Table of Contents and Descriptions

Transcription

1 Table of Contents and Descriptions Filing Status and Exemptions, Filing Requirements and Penalties This segment covers Filing Status, Standard Deductions, Additional Standard Deductions, Exemptions, Filing Requirements and Statute of Limitations. Income Inclusions and Exclusions.12 This segment covers Gross Income, Employee Compensation, Interest Income, Dividends, Rents and Royalties, Self-Employed Business Income, Alimony and Separate Maintenance Agreements, Full Inclusion - Other Topics, Partial Exclusion or Limitations, Full Exclusion Deductions For Adjusted Gross Income...20 This segment covers Classification of Deductions, General Deductions, Self-Employed Taxpayers, Cost Recovery and Depreciation Expense, Passive Activity and Rental Losses Deductions From Adjusted Gross Income...31 This segment covers Standard VS. Itemized Deductions, Medical Expenses, Taxes, Interest Deduction, Charitable Contributions, Casualty Losses, Miscellaneous 2% Deductions, Other Miscellaneous Deductions, Limitation On Itemized Deductions and Exemptions, Schedule A (Form 1040) - Itemized Deductions Accounting Methods and Periods, and Computation of Tax Liability and Tax Credits..42 This segment covers Accounting Methods, Accounting Periods, Computation of an Individual's Tax Liability and Credits, Alternative Minimum Tax, Self-Employment Tax, Computation of Tax Credits, Estimated Income Tax Payments, Tax Rate Schedule Capital Transactions This segment covers General Rule, Basis Computations, Like-Kind Exchanges, Capital Assets and Section 1231 Assets, Recapture Rules Taxation of Gifts, Estates and Fiduciaries...68 This segment covers The Transfer of Wealth, Estate Taxation, Gift Taxation, Income Taxation Of Fiduciaries, Taxation Of Exempt Organizations, Unified Transfer Tax Rates, Form 706, Form 709, Form 1041 i

2 The Lambers Tax Guide is offered in order to reinforce commonly found tax rules. This book is in PDF form and is searchable. Important Note: The Lambers Tax Guide does not follow the course chapter by chapter. It is only meant as a reference guide. Filing Status and Exemptions, Filing Requirements and Penalties OVERVIEW TO INDIVIDUAL TAXATION. 2 FILING STATUS... 3 Single, or Unmarried Married Filing Jointly Married Filing Separately Head of Household Qualifying Widow(er) with Dependent Child STANDARD DEDUCTION. 4 ADDITIONAL STANDARD DEDUCTION Taxpayer age 65 or over Blind EXEMPTIONS... Personal Exemptions Dependency Exemptions Qualifying Child Qualifying Relative Exceptions to Dependency Rules Multiple Support Agreements Support of Divorced or Separated Parents 4 5 FILING REQUIREMENTS... 7 WHEN TO FILE 8 STATUTE OF LIMITATIONS. General Rule Omission of Income Fraudulent Return Other Statutes 7 FORM ALPHABETICAL INDEX

3 Filing Status and Exemptions, Filing Requirements and Penalties OVERVIEW TO INDIVIDUAL TAXATION The taxation of individuals starts with a very basic formula: Gross income Minus deductions Equals taxable income In this guide you will examine what makes up the gross income and allowable deductions of individuals. The examination will test you on various components of the income and deductions, as well as various methods of determining the tax and a host of tax credits. This very basic formula will expand as you are introduced to various classifications of deductions. You will be exposed to limitations on certain deductions based upon thresholds or ceilings, as well as phaseouts for exemptions and special rates. To be sure, there is a lot of complexity. But in the end, it comes back to income minus deductions equals taxable income. In broad terms, gross income includes all items of income, unless specifically excluded by the Internal Revenue Code. By contrast, nothing is deductible unless specifically allowed by the Code. As a result, you will find that Chapter 2, which deals with inclusions and exclusions of income, is relatively short in comparison to the size of Chapters 3 and 4, which deal with the various deductions. To help you better understand this Chapter and what lies ahead, follow through this simple example. Example 1: K is single, aged 63 and earned $12,000 working part-time. In addition, K earned interest income of $1,500 and dividend income of $1,000. K also received social security benefits this year of $2,000. K does not itemize her deductions. K s taxable income for 2015 is computed as follows: Salary income $ 12,000 Interest income 1,500 Dividend income 1,000 Total gross income 14,500 Less: Standard deduction (6,300) Less: Personal exemption (4,000) Taxable income $ 4,200 K s gross income, as more fully explained in Chapter 2, is comprised of salary, interest and dividend income. Social security benefits are not included in gross income unless they pass a threshold test as you will learn about in Chapter 2. Since K does not itemize her deductions, she is allowed a standard amount of deductions. You will learn more about itemized deductions in Chapter 4. For 2015, the standard deduction is $6,300 for single taxpayers. The amount of the standard deduction is based upon the filing status of the taxpayer. This is addressed in this chapter. The other deduction is the personal exemption and for 2015 it is $4,000. This, too, is discussed in this chapter. 2

4 This is the most comprehensive problem you need to understand in this chapter. Now let s look at the taxpayer s Filing Status and Exemptions in detail. FILING STATUS There are five filing statuses available to individual taxpayers. Since filing status determines your tax rate structure (See Chapter 5 for the complete rate structure) and the amount of your standard deduction, choosing the proper filing status is important in minimizing your taxes. 1. Single, or unmarried. If a taxpayer is unmarried on the last day of the tax year, or is separated by a decree of divorce or separate maintenance, that taxpayer is considered single. Assuming the taxpayer does not qualify for a more favorable filing status such as head of household, or qualifying widower, an unmarried taxpayer must file as a single taxpayer. 2. Married Filing Jointly. To qualify for this status, the taxpayer must be married as of the last day of the year. In the event of the death of the spouse during the year, the spouse need only be alive on the first day of that year in order to qualify as being married for the entire year. Taxpayers are prohibited from filing jointly if their spouse is a non-resident alien or they have different tax year-ends from one another. Couples filing jointly may use different accounting methods in filing their joint return. A further discussion of these accounting methods can be found in Chapter 5. For federal tax purposes, a marriage means only a legal union between a man and a woman as husband and wife unless state law allows for the marriage of same sex partners to be recognized in that state. 3. Married Filing Separately. Married taxpayers may elect to file separate returns for a number of reasons. Issues of privacy, disclosure of tax returns by public officials, and possible tax planning in the shifting of deductions are some reasons as to why this status is available. In filing a separate return, both taxpayers must agree to either claiming (splitting) the standard deduction, or itemizing their deductions. One cannot itemize and the other claim the standard deduction. 4. Head of Household. This status is available to an unmarried taxpayer who: 1. maintains a household and provides for more than 50% of the year the cost for 2. their qualifying child or any other relative who is a dependent as a member of his household. (Discussed later in this chapter) In determining the cost of maintaining the household, you would include the cost of the food consumed in the home, as well as mortgage interest and real estate taxes (or rent), utilities and repairs. A special exception to this rule is that the taxpayer s parents are not required to live with the taxpayer. The taxpayer must maintain more than 50% of the parent s home, or more than 50% of their nursing home costs, in order to qualify. The parent must also qualify as the taxpayer s dependent. 5. Qualifying widow(er) with dependent child. This is also referred to as surviving spouse. If your spouse dies during the taxable year, you are entitled to file married, filing jointly for that year. In the two years following the death of your spouse, the taxpayer may elect qualifying widow(er) if: 1. The taxpayer has not remarried, and 2. maintains more than 50% of the cost of the home where, 3. the dependent child resides for the entire year. 3

5 STANDARD DEDUCTION Once the determination of the appropriate filing status has been made, the amount of the standard deductions are as follows: 2015 Single, or unmarried $6,300 Married, filing jointly 12,600 Married, filing separately 6,300 Head of household 9,250 Qualifying widow(er) 12,600 You do not need to memorize these amounts. On past exams the candidate has been provided with these amounts as needed. You should, however, understand how amounts change in relation to one another. For example, both single and married filing separately are exactly one-half of the married filing jointly. Head of household is between single and married. This relationship is important should the examiners ask you to determine what the most beneficial filing status is. ADDITIONAL STANDARD DEDUCTION There is an additional standard deduction available to the taxpayer who is 65 years or older, or blind. The additional standard deduction is added to the basic standard deduction in the determination of taxable income. The amounts are as follows: 2015 Single or head of household $ 1,550 Married or surviving spouse 1,250 Example 2: T is single, 67 and blind. For 2015, she is entitled to a total standard deduction of: Regular standard deduction $ 6,300 Additional standard deductions: 65 or over 1,550 Blind 1,550 Total standard deduction $ 9,400 4

6 EXEMPTIONS The second deduction introduced in the illustrative Example 1 was the exemption. For 2015, the allowable deduction for an exemption is $4,000. Exemptions are divided into two types: Personal and Dependency. On the exam, you need to carefully read the each question to determine whether the examiners are asking you about total exemptions, personal exemptions, or dependency exemptions. PERSONAL EXEMPTIONS General Rule In general, each taxpayer is entitled to one personal exemption when filing their return. When a taxpayer files married filing jointly, they are entitled to two personal exemptions. When married filing separately, the taxpayer may claim two personal exemptions provided that the spouse has no gross income and is not the dependent of another taxpayer. Exceptions No personal exemption is allowed for a taxpayer who is allowed to be claimed as a dependent of another taxpayer. Example 3: M is allowed to claim P, her ten year old son, as her dependent. If P files his return, he is not entitled to a personal exemption because M is allowed to claim P. DEPENDENCY EXEMPTIONS General Rule When filing a return, a taxpayer is allowed an exemption of $4,000 for each person who qualifies as a dependent. To qualify, you must be either a qualifying child or qualifying relative. Qualifying Child A qualifying child must meet 4 tests: Support test Relationship test Age Test Abode Test 1. Support Test: The dependent must not be self-supporting. This basically means that the dependent must receive more than 50% of their support from the taxpayer. Support includes, but is not limited to room and board, medical expenses, tuition payments, and purchasing of capital assets such as a car. In determining the percentage, the total support is based upon the amounts expended. Example 4: If M paid $4,000 for her son s room, board and medical costs; and her son earned and saved $1,000 from his paper route, M would have provided 100% of his support. Since his earnings were saved and not used for his support, they are not considered in determining his total support requirement. 5

7 2. Relationship Test: A qualifying child means 1. Son or daughter, or descendant (grandchild) 2. Adopted child or stepchild 3. Eligible foster child 4. Brother or sister 5. Half brother or half sister 6. Step brother or step sister 7. Or descendants of any of the above 3. Age Test: A qualifying child must be under the age of 19, or if they are a full-time student, under the age of 24. A student is full-time if they are enrolled for five months during the year. 4. Abode Test: A qualifying child must live with the taxpayer for more than one-half of the year. Temporary absences such as being away at school count as being with the taxpayer. Qualifying Relative A qualifying relative must meet 3 tests: * Support test * Relationship test * Gross income 1. Support test: Previously covered. 2. Relationship Test: A qualifying relative means 1. Father, mother, or ancestor (grandparent) 2. Children who do not meet qualifying child 3. Brothers and sisters, and descendants 4. Uncle or aunt 5. In-laws: Son, daughter, father, mother, brother or sister 6. None of the above, but only if the individual is a member of the taxpayer s household for the entire year. On the exam this could be a good friend of the family, like an Uncle Charlie who is really not an uncle, but lives with you for the entire year as his principal abode. Caution: Cousins are not considered a relationship unless they meet the sixth criteria. 3. Gross Income Test: The dependent s gross income must be less than the exemption amount. For 2015, this amount is $4,000. Additional Rules In addition to the above rules, for both the qualifying child and qualifying relative, there are two additional tests. 1. Joint Return Test: The dependent does not file a joint return with his spouse (if married). If dependent is not required to file a joint return, but does so only to receive a refund of withheld taxes, then this does not disqualify the child as a dependent. Example 5: M s son P is 20 years old, married to Q and does not attend college. M provides 80% of P and Q s support. P and Q earned $2,000 working and are not required to file a return. P and Q file a return only to receive back the $60 withheld in federal income taxes. P does not violate the joint return test. M may claim P and Q as her dependents. 2. Citizenship Test: The dependent must be a citizen or resident of the United States, or resident of Canada or Mexico. 6

8 EXCEPTIONS TO DEPENDENCY RULES Frequently tested exceptions to the general dependency rules are as follows: Multiple Support Agreements: In determining support, it is not unusual that one taxpayer alone does not provide more than 50% support of a dependent. Suppose several adult children support an elderly parent for part of a year, yet no one provides more than 50% of their support. When this occurs, taxpayers may enter into a multiple support agreement to allow one of the eligible taxpayers to claim them as dependent. To qualify under the multiple support agreement, the rules state: 1. Those party to the agreement must meet the other dependency requirements. 2. To be entitled to the deduction, you must contribute more than 10% of the support. 3. No one party contributes more than 50% of the support. 4. The written consent must be filed with the return. Support of Divorced or Separated Parents: In general, the custodial parent is entitled to the dependency deduction regardless of the amount of support provided. For agreements after 1984, the non-custodial parent is entitled to the dependency exemption only if written consent is given by the custodial parent. For agreements before 1985, the non-custodial parent must contribute at least $600 towards the support of the child in order to claim the exemption. FILING REQUIREMENTS Individuals must file a tax return if certain levels of gross income have been received by the taxpayer. Generally, that level represents the appropriate standard deduction plus the exemption amount. Example 6: A single taxpayer claiming the standard deduction would be required to file a return for 2015 if his gross income exceeded $10, Standard deduction $ 6,300 Personal exemption 4,000 Threshold for filing $ 10,300 Using the standard deduction and exemption amounts just previously discussed, you can easily determine the filing requirements for taxpayers under the age of 65* as follows: 2015 Single $ 10,300 Married, filing jointly 20,600 Married, filing separately** 4,000 Head of household 13,250 Surviving spouse 16,600 * Note that for taxpayers 65 or older, or blind, add the additional standard deduction ($1,550 or $1,250) as appropriate. ** Note that for married, filing separately, the filing threshold is only the exemption amount. The low threshold is because of the rule related to both spouses using the same election as to the standard or itemized deductions. This, in essence, forces a return to be filed. *** If the taxpayer is a dependent, the general rule is the filing requirement is equal to the standard deduction only. See special rules in Chapter 5 for the Kiddie Tax. 7

9 WHEN TO FILE Tax returns (Form 1040) are due on or before the 15th day of the fourth month following the close of the taxable year. For most taxpayers who file on a calendar year, this means April 15th. If the due date of the return falls on a Saturday, Sunday or legal holiday, then the due date in the next business day. An individual taxpayer may request an extension of up to six months of time to file their return by filing Form A copy of both pages of Form 1040 is presented at the end of this chapter. PENALTIES Failure to file a return by the due date may result in a failure to file penalty if there is a tax deficiency. The penalty is effectively 5% per month for a maximum of 5 months. If the taxpayer has a balance due, there is also a failure to pay penalty of.5% per month. This failure to pay penalty is offset against the failure to file penalty for the first five months. STATUTE OF LIMITATIONS General Rule Once a return is filed, the government can audit the return at any time during the three year period beginning on the later of (1) the date the return was filed, or (2) the due date of the return. This is the same time period a taxpayer has to amend a tax return as well. Example 7: K files her 2015 return on March 11, The statute of limitations expires on April 15, Example 8: Instead, K files her 2015 return late on November 10, The statute of limitations expires on November 10, Omission of Income When there is an understatement of gross income by at least 25% of the amount reported on the return, the statute extends from three years to six years. Example 9: K reported gross income of $20,000 from her salary but failed to report $6,000 she received as an award. K believed that the award was not taxable, but it really was. Since she omitted at least 25% of the amount report on her return (25% of $20,000, or $5,000), the IRS has a six year period to audit the return. Fraudulent Return When a taxpayer files a fraudulent return, the statute of limitations does not begin to run. The return may be audited at any time. Failure to File a Return Should a taxpayer fail to file a return, the statute does not begin to run. Once the tax return is filed, the statute runs from that date. 8

10 Other Statute Provisions In requesting a refund for prior taxes paid, the statute is the later of (1) the three year period, or (2) two years from the date the tax was paid. The taxpayer would file Form 1040X to amend a tax return previously filed. If the nature of the refund is from a bad debt or worthless security, the statute is seven years rather than three years. 9

11 Form 1040 Department of the Treasury Internal Revenue Service (99) U.S. Individual Income Tax Return 2015 OMB No IRS Use Only Do not write or staple in this space. For the year Jan. 1 Dec. 31, 2015, or other tax year beginning, 2015, ending, 20 See separate instructions. Your first name and initial Last name Your social security number If a joint return, spouse s first name and initial Last name Spouse s social security number Home address (number and street). If you have a P.O. box, see instructions. Apt. no. Make sure the SSN(s) above and on line 6c are correct. City, town or post office, state, and ZIP code. If you have a foreign address, also complete spaces below (see instructions). Presidential Election Campaign Foreign country name Foreign province/state/county Foreign postal code Check here if you, or your spouse if filing jointly, want $3 to go to this fund. Checking a box below will not change your tax or refund. You Spouse Filing Status 1 Single 4 Head of household (with qualifying person). (See instructions.) If 2 Married filing jointly (even if only one had income) the qualifying person is a child but not your dependent, enter this Check only one 3 Married filing separately. Enter spouse s SSN above child s name here. box. and full name here. 5 Qualifying widow(er) with dependent child 6a Yourself. If someone can claim you as a dependent, do not check box 6a..... Boxes checked Exemptions } on 6a and 6b b Spouse No. of children c Dependents: (2) Dependent s (3) Dependent s (4) if child under age 17 on 6c who: (1) First name Last name social security number relationship to you qualifying for child tax credit lived with you (see instructions) did not live with you due to divorce If more than four or separation (see instructions) dependents, see Dependents on 6c instructions and not entered above check here Add numbers on d Total number of exemptions claimed lines above Income 7 Wages, salaries, tips, etc. Attach Form(s) W a Taxable interest. Attach Schedule B if required a b Tax-exempt interest. Do not include on line 8a... 8b Attach Form(s) 9 a Ordinary dividends. Attach Schedule B if required a W-2 here. Also attach Forms b Qualified dividends b W-2G and 10 Taxable refunds, credits, or offsets of state and local income taxes R if tax 11 Alimony received was withheld. 12 Business income or (loss). Attach Schedule C or C-EZ Capital gain or (loss). Attach Schedule D if required. If not required, check here 13 If you did not 14 Other gains or (losses). Attach Form get a W-2, see instructions. 15 a IRA distributions. 15a b Taxable amount... 15b 16 a Pensions and annuities 16a b Taxable amount... 16b 17 Rental real estate, royalties, partnerships, S corporations, trusts, etc. Attach Schedule E Farm income or (loss). Attach Schedule F Unemployment compensation a Social security benefits 20a b Taxable amount... 20b 21 Other income. List type and amount Combine the amounts in the far right column for lines 7 through 21. This is your total income Educator expenses Adjusted 24 Certain business expenses of reservists, performing artists, and Gross fee-basis government officials. Attach Form 2106 or 2106-EZ 24 Income 25 Health savings account deduction. Attach Form Moving expenses. Attach Form Deductible part of self-employment tax. Attach Schedule SE Self-employed SEP, SIMPLE, and qualified plans Self-employed health insurance deduction Penalty on early withdrawal of savings a Alimony paid b Recipient s SSN 31a 32 IRA deduction Student loan interest deduction Tuition and fees. Attach Form Domestic production activities deduction. Attach Form Add lines 23 through Subtract line 36 from line 22. This is your adjusted gross income For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see 10 separate instructions. Cat. No B Form 1040 (2015)

12 Form 1040 (2015) Page 2 38 Amount from line 37 (adjusted gross income) a Tax and Check You were born before January 2, 1951, Blind. Total boxes { } if: Spouse was born before January 2, 1951, Blind. checked Credits 39a b If your spouse itemizes on a separate return or you were a dual-status alien, check here 39b Standard 40 Itemized deductions (from Schedule A) or your standard deduction (see left margin).. 40 Deduction for 41 Subtract line 40 from line People who 42 Exemptions. If line 38 is $154,950 or less, multiply $4,000 by the number on line 6d. Otherwise, see instructions 42 check any box on line 43 Taxable income. Subtract line 42 from line 41. If line 42 is more than line 41, enter a or 39b or 44 Tax (see instructions). Check if any from: a Form(s) 8814 b Form 4972 c 44 who can be claimed as a 45 Alternative minimum tax (see instructions). Attach Form dependent, see 46 Excess advance premium tax credit repayment. Attach Form instructions. 47 Add lines 44, 45, and All others: 48 Foreign tax credit. Attach Form 1116 if required Single or Married filing 49 Credit for child and dependent care expenses. Attach Form separately, $6, Education credits from Form 8863, line Married filing 51 Retirement savings contributions credit. Attach Form jointly or Qualifying 52 Child tax credit. Attach Schedule 8812, if required widow(er), $12, Residential energy credits. Attach Form Head of 54 Other credits from Form: a 3800 b 8801 c 54 household, $9, Add lines 48 through 54. These are your total credits Subtract line 55 from line 47. If line 55 is more than line 47, enter Self-employment tax. Attach Schedule SE Other 58 Unreported social security and Medicare tax from Form: a 4137 b Additional tax on IRAs, other qualified retirement plans, etc. Attach Form 5329 if required.. 59 Taxes 60 a Household employment taxes from Schedule H a b First-time homebuyer credit repayment. Attach Form 5405 if required b 61 Health care: individual responsibility (see instructions) Full-year coverage Taxes from: a Form 8959 b Form 8960 c Instructions; enter code(s) Add lines 56 through 62. This is your total tax Payments 64 Federal income tax withheld from Forms W-2 and estimated tax payments and amount applied from 2014 return 65 If you have a qualifying child, attach Schedule EIC. Refund Direct deposit? See instructions. Amount You Owe Third Party Designee Sign Here Joint return? See instructions. Keep a copy for your records. Paid Preparer Use Only 66a Earned income credit (EIC) a b Nontaxable combat pay election 66b 67 Additional child tax credit. Attach Schedule American opportunity credit from Form 8863, line Net premium tax credit. Attach Form Amount paid with request for extension to file Excess social security and tier 1 RRTA tax withheld Credit for federal tax on fuels. Attach Form Credits from Form: a 2439 b Reserved c 8885 d Add lines 64, 65, 66a, and 67 through 73. These are your total payments If line 74 is more than line 63, subtract line 63 from line 74. This is the amount you overpaid 75 76a Amount of line 75 you want refunded to you. If Form 8888 is attached, check here. 76a b Routing number c Type: Checking Savings d Account number 77 Amount of line 75 you want applied to your 2016 estimated tax Amount you owe. Subtract line 74 from line 63. For details on how to pay, see instructions Estimated tax penalty (see instructions) Do you want to allow another person to discuss this return with the IRS (see instructions)? Yes. Complete below. No Designee s Phone Personal identification name no. number (PIN) Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge. Your signature Date Your occupation Daytime phone number Spouse s signature. If a joint return, both must sign. Date Spouse s occupation Print/Type preparer s name Preparer s signature Date If the IRS sent you an Identity Protection PIN, enter it here (see inst.) PTIN Check if self-employed Firm s name Firm's EIN Firm s address Phone no. Form 1040 (2015) 11

13 Income Inclusions and Exclusions GROSS INCOME EMPLOYEE COMPENSATION Health Insurance Group-term Life Insurance Death Benefits Cafeteria Plans Employee Discounts De Minimis Fringe Benefits Moving Expense Reimbursements Reimbursed Expenses Qualified Transportation Benefits Qualified Employer-Provided Educational Assistance Dependent Day Care INTEREST INCOME Municipal Bond Interest U.S. Savings Bonds Educational Savings Bonds DIVIDENDS RENTS AND ROYALTIES SELF-EMPLOYED BUSINESS INCOME ALIMONY AND SEPARATE MAINTENANCE AGREEMENTS FULL INCLUSION - OTHER TOPICS Gambling Winnings Jury Duty Pay Unemployment Compensation PARTIAL EXCLUSION OR LIMITATIONS Social Security Benefits Annuity Contracts and Pensions Tax Benefit Rule Prizes and Awards Discharge of Indebtedness Foreign Income Armed Services Qualified Tuition Programs FULL EXCLUSION Inheritances and Gifts Life Insurance Personal Injury Scholarships Rental Value of Parsonage ALPHABETICAL INDEX

14 Income Inclusions and Exclusions GROSS INCOME As a general rule, the Internal Revenue Code defines gross income as all income, from whatever source derived. Included in this broad definition of income is compensation for services, business income, property transactions, interest, dividends, rents, royalties, alimony, annuities, pensions, and discharge of indebtedness. This is not an all inclusive group, nor are all the items listed always fully included as gross income. If an item is to be excluded from gross income, there must be a specific code section excluding it. On the exam, you need to be aware of these exceptions because the examiners will concentrate on these areas. Also, the receipt of cash is not necessarily a prerequisite to the recognition of income. Receiving property with a fair market value of $100 for services rendered is included as income just the same as receiving $100 in cash. See Chapter 5 for a full discussion of the methods of accounting for income and deductions. EMPLOYEE COMPENSATION An employee receives compensation in a number of ways. Some compensation is fully taxable, some is fully excluded, and some is partially excluded. Gross income that is fully included in gross income typically includes salaries and wages, bonuses, and commissions. Besides paying for compensation directly, an employee may receive other benefits which may or may not be taxable. Employee Fringe Benefits Health Insurance Premiums and Benefits: The premiums paid by an employer for an employee's health insurance coverage are not included as gross income, nor are any of the benefits received from the policy. The nontaxable benefits can be for the employee, spouse, or dependent. This also generally applies to long-term care benefits as well. Group-term Life Insurance: An employer may provide an employee with group-term life insurance coverage of up to $50,000 as a non-taxable fringe benefit. The cost of coverage in excess of the $50,000 is considered income to the employee. The cost of coverage may be determined by the lessor of actual cost or by IRS tables based upon the age of the taxpayer. Death Benefits: Death benefits paid by a company directly to an employee's family are fully taxable to the recipients. Cafeteria Plans: Companies may offer a variety of non-taxable benefits which an employee may choose from, similar to a cafeteria. There is generally no minimum waiting period for employees to take advantage of this plan. Employee Discounts: Allowed as a tax-free benefit when the discount on services is not greater than 20% and when the discount on purchases is not below the employer's cost. De minimis Fringe Benefits: Refers to non-taxable benefits such as subsidized eating facilities when a plant is located in a remote location; occasional use of the company copy machine; use of company typing services, etc. Moving Expense Reimbursements: Reimbursements in excess of qualified moving expenses are includible in gross income. Moving expenses are described in Chapter 3. Reimbursed Expenses: When an employee incurs expenses on behalf of his employer, and the amount of the expenditure is reimbursed by the employer after the employee makes an adequate accounting, that amount is not income to the employee. However, if the employee merely receives a monthly draw and is not required to provide an adequate accounting, that amount is included as gross income. 13

15 Qualified Transportation Benefits: Employers may provide employees with a transit pass for the use of mass transit. The employee may exclude the value of up $130 per month. In addition, employers may provide free parking of up to $250 in value per month. And for those taxpayers who bicycle to work, the employer may provide up to $20 per month in reimbursements tax free. Qualified Employer-Provided Educational Assistance: For undergraduate and graduate studies, the amounts paid by the employer under a qualified plan for tuition, fees, books and supplies is excluded up to an annual amount per employee of $5,250. Dependent Day Care and Adoption Expenses: An employee may exclude, up to $5,000 per year, the cost of child and dependent care services paid by the employer to enable the employee to work. The exclusion may not exceed the earned income of the spouse with the lesser income when the taxpayer is married. In addition, an employee may exclude up to $13,400 of qualified adoption expenses. INTEREST INCOME Interest earned by a taxpayer is generally included as gross income. Interest income is reported on Schedule B and typically represents interest on savings accounts, certificates of deposits, tax refunds, loans by the taxpayer, bonds and other investments. Investments include federal obligations such as U. S. Treasury Certificates and Savings Bonds. However, there are special provisions and various elections a taxpayer may make to defer or exclude from gross income the interest from certain federal obligations. Such provisions are discussed later. Interest is recognized by cash basis taxpayer when it is credited to his account. Accrual based taxpayers recognize the income when earned. Occasionally, a taxpayer may receive a gift when opening up a savings account or certificate of deposit. The fair market value of that gift is also included as interest income. Municipal Bond Interest: Interest on state and municipal obligations is excluded from gross income. Also excluded is interest on obligations of a possession of the United States, such as Puerto Rico. Tax refunds are not considered to be obligations of the state and any interest earned on the refunds are fully taxable. Also, any gain from the sale of municipal obligations is included in gross income. U. S. Savings Bonds: Series E (before 1980) and Series EE (after 1979) Savings Bonds are issued at a discount, do not pay out interest, but are redeemed for fixed amounts in the future. The difference between the purchase price and the redemption price is recognized as interest income. Whereas the interest is not recognized until the bonds are redeemed, there is a deferral available to taxpayers. In addition, the Series E Bonds may be exchanged for Series HH Bonds and the interest deferred even further. A taxpayer, however, may elect to recognize the interest income annually rather than waiting until redemption. Once this method is elected, it must be used for all future years unless the change is approved by the Commissioner. Educational Savings Bonds: In an effort to assist parents in affording the spiraling cost of higher education, Congress passed a law stating that the interest earned on U. S. Savings Bonds is excluded from gross income if certain restrictions are met. For the exclusion to apply: The Series EE US Savings Bonds must be issued after December 31, At the time of issuance, the individual to whom the bonds are issued must be at least 24 years old. All the proceeds must be used for the qualified higher educational expenses (tuition and fees) of the taxpayer, his spouse or dependent. Qualified higher education expenses must be reduced by other scholarships or veterans' benefits received. At the time of redemption, the taxpayer's Modified Adjusted Gross Income (MAGI) does not exceed the specified limit described below. (MAGI is the adjusted gross income before the foreign earned income exclusion and Educational Savings Bond Interest Exclusion itself). This is not available to those electing married filing separately. 14

16 Note that these bonds are not being bought by the parent and held in the child's name. That is a completely different tax planning strategy. Also note that a grandparent or uncle cannot buy the bonds to have this rule apply unless the child they are buying for is their dependent. Limitations on the Exclusion: In computing the limitation referred to above, there are two limitations which must be observed. If the total amount from the redemption (both principal and interest) exceeds the qualified higher education expenses, then there is a pro-rata reduction in the amount of interest that can be excluded. For married taxpayers, if their MAGI in 2015 exceeds $115,750, the exclusion from is phased-out on a pro-rata basis over the next $30,000. If the taxpayer is single, the MAGI amount is $77,200 and the range is over $15,000. The MAGI limitation imposed by Congress severely reduces the appeal of this provision. Those who qualify without limitation, may not be able to afford to purchase the bonds. Those who are financially able to afford them will not qualify. Other Provisions: Interest on Veterans Administration insurance dividends left on deposit with the Veterans Administration is also excluded from gross income. DIVIDENDS Dividends represent distributions from a corporation's earning and profits, and are generally fully included as gross income. Dividends are reported on Schedule B. When a corporation makes a distribution in excess of its earnings and profits, the excess represents a return of the investor's cost or basis. For 2015, qualifying dividends will be taxed at the long-term capital gains rates. This means a taxpayer in the: 10% or 15% tax bracket will be taxed at 0% 25% to 35% tax bracket will be taxed at 15% The new 39.6% bracket will be taxed at 20%. In order to be qualifying the taxpayer must have held the stock (in a domestic corporation) for at least 60 days. The dividend is still reported on Schedule B but is taxed on Schedule D. Dividends received on a life insurance policy generally do not represent income, but rather represent a return of a premium. Also, the receipt of a stock dividend is generally excluded from income. However, if the taxpayer has the option to receive cash (or other property) instead of stock, the shareholder will recognize dividend income to equal to the fair market value of the distribution. RENTS AND ROYALTIES Amounts received from rental property, less the related rental expenses are included as gross income. Also, royalties from books, articles, reproductions, oil and gas, etc., are included as gross income. These amounts are reported on Schedule E - Supplementary Income and Loss, along with other items of income from sources such as S Corporations, Partnerships and Trusts. Any increase in the value of the rental property as the result of improvements made by the lessee are generally excluded from the lessor's gross income. However, if the improvements were made in lieu of rent, the fair market value of the improvements would be included as gross income. The lessee may also provide the lessor with a security deposit. A security deposit does not represent gross income as a right of return exists to the lessee at the end of the lease. However, a prepayment of the last month's rent does represent gross income in the year received. 15

17 SELF-EMPLOYED BUSINESS INCOME Income from carrying on a trade or business on an unincorporated basis is reported on Schedule C. This is typical income from services provided (consulting, tax returns, etc.) See Chapter 3 for the various business deductions. ALIMONY AND SEPARATE MAINTENANCE PAYMENTS When a married couple obtains a divorce, there is generally a requirement for one spouse to support the other. These payments are referred to as alimony (or separate maintenance payments if they are legally separated). In general, these payments are deductible by the payor spouse, and included as income by the spouse receiving them. Should the spouse also have children, there may be an element of the payment which includes child support. Child support is not a taxable to the recipient. If the agreement further calls for the division of marital property, such as a house, investments and other property, this division, or transfer is not a taxable event. In addition, if the division of marital property includes the continuation of the mortgage payments, this amount will not be considered alimony because the mortgage payments will not terminate at the death of the former spouse. Because of the various tax consequences of these different transactions, it is important for the taxpayer as well as the IRS to be able to clearly identify what a transaction is so that both parties treat the transaction consistently. Payments made under written decrees and agreements after 1984 are considered to be alimony only if: Payments are made in cash (distinguishes it from property). Agreement does not state the payments are not alimony (directly or indirectly). The former couple are not members of the same household during the time of the payments. The former couple do not file a joint return. Payments stop after the death of the payee spouse. Example 1: B and D were married and have one child who resides with D. They are now divorced under an agreement dated They do not reside together. B is required to pay D $2,000 per month until D dies. Of the $2,000 payment, $400 is designated in the agreement as child support. Therefore, $1,600 is considered alimony and is included in D's gross income. Example 2: C and E were married and have one child who resides with E. They are now divorced under an agreement dated They do not reside together. C is required to pay E $2,000 per month until E dies. The written decree states the payment decreases to $1,600 after the child reaches age 21. Indirectly, the decree states that $400 is not alimony. Therefore, $1,600 is considered alimony and is included in E's gross income. If payments made during the year are less than the payments required by the written decree or agreement, in determining the amount of alimony, payments are first allocated to the non-alimony (child support), and then the alimony. You do not pro-rate the payments. Example 3: B and D were married and have one child who resides with D. They are now divorced under an agreement dated They do not reside together. B is required to pay D $2,000 per month until D dies. Of the $2,000 payment, $400 is designated as child support. However, B only made 10 payments totaling $20,000 during the year. Total payments made $ 20,000 Amount not alimony: ,800 Alimony component $ 15,200 16

18 Because the alimony payments are deductible by the payor, certain taxpayers have attempted to obtain tax advantages by structuring the agreement to make large payments in the early years and smaller payments in subsequent years. Theoretically, a high income tax-bracket payor could make a very large payment to the payee who may be in a low bracket in the year of, or year after the divorce. A $50,000 payment could result in a significant, overall net tax savings. To prevent what is referred to as front-loading, agreements signed after 1986 state that if payments made in the first or second year exceed $15,000, alimony recapture may exist for the excess amount over an average. The computations are beyond the scope of the exam, but this concept is not. Alimony recapture effectively causes a reduction in the gross income recognized by the payee spouse and a reduction in the deduction claimed by the payor spouse. The payor's deduction for making alimony payments is addressed in Chapter 3. Finally, alimony is considered to be earned income to the recipient. This is important because the earned income of the contributor determines the allowable IRA contribution. Remember this as you review the IRA deduction in Chapter 3. Full Inclusion -- Other Topics Gambling Winnings: Amounts received from gambling winnings, lotteries, etc., are included in gross income. Gambling losses are deductible only to the extent of the gambling winnings. See Chapter 4. Jury Duty Pay: Compensation received while performing jury duty is included in gross income Unemployment Compensation: Various states provide benefits to unemployed workers for a set period of time. Unemployment benefits received are included in gross income. Partial Exclusion or Limitations Social Security Benefits: In general, these benefits are excluded from gross income. However, when a taxpayer's modified adjusted gross income (or provisional income) exceeds a base amount, they may have to include 50% to 85% of their social security benefits as gross income. The provisional income represents adjusted gross income plus tax-exempt income and one-half of the social security benefits received. However, if the taxpayer has the higher level of provisional income, 85% of the benefits will be included. For married taxpayers filing separately, there is no base amount and 85% of all benefits received will be taxed. The base amounts for the provisional income test and benefit inclusion rate are as follows: Filing Status 0% Taxed 50% Taxed 85% Taxed Single or head of household Up to $25,000 $25,000 to $34,000 Over $34,000 Married Up to $32,000 $32,000 to $44,000 Over $44,000 Annuity Contracts and Pensions: Annuities represent an investment whereby the taxpayer contributes a sum of money to an organization and receives over time a return of his investment and interest. The issue is generally the proration of the cost, or basis of the investment, over the stream of payments. The allowable methodology is a straight-line recovery of the cost. If the annuity continues after the recovery of cost, the entire payments represent income. However, if the annuitant dies before recovering the cost of the investment, the unrecovered cost is treated as a miscellaneous itemized deduction, not subject to the 2% floor (See Chapter 4). Example 4: Y invests $40,000 in annuity that will pay her $12,000 per year for the next 5 years. Her expected payout is $60,000. During the year, Y receives $12,000 of which $8,000 is a nontaxable return of her investment and the $4,000 is recognized as income. Original investment $ 40,000 Number of years 5 years Annual recovery of $8, $12,000 less recovery of $8,000 = $4,000 income

19 Tax Benefit Rule: When a taxpayer claims a deduction in one year, and receives a refund in the subsequent year, the amount of the refund must be reported as income. However, if claiming the deduction did not result in a tax benefit, then the refund is not taxable. Example 5: In filing his 2014 tax return, J claimed $5,000 in medical deductions. Because of his threshold limitation of $4,500 (AGI of $45,000 times the medical limitation of 10% in 2014), J was only able to deduct $500 of the $5,000. Late in 2015, J received a $800 refund from his health insurance company due to a disputed bill he paid in Of the $800, the first $500 represents income because L received a tax benefit by being able to deduct $500 of the expenses in The balance of $300 is not included as income because J never received a tax benefit from the expense. Prizes and Awards: The fair market value of prizes and awards is generally included as gross income. This includes prizes from game shows, door prizes and employer awards. However, an employee achievement award may be excluded if it is based upon length of service or safety, and does not exceed $400, or $1,600 if it is under a qualified plan. In order for other awards to be excluded from gross income, the award must meet all the following criteria: The award is for recognition of religious, charitable scientific, artistic, literary or civic achievement. The taxpayer was selected without any action on his part to enter the contest. There is no requirement for the taxpayer to render services in the future. The taxpayer contributes the award to a nonprofit organization or qualified governmental unit. Discharge of Indebtedness: When a taxpayer is obligated to pay a mortgage, loan or other indebtedness, and the lender discharges the taxpayer from the obligation, the amount of the discharge generally represents ordinary income. However, if the taxpayer is insolvent or bankrupt at the time of the discharge, it will not be income. Another exception exists for individuals who are released from indebtedness related to qualified real property business indebtedness. Rather than recognizing income, the taxpayer may reduce the basis of the real property. There is an exclusion for students with student loans. If the forgiveness is contingent upon the student fulfilling a work requirement in the state, the forgiveness of debt will not constitute gross income. Foreign Income: When a taxpayer earns income from working in a foreign country, there is an exclusion available which is limited to the lesser of $100,800 or the foreign earned income. In addition, a taxpayer may exclude a housing allowance for amounts up to 14% of the exclusion amount. In addition, the taxable portion of the foreign income is now taxable under the stacking rate provisions which effectively consider the tax exemption portion of the foreign earned income in the computation of the tax.. In general, there are two different tests to determine the exclusion: Bona Fide Resident Test: Must a be a resident for a full taxable year. Physical Presence Test: Must be physically present in the foreign country at least 330 days in a consecutive 12 month period. When the US taxpayer is not present in the foreign country for a full year, the exclusion is prorated on a daily basis Armed Services: There are various benefits available to members of the Armed Services. In particular is the exclusion of pay from gross income when enlisted men are serving in combat areas. For officers, the exclusion is only on the first $500 of pay per month. The housing allowance for the servicemen is also excluded. 18