B. Form Schedule B, box 2b C. Form 1098, box 3 D. Form 1099-INT box 3 5. Which of the following is an acceptable maturity period for Treasury Bills? A. 4-week, B. 15-week, C. 30-week D. None of the above 6. Dividends that really are interest come from the following sources, except A. Cooperative banks B. Credit Unions C. Domestic building and loan associations D. Mutual fund accounts 67

74 Interest and Dividends 7. The difference between the discounted price the taxpayer pays for the bills and the received at maturity is interest income. A. Face value B. Original issue discount C. Cooperative amount D. None of the above 8. When a long-term debt instrument is issued at a price that is lower than its stated redemption value, the difference is called which of the following? A. Capital loss B. Discounted debt C. Original issue discount D. Ordinary dividend 9. The taxpayer is allowed to use Form 1040EZ if interest income is less than. A. $400 B. $1500 C. $1200 D. None of the above 10. $100 of interest was credited on the taxpayer s frozen deposit during The taxpayer withdrew $80 but could not withdraw any more as of the end of the year. The taxpayer must include in their income. A. $100. B. $20 C. $80 D. $0 11. When the registered owner receives a 1099-INT, but the interest actually belongs to someone else it is considered: A. A mistake B. Nominee Interest C. Mortgage Interest D. None of the above 12. are distributions of money, stock or other property paid to the taxpayer by a corporation. A. Dividends B. Stocks C. Bonds D. Interest 68

75 Interest and Dividends 13. Which of the following are not ways dividends may be received? A. Partnership B. Estate C. Corporation D. Fringe Benefits 14. The most common type of dividends paid out of earnings and profits of a corporation are called: A. Qualified Dividends B. Ordinary Dividends C. Standard Dividends D. Bank Dividends 15. A nondividend distribution reduces the basis of the stock. It is not taxed until the basis in the stock is fully recovered. A. True B. False 16. Tax on is taxed at the same rate as long-term capital gains received in A. Qualified Dividends B. Ordinary Dividends C. Adjusted Gross Income D. Schedule D 17. Ordinary dividends reinvested into stock through a dividend reinvestment plan must be reported as: A. Adjustment to income B. Income C. Credit on tax due D. Deduction 18. Regulated investment companies (mutual funds) and real estate investment trusts (REITs) pay capital gain distributions. A. True B. False 69

76 Interest and Dividends Chapter 6 Answers to Sample Questions 1. C Capital gain distributions are reported either on Schedule D or on line 13 of Form 1040 and check the box. (Form 1040 inst., page 22) 2. B - The taxpayer must complete Schedule B if filing Form 1040 and any of the following apply: (Pub 17, Pg 57) 3. A - Interest on U.S. obligations, such as U.S. Treasury bills, notes, and bonds, issued by any agency or instrumentality of the United States is taxable for federal income tax purposes is a true statement. (Pub 17, pg 56) 4. Taxable interest from U.S. savings bonds are reported to the taxpayer using Form 1099-INT box 3. (Pub 17, pg 59) 5. A - Treasury Bills generally have a 4-week, 13-week, 26-week, or 52-week maturity period. (Pub 17, pg 60) 6. D - Mutual fund dividends are dividends. (Pub 17, pg 56) 7. A - The difference between the discounted price the taxpayer pays for the bills and the face value received at maturity is interest income. (Pub 17, pg 60) 8. C - When a long-term debt instrument is issued at a price that is lower than its stated redemption value, the difference is called original issue discount. (Pub 17, pg 56) 9. B - The taxpayer is allowed to use Form 1040EZ if interest income is less than $1500. (Pub 17, pg 61) 10. C - $100 of interest was credited on the taxpayer s frozen deposit during The taxpayer withdrew $80 but could not withdraw any more as of the end of the year. The taxpayer must include $80 in their income A deposit is frozen if, at the end of the year, you cannot withdraw any part of the deposit because: The financial institution is bankrupt or insolvent, or The state where the institution is located has placed limits on withdrawals because other financial institutions in the state are bankrupt or insolvent. The amount of interest you must exclude is the interest that was credited on the frozen deposits minus the sum of: The net amount you withdrew from these deposits during the year, and The amount you could have withdrawn as of the end of the year (not reduced by any penalty for premature withdrawals of a time deposit). (Pub 17, pg 57) 70

77 Interest and Dividends 11. When the registered owner receives a 1099-INT, but the interest actually belongs to someone else it is considered nominee interest. (Pub 17, pg 62) 12. A - Dividends are distributions of money, stock or other property paid to the taxpayer by a corporation. (Pub 17, pg 63) 13. D- is incorrect. Dividends may be received from a partnership, an estate, or a corporation. (Pub 17, pg 63) 14. B - The most common type of dividends paid out of earnings and profits of a corporation are called ordinary dividends. (Pub 17, pg 63) 15. A -A nondividend distribution reduces the basis of the stock. It is not taxed until the basis in the stock is fully recovered. This is a true statement. (Pub 17, pg 65) 16. A - Tax on qualified dividends is taxed at the same rate as long-term capital gains received in (Pub 17, pg 63) 17. B - Ordinary dividends reinvested to buy more stock at the fair market value into through a dividend reinvestment plan must be reported as income. (Pub 17, pg 64) true statement. (Pub 17, pg 65) 18. A - Regulated investment companies (mutual funds) and real estate investment trusts (REITs) pay capital gain distributions is a 71

78 Recoveries and Alimony Chapter 7 Recoveries and Alimony Received A recovery is a return or an amount the taxpayer deducted or took a credit for in an earlier year. The most common recoveries are refunds, reimbursements and rebates of deductions itemized on Schedule A. The taxpayer may also have recoveries of non-itemized deductions (such as payments on previously deducted bad debts and recoveries of items which the taxpayer previously claimed as a credit. If the refund or other recovery and the expense occur in the same year, the recovery reduces the deduction or credit and is not reported as income. For additional information regarding recoveries refer to Pub

79 Recoveries and Alimony State Tax Refund Excerpt from Pub 17 73

80 Recoveries and Alimony The form below is an example of a state tax refund which is taxable from 2009 to The taxpayer is married filing a joint return. Refer to Pub 525 for more information. Below is an example from the same return as above with a state tax refund which will be taxable on their 2011 return. Alimony Received Alimony, maintenance, separate maintenance payments, support and spousal support are interchangeable terms for federal tax purposes. Payments that qualify are deductible by the payer spouse and taxable to the payee spouse. Alimony received is reported on Line 11 of Form

81 Recoveries and Alimony To qualify as alimony payments must be: 1. Cash (including checks and money orders) 2. Required by decree 3. Spouse cannot be of the same household 4. Payments may not be treated as child support 5. Payer's liability must cease at death 6. Parties may not file a joint return Payments that do not qualify: 1. Child support 2. Non-cash property settlements 3. Payments that are the spouse's part of community property 4. Payments for use of property 5. Payments to keep up the payer s property. Refer to Pub 504 for more information. 75

82 Recoveries and Alimony Chapter 7 - Sample Questions 1. The type of deduction allowed in the year of repayment depends on the type of income included in the earlier year. A. True B. False 2. A State Tax Refund from the prior year may be taxable in the current year if the taxpayer A. Paid state tax in the current tax year B. Itemized their deductions in the prior year C. Took the Standard Deduction in the prior year D. Contributed to an IRA account 3. For 2010, the state refund that the taxpayer must include in income is limited to the excess of the sales tax or the state income tax chosen to deduct over the sales tax or the state income tax not chosen to deduct. A. True B. False 4. Form 1040 line 10 is used to report: A. Property tax B. Refunds from state or local taxing authorities C. Business tax D. Federal income tax refunds 5. Which of the following is not a qualification for alimony included in income by one spouse and deducted by the other? A. Payment must be in cash (check or money order) B. Required by decree C. Parties must include child support D. Payer s liability must cease at death 76

83 Recoveries and Alimony Chapter 7 Answers to Sample Questions 1. A True, the type of deduction depends on the type of income; for example self employment income reported on Schedule C would be a business expense on Schedule C in the year of repayment. 2. B - A State Tax Refund from the prior year may be taxable in the current year if the taxpayer itemized their deductions in the prior year. 3. A It is a true statement that for 2010, the state refund that the taxpayer must include in income is limited to the excess of the sales tax or the state income tax chosen to deduct over the sales tax or the state income tax not chosen to deduct. 4. B - Form 1040 line 10 is used to report refunds from state or local taxing authorities. 5. C Child support is never considered alimony. 77

84 Chapter 8 Schedule C-EZ Schedule C-EZ Independent Contractor vs. Employee The classification of workers is important for both the worker and the employer. If an employee is classified as an independent contractor then they are responsible for paying self-employment tax on their earnings. If the worker is classified as an employee the employer becomes responsible for: Employment taxes being withheld, such as FICA, federal and state income taxes Employers share of FICA State and federal unemployment taxes Retirement plan eligibility This definition is from IRS Publication 334. Common Law Rules are a set of factors arising out of Revenue Ruling used to determine if a worker is an employee or an independent contractor: 1. Behavior control factor An employer retains the right to control how the work is done. Usually an independent contractor retains control over the work 2. Financial control factor- An employer has the right to control how the business aspects of an employee s business are conducted. The employer would realize the profit or loss and make a significant investment in the business. An independent contractor controls his or her own business activities. 3. Relationship factor - An employer would have a continuing relationship with the employee, who would be an integral part of the business and as such provide benefits for the employee. An independent contractor would have a written agreement determining method of payment, handling of expenses and how and when the work is to be done, designating the worker as an independent contractor. 4. There are many other less important factors that are also weighed in determining the status, such as: The right to discharge a worker or the worker s right to quit Part or full-time work requirement Work required at the employers location Setting hours and sequence of work Any income connected to a business is business income. A connection exists if it is clear that the payment of income would not have been made if the business did not exist. Income from work 78

85 Schedule C-EZ done in addition to a full time job can also be considered business income; the work does not have to be on a regular full-time basis. Business income from the sale of products or services is reported on Schedule C or C-EZ. Schedule C is designed to report income by a sole proprietor (single owner of a business). All Schedule C income must be classified by their activity. An activity code based on the North American Industry Classification System must be entered in block B on Schedule C. All moneys received from business must be included in income unless excluded by law. Income from miscellaneous sources are reported on 1099-MISC, whether the income is reported on a 1099 or not it must be included in income. Accounting of gross receipts should be kept according to generally accepted accounting practices on a daily basis. Refer to Pub 583 for record keeping requirements. Other Kinds of Income 1. Bartering is an exchange of property for services. Bartering income must be included in gross receipts determined by the fair market value of the goods or services. Both people or companies involved in the exchange must report the income.(barter income is reported on 1099-B) 2. Personal property renting (equipment, vehicle rental, formal wear) income must be included in gross receipts. 3. Income created from debt cancellation is business income if the debt is incurred in the business. 4. Other items of income reported on Schedule C: Restricted property Promissory notes Lost income payments Patent infringement Breach of contract Antitrust injury Kickbacks Recovery of items previously deducted Recapture of depreciation: Listed property which falls below 50% business use (refer to Pub 926) Section 179 expense taken on property where the business percentage falls below 50% before the end of the recovery period. (refer to Pub 926) Sale or exchange of depreciable property at a gain (refer to Pub 544) 79

86 Schedule C-EZ Items that are Not Income 1. Loans 2. Sales tax 3. Appreciation 4. Leasehold improvements 5. Exchange of like-kind property 6. Consignments 7. Construction allowances 8. Short-term lease 9. Retail space 10. Qualified long-term real property If the following four conditions are met, generally the earnings are reported as nonemployee compensation. 1. The payment was to someone who is not an employee; 2. The payment was made for services in the course of a trade or business (including government agencies and nonprofit organizations); 3. The payment was to an individual, partnership, estate, or, in some cases, a corporation; and 4. The payments to the payee totaled at least $600 during the year. 80

87 Schedule C-EZ The following are some examples of payments to be reported in box 7 which are usually considered business income for purposes of Schedule C and C-EZ, and are normally subject to self-employment tax. Professional service fees, such as fees to attorneys (including corporations), accountants, architects, contractors, engineers, etc. Fees paid by one professional to another, such as fee-splitting or referral fees. Payments by attorneys to witnesses or experts in legal adjudication. Payment for services, including payment for parts or materials used to perform the services if supplying the parts or materials was incidental to providing the service. Commissions paid to nonemployee salespersons that are subject to repayment but not repaid during the calendar year. A fee paid to a nonemployee, including an independent contractor, or travel reimbursement for which the nonemployee did not account to the payer, if the fee and reimbursement total at least $600. Payments to nonemployee entertainers for services. Exchanges of services between individuals in the course of their trades or businesses.. Taxable fringe benefits for nonemployees. Gross oil and gas payments for a working interest. Payments to an insurance salesperson who is not your common law or statutory employee. Box 9. Payer Made Direct Sales of $5,000 or More Enter an X in the checkbox for sales by you of $5,000 or more of consumer products to a person on a buy-sell, deposit-commission, or other commission basis for resale (by the buyer or any other person) anywhere other than in a permanent retail establishment. Do not enter a dollar amount in this box. If you are reporting an amount in box 7, you may also check box 9 on the same Form 1099-MISC. The report you must give to the recipient for these direct sales need not be made on the official form. It may be in the form of a letter showing this information along with commissions, prizes, awards, etc. 81

88 Schedule C-EZ Business Income Schedule C-EZ 82

89 Schedule C-EZ 83

90 Schedule C-EZ Schedule SE Use Schedule SE (Form 1040) to figure the tax due on net earnings from self-employment. The Social Security Administration uses the information from Schedule SE to figure the taxpayers Social Security Benefits under the social security program. The taxpayer with income subject to SE tax receives one credit for every $1120 of income subject to SE in Generally, the taxpayer must pay SE Tax and file Schedule SE if the net earnings from selfemployment were $400 or more. The SE Tax rate is 15.3% (12.4% social security tax plus 2.9% Medicare Tax). The first $106,800 of wages, tips and net earnings are subject to the 12.4% social security part of self-employment tax. All of the combined wages tips and net earnings are subject to the 2.9% Medicare part of self-employment tax. Reasons to use the Optional Methods of computing SE tax if there is a loss or a small net profit where filing Schedule SE is not required The taxpayer receives credit for social security benefit coverage The optional method may increase the earned income component for computing child or dependent care credit The optional method may increase the earned income component for computing an earned income credit The optional method may increase the earned income component for computing an additional child tax credit The taxpayer can deduct onehalf of the SE tax as an adjustment to income on line 27 of Form Refer to Pub 334 for a detailed discussion of the methods for figuring net earnings from self-employment. Refer to Schedule SE in Chapter 14 of this syllabus. 84

91 Schedule C-EZ Chapter 8 - Sample Questions 1. Independent contractors are not responsible for paying self-employment tax: A. True B. False 2. When a worker is classified to be independent contractors, which of the following statements apply? A. The employer has the right to control how the business aspects of the contractor s business are conducted. B. The employer must have a continuing relationship with the contractor C. The employer retains the right to control how the work is done D. None of the above 3. Which one of the following describes the three main factors for determining if a worker is an employee or a contractor? A. Behavior Control, Financial Control, Relationship B. Performance Control, Economic Control, Association C. Production Control, Industry Control, Companionship D. None of the above 4. Form 1099-MISC must be issued for a nonemployee worker who earns $458 during the year. A. True B. False 5. Barter income is determined by the fair market value of goods and services. A. True B. False 6. Schedule C-EZ can be used when the taxpayer has business expenses of $10,000, if there is a net profit. A. True B. False 7. What is the responsibility of a sole proprietor who receives money that is not reported on a 1099-MISC? A. They do not have to report the money B. They can report it if they choose C. Report 50 percent of the money D. They must include the money in income, unless excluded by law 8. Self-employment tax (SE tax) is primarily for which of the following? A. Employees B. Sole proprietors C. Individuals who are not employed D. Individuals who do not want their employers to withhold social security and Medicare taxes from their pay. 85

92 Schedule C-EZ 9. By not reporting all of the self-employment income from their business the taxpayer may cause the social security benefits to be lower upon retirement. A. True B. False 10. Which of the following methods can be used to compute net earnings from self-employment to compute SE tax? A. The regular method B. The nonfarm optional method C. The farm optional method D. All of the above 11. The taxpayer must pay for the Medicare portion of S/E taxes on all net earnings. A. 20% B. 15.3% C. 2.9% D % 12. How much of the SE tax is deducted as an adjustment to income on Form 1040? A. One-third B. One-half C. 10 percent D. None of the above 13. In 2010, only the first $106,800 of combined wages, tips and net earnings are subject the Social Security Tax portion of the self-employment tax. A. True B. False. 86

93 Schedule C-EZ Chapter 8 Answers to Sample Questions 1. B- Independent contractors are responsible for paying self-employment tax. Income earned which the contractor has the right to control A. True B. False 2. D-When a worker is classified to be independent contractor they Control the way they work Control the expenses and business activities Control their hours, work place and activities The right to discharge a worker or the worker s right to quit Part or full-time work requirement Work required at the employers location Setting sequence of work 3. A - The three main factors for determining if a worker is an employee or a contractor is Behavior Control, Financial Control, Relationship. Both people or companies involved in the exchange must report the income 4. B - Form 1099-MISC must be issued for a nonemployee worker who earns $458 during the year is false. A 1099-MISC is issued if the nonemployee compensation is $600 or more. 5. A - Barter income is determined by the fair market value of goods and services. 6. B - Schedule C-EZ can be used when the taxpayer has business expenses of $5,000 or less 7. D - A sole proprietor who receives money that is not reported on a 1099-MISC must include the money in income, unless excluded by law. 8. B - Self-employment tax (SE tax) is primarily for sole proprietors. 9. A It is true that by not reporting all of the self-employment income from their business the taxpayer may cause the social security benefits to be lower upon retirement. 10. D - All of the following methods can be used to compute net earnings from self-employment to compute SE tax. The regular method The nonfarm optional method The farm optional method 11. C - The taxpayer must pay 2.9% for the Medicare portion of S/E taxes on all net earnings. 12. B - One-half of the SE tax is deducted as an adjustment to income on Form 1040? 13. A It is true that in 2010, only the first $106,800 of combined wages, tips and net earnings are subject the Social Security Tax portion of the self-employment tax. 87

94 Capital Assets Schedule D Chapter 9 - Capital Assets Most properties owned and used for personal purposes, pleasure or investment are capital assets, such as a personal residence, furniture, car, stocks and bonds. A capital asset is any property held by the taxpayer except: Stock in trade or other property included in inventory or held mainly for sale to customers Accounts or notes receivable for services performed in the ordinary course of trade or business Depreciable property used in trade or business Copyrights, literary, musical or artistic compositions, letters or memoranda or similar property (a) Created by the taxpayer s personal efforts (b) Prepared or produced by the taxpayer (c) Received from someone who created them or for whom they were created, as mentioned in (a) or (b) in a way that entitled the taxpayer to the basis of the previous owner. U.S. Government record including the Congressional Record Certain commodities derivative financial instruments held by a dealer (Section 1221(a)(6)) Certain hedging transactions entered into in the normal course of trade or business. (Section 1221(a)(7)) Supplies regularly used in the trade or business Basis of Property The basis of property bought is usually its cost. The cost is the amount paid in cash, debt obligations, other property or services. The cost also includes amounts paid for the following items: Sales tax Freight Installation and heating Excise taxes Legal and accounting fees (when they must be capitalized) Revenue stamps Recording fees Real estate taxes (if assumed for the seller) Real property, also called real estate, is land and generally anything built on, growing on, or attached to land. Land is not depreciable if the cost is a lump sum; allocate the cost according to the fair market value of the land and buildings at the time of purchase. Fair market value (FMV) is the price at which the property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the necessary facts. 88

95 Capital Assets Schedule D Adjusted basis before figuring gain or loss on a sale, exchange, or other disposition of property or figuring allowable depreciation, depletion or amortization, certain increases or decreases to the basis may be needed. The result of the increases or decreases is the adjusted basis. This chart is from Publication 17, Part 3, Gains and Losses. Basis other than cost is computed by using the fair market value or the adjusted basis. If property is received for services the property is included in income at the fair market value. This FMV becomes the basis. If an asset is purchased at bargain prices (less than the FMV) include the difference between the discounted cost and the FMV in income and the FMV becomes the basis. A taxable exchange is one in which the gain is taxable or the loss is deductible. A taxable gain and deductible loss is also known as a recognized gain or loss. The basis of property received in exchange for other property in a taxable exchange is usually the FMV at the time of the exchange. The most common taxable exchange is an involuntary conversion. If the taxpayer receives property due to an involuntary conversion, such as a casualty theft or condemnation, the basis of the replacement property is computed by using the basis of the converted property. If the property received is similar or related in service or use to the converted property, the new basis is the same as the converted property on the date of the conversion, with the following adjustments: Decreasing the basis by any loss recognized on the conversion and any money received that was not spent on similar property Increase the basis by any gain recognized on the conversion and any cost of acquiring the replacement property A nontaxable exchange is an exchange in which the taxpayer is not taxed on the gain and not able to deduct the loss. In these transactions the basis is generally the same as the property transferred. 89

96 Capital Assets Schedule D A like-kind exchange is an exchange of property for the same kind of property and is the most common type of nontaxable exchange. In a like-kind exchange the property traded and the property received must both be qualifying property and like-kind property. Qualifying property in an exchange must either be held for investment or for productive use in a trade or business. Like-kind property is property of the same nature and character, even if it differs in quality or grade. The exchange of real property for real property or personal property for personal property is an exchange of like property. A like kind exchange is reported on Form 8824 refer to these instructions for more information. The basis of property received as a gift is the FMV less the donor s adjusted basis. To determine this amount the taxpayer must determine whether there is a gain or a loss when disposing of the property. The basis for figuring the gain is the donor s adjusted basis plus or minus any required adjustments to basis while the property was held. The basis for figuring a loss is the FMV when the gift was received plus or minus any required adjustments. (Refer to Pub 551.) Stocks, Bonds and Mutual Funds The basis of stocks or bonds generally is the purchase price plus any costs of purchase, such as commissions and recording or transfer fees. If the taxpayer receives stocks or bonds other than by purchase, the basis is determined by the fair market value or the previous owner s adjusted basis. The basis is also adjusted by certain events that occur after purchase such as stock splits, where the number of the old and new shares must divide the basis of the old stock if the new stock received is identical to the old stock. Nontaxable distributions also reduce the basis. First-In, First-Out Method of Identification Under this method it is assumed the first share sold in an account was first share bought. The basis is determined by the order the funds were purchased. The First In First Out method is referred to as FIFO. It is a straight- forward concept--the first shares bought are always the first shares sold. The IRS likes this method because in a generally rising stock market, it maximizes the capital gain tax that they will collect. Absent any action on the part of the investor, this is the method that brokerage firms will apply to the sale of a stock that has multiple tax lots. (It applies to bonds, too, but usually the difference in cost between bond tax lots is minor, unlike stocks which can vary substantially over time.) Specific Identification Method The Specific Identification method is the most flexible in terms of controlling the tax liability. The investor can pick and choose which tax lots they want to sell based on how much taxable gain or loss to be recognize. Identify the specific tax lot (meaning the purchase date of the shares that the investor wants to sell) and inform the broker before the trade is executed. This is called a "versus purchase" trade. It is often denoted by "VSP" with the original tax lot purchase date printed on the trade confirmation for the sale in order to document that the specific identification method was used. Average Cost Basis, Single Category Method (Mutual Funds) Calculate the average cost basis based on the price paid for each share bought, including any 90

97 Capital Assets Schedule D reinvested dividends and reinvested capital gains. The average cost basis is the total purchase price of all shares divided by the number of shares owned. When some shares are sold, it is assumed the shares are sold on a first-in, first-out basis. The capital gain is calculated using the holding period of the oldest shares being sold, even if the stocks being sold are a mixture of long-term and short-term shares. The Average Cost Single Category method is one of the most commonly used ones for mutual fund holdings with many tax lots. It is the one that most mutual fund companies use as the default method because it is easy to display a single number on an account statement It cannot be used if the taxpayer has any shares in physical certificate form. Average Cost Basis, Double Category Method (Mutual Funds) The Average Cost Double Category method is only available to use for mutual fund holdings and dividend reinvestment plans until 4/1/2011. It involves calculating the average cost separately for two buckets of tax lots--one short-term (less than one year since purchase) and the other longterm holdings. This method cannot be used if they have any shares in physical certificate form. For additional information on methods of determining basis of stocks having to do with how the stocks were acquired. (Refer to Pub. 550.) The basis in mutual funds is determined in the same manner as stocks and bonds. If the taxpayer sells mutual fund shares at various times and prices the taxpayer can choose to use an average basis. (Refer to Pub 564.) Sale of Property Form 1099-B or equivalent statement is issued when stocks, bonds or certain commodities are sold through a broker. A sale is generally a transfer of property for money or a mortgage, note or other promise to pay money. A trade is a transfer of property for other property or services and may be taxed the same way as a sale. Redemption of stock is treated as a sale or trade and is subject to the capital gain or loss provisions unless the redemption is a dividend or other distribution on stock. The gross sales price of the item is shown in Box 2 of 1099-B. Redemption or retirement of bonds is considered a sale. A worthless security that became worthless during the year is treated as though it was sold on the last day of the year. If real estate is sold the transaction is reported on 1099-S. Gross proceeds from the sale or exchange is shown in Box 2. Reportable real estate is defined as any present or future ownership interest in any of the following: Improved or unimproved land Inherently permanent structures, including residential, commercial or industrial buildings A condominium unit and its accessory fixtures and common elements, including land Stock in cooperative housing corporation 91

98 Capital Assets Schedule D Sale expenses are added to the basis. Sale expenses include commissions, state and local transfer tax, broker s fees and option premiums. For real estate sales expense of sale includes attorney fees, title and escrow fees, broker s fees and mortgage lender fees. Gain and Loss To compute a gain or loss on the sale of property compare the amount realized with the adjusted basis of the property. If the amount realized is more than the adjusted basis of the property transferred, the difference is a gain. If the adjusted basis is more than the amount realized, the difference is a loss. The amount realized is everything received for the property. The sales price in a sale or trade of property is everything received for that property. This includes money, plus the fair market value of property or services received for that property. Capital Gain Tax Rates 92

99 Capital Assets Schedule D Schedule D Tax Worksheet The following worksheet is used if the taxpayer must file Schedule D and Line 18 or 19 is more than -0-. This worksheet is from Pub. 17 as part of the comprehensive example (Pub 17, pg 116) 93

100 Capital Assets Schedule D Refer to the instructions for Schedule D on the proper reporting on Page 2 of Schedule D of capital gains in each tax bracket. There is a limitation on the amount of capital loss allowed in the current year. The allowable capital loss in the current year is the lesser of: 1. $3,000 ($1,500 if married filing a separate return) 2. The total net loss shown on Schedule D If there is a total net loss more than the yearly limit on capital loss deductions, the unused part is a short or long-term carryover to the next year. It can be carried over until used up. The allowable deduction in the current year must be taken into account when computing the carryover, whether or not the deduction was claimed. The carryover loss remains either long term or short term. A long-term carryover loss that is carried to the next year will reduce that year s long-term gain before it is used against that year s short-term gains. (Refer to the Capital Loss Carryover Worksheet in Pub 550). Short Term Gain or Loss is a capital gain or loss on the sale or trade of investment property held 1 year or less. Report on Schedule D, Part I. Short-term carryover losses are used first when figuring the capital loss carryover even if the long-term losses were created after the short-term losses. To figure the net short-term capital gain or loss combine short-term losses from partnerships, S- corporations and fiduciaries and any short-term carryover losses with other short-term gains or losses. Long-term gains and losses are defined as a capital gain or loss on the sale of investment property held more than one year. Report long-term capital gains and losses in Part II of Schedule D. Also report the following items in Part II of Schedule D: 1. Undistributed long-term capital gains from a regulated investment company (mutual funds) or real estate investment trust (REIT) 2. The taxpayer share of long-term capital gains or losses from partnerships, S-corporations and fiduciaries. 3. All capital gain distributions from mutual funds and REIT s not reported directly on Form Long-term capital loss carryovers. Schedule D-1 is a continuation form for Schedule D, it is used to list additional sales of stocks, bonds or other assets. 94

101 Capital Assets Schedule D Schedule D 95

102 Capital Assets Schedule D Collectibles gain or loss is a capital gain or loss from the sale or trade of a work of art, rug, antique, metal (such as gold, silver or platinum) gem, stamp, coin, or alcoholic beverage held more than one year. If the taxpayer realizes a gain on qualified small business stock held more than 5 years under the provisions of Section 1202, half the gain can be excluded from income. The taxable portion of the gain is taxed at 28%. (Refer to Pub 550.) Unrecaptured Section 1250 gain is any part of a capital gain from selling of Section 1250 property (real property) due to depreciation (but not more than the net section 1231 gain) reduced by any net loss from the 28% group. To compute the Unrecaptured Section 1250 gain refer to the work sheet in Schedule D instructions, Form 4797 instructions or Pub 544). 96

103 Capital Assets Schedule D Sale of Personal Residence For sales of a personal residence after May 6, 1997, a homeowner may exclude from income up to $250,000 of gain and a married couple may exclude up to $500,000 of gain realized on the sale. The Section 121 exclusion requires individuals to meet the following conditions: Ownership and use test: The individual must have owned and used the home as a principal residence for at least two out of the five years prior to the sale (the two years do not have to be consecutive). The taxpayer must own the home directly not through an entity Frequency limitation: The exclusion applies to only one sale every two years The Section 121 exclusion requires married couple to meet the following conditions: Joint return: The married couples must file a joint return Ownership: Either or both spouse(s) must have owned and used the home as a principal residence for at least two out of the five years prior to the sale (the two years do not have to be consecutive). The taxpayer must own the home directly not through an entity Use: Both spouses must have used the residence as their principal residence for at least two out of five years prior to the sale Neither spouse may have sold a home more than once every two years Reduced exclusion: taxpayers who do not meet the two-year ownership and use test of Section 121 may qualify for a reduced exclusion if the taxpayer sold a home due to: Job relocation - The new job location must also be at least 50 miles farther from the residence sold than was the former place of employment Health - A sale is due to health if the primary reason for the sale is to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of disease, illness or injury of a qualified individual Unforeseen circumstances such as the following: Natural and man-made disasters or acts of war or terrorism resulting in a casualty to the residence. Death, loss of job, change in job status, divorce or legal separation, multiple births from the same pregnancy. Involuntary conversion of residence An event the IRS determines as an unforeseen circumstance. A prorated exclusion of gain based on the period of time the homeowner meets the ownership and use requirements, and the period of time between the most recent sale of home and current sale. (Refer to Pub 544 for the Sale of Home worksheet.) 97

104 Capital Assets Schedule D Chapter 9 - Sample Questions 1. Most properties owned and used for personal purposes, pleasure or investment are capital assets. A. True B. False 2. The following are examples of a capital asset; except: A. Personal residence B. Furniture C. Supplies regularly used in the trade or business D. Car 3. The basis of property bought is usually. A. The property current value B. The property cost C. The property current value less the cost D. All of the above 4. The price at which property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the necessary facts is the of the property. A. Cost or basis B. Adjusted basis C. Fair market value (FMV) D. Taxable exchange 5. Which of the following increases the basis of property? A. Capital improvements B. Casualty losses- restoring damaged property C. Zoning costs D. All of the above 6. The most common taxable exchange is which of the following? A. Voluntary conversion B. Involuntary exchange C. Voluntary exchange D. Involuntary conversion 7. Which of the following is the most common nontaxable exchange? A. Bartering B. Like-kind exchange C. Exchange of different kinds of property D. None of the above 98

105 Capital Assets Schedule D 8. The basis of stocks or bonds generally is which of the following? A. Fair Market Value B. Current value C. Purchase price plus any costs of purchase D. None of the above 9. When purchasing stocks or bonds, the cost of purchase can include which of the following? A. Commissions B. Recording Fees C. Transfer Fees D. All of the above 10. Which form is issued when stocks, bonds or certain commodities are sold through a broker? A MISC B C INT D B 11. If filing a joint tax return, which of the following is the allowable capital loss in the current year? A. $3000 or the total loss shown on Schedule D if less than $3,000 B. $5000 or the total loss shown on Schedule D if less than $5,000 C. $3000 or the total loss shown on Schedule E if less than $3,000 D. None of the above 12. Which form is used to report capital gain distributions from mutual funds not reported directly on Form 1040? A. Schedule D, part II B. Schedule B C. Schedule A D. Schedule E 13. After May 6, 1997, a married couple, filing a joint return, can exclude of the gain realized on the sale of their personal residence if they meet certain conditions. A. $250,000 B. $520,000 C. $500,000 D. None of the gain can be excluded 99

106 Capital Assets Schedule D Chapter 9 - Answers to Sample Questions 1. A - Most properties owned and used for personal purposes, pleasure or investment are capital assets is a true statement. An example of this is a personal residence, furniture, cars, stocks and bonds. 2. C - Supplies are used regularly in the trade or business are not capital assets and are not depreciable. 3. B - The basis of property bought is usually the cost. The cost is the amount paid in cash, debt obligations, other properties or services. 4. C -The price at which property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the necessary facts is the fair market value of the property. 5. D -All of the following increases the basis of property Capital improvements Casualty losses- restoring damaged property Zoning costs Assessments Legal Fees 6. D - The most common taxable exchange is an involuntary conversion, such as casualty, theft or condemnation. 7. B A like-kind exchange of property of the same nature is the most common nontaxable exchange? 8. The basis of stocks or bonds generally is the purchase price plus any costs of purchase 9. D -When purchasing stocks or bonds, the cost of purchase can include commissions, recording fees and transfer fees. 10. D - Stocks, bonds or certain commodities sold through a broker is reported on Form 1099-B. 11. A - The allowable reportable capital loss in the current year is $3,000, unless the filing status is MFS, then it is limited to $1, A - Capital gain distributions from mutual funds not reported directly on Form 1040, are reported on Schedule D, part II. 13. C - After May 6, 1997, a married couple, filing a joint return, can exclude under 121 $500,000 of the gain realized on the sale of their personal residence if they meet certain conditions. 100

107 IRA s and Pension Plans Chapter 10 - Types of IRA s and Employer Sponsored Pension Plans - Distributions Refer to IRS Pub 590 for an explanation of each plan, limitations and allowed contributions. The following quote comes from Topic 451 released by the IRS in December 2009 An individual retirement arrangement, or IRA, is a personal savings plan which allows you to set aside money for retirement, while offering you tax advantages. You may be able to deduct some or all of your contributions to your IRA. You may also be eligible for a tax credit equal to a percentage of your contribution. Amounts in your IRA, including earnings, generally are not taxed until distributed to you. IRA's cannot be owned jointly. However, any amounts remaining in your IRA upon your death can be paid to your beneficiary or beneficiaries. To contribute to a traditional IRA, you must be under age 70 1/2 at the end of the tax year. You, and/or your spouse if you file a joint return, must have taxable compensation, such as wages, salaries, commissions, tips, bonuses, or net income from self employment. Taxable alimony and separate maintenance payments received by an individual are treated as compensation for IRA purposes. Compensation does not include earnings and profits from property, such as rental income, interest and dividend income or any amount received as pension or annuity income, or as deferred compensation. Please refer to Publication 590 for information on the amounts you will be eligible to contribute to your IRA account. The deadline for contributions to a traditional IRA for the year is the due date of your return, not including any extensions of time to file. Amounts you withdraw from your IRA are fully or partially taxable in the year you withdraw them. If you made only deductible contributions, withdrawals are fully taxable. Use Form 8606 to figure the taxable portion of withdrawals. The following quote comes from Topic 309 released by the IRS in March 2010 A Roth IRA is an account or annuity set up in the United States solely for the benefit of you or your beneficiaries. It is an individual retirement plan. However, it differs from traditional IRAs in that contributions are not deductible. For information on contributions and the limitations please refer to Chapter 2 of the Publication 590, Individual Retirement Arrangements. Roth IRA Distributions Qualified distributions from a Roth IRA are tax free and are not included in gross income. To be a qualified distribution, the following requirements must be met: The distribution is made after the five-year period beginning with the first taxable year for which the contribution was made to a Roth IRA. The distributions is one of the following: o Made on or after age 59 ½ o Made because the taxpayer was disabled o Made to a beneficiary or an estate o Made to pay qualified first-time homebuyer amounts ($10,000 lifetime limit) Reporting Distributions The following are reported on Form 1040 Line 15a and 15b: 1. Traditional IRA 2. Roth IRA 101

108 IRA s and Pension Plans 3. Simplified Employee Pension (SEP) IRA 4. Savings Incentive Match Plan for Employees (SIMPLE) IRA Distributions from IRA s are reported to the taxpayer on Form 1099-R, with an X in the IRA/SEP/SIMPLE check box. Pension Distributions Retirement benefits in the form of a pension or annuity payment from a qualified employer retirement plan may be fully or partially taxable. These payment are reported to the taxpayer on Form 1099-R. Pension or annuity payments are usually fully taxable if the following are true: The employer paid all the cost The employer did not withhold any part of the cost from the taxpayer s pay The taxpayer made pre-tax contributions If the taxpayer contributed after tax-dollars (basis) to the pension or annuity the payments are partially taxable. The taxpayer does not pay tax on the part of the payment that represents a return of basis. On Form 1099-R if the amount in Box 2a is blank and 2b is checked, special calculations using the Simplified Method or the General rule apply. See below and Pub 575 for additional information. The following are reported on Form 1040 Line 16a and 16b: 1. Qualified pension, profit sharing, stock bonus, money-purchase, Keogh plans etc. Complies with special rules imposed by Internal Revenue Code and IRS regs. Contributions allowed by both the employer and employee It cannot discriminate between certain employees It must be permanent It must satisfy minimum vesting requirements 2. Section 401(k) plans - employer controlled. Allows employee to defer compensation tax free. 3. Plans established by the United States, a state or political subdivision (does not include Section 457 plans). 4. Section 457(b) plans available for certain state and local governments and entities tax exempt under Section 501. Allows employee deferred compensation. 5. Tax-sheltered annuity plans Section 403(b) - Employee of a charitable, religious or educational organization. Allow employees to defer compensation tax free. 6. SEP plans Section 408 (k) - anyone with S/E income, contributions treated the same as an IRA. 102

109 IRA s and Pension Plans Distributions before age 59 1/2 Before age 59 ½ distributions from an IRA or qualified pension plan are taxable as ordinary income (except for the part that represents a return of capital) and are subject to a 10% penalty for early withdrawal. SIMPLE plans have a 25% early withdrawal penalty if the taxpayer has been in the plan less than 2 years. (Form 5329) When a taxpayer is between 59 ½ and 70 ½ distributions are taxable as ordinary income (except the portion that represents return of capital). There is no early withdrawal penalty. The plan participant has total control over the amounts of the distributions and the timing. No distribution is required. Required Minimum Distribution When a taxpayer is age 70½ distributions from Non-Roth IRA s are required to begin. Distributions are taxable as ordinary income (except the portion that represents return of capital). Distributions can be lump-sum or periodic as long as the required minimum distribution (RMD) is made in the year. The RMD can come from one account or several accounts. For participants in qualified pension plans other than 5% owners the RMD rules do not apply until the participant reaches 70 ½ or retires whichever is later. If the employee starts the distributions later than 70 ½, the employee s accrued benefit must be actuarially increased to reflect the value of the benefits the employee would have received if the distributions started at age 70 ½. Note: Required minimum distribution rules do not apply to Roth IRA s. Distributions from Roth IRA s are required after the death of the participant. The basic calculation of the RMD is determined by dividing the account balance by the distribution period. For years after the year of death the distribution period is generally the remaining life expectancy of the designated beneficiary. The distribution period is based on the age of the beneficiary as of his/her birthday in the year following the owner s death, reduced by one year for each year that has elapsed since the owner s death. If the beneficiary is the surviving spouse the distribution period is based on the age of the spouse as of his/her birthday in the year following the owner s death, reduced by one year for each year that has elapsed since the owner s death. If the owner died before he/she reached 70 ½, the surviving spouse is not required to begin distributions until he/she reached 70 ½. (Refer to Pub 575). Rollovers of Pensions and IRA s A rollover is taking receipt of assets for up to 60 days before reinvesting in a new retirement plan. A transfer is moving the assets directly from one custodian to another. Qualifying Rollovers 1. From one IRA to another IRA within the 60 day period with the taxpayer taking possession of the IRA during the 60 day period. IRA s cannot be rolled over more than once in a 12-month period. 2. From an employer plan to an IRA within the 60-day period with the taxpayer taking possession of the distribution. The 60-day rule applies even if the distribution was in 103

110 IRA s and Pension Plans error. 3. A traditional IRA can be rolled into a qualified retirement plan. Nondeductible after tax dollars are not eligible to be rolled into an employer plan but can be rolled over from one IRA into another IRA. 4. A SIMPLE IRA to a qualified retirement plan - the participant must be in the plan for 2 years. If the participant was not in the plan for 2 years the SIMPLE IRA can only be rolled into another SIMPLE IRA. 5. From a 457 plan to a qualified retirement plan. 6. From a 403(b) annuity plan to a qualified retirement plan 7. From a deceased spouse s plan to the surviving spouse s qualified plan 8. Rollover of after-tax contributions provided a direct trustee to trustee transfer is made. The taxpayer is responsible for tracking the basis on Form A Roth IRA can be rolled over to another Roth IRA but cannot be rolled over to a traditional IRA. Losses on the tax-deferred portion of IRA s, pension plans and annuities are generally not deductible because the taxpayer has not paid tax on the money lost. Simplified Method and General Rule 104

111 IRA s and Pension Plans Simplified Method Worksheet from Pub 17 In order to determine the amount that is taxable under the Simplified Method the participant s cost must be established. The cost is everything the participant paid into the plan and taxable contributions by the employer. Cost does not include amounts excluded from income. Refunds of premiums, rebates, dividends, unpaid loans, or other tax-free amounts must be subtracted. The cost should be shown in Box 5 of Form 1099-R. Under the Simplified Method the tax-free part of each monthly annuity payment is computed by dividing the cost by the total number of expected monthly payments. For an annuity that is payable for the lives of the annuitants, this number is based on the annuitants ages on the annuity starting date and is determined from a table. For any other annuity the number is the number of monthly annuity payments in the contract. (Refer to Pub 17 or 590 for worksheet) 105

112 IRA s and Pension Plans Form 1099-R Excerpt from Pub 590 regarding 2010 conversions of a traditional IRA to a Roth IRA. Assets withdrawn from a traditional IRA and reinvested by the 60 th day, following the day of distribution, to a Roth IRA are called a conversion. The 10% penalty on the distribution will not apply. The amount converted cannot include the required minimum distribution for a taxpayer over 70 ½ years of age. Form 8606 must be included to report the conversion. 106

113 IRA s and Pension Plans Distributions Codes 1099 R Box 7 107

114 108 IRA s and Pension Plans

115 IRA s and Pension Plans Recharacteriztion The taxpayer cannot deduct the contribution for the first IRA. Any net income transferred with the recharacterized IRA is treated as earned income to the second IRA. Lump-Sum Distributions ((Form 4972) (10-Year averaging)) is available for taxpayers born before See instructions for Form 4972 for qualifications and ten-year averaging tables. Additional Taxes on Qualified Plans (including IRA s) Form 5329 An additional tax is due if the taxpayer received an early distribution from a Roth IRA and Form 8606 line 21 is more than Form 8606 Line 23 (See Form 8606 instructions) or an early distribution from a qualified retirement plan other than a Roth IRA. An early distribution is before the participant reaches age 59 ½. The additional tax for early distributions from a qualified retirement plan is 10% unless the distribution is from a SIMPLE IRA within the first 2 years the participant is in the plan. In that case the penalty is 25%. If a contribution is more than the smaller of compensation or $4,000 ($5,000 if over 50), it is considered an excess contribution. A contribution made for the year a taxpayer turns 70 ½ or any later year, is also an excess contribution. There is a 6% excise tax each year on excess amounts that remain in an IRA. The excise tax will not apply if the excess is removed before the due date. Use Form 5329 to report additional taxes on: IRAs, Other qualified retirement plans, Modified endowment contracts, Coverdell ESAs, QTPs, Archer MSAs, or HSAs. 109

116 IRA s and Pension Plans The taxpayer must file Form 5329 if any of the following apply. The taxpayer received an early distribution from a Roth IRA. The taxpayer received an early distribution subject to the tax on early distributions from a qualified retirement plan (other than a Roth IRA). However, if distribution code 1 is correctly shown in box 7 of all your Forms 1099-R, and you owe the additional tax on each Form 1099-R, you do not have to file Form Instead, see the instructions for Form 1040, line 58, for how to report the additional 10% tax directly on that line. The taxpayer received an early distribution subject to the tax on early distributions from a qualified retirement plan (other than a Roth IRA), and met an exception to the tax on early distributions, and distribution code 1 is shown in box 7 of Form 1099-R. The taxpayer received an early distribution subject to the tax on early distributions from a qualified retirement plan (other than a Roth IRA), and met an exception to the tax on early distributions from the list on page 3 but box 7 of your Form R does not indicate an exception or the exception does not apply to the entire distribution. The taxpayer received taxable distributions from Coverdell ESAs or QTPs. The contributions for 2010 to a traditional IRAs, Roth IRAs, Coverdell ESAs, Archer MSAs, or HSAs exceed the maximum contribution limit. The taxpayer did not receive the minimum required distribution from their qualified retirement plan Form 5329, Line 2 The additional tax on early distributions does not apply to the distributions described below. Enter on line 2 the amount that can be excluded. In the space provided, enter the applicable exception number (01-12). No. Exception 01 Qualified retirement plan distributions (does not apply to IRAs) you receive after separation from service in or after the year you reach age 55 (age 50 for qualified public safety employees). 02 Distributions made as part of a series of substantially equal periodic payments (made at least annually) for your life (or life expectancy) or the joint lives (or joint life expectancies) of you and your designated beneficiary (if from an employer plan, payments must begin after separation from service). 03 Distributions due to total and permanent disability. 04 Distributions due to death (does not apply to modified endowment contracts). 05 Qualified retirement plan distributions up to (1) the amount you paid for unreimbursed medical expenses during the year minus (2) 7.5% of your adjusted gross income for the year. 06 Qualified retirement plan distributions made to an alternate payee under a qualified domestic relations order (does not apply to IRAs). 07 IRA distributions made to unemployed individuals for health insurance premiums. 110

117 IRA s and Pension Plans IRA Exceptions - Continued 08 IRA distributions made for higher education expenses. 09 IRA distributions made for purchase of a first home, up to $10, Distributions due to an IRS levy on the qualified retirement plan. 11 Qualified distributions to reservists while serving on active duty for at least 180 days. 12 Other (see Other, below). Also, enter this code if more than one exception applies. 111

118 IRA s and Pension Plans Chapter 10 - Sample Questions 1. An individual retirement arrangement, or IRA, is a personal savings plan which allows a taxpayer to set aside money for retirement, while offering tax advantages. A. True B. False 2. A qualified distribution from a is nondeductible, and the interest earned is tax deferred. A. IRA B. Roth IRA C. SEP D. SIMPLE 3. The taxpayer s basis in a pension or annuity includes the taxpayer s costs or other amounts paid that were deducted by the taxpayer. A. True B. False 4. Before age distributions from an IRA are taxable as ordinary income and subject to a 10% penalty for early withdrawal. A. 65 B. 55 ½ C. 59 ½ D When a taxpayer is age 70 ½ distributions from non-roth IRA s are required to begin. A. True B. False 6. A is taking receipt of assets for up to 60 days before reinvesting in a new retirement plan. A. Transfer B. Rollover C. Distributions D. None of the above 7. Which form will be used to report a conversion from a traditional IRA to a Roth IRA? A. Form 8606 B. Form 5498 C. Form 5329 D. None of the above 8. A is moving the assets directly from one custodian to another. A. Rollover 112

119 IRA s and Pension Plans B. Distribution C. Transfer D. SEP 9. A Roth IRA can be rolled over to another Roth IRA but cannot be rolled over to a traditional IRA. A. True B. False 10. At what age must a taxpayer begin Required Minimum Distributions from Non-Roth IRA s? A. 65 B. 59 ½ C. 70 ½ D For rollovers from qualified retirement plans to a Roth IRA in 2010, any amounts that are required to be included in income must be in income in A. True B. False 12. The following are exceptions to the additional tax on Form 5329, except: A. IRA distributions made for higher education B. Distribution due to death C. Distribution due to total and permanent disability D. IRA distributions made for purchase of a second home 113

120 IRA s and Pension Plans Chapter 10 -Answers to Sample Questions 1. A -An individual retirement arrangement, or IRA, is a personal savings plan which allows a taxpayer to set aside money for retirement, while offering tax advantages. (Pub17, page 74) 2. B - A qualified distribution from a Roth IRA is nondeductible, and the interest earned is tax deferred. (Pub17, page 74) 3. B - The taxpayer s basis in a pension or annuity includes the taxpayer s costs or other amounts paid that were deducted by the taxpayer is a false statement. (Pub17, page 75) Before the taxpayer can figure how much, if any, of a distribution from a pension or annuity plan is taxable, the taxpayer must determine their cost (the investment in the contract) in the pension or annuity. The total cost in the plan includes the total premiums, contributions, or other amounts paid. This includes the amounts the employer contributed that were taxable when paid. Cost does not include any amounts deducted or were excluded from the taxpayer s income. 4. C - Before age 59 1/2 distributions from an IRA are taxable as ordinary income and subject to a 10% penalty for early withdrawal. (Pub17, page 81) 5. A - When a taxpayer is age 70 ½ distributions from non-roth IRA s are required to begin is a true statement. (Pub17, page 81) 6. A - A rollover is taking receipt of assets for up to 60 days before reinvesting in a new retirement plan is a true statement. (Pub17, page 80) 7. A- Form 8606 will be used to report a conversion from a traditional IRA to a Roth IRA.. (Pub17, page 81) 8. C - A transfer is moving the assets directly from one custodian to another. (Pub17, page 79, 80, 81) 9. A - A Roth IRA can be rolled over to another Roth IRA but cannot be rolled over to a traditional IRA is a true statement. (Pub17, page 78) 10. At age 59 1/2 a taxpayer must begin Required Minimum Distributions from a Non-Roth IRA s? (Pub17, page 82) 11. B - For rollovers from qualified retirement plans to a Roth IRA in 2010, any amounts that are required to be included in income must be in income in 2010 is false, see the excerpt. (Pub17, page 81) 114

121 IRA s and Pension Plans 12. D - The following are exceptions to the additional tax on Form 5329: IRA distributions made for higher education Distribution due to death Distribution due to total and permanent disability IRA distributions made for purchase of a second home is not an exception. (Form 5329, instructions) 115

122 Miscellaneous Income Chapter 11 - Unemployment Compensation, Social Security Benefits and Miscellaneous Income Unemployment Compensation The taxpayer must include in income all unemployment compensation received. The taxpayer should receive a Form 1099-G showing in box 1 the total unemployment compensation paid. Generally, enter unemployment compensation on line 19 of Form 1040, line 13 of Form 1040A, or line 3 of Form 1040EZ. Types of unemployment compensation. Unemployment compensation generally includes any amount received under an unemployment compensation law of the United States or of a state. It includes the following benefits: Benefits paid by a state or the District of Columbia from the Federal Unemployment Trust Fund. State unemployment insurance benefits. Railroad unemployment compensation benefits. Disability payments from a government program paid as a substitute for unemployment compensation. (Amounts received as workers' compensation for injuries or illness are not unemployment compensation Trade readjustment allowances under the Trade Act of Unemployment assistance under the Disaster Relief and Emergency Assistance Act. Governmental program. If the taxpayer contributes to a governmental unemployment compensation program and the contributions are not deductible, amounts they receive under the program are not included as unemployment compensation until they recover those contributions. If the taxpayer deducted all of the contributions to the program, the entire amount received under the program is included in income. Tax withholding. The taxpayer can choose to have federal income tax withheld from unemployment compensation. To make this choice the taxpayer completes Form W-4V, Voluntary Withholding Request. 116

123 Miscellaneous Income Social Security Benefits Social Security benefits may be taxable. To find out whether any of the Social Security Benefits received are taxable compare one-half of the benefits plus all other income including taxexempt with the base amount. The base amount is $25,000 if single, head of household or qualifying widow(er) $25,000 if married filing separately and lived apart from the spouse for the tax year $32,000 if married filing jointly, or -0- if married filing separately and lived with the spouse at any time during the year If one-half of the benefits plus all other income is less than the base amount none of the social security benefits are taxable. If one-half of the benefits plus all other income is more than the base amount some of the social security benefits are taxable. The total amount of social security benefits are reported on Line 20A of Form 1040 and the taxable amount is reported on Line 20b. The following is an example of the worksheet figuring taxable Social Security from Pub 17. George White is single and files Form 1040 for He received the following income in 2010: Fully taxable pension $18,600 Wages from part-time job 9,400 Taxable interest income 990 Total $28,990 George also received social security benefits during The Form SSA-1099 he received in January 2011 shows $5,980 in box 5. To figure his taxable benefits, George completes the worksheet shown here. 117

124 Miscellaneous Income Worksheet 1. Figuring Your Taxable Benefits 1. Enter the total amount from box 5 of ALL your Forms SSA-1099 and RRB Also enter this amount on Form 1040, line 20a, or Form 1040A, line 14a $5, Enter one-half of line 1 2, Combine the amounts from: Form 1040: Lines 7, 8a, 9a, 10 through 14, 15b, 16b, 17 through 19, and 21. Form 1040A: Lines 7, 8a, 9a, 10, 11b, 12b, and 13 28, Enter the amount, if any, from Form 1040 or 1040A, line 8b -0- Enter the total of any exclusions/adjustments for: Adoption benefits (Form 8839, line 26), Foreign earned income or housing (Form 2555, lines 45 and 50, or Form EZ, line 18), and Certain income of bona fide residents of American Samoa (Form 4563, line 15) or Puerto Rico Combine lines 2, 3, 4, and 5 31,980 Form 1040 filers: Enter the amount from Form 1040, lines 23 through 32, and 7. any write-in adjustments you entered on the dotted line next to line 36. Form 1040A filers: Enter the amount from Form 1040A, lines 16 and Is the amount on line 7 less than the amount on line 6? No. None of your social security benefits are taxable. Enter -0- on Form 1040, line 20b, or Form 1040A, line 14b. Yes. Subtract line 7 from line 6 31, If you are: Married filing jointly, enter $32,000 Single, head of household, qualifying widow(er), or married filing separately and you lived apart from your spouse for all of 2010, enter $25,000 25,000 Note. If you are married filing separately and you lived with your spouse at any time in 2010, skip lines 9 through 16; multiply line 8 by 85% (.85) and enter the result on line 17. Then go to line Is the amount on line 9 less than the amount on line 8? No. None of your benefits are taxable. Enter -0- on Form 1040, line 20b, or on Form 1040A, line 14b. If you are married filing separately and you lived apart from your spouse for all of 2010, be sure you entered D to the right of the word benefits on Form 1040, line 20a, or on Form 1040A, line 14a. Yes. Subtract line 9 from line 8 6, Enter $12,000 if married filing jointly; $9,000 if single, head of household, qualifying widow(er), or married filing separately and you lived apart from your spouse for all of , Subtract line 11 from line 10. If zero or less, enter

125 Miscellaneous Income 13. Enter the smaller of line 10 or line 11 6, Enter one-half of line 13 3, Enter the smaller of line 2 or line 14 2, Multiply line 12 by 85% (.85). If line 12 is zero, enter Add lines 15 and 16 2, Multiply line 1 by 85% (.85) 5, Taxable benefits. Enter the smaller of line 17 or line 18. Also enter this amount on Form 1040, line 20b, or Form 1040A, line 14b $2,990 The amount on line 19 of George's worksheet shows that $2,990 of his social security benefits is taxable. On line 20a of his Form 1040, George enters his net benefits of $5,980. On line 20b, he enters his taxable benefits of $2,990. A worker is eligible for early retirement benefits at age (62). Early retirement reduces the amount of benefits. If a worker starts collecting unemployment benefits at 62, the benefits will be reduced by 25%. The following is a chart from the Social Security Administration: Year of Birth* Full Retirement Age 1937 or earlier and 2 months and 4 months and 6 months and 8 months and 10 months and 2 months and 4 months and 6 months and 8 months and 10 months 1960 and later 67 *If you were born on January 1st of any year you should refer to the previous year. Refer to Pub 915 for additional information. 119

126 Miscellaneous Income Early retirement permanently reduces the amount of benefits. If receiving early retirement benefits there is an earnings limit on receiving benefits. For 2010 the earnings limit is $14,160, benefits are reduced by $1 for each $2 earned. Delayed retirement is available for a worker over the full retirement age. At age 70 the worker automatically starts receiving benefits. Benefits are increased by a monthly percentage if the worker delays retirement. If a taxpayer, spouse or dependent does not have a Social Security Number refer to the Social Security Administration website at or phone to apply. (Refer to Pub 517) This section left purposely blank. 120

127 Miscellaneous Income Miscellaneous Income Line 21 Form

128 Miscellaneous Income Foreign Earned Income Exclusion Form 2555-EZ U.S. Citizens and resident aliens are subject to U.S. income tax on their worldwide income. It does not matter where they live or if the income is taxed by the country in which it was earned. Refer to Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad for additional information. Foreign income retains its character and is reported on the applicable line for Form For example, foreign wages are included on Line 7, Form The maximum Foreign Earned Income Exclusion is $91,500 for The taxpayer can file Form 2555-EZ to claim the foreign warned income exclusion if they meet all the following requirements, otherwise they must use Form The taxpayer is a U.S. citizen or resident alien. The total foreign earned income for the year is $91,500 The taxpayer has earned wages/salaries in a foreign country The taxpayer is filing a calendar year return There is no self-employment income in the year The taxpayer is not claiming a housing allowance The taxpayer qualifies for the tax benefits available to taxpayers who have foreign earned income if both of the following apply. They meet the tax home test You meet either the bona fide residence test or the physical presence test. Tax home test. To meet this test, your tax home must be in a foreign country, or countries, throughout your period of bona fide residence or physical presence, whichever applies. For this purpose, your period of physical presence is the 330 full days during which you were present in a foreign country, not the 12 consecutive months during which those days occurred. The tax home is the regular or principal place of business, employment, or post of duty, regardless of where they maintain their family residence. If the taxpayer does not have a regular or principal place of business because of the nature of the trade or business, the tax home is the regular place where the taxpayer lives regularly. They are not considered to have a tax home in a foreign country for any period during which your abode is in the United States. However, if they are temporarily present in the United States, or maintain a dwelling in the United States (whether or not that dwelling is used by the spouse and dependents), it does not necessarily mean that their abode is in the United States during that time. Bona Fide Residence Test The taxpayer must meet one of the following: A U.S. citizen who is a bona fide resident of a foreign country, or countries, for an uninterrupted period that includes an entire tax year (January 1 December 31, if filing a calendar year return), or 122

129 Miscellaneous Income A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country, or countries, for an uninterrupted period that includes an entire tax year (January 1 December 31, if calendar year return). See Pub. 901, U.S. Tax Treaties, for a list of countries with which the United States has an income tax treaty in effect. Whether the taxpayer is a bona fide resident of a foreign country depends on the intention about the length and nature of the stay. See Pub. 54 for more information and examples. Physical Presence Test To meet this test, the taxpayer must be a U.S. citizen or resident alien who is physically present in a foreign country, or countries, for at least 330 full days during any period of 12 months in a row. A full day means the 24-hour period that starts at midnight. The amount of the exclusion is reported on Line 21 of Form For additional information, see Form 2555 instructions or Pub 54. Cancelled Debt Debt includes any indebtedness: For which the borrower is liable Subject to which the borrower holds property Recourse debt is debt in which the borrower is personally liable for the repayment of the debt. Cancelled recourse debt must be included in the taxpayer s income as ordinary income. However, they may be eligible to exclude all or part of the cancelled debt from income. Non-recourse debt is debt that the borrower is not personally liable for. This means that if non-recourse debt is cancelled, the property securing the debt is the lenders only claim. Foreclosure and repossession occurs when the borrower does not make the payments they owe on a loan and the lender forecloses or repossesses the property securing the loan. Abandonment of a property is when a person voluntarily and permanently gives up possession of the property with the intention of ending their ownership of the property. Report taxable nonbusiness cancelled debt as ordinary income, on Line 21 of Form

130 Miscellaneous Income Form 1099-C Cancellation of Debt Excerpt from Pub Box 3 Interest if Included in Box 2 Any interest portion of the debt cancelled that is included in box 2 will be shown in box 3. If the interest shown in box 3 would be deductible, subtract the amount in box 3 from the amount in box 2 to determine the taxable amount of debt cancelled. Discounts and Loan Modifications A lender may offer a discount that would reduce the principal balance of a loan if paid off early; or a lender may agree to a loan modification which includes a reduction of the principal balance of a loan. The amount of the discount or the amount of the principle reduction is cancelled debt whether or not the taxpayer is personally liable for the debt. If the loan is a nonrecourse loan and the taxpayer did not retain the collateral, the taxpayer does not have cancellation of debt income. Foreclosures and Repossessions Recourse Debt - The foreclosure or repossession of property where the taxpayer is personally liable for the debt is treated as a sale or disposition of the property by the taxpayer if the amount owed on the loan exceeds the FMV of the property. Ordinary income may result if the lender forgives part or all of the excess of the loan. The excess of the loan is the balance of the loan minus the FMV of the property. The gain or loss of the disposition of the property is figured by using the FMV as the amount realized. 124

131 Miscellaneous Income Nonrecourse Debt The foreclosure or repossession of property that the taxpayer is not personally liable for the debt will not result in ordinary income. The taxpayer may have a gain or loss from the transaction. The realized amount is the larger of the principal amount of debt or the FMV of the property. Cancellation of debt income usually will not result if the debt is cancelled or forgiven as a gift. Deductible Debt is not included in cancelled debt income if the taxpayer is using the cash method of accounting and the cancelled debt would have been a deductible business expense. If the taxpayer is using the accrual method of accounting, the cancelled debt must be included in ordinary income because the expense was deductible when the taxpayer incurred the debt. Price reduced after purchase (IRS Pub. 4681). If debt the taxpayer owes the seller for the purchase of property is reduced by the seller at a time the taxpayer is not insolvent and the reduction does not occur in a title 11 bankruptcy, the reduction does not result in cancellation of debt income. However the taxpayer must reduce their basis in the property by the amount of the reduction of their debt to the seller. Exclusions After applying any exceptions above, the following are reasons that the taxpayer may not have to include cancelled debt in their income: Bankruptcy Debt cancelled in a title 11 bankruptcy case is not included in the taxpayer s income. This includes all chapters in title 11. Insolvency The taxpayer was insolvent immediately before the cancellation to the extent that the total of the taxpayer s liabilities was more than the FMV of all of their assets immediately before the cancellation. To determine insolvency, the taxpayer must include in assets the value of everything they own including assets that serve as collateral for debt and exempt assets which are beyond the reach of their creditors under the law such as the taxpayer s interest in a pension plan and the value of the taxpayers retirement account. Liabilities include the following (IRS Pub 4681): The entire amount of recourse debts, The amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt, and The amount of nonrecourse debt in excess of the FMV of the property subject to the nonrecourse debt to the extent nonrecourse debt in excess of the FMV of the property subject to the debt is forgiven. This exclusion does not apply to a cancellation of debt that occurs in a title 11 bankruptcy. 125

132 Miscellaneous Income Student Loans Excerpt IRS Pub Education loan repayments made to the taxpayer by the National Health Service Corps Loan Repayment Program or a state education loan repayment program eligible for funds under the Public Health Service Act are not taxable if the recipient of the repayment agrees to provide primary health services in health professional shortage areas. Amounts received after 2008 under any other state loan repayment or loan forgiveness program also are not taxable if the program is intended to increase the availability of health care services in underserved areas or areas with a shortage of health professionals (IRS Pub. 4681). Qualified Principal Residence Indebtedness is a mortgage the taxpayer took out to buy, build, or substantially improve their main home. This also includes if the taxpayer refinances their mortgage to buy, build, or substantially improve their main home, but only up to the amount of the old mortgage principal just before the refinancing. The taxpayer s main home is the home they ordinarily live in most of the time. They can have only one main home at a time. This provision applies to debt forgiven in calendar years 2007 through 2012.The exclusion limit for this exclusion is $2 million ($1 million if married filing separately). In order to use this exclusion the reason for the cancellation must be directly related to the decline in the home value or to the taxpayer s financial situation. The taxpayer cannot use this exclusion if the cancellation was for services performed for the lender. 126

133 Miscellaneous Income The taxpayer must apply the Discharge of Indebtedness in Title 11 Case exclusion instead of the Qualified Principal Residence Indebtedness exclusion if the qualified principal residence debt is cancelled in a title 11 bankruptcy case. If the taxpayer was insolvent immediately before the cancellation the taxpayer may elect to use the discharge of indebtedness to the extent insolvent exclusion instead of applying the qualified principal residence indebtedness exclusion. If only part of the cancellation is qualified principal residence debt, the remaining part may qualify for one of the other exclusions. Excerpt: IRS Pub

134 Miscellaneous Income Chapter 11 - Sample Questions 1. Taxable and nontaxable income is reported on Line 21 of Form A. True B. False 2. Which of the following is a true statement regarding unemployment compensation? A. Reported to the taxpayer on Form 1099-G and is not taxable. B. Reported to the taxpayer on Form 9910-G and is taxable. C. Reported to the taxpayer on Form 1099-G and is taxable. D. Unemployment compensation is never taxable. 3. All of the following is true regarding Social Security, except: A. Delayed retirement is available for a worker over the full retirement age. B. For a person born in 1937 the full retirement age is 65. C. At age 70 a worker loses social security benefits D. There is an earnings limit if a worker chooses early retirement. 4. A worker is eligible for early retirement benefits at: A. Age 59 1/2 B. Age 62 C. Age 63 D. Age plus all other income including tax exempt income is compared to the base amount to determine whether any Social Security benefits are taxable: A. Interest B. One-half Social Security Benefits C. Wages D. Dividends 6. For 2010 the earnings limit is $14,160 if a taxpayer starts to draw social security benefits at 62 years of age, these benefits are reduced by $1 for each $2 earned. A. True B. False 7. Hobby income is: A. Income that must be reported and accurate records must be kept B. Expenses are allowed up to the amount of income C. Not for profit income D. All of the above 128

135 Miscellaneous Income 8. Which of the following items is generally not taxable? A. Prizes and awards B. Jury duty C. Illegal income D. Foster care provider payments 9. The amount of a loan which the taxpayer is personally liable exceeds the FMV of the property. This is the definition of which of the following? A. Recourse Debt B. Nonrecourse debt C. Both A and B D. Neither A or B 10. Education loan repayments made to the taxpayer by the National Health Service Corps Loan Repayment Program or a state education loan repayment program eligible for funds under the Public Health Service Act are not taxable if the recipient of the repayment agrees to provide primary health services in health professional shortage areas: A. True B. False 129

136 Miscellaneous Income Chapter 11 Answers to Sample Questions 1. B- Taxable and nontaxable income is reported on Line 21 of Form 1040 is a false statement, only taxable income is reported on Line 21. (Form 1040, Line 21 instructions) 2. C - (Pub 17, page 89) 3. C- All of the following is true regarding Social Security Benefits: Delayed retirement is available for a worker over the full retirement age. For a person born in 1937 the full retirement age is 65. At age 70 the worker automatically starts receiving Social Security Benefits, the benefits are increased by a monthly percentage if retirement is delayed. There is an earnings limit if a worker chooses early retirement. ( 4. B - A worker is eligible for early retirement benefits at age 62. ( 5. B One-half Social Security Benefits plus all other income including tax exempt income is compared to the base amount to determine whether any Social Security benefits are taxable.(pub 17, pg 85) 6. A - For 2010 the earnings limit is $14,160 if a taxpayer starts to draw social security benefits at 62 years of age, these benefits are reduced by $1 for each $2 earned is a true statement. ( 7. D - Hobby income is: (Pub 17, pg 93) Income that must be reported and accurate records must be kept Expenses are allowed up to the amount of income Not for profit income 130

137 Miscellaneous Income shortage areas is a true statement. (Pub 17, Pg 88) 8. D- Foster care provider payments are generally not taxable. (Pub 17, pg 94) 9. A - The amount owed on a loan which the taxpayer is personally liable for exceeds the FMV of the property is a recourse debt (Pub 17, pg 85). 10. A - Education loan repayments made to the taxpayer by the National Health Service Corps Loan Repayment Program or a state education loan repayment program eligible for funds under the Public Health Service Act are not taxable if the recipient of the repayment agrees to provide primary health services in health professional 131

138 Adjustment to Income Chapter 12- Adjustments to Income If the taxpayer is an eligible educator, they can deduct up to $250 ($500 if married filing joint and both spouses are educators, but not more than $250 each) of any unreimbursed expenses [otherwise deductible as a trade or business expense] paid or incurred for books, supplies, computer equipment (including related software and services), other equipment, and supplementary materials that you use in the classroom. For courses in health and physical education, expenses for supplies are qualified expenses only if they are related to athletics. This deduction is for expenses paid or incurred during the tax year. The deduction is claimed on either line 23 of Form 1040 or line 16 of Form 1040A. If the taxpayer is an eligible teacher, instructor, counselor, principal or aide who worked at least 900 hours a school year in a school that provides elementary or secondary education (K-12), as determined under state law. Form 1040, line 24 is where an adjustment for certain business expenses of reservists, performing artists and fee-based government officials are reported. Reservists have now been added to the special rules allowing an adjustment for these expenses rather than an itemized deduction like other employee business expenses. These adjustments are computed on Form 2106, like other business expenses. (Refer to Pub 463 for more information.) The adjustment coming from Form 2106 for reservists, performing artists and fee-based government employees is claimed on Form 1040, line

139 Adjustment to Income Health Savings Account A health savings account (HSA) is a tax-exempt trust or custodial account that is set up with a U.S. financial institution (such as a bank or an insurance company). Health Savings Accounts are designed to allow the taxpayer to save for current and post-retirement qualified medical expenses on a tax free basis. This account must be used in conjunction with a high deductible health plan (HDHP). The adjustment for health savings account is claimed on Form 1040, line 25. To be eligible to have contributions made to an HSA, the taxpayer must be covered under HDHP and have no other health coverage except permitted coverage. Anyone can contribute to an eligible individual s HSA. However, the taxpayer cannot be enrolled in Medicare or be claimed as a dependent on another person's tax return. The taxpayer be, or be considered, an eligible individual on the first day of a month to take an HSA deduction for that month. The HSA can be established using a qualified trustee or custodian that is different from the HDHP provider. Contributions to an HSA must be made in cash or through a cafeteria plan. Contributions of stock or property are not allowed. Benefits of an HSA: The HSA is tax deductible even if the taxpayer is not itemizing Contributions made by the employer (including contributions through a cafeteria plan) may be excluded from gross income The contributions remain in the account from year to year until used The interest or other earnings on the assets in the account are tax free Distributions are tax free if used for qualified expenses (See Schedule A medical and dental expenses) An HSA is portable and stays with the taxpayer. Contributions to an HSA are generally limited to the maximum allowable deduction for the year or the HDHP annual deductible. Individuals age 55 or over are allowed catch up contributions. Form 8889 is used to: Report health savings account (HSA) contributions (including those made on the taxpayer s behalf and employer contributions), Figure the HSA deduction, Report distributions from HSAs, and Figure amounts the taxpayer must include in income and additional tax they may owe if they fail to be an eligible individual. Moving expenses are reported on Form Moving costs are allowed for moving household goods and personal effects and travel expenses for one trip for the taxpayer and each member of the household. Household members do not have to travel together or at the same time. The standard mileage rate for moving expenses for 2010 is 16.5 cents per mile. The adjustment for moving expenses is claimed on Form 1040, line

140 Adjustment to Income To file Form 3903 the taxpayer must meet the following general rules: The taxpayer must move within the U.S. or be an U.S. citizen The distance test is met if the new place of work is at least 50 miles farther from the former home than the old main job location was The employee must work at the new job for at least 39 weeks to qualify, for married filing joint returns only one spouse needs to work If there is any self-employment income compute Schedule SE first and then deduct ½ of the selfemployment tax on line 27. The following is a chart from Pub 560 regarding retirement plans which are reported on line 28 of Form A self-employed health insurance deduction is deductible if the taxpayer was self-employed and had a net profit or the taxpayer received wages from an S-corporation in which the taxpayer was a 2% shareholder. The insurance plan must be established under the business and there must be net profit equal to or more than the self-employed health insurance premiums. (Refer to Pub 535). The adjustment for self-employed health insurance is claimed on Form 1040, line

141 Adjustment to Income In 2010, eligible self-employed individuals can use the self-employed health insurance deduction to reduce their social security self-employment tax liability in addition to their income tax liability. As in the past, eligible taxpayers claim this deduction on Form 1040 Line 29. But in 2010, eligible taxpayers can also enter this amount on Schedule SE Line 3, thus reducing net earnings from self-employment subject to the 15.3 percent social security self-employment tax. Premiums paid for health insurance covering the taxpayer, spouse and dependents generally qualify for this deduction. Premiums paid for coverage of an adult child under age 27 at the end of the year, for the time period beginning on or after March 30, 2010, also qualify for this deduction, even if the child is not the taxpayer s dependent. As in previous years, the insurance plan must be set up under the taxpayer s business, and the taxpayer cannot be eligible to participate in an employer-sponsored health plan. Details, including a worksheet, are in the instructions to Form Enter the penalty on early withdrawal from savings or certificate reported on Form 1099-INT or 1099-OID. This amount does not get deducted from taxable interest. The adjustment for penalty on early withdrawal is claimed on Form 1040, line 30. Alimony Paid Alimony is a payment to or for a spouse or former spouse under a divorce or separation instrument. It does not include voluntary payments not in the decree. Alimony is deductible by the payer and must be included in income by the payee. Payments not alimony: 1. Child Support 2. Noncash property settlement 3. Payments that are the spouses part of community property 4. Payment s to keep up the payer s property 5. Use of property Payments included as alimony Payments to a third party Life insurance premium Payments for a jointly-owned home Mortgage payments Taxes and Licenses Only the taxpayers share (1/2) of payments for a jointly owned home, mortgage interest and taxes and licenses can be deducted as alimony. The spouse s Social Security Number must be provided; there may be a $50 penalty and the deduction may be disallowed. The adjustment for alimony paid is claimed on Form 1040, line 31. (Refer to Pub 504) 135

142 Adjustment to Income Individual Retirement Arrangement A traditional IRA is any IRA that is not a Roth IRA or a SIMPLE IRA. Two advantages to a traditional IRA are: Some or all of the contribution may be deducted and Generally, amounts in the IRA are not taxed until they are distributed. IRA Contributions are reported on Line 32, Form Qualifications for a traditional IRA include: Must not be over 70 ½ by the end of the tax year Must have earned income (if married filing jointly a spouse can make contributions based on the other spouse s earned income - Spousal IRA) No gross income limitations for individuals who are not participating in a qualified plan If taxpayer is in a qualified plan (active participant in an employer retirement plan), contribution is subject to phase out of modified adjusted gross income see the excerpt from Pub 590. All distributions are taxable 136

143 Adjustment to Income Qualifications for a Spousal IRA include: The spouse must not be over 70½ by the end of the tax year Must have earned income (spouse can make contributions based on the taxpayers income) No gross income limitations for individuals who are not participating in a qualified plan If working spouse is in a qualified plan (active participant in an employer retirement plan), the non-working spouse s contribution is subject to phase out rules AGI between $167,000 and $176,000 in 2010; All distributions are taxable 137

144 Adjustment to Income IRA Deductions Excerpt from Pub 17 Nondeductible IRA Contributions Form 8606 Although deductions for traditional IRA contributions may be reduced or eliminated, contributions can be made to an IRA up to the general limit or if it applies the spousal IRA limit. The difference between the total permitted contribution and the IRA deduction, if any, is the nondeductible IRA contribution. To designate contributions as nondeductible the taxpayer must file Form Pub 17 excerpt The earnings of a nondeductible IRA are taxed when distributed. If the taxpayer contributes to a nondeductible IRA, the cost basis of the traditional IRA is the sum of the nondeductible contributions minus any withdrawals or distributions of nondeductible contributions. 138

145 Adjustment to Income A Roth IRA is an individual retirement arrangement that except as explained in this chapter is subject to the rules that apply to a traditional IRA with exception of the 70½ age rule for required distribution. The age rule does not apply to Roth IRA s. The IRA can be either an account or annuity. Roth IRAs can be set up anytime during the year, generally the taxpayer can contribute to a Roth IRA if they have compensation during the year. Refer to the AGI limitations in the excerpt from Pub 590. Excerpt from Pub 590 Roth IRA s are not deductible. Distributions from Traditional IRA s are taxable upon distribution, with Roth IRA s only the interest earned is taxable. Roth IRA can convert to a traditional IRA, but is taxable upon conversion as ordinary income. After conversion all traditional IRA rules apply (Refer to Pub 590). Student Loan Interest is deductible (up to $2,500) if the taxpayer meets the following restrictions: The taxpayer cannot be a dependent on another return Not available for married filing separate taxpayers The taxpayer must have the primary obligation to repay the loan Interest on a loan from a related party does not qualify Loans made under a qualified employer plan do not qualify for the deduction The deduction is phased out for 2010 when modified AGI is $60,000 to $75,000 ($120,000 to $150,000 MFJ) Qualified loans are loans for tuition, fees, room and board, books, equipment and transportation paid for attendance at an eligible institution. The adjustment for student loan interest is be claimed on Form 1040, line 33. Form 1098-E is sent to the taxpayer by the lender if student loan interest more than $600 was paid during the year. 139

146 Adjustment to Income Tuition and fees deduction can be taken if all of the following apply: Qualified tuition and fees were paid for the taxpayer, spouse or dependent The filing status on the return is any filing status other that married filing separately The modified adjusted gross income is not more than $80,000 for single, head of household, qualifying widow(er); $160,000 if married filing joint The taxpayer cannot be claimed as a dependent on another return There cannot be an education credit for the same return The taxpayer must be a U.S. citizen Form 8917 is used to compute the allowable deduction and reported on Form 1040, Line 35. Form 1098-T is issued by the financial institution each year showing the amount of tuition paid. The following is an excerpt from the instructions for the financial institution: Qualified tuition and fees must be reduced by the following: Excludable U.S. series EE bonds Nontaxable qualified state tuition programs Nontaxable earnings from education savings account Any scholarship, educational assistance or other payment Taxpayers must file Form 1040 to take this deduction for up to $4,000 of tuition and fees paid to a post-secondary institution. It cannot be claimed on Form 1040A. The adjustment for tuition and fees is claimed on Form 1040, line 34 Enter any other miscellaneous deductions and identify each deduction on the dotted line on line 36. Some of these deductions are: Jury Duty Pay (if pay turned over to employer) Deductible expenses related to income reported on line 21 from rental of personal property engaged in for profit. Identify as PPR Reforestation amortization. Identify as RFST Contributions to Section 501(c) (18)(d) pension plan. Identify as Section 501 (c)(18)(d) Contributions by certain chaplains to Section 403(b) plans. Identify as Section 403(b) plans 140

147 Adjustment to Income Chapter 12 - Sample Questions 1. An eligible educator can deduct as an adjustment to income rather than as an itemized deduction. A. Mileage to and from school B. All expenses having to do with education C. Up to $250 of qualified expenses D. All of the above 2. Reservists have been added to the special rules allowing an adjustment to income. A. True B. False 3. The Health Savings Account is designed to allow the taxpayer to save for current and post retirement on a tax free basis A. Qualified medical expenses B. Charitable contributions C. Health insurance premiums D. None of the above 4. A Health Savings Account (HSA) is set up with A. The employer B. The pharmacy C. A U.S. financial institution D. The health care provider 5. The 2010 standard mileage rate for moving expenses is A. 10 cents per mile B cents per mile C. 12½ cents per mile D. 22 cents per mile 6. When filing Form 3903, the taxpayer must meet some general rules. Which rule is correct? A. The taxpayer may move outside the U.S if they are a U.S. citizen B. The new job location is at least 50 miles farther from the former home than the old place of work C. The employee must work at the new job for at least 28 weeks. D. All of the above 7. One-half of Social Security wages are deductible from income A. True B. False 141

148 Adjustment to Income 8. Premiums paid for health insurance established under the taxpayer s business for a child who is 26 and not the taxpayer s dependent is eligible for the self-employed health insurance deduction. A. True B. False 9. Which does not qualify as alimony? A. Child support B. Payments to keep up the payer s property C. Use of property D. All of the above 10. Deductible traditional IRA contributions for 2010 are A. The lesser of $5,000 or taxable compensation B. The lesser $6,000 if age 50 or older or taxable compensation C. Both A and B above D. Neither A or B 11. Qualifications for a traditional IRA include A. Must be at least 55 years old B. Must not be over 65 years old C. Must not be over 70½ years old by the end of the tax year D. Must not be over 70½ years old by the filing due date IRA contributions are subject to phase out rules if the taxpayer is in a qualified plan A. Phase out is between $89,000 and $109,000 for MFJ B. Phase out is between $56,000 and $66,000 for Head of Household C. Phase out is between $0 and $10,000 for married filing separate D. All of the above are true 13. Tuition and fees deduction cannot be taken if A. Filing status is Head of Household B. Modified AGI is $65,000 or less C. There is an education credit for the same return D. The qualified tuition and fees were paid for the taxpayer, spouse, or dependent 14. Jury Duty pay is a miscellaneous deduction for line 36 of Form 1040 if turned over to employer A. True B. False 142

149 Adjustment to Income Chapter 12 Answers to Sample Questions 1. C - An eligible educator can deduct up to $250 of qualified expenses as an adjustment to income rather than as an itemized deduction.(pub 17, page 198) 2. A - Reservists have been added to the special rules allowing an adjustment to income is a true statement. (Pub 17, page 189) 3. A - The Health Savings Account is designed to allow the taxpayer to save for current and post retirement qualified medical expense on a tax free basis. (Pub 17, page 49) 4. C - A Health Savings Account (HSA) is set up with a U.S. financial institution. (Pub 17, page 49 Refer to Pub 590) 5. B - The 2010 standard mileage rate for moving expenses is 16.5 cent per mile. (Pub 17, page 3, Pub 521) 6. B - When filing Form 3903, the taxpayer must meet some general rules. The correct rule is the new job location is at least 50 miles farther from the former home than the old place of work. (Form 3903, instructions) 7. B - One-half of Social Security wages are deductible from income is false. One- half selfemployment tax is an adjustment to income. (Pub 17, page 149) 8. A - Premiums paid for health insurance established under the taxpayer s business for a child who is 26 and not the taxpayer s dependent is eligible for the self-employed health insurance deduction is a true statement. 9. Child Support does not qualify as alimony.. (Pub 17, page 135, Table 18.1) 143

150 Adjustment to Income 10. C - Deductible traditional IRA contributions for 2010 are the lesser of $5,000 or $6,000 if age 50 or older. (Pub 17, Chap 17, page 122) 11. C The taxpayer cannot be over 70½ years old by the end of the tax year to contribute to a traditional IRA. (Pub 17, Chap 17, page 122) 12. D IRA contributions are subject to the following phase out rules if the taxpayer is in a qualified plan. (Pub 17, Chap 17, page 122) Phase out is between $89,000 and $109,000 for MFJ Phase out is between $56,000 and $66,000 for Head of Household Phase out is between $0 and $10,000 for married filing separate 13. D - Tuition and fees deduction cannot be taken if there is an education credit for the same return. (Pub 17, page 136) 14. A - Jury Duty pay is a miscellaneous deduction for line 36 of Form 1040 if turned over to employer. (Pub 17, page 95) 144

151 Itemized Deductions Chapter 13 Itemized Deductions Standard Deduction vs. Itemized Deductions 145

152 Itemized Deductions Standard Deduction 2010 Age 65 or Older/Blind Single 5,700 1,400 Married Filing Joint or Qualified Widow(er) 11,400 1,100 Head of Household 8,350 1,400 Married Filing Separate 5,700 1,100 Enter the greater of itemized deductions or the standard deduction on Line 40 of Form Refer to Chapter 2 of this text for additional information and worksheets regarding the Standard Deduction. Itemized Deductions Medical and Dental Expenses The part of medical and dental expenses that exceeds 7.5% can be deducted to the extent they were not reimbursed. The following chart is from Pub 17: 146

153 Itemized Deductions The taxpayer can generally include medical expenses paid for themselves, as well as their spouse and dependent if they were their spouse or dependent at the time the services were provided or when the services were paid for. Insurance premiums paid for by the employer or with pretax dollars is not deductible Transportation costs primarily for and essential to the medical care of the taxpayer, spouse and dependent is deductible. If the actual expense of transportation is not used the standard mileage rate of 16.5 cents per mile plus tolls and parking can be deducted. below: Long-term care premiums under 213(d)(10) are includable as a medical deduction on Schedule A. These premiums are limited each year. The 2010 limits from Pub. 502 are amounts (based on the taxpayer s records); or Predetermined deduction amounts from IRS tables. Taxes Individual taxpayers have the option of claiming deduction on Schedule A for either (1) general sales and local sales taxes; or (2) state and local income taxes. Sales taxes can be deducted either as Actual sales tax Refer to Form 1040, Schedule A Instructions, Pages A-3 and A-4; the IRS also has a sales tax calculator on the IRS website State and local income taxes that may be deducted include the following: State and local income taxes withheld on Forms W-2 s or 1099 s State and local income taxes paid for a prior year State and local estimated tax payments made in the taxable year State and local tax refunds applied to the current year tax Mandatory contributions to State Disability Insurance (SDI) or Supplemental Workmen s Compensation Fund 147

154 Itemized Deductions Refer to Pub 17, page 147 for additional information and references on taxes. Real Estate Taxes Deductible real estate taxes are any state, local or foreign taxes on real property levied for the general public welfare. The taxes must be based on the assessed value of the real property and charged uniformly against all property under the jurisdiction of the taxing authority. Personal Property Tax Deductible real estate taxes generally do not include taxes charged for local benefits and improvements that increase the value of the property. Interest Home mortgage interest is any loan that is secured by the main home or second home. It includes first and second mortgages, home equity lines and refinancing mortgages.. Home mortgage interest is generally reported on Form Qualified residence interest is interest paid on a loan secured by the taxpayer s main home or a second home. The main home is where the taxpayer lives most of the time. It can be a house, cooperative apartment, condominium, mobile home, house trailer, or houseboat that has sleeping, cooking and toilet facilities. Defined by IRS Topic

155 Itemized Deductions Refer to Pub 17, page 151 for references and additional information. Points or loan origination fees and mortgage interest are reported to the taxpayer on Form If the recipient is an individual, the taxpayer must include the recipient s Social Security Number. If points are reported on settlement papers rather than on Form 1098, report the points on Line 12 of Schedule A. Points are fully deductible in the year paid if identified clearly on the settlement papers and are a percentage of the principal amount. 149

156 Itemized Deductions Generally, if points are charged when refinancing they are deductible over the life of the loan with the remaining portion deductible when the mortgage is paid off. 150

157 Itemized Deductions Mortgage Insurance Premiums Mortgage insurance premiums paid or accrued in 2010 in connection with acquisition indebtedness on a taxpayer s primary or second home are deductible as personal interest. Mortgage insurance premiums are reported on Form The deduction is not available for taxpayers with an adjusted gross income is more than $109,000 ($54,500 if married filing separately) Form 1098 The statement will show the total mortgage interest paid during the year, any mortgage insurance premiums paid, and if a new home was purchased it will show deductible points. Investment Interest Investment interest is interest paid by the taxpayer on money borrowed that is allocable to property held for investment. It does not include any interest allocable to passive activities or to securities that generate tax-exempt interest income. Investment interest is reported on Form 4952 and carried to Schedule A. Refer to Part II of this syllabus for additional information regarding Form Gifts to Charity Contributions may be in cash (keep canceled checks, receipts or other reliable documentation). Out of pocket expenses incurred when doing volunteer work for a charitable organization is deductible. If the taxpayer drove to and from volunteer work, they may deduct either 14 cents per mile or the actual cost of gas and oil. Parking and tolls are also included. 151

158 Itemized Deductions Gifts that include a benefit to the taxpayer are deductible only to the extent of the donation. For example the taxpayer paid $70 for a charitable dinner; the dinner was valued at $40. The deductible portion of the $70 is $30. Gifts of $250 or more are deductible only if there is a statement issued by the charitable institution indicating the amount of the gift and whether the organization did or did not give any goods or services in return for the donation. In computing whether a charitable donation is over $250 treats each donation separately. For example, if the taxpayer gives a church $25 a week totaling $1,300 treat each $25 as a separate gift. (Refer to Pub 526) Limits on charitable Contributions apply when the contributions exceed 50% of the adjusted gross income. Charitable organizations classified as 50% organizations are most of the common charitable organizations such as churches, religious organization hospitals, medical research, schools etc. A reduced limit of 30% (capital gain property and any organization not listed as a 50% organization such as veteran s organizations) and 20% (capital gain property donated to an organization that is not a 50% organization). If a charitable donation exceeds the AGI limit in the current year the remaining portion must be carried over to each of the five subsequent years. Carryovers retain the original percentage limits and are deducted after deducting the contributions for the current year. Form 8283 Contributions of property to a qualified organization can qualify as a charitable contribution. The amount of the contribution is generally the fair market value which is what a willing buyer would pay a willing seller when neither has to buy or sell and both are aware of the condition of sale. (Refer to Pub 561). If the deduction is more than $500 the taxpayer is required to file form If the total deduction is over $5,000 appraisals on the value of the donation may be required. The following are excerpts from Pub

159 Itemized Deductions Eight Tips for Deducting Charitable Contributions The following article regarding charitable donations is IRS Tax Tip published by the IRS on March 22, 2011, these items are common discussions during yearly tax interviews. Charitable contributions made to qualified organizations may help lower the tax bill. The IRS has put together the following eight tips to help ensure taxpayer s contributions are deductible. 1. The taxpayer must be giving to a qualified organization. The taxpayer cannot deduct contributions made to specific individuals, political organizations and candidates. See IRS Publication 526, Charitable Contributions, for rules on what constitutes a qualified organization. 2. To deduct a charitable contribution, the taxpayer must file Form 1040 and itemize deductions on Schedule A. 3. Benefits received as a result of a charitable contribution such as merchandise, tickets to a ball game or other goods and services, and then only the amount that exceeds the fair market value of the benefit received can be deducted. 4. Donations of stock or other non-cash property are usually valued at the fair market value of the property. Clothing and household items must generally be in good used condition or better to be deductible. Special rules apply to vehicle donations. 5. Fair market value is generally the price at which property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the relevant facts. 6. Regardless of the amount, to deduct a contribution of cash, check, or other monetary gift, the taxpayer must maintain a bank record, payroll deduction records or a written communication from the organization containing the name of the organization, the date of the contribution and amount of the contribution. For text message donations, a telephone bill will meet the record-keeping requirement if it shows the name of the receiving organization, the date of the contribution, and the amount given. 7. To claim a deduction for contributions of cash or property equaling $250 or more the taxpayer must have a bank record, payroll deduction records or a written acknowledgment from the qualified organization showing the amount of the cash and a description of any property contributed, and whether the organization provided any goods or services in exchange for the gift. One document may satisfy both the written communication requirement for monetary gifts and the written acknowledgement requirement for all contributions of $

160 Itemized Deductions or more. If the total deduction for all noncash contributions for the year is over $500, the taxpayer must complete and attach IRS Form 8283, Noncash Charitable Contributions, to your return. 8. Taxpayers donating an item or a group of similar items valued at more than $5,000 must also complete Section B of Form 8283, which generally requires an appraisal by a qualified appraiser. Casualty and Theft Casualty or theft losses include losses caused by theft, vandalism, fire, storm or similar circumstances and car, boat or other accidents. Insurance reimbursements reduce the amount of loss. The standard deduction is no longer increased by the excess of the taxpayer s personal casualty loss. Complete and attach Form 4684 to report Casualty and Theft Losses. Refer to Part II of this syllabus for additional information regarding Form

161 Itemized Deductions Job Expenses and Other Miscellaneous Deductions Job expenses and other miscellaneous deductions must exceed 2% of the adjusted gross income. The following unreimbursed employee expenses may be deducted if they were paid or incurred during the tax year, for carrying on the trade or business of being an employee and the expenses were ordinary and necessary. Safety equipment Union dues Uniform required by employer Protective clothing Physical examinations required by employer Dues to professional organizations or chambers of commerce Legal fees related to the job Job search expenses Tools used for work Licenses and regulatory fees Malpractice Insurance premiums Medical examinations required by the employer Subscription to professional journals Fees to employment agencies when looking for a new job Certain business use of home Certain education expenses Unreimbursed employee business expenses include ordinary and necessary job expenses paid for by the taxpayer and not reimbursed. An ordinary expense is one common for the industry of employment of the taxpayer. If the taxpayer claims any travel, transportation, meal or entertainment expenses for the job or the employer paid for any job expenses Form 2106 is required. 155

162 Itemized Deductions Form Employee Business Expenses Refer to the instructions for Form 2106 EZ at the top of the Form. Refer to the discussion in Part II of Form 2106 for additional information. 156

163 Itemized Deductions The taxpayer cannot deduct ordinary expenses which are common and accepted for travel (including meals unless the standard meal allowance is used) entertainment, gifts, or use of the car or other listed property unless proper record keeping and journals of expenses are kept. Generally receipts are required for all lodging expenses (regardless of the amounts) and any other expense of $75 or more. Special rules apply for qualified performing artists, fee-basis state or local government employees or reservists. Officials paid on a fee basis. Certain fee-basis officials can claim their employee business expenses whether or not they itemize their other deductions on Schedule A (Form 1040). Feebasis officials are persons who are employed by a state or local government and who are paid in whole or in part on a fee basis. They can deduct their business expenses in performing services in that job as an adjustment to gross income rather than as a miscellaneous itemized deduction. Expenses of certain performing artists. If the taxpayer is a performing artist, they may qualify to deduct employee business expenses as an adjustment to gross income rather than as a miscellaneous itemized deduction. To qualify, all of the following requirements must be met. During the tax year, the taxpayer performs services in the performing arts as an employee for at least two employers The taxpayer receives at least $200 each from any two of these employers The related performing-arts business expenses are more than 10% of the gross income from the performance of those services The adjusted gross income is not more than $16,000 before deducting these business expenses Armed Forces reservists traveling more than 100 miles from home. If the taxpayer is a member of a reserve component of the Armed Forces of the United States and travels more than 100 miles away from home in connection with performance of services as a member of the reserves, the taxpayer can deduct travel expenses as an adjustment to gross income rather than as a miscellaneous itemized deduction. The amount of expenses which are deductible as an adjustment to gross income is limited to the regular federal per diem rate (for lodging, meals, and incidental expenses) and the standard mileage rate (for car expenses) plus any parking fees, ferry fees, and tolls Meals and entertainment are deductible if the meal or entertainment expense is directly related to or associated with the active conduct of a trade or business or for the production or collection of income. Meals with business partners are usually not deductible unless the taxpayer can establish a clear business purpose. Lavish and extravagant expenses are not allowed, the expenses must be reasonable according to the circumstances. The deduction for meals and entertainment is limited to 50% of the amounts that would otherwise be eligible. Taxes and tips, cover charges and parking are included in the 50% limit. The following items are not included in the 50% limit: 157

164 Itemized Deductions De minimis fringe benefits Expenses for meals and entertainment that are treated as taxable compensation to the employee and fully deductible by the employer Promotional activities made available by the taxpayer to the general public Employer-provided expenses for the benefit of employees that are not highly compensated, such as company picnics Meals and entertainment sold to customers such as a restaurant Business gifts made in the course of a taxpayer s trade or business are limited to $25 to any one individual per year. Exceptions to the $25 business gift rule includes items costing $4 or less containing and imprint; signs, displays, racks or other promotional items; incidental costs, such as engraving; awards of tangible property costing $400 or less given an employee for length of service. Travel away from the tax home expenses are 100% deductible if the taxpayer is away long enough that it cannot be reasonable to expect the taxpayer to complete the trip without sufficient sleep and rest. The tax home is determined by the taxpayer s business being in the same general vicinity of the main residence; the taxpayer incurs duplicate expenses while on business travel; and the taxpayer has not changed his/her historic place of main residence. Travel expenses include the following: Transportation Transportation to and from airports etc Baggage and shipping Car Lodging and meals (at 50%) Dry cleaning and laundry Telephone Tips Other similar, ordinary and necessary expense Expenses for temporary employment away from home are deductible, when the time of employment exceeds one year, it is considered permanent and is not deductible. Excess reimbursement to an employee must be included in income. Only the standard mileage rate can be used on Form 2106 EZ (Refer to Part II of this syllabus for information on actual vehicle expenses). Automobiles are listed property and are subject to rules under Internal Revenue Code Section 280(f). Regardless of which method the taxpayer uses to compute the automobile expenses the taxpayer must keep records of the following information: Total miles driven in the year Total business miles driven in the year The basis of the vehicle Date placed in service The standard mileage rate can be used for either a leased vehicle or an owned vehicle. If the 158

165 Itemized Deductions standard mileage rate is used for a leased vehicle, it must be used for the entire lease period. To compute the deductible expenses using the standard mileage rate multiply the SMR by the number of business miles driven during the tax year. Parking fees and tolls can be taken in addition to the standard mileage rate. The standard mileage rate for 2010 is 50 cents per mile. Recordkeeping Generally there must be documentary evidence to prove expenses, such as receipts, canceled checks, or bills to support the deduction. If there is an accountable plan through the employer evidentiary documentation is not required, or the expense, other than lodging, is less than $75 or a transportation expense where a receipt is not readily available. An accountable plan is an employer reimbursement plan for an employee s business expenses that are deductible to the employer and are not included in the employee s income. The employee must substantiate the expenses and return any excess reimbursements in a reasonable amount of time. Documentary evidence ordinarily will be considered adequate if it shows the amount, date, place and essential character of the expense. A canceled check together with a bill from the payee establishes cost. The records should be kept in a timely method and provide a written statement of the business purpose. Form 2106 or 2106 EZ is completed and the total of the expenses are reported on Schedule A line 21 subject to 2% of adjusted gross income. Excess reimbursements are included on Line 7 of Form Business expenses for self-employed persons are reported on Schedule C and reduce the amount of self-employment tax. The same limits apply for automobiles and other business expenses as employee business expenses. Qualifying work-related education can be deducted as a business expense. The education must meet at least one of the following two tests The education is required by the employer or the law to keep the taxpayer s present salary status 1. The required education must serve a bona fide business purpose of employment. 2. The education maintains or improves skills needed in the present work. Even if the education meets one or both of the above tests, it is not qualifying education if it: Is needed to meet the education requirements of the taxpayers present job Is part of a program of study that will qualify the taxpayer for a new trade or business? 159

166 Itemized Deductions Deductions Subject to 2% of Adjusted Gross Income Income that is used to produce or collect income that must be included in gross income, to manage conserve or maintain property held for the production of income or to determine contest, pay or claim a refund of any tax are reported on Line 22 of Schedule A. The following items are subject to the 2% of adjusted gross income limitation: Tax preparation fees Excess deductions of an estate Fees to collect interest and dividends Hobby expenses Indirect deductions of pass-through entities Investment fees and expenses Legal expenses Loss on deposits Repayments of Income Repayments of Social Security benefits Trustee administrative fees for an IRA Deductions Not Subject to 2% limit Schedule A, Line 28 Gambling losses up to the amount of gambling winnings reported on Form 1040, line 21. Amortizable bond premiums (the amount paid is greater than its stated interest the excess is the bond premium) Federal estate tax on income in respect of a decedent Unrecovered investment on annuity reported on final return of decedent Nondeductible Expenses Brokers commissions Adoption expenses Campaign expenses Check-writing fees Club dues Commuting expenses Fines or penalties Health Spas Home security system Homeowners insurance premiums Investment related seminars Life insurance premiums Lobbying expenses 160

167 Itemized Deductions Chapter 13 - Sample Questions 1. Which medical and dental expenses qualify for itemized deductions? A. The unreimbursed expenses that exceed 2% of AGI B. The reimbursed expenses that exceed 5% of AGI C. The unreimbursed expenses that exceed 7.5% of AGI D. The unreimbursed expenses that exceed 10% of AGI 2. Which is not a medical expense? A. Nursing help B. Teeth whitening C. Insurance premiums for medical and dental care D. Acupuncturist expenses 3. Which of the following are not deductible as taxes on Schedule A A. Foreign taxes B. State Disability Insurance C. Federal income taxes D. State income taxes 4. Which of the following is a true statement? A. A taxpayer can claim some sales tax and some state and local income tax on Schedule A. B. SDI cannot be claimed as a deduction on Schedule A. C. Personal property taxes based on the value of an asset are not deductible. D. Individuals can deduct the larger of either the general sales tax or state and local income tax. 5. Home mortgage interest is for any loan secured by A. The taxpayer s main home or second home B. The third home C. The second and third home D. None of the above 6. A home must provide basic living accommodations including A. Living space, cooking facilities, garage B. Cooking facilities, garage, sleeping space C. Garage, sleeping space, toilet D. Sleeping space, toilet, cooking facilities 161

168 Itemized Deductions 7. Limits apply to home mortgages taken out A. After October 31 st, 1987 B. After October 31 st, 1988 C. After October 13 th, 1987 D. After October 13 th, Which of the following is not reported on Form 1098? A. Home mortgage interest paid B. Points paid on home acquisition C. Interest income D. Mortgage insurance premiums 9. Points charged when refinancing A. Are deductible over the life of the loan B. Are deductible (the remaining portion) when the mortgage is paid off C. Both A and B above D. Neither A or B above 10. Donations to civic leagues, social and sports clubs are deductible as a charitable contribution on Schedule A. A. True B. False 11. Form 8283 is required if the contribution of noncash goods is more than A. $500 B. $1,000 C. $3,000 D. $5, Non-business casualties or thefts are deductible if the amount of the loss in excess of $100 is more than A. 2% of AGI B. 5% of AGI C. 10% of AGI D. 12% of AGI 13. Which of the following is true regarding Form 2106 EZ? A. The employee is deducting ordinary and necessary expenses attributable to their job. B. The taxpayer is not reimbursed for any of their expenses C. The taxpayer is using the standard mile rate D. All of the above 162

169 Itemized Deductions Chapter 13 - Answers to Sample Questions 1. C - Unreimbursed medical and dental expenses paid in the current year regardless of when the services were provided qualify for itemized deductions if they exceed 7.5% of the adjusted gross income. (Pub 17, page 142) 2. B - Teeth whitening is not a medical expense (Pub 17, page 142, Table 21-1) 3. C- Federal income taxes are not deductible as taxes on Schedule A. (Pub 17, page 147, Table 22-1) 4. D - Individuals can deduct the larger of either the general sales tax or state and local income tax. (Form 1040, Schedule A instructions, pages A-3 and A-4) 5. A - Home mortgage interest is for any loan secured by the taxpayer s main home or second home. The loan may be a mortgage to buy the home, a second mortgage, a line of credit, or a home equity loan. (Pub 17, page 150) 6. D - Qualified residence interest is interest paid on a loan secured by the main home or a second home. The main home is where the taxpayer lives most of the time. It can be a house, cooperative apartment, condominium, mobile home, house trailer, or houseboat that has sleeping, cooking and toilet facilities. (IRS Topic 505) 7. C - Limits apply to home mortgages taken out after October 13, (Excerpt from Pub 17, pg 150) 8. C- From 1098 reports mortgage interest paid of $600 or more during the year (including certain points and mortgage insurance premiums) (Pub 17, page 155) 9. C - Points charged when refinancing are deductible over the life of the loan, any remaining portion when the loan is paid off is deductible in that year. (Pub 17, page 152 and 153) 10. B - Donations to civic leagues, social and sports clubs are deductible as a charitable contribution on Schedule A is a false statement. Civic leagues, social and sports clubs, labor unions, chamber of commerce and political donations are among the items that are not considered a charitable contribution. (Pub 17, page 157 and 158) 11. A - Form 8283 is required if the contribution of noncash goods is more than $500. (Pub 17, page 161) 163

170 Itemized Deductions 12. C - Non-business casualties or thefts are deductible if the amount of loss in excess of $100 is more than 10% of the adjusted gross income for the year. (Pub 17, page 166) 13. D All of the following are true regarding Form 2106 EZ The employee is deducting ordinary and necessary expenses attributable to their job. The taxpayer is not reimbursed for any of their expenses The taxpayer is using the standard mile rate (Form 2106 EZ instructions) 164

171 Taxes and Credits Chapter 14 Taxes and Credits The income tax is based on taxable income. After the income tax is computed subtract any tax credits and add any other taxes owed. The result is total tax. Compare the total tax with total payments to determine whether the taxpayer is entitled to a refund or there is an amount owed. Tax Most taxpayers use either the tax table or the tax rate schedule to figure their income tax. However there are special methods if the taxpayer has any of the following items included in their return: Capital Gain Tax Rates Capital gains tax is computed on Schedule D, page 2 using the following tax brackets according to the type of income. Refer to Chapter 9 of this Syllabus for a discussion on the computation of tax with Capital Gains and Qualified Dividends Ordinary Income Tax Rate Shortterm Capital Gains Longterm Capital Gains Tax Rate Tax Rate 10% 10% 0% 15% 15% 0% 25% 25% 15% 28% 28% 15% 33% 33% 15% 35% 35% 15% Qualified dividends taxed at capital gain rates - when there is a qualified dividend the tax is computed on Schedule D, page 2. Qualified dividends differ from capital gain distributions in as much as they do not net with capital gains and get included in the total of Schedule D. Qualified dividends are included in income on Schedule B and only affect the tax computation on Schedule D. Lump Sum Distributions-is a ten-year tax option used to compute the tax on the ordinary income portion of the lump sum distribution. The tax is paid only once in the year the lump-sum distribution is received. The special treatment can be elected only once for any plan participant and only if the participant was born before January 2, 1936 (and beneficiaries of such individuals) (Refer to Form 4972 instructions) Farm income averaging - allows farmers to average their income over a three year period (the tax is paid in the current year). (Refer to Schedule J Instructions and Part II of this syllabus) 165

172 Taxes and Credits Credits After the income tax is determined, the tax credits are determined. There are two kinds of credit, refundable and nonrefundable. The nonrefundable credits can reduce the tax to zero but any excess is not refundable. The refundable credit is treated as payments and is refundable. The refundable credits are added to withholding and estimate payments. If this total is more than the total tax the excess is refunded to the taxpayer. Adoption Expense Credit (Internal Revenue Code Section 23) The Affordable Care Act raises the maximum adoption credit to $13,170 per child for It also makes the credit refundable, meaning that eligible taxpayers can get it even if they owe no tax for that year. In general, the credit is based on the reasonable and necessary expenses related to a legal adoption, including adoption fees, court costs, attorney s fees and travel expenses. Income limits and other special rules apply. Qualifying adoption expenses are reasonable and necessary adoption costs, court costs, attorney fees, traveling expenses while away from home and other expenses that are directly related to and for the purpose of the legal adoptions of an eligible child. Nonqualifying expenses: Any expenses that violates state or federal law The carrying out of a surrogate parenting arrangement The adoption of a spouse s child Using funds paid from any state or Federal program Allowed as a deduction under any other federal income tax rule Paid or reimbursed by the employer or anyone else Eligible Child means: Under 18 years old or Physically or mentally handicapped A child with special needs means: He or she is a citizen or resident of the United States; and A state (including the District of Columbia) determines that the child cannot or should not be returned to his or her parents home and probably will not be adopted unless adoptive assistance is provided to the adoptive parents The credit can generally be taken in any year prior to the adoption becoming final. Use Form (Refer to Form 8893 instructions and Pub 968). If the full amount of the credit cannot be taken in the current year due to the tax liability, the credit can be carried forward five years. 166

173 Taxes and Credits Adoption Benefits Amounts paid or expenses incurred by an employer for qualified adoption expenses under an adoption assistance program are not subject to federal income tax withholding and are not reportable in box 1, of Form W-2. However, these amounts (including adoption benefits paid from a section 125 (cafeteria) plan, but not including adoption benefits forfeited from a cafeteria plan) are subject to social security, Medicare, and railroad retirement taxes and must be reported in boxes 3 and 5. Also, the total amount must be reported in box 12 with code T. Example Form W-2 (Adoption Benefits the child is not a special needs child) Box 1 Wages - $47,930 Box 3 Social Security Wages - $56,930 Box 5 Medicare Wages and Tips - $56,930 Box 12 - Code T - Adoption Benefits - $7,000, the adopted child is not a child of special needs. 167

174 Taxes and Credits The $7,000 of employer provided adoption benefits are included in the social security and Medicare wages in the example. 168

175 Taxes and Credits 169

176 Taxes and Credits Child and Dependent Care Credit (IRC Section 21) If the taxpayer pays someone to care for a dependent that is under the age of 13 or for the spouse or dependent that is not able to care for him or herself, the taxpayer may be able to claim a credit. The credit can be up to 35% of the expenses. The expenses must be so the taxpayer can work. To claim the credit the taxpayer must meet all of the following tests; 1. The care must be for one or more qualified person who is identified on Form The taxpayer and the spouse if married must maintain the home of the qualifier for the credit. 170

177 Taxes and Credits 3. The taxpayer and spouse if married must have earned income during the year. 4. The child and dependent care expenses must be so the taxpayer and spouse if married can work or look for work. 5. The person paid to care for a dependent cannot be a dependent of the taxpayer and must be 19 or older. 6. The filing status cannot be married filing separate. 7. The care provider must be identified with either a Social Security Number or a Federal Identification Number. 8. Dependent care benefits paid by the employer must be excluded from expenses before computing the credit. The dollar limit on the amount of the work-related expenses allowed for the credit is $3,000 for one qualifying person and $6,000 for two or more qualifying persons. The amount of the credit is determined by multiplying the work-related expenses (after applying the earned income and dollar limits) by a percentage. The percentage depends on the adjusted gross income refer to Form 2441 instructions for the percentage. The amount of credit that can be claimed is limited to the amount of the regular tax (after reduction by any allowable foreign tax credit) that is multiplied by a percentage. This credit is not refundable and does not allow a carry forward. Report the credit on Form Child Tax Credit (IRC Section 24) The maximum amount of credit is $1,000. The credit is limited to tax liability and is eliminated if the adjusted gross income is above $110,000 for taxpayers filing joint; $75,000 for taxpayers filing single, head of household or qualifying widow(er); and $55,000 for married filing separately. For 2010 the adjusted gross income is the amount on line 37 of Form 1040, unless the taxpayer worked in a foreign country, Puerto Rico or American Samoa. A qualifying child for child tax credit purposes is a child that must be all of the following: 1. Under age 17 at the end of the tax year. 2. A citizen or resident of the United States. 3. Claimed as the taxpayer s dependent. 4. Must be one of the following relationships: Son Descendent of any of those Daughter listed above. Adopted child Brother Stepchild Sister Step brother or sister Any descendent of any of those listed above that the taxpayer cares for as their own Eligible foster child 171

178 Taxes and Credits Additional Child Tax Credit This credit is for certain individuals who get less than the full amount of Child Tax Credit. This is a refundable credit that allows the credit whether or not there is any tax liability. Complete the child tax credit before computing the additional child tax credit. Below is an example of Form 8812 from Pub

179 Taxes and Credits 173

180 Taxes and Credits Education Credits (IRC Section 25(A)) The following three criteria must be met to take either the American Opportunity Credit or the Lifetime Learning Credit: i. The taxpayer pays the qualified education expenses for higher education ii. The tuition and related expenses are for an eligible student iii. The eligible student is the taxpayer, the spouse or a dependent that the taxpayer claims an exemption for on the return. The taxpayer cannot claim an education credit for 2010 if any of the following apply: The filing status is married filing separately The taxpayer is a dependent on another return American Opportunity Credit: The modified adjusted gross income is $90,000 ($180,000 if married filing jointly) Lifetime Learning Credit: The modified adjusted gross income is $60,000 ($120,000 if married filing jointly) The taxpayer is a nonresident alien in the tax year Expenses that are not considered to be qualified education expenses: o Room and board o Insurance o Medical (including student health fees o Transportation If the qualified education expenses were paid from the proceeds of a loan, figure the credit for the year in which the education expenses are paid and not the year in which the loan is repaid. The education credits are computed on Form

181 Taxes and Credits Mortgage Interest Credit (IRC Section 25) The mortgage interest credit is intended to help lower income individuals purchase a home. If the taxpayer qualifies they can receive a credit for part of the interest they paid. The deductible interest on Schedule A is reduced by the amount used to compute the credit. To qualify the taxpayer must be issued a certificate by state or local government. The credit rate on the certificate is multiplied by the interest allowed. If the credit rate is over 20%, the maximum amount of the credit is $2,000. The credit is reported on Form If the credit is more than the tax liability, the excess can be carried forward for three years. (Refer to Pub. 530). Excerpt from Pub 17 Retirement Savings Contribution Credit (IRC Section 25B) The taxpayer may be able to take a credit of up to $1,000 ($2,000 if married filing joint) if they are eligible contributions to an employer sponsored retirement plans or an IRA. The credit is a percentage of the retirement contribution with highest credit for the lowest income taxpayers. Eligible contributions include contributions to: Traditional or Roth IRA s Tax-exempt employee-funded pension plans (501)(c)(18)(D) Elective deferrals 401(k), 403(b) annuities, nonqualified deferred compensation plans Elective deferrals to SIMPLE s or SARSEP s Voluntary after tax employee contribution to any qualified retirement plan, annuity or IRA The amount of the credit depends on the amount of the adjusted gross income, filing status and eligible contributions. The credit is claimed on Form (Refer to Pub 590 for further information). The credit cannot be taken if the following apply: The amount of the taxpayer s adjusted gross income is more than $27,750 ($41,625 for head of household and $55,500 for married filing joint) The taxpayer was not at least 18 by the end of the year. The taxpayer was claimed as a dependent on another return The taxpayer was a full-time student 175

182 Taxes and Credits Social Security and Medicare taxes on tips not reported to the employer are reported on Form If a taxpayer received $20 or more in cash or charge tips in a month from any one job and did not report all of those tips to the employer, the taxpayer must report the social security and Medicare taxes on the unreported tips as an additional tax on the return. Form 4137 is reported on Form 1040 on Line 58. (See Chap. 18) Schedule R is a nonrefundable credit for the elderly US citizen over the age of 65 or under the age of 65 who is retired on total and permanent disability and received taxable disability payments. The taxpayer must supply a physician statement. The income requirements for this form are very low and it is only claimed by people with very little income. Excerpt Pub

183 Taxes and Credits Making Work Pay Credit Excerpt from Pub 17. Reported on Schedule M, this credit is scheduled to expire for tax years after

184 Taxes and Credits First-Time Home Buyer Credit (Form 5405) The taxpayer is considered a first-time homebuyer if they meet all of the following requirements. 1. Purchased their main home located in the United States: a. After December 31, 2009, and before May 1, 2010, or b. After April 30, 2010, and before October 1, 2010, and you entered into a binding contract before May 1, 2010, to purchase the home before July 1, The taxpayer (and spouse if married) did not own any other main home during the 3-year period ending on the date of purchase. The taxpayer cannot claim the credit if any of the following apply. 1. The purchase price of the home is more than $800, The modified adjusted gross income is $145,000 or more ($245,000 or more if married filing jointly). 3. The taxpayer can be claimed as a dependent on another person's tax return. 4. The taxpayer (and spouse if married) are under age 18 on the date of purchase. 5. The taxpayer is a nonresident alien. 6. The home is located outside the United States. 7. The taxpayer sells the home, or it ceases to be your main home, before the end of the year in which you purchased it. 8. The home is a gift or inheritance. 9. The home is acquired your home from a related person or a person related to the spouse. First-time homebuyer. Generally, the credit is the smaller of: $8,000 ($4,000 if married filing separately), or 10% of the purchase price of the home. Long-time resident of the same main home. Generally, the credit is the smaller of: $6,500 ($3,250 if married filing separately), or 10% of the purchase price of the home. Credit Repayment If the taxpayer purchased the home after 2008, and they own it and use it as their main home for at least 36 months beginning on the purchase date, they do not have to repay any of the credit or file Form 5405 again. For homes purchased in 2008, generally the credit must be repaid starting in 2010 and Form 5405 must be filed. Refer to Pub 17 or Form 5405 for further information. 178

185 Taxes and Credits DC First-Time Home Buyer Credit (Form 8859) This credit cannot be taken if the taxpayer the First Time Home Buyers Credit (Form 5405) 179

186 Chapter 14 Sample Questions 1. Which of the following do taxpayers use to figure their income tax? A. Tax Table Chart B. Tax Rate Schedule C. Either A or B D. Neither A or B 2. There are two kinds of credits: A. Favorable and unfavorable B. Refundable and nonrefundable C. Fortunate and unfortunate D. Useful and not useful Taxes and Credits 3. The maximum tax credit that may be allowed for qualifying expense paid to adopt an eligible child with special needs is: A. $13,170 B. $16,010 C. $1,016 D. None of the above 4. A taxpayer pays someone to care for their spouse that is not able to care for him or herself so that the taxpayer can work. What is the maximum credit for the expenses that can be claimed? A. 35% B. 53% C. 25% D. 40% 5. Which of the following is a true statement regarding The Child Tax Credit? A. The Child Tax Credit must be reduced by any advanced payments of Child Tax Credit. B. The Child Tax Credit is limited to the tax liability. C. The maximum Child Tax Credit is $1,000. D. All of the above 6. Which if the following is true regarding the Additional Child Tax Credit: A. This credit is for certain individuals who get less than the full amount of Child Tax Credit. B. This is a refundable credit that allows the credit whether or there is any tax liability. C. Complete the child tax credit before computing the additional child tax credit. D. All of the above 180

187 Taxes and Credits 7. Which of the following is not true about the Mortgage Interest Credit? A. The deductible interest on Schedule A is reduced by the amount used to compute the credit. B. To qualify the taxpayer must be issued a certificate by the IRS. C. The credit rate on the certificate is multiplied by the interest allowed. D. If the credit rate is over 20%, the maximum amount of the credit is $2, The taxpayer may be able to take the Retirement Savings Contribution Credit if they had eligible contributions to which of the following? A. A traditional IRA or Roth IRA. B. An employer sponsored retirement plan. C. A money market savings account D. Both A and B above 10. Which of the following are reported on Form 4137? A. Social Security and Medicare taxes on tips not reported to the employer B. Wages earned as a waitress C. Health insurance coverage paid by the employer D. All of the above 11. The maximum credit per eligible student for the American Opportunity Credit is: A. $2,500 B. $1,800 C. $2,000 D. $5, What percentage of the American Opportunity Credit may be refundable? A. 10% B. 25% C. 30% D. 40% 13. The Making Work Pay credit can be taken on Form 1040 EZ without filing Schedule M. A. True B. False 14. Which of the following forms is used to report the First-Time Homebuyer Credit? A. Form 5405 B. Form 8863 C. Form 2441 D. None of the above 181

188 Taxes and Credits Chapter 14 - Answers to Sample Questions 1. C - Taxpayers can use either the tax table or the tax rate schedule to compute their tax. (Pub 17, page 202) 2. B - There are two kinds of credits, refundable and nonrefundable. Nonrefundable credits can reduce the tax, but if the credit exceeds the tax it is not refunded. Refundable credits are treated as payments of tax. If the total of these credits, withheld federal income tax, and estimated tax payments is more than your total tax, the excess is refunded. (Pub. 17, page 249 and 250) 3. A - The maximum tax credit that may be allowed for qualifying expense paid to adopt an eligible child with special needs is $13,170. (Pub. 17, page 250) 4. A - A taxpayer pays someone to care for their spouse that is not able to care for him or herself so that the taxpayer can work. What is the maximum credit for the expenses that can be claimed? (Pub. 17, page 214) 5. D - All of the following are true statement regarding The Child Tax Credit: The Child Tax Credit must be reduced by any advanced payments of Child Tax Credit. The Child Tax Credit is limited to the tax liability. The maximum Child Tax Credit is $1,000. (Pub. 17, page 225) 6. D All of the following is true regarding the Additional Child Tax Credit: This credit is for certain individuals who get less than the full amount of Child Tax Credit. This is a refundable credit that allows the credit whether or there is any tax liability. Complete the child tax credit before computing the additional child tax credit. (Pub. 17, page 227) 7. B To qualify for the Mortgage Interest Credit the taxpayer must be issued a qualified mortgage credit certificate (MCC) from their state or local government, not from the IRS. It is also true that the deductible interest on Schedule A is reduced by the amount used to compute the credit; the credit rate on the certificate is multiplied by the interest allowed; and if the credit rate is over 20%, the maximum amount of the credit is $2,000. (Pub. 17, page 250) 182

189 Taxes and Credits 8. The taxpayer may be able to take the Retirement Savings Contribution Credit if they had eligible contributions to: A traditional IRA or Roth IRA; An employer sponsored retirement plan; Elective deferrals 401(k) or 403(b), 457, SEP or SIMPLE; Voluntary employee contributions to a qualified plan; or Contributions to 501(c) plan (Pub. 17, page 249) 9. A - Social Security and Medicare taxes on tips not reported to the employer are reported on Form (Pub. 17, page 56) 10. The maximum credit per eligible student for the American Opportunity Credit is $2500. (Pub. 17, page 230) 11. D - Up to 40% of the American Opportunity Credit may be refundable. (Pub. 17, page 230) 12. A - The Making Work Pay credit can be taken on Form 1040 EZ without filing Schedule M is a true statement. 13. A - Form 5405 is used to report the First- Time Homebuyer Credit. 183

190 Earned Income Credit Chapter 15 Earned Income Credit Earned Income Credit The earned income credit is a tax credit for certain people who work and have income under a certain amount. Everyone must meet all the following seven rules to qualify. Excerpt from 2010 Pub 17 Part A # 2- The taxpayer and or spouse must have a valid Social Security Number issued by the Social Security Administration. Any qualifying child listed on Schedule EIC must also have a valid SSN. Part B #8 184

191 Earned Income Credit Part A #7 Earned income generally means wages, salaries, tips, other taxable employee compensation and net earnings from self-employment. Part B #8 Relationship test Son Daughter Adopted child Stepchild Descendent of any of those listed above. Brother Sister Step brother Step sister Any descendent of any of those listed above that the taxpayer cares for as their own Eligible foster child Age Test the child must be either under the age of 19 at the end of the year; a full-time student under the age of 24 at the end of the year or; permanently and totally disabled at any time during the year, regardless of age. Residency Test the child must have lived with the taxpayer in the United States for more than half of the year. Part B #9 - Tie Breaker Rules Excerpt from Pub 17, page

192 Earned Income Credit EIC Eligibility Checklist, Pub 17, Page

193 Earned Income Credit Earned Income Credit Example from Pub

194 Earned Income Credit To figure the amount of the earned income credit use the EIC worksheet found in the instruction booklet for Form 1040, 1040A or 1040EZ. Taxpayers who fraudulently claim Earned Income Credit are disqualified from taking it the credit for the next ten years. Taxpayers who improperly claim the EIC with a reckless disregard of the rules are disqualified for the next two years. Taxpayers must file Form 8862 to be reinstated for eligibility in the future. 188

195 Earned Income Credit Earned Income Worksheet This worksheet can be found in the instructions for Form 1040/1040A or 1040EZ. The following is from an example in Pub 17, page 245. EITC Due Diligence The following is from the IRS website: Paid preparers must meet four due diligence requirements on returns with EITC claims or face possible penalties. New expanded regulations clarify these requirements and set a performance standard for the "knowledge" requirement--what a reasonable and wellinformed tax return preparer, knowledgeable in the law, would do. When preparing EITC returns and claims for refund, paid preparers must: Evaluate information received from clients Apply a consistency and reasonableness standard to the information Ask additional questions if the information appears incorrect, inconsistent or incomplete Document and retain the record of inquiries made and client responses Refer to Pub 4687 EITC Due Diligence for additional information. 189

196 Earned Income Credit The four due diligence requirements are: Requirement Description 1. Completion of Eligibility checklist Either complete Form 8867 or its equivalent Complete checklist based on information provided by the taxpayer for the preparer 2. Computation of the Credit Keep the EIC worksheet or an equivalent that demonstrates how the EIC was computed 3. Knowledge 4. Record Retention Not know or have reason to know that any information used in determining the taxpayer's eligibility for, or the amount of, the EIC is incorrect, incomplete or inconsistent Not ignore the implications of information furnished or known Make reasonable inquiries if a reasonable and well-informed tax return preparer, knowledgeable in the law, would conclude the information furnished appears to be incorrect, inconsistent or incomplete Document in your records any additional inquiries made and your client's responses. Retain Form 8867 and EIC worksheet or the equivalent Maintain record of how and when the information used to complete these forms was obtained Verify the identity of the person furnishing the information Retain records for 3 years after the June 30th following the date the return or claim was presented for signature Consequences of Non-Compliance EITC return preparers, who fail to meet the knowledge standard and other due diligence requirements, are subject to civil penalties. Their clients who filed a return with a false EITC claim could also face penalties in addition to repaying any credit paid in error plus interest. Penalties include: $100 penalty for each due diligence failure to comply for return preparers or their employers. A minimum $1,000 penalty against return preparers who prepare EITC claims if any part of an understatement of tax liability is due to an unreasonable position. A minimum $5,000 penalty against return preparers who prepare EITC claims if any part of an understatement of tax liability is due to reckless or intentional disregard of rules or regulations by the tax preparer. Your clients face accuracy and/or fraud penalties, plus a ban from claiming EITC for 2 or 10 years for incorrect claims. Return-related preparer penalties can also result in: Disciplinary action by the IRS Office of Professional Responsibility. Suspension or expulsion of the preparer s firm from participation in IRS e-file. Injunction barring preparation of federal tax returns. 190

197 Earned Income Credit Chapter 15 - Sample Questions 1. Rules everyone must follow for EIC, include the following, except: A. The taxpayer, spouse and qualifying child must all have valid Social Security Numbers. B. The taxpayer must be a U.S. citizen or resident alien for the entire year. C. The taxpayer cannot claim the earned income credit if they file Form 2555 to exclude foreign income. D. The earned income credit cannot be claimed unless the taxpayer s investment income is $5,000 or less. 2. The taxpayer must be at least 25 but under age 65 at the end of the year. If married filing a joint return, either the taxpayer or the spouse must be at least 25 but under 65 at the end of the year. It does not matter which spouse meets the age test, as long as one does. A. True. B. False 3. If your social security card says "Not valid for employment" and your SSN was issued so that you (or your spouse) could get a federally funded benefit, you can get the EIC. A. True B. False 4. Earned income generally means wages, salaries, tips, other taxable employee compensation and net earnings from self-employment. A. True B. False 5. Special penalties apply to fraudulently claiming Earned Income Credit, which of the following are true A. Taxpayers who fraudulently claim Earned Income Credit are disqualified from taking the credit for the next ten years. B. Taxpayers who improperly claim the EIC with a reckless disregard of the rules are disqualified for the next two years. C. Taxpayers must file Form 8862 to be reinstated for eligibility in the future D. All of the above 191

198 Earned Income Credit Chapter 15 Answers to Sample Questions 1. D Is incorrect, the earned income credit cannot be claimed unless the investment income is $3,100 or less Part A#6 (Pub 17, page 234) 2. A - The taxpayer must be at least 25 but under age 65 at the end of the year. If married filing a joint return, either the taxpayer or the spouse must be at least 25 but under 65 at the end of the year. It does not matter which spouse meets the age test, as long as one does. This is a true statement Part B #11. (Pub 17, page 234) 3. B - If your social security card says "Not valid for employment" and your SSN was issued so that you (or your spouse) could get a federally funded benefit, you can get the EIC, is a false statement. It must be valid for employment not only for Federally funded benefits such as Medicaid Part A #2 (Pub 17, page 234) 4. A Earned Income (Pub 17, page 241) 5. D All the following special penalties apply to fraudulently claiming Earned Income Credit, which of the following are true Taxpayers who fraudulently claim Earned Income Credit are disqualified from taking the credit for the next ten years. Taxpayers who improperly claim the EIC with a reckless disregard of the rules are disqualified for the next two years. Taxpayers must file Form 8862 to be reinstated for eligibility in the future (IRS website 192

199 Refunds, Amount Due and Electronic Filing Chapter 16 Refunds, Amount Due & Electronic Filing Refund If there is withholding, estimated tax or a refundable credit in excess of the total tax liability, there is an overpayment which can be refunded, unless there is unpaid child or spousal support, other federal debts or state tax judgment. If the taxpayer files Form 1040 or 1040A they can choose to have part or all of the refund applied to the next year tax. The taxpayer can elect to have the refund directly deposited to either a savings or checking account in the taxpayer s name. A bank account number and the routing number of the bank are required for direct deposit. The routing number should either be furnished by the bank or taken directly from a check. 193

200 Miscellaneous Forms Form 8888 If the taxpayer wants the refund to go to one bank only the routing and bank account number is entered directly on Form

201 Refunds, Amount Due and Electronic Filing Amount Owed If the withholding or estimated tax payments were not enough to cover the tax liability there is an amount owed. Payments can be made in several ways: If payment is by check, make the check payable to the United States Treasury; write the SSN on the check and 2010 Form Complete the payment voucher V and send that with the check loose on top of the return Credit Card payments can be made through service providers. The IRS accepts American Express, Master Card, Discover and Visa. The taxpayer will be charged a convenience fee The taxpayer can also make a direct deposit through their financial institution. The taxpayer will have to register first by going to Electronic Filing Information in this section is from the IRS website. A new law requires many paid tax return preparers to electronically file federal income tax returns prepared and filed for individuals, trusts, and estates starting Jan. 1, The e-file requirement will be phased in over two years. As a result of the new rules, preparers will be required to start using IRS e-file beginning: January 1, 2011 for preparers who anticipate filing 100 or more Forms 1040, 1040A, 1040EZ and 1041 during the year; or January 1, 2012 for preparers who anticipate filing 11 or more 1040, 1040A, 1040EZ and 1041 during the year. The rules require members of firms to compute the number of returns in the aggregate that they reasonably expect to file as a firm. If that number is 100 or more in calendar year 2011 (11 or more in 2012 and thereafter), then all members of the firm must e-file the returns they prepare and file. This is true even if a member prepares and files fewer than the threshold on an individual basis. 195

202 Miscellaneous Forms The requirement applies to any return of income tax imposed by subtitle A of the Internal Revenue Code on individuals, estates, and trusts, such as Forms 1040, 1040A, 1040EZ, and Forms 1040NR, 1041QFT, and 990T (when the exempt organization is a trust subject to tax on unrelated business taxable income under section 511(b)) also meet the definition of a return of income tax, but because these forms cannot be electronically filed at this time they are exempt from the requirement, and will not count towards the 11-return threshold (100 or more returns in 2011 only). Form 8879 is the declaration document and signature authorization for an e-filed return filed by an electronic return originator. This form is not sent to the IRS it is retained in the practitioner s files. 196

203 Refunds, Amount Due and Electronic Filing 197

204 Miscellaneous Forms Form

205 Refunds, Amount Due and Electronic Filing Form 8633 is used for a practitioner to apply for IRS acceptance as an authorized provider. A separate application is required for each business location originating e-file returns. Authorized electronic filing providers include the following: Electronic return originator- most tax preparer s who offer electronic filings are ERO s. Commonly, the ERO completes the client s tax return and then transmits the data to the software provider. The software provider then transmits the return to the IRS. The practitioner can also transmit directly to the IRS. Reporting agents are accounting services, franchisers, banks or others authorized to electronically prepare a Form 940 or Form 941 for a taxpayer. Transmitters send electronic data directly to the IRS. Online providers transmit tax return information prepared by a taxpayer using purchased commercial software. Software developers create software to format electronic tax return information. Intermediate service providers take tax return information from an ERO, and either forward the information to a transmitter or send the return back to the ERO. Each tax practitioner must go through a finger printing process and a suitability check. A finger print card must be submitted with Form 8633 for each responsible official, corporate officer, owner or partner listed on the application. Once accepted into the program, the provider is assigned an Electronic Filing Identification Number (EFIN). Once the form is received by the FTB they will ensure that all business entities are valid and licensed, and all personal and business tax returns are filed timely, and all liabilities are current. They will then issue an acceptance letter; at that point the practitioner s EFIN is valid for both Federal and state. Electronic Filing Identification Numbers are currently issued on a firm basis. All preparers in the firm are covered by one EFIN. Note that a sole proprietorship is considered a firm for EFIN purposes. Forms 1040NR, 1041QFT, and 990T (when the exempt organization is a trust subject to tax on unrelated business taxable income under section 511(b)) meet the definition of a return of income tax, but because these forms cannot be electronically filed at this time they are exempt from the e-file requirement, and will not count towards the 11-return threshold (100 or more returns in 2011 only). This also includes amended income tax returns, such as Form 1040X, fiscal year returns for Form 1040, and fiscal year returns for Form 1041 for certain periods (i.e., fiscal year Form 1041 returns ending during any month after June 30 of the current processing year). See Notice In addition, some Forms 1040, 1040A, 1040EZ, and 1041 cannot be e-filed if they have attached forms, schedules, or documents that IRS does not accept electronically. However, if the form, schedule or document can be sent to the IRS separately using Form 8453 or 8453-F as a transmittal document, the rest of the return must be e-filed. Only the returns that cannot be e-filed are exempt from the requirement. See the instructions for Forms 8453 and 8453-F to identify which forms, schedules and documents apply. See Notice Finally, the IRS is beginning to offer some capability to e-file returns for years other than the current tax year. Because this capability is limited for now, prior year returns are exempt from the electronic filing requirement at this time. There are some additional rare circumstances that can be found in Notice , sections C1 and C2. For all of these 199

206 Miscellaneous Forms returns, the taxpayer does not have to request a waiver on Form 8944 or attach Form 8948 to the paper return. Form 8453 The Individual Income Tax Transmittal for an IRS e-file return. Within 3 days after receiving an acknowledgement that the IRS has accepted the electronically filed return, the ERO must mail Form 8453.The only forms allowed to be attached to Form 8453 are those listed on the form. Taxpayers may independently choose to file a paper return. "Electronic filing is the safest, fastest and easiest way for taxpayers to file their tax returns. E-filing is good for the tax system, good for taxpayers and good for the tax preparation industry," said IRS Commissioner. "This requirement reflects the realities of the modern world where technology has evolved to the point that everyone should be filing their tax returns electronically." To comply with the new law, a tax return preparer who is subject to the electronic filing requirement and does not already provide e-file for clients must become an authorized IRS e-file provider, which means he, she, or the firm, if the preparer is a member of a firm, must obtain an electronic filing identification number (EFIN). It takes up to 45 days to obtain an EFIN so return preparers who have not started the process should start immediately. Proposed regulations issued Dec detail the two-year phase-in plan and provide exclusions from the e-file requirement for undue hardship waivers approved by the IRS and for certain administrative exemptions. In addition, under the proposed regulations, the e-file requirement does not apply to an individual income tax return when a tax return preparer s taxpayer-client chooses to have the return completed in paper format and the taxpayer-client, and not the preparer, will file the paper return with the IRS. A notice issued with the proposed regulations contains a proposed revenue procedure on undue hardship waivers and taxpayer choice statements to file in paper format. Advantages of IRS e-file The e-file requirement for paid tax return preparers was approved by Congress in 2009, based on recommendations from the IRS, the Treasury Inspector General for Tax Administration and the Electronic Tax Administration Advisory Council. Numerous states already have a similar electronic filing requirement. In 1998, Congress set a goal of having 80 percent of tax returns electronically filed. Last year, two of every three individual tax returns were transmitted through IRS e-file. IRS e-file benefits taxpayers and tax return preparers. For the tax return preparer, it can mean a more efficient, productive business and fewer errors on the tax return. It is safe and secure. For taxpayers, it can mean faster refunds, the ability to file now and pay later and peace of mind that comes with a receipt acknowledgement. This year marks the 20th anniversary of IRS e-file as a national program. And in those 20 years, IRS e-file has transmitted more than 800 million tax returns safely and securely. 200

207 Refunds, Amount Due and Electronic Filing Form

208 Miscellaneous Forms Form

209 Refunds, Amount Due and Electronic Filing Chapter 16 Sample Questions 1. Which form would be used to purchase U.S. Savings Bond with a refund? A. Form 1040V B. Form 1040ES C. Form 8888 D. None of the above 2. A refund from a married filing joint account can be deposited into the wife s account whether or not the husband is on the bank account. A. True B. False 3. Which of the following is not true regarding the new electronic filing regulations? A. A tax preparer who files 150 returns must electronically file in 2010 and 2011 B. An explanation is required if the taxpayer refuses to electronically file. C. Form 8453 is filed with every electronically filed return. D. None of the above 4. Form 8948 is used to inform the IRS why a preparer is not electronically filing a return? A. True. B. False 5. Which of the following cannot be attached to Form 8453? A. Form 1098-C B. Form 8283 C. Form 8879 D. Form

210 Miscellaneous Forms Chapter 16 Answers to Sample Questions 1. C - Form 8888 would be used to purchase U.S. Savings Bond with a refund. (Form 8888 instructions) 2. B - A refund from a married filing joint account can be deposited into the wife s account whether or not the husband is on the bank account is a false statement. (Form 8888 instructions) 3. C Form 8453 is only filed when one of the designated forms on Form 8453 is required. (Form 8453 instructions) 4. A - Form 8948 is used to inform the IRS why a preparer is not electronically filing a return is a true statement. Form 8948 is filed with Form 1040/1040A/1040EZ or Form (Form 8948 instructions) 5. C Form 8879 cannot be attached to Form 8453, only the forms listed on Form Form 8879 is retained in the preparer s file. (Form 8879 and 8453 instructions) 204

211 Miscellaneous Forms Chapter 17 Miscellaneous Forms Form Injured Spouse Allocation

212 Miscellaneous Forms Form 8379 is filed by one spouse (the injured spouse) on a jointly filed tax return when the joint overpayment was (or is expected to be) applied (offset) to a past-due obligation of the other spouse. By filing Form 8379, the injured spouse may be able to get back his or her share of the joint refund. The taxpayer may be an injured spouse if they file a joint tax return and all or part of the portion of the overpayment was, or is expected to be, applied (offset) to the spouse's legally enforceable past-due federal tax, state income tax, child or spousal support, or a federal nontax debt, such as a student loan. Complete Part I to determine if there is an injured spouse. 206

213 Miscellaneous Forms Form 9465 Installment Agreement Form 9465 is to request a monthly installment plan if the taxpayer cannot pay the full amount shown on the tax return or on an IRS notice. Generally the IRS allows up to 60 months to pay the amount owed If the taxpayer can pay the total amount in full within 120 days they should contact the IRS to avoid paying the fee to establish an installment agreement. The following excerpts are from Form 9465 instructions

214 Miscellaneous Forms Form W-7- Application for IRS Individual Taxpayer Identification Number 208

215 Miscellaneous Forms Form W-7 is used to apply for an IRS individual taxpayer identification number (ITIN). An ITIN is a nine-digit number issued by the U.S. Internal Revenue Service (IRS) to individuals who are required for U.S. tax purposes to have a U.S. taxpayer identification number but who do not have and are not eligible to get a social security number (SSN). The ITIN is for federal tax purposes only. It does not entitle the individual to social security benefits and does not change the immigration status or the right to work in the United States. Also, individuals filing tax returns using an ITIN are not eligible for the earned income credit (EIC). Form W-7 should not be completed if the individual has a Social Security Number. Any individual who is not eligible to get an SSN but who must furnish a taxpayer identification number must apply for an ITIN on Form W-7. Examples include the following. A nonresident alien individual eligible to get the benefit of reduced withholding under an income tax treaty. See Pub. 515, Withholding of Tax on Nonresident Aliens and Foreign Entities. A nonresident alien individual not eligible for an SSN who is required to file a U.S. tax return or who is filing a U.S. tax return only to claim a refund. A nonresident alien individual not eligible for an SSN who elects to file a joint U.S. tax return with a spouse who is a U.S. citizen or resident alien. A U.S. resident alien (based on the substantial presence test) who files a U.S. tax return but who is not eligible for an SSN. For information about the substantial presence test, see Pub. 519, U.S. Tax Guide for Aliens. An alien spouse claimed as an exemption on a U.S. tax return who is not eligible to get an SSN. An alien individual eligible to be claimed as a dependent on a U.S. tax return but who is not eligible to get an SSN. To determine if an alien individual is eligible to be claimed as a dependent on a U.S. tax return, see Pub. 501, Exemptions, Standard Deduction, and Filing Information, and Pub A nonresident alien student, professor, or researcher who is required to file a U.S. tax return but who is not eligible for an SSN, or who is claiming an exception to the tax return filing requirement. A dependent/spouse of a nonresident alien holding a U.S. visa who is not eligible for an SSN. Related Publications which will provide additional information are Pubs. 501, 515, and 519, Pub. 1915, Understanding Your IRS Individual Taxpayer Identification Number (ITIN and Form W-7 instructions

216 Miscellaneous Forms Form 8821 Tax Information Authorization The following information is an excerpt from Form 8821 instructions: 210

217 Miscellaneous Forms Chapter 17 Sample Questions 1. Form 8379 is filed by one spouse (the injured spouse) on a jointly filed tax return when the joint overpayment was (or is expected to be) applied (offset) to a past-due obligation of the other spouse. A. True B. False 2. Which of the following may file Form W-7 for an ITIN? A. A nonresident alien individual eligible to get the benefit of reduced withholding under an income tax treaty. B. A nonresident alien individual not eligible for an SSN who elects to file a joint U.S. tax return with a spouse who is a U.S. citizen or resident alien. C. A U.S. resident alien (based on the substantial presence test) who files a U.S. tax return but who is not eligible for an SSN. D. All of the above. 3. Form 8821 when submitted to the IRS within 60 days authorizes the appointee to advocate on behalf of the taxpayer. A. True B. False 4. If a taxpayer can pay the amount they owe in full within days, they should not file Form A. 240 B. 120 C. 30 D

218 Miscellaneous Forms Chapter 17 Answers to Sample Questions 1. A - Form 8379 is filed by one spouse (the injured spouse) on a jointly filed tax return when the joint overpayment was (or is expected to be) applied (offset) to a past-due obligation of the other spouse, is a true statement. (Refer to Form 8379 instructions and the IRS website for additional information) 2. D - All of the following may file Form W-7 for an ITIN: A nonresident alien individual eligible to get the benefit of reduced withholding under an income tax treaty. A nonresident alien individual not eligible for an SSN who elects to file a joint U.S. tax return with a spouse who is a U.S. citizen or resident alien. A U.S. resident alien (based on the substantial presence test) who files a U.S. tax return but who is not eligible for an SSN. (Pub 1915) 3. B - Form 8821 when submitted to the IRS within 60 days authorizes the appointee to access the taxpayer s information but does not authorize them to advocate for the taxpayer. (Form 8821 instructions) 4. If a taxpayer can pay the amount they owe in full within 120 days, they should not file Form (Form 9465) 212

219 Part II 213

220 Schedule C/Form 4562 and 2106 Chapter 18 Schedule C/Form 4562 and 2106 Business Income Schedule C Accounting Periods The annual accounting period for a tax return is called the tax year. The tax year is either: Calendar year 12 consecutive months beginning January 1 and ending December 31. The calendar tax year must be used if any of the following applies Fiscal tax year 12 consecutive months ending on the last day of any month except December 31. Accounting Methods Accounting methods are a group of rules used to determine when and how income and expenses are reported Excerpt From Pub. 334 Cash Method Most individuals and many sole proprietors with no inventory use the cash method because they find it easier to keep cash method records. However, if an inventory is necessary to account for your income, you must generally use an accrual method of accounting for sales and purchases. Accrual Method Under an accrual method of accounting, income is reported in the year earned and deduct or capitalize expenses in the year incurred. The purpose of an accrual method of accounting is to match income and expenses in the correct year. Material Participation A trade or business activity is not a passive activity if the taxpayer materially participated in the activity. Material participation tests. The taxpayer materially participated in a trade or business activity for a tax year if you satisfy any of the following tests. 1. Participated in the activity for more than 500 hours. 2. The taxpayer s participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity. 3. Participated in the activity for more than 100 hours during the tax year, and participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year. 4. The activity is a significant participation activity, and the taxpayer participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which the taxpayer participated for more than 100 hours during the year and in which they did not materially participate under any of the material participation tests, other than this test. 214

221 Schedule C/Form 4562 and The taxpayer materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years. 6. The activity is a personal service activity in which the taxpayer materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor. 7. Based on all the facts and circumstances, the taxpayer participated in the activity on a regular, continuous, and substantial basis during the year. The material participation rules above apply to Schedule E, F and K-1 s. Special Rules The following are special rules that apply to advance payments, estimating income, and changing a payment schedule for services. Change in payment schedule for services. If services are performed for a basic rate specified in a contract, then the income must be accrued at the basic rate, even if there is an agreement to receive payments at a lower rate until completion of the services and then receive the difference. Advance payments for sales. Special rules apply to including income from advance payments on agreements for future sales or other dispositions of goods held primarily for sale to customers in the ordinary course of business. If the advance payments are for contracts involving both the sale and service of goods, it may be necessary to treat them as two agreements. An agreement includes a gift certificate that can be redeemed for goods. Treat amounts that are due and payable as amounts you received. Generally include an advance payment in income for the tax year in which it is received. However, you can use an alternative method. For additional information refer to Publication 538. Expenses Under an accrual method of accounting, generally deduct or capitalize a business expense when both the following apply. 1. The all-events test has been met. The test has been met when: a. All events have occurred that fix the fact of liability, and b. The liability can be determined with reasonable accuracy. 2. Economic performance has occurred, property is provided or services are rendered Combination Method Generally any combination of cash, accrual of accounting is acceptable if the combination clearly shows income and expenses and it is used consistently. However, the following restrictions apply. If an inventory is necessary to account for the income, generally the taxpayer must use an accrual method for purchases and sales. 215

222 Schedule C/Form 4562 and 2106 If the cash method is used for figuring income, then the cash method for reporting expenses must be used. If an accrual method for reporting expenses is used, then an accrual method for figuring income must be used If a combination method is used that includes the cash method, treat that combination method as the cash method. Schedule C Any income connected to a business is business income. A connection exists if it is clear that the payment of income would not have been made if the business did not exist. Income from work done in addition to a full time job can also be considered business income; the work does not have to be on a regular full-time basis. Business income from the sale of products or services is reported on Schedule C or C-EZ (refer to Part I of this syllabus). Schedule C is designed to report income by a sole proprietor (single owner of a business). All Schedule C income must be classified by their activity. An activity code based on the North American Industry Classification System must be entered in block B on Schedule C. All moneys received from business must be included in income unless excluded by law. Income from miscellaneous sources are reported on 1099-MISC, whether the income is reported on a 1099 or not it must be included in income. Accounting of gross receipts should be kept according to generally accepted accounting practices on a daily basis. Refer to Pub 583 for record keeping requirements. Other Kinds of Income Bartering is an exchange of property for services. Bartering income must be included in gross receipts determined by the fair market value of the goods or services. Both people or companies involved in the exchange must report the income.(barter income is reported on 1099-B) Personal property renting (equipment, vehicle rental, formal wear) income must be included in gross receipts. 216

223 Schedule C/Form 4562 and 2106 Income created from debt cancellation is business income if the debt is incurred in the business. Other items of income reported on Schedule C: o Restricted property o Promissory notes o Lost income payments o Patent infringement o Breach of contract o Antitrust injury o Kickbacks o Recovery of items previously deducted o Recapture of depreciation: o Listed property which falls below 50% business use (refer to Pub 926) o Section 179 expense taken on property where the business percentage falls below 50% before the end of the recovery period. (refer to Pub 926) o Sale or exchange of depreciable property at a gain (refer to Pub 544) Items that are Not Income Loans Sales tax Appreciation Leasehold improvements Exchange of like-kind property Consignments Construction allowances Short-term lease Retail space Qualified long-term real property 217

224 Schedule C/Form 4562 and 2106 IRS Publication 334 each tax year. Cost of Goods Sold If the business makes or buys goods to sell, the cost of goods sold can be deducted from gross receipts on Schedule C. To determine the cost of goods sold the inventory must be valued at the beginning and the end of Inventory at Beginning of the Year The cost of merchandise on hand at the beginning of the year that is available to be sold to customers. Purchases less cost of items withdrawn for personal use a merchant uses the cost of all merchandise, bought for sale; a manufacturer or producer includes the cost of all the raw materials or parts purchased for manufacture into the finished product. Trade discounts - The difference between the stated amount and the actual amount. The cost of purchases is the amount actually paid Cash discounts - Amount discounted from invoices for prompt payment, must be credited to either a separate account or subtracted from purchases Purchase returns and allowances - Must be deducted from purchases Merchandise withdrawn for personal use must be excluded from cost Cost of labor Labor costs are usually an element of the cost of goods sold only in manufacturing and mining. Materials and Supplies some supplies such as hardware and chemicals used in manufacturing are charged to cost of goods sold. These can also be deducted as business expenses. Cost of Goods Sold = Cost of inventory on hand at the beginning of the year plus Cost of inventory acquired during the year plus Shipping costs to receive inventory (not the finished product) plus Direct cost of labor that produces inventory plus Depreciation on machinery that produces the inventory minus Inventory removed for personal use minus Cost of inventory on hand at the end of the year. Gross Receipts minus Cost of Goods Sold plus Other Income = Gross Income minus Business Expenses = Tentative Profit minus Business Use of Home = Net Profit or Loss 218

225 Schedule C/Form 4562 and 2106 Business Expenses an ordinary expense is one that is common and accepted in the field of business. A necessary expense is one that is helpful and appropriate. Excerpt from Pub 334 Refer to Pub 535 for more information on business expenses. Record keeping is an essential part of business. The tax practitioner should instruct the taxpayer to bring adequate records to the tax interview. To meet adequate recordkeeping requirements the taxpayer must maintain an account book, diary, log, statement of expense, trip sheet and/or similar record or other documentary evidence that together with the receipt is sufficient to establish each element of an expenditure or use. The information already shown on the receipt does not have to be repeated in the record; however the records should back up the receipts. An adequate record contains enough information on each element of every business or investment use. If an asset is being depreciated notes must be kept in regards to the basis. If Section 179 is claimed in the first year, all the information should not only be noted on the correct form in the tax returns, but in the record keeping, so the basis can easily be determined. Meals and Entertainment are deductible only if they are directly related or associated with the active trade or business incurred while the taxpayer or his employee is present at a meal. A facility used for the meal cannot be deducted. Meals and entertainment expenses are taken at 50%. Refer to Pub 463 for more information. Travel for business expenses while away from the tax home are deductible. The tax home is the main place business is conducted regardless of where the personal residence is located. Refer to Pub 463 for more information. 219

226 220 Schedule C/Form 4562 and 2106

227 Schedule C/Form 4562 and

228 Schedule C/Form 4562 and 2106 Depreciation (Form 4562) Depreciation is the annual deduction allowed to recover the cost or other basis of business or other investment property through yearly deductions. Depreciation reduces the basis through yearly tax deductions. Only the part of property used for business or rental purposes can be depreciated. Three basic factors determine how much depreciation can be deducted each year. 1. The basis in the property 2. The recovery period for the property 3. The depreciation method used. Depreciation starts when the property is first used in business or for the production of income. It ends when the property is taken out of service, deduct all depreciable cost or other basis, or no longer use the property in the business or for the production of income. The basis of property must be reduced by the full amount of depreciation that could have been deducted, whether or not the depreciation was taken. The tax return can be amended if the proper amount of depreciation was not taken each tax year. Depreciation can be taken on property that meets all the following requirements: The taxpayer owns the property, even if there is debt on the property The property is used in a business or an income producing activity The property has a determinable useful life (something that wears out, decays, gets used up, becomes obsolete or loses value due to natural causes The property is expected to last more than one year The property is not property that is placed in service and disposed of in the same year or a Section 197 intangible Land can never be depreciated because land never wears out, becomes obsolete or gets used up. No deduction greater than basis may be taken. The total of the yearly deductions cannot be more than the cost or adjusted basis of the property. The total depreciation includes the depreciation deductions taken or was allowed to be claimed. The type of property and the date placed in service: 1. MACRS - Modified Accelerated Cost recovery System) for property placed in service after ACRS - Accelerated Cost Recovery System for property placed in service after 1980 but before Useful lives and either straight line or accelerated method of depreciation, such as declining balance method, for property placed in service before 1981 If property was placed in service before 2010 the same method of depreciation must be continued. To depreciate assets placed in service in 2010 the classification of the asset or recovery period must be determined: 222

229 Schedule C/Form 4562 and year property includes (200% declining balance): A race horse that is more than 2 years old at any time it is placed in service Any horse other than a race horse that is more than 12 years old at the time it is placed in service Any qualified rent-to-own property 5-year property includes (200% declining balance): Automobiles Light general purpose trucks Typewriter, calculators, copiers etc. Any semi-conductor manufacturer Section 1245 property used in connection with research and experimentation Certain energy property Appliances, carpets, furniture, etc. 7-year property includes (200% declining balance): Office furniture and equipment Railroad track Any property that does not have a class life and is not otherwise classified 10-year property includes (200% declining balance): Vessels, barges, tubs Any single purpose agricultural structure Any tree or vine bearing fruit 15-year property includes (150% declining balance): Any municipal wastewater treatment plant Any telephone distribution plant Any section 1250 property that is a retail motor fuels outlet 20-year property includes (150% declining balance): Farm buildings Municipal sewers not classified as 25 years 25-year property includes (straight-line method): Property that is an integral part of the gathering, treatment or commercial use of Municipal sewers Residential rental property 27.5 years (straight line method) Nonresidential real property 39 years (straight line method) 50-year property improvement to roadbed or right-of-way railroad track Report depreciation on Form 4562 and carry the deduction to the appropriate schedule. Use one Form 4562 per business or rental. Section 179-expense deduction is property described in Section 1245(a) (3) that was acquired by purchase for use in active conduct of the trade or business and is either Tangible property that can be depreciated under MACRS or 223

230 Schedule C/Form 4562 and 2106 Off-the-shelf computer software Section 179 does not include Property held for investment Property used mainly outside the United States Property used mostly to furnish lodging or in connection with the furnishing or lodging Property used by a tax-exempt organization Property used by a governmental unit or foreign person or entity Air conditioning or heating units Amortization is similar to the straight-line depreciation in that an annual deduction is allowed to recover certain costs over a fixed time period. Amortization can be taken on such items as the costs of starting up a business, goodwill and certain intangibles. Listed property generally includes: Passenger automobiles weighing 6,000 pounds or less Any other property used for transportation of the nature that the property lends itself to personal use, such as motorcycles Any property used for entertainment or recreational purposes Computers or peripheral equipment Special Depreciation Allowance 224

231 Schedule C/Form 4562 and 2106 The following is an example of office equipment placed in service on 02/01/2010. The cost is $1,450 and it is depreciated using MACRS 7-year %, which is 200% declining balance. As shown in the example special depreciation is taken on this asset. Form 4562 (see below) Line 14 shows the 50% special depreciation allowance of $725. Line 19c shows the current year depreciation on the basis for depreciation of $725 50% of the original basis of $1450. In this example the basis for depreciation equals cost minus special depreciation allowance. 225

232 226 Schedule C/Form 4562 and 2106

233 Schedule C/Form 4562 and 2106 Self-Employed Health Insurance Health insurance paid on behalf of employees is a business expense. Medical and dental insurance for the taxpayer and his/her family is an adjustment to income reported on Form 1040, line 29. Refer to Form 1040 instructions for the worksheet or Pub 535. Pension Plans (Refer to Chap10) A small business can set up retirement plans for the taxpayer and employees SEP (Simplified Employee Pension) plans SIMPLE (Savings Incentive Match Plan for Employees) plans Qualified plans (including Keogh or H.R. 10) Contributions to a plan made for an employee can be deducted on Schedule C, if the contribution is for the taxpayer it is deducted on line 28 of Form (Refer to Pub. 560). Before computing the business use of home complete Schedule C through the tentative profit by subtracting the business expenses from the gross income. Business Use of Home Form 8824 To qualify to claim expenses for the business portion of a home specific requirement must be met: 1. Use of the business part of the home must be exclusive (a room or identifiable place), regular (continuing basis), for the specific business and 2. Must be one of the following: Principal place of business (can have more than one place of doing business, including the home) A place to meet and deal with patients, clients or customers in the normal course of doing business A separate structure used in the course of business If the gross income from the business use of the home equals or exceeds the total business expenses, the business expenses related to the office in the home are deductible. If the gross income from business use of the home is less than the total business expenses the deduction for the business use of the home is limited. The deduction of otherwise nondeductible items such as insurance, utilities, and depreciation (with depreciation taken last) allocable to the business is limited to the gross income from the business use of the home minus the sum of the following: The business part of expenses that could be deducted even if the home was not used for business (such as itemized deductions) The business activities that relate to the business activity on the home but not to the home itself (such as the telephone costs) The net profit is computed by subtracting any office in home expense from the tentative profit. Refer to Form 8829 instructions or Pub

234 Schedule C/Form 4562 and 2106 Schedule SE Use Schedule SE (Form 1040) to figure the tax due on net earnings from self-employment. The Social Security Administration uses the information from Schedule SE to figure the taxpayers Social Security Benefits under the social security program. The taxpayer with income subject to SE tax receives one credit for every $1120 of income subject to SE in

235 Schedule C/Form 4562 and 2106 Generally, the taxpayer must pay SE Tax and file Schedule SE if the net earnings from selfemployment were $400 or more. The SE Tax rate is 15.3% (12.4% social security tax plus 2.9% Medicare Tax). The first $106,800 of wages, tips and net earnings are subject to the 12.4% social security part of self-employment tax. All of the combined wages tips and net earnings are subject to the 2.9% Medicare part of self-employment tax. Reasons to use the Optional Methods of computing SE tax if there is a loss or a small net profit where filing Schedule SE is not required The taxpayer receives credit for social security benefit coverage The optional method may increase the earned income component for computing child or dependent care credit The optional method may increase the earned income component for computing an earned income credit The optional method may increase the earned income component for computing an additional child tax credit The taxpayer can deduct one-half of the SE tax as an adjustment to income on line 27 of Form Refer to Pub 334 for a detailed discussion of the methods for figuring net earnings from self-employment. Earnings for Clergy For income tax purposes, a licensed, commissioned, or ordained minister is generally treated as a common law employee of his or her church, denomination, or sect. There are, however, some exceptions such as traveling evangelists who may be treated as independent contractors. Minister performing ministerial services, are taxed on wages, offerings, and fees received for performing marriages, baptisms, funerals, etc. 229

236 Schedule C/Form 4562 and 2106 The services performed are generally subject to self-employment tax (social security and Medicare taxes). See Publication 517, Social Security and Other Information for Members of the Clergy and Religious Workers, for limited exceptions from selfemployment tax. Even though, for social security tax and Medicare tax purposes, the minister is considered a self-employed individual in performing ministerial services, the minister may be considered an employee for income tax or retirement plan purposes. For income tax or retirement plan purposes, some of the income may be considered self-employment income and other income may be considered wages. Depending on all the facts and circumstances, under common-law rules the minister is considered either an employee or a self employed-person. Generally, a minister is an employee if the church or organization has the legal right to control both what they do and how they do it, even if they have considerable discretion and freedom of action. If the minister is employed by a congregation for a salary, they are generally a common-law employee and income from the ministry is considered wages for income tax purposes. However, amounts received directly from members of the congregation, such as fees for performing marriages, baptisms, or other personal services, are considered self-employment income. Offerings or fees received for performing marriages, baptisms, funerals, etc., are reported on Schedule C, Profit or Loss from Business, or Form 1040, to report these earnings and expenses. The gross income of a licensed, commissioned or ordained minister does not include the fair rental value of a home (a parsonage provided), or a housing allowance paid, as part of the minister's compensation for services performed that are ordinarily the duties of the minister. A minister who is furnished a parsonage may exclude from income the fair rental value of the parsonage, including utilities. However, the amount excluded cannot be more than the reasonable pay for the minister's services. A minister who receives a housing allowance may exclude the allowance from gross income to the extent it is used to pay expenses in providing a home. Generally, those expenses include rent, mortgage interest, utilities, repairs, and other expenses directly relating to providing a home. The amount excluded cannot be more than the reasonable pay for the minister's services. The minister's employing organization must officially designate the allowance as a housing allowance before paying it to the minister. The fair rental value of a parsonage or the housing allowance is excludable from income only for income tax purposes. No exclusion applies for self-employment tax purposes. For Social Security and Medicare tax purposes, a duly ordained, licensed or commissioned minister is self-employed. 230

237 Schedule C/Form 4562 and 2106 For more information, refer to Publication 517, Social Security and Other Information for Members of the Clergy and Religious Workers Form W-2 Example Form W-2 Box 1 Wages - $9,747 Box 3 Social Security Wages - $0 Box 5 Medicare Wages and Tips - $0 Box 14 Minister Housing Allowance - $24,

238 Schedule C/Form 4562 and 2106 Tips W-2 Boxes 7 and 8 If the employer allocated tips to the employee, they are shown separately in box 8 of Form W-2. They are not included in box 1 with wages and reported tips Allocated tips are tips that the employer assigned to the employee in addition to the tips the employee reported to the employer for the year. No income, social security, or Medicare taxes are withheld on allocated tips. The tips allocated to the employee are their share of an amount figured by subtracting the reported tips of all employees from 8% (or an approved lower rate) of food and drink sales (other than carryout sales and sales with a service charge of 10% or more).the employee s share of that amount was figured using either a method provided by an employer-employee agreement or a method provided by IRS regulations based on employees' sales or hours worked. For information about the exact allocation method used, advise the client to ask their employer. The following are the instructions for Form W-2, Box 7 Box 7 Social security tips. Show the tips that the employee reported to the employer even if the employer did not have enough employee funds to collect the social security tax for the tips. The total of boxes 3 and 7 should not be more than $106,800 (the maximum social security wage base for 2011). Report all tips in box 1 along with wages and other compensation. Include any tips reported in box 7 in box 5 also. If the instructions for Box 7 are complete, no additional social security or Medicare tax is needed on the amount in Box

239 Schedule C/Form 4562 and 2106 Below is an example of Form W- 2 (Social Security and Allocated Tips). Box 1 Wages - $20,509 Box 3 Social Security Wages - $9,028 Box 5 Medicare Wages and Tips - $20,509 Box 7 Social Security Tips - $11,481 Box 8 Allocated Tips - $5,230 The total of social security wages and social security tips equal the amount of wages, as a result there are no additional social security wages to be computed on Form The unreported tips are subject to social security tips, entered on Line 1c. 233

240 Schedule C/Form 4562 and 2106 Form Employee Business Expenses 234

241 Schedule C/Form 4562 and 2106 The taxpayer cannot deduct ordinary expenses which are common and accepted for travel (including meals unless the standard meal allowance is used) entertainment, gifts, or use of the car or other listed property unless proper record keeping and journals of expenses are kept. Generally receipts are required for all lodging expenses (regardless of the amounts) and any other expense of $75 or more. Special rules apply for qualified performing artists, fee-basis state or local government employees or reservists. 235

242 Schedule C/Form 4562 and 2106 Officials paid on a fee basis. Certain fee-basis officials can claim their employee business expenses whether or not they itemize their other deductions on Schedule A (Form 1040). Feebasis officials are persons who are employed by a state or local government and who are paid in whole or in part on a fee basis. They can deduct their business expenses in performing services in that job as an adjustment to gross income rather than as a miscellaneous itemized deduction. Expenses of certain performing artists. If the taxpayer is a performing artist, they may qualify to deduct employee business expenses as an adjustment to gross income rather than as a miscellaneous itemized deduction. To qualify, all of the following requirements must be met. During the tax year, the taxpayer performs services in the performing arts as an employee for at least two employers The taxpayer receives at least $200 each from any two of these employers The related performing-arts business expenses are more than 10% of the gross income from the performance of those services The adjusted gross income is not more than $16,000 before deducting these business expenses Armed Forces reservists traveling more than 100 miles from home. If the taxpayer is a member of a reserve component of the Armed Forces of the United States and travels more than 100 miles away from home in connection with performance of services as a member of the reserves, the taxpayer can deduct travel expenses as an adjustment to gross income rather than as a miscellaneous itemized deduction. The amount of expenses which are deductible as an adjustment to gross income is limited to the regular federal per diem rate (for lodging, meals, and incidental expenses) and the standard mileage rate (for car expenses) plus any parking fees, ferry fees, and tolls Meals and entertainment are deductible if the meal or entertainment expense is directly related to or associated with the active conduct of a trade or business or for the production or collection of income. Meals with business partners are usually not deductible unless the taxpayer can establish a clear business purpose. Lavish and extravagant expenses are not allowed, the expenses must be reasonable according to the circumstances. The deduction for meals and entertainment is limited to 50% of the amounts that would otherwise be eligible. Taxes and tips, cover charges and parking are included in the 50% limit. The following items are not included in the 50% limit: De minimis fringe benefits Expenses for meals and entertainment that are treated as taxable compensation to the employee and fully deductible by the employer Promotional activities made available by the taxpayer to the general public Employer-provided expenses for the benefit of employees that are not highly compensated, such as company picnics Meals and entertainment sold to customers such as a restaurant 236

243 Schedule C/Form 4562 and 2106 Business gifts made in the course of a taxpayer s trade or business are limited to $25 to any one individual per year. Exceptions to the $25 business gift rule includes items costing $4 or less containing and imprint; signs, displays, racks or other promotional items; incidental costs, such as engraving; awards of tangible property costing $400 or less given an employee for length of service. Travel away from the tax home expenses are 100% deductible if the taxpayer is away long enough that it cannot be reasonable to expect the taxpayer to complete the trip without sufficient sleep and rest. The tax home is determined by the taxpayer s business being in the same general vicinity of the main residence; the taxpayer incurs duplicate expenses while on business travel; and the taxpayer has not changed his/her historic place of main residence. Travel expenses include the following: Transportation Transportation to and from airports etc Baggage and shipping Car Lodging Meals (at 50%) Dry cleaning and laundry Telephone Tips Other similar, ordinary and necessary expense Expenses for temporary employment away from home are deductible, when the time of employment exceeds one year, it is considered permanent and is not deductible. Excess reimbursement to an employee must be included in income. There are two ways to compute the amount of vehicle expense taken on a return, either actual expenses or the standard mileage rate. Automobiles are listed property and are subject to rules under Internal Revenue Code Section 280(f). Regardless of which method the taxpayer uses to compute the automobile expenses the taxpayer must keep records of the following information: Total miles driven in the year Total business miles driven in the year The basis of the vehicle Date placed in service The standard mileage rate can be used for either a leased vehicle or an owned vehicle. If the standard mileage rate is used for a leased vehicle, it must be used for the entire lease period. To compute the deductible expenses using the standard mileage rate multiply the SMR by the number of business miles driven during the tax year. Parking fees and tolls can be taken in addition to the standard mileage rate. The standard mileage rate for 2010 is 50 cents per mile. 237

244 Schedule C/Form 4562 and 2106 Actual car expenses include the following: Depreciation Garage Rent Gas Lease payments Licenses Oil Parking Fees Registration Fees Repairs Tires Tolls The actual expense method can be taken on lease vehicles. Lease payments can be deducted for business purposes. If the lease payment is for more than 30 days, an inclusion amount is required, refer to Pub 463 for inclusion tables. Recordkeeping Generally there must be documentary evidence to prove expenses, such as receipts, canceled checks, or bills to support the deduction. If there is an accountable plan through the employer evidentiary documentation is not required for the expense, other than lodging, if less than $75 or a transportation expense where a receipt is not readily available. An accountable plan is an employer reimbursement plan for an employee s business expenses that are deductible to the employer and are not included in the employee s income. The employee must substantiate the expenses and return any excess reimbursements in a reasonable amount of time. Documentary evidence ordinarily will be considered adequate if it shows the amount, date, place and essential character of the expense. A canceled check together with a bill from the payee establishes cost. The records should be kept in a timely method and provide a written statement of the business purpose. Form 2106 is completed and the total of the expenses are reported on Schedule A line 21 subject to 2% of adjusted gross income. Excess reimbursements are included on Line 7 of Form Business expenses for self-employed persons are reported on Schedule C, not on Form 2106 and reduce the amount of self-employment tax. The same limits apply for automobiles and other business expenses as employee business expenses. 238

245 Schedule C/Form 4562 and 2106 Chapter 18 Sample Questions 1. If an inventory is necessary to account for income, the taxpayer must generally use an cash method of accounting for sales and purchases. A. True B. False 2. Business expenses must be? A. Helpful and appropriate B. Common and accepted in their field of business. C. Ordinary and necessary D. All of the above. 3. Which property cannot be depreciated? A. Property the taxpayer leased for 12 months B. Property with a useful life longer than 1 year C. Property held to produce income. D. Property with a determinable useful life. 4. If the gross income from the business use of the home equals or exceeds the total business expenses, the business expenses related to the office in the home are deductible. If the gross income from business use of the home is less than the total business expenses the deduction for the business use of the home is limited. A. True B. False 5. The SE Tax rate is? A. 15.3% B. 5.8% C. 5.6% D. 6.5% 6. Which of the following is a reason to use the Optional Methods of computing SE tax if there is a loss or a small net profit where filing Schedule SE is not required A. The taxpayer receives credit for social security benefit coverage B. The optional method may increase the earned income component for computing child or dependent care credit C. The optional method may increase the earned income component for computing an additional child tax credit D. All of the above 7. Automobile expenses for a self-employed individual filing a Schedule C, file Form 2106 to report the auto expenses. A. True B. False 239

246 Schedule C/Form 4562 and 2106 Chapter 18 Answers to Sample Questions 1. B - If an inventory is necessary to account for income, the taxpayer must generally use an cash method of accounting for sales and purchases is a false statement. Most individuals and many sole proprietors with no inventory use the cash method because they find it easier to keep cash method records. However, if an inventory is necessary to account for your income, you must generally use an accrual method of accounting for sales and purchases. (Pub 334, pg 13) 2. D All or the requirements below are correct, business expenses must be: Helpful and appropriate Common and accepted in their field of business. Ordinary and necessary (Pub 334, page 33) 3. A The property must be owned by the taxpayer or business to be depreciated. (Pub 334, pg 33) 4. A - If the gross income from the business use of the home equals or exceeds the total business expenses, the business expenses related to the office in the home are deductible. If the gross income from business use of the home is less than the total business expenses the deduction for the business use of the home is limited is a true statement. (Pub 334, page 39) 5. A - The SE Tax rate is 15.3% (12.4% social security tax plus 2.9% Medicare Tax).(Pub 334, page 41) 6. D- All of the following are reasons to use the Optional Methods of computing SE tax if there is a loss or a small net profit where filing Schedule SE is not required (Pub 334, pg 43) The taxpayer receives credit for social security benefit coverage The optional method may increase the earned income component for computing child or dependent care credit The optional method may increase the earned income component for computing an additional child tax credit. 7. B - Automobile expenses for a self-employed individual filing a Schedule C, file Form 2106 to report the auto expenses.(pub 17, Page 145) 240

247 Rental and K-1 Income Chapter 19 - Rental Real Estate, K-1 Income and Loss, Passive Activities Rental Income - Pub 527 Rental income is any payment the taxpayer receives for the use or occupation of property or a dwelling unit. A dwelling unit includes apartments, condominiums, mobile home, boat, vacation home, or similar property. A dwelling unit has basic living accommodations such as sleeping space, a toilet and cooking facilities. Income from room rentals of a hotel or motel is not considered rental income and should be reported on a Schedule C. Included in rental income are the following items: Security deposits - that are kept by the property owner or landlord or used as the last month s rent, included in rent. Security deposits that are returned to the tenant are not income Advance rent is any amount received before the period that it covers. Include advance rent in rental income in the year it is received, regardless of the period it covers or the method of accounting used Payment for canceling a lease is included in income in the year received Expenses paid by the tenant are rental income and can be deducted as any other rental expense If property or services are received instead of money as part of the rent include the fair market value in income. If services are agreed upon at a specified price, that price is the fair market value If the tenant has a lease with an option to buy, the payments received under the agreement are usually rental income. If the tenant exercises the right the payments received after the date of sale are considered part of the selling price Rental Expenses Ordinary and necessary expenses are deductible for managing, conserving or maintaining rental property from the time it is first available for rent. Accurate record keeping is mandatory for expenses to be deductible. Ordinary and necessary expense can be taken when a rental is vacant, but no losses can be deducted for the period the rental is vacant. Repairs are considered an expense and deductible in the year they are paid. Improvements add to the basis of the property and are depreciated. An improvement adds to the value of property, prolongs its useful life or adapts it to new uses. The cost of an improvement must be capitalized and can generally be depreciated as if the improvement was separate property. Repairs made within extensive remodeling or restoration of property are included as part of the improvement and capitalized. Work done on the rental property that does not add much to either the value of the house or the life of the property, but rather keeps the property in good condition is considered a repair, not an improvement. Repainting, fixing gutters, floors, or replacing broken windows are examples of repairs. 241

248 Rental and K-1 Income The following is a list of common rental expenses: Advertising Cleaning and maintenance Utilities Insurance Taxes Interest Points Commissions Tax return preparation fees Local transportation costs Rental payments or leases on equipment Mortgage interest reported to the owner of the property on Form 1098 (if over $600) is a deductible expense. Points or loan origination fees, if any are charges solely for the use of the money and are considered interest. Insurance premiums paid in advance cannot be deducted in full in the year paid. The premium must be allocated to the period covered and deducted in that year. Local benefit taxes that increase the value of the property, such as charges for putting in sewers, streets or sidewalks are non-depreciable capital expenditures and are added to the basis only. The ordinary and necessary expenses of traveling are deductible if the primary purpose of the trip was to collect rents, or to manage, conserve, or maintain the rental property. The travel expenses must be properly allocated between rental and non-rental activities. (See Pub 463). The ordinary local transportation expenses to collect rents, or to manage, conserve, or maintain the rental property is deductible. Generally if the taxpayer uses his/her personal vehicle the expenses can be deducted using one of two methods: actual expense or standard mileage rate. In 2010 the standard mileage rate is $.50 per mile. (Refer to Pub 463) Condominiums and Cooperatives Special rules apply to the rental of a condominium or cooperative. A condominium is a dwelling in a multi-unit building. Along with owning the unit, the owner also owns some of the common elements of the structure such as land, lobbies, elevators, and service areas. The owners of the units may pay dues or assessments for the care of these common areas. If the condominium is a rental, expenses such as depreciation, repairs, upkeep, dues, interest, taxes and assessments for the care of the common parts of the structure are deductible. Any special assessments for improvements to the rental must be capitalized and depreciated. All of the maintenance fees paid to cooperative housing authority for a cooperative apartment rented to others are deductible. Any payment for improvements or a capital asset cannot be 242

249 Rental and K-1 Income deducted. The payment is added to the basis of the stock in the cooperative. In addition to the maintenance fees direct payments for repairs, upkeep and other rental expenses can be deducted. (Refer to Pub. 527) The personal use of a dwelling unit comes into play if a personal residence or any other property was changed to a rental at any time during the year other than the beginning of the tax year. The yearly expenses such as taxes and insurance must be divided between rental and personal use. For depreciation purposes, treat the property as being placed in service on the conversion date. If only part of a property is rented the expenses and depreciation must be divided between the rental and personal use. Direct expenses of the rental do not have to be divided. The cost of the first phone line cannot be deducted, but a portion of other utilities can be deducted. The most common way to divide the expenses is either by square footage or number of rooms. The tax treatment of rental income and expenses for a dwelling unit that is also used for personal purposes depends on whether it is used as a home. The dwelling unit is considered a home for tax purposes if during the year it is used for personal purposes more than the greater of: days or 2. 10% of the total days it is rented to others at a fair rental price. If a home is rented fewer than 15 days during the year, none of the rental income or expenses is to be included. If the home is rented more than 15 days all the income and expense must be reported, including depreciation. All expenses and depreciation must be allocated between personal and rental use. (Refer to the passive section of this chapter for limitations of losses) Rental income, expenses and depreciation are reported on Part I of Schedule E. Schedule E Schedule E is used to report the following income or losses: Real estate rental activities (Page 1) Royalty income and expenses from oil, gas or mineral properties (Page 1) Income or loss from partnership s and LLC s that are treated as partnerships Required unreimbursed partnership expenses Income/loss from an S-corporation Income or loss from estates or trusts Income or loss from REMIC Net farm rental income Classification of Activities 1. Passive activities - investment in a trade or business with no material participation (participated more than 100 hours in the tax year or more than a total of 500 hours), most rental activities, limited partnerships. There are limits on passive activity deductions and credits. Generally, income cannot be offset by passive losses (other than passive income). Nor can taxes be offset by income (other than passive income) with the credits resulting from passive activities. Any excess loss or credit is suspended to the next year 243

250 Rental and K-1 Income Rental real estate activities are generally considered a passive activity and the amount of deduction allowed is limited. Active participation in rental real estate activity allows a taxpayer with an adjusted gross income of under $100,000 to deduct up to $25,000 ($12,500 if married filing separately) in passive losses against non-passive income. Taxpayers are considered actively participating if they own 10% of the rental activity and make management decisions in a significant and bona fide sense. Use Form 8582 to compute and track passive activities and suspended amounts from year to year 2. Non-passive activities - trade or business activate with material participation. Include wages and SE income. A person engaged in a trade or business is not subject to passive loss rules if material participation rules are met. Refer to Pub 925 for material participation criteria) 3. Portfolio Income - interest, dividends, and royalties from investments such as stocks, bonds and interest bearing accounts. Exception for real estate professionals. Rental activities in which you materially participated during the year are not passive activities if, for that year, you were a real estate professional. For a detailed discussion of the requirements, see Publication 527. For a detailed discussion of material participation, see Publication 925. Royalty Income Royalty from copyrights, patents and oil, gas and mineral properties are taxed as ordinary income which is generally reported on Schedule E. If the royalties are received as a selfemployed writer, inventor or artist, report the royalties on Schedule C. Copyright and patent income is generally paid to the taxpayer for the right to use the taxpayer s work over a period of time. Royalties from oil and gas are paid by a person or company who leases the property from the taxpayer. (Refer to Schedule E instructions for additional information). 244

251 Rental and K-1 Income Rental and royalty income are reported on Schedule E page 1, and the total is carried to page 2 line. The pass-through K-1 s are reported on page 2 of Schedule E. 245

252 Rental and K-1 Income Note the example of passive losses and the limitations of the rental loss on lines 22 and 23 of Schedule E. Page 2 of Schedule E show the allowed loss from the partnership. Passive activity loss limitations are computed on Form 8582 and related worksheets as illustrated below. 246

253 Rental and K-1 Income Form 8582 is used by noncorporate taxpayers to figure the amount of any passive activity loss (PAL) for the current tax year. A PAL occurs when total losses (including prior year unallowed losses) from all passive activities exceed the total income from all passive activities. Generally, passive activities include: 247

254 Rental and K-1 Income Trade or business activities in which the taxpayer did not materially participate for the tax year. Rental activities, regardless of participation. PALs cannot be used to offset income from nonpassive activities. However, a special allowance for rental real estate activities may allow some losses even if the losses exceed passive income. PALs not allowed in the current year are carried forward until they are allowed either against passive activity income, against the special allowance, if applicable, or when you sell or exchange your entire interest in the activity in a fully taxable transaction to an unrelated party. Individuals and qualifying estates who actively participated in rental real estate activities must include the income or loss from those activities in Worksheet 1 to figure the amounts to enter on lines 1a through 1c of Form Worksheet 5 shows the allocation of unallowed losses, this is done by Dividing each of the individual losses shown in column (a) by the total of all the losses in column (a) and enter this ratio for each activity in column (b). The total of all the ratios must equal 1.00 Worksheet 6 and 7: These worksheets allocate your unallowed and allowed losses for each activity.if there are losses from any activity that are reported on two or more different forms or schedules, use Worksheet 7 instead of Worksheet 6 for that activity 248

255 Rental and K-1 Income Pass-through Income from Partnership, S-Corporation, Estate or Trust K-1 s Schedule E, Page 2 is where all pass-through K-1 income or loss is reported. Partners and S Corporation shareholders and estate or trust beneficiaries should get a separate Schedule K-1 (or substitute statement) of income, expenses, deductions and credits for each activity engaged in by the partnership or S-corporation. Every K-1 should have instructions regarding the correct reporting of the partner or shareholder s share of the items. Schedule K-1 is not attached to the individual return. The taxpayer may deduct unreimbursed ordinary and necessary expenses paid on behalf of the partnership if required to pay these expenses under the partnership agreement. The K-1 instructions will tell where the income or loss is to be reported. Ordinary or rental income or loss from a partnership, S-corporation or an estate or trust is reported on Schedule E, page 2. If the partner is classified as a limited partner (did not materially participate in the partnership), the income from the K-1 is also passive. A sale of a passive activity is considered to be a nonpassive transaction. Passive activity losses that have not been deducted in a prior year (suspended) are generally allowed in the year of disposition. This includes the current year loss and any losses suspended from a prior year. This rule applies if the entire entity is disposed of and the sale is not made to a related party. The following three pages show items reported on a K-1 are to be reported on an individual return. 249

256 Rental and K-1 Income Form 1065, K-1, Page 2 250

257 Rental and K-1 Income Form 1120S, K-1, page 2 251

258 Rental and K-1 Income Form 1041, K-1, page 2 252

259 Rental and K-1 Income Chapter 19 - Sample Questions 1. A renter signs a 10-year lease to rent the taxpayer s property. In the first year, the taxpayer receives $5,000 for the first year's rent and $5,000 as rent for the last year of the lease. The taxpayer must include $ in income in the first year. A. $2,500 B. $5,000 C. $7,500 D. $10, If the taxpayer or spouse actively participated in a passive rental real estate activity, after considering income limitations, they can deduct up to $ of loss from the activity from their nonpassive income A. $5,000 B. $12,000 C. $15,000 D. $25, A single taxpayer has a rental loss of $6,000, he estimates his modified adjusted gross income is between $100,000 and $130,000, how much should he estimate to be his allowable rental loss? A. None the rental loss is not allowed B. 50% of the difference between his modified adjusted gross income and $150,000. C. $25,000 D. None of the above 3. Local benefit taxes that increase the value of the property, such as charges for putting in sewers, streets or sidewalks are non-depreciable capital expenditures and are added to the basis only A. True B. False 253

260 Rental and K-1 Income Chapter 19 Answers to Sample Questions 1. A renter signs a 10-year lease to rent the taxpayer s property. In the first year, the taxpayer receives $5,000 for the first year's rent and $5,000 as rent for the last year of the lease. The taxpayer must include $10,000 in income in the first year. Advance rent is any amount received before the period that it covers. Include advance rent in the rental income in the year it is received regardless of the period covered or the method of accounting used. (Pub 17, page 67) 2. If the taxpayer or spouse actively participated in a passive rental real estate activity, after considering income limitations, they can deduct up to $25,000 of loss from the activity from their nonpassive income. The $25,000 allowance is a special allowance for active participation in rental real estate and is an exception to the general rule disallowing losses in excess of income from passive activities. (Pub 17, page 71) 3. B - A single taxpayer has a rental loss of $6,000, he estimates his modified adjusted gross income is between $100,000 and $130,000, how much should he estimate to be his allowable rental loss? He should estimate his allowable rental loss to be 50% of the difference between his modified adjusted gross income and $150,000. If the modified adjusted gross income (MAGI) is $100,000 or less for a single taxpayer he can deduct a loss up to the amount $25,000. If the MAGI is more than $100,000 the special allowance is limited to 50% of the difference between $150,000 and the taxpayer s MAGI. Generally, if your MAGI is $150,000 or more, there is no special allowance. (Pub 17, page 71) 4. A - Local benefit taxes that increase the value of the property, such as charges for putting in sewers, streets or sidewalks are non-depreciable capital expenditures and are added to the basis is a true statement. (Pub 17, page 128) 254

261 Schedule F Chapter 20 Schedule F Farm Income Sources of Income Subject to SE Tax Sales of livestock and other items bought for resale Sales of livestock, produce, grains, etc. that the taxpayer raised Distributions received from cooperatives Agricultural program payments Custom hire work Federal and state fuel tax credits Accounting Methods for Farmers 1. Cash method - income is reported when actually received or constructively received. Expenses are deducted in the year paid. 2. Accrual method required for certain farm corporations and partnerships, and for all tax shelters. Report income in the year in which it was earned and expenses in the year incurred. 3. Special methods of accounting for certain items of income and expenses. Crop method is a method used by farmers who do not complete harvesting and disposing of crops within the tax year they are planted. The entire cost of the crop is deducted in the year the income is realized. 4. Combination hybrid method using elements of 1, 2, and 3. Farm Inventory If the taxpayer is required to keep an inventory, they should keep a complete record of their inventory as part of their farm records. This record should show the actual count or measurement of the inventory. It should also show all factors that enter into its valuation, including quality and weight, if applicable. Hatchery business. - use an accrual method of accounting, include in inventory eggs in the process of incubation. Products held for sale. All harvested and purchased farm products held for sale or for feed or seed, such as grain, hay, silage, concentrates, cotton, tobacco, etc., must be included in inventory. Supplies. Supplies acquired for sale or that become a physical part of items held for sale must be included in inventory. Deduct the cost of supplies in the year used or consumed in operations. Do not include incidental supplies in inventory as these are deductible in the year of purchase. Livestock. Livestock held primarily for sale must be included in inventory. Livestock held for draft, breeding, or dairy purposes can either be depreciated or included in inventory. Growing crops. Generally, growing crops are not required to be included in inventory. 255

262 Schedule F However, if the crop has a preproductive period of more than 2 years, you may have to capitalize (or include in inventory) costs associated with the crop. Items to include in inventory. Inventory should include all items held for sale, or for use as feed, seed, etc., whether raised or purchased, that are unsold at the end of the year. Uniform capitalization rules. The following applies for those who are required to use an accrual method of accounting. The uniform capitalization rules apply to all costs of raising a plant, even if the preproductive period of raising a plant is 2 years or less. The costs of animals are subject to the uniform capitalization rules. Inventory valuation methods. The following methods, described below, are those generally available for valuing inventory. Cost. Lower of cost or market. Farm-price method. Unit-livestock-price method. See Publication 538 or Pub 225 for information on valuation methods. There are many requirements when valuing inventory unique to livestock and crops, review the above publications. Uniform capitalization rules. A farmer can determine costs required to be allocated under the uniform capitalization rules by using the farm-price or unit-livestock-price inventory method. This applies to any plant or animal, even if the farmer does not hold or treat the plant or animal as inventory property sale Principal Agricultural Codes - are included on page 2 of Schedule F. An activity code must be included on all Schedule F s to classify farms. These codes are based on the North American Industry Classification Industry. An election can be made to figure the tax by averaging over the previous three base years. Making this election may provide a lower tax if the current year tax is high and in one of the previous three years the tax is low. Income The sale of farm products bought for resale, the profit or loss is the difference between the selling price (money plus the fair market value of any property) and the basis in the item (usually the cost). The rent received for the use of your farmland when the taxpayer materially participates in farming operations on the land is farm income. If the taxpayer pastures someone else s livestock and takes care of them for a fee, the income is from your farming business. The taxpayer must include rent you receive in the form of crop shares in income in the year you convert the shares to money or the equivalent of money. Crop shares you 256

263 Schedule F receive as a landlord and feed to your livestock are considered converted to money when fed to the livestock. Generally, do not report loans received as income. However, if part or all of the production is pledged to secure a CCC loan, treat the loan as if it were a sale of the crop and report the loan proceeds as income in the year you receive them. If a CCC loan is reported as income for the year received, generally they must be reported as income for all CCC loans in that year and later years in the same way The taxpayer must include in income any crop insurance proceeds received as the result of crop damage. Generally include them in the year received. Treat as crop insurance proceeds the crop disaster payments received from the federal government as the result of destruction or damage to crops, or the inability to plant crops, because of drought, flood, or any other natural disaster 257

264 Schedule F Schedule F Deductible Expenses The ordinary and necessary costs of operating a farm for profit are deductible business expenses. Part II of Schedule F lists some common farm expenses that are typically deductible. Reimbursed expenses. If the reimbursement is received in the same year that the expense is claimed, reduce the expense by the amount of the reimbursement. If the reimbursement is received in a year after the expense is claimed, include the reimbursement amount in income. Form Farm Rental Income and Expense Section 179 Deductions - Farm Property Trade or business property that qualifies for a Section 179 deduction includes: Tangible personal property such as machinery and equipment, milk tanks, automatic feeders, barn cleaners and office equipment Livestock Single-purpose agricultural and horticultural structures such as greenhouse, hay storage, integrated hog raising facility Milk parlor Poultry house Review Pub 225 for a listing of prepaid expenses and how they are handled. 258

265 Schedule F Depreciation To depreciate items on a farm use of either the General Depreciation System (GDS) or the Alternative Depreciation System (ADS) to depreciate property under MACRS. Generally use GDS unless specifically required by law to use ADS or an election to use ADS is made. Required use of ADS. The taxpayer must use ADS for the following property. All property used predominantly in a farming business and placed in service in any tax year during which an election not to apply the uniform capitalization rules to certain farming costs is in effect. Listed property used 50% or less in a qualified business use Any tax-exempt use property. Any tax-exempt bond-financed property. Any property imported from a foreign country for which an Executive Order is in effect because the country maintains trade restrictions or engages in other discriminatory acts. Any tangible property used predominantly outside the United States during the year. If required to use ADS to depreciate, the special depreciation allowance can not be claimed Electing ADS. Although the property may qualify for GDS, the taxpayer can elect to use ADS. The election generally must cover all property in the same property class placed in service during the year. However, the election for residential rental property and nonresidential real property can be made on a property-by-property basis. Once made this election, can never be revoked. The election by completing line 20 in Part III of Form Which Property Class Applies Under GDS? The following is a list of the nine property classes under GDS year property year property year property year property year property year property year property. 8. Residential rental property. 9. Nonresidential real property. Figuring depreciation using the 150% DB method and half-year convention. The IRS table has the percentages for 3-, 5-, 7-, and 20-year property. The percentages are based on the 150% declining balance method with a change to the straight line method. This table covers only the half-year convention and the first 8 years for 20-year property. See Appendix A in Publication 946 for complete MACRS tables, including tables for the mid-quarter and mid-month convention 259

266 Schedule F Schedule J Refer to Schedule J Instructions or Pub 225 for additional information. 260

267 Schedule F Chapter 20 Sample Questions 1. All harvested and purchased farm products held for sale or for feed or seed, such as grain, hay, silage, concentrates, cotton, tobacco, etc., must be included in inventory. A. True B. False 2. The taxpayer must use ADS for which of the following property? A. All property used predominantly in a farming business and placed in service in any tax year during which an election not to apply the uniform capitalization rules to certain farming costs is in effect. B. Listed property used 50% or less in a qualified business use C. Any tangible property used predominantly outside the United States during the year. D. All of the above 261

268 Schedule F Chapter 20 Answers to Sample Questions 1. A - All harvested and purchased farm products held for sale or for feed or seed, such as grain, hay, silage, concentrates, cotton, tobacco, etc., must be included in inventory is a true statement.(pub 225, page 6) 2. D - The taxpayer must use ADS for under all the following circumstances. All property used predominantly in a farming business and placed in service in any tax year during which an election not to apply the uniform capitalization rules to certain farming costs is in effect. Listed property used 50% or less in a qualified business use Any tangible property used predominantly outside the United States during the year. (Pub 225, page 43) 262

269 Foreign Income Chapter 21 Form 1040NR, 1040PR, Form 2555 and Form 1116 Form 1040NR - U.S. Nonresident Alien Income Tax Return Form 1040NR should be filed if any of the following four conditions applies: 1. The individual is a nonresident alien engaged in a trade or business in the United States during File even if: a. There is no income from a trade or business conducted in the United States, b. No U.S. source income, or c. The income is exempt from U.S. tax under a tax treaty or any section of the Internal Revenue Code. If there is no gross income for 2010, the schedules for Form 1040NR should not be completed. Instead, attach a list of the kinds of exclusions claimed and the amount of each. 2. The individual is a nonresident alien not engaged in a trade or business in the United States during 2010 and: a. Received income from U.S. sources that is reportable on Schedule NEC (tax on income not effectively connected with U.S. trade or business), lines 1 through 12, and b. Not all of the U.S. tax that is owed was withheld from that income. 3. The individual represents a deceased person who would have had to file Form 1040NR. 4. The individual represents an estate or trust that has to file Form 1040NR. Other situations when the taxpayer must file. File a return for 2010 if any special taxes are owed, including any of the following. Alternative minimum tax. Additional tax on a qualified plan, including an individual retirement arrangement (IRA), or other tax-favored account. Form 5329 can be filed by itself. Household employment taxes. Schedule H can be filed by itself. Social security and Medicare tax on tips not reported to the employer or on wages received from an employer who did not withhold these taxes. Recapture of first-time homebuyer credit. See the instructions for line 58 on page 27. Write-in taxes or recapture taxes, including uncollected social security and Medicare or RRTA tax on tips reported to the employer or on group-term life insurance and additional taxes on health savings accounts. See the instructions for line 59 on page 27. The taxpayer had net earnings from self-employment of at least $400 and are a resident of a country with whom the United States has an international social security agreement. See the instructions for line 54 on page

270 Foreign Income Exceptions. Form 1040NR does not need to be filed if: 1. Only U.S. trade or business was the performance of personal services; and a. Wages were less than $3,650; and b. There is no other need to file a return to claim a refund of over withheld taxes, to satisfy additional withholding at source, or to claim income exempt or partly exempt by treaty; or 2. The taxpayer was a nonresident alien student, teacher, or trainee who was temporarily present in the United States under an F, J, M, or Q visa, and have no income that is subject to tax under section 871 (that is, the income items listed on page 1 of Form 1040NR, lines 8 through 21, and on page 4, Schedule NEC, lines 1 through 12). 3. The taxpayer was a partner in a U.S. partnership that was not engaged in a trade or business in the United States during 2010 and Schedule K-1 (Form 1065) includes only income from U.S. sources that is reportable on Schedule NEC, lines 1 through 12. Resident Alien or Nonresident Alien If the taxpayer is not a citizen of the United States, specific rules apply to determine if they are a resident alien or a nonresident alien for tax purposes. Generally, they are considered a resident alien if they meet either the green card test or the substantial presence test for Generally, the taxpayer is considered a nonresident alien for the year if they are not a U.S. resident under either of these tests. For more details on resident and nonresident status, the tests for residence, and the exceptions to them, see Pub Green Card Test The taxpayer is a resident for tax purposes if they were a lawful permanent resident (immigrant) of the United States at any time during 2010 and they took no steps to be treated as a resident of a foreign country under an income tax treaty Substantial Presence Test The taxpayer is considered a U.S. resident if they meet the substantial presence test for They meet this test if they were physically present in the United States for at least: days during 2010, and days during the period 2010, 2009, and 2008, using the following chart. (a) (b) (c) (d) Year Days of physical presence Multiplier Testing days (multiply (b) times (c)) Total testing days (add column (d)) 264

271 Foreign Income Generally, the taxpayer is treated as present in the United States on any day that they are physically present in the country at any time during the day. Exempt individual. For these purposes, an exempt individual is generally an individual who is a: Foreign government-related individual; Teacher or trainee who is temporarily present under a J or Q visa; Student who is temporarily present under an F, J, M, or Q visa; or Professional athlete who is temporarily in the United States to compete in a charitable sports event. Note. Alien individuals with Q visas are treated as either students, teachers, or trainees and, as such, are exempt individuals for purposes of the substantial presence test if they otherwise qualify. Q visas are issued to aliens participating in certain international cultural exchange programs. See Pub. 519 for more details regarding days of presence in the United States for the substantial presence test. Closer Connection to Foreign Country Even though they otherwise would meet the substantial presence test, the taxpayer can be treated as a nonresident alien if they: Were present in the United States for fewer than 183 days during 2010, Establish that during 2010 they had a tax home in a foreign country, and Establish that during 2010 they had a closer connection to one foreign country in which they had a tax home than to the United States unless they had a closer connection to two foreign countries. See Pub. 519 for more information. Closer connection exception for foreign students. If the taxpayer was a foreign student in the United States, and they have met the substantial presence test, they still may be able to claim they are a nonresident alien. The taxpayer must meet both of the following requirements. 1. Establish that they do not intend to reside permanently in the United States. The facts and circumstances of the situation are considered to determine if they do not intend to reside permanently in the United States. The facts and circumstances include the following. a. Whether they have taken any steps to change their U.S. immigration status to lawful permanent resident. b. During the stay in the United States, whether they have maintained a closer connection with a foreign country than with the United States. 2. The taxpayer has substantially complied with the visa requirements. The taxpayer must file a fully completed Form 8843 with the IRS to claim the closer connection exception. See Form 8843 in chapter 1 of Pub

272 Foreign Income Form 1040NR The first 3 pages of Form 1040NR basically gathers information in the same format as Form 1040 and Schedule A. Below is Schedule NEC, Tax on Income Not Effectively Connected with U.S. Trade or Business. Form 1040NR due date is the same as Form All information regarding Form 1040NR came from Form 1040NR instructions. 266

273 Foreign Income 267

274 Foreign Income Form 1040 SS U.S. Self-Employment Tax Return, Including the Additional Child Tax Credit for Bona Fide Residents of Puerto Rico U.S. Virgin Islands, Guam, American Samoa, the Commonwealth of the Northern Form 1040NR is the Spanish version of Form 1040SS. Form 1040SS is for residents of the U.S. Virgin Islands (USVI), Guam, American Samoa, the Commonwealth of the Northern Mariana Islands (CNMI), and the Commonwealth of Puerto Rico (Puerto Rico) who are not required to file a U.S. income tax return. One purpose of the form is to report net earnings from self-employment to the United States and, if necessary, pay SE tax on that income. The Social Security Administration (SSA) uses this information to figure the benefits under the social security program. SE tax applies no matter how old they are and even if they already are receiving social security or Medicare benefits. Form 1040-SS must be filed if all three requirements below are met: The taxpayer or spouse if filing a joint return, had net earnings from self-employment (from other than church employee income) of $400 or more (or you had church employee income of $ or more. There is no filing requirement for Form 1040 with the United States. The individual is a resident of: o Guam, o American Samoa, o The USVI, o The CNMI, or o Puerto Rico (file either Form 1040-PR (in Spanish) or Form 1040-SS). In general, taxpayers with income from sources within Puerto Rico must file returns with both Puerto Rico and the United States. The income reported on each return depends on the taxpayer s residency status in Puerto Rico. Refer to Form 1040SS instructions for additional information. Or the Departamento de Hacienda

275 Foreign Income Form 2555 Foreign Income Exclusion If the individual is a U.S. citizen or a U.S. resident alien living in a foreign country, they are subject to the same U.S. income tax laws that apply to citizens and resident aliens living in the United States. Specific rules apply to determine if you are a resident or nonresident alien of the United States. See Pub. 519, U.S. Tax Guide for Aliens, for details. Foreign income retains its character and is reported on the applicable line for Form For example, foreign wages are included on Line 7, Form The maximum Foreign Earned Income Exclusion is $91,500 for Foreign country. A foreign country is any territory under the sovereignty of a government other than that of the United States. The term foreign country includes the country's territorial waters and airspace, but not international waters and the airspace above them. It also includes the seabed and subsoil of those submarine areas adjacent to the country's territorial waters over which it has exclusive rights under international law to explore and exploit the natural resources. The term foreign country does not include U.S. possessions or territories. It does not include the Antarctic region. The taxpayer qualifies for the tax benefits available to taxpayers who have foreign earned income if both of the following apply. They meet the tax home test You meet either the bona fide residence test or the physical presence test. Tax home test. To meet this test, your tax home must be in a foreign country, or countries, throughout your period of bona fide residence or physical presence, whichever applies. For this purpose, your period of physical presence is the 330 full days during which you were present in a foreign country, not the 12 consecutive months during which those days occurred. The tax home is the regular or principal place of business, employment, or post of duty, regardless of where they maintain their family residence. If the taxpayer does not have a regular or principal place of business because of the nature of the trade or business, the tax home is the regular place where the taxpayer lives regularly. They are not considered to have a tax home in a foreign country for any period during which your abode is in the United States. However, if they are temporarily present in the United States, or maintain a dwelling in the United States (whether or not that dwelling is used by the spouse and dependents), it does not necessarily mean that their abode is in the United States during that time. 269

276 Foreign Income Bona Fide Residence Test The taxpayer must meet one of the following: A U.S. citizen who is a bona fide resident of a foreign country, or countries, for an uninterrupted period that includes an entire tax year (January 1 December 31, if filing a calendar year return), or A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country, or countries, for an uninterrupted period that includes an entire tax year (January 1 December 31, if calendar year return). See Pub. 901, U.S. Tax Treaties, for a list of countries with which the United States has an income tax treaty in effect. Whether the taxpayer is a bona fide resident of a foreign country depends on the intention about the length and nature of the stay. See Pub. 54 for more information and examples. Physical Presence Test To meet this test, the taxpayer must be a U.S. citizen or resident alien who is physically present in a foreign country, or countries, for at least 330 full days during any period of 12 months in a row. A full day means the 24-hour period that starts at midnight. The amount of the exclusion is reported on Line 21 of Form For additional information, see Form 2555 instructions or Pub

277 Foreign Income Form Foreign Tax Credit (IRC Section 901(a)) Generally any foreign income taxes paid or accrued are eligible for the Foreign Tax Credit, unless the income has been excluded from income on Form The credit is limited to the tax liability and multiplied by the following fraction: Taxable income from sources outside the United States Total taxable income from U.S. and foreign sources The foreign tax credit is reported on Form 1116 (Refer to Pub 514 for more information). Foreign taxes paid or accrued on dividends, interest or royalties less than $300 ($600 if married filing jointly) can be reported directly on Form If Form 1116 is used in the return and the full amount of the credit is not allowed due to the tax liability, the foreign tax credit can be carried back 1 year and carried forward for 10 years. For more information about, or assistance with, figuring the foreign tax credit, the following IRS resources are available. IRS Call (in U.S. and Puerto Rico). Contacts Call (overseas) (not toll free). Contact IRS offices at U.S. Embassies in Beijing, London, Paris, or the U.S. consulate in Frankfurt. Before January 3, 2011, write to Internal Revenue Service, International Section, P.O. Box 920, Bensalem, PA After January 2, 2011, write to Internal Revenue Service, International Section, Philadelphia, PA Publications Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. Pub. 514, Foreign Tax Credit for Individuals. Pub. 519, U.S. Tax Guide for Aliens. Pub. 570, Tax Guide for Individuals With Income From U.S. Possessions. Pub. 575, Pension and Annuity Income 271

278 Foreign Income Chapter 21 Sample Questions 1. If a nonresident alien is engaged in a trade or business in the United States during 2010 and did not have income, Form 1040 NR does not have to be filed. A. True B. False 2. All the following are true regarding the Foreign Income Exclusion, except A. Foreign income retains its character and is reported on the applicable line for Form B. The maximum Foreign Earned Income Exclusion is $91,500 for C. A foreign country is any territory under the sovereignty of a government other than that of the United States. D. All of the above 3. Which of the following is not correct regarding computation of the Foreign Tax Credit? A. The Foreign Tax Credit is limited to the total income from source outside the U.S. over total income from U.S. and foreign sources. B. The Foreign Tax Credit is filed on Form 2555 C. The foreign tax credit can never be carried over D. None of these statements are true 272

279 Foreign Income Chapter 21 Answers to Sample Questions 1. B- If a nonresident alien is engaged in a trade or business in the United States during 2010, they must file even if they have no income.(form 1040NR instructions) 2. D - All the following are true regarding the Foreign Income Exclusion: Foreign income retains its character and is reported on the applicable line for Form The maximum Foreign Earned Income Exclusion is $91,500 for A foreign country is any territory under the sovereignty of a government other than that of the United States. (Form 2555, instructions) 3. C The Foreign Tax Credit is filed on Form 1116 not Form 2555.(Pub 17, Page 248) 273

280 Kiddie Tax Chapter 22 Kiddie Tax Kiddie Tax - Tax on Investment Income of Certain Minor Children (Form 8814 or Form 8615) If a child s interest, dividends and other investments total more than $1,900 part of that income may be taxed at the parent s tax rate instead of the child s. If the interest and dividend income totals less than $9,500 the child s parent may be able to choose to include that income on the parent s return rather than file a return for the child. These rules apply whether or not the child is a dependent. The additional tax is computed on Form 8814 to figure the child s interest, dividend or capital gain distribution on the tax return. Only the amount over $1,900 is added to the parent s income. If there is more than one child, compute Form 8814 for each child. The total amount of income computed on Form 8814 is added to Line 21 of Form If the income includes capital gain distributions or qualified dividends a special worksheet must be used to compute the tax. 274

281 Kiddie Tax Investment income is generally all income other than salaries, wages and other amounts received as pay for work done. It includes taxable interest, dividends, capital gains, the taxable part of social security and pension payments, certain distributions from trusts. Investment income includes amounts produced by assets the child obtained with earned income. Parents can elect to report the child s income on their tax return if all of the following apply: The child was under age 18 on January 1, 2010, or is and a full time student The child s only income was from interest and dividends The child s gross income was less than $9,500 The child is required to file for the tax year There were no estimated tax payments for the child There was no federal income tax withheld for the child The child did not file a joint return No estimated taxes were filed for the child The election to report the income on the parent s return avoids the filing of a return for the child, but the election can affect the parent s return Tax rate may be higher The child does not get benefit of any of the following deductions: o Higher standard deduction for a blind child o The deduction for a penalty on early withdrawal of the child s interest o Itemized deductions Reduced deduction of credits Penalty for underpayment of estimated tax The tax computed on Form 8814 is added to the tax computed on the taxpayer s Form If there is more than one Form 8814 add the total of the computed tax to the taxpayer s Form Part II of Form 8814 is used to figure the tax on the $1,900 of the child s interest and dividends that does not get included in income. The additional tax is the smaller of: b. 10% X (the child s gross income - minus - $950) or c. $

282 Kiddie Tax Form 8615 If a child's interest, dividends, and other investment income total more than $1,900, part of that income may be taxed at the parent's tax rate instead of the child's tax rate. If the parent does not or cannot choose to include the child's income on the parent's return, use Form 8615 to figure the child's tax. Attach the completed form to the child's Form 1040 or Form 1040A. When Form 8615 must be filed. Form 8615 must be filed for a child if all of the following statements are true. 1. The child's investment income was more than $1, The child is required to file a return for The child either: a. Was under age 18 at the end of the year, b. Was age 18 at the end of the year and did not have earned income that was more than half of his or her support, or 276

283 Kiddie Tax c. Was a full-time student over age 18 and under age 24 at the end of the year and did not have earned income that was more than half of his or her support. 4. At least one of the child's parents was alive at the end of The child does not file a joint return for Earned income. Earned income includes wages, tips, and other payments received for personal services performed. It does not include investment income as defined later in this chapter. Support. Your child's support includes all amounts spent to provide the child with food, lodging, clothing, education, medical and dental care, recreation, transportation, and similar necessities. To figure your child's support, count support provided by you, your child, and others. However, a scholarship received by your child is not considered support if your child is a full-time student. See chapter 3 for details about support. Investment income defined. Investment income is generally all income other than salaries, wages, and other amounts received as pay for work actually done. It includes taxable interest, dividends (including capital gain distributions), capital gains, the taxable part of social security and pension payments, and certain distributions from trusts. Investment income includes amounts produced by assets the child obtained with earned income (such as interest on a savings account into which the child deposited wages). Nontaxable income. For this purpose, investment income includes only amounts the child must include in total income. Nontaxable investment income, such as tax-exempt interest and the nontaxable part of social security and pension payments, is not included. Income from property received as a gift. A child's investment income includes all income produced by property belonging to the child. This is true even if the property was transferred to the child, regardless of when the property was transferred or purchased or who transferred it. A child's investment income includes income produced by property given as a gift to the child. This includes gifts to the child from grandparents or any other person and gifts made under the Uniform Gift to Minors Act 277

284 Kiddie Tax Chapter 22 Sample Questions 1. Investment income is generally all income other than salaries, wages and other amounts received as pay for work done. It includes which of the following? A. Taxable interest, B. Dividends, C. Distributions from trusts D. All of the above 2. Earned income includes all investment income. A. True B. False 278

285 Kiddie Tax Chapter 22 Answer to Sample Questions 1. D - Investment income is generally all income other than salaries, wages and other amounts received as pay for work done. It includes all of the following: Taxable interest Dividends Capital gains Taxable part of social security Pension payments Certain distributions from trusts. (Pub 17, Pg 209) 2. B - Earned income includes all investment income is false. Earned income includes wages, tips, and other payments received for personal services performed. It does not include investment income. (Pub 17, Pg 209) 279

286 AMT and GBC Chapter 23 General Business Credit and Alternative Minimum Tax Form Alternative Minimum Tax Alternative Minimum Tax (AMT) exists to make sure that taxpayers with substantial income are not able to avoid paying tax. The law limits the benefits a taxpayer can receive from favorable treatment of certain items. The AMT uses a separate accounting method with its own rules that govern the recognition and timing of income and expenses. The taxpayer is liable for either AMT or regular tax, whichever is more. AMT may be due if the taxable income for regular tax purposes is over the exemption amount for regular tax combined with certain adjustments and preferences. Exemption amounts for 2010: $47,450 for single or head of household $72,450 for married filing jointly or qualifying widow(er) $36,225 for married filing separately The most common exemptions and preferences include the following items: Addition of personal exemptions Addition of standard deduction Addition of itemized deductions claimed for state and local income taxes, certain interest, most miscellaneous deductions and part of medical expenses Subtraction of any refund of state and local taxes included in gross income Changes to accelerated depreciation of certain property Difference between gain or loss on the sale of property reported for regular tax purposes and AMT purposes Addition of certain income from incentive stock options Change in certain passive activity loss deductions Addition of certain depletion that is more than the basis of the property Addition of part of the deduction for certain intangible drilling costs, and Addition of tax-exempt interest on certain private activity bonds AMT for individuals is calculated and reported on Form This form has three parts: Part 1 identifies adjustments and preferences which comprise the alternative minimum taxable income (AMTI) on Line

287 AMT and GBC Part II is for calculating the alternative minimum tax, which is arrived at by reducing the AMTI by the appropriate exemption amount (listed above). The result is the AMT on line 35. Part III is a computation using that maximum capital gains rates, which is carried to Part II to determine the tax. To compute AMTI regular taxable income is increased or decreased by AMT adjustments and preferences. Preferences are items that receive special treatment for regular tax purposes, so they only increase AMTI. 281

288 AMT and GBC Adjustments are items of income and deduction that are computed differently for AMT than regular tax purposes. Adjustments can increase or decrease AMTI. Netting positive and negative adjustments is allowed. 282

289 AMT and GBC Depreciation - Generally, the taxpayer must refigure depreciation for the AMT, including depreciation allocable to inventory costs, for: Property placed in service after 1998 that is depreciated for the regular tax using the 200% declining balance method (generally 3-, 5-, 7-, and 10-year property under the modified accelerated cost recovery system (MACRS), except for qualified property eligible for the special depreciation allowance (discussed later on this page)); Section 1250 property placed in service after 1998 that is not depreciated for the regular tax using the straight line method; and Tangible property placed in service after 1986 and before (If the transitional election was made under section 203(a)(1)(B) of the Tax Reform Act of 1986, this rule applies to property placed in service after July 31, 1986.) Property placed in service before Refigure depreciation for the AMT using ADS, with the same convention used for the regular tax. See the following table for the method and recovery period to use. IF the property is... section 1250 property tangible property (other than section 1250 property) depreciated using straight line method for the regular tax any other tangible property Property Placed in Service Before 1999 THEN use the... straight line method over 40 years. straight line method over the property's AMT class life. 150% declining balance method, switching to straight line method the first tax year it gives a larger deduction, over the property's AMT class life. Property placed in service after Use the same convention and recovery period used for the regular tax. For property other than section 1250 property, use the 150% declining balance method, switching to straight line the first tax year it gives a larger deduction. For section 1250 property, use the straight line method. Refer to Pub 946 for additional information Alternative minimum tax is calculated in Part II of Form The computation actually starts with the AMTI on Line 28, which is reduced by the AMT exemptions listed above. The AMT exemption is reduced by 25% of the amount by which the taxpayer s AMTI exceeds the amount shown below for the filing status. Filing Status AMTI Single or Head of Household $112,500 Married Filing Joint or Qualifying Widow(er) $150,000 Married Filing Separately $75,

290 AMT and GBC Line 44 If the taxpayer is filing Form 1040NR, enter on Form 6251, line 44, the amount from line 5 of the Qualified Dividends and Capital Gain Tax Worksheet in the instructions for Form 1040NR, line 42, or the amount from line 14 of the Schedule D Tax Worksheet on page D-10 of the instructions for Schedule D (Form 1040), whichever applies (as figured for the regular tax). If these worksheets were not used, enter -0-. Line 53 If the taxpayer is filing Form 1040NR and Form 6251, line 36, is $175,000 or less ($87,500 or less if you checked filing status box 3, 4, or 5), multiply line 36 by 26% (.26). Otherwise, multiply line 36 by 28% (.28) and subtract $3,500 ($1,750 if filing status box 3, 4, or 5 is checked) from the result. 284

291 AMT and GBC Form General Business Credit General Business Credit is a credit made up of several separate business related credits. The General Business Credit is calculated on Form 3800 and consists of carry forward from prior years plus the total of current year business credits. All of the following are part of the General Business Credit: To claim any of these credits start with the Form listed above and the instructions including the qualifications and requirements. If the taxpayer is claiming more than one credit or carryover or carry back use Form (Refer to the instructions for Form 3800 for an overview of the credits refer to Pub 334). 285

292 AMT and GBC Form 8801 Credit for Prior Year Minimum Tax A portion of the Alternative Minimum Tax paid by a taxpayer in prior years can generate a minimum tax credit (MTC) under 53 in subsequent year. The MTC is generated only for AMT caused by deferral items (timing). Deferral items occur when an item is currently excluded under regular tax, but is recognized at a later date. This is common with incentive stock options (ISOs). The ISO benefit is excluded from gross income when exercised, but is included in regular tax when the stock is sold. Therefore the additional tax imposed by the AMT deferral adjustment generates a credit to reduce regular tax in the future. The MTC is not allowed for exclusion preference items (permanent differences). Exclusion items include the following Standard deduction Personal exemptions Itemized deductions disallowed for AMT purposes Excess depletion Tax exempt interest from private activity bonds issued after August 7, However, tax-exempt interest from private activity bonds in 2009 or 2010 is not a tax preference item. 7% of 1202 exclusion from the sale of qualified small business stock All other AMT adjustments and preferences are deferral items that may generate a MTC. Taxpayers must file Form 8801, Credit for Prior Year Minimum Tax. Form 8801 is used for Individuals, Estates and Trusts to figure the credit. In general, the MTC equals the taxpayer s adjusted net minimum tax which is the taxpayer s actual AMT, less the amount that would be AMT if only the exclusion items (permanent differences) were taken into consideration. Minimum Tax Credit Limitation In general, the MTC is used to reduce the taxpayer s regular tax liability in subsequent years. However, the MTC cannot reduce the taxpayer s regular tax below the tentative minimum tax for that year. Any unused minimum tax credit is carried forward indefinitely. The MTC cannot be carried back. 286

293 AMT and GBC Chapter 23 Sample Questions 1. AMT preferences only increase the Alternative Minimum Taxable Income. A. True B. False 2. Which of the following is a true statement regard Form 8801, Credit for Prior Year Minimum Tax? A. Deferral items occur when an item is currently excluded under regular tax, but is recognized at a later date B. The MTC can reduce the taxpayer s regular tax below the tentative minimum tax for that year C. Exclusion items include the standard deduction D. All of the above. 3. General Business Credits reported on Form 3800 are treated as used on a first-in, first-out basis offsetting the earliest earned credits first. A. True B. False 287

294 AMT and GBC Chapter 23 Answers to Sample Questions 1. A - AMT preferences only increase the Alternative Minimum Taxable Income is a true statement. 2. A - The MTC can reduce the taxpayer s regular tax below the tentative minimum tax for that year is a false statement; it cannot reduce the taxpayer s regular tax below the tentative minimum tax for that year 3. General Business Credits reported on Form 3800 are treated as used on a first-in, first-out basis offsetting the earliest earned credits first. A. True B. False 288

295 4797/6252/8824/4952/6198 Chapter 24 Form 4797, 6252, 8824, 4952, 6198 Form 4797 Sale of Business Property Sale and Exchange - A sale is a transfer of property for money or a mortgage, note, or other promise to pay money. An exchange is a transfer of property for other property or services. You usually realize gain or loss when property is sold or exchanged. A gain is the amount you realize from a sale or exchange of property that is more than its adjusted basis. A loss is the adjusted basis of the property that is more than the amount you realize. Gain or Loss If the adjusted basis is more than the amount realized then it is a loss; if the amount realized is more than the adjusted basis, then it is a gain Basis. The taxpayer must know the basis of their property to determine whether you have a gain or loss from its sale or other disposition. The basis of property is usually its cost. However, if the property is acquired by gift, inheritance, or in some way other than buying it, use a basis other than its cost. See Basis Other Than Cost in Publication 551, Basis of Assets. Adjusted basis. The adjusted basis of property is the original cost or other basis plus certain additions and minus certain deductions, such as depreciation and casualty losses. See Adjusted Basis in Publication 551. In determining gain or loss, the costs of transferring property to a new owner, such as selling expenses, are added to the adjusted basis of the property. Amount realized. The amount realized from a sale or exchange is the total of all money received plus the fair market value (defined below) of all property or services received. The amount realized also includes any of the liabilities that were assumed by the buyer and any liabilities to which the property transferred is subject, such as real estate taxes or a mortgage. Fair market value. Fair market value (FMV) is the price at which the property would change hands between a buyer and a seller when both have reasonable knowledge of all the necessary facts and neither has to buy or sell. If parties with adverse interests place a value on property in an arm's-length transaction, that is strong evidence of FMV. If there is a stated price for services, this price is treated as the FMV unless there is evidence to the contrary. Amount recognized. The gain or loss realized from a sale or exchange of property is usually a recognized gain or loss for tax purposes. Recognized gains must be included in gross income. Recognized losses are deductible from gross income. However, the gain or loss realized from certain exchanges of property is not recognized for tax purposes.. 289

296 4797/6252/8824/4952/6198 Interest in property. The amount realized from the disposition of a life interest in property, an interest in property for a set number of years, or an income interest in a trust is a recognized gain under certain circumstances. If the taxpayer received the interest as a gift, inheritance, or in a transfer from a spouse or former spouse incident to a divorce, the amount realized is a recognized gain. Ther basis in the property is disregarded. This rule does not apply if all interests in the property are disposed of at the same time Property Used Partly for Business or Rental If the taxpayer sells or exchanges property used partly for business or rental purposes and partly for personal purposes, the gain or loss on the sale or exchange must be figured as though they had sold two separate pieces of property. The taxpayer must allocate the selling price, selling expenses, and the basis of the property between the business or rental part and the personal part. The taxpayer must subtract depreciation you took or could have taken from the basis of the business or rental part. For information on Form 1099-C foreclosure and repossession see Chapter 11. Abandonments The abandonment of property is a disposition of property. The taxpayer abandons property when they voluntarily and permanently give up possession and use of the property with the intention of ending the ownership but without passing it on to anyone else. Generally, abandonment is not treated as a sale or exchange of the property. If the amount realized (if any) is more than the adjusted basis, then there is a gain. If the adjusted basis is more than the amount realized (if any), then there is a loss. Loss from abandonment of business or investment property is deductible as a loss. A loss from an abandonment of business or investment property that is not treated as a sale or exchange generally is an ordinary loss. This rule also applies to leasehold improvements the lessor made for the lessee that were abandoned. The abandonment loss is deducted in the tax year in which the loss is sustained. If the abandoned property is secured by debt, special rules apply. The tax consequences of abandonment of property that is secured by debt depend on whether you are personally liable for the debt (recourse debt) or you are not personally liable for the debt (nonrecourse debt). For more information, including examples, see Chapter 11 in this syllabus or Publication 4681 Canceled Debt, Foreclosures, Repossessions, and Abandonments. Forms 1099-A and 1099-C. If the abandoned property secures a loan and the lender knows the property has been abandoned, the lender should send a Form 1099-A showing information needed to figure the loss from the abandonment. However, if the debt is canceled and the lender must file Form 1099-C, the lender may include the information about the abandonment on that form instead of on Form 1099-A. Refer to Chapter 11 of this syllabus. 290

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299 4797/6252/8824/4952/6198 Form 4797 Use Form 4797 to report gain or loss from a sale, exchange, or involuntary conversion of property used in your trade or business or that is depreciable or amortizable. Form 4797 can be used with Forms 1040, 1065, 1120, or 1120S. Section 1231: Includes gains and losses from sales of real property or depreciable property used in a business or rental activity. Net long term gains that exceed the amount of depreciation taken are given capital gain treatment and are subsequently reported on Schedule D. Net losses are treated as ordinary losses and reduce other ordinary income (such as wages, interest and dividends) Show any section 1231 gains and losses in Part I. Carry a net gain to Schedule D (Form 1040) as a long-term capital gain. Carry a net loss to Part II of Form 4797 as an ordinary loss. Ordinary gains and losses. Show any ordinary gains and losses in Part II. This includes a net loss or a recapture of losses from prior years figured in Part I of Form It also includes ordinary gain figured in Part III. Section 1245: Refers to gains from sales of depreciable personal property (and certain real estate) used in a business or rental activity. Gains to the extent of depreciation claimed are treated as ordinary income. Ordinary income from depreciation. Figure the ordinary income from depreciation on personal property and additional depreciation on real property (as discussed in chapter 3) in Part III. Carry the ordinary income to Part II of Form 4797 as an ordinary gain. Carry any remaining gain to Part I as section 1231 gain, unless it is from a casualty or theft. Carry any remaining gain from a casualty or theft to Form Section 1250: Refers to the gains from sales of depreciable personal property used in business or rental activity. Gains to the extent of the excess of depreciation claimed over straight line (SL) are treated as ordinary income. For residential rental building depreciated under the prescribed pre-1986 ACRS percentages, the excess over SL depreciation is recaptured as ordinary income. 293

300 4797/6252/8824/4952/6198 Commercial and residential rental buildings depreciated under MACRS are depreciated SL, so there is no Section 1250 recapture of accelerated depreciation. Gains to the extent of SL depreciation allowed are considered unrecaptured Section 1250 gain and are taxed as capital gains subject to 25% rate. Form Installment Sales An installment sale is a sale of property where the taxpayer receives at least one payment after the tax year of the sale. The installment sales method cannot be used for the following. Sale of inventory. The regular sale of inventory of personal property does not qualify as an installment sale even if you receive a payment after the year of sale. Dealer sales. Sales of personal property by a person who regularly sells or otherwise disposes of the same type of personal property on the installment plan are not installment sales. This rule also applies to real property held for sale to customers in the ordinary course of a trade or business. However, the rule does not apply to an installment sale of property used or produced in farming. Special rule. Dealers of time-shares and residential lots can treat certain sales as installment sales and report them under the installment method if they elect to pay a special interest charge 294

301 4797/6252/8824/4952/6198 Stock or securities. You cannot use the installment method to report gain from the sale of stock or securities traded on an established securities market. You must report the entire gain on the sale in the year in which the trade date falls. Installment obligation. The buyer's obligation to make future payments to you can be in the form of a deed of trust, note, land contract, mortgage, or other evidence of the buyer's debt to you. General Rules If a sale qualifies as an installment sale, the gain must be reported under the installment method unless you elect out of using the installment method. Sale at a loss. If the sale results in a loss, it cannot qualify as for the installment method. If the loss is on an installment sale of business or investment property, it can be deductedt only in the tax year of sale. Figuring Installment Sale Income Each payment on an installment sale usually consists of the following three parts. Interest income. Return of your adjusted basis in the property. Gain on the sale. In each year a payment is received, the taxpayer must include in income both the interest part and the part that is the gain on the sale. Return of your basis in the property is not included. Basis is the amount of the investment in the property for installment sale purposes. Interest Income Interest is reported as ordinary income. Interest is generally not included in a down payment. Interest provided in the agreement is called stated interest. If the agreement does not provide for enough stated interest, there may be unstated interest or original issue discount. Adjusted Basis and Installment Sale Income (Gain on Sale) After the taxpayer has determined how much of each payment to treat as interest, then treat the rest of each payment as if it were made up of two parts. A tax-free return of the adjusted basis in the property, and The gain (referred to as installment sale income on Form 6252). Gross profit. Gross profit is the total gain reported on the installment method. To figure the gross profit, subtract theadjusted basis for installment sale purposes from the selling price. 295

302 4797/6252/8824/4952/6198 Contract price. Contract price equals: 1. The selling price, minus 2. The mortgages, debts, and other liabilities assumed or taken by the buyer, plus 3. The amount by which the mortgages, debts, and other liabilities assumed or taken by the buyer exceed your adjusted basis for installment sale purposes. Gross profit percentage. A certain percentage of each payment (after subtracting interest) is reported as installment sale income. This percentage is called the gross profit percentage and is figured by dividing your gross profit from the sale by the contract price. The gross profit percentage generally remains the same for each payment you receive. However, see the Example under Selling Price Reduced, later, for a situation where the gross profit percentage changes. Refer to Form 6252 Instructions and Pub 537 Form 8824 Like-Kind Exchange The exchange of property for the same kind of property is the most common type of nontaxable exchange. To be a like-kind exchange, the property traded and the property received must be both of the following: Qualifying property. Like-kind property. Basis of property received. If you acquire property in a like-kind exchange, the basis of that property is generally the same as the basis of the property you transferred. Money paid. If, in addition to giving up like-kind property, you pay money in a like-kind exchange, you still have no recognized gain or loss. The basis of the property received is the basis of the property given up, increased by the money paid. Sale and purchase. If you sell property and buy similar property in two mutually dependent transactions, you may have to treat the sale and purchase as a single nontaxable exchange. Reporting the exchange. Report the exchange of like-kind property, even though no gain or loss is recognized, on Form 8824, Like-Kind Exchanges. The instructions for the form explain how to report the details of the exchange. Exchange expenses. Exchange expenses are generally the closing costs paid by the taxpayer. They include such items as brokerage commissions, attorney fees, and deed preparation fees. Subtract these expenses from the consideration received to figure the amount realized on the exchange. Also, add them to the basis of the like-kind property received. If the taxpayer received cash or unlike property in addition to the like-kind property and realize a gain on the exchange, subtract the expenses from the cash or fair market value of the unlike property. Then, use the net amount to figure the recognized 296

303 4797/6252/8824/4952/6198 gain. Qualifying Property In a like-kind exchange, both the property you give up and the property you receive must be held by you for investment or for productive use in your trade or business. Machinery, buildings, land, trucks, and rental houses are examples of property that may qualify. The rules for like-kind exchanges do not apply to exchanges of the following property. Property you use for personal purposes, such as your home and your family car. However, see below. Stock in trade or other property held primarily for sale, such as inventories, raw materials, and real estate held by dealers. Stocks, bonds, notes, or other securities or evidences of indebtedness, such as accounts receivable. Partnership interests. Certificates of trust or beneficial interest. Choses in action, such as a lawsuit in which you are the plaintiff. Certain tax-exempt use property subject to a lease. For more information, see section 470(e) of the Internal Revenue Code. An exchange of the assets of a business for the assets of a similar business cannot be treated as an exchange of one property for another property. Like-Kind Property There must be an exchange of like-kind property. Like-kind properties are properties of the same nature or character, even if they differ in grade or quality. The exchange of real estate for real estate and the exchange of personal property for similar personal property are exchanges of like-kind property. For example, the trade of land improved with an apartment house for land improved with a store building, or a panel truck for a pickup truck, is a like-kind exchange. An exchange of personal property for real property does not qualify as a like-kind exchange. For example, an exchange of a piece of machinery for a store building does not qualify. Also, the exchange of livestock of different sexes does not qualify. Real property. An exchange of city property for farm property, or improved property for unimproved property, is a like-kind exchange. The exchange of real estate you own for a real estate lease that runs 30 years or longer is a like-kind exchange. However, not all exchanges of interests in real property qualify. The exchange of a life estate expected to last less than 30 years for a remainder interest is not a like-kind exchange. An exchange of a remainder interest in real estate for a remainder interest in other real estate is a like-kind exchange if the nature or character of the two property interests is the same. Personal property. Depreciable tangible personal property can be either like-kind or like-class to qualify for nonrecognition treatment. 297

304 4797/6252/8824/4952/6198 Exchange A deferred exchange is an exchange in which the taxpayer transfers property used in business or held for investment and later receives like-kind property that will be used in business or held for investment. The transaction must be an exchange (that is, property for property) rather than a transfer of property for money used to buy replacement property. In addition, the replacement property will not be treated as like-kind property unless the identification and the receipt requirements are met. Actual and constructive receipt. For purposes of a deferred exchange, the taxpayer actually receives money or unlike property when the money or unlike property is received or receive the economic benefit of the money or unlike property. The following rules also apply. Whether the taxpayer actually or constructively receive money or unlike property is determined without regard to your method of accounting. Actual or constructive receipt of money or unlike property by the taxpayer s agent is actual or constructive receipt by the taxpayer. Whether the taxpayer actually or constructively receive money or unlike property is determined without regard to certain arrangements the taxpayer makes to ensure the other party carries out its obligations to transfer the replacement property to them.. Identification requirement. The taxpayer must identify the property to be received within 45 days after the date transferred the property given up in the exchange. This period of time is called the identification period. Any property received during the identification period is considered to have been identified. Identifying replacement property. The taxpayer must identify the replacement property in a signed written document and deliver it to the person obligated to transfer the replacement property or any other person involved in the exchange other than you or a disqualified person. Replacement property to be produced. Gain or loss from a deferred exchange can qualify for nonrecognition even if the replacement property is not in existence or is being produced at the time the taxpayer identifies it as replacement property. If taxpayer needs to know the fair market value of the replacement property to identify it, estimate its fair market value as of the date expected to receive it. 298

305 4797/6252/8824/4952/6198 Receipt requirement. The property must be received by the earlier of the following dates. The 180th day after the date on which the taxpayer transfers the property given up in the exchange. The due date, including extensions, for the tax return for the tax year in which the transfer of the property given up occurs. This period of time is called the exchange period. The taxpayer must receive substantially the same property that met the identification requirement. Form 4952 Investment Interest Expense Deduction Investment Interest The interest on borrowed money to buy property held for investment is investment interest. Investment interest is deductible subject to the limitations. Interest incurred to produce tax-exempt income is not deductible. Investment Property Property held for investment includes property that produces interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. It also includes property that produces gain or loss (not derived in the ordinary course of a trade or business) from the sale or trade of property producing these types of income or held for investment (other than an interest in a passive activity). Investment property also 299

306 4797/6252/8824/4952/6198 includes an interest in a trade or business activity in which you did not materially participate (other than a passive activity). Limit on Deduction Generally, the deduction for investment interest expense is limited to the amount of the net investment income. The taxpayer can carry over the amount of investment interest that could not deduct because of this limit to the next tax year. The interest carried over is treated as investment interest paid or accrued in that next year. The taxpayer can carry over disallowed investment interest to the next tax year even if it is more than the taxable income in the year the interest was paid or accrued. Net Investment Income Determine the amount of your net investment income by subtracting the investment expenses (other than interest expense) from the investment income. Investment income. This generally includes the gross income from property held for investment (such as interest, dividends, annuities, and royalties). Investment income does not include Alaska Permanent Fund dividends. It also does not include qualified dividends or net capital gain unless you choose to include them. Form 6198 At Risk Limitations Use Form 6198 to figure: The profit (loss) from an at-risk activity for the current year (Part I). The amount at risk for the current year (Part II or Part III). The deductible loss for the current year (Part IV). The at-risk rules of section 465 limit the amount of the loss the taxayer can deduct to the amount at risk. For more details, see Pub. 925, Passive Activity and At-Risk Rules. Who Must File Form 6198 is filed by individuals (including filers of Schedules C, E, and F (Form 1040)), estates, trusts, and certain closely held C corporations described in section 465(a)(1)(B), as modified by section 465(a)(3). 300

307 4797/6252/8824/4952/6198 At-Risk Activities The at-risk limitation rules apply to losses from the following activities carried on as a trade or business or for the production of income. 1. Holding, producing, or distributing motion picture films or video tapes. 2. Farming as defined in section 464(e)(1). 3. Leasing any section 1245 property as defined in section 1245(a)(3). 4. Exploring for or exploiting oil and gas resources. 5. Exploring for or exploiting geothermal deposits as defined in section 613(e)(2). 6. Any other activity that is not included in (1) through (5) above. Exception. Holding real property placed in service before 1987 and holding an interest acquired before 1987 in a partnership, an S corporation, or other pass-through entity already engaged in an activity of holding real property before 1987 are not affected by the at-risk rules. This exception does not apply to holding mineral property. A special exception to the at-risk rules applies to a qualifying business of a qualified C corporation. See Pub. 925 for details. Amounts Not at Risk The taxpayer is not considered at risk for any of the following. 1. Nonrecourse loans used to finance the activity, to acquire property used in the activity, or to acquire the interest in the activity (unless the nonrecourse loan is secured by your own property that is not used in the activity). 2. Cash, property, or borrowed amounts used in the activity that are protected against loss by a guarantee, stop-loss agreement, or other similar arrangement (excluding casualty insurance and insurance against tort liability). 3. Amounts borrowed for use in the activity from a person who has an interest in the activity other than as a creditor or who is related under section 465(b)(3)(C) to a person (except you) having such an interest. However, this does not apply to (a) amounts borrowed by a corporation from a person whose only interest in the activity is as a shareholder of the corporation, or (b) amounts borrowed after May 3, 2004, and secured by real property used in the activity of holding real property (other than mineral property) that, if nonrecourse, would be qualified nonrecourse financing. See Pub. 925 for definitions. 4. Any cash or property contributed to the activity or to the interest in the activity that is: a. Financed through nonrecourse indebtedness or protected against loss through a guarantee, stop-loss agreement, or other similar arrangement, or b. Borrowed from a person who has an interest in the activity other than as a creditor or who is related under section 465(b)(3)(C) to a person (except you) having such an interest. However, this does not apply to (i) amounts 301

308 4797/6252/8824/4952/6198 borrowed by a corporation from a person whose only interest in the activity is as a shareholder of the corporation, or (ii) amounts borrowed after May 3, 2004, and secured by real property used in the activity of holding real property (other than mineral property) that, if nonrecourse, would be qualified nonrecourse financing. See Pub. 925 for definitions. 302

309 4797/6252/8824/4952/6198 Chapter 24 Sample Questions 1. For dispositions of business property and depreciable property, use Form. A B C D When you exchange property for other property, it is considered a disposition of property. A. True B. False 3. If you receive a gift of property and your basis is determined by the donor's adjusted basis, your holding period is considered to have started on the same day the donor's holding period started. A. True B. False 303

310 4797/6252/8824/4952/6198 Chapter 24 Answers to Sample Questions 1. A - For dispositions of business property and depreciable property, use Form (Pub 334,pg 18) 2. A -When you exchange property for other property, it is considered a disposition of property is a true statement. (Pub 334, pg 17) 3. A - If the taxpayer receives a gift of property and the basis is determined by the donor's adjusted basis, the holding period is considered to have started on the same day the donor's holding period started is a true statement. (Pub 334, pg 17) 304

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312 Other Items Chapter 25 Other Items Form 8903 Domestic Production Activities Deduction The domestic production deduction, Section 199, is a provision enacted in the American Jobs Creations Act of 2004 that generally allows taxpayers to receive a deduction based on qualified production activities income resulting from domestic production. This issue has been designated as a tier one issue. The revenue impact of this provision is anticipated to be $76 billion over the first ten years of its life. In the initial years, 2005 and 2006, the deduction is 3% moving to 6% from 2007 to 2009 and then 9% thereafter. Qualifying domestic production includes the manufacture of tangible personal property; the production of computer software, sound recordings and certain films; the production of electricity, natural gas, or water; and construction, engineering, and architectural services. Refer to the IRS website Form 8910 Alternative Motor Vehicle Credit A credit for the taxpayer that place an Alternative Motor Vehicle in Service in An alternative motor vehicle is a new vehicle that qualifies as one of the following four types of vehicles. Qualified hybrid vehicle (must weigh 8,500 pounds or less). Advanced lean burn technology vehicle. Qualified alternative fuel vehicle. Qualified fuel cell vehicle. A credit is also allowed for the cost of converting a vehicle to a qualified plug-in electric drive vehicle. Generally, the taxpayer can rely on the manufacturer's (or, in the case of a foreign manufacturer, its domestic distributor's) certification that a specific make, model, and model year vehicle qualifies for the credit and the amount of the credit for which it qualifies. Ordinarily the amount of the credit is 100% of the manufacturer's (or domestic distributor's) certification of the maximum credit allowable. However, the credit for converting a vehicle to a qualified plug-in electric drive vehicle is the smaller of (a) $4,000, or (b) 10% of the cost of the conversion. If the taxpayer purchased a qualified hybrid vehicle weighing 8,500 pounds or less or an advanced lean burn technology vehicle from a manufacturer who previously sold at least 60,000 of these vehicles, the amount of the credit may be reduced. The manufacturer should give you the information needed to figure the reduced credit. Also see the Form 8910 instructions. (Pub 17, page 247) 306

313 Other Items Form 8919 Uncollected Social Security and Medicare Tax on Wages 307