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Volume

THE TAX COLLEGE


Educational Series

Federal Income
Tax Course 2015

EDUCATIONAL SERIES - VOLUME 1

Federal Income Tax Course 2015

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Table of Contents
H O W T O U S E O U R I N C O M E T A X C O U R S E .................................................... xxiii
K E Y T A X N U M B E R S 2 0 1 4 ........................................................................................xxiv

Lesson 1 - Our Federal Tax System ................................................................. 1


The Revolutionary War Period ........................................................ 2
The Post-Revolutionary War Period ................................................ 4
The Civil War Period ....................................................................... 4
The Post-Civil War Period ............................................................... 5
The 16th Amendment...................................................................... 7
The 1920s .................................................................................... 13
The 1930s .................................................................................... 18
The Social Security Act ............................................................................................................20
The World War II Period ................................................................ 23
The Post-World War II Period ....................................................... 24
The 1960s .................................................................................... 25
Medicare .......................................................................................................................................27
The Economic Recovery Tax Act of 1981 ..................................... 28
The Tax Reform Act of 1986 ......................................................... 28
The Internal Revenue Service Restructuring and Reform Act of 1998
30
The Economic Growth and Tax Relief Reconciliation Act of 2001 30
The Jobs and Growth Tax Relief Reconciliation Act of 2003 ........ 32
The Patient Protection and Affordable Care Act of 2010............... 32
The Health Care and Education Reconciliation Act of 2010 .......... 34
The American Taxpayer Relief Act of 2012 ................................... 35
The Modern Income Tax ............................................................... 35
What are the different types of taxes? ........................................... 39
Income Tax ...................................................................................................................................39
Sales Tax .......................................................................................................................................39
Use Tax ..........................................................................................................................................40
Excise Tax ......................................................................................................................................40
Real Estate Tax ............................................................................................................................40
Personal Property Tax ..............................................................................................................41
Tolls and Permits .......................................................................................................................41
Estate, Gift and Inheritance Taxes .......................................................................................41
ii

Tariffs .............................................................................................................................................41
Value Added Tax (VAT) ............................................................................................................42

Lesson 2 - The Tax Return Preparation Process ............................................ 43


History of the Tax Preparation Industry ......................................... 44
The Return Preparation Process ................................................... 46
The Client Organizer/Checklist...................................................... 48
Tax Estimator ................................................................................ 48
The Three Stages ......................................................................... 48
Welcoming the Taxpayer .............................................................. 48
Establishing Rapport ..................................................................... 49
Be an Active Listener .................................................................... 49
Asking Questions Effectively ......................................................... 50
Dealing with Communication Barriers ........................................... 50
The Burden of Proof for Individual Tax Returns ............................ 51
Completing the Tax Return ........................................................... 54
Complex Tax Returns ................................................................... 55
Frequently Asked Questions ......................................................... 58
E-filing ...........................................................................................................................................58
What If a Taxpayer or Dependent Does Not Have a Social Security Number? ..59
What if a Taxpayer Moves? ....................................................................................................59
Which Address Should Taxpayers Use: Their Street Address or Their PO Box? .59
How Long Should Taxpayers Keep Their Tax Returns and Documentation? ......60
Recordkeeping Review ............................................................................................................61
Lesson Summary .......................................................................... 66

Lesson 3 - Taxpayer Identification Numbers ................................................... 68


Social Security Number Verification .............................................. 70
Individual Taxpayer Identification Numbers .................................. 70
Who Needs an ITIN? ................................................................................................................70
The Procedure for Acquiring an ITIN .................................................................................71
Form W9 and Backup Withholding ................................................ 73
Community Property States .......................................................... 75
Community or Separate Property and Income ...............................................................75
Community Property ................................................................................................................75
Community Income ..................................................................................................................76
Separate Property......................................................................................................................76
Separate Income ........................................................................................................................76
Lesson Summary .......................................................................... 80

Lesson 4 - Aliens ............................................................................................ 82


iii

Determining Alien Status ............................................................... 83


The Three Statuses ....................................................................................................................83
Resident Status ...........................................................................................................................83
Nonresident Status ...................................................................................................................85
Dual-Status Aliens .....................................................................................................................88
Undocumentated Aliens .........................................................................................................88
Children Born Abroad - Obtaining a Social Security Number ..................................90
Questions Commonly Asked by or About Aliens ........................... 92
Lesson Summary .......................................................................... 99
Questions Taxpayers Ask ........................................................ 100

Lesson 5 - Filing Statuses and Who Should File a Tax Return ..................... 103
Single Taxpayers ........................................................................ 105
Married Filing Jointly ................................................................... 105
Innocent and Injured Spouses..................................................... 108
Married Filing Separately ............................................................ 109
Head of Household ..................................................................... 113
Keeping Up a Home .............................................................................................................. 113
Qualifying Criteria .................................................................................................................. 114
Married and Living Apart with Dependent Child .......................... 117
Table for Determining Status: ............................................................................................ 118
Reporting................................................................................................................................... 119
Qualifying Widow(er) With Dependent Child ............................... 120
Qualifying Criteria .................................................................................................................. 120
After the Spouse's Death ............................................................ 124
Who Must File Versus Who Should File ...................................... 125
Dependents Who Must or Should File a Return .......................... 127
People Age 65 or Older or Blind.................................................. 127
Other Situations When You Must File ......................................... 127
Who Should File .......................................................................... 128
Who Should Not File ................................................................... 129
Which Form to Use ..................................................................... 129
Form 1040EZ ............................................................................................................................ 129
Form 1040A .............................................................................................................................. 129
Form 1040 ................................................................................................................................. 130
Lesson Summary ........................................................................ 131

Lesson 6 - Personal and Dependency Exemptions ....................................... 133


Overview of the Dependency Exemption Rules: ......................... 134
The Taxpayer .............................................................................. 137
iv

The Spouse ................................................................................. 137


Dependency Exemptions ............................................................ 138
Tests for all Dependents ............................................................. 139
The Four Tests.......................................................................................................................... 139
Relationship Test .................................................................................................................... 140
Support Test ............................................................................................................................. 140
Residency Test ......................................................................................................................... 141
Age Test ..................................................................................................................................... 141
Tie Breaker Rules ....................................................................... 141
Qualifying Relative Tests ............................................................ 142
Dependency Tests .................................................................................................................. 142
Citizen or Resident Test ....................................................................................................... 143
Joint Return Test ..................................................................................................................... 143
The Member of Household or Relationship Test ........................................................ 143
The Qualifying Child of another Taxpayer Test ........................................................... 145
The Gross Income Test ......................................................................................................... 145
The Support Test .................................................................................................................... 146
Multiple Support .......................................................................... 147
How do you determine who should claim the exemption? .................................... 147
Special Rules for Children of Divorced or Separated Parents ................................ 148
Determining the Number of Exemptions to Claim ....................... 149
Completing the Exemptions Section of the Return ...................... 150
Lesson Summary ........................................................................ 152

Lesson 7 - Income - Part I ............................................................................. 154


Nontaxable Income ..................................................................... 158
Medical Reimbursements ............................................................ 163
Where to Report Income ............................................................. 163
Earned Income - Wages, Salaries, and Tips ............................... 165
Form W-2 .................................................................................................................................. 165
Household Employees ................................................................ 172
Household Employers Checklist ........................................................................................ 173
Incorrect Form W-2 ..................................................................... 175
Missing Form W-2 ....................................................................... 175
Form 4852 ................................................................................... 175
Fraudulent Form W-2 .................................................................. 177
How Do You Report Suspected Tax Fraud Activity? .................................................. 178
Earned Income ............................................................................ 178
Form 1099-MISC......................................................................... 179
v

Tip Income .................................................................................. 180


Allocated Tips .......................................................................................................................... 181
Tip Income Requiring Form 1040 ..................................................................................... 182
Scholarships and Fellowships ..................................................... 183
Interest Income ........................................................................... 184
Seller-Financed Mortgages ................................................................................................. 186
U.S. Savings Bonds - Series EE and Series I ............................. 187
U.S. Savings Bonds - Series HH Bonds and Other U.S. Obligations188
Co-owners ................................................................................................................................. 188
Deferred Interest Accounts ......................................................... 189
One Year or Less ..................................................................................................................... 189
More Than One Year ............................................................................................................. 189
Original Issue Discount (OID) ..................................................... 190
Lesson Summary ........................................................................ 198

Lesson 8 - Income - Part II ............................................................................ 201


Coverdell ESA's .......................................................................... 203
Tax-Exempt Interest .................................................................... 206
Tax Free Interest Rate Equivalents ................................................................................... 207
Form 1099-INT ............................................................................ 207
Reporting Interest........................................................................ 215
Form 1040EZ ............................................................................................................................ 215
Forms 1040 and 1040A ........................................................................................................ 215
Form 1040 ................................................................................................................................. 216
Foreign Investment Accounts and Trusts ...................................................................... 217
Dividends and Corporate Distributions ........................................ 219
How to Report Ordinary Dividends .............................................. 222
Spouses ...................................................................................... 223
How to Report Capital Gain Distributions .................................... 224
Sick Pay ...................................................................................... 225
Qualified Long-term Care Insurance ........................................... 227
State and Local Refunds ............................................................. 227
Alimony ....................................................................................... 229
Specific Rules Regarding Alimony Payments ............................................................... 230
Specific Rules Regarding Property Transferred Pursuant To Divorce ................. 231
Unemployment Compensation .................................................... 233
Supplemental Unemployment Benefits ....................................... 236
Union Benefits ............................................................................. 237
Veterans Benefits ........................................................................ 238
vi

Royalty Income ........................................................................... 238


REMIC Income ............................................................................ 239
Other Income .............................................................................. 240
Lesson Summary ........................................................................ 243

Lesson 9 - Self Employment Income............................................................. 246


The Role of Small Business ........................................................ 247
Types of Business Organizations ................................................ 248
Starting a Business ..................................................................... 254
Employee or Independent Contractor? ....................................... 256
Who is an Independent Contractor? ............................................................................... 257
How should payments made to Independent Contractors be reported? ......... 260
Who is a Common-Law Employee? ................................................................................. 260
Who is a Statutory Employee? ........................................................................................... 260
Who is a Statutory Nonemployee? .................................................................................. 261
Misclassification of Employees .......................................................................................... 261
Due Dates for Small Business Tax Returns ................................ 262
Accounting Periods and Methods................................................ 263
Calendar Year ........................................................................................................................... 266
Income and Expenses................................................................. 266
Income........................................................................................................................................ 266
Expenses .................................................................................................................................... 268
The Burden of Proof for Business Tax Returns (Including Schedule C)
270
Cost of Goods Sold ................................................................................................................ 275
Capital Expenses ..................................................................................................................... 277
Going into Business ............................................................................................................... 278
Partially Deductible Expenses ........................................................................................... 279
Payments in Kind .................................................................................................................... 279
Who May Use Schedule C-EZ .................................................... 282
Schedule C-EZ.......................................................................................................................... 282
Total Expenses ........................................................................... 283
Leasing vs. Buying Equipment .................................................... 289
Conditional Sales Contracts ................................................................................................ 290
Capitalizing Rent Expenses ................................................................................................. 290
Business and Personal Use .................................................................................................. 290
Business Travel Expenses .......................................................... 292
Car Expenses.............................................................................. 294
Standard Mileage Rate Method ........................................................................................ 295
Actual Car Expense Method ............................................................................................... 298
vii

Net Profit ..................................................................................... 300


Limits on Losses ...................................................................................................................... 300
Part III: Information on Your Vehicle ........................................... 301
Schedule SE ............................................................................... 302
Who Must File Schedule SE ................................................................................................ 306
Reporting the Self-Employment Tax ............................................................................... 306
Home Office Deductions ............................................................. 308
Safe-Harbor Rules .................................................................................................................. 309
Principal Place of Business ......................................................... 312
How to Apportion Total Annual Expenses for New Businesses? .......................... 315
Depreciation ................................................................................ 315
Listed Property ........................................................................................................................ 317
Basis ............................................................................................................................................. 323
Adjusted Basis .......................................................................................................................... 323
MACRS Method of Depreciation ...................................................................................... 324
Placed in Service Date .......................................................................................................... 325
Property Classes and Recovery Periods ......................................................................... 326
Applying Recovery Periods ................................................................................................. 327
First Year Expensing (Section 179) ................................................................................... 327
Hobby Income and Losses .......................................................... 331
Sale of Business Property ........................................................... 332
Recapture of Depreciation Deductions .......................................................................... 333
Net Operating Losses ................................................................. 339
Form 1045 - Schedule A ...................................................................................................... 340
How to Carry an NOL Back or Forward .......................................................................... 340
"Going Out of Business" Checklist .............................................. 345
Causes of Small Business failures ..................................................................................... 345
Summary of Employment Taxes and Forms ............................... 347
General Business Credits ........................................................... 348
How to Claim the Credit ...................................................................................................... 348
Business Tax Return Due Dates ................................................. 352
Lesson Summary ........................................................................ 354

Lesson 10 - Sale of Investment Property ...................................................... 356


Stock Fundamentals ................................................................... 359
Capital Assets ........................................................................................................................... 359
Capital Gain Distributions.................................................................................................... 360
Where to Report Gains and Losses ............................................ 363
When Do You Need To File Form 8949 and Schedule D ......................................... 364
viii

Basis of Stock ............................................................................. 364


Adjusted Basis .......................................................................................................................... 364
Holding Period - Long-Term or Short-Term ................................. 365
Blocks of Stock............................................................................ 366
Tax-Free Stock Dividends and Stock Splits ................................ 367
Taxable Dividends....................................................................... 367
Demutualization .......................................................................... 368
Wash Sales ................................................................................. 368
Form 1099-B ............................................................................... 369
Determining the Basis of Stock ................................................... 370
Reporting Form 1099-B Information - Where the Data Goes ...... 371
1099 Consolidated Statements ................................................... 373
Schedule D - Outline of the Three Parts ..................................... 374
Reporting Stock Gains or Losses ................................................ 375
Reporting Other Gains ................................................................ 376
Capital Loss Carryovers .............................................................. 377
Divorced and MFS Taxpayers ............................................................................................. 378
Deducting Worthless Securities .................................................. 378
Like-Kind Exchanges .................................................................. 380
Like-Kind Property ................................................................................................................. 381
Like Class ................................................................................................................................... 381
Lesson Summary ........................................................................ 387

Lesson 11 - Sale of Home ............................................................................ 389


Eligibility Requirements for the Exclusion ................................... 389
Reporting the Exclusion .............................................................. 391
Definition of Main Home .............................................................. 391
More than One Home.................................................................. 392
Ownership and Use Test - Period of Ownership and Use ........... 392
Married Homeowners .................................................................. 394
Exclusion of Gain on Sale of Principal Residence by a Surviving Spouse .......... 394
Reduced Exclusion ..................................................................... 395
Unforeseen Circumstances ................................................................................................. 395
Gain on Sale of Main Home ........................................................ 396
Selling Price .............................................................................................................................. 396
Amount Realized .................................................................................................................... 396
Basis ............................................................................................................................................. 396
Adjusted Basis .......................................................................................................................... 397
Repairs ........................................................................................ 399
ix

Figuring the Gain......................................................................... 399


Form 1099-S ............................................................................... 400
Home Foreclosures ..................................................................... 400
Step 1 .......................................................................................................................................... 400
Step 2 .......................................................................................................................................... 402
The Mortgage Forgiveness Debt Relief Act of 2007.................................................. 402
Installment Sales ......................................................................... 405
Installment Sale Interest....................................................................................................... 405
Lesson Summary ........................................................................ 406
Questions Taxpayers Ask ........................................................ 408

Lesson 12 - Pension Income......................................................................... 411


Disability Pensions ...................................................................... 415
Annuities ..................................................................................... 415
Individual Retirement Accounts (IRAs) ........................................ 416
Social Security Benefits .............................................................. 417
Railroad Retirement Benefits (RRB's) ......................................... 426
Other Types of Pension Plans .................................................... 427
Form 1099-R ............................................................................... 427
Form SSA-1099 .......................................................................... 429
Form RRB-1099 and Form RRB-1099R ..................................... 430
Tier 1 Railroad Retirement Benefits ............................................ 430
Pensions with Taxable Amount Determined ............................... 431
Pensions in General .................................................................... 431
"Before-Tax" vs. "After-Tax" Contributions ................................................................... 432
Partially Taxable Pensions and Annuities Other than IRAs...................................... 432
General Rule ............................................................................................................................. 432
Simplified Method ................................................................................................................. 432
Taxation of Individual Retirement Accounts ................................ 433
Traditional IRA ......................................................................................................................... 434
Savings Incentive Match Plans for Employees (SIMPLE) IRA .................................. 434
Simplified Employee Pension (SEP) IRA ......................................................................... 434
Roth IRAs ................................................................................................................................... 434
Taxation of Social Security Benefits ............................................ 436
What is the Social Security Lump Sum Election? ........................................................ 437
Disability Pension Income ........................................................... 438
Reporting Pension Income.................................................................................................. 438
Disability Income Reporting ............................................................................................... 439
Reporting Social Security Benefits .............................................. 440
x

Repayment of benefits ......................................................................................................... 440


Reporting IRA Distributions ......................................................... 441
Traditional IRA, SIMPLE IRA, or SEP IRA ......................................................................... 441
Premature Distributions ............................................................... 442
Lump-Sum Distributions .............................................................. 443
Taxpayers born before January 2, 1936 ..................................... 445
Minimum Distributions ................................................................. 446
Lump-Sum Benefit Payments...................................................... 447
Withdrawal of Excess IRA Contributions ..................................... 448
Pension Withholding and Estimated Tax Payments .................... 449
Lesson Summary ........................................................................ 454
Questions Taxpayers Ask ........................................................ 455

Lesson 13 - Rental Income and Expenses .................................................... 457


Rental Income ............................................................................. 458
Rental Expenses ......................................................................... 459
Mortgage Interest and Property Taxes ........................................................................... 460
Deduction of Property Taxes .............................................................................................. 460
Other Deductible Rental Expenses ................................................................................... 461
Auto and Travel Expenses ................................................................................................... 461
Advance Insurance Premiums ............................................................................................ 463
Special Allocations ................................................................................................................. 463
Rental vs. Personal Use .............................................................. 463
Days Used for Repairs and Maintenance ....................................................................... 463
Deductibility Limitations ...................................................................................................... 464
Rental Losses ............................................................................. 465
Passive Activity vs. Active Participation .......................................................................... 465
Passive Activity Losses .......................................................................................................... 466
Active Participation ................................................................................................................ 467
Phase-Out of Offset ............................................................................................................... 467
Reporting Rental Losses ............................................................. 468
Self-Employment Tax .................................................................. 469
Lesson Summary ........................................................................ 470

Lesson 14 - Foreign Earned Income Exclusion ............................................. 472


Eligibility Requirements ............................................................... 474
Married Couples .......................................................................... 474
Qualifying Tax Home................................................................... 474
Military Personnel........................................................................ 474
Choosing the Exclusion ............................................................... 475
xi

Revoking the Exclusion ............................................................... 475


Determining the Tax Home ......................................................... 475
Period of Stay.............................................................................. 477
Bona Fide Residence Test .................................................................................................... 477
Physical Presence Test .......................................................................................................... 477
Figuring the 12-month Period ........................................................................................... 477
Waiver of Time Requirements ........................................................................................... 478
Qualifying Income ....................................................................... 478
Form 2555 ................................................................................... 482
Form 2555-EZ .......................................................................................................................... 482
Deductions Allocable to Excluded Income.................................................................... 484
Self-Employment Tax ............................................................................................................ 484
Itemized Deductions ............................................................................................................. 485
Moving Expenses .................................................................................................................... 485
Net Exclusion............................................................................................................................ 486
Tax Guide for U.S. Citizens and Resident Aliens Abroad ........... 486
Lesson Summary ........................................................................ 486
Questions Taxpayers Ask... ........................................................ 487

Lesson 15 - Adjustments to Income - Part I .................................................. 489


Archer Medical Savings Accounts (MSA) .................................... 490
Archer MSA Contributions of Self Employed Persons .............................................. 490
Archer MSA Distributions .................................................................................................... 492
Certain business expenses of reservists, performing artists, and fee-basis
government officials .................................................................... 492
Health Savings Accounts (HSAs) ................................................ 493
What are the benefits of an HSA? .................................................................................... 493
Contributions to an HSA ...................................................................................................... 494
Limit on contributions .......................................................................................................... 494
Filing Form 8889 ..................................................................................................................... 496
Moving Expenses ........................................................................ 497
One Half of Self-Employment Tax ............................................... 501
Simplified Employee Pensions (SEP) ......................................... 504
Savings Incentive Match Plan for Employees (SIMPLE) ............. 505
SIMPLE Distributions ............................................................................................................. 505
Keogh Plans ................................................................................ 505
Self-Employed Health Insurance Deduction ................................ 508
Penalty on Early Withdrawal of Savings ...................................... 509
Alimony Paid ............................................................................... 511
xii

Specific Rules Regarding Alimony Payments ............................................................... 512


Specific Rules Regarding Property Transferred Pursuant To Divorce ................. 514
Lesson Summary ........................................................................ 516

Lesson 16 - Adjustments to Income - Part II ................................................. 520


Individual Retirement Accounts (IRAs) ........................................ 520
Non Tax Deductible IRAs ..................................................................................................... 524
Roth IRAs ................................................................................................................................... 525
IRA Distributions ..................................................................................................................... 527
Student Loan Interest Deduction ................................................. 529
Qualified Student Loan Interest ........................................................................................ 529
Who Can Claim the Deduction? ........................................................................................ 530
Eligible Educational Institution .......................................................................................... 531
Eligible Student ....................................................................................................................... 531
Reductions to Qualified Expenses .................................................................................... 532
Deduction Limits ..................................................................................................................... 532
Reporting Student Loan Interest ...................................................................................... 535
Tuition and Fees Deduction ........................................................ 536
What expenses qualify? ........................................................................................................ 536
What expenses do not qualify? ......................................................................................... 536
Is there a deduction if the expenses were paid with borrowed funds? .............. 537
What is an "Eligible Educational Institution"? .............................................................. 537
What are "Related Expenses"? ........................................................................................... 537
Adjustments to Qualified Education Expenses ............................................................ 539
Form 1098-T - Tuition Statement ..................................................................................... 540
Comprehensive or bundled fees ....................................................................................... 541
Jury Duty Pay Given to Employer ............................................... 542
Domestic Production Activities Deduction ................................... 543
Other Adjustments to Income ...................................................... 546
Lesson Summary ........................................................................ 547

Lesson 17 - Individual Retirement Accounts ................................................. 550


What is an IRA? .......................................................................... 551
Contributions ............................................................................... 553
General Contribution Limits ............................................................................................... 555
Deemed IRAs............................................................................................................................ 555
Spousal Contribution Limits ............................................................................................... 556
Excess Contributions ............................................................................................................. 556
Additional Taxes and Penalties ................................................... 557
IRA Rollovers ............................................................................................................................ 557
xiii

Deductible IRA Contributions ...................................................... 562


Taxpayers Not Covered by an Employer Retirement Plan ...................................... 562
Filing Status .............................................................................................................................. 563
Modified Adjusted Gross Income (MAGI) ..................................................................... 563
Taxpayers Covered by an Employer Retirement Plan ............................................... 564
When to Deduct Traditional IRA Contributions ............................ 566
Reporting the Deduction ..................................................................................................... 567
Non-deductible IRA Contributions ............................................... 567
Additional Taxes & Penalties ...................................................... 568
Lesson Summary ........................................................................ 568
Questions Taxpayers Ask... ........................................................ 569

Lesson 18 - Standard and Itemized Deductions - Part I ................................ 571


What Are Deductions? ................................................................ 571
Standard and Itemized Deductions ............................................. 572
The Standard Deduction ............................................................. 573
Criteria for Blindness ................................................................... 574
Personal Exemption on Form 1040EZ ........................................ 575
Taxable Income on Form 1040EZ ............................................... 575
Married Filing Separately ............................................................ 575
Medical and Dental Expenses ..................................................... 577
Taxes .......................................................................................... 584
Interest ........................................................................................ 588
Investment Interest ................................................................................................................ 588
Home Mortgage Interest ..................................................................................................... 592
Itemized Deduction Reduction .................................................... 600
For Tax Years 2013 and Later: ............................................................................................ 600
Lesson Summary ........................................................................ 601

Lesson 19 - Standard and Itemized Deductions - Part II ............................... 604


Home Mortgage Points ............................................................... 605
Gifts to Charity ............................................................................ 610
Deduction Limits ..................................................................................................................... 610
Gifts To Reduce The Public Debt ...................................................................................... 614
Reporting Contributions ...................................................................................................... 615
Restrictions on Charitable Contributions made after August 17, 2006 .............. 616
Casualty and Theft Losses .......................................................... 617
Involuntary Conversions ...................................................................................................... 622
Declared Disaster Areas ....................................................................................................... 622
Grants under the Disaster Relief Act of 1974 ............................................................... 622
xiv

Miscellaneous Deductions .......................................................... 623


Deductions subject to the 2% limit .................................................................................. 623
Employee Business Expenses .................................................... 629
Accountable Plans .................................................................................................................. 634
Deductions not subject to the 2% limit ........................................ 636
Gambling Losses ........................................................................ 637
Non-deductible Expenses ........................................................... 638
Lesson Summary ........................................................................ 639

Lesson 20 - Alternative Minimum Tax ........................................................... 643


Alternative Minimum Tax Credit .................................................. 647
Lesson Summary ........................................................................ 647
Questions Taxpayers Ask... ........................................................ 652

Lesson 21 - Credit for Child and Dependent Care Expenses ........................ 656
Five Eligibility Tests..................................................................... 664
Qualifying Person Test .......................................................................................................... 664
Earned Income Test ............................................................................................................... 665
Work-Related Expense Test ................................................................................................ 666
Joint Return Test ..................................................................................................................... 667
Provider Identification Test ................................................................................................. 667
Limit on Expenses ....................................................................... 670
General Limit ............................................................................................................................ 670
Dependent Care Benefit Limit............................................................................................ 670
Non-working Spouse ................................................................... 671
Lesson Summary ........................................................................ 672

Lesson 22 - Child Tax Issues ........................................................................ 674


The Child Tax Credit ................................................................... 675
Qualifying Child ........................................................................... 675
Eligible Descendent ............................................................................................................... 675
Adopted Child ......................................................................................................................... 676
Eligible Foster Child ............................................................................................................... 676
Exceptions for Children of Divorced or Separated Parents ..................................... 676
Amount of Credit ......................................................................... 677
Figuring the Credit....................................................................... 680
Additional Child Tax Credit .......................................................... 680
The Trade Preferences Extension Act of 2015 ........................... 680
Child Tax Returns Kiddie Tax................................................... 681
Tax Returns for Students ............................................................ 687
Penalties ..................................................................................................................................... 688
xv

Adopting a Child .......................................................................... 688


Adoption Credit ...................................................................................................................... 689
Employer Adoption Assistance Exclusion ...................................................................... 690
Lesson Summary ........................................................................ 691

Lesson 23 - Credit for the Elderly or Disabled ............................................... 695


Personal Qualifications for the Credit .......................................... 696
Physician Statements.................................................................. 698
Sheltered Employment ................................................................ 698
Income Limits for the Credit ........................................................ 698
Taking the Credit ......................................................................... 700
Medicare ..................................................................................... 701
What is covered by Medicare? .......................................................................................... 701
How do taxpayers enroll in Medicare? ........................................................................... 702
Medigap Insurance ................................................................................................................ 702
What's does Medigap insurance typically cover? ....................................................... 703
Medicaid .................................................................................................................................... 703
Eldercare ..................................................................................... 707
Lesson Summary ........................................................................ 711
Questions Taxpayers Ask... ........................................................ 711
Lesson 24 Primer: College Planning ........................................... 716
How Much Does a College Education Cost? ................................................................ 716
College Savings Requirements Worksheet ................................................................... 718
Financial Aid Calendar .......................................................................................................... 719
How to Improve Your Client's Chances of Getting Financial Aid... ....................... 720
Key College Planning Websites ......................................................................................... 723

Lesson 24 - Education Credits and Programs ............................................... 725


The Credits ................................................................................. 726
American Opportunity Credit Eligible Student ............................. 728
Eligible Educational Institution .................................................... 730
Income Requirements ................................................................. 730
Modified Adjusted Gross Income (MAGI) .................................... 732
Tuition and Fees ......................................................................... 733
Related Expenses .................................................................................................................... 733
Non-qualifying Expenses ..................................................................................................... 733
Non-credit Courses................................................................................................................ 733
Prepaid Expenses .................................................................................................................... 734
Payments with Borrowed Funds ....................................................................................... 734
Expenses Paid by Others...................................................................................................... 734
xvi

The Trade Preferences Extension Act of 2015 ........................... 736


What Is the American Opportunity Credit? .................................. 736
Figuring the Credit ................................................................................................................. 738
What Is the Lifetime Learning Credit? ......................................... 739
Differences between the Two Education Credits ........................ 741
No Double Benefits ............................................................................................................... 742
Adjustments to Qualified Expenses............................................. 742
Refunds ....................................................................................... 743
Qualified Tuition Programs (QTPs) (Section 529 Plans) ............. 744
Coverdell ESAs .......................................................................... 746
Excludable U.S. Savings Bond Interest ....................................... 749
Educational Assistance Plans ..................................................... 751
Work Related Education Expenses ............................................. 751
What is the tax benefit of taking a business deduction for work-related
education?................................................................................................................................. 752
Qualifying Work-Related Education ................................................................................ 752
Education Required by Employer or by Law ................................................................. 752
Education To Maintain or Improve Skills ....................................................................... 753
Maintaining Skills vs. Qualifying for a New Job .......................................................... 753
Temporary Absences ............................................................................................................. 753
Indefinite Absences ............................................................................................................... 753
Education To Meet Minimum Requirements ............................................................... 754
Requirements for Teachers ................................................................................................. 754
Certification in a New State ................................................................................................ 754
Education That Qualifies The Taxpayer for a New Trade or Business ................. 755
Teaching and Related Duties ............................................................................................. 755
What Expenses Can Be Deducted .................................................................................... 755
Deductible Expenses ............................................................................................................. 755
Non-deductible Expenses ................................................................................................... 755
Unclaimed Reimbursement ................................................................................................ 756
Transportation Expenses ...................................................................................................... 756
Temporary Basis ...................................................................................................................... 756
Attendance Not on a Temporary Basis ........................................................................... 756
Deductible Transportation Expenses ............................................................................... 756
Using His Own Car ................................................................................................................. 757
Travel Expenses ....................................................................................................................... 757
Mainly Personal Travel .......................................................................................................... 757
Cruises and Conventions ..................................................................................................... 758
xvii

50% Limit on Meals ............................................................................................................... 758


Travel as Education ................................................................................................................ 758
No Double Benefit Allowed ................................................................................................ 758
Adjustments to Qualifying Work-Related Education Expenses ............................. 758
Tax-free Educational Assistance ........................................................................................ 759
Amounts That Do Not Reduce Qualifying Work-related Education Expenses 759
How To Treat Reimbursements ......................................................................................... 759
Accountable Plans .................................................................................................................. 760
Accountable Plan Rules Not Met ...................................................................................... 760
Expenses Equal Reimbursement ....................................................................................... 760
Excess Expenses ...................................................................................................................... 760
Allocating the Taxpayers Reimbursements for Meals .............................................. 760
Non-Accountable Plans ....................................................................................................... 761
Reimbursements for Non-deductible Expenses .......................................................... 761
Self-Employed Persons ......................................................................................................... 761
Employees ................................................................................................................................. 761
Form 2106 or 2106-EZ .......................................................................................................... 762
Form 2106 or 2106-EZ Not Required .............................................................................. 762
Using Form 2106-EZ .............................................................................................................. 762
Performing Artists and Fee-Basis Officials .................................................................... 763
Impairment-Related Work Expenses ............................................................................... 763
Lesson Summary ........................................................................ 766

Lesson 25 - The Earned Income Tax Credit.................................................. 768


Filing Requirements .................................................................... 769
Income Requirements ................................................................. 770
Taxpayer Identification Numbers................................................. 770
Taxpayers With Qualifying Children ............................................ 771
Taxpayers Without Qualifying Children ....................................... 771
Earned Income ............................................................................ 771
Income Not Considered Earned Income for EIC ......................................................... 772
Household Employee Income ............................................................................................ 772
Qualifying Child ........................................................................... 773
Three Tests for the EIC .......................................................................................................... 773
Relationship Test .................................................................................................................... 773
Residency Test ......................................................................................................................... 774
Age Test ..................................................................................................................................... 774
Qualifying Child of More Than One Taxpayer ............................................................. 775
EIC Qualification Checklist .......................................................... 776
xviii

Schedule EIC .............................................................................. 776


Disallowed EIC ............................................................................ 776
Deficiency Procedures .......................................................................................................... 776
Reasons for Disallowed EIC................................................................................................. 777
EIC Certification ....................................................................................................................... 777
Earned Income Credit Summary ................................................. 778
Lesson Summary ........................................................................ 784

Lesson 26 - The Foreign Tax Credit.............................................................. 786


Qualifying Taxes ......................................................................... 787
No Economic Benefit................................................................... 788
Country Restrictions .................................................................... 788
Form 1116 ................................................................................... 789
Types of Income.......................................................................... 792
Passive Income ........................................................................................................................ 792
High Withholding Tax Interest .......................................................................................... 792
General Limitation Income .................................................................................................. 792
Completing Form 1116 ................................................................ 793
Foreign Earned Income Exclusion..................................................................................... 794
Cash Basis vs. Accrual Basis Taxpayers ........................................................................... 794
Lesson Summary ........................................................................ 794

Lesson 27 - Miscellaneous Tax Credits ........................................................ 803


Qualified Retirement Savings Contributions ................................ 806
Eligible Contributions............................................................................................................ 808
Married Filing Jointly ............................................................................................................. 809
Residential Energy Efficient Property Credit ............................... 810
Alternative Motor Vehicle Credit .................................................. 811
Plug-in Electric Drive Vehicle Credit............................................ 812
Mortgage Interest Credit ............................................................. 813
Health Coverage Tax Credit ........................................................ 814
General Business Credits ........................................................... 814
Lesson Summary ........................................................................ 815

Lesson 28 - Electronic Filing and Bank Products .......................................... 820


Electronic Filing ........................................................................... 823
The History of IRS e-file ....................................................................................................... 823
IRS e-file Historical Timeline ............................................................................................... 823
Security of IRS e-file .............................................................................................................. 825
What is the Self-Select PIN method? .............................................................................. 826
State E-file Mandates ............................................................................................................ 827
xix

Refund Options ........................................................................... 828


Straight Electronic Filing (Direct Deposit) ..................................................................... 828
Straight Electronic Fling (Paper Check) .......................................................................... 828
Mail in Return (Direct Deposit) .......................................................................................... 828
Mail in Return (Paper Check).............................................................................................. 828
How to Get Started with e-file...................................................... 828
Bank Products ............................................................................. 829
General Purpose Reloadable Prepaid Cards ................................................................. 831
Our Refund Settlement Products ..................................................................................... 833
Check Cashing Alternatives ................................................................................................ 836
Federal Refund Anticipation Loan (RAL) ........................................................................ 838
Military RAL Exclusion ........................................................................................................... 839
RAL Product Features & Benefits...................................................................................... 839
Federal Electronic Refund Check (ERC) .......................................................................... 840
ERC Product Features & Benefits...................................................................................... 840
Federal Electronic Refund Direct Deposit (ERDD) ...................................................... 841
State Electronic Refund Check (SERC) ............................................................................ 841
SERC Product Features & Benefits ................................................................................... 841
Lesson Summary ........................................................................ 843

Lesson 29 - Finishing The Tax Return .......................................................... 846


Income Tax Withholding .............................................................. 848
Estimated Income Tax Payments................................................ 855
Refundable Credits ..................................................................... 857
Overpayment or Tax Due ............................................................ 857
Refunds ....................................................................................... 857
Buying U.S. Series I Savings Bonds .................................................................................. 858
Direct Deposit .......................................................................................................................... 858
Payment by Check or Money Order ............................................ 858
Electronic Payment Options ........................................................ 859
Monthly Installment Options ........................................................ 860
Estimated Tax Penalty ................................................................ 861
Estimated Tax ............................................................................. 863
Withheld Taxes ........................................................................................................................ 863
Taxes Not Withheld ............................................................................................................... 863
Who Must Pay Estimated Tax ............................................................................................ 864
When to Pay Estimated Tax ................................................................................................ 867
Option to Apply an Overpayment ................................................ 869
How to Make Payments .............................................................. 869
xx

Forms W-4, W-4P, W-4V, and W-4S........................................... 870


Form W-4 .................................................................................................................................. 870
Form W-4P ................................................................................................................................ 870
Form W-4V................................................................................................................................ 871
Form W-4S ................................................................................................................................ 871
How Much to Withhold........................................................................................................ 872
Completing Forms W-4 and W-4P................................................................................... 873
Multiple Incomes .................................................................................................................... 877
Attaching Forms and Schedules ................................................. 877
Signatures ................................................................................... 878
Returns for Children .............................................................................................................. 878
Combat Zone ........................................................................................................................... 878
Deceased Taxpayers .................................................................. 879
Claiming the Decedent's Refund ...................................................................................... 881
Federal Estate Tax ...................................................................... 881
Federal Gift Tax .......................................................................... 885
State Estate and Inheritance Tax ................................................ 888
Probate ....................................................................................................................................... 889
Deceased Spouses ..................................................................... 890
Third Party Designee .................................................................. 892
Ending the Interview.................................................................... 893
Checking on Refunds .................................................................. 894
Financial Management Service ................................................... 895
Lesson Summary ........................................................................ 896

Lesson 30 - IRS Audits ................................................................................. 899


The taxpayer received a notice from the IRS........................... 901
The taxpayer received a notice from the IRS thats wrong. .................................... 902
What to do if there's Form W-2 or Form 1099 discrepancies. ............................... 902
What if the taxpayer hasn't filed tax returns for several years? ... 903
What are the penalties and interest and can they be avoided? ... 904
Acting on bad advice from the IRS .................................................................................. 907
Honest mistakes ...................................................................................................................... 907
Disputing assessed tax penalties ...................................................................................... 907
Taxpayer Advocate Helpline ....................................................... 909
IRS Directory ............................................................................... 910
The High-Risk Tax Audit Areas ................................................... 913
High Wages .............................................................................................................................. 913
Large Amounts of Itemized Deductions ........................................................................ 914
xxi

High DIF ..................................................................................................................................... 915


Unreported Taxable Income ............................................................................................... 915
Self Employment ..................................................................................................................... 916
Home Office Tax Deductions ............................................................................................. 916
Unreported Alimony.............................................................................................................. 916
Automobile Logs .................................................................................................................... 918
Self-defense Pays Off ............................................................................................................ 919
How to Prepare for an IRS Audit ................................................. 919
What is an Offer in Compromise? ............................................... 922
Spouse Relief .............................................................................. 925
Innocent Spouse Relief ......................................................................................................... 926
Separation of Liability Relief ............................................................................................... 927
Equitable Relief........................................................................................................................ 929
Questions and Answers About Applying for Relief .................................................... 932
Injured Spouse Relief .................................................................. 934
What are a taxpayers appeal rights? .......................................... 935
How does the Statute of Limitations affect tax collections? ......... 938
Statute of Limitations for Collecting Tax Already Assessed .................................... 939
Statute of Limitations on Taxpayers to Claim a Tax Refund ....... 941
What is the Taxpayer Bill of Rights? ........................................... 941
How does the Bankruptcy Code affect tax obligations? .............. 943
Lesson Summary ........................................................................ 944

Glossary ....................................................................................................... 948

xxii

H O W TO U S E O U R I N C O M E TA X C O U R S E
QUESTIONS, COMMENTS, AND NOTES:
Our course is intentionally designed with a wide left margin to allow space for your
questions, comments, and notes.
ICON AND COLOR KEY:
The following icon and color coding is used in our Side Bars and Tips:
ICON

TYPE

DESCRIPTION

TAX QUOTE

Tax Quotes appear in boxes with a lavender background.

SIDE BAR

Side Bars appear in boxes with a light yellow background.

TAX TIP
TAX PLANNING
TIP
TAX PRACTICE
TIP

Tax Tips appear in boxes with a light blue background.


Tax & Financial Planning Tips appear in boxes with a light
green background.
Tax Practice Tips appear in boxes with a light grey
background.

HOW TO COMPLETE YOUR STUDIES QUICKLY


If you are taking our course because you need to obtain your IRS Continuing Education
hours quickly to renew your PTIN; or you are starting a job at a tax preparation office and
you need to learn the material quickly before the tax season starts; you can skip reading the
Tax Quotes, Sidebars, Tax Tips, Tax Planning Tips and Tax Practice Tips. The information
discussed in them is not covered on the quizzes or final exam. You can return next summer
when you have more time and read them at that time.
However, if you are not in a hurry we strongly recommend that you read all of the above as
they will enhance your knowledge of the tax laws and expand your understanding of the
topics covered in this course.

xxiii

KEY TAX NUMBERS 2014


Adoption Credit
Child with special needs
Other adoptions, qualified expenses
Alternative Minimum Tax
Exemptions
Married Filing Jointly
Married Filing Separately
Single or Head of Household
Tax Rates
First $182,500 ($91,250 MFS) of AMTI
Over $182,500 of AMTI
Capital Gains (Long Term) and Qualifying Dividends Tax Rates
10% or 15% Tax Bracket

$13,190
Up to $13,190

$82,100
$41,050
$52,800
26%
28%
0%
15%
20%
25%
28%

More Than 15% But Less Than 39.6% Tax Bracket

39.6% Tax Bracket


Un-recaptured Section 1250 Gains
Capital Gains on Collectibles
Domestic Production Activities Deduction
Earned Income Tax Credit
Single, Head of Household, Qualifying Widow Maximum Earnings
No Children
$14,590
One Child
$38,511
Two Children
$43,756
Three Children
$46,997
Married Filing Jointly
No Children
$20,020
One Child
$43,941
Two Children
$49,186
Three Children
$52,427
Education
American Opportunity Credit
Coverdell ESA
Lifetime Learning Credit
Student Loan Interest Deduction
Tuition and Fees Deduction Tier 1
xxiv

9%
Maximum EITC
$496
$3,305
$5,460
$6,143
$496
$3,305
$5,460
$6,143
$2,500
$2,000
$2,000
$2,500
$4,000

Tuition and Fees Deduction Tier 2


Elective Deferrals Limits
401(k), 403(b), 457 plans
Salary Reduction SEP
Additional Contribution Age 50 or Older
SIMPLE IRA
Additional Contribution Age 50 or Older
Employer Provided Transportation Exclusion
Transit Passes and Commuter Vehicles
Qualified Parking
Qualified Bicycle Commuting
Exemptions
Personal and Dependent
Estate
Simple Trust
Complex Trust
Exemption and Itemized Deduction Phase-out's (beginning at)
Single
Married Filing Jointly or Qualifying Widow(er)
Married Filing Separately
Head of Household
Filing Requirements

$2,000
$17,500
$17,500
$5,500
$12,000
$2,500
$250 per month
$250 per month
$20 per month
$3,950
$600
$300
$100
$254,200
$305,050
$152,525
$279,650

THEN you
should file a
AND at the end of 2014
return if your
you were
gross income
was at least
Under 65
$10,150
65 or older
$11,700
Under 65 (both spouses)
$20,300
65 or older (one spouse)
$21,500
65 or older (both
$22,700
spouses)
Any age
$3,950
Under 65
$13,050
65 or older
$14,600
Under 65
$16,350
65 or older
$17,550

IF you're filing status is

Single

Married Filing Jointly


Married Filing Separately
Head of Household
Qualifying Widow(er)
xxv

Foreign Earned Income Exclusion

$99,200

Gift Tax
Exclusion
Spouse
Non-U.S. Citizen Spouse
Health Savings Accounts (HSAs)
Maximum Annual Contribution Limits
Self-Only Coverage
Family Coverage
Additional Over Age 55
Minimum Deductible
Self-Only Coverage
Family Coverage
Maximum Out of Pocket
Self-Only Coverage
Family Coverage
IRA Contributions
Traditional
Age 50 or Older
Roth
Age 50 or Older
Kiddie Tax
Age Limit
Unearned Income Limitation
Long Term Care Premiums (deductible)
Age 40 or Under
Age 41 to 50
Age 51 to 60
Age 61 to 70
Age 71 and Over
Medical Savings Accounts (MSAs)
Premium for High Deductible
Self Coverage
Family Coverage
Maximum Out of Pocket
Self Coverage
Family Coverage
Mileage Rates

$14,000
Unlimited
$145,000

$3,300
$6,550
$1,000
$1,250
$2,500
$6,350
$12,700
$5,500
$6,500
$5,500
$6,500
18
$2,000
$370
$700
$1,400
$3,720
$4,660

$2,200-$3,250
$4,350-$6,550
$4,350
$8,000
xxvi

Business
Medical and Moving
Charitable

$0.56
$0.235
$0.14

Section 179 Expense

$500,000

Social Security Payback


At full retirement age or older

No limit on earnings
$1 of benefits will be deducted for each $2
earned above $15,480
$1 of benefits will be deducted for each $3
earned above $41,400

Under full retirement age


In the year full retirement is reached
Social Security Wage Base
Social Security Wage Base
Maximum Social Security Tax
Standard Deductions

$117,000
$7,254
Base Amount
$6,200
$12,400
$6,200
$9,100
$12,400
$1,000 or Earned
Income + $350

Single
Married Filing Jointly
Married Filing Separately
Head of Household
Qualifying Widow(er)
Dependent of Another

xxvii

Add for Blind or > 65


$1,550
$1,200
$1,200
$1,550
$1,200
$1,200 or $1,550 if
Single or HOH

LESSON

OUR

FEDERAL

TAX

SYSTEM

Lesson

1
Lesson 1 - Our Federal Tax System
In this lesson you'll learn about the history of our federal tax system and how
it works today. The following topics are discussed in this lesson:
The Revolutionary War
Period
The Post-Revolutionary War
Period
The Civil War Period
The Post-Civil War Period
The 16th Amendment
The 1920s
The 1930s
The Social Security Act
The World War II Period

The Post-World War II Period


The 1960s
Medicare
The Economic Recovery Tax
Act of 1981
The Tax Reform Act of 1986
IRSRRA of 1998
EGTRRA of 2001
JGTRRA of 2003
The Modern Income Tax
What are the different types
of taxes?

he federal tax system in the United States has been marked by


significant changes over the years in response to the ever changing
role of the government. While the law itself is complex, the concept is
relatively simple. Income from all sources is taxed, unless specifically
exempted by the law.
The types and amounts of tax collected are completely different than they
were 200 years ago. Some of these changes are traceable to specific events,
such as a war, or the passage of the 16th Amendment which gave Congress
1

LESSON

OUR

FEDERAL

TAX

SYSTEM

the power to levy a tax on personal income. Other changes were more
gradual, responding to changes in society, the economy, and in the role of
the federal government. For most of our country's history, individuals rarely
had any contact with the federal government as most of the government's
tax revenues were derived from excise taxes, tariffs, and customs duties.
In 1765, the English Parliament needing funds to pay for its war against
France, passed the Stamp Act, the first tax imposed directly on the American
colonies. Colonists lacked representation in the English Parliament. This led
to the rallying cry of the American Revolution "taxation without
representation is tyranny" and established a persistent wariness regarding
taxation.
On December 16, 1773 a group of Americans disguised as Indians board a
ship and throw 342 chests filled with tea into Boston Harbor to protest
Englands tax on tea. The Boston Tea Party is perhaps the most famous
event in U.S. tax history.
Before the Revolutionary War, the federal government had only a limited
need for revenue, while each of the colonies had greater responsibilities and
revenue needs, which were met with different types of taxes. The south
taxed primarily imports and exports, the middle colonies imposed a
property tax and a "head" or poll tax levied on each adult male, and the
northern colonies taxed real estate, had excises taxes, and taxes based on
occupation.

The Revolutionary War Period


To pay the debts of the Revolutionary War, Congress levied excise taxes on
distilled spirits, tobacco and snuff, refined sugar, carriages, property sold at
auctions, and various legal documents.
The Articles of Confederation of 1781 reflected the American fear of a
strong federal government. The federal government had few responsibilities
and no tax. It relied solely on donations from the States. When the
Constitution was passed in 1789, it was recognized that no government
could function if it relied entirely on other governments for its resources.
Therefore, the federal government was granted the authority to raise taxes.
Article I, Section 8, Clause 1 of the U.S. Constitution states Congress shall
have the power to impose "Taxes, Duties, Imposts and Excises,". However
2

LESSON

OUR

FEDERAL

TAX

SYSTEM

Article I, Section 9 requires that, "No Capitation, or other direct, tax shall be
laid, unless in Proportion to the Census or enumeration herein before
directed to be taken." Therefore, any taxes imposed had to be uniform
throughout the United States. The Constitution limited Congress' ability to
impose direct taxes, by requiring it to distribute taxes in proportion to each
state's population.
The table below shows how long it took the average American to prepare
his or her tax return last year.

Average Time Burden (Hours)


Major
Form Filed PercentForm Compor Type of age of Total Record
Tax
letion &
All
Taxpayer Returns Time Keeping
Planning
Submission Other
All
Taxpayers 100%
13
6
2
4
1

Average
Cost
$200

Major forms filed:


1040

69%

16

$260

1040A

19%

$80

1040EZ

12%

$40

Type of Taxpayer:
Nonbusiness *
68%

$110

Business *

24

13

$410

32%

* Taxpayers are considered business filers if they file one or more of the following with
Form 1040: Schedule C, C-EZ, E, F, Form 2106 or 2106-EZ. Taxpayers are considered
nonbusiness filers if they did not file any of those schedules or forms with Form 1040 or
if they file Form 1040A or 1040EZ.
Source: Internal Revenue Service
Table: Time it takes to prepare return

Tax Quote

"It would be thought a hard government that should tax its people one
tenth part."
Benjamin Franklin (1706-1790) Founding Father of the United States

LESSON

OUR

FEDERAL

TAX

SYSTEM

The Post-Revolutionary War Period


After the Revolutionary War the citizens had representation, but many still
opposed taxes. From 1791 to 1802, the federal government was supported
by taxes on distilled spirits, carriages, refined sugar, tobacco and snuff,
property sold at auction, corporate bonds, and slaves. In 1794, farmers in
Pennsylvania opposed the tax on whiskey, forcing President Washington to
send federal troops to suppress the Whiskey Rebellion, and establishing the
important precedent that the federal government was determined to
enforce its revenue laws. On the other hand, The Whiskey Rebellion also
established that the resistance to taxes that led to the Declaration of
Independence and the Revolutionary War did not evaporate with the new
federal government.
To raise money for the War of 1812, Congress imposed additional excise
taxes, sales taxes on gold, silverware, jewelry, and watches, and raised
certain customs duties. Congress also raised money by issuing Treasury
notes. In 1817 Congress did away with those taxes, relying solely on tariffs
on imported goods, and for the next 44 years the federal government
collected no taxes.

Tax Quote

"Our Constitution is in actual operation; everything appears to promise that


it will last; but in this world nothing is certain but death and taxes."
Benjamin Franklin (1706-1790) Founding Father of the United States

The Civil War Period


The Revenue Act of 1861, the first U.S. personal income tax, was imposed on
August 5, 1861. This tax on personal income was a new direction for a
federal tax system. It was amended on July 1, 1862. It taxed 3% of all
incomes from $600 to $10,000 per year. The standard deduction was $600.
Individuals with an annual income of more than $10,000 paid a 5% tax rate.
This tax was the forerunner of our modern personal income tax as it was
based on the concepts of graduated taxation and "withholding at the
source" by employers. An "inheritance" tax also made its debut.
The Act of 1862 established the office of Commissioner of Internal Revenue.
The Commissioner was given the power to assess, levy, and collect taxes,
4

LESSON

OUR

FEDERAL

TAX

SYSTEM

and the right to enforce the tax laws through seizure of property and
through prosecution.
By 1866, tax collections had reached their highest point in history. The
federal government collected more than $310 million. In 1867, heeding
public opposition to the income tax, Congress cut the tax rate. The need for
federal revenue declined sharply after the war and the personal income tax
was abolished in 1872.

The Post-Civil War Period


With the passage of The Wilson Tariff Act in 1894 Congress revived the flat
rate federal income tax at a rate of 2%. The Bureau of Internal Revenue was
created with an income tax division. However, the Supreme Court ruled the
law unconstitutional in Pollock v. Farmers' Loan & Trust Co. the following
year. The Supreme Court ruled that taxes on rents from real estate, interest
income, dividend income, and from personal property were direct taxes on
property, and therefore had to be apportioned according to the population
of each state. Under the Constitution, Congress could impose direct taxes
only if they were levied in proportion to each State's population. Thus, a
federal income tax was impractical from the time of the Pollock decision
until ratification of the Sixteenth Amendment in 1913. What seemed to be a
straightforward limitation in the Constitution on the power of the Congress
proved inexact and unclear when applied to an income tax. The Bureau of
Internal Revenues income tax division was closed.
From 1896 until 1910 the Federal government relied heavily on high tariffs
for its revenues. The War Revenue Act of 1899 raised funds for the SpanishAmerican War through the sale of bonds, taxes on recreational facilities, and
it doubled the tax on beer and tobacco. The War Revenue Act expired in
1902. From 1868 to 1913, 90% of all revenue was collected from excise
taxes on liquor, beer, wine and tobacco.
In 1909 the Payne-Aldrich Tariff Act enacted an income tax on the privilege
of conducting business as a corporation. It was affirmed by the Supreme
Court in Flint v. Stone Tracy Co. Sometuimes referred to as the Corporate
Income Tax Act of 1909, it was the United States's first corporate income tax
law. It layed the ground work for the 16th Ammendment - the individual
income tax.

LESSON

OUR

FEDERAL

TAX

SYSTEM

The table below shows how long Americans work each year to pay their
taxes:
Number of Days Per
Year Spent Working

All Taxes as a

Year

to Pay Taxes

Percentage of Income

1900

22

5.9%

1910

19

5.0%

1920

44

12.0%

1930

43

11.7%

1940

55

17.9%

1950

91

24.6%

1960

102

27.7%

1970

110

29.6%

1980

112

30.7%

1990

113

30.8%

1997

119

32.5%

1998

122

33.2%

1999

122

33.3%

2000

125

34.0%

2001

121

33.0%

2002

111

30.3%

2003

108

29.5%

2004

109

29.7%

2005

116

31.5%

2006

118

32.3%

2007

120

32.7%

2008

113

30.8%

2009

103

28.2%

2010

99

26.9%

2011

102

27.7%

2012

107

29.2%

Source: www.taxfoundation.org
Table: Total Effective Tax Rates

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The 16th Amendment


In 1909 President Taft recommended that Congress propose a
constitutional amendment that would give the government the power to
tax incomes without apportioning the burden among the states
populations.
The 16th amendment was ratified by Wyoming on February 3, 1913,
providing the three-quarter majority of states necessary to amend the
Constitution. It allowed the Federal government to tax the income of
individuals without regard to the population of each State. The 16th
Amendment states "The Congress shall have power to lay and collect taxes
on incomes, from whatever source derived, without apportionment among
the several States, and without regard to any census or enumeration". It
made the income tax a permanent fixture in the U.S. tax system and
resulted in a revenue law that taxed incomes of both individuals and
corporations.
On October 3, 1913 President Woodrow Wilson signed into law the
Revenue Act of 1913, also known as the Tariff Act of 1913. Congress levied a
1% tax on net personal incomes above $3,000 - rising to 6% on incomes of
more than $500,000.
Less than 1% of the population was subject to the income tax in 1913. At
that time the average annual wage for a worker in the U.S. was under
$1,300, so only the wealthy had to file a tax return. The $3,000 filing
threshold in 1913, when adjusted for inflation, is the equivalent of about
$69,573 in todays dollars. The income tax only applied to 358,000 highincome taxpayers. By 1944 that number grew to 47.1 million, and today it
stands at nearly 150 million.
The Revenue Act of 1913 also lowered basic tariff rates from 40% to 25%,
the lowest rates since the Walker Tariff of 1857.
In 1913 the first Form 1040 appeared as the standard tax reporting form,
and March 1st was the date specified as the filing deadline. The 1 page of
instructions for Form 1040 has since grown to 189 pages.
Payment was not sent with the first Form(s) 1040. The return was verified by
a field agent who then sent out tax bills on June 1st with payment due by
June 30th. See the top of the first Form 1040 below.
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Figure 1-0: Form 1040 page 1, circa 1913.

To view the entire 1913 Form 1040 see Appendix A or click here.
Before the income tax most citizens were able to pursue their financial
affairs without any knowledge by the federal government. Individuals

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earned their money and wealth was accumulated and dispensed with little
or no interaction with the federal government.

Side Bar

How does a Bill become a Tax Law?


The U.S. Constitution specifically spells out how Congress must consider
and adopt tax legislation.
Most tax legislation begins with the president who consults with his
financial advisors and Treasury Department officials before sending a
plan to Congress. He can do this at any time, but he usually does it
shortly after the State of the Union address.
All tax legislation must originate in the House Committee on Ways and
Means. The panel which consists of the most senior and powerful
members of the House, holds hearings, makes changes, and forwards the
bill to the full House.
The bill that the House of Representatives gets from the Committee on
Ways and Means is then drafted into legislation and is accompanied by a
detailed report that gives the Committee's reasons for recommending
the bill. The IRS and the courts may later use this Committee report as an
interpretation of the legislation. If the House approves the bill it is sent to
the Senate Finance Committee.
The Senate Finance Committee is responsible for all Senate legislation
dealing with tax matters. They hold hearings and usually make changes
before sending the bill to the full Senate.
The Senate debates the bill and usually makes additional changes before
holding a vote before the full Senate. If the Senate approves an
unchanged version of the bill it received from the House, the bill goes to
the White House for the president's signature.
If the Senate makes changes in the bill it received from the House, it goes
to a conference committee whose members are appointed by the
Speaker of the House and the President of the Senate. This committee
combines the two versions into compromise legislation. The compromise
bill goes back to the full House and the full Senate, which each must
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approve the same version of the bill.


Once Congress votes, the bill goes to the President for his signature.

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SIDE BAR

What is the Federal Reserve and what does it do?


In 1791 the U.S. Government chartered the first Bank of the United States to
act as the U.S. central bank for 20 years. In 1811 Congress declined to renew
its charter as it was believed to be unnecessary. In 1816 the second Bank of
the United States was chartered for 20 years. In 1836 Congress declined to
renew its charter as it was also believed to be unnecessary.
The Panic of 1907 was started by a failed attempt to corner the stock of
United Copper. Subsequent bank and brokerage failures only halted when
J.P. Morgan convinced other trust company presidents to provide backing to
the Trust Company of America.
The Federal Reserve System (Federal Reserve) is the central bank of the
United States. It was created in 1913 with the enactment of the Federal
Reserve Act in response to a series of financial panics, especially the financial
Panic of 1907.
In the Federal Reserve Act Congress established three key objectives for
monetary policy - maximum employment, stable prices, and moderate longterm interest rates. The first two objectives are sometimes referred to as the
Federal Reserve's dual mandate.
The Federal Reserves duties include administering the nation's monetary
policy, supervising and regulating banks, maintaining a stable financial
system and providing banking and monetary services to depository
institutions, the U.S. government, and foreign institutions.

The United States entry into World War I greatly increased the need for
revenue. One problem with the income tax law was how to define
"lawful" income. Congress responded by passing the 1916 Revenue Act.
It deleted the word "lawful" from the definition of income.
Consequently, all income, regardless of how it was obtained, became
subject to tax. The Supreme Court would subsequently rule the Fifth
Amendment could not be used by bootleggers and others who earned
income through illegal activities to avoid paying income taxes. As a
result, many who broke various laws and were able to escape
prosecution for those crimes were convicted on tax evasion charges.

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The 1916 Act raised the lowest tax rate from 1% to 2% and raised the top
rate to 15% on taxpayers with incomes in excess of $1.5 million. The 1916
Act also imposed taxes on estates and excess business profits.
The income tax fundamentally changed the relationship between the
citizens and the federal government by giving the federal government the
right and the need to know all about an individuals or business's financial
life. Consequently, in 1916 Congress required that information from income
tax returns be kept confidential.
Needing still more tax revenue, the War Revenue Act of 1917 lowered
exemptions and greatly increased income tax rates. Tax revenues increased
from $809 million in 1917 to $3.6 billion in 1918.
The Revenue Act of 1918, passed to raise even greater sums for the World
War I effort, increased income tax rates once again, this time raising the
lowest rate to 6%. The top rate of income tax rose to 77%. The Revenue Act
of 1918 codified all existing tax laws and pushed the filing deadline forward
to March 15th where it remained until 1954 when it was moved ahead to
April 15th. In 1918, 5% of the U.S. population paid income taxes, as
compared to just 1% five years earlier. By 1939 that number would rise to
6%, and six years later by the end of World War II it would stand at 75%.
Today the federal income tax affects 90% of all Americans.

The 1920s
The Prohibition Unit was established to enforce the National Prohibition Act
of 1919, commonly known as the Volstead Act, which, under the 18th
Amendment to the Constitution prohibited the manufacture, sale, and
transportation of alcoholic beverages. When it was first established in 1920,
the Prohibition Unit was a division of the Bureau of Internal Revenue. On
April 1, 1927 it became an independent entity within the Department of the
Treasury, changing its name from the Prohibition Unit to the Bureau of
Prohibition.
The tax rates dropped sharply after World War I. During the 1920s, with a
booming economy, Congress cut taxes five times returning the lowest tax
rate to 1% and lowering the highest rate to 25%. As tax rates and tax
collections declined, the economy got even stronger.

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On a cold wintry morning in February, 1929


two cars; a Cadillac sedan and a Peerless,
both outfitted to look like Chicago Police
detective sedans, pulled up to the SMC
Cartage Company garage at 2122 North
Clark Street in the Lincoln Park
neighborhood on Chicago's North Side that
served as the headquarters of Bugs Morans
North Side Gang. Four gunmen, two
disguised as police officers and toting
Thompson submachine guns, killed seven
men in a storm of seventy machine-gun Figure 1-1: George "Bugs" Moran
bullets and two shotgun shells.
To show by-standers that everything was under control, the two men in
street clothes were "arrested" and came out with their hands up, led by the
two phony uniformed cops.
Al Capone, the Chicago gangster, had orchestrated the most notorious
gangland killing of the 20th century - the St. Valentine's Day Massacre. The
massacre was Capone's effort to dispose of Bugs Moran, who, as it turned
out, wasnt in the garage at the time. Moran, spotting the police cars
outside, had decided to keep walking. No one was ever arrested for the
crime.
The economy grew steadily during most of the 1920s. It was a golden age
as innovations such as radio, automobiles, aviation, and the telephone
became popular. On August 24, 1921, the Dow Jones Industrial Average
stood at 63.9. By September 3, 1929 it had risen more than six fold to 381.2.
During the summer of 1929 it became clear that the economy was
contracting and that the stock market would soon go through a series of
unsettling price declines.
When the New York Stock Exchange opened on the morning of October 24,
1929, nervous traders sensed something was wrong. By 11:00 AM the
market was plunging. At noon a group of powerful bankers met secretly at
J.P. Morgan & Co., next door to the New York Stock Exchange, and agreed
to spend $240 million of their own funds to stabilize the stock market.

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This strategy worked for a few days but the panic broke out again the
following Tuesday, October 29, 1929, and there was no stopping it. The
stock market crashed. Within three months the stock market lost 40% of its
value. $26 billion of wealth disappeared. AT&T lost one-third of its value.
General Electric lost one-half of its value. RCA's stock fell by three-quarters
within a matter of months. It would take 25 years for the stock market to
return to its pre-crash level.
The Great Depression began and over the next few years:

Unemployment exceeded 25%


10,000 banks failed
The Gross National Product
declined from $105 billion in 1929
to $55 billion in 1933
Compared to 1920's levels, net new
business investment was minus $5.8
billion in 1932
Wages paid to workers declined
from $50 billion in 1929 to $30
billion in 1932

Figure 1-2: Chart of the US Gross


National Product from 1926 to 1934.

As the economy shrank, government tax receipts also fell dramatically.

Side Bar

How do taxes affect the economy?


Seventy-two percent of our economy is based on consumer spending.
Raising taxes takes money from consumers and dampens the economy,
because consumers have less money to spend. This results in less retail
and home sales and lower investment and savings rates. However, raising
taxes can increase public-sector jobs, provided the increased revenues
are spent that way. It also helps decrease government debts which
dampen the economy. During wartime government spending is much
higher and it boosts all phases of the economy.
Lowering taxes puts extra money in consumers' pockets. Consumers can
then spend this money, boosting retail and home sales and investment
and savings rates. However, the extent of this boost depends on how
large the tax cut is, and which taxes are cut. Cuts for middle-income and
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low-income people tend to put more money into the economy because
these taxpayers are more likely to spend their extra cash right away, on
purchases or renovations they have been putting off. Cuts for highincome taxpayers tend not to have the same effect, because this group
already has enough money to buy everything they need. High-income
taxpayers tend to save their extra money, so cuts for these taxpayers end
up being used for investments and savings. Cuts for high-income
taxpayers improve the outlook on Wall Street. Cuts in corporate and
business taxes give businesses more money to spend, often creating jobs
and boosting the bottom line.
In 1932, the federal government collected only $1.9 billion in taxes,
compared to $6.6 billion in taxes in 1920. In the face of rising budget
deficits which reached $2.7 billion in 1931, Congress followed the prevailing
economic wisdom of the time and passed the Tax Act of 1932 which
dramatically increased tax rates. This further improved the government's
finances while further weakening the economy. In retrospect, Congress
should have lowered tax rates instead of raising them. By 1936 the lowest
personal income tax rate had risen to 4% and the highest tax rate had risen
to 79%.

Side Bar

How does the federal budget process work?


On or before the first Monday in February of each year, the President is
required by law to submit to the Congress a budget proposal for the
fiscal year that begins the following October. The budget plan sets forth
the Presidents proposed receipts, spending, and the surplus or deficit for
the Federal Government. The plan includes recommendations for new
legislation as well as recommendations to change, eliminate, and add
programs. After receiving the Presidents proposal, the Congress reviews
it and makes changes. It first passes a budget resolution setting its own
targets for receipts, outlays, and the surplus or deficit. Next, individual
spending and revenue bills that are consistent with the goals of the
budget resolution are enacted.

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Flowchart: Federal Income and Expenses

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Side Bar

Herbert Hoover Presidential Library and Museum


Further information about The Great Depression is available in Gallery Six
of the Herbert Hoover Presidential Library and Museum.

The 1930s
During a routine warehouse raid in Chicago
in 1931 by the Treasury Departments
Bureau of Prohibition, agents Eliot Ness and
The Untouchables discovered what was
clearly a crudely coded set of accounts in a
desk drawer. They, and Frank Wilson, an
undercover agent in the Bureau of Internal
Revenues
Intelligence
Unit,
then
concentrated on gathering evidence and
pursuing Public Enemy No. 1, Al Capone, for
Figure 1-3: Alphonse Gabriel
his failure to pay income tax on this
Capone a.k.a. "Scarface Al"
substantial illegal income.
Capone had always done his business through front men and it was
previously believed he had no books or accounting records in his own
name. Even his mansion was in his wife's name.
Capone was tried in federal court in 1931. Capone was found guilty on five
of 22 counts of tax evasion for the years 1925, 1926, and 1927, and willful
failure to file tax returns for 1928 and 1929. Capone's legal team offered to
pay all outstanding income taxes plus interest and told their client to expect
a severe fine. On October 17, 1931 the judge sentenced Capone to eleven
years in a federal prison and one year in the county jail, as well as an earlier
six-month contempt of court sentence. He ultimately served only six and a
half years because of time off for good behavior. He also had to pay fines
and court costs totaling $80,000. Capones isolation from his associates and
the repeal of Prohibition ended his criminal career.

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Other notable tax evaders:

On October 10, 1973, Spiro T. Agnew, the 39th Vice President of the
United States, resigned and then pleaded nolo contendere (no
contest) to criminal charges of tax evasion and money laundering;

Soviet spy Aldrich Ames earned more than $2 million for his
espionage and was also charged with tax evasion as none of the
money was reported on his income tax returns. Ames attempted to
have the tax evasion charge dismissed on the grounds his espionage
profits were illegal, but the charges stood. The $2 million remains to
this day in an undisclosed bank account. Russian intelligence has
refused to disclose this bank account information in order for the
United States to seize it, arguing that that money was rightfully
earned by Ames;

Leona Helmsley the billionaire New York City hotel operator and real
estate investor nicknamed "The Queen of Mean." She was convicted
of federal income tax evasion in 1989 and served 19 months in
prison, after receiving an initial sentence of 16 years;

Irwin A. Schiff, a prominent member of the group which refers to


itself as the tax honesty movement, and which has been referred to
by the Internal Revenue Service and other government agencies as
the tax protester movement. Schiff is known for writing and
promoting literature that claims the United States income tax is
applied incorrectly. He has lost several civil cases against the federal
government and has a record of multiple convictions for various
federal tax crimes. Schiff is serving a 13-plus year sentence for tax
crimes as Inmate #08537-014 at the Federal Correctional Institution
at Fort Worth, Texas. His projected release date is July 26, 2017.

Side Bar

Who was J.K. Lasser?


Jacob Kay Lasser was born in Newark, NJ in 1896. He took night classes in
accounting at New York University from 1915-1917 and became a
Certified Public Accountant practicing in New York City in 1923. In 1938
the publishing house Simon & Schuster commissioned him to author an
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income tax guide. Its first publication in 1939 sold 23,000 copies and hit
the best sellers list. Mr. Lasser became an adjunct professor at New York
University in 1942 and served as the Institute on Taxations chairman until
his death. Mr. Lasser revised the tax guide each year and by 1946 seven
million copies were sold. His books on taxation were used as texts in
more than 160 colleges and universities. He died from a heart attack at
the age of 57 in 1954. His best selling tax guide, J.K. Lassers Your Income
Tax is in its 76th year of continuous publication and today is published by
John Wiley & Sons, Inc.
We strongly recommend that you purchase a copy of J.K. Lassers Your
Income Tax each year. You can do so from Lesson 30 on the Homework
Page. The Tax College is not affiliated with the J.K. Lasser Institute.

Tax Quote

"Anyone may arrange his affairs so that his taxes shall be as low as
possible; he is not bound to choose that pattern which best pays the
treasury. There is not even a patriotic duty to increase one's taxes. Over and
over again the Courts have said that there is nothing sinister in so
arranging affairs as to keep taxes as low as possible. Everyone does it, rich
and poor alike and all do right, for nobody owes any public duty to pay
more than the law demands."
Judge Learned Hand - (1872-1961), Judge, U. S. Court of Appeals for the
2nd Circuit Gregory v. Helvering 69 F.2d 809, 810 (2d Cir. 1934), aff'd, 293
U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935)
The Social Security Act
In 1935 Congress passed the Social Security Act.
President Franklin D. Roosevelt signed the program
into law on Aug. 14, 1935. This law provides
payments to the aged, the needy, the handicapped,
and to certain minors. These programs were initially
financed by a 2% tax, one-half of which was
withheld directly from an employee's paycheck and
one-half of which was collected from employers.
The tax was levied on the first $3,000 of the
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employee's salary or wages.

Figure 1-4: Ernest Ackerman

Under the original 1935 law,


monthly benefits were to start in
1942 (which was subsequently
changed to 1940). From 1937 until
1940, Social Security paid benefits to
retirees in the form of a single,
lump-sum refund payment. The
earliest reported applicant for a
lump-sum refund was a retired
Cleveland motorman named Ernest
Ackerman, who retired one day after
the Social Security program began.

During his one day of participation in the program, a nickel was withheld
from Mr. Ackermans pay for Social Security, and, upon retiring, he received
a lump-sum payment of 17 cents. The average lump-sum payment during
this period was $58.06. The smallest payment ever made was for 5 cents.
Ida May Fuller of Ludlow, Vermont filed her retirement claim on November
4, 1939. While running an errand she dropped by the Rutland, VT Social
Security office to ask about possible benefits. She would later say: "It wasn't
that I expected anything, mind you, but I knew I'd been paying for
something called Social Security and I wanted to ask the people in Rutland
about it."
Her claim was taken by Claims Clerk Elizabeth Corcoran Burke and
transmitted to the Claims Division in Washington, D.C. for adjudication. The
case was reviewed and sent to the Treasury Department for payment. In
those days claims were grouped in batches of 1,000 and a Certification List
for each batch was sent to the Treasury Department. Miss Fuller's claim was
the first one on the first Certification List.

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On January 31, 1940, Ida May Fuller popped


open her mailbox and found Social Security
check number 00-000-001 payable to her in
the amount of $22.54. Though hardly a
fortune, the check was nonetheless a
milestone: it was the first monthly
retirement payment made under the Social
Security Act.
Ida May Fuller had worked for three years
under the Social Security program.

Figure 1-5: Ida May Fuller

The accumulated taxes on her salary during those three years were a total of
$24.75. Her initial monthly check was $22.54. She didnt do too badly under
Social Security - during her remaining thirty-five years she collected a total
of $22,888.92 in Social Security benefits nearly 1,000 times more than she
contributed. Miss Fuller lived to be 100 years old, dying in 1975.
Soon after it was passed in 1935, Social Security morphed from a fully
funded pension system into a pay-as-you-go system where every
generation (except for Ernests and Ida Mays) pays into the system to
support the currently-retired generation and relies on the next generation
to pay its Social Security benefits.
When Ida May Fuller retired, 40 workers were paying taxes to support each
Social Security recipient. In 1960, there were 4.9 workers paying Social
Security taxes for each person receiving benefits. Today, there are 2.8
workers for each beneficiary, a ratio that will drop to 1.9 workers by 2035,
according to projections by the Congressional Budget Office.
In 1940, when the Social Security Administration mailed Ida May Fuller the
first monthly retirement payment, the retirement age was 65. At that time,
workers who survived to age 65 had a remaining life expectancy of 12.7
years for men and 14.7 years for women. By 2011, life expectancy at age 65
was 18.7 years for men and 20.7 years for women, an increase of six full
years for both. In 20 more years, life expectancy at age 65 for men is
expected to be more than 20 years and more than 22 years for women.
In 1940, 220,000 people received Social Security benefits, out of a total
population of 132 million. At that time, .1666 percent of the total population
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received benefits. In 2012, 57 million people received Social Security


benefits, out of a total population of 315 million. Today, about 18 percent of
the total population receive benefits. These figures dont include some 8.3
million people who receive payments under Supplemental Security Income,
a program aimed primarily at the blind and disabled that launched in the
1970s.

Side Bar

Fast Facts & Figures About Social Security


Fast Facts & Figures About Social Security answers the most frequently
asked questions about the programs the Social Security Administration
administers. To get your copy click here.
In 1939, Congress again codified the income tax laws and all subsequent tax
legislation until 1954 amended the 1939 tax code.

The World War II Period


The Revenue Act of 1942 was hailed by President Franklin Roosevelt as "the
greatest tax bill in American history". It increased taxes and the number of
Americans subject to the income tax, created deductions for medical
expenses and investment expenses, and reduced the personal exemption
amount from $1,500 to $1,200 for married couples. The exemption amount
for each dependent was reduced from $400 to $350 and a 5% Victory tax
on all individuals with incomes over $624 was created, with postwar credit.
The top tax rate reached 94% during the World War II and remained at 91%
until 1964.
In 1943 Congress re-introduced payroll withholding, as had been done
during the Civil War, with the Current Tax Payment Act. This greatly eased
the collection of the tax for the Bureau of Internal Revenue. It also greatly
reduced the taxpayer's awareness of the income tax by increasing its
transparency, which made it easier to raise taxes in the future.

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Figure 1-6: Form W-2 - Statement of Income Tax Withheld on Wages, circa 1943. Payroll
withholdings are reported to the employee and the IRS on Form W-2.

Tax withholding was also introduced in the Tariff Act of 1913, but repealed
by the Income Tax Act of 1916. The Current Tax Payment Act required
employers to withhold taxes from employees' wages and pay them directly
to the government on the workers' behalf quarterly.
In 1944 Congress passed the Individual Income Tax Act, which created the
standard deductions on Form 1040, raised individual income tax rates, and
repealed the Victory Tax. It standardized the value of personal exemptions
at $500 per person. There were about 60 million taxpayers.

The Post-World War II Period


President Eisenhower reorganized the Bureau of Internal Revenue in 1953
and replaced its patronage system with career, professional employees. The
IRS commissioner and chief counsel are selected by the president and
confirmed by the Senate. The Bureaus name was changed to the Internal
Revenue Service to stress the "service" aspect of its work.
On August 16, 1954 the Internal Revenue Code of 1954 was enacted by
Congress, succeeding the Internal Revenue Code of 1939. The Code
temporarily extended the Revenue Act of 1951's 5% increase in corporate
tax rates through March 31, 1955, increased depreciation deductions by
providing additional depreciation schedules, and created a 4% dividend tax
credit for individuals. References to the Internal Revenue Code subsequent
to 1954 generally mean Title 26 of the United States Code, as amended. The
basic structure of Title 26 remained the same until the enactment of the
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comprehensive revisions contained in Tax Reform Act of 1986, although


individual provisions of the law were changed regularly.
The Social Security system remained basically unchanged until 1956. In 1956
Social Security began an evolution and more and more benefits were
added, beginning with Disability Insurance benefits. In 1958, benefits were
extended to dependents of disabled workers. In 1967, disability benefits
were extended to widows and widowers.
By 1959, the IRS had become the world's largest accounting, collection, and
forms processing organization. Computers were introduced to automate
and streamline its work and to improve service to taxpayers. In 1961,
Congress passed a law requiring individual taxpayers to use their Social
Security numbers on tax forms.

The 1960s
The Revenue Act of 1964 was signed by President Lyndon Johnson on
February 26th, 1964. It reduced individual income tax rates from 91% to
70%, and reduced the top corporate rate from 52% to 48%. A minimum
standard deduction of $300 plus $100 per exemption was created.

Side Bar

Does raising income tax rates increase revenues to the federal


government?
Although conventional wisdom holds that increasing income tax rates or
eliminating deductions for wealthier Americans will generate greater
revenue for the U.S. Treasury, history shows otherwise.
The Dow Jones Industrial Average dropped by about half, from 119 in
November 1919 to 64 in August 1921. Double digit unemployment
ensued. The federal government made it clear it would not intervene
except to raise interest rates, cut taxes and reduce the size of the
government. The economy recovered so quickly that the stock market
crash of of 1919 is largely forgotten.
During the 1920's Presidents Warren Harding and Calvin Coolidge cut the
top marginal income tax rates from 77% to 25% only to see federal
revenues rise dramatically as the economy grew increasingly stronger.
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The rich, who at that time were earning more than $50,000 per year, went
from paying 44% of total income tax revenues to paying 78.4%.
On December 14, 1962 the 35th President of the United States, John F.
Kennedy delivered a speech to the Economic Club of New York in which
he stated: It is increasingly clear that... an economy hampered by
restrictive tax rates will never produce enough revenues to balance our
budget just as it will never produce enough jobs or enough profits... In
short, it is a paradoxical truth that tax rates are too high today and tax
revenues are too low and the soundest way to raise the revenues in the
long run is to cut the rates now. After Presidents Kennedy and Lyndon
Johnson slashed the capital gains tax and cut the top marginal tax rate
from 91% to 70% federal tax revenues rose from $91 billion in 1960 to
$153 billion in 1968. During those years the rich saw their total share of
revenues increase by 57% while the poor's share increased by just 11%.
During President Ronald Reagan's term in office (1981-1989) he cut taxes
but doubled revenue, and decreased unemployment from 7% to 5.4%
and inflation from 13.5% to 4.1%. In the Reagan years, the top 1% of
earners paid 57.2% of taxes, up from 48%.

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The table below shows how much money the federal government
collects each year in taxes:

Year
1960
1970
1980
1990
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

Total Tax
Collections
$91,774,803,000
$195,722,096,000
$519,375,273,000
$1,056,365,652,000
$2,096,916,925,000
$2,128,831,182,000
$2,016,627,269,000
$1,952,928,045,000
$2,018,502,103,000
$2,268,895,122,000
$2,518,680,230,000
$2,691,537,557,000
$2,745,035,410,000
$2,345,337,177,000
$2,345,055,978,000
$2,414,952,112,000
$2,524,320,134,000
$2,855,059,420,000
$3,064,301,358,000

%
Increase
113%
165%
103%
99%
2%
-5%
-3%
3%
12%
11%
7%
2%
-15%
0%
3%
5%
13%
7%

Total Individual
Individual
Income Tax
%
Tax % of
Collections
Increase
Total
$44,945,711,000
48.97%
$103,651,585,000
131%
52.96%
$287,547,782,000
177%
55.36%
$540,228,408,000
88%
51.14%
$1,137,077,702,000
110%
54.23%
$1,178,209,880,000
4%
55.35%
$1,037,733,908,000
-12%
51.46%
$987,208,878,000
-5%
50.55%
$990,248,760,000
0%
49.06%
$1,107,500,994,000
12%
48.81%
$1,236,259,371,000
12%
49.08%
$1,366,241,437,000
11%
50.76%
$1,425,990,183,000
4%
51.95%
$1,190,382,757,000
-17%
50.76%
$1,175,989,528,000
-1%
50.15%
$1,346,182,227,000
14%
55.74%
$2,172,233,368,000
61%
86.05%
$2,462,201,645,000
13%
86.24%
$2,575,871,018,000
5%
84.06%

Table: Internal Revenue Gross Collections

Medicare
In 1965 Congress enacted the Medicare program which provides for the
medical needs of persons aged 65 or older. Social Security Amendments
created the Medicaid program which provides medical assistance for
people with low incomes and resources. The expansions of Social
Security and the creation of Medicare and Medicaid required additional
tax revenues. In 1972 benefits were indexed for the cost of living. In
1949 the FICA payroll tax rate was 2%. The expansions in 1965 led to
further rate increases, with the combined payroll tax rate climbing to
15.3 % by 1990. The maximum Social Security tax burden rose from $60
in 1949 to $7,849 by 1990.

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The Economic Recovery Tax Act of 1981


In the late 1960s and through the 1970s there was persistent and rising
inflation, ultimately reaching 13.3% in 1979. During this time, the income tax
was not indexed for inflation. Despite repeated tax cuts, the tax burden of
the citizens rose. The Economic Recovery Tax Act of 1981, which enjoyed
strong bi-partisan support in Congress, was passed on August 4, 1981 and
was signed into law by President Ronald Regan on August 13, 1981. It was
the largest tax cut in U.S. history. It amended the Internal Revenue Code of
1954 to encourage economic growth through reductions in individual
income tax rates, first year expensing of depreciable property, incentives for
small businesses, and incentives for savings. The Accelerated Cost Recovery
System was implemented for depreciation. The Act reduced the income tax
rates by approximately 25% over three years with the top rate falling from
70% to 50% and the bottom rate falling to 11%. The rates were indexed for
inflation, although indexing was delayed until 1985, and a 10% Investment
Tax Credit was implemented to spur capital formation. The tax cuts resulted
in deficits in the federal budget in the 1980s and early 1990s, but also
created an economic expansion.
The Tax Reform Act of 1984 tries to plug loopholes and ensure that all
taxpayers pay a fair share of the tax burden. It also reforms taxation of
international income, and tries to improve the administration and efficiency
of the tax system.

The Tax Reform Act of 1986


The Congress passed the Tax Reform Act of 1986 on October 22, 1986.
President Reagan signed the most significant piece of tax legislation in 30
years. It contained 300 provisions and took three years to implement. The
Act codified the federal tax laws for the third time since the Revenue Act of
1918. It simplified the income tax code, broadened the tax base and
eliminated many tax shelters and other preferences. The top tax rate was
lowered from 50% to 28%, the lowest it had been since 1916, while the
bottom rate was raised from 11% to 15% - the only time in history that the
top rate was reduced and the bottom rate increased concurrently. 15% and
28% became the only two income tax brackets. The capital gains tax rate
was the same as for ordinary income. Interest on consumer loans and state
and local sales tax were no longer deductible. Income averaging, which
reduced taxes for those only recently making a much higher income than
before, was eliminated. The Act increased the personal exemption and the
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standard deduction. Deductions for passive activities were limited to


remove the tax benefits of many tax shelters, especially for real estate
investments. Also in 1986, limited electronic filing began.

Flowchart: Number of Days Worked

Tax Quote

"Government is saying to the average citizen every January 1: 'For the next
five months youll be working for us, for goals we shall determine. Is that
clear? After May 5 you may look after your own needs and ambitions, but
report back to us next January. Now move along.'
If nearly half of what you make is spent by someone else, that means that
half your work time is spent working for someone else. Call me a radical,
but I think that comes dangerously close to being a form of indentured
servitude."
Richard "Dick" Armey (1940 - ) House Majority Leader (1995-2003)

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The Internal Revenue Service


Restructuring and Reform Act of 1998
The Internal Revenue Service Restructuring and Reform Act of 1998 resulted
from hearings held by the Congress in 1996 and 1997. It prompted the
most comprehensive reorganization and modernization of IRS in nearly half
a century. The Act, which expanded taxpayer rights and called for
reorganizing the agency into four operating divisions aligned according to
taxpayer needs, included numerous amendments to the Internal Revenue
Code of 1986. It provides that individuals who fail to provide their taxpayer
identification numbers are not allowed to take the earned income credit for
the year in which the failure occurs and that individuals are allowed to
deduct interest expense paid on certain student loans. The Taxpayer Bill of
Rights III was enacted on July 22, 1998 as title III of the Act. It established a
Taxpayer Advocate Service as an independent voice inside the IRS.
During the 1990s the top income tax rate rose again, standing at 39.6% by
the end of the decade. In 2000 the IRS ended its geographic based structure
and implemented the four major operating divisions required by the
Restructuring and Reform Act of 1998: Wage and Investment, Small
Business/Self-Employed, Large and Mid-Size Business, and Tax Exempt and
Government Entities.

The Economic Growth and Tax Relief


Reconciliation Act of 2001
The top income tax rate was cut to 35% and the bottom rate was cut to
10% by the Economic Growth and Tax Relief Reconciliation Act of 2001
(EGTRRA). EGTRRA made significant changes in several areas of the Internal
Revenue Code, including income tax rates, estate and gift tax exclusions,
and qualified and retirement plan rules for Individual retirement accounts,
401(k) plans, 403(b), and pension plans. Many of the tax reductions in
EGTRRA were designed to be phased in over a period of up to 9 years.
One of the most notable characteristics of EGTRRA is that its provisions are
designed to sunset, or revert to the provisions that were in effect before it
was passed. EGTRRA will sunset on January 1, 2011 unless further legislation
is enacted to make its changes permanent.

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EGTRRA brought to prominence a lesser known provision of the Internal


Revenue Code, the Alternative Minimum Tax (AMT). It is an alternate system
of calculating a taxpayer's liability that removes many so called "tax
preference items". The applicable AMT rates were not adjusted in step with
the lowered rates of EGTRRA and the 2003 act, causing many more people
to face higher taxes because of the AMT than had originally been planned.
The AMT was originally designed as a way of making sure that wealthy
taxpayers could not take advantage of "too many" tax incentives and reduce
their tax obligation by too much. When it was introduced in 1969 it was
intended to target 155 high-income households that had been eligible for
so many tax benefits that they owed little or no income tax. In 1970, 20,000
taxpayers owed AMT. In 2006, 3.5 million taxpayers owed AMT, because of a
temporarily higher exemption, which expires at the end of the year. In 2007,
unless Congress acts, 23.4 million taxpayers will owe AMT. If the 2001-2006
tax cuts expire as scheduled at the end of 2010, 39 million taxpayers, more
than one-third of all taxpayers, will be hit with the AMT in 2017. If the tax
cuts are extended, that number jumps to 53 million taxpayers, about half of
all taxpayers.
EGTRRA changed the rate of tax on dividend income starting in 2003 to
5% for those in the 0% or 15% brackets, falling to 0% in 2008. It was
lowered to 15% for all other brackets. The capital gains tax on qualified
gains of property or stock held for five years was reduced from 10% to
8%.

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The table below shows the current federal income tax brackets:
2001

(1)

Rebate

15.0%

27.5%

30.5%

35.5%

39.1%

2002

10.0%

15.0%

27.0%

30.0%

35.0%

38.6%

2003-12

10.0%

15.0%

25.0%

28.0%

33.0%

35.0%

2013+

10.0%

15.0%

25.0%

28.0%

33.0%

35.0% 39.6%

(2)

(1)

In 2001 a new 10% tax bracket was introduced and tax rates were lowered. The
planned tax rates through 2010 were passed as part of the Tax and Economic
Recovery Acts in 2001 and 2003. They were extended in late 2010 through 2012.
They were extended again in January 2013, with a 39.6% rate for high income
earners.
(2)

Taxpayers in this bracket may also be subject to Affordable Care Act surtax of
0.9%.
Table: Individual Income Tax Brackets

The Jobs and Growth Tax Relief


Reconciliation Act of 2003
The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), was
passed by Congress on May 23, 2003 and signed by President Bush on May
28, 2003. The act increased the exemption amount for the individual
Alternative Minimum Tax, lowered taxes on dividends and capital gains,
accelerated the tax rate cuts that had been enacted in 2001, and temporarily
reduced the tax rate on capital gains and dividends to 15%. Many of the
slow phase-ins enacted in 2001 were accelerated by the Act of 2003, which
removed the waiting periods for many of EGTRRA's changes.
Two tax bills signed in 2005 and 2006 extended through 2010 the favorable
rates on capital gains and dividends, raised the exemption levels for the
Alternative Minimum Tax, and enacted new tax incentives designed to
persuade individuals to save more for retirement.

The Patient Protection and Affordable Care


Act of 2010
The Patient Protection and Affordable Care Act ("The Act") fundamentally
alters the health care system for individuals and employers. All individuals
not covered by Medicaid or Medicare must obtain health care coverage or
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pay a tax penalty. Employer-provided coverage will generally satisfy the


coverage requirement. Lower-income individuals and some middle-class
families will receive a credit or voucher to help them pay for their health
insurance. Employers electing not to offer qualifying coverage are subject to
an additional tax. Exceptions are made for small businesses.
The key provisions of The Act, as amended by the House Reconciliation Act
(see below), include:
Tax Penalty: All individuals not covered by Medicaid or Medicare must
obtain health care coverage or pay a tax penalty which increases from the
greater of $95 or 1% of income in 2014 to the greater of $695 or 2.5% of
income in 2016 and thereafter, indexed for inflation.
Adult Children Coverage: The Act extends the employer-provided health
coverage gross income exclusion to coverage for adult children under age
27 as of the end of the tax year.
Employers: The Act does not require employers to provide health insurance
coverage. However, large employers (businesses with 50 or more "fulltime employees", which are defined as employees working 30 or more
hours per week) that do not provide minimum essential coverage are liable
for an additional tax.
Additional Medicare Payroll Tax: The Act broadens the Medicare tax base for
higher income taxpayers by:
1. Imposing an additional of 0.9 percent tax on earned income in excess of
$200,000 for individuals and $250,000 for families; and
2. Imposing an unearned income Medicare contribution tax of 3.8 percent
on investment income for individuals with Adjusted Gross Income (AGI)
above $200,000 and joint filers with AGI above $250,000. Net investment
income includes interest, dividends, royalties, rents, gain from the
disposition of property, and income earned from a trade or business that is
a passive activity.
Tax on High-Cost Insurance: The Act imposes a 40% non-refundable excise
tax on group insurers if annual premium payments exceed an inflation
adjusted $10,200 for individual coverage and $27,500 for family coverage
beginning in 2018.
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Market Sector Fees: The Act imposes annual nondeductible fees on various
health-related industries, such as medical device manufacturers and
importers, health insurance providers and others.
Medical Expense Deduction: The Act raises the threshold for the itemized
medical expense deduction from 7.5% of AGI to 10% of AGI for regular
income tax purposes effective for 2013. However, individuals age 65 and
older (and their spouses) are temporarily exempt from the increase until
2017.
Medicare Part D: The Act eliminates the deduction for the subsidy for
employers that maintain prescription drug coverage for retirees who are
eligible for Medicare Part D.
Tax-Exempt Hospitals: The Act requires Code Sec. 501(c)(3) hospitals to
conduct periodic community health needs assessments and adopt written
financial assistance policies. Individuals who qualify for financial assistance
are billed at the same rates as insured individuals.
Health Insurance Executive Pay: The Act modifies Code Sec. 162(m) as it
applies to compensation paid by health insurance providers to high-level
executives. If at least 25 percent of the insurers premium income does not
meet minimum essential coverage requirements under the Act, no Code
Sec. 162(m) deduction is allowed if compensation exceeds $500,000.
Indoor Tanning Tax: The Act imposed a tax of 10% on qualified indoor
tanning services effective July 1, 2010.
For complete details on The Patient Protection and Affordable Care Act see
the Affordable Care Act (ACA) Tax Preparer Course available for download
at the Lesson 1 Homework section.

The Health Care and Education


Reconciliation Act of 2010
The Health Care and Education Reconciliation Act of 2010 ("The
Reconciliation Act"), signed by President Obama on March 30, 2010,
completed a massive overhaul of the nations health insurance and health
delivery systems. The Reconciliation Act amends the Patient Protection and
Affordable Care Act of 2010, which President Obama signed on March 23rd.
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Combined, the two new laws include more than $400 billion in revenue
raisers and new taxes on employers and individuals.

The American Taxpayer Relief Act of 2012


The American Taxpayer Relief Act makes permanent for 2013 and thereafter
the Bush tax cuts, except for married taxpayers filing jointly (MFJ) with
taxable income above $450,000, taxpayers filing as Head of Household
(HOH) with taxable income above $425,000, and taxpayers filing Single (S)
with taxable income above $400,000. Income above the aforementioned
levels is now taxed at 39.6%.
The key provisions of the American Taxpayer Relief Act include:

a 20% capital gains and dividend tax rate for the aforementioned
taxpayers

a permanent fix for the Alternative Minimum Tax, by increasing the


exemption amounts and adjusting them annually for inflation

a revival of the "Pease Limitation" which limits itemized deductions


for taxpayers with income above $300,000 (MFJ), $275,000 (HOH),
$250,000 (S), and $150,000 (MFS)

a revival of the Personal Exemption phase-out for taxpayers with


income above $300,000 (MFJ), $275,000 (HOH), $250,000 (S), and
$150,000 (MFS)

a maximum federal estate tax rate of 40% with a $5,000,000


"portable" (between spouses) exclusion, which is adjusted annually
for inflation, and

a revival of many "tax extenders".

For complete details on The American Taxpayer Relief Act of 2012 see the
CCH Tax Briefings available for download at the Lesson 1 Homework
section.

The Modern Income Tax


The current Federal tax system has four main elements: (1) an income tax on
individuals and corporations (which consists of both a regular income tax
and an alternative minimum tax); (2) payroll taxes on wages (and
35

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corresponding taxes on self-employment income) to finance certain social


insurance programs; (3) estate, gift, and generation-skipping taxes, and (4)
excise taxes on selected goods and services.
The United States imposes an income tax on individuals, corporations,
trusts, and certain estates. This tax is imposed on income, such as wages,
and realization of a gains on the disposition of property. An individual's tax
bracket depends upon their income and their filing status. There are five (5)
filing statuses: single, married filing jointly, married filing separately, head of
household and qualifying widow or widower.
Tax rates can be progressive, regressive, or flat. With a progressive tax the
rate of tax increases as the amount of taxable income increases. The U.S.
income tax is a progressive tax. There are seven tax brackets for ordinary
income ranging from 10% to 39.6%.
An individual pays tax at a given bracket only for each dollar within that
bracket's range. The individual's marginal tax rate, the percentage of tax on
the last dollar earned, has no effect on any underlying income taxed at a
lower bracket. This ensures that every rise in a person's pre-tax salary results
in an increase of their after-tax salary.
Income tax systems often have deductions available that lessen the income
tax liability by reducing taxable income. Claiming deductions may reduce an
individual's tax liability by a rate equal to the marginal tax rate of their
particular tax bracket. If an individual is able to increase the amount of their
tax deductions by $1,000 and the individual's marginal tax rate is 25%, the
tax deductions will reduce the individuals tax liability by $250 ($1,000 x
25%). Please note that if part of the individuals $1,000 of income that was
offset by $1,000 of tax deductions was taxed in a lower tax bracket then the
reduction in tax liability would be less than $250.
Short-term capital gains are taxed at the ordinary income tax rates. Longterm capital gains have lower tax rates, with special tax rates in some
circumstances.

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Tax Tip

Who must file a tax return?


Generally, if the taxpayers income is less than his personal exemption
and standard deduction, he doesn't need to file a tax return unless he is
entitled to refund of federal tax withheld from his paycheck or if he
qualifies for the Earned Income Tax Credit, Additional Child Tax Credit, or
Adoption Credit. However there are exceptions that well explain in
Lesson 5.

SIDE BAR

How much is a fair share?


We hear it all the time. Politicians speak about the Tax Code and
make statements such as Everyone has to pay their fair share.
Sounds good, right?
But did you ever wonder exactly how many dollars are in a fair
share?
Its impossible to tell because what is completely fair under one
political ideology is completely unfair under another political
ideology. There is simply no way to determine exactly how much a
fair share is.

37

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The table below shows how much money the Federal Government
collects from each type of tax:
Gross Collections in Fiscal
Type of Tax

2014

Percentage of 2014

(1)

Total

Business Income Tax

$353,141,112

11.52%

Individual Income Tax

$2,575,871,018

84.06%

Unemployment Ins. Tax

$8,611,877

0.28%

Railroad Retirement Tax

$5,953,524

0.19%

Estate / Trust Income Tax

$29,410,796

0.96%

Estate Tax

$17,572,338

0.57%

Gift Tax

$2,582,617

0.08%

Excise Tax

$71,158,076

2.32%

Grand Total

$3,064,301,358

100.00%

(1)

Dollar amounts are in thousands of dollars and rounded.

Table: Internal Revenue Collections By Type

SIDE BAR

Do the rich pay taxes?


In a nutshell, yes. While a small percentage of the rich pay no income
taxes in any given year for various different reasons, the rich as a
group pay the greatest share of income taxes - more than any other
group. Consider the following facts:

According to the IRS, taxpayers with adjusted gross incomes


greater than $434,682 were in the top 1% of all US households
in terms of income in 2012.
The top 1% of taxpayers contributed 38.1% of all income taxes
collected by the U.S government. The top 50% of taxpayers
contributed 97.2% of all income taxes collected. The bottom
50% of taxpayers contributed 2.8% of all income taxes
collected.
In 2012 the top 1% paid an average effective tax rate of 22.8%
on their income far more than any other group, and almost
seven times the average effective rate of the bottom 50%, who
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paid 3.3% percent on average.


The wealthy's share of income taxes paid has increased
dramatically since 1986. However, so has their income.

(Sources: Internal Revenue Service, TaxFoundation.org)

What are the different types of taxes?


Income Tax
The federal government taxes income as its main source of revenue. Fortythree (43) states and a few counties and cities also levy income tax. Seven
states - Alaska, Florida, Nevada, South Dakota, Texas, Washington and
Wyoming - collect no income tax. Two others, New Hampshire and
Tennessee, only collect tax on dividend and interest income, not wages.
Income can be taxed at a flat rate - or on a graduated scale, with the people
who earn the most money paying a greater percentage of income tax.
Advantage: Graduated income taxes are a progressive tax, which means the
taxpayers with lower incomes pay less in income tax than those with higher
incomes.
Disadvantage: Truly fair and equitable income taxes are difficult to assess.
Sales Tax
Sales tax is levied on the purchase of such things as furniture, clothing and
movie tickets. The federal government does not have a sales tax, but states,
counties, and cities often rely heavily on sales tax. The tax rate and the types
of goods subject to these taxes vary from place to place.
Advantage: Sales tax is collected by the merchant, making it easy for
governments to track.
Disadvantage: Sales taxes are regressive, meaning that they impact most
heavily on those with the least ability to pay. Both poor and wealthy people
pay the same tax for the same item, although that sum represents a higher
percentage of the poor person's income than it does of the wealthy
person's income.

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Use Tax
Similar to sales tax, these taxes are levied for services such as telephone,
electric and other utilities, and for leases and rentals. They are also levied on
"users" of goods purchased "sales tax free" in another state.
Advantage: Use taxes are collected by the vendor, making it easier for
governments to track.
Disadvantage: Use taxes are regressive, meaning that they impact most
heavily on those with the least ability to pay.
Excise Tax
Excise tax, sometimes called "luxury tax," is used by both the state and
federal governments. Some examples of items subject to excise tax are
heavy tires, fishing equipment, airplane tickets, gasoline, beer and liquor,
firearms, and cigarettes.
Advantage: These taxes can sometimes be used to discourage the use of
items such as cigarettes and alcohol, or to reduce demand for items that
may be scarce.
Disadvantage: Excise taxes are regressive, meaning that they impact most
heavily on those with the least ability to pay.
Real Estate Tax
Federal and state governments do not tax real estate. Real estate tax is most
local government's main source of revenue. Most localities tax private
homes, land, and business property based on the property's value (ad
valorem). When real estate is mortgaged, real estate taxes are ordinarily
collected and escrowed monthly by the mortgage lender along with the
mortgages principal and interest payment. The escrowed real estate tax is
then remitted to the taxing authority once a year.
Advantage: This is a progressive tax, which means people with lower
property values pay less in real estate taxes than the wealthy who usually
own property of higher value.
Disadvantage: If re-assessments are not made by the Property Tax Assessor
annually, owners of new homes pay more than those who own older homes
that have appreciated in value over the years.
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Personal Property Tax


Some local governments also assess tax on personal property such as boats,
cars, airplanes, appliances, and furniture.
Advantage: This is a progressive tax. The poor usually pay less in property
tax than the wealthy, because they own less property and property of lower
value, than the wealthy.
Tolls and Permits
These are use fees for such public services as highways, parking lots and
public parks.
Advantage: Tools and permits place the burden of paying the tax only on
the people who use the services. Revenue from tolls is often used to build
and maintain highways and bridges and only people who drive on those
highways and bridges pay the tax.
Disadvantage: Tolls and permits are considered regressive, meaning that
they impact most heavily on those with the least ability to pay.
Estate, Gift and Inheritance Taxes
Estate tax is imposed on the entire estate of the individual. Inheritance tax is
imposed on the transfer of property after the owner's death. Under the
inheritance tax system, the beneficiary of the property must pay the tax. A
gift tax is levied on large gifts from one individual to another, usually parent
to child. The federal government has an estate tax and a gift tax. Many
states have some type of inheritance tax.
Advantage: Estate, inheritance or gift taxes are progressive since they are
levied only on those whose wealth has increased.
Disadvantage: Death taxes sometimes require the sale of some or all of the
property to pay the taxes.
Tariffs
Tariffs are taxes that governments levy on imports and exports. The tariff is
usually paid by the person or vendor doing the importing and passed on to
the consumer.
Advantage: Tariffs make foreign goods more expensive, thus making
American made items more attractive.
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Disadvantage: Tariffs are regressive, meaning that they impact most heavily
on those with the least ability to pay.
Value Added Tax (VAT)
Value Added Tax is similar to a sales tax. However it is a tax on the
estimated market value added to a product or material at each stage of its
manufacture, production or distribution. As with a sales tax, a VAT is
ultimately passed on to the consumer. The consumer is often unaware
exactly how much VAT is built into the price they pay for a product.
Conversely, the consumer can see the amount of sales tax charged on their
sales receipt. VAT allows countries to collect tax from foreign consumers
when they purchase exported products. Of 192 countries, only 62 have an
income tax, yet 132 have a VAT.
VAT is becoming increasingly attractive since there are few other revenue
raising options. Politically however, VAT poses some major obstacles.
Conservatives perceive a VAT as a hidden tax which can be raised without
the knowledge of the consumer. Liberals see a VAT as a highly regressive
tax which hits low and middle income taxpayers more severely.
Advantage: VAT is collected by the business, making it easy for
governments to track and collect.
Disadvantage: VAT is regressive, meaning that it impacts most heavily on
those with the least ability to pay.

IMPORTANT REMINDERS

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify you're understanding of the
most important lesson content, and will also help you pass the
Final Exam.
Do the Homework - While completing the homework is not
mandatory, we strongly recommend that you complete each
lesson's homework assignment. It will expand your knowledge
and understanding of the topics covered in this course.

42

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PREPARATION

PROCESS

Lesson

2
Lesson 2 - The Tax Return
Preparation Process
In this lesson you'll learn about the tax return preparation process. The
following topics are discussed in this lesson:
History of the Tax
Preparation Industry
The Return Preparation
Process
The Client
Organizer/Checklist
Tax Estimator
The Three Stages
Welcoming the Taxpayer
Establishing Rapport
Be an Active Listener
Asking Questions Effectively
Dealing with
Communication Barriers
Completing the Tax Return

43

Complex Tax Returns


Frequently Asked Questions
E-filing
What If a Taxpayer or
Dependent Does Not Have a
Social Security Number?
What if a Taxpayer Moves?
Which Address Should
Taxpayers Use: Their Street
Address or Their PO Box?
How Long Should Taxpayers
Keep Their Tax Returns and
Documentation?
Recordkeeping Review
What records should be
kept?

LESSON

THE

TAX

RETURN

PREPARATION

PRO CESS

ver the past twenty years, there has been a fundamental change in
the way that taxpayers file their tax returns. Increased use of paid
tax return preparers has altered the way in which tax returns are
filed. For many taxpayers their tax return filing represents one of the biggest
financial transactions they undertake each year. More than ever, taxpayers
are relying on tax return preparers to help them prepare their tax returns.
Tax return preparers have an opportunity to educate taxpayers about the
tax laws and reduce the stress and anxiety often associated with the tax
filing season. Tax return preparers may explain to the taxpayer his or her
rights and responsibilities. A well-educated and competent tax return
preparer can prevent inadvertent errors, possibly saving the taxpayer from
unwanted problems later with the IRS.

History of the Tax Preparation Industry


Commercial tax return preparation began primarily as an ancillary service for
those in the accounting, bookkeeping and legal businesses. Tax return
preparation was considered an extension of the services that those
businesses were providing their clients. Many of the businesses that
provided tax return preparation to their clients in the first part of the 20th
century did so as a courtesy for little or no charge. Most individual taxpayers
who were required to pay income taxes and file returns during this time
either prepared their own returns or had their returns prepared by their
local IRS office. Less than six percent (6%) of Americans were required to file
an income tax return in 1939. However, on average, more than seventy-five
percent (75%) of Americans were required to file an income tax return
during World War II. By the end of World War II ninety percent (90%) of
Americans were required to file income tax returns.
The number of persons affected by the federal income tax during and after
World War II increased the importance of the tax preparation industry. In
the 1950's the IRS discontinued preparing tax returns for most taxpayers.
Most taxpayers could no longer walk into their local IRS office and have
their return prepared for free. Tax return preparation was no longer a side
line business for accounting, bookkeeping and legal businesses. It became a
"stand alone" business.
Prior to the mid-1980's most tax preparers either prepared the tax forms by
hand, filling in the form with a pencil, or completed data entry forms and
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sent their client's tax information to regional service centers such as CompuTax or Dyna-Tax for processing. The processing companies maintained
main-frame computers to prepare the tax returns which were then printed
and mailed overnight to the tax preparer.
Shortly after the advent of the personal computer in the early 1980's tax
software became readily available. The software was installed from 5 1/4"
floppy disks. The returns were printed using the original Hewett-Packard
Laser Jet 1 printer and a Tax 1 font cartridge. Today, advanced tax preparers
prepare their tax returns online (in the cloud) and download and print
Acrobat PDFs of the tax returns. Since the tax preparer doesn't have to
spend time installing and maintaining software and backing up data files his
time is freed for what he does best - marketing and working with taxpayers.
Today, the tax return preparation industry is a multibillion dollar industry
with tens of thousands of commercial tax return preparation businesses
open nationwide. The largest of these businesses has over 12,000 tax
offices, while the smallest businesses may operate out of rented kiosk space
in a local shopping mall or from the sole proprietors residence. Many tax
return preparers operate year round; others may operate only during the
first four months of the year.
A majority of taxpayers rely on tax return preparers to assist them in filing
their tax returns. Between 1993 and 2005, the number of taxpayers who
prepared their own tax returns without outside assistance fell by more than
two-thirds. In 2014 nearly 55% percent of all federal tax returns were e-filed
using a paid tax return preparer. Over 70 million federal individual income
tax returns were prepared and e-filed by paid tax return preparers. The
number of paid tax return preparers is believed to be about 650,000.
Attorneys, certified public accountants, enrolled agents and other
individuals authorized to practice before the IRS who prepare returns are
subject to federal oversight. Collectively known as "Practitioners", these
individuals must adhere to the standards of practice promulgated in Part 10
of Title 31 of the Code of Federal Regulations and reprinted in Treasury
Department Circular 230. Practitioners who violate these standards of
practice or who are shown to be incompetent or disreputable may be
censured, suspended or disbarred from practice. The IRS Office of
Professional Responsibility is charged with investigating allegations of
Practitioner misconduct and conducting disciplinary proceedings.
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All paid tax return preparers are subject to civil penalties for actions ranging
from knowingly preparing a return that understates the taxpayers liability to
failing to sign or provide an identification number on a return they prepare.
Tax return preparers who demonstrate a pattern of misconduct may be
enjoined from preparing further returns. Additionally, the IRS may pursue
and impose criminal penalties against a tax return preparer for the most
egregious misconduct.

Tax Quote

"We stand today at a crossroads: One path leads to despair and utter
hopelessness. The other leads to total extinction. Let us hope we have the
wisdom to make the right choice."
Woody Allen - American film director and comedian

The Return Preparation Process


The three-stage tax return preparation process combines good techniques
and tools, which makes the process more effective and comfortable for
both you and the taxpayer. The process helps educate the taxpayers and
produces more accurate returns.

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Flowchart: Income Tax Calculation

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The Client Organizer/Checklist


The Client Organizer or Checklist will guide your clients through providing
important tax informationsaving you time when you prepare the tax
return. Use the Client Organizer or Checklist to engage your taxpayer in
preparing an accurate return. Use them as a starting point for a
comprehensive interaction with the taxpayer, in combination with all the
source documents provided by the taxpayer.
During the interview confirm each item on the Client Organizer or Checklist
to make sure you and the taxpayer have considered all the necessary
information. Ensure that all questions and issues have been addressed. To
ensure accurate reporting of any deductions or adjustments to income,
verify the taxpayer's expenses.

Tax Estimator
Tax Estimator is a fully integrated quick refund estimator. It is extremely
useful in providing a client with a quick estimate of their balance due or
refund amount in less than 2 minutes!

The Three Stages


The three stages in the tax return preparation process are:

Welcome the taxpayer and get acquainted


Use the Client Organizer and effective communication techniques to
conduct a probing interview
Complete the tax return and file it

Welcoming the Taxpayer


Here are suggestions for welcoming the taxpayer:

Greet the taxpayer and introduce yourself


Take a few moments for small talk (weather, traffic, etc.)
Explain the tax preparation processes

Give the taxpayer a blank Client Organizer and ask them to complete it to
the best of their ability. Ask the taxpayer if they have any questions.

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Once the taxpayer has completed the Client Organizer to the best of their
ability, you must interview them. Throughout this process listen for clues
that will assist in completing their returnmarried or single; number of
children, childcare, investments, unreported income, etc.
Review the identification and reporting documents at the top of the Client
Organizer and verify the taxpayer's identity with a picture ID (drivers
License) or other acceptable method.

Establishing Rapport
To obtain accurate information from taxpayers, you must ask them certain
questions about themselves and their families. Sometimes these questions
are of a personal nature. Try to establish the taxpayer's trust and confidence
from the beginning. As you welcome the taxpayer:

Make small talk while being friendly but respectful


Speak clearly and simply
Express appropriate emotions
Explain the process so the taxpayer understands what will happen
next
Encourage the taxpayer to ask questions.

Be an Active Listener
Active listening reassures the other person that you are paying close
attention and that you care about what they are saying. Here are ways you
can be an active listener:

Use nonverbal clues such as nodding, smiling appropriately, and


making eye contact

Letting the other person take the time they need to express
themselves

Restating what the other person has said to ensure that you
understand

Expressing sympathy or other appropriate emotions.

It can be easy for you to launch into talking about your aims, ambitions,
and ways of doing things and never come up for air. But you are not
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going to learn anything if you dont allow the taxpayer to speak.


Remember to ask questions, listen and take notes.
There is a reason that God gave you two ears, but only one mouth.

Asking Questions Effectively


At this point in the interview youll need to begin asking personal questions.
When asking the first tax-related question in an interview, a good approach
is to explain why the tax information is needed. Follow these steps:

Begin with an open-ended question such as, "What have you


brought with you today?"

Do not make assumptions about taxpayerslet them speak for


themselves.

Avoid "leading" questions that make the taxpayer feel you have a
specific answer in mind.

The taxpayer is now answering questions that may be upsetting to him.


Even so, continue to ask the questions until you get enough information to
complete the return. Define any terms that may be unfamiliar to the
taxpayer. As the interview continues:

Check your own comfort level


Respond to any misunderstandings
Continue with effective questioning and active listening.

Dealing with Communication Barriers


During the interview the taxpayer may become upset because of the issues
youre asking about. If this happens, do your best to stay on track by doing
the following:

Explain why you are asking the question, the tax implications
Say "I hear you" or "I understand" and repeat the question rephrasing it a little differently
Allow adequate time for a response
Dont make any assumptions
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Deal with the taxpayer's emotional state:

If silent say "Tell me more about..."


If upset paraphrase...
Concentrate, not just on the question, but on working with the
taxpayer.

The Burden of Proof for Individual Tax


Returns
The responsibility to prove entries, deductions, and statements made on
a tax return is known as the burden of proof. You, the tax return
preparer, must be able to substantiate expenses to deduct them on a
taxpayer's return. Generally, you'll meet the burden of proof by having
copies of the information for income and receipts for expenses. You
should keep adequate records in your file to prove the taxpayer's
expenses. You must have documentary evidence, such as receipts,
canceled checks, bills, invoices or credit card statements to support the
expenses.
Hand written or typewritten statements without receipts, canceled
checks, bills, invoices or credit card statements do not constitute
adequate proof. If the taxpayer cannot produce the aforementioned
proof, you should either refuse to enter that item of income or expense
on the return, or refuse to prepare the return in its entirety.
You might lose a client and a few dollars that you could have made
today, but that is better than serving a prison sentence for several years
for submitting false claims to the U.S. Government, which is a federal
crime. 26 U.S. Code 7206 States: Fraud and false statements
Any person who (1) Declaration under penalties of perjury
Willfully makes and subscribes any return, statement, or other
document, which contains or is verified by a written declaration that it is
made under the penalties of perjury, and which he does not believe to
be true and correct as to every material matter; or
(2) Aid or assistance
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Willfully aids or assists in, or procures, counsels, or advises the


preparation or presentation under, or in connection with any matter
arising under, the internal revenue laws, of a return, affidavit, claim, or
other document, which is fraudulent or is false as to any material matter,
whether or not such falsity or fraud is with the knowledge or consent of
the person authorized or required to present such return, affidavit, claim,
or document
shall be guilty of a felony and, upon conviction thereof, shall be fined
not more than $100,000 ($500,000 in the case of a corporation), or
imprisoned not more than 3 years, or both, together with the costs of
prosecution.
What Records Should You Have?
You must keep records obtained from the taxpayer so that you can
prepare a complete and accurate income tax return. You should keep
copies of all W-2's, 1099's, receipts, canceled checks or other proof of
payment, and any other records to support any deductions or credits
claimed.
Good records help to:
Identify sources of income
Keep track of expenses
Keep track of the basis of property
Support all items reported on the tax return
Kinds of Records to Store
You'll need copies of the underlying documents, such as receipts and
sales slips, that support any deductions.
You should keep copies of the tax returns that you prepare. They can
help you prepare future tax returns for that taxpayer, and you will need
them if you need to file an amended return for the taxpayer, or the
taxpayer is audited.
Basic Records
Basic records are the records that prove the items of income and
expenses.
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Income - Basic records prove the amounts reported on the tax return.
Income may include wages, dividends, interest, and partnership or S
corporation distributions. Records also can prove that certain amounts
are not taxable, such as tax-exempt interest.
You should advise taxpayers to keep copies of Form W-2, Copy C
indefinitely, until they begin receiving social security benefits. This will
help protect their benefits in case there is a question about their work
record or earnings in a particular year.
Expenses - Basic records prove the expenses for which the taxpayer
claimed a deduction (or credit) on the tax return. Deductions may
include alimony, charitable contributions, mortgage interest, and real
estate taxes. There may also be child care expenses for which the
taxpayer can claim a credit.
Home - Basic records should enable you to determine the basis or
adjusted basis of the taxpayer's home. The taxpayer will need this
information to determine if he has a gain or loss when he sells his home
or to figure depreciation if he uses part of the home for business
purposes or for rent. Records should show the purchase price,
settlement or closing costs, and the cost of any improvements. They also
may show any casualty losses deducted and insurance reimbursements
for casualty losses. Records also should include a copy of Form 2119,
Sale of Your Home, if the taxpayer sold his previous home before May 7,
1997, and postponed tax on the gain from that sale.
Investments - Investments include stocks, bonds, and mutual funds.
Basic records should enable you to determine the taxpayer's basis in an
investment and whether he has a gain or loss when he sells it. Records
should show the purchase price, sales price, and commissions. They may
also show any reinvested dividends, stock splits and dividends, sales
load charges, and original issue discount (OID).
Proof of Payment
One of the basic records is proof of payment. The taxpayer should have
these records to support the amounts shown on the tax return. Proof of
payment alone may not be proof that the item to be claimed on the tax
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return is deductible. The taxpayer should also provide other documents


that will help prove that the item is deductible.
Payments can be proved with cash receipts, financial account
statements, credit card statements, or canceled checks. If the taxpayer
made payments in cash, you should get a dated receipt (and if paid to
an individual it should include that individual's complete contact
information and be signed by that individual) showing the amount and
the reason for the payment.
Account statements - The taxpayer may be able to prove payments with
a legible financial account statement, such as a bank statement or credit
card statement, prepared by his bank or other financial institution.
Pay statements - The taxpayer may have deductible expenses withheld
from his paycheck, such as union dues or medical insurance premiums.
He should keep his year-end or final pay statements as proof of
payment of these expenses. NOTE: You cannot file tax returns without
actual W-2's. You cannot use a final pay statement to file a tax return.
Electronic Records
All requirements that apply to hard copy books and records also apply to
electronic storage systems that maintain tax books and records. The
electronically stored documents must be maintained for as long as they are
material to the administration of tax law.

SIDE BAR

The Burden of Proof


For complete details about the burden of proof read Appendix R - The
Burden of Proof - A Treatise on the Supporting Document Requirements for
Tax Return Preparers, which you can obtain from the Appendix section of
our web site, or by clicking here.

Completing the Tax Return


Preparing an accurate return for each taxpayer is the most important aspect
of providing quality service. Accuracy is essential to your credibility.
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The components of the tax return preparation process include:

Understanding and applying tax law


Obtaining a complete Client organizer
Using references, resources, and tools, to ensure a high quality return

Use all of these important components to take the guess work out of return
preparation.

Tax Tip

When are federal tax returns due?


Ordinarily federal tax returns are due April 15th of each year. However,
when April 15th falls on a Saturday, Sunday, or federal legal holiday the
due date is delayed until the next day that isn't a Saturday, Sunday, or
legal holiday. A statewide legal holiday only delays a federal due date if
the IRS Service Center where the taxpayer is required to file is located in
that state.

Complex Tax Returns


To ensure accurate returns, complete tax forms and schedules on which you
have been trained. Do not go beyond the scope of your training "live" with
the taxpayer. If you do, you risk making errors and causing difficulties for
taxpayers. Theres nothing wrong with saying any of the following:

This is a complex return and Ill have it ready in a few days. Set a final
appointment.

"Ill have to research an issue"

"I dont know the answer to your question but Ill get you the
answer".

If some parts of a taxpayers return are beyond the scope of your training
youll need to conduct research.

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Side Bar

What are all those letters after everyone's name?


The Certified Public Accountant (CPA) designation was established on
April 17, 1896. It is the statutory title of qualified accountants in the
United States. In order to become a CPA the candidate must sit for and
pass the Uniform Certified Public Accountant Examination which is
written by the American Institute of Certified Public Accountants (AICPA)
and administered by the National Association of State Boards of
Accountancy (NASBA).
Enrolled Agent (EA) is a designation issued by the Internal Revenue
Service. You'll learn more about Enrolled Agents later in this course.
Other professional designations include Accredited Tax Advisor (ATA) and
Accredited Tax Preparer (ATP) issued by the Accreditation Council for
Accountancy and Taxation; Certified Tax Specialist (CTS) issued by the
Institute of Business & Finance; and Public Accountant (PA) issued by the
State Boards of Accountancy
You can see all 140 financial professional designations issued in the
United States in Appendix B or by clicking here.

TAX PLANNING TIP

What is Tax Planning?


Year-end tax planning always makes good sense and it's unfortunate that
so many taxpayers forget about their taxes until after the first of the year.
A little planning at the end of the year can go a long way toward
reducing tax bills.
As year-end approaches you and your clients should take some time to
think about their tax situation. Look closely at how much they are
earning, spending, and how that effects their tax situation.
Year-end tax planning is about timing. Conventional wisdom holds that
taxpayers should postpone income until next year and accelerate
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deductions into the current year. However, for most taxpayers, it is much
more difficult to shift income from one year to another than to shift
deductions. The premise here is that a dollar saved today is worth more
than a dollar saved tomorrow, so lowering this year's taxes is better than
lowering next year's taxes. But this isnt always true.
Some of the changes in life that can affect a taxpayers tax bracket and
require tax planning include: 1) The taxpayer switches to a job that pays
more money 2) A spouse may be returning to work after a jobless period
3) The taxpayer(s) may be moving to a state with either a higher or a
lower tax rate or no income tax at all 4) An upcoming marriage or divorce
may affect the taxpayers tax bracket.
Will the taxpayer work a full year in 2015 and 2016? Depending on how
the taxpayers year went, his adjusted gross income might be lower or
higher next year. The only way to tell is to estimate his 2015 and 2016
income. If it looks like he may have a lot more income next year he might
want to maximize income this year while deferring tax deductions until
next year. If he believes that his tax bracket will be higher this year than
next, he may want to accelerate deductions.
What is Financial Planning?
Financial planning is a process of setting long term goals and objectives,
assessing income and expenses, assets and liabilities, and other
resources, and then making plans to achieve said goals and objectives.
Financial planning involves managing finances wisely, including insurance
management and investing. College planning, tax planning, retirement
planning, and estate planning are typically included as well.
The steps to create a financial plan are:

Establish Goals and Objectives


Gather Income-Expense and Asset-Liability Information
Analyze and Evaluate the Client's Financial Status
Develop a Financial Plan
Implement the Financial Plan
Monitor the Plan and Make Necessary Adjustments

Throughout our course you'll see many tax planning tips. We've also
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included some financial planning side bars and tips too.

Frequently Asked Questions


This topic covers taxpayers' frequently asked questions and provides the
correct answers. Use this topic as a quick source of information to help you
build a variety of responses for taxpayers. Frequently asked taxpayer
questions generally fall under the following categories:

e-filing
Social Security Numbers
Taxpayer Addresses
Prior Years' Returns
Reducing the Public Debt

E-filing
E-filing allows taxpayers to file their tax returns through a tax professional,
like you, or on the computer through an Internet Web site or third-party
transmitter. Information about e-filing is included in many commercial tax
preparation software packages. Also, some software companies offer tax
preparation and electronic filing software that can be downloaded from the
Web. Many Web sites also provide the option for individuals to prepare and
file their returns on the Internet.
Inform the taxpayer that you provide electronic filing and that you will be
more than happy to e-file their tax return. Also inform the taxpayer that
there are a number of different refund options to select from and you will
go over all of the options once the tax return is completed.

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SIDE BAR
What
is an Electronic Filing Identification Number (EFIN)?
In order to e-file tax returns professionally for your clients the IRS requires
you to have an EFIN which identifies you as a professional tax preparer.
An EFIN is a unique six-digit number assigned by the IRS to a tax
preparer after an approval process. Once you have an EFIN you'll be an
Electronic Return Originator (ERO).
What If a Taxpayer or Dependent Does Not Have a Social
Security Number?
Taxpayer Identification Numbers are required for all taxpayers and
dependents. The Social Security Number (SSN) serves as an identification
number for tax purposes for those persons who qualify for one. Taxpayers
who do not have a Social Security Number must apply for one by using
Form SS-5 - Application for a Social Security Card. This form is available from
the Social Security Administration. U.S. Citizens must show proof of age,
identity, and citizenship when they apply for a Social Security Number.
Individuals who are age 18 or older must apply at the Social Security
Administration office in person rather than by mail.
Further information on SSNs and Individual Taxpayer Identification
Numbers (ITINs) is provided in our Taxpayer Identification Number lesson
that youll be taking in a few days.
What if a Taxpayer Moves?
Taxpayers should use Form 8822 - Change of Address to notify the IRS of
any change of address. If taxpayers move after sending the return and
before a refund is received, they should notify their old post office and the
IRS of their new address.
Which Address Should Taxpayers Use: Their Street Address
or Their PO Box?
Taxpayers should use their post office box only if the post office delivers all
their mail to the post office box rather than to a street address. In this case,
enter the PO Box number on the line for the present home address.

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TAX QUOTE

"As a taxpayer, you are required to be fully in compliance with the United
States Tax Code, which is currently the size and weight of the Budweiser
Clydesdales."
Dave Barry (1947- ) Humorist
How Long Should Taxpayers Keep Their Tax Returns and
Documentation?
Taxpayers should keep copies of tax returns, worksheets used, and records
of all items appearing on the returns (such as Forms 1099) until the statute
of limitations runs out for that return. Usually, this is three years from the
date the return was due or filed, or two years from the date the tax was
paid, whichever is later. The same statute of limitations applies to the YEAR
OF SALE for long term assets. Taxpayers should keep the following records
for three years from the tax return's due date, or two years from the date
the tax was paid, whichever is later:

Property records (including those on a home)


Closing statements for a home
Brokerage statements showing the purchase price of stock

Keep in mind the important words in the paragraph above are YEAR OF
SALE. Until long term assets are SOLD taxpayers should retain all cost
information, and any other information that could affect their basis in the
property. If a taxpayer bought common stock in 1957 and sold it this year,
hell need his cost and any additional basis information this year, so that his
capital gain can be determined. Without adequate information regarding
the taxpayer's basis in the property it will be impossible for you to complete
the tax return. In addition, W-2 forms should be kept until the Social
Security Administration has recorded the earnings reflected on the forms.
This is generally resolved now with reports of earnings to all participants,
provided the taxpayer actually looks at and verifies his report, which most
dont until they are approaching retirement. So its probably a good idea to
keep W-2s indefinitely, or at least until the taxpayer begins receiving
benefits and there are no disputes regarding benefits. Finally, taxpayers
should keep:
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Records on contributions to nondeductible IRAs until all IRA funds


are withdrawn

Calculations determining the nontaxable portion of pension income


until all of the pension income is taxable

Recordkeeping Review
How long should a taxpayer keep tax related records?

retain records for 3 years from the time the tax return was due, filed,
or amended; or 2 years from the date the tax was paid, whichever is
later

retain records for 6 years if income is understated by 25% or more

retain records forever if there is a fraud or failure to file issue

retain capital gain/loss, net operating loss, and similar records which
may form the basis of claims made on future tax returns indefinitely.

What records should be kept?


FOR items
concerning...
Income

Expenses

Home

KEEP as basic records...

Form(s) W-2
Form(2) 1099
Bank statements

Sales slips
Invoices
Receipts

Canceled checks or
other proof of
payment

Closing
statements
Purchase and
sales invoices
Brokerage
statements
Mutual fund
statements

Proof of payment
Insurance records

Form(s) 1099
Form(s) 2439

Investments

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Brokerage
statements
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What should the taxpayer's statements show?


IF payment is by...
Cash

Check

Debit or Credit
Card
Electronic Funds
Transfer

Payroll Deduction

THEN the statement must show the...


Amount
Payee's name
Transaction date
Check number
Amount
Payee's name
Date the check amount was posted to the
account by the financial institution
Amount charged
Payee's name
Transaction date
Amount transferred
Payee's name
Date the transfer was posted to the account by
the financial institution
Amount
Payee code
Transaction date

SIDE BAR

What is a Preparer Tax Identification Number (PTIN)?


Preparer Tax Identification Numbers were created in 1999 to protect the
privacy of tax return preparers. Prior to 2000 tax preparers were required
to sign Form 1040 and provide their Social Security Numbers. Starting
with the 2000 filing season, the IRS gave preparers the option of using
either their SSNs or PTINs.
Between August 1999 and August 2010, the IRS issued more than 1
million PTINs. Starting January 1, 2011, use of the PTIN became
mandatory.

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TAX TIP

Are taxpayers required to keep their records contemporaneously?


There isnt any IRS requirement that taxpayers keep a contemporaneous
record of their tax deductible expenses. However, the sooner that they
record their expenses the more accurate they are assumed to be by IRS
auditors, and thus the more valuable the records are in proving
deductions.
Everyone has probably heard the horror story of the business that was
audited by the IRS. The seemingly simple audit just got bigger and bigger
and the IRS auditor was still conducting the audit at the business three
months later. The number one reason that happens is because the
business owner, when requested, couldnt produce records of his income
and expenses. So the auditor just keeps digging deeper and deeper and
deeper.
Another benefit of keeping contemporaneous records, while each item is
fresh on the taxpayers mind, is that business owners often discover even
more deductions than they thought they had!
For additional information on record keeping, see Tax Topic 305 Recordkeeping.

TAX PRACTICE TIP

What are the tax preparer record keeping requirements?


For a list of IRS e-file Record Keeping Requirements for Electronic Return
Originators (that's you) see Appendix C or click here.

TAX PRACTICE TIP

Due Diligence Requirements under IRC 6694


The Internal Revenue Code, Regulations, and Procedures prescribe
due diligence requirements for tax return preparers. For instance, you
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are not required to audit information received from clients as you can
rely in good faith on the information clients provide. However, actions
such as those summarized in Revenue Procedure 8040 are often
required which address due diligence for avoiding a preparer penalty
under 6694(a) which states:
"the preparer may not ignore the implications of information
furnished to the preparer or which was actually known by the
preparer. The preparer shall make reasonable inquiries if the
information as furnished appears to be incorrect or incomplete.
Additionally, some sections of the Code require the existence of
specific facts and circumstances, such as maintenance of specific
documents, before a deduction may properly be claimed. The
preparer shall make appropriate inquiries to determine the existence
of facts and circumstances required by a Code section or regulations
as a condition to claiming a deduction."
Tax return preparers due diligence obligations are also specified in
Treasury Department Circular 230, 10.22 which states:
10.22 Diligence as to accuracy.
(a) In general. A practitioner must exercise due diligence
(1) In preparing or assisting in the preparation of, approving, and
filing tax returns, documents, affidavits, and other papers relating to
Internal Revenue Service matters;
(2) In determining the correctness of oral or written representations
made by the practitioner to the Department of the Treasury; and
(3) In determining the correctness of oral or written representations
made by the practitioner to clients with reference to any matter
administered by the Internal Revenue Service.
(b) Reliance on others. Except as provided in 10.34, 10.35 and 10.37,
a practitioner will be presumed to have exercised due diligence for
purposes of this section if the practitioner relies on the work product
of another person and the practitioner used reasonable care in
engaging, supervising, training, and evaluating the person, taking
proper account of the nature of the relationship between the
practitioner and the person.
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(c) Effective/applicability date. This section is applicable on September


26, 2007.
While not binding on non-CPA tax preparers, you would still be well
advised to become familiar with, and follow, the rules detailed in
AICPA Statement on Standards for Tax Services (SSTS) No. 3 - Certain
Procedural Aspects of Preparing Returns.

TAX PRACTICE TIP

Protecting Confidential Taxpayer Information


Tax preparers you must take certain steps to protect confidential taxpayer
information on their computers or laptops. Remember, all computers and
laptops used in the preparation of tax returns MUST include the following
safeguards:

A mandatory login (Windows login User ID and Password) for


each member of your staff which is unique only to that person;
Regularly updated anti-virus software program; and
Firewall protection.

These requirements apply even when preparers prepare the tax returns
online and merely store Adobe Acrobat .PDF files on their computers, as
those .PDF files contain confidential taxpayer information.
Remember:

Current and previous year customer documents MUST be stored


in a locked room and/or locked filing cabinet when not in use.
Documents containing confidential information may not at any
time be left in areas accessible to the public.
Checks, check stock and debit cards MUST be stored in a locked
cabinet, safe or locked drawer.
All office and access doors MUST be locked when no employees
are onsite.
Only the tax preparer and authorized employees or contractors
may have access to customer documents and information.
Customer information MUST be shredded when no longer
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needed and then disposed of securely.


Confidential taxpayer information includes data in both physical and
electronic form and includes, but is not limited to, a taxpayers:

Names
Social Security Number(s)
Date(s) of Birth
Address(es)
Phone Number(s)
Financial information such as loan or account numbers and
brokerage account information
Tax information
Bankruptcy information
W-2 and employment information

TAX PRACTICE TIP

Be Sure to Verify All Fees


Always be sure to check your bill and ALL of the fees PRIOR to
transmitting a tax return. If there is an error in your bill or fees DO NOT efile the return and hope that the error will correct itself later - because it
won't. Either adjust the bill or call Technical Support. Also be sure to
check the amounts on any bank product checks that you give to
taxpayers PRIOR to handing them the check.

Lesson Summary
Lets take a few minutes and review what youve learned in this lesson.
The three-stage tax return preparation process combines good techniques
and tools, which makes the process more effective and comfortable for
both you and the taxpayer.
The Client Organizer will guide your clients through providing important tax
informationsaving you time when you prepare the tax return.

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Tax Estimator is a fully integrated quick refund estimator. It is extremely


useful in providing a client with a quick estimate of their balance due or
refund amount in less than 2 minutes!
The three stages in the tax return preparation process are:

Welcome the taxpayer and get acquainted

Use the Client Organizer and effective communication techniques to


conduct a probing interview

Complete the tax return and file it

To obtain accurate information from taxpayers, you must ask them certain
questions about themselves and their families. Sometimes these questions
are of a personal nature. Try to establish the taxpayer's trust and confidence
from the beginning.
Active listening reassures the other person that you are paying close
attention and that you care about what they are saying.
When asking the first tax-related question in an interview, a good approach
is to explain why the tax information is needed.
Preparing an accurate return for each taxpayer is the most important aspect
of providing quality service. Accuracy is essential to your credibility.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify you're understanding of the
most important lesson content, and will also help you pass the
Final Exam.
Do the Homework - While completing the homework is not
mandatory, we strongly recommend that you complete each
lesson's homework assignment. It will expand your knowledge
and understanding of the topics covered in this course.

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Lesson

3
Lesson 3 - Taxpayer Identification
Numbers
In this lesson you'll learn about Taxpayer Identification Numbers, ITIN's,
Backup Withholding, and Community Property. The following topics are
discussed in this lesson:
Social Security Numbers
Social Security Number
Verification
Individual Taxpayer
Identification Numbers
Who Needs an ITIN?
The Procedure for Acquiring
an ITIN
Form W9 and Backup
Withholding

Community Property States


Community or Separate
Property and Income
Community property
Community income
Separate property
Separate income

ach year hundreds of thousands of returns are delayed in processing


and/or credit and deductions are disallowed because names and
social security numbers listed on the returns do not match the Social
Security Administration's (SSA) records. As a tax preparer, you can do your
part to prevent delays in the processing of paper and electronically filed
returns by checking the accuracy of each social security number, as well as
the spelling of the name associated with the number.
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There are many cases each year in which divorced couples each file income
tax returns using the same dependent information. Since only one original
return can be filed each year using any given social security number, and
since a dependent can only be claimed on one return, this scenario can
cause a delay in processing any or all of the returns associated with that
social security number. Credits and/or deductions may be disallowed.
One of the first things you should do when preparing an individual's tax
return is to ask for a social security card or other proof for each individual
who will be listed on the return. Then, verify the accuracy of the social
security number and the spelling of the individual's name by ensuring that
the information on the tax return matches the social security card.
If an individual does not have a social security card, you may accept either
one of the following documents:

Social Security Administration 1099 benefit statements


A letter from the Social Security Administration

Driver's licenses or passports are acceptable proof of identity, but are not
acceptable proof of Social Security Numbers, because they might not
display names as they appear on SSA record, and because they do not
contain social security numbers.
If the taxpayer(s) had a baby last year, theyll need to get a Social Security
number for their child before they file their tax return. The IRS will not allow
taxpayers to claim a Dependency Exemption, Child Tax Credit or Earned
Income Tax Credit without a valid Social Security number. If the taxpayer
hasnt received the childs Social Security number by the filing deadline they
can file Form 4868 - Application for Automatic Extension of Time to File U.S.
Individual Income Tax Return to receive an automatic six month extension.

TAX TIP

Deduction or Credit - Whats the difference?


Deductions reduce the amount of income on which any tax due is
calculated. Credits are subtracted from any income tax due, resulting in a
dollar-for-dollar reduction of any tax that must be paid. Its an important
difference as a deduction of $1,000 is worth only $250 for a taxpayer in
the 25% tax bracket while a credit of $1,000 reduces the taxpayers tax
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liability by the full $1,000.

Social Security Number Verification


Occasionally, when electronically filing tax returns, the return will be rejected
by the IRS because the taxpayers name and social security number (SSN)
do not match. Correct names and SSNs are required on tax returns. Without
a correct name and SSN the IRS will not accept the return. Some taxpayers
may be adamant that they furnished the correct name and SSN, even
though they didnt. When this occurs you should verify the name and SSN
that you entered into the tax return with the name and SSN on the
taxpayers social security card.

Individual Taxpayer Identification Numbers


Some individuals who need to file tax returns do not have social security
numbers. The IRS issues an Individual Taxpayer Identification Number (ITIN)
to nonresident or resident aliens who are required to have a U.S. taxpayer
identification number (TIN) but who do not have, and are not eligible to
obtain, a Social Security Number (SSN). An ITIN is a nine-digit number that
always begins with the number 9 and has a range of 70-99 in the fourth and
fifth digit. The ITIN is formatted like an SSN (XXX-XX-XXXX).
The ITIN is for tax purposes only. The issuance of an ITIN does not:

Entitle the recipient to social security benefits or the Earned Income


Tax Credit

Create a presumption regarding the individual's immigration status

Give the individual the right to work in the United States

Any individual who is legally eligible for employment in the United States
must have a Social Security Number.
Who Needs an ITIN?
Individuals needing an ITIN include:

A nonresident alien individual eligible to obtain the benefits of a


reduced rate of withholding under an income tax treaty

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A nonresident alien required to file a U.S. tax return or filing a U.S. tax
return only to claim a refund

A nonresident alien electing to file a joint tax return with a spouse


who is a U.S. citizen or resident alien

An alien individual claimed as a spouse for an exemption on a U.S.


tax return

An alien individual claimed as a dependent on another person's U.S.


tax return

A nonresident alien student, professor, or researcher filing a U.S. tax


return or claiming an exception to the tax return filing requirement,
or

A party to a foreign person's disposition of a U.S. real property


interest

Taxpayers who do not have and cannot obtain a valid SSN

IRS regulations require that each person listed on a U.S. federal income tax
return have a valid TIN. The ITIN is entered on the return wherever the social
security number is requested.
The Procedure for Acquiring an ITIN
To apply for an ITIN file Form W-7 - Application for Individual Taxpayer
Identification Number and show that the taxpayer has a federal tax purpose
for seeking the ITIN. Along with the completed Form W-7, the taxpayer
must submit identity documents, and either a federal tax return, or other
documentation to show the federal tax purpose for which the ITIN is
needed. It usually takes about 4 to 6 weeks to get an ITIN.

SIDE BAR

What is an ITIN Acceptance Agent?


An ITIN Acceptance Agent is an individual, business or organization such
as a college, financial institution or accounting firm authorized by IRS to
assist individuals in obtaining ITINs. They play a critical role in the ITIN
Program due to their close proximity in the community to taxpayers.
Acceptance Agents determine whether their clients are eligible for Social
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Security Numbers, and if not, they proceed with the ITIN application
process by completing and filing Forms W-7. During this process, they
review supporting and supplemental documentation and forward
applicable documents, certificates of accuracy and completed Forms W-7
to the IRS for processing.

SIDE BAR

What to do when taxpayers with an ITIN are assigned a Social


Security Number (SSN)
Once the taxpayer receives an SSN they must use that number for tax
purposes and discontinue using their ITIN. It is improper to use both the
ITIN and the SSN assigned to the same person to file tax returns. It is the
taxpayer's responsibility to notify the IRS so they can combine all of the
tax records under one identification number. If the IRS isn't notified when
the taxpayer is assigned an SSN the taxpayer may not receive credit for all
wages paid and taxes withheld which could reduce the amount of any
refund due. The taxpayer can visit any local IRS office or write a letter
explaining that they have now been assigned a SSN and want their tax
records combined. Taxpayers should include their complete name,
mailing address, and ITIN along with a copy of their social security card
and a copy of the CP 565 - Notice of ITIN Assignment, if available. The IRS
will void the ITIN and associate all prior tax information filed under the
ITIN with the SSN. Send the letter to:
Internal Revenue Service
Austin, TX 73301-0057
For further information refer to Publication 1915 - Understanding Your IRS
Individual Taxpayer Identification Number or click here.

TAX QUOTE

"If our Trade be taxed, why not our Lands, or Produce in short, everything
we possess? They tax us without having legal representation."

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Samuel Adams (1722 1803) Founding Father of the United States

Form W9 and Backup Withholding


Investment income is generally not subject to regular income tax
withholding, like wages, however, it may be subject to backup withholding
to ensure that income tax is collected on this taxable income. Backup
Withholding can be taken by the IRS from the taxpayers investment income
if:

the taxpayer fails to furnish his taxpayer identification number on


Form W9 - Request for Taxpayer Identification Number and
Certification, to payers of interest or dividend income

Figure 3-1: Form W-9 - Request for Taxpayer Identification Number and Certification.

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the taxpayer gives them the wrong number, or

the taxpayer ignores notices from the IRS claiming that he has under
reported interest or dividend income

Under Backup Withholding, when the taxpayer opens a new account he


must certify under penalties of perjury that his social security number is
correct and that he is not subject to Backup Withholding, on Form W9,
Request for Taxpayer Identification Number and Certification. If the taxpayer
fails to make this certification on a Form W-9, or similar statement, Backup
Withholding may begin immediately. The Backup Withholding tax rate is
28%. 28% of the interest or payments paid on the taxpayers account will be
withheld for income tax.
Additionally, if the taxpayer doesn't give the payer his taxpayer identification
number the following can be subject to backup withholding:

money the taxpayer earns an independent contractor if his fees are


$600 or more
payments from brokers
royalty payments, and
gambling winnings

There are both civil and criminal penalties if for providing false information,
such as a fake taxpayer identification number, to avoid backup withholding.

TAX PRACTICE TIP

W-2s are Required


Authorized IRS e-file Providers are prohibited from submitting electronic
returns to the IRS prior to the receipt of all Forms W-2, W-2G, and 1099-R
from the taxpayer. Preparing tax returns using year-end paystubs is
unacceptable. You are required to prepare tax returns using a W-2. If the
taxpayer is unable to secure and provide a correct Form W-2, W-2G, or
1099-R, the return may be electronically filed after IRS Form 4852
Substitute for Form W-2, Wage and Tax Statement, or Form 1099-R,
Distributions From Pensions, Annuities, Retirement or Profit-Sharing
Plans, IRAs, Insurance Contracts, etc. is completed in accordance with the
rules of that form. The IRS DOES NOT allow Form 4852 to be filed until
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AFTER February 15th. E-filing returns without W-2's will result in your
termination, by the IRS, from the IRS e-file program. Dont put your
business at risk only submit tax returns when the required forms are
turned in by the taxpayer. For further information, see IRS Publication
1345 - Handbook for Authorized IRS e-file Providers of Individual Income
Tax Returns Chapter 3, "Submitting the Electronic Return to the IRS".

Community Property States


In a community property state the income and property that the taxpayer
and spouse acquire during their marriage is usually community property.
Even if legal title is in one spouses name they each own one half. There are
some exceptions.
For tax purposes, income and income tax refunds in community property
states are considered to belong half to each spouse regardless of who
actually earned the income. There are some exceptions.
How income from separate property is treated is determined by state law.
Community or Separate Property and Income
If the taxpayer files a federal tax return separately from his spouse, he must
report half of all community income and all of his separate income.
Generally, the laws of the state in which the taxpayers are domiciled govern
whether they have community property and community income or separate
property and separate income for federal tax purposes. Below is a summary
of the general rules.
Community Property
Generally, community property is property that:

the taxpayer, spouse, or both acquire during their marriage while


they are domiciled in a community property state.

the taxpayer spouse agreed to convert from separate to community


property.

cannot be identified as separate property.

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Community Income
Generally, community income is income from:

Community property.

Salaries, wages, and other pay received for the services performed by
the taxpayer, the spouse, or both during their marriage.

Real estate that is treated as community property under the laws of


the state where the property is located.

Separate Property
Generally, separate property is:

Property that the taxpayer or spouse owned separately before their


marriage.

Money earned while domiciled in a non-community property state.

Property that the taxpayer or spouse received separately as a gift or


inheritance during their marriage.

Property that the taxpayer or spouse bought with separate funds, or


acquired in exchange for separate property, during your marriage.

Property that the taxpayer and spouse converted from community


property to separate property through an agreement valid under
state law.

The part of property bought with separate funds, if part was bought
with community funds and part with separate funds.

Separate Income
Generally, income from separate property is the separate income of the
spouse who owns the property.
There are nine community property states: Arizona, California, Idaho,
Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Puerto
Rico allows property to be owned as community property also. Alaska is an
opt-in community property state; property is separate property unless both
parties agree to make it community property through a community
property agreement or a community property trust.
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Because income and income tax refunds in community property states are
considered to belong one half to each spouse, if a husband and wife file
separate tax returns they each have to report one half of the income on
each tax return regardless of who earned it.
To avoid this tax rule the following tests must be met:

the spouses must have lived apart for the entire tax year
none of the income may be transferred in any way between spouses
(transfers for child support do not count)
the spouses cannot file a joint tax return

If the above tests are met the income on the tax returns is allocated as
follows:

earned income other than business and partnership income is


taxable to the spouse who earned it

business income is taxable to the spouse who carried on the


business

partnership income is taxable to the spouse who is entitled to a


distributive share of partnership profits

Tax returns of married taxpayers filing separately from a community


property state are not eligible for the IRS e-file program. An exception is
made for tax returns with military indicators.
For more information about community property refer to Publication 555 Community Property.

TAX PLANNING TIP

What is the taxpayers tax bracket?


Many taxpayers dont know their "tax bracket", which is tax rate on their
last dollar of income. Yet the key to successful tax planning is to know
this percentage rate because thats how much the taxpayer will save in
taxes by having additional deductions or delaying income. If the
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taxpayers tax bracket is 35% and they have an additional deduction of


$1,000 theyll save $350 in tax. Knowing how much a taxpayer keeps after
taxes is critical in choosing and implementing all kinds of investment and
tax planning decisions.
The table below shows the tax rate schedules. By using the appropriate
schedule for the taxpayer's filing status you can determine the taxpayer's
tax bracket. The tax brackets are adjusted each year for inflation. If the
inflation rate in 2015 is 5%, the 15% bracket for 2015 will be increased by
5% - rounded down to the nearest $50. The taxpayer's tax bracket is the
amount of tax that the taxpayer pays on his "top dollar" of income. The
actual tax rate that the taxpayer pays on his taxable income below his
"top dollar" is less because the tax rates are graduated and because they
are applied to the taxpayer's taxable income after deductions and
exemptions. The taxpayer may also be entitled to tax credits against any
tax due.
Determine the taxpayer's taxable income from Form 1040 Line 43 and in
the far left column of the appropriate schedule for the taxpayer's filing
status locate his income bracket. The percentage figure in the third
column to the right titled "The tax is:" shows the taxpayer's tax bracket.
CAUTION: You should only use the schedules below to determine the
taxpayer's tax due if the taxpayer's taxable income (Form 1040, Line 43) is
$100,000 or more. Even though you cannot use the tax rate schedules
below if the taxpayer's taxable income is less than $100,000, all levels of
taxable income are shown so you can see what the taxpayer's tax bracket
is.

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ScheduleXSingle
If taxable income is over-- But not over-- The tax is:
$0
$9,075
10% of the amount over
$0
$9,075
$36,900
$907.50 + 15% of the amount over
$9,075
$36,900
$89,350
$5,081.25 + 25% of the amount over $36,900
$89,350
$186,350
$18,193.75 + 28% of the amount over $89,350
$186,350
$405,100
$45,353.75 + 33% of the amount over $186,350
$405,100
$406,750 $117,541.25 + 35% of the amount over $405,100
$406,750

No Limit $118,118.75 + 39.6% of the amount over $406,750

ScheduleY-1MarriedFilingJointlyorQualifyingWidow(er)
If taxable income is over-- But not over-- The tax is:
$0
$18,150
10% of the amount over
$18,150
$73,800
$1,815.00 + 15% of the amount over
$73,800
$148,850
$10,162.50 + 25% of the amount over
$148,850
$226,850
$28,925.00 + 28% of the amount over
$226,850
$405,100
$50,765.00 + 33% of the amount over
$405,100
$457,600 $109,587.50 + 35% of the amount over
$457,600
No Limit $127,962.50 + 39.6% of the amount over

$0
$18,150
$73,800
$148,850
$226,850
$405,100
$457,600

ScheduleY-2MarriedFilingSeparately
If taxable income is over-- But not over-- The tax is:
$0
$9,075
10% of the amount over
$0
$9,075
$36,900
$907.50 + 15% of the amount over
$9,075
$36,900
$74,425
$5,081.25 + 25% of the amount over $36,900
$74,425
$113,425
$14,462.50 + 28% of the amount over $74,425
$113,425
$202,550
$25,382.50 + 33% of the amount over $113,425
$202,550
$228,800
$54,793.75 + 35% of the amount over $202,550
$228,800
No Limit $63,981.25 + 39.6% of the amount over $228,800
ScheduleZHeadofHousehold
If taxable income is over-- But not over-- The tax is:
$0
$12,950
10% of the amount over
$12,950
$49,400
$1,295.00 + 15% of the amount over
$49,400
$127,550
$6,762.50 + 25% of the amount over
$127,550
$206,600
$26,300.00 + 28% of the amount over
$206,600
$405,100
$48,434.00 + 33% of the amount over
$405,100
$432,200 $113,939.00 + 35% of the amount over
$432,200
No Limit $123,424.00 + 39.6% of the amount over
Table: Individual Tax Rate Schedules

79

$0
$12,950
$49,400
$127,550
$206,600
$405,100
$432,200

LESSON

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TAX QUOTE

"Taxation with representation ain't so hot either."


Gerald Barzan - Humorist

Lesson Summary
Each year hundreds of thousands of returns are delayed in processing
and/or credit and deductions are disallowed because names and social
security numbers listed on the returns do not match the Social Security
Administration's (SSA) records.
There are many cases each year in which divorced couples each file income
tax returns using the same dependent information. Since only one original
return can be filed each year using any given social security number, and
since a dependent can only be claimed on one return, this scenario can
cause a delay in processing any or all of the returns associated with that
social security number.
One of the first things you should do when preparing an individual's tax
return is to ask for a social security card or other proof for each individual
who will be listed on the return.
If an individual does not have a social security card, you may accept either
one of the following documents:

Social Security Administration 1099 benefit statements


A letter from the Social Security Administration

The ITIN is for tax purposes only. The issuance of an ITIN does not:

Entitle the recipient to social security benefits or the Earned Income


Credit

Create a presumption regarding the individual's immigration status

Give the individual the right to work in the United States

In general, to receive an ITIN, the taxpayer must file Form W-7 Application
for Individual Taxpayer Identification Number and supply documentation
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that will establish foreign status and true identity. It usually takes about 4 to
6 weeks to get an ITIN.
Backup Withholding can be taken by the IRS from the taxpayers investment
income if:

the taxpayer fails to furnish his taxpayer identification number on


Form W9, Request for Taxpayer Identification Number and
Certification, to payers of interest or dividend income

the taxpayer gives them the wrong number, or

the taxpayer ignores notices from the IRS claiming that he has under
reported interest or dividend income

The Backup Withholding tax rate is 28%. 28% of the interest or payments
paid on the taxpayers account will be withheld for income tax.
There are both civil and criminal penalties if for providing false information,
such as a fake taxpayer identification number, to avoid backup withholding.
In a community property state the income and property that the taxpayer
and spouse acquire during their marriage is usually community property.
Even if legal title is in one spouses name they each own one half.
If the taxpayer files a federal tax return separately from his spouse, he must
report half of all community income and all of his separate income.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify you're understanding of the
most important lesson content, and will also help you pass the
Final Exam.
Do the Homework - While completing the homework is not
mandatory, we strongly recommend that you complete each
lesson's homework assignment. It will expand your knowledge
and understanding of the topics covered in this course.

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ALIENS

Lesson

4
Lesson 4 - Aliens
In this lesson you'll learn about Aliens and which tax returns they must file.
This lesson provides detail on issues related to determining alien status for tax
purposes. The lesson also goes over the process for obtaining a social security
number for a child born overseas so that you can assist taxpayers who may
have questions about this issue. After completing this lesson, you will be able
to:
Determine whether aliens should file a resident, nonresident, or dualstatus tax return
Determine what sources of income aliens must report on their returns
Explain the proper use of the ITIN (Individual Taxpayer Identification
Number) for undocumented aliens
Explain the process for securing a social security number for children
born abroad
The following topics are discussed in this lesson:

Determining Alien Status


Resident Status
First-Year Choice
Nonresident Status
Choice to Treat Nonresident
Spouse as a Resident

Dual-Status Aliens
Undocumented Aliens
Children Born Abroad Obtaining an SSN
Questions Commonly Asked
by or About Aliens
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Determining Alien Status

his topic covers the following subtopics:

The Three Statuses


Resident Status
Nonresident Status
Dual-Status Aliens
Undocumented Aliens

The Three Statuses


This topic defines the terms resident, nonresident and dual-status alien, and
discusses the rules for determining the status of an alien for tax purposes.
Once you've determined that a taxpayer is an alien (not a U.S. citizen), you
must then determine his or her alien status for tax purposes. An alien has
one of the following statuses:

Resident: Is a U.S. resident for tax purposes by meeting either the


green card test or the substantial presence test

Nonresident: Is not a resident of the United States

Dual status: Is both a nonresident and resident alien for the tax year

Placement in the correct category is crucial in determining what income to


report and which tax return to file.
Resident Status
An alien may qualify as a U.S. resident for tax purposes by meeting either
the green card test or the substantial presence test for the calendar year.
Resident aliens generally are taxed on their worldwide income, the same as
U.S. citizens. Therefore, resident aliens should use the same tax forms as U.S.
citizens.

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A summary of each test is provided below for your review:

Green card test: An alien is a resident for tax purposes if he or she is


a lawful permanent resident of the United States (holder of a green
card) at any time during the calendar year

Substantial presence test: If the alien does not meet the green card
test, but was physically present in the United States for at least 31
days during the prior calendar year, and for a total of at least 183
days in the prior and the two preceding calendar years.

For purposes of counting days for the substantial presence test, there are
exceptions and special criteria to consider for:

Regular commuters from Canada or Mexico


Persons in transit through the United States
Persons who are unable to leave because they have become ill while
in the United States
Diplomats
Employees of international organizations
Teachers
Trainees
Students

First-Year Choice
Aliens who do not meet the green card test or the substantial presence test
for 2014 or 2015, and did not choose to be treated as residents for part of
2014, but will meet the substantial presence test for 2014, can choose to be
treated as U.S. residents for part of 2015. To make this choice, the
individual must have been:

Present in the U.S. for at least 31 consecutive days in 2015 and


Present in the U.S. for at least 75% of the days beginning with the
first day of the 31-day period and ending with the last day of 2015

Refer to Publication 519 - U.S. Tax Guide for Aliens, for complete details
concerning this special first-year choice. This choice, once made, cannot be
revoked without the consent of the Internal Revenue Service.
As a general rule, most alien enlistees in the Armed Forces are resident
aliens. This is certainly true of aliens who were permanent residents of the
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United States before enlistment. In peacetime, all enlistees in the Armed


Services must be U.S. citizens or permanent residents.
Alien enlistees will generally be classified as resident aliens if they are:

Enlisting voluntarily and


Have been granted permanent residency in the U.S.

The United States has treaties with certain nations that allow a very limited
number of their citizens to retain their nonresident alien status. Alien
enlistees in this category should seek advice from their base legal officer.
Other aliens who are present in the United States merely because of military
assignments and who have residences outside the United States are
nonresident aliens.

TAX QUOTE

"Governments last as long as the undertaxed can defend themselves


against the overtaxed."
Bernard Berenson (1865-1959) American art historian
Nonresident Status
Nonresident aliens generally must pay tax only on income received from
sources within the United States. If the income is connected with
conducting a trade or business in the United States, the income after
allowable deductions is taxed at regular U.S. tax rates. If other income from
U.S. sources is not connected with conducting a trade or business in the
United States, it is taxed at a flat 30% or lower treaty rate.
Nonresident aliens must file a Form 1040NR - U.S. Nonresident Alien Income
Tax Return.

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Choice to Treat Nonresident Spouse as a Resident


A nonresident alien spouse may choose to be treated as a resident alien if
all the following conditions are met:

The nonresident alien spouse must be married to a U.S. citizen or


resident alien at the end of the tax year

Both spouses must choose to treat the alien spouse as a resident


alien

One of the spouses must be a U.S. citizen or resident alien on the last
day of the tax year
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A statement signed by both spouses must be attached to the joint return


for the first tax year for which the choice applies. The statement should
contain:

A declaration that one spouse was a nonresident alien and the other
spouse was a U.S. citizen or resident alien on the last day of the tax
year and that the nonresident alien spouse chooses to be treated as
a U.S. resident for the entire tax year, and

The name, address, and taxpayer identification number (SSN/ITIN) of


each spouse. If one spouse died, include the name and address of
the person who makes the choice for the deceased spouse.

If the nonresident alien spouse is not eligible to get a social security


number, he or she should file Form W-7 - Application for IRS Individual
Taxpayer Identification Number.
Once the choice is made, it applies to all later tax years unless one of the
following situations occurs:

Revocation by either spouse


Death of either spouse
Legal separation
Inadequate records

If the choice is ended for any of these reasons, neither spouse can make a
choice for any future year.
If the choice is made to treat the nonresident spouse as a nonresident for
tax purposes, the following rules apply:

The nonresident alien spouse cannot file a joint return

The nonresident alien spouse is generally not eligible for certain


credits, such as the earned income credit or the education credits

The spouse who is a U.S. citizen or resident may claim an exemption


for the nonresident alien spouse if the nonresident alien has no
gross income for U.S. tax purposes and is not another U.S. taxpayers
dependent.
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The nonresident alien spouse does not have to file a federal income
tax return if he or she had no U. S. source income. Nonresident alien
spouses do not have to report any income from sources outside the
United States so long as they remain nonresident aliens.

Further information about these complex issues can be found in


Publication 519 - U.S. Tax Guide for Aliens.
Dual-Status Aliens
An alien may be both a nonresident and resident alien during the same
tax year. The most common dual-status tax years are the years of arrival
and departure. Dual-status aliens are taxed on income from all sources
for the part of the year they are resident aliens. They are taxed on
income from U.S. sources only for the time they are nonresident aliens.
Dual-status aliens must file Form 1040 and mark it "Dual-Status Return" if
they are resident aliens on the last day of the tax year. If they are
nonresident aliens at the end of the year, they must file Form 1040NR and
mark it "Dual-Status Return."
In either case, they must attach a separate statement to explain their income
and compute the tax for the other part of their dual-status year. Dual-status
aliens must either itemize their allowable deductions or claim zero
deductions because they cannot use the standard deduction.
Undocumentated Aliens
In addition to dual-status aliens, you may encounter undocumented aliens
who wish to file tax returns. Typically, undocumented aliens who meet the
substantial presence test are considered resident aliens for tax purposes.
Although undocumented aliens are not eligible for a social security number
because they do not have legal work authorization, they are eligible for an
ITIN, which enables them to file a tax return.
Spouses of U.S. citizens or residents who are illegal resident aliens should
have an ITIN.

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SIDE BAR

How does the Affordable Care Act (ACA) affect Aliens and U.S.
Citizens Living Abroad?
Are Non-resident aliens covered by the ACA?
Non-resident aliens do not live in the United States and are exempt from
the ACA.
Are Resident aliens covered by the ACA?
The answer is, it depends on what kind of Resident alien.
Aliens present in the US who are Lawful Permanent Residents (i.e. Green
Card Holders) are covered by the ACA.
Aliens present in the US who are not Lawful Permanent Residents (i.e.
Illegal Aliens) are not covered by the ACA.
Are U.S. citizens living abroad covered by the ACA?
U.S. citizens living abroad for at least 330 days of the year will be treated as
if they have qualifying insurance coverage and won't owe any tax penalty.
That's true regardless of whether the U.S. citizen actually has health
insurance in the country where he or she lives.

TAX PRACTICE TIP

ITIN / SSN Mismatches


You may encounter the following scenario that often causes processing
problems for the IRS: An undocumented alien "acquires" (buys, trades
etc.) a social security number to provide to a prospective employer. The
employer hires the alien and gives the alien a W-2 at the end of the year
with the invalid SSN. The alien then files a tax return with their ITIN listed
as their taxpayer identification number. This causes a processing problem
for the IRS. The refund will most likely be held until the issue can be
resolved.

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How to deal with this problem:


The TIN entered in the Form W-2 - Wage and Tax Statement of the tax
software must be identical to the TIN on the paper version provided by
the taxpayer. The IRS requires taxpayers filing tax returns with an
Individual Taxpayer Identification Number reporting wages paid to show
the Social Security Number under which they earned the wages. This
creates an identification number (ITIN/SSN) mismatch. The IRS maintains
a database of these mismatches. Use the taxpayer's correct ITIN as the
identifying number at the top of Form 1040 - U.S. Individual Income Tax
Return. When inputting the Form W-2 information enter the taxpayers
SSN(s) exactly as shown on the Form(s) W-2 issued by the employer.
Children Born Abroad - Obtaining a Social Security Number
Families who wish to apply for a social security number for a child born
overseas should begin the process by first contacting their base legal office
or U.S. embassy officials to obtain a Report of Birth Abroad.
To register the birth of a child born abroad, the parents should bring the
child to the Embassy/Consulate office along with:

The child's original birth certificate


The parents' marriage certificate
Any original divorce decree or death certificate from any previous
marriage
Cash or bank check to pay the fee

While applying for the Report of Birth Abroad, parents should also apply for
a social security number and passport for their child. The Social Security
International Office in Baltimore, Maryland assigns the SSN. The SSN will be
mailed directly to the taxpayer.
The process takes several months. Without a social security number the
parents will NOT be able to claim the child as a dependent or take
advantage of credits such as the Earned Income Tax Credit or the Child Tax
Credit, even if all of the other prerequisites are met.

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TAX QUOTE

"Tax reform is taking the taxes off things that have been taxed in the past
and putting taxes on things that haven't been taxed before."
Art Buchwald (1925-2006) American Humorist and Columnist

SIDE BAR

What are Totalization Agreements?


Since the late 1970's the United States has entered into bilateral
agreements , often called Totalization Agreements, with several nations for
the purpose of avoiding double taxation of income with respect to Social
Security taxes, and for the purpose of coordinating the U.S. Social Security
program with the comparable programs of other countries.
Totalization agreements have two main purposes. They eliminate dual
Social Security taxation (which occurs when a worker from one country
works in another country and is required to pay Social Security taxes to
both countries on the same earnings) and they help fill gaps in benefit
protection for workers who have divided their careers between the United
States and another country.
These agreements must be taken into account when determining whether
any alien is subject to the U.S. Social Security/Medicare tax and whether a
U.S. citizen is subject to the Social Security taxes of a foreign country.
For further information on Totalization Agreements see:
http://www.ssa.gov/international/agreements_overview.html
http://www.irs.gov/Individuals/International-Taxpayers/TotalizationAgreements

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Questions Commonly Asked by or About


Aliens
What is the difference between a resident alien and a nonresident alien
for tax purposes? For tax purposes, an alien is an individual who is not a
U.S. citizen. Aliens are classified as resident aliens and nonresident aliens.
Resident aliens are taxed on their worldwide income, the same as U.S.
citizens. Nonresident aliens are taxed only on their U.S. source income.
What is the difference between the taxation of income that is
effectively connected with a trade or business in the United States and
income that is not effectively connected with a trade or business in the
United States? The difference between these two categories is that
effectively connected income, after allowable deductions, is taxed at
graduated rates. These are the same rates that apply to U.S. citizens and
residents. Income that is not effectively connected is taxed at a flat 30% (or
lower) treaty rate.
I am a student with an F-1 Visa. I was told that I was an exempt
individual. Does this mean I am exempt from paying U.S. tax? The term
"exempt individual" does not refer to someone exempt from U.S. tax. You
were referred to as an exempt individual because as a student temporarily
in the United States on an F Visa, you do not have to count the days you
were present in the United States as a student during the first 5 years in
determining if you are a resident alien under the substantial presence test.
I am a resident alien. Can I claim any tax treaty benefits? Generally, you
cannot claim tax treaty benefits as a resident alien. However, there are
exceptions.
I am a nonresident alien with no dependents. I am working temporarily
for a U.S. company. What return do I file? You must file Form 1040NR if
you are engaged in a trade or business in the United States, or have any
other U.S. source income on which tax was not fully paid by the amount
withheld. You can use Form 1040NR-EZ instead of Form 1040NR if you
meet all 11 conditions listed under Form 1040NR-EZ in Publication 519,
Chapter 7.

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I came to the United States on June 30th of last year. I have an H-1B
Visa. What is my tax status, resident alien or nonresident alien? What
tax return do I file? You were a dual-status alien last year. As a general rule,
because you were in the United States for 183 days or more, you have met
the substantial presence test and you are taxed as a resident. However, for
the part of the year that you were not present in the United States, you are
a nonresident. File Form 1040. Print "Dual-Status Return" across the top.
Attach a statement showing your U.S. source income for the part of the year
you were a nonresident. You may use Form 1040NR as the statement. Print
"Dual-Status Statement" across the top. See First Year of Residency in
Publication 519 Chapter 1 for rules on determining your residency starting
date. An example of a dual-status return is in Publication 519 Chapter 6.
When is my Form 1040NR due? If you are an employee and you receive
wages subject to U.S. income tax withholding, you must generally file by the
15th day of the 4th month after your tax year ends. If you file for the 2008
calendar year, your return is due April 15, 2009. If you are not an employee
who receives wages subject to U.S. income tax withholding, you must file by
the 15th day of the 6th month after your tax year ends. For the 2008
calendar year, file your return by June 16, 2009. For more information on
when and where to file, see Publication 519 Chapter 7.
My spouse is a nonresident alien. Does he need a social security
number? A social security number (SSN) must be furnished on returns,
statements, and other tax-related documents. If your spouse does not have
and is not eligible to get an SSN, he should apply for an individual taxpayer
identification number (ITIN). If you are a U.S. citizen or resident and you
choose to treat your nonresident spouse as a resident and file a joint tax
return, your nonresident spouse needs an SSN or an ITIN. Alien spouses
who are claimed as exemptions or dependents are also required to furnish
an SSN or an ITIN. See Identification Number in Publication 519 Chapter 5
for more information.
I am a nonresident alien. Can I file a joint return with my spouse?
Generally, you cannot file as married filing jointly if either spouse was a
nonresident alien at any time during the tax year. However, nonresident
aliens married to U.S. citizens or residents can choose to be treated as U.S.
residents and file joint returns. For more information on this choice, see
nonresident Spouse Treated as a Resident in Publication 519 Chapter 1.
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I have an H-1B Visa and my husband has an F-1 Visa. We both lived in
the United States all of last year and had income. What kind of form
should we file? Do we file separate returns or a joint return? Assuming
both of you had these visas for all of last year, you are a resident alien. Your
husband is a nonresident alien if he has not been in the United States as a
student for more than 5 years. You and your husband can file a joint tax
return on Form 1040, 1040A, or 1040EZ if he makes the choice to be treated
as a resident for the entire year. See Nonresident Spouse Treated as a
Resident in Publication 519 Chapter 1. If your husband does not make this
choice, you must file a separate return on Form 1040 or Form 1040A. Your
husband must file Form 1040NR or 1040NR-EZ.
Is a "dual-resident taxpayer" the same as a "dual-status tax-payer"?
No. A dual-resident taxpayer is one who is a resident of both the United
States and another country under each countrys tax laws. See Effect of Tax
Treaties in Publication 519 Chapter 1. You are a dual-status taxpayer when
you are both a resident alien and a nonresident alien in the same year. See
Publication 519 Chapter 6.
I am a nonresident alien and invested money in the U.S. stock market
through a U.S. brokerage company. Are the dividends and the capital
gains taxable? If yes, how are they taxed? The following rules apply if the
dividends and capital gains are not effectively connected with a U.S. trade or
business:

Capital gains are generally not taxable if you were in the United
States for less than 183 days during the year. See Sales or Exchanges
of Capital Assets in Publication 519 Chapter 4 for more information
and exceptions.

Dividends are generally taxed at a 30% (or lower treaty) rate. The
brokerage company or payer of the dividends should withhold this
tax at source. If tax is not withheld at the correct rate, you must file
Form 1040NR to receive a refund or pay any additional tax due.

If the capital gains and dividends are effectively connected with a U.S. trade
or business, they are taxed according to the same rules and at the same
rates that apply to U.S. citizens and residents.

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I am a nonresident alien. I receive U.S. social security benefits. Are my


benefits taxable? If you are a nonresident alien, 85% of any U.S. social
security benefits (and the equivalent portion of tier 1 railroad retirement
benefits) you receive is subject to the flat 30% tax, unless exempt, or subject
to a lower treaty rate. See The 30% Tax in Publication 519 Chapter 4.
Do I have to pay taxes on my scholarship? If you are a nonresident alien
and the scholarship is not from U.S. sources, it is not subject to U.S. tax. See
Scholarships, Grants, Prizes, and Awards in Publication 519 Chapter 2 to
determine whether your scholarship is from U.S. sources. If your scholarship
is from U.S. sources or you are a resident alien, your scholarship is subject to
U.S. tax according to the following rules:

If you are a candidate for a degree, you may be able to exclude from
your income the part of the scholarship you use to pay for tuition,
fees, books, supplies, and equipment required by the educational
institution. However, the part of the scholarship you use to pay for
other expenses, such as room and board, is taxable. See Scholarships
and Fellowship Grants in Publication 519 Chapter 3 for more
information.

If you are not a candidate for a degree, your scholarship is taxable.

I am a nonresident alien. Can I claim the standard deduction?


Nonresident aliens cannot claim the standard deduction. However, see
Students and business apprentices from India, under Itemized Deductions in
Publication 519 Chapter 5 for an exception.
I am a dual-status taxpayer. Can I claim the standard deduction? You
cannot claim the standard deduction allowed on Form 1040. However, you
can itemize any allowable deductions.
I am filing Form 1040NR. Can I claim itemized deductions? Nonresident
aliens can claim some of the same itemized deductions that resident aliens
can claim. However, nonresident aliens can claim itemized deductions only
if they have income effectively connected with their U.S. trade or business.
See Itemized Deductions in Publication 519 Chapter 5.
I am not a U.S. citizen. What exemptions can I claim? Resident aliens can
claim personal exemptions and exemptions for dependents in the same way
as U.S. citizens. However, nonresident aliens generally can claim only a
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personal exemption for themselves on their U.S. tax return. There are special
rules for residents of Mexico, Canada, and the Republic of Korea (South
Korea); for U.S. nationals; and for students and business apprentices from
India. See Exemptions in Publication 519 Chapter 5.
What exemptions can I claim as a dual-status taxpayer? As a dual-status
taxpayer, you usually will be able to claim your own personal exemption.
Subject to the general rules for qualification, you can claim exemptions for
your spouse and dependents when you figure taxable income for the part
of the year you are a resident alien. The amount you can claim for these
exemptions is limited to your taxable income (figured before subtracting
exemptions) for the part of the year you are a resident alien. You cannot use
exemptions (other than your own) to reduce taxable income to less than
zero for that period.
I am single with a dependent child. I was a dual-status alien last year.
Can I claim the earned income credit on my tax return? If you are a
nonresident alien for any part of the year, you cannot claim the earned
income credit. See Publication 519 Chapter 6 for more information on dualstatus aliens.
I am a nonresident alien student. Can I claim an education credit on my
Form 1040NR? If you are a nonresident alien for any part of the year, you
generally cannot claim the education credits. However, if you are married
and choose to file a joint return with a U.S. citizen or resident spouse, you
may be eligible for these credits. See Nonresident Spouse Treated as a
Resident in Publication 519 Chapter 1.
I am a nonresident alien, temporarily working in the U.S. under a J visa.
Am I subject to social security and Medicare taxes? Generally, services
you perform as a nonresident alien temporarily in the United States as a
nonimmigrant under subparagraph (F), (J), (M), or (Q) of section 101(a)(15)
of the Immigration and Nationality Act are not covered under the social
security program if you perform the services to carry out the purpose for
which you were admitted to the United States. See Social Security and
Medicare Taxes in Publication 519 Chapter 8.
I am a nonresident alien student. Social security taxes were withheld
from my pay in error. How do I get a refund of these taxes? If social
security or Medicare taxes were withheld in error from pay that is not
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subject to these taxes, contact the employer who withheld the taxes for a
refund. If you are unable to get a full refund of the amount from your
employer, file a claim for refund with the Internal Revenue Service on Form
843, Claim for Refund and Request for Abatement. See Refund of Taxes
Withheld in Error in Publication 519 Chapter 8.
I am an alien who will be leaving the United States. What forms do I
have to file before I leave? Before leaving the United States, aliens
generally must obtain a certificate of compliance. This document, also
popularly known as the sailing permit or departure permit, is part of the
income tax form you must file before leaving. You will receive a sailing or
departure permit after filing a Form 1040-C or Form 2063. These forms are
discussed in Publication 519 Chapter 11.
I filed a Form 1040-C when I left the United States. Do I still have to file
an annual U.S. tax return? Form 1040-C is not an annual U.S. income tax
return. If an income tax return is required by law, you must file that return
even though you already filed a Form 1040-C. Publication 519 Chapters 5
and 7 discuss filing an annual U.S. income tax return.

TAX PLANNING TIP

What are the different tax planning strategies?


Income Deferral Strategies

Have the taxpayers employer pay out any bonuses after January
1st.

Postpone selling stocks and other investments with taxable gains


until after January 1st.

Postpone taking IRA or other retirement account distributions


until after January 1st.

Income Acceleration Strategies

Have the taxpayers employer pay out any bonuses before


December 31st.

Sell stocks and other investments with taxable gains before


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December 31st.

Take IRA or other retirement account distributions before


December 31st.

Deduction Deferral Strategies

Postpone paying medical bills, charitable donations, property tax


and other deductions until after January 1st.

Postpone selling stocks and other investments with losses until


after January 1st.

Deduction Acceleration Strategies

Pay medical bills, charitable donations, and property tax before


December 31st.

Sell stocks and other investments with losses before December


31st.

Increase retirement plan contributions throughout the year.

Taxpayers who choose to accelerate income or defer deductions should


make sure their estimated tax payments and/or withholding cover the
additional income tax this year to avoid estimated tax penalties.
When accelerating deductions keep in mind that they can only be
accelerated for the immediately subsequent year. Taxpayers cannot
deduct, this year, pre-paid deductible expenses for the next five or ten
years. The IRS will disallow the deduction.
Other than accelerating or postponing income and deductions, are
there any other tax planning techniques?
Yes, there are. Here are some of the things taxpayers can do to lower
their income taxes:

Invest their money to take advantage of long term capital gains


and qualifying dividends, both of which are taxed at a maximum
20% tax rate instead of the maximum 39.6% personal income tax
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rate.

Invest their money in tax exempt municipal bonds and Roth IRAs.

Seek tax free employment benefits such as such as health and life
insurance.

Take advantage of tax free education benefits.

Seek employment or take a position with their current employer


overseas to take advantage of the Foreign Earned Income
Exclusion.

Defer income through qualified retirement plans, 401(k) plans,


Keogh plans, and traditional IRAs.

Defer income on the sale of appreciated property through the use


of installment sales.

Defer income by investing in US Savings Bonds.

Self employed business owners may be able to use income


splitting with family members.

Defer tax on appreciated property by utilizing tax free exchanges.

Purchase a home to convert non-deductible rent into deductible


mortgage interest and property taxes. Homeowners can also
borrow on any home equity and, within limitations, deduct that
interest too. They may also receive part or all of any gain upon its
sale tax free.

Many of the above techniques will be discussed in the Lessons that


follow.

Lesson Summary
An alien has one of the following statuses:

Resident: Is a U.S. resident for tax purposes by meeting either the


green card test or the substantial presence test
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Nonresident: Is not a resident of the United States


Dual status: Is both a nonresident and resident alien for the tax year

An alien may qualify as a U.S. resident for tax purposes by meeting either
the green card test or the substantial presence test for the calendar year.
Resident aliens generally are taxed on their worldwide income, the same as
U.S. citizens.
As a general rule, most alien enlistees in the Armed Forces are resident
aliens. This is certainly true of aliens who were permanent residents of the
United States before enlistment. In peacetime, all enlistees in the Armed
Services must be U.S. citizens or permanent residents.
Nonresident aliens generally must pay tax only on income received from
sources within the United States.
An alien may be both a nonresident and resident alien during the same tax
year. The most common dual-status tax years are the years of arrival and
departure. Dual-status aliens are taxed on income from all sources for the
part of the year they are resident aliens. They are taxed on income from U.S.
sources only for the time they are nonresident aliens.
In addition to dual-status aliens, you may encounter undocumented aliens
who wish to file tax returns. Typically, undocumented aliens who meet the
substantial presence test are considered resident aliens for tax purposes.
Although undocumented aliens are not eligible for a social security number
because they do not have legal work authorization, they are eligible for an
ITIN, which enables them to file a tax return.
Nonresidents should file Form 1040NR or 1040NR-EZ. Dual-status aliens
can file either Form 1040 if they were residents at the end of the year or
Form 1040NR/1040NR-EZ if they were nonresidents at the end of the year.
This lesson also explained how to obtain a Social Security Number for
children born abroad.

Questions Taxpayers Ask


Question: "Do I have to pay tax on employee achievement awards?"

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Answer: You can exclude from taxable income employee achievement


awards you receive only if your employer can deduct the employee
achievement awards on its tax return. To be tax deductible by your
employer on its tax return, and excluded from your tax return, the employee
achievement awards must meet ALL the following requirements:

Be given for length of service after a minimum of five years of


service, or for safety achievement. Only one length of service award
can be given every five years

Be tangible personal property, other than cash, gift certificates or


equivalent items

Be given under conditions and circumstances that do not create a


significant likelihood of the payment being disguised compensation

Be given as part of a meaningful presentation

Be no more than the specified dollar limits

There are two types of employee achievement award plans, tax qualified
and non-tax qualified. A tax qualified employee achievement award plan is
an established written plan that does not discriminate or favor highly
compensated employees. A tax qualified employee achievement award plan
can deduct up to $1,600 for all employee achievement awards to the same
employee on its tax return during a taxable year. The average cost of all
employee achievement awards during the tax year for all employees cannot
exceed $400.
For a non-tax qualified employee achievement award plans, the tax
deduction limit on the employer's tax return is $400 for each employee.
Question: "Do I have to pay tax on a holiday gift from my employer?"
Answer: If your employer gives you a turkey, ham, or other item of nominal
value as a Christmas or other holiday gift, the value of the holiday gift is not
taxable income and you don't need to report it on your tax return. However,
a holiday gift payment may be called a holiday gift but may still be taxable
income which you must report on your tax return. A holiday gift payment
that is related to your past or future services is taxable income. If your
employer gives you a holiday gift of cash, a holiday gift certificate, or similar
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holiday gift item that you can easily exchange for cash, the value of the
holiday gift is extra taxable salary or wages regardless of the amount
involved which you must report on your tax return.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify you're understanding of the
most important lesson content, and will also help you pass the
Final Exam.
Do the Homework - While completing the homework is not
mandatory, we strongly recommend that you complete each
lesson's homework assignment. It will expand your knowledge
and understanding of the topics covered in this course.

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LESSON 5 - FILING
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STATUSES

AND

WHO

SHOULD

FILE

Lesson

5
Lesson 5 - Filing Statuses and Who
Should File a Tax Return
This lesson is designed to teach you about the five different filing statuses
and how to determine which filing status and which tax form a taxpayer
should use. At the end of this lesson, you will be able to:

Apply the requirements for each of the five filing statuses


Select the correct filing status for various taxpayers
Determine who must file
Determine who should file
Select the appropriate tax return form to use

The following topics are discussed in this lesson:


What Are the Filing
Statuses?
Single Taxpayers
Married Filing Jointly
Innocent and Injured
Spouses
Married Filing Separately
Head of Household
Keeping Up a Home
Married and Living Apart
with Dependent Child

After the Spouse's Death


Who Must File Versus Who
Should File
Dependents Who Must or
Should File a Return
People Age 65 or Older or
Blind
Other Situations When
Taxpayers Must File
Who Should File
Who Should Not File
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STATUSES

Qualifying Widow(er) With


Dependent Child

AND

WHO

SHOULD

FILE

Which Form to Use

axpayers must file under one of five filing statuses. The five filing
statuses, from lowest to highest tax rate, are:
Married Filing Jointly
Qualifying Widow(er) With Dependent Child
Head of Household
Single
Married Filing Separately

Instructors Note: Throughout our course you'll see graphics like the one
below, that are part of Form 1040 and Schedules A & B. Where applicable,
the graphics will be highlighted to direct your attention to the appropriate
area. To obtain a full sized, printable version of Form 1040 for your
reference click here. You may also want to get Schedules A & B.

Figure 5-1: The Filing Status section of Form 1040.

The first step in determining the taxpayer's filing status is to confirm their
marital status on the last day of the tax year.

Tax Tip

Annulment vs. Divorce Whats the difference?


Both an annulment and a divorce are court proceedings that dissolve a
marriage. But, unlike a divorce, an annulment treats the marriage as
though it never happened. A seemingly inconsequential difference. But
not as far as the IRS is concerned. Married couples that have filed their
tax returns as such, and subsequently have the marriage annulled, need
to file Form 1040-X - Amended U.S. Individual Income Tax Return and
then file two separate tax returns as single taxpayers.

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STATUSES

AND

WHO

SHOULD

FILE

Single Taxpayers
A taxpayer is considered Single if, on the last day of the tax year, the
taxpayer was either:

Never married
Legally separated or divorced
Widowed before the first day of the tax year and not remarried
during the year

Figure 5-2: The Filing Status section of Form 1040 with the Single filing status highlighted.

Single taxpayers may also qualify for another filing status that results in a
lower tax, such as Head of Household or Qualifying Widow(er) with
Dependent Child, which will be discussed later in this lesson. If you realize
more than one filing status may apply, prompt the taxpayer for more
information so you can choose the filing status that will result in the lowest
tax.

Tax Quote

"Too bad all the people who know how to run this country are busy
running taxicabs or cutting hair."
George Burns (1896-1996) Comedian

Married Filing Jointly


Taxpayers may use the Married Filing Jointly filing status if one of the
following applies on the last day of the tax year:

They are married and:


o Live together as husband and wife, or
o Live apart but are not legally separated or divorced
They live together in a recognized common-law marriage
They are separated under an interlocutory (not final) divorce decree

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The taxpayer's spouse died during the year and the taxpayer has not
remarried

Figure 5-3: The Filing Status section of Form 1040 with the Married Filing Jointly filing status
highlighted.

A marriage means only a legal union between a man and a woman as


husband and wife. The IRS recognizes a common-law marriage if it is
recognized by the state where the taxpayers now live or where the
common-law marriage began.
Currently, the following jurisdictions recognize common law marriage:

Alabama
Colorado
District of Columbia
Georgia (if created before 1/1/97)
Idaho (if created before 1/1/96)
Iowa
Kansas
Montana
Ohio (if created before 10/10/91)
Oklahoma
Pennsylvania (if created before 1/1/05)
Rhode Island
South Carolina
Texas
Utah

In order to have a valid common law marriage the couple must do all of the
following:

live together for a significant period of time

hold themselves out as a married couple by doing such things as


using the same last name, referring to each other as "my husband"
or "my wife", and
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intend to be married.

If the common law marriage is recognized in the state where the taxpayers
live or in the state where the common law marriage began then the
marriage is recognized under federal law and the taxpayers are considered
married for federal tax purposes and they can file a joint tax return.
Some states recognize a common law marriage originated and approved in
another state, but will not recognize common law marriage originating in
their state. Check the law for each state for specific rules regarding common
law marriage. Legal advice may be required to determine if a common-law
marriage exists.
Taxpayers can choose either the Married Filing Jointly status or the Married
Filing Separately status even if only one spouse has income. Married Filing
Jointly status generally provides a lower combined tax than any other filing
status.
Taxpayers who file a joint return must combine their income and deductions
on the same return. Both husband and wife:

Must sign the return


Are responsible for any tax owed on the return

A U.S. resident or citizen who is married to a nonresident alien can file a


joint return as long as both spouses agree to be taxed on their worldwide
income. See Publication 519 - Tax Guide for Aliens, for more information.

Tax Tip

If the Taxpayer Changed Her Name Due to Marriage or Divorce


If the taxpayer changed her name as a result of a recent marriage or
divorce shell want to take the necessary steps to notify the Social
Security Administration (SSA) to ensure the name on her tax return
matches the name registered with the SSA. A mismatch between the
name shown on her tax return and the SSA records will cause problems in
processing the tax return and will delay her refund.
When newly married women file a tax return using their new last names,
IRS computers cant match the new name with their Social Security
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WHO

SHOULD

FILE

Number and IRS will reject the tax return. The e-filed return will rejected
for Business Rule 503 - Spouse SSN and the Spouse Name Control in the
Return Header must match the e-File database.
If you receive this rejection check with the taxpayers to ensure the SSA
was notified. Get a copy of the Social Security card from the taxpayer to
verify the information. Focus on matching the first four characters of the
first and last names. That's what the IRS verifies.
When an individual visits the SSA and makes a name or social security
number change you must wait 10 days before re-transmitting the return
in order to allow sufficient time for the IRS to update their records.
Be aware: Some "503's" may be related to an individual's use of
unauthorized or stolen Social Security information.
If she was recently divorced and changed back to her previous last name,
shell also need to notify the SSA of this name change.
Informing the SSA of a name change is easy. Shell just need to file a
Form SS-5 - Application for a Social Security Card at her local SSA office
and provide a recently issued document as proof of her legal name
change. Her new card will have the same number as her previous card,
but will show her new name.

Innocent and Injured Spouses


Many married taxpayers choose to file a joint tax return because of certain
benefits this filing status allows. Both taxpayers are jointly and individually
responsible for the tax and any interest or penalty due on the joint return
even if they later divorce. This is true even if a divorce decree states that a
former spouse will be responsible for any amounts due on previously filed
joint returns. One spouse may be held responsible for all the tax due even if
all the income was earned by the other spouse.
In some cases, a spouse, or former spouse, will be relieved of the tax,
interest, and penalties on a joint tax return. Three types of relief are
available:

Innocent Spouse Relief


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WHO

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FILE

Separation of Liability Relief


Equitable Relief

Publication 971 - Innocent Spouse Relief, explains these types of relief, who
may qualify for them, and how to get them. Taxpayers can also use the
Innocent Spouse Tax Relief Eligibility Explorer at http://www.irs.gov to see if
they qualify for innocent spouse relief. Click on "Individuals," "Tax
Information for Innocent Spouses," and "Explore if you are an Eligible
Innocent Spouse."
Married persons who did not file joint returns, but who live in community
property states, may also qualify for relief. See Community Property Laws, in
Publication 971.
Further information about Innocent and Injured Spouse Relief is included in
Lesson 30, IRS Audits.

Married Filing Separately


Taxpayers who are married may choose the Married Filing Separately status,
which means the husband and wife report their own incomes and
deductions on separate returns, even if one spouse had no income. One
spouse may not want to be responsible for the other spouse's tax owed. In
certain cases, filing separately may result in a lower total tax. If one spouse
has high medical or miscellaneous expenses, or large casualty losses,
separate returns may result in lower taxes because a lower adjusted gross
income allows more expenses or losses to be deducted.

Figure 5-4: The Filing Status section of Form 1040 with the Married Filing Jointly filing status
highlighted.

The Filing Status section of Form 1040 with the Married Filing Jointly filing
status highlighted.
If a married couple files separately and one spouse itemizes deductions, the
other spouse must either:

Also itemize deductions, or


Claim "0" (zero) as the standard deduction
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In other words, a taxpayer whose spouse itemizes deductions cannot take


the standard deduction.
A married taxpayer who files separately must show the spouse's name and
social security number on the return.
Taxpayers who live in a community property state must follow state law to
determine their separate income.
For more information, see Publication 555 - Community Property.
Married taxpayers must generally file either as Married Filing Jointly or
Married Filing Separately. There is one exception. Some taxpayers who are
still legally married but living apart from their spouse and supporting
dependent children may qualify to file as Head of Household, which results
in a lower tax than Married Filing Separately.
In a few limited situations married taxpayers must file separately:

if the spouses have different tax years and this difference is not due
to the death of either spouse (either spouse may be able to obtain
IRS consent to change to a "matching" tax year by filing Form 1128 Application to Adopt, Change, or Retain a Tax Year)

if either spouse at any time during the year is a nonresident alien


and the couple chooses not to treat the nonresident alien spouse as
a U.S. resident subject to tax on worldwide his or her income, or

if a spouse has died during the year and the personal representative
of the estate elects to file a separate return

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Tax Tip

When should married couples consider filing separately?


If both spouses have separate income, and one has substantial medical
expenses, it may be worth it to file separately. Filing separately can make
the 7 % floor for deducting medical expenses a much lower dollar
amount for the spouse who is ill thus creating a larger tax deduction. A
similar situation arises with miscellaneous itemized deductions with the
2% threshold, and non-business casualty losses with the 10% threshold.
These issues are discussed in detail in Lessons 18 and 19.
Remember, when filing separately, both spouses must either itemize or
take the standard deduction on each of their separate tax returns.
Other tax issues regarding married couples filing separately, such as loss
of tax credits and deductions, increased taxes on social security benefits,
and phase-out rules for the IRA deduction are covered in detail in the Tax
Tip titled "Should married taxpayers file jointly or separately?" in Lesson
16 at the Student Loan Interest Deduction section.
Married taxpayers who have filed Separately have three (3) years from the
due date of the return to change the returns to Married Filing Jointly
status. Use Form 1040-X - Amended U.S. Individual Income Tax Return to
make the change. However, returns filed Jointly cannot be changed to
Married Filing Separately once the due date has passed.
The table below shows which spouse gets to deduct what:
IF you paid...

AND you...

Medical Expenses

paid with funds deposited


in a joint checking
account in which you and
your spouse have an
equal interest
file a separate state
income tax return

State Income Tax

file a joint state income


tax return and you and
your spouse are jointly

111

THEN you can deduct


on your separate federal
return...
half of the total medical
expenses, subject to
certain limits, unless you
can show that you alone
paid the expenses.
the state income tax you
alone paid during the
year.
the state income tax you
alone paid during the
year.

LESSON 5 - FILING
A TAX RETURN

IF you paid...

STATUSES

AND

AND you...

and individually liable for


the full amount of the
state income tax
file a joint state income
tax return and you are
liable for only your own
share of state income tax

Property Tax

Mortgage Interest

Casualty Loss

paid the tax on property


held as tenants by the
entirety
paid the interest on a
qualified home held as
tenants by the entirety
have a casualty loss on a
home you own as tenants
by the entirety

WHO

SHOULD

FILE

THEN you can deduct


on your separate federal
return...

the smaller of:


the state income
tax you alone
paid during the
year, or
the total state
income tax you
and your spouse
paid during the
year multiplied by
the following
fraction: the
numerator is your
gross income and
the denominator
is your combined
gross income.
the property tax you alone
paid.
the mortgage interest you
alone paid.
half of the loss, subject to
the deduction limits.
Neither spouse may
report the total casualty
loss.

Tax Tip

What filing status should newlyweds use?


A taxpayers filing status for the entire tax year is determined by their
marital status as of December 31st. So if the taxpayers are married on
December 31st then, for tax purposes, their filing status is married for the
entire year. And if the taxpayer is single, divorced, or legally separated on
December 31st then he is single for the entire year. Taxes are probably
the last thing people want to think about when they are getting married
or divorced but they should. It might pay to either get married or
divorced on either December 31st or January 1st. That takes tax planning!
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Head of Household
Head of Household status generally results in a lower tax than the Single
status. So unmarried taxpayers, and certain married taxpayers, should use
the Head of Household status if they qualify.

Figure 5-5: The Filing Status section of Form 1040 with the Head of Household filing status
highlighted.

Keeping Up a Home
In general, the Head of Household status is for unmarried taxpayers who
paid more than half the cost of keeping up a home for a qualified
dependent relative who lived with them in the home more than half the tax
year. Valid household expenses include:

Rent, mortgage interest, real estate taxes


Home insurance, repairs, utilities
Domestic help
Food eaten in the home

Welfare payments are not considered amounts that the taxpayer provides
to keep up a home.

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Tax Tip

Is it possible to claim Head of Household filing status if the


taxpayer's parents live in their own home, or are in a nursing
home?
To claim the Head of Household filing status, ordinarily the household
must be the taxpayers own home. However, the taxpayers parents
can be supported (over of the parents household expenses are
paid by the taxpayer) in a household outside of the taxpayers home
and the taxpayer will still qualify for Head of Household status.
Taxpayers can also qualify as Head of Household when they support a
parent in a nursing home. This exception applies to parents only. Not
to other dependents, or even a disabled child.
The support test requires that taxpayers count what a parent actually
spends for his or her own support, not all of the funds available for
support. Only count the money that the taxpayers parents actually
spend from their own resources.
Many filing status errors involve the Head of Household status, so be sure
the taxpayer meets ALL the qualifications before selecting Head of
Household status.
Qualifying Criteria
Taxpayers may use the Head of Household status if they meet two criteria.
The first criterion is that the taxpayer either:

Was unmarried (single, divorced, or legally separated) on the last day


of the year, or

Met the tests for married persons living apart with dependent
children

The second criterion is that for more than half the year (except for
temporary absences), the taxpayer must have paid more than half the cost
of keeping up the main home of any of the following who lived with them:

The taxpayer's qualifying child


The taxpayer's qualifying relative
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The table below shows who is a qualifying person:


IF the person is
your...
qualifying child (such
as a son, daughter, or
grandchild who lived
with you more than
half the year and
meets certain other
tests)

AND...
he or she is single

he or she is married
and you can claim an
exemption for him or
her
he or she is married
and you cannot claim
an exemption for him
or her

THEN that person


is...
a qualifying person,
whether or not you
can claim an
exemption for the
person.
a qualifying person.

not a qualifying
person.

qualifying relative
a qualifying person.
who is your father or
not a qualifying
mother
person.
qualifying relative
a qualifying person.
other than your
not a qualifying
father or mother
person.
(such as a
not a qualifying
grandparent, brother,
person.
or sister who meets
not a qualifying
certain tests)
person.
Relatives who do not have to live with you. A person related to you in
any of the following ways does not have to live with you all year as a
member of your household to meet this test:
Your child, stepchild, foster child, or a descendant of any of them (for
example, your grandchild). (A legally adopted child is considered your
child.)
Your brother, sister, half brother, half sister, stepbrother, or stepsister.
Your father, mother, grandparent, or other direct ancestor, but not
foster parent.
Your stepfather or stepmother.
A son or daughter of your brother or sister.
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A brother or sister of your father or mother.


Your son-in-law, daughter-in-law, father-in-law, mother-in-law,
brother-in-law, or sister-in-law.
Any of these relationships that were established by marriage are not
ended by death or divorce.
Please Note: If you are a noncustodial parent, the term qualifying
child for head of household filing status does not include a child who
is your qualifying child for exemption purposes only because of the
rules for children of divorced or separated parents or parents who live
apart. If you are the custodial parent and those rules apply, the child
generally is your qualifying child for head of household filing status
even though the child is not a qualifying child for whom you can claim
an exemption.
Temporary absences include those for school, vacation, illness, business, or
military service.
The taxpayers qualifying child includes: the taxpayers child or stepchild
(whether by blood or adoption), foster child, sibling or step sibling, or a
descendant of one of these. Taxpayers cannot claim the Head of Household
status if the only dependent they can claim is under a multiple support
agreement, which is discussed in the Personal and Dependency Exemptions
lesson.
The table below summarizes the qualifying relationships for the Head of
Household filing status:
Relationship to
Taxpayer

Must Live with


Taxpayer?

Must Be Taxpayer's
Dependent?

Qualifying child

Yes, for more than half


the year

Yes, unless a noncustodial parent claims


the child as a dependent

Married child

Yes, for more than half


the year

Yes, unless a noncustodial parent claims


the child as a dependent

Parent

No

Yes

Other relatives

Yes, for more than half


the year

Yes

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Tax Tip

Should divorced taxpayers file as Single or Head of Household?


Taxpayers, provided they qualify, will get a bigger refund if they file as
Head of Household as the tax rates are lower and the standard deduction
is higher. If the taxpayers ex-spouse claims their child as a dependent on
his or her tax return, but the child lives with the taxpayer, then the
taxpayer probably can still file as Head of Household. Ditto if the taxpayer
can claim a parent, grandparent, nephew, niece, brother or sister as a
dependent.
A custodial parent who has released the right to claim his or her child as a
dependent to their ex-spouse still has the right to claim Head of
Household status, the Earned Income Tax Credit, and the Dependent
Care Credit. The non-custodial parent has the right to claim the $1,000
Child Tax Credit and the Dependency Exemption.
Separated couples with two or more children might be able to work out
an arrangement whereby each gets a dependent child to live with them
and each qualifies as a Head of Household thereby qualifying both for
lower tax rates.

Married and Living Apart with Dependent


Child
Some married taxpayers who live apart from their spouses and provide for
dependent children may be considered unmarried for tax purposes. These
taxpayers are permitted to file as Head of Household and receive the
benefit of lower tax amounts if they meet all the following criteria:

The taxpayer chooses to not file a joint return with his or her spouse

The taxpayer paid more than half the cost of keeping up the
qualifying child 's home for the year

The taxpayer's spouse did not live in the home during the last six
months of the year
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The taxpayer's home was the main home of the taxpayer's qualifying
child for more than half the year or the taxpayer's foster child for the
entire year

For these married taxpayers, "qualifying child" includes biological, adopted,


foster, and stepchildren, but does not include grandchildren, brother, sister
or their descendants (for example, niece or nephew). Only unmarried
taxpayers may be able to use a grandchild as a qualifying child for Head of
Household status.
The last criterion a married taxpayer must meet to file as Head of
Household is:

The taxpayer claims the qualifying child as a dependent, unless:


o The taxpayer signed a statement allowing the non-custodial
parent to claim the child as a dependent, or
o The non-custodial parent provided at least $600 for the
child's support and can claim the dependent under a pre1985 agreement

Parents of children who are presumed to have been kidnapped by someone


who is not a family member may be able to take the child into account in
determining their eligibility for the Head of Household or Qualifying
Widow(er) filing status, deduction for dependents, the Child Tax Credit, and
the Earned Income Credit (EIC). For details, see Publication 501 - Exemptions,
Standard Deductions, and Filing Information or Publication 596 - Earned
Income Credit.
Table for Determining Status:
The table below is used to determine a taxpayer's correct filing status.

Were you married on the last day of the year?


NO:
Did you pay more than half the costs
of keeping up a home for a qualifying
child or relative for more than 6
months?

118

YES:
Did you and your spouse live apart
during
the last 6 months of the year?

LESSON 5 - FILING
A TAX RETURN

NO:
Single

STATUSES

YES:
Head of
Household

AND

WHO

SHOULD

FILE

NO:
Married Filing
Jointly OR Married
Filing Separately

YES:
Did you pay
more than half
the costs of
keeping up a
home for a
qualifying child
who lived with
you more than 6
months?

NO:
Married Filing
Jointly OR Married
Filing Separately

YES:
Head of
Household

Reporting
Taxpayers must specify the person who qualifies them for the Head of
Household status. Otherwise the IRS must delay processing until contacting
the taxpayer and obtaining the information.

If the qualifying person is a dependent, enter the dependent's name


on line 6c of the return's Exemptions section

If the qualifying person is the taxpayer's unmarried child who is not a


dependent, enter the child's name on line 4 in the return's Filing
Status section

Some married taxpayers who live apart from their spouse may qualify as
Head of Household and not even know it. You can help by advising them to
use the Head of Household status to get a lower tax rather than using the
Married Filing Separately status.

Tax Quote

"We contend that for a nation to try to tax itself into prosperity is like a
man standing in a bucket and trying to lift himself up by the handle."
Sir Winston Churchill (1874-1965) Prime Minister of the United Kingdom

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Qualifying Widow(er) With Dependent Child


A widow or widower with one or more dependent children may be able to
use the widow(er) with dependent child filing status. This filing status yields
as low a tax amount as Married Filing Jointly, and is available for only two
years following the year of the spouse's death.

Figure 5-6: The Filing Status section of Form 1040 with the Qualifying Widow(er) filing
status highlighted.

Qualifying Criteria
To qualify for the widow(er) with dependent child filing status, the taxpayer
must:

Not have remarried before the end of the tax year

Have been eligible to file a joint return for the year the spouse died;
it does not matter if a joint return was actually filed

Have a child, stepchild, or adopted child who qualifies as the


taxpayer's qualifying child for the year

Have furnished over half the cost of keeping up the child's home for
the entire year

An adopted child is a child placed with the taxpayer by an authorized


placement agency for legal adoption.
Social Security survivor benefits received on behalf of the child do not count
toward the taxpayer's cost of keeping up the home because those benefits
are considered to be amounts furnished by the child, not by the parent.
The following table summarizes the filing statuses:

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Filing
Status

Marital Status

Conditions

Single

Never married - no dependents


Never married - with dependents (conditions
apply)
Living together or apart as of 12/31/2015

Married

S
HH
MJ / MS

Separated (not legally) with dependents

HH

Before 1/1/15, didn't remarry in 2015, no


dependents

In 2015, didn't remarry in 2015

Widowed

Divorced/Legally
Separated

Before 1/1/14, didn't remarry in 2015, with


dependents
Spouse died in 2012, 2013, or 2014, and didn't
remarry in 2015 and:
1) taxpayer was eligible to file joint in year of
death
2) dependent children lived with taxpayer for all of
2015
3) paid more than 50% to maintain home for
dependents

MJ
HH / QW

QW

No dependents

With dependents (conditions apply)


Living apart as of 12/31/2015

HH
MJ / MS

If all conditions below apply:


1) both spouses file separate tax returns
Separated (not
legally)

2) taxpayers lived apart the last 6 months of 2015


3) paid more than 50% to maintain a home in
2015
4) home was the main home for child for more
than 6 months in 2015
5) either spouse can claim child as dependent

HH

Table: Filing Status

Tax Tip

What filing status do married couples of the same-sex use?


In the past, Federal tax law did not recognize same-sex marriages so a
same-sex couple couldn't file a Joint federal tax return. They had to file
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using the Single filing status. About 20 states have some kind of law
recognizing same-sex marriages. In states that recognize same-sex
marriages, they might be able to file their state tax return using a married
filing status.
On June 26, 2013 the U.S. Supreme Court ruled the Defense of Marriage
Act (which prevented the IRS from recognizing same-sex couples)
unconstitutional. Below is the IRS announcement.
Treasury and IRS Announce That All Legal Same-Sex Marriages
Will Be Recognized For Federal Tax Purposes; Ruling Provides
Certainty, Benefits and Protections Under Federal Tax Law for
Same-Sex Married Couples
WASHINGTON The U.S. Department of the Treasury and the
Internal Revenue Service (IRS) today ruled that same-sex couples,
legally married in jurisdictions that recognize their marriages, will be
treated as married for federal tax purposes. The ruling applies
regardless of whether the couple lives in a jurisdiction that recognizes
same-sex marriage or a jurisdiction that does not recognize same-sex
marriage.
The ruling implements federal tax aspects of the June 26 Supreme
Court decision invalidating a key provision of the 1996 Defense of
Marriage Act.
Under the ruling, same-sex couples will be treated as married for all
federal tax purposes, including income and gift and estate taxes. The
ruling applies to all federal tax provisions where marriage is a factor,
including filing status, claiming personal and dependency exemptions,
taking the standard deduction, employee benefits, contributing to an
IRA and claiming the earned income tax credit or child tax credit.
Any same-sex marriage legally entered into in one of the 50 states,
the District of Columbia, a U.S. territory or a foreign country will be
covered by the ruling. However, the ruling does not apply to
registered domestic partnerships, civil unions or similar formal
relationships recognized under state law.

122

LESSON 5 - FILING
A TAX RETURN

STATUSES

AND

WHO

SHOULD

FILE

Legally-married same-sex couples generally must file their federal


income tax return using either the married filing jointly or married
filing separately filing status.
Individuals who were in same-sex marriages may, but are not required
to, file original or amended returns choosing to be treated as married
for federal tax purposes for one or more prior tax years still open
under the statute of limitations.
Generally, the statute of limitations for filing a refund claim is three
years from the date the return was filed or two years from the date
the tax was paid, whichever is later. Some taxpayers may have special
circumstances, such as signing an agreement with the IRS to keep the
statute of limitations open, that permit them to file refund claims for
earlier tax years.
Additionally, employees who purchased same-sex spouse health
insurance coverage from their employers on an after-tax basis may
treat the amounts paid for that coverage as pre-tax and excludable
from income.
How to File a Claim for Refund
Taxpayers who wish to file a refund claim for income taxes should use
Form 1040X, Amended U.S. Individual Income Tax Return.
Taxpayers who wish to file a refund claim for gift or estate taxes
should file Form 843, Claim for Refund and Request for Abatement.
For information on filing an amended return, see Tax Topic 308,
Amended Returns, available on IRS.gov, or the Instructions to Forms
1040X and 843. Information on where to file amended returns is
available in the instructions to the form.
Revenue Ruling 2013-17, along with updated Frequently Asked
Questions for same-sex couples and updated FAQs for registered
domestic partners and individuals in civil unions, are available today
on IRS.gov. See also Publication 555, Community Property.

123

LESSON 5 - FILING
A TAX RETURN

STATUSES

AND

WHO

SHOULD

FILE

After the Spouse's Death


In the year a taxpayer's spouse dies, if the taxpayer does not remarry, he or
she can:

Use either the Married Filing Jointly filing status or the Married Filing
Separately status

Claim an exemption for the deceased spouse

In the year of death widowed taxpayers often file a joint return with their
deceased spouse. Otherwise the widow(er) must file a separate return on
behalf of the deceased spouse whose income exceeded certain limits. See
Publication 559 - Survivors, Executors, and Administrators for more
information.
For the first and second years after the spouse's death, the widowed
taxpayer with dependent child(ren):

May no longer claim an exemption for the deceased spouse

Can file as a widow(er) with dependent child (unless the taxpayer


remarries)

After the second year following the year of death, the widowed taxpayer
may no longer use the widow(er) filing status, however might qualify for
Head of Household filing status.
The table below shows which filing status to use for a widowed taxpayer
who does not remarry and has a qualifying dependent:
Tax Year

Filing Status

Exemption for
Deceased Spouse?

Year of death

Married Filing Jointly or


Married Filing Separately

Yes

First year after death

Qualifying widow(er)

No

Second year after death

Qualifying widow(er)

No

124

LESSON 5 - FILING
A TAX RETURN

Tax Year
After second year of
death

STATUSES

AND

Filing Status

Head of Household

WHO

SHOULD

FILE

Exemption for
Deceased Spouse?
No

Side Bar

How does getting remarried affect Social Security benefits?


Taxpayers that were receiving spousal benefits based on their former
spouse's work record will generally lose those benefits upon remarriage.
However, if the taxpayer was over age 60 when she remarried (or age 50
and disabled) her eligibility for the spousal benefits under her first
spouse's work record remains intact. For widows under age 60 (or
disabled and under age 50) remarriage ends any benefits based on the
record of their deceased spouse.
Remarried taxpayers can receive spousal benefits under the new marriage
if she is eligible for a higher allowance through her new spouse. Remarried
taxpayers who would receive higher benefits based on their own work
record can receive those benefits.
For working spouses during the first marriage a remarriage does not
change the benefits paid to either the new spouse or the ex-spouse.

Who Must File Versus Who Should File


To decide whether someone must file a tax return, you need to know the
individual's:

Filing status
Age
Gross Income
If the person can be claimed as a dependent on another's tax return
If the person is blind
If special taxes might be owed on different types of income
If some of the income is excludable or exempt
125

LESSON 5 - FILING
A TAX RETURN

STATUSES

AND

WHO

SHOULD

FILE

Whether the taxpayer owes taxes or not, individuals must file a return
whenever the table above shows they must file. For a minor who is unable
to file, the child's parent or guardian must complete and sign a return for
the child.
The following table summarizes who must file a tax return:

If the taxpayer's filing

and at the end of

the taxpayer must file

status is:

2014 the taxpayer

a tax return if his

was:

gross income was at


least:

Single

under 65

$10,150

65 or older *

$11,700

Married, living together both spouses under 65

$20,300

at the end of 2014, and one spouse 65 or older

$21,500

filing jointly

*
both spouses 65 or

$22,700

older*
Married, living together any age

$3,950

at the end of 2014, and


filing separately
Married and living apart any age

$3,950

at the end of 2014


Head of Household

under 65

$13,050

65 or older *

$14,600

Qualifying widow(er)

under 65

$16,350

with dependent child

65 or older *

$17,550

* Age 65 or older - even if if born on 1/1/1950.


Table: Who Must File

126

LESSON 5 - FILING
A TAX RETURN

STATUSES

AND

WHO

SHOULD

FILE

Dependents Who Must or Should File a


Return
Dependents who must file a tax return include:

A married dependent with at least $5 of income whose spouse


itemizes deductions on a separate Form 1040

A dependent with at least $400 of net self-employment income

However, dependents who are not required to file should file a return to
claim:

A refund of withheld taxes


The earned income tax credit

People Age 65 or Older or Blind


Make sure to complete the appropriate age/blindness boxes. Failure to
complete these boxes is one of the most frequent tax return errors.

Figure 5-7: The Tax and Credits section of Form 1040 with the Age and Blindness
section highlighted.

Other Situations When You Must File


There may be other conditions that require the taxpayer to file a return,
such as:

Special taxes
127

LESSON 5 - FILING
A TAX RETURN

STATUSES

AND

WHO

SHOULD

FILE

Self-employment income of a certain amount


Income from certain church organizations of a certain amount

If any of the four conditions listed below apply, a tax return must be filed.
1. The taxpayer owes any special taxes, such as:

Social Security or Medicare tax on tips not reported to the employer.


Social Security or Medicare tax on wages you received from an
employer who did not withhold these taxes.
Uncollected Social Security, Medicare, or Railroad Retirement tax on
tips reported to your employer.
Uncollected Social Security, Medicare, or Railroad Retirement tax on
group-term life insurance. This amount should be shown in box 12
of Form W-2.
Alternative Minimum Tax.
Additional tax on a qualified retirement plan, including an Individual
Retirement Arrangement (IRA).
Additional tax on an Archer MSA or Health Savings Account.
Additional tax on a Coverdell ESA or qualified tuition program.
Recapture of an investment credit or a low-income housing credit.
Recapture of the qualified electric vehicle credit.
Recapture of an education credit.
Recapture of the Indian employment credit.
Recapture of the new markets credit.
Recapture of the alternative motor vehicle credit.
Recapture of the first-time homebuyer credit.
Household employment taxes.

2. The taxpayer had net earnings from self-employment of at least $400.


3. The taxpayer had wages of $108.28 or more from a church or qualified
church-controlled organization that is exempt from employer Social
Security and Medicare taxes.

Who Should File


Although some individuals may not be required to file, they should file a
return to claim:
128

LESSON 5 - FILING
A TAX RETURN

STATUSES

AND

WHO

SHOULD

FILE

A refund of withheld taxes


The earned income tax credit
The additional child tax credit
A credit for federal telephone excise tax paid
The health coverage tax credit

Who Should Not File


The IRSs Reduce Unnecessary Filing Program (RUF) is intended to:

Save time and effort of tax preparers and their clients


Reduce cost to all taxpayers of processing unnecessary returns

Which Form to Use


The information below is for your use only. 1040 ValuePak automatically
determines and prints/e-files the correct tax form based upon the
information below.
Form 1040EZ
Form 1040EZ is the simplest of the tax return forms. The one-page form is
designed for single and joint filers with no dependents. It shows the filing
status, income, adjusted gross income, standard deduction, taxable income,
tax, earned income credit (EIC), amount owed or refund, and signature. The
form's only worksheet is for figuring the standard deduction for individuals
who can be claimed as a dependent on another taxpayer's return.
Form 1040A
Form 1040A is a two-page form. Page 1 shows the filing status, exemptions,
income, and adjusted gross income. Page 2 shows standard deduction,
exemption amount, taxable income, tax, credits, payments, amount owed or
refund, and signature.
Form 1040A may be filed with up to four schedules:

Schedule 1 to report interest and/or dividend income more than


$1,500

Schedule 2 to report child and dependent care expenses and to


figure the credit

Schedule 3 to claim the credit for the elderly or disabled


129

LESSON 5 - FILING
A TAX RETURN

STATUSES

AND

WHO

SHOULD

FILE

Schedule EIC to provide information about a child that qualifies the


taxpayer for the earned income credit

Form 1040
Form 1040 is a two-page form that contains all the entries on Form 1040A
plus entries for more types of income, itemized deductions, and other taxes.
Four of the schedules that may be used with Form 1040 are equivalent to
those for Form 1040A. In addition, Form 1040 provides schedules for
reporting various types of income and deductions.
The table below shows which form to use:
Form 1040EZ
Filing status
Exemptions and
exemption
amount and
Income
adjusted gross
income
Standard
deduction
Itemized

Form 1040A

Form 1040

Yes
No

Yes
Yes

Yes
Yes

Yes

Yes

Yes

Yes

Yes

Yes

deductions
Taxable income,
tax, and EIC
Other credits

No

No

Yes

Yes

Yes

Yes

No

Yes

Yes

Other taxes

No

No

Yes

Payments

Yes

Yes

Yes

Amount owed or
refund
Schedules 1, 2, 3,
and EIC

Yes

Yes

Yes

No

Yes

No

No

No

Yes

Schedules A, B, C,
and EIC, and
others

130

LESSON 5 - FILING
A TAX RETURN

STATUSES

AND

WHO

SHOULD

FILE

Lesson Summary
Lets take a moment to review what you have covered in this lesson:
The five filing statuses, from lowest to highest tax rate, are:

Married Filing Jointly


Qualifying Widow(er) With Dependent Child
Head of Household
Single
Married Filing Separately

If taxpayers qualify for more than one filing status, choose the one that
results in a lower tax.
In most cases, a married couple will pay a lower total tax amount if they file
a joint return. If they choose to file separately, they must show their
spouse's name and social security number on the return.
The Head of Household status is for unmarried taxpayers who paid more
than half the cost of keeping up a home for a qualified person during the
tax year. Some married taxpayers who live apart from their spouses and
provide for dependent children may qualify to file as Head of Household.
In the year a taxpayer's spouse dies, if the taxpayer does not remarry, he or
she can:

Use either the Married Filing Jointly filing status or the Married Filing
Separately status

Claim an exemption for the deceased spouse

For the first and second years after the spouse's death, the widowed
taxpayer with dependent child(ren):

May no longer claim an exemption for the deceased spouse

Can file as a widow(er) with dependent child (unless the taxpayer


remarries)

131

LESSON 5 - FILING
A TAX RETURN

STATUSES

AND

WHO

SHOULD

FILE

Even individuals who are not required to file should file a return to claim a
refund of withheld taxes, the earned income tax credit, the additional child
tax credit, or if they qualify, for the health coverage tax credit.
There are three tax return forms:

Form 1040EZ is for single and joint filers with no dependents and
limited types of income totaling under $100,000

Form 1040A provides entries and schedules for certain tax


exemptions and for reporting certain interest and dividend income,
dependent exemptions, adjustments, deductions and credits

Form 1040 can be used to report all types of income, adjustments,


deductions and credits

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify you're understanding of the
most important lesson content, and will also help you pass the
Final Exam.
Do the Homework - While completing the homework is not
mandatory, we strongly recommend that you complete each
lesson's homework assignment. It will expand your knowledge
and understanding of the topics covered in this course.

132

LESSON

PERSONAL

AND

DEPENDENCY

EXEMPTIONS

Lesson

6
Lesson 6 - Personal and
Dependency Exemptions
In this lesson you'll learn about Personal and Dependency Exemptions. The
following topics are discussed in this lesson:

The Taxpayer
The Spouse
Dependency Exemptions
Tests for all Dependents
Relationship Test
Support Test
Residency Test
Age Test
Tie Breaker Rules
Qualifying Relative Tests
Dependency Tests
Citizen or Resident Test
Joint Return Test
The Member of Household or
Relationship Test

The Qualifying Child of


another Taxpayer Test
The Gross Income Test
The Support Test
Multiple Support
How do you determine who
should claim the exemption?
Special Rules for Children of
Divorced or Separated
Parents
Determining the Number of
Exemptions to Claim
Completing the Exemptions
Section of the Return

n exemption is a dollar amount that can be deducted from an


individual's total income, thereby reducing the taxable income.
Taxpayers are often concerned about how to determine the correct
number of exemptions to claim.
133

LESSON

PERSONAL

AND

DEPENDENCY

EXEMPTIONS

Figure 6-1: The Exemptions section of Form 1040.

Taxpayers can claim two kinds of exemptions:

Personal exemptions
Dependency exemptions

While both exemptions are worth the same amount, different rules apply to
each type. The exemption amount is indexed for inflation and generally
changes every year. The amount taxpayers can deduct for each exemption
was $3,950 for 2014.

Number of

Allowed

Number of

Allowed

Exemptions

Deduction

Exemptions

Deduction

$3,950

$23,700

$7,900

$27,650

$11,850

$31,600

$15,800

$35,550

$19,750

10

$39,500

Table: Exemptions Table

A personal exemption allows taxpayers to claim themselves as exemptions


on their tax return. Also included in this category is the taxpayer's spouse,
when filing a joint return. Dependency exemptions are allowed for
qualifying dependents who meet the criteria of the Qualifying Child or
Qualifying Relative tests. A taxpayer can claim one exemption for each
dependent.

Overview of the Dependency Exemption


Rules:

You cannot claim any dependents if you, or your spouse if filing


jointly, could be claimed as a dependent by another taxpayer.
134

LESSON

PERSONAL

AND

DEPENDENCY

EXEMPTIONS

You cannot claim a married person who files a joint return, as a


dependent, unless that joint return is only a claim for refund and
there would be no tax liability for either spouse on separate returns.

You cannot claim a person as a dependent unless that person is a


U.S. citizen, U.S. resident alien, U.S. national, or a resident of Canada
or Mexico.1

You cannot claim a person as a dependent unless that person is your


qualifying child or qualifying relative.

The table below shows the tests to be a qualifying child or qualifying


relative:
Tests To Be a Qualifying Child

Tests To Be a Qualifying Relative

1.
The child must be your son,
daughter, stepchild, foster child,
brother, sister, half brother, half sister,
stepbrother, stepsister, or a descendant
of any of them.

1.
The person cannot be your
qualifying child or the qualifying child
of any other taxpayer.
2. The person either (a) must be
related to you in one of the ways listed
under "Relatives who do not have to
live with you" below, or (b) must live
with you all year as a member of your
household (and your relationship must
not violate local law.)

2. The child must be (a) under age 19


at the end of the year and younger
than you (or your spouse if filing
jointly), (b) under age 24 at the end of
the year, a full-time student, and
younger than you (or your spouse if
filing jointly), or (c) any age if 3. The person's gross income for the
year must be less than $3,950.3
permanently and totally disabled.
3. The child must have lived with you
for more than half of the year.2

4. You must provide more than half of


4
4. The child must not have provided the person's total support for the year.
more than half of his or her own
support for the year.
5. The child is not filing a joint return
for the year (unless that joint return is
filed only as a claim for refund).
6. If the child meets the rules to be a

135

LESSON

PERSONAL

AND

Tests To Be a Qualifying Child

DEPENDENCY

EXEMPTIONS

Tests To Be a Qualifying Relative

qualifying child of more than one


person, you must be the person
entitled to claim the child as a
qualifying child.
Relatives who do not have to live with you. A person related to you in any of the
following ways does not have to live with you all year as a member of your
household to meet this test:

Your child, stepchild, foster child, or a descendant of any of them (for


example, your grandchild). (A legally adopted child is considered your
child.)

Your brother, sister, half brother, half sister, stepbrother, or stepsister.

Your father, mother, grandparent, or other direct ancestor, but not foster
parent.

Your stepfather or stepmother.

A son or daughter of your brother or sister.

A brother or sister of your father or mother.

Your son-in-law, daughter-in-law, father-in-law, mother-in-law, brotherin-law, or sister-in-law.

Any of these relationships that were established by marriage are not ended by
death or divorce.
1

There is an exception for certain adopted children.

There are exceptions for temporary absences, children who were born or died
during the year, children of divorced or separated parents or parents who live
apart, and kidnapped children.
3

There is an exception if the person is disabled and has income from a sheltered
workshop.
4

There are exceptions for multiple support agreements, children of divorced or


separated parents or parents who live apart, and kidnapped children.

136

LESSON

PERSONAL

AND

DEPENDENCY

EXEMPTIONS

TAX QUOTE

"The collection of taxes which are not absolutely required, which do not
beyond reasonable doubt contribute to the public welfare, is only a species
of legalized larceny. The wise and correct course to follow in taxation is not
to destroy those who have already secured success, but to create conditions
under which everyone will have a better chance to be successful."
Calvin Coolidge, (1872 1933) 30th President of the United States (1923
1929)

The Taxpayer
A taxpayer can check the box next to "Yourself," as long as that same
taxpayer cannot be claimed as a dependent on another person's tax return.
If a taxpayer can be claimed as a dependent on someone else's return, the
taxpayer cannot claim a personal exemption, even if the other taxpayer
does not claim this person as a dependent. It is possible to claim "0"
exemptions if another person can claim the taxpayer as a dependent.

Figure 6-2: The Exemptions section of Form 1040 with the Taxpayer's exemption line
highlighted.

The Spouse
A taxpayer's spouse can be claimed as a personal exemption on a return if
these conditions are met:

The taxpayers must be married by December 31 of the tax year

The taxpayer's spouse cannot be claimed as a dependent on another


person's tax return, even if the other taxpayer does not claim this
person as a dependent

137

LESSON

PERSONAL

AND

DEPENDENCY

EXEMPTIONS

The taxpayer files a joint return OR a separate return and the spouse
had no gross income

Figure 6-3: The Exemptions section of Form 1040 with the Spouse's exemption line
highlighted.

If a taxpayer is divorced or legally separated at the end of the tax year, he or


she cannot claim his or her former spouse as an exemption.
You may have to deal with the death of a taxpayer's spouse as it relates to
the taxpayer's return. If a taxpayer's spouse died during the year and the
taxpayer did not remarry by December 31, he or she can generally claim the
personal exemption for the deceased spouse. This exemption can be
claimed only if the taxpayer was not divorced or legally separated from his
or her spouse on the date of death and would have been able to claim the
exemption under regular circumstances.

Dependency Exemptions
Dependency exemptions involve individuals other than the taxpayer or
spouse. A dependent is a person other than the taxpayer or spouse who
entitles the taxpayer to claim a dependency exemption. Some examples of
dependents include:

Child
Stepchild
Brother
Sister
Parent

138

LESSON

PERSONAL

AND

DEPENDENCY

EXEMPTIONS

Figure 6-4: The Exemptions section of Form 1040 with the Dependent's exemption lines
highlighted.

SIDE BAR

According to Money Magazine, "seven million children vanished from the


nations tax returns" in 1987 when the IRS first started requiring their
Social Security numbers to be reported. "11,627 families reported a
decrease of seven or more dependents."

Tests for all Dependents


There are tests that apply to all dependents. The Citizen test requires that all
dependents must be a citizen or resident of the United States, or a resident
of Canada or Mexico. The Joint Return test requires that individuals cannot
be claimed as dependents if they filed a joint return for the same taxable
year, unless the dependent and spouse had no tax liability and filed only to
claim a refund.
The taxpayer, or spouse if filing jointly, must not be claimed as a dependent
on someone else's return.
The Four Tests
Dependents who meet the criteria of the Citizen and Joint Return tests,
must also meet all four Qualifying Child tests, which include:

Relationship Test
Support Test
Residency Test
Age Test

A taxpayer can take one exemption for each dependent who meets all four
tests.
139

LESSON

PERSONAL

AND

DEPENDENCY

EXEMPTIONS

TAX TIP

Newborn Children
Taxpayers can take a Dependency Exemption for each dependent who
was alive during some part of the tax year. This includes a baby born in
the tax year or a dependent who died during the tax year.
Relationship Test
To meet the relationship test, the child must be the taxpayer's
Child, stepchild or adopted child, or
Grandchild, or
Brother, sister, stepbrother, stepsister, or
Niece or nephew, or
Foster child placed with the taxpayer by an authorized placement
agency or court order
A legally adopted child is considered to be the taxpayer's child. If the child is
adopted and begins living with the taxpayer at any point in the year, the
taxpayer may claim an exemption even though the child did not live with
the taxpayer for the entire year.
Parents of children who are presumed to have been kidnapped by someone
who is not a family member may be able to take the child into account in
determining their eligibility for head of household or qualifying widow(er)
filing status, deduction for dependents, child tax credit (CTC), and the
earned income credit (EIC).
If a child was born alive during the year and meets the dependency tests,
the taxpayer can take the exemption, even if the child lived only for a
moment. No exemption is allowed for a stillborn child. State or local laws
determine if a child was born alive or stillborn.
Support Test
To meet the support test, a child cannot have provided more than half of his
or her own support during the tax year.

140

LESSON

PERSONAL

AND

DEPENDENCY

EXEMPTIONS

Residency Test
To meet this test, the child must have lived with the taxpayer for more than
half of the year. Exceptions apply, in certain cases, for children of divorced,
separated, or unmarried parents, kidnapped children, or for children who
were born or died during the year.
The child is considered to have the same place of residence as the taxpayer
even if the child (or the parent) is temporarily absent due to special
circumstances such as education, illness, vacation, business or military
service.
Age Test
To meet the Age Test, a child must be under age 19, or age 24 if they are a
full-time student. A permanently disabled child can be any age.
To be considered a student, the taxpayer's child must attend school full time
for some part of each of five calendar months of the year. The five months
do not have to be consecutive in order to qualify. School generally does not
include night schools, on-the-job training courses, or correspondence
schools.

TAX TIP

Kidnapped Children
The principal place of abode test is considered met for a child under age
18 who met the test prior to being kidnapped by a non-family member.
Expenses of trying to locate a kidnapped child are not tax deductible,
however, payment of ransom to a non-family member kidnapper is
generally tax deductible as a theft loss.

Tie Breaker Rules


As you apply these rules, you may find that a child qualifies as a dependent
for more than one person. If the taxpayer and someone else (other than the
taxpayer's spouse filing jointly) both want to claim the child as a Qualifying
Child, and cannot agree, apply the Tie Breaker rules, as shown in the table
below.
141

LESSON

PERSONAL

AND

DEPENDENCY

EXEMPTIONS

IF more than one person files a


return claiming the same qualifying
child and ...

THEN the child will be treated the


qualifying child of the...

only one of the persons is the child's


parent

parent.

two of the persons are parents of the


child, and they do not file a joint return
together

parent with whom the child lived for


the longer period of time during the
year.

two of the persons are parents of the


child, they do not file a joint return
together, and the child lived with each
parent the same amount of time
during the year

parent with the higher adjusted gross


income (AGI).

none of the persons are the child's


parent

person with the highest AGI.

Qualifying Relative Tests


This topic will help you understand the six qualifying relative tests that
determine whether an individual who is not the taxpayer's qualifying child
meets the criteria required for dependent status.
Upon completing this topic you will be able to use the six tests to determine
whether an individual is a qualifying relative and can be claimed as a
dependent on a taxpayer's tax return.
Dependency Tests
A taxpayer can claim a qualifying relative as a dependent only if that person
meets the criteria of all six dependency tests. These tests are:

Citizen or Resident Test


Joint Return Test
Member of Household or Relationship Test
Qualifying Child of another taxpayer
Gross Income Test
Support Test

142

LESSON

PERSONAL

AND

DEPENDENCY

EXEMPTIONS

A taxpayer can take one exemption for each dependent who meets all six
tests. Recall that the citizen and joint return tests apply to all dependents.
This topic will discuss each of these tests in more detail.
Another way of looking at these tests is to think of them as a series of
questions to discuss with the taxpayer to determine the dependency status
of an individual.
Citizen or Resident Test
To meet the citizen or resident test, a person must be a U.S. citizen or
resident, or a resident of Canada or Mexico, for at least some part of the
year. Usually, children are citizens or residents of the country of their
parents. A child born in a foreign country can be recognized as a U.S. citizen
for tax purposes if either parent is a U.S. citizen. Individuals who do not
meet this test cannot qualify as a dependent.
If a taxpayer who is a U.S. citizen legally adopts a child who is not a U.S.
citizen or resident, and the other dependency tests are met, the taxpayer
can claim the child as a dependent. The taxpayer's home must be the child's
main home, and the child must be a member of the household for the
entire tax year.
Foreign exchange students generally are not U.S. residents and do not meet
the citizen or resident test; therefore, they cannot be claimed as
dependents.
Joint Return Test
To meet the joint return test, the taxpayer's dependent cannot have filed a
joint return for the tax year in question. However, the joint return test does
not apply if the dependent and his or her spouse filed the joint return
merely as a claim for refund and no tax liability would exist for either spouse
on separate returns.
The Member of Household or Relationship Test
To meet this test, the person must either:

Be related to the taxpayer in one of the ways listed below, or


Have lived with the taxpayer as a member of the household for the
entire year, temporary absences allowed

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In addition, the relationship must not violate local law. If the individual
doesn't meet this test, he or she cannot qualify as a dependent.
A person away on temporary absences is considered as living with the
taxpayer and as a member of the household the entire year. Temporary
absences include attending school, taking vacations, hospital stays due to
illness, and military service.
Relatives who meet the relationship test include the following:

Child, grandchild, great grandchild (also covered in the Qualifying


Child test)

Stepchild (also covered in the Qualifying Child test)

Brother, sister, half brother, half-sister, stepbrother, stepsister (also


covered in the Qualifying Child test)

Parent, grandparent, or other direct ancestor, but not foster parent

Stepmother or stepfather

Brother or sister of your father or mother

Son or daughter of your brother or sister (also covered in the


Qualifying Child test)

Father-in-law, mother-in-law, son-in-law, daughter-in-law, brotherin-law, or sister-in-law

These relatives may live with the taxpayer but are not required to in order to
meet the test.
A cousin does not meet the relationship test. A cousin must live with the
taxpayer for the entire year (except for temporary absences) to meet the
member of household test.
A person who died during the year and met the relationship test or was a
member of the taxpayer's household until death meets the test, and may be
claimed as an exemption.
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For federal income tax purposes, a relationship established by marriage,


such as "mother-in-law" or "sister-in-law," does not end with divorce or
death of a spouse.

TAX TIP

Death of a Dependent
You can claim a deceased family member as a dependent if both if these
apply:

The deceased lived in your home while alive.


The deceased met all the requirements to qualify as a dependent.

Also, if the deceased dependent let you qualify for these benefits, you
can still have the benefits in the year your dependent died:

File as head of household or qualifying widow(er)


Claim certain tax deductions or credits

The Qualifying Child of another Taxpayer Test


The dependent cannot meet the tests to be another taxpayer's qualifying
child for the tax year, even if that other taxpayer is not claiming them as a
dependent.

TAX TIP

Can a dependent of another claim an exemption for his or her own


dependent(s)?
No. Any taxpayer that can be claimed as a dependent on someone else's
tax return cannot claim an exemption for a dependent of their own.
However, the dependents parents (if that is who is claiming him or her)
would probably be able to claim their dependents dependent, such as a
grandchild, as a dependent on their own tax return.
The Gross Income Test
To meet the gross income test, generally the person cannot have income
that equals or exceeds the exemption amount. The exemption amount for
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2014 is $3,950. Gross income is all taxable income in the form of money,
goods, property, and services. It includes all unemployment compensation
and certain scholarships. It does not include welfare benefits or nontaxable
social security benefits.
The Support Test
The most involved test is the support test. For an individual to be
considered a dependent, the taxpayer must have provided more than half
the person's total support for the entire year. To determine how much
support the taxpayer provided, compare the taxpayer's contributions with
the entire amount of support the person received from all sources, including
the dependent's own funds.
You may need to ask the taxpayer about the dependent's own sources of
support, for example:

Income received, both taxable and nontaxable


Savings accounts (not spent, but saved and invested)
Borrowed amounts, such as student loans and car loans
Tax-exempt income, including social security benefits, life insurance
proceeds
Nontaxable pensions, gifts, and tax-exempt interest

Only the amount of a dependent's own funds that is actually spent on


support is counted. For example, scholarships received by full-time students
are not included in total support.
The taxpayer should be prepared to discuss how much support he or she
provided toward the following for the dependent:

Food, clothing
Shelter (at fair rental value)
Education
Medical and dental care
Recreation
Transportation
Furniture, appliances or autos (provided the items were solely for the
dependent's benefit)

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State benefit payments like welfare, TANF (Temporary Assistance for Needy
Families), food stamps, Medicaid or housing assistance are considered
support provided by the state, not by the parent, even though the parent
applied for and negotiated the benefits.

Multiple Support
Multiple support is one of the exceptions to the support test. It applies to
situations where two or more people together provide more than half of an
individual's support, instead of just one person providing the support. In this
situation, anyone who separately provides more than 10% of the person's
total support and meets the other tests is eligible to claim the exemption for
the dependent. However, only one person can claim the exemption. The
taxpayers decide among themselves who will take the exemption for the
year. You do not decide.
How do you determine who should claim the exemption?
First, all individuals who provided more than 10% of the person's support
and who meet the other dependency tests must agree on who should claim
the exemption. Then, each individual must sign a written statement
agreeing not to claim the exemption for that year. Form 2120 - Multiple
Support Declaration serves this purpose. The person who is claiming the
exemption must attach this form to his or her current year's tax return.

TAX TIP

Can divorced parents "split up" the kids for tax purposes?
Yes. The custodial parent has the right to claim the child as a dependent
unless that right is released to the non-custodial parent. It can make
sense to shift the exemption for a child from the custodial parent to the
non-custodial parent if the non-custodial parent is in a higher tax bracket.
If released, the waiver needs to be in writing, signed, and attached to the
non-custodial parent's tax return. The waiver can be for one year or
permanently, Form 8332 - Release of Claim to Exemption for Child of
Divorced or Separated Parents is the official IRS form. See the rules
below.
Incidentally, the custodial parent still has the right to claim Head of
Household filing status, the Earned Income Tax Credit, and the
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Dependent Care Credit even if he or she has released the right to claim
their child as a dependent. If waived, the non-custodial parent claims the
$1,000 Child Tax Credit along with the Dependency Exemption.
Special Rules for Children of Divorced or Separated Parents
The other exception to the support test applies to children of divorced or
separated parents. The parent who has custody of the child for the greater
part of the year (the custodial parent) will generally be considered as having
provided over half of the child's support. That parent can claim the child as
a dependent, if all of the following conditions are met:

The child has received more than half of his or her total support from
one or both parents

The parents are divorced, legally separated, separated under a


written separation agreement, or have lived apart at all times during
the last six months of the calendar year

The child was in the custody of one or both parents for more than
half of the calendar year

The custodial parent will not be considered as having provided more than
half of the child's support if any of the following conditions exist:

Over half of the child's support is considered to have been received


from a third party, such as a relative or friend

The custodial parent signed Form 8332 - Release of Claim to


Exemption for Child of Divorced or Separated Parents or a similar
statement, which allows the non-custodial parent to claim the
exemption (this statement must be attached to the non-custodial
parent's return)

In addition, the custodial parent is not considered as having provided over


half of the child's support if:

The custodial parent signs a decree or agreement executed after


1984 that states that he or she will not claim the exemption for the
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child, and that the non-custodial parent can claim the exemption for
the child without regard to any condition

A qualified decree or agreement executed before 1985 states that


the non-custodial parent is entitled to the exemption for the child
and the non-custodial parent contributed $600 toward the child's
support during the tax year, unless the pre-1985 agreement is
modified after 1984 to specify that this provision will not apply

A non-custodial parent claiming an exemption for a child can no longer


attach certain pages from a divorce decree or separation agreement instead
of Form 8332 if the decree or agreement was executed after 2008. The noncustodial parent must attach Form 8332 or a similar statement signed by
the custodial parent and whose only purpose is to release a claim to the
exemption.

TAX TIP

Ex-Spouses Who Incorrectly Claim Dependents


The custodial parent is the one who can ordinarily claim a child as a
dependent on their tax return unless he or she has signed a written
document allowing the other parent to claim the child. If the noncustodial parent e-files his or her tax return before the custodial parent
does, and incorrectly claims the child as his or her dependent, when the
custodial parent e-files his or her tax return it will be rejected by the IRS
because the IRSs records show the ex-spouse as having already claimed
the child as a dependent, or for the Earned Income Tax Credit. The SSN
has already been used. The Earned Income Tax Credit belongs to the
custodial parent even if he or she has signed a written document
allowing the other parent to claim the child as a dependent. If this
situation occurs, the custodial parent should file a paper return and
attach a note explaining the situation to the IRS.

Determining the Number of Exemptions to


Claim
When determining the number of exemptions to claim, first look at the
personal exemptions.
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Can the taxpayer claim him or herself? (Taxpayers who cannot be


claimed as a dependent on another person's return can claim
themselves as personal exemptions.)

If the taxpayer is married, can the spouse be claimed as a personal


exemption? (The spouse must meet certain conditions discussed in a
previous topic.)

If the taxpayer wants to take a dependency exemption, review each


dependency test to make sure the dependent qualifies. There are many
factors to consider as well as several exceptions.

TAX QUOTE

"The Declaration of Independence, the words that launched our nation 1,300 words. The Bible, the word of God - 773,000 words. The Tax Code, the
words of politicians - 7,000,000 words and growing!"
Steve Forbes (1947- ) Publisher of Forbes Magazine, US Presidential
candidate in 1996 & 2000

Completing the Exemptions Section of the


Return
Exemptions are claimed on Lines 6a through 6d of Forms 1040 and 1040A.
The Exemptions section is the same for each form.

Figure 6-5: The Exemptions section of Form 1040.

1040 ValuePak will determine the exemptions for the taxpayer and spouse
from the information that you enter on the Personal Information
Worksheet. It will determine the exemptions for dependents from the
information that you enter on the Dependents/Non-Dependents
Worksheet.
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Don't assume that taxpayers will have the same number of exemptions on
their current return as they did on last year's return. Youll need to ask a few
probing questions. There may have been deaths or births in the household.
You must provide a tax identification number, generally the social security
number, for all dependents listed on Line 6c. Otherwise the return will be
processed without the benefit of the dependency exemption, which will
result in an increased tax or decreased refund. Taxpayers who need to
obtain a social security number should contact their local Social Security
Administration Office. A certified copy of the dependent's birth certificate
will be required when applying. The process takes a few weeks.
A resident or nonresident alien who does not have and is not eligible for a
social security number should file a Form W-7 with the IRS to apply for an
Individual Tax Identification Number (ITIN). The ITIN is entered on the return
wherever the social security number is requested, and is used for tax
purposes only. A taxpayer who has an ITIN and later receives a social
security number should no longer use the ITIN on tax returns.

TAX TIP

Should a married child, who is also a parents dependent, file


Separately?
When a child who is married is also a dependent of his or her parent
consider having the child file with his or her spouse Separately. Married
children who use the Married Filing Jointly filing status cannot be claimed
as an exemption by their parent. The loss of the exemption for the parent
may cost more than the married child would save by filing Jointly.

TAX PLANNING TIP

Are there any financial planning steps parents should take when a
baby is born?
Yes. As soon as reasonably possible they should talk to an attorney and a
life insurance agent.
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The parents should make sure that their wills are up to date which they
wont be since they just had a baby. Theyll need to designate a legal
guardian in their wills, who is a person chosen to raise the child in the
event they both die, like in an automobile accident. They may also want
to consider setting up a trust for the child. They can appoint a trustee
who is a different person from the guardian. The trust can ensure that
their estate is paid to their child according to their wishes.
There are many reasons theyll also want to purchase life insurance. Life
insurance is addressed at the end of Lesson 21.

Lesson Summary
There are two types of exemptions: personal and dependency. Each
exemption reduces taxable income by $3,950. A personal exemption can be
claimed for a taxpayer and spouse if neither the taxpayer nor the spouse
can be claimed on another taxpayer's return.
To claim a dependency exemption, the dependent must meet either the six
Qualifying Child tests or the six tests for Qualifying Relative. The six tests for
Qualifying Child are:

Relationship
Residency
Age
Support
Citizen or Resident
Joint Return

The six tests for Qualifying Relative are:

Member of Household or Relationship


Citizen or Resident
Joint Return
Qualifying Child of another taxpayer
Gross Income
Support

The only exception to the gross income test is for a disabled person in a
sheltered workshop.
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There are two exceptions to the support test:

The Multiple Support Agreement


Special rules for Children of divorced or separated parents

Social security numbers are generally required for all dependents. Failure to
enter the correct social security number will cause the return to be
processed without the benefit of the dependency exemption. This will result
in increased tax or decreased refund.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify you're understanding of the
most important lesson content, and will also help you pass the
Final Exam.
Do the Homework - While completing the homework is not
mandatory, we strongly recommend that you complete each
lesson's homework assignment. It will expand your knowledge
and understanding of the topics covered in this course.

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Lesson

7
Lesson 7 - Income - Part I
In this lesson you'll learn about taxable and non-taxable income. The
following topics are discussed in this lesson:

Taxable Income
Nontaxable Income
Medical Reimbursements
Where to Report Income
Earned Income - Wages,
Salaries, & Tips
Form W-2 Interest Income
Household Employees
Incorrect Form W-2
Missing Form W-2
Form 4852
Fraudulent Form W-2
Earned Income
Form 1099-MISC

Tip Income
Allocated Tips
Tip Income Requiring Form
1040
Scholarships and Fellowships
U.S. Savings Bonds - Series EE
and I
U.S. Savings Bonds - Series
HH Bonds and Other U.S.
Obligations
Co-owners
Deferred Interest Accounts
Original Issue Discount (OID)

axable income is any income that is subject to federal income tax. All
taxable income must be reported on a tax return unless the amount
is so small that the individual is not required to file a return.

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Figure 7-1: The Income section of Form 1040.

Most employment compensation is taxable, including:

Wages, salaries, bonuses, and commissions


Certain fringe benefits
Tips and compensation for personal services

Wages and other employment income are included on Form W-2, prepared
by the employer, and mailed to the taxpayer.

Figure 7-2: Form W-2 - Wage and Tax Statement.

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Other forms of taxable income include:

Interest
Dividends
Refunds of state and local taxes
Alimony or separate maintenance payments received
Business income
Capital gains
Sale or conversion of property

Taxable income may also include:

IRA distributions (part or all may be nontaxable)


Pensions and annuities (part may be nontaxable)
Rents, royalties, and estate or trust income received
Unemployment compensation and supplemental benefits
Railroad retirement benefits (part or all may be nontaxable)
Social security benefits (part or all may be nontaxable)

Distributions from pensions, annuities, retirement or profit-sharing plans,


IRAs, Insurance Contracts, etc. are reported to recipients on Form 1099-R.

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Figure 7-3: Form 1099-R - Distributions from Pensions, Annuities, Retirement or ProfitSharing Plans, IRAs, Insurance Contracts, etc.

Form 1099-R amounts are not earned income, and are not reported with
W-2 income. Pensions are reported on the "Pensions and annuities" line of
the return.
The following taxable income is included in the "Other Income" total on
Form 1040's line 21:

Jury duty pay


Executors' fees
Gambling winnings (including lotteries, contests, raffles, etc.)
Hobby income, but a hobby losses are not deductible
Non-qualifying scholarships and fellowships
Payments for punitive damages and damages not attributable to
physical injuries or sickness
Certain long-term care benefits
1099 MISC income reported in Box 3

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TAX QUOTE

"I'm proud to pay taxes in the United States; the only thing is, I could be just
as proud for half the money."
Arthur Godfrey (1903-1983) US Variety Show Host

Nontaxable Income
Nontaxable income is income that is exempt from tax. Most nontaxable
income is not reported. Some types of nontaxable income will be shown on
the return, but will not be added into the amount of income subject to tax.
The following types of income are nontaxable:

Child support

Federal income tax refunds

Certain life insurance proceeds and accelerated death benefits of the


terminally ill

Sales proceeds of life insurance to a viatical settlement company by


the terminally ill

Gifts and bequests

Inheritances

Insurance and certain other payments for physical injury and sickness

The 65% subsidy for payment of COBRA health care coverage


continuation premiums is not taxable for federal income tax
purposes

Although gifts and bequests may be exempt from federal income taxes,
they may be subject to state and local taxes. Inheritances are usually not
taxable except for IRAs and Pensions.
The following types of income are also exempt from taxes:

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Interest on certain Series EE and Series I savings bonds redeemed to


pay for qualified higher education expenses
Interest on certain state and local obligations (municipal bonds)
Most life insurance proceeds paid upon death

Other nontaxable forms of income include:

Public assistance payments (certain TANF payments)


Certain railroad retirement benefits (part may be exempt)
Social security benefits (part may be exempt)
Department of Veterans Affairs (VA) disability benefits
Workers' compensation
Accident and health insurance benefits for personal injuries or
sickness
Qualified scholarships and fellowships
Certain dependent care services provided by employer
Certain employer-provided educational benefits (up to $5,250)
Interest on insurance dividends left with VA
Employer-provided assistance for qualifying adoption expenses
Restitution payments and excludable interest received by Holocaust
victims, their estates, or their heirs
Certain long-term care benefits

The Temporary Assistance for Needy Families program (TANF) replaced the
Aid to Families with Dependent Children program (AFDC).
Certain accelerated death benefits or payments received under a life
insurance contract on the life of a terminally or chronically ill individual,
before the individual's death, may also be nontaxable income.
A taxpayer who receives Copy C of Form 1099-LTC - Long-term Care and
Accelerated Death Benefits is not the policyholder. He is the insured. The
form is for information only and should be disregarded because none of the
benefits are taxable to the recipient of Copy C.

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Figure 7-4: Copy C of Form 1099-LTC - Long-term Care and Accelerated Death Benefits.

However, some of the benefits reported on Copy B of Form 1099-LTC may


be taxable.

Figure 7-5: Copy B of Form 1099-LTC - Long-term Care and Accelerated Death Benefits.

TAX TIP

Nontaxable Transactions
Some exchanges of insurance and annuity contracts are not taxable
events if the insured or annuitant is the same under both the old and new
contract. This applies to transactions such as exchanging:

a life insurance policy for another


a life insurance policy for an endowment or annuity contract
an endowment contract for an annuity contract
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an endowment contract for another endowment contract that


provides for regular payments beginning no later than the date on
the original contract
one annuity contract for another

Certain types of stock transactions are not taxable events:

exchanges of stock for other stock in the same corporation as


long as the exchange is common stock for common stock, or
preferred stock for preferred stock, regardless of whether the
trade is between two stockholders or between the corporation
and a stockholder
exchanges of stock for other stock in the same or a different
corporation that occurs because of a merger, acquisition,
recapitalization, or some other form of reorganization, provided
certain rules are followed
conversion of a convertible bond into shares of stock, or
convertible preferred shares of stock into common shares of stock
transfers of property to a corporation in exchange for stock in the
corporation provided the taxpayer or the group of investors own
at least 80% of the corporation after the transfer (this generally
means that incorporating a business is not a taxable event)

SIDE BAR

Taxable and Non-taxable Income


For a list of the types of income that are taxable and nontaxable see
Appendix D or click here.

TAX TIP

Is combat pay taxable income?


Combat pay is federally tax-exempt. However, members of the military in
combat can still claim the Earned Income Tax Credit (see Lesson 25) and
the Additional Child Tax Credit (see Lesson 22). Just include the combat
pay as income for the purposes of these two credits. Servicemen and
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women with both regular taxable income and combat pay base these
credits on whichever income will give them the largest credit. See Special
Rules for Members of the Armed Forces at the end of this lesson.

TAX PLANNING TIP

Are there any tax benefits to lowering the taxpayer's Adjusted Gross
Income?
Lowering a taxpayers Adjusted Gross Income (AGI) can increase
allowable itemized deductions for:

Casualty and theft losses (allowable only to the extent such


uninsured losses exceed $100 for each casualty or theft, plus 10%
of AGI (see Lesson 19);
Medical expenses (deductible only for the amount above 10% of
AGI (see Lesson 18); and
Most miscellaneous itemized deductions (allowable for the
portion above 2% of AGI (see Lesson 19).

Lowering AGI can also increase the amounts deductible for contributions
to traditional Individual Retirement Accounts (see Lesson 17) and for
losses on rental properties (see Lesson 13). It can also decrease the
amount the taxpayer is taxed on his or her Social Security benefits (see
Lesson 12).
Deferring Income
Most employees have no control as to when they report their salaries.
However self-employed taxpayers have a great deal of control over when
to receive and report income. Self-employed taxpayers can delay the
mailing of bills to clients until after December 31st. They can also avoid
pressing clients for payment until after January 1st. Self-employed
taxpayers can also pay business expenses before December 31st.

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Medical Reimbursements
Although reimbursements for medical care are generally not taxable, they
may reduce the taxpayer's medical expense deduction on Schedule A.
However, excess medical reimbursements from group insurance
(reimbursements greater than expenses), when the employer paid some or
all of the premium, may be taxable. See the flow chart below.

Likewise, taxpayers can get money tax free from their Archer Medical
Savings Account as long as they use the money to pay for qualified medical
expenses. For more information, refer taxpayers to Publication 969 - Medical
Savings Accounts (MSAs) and Publication 502 - Medical and Dental Expenses.

Where to Report Income


This topic explains where and how to properly report taxable wage income
on a tax return, including cases when a taxpayer does not receive a Form W2.
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To ensure accurate reporting of income, verify that the taxpayers wages are
accurate and that all income from Form(s) W-2 and other income
documents, such as Form(s) 1099, have been given to you. Be sure to ask
the taxpayer if they had any other income.
Form 1040EZ
Of the three tax return forms, Form 1040EZ is the simplest. The only income
taxpayers can report on Form 1040EZ are:

Wages, salaries, and tips


Unemployment compensation
Qualified state tuition program payments
Alaska Permanent Fund dividends
Taxable scholarship and fellowship grants
Interest income of $1,500 or less

Form 1040A
Taxpayers can use Form 1040A to report all the types of income that can be
reported on Form 1040EZ, plus:

Interest income greater than $1,500


Dividends and capital gain distributions
IRA distributions, pension, and annuity income
Social security and equivalent railroad retirement benefits

Form 1040
Form 1040 can be used to report all Form 1040EZ and Form 1040A items,
plus all other income, deductions, and credits.

SIDE BAR

Where to Report Certain Items


We've compiled an extensive Summary Table of where to report certain
types of income. See Appendix E or click here.
Instructors Note: Always be sure, when completing a tax return, to
double check the form line number in the above table. From time to time
the line numbers do change - sometimes without notice. So, if a line
number on the form looks wrong, look at the line(s) immediately above

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or below it.

Earned Income - Wages, Salaries, and Tips


The total of wages, salaries, tips, and taxable scholarships and fellowships
are reported on Form 1040 line 7.

Figure 7-6: The Income section of Form 1040 with line 7 "Wages, salaries, tips, etc."
highlighted.

Wages, salaries, and tips are primary examples of earned income received
for services performed. Wages and salaries are compensation received. Tips
are money and goods received as a gratuity by food servers, maids, porters,
and other types of service workers. The taxpayer should report the fair
market value of any property received as a tip.
Form W-2
Form W-2 - Wage and Tax Statement, reports the employee's earned
income for the year. Employers should issue Form W-2 to every employee
and a copy to the Social Security Administration.
Box 1, Wages, tips, other compensation, shows the amount of payments
received in cash, goods and services, bonuses, supplemental unemployment
benefits, awards, and taxable employee benefits. This amount should be
included on the return.

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Figure 7-7: Form W-2 - Wage and Tax Statement with box 1 "Wages, tips, other
compensation" highlighted.

When an individual taxpayer or a couple filing jointly have two or more


Forms W-2 from various employers 1040 ValuePak will automatically add all
of the W-2s together. Just enter the information from each on the Form W2 - Wage and Tax Statement screen.
Some fringe benefits are treated differently than regular income for tax
purposes. The benefits to which special rules apply are:

Dependent care benefits if the employer reports these in Box 10


of Form W-2, the taxpayer must file Form 2441 - Child and
Dependent Care Expenses, to determine whether he or she can
exclude the full amount from taxable income.
Adoption benefits if the employer reports these in Box 12, code T,
the taxpayer must file Form 8839 - Qualified Adoption Expenses, to
determine whether he or she can exclude the full amount from
taxable income.
Employer's contributions to an Archer Medical Savings Account
(MSA) if the employer reports these in Box 12, code R, the
taxpayer must file Form 8853 - Archer MSAs and Long-Term Care
Insurance Contracts, to determine whether he or she can exclude the
full amount from taxable income.
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The table below shows which fringe benefits are, and are not, subject to
employment tax withholding:

Type of Fringe
Benefit
Accident and
Health Benefits

Achievement
Awards
Adoption
Assistance
Athletic Facilities

De minimis
(minimal) Benefits
Dependent Care
Assistance
Educational
Assistance
Employee
Discounts
Employee Stock
Options
Group Term Life
Insurance

Health Savings
Accounts (HSAs)
Lodging on the
Business Premises
Meals

Moving Expense
Reimbursements
No-additional-cost
Services
Retirement
Planning Services
Transportation
(commuting)
Benefits

Income Tax
Withholding

Social Security
and Medicare

Federal
Unemployment
(FUTA)

1,2

Exempt except
Exempt, except for
for long-term care
certain payments to
benefits provided
S corporation
Exempt
through a flexible
employees who are
spending or similar 2% shareholders.
arrangement.
Exempt up to $1,600 for qualified plan awards - $400 for
nonqualified awards.
1,3

Exempt

Taxable

Taxable

Exempt if substantially all use during the calendar year is by


employees, their spouses, and their dependent children and the
facility is operated by the employer on premises owned or leased
by the employer.
Exempt

Exempt

Exempt

Exempt up to certain limits, $5,000 ($2,500 for married


employee filing a separate return).
Exempt up to $5,250 of benefits each year.
3

Exempt up to certain limits.


Varies.
1,4

Exempt up to the
cost of $50,000 of
Exempt
coverage. (Special
Exempt
rules apply to
former employees.)
Exempt for qualified individuals up to the HSA contribution limits.
1

Exempt if furnished for your convenience as a condition of


employment.
Exempt if furnished on the business premises for the employer's
convenience.
Exempt if de minimis.
1
Exempt if the expenses would have been deductible by the
employee if the employee had paid them.
3

Exempt

Exempt

Exempt
Exempt
1

Exempt

Exempt

Exempt up to certain limits if for rides in a commuter highway


vehicle and/or transit passes ($230), or qualified parking ($230).
Exempt if de minimis.

167

LESSON

INCOME

Type of Fringe
Benefit
Tuition Reduction

PART

Federal
Unemployment
(FUTA)
3
Exempt if for undergraduate education (or graduate education if
the employee performs teaching or research activities).
Income Tax
Withholding

Social Security
and Medicare

Working Condition
Exempt
Exempt
Exempt
Benefits
1
Exemption does not apply to S corporation employees who are 2% shareholders.
2
Exemption does not apply to certain highly compensated employees under a selfinsured plan that favors those employees.
3
Exemption does not apply to certain highly compensated employees under a program
that favors those employees.
4
Exemption does not apply to certain key employees under a plan that favors those
employees.
5
Exemption does not apply to services for tax preparation, accounting, legal, or
brokerage services.

TAX TIP

What are the tax benefits of group term life insurance?


Group term life insurance is a life insurance policy that insures multiple
people who belong to a particular group, such as employees who work
for the same employer. It offers protection against premature death.
Employers typically provide a certain amount of coverage per employee.
Some employers provide coverage that is a multiple of an employee's
annual earnings. Some policies offer additional life insurance coverage for
spouses and children of the employee which is typically less than the
coverage for the employee.
The employers cost to provide coverage of up to $50,000 is tax
deductible by the employer but not includable in the employees income.
Additionally, the employee's beneficiary will not pay federal income tax
on any death benefits. Some states may tax the death benefits. Employers
that provide more than $50,000 of group term life insurance coverage
include the "economic value" of the cost of the excess life insurance as
taxable income on the employees W-2, as "additional compensation".
Shareholders of S corporations and partners who own more than 2% of
the company, and sole proprietors, are not considered employees.
Premiums paid for their group term life insurance are not tax deductible
to the business. C corporation premiums paid for all employees, including
any owner-employees, are tax deductible.

168

LESSON

INCOME

PART

Some policies offer an accelerated death benefit that allows terminally ill
employees to collect a certain percentage of his or her coverage prior to
death. An accelerated death benefit is any amount paid under a life
insurance contract for an insured individual who is terminally or
chronically ill. It also includes any amount paid by a viatical settlement
provider for the sale or assignment of a death benefit under a life
insurance contract for a chronically or terminally ill individual.
Taxpayers who receive accelerated death benefits will receive Form 1099LTC, Long-Term Care and Accelerated Death Benefits, from the provider.

TAX TIP

Special Rules for Members of the Clergy


There are some special income tax rules for ordained rabbis, ministers,
and cantors.
Housing Allowances:

Current or retired clergy members do not pay tax on the fair


market rental value of a home or a cash housing allowance that's
paid as part of their salary for ministerial services if its designated
a housing allowance by the church or organization that employs
them - provided they use the housing allowance, in the year
received, to provide a home - or to pay utilities, interest, tax, and
repairs, for a home with which they were provided.
The exclusion is limited to the fair market rental value of a home
including furnishing and utilities.
A definite amount must be designated in writing as the housing
allowance. The amount of the housing allowance cannot be
determined at a later date.
The amount of the housing allowance excluded from taxable
income cannot be more than the reasonable compensation for
ministerial services provided as a clergy member.
Clergy members do not include in taxable income a housing
allowance even if it is used as a down payment to buy a house.
Special rules may apply.
If they own a home they may deduct real estate taxes and
169

LESSON

INCOME

PART

mortgage interest even if they pay these expenses with their


housing allowance.
A housing allowance is subject to self employment tax. If the
housing allowance is not received in cash (such as free rent) the
fair market rental value is included for self employment tax
purposes.
Clergy members who are not ordained do not qualify for the
exclusion.

Other Rules:

Clergy members must include in their taxable income offerings


and fees they receive for performing religious ceremonies, such as
a wedding. However, if the offering is made to the religious
organization it is not taxable.
Members of religious orders who have taken a vow of poverty and
who turn over their wages or salary to the order are not taxed on
these earnings provided that they perform the services as duties
required by the order, for the church, another agency of the
church, or an associated institution. If they work outside the
church, they must pay tax on this income.

Employer Provided Automobiles


If an employer-provided vehicle was available for the employee's use, the
employee received a fringe benefit. Generally, the employer must include
the value of the use or availability in the employee's income as pay.
However, there are exceptions if the use of the vehicle qualifies as a working
condition fringe benefit. A working condition fringe benefit is any property
or service provided to the employee for which the employee could deduct
the cost as an employee business expense if he had paid for it. A qualified
non-personal use vehicle is one that is not likely to be used more than
minimally for personal purposes because of its design.
The employee may be able to deduct the actual expenses of operating the
vehicle for business purposes. The amount the employee can deduct
depends on the amount that the employer included in his income and the
business and personal miles driven during the year. The employee cannot
use the standard mileage rate.
170

LESSON

INCOME

PART

Value reported on Form W-2


The employer can figure and report either the actual value of the
employee's personal use of the car or the value of the car as if the employee
used it only for personal purposes (100% income inclusion). The employer
must separately state the amount if 100% of the annual lease value was
included in the employee's income.
Use the table below to calculate the lease value of employer provided
vehicle benefits.
Fair Market Value Lease Value

Fair Market Value Lease Value

0-999

600

22,000-22,999

6,100

1,000-1,999

850

23,000-23,999

6,350

2,000-2,999

1,100

24,000-24,999

6,600

3,000-3,999

1,350

25,000-25,999

6,850

4,000-4,999

1,600

26,000-26,999

7,250

5,000-5,999

1,850

27,000-27,999

7,250

6,000-6,999

2,100

28,000-29,999

8,250

7,000-7,999

2,350

30,000-31,999

8,750

8,000-8,999

2,600

32,000-33,999

9,250

9,000-9,999

2,850

34,000-35,999

9,750

10,000-10,999

3,100

36,000-37,999

10,250

11,000-11,999

3,350

38,000-39,999

10,750

12,000-12,999

3,600

40,000-41,999

11,250

13,000-13,999

3,850

42,000-43,999

11,750

14,000-14,999

4,100

44,000-45,999

11,750

15,000-15,999

4,350

46,000-47,999

12,250

16,000-16,999

4,600

48,000-49,000

12,750

17,000-17,999

4,850

50,000-51,999

13,250

18,000-18,999

5,100

52,000-53,999

13,750

19,000-19,999

5,350

54,000-55,999

14,250

20,000-20,999

5,600

56,000-57,999

14,750

21,000-21,999

5,850

58,000-59,000

15,250
($0.25 x

Over 59,999
Table: Employer Provided Auto

171

FMV)+$500

LESSON

INCOME

PART

The employee can deduct the value of the business use of an employerprovided car if the employer reported 100% of the value of the car in the
employee's income.
On the employee's Form W-2, the amount of the value will be included in
box 1, Wages, tips, other compensation, and box 12. To claim expenses,
complete Part II, Sections A and C, of Form 2106. Enter the actual expenses
on line 23 of Section C and include the entire value of the employerprovided car on line 25. If less than the full annual lease value of the car was
included on Form W-2, this means that Form W-2 only includes the value of
the employee's personal use of the car. Do not enter this value on Form
2106 as it is not deductible.
If the employee paid any actual costs to operate the car, that the employer
did not provide or reimburse the employee for, the employee can deduct
the business portion of those costs. Examples of costs are gas, oil, and
repairs. Complete Part II, Sections A and C, of Form 2106. Enter the actual
costs on line 23 of Section C and leave line 25 blank.

TAX QUOTE

"The only difference between a tax man and a taxidermist is that the
taxidermist leaves the skin."
Mark Twain

Household Employees
If a household employee earns less than $1,900 a year while working in the
employer's home, the employer is not required to provide the employee
with a Form W-2. However, a Form W-2 is required if the employer
withholds federal income taxes. In either case, the employee must report
the income on line 1 of Form 1040EZ or on line 7 of Form 1040A or Form
1040.

172

LESSON

INCOME

PART

Below are the rules for Household Employers:


If the Household EMPLOYER.....
A Pays cash wages of $1900 in 2015 to
any one household employee. Do not
count wages paid to:
Spouse
Child under the age of 21
Parent
Any employee under the age of
18 at any time in 2015

then the EMPLOYER must....


Withhold and pay Social Security and
Medicare taxes on all wages, including the
first $1900.
The taxes are 15.3% of cash wages.

Pays cash wages of $1,000 or more in Must pay federal unemployment tax
any calendar quarter of 2013 or 2014 (FUTA).
to household employees.
The tax is 6.2% of cash wages.
Do not count wages paid to a spouse,
a child under the age of 21, or a
Wages over $7,000 a year per
parent.
employee are not taxable.
The employer may also owe state
unemployment tax. Employers who pay
state unemployment tax, on a timely
basis, will receive an offset credit of up
to 5.4%, regardless of the rate of tax
they pay the state. Therefore, the net
FUTA tax rate is generally 0.8% (6.2% 5.4%), for a maximum FUTA tax of
$56.00 per employee, per year (.008 X
$7,000. = $56.00). State law determines
individual state unemployment insurance
tax rates.

Table: Household Employee Filing Requirements

Household Employers Checklist


Below is the Household Employers Checklist:
When you hire a household
employee:

Find out if the person can legally work in


the United States.
Find out if you need to pay state taxes.

173

LESSON

INCOME

When you pay your


household employee:

PART

Before February 1, 2016:

Withhold social security and Medicare


taxes.
Withhold federal income tax.
Make advance payments of the earned
income credit.
Decide how you will make tax payments.
Keep records.
Get an employer identification number
(EIN).
Give your employee Copies B, C, and 2 of
Form W-2, Wage and Tax Statement.

Before February 29, 2016


(March 31, 2016 if you file
Form W-2 electronically):

Send Copy A of Form W-2 to the Social


Security Administration (SSA).

By April 15, 2016:

File Schedule H, Household Employment


Taxes, with your 2015 federal income tax
return (Form 1040). If you do not have to
file a return, use one of the other filing
options, such as the option to file
Schedule H by itself.

TAX TIP

Is it a good idea to hire household employees "under the table" and


save some money?
Its definitely a bad idea because the tax laws (setting aside possible
illegal immigration issues) provide substantial penalties for
noncompliance with payroll tax withholding. The back taxes, interest, and
penalties on the Social Security, Medicare, and Unemployment taxes over
the years could add up to tens of thousands of dollars.
While at first glance it may seem like the chances of getting caught are
slim, think again. If a former employee files for unemployment benefits
the state will report the employer to the IRS and this will trigger an audit
of the employer that may go back many years.

174

LESSON

INCOME

PART

The Household Employer files Schedule H and pays employment taxes on


Form 1040 line 60a.

Figure 7-8: The Other Taxes section of Form 1040 with line 60a "Household employment
taxes from Schedule H" highlighted.

Incorrect Form W-2


Taxpayers who receive an incorrect Form W-2 or do not receive one at all,
must contact their employer as soon as possible.
An employer who prepared an incorrect Form W-2 must issue a Form W-2c
- Corrected Wage and Tax Statement. For employees who receive Form W2c:

Use the W-2c amounts on the return


Be sure to attach the Form W-2c to the taxpayer's return
Only an employer can issue a Form W-2 or a Form W-2c

Missing Form W-2


All wage, salary, and tip income must be reported on the return, even if the
employee does not receive a Form W-2.
A taxpayer who does not receive a Form W-2 by January 31st should first
contact the employer and find out if or when the Form W-2 was mailed. If
the taxpayer does not receive the Form W-2 after a reasonable amount of
time, the taxpayer should contact the IRS for assistance at 1-800-829-1040,
but not before February 15.

Form 4852
A taxpayer who has requested a Form W-2 or Form 1099-R and has still not
received it by the due date of the return should file Form 4852 - Substitute
for Form W-2, Wage and Tax Statement, or Form 1099-R, Distributions from
Pensions, Annuities, Retirement or Profit-Sharing Plans, IRA's, Insurance
Contracts, Etc.
175

LESSON

INCOME

PART

Figure 7-9: Form 4852 - Substitute for Form W-2, Wage and Tax Statement, or Form 1099-R,
Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRA's, Insurance
Contracts, Etc.

The taxpayer should:

Keep a copy of Form 4852 and file a copy with the Social Security
Administration to ensure proper social security credit, and
Attach Form 4852 to the tax return

176

LESSON

INCOME

PART

TAX PRACTICE TIP

Use of Leave/Earnings Statement in preparing tax returns


Although income tax returns may be prepared using a Leave and
Earnings Statement or other documentation of income and federal tax
withholding, the return must not be e-filed prior to receiving the related
Form W-2, W-2G or 1099-R. Doing so is a violation of IRS Regulations.
Form 4852 - Substitute for Form W-2, Wage and Tax Statement..., may be
used only if the taxpayer cannot obtain and provide a correct Form W-2,
W-2G or 1099-R. It must be completed in accordance with the
instructions. For e-filed returns, the non-standard W-2 indicator must be
included in the electronic record if Form 4852 is used. Check the box on
the W-2 screen. Retain Form 4852 in the same manner as Forms W-2, W2G and 1099-R. Never advertise that returns may be e-filed prior to
the receipt of Forms W-2, W-2G and 1099-R as the IRS will shut
down your business. Form 4852 should not be used prior to
February 15th and doing so may result in your termination from the
IRS E-file Program.

Fraudulent Form W-2


You should be alert to the following possible indications of fraudulent
activity:

Any Form W-2 that is typed, handwritten, or has noticeable


corrections

Any Form W-2 that is different from other Forms W-2 issued by the
same employer

Suspicious person(s) accompanying the taxpayer and observed on


other occasions

Multiple refunds directed to the same address or P.O. Box

Poorly documented employment or earnings that are a basis for


refundable credits, such as the Earned Income Credit

177

LESSON

INCOME

PART

Similar returns among different taxpayers, such as the same amount


of refund, or same number of dependents, or same number of
Forms W-2

How Do You Report Suspected Tax Fraud Activity?


If you suspect, or know of, an individual or company that is not complying
with the tax laws you may report this activity by completing Form 3949-A.
You may fill out Form 3949-A online and print it and mail it to:
Internal Revenue Service
Fresno, CA 93888
If you do not wish to use Form 3949-A, you may send a letter to the address
above. Include the following information, if available:

Name and address of the person you are reporting

The taxpayer identification number (social security number for an


individual or employer identification number for a business)

A brief description of the alleged violation, including how you


became aware of or obtained the information

The years involved

The estimated dollar amount of any unreported income

You should also include your name, address and daytime telephone
number. Although you are not required to identify yourself, it is helpful to
do so. Your identity can be kept confidential. You may also be entitled to a
reward.
Alternatively, you can call the IRS at the phone number on Form 3949-A.

Earned Income
This topic discusses how to report taxable earned income on a tax return,
including income from tips, scholarships, and fellowships. All income is
taxable unless it is specifically excluded by law.
Review the Client Organizer submitted by the taxpayer to find out if the
taxpayer or spouse received:
178

LESSON

INCOME

PART

Investment income (such as interest and dividends)


A distribution from and IRA or retirement plan, such as a 401k
Social security payments
Unemployment payments
Income not reported on Form(s) W-2 or Form(s) 1099 (such as from
alimony, self-employment, gambling, etc.)

TAX TIP

Are foster care payments received from a state agency taxable


income?
Foster care payments received from a state agency to reimburse the
taxpayer for the costs of caring for a foster child in his or her home are
not taxable income unless the taxpayer provides care to more than 5
children age 19 or older. Foster care expenses that exceed foster care
payments received can be deducted as cash charitable contributions.

Form 1099-MISC
Taxpayers who receive earnings reported on Form 1099-MISC Miscellaneous Income, may be considered self-employed. Box 7 of Form
1099-MISC is used to report Nonemployee compensation.

179

LESSON

INCOME

PART

Figure 7-10: Form 1099-MISC - Miscellaneous Income.

These amounts should be reported on Schedule C-EZ - Net Profit from


Business, or Schedule C - Profit or Loss from Business. Net losses and profits
are carried over to line 12 of Form 1040.

Figure 7-11: The income section of Form 1040 with line 12 "Business income or (loss)"
highlighted.

Tip Income
All tip income is subject to federal income tax. Individuals who receive $20
or more per month in tips from one job must report their tip income to
180

LESSON

INCOME

PART

their employer. Tips that are reported to employers are included with wages
on Form W-2, box 1.
Taxpayers who receive tips worth $20 or more in a month and do not report
all of those tips to the employer must report the social security and
Medicare taxes on the unreported tips as additional tax on Form 1040; they
cannot be reported on Form 1040EZ or 1040A. Use Form 4137 - Social
Security and Medicare Tax on Unreported Tip Income to compute and report
the additional tax.
A taxpayer who fails to report tip income to the employer may be subject to
a penalty equal to 50% of the social security and Medicare taxes owed on
unreported tips.
Individuals who receive less than $20 per month in tips while working one
job do not have to report their tip income to their employer. They do not
have to report non-cash tips, such as tickets or passes, to their employer
either.
Tips of less than $20 per month or non-cash tips are:

Exempt from social security and Medicare taxes


Subject to federal income tax and must be reported on line 7 of
Form 1040 or Form 1040A, or line 1 of Form 1040EZ

Employees may protect themselves from having to pay an unexpectedly


large amount of tax if they carefully keep track of their tips using Form
4070A - Employee's Daily Record of Tips which is found in Publication 1244
- Employee's Daily Record of Tips and Report to Employer. If they split their
tips with other workers they should also write down the names of the other
employees and the amounts they paid them.
Allocated Tips
Allocated tips are tips an employer assigns to an employee. They are in
addition to the tips the employee reports to the employer. Restaurants,
cocktail lounges, and similar businesses must allocate tips to employees.
Allocated tips are shown separately in box 8 of Form W-2, Allocated tips.
They are not included in the amount in box 1.

181

LESSON

INCOME

PART

Figure 7-12: Form W-2 - Wage and Tax Statement with box 8 "Allocated tips" highlighted.

Taxpayers must report allocated tips on their tax return unless either of the
following exceptions applies:

The taxpayer kept a daily tip record, or other evidence that is as


credible and as reliable as a daily tip record, as required under rules
explained earlier.

The taxpayer's tip record is incomplete, but it shows that the actual
tips were more than the sum of the tips reported to the employer
plus the allocated tips.

If either exception applies you should report the actual tips on the return.
Do not report the allocated tips. Allocated tips are subject to social security
and Medicare taxes.
Tip Income Requiring Form 1040
The following individuals cannot file Form 1040EZ or 1040A; they must file
Form 1040:

Individuals who received $20 or more in tips in any month while


working for one employer and who did not report the full amount to
182

LESSON

INCOME

PART

the employer. These tips are subject to social security and Medicare
tax.

Taxpayers who's Form W-2 has an amount entered in box 8,


Allocated tips. For more information, see Publication 531 - Reporting
Tip Income.

Scholarships and Fellowships


Some scholarships and fellowships may be partially taxable regardless of
whether or not the taxpayer received a Form W-2 for the scholarship or
fellowship. Students who receive academic scholarships may exclude from
taxable income the amount required for tuition, fees, books and supplies.
However, they must report as taxable income any academic scholarship
funds used for other expenses, such as room and board.
Qualified academic scholarships and fellowships are treated as tax free
amounts if all of the following conditions are met:

the student is a candidate for a degree at an educational institution

amounts the student receives as an academic scholarship or


fellowship are used for tuition and fees required for enrollment or
attendance at the college, or for books, supplies, and equipment
required for college courses of instruction, and

the amounts received as an academic scholarship are not a payment


for the students services, such as teaching other students

The table below shows the taxability of Scholarships and Fellowships:


IF you use the
payment for...
Tuition
Fees
Books
Supplies

AND you are...

THEN your payment


is...

A degree candidate

Tax free

Not a degree candidate


A degree candidate
Not a degree candidate
A degree candidate
Not a degree candidate
A degree candidate

Taxable
Tax free
Taxable
Tax free
Taxable
Tax free

183

LESSON

INCOME

IF you use the


payment for...
Equipment
Room
Board
Travel

PART

AND you are...

THEN your payment


is...

Not a degree candidate


A degree candidate
Not a degree candidate
A degree candidate
Not a degree candidate
A degree candidate
Not a degree candidate

Taxable
Tax free
Taxable
Taxable
Taxable
Taxable
Taxable

A degree candidate

Taxable

Not a degree candidate

Taxable

To determine if any part of a scholarship or fellowship is taxable, see the


instruction booklet for Form 1040A or Form 1040, and Publication 970 - Tax
Benefits for Education.

SIDE BAR

Highlights of Tax Benefits for Education... is our comparison chart


detailing the different tax benefits for the various education deductions,
credits, and programs.
Part I - Covers Scholarships, Fellowships, Grants, and Tuition Reductions;
the Hope Credit; the Lifetime Learning Credit; Student Loan Interest
Deductions; and the Tuition and Fees Deduction. You can review Part I in
Appendix F or by clicking here.
Part II - Covers Coverdell Educational Savings Accounts (ESA's); Qualified
Tuition Programs (QTP's); the Educational Exception to Additional Tax on
Early IRA Distributions; the Education Savings Bond Program; EmployerProvided Educational Assistance; and the Business Deduction for WorkRelated Education. You can review Part II in Appendix G or by clicking
here.

Interest Income
This topic discusses taxable interest. It will help you determine taxable
interest income from savings accounts, U.S. savings bonds, deferred interest
184

LESSON

INCOME

PART

accounts and certificates of deposit. Tomorrow, in Income - Part II we'll


cover insurance proceeds, and Coverdell Educational Savings Accounts
(ESA's), tax-exempt interest, and dividends, etc.
Interest Income entered on Schedule B - Interest and Ordinary Dividends...

Figure 7-13: Schedule B - Interest and Ordinary Dividends.

...flows through to Form 1040 line 8a.

Figure 7-14: The income section of Form 1040 with line 8a "Taxable interest" highlighted.

185

LESSON

INCOME

PART

Money earns interest when it is:

Deposited in accounts in banks, savings and loans, and credit unions,


or
Used to buy certificates of deposit or bonds, or
Lent to another person or business

Some savings and loans, credit unions, and banks call their distributions
"dividends." These "dividends" are really interest and are reported as
interest. True corporate dividends are different, and are discussed in a
different topic.
Amounts received from money market mutual funds should be reported as
dividends, not interest.
Interest is reported in the year that it is credited to the taxpayer's account
and is available for withdrawal by the taxpayer. The taxpayer should report
all interest received during the year, even if the interest is not entered in the
taxpayer's passbook.
Seller-Financed Mortgages
If the taxpayer is holding a mortgage on property that the buyer uses as his
or her personal residence you must list the amount of interest he received
from the buyer as the first interest item on Line 1 of Schedule B. Be sure to
include the buyer's name, Social Security number and address. Otherwise
the taxpayer will be liable for a $50 penalty.

TAX TIP

Amortizable Bond Premiums


If the taxpayer paid a premium to purchase a bond he can make an
election to deduct a portion of the premium each year while he holds the
bond. If he makes this election he must make it for every bond he owns
and for every bond he purchases in the future until he revokes the
election. His broker can determine the amount of the premium paid and
the amount of amortization to deduct each year. Deduct this amount
from the rest of his interest income entered on Line 1 of Schedule B by
entering the amortizable bond premium as negative number on the line
directly below the interest income. Label it "ABP".
186

LESSON

INCOME

PART

U.S. Savings Bonds - Series EE and Series I


The most common type of U.S. savings bonds are Series EE bonds. They are
issued at a discount, and the interest is the difference between the purchase
price and the amount received when the bonds are cashed in.
Series I bonds, first offered in 1998, are issued at face value with a maturity
period of 30 years. As with Series EE bonds the interest is paid when the
bonds are redeemed.
The purchase price for discounted Series EE bonds is less than the amount
shown on the bond. The purchase price for face value Series I bonds is the
amount shown on the bond. The interest is the increase in the bond's value
over a period of time.

TAX TIP

What options do taxpayers have for paying income tax on U.S.


Savings Bonds?
Taxpayers have the following three options:

Declare and pay tax on the interest from Series E or EE bonds as it


builds up each year without cashing in the bonds.

Delay reporting the interest and let it accumulate until the bonds
are cashed. If the taxpayer waits until he or she is in a low tax
bracket (such as during retirement) the deferral of income tax on
the interest may essentially make the interest almost tax free.

Trade the EE bonds for HH bonds, which pay current income. This
tax free swap defers having to pay tax on the interest accumulated
in the Series EE bonds until the HH bonds are cashed or reach
final maturity. At the time of the exchange, the deferred interest
on the EE bonds is stamped on the HH bonds.

Taxpayers must generally use the same method for all the Series EE and
Series I bonds they own.
If the taxpayer selects the first option above, when he cashes in the bonds
hell receive a Form 1099-INT that shows the difference between what he
paid for the bonds and what he received when he cashed them in even
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though he already paid the tax during the years he held the bonds. To
solve this, declare the full amount of the interest reported on the Form
1099-INT on Schedule B and on the line directly below it enter
"Previously Reported US Savings Bond Interest" and enter the amount of
interest that tax was already paid on as a negative number.

U.S. Savings Bonds - Series HH Bonds and


Other U.S. Obligations
Series HH U.S. savings bonds are issued at face value and pay interest twice
a year. Taxpayers must report the interest in the year it is paid. Interest on
other U.S. obligations, such as U.S. Treasury Notes, Bonds, and Bills is fully
taxable when received.
The table below shows the US Savings Bond Maturity Dates:
Bond Type

Bond Issue Date

Series E

May 1941-November 1965

Bond Maturity
40
yrs. after issue
Date

Series E

December 1965-June 1980

30 yrs. after issue

Series EE

January 1980-present

8-20 yrs. after issue

Savings Notes
(Freedom Shares)

May 1967-October 1970

30 yrs. after issue

Series H

February 1957-December 1979

30 yrs. after issue

Series HH

January 1980-present

20 yrs. after issue

Series I Bonds

Present

30 yrs. after issue

Co-owners
If a U.S. savings bond is issued in the names of co-owners, such as the
taxpayer and a child, or the taxpayer and spouse, then the bond's interest is
generally taxable to the co-owner who purchased the bond.
The table below shows who must report the interest:
IF...

THEN the interest must be reported


by...

you buy a bond in your name and the you.


name of another person as co-owners,
using only your own funds

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THEN the interest must be reported


by...

you buy a bond in the name of another the person for whom you bought the
person, who is the sole owner of the bond.
bond
you and another person buy a bond as both you and the other co-owner, in
co-owners, each contributing part of proportion to the amount each paid for
the purchase price
the bond.
you and your spouse, who live in a you and your spouse. If you file
community property state, buy a bond separate returns, both you and your
that is community property
spouse generally report one-half of the
interest.

Deferred Interest Accounts


Deferred interest accounts pay interest at fixed intervals. Some examples are
certain certificates of deposit (CDs), certain money market certificates, and
some U.S. Treasury bonds.
One Year or Less
Interest that is paid in intervals of one year or less is included in taxable
income when it is received or when the taxpayer could receive it (that is,
when it is credited to the account) without paying a substantial penalty.
If an account matures in one year or less, such as a six-month certificate,
and provides a single interest payment at maturity, then the interest is
taxable when the account matures and the taxpayer receives the interest.
More Than One Year
If interest on a CD is deferred for more than one year, the taxpayer must
include a part of the interest in income each year. The taxpayer should
receive Form 1099-INT - Interest Income stating the amount to report.

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Figure 7-15: Form 1099-INT - Interest Income.

Original Issue Discount (OID)


Long-term obligations that pay no interest before maturity are issued at a
discount. OID is the amount by which the bond's or note's principal amount
(redemption price at maturity) exceeds its issue price. Taxpayers include OID
in their income as it accrues over the term of the obligation, whether or not
an income is received.

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Form 1099-OID - Original Issue Discount, reports the amount of OID


income that the taxpayer should report as income for the year.

Figure 7-16: Form 1099-OID - Original Issue Discount.

A copy of Form 1099-OID is also sent to the IRS. Box 1 shows the amount of
OID interest for the year if the taxpayer bought the obligation at its original
issue and held the issue all year. Otherwise, box 1 reports the OID interest
for the part of the year the taxpayer owned it. Box 2 reports non-OID
interest paid or credited on the obligation during the year. The sum of
boxes 1 and 2 are reported as taxable interest income on line 8a of Form
1040 or 1040A.

TAX PRACTICE TIP

Income From Estates and Trusts


Trusts and estates are recognized as separate taxable entities for federal
income tax purposes. Estates and trusts with gross income of $600 or
more file their own income tax return on Form 1041 - U.S. Income Tax
Return for Estates and Trusts - on or before the 15th day of the fourth
month following the close of the tax year. A trust generally must have a
calendar tax year, but an estate may have a fiscal year. For 2015, once the
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estate or trust has taxable income in excess of $12,300, the top tax rates
of 39.6% for ordinary income and 20% for long-term capital gains apply.
Additionally, the 3.8% Medicare surtax applies.
An estate or trust is generally considered to be a conduit of its income
and is allowed a deduction for the portion of income that is currently
distributable or distributed to the beneficiaries. Each beneficiary's share of
income, deductions, credits, and other tax items is reported to them on
Schedule K-1 - Beneficiary's Share of Income, Deductions, Credits, etc. A
copy of each Schedule K-1 is filed with the IRS along with the estate or
trust's Form 1041 and each beneficiary receives a copy. Income allocated
to a beneficiary is taxed to the beneficiary, retaining the same character
that it had in the estate or trust.
Schedule K-1s from an estate or trust are not filed with Form 1040. Each
item that is separately stated on the K-1 is transferred to the appropriate
section of the taxpayers Form 1040. For instance, Line 1 of Schedule K-1,
"Interest income," should be transferred to Line 1, Part I, of the taxpayers
Schedule B. The Schedule K-1 contains line-by-line instructions as to
exactly where on the taxpayers forms each item must be reported.
Usually most items on Schedule K-1 consist of interest, dividends, and
capital gains that are transferred to Schedules B and D. However, if the
trust operates a business or operates some rental property, income from
those activities should be reported on Part III of Schedule E Supplemental Income and Loss.
The amounts reported on Schedule K-1 may be different from the
amounts actually received by the taxpayer. If the trust instrument requires
that the beneficiaries be paid all current income each beneficiary will be
taxed on his or her share, regardless of whether or not he or she actually
received it.

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TAX TIP

Special Rules for Members of the Armed Forces


Members of the Armed Forces in regular and reserve units controlled by
the Secretaries of Defense, Navy, Army, Air Force, and Coast Guard
receive the following tax benefits.
Tax Free Income
The following income and benefits are tax free:

Accrued leave pay for any month served in a combat zone


Awards for suggestions and inventions submitted while in a
combat zone
Basic Allowance for Housing (BAH)
Basic Allowance for Subsistence (BAS)
Combat pay for commissioned officers, at the highest rate of pay
for enlisted service members while on active duty in a combat
zone
Combat pay for enlisted service members while hospitalized for
any wound, injury, or disease resulting from serving in a combat
zone
Combat pay for enlisted service members while on active duty in a
combat zone
Commissary and exchange discounts
Death Allowances for burial services, death gratuity payments to
eligible survivors, and for travel of dependents to the burial site
Defense counseling payments
Dependent care assistance
Disability payments received for injuries incurred as a direct result
of a terrorist or military action
Disability retirement pay
Dislocation allowance to reimburse expenses such as lease
forfeitures, temporarily living in a hotel, and household relocation
expenses (moving household and personal items, storage, etc.)
Education and training allowances paid by the Department of
Veterans Affairs
Family allowances for emergencies, educational expenses of
dependents, evacuation, and separation
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GI insurance dividends
Hostile fire and imminent danger pay
Housing and cost-of-living allowances abroad, regardless of
whether they are paid by the U.S. government or by a foreign
government
Interest on dividend deposits with the Department of Veterans
Affairs
Legal assistance
Medical and dental care
Medical treatment in U.S. Government hospitals
Military base realignment and closure benefits
Moving-in housing allowance outside the U.S.
Pay adjustments for inflated foreign currency losses
Pay forfeited after a court marshal
Payments by the Department of Veterans Affairs to disabled
veterans under the Compensated Work Therapy Program
Payments for inhumane treatment to former prisoners of war by
the U.S. Government
Reenlistment bonus if in a combat zone
Retirement protection plan premiums
ROTC Allowances
Service Members Group Life Insurance benefits
Space-available travel on government aircraft
State and municipal bonuses paid to active or former service
members, or their dependents, due to service in a combat zone
Student loan repayments earned for each month of military
service in a combat zone
Survivor protection plan premiums
Temporary lodging and temporary lodging expenses for 10 days
in the U.S. and 60 days abroad
Travel allowances for an annual round trip for dependent
students, leave between consecutive overseas tours, reassignment
in a dependent restricted status, and transportation for the service
member or his or her dependents during ship overhaul or
inactivation
Uniform allowances paid to officers
Uniforms provided to enlisted service members
Variable Housing Allowance (VAH)
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The exclusion for combat pay for enlisted service members while
hospitalized ends after 24 months of hospitalization.
Tax free combat pay can be considered as earned income for
determining the Earned Income Tax Credit (EITC), the Additional Child Tax
Credit, and for making IRA contributions.
Education and training allowances paid by the Department of Veterans
Affairs are tax free, however tax deductible education costs must be
reduced by any allowance.
For military base realignment and closure benefits the maximum
excludable amount cannot be more than 95% of the fair market value of
the property prior to the public announcement of intent to close all or
part of the military base or installation for which the payments were
made minus the propertys fair market value at the time of sale. The
Department of Defense makes the "95% of the fair market value"
determination.
Service members can deduct mortgage interest and real estate taxes paid
on their home even if these expenses are paid with money received from
their tax free Basic Housing Allowance.
Service Members Group Life Insurance death benefits can be rolled over
to a Roth IRA or Coverdell Education Savings Account within one year of
receipt without regard to the contribution amount or income limitations.
This results in the tax free funds being deposited into a tax free account.
Tax Deductions
The following Miscellaneous Itemized Deductions, subject the 2% of
Adjusted Gross Income floor, are available for members of the Armed
Forces:

Costs of collars, rank insignia, gold braids, including the cost of


alterations when promoted
Costs of obtaining higher retirement pay
Food, lodging, and transportation costs while on official travel
status
Legal fees for a court martial if successful in defending a "conduct
unbecoming an officer" charge
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Lodging and board expenses while on temporary duty away from


their home base that are not reimbursed by the government
Moving expenses for service related moves, provided they are not
reimbursed
Payments into a "Company" fund provided they are not made to
stimulate morale and they are made according to the regulations
Professional journal subscriptions
Professional society dues provided its not for "clubs"
Uniforms provided they must be worn on-duty and cannot be
worn off-duty under the rules but only to the extent that the
expense exceeds any tax free uniform allowance received

The ordinary Moving Expense tests and requirements do not apply to


moving expenses for service related moves.
Mileage and per diem subsistence allowances are taxable if the service
member deducts the entire amount of food, lodging, and transportation
costs while on official travel status.
Filing Deadline
Service members on duty outside the U.S. and Puerto Rico receive an
automatic two (2) month extension to file their income tax returns.
Filing Deadline for Service Members in a Combat Zone or in Contingency
Operation Service
The deadline for filing a tax return is extended for 180 days after the later
of:

the last day the service member is in a combat zone or serving in a


contingency operation

the last day of any continuous hospitalization (up to 5 years) for


an injury in a combat zone or contingency operation service

Add to the 180 days any time the service member had left to file before
entering the combat zone or contingency operation service.

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Tax Forgiveness Upon Death


If a service member dies in a combat zone, or from injuries received in a
combat zone, there is no income tax liability for the year of death and any
earlier year served in the combat zone. The estate is entitled to a tax
refund for any income tax paid while serving in a combat zone.
The date of death for prisoners of war and MIAs is the date their name is
removed from "missing status" for military pay purposes.
Other Items
Prisoners of war and MIAs are considered still serving in a combat zone
as long as that status remains for their military pay. Said time extends the
filing deadline under the rules above.
Members of the reserves can deduct travel expenses (transportation,
lodging, meals) as an adjustment to income when they travel overnight
more than 100 miles away from home in connection with their duties.
Military pay is subject to community property laws if the service member
is regularly domiciled in Arizona, California, Idaho, Louisiana, Nevada,
New Mexico, Texas, Washington, and Wisconsin.
"Differential wages" paid by former employers to active duty service
members are not excludable combat pay. However, such wages are not
subject to FICA withholding.
Reservists on active duty for at least 180 days are not subject to the 10%
penalty for early distributions from IRAs and retirement plans.
Reservists on active duty for at least 180 days may, under certain
conditions, withdraw unused benefits from a Health Flexible Spending
Account.
Service members cannot exclude from income the value of personal use
of government provided vehicles.
Some states subject the pay of regular Armed Forces members to state
payroll withholding.
The above benefits are not available to members of the Red Cross or
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Merchant Marine.
Service members file their tax returns at the IRS Service Center for where
they are stationed, not the IRS Service Center for their regular place of
domicile.
Further information can be found in Publication 3 - Armed Forces' Tax
Guide.

Lesson Summary
Lets take a moment to review what you have learned in this lesson:
Taxable income is any income that is subject to federal income tax. All
taxable income must be reported on a tax return unless the amount is so
small that the individual is not required to file a return.
Wages and other employment income are included on Forms W-2,
prepared by the employer, and mailed to the taxpayer.
Distributions from pensions, annuities, profit sharing, and retirement plans
are reported to recipients on form 1099-R.
Nontaxable income is income that is exempt from tax. Most nontaxable
income is not reported. Some types of nontaxable income will be shown on
the return, but will not be added into the amount of income subject to tax.
Although reimbursements for medical care are generally not taxable, they
may reduce the taxpayer's medical expense deduction on Schedule A.
Form 1040EZ
Of the three tax return forms, Form 1040EZ is the simplest. The only income
taxpayers can report on Form 1040EZ are:

Wages, salaries, and tips


Unemployment compensation
Qualified state tuition program payments
Alaska Permanent Fund dividends
Taxable scholarship and fellowship grants
Interest income of $1,500 or less
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Form 1040A
Taxpayers can use Form 1040A to report all the types of income that can be
reported on Form 1040EZ, plus:

Interest income greater than $1,500


Dividends and capital gain distributions
IRA distributions, pension, and annuity income
Social security and equivalent railroad retirement benefits

Form 1040
Form 1040 can be used to report all Form 1040EZ and Form 1040A items,
plus all other income, deductions, and credits
Taxpayers who receive an incorrect Form W-2 or do not receive one at all,
must contact their employer as soon as possible.
All wage, salary, and tip income must be reported on the return, even if the
employee does not receive a Form W-2.
A taxpayer who has requested a Form W-2 or Form 1099-R and has still not
received it by the due date of the return should file Form 4852 - Substitute
for Form W-2, Wage and Tax Statement, or Form 1099-R - Distributions from
Pensions, Annuities, Retirement or Profit-Sharing Plans, IRA's, Insurance
Contracts, Etc.
Fraudulent Form W-2
You should be alert to the following possible indications of fraudulent
activity:

Any Form W-2 that is typed, handwritten, or has noticeable


corrections

Any Form W-2 that is different from other Forms W-2 issued by the
same employer

Suspicious person(s) accompanying the taxpayer and observed on


other occasions

Multiple refunds directed to the same address or P.O. Box

Poorly documented employment or earnings that are a basis for


refundable credits, such as the Earned Income Credit
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Similar returns among different taxpayers, such as the same amount


of refund, or same number of dependents, or same number of
Forms W-2

Taxpayers who receive earnings reported on Form


Miscellaneous Income, may be considered self-employed.

1099-MISC,

All tip income is subject to federal income tax. Individuals who receive $20
or more per month in tips from one job must report their tip income to
their employer. Tips that are reported to employers are included with wages
on Form W-2, box 1.
Allocated tips are tips an employer assigns to an employee. They are in
addition to the tips the employee reports to the employer.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify you're understanding of the
most important lesson content, and will also help you pass the
Final Exam.
Do the Homework - While completing the homework is not
mandatory, we strongly recommend that you complete each
lesson's homework assignment. It will expand your knowledge
and understanding of the topics covered in this course.

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II

Lesson

8
Lesson 8 - Income - Part II
In this lesson you'll learn more about taxable and non-taxable income. The
following topics are discussed in this lesson:
Life Insurance Proceeds and
Interest
Coverdell ESAs
Tax-Exempt Interest
Form 1099-INT
Reporting Interest
Dividends and Corporate
Distributions
How to Report Ordinary
Dividends
How to Report Capital Gain
Distributions
Sick Pay Other Income

Qualified Long-term Care


Insurance
State and Local Refunds
Alimony
Unemployment
Compensation
Supplemental
Unemployment Benefits
Union Benefits
Veterans Benefits
Royalty Income
REMIC Income

ife insurance death benefits are generally exempt from income tax.
However, if the insurance proceeds pay interest, then the interest
payments must be included as taxable income.

Taxpayers can receive life insurance benefits paid upon the death of the
insured either in a lump sum or in installments. If the payments are received
in installments, the portion that is interest must be included in the
taxpayer's income. Form 1099-INT shows this portion of the proceeds in
box 1.
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II

Figure 8-1: Form 1099-INT - Interest Income with box 1 "Interest Income" highlighted.

Two exceptions to the rules on interest payments from life insurance


proceeds are:

If a taxpayer's insured spouse died before October 23, 1986 and the
taxpayer receives the payments in installments, then the first $1,000
of interest income received each year is not taxed. This exclusion
does not apply if proceeds are left on deposit with the insurance
company and only interest is paid.

Interest on insurance proceeds that have been left on deposit with


the Department of Veterans Affairs (VA) is not taxable. Any return
that reports VA proceeds interest as taxable can be amended for a
tax refund provided it is within the three (3) year statute of
limitations.

Veteran's life insurance proceeds are not taxable either to the veterans or to
their beneficiaries. This is also true of the proceeds of a veterans
endowment policy paid before death.
Life insurance policies surrendered for their cash value are taxable as
ordinary income (not capital gains) if the cash received exceeds sum of the
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II

premiums paid less any dividends received. There is no loss deduction upon
surrender of a life insurance policy. An exchange for a paid up policy has no
tax consequences.

TAX TIP

Are life insurance proceeds subject to Federal Estate Tax?


Life insurance proceeds may be subject to federal estate tax if the
decedent has what's known as "incidents of ownership" in the life
insurance policy. If the decedent controlled the policy in any way then he
or she probably had "incidents of ownership" in the policy. The proceeds
of the policy may be subject to federal estate tax upon death.

TAX PLANNING TIP

What is a Life Insurance Trust?


A life insurance trust purchases a life insurance policy on the grantor (the
person who established the trust). The trust owns the life insurance policy
and collects the death benefits when the grantor dies. The trustee then
distributes the death proceeds (which may be over many years) to the
trust beneficiaries according to the terms of the trust. The trust document
identifies who the beneficiaries are and how and when they may receive
distributions. The trust document may also limit how the money in the
trust may be invested.
Life insurance trusts that are established correctly may provide security
for the decedents family while providing limits as to how the death
proceeds may be invested or distributed. Life insurance trusts may also
avoid federal estate taxes under certain circumstances. You should advise
taxpayers who could benefit from a life insurance trust to consult with a
good estate planning attorney.

Coverdell ESA's
The Coverdell Educational Savings Account (ESA), formerly the Education
IRA, is an account that helps individuals save for the cost of elementary,
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II

high school or higher education. Generally, an individual can establish a


Coverdell ESA for a child who is under age 18.
Contributions to a Coverdell ESA are not deductible. Amounts in the ESA
grow tax-free until they are distributed. No tax is due on distributions if the
beneficiary had qualified education expenses that were at least as much as
the distributions during the year.
Ask taxpayers to specify exactly what they are using as education expenses.
Qualified education expenses include tuition, books, equipment, and certain
other expenses needed to enroll at or attend an eligible educational
institution.
The taxpayer will receive a Form 1099-Q - Payments from Qualified
Education Programs, for each of the Coverdell ESA's from which money was
distributed during the tax year. The amount of gross distribution will be
shown in box 1.

Figure 8-2: Form 1099-Q - Payments from Qualified Education Programs with box 1 "Gross
Distribution" highlighted.

If the taxpayer has received a distribution from a Coverdell ESA, ask the
taxpayer whether the distribution was more than the amount spent on any
of the following:

Tuition, fees, books, supplies, and equipment needed to enroll at or


attend a qualified educational institution

A qualified tuition program


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II

Room and board if the beneficiary is at least a half-time student at


the educational institution

If the distribution was not more than the amount spent in these ways, the
entire distribution is tax-free. Report it on Form 1040, line 15a, and leave line
15b blank.

Figure 8-3: The Income section of Form 1040 with line 15 "IRA distributions" highlighted.

Taxpayers can claim either the Hope or Lifetime Learning Credit in the same
year they take a tax-free withdrawal from a Coverdell ESA only if the
distribution from their Coverdell ESA was not used for the same expenses
for which a Hope or Lifetime Learning Credit was claimed.

SIDE BAR

Highlights of Tax Benefits for Education... is our comparison chart


detailing the different tax benefits for the various education deductions,
credits, and programs.
Part I - Covers Scholarships, Fellowships, Grants, and Tuition Reductions;
the Hope Credit; the Lifetime Learning Credit; Student Loan Interest
Deductions; and the Tuition and Fees Deduction. You can review Part I in
Appendix F or by clicking here.
Part II - Covers Coverdell Educational Savings Accounts (ESA's); Qualified
Tuition Programs (QTP's); the Educational Exception to Additional Tax on
Early IRA Distributions; the Education Savings Bond Program; EmployerProvided Educational Assistance; and the Business Deduction for WorkRelated Education. You can review Part II in Appendix G or by clicking
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II

here.

Tax-Exempt Interest
Certain types of interest are exempt from federal income tax. Bonds issued
by the following entities generally pay tax-exempt interest:

District of Columbia
U.S. possessions and political subdivisions
States, counties and cities

Specific examples of governmental entities that may issue tax-exempt


bonds include port authorities, toll-road commissions, utility service
authorities, community redevelopment agencies, and qualified volunteer
fire departments.
Although tax-exempt interest is not taxable, the taxpayer must report all
tax-exempt interest on Form 1040 line 8b.

Figure 8-4: The Income section of Form 1040 with line 8b "Tax-exempt interest"
highlighted.

TAX PLANNING TIP

Do investors receive a better overall return in municipal bonds?


Taxpayers in high tax brackets can often benefit by switching their fully
taxable income investments, such as certificates of deposit and money
market funds, to municipal bond funds or other tax-exempt investments.
But keep in mind, the number one consideration is the net (after tax)
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II

investment return. See the table below.

Tax Free Interest Rate Equivalents


The table below shows the taxable interest rate a taxpayer would have to
obtain in order to be left with the same amount of money, after taxes, as
compared to various tax free interest rates - based on the taxpayer's tax
bracket:

2%

3%

Tax
Rate

8%

9%

8.89
9.41
10.67
11.11
11.94
12.31
13.25

10.00
10.59
12.00
12.50
13.43
13.85
14.90

Equivalent Taxable Rate of Interest

10%
15%
25%
28%
33%
35%
39.6%

Tax Free Rate of Interest


4%
5%
6%
7%

2.22
2.35
2.67
2.78
2.99
3.08
3.31

3.33
3.53
4.00
4.17
4.48
4.62
4.97

4.44
4.71
5.33
5.56
5.97
6.15
6.62

5.56
5.88
6.67
6.94
7.46
7.69
8.28

6.67
7.06
8.00
8.33
8.96
9.23
9.93

7.78
8.24
9.33
9.72
10.45
10.77
11.59

TAX QUOTE

"It is a good thing that we do not get as much government as we pay for."
Will Rogers

Form 1099-INT

SIDE BAR

Where to Report Investment Income


To review our publication "Where to Report Investment Income" see
Appendix H or click here.

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II

Interest income is reported to the taxpayer on Form 1099-INT - Interest


Income. A copy of Form 1099-INT is also sent to the IRS. Box 1 of each Form
1099-INT shows taxable interest income received from the payer.

Figure 8-5: Form 1099-INT - Interest Income with box 1 "Interest Income" highlighted.

In some cases, although the taxpayer has not received a copy of Form 1099
they may know the reportable income amount. In these cases, report the
income on the appropriate line of the return. If a taxpayer cannot accurately
determine the reportable income amount, advise them to contact the payer
of the income to get the missing information.

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II

To enter interest income double click Form 1040 line 8a...

Figure 8-6: The Income section of Form 1040 with line 8a "Taxable interest" highlighted.

...to drill down to Schedule B (go to page 2 of the PDF) - Interest and
Ordinary Dividends.

Figure 8-7: Form 1040 Schedule B - Interest and Ordinary Dividends.

Then in Part I double click again to drill down to the Interest Income
Worksheet.

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II

Enter the interest there. 1040 ValuePak will add the taxable interest earned
from all of the taxpayer's Forms 1099-INT, and report the total on line 8a of
Form 1040. Box 8 shows Tax Exempt interest income.

Figure 8-8: Form 1099-INT - Interest Income with box 8 "Tax-exempt interest" highlighted.

Report the total non-taxable interest on the Interest Income Worksheet and
1040 ValuePak will carry it to line 8b of Form 1040.

Figure 8-9: The Income section of Form 1040 with line 8b "Tax-exempt interest"
highlighted.

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II

If a taxpayer withdrew funds from a time deposit before an account's


maturity date and incurs a penalty, the penalty is shown in box 2.

Figure 8-10: Form 1099-INT - Interest Income with box 2 "Early withdrawal penalty"
highlighted.

Do not subtract the penalty from the total interest entered on line 8a of
Form 1040. The early withdrawal penalty is an adjustment to income and is
entered on the Interest Income Worksheet. 1040 ValuePak will then carry
that entry to Form 1040 line 30.

Figure 8-11: The Adjusted Gross Income section of Form 1040 with line 30 "Penalty on early
withdrawal of savings" highlighted.

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Forms 1099-INT box 3 shows U.S. Savings Bond and Treasury obligations
interest.

Figure 8-12: Form 1099-INT - Interest Income with box 3 "Interest on U.S. Savings Bonds
and Treas. obligations" highlighted.

Be sure to ask taxpayers about the interest income shown in box 3. The
amount shown may be too high if the taxpayer was not the bond's original
owner or if the taxpayer has reported the interest income each year as it
was earned. Also, the box 3 amount may be tax-exempt in some states.

TAX TIP

Accrued Interest on Bonds


Taxpayers who buy bonds in between the interest payment dates will
receive a Form 1099-INT which includes any accrued interest since the
last interest payment date before they purchased the bond. This will
appear as taxable income. However, they can deduct the accrued interest
from the 1099-INT. On the first line on Schedule B report the full amount
of interest as reported on Form 1099-INT and on the next line write the
amount of accrued interest as a negative number.

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Some Forms 1099-INT have entries in box 4 indicating that federal income
tax has been withheld from the interest paid.

Figure 8-13: Form 1099-INT - Interest Income with box 4 "Federal income tax withheld"
highlighted.

Be sure to include the amount shown in box 4 on the Interest Income


Worksheet. 1040 ValuePak will carry the federal tax withheld to Form 1040
line 64.

Figure 8-14: The Payments section of Form 1040 with line 64 "Federal income tax withheld
from Forms W-2 and 1099" highlighted.

This total includes all income tax withheld from Forms W-2 and 1099.

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TAX PRACTICE TIP

Missing Form 1099?


If your client receives certain types of income during the year he may get
a Form 1099. Form 1099 is an information return provided by the payer
of the income by January 31st of each year. There are several different
forms in the 1099 series, including:

Form 1099-B, Proceeds From Broker and Barter Exchange


Transactions
Form 1099-C - Cancellation of Debt
Form 1099-DIV - Dividends and Distributions
Form 1099-G - Certain Government Payments
Form 1099-INT - Interest Income
Form 1099-K - Merchant Card and Third Party Network Payments
Form 1099-LTC - Long-Term Care and Accelerated Death Benefits
Form 1099-MISC - Miscellaneous Income
Form 1099-OID - Original Issue Discount
Form 1099-Q - Payments From Qualified Education Programs
Form 1099-QA - Distributions from ABLE Accounts
Form 1099-R - Distributions from Pensions, Annuities, Retirement
or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
Form 1099-S - Proceeds From Real Estate Transactions
Form RRB-1099 - Payments by the Railroad Retirement Board
Form SSA-1099 - Social Security Benefit Statement
Form(s) 1099 from different financial institutions may not look
alike because the IRS doesn't require a particular format.

If your client hasnt received an expected Form 1099 by a few days after
January 31st he should contact the payer. Perhaps the payer has an
incorrect or incomplete address for your client. Even if the payer says it's
in the mail, have your client ask for a duplicate. If he still does not receive
the form by February 15th he should call the IRS for assistance at 800829-1040.
You don't necessarily have to wait for the Form 1099 to complete and file
the return. You may be able to obtain the information that would be on
the Form 1099 from other sources. For example, your clients bank,
broker, or investment company may put a summary of the interest paid
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during the year on the December or January statement. The easiest way
to get this missing data is to have your client call the payer and ask for
the information over the phone. Many payers make the information
available through their automated customer service phone number or
their web site. As long as you have the correct information you can put it
on the tax return without having the Form 1099 in hand.
You will not ordinarily attach a Form 1099 to the tax return, except for
Form(s) 1099-R that show income tax withheld. You should keep a copy
of all the 1099s in your client file.
Schedule K-1
While it's true that your client should receive most of his tax documents
by the January 31st deadline, Schedule K-1 is an exception. If your client
is the beneficiary of a trust or estate, a member of an LLC taxed as a
partnership, a partner in a partnership, or a shareholder in an S
corporation taxed as a partnership, he will receive what's known as a
Schedule K-1. The Schedule K-1 reports his share of income and
expenses attributable to the estate, trust, LLC, partnership or S
corporation. Schedules K-1 cannot be issued until the underlying
fiduciary or corporate tax return has been completed, so it's not unusual
to receive those forms after the January 31st Form 1099 deadline, all the
way up to the Form 1040 filing deadline.
If you file your clients return and he later receives a Form 1099 or
Schedule K-1 for income that was not included on the return, you should
report the income and take credit for any income tax withheld by filing
Form 1040X - Amended U.S. Individual Income Tax Return.

Reporting Interest
Form 1040EZ
Taxpayers who file Form 1040EZ report their taxable interest income on line
2.
Forms 1040 and 1040A
Taxpayers who file Form 1040A or 1040 report their taxable interest income
on line 8a and their tax-exempt interest on line 8b. Double click Form 1040
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line 8a to drill down to Schedule B - Interest and Ordinary Dividends and


then in Part I double click again to drill down to the Interest Income
Worksheet. Enter the interest there. 1040 ValuePak will add the taxable
interest earned from all the taxpayer's Forms 1099-INT and report the total
on line 8a of Form 1040 or 1040A.
Form 1040A filers must complete Schedule 1 Part I and Form 1040 filers
must complete Schedule B Part I if they:

Have interest income of more than $1,500, or


Want to claim an exclusion for savings bond interest the same year
they qualified for higher education expenses, or
Receive Form 1099-INT for tax-exempt interest

A taxpayer who receives a Form 1099-INT for tax-exempt interest must


report the interest on Form 1040A Schedule 1 or Form 1040 Schedule B, line
1 as follows:

Payers' names and amounts of all taxable interest


Payers' names and amounts of all tax-exempt interest
The subtotal of all the interest below the last entry on line 1
The total of tax-exempt interest labeled "Tax-exempt interest" below
the subtotal

The amount entered on line 2 should equal the subtotal minus the taxexempt interest.
Form 1040
Taxpayers must report the following types of interest income on Form 1040:

OID that's different from the amount reported on Form 1099-OID


Accrued interest received or paid on securities transferred between
payment dates, and
Bond interest reduced by amortizable bond premium

These types of income cannot be reported on Form 1040EZ or 1040A.


In addition, taxpayers must complete Form 1040 Schedule B, Part III, Foreign
Accounts and Trusts, if they:

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Had over $1,500 in interest or dividends


Had a foreign account
Received a distribution from, or were a grantor of, or a transferor of,
a foreign trust.

Figure 8-15: Form 1040 Schedule B, Part III, Foreign Accounts and Trusts.

Foreign Investment Accounts and Trusts


Every taxpayer who had a foreign account or was a beneficiary, grantor, or
transferor to a foreign trust must complete Part III. Part III asks two
questions.
The first question is: "At any time during the tax year, did you have an
interest in or a signature or other authority over a financial account in a
foreign country, such as a bank account, securities account, or other
financial account?"
Do not check the "yes" box if:

the combined value of the accounts was $10,000 or less during the
year;

the accounts were with a U.S. military banking facility; or

the taxpayer is an officer or employee of a commercial bank


supervised by a U.S. agency, or of a domestic corporation listed on a
national exchange or with assets of more than $1 million and with at
least 500 shareholders, and he had no personal interest in the
account.

If these exceptions don't apply, check the "yes" box. Also check the "yes"
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box if the taxpayer owns more than half of the stock in a company that
owns one or more foreign bank accounts, or he directly owns or has an
interest in such an account. This does not include foreign securities held in a
U.S. securities account.
If you checked the "yes" box, you must write the name of the country or
countries on Line 7b and also file FinCEN Form 114 - Report of Foreign Bank
and Financial Accounts with the Treasury Department by June 30th each
year. The penalty for failing to file Form 114 is up to $10,000.
FinCEN Form 114 supersedes TD F 90-22.1 (the FBAR form that was used in
prior years) and is only available online through the BSA E-Filing System
website. The system allows the filer to enter the calendar year reported,
including past years, on the online FinCEN Form 114. It also offers an option
to explain a late filing, or to select Other to enter up to 750-characters
within a text box where the filer can provide a further explanation of the late
filing or indicate whether the filing is made in conjunction with an IRS
compliance program.
FinCEN has posted a notice on their internet site that introduced a new
form to filers who submit FBARs jointly with spouses or who wish to have a
third party preparer file their FBARs on their behalf. The new FinCEN Form
114a, Record of Authorization to Electronically File FBARs, is not submitted
with the filing but, instead, is maintained with the FBAR records by the filer
and the account owner, and made available to FinCEN or IRS on request.
Under the Foreign Account Tax Compliance Act (FATCA) certain U.S.
taxpayers holding specified foreign financial assets with an aggregate value
exceeding $50,000 must also report information about those assets on
Form 8938 - Statement of Specified Foreign Financial Assets which must be
attached to the taxpayers annual income tax return.
For further information see the Tax Tip titled "Is your client cheating on
his taxes?" in Lesson 14.
The second question is: "Did you receive a distribution from, or were you
the grantor of, or transferor to, a foreign trust?"

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If the answer to that question is "yes" the taxpayer may have to file Form
3520 - Annual Return to Report Transactions with Foreign Trusts and Receipt
of Certain Foreign Gifts.
Dont forget that if the taxpayer had a foreign bank or investment account
it's likely that he paid some foreign taxes on it and he may be entitled to a
foreign tax credit which is discussed in length in Lesson 26.

TAX PLANNING TIP

Deferring Taxable Interest Income


Tax can be shifted from one year to the next on income generated by
taxable interest paying accounts, such as CDs or money market funds, by
buying 3 or 6 month Treasury Bills that mature next year. Treasury Bills
are sold at a discount and mature for their face value. The difference is
the interest, which is not reportable as taxable income until maturity.
Treasury Bill interest is exempt from state and local taxes.

Dividends and Corporate Distributions


Corporations make several types of distributions to their shareholders.
Although most dividends are paid in cash, others are paid in property,
services, or additional shares of stock. Most corporations use Form 1099DIV to report distributions to shareholders.

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Figure 8-16: Form 1099-DIV - Dividends and Distributions.

Ordinary dividends are corporate distributions paid in cash, as opposed to


property, services, or shares of stock. They come from a corporation's net
earnings and profits. Ordinary dividends can be reported on Form 1040A or
Form 1040, as can capital gain distributions that don't involve activity other
than distributions. All other corporate distributions must be reported on
Form 1040.
When a corporation is liquidated taxpayers receive liquidating distribution
payments which are shown in Boxes 8 or 9 of Form 1099-DIV. To the extent
that they repay the taxpayers basis in the stock these are nontaxable
distributions. If the taxpayer receives more than his basis the excess will be a
capital gain. If he receives less than his basis the shortage will be a capital
loss.
Capital gain distributions come from mutual funds and real estate
investment trusts (REIT's). These distributions are treated as long-term
capital gains, regardless of how long the taxpayer holds the shares.
Dividend reinvestment is when stockholders ask the corporation to use their
dividends to purchase more shares of the corporation's stock. However, the
dividend is still taxable at the time it would be if it were paid in cash.
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Return of capital represents a return of part of the taxpayer's investment in


company stock. This distribution reduces the basis of the stock, and is not
taxed until the taxpayer's basis in the stock is fully recovered. However, any
return on capital in excess of basis is treated as a capital gain.
Stock dividends increase the taxpayer's number of company shares and are
generally not taxable.
Non-taxable dividends include:

Exempt-interest dividends paid by mutual funds (reported on line 8b


of Form 1040)

Insurance policy dividends, as long as they do not exceed the total of


all premiums paid by the taxpayer

Dividends on veterans' insurance

Certain patronage dividends

What is the tax rate on dividends?


0%

for Individuals in the 10% or 15% income tax brackets

15%

for Individuals in income tax brackets > than 15% and less
than 39.6%
for Individuals in the 39.6% income tax bracket

20%

TAX TIP

Fake Dividends
Distributions from the following financial institutions are called
"dividends" but they are actually interest: credit unions, mutual savings
banks, cooperative banks, savings and loan associations, and building
and loan associations. The interest is reported to the taxpayer on Form
1099-INT."Dividends" on life insurance are a refund of premiums paid
and are tax free until they exceed the premiums paid for the policy.

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How to Report Ordinary Dividends


Form 1099-DIV - Dividends and Distributions, reports dividend income to
the taxpayer and to the IRS. Ordinary dividends are shown in box 1a.

Figure 8-17: Form 1099-DIV - Dividends and Distributions with box 1a "Total ordinary
dividends" highlighted.

Double click Form 1040 line 9a to drill down to Schedule B - Interest and
Ordinary Dividends...

Figure 8-18: The Income section of Form 1040 with line 9a "Ordinary dividends"
highlighted.

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...and then, in Part II, double click again to drill down to the Dividend Income
Worksheet. Enter the dividend there.

Figure 8-19: Form 1040 Schedule B - Interest and Ordinary Dividends Part II "Ordinary
Dividends.

1040 ValuePak will add the dividends earned from all of the taxpayer's
Forms 1099-DIV, and report the total on line 9a of Form 1040 or 1040A.

TAX QUOTE

"Unquestionably, there is progress. The average American now pays out


twice as much in taxes as he formerly got in wages."
H. L. Mencken

Spouses
If a husband and wife receive income from shares they own jointly, and they
file separate returns, then divide the dividend by two and report half on
each of their returns. If the total for both spouses is more than $1,500 but
less than $1,500 for each spouse, they still must use Schedule I or Schedule
B.
If the taxpayer has a substitute Form 1099-DIV from a brokerage firm, and
the form shows a total for dividends received, enter the brokerage firm as
the payer of the dividends and the total dividend amount.

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How to Report Capital Gain Distributions


Capital gain distributions occur when a mutual fund:

Sells assets for more than their cost, and


Distributes the realized capital gains to the fund's shareholders

Payers report capital gain distributions on box 2a of Form 1099-DIV. Capital


gain distributions are also called capital gain dividends.

Figure 8-20: Form 1099-DIV - Dividends and Distributions with box 2a "Total capital
gain distr." highlighted.

Capital gains and capital gain distributions are two different things. A capital
gain occurs when the owner of a capital asset sells it for more than the cost
and realizes a capital gain.
Enter capital gain distributions on the 1040 ValuePak Dividend Income
screen.
A Schedule D must be filed when the taxpayer has more than just capital
gain distributions to report.

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Sick Pay
Sick pay is taxable as wages and must be reported unless it qualifies as
workers' compensation. Generally, amounts taxpayers receive from their
employer while they are sick or injured are part of their salary or wages and
must be reported. The taxpayer must report as taxable income any amount
he receives for disability through an accident or health insurance plan paid
for by the employer. If the taxpayer paid for the plan the benefits are tax
free. If both the taxpayer and the employer have paid for the premiums of
the plan, only the amount received for disability that is due to the
employer's payments is reported as taxable income. The remainder is tax
free. If the taxpayer pays the premiums of a health or accident insurance
plan through a cafeteria plan, and the amount of the premium was not
included in the taxpayers taxable income, the premiums are considered
paid by the employer and any benefits are taxable.
If the benefits are taxable the taxpayer should receive a Form W-2. Report
the amount received on Line 7, Form 1040; Line 7, Form 1040A; or Line 1,
Form 1040EZ.
The taxpayer must include in taxable income sick pay from any of the
following:

A welfare fund
A state sickness or disability fund
An association of employers or employees
An insurance company, if the employer paid for the plan

The table below shows the tax rules for Sickness and Injury Benefits:
Type of Benefit

General Rule

Workers' Compensation

Not taxable if paid under a workers'


compensation act or a statute in the
nature of a workers' compensation
act and paid due to a work related
sickness or injury. However,
payments received after returning
to work are taxable.

Federal Employees'

Not taxable if paid because of


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Type of Benefit

General Rule

Compensation Act (FECA)

personal
injury
or
sickness.
However, payments received as
"continuation of pay" for up to 45
days while a claim is being decided
and pay received for sick leave
while a claim is being processed are
taxable.

Compensatory Damages

Not taxable if received for injury or


sickness.

Accident or Health Insurance


Benefits

Not taxable if the taxpayer paid the


insurance premiums.

Disability Benefits

Not taxable if received for loss of


income or earning capacity due to
an injury covered by a "no-fault"
automobile policy.

Compensation for Permanent


Loss or Loss of Use of a Part or
Function of Your Body, or for
Permanent Disfigurement

Not taxable if paid due to the injury.


The payments must be figured
without regard to any period of
absence from work.

Reimbursements for Medical


Care

Not taxable - but the reimbursement may reduce the taxpayer's


medical expense deduction.

Please Note: The table above is intended as a general overview. Additional


tax rules may apply depending on the tax situation. For more information
about benefits, see "Other Sickness and Injury Benefits" in IRS Publication
17.

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TAX PLANNING TIP

What is Disability Income Insurance?


Disability Income insurance pays a monthly benefit if the insured
becomes disabled. If the taxpayers employer doesnt offer disability
income insurance the taxpayer should think about purchasing a policy
himself. Disability Income insurance premiums are not tax deductible.
Benefits received from a Disability Income insurance policy that the
taxpayer bought himself are tax free.

Qualified Long-term Care Insurance


Payments received from qualified long-term care insurance contracts are
generally excluded from taxable income as amounts received for personal
injury or sickness.

State and Local Refunds


Taxpayers who receive a refund of state or local taxes may receive Form
1099-G - Certain Government Payments with their refund amount shown in
box 2.

Figure 8-21: Form 1099-G - Certain Government Payments.

Taxpayers who claimed the standard deduction on their tax return for the
year they received a refund do not have to include the refund in their
taxable income. However, taxpayers who itemized deductions and received
a state or local refund may have to include all or part of the refund in their
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taxable income because they took a deduction for this amount on their
federal income tax return in a prior year.
Enter the tax refund in 1040 ValuePak in the State and Local Tax Refund
field.

Figure 8-22: The Income section of Form 1040 with line 10 "Taxable refunds, credits,
or offsets of state and local income taxes" highlighted.

TAX TIP

Recoveries of Previously Deducted Items


Taxpayers who recover an amount that they deducted on a prior year's
tax return generally must report the recovered amount as income in the
year they receive it. This saves them the trouble of having to file an
amended tax return for the prior year.
If the taxpayer itemized deductions in the year to which the recovery
applies he must report the recovery as income. If he did not itemize
deductions he doesnt have to report the recovery as income since he
didn't gain any tax benefit from it. Federal tax refunds are not reported
because taxpayers cannot claim an itemized deduction for federal taxes.
The rule that taxpayers must report the recovery only if they got some tax
benefit from it in a previous year applies generally to all types of refunds
and recoveries. They only have to report recoveries of items to the extent
the prior deduction helped their itemized deductions exceed the
standard deduction for the year in question. If the actual deduction for
the item was less than the amount recovered they only have to report a
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taxable recovery for the amount that they had actually deducted.

Alimony
Alimony or separate maintenance payments made under a court order are
taxable income to the person receiving them and reported on Form 1040
line 11.

Figure 8-23: The Income section of Form 1040 with line 11 "Alimony received"
highlighted.

They are tax deductible for the person paying them and reported on Form
1040 line 31a as an adjustment to income.

Figure 8-24: The Adjusted Gross Income section of Form 1040 with line 31a "Alimony
paid" and 31b "Recipient's SSN" highlighted.

Child support payments are not deductible to the payer and are not
included in the income of the recipient.
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Specific Rules Regarding Alimony Payments


Payments ARE alimony if ALL of the following are true:

Payments are required by a divorce or separation instrument.


Payer and recipient spouse do not file a joint return with each other.
Payment is in cash (including checks or money orders).
Payment is not designated in the instrument as not alimony.
Spouses legally separated under a decree of divorce or separate
maintenance are not members of the same household.
Payments are not required after death of the recipient spouse.
Payment is not treated as child support.

The above payments are deductible by the payer and includible in income
by the recipient.
Payments are NOT alimony if ANY of the following are true:

Payments are not required by a divorce or separation instrument.


Payer and recipient spouse file a joint return with each other.
Payment is:
Not in cash
A non-cash property settlement,
Spouse's part of community income, or
To keep up the payer's property.
Payment is designated in the instrument as not alimony.
Spouses legally separated under a decree of divorce or separate
maintenance are members of the same household.
Payments are required after death of the recipient spouse.
Payment is treated as child support.

The above payments are neither deductible by the payer nor includible in
income by the recipient.

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SIDE BAR

Should soon to be married couples have a Prenuptial Agreement?


Prenuptial agreements can be sensitive to discuss but they are
worthwhile considering. They address the areas of assets, liabilities,
divorce, and estate planning. Couples may want to consider a Prenuptial
agreement if one or the other spouse has:

children or grandchildren from a previous marriage


substantially more wealth than the other spouse
a successful business
the possibility of receiving a large inheritance
been paying for the education of the other spouse

Each party should be represented by his or her own lawyer when ironing
out the details of a Prenuptial Agreement.
Nolo has some great additional information on the legal aspects (we're
not lawyers) of many of the financial planning topics covered in our
course, including Prenuptial Agreements.
Specific Rules Regarding Property Transferred Pursuant To
Divorce
IF you transfer...

THEN you...

AND your spouse or


former spouse...

income-producing
property (such as an
interest in a business,
rental property, stocks,
or bonds)

include on your tax


return any profit or loss,
rental income or loss,
dividends, or interest
generated or derived
from the property during
the year until the
property is transferred.

reports any income or


loss generate or derived
after the property is
transferred.

interest in a passive
activity with unused
passive activity losses

cannot deduct your


accumulated unused
passive activity losses

increases the adjusted


basis of the transferred
interest by the amount

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THEN you...

AND your spouse or


former spouse...

allocable to the interest

of the unused losses.

investment credit
property with recapture
potential

do not have to recapture


any part of the credit.

may have to recapture


part of the credit if he or
she disposes of the
property or changes its
use before the end of
the recapture period.

interests in non statutory


stock options and non
qualified deferred
compensation

do not include any


amount in gross income
upon the transfer

includes an amount in
gross income when he or
she exercises the stock
options or when the
deferred compensation
is paid or made available
to him or her.

IF you transfer...

TAX PLANNING TIP

Should joint debts be paid off when getting divorced?


Divorce can be more than just an emotional experience. If the couple has
joint debts each spouse is liable for the full amount until the balance is
paid off. Additionally, even if the debt is in the name of just one spouse, if
the debt was incurred for "household or family" purposes both spouses
may be liable for it in some states. Spouses that came into the marriage
with prior personal debt remain solely liable for those debts.
Often during and after divorce the prior couple's financial situations
deteriorate. This is probably more the result of the fact that 75% of
divorced couples say finances played an important role in leading to their
divorce. Parting couples should always agree to first pay off any joint
debts before agreeing to any property settlement. Otherwise, if one
former spouse doesn't pay a joint debt (even if agreed to or ordered to
by the court) the other former spouse's credit rating may be ruined for up
to 7 years.

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TAX PLANNING TIP

Accelerating Alimony Payments


Taxpayers may be able to cut their tax bill by making alimony payments
before years end. They should probably check with their ex-spouse first,
as he or she will have to claim the payments as taxable income.

Unemployment Compensation
Unemployment compensation includes benefits that a state or the District
of Columbia paid from the Federal Unemployment Trust Fund to
unemployed individuals.

SIDE BAR

Who is eligible for unemployment compensation?


Taxpayers are eligible for unemployment benefits if they:

were previously employed (for a certain amount of time in some


states, which varies from state to state)
are currently unemployed
meet certain income requirements
are willing and able to work

Taxpayers are not eligible for unemployment's if they:

quit their job


were fired for insubordination
were fired for committing a crime
have never had a job

The formula for determining benefits varies from state to state. In most
states benefits continue for up to 26 weeks. During periods of high
unemployment, benefits may be extended for longer periods of time by
the state or federal government.

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Unemployment compensation is reported to the recipient on Form 1099-G


box 1 and is taxable.

Figure 8-25: 1099-G - Certain Government Payments with box 1 "Unemployment


compensation" highlighted.

Form 1099-G amounts should be entered on the Form 1099-G data entry
screen. Double click Line 19 of Form 1040 to drill down to the Form 1099-G
data entry screen.

Figure 8-26: The Income section of Form 1040 with line 19 "Unemployment
compensation" highlighted.

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The table below shows how much employers pay under the Federal
Unemployment Tax Act:
Maximum Wages Subject to FUTA tax
FUTA tax rate on taxable wages

$7,000.00

6.0% 2

Maximum FUTA tax 1


Footnotes:

$420.00

Only the employer pays FUTA tax.

The employer may also owe state unemployment tax. Employers who pay state

unemployment tax, on a timely basis, will receive an offset credit of up to 5.4%,


regardless of the rate of tax they pay the state. Therefore, the net FUTA tax rate is
generally 0.6% (6% - 5.4%), for a maximum FUTA tax of $42.00 per employee, per
year (.006 X $7,000. = $42.00). State law determines individual state
unemployment insurance tax rates.
Table: FUTA Rates

SIDE BAR

What is COBRA?
COBRA is an acronym for the Consolidated Omnibus Budget
Reconciliation Act of 1986. Prior to passage of COBRA, changing jobs
often meant losing employment based health insurance coverage for
most employees.
COBRA protects employees and their dependents from losing health
insurance coverage as a result of job changes until new coverage begins.
COBRA entitles employees to continue coverage for up to 18 months (36
months in some situations). Employers with 20 or more employees are
required to offer COBRA coverage. The Health Insurance Portability and
Accountability Act of 1996 (HIPAA) expanded certain COBRA provisions
to companies with 2 to 50 employees, the self-employed, and mothers
and newborn infants.

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Supplemental Unemployment Benefits


Supplemental unemployment benefits received from a company-financed
fund to which the employees did not contribute are not unemployment
compensation but rather taxable wages subject to income tax withholding
but not subject to Social Security tax, Medicare tax or Federal
Unemployment tax. These supplemental unemployment benefits are usually
paid under guaranteed annual wage plans and must be reported. This
income is reported to the employee on Form W-2 box 1 and should be
included in the amount reported for wages, salaries and tips.
The taxpayer may have to repay some of the supplemental unemployment
benefits to qualify for trade readjustment allowances under the Trade Act of
1974. If the taxpayer repays supplemental unemployment benefits in the
same tax year received, reduce the total supplemental unemployment
benefits by the amount repaid. However, if the taxpayer repays the
supplemental unemployment benefits in a later tax year, the taxpayer must
include the full amount of the supplemental unemployment benefits
received in taxable income for the tax year received.
If the supplemental unemployment benefits repayment is $3,000 or less
claim a tax deduction on line 36 of Form 1040 and to the left write "sub-pay
TRA".

Figure 8-27: The Adjusted Gross Income section of Form 1040 with line 36
highlighted.

If the supplemental unemployment benefits repayment is greater than


$3,000 the taxpayer can take a deduction on line 28 of Form 1040, Schedule
A or claim a tax credit. The deduction is not subject to the 2% AGI floor.
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Figure 8-28: The Other Miscellaneous Deductions section (line 28) of Form 1040
Schedule A - Itemized Deductions.

Under Internal Revenue Code Section 1341 the taxpayer can re-compute tax
for the prior tax year as if the taxpayer had not received the repaid
supplemental unemployment benefits. The taxpayer can claim a tax credit
for the difference between the actual tax paid and the tax that would have
been paid had he not received the repaid supplemental unemployment
benefits. Claim the tax credit on Line 62 of Form 1040. Next to the line write
"IRC 1341".

Figure 8-29: The Payments section of Form 1040 with line 62 "Federal income tax
withheld from Forms W-2 and 1099" highlighted.

Union Benefits
Union benefits paid to the taxpayer as an unemployed member of a union
out of regular union dues are taxable and included in gross income on Line
21 of Form 1040.

Figure 8-30: The Income section of Form 1040 with line 21 "Other income"
highlighted.

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Unemployment benefits received from a union or private fund to which the


taxpayer contributed are taxable only to the extent that the union benefits
exceed the taxpayers contributions to the union or private fund. Report this
income on Line 21 of Form 1040.
Payments the taxpayer receives from his employer during periods of
unemployment, under a union agreement that guarantees the taxpayer full
pay during the year, are taxable as wages and must be reported.
Amounts deducted from the taxpayers pay for union dues, assessments,
contributions, or other payments to a union cannot be excluded from salary
or wages. The taxpayer must include them in taxable income as wages.
The taxpayer may be able to deduct some of these payments as a
miscellaneous itemized tax deduction on his tax return subject to the 2%
AGI floor if they are related to his job and he itemizes deductions on
Schedule A of Form 1040.
Union benefits paid to the taxpayer by a union from union dues as strike or
lockout union benefits, including both cash and the fair market value of
other property, are usually included in taxable income as wages. The
taxpayer can exclude these union benefits from taxable income only when
the facts show that the union intended them as gifts.

Veterans Benefits
Veteran's benefits are generally not taxable. Veterans benefits under any
law, regulation, or administrative practice that was in effect on September 9,
1986, and administered by the Department of Veterans Affairs (VA) are not
included in gross taxable income.

Royalty Income
Royalties are payments received for the use of property that are often based
on the number of units that are sold. The four most common types of
royalties are those paid for:

the use of a name


the use of patents, copyrights, and trademarks
the right to extract oil, gas, or minerals from land
the sale of products using certain proprietary processes
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Income and deductions related to royalties are reported on Schedule E Supplemental Income and Loss unless the taxpayer is in the business, such
as a self-employed photographer, musician, artist, author, or inventor, and
the royalties are a result of a copyright, trademark, or patent the taxpayer
created. In those cases the royalties are reported as business income on
Schedule C.
Reporting royalties on Schedule C would also apply to taxpayers that hold
an operating interest in the oil, gas, or minerals as compared to merely
owning the land.

REMIC Income
Real Estate Mortgage Investment Conduits (REMICs) are entities formed to
hold a pool of mortgages secured by real estate, collect the interest and
principal, and pay the income to investors. Investment income from a
"regular" interest is treated like any other interest and is reported on Form
1099-INT and Form 1099-OID.
A "regular" interest entitles the holder to a specific principal amount. Any
interest payments must be based on a specified interest rate or a specified
percentage of the interest on the mortgages. Interests that are not "regular"
interests are "residual" interests.
A REMIC files Form 1066 - U.S. Real Estate Mortgage Investment Conduit
(REMIC) Income Tax Return and provides taxpayers holding "residual"
interests Schedule Q. Information from the Schedule Q is entered into
Schedule E - Supplemental Income and Loss, Part IV. Complete instructions
are included on Schedule Q. Do not file Schedule Q with the taxpayer's
Form 1040.

TAX TIP

Special Rules for Farmers


If a taxpayer is the business of farming he may have some special tax
rules:

Deductible Farm Expenses - The ordinary and necessary costs of


operating a farm for a profit are deductible business expenses.

Items Purchased for Resale - Farmers may be able to deduct the


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cost (including freight charges) of livestock and other items


purchased for resale in the year of sale.

Sales Caused by Weather-Related Conditions - If the farmer sells


more livestock or poultry than he normally would because of
weather-related conditions, he may be able to postpone reporting
the gain until the next tax year.

Crop Insurance Proceeds - Farmers must include in income,


ordinarily in the year received, any crop insurance proceeds they
received due to crop damage.

Net Operating Losses - If the farmer's deductible loss from


operating the farm is more than his other income for the tax year
he may have a net operating loss. Net operating losses can be
carried back and forward to other tax years. Net operating loss
carry backs can result in a refund of all or part of any income tax
paid in prior years. See Lesson 9.

Farm Income Averaging - Farmers may be able to average all or


part of their current year's taxable farm income (and refigure their
tax) over the three prior years. This may result in a lower tax if the
farmer's current year taxable income from farming is high, but his
taxable income from one or more of the three prior years was low.

Fuel and Road Use Excise Taxes - Farmers may be eligible to claim
a credit or refund for excise taxes paid on fuel used on a farm for
farming purposes.

Additional information about farm income and deductions can be found


in Publication 225 - Farmer's Tax Guide.

Other Income
Line 21 of Form 1040 is used to report income from other sources, such as:

Jury Duty Pay


Hobby income
Prizes, awards, lottery and gambling winnings

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The taxpayer must include the amount and description, using an


attachment if necessary.
See "Miscellaneous Income" in Publication 525 - Taxable and Nontaxable
Income.

TAX TIP

Court Awards, Damages, and Legal Settlements


Court awards, damages, and legal settlements may be taxable income
depending on the nature of the injury for which they compensate. After
August 20, 1996 a legal settlement or court award received is only tax
free if it is on account of physical injury or physical sickness. Specifically,
compensatory damages for personal physical injury or physical sickness,
and damages for emotional distress related to a physical injury or
sickness, are not taxable. However, the following types of damages are
taxable as ordinary income:

amounts received to settle pension rights, if the taxpayer did not


contribute to the plan

amounts received under the Age Discrimination in Employment


Act

attorney fees and court costs awarded in civil rights suits involving
a claim of unlawful discrimination, a claim against the federal
government, or a claim under the Medicare Secondary Payer
provisions of the Social Security Act.

back pay and damages for emotional distress in Civil Rights Act
claims

compensation for breach of contract

compensation for interference with business operations

compensation for lost wages or lost profits

compensation for patent or copyright infringement

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interest on any type of award

punitive damages

II

Awards for emotional distress not related to physical injury or physical


sickness are includable in taxable income. However, a legal settlement or
court award up to the amount paid for medical care expenses
attributable to emotional distress is tax free.
Taxpayers must include in ordinary taxable income interest paid on any
legal settlement or court award even if the award itself is tax free.
Funds Paid Directly To Attorney's
If a taxpayer hires a lawyer on contingency, and wins or settles a lawsuit, a
third or more of the money will be paid directly to his lawyer. Even so, the
IRS treats ALL of the money as 100% paid to the taxpayer - and it is all
taxable income to the taxpayer. However, there are two cases in which
the taxpayer wont have to pay tax on the money paid to the lawyer. The
first is if 100% of the damages arent taxable, such as damages for
physical injuries sustained in an automobile accident. The second is
certain cases against the taxpayer's employer.
In other suits, attorney's fees are income to the taxpayer but the
deduction for them is only a Miscellaneous Itemized Deduction, subject
to strict limits and to the Alternative Minimum Tax.

TAX TIP

Cancellation of Debt
Taxpayers ordinarily receive Form 1099-C when they have a loan or debt
cancelled or forgiven. This is because the taxpayer already received some
benefit at the time he borrowed the money, so canceling or forgiving the
debt is the equivalent of transferring the benefit to him free of charge.
Generally, the amount of cancelled or forgiven debt needs to be entered
as income on Form 1040 Line 21.
However, an exception applies, usually to businesses. If the future
principal payments would have been tax deductible then the canceled
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debt should not be reported as income.


Another exception applies. If the debt was cancelled or forgiven as part of
a bankruptcy proceeding it is not includable in income. The same is true if
the taxpayer was insolvent under state law when the debt was cancelled
or forgiven. The common law definition of insolvency is when the total of
the taxpayers liabilities exceed the total of his assets.

Lesson Summary
Lets take a moment to review what you have learned in this lesson:
Life insurance proceeds are generally exempt from tax. However, if the
insurance proceeds pay interest, then the interest payments must be
included as taxable income.
Certain types of interest are exempt from federal income tax. Bonds issued
by the following entities generally pay tax-exempt interest:
District of Columbia
U.S. possessions and political subdivisions
States, counties and cities
Interest income is reported to the taxpayer on Form 1099-INT - Interest
Income. A copy of Form 1099-INT is also sent to the IRS. Box 1 of each Form
1099-INT shows taxable interest income received from the payer.
Form 1099-OID - Original Issue Discount reports the amount of OID income
that the taxpayer should report as income for the year. A copy of Form
1099-OID is also sent to the IRS. Box 1 shows the amount of OID interest for
the year if the taxpayer bought the obligation at its original issue and held
the issue all year.
Corporations make several types of distributions to their shareholders.
Although most dividends are paid in cash, others are paid in property,
services, or additional shares of stock. Most corporations use Form 1099DIV to report distributions to shareholders.
Form 1099-DIV - Dividends and Distributions reports dividend income to the
taxpayer and to the IRS.
Ordinary dividends are shown in box 1.
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Capital gain distributions occur when a mutual fund:

Sells assets for more than their cost, and


Distributes the realized capital gains to the fund's shareholders

Payers report capital gain distributions on box 2a of Form 1099-DIV. Capital


gain distributions are also called capital gain dividends.
Refunds of state and local taxes are taxable only if the taxpayer itemized
deductions in a prior year and the individual's federal tax liability was
reduced because of the deduction.
Alimony or separate maintenance payments made under a court order are
taxable income to the person receiving them and reported on Form 1040
line 11. They are tax deductible for the person paying them and reported on
Form 1040 line 31a as an adjustment to income. Child support payments
are not deductible to the payer and are not included in the income of the
recipient.
Unemployment compensation includes benefits that a state or the District
of Columbia paid from the Federal Unemployment Trust Fund to
unemployed individuals. This income is reported to the recipient on Form
1099-G and is taxable.
Line 21 of Form 1040 is used to report income from other sources, such as:

Jury Duty Pay


Hobby income
Prizes, awards, lottery and gambling winnings

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Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify you're understanding of the
most important lesson content, and will also help you pass the
Final Exam.
Do the Homework - While completing the homework is not
mandatory, we strongly recommend that you complete each
lesson's homework assignment. It will expand your knowledge
and understanding of the topics covered in this course.

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Lesson

9
Lesson 9 - Self Employment
Income
In this lesson you'll learn about Self Employment Income. After completing
this lesson youll be able to prepare tax returns for self-employed individuals.
The following topics are discussed in this lesson:
The Role of Small Business
Types of Business
Organizations
Starting a Business
Employee or Independent
Contractor?
Due Dates for Small Business
Tax Returns
Accounting Periods and
Methods
Income and Expenses
Who May Use Schedule C-EZ
Schedule C-EZ
Eligibility Flowchart
Figure Your Net Profit - Gross
Receipts
Total Expenses
Leasing vs. Buying Equipment
Business Travel Expenses
Car Expenses
246

Deduction of SelfEmployment Tax


Home Office Deductions
Principal Place of Business
What can be deducted?
Deduction Limits
Sideline Businesses
Depreciation
Basis
Adjusted Basis
MACRS Method of
Depreciation
Placed in Service Date
Property Classes and
Recovery Periods
Applying Recovery Periods
Hobby Income and Losses
Sale of Business Property
Net Operating Losses
"Going Out of Business"

LESSON

SELF

EMPLOYMENT

Standard Mileage Rate


Method
Actual Car Expense Method
Net Profit
Information on Your Vehicle
Schedule SE
Who Must File Schedule SE
Reporting the SelfEmployment Tax

INCOME

Checklist
Summary of Employment
Taxes and Forms
General Business Credits
Business Tax Return Due
Dates
IRS Publications for Business

The Role of Small Business

mall businesses play a vital role in the economy of the United States.
This was not true in the past. However, gone are the days of the
Industrial Revolution when the large publicly traded corporations
employed most workers. After World War II General Motors employed,
either directly or indirectly, one out of every seven (7) US workers. When
GM emerged from bankruptcy in July 2009 it employed just 65,000 workers
worldwide!
Consider the facts:

Small businesses create 75 percent of all new jobs.

Small businesses create more than 50 percent of the nonfarm private


Gross Domestic Product (GDP).

Small businesses make up more than 99.7% of all employers.

Small businesses employ about 60 million Americans - 50 percent of


all private sector workers.

Home-based businesses account for 53 percent of all small


businesses.

Small businesses with employee's start-up at a rate of over 500,000


per year.

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Nationally, only two thirds of small business startups survive the first two
years and less than half make it to five years. While the failure rate of new
small businesses is high, the profits the owner will reap if successful far
outweigh the risks. While small business owners often work much longer
than 40 hours a week, six and even seven figure incomes are not
uncommon. Consider starting your own small business - perhaps even a tax
preparation business!

TAX QUOTE

"Alexander Hamilton started the U.S. Treasury with nothing, and that was
the closest our country has ever been to being even."
Will Rogers

Types of Business Organizations


Of all the choices taxpayers make when starting a business, one of the most
important is the type of legal organization they select for their company.
This decision can affect how much they pay in taxes, the complexity of
formalities and accounting the business must comply with, the amount of
paperwork the business is required to do, the personal liability faced by the
owner(s), and the businesses ability to borrow money. Business formation is
controlled by the law of the state where the business is organized.
The most common forms of businesses are:

Sole Proprietorships
Partnerships
Corporations
Subchapter S Corporations
Limited Liability Companies (LLC)

While state law controls the formation of the business, the Internal Revenue
Code controls how the business is taxed at the federal level.

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SIDE BAR

Comparison of Business Entities


Our publication Comparison of Business Entities details the different
characteristics of each type of business entity. To review it see Appendix I
or click here.
All businesses must file an annual tax return. The form used depends on
how the business is organized. Sole proprietorships and corporations file an
income tax return. Partnerships and S Corporations file an information
return. For an LLC with at least two members, except for some businesses
that are automatically classified as a corporation, it can choose to be
classified for tax purposes as either a corporation or a partnership. An LLC
with a single member can choose to be classified as either a corporation or
disregarded as an entity separate from its owner, that is, a "disregarded
entity." As a disregarded entity the LLC will not file a separate tax return.
Instead all the income or loss is reported by the single member/owner on
Schedule C and attached to his annual Form 1040 tax return.
The table below shows a summary of Corporation and Partnership
Income and Taxation:
Taxation

S Corporation
Income and
deduction are
passed through to
shareholders,
avoiding
corporate-level
tax. An S
corporation does
not pay income
tax at the entity
level.

C Corporation
Income is taxed as
the corporate
level. Profits are
distributed to
shareholders as
taxable dividends,
creating "double
tax."

249

Partnership
Income and
deductions are
passed through to
the partners. A
partnership does
not pay income
tax at the entity
level.

LESSON

Income

Business Losses

Capital Gains
and Losses

SELF

EMPLOYMENT

INCOME

S Corporation
Income from an S
corporation is
passed through to
shareholders and
taxed as ordinary
income.

C Corporation
After-tax profits of
a C corporation
are distributed to
shareholders as
dividends.
Qualified
dividends are
generally taxed to
the individual
shareholder at
long-term capital
gain rates (15% or
20%).

Business losses
passing through
to an S
corporation
shareholder are
treated as
ordinary losses.
Capital gains and
losses pass
through to
shareholders as
separately stated
items on Schedule
K-1, Form 1120S.

A C corporation
does not pass
losses through to
its shareholders.

Capital gains
earned by a C
corporation are
taxable to the
corporation at the
same rate as
ordinary income.
Losses are not
passed through to
shareholders.

Partnership
Income from a
partnership is
passed through to
shareholders and
taxed as ordinary
income.
Guaranteed
payments and
general partners'
share of income is
subject to selfemployment tax
at the individual
level.
Business losses
passing through
to partners are
treated as
ordinary losses.

Capital gains and


losses pass
through to
shareholders as
separately stated
items on Schedule
K-1, Form 1065.

TAX PRACTICE TIP

Income from Partnerships, S Corporations, and Limited Liability


Companies
A partnership is not, in and of itself, a taxable business entity. Partnerships
file Form 1065 - U.S. Partnership Return of Income but pay no tax. With
Form 1065 the partnership files a Schedule K-1 for each partner and
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furnishes each partner a copy. Schedule K-1 shows each partners share of
all partnership tax items. The partner then reports these items on Part II
of Schedule E.
The partners share of losses on his Schedule K-1 may not be deductible
as they are generally limited to his tax basis in the partnership. The
partnership isn't responsible for keeping track of its individual partners
tax basis - the partners are.
A limited liability company (LLC) is a business structure authorized and
organized under state law. The IRS doesnt recognize an LLC, in and of
itself, as an entity for federal tax purposes. LLCs elect which type of entity
they would like to be taxed as by filing Form 8832 - Entity Classification
Election. LLCs that elect to be treated for tax purposes as either a C
corporation, S corporation, or a partnership file tax returns. But only C
corporations pay any tax directly to the IRS.
A single member of an LLC that has elected to be taxed as sole
proprietorship reports income and expenses on Schedule C.
Members of an LLC that have elected to be taxed as a partnership report
income and expenses on Part II of Schedule E after receiving their
Schedule K-1 - in the same manner as described above for partnerships.
Members of an LLC that elect to be taxed as an S Corporation file Form
2553 - Election by a Small Business Corporation after filing Form 8832.
Then the corporation files Form 1120-S - U.S. Income Tax Return for an S
Corporation but pays no tax. Shareholders receive a Schedule K-1, which
is handled in the same manner as any S Corporation K-1.
Members of an LLC that have elected to be taxed as a C Corporation
have the corporation file Form 1120 - U.S. Corporation Income Tax Return
with which the corporation pays tax.
Members with an interest that is classified as a passive activity that have
losses for the year have to complete Form 8582 - Passive Activity Loss
Limitations to compute their allowable passive losses, if any. Generally
passive losses are allowed only to the extent of passive income for the
year. Disallowed losses are usually deductible in full in the year the
activity is disposed of.
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The table below shows which tax forms the different types of business
organizations file:
Entity
Sole Proprietor

Partnership
Partner in a
partnership
(individual)
Corporation or
S Corporation

Tax Liability
Income tax

Self-Employment tax
Estimated tax
Employment Taxes:
Social Security and
Medicare tax withholding
Federal unemployment
tax (FUTA)
Depositing employment
taxes
Annual return of income
Employment taxes
Income tax
Self-employment tax
Estimated tax
Income tax
Estimated tax

S corporation
shareholder

Employment taxes
Income tax
Estimated tax

Use Form...
1040 and Schedule C
(Schedule F for Farm
businesses)
1040 and Schedule SE
1040-ES
941 (943 for farm
employees)
940
8109 (do not use if taxes
deposited electronically)
1065
Same as sole proprietor
1040 and Schedule E
1040 and Schedule SE
1040-ES
1120 (C corporation)
1120S (S corporation)
1120-W (corporation)
8109 (do not use if taxes
are deposited
electronically)
Same as sole proprietor
1040 and Schedule E
1040-ES

A sole proprietorship is the most common form of business organization.


Sole proprietorships will be the focus of this lesson. We will not get overly
involved in partnerships, corporations, or LLCs as those tax and accounting
issues are beyond the scope of this course. To learn more about the
taxation of those entities be sure to purchase J.K. Lasser's Small Business
Taxes from the Homework page.

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Its easy to form a sole proprietorship and it offers complete control to the
owner. It is any unincorporated business owned entirely by one individual.
Usually the sole proprietor is personally liable for all financial obligations
and debts of the business.
Sole proprietors can operate any kind of business. For tax purposes it must
be a real business, not an investment or hobby. It can be full-time or parttime work.
Every sole proprietor is required to keep sufficient records to comply with
federal tax law regarding business records.
Sole proprietors file Schedule C or C-EZ - Profit or Loss from Business with
their Form 1040.

TAX PRACTICE TIP

The Importance of Entering the Correct Business Code


In 1998 a set of business codes were issued based on the North American
Industry Classification System (NAICS). This eliminated the old Standard
Industrial Classification (SIC) code system. At the top of Schedule C, in
Box B, youll enter a six-digit code for the business.
It's very important that you use the correct NAICS business code. The IRS
uses this code as a screening device to determine whether the taxpayers
income and expenses are unusual for that type of business. They may
decide to conduct an audit if the income and expenses seem unusual.
Entering an incorrect NAICS business code it could trigger an audit of
your clients tax return.
It can be hard to find the correct code in the standard table. You can go
to http://www.naicscode.com/ to quickly sift through government
industry descriptions to get the most accurate description of the business
for reporting purposes.
If you find that the business does not cleanly fit into one of the business
codes listed by the IRS it may mean that your client is actually operating
more than one business. Separate sets of books and two (2) Schedule Cs
may be called for.

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If you are convinced that the taxpayer is only operating one business
then use the code that applies to the majority of his income and
expenses. The IRS provides code 999999 for business owners that are
unable to classify their operations but it should be used only as a last
resort.
Sole proprietor farmers file Schedule F - Profit or Loss from Farming. The
sole proprietor's net business income or loss is combined with his other
income and deductions and taxed at individual rates on his personal tax
return.
Sole proprietors must also pay self-employment tax on the net income
reported on Schedule C or Schedule F on Schedule SE - Self-Employment
Tax. They may be able to deduct one-half of Self-Employment tax on Form
1040.
Sole proprietors do not have taxes withheld from their business income so
they will usually need to make quarterly estimated tax payments if they
expect to make a profit. These estimated payments include both income tax
and self-employment taxes for Social Security and Medicare.

Starting a Business
Among the many steps that may be taken when starting a new business are:

Obtain a federal Employer Identification Number (EIN) by filing IRS


Form SS-4.

Register with the state employment department to make payments


of state unemployment compensation tax (SUTA).

Have each employee fill out IRS Form W-4, Employee's Withholding
Allowance Certificate, and keep them on file.

Set up a payroll system for withholding taxes and making regular


payroll tax deposits or hire someone to do this.

File IRS Form 941, Employer's Quarterly Federal Tax Return, after the
end of each quarter.

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File IRS Form 940 or 940-EZ to report federal unemployment


compensation tax (FUTA) after the end of each year.

File a Form W-2 for each employee annually to report wages to the
IRS and state.

File a Form 1099-MISC to report payments to each independent


contractor paid over $600 per year.

File Form SS-4 if the applicant entity does not already have an EIN but is
required to show an EIN on any return, statement, or other document.
The table below shows whether or not the taxpayer needs an Employer
Identification Number (EIN):

IF the applicant....

AND...

Started a new business

Does not currently have (nor


expect to have) employees

Hired (or will hire)


employees, including
household employees

Does not already have an


EIN

Changed a bank
account

Needs an EIN for Banking


Purposes only

Changed a type of
organization

Either the legal character of


the organization or its
ownership changed (for
example, you incorporate a
sole proprietorship or form a
partnership)
Does not already have an
EIN
The trust is other than a
grantor trust or an IRA trust
Needs an EIN for reporting
purposes
Needs an EIN to report
estate income on Form 1041

Purchased a going
business
Created a trust
Created a pension plan
as a plan administrator
Is a foreign person
needing an EIN to
comply with IRS
withholding regulations
Is administering an

Is an agent, broker, fiduciary,

255

THEN, complete the


following lines of Form
SS-4...
Complete lines 1, 2, 4a8a, 8b-c (if applicable), 9a,
9b (if applicable), and 1014 and 16-18.
Complete lines 1,2, 4a-6,
7a-b (if applicable), 8a,
8b-c (if applicable), 9a, 9b
(if applicable), 10, and 18.
Complete lines 1-5b, 7a7b (if applicable), 8a, 8b-c
(if applicable), 9a, 9b (if
applicable) 10, and 18
Complete lines 1-8 (as
applicable)

Complete lines 1-8 (as


applicable)
Complete lines 1-8 (as
applicable)
Complete lines 1,3, 4a-5b,
9a, 10 and 18
Complete lines 1-5b, 7a7b (SSN or ITIN optional),
8a, 8b-c (if applicable), 9a,
9b (if applicable) 10, and
18
Complete lines 1-6, 9a,

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INCOME

IF the applicant....

AND...

estate

manager, tenant, or spouse


who is required to file Form
1042, Annual Withholding
Tax Return for U.S. Source
Income of Foreign Persons
Serves as a tax reporting
agent for public assistance
recipients under Rev. Proc.
80-4, 1980-1 C.B.581

Is a withholding agent
for taxes on non-wage
income paid to an alien
(i.e., individual,
corporation, or
partnership, etc.)
Is a state or local
agency

THEN, complete the


following lines of Form
SS-4...
10-12, 13-17 (if
applicable), and 18

Complete lines 1,2,3, (if


applicable), 4a-5b, 7a-b (if
applicable), 8a, 8b-c (if
applicable) 9a, 9b (if
applicable) 10 and 18

Serves as a tax reporting


Complete lines 1,2, 4a-5b,
agent for public assistance
9a, 10 and 18
recipients under Rev. Proc.
80-4, 1980-1 C.B.581
Is a single-member LLC Needs an EIN to file Form
Complete lines 1-8 (as
8832, Classification Election, applicable)
for filing employment tax
returns, or for state reporting
purposes.
Is an S corporation
Needs an EIN to file Form
Complete lines 1-8 (as
2553, Election by a Small
applicable)
Business Corporation
Also see the separate instruction for each line on Form SS-4.

There are many more steps and all of the steps involved in starting a new
business are beyond the scope of this tax course. Many good books on the
subject are available at Amazon.com by clicking here. In the search box
select "Books" and search for "starting a business".

Employee or Independent Contractor?


How workers are classified has major tax consequences because employees
and independent contractors are treated differently for tax purposes.
Potential disasters await any business if the worker is classified improperly.
Improper classification can cause problems that could financially destroy a
business.
Government entities, interested or damaged third parties, and perhaps even
the worker himself will often later challenge the classification as
independent contractor for a variety of reasons. Enormous tax problems can
result from improper classification.

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People such as lawyers, contractors, subcontractors, public stenographers,


and auctioneers who follow an independent trade, business, or profession in
which they offer their services to the public, are generally not employees.
However, whether such people are employees or independent contractors
depends on the facts in each case. The earnings of a person who is working
as an independent contractor are subject to Self-Employment (SE) tax
payable by the independent contractor.
The taxpayer must first know the business relationship that exists between
him and the person performing the services. The person performing the
services may be:

An independent contractor
A common-law employee
A statutory employee
A statutory nonemployee

In determining whether the person providing service is an employee or an


independent contractor, all information that provides evidence of the
degree of control and independence should be considered.
It is critical that the employer correctly determine whether the individual
providing services is an employee or independent contractor. Generally,
employers must withhold income taxes and Social Security and Medicare
taxes, and pay unemployment tax on wages paid to an employee. They do
not generally have to withhold or pay any taxes on payments to
independent contractors.
If an employer incorrectly classifies an employee as an independent
contractor, he can be held liable for the employment taxes for that worker,
plus a penalty.
Who is an Independent Contractor?
A general rule is that if the employer has the right to control or direct only
the result of the work done by a person, and not the means and methods of
accomplishing the result, then that person is an independent contractor.
The IRS has developed twenty common law factors which are used on a
case by case basis to determine whether a worker is an independent
contractor or an employee. Independent contractors do not have to satisfy
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all of the twenty common law factors. It is best to think of the factors as
weights on a balance scale. Use the table below to review the 20 common
law factors for determining whether the worker is an employee or
independent contractor.
Fact
Instructions

Employee
Complies with instructions
about when, where, and how
work is to be performed.

Independent Contractor
Works their own schedule. Does
the job their own way.

Training

Trained by an experienced
employee working with them.
Required to take
correspondence courses.
Required attendance at
meetings and by other
methods indicates that the
employer wants the services
performed in a particular
method.
Services of the individual are
merged into the business.
Success and continuation of
the business depends upon
services. Employer
coordinates work with that of
other workers.

Uses their own methods and


receives no training from their
customer.

Services
Rendered
Personally

Services must be rendered


personally. Not able to engage
other people to do the work.

The Independent Contractor is


able to assign one of their
people to do the job.

Hiring,
Supervising
and Paying
Assistance

Hires, supervises and pays


workers at the direction of the
employer (acts as foreman or
representative of the
employer).

Continuing
Relationship

The individual continues to


work for the same person year
after year.
The hours and days are set by
the employer.
Must devote full time to the
business of the employer. The
employer restricts the
employee from doing other
gainful work.

Hires, supervises and pays


workers as the result of a
contract under which they
agreed to provide materials and
labor. Is responsible for the
results.
Hired to do one job. There is no
continuous relationship.

Integration

Set Hour of
Work
Full Time
Required

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Success and continuation of


business aren't dependent on
the services performed.

The Independent Contractor


determines his own schedule.
Free to work when and for whom
they choose.

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Fact
Doing Work
on
Employer's
Premises
Order or
Sequence Set

Employee
Implies that the employer has
control, is physically within the
employer's discretion and
supervision.
Performs services in the order
or sequence set by the
employer. Salesperson reports
at the office at specified times,
follows up on leads and
performs certain tasks at
certain times.

Independent Contractor
Works off employer's premises,
uses own office, desk, and
telephone.

Oral or
Written
Reports
Pay by Hour,
Week, Month

Required to submit regular oral


or written reports to the
employer.
Paid by the employer of
regular amounts as stated
intervals.
The employer pays the
worker's business and/or
traveling expenses.

Submits no reports.

Employer furnishes, tools,


materials, etc.

Furnishes own tools.

Has a lack of investment and


depends on the employer for
facilities.
Cannot realize a profit or loss
by making good or bad
decisions.
Usually works for one
employer.

Has a real, essential and


adequate investment.

Does not make their own


services available except
through some company or
business they do not have an
interest in.
Can be discharged at anytime.

Has own office assistants. Holds


business license, listed on
business directories or maintains
business telephone. Advertises
in newspaper, etc.
Cannot be fired so long they
produce a result which meets
contract specifications.
Agrees to complete a specific
job. Is responsible for its
satisfactory completion or is
legally obligated to make good.

Payment of
Business
and/or
Traveling
Expenses
Furnishing of
Tools,
Materials
Significant
Investment
Realization of
Profit/Loss
Working for
More Than
One Firm at a
Time
Making
Service
Available to
General
Public
Right to
Discharge
Right to
Terminate

Can end their own relationship


with the employer at anytime.

259

Services performed at their own


pace. Salesperson works own
schedule and usually has own
office.

Paid by the job on a straight


commission.
Takes care of own expenses
and is accountable only to
themselves for expenses.

Can realize a profit or suffer a


loss as a result of their service.
Works for a number of persons
or firms at the same time.

LESSON

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If a worker clearly is an independent contractor, a complete agreement to


that effect is useful and recommended; however, any agreement, no matter
how well drafted and explained to each party and signed, will not change
the results if a person is held to be an employee under the facts and
circumstances.
How should payments made to Independent Contractors be
reported?
The employer may be required to file information returns to report certain
types of payments made to independent contractors during the year. For
example, the employer must file Form 1099-MISC - Miscellaneous Income to
report payments of $600 or more to persons not treated as employees for
services performed for the trade or business.
Who is a Common-Law Employee?
Under common-law rules, anyone who performs services is an employee if
the employer can control what will be done and how it will be done. This is
so even when the employer gives the employee freedom of action. What
matters is that the employer has the right to control the details of how the
services are performed.
To determine whether an individual is an employee or independent
contractor under the common law, the relationship of the worker and the
business must be examined. In an employee-independent contractor
determination, all information that provides evidence of the degree of
control and degree of independence must be considered.
Who is a Statutory Employee?
If workers are independent contractors under the common law rules, such
workers may nevertheless be treated as employees by statute for certain
employment tax purposes if they fall within any one of the following four
categories and meet the three conditions described under Social security
and Medicare taxes below:

A driver who distributes beverages (other than milk) or meat,


vegetable, fruit, or bakery products; or who picks up and delivers
laundry or dry cleaning, if the driver is the employer's agent or is
paid on commission.

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A full-time life insurance sales agent whose principal business activity


is selling life insurance or annuity contracts, or both, primarily for one
life insurance company.

An individual who works at home on materials or goods that the


employer supplies and that must be returned to the employer or to a
person the employer names, if the employer also furnishes
specifications for the work to be done.

A full-time traveling or city salesperson who works on the employer's


behalf and turns in orders to the employer from wholesalers,
retailers, contractors, or operators of hotels, restaurants, or other
similar establishments. The goods sold must be merchandise for
resale or supplies for use in the buyer s business operation. The work
performed for the employer must be the salespersons principal
business activity.

Who is a Statutory Nonemployee?


There are two categories of statutory nonemployees: direct sellers and
licensed real estate agents. They are treated as self-employed for all Federal
tax purposes, including income and employment taxes, if:

Substantially all payments for their services as direct sellers or real


estate agents are directly related to sales or other output, rather than
to the number of hours worked, and

Their services are performed under a written contract providing that


they will not be treated as employees for Federal tax purposes.

Misclassification of Employees
If the employer classifies an employee as an independent contractor and
has no reasonable basis for doing so, the employer may be held liable for
employment taxes for that worker. Improperly classified employees can
cause business owners to end up with hefty tax penalties for nonpayment of
employment tax. Those who need help deciding if their workers are
employees or independent contractors can submit Form SS-8 Determination of Employee Work Status for Purposes of Federal Employment
Tax and Income Tax Withholding to the IRS. The IRS will tell them if their
workers are employees or independent contractors.

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TAX PLANNING TIP

Deferring Income
One way a business owner may be able to lower his taxes is by deferring
income into the next year. This can be accomplished by not sending late
December invoices to customers until after January 1st.
Under the cash method of accounting income is recognized when it is
actually or constructively received. "Constructive receipt" occurs when
money is made available to the taxpayer without restriction or is received
by his agent. Taxpayers cant defer income by refusing to take control of
money that they are entitled to receive.
A conflict may arise when two taxpayers are both trying to accomplish
some year-end tax planning. Bob, a business owner, is trying to defer
income. Tom, who is Bobs customer, is trying to accelerate expenses.
Tom hands Bob a check for $10,000 at the close of business on
December 31st.
Since Bob received the check on December 31st he cannot defer it into
next year simply by not depositing the check until after the first of the
year.
The question is, is Bob legally entitled to receive the payment on
December 31st, or is the payment actually for goods and services to be
delivered or performed in January that he would not have invoiced until
January. If the later is true Bob can either refuse the check (or deposit it
after the first of the year) since on December 31st Tom doesn't actually
owe him any money.

Due Dates for Small Business Tax Returns


The table below shows the due dates for small business tax returns:
IF the taxpayer is liable
for:
Income Tax
Self-Employment Tax

THEN use Form:


1040 and Schedule C or
2
C-EZ

DUE by:
15th day of 4th month
after end of the tax year.

Schedule SE

File with Form 1040.

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IF the taxpayer is liable


for:
Estimated Tax

Social Security and


Medicare taxes and
income tax withholding

INCOME

THEN use Form:


1040-ES

DUE by:
15th day of 4th, 6th, and
9th months of the tax
year, and 15th day of 1st
month after the end of the
tax year.
April 30, July 31, October
4
31, and January 31

941 or 944
8109 (to make deposits)

See IRS Publication 15

Providing information on
Social Security and
Medicare taxes and
income tax withholding

W-2 (to employee)

January 31

W-2 and W-3 (to the


Social Security
Administration)

Last day of February


(March 31 if filing
4
electronically)

Federal Unemployment
Tax (FUTA)

940

January 31

8109 (to make deposits)

Filing information returns


for payments to nonemployees and
transactions with other
persons

See Information Returns


at http://www.irs.gov.

April 30, July 31, October


31, and January 31, but
only if the liability for
unpaid tax is more than
$500.
Form 1099- to the
recipient by January 31
and to the IRS by
February 28 (March 31 if
filing electronically).
Other forms- See the
General Instructions for
Forms 1099, 1098, 5498,
and W-2G at
http://www.irs.gov.

Excise Tax

See Excise Taxes at


http://www.irs.gov.

See the instructions.

If a due date falls on a Saturday, Sunday, or legal holiday, the due date is the next
business day. For more information, see IRS Publication 509 - Tax Calendars.
2

File a separate schedule for each business.

Do not use if you deposit taxes electronically.

See the form instructions if you go out of business, change the form of your
business, or stop paying wages.

Accounting Periods and Methods


Every taxpayer, whether an individual or a business organization, must
figure taxable income on an annual accounting period called a tax year. The
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calendar year is the most common tax year. Nearly all individuals, including
sole proprietors, are calendar year taxpayers. Other tax years are a fiscal year
and a short tax year.
Each taxpayer must also use a consistent accounting method, which is a set
of rules for determining when to report income and expenses. The most
commonly used accounting methods are the cash method and the accrual
method. Nearly all individuals, including sole proprietors, are cash method
taxpayers.
Taxpayers must use the same accounting method from year to year. The
taxpayer chooses an accounting method when the first tax return is filed. If
the taxpayer later wants to change the accounting method, he must get IRS
approval.
Under the cash method, the taxpayer reports income in the tax year in
which he receives it, and deducts expenses in the tax year in which they are
paid. Under the accrual method, taxpayers report income in the tax year in
which they earn it, regardless of when payment is received. Accrual method
taxpayers deduct expenses in the tax year they are incurred, regardless of
when payment is made.

TAX TIP

Which accounting method is more accurate?


The accrual method gives a more accurate picture of the businesses
financial situation than the cash method. This is because income is
recorded in the books when it is actually earned, and expenses are
recorded when they are actually incurred. Income earned in one period is
accurately matched against the expenses that correspond to that period,
so the business owner gets a better picture of his net profits for each
period. None-the-less, most small businesses prefer to use the cash
method as it is easier for the owner to understand.
The IRS doesn't prescribe any particular format for keeping business records
as long as the records clearly reflect income and expenses. Taxpayers can
choose either a handwritten or computerized accounting system. Poor
accounting, such as missing receipts, is the number one reason small
businesses lose IRS audits.
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The table below shows the accounting method certain taxpayers are
required to use:
General rule:
Tax shelters:
$1 million or
less average
annual gross
receipts:
$10 million or
less average
annual gross
receipts

The accrual method is required for purchases and sales if it is


necessary to keep an inventory in order to clearly reflect income.
Tax shelters are prohibited from using the cash method,
regardless of average annual gross receipts or entity
classification.
Taxpayers can use the cash method even if inventories are kept.
A deduction for inventory costs is not allowed until the inventory
item is sold or paid for, whichever is later. Tax shelters cannot use
the cash method under this procedure.
Service type industries can use the cash method even if
inventories are kept. Exceptions: Mining, manufacturing,
wholesale trade, retail trade, and information industries cannot
use this procedure. Tax shelters, C corporations, and farming C
corporations cannot use this procedure.

Over $1
million

Farming C Corporations and farming partnerships with C


corporation partners, except for family farming corporations, are
required to use the accrual method.

Over $25
million

C Corporations and partnerships with C corporation partners,


except for PSCs and family farming corporations, are prohibited
from using the cash method.
Family farming C Corporations and family farming partnerships
with C corporations partners are required to use the accrual
method.

Over $25
million:

Taxpayers must use a tax year to figure their taxable income. A tax year is an
annual accounting period for keeping records and reporting income and
expenses.
Unless the taxpayer has a required tax year, he adopts a tax year by filing his
first income tax return using that tax year. A required tax year is a tax year
required under the Internal Revenue Code or the Income Tax Regulations. A
taxpayer CANNOT adopt a tax year by merely:

Filing an application for an extension of time to file an income tax


return;

Filing an application for an Employer Identification Number (Form


SS-4); or

Paying estimated taxes.

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If the taxpayer would like to change his tax year hell need to get permission
from the IRS. The IRS will not allow him to change it again within 10 years.
Calendar Year
A calendar year is 12 consecutive months beginning on January 1st and
ending on December 31st. If the taxpayer adopts the calendar year, he must
maintain his books and records and report his income and expenses from
January 1st through December 31st of each year.
If the taxpayer files his first tax return using the calendar tax year and he
later begins a business as a sole proprietor, becomes a partner in a
partnership, or becomes a shareholder in an S-corporation, he must
continue to use the calendar year unless he obtains approval from the IRS
to change it, or is otherwise allowed to change it without IRS approval.

Income and Expenses


Income
Most sole proprietors use the cash method of accounting. Under the cash
method, you include in the taxpayers gross income all items of income
actually or constructively receive during the tax year. If the taxpayer receives
property and services, you must include their fair market value (FMV) in the
taxpayers income.
Taxpayers who receive earnings reported on Form 1099-MISC Miscellaneous Income may be considered self-employed. Independent
contractors often receive Form 1099-MISC and file Schedule C.

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Figure 9-1: Form 1099-MISC - Miscellaneous Income.

Additionally, businesses that accept credit and debit cards receive Form
1099-K - Payment Card and Third Party Network Transactions.

Figure 9-1(a): Form 1099-K - Payment Card and Third Party Network Transactions.

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Expenses
Almost any expenditure that is ordinary and necessary for the production of
business income is deductible. Some expenses are immediately deductible
and others must be spread out over future years. Vehicle and local travel
expenses can provide major deductions using either the standard mileage
rate or actual expense method - as can retirement plans. The costs of going
into business are deductible under special rules.
To be deductible, a business expense must be both ordinary and necessary.
An ordinary expense is one that is common and accepted in the taxpayers
industry. A necessary expense is one that is helpful and appropriate for the
taxpayers trade or business. An expense does not have to be indispensable
to be considered necessary. It is important to distinguish business expenses
from:

Expenses used to figure cost of goods sold


Capital expenses, and
Personal expenses
TAX TIP

Are all business expenses tax deductible?


Generally, yes. However there are some expenses that, although they
seem legitimate, are not deductible such as:

lobbying expenses
political contributions
fines and penalties
speeding tickets
parking tickets
illegal payments such as bribes, kickbacks, and "push money"

The table below shows which business expenses are deductible and
non-deductible:
Deductible Expenses:
Non-deductible Expenses:

advertising
automobile expenses

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capital expenditures
charitable contributions by a

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Deductible Expenses:

INCOME

Non-deductible Expenses:

bad debts (if using the


accrual method of
accounting)
bank charges and fees
clothing, uniforms, and
protective equipment that
cant be worn during nonworking hours
commissions and fees
cost of goods sold
depreciation
dues for trade associations
employee benefits
gifts to customers
insurance premiums for
liability and casualty
insurance
interest
legal and professional fees
meals and entertainment
office expenses
payments to independent
contractors
pension and profit-sharing
plans
publications
rent or lease payments
repairs and maintenance
supplies and materials if not
included in the cost of
goods sold
travel expenses
utilities
wages paid to employees

269

business that's not a C


corporation
clothing, uniforms, and
protective equipment that
can be worn during nonworking hours
commuting to work
expenses
country, athletic, and social
club dues
family expenses
federal estate tax
federal gift tax
federal income tax
fines and penalties incurred
for violations of law
gifts to employees of more
than $25
gifts to individuals unless
they are business related,
ordinary and necessary
hobby losses in excess of
hobby income
job hunting expenses for a
new business
life insurance premiums if
the business or business
owner is a direct or indirect
beneficiary
lobbying expenses
personal expenses
political contributions
state inheritance tax
tax penalties
transfer taxes on business
property

LESSON

SELF

EMPLOYMENT

INCOME

Generally, taxpayers cannot deduct personal, living, or family expenses.


However, if the taxpayer has an expense for something that is used partly
for business and partly for personal purposes, divide the total cost between
the business and personal parts and deduct the business part.

The Burden of Proof for Business Tax


Returns (Including Schedule C)
The responsibility to prove entries, deductions, and statements made on
a tax return is known as the burden of proof. You, the tax return
preparer, must be able to substantiate certain elements of expenses to
deduct them on a taxpayer's return. Generally, you'll meet the burden of
proof by having copies of the information for income and receipts for
the expenses. You should keep adequate records in your file to prove
the taxpayer's expenses. You must have documentary evidence, such as
receipts, canceled checks, or bills, to support the expenses. Additional
evidence is required for travel, entertainment, gifts, and auto expenses.
Hand written or typewritten statements without receipts, canceled
checks, bills, invoices or credit card statements do not constitute
adequate proof. If the taxpayer cannot produce the aforementioned
proof you should either refuse to enter that item of income or expense
on the tax return, or refuse to prepare the return in its entirety.
You might lose a client and a few dollars that you could have made
today, but that is better than serving a prison sentence for several years
for submitting false claims to the U.S. Government, which is a federal
crime. 26 U.S. Code 7206 States: Fraud and false statements
Any person who (1) Declaration under penalties of perjury
Willfully makes and subscribes any return, statement, or other
document, which contains or is verified by a written declaration that it is
made under the penalties of perjury, and which he does not believe to
be true and correct as to every material matter; or
(2) Aid or assistance
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Willfully aids or assists in, or procures, counsels, or advises the


preparation or presentation under, or in connection with any matter
arising under, the internal revenue laws, of a return, affidavit, claim, or
other document, which is fraudulent or is false as to any material matter,
whether or not such falsity or fraud is with the knowledge or consent of
the person authorized or required to present such return, affidavit, claim,
or document
shall be guilty of a felony and, upon conviction thereof, shall be fined
not more than $100,000 ($500,000 in the case of a corporation), or
imprisoned not more than 3 years, or both, together with the costs of
prosecution.
What Records Should You Have?
The taxpayer may choose any recordkeeping system suited to his
business that clearly shows his income and expenses. The business he is
in affects the type of records he needs to keep for federal tax purposes.
His recordkeeping system should include a summary of his business
transactions. This summary is ordinarily made in the business books (for
example, accounting journals and ledgers). His books must show his
gross income, as well as his deductions and credits. For most small
businesses, the business checking account is the main source for entries
in the business books.
Some businesses choose to use electronic accounting software
programs or some other type of electronic system to capture and
organize their records. The electronic accounting software program or
electronic system choosen should meet the same basic recordkeeping
principles mentioned above. All requirements that apply to hard copy
books and records also apply to electronic records.
Supporting Business Documents
Purchases, sales, payroll, and other transactions the taxpayer has incured
in his business will generate supporting documents. Supporting
documents include sales slips, paid bills, invoices, receipts, deposit slips,
and canceled checks. These documents contain the information
recorded in his books. It is important to keep these documents because
they support the entries in the books and on the taxpayer's tax return.
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He should keep them in an orderly fashion and in a safe place. For


instance, organize them by year and type of income or expense.
Following are some of the types of records taxpayers should provide
you in order to substantiate the income and expenses claimed on their
tax returns. When the business is a separate legal entity, such as a
corporation or partnership, and the entity's tax return was prepared by
someone else, such as an accountant or CPA, it may be acceptable to
use the Form K-1 for the entries that you'll be placing on Form 1040.
That is a judgment call, and you will need to determine on a case-bycase basis whether you are comfortable not inspecting or requiring the
original documentation.
Gross Receipts
Gross receipts are the income the taxpayer's business receives.
Supporting documents should show the amounts and sources of gross
receipts. Documents supporting gross receipts include the following:

Cash register tapes


Deposit information (cash and credit sales)
Receipt books
Invoices
Forms 1099-MISC

Purchases and Expenses


Purchases and expenses are the items the taxpayer buys to carry on his
business, such as office supplies, and the items the taxpayer buys to
resell to customers. If the taxpayer is a manufacturer or producer, this
includes the cost of raw materials or parts purchased for manufacture
into finished products.
Supporting documents should show the payee, amount paid, the date of
payment, and what the purchase was for, and a description that shows
that the amount was for a business expense. Documents supporting
purchases include the following:

Account statements
Canceled checks
Cash register tape receipts
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Credit card receipts and statements


Invoices
Petty cash slips for small cash payments

Travel, Transportation, Entertainment, and Gift Expenses


If the taxpayer deducts travel, entertainment, gift or transportation
expenses, he must be able to prove certain elements of expenses. For
additional information, refer to Publication 463, Travel, Entertainment,
Gift, and Car Expenses: http://www.irs.gov/pub/irs-pdf/p463.pdf
Assets
Assets are the property, such as machinery and furniture, the business
owns. The taxpayer must keep records to verify certain information
about business assets. You'll need records to compute the annual
depreciation and the gain or loss when the taxpayer sells the assets.
Supporting documents for assets must show the following information:

When and how the assets were acquired


Purchase price
Cost of any improvements
Section 179 deduction taken
Deductions taken for depreciation
Deductions taken for casualty losses, such as losses resulting from
fires or storms
How the asset was used
When and how the asset was disposed of
Selling price
Expenses of sale

The following documents may show this information:


Purchase and sales invoices
Real estate closing statements
Canceled checks or other documents that identify payee, amount,
and proof of payment/electronic funds transferred
Electronic Records
All requirements that apply to hard copy books and records also apply to
electronic storage systems that maintain tax books and records. The
taxpayer must maintain the electronic storage systems and the
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electronically stored documents for as long as they are material to the


administration of tax law.

SIDE BAR

The Burden of Proof


For complete details about the burden of proof read Appendix R - The
Burden of Proof - A Treatise on the Supporting Document Requirements for
Tax Return Preparers, which you can obtain from the Appendix section of
our web site, or by clicking here.

TAX TIP

Should sole proprietors open a separate business checking account?


When sole proprietors pay themselves they simply write themselves a
check or withdraw money from the bank. They don't have to issue a
paycheck to themselves and withhold payroll taxes. When sole
proprietors need to contribute some personal money to the business
(capital) they simply deposit it into the checking account. They don't have
to formally account for capital contributions as they would with a
partnership or a corporation.
Most sole proprietors rely on their business checkbook as a
recordkeeping device. It's important that they have both a business
checking account and a personal checking account. When they make a
deposit into the business checking account they should note the source
of the funds.
Once theyve opened the business checking account they should deposit
all business income and pay all business expenses, and only business
expenses, from the business checking account. All personal income
should be deposited into their personal checking account and all
personal expenses should be paid from that account.
Should the IRS ever audit the sole proprietor the auditor will pay much
less scrutiny to the income and expenses if only business income is
deposited into the business checking account and only business

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expenses are paid from the business checking account.

Cost of Goods Sold


If the taxpayers business manufactures products or purchases them for
resale, he generally must value inventory at the beginning and end of each
tax year to determine his cost of goods sold. Some of his business expenses
may be included in figuring cost of goods sold. Cost of goods sold is
deducted from gross receipts to figure gross profit for the year. If you
include an expense in the cost of goods sold, you cannot deduct it again as
a business expense. The following are types of expenses that go into
figuring cost of goods sold:

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The cost of products or raw materials, including freight


Storage
Factory overhead
Direct labor (including contributions to pension or annuity plans) for
workers who produce the products

Taxpayers must use the same method to value their entire inventory and
they may not change to another method without the IRS's consent. The IRS
is less concerned about the specific inventory valuation method and more
concerned with the taxpayer being consistent from year to year so that the
inventory method accurately reflects income.
The table below shows which merchandise is included in inventory:
Include the following
Do not include the following
merchandise in inventory:
items in inventory:
Purchased merchandise if title has
Goods the taxpayer has sold, if title
passed to the taxpayer, even if the
has passed to the buyer.
merchandise is in transit or the
taxpayer does not have physical
possession of it for some other
reason.
Merchandise the taxpayer agreed
to sell, by has not separated from
other similar merchandise he owns
to supply to the buyer.

Supplies that do not physically


become part of the item intended
for sale.

Goods the taxpayer has placed with Goods ordered for future delivery, if
another person or business to sell
the taxpayer does not yet have title.
on consignment.
Goods held for sale in display
rooms, merchandise rooms, or
booths located away from the
taxpayer's place of business.

Assets such as land, buildings, and


equipment used in the taxpayer's
business.
Goods consigned to the taxpayer.

For more information, see Cost of goods sold in chapter 6 of Publication


334 - Tax Guide for Small Business.
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TAX TIP

How should taxpayers deduct losses of business inventory?


Losses of business inventory may be deducted either as part of the cost
of goods sold or as a casualty loss. Taxpayers are usually better off
deducting these losses as part of the cost of goods sold as they will have
less net income, which may save them some Self-Employment tax.
Capital Expenses
There are many different kinds of business assets; for example, land,
buildings, machinery, furniture, trucks, patents, and franchise rights.
Usually, taxpayers recover costs for a particular asset through depreciation.
However, the taxpayer will amortize certain costs for setting up the
business.
You must capitalize, rather than deduct, some costs. These costs are a part
of the taxpayer's investment in the business and are called "capital
expenses." Capital expenses are considered assets in the business. You must
fully capitalize the cost of these assets, including freight and installation
charges. There are, in general, three types of costs you'll capitalize:

Business start-up costs


Business assets
Improvements

Although taxpayers generally cannot take a current deduction for a capital


expense, they may be able to recover the amount they spend through
depreciation, amortization, or depletion. These recovery methods allow
taxpayers to deduct part of their cost each year. In this way, they are able to
recover their capital expenses. They may also be allowed a Section 179
deduction. For information on the Section 179 deduction and depreciation,
see First Year Expensing below and Publication 946 - How to Depreciate
Property.
The costs of making improvements to a business asset are capital expenses
if the improvements add to the value of the asset, appreciably lengthen the
time the taxpayer can use it, or adapt it to a different use. Improvements are
generally major expenditures. Some examples are: new electric wiring, a
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new roof, a new floor, new plumbing, bricking up windows to strengthen a


wall, and lighting improvements.
Taxpayers can currently deduct repairs that keep their property in a normal
efficient operating condition, as a business expense. Treat as repairs
amounts paid to replace parts of a machine that only keep it in a normal
operating condition.

Going into Business


The costs of getting set up in business, before the taxpayer actually begins
business operations, are capital expenses. Start-up costs are those expenses
a business incurs before opening up for business such as advertising, travel,
wages for training employees, market research, finding the right location,
determining the appropriate licenses and obtaining them, recruiting staff,
setting up the office or store, issuing initial press releases or
announcements, and setting up the books. Organization costs also include
setting up an LLC or corporation, issuing stock, getting investors, and more.
Treat all costs to get the business "up and running" as capital expenses.
Costs incurred to purchase an existing, ongoing business do not qualify as
startup expenses. However, costs incurred to investigate several existing
businesses in a particular trade or location may qualify.
Normally, start-up costs and organization costs, which are capital expenses,
are deducted over 15 years. Businesses can however, currently deduct the
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first $10,000 worth of start-up costs, providing total start-up costs are
under $60,000. Organization costs are limited to $5,000.

TAX TIP

Deduct Start-up Costs As Soon As Possible


It's usually best to claim the 15 year amortization as soon as possible
because if the IRS determines that the business began in a year before
the election to amortize startup costs was made, the right to deduct
those costs in the earlier year is lost.
If your client wants to claim start-up cost deductions make sure he:
1. Opens his doors and starts selling his product or service in the tax year
that he wants to start taking deductions. Generate meaningful income.
2. Document his efforts to generate sales that year. Take important steps to
sell something that year. If the taxpayer didn't make the sale then document
his efforts that will generate much more revenue the following year.
If the taxpayer doesn't perform the two steps above the IRS may classify his
business as a mere hobby.
Partially Deductible Expenses
If the taxpayer recovers part of an expense in the same tax year in which he
would have claimed a deduction, reduce the current year expense by the
amount of the recovery. If the taxpayer has a recovery in a later year, include
the recovered amount in income in the later year. However, if the deduction
for the expense in the prior year did not ultimately reduce the taxpayer's
prior year tax liability, you do not have to include the recovered amount in
income in the later year.
Payments in Kind
If the taxpayer provides services to pay a business expense, the amount he
can deduct is limited to his actual out-of-pocket costs. He cannot deduct
the cost of his own labor.
Similarly, if he pays a business expense in goods or other property, he can
deduct only what the goods or property actually cost him. If the cost is
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included in the cost of goods sold, do not deduct them as a business


expense.

Business income or loss is first reported on either:

Schedule C-EZ - Net Profit From Business, or


Schedule C - Profit or Loss From Business

Then the total amount is transferred to Form 1040 line 12.

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Figure 9-2: The Income section of Form 1040 with line 12 "Business income or (loss)"
highlighted.

1040 ValuePak will automatically select the correct form, Schedule C or


Schedule C-EZ, for you.

TAX PLANNING TIP

Can a business owner save taxes by hiring his or her own children?
Yes, since the taxpayer can deduct their wages as a business expense.
Generally, even children under 16 may be hired to work in Mom's or
Pop's business. But be sure to check with a local labor lawyer as the laws
vary from state to state.
Write up a job description for legitimate services to be performed, such
as office work or maintenance, pay them a reasonable wage by company
check every payday, keep records, and send them a W-2 in January. Any
child can earn up to $6,200 tax free. The child's earned income will
probably be low enough that he or she won't need to file a tax return.
Another tax benefit: If the business owners child is under 18 years old the
business owner doesnt have to pay any social security or Medicare taxes
on the child's wages. Taxpayers may have to pay state payroll taxes even
if they don't pay federal payroll taxes for the child. Check with a local
labor lawyer.
The child can also make a contribution to a traditional IRA or Roth IRA up
to the lesser of their wages or $5,500. Imagine how much a Roth IRA
contribution of $2,000 made for a 13 year old could grow to tax-free over
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the fifty years before the child retires.

Who May Use Schedule C-EZ


Taxpayers can use Schedule C-EZ only if they:

Had business expenses of $5,000 or less


Used the cash method of accounting
Did not have an inventory at any time during the year
Did not have a net loss from their business
Were the sole proprietor for only one business
Had no employees during the year
Were not required to file Form 4562 - Depreciation and Amortization
Did not deduct expenses for business use of their home
Did not have prior-year un-allowed passive activity losses from their
business

Schedule C-EZ
This topic explains how to complete Parts I, II, and III of Schedule C-EZ, Net
Profit From Business.
Part I: General Information - Eligibility Flowchart
The flowchart at the top of Schedule C-EZ is used to determine whether the
taxpayer is eligible to use this form instead of Schedule C for reporting selfemployment income. If a self-employed taxpayer meets all the criteria, you
can complete the rest of the form.

Part II: Figure Your Net Profit - Gross Receipts


Line 1, Gross receipts, includes all receipts from a trade or business,
including income reported on Form 1099-MISC, Miscellaneous Income. All
items of taxable income received during the tax year are included. Gross
receipts are entered on Part II, line 1 of Schedule C-EZ.
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Many taxpayers erroneously report amounts from Form 1099-MISC with


wages or other income. This income should instead be reported on
Schedule C or C-EZ and on Schedule SE. If the income is reported
incorrectly, the IRS may later issue a notice of proposed tax increase for the
Self-Employment tax.
Statutory Employees
If the taxpayer is a Statutory Employee the "Statutory Employee" checkbox
in box 13 of the taxpayer's Form W-2 will be checked:

Figure 9-3: Form W-2 - Wage and Tax Statement with box 13 "Statutory employee"
highlighted.

Check the box next to line 1 of Schedule C-EZ


Report the amount shown in box 1 of the taxpayer's Form W-2 in
box 1 of Schedule C-EZ

Total Expenses
Total expenses, entered on line 2, include the total amount of all deductible
business expenses actually paid during the year. Examples of these
expenses include:

Advertising
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Car and truck expenses


Commissions
Insurance
Interest
Legal and professional services and fees
Office expenses
Rent or lease expenses
Repairs and maintenance
Supplies
Taxes
Travel
50% of business meals and entertainment
Utilities (including telephone)

Businesses can deduct the full cost of providing an occasional social or


recreational event for its employees, such as a company picnic or holiday
party, not just the 50% meals and entertainment deduction.
If business expenses total more than $5,000, the taxpayer must use
Schedule C.

TAX TIP

Are business bad debts tax deductible?


Deductions are only allowed for business bad debts if they were
previously included in income which they ordinarily wouldnt be for a
cash basis taxpayer. Presumably, the taxpayer already deducted his or her
costs of time and materials with his or her regular business expenses.
Fringe benefits are valuable additions to a business owner's or employee's
compensation. A fringe benefit is tax deductible to the business and either
wholly or partly tax free to the business owner or employee. The Internal
Revenue Code imposes strict rules and limitations on fringe benefits.
Tax-advantaged retirement plans are the most valuable of all fringe
benefits, as the tax deductions can be very large. Automobiles used both on
and off the job are another important fringe benefit. Travel for business
with some pleasure mixed in is another popular fringe benefit.
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TAX PLANNING TIP

Accelerating Business Expenses


Under the cash method of accounting taxpayers claim income and
deduct expenses in the year they are received or paid. Under the accrual
method of accounting taxpayers claim income and deduct expenses in
the year they accrue. The discussion immediately below pertains to
business owners using the cash method of accounting.
December may be the time to stock-up. Business owners can purchase
items for their business that they will need in the immediate future to
maximize deductions for the current year. They can accelerate their
expenses for the current year by buying office supplies and any other tax
deductible items before December 31st. Make sure they save their
receipts for tax time!
They can also pay bills for telephone, cell phone, subscriptions, rent,
insurance, and utilities early to take the deduction in the current year.
Newly purchased office equipment must be "placed in service" by yearend.
The table below shows the 15 most common operating expenses for
small businesses:
Percentage of Business Owners
Expense
Who Claimed the Expense
Car and truck expenses
81%
Utilities
68%
Supplies (other than office supplies)
60%
Office Supplies
60%
Legal and professional services
60%
Insurance
54%
Taxes
51%
Meals and entertainment
47%
Advertising
43%
Repairs
40%
Travel
31%
Rent on business property
26%
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Expense
Home office
Rent on equipment and machinery
Interest

INCOME

Percentage of Business Owners


Who Claimed the Expense
21%
21%
18%

The table below shows the rules regarding business entertainment


expenses:
General Rule
You can deduct ordinary and necessary expenses to
entertain a client, customer, or employee if the
expenses meet the Directly-Related test or the
Associated test.
Definitions
Entertainment includes any activity generally
considered to provide entertainment, amusement, or
recreation, and includes meals provided to a
customer or client.
An ordinary expense is one that is common and
accepted in your field of business, trade, or
profession.
A necessary expense is one that is helpful and
appropriate, although not necessarily required, for
your business.
Tests to be met
Directly-Related test
Entertainment took place in a clear business setting,
or
Main purpose of entertainment was the active
conduct of business, and you did engage in business
with the person during the entertainment period,
and you had more than a general expectation of
getting income or some other specific business
benefit.
Associated test
Entertainment is associated with your trade or
business, and
Entertainment directly precedes or follows a
substantial business discussion.
Other rules
You cannot deduct the cost of your meal as an
entertainment expense if you are claiming the meal
as a travel expense.
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You cannot deduct expenses that are lavish or


extravagant under the circumstances.
You generally can deduct only 50% of your
unreimbursed entertainment expenses.

The table below shows what information must be produced for business
expense tax deductions:
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IF you have
expenses for...

Travel

Entertainment

SELF

EMPLOYMENT

INCOME

THEN you must keep records that show details of the


following...
Business
Place or
Purpose and
Amount
Time
Description
Business
Relationship
Cost of each
Dates you Destination or
Purpose:
separate
left and
area of your
Business
expense for
returned
travel (name of purpose for the
travel, lodging, for each
city, town, or
expense or the
& meals.
trip and
other
business benefit
Incidental
number of designation).
gained or
expenses may days
expected to be
be totaled in
spent on
gained.
reasonable
business
categories.
(Taxis, daily
meals for
traveler, etc.)

Cost of each
separate
expense.
Incidental
expenses such
as taxis,
telephones,
etc., may be
totaled on a
daily basis.

Date of
entertainment.

288

Name and
address or
location of
place of
entertainment.
Type of
entertainment
if not
otherwise
apparent.

Relationship: N/A
Purpose:
Business
purpose for the
expense or the
business benefit
gained or
expected to be
gained. For
entertainment,
the nature of the
business
discussion or
activity. If the
entertainment
was directly
before or after a
business
discussion; the
date, place,
nature, and
duration of the
business
discussion, and
the identities of
the persons who
took part in both
the business
discussion and
the entertainment
activity.

LESSON

IF you have
expenses for...
Gifts

Transportation

SELF

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THEN you must keep records that show details of the


following...
Cost of the gift. Date of
Description of
Relationship:
the gift.
the gift.
Occupations or
other information
(such as names,
titles, or other
designations)
about the
recipients that
shows their
business
relationship to
you. For
entertainment,
you must also
prove that you or
your employee
was present if
the entertainment
was a business
meal.
Cost of each
Date of
Your business Purpose:
separate
the
destination.
Business
expense. For
expense.
purpose for the
car expenses,
For car
expense.
the cost of the
expenses,
car and any
the date
Relationship: N/A
improvements, of the use
the date you
of the car.
started using it
for business,
the mileage for
each business
use, and the
total miles for
the year.

The IRS does not require businesses to keep any specific forms of
records so long as the records accurately reflect income and expenses
for the year.

Leasing vs. Buying Equipment


In general, taxpayers may deduct ordinary and necessary expenses for
renting or leasing property used in a trade or business.
Rented or leased property includes real estate, machinery, and other items
that a taxpayer uses in his or her business and does not own. Payments for
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the use of this property may be deducted as long as they are reasonable.
However, special rules and limitations apply to business use of the
taxpayers rented personal residence and leased automobiles. More
information on these topics is in Publication 587 - Business Use of Your
Home and Publication 463 - Travel, Entertainment, Gift, and Car Expenses.
Conditional Sales Contracts
Sometimes payments are listed as rent when in reality they are actually for
the purchase of the property. A conditional sales contract generally exists
when at least part of the payments are applied toward the purchase or
entitle the taxpayer to acquire the property under advantageous terms.
Payments made under a conditional sales contract are not deductible as
rent expense but qualify for depreciation expense over the useful life of the
asset.
Capitalizing Rent Expenses
Under certain conditions taxpayers who are in the business of producing
real property or tangible personal property for resale, or who purchase
property for resale, may not claim rental or lease expenses as a current
deduction. Instead, they must include some or all of these costs in the basis
of the property they produce or acquire for resale. These costs are
recovered when the property is sold.
Business and Personal Use
If a taxpayer has both business and personal use of rented or leased
property he or she may deduct only the amount used for business. To
compute the business percentage, compare the size of the property used
for business to the entire size of the property. Use the resulting percentage
to figure the business portion of the rent expense.
The table below shows a comparison of Leasing vs. Buying:
Tax Treatment

Leasing
Lease payments are a
currently deductible
business operating
expense.

290

Buying
Up to $500,000 in
equipment purchases
can be deducted in
one year under Section
179, if the
requirements are

LESSON

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Tax Treatment

Initial Cash Outlay

EMPLOYMENT

INCOME

Leasing

Buying
satisfied. Otherwise,
the cost is depreciated
over several years usually 5 to 7 years.

No depreciation or
Section 179 deductions
are allowed.
Small. No, or a very
low, deposit is
ordinarily required.

Interest on loans to
buy equipment is
currently deductible.
Large. At least a 20%
down payment is
usually required. A
bank loan may be
required to finance the
remaining cost.
You own the
equipment.

Ownership

You own nothing at


end of the lease term.

Costs of Equipment
Obsolescence

Borne by the lessor


because it owns the
equipment. The lessee
may lease new
equipment when lease
expires.

Borne by buyer
because the buyer
owns the equipment,
which may have little
resale value.

Leasing Automobiles
If a vehicle is leased for 30 days or more the lease deduction must be
reduced by an inclusion value if the fair market value of the vehicle
exceeded the value shown below on the first day of the lease.
Beginning in year 2003 there are separate provisions for leased trucks
and vans which are defined as passenger vehicles built on a truck chassis
including minivans and SUVs.

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The table below shows the amounts that a lease deduction must be
reduced by:
Lease Began
Fair Market Value

Auto

Truck/van

2003

$18,000

$18,500

2004

$17,500

$18,000

2005-2006

$15,200

$16,700

2007

$15,500

$16,400

2008

$18,500

$19,000

2009

$18,500

$18,500

2010-2012

$18,500

$19,000

2013

$19,000

$19,000

2014

$18,500

$19,000

Table: Vehicle Leasing

Business Travel Expenses


Business travel expenses are the ordinary and necessary expenses of
traveling away from home for business. Taxpayers cannot deduct expenses
that are lavish or extravagant or that are for personal purposes.

Deductible travel expenses while away from home include, but are
not limited to, the costs of:

Travel by airplane, train, bus, or car between the taxpayer's home


and business destination. (If the taxpayer is riding free under a
frequent flyer program, his cost is zero)

Using a car while at the business destination

Fares for taxis or other types of transportation between the airport or


train station and hotel, the hotel and the business work location, and
from one customer to another, or from one place of business to
another

Meals and lodging

Tips paid for services related to any of these expenses


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Dry cleaning and laundry

Business calls and faxes while on the business trip

Other similar ordinary and necessary expenses related to the


business travel. These expenses might include transportation to and
from a business meal, public stenographer's fees, and computer
rental fees

The taxpayer is traveling away from home if his business duties require him
to be away from the general area of his tax home for a period substantially
longer than an ordinary day's work, and he needs to get sleep or rest to
meet the demands of work while away.
Generally, a tax home is the entire city or general area where the taxpayer's
main place of business is located, regardless of where he maintains his
family home. For example, the taxpayer lives with his family in Philadelphia
but owns a business in Baltimore where he stays in a hotel and eats in
restaurants. He returns to Philadelphia every weekend. He may not deduct
any of his travel, meals, or lodging in Baltimore because that is his tax home.
His travel on weekends to his family home in Philadelphia is not for
business, so these expenses are also not deductible.
Travel expenses for conventions are deductible if the taxpayer can show that
his attendance benefits his business. Special rules apply to conventions held
outside the North American area.
Conventions held on cruise ships are subject to a limit of $2,000 per year
that can be deducted. Foreign conventions have a variety of rules that must
be met before the expenses are deductible, however, conventions held in
North America (Canada, Mexico, etc.) are not considered foreign
conventions.
Instead of keeping records of meal expenses and deducting the actual cost,
taxpayers can generally use a standard meal allowance, which varies
depending on where they travel.

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Business travel expenses are deductible on Schedule C or C-EZ, or Schedule


F for farmers.

Car Expenses
Taxpayers who use their car or truck exclusively for business purposes can
deduct expenses related to using the car or truck. You can deduct actual car
expenses, which includes depreciation (or lease payments), gas and oil, tires,
repairs, tune-ups, insurance, and registration fees.

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If the taxpayer uses his car or truck for both business and personal
purposes, you must divide his expenses based on actual mileage.
To determine the amount of car and truck expenses that can be included in
total business expenses reported, you must use one of the following two
methods:

Standard Mileage Rate Method


Actual Car Expenses Method

You must select ONE of the above two methods. You cannot select both,
and you cannot mix parts of each. For instance, you cannot take the
standard mileage rate and add depreciation to it.
If the taxpayer is self-employed, he can also deduct the business part of
interest on his car loan, state and local personal property tax on the car,
parking fees, and tolls, whether or not he claims the standard mileage rate.
For more information on car expenses and the rules for using the standard
mileage rate, see Publication 463 - Travel, Entertainment, Gift, and Car
Expenses.
If a taxpayer depreciates his car or truck he cannot use Schedule C-EZ. He
must use Schedule C.
Standard Mileage Rate Method
To use the Standard Mileage Rate Method:

Multiply the business miles by the applicable mileage rate


Add that amount to the business-related parking and tolls

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The standard mileage rate for business use of a vehicle is shown in the table
below.
Type of Mileage
Business*
Medical/Moving
Charitable

2012
55.5 per mile
23 per mile
14 per mile

2013
56.5 per mile
24 per mile
14 per mile

2014
56 per mile
23.5 per mile
14 per mile

2015
57.5 per mile
23 per mile
14 per mile

*These tax deductible rates are available for individuals who own the vehicle and operate
only one vehicle for business purposes at a time. The election to use this method must be
made during the first tax year the vehicle is used for business.
Table: Mileage Rates

The standard mileage rate can be used for leased cars provided that the
taxpayer continues to use this method for the entire lease term.
The standard mileage rate may not be used to compute the deductible
expenses for:

five or more vehicles owned or leased by a taxpayer and used


simultaneously

vehicles depreciated using any method other than straight line for
which the taxpayer claimed any special depreciation allowance

vehicles for which the taxpayer claimed a section 179 deduction

vehicles used by a rural mail carrier who received a qualified


reimbursement

vehicles used for hire, such as taxis

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The table below shows the depreciation component included in the


standard mileage rate:
The standard mileage rate includes a depreciation component. When
disposing of a vehicle where the standard mileage rate was used to
calculate the deduction for business use of the vehicle the basis of the
vehicle must be reduced by the depreciation component of the standard
mileage rate shown below:
Year

Amount

2007

19 per business mile

2008

21 per business mile

2009

21 per business mile

2010

23 per business mile

2011

22 per business mile

2012 - 2013

23 per business mile

2014

22 per business mile

Table: Depreciation Component Standard Mileage Rate

TAX TIP

Can taxpayers with a home office deduct more automobile


expenses?
Taxpayers who have a deductible home office may be able to take
automobile expenses for otherwise nondeductible commuting costs
between their home office and other work locations. This is true whether
the destination is another regular place of business of the taxpayer, a
temporary place of business, or a destination such as the post office, a
supplier, or the bank, etc.

TAX TIP

Maximizing Deductible Business Use of an Automobile


The taxpayers cost of traveling between his home and his regular place
of business is not tax deductible. However, the taxpayers cost of traveling
between his home and a business location that is not his regular place of
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business is tax deductible. Taxpayers can take advantage of this rule by


making a business related-stop on the way, and close to, their regular
place of business and again on the way, and close to, their home. This
changes some of the taxpayer's non-deductible commute into tax
deductible business travel.
Actual Car Expense Method
Under the actual car expense method the cost of operating a vehicle
includes these tax deductible expenses:

auto club membership


automobile insurance
cleaning and waxing
depreciation, if the taxpayer owns the vehicle
gas and oil
interest on a car loan
lease payments
license fees if substantially based on the value of the vehicle
parking fees and garage rental fees
personal property taxes
repairs and maintenance
tires and supplies
tolls

If the taxpayer chooses to use actual car expenses 1040 ValuePak will use
the following method to ensure that only the business portion of the
expenses is deducted:

Compute the percentage of business use on the vehicle by dividing


the business miles by the total number of miles:
o Business miles / Total miles = % Business use

Determine the deductible expenses by multiplying the total amount


of actual expenses by the % business use:
o Actual expenses x % Business use

Add that amount to the business-related parking and tolls


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If the taxpayer leases his car he can use either the standard mileage rate or
the actual car expense method, but some special rules apply.
If the taxpayer leases a vehicle for his business he can deduct each lease
payment as a rental expense and use the actual car expense method of
computing his other vehicle expenses.
When the use of a leased vehicle is less than 100% for business the tax
deduction is reduced in proportion to the personal use. If an automobile
with a fair market value greater than $18,500 is leased the taxpayer must
subtract the excess from the otherwise deductible amount to offset a
portion of the lease payments. See the above "Leasing Automobiles" table
at Leasing vs. Buying Equipment for the inclusion amounts. This prevents
taxpayers from avoiding the luxury car depreciation limits that apply to
purchased vehicles.
Automobiles Provided to Employees
The following rules apply to automobiles used by employees:

if the taxpayer provides a company automobile to an employee the


total cost of providing it is a business deduction for the taxpayer. The
value of the employee's personal use of the automobile is a taxable
fringe benefit to the employee.

if the taxpayer reimburses an employee for automobile expenses the


tax treatment is determined based on whether the company uses an
"accountable plan" or a "non-accountable plan." Reimbursements
made under an accountable plan are deductible business expenses
to the taxpayer and are excluded from the employees' taxable
income.

if the taxpayer provides an automobile to an employee for the entire


year for both personal and business use, the taxpayer may put a
price tag on this fringe benefit for tax purposes by using the
automobile's annual lease value.

if the taxpayer does not reimburse an employee for automobile


expenses the employee is able to deduct these expenses on their
individual tax return as a miscellaneous itemized deduction.

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TAX TIP

Is it better to take the standard mileage deduction or actual


expenses?
Usually the actual expense method provides the biggest deduction. But
to be sure, the only way to know is to figure the deduction both ways.

Net Profit
Line 3, Net profit, is the difference between gross receipts (line 1) and total
expenses (line 2).
If line 3 shows a profit 1040 ValuePak will transfer this amount to Form 1040
line 12, and to Schedule SE - Self-Employment Tax line 2 (except statutory
employees). If line 3 is zero or a loss 1040 ValuePak will transfer the amount
only to Form 1040 line 12.

Figure 9-4: Income section of Form 1040 with line 12 "Business income or (loss)"
highlighted.

Limits on Losses
If the taxpayer's deductions for a business activity are more than the income
it brings in, he has a loss. There may be limits on how much of the loss he
can deduct.
Not-for-Profit Limits
If the taxpayer carries on his business activity without the intention of
making a profit, he cannot use a loss from it to offset other income.
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At-risk Limits
Generally, a deductible loss from a trade or business or other incomeproducing activity is limited to the investment the taxpayer has "at risk" in
the activity. Taxpayers are at risk in any activity for the following:

The money and adjusted basis of property they contribute to the


activity.

Amounts they borrow for use in the activity if:


o The taxpayer is personally liable for repayment, or
o The taxpayer pledges property (other than property used in
the activity) as security for the loan.

Passive Activities
Generally, the taxpayer is in a passive activity if he has a trade or business
activity in which he does not materially participate. In general, deductions
for losses from passive activities only offset income from passive activities.
Taxpayers cannot use any excess deductions to offset other income. In
addition, passive activity credits can only offset the tax on net passive
income. Any excess loss or credits are carried over to later years. Suspended
passive losses are fully deductible in the year the taxpayer completely
disposes of the activity.
Net Operating Loss
If the taxpayer's deductions are more than his income for the year, he may
have a "net operating loss." He can use a net operating loss to lower taxes
in other years. See Net Operating Losses below and Publication 536 - Net
Operating Losses for more information.

Part III: Information on Your Vehicle


Part III of Schedule C-EZ should be completed if the taxpayer is claiming car
and truck expenses in Part II. The taxpayer needs to provide information
about how the vehicle was used, its mileage, who drove it, and other data,
as well as whether the taxpayer has written records to validate the data. Ask
taxpayers who claim car or truck expenses if they maintain a written log of
mileage.

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Shown below is a sample of a vehicle expense log which is available at most


office supply stores.
Destination
(City,
Town, or
Area)

Date

Business
Purpose

6/4/2008

Local (St.
Louis)

6/5/2008

Indianapolis

Sales
calls
Sales
calls

Louisville

See Bob
Smith
(Pot.
Client)

6/6/2008

6/7/2008

Return to
St. Louis

6/8/2008

Local (St.
Louis)

6/9/2008

Odometer Readings

Expenses
Type
(Gas,
oil, tolls,
etc.)

Start

Stop

Miles
this
trip

8,097

8,188

91

Gas

8,211

8,486

275

Parking

Amount

$34.50

$6.50

Gas

$36.00

8,486

8,599

113

Repair
flat tire

$55.00

8,599

8,875

276

Gas

$35.50

Local (St.
Louis)

8,914

9,005

91

Weekly
Total

8,097

9,005

846

Sales
calls

6/10/2008

Total Year-to-Date

6,236

$167.50
$2,313.00

TAX QUOTE

"The hardest thing in the world to understand is the income tax. This is too
difficult for a mathematician. It takes a philosopher."
Albert Einstein

Schedule SE
This topic discusses who is required to pay Self-Employment tax and how to
report the tax on Schedule SE - Self-Employment Tax.
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The Self-Employment Contributions Act (SECA) tax is the same as the FICA
tax that employees pay, but its paid by self-employed business owners. Like
FICA it is made up of "contributions" to both the Social Security and
Medicare programs. Under FICA the employee and the employer each pay
one half of the tax. Under SECA the self-employed business owner pays the
entire amount of tax.
Because only the net income from the business is taxed for SECA, income
from interest and dividends, the sale of business property, and rental
income are not taxed unless such income is generated as a part of the
businesses core venture.
Business partners include their distributions from the partnership and any
guaranteed payments as net self-employment income subject to SECA tax.

TAX PLANNING TIP

The S Corporation Loophole


Unlike partners, S corporation shareholders who work for the company
can receive wages just like any other employee. FICA tax is withheld on
their wages. Non-wage distributions from the S Corporation generally do
not count as self-employment income and are not subject to either FICA
or SECA tax.
Thus, a sole proprietor or partner who receives $250,000 a year pays
SECA tax on the entire amount. An S Corporation shareholder who
receives $100,000 in wages and $150,000 in distributions only pays FICA
tax on the $100,000.
Can an S Corporation shareholder that works for the company take
all of his pay as distributions instead of wages?
No. A reasonable amount of compensation for the shareholders services
must be considered salary or wages on which Social Security, Medicare,
and income tax are withheld.

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TAX PLANNING TIP

Can shareholder-owners of a closely held C corporation pay out all


distributions as salaries?
As you know, wages and salaries paid to employees (including
shareholder-owners who work for a corporation) are tax deductible to
the corporation and taxable to the employees. Dividends on the other
hand, work differently. Dividends are first taxed at the corporate level,
before being paid to the shareholders. Then, when the shareholder
receives the dividend, he pays individual income tax on it.
In order to get around the double taxation of corporate dividends some
shareholder-owners of closely held C corporations take all of their
distributions as salaries. Unfortunately, if a closely held corporation is
profitable but does not pay any dividend at all for a long period time the
IRS will conclude that some of the salaries paid to shareholder-owners
are really dividends in disguise circumventing the corporate income tax.
When this happens the IRS will re-characterize the salaries as dividends
resulting in a large corporation income tax bill, plus interest and penalties.
Shareholder-owners can, however, pay themselves salaries that are
reasonable when compared to the salaries paid by other companies in
their industry.
There are special exemptions from SECA tax that apply to members of
certain religions or who work for religious groups. Members of religious
orders who have taken a vow of poverty are exempt from SECA tax as long
as they are working for the church or a church agency.
Resident aliens are subject to the same tax rules as U.S. citizens including
SECA tax rules. Residents of the Virgin Islands, Puerto Rico, Northern
Mariana Islands, Guam, and American Samoa are subject to SECA tax.
Nonresident aliens are not subject to SECA tax on income earned in the U.S.
unless they are a citizen of a country that has a Totalization Agreement or
treaty with the U.S. If there is an agreement the terms of the agreement
dictate the rules.

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Non-professional executors or administrators of estates are exempt from


SECA tax. These fees are reported as other income on Line 21 of Form 1040.
Professional fiduciaries file a Schedule C to report their income and they pay
SECA tax.
Statutory employees have FICA tax withheld from their pay.
Fees received as a notary public are not subject to SECA tax.
The tax is computed on either Short Schedule SE or Long Schedule SE, SelfEmployment Tax and transferred to Form 1040 to be added to other taxes
owed. 1040 ValuePak will automatically select the correct form for you.

Flowchart: Schedule SE

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Who Must File Schedule SE


Taxpayers must file Schedule SE if they have net earnings from selfemployment of $400 or more, other than church employee income; or
church employee income of $108.28 or more.
Taxpayers who would otherwise have to file Schedule SE are exempt from
doing so if:

Their only self-employment income was from earnings as a minister,


member of a religious order, or Christian Science practitioner, and

They have filed Form 4361 - Application for Exemption From SelfEmployment Tax for Use by Ministers, Members of Religious Orders
and Christian Science Practitioners, and

They have received IRS approval not to be taxed on these earnings

For these special cases check the box on Schedule SE.


Reporting the Self-Employment Tax
There is a short version of Schedule SE (Section A), and a long version
(Section B). Most taxpayers are eligible to use Section A.

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The table below shows the Social Security and Medicare tax rates:

2015 Maximum Wages Subject to Social Security tax

$118,500.00

Social Security tax rate (Employee)

6.20%

Maximum Social Security tax (Employee)

$7,347.00

Social Security tax rate (Employer)

6.20%

Maximum Social Security tax (Employer)


Social Security tax rate (Self Employed)

$7,347.00

Maximum Social Security tax (Self Employed)

12.40%
1

2015 Maximum Wages Subject to Medicare tax

$14,694.00
Unlimited

Medicare tax rate (Employee)

1.45%

Medicare tax rate (Employer)

1.45%

Medicare tax rate (Self Employed)

2.90%

Footnotes:
Self employed persons are entitled to deduct one-half of their self

employment tax on Line 27 of Form 1040.


Table: FICA Rates

Deduction of Self-Employment Tax


Self-employed people may claim an adjustment to income of one-half of
their Self-Employment tax entered on line 5 of Schedule SE. 1040 ValuePak
will automatically calculate 50% of line 5, enter the deduction on Schedule
SE line 6, and transfer that amount to Form 1040 line 27 as an adjustment
to income.

Figure 9-5: The Adjusted Gross Income section of Form 1040 with line 27 "Deductible part
of self-employment tax" highlighted.

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Home Office Deductions


Working at home has come a long way, due to instant communication,
improved internet access, and more stable virtual network connections.
One source says that the number of employees regularly telecommuting
more than one day a week grew 73% between 2005 and 2011.
A business is any activity carried on with a profit motive. It does not have to
make a profit every year. Many home based business owners can deduct
depreciation for part of their home or deduct part of their rent. Home office
expenses must be claimed on Form 8829 - Expenses for Business Use of Your
Home. Expenses incurred at home for business are deductible even if the
home office doesn't qualify for a deduction.
If the taxpayer uses part of his home for business, he may be able to deduct
expenses for the business use of the home.
Taxpayers have two ways to show the IRS that their home office space
qualifies for a tax deduction. They must show that they use their home
office exclusively and regularly as:

their "principal place of business"; or


the place where they meet with patients, clients, or customers in the
normal course of business.

TAX TIP

Are taxpayers better off deducting mortgage interest and real estate
taxes on Form 8829, or taking an itemized deduction?
Homeowners can deduct all of their real estate taxes and qualified
mortgage interest as itemized deductions, regardless of whether or not
they use their home for business. However, claiming these expenses as
part of the home office deduction means shifting them from Schedule A
to Form 8829 Expenses for Business Use of Your Home, and may
provide some tax savings.
An advantage to shifting these expense to Form 8829 is that by claiming
these expenses as business deductions taxpayers reduce the net income
on which they must pay Self-Employment taxes. Additionally, claiming
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the expenses on Form 8829 means that some of the real estate taxes and
mortgage interest will be used to reduce Adjusted Gross Income (AGI),
which improves the taxpayers eligibility for numerous tax benefits that
get phased-out based on AGI limits or are not deductible until being
above an AGI floor, such as miscellaneous itemized deductions and
medical expenses. Itemized deductions are discussed more fully in
Lessons 18 and 19.
However, a possible disadvantage is that, by deducting these expenses
on Form 8829, which flows to Schedule C, the taxpayer may not have
enough remaining expenses to itemize deductions at all. The effects will
be different for each taxpayer so you'll need to make a determination for
each taxpayer separately. That's where you're being a savvy tax preparer
produces big benefits for your clients!
The business use of home tests for the self-employed are:
Exclusive use test. Exceptions: Storage of inventory or product
samples; day care facilities.
Regular use test.
Trade or business test
Principal place of business test including administrative and
management activities. Exceptions: Meeting patients, clients, or
customers in home office; separate free-standing structure.
The additional business use of home tests for employees are:
Convenience of employer test.
No renting to employer rule.
Business use of home depreciation is 39-Year Nonresidential Real
Property.
Safe-Harbor Rules
In January, 2013 the IRS announced a safe-harbor method that will make
it easier for taxpayers to take the deduction. Under the safe-harbor
method, beginning with returns filed in 2014, the deduction amount
may be determined by a formula based on the square footage used as a
home office. The basic qualification rules have not changed.

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Individual taxpayers who elect this method can deduct an amount


determined by multiplying the allowable square footage, not to exceed
300 square feet, by $5, which is not inflation adjusted. Therefore, the
maximum a taxpayer can deduct annually under the safe harbor is
$1,500.
Taxpayers who use the safe-harbor method cannot also deduct actual
expenses; however, business expenses that are unrelated to the use of
the home (such as advertising) can be deducted. No depreciation is
allowed for the years in which the safe-harbor is elected.

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The table below shows the types of deductible and non-deductible


expenses:
Expense
Description
Deductibility
Direct
Expenses only for the
Deductible in full, subject to
business part of your home. deduction limits. Exception:
Example: Painting or repairs May be only partially
only in the area used for
deductible in a daycare
business.
facility.
Indirect
Expenses for keeping up and Deductible based on the
running your entire home.
percentage of your home
Example: Insurance, utilities, used for business, subject to
and general repairs.
deduction limits..
Unrelated Expenses only for the parts
Not deductible.
of your home not used for
business. Example: Lawn
care or painting a room not
used for business.

Principal Place of Business


In order for the taxpayers home office to qualify as his principal place of
business he must spend most of his working hours in the home office
and most of his taxable business income must come from activities in
the home office.
That has been harder to prove since the Supreme Court tightened the
definition in 1993. To meet this test now, the taxpayer must be able to show
that his home office is the most important place of doing business or that
he spends more time working in his home office than anywhere else. So
make sure the taxpayer has records of his activities in the home office and a
log of the time spent working at the home office as opposed to his
employer's office.
If the taxpayers home office was in a structure not attached to his home,
such as a stand-alone garage, chances are he can take the deduction with
ease if he satisfies the exclusive use test and regular basis test. A detached
structure does not have to qualify as a principal place of business or a place
for meeting patients, clients, or customers.

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What can be deducted?


Taxpayers can deduct real estate tax, mortgage interest, utilities, insurance,
repairs, operating expenses, and depreciation. They cannot deduct the total
that they incur for all of the above expenses. They must allocate the
expenses to business and personal use. Use one of the two (2) following
methods:
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if all of the rooms are not equal size divide the number of square
feet used for home office space by the number of total square feet
of the home. Apply the resulting percentage to the deductible
expenses. (i.e. 100 sq. ft. used for a home office divided by 1000 sq.
ft. total size of home equals .10 or 10%. Apply 10% to the total of
each deductible expense);

if all the rooms are the same size the taxpayer may base the home
office tax deduction on a comparison of the rooms used for home
office space versus the total number of rooms. (i.e. the taxpayers
home has 10 rooms and 2 rooms are used for the home office. The
taxpayer can deduct 20% of the total expenses)

TAX TIP

Is it a good idea for taxpayers to take a depreciation deduction for


their home office?
Taking a depreciation deduction for a home office will certainly save taxes
today. However, taxpayers are not required to take this deduction, and if
they do when they eventually sell the home they must reduce the
amount of gain they can exclude on the sale of the home. The exclusion
is discussed more fully in Lesson 11. The taxpayer will be required to pay
tax on the amount of capital gain that's equal to the amount of
depreciation he claimed over the years on his home office.
If the taxpayer expects to be in a low or zero tax bracket when he sells the
home, such as in retirement, then its probably a good idea to take the
depreciation now.
A different rule applies when a completely separate part of the property,
such as a separate building or a separate unit of a two family house, was
used for business. If the separate part of the property is used for business
in the year of the sale the taxpayer must treat the sale as the sale of two
separate properties. The sale of the business part of the property is
reported on Form 4797 - Sales of Business Property.

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How to Apportion Total Annual Expenses for New


Businesses?
The table below shows apportionment percentages:
IF the taxpayer first used his home THEN the following percentage
for business in the following
is deductible.
month...
January
2.46%
February
2.25%
March
2.03%
April
1.82%
May
1.61%
June
1.39%
July
1.18%
August
0.96%
September
0.75%
October
0.54%
November
0.32%
December
0.11%
Deduction Limits
The taxpayers deductions for utilities, maintenance, and insurance costs,
depreciation, or rent, may not exceed the net income derived from the
home office after mortgage interest, real estate tax, and casualty losses are
subtracted. If the taxpayer has no income for the year no deduction is
allowed. The taxpayer may carry forward to future tax years any deductible
expenses disallowed in the current tax year.
Sideline Businesses
If the taxpayer has a principal occupation and also a sideline business the
expenses of the sideline business are tax deductible if the above tax tests
are met. Use Form 8829 - Expenses for Business Use of Your Home to figure
the taxpayers deductions. For further information see Publication 587 Business Use of Your Home.

Depreciation
The cost of property with a useful life of one year or more used in a trade or
business or held for the production of income is recovered by allowing an
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annual deduction called depreciation. Only property used in a trade or


business or other income producing activity can be depreciated.
Taxpayers can depreciate most types of tangible property, such as buildings,
machinery, vehicles, furniture, and equipment and any cost for additions or
improvements to the property. They also can depreciate certain intangible
property, such as patents, copyrights, and computer software. The value of
land is not depreciable, so the cost of clearing, grading, planting or other
land improvements are also not depreciable.
To be depreciable, the property must meet all the following requirements.

it must be property the taxpayer owns


it must be used in his business or income-producing activity
it must have a determinable useful life
it must be expected to last more than one year

Taxpayers are considered to own property even if it is subject to a mortgage


or other indebtedness. Even if a taxpayer meets the preceding requirements
he cannot depreciate the following property:

Land, which must be subtracted from the cost of a property before


calculating depreciation

Property placed in service and disposed of in the same year

Equipment used to build capital improvements. A taxpayer must add


otherwise allowable depreciation on the equipment during the
period of construction to the basis of the improvements

The costs of clearing, grading, planting, landscaping, or demolishing


buildings on land are not depreciable, but are added to the basis of
the land which reduce the taxable gain on the sale of the property

Personal Property

Inventory

Property leased or rented from others. However, some permanent


improvements on leased property are depreciable

Certain term interests


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You must identify several items to ensure the proper depreciation of a


property, including:

The depreciation method for the property


The class life of the asset
Whether the property is Listed Property
Whether the taxpayer elects to expense any portion of the asset
under Section 179 (see First Year Expensing below)
Whether the taxpayer qualifies for any bonus first year depreciation
The depreciable basis of the property

Depreciation begins when a taxpayer places property in service for use in a


trade or business or for the production of income and ends when the
taxpayer has fully recovered the propertys cost or other basis or when the
taxpayer retires it from service, whichever comes first.
Taxpayers cannot claim depreciation on property that they hold for personal
purposes, such as a personal residence or a boat. Inventory and property
held for sale to customers cannot be depreciated. Goodwill, going concern
value, covenants not to compete, information databases, customer lists,
franchises, licenses, trademarks, and other intangibles cannot be
depreciated; but they are amortizable over fifteen (15) years. Amortization is
similar to depreciation.
Listed Property
Some business property is called "listed property" and is subject to special
depreciation rules. Listed property includes:

cars and other vehicles (but not those exceeding 14,000 pounds or
those that are unlikely to be used for personal purposes)

equipment that is normally used for entertainment or recreation,


such as communication, photographic, and video and audio
recording equipment

computers unless they are used at a regular business establishment


(including a tax deductible home office)

Business usage of listed property must exceed 50% in order for a taxpayer
to take the special expensing election or to depreciate the property under
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MACRS (see below). Otherwise, the taxpayer must use straight line ADS
depreciation method.
If the taxpayers business use of listed property drops below 51% the
second year and thereafter that the taxpayer first used the property in his
business, but before the property's depreciation period has ended, he may
have to recapture some of the excess depreciation he claimed.
The table below shows the tax treatment of business assets:
Asset
Tax Treatment
Building
Depreciate over 39 years
Copyrights & Patents
Amortize over 15 years
Customer Lists
Amortize over 15 years
Employee Contracts
Amortize over 15 years
Equipment
Depreciate over 3, 5, or 7 yrs. based on class
Franchise
Amortize over 15 years
Goodwill
Amortize over 15 years
Inventory
Book when sold, write off un-saleable items
Land
Not deductible; capitalize instead
Non-Compete Covenant
Amortize over 15 years
Trademark or Trade Name Amortize over 15 years
File Form 8594 to identify the components of the asset's valuation and to
allocate the purchase price among the assets.

TAX TIP

Should a taxpayer always take a depreciation deduction?


Yes. Taxpayers should claim the correct amount of depreciation every
year. Taxpayers who do not claim the depreciation they are entitled to
must still reduce their basis in the property by the amount of
depreciation that they could have deducted, but didnt, when they sell
the property. Which means they never got the benefit of the deduction,
but now have to pay income tax on the gain.
Note: 1040 ValuePaks Asset Center will automatically calculate depreciation
for all assets. Youll simply enter the items of information described below.
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The three basic factors affecting the amount of depreciation are:

Basis of the property


Recovery period for the property
Depreciation method used

The most common methods for determining depreciation are:

MACRS (Modified Accelerated Cost Recovery System), for property


placed in service after 1986

ACRS (Accelerated Cost Recovery System), for property placed in


service after 1980 and before 1987, and

Straight line or declining balance, for property placed in service


before 1981

MACRS is the proper depreciation method for most property. This lesson
focuses on the MACRS method.
The table below shows the recovery periods under MACRS:
3-year property:

Tractor units for over-the-road use.

Any race horse over two years old when placed in service.
Any other horse (other than a race horse) over 12 years old when placed in
service.

Qualified rent-to-own property.

5-year property:

Automobiles, taxis, buses, and trucks.

Computers and peripheral equipment.

Office machinery (such as typewriters, calculators, and copiers).

Any property used in research and experimentation.

Breeding cattle and dairy cattle.

Appliances, carpets, furniture, etc., used in a residential rental real estate activity.

Any qualified Liberty Zone leasehold improvement property.

Certain, geothermal, solar, and wind energy property.

7-year property:

Office furniture and fixtures (such as desks, files, and safes)

Agricultural machinery and equipment


Any property that does not have a class life and has not been designated by law
as being in any other class.

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Certain motor sports entertainment complex property placed in service after


October 22, 2004, and before January 1, 2008.

Any natural gas gathering line placed in service after April 11, 2005.

10-year property:

Vessels, barges, tugs, and similar water transportation equipment.

Any single purpose agricultural or horticultural structure.

Any tree or vine bearing fruits or nuts.

15-year property:
Certain improvements made directly to land or added to it (such as shrubbery,
fences, roads, and bridges)

Any retail motor fuels outlet, such as a convenience store.

Any municipal wastewater treatment plant.


Any qualified leasehold improvement property placed in service after October
22, 2004., and before January 1, 2008
Any qualified restaurant property placed in service after October 22, 2004, and
before January 1, 2008
Initial clearing and grading land improvements for gas utility property placed in
service after October 22, 2004.

20-year property:

Farm buildings (other than single purpose agricultural or horticultural structures).

Municipal sewers not classified as 25-year property.


Initial clearing and grading land improvements for electric utility transmission
and distribution plants placed in service after October 22, 2004.

25-year property:
This class is water utility property, which is either of the following:
Property that is in integral part of the gathering, treatment, or commercial
distribution of water, and that, without regard to this provision, would be 20year property.
Municipal sewers placed in service after June 12, 1996, other than property
placed in service under a binding contract in effect at all times since June 9,
1996.
27.5-year residential real property:
This is any building or structure, such as a rental home (including a mobile home), if 80%
or more of its gross rental income for the tax year is from dwelling units. A dwelling unit
is a house or apartment used to provide living accommodations in a building or
structure. It does not include a unit in a hotel, motel, or other establishment where more
than half the units are used on a transient basis. If the taxpayer occupies any part of the
building or structure for personal use, its gross rental income includes the fair rental
valued of the part occupied by the taxpayer.
39-year non-residential real property:
This is Section 1250 property, such as an office building, store, or warehouse, this is
neither residential rental property nor property with a class life of less than 27.5 years.

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You must use Form 4562 - Depreciation and Amortization to report


depreciation. Form 4562 is divided into six sections and 1040 ValuePak will
automatically complete the form for you.
Submit a separate Form 4562 for each business activity on Form 1040. Form
4562 must be filed if:

Depreciable property is placed in service during the tax year.


Section 179 expense deduction is taken.
Depreciation is claimed on any vehicle or listed property regardless
of the year placed in service.
Amortization of costs began during the tax year.
A vehicle deduction is claimed on any form other than Schedule C or
C-EZ.

1040 ValuePak will automatically e-file and/or print Form 4652 Depreciation and Amortization if it is required.
Depreciation deductions entered on Form 4562 are carried over to Line 13
of Schedule C for sole proprietors, or to Form 1120 for a C corporation,
Form 1120S for an S corporation, or to Form 1065 for a Partnership.
The table below shows the percentage of depreciation if the taxpayer
uses his car 50% or less for business:
If a vehicle is used 50% or less for business in the initial year of service
depreciation must be calculated using the 5 year straight line method
percentages below.
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
10%
20%
20%
20%
20%
10%
If the vehicle is used more than 50% in the initial year, but then falls to
50% or less in a subsequent year, switching to the straight line method
above is required. The excess depreciation taken in the previous years
must be recaptured and included in income, and the basis of the vehicle
adjusted.
The table below shows the depreciation limitations on automobiles:

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2005

2006

2007 3
2008

no bonus
bonus
Auto
Van/Truck
Electric
Auto
Van/Truck
Electric
Auto
Van/Truck 4

$3,260

Auto
Van/Truck

2009

Auto
Van/Truck

2014

Auto
Van/Truck

2013

Auto
Van/Truck

2012

Auto
Van/Truck

2011

Auto
Van/Truck

2010

INCOME

Maximum Annual Depreciation Limits 1


Year 1
Year 2
Year 3
Year 4+
$2,960
$4,800
$2,850
$1,675
$10,610
$4,800
$2,850
$1,675
$2,960
$4,700
$2,850
$1,675
$3,260
$5,200
$3,150
$1,875
$8,880
$14,200
$8,450
$5,125
$2,960
$4,800
$2,850
$1,775
$3,260
$5,200
$3,150
$1,875
$8,980
$14,400
$8,650
$5,225
$3,060
$4,900
$2,050
$1,775

Year placed
in service
2004 2

EMPLOYMENT

Auto
Van/Truck

$5,200

$3,050

$1,875

$2,960

$4,800

$2,850

$1,775

$3,160

$5,100

$3,050

$1,875

$2,960

$4,800

$2,850

$1,775

$3,060

$4,900

$2,950

$1,775

$3060

$4,900

$2,950

$1,775

$3,060

$5,100

$3,050

$1,875

$3,060

$4,900

$2,950

$1,775

$3,260

$5,200

$3,150

$1,875

$3,160

$5,100

$3,050

$1,875

$3,360

$5,300

$3,150

$1,875

$3,160

$5,100

$3,050

$1,875

$3,360

$5,400

$3,250

$1,975

$3,160

$5,100

$3,050

$1,875

$3,460

$5,500

$3,350

$1,975

At 100% business use. Vehicles with original cost more than $14,800. Trucks/SUVs less
than 6,000 lbs.
2

New (not used) cars acquired in 2003 and 2004 may take bonus first year depreciation.
The amount that may be taken is based on the date of the acquisition.
3

For 2007 and after the Auto category includes electric automobiles.

For certain SUVs that are over 6,000 lbs., if exempt from the Luxury Auto Rules, a
$25,000 Section 179 limit may apply.
5
For 2008-2014 taxpayers may elect to take an additional special depreciation allowance
of $8,000.
Table: Automobile Depreciation

Vans, trucks, or sport utility vehicles (SUVs) that weighs over 6,000 pounds
Gross Vehicle Weight Rating (GVWR) are not subject to the annual
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depreciation dollar caps or the annual lease income inclusion rules. In


addition, the luxury car excise ("gas guzzler") tax does not apply to these
types of vehicles. The GVWR is usually indicated on a plate attached to the
left front door or the door jamb.
The law limits the cost of a SUV and pick-up trucks with a cargo bed shorter
than 6 feet that may be expensed in the first year under Section 179 to
$25,000. The reduced election amount applies to SUVs placed in service
after October 22, 2004.
The "gas guzzler" tax is imposed on new cars that fail to meet federal fuel
economy standards. This tax is imposed on the manufacturer and it
becomes part of the retail price paid by the taxpayer. Before computing a
depreciation deduction for a business automobile you must first reduce the
basis of the automobile by the amount of any "gas guzzler" tax as taxpayers
can't recover this tax through depreciation.
Basis
The total of the yearly deductions for depreciation can never total more
than the cost or other basis of the property. Generally, the cost of the
property including the cost of improvements is the basis for depreciation.
When property is converted from personal use to business use, the basis is
the lesser of the adjusted basis or fair market value (FMV) at the time of
conversion.
For taxpayers who acquired the property through inheritance, gift, or
building it themselves, the basis may be figured differently than using the
original cost.
To learn more, refer to Publication 551 - Basis of Assets.
Adjusted Basis
The basis of property must be increased or decreased to reflect certain
adjustments before the depreciation deduction is computed. To find the
adjusted basis, add the purchase price of the property to the cost of any
improvements minus:

Any casualty losses or depreciation previously deducted, and


Land value

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The basis of depreciable property should also be adjusted when it is


acquired in a purchase with a trade-in. Again, the value of any associated
land must be excluded from the basis of the property.
MACRS Method of Depreciation
To figure a MACRS deduction you need to know the property's:

Placed in service date


Recovery period
Depreciable basis

The applicable convention determines the portion of the tax year for which
depreciation is allowable during a year property is either placed in service or
disposed of. There are three types of conventions, as detailed below.
Half Year Convention
All property is treated as placed in service or disposed of at the midpoint of
the tax year. Generally this convention applies to all property except
residential rental property, nonresidential real property, railroad gradings, or
tunnel bores.
Mid Quarter Convention
All property is treated as placed in service or disposed of at the midpoint of
the quarter. This convention must be used when the total depreciable bases
of MACRS property placed in service during the last 3 months of the tax
year is more than 40% of the total depreciable bases of all MACRS property
placed in service during the tax year with some modification.
This convention does not apply to nonresidential real property, residential
rental property, or property placed in service and disposed of in the same
year.
Mid Month Convention
All property is treated as placed in service or disposed of at the midpoint of
the month. This convention is used for nonresidential real property,
residential rental property, railroad gradings and tunnel bores.
To select the correct convention you must know the type of property and
when the property was placed in service.

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The table below shows what the percentage rate of depreciation is each
year for property with various recovery periods.
3,5,7,10,15, and 20 Year Property - Regular MACRS Half-Year
Convention
Depreciation rate for recovery period
200DB
200DB
200DB
200DB
150DB
150DB
Year 3-year
5-year
7-year
10-year 15-year 20-year
1
33.33%
20.00%
14.29%
10.00%
5.00%
3.75%
2
44.45
32
24.19
18
9.5
7.219
3
14.81
19.2
17.49
14.4
8.55
6.677
4
7.41
11.52
12.49
11.52
7.7
6.177
5
11.52
8.93
9.22
6.93
5.713
6
5.76
8.92
7.37
6.23
5.285
7
8.93
6.55
5.9
4.888
8
4.46
6.55
5.9
4.522
9
6.56
5.91
4.462
10
6.55
5.9
4.461
11
3.28
5.91
4.462
12
5.9
4.461
13
5.91
4.462
14
5.9
4.461
15
5.91
4.462
16
2.95
4.461
17
4.462
18
4.461
19
4.462
20
4.461
21
2.231
Placed in Service Date
A property's depreciation deduction is prorated in the year it is placed in
service. For depreciation purposes, property is considered placed in service
when it is in a condition or state of readiness and availability for use.
However, a depreciation deduction may not be claimed until the property is
actually used either in business or for the production of income.

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Property Classes and Recovery Periods


Each item of depreciable property is assigned to a property class. Property
classes:

Are based on the property's class life, and


Determine a property's recovery period

Both the MACRS and ACRS methods use the class life of depreciable
property to determine the recovery period.
The table below shows the MACRS Recovery Periods for the most
common small business items:
Type of Property
Computers and their
peripheral equipment

General Depreciation
System

Alternative Depreciation
System

5 years

5 years

Office machinery, such


as:

Typewriters

Calculators

Copiers

5 years

6 years

Automobiles

5 years

5 years

Light trucks

5 years

5 years

Appliances, such as:

Stoves

Refrigerators

5 years

9 years

Carpets

5 years

9 years

Furniture used in Rental


property

5 years

9 years

7 years

10 years

Office furniture and


equipment, such as:

Desks

Files
Any property that does
not have a class life and
that has not been
designated by law as
being in any other class

7 years

12 years

Roads

15 years

20 years

Shrubbery

15 years

20 years

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Type of Property

EMPLOYMENT

General Depreciation
System

Alternative Depreciation
System

15 years

20 years

Fences
Residential rental property
(buildings or structures)
and structural
components such as
furnaces, water pipes,
venting, etc...
Additions and
improvements, such as a
new roof

INCOME

27.5 years
40 years
The same recovery period as that of the property to
which the addition or improvement is made,
determined as if the property were placed in service at
the same time as the addition or improvement.

Applying Recovery Periods


Under MACRS:

A home converted in 1998 to a rental property would be depreciated


over a recovery period of 27.5 years

A stove used in this same rental property would be assigned a 7-year


recovery period

Foreign Property
Property located outside the United States has a longer recovery period
than property in the U.S., and the taxpayer must use the Alternative
Depreciation System (ADS) under MACRS. ADS generally increases the
number of years over which the property is depreciated and therefore
decreases the annual deduction. For instance, residential rental property
located in a foreign country would be depreciated over a 40-year recovery
period.
First Year Expensing (Section 179)
Section 179 allows businesses to immediately deduct the cost of certain
types of property as an expense, rather than requiring the property to be
depreciated. This property is generally limited to tangible personal property
such as equipment and vehicles. Buildings are not eligible for section 179
deductions. Depreciable property that is not eligible for a section 179
deduction is still deductible over a number of years through MACRS
depreciation.

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The section 179 deduction is intended for small businesses. See the table
below for the maximum section 179 deduction a company may take in a
year.

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Maximum Tax Deductible


Year

Expense

1998

$18,500

1999

$19,000

2000

$20,000

2001 - 2002

$24,000

2003

$100,000

2004

$102,000

2005

$105,000

2006

$108,000

2007

$125,000

2008 - 2009

$250,000

2010 - 2014

$500,000

IRC Section 179 allows taxpayers to write-off a fixed amount of capital


expenditures on their tax return each tax year ($500,000 in 2014), rather
than depreciate them over multiple tax years. The maximum expensing tax
deduction for an automobile placed in service in 2014 is $11,160.
There are two primary limitations. The first reduces the amount that can be
expensed on the tax return under this section if taxpayers acquire more
than $2,000,000 in Section 179 eligible property during the tax year. The
available $500,000 tax deduction is reduced dollar for dollar for each
dollar of Section 179 property placed in service during the tax year above
$2,000,000. If $2,500,000 of Section 179 property is placed in service the
available tax deduction is $0.
The second limitation is that Section 179 expense cannot be greater than
the net income generated by the business for which the property was
acquired.
Table: Section 179 Expense

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TAX TIP

Beating the Net Income Limit


The total cost of property that may be expensed under Section 179 for
any tax year cannot exceed the total amount of taxable income
generated by the business for which the property was acquired. For sole
proprietorships, partnerships, and S corporations this includes any salary
or wages from other employment of the taxpayer or his spouse, because
they are unincorporated.
If the taxpayer purchased equipment that exceeds the $500,000 limit, or if
he claims more than the maximum dollar amount, he can depreciate the
excess amount under the regular depreciation rules.
If, in any year after the year the taxpayer claimed a Section 179 expense
deduction, he either sells the property or stops using it more than 50% for
business he may have to recapture some of the tax deduction he previously
claimed.
For further information see Publication 946 - How to Depreciate Property.

TAX TIP

Which assets is it best to expense?


When the taxpayer has a choice it's best to expense the assets with the
longest depreciation periods. This way he can claim a quicker write-off for
them. If the asset has a shorter depreciation period expensing it in the
first year is not going to make as much of an overall difference.

TAX PLANNING TIP

Taking Advantage of Section 179 for Tax Planning


Unlike the regular depreciation deduction, the full Section 179 deduction
is available regardless of when the property was placed in service.
Therefore, if the taxpayer purchases new computers has them up and
running at any time during the year including just before the close of
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business on December 31st he is entitled to the full Section 179


deduction for the entire year.

Hobby Income and Losses


If the taxpayer does not carry on his business activity to make a profit, he
cannot use a loss from the activity to offset other income. Activities he does
as a hobby, or mainly for sport or recreation, are often not entered into for
profit. The IRS defines a hobby as an activity that the taxpayer pursues
without expecting to make a taxable profit - such as coin or stamp
collecting - as opposed to setting up a dealership. Taxpayers must include
hobby income on their tax returns.
Among the factors to consider are whether:

the taxpayer carries on the activity in a businesslike manner

the time and effort he puts into the activity

he depends on the income for his livelihood

his losses are due to circumstances beyond his control

he changes his methods of operation in an attempt to improve


profitability

the taxpayer has the knowledge needed to carry on the activity as a


successful business

the taxpayer was successful in making a profit in similar activities in


the past

the activity makes a profit in some years, and

the taxpayer can expect to make a future profit from the


appreciation of the assets used in the activity

The IRS assumes the taxpayer is trying to make a taxable profit if he actually
made money in at least three (3) years of the past five (5) years, including
the current year. For horse breeding, racing, training, or showing the test is
taxable profits in two (2) years of seven (7) consecutive years. However,
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regardless of whether or not the taxpayer meets the above taxable profit
tests, the IRS may still try to rebut the presumption and disallow the tax
deductions.
If, in the early years, the IRS tries to disallow tax losses, taxpayers may make
an election on Form 5213 - Election To Postpone Determination as To
Whether the Presumption Applies That an Activity Is Engaged in for Profit, to
postpone the determination of whether the above tests apply. The taxpayer
must make the election and file the Form 5213 within three (3) years of the
due date of the first tax return for the activity. The postponement is until the
end of the fourth (4th) year (sixth (6th) year for horses) following the first
year of the activity. By filing the form the taxpayer agrees to waive all statute
of limitations issues for that activity. The taxpayer can file Form 5213 within
sixty (60) days after receiving an IRS notice disallowing tax deductions so
long as the taxpayer is still within the three (3) years described above.
If the taxpayer loses money pursuing a hobby, the taxpayer cannot deduct
hobby losses from other income, but can deduct expenses up to the
amount of hobby income. A hobby loss is a miscellaneous itemized
deduction, though, and limited by the 2% of AGI limit.
A profitable sale of a hobby collection, such as stamps or coins, is taxable as
a capital gain. A loss upon the sale of a hobby collection is not tax
deductible.

Sale of Business Property


When taxpayers sell or otherwise remove a capital asset from their business
they have to pay tax on any gain from the sale. The gain may be a longterm capital gain, and long-term capital gains are taxed at a lower rate than
other income. If the taxpayer has a loss on property used in a trade or
business he can deduct it. Gain or loss is computed by subtracting the
taxpayers adjusted tax basis for the property from the amount realized on
the sale. You'll use Form 4797 - Sale of Business Property to report:

The sale or exchange of:


o Property used in a trade or business;
o Depreciable and amortizable property;
o Oil, gas, geothermal, or other mineral properties; and
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o Section 126 property.

The involuntary conversion (from other than casualty or theft) of


property used in a trade or business and capital assets held in
connection with a trade or business or a transaction entered into for
profit.

The disposition of noncapital assets (other than inventory or


property held primarily for sale to customers in the ordinary course
of a trade or business).

The disposition of capital assets not reported on Schedule D.

The gain or loss (including any related recapture) for partners and S
corporation shareholders from certain Section 179 property
dispositions by partnerships (other than electing large partnerships)
and S corporations.

The computation of recapture amounts under Internal Revenue


Code Sections 179 and 280F(b)(2) when the business use of Section
179 or listed property decreases to 50% or less.

Recapture of Depreciation Deductions


If the taxpayer realizes a capital gain on the sale or other disposition of
property used in his trade or business he probably won't get the full benefit
of the long term capital gains tax rate on the entire amount of the gain
because he must first "recapture" some of the depreciation deductions he
has been claiming for all the years he owned the property. The tax rules for
recapture depend on whether the property is real estate or personal
property.
Real Estate
Gain on the sale of real estate is treated as ordinary income to the extent of
any additional depreciation deducted above what could be taken using the
straight-line method for property held over a year.
Personal Property
If the taxpayer has a capital gain on personal property he must report all or
part of the gain as ordinary income up to the amount of depreciation and
any first-year expensing deductions previously claimed.
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TAX PLANNING TIP

When is it best to recapture depreciation?


Taxpayers should try to recapture depreciation in a year their business
has an operating loss which can be used to offset the recapture amount,
rather than in a year with a profit, when the recapture will increase their
taxable income and possibly move them into a higher tax bracket.
The table below shows the classification of assets:
IRC Section Description
Characteristics
1231
Long term real
gains exceed the amount of
depreciable
the accumulated depreciation
property
gains are long term capital
gains
losses are ordinary losses
report on Part I of Form 4797
1244

Loss on sale of
small business
stock

1245

1250

1252

Gains from
personal business
assets and
commercial real
estate

Gains from real


estate
depreciated
property not 1245

Gain on certain
farmland held for
1-10 years

334

losses up to $50,000 ($100,000


if MFJ)
ordinary losses, Any excess
loss is a capital loss
report Part II of Form 4797
gains from claimed or allowed
depreciation
excess is treated as ordinary
income
report Part I of Form 4797
recaptures of accelerated
depreciation for select assets
report Part II of Form 4797
gain subject to recapture rules
report gains Part I of Form
4797
losses Part I of Form 4797

LESSON

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EMPLOYMENT

INCOME

Use the table below to determine where to enter the sale of business assets
and other items reportable on Form 4797.
Short Term or Long Term?
Separate the gains and losses according to how long the taxpayer held or owned the
property. The holding period for short-term gains and losses is 1 year or less. The
holding period for long-term gains and losses is more than 1 year. To figure the
holding period, begin counting on the day after the taxpayer received the property and
include the day the taxpayer disposed of it..
Part I - Sales or Exchanges of Property Used in a Trade or Business and Involuntary
Conversion From Other Than Casualty or Theft - Property held More Than 1 Year
Part II - Ordinary Gains and Losses
Part III - Gain From Disposition of Property Under Sec.1245,1250,1252,1254 & 1255
Part IV - Recapture Amounts Under Sections 179 and 280F(b)(2) When Business
Use Drops to 50% or Less
Short Term*
Long Term*
Type of Property
Depreciable trade or business property:
Sold or exchanged at a gain
Part II
Part III (Sec. 1245,1250
Sold or exchanged at a loss
Part II
Part I
Depreciable residential rental property:
Sold or exchanged at a gain
Part II
Part III (Section 1250)
Sold or exchanged at a loss
Part II
Part I
Farmland held less than 10 years upon which soil, water or land clearing expenses
were deducted:
Sold at a gain
Part II
Part III (Section 1252)
Sold at a loss
Part II
Part I
Disposition of cost-sharing payment
Part II
Part III (Section 1255)
property described in Section 126:
Type of Property

Held less than Held 24 months or


24 months
more

Cattle and horses used in a trade or business for draft, breeding, dairy or sporting
purposes:
Sold at a gain
Part II
Part III (Section 1245)
Sold at a loss
Part II
Part I
Part
II
Part I
Raised cattle and horses sold at a gain:
Short Term*
Long Term*
Type of Property
Livestock other than cattle and horses used in a trade or business for draft,
breeding, dairy or sporting purposes:
Sold at a gain
Part II
Part III (Section 1245)
Sold at a loss
Part II
Part I
Part II
Part I
Raised livestock sold at a gain:
Table: Form 4797

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LESSON

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EMPLOYMENT

INCOME

TAX TIP

Trade-ins
If the taxpayer trades-in equipment that was used 100% for business, for
new business equipment of the same asset category, the trade-in will be
treated as a "like-kind exchange", and thus will not be a taxable event.
The tax basis of the new equipment will be the same as the adjusted
basis of the old equipment plus any additional money paid for the new
equipment. This tax basis represents the maximum amount the taxpayer
can use as basis to determine depreciation on the new equipment.
Vehicle Trade-ins with Partial Business Use
If the taxpayer trades-in a vehicle that was used partly for business and
part personally he must use the following computation to determine the
depreciable tax basis of the new vehicle:

to the adjusted basis of the old vehicle

add any additional money paid for the replacement vehicle

and subtract the excess, if any, of the total amount of depreciation


that would have been allowable during the years before the tradein if 100% of the use of the vehicle had been business use, over
the total amounts actually allowable as depreciation during those
years.

The table below shows the depreciation allowed in the year of disposal:
Depreciation Allowed in the Year of Disposal
ACRS: No depreciation except for real property.

15 year property use full month convention

18 year property placed in service before June 23, 1984


18 or 19 year property placed in service after June 22, 1984 use mid-month
convention

MACRS:
Residential rental or nonresidential real property use mid-month convention.
All other property use percentage of full year depreciation based on quarter of
disposition shown below.

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Convention
Half-year
Mid-quarter

INCOME

1st
Quarter

2nd
Quarter

3rd
Quarter

4th
Quarter

50%

50%

50%

50%

12.50%

37.50%

62.50%

87.50%

TAX PLANNING TIP

Selling a Sole Proprietorship


When a sole proprietor sells his or her business each of the assets sold
with the business are treated separately for tax purposes. You must
determine the adjusted basis of every asset in the sale, but smaller items
can be lumped together into categories.
Unlike buying or selling a home, with a business the buyer and seller
must determine not just the total purchase price for the business, but
also the part of the purchase price that will be applied to each individual
asset, and to intangible assets such as goodwill. It is important to make
this determination prior to your client entering into a contract to buy or
sell an existing business. Allocating the purchase price placed on certain
items can be a big bone of contention between buyers and sellers. Buyers
and sellers rarely agree, after the closing, how the purchase price should
be allocated. And disputes over allocation can even cause otherwise
perfectly good, and signed, Purchase and Sale Agreements to "bust out",
and then the deal doesn't go through at all.
The buyer wants as much value as possible to be allocated to items that
are currently tax deductible and to assets that can be depreciated quickly
under the tax rules. This will free up much need operating cash in the
early years that the buyer uses to operate the business. On the other
hand, the seller wants as much value as possible allocated to assets on
which the gain is treated as a long term capital gain instead of as ordinary
income. The seller may also have to recapture depreciation, creating a
large tax bill.
Sellers can't claim allocation on their tax return that is different than the
allocation used by the buyer, and vice versa. For instance, the seller can't
declare the entire sales price as goodwill, which is taxed as a long term
capital gain, while the buyer declares the entire purchase price as fixed
assets, which are depreciable over a short term. The IRS requires that
337

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both the buyer and the seller allocate items in the same way. If they don't,
and either is audited, the IRS can re-allocate and charge either, or even
both, additional taxes, interest, and penalties, which can be substantial.
And it is customary, in this situation, for the IRS to audit both taxpayers.
Most successful small business owners are in a high tax bracket and
getting the best allocation for your client can save him or her a lot of
money at tax time. Thats where tax planning comes in!
Selling a C Corporation
As previously mentioned, it is important to determine exactly how the
taxpayer is buying or selling a business in advance, prior to his
entering into a contract to buy or sell the business. Exactly what is
being sold, and how, can become a big bone of contention between
buyers and sellers. Buyers and sellers rarely agree, after the contract is
signed, on exactly what is being sold. And, as previously mentioned,
disputes can cause a signed Purchase and Sale Agreement to "bust
out", and then the deal doesn't go through at all.
Buyers inevitably want to buy the assets of a corporate business, not
its stock, for two reasons:

First, if buying the business itself (stock), the buyer inherits


successor liability for past corporate acts, even if those
liabilities are currently unknown. Think "Superfund Site". Buyers
are able to avoid these liabilities by buying the assets and
abandoning the corporate shell.

Second, buyers want to buy the corporate assets because they


get a new tax basis in the assets. A higher basis means more
depreciation can be claimed. In contrast, if the buyer bought
the corporate stock, it cant be depreciated, and the buyer is
stuck with the low asset basis locked inside the corporation.

Sellers, on the other hand, prefer to sell stock, not assets, also for tax
reasons. If a C corporation sells its assets and then distributes the
sales proceeds to shareholders, the combined corporate and
shareholder tax rate could exceed 50%. On any dividend upon which
338

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the maximum tax rates are paid, the combined tax rate would be a
35% corporate tax rate, and a 23.8% dividend tax rate - 58.8% total.
On the other hand, a sale of stock by a shareholder(s) might incur tax
as low as 15%, but probably never higher than 23.8%, which includes
the long-term capital gain rate of 20% and the Net Investment
Income Tax rate of 3.8%.

SIDE BAR

What is a Buy-Sell Agreement?


A buy-sell agreement is a contract between two or more parties that
provides for the future sale of a business. Often these agreements are
entered into by partners in a partnership or co-owners of a business to
insure the continued operation of the business without the deceased
partners spouse becoming a partner or co-owner. Buy-sell agreements
are also known as buyout agreements and business continuation
agreements. The buy-sell agreement transfers the seller's business
interest to the buyer at the occurrence of an event such as death,
disability, or retirement. Buy-sell agreements are often fully funded with
life insurance.
One disadvantage of buy-sell agreements is that they often limit the
owners ability to sell the business to outside parties.

Net Operating Losses


If the taxpayers deductions for the year are more than his income for the
year, he may have a Net Operating Loss (NOL). An NOL produces tax
benefits, and there are some rules about taking NOL deductions. The
manner in which tax benefits are claimed from a loss depends on the form
of the business entity, i.e. sole proprietor, partnership, corporation, or LLC. In
all business entities except C corporations, losses pass through to the
individual owners who are active in the operation. C corporation losses
belong to the corporation and not to the shareholders, and thus, are utilized
on the C corporation's tax return.
An NOL year is the year in which an NOL occurs. The taxpayer can use an
NOL by deducting it from income in another year or years.
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To have an NOL, the taxpayers loss must generally be caused by


deductions from his:

Trade or business
Work as an employee
Casualty and theft losses
Moving expenses, or
Rental property

A loss from operating a business is the most common reason for an NOL.
Partnerships and S corporations generally cannot use an NOL, as they are
pass-through entities. However, partners or S corporation shareholders can
use their separate shares of the partnerships or S corporations business
income and business deductions to figure their individual NOLs.
You must help the taxpayer decide whether to carry the NOL back to a prior
year or to waive the carry back period and instead carry the NOL forward to
future years. If the NOL deduction includes more than one of the sources
above in the NOL amount this step must be done separately for each NOL
amount, starting with the amount from the earliest year.
Form 1045 - Schedule A
Use Form 1045 - Application for Tentative Refund, Schedule A to figure an
NOL. First, complete Schedule A, line 1, using amounts from the tax return.
If line 1 is a negative amount, the taxpayer may have an NOL. Complete the
rest of Schedule A to figure the NOL.
Generally, if the taxpayer had an NOL for a for a post-1997 tax year, he must
carry back the entire amount of the NOL to the two (2) tax years before the
NOL year (the carry back period), and then carry forward any remaining
NOL for up to twenty (20) years after the NOL year (the carry forward
period).
How to Carry an NOL Back or Forward
If the taxpayer chooses to carry back the NOL, he must first carry the entire
NOL to the EARLIEST carry back year. If the NOL is not used up, he can carry
the rest to the next earliest carry back year, and so on.
If he does not use up the NOL in the carry back years, carry forward what
remains of it to the twenty (20) tax years following the NOL year. Start by
340

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carrying it forward to the first tax year after the NOL year. If it is not used up,
carry the unused part to the next year. Continue to carry any unused part of
the NOL forward until the NOL is used up, or the twenty (20) year carry
forward period is completed.
Net Operating Loss Example 1:

The taxpayer started his business as a sole proprietor in 2014 and had a $42,000
NOL for the year. No part of the NOL qualifies for the 3-year, 5-year, or 10-year
carryback. He begins using the NOL carryback in 2012, the second year before
the NOL year, as shown in the following chart.
Year
Carryback
Carryforward
Used Loss
Unused Loss
2012
$42,000
$2,000
$40,000
2013
$40,000
$3,000
$37,000
2014 (NOL
year)
2015
$37,000
$5,500
$31,500
2016
$31,500
$9,000
$22,500
2017
$22,500
$9,800
$12,700
2018
$12,700
$8,700
$4,000
2019
$4,000
$4,000
-0If the taxpayer's losses were larger, he could carry them forward until the year
2034. If he still had an unused 2014 carryforward after the year 2034, he could
not deduct it.
Table: NOL Example 1

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Net Operating Loss Example 2:


Assume the same facts as in Example 1, except that $4,000 of the NOL is
attributable to a casualty loss and this loss qualifies for a 3-year carryback
period. You begin using the $4,000 in 2011. As shown in the following chart,
$3,000 of this NOL is used in 2011. The remaining $1,000 is carried to 2012 with
the $38,000 NOL that you must begin using in 2012.
Year
2011
2012
2013
2014 (NOL
year)
2015
2016
2017
2018
2019

Carryback
$4,000 (of
$42,000)
$39,000
$37,000

Carryforward

$34,000
$28,500
$19,500
$9,700
$1,000

Used Loss

Unused Loss

$3,000
$2,000
$3,000

$1,000
$37,000
$34,000

$5,500
$9,000
$9,800
$8,700
$1,000

$28,500
$19,500
$9,700
$1,000
-0-

If the taxpayer's losses were larger, he could carry them forward until the year
2034. If he still had an unused 2014 carryforward after the year 2034, he could
not deduct it.
Table: NOL Example 2

TAX TIP

Should new business owners who lose money file a tax return?
Yes. One mistake new business owners often make is not filing a tax
return when they lost money for the year. It may be that they think, since
not making any money from employment for the year often allows
individual taxpayers to skip filing a tax return, then businesses work the
same way. Or it may be that they are trying to avoid tax preparation fees.
However, had they filed a tax return with their business losses they could
have taken advantage of the opportunity to carry losses back to prior
years (getting a quick cash infusion) and/or forward to future years in
which they have a profit, lowering tax in those years. Because carrying
back a net operating loss to a prior tax year will usually result in a quick
refund of taxes previously paid it is usually unwise to pass up the carry
back.
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Filing a tax return also establishes the business's existence and shows that
the business activity was undertaken for a profit. This could head off a
future IRS claim that the business is actually a hobby.
Should you have a client that didn't file a tax return(s) to take advantage
of the losses as described above remember you have three (3) years to
file those tax returns and carry those losses back.
Also, dont forget that business owners can deduct a loss from income
from other business ventures or from salary, wages, and other earnings
including those of a spouse.
On February 17, 2009 President Barack Obama signed the American
Recovery and Reinvestment Act which allows eligible small businesses to
elect up to a five year carry back of a net operating loss for a tax year
ending or beginning in 2008.
Prior to 1998 the carry back period was three (3) tax years and the carry
forward period was fifteen (15) tax years.
Waiving the Carry Back Period
The taxpayer can choose not to carry back the NOL and only carry it
forward. If he makes this choice, then he can use the NOL only in the twenty
(20) year carry forward period. This choice means he also applies to carry
back any Alternative Tax NOL. The Alternative Minimum Tax is discussed in
Lesson 20.
He cannot deduct any part of the NOL remaining after the twenty (20) year
carry forward period; fifteen (15) year carry forward period for pre-1998
NOLs.
To make this choice, attach a statement to the original return filed by the
due date, including extensions, for the NOL year. This statement must show
that the taxpayer is choosing to waive the carry back period under section
172(b)(3) of the Internal Revenue Code.
If the taxpayer filed his return timely but did not file the statement with it, he
must file the statement with an amended return for the NOL year within six
(6) months of the due date of the original return, excluding extensions.
Enter "Filed pursuant to section 301.9100-2" at the top of the statement.
343

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INCOME

Once the taxpayer chooses to waive the carry back period, it is irrevocable. If
he chooses to waive the carry back period for more than one NOL, he must
make a separate choice and attach a separate statement for each NOL year.
If the taxpayer does not file this statement on time, he cannot waive the
carry back period.
Deducting a Carry Back
If you carry back the NOL, you can use either Form 1045 or Form 1040X Amended U.S. Individual Income Tax Return. The taxpayer can get his refund
faster by using Form 1045, but you have a shorter time to file it.
The taxpayer must file Form 1045 on or after the date he files his tax return
for the NOL year, but not later than one year after the NOL year, i.e. no later
than December 31st. If the last day of the year falls on a Saturday, Sunday,
or holiday, the form will be considered timely if postmarked on the next
business day.
You can use one (1) Form 1045 to apply an NOL to ALL carry back years. If
you use Form 1040X, you must use a separate Form 1040X for each carry
back year to which you apply the NOL.
Form 1045 results in a tentative adjustment of tax in the carry back year(s). If
the IRS refunds or credits an amount to the taxpayer from Form 1045 and
later determines that the refund or credit is too much, the IRS may assess
and collect the excess immediately.
If the taxpayer does not file Form 1045, he can file Form 1040X to get a
refund of tax due to an NOL carry back. File Form 1040X within three (3)
years after the due date, including extensions, for filing the return for the
NOL year. Be sure to attach a computation of the NOL using Schedule A
(Form 1045) and, if it applies, the NOL carryover using Schedule B (Form
1045).
Deducting a Carry Forward
If you carry forward the taxpayers NOL to a tax year after the NOL year, list
the NOL deduction as a negative figure on the Other income line of Form
1040 (line 21), or Form 1040NR (line 21).
You must attach a statement that shows all the important facts about the
NOL. The statement should include a computation showing how you
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figured the NOL deduction. If the taxpayer deducts more than one NOL in
the same year, the statement must cover each of them.
Change in Marital Status
If the taxpayer and spouse were not married to each other in all years
involved in figuring NOL carry backs and carryovers, only the spouse who
had the loss can take the NOL deduction. If they file a joint return, the NOL
deduction is limited to the income of that spouse.
If the taxpayer is not married in the NOL year (or is married to a different
spouse), and in the carry back year he was married and filed a joint return,
his refund for the overpaid joint tax may be limited. He can claim a refund
for the difference between his share of the refigured tax and his
contribution toward the tax paid on the joint return. The refund cannot be
more than the joint overpayment. Attach a statement showing how you
figured the refund.

"Going Out of Business" Checklist


Why do small businesses close? Declining consumer spending due to
massive layoffs and lack of confidence in the economy, credit constraints,
and foreclosures are only part of the increasing pressure that will probably
lead to record numbers of business failures, closures and bankruptcy in the
next few years.
Causes of Small Business failures
According to the U.S Small Business Administration, approximately half of
the small businesses started in the United States fail within the first five
years. Ninety-one percent will fail within the first ten years. The principle
reasons for small business failures include:

Lack of experience
Over-investment in fixed assets
Insufficient capital
Selecting a bad location
Poor inventory management and control
Insufficient credit arrangements
Using business funds to pay personal expenses
Unexpectedly fast growth
Competition
Absence of a comprehensive written business plan
345

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INCOME

Use the checklist below to advise clients that are going out of business:
IF the taxpayer THEN he may need to:
is liable for:
Income Tax

File Schedule C or C-EZ with your Form


1040 for the year in which you go out of
business.

File Form 4797 with your Form 1040 for


each year in which you sell or exchange
property used in your business or in which
the business use of certain Section 179 or
Listed Property drops to 50% or less.

File Form 8594 with your Form 1040 if you


sold your business.

SelfEmployment
Taxes

File Schedule SE with your Form 1040 for


the year in which you go out of business.

Employment
Taxes

File Form 941 (or Form 944) for the calendar


quarter in which you make final wage
payments. Note: Do not forget to check the
box and enter the date final wages were
paid on line 18 of Form 941 or line 17 of
Form 944.

File Form 940 for the calendar year in which


final wages were paid. Note: Do not forget
to check box d, Business closed or stopped
paying wages, under Type of Return.

Provide Forms W-2 to your employees for


the calendar year in which you make final
wage payments. Note: These forms are
generally due by the due date of your final
Form 941 or Form 944.

File Form W-3 with the Forms W-2. Note.

Information
Returns

346

LESSON

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INCOME

IF the taxpayer THEN he may need to:


is liable for:
These forms are generally due within 1
month after the due date of your final Form
941 or Form 944.

Provide Forms 1099-MISC to each person


to whom you have paid at least $600 for
services (including parts and materials)
during the calendar year in which you go
out of business.

File Form 1096 with the Forms 1099-MISC.

Further information about closing a business is available at:


http://www.irs.gov/businesses/small/article/0,,id=98703,00.html

Summary of Employment Taxes and Forms


Below is a Summary of Employment Taxes and Forms:

Tax
FUTA

Form
940, 940-EZ

FICA

941

FIT

Depositing
Employment Tax

Send
Form
To
IRS

Additional
Forms
Required
8109

Due Date
January
31st
One month
after end of
reporting
quarter

Payer
Employer
Employer and
employee
(through FICA
withholding
and matching)

IRS

8109, W-2,
W-3

941

One month
after end of
reporting
quarter

Employer
withholds FIT
from
employees'
pay

IRS

8109, W-2,
W-3

8109

On dates
determined
by
depositor
status

Employer

Federal Reserve
Bank or authorized
financial institution

Table B - Information and Request Forms

347

LESSON

Tax

SELF

Form

EMPLOYMENT

Due Date
Important
Dates
Send a
copy to
employees
by Jan. 31
after
reporting
year

Form
W-2

Purpose
Summary of
income and
withholding
information
on one
employee for
one calendar
year

W-3

Summary of
information
from all
Forms W-2
for one year;
attach Copy
A of each
Form W-2

File by last
day of Feb.
after
reporting
year

SS-4

Use to obtain
an employer
identification
number (EIN)
for your
business

Apply for
an EIN
when you
start up
your
business

INCOME

Payer
File With
Employees
(copies to
Social Security
Administration)

Social Security
Administration

IRS

Send
Form
To

Additional
Forms
Required

Penalties for Late


Filing?
Yes

Yes

An EIN must be
included on all
employment tax
returns.

General Business Credits


A taxpayer's general business credit for the year consists of the carry
forward of business credits from prior years plus the total of the current year
business credits. In addition, the general business credit for the current year
may be increased later by the carry back of business credits from later years.
How to Claim the Credit
To claim a general business credit, complete the form(s) needed to claim
the current year business credit(s). In addition to the credit form, in most
cases you will need to file Form 3800 - General Business Credit.

348

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INCOME

The table below shows the tax credits that are available to businesses:
Tax Credit
Alternative Motor
Vehicle Credit

Description
Credit for purchase
of new (not used)
qualified
alternative motor
vehicle (typically
hybrid vehicles).

Child Care
Facility

Employer credit for


expenses paid for
employee
childcare. Credit
limit is $150,000.

Disabled Access

Credit for
expenses incurred
to provide access
to persons with
disabilities to
comply with the
Americans with
Disabilities Act of
1990.
Wage payments to
military personnel

Differential Wage
Credit

Distilled Spirits

Electric Vehicle
Credits

Credit for qualified


distillers importers
and wholesalers of
distilled spirits
subject to excise
tax.
Plug-in vehicle
credit
Electric drive
vehicle

Amount
Varies by make,
model and year.
Subject to
manufacturer phaseout after 60,000
vehicles are sold.
Credit ranges from
$250 to $4,000.
25% of qualified
employee child care
expense. 10% of
qualified expenses
paid for child
resource and referral
service.
50% of eligible
access expenses that
exceed $250 but do
not exceed $10,250.

20% of eligible
payments to
employee on active
duty. Limit is $20,000
per employee.
Cases purchased or
stored times the
average tax financing
cost per case.

10% of vehicle cost to


a maximum of
$2,500.
$2,500 plus $417 per
kilowatt hour of
traction battery
capacity over four
kilowatt hours.
Maximum: $7,500$15,000 depending
on GVWR.

349

IRS
Pub.

IRS
Form
8910
8911

8882

334

8826

15

8932

8906

8834

8936

LESSON

Tax Credit
Employer paid
FICA on tips

Empowerment
Zone &
Renewable
Community

Energy Efficient
Home and
Appliances

Fuel Credits

Health Insurance

Indian
Employment

Investment:
Rehabilitation
Property
Investment:
Energy

Investment:
Reforestation

SELF

EMPLOYMENT

Description
Credit equal to the
FICA paid by the
employer on tips
received by
employees of food
and beverage
establishments.
Credits for hiring in
distressed areas or
hiring the
underemployed.

Credits for
purchasing an
energy efficient
home or
appliances.
Bio-diesel; low
sulfur; alcohol.

For employers
contributions to
employees health
insurance.
Non-refundable
credit for wages
and health
insurance for hiring
members of Indian
tribes or their
spouses.
Applies to
expenses to
rehabilitate certain
buildings.
Expenses for solar
or geothermal
energy property
placed in service
this tax year.
Credit for part of
expenses to forest
or reforest

INCOME

Amount
100% of eligible
amounts.

IRS
Pub.
334

20% wage credit on


the first $15,000 of
annual wages of
residents in the
empowerment zone.
15% wage credit on
the first $10,000 of
annual wages of
residents in the
Renewable
Community.
Home: up to $2,000.
Appliances: varies by
appliance.

Various credits for the


production and use of
alternative fuels.

IRS
Form
8846

8844

8908
8909

See
Chapter
2 of
Pub.
510

35% of the lesser of


employer contributions, or a preset
amount set by HHS.
20% wage credit on
the first $20,000 of
qualified annual
wages over what was
paid in 1993.

8864;
6478;
8896;
8907.
8941

8845

10% for pre-1936


buildings; 20% for
historic structures.

334;
535

3468

10% of basis.

334;
535.

3468

10% of amortizable
basis.

334;
535.

3468

350

LESSON

SELF

EMPLOYMENT

INCOME

Tax Credit

Description
property.

Amount

Low-Income
Housing

Qualified lowincome housing


placed in service
after 1986.
Credit for
investments in lowincome
communities.

Percentage of
qualified building
basis over 10 years.

New Markets

Pension Plan
Start-up

Railroad Track
Maintenance

Renewable
Electricity
Production
Research
Activities
Work
Opportunity

Credit given to
small employers to
establish and
maintain employee
retirement savings
accounts.
Credit for certain
expenses to
upgrade and
maintain certain
railroad tracks.
Sellers of electricity
for the 10 years
after the facility is
placed in service.
Incentive to
increase research
activities.
Incentive to hire
individuals from
targeted groups
that have high
unemployment.

IRS
Pub.
334

IRS
Form
8586

5% of the investment
in a CDE for 1st 3
allowance dates; 6%
for the next 4
allowance dates.
Total credit limited to
39% of the
investment.
50% of program start
up costs with a $500
credit limit.

8874

50% of qualified
expenses up to a
maximum of $3,500
per mile of track.

8900

1.5 to 1.8 cents per


kilowatt hour sold;
plus inflation
adjustment factor.

40% of first $6,000 of


first year wages.
($3,000 for summer
youth help). 25% for
those meeting only
minimum
employment levels.
$10,000 for long-term
family assistance.
$12,000 for qualified
veterans.

351

8881

334

8835

334

6765

5884;
8850.

LESSON

SELF

EMPLOYMENT

INCOME

SIDE BAR

IRS Publications for Business Reference


An alphabetical listing of all IRS Publications for Business can be viewed at
Appendix J.

Business Tax Return Due Dates


Below are the due dates of the various business and entity income tax
returns.
Due Date for
Fiscal Year Filers
Tax Return
Form 706:
Estate Tax
Form 709:

(1)

9 months after the


date of the
decedent's death.

Due Date for


Calendar Year
(1)
Filers
N/A

Extension
Form 4768 for a
six month
extension.

15th day of the 4th


month following the
year of the gift.

April 15th

Form 4868 for a


four month
extension.

15th day of the 5th


month following the
close of the tax
year.

May 15th

15th day of the 4th


month following the
close of the tax
year.
15th day of the 4th
month following
close of the tax
year.

April 15th

Form 8868 Part I


for a three month
extension; six
months for Form
990-T. Form 8868
Part II for an
additional three
month extension.
Form 7004 for a
six month
extension.

April 15th

Form 7004 for a


six month
extension.

15th day of the 3rd


month following the
close of the tax
year.

March 15th

Form 7004 for a


six month
extension.

March 15th

S-Corporations &
LLCs taxed as SCorps

15th day of the 3rd


month following the
close of the tax
year.

Form 7004 for a


six month
extension.

Forms 5500:

Last day of the 7th

July 31st

Form 5558 for a

Gift Tax
Form 990:
Exempt
Organizations

Form 1041:
Estates & Trusts
Form 1065:
Partnerships &
LLCs taxed as
Partnerships
Form 1120:
Corporations &
LLCs taxed as
Corps
Forms 1120S:

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EMPLOYMENT

Due Date for


Fiscal Year Filers
Tax Return
Employee Benefit
Plans

(1)

INCOME

Due Date for


Calendar Year
(1)
Filers

month following the


close of the tax
year.

Extension
two and one half
month extension.

(1) The above dates are the dates the returns are ordinarily due. The dates may
vary in any given year due to Saturdays, Sundays, and Holidays. Check your
calendar or click here the link below:
IRS Publication 509 - Tax Calendars

SIDE BAR

Should sole proprietors and partners have business life insurance?


Probably. Sole proprietors and partners are personally liable for all of the
debts of the business. The debts of the business may include:

Business loans
Employment taxes
Fees due lawyers and accountants
Lease payments on business facilities
Mortgage balance on business facilities
Mortgage payments on business facilities
Payments due to vendors and suppliers
Sales taxes
Wages due to employees

A sole proprietorship or partnership dies when an owner dies. Any


financial obligations due at the time of the sole proprietors or partners
death become a liability of his or her estate. It is possible that the sole
proprietor's or partners personal assets may have to be sold to pay off
any business debts. Life insurance can be used to cover these debts.
Premium payments for business life insurance on the life of a sole
proprietor or partner are not tax deductible, buy any death proceeds are
income tax free.

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Lesson Summary
This lesson explained how to complete Parts I, II, and III of Schedule C-EZ,
Net Profit From Business.
The flowchart at the top of Part I is used to determine whether the taxpayer
is eligible to use this form instead of Schedule C for reporting selfemployment income. The rest of Part I is for general information about the
taxpayer's business.
Part II is used to enter gross receipts and total expenses, and to calculate
the net profit. If the profit is more than zero, the taxpayer must also file
Schedule SE. If there is a net loss, then the taxpayer must file Schedule C
instead of Schedule C-EZ.
Part III should be completed only if the taxpayer is claiming car and truck
expenses in Part II.
This lesson also explained who is required to pay self-employment tax and
how to report the tax on Schedule SE, Self-Employment Tax.
Self-employment tax is social security tax and Medicare tax for persons who
work for themselves. Generally, taxpayers must file Schedule SE if they have
either net earnings from self-employment of $400 or more, other than
church employee income, or Church employee income of $108.28 or more.
The cost of certain property used for the production of income is recovered
by an annual deduction called depreciation. Taxpayers should claim the
correct amount of depreciation every year. If they don't, they still must
reduce their basis in the property by the amount of depreciation that they
could have deducted.
Depreciable property includes buildings, machinery, furniture, equipment,
vehicles, and any cost for additions or improvements to the rental property.
(The value of land is not depreciable.)
Generally, the cost of the property including the cost of improvements is the
basis for depreciation. A property's depreciation deduction is prorated in
the year it is placed in service.
Each item of depreciable property is assigned to a property class, which is
based on class life. Property classes determine a property's recovery period.
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INCOME

Section 179 allows businesses to immediately deduct the cost of certain


types of property as an expense, rather than requiring the property to be
depreciated.
The IRS defines a hobby as an activity that the taxpayer pursues without
expecting to make a taxable profit - such as coin or stamp collecting - as
opposed to setting up a dealership. Taxpayers must include hobby income
on their tax returns.
The IRS assumes the taxpayer is trying to make a taxable profit if he actually
made money in at least three (3) years of the past five (5) years, including
the current year.
If, in the early years, the IRS tries to disallow tax losses, taxpayers may make
an election on Form 5213 - Election To Postpone Determination as To
Whether the Presumption Applies That an Activity Is Engaged in for Profit to
postpone the determination of whether the above tests apply.
A profitable sale of a hobby collection, such as stamps or coins, is taxable as
a capital gain. A loss upon the sale of a hobby collection is not tax
deductible.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify you're understanding of the
most important lesson content, and will also help you pass the
Final Exam.
Do the Homework - While completing the homework is not
mandatory, we strongly recommend that you complete each
lesson's homework assignment. It will expand your knowledge
and understanding of the topics covered in this course.

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Lesson

10
Lesson 10 - Sale of Investment
Property
In this lesson you'll learn about how the sale of investment property is treated
for tax purposes. This lesson is designed to teach tax preparers how to
determine capital gain and loss on the sale of investment assets, use Schedule
D - Capital Gains and Losses to figure the tax, and calculate capital loss
carryovers. You'll learn how to determine the gain or loss on the sale of these
asset The following topics are discussed in this lesson:.
Required Data for Form 8949
and Schedule D
Stock Fundamentals
Capital Assets
Capital Gain Distributions
When Do You Need To File
Schedule D
Basis of Stock
Adjusted Basis
Holding Period - Long or
Short Term
Blocks of Stock
Tax-Free Stock Dividends and
Splits
Taxable Dividends
Demutualization
Wash Sales
356

Form 1099-B
Determining the Basis
Reporting Form 1099-B
Information
1099 Consolidated
Statements
Schedule D
Reporting Stock Gains or
Losses
Reporting Other Gains
Capital Loss Carryovers
Deducting Worthless
Securities
Like-Kind Exchanges
Like-Kind Property

LESSON

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orm 8949 - Sales and Other Dispositions of Capital Assets is used for
reporting capital gains and losses from the sale of investment
property. The totals are then transferred to Schedule D - Capital Gains
and Losses. Form 8949 requires the following taxpayer records:

Form 1099-B - Proceeds From Broker and Barter Exchange


Transactions or a 1099 Consolidated Statement provided by the
broker to report the sales price of stock

Figure 10-1: Form 1099-B - Proceeds From Broker and Barter Exchange Transactions.

Records of the taxpayer's basis in the investment property sold

Records of the date the taxpayer originally acquired the investment


property

Capital Loss Carryover Worksheet from last year's tax return, if the
taxpayer is carrying over a loss

The IRS receives copies of Form 1099-B from the broker and copies of Form
1099-DIV from the payer.

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Figure 10-2: Form 1099-DIV - Dividends and Distributions.

Taxpayers should not file these items with the return; instead, they should
keep them with their records.

SIDE BAR

Where to Report Investment Income


To obtain your copy of our publication "Where to Report Investment
Income" see Appendix H or click here.
The table below shows the maximum tax rates on the different types of
investment income:
and the asset is
held...

then the
maximum
tax rate is

Gain from the sale of collectibles

More than 1 year

28%

Taxable portion of gain on qualified small


business stock (Section 1202 exclusion)
Un-recaptured Section 1250 gain

More than 5 years

28%

More than 1 year

25%

If the income is...


Capital Gains

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Long-term capital gain for taxpayers


subject to a regular tax rate of 39.6%
Long-term capital gain for taxpayers
subject to a regular tax rate of > 15% and
< 39.6%
Long-term capital gain for taxpayers
subject to a regular tax rate of 10% or 15
%

More than 1 year

then the
maximum
tax rate is
20%

More than 1 year

15%

More than 1 year

0%

Short term capital gain

One year or less

39.6%

60 days or more

20%

60 days or more

15%

60 days or more

0%

Less than 60 days

39.6%

and the asset is


held...

If the income is...

Dividends
Qualified dividend income for taxpayers
subject to a regular tax rate of 39.6%
Qualified dividend income for taxpayers
subject to a regular tax rate of > 15% and
< 39.6%
Qualified dividend income for taxpayers
subject to a regular tax rate of 10% or
15%
Ordinary Dividend income

Stock Fundamentals
This topic explains some fundamental terms and concepts related to the
sale of stock or other investment property.

TAX QUOTE

"Income tax returns are the most imaginative fiction being written today."
Herman Wouk
Capital Assets
A capital asset is any asset held either for personal use (personal property)
or for investment. For example:

Personal property includes a taxpayer's home and car


Investment property includes stocks and bonds
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The only capital asset discussed in this lesson is corporate stock. Property
used in a trade or business, such as inventory or machinery, is not a capital
asset.

TAX TIP

Day Traders
Day traders can get the tax benefits of doing a "mark-to-market" election
which allows them to disregard the wash sale rules (explained below) and
to deduct more than $3,000 in capital losses a year on their tax return.
They can also deduct regular business expenses. One big disadvantage:
Day traders ordinarily cannot use the long term capital gains tax rates
because they are not investors. They are operating a business. Further
information is at the end of this Lesson.
Capital Gain Distributions
Capital gain distributions occur when a mutual fund or other entity that
owns a capital asset sells the asset and passes the gain on to its
shareholders. Taxpayers who have received only capital gain distributions
from mutual funds generally do not need to file Schedule D.

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Figure 10-3: Form 1099-DIV - Dividends and Distributions with box 2a "Total capital
gain distr." highlighted.

SIDE BAR

What are mutual funds?


Mutual funds are pools of securities. The mutual fund owns the securities
in the pool and investors in turn own shares of the mutual fund. Mutual
funds invest in a variety of securities, including common stocks, corporate
and government bonds, and money market instruments.
Investors hope to derive profits from both appreciation in the value of
the mutual fund shares (caused by any appreciation in the value of the
underlying securities that the mutual fund holds) and from distributions
of income such as dividends, interest, and long-term capital gains. Mutual
funds distribute both the dividends it receives from the underlying
securities it holds and capital gains on any securities it sells for a profit.
Short-term capital gains are passed on to shareholders as a dividend.
Long-term capital gains are reported separately as capital gains
distributions.

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What are the different types of mutual funds?


Equity Funds

Fixed Income Funds

Aggressive Growth
Balanced
Country/Regional
Emerging Market
Global
Growth
Growth and Income
International
Sector
Small Cap

Government Agency
High Yield
International Bond
Long-Term Corporate
Long-Term Government
Money Market
Mortgage Backed
Short-Term Bond
Tax-Advantaged
Tax-Advantaged Money
Market

TAX PLANNING TIP

Delay Mutual Fund Purchases


The later in the year that a taxpayer purchases a mutual fund the more
likely it is that he or she will receive capital gains distributions on shares
they didnt own except for a short time during the year. If they buy shares
just before the ex-dividend date, they'll get back part of the money they
just invested and owe taxes on it. This is true even if they dont actually
receive the money and automatically reinvest it in additional shares.
Check the mutual funds distribution schedule and if it's late in the year
have the taxpayer wait until after the ex-dividend date to buy into the
fund - assuming market conditions are favorable for waiting.
Index Funds
Index funds are mutual funds and exchange traded funds in which the
investment objective is to mirror the performance in a particular index,
such as the Dow Jones Industrials Average or the Standard & Poor's 500.
Investing in an index fund instead of a diversified mutual fund can save
taxes because index funds dont sell their portfolio shares as often as
mutual funds. Generally, index finds only buy and sell shares when they
have to re-align with the index, which is ordinarily once per year. The
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result will usually be a lower amount of capital gains to report.

Where to Report Gains and Losses


The table below shows where to report gains and losses:
If you sold...
Stocks, Bonds, Mutual
Fund shares, or land
held for investment
purposes
Accounts or Notes
receivable acquired in
the ordinary course of
business or from sales
of inventory or property
held for sale to
customers. Inventory of
a business held for sale
to customers.

Depreciable: residential
rental property, cars,
trucks, computers,
machines, fixtures,
equipment, used in your
business.

Personal residence,
autos, jewelry, furniture,
art, coin or stamp
collections, held for
personal use.

Your gain
is...
Capital Gain.
See Holding
Periods.

Your loss is...


Capital Loss. See
Holding Periods.

Ordinary
income.

Ordinary loss.

IRC section
1231
determines
whether the
gain is
ordinary
income or
capital gain.
Capital Gain.
See Holding
Periods.

Ordinary loss if
there is a net
IRC section 1231
loss.

363

Not tax
deductible.
Although profits
are taxable,
losses are not
tax deductible.

Report it
on...
Form 8949,
Schedule D,
Form 1040.
Form 1040,
Schedule C
if selfemployed;
Schedule F if
a farmer;
Form 1065 if
a
partnership;
Form
1120/1120-S
for a
corporation.
Form 1040,
Form 4797

Form 8949,
Schedule D,
Form 1040.

LESSON

10

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PROPERTY

When Do You Need To File Form 8949 and Schedule D


Taxpayers who sold stocks:

Will receive Form 1099-B from the broker, and


Must file Form 1040, Form 8949 and Schedule D, and
Cannot report their capital gain distributions on Form 1040A

Basis of Stock
One piece of information taxpayers must provide for Schedule D is their
basis in the property.
The basis of property is usually its cost plus certain additional costs relating
to the property's purchase. If taxpayers cannot provide their basis in the
property, the IRS will deem it to be zero.
An example of an expense included in the basis of stock is the commission
or fee paid to a broker when stock is purchased.
Adjusted Basis
Events after purchase can require adjustments - increases or decreases to
the basis of property.
For example, when a stock dividend or stock split is declared, the
stockholder receives additional shares of stock. Some of the basis from the
original stock is then allocated to the new stock. This change reduces the
basis per share of the original shares. The adjustment may also include an
additional commission or fee paid to the broker.

TAX PLANNING TIP

What is the difference between "stepped up" basis and "carryover"


basis?
These are estate tax terms which we discuss in more detail in Lesson 29.
In the case of stocks and bonds, basis equals the purchase price of the
stocks and bonds. In the case of real estate, basis equals the purchase
price plus the value of all capital improvements."
Stepped up" basis means that, regardless of what a decedent paid for the
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property, the heir's basis in the property is its fair market value on the
decedent's date of death. Thus, any pre-death appreciation in the
underlying value of the asset is received tax free."
Carryover basis means that the heir's basis in the property is the same as
the decedent's basis.
There is an optional valuation date that can be elected by the executor or
administrator of the estate, which is nine (9) months after the decedent's
date of death.
When a beneficiary sells inherited property any post-death gain is treated
as a long term capital gain or loss, regardless of whether or not the
beneficiary held the property for one year or less after inheriting it. See
below.

TAX TIP

Property Owned Jointly With Someone Other Than A Spouse


If a taxpayer owns property jointly with someone other than his or her
spouse, and the joint owner dies, then the surviving taxpayers basis will
be his or her original basis on his or her share increased by the deceased
owner's portion of the value of the property on the decedents date of
death.

Holding Period - Long-Term or Short-Term


Schedule D classifies capital gains and losses as either long-term or shortterm, depending on how long the taxpayer owned the stock. Stock held for
more than one year has a long-term holding period. Stock held for one year
or less has a short-term holding period.
The table below shows where to report gains:
Asset Held for...
Your capital gain is...
Short term. Report this on Form 8949 Part I. The
One year or less
totals transfer to Schedule D.
Long term. Report this on Form 8949 Part II. The
More than one year
totals transfer to Schedule D.
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The table below shows when the holding periods for different types of
assets start:
Type of Asset:
Stocks and Bonds bought on a
securities exchange.

U.S Treasury Notes and Bonds

Non-taxable exchanges
Gifts

Real Property
Real Property (repossessed)

When the holding period starts:


The day after the trade date you
bought the security. Ends on the
trade date you sold the security. The
purchase trade date is not included
in the holding period, but the sale
trade date is included in the holding
period.
If bought at auction, the day after
notification of bid acceptance. If
bought through subscription, the
day after the subscription was
submitted.
The day after date you acquired the
old property.
If your basis is the giver's adjusted
basis, same day as giver's holding
period began. If your basis is Fair
Market Value (FMV), the day after
the date of the gift.
Generally, the day after the date you
received title to the property.
The day after the date you originally
received title to the property, but
does not include the time between
the original sale and date of
repossession.

Blocks of Stock
Some taxpayers may own shares of stock they bought on different dates or
for different prices. This means they own more than one block of stock. Each
block may differ from the others in its holding period, its basis, or both. In
directing a broker to sell stock, the taxpayer may specify which block, or part
of a block, to sell. If the taxpayer does not identify the specific block at the

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time of sale, shares sold are treated as coming from the earliest block
purchased.
Specification can make a difference in determining the holding period or
basis of the stock sold, giving the taxpayer an element of control and
versatility in handling an investment. Any such specification must be made
before or at the time of sale. It cannot be made after the sale, such as on the
day the taxpayer is have his tax return prepared.

Tax-Free Stock Dividends and Stock Splits


When taxpayers receive stock in a stock dividend or split there is nothing to
report on their tax return if they don't sell any of the stock.
Apportion their cost basis of the old stock to both the old stock and the
new stock received in the stock split or dividend.
Stock acquired in a tax-free stock dividend or stock split has the same
holding period as the original stock owned. If the original stock has a longterm holding period, stock received in a tax-free stock dividend also has a
long-term holding period. If the original stock has a holding period of three
months, the new stock immediately has a three-month holding period.
Although stock splits and stock dividends do not occur often, you should
not assume they never happen. Ask taxpayers if they received any additional
shares from a stock split or stock dividend.

Taxable Dividends
Stock acquired in a taxable dividend does not always have the same holding
period as the original stock. One example is a dividend reinvestment plan,
which uses the dividends to purchase more shares of the stock. The stock
shares acquired through the dividend reinvestment plan are added to the
taxpayer's basis at fair market value on the date of reinvestment. This means
the new shares could have a different holding period than the original stock.
If taxpayers do not know the basis of their stock shares, refer them to their
stockbroker or financial planner.

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TAX TIP

What are DRIPs?


DRIPs are Dividend Reinvestment Programs offered by some companies.
DRIPs automatically reinvest a shareholder's dividends in additional
shares of the company, often without incurring a brokerage commission.
In some cases the DRIP may provide the additional shares at a discount
to the current market price. Regardless of the fact that the dividends were
reinvested, they are taxable income in the year constructively received. It's
as if the company mailed the shareholder a dividend check and the
shareholder endorsed the check and mailed it back to the company to
buy additional shares.

Demutualization
Some taxpayers have been informed by their mutual insurance company
that the company has been demutualized. When this happens, the
policyholder receives either a block of stock or the cash equivalent of
company stock.
The holding period for such stock is the length of time the policy was in
effect, usually many years.
The basis for this stock is zero. The taxpayer must report all of the proceeds
as a capital gain on Schedule D.

Wash Sales
Generally, a wash sale occurs when stock is sold and, within 30 days before
or after the sale, substantially identical stock is bought. A loss on a wash sale
is not deductible, and special rules relate to the basis of the replacement
stock. A gain on a wash sale must be reported.

SIDE BAR

What is market timing?


Market timing is a stock market strategy in which investors attempt to
identify the best times to be in and out of the market. Market timing
relies on technical stock market analysis using stock and index charts and
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a few of the several hundred technical indicators and oscillators. By


timing the market investors attempt to "buy low" and "sell high".
When market timing signals are received in close succession, the trades
often result in wash sales.

Form 1099-B
The stockbroker reports the sales price of sold stock shares in box 2 of Form
1099-B, Proceeds From Broker and Barter Exchange Transactions.
Brokers who report the gross proceeds as the sales price do not subtract
commissions and fees.
Brokers who report the net proceeds as the sales price do subtract
commissions and fees from the gross proceeds. The broker checks the
appropriate square at the right of box 2 to indicate whether the gross or net
proceeds were reported to the IRS.

Figure 10-4: Form 1099-B - Proceeds From Broker and Barter Exchange Transactions with
box 2a "Reported to IRS" highlighted.

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Determining the Basis of Stock


How you determine the taxpayer's capital gain from the sold shares
depends on how the broker reported the sales price on Form 1099-B:

If box 2 shows gross proceeds, you need to increase the taxpayers


basis in the stock by the sales commission.

If box 2 shows net proceeds, the broker already subtracted the


commissions and fees, so you do not need to make any adjustments.

TAX PLANNING TIP

Give Appreciated Stock to Charity Sell the Losers


If the taxpayer is thinking about making a gift to a charity and has some
appreciated stock that hes owned for over a year he should consider
donating the shares to charity. Generally, he can claim an itemized
charitable contribution deduction (see Lesson 19) for the full market value
of the stock at the time of the donation - and hell avoid any capital gains
tax.
Taxpayers must give the shares of stock directly to the charity. Don't sell
the stock and give the cash proceeds to the charity.
Conversely, taxpayers shouldnt donate stock with a loss. Their charitable
contribution deduction is limited to the property's fair market value at the
time of the donation. They should sell the shares, take the capital loss on
their tax return, and give the cash proceeds to the charity. That way theyll
write off the full amount of the cash donation while keeping the taxsaving capital loss. Incidentally, when a charity receives a donation of
stock on which the donor had a capital loss, the charity doesnt get to
utilize the capital loss either.
Generally, taxpayers can deduct up to 50 percent of their Adjusted Gross
Income (AGI) for gifts of cash to charities. However, there can be
limitations of 30% or 20% of AGI on the amount they can claim for
contributions of appreciated assets. Since these taxpayers are probably
giving large sums of money to charities a good tax and estate attorney
should probably be consulted.
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Reporting Form 1099-B Information - Where


the Data Goes
Information from Form 1099-B is entered on Form 8949 and it then
transfers to Schedule D and Form 1040. Parts I of Form 8949 and Schedule
D are for short-term holdings.
Parts I are for short-term holdings.

Figure 10-5(a): Form 8949 - Sales and Other Dispositions of Capital Assets Part I Short-Term Capital Gains and Losses - Assets Held One Year or Less.

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Figure 10-5(b): Form 1040 Schedule D - Capital Gains and Losses Part I - Short-Term
Capital Gains and Losses - Assets Held One Year or Less.

Parts II are for long-term holdings.

Figure 10-6(a): Form 8949 - Sales and Other Dispositions of Capital Assets Part II - LongTerm Capital Gains and Losses - Assets Held More Than One Year.

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Figure 10-6(b): Form 1040 Schedule D - Capital Gains and Losses Part II - Long-Term
Capital Gains and Losses - Assets Held More Than One Year.

The table below shows where to report the information on Form 1099-B:
IF Form 1099-B shows
THEN report it on:
information in:
Form 8949, column (d). Either Part I,
Box 1a, Date Sold
line 1, or Part II, line 3
Box 2, Sales Price reported to the
Form 8949, column (e). Either Part I,
IRS (gross or net proceeds)
line 1, or Part II, line 3
Box 4, Federal Income Tax Withheld Form 1040, line 62
Form 8949, column (a). Either Part I,
Box 7, Description of Property Sold
line 1, or Part II, line 3
If Form 1099-B does not include the date the taxpayer purchased the stock
or how much the taxpayer paid for it then the taxpayer must provide you
with this information.

TAX QUOTE

"America is a land of taxation that was founded to avoid taxation."


Dr. Laurence J. Peter

1099 Consolidated Statements


Some brokers do not issue standard Forms 1099-B. Instead they issue a
statement, sometimes entitled "A 1099 Consolidated Statement," which
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shows stock sales and other types of distributions, such as dividends and
interest.

TAX TIP

Which stocks should taxpayers sell to offset short-term gains?


Theyll get the most tax savings with a short- term loss because shortterm losses first go to offset short-term gains that would otherwise be
taxed at the taxpayers regular income tax rate which can be as high as
39.6% - and then they go to offset long-term 20% gains.
Taxpayers can further reduce taxes by telling their stock broker to sell
their highest cost basis shares first. Using this method requires the
taxpayer or broker to identify the shares to be sold by specifying their
cost and purchase dates. The taxpayer must also receive a written
confirmation of their instructions from the broker, or keep a record of
their oral instructions in their tax file.
If taxpayers don't follow this procedure, they must use the first-in, firstout (FIFO) method, meaning the shares they bought first are considered
sold first. Those are the shares most likely to have the largest capital gains
and tax hit.
If the taxpayer has both gains and losses in his stock portfolio which
ones should he sell first?
First, sell the long-term winners - stock held for over 12 months. Hell
benefit from the 20% maximum long-term capital gains rate.

Schedule D - Outline of the Three Parts


Form 1040 Schedule D - Capital Gains and Losses is used to report gain or
loss on the sale of investment property and other capital gain distributions.
Schedule D is divided into three parts:
Part I, Short-Term Capital Gains and Losses, for assets held one year or less.
Part II, Long-Term Capital Gains and Losses, for assets held more than one
year.
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Part III, Taxable Gain or Deductible Loss. Part III also identifies the portion of
gains subject to the 28% tax rate.

Figure 10-7: Form 1040 Schedule D - Capital Gains and Losses Part III - Summary.

The 28% rate applies to gains from the sale or exchange of qualified small
business stock and to collectibles, referred to as Section 1202 gains.

Reporting Stock Gains or Losses


The taxpayer should receive Form 1099-B or a 1099 Consolidated Statement
for each sale of investment property. Figure the gain or loss by subtracting
the adjusted basis of stock sold from its sales price.
If the sales price is greater, the taxpayer has gain on the sale. If the adjusted
basis is greater than the sales price, the taxpayer has a loss on the sale.
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TAX PRACTICE TIP

No Records of a Stock Purchase


If the taxpayer sells inherited stock he won't need to look to far for
original purchase records as his basis is the fair market value of the stock
on the decedents date of death. If the stock isn't inherited and the
taxpayer has no records of the original purchase then you should contact
a stock broker. The issue (purchase) date appears on the stock certificate.

TAX TIP

Capital Gains of Low Income Taxpayers


This years top capital-gains tax rate of 20% is the second lowest in
decades. Keep in mind that if the taxpayer is in the 10-15% income tax
bracket, his current tax rate for long-term capital gains is 0%. In that case
they are best just claiming the capital gain immediately as it is tax free.
The capital gains tax rate is almost certain to rise as the government
scrambles to pay down the deficit.

Reporting Other Gains


If the taxpayer received Form 1099-DIV - Dividends and Distributions see
whether an amount is shown in box 2a. Box 2a shows capital gain
distributions. Enter the capital gain distributions on Schedule D, Part II, line
13, column (h).

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Figure 10-8: Form 1099-DIV - Dividends and Distributions with box 2a "Total capital gain
distr." highlighted.

If the only capital gains or losses a taxpayer had were capital gain
distributions reported on Form 1099-DIV the taxpayer may not have to use
Schedule D. Refer to the 1099-DIV section of the Income lesson for further
details.

Capital Loss Carryovers


A taxpayer can deduct losses up to the amount of gains. They cancel each
other out. A taxpayer cannot take net losses against other income of more
than $3,000 ($1,500 for married taxpayers filing separately) in figuring
taxable income for the year. The allowable loss is referred to as the
deduction limit. Unused losses are not gone forever. Rather, they are carried
over to the next year. The carryover losses are combined with the gains and
losses that actually occur in that next year. Unused losses are recycled this
way, year after year, until they are all deducted. There is no limit on how
many times a loss can be carried over during the taxpayer's life. However, at
death, any remaining unused carryover losses are cancelled and may not be
deducted by the decedents estate, except for those used on the decedents
final income tax return.

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Divorced and MFS Taxpayers


If a taxpayer and spouse previously filed jointly and are now divorced or
filing separately, any capital loss carryover from the joint tax return may only
be claimed on the separate tax return of the spouse who originally incurred
the loss.
1040 ValuePak will automatically carry over the taxpayers losses from year
to year when you import last years return information into the current
years program.

TAX TIP

Offsetting Capital Gains and Losses


Even though the stock market has gone up substantially from the lows of
March 2009, many investors still have long-term capital losses on
investments theyve held longer than one year. If they have capital gains
they can take losses to offset some of the capital gains by selling losing
investments. If they have capital losses they can take some gains if they
do not need the capital loss deduction this year. Losses offset gains dollar
for dollar, and losses in excess of any gains can be deducted, up to
$3,000 per year against ordinary income.
EXAMPLE: The taxpayer sells his stock for a $60,000 capital loss. If he
doesn't have any capital gains to offset the loss, he can only deduct
$3,000 against other income on his current tax return and the other
$57,000 is carried forward to the next year. At $3,000 per year, it will take
an additional 19 years to fully use the capital loss, unless he has capital
gains in the future to use up the loss.

Deducting Worthless Securities


If the taxpayer owns securities and they become totally worthless the
taxpayer can take a tax deduction for the loss. Stocks and bonds that
became completely worthless during the tax year are treated as though
they were sold for zero dollars on the last day of the tax year. This affects
whether the taxpayers capital loss is long-term or short-term although
most securities do not become worthless in the year they are purchased or
otherwise acquired - so losses from worthless securities are almost always
long-term losses.
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Worthless means of absolutely no value. Just because a company is not


doing very well financially, its shares declined in price, its shares were delisted by the stock exchange or NASDAQ, or the company filed for
bankruptcy protection, does not necessarily mean the securities are
worthless. Be prepared to prove to the IRS that the securities are completely
worthless.
The taxpayer can't take the deduction in any other tax year than the one in
which the securities became completely worthless. If the taxpayer has now
learned that the securities became worthless in a prior tax year for which he
has already filed a return he can file an amended return, Form 1040X, within
seven (7) years of the due date of the original tax return for the tax year in
which the securities became worthless.
The worthless securities are treated as though they were capital assets and
sold on the last day of the tax year if they were capital assets in the
taxpayer's hands. Unless the worthless securities are Internal Revenue Code
Section 1244 stock, for which ordinary loss treatment applies, capital loss
treatment applies.
The taxpayer must show the following in order to take the tax deduction:

The securities became totally worthless in 2015. The taxpayer must


be able to reasonably fix the date they became worthless, such as
the date the company stopped doing business, and

The securities had some value in 2014.

The taxpayer cannot take a deduction for partially worthless securities. If the
securities are partially worthless the taxpayer can sell them and then take
the tax deduction as he would take in an ordinary sale of securities. No tax
deduction can be taken for a partially worthless corporate bond.
Report worthless securities on Form 8949 line 1 or line 3, whichever applies.
In columns (d) write "Worthless."

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TAX TIP

Non-business Bad Debts and Loans to Family Members


Non-business Bad Debts
Non-business bad debts are deductible as a short-term capital loss on
Schedule D in the year the debt becomes totally worthless. You must
describe the loan, the taxpayer's relationship to the debtor, any collection
efforts made, and how the taxpayer determined the debt was worthless
on a separate statement. Taxpayers dont have to wait until maturity to
deduct the bad debt, so long as they can prove that it is completely
worthless.
Loans to Family Members
Loans to family members should always be in writing, just like a loan to
any third party. Taxpayers can obtain loan documents along with other
legal documents at their local office supply store on CD ROM, or online.
Memorializing the agreement in writing will not only avoid bitter family
fights later on when memories have faded, but will also protect the
taxpayer from a subsequent IRS claim that the "loan" was actually a gift
which may be subject to gift tax if the "loan" exceeds the annual gift tax
exclusion of $14,000.
Taxpayers are often reluctant to treat financial transactions with family
members as they would treat the same transaction with a total stranger.
But they should, because conducting business with family members can
leave them in a vulnerable position. Encourage taxpayers to "get it in
writing". Getting it in writing now can avoid a split-up of the family later.

Like-Kind Exchanges
Generally, if you exchange business or investment property solely for
business or investment property of a like-kind, no gain or loss is recognized
under Internal Revenue Code Section 1031. If, as part of the exchange, you
also receive other (not like-kind) property or money (called "boot"), gain is
recognized to the extent of the other property and money received, but a
loss is not recognized.
Section 1031 does not apply to exchanges of inventory, stocks, bonds,
notes, other securities or evidence of indebtedness, or certain other assets.
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Like-Kind Property
Properties are of like-kind, if they are of the same nature or character, even
if they differ in grade or quality. Personal properties of a like class are likekind properties. However, livestock of different sexes are not like-kind
properties. Also, personal property used predominantly in the United States
and personal property used predominantly outside the United States are
not like-kind properties.
Real properties generally are of like-kind, regardless of whether the
properties are improved or unimproved. However, real property in the
United States and real property outside the United States are not like-kind
properties.
Like Class
Gain on an exchange is also not currently taxed if the exchange is "likeclass". A like-class exchange occurs when both properties are in the same
General Asset Class or the same Product Class at the time of transfer.
When Like Kind exchanges are made of depreciable property the basis in
the new property is the same as the basis in the old property.
For further information refer to Publication 544 - Sales and Other
Dispositions of Assets.

TAX TIP

Incentive Stock Options


Employees who receive stock options granted under an incentive stock
option plan or an employee stock purchase plan generally do not include
any amount in their gross taxable income in the year the option is
received or the year the stock is subsequently received as a result of the
grant or exercise of the stock option. However, the stock option spread
may be subject to Alternative Minimum Tax.
However, if the fair market value of the stock for which the stock options
may be exercised in a particular year is greater than $100,000 on the date
of the grant, the excess above $100,000 is taxable income.
Non-qualified stock options may or may not result in taxable income in
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the year received.


Employees generally treat income or loss from the subsequent sale of the
underlying stock obtained from the exercise of the stock option as a
taxable capital gain or loss. In order to take advantage of the favorable
capital gains tax rates employees who receive stock should hold the
shares for at least one year and a day after the Exercise Date at which
time they received the stock. That's when the capital gains clock starts
ticking - not at the time the option was granted. Stock received under an
incentive stock option plan which is sold before one year and a day is
taxed as ordinary income.

TAX PLANNING TIP

Sales of Property to Related Parties


If a taxpayer sells capital assets to a close family member or business that
he owns or controls he may not get the benefits of the lower long term
capital gains tax rates, or he may not be able to deduct his losses.
If a taxpayer sells property to a corporation or partnership of which he
either directly or indirectly has more than 50% control, and the property
is depreciable in the hands of the corporation or partnership, his gain is
taxed as ordinary income instead of as a long term capital gain.
If a taxpayer sells or trades property at a loss, other than as part of a
complete liquidation of a corporation, he can't deduct the loss if the
transaction is directly or indirectly between him and the following related
parties:

members of the taxpayer's family, including his spouse, siblings or


half-siblings, ancestors, or descendants

a partnership or corporation in which he controls more than 50%

a tax-exempt or charitable organization controlled by the taxpayer


or a member of his family

Losses on sales of property between businesses controlled by the same


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owner(s) and some closely related trusts are also disallowed. If the
taxpayer sells multiple properties, some at a gain, and others at a loss, the
gains will be taxable and the losses cannot be used to offset the gains.
Additionally, when the business or trust sells the property it won't be
allowed to deduct the capital loss that was disallowed to the original
business or trust.
If the taxpayer does a like-kind exchange of business or investment
property to a related party generally no gain or loss is recognized. If the
related party sells the property within two years both parties will have to
pay tax on any gains they deferred through the like-kind exchange
unless the sale occurs because of the death of either person, an
involuntary conversion such as a casualty loss or condemnation, or if both
parties can prove that the purpose of the like-kind exchange and
subsequent sale were not primarily done to avoid taxes.

TAX TIP

Special Rules for Day Traders


Day trading is the business of buying and selling securities within the
same day. Day traders rarely hold positions overnight because they
purchase the positions based on chart patterns and thus have not
researched the company. In fact, they may not even know the name of
the company - just its ticker symbol. Many day traders prefer not to know
the name of the company as it could cloud their analytical judgment.
Investors typically buy and sell securities and expect income from
dividends, interest, or capital appreciation. In the IRS's eyes just about
everybody is an investor. It does not matter whether your client calls
himself a "trader" or "day trader." Even traders who have several hundred
trades a year are considered investors by the IRS.
Investors account for their gains and losses on Form 8949 and Schedule
D - Capital Gains and Losses. Expenses such as investment counseling and
advice, legal and accounting fees, investment newsletters and investment
interest expense (such as margin interest) are deducted on Schedule A as
Miscellaneous Itemized Deductions subject to the 2% of AGI floor. See
Lesson 19. Investors cannot claim a home office deduction. Nor can they
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claim a Section 179 First Year Expensing deduction for equipment such as
computers and other office equipment because they don't file Schedule C
- Profit or Loss From Business. Commissions and other costs of buying or
selling securities are used to determine gain or loss upon the sale of the
securities.
On the other hand, expenses of day traders are deductible on Schedule C.
The limit on investment interest expense does not apply to interest paid
or incurred in a trading business. Traders can take an immediate write-off
(under Section 179) for equipment used in their trading business more
than 50% of the time, such as computers and other office equipment.
Home office deductions are also available to day traders. Schedule C
write-offs reduce adjusted gross income, thereby lowering the Adjusted
Gross Income based phase-outs. Lastly, traders do not have to pay selfemployment tax on their net profit because capital gains are exempt
from self-employment tax.
Traders also report their gains and losses on Form 8949 and Schedule D
and thus can still only deduct $3,000 in net capital losses each year. So
Schedule C shows all of the expenses and Form 8949 and Schedule D
show all of the income. The IRS usually audits these types of tax returns
because they look fishy so it's a good idea to attach a statement to the
tax return explaining the situation.
To be engaged in business as a trader in securities a taxpayer must meet
all of the following conditions:

He must seek to profit from daily market movements in the prices


of securities and not from dividends, interest, or capital
appreciation;

The activity must be substantial, and

He must carry on the activity with continuity and regularity.

The following facts and circumstances should be considered in


determining if the taxpayer's activity is a securities trading business:

Typical holding periods for securities bought and sold;

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The frequency and dollar amount of trades during the year;

The extent to which he pursues the activity to produce income for


a livelihood, and

The amount of time he devotes to the activity.

Be aware that, because investors try to claim they are traders to get the
special tax benefits, the IRS often disputes tax returns of taxpayers
claiming "trader" status.
Ordinarily when a taxpayer sells a stock at a loss he gets to deduct the
loss. But if he buys the same stock either before or after 30 days of the
sale the IRS considers it a "wash sale" and the loss is not deductible.
However, traders can make a "mark-to-market" election automatically
exempting themselves from the wash-sale rule.
Mark-to-Market Election
Under the mark-to-market rules a trader pretends to sell all of his
holdings, if he has any, at the closing bell on December 31st of each year.
For tax purposes he books all gains and losses as of that day and time.
Traders then begin the new year with no unrealized gains or losses.
Why do traders make the mark-to-market election? Because most traders
have substantial losses in their early years of trading as they have little or
no experience. Sometimes they lose several hundred thousand or even
millions of dollars. If they don't make the mark-to-market election they
can only deduct $3,000 of those losses each year. And any capital loss
carry forward is lost upon death - the estate or heirs get no benefit from
it. However, if they make the mark-to-market election they can deduct an
unlimited amount of losses. Mark-to-market traders report their gains
and losses on Part II of Form 4797 - Sales of Business Property. Since
ordinarily a traders short term gains are taxed just like other income but
loss deductions are limited to $3,000 per year it makes sense to make the
mark-to-market election.
A mark-to-market election must be made by the due date of the tax
return for the year prior to the year for which the election becomes
effective. The election is made by attaching a statement to the tax return.
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The statement should include the following information:

That the taxpayer is making an election under section 475(f) of the


Internal Revenue Code;

The first tax year for which the election is effective; and

The trade or business for which the election is being made.

The Schedule D Instructions have further information on how to make


the mark-to-market election.
After making the election to change to the mark-to-market method of
accounting the taxpayer must change his method of accounting by filing
Form 3115 - Application for Change in Accounting Method. The
procedures for making an election are described in Publication 550 Investment Income and Expenses in the section titled "Special Rules for
Traders in Securities".
After making the election the only way to stop using the mark-to-market
accounting method is to request and receive written permission from the
IRS to revoke the election. Non-filing of Form 3115 will not invalidate a
timely and valid election. To request permission to revoke the election
taxpayers must file a second Form 3115 and pay a fee.
A taxpayer may be a trader in some securities and hold other securities
for investment. That allows the trader to take advantage of the lower long
term capital gains tax rates for securities he holds for more than one year.
The special rules for traders do not apply to any securities a trader holds
for investment. A trader must keep detailed records to distinguish the
securities held for investment from the securities in the trading business.
They can't be swapped back and forth based on market performance.
The securities held for investment must be identified as such in the
trader's records on the day he or she acquires them. It's best to use a
separate brokerage account for securities held for investment.
For further information refer to Topic 429 - Traders in Securities at
IRS.gov.

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Lesson Summary
Lets take a moment to review what you have learned in this lesson.
The capital gains tax rates are:
Type
Description
Tax Rate
Short-Term - Capital
Taxed as ordinary income up to 39.6%
assets held one year
or less
Long-Term - Capital Individuals in the 10%
0%
assets held for more or 15% income tax
bracket
than one year
Income <$400,000 S;
<$450,000 MFJ;
15%
<$425,000 HOH

Income >$400,000 S;
>$450,000 MFJ;
>$425,000 HOH
39.6% income tax
bracket
Collectibles

Unrecaptured IRC
Section 1250 gains

Gains on items
deemed collectibles
(stamps; coins etc.)
Depreciation recapture
on sold assets

20%

23.8% (including 3.8%


Medicare surtax)
28%
25%

Table: Capital Gains Rates

Completion of Form 8949 requires information from Forms 1099-B and


1099-DIV or 1099 Consolidated Statement and from taxpayer records (basis
in the stock sold and purchase date). A new taxpayer who is carrying over a
loss from last year must also provide the Capital Loss Carryover Worksheet
from last year's Schedule D instructions.
Form 1099-B information reported on Form 8949 and Schedule D includes
the description of property sold, date acquired, date sold, sales price, and
cost or other basis. The broker checks the appropriate square at the right of
box 2 to indicate whether the gross or net proceeds were reported to the
IRS.
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Short-term gains and losses are reported in Part I of Form 8949 and longterm gains and losses are reported in Part II. The totals are then carried over
to Schedule D.
Part III of Schedule D summarizes the information of Parts I and II and
determines the amount of the taxpayer's net taxable gain or deductible loss.
Generally, if you exchange business or investment property solely for
business or investment property of a like-kind, no gain or loss is recognized
under Internal Revenue Code Section 1031.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify you're understanding of the
most important lesson content, and will also help you pass the
Final Exam.
Do the Homework - While completing the homework is not
mandatory, we strongly recommend that you complete each
lesson's homework assignment. It will expand your knowledge
and understanding of the topics covered in this course.

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Lesson

11
Lesson 11 - Sale of Home
In this lesson you'll learn about the tax implications of selling a main home.
This lesson discusses the general tax rules that apply when a taxpayer sells his
or her main home. The following topics are discussed in this lesson:

The Exclusion
Reporting the Exclusion
Definition of Main Home
More than One Home
Period of Ownership and Use
Married Homeowners
Reduced Exclusion
Unforeseen Circumstances
Gain on Sale of Main Home

Selling Price
Amount Realized
Basis
Adjusted Basis
Repairs
Form 1099-S
Home Foreclosures
Installment Sales
Installment Sale Interest

axpayers who have a gain from the sale of their main home may
exclude up to $250,000 of the gain from their taxable income
($500,000 if Married Filing Jointly), if all conditions are met. This
lesson does not cover the sale of a main home used as rental property or
partially used for business.

Eligibility Requirements for the Exclusion


To be eligible for the exclusion, taxpayers must:

Have sold the home that has been their main home
Meet the ownership and use test
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Not have excluded gain in the two years before the current sale of
the home

The table below shows how the gain on the sale of a principal residence
is taxed:
Gains from the sale of a Principal Residence after August 5, 1997 are
excludable based on filing status. Use of the exclusion is optional. Any
gains exceeding the exclusion are taxable. The Internal Revenue Code
Section 1034 rollover requirements, and the Over Age 55 - $125,000
Exclusion were repealed.
Maximum Excludable Gain
Filing Status
Maximum Exclusion
Married Filing Jointly
$500,000 (1)
All Others
$250,000
(1)
To exclude $500,000 one spouse must meet the ownership test and
both spouses must meet use test. Tests (measured in days) (2) :

Ownership Test: 2 years of the 5 years preceding date of sale.


Use: any 2 years of the 5 years preceding date of sale
Available once during 2 year period ending on date of sale

(2)

Special Rules apply to taxpayers with disabilities/incapacities. If the Use


or Ownership Tests are not met due to a change in health or place of
employment, the exclusion is prorated based on the proportion of the
days of use to 730 days (2 years). Effective for 2010, the exclusion is
available to a decedent's estate, heir, or qualified revocable trust if the
decedent met all the other rules.

TAX TIP

How much can unmarried co-owners exclude?


As much as $250,000 each ($500,000 total) can be excluded from income
on the sale of a residence owned jointly by individuals who are not
husband and wife -- for example, a parent and child, a brother and sister
or an unmarried couple sharing the home. As long as each unmarried
joint owner passes the ownership and use tests, each one gets to exclude

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up to $250,000 of his or her share of the profit.

Reporting the Exclusion


Taxpayers do not have to report the sale of a home on their tax return
unless they have a gain and at least part of it is taxable (more than the
exclusion amount of $250,000 or $500,000). A gain on the sale of a home
that is taxable should be reported on Form 8949 - Sales and Other
Dispositions of Capital Assets. It is then carried over to Schedule D - Capital
Gains and Losses.

Figure 11-1: Form 1040 Schedule D - Capital Gains and Losses Part II - Long-Term
Capital Gains and Losses - Assets Held More Than One Year.

A loss on the sale of the taxpayers main home cannot be deducted on his
or her tax return.

TAX QUOTE

"Congress can raise taxes because it can persuade a sizable fraction of the
populace that somebody else will pay."
Milton Friedman

Definition of Main Home


It is important to have a clear understanding of what is, and what is not, an
individual's main home. Only a gain from the sale of a taxpayer's main
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home is eligible to be excluded from the taxpayer's income. A gain from a


sale of a home that is not the taxpayer's main home will generally have to
be reported as income. Any gain that must be reported as income is taxable
gain and is reported on Form 1040 Schedule D, Capital Gains and Losses.
A taxpayer's main home does not have to be a traditional house. It simply
has to be the residence where the taxpayer lives most of the time. A
taxpayer's main home can be a:

House
Houseboat
Mobile home
Cooperative apartment, or
Condominium

Additionally, the location of the taxpayers principal residence does not


matter. It can be in a country other than the United States.

More than One Home


In most cases taxpayers own a single home in which they live all the time.
Taxpayers who have more than one home cannot choose which home to
designate as their main home. If a taxpayer has more than one home, you
must determine which home he or she lives in most of the time. You have
to be sure that the owner of a single home meets the requirement of living
in the home most of the time.
Never assume that a house sold during the year was the taxpayers main
home, even if the house was the only one owned by the taxpayer. Be sure to
check that the house was, in fact, the individuals main home. A taxpayer's
main home is not necessarily a home that is owned by the taxpayer. A rental
home may be a main home.

Ownership and Use Test - Period of


Ownership and Use
To claim the exclusion on the gain from the sale of a home, the taxpayer
must meet the ownership and use test. This means that the taxpayer must
have:

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Owned his or her part of the home for at least two years during the
five-year period ending on the sale date (the ownership test), and
Used the home as a principal residence for at least two years during
that five-year period (the use test).

In addition, during the two-year period ending on the date of the sale, the
taxpayer must not have claimed an exclusion on a gain from the sale of
another home.
The required two years of ownership and use do not have to be consecutive
or continuous. Taxpayers meet the test if they can show that they owned
and lived in the property as their main home for either 24 full months or
730 days during the five-year period. Short, temporary absences, even if the
property is rented during those absences, are counted as periods of use.
Ownership and use tests can be met during different two-year periods.
However, a taxpayer must meet both tests during the five-year period
ending on the date of the sale.

TAX TIP

Can divorced couples get the full $500,000 exclusion?


Home sales often occur during or shortly after divorces. When this
happens both spouses ordinarily qualify to each claim the $250,000
exclusion upon the sale of the home, provided each person meets the
ownership and use test.
But what happens when the non-resident ex-spouse has continued
ownership many years after the divorce, even though only one ex-spouse
lives there? Does the non-resident ex-spouse lose his or her $250,000
exclusion?
After three years of being out of the house, the non-resident ex-spouse
will fail the two-out-of-five-years use test. So if the home is sold years
later for a gain, the non-resident ex-spouses share will be fully taxable to
him or her.
However, the person who will be the non-resident ex-spouse can insist
that the divorce papers stipulate that, as a condition of the divorce
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agreement, the other ex-spouse can continue to occupy the home for

as long as he or she wants, or


until the children reach a certain age, such as age 18, or
for a specified number of years.

Once that date is reached, the home can be put up for sale with the
proceeds split according to the divorce agreement.
This language in the divorce agreement allows the non-resident exspouse to receive credit for the other ex-spouse's continued use of the
property as a principal residence. So when the home is finally sold, the
non-resident ex-spouse will still pass the two-out-of-five-years use test
and thereby qualify for the $250,000 exclusion.

Married Homeowners
The ownership and use tests are applied somewhat differently to married
homeowners. Married homeowners can exclude up to $500,000 if they
meet all the following conditions:

They file a joint return


Either spouse meets the ownership test
Both individuals meet the use test
Neither individual excluded gain in the two years before the current
sale of the home

If either spouse does not satisfy all these requirements, they cannot claim
the maximum $500,000 exclusion. The most that can be claimed by the
couple is the total of the maximum exclusions that each couple would
qualify for if not married and the amounts were figured separately. For this
purpose, each spouse is treated as owning the property during the period
that either spouse owned the property.
Exclusion of Gain on Sale of Principal Residence by a
Surviving Spouse
For sales or exchanges after December 31, 2007, the $500,000 exclusion will
also apply to unmarried individuals whose spouse is deceased on the date
of sale provided the sale occurs not later than 2 years after the date of
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death of the deceased spouse, and the couple would have qualified for the
$500,000 exclusion if the sale had occurred immediately before the date of
death.

Reduced Exclusion
Taxpayers who owned and used a home for less than two years may be able
to claim a reduced exclusion, if the taxpayer sold the home due to:

A change in place of employment


Health, or
Unforeseen circumstances

If this situation applies to a taxpayer then you should complete the Reduced
Maximum Exclusion worksheet.

Figure 11-2: The Income section of Form 1040 with line 13 "Capital gain or (loss)"
highlighted.

Unforeseen Circumstances
An unforeseen circumstance is an event that a taxpayer does not anticipate
before purchasing and occupying his or her main home. The following
events qualify as unforeseen circumstances:

An involuntary conversion of a taxpayer's home


A natural or man-made disaster or acts of war or terrorism resulting
in a casualty to your home, whether or not your loss is deductible

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Gain on Sale of Main Home


Taxpayers who have a gain from the sale of their main home may exclude
up to $250,000 of the gain from their taxable income ($500,000 if Married
Filing Jointly), if all conditions are met. Once you've determined that a
taxpayer is eligible for the exclusion, to figure the gain (or loss) on the sale
of a taxpayers main home, you must know the following about the home:

Selling price
Amount realized
Basis
Adjusted basis

Selling Price
The selling price is the total amount the taxpayer (seller) received for his or
her main home. It includes money, all notes, mortgages, or other debts
taken over by the buyer as part of the sale, and the fair market value of any
other property or services that the seller received.
Amount Realized
The amount realized is the selling price minus selling expenses. Selling
expenses include commissions, advertising fees, legal fees, and loan charges
paid by the seller, such as points.
Selling price - Selling expenses = Amount realized
Basis
The basis in a home is determined by how the taxpayer obtained the home.
If a taxpayer bought or built a home the basis is what it cost the taxpayer to
buy or build that home. If a taxpayer received a home as a gift the basis is
the grantor's adjusted basis of the home on the date of the gift - Carryover
Basis. If the taxpayer inherited the home the basis is its fair market value on
the date of the decedent's death, or the later alternate valuation date
chosen by the representative for the estate - Stepped-up Basis. That
eliminates taxes on the amount the home appreciates above the exclusion
amount during the previous owner's lifetime. Alternative valuation issues
can be complex. For further information see Publication 523 - Selling Your
Home.

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TAX PRACTICE TIP

Basis Under The Prior Rollover Rule


Under the law prior to May 7, 1997 there was no exclusion on the gain
from the sale of a main home. Taxpayers could avoid capital gains tax on
the sale if within two years before or after the sale they purchased and
lived in another main home that cost more than the sales price of the old
home.
Taxpayers who took advantage of this rule simply deferred the gain. The
amount of the gain they would have otherwise recognized was deducted
from the cost of the replacement home, so the basis of their current
replacement home is probably lower than what they paid.
You'll need to look back at their tax return for the year in which they sold
the old main home and see if it includes Form 2119 - Sale of Your Home.
That is where youll find their adjusted basis of their current replacement
home, which is what youll use as the initial basis of the current
replacement home.
Adjusted Basis
The adjusted basis is the taxpayer's basis in a home increased or decreased
by certain amounts. Increases include additions or improvements to the
home such as building a recreation room in an unfinished basement,
adding another bathroom or bedroom, putting up a fence, putting in new
plumbing or electrical wiring, putting on a new roof, or paving the driveway.
Improvements add to the value of the home, prolong its useful life, or adapt
it to new uses. In order to be considered an increase in basis, an addition or
improvement must have a useful life of more than one year. Repairs that
maintain the home in good condition are not considered improvements
and should not be added to the basis of the property. Decreases to basis
include deductible casualty losses, gains a taxpayer postponed from the sale
of a previous home before May 7, 1997, or credits such as first-time homebuyer credit.
Basis + Increases - Decreases = Adjusted basis
The table below shows examples of increases and decreases to basis:
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Increases to Basis

Decreases to Basis

Capital improvements:
Putting an addition on your
home
Replacing an entire roof
Paving your driveway
Installing central air
conditioning
Rewiring your home

Assessments for local


improvements:
Water connections
Extending utility service
lines
Sidewalks
Roads

Casualty losses:
Restoring damaged
property

Exclusion from income of


subsidies for energy
conservation measures.
Casualty or theft loss
deductions and insurance
reimbursements
Qualified electric vehicle
credit (Form 8834)
Postponed gain from the
sale of a home
Alternative fuel vehicle
refueling property credit
(Form 8911)
Residential energy credits
(Form 5695)
Depreciation and section
179 deduction
Certain canceled debt
excluded from income.
Easements

Legal fees:
Cost of defending title
Fees for reduction of and
assessment
Zoning costs.

TAX TIP

Do small home improvements count too?


Home improvements dont necessarily need to be large in order to be
deductible. Drapery rods, towel racks, window shades, lighting fixtures,
and kitchen cabinet knobs are all improvements. If the taxpayer keeps
track of these expenses they can add up over the years.
Taxpayers should purchase an accordion file at their local office supply
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store to archive their home improvement receipts. They should also


photocopy any thermal printer receipts, like the receipts printed by most
cash registers, as the thermal print fades with time and the receipt will
probably be blank by the time they need it.

Repairs
Home repairs maintain a home in good condition. They do not add to its
value or prolong its life. Some examples of home repairs include repainting
the house inside or outside, fixing the gutters or floors, repairing leaks,
plastering, and replacing broken window panes. Taxpayers cannot deduct
home repairs.

TAX TIP

Is there any way around the non-deductibility of home repairs?


It may be worth it to delay small repairs until they can be performed in
connection with an extensive remodeling project. The entire job will be
considered a home improvement if items that would otherwise be
considered home repairs are done as part of extensive remodeling or
restoration of the home. That way some items that would otherwise be
considered non-deductible repairs, such as painting rooms, can be
included in the cost of the larger remodeling project and added to the
home's basis.

Figuring the Gain


To determine whether a taxpayer has a gain or a loss on the sale of a home,
compare the amount realized to the adjusted basis.
A taxpayer cannot exclude the part of any depreciation allowed or allowable
for the business use of his or her home.
If the amount realized is more than the adjusted basis, the difference is a
gain and the taxpayer may be able to exclude all or part of it. If the amount
realized is less than the adjusted basis, the difference is a nondeductible
loss.
Gain = Amount realized > Adjusted basis
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Loss = Amount realized < Adjusted basis

Form 1099-S
If the taxpayer received Form 1099-S - Proceeds From Real Estate
Transactions use it to figure the selling price for the taxpayer's home. Box 1
shows the date of sale (closing) and box 2 shows the gross proceeds
received from the sale of his or her main home.

Figure 11-3: Form 1099-S - Proceeds From Real Estate Transactions with box 1 "Date of
closing" and box 2 "Gross proceeds" highlighted.

If the taxpayer can exclude the entire gain from a sale, the person
responsible for closing the sale, such as the settlement agent, generally will
not have to report it on Form 1099-S. For taxpayers who did not receive a
Form 1099-S, use sale documents and other records.

Home Foreclosures
Taxpayers may have to report home foreclosure as taxable income. This
determination requires a multi-step process.
Step 1
You must determine whether the taxpayer has taxable income that must be
reported from the discharge of indebtedness caused by a home foreclosure.
The taxpayer has taxable income caused by the home foreclosure if the
taxpayer is personally liable on the mortgage debt and the debt discharged
exceeds the fair market value of the property at the time of the home
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foreclosure. Discharge of indebtedness is taxable as other income on Form


1040 Line 21.

Figure 11-4: The Income section of Form 1040 with line 21 "Other income" highlighted.

The taxpayer may have received either a Form 1099-A or Form 1099-C, or
both. The taxpayer should examine both forms carefully and notify the
lender immediately if any of the information shown is incorrect.

Figure 11-5: Form 1099-A - Acquisition or Abandonment of Secured Property.

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Figure 11-6: Form 1099-C - Cancellation of Debt.

The taxpayer may be able to exclude from income the discharge of


indebtedness caused by the home foreclosure if the taxpayer has filed
bankruptcy; is insolvent; or has a qualified farm debt. See Publication 908 Bankruptcy Tax Guide and Form 982 - Reduction of Tax Attributes Due to
Discharge of Indebtedness for more information.
Step 2
You may also have to compute taxable gain or loss and include it on the
taxpayers return. Gain or loss is the difference between the taxpayers
adjusted basis in the property and the amount realized through the
foreclosure, even if the taxpayer received no cash or property in the
foreclosure "sale" transaction. You must still follow this step even if the
taxpayer has no discharge of indebtedness from step one. The difference
between the amount realized less any reportable discharge of indebtedness
from the foreclosure sale and the taxpayers adjusted basis is the taxpayers
gain or loss that must be reported on the tax return. If the property is
business property, report it on Form 4797 - Sales of Business Property and
follow the normal rules. If the property is a personal home, report it on Form
1040, Schedule D, following the normal rules for the sale of a main home.
The Mortgage Forgiveness Debt Relief Act of 2007
The Mortgage Forgiveness Debt Relief Act of 2007 adds an exclusion for
discharge of debt income on a principal residence. In general, if a taxpayer
owes a debt that is canceled or forgiven, the canceled amount is taxable
income. Exceptions to this rule include the following:
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Debt that is canceled in a title 11 bankruptcy case.


Debt that is canceled when the taxpayer is insolvent.
Debt that is canceled that is considered a gift to the borrower.
The cancellation of qualified farm debt.
The cancellation of qualified real property business debt.
The cancellation of a student loan in exchange for public services.
An adjustment made to the purchase price after the purchase by the
seller is generally treated as a purchase price adjustment that
reduces basis.
Debt that is canceled as a result of Hurricane Katrina.

Beginning with discharges of indebtedness on or after January 1, 2007 and


before January 1, 2015, gross income does not include the cancellation of
qualified principal residence indebtedness. For purposes of this rule, the
following applies:

The exclusion is limited to $2 million of acquisition debt.

The exclusion is limited to $1 million for a married person filing a


separate return.

To qualify, the debt must have been used to buy, build or


substantially improve the taxpayers principal residence and be
secured by that residence.

Refinanced debt proceeds used for the purpose of substantially


improving the taxpayers principal residence also qualify for the
exclusion.

Proceeds of refinanced debt used for other purposes for example,


to pay off credit card debt do not qualify for the exclusion.

Acquisition debt has the same meaning as acquisition debt for


purposes of the mortgage interest deduction rules, except that the
$1 million debt limit is increased to $2 million for purposes of the
exclusion rule.

The taxpayer may exclude debt reduced through mortgage


restructuring, as well as mortgage debt forgiven in a foreclosure.

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Any amount excluded reduces the taxpayers basis in the residence.


The basis of the principal residence must be reduced (but not below
zero) by the amount excluded from gross income. A principal
residence has the same meaning as that used under IRC Section 121
for purposes of excluding gain on the sale of a principal residence.

The exclusion does not apply to debt discharged on account of


services performed for the lender or any other factor not directly
related to a decline in the value of the residence or to the financial
condition of the taxpayer.

If a portion of a loan that is discharged is not qualified principal


residence indebtedness, the exclusion is limited to the amount
discharged that exceeds the amount of the loan that is not qualified
principal residence indebtedness.

The exclusion for discharge of debt due to insolvency does not apply
if the exclusion for discharge of debt on a qualified principal
residence applies, unless the taxpayer elects to apply the insolvency
exclusion instead.

Form 982 - Reduction of Tax Attributes Due to Discharge of Indebtedness


For taxpayers that qualify for the exclusion for mortgage debt forgiveness,
check the box for line 1e and enter the basis reduction on line 10b of Form
982. Complete the rest of the form per the instructions for any other
reduction of tax attributes due to discharge of indebtedness that may apply.
For more information about the Mortgage Forgiveness Debt Relief Act of
2007 get IRS Publication 4681 - Canceled Debts, Foreclosures, Repossessions
and Abandonments.
You can also use the Interactive Tax Assistant available on the IRS website to
determine if the cancellation of debt is taxable. The tool is a tax law resource
that takes you through a series of questions and provides you with
responses to tax law questions.

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TAX QUOTE

"The avoidance of taxes is the only intellectual pursuit that carries any
reward."
John Maynard Keynes

Installment Sales
An installment sale is a sale of property at a gain where at least one
payment is to be received in a later tax year. The taxpayer may be required
to report the sale as an installment sale unless he "elects out" of such
treatment in the year of the installment sale. If the taxpayer elects out of the
installment sale method all of the taxable gain is taxable income in the tax
year of the installment sale. However, because the taxpayer is not deferring
the tax the taxpayer may pay more tax by electing out of the installment
sale method. The taxpayer cannot defer a loss under the installment sale
method - nor can the taxpayer use it to report a taxable gain from the sale
of inventory, or securities publicly traded on a securities exchange or
market.
If the taxpayer treats the installment sale transaction as an installment sale
for tax purposes he will include in taxable income only a proportionate
amount of the gain, plus the interest, that he receive, or is considered to
have received, each tax year.
Use Form 6252 - Installment Sale Income to compute taxable income. You
may need to attach Form 4797 - Sales of Business Property.
If the taxpayer repossess property after making an installment sale, see
Publication 537 - Installment Sale under "Repossession" for special tax rules
for computing gain or loss and determining the new basis in the
repossessed property.
Installment Sale Interest
Interest should be charged on any installment sale. If interest is not charged
on an installment sale the tax law states that there is a minimum amount of
interest that the taxpayer, as a seller, is considered to have received on the
installment sale and must include as taxable income. This is "imputed" or
"unstated " interest and it is taxable even if the taxpayer didn't receive the
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installment sale interest. To calculate the amount of imputed installment


sale interest that is taxable or to charge the lowest interest rate allowed by
tax law, the taxpayer should use the Applicable Federal Rate (AFR) that
applies to the term of the installment sale at the time of the sale. The
Applicable Federal Rate is published monthly in the Internal Revenue
Bulletin. You can also get this information by going to http://www.irs.gov
and typing "Applicable Federal Rate" in the search box at the upper right or
by calling the IRS at 1-800-829-1040.

Lesson Summary
This lesson discussed the simplified rules that apply to homeowners who
sell their main home.
A taxpayer's main home does not have to be a traditional house. It simply
has to be the residence where the taxpayer lives most of the time. A
taxpayer's main home can be a:

House
Houseboat
Mobile home
Cooperative apartment, or
Condominium

Taxpayers who have a gain from the sale of their main home may exclude
up to $250,000 of the gain from their taxable income ($500,000 if Married
Filing Jointly), if all conditions are met.
To be eligible for the exclusion, taxpayers must:

Have sold the home that has been their main home
Meet the ownership and use tests
Not have excluded gain in the 2 years before the current sale of the
home

During the five-year period ending on the date of the sale, the taxpayer
must have:

Owned the home for at least two years (the ownership test), and
Lived in the home as his or her main home for at least two years (the
use test)
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In addition, during the two-year period ending on the date of the sale, the
taxpayer must not have claimed an exclusion on a gain from the sale of
another home.
The table below shows the increases and decreases to basis for home
improvements:
Increases to Basis Include
Improvements such as:
Putting an addition on
your home
Replacing the entire roof
Paving the driveway
Installing central air
conditioning
Rewiring the home
Assessments for local
improvements.
Amounts spent to restore
damaged property.

Decreases to Basis Include


Insurance or other
reimbursements for casualty
losses.
Deductible casualty loss not
covered by insurance.
Payments received for easement
or right-of-way granted.
Depreciation allowed or allowable
if the home is used for business
or rental purposes.
Value of subsidy for energy
conservation measure excluded
from income.

The total amount of any gain should be entered in Part II of Schedule D Capital Gains and Losses.
Taxpayers may have to report home foreclosure as taxable income. This
determination requires a multi-step process.
An installment sale is a sale of property at a gain where at least one
payment is to be received in a later tax year.
Interest should be charged on any installment sale. If interest is not charged
on an installment sale the tax law states that there is a minimum amount of
interest that the taxpayer, as a seller, is considered to have received on the
installment sale and must include as taxable income.
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Questions Taxpayers Ask


Question: "Do I have to pay tax on historic preservation grants?"
Answer: No, you don't have to pay tax on historic preservation grants. If
you received a historic preservation grant on or after December 12, 1980
under the National Historic Preservation Act to preserve a historically
significant property do not include it on your tax return.

TAX PRACTICE TIP

Abusive Return Preparers


The IRS Criminal Investigation Return Preparer Program (RPP) was
implemented in 1996. It established procedures to foster compliance by
identifying, investigating and prosecuting abusive return preparers. The
program was developed to enhance compliance in the return-preparer
community by engaging in enforcement actions and/or asserting
appropriate civil penalties against unscrupulous or incompetent return
preparers. This is a significant problem for both the IRS and taxpayers.
Abusive return preparers frequently prepare bad returns for large
numbers of taxpayers who, at best, are stuck with paying additional taxes
and interest and at worse, depending on culpability, are subject to
penalties and maybe even criminal prosecution.
Definition: A Return Preparer is defined as any person (including a
partnership or corporation) who prepares for compensation all or a
substantial portion of a tax return or claim for refund under the income
tax provisions of the Internal Revenue Code.
Return Preparer Fraud generally involves the orchestrated preparation
and filing of false income tax returns (in either paper or electronic form)
by unscrupulous preparers who may claim, for example:

inflated personal or business expenses,


false deductions,
unallowable credits or excessive exemptions,
fraudulent tax credits, such as the Earned Income Tax Credit (EITC),
refunds and/or refundable credits using stolen identities,
direct deposit of alleged taxpayer refunds into the preparer's own
bank account.
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The preparers' clients may or may not have knowledge of the false
expenses, deductions, exemptions and/or credits, or RTN and DAN
shown on their tax returns when the returns are filed electronically.
Electronic Filing
The advent of electronic filing of income tax returns has provided
additional means for abusive preparers to commit fraud.
Criminal Investigation, since 1977, has been screening suspected
fraudulent returns. This is done by the Criminal Investigation Fraud
Detection Centers (FDC) at each of the IRS campuses where tax returns
are filed. The purpose of the FDC is to detect refund fraud and return
preparer schemes and refer them to the Criminal Investigation field
offices for further investigation. Since its inception, Criminal Investigation
at the processing centers has been successful in identifying in excess of
$2 billion in fraudulent refunds.
Criminal Investigation in conjunction with Information Technology
Services has developed the Electronic Fraud Detection System (EFDS).
EFDS is a computer system used by Criminal Investigation that greatly
enhances Criminal Investigations ability to identify and stop fraudulent
filings. EFDS receives computer identification output of potentially
fraudulent electronically filed tax returns, provides increased data for
analysis, and assists in the development of information relating to paper
and electronic filing schemes. Criminal Investigation also uses information
and leads submitted by tax return preparers to identify fraudulent return
schemes.
Tactics Used by Abusive Return Preparers
Dishonest return preparers use a variety of methods to formulate
fraudulent and illegal deductions reducing taxable income. These include,
but are not limited to, the following:

Preparing fraudulent Schedule C - Profit or Loss from Business,


claiming deductions for expenses that have not been paid by the
taxpayer to offset Form 1099 - Miscellaneous Income, or income
earned from outside employment;

Including false and inflated itemized deductions on Schedule A 409

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Itemized Deductions for charitable contributions and medical and


dental expenses;

Claiming false losses on Schedule E - Supplemental Income and


Loss;

Claiming false dependents

The IRS encourages tax preparers to notify them if there is suspicion of


fraud. Suspected fraud can be reported to the IRS by calling (800) 8290433. You can also report fraudulent or abusive returns, including those
with questionable Forms W-2, to the IRS by submitting Form 3949A Information Referral.

SIDE BAR

IRS Form Reference


An alphabetical listing of all IRS forms can be viewed at Appendix K.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify you're understanding of the
most important lesson content, and will also help you pass the
Final Exam.
Do the Homework - While completing the homework is not
mandatory, we strongly recommend that you complete each
lesson's homework assignment. It will expand your knowledge
and understanding of the topics covered in this course.

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Lesson

12
Lesson 12 - Pension Income
In this lesson you'll learn about Pension Income. The following topics are
discussed in this lesson:
Disability Pensions
Annuities
Individual Retirement
Arrangements (IRA)
Social Security Benefits
Railroad Retirement Benefits
(RRBs)
Other Types of Pension Plans
Form 1099-R
Form SSA-1099
Form RRB-1099 and Form
RRB-1099R
Tier 1 Railroad Retirement
Benefits
Pensions with Taxable
Amount Determined
"Before-Tax" vs. "After-Tax"
Contributions
Partially Taxable Pensions
and Annuities Other than
IRAs
General Rule
Simplified Method
411

Savings Incentive Match


Plans for Employees (SIMPLE)
IRA
Simplified Employee Pension
(SEP) IRA
Roth IRAs
Taxation of Social Security
Benefits
Disability Pension Income
Reporting Pension Income
Disability Income Reporting
Reporting Social Security
Benefits
Reporting IRA Distributions
Traditional IRA, SIMPLE IRA,
or SEP IRA
Premature Distributions
Lump-Sum Distributions
Taxpayers born before
January 2, 1936
Minimum Distributions
Lump-Sum Benefit Payments
Withdrawal of Excess IRA

LESSON

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Taxation of Individual
Retirement Arrangements
Traditional IRA

Contributions
Pension Withholding and
Estimated Tax Payments

pension is a series of definitely determinable payments made to an


employee or survivor (the beneficiary of a deceased employee) after
the employee retires from work. Payments are made regularly and
are for past services with an employer.
A pension is fully or partially taxable depending on whether the employee
contributed to the pension plan. The total amount of the pension usually
depends on how long the taxpayer worked for the company and how much
the taxpayer earned over the years.
Employee contributions that are "after-tax" contributions are amounts that
the employer usually deducts from wages and deposits into the pension
fund on behalf of the employee.
Each year, the employee pays tax on the amount that he or she contributed
that year. The employee's contributions are included in his or her Form W-2.
Employee contributions are often referred to as the cost of the pension or
as the investment in the annuity contract.
Employee contributions that are "before-tax" include amounts deposited to
a 401(k) or 403(b) program. Each year, the employee pays income tax on his
or her salary after the "before-tax" contributions have been deducted.

SIDE BAR

What is "inflation"?
Inflation is the increase in the price of goods and services, typically
measured by the Consumer Price Index (CPI). The CPI is determined each
month from a survey by the U.S. Bureau of Labor Statistics. The CPI
compares the price of a "market basket" of goods from various industries
including housing, food, transportation, and apparel. Since 1945 prices
have risen in every year but two, 1949 and 1950. The annual inflation rate
in modern times is typically 2-4%.

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Taxpayers investing for major goals years away, such as retirement, can't
afford to ignore inflation i.e. rising prices.
Related Terms:
Deflation is when the general level of prices fall. This is the opposite
of inflation.
Hyperinflation is unusually rapid inflation. In extreme cases this can
lead to the breakdown of a nation's monetary system.
Stagflation is the combination of high unemployment and economic
stagnation with high inflation.

For more information on inflation visit InflationData.com. Be sure to


check out their Inflation Rate Calculator.

TAX PLANNING TIP

How much of their pre-retirement income do people need in


retirement?
A quick rule of thumb has always been that most people need about 7075% of their final working years' income each year to maintain their
lifestyle after retiring. But new research from Duke University shows that
retiree's may need as much as 135% of their pre-retirement income to
retire comfortably and do all of the things they dream of.
A study done by Fidelity Investments recently concluded that retirees
needed to replace 85% of their pre-retirement salary, when including
Social Security benefits. And that would require a lump sum of at least 8
times their salary. However, consulting firm Aon Hewitt says youll need
11 times your salary saved to pay for retirement expenses.
Keep in mind that any tool or guide that promises to tell you how much
you need to save is using assumptions that may or may not fit your
situation.
The table below shows how much the taxpayer's pension will really be
worth. It shows how much $1 today will be worth in future dollars after
subtracting inflation. Multiply by the appropriate factor below.

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Years to

Rate of Inflation

Retirement
2%
3%
4%
5%
6%
7%
4
0.93
0.89
0.86
0.82
0.79
0.76
6
0.89
0.84
0.8
0.74
0.7
0.65
8
0.86
0.79
0.73
0.67
0.62
0.58
10
0.83
0.75
0.68
0.61
0.55
0.5
12
0.79
0.71
0.63
0.55
0.49
0.44
14
0.76
0.67
0.58
0.5
0.44
0.38
16
0.73
0.63
0.54
0.45
0.39
0.33
18
0.7
0.59
0.5
0.41
0.34
0.29
20
0.68
0.56
0.46
0.37
0.31
0.25
22
0.65
0.53
0.43
0.34
0.27
0.22
24
0.63
0.5
0.39
0.31
0.24
0.19
26
0.6
0.47
0.36
0.28
0.21
0.17
28
0.58
0.44
0.34
0.25
0.19
0.15
30
0.56
0.42
0.31
0.23
0.17
0.13
Example: Assume savings of $100,000, an anticipated annual inflation rate of 5%,
and 16 years to retirement. The rate and years intersect at .45 - thus $100,000
will have $45,000 of purchasing power 16 years from now.

TAX PLANNING TIP

Accelerating Retirement Plan Contributions


Contributions to most retirement plans reduce taxable income. Taxpayers
should review their retirement plan options and decide on setting up a
retirement plan early. Many retirement plans need to be established by
December 31st to make tax-deductible contributions for the current year.
Ordinarily taxpayers can contribute an entire year's retirement plan
contribution each year, even if they started their new job in the last
quarter of the year. Some taxpayers who begin a new job in the last
quarter arrange to have their entire paycheck go into the retirement plan
- which may eliminate their taxable income.

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SIDE BAR

What is a Retirement Plan?


A retirement plan is a fund established, usually on a tax favored basis, to
pay retirement benefits for the owners and employees of a company.
Generally, contributions are tax deductible and interest and gains within
the plan are tax deferred. Employers are required to include most
employees in a retirement plan, i.e. a portion of the contributions must be
allocated to participating employees. There are several different types of
retirement plans each offering advantages and disadvantages:

401(k) Plans
Defined Benefit Plans
Defined Contribution Plans
Money Purchase Pension Plans
Profit-sharing Plans
SIMPLE IRA Retirement Plans

Disability Pensions
A disability pension is generally paid to a taxpayer who retires because of a
disability before the minimum retirement age set by the employer. The
disability pension is treated as wages until the taxpayer reaches minimum
retirement age. From then on the disability pension is treated as regular
pension income.

Annuities
An annuity is a series of payments under a contract from an insurance
company, a trust company, or an individual. Annuity payments are made at
regular intervals over a period of more than one full year.

SIDE BAR

What is a deferred annuity?


A deferred annuity is an investment contract with an insurance company
under which the taxpayer makes regular monthly payments, or pays a
lump sum, and purchases fixed or variable investments. Any interest or
415

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gains in the annuity accumulate tax deferred, i.e. no tax is due until the
funds are withdrawn. At a later time, presumably retirement, the taxpayer
can either withdraw the funds or receive a monthly payment from the
insurance company. Taxpayers can purchase non-qualified deferred
annuities from most insurance companies.
Any withdrawals before the taxpayer reaches age 59 are subject to a
10% penalty in addition to any gain being taxed as ordinary income.
However the 10% percent penalty does not apply to payments from
deferred annuity contracts if the payments are:

allocable to an investment in the contract before August 14, 1982

made from an annuity contract under a qualified personal injury


settlement

made under an immediate annuity contract

made under a deferred annuity contract purchased by an


employer at the termination of a qualified retirement plan or
qualified annuity that is held by the employer until the taxpayer
separates from service

Individual Retirement Accounts (IRAs)


An Individual Retirement Account (IRA) is a personal savings plan that
provides tax advantages for setting money aside for retirement.

TAX QUOTE

"The income tax has made more liars out of the American people than golf
has."
Will Rogers

416

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Social Security Benefits


Social Security benefits are payments made under Title II of the Social
Security Act. They include old-age, survivors, disability insurance, and some
workers' compensation benefits.
Is everyone insured under the Social Security program?
A quarter of coverage is the basic unit for determining whether a worker
is insured under the Social Security program. A maximum of 4 quarters
can be earned per year. For persons born after 1928, 40 quarters are
needed to be eligible for retirement benefits.
The table below shows the amount of earnings that are needed to earn
a quarter of coverage under Social Security:

417

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Year
pre 1975
1975-1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010-2011
2012
2013
2014
2015

PENSION

INCOME

Amount of Earnings needed to earn one quarter of coverage


See note below
$50
$250
$260
$290
$310
$340
$370
$390
$410
$440
$460
$470
$500
$520
$540
$570
$590
$620
$630
$640
$670
$700
$740
$780
$830
$870
$890
$900
$920
$970
$1,000
$1,050
$1,090
$1,120
$1,130
$1,160
$1,200
$1,220

Table: Social Security Quarter of Coverage

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For years prior to 1978, a quarter of coverage was earned for each quarter
wages were $50 or more, limited to 4 quarters per year. Annual wage
reporting began in 1978, and a fixed dollar amount (subject to COLA
adjustments) was established to earn one quarter, limited to 4 quarters per
year. Self-employed persons are subject to the same rate. Prior to 1978, selfemployed persons needed $400 per year to earn 4 quarters per year.
Social Security Maximum Earnings Subject to Tax
The table below shows the maximum earnings subject to Social Security
and Medicare Tax each year since inception of the programs.
Year
1937-1950
1951-1954
1955-1958
1959-1965
1966-1967
1968-1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993

Social Security Maximum


Annual Covered Earnings
$3,000
$3,600
$4,200
$4,800
$6,600
$7,800
$9,000
$10,800
$13,200
$14,100
$15,300
$16,500
$17,700
$22,900
$25,900
$29,700
$32,400
$35,700
$37,800
$39,600
$42,000
$43,800
$45,000
$48,000
$51,300
$53,400
$55,500
$57,600

419

Medicare Maximum
Annual Covered Earnings
n/a
n/a
n/a
n/a
$6,600
$7,800
$9,000
$10,800
$13,200
$14,100
$15,300
$16,500
$17,700
$22,900
$25,900
$29,700
$32,400
$35,700
$37,800
$39,600
$42,000
$43,800
$45,000
$48,000
$51,300
$125,000
$130,200
$135,000

LESSON

12

PENSION

Year
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009-2011
2012
2013
2014
2015

INCOME

Social Security Maximum


Annual Covered Earnings
$60,600
$61,200
$62,700
$65,400
$68,400
$72,600
$76,200
$80,400
$84,900
$87,000
$87,900
$90,000
$94,200
$97,500
$102,000
$106,800
$110,100
$113,700
$117,000
$118,500

Medicare Maximum
Annual Covered Earnings

Unlimited

SIDE BAR

How much has a worker that is retiring today and his employer paid
in Social Security tax if the worker earned the maximum wages
subject to tax?
To find out see our paper Social Security Taxes Paid For An Employee
Retiring Today in Appendix L or click here.

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The table below shows Social Security Facts:


Insured events: Death, Retirement, Disability, and Health
Normal retirement age: Age 65 - 67, depending on year of birth
Minimum Work Requirements: 10 years; 40 quarters (1 credit less for each year
living prior to (1929) made tax payments under FICA (Federal Insurance
Contributions Act). A Pre-1978 worker must have worked in each quarter;
afterwards annual earnings applies.
Quarterly Credit: Earned with $1,220 of Qualified FICA earnings in 2015.
Benefit Amount: The amount of Social Security benefits depends on two things,
1) Lifetime average earnings, and 2) Age when benefits begin.
Annual earnings limit before
benefits reduced:
2014
2015
Under full retirement age
$15,480
$15,720
Year individual reaches full retirement
age
$41,400
$41,880
Estimated Average monthly benefits:
COLA increase (from prior year)
1.50%
1.70%
All Retired Workers
$1,294
$1,328
Couple - Both With Benefits
$2,111
$2,176
Aged Widow
$1,243
$1,274
Disabled Worker
$1,148
$1,165
Widow With 2 Children
$2,622
$2,680
Disabled Worker, Spouse & 1 +
Children
$1,943
$1,976
Table Social Security Facts

Social Security Family benefits are payments made to family members in


addition to payments made to the key recipient due to retirement or
disability.

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The table below shows the Social Security Family Benefits, as a


percentage of the worker's full benefit:

Family Member

Current Spouse2

% of Worker's Full
Benefit1 to family
member
50%
32.5 - 50%
50%

50%
Former Spouse3
32.5 - 50%

Unmarried
children

50%

Qualifications
Age 65 or older
Age 62-64 and 11 mo.
Any age if caring for a worker's
qualified child under the age 16
or disabled
If all three apply:
1. 65 or older
2. Married to worker at least 10
years
3. Currently married
If all three apply:
1. Age 62-64 and 11 months
2. Married to worker at least 10
years
3. Currently married
Under age 18 (19 if in high
school) or disabled before age
22

Footnotes:
1
Worker must be retired or disabled and qualify for Social Security Benefits.
2
Either gender and party to legal marriage.
3
Divorced spouse may receive benefits even if worker is not yet retired (if
divorced at least two years)

TAX PLANNING TIP

Do children receive money from Social Security when a worker dies?


Yes, quite often they do. To be eligible for Social Security benefits upon
the taxpayers death the children must be age 18 or less (19 if still in high
school), and unmarried. Additionally the taxpayer must have been taxed
for at least six quarters of coverage.
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TAX PLANNING TIP

Are there any additional Social Security benefits for couples in a


"May/December" marriage?
There may be. A spouse of any age taking care of a retired worker's child
under the age of 16 (or disabled) will receive up to one-half of the retired
worker's monthly benefits. Additionally, the child (or children) up to age
18 (or 19 if they are full-time students and have not yet graduated high
school) will receive up to one-half of the retired worker's monthly
benefits.
These benefits are subject to maximum family benefit caps.

TAX TIP

Child's Social Security Family Benefits


If a child receives Social Security Family Benefits, the benefits are reported
on the child's tax return and not the parent's tax return. Social Security
Benefits paid to a child will almost always be tax free because a child's
income is usually not high enough for them to be taxable. However,
exceptions can apply.
The earliest a person can start to receive benefits is age 62. Full retirement
benefits are obtained upon reaching the "Full Retirement Age" shown in the
chart below. Based on when Social Security benefits are started, for every
month short of "Full Retirement Age" Social Security Benefits are
permanently reduced by the monthly factor shown below.

Year of Birth

Full Retirement Age

Age 62 Reduction Months

Monthly %
Reduction

Total %
Reduction

1937 or earlier

65

36

0.555

20

1938

65 years 2 mos.

38

0.548

20.83

1939

65 years 4 mos.

40

0.541

21.67

1940

65 years 6 mos.

42

0.535

22.5

423

LESSON

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Year of Birth

Full Retirement Age

Age 62 Reduction Months

Monthly %
Reduction

Total %
Reduction

1941

65 years 8 mos.

44

0.53

23.33

1942

65 years 10 mos.

46

0.525

24.17

1943-1954

66 years

48

0.52

25

1955

66 years 2 mos.

50

0.516

25.84

1956

66 years 4 mos.

52

0.512

26.66

1957

66 years 6 mos.

54

0.509

27.5

1958

66 years 8 mos.

56

0.505

28.33

1959

66 years 10 mos.

58

0.502

29.17

1960 and later

67

60

0.5

30

TAX PLANNING TIP

Should taxpayers retire at age 62 and start collecting Social Security


benefits or should they wait until age 66?
Taxpayers will end up with more money if they start collecting Social
Security benefits at age 62, unless they live past age 78.
Taxpayers receive approximately 25% less per month by collecting Social
Security benefits at age 62 than they would receive by waiting until age
66. Although they receive less per month theyll receive 48 more benefit
checks than if they wait until age 66. Thus, if a taxpayer waits until age 66
to begin receiving benefits it takes until age 78 to make up for the four
years of benefit payments they didnt receive.
The above analysis assumes that the taxpayer is actually retiring at age
62. If he continues to work full-time past age 62 hell have the
opportunity to increase his eventual benefits, especially if he is in his peak
earnings years between age 62 and 66. This is due to the fact that the
Social Security Administration uses the 35 highest earnings years to
calculate benefits.
But keep in mind that those early Social Security benefits may be subject
to benefit reductions and income taxes - depending on how much
money the taxpayer earns.
Social Security Payments are increased if your client delays receipt of
benefits beyond full retirement age. The maximum bonus is obtained at age
424

LESSON

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70. The bonus is applied for each year the retirement date is delayed. There
is no benefit to delaying benefits beyond age 70.
The table below shows the increase in benefits received by delaying Social
Security retirement benefits past full retirement age:
Year of Birth
Pre 1917
1917-1924
1925-1926
1927-1928
1929-1930
1931-1932

Yearly Bonus
1.00%
3.00%
3.50%
4.00%
4.50%
5.00%

Year of Birth
1933-1934
1935-1936
1937-1938
1939-1940
1941-1942
1943 or later

Yearly Bonus
5.50%
6.00%
6.50%
7.00%
7.50%
8.00%

SIDE BAR

How to Check Your Social Security Statement Online


Social Security Statements used to be sent annually to all workers age 25
and older who were not already receiving monthly Social Security
benefits. The statements provided estimates of the Social Security
retirement, disability, and survivor's benefits.
However, the Social Security Administration discontinued mailing paper
statements in 2011. It then reversed course in February 2012 and
resumed mailing statements to workers age 60 and older who are not
already receiving Social Security benefits. It also mails statements to
workers at age 25.
Everyone else can check their Social Security statements online. Go to:
http://www.ssa.gov/mystatement/
You'll need to create a My Social Security account. For security reasons
youll need to provide information about yourself that matches the
information on file with the Social Security Administration, as well as
some information that matches your Experian credit report.
In addition to showing your earnings record, the statement shows your
estimated Social Security retirement benefits at age 62, your full
retirement age (66 to 67, depending on your year of birth), and at age 70.
425

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The estimates are based on your average earnings to date and assume
you will earn the same annual income from now until retirement. The
statement also shows the amount of survivors benefits your child and
spouse may receive.
Taxpayers should examine their statements annually and carefully
confirm the years they have worked, and the Social Security taxes paid.
Earnings and Benefit Estimate Statements are also available from the
Social Security Administration and can be ordered by calling (800) 7721213 or online at http://www.socialsecurity.gov.

TAX PLANNING TIP

Are there any special strategies as to when and how couples


should collect Social Security?
Yes, there are. Some complex strategies can actually help a married
couple collect tens of thousands of dollars of additional income
during their retirement. For instance, there is the "File and Suspend"
strategy and the "Restricted" application strategy.
For further information visit Social Security Timing.com. Social
Security Timing offers a software program for pre-retirees and
advisers to run scenarios to assess the different strategies. They also
offer a free calculator.
For Additional Information See:
Couples Can Boost Their Social Security Checks
How The Social Security Claiming Decision Affects Portfolio Longevity
The Decision To Delay Social Security Benefits: Theory And Evidence
With Rates Low It Pays To Delay Social Security

Railroad Retirement Benefits (RRB's)


Railroad Retirement Benefits (RRB's) are benefits paid to railroad employees
working in jobs that are covered by the Railroad Retirement Act (RRA). The

426

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RRA has two components. Tier 1 is the equivalent of social security benefits
and Tier 2 is like an employer's pension plan.

Other Types of Pension Plans


There are several other types of pension plans you should be aware of
including the 403(b), Keogh, SEP and SIMPLE plans. Payments from any of
these types of plans should be reported to the taxpayer on Form 1099-R.
You will use this form to prepare the tax return.

Form 1099-R
Form 1099-R is used by payers to report distributions from:

Pensions
Annuities
Retirement or profit sharing plans
IRAs
Insurance contracts

Figure 12-1: From 1099-R - Distributions From Pensions, Annuities, Retirement or


Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

427

LESSON

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TAX TIP

Are some payments from pension plans non-taxable?


Some employer retirement plans are "noncontributory" which means the
employer pays all of the contributions. Other plans such as 401(k)s permit
employees to make voluntary before tax contributions. In other words,
the employee contributions are subtracted from the employees W-2
wages, and only the amount of wages after subtracting the 401(k)
contributions are reported on Form W-2. Thats why there isnt a line to
deduct 401(k) contributions on Form 1040.
Because these contributions are made pre-tax any distributions from
these plans are taxable income to the employee. However, in some
circumstances an employee may make non-deductible after-tax
contributions to the plan.
In that case the employee can recover his after-tax contributions tax free
when he receives distributions. A portion of each payment is non-taxable.
Ordinarily, the amount of the after-tax contributions that the employee
received during the year is shown in Box 5 of Form 1099-R (See the Form
1099-R above). However, for pensions that began before 1993 the payer
isnt required to report this amount.
How is the non-taxable portion of those payments computed? We
explain that in the section titled "Partially Taxable Pensions and Annuities
Other than IRAs" below.
While it is important to review all of the boxes on the form, you should be
most concerned about the entries in boxes 1, 2a, 2b, 4, 5, 7, and the little
box (next to box 7) that indicates if this is an IRA/SEP/SIMPLE payment.
Some payers receive permission to customize the form, however, the box
numbers will remain the same.
Instructions to the taxpayer can be found on the back of copies B and C of
the Form 1099-R. It is very important to read these instructions, particularly
428

LESSON

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those describing box 7. Box 7 will show a code that represents the type of
distribution the taxpayer received. For example, the number 3 represents
"Disability" and the letter G indicates "Direct rollover to a qualified plan."

Form SSA-1099
Social security benefits are reported to the taxpayer on Form SSA-1099,
Social Security Benefit Statement. Sometimes taxpayers do not bring this
form with them because they think that social security benefits are not
taxable. To correctly calculate their tax returns, you need to know the
amount in box 5 (Net Benefits) of the form. You may have to ask taxpayers
to return with their Form SSA-1099s. Taxpayers who did not receive the
Form SSA-1099, or have misplaced it, can get a printout of benefits from the
local Social Security office.

Figure 12-2: Form 1099-SSA - Social Security Benefit Statement.

TAX PLANNING TIP

Do women need to save more money than men for retirement?


Yes they do. Generally, women earn less (about 80%) than men and work
429

LESSON

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fewer years. Women are often unable to invest as much as men because
they make less money. On top of that, women live about 3 years longer
than men.
Women usually receive lower Social Security benefits because of their
lower income and because the benefits are based on the participants
highest 35 years of earnings. When women havent worked for the full 35
years the Social Security Administration adds zeros for the missing years.
This lowers monthly benefits.
But there is some good news for women. They are generally better
investors than men and make higher returns. Recent research indicates
that men are more emotional than women when investing - and this is
detrimental to their success as investors. Some years ago researchers at
the University of California analyzed the stock investments of 35,000
households and found that men traded 45% more than women. This
resulted in more transaction costs and a net return that was 1.4% less.

Form RRB-1099 and Form RRB-1099R


Form RRB-1099, Payments by the Railroad Retirement Board, and Form
RRB-1099R, Annuities or Pensions by the Railroad Retirement Board, are
used to report railroad retirement benefits paid to railroad employees under
the Railroad Retirement Act. These benefits fall into two categories:

Tier 1 railroad retirement benefits


Tier 2 benefits

These categories are treated differently for income tax purposes.

Tier 1 Railroad Retirement Benefits


Tier 1 railroad retirement benefits are equal to the social security benefit
that a railroad employee or beneficiary would have been entitled to receive
under the social security system. These benefits are called "social security
equivalent benefits" and for tax purposes are treated like social security
benefits. These benefits are shown on the BLUE part of Form RRB-1099. Box
5 shows the net social security equivalent benefits for Tier 1.

430

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Figure 12-3: Form RRB-1099 - Payments by the Railroad Retirement Board.

The Tier 2 benefits consist of the rest of the Tier 1 benefits, called the "nonsocial security equivalent benefits," any Tier 2 benefits, vested dual benefits,
and supplemental annuity benefits. These benefits are shown on the GREEN
part of the Form RRB-1099R, and are treated as an amount received from a
qualified employer plan. Vested dual benefits and supplemental annuity
benefits are fully taxable pensions. Boxes 5 and 6 show the Tier 2 benefits.
For additional information refer to Publication 575 - Pension and Annuity
Income.

Pensions with Taxable Amount Determined


To make the correct determinations about the taxability of the taxpayers
retirement income, you may need to ask the taxpayer several questions.
When taxpayers cannot provide the required information, suggest that they
contact the former employer or annuity administrator. You may want to
give taxpayers a written list of questions that should be answered by the
employer.

Pensions in General
Pension or annuity payments received each year by a taxpayer is fully
taxable if the taxpayer did not pay any part of the cost of their employee
pensions or annuities, and their employers did not withhold part of the cost
from the taxpayers' pay while they worked.

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LESSON

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"Before-Tax" vs. "After-Tax" Contributions


If the taxpayer made contributions to a pension plan with "before-tax"
dollars, then the entire distribution will be taxable. This is common in 401(k)
and Thrift Savings plans.
Taxpayers who paid part of the cost of the annuity or pension with "aftertax" dollars are not taxed on the part of the annuity or pension that they
receive that represents a return of their cost. This amount will be clearly
stated on the Form 1099R.
Partially Taxable Pensions and Annuities Other than IRAs
There are two methods you can use to figure the taxable portion of each
pension or annuity payment:
The General Rule
The Simplified Method
Most taxpayers who retire after 1996 can no longer use the General Rule.
Unless the exception applies, retirees must use the Simplified Method for
annuity payments from a qualified plan.
General Rule
The General Rule is based on the ratio of the investment in the contract to
the total expected return. It must be used if the pension or annuity payment
is from a nonqualified plan (i.e. a private annuity, a purchased commercial
annuity, or a nonqualified employee plan), or the taxpayer is 75 or older on
the annuity starting date and the annuity payments are guaranteed for at
least 5 years.
For further information see Publication 939 - General Rule for Pensions and
Annuities.
Simplified Method
Using the Simplified Method Worksheet, you can figure the tax-free portion
of each pension/annuity payment by dividing the taxpayer's cost in the
contract by the total number of expected monthly payments. The number
of monthly payments is based on the taxpayer's age on the annuity start
date and is determined from a table on the worksheet.
Taxpayer's cost Number of monthly payments = Tax-Free Portion

432

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Once you've figured the tax-free portion of the pension or annuity, the
monthly exclusion amount remains the same, even if the pension payment
amount increases. For pensions starting after December 31, 1986, the
taxpayer will exclude the nontaxable pension amount until the pension cost
is recovered. Once the pension cost is recovered, the entire pension income
is taxable.

SIDE BAR

What does the term "vesting" mean?


Vesting occurs when the ownership of funds in a pension or profit
sharing plan transfers from the trust to the employee-participant.
Common vesting periods are from 3 to 10 years. During that time an
increasing percentage of the funds become property of the participant
each year.
Employer matching contributions to 401(k) plans usually use one of these
two vesting schedules:

"Cliff" vesting which provides no vested benefit until the 3rd year.
After 3 years of participation 100% of the employer's contributions
are vested.

"Graded" vesting which provides no vested benefit until the 2nd


year. Then the employer contributions vest 20% each year.

Taxation of Individual Retirement Accounts


Earnings and gains in a taxpayer's IRA generally accumulate tax free until
they are withdrawn as taxable, nontaxable or partly taxable distributions.
There are four kinds of IRAs, each of which offers tax advantages:

Traditional IRA
Savings Incentive Match Plans for Employees (SIMPLE) IRA
Simplified Employee Pension (SEP) IRA
Roth IRA

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LESSON

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INCOME

Traditional IRA
Taxpayers who made nondeductible contributions into an IRA do not have
to pay income tax on those contributions again when receiving them later
as part of a distribution from the traditional IRA.
Taxpayers who made nondeductible contributions to a traditional IRA have
a cost basis (investment in the contract) equal to the amount of those
contributions. The nondeductible contributions are not taxed when they are
distributed. They are a return of investment.
Taxpayers who made nondeductible contributions to traditional IRAs and
received distributions from those IRAs must complete Form 8606 Nondeductible IRAs . Use Form 8606 to determine the nontaxable
distributions for the year and the taxpayer's basis in the IRA. Form 8606
must be attached to the tax return.
Taxpayers cannot exclusively withdraw nondeductible contributions from
traditional IRAs. If there have been any earnings or gains on contributions,
or if deductible contributions have been made to any traditional IRA, part of
each distribution will be taxable.
Savings Incentive Match Plans for Employees (SIMPLE) IRA
Some employers offer their employees, including self-employed individuals,
the chance to contribute part of their pay to an IRA as part of a SIMPLE plan.
The employer is also generally required to make contributions on behalf of
eligible employees. Employees are not currently taxed on their contributions
when they are paid into the IRA. Distributions from a SIMPLE IRA are
generally fully taxable.
Simplified Employee Pension (SEP) IRA
Some employers offer their employees a chance to take part in an SEP. Selfemployed people also can establish an SEP IRA for themselves. SEP IRA
contributions are not included in an employees income when paid into the
IRA. Distributions are generally fully taxable when the employee receives
them in later years.
Roth IRAs
Qualified Distributions from a Roth IRA are tax free if they meet certain
conditions, even if they represent earnings that accumulated in the Roth
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IRA. For the distribution of earnings to be excluded from income, the


following requirements must be met:

The distribution is made after the 5-year period beginning with the
first taxable year for which a contribution was made to a Roth IRA set
up for the taxpayers benefit, and

The distribution is:


o
o
o
o

Made on or after age 59 1/2


Made because the taxpayer was disabled
Made to a beneficiary or to an estate, or
To pay certain qualified first-time homebuyer amounts

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Taxation of Social Security Benefits


The taxable amount, if any, of a taxpayer's social security benefits depends
upon the rest of the taxpayers income and filing status. The higher the total
income, the more benefits that must be included in taxable income - up to
85%. Social security benefits are reported to the taxpayer on Form SSA1099, Social Security Benefit Statement. Part of the following benefits
received by the taxpayer may be taxable:

Social security benefits, or


The social security equivalent portion of Tier 1 railroad retirement
benefits

If social security benefits were the taxpayer's only source of income, the
benefits are not taxable and the taxpayer probably does not need to file a
federal income tax return. If the taxpayer received social security benefits
plus other income, you can calculate how much, if any, is taxable by
completing the Social Security Benefits Worksheet. Double click Form 1040
line 20a to go there.

Figure 12-4: Income section of Form 1040 with line 20a "Social security benefits"
highlighted.

Social security benefits include monthly survivor benefits and disability


benefits. They do not include supplemental security income (SSI) payments,
which are not taxable. Some of the benefits received are taxable if total
income, plus one-half of the benefits received, is more than the base
income amounts shown below.

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Filing Status

Base Income

Single, Head of Household, Qualifying Widow(er)


and Married Filing Separately (lived apart all year)

$25,000

Married Filing Jointly

$32,000

Married Filing Separately (living together)


The base income includes the following:

$0

1. All taxable income.


2. Tax exempt interest and dividends.
3. 50 percent of Social Security benefits received.
4. Other factors to add: US savings bond interest excluded, adoption benefits
excluded, foreign income/housing excluded.
5. Less all subtractions from income to arrive at AGI (lines 23 thru 35) except
student loan interest (line 33), tuition and fees deduction (line 34), and
domestic production activities deductions (line 35). Also subtract any write-in
adjustments from line 36.
If the base income exceeds the above dollar amounts, part of the Social Security
benefits will be taxable.
Filing Status
Single, Head of
Household, Qualifying
Widow(er)
and Married Filing
Separately (lived apart
all year)

Married Filing Jointly

Married Filing Separately


(living together)

Base Income

Taxable Social Security


Benefits

less than $25,000

none

$25,000 to $34,000

not more than 50% of total


benefits

over $34,000

not more than 85% of total


benefits

less than $32,000

none

$32,000 to $44,000

not more than 50% of total


benefits

over $44,000

not more than 85% of total


benefits

more than $0

not more than 85% of total


benefits

What is the Social Security Lump Sum Election?


If current year social security payments include lump sum benefits paid for a
prior year(s), the lump sum election method allows for recalculation of
taxable benefits for the earlier year (including the lump sum benefit) using
the prior year's income. This may result in an overall lower tax on all benefits
received and taxable in the current year.

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Lump sum payments are reported on SSA-1099 or RRB-1099 in Box 3 and


will indicate the prior year(s) and related amount(s).

TAX QUOTE

"The taxpayer? That's someone who works for the federal government, but
doesn't have to take a civil service examination."
Ronald Reagan (1911-2004) 40th President of the United States (19811989)

Disability Pension Income


Taxpayers who retire on disability must include all of their disability
payments in income. Disability payments are taxed as wages until the
taxpayer reaches the minimum retirement age, which is set by the
employer. After the taxpayer reaches the minimum retirement age, disability
payments are treated as pension income. Minimum retirement age is
generally the earliest age at which taxpayers may receive a pension whether
or not they are disabled.
Reporting Pension Income
To report pension income double click line 16a on Form 1040 to drill down
to the Form 1099-R input screen.

Figure 12-5: The Income section of Form 1040 with line 16a "Pensions and annuities"
highlighted.

If the taxpayer has more than one pension or annuity that is not fully
taxable, figure the taxable part of each separately.
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Disability Income Reporting


Employers may report disability income on the following two forms:

Form W-2 - Wage and Tax Statement, or


Form 1099-R - Distributions from Pensions, Annuities, Retirement or
Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

Enter disability income on Form W-2 on the Form W-2 input screen by
double clicking on line 7 of Form 1040. Disability income is included as
wages in box 1 of Form W-2.
Box 2a of Form 1099-R indicates the taxable amount of disability income
reported by an employer.

Figure 12-6: Form 1099-R - Distributions From Pensions, Annuities, Retirement or ProfitSharing Plans, IRAs, Insurance Contracts, etc. with box 2a "Taxable amount" and box 7
"Distribution code(s)" highlighted.

Check to see if box 7 (Distribution Code) shows the code number 3


(Disability). If box 7 indicates that the taxpayer is receiving disability
payments, then determine if the taxpayer has reached the minimum
retirement age, which has been set by the employer.
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If the taxpayer has not reached the minimum retirement age, report the
disability income as wages on line 7 of Form 1040. If the taxpayer has
reached the minimum retirement age, report the disability income as a
taxable pension as follows:

If the disability payments are partially taxable, use Form 1040 lines
16a and 16b

If the payments are fully taxable, enter the taxable amount on line
16b; do not make an entry on line 16a

Figure 12-7: The Income section of Form 1040 with line 16b "Pensions
and annuities - Taxable amount" highlighted.

Reporting Social Security Benefits


Report social security benefits by double clicking on Form 1040 line 20a to
drill down to the Social Security Benefits Worksheet. Then complete the
lines of the worksheet to have 1040 ValuePak determine if any of the
benefits are taxable. The taxable portion of social security benefits is never
more than 85 percent of the net benefits the taxpayer has received. In many
cases, the taxable portion is less than 50 percent.
Repayment of benefits
Occasionally taxpayers may receive Social Security benefits to which they
were not entitled. In these instances the Social Security Administration,
upon learning of the overpayment, will contact the taxpayer and demand
repayment. Any repayment of social security benefits the taxpayer made
must be subtracted from the gross benefits received for the year. It does not
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matter whether the repayment was for a benefit received in the current year
or in an earlier year.
In some situations, Form SSA-1099 or Form RRB-1099 will show that the
total benefits repaid (box 4) are more than the gross benefits received (box
3). If this occurred, the net benefits in box 5 will be a negative figure (a
figure in parentheses) and none of the benefits will be taxable.
If the total amount shown in box 5 of all of Forms SSA-1099 and RRB-1099
is a negative figure, the taxpayer can take an itemized deduction for the part
of this negative figure that represents benefits included in gross income in
an earlier year.

Reporting IRA Distributions


IRA distributions are reported on Form 1099-R, Distributions from Pensions,
Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
Traditional IRA, SIMPLE IRA, or SEP IRA
For Traditional, SIMPLE and SEP IRAs, box 7 of Form 1099-R will show a "7"
as the code for a normal distribution, and the box "IRA/SEP/SIMPLE" will be
checked.

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Figure 12-8: Form 1099-R - Distributions From Pensions, Annuities, Retirement or


Profit-Sharing Plans, IRAs, Insurance Contracts, etc. with box 7 "Distribution code(s)"
highlighted.

Ask the taxpayer whether he or she deducted all Traditional IRA


contributions from income in the year they were made. If so, the entire
distribution is taxable. Report it on Form 1040 lines 15a and b.

Figure 12-9: The Income section of Form 1040 with line 15a "IRA distributions" and line 15b
"Taxable amount" highlighted.

Distributions from a SIMPLE IRA and from a SEP IRA are generally fully
taxable.

Premature Distributions
A premature distribution is an early withdrawal from a pension fund, for
purposes other than retirement, by a taxpayer who is under 59 1/2. Early
distributions are subject to an additional tax of 10 percent. The tax applies
to the taxable portion of the distribution or payment. Certain early
distributions are excluded from the early distribution tax. If the distribution
code in box 7 of Form 1099-R is 2, 3, or 4, the taxpayer does not have to
pay the additional tax.
The following premature distributions are exempt from the 10% penalty:

Rollovers
Total disability
Separation from service if age 55 or older
Medical expenses exceeding 10% of adjusted gross income
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Substantially equal payments made over the participants life


expectancy after separation from service
Payments to beneficiaries
Distributions to reservists called to active duty for more than 179
days
Public safety employees separated from service at age 50 or older
IRS levies
Qualified Domestic Relations Orders
Distributions made before 1984 pursuant to TEFRA
Separation from service before March 2, 1986

If the taxpayer's Form 1099-R shows a code 1 in box 7, you may need to
complete Form 5329 to determine the additional tax on the distribution.
1040 ValuePak will automatically call up Form 5329.

Lump-Sum Distributions
A lump-sum distribution is the distribution or payment within a single tax
year of an employees entire balance from all qualified pension, stock
bonus, or profit-sharing plans that the employer maintains.
Distributions from IRAs or tax-sheltered annuities do not qualify as lumpsum distributions. This distribution does not include deductible voluntary
employee contributions and certain amounts forfeited or subject to
forfeiture.
To qualify as a lump-sum distribution, the payment must have been made:

Because the plan participant died, or

After the participant reached age 59 1/2, or

Because the participant, not including a self-employed individual,


separated from service with the employer, or

After the participant, if a self-employed individual, becomes totally


and permanently disabled

Lump-sum distributions are reported on Form 1099-R like any other


pension distribution. Some lump-sum distributions qualify for special tax
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treatments. Code A shown in box 7 of Form 1099-R indicates that the


distribution is a lump-sum distribution and qualifies for special tax
treatments such as:

Distributions allocable to pre-1974 participation being taxed at a


special rate (there will be an amount in box 3 of Form 1099-R); the
part after 1973 is ordinary income

Ten-year tax option to figure the tax on the total taxable amount

Tax-free rollover of the distribution into an IRA

TAX TIP

What options are available for taxpayers who receive lump-sum


distributions?
Generally, taxpayers have these two options:
1. Receive the payment in cash. If the taxpayer receives the distribution
and doesnt roll it over it will be taxed as ordinary income in the year it is
received. Additionally the taxpayer may have to pay an extra 10% penalty
if the distribution is "premature" (i.e. before age 59-1/2). 20% of the
distribution will be withheld for income taxes. 25% if the distribution is
from a SIMPLE plan during the first two years of participation. If the later
is the case Form 1099-R will have a distribution code of "S" in Box 7.
2. Roll the distribution over into an IRA or another qualified plan. Any
after-tax contributions cannot be rolled over. The plan administrator will
report the taxable amount in Box 2a of Form 1099-R. That is the amount
that can be rolled over to an IRA. Distributions from the IRA will be
taxable as ordinary income when they are taken.
When considering an IRA rollover taxpayers should keep one important
point in mind. Once rolled over the funds are subject to the IRA rules
regardless of their source. Thus, the plan participant may be giving up the
more favorable qualified plan rules.

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TAX TIP

Obtaining a Tax Free and Interest Free Loan


Taxpayers may have heard that they can get a short term "loan" from
their IRA account. Taxpayers have 60 days to roll over lump-sum
distributions and other IRAs to a new IRA. During that time they can
effectively give themselves a short term "loan" and use the funds
however they are needed. But be cautious, because if the rollover isnt
completed within 60 days of the distribution it will be taxable as ordinary
income.
Additionally, the taxpayer may have to pay a 10% early withdrawal
penalty if the distribution was premature (made before age 59 1/2). Then,
if the taxpayer decides to place the funds back into another IRA account
for retirement, he must treat it as a new IRA contribution for the current
tax year. A 15% excise tax will apply to any portion of the funds that
exceed $5,500 ($6,500 for those age 50 and above). A taxpayer in the
35% tax bracket will effectively lose 60% of his original account balance
to taxes.
Failed rollovers are reported on Form 5329 - Additional Taxes on Qualified
Plans (Including IRAs) and Other Tax-Favored Accounts.
Also be aware that if the taxpayer makes a trustee-to-trustee transfer
directly to the new IRA sponsor there will be no income tax withholding
on the lump-sum payment. However, if the taxpayer receives the lump
sum in cash, even with the intention of rolling it over within 60 days, the
retirement plan administrator must withhold 20% of the payment for
income taxes. If the taxpayer actually does roll over the funds within 60
days hell get the 20% withholding back with his tax refund.
Taxpayers will receive Form 1099-R from the plan administrator showing
the amount paid in Box 1. This total is reported on Line 16a of Form 1040.
Any amount that was not rolled over is reported on Line 16b.

Taxpayers born before January 2, 1936


The taxpayer may use the Special Averaging Method to determine the tax
on the lump sum distribution if he was born before January 2, 1936 and he
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hasn't previously used the Special Averaging Method for figuring tax after
1986. Utilizing the Special Averaging Method is a once in a lifetime election.
Lump sum distributions that qualify for the Special Averaging Method will
have Code A appear in box 7 of Form 1099-R.
The taxpayer must meet all the tests below:

The taxpayer received everything due him from the plan within one
tax year

The taxpayer participated in the plan for at least five years prior to
the tax year of lump sum distribution

The plan was a tax qualified plan

The taxpayer was at least age 59 when the lump sum distribution
was made, or, was self employed and totally disabled if the lump
sum distribution was made before age 59.

The lump sum distribution that reported may qualify for special tax
treatment that includes the 10 year averaging tax option, and the
20% capital gain tax treatment.

The 20% capital gain tax election can be made to compute the tax on the
taxable part of the lump sum distribution that applies to the portion
received for participating in the plan before 1974. These choices allow
taxpayers who were born before 1936 to have the pre-1974 taxable portion
taxed at a 20% tax rate, and the rest of the lump sum distribution, including
the portion for all post-1973 participation, taxed as ordinary income using
the 10 year averaging option.

Minimum Distributions
Taxpayers are required to begin receiving distributions from their qualified
plan by April 1 of the calendar year following the year in which they:

Reach age 70 1/2, or


Retire from their place of employment

In other words, taxpayers who turn 70 1/2 or retire during 2015 must take
their first distribution for 2015 no later than April 1, 2016, and their next
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distribution, for 2016, no later than December 31, 2016. These required
distributions are called minimum distributions.
For IRAs, it doesn't matter whether the taxpayer is employed. Distributions
must begin by April 1 of the year following the calendar year in which the
taxpayer reaches 70 1/2.
Qualified plans include:
Employee retirement plans
Qualified annuity plans
Deferred compensation plans
Tax-sheltered annuity plans, and
Individual Retirement Accounts (IRAs) other than Roth IRAs
After the starting year for periodic distributions, taxpayers must receive the
minimum distribution for each year by December 31 of that year. The
starting year is the year in which the taxpayer reaches 70 1/2 or retires. If no
distribution is received during the taxpayer's starting year, the minimum
required distributions for two years must be received the following year.
If the taxpayer does not receive the minimum distribution, an excise tax may
be imposed. The tax is 50 percent of the difference between the minimum
distribution and the amount actually distributed for the tax year.

Lump-Sum Benefit Payments


Some taxpayers may have received a lump-sum benefit payment. This
payment could be for both the current tax year and the prior tax year. The
lump-sum payment will be included in box 3 of the taxpayer's Form SSA1099 or Form RRB-1099.
The form will also show the year, or years, of the payment. When figuring
the taxable portion of social security benefits, two options are available for
lump-sum benefit payments. The first option allows the taxpayer to report
the whole payment in the year it was received. When the taxpayer chooses
this option, complete the Social Security Benefits Worksheet as usual by
including the entire lump-sum payment on line 1.
The taxpayer also has the option of treating the payment as received in the
earlier year or years. This is done by figuring whether any part of these
benefits is taxable, based on the earlier years income. Any part that is
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taxable is then added to any taxable benefits for the current year and
included on Form 1040 line 20b.

Figure 12-10: Income section of Form 1040 with line 20b "Social security benefits Taxable amount" highlighted.

If the taxpayer chooses to spread the payments back to earlier years, only
current year income will be adjusted. The taxpayer does not file amended
returns for the earlier years. However, a special procedure must be used to
figure the taxable portion of the benefits assigned to the earlier years. If
taxpayers want to use this option refer to Publication 915 - Social Security
and Equivalent Railroad Retirement Benefits.

Withdrawal of Excess IRA Contributions


If taxpayers made excess IRA contributions, and if they withdrew the excess
contributions and any earnings by the due date of the return, they will not
be subject to an additional 6 percent tax on the excess contribution. The
withdrawal must be completed by the due date of the tax return for that
year, including extensions.
The withdrawn excess contribution is not included in the taxpayers gross
income if both of the following conditions are met:

No deduction was allowed for the excess contribution


All interest or other income earned on the excess contribution is
withdrawn

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However, taxpayers must include in their gross income the interest or other
income that was earned on the excess contribution. Report it on the return
for the year in which the excess contribution was made.
The withdrawal of interest or other income may be subject to an additional
10 percent tax on early withdrawals. Taxpayers will receive Form 1099-R
indicating the amount of the withdrawal. If the excess contribution was
made in a previous tax year, the form will indicate the year in which the
earnings are taxable.
In general taxpayers must include all withdrawals from their traditional IRA
in gross income. However, if the total contributions to an IRA, other than
rollover contributions for the year, are $5,500 or less ($6,500 or less if
taxpayer is age 50 or older), and there are no employer contributions for the
year, taxpayers can withdraw any excess contribution after the due date for
filing the tax return for that year, including extensions, and not include the
amount withdrawn in their gross income.
This rule applies only to the part of the excess for which the taxpayer did
not take a deduction. For more information on excess contributions, see
Publication 590-B - Distributions from Individual Retirement Arrangements
(IRAs).

Pension Withholding and Estimated Tax


Payments
Income tax is normally withheld from the taxable part of a pension or
annuity. At the taxpayers request, the payer of the pension or annuity can
adjust the withholding amount or stop the withholding completely. Form
W-4P - Withholding Certificate for Pension and Annuity Payments is used to
request a change in withholding on a pension. The taxpayer should
complete the form and send it to the payer of the pension.

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Figure 12-11: Form W-4P - Withholding Certificate for Pension or Annuity Payments.

The taxpayer can request withholding from their social security benefits by
completing Form W-4V - Voluntary Withholding Request and filing it with
the Social Security Administration.

Figure 12-12: Form W-4V - Voluntary Withholding Request.

A taxpayer who chooses not to have tax withheld may have to pay
estimated tax. Failure to have enough federal income tax paid in throughout
the year can result in an estimated tax penalty. Also, it can result in a large
amount of tax due when the return is filed. If the taxpayer owes $1,000 or
more on the tax return, you should discuss their withholding and estimated
tax options with them.

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For more information about estimated tax or withholding see Publication


505 - Tax Withholding and Estimated Tax.

TAX TIP

Re-Cap of Important Age Related Retirement Plan Dates


Age 50: Extra Retirement Plan Account Contributions Are Allowed
Taxpayers age 50 and older at year end can make additional catch up
contributions to 401(k) plans, Section 403(b) tax deferred annuity
plans, governmental Section 457 plans (up to $6,000 for 2015), and
SIMPLE plans (up to $3,000).
Taxpayers also have until the filing deadline to make additional catch
up contributions of up to $1,000 to a Traditional or Roth IRA.
Age 55 and 59 1/2: Penalty Free Retirement Account Withdrawals Are
Allowed
After age 55 taxpayers can receive penalty free payouts from their
former employer's (they must be permanently separated) qualified
retirement plan(s) without being assessed the 10% premature
withdrawal penalty tax that applies to most pay outs received before
age 59 1/2.
After reaching age 59 1/2 they can receive penalty free pay outs from
any retirement plan including IRAs.
Age 62: Start Date for Reduced Social Security Benefits
Taxpayers can start receiving Social Security benefits at age 62 but
they are lower than if they wait until they hit the full-retirement age of
66. Benefits will be further reduced if the taxpayer works and his 2015
earnings exceed $15,720. Up to 85% of the benefits may be subject
to federal income tax.
Age 66: Start Date for Full Social Security Benefits
Taxpayers born between 1943 and 1954 are entitled to full Social
Security benefits at age 66. They don't lose any benefits if they work
in years after age 66. However if they turn 66 in 2015 their benefits
will be reduced if their earnings from working exceed $41,880.
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Age 70: Start Date for Enhanced Social Security Benefits


Taxpayers who defer Social Security benefits until after age 70 receive
higher benefits than if they started earlier. If they make this choice
they won't have to worry about reduced payments if they continue
working, but this option only makes sense for those in good health.
Age 70 1/2: Retirement Account Mandatory Withdrawal Rules Start
Taxpayers must start taking annual required minimum withdrawals
from their tax favored retirement plan accounts by December 31st
and pay income taxes on the funds received. Withdrawals from Roth
IRAs are not required.
The penalty tax for not taking required mandatory withdrawals is
equal to 50% of the shortfall between the amount they should have
withdrawn for the year and the amount they actually withdraw.
The initial required withdrawal should be taken in the year the
taxpayer turns 70 1/2 but they can postpone taking that initial
withdrawal until April 1st of the following year. However, they then
must take two required withdrawals in that year and pay the resulting
tax on both withdrawals. Thus, this option should only be used when
the taxpayer failed to take the required withdrawal in the year in
which they turned 70 1/2.
Exception: Taxpayers who continue working after age 70 1/2 and don't
own over 5% percent of the business that employs them can delay taking
any required withdrawals from that employer's plan(s) for as long as they
keep working.

TAX PRACTICE TIP

Reporting Fraud and Abuse Within the IRS E-File Program


Falsified W-2 forms. Stolen Identities. Stolen Social Security numbers.
Multiple taxpayer refunds being deposited into the same bank account.
These are the tools of "taxpayers" who electronically file fake returns
claiming refunds to which theyre not entitled, so that they can cash in on
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tax refunds.
The Internal Revenue Services Criminal Investigation unit has warned that
this area of fraud is growing rapidly. One in every 966 e-filed returns is
fraudulent. Five years ago the number of fraudulent e-filed returns was
one in 4,789. This is an important issue particularly for store front tax
preparation services because they have a continually changing client
base.
A "fraudulent return" is a return in which the individual is attempting to
file using someone elses name or SSN on the return or where the
taxpayer is presenting documents or information that have no basis in
fact.
Fraudsters pose as taxpayers while using bogus W-2 forms as well as
stolen identification. They may have been recruited just to go into the tax
preparation office using false identification and stolen Social Security
numbers. They are not who they purport to be to the tax practitioners.
Sometimes the same "taxpayers" will return to the exact same tax offices
multiple times, each time carrying different tax documents and using
different names.
Another group of fraudsters is made up of perpetrators who infiltrate tax
preparation offices by taking jobs as tax preparers. They put the returns in
the system when the ERO isn't looking. At least 75 percent of all
fraudulently e-filed returns come from EROs, and many ERO offices are
specifically targeted if the perpetrators have determined that security
controls are weak.
The IRS has a sophisticated system called the Electronic Fraud Detection
System. The system includes a scoring model based on data-mining
technology that compares relationships and issues on tax returns to
information in various databases, scoring the returns for fraud potential.
Every tax return with a refund goes through the Electronic Fraud
Detection System. However, problems can arise when it takes the IRS up
to two weeks to electronically process tax returns, especially in the peak
of the filing season in early February.
All Authorized IRS e-file Providers must be on the lookout for fraud and
abuse in the IRS e-file Program. Tax preparers should be on the lookout
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for suspicious-looking documents such as non-electronically produced


W-2s and refunds that are to be mailed to post office boxes. Indicators of
abusive or fraudulent returns may be unsatisfactory responses to filing
status questions, multiple tax returns for multiple taxpayers filed with the
same mailing address, and missing or incomplete Schedules A and C
income and expense documentation. Fraudulent tax returns should NOT
be filed with the IRS.
A "potentially abusive return" is a return that:

is not a fraudulent return;


the taxpayer is required to file;
but may contain inaccurate information and may lead to an
understatement of a liability or an overstatement of a credit
resulting in a refund to which the taxpayer may not be entitled.

The IRS encourages EROs to notify them if there is suspicion of fraud.


Suspected fraud can be reported to the IRS by calling (800) 829-0433.
You can also report fraudulent or abusive returns, including those with
questionable Forms W-2, to the IRS by submitting Form 3949A Information Referral.
Employment Background Checks
EROs should take extra time in checking the backgrounds of the
employees they consider hiring and should be diligent of how they
screen and hire them. Some payroll processors, such as ADP, provide
screening and selection services which include criminal background
checks of prospective employees, for a fee.

Lesson Summary
This lesson discussed pensions and annuities. Pensions or annuities may
have a tax-free portion if the taxpayer made after-tax contributions to the
plan.
To determine the taxable portion of the annuity payments of a taxpayer,
use:

The Simplified Method if the taxpayers annuity starting date is after


November 18, 1996 and annuity payments are from a qualified plan.
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INCOME

For annuity starting dates after 1997, use the annuitants age (or
combined ages if more than one annuitant) at the annuity starting
date of the taxpayer(s).

The General Rule for annuity payments from a nonqualified plan and
for certain retirees age 75 or older.

Total pension or annuity income and taxable pension or annuity income are
entered on Form 1040 lines 16a and 16b.
Social security benefits can be nontaxable or taxable. To determine the
taxable portion of social security payments received by a taxpayer, use the
Social Security Benefits Worksheet. Total social security benefits and taxable
portion are entered on Form 1040 lines 20a and 20b.
Qualifying distributions from a profit sharing or retirement plan may be
taxed at a lower rate using the 10 Year Special Averaging Method. If the
distribution includes a capital gain component, an election to tax it at lower
capital gains rates may be made. To qualify for 10 year averaging, the
following conditions apply:
1. The plan must be a qualified plan.
2. The full account balance must be distributed in one tax year.
3. The employee was a plan participant for 5 years prior to the year of
distribution unless distributed due to death.
4. The distribution resulted from death or employment termination
(quit, laid-off, retired, or fired), or reached age 59-1/2.
5. The employee was born prior to January 2, 1936.
Federal income tax on pension, annuity and social security income can be
withheld by the payer, or the taxpayer may choose to pay estimated tax.

Questions Taxpayers Ask


Question: "My employer won't pay me my pension. What should I do?"
Answer: If you are having problems related to your pension payments, you

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INCOME

need to contact the Pension Benefit Guaranty Corporation (PBGC). Call their
toll-free pension hotline at 1-800-998-7542.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify you're understanding of the
most important lesson content, and will also help you pass the
Final Exam.
Do the Homework - While completing the homework is not
mandatory, we strongly recommend that you complete each
lesson's homework assignment. It will expand your knowledge
and understanding of the topics covered in this course.

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LESSON

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RENTAL

INCOME

AND

EXPENSES

Lesson

13
Lesson 13 - Rental Income and
Expenses
In this lesson you'll learn about Rental Income and Expenses. The following
topics are discussed in this lesson:
Rental Income
Rental Expenses
Mortgage Interest and
Property Taxes
Deduction of Property Taxes
Other Deductible Rental
Expenses
Auto and Travel Expenses
Repairs vs. Improvements
Advance Insurance
Premiums
Special Allocations

Rental vs. Personal Use


Days Used for Repairs and
Maintenance
Deductibility Limitations
Rental Losses
Passive Activity vs. Active
Participation
Passive Activity Losses
Active Participation
Phase-Out of Offset
Reporting Rental Losses
Self-Employment Tax

eporting rental income and expenses is a frequent occurrence.


Taxpayers who cannot sell their homes when moving often rent out
their homes. Additionally, investors purchase homes for long term
capital appreciation. Rental income and expenses are recorded on Part I of
Schedule E - Supplemental Income and Loss. 1040 ValuePak carries the total
on Schedule E to Form 1040 line 17.
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INCOME

AND

EXPENSES

Figure 13-1: The Income section of Form 1040 with line 17 "Rental real estate, royalties,
partnerships, S corporations, trusts, etc." highlighted.

TAX TIP

Should taxpayers obtain an appraisal prior to renting their home?


When taxpayers convert their home to a rental property they may
depreciate the property based on the lower of its fair market value or its
adjusted basis on the date of conversion. Obtaining an appraisal at the
time of conversion will help support the taxpayers depreciation
deduction and the calculation of any capital gain or loss at the time of
sale.

Rental Income
Generally, taxpayers must include in gross income all amounts received
from rental properties, including rental receipts received from a former
residence.
Both U.S. citizens and resident aliens must report rental income, regardless
of whether the rental property is located in the United States or in a foreign
country.
Rental income may include other payments in addition to the normal and
ordinary rents received, such as:

Advanced rent
Security deposits
Payments for breaking a lease
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Expenses paid by the tenant


Fair market value of property or services received in exchange for
rental payments

Remember to include these additional payments, except for security


deposits, in the taxpayer's gross rental income.
The security deposit is not included in income when the taxpayer plans on
returning the deposit at the end of the lease. If the tenant subsequently
breaks the lease or causes damages include the amount of the forfeited
security deposit in income at that time. If the security deposit is intended to
serve as the last month's rent, then it should be included in income when
received.
The taxpayer's method of accounting affects when the rental income is
reported:

Taxpayers using the cash basis method of accounting report the


income the year they actually receive it. Nearly all taxpayers use the
cash basis.

Taxpayers using the accrual method of accounting report the income


in the year they are entitled to receive payments

The cash method of accounting reports income when received and


expenses when paid, as opposed to the accrual method, which reports
income when earned and expenses when incurred.

TAX QUOTE

"The difference between death and taxes is death doesn't get worse every
time Congress meets."
Will Rogers

Rental Expenses
Deductible rental expenses are reported on Schedule E, Part I, lines 5
through 18.
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RENTAL

INCOME

AND

EXPENSES

Deductible expenses include any ordinary and necessary expenses, such as


mortgage interest, repairs, maintenance, and certain operating expenses.
Additional information on rental income and expenses can be found in
Publication 527 - Residential Rental Property.

TAX TIP

Can taxpayers deduct expenses even if their property is vacant?


Taxpayers can deduct expenses for renting their home even if they don't
have tenants as long as they are actively seeking tenants. One way to
document that the taxpayer is actively seeking tenants is get a copy of
the listing agreement, a copy of any advertising invoices, or clip out and
save the ads in the newspaper showing that the rental home is available
for lease.
Mortgage Interest and Property Taxes
Homeowners who live in their homes generally report their mortgage
interest and real estate taxes on Schedule A - Itemized Deductions. However,
taxpayers who rent out their home need to report those expenses on
Schedule E for the months their home is rented. In the first year of the
rental, you might have to divide the mortgage interest and real estate taxes
between Schedule A and Schedule E. To do this:

Divide the total mortgage interest and property taxes by 12 months,


and

Multiply by the number of months the home was used for each
purpose

Deduction of Property Taxes


The property tax amount you enter on Schedule E is deductible. However, if
any part of the property tax is considered a special assessment for local
benefits, such as putting in streets and sidewalks that increase the value of
the property, then you:

Add that portion of the tax to the basis of the property, and
Do not deduct that portion of the tax as an ordinary rental expense
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EXPENSES

Other Deductible Rental Expenses


In addition to mortgage interest and property taxes, deductible rental
property expenses include:

Advertising
Auto and travel expenses to check on the property
Cleaning and maintenance
Commissions paid for collecting rental income
Insurance premiums
Legal and professional fees
Property management fees
Repairs
Utilities paid for the tenant
Other rental-related expenses, such as rental of equipment and long
distance phone calls

Auto and Travel Expenses


Ordinary and necessary travel and transportation expenses attributable to
the production of rental income are deductible. If the travel was into or
outside of the United States, the taxpayer should substantiate the pleasure
vs. business portions of the trip and allocate the expenses accordingly.
Taxpayers who use their personal automobile for rental-related trips may
use either the standard mileage rate for business mileage or the actual
expense method:

The standard mileage rate for business mileage is shown in the table
below. In addition, parking fees and tolls may be deducted. This
method can be selected on a yearly basis.

The actual expense method for computing costs may not be used if
the automobile is not used more than 50% for business.

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Type of Mileage
Business*
Medical/Moving
Charitable

RENTAL

2012
55.5 per mile
23 per mile
14 per mile

INCOME

AND

2013
56.5 per mile
24 per mile
14 per mile

EXPENSES

2014
56 per mile
23.5 per mile
14 per mile

2015
57.5 per mile
23 per mile
14 per mile

*These tax deductible rates are available for individuals who own the vehicle and operate
only one vehicle for business purposes at a time. The election to use this method must be
made during the first tax year the vehicle is used for business.
Table: Mileage Rates

Repairs vs. Improvements


Whether action taken with respect to a rental property qualifies as a repair
or as an improvement is a matter of common confusion with significant
differences in tax treatment. A repair keeps the property in good operating
condition. The cost of a repair is a current year deduction. An improvement
adds to the life or material value of the property or adapts it to new uses.
The cost of an improvement must be depreciated over the useful life of the
improvement.
An improvement to a rental property:

Is a capital expenditure
Increases the basis of the property
Must be depreciated

The total cost of an improvement includes material, labor, and installation.


Additional information on rental income can be found in Publication 527 Residential Rental Property and Publication 946 - How to Depreciate
Property.

TAX TIP

Can taxpayers deduct improvements in the current year if they had


to make the improvements because their property was vandalized?
If the taxpayers rental property is damaged by vandalism, the repair costs
to restore the property to its previous condition are tax deductible as
repairs and maintenance in the current year, instead of as improvements
- which need to be depreciated.

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INCOME

AND

EXPENSES

Advance Insurance Premiums


Taxpayers who pay an insurance premium fo