KEIR EDUCATIONAL RESOURCES

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1 INCOME TAX PLANNING 2015 Published by: KEIR EDUCATIONAL RESOURCES 4785 Emerald Way Middletown, OH FAX Keir Educational Resources

2 TABLE OF CONTENTS Title Page Income Tax Planning (Topics 32-43) Topic 32: Income Tax Law Fundamentals Topic 33: Tax Compliance Topic 34: Income Tax Fundamentals and Calculations Topic 35: Characteristics and Income Taxation of Business Entities Topic 36: Income Taxation of Trusts and Estates Topic 37: Basis Topic 38: Tax Consequences of the Disposition of Property Topic 39: Alternative Minimum Tax (AMT) Topic 40: Tax Reduction/Management Techniques Topic 41: Passive Activity and At-Risk Rules Topic 42: Tax Implications of Special Circumstances Topic 43: Charitable Contributions and Deductions Appendix Ridgeway Case Appendix 1 Keller Case Appendix 7 Powers Case Appendix 18 Adams Case Appendix 28 Carlisle Case Appendix 36 Tingey Case Appendix 39 Beals Case Appendix 42 Mocsin Case Appendix 54 Loudon Case Appendix 66 Young Case Appendix 75 Jones Case Appendix 85 Smith Case Appendix 100 Walker Case Appendix 116 Tax Forms Appendix 137 Selected Facts and Figures Appendix Topic List Appendix 161 Glossary Glossary 1 Index Index Keir Educational Resources

3 Income Tax Fundamentals and Calculations (Topic 34) (This sample does not start with the beginning of the topic.) Imputed Income Most of the time, tax law requires the payment of tax when income has actually been received by the taxpayer and the cash is available to pay the tax. In a few instances, however, income is imputed to the taxpayer even when no income is received by the taxpayer. As a result, taxes could be owed, even though a taxpayer does not receive the cash to pay them. Three of the most common instances involve imputed interest income, described as follows: First, if a taxpayer loans an amount greater than $10,000 and does not charge at least the applicable federal rate (AFR) for the stated term, the difference between the AFR and the rate actually charged will be imputed to the lender as interest income. The lender must pay tax even though the lender did not receive the interest. There are two exceptions to the above imputed interest rules on loans in excess of $10,000. The first exception will cause imputed interest if the loan proceeds are used to purchase income producing assets even if the loan balance is less than $10,000. The second exception applies if the outstanding loan balance does not exceed $100,000 for the year. In this situation, the imputed interest will equal the borrower s annual net investment income. If the borrower s annual net investment income is less than $1,000, the taxpayer will not be required to impute interest income for the year. Second, if a taxpayer purchases a fixed-income security for a lower amount than the issuer will ultimately pay at maturity, the difference between the amount paid and the maturity value is the original issue discount (OID). An example is a zero-coupon bond. A portion of the OID is imputed to the owner of the security each year and must be included in income even though the amount is not actually received until maturity. There is an exception to this rule for U.S. savings bonds. When property is sold in return for a series of installment payments, the payments may be agreed to without any mention of interest or with an interest rate below the AFR. When this is the case, the AFR will be used to discount the payments to be received, with the difference between the future value and the present value being imputed as interest income. This amount is then ordinary income, subject to ordinary income tax rates, rather than the more favorable capital gains tax rates Keir Educational Resources

4 Sales where the price is less than $3,000 are exempt from this requirement. Adjustments for Adjusted Gross Income (AGI) Sec. 62 The IRC provides specifically for reductions of gross income in calculating adjusted gross income, or AGI. This calculation is particularly important because AGI is used in many other calculations, including limitations on deductions, exemptions, and certain credits. Planners should pay particular attention to methods that will reduce AGI. The following are subtracted from gross income to calculate AGI: 1. Contributions by self-employed persons (sole proprietors and partners) to pension, profit-sharing, and annuity plans 2. Cash contributions of up to $5,500 (those 50 years or older can contribute up to $6,500) for each spouse to a traditional deductible IRA if the contribution is made before April 15 of the year following the year for which the return is being filed (limited if either spouse is an active participant in a retirement plan sponsored by an employer) 3. Alimony or separate maintenance payments (paid by the taxpayer) 4. One-half of self-employment tax % of medical insurance costs paid for coverage on a self-employed taxpayer, spouse, and dependents (limited to the amount of self-employment income). In Chief Counsel Advice , IRS has now expanded its guidance on when Medicare premiums are deductible under Code Sec. 162(l) to include all Medicare premiums. To qualify a partner in a partnership or a greater than 2% s-corp. owner must either be reimbursed for premium payments by the business entity or the entity must pay the premiums. A sole proprietor may pay the Medicare premiums directly. 6. Penalty on early withdrawal of savings (e.g., cashing in a CD early). This is not the 10% early withdrawal penalty from retirement plans. 7. Expenses for the transportation of household items and travel for the taxpayer s family when moving from one location to another when the move is related to starting work in a new location 8. Interest on qualified education loans up to $2,500. This adjustment is reduced for joint taxpayers whose modified AGI is between $130,000 and $160,000 and for single taxpayers whose modified AGI is between $65,000 and $80,000 in Contributions to a Medical Savings Account or Health Savings Account (which can be used to pay qualified medical expenses in conjunction with a high-deductible insurance program), up to the allowable amount 2015 Keir Educational Resources

5 10. Certain business expenses of reservists, performing artists, and fee-basis government officials 11. Domestic production activities. The deduction is up to 6% of qualified production activities income (deduction based on the taxpayer s AGI and no more than 50% of wages). 12. As of the time of printing, the above-the-line deduction of up to $4,000 for qualified tuition expenses has expired for It is possible that Congress and President Obama will extend the deduction, so planners should check for updates periodically. 13. Educator expenses As of the time of printing, the abovethe-line deduction of up to $250 for K-12 educator classroom expenses has expired for It is possible that Congress and President Obama will extend the deduction, so planners should check for updates periodically. Above-the-Line or Below-the-Line Deductions The calculation of AGI is the last step on side one of Form The deductions that reduce gross income on the front of Form 1040 are referred to as the above-the-line deductions, and the deductions that appear on the back of Form 1040 are referred to as the below-the-line deductions. The above-the-line deductions are available to all taxpayers, while the below-the-line deductions are only available to taxpayers if they itemize deductions. The back of the first page of Form 1040 begins with determining whether the taxpayer will claim the standard deduction or itemize deductions. Standard Deduction To calculate taxable income, the IRC provides, first, for the deduction of the greater of the standard deduction or itemized deductions from AGI. The standard deduction depends on the filing status and is summarized below for Married filing jointly $12,600 Married filing separately $6,300 Head of household $9,250 Single $6,300 An additional amount of standard deduction is available for taxpayers and spouses who are over 65 or blind: 2015 Married (joint or separate) $1, Keir Educational Resources

6 Single $1,550 The standard deduction for individuals who are claimed as dependents cannot exceed the greater of: (a) $1,050, or (b) $350 plus the individual s earned income, up to the regular standard deduction for single taxpayers of $6,300 in Practice Question What is the standard deduction available to a married couple filing jointly if both spouses are over age 65 in 2015? A. $1,250 B. $2,500 C. $12,600 D. $15,100 Answer: A married couple over age 65 is entitled to an additional $1,250 in standard deduction for each spouse, so the total standard deduction is the $12,600 for a married couple filing jointly, plus $2,500. The answer is D Schedule A: Itemized Deductions Sec. 63 Itemized Deductions Medical Expenses A taxpayer subtracts the total of the following itemized deductions from AGI if the total is greater than the applicable standard deduction: (1) Medical expenses for the taxpayer, spouse, and dependents, including: Insurance premiums for medical or long-term care coverage Prescriptions Doctor and hospital costs Dental work Travel and overnight stays necessary for medical care Any costs reimbursed by a health plan are not deductible, and any portion deductible for AGI (self-employed health premiums) is not deductible. Taxpayers may only deduct medical costs to the extent that they exceed 10% of AGI. Editor s Note: The 2010 Health Care Reform increased the AGI threshold for deducting medical expenses from 7.5% to 10% AGI starting in However, if the taxpayer or spouse reaches age 65 or older by the end of the year, they will be allowed to use the 2015 Keir Educational Resources

7 7.5% threshold through Taxes Paid (2) Taxes paid, including: Personal property taxes The part of an auto registration that is based on the value of the vehicle (if any) is a deductible tax. Real estate taxes on an unlimited number of properties. State and local income taxes. Editor s Note: As of the time of printing, the election for taxpayers to deduct the greater of their state and local income taxes or their state and local sales taxes has expired for It is possible that Congress and President Obama will extend this election, so planners should check for updates periodically. Mortgage Interest (3) Mortgage interest on a principal and a second residence is deductible up to a maximum acquisition cost of $1,000,000, and interest on home equity loans is deductible up to $100,000 (not to exceed the fair market value of the home, less the debt incurred to acquire the home). Mortgage interest on refinanced loans is also deductible on the loan balance that was outstanding at the time of the refinance, plus up to $100,000 for a home equity loan. Generally, points paid on the acquisition of a principal residence are deductible in the year paid, even if paid by the seller. Points paid on refinancing a mortgage must be amortized over the life of the loan. For only, taxpayers were able to also deduct premiums paid on mortgage insurance related to loans taken out after December 31, The deduction started phasing out once a taxpayer s AGI reached $100,000. Taxpayers lost 10% of the deduction for every $1,000 or fraction thereof that their AGI exceeded $100,000. As a result, the deduction was completely phased out once the taxpayer s AGI reached $110,000. For taxpayers using married filing separately status, the phaseout range was $50,000 to $55,000 (these taxpayers lost 10% for every $500 or fraction thereof that their AGI exceeded $50,000). Qualified Charitable Contributions (4) Contributions of cash or property to qualified charitable organizations are deductible from AGI. The overall limit on cash contributions is 50 percent of AGI. Contributions of appreciated capital gain property are deductible at their fair market value, up to 20 or 30 percent of AGI, depending on the type of entity receiving the contribution Keir Educational Resources

8 Contributions should not be payments with expectations of something of value in return (i.e., purchases at a charity auction are only deductible to the extent that the price was more than the value of the item). See Topic 43 for additional details on charitable deductions. Editor s Note: For 2006 through 2013, taxpayers over age 70½ were able to directly contribute up to $100,000 from an IRA to a charity and treat it as their required minimum distribution for the year. The taxpayer did not have to report the distribution as income, but the taxpayer did not get to claim the charitable deduction. As of the time of printing, this provision has expired for 2014 and It is possible that Congress and President Obama will extend it, so planners should check for updates periodically. Casualty and Theft Losses (5) Casualty and theft losses in excess of 10% of AGI, less $100 per loss, are deductible. Casualty losses are damage or destruction of property from a sudden, unexpected, or unusual cause, such as a fire, earthquake, storm, or car crash. Gradual deterioration or wear and tear is not the sudden event required for a casualty. Mislaid or misplaced property is not a deductible loss. Only the amount of loss that exceeds any reimbursement from insurance is deductible. If the property is covered by insurance, an insurance claim must be filed, in order for the taxpayer to take any deduction. The deduction is only for personal casualty losses because business casualty losses will be deducted in connection with the business activity. Such business losses are not then subject to the $100 per loss reduction or the 10% floor. KEY SUMMARY 34 1 Casualty Losses To calculate the deduction for casualty losses: Determine the lesser of the fair market value or adjusted basis. Subtract any reimbursement from insurance. Subtract $100 (per event). Subtract 10% of the taxpayer s AGI. Gambling Losses (6) Gambling losses are deductible to the extent of gambling income Keir Educational Resources

9 Investment Interest (7) Investment interest costs are deductible to the extent of net investment income (interest, dividends, and capital gains). Investment interest is interest from loans attributable to property held for investment. Property held for investment is generally property that produces portfolio income, such as stocks or bonds. Thus, interest on a margin account is investment interest. Qualified residence interest is not investment interest. Investment income includes interest and short-term capital gains. Investment income includes long-term gains only if the taxpayer elects to have the gains taxed as ordinary income and not at the lower long-term capital gains rates. If dividends are treated as investment income to support an investment interest deduction, the dividends will not qualify for the reduced rates on dividends. Tax-exempt interest is not counted toward investment income. Net investment income is the excess of investment income over investment expenses. Investment expenses are deductible expenses directly connected with the production of investment income, but excluding investment interest. Investment expenses are deducted only to the extent that they exceed the 2% of AGI floor for miscellaneous deductions. Example: A taxpayer has AGI of $75,000 and has received $7,000 in interest and short-term capital gains on securities in his brokerage account. The taxpayer has paid fees of $2,000 for investment advice. The taxpayer s net investment income is calculated as follows: Advisor fee (investment expense) $2,000 [Minus] 2% of AGI (2% of $75,000) 1,500 [Equals] Allowable offset $ 500 Investment income $7,000 [Minus] Allowable offset 500 [Equals] Net investment income $6,500 If investment interest cannot be deducted because it exceeds the net investment income, the excess can be carried over and deducted in future years in which the net investment income limit is not exceeded. Itemized Miscellaneous (8) The remaining miscellaneous itemized deductions are only 2015 Keir Educational Resources

10 Deductions deductible to the extent that the aggregate of all the miscellaneous deductions exceed 2 percent of AGI. These miscellaneous items include: - Tax return preparation fees - Union dues - Home office expense - Work clothes - Investment expense - Safe-deposit box fee - Professional dues/subscriptions - Uniforms - Unreimbursed employee expense - Hobby expense to the extent of hobby income Hobby loss rules Hobby losses are a miscellaneous deduction. The tax law presumption is that an activity producing profit (net income) in 3 out of 5 consecutive years is a business, rather than a hobby. For horses, a profit in 2 out of 7 years is sufficient. For an activity that is a hobby, expenses are only deductible to the extent of income from the activity. Practice Question Which of the following statements concerning hobby losses is correct? A. Profit from a hobby activity is not taxable income until losses are recovered. B. The law presumes that the hobby activity is profitable. C. A hobby must be profitable for 3 of the past 7 years for expenses to be deductible. D. Hobby losses are deductible if miscellaneous deductions exceed 2% of AGI. Answer: Hobby loss rules presume that an activity generating profit in 3 out of 5 years is a business and not a hobby. The profit (income) is taxable, but expenses are only deductible to the extent of income. The hobby loss is a miscellaneous deduction, subject to the 2% threshold. The answer is D Keir Educational Resources

11 Application Questions 1. For 2015, Mr. and Mrs. Green, who file jointly, have AGI of $393,900 and itemized deductions of $46,000 (taxes, mortgage interest, and charitable contributions). The Greens have three children living at home, who are all under 19. Approximately what will the Greens taxable income be for 2015? A. $327,900 B. $341,500 C. $347,900 D. $344, Jeff Monroe, a single taxpayer, received the following amounts for the year: Salary of $56,000, less $900 in medical insurance deducted from his checks for a cafeteria plan Workers compensation payments of $1,400 related to medical bills after falling on a wet floor at work. Employer-paid medical insurance, totaling $900 Reimbursements of $2,400 from medical insurance for a hospital stay A car allowance of $300/month; Jeff was not required to keep records of mileage What is Jeff s gross income? A. $55,100 B. $58,700 C. $60,100 D. $60, The Singletons file their tax return jointly. For 2015, their AGI is $74,000 (each spouse makes $37,000), and they do not itemize. The Singletons have three children. Judy, age 20, is a full-time student at State University and is in her sophomore year. Mark, age 16, attends high school and works summers in an auto garage. Marci, age 9, attends a day-care program after school and during the summer, at a cost of $4,100 per year. During 2015, the Singletons paid $4,000 for Judy s tuition and $500 for her books. What is their tax liability after applicable credits? A. $188 B. $ Keir Educational Resources

12 C. $2,188 D. $5, Which of the following statements concerning interest expenses is (are) true? (1) Interest paid for the first and second mortgages on a primary residence is deductible as an itemized deduction. (2) When the home is not rented out, interest on a vacation home mortgage is deductible in calculating AGI. (3) Investment interest is deductible, up to 10% of AGI. (4) Interest paid on qualified educational loans is a tax credit for taxpayers below the AGI threshold. A. (1) only B. (1) and (2) only C. (2) and (3) only D. (1), (2), and (4) only E. (1), (2), (3), and (4) 5. Which of the following statements are true with regard to adjusted gross income (AGI)? (1) Expenses of maintaining rental properties are deducted in calculating AGI when they do not exceed rental income. (2) AGI is used to calculate the reduction in the child tax credit. (3) Allowed investment interest is subtracted from AGI to calculate taxable income (when a taxpayer itemizes). (4) The allowed deduction for personal casualty losses is not determined by reference to AGI. A. (1) and (4) only B. (1) and (2) only C. (1), (2), and (3) only D. (2), (3), and (4) only 2015 Keir Educational Resources

13 Answers and Explanations 1. D is the answer. Because their AGI is over the threshold of $309,900 for MFJ, their itemized deductions and personal exemptions will be reduced by the phase out provisions. Their itemized deductions are reduced by 3% of AGI over the $309,900 threshold. This results in a reduction of $2,520 ($84,000 excess over the threshold x 3%). Since this does not reduce their itemized deductions by more than 80%, the full reduction applies. Their personal exemptions are phased out at the rate of 2% for every $2,500 or fraction thereof by which AGI exceeds the threshold of $309,900. This results in a phase out of 68% [(84,000/2,500) x.02] of their personal exemptions. Since they started with a total of $20,000 ($4,000 x 5) in personal exemptions, $13,600 is phased out. The remaining personal exemptions are $6,400. Their taxable income is: AGI $393,900 Less: Itemized deductions $ 43,480 ($46,000 $2,520) Personal exemptions $ 6,400 ($20,000 x (1.68) Taxable income $344, B is the answer. Workers compensation payments, employer-paid medical insurance, and reimbursements from medical insurance are excluded from gross income. Also, the amount Jeff paid for premiums through a cafeteria plan are excluded. Jeff s salary of $56,000 less the cafeteria plan amount is $55,100 included in gross income. Because the $300/month is an allowance and does not require an accounting, it is also included, for a total of $58,700. If Jeff s employer had reimbursed him for miles traveled, based on expense reports, the reimbursements would be excluded. 3. A is the answer. The Singletons taxable income is calculated in the following manner: AGI $74,000 Less: Standard deduction $12,600 (for married filing jointly) Less: Exemptions $20,000 (5 x $4,000) Judy qualified because she is a fulltime student. Taxable income $41,400 From the Tax Table $ 5288 [$1,845 + ($41,400 $18,450) x 15%] Less: AOTC $ 2,500 (100% of the first $2,000 and 25% of second $2,000) Less: Child tax credit $ 2,000 (2 children under 17 yrs. x $1,000) Less: Child care tax credit $ 600 [20% of $3,000 (lesser of amount paid, or $3,000 or amount earned by lower-paid spouse for each child under 13 yrs., up to 2 children)] Tax liability $ A is the answer. Interest on the first and second mortgages secured by a primary residence up to $1,000,000 in acquisition indebtedness and $100,000 in home equity indebtedness (also 2015 Keir Educational Resources

14 limited to the FMV of the home) is qualified residence interest and is an itemized deduction. Interest on a second home is deductible from AGI but is not deductible in calculating AGI. Investment interest is only deductible to the extent of investment income, which can include capital gains. Interest on qualified educational loans is deductible up to $2,500 in calculating AGI. It is not a credit like the American Opportunity Tax credit or Lifetime Learning credit. 5. C is the answer. Expenses of maintaining rental properties are subtracted from rental income to calculate AGI. AGI over threshold reduces child tax credits. Investment interest is an itemized deduction which is subtracted from AGI. However, personal casualty losses are deductible only after subtracting $100) from the amount of the loss and comparing the loss with 10% of AGI. Only the amount over 10% is an itemized deduction Keir Educational Resources