Module 35: Individual Taxation

Overview

This module covers the area of individual taxation in the same order in which topics appear in the individual tax formula. The module begins with exclusions and progresses to items to be included in gross income, tax accounting periods and methods, business income and deductions including depreciation, and deductions subtracted from gross income to arrive at adjusted gross income. Next reviewed is the standard deduction as well as the various categories of itemized deductions, together with personal and dependency exemptions, all of which are subtracted from adjusted gross income to arrive at taxable income. This is followed by a review of filing status, alternative minimum tax, and the various tax credits for which an individual might be eligible. The module concludes with an overview of farming income and expenses, tax procedures including assessments and claims for refund, choice of courts, and taxpayer penalties.

I. Gross Income on Individual Returns

A. In General

B. Exclusions from Gross Income

C. Items to Be Included in Gross Income

D. Accounting Periods

E. Tax Accounting Methods

F. Business Income and Deductions

G. Depreciation, Depletion, and Amortization

H. Domestic Production Activities Deduction

(DPAD)

II. “Above the Line” Deductions

A. Reimbursed Employee Business Expenses

B. Expenses Attributable to Property

C. Self-Employment Tax

D. Self-Employed Medical Insurance

Deduction

E. Moving Expenses

F. Contributions to Certain Retirement Plans

G. Deduction for Interest on Education Loans

H. Deduction for Qualified Tuition and Related

Expenses

I. Penalties for Premature Withdrawals from

Time Deposits

J. Alimony

K. Jury Duty Pay Remitted to Employer

L. Costs Involving Discrimination Suits

M. Expenses of Elementary and Secondary

Teachers

III. Itemized Deductions from Adjusted Gross

Income

A. Medical and Dental Expenses

B. Taxes

C. Interest Expense

D. Charitable Contributions

E. Personal Casualty and Theft Gains and

Losses

F. Miscellaneous Deductions

G. Reduction of Total Itemized Deductions

IV. Exemptions

V. Tax Computation

A. Tax Tables

B. Tax Rate Schedules

C. Filing Status

D. Alternative Minimum Tax (AMT)

E. Other Taxes

VI. Tax Credits/Estimated Tax Payments

A. General Business Credit

B. Business Energy Credit

C. Credit for Rehabilitation Expenditures

D. Work Opportunity Credit

E. Alcohol Fuels Credit

F. Research Credit

G. Low-Income Housing Credit

H. Disabled Access Credit

I. Empowerment Zone Employment Credit

J. Employer Social Security Credit

K. Employer-Provided Child Care Credit

L. Credit for the Elderly and the Disabled

M. Child and Dependent Care Credit

N. Foreign Tax Credit

O. Earned Income Credit

P. Credit for Adoption Expenses

Q. Child Tax Credit

R. American Opportunity Credit (AOC)

S. Lifetime Learning Credit

T. Credit for Qualified Retirement Savings

U. Estimated Tax Payments

VII. Filing Requirements

VIII. Farming Income and Expenses

IX. Tax Procedures

A. Audit and Appeal Procedures

B. Choice of Courts

C. Assessments

D. Collection from Transferees and Fiduciaries

E. Closing Agreement and Compromise

F. Claims for Refund

G. Interest

H. Taxpayer Penalties

Key Terms

Multiple-Choice Questions

Multiple-Choice Answers and Explanations

Simulations

Simulation Solutions

This section outlines (1) gross income in general, (2) exclusions from gross income, (3) items to be included in gross income, (4) tax accounting methods, and (5) items to be included in gross income net of deductions (e.g., business income, sales, and exchanges).

I. GROSS INCOME ON INDIVIDUAL RETURNS

A. In General

B. Exclusions from Gross Income (not reported)

1. Payments received for support of minor children

a. Must be children of the parent making the payments

b. Decree of divorce or separate maintenance generally must specify the amount to be treated as child support, otherwise payments may be treated as alimony

2. Property settlement (division of capital) received in a divorce

3. Annuities and pensions are excluded to the extent they represent a return of capital

a. Excluded portion of each payment is

b. “Expected total annuity payments” is calculated by multiplying the annual return by

(1) The number of years receivable if it is an annuity for a definite period

(2) A life expectancy multiple (from IRS tables) if it is an annuity for life

c. Once this exclusion ratio is determined, it remains constant until the cost of the annuity is completely recovered. Any additional payments will be fully taxable.

---

EXAMPLE

Mr. Jones purchased an annuity contract for $3,600 that will pay him $1,500 per year beginning in 2013. His expected return under the contract is $10,800. Mr. Jones’ exclusion ratio is $3,600 ÷ $10,800 = 1/3. For 2013, Mr. Jones will exclude $1,500 × 1/3 = $500; and will include the remaining $1,000 in gross income.

---

d. If the taxpayer dies before total cost is recovered, unrecovered cost is allowed as a miscellaneous itemized deduction on the taxpayer’s final tax return.

4. Life insurance proceeds (face amount of policy) are generally excluded if paid by reason of death

a. If proceeds are received in installments, amounts received in excess of pro rata part of face amount are taxable as interest.

b. Dividends on unmatured insurance policies are excluded to the extent not in excess of cumulative premiums paid.

c. Accelerated death benefits received under a life insurance policy by a terminally or chronically ill individual are generally excluded from gross income

(1) Similarly, if a portion of a life insurance contract on the life of a terminally or chronically ill individual is assigned or sold to a viatical settlement provider, proceeds received from the provider are excluded.

(2) For a chronically ill individual, the exclusion is limited to the amount paid by the individual for unreimbursed long-term care costs. Payments made on a per diem basis, up to $300 per day for 2011, are excludable regardless of actual long-term care costs incurred.

d. All interest is taxable if proceeds are left with insurance company under agreement to pay only interest.

e. If insurance proceeds are paid for reasons other than death or under c. above, or if the policy was obtained by the beneficiary in exchange for valuable consideration from a person other than the insurance company, all proceeds in excess of cost are taxable. Annuity rules apply to installment payments.

---

EXAMPLE

Able was the owner and beneficiary of a $30,000 life insurance policy on Baker. Able sold the policy for $10,000 to Carr who subsequently paid $6,000 of premiums. If Baker dies, Carr’s gross income from the proceeds of the life insurance policy would total $30,000 − ($10,000 + $6,000) = $14,000.

---

f. Company-owned life insurance. In the case of an employer-owned life insurance contract, the amount of insurance proceeds that can be excluded from gross income by the employer (or related person) is generally limited to the sum of the premiums and other amounts paid by the policyholder for the contract. However, the full amount of proceeds paid at death can be excluded if specified notice and consent requirements as well as additional requirements are met.

(1) The notice and consent requirements specify that the employee must (a) be notified in writing of the intent to insure the employee’s life and the maximum amount for which the employee could be insured, (b) provide written consent to being insured and acknowledge that coverage may continue after the employee terminates employment, and (c) be informed in writing that the employer (or related person) will be the beneficiary of proceeds payable upon the death of the employee.

(2) Additionally, the insured must have been an employee at any time during the 12-month period before the insured’s death, or at the time the contract was issued was a director or highly compensated employee. Alternatively, the proceeds must be paid to a member of the insured’s family or designated beneficiary of the insured, or the proceeds are used to buy an equity (or capital or profits) interest in the employer from insured’s heir.

5. Certain employee benefits are excluded

a. Group-term life insurance premiums paid by employer (the cost of up to $50,000 of insurance coverage is excluded). Exclusion not limited if beneficiary is the employer or a qualified charity.

b. Insurance premiums employer pays to fund an accident or health plan for employees are excluded.

c. Accident and health benefits provided by employer are excluded if benefits are for

(1) Permanent injury or loss of bodily function

(2) Reimbursement for medical care of employee, spouse, or dependents

(a) Employee cannot take itemized deduction for reimbursed medical expenses

(b) Exclusion may not apply to highly compensated individuals if reimbursed under a discriminatory self-insured medical plan

d. Employees of small businesses (50 or fewer employees) and self-employed individuals may qualify for a medical savings account (MSA) if covered under a high-deductible health insurance plan. An MSA is similar to an IRA, except used for health care.

(1) Employer contributions to an employee’s MSA are excluded from gross income (except if made through a cafeteria plan), and employee contributions are deductible for AGI.

(2) Contributions are limited to 65% (75% for family coverage) of the annual health insurance deductible amount.

(3) Earnings of an MSA are not subject to tax; distributions from an MSA used to pay qualified medical expenses are excluded from gross income.

e. Meals or lodging furnished for the convenience of the employer on the employer’s premises are excluded.

(1) For the convenience of the employer means there must be a non compensatory reason such as the employee is required to be on duty during this period.

(2) In the case of lodging, it also must be a condition of employment.

f. Employer-provided educational assistance (e.g., payment of tuition, books, fees) derived from an employer’s qualified educational assistance program is excluded up to maximum of $5,250 per year. The exclusion applies to both undergraduate as well as graduate-level courses, but does not apply to assistance payments for courses involving sports, games, or hobbies, unless they involve the employer’s business or are required as part of a degree program. Excludable assistance does not include tools or supplies that the employee retains after completion of the course, nor the cost of meals, lodging, or transportation.

g. Employer payments to an employee for dependent care assistance are excluded from an employee’s income if made under a written, nondiscriminatory plan. Maximum exclusion is $5,000 per year ($2,500 for a married person filing a separate return).

h. Qualified adoption expenses paid or incurred by an employer in connection with an employee’s adoption of a child are excluded from the employee’s gross income. For 2013, the maximum exclusion is $12,970 per eligible child (including special needs children) and the exclusion is ratably phased out for modified AGI between $194,580 and $234,580.

i. Employee fringe benefits are generally excluded if

(1) No additional-cost services—for example, airline pass

(2) Employee discount that is nondiscriminatory

(3) Working condition fringes—excluded to the extent that if the amount had been paid by the employee, the amount would be deductible as an employee business expense

(4) De minimis fringes—small value, impracticable to account for (e.g., coffee, personal use of copying machine)

(5) Qualified transportation fringes

(a) Up to $245 per month for 2013 can be excluded for employer-provided transit passes and transportation in a commuter highway vehicle if the transportation is between the employee’s home and work place.

(b) Up to $245 per month for 2013 can be excluded for employer-provided parking on or near the employer’s place of business.

(6) Qualified moving expense reimbursement—an individual can exclude any amount received from an employer as payment for (or reimbursement of) expenses which would be deductible as moving expenses if directly paid or incurred by the individual. The exclusion does not apply to any payment (or reimbursement of) an expense actually deducted by the individual in a prior taxable year.

j. Workers’ compensation is fully excluded if received for an occupational sickness or injury and is paid under a workers’ compensation act or statute.

6. Accident and health insurance benefits derived from policies purchased by the taxpayer are excluded, but not if the medical expenses were deducted in a prior year and the tax benefit rule applies.

7. Damages for physical injury or physical sickness are excluded.

a. If an action has its origin in a physical injury or physical sickness, then all damages therefrom (other than punitive damages) are excluded (e.g., damages received by an individual on account of a claim for loss due to a physical injury to such individual’s spouse are excludible from gross income).

b. Damages (other than punitive damages) received on account of a claim of wrongful death, and damages that are compensation for amounts paid for medical care (including medical care for emotional distress) are excluded.

c. Emotional distress is not considered a physical injury or physical sickness. No exclusion applies to damages received from a claim of employment discrimination, age discrimination, or injury to reputation (even if accompanied by a claim of emotional distress).

d. Punitive damages generally must be included in gross income, even if related to a physical injury or physical sickness.

8. Gifts, bequests, devises, or inheritances are excluded.

a. Income subsequently derived from property so acquired is not excluded (e.g., interest or rent).

b. “Gifts” from employer except for noncash holiday presents are generally not excluded.

9. The receipt of stock dividends (or stock rights) is generally excluded from income, but the FMV of the stock received will be included in income if the distribution

a. Is on preferred stock

b. Is payable, at the election of any shareholder, in stock or property

c. Results in the receipt of preferred stock by some common shareholders, and the receipt of common stock by other common shareholders

d. Results in the receipt of property by some shareholders, and an increase in the proportionate interests of other shareholders in earnings or assets of the corporation

---

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 1 THROUGH 14

---

10. Certain interest income is excluded.

a. Interest on obligations of a state or one of its political subdivisions (e.g., municipal bonds), the District of Columbia, and US possessions is generally excluded from income if the bond proceeds are used to finance traditional governmental operations.

b. Other state and local government-issued obligations (private activity bonds) are generally fully taxable. An obligation is a private activity bond if (1) more than 10% of the bond proceeds are used (directly or indirectly) in a private trade or business and more than 10% of the principal or interest on the bonds is derived from, or secured by, money or property used in the trade or business, or (2) the lesser of 5% or $5 million of the bond proceeds is used (directly or indirectly) to make or finance loans to private persons or entities.

c. The following bonds are excluded from the private activity bond category even though their proceeds are not used in traditional government operations. The interest from these bonds is excluded from income.

(1) Qualified bonds issued for the benefit of schools, hospitals, and other charitable organizations

(2) Bonds used to finance certain exempt facilities, such as airports, docks, wharves, mass commuting facilities, etc.

(3) Qualified redevelopment bonds, small-issue bonds (i.e., bonds not exceeding $1 million), and student loan bonds

(4) Qualified mortgage and veterans’ mortgage bonds

d. Interest on US obligations is included in income.

11. Savings bonds for higher education

a. The accrued interest on Series EE US savings bonds that are redeemed by the taxpayer is excluded from gross income to the extent that the aggregate redemption proceeds (principal plus interest) are used to finance the higher education of the taxpayer, taxpayer’s spouse, or dependents.

(1) The bonds must be issued after December 31, 1989, to an individual age twenty-four or older at the bond’s issue date.

(2) The purchaser of the bonds must be the sole owner of the bonds (or joint owner with his or her spouse). Married taxpayers must file a joint return to qualify for the exclusion.

(3) The redemption proceeds must be used to pay qualified higher education expenses (i.e., tuition and required fees less scholarships, fellowships, and employer-provided educational assistance) at an accredited university, college, junior college, or other institution providing postsecondary education, or at an area vocational education school.

(4) If the redemption proceeds exceed the qualified higher education expenses, only a pro rata amount of interest can be excluded.

---

EXAMPLE

During 2013, a married taxpayer redeems Series EE bonds receiving $6,000 of principal and $4,000 of accrued interest. Assuming qualified higher education expenses total $9,000, accrued interest of $3,600 ($9,000/$10,000 × $4,000) can be excluded from gross income.

---

b. If the taxpayer’s modified AGI exceeds a specified level, the exclusion is subject to phase-out as follows:

Filing status	2013 AGI phase-out range
Married filing jointly	$112,050 − $142,050
Single (including head of household)	$74,700 − $89,700

(1) The reduction of the exclusion is computed as

(2) If the taxpayer’s modified AGI exceeds the applicable phase-out range, no exclusion is available.

---

EXAMPLE

Assume the joint return of the married taxpayer in the above example has modified AGI of $132,050 for 2013. The reduction would be ($20,000/$30,000) × $3,600 = $2,400. Thus, of the $4,000 of interest received, a total of $1,200 could be excluded from gross income.

---

---

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 15 THROUGH 22

---

12. Scholarships and fellowships

a. A degree candidate can exclude the amount of a scholarship or fellowship that is used for tuition and course-related fees, books, supplies, and equipment. Amounts used for other purposes including room and board are included in income.

b. Amounts received as a grant or a tuition reduction that represent payment for teaching, research, or other services are generally not excludable.

c. Non degree students may not exclude any part of a scholarship or fellowship grant.

d. The exclusion from gross income also applies to scholarships with obligatory service requirements received by degree candidates at qualified educational organizations from the National Health Service Corps Scholarship Program and the F. Edward Hebert Armed Forces Health Professions Scholarship Program.

13. Political contributions received by candidates’ campaign funds are excluded from income, but included if put to personal use.

14. Rental value of parsonage or cash rental allowance for a parsonage is excluded by a minister.

15. Discharge of indebtedness normally results in income to debtor, but may be excluded if

a. A discharge of certain student loans pursuant to a loan provision providing for discharge if the individual works in a certain profession for a specified period of time

b. A discharge of a corporation’s debt by a shareholder (treated as a contribution to capital)

c. The discharge is a gift

d. The discharge is a purchase money debt reduction (treat as a reduction of purchase price)

e. The discharge is a cancellation of up to $2 million ($1 million for married filing separately) of acquisition indebtedness on a principal residence before January 1, 2014. The amount excluded from income reduces the taxpayer’s basis for the principal residence (but not below zero).

f. Debt is discharged in a bankruptcy proceeding, or debtor is insolvent both before and after discharge

(1) If debtor is insolvent before but solvent after discharge of debt, income is recognized to the extent that the FMV of assets exceeds liabilities after discharge

(2) The amount excluded from income in e. above must be applied to reduce tax attributes in the following order

(a) Net Operating Loss (NOL) for taxable year and loss carryovers to taxable year

(b) General business credit

(c) Minimum tax credit

(d) Capital loss of taxable year and carryovers to taxable year

(e) Reduction of the basis of property

(f) Passive activity loss and credit carryovers

(g) Foreign tax credit carryovers to or from taxable year

(3) Instead of reducing tax attributes in the above order, taxpayer may elect to first reduce the basis of depreciable property

16. Lease improvements. Increase in value of property due to improvements made by lessee is excluded from lessor’s income unless improvements are made in lieu of fair value rent.

17. Foreign earned income exclusion. An individual meeting either a bona fide residence test or a physical presence test may elect to exclude up to $97,600 of income earned in a foreign country for 2013. Qualifying taxpayers also may elect to exclude additional amounts based on foreign housing costs.

a. To qualify, an individual must be a (1) US citizen who is a foreign resident for an uninterrupted period that includes an entire taxable year (bona fide residence test), or (2) US citizen or resident present in a foreign country for at least 330 full days in any twelve-month period (physical presence test).

b. An individual who elects to exclude the housing cost amount can exclude only the lesser of (1) the housing cost amount attributable to employer-provided amounts, or (2) the individual’s foreign earned income for the year.

c. Housing cost amounts not provided by an employer can be deducted for AGI, but deduction is limited to the excess of the taxpayer’s foreign earned income over the applicable foreign earned income exclusion.

---

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 23 THROUGH 25

---

C. Items to Be Included in Gross Income

Gross income includes all income from any source except those specifically excluded. The more common items of gross income are listed below. Those items requiring a detailed explanation are discussed on the following pages.

1. Compensation for services, including wages, salaries, bonuses, commissions, fees, and tips

a. Property received as compensation is included in income at FMV on date of receipt.

b. Bargain purchases by an employee from an employer are included in income at FMV less price paid.

c. Life insurance premiums paid by employer must be included in an employee’s gross income except for group-term life insurance coverage of $50,000 or less.

d. Employee expenses paid or reimbursed by the employer unless the employee has to account to the employer for these expenses and they would qualify as deductible business expenses for employee.

e. Tips must be included in gross income

(1) If an individual receives less than $20 in tips while working for one employer during one month, the tips do not have to be reported to the employer, but the tips must be included in the individual’s gross income when received.

(2) If an individual receives $20 or more in tips while working for one employer during one month, the individual must report the total amount of tips to the employer by the tenth day of the following month for purposes of withholding of income tax and social security tax. Then the total amount of tips must be included in the individual’s gross income for the month in which reported to the employer.

2. Gross income derived from business or profession

3. Distributive share of partnership or S corporation income

4. Gain from the sale or exchange of real estate, securities, or other property

5. Rents and royalties

6. Dividends

7. Interest including

a. Earnings from savings and loan associations, mutual savings banks, credit unions, etc.

b. Interest on bank deposits, corporate or US government bonds, and Treasury bills

(1) Interest from US obligations is included, while interest on state and local obligations is generally excluded.

(2) If a taxpayer elects to amortize the bond premium on taxable bonds acquired after 1987, any bond premium amortization is treated as an offset against the interest earned on the bond. The amortization of bond premium reduces taxable income (by offsetting interest income) as well as the bond’s basis.

c. Interest on tax refunds

d. Imputed interest from interest-free and low-interest loans

(1) Borrower is treated as making imputed interest payments (subject to the same deduction restrictions as actual interest payments) which the lender reports as interest income.

(2) Lender is treated as making gifts (for personal loans) or paying salary or dividends (for business-related loans or corporation-shareholder loans) to the borrower.

(3) Rate used to impute interest is tied to average yield on certain federal securities and is compounded semiannually; if the federal rate is greater than the interest rate charged on a loan (e.g., a low-interest loan), impute interest only for the excess.

(a) For demand loans, the deemed transfers are generally treated as occurring at the end of each year, and will fluctuate with interest rates.

(b) For term loans, the interest payments are determined at the date of the loan and then allocated over the term of the loan; lender’s payments are treated as made on date of loan.

(4) No interest is imputed to either the borrower or the lender for any day on which the aggregate amount of loans between such individuals (and their spouses) does not exceed $10,000.

(5) For any day that the aggregate amount of loans between borrower and lender (and their spouses) does not exceed $100,000, imputed interest is limited to borrower’s “net investment income;” no interest is imputed if borrower’s net investment income does not exceed $1,000.

---

EXAMPLE

Parents make a $200,000 interest-free demand loan to their unmarried daughter on January 1, 2013. Assume the average federal short-term rate is 3% for 2013. If the loan is outstanding for the entire year, under Step 1, the daughter is treated as making a ($200,000 × 3% ×1/2) + ($203,000 × 3% × 1/2) = $6,045 interest payment on 12/31/13, which is included as interest income on the parents’ 2013 tax return. Under Step 2, the parents are treated as making a $6,045 gift to their daughter on 12/31/13. (Note that the gift will be offset by annual exclusions totaling $28,000 (for 2013) for gift tax purposes as discussed in Module 39.)

---

8. Alimony and separate maintenance payments

a. Alimony is included in the recipient’s gross income and is deductible toward AGI by the payor. In order for a payment to be considered as alimony, the payment must

(1) Be made pursuant to a decree of divorce or written separation instrument

(2) Be made in cash and received by or on behalf of the payee’s spouse

(3) Terminate upon death of the recipient

(4) Not be made to a member of the same household at the time the payments are made

(5) Not be made to a person with whom the taxpayer is filing a joint return

(6) Not be characterized in the decree or written instrument as other than alimony

b. Alimony recapture may occur if payments sharply decline in the second or third years. This is accomplished by making the payor report the recaptured alimony from the first and second years as income (and allowing the payee to deduct the same amount) in the third year.

(1) Recapture for the second year occurs to the extent that the alimony paid in the second year exceeds the third-year alimony by more than $15,000.

(2) Recapture for the first year occurs to the extent that the alimony paid in the first year exceeds the average alimony paid in the second year (reduced by the recapture for that year) and third year by more than $15,000.

(3) Recapture will not apply to any year in which payments terminate as a result of the death of either spouse or the remarriage of the payee.

(4) Recapture does not apply to payments that may fluctuate over three years or more and are not within the control of the payor spouse (e.g., 20% of the net income from a business).

---

EXAMPLE

If a payor makes alimony payments of $50,000 in 2011 and no payments in 2012 or 2013, $50,000 − $15,000 = $35,000 will be recaptured in 2013 (assuming none of the exceptions apply).

---

---

EXAMPLE

If a payor makes alimony payments of $50,000 in 2011, $20,000 in 2012, and nothing in 2013, the recapture amount for 2012 is $20,000 − $15,000 = $5,000. The recapture amount for 2011 is $50,000 − ($15,000 + $7,500) = $27,500. The $7,500 is the average payments for 2012 and 2011 after reducing the $20,000 year 2012 payment by the $5,000 of recapture for 2012. The recapture amounts for 2011 and 2012 total $32,500 and are reported in 2013.

---

c. Any amounts specified as child support are not treated as alimony.

(1) Child support is not gross income to the payee and is not deductible by the payor.

(2) If the decree or instrument specifies both alimony and child support, but less is paid than required, then amounts are first allocated to child support, with any remainder allocated to alimony.

(3) If a specified amount of alimony is to be reduced upon the happening of some contingency relating to a child, then an amount equal to the specified reduction will be treated as child support rather than alimony.

---

EXAMPLE

A divorce decree provides that payments of $1,000 per month will be reduced by $400 per month when a child reaches age twenty-one. Here, $400 of each $1,000 monthly payment will be treated as child support.

---

9. Social security, pensions, annuities (other than excluded recovery of capital)

a. Up to 50% of social security retirement benefits may be included in gross income if the taxpayer’s provisional income (AGI + tax-exempt income + 50% of the social security benefits) exceeds a threshold that is $32,000 for a joint return, $0 for married taxpayers filing separately, and $25,000 for all other taxpayers. The amount to be included in gross income is the lesser of

(1) 50% of the social security benefits, or

(2) 50% of the excess of the taxpayer’s provisional income over the base amount.

---

EXAMPLE

A single taxpayer with AGI of $20,000 received tax-exempt interest of $2,000 and social security benefits of $7,000. The social security to be included in gross income is the lesser of

1/2 ($7,000) = $3,500; or

1/2 ($25,500 − $25,000) = $250.

---

b. Up to 85% of social security retirement benefits may be included in gross income for taxpayers with provisional income above a higher second threshold that is $44,000 for a joint return, $0 for married taxpayers filing separately, and $34,000 for all other taxpayers. The amount to be included in gross income is the lesser of

(1) 85% of the taxpayer’s social security benefits, or

(2) The sum of (a) 85% of the excess of the taxpayer’s provisional income above the applicable higher threshold amount plus (b) the smaller of (i) the amount of benefits included under a. above, or (ii) $4,500 for single taxpayers or $6,000 for married taxpayers filing jointly.

c. Rule of thumb: Social security retirement benefits are fully excluded by low-income taxpayers (i.e., provisional income less than $25,000); 85% of benefits must be included in gross income by high-income taxpayers (i.e., provisional income greater than $60,000).

d. Lump-sum distributions from qualified pension, profit-sharing, stock bonus, and Keogh plans (but not IRAs) may be eligible for special tax treatment.

(1) The portion of the distribution allocable to pre-1974 years is eligible for long-term capital gain treatment.

(2) If the employee was born before 1936, the employee may elect ten-year averaging.

(3) Alternatively, the distribution may be rolled over tax-free (within sixty days) to a traditional IRA, but subsequent distributions from the IRA will be treated as ordinary income.

10. Income in respect of a decedent is income that would have been income of the decedent before death but was not includible in income under the decedent’s method of accounting (e.g., installment payments that are paid to a decedent’s estate after his/her death). Such income has the same character as it would have had if the decedent had lived and must be included in gross income by the person who receives it.

11. Employer supplemental unemployment benefits or strike benefits from union funds

12. Fees, including those received by an executor, administrator, director, or for jury duty, or precinct election board duty

13. Income from discharge of indebtedness unless specifically excluded

14. Stock options

a. An incentive stock option receives favorable tax treatment.

(1) The option must meet certain technical requirements to qualify.

(2) No income is recognized by employee when option is granted or exercised.

(3) If employee holds the stock acquired through exercise of the option at least two years from the date the option was granted, and holds the stock itself at least one year, the

(a) Employee’s realized gain will be long-term capital gain

(b) Employer receives no deduction

(4) If the holding period requirements above are not met, the employee has ordinary income to the extent that the FMV at date of exercise exceeds the option price.

(a) Remainder of gain is short-term or long-term capital gain.

(b) Employer receives a deduction equal to the amount employee reports as ordinary income.

(5) An incentive stock option may be treated as a nonqualified stock option if a corporation so elects at the time the option is issued.

b. A nonqualified stock option is included in income when received if option has a determinable FMV.

(1) If option has no ascertainable FV when received, then income arises when option is exercised; to the extent of the difference between the FV when exercised and the option price.

(2) Amount recognized (at receipt or when exercised) is treated as ordinary income to employee; employer is allowed a deduction equal to amount included in employee’s income.

c. An employee stock purchase plan that does not discriminate against rank and file employees

(1) No income when employee receives or exercises option

(2) If the employee holds the stock at least two years after the option is granted and at least one year after exercise, then

(a) Employee has ordinary income to the extent of the lesser of

[1] FMV at time option granted over option price, or

[2] FMV at disposition over option price

(b) Capital gain to the extent realized gain exceeds ordinary income

(3) If the stock is not held for the required time, then

(a) Employee has ordinary income at the time of sale for the difference between FV when exercised and the option price. This amount also increases basis.

(b) Capital gain or loss for the difference between selling price and increased basis

15. Prizes and awards are generally taxable.

a. Prizes and awards received for religious, charitable, scientific, educational, artistic, literary, or civic achievement can be excluded only if the recipient

(1) Was selected without any action on his/her part,

(2) Is not required to render substantial future services, and

(3) Designates that the prize or award is to be transferred by the payor to a governmental unit or a tax-exempt charitable, educational, or religious organization

(4) The prize or award is excluded from the recipient’s income, but no charitable deduction is allowed for the transferred amount.

b. Employee achievement awards are excluded from an employee’s income if the cost to the employer of the award does not exceed the amount allowable as a deduction (generally from $400 to $1,600).

(1) The award must be for length of service or safety achievement and must be in the form of tangible personal property (cash does not qualify).

(2) If the cost of the award exceeds the amount allowable as a deduction to the employer, the employee must include in gross income the greater of

(a) The portion of cost not allowable as a deduction to the employer, or

(b) The excess of the award’s FMV over the amount allowable as a deduction.

16. Tax benefit rule. A recovery of an item deducted in an earlier year must be included in gross income to the extent that a tax benefit was derived from the prior deduction of the recovered item.

a. A tax benefit was derived if the previous deduction reduced the taxpayer’s income tax.

b. A recovery is excluded from gross income to the extent that the previous deduction did not reduce the taxpayer’s income tax.

(1) A deduction would not reduce a taxpayer’s income tax if the taxpayer was subject to the alternative minimum tax in the earlier year and the deduction was not allowed in computing AMTI (e.g., state income taxes).

(2) A recovery of state income taxes, medical expenses, or other items deductible on Schedule A (Form 1040) will be excluded from gross income if an individual did not itemize deductions for the year the item was paid.

---

EXAMPLE

Individual X, a single taxpayer, did not itemize deductions but instead used the standard deduction of $5,950 for 2012. In 2013, a refund of $300 of 2012 state income taxes is received. X would exclude the $300 refund from income in 2013.

---

---

EXAMPLE

Individual Y, a single taxpayer, had total itemized deductions of $6,150 for 2012, including $800 of state income taxes. In 2013, a refund of $300 of 2012 state income taxes is received. Since Y’s total itemized deductions of $6,150 exceeded his available standard deduction of $5,950 by $200, Y must include $200 of the refund in gross income for 2013.

---

17. Embezzled or other illegal income

18. Gambling winnings

19. Unemployment compensation must generally be included in gross income.

---

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 26 THROUGH 43

---

D. Accounting Periods

E. Tax Accounting Methods

Tax accounting methods often affect the period in which an item of income or deduction is recognized. Note that the classification of an item is not changed, only the time for its inclusion in the tax computation.

1. Cash method or accrual method is commonly used.

a. Cash method recognizes income when first received or constructively received; expenses are deductible when paid.

(1) Constructive receipt means that an item is unqualifiedly available without restriction (e.g., interest on bank deposit is income when credited to account).

(2) Not all receipts are income (e.g., loan proceeds, return of investment); not all payments are deductible (e.g., loan repayment, expenditures benefiting future years generally must be capitalized and deducted over cost recovery period).

b. Under the cash method, expenses are generally deductible when paid. Payment by check is considered payment so long as the check is honored by the bank. A payment by credit card is considered a payment at the time of the charge.

(1) Generally, a capital expenditure or prepayment that results in a benefit that extends substantially beyond the end of the tax year does not result in an immediate deduction. However, a cash method taxpayer is not required to capitalize a payment so long as (1) the benefit does not extend beyond 12 months after the first date that the benefit is received, and (2) the benefit does not extend beyond the end of the taxable year following the taxable year in which payment is made.

---

EXAMPLE

On December 1, 2013, a calendar-year taxpayer pays a $10,000 property insurance premium with a 1-year term that begins on February 1, 2014. The amount paid must be capitalized and is not deductible for 2013 because the benefit attributable to the $10,000 payment extends beyond the end of the taxable year following the taxable year in which the payment is made. The premium will be deductible over the period to which it relates.

---

---

EXAMPLE

Assume the same facts as in the example above, except that the policy has a term beginning on December 15, 2013. The 12-month rule applies to the $10,000 payment because the benefit attributable to the payment extends neither more than 12 months beyond December 15, 2013, nor beyond the end of the taxable year following the taxable year in which the payment is made. Thus, the taxpayer is not required to capitalize the payment, and may deduct the $10,000 payment in 2013.

---

(2) The 12-month rule in (1) above does not apply to prepaid interest, which generally must be deducted over the loan period to which it is allocated.

c. The cash method cannot generally be used if inventories are necessary to clearly reflect income, and cannot generally be used by C corporations, partnerships that have a C corporation as a partner, tax shelters, and certain tax-exempt trusts. However, the following may use the cash method:

(1) A qualified personal service corporation (e.g., corporation performing services in health, law, engineering, accounting, actuarial science, performing arts, or consulting) if at least 95% of stock is owned by specified shareholders including employees.

(2) An entity (other than a tax shelter) if for every year it has average annual gross receipts of $5 million or less for any prior three-year period and provided it does not have inventories for sale to customers.

(3) A small business taxpayer with average annual gross receipts of $1 million or less for any prior three-year period can use the cash method and is excepted from the requirements to account for inventories and use the accrual method for purchases and sales of merchandise.

(4) A small business taxpayer is eligible to use the cash method of accounting if, in addition to having average gross receipts of more than $1 million and less than $10 million, the business meets any one of three requirements.

(a) The principal business activity is not retailing, wholesaling, manufacturing, mining, publishing, or sound recording;

(b) The principal business activity is the provision of services, or custom manufacturing; or

(c) Regardless of the principal business activity, a taxpayer may use the cash method with respect to any separate business that satisfies (a) or (b) above.

(5) A taxpayer using the accrual method who meets the requirements in (3) or (4) can change to the cash method but must treat merchandise inventory as a material or supply that is not incidental (i.e., only deductible in the year actually consumed or used in the taxpayer’s business).

d. Accrual method must be used by taxpayers (other than small business taxpayers) for purchases and sales when inventories are required to clearly reflect income.

(1) Income is recognized when “all events” have occurred that fix the taxpayer’s right to receive the item of income and the amount can be determined with reasonable accuracy.

(2) An expense is deductible when “all events” have occurred that establish the fact of the liability and the amount can be determined with reasonable accuracy. The all-events test is not satisfied until economic performance has taken place.

(a) For property or services to be provided to the taxpayer, economic performance occurs when the property or services are actually provided by the other party.

(b) For property or services to be provided by the taxpayer, economic performance occurs when the property or services are physically provided by the taxpayer.

(3) An exception to the economic performance rule treats certain recurring items of expense as incurred in advance of economic performance provided

(a) The all-events test, without regard to economic performance, is satisfied during the tax year;

(b) Economic performance occurs within a reasonable period (but in no event more than 8.5 months after the close of the tax year);

(c) The item is recurring in nature and the taxpayer consistently treats items of the same type as incurred in the tax year in which the all-events test is met; and

(d) Either the amount is not material or the accrual of the item in the year the all-events test is met results in a better matching against the income to which it relates.

2. Special rules regarding methods of accounting

a. Rents and royalties received in advance are included in gross income in the year received under both the cash and accrual methods.

(1) A security deposit is included in income when not returned to tenant.

(2) An amount called a “security deposit” that may be used as final payment of rent is considered to be advance rent and included in income when received.

---

EXAMPLE

In 2013, a landlord signed a five-year lease. During 2013, the landlord received $5,000 for that year’s rent, and $5,000 as advance rent for the last year (2017) of the lease. All $10,000 will be included in income for 2013.

---

b. Dividends are included in gross income in the year received under both the cash and accrual methods.

c. No advance deduction is generally allowed for accrual method taxpayers for estimated or contingent expenses; the obligation must be “fixed and determinable.”

3. The installment method applies to gains (not losses) from the disposition of property where at least one payment is to be received after the year of sale. The installment method does not change the character of the gain to be reported (e.g., ordinary, capital, etc.), and is required unless the taxpayer makes a negative election to report the full amount of gain in year of sale.

a. The installment method cannot be used for property held for sale in the ordinary course of business (except time-share units, residential lots, and property used or produced in farming), and cannot be used for sales of stock or securities traded on an established securities market.

b. The amount to be reported in each year is determined by the formula

(1) Contract price is the selling price reduced by the seller’s liabilities that are assumed by the buyer, to the extent not in excess of the seller’s basis in the property.

---

EXAMPLE

Taxpayer sells property with a basis of $80,000 to buyer for a selling price of $150,000. As part of the purchase price, buyer agrees to assume a $50,000 mortgage on the property and pay the remaining $100,000 in 10 equal annual installments together with adequate interest.

The contract price is $100,000 ($150,000 − $50,000); the gross profit is $70,000 ($150,000 − $80,000); and the gross profit ratio is 70% ($70,000 ÷ $100,000). Thus, $7,000 of each $10,000 payment is reported as gain from the sale.

---

---

EXAMPLE

Assume the same facts as above except that the seller’s basis is $30,000. The contract price is $120,000 ($150,000 − mortgage assumed but only to extent of seller’s basis of $30,000); the gross profit is $120,000 ($150,000 − $30,000); and the gross profit ratio is 100% ($120,000 ÷ $120,000). Thus, 100% of each $10,000 payment is reported as gain from the sale. In addition, the amount by which the assumed mortgage exceeds the seller’s basis ($20,000) is deemed to be a payment in year of sale. Since the gross profit ratio is 100%, all $20,000 is reported as gain in the year the mortgage is assumed.

---

(2) Any depreciation recapture under Sections 1245, 1250, and 291 must be included in income in the year of sale. Amount of recapture included in income is treated as an increase in the basis of the property for purposes of determining the gross profit ratio. Remainder of gain is spread over installment payments.

---

EXAMPLE

Baxter sells equipment with an adjusted basis of $50,000 to a buyer for $50,000 cash plus a $50,000 interest-bearing note to be paid next year. The equipment had originally cost $90,000, and Baxter had deducted depreciation of $40,000 on the equipment. Baxter realizes a gain of $100,000 − $50,000 = $50,000 on the installment sale, and must immediately recognize gain to the extent of Sec. 1245 depreciation recapture of $40,000, which is not eligible for installment reporting. The gross profit ratio is determined after adding the $40,000 of recapture to the $50,000 of adjusted basis, resulting in a gross profit ratio of 10% [$100,000 − $90,000)/$100,000]. As a result, the $40,000 of depreciation recapture plus 10% × $50,000 cash payment = $5,000 must be recognized this year, while the remaining 10% × $50,000 = $5,000 of gain will be recognized next year when payment on the note is received.

---

(3) The receipt of readily tradable debt or debt that is payable on demand is considered the receipt of a payment for purposes of the installment method. Additionally, if installment obligations are pledged as security for a loan, the net proceeds of the loan are treated as payments received on the installment obligations.

(4) Installment obligations arising from non dealer sales of property used in the taxpayer’s trade or business or held for the production of rental income (e.g., factory building, warehouse, office building, apartment building) are subject to an interest charge on the tax that is deferred on such sales to the extent that the amount of deferred payments arising from all dispositions of such property during a taxable year and outstanding as of the close of the taxable year exceeds $5,000,000. This provision does not apply to installment sales of property if the sales price does not exceed $150,000, to sales of personal use property, and to sales of farm property.

4. Percentage-of-completion method can be used for contracts that are not completed within the year they are started.

a. Percentage-of-completion method recognizes income each year based on the percentage of the contract completed that year.

b. Taxpayer may elect not to recognize income or account for costs from a contract for a tax year if less than 10% of the estimated total contract costs have been incurred as of the end of the year.

---

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 44 THROUGH 59

---

F. Business Income and Deductions

G. Depreciation, Depletion, and Amortization

H. Domestic Production Activities Deduction (DPAD)

1. The deduction is available to all taxpayers including C corporations, farming cooperatives, estates, trusts, and their beneficiaries, and partners and shareholders of S corporations (not to partnerships or S corporations themselves).

2. The DPAD equals 9% of the lesser of the taxpayer’s (1) qualified production activities income (QPAI), or (2) taxable income (or in the case of an individual, trust, or estate, adjusted gross income) computed before this deduction. The amount of the allowable deduction for any taxable year is limited to 50% of the W-2 wages paid by the taxpayer for the taxable year allocable to the taxpayer’s domestic production gross receipts (DPGR). W-2 wages include wages, tips and other compensation as well as elective deferrals to 401(k) and certain other plans.

---

EXAMPLE

Assume unrelated manufacturing corporations A, B, and C incurred the following amounts for the current taxable year. Their Sec. 199 DPAD would be computed as follows:

Corporation A’s deduction equals 9% of its taxable income of $100,000 or $9,000. Corporation B’s deduction equals 9% of its QPAI of $200,000, or $18,000. Corporation C’s tentative deduction of 9% of its QPAI of $200,000, or $18,000, is limited to 50% of the $30,000 of W-2 wages that it paid, or $15,000.

---

a. QPAI is equal to the excess of DPGR over the sum of the cost of goods sold allocable to such receipts, and other expenses and deductions allocable to such receipts.

b. If a manufacturer produces some of its finished products at an overseas facility and some of its products at a US plant, only income from the products produced in the US will qualify for the deduction. As a result, the taxpayer must segregate qualifying gross receipts from non qualifying gross receipts, and must apportion the cost of goods sold and other expenses and deductions accordingly. A taxpayer can treat all gross receipts as DPGR if less than 5% of the taxpayer’s gross receipts are non-DPRG.

3. Qualified production activities eligible for the deduction include (1) the manufacture, production, growth or extraction of tangible personal property such as goods, clothing, or food, as well as computer software and music recordings within the US; (2) film production if at least 50% of the total compensation relating to the production is for services performed within the US; and (3) construction or substantial renovation of residential and nonresidential buildings, and infrastructure such as roads, power lines, water systems, and communication facilities, as well as engineering and architectural services performed in the US relating to such property. Qualified production activities do not include the sale of food and beverages prepared by the taxpayer at a retail establishment, and the transmission or distribution of electricity, natural gas, or potable water.

II. “ABOVE THE LINE” DEDUCTIONS

“Above the line” deductions are taken from gross income to determine adjusted gross income. Adjusted gross income is important, because it may affect the amount of allowable charitable contributions, medical expenses, casualty losses, and miscellaneous itemized deductions. The deductions that reduce gross income to arrive at adjusted gross income are

A. The treatment of reimbursed employee business expenses depends on whether the employee makes an adequate accounting to the employer and returns amounts in excess of substantiated expenses.

1. Per diem reimbursements at a rate not in excess of the federal per diem rate and 56.5¢ per mile are deemed to satisfy the substantiation requirement if employee provides time, place, and business purpose of expenses.

2. If the employee makes an adequate accounting to employer and reimbursements equal expenses, or if the employee substantiates expenses and returns any excess reimbursement, the reimbursements are excluded from gross income and the expenses are not deductible.

3. If the employee does not make an adequate accounting to the employer or does not return excess reimbursements, the total amount of reimbursement is included in the employee’s gross income and the related employee expenses are deductible as miscellaneous itemized deductions subject to the 50% limitation for business meals and entertainment and the 2% of AGI floor (same as for unreimbursed employee business expenses).

B. Expenses attributable to property held for the production of rents or royalties are deductible “above the line.”

1. Rental of vacation home

a. If there is any personal use, the amount deductible is

(1)

(2) Personal use is by taxpayer or any other person to whom a fair rent is not charged.

b. If used as a residence, amount deductible is further limited to rental income less deductions otherwise allowable for interest, taxes, and casualty losses.

(1) Used as a residence if personal use exceeds greater of fourteen days or 10% of number of days rented

(2) These limitations do not apply if rented or held for rental for a continuous twelve-month period with no personal use.

---

EXAMPLE

Use house as a principal residence and then begin to rent in June. As long as rental continues for twelve consecutive months, limitations do not apply in year converted to rental.

---

c. If used as a residence (above) and rented for less than fifteen days per year, then income therefrom is not reported and rental expense deductions are not allowed.

---

EXAMPLE

Taxpayer rents his condominium for 120 days for $2,000 and uses it himself for 60 days. The rest of the year it is vacant. His expenses are

Mortgage interest	$1,800
Real estate taxes	600
Utilities	300
Maintenance	300
Depreciation	2,000
	$5,000

Taxpayer may deduct the following expenses:

	Rental expense	Itemized deduction
Mortgage interest	$1,200	$600
Real estate taxes	400	200
Utilities	200	__
Maintenance	200	__
Depreciation	__	__
	$2,000	$800

Taxpayer may not deduct any depreciation because his rental expense deductions are limited to rental income when he has made personal use of the condominium in excess of the fourteen-day or 10% rule.

---

C. For 2013 a self-employed individual can deduct 50% of self-employment taxes in arriving at AGI. For 2011 and 2012, a self-employed individual could deduct (6.2%/10.4%) = 59.6% of applicable OASDI taxes and 50% of applicable Medicare (HI) taxes [e.g., if the amount of self-employment tax that an individual paid for 2012 consisted of OASDI taxes of $5,200 and HI taxes of $1,450, the self-employed individual could deduct ($5,200 × 59.6%) + ($1,450 × 50%) = $3,824 in arriving at AGI].

D. A self-employed individual can deduct 100% of the premiums for medical insurance for the individual, spouse, dependents, and any child of the taxpayer under age 27 as of the close of the tax year in arriving at AGI.

1. This deduction cannot exceed the individual’s net earnings from the trade or business with respect to which the plan providing for health insurance was established. For purposes of this limitation, an S corporation more-than-two-percent shareholder’s earned income is determined exclusively by reference to the shareholder’s wages received from the S corporation.

2. No deduction is allowed if the self-employed individual or spouse is eligible to participate in an employer’s subsidized health plan. The determination of whether self-employed individuals or their spouses are eligible for employer-paid health benefits is to be made on a calendar month basis.

3. Any medical insurance premiums not deductible under the above rules are deductible as an itemized medical expense deduction from AGI.

4. The deduction for medical insurance premiums can also be subtracted in computing an individual’s self-employment tax.

E. Moving Expenses

F. Contributions to Certain Retirement Plans

G. Deduction for Interest on Education Loans

H. Deduction for Qualified Tuition and Related Expenses

I. Penalties for Premature Withdrawals from Time Deposits

J. Alimony or Separate Maintenance Payments Are Deducted “Above the Line.”

K. Jury Duty Pay Remitted to Employer

L. Costs Involving Discrimination Suits

M. Expenses of Elementary and Secondary Teachers

III. ITEMIZED DEDUCTIONS FROM ADJUSTED GROSS INCOME

Itemized deductions reduce adjusted gross income, and are sometimes referred to as “below the line” deductions because they are deducted from adjusted gross income. Itemized deductions (or a standard deduction) along with personal exemptions are subtracted from adjusted gross income to arrive at taxable income.

A taxpayer will itemize deductions only if the taxpayer’s total itemized deductions exceed the applicable standard deduction that is available to the taxpayer. The amount of the standard deduction is based on the filing status of the taxpayer, whether the taxpayer is a dependent, and is indexed for inflation. Additional standard deductions are allowed for age and blindness.

A dependent’s basic standard deduction is limited to the lesser of (1) the basic standard deduction for single taxpayers of $6,100 or (2) the greater of (a) $1,000, or (b) the dependent’s earned income plus $350. For example, a dependent who receives wages (earned income) of $1,200 would have a basic standard deduction of $1,200 + $350 = $1,550.

An unmarried individual who is not a surviving spouse, and is either age sixty-five or older or blind, receives an additional standard deduction of $1,500 for 2013. The standard deduction is increased by $3,000 if the individual is both elderly and blind. The increase is $1,200 for 2013 for each married individual who is age sixty-five or older or blind. The increase for a married individual who is both elderly and blind is $2,400. An elderly or blind individual who may be claimed as a dependent on another taxpayer’s return may claim the basic standard deduction plus the additional standard deduction(s). For example, an unmarried dependent, age sixty-five, with only unearned income would have a standard deduction of $1,000 + $1,500 = $2,500.

The major itemized deductions are outlined below. It should be remembered that some may be deducted in arriving at AGI if they are incurred by a self-employed taxpayer in a trade or business, or for the production of rents or royalties.

A. Medical and Dental Expenses

B. Taxes

C. Interest Expense

D. Charitable Contributions

Contributions to qualified domestic charitable organizations are deductible in the year actually paid or donated (for both accrual- and cash-basis taxpayers) with some carryover allowed. A “pledge” is not a payment. Charging the contribution on your credit card does constitute payment.

1. Qualified organizations include

a. A state, a US possession or political subdivision, or the District of Columbia if made exclusively for public purposes

b. A community chest, corporation, foundation, etc., operated exclusively for charitable, religious, educational, scientific, or literary purposes, or for the prevention of cruelty to children or animals, or for fostering national or international amateur sports competition (unless they provide facilities or equipment)

(1) No part of the earnings may inure to any individual’s benefit

(2) May not attempt to influence legislation or intervene in any political campaign

c. Church, synagogue, or other religious organizations

d. War veterans’ organizations

e. Domestic fraternal societies operating under the lodge system (only if contribution used exclusively for the charitable purposes listed in b. above)

f. Nonprofit cemetery companies if the funds are irrevocably dedicated to the perpetual care of the cemetery as a whole, and not a particular lot or mausoleum crypt

2. Dues, fees, or assessments paid to qualified organizations are deductible to the extent that payments exceed benefits received. Dues, fees, or assessments are not deductible if paid to veterans’ organizations, lodges, fraternal organizations, and country clubs

3. Out-of-pocket expenses to maintain a student (domestic or foreign) in a taxpayer’s home are deductible (limited to $50/month for each month the individual is a full-time student) if

a. Student is in 12th or lower grade and not a dependent or relative

b. Based on written agreement between taxpayer and qualified organization

c. Taxpayer receives no reimbursement

4. Payments to qualified organizations for goods or services are deductible to the extent the amount paid exceeds the fair market value of benefits received.

5. A taxpayer who makes a payment to or for the benefit of a college or university and is thereby entitled to purchase tickets to athletic events is allowed to deduct 80% of the payment as a charitable contribution. Any payment that is attributable to the actual cost of tickets is not deductible as a charitable contribution.

6. Unreimbursed out-of-pocket expenses incurred while rendering services to a charitable organization without compensation are deductible, including actual auto expenses or a standard rate of 14¢ per mile.

7. No deduction will be allowed for contributions of cash, checks, or other monetary gifts unless the donor maintains a canceled check, a receipt, or letter or other written communication from the donee, indicating the donee’s name, contribution date, and the amount.

8. No charitable deduction is allowed for any contribution of $250 or more unless the donor obtains written acknowledgment of the contribution from the donee organization including a good-faith estimate of the value of any goods or services provided to the donor in exchange for the contribution. The acknowledgement must be received by the earlier of the date the taxpayer’s return is filed, or the due date (including extensions) for filing the taxpayer’s return. A canceled check is not sufficient substantiation for a contribution of $250 or more.

9. For any noncash property donation exceeding $500 in value, the taxpayer must maintain a written record containing (1) the approximate date and manner of acquisition of the property, and (2) the cost or other basis of the property if it was held less than twelve months. Additionally, a description of the donated property must be included with the return for the tax year in which the contribution was made. If the donated item exceeds $5,000 in value, the taxpayer is required to obtain a qualified appraisal and attach a summary of the appraisal to the return. If the donated item exceeds $500,000 in value, a qualified appraisal must be attached to the return. Similar noncash items, whether donated to a single donee or multiple donees, must be aggregated for purposes of determining whether the above dollar thresholds are exceeded.

10. Nondeductible contributions include contributions to/for/of

a. Civic leagues, social clubs, and foreign organizations

b. Communist organizations, chambers of commerce, labor unions

c. The value of the taxpayer’s time or services

d. The use of property, or less than an entire interest in property

e. Blood donated

f. Tuition or amounts in place of tuition

g. Payments to a hospital for care of particular patients

h. “Sustainer’s gift” to retirement home

i. Raffles, bingo, etc. (but may qualify as gambling loss)

j. Fraternal societies if the contributions are used to defray sickness or burial expenses of members

k. Political organizations

l. Travel, including meals and lodging (e.g., trip to serve at charity’s national meeting), if there is any significant element of personal pleasure, recreation, or vacation involved

11. Contributions of property to qualified organizations are deductible

a. At fair market value when FMV is below basis

b. At basis when fair market value exceeds basis and property would result in short-term capital gain or ordinary income if sold (e.g., gain would be ordinary because of depreciation recapture or if property is inventory)

c. If contributed property is capital gain property that would result in LTCG if sold (i.e., generally investment property and personal-use property held more than one year), the amount of contribution is the property’s FMV. However, if the contributed property is tangible personal capital gain property and its use is unrelated to the charity’s activity, the amount of contribution is restricted to the property’s basis.

d. Appraisal fees on donated property are a miscellaneous itemized deduction.

12. For contributions of vehicles (automobiles, boats, and airplanes) with a claimed value exceeding $500, the charitable deduction is limited to the gross proceeds received by the charitable organization upon subsequent sale of the vehicle. Additionally, the donee organization must provide the donor with a written acknowledgement within 30 days of (1) the contribution of the qualified vehicle, or (2) the date of sale of the qualified vehicle. If the vehicle is not sold, the donee must provide certification of the intended use of the vehicle and the intended duration of use.

13. For contributions of patents and other intellectual property, the amount of deduction is limited to the lesser of (1) the taxpayer’s basis for the property, or (2) the property’s FMV. A donor is also allowed an additional charitable deduction for certain amounts in the year of contribution and in later years based on a specified percentage of qualified donee income received or accrued by the charity from the donated property.

14. The overall limitation for contribution deductions is 50% of adjusted gross income (before any net operating loss carryback). A second limitation is that contributions of long-term capital gain property to charities in Section 14.a. below (where gain is not reduced) are limited to 30% of AGI. A third limitation is that some contributions to certain charities are limited to 20% of AGI or a lesser amount.

a. Contributions to the following are taken first and may be taken up to 50% of AGI limitation

(1) Public charities

(a) Churches

(b) Educational organizations

(c) Tax-exempt hospitals

(d) Medical research

(e) States or political subdivisions

(f) US or District of Columbia

(2) All private operating foundations, that is, foundations that spend their income directly for the active conduct of their exempt activities (e.g., public museums)

(3) Certain private non operating foundations that distribute proceeds to public and private operating charities

b. Deductions for contributions of long-term capital gain property (when the gain is not to be reduced) to organizations in Section 14.a. above are limited to 30% of adjusted gross income; but, taxpayer may elect to reduce all appreciated long-term capital gain property by the potential gain and not be subject to this 30% limitation.

c. Deductions for contributions to charities that do not qualify in Section 14.a. above (generally private non operating foundations) are subject to special limitations.

(1) The deduction limitation for gifts of

(a) Ordinary income property is the lesser of (1) 30% of AGI, or (2) (50% × AGI) − gifts to charities in Section 14.a. above

(b) Capital gain property is lesser of (1) 20% of AGI, or (2) (30% × AGI) − gifts of long-term capital gain property to charities in Section 14.a. above where no reduction is made for appreciation

(2) These deductions are taken after deductions to organizations in Section 14.a. above without the 30% limitation on capital gain property in Section 14.b. above.

---

EXAMPLE

An individual with AGI of $9,000 made a contribution of capital gain appreciated property with an FMV of $5,000 to a church, and gave $2,000 cash to a private non operating foundation. Since the contribution to the church (before the 30% limit) exceeds 50% of AGI, no part of the contribution to the foundation is deductible this year. Assuming no election is made to reduce the contribution of the capital gain property by the amount of its appreciation, the current deduction for the contribution to the church is limited to 30% × $9,000 = $2,700.

---

15. Contributions in excess of the 50%, 30%, or 20% limitation can be carried forward for five years and remain subject to the 50%, 30%, or 20% limitation in the carry forward years.

---

EXAMPLE

Ben’s adjusted gross income is $50,000. During the year he gave his church $2,000 cash and land (held for investment more than one year) having a fair market value of $30,000 and a basis of $22,000. Ben also gave $5,000 cash to a private foundation to which a 30% limitation applies.

Since Ben’s contributions to an organization to which the 50% limitation applies (disregarding the 30% limitation for capital gain property) exceed $25,000 (50% of $50,000), his contribution to the private foundation is not deductible this year. The $2,000 cash donated to the church is deducted first. The donation for the gift of land is not required to be reduced by the appreciation in value, but is limited to $15,000 (30% × $50,000). Thus, Ben may deduct only $17,000 ($2,000 + $15,000). The unused portion of the land contribution ($15,000) and the gift to the private foundation ($5,000) are carried over to the next year, still subject to their respective 30% limitations.

Alternatively, Ben may elect to reduce the value of the land by its appreciation of $8,000 and not be subject to the 30% limitation for capital gain property. In such case, his current deduction would be $25,000 ($2,000 cash + $22,000 land + $1,000 cash to private foundation), but only the remaining $4,000 cash to the private foundation would be carried over to the next year.

---

---

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 132 THROUGH 141

---

E. Personal Casualty and Theft Gains and Losses

F. Miscellaneous Deductions

G. Reduction of Total Itemized Deductions

IV. EXEMPTIONS

Personal exemptions are similar to itemized deductions in that they are deducted from adjusted gross income. Personal exemptions are allowed for the taxpayer, spouse, and dependent if the dependent is a US citizen or resident.

V. TAX COMPUTATION

A. Tax Tables

B. Tax Rate Schedules

1. For 2013 the tax rates for individuals are as follows:

2. Kiddie tax on unearned income. The earned income of a child of any age and the unearned income of a child 24 years or older as of the end of the taxable year is taxed at the child’s own marginal rate. However, the unearned income in excess of $2,000 ($1,900 for 2012) of a child under age eighteen is generally taxed at the rates of the child’s parents.

a. This rule also applies to 18-year-old children, as well as 19 to 23-year-old children who are full-time students, if they do not provide at least half of their support with earned income.

b. Unearned income will be taxed at the parents’ rates regardless of the source of the assets creating the child’s unearned income so long as the child has at least one living parent as of the close of the tax year and does not file a joint return.

c. The amount taxed at the parents’ rates equals the child’s unearned income less the sum of (1) any penalty for early withdrawal of savings, (2) $1,000, and (3) the greater of $1,000 or the child’s itemized deductions directly connected with the production of unearned income.

(1) Directly connected itemized deductions are those expenses incurred to produce or collect income, or maintain property that produces unearned income, including custodian fees, service fees to collect interest and dividends, and investment advisory fees. These are deductible as miscellaneous itemized deductions subject to a 2% of AGI limitation.

(2) The amount taxed at the parents’ rates cannot exceed the child’s taxable income.

---

EXAMPLE

Janie (age 11) is claimed as a dependent on her parents’ return and in 2013 receives interest income of $10,000, and has no itemized deductions. Janie’s taxable income would be $9,000 ($10,000 − $1,000 basic standard deduction). The amount of Janie’s income taxed at her parents’ tax rates would be $8,000 [$10,000 − ($1,000 + $1,000)], with the remaining $1,000 of taxable income taxed at Janie’s tax rate.

---

---

EXAMPLE

Brian (age 12) is claimed as a dependent on his parents’ return and in 2013 receives interest income of $15,000 and has itemized deductions of $1,200 that are directly connected to the production of the interest income. The amount of Brian’s income taxed at his parents’ tax rates is $12,800 [$15,000 − ($1,000 + $1,200)].

---

---

EXAMPLE

Kerry (age 10) is claimed as a dependent on her parents’ return and in 2013 receives interest income of $12,000, has an early withdrawal penalty of $350, and itemized deductions of $400 that are directly connected to the production of the interest income. The amount of Kerry’s income taxed at her parents’ tax rates is $9,650 [$12,000 − ($350 + $1,000 + $1,000)].

---

d. A child’s tax liability on unearned income taxed at the parents’ rates is the child’s share of the increase in tax (including alternative minimum tax) that would result from adding to the parents’ taxable income the unearned income of their children subject to this rule.

e. If the child’s parents are divorced, the custodial parent’s taxable income will be used in determining the child’s tax liability.

f. If child’s parents are divorced and both parents have custody, the taxable income of the parent having custody for the greater portion of the calendar year will be used in determining the child’s tax liability.

3. Reporting unearned income of a child on parent’s return. For 2013, parents may elect to include on their return the unearned income of their child under age eighteen whose income consists solely of interest and dividends and is between $1,000 and $10,000 ($950 and $9,500 for 2012).

a. The child is treated as having no gross income and does not have to file a tax return for the year the election is made.

b. The electing parents must include the child’s gross income in excess of $2,000 on their return for the tax year, resulting in the taxation of that income at the parents’ highest marginal rate. Also, the parents must report additional tax liability equal to 10% of the child’s income between $1,000 and $2,000.

c. The election cannot be made if estimated tax payments were made for the tax year in the child’s name and social security number, or if the child is subject to backup withholding.

C. Filing Status

D. Alternative Minimum Tax (AMT)

1. The alternative minimum tax for non corporate taxpayers is computed by applying a two-tiered rate schedule to a taxpayer’s alternative minimum tax base. A rate of 26% generally applies to the first $179,500 of a taxpayer’s alternative minimum taxable income (AMTI) in excess of the exemption amount. A 28% rate generally applies to AMTI greater than $179,500 ($89,750 for married taxpayers filing separately) above the exemption amount. The AMT treatment of net capital gain and qualified dividends is the same as for regular tax purposes, including the netting of capital gains and losses into separate tax-rate groups. Thus, net capital gain and qualified dividends are taxed at the same reduced rates for AMT as they are for regular tax purposes (generally 15%).

2. A taxpayer’s AMT is generally the amount by which the applicable percentage (26% or 28%) of AMTI as reduced by an exemption amount and reduced by the AMT foreign tax credit exceeds the amount of a taxpayer’s regular tax as reduced by the regular tax foreign tax credit.

3. AMT computation formula

4. Exemption. AMTI is offset by an exemption. However, the AMT exemption amount is phased out at the rate of 25% of AMTI between certain specified levels. For 2013, the exemption and phase-out ranges are

Filing status	AMT exemption	Phase-out range
Married filing jointly;
Surviving Spouse	$80,800	$153,900 − $477,100
Single; Head of Household	$51,900	$115,400 − $323,000
Married filing separately	$40,400	$ 76,950 − $238,550

In the case of a child under the age of eighteen, the AMT exemption (normally $51,900) is limited to the child’s earned income plus $7,150 (for 2013).

5. Adjustments. In determining AMTI, taxable income must be computed with various adjustments. Example of adjustments include

a. For real property placed in service after 1986 and before 1999, the difference between regular tax depreciation and straight-line depreciation over forty years.

b. For personal property placed in service after 1986, the difference between regular tax depreciation using the 200% declining balance method and depreciation using the 150% declining balance method (switching to straight-line when necessary to maximize the deduction).

c. Excess of stock’s FMV over amount paid upon exercise of incentive stock options.

d. The medical expense deduction is computed using a 10% floor (instead of the 7.5% floor that may have been used for regular tax).

e. No deduction is allowed for home mortgage interest if the loan proceeds were not used to buy, build, or improve the home.

f. No deduction is allowed for personal, state, and local taxes, and for miscellaneous itemized deductions subject to the 2% floor for regular tax purposes.

g. No deduction is allowed for personal exemptions and the standard deduction.

h. For long-term contracts, the excess of income under the percentage-of-completion method over the amount reported using the completed-contract method.

i. The installment method cannot be used for sales of dealer property.

6. Preference items. The following are examples of preference items added to taxable income (as adjusted above) in computing AMTI:

a. Tax-exempt interest on certain private activity bonds reduced by related interest expense that is disallowed for regular tax purposes. Tax-exempt interest on private activity bonds issued in 2009 and 2010 is not an item of tax preference.

b. Accelerated depreciation on real property and leased personal property placed in service before 1987—excess of accelerated depreciation over straight-line

c. The excess of percentage depletion over the property’s adjusted basis

d. 7% of the amount of excluded gain from the sale of Sec. 1202 qualified small business stock (QSBS). However, there is no preference for QSBS gains qualifying for the 100% exclusion through 2013.

7. Tax credits. Generally, an individual’s tax credits are allowed to reduce regular tax liability, but only to the extent that regular income tax liability exceeds tentative minimum tax liability.

a. All nonrefundable personal credits are allowed to offset both regular tax liability and the alternative minimum tax.

b. An individual’s AMT is also reduced by the alternative minimum tax foreign tax credit, the alcohol fuels credit, the renewable electricity production credit, and several other specified credits.

8. Minimum tax credit. The amount of AMT paid (net of exclusion preferences) is allowed as a credit against regular tax liability in future years.

a. The amount of the AMT credit to be carried forward is the excess of the AMT paid over the AMT that would be paid if AMTI included only exclusion preferences (e.g., disallowed itemized deductions and the preferences for excess percentage depletion, and tax-exempt interest).

b. The credit can be carried forward indefinitely, but not carried back.

c. The AMT credit can only be used to reduce regular tax liability, not future AMT liability.

---

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 173 THROUGH 179

---

E. Other Taxes

VI. TAX CREDITS/ESTIMATED TAX PAYMENTS

Tax credits directly reduce tax liability. The tax liability less tax credits equals taxes payable. Taxes that have already been withheld on wages and estimated tax payments are credited against tax liability without limitation, even if the result is a refund due to the taxpayer.

A. General Business Credit

B. Business Energy Credit

C. Credit for Rehabilitation Expenditures

D. Work Opportunity Credit

E. Alcohol Fuels Credit

F. Research Credit

G. Low-Income Housing Credit

H. Disabled Access Credit

I. Empowerment Zone Employment Credit

J. Employer Social Security Credit

K. Employer-Provided Child Care Credit

L. Credit for the Elderly and the Disabled

M. Child and Dependent Care Credit

N. Foreign Tax Credit

1. Foreign income taxes on US taxpayers can either be deducted or used as a credit at the option of the taxpayer each year.

2. The credit is limited to the overall limitation of

3. The foreign tax credit limitation must be computed separately for general category income and passive category income (i.e., dividends, interest, royalties, rents, and annuities).

4. Foreign tax credit in excess of the overall limitation is subject to a one-year carryback and a ten-year carry forward.

5. There is no limitation if foreign taxes are used as a deduction.

---

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 187 THROUGH 195

---

O. Earned Income Credit

P. Credit for Adoption Expenses

Q. Child Tax Credit (CTC)

R. American Opportunity Credit (AOC)

S. Lifetime Learning Credit

T. Credit for Qualified Retirement Savings

U. Estimated Tax Payments