Income Tax Acc - Exam 2

Income Tax Formula

Gross Income

Less: Deductions for AGI

Adjusted Gross Income (AGI)

Less: Deductions from AGI

Less: Qualified Business Income (QBI) Deduction

Taxable Income

Tax

Less: Tax Credits

Tax Liability

Less: Prepayments

Tax Due (or Refund)

Common Deductions for AGI (Exhibit 4-5)

• alimony paid (pre-2019 divorce decree)

• health insurance deduction for self-employed taxpayers

• rental & royalty expenses

• net capital losses (limited to 3k, only 1.5k for married filing separately)

• one-half of self-employment taxes paid

• business expenses

• losses on dispositions of assets used in a trade or business

• contributions to qualified retirement accounts (401k plans & traditional individual retirement accounts, IRAs)

Significance of AGI

important reference point that is used in other tax calculations

Examples of Itemized Deductions (Schedule A, exhibit 4-6)

• medical & dental expenses

• taxes

• interest expense

• gifts to charity

• other miscellaneous deductions

Child Tax Credit Rules

• qualify for $2,200 if under age 17 at yr end

• qualify for $500 for qualifying dependents who do not meet the requirements for higher credit amount

Tests for Qualifying Child

• Relationship

• Age

• Residence

• Support

Test for Qualifying Relative

• Relationship

• Support

• Gross Income

• Other

Relationship Test for Qualifying Child

is taxpayer’s child, stepchild, foster child, sibling, half-sibling, stepsibling, or a descendant of any of these relatives

Age Test for Qualifying Child

• younger than the taxpayer claiming the individual as a qualifying child

• under age 19 or a full-time student under age 24

• also anyone totally & permanently disabled

Residence Test for Qualifying Child

• lives w/ taxpayer for more than half of the yr

• includes temporary absences for things such as illness & education

Support Test for Qualifying Child

the qualifying child must not provide more than half of their own support

Relationship Test for Qualifying Relative

Taxpayer’s descendant or ancestor, sibling, stepparent, stepsibling, child of taxpayer’s sibling, sibling of the taxpayer’s parents, in-laws, & anyone else who has the same principal place of abode as the taxpayer for the entire year (even if not otherwise related)

Support Test for Qualifying Relative

taxpayer must have provided more than half of the support for the qualifying relative

Gross Income Test for Qualifying Relative

Gross income of the relative is less than $5,200 in 2025

Other Test for Qualifying Relative

must not be a qualifying child

Tiebreaking Rules for Qualifying Child

• if the person is a qualifying child of a parent & a nonparent, the parent is entitled or has priority to claim the person as a dependent

• if the individual is a qualifying child to more than one parent, the parent whom the child has resided for the longest period of time during the yr has priority

  • if the child resides w/ each parent for equal amounts of time during the yr, the parent w/ the higher AGI gets to claim the child as dependent

• if the child is a qualifying child of more than one nonparent, the nonparent w/ the highest AGI gets to claim the child as dependent

What constitutes support / multiple support agreements?

• no one taxpayer paid over ½ of the individual’s support for the yr

• the taxpayer & at least one other person together provided more than half the support of the individual, & the taxpayer and the other person(s) would have been allowed to claim the individual as a dependent except for the fact they did not provide half the support individually

• the taxpayer contributed over 10% of the individual’s support for the yr

• each other person who provided over 10% of the individual support provides a signed statement to the taxpayer agreeing not to claim the individual as a dependent

• commonly used in situations when siblings support elderly parents

Types of Filing Statuses

• single

• married filing separately

• married filing jointly

• qualifying surviving spouse

• head of household

Requirements for Single Status

• unmarried as of the last day of the yr

  • or legally separated from their spouse under a divorce or separate maintenance decree

• does not qualify for any of the other filing statuses

Requirements for Married Filing Separately Status

• taxpayers are legally married as of the last day of the yr

• generally no tax advantage to filing separately (usually a disadvantage)

• each spouse is ultimately responsible for paying their own tax

• couples may choose to file separately (generally for nontax reasons)

Requirements for Married Filing Jointly Status

• must be legally married as of the last day of the yr

• if one spouse dies, the surviving spouse is considered to be married to decedent spouse at yr end

  • exception: the surviving spouse remarries before yr’s end

• both spouses responsible for paying joint tax

Requirements for Qualifying Surviving Spouse Status

when a taxpayer’s spouse dies, the surviving spouse can file as a qualifying surviving spouse for 2 yrs after the yr of the spouse’s death if the surviving spouse remains unmarried & maintains a household for a dependent child

Requirements for Head of Household Status

• unmarried as of the last day of the yr

  • or legally separated from their spouse under a divorce or separate maintenance decree

• not be a qualifying surviving spouse

• pay more than half the costs of keeping up a home for the yr

• have a qualifying person live in the taxpayer’s home for more than half the yr

  • excludes temporary absences for military service, illness, or education

  • if the person is the taxpayer’s parent, the parent is not required to live w/ the taxpayer

Qualifying Person Requirements for Head of Household Status

• may not qualify more than one person for head of household filing status

• if taxpayer can only claim a person as dependent bc of multiple support agreement, that person is not a qualifying person

• if a custodial parent agrees under divorce decree to allow the noncustodial parent to claim the person as a dependent, the agreement is ignored for purposes of the head of household filing status test

Gross Income (IRC 61)

• means all income from whatever source derived

• includes income realized in any form, whether in money, property, or services

• recognized when:

  • they receive an economic benefit

  • they realize the income

  • the tax law does not provide for exclusion or deferral

Economic Benefit

borrowed funds represent a liability, not gross income

Realization Principle

• taxpayer engages in a transaction w/ another party

• transaction results in a measurable change in property rights

Recognition

realized income is assumed to be recognized absent a deferral or exclusion provision

Accrual Method

• income recognized when earned

• expenses deducted in the period when liabilities are incurred

• mostly used by large corps

Cash Method

• income recognized when received

• expenses deducted when made rather than when liabilities are incurred

• mostly used by individuals

Constructive Receipt Doctrine

• judicial doctrine that provides that a taxpayer must recognize income when it is actually or constructively received

• deemed to have occurred if the income has been credited to the taxpayer’s account or if the income is unconditionally available (accessible w/o limits) to the taxpayer, the taxpayer is aware of the income’s availability, & there are no restrictions on the taxpayer’s control over the income

• for cash method users

Claim of Right Doctrine

• judicial doctrine that states that income has been realized if a taxpayer receives income & there are no restrictions on the taxpayer’s use of the income

• addresses when a taxpayer receives income in one period but is required to return the payment in a subsequent period

• potentially have to repay but currently no restrictions on the use of income

Assignment of Income

• judicial doctrine holding that earned income is taxed to the taxpayer providing the service

• income from property is taxed to the individual who owns the property when the income accrues

• to shift income from property to another person, a taxpayer must also transfer ownership in the property to the other person

Earned Income

• income from services

• income from labor most common source of gross income

• generated by the efforts of taxpayer

Unearned Income

• income from property

• includes gains or losses from sale of property, dividends, interests, rents, royalties, & annuities

• depends on type of income & type of transaction generating income

Examples of Earned Income

• wages

• salary

• fees that a taxpayer earns through services

• unemployment compensation

Examples of Unearned Income

• gains or losses from sale of property

• interest

• dividends

• rents

• royalties

• annuities

Concept of Income from Flow-Through Entities

• applies to legal entities, like partnerships, LLCs, and S corps, that do not pay income tax

• income and losses from these entities are allocated to their owners

• each partner & shareholder report their share of the entity’s income & deductions in proportion to their ownership % on their individual tax return

Alimony

• a transfer of cash made under a written separation agreement or divorce decree

• the separation or divorce decree does not designate the payment as nonalimony

• in the case of legally separated (or divorced) taxpayers under a separation or divorce decree, the spouses do not live together when the payment is made

• the payments cannot continue after the death of the recipient

• types of payments that do not qualify:

  • property divisions

  • child support payments fixed by the divorce or separation agreement

• if executed before 1/1/2019, alimony is included in gross income of the recipient & deductible for AGI by the payor

• if executed after 12/31/2018, alimony is not taxable to the recipient or deductible by the payor

Prizes / Awards / Gambling

• raffles, sweepstakes prizes, or lottery winnings are included in gross income

• exclusions rules:

  • for scientific, literary, or charitable achievement under certain conditions

  • for employee length of service or safety achievement ($400 tangible property limit per employee per yr)

  • to Team USA athletes from US Olympic Committee on account of their competition in Olympic & Paralympic games (AGI limit applies)

What constitutes a prize?

• any valuable item you receive from a contest, drawing, sweepstakes, or lottery that must be included in your gross income

• this applies to both cash and non-cash items, regardless of their value

What represents income for income tax purposes?

• wages & salary

• self-employment income

• investment income

• retirement income

• gambling winnings, prizes, awards

• unemployment compensation

• alimony received from a divorce or separation agreement executed before 1/1/2019

Imputed Income

• income from an economic benefit the taxpayer receives indirectly rather than directly

• for low interest loans, the amount of imputed income is the difference between the amount of interest using the applicable federal interest rate & the amount of interest the taxpayer actually pays

• The borrower is deemed to pay imputed interest
  (interest expense to borrower, interest income to lender),
  and then the lender is deemed to have returned the
  imputed amount (the tax consequences depend on
  relationship between borrower and lender).

• Imputed interest rules do not apply to aggregate loans of
  $10,000 or less between the lender and borrower

Forgiveness of Debt

• amount of debt relief is included in gross income by taxpayer

  • exceptions exist for certain types of loans

• a discharge of indebtedness is not taxable for insolvent taxpayers

  • taxpayers w/ liabilities exceeding their assets

• if the discharge of indebtedness makes the taxpayer solvent, the taxpayer recognizes taxable income to the extent of his solvency

  • taxpayers w/ assets > liabilities

• regardless of solvency, taxpayers are also allowed to exclude from gross income most discharges of student loans after 2020 & before 2026

Scholarships

• ones that pay for required tuition, fees, books, & supplies are excludable

• applies only if the recipient is not required to perform services in exchange for receiving the scholarship (limited exception for tuition waivers for student employees & teaching & research assistants)

• does not apply to dorming

529 Plans

• taxpayers allowed to exclude from gross income earnings on investments in qualified education plans as long as they use the earnings for qualifying educational expenditures

Series EE Savings Bond Interest

• can elect to exclude interest earned when the redemption proceeds are used to pay qualified higher-education expenses

• the exclusion of interest is restricted to taxpayers w/ modified AGI below specific limits

When is Social Security Taxable?

• Single taxpayers: if modified AGI + 50% of Social Security Benefits > $25,000

• Taxpayers filing married separate: taxable if living together

• Taxpayers filing married joint: if modified AGI + 50% of Social Security Benefits > $32,000

Annuities

• an investment that pays a stream of equal payments over a time period

• a portion of each annuity payment declared as a nontaxable return of capital & the remainder as gross income

• taxpayers use the annuity exclusion ratio to determine the return of capital (nontaxable) portion of each payment

• Annuity exclusion ratio = original investment / expected value of annuity

Taxation of Annuities

• Return on capital principal

  • exclusion ratio = original investment / expected value of annuity

  • return on capital = payment times exclusion ratio

  • taxable amount = payment times (1 - exclusion ratio)

Taxation of Property Distributions

Selling Price

Less: Selling Expense

Adjusted Selling Price

Less: Adjusted Basis

Realized Gain / Loss

Gifts & Inheritances

• individuals may receive property as gifts or from a decedent’s estate (inheritance)

• while the receipt of property is most certainly real income to the recipient, the value of gifts & inheritances is excluded from gross income because these transfers are subject to a federal gift & estate tax

Life Insurance Proceeds

• amounts received due to the death of the insured are excluded from the income of the recipient

• similar to inheritances, they are typically subject to the federal estate tax

• if the proceeds are paid over a period of time rather than in a lump sum, a portion of the payments represents interest & must be included in gross income

Taxable Fringe Benefits

• employees recognize compensation income on all benefits received unless specifically excluded by tax laws

• treats benefits received like taxable cash compensation

• employer deducts cost & pays employee’s share of FICA taxes on benefit

• employees must recognize a certain amount of gross income when employers pay life insurance premiums for the employee for policies w/ a death benefit in excess of $50,000

Employee Considerations for Taxable Fringe Benefits

employees may prefer it to an equivalent amount of cash when they benefit from employer-provided quantity or group discounts associated w/ the benefit

Computation for Annual Taxable Benefit

1) Subtract $50,000 from the death benefit of their employer-provided group-term life insurance policy

2) Divide the result in 1) by $1,000

3) Multiply the result in 2) by the cost per $1,000 of protection for one month from the table provided in the Treasury Regulations based on the taxpayer’s age

4) Multiply the result in 3) by 12 to annualize it

Nontaxable Fringe Benefits

Capital Assets

• bought and held for appreciation potential

• in general, an asset other than an asset used in a trade or business or an asset such as an account or note receivable acquired in a business from the sale of services or property

• typically investment-type and personal-use assets

• examples include:

  • artwork

  • corporate stock

  • bonds

  • personal residence

  • phone

Not Considered Capital Assets

• asset used in trade or business

• accounts or notes receivable acquired in business from sale of services or property

• inventory

Amount Realized

the value of everything received by the seller in a transaction minus selling costs

Tax basis

• the amount of a taxpayer’s unrecovered cost of or investment in an asset

• generally the cost of acquiring the asset, including initial purchase price & other costs incurred to purchase or improve the asset

Tax Rates for Net Long Term Capital Gains

Tax Rate for Net Short Term Capital Gains

ordinary rates

Certain gains from the sale of depreciable real estate held long term are taxed at a maximum rate of _?

25%

Capital Assets taxed at 28%

• collectibles: consists of art, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages, or other similar items held for more than one yr

• qualified business stock: stock received at original issue from a C corp w/ a gross tax basis in its assets both before & after the issuance of no more than $50,000,000 & w/ at least 80% of the value of its assets used in the active conduct of certain qualified trades or businesses

Exclusions of Tax for Qualified Business Stock Sold after being held for longer than 5 yrs

Netting Process for Capital Gains / Losses

1) combine ST gains/losses and separately combine LT gains/losses (including losses carried over from prior yrs)

2) if both ST & LT are both + or -, the net process is complete. ST taxed at ordinary & LT taxed at 0/15/20 percent

3) if ST & LT are not both + or -, then combine the results of ST & LT to get final net gain or net loss, depending on which outcome is greater determines whether it is ST or LT

Limits for Capital Loss Deductions

• individuals can deduct up to $3,000 of net capital loss against ordinary income

• remainder carries over indefinitely to subsequent yrs

Long-term requirments

held more than a yr

Short-term requirements

held for a yr or less

Appropriate Forms for Reporting Sales of Dispositions of Capital Assets

• 8949

• 1099-B

• Schedule D

Losses on the Sale of Personal-Use Assets

• gains are taxable as capital gains

• losses are not deductible

Capital Losses on Sales to Related Parties

• capital losses from sales to “related parties” are not deducted currently

  • the related party may eventually be able to deduct all, a portion, or none of the disallowed loss on a subsequent sale of the property

Wash Sale Rules

• disallows the loss on stocks sold if the taxpayer purchases the same or “substantially identical” stock within a 61-day period centered on the date of sale

  • 30 days before the sale

  • the day of sale

  • 30 days after sale

• intended to ensure that taxpayers cannot deduct losses from stock sales while essentially continuing their investment