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I. History of Taxation
II. Types of Taxes
A. Property taxes (ad valorem taxes)
1. Realty--real estate and any capital improvements thereto that comprise fixtures
2. Personalty--all assets that are not realty
a. Tangible and intangible
B. Transaction taxes (transfer taxes)
1. Federal excise taxes
a. On items such as tobacco products, fuel and gasoline sales, telephone usage, and air travel passenger tickets
b. Alcohol taxes
c. Manufacturer excise taxes on trucks, trailers, tires, firearms, sporting equipment, coal, and gas guzzler tax on automobiles
d. Luxury tax--6% excise tax on automobiles in excess of $36,000; to be phased out by 2003.
2. State excise taxes
a. Use tax--ad valorem tax on use, consumption, or storage of tangible property.
3. General sales taxes
4. Severance taxes--tax imposed when natural resources are extracted.
C. Death taxes--tax on the right to transfer property or to receive property upon the death of the owner
1. Federal estate tax (tax on right to pass property at death)--TRA '97 phased in increase of unified credit--effective exemption increases from $600,000 to $1,000,000 in 2006. In 1999, the credit covers a tax base of $650,000.
2. State death tax (usually an inheritance tax--on right to receive property from a decedent).
D. Gift taxes--an excise tax levied on the right to transfer property
1. Federal gift tax--$10,000 per year per donee annual exclusion.
2. State gift taxes
E. Income taxes--federal, state, local
F. Employment taxes
1. FICA
a. Medicare portion--1.45%--No "cap" on wage base
b. Social security (disability, old age, survivors insurance--(6.2%)--"cap" is $72,600 for 1999
2. UTA (Federal and state)
G. Other
1. Federal customs duties--tariff on imported goods
2. Franchise tax
3. Occupational tax
H. Proposed taxes
1. VAT (value added tax)
2. Flat Tax--Rep Dic Armey--17%
3. National sales tax--Rep Bill Archer
III. Tax Administration
A. Internal Revenue Service--branch of Treasury Department
B. Statute of Limitations
1. General rule--IRS may access an additional tax liability against a taxpayer within 3 years of the later of the filing of the return or the due date (April 15 for individuals) of the return
2. If gross receipts > 25% are omitted--6 years
3. If no return filed or fraud--no statute of limitations
C. Interest and Penalties
1. Failure to file--5% per month up to max of 25% of tax shown as due
2. Failure to pay--.5% per month up to 25%
D. Tax practice
1. Statement of Responsibilities of Tax Practice
2. Statutory penalties
IV. Determination of Law
A. Revenue needs
B. Economic considerations
C. Social considerations
D. Equity considerations
E. Political considerations
F. Influence of the IRS
G. Influence of the courts
I. Tax Sources--Legislative (statutory); Executive (administrative); Judicial
A. Statutory source
1. 16th amendment-->IRC of '39-->IRC of '54-->IRC of '86
2. Legislative process (page 28-5)--generally starts in House Ways & Means
3. Unless a Constitutional issue is involved, Congress can override the U.S. Supreme Court decision by amending the Code.
4. Check Committee Reports for Congressional intent (thomas.loc.gov)
B. Administrative sources--issued by U.S. Treasury Dept or one of its instrumentalities
1. Treasury department regulations
a. Proposed, temporary (same authoritative value as final), and final--approved by Secretary of the Treasury
b. Legislative, interpretive, and procedural
2. Revenue rulings--official pronouncements of Nat'l Office of the IRS which provide interpretation of the tax law
3. Revenue procedures--issued by IRS; deal with internal management practices and procedures
4. Letter rulings--issued by National Office of the IRS to individuals describing how IRS will treat proposed transaction for tax purposes. Considered substantial authority for accuracy-related penalty--post '84 rulings
5. Other--Treasury decisions; determination letters (issued by District Director on completed transactions); Technical advise memoranda (initiated during audits)
C. Judicial sources
1. Federal Judicial System: Trial Courts (pp 28-13, 28-15)
a. Particular Court of Appeals need not follow other Court of Appeals decisions
b. Tax Court will decide a case as it feels the law should be applied only if the Court of Appeals of the appropriate jurisdiction has not yet passed on the issue or has previously decided a similar case in accord with the Tax Court's decision. If the Court of Appeals has previously held otherwise, Tax Court will conform even if they disagree (Golsen rule).
II. Working with the Tax Law
A. Tax research--the process of finding a competent and professional conclusion to a tax problem.
B. Tax planning--primary purpose is to maximize the taxpayer's after-tax wealth.
I. Taxable Entities
A. Individual taxpayers (Form 1040--Page B-11 of text--or variation)
1 U.S. citizens and resident aliens
a. Resident alien--Green card under INS rules (Immigration and Naturalization Service)
(1) File Form 1040--taxed on worldwide income following same rules as U.S. citizens
2. Foreign taxpayers--nonresident aliens
a. File Form 1040NR--generally taxed only on income from sources within the U.S.
(1) Income that is effectively connected with trade or business in U.S. taxed at same graduated rates as all citizens or residents
(2) If not effectively connected with trade or business, tax at flat 30% unless a lower treaty rate prevails
B. Corporate taxpayers--domestic and foreign-owned corps--(Form 1120)
1. "S" Corporations (Form 1120S)
C. Fiduciary taxpayers--person who is entrusted with property for the benefit of another, the beneficiary (Form 1041)
D. Partnerships (Form 1065--information return)
E. Limited Liability Company (Information from Society of Louisiana Certified Public
Accountants booklet, Limited Liability Companies (A New Way of Doing Business
in Louisiana))
1. General information--Limited Liability Company Law (LLC Law)
a. LLC law is comprised of Louisiana Revised Statutes 12:1301 through 1369.
b. An unincorporated association having two or more members that affords its owners protection from obligations of the business (limited liability) with the advantages of partnership taxation
c. Not a "bulletproof" statute--i.e. does not contain requirements that guarantee that an LLC will qualify as a pass-through entity for federal income tax purposes
d. LLC Law contains provisions that facilitate the merger of non-LLCs
into LLCs, or the consolidation of non-LLCs with LLCs.
2. Tax Issues Relating to LLCs
a. Unless LLC has at least three of four corporate characteristics, it will be treated as a partnership for federal income tax purposes.
(1) Continuity of life
(2) Centralization of management
(3) Liability for organization's debts limited to the organization's property
(4) Free transferability of interests
b. No published revenue rulings have yet been issued by the IRS concerning whether a Louisiana LLC may qualify for tax treatment as a partnership
c. Request private letter rulings
d. For Louisiana state income tax purposes, an LLC is treated and
taxed in the same manner that the LLC is treated and taxed for
federal income tax purposes
II. Comparison of Forms of Business Ownership (see table at end of these notes)
III. Tax Formula (Figure 2-1, page 2-2)
A. Income (broadly conceived)
B. Exclusions (Exhibit 2-1, page 2-4, line 8b of Form 1040)
C. Gross income (section 61)--income from whatever source derived, reduced by
those items specifically exempt from income. (Exhibit 2-2, page 2-4)
D. Deductions for Adjusted Gross Income
E. Adjusted Gross Income
F. Deductions from AGI (greater of)
1. Itemized deductions--Schedule A (these are limited for high-income taxpayers--will be discussed in Chapter 9)
2. Standard deduction
a. Two components
(1) Basic--varies by taxpayer classification (Table 2-1, page 2-8)
(2) Additional for elderly and blind--$850 MFJ; $1050 Single
b. No standard deduction for:
(1) Separate return if spouse itemizes
(2) Nonresident alien
(3) Return for period of less than 12 months
c. Reduced SD for dependents
(1) Lesser of
(a) SD for individuals
or
(b) Greater of:
I. $700 (indexed) or
2. Earned income plus $250, but not to exceed regular SD
(2) Additional SD for blind and age is OK
G. Exemptions--personal and dependency ($2,750 for 1999)
1. Note that failure to report the correct Social Security number of a dependent will result in the denial of the dependency exemption and the dependent (child) care credit. (Loss of the exemption may also result in the loss of other tax benefits, e.g., head of household status for a married child living with the taxpayer.)
H. Taxable income
I. Tax
1. Must use tax tables if able. The following must use tax schedules: taxable income over $100,000, taxable year less than one year due to acct. period change, estate or trust
a. Rates--15, 28, 31, 36, 39.6
2. Special computations--Kiddie Tax
a. Children under age 14--denied personal exemption, limited standard
deduction. Taxed at parent's marginal tax rate (parent with custody)
if have net unearned income (capital gains, dividends, interest,
rents, royalties, pensions, annuities, trust income).
b. Computation of Net unearned income
Unearned income
less
$700 plus the greater of $700 or related itemized deductions
c. Tax all at child's rate if higher
d. Election to report child's income on parent's return if income
between $700 and $7000 and is dividends or interest only (Form
8814) and no estimated tax paid in child's name. If a separate
return is filed, compute on Form 8615.
J. Credits--direct reduction in tax liability
1. Nonrefundable credits
a. Child and dependent care credit
b. Credit for the elderly
c. Foreign tax credit
d. Child tax credit
e. HOPE credit
f. Life-learning credit
2. Refundable credits
a. Earned income credit
K. Other taxes (such as self-employment taxes)
L. Prepayments (estimated taxes and withholding)
M. Tax due
IV. Personal and Dependency Exemptions
A. Amount--indexed to reflect increased in CPI beginning in 1990; $2750 in 1999
B. Personal exemption--taxpayer and spouse
1. Individual filing married filing separately (MFS) not entitled to exemption for spouse unless spouse has no GI and not claimed as dependent by another
2. Taxpayer claimed as dependent on another return not entitled to personal
exemption
C. Dependency exemptions--one per qualifying dependent
1. Support test--taxpayer must provide over 50% of dependent's total support (Year in which support is received, not paid governs)
a. Three areas of support (Note: This is not the same as maintaining a household)
(1) FMV of lodging furnished
(2) Any amount spent by or on behalf of dependents--what a reasonable individual would consider a reasonable expenditure--basic necessities such as food, clothing, medical and dental care plus toys, education, gifts, entertainment.
(a) Must actually be spent; disregard source of money, i.e. tax-exempt income; inclusion or exclusion from support does not carryover to GI
(b) Treat SS as paid by recipient; welfare payments by the state
(3) Proportionate share of HH costs (Reg 1.152-1(a)(2)(I))
b. Not considered support:
(1) Income taxes paid by dependent child from child's own income
(2) Funeral expenses of dependent
(3) Costs of exercising visitation rights by parent
(4) Life insurance premium costs
c. Multiple-support agreements
(1) No one person contributed over 50%
(2) Over half was provided by a group of qualifying individuals
(3) Citizenship, joint return, relationship, and GI met
(4) Exemption assigned by agreement to group member who contributed more than 10% to total support (Form 2120)
(a) Good idea for person paying medical to take
exemption so expenses can be claimed as itemized by
taxpayer
d. Children of divorced or separated parents
(1) Pre-1985 rules
(a) Decree can specify that noncustodial parent will get exemption as long as a minimum of $600 in support/child
(b) If decree is silent: Noncustodial can claim if provide minimum of $1200 and custodial can not prove that he/she provides more
(2) Post-1984 rules
(a) General: custodial parent gets exemption unless noncustodial parent is granted exemption on Form 8332. Waiver can be for any time period. Still must meet all other dependency requirements.
(3) No problem with medical expenses here: entitled to deduct medical expenses paid for child as itemized deduction even if no exemption claimed
2. Gross Income Test
a. Dependent's GI (taxable portion) must be less than exemption amount. Exception: child of taxpayer who is under 19 or full-time student under 24
3. Relationship or member of household
a. Code Section 152 (a) describes 9 qualifying relationships which are all familial except one
(1) Son or daughter or descendent of either
(2) Stepson or stepdaughter
(3) Brother, sister, stepbrother, stepsister
(4) Father, mother, or ancestor of either
(5) Stepfather or stepmother
(6) Niece or nephew (child of bro or sis)
(7) Aunt or uncle (sis/bro of parents)
(8) Son-in-law, sister-in-law, daughter-in-law, brother-in-law, mother-in-law, father-in-law
(9) Person who lived with taxpayer and was member of household for entire year
4. Joint return test
a. Can not file a joint return unless:
(1) Neither spouse is required to file joint return
(2) File only to claim refund because of zero tax liability (Rev Rul 65-34, 1965-1 CB 86)
(3) No liability would exist for either spouse on separate returns
5. Citizenship or residency test
a. Citizen or U.S. national or resident of U.S., Canada, Mexico
D. Phase-out of Exemptions (Formula on page 2-15)
V. Filing Requirements
A. General--not required to file if Gross Income is less than the total of Standard Deduction (plus elderly but not blind) and personal exemptions (non-taxable income not considered)
B. Must file:
1. Taxpayer who has self-employment net earnings of $400 or more
2. Individuals claimed as dependent by another
a. EI only: If GI > SD + B + Age
b. UI only: If GI > $700 + B + Age
c. Both: If GI > the larger of SD allowed or $700 + B + Age
3. Any person who receives advance payments of earned income credit or to
qualify for Earned Income Credit
VI. Filing Status (Note: There are 5 filing statuses on Form 1040, but only 4 tax rate schedules)
A. Married filing jointly
1. Status determined on last day of tax year or at time of spouse's death (state law governs)
a. Unmarried if legally separated under final decree of divorce or court
decree of separate maintenance (state law governs)
2. No joint return if either spouse was nonresident alien or two have different
tax years
3. Jointly and severally liable (Code Section 6013(d)(3))
a. The Taxpayer Bill of Rights II commissioned a study to review all
joint-return related issues--one of which was to look at the "fairness"
of joint and several liability
4. Once joint return filed, can not amend to separate after due date
B. Surviving spouse (qualifying widower) status (for up to 2 years after spouse's
death)
1. Must have been able to file joint return in year of spouse's death
2. Taxpayer provides over half cost of maintaining home in which she and dependent son, daughter, stepson, or stepdaughter live
3. Taxpayer is unmarried
C. Head of Household
1. Two conditions
a. Unmarried or considered unmarried (abandoned spouse) on last day
of tax year
(1) Abandoned spouse
(a) Spouse must not have lived in home at any time during last 6 months of tax year
(b) Provide over half cost for son, daughter, stepson, stepdaughter for whom dependency exemptions is claimed or could be claimed except noncustodial parent has exemption
(c) Above live in home more than one-half year
b. Taxpayer provides over one-half cost of maintaining home (property insurance, domestic help, food) in which a qualifying relative lives for more than one-half year
(1) Qualifying relative if dependent and lives in taxpayers
household except:
(a) Unmarried child, grandchild, step-child, adopted child need not be dependent; foster child must be dependent (Rev Rul 84-89, 1984-1, CB5)
(b) Parents need not live in home but at least one of them must be a dependent
(c) Married child, grandchild, stepchild, adopted child who could be dependent except that
i) Taxpayer let noncustodial parent have exemption
ii) Noncustodial provides at least $600 in pre-1985
2. No head of household for:
a. Multiple support agreement
b. No class #9 individual--must be qualifying relative
c. Non-resident alien (but one spouse can be)
E. Single
F. Married filing separately
1. If one spouse itemizes, the other must itemize.
2. Can't take:
a. Credit for child and dependent care expenses
b. Earned income credit
VII. Gains and Losses from Property Transactions--In General
A. Two basic types of property
1. Realty--land and any structure attached thereto
2. Personalty--anything not defined as realty
a. Distinguish between personal property and personal use property
B. Basic Computation: Amount realized
-Adjusted basis
Gain or (loss) realized
1. AR = Selling price less costs of disposition
2. Adjusted basis = Cost + capital additions - depreciation or other cost recoveries
C. Character of gain or loss
1. Any recognized gain or loss must be characterized as either ordinary or capital
2. Capital assets (Code section 1221)
a. In general, most personal use property and assets held for investment
purposes are capital assets
b. Code says all assets other than
(1) Inventory or stock in trade
(2) Depreciable or real property used in trade or business (1231 assets)
(3) Trade or accounts receivable
(4) Copyrights, literary, musical, or artistic compositions; letters or memos held by the person who created them
(5) U.S. Government publication
D. Holding Period
1. Short-term--assets held 12 months or less --rate is the ordinary tax rate--that is, taxed as ordinary income.
2. Long-term--assets held > 12 months--maximum rate is 20% (10% for taxpayers
in the 15-percent bracket; 28% for gains on the sale of collectibles).
E. Netting process (Please note: This process is further complicated by the tax rate at
which these gains/losses are taxed. The information below is an overview only.)
1. Net LTCG with LTCL to get either NLTCG or NLTCL
2. Net STCG with STCL to get NSTCG or NSTCL
3. NLTCG-NSTCG--net capital gain
4. NLTCL-NSTCL--net capital loss
F. Deductions
1. Non-corporate taxpayers--$3000 loss limit; use STCL first; carryovers retain nature
2. Corporate taxpayers--offset CL only against CG. Unused portion is carried back
3 years and forward 5 years.
| IRS Pub | IRS Form | Entity Description | Advantages | Disadvantages | |
| Sole Proprietorship | 334 | Sch. C,
Form 1040 |
One individual who carries on trade or business as self-employed person. Liable for all business debts and actions. Receives all profits from business. | Easiest to organize
Owner makes all decisions Minimum legal restrictions Business easy to terminate Losses can offset other income |
Unlimited liability to owner
Limited ability to raise capital Limited skills of owner Income tax can not be deferred by retaining profits |
| Partnership | 541 | Form 1065 | An association of two or more persons who carry on as co-owners as business for profit. Each partner contributes cash, property, and/or services for purpose of making a profit. Can be a syndicate, pool, group, or joint venture. | Easy to organize
Better financial strength than sole Skills/judgement of more than one Each partner has personal interest in business If partner actively participates, losses can offset other income. |
Unlimited liability for partners
Authority for decisions divided Income tax can not be deferred by retaining profits |
| Corporation | 542 | Form 1120 | An organization that has its own legal identity, rights, and liabilities similar to an individual. Includes associations, joint stock companies, insurance companies, trusts and partnerships that operate like corporations. Characteristics include continuity of life, central management, limited liability of owners, free transferability of ownership. | Life of business is perpetual
Stockholders have limited liability Easy transfer of ownerships Ease in raising capital Shared management Tax-free fringe benefits to owner/employees Corporate tax rates may be less than individual rates |
Double taxation--taxed at corp
level; dividends at individual level
Difficult/expensive to organize Charter restricts business activities Federal/state controls Personal service corps (PSC) taxed at higher rate Losses must be carried to year with profits Capital losses can only offset gains |
| S Corporation | 589 | Form 1120S | A special election made by a regular corporation on Form 2553. Income or loss passed through to shareholders and taxed at individual level as in a partnership. Must meet certain requirement: not more than 35 shareholders; domestic corporation; cannot be member of affiliated group; one class of stock; may not have nonresident alien as shareholder--only individuals, estates, and certain trusts. | Double taxation avoided
Limited liability Passthrough of profits not subject to self-employment tax as in partnership If shareholders actively participate, losses can offset other income
|
Fringe benefits restricted
Shareholders pay tax on undistributed profits Less flexibility in choosing tax yr Can't have > 35 shareholders Contribution limited to qualified retirement plan based on employee- shareholder wage--not overall profits as in sole prop No FICA & FUTA tax exemption for child employed by parent |
| Limited Liability
Company |
Form 1065 | Entity that combines passthrough attributes of p'ship with limited liability characteristics of a corporation. Entity must lack 2 of the following 3 characteristics: free trans-ferability of ownership; centralized management, continuity of life. | Unlike S corp, can have more than
35 shareholders
Can be owned by corporations Avoids certain S corporation restrictions Can be part of affiliated group |
Must have at least 2 owners
Can't have certain corporate characteristics Earnings subject to SE tax Not available in all states Income tax can't be deferred Certain states limit life of LLC |
I. Income
A. Definition--Section 61(a)--except as otherwise provided in this subtitle, gross income means all income from whatever source derived...
B. Economic income vrs. accounting income (realization principle)
C. Form of benefit or form of receipt principle
1. Reg 1.61-1(a)--gross income includes income realized in any form, whether in money, property, or services
D. Return of capital doctrine (Section 1001(a))
1. Adjusted basis is return of capital--not income
2. GI not = gross receipts; in Regs--GI = S - COGS
II. Accounting Periods
A. Taxable year (need permission to change once adopt)
1. Calendar year
2. Fiscal year (if keep accurate books and records)
a. 52-53 week year
b. 12-month period--1986 Act introduced provisions that restrict use of fiscal years by p'ships, S Corps, and PSCs. Must have substantial business reason for having other than required year.
(1) Partnership--fiscal year of majority interest partners (more than 50%) or fiscal year of principal (5%) partners or least aggregate deferral of income
(2) S Corp and PSC--almost always calendar year. If have to choose
different, must have business purpose, must have year within 3
months of calendar year, must have same year end as 1987, and
must make advance payments to government. (Section 444 election)
B. Short year--accounting period less than 12 months
1. Reasons for--change in accounting period. (Note: a taxpayer not in existence for 12 months does not present a problem.)
2. Four steps in calculation of tax
III. Accounting Methods
A. Must clearly reflect income; IRS has power to determine method; changes in method
require IRS approval
B. Cash method--report items of income and deductions in year in which actually or
constructively received or paid--cash equivalent doctrine. (Note: May enter into
contract in advance of performance of services to delay payment.)
1. Constructive receipt doctrine (Reg. 1.451-2)
a. Requirements for constructive receipt
(1) Control over amount without substantial limitations and/or restrictions
(2) Amount has been set aside or credited to taxpayer's account
(3) Funds are available for payment
2. Limitations on use of cash method
a. Normally prohibited for regular C corp; p'ships other than PSCs which have regular C corps as partners; tax shelters
b. Exceptions
(1) Small corp--any corp or p'ship whose annual gross receipts for all preceding years do not exceed $5 million (average 3 year period)
(2) Certain farming businesses
(3) Qualified PSC
3. Special Exceptions Applicable to Cash Basis taxpayers
a. Original issue discount--interest bearing corporate bonds issued at less
than face value; complex rules; in effect amortize over period held--that is,
report as earned (does not apply if maturity is one year or less)
b. Series E (1941-80) and EE (1980-) Savings Bonds
(1) Option to recognize income as go (catch up back interest) or at
redemption; applies to all past and future issues once election is
made. The election is mandatory even if a return is not otherwise
required.
(a) Once selected can switch methods after 5 years. File Form 3115--"Application for Change in Accounting Method"--write "filed under Rev. Proc. 89-46" and attach explanation.
(b) Within one year of maturity, taxpayer may exchange Series E or EE bonds for Series HH bonds (interest payable semiannually). Income from HH bonds must be reported annually, but income from E/EE is deferred until HH are redeemed.
B. Accrual method (Reg. 1.451.1(a))--when earned
1. All events test--income earned when all events have occurred that:
a. Fix right to receive such income and
b. Amount of income can be determined with reasonable accuracy
2. Must be used by tax shelters; through GP if inventories; by C corp except PSCs
3. Special Exceptions Applicable to Accrual Basis Taxpayers
a. Generally, prepaid income is taxed in the year received, even for an
accrual basis taxpayer. This is true of prepaid rent, prepaid interest, and
amounts received under guarantee or warranty contracts.
b. Prepaid service income (Rev Pro 71-21)
(1) Can recognize revenue in year of collection or
(2) If services performed in current year and next tax year, may accrue as earned. Otherwise, all income when received.
(a) Where substantial services are performed for rentals such as hotels, motels, etc, these rules apply.
(b) Otherwise, Rev Pro 71-21 does not apply to prepaid rent, prepaid interest, or amount received under guarantee or warranty contracts)
c. Dues and subscriptions--ratably over period earned not to exceed 36
months for dues
d. Advance payments for goods
(1) Can be reported as collected or generally can elect to defer recognition of income from advanced payment of goods if method of accounting for sale is the same for both tax and financial purposes
(2) Can elect to report as accrued if goods are not in stock on last day of year and seller has not received substantial (exceeding cost) payments
(3) Report at earlier of period reported for financial purposes or 2nd
taxable year after tax year in which receipts exceed cost and goods
are in ending inventory
C. Hybrid method
IV. Income Sources
A. Income from personal services
1. Generally taxable to person who earned (performed services or owned property)
"Fruit of the Tree Doctrine--"Lucas v Earl"--fruits can not be attributed to a
different tree from that on which they grew
B. Income from property
1. Generally, included in income of owner of property
2. Interest income
a. Gifts--cash basis donor reports accrued interest to date of gift as income when donee collects; accrual basis reports income as earned (Tax Court)
b. Sale--both cash basis and accrual basis recognize interest as accrued at
time of sale
3. Dividends
a. Gifts--donor taxed on dividends if transfer is after declaration date and before record date.
b. Sale--person who owns on date of record reports income.
C. Income received by agent--considered received by taxpayer when received by agent
D. Income from P'ships, S corp, trusts, and estates
E. Income in Community Property States
V. Other Items Specifically Included in Gross Income
A. Alimony and separate maintenance payments (Section 71, Pub 504)
1. Property settlement (other than cash) is transfer in exchange for release of
marital claims--not taxable or deductible. Former owner's basis transfers with
property. (Post 1984 divorces)
2. Alimony is deductible by payor in year paid and taxable to payee in year
received regardless of whether cash or accrual basis--"general obligation to
support"--if certain requirements met.
a. Pre-1985 divorces--rules particular as to what periodic payments are.
b. Post 1984 agreements and decrees
(1) Considered alimony if all the following requirements met:
(a) Made in cash
(b) Agreement does not specify that payments are not alimony
(c) Payor and payee don't live or file together
(d) Payments cease with payee's death
(2) Front-loading limitations--Post 1986 or Pre-1987 instruments modified after 1986
(a) Rule does not apply if payments are not more than $15,000 in any of first two post-separation years
(b) Payments made in second post-separation year will be recaptured if those payments exceed the payments made in the third post-separation year by more than $15,000.
(c) Payments made in first post separation year will be recaptured
if those payments exceed the average of the alimony payments
made in the second and third post-separation years by more
than $15,000. The excess amounts for both the first and
second post-separation years will be recaptured only in the
third post-separation year.
NOTE: The first post-separation year is the first calendar year in which alimony is paid. The
second and third post-separation years are the next two calendar years, whether or
not payments are made during those years. The first post-separation year does not
have to start with the year of separation or divorce; or with the year in which
payments are made, if no payments during that year qualify as alimony.
(d) Front-loading rules don't apply if payments:
(i) Cease because of death of either in 3-year period
(ii) Cease because of remarriage in 3-year period
(iii) Made under support agreement
(iv) Payments are contingent amount to be paid for at least 3
years and based on revenues from a business, from
property, or from employee or self-employment
compensation (contingent amounts beyond the payer's
control)
B. Child support--nondeductible and nontaxable
1. Post 1984 agreements
a. Requirements which must be met or treat as alimony
(1) Specific amount fixed or contingent on child's status
(2) Paid solely for support of minor children
(3) Payable by decree, instrument, or agreement
b. Once support established, no payments are alimony until all past and current child support payments are made
(1) Since child support payments are considered fixed, any reduction in
child support which are not part of original decree or subsequently
court-approved modified divorce decree are considered reductions
in alimony not child support
2. Pre-1985 agreements--payments presumed to be alimony unless expressly
designated as child support
C. Imputed Interest on Below-market loans (Section 7872)
1. Definition--a loan on which no interest is charged or on which interest is charged at a rate below the applicable federal rate. (Use rate in effect on day loan was made)
a. Federal rates--issued monthly in Revenue Ruling; short-term 0 to 3 yrs;
mid-term over 3 to 9 yrs; long-term over 9 yrs.
2. Must classify loan as one of four types as follows: Gift loan, compensation-related loans, corporation-shareholder loans, tax avoidance loans.
a. Each loan which does not meet an exception will have interest income to
lender, interest expense to borrower (imputed interest) which may or may
not be deductible
b. Each loan will also result in either gift, compensation, or dividends
3. Two transactions per classification:
| Classification | Lender | Borrower |
| Gift | Interest Income
Gift made |
Interest Expense
Gift received |
| Compensation-related | Interest Income
Compensation Expense |
Interest Expense
Compensation Income |
| Corporation-
shareholder |
Interest Income
Dividends paid |
Interest Expense
Dividend income |
4. Treatment will depend on whether it is a demand loan (payable on demand
or no time period stated) or a term loan
a. Demand loan--use foregone interest
(1) Foregone interest is the amount of interest that would be payable for that period if interest accrued at the applicable federal rate and was payable annually on 12/31, over any interest actually payable.
b. Term loan--use term to determine interest rate.
(1) Face of loan less PV of payments due is equal to original issue
discount. Interest determined similar to effective interest method.
See later example.
5. Exemptions from rules on below-market loans (Section 7872)--relates only
to interest portion (See page 3-27 of text for good summary of these rules)
a. Loans not exceeding $10,000
(1) Between natural persons--If total outstanding gift loans are
$10,000 or less and borrower doesn't use the loan proceeds to
purchase income-producing assets, do not need to consider
imputed interest rules.
(2) Compensation-related or corporation-shareholder--If less than
$10,000, and avoidance of federal tax is not the main purpose of
the loan, do not need to consider imputed interest rules.
b. Cap on interest income for loans between individuals not exceeding
$100,000 (not tax avoidance loans)
(1) Amount of interest imputed limited to amount of borrower's net
investment income (if less than imputed interest). The limitation
does not apply to gift made, compensation, or dividend portion.
(2) If borrower's investment income does not exceed $1,000, no
imputed interest is recognized.
D. Annuities (Section 72)
1. Definition--contract requiring fixed amount of money to be paid to owner at
specific intervals for either a certain period of time or for life.
2. Types
a. Simple annuity or term annuity--payout period is fixed.
b. Life annuity--payout is predicated on life of taxpayer.
(1) Single-premium deferred life annuity provides income after specified future date
(2) Single-premium immediate life annuity provides income for life beginning at once
c. Joint and survivor annuity--payout determined by two persons lives.
3. Interest earned by an individual is tax deferred
a. After 8/13/82, early withdrawals (wd before annuity starting date) treated
as distributions of interest (not return of capital) and subject to 10%
penalty; prior to 8/13/82 treated as return of capital
b. Exclusion ratio: (WD after the annuity starting date)
Investment in Contract x Current = ROC (Excluded Amount)
Expected Return Payment
(1) Pre 1987 annuity--use exclusion ratio for each year--even beyond
recovery of capital. However, no break if taxpayer dies before
recoups investment.
(2) Post 1986--exclude only to extent of original investment; however,
if not recouped by death, get itemized deduction for unrecouped
portion without being subject to 2% rule
c. A simplified method of computing an exclusion ratio for annuities received under a qualified employer retirement plans was provided by 1996 tax legislation (see legislation)
d. Use of tables
(1) To compute expected return: Prior to 7/1/86 had gender-based
tables. After 7/1/86, gender-neutral. For investment in annuities
made both before and after 7/1/86, can elect to use gender-neutral
tables for exclusion or can compute 2 ratios.
Inv. prior to 7/86 Inv after 7/86
ER--gender tables ER--Neutral
E. Prizes and awards (Section 74)
1. Taxable to extent of FMV unless:
a. Made in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievements if:
b. Recipient selected without direct action on his or her part
c. Recipient not required to perform substantial future services as condition of award
d. Prize or award given by payor to a governmental unit or tax-exempt
organization. Transfer must be made by payor. May not claim a
charitable deduction for the assignment of prize. IRS has specific
guidelines and forms.
2. Employee Achievement Awards
a. Tangible personal property
b. Made in recognition of length of service or safety achievement
c. $400/year ceiling unless qualified plan then $1600/year
F. Group-term life insurance (Section 79)
1. Paid by employer; generally taxable with exception
a. First $50,000 of group-term life insurance excludable from income.
Excess triggers TI subject to FICA/FIT computed using Regs tables, not
amount paid by employer
2. Won't apply to key employees if plan is discriminatory--they must exclude
greater of actual premiums paid or Regs tables computations
G. Unemployment compensation (Section 83)--all taxable
H. Social Security benefits--taxable to certain extent
1. Definitions
a. Base amounts
(1) Set One: $32,000 MFJ; $0 MFS; $25,000 others
(2) Set Two: $44,000 MFJ; $0 MFS; $34,000 others
b. MAGI--Modified Adjusted Gross Income = AGI + Tax exempt interest +
Foreign earned income
2. Computations:
a. If MAGI + .50 SS > Set One but not Set Two Base, the taxable amount of SS benefits is the lesser of:
(1) 50% of SS benefits or
(2) 50% of (Modified AGI + .50 SS - Set One Base Amount)
b. If MAGI + .50 SS > than Set Two Base Amounts, then the taxable amount of SS benefits is the lesser of:
(1) 85% of excess "provisional income" (MAGI + .50SS) over $34,000 or $44,000, plus
(2) The lesser of
(i) amount included under present law, or
(ii) $4,500 S, $6,000 MFJ
I. Donative Items
A. Gifts and inheritances--Excluded from income and nontaxable, although income
earned on property transferred is taxable
1. Gift--voluntary transfer of property by one to another without adequate consideration or compensation therefrom (donor's intent rules)
a. Elements of a gift
(1) Present intention to give
(2) Transfer of title and delivery
(3) Acceptance by donee
b. Must be made out of "detached and disinterested generosity" or out of feelings of "affection, respect, admiration, charity, or like impulses."
2. Bequest--transfer of personal property by will
3. Devise--transfer of real property by will
4. Inheritances
5. Exclusion not available
a. Assignment of income
b. Specific sum paid from trust or estate in more than three installments is
taxable to extent paid from earnings
B. Life insurance proceeds paid by reason of death (Section 101)
1. Generally not taxable to beneficiary who has insurable interest
a. Lump sum generally not taxable
b. Proceeds left with insurance company nontaxable but interest earned is taxable
c. Paid in installments--excess over pro rata distribution of face is taxable interest
d. Paid over life of beneficiary--use annuity exclusion ratio
Face of policy
# of years x payments/year
e. Policy transferred for valuable consideration--purchase price is basis; excess is taxable. Four exceptions:
(1) Partner of insured
(2) P'ship in which partner
(3) Corp in which insured is shareholder or officer
(4) Transferee whose basis in policy is determined by reference to
transferor's basis. (Tax-free exchange or gift)
2. New provisions under 1996 tax legislation
a. Accelerated death benefits received under a life insurance policy by a
terminally or chronically ill individual are generally excludable as life
insurance proceeds.
b. Similarly, proceeds from the assignment or sale of a life insurance policy
on the life of a terminally ill individual are generally excludable.
Note: A terminally ill individual is one whom a medical doctor certifies as
having an illness that is reasonably expected to cause death within 24
months.
c. In the case of a chronically ill individual, the exclusion is limited to the
amount paid by the individual for unreimbursed long-term care costs.
(Payments made on a per diem basis, up to $175 per day, are
excludable regardless of actual long-term costs incurred.)
Note: An individual is chronically ill if he or she is certified as being unable to perform without assistance certain activities of daily living.
d. These provisions allow qualified individuals to cash out their life insurance policies prior to death and still obtain tax-free treatment for the proceeds.
C. Employee death benefits (Section 101(b))
1. Generally taxable
2. See page 4-5 for a discussion of judicial interpretations which may allow
payments to qualify as gifts
D. Scholarships and fellowships (Code Section 117)
1. Payments received by student at an educational institution may be:
a. Compensation for services
(1) Tuition reduction and other amounts received in exchange for
teaching, research, or other part-time employment are included in
GI. Amount determined by reference to going rates of pay for
similar services.
b. Gift
c. Scholarship
(1) A scholarship is an amount paid or allowed to, or for the benefit of, an individual to aid such individual in the pursuit of study or research.
(2) Scholarships granted with expectation of future services taxable to recipient.
(3) Degree candidate--Nontaxable if used for tuition and fees necessary for enrollment or attendance at an educational institution; and fees, books, supplies, and equipment required for the course of study. Nondegree candidate--fully taxable.
(a) Taxable part is considered earned income
2. Educational benefits from an employer are generally taxable income with
exceptions.
a. Qualified tuition reduction by educational institutions--for courses below
graduate level; for employee, spouse, dependent children; for graduate
study if recipient is teaching or research assistance and other university
employees are granted the same benefit.
3. If receipt of cash in one year and pays in subsequent year, transaction is
held open until the educational expenses are paid.
II. Personal and Welfare Items (Section 104)
A. Compensation for personal injuries and sickness
1. Compensatory damages--intended to compensate taxpayer for injuries
incurred.
2. Punitive damages--intended to punish the person who caused harm.
3. Small Business Job Protection Act of 1996) requires that effective for amounts received after August 20, 1996, in tax years ending after that date, compensatory damages received on account of nonphysical injuries and ALL punitive damages are NOT excludable. (Note: If court order issued before 9/13/95, old rules apply.)
a. Damages for emotional distress are not treated as being received on account of physical injuries or sickness except to the extent of amounts attributable to medical care for emotional distress.
b. Punitive damages awarded in a wrongful death action are excludable if applicable state law provides for only punitive damages in such actions.
c. Age discrimination and injury to reputation are NOT physical injury or
sickness
3. See Concept Summary 4-1 on page 4-11
B. Government transfer payments
1. Social security may be partially taxable
2. Worker's comp resulting from work-related injury is excluded
3. Public assistance or welfare nontaxable
C. Accident and health insurance benefits--treatment depends on who purchased
plan. If purchased by taxpayer, exclude. If purchased by employer, see next
section.
III. Wage and Salary Supplements
A. Employer-Sponsored Accident and Health Plans (Sections 105/106)
1. New nondiscrimination rules apply after 1988 to accident or health plans;
group-term life insurance premiums; and dependent care assistance
programs.
2. Employer-paid premiums for health, accident, disability insurance are
deductible business expenses for employer and are excluded from employee
gross income. Note also that benefits received under a self-insured plan can
be excluded from the employee's income, if the plan does not discriminate
in favor of highly compensated employees.
3. Health insurance benefits
a. Not taxable if for reimbursement for medical care and/or payments for permanent injury of loss of member or body function of employee, spouse, dependent
b. Reimbursement of already deducted expenses are includable in income
to extent of tax benefit obtained for prior year's deduction
4. Accident insurance benefits/disability insurance benefits
a. Amounts received under employer-financed plan taxable except for permanent loss or use of a function or member of body or for permanent disfigurement (105)(c) or (105)(b)
b. Taxpayer-financed plan--all nontaxable
c. Pro rate for mixed financing
d. Payments that are substitute for salary (related to time absent) are
taxable.
5. New provision: Medical savings accounts (effective for tax years beginning
after December 31, 1996)
a. An eligible individual can deduct contributions to a medical savings account (MSA).
(1) Employees of small employers (50 or fewer employees) and self-employed individuals qualify for an MSA if the individual is covered under a high deductible ($2,000) health plan.
b. An individual can deduct (FOR AGI) contributions to an MSA equal to 65 percent (75 percent in the case of family coverage) of the annual health plan deductible.
c. Earnings of an MSA are not subject to tax; neither are distributions from an MSA to pay for medical expenses not covered under the high deductible plan.
d. Amounts remaining in an MSA must be distributed under rules similar to IRAs. Distributions not used for qualified medical expenses will be includable in gross income and, if distributed prior to age 65, death, or disability, an additional 15 percent penalty will apply.
e. As an alternative to an employee's deduction to an MSA, employer contributions to an employee's MSA are excludable from gross income.
f. MSAs are available on a four-year pilot basis and eligibility is to be
limited to approximately 750,000 individuals each year on a first-come,
first-served basis.
B. Employer-provided meals and lodging--Section 119--not taxable if:
1. Meals--for convenience of employer and on employer's premises (two-pronged test)
2. Lodging--employer's convenience, on premises, and required to occupy quarters in order to perform employment duties (three-pronged test)
a. Employee could not perform the services unless such lodging was furnished
b. Other lodging exclusions
(1) Employees of educational institutions--must pay annual rents => 5% of facility's appraised value or include deficiency in income
(2) Ministers of the Gospel
(3) Military personnel
C. Additional employee benefits--Code Section 132--specific exclusions from
employee income--See page 4-26 for excellent summary of Excluded Benefits--also IRS Pub 535
1. Working condition fringe benefits--not subject to discriminatory rules--deductible to extent employees could deduct if were reimbursed or otherwise paid the costs.
2. DeMinimis fringe benefits--not subject to discriminatory rules
3. Qualified transportation fringe--created by Energy Policy Act of 1992--not subject to discriminatory rules
a. Limited to $65 per month for combination of following:
(1) Transportation in commuter highway vehicle (six adults) between employee's residence and place of employment--80% of use
(2) A transit pass
b. Limited to $175 per month (1999 amount)
(1) Qualified parking
4. No-additional-cost services in same line or reciprocal O.K.; if other line,
employee pays 30% nondeductible excise tax; can't be discriminatory--If
discriminatory, those who receive discriminatory benefit lose all of exclusion.
(Note: Partners, for these provisions, are employees according to the
Regulations.)
5. Qualified employee discounts (reciprocal taxable)
a. Merchandise discount exclusion limited to employer's normal profit and not available for real property or personal property held for investment (such as stock)
b. Services--discount may not exceed 20% of price charged to customers
c. Can't be discriminatory--If discriminatory, those who receive discriminatory benefit lose all of exclusion
d. Must be in same line of business
6. Cafeteria plans--Section 125--employee may choose nontaxable, fringe benefits rather than cash compensation; "use it or lose it." Qualifying benefits, among others, include:
a. Group term life insurance premium costs
b. Disability income and accident insurance costs
c. Health insurance and premium costs
d. Dental insurance premium costs
e. Medical costs not covered by insurance
f. Qualified dependent care costs
g. Contribution to 401(k) plan
7. Child and dependent care services--$5,000/year with limits--cost of the
benefit may be paid through employee contributions or salary reductions
under a cafeteria plan or a combination of both.
8. Athletic facilities
9. Qualified moving expense reimbursements--Section 217
10. Flexible spending plans--flexible benefit plans--similar to cafeteria plans.
(Can't be used to pay long-term care insurance premiums.)
IV. Other Exclusions
A. Foreign Earned Income--earnings from an individual's personal services in a
foreign country. Two options:
1. Include in income and take tax credit for foreign taxes paid--election applies
to all subsequent years unless officially revoked. Revocation applies to year
of change and 4 subsequent years.
2. Take exclusion ($74,000 or pro rata amount)--Form 2555
a. Conditions
(1) Bonafide resident of foreign country or
(2) Present in a foreign country for at least 330 days during any 12
consecutive months.
Puerto Rico
U.S. Virgin Islands
Guam
North Mariana Island
Any U.S. possession
The Antarctic Region
B. Interest on certain state and local government obligations (report, however, on
Line 8b, Form 1040)
C. Dividends--distributions to stockholders--Schedule B
1. Three tax treatments of distributions (1099-DIV)
a. Ordinary dividends
b. Capital gain distributions
c. Nontaxable distributions
2. Forms of dividends
a. Cash and property dividends--taxable as ordinary income to extent from current and accumulated E & P
(1) If dividends exceed E & P, nontaxable return of capital to extent of
basis; capital gains thereafter
b. Stock dividends
(1) Usually nontaxable if common to common or nonconvertible preferred to common as long as proportion of ownership does not change.
(a) Shareholders who have right to choose between receiving dividends in cash or stock, all taxable and none qualified for stock dividend exclusion. (FMV)
(2) Stock dividend to certain preferred shareholders is treated like
cash dividends and is taxable
FYI: Dividends declared by a mutual fund in the last quarter of the year
but paid in January of the following calendar year, are treated as
paid in the earlier year.
Failure to provide a current taxpayer ID number to a payer
results in a 31% withholding rate.
D. Educational savings bonds (Code Section 135)--Pub 550--Forms 8818, 8815
1. Accrued interest on Series EE bonds issued after 1989 exempt from tax
when accrued interest and principal are used to pay for qualified educational
expenses of the taxpayer or taxpayer's spouse or dependents.
a. Exclusion available only for bonds issued to individuals who are at least
24 years old and are original purchaser or spouse; not available to
married couple who files separately
b. Calculation:
(1) Calculate accrued interest exclusion:
Qualified Ed. Exp Paid x Accrued Int
Redemption Proceeds
(2) Calculate exclusion phase out
MAGI - Phase-Out Amount x Exclusion = Reduction
15,000 or 30,000
c. Qualified education expenses--tuition reduced by excludable
scholarships, veterans' benefits received
E. Qualified State Tuition Programs
1. Amounts contributed must be used for qualified higher education expenses including tuition, fees, books, supplies, and equipment required for enrollment or attendance at college or university.
2. Difference between amount contributed and amount used to pay qualified
higher ed expenses is included in gross income of student.
F. Income from the discharge of indebtedness
1. Transfer of appreciated property in satisfaction of debt treated as sale of
appreciated property followed by payment of debt.
a. For tax years after 92, taxpayers other than C corp may elect to exclude
portion of income realized if property used in connection with trade or
business if property was used to secure debt. Reduce basis of property
by amount excluded. See supplement to text.
2. Foreclosure by creditor also treated as sale or exchange of property.
3. Income when all or part of debt is forgiven.
4. Special treatment
a. Creditors' gifts--not taxable if act of love, affection or generosity
b. Discharges under Federal bankruptcy law
c. Discharges that occur when debtor insolvent
d. Discharge of farm debt of solvent taxpayer
e. Discharge of qualified real property business indebtedness
f. Seller's cancellation of buyer's indebtedness
(1) In situations b, c, d, e, f: Debtor reduces basis in assets by realized gain from discharge
g. Shareholder's cancellation of corporation's indebtedness--contribution of capital
h. Forgiveness of loans to students--excluded from gross income if
circumstances such as must practice in state "X" number of years, etc.
I. Classification of Expenses
A. For AGI (above the line)--See page 1 of Form 1040
1. Section 62 lists FOR AGI deductions--this section classifies the expenses but
does not allow for the deduction itself. If not listed in Section 62, it is not a
deduction For AGI.
2. List of common AGI deductions
| Item | Location on Tax Return |
| Section 162 trade or business expenses
(not an employee) |
Shown on Schedule C--net income from Schedule C transferred to Line 12 |
| Reimbursed employee business expenses | Under accountable plan--not reported in income; not deducted on return |
| Losses from sale or exchange of property
--capital assets |
Shown on Schedule D--transferred to Line 13 of Form 1040 |
| Section 212--Deductions attributable to property held for the production of income | Shown on Schedule E and transferred to Line 17 of Form 1040 |
| Deductible IRA contributions | Line 23 of Form 1040 |
| Student Loan Interest | Line 24 of Form 1040 |
| Medical savings account deduction | Line 25 of Form 1040 |
| Moving expenses (From Form 3903) | Line 26 of Form 1040 |
| Deduction for ½ self-employment tax | Line 27 of Form 1040 |
| Self-employed health insurance deduction | Line 28 of Form 1040 |
| Contributions to pension, profit-sharing, and annuity plans | Line 29 of Form 1040 |
| Premature withdrawal of funds | Line 30 of Form 1040 |
| Alimony payments | Line 31 of Form 1040 |
B. From AGI (below the line)--Itemized deductions--See Schedule A
1. Medical expenses
2. Taxes
3. Interest
4. Charitable contributions
5. Casualty and theft losses
6. Miscellaneous itemized deductions
II. General Rules--"Legislative grace" allows deduction
A. Section 162 trade or business expenses--all ordinary and necessary expenses
paid or incurred during taxable year in carrying on any trade or business (For AGI
on Schedule C unless an employee, then from AGI)
B. Section 212--all ordinary and necessary expenses paid or incurred during taxable
year: (For AGI if attributable to rents or royalties)
1. For production or collection of income (investment fees)
2. For management, conservation, or maintenance of property held for production of income (rental income)
3. In connection with determination, collection, or refund of any tax (tax return preparation fee for sole proprietorship is For AGI)
C. Requirements for deduction
1. Related to carrying on trade or business or income-producing activity
a. Trade or business--entered into for profit; expense motivated by business concerns; sufficient degree of taxpayer activity in order to distinguish the activity from passive investment
b. Income producing activity; profit motive; reasonable relationship to
income-producing activity
2. Ordinary and necessary (Both 162 and 212)
a. Ordinary--normally incurred in the type of business in which the taxpayer is involved and not capital in nature
b. Necessary--appropriate, helpful, or capable of making a contribution to the taxpayer's profit seeking activities
3. Reasonable--courts have held it is implied in phrase "ordinary and necessary" although it specifically refers to compensation
4. Paid or incurred during taxable year
a. Cash basis taxpayers--deductible when paid with some restrictions
(1) Must use accrual through gross profit
(2) Reg. 1.446-1(a)(1)--partial deductibility if useful life extends "substantially" beyond close of taxable year
(a) Prepaid rent/insurance--in general, deducted only in period to which they relate unless two conditions present
i) Period for which payment is made does not exceed one year
ii) Taxpayer is contractually obligated to prepay amount for
a period extending beyond close of year
(b) Other prepayments-deductible if asset will be consumed by close of following year, there is a business purpose for the expenditure, no material distortion of income
b. Accrual basis taxpayers--when incurred, that is, when all events test is
satisfied and economic performance has occurred.
(1) All events test--all events establishing existence of liability must have occurred and the amount of the liability can be determined
(2) Economic performance--when the service, property, or use of property giving rise to the liability is actually performed for, provided to, or used by the taxpayer.
(3) Expense may be accrued and deducted if:
(a) All events test is satisfied
(b) Economic-performance occurs within 8 1/2 months of close of tax year
(c) Item is recurring in nature and taxpayer treats consistently
(d) Item is immaterial or accrual in earlier year results in better match against income than accruing the item when economic performance occurs
D. Employee business expenses
1. Note that an employee is treated as being in the business of being an employee
2. Section 162 then serves as the authority for the deduction of most employee
business expenses such as union dues, dues to trade and professional
societies, and subscriptions to professional journal
III. Deduction for Losses (Code Section 165)
A. General rule--three types of losses deductible by individuals
1. Losses incurred in trade or business (Schedule C)
2. Losses incurred in transaction entered into for profit (Schedule E (passive rules) or Schedule D)--These losses may be limited.
3. Casualty losses--losses of property not connected with trade or business if
such losses arise by fire, storm, shipwreck, theft, other casualty. (Schedule
A)
IV. Limitations/Disallowances of Deductions
A. Public policy restrictions
1. Bribes and kickbacks (in case of foreign, only if US Foreign Corrupt Practices Act of 1977 is violated)
2. Fines and penalties paid to govt for violation of law
3. 2/3 of treble damage payments made to claimants resulting from violation of
the antitrust law
B. Legal expenses incurred in defense of civil or criminal penalties
1. Must be related to trade or business, income-producing activity, or
determination, collection, or refund of tax
C. Expenses of illegal business are deductible unless classified under A above or associated with drug trafficking
D. Lobbying and political contributions
1. Lobbying--may not deduct expenses to influence state or Federal legislation or action of certain high ranking public officials
a. Disallowance does not apply to activities devoted solely to (1) monitoring legislation; (2) lobbying expenses at the local govt level; or (3) De Minimis rule permits deductions for up to $2,000 of "in house" lobbying expenditures.
2. Political contributions-no deduction for any contributions, gifts, or other
amounts paid to a political party, action committee, or group or candidate
related to a candidate's campaign
E. Excessive Executive Compensation--for publicly-held corporations, limits deduction to $1 million annually for CEO and 4 most highly compensated officers. See page 5-14 for what is excluded from the definition of compensation.
F. Business investigation expenses and startup costs
1. General rule--If same trade or business, costs of investigation and startup are wholly deductible in year paid or incurred regardless of whether or not taxpayer undertakes the business
2. If taxpayer is not in the same trade or business, treatment depends on whether or not new business was entered into
a. Enter new business (Section 195)--capitalize or elect to capitalize and amortize over a period of net less than 60 months
b. Does not enter business are generally not deductible.
G. Job seeking expenses--deductible as MID subject to 2% floor if job is in same
business as present
H. Hobby expenses and losses--Section 183--activities not engaged in for profit
1. General rule--If deemed a hobby, deductible expense to extent of gross
income of activity
2. Deduction limitation
a. Gross income from activity (include in AGI)
-Category 1 (otherwise deductible--take as ID)
-Category 2 (others limited to GI--take as MID)
-Category 3 (depreciation (basis adj)--take as MID)
3. To illustrate profit motive and escape hobby rules--nine factors as set out by
Regs (See page 5-16)
a. Presumptive rule--burden of proof transfers to IRS if taxpayer shows profit in 3 of 5 consecutive years; 2 of 7 if horse-related)
b. Election to use rule extends statute of limitations to 2 years after due
date of return for last year in 5-year period
I. Vacation home rentals (See IRS Pubs 527, 936)--Section 280A --Also see good summary on page 5-24
1. Treatment depends on amount of personal use and rental activity
a. Primarily personal use: Nominal rental use of less than 15 days; no income and no deductions; ignore; otherwise allowable deductions (mortgage interest and property taxes) may be deducted from AGI as Schedule A itemized deductions
b. Personal/Rental use--Substantial owner use--treated as residence if personal use is more than the greater of 14 days or 10% of # of days actually rented out and residence is rented for 15 or more days. Deductions restricted as follows:
(1) Expenses allocable to rental use to extent of GI less otherwise
allowable; same order as hobby rules except can carryover
unused expenses (Show on Schedule E)
Gross income from activity (include in AGI)
-Category 1 (otherwise deductible)
-Category 2 (others limited to GI)
-Category 3 (depreciation (basis adj)
(2) Take personal expenses authorized by Code on Schedule A
(mortgage interest and property taxes)
(3) Can not have loss but can get qualified residence interest if
primary or secondary
(4) Computations vary. The IRS differs with Court opinions.
(a) Allocate expenses between personal and rental:
(i) IRS uses functional use rule. Allocate all expenses as
follows:
Deduction x rental days
total days used
(ii) Courts use Bolton rule for "otherwise allowable" and
functional use rule for other categories
Bolton rule: Deduction x rental days
365
c. Primarily rental use--Used as rental property--taxpayer use is not greater of 14 days or 10% of number of days rented out
(1) Three step process to income/loss:
(a) Expenses allocable to rental use are fully deductible subject only to PAL (passive activity) rules (Schedule E).
(b) Expenses allocable to personal use allowed if authorized by Code (Schedule A); these are expenses which do not reduce basis; however, no residence interest since not a residence; possibly investment interest.
2. Conversion to rental property (see page 5-22)
FYI: When renting to relatives, the IRS accepts a rent that is up to 20%
less than the fair rental value and the homeowner is still eligible for full
deductions.
J. Personal living expenses
1. Section 262 specifically prohibits deduction of any personal, living, or family
expenses unless allowed elsewhere by Code.
K. Disallowance of deductions for unrealized losses
L. Disallowance of deductions for capital expenditures
1. Tangible, fixed assets--Capitalize and depreciate using acceptable depreciation methods
2. Intangible assets--If acquired after 8/10/93, amortize over 15 years using
straight-line method.
M. Related party transactions (Section 267)--provides for disallowance of any losses
from sales or exchanges of property directly or indirectly between related parties
1. Definition of related party
a. Family members: siblings, spouse, ancestors, lineal descendants (in-laws exempt from rules)
b. Shareholder and his or her more than 50% corp using constructive ownership rules which say that taxpayer owns the following:
(1) Stock owned directly or indirectly by his or her family
(2) His or her proportionate share of any owned by a corp, p'ship, estate, or trust in which he or she has interest
(3) Stock owned directly or indirectly by his or her parents
c. Two corporations that are members of a controlled group
d. PSC and an employee who owns any stock in the corporations
2. Losses on sales between related parties
a. General rule disallows loss. On subsequent disposition of property, previously disallowed loss may be used to reduce any gain realized on the transaction.
3. Unpaid expenses and interest to a related party
a. Where accrual basis taxpayer makes payment to related party who is on
cash basis, expense is deductible only in year in which recipient reports
the amount as income.
N. Payment of another's obligation
1. Taxpayer not entitled to deduct payment of deductible expense of another--must be taxpayer's obligation. Exception for medical expenses of a dependent or a person who would have been a dependent except for the gross income test.
O. Expenses and interest relating to tax-exempt income (Section 265)
1. No deduction for interest expense or nonbusiness expense related to tax-exempt income.
a. IRS will look to purpose of loan to see if there is a sufficiently direct
relationship between borrowing and tax-exempt income
2. Business life insurance (Section 264)--no deduction for life insurance
premiums paid on policies covering life of any officer, employee, or any other
person that may have a financial interest in the taxpayer's trade or business
if the taxpayer is the beneficiary.
I. Bad Debts (Section 166)
A. General requirements
1. Bona fide debt--promise to repay a fixed and determinable sum; the obligation must be valid and enforceable under local law.
a. Facts and circumstances determine
(1) Evidenced by note
(2) Secured by collateral
(3) Reasonable interest rate
(4) Fixed schedule of repayment
2. Basis--taxpayer may take deduction only if he or she has a basis in the debt.
3. Worthlessness (or partial worthlessness)--IRS
B. Classification of debt
1. Business bad debts (ordinary loss) are those that arise in connection with taxpayer's trade or business; all corporate debt is business bad debt
a. Deductible without limitation like any business expense
b. Deduction for partial worthlessness (optional)
2. Nonbusiness bad debt--any debt other than one acquired in connection with the taxpayer's trade or business; treated as capital asset held for less than 18 months (i.e. short-term capital loss) subject to limitation of $3000 per year
a. Deductible with limitations
b. Must be totally worthless
c. Personal loans and investment-related loans will provide nonbusiness
bad debt
C. Deductible in year of worthlessness even if not due until later year
D. Methods of deduction
1. Direct write off method (Specific charge off)
a. Partial worthlessness--only on a business bad debt; must write off books also.
b. Total worthlessness--gets deduction without having to write off
2. Service businesses on accrual method may use experience method if don't charge interest or late charges
E. Loans between Related Parties (must be bonafide loan)
II. Losses of Deposits in Insolvent Financial Institutions (Section 165(l))
A. General rule: bad debt deduction (nonbusiness bad debt) in year in which
loss can finally be determined
B. Elections (retroactively effective for tax years beginning after 1981) to
qualified individuals--treat their reasonably estimated losses as casualty
losses in year amount of loss can be reasonably estimated
1. Qualified individual--any individual other than:
a. Owner of 1% or more value of stock in insolvent institution
b. Officer of institution
c. Certain relatives and other persons who are tax-related to a and b
III. Worthless Securities (Section 165)
A. Definition of security--stock, stock rights, and bonds, notes, or other forms of
indebtedness issued by a corporation or the government; must qualify as capital
asset to fall under these rules
B. General rule--treated as capital loss on last day of taxable year in which they
become worthless. Taxpayer may not defer taking loss.
1. IRS keeps list of companies whose stock becomes worthless during year. If
not on list, IRS will not accept deduction unless there is a real transaction or
worthlessness can be otherwise proven.
C. Exceptions
1. Section 1244 Small Business Stock (classified as such at incorporation);
domestic corporation meeting specific requirements
a. Total capitalization is $1 million or less
b. Original stockholder (individuals or through p'ships) can take ordinary loss up to $50,000 ($100,000 joint) with excess deductible as capital loss
(1) For NOL purposes, $50,000 or $100,000 treated as business loss;
remainder as capital loss
D. No deduction allowed, except to bank, for worthlessness of securities by reason
of the worthlessness of any debt, regardless of how it arose, owed by a political
party.
E. Taxpayer can go back 7 years to claim deductions for worthless securities on
amended returns.
IV. Casualty and Theft Losses (property owned by taxpayer)
A. General rules
1. Casualty must result from some sudden, unexpected, or unusual event,
caused by some external force, but not from willful or negligent acts; no loss
from progressive deterioration; vandalism loss has been found to be casualty
loss
2. Deductible if related to trade or business (162 expense); income-producing
property (212 expense--deduction for AGI if rents or royalties; otherwise ID
on Schedule A); personal use property where loss arises from fire, storm,
shipwreck, theft, or other casualty (Form 4684 then Schedule A ID)
3. Theft losses are deductible as casualty losses if they result from acts illegal
under state law and done with criminal intent.
B. Amount of deductible loss depends on type of property
1. Business or income-producing property
a. Completely destroyed-deduction is adjusted basis of property less
insurance reimbursement (For AGI deduction)
b. Partially destroyed--deduction is lesser of adjusted basis of property or
decline in value less the insurance reimbursement (For AGI deduction
if related to rents/royalties; NOTE: Prior to the Tax and Trade Relief
Extension Act of 1998, casualty losses from income-producing
property other than rental was treated as MID subject to 2% floor.
This is changed retroactively for all losses incurred after TRA '86.
The loss os NOT subject to 2% of AGI. Further, these losses are
not subject to the phasing out of itemized deductions.)
c. Stolen property--adjusted basis reduced by insurance reimbursement
2. Personal use property (Form 4684 to Schedule A--From AGI ID)
a. Deduction:
Lesser of Adj. Basis or decline in value
-Insurance reimbursement
-$100 floor (per event) if applicable
Casualty loss
-10% AGI aggregate floor if netting process below
results in net losses
Casualty loss deduction
b. Netting process-must net gains/losses
(1) If net gain, each item treated as capital gain or loss and goes through another netting process
(a) Possible special treatment for gains if reinvestment
(2) If net loss, itemized deduction subject to limitations (10% AGI)
c. No deduction is permitted for casualty losses of nonbusiness property
for which taxpayer is insured, unless a timely insurance claim is filed.
However, a casualty loss for uninsured portion (deductible) is allowed.
3. Property used partly for personal and partly for nonpersonal purposes--apportion
a. Special rules for listed property used less than 100% in business. The
adjusted basis is reduced by depreciation based on 100% usage.
C. Amount of gain from casualty
1. Amount by which insurance reimbursement exceeds adjusted basis (See Form 4684)
D. Year deductible
1. Generally, casualty in year in which loss occurs; theft loss in year of
discovery
a. Reduce loss by amount taxpayer expects to receive; (Regs say no deduction may be taken in year of loss for any portion of the loss for which there is reasonable prospect of recovery in a later year. (Remaining loss in year no further reimbursements expected.)
(1) Only one $100 floor; 10% each year
b. If "disaster area" may elect to deduct loss in taxable year immediately preceding year of loss
(1) Return must be filed by due date of current year and no extensions
allowed. Election becomes irrevocable on 91st day after it is
made, but Tax Court has allowed.
E. Basis of property after casualty--reduce by allowable loss deduction; reduce by
insurance recovery; add gain back to basis
V. Research and Experimental Expenditures (Section 174)
A. Definition--all costs incident to the development of an experimental or pilot model,
a plant process, a product, a formula, an invention, or similar property, and the
improvement of already existing property of the type mentioned.
B. Three treatments
1. Expense in year paid or incurred
2. Defer until taxpayer realized benefits from the experimental expenditure and amortize over period of not less than 60 months
3. Capitalize
VI. Net Operating Loss (Section 172)
A. Carryback 3 years and carryforward 15 years unless elect to forgo the carryback
and carryforward only for NOLs attributable to casualty losses of individuals
in disaster areas.. Make irrevocable election by due date (including extensions)
of return for year of loss. For NOLs after enactment date of TRA 97, carryback
2 years and forward 20 years.
B. Procedure
1. Refund or credit claimed by filing amended return on Form 1040X or Form 1045, if filed by close of tax year following NOL year
I. Overview
A. General rule allows for the write-off of the cost of certain realty and personal assets with a determinable life that is either used in a trade or business or held for the production of income. In essence, a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property.
1. Tangible assets--depreciated
2. Natural resources--depleted
3. Intangible assets--amortized
B. Basis subject to write-off
1. Adjusted basis--usually cost.
a. Converted property--lower of fmv or adj. basis at time of conversion.
2. Basis for must be reduced by depreciation allowed or allowable.
FYI: Taxpayer can break out personal property portion of a building
purchase and receive larger depreciation deductions. Examples of
items which can be isolated are cabinetry, carpet, decorative
lighting, draperies/blinds, furniture, security systems, movable
partitions, portable fire extinguisher, signs, and window air
conditioning systems.
C. Methods of depreciation
1. Code Section 167: Pre-1981 Depreciation Rules--Before January 1, 1981
2. Code Section 168: Pre-1987 ACRS (Accelerated Cost Recovery System)--January 1, 1981 through December 31, 1986--Introduced by ERTA (Economic Recovery Tax Act of 1981)
3. Code Section 168: Post-1986 MACRS (Modified Accelerated Cost Recovery
System)--January 1, 1987-present--Introduced by TRA--Tax Reform Act of
1986
D. Depreciation is deducted on Form 4562. For more information on depreciation
see Publication 534.
FYI: No depreciation deduction is allowed for property placed in service
and disposed of during the same taxable year.
II. ACRS Depreciation (Section 168)--in textbook.
III. MACRS Depreciation (Section 168)
A. Section 168 property is all depreciable, tangible property, both real and personal, new or used. MACRS is mandatory with elections to use SL or the Alternative Depreciation System (ADS)
B. Property below may not use MACRS
1. Property depreciated using a method not based on years
2. Automobiles if taxpayer has elected to use standard mileage rate
3. Property for which special amortization is provided and elected
4. Certain motion picture films, video tapes, sound recordings, and public utility property
5. Any property that taxpayer or related party owned or used prior to 1986 (anti-churning rules; also had for ACRS dep)
C. Calculating depreciation
1. Function of three factors
a. Recovery Period
(1) Assigned to one of eight classes--six classes of personalty (see 7-5 and 7-6) and two classes of realty
(2) For regular MACRS purposes, assets which do not fit into any
prescribed asset class are assigned a 7-year recovery period.
(3) For ADS purposes, assets which so not fit into any prescribed
asset class are assigned a 12-year recovery period.
b. Depreciation Method
(1) Personalty
(a) Statutory Percentage--MACRS Recovery Period (DDB for 3, 5, 7, 10 year and 150% for 15 and 20 year property)
(b) MACRS Straight-line
(c) ADS (Alternative Depreciation System)--150% DB (Must be used for Alternative Minimum Tax)
(d) ADS Straight-line
| Straight-line over recovery period |
(2) Realty
(a) Statutory Percentage--Straight-line (27.5 years for
residential rental or 31.5 years for non-residential)--Note that
nonresidential real property placed into service after 5/12/93
has 39-year recovery period (unless binding contract existed
on 5/12/93 and placed into service before 12/31/93)
(b) ADS Straight-line--40 years (which must be used for
Alternative Minimum Tax (AMT))
| Recovery Period | Methods Allowed | |
| Before 1-01-81 | Useful life | DB/SL |
| After 12-31-80 | 15 years | ACRS, SL |
| After 3-15-84 | 18 years | ACRS, SL |
| After 5-08-85 | 19 years | ACRS, SL |
| After 12-31-86 | 27.5/31.5 years | SL |
| After 5-12-93 | 27.5/39 years | SL |
c. Accounting Conventions
(1) Half-year applies to all property other than nonresidential real
property and residential rental property; ½ year of depreciation is
allowed regardless of when asset placed in service or sold during
the year
(2) Mid-quarter convention applies to all personal property if more
than 40% of the aggregate bases of all personal property placed
in service during the taxable year is placed in service during the
last 3 months of the year
(3) Mid-month convention applies to residential real and residential rental property; ½ month is allowed for month asset is placed in service or sold and a full month for each additional month of the year that the asset is in service; ½ month in year of disposition
D. Irrevocable elections out of MACRS
1. MACRS Straight-line election is made annually by class; allows SL with same
recovery period and convention method ignoring salvage. Must attach
statement to tax return.
2. Alternate Depreciation System (ADS)
a. Elect on a class by class, year by year basis except for realty where election is made on a property by property basis
b. Use no salvage; use class life unless no class life is known (then 12 years) or a special class life has been designated.
(1) Rev Proc 87-56 lists recovery periods
c. Methods
(1) Real property use straight-line
(2) Personal property use SL or 150% DB
d. Must be used in certain circumstances
(1) To calculate AMT depreciation resulting in AMT adjustment
(2) To compute depreciation for E & P
(3) To compute depreciation on the following property:
(a) Foreign use property
(b) Property leased to tax exempt entity
(c) Property financed directly or indirectly by issuance of tax-exempt bonds
(d) Imported property from foreign countries that maintain discriminatory trade practices
(e) Luxury automobiles and other listed property used 50% or
less for business
IV. Special Topics
A. Code Section 179 election
1. Elect to expense up to $19,000 (in 1999) of cost of eligible property placed in service that year. Not prorated, but subject to two limitations:
a. Must decrease dollar for dollar for each $1 of cost in excess of $200,000. No carryover of this amount lost.
b. Can not exceed aggregate taxable income from any trade or business but can carryover unused portion.
2. The amount that may be expensed under 179 as follows:
Taxable year begins in: Maximum amount:
1999 $19,000
2000 $20,000
2001 & 2002 $24,000
2003 & thereafter $25,000
3. Eligible property
a. Recovery property
b. Section 38 property that would have qualified for investment credit (not buildings)
c. Tangible, personal property used in trade or business (but not rental activity)
(1) However, if trade or business is passive activity, can not take 179 deduction
(2) Not eligible if T or B use is not > 50%
FYI: IRS Regulations define active T or B to include T or B of being
an employee. (i.e., include salary in the test)
d. Property purchased from unrelated party (but not property acquired by
gift, inheritance, or from related party)
e. 1996 Act clarifies that air conditioning and heating units and rental property do not qualify as Section 179 assets.
4. Must recapture benefit of expensing if at any time, property is converted to
nonbusiness use (show as ordinary income on 4797) or if business use falls
to 50% or less
B. Limitations for automobiles (Section 280F)
1. For autos placed in service after 12/31/86
a. Used MORE than 50% for business in first year (MACRS)-- lesser of
statutory % or following amounts:
Year 1: $3,060 Year 4: $1,775
Year 2: 5,000 Year 5: $1,775
Year 3: 2,950 Year 6 and thereafter: $1,775
(1) Statutory %: 20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%
b. Used 50% or LESS for business in first year (Straight-line)--lesser of
statutory % or amounts listed above
(1) Statutory %: 10%, 20%, 20%, 20%, 20%, 10%
2. Note: Reduced Business Use
a. Above caps are based on 100% business or investment use of auto. If business use less than 100%, maximum annual limits must be reduced to reflect usage.
C. Limitations for partial business use of listed property
1. Listed property
a. Passenger automobiles
b. Other property used for transportation
c. Computer or peripheral equipment unless used exclusively in a regular business establishment
d. Property used for entertainment, recreation, or amusement
e. Cellular phones (after 12/31/89)
f. Additional property to be added by Regulation
2. To determine allowances, determine if the asset is used more than 50% in
trade or business. If so, can depreciate the T/B portion and the Production
of Income portion using MACRS. If use is less than 50% must use ADS SL.
3. Can not take 179 deduction if business use is 50% or less
4. Restrictions are imposed if property not used primarily for business in first
year
5. Special rules for Employer-Provided cars
6. Recapture provisions--when business use drops to 50% or less before totally
depreciated, taxpayer is required to recompute the depreciation in prior years
using ADS and include in income the excess of the depreciation actually
claimed over the ADS amounts. Depreciation in future years is computed
using SL.
D. Leased automobiles--report inclusion amount computed from IRS table; deduct
lease payments as Section 162 expense.
E. Computer software--if purchased after 8/10/93, generally depreciated over 36
months using SL, prorated by months in year placed into service
F. Other Write-offs
1. Amortization of intangibles (§197)
a. Goodwill, going concern value, other customer-based intangibles, covenant not to compete, trade names, trademarks, franchises, copyrights, patents, and computer software acquired in connection with purchase of business and not available to general public acquired after 8/10/93 and associated with a T or B may be amortized over 15-year period
NOTE: An election is available to apply the 15-year period to all
intangibles acquired between 7/25/91 and 8/10/93. File
amended returns. Prior to 8/10/93, goodwill could not be
amortized.
2. Natural resources
a. Cost of resource--owner of interest writes off cost of resource through depletion. Deductions for AGI. Basis reduced by amount of depletion. Two methods allowed as follows:
(1) Cost depletion
Adjusted Basis x Units sold
Estimated Recoverable Units
(2) Percentage (statutory) depletion: (% x gross income) not to
exceed 50% of taxable income from property
b. Intangible drilling and development costs--costs incurred in making property ready for drilling.
(1) Charge off as expense in year incurred
(2) Binding election to capitalize and write off through depletion.
I. Employment-related Expenses
A. Employment classification
1. Independent contractor--self-employed--Sole proprietor reports expenses on
Schedule C of Form 1040--For AGI deduction. (They pay SE tax)
2. Employee--subject to will and control of employer with respect not only to
what shall be done but also how it should be done--both method and
outcome is controlled. See Revenue Ruling 87-41. Whether or not expense
is For AGI or From AGI depends on whether reimbursed or not reimbursed.
See "B" below. (They pay their portion of FICA)
3. Statutory employee--IRC 3121(d)(3)--Statutory employee box on W-2 must be checked. Use Schedule C of Form 1040--For AGI deduction. (SE tax)
B. General rules for deducting employee expenses
1. Not reimbursed---employee business expenses are reported on Form 2106
and are deducted on Line 20 of Schedule A, subject to 2% AGI limitation--From AGI deduction
2. Reimbursed under accountable plan--Employee furnishes documentation of
expenses to employer.
a. If reimbursements = expenses, employer does not include reimbursements on W-2; employee does not include reimbursements in gross income nor deducts expenses. (Considered "For AGI" by our text in that the reimbursement is not reported in income and the expenses are not deducted on the tax return).
b. If reimbursements exceed expenses, reimbursements are either returned
to employer or included on W-2 as income. NOTE: If the excess
reimbursements are not returned, must treat as though a
nonaccountable plan.
c. If expenses exceed reimbursements (or are not reimbursed), employee
business expenses are reported on Form 2106 and are deducted on
Line 20 of Schedule A, subject to 2% AGI limitation.
3. Reimbursed under nonaccountable plan--Employer includes entire amount
of reimbursement in Box 1 W-2 wages; expenses are reported on Form 2106
and are deducted on Line 20 of Schedule A, subject to 2% AGI limitation
C. Exceptions
1. Qualified performing artist--For AGI deduction by completing Form 2106 and
"writing in" total on Line 30 of Form 1040 and writing "QPA" in the space to
the left of Line 30. Requirements:
a. An individual who has performed services as an employee for at least
3 employers in the tax year, and has received at least $200 from each
of any two of these employers;
b. Has allowable business expenses attributable to the performing arts of
more than 10% of gross income from the performing arts; and
c. Has adjusted gross income (combined AGI on joint return) of $16,000 or
less without including expenses as a performing artist.
FYI: Writers and painters are not included in this category.
2. For AGI for officials of state or local government provided the official is
compensated in whole or in part on a fee basis
II. Transportation Expenses
A. Must be ordinary, necessary, and related to taxpayer's trade or business or
income-producing activity
B. Expenses of commuting between taxpayer's home and one or more regular places
of business are nondeductible personal expenses. Exceptions:
1. Same mode test for additional expenses of hauling tools--deductible
2. Commuting between jobs/work stations--deductible
3. Commuting to a temporary assignment if return home daily--deductible
C. Computing automobile expenses
1. Two methods
a. Actual operating costs of business or income-producing use
b. Automatic (standard) mileage rate--In 1999, 32.5 cents/mile plus
parking/tolls from 1/1/98 - 3/31/99 and 31.0 cents/mile plus thereafter
(1) May use if:
(a) Car must be owned by taxpayer
(b) Can't be one of 2 or more used simultaneously
(c) Car can't be for hire
(2) Can't use if:
(a) Taxpayer has ever claimed ACRS or MACRS depreciation
(b) Taxpayer has ever claimed Section 179 expense
(c) Taxpayer has ever used any depreciation method other than SL
(3) Basis adjustment if change from automatic mileage method to
actual operating costs method--12 cents per mile in 1999
2. May switch methods from year to year except can't use ACRS (MACRS) depreciation once mileage method has been used
III. Travel Expenses (includes transportation, meals, lodging, etc.)
A. General rule--deductible when "away from tax home" overnight in pursuit of trade
or business or in connection with income-producing property.
1. Deduction of travel expenses ultimately depends on facts
2. When a taxpayer regularly works in more than one location, the tax home is
the area where most of the time, income, or degree of business activity
occurs.
3. Revenue Ruling 93-86
a. Temporary employment away from home (expenses are deductible)--Employment away from home is realistically expected to last one year
or less and actually does last for one year or less.
b. Indefinite time period (expenses are not deductible)--Employment away
from home is realistically expected to last for more than one year
(regardless of whether it actually lasts for more than one year).
c. If expected to last less than one year but at a later date is expected to
last more than one year, employment will be treated as temporary until
date taxpayer realistically realizes that one-year period will be
exceeded.
4. As a result of RRA of 1993, no deduction allowed for spouse, dependent, or
other individual accompanying taxpayer on business trip unless that
individual is employee, travel is for bona fide business purpose, and
expenses would otherwise be deductible (effective after 12/31/93).
a. Rules prior to 1994--"the little woman" deduction
B. Combined business and pleasure travel
1. Domestic travel--deductible if trip is primarily for business
a. Transportation expense either all deductible if trip primarily business or
none deductible if personal
(1) Primarily business--more than 50% of the days away from home
are "business days"
(a) Business days--greater than ½ of the day (more than 4 hours) must be spent on business
(b) Weekend days between business days are considered business days
(c) Travel days are business days
b. Other travel expenses deductible to extent business. (Meals subject to
50% limitation to be discussed later.)
FYI: IRS Letter Ruling 9237014 allows a deduction for additional
meals and lodging if taxpayer's business trip is extended an
extra day to take advantage of reduced air fare.
2. Foreign travel: generally allocate transportation expenses between business
and personal
a. If travel is primarily business, no allocation is required if one of the
following conditions is satisfied:
(1) Travel outside US does not exceed 7 consecutive days (Don't count day of departure, do count day of return)
(2) Nonbusiness days represent less than 25% of the total # of days on the trip
(3) Taxpayer has no substantial control over arranging the business trip
(4) Personal vacation not major consideration in making the trip
b. If travel is primarily business but doesn't meet 1-4 above, allocate:
business days
total days x total travel = deduction
c. If travel is primarily personal, no transportation expense is deductible but
business portion of meals and lodging is.
C. Luxury water travel--generally, transportation expense is limited to twice the
highest per diem amount allowed to Federal employees while away from home
but serving in the 48 contiguous states. Also may deduct 50% of meals and
entertainment.
D. Educational travel--only deductible if for specific purpose not "general"
educational value.
E. Cruise ships
1. No deduction unless:
a. Ship is U.S. flagship (registered in US) and sails only between ports in US or possessions
b. Meeting is directly related to business or income-producing activity
c. Detailed information submitted with return--two statements
(1) # of hours each day devoted to business
(2) Officer of sponsoring organization must sign a detailed schedule
2. Limited to $2000 per calendar year
F. Foreign Conventions
1. No deductions for outside North America unless:
a. Meeting is directly related to active conduct of trade or business or income-producing
b. Reasonable to hold meeting outside North America
IV. Moving Expenses (Section 217)
A. Expenses incurred in connection with beginning employment or changing job
locations
B. Two tests must be met
1. Distance requirement--distance between the old residence and the new job
site must be at least 50 miles greater than the distance between the old
residence and the old job site
2. Time test: full-time employee at new job location for 39 weeks in 12-month
period (78 weeks during 24 months if employee and/or self-employed)
a. Waived if taxpayer dies, becomes disabled, or is involuntarily dismissed
or involuntarily transferred
C. Qualified moving expenses (must be reasonable) are deductible
1. Costs of moving household goods and personal effects and
2. Costs of one trip (lodging but not meals) from the old location to the new
location. Mileage for 1999 is 10 cents per mile.
D. How deducted
1. Reimbursements not includable in W-2 Box 1 income if otherwise deductible.
Amount reimbursed is entered by employer in Box 13 of employee W-2 under
Code P. Form 3903 is not needed.
2. Nondeductible reimbursed moving expenses are included in Box 1 W-2
income. No deduction allowed.
3. Self-employed taxpayer or employed taxpayer for nonreimbursed deductible
moving expense--use Form 3903. A For AGI deduction for both.
V. Education Expenses
A. Qualifying expenses--books, tuition, typing, transportation, travel, writing
expenses, lab fees, degree costs, insurance
B. Requirements for deduction
1. Related to taxpayer's present trade or business and maintain or improve the
skills used in business or
2. Required by employer or by law to retain taxpayer's salary or position.
3. However, even if (1) or (2) met, no deduction if education is needed to meet minimum requirements or qualifies taxpayer for new trade or business.
C. How deducted--see I on this outline
VI. Meals and Entertainment Expenses (Code Section 274)
A. General provisions
1. Expense must be ordinary and necessary and must be "directly related to"
or "associated with" taxpayer's trade or business or exception
a. Directly related to
(1) Have reasonable expectation of a business benefit--more than
goodwill
(2) Taxpayer must be present and discussion must be in clear
business setting--can not be substantial distractions
b. Associated with--entertainment is immediately before or after a
substantial business discussion (on same day)
FYI: Generally, entertaining subordinates and co-workers is a
personal, nondeductible expense unless reimbursed by
employer.
2. Amount of deduction for food or beverages or any expense that constitutes
entertainment, amusement, or recreation is limited to 50% of otherwise
deductible expense
a. Exceptions to 50% rule
(1) Reimbursed expenses--limitation imposed on party making
reimbursement, not taxpayer, with the exception of the moving
expense meal
(2) Excludable fringe benefit (de minimus, bottled wine or holiday
turkey)
(3) Employer paid recreation expense for employees
(4) Charitable sporting event--costs of tickets not subject to reduction
rule if event related to charitable fund-raising
(5) Employee expense for meals and entertainment treated as taxable
compensation to employee (vacation prize)
B. Specific provisions
1. Entertainment facilities--club dues (country clubs, athletic clubs, social clubs,
etc.) no longer deductible; actual meal expenses deductible if qualified
subject to 50% rule
2. Club dues in business leagues, trade associations, and professional
associations still deductible (not subject to 50% limitation)
3, Business Gifts (not subject to 50% limitation)
a. Inclusion or exclusion depends on whether legal obligation exists,
employer's intention, whether employer deducts for tax purposes,
whether amount is nominal--$25 limit/donee; $4 for de minimus gifts
such as pens, etc.
b. Any item that might be considered either a gift or entertainment generally will be considered entertainment. However:
(1) If give customer packaged food or beverages intended to be used at a later date, it is a gift.
(2) If provide tickets to theater performance or sporting event for a
business customer and do not go with the customer to the
performance or event, you can treat the tickets as either a gift or
entertainment, whichever is to your advantage.
(3) If provide tickets to theater performance or sporting event for a business customer and go with the customer, it is entertainment subject to 50% limitation.
VII. Home Office Expenses (Section 280A)
A. Requirements for deductibility
1. Use "exclusively" on a "regular" basis:
a. As principal place of business for any business of taxpayer.
(1) Supreme Court decision has two-pronged test to determine if
principal place of business:
(a) Relative importance test: determine the relative importance
of activities performed at each business location
(b) Time test: determine and compare the amount of time spent
at each location
If test (a) is inconclusive, test (b) will be applied.
(2) NOTE: TRA '97 expands definition of principal place of
business to include home office used by taxpayer to conduct
administrative or management activities of business provided
there is no other fixed location where such can be done.
(Effective after 12/31/98).
b. As place of business used regularly by clients in meeting with taxpayer
in normal course of business, or
c. In connection with taxpayer's trade or business when the office is
located in a separate structure
2. If taxpayer is employee, must also be for convenience of employer
3. Exceptions for day care facilities/storage of inventory
4. Note: 1996 Act adds provisions which allows individuals to deduct expenses allocable to space within a home which is used on a regular basis as the storage unit for inventory or product samples (change highlighted) used in the taxpayer's trade or business.
B. Amount deductible--Three tiers (Form 8829)--(note: For AGI on Schedule C if
self-employed; from AGI deduction if employee)
1. Home office expenses are allowed to extent of GI (less normal op exp)
applied in the following order (similar to hobby):
Gross from T or B $xxxxxx
Less: Operating expenses of T or B xxxxx
Maximum allowed Home Office Deduction $xxxxx
Home office expenses deducted in following order:
Otherwise allowable expenses such as
mortgage interest, property taxes xxxx
Expenses of the home office which do not
adjust basis such as maintenance,
insurance, telephone, etc. xxx
Depreciation xx
a. Excess not deductible may be carried over to next year--maintains nature for consideration next year.
b. Reduce basis of home only to extent of depreciation actually allowed.
C. Where deducted
1. Self-employed taxpayer: Schedule C
2. Employee: Otherwise allowable on Schedule A as appropriate; all others on
Schedule A as MID subject to the 2% limitation
D. No home office deduction allowable where employee leases a portion of home to
employer.
E. Home office traps
1. Deferral of gain on sale of residence, as well as use of $125,000 exclusion,
may be limited because of depreciation taken on home. Solution: disqualify
the office-in-home deduction in year of sale.
VIII. Other Employee Expenses--Code does not give complete list of what is and is not deductible. Must be ordinary and necessary business expenses. (Job-seeking expenses, but not for first job)
A. Examples--Special clothing; union dues, professional expenses, professional
dues, professional meetings, job seeking expenses for seeking employment in
same T/B
IX. Individual Retirement Accounts (IRA)
A. Traditional IRA
1. A personal savings plan that allows a taxpayer to accumulate money tax-deferred until retirement.
2. Contributions may or may not be deductible
a. Employees not covered by another plan may contribute and deduct
smaller of $2000 ($4000 for spousal IRAs) or 100% of compensation
(wages, salary, bonuses, self-employment income, nonpassive
partnership income, taxable alimony)
b. If taxpayer or spouse is an active participant in qualified plan--allowable deduction for contribution is phased out.
(1) TRA Increased income phase-out ranges for deductible IRAs for individual who is an active participant
(a) 1998: Phase-out ranges increased to $50,000 - $60,000 for MFJ and $30,000 - $40,000 for S.
(b) Limits increased each year until finally reach $80,000 -
$100,000 for MFJ by 2007 and $50,000 - $60,000 for S by
2005.
(2) TRA Increased income phase-out ranges for deductible IRAs for
spouse of active participant who is not an active participant
him/her self ($150,000 - $160,000)
c. Excess contributions subject to 6% penalty.
d. Report nondeductible contributions on Form 8606.
Note: Although an IRA contribution must be made by the due date of the return not including extensions, the designation may be changed from deductible to nondeductible, or vice versa, on an amended return.
3. Interest on both deductible and nondeductible contributions accumulates tax
free.
4. Withdrawals
a. After age 59 ½--taxed under annuity rules; (nondeductible contributions part of exclusion ratio)
b. Before age 59 ½ subject to nondeductible 10% penalty
(1) TRA 97 provides for penalty free withdrawal for qualified higher education expenses--tuition, fees, books, room, board of taxpayer, spouse, child, grandchild (after 12/31/97)
(2) Certain medical expenses also qualify
c. Must begin withdrawals no later than April 1 of year following end of tax year in which taxpayer reaches age 70 ½.
B. Tax-free non-deductible IRA (Roth IRA or backloaded IRAs)
1. Maximum annual contribution is lesser of $2,000, reduced by deductible IRA
contributions, or individual's compensation for the year. Contributions not tax
deductible but withdrawals are not taxable
2. Eligibility phases out between $95,000-$110,000 AGI for S and $150,000 -
$160,000 for MFJ
3. Qualified distributions from the following are not includable in gross income
or subject to the additional 10% tax on early withdrawals.
a. Made after 5-year period beginning with first tax year individual made
contribution to Roth IRA.
AND ONE OF THE FOLLOWING
b. Made on or after individual reaches age 59 ½
c. Made to beneficiary or individual's estate on or after individual's death
d. Attributable to the individual's being disabled;
OR
e. A qualifying special purpose distribution, including those made for up to
$10,000 of first-time home buyer expenses.
4. No mandatory withdrawal age but must wait to age 59 ½ except for above
5. May rollover from traditional to Roth without 10% penalty; if rollover is before
1/1/99 may spread taxable income over 4-year period.
6. Under ordering rules, distributions are treated as first made from
contributions (return of capital) and then from earnings.
C. Education IRA
1. A trust or custodial account created or organized exclusively for paying the
qualified higher education expenses of account holder
2. Non-deductible contributions of up to $500 per child (1998) for beneficiaries
under 18. Earnings build up tax free and withdrawals will be tax free to
extent that distributions do not exceed qualified higher ed expenses--tuition,
fees, books, equipment, room and board if half-time student-- incurred during
year of distribution
a. Portion not so used is includable in GI and subject to additional 10%
penalty
3. Contribution phase-outs--Income phase-outs--$150,000 for joint filers and
$95,000 for singles
4. May be rolled over to another child in same family (before beneficiary
reaches age 30)
5. If child doesn't attend college, money most be withdrawn when intended
recipient turns 30.
6. Effective date--after 12/31/97
7. May not claim either HOPE Scholarship Credit of Lifetime Learning Credit
with Education IRA.
X. Miscellaneous Itemized Deductions
A. Subject to 2% floor (page 8-26)
B. Not subject to 2% floor (page 8-26)
1. Impairment-related work expenses of handicapped individuals
2. Gambling losses to extent of gambling winnings
3. Certain terminated annuity payments
I. Medical Expenses
A. General rule: deduction for amounts paid for the diagnosis, cure, relief, treatment or prevention of disease of the taxpayer, his or her spouse, and dependents (or any person who would otherwise qualify as dependent except for the gross income or separate return tests, multiple support agreement, or noncustodial parent)
1. Prepayment does not qualify as a current deduction unless taxpayer is required to make the payment as a condition of receiving the medical services.
2. Credit card charges considered paid in year made.
B. Limitation--amount which exceeds 7.5% of AGI
C. Special items
1. Capital improvement--must be medical necessity recommended by physician,
used primarily by patient, and reasonable expense
a. If to taxpayer's property, deduct only the amount of the expenditure which exceeds the increase in the value of the property improved. If property owned by another, all deductible.
b. Home-related capital expenditures incurred by physically handicapped individual entirely deductible, but still subject to 7.5%.
2. Special care facilities other than hospital--entire cost qualifies if the principal reason an individual is in an institution is availability of medical care
a. One-time medical payment for lifetime of medical care in nursing home is fully deductible in year paid. (Letter Ruling 8630005)
3. Transportation costs or 10 cents/mile plus parking fees and tolls. Lodging at $50/night/individual necessary to travel with taxpayer. No meals unless part of medical care and furnished at medical facility
4. Medical insurance premiums deductible; treatment of reimbursement depends on previous years benefit
a. If deduction taken in prior year, include in GI lesser of previous med expense deduction or excess of taxpayer's ID over SD--Tax Benefit Rule
b. Self-employed taxpayer and spouse and dependents: 60% of insurance
premiums for medical coverage deductible as Trade or Business
expense--For AGI deduction. Excess is on Schedule A--Itemized
Deduction--From AGI.
5. Medical expenses paid within one year after date of death of taxpayer may
be treated as having been paid at time the services were provided. If
deducted on Form 1040, not also deductible on Federal Estate Tax Return.
6. Medical Savings Accounts (MSAs)--Health Insurance Portability and
Accountability Act of 1996
II. Taxes (Code Section 164)
A. General provisions
1. Deductible only if (a) imposed on the taxpayer's income or property and (b) paid or incurred by the taxpayer in the taxable year for which a deduction is being claimed
2. For AGI if related to trade or business (except income taxes); otherwise a
Schedule A Itemized Deduction
B. Taxes specifically allowed
1. State, local, and foreign income taxes, war profits, and excess profits taxes
a. Deduct withholding, estimated payments, current payments of prior taxable year
b. Refunds included in income to extent of benefits received
c. Amounts paid to a foreign country or a U.S. possession may either be
deducted or claimed as a credit against the U.S. income tax
2. State and local personal property taxes deductible if ad valorem taxes (based
on value of property)
3. State, local, and foreign real property taxes should be apportioned between buyer and seller and adjusted basis and amount received
a. Permanent special assessments such as sewer, sidewalks, street paving, etc.: Principal added to basis of land and interest deductible as real estate taxes
b. Assessments allocated to maintenance and repairs of property--both principal and interest are deductible as real estate taxes
FYI: If property with delinquent real estate taxes is acquired and
the back taxes are then paid, no deduction is allowed since
the taxes were not the taxpayer's obligation. Rather, the basis
in the property is increased.
4. The environmental tax
C. Non-deductible taxes
1. Federal income and excise taxes
2. Social security, Medicaid, railroad retirement taxes
3. Custom duties
4. Federal estate and gift taxes
5. Sales tax
6. License fees (marriage, driver's license, dog license, boats, trailers)--if
personal in nature
III. Interest Expense (See excellent summary on page 9-19)
A. General rules
1. Taxpayer must show that amount paid or accrued was the result of a bonafide indebtedness
2. Taxpayer must be legally liable to pay the interest (which is compensation for the use or forbearance of money)
3. Type of deduction depends on how loan proceeds spent except for qualified residence interest
4. Generally deductible in year paid or incurred
5. No deduction for interest expense on loan used to purchase or carry tax-free
securities
B. Identification of funds
1. Proceeds deposited in borrower's account are considered investment interest
until expenditures are made. Then identify.
2. With commingled funds all expenditures from the account after the loan is
deposited are deemed to come first from borrowed funds. (IRS Ordering
Rules)
TIP: Keep loan proceeds separate from other funds if possible.
3. 15-day rule allows borrower to elect to treat any expenditure made within 15 days after the loan proceeds are deposited as having been made from proceeds of that loan and spent for purpose claimed by taxpayer. If proceeds are held > 15 days, proceeds are presumed to have been for a personal expenditure.
4. Debt repayments applied in specific order:
a. Personal expenditures
b. Investment expenditures
c. Rental real estate expenditures
d. Former passive activity expenditures
e. Trade or business expenditures
C. When deductible
1. Cash basis taxpayer-- when paid, except no prepaid interest other than points paid separately on purchase of residence
2. Accrual basis taxpayer--as incurred
D. Classification of interest expense
1. Student Loan Interest--TRA 97
a. Amount deductible as FOR AGI deduction
1998 $1,000
1999 1,500
2000 2,000
2001 2,500
b. Ratable phase-out: $60,000 - $75,000 MFJ; $40,000 - $55,000 others
c. Interest paid on qualified education loan during first 60 months in which
interest payments required
(1) Indebtedness incurred to pay for qualified higher education expenses (tuition, fees, room/board) reduced by certain educational benefits excludable from GI (Section 135, education IRA, 117 scholarship, 127 educational assistance)
(2) Student must be half-time
d. Effective date: Payments due or paid after 12/31/97
2. Investment interest
a. General rule: Deduction is limited to taxpayer's net investment income; remainder can be carried over
(1) Investment income--gross income from interest, dividends, royalties, and ordinary income from depreciation recapture on investment property. As of 12/31/92, net capital gains from disposition of investment property is not considered investment income. However, taxpayer may elect to include these capital gains as investment income provided taxpayer reduces the amount of net capital gain eligible for the 28% maximum capital gains rate by the same amount.
(2) Investment expenses are trade or business expenses, real and
personal property taxes, bad debt deductions, depreciation,
depletion, and 212 deductions that are directly connected with the
production of investment income.
(3) Net investment income--excess of the taxpayer's current
investment income over investment expenses
b. Generally file Form 4952--Investment Interest Expense Deduction
c. Limits imposed on taxpayers, other than regular corporations, who have paid or incurred interest expense to purchase or carry investments.
(1) If related to rental property--deduction is a For AGI deduction on Schedule E
(2) If not related to rental property--deduction is a From AGI deduction on Schedule A--Itemized Deductions
3. Qualified residence interest
a. Defined as any interest paid or accrued on acquisition indebtedness or home equity indebtedness secured by the taxpayer's primary (principal) or secondary residence--Schedule A ID
b. Current rules--Omnibus Reconciliation Act of 1987
(1) Allowed in full on debt incurred on or before 10/13/87 and not
increased after that date. However, pre 10/14/87 indebtedness
reduces the amount of the $1 million limitation discussed below for
additional debt after 10/13/87
(2) Acquisition indebtedness (cost of acquiring, constructing, or improving principal or secondary residence) can not exceed $1 million
(a) A qualifying residence's acquisition debt is reduced by
principal payments and can not be increased unless loan
proceeds used for home improvements
(3) Home equity indebtedness limited to lesser of $100,000 or (FMV
less acquisition indebtedness)
(4) Interest on debt above these limits in (2) and (3) treated as personal consumer interest
c. Points (compensation to a lender solely for the use or forbearance of money)
(1) Paid by buyer
(a) If on new mortgage or home improvement loan currently deductible if paid with separate funds. Do not use loan proceeds to pay points.
(b) If on refinancing existing mortgage--capitalize and amortize
over life of loan.
(2) Paid by seller--after 12/31/90 may be treated as paid by buyer.
See Rev Proc 94-27.
d. Prepayment penalty--interest expense in year paid
4. Trade or business--deductible on Schedule C
5. Passive activity interest expense incurred by a passive activity itself is
treated as a deduction relating to the passive activity and is limited by the
passive loss rules in Chapter 8.
6. Personal interest--in general, not deductible since after tax year 1990
IV. Charitable Contribution (Section 170)
A. General requirements
1. Must be a gift of money or other property to a qualified donee made during
the current year or carried forward from prior years due to annual deduction
limitation
2. Qualifying donees include organizations as listed in Cumulative List of Organization, IRS Publication 78
6. Nondeductible items
a. No deduction for contribution of services, but out-of-pocket expense may qualify for deduction. Transportation is deductible at 14 cents per mile.
b. To extent taxpayer receives tangible benefit
c. Dues for country clubs, lodges, fraternal orders
d. Cost of raffle, bingo, or lottery tickets
e. Tuition paid for individual
f. Donations to individuals
g. Blood donated
h. Rental value of property donated, but out-of-pocket expenses such as utilities paid for a charity are deductible
B. Measure of the amount contributed
1. Cash--face value
2. Ordinary income property--any property which, if sold, would require the
owner to recognize other than long-term gain (inventory, property held 18
months or less, depreciation recapture)
a. Appreciated ordinary income property--Adjusted Basis (FMV minus
Appreciation)
b. Unappreciated ordinary income property--lower of adjusted basis or fmv
3. Capital gain property--property which, if sold, would result in LT capital gain or 1231 gain
a. Amount of contribution is the FMV of item except in the following three
cases in which the Adjusted Basis (FMV - LTCG) must be used:
(1) Tangible (stock is intangible) personal property put to an unrelated
use (not used in activities for which tax-exempt status has been
granted)
(2) Any capital gain property to a private non-operating foundation
(3) Taxpayer may elect to use adjusted basis and disregard the 30% rule
C. Maximum amount deductible
1. In no case can deductible charitable contribution exceed 50% of the taxpayer's AGI--Amount may be less depending on (1) the type of property contributed and (2) the type of donee.
2. Contributions to Public Charities, to private operating foundations and certain
private nonoperating foundations--referred to as 50% organizations
a. Overall 50% AGI limitation
b. Contributions of appreciated capital gain property
(1) Generally limited to 30% of AGI after first considering contributions of money. Note: the 30% limit is nested in the 50% limit.
(2) A special election is available regarding the contribution of appreciated capital gain property. The 30% limit may be disregarded if the amount of the contribution is reduced by the LTCG. Known as the reduced deduction election--Use Adjusted Basis instead of FMV as measure of the contribution.
(a) Election applies to all contributions of capital gain property
in that year
3. Contributions to Private Charities (30% organizations)
a. Public charity contributions are considered first.
b. For non-capital gain property, the deductible amount is limited to the Lesser of:
(1) 30% of AGI, or
(2) The remainder of the 50% of AGI maximum limit after reduction for contributions to public charities (ignoring the 30% limit imposed on capital gain property)
c. Limits for contributions of capital gain property to private charities--the lesser of
(1) 20% of AGI, or
(2) The remainder of the 30% of AGI over capital gain property
contributed to public charities
D. Contribution Carryovers
1. Contributions which exceeded 20%, 30%, or 50% limitations may be carried over 5 years
2. In subsequent years, deduct current year amount first, than carryovers of FIFO basis
3. If taxpayer does not itemize deduction in any of the carryover years, he must reduce the carryover by the amount that would have been deductible had he itemized.
D. Substantiation rules in effect for charitable contributions in tax years after 1993--need "contemporaneous written substantiation" of contributions in excess of $250.
1. File Section A of Form 8283 for contributions between $500 and $5,000; also File Section B for noncash contributions greater than $5,000.
V. Miscellaneous Itemized Deductions
A. Subject to 2% AGI limitation (see page 9-27)
B. Other itemized deductions (see page 9-28)
VI. Phase-Out of Certain Itemized Deductions (cutback adjustment)
A. Cutback applies to all ID expect medical, investment interest, casualty & theft, wagering losses to extent of gains
B. Must reduce itemized deductions by 3% of excess of AGI over threshold but not
more than 80% of covered itemized deductions
THE CHARITABLE CONTRIBUTIONS EXAMPLES ARE AT THE END OF THIS SET OF OUTLINES (AFTER CHAPTER 11).
I. At Risk Rules (for individuals, closely-held corp and on ownership level for s corp and partnerships--See Concept Summary 10-1 on page 10-5 for good summary)
A. Limit the deductibility of losses from business and income-producing activities
1. "At risk"--the objective of the at risk rules is to limit a taxpayer's tax shelter deduction to the amount at risk, i.e., what the taxpayer stands to lose
a. Increases
(1) The amount of cash and adjusted basis of property contributed to
the activity
(2) Amounts borrowed for use in the activity for which taxpayer has
personal liability or has pledged as security property not used in
activity
(3) Taxpayer generally not considered at risk for nonrecourse loans
except in the case of an activity involving holding of real property,
a taxpayer is considered at risk for his or her share of any qualified
nonrecourse financing that is secured by real property used in the
activity.
(4) Increased by taxpayer's share of income
b. Decreases
(1) Share of losses
(2) Withdrawals
(3) Debt repayments
B. Disallowed losses carried over and deducted in first succeeding year in which
there is positive at-risk amount.
C. Compute on Form 6198--must be filed for years in which there is a loss in an
activity if any amounts invested in activity are not at-risk.
D. At risk limitations must be applied before passive loss limitations are calculated.
E. If a taxpayer's at-risk basis decreases to below zero, all or a portion of a
previously allowed loss must be recaptured as income.
II. Passive Activity Limitations (Code Section 469; Form 8582)
A. PAL rules apply to individuals, estates, trusts, closely held C corporations, and personal service corporations. Passive income or loss from investments in S corporations or partnerships flow through to owners--rules applied at owner level.
1. Personal service corporation (PSC)
a. Principal activity is performance of personal services
b. Services are substantially performed by owner-employees
c. More than 10% of stock held by owner-employees
2. Closely-held corporation--any time during the year more than 50% of value
of outstanding stock is owned, directly or indirectly, by or for not more than
5 individuals.
NOTE: A closely-held corp may offset passive income against active, but not portfolio, income.
B. Classification of income/losses--Active, Passive, Portfolio
1. Active--wages, salaries, commissions, bonuses, payments for services, T or
B profits if material participant; gain on sale of assets in active T or B; income
from intangible property related to individual efforts
2. Passive--see discussion in "C" below
3. Portfolio--investment income such as dividends, interest, annuities, royalties
not from T/B, gain or loss on disposition of property that produces portfolio
income or held for investment purposes and interest, but not T or B
C. Characterization as passive generally depends on level of taxpayer's involvement in the activity, the nature of the activity, or the form of ownership
1. Excluded from definition of passive
a. Trade or business in which taxpayer materially participates
b. Working interest in an oil or gas well drilled or operated pursuant to a
working interest held directly or as a general partner (other than as a
limited partner)
c. Rental of a dwelling unit that was also used for personal purposes and
is classified as a residence--used greater of 14 days or 10% of days
rented
d. Low-income housing activities
2. The following are passive:
a. Any activity which involves the conduct of a trade or business in which
taxpayer does not materially participate
(1) Material participation shown by regular, continuous, substantial
participation;
(a) See text for Regs regarding what constitutes material participation (7 tests)--beginning on page 10-15
(i) Tests based on current participation
(ii) Tests based on past participation
(iii) Tests based on facts and circumstances\
(b) Generally, a limited partner is not considered a material participant unless test 1, 5, or 6 (from text) are met.
| FYI: The Regs do not require any recordkeeping as to the number of hours spent at an activity. |
(2) Activity
(a) Apply passive activity rules independently to each
separate activity.
(b) An undertaking is the smallest unit that constitutes an
activity--Activities which form "an appropriate economic
unit" for measuring gain or loss.
(i) There are newly issued regulations in this area which
are effective for tax years ending after 5/10/92--facts
and circumstances test.
(ii) Facts and circumstances factors--similarities in
business, common control, common ownership,
geographical location, interdependencies
(c) Usually one or more trade or businesses or rental activities of taxpayer will be treated as single activity if the activities constitute an appropriate economic unit.
(d) All business operations at one location under one
ownership might be considered one activity, except rental
and non-rental activity which should generally be treated
as separate activities.
(e) Rental activity may be grouped with trade or business
activity only if one activity is insubstantial in relation to the
other. Proposed Regs don't give details--Old rules: when
less than 20% of AGI is attributable to rental or nonrental,
treat all as one activity.
(f) Taxpayers may not treat an activity involving the rental of
real property and an activity involving the rental of
personal property as a single activity unless personal
property provided in connection with the real property.
(g) Limited partnerships are not to be combined with other
activities.
(h) Can't change groupings
b. Any rental activity (any activity where payments are received
principally for use of tangible property) regardless of level of
taxpayer's participation.
(1) To get out of rental activity status:
(a) 0-7 days rental
(b) 8 to 30 days rental and significant personal services provided such as motel
(c) Over 31 days rental & extraordinary personal services provided
(d) Rental of such property is treated as incidental to a nonrental activity of taxpayer
(e) Taxpayer customarily makes property available during defined business hours for nonexclusive use by various customers
(f) Property is provided for use in an activity conducted by a
partnership, S corp, or joint venture in which taxpayer
owns an interest
(2) Exceptions
(a) Individuals, estates, and trusts actively participating in the
rental activity may deduct up to $25,000 of losses
annually (reduced by 50% of excess of taxpayer's
modified AGI over $100,000). Applies only to real estate.
(1) Active involves decision making rather than time devoted to business; lesser standard than "material"
(2) Not active participant if ownership is less than 10%
interest
Note: A limited partner can not meet this test of
"active" participation.
(b) Real estate professionals
(1) After 1993, losses from rental activities will not be passive if the taxpayer performs more than 1/2 of his/her personal service activities as a "material participant" in real property trades or businesses and performs more than 750 hours of services in these businesses.
(c) Favorable treatment for investors in low-income housing is not passive for up to 7 years from date of original investment.
C. General rule: Expenses related to passive activities can be deducted only to
extent of income from all such passive activities
1. Unused PALS are held in suspension, carried forward to be used to offset
other passive income in future years.
2. In year in which taxpayer disposes of interest in the activity, offset carried
forward losses in the following order:
a. Gain on disposition of the interest itself
b. Net income from all passive activities for the year
c. Any other income or gain
3. Some income and deductions not allowed in computing passive income
or loss
D. Passive credits can be utilized only against regular tax attributable to passive
income. Excess credits are carried over indefinitely but may be lost when
activity disposed of.
E. Disposition of passive activities
1. Taxable disposition of entire interest--suspended losses may be utilized.
2. At death--suspended losses allowed to extent they exceed amount of step-up basis allowed.
3. By gift--suspended losses added to adjusted basis.
4. Installment sale--losses recognized as gains are recognized.
5. PA changes to active--suspended losses allowed to extent of income from
now active businesses.
6. Nontaxable exchange of passive activity--keep suspended losses until
sale of property.
I. Overview
A. Dollar for dollar reduction in tax liability
1. Refundable--paid to the taxpayer even if amount of credit exceeds
taxpayer's tax liability. Primary one is the Earned Income Credit.
2. Nonrefundable--credit may not exceed tax liability. In some cases, excess
is subject to carryover.
B. Credits must be used in order specified in Code--see page 11-5, Exhibit 11-1
II. General Business Credit
A. General provisions
1. Nonrefundable credit claimed on Form 3800 (individual components are
claimed on various forms and consolidated of Form 3800)
2. Limitations
a. For any tax year, can not exceed taxpayer's "net income tax" reduced
by greater of "tentative minimum tax" or 25% of "net regular tax
liability" that exceeds $25,000.
b. Unused credits may be carried back 1 year and carried forwarad 20
years (FIFO)
B. Components
1. Tax credit for rehabilitation expenditures (Form 3468)--credit for
expenditures incurred to rehabilitate industrial and commercial buildings
and certified historic structures.
a. Rate--10% on nonresidential buildings and residential rental property
other than certified historic structures placed in service prior to 1936;
20% on residential and nonresidential certified historic structures
b. To qualify:
(1) Building must be substantially rehabilitated (spend greater of adjusted basis or $5,000)
(2) Depreciate rehab costs using SL
(3) Property must be 15, 18, or 19 ACRS property or real property under MACRS
(4) Post-rehab must be for business or production of income use
(5) Strict structural requirements
c. Basis of building is reduced by full rehab credit allowed
d. Recapture if property disposed of prematurely or if ceases to qualify
(see page 11-8)--add recapture amount to basis
2. Business energy credits (Form 3468)--10%
a. Credit for solar energy property
b. Credit for geothermal property
3. Work opportunity credit (formerly called the targeted jobs tax credit)--enacted to encourage employers to hire individuals from one or more
targeted and economically disadvantaged groups. At present, not
available for employess hired after 6/30/99. May be extended.
a. 40% of first $6,000 of wages (per eligible employee) for first 12 months of employment. If credit elected, employer's tax deduction for wages is reduced by amount of credit. (Credit amount is 25% for employment of less than 400 hours but at least 120 hours)
b. Qualify only if employees remains employed for at least 180 days (of 400 hours of services.)
c. For qualified summer youth employees (May 1 - September 15) , only first $3,000 of wages qualify; individual must be employed for at least 20 days (or 120 hours).
d. Targeted groups: summer youth employees (16 or 17 on hiring date), veterans, ex-felons, high-risk youths, qualified food stamp recipients, and other hard-to-hire individuals.
e. Employer's wage deduction is reduced by the amount of the work opportunity credit claimed.
4. Welfare-to-work credit--available to employers
a. 35% on first 10,000 eligible wages for first year of employment and
50% on next $10,000. Max of $8,500 per qualified employer.
b. Eligible employee--qualified long-term (18 months) AFDC recipient
beginning work on or after 1/1/98-6/30/99.
5. Research activities credit--expired 6/30/99. Sum of two components:
a. Incremental research activities credit
b. Basic research credit (not available to individual taxpayers)
6. Low-income housing credit (Forms 8586, 8609, 8610)
a. RRA of '93 retroactively extended on a permanent basis from previous expiration of 6/30/92.
b. Available to owners of residential rental building providing low-income housing
c. Credit is 30% to 70% of qualified building basis taken over 10 years
for building placed in service after 1986.
7. Disabled access credit (Form 8826; IRS Pub 907)
a. Available to eligible small businesses (those with gross receipts of $1
million or less or not greater than 30 full-time employees)
b. Credit is 50% of eligible access expenditures incurred after 11/5/90
that exceed $250 but do no exceed $10,250. Reduce depreciable
basis by amount of credit.
(1) Eligible access expenditures--expenditures to remove
architectural, communication, physical, or transportation
barriers that would otherwise make a business inaccessible to
disabled and handicapped individuals.
c. Not available to facility placed in service after 11/5/90.
III. Earned Income Credit (IRS Pub 596; Schedule EIC)
A. A refundable credit--sometimes called a negative income tax
B. Available to taxpayer(s) with earned income, who is (are) not filing separately,
is (are) filing a return which covers a full 12 months except in year of death, is
(are) not a qualifying child of another person, did not file for the foreign earned
income exclusion, and has (have) one or more qualifying children. Also
available to certain workers without qualifying children.
1. Qualifying child must meet three tests
a. Relationship test--son, daughter, descendent of son or daughter, stepson, stepdaughter, eligible foster child, legally adopted child. (Note: if the child is married, parent must have claimed as dependent except in case of divorced parents.)
b. Residency test--lives in same residence as taxpayer for over 1/2 year
(full year for foster children)
c. Age test--not yet 19 or under 24 if full-time student; no age
requirement if permanently and totally disabled
2. Workers without children--must be age 25-64; not a dependent of another.
C. Parent with highest AGI can claim; qualifying child can't also claim credit; if
married, must file joint return
D. A taxpayer will not qualify for EIC if "disqualified income (taxable interest &
dividends, tax-exempt interest, net income from nonbusiness rents & royalties)
exceeds $2,300 for taxable year, even if all other qualifications are met.
E. EIC is phased out if earned income or modified adjusted gross income (changed from adjusted gross income) exceeds the threshold amounts. MAGI is defined as AGI computed without regard to any capital loss deduction (section 1211(b)), net loss from estates and trusts, net loss from nonbusiness rents and royalities, and 50 percent of the net loss from trade or business.
IV. Tax Credit for the Elderly and Disabled (Schedule R)
A. A nonrefundable credit
B. Eligibility--taxpayer or his/her spouse must be either:
1. Age 65 or older by end of 1995, or
2. Under age 65 by end of tax year and retired on permanent and total disability and had taxable disability income in tax year
C. Computations--see Schedule R
V. Foreign Tax Credit
A. Available to both individuals and corporations--tax cfredit for foreign income tax
paid on income earned and subject to tax in another country or U.S.
possession
B. Computation: Lesser of foreign taxes imposed or the overall limitation as
follows--
Foreign-source taxable income x U.S. tax before FTC
Worldwide taxable income (before exemptions)
VI. Adoption Expenses Credit (new section 23 of 1996 ACT)
A. Provides a nonrefundable credit for the amount of qualified adoption expenses
paid or incurred in the adoption of a qualified child. (Effective for tax years
after 12/31/96).
B. Up to $5,000 ($6000 for "child with special needs") of costs incurred to adopt
an eligible child (under 18 or physically or mentally incapable of taking care of
self) qualify for credit.
C. Subject to phase-out
VII. Child Tax Credit (Section 24) --introduced by TRA '97 (effective for 1998)
A. Generally, a nonrefundable credit
B. In 1998, $400/qualifying child (U.S. citizen/national/resident under 17 who
qualifies as taxpayer's dependent descendent, stepchild, or foster child); $500
per child in 1999 and years thereafter (Note: On Congress' agenda--an
increase in amount.)
C. Subject to phase out when AGI reaches $110, 000 (MFJ); $75,000 (S)
D. Computation--see Form 8812
VIII. Child and Dependent Care Credit (Form 2441)
A. A nonrefundable credit
B. Five requirements
1. Filing status is not married filing separately
2. Care was provided for qualifying individual(s) so that taxpayer (and spouse, if married) could work or look for work. Note: Expenses must be prorated if work test is only met for part of the year.
a. Qualifying individuals
(1) Under age 13 and for whom taxpayer is entitled to a dependency deduction (prorate to age 13)
(2) Dependent of taxpayer, and physically or mentally incapable of caring for self
(3) Spouse of taxpayer, if he/she is physically or mentally incapable of caring for his/herself
(4) Child meeting special dependency tests of divorced parents
(5) Person who is physically or mentally incapable of caring for self
for whom taxpayer would be entitled to claim dependency
exemption except that person had too much gross income, such
as an elderly parent
3. Taxpayer (and spouse, if married) must have earned income (unless one
spouse is full-time student or one spouse is physically or mentally
incapable of self care)
4. Taxpayer (and spouse, if married) paid over half the cost of maintaining
a home in which taxpayer and qualifying individual(s) lived
5. Care provider was not taxpayer's spouse or dependent
C. Qualifying expenses
1. Household service for care of qualifying individual--maid, housekeeper,
babysitter
2. Employment taxes paid on household employee wages for qualifying child
and dependent care expenses
3. Payments for services outside the home for dependents under age 13 or
other qualifying individuals who regularly spend eight hours per day in
household
4. Nursery school and kindergarten costs
5. Special school expenses not claimed as medical expenses
6. Summer day camp expenses, but not overnight camp expenses.
D. Computation:
% x Unreimbursed expenses of up to $2400 for one/$4800 for two
qualifying individuals, but limited to lesser earned income of
spouses (student, physically or mentally disabled is deemed to
have earned $200/$400 per month)
(1) Percentage varies
IX. Education Tax Credits
A. Hope Credit
1. Provides a nonrefundable credit of up to $1,500 per student for qualified
tuition and fees paid during the year on behalf of a student (TP, TP
spouse, dependent)--tuition/fees but NOT books
a. 100% of first $1,000 and 50% on next $1,000 of expenses
2. Requirements
a. Must be half-time student
b. Available for first 2 years of post-secondary only (college or
vocational)
3. Phaseout--between $80,000 - $100,000 AGI for MFJ; $40,000 - $50,000
other
4. Election--20% life-time learning credit or exclusion from GI for certain
distributions from an education IRA
5. Effective date: Expenses paid after 12/31/97
B. Lifetime-learning credit
1. Provides for a 20% (of tuition and fees but not books--undergrad/grad/professional) nonrefundable credit
a. Amount of credit
(1) For expenses paid before 1/1/2003--up to $5,000 expense available for credit (thus, max of $1,000)
(2) For expenses paid after 12/31/2002--up to $10,000 expense
available for credit
2. Same phase-out as Hope credit
3. Based on per taxpayer return basis, but no year limit
4. Effective date--after 6/30/98
C. May not take both HOPE and lifetime learning credit in same year on the same student; may switch from year to year
EXAMPLE ONE:
AGI..........$50,000
50% limitation = $25,000
Contributed to 50% organization:
Cash......................$6,000
Stock held 2 months......$25,000 FMV; $21,000 Basis
1. Contribution to 50% organizations:
a. Cash contributions first:
Cash $6,000
b. Contributions of ordinary income prop:
Stock.(basis because <1 year)= $21,000, however
50% limitation limits total contribution to
$25,000 19,000
Total deduction $25,000
Carryover: $21,000 amount of contribution for ordinary income property--$19,000 allowed currently, $2,000 carryover to next year retains its nature.
The 30% limitation does not apply since capital gain property not involved.
EXAMPLE TWO:
AGI..........$50,000
50% limitation = $25,000
30% limitation = $15,000
Contributed to 50% organization:
Cash......................$3,000
Stock held 2 months......$7,000 FMV; $6,000 Basis
Stock held 20 months.....$17,000 FMV; $16,000 Basis
1. Contribution to 50% organizations:
a. Cash contributions first:
Cash $3,000
b. Contributions of ordinary income property:
Stock (basis because <1 year) 6,000
c. Contributions of capital gain property:
Stock--amount of contribution is $17,000, that is, the
FMV of the property . However, the 30% limitation limits
the deduction to $15,000 currently. The 50% limitation
must also be checked. That is, after "a" and "b", only
$16,000 would be allowed. That is not exceeded. . 15,000
Total deduction $24,000
The carryover is $17,000 amount of contribution of "c" property less the $15,000
allowed. The $2,000 carryover retains its nature.
As an alternative, the 30% limitation could have been waived by taking the basis (or $16,000)
as the current deduction for "c."
EXAMPLE THREE:
AGI.............$50,000
Contributed to Public Charity (50% organization):
Cash......................$2,000
Stock held 16 months.....$12,000 FMV; $10,000 Basis
Contributed to Private Charity (20% organization):
Stock held 18 months.....$18,000 FMV; $16,000 Basis
1. Contribution to 50% organizations:
a. Cash contributions first:
Cash $2,000
b. Contributions of ord. income property:
None in this example
c. Contributions of capital gain property:
Stock (30% limitation) 12,000
2. Contribution to 20% organization:
a. Lesser of: Basis...$16,000
20%..... 10,000
30%.....$15,000 (of which $12,000 used above) 3,000
Total deduction $17,000
Total carryover ($16,000 basis of 20% property -3,000 allowed deduction)$13,000