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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.
454

LESSON

12

PENSION

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

455

LESSON

12

PENSION

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.

456

LESSON

13

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.
457

LESSON

13

RENTAL

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
458

LESSON

13

RENTAL

INCOME

AND

EXPENSES

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.
459

LESSON

13

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
460

LESSON

13

RENTAL

INCOME

AND

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.

461

LESSON

13

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.

462

LESSON

13

RENTAL

INCOME

AND

EXPENSES

Advance Insurance Premiums


Taxpayers who pay an insurance premium for more than one year in
advance cannot deduct the entire amount in one year. The advanced
premium must be pro-rated over the period covered by the policy by both
the cash basis and accrual basis taxpayer.
If the rental is a condominium or cooperative, the maintenance fee is
deductible.
Mortgage interest expense is fully deductible.
Special Allocations
Renting a room to a tenant is a business activity. When the room is in a
property a taxpayer also uses for personal purposes, the rental income and
expenses must be allocated separately from the taxpayer's personal
expenses. This topic explains when to report rental income and when to
deduct rental expenses for property that the taxpayer also uses for personal
purposes.

Rental vs. Personal Use


Expenses that apply to just the rental part of a property should be reported
in full on Schedule E, because they are business expenses.
Expenses that benefit the entire property must be divided between rental
use and personal use. The taxpayer may use any reasonable method to
allocate the expenses. The most common methods are based on the
number of rooms in the dwelling or on the total square foot area of the
dwelling.
Days Used for Repairs and Maintenance
Any day the taxpayer spent working substantially full time repairing and
maintaining the rental property should not be counted as a day of personal
use, even if the taxpayer's family members used the property for recreation
purposes on the same day.
Personal Use of Rental Property
Taxpayers who do not use a dwelling unit as a home should:

Include all the rent in their income, and


Deduct all the rental expenses, even if expenses exceed income
463

LESSON

13

RENTAL

INCOME

AND

EXPENSES

Taxpayers who do use a dwelling unit as a home and rent it out 15 days or
more during the year should:

Include the rent in their income, and


Deduct the rental expenses

However, rental expenses that exceed rental income may not be deductible.
Taxpayers who do use a dwelling unit as a home and rent it out fewer than
15 days during the year should:

Not include the rent in their income, and


Not deduct the rental expenses

Deductibility Limitations
Deductibility limitations apply to rental expenses for a dwelling unit the
taxpayer uses as a home more than the greater of:

14 days or
10% of the number of days during the tax year the property is rented
at fair market value

A dwelling unit might be a house, apartment, condominium, mobile home,


boat, or similar property. The limitations do not apply to hotels, motels, inns,
or similar dwelling units.
Exception
Taxpayers who used a dwelling unit as their main home may not have to
count all that time as "days of personal use" if, for 12 or more consecutive
months, they rented or tried to rent the dwelling unit at a fair rental price. In
this case, days of personal use do not include the time the taxpayer used
the property as his or her main home before or after renting it or offering it
for rent. This exception applies for the purposes of determining whether to
limit the deductibility of rental expenses. It does not apply when dividing
expenses between rental and personal use.
Carryover
Taxpayers who cannot deduct a loss from other income due to these
personal use rules may carry over the disallowed loss to the following year.

464

LESSON

13

RENTAL

INCOME

AND

EXPENSES

TAX TIP

Do taxpayers who rent their home for just a few days have to
declare the rental income?
No, taxpayers who rent their personal or vacation home for 14 days or
less don't need to report their rental income or expenses. They also
cannot deduct expenses other than those they would ordinarily deduct as
a homeowner. However, if the home is an investment property then the
taxpayer would report rental income and expenses even if it is rented for
14 days or less.

Rental Losses
This topic explains how the at-risk rule and passive activity law can restrict
how much rental loss can offset other sources of income.
Passive Activity vs. Active Participation
A passive activity is a business activity in which the taxpayer did not
materially participate. Rental activities are generally passive activities,
whether or not the taxpayer materially participated.
Deducting all of the rental expenses and depreciation from the taxpayer's
rental income may result in a loss. Because rental activities are generally
considered passive activities, rental losses are not fully deductible. However,
taxpayers who actively participated in the renting of the property may
deduct up to $25,000 of their rental losses.
Passive rental activity means receiving income mainly from the use of
property rather than for services. Active participation means making
significant management decisions, such as approving rental terms, repairs,
expenditures, and new tenants. Taxpayers who use a leasing agent or
property manager are still considered active participants if they retain final
management rights.
For more information see Publication 925 - Passive Activity and At-Risk
Rules.

465

LESSON

13

RENTAL

INCOME

AND

EXPENSES

Passive Activity Losses


The two restrictions on how much of a loss from passive activity can offset
other sources of income are the:

At-risk Rule
Passive Activity Loss Rule

The at-risk rule restricts taxpayers from claiming a loss for more than they
could actually lose from the activity. That is, they can claim a loss only up to
the amount for which they are personally at-risk in the activity.
Taxpayers are generally considered at-risk for the amount of cash and
property they contributed to the activity from which they are not protected
against personal liability, with the exception of casualty insurance.
The passive activity rule states that passive activity losses can be deducted
only from passive activity income. That is, losses that exceed rental income
are not deductible.
Passive income does not include salary, dividends, or investments, but is
generally attributed to such things as equipment leasing, rental real estate,
most limited partnerships, S-Corporations, and limited liability companies in
which the taxpayer does not materially participate.
Passive Activity Losses that cannot be currently deducted are carried
forward indefinitely to future years where they may or may not be
deductible. Any unused losses may be deducted upon a disposition of the
taxpayers interest in the property.

TAX PRACTICE TIP

Looking for Carryovers from Prior Years


Remember to review you new clients prior year's tax return(s) to see if
there are any Passive Activity Loss or other carryovers that need to be
brought over to this year's tax return.

466

LESSON

13

RENTAL

INCOME

AND

EXPENSES

Active Participation
An exception to the general passive activity loss rule provides that taxpayers
who actively participate in the rental activity can use up to $25,000 of their
rental losses to offset any other non-passive income. The limit is $12,500 for
married taxpayers filing separately and living apart for the entire year.
Examples of non-passive income are salaries, wages, commissions, tips, selfemployment income, interest, dividends, annuities, and some royalties.
Taxpayers can show active participation by keeping:

a record of phone calls showing the date, time, and purpose of calls
an appointment book, calendar, or log of the days and time spent
"participating".

Phase-Out of Offset
The amount allowed to offset non-passive income is:

Reduced once the taxpayer's adjusted gross income exceeds


$100,000 ($50,000 for married filing separately)

Completely phased out when adjusted gross income (AGI) exceeds


$150,000 ($75,000 for married filing separately)

The table below shows the Passive Activity Loss Allowance at various levels
of AGI:
If the taxpayer's modified AGI
is...
Up to $100,000
$110,000
$120,000
$130,000
$140,000
$150,000 or more

His passive activity loss


allowance is...
$25,000
$20,000
$15,000
$10,000
$5,000
$0

467

LESSON

13

RENTAL

INCOME

AND

EXPENSES

TAX QUOTE

"Be wary of strong drink. It can make you shoot at tax collectors... and
miss."
Robert A. Heinlein

Reporting Rental Losses


The taxpayer may be required to file Form 8582 - Passive Activity Loss
Limitations. The form summarizes losses and income from all passive
activities.
Generally, taxpayers are not required to file Form 8582 if they have:

Only one passive loss generated from a rental activity, and


An adjusted gross income of less than $100,000

468

LESSON

13

RENTAL

INCOME

AND

EXPENSES

Self-Employment Tax

TAX TIP

Should taxpayers always take depreciation on their rental property?


Yes. taxpayers should always take depreciation on their rental property
because the IRS considers depreciation to be taken each year, regardless
of whether or not they actually took the depreciation. Upon its sale, gain
or loss must be realized as if the depreciation was taken, even if it wasnt.

469

LESSON

13

RENTAL

INCOME

AND

EXPENSES

Lesson Summary
Lets take a moment to review what you have learned in this lesson.
Rental income and deductible rental expenses are recorded on Part I of
Schedule E - Supplemental Income and Loss. U.S. citizens and resident aliens
must report rental income for the months their home is rented, regardless
of whether the rental property is located in the United States or in a foreign
country.
Some examples of deductible rental expenses are mortgage interest,
property taxes, cleaning, home insurance, property management fees, and
repairs.
When renting part of the property, certain expenses must be divided
between rental use and personal use:

Taxpayers who do not use a dwelling unit as a home should include


all the rent in their income and deduct all the rental expenses.

Taxpayers who do use a dwelling unit as a home and rent it out 15


days or more during the year may not be able to deduct rental
expenses that exceed rental income.

Taxpayers who do use a dwelling unit as a home and rent it out


fewer than 15 days during the year should not report any of the
income or deduct any of the rental expenses.

The cost of a repair is a current year deduction. The cost of an improvement


is a capital expenditure and must be depreciated over the useful life of the
improvement.
The at-risk rule, which restricts taxpayers from claiming a passive loss for
more than they could actually lose, and passive activity law, restricts how
much rental loss can offset other sources of income. Rental activities are
generally considered passive activities, therefore rental losses are not fully
deductible. However, taxpayers who actively participated in the renting of
the property may deduct up to $25,000 of their rental losses (up to $12,500
for married taxpayers filing separately and living apart).

470

LESSON

13

RENTAL

INCOME

AND

EXPENSES

Taxpayers with rental losses may be required to file Form 8582 - Passive
Activity Loss Limitations.

SIDE BAR

IRS Publication Reference


An alphabetical listing of all IRS Publications can be viewed at Appendix M.

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.

471

LESSON

14

FOREIGN

EARNED

INCOME

EXCLUSION

Lesson

14
Lesson 14 - Foreign Earned Income
Exclusion
In this lesson you'll learn about the Foreign Earned Income Exclusion. This
lesson explains how to determine whether a taxpayer qualifies for the
exclusion. After completing this lesson, you will be able to:
Describe the foreign earned income exclusion
Determine whether a taxpayer's foreign home qualifies as his or her
tax home
Determine whether a taxpayer's period of stay overseas qualifies for
the exclusion
Determine whether a taxpayer's income is foreign earned income
Determine whether a taxpayer should file Form 2555 or Form 2555-EZ
The following topics are discussed in this lesson:
What Is the Foreign Earned
Income Exclusion?
Eligibility Requirements
Married Couples
Qualifying Tax Home
Military Personnel
Choosing the Exclusion
Revoking the Exclusion
Determining the Tax Home
Period of Stay
Bona Fide Residence Test

472

Figuring the 12 mo. Period


Waiver of Time Requirements
Qualifying Income
Form 2555
Deductions Allocable to
Excluded Income
Self-Employment Tax
Itemized Deductions
Moving Expenses
Net Exclusion
Tax Guide for U.S. Citizens

LESSON

14

FOREIGN

EARNED

Physical Presence Test

INCOME

EXCLU SION

and Resident Aliens Abroad

axpayers who are U.S. citizens or residents and work overseas are
taxed on their worldwide income. The foreign earned income
exclusion allows qualified taxpayers to exclude up to $99,200 for
2014 of their foreign earnings from their taxable income. The exclusion
does not apply to the wages and salaries of military and civilian employees
of the U.S. government; however, other foreign income earned by the
spouses of military personnel may be eligible for the exclusion. Civilian
employees of the government include those who work at Armed Forces
post exchanges, officers' and enlisted personnel clubs, and embassy
commissaries.
For tax years beginning after 2005, non-excluded income is taxed for both
the regular tax and the Alternative Minimum Tax (AMT) at the rates that
would apply if taxable income included the foreign earned income exclusion
and foreign housing deduction.
The table below shows the Foreign Earned Income Exclusion amounts, year
by year:
Tax Year
2000
2001
2002-2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Future Years

Excludable amount
$76,000
$78,000
$80,000
$82,400
$85,700
$87,600
$91,400
$91,500
$92,900
$95,100
$97,600
$99,200
Indexed for Inflation

Table: Foreign Earned Income Exclusion

473

LESSON

14

FOREIGN

EARNED

INCOME

EXCLU SION

Eligibility Requirements
To claim the foreign earned income exclusion the taxpayer must:

Demonstrate that his or her tax home is in a foreign country


Meet either the bona fide residence test or the physical presence test
Have income that qualifies as foreign earned income

"Foreign country" does not include Puerto Rico, Guam, the Northern
Mariana Islands, the Virgin Islands, or U.S. possessions such as America
Samoa, Wake Island, the Midway Islands, and Johnston Island.

Married Couples
The requirements are applied separately to each individual. If a husband
and wife are each working overseas, each must meet all requirements to
qualify for the exclusion. If they do qualify, each is entitled to an exclusion of
up to $99,200 for 2014. Remember, military pay is not eligible for the
exclusion.

Qualifying Tax Home


To claim the foreign earned income exclusion, the taxpayer's tax home must
be in a foreign country. The tax home is defined as the country in which the
taxpayer is permanently or indefinitely engaged to work as an employee or
self-employed individual, regardless of where the taxpayer maintains his or
her family home.
For taxpayers who work abroad, but do not have a regular place of business
because of the nature of the work, their tax home is the place where they
regularly live.

Military Personnel
The tax home for military personnel is the permanent duty station, either
land-based or on a ship. This is true whether it is feasible or permissible for
the taxpayers family to live with him or her. Most military personnel and
their dependents will not qualify for the foreign earned income exclusion.

474

LESSON

14

FOREIGN

EARNED

INCOME

EXCLU SION

TAX QUOTE

"The income tax created more criminals than any other single act of
government."
Barry Goldwater

Choosing the Exclusion


The foreign earned income exclusion is voluntary. There are times when it
may be to the taxpayers advantage to not claim the exclusion. For example,
taxpayers who wish to claim the Earned Income Tax Credit should not claim
the exclusion, since they are not allowed to claim both. Taxpayers who wish
to claim the exclusion must file either Form 2555 or Form 2555-EZ with a
timely return, including extensions. Exceptions do apply that allow the initial
choice to be made after a return is filed.

Revoking the Exclusion


The taxpayer may revoke the exclusion for any tax year. When the exclusion
is revoked, the taxpayer may not claim the exclusion again for the next five
tax years without the approval of the IRS.

Determining the Tax Home


To qualify for the foreign earned income exclusion, the taxpayer's tax home
must be in a foreign country throughout his or her period of bona fide
residence or physical presence abroad. While this seems straightforward, it
can be challenging to determine which location constitutes the taxpayer's
tax home.
To determine a taxpayer's tax home, you must first understand the term
"regular place of abode." For purposes of the foreign earned income tax
exclusion, if a taxpayer works overseas for an indefinite period of time, and
his or her regular place of abode is in the U.S., the taxpayer cannot
designate the foreign country as the tax home. Regular place of abode is
variously defined as one's home, habitation, domicile or place of dwelling. It
does not necessarily include one's principal place of business. The location
of a taxpayer's regular place of abode often depends on where he or she
maintains economic, family and personal ties.

475

LESSON

14

FOREIGN

EARNED

INCOME

EXCLU SION

For example, when the taxpayer has a tax home in the U.S. and goes
overseas temporarily, or on business, the tax home has not changed.
However, if the taxpayer maintains a place of business, or is assigned to
overseas employment in a foreign country for an indefinite period, and does
not maintain a regular place of abode in the U.S., the tax home is overseas
and the taxpayer may be eligible for the foreign earned income exclusion.
Indefinite is defined as overseas employment that exceeds one year.
Three questions are important in determining whether a U.S. home is the
taxpayer's regular place of abode. The questions that you should ask the
taxpayer are:

Did you use your home in the United States as a residence while you
worked at your job in the United States just before going abroad to
your new job, and did you continue to maintain work in that area in
the United States during the time you worked abroad?

Are your living expenses duplicated at the U.S. and foreign home
because your work requires you to be away from your U.S. home?

Do you have a family member or members continuing to live at your


U.S. home, or do you frequently use your U.S. home for lodging
during the period you work abroad?

If the taxpayer cannot answer "yes" to at least two of the three questions,
the taxpayer is considered to be indefinitely assigned to the new location
abroad and is eligible for the foreign earned income exclusion.
If the taxpayer answers "yes" to all three questions, and the job duration is
for less than one year with the taxpayer returning to his or her U.S. home,
the taxpayer is considered temporarily away from home. The taxpayer does
not qualify for the foreign earned income exclusion, but may qualify to
deduct away-from-home expenses.
If the taxpayer answers "yes" to two of the three questions, with the same
expectation of job duration and return to the U.S. home, the location of the
tax home depends on all the facts and circumstances.

476

LESSON

14

FOREIGN

EARNED

INCOME

EXCLU SION

Period of Stay
To meet the period of stay requirement, the taxpayer must be either:

A U.S. citizen or resident alien from a tax treaty country who is a


bona fide resident of a foreign country (or countries) for an
uninterrupted period that includes an entire tax year, or

A U.S. citizen or U.S. resident alien who is physically present in a


foreign country or countries for at least 330 full days during any
period of 12 consecutive months.

Bona Fide Residence Test


To meet the bona fide residence test, taxpayers must show that they have
set up permanent quarters in a foreign country for an entire, uninterrupted
tax year. Simply going to another country to work for a year or more is not
enough to meet the bona fide residence test. A taxpayer must establish a
residence in the foreign country. Taking a brief trip to the U.S. will not
prevent the taxpayer from being a bona fide resident, as long as the
intention is clear to return to the foreign country.
Physical Presence Test
The other test that may be met instead of the bona fide residence test is the
physical presence test. To qualify, the taxpayer must be physically present in
a foreign country 330 full days during a period of twelve consecutive
months. In order for a day to count for the test, it must be a full day in a
foreign country. When arriving from the U.S., or returning to the U.S., any
day in which part of the time is spent in the U.S. or over international waters
does not count as a qualifying day in a foreign country. Taxpayers can count
days spent abroad for any reason. It does not have to be for employment
purposes only. Vacation days count as well.
The taxpayer may move about from one place to another in a foreign
country or to another foreign country without losing full days. But if any
part of the taxpayer's travel is not within a foreign country or countries and
takes 24 hours or more, the taxpayer will lose full days.
Figuring the 12-month Period
Any 12-month period may be used if the 330 days in a foreign country fall
within that period. If necessary, more than one period may be used,
including periods that overlap. By using more than one period, it may be
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possible to meet the physical presence test for an entire stay, even though
there may have been intervening visits to the U.S.
Waiver of Time Requirements
The minimum time requirements for period of stay may be waived if the
taxpayer is forced to leave a foreign country because of war, civil unrest, or
similar adverse conditions in that country. The taxpayer must show that
he/she could have met the minimum time requirements if it had not been
for the adverse conditions.

Qualifying Income
To qualify for the exclusion, income must be earned income. Earned income
includes:

Salaries
Wages
Commissions
Professional fees

To qualify for the exclusion, the earned income must be for services, other
than military or U.S. government, performed in a foreign country.
Earned income does not include:

Dividends
Interest
Capital gains
Alimony
Social security benefits
Pensions
Annuities

Amounts paid by the United States or its agencies to its employees do not
qualify for the exclusion. This includes military pay and payment for such
activities as post exchanges, commissaries, and officers clubs.
To qualify for the exclusion, services must be performed in a foreign
country. Where the payments come from for the service or where they are
deposited is not a factor in determining the source of the income. If a
taxpayer works predominantly in a foreign country, but does some work in
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the U.S., an adjustment must be made to the total of foreign earned


income.

TAX TIP

Is your client cheating on his taxes?


You don't have to be rich to have foreign bank accounts and financial
assets. Many resident aliens and U.S. citizens have foreign bank accounts
and financial assets for legitimate reasons. They may have kept accounts
open from the past when they worked abroad, they may have had
accounts before they immigrated to the U.S., or they may have inherited
money from relatives abroad, including money in an estate that is being
administered and closed shortly after the relative's death.
All Americans have to report their worldwide income on their income tax
return. Taxpayers must report all income earned, even if it's earned in
another country. Taxpayers must also report the balance of an account to
the U.S. Treasury Department if the balance is $10,000 or more at any
time during the year - regardless of the income earned. Thats called the
FBAR report, or FinCEN Form 114 - Report of Foreign Bank and Financial
Accounts. All FBARs must now be e-filed.
This form is due on June 30th of each year. The penalty for failing to file
Form 114 is up to $10,000.
Taxpayers can reduce the U.S. tax impact of any foreign taxes paid
because the U.S. taxes will be offset by any taxes paid overseas.
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
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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.
If your client hasn't previously reported his foreign financial accounts
you'll need to correct the past failures to avoid his getting in trouble for
violating FBAR reporting rules. Your client potentially falls into the FBAR
trap by the mere fact of having unreported income on an account the
Treasury Department doesnt know about. The penalties on these
overseas accounts range from 5% to 100% of the balance of the
accounts, plus interest. Yes, your client can wind up owing more than the
entire balance of the account if disclosure is not made. Keep in mind that
if your client has signature authority along with foreign relatives on their
account in a foreign country, for FBAR purposes, its your client's account
and must be reported.
Clients often think that since their family overseas is taking care of
reporting the income and paying any tax they dont have to do
anything. Even if tax was paid on the interest or dividends in the
foreign country it must be reported on the U.S. taxpayer's tax return. If
the taxpayer lives in one of the forty-three states with an income tax
any interest or dividends will also need to be reported on the
taxpayer's state income tax return. Most states don't have credits for
foreign taxes paid.
Clients who have accounts in their country of origin, country of previous
residence, or where their family lives often forget to report those
accounts. This is especially true if they seemingly don't have to file
Schedule B because their taxable interest and ordinary dividends are less
than $1,500 - as the questions in Part III at the bottom of that form often
trigger a discussion between the preparer and the taxpayer. However, a
Schedule B must be filed if "You had a financial interest in, or signature
authority over, a financial account in a foreign country or you received a
distribution from, or were a grantor of, or transferor to, a foreign trust" regardless of how much interest or dividends the taxpayer earned for the
year.

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See this IRS page for more on when and where to file the FBAR:
http://www.irs.gov/Businesses/Small-Businesses-&-SelfEmployed/Report-of-Foreign-Bank-and-Financial-Accounts-FBAR
You can also download the FBAR Reference Guide:
http://www.irs.gov/pub/irs-utl/IRS_FBAR_Reference_Guide.pdf
If you have FBAR questions, you can email FBARquestions@irs.gov.
Foreign Asset Reporting Requirements
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 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. Higher
asset thresholds apply to U.S. taxpayers who file a joint tax return or
who reside abroad.
This requirement is in addition to the fact that taxpayers with
accounts overseas worth $10,000 or more generally are required to
report those funds to the U.S. Treasury on the FBAR form. The FATCA
rules encompass more types of financial assets than the FBAR.
For a comparison of the Form 8938 - Statement of Specified Foreign
Financial Assets and the Form 114 - Report of Foreign Bank and
Financial Accounts (FBAR) reporting requirements click here:
http://www.irs.gov/Businesses/Comparison-of-Form-8938-and-FBARRequirements
Additional information about FATCA is available at IRS.gov by clicking
here:
http://www.irs.gov/Businesses/Corporations/Foreign-Account-TaxCompliance-Act-FATCA
How To Report Foreign Gifts And Bequests
U.S. citizens and resident aliens must report all income annually even
if its taxed somewhere else. However, gifts and inheritances are not
taxable income. If there is a gift or estate tax the person or estate
giving the money or property is responsible for any tax due. So
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taxpayers who receive a gift or inheritance dont owe any tax on it.
However taxpayers should file Form 3520 - Annual Return to Report
Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts if
they receive either of the following during the tax year:
1. More than $100,000 from a nonresident alien individual or a foreign
estate (including foreign persons related to a nonresident alien
individual or foreign estate) that the taxpayer treats as a gift or
bequest; or
2. More than $15,358 (Form 3520, Part IV) from foreign corporations
or foreign partnerships (including foreign persons related to such
foreign corporations or foreign partnerships) that the taxpayer treats
as a gift.
Form 3520 is required in the year the gift or bequest is actually or
constructively received.
The penalty for reporting a gift late is 5% of its value for each month
the gift is not reported (maximum 25%). However, no penalty applies
if the IRS is convinced the failure to report was due to reasonable
cause and not willful neglect.

Form 2555
Taxpayers who wish to claim the foreign earned income exclusion must
complete Form 2555 or Form 2555-EZ and attach it to their Form 1040. The
tax return should be filed with:
Internal Revenue Service Processing Campus
Philadelphia, PA 19255
Form 2555-EZ
To be able to use Form 2555-EZ, the taxpayer must:

Be a U.S. citizen or resident alien who has wages and salaries, but not
self-employment
Have a total foreign earned income of $91,500 or less
Not be claiming any business or moving expenses
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Taxpayers who do not meet these restrictions should file Form 2555 to
claim the exclusion.
Part I
All taxpayers who wish to claim the foreign earned income exclusion must
complete Part I, General Information. Taxpayers who qualify under the bona
fide residence test must complete Part II. Taxpayers who qualify under the
physical presence test must complete Part III.
Part IV
All taxpayers must complete Part IV, which asks for detailed information on
the foreign earned income. Part IV must be completed in U.S. dollars. If the
taxpayer has difficulty in converting income, the IRS can provide exchange
rates. However, the taxpayer is not required to use rates provided only by
the IRS or the federal government. Note that earned income includes not
only wages and salaries but also non-cash income and allowances and
reimbursements received by the taxpayer. Do not list military wages in this
section; they are not considered foreign earned income.
Part V, Part VI and Part VII
Page 3 of the form is where the exclusion is computed. Taxpayers claiming
only the basic exclusion fill out Parts V and VII. Taxpayers who want to claim
a housing exclusion must complete Part VI. Most of the lines in Parts V, VI,
and VII are self-explanatory.
For tax years beginning after 2005, the foreign housing deduction is
modified as follows:

The housing cost floor is 16% of the maximum foreign earned


income exclusion

Actual housing expenses generally are capped at 30% of the


maximum foreign earned income exclusion

Generally, armed forces personnel and their spouses will not qualify for the
housing exclusion because the housing allowance is already considered
nontaxable income.
In Part VII, it important that taxpayers enter the correct number of days for
the qualifying period. For those qualifying under the bona fide residence
test, this qualifying period is the period of actual residence. For the physical
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presence test, the qualifying period(s) is (are) chosen by the taxpayer. Any
period may be chosen as long as 330 days are spent in a foreign country
during the period. If the number of qualifying days in the tax year is less
than 365, the $99,200 exclusion limit is lowered proportionally.
Part VIII
If the taxpayer is claiming a housing exclusion, you must complete Part VIII.
Deductions Allocable to Excluded Income
Taxpayers are required to list the deductions used to adjust their gross
income in Part VIII of Form 2555. The deductions that are allocable to the
excluded foreign income are entered on line 44. The foreign earned income
exclusion is reduced by the deduction. The three most common deductions
that may affect the exclusion are:

Self-employment tax
Itemized deductions
Moving expenses

Self-Employment Tax
Taxpayers must take all earned income into account in figuring selfemployment tax, even though the income is exempt from income tax
because of the foreign earned income exclusion. An individual is allowed a
deduction for one-half of self-employment tax on Form 1040. This
deduction is related to the operation of the business. If foreign earned
income is excluded, the deduction for self-employment tax must be
allocated to the excluded income. The amount allocated to the excluded
income reduces the foreign earned income exclusion allowed.
When the qualifying earned income is fully excluded none of the selfemployment tax deduction is allowed; therefore, the full amount of this
deduction is entered on line 44 of Form 2555. This will reduce the foreign
earned income exclusion by the amount of the deduction. However, the
self-employment tax deduction is still entered on line 27 of Form 1040.

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Figure 14-1: The Adjusted Gross Income section of Form 1040 with line 27 "Deductible part
of self-employment tax" highlighted.

TAX QUOTE

"There may be liberty and justice for all, but there are tax breaks only for
some."
Martin A. Sullivan
Itemized Deductions
The treatment for itemized deductions is somewhat different. In reporting
itemized deductions on Form 1040 Schedule A that are wholly or partly
allocable to excluded income, the taxpayer must reduce the gross
deduction by the disallowed amount in arriving at the net deduction shown
on Schedule A.
In addition, the taxpayer must attach a statement showing how the
deductible amount was figured and write "Form 2555" in the upper-right
corner of Schedule A. The most common itemized deductions that are
allocable to excluded foreign earned income are un-reimbursed employee
business expenses.
Moving Expenses
The rules for deducting moving expenses allocable to excluded income are
more complex. During the year of the move, taxpayers who have at least
120 days in their qualifying period during the tax year must allocate the
moving expense solely to the year of the move. Taxpayers who have less
than 120 full days in the tax year must allocate the moving expense to
income in the year of the move, and the year after.
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Net Exclusion
After adjusting the exclusion for any deductions allocable to excluded
income, the net exclusion is carried to Form 1040. The amount from Form
2555-EZ line 18 or Form 2555 line 45 is entered in parentheses on Form
1040 line 21. It is subtracted from other sources of income.

Figure 14-2: The Income section of Form 1040 with line 21 "Other income"
highlighted.

Tax Guide for U.S. Citizens and Resident


Aliens Abroad
For further information on the Foreign Earned Income Exclusion and
Foreign Housing Exclusion or Deduction see IRS Publication 54 - Tax Guide
for U.S. Citizens and Resident Aliens Abroad.
Additional information regarding international taxpayers is available at the
IRS's International Taxpayer page.

Lesson Summary
Taxpayers who are U.S. citizens or residents and work overseas are taxed on
their worldwide income. The foreign earned income exclusion allows
qualified taxpayers to exclude up to $99,200 for 2014 of their foreign
earnings from their taxable income. The exclusion does not apply to the
wages and salaries of military and civilian employees of the U.S.
government; however, other foreign income earned by the spouses of
military personnel may be eligible for the exclusion. Civilian employees of
the government include those who work at Armed Forces post exchanges,
officers' and enlisted personnel clubs, and embassy commissaries.
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To claim the foreign earned income exclusion the taxpayer must:

Demonstrate that his or her tax home is in a foreign country


Meet either the bona fide residence test or the physical presence test
Have income that qualifies as foreign earned income

The foreign earned income exclusion is voluntary. There are times when it
may be to the taxpayers advantage to not claim the exclusion. For example,
taxpayers who wish to claim the Earned Income Tax Credit should not claim
the exclusion, since they are not allowed to claim both.
Taxpayers who wish to claim the foreign earned income exclusion must
complete Form 2555 or Form 2555-EZ and attach it to their Form 1040. The
tax return should be filed with:
Internal Revenue Service Processing Campus
Philadelphia, PA 19255
Taxpayers must take all earned income into account in figuring selfemployment tax, even though the income is exempt from income tax
because of the foreign earned income exclusion.
After adjusting the exclusion for any deductions allocable to excluded
income, the net exclusion is carried to Form 1040. The amount from Form
2555-EZ line 18 or Form 2555 line 45 is entered in parentheses on Form
1040 line 21. It is subtracted from other sources of income.

Questions Taxpayers Ask...


Question: "Do I have to pay tax on my Fulbright Award?"
Answer: A Fulbright Award for research, lecturing, or teaching is taxable
unless you can claim the foreign earned income exclusion. If you don't
qualify for the exclusion of your Fulbright Award and your overseas stay is
temporary and you intend to return to your regular teaching position in the
U.S., you may deduct the cost of your travel, meals, and lodging overseas.
If at least 70% of a Fulbright Award is paid in a foreign currency that is
"blocked" and not convertible to U.S. currency, you can pay your U.S.
income tax due in the foreign currency.
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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

15
Lesson 15 - Adjustments to Income
- Part I
In this lesson you'll learn about Adjustments to Income. This lesson is designed
to teach you about adjustments to income, including those related to medical
and health savings accounts, moving expenses, self-employment tax,
pensions, self-employed health insurance, savings account penalties, and
alimony payments. Upon completing this lesson you will be able to determine
whether certain taxpayers are eligible to claim these adjustments to income
on their tax return.
The following topics are discussed in this lesson:
Archer Medical Savings
Accounts (MSA)
Health Savings Accounts
(HSAs)
Moving Expenses
One Half of Self-Employment
Tax
Simplified Employee Pensions
(SEP)

Savings Incentive Match Plan


for Employees (SIMPLE)
Keogh Plans
Self-Employed Health
Insurance Deduction
Penalty on Early Withdrawal
of Savings
Alimony Paid

djustments to Income are subtractions from total income. Total


income minus adjustments equals the Adjusted Gross Income (AGI).
AGI is used to figure certain limitations and also to figure income
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tax for some states. Taxpayers cannot take any adjustments on Form
1040EZ. Form 1040A allows taxpayers to take some adjustments. All other
adjustments must be taken on Form 1040.

Figure 15-1: The Adjusted Gross Income section of Form 1040.

Archer Medical Savings Accounts (MSA)


Archer MSA's are in the process of being replaced by Health Savings
Accounts (HSA's). Archer MSA's are designed to pay the costs of routine
medical expenses for employees of small businesses and self employed
persons. The medical plan combines a high deductible health insurance
policy with the medical savings account. An Archer MSA is similar to an IRA.
Earnings in the account accumulate tax free.
Archer MSA Contributions of Self Employed Persons
A self employed person can deduct the health insurance premium element
from his or her tax return. A tax deduction of 100% of the health insurance
premium is deducted on line 29 of Form 1040.

Figure 15-2: The Adjusted Gross Income section of Form 1040 with line 29 "Self-employed
health insurance deduction" highlighted.

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Contributions to the Archer MSA's savings account element are reported on


Form 8853 and deducted on line 36 of Form 1040. On the dotted line next
to Form 1040 line 36 enter MSA and the amount. A tax deduction of 65%
(75% of the deductible for families) of the health plan deductible is
deducted. The contributions may not exceed net self employment income
from that business.

Figure 15-3: The Adjusted Gross Income section of Form 1040 with line 36
highlighted.

The table below shows the amount of Archer MSA deductible


contributions:
MSA High Deductible Health Plan
Minimum
Annual plan deductibles
Maximum
Out-of-pocket expense limitation
Maximum annual contribution

2015 Individual
$2,200
$3,300
$4,450
65% of deductible

2015 Family
$4,450
$6,650
$8,150
75% of deductible

Table: Archer MSA Deductibles

Archer MSA Contributions of or for Employees


If a small business has an average of less than 51 employees in either of the
prior two calendar years they can offer Archer MSA's for their employees.
The employer can pay for everything or let the employee pay for the
Medical Savings Account. If the employer pays for the entire cost of the plan
the payments are not taxable to the employee on his/her tax return. If the
employee contributes to the Medical Savings Account the employee reports
the contributions on Form 8853 and deducts the contributions on Line 36
of Form 1040. On the dotted line next to Form 1040 line 36 enter MSA
and the amount.
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Archer MSA Distributions


A distribution from a Medical Savings Account is tax free if it is used to pay
for qualifying medical expenses of the taxpayer, spouse, or dependents.
Qualifying medical expenses are costs that could be claimed as an itemized
tax deduction on the tax return if the taxpayer paid them directly. Premiums
for long term care insurance, for health insurance while receiving
unemployment benefits, or for COBRA coverage from a former employer
qualify.
A taxable distribution is subject to a 15% tax penalty unless the taxpayer is
age 65 or older, or disabled.
For further information see Publication 969 - Health Savings Accounts and
Other Tax-Favored Health Plans.

TAX QUOTE

"The purpose of a tax cut is to leave more money where it belongs: in the
hands of the working men and working women who earned it in the first
place."
Robert Dole

Certain business expenses of reservists,


performing artists, and fee-basis
government officials
If the taxpayer is a qualified performing artist, or a state (or local)
government official who is paid in whole or in part on a fee basis, the
taxpayer can deduct the cost of his qualifying work-related education as an
adjustment to gross income rather than as an itemized deduction.
Include the cost of the taxpayers qualifying work-related education with
any other employee business expenses on Form 1040 line 24. The taxpayer
does not have to itemize deductions on Schedule A (Form 1040), and,
therefore, the deduction is not subject to the 2%-of-adjusted-gross-income
limit.

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Figure 15-4: The Adjusted Gross Income section of Form 1040 with line 24 "Certain
business expenses of reservists, performing artists, and fee-basis government officials"
highlighted.

Health Savings Accounts (HSAs)


A health savings account (HSA) is a tax-exempt trust or custodial account
that the taxpayer sets up with a qualified HSA trustee to pay or reimburse
certain medical expenses. The taxpayer must be an eligible individual to
qualify for an HSA.
No permission or authorization from the IRS is necessary to establish an
HSA. When the taxpayer sets up an HSA, the taxpayer will need to work with
a trustee. A qualified HSA trustee can be a bank, an insurance company, or
anyone already approved by the IRS to be a trustee of individual retirement
arrangements (IRAs) or Archer MSAs. The HSA can be established through a
trustee that is different from the taxpayer health plan provider.
What are the benefits of an HSA?
The taxpayer may enjoy several benefits from having a Health Savings
Account:

The taxpayer can claim an adjustment to income for contributions


the taxpayer, or someone other than the taxpayers employer, make
to the taxpayers HSA even if the taxpayer does not itemize
deductions on Form 1040

Contributions to the taxpayers HSA made by the taxpayers


employer (including contributions made through a cafeteria plan)
may be excluded from the taxpayers gross income

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The contributions remain in the taxpayers account from year to year


until the taxpayer uses them

The interest or other earnings on the assets in the account are tax
free

Distributions may be tax free if the taxpayer pays qualified medical


expenses

An HSA is "portable" so it stays with the taxpayer if the taxpayer


changes employers or leaves the work force

Contributions to an HSA
Any eligible individual can contribute to an HSA. For an employee's HSA,
the employee, the employee's employer, or both may contribute to the
employee's HSA in the same year. For an HSA established by a selfemployed (or unemployed) individual, the individual can contribute. Family
members or any other person may also make contributions on behalf of an
eligible individual.
Contributions to an HSA must be made in cash. Contributions of stock or
property are not allowed.
Limit on contributions
The amount the taxpayer or any other person can contribute to the
taxpayer HSA depends on the type of HDHP coverage the taxpayer have
and the taxpayer age. For 2015, if the taxpayer has self-only coverage, the
taxpayer can contribute up to the amount of the taxpayers annual health
plan deductible but not more than $3,300. If the taxpayer has family
coverage, the taxpayer can contribute up to the amount of the taxpayers
annual health plan deductible, but not more than $6,650.

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The table below shows the amount of HSA deductible contributions and
limits:
Qualifications:

taxpayer must be in a qualified high deductible medical insurance plan

taxpayer must not be covered under another health plan or enrolled in Medicare
Parts A or B

taxpayer cannot be claimed as a dependent


Qualified High Deductible Health Plan
Total annual deductible
Minimum Annual
and out of pocket
Coverage
Deductible
expenses *
Self
$1,250
$6,350
Family
$2,500
$12,700
* This limit does not apply if the plan uses a network of providers.
Maximum HSA Contribution Limits
1. The maximum Health Spending Account (HSA) contribution limits for a Single taxpayer
is $3,300. For a Family it is $6,550.
2. The taxpayer may add $1,000 to catch up if the taxpayer is between the ages of 55
and 64. $2,000 for family's.
3. If the taxpayer is eligible for an HSA during the last month of the year he is eligible for
every month.
4. Reduce the contribution limits for any other Archer MSA's or HSA's.
5. HSA contribution limits are no longer limited to the annual deductible under the
insurance plan.
6. Excess contributions are subject to a penalty of 6%.
7. Participation in a Flexible Spending Account (FSA) is disregarded in determining
eligibility for an HSA provided the balance of the FSA is $0 at year end OR the taxpayer
is making a qualified HSA distribution equal to the balance in the FSA.
Table: Health Savings Accounts

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Flowchart: HDHP Deduction Limitations

Filing Form 8889


The taxpayer must file Form 8889 with the taxpayers Form 1040 if the
taxpayer (or the taxpayer's spouse, if married filing a joint return) had any
activity in the taxpayers HSA during the year. The taxpayer must file the
form even if only the taxpayers employer or the taxpayers spouse's
employer made contributions to the HSA. Deductible amounts from Form
8889 carry over to Form 1040 line 25.

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Figure 15-5: The Adjusted Gross Income section of Form 1040 with line 25 "Health
savings account deduction" highlighted.

For further information see Publication 969 - Health Savings Accounts and
Other Tax-Favored Health Plans.

Moving Expenses
If the taxpayer moved because of a change in his job location or because he
started a new job, he may be able to deduct the moving expenses if the
move is closely related to the start of work. It is not necessary for family
members to all move at the same time to claim a deduction for moving
expenses. To qualify for the moving expense deduction, the taxpayer must
meet both the distance and the time tests, unless the taxpayer is a member
of the armed forces and the move was due to a permanent change of
station.
The taxpayers move will meet the distance test if the new main job location
is at least 50 miles farther from his former home than the old main job
location was. Use the shortest distance of the most commonly traveled
routes between these points. To determine this, first figure the distance
between the taxpayers former residence and the new job and then subtract
the distance between the taxpayers former residence and the old job. If the
result is 50 miles or more, the taxpayer has met the distance test. For
example, if the distance from the taxpayers former residence to the new job
is 70 miles and the distance from the taxpayers former residence to the old
job is 5 miles, the taxpayer will meet the distance test.

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The second test concerns time. If the taxpayer is an employee, he must work
fulltime for at least 39 weeks during the 12 months right after the move. If
the taxpayer is selfemployed, he must work full time for at least 39 weeks
during the first 12 months and for a total of at least 78 weeks during the
first 24 months after the move. There are exceptions to the time test in case
of death, disability and involuntary separation (termination for other than
willful misconduct).

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If the taxpayer meets the requirements then he can deduct the reasonable
expenses of moving his household goods and personal effects to the new
home. The taxpayer can also deduct the expenses of traveling to the new
home, including his lodging expenses. The taxpayer cannot, however,
deduct meals.

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The table below shows the Medical/Moving Standard Mileage Rate:


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

Moving expenses are figured on Form 3903 and deducted as an adjustment


to income on Form 1040 line 26.

Figure 15-6: The Adjusted Gross Income section of Form 1040 with line 26 "Moving
expenses" highlighted.

The taxpayer cannot deduct any moving expenses that were reimbursed by
his employer. If an employer reimburses the employee for a loss on the sale
of his or her home the reimbursement is taxable as regular pay.
Then tables below shows where taxpayers report employer
reimbursements of qualified moving expenses:
Type of
Reimbursement
Employer to third
party

Reported by
Employer
Excluded from income.
Not reported on Form
W-2.
Employer to employee Excluded from income.
under an accountable
500

Employee Must:
File Form 3903 only if
excess expenses
claimed.
File Form 3903 only if
excess expenses

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Type of
Reimbursement
plan. Employee
returns any excess
reimbursement.
Employer to employee
under nonaccountable plan

Reported by
Employer

Included in income.
Reported in box 1 of
Form W-2.

File Form 3903 to claim


deduction and/or
report excess
reimbursements.

IF the Form W-2


shows...
the reimbursement
reported only in box
12 with code P.

AND you have...

THEN...

moving expenses
greater than the
amount in box 12

the reimbursement
reported only in box
12 code P
the reimbursement
divided between box
12 and box 1

moving expenses
equal to the amount in
box 12
moving expenses
greater than the
amount in box 12

file Form 3903


showing all allowable
expenses and
reimbursements.
do not file Form 3903.

the entire
reimbursement
reported as wages in
box 1
no reimbursement

moving expenses

moving expenses

Employee Must:
claimed.

file Form 3903


showing all allowable
expenses, but only the
reimbursements
reported in box 12.
file Form 3903
showing all allowable
expenses, but no
reimbursements.
file Form 3903
showing all allowable
expenses.

For additional information, refer to Publication 521 - Moving Expenses.

One Half of Self-Employment Tax


If the taxpayer had net earnings from self employment of $400.00 or more
the taxpayer is liable for Self Employment Tax. Net earnings are calculated
by subtracting ordinary and necessary trade or business expenses from the
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taxpayers total self employment income. Taxpayers are self employed for
this purpose if the taxpayer is a sole proprietor, an independent contractor,
a member of a partnership, or otherwise in business. Taxpayers can be
liable for paying self employment tax even if the taxpayer is currently
receiving Social Security benefits.
If the taxpayer had a small profit or net loss from the business but wants to
pay into the Social Security system, the taxpayer may be eligible to file Form
1040 Schedule SE and use one of the two optional methods to compute
taxpayers net earnings from self employment. See Publication 334 - Tax
Guide For Small Business to see if the taxpayer qualifies to use an optional
self employment tax computation method. This self employment tax
computation method may also allow the taxpayer to qualify for the earned
income tax credit or the child and dependent care tax credit.
Self employed persons can deduct one-half of their self employment tax on
Form 1040 line 27. Married couples who are both self employed may each
deduct one-half of their respective self employment tax on their tax return.

Figure 15-7: The Adjusted Gross Income section of Form 1040 with line 27 "Deductible part
of self-employment tax" highlighted.

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The table below shows the Social Security and Medicare maximum
wages subject to tax and the 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

Self Employment Tax is computed on Schedule SE and reported on line 57


of Form 1040.

Figure 15-8: The Other Taxes section of Form 1040 with line 57 "Self-employment tax"
highlighted.

If taxpayer is an employee of a church or qualified church-controlled


organization that elected exemption from Social Security and Medicare tax,
the taxpayer must pay self employment tax if the taxpayer is paid $108.28 or
more in a tax year. If the taxpayer is required to pay self employment tax,
the taxpayer must file Form 1040 and attach Schedule SE. For more
information on church related income and self employment tax see
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Publication 517 - Social Security and Other Information for Members of the
Clergy and Religious Workers.

Simplified Employee Pensions (SEP)

SIDE BAR

Retirement Plan Comparison Chart


Our Retirement Plan Comparison Chart details the differences between
the various different types of retirement plans. To view it see Appendix N
or click here.
With a Simplified Employee Pension (SEP) a taxpayer can contribute and
deduct more than is allowed with an IRA. Contributions are based on a
written allocation formula. Contributions cannot be discriminatory in favor
of the owner(s) or management and must be made for employees. If the
taxpayer is self-employed, tax deductible contributions to the taxpayers
personal SEP may not exceed 25% of taxpayers net earnings, or $53,000.
Net earnings are reduced by taxpayers self employment tax deduction.
SEP's are deducted on Form 1040 line 28.

Figure 15-9: The Adjusted Gross Income section of Form 1040 with line 28 "Self-employed
SEP, SIMPLE, and qualified plans" highlighted.

The deadline for establishing and contributing to a Simplified Employee


Pension is the due date or taxpayers tax return, including extensions.

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Savings Incentive Match Plan for


Employees (SIMPLE)
SIMPLE IRA accounts are salary reduction retirement plans intended for
small businesses. As many as 36 million people working for companies with
100 or fewer employees could benefit from the small business pension plan
called SIMPLE, for Savings Incentive Match Plan for Employees. Employees
can make tax deductible contributions of up to $12,500 ($15,500 for
participants age 50 or older) per tax year. Employers match the contribution.
The money isn't taxed until withdrawn.
A SIMPLE plan can be maintained by an employer that meets the two (2)
following qualifications:

in the previous calendar year had no more than 100 employees who
earned compensation of $5,000 or more; and
does not maintain any other retirement plan

To be eligible to contribute to a SIMPLE an employee must reasonably be


expected to earn $5,000 or more; provided at least $5,000 of earnings was
received by the employee in any two prior tax years. Employees make
elective salary reduction contributions of up to $12,500 and employers
make either a matching contribution or a fixed non-elective contribution. All
contributions are fully vested and non-forfeitable when made. Employee
contributions are subject to FICA tax withholding.
If an employer chooses matching contributions the employee's contribution
is matched by the employer up to 3% of the employee's compensation. If
an employer chooses the non-elective contribution the employer must
contribute 2% of the employee's compensation.
SIMPLE Distributions
Distributions from SIMPLE are subject to the regular distribution tax rules of
IRAs. However, during the first two (2) years the early distribution penalty
tax is 25%.Like SEP's, SIMPLE's are deducted on Form 1040 line 28.

Keogh Plans
A self employed person can establish a Keogh Plan and make tax deductible
contributions entered on Form 1040 line 28. This is true even if the taxpayer
also works as an employee and is covered by that employers tax qualified
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retirement plan. The taxpayer can also establish an IRA under the same tax
rules as other taxpayers. Keogh Plan contributions and interest or gains
thereon are not taxed until withdrawn.
The two types of Keogh Plans are defined contribution plans and defined
benefit plans. Retirement benefits received from a defined contribution plan
are based on the tax deductible contributions and accumulated interest and
gains. Retirement benefits received from a defined benefit plan are based
on a benefit formula. Tax deductible contributions to a defined benefit plan
are adjusted to provide the required benefit.
The maximum tax deductible contribution to a defined contribution plan is
the lesser of $53,000 or 100% of compensation.
The maximum tax deductible contribution to a defined benefit plan is the
amount needed to produce the required benefits under the formula. For
2015 the maximum annual retirement benefit which may be funded may
not exceed the lesser of 100% of the participant's average compensation for
the highest three consecutive tax years as an active participant; or,
$265,000.
Provided the Keogh Plan is established by the last day of the tax year,
taxpayer can make tax deductible contributions up to the due date of
taxpayers tax return.
Many other tax rules apply and a taxpayer should seek the help of a
qualified professional before establishing a tax deductible Keogh Plan.

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The table below shows the retirement plan contribution limits:


Contribution limits are the lesser of:
SEPs
SIMPLE IRAs

401(k) Plans, 403(b) Plans,


and SARSEPs
Defined Contribution Plans

Defined Benefit Plans

$53,000 or 25% of the participants


compensation, not to exceed $265,000
Lesser of $12,500 (add $3,000 if age 50
or over) or total compensation. There is
no % of income limit. The compensation
limit is $265,000. Employer contribution
of 2% of all employee compensation
over $5,000 OR 3% of participating
employee compensation.
Under age 50 - Elective deferrals up to
$18,000. Age 50 or older +$6,000.
$53,000 or 100% of employee taxable
compensation, not to exceed $265,000
in compensation.
The amount needed to provide an
annual retirement benefit no larger than
the smaller of:

$210,000

100% of the average taxable


compensation for the highest three
consecutive years, not to exceed
$265,000
The compensation amounts used above are after the deduction of the
contribution AND Self Employment Tax.
Table: Retirement Plan Contributions

The table below shows the deadlines for establishing retirement


accounts:
Plan Type

Deadline for Establishing Plan

Traditional IRA

Due date of tax return (April 15th plus extensions)

Roth IRA

Due date of tax return (April 15th plus extensions)

SEP-IRA

Due date of tax return (April 15th plus extensions)

SIMPLE IRA

October 1st

Keogh Profit Sharing Plan

December 31st

Keogh Money Purchase Plan

December 31st

Keogh Defined Benefit Plan

December 31st

401(k) Plan

December 31st

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TAX QUOTE

"Isn't it appropriate that the month of the tax begins with April Fool's Day
and ends with cries of May Day?"
Rob Knauerhase

Self-Employed Health Insurance Deduction


Self-employed taxpayers (including general partners in partnerships, limited
partners receiving guaranteed payments, and taxpayers who receive wages
from S-corporations in which they own more than 2% of the common
stock) who have a net profit for the year can deduct 100% of the self
employed health insurance premiums they paid for themselves, their
spouse, and their dependents on Form 1040 line 29.

Figure 15-10: The Adjusted Gross Income section of Form 1040 with line 29 "Selfemployed health insurance deduction" highlighted.

They can include the tax deductible portion of the self employed health
insurance premiums paid for tax qualified long term care policies. Additional
rules apply.
The table below shows the deductible amount of Long Term Care policy
premiums:

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Age
Maximum Tax Deductible Premium
Under 41
$370
41-50
$700
51-60
$1,400
61-70
$3,720
Over 70
$4,660
Benefits paid by qualified long term care policies:
To the extent that they reimburse long term care expenses, benefits paid by an indemnity
type contract are tax free. Benefits paid by a per diem contract are tax free up to $330
per day.
Table: Medical Long Term Care Premiums

The taxpayers self employed health insurance tax deductions cannot


exceed the net profit from the business from which the self employed
health insurance premiums are paid, - less their tax deductions for self
employment tax and any Keogh, SEP, or SIMPLE plan contributions.
They cannot take the special 100% tax deduction for self employed health
insurance premiums in any month in which they are eligible to participate in
any subsidized health plan maintained by their employer or their spouse's
employer.

Penalty on Early Withdrawal of Savings


Depositors may withdraw funds from an ordinary savings account any time
they wish. However, if they withdraw funds from a time deposit, such as a
certificate of deposit, before its maturity date, they must pay a penalty. Form
1099-INT box 1 shows the Interest Income and box 2 reports any Early
Withdrawal Penalty.

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Figure 15-11: Form 1099-INT - Interest Income with box 1 "Interest income" and box 2
"Early withdrawal penalty" highlighted.

Taxpayers can claim the penalty as an adjustment on Form 1040 line 30.

Figure 15-12: The Adjusted Gross Income section of Form 1040 with line 30 "Penalty on
early withdrawal of savings" highlighted.

The entire penalty is deducted, even if it is greater than the interest income.
Taxpayers must report the total of all their interest income, and then enter
the early withdrawal penalty separately on line 30 so it will be subtracted
from the total interest income on their tax return.
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Alimony Paid
Alimony is an amount paid by a person to a spouse or former spouse under
a divorce or separation agreement. Usually, these alimony payments
provide support to a spouse or former spouse with whom the taxpayer no
longer lives. Alimony does not include child support payments or property
settlement amounts.
Taxpayers who pay alimony or separate maintenance payments can claim
the amounts paid during the tax year as an adjustment to income on line
31a of Form 1040.

Figure 15-13: The Adjusted Gross Income section of Form 1040 with line 31a "Alimony
paid" and 31b "Recipient's SSN" highlighted.

Be sure to enter the recipient's social security number on line 31b - as the
recipient must report alimony received as taxable income on Form 1040 line
11.

Figure 15-14: The Income section of Form 1040 with line 11 "Alimony received"
highlighted.

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Unlike alimony and separate maintenance payments, child support is not


taxable to the recipient and cannot be claimed as an adjustment to income
by the payer.
Several tax tests must be met in order for alimony payments to be tax
deductible, as follows:

The alimony must be paid under a decree of divorce or legal


separation agreement, written separation agreement, or a decree of
support. Voluntary payments are not tax deductible to the payer or
taxable on the recipients tax return;

The agreement must provide for cash payments. For rules regarding
minimum payout periods and amounts see Publication 504 Divorced or Separated Individuals;

Payments for child support, and any amount of the "alimony" paid
for child support, are disqualified from being tax deductible;

The taxpayer and former spouse may not live in the same household
(there are certain exceptions); and

The taxpayers liability to pay the alimony must terminate upon the
death of the former spouse.

Partial payments that include both alimony and child support are allocated
first to non tax deductible child support.
The taxpayer and former spouse may state in their divorce decree that
alimony is neither tax deductible for the payer nor taxable to the recipient.
The statement disqualifies the alimony payments from being tax deductible.
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.

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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.

TAX TIP

Property Settlements Disguised as Alimony


In order to prevent property settlements from being disguised as alimony
a provision of the tax code requires that when over $15,000 of alimony is
paid in the first or second year following divorce, and significantly less is
paid in the third year, a portion of the alimony deducted by the payer in
the first two years is recaptured by being added back to his or her taxable
income in the third year. When the recapture rule applies, the recipient of
the alimony is entitled to a corresponding tax deduction in the third year.
The recapture rule does not apply to:

alimony paid under temporary support orders entered before final


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divorce

declines in alimony in the third year due to the death or


remarriage of the recipient

declines in alimony in the third year due to the original amount of


alimony being based on a fixed portion of the payer's income
from a business, property, or other compensation

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
allocable to the interest

increases the adjusted


basis of the transferred
interest by the amount
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

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IF you transfer...

THEN you...

TO

INCOME

PART

AND your spouse or


former spouse...
to him or her.

TAX TIP

Is interest paid by one spouse to the other on property settlements


tax deductible?
Interest paid on property settlements that occur over time may be tax
deductible, depending on the nature on the underlying property. It works
the same way as the regular rules for deducting interest. For instance, if
the underlying property the interest is paid on is an automobile then the
interest would not be deductible, as taxpayers cannot deduct interest on
automobile loans. However, if the underlying property the interest is paid
on is a principal residence then the interest is deductible as mortgage
interest.

TAX TIP

What is the cost basis of property received in a divorce settlement?


The cost basis and holding period of property received from an exspouse in a divorce settlement is the same basis and holding period the
ex-spouse had. If one spouse is in a lower tax bracket, it can save taxes to
transfer appreciated property to the lower tax bracket spouse in the
property settlement. Since gains on the sale of a home are not usually
taxable, it ordinarily wouldnt save taxes to transfer the home to the lower
tax bracket spouse.

TAX TIP

How are transfers of property pursuant to a divorce to a third party


treated?
Transfers of property pursuant to a divorce settlement to a third party are
treated as if the property was first transferred to the ex-spouse, and then
from the ex-spouse to the third party. Thus, the transfer is tax free to the
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transferor. Such a transfer must be performed pursuant to a written


agreement entered into prior to the transfer, and the agreement must
state that the transfer is being made pursuant to the tax free exchange
rules of Internal Revenue Code section 1041.

Lesson Summary
Take a moment to review what you have covered in this lesson:
Adjustments to income are subtractions from total income. Total income
minus adjustments equals the adjusted gross income (AGI). Adjustments
that taxpayers can claim on either Form 1040A or 1040 are the deductions
for Student loan interest and Traditional IRA contributions. Other
adjustments to income must be reported on Form 1040.
A self employed person can deduct the health insurance premium element
of an Archer MSA from his or her tax return. A tax deduction of 100% of the
health insurance premium is deducted on Line 29 of Form 1040.
If the employee contributes to an Archer MSA the employee reports the
contributions on Form 8853.
If the taxpayer is a qualified performing artist, or a state (or local)
government official who is paid in whole or in part on a fee basis, the
taxpayer can deduct the cost of his qualifying work-related education as an
adjustment to gross income rather than as an itemized deduction.
The taxpayer may enjoy several benefits from having a Health Savings
Account:

The taxpayer can claim an adjustment to income for contributions


the taxpayer, or someone other than the taxpayers employer, make
to the taxpayers HSA even if the taxpayer does not itemize
deductions on Form 1040

Contributions to the taxpayers HSA made by the taxpayers


employer (including contributions made through a cafeteria plan)
may be excluded from the taxpayers gross income

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The contributions remain in the taxpayers account from year to year


until the taxpayer uses them

The interest or other earnings on the assets in the account are tax
free

Distributions may be tax free if the taxpayer pays qualified medical


expenses

An HSA is "portable" so it stays with the taxpayer if the taxpayer


changes employers or leaves the work force

If the taxpayer moved because of a change in the taxpayers job location or


because the taxpayer started a new job, the taxpayer may be able to deduct
the taxpayers moving expenses if the taxpayers move is closely related to
the start of work. To qualify for the moving expense deduction, the taxpayer
must meet both the distance and the time tests, unless the taxpayer is a
member of the armed forces and the taxpayers move was due to a
permanent change of station.
The table below shows the Moving Expense time test:
IF you are...
an employee
self-employed
both self-employed and an
employee at the same time

both self-employed and an


employee, but unable to satisfy the
39-week test for employees

THEN you satisfy the time test by


meeting the...
39-week test for employees.
78-week for self-employed persons.
78-week test for a self-employed
person or the 39-week test for an
employee. Your principal place of
work determines which test applies.
78-week test for self-employed
persons.

Self employed persons can deduct one-half of their self employment tax on
Form 1040 line 27.
Married couples who are both self employed may each deduct one-half of
their respective self employment tax on their tax return.
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Tax deductible contributions to the taxpayers personal Simplified Employee


Pension may not exceed 25% of taxpayers net earnings, or $53,000.
Employees can make tax deductible contributions to a SIMPLE of up to
$12,500 ($15,500 for participants age 50 or older) per tax year. Employers
match the contribution. The money isn't taxed until withdrawn.
A self employed person can establish a Keogh Plan and make tax deductible
contributions entered on Form 1040 line 28. The two types of Keogh Plans
are defined contribution plans and defined benefit plans.
The maximum tax deductible contribution to a defined contribution plan is
the lesser of $53,000 or 100% of compensation.
The maximum tax deductible contribution to a defined benefit plan is the
amount needed to produce the required benefits under the formula. For
2015 the maximum annual retirement benefit which may be funded may
not exceed the lesser of 100% of the participant's average compensation for
the highest three consecutive tax years as an active participant; or,
$265,000.
Self-employed taxpayers who have a net profit for the year can deduct
100% of the self employed health insurance premiums they paid for
themselves, their spouse, and their dependents on Form 1040 line 29.
Taxpayers who had to pay a penalty for early withdrawal from a time
deposit savings account can claim the penalty as an adjustment to income
on Form 1040 line 30.
Taxpayers who pay alimony or separate maintenance payments can claim
the amounts paid during the tax year as an adjustment to income on line
31a of Form 1040. Unlike alimony and separate maintenance payments,
child support is not taxable to the recipient and cannot be claimed as an
adjustment to income by the payer.

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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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II

Lesson

16
Lesson 16 - Adjustments to Income
- Part II
In this lesson you'll learn about adjustments to income, including those
related to Individual Retirement Accounts, Student Loan Interest, Jury Duty,
and Domestic Production Activities. Upon completing this lesson you will be
able to determine whether certain taxpayers are eligible to claim these
adjustments to income on their tax return.
The following topics are discussed in this lesson:
Individual Retirement
Accounts (IRAs)
Student Loan Interest
Deduction
Tuition and Fees Deduction

Jury Duty Pay Given to


Employer
Domestic Production
Activities Deduction
Other Adjustments to Income

Individual Retirement Accounts (IRAs)

he Individual Retirement Account (IRA) was once a popular tax


deductible way to save for retirement but lost much of its luster after
Congress tightened eligibility requirements in the 1986 tax law.
However, since the 1997 tax law changes took effect IRAs have been worth
taking a second look at.
Both the taxpayer and taxpayers spouse can take a tax deduction for
contributions to a regular IRA for 2015 of up to $5,500 ($6,500 if age 50 or
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II

over) or 100% (whichever is less) of wage, salary, or self employment taxable


earnings if neither the taxpayer nor taxpayers spouse have a retirement
plan coverage at work. Taxable alimony is included for the purposes of
determining taxable earnings. Taxpayer have until the filing deadline to
make IRA contributions. Taxpayers must make contributions by the
deadline even if taxpayer gets an extension to file the tax return. Taxpayers
can only make contributions for years prior to the taxpayers attaining age
70 1/2. On a joint tax return, provided the taxpayer has taxable earnings of
at least $11,000, the taxpayer and the taxpayers spouse can contribute
$5,500 each to an IRA even if only one spouse works.

Figure 16-1: The Adjusted Gross Income section of Form 1040 with line 32 "IRA
deduction" highlighted.

If either the taxpayer or the taxpayers spouse is an "active participant" in an


employer retirement plan or self employed retirement plan for any part of
the plan year the taxpayer may not be able to make tax deductible IRA
contributions. If the taxpayer is an employee and the taxpayer was covered
by an employer retirement plan the Retirement Plan Box, Box 13, of
taxpayers Form W-2 will be checked.

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Figure 16-2: Form W-2 - Wage and Tax Statement with box 13 "Retirement plan"
highlighted.

An employer retirement plan is:

A qualified pension, profit sharing, or stock bonus plan, including a


qualified self employed Keogh Plan, SIMPLE IRA, or SEP

A qualified annuity plan

A tax sheltered annuity, and

A plan established for employees by the United States, a state or


political subdivision, or any agency or instrumentality of the United
States or a state or political subdivision. Eligible state Section 457
plans are not included as employer retirement plans.

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The table below shows the annual contribution limits for various types of
retirement plans:
Annual Contribution Limits

Year
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016 &
Future
Years

IRA's (Including ROTH


IRA's)
Regular
50 & Over
$3,000
$3,500
$3,000
$3,500
$3,000
$3,500
$4,000
$4,500
$4,000
$5,000
$4,000
$5,000
$5,000
$6,000
$5,000
$6,000
$5,000
$6,000
$5,000
$6,000
$5,000
$6,000
$5,500
$6,500
$5,500
$6,500
$5,500
$6,500
$5,500 plus
Regular
indexed to amount at
inflation in
left plus
$500
$1,000
increments

Table: Annual Contribution Limits

401(k) & 403(b)s 457


and salary reduction
SEPs
Regular
50 & Over
$11,000
$12,000
$12,000
$14,000
$13,000
$16,000
$14,000
$18,000
$15,000
$20,000
$15,500
$20,500
$15,500
$20,500
$16,500
$22,000
$16,500
$22,000
$16,500
$22,000
$17,000
$22,500
$17,500
$23,000
$17,500
$23,000
$18,000
$24,000
$18,000
Regular
plus
amount at
indexed to
left plus
inflation in
$6,000
$500
increments

523

SIMPLE Plans
Regular
50 & Over
$7,000
$7,500
$8,000
$9,000
$9,000
$10,500
$10,000
$12,000
$10,000
$12,500
$10,500
$13,000
$10,500
$13,000
$11,500
$14,000
$11,500
$14,000
$11,500
$14,000
$11,500
$14,000
$12,000
$14,500
$12,000
$14,500
$12,500
$15,500
$12,500
Regular
plus
amount at
indexed to
left plus
inflation in
$3,000
$500
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The table below shows when IRA contributions are phased out:
If the taxpayer or spouse is covered by a retirement plan at work the tax deduction begins
to phase out at:
$60,000 if the taxpayer's filing status is single, head of household, or married filing
separately and he lived apart from his spouse for all of 2014;
$96,000 if the taxpayer's filing status is married filing jointly and both the taxpayer and
spouse are active plan participants, or the taxpayer is a qualifying widow or widower;
$96,000 if the taxpayer's filing status is married filing jointly and the taxpayer is active plan
participant but the spouse is not. The spouse uses the $181,000 threshold;
$181,000 if the taxpayer's filing status is married filing jointly and the taxpayer was not an
active plan participant but the spouse was. The spouse uses the $96,000 threshold; and
$0 if the taxpayer's filing status is married filing separately and he lived with the spouse at
any time in 2014.
These limits will rise through in future years.
Phase-outs
The tax deduction
If the phase-out threshold
phases out at...
is...
$60,000
$60,001-$70,000
$96,000
$96,001-$116,000
$181,000
$181,001-$191,000
$0
$0-$9,999

No tax deduction
is allowed at...
$70,000 +
$116,000 +
$191,000 +
$10,000 +

Table: IRA Contribution Phase-out Rules

TAX QUOTE

"The art of taxation consists in so plucking the goose as to obtain the


largest amount of feathers with the least amount of hissing."
Jean-Baptiste Colbert
Non Tax Deductible IRAs
These are basically non tax deductible retirement savings accounts for
people who don't qualify for the tax deductible or Roth IRA. In these non tax
deductible accounts, contributions are taxed but the earnings and interest
grow tax deferred. When it comes time to withdraw the money, the
taxpayer pays tax on the earnings.

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Roth IRAs
Taxpayers can make non tax deductible IRA contributions to a regular IRA
but the taxpayer is probably better off contributing to a Roth IRA instead.
While both plans accumulate earnings tax free until withdrawal, the Roth
IRA after five (5) years offers completely tax free withdrawals of earnings if
taxpayer are 59 1/2 or older, disabled, or the taxpayer withdraw no more
than $10,000 for first time home buyer expenses.
The table below shows how the AGI Phase-out Rules work for Roth IRA
contributions:
IF you have taxable
compensation and your
filing status is....
married filing jointly, or
qualifying widow(er)

AND your modified AGI is... THEN...

less than $181,000

you can contribute up to


$5,500 ($6,500 if you are 50
older).
at least $181,000 but less
the amount you can
than $191,000
contribute is reduced as
explained under
Contribution limit reduced
in Publication 590-A.
$191,000 or more
you cannot contribute to a
Roth IRA.
married filing separately
zero (-0-)
you can contribute up to
and your lived with your
$5,500 ($6,500 if you are 50
spouse at any time during
or older).
the year
more than zero (-0-) but less the amount you can
than $10,000
contribute is reduced as
explained under
Contribution limit reduced
in Publication 590-A.
$10,000 or more
you cannot contribute to a
Roth IRA.
single, head of household, less than $114,000
you can contribute up to
or married filing separately
$5,500 ($6,500 if you are 50
and you did not live with your
or older).
spouse at any time during
at least $114,000
the amount you can
the year
contribute is reduced as
but less than $129,000
explained under
Contribution limit reduced
in Publication 590-A.
$129,000 or more
you cannot contribute to
Roth IRA.
Table: Roth IRA Contribution Rules

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The table below shows the deadlines for establishing retirement


accounts:
Plan Type

Deadline for Establishing Plan

Traditional IRA

Due date of tax return (April 15th plus extensions)

Roth IRA

Due date of tax return (April 15th plus extensions)

SEP-IRA

Due date of tax return (April 15th plus extensions)

SIMPLE IRA

October 1st

Keogh Profit Sharing Plan

December 31st

Keogh Money Purchase Plan

December 31st

Keogh Defined Benefit Plan

December 31st

401(k) Plan

December 31st

TAX PLANNING TIP

Are 401(k) plans a good investment?


A 401(k) is a type of retirement savings plan which takes its name from
subsection 401(k) of the Internal Revenue Code.
One of the best tax tips for most taxpayers is to maximize their 401(k)
contributions. 401(k)s lower taxable income reported on the taxpayers
W-2, all earnings are tax-deferred until distributions are received, the
employer often offers a matching contribution, and any money in the
401(k) is protected by law against creditors. Plus, many 401(k) plans allow
participants to take loans against the plan, thus avoiding any taxes and
penalties that would ordinarily be incurred on early distributions. Interest
must be paid on the 401(k) loan, but the interest goes into the
participants own 401(k) account.
Theres one bad point about 401(k) loans. Participants who leave their job
before they are finished paying back the loan must pay back the
remaining balance or it will be treated as an early distribution subject
penalties and taxes.
Ultimately however, how good of an investment a 401(k) is will be
determined by the performance of the underlying investment(s), not by
the tax law or rules.
What is an Individual 401(k) plan?
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An Individual 401(k) plan is a regular 401(k) plan combined with a profitsharing plan. An individual 401(k) plan can only be established by selfemployed individuals or small business owners who have no other fulltime employees, other than a spouse.
IRA Distributions
Any distribution that taxpayers take from tax deductible contributions or
earnings that is not rolled over or re-deposited within sixty (60) days is
taxable and must be reported on taxpayers tax return.

Figure 16-3: The Income section of Form 1040 with line 15a "IRA distributions" and line 15b
"Taxable amount" highlighted.

Taxpayers are also subject to a 10% penalty tax unless:

The taxpayer is over age 59 1/2

The taxpayer is totally disabled

The taxpayer meets the exceptions below and pays medical costs

The taxpayer receives unemployment compensation for at least 12


consecutive weeks and pays medical insurance premiums with the
distribution

The taxpayer pays qualified higher education expenses with the


distribution

The distribution is $10,000 or less and used for qualified first time
home buyer expenses
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The taxpayer is a beneficiary receiving the distribution following the


death of the owner, or

The taxpayer receives annual payments under an annuity schedule

On or before April 1st of the tax year after the tax year in which taxpayer
reaches age 70 1/2 the taxpayer must begin taking taxable distributions. A
penalty tax of 50% applies to amounts that the taxpayer was required to
take and didn't.
Medical expenses
There are penalty-free withdrawals from IRAs to pay for medical expenses
that exceed 10% of adjusted gross income. The taxpayer still has to pay
regular income tax on this money, however. Also, there are penalty-free
withdrawals for unemployed people to pay for health insurance.
Higher education expenses
The 10% penalty tax that applies to most withdrawals from IRAs before a
taxpayer reaches age 59 1/2 will not apply to withdrawals for taxpayers
higher education expenses, or those of the taxpayers spouse, children, or
grandchildren. This change applies to distributions after 1997 for expenses
paid for academic periods after 1997.
First time home buyers
The law also permits a penalty-free qualified first-time homebuyer
distribution, subject to a $10,000 lifetime limit. The penalty-free distribution
must be used to acquire a principal residence of the taxpayer, a spouse,
child, grandchild, or ancestor.

TAX PLANNING TIP

Are 403(b) plans a good investment?


A 403(b) plan is another type of retirement savings plan. It takes its name
from subsection 403(b) of the Internal Revenue Code. 403(b) plans are
also known as tax-sheltered annuities and are available to employees of
certain tax-exempt organizations such as public schools, churches,
hospitals, and charities. The employer establishes the plan and the
employees participate.
Participants in 403(b) plans contribute "salary reductions", thus lowering
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taxable income reported on the taxpayers W-2. All earnings are taxdeferred until distributions are received. Occasionally employers make
matching contributions.
In some cases plan loans are permitted. Some employers also allow
participants to make after-tax contributions to 401(k) and 403(b) plans.
These contributions and related earnings are usually tax free when paid
out to the participant.

Student Loan Interest Deduction


Taxpayers who paid interest on a student loan during the tax year may be
able to deduct up to $2,500 of the interest paid, even if they took out the
loan before the tax year.
If the taxpayer paid $600 or more in interest to a single lender, the taxpayer
should receive a Form 1098-E and box 1 will show the amount of interest
paid.

Figure 16-4: Form 1098-E - Student Loan Interest Statement with box 1 "Student loan
interest received by lender" highlighted.

This information will assist you in completing the student loan interest
deduction.
Qualified Student Loan Interest
Generally, student loan interest is the interest paid during the year on a loan
for qualified higher education expenses that were:
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For the taxpayer or the taxpayer's spouse (if filing a joint return), or a
person who was the taxpayer's dependent when the loan was
obtained, and

Paid within a reasonable period of time before or after obtaining the


loan, and

For an eligible student

Qualified higher education expenses include tuition, fees, room and board,
books, supplies, equipment, and other necessary expenses, such as
transportation.
An eligible student is one enrolled in and carrying at least one-half the
normal load for a qualified program.
Qualified Interest can be any of the following:

Interest paid during the life of the loan


Loan origination fees
Capitalized interest
Interest on revolving lines of credit
Interest on refinanced student loans

Qualified Interest cannot include interest on a loan:

From a related person


From a qualified employer plan
For which the taxpayer is not legally liable

Who Can Claim the Deduction?


To claim the deduction, the taxpayer must have paid qualified student loan
interest for an eligible student under all the following conditions:

Married taxpayers must file a joint return with their spouse

The taxpayer cannot be claimed as a dependent on someone else's


return

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The loan was used to pay tuition and other qualified expenses for
the taxpayer, the taxpayer's spouse, or someone whom the taxpayer
claimed as a dependent, when the loan was taken out

The education expenses were paid or incurred within a reasonable


period of time before or after the loan was taken out

If someone else made interest payments on behalf of a taxpayer who is


legally obligated to pay the qualified loan, then the taxpayer is treated as
receiving payments from the other person and then making the payments.
So, the taxpayer is allowed to deduct the payments.
Dependent taxpayers cannot claim the deduction, however, they can deduct
interest payments made in later years when they can no longer be claimed
as a dependent.
Eligible Educational Institution
For the student loan interest deduction, an eligible educational institution is
generally either of the following:

A college, university, vocational school, or other post-secondary


educational institution eligible to participate in Department of
Education student aid programs. This category includes virtually all
accredited public, nonprofit, and privately owned profit-making
post-secondary institutions.

An institution conducting an internship or residency program


leading to a degree or certificate from an institution of higher
education, a hospital, or a healthcare facility that offers postgraduate
training.

If a taxpayer does not know if the educational institution is an eligible


institution, the taxpayer should contact the school.
Eligible Student
An eligible student is someone who is enrolled at least half-time in a
program leading to a degree, certificate, or other recognized educational
credential. The standard for what is half the normal full-time work load is
determined by each eligible educational institution.

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An eligible program may include study abroad that is approved for credit by
the institution where the student is enrolled.
Reductions to Qualified Expenses
Before reporting qualified expenses on a tax return, the following tax-free
income amounts must be subtracted:

Employer-provided educational assistance benefits


Tax-free withdrawals from a Coverdell ESA
Tax-free withdrawals from a qualified tuition program
U.S. savings bond interest excluded from income because it is used
to pay qualified higher education expenses
Qualified scholarships
Veterans' educational assistance benefits
Any other nontaxable payments (other than gifts, bequests, or
inheritances) received for educational expenses

Deduction Limits
The student loan interest deduction is generally the smaller of $2,500 or the
interest payments paid during the tax year. This amount may be reduced or
eliminated based on the taxpayer's filing status and modified adjusted gross
income (MAGI).

TAX TIP

Should married taxpayers file jointly or separately?


Unless the taxpayers have large medical expenses or items such as
casualty losses to deduct, in most cases theyll pay lower taxes by filing a
joint return. Another benefit of filing jointly - filing separately disqualifies
married taxpayers from taking the Earned Income Tax Credit and some of
the other major credits and deductions, including the:

Adoption Credit / Exclusion


American Opportunity Credit
Dependent Care Credit
Elderly or the Disabled Credit
Lifetime Learning Credit
Savings Bond Interest
Student Loan Interest Deduction
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Tuition & Fees Deduction

That's why it says "No Credit", "No Exclusion", or "No Deduction" for
those items in the AGI Phase-out Range Table directly below.
If either spouse is receiving Social Security benefits and they are married
and lived together at any time during the year the amount of benefits on
which income tax must be paid is higher for spouses filing separately
because the base income that is deducted before determining the
amount of Social Security benefits that are taxed is $0.
Married couples who lived together at any time during the year must also
file jointly in order to claim the more lenient phase-out rules for the IRA
deduction when an individual does not participate in an employersponsored plan, but their spouse is covered by an employer's pension
plan.
The table below shows the phase-out ranges for various deductions,
exemptions, and credits. They begin to phase-out at the lower amount, and
are completely phased out at the higher amount. Thus, once the higher
amount is reached there is no tax benefit to that item.

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Married filing Joint/


Qualifying Widower

Single or Head of
Household

Married filing
Separately

$197,880-$237,880

$197,880-$237,880

No Credit

$160,000-$180,000

$80,000-$90,000

No Credit

$156,500-$484,900

$117,300-$328,500

$78,250-$242,450

$110,000-$130,000

$75,000-$95,000

$55,000-$75,000

$190,000-$220,000

$95,000-$110,000

$95,000-$110,000

$15,000-$43,000

No Credit

$7,500-$17,500

$5,000-$12,500

$60,000-$70,000

$0-$10,000

$254,200 (s)
$279,650 (hoh)

$152,525

$54,000-$64,000

No Credit

Passive Activity Loss $100,000-$150,000

$100,000-$150,000

$50,000-$75,000

Personal Exemptions $305,050-$427,550

$254,200-$376,700 $152,525-$213,775

Retirement Savings
Credit

No limit

$18,000-$30,000 (s)
$27,000-$45,000
No limit

$181,000-$191,000

$114,000-$129,000

$0-$10,000

$113,950-$143,950

$76,000-$91,000

No Exclusion

$130,000-$160,000

$65,000-$80,000

No Deduction

$130,000-$160,000

$65,000-$80,000

No Deduction

$17,500

$17,500

$17,500

Benefit
Adoption Credit /
Exclusion
American
Opportunity Credit
AMT Exemption (1)
Child Tax Credit (1
child)
Coverdell ESA

Dependent Care
$15,000-$43,000
Credit
Elderly/Disabled
$10,000-$20,000
Credit
(if both eligible)
$10,000-$25,000
IRA Income Limit
$96,000-$116,000
with Pension
Itemized Deductions,
$305,050 +
beginning at
Lifetime Learning
$108,000-$128,000
Credit

Rollover to Roth IRA


Roth IRA Income
Limit
Savings Bond
Interest
Student Loan
Interest Ded.
Tuition & Fees
Deduction
401(k)/403(b)
Elective Def. (2)

$36,000-$60,000

$18,000-$30,000
No Limit

(1) Phaseout applies to AMT income rather than AGI.


(2) Add $5,500 if age 50 or over.
Table: AGI Phase-out Ranges

MAGI is the adjusted gross income BEFORE taking the deduction for
student loan interest payments, but AFTER adding exclusions/deductions
for foreign earned income; foreign housing; qualified tuition and related
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expenses; and income for bona fide residents of Guam, Puerto Rico,
American Samoa, or Northern Mariana Islands.
Reporting Student Loan Interest
Student loan interest is reported to the taxpayer on Form 1098-E box 1. The
deductible amount is calculated using the Student Loan Interest Deduction
Worksheet.

Figure 16-5: The Adjusted Gross Income section of Form 1040 with line 33 "Student loan
interest deduction" highlighted.

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. To view Part I see
Appendix F or click 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. To view Part II see Appendix G or click here.

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Tuition and Fees Deduction


Editors Note: The Tuition and Fees Deduction has been extended through
2014.
The taxpayer may be able to deduct by up to $4,000 of qualified education
expenses paid during the year for himself, his spouse, or his dependents.
The taxpayer cannot claim this deduction if his filing status is married filing
separately or if another person can claim an exemption for him as a
dependent. The qualified expenses must be for higher education.
What expenses qualify?
The tuition and fees deduction is based on qualified education expenses the
taxpayer pays for himself, his spouse, or his dependent for which he claims
an exemption on his tax return. Qualified education expenses are tuition
and certain related expenses required for enrollment or attendance at an
eligible educational institution. Generally, the deduction is allowed for
qualified education expenses paid in connection with enrollment at an
institution of higher education for an academic period beginning in 2014 or
in the first 3 months of 2015.
What expenses do not qualify?
Insurance
Medical expenses (including student health fees)
Room and board
Transportation, or
Similar personal, living, or family expenses.
This is true even if the amount must be paid to the institution as a condition
of enrollment or attendance.
Sports, games, hobbies, and noncredit courses.
Qualified education expenses generally do not include expenses that relate
to any course of instruction or other education that involves sports, games
or hobbies, or any noncredit course. However, if the course of instruction or
other education is part of the student's degree program, these expenses
can qualify.

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Is there a deduction if the expenses were paid with


borrowed funds?
The taxpayer can claim a tuition and fees deduction for qualified education
expenses paid with the proceeds of a loan. Use the expenses to figure the
deduction for the year in which the expenses are paid, not the year in which
the loan is repaid. Treat loan payments sent directly to the educational
institution as paid on the date the institution credits the student's account.
What is an "Eligible Educational Institution"?
An eligible educational institution is any college, university, vocational
school, or other postsecondary educational institution eligible to participate
in a student aid program administered by the Department of Education. It
includes virtually all accredited public, nonprofit, and proprietary (privately
owned profit-making) postsecondary institutions. The educational
institution should be able to tell you if it is an eligible educational
institution.
What are "Related Expenses"?
Student-activity fees and expenses for course-related books, supplies, and
equipment are included in qualified education expenses only if the fees and
expenses must be paid to the institution as a condition of enrollment or
attendance.
Deduction Provisions:

Expenses for the taxpayer, spouse, and dependants are eligible.

No deduction is allowed if the filing status is Married Filing


Separately.

Post secondary education qualifying expenses are defined as the


same as for the American Opportunity and Lifetime Learning Credits.

The academic year must begin during, or 3 months following, the


year in which the expenses are paid and the deduction is taken.

The deduction is not available for the same student in the year the
American Opportunity or Lifetime Learning Credit is taken.

Qualified expenses must be reduced if applied to:


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o Non-taxable distributions from Qualified Tuition Plans and


Coverdell Educational Savings Accounts.
o US Savings Bond interest exclusion.

The deduction is not available to an individual who is claimed as a


dependant by another taxpayer.

There is no Modified AGI phase-out. If Modified AGI is above a


specified dollar income limit the deduction is not available. See the
table below.

There is no deduction if modified AGI exceeds the limits below:


Income limit by filing status
Single
Married Filing Jointly
Qualified expense deduction limit
$65,000
$130,000
$4,000
$80,000
$160,000
$2,000
Table: Tuition and Fees Deduction

Who claims the deduction?


IF your dependent is
an eligible student
and you....
AND...
claim an exemption
you paid all qualified
for your dependent.
education expenses for
your dependent

claim an exemption
for your dependent.
do not claim an
exemption for your
dependent, but are
eligible to
do not claim an
exemption for your
dependent, but are
eligible to

your dependent paid


all qualified education
expenses
you paid all qualified
education expenses

your dependent paid


all qualified education
expenses
538

THEN..
only you can deduct
qualified education
expenses that you
paid. Your dependent
cannot take a
deduction.
no one is allowed to
take a deduction.
no one is allowed to
take a deduction

no one is allowed to
take a deduction

LESSON

16

ADJUSTMENTS

IF your dependent is
an eligible student
and you....
are not eligible to
claim an exemption for
your dependent
are not eligible to
claim an exemption for
your dependent

TO

INCOME

AND...
you paid all qualified
education expenses
your dependent paid
all qualified education
expenses

PART

II

THEN..
only your dependent
can deduct the
amount you paid.
only your dependent
can take a deduction.

No double benefits are allowed. The taxpayer cannot do any of the


following:

Deduct qualified education expenses deducted under any other


provision of the law, for example, as a business expense.

Deduct qualified education expenses for a student if he or anyone


else claims a Hope or Lifetime Learning Credit for that same student
in the same year.

Deduct qualified education expenses that have been used to figure


the tax-free portion of a distribution from a Coverdell Education
Savings Account (ESA) or a Qualified Tuition Program (QTP). For a
QTP, this applies only to the amount of tax-free earnings that were
distributed, not to the recovery of contributions to the program.

Deduct qualified education expenses that have been paid with taxfree interest on U.S. Savings Bonds.

Deduct qualified education expenses that have been paid with taxfree scholarship, grant, or employer- provided educational
assistance.

Adjustments to Qualified Education Expenses


If the taxpayer pays qualified education expenses with certain tax-free
funds, he cannot claim a deduction for those amounts. He must reduce the
qualified education expenses by the amount of any tax-free educational
assistance and refund(s) received such as:

The tax-free part of scholarships and fellowships,


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PART

II

Pell grants,
Employer-provided educational assistance,
Veterans' educational assistance, and
Any other nontaxable (tax-free) payments (other than gifts or
inheritances) received as educational assistance.

Form 1098-T - Tuition Statement


To help figure the tuition and fees deduction the taxpayer should receive
Form 1098-T.

Figure 16-6: Form 1098-T - Tuition Statement with box 1 "Payments received for qualified
tuition and related expenses" and box 2 "Amounts billed for qualified tuition and related
expenses" highlighted.

Generally, an eligible educational institution must send Form 1098-T to each


enrolled student by January 31st. An institution may choose to report either
payments received (box 1), or amounts billed (box 2), for qualified education
expenses. However, the amount in boxes 1 and 2 of Form 1098-T may be
different than what was actually paid. When figuring the deduction, use only
the amounts actually paid for qualified education expenses.

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Figure 16-7: The Adjusted Gross Income section of Form 1040 with line 34 "Tuition
and fees" highlighted.

Comprehensive or bundled fees


Some eligible educational institutions combine all of their fees for an
academic period into one amount. If the taxpayer does not receive, or does
not have access to, an allocation showing how much was paid for qualified
education expenses and how much was paid for personal expenses contact
the institution. The institution is required to make this allocation and
provide the taxpayer with the amount paid for qualified education expenses
on Form 1098-T - Tuition Statement.
The eligible educational institution may ask for a completed Form W-9S Request for Student's or Borrower's Taxpayer Identification Number and
Certification or similar statement to obtain the student's name, address, and
taxpayer identification number.

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Figure 16-8: Form W-9S - Request for Student's or Borrower's Taxpayer Identification
Number and Certification.

TAX QUOTE

"The way taxes are, you might as well marry for love."
Joe E. Lewis (1902-1971) Comedian

Jury Duty Pay Given to Employer


Jury Duty Pay is usually reported as taxable income on line 21 (Other
income) of Form 1040.

Figure 16-9: The Income section of Form 1040 with line 21 "Other income"
highlighted.

However, some employees continue to receive their regular wages when


they serve on jury duty even though they are not at work and their jury pay
is turned over to their employers. In this case, the employee still has to
report the entire amount of Jury Duty Pay as taxable income, but may claim
the amount of Jury Duty Pay given to the employer as an adjustment to
income.

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Figure 16-10: The Adjusted Gross Income section of Form 1040 with line 36 highlighted.

Domestic Production Activities Deduction


The American Jobs Creation Act of 2004 added the Domestic Production
Activities Deduction, a business related tax benefit for certain domestic
production activities. This deduction provides tax savings against income
attributable to domestic production activities. It replaced certain export
subsidies. The Act created new Internal Revenue Code section 199 and is
available to corporations, individuals, and pass-thru entities such as S
Corporations, partnerships, estates and trusts. For the pass-thru entities, the
deduction is applied at the individual partner, shareholder, or similar level.
This deduction is available for tax years beginning after December 31, 2004.

Figure 16-11The Adjusted Gross Income section of Form 1040 with line 35 "Domestic
production activities deduction" highlighted.

The deduction equals 9% of the lesser of: (a) qualified production activities
income; or (b) taxable income for the tax year. However, the deduction for a
tax year is limited to 50% of the W-2 wages paid by the taxpayer during the
calendar year that ends in such tax year.
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Qualified production activities include manufacturing, producing, growing,


and extracting tangible personal property, computer software, and sound
recordings, and the construction and substantial renovation of real property
including infrastructure. The production of certain films is also a qualifying
activity as are certain engineering or architectural services.
For gross receipts to be considered domestic production gross receipts that
are used in calculating qualified production activities income, the gross
receipts must be the result of a lease, rental, sale, license, exchange or other
disposition of the property and the qualified production activity that created
these receipts must have occurred in whole or in significant part within the
United States. There is a safe harbor to determine if the property is
produced in whole or in significant part within the United States. To qualify
for the safe harbor, direct labor and related factory burden incurred by the
taxpayer in the United States for the manufacture, production, growth or
extraction of the property, must be at least 20% of the total cost of goods
sold of the property. There are special rules for the production of films,
computer software, sound recordings, utilities, and food and beverages.
There are also special rules for construction and engineering or architectural
services.
A taxpayer is required to determine the portion of its gross receipts that are
domestic production gross receipts and the portion that are not domestic
production gross receipts. The taxpayer must use a reasonable allocation
method to make this determination. All of a taxpayers gross receipts will be
treated as domestic production gross receipts if less than 5% of the total
gross receipts are not domestic production gross receipts. Once domestic
production gross receipts are determined, you'll compute qualified
production activities income. This is done by reducing domestic production
gross receipts by the cost of goods sold that are allocable to such receipts,
other deductions that are directly allocable, and a ratable amount of indirect
expenses. A simplified method for allocating costs (other than cost of goods
sold) is available for businesses that have average annual gross receipts of
$25 million or less. Another simplified cost allocation method, the small
business simplified overall method, is available to a qualifying small
taxpayer. Under this method all costs, including costs of goods sold, are
apportioned based on gross receipts. Generally, a small taxpayer is one that
has average annual gross receipts of $5,000,000 or less.

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The 50% of W-2 wages limitation is based only on the wages of the
taxpayers common law employees. There are three methods provided to
compute the W-2 wages. The simplest method computes wages using the
total entries in Box 1 or Box 5 of the Form W-2.
Here's a recap of the Domestic Production Activities Deduction:
Who Qualifies? Traditional manufacturing of tangible personal property,
U.S. construction, software production, plus others.
The deduction is the lesser of:

9% of Qualified Domestic Activity


50% of W-2 wages
Business net income

Calculation: domestic production gross receipts; less (allocable COGS +


direct and indirect deductions/expenses/losses)

TAX PLANNING TIP

Are there any ways businesses can increase their Domestic


Production Activities Deduction?
Yes, there are, such as:

Stop Outsourcing. Over the last 25 years it has become popular


for businesses to outsource work. By doing so businesses can
often obtain the labor at a lower cost as they do not have to pay
payroll taxes and employee benefits. However outsourcing also
lowers W-2 wages, and thus their Domestic Production Activities
Deduction.
Merge Prices. Companies that charge separately for support or
warranties should consider adding the price of those items into
the basic price of the product. This will increase gross receipts
from qualified production activities and thus increase their
deduction.
Bring Jobs Home. To qualify as domestic production gross
receipts companies need to have at least 20% of their overhead
and labor costs incurred in the U.S. If they currently have less than
20% consider bringing some work back to the U.S.
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Other Adjustments to Income


Use the descriptions in the table below to report other adjustments to
income:
Describe on Line
Adjustment Item
36 as
Attorney's fees for settlements after October 22,
UDC
2004, in connection with unlawful discrimination,
but only to the extent of the amount included in
income.
Contributions by certain chaplains to Section 403(b)
403(b)
plans.
Contributions to Section 501(c)(18)(D) pension
501(c)(18)(D)
plans. This amount should be identified with Code H
in box 12 of Form W-2.
Expenses from the rental of personal property if the
PPR
income from the rental of personal property was
reported on line 21.
Forestation or reforestation amortization if the
RFST
taxpayer could claim a deduction for these costs
and did not have to file Schedule C, C-EZ or F.
Repayment of supplemental unemployment
Sub-Pay TRA
benefits under the Trade Act of 1974. Alternatively,
the taxpayer may be able to claim a credit against
tax.

Figure 16-12: The Adjusted Gross Income section of Form 1040 with line 36
highlighted.

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TAX TIP

Armed Forces Reservists and National Guard Members


Armed Forces Reservists and National Guard members who travel over
100 miles away from home and stay overnight to attend drills or
meetings can deduct their un-reimbursed travel expenses as an
adjustment to income. Allowable expenses include meals, lodging, and
automobile expenses. The amount of the allowable expenses cannot
exceed the per diem rates that federal government employees receive for
travel expenses for that locality.

Lesson Summary
Let's take a moment to review what you have covered in this lesson:
Both the taxpayer and taxpayers spouse can take a tax deduction for
contributions to a regular IRA of up to $5,500 ($6,500 if age 50 or over) or
100% (whichever is less) of wage, salary, or self employment taxable
earnings if neither the taxpayer nor the taxpayers spouse have a retirement
plan coverage at work.
Taxpayers may be able to deduct up to $2,500 for student loan interest
paid in the tax year. The maximum deduction is subject to certain limits
based on the taxpayer's MAGI. This lesson has explained the qualifying
criteria and reporting requirements for claiming the deduction for student
loan interest. Taxpayers cannot claim the student loan interest deduction for
a year that they can be claimed as a dependent on another taxpayer's
return; are married and do not file a joint return; can deduct the interest
under another tax provision; or if they obtained the loan from a relative.
The table below is a recap of the Student Loan Interest Deduction:
Feature
Maximum
benefit
Loan
qualifications

Description
You can decrease your income subject to tax by up to
$2,500.
Your student loan:
must have been taken out solely to pay
qualified education expenses, and
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Feature

Description
cannot be from a related person or made
under a qualified employer plan.

Student
qualifications

The student must be:


you, your spouse, or your dependent, and
enrolled at least half-time in a degree program.

Time limit on
deduction
Phase-out

You can deduct interest paid during the remaining


period of your student loan.
The amount of your deduction depends on your
income level.

The table below is a recap of the Tuition and Fees Deduction:


Question
Answer
What is the
You can reduce your income subject to tax by up to
maximum benefit? $4,000.
Where is the
deduction taken?
As an adjustment to income on Form 1040.
For whom must the A student enrolled in an eligible educational
expenses be paid? institution who is either:
you,
your spouse, or
your dependent for whom you claim an
exemption.
What tuition and
Tuition and fees required for enrollment or
fees are
attendance at an eligible postsecondary educational
deductible?
institution, but not including personal, living, or
family expenses, such as room and board.
Employees who continue to receive their regular wages when they serve on
jury duty must report their jury pay as taxable income, even though it is
turned over to their employers. However, they may claim the amount of
Jury Duty Pay given to the employer as an adjustment to income.
The American Jobs Creation Act of 2004 added the domestic production
activities deduction, a tax benefit for certain domestic production activities.
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The deduction equals 9% of the lesser of: (a) qualified production activities
income; or (b) taxable income for the taxable year. However, the deduction
for a taxable year is limited to 50 percent of the W-2 wages paid by the
taxpayer during the calendar year that ends in such taxable year.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify your 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

17
Lesson 17 - Individual Retirement
Accounts
Youll learn more about Individual Retirement Accounts (IRAs) and the
difference between a traditional and nontraditional IRA. This lesson explains
how to determine taxpayers' deductible and nondeductible traditional IRA
contributions. At the end of this lesson, you will be able to:

Explain IRAs
Identify the contribution limits for IRAs
Explain deductible and nondeductible IRA contributions
Determine and report deductible and nondeductible IRA contributions

The following topics are discussed in this lesson:


What is an IRA?
Contributions
General Contribution Limits
Deemed IRAs
Spousal Contribution Limits
Excess Contributions
Additional Taxes and
Penalties
Deductible IRA Contributions
Taxpayers Not Covered by an
Employer Retirement Plan

550

Filing Status
Modified Adjusted Gross
Income (MAGI)
Taxpayers Covered by an
Employer Retirement Plan
When to Deduct Traditional
IRA Contributions
Nondeductible IRA
Contributions
Additional Taxes & Penalties

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What is an IRA?

n IRA is a tax-sheltered savings plan set up by a taxpayer, generally


for retirement income. A traditional IRA is any IRA other than a:

Roth IRA
SIMPLE IRA
Coverdell Education Savings Account (ESA)

SIMPLE IRAs were discussed in Lesson 12: Pension Income.

TAX TIP

Are Roth IRAs better than traditional IRAs?


In most cases a Roth IRA is better than a traditional IRA. Although
contributions to Roth IRAs are not tax deductible, money taken out of the
account after age 59 is tax free. If the taxpayers tax bracket will be
approximately the same or higher when he retires than it is now, or if he
doesn't want to take mandatory distributions at age 70 , then a Roth
IRA is the way to go.
The younger the taxpayer is the more advantageous the Roth IRA is
because the investment will grow tax free for a longer period of time.

SIDE BAR

IRA Comparison Chart


To view our comparison chart of Traditional IRAs vs. Roth IRAs see
Appendix O or click here.

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Use the table below to compare Regular IRAs, Roth IRAs, and Coverdell
ESAs:
Feature
Regular IRA
Annual Contribution $5,500 (+$1,000 if 50
or over)
Contribution
Yes
Deductible
Contribution
April 15th following
Deadline
year
Contributions End Age 70 1/2
Earnings
Tax deferred

Roth IRA
Coverdell ESA
$5,500 (+$1,000 if 50 $2,000 per student
or over)
No
No

Withdrawals

Tax free if held over 5


years and over age
59 1/2
10% and earnings
are taxed as ordinary
income if under age
59 1/2 unless for 1st
home up to $10,000,
disability, or death.
Withdrawals are
contribution 1st,
taxable earnings 2nd.

Taxed as ordinary
income if over age 59
1/2
Withdrawal Penalty 10% if under age 59
1/2 unless for
medical, health
insurance if
unemployed, higher
education, 1st home
up to $10,000,
disability, or death. *

Distributions

April 15th following


year
Continue indefinitely
Tax free if held over 5
years

April 15th following


year
Student if age 18
Tax free if used for
qualified education
expense
Tax free for qualified
education expense if
under age 30
10% and earnings
taxed if not used for
qualified education
expenses or if after
student's 30th
birthday.

Mandatory at age 70 Non-mandatory


1/2
Yes. Taxed if rolled
Yes, into most other
into a Roth IRA.
IRAs.

Mandatory before
age 30
Rollover
May be rolled over
into another child's
Coverdell ESA or
IRA.
* Withdrawals can also be taken in substantially equal distributions to avoid the withdrawal
penalty.
Table: IRA Options

Contributions to a traditional IRA can be deductible or nondeductible. A


deductible contribution is the dollar amount taxpayers may deduct from
their adjusted gross income (AGI), if certain requirements are met.
Taxpayers may claim full or partial deductions for traditional IRA
contributions.
Contributions to nontraditional IRAs are not deductible from a taxpayers
adjusted gross income (AGI). For more information on nontraditional IRAs,
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see Publication 590-A - Contributions to Individual Retirement Arrangements


(IRAs).
Nondeductible contributions are:

Traditional IRA contributions that taxpayers may not deduct from


their adjusted gross income because the taxpayers do not meet the
requirements, or
The remaining contributions from a partial IRA deduction

TAX QUOTE

"In levying taxes and in shearing sheep it is well to stop when you get down
to the skin."
Austin O'Malley

Contributions
Taxpayers must meet certain requirements to contribute to a traditional IRA,
for example, they must:

Be under 70 1/2 years of age at the end of the tax year, and
Have taxable compensation

Taxpayers who are 70 1/2 years of age or older before the end of the tax
year cannot contribute to a traditional IRA and must take required minimum
distributions from their traditional IRAs. If the distribution is less than the
minimum required distribution, a 50% excise tax may be imposed on the
shortfall. Minimum distributions do not apply to Roth IRAs. They can
contribute to a Roth IRA if they otherwise qualify.
Taxable compensation includes:

Wages
Salary
Commissions
Tips
Bonuses
Alimony or separate maintenance
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Professional fees
Earnings from self-employment
Non-taxable combat pay
Alimony or separate maintenance payments that are included in total
income are also considered to be compensation for traditional IRA
purposes.
Compensation does not include:

Interest
Rents
Dividends
Pensions
Annuity income
Deferred compensation received
Certain partnership income
Income that can be excluded

If both the taxpayer and spouse have compensation and both are under
age 70 1/2, each can set up an IRA. However, they cannot participate in the
same IRA - they must have separate accounts.
Individuals serving in the U.S. Armed Forces in designated "combat zones"
have additional time to make a qualified retirement contribution to a
traditional IRA. For more information on this extension see Publication 3 Armed Forces Tax Guide.

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IRA contribution information is reported on Form 5498.

Figure 17-1: Form 5498 - IRA Contribution Information.

General Contribution Limits


There is a limit on the amount taxpayers can contribute to traditional IRAs.
The most that can be contributed to a traditional IRA is the smaller of:
A taxpayer's compensation includable as income for the year, or
$5,500 ($6,500 if age 50 or older)
Taxpayers who have more than one traditional IRA must combine them and
treat them as one when figuring the amount that can be contributed for the
year.
Deemed IRAs
The general limit rules for traditional IRA contributions also apply to
"deemed IRAs." A deemed IRA is a separate account or annuity maintained
under a qualified employer retirement plan for the purpose of receiving
voluntary employee contributions. A deemed IRA can be a traditional or a
Roth IRA.

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Taxpayers who have a regular IRA, a deemed IRA, or a ROTH IRA, can divide
contributions between them in any manner, but total contributions cannot
exceed the $5,500/$6,500 contribution limit.
Spousal Contribution Limits
Spousal IRAs are also subject to certain limitations. If married taxpayers file a
joint return and one spouse's compensation is less than the other spouse's
compensation, the most that can be contributed for the year to the spousal
IRA is the smaller of the following amounts:

$5,500 ($6,500 if age 50 or older), or

the total compensation includable in the gross income of both


spouses for the year reduced by all of the following:
o IRA contributions
compensation

for

the

spouse

with

the

greater

o nondeductible IRA contributions of the spouse with the


greater compensation, and
o any contribution for the year to a Roth IRA for the spouse
with the greater compensation
This means that the total combined contributions to both spouses'
traditional IRAs cannot exceed the smaller of the following amounts:

$11,000 ($13,000 if both individuals are age 50 or older), or


The total taxable compensation of both spouses

Taxpayers who have taxable compensation, but can no longer contribute to


a traditional IRA because of their age (70 1/2 or older), may contribute to a
spouse's traditional IRA until the year in which the spouse reaches 70 1/2.
Excess Contributions
Excess contributions are amounts contributed to a traditional IRA that
exceed either of the following, whichever amount is smaller:

A taxpayer's taxable compensation for the year, or


$5,500 ($6,500 if age 50 or older)
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Contributions made in the year a taxpayer reaches 70 1/2 and any later year
are also considered excess contributions.
Excess contributions are nondeductible contributions.
In general, an excess contribution and any earnings on it are subject to an
additional 6 percent tax if the taxpayer does not withdraw the contribution
by the due date of the tax return, including extensions.
Each year that the excess amounts remain in the traditional IRA the taxpayer
must pay a 6 percent tax. The tax will never be more than 6 percent of the
value of the IRA at the end of the tax year.
To figure the excise tax use Form 5329 - Additional Taxes on Qualified Plans
(Including IRAs) and Other Tax-Favored Accounts.

Additional Taxes and Penalties


In general, taxpayers may be required to pay additional taxes and penalties
for not following tax law regarding IRAs, including:

Contributing more to a traditional IRA than is allowed


Making traditional IRA withdrawals before age 59 1/2
Not withdrawing enough traditional IRA funds after age 70 1/2
Investing in collectibles

IRA Rollovers
Taxpayers can avoid additional taxes and penalties by rolling over funds to
their traditional IRA from the following retirement plans:

a qualified employer plan


a traditional IRA inherited from a deceased spouse
a tax-sheltered annuity plan (403(b) plan)
a government deferred-compensation plan (457 plan)

TAX TIP

IRA Rollovers vs. IRA Transfers


Moving IRA funds from one IRA trustee directly to another trustee is
called a trustee-to-trustee transfer. It is not a rollover because nothing
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was paid to the taxpayer. Taxpayers can have as many transfers as they
like each year and there are no waiting periods between transfers. They
don't have to be reported on the taxpayer's tax return.
Conversely, a rollover is a distribution of funds that are paid to the
taxpayer. The taxpayer then contributes those funds to a different IRA
within 60 days. If not rolled over within 60 days the distribution is taxable
as ordinary income. Within one year after the taxpayer receives funds
from an IRA, and rolls over any part of the funds, he cannot make another
rollover from the same IRA. The once a year limit does not apply to
eligible rollover distributions from an employer plan.
Taxpayers that are simply moving their IRA from one financial institution
to another should use the trustee-to-trustee transfer method.
The table below shows how IRA withdrawals and IRA direct rollovers
(trustee-to-trustee transfers) are treated:
Tax result of a
Tax result of a direct
Affected Item
withdrawal
rollover
Withholding
The payer must
There is no
withhold 20% of the
withholding.
taxable part.
Additional Tax
If the taxpayer is under There is no 10%
age 59 1/2, a 10%
additional tax.
additional tax may
apply to the taxable
part (including an
amount equal to the
tax withheld) that is
not rolled over.
When to Report as
Any taxable part
Any taxable part is not
Income
(including the taxable
income until later
part of any amount
distributed from the
withheld) not rolled
IRA.
over is income in the
year paid.

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The 10% Early Withdrawal Penalty for withdrawals prior to age 59 1/2 does
not apply to the following taxable IRA Distributions:

Medical costs in excess of 10% of Adjusted Gross Income actually


paid in the same year of the distribution.

Medical insurance premiums after loss of employment.

Disability or Death.

A series of equal payments over the taxpayer's life expectancy


(minimum of 5 years or until age 59 1/2, whichever is longer).

Qualified higher education expenses actually paid in the same year


of the distribution.

Up to $10,000 for first time home buyers.

Payments to a beneficiary of a deceased IRA owner.

Payments made to qualified military reservists called to active duty.


Certain dates apply.

TAX PLANNING TIP

Is it a good idea to withdraw funds from an IRA for higher education


expenses?
Probably not. Both Traditional and Roth IRAs allow taxpayers to withdraw
funds for qualified higher education expenses before age 59 without
incurring a 10% penalty for early withdrawal. However, taxpayers should
consider the tax consequences if the proposed withdrawal is based on
funds from tax deductible contributions.
Any funds withdrawn must be included in taxable income in the year
withdrawn. Additionally, the withdrawal may put the taxpayer in a higher
tax bracket. The increased AGI may also effect the taxpayers itemized
deduction floors (see Lessons 18 & 19), and phase-outs based on AGI.
The taxpayer will also need to consider the effect of the withdrawal on his
or her retirement plans especially if retirement is a short time away.

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The table below shows the Exception Codes (to the penalty for Early
Withdrawals) that appear in the Distribution Code box of Form 1099-R
(Box 7):
No. Exception
01 Qualified retirement plan distributions if the taxpayer separated
from service in or after the year of reaching age 55 (does not apply
to IRAs).
02 Distributions made as part of a series of substantially equal periodic
payments (made at least annually) for life (or life expectancy) or the
joint lives (or joint life expectancies) of the taxpayer and designated
beneficiary (if from an employer plan, payments must begin after
separation from service).
03 Distributions due to total and permanent disability.
04 Distributions due to death (does not apply to modified endowment
contracts).
05 Qualified retirement plan distributions up to (1) the amount paid for
unreimbursed medical expenses during the year minus (2) 10% of
adjusted gross income for the year.
06 Qualified retirement plan distributions made to an alternate payee
under a qualified domestic relations order (does not apply to IRAs).
07 IRA distributions made to unemployed individuals for health
insurance premiums
08 IRA distributions made for higher education expenses
09 IRA distributions made for purchase of a first home, up to $10,000
10 Distributions due to an IRS Levy on the qualified retirement plan.
11 Distributions to reservists while serving on active duty for at least
180 days.
12 Other exceptions may apply

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Figure 17-2: Form 1099-R - Distributions From Pensions, Annuities, Retirement or


Profit-Sharing Plans, IRAs, Insurance Contracts, etc. with box 7 "Distribution code(s)"
highlighted.

TAX TIP

Are inheritances taxable?


Ordinarily, inheritances are not taxable for federal income tax purposes.
Taxpayers don't report inheritances on their income tax return. But there
is an exception - if the taxpayer inherited a traditional IRA or a retirement
account such as a 401(k). In that case any distributions received from
those retirement accounts are reported as income on the beneficiarys tax
return. The taxpayer will receive a Form 1099-R showing the amounts of
income to report. Inherited Roth IRAs, on the other hand, pass to the
beneficiary's income tax-free.
My spouse died. Is his IRA taxable to me?
If inherited from a spouse, the surviving spouse may:

Treat it as one's own IRA by changing account ownership. This also


occurs if contributions are made to the inherited IRA, or required
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minimum distributions are not taken for the year as a beneficiary, or


if a sole beneficiary, there is an unlimited right to withdraw amounts.

Treat it as one's own by rolling into an existing IRA, or rolling the


taxable portion into a qualified employer 403 (a), 403 (b) or 457 plan.

Treat the IRA as a beneficiary IRA.

Effective in 2007 as per PPA 2006 a non-spouse beneficiary may:

Treat the distribution as taxable.


Roll over the distribution using a trustee to trustee transfer. The post
transfer IRA must be considered an Inherited IRA, and the beneficiary
does not assume ownership of the assets, and may not roll over the
proceeds into another IRA. Distribution options are more flexible
whereby the minimum distribution rules may apply. See IRS Notice
2007-7 for an explanation of distribution options.

Deductible IRA Contributions


Taxpayers who contribute to a traditional IRA are eligible to deduct the
lesser of:

Contributions to their traditional IRA for the year, or


The general contribution limit (or the spousal IRA limit if it applies)

Only taxpayers who are under 70 1/2 and have taxable compensation can
contribute to a traditional IRA.
The deductible amount for a traditional IRA depends on answers to the
following questions:

Was the taxpayer or taxpayer's spouse covered by an employer's


retirement plan for any part of the year?
What is the taxpayer's filing status?
What is the taxpayer's modified adjusted gross income?

Taxpayers Not Covered by an Employer Retirement Plan


One of the most important factors in determining a taxpayer's traditional
IRA deductible is whether or not the taxpayer is covered by an employer's
retirement plan. Taxpayers who contributed to an IRA and are not covered
by an employer's retirement plan can often take the full IRA deduction.
562

LESSON

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INDIVIDUAL

RETIREMENT

ACCOUNTS

Taxpayers who are covered by a retirement plan may have to take a


reduced deduction or may not be able to take the deduction at all.
Filing Status
The next factor to consider is the taxpayer's filing status. Taxpayers who are
not covered by employer retirement plans and whose filing status is one of
the following can take the full traditional IRA deduction:

Single
Head of Household
Qualifying widower

Figure 17-3: The Filing Status section of Form 1040 with box 1 "Single" box 4 "Head of
Household" and box 5 "Qualifying widow(er) highlighted.

Married taxpayers who are not covered by an employer's retirement plan


may each be able to take the full traditional IRA deduction, regardless of
whether they file joint or separate returns. The total deduction for both
spouses on a joint return cannot exceed $11,000 ($13,000 if both
individuals are age 50 or older). Spouses should figure each deduction
separately when determining the allowable deduction.
Married taxpayers not covered by an employer retirement plan, who file
separate returns for a taxable year and live apart at all times during the
taxable year, are treated as single and can take a full IRA deduction. This is
true even if the other spouse is covered by an employer retirement plan.
Modified Adjusted Gross Income (MAGI)
The third factor is the taxpayer's modified adjusted gross income (MAGI),
which becomes important when taxpayers have contributed to traditional
IRAs and are covered by employer's retirement plans. MAGI is also used to
determine the deduction amount when a taxpayer is not covered by an
employer's retirement plan but the spouse is.
MAGI is the amount from line 37 of Form 1040 without consideration of
certain deductions.

563

LESSON

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RETIREMENT

ACCOUNTS

Figure 17-4: The Adjusted Gross Income section of Form 1040 with line 37 "Adjusted
Gross Income" highlighted.

To figure a taxpayer's MAGI combine the amount on line 37 of Form 1040


with:

The IRA deduction


Student loan interest deduction
Foreign earned income exclusion
Foreign housing exclusion or deduction
Exclusion of qualified savings bond interest shown on Form 8815
Exclusion of employer-paid adoption expenses shown on Form 8839

TAX QUOTE

"The difference between tax avoidance and tax evasion is the thickness of a
prison wall."
Denis Healey
Taxpayers Covered by an Employer Retirement Plan
Taxpayers who are covered by an employer's retirement plan may not be
able to take the IRA deduction or may only be eligible for a partial
deduction. It depends upon their filing status and MAGI.
If Box 13 - "Retirement Plan", on Form W-2 is checked the taxpayer is
covered by an employer retirement plan.

564

LESSON

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INDIVIDUAL

RETIREMENT

ACCOUNTS

Figure 17-5: Form W-2 - Wage and Tax Statement with box 13 "Retirement plan"
highlighted.

If the taxpayer does not agree with his Form W-2 he must contact his
employer.
Taxpayers with questions on their employer retirement plans, military
reservists, and volunteer firefighters should consult Publication 590-A Contributions to Individual Retirement Arrangements (IRAs) to determine if
they are covered by an employer retirement plan.

565

LESSON

17

INDIVIDUAL

RETIREMENT

ACCOUNTS

To determine the traditional IRA deduction amount for taxpayers


covered by an employer's retirement plan, refer to the following table,
which you may remember from the previous lesson:
If the taxpayer or spouse is covered by a retirement plan at work the tax deduction begins
to phase out at:
$60,000 if the taxpayer's filing status is single, head of household, or married filing
separately and he lived apart from his spouse for all of 2014;
$96,000 if the taxpayer's filing status is married filing jointly and both the taxpayer and
spouse are active plan participants, or the taxpayer is a qualifying widow or widower;
$96,000 if the taxpayer's filing status is married filing jointly and the taxpayer is active plan
participant but the spouse is not. The spouse uses the $181,000 threshold;
$181,000 if the taxpayer's filing status is married filing jointly and the taxpayer was not an
active plan participant but the spouse was. The spouse uses the $96,000 threshold; and
$0 if the taxpayer's filing status is married filing separately and he lived with the spouse at
any time in 2014.
These limits will rise through in future years.
Phase-outs
The tax deduction
If the phase-out threshold
phases out at...
is...
$60,000
$60,001-$70,000
$96,000
$96,001-$116,000
$181,000
$181,001-$191,000
$0
$0-$9,999

No tax deduction
is allowed at...
$70,000 +
$116,000 +
$191,000 +
$10,000 +

Table: IRA Contribution Phase-out Rules

When to Deduct Traditional IRA


Contributions
Individuals may deduct traditional IRA contributions on their tax return if the
contributions are made during the tax year or by April 15th (or the filing
deadline) of the following year.
The contributions do not have to be made before the return is filed.
However, if the taxpayer deducts traditional IRA contributions on their tax
return but does not make the traditional IRA contributions by the filing
deadline, for the exact amount deducted, the taxpayer must file an
amended tax return.
Taxpayers may not deduct on their current tax return contributions made
which were already deducted on a prior tax return.
566

LESSON

17

INDIVIDUAL

RETIREMENT

ACCOUNTS

Reporting the Deduction


Use the 1040 ValuePak IRA Contribution Information Worksheet to assist
taxpayers in figuring their traditional IRA deductions.

Figure 17-6: The Adjusted Gross Income section of Form 1040 with line 32 "IRA
deduction" highlighted.

Non-deductible IRA Contributions


Although taxpayers' traditional IRA contribution deductions may be
reduced or eliminated because of the MAGI limitation taxpayers may still
contribute up to:

The general limit ($5,500 or $6,500 if 50 or older), or


100% of taxable compensation (whichever is less), or
The spousal IRA limit (if it applies)

The difference between total permitted contributions and the allowable IRA
deduction, if any, is the amount of the non-deductible contribution.
Like deductible contributions, earnings and gains on non-deductible
contributions are not taxed until they are distributed to the taxpayer.
Taxpayers are not required to claim their IRA contributions as taxdeductible. The entire contribution may be treated as a non-deductible. To
designate and report an IRA contribution as non-deductible, taxpayers must
complete Form 8606 - Nondeductible IRAs. If a taxpayer does not report
non-deductible contributions, all contributions to the traditional IRA will be
treated as deductible. This means all distributions will be taxed unless
taxpayers can show, with satisfactory evidence, that they made nondeductible contributions.
567

LESSON

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INDIVIDUAL

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ACCOUNTS

The taxpayer will have a cost basis in the IRA if there are non-deductible
contributions. The cost basis is the sum of the non-deductible contributions
to the IRA minus any withdrawals or distributions of nondeductible
contributions.

TAX PRACTICE TIP

Recordkeeping for Non-deductible IRA Contributions


Be sure to remind taxpayers that they should keep a separate record of
deductible contributions made and a separate copy of Form 8606 forever
as they will need it someday to substantiate to the IRS that part of their
distributions that are not taxable, as they were from non-deductible
contributions.
Additionally, a loss on an IRA may be tax deductible if, after the entire IRA
account has been distributed, the entire amount of non-deductible
contributions have not been received.

Additional Taxes & Penalties


Taxpayers are subject to additional taxes and penalties for:

Overstating the amount of nondeductible contributions on Form


8606 for any tax year
Failing to file Form 8606 when required

Penalties are $100 for each overstatement on Form 8606 and $50 for failing
to file Form 8606.

Lesson Summary
Adjustments to Income for traditional IRA contributions, which are not Roth,
SIMPLE, or Education IRAs, can be claimed on either Form 1040 or 1040A.
Individuals who are 70 1/2 years old or older by the end of the tax year
cannot make traditional IRA contributions for that tax year.
Traditional IRA contributions generally cannot be more than the taxpayer's
taxable compensation or $5,500 ($6,500 if age 50 or older), whichever
amount is smaller. The maximum contribution married taxpayers who file
568

LESSON

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jointly can contribute is the lesser of either the taxpayers' total taxable
compensation for the year or $11,000 ($13,000 if age 50 or older).
For IRA purposes compensation:
Includes...
wages, salaries, etc.
commissions
self-employment income
alimony and separate maintenance
nontaxable combat pay

Does not include...


earnings and profits from property
interest and dividend income
pension or annuity income
deferred compensation
income from certain partnerships
any amounts you exclude from
income

Individuals who are not covered by retirement plans at work may make
deductible contributions regardless of their modified adjusted gross income
(MAGI). Taxpayers who are covered by retirement plans at work may deduct
all, part or none of their traditional IRA contributions depending on their
MAGI and filing status.
Taxpayers may be subject to additional tax for:

Contributing more to a traditional IRA than is allowed


Making traditional IRA withdrawals before age 59 1/2
Not withdrawing enough traditional IRA funds after age 70

Questions Taxpayers Ask...


Question: "Can I take a tax deduction for my 401k Contribution?"
Answer: You can't take a tax deduction for your 401k contribution because
it has not been included in your taxable income. Your 401k contribution is
not included as taxable income on your Form W-2.

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RETIREMENT

ACCOUNTS

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify your 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.

570

LESSON
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STANDARD

AND

ITEMIZED

DEDUCTIONS

Lesson

18
Lesson 18 - Standard and Itemized
Deductions - Part I
In this lesson youll learn about standard and itemized deductions, including
which expenses taxpayers can include in their itemized deductions.
The following topics are discussed in this lesson:
What Are Deductions?
Standard and Itemized
Deductions
The Standard Deduction
Criteria for Blindness
Personal Exemption on Form
1040EZ
Taxable Income on Form
1040EZ

Married Filing Separately


Medical and Dental Expenses
Taxes
Interest
Home Mortgage Interest
Itemized Deduction
Reduction

What Are Deductions?

eductions are subtractions from a taxpayer's Adjusted Gross


Income (AGI). They reduce the amount of income that is taxed and
ultimately, the amount of tax that is owed.

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DEDU CTIONS

Standard and Itemized Deductions


The standard deduction can be taken on Forms 1040EZ, 1040A, or 1040.
Taxpayers who choose to itemize their deductions must file Form 1040 and
Schedule A.
In general taxpayers with qualified deductions should:

Use Form 1040 and Schedule A to calculate the total of their


itemized deductions and compare it to their standard deduction
Choose the method that results in the greater reduction to their
taxable income

Itemized deductions include amounts paid for medical and dental expenses,
state and local income taxes, real estate taxes, personal property taxes,
home mortgage interest, gifts to charity, casualty and theft losses, job
expenses, and miscellaneous deductions.
After entering the taxpayers itemized deductions on Schedule A - Itemized
Deductions, 1040 ValuePak will automatically select either the Standard
Deduction or Itemized Deductions - whichever will result in the lowest
taxable income and tax.

Figure 18-1: The Tax and Credits section of Form 1040 with line 40 "Itemized deductions"
highlighted.

572

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DEDU CTIONS

TAX PLANNING TIP

Bunching Itemized Deductions


If the taxpayers total itemized deductions are close to the standard
deduction each year, consider bunching together expenses for itemized
deductions every other year. Itemize in those years to deduct more than
the standard deduction amount. Then claim the standard deduction in
the other years. Over time, this technique can save thousands of dollars in
taxes by significantly increasing the taxpayers cumulative write-offs.

The Standard Deduction


All taxpayers must figure their standard deduction, even if they file Form
1040 and itemize their deductions. The standard deduction amount
depends on:

The taxpayer's filing status


Whether the taxpayer (or spouse) is 65 or older or blind
Whether the taxpayer can be claimed as a dependent on another
taxpayer's return

Based on each taxpayer's situation, you can determine the amount of


the standard deduction using the following table:
If the taxpayer's filing
status is:
Single
Married filing a joint tax
return or Qualifying
widow(er) with dependent
child
Married filing a separate tax
return
Head of Household
Dependent Children(1)

If 65 or over AND/OR blind


The standard deduction is: add for EACH
$6,200
$1,550
$12,400

$1,200

$6,200

$1,200

$9,100
$1,550
The greater of $1,000 OR the amount of earned income,
plus $350. Not to exceed $5,850 unless the dependent is
blind. If blind add $1,550.

(1)

The reduced standard deduction rule for dependents applies to dependents who can
be claimed on another tax return regardless of whether or not they actually are claimed.
Table: Standard Deduction Table

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LESSON
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DEDU CTIONS

The following taxpayers are not eligible to use the standard deduction:

married taxpayers filing separately if the spouse itemized deductions.


This prevents one spouse from claiming all of the itemized
deductions and the other spouse from claiming the standard
deduction.

nonresident aliens, or those who were both nonresident and resident


aliens during the year, unless they are married to U.S. citizens or
residents and elect to be taxed as residents for the year; and

those who are filing a tax return for a short tax year because they are
changing to a fiscal year

TAX PRACTICE TIP

Switching from the Standard to Itemized Deductions


If a client that you just met took the standard-deduction in prior years,
and upon reviewing his tax returns you discover that itemizing
deductions would have saved him more money, you can switch to
itemized deductions by amending the returns using Form 1040X. This can
be done anytime within the three (3) year period allowed for amending
returns. Taxpayers using the Married Filing Separately filing status must
both consent and make the same change to both returns as Married
Filing Separately taxpayers must both either take the standard deduction
or itemize.

Criteria for Blindness


Determining legal blindness may require your interview skills. Individuals
whose sight is not better than 20/200 in their best eye while wearing
corrective lenses, or whose field of vision is 20 degrees or less, might be
legally blind.
A taxpayer who was totally blind on the last day of the tax year should
attach a statement to the tax return describing the blindness.

574

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DEDU CTIONS

Taxpayers who were partially blind on the last day of the tax year should
attach a statement from an eye physician or registered optometrist verifying
that either the vision in their best eye is no better than 20/200 with
corrective lenses or their field of vision is no more than 20 degrees.
Taxpayers should retain a copy of the certified statement in their records.

TAX QUOTE

"I wouldn't mind paying taxes if I knew they were going to a friendly
country."
Dick Gregory

Personal Exemption on Form 1040EZ


In addition to the standard deduction there is the personal exemption
deduction. Form 1040EZ combines the standard deduction and personal
exemption into one entry on line 5.
Forms 1040A and 1040 handle the personal exemption differently than
Form 1040EZ. Exemptions are covered in Lesson 6 - Personal and
Dependency Exemptions.

Taxable Income on Form 1040EZ


Once you enter the personal exemption including the standard deduction
on line 5 of Form 1040EZ, 1040 ValuePak will calculate the taxable income
by subtracting line 5 from adjusted gross income on line 4.

Married Filing Separately


If spouses file separately, and one of them itemizes deductions, the other
spouse will not qualify for the standard deduction and must also itemize.
They both must make the same election.
The following taxpayers are not allowed to use the standard deduction even
if it results in a lower tax than itemizing deductions:

575

LESSON
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18

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AND

ITEMIZED

DEDU CTIONS

A married taxpayer who files separately and whose spouse itemizes


deductions (indicated on line 39b of Form 1040) is not allowed to
claim the standard deduction; the taxpayer must either itemize
deductions or take "0" for the standard deduction

Nonresident aliens cannot claim the standard deduction

Figure 18-2: The Tax and Credits section of Form 1040 with line 39b highlighted.

A married taxpayer who files a separate return and whose spouse itemizes
deductions will usually find it more beneficial to itemize deductions than to
take "0" as the standard deduction.
For state tax purposes, some taxpayers whose standard deduction is higher
than the total for their itemized deductions may benefit by itemizing
deductions anyway.
Each spouse can only take the itemized deductions he or she is liable for,
and actually pays. Thus, if the husband is liable for an otherwise tax
deductible expense, and the wife pays it, then the husband cannot take the
deduction. If the wife does not file a tax return then she cant take the
deduction either. It is lost.
Deductible expenses that are paid out of separate funds, such as medical
expenses, are deductible on the tax return of the spouse who paid them. If
these expenses are paid from community funds, the deduction on the
576

LESSON
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DEDU CTIONS

return depends on whether or not the taxpayers live in a community


property state. In a community property state, the deduction on the returns
is divided equally between the taxpayer and spouse.
See Publication 504 - Divorced or Separated Individuals for information on
how to allocate tax deductible expenses.

Medical and Dental Expenses


Medical and dental expenses are reported on lines 1 through 4 of Schedule
A and include expenses paid for:

The taxpayer and spouse


Dependents claimed on the return
Others who could have been claimed as dependents except that
they either:
o Had a gross income of $3,950 or more, or
o Filed a joint return

Figure 18-3: The Medical and Dental Expenses section of Form 1040 Schedule A Itemized Deductions.

If a child of divorced or separated parents is claimed as a dependent on


either parent's return, both parents may deduct the medical expenses that
they individually paid for the child.
You can deduct unreimbursed medical expenses only in the year they were
actually paid. There is no tax deduction for medical expenses that are
reimbursed by insurance or from other sources.
The portion of medical and dental expenses that exceeds 10% of the
taxpayer's AGI is deductible on Schedule A.

577

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AND

ITEMIZED

DEDU CTIONS

TAX TIP

Should taxpayers participate in Flexible Spending Accounts at work?


Medical expenses can rarely be taken as an itemized deduction by most
taxpayers because of the 10% of Adjusted Gross Income limitation.
However, if the taxpayer has available a Flexible Spending Account
through his company's cafeteria plan he can set aside tax-free earnings
(they are deducted from his W-2 wages) to cover medical and dental
expenses through the plan offered by his employer. Taxpayers are now
be able to carry over up to $500 of unused funds at the end of the year.
Taxpayers should be sure to use up any funds in excess of $500 in their
Flexible Spending Accounts before December 31st. If they dont they risk
losing that money forever. Advise them to schedule end-of-year doctor,
dentist, optometrist, acupuncturist, and chiropractor appointments, buy
new prescription glasses or contact lenses, hearing aids, and medicines
they'll need next year before December 31st. Then submit their receipts
for eligible expenses within the time required by the plan. Some plans
allow participants an extra 2 months after the end of the year to use
the unspent amount. They can check with their plan administrator for the
deadline.
The table below shows most deductible and non-deductible medical
expenses:
You CAN deduct the following...

You CANNOT deduct the following...

Admission and transportation


to a medical conference
relating to the chronic disease
of a dependent, if it is primarily
for and essential to the care of
the dependent

Birth control pills prescribed by


your doctor

Capital expenses for


equipment or improvements

578

Diaper service

Diet foods

Expenses for your general


health (even if following your
doctor's advice. However if you
doctor has recommended a
program as treatment for a
specific condition, the IRS has
indicated that the cost would
be deductible) such as

LESSON
PART I

18

STANDARD

AND

You CAN deduct the following...

ITEMIZED

DEDU CTIONS

You CANNOT deduct the following...

to your home needed for


medical care, or to make the
home suitable for a disabled
person. (See IRS Publication
502)

Health club dues

Household help (even


if recommended by a
doctor.)

Childbirth classes for mothersto-be

Social activities, such as


dancing or swimming
lessons.

Cost and care of guide dogs or


other animals aiding the blind,
deaf or disabled.

Trip for general health


improvement.

Weight loss program.

Cost of lead-based paint


removal (See IRS Publication
502)

Funeral, burial or cremation


expenses.

Illegal operation or treatment.

Life insurance or income


protection policies, or policies
providing payment for loss of
life, limb, sight, etc.

Dental and orthodontic care

Expenses of an organ donor.

Hospital services fees (lab


work, therapy, nursing services,
surgery, etc.)

Legal abortion

Maternity clothes

Legal operation to prevent


having children.

Meals and lodging provided by


a hospital during medical
treatment.

Meals and lodging while


attending a medical
conference related to the
chronic disease of a dependent

Meals and lodging provided by


a nursing home during medical
treatment.

Medical expenses paid from a


medical savings account
(MSA).

Medical expenses paid from a


flexible savings account (FSA)

Medical insurance included in


a car insurance policy covering
all persons injured in or by

Medical, hospital, dental and


long-term care insurance
premiums (subject to the age
limits) (See IRS Publication 17

579

LESSON
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STANDARD

AND

You CAN deduct the following...

ITEMIZED

You CANNOT deduct the following...

for details).

DEDU CTIONS

your car.

Medical services fees (from


doctors, dentists, surgeons,
specialists, and other medical
practitioners.)
Medicare A premiums for
persons not enrolled in Social
Security, and Medicare B
premiums
Nurse's services - including inhome services ( see IRS
Publication 502)

Medical insurance premiums


paid with pre-tax dollars

Medicine you buy without a


prescription.

Nonprescription drugs or
medicines.

Nonprescription nicotine gum,


patches, or lozenges.

Nursing home policies, if the


policy ensures a maximum
out-of-pocket expense per
day.

Oxygen equipment and


oxygen

Part of life-care fee paid to


retirement home designated
for medical care.

Babysitting, childcare, and


nursing care for a healthy
baby.

Prescription medicines (those


requiring a prescription by a
doctor for their use by an
individual) and insulin.

Payroll tax paid for Medicare A.

Surgery for purely cosmetic


reasons.

Psychiatric care at a specially


equipped medical center
(includes meals and lodging.)

Toothpaste, toiletries,
cosmetics, etc.

Social Security tax, Medicare


tax, FUTA, and state
employment tax for worker
providing medical care (See
Wages for nursing services
below.)

Special items (artificial limbs,


false teeth, eyeglasses, contact

580

LESSON
PART I

18

STANDARD

AND

You CAN deduct the following...

ITEMIZED

DEDU CTIONS

You CANNOT deduct the following...

lenses, hearing aids, crutches,


wheelchairs, braces, etc.)

Special school or home for


mentally or physically disabled
persons (see IRS Publication
502 for details).

Stop smoking programs,


including cost of prescription
drugs designed to alleviate
nicotine withdrawal.

Transportation for needed


medical care at the IRS
published rate per mile, or
actual out-of-pocket expenses,
plus parking fees and tolls.
(See IRS Publication 17 for
details).

Treatment at drug or alcohol


center (includes meals and
lodging provided by the
center.)

Weight-loss programs to treat


obesity and other diseases
diagnosed by a physician

TAX TIP

Can a taxpayer deduct medical expenses paid for an ex-spouse?


If the taxpayer is legally required to pay any medical expenses for his or
her ex-spouse he or she can deduct the expenses. Better yet, he or she
can deduct them as alimony instead of as an itemized deduction. The
benefit of deducting the medical expenses as alimony is that most
medical expenses on Schedule A are disallowed because of the 10% of
581

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DEDU CTIONS

AGI limit.
Taxpayers cannot deduct employer health insurance premiums paid with
pre-tax dollars because the premiums are not included in Box 1 of Form W2.
Surgery that does not correct a congenital abnormality, or an abnormality
caused by disease or injury is considered unnecessary and therefore, purely
cosmetic.

SIDE BAR

What is Long Term Care insurance?


Long Term Care insurance is an insurance policy that pays a fixed dollar
amount per day for nursing care performed for the basic activities of daily
living such as eating, dressing, and bathing. The insured's inability to
perform these activities must be due to an illness, injury, or cognitive
disorder.
While the elderly are often associated with Long Term Care insurance it
actually applies to the ongoing care of individuals of any age who cannot
perform these functions. Covered care may be provided in various
different places such as nursing homes, private homes, assisted-living
facilities, adult day-care centers, and hospices.
Long Term Care insurance premiums can be high so its important to
purchase a policy at a relatively young age.

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DEDU CTIONS

The table below shows the deductible amount of Long Term Care
insurance policy premiums:
Age
Maximum Tax Deductible Premium
Under 41
$370
41-50
$700
51-60
$1,400
61-70
$3,720
Over 70
$4,660
Benefits paid by qualified long term care policies:
To the extent that they reimburse long term care expenses, benefits paid by an indemnity
type contract are tax free. Benefits paid by a per diem contract are tax free up to $330
per day.
Table: Medical Long Term Care Premiums

TAX TIP

Are home improvements made for medical reasons tax deductible?


Expenses for home improvements for qualified medical reasons are
deductible to the extent that the cost exceeds the increase in the value of
the taxpayers home. Examples of home improvements for medical
reasons are remodeling a bathroom to make it accessible, installing an
elevator, or constructing a swimming pool prescribed by a doctor for
arthritis treatment. To avoid possible misunderstandings with their doctor
and disputes with the IRS, taxpayers should obtain a Certificate of
Medical Necessity from their doctor before beginning construction.
If you and a taxpayer disagree as to whether a particular expense is
deductible then look it up and show the taxpayer. Further information is
contained in Publication 502 - Medical and Dental Expenses and Publication
969 - Health Savings Accounts and Other Tax-Favored Health Plans.

TAX PLANNING TIP

Pre-paying Medical Expenses


Medical expenses are one of the least useful tax deductions because
taxpayers must spend more than 10% of their adjusted gross income on
medical expenses for themselves and their dependents to claim any tax
583

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DEDU CTIONS

deduction. But there may be a way around that for some taxpayers. Have
the taxpayer get the doctors or dentists actual services performed
before December 31st and bunch together payments for insurance
premiums, eyeglasses, and prescription drugs for two adjoining tax years
whenever possible. Ordinarily the IRS wont allow deductions for
payments made in one year for services that wont be performed until the
following year by doctors, dentists, and hospitals.

Taxes
To be deductible, a tax must be both imposed on the taxpayer and paid by
the taxpayer during the tax year. Taxpayers cannot deduct a tax that they
did not owe but paid for someone else, that they owed but someone else
paid, or that was not paid in the tax year. Deductible taxes are reported on
lines 5 through 9 of Schedule A.

Figure 18-4: The Taxes You Paid section of Form 1040 Schedule A - Itemized
Deductions.

Taxpayers can elect to deduct state, local, and foreign income taxes. These
taxes include tax withheld, estimated payments, and tax paid for an earlier
year. Do not include penalties or interest, as they are not deductible.
State, local, and foreign real estate taxes are deductible the year they are
paid, and include tax payments made on real property, such as the
taxpayer's house or land. Taxes paid with a mortgage payment and held in
escrow are not deductible until they are paid by the mortgage lender.
Personal property taxes that state and local governments charge on the
value of personal property are deductible.

584

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

TAX TIP

Are condominium and homeowners association assessments tax


deductible?
Generally, no. Condominium owners and homeowners can however
deduct real estate taxes assessed against their dwelling unit. They
ordinarily cannot deduct condominium and homeowners association
assessments. However, in some localities the owner receives a tax bill
assessed against his or her dwelling unit, and the condominium or
homeowner association receives a tax bill assessed against all the
common elements. The association may collect a share of its tax bill from
each unit owner with the maintenance assessment. In that situation each
owner can deduct their share of the association's tax bill.
Co-op owners can deduct amounts paid to the corporation to the extent
that they represent the owner's proportionate share of real estate taxes
paid by the corporation.

TAX PRACTICE TIP

Dont Forget Last Years Taxes


When preparing the taxpayers return dont forget to deduct this year any
state or local taxes paid when the taxpayer filed his or her state or local
tax return last year. Also include any state or local tax refunds from last
year that the taxpayer had credited to estimated tax instead of taking a
check.
The following table lists which taxes are and are not deductible:
Tax

You CAN deduct the


following taxes

Income Tax

State and local


income tax.
Foreign income tax.
585

You CANNOT
deduct the
following taxes
Federal income tax.
Employee
contributions to

LESSON
PART I

18

STANDARD

Tax

Real Estate Tax

AND

ITEMIZED

You CAN deduct the


following taxes

Employee
contributions to state
funds listed under
State benefit funds.
State and local real
estate tax.
Foreign real estate
tax.

Personal Property
Tax
Sales Tax

Other Tax

Tenant's share of real


estate tax paid by
cooperative housing
corporation.
State and local
personal property tax.
State and Local sales
taxes are deductible
provided you make
the election on
Schedule A, line 5, to
claim them in lieu of
State and Local
income taxes.
Tax that is an expense
of your trade or
business.
One half of self
employment tax paid.
Tax on property
producing rent or
royalty income.
586

DEDU CTIONS

You CANNOT
deduct the
following taxes
private or voluntary
disability plans.

Tax for local benefits.


Trash and garbage
pickup fees.
Rent increase due to
higher real estate tax.
Homeowner's
association charges.
Import duties.

Taxes on alcoholic
beverages, cigarettes,
and tobacco. Taxes
on gasoline, diesel,
and other motor fuels
used in a nonbusiness vehicle.
Federal social security
(FICA), railroad
retirement, gift, and

LESSON
PART I

18

STANDARD

Tax

AND

ITEMIZED

You CAN deduct the


following taxes

Occupational tax.

Fees and Charges

Fees and charges that


are expenses of your
trade or business or
of producing income.

DEDU CTIONS

You CANNOT
deduct the
following taxes
excise taxes or
customs duties.
Per capita taxes. (See
IRS Publication 17 for
details.)
Fees and charges,
such as those for
driver's, hunting,
fishing, or dog
licenses; fines and
penalties; or water,
sewer, and utility
taxes or bills,
generally are not tax
deductible. (See IRS
Publication 17 for
details.)

TAX PLANNING TIP

Pre-paying Property Taxes


If the taxpayer is not affected by the Alternative Minimum Tax, and he
doesn't think his personal income tax bracket will be higher next year, he
might want to pre-pay his property taxes and take the deduction now. If
he pre-pays next years property taxes before January 1st, he can deduct
that amount along with the taxes paid for the current year on this year's
tax return.
Taxpayers can also pre-pay the 4th quarter installment of their estimated
state and local income tax before December 31st instead of waiting until
it becomes due in January provided they actually expect to owe the
additional state or local tax.
Note: Deductions for state and local income and property taxes are
587

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

completely disallowed under the Alternative Minimum Tax rules.

Interest
Interest is the amount someone pays to borrow money. To be deductible,
the interest must be paid by the taxpayer during the tax year. Only
taxpayers who are legally liable for the debt can deduct the interest.
Deductible interest is reported on lines 10 through 15 of Schedule A.

Figure 18-5: The Interest You Paid section of Form 1040 Schedule A - Itemized
Deductions.

Members of the clergy and military can deduct qualified mortgage interest
even if they receive a nontaxable housing allowance.
Interest that cannot be deducted includes:

Interest on car loans where the car is used for personal purposes
Interest on boat loans (provided the boat is not a second home)
Interest on personal loans
Fees for services needed to get a loan
Finance charges for personal credit card purchases

Investment Interest
Investment interest such as margin interest paid to a brokerage house and
other interest paid on loans taken to invest in income generating securities
is tax deductible.
As far as the tax deduction of investment interest is concerned, the IRS looks
at how the proceeds of a loan are invested not what collateral was used to
get the loan. If the loan proceeds are invested to produce dividends,
interest, annuities, royalties, or gains or losses, and it is not a trade or
business or a passive activity, the interest on the loan will be considered to
588

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

be "investment interest". Taxpayers should be sure to keep accurate records


proving that they used the loan proceeds to invest in income producing
investments.
Taxpayers cannot deduct interest on loans taken out to purchase the
following:

annuities
endowment contracts
municipal bonds
single-premium life insurance policies
straddle options

Investment interest can be deducted against investment income but cannot


be deducted against passive activity income.
Taxpayers must first reduce their total investment income by the amount of
other investment expenses deducted (but only to the extent that those
expenses exceed 2% of AGI and can actually be deducted as miscellaneous
itemized deductions) and then they can deduct their investment interest, up
to the amount of their remaining investment income. Investment income
includes interest and dividends. Long-term capital gains are not investment
income but short-term capital gains are. Any investment interest that
cannot be deducted in the current year is carried forward to future years.

TAX TIP

Is it a good idea for taxpayers to deduct their investment interest


against long term capital gains?
Some taxpayers choose to report part or all of their long-term capital
gains as short-term capital gains thereby making more of their
investment interest expense deductible. However, in doing so they
eliminate having the gains taxed at the more favorable long term capital
gains tax rate.
If the taxpayer expects to have more investment income in later years he
may be better off not to include the long term capital gains so that he
gets the benefit of the lower long term capital gains tax rate now - and
carries over the investment interest expense deduction to future years.
589

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

That way the investment interest expense deduction will offset more
ordinary income at the higher tax rates in future years.

Use Form 4952 - Investment Interest Expense Deduction to deduct


investment interest. This form must be completed unless all of the following
are true:

the only investment income was from interest or dividends. In


making this determination taxpayers must include investment
income reported by a partnership or S corporation, by an estate or
trust, and the taxpayer's child's investment income reported on the
taxpayers tax return.

the taxpayer has no other deductible expenses connected with the


production of the interest or dividends

the taxpayers investment interest is less than or equal to his total


investment income

the taxpayer has no carryover interest deductions from previous


years

TAX PLANNING TIP

Is it worth it for taxpayers to pay off non-deductible personal loan(s)


by taking out a tax deductible home equity loan?
Generally, yes. It makes sense to payoff non-deductible personal and
automobile loans with funds obtained through a tax deductible home
equity loan provided the interest rates are comparable or lower on the
home equity loan. Taxpayers should also consider any loan fees when
deciding if it makes sense to convert non-deductible loans into tax
deductible home equity loans.
However, this tax planning technique wont work if the taxpayer is subject
to the Alternative Minimum Tax (AMT) as there is no deduction for
interest on home equity loans obtained for reasons other than to acquire,
590

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

construct or substantially improve a first or second home for taxpayers


subject to the AMT.
The table below shows where to deduct interest:
IF you have...

THEN deduct it on...


Form 1040, line 33 or
Form 1040A, line 18

Deductible student loan interest


Deductible home mortgage interest and points reported on
Form 1098
Deductible home mortgage interest not reported on Form 1098
Deductible points not reported on Form 1098
Deductible investment interest (other than interest incurred to
produce rents or royalties)
Deductible business interest (non-farm)
Deductible farm business interest
Deductible interest incurred to produce rents or royalties
Personal interest

Schedule A, line 10
Schedule A, line 11
Schedule A, line 12
Schedule A, line 14
Schedule C or C-EZ
Schedule F
Schedule E
Not Deductible

Table: Where to Deduct Interest

TAX TIP

Can taxpayers pay interest with borrowed funds?


In order to take an interest deduction the taxpayer has to actually pay the
interest. When a creditor adds the interest to the debt or loans the debtor
funds to make the payment no tax deduction is allowed. However, the
taxpayer can borrow money from a different creditor to make the
payments and the interest will be fully deductible.

591

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

Home Mortgage Interest


Home mortgage interest reported on Form 1098 appears in box 1.

Figure 18-6: Form 1098 - Mortgage Interest Statement with box 1 "Mortgage interest
received from payer(s)/borrower(s)" highlighted.

The amount of home mortgage interest a taxpayer can deduct depends on


the:

Date of the loan


Amount of the loan
Use of the loan's proceeds

If a mortgage debt was incurred on or before October 13, 1987, and it was
secured by a main or second home, the loan's interest is fully deductible
regardless of the loan amount or use of the loan proceeds. A main home is
the one the taxpayer lives in most of the time. "Grand fathered debt" is the
term for mortgages taken out on or before October 13, 1987.
If a mortgage debt was incurred after October 13, 1987, and it was secured
by a main or second home, the loan's interest is fully deductible if:

The loans plus any grand fathered debt do not exceed $1 million
($500,000 if married filing separate returns), and

The proceeds were used to buy or build (Acquisition Debt), or


improve the home

592

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

TAX TIP

Mortgage Credit Certificates (MCCs)


A few states and localities issue Mortgage Credit Certificates and if
taxpayers obtain a certificate they can claim a tax credit (rather than a tax
deduction) for the interest they paid. Taxpayers are usually better off
taking the credit.
These certificates are usually only available to first-time homebuyers
whose income is below the median income for the area where the home
is located. If the taxpayer is eligible to take the credit claim it on Form
8396 - Mortgage Interest Credit.

SIDE BAR

How expensive of a house can a person typically afford?


Conventional wisdom holds that the average person can afford a home
worth 2 times their annual salary. But there are certainly many other
factors to consider, such as any other debts that must be repaid, the
property taxes that must be paid, current interest rates on mortgages,
and how much the mortgage company determines the person can afford
in monthly payments.
Taxpayers can deduct the interest expense on construction loans from the
time that construction begins. If construction lasts longer than 24 months,
any mortgage interest after 24 months is not deductible. The interest on the
permanent mortgage loan is deductible once the home is completed.

593

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

TAX TIP

Are the closing costs incurred on a home purchase tax deductible?


At closing or settlement the buyer and the seller receive a form called a
HUD-1 - Settlement Statement. This form itemizes and balances both the
buyers and sellers credits and debits and typically includes the following
charges:

Appraisal fee for determining the value of the property for the
lender

Attorneys fees for preparing and reviewing the loan and closing
documents

Lenders Fees for loan and document preparation

Points which are an additional lender charge - each point is equal


594

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

to 1% of the loan amount

Prepaid interest representing mortgage interest on the loan from


the day of settlement to the last day of the current month

Real estate taxes

Recording fee payable to the city or county for recording the deed

Stamp tax which is a tax charged on real estate transactions

Title search fee to insure there are no liens, encumbrances, or


outstanding claims recorded against the property

Most settlement fees and closing costs are not tax deductible. Instead,
they are added to the cost basis of the home. However, real estate taxes
and mortgage points found on the taxpayers settlement statement are
usually deductible as an itemized deduction. "Prepaid interest" is
mortgage interest shown on the settlement statement and is usually
already included in the Form 1098 the taxpayer receives from his
mortgage lender.
See Publication 530 - Tax Information for First Time Homeowners for more
information about settlement or closing costs and determining the basis
of a home.
Taxpayers can also deduct interest on other loans secured by a main or
second home if:

The total of these loans does not exceed $100,000 ($50,000 if


Married Filing Separately), and

The total amount of the secured debt is not more than the home's
fair market value minus:
o Any outstanding acquisition debt, and
o Any grand fathered debt on the home

595

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

Interest on personal car loans, credit card balances, and installment loans is
considered personal interest, and it cannot be claimed as an itemized
deduction.

TAX TIP

Can a taxpayer pay his childs mortgage payment or real estate tax
and deduct them?
No. If a parent taxpayer pays his childs mortgage payment or real estate
tax he cannot deduct the payments because he is not legally liable for
them - unless he is a co-owner of the property. Worse yet, nor can the
child deduct those payments because he didnt pay them. Advise your
client not to pay the bills directly. Instead make a gift to the child and
have the child pay the mortgage and taxes.

596

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

TAX QUOTE

"Next to being shot at and missed, nothing is quite as satisfying as an


income tax refund."
F. J. Raymond

597

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

The table below shows where to deduct interest and taxes:


IF you are eligible to deduct....

real estate taxes


home mortgage interest and points reported on Form 1098
home mortgage interest not reported on Form 1098
points not reported on Form 1098
qualified mortgage insurance premiums

THEN report the amount


on Form 1040 Schedule
A...
line 6
line 10
line 11
line 12
line 13

Table: Where to Deduct Interest and Taxes

TAX TIP

Can taxpayers deduct late fees as home mortgage interest?


Yes, taxpayers can deduct late fees as home mortgage interest so long as
the late fees were not for a specific service performed by the lender.
The table below shows the tax deductions allowed and alimony that
must be claimed if the taxpayer is divorced but still pays the expenses of
a home his ex-spouse lives in, but he doesn't live in:
IF you must
pay all of the...

AND your
home is...

Mortgage
Payments
(principal and
interest)

jointly owned

Real Estate
Taxes and
Home

held as tenants
in common

THEN you can


deduct and
your spouse (or
former spouse)
must include as
alimony...
half of the total
payments

half of the total


payments
598

AND you can


claim as an
itemized
deduction...

half of the
interest as
interest
expense (if the
home is a
qualified
home).
half of the real
estate taxes
and none of the

LESSON
PART I

18

IF you must
pay all of the...

STANDARD

AND

AND your
home is...

ITEMIZED

DEDU CTIONS

THEN you can


deduct and
your spouse (or
former spouse)
must include as
alimony...

Insurance

AND you can


claim as an
itemized
deduction...

home insurance
held as tenants
by the entirety
or in joint
tenancy

none of the
payments

all of the real


estate taxes
and none of the
home insurance

TAX TIP

What should a taxpayer who is liable on a joint mortgage with


someone other than his or her spouse do if they dont receive a
Form 1098?
If the taxpayer is jointly liable on a mortgage with someone other than
his or her spouse (with whom he or she filed a joint tax return), and the
taxpayer doesnt receive a Form 1098, the taxpayer can deduct his or her
share of the interest and attach a statement to the tax return with the
name and address of the person who received the Form 1098.

TAX TIP

Are mortgage pre-payment penalties tax deductible?


Yes. If the taxpayer pays off (or refinances) his mortgage early and incurs
a pre-payment penalty be sure to include the penalty with his itemized
deduction for mortgage interest. Dont forget to deduct any points that
were previously being deducted ratably over the life of the loan, such as
points incurred on a previous refinance.

599

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

TAX PLANNING TIP

Making an Extra Mortgage Payment


Have the taxpayer make an additional mortgage payment on or before
December 31st so he can deduct the additional interest paid. Make sure
that the additional interest payment is included on his Form 1098Mortgage Interest Statement that he receives from the lender in January.
If not, you may need to manually add the interest amount to the amount
reported by the lender. Be sure you can prove to the IRS that you added
the correct amount as they may question it as it was not included in the
amount reported on Form 1098. You can also attach a short statement to
the return explaining why the lender's statement is incorrect.
Ordinarily taxpayers cant deduct prepaid interest. They must deduct it in
the year to which it applies. However, there is an exception to this rule for
the first mortgage payment of the next year when it is paid during the
last month of the current year. Why is there an exception? Because
mortgage interest is paid in arrears. Thus, the January 1st payment is for
interest applied in December.

Itemized Deduction Reduction


Editors Note: There was no Itemized Deduction Reduction (described
below) for tax years 2010-2012.
For Tax Years 2013 and Later:
There is a 3% itemized deduction reduction and taxpayers should take this
into account before deciding to earn extra income above certain limits.
As much as 80% of the benefits of itemized deductions may be lost if the
taxpayers Adjusted Gross Income (AGI) exceeds $305,050 for 2014 (for
married individuals filing separate tax returns the threshold is $152,525).
Itemized deductions that otherwise would have been allowed, excluding
medical expenses, casualty and theft losses, and investment interest
expense, are reduced by 3% of the amount by which the taxpayers AGI,
including capital gains, exceeds $305,050. The amount that the taxpayers
itemized deductions can be reduced is capped at 80%.

600

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

Figure 18-7: The Total Itemized Deductions section of Form 1040 Schedule A Itemized Deductions.

So, if the taxpayers have an AGI of $505,050 which is $200,000 over the
itemized deduction reduction threshold and itemized deductions of
$55,000, the taxpayers itemized deductions are reduced by $6,000 (3% of
$200,000) to $49,000. Put another way, the taxpayers taxable income
increases $6,000, and the taxpayers tax increases $2,376 (39.6% of
$6,000).
The disallowance of itemized deductions is applied after taking into account
other limitations, such as the 2% floor for miscellaneous itemized
deductions.

TAX TIP

Reimbursed Prior Deductions


When a taxpayer receives reimbursement from insurance or another
source for an item he or she deducted in a prior year the reimbursement
is taxable income. Items that may be reimbursed include:

Bad debts
Casualty and theft losses (including returned stolen property)
Donated property claimed as a charitable deduction
Medical expenses
Mortgage interest
Real estate taxes

Lesson Summary
Lets take a moment to review what you have learned in this lesson:
Deductions and exemptions are subtracted from the adjusted gross income
(AGI) to arrive at the taxable income. They reduce the amount of income
that is taxed and ultimately, the amount of tax that is owed. The standard
deduction can be taken on Forms 1040EZ, 1040A, or 1040.
601

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

Itemized deductions include amounts paid for medical and dental expenses,
state and local income taxes, real estate taxes, personal property taxes,
home mortgage interest, gifts to charity, casualty and theft losses, job
expenses, and miscellaneous deductions.
Determining legal blindness may require your interview skills. Individuals
whose sight is not better than 20/200 in their best eye while wearing
corrective lenses, or whose field of vision is 20 degrees or less, might be
legally blind.
The following taxpayers are not allowed to use the standard deduction even
if it results in a lower tax than itemizing deductions:

A married taxpayer who files separately and whose spouse itemizes


deductions (indicated on line 39b of Form 1040) is not allowed to
claim the standard deduction; the taxpayer must either itemize
deductions or take "0" for the standard deduction

Nonresident aliens cannot claim the standard deduction

Each spouse can only take the itemized deductions he or she is liable for,
and actually pays. Thus, if the husband is liable for an otherwise tax
deductible expense, and the wife pays it, then the husband cannot take the
deduction. If the wife does not file a tax return then she cant take the
deduction either. It is lost.
Taxpayers who choose to itemize their deductions must file Form 1040 and
report them on Schedule A as follows:

The portion of medical and dental expenses that exceeds 10% of the
taxpayer's AGI is deductible and reported on lines 1 through 4.

Deductible taxes are reported on lines 5 through 9. In the " Taxes


You Paid " section, taxpayers can elect to deduct state and local
income taxes. The tax must have been imposed on the taxpayer and
paid by the taxpayer during the tax year.

Deductible interest is reported on lines 10 through 15.

Home mortgage interest is generally deductible provided:


602

LESSON
PART I

18

STANDARD

AND

ITEMIZED

DEDU CTIONS

the loan is secured by a principal residence or second home

acquisition debt for transactions entered into after 10/13/87 does


not exceed $1,000,000

home equity debt does not exceed the lesser of $100,000 or the fair
market value of the home

The $1,000,000 limit is inclusive of all of the above.


There is a 3% itemized deduction reduction and taxpayers should take this
into account before deciding to earn extra income above certain limits.
1040 ValuePak will compare the taxpayers total itemized deductions to
their standard deduction and enter the larger amount on line 40 of Form
1040.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify your 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.

603

LESSON
PART II

19

STANDARD

AND

ITEMIZED

DEDUCTIONS

Lesson

19
Lesson 19 - Standard and Itemized
Deductions - Part II
In this lesson you'll learn about additional Standard and Itemized Deductions.
The following topics are discussed in this lesson:

Home Mortgage Points


Gifts to Charity
Reporting Contributions
Restrictions on Charitable
Contributions made after
August 17, 2006
Casualty and Theft Losses
Involuntary Conversions
Declared Disaster Areas
Grants under the Disaster
Relief Act of 1974
Disaster Unemployment
Assistance

Miscellaneous Deductions
Deductions subject to the 2%
limit
Legal Fees
Legal Fees to Collect Alimony
Legal Fees for Divorce
Employee Business Expenses
Accountable Plans
Deductions not subject to the
2% limit
Gambling Losses
Non-deductible Expenses

604

LESSON
PART II

19

STANDARD

AND

ITEMIZED

DEDUCTIONS

Home Mortgage Points

oints are the charges paid by a borrower and/or seller to a lender to


secure a loan. If the taxpayer can deduct all of the interest on his
mortgages, he may also be able to deduct all of the points paid on
the mortgage. Points are also called:

Loan origination fees, including VA and FHA fees


Maximum loan charges
Premium charges
Loan discount points

Only points paid as a form of interest (for the use of money) can be
deducted on Schedule A. Points paid only for the use of money are
considered prepaid interest. This interest, even if it qualifies for home
mortgage interest, must be:

Spread over the life of the mortgage


Paid and deductible over that period

The taxpayer can deduct the points in full in the year they are paid, if all the
following requirements are met:

The taxpayers loan is secured by his main home (main home is the
one lived in most of the time).

Paying points is an established business practice in the area.

The points paid were not more than the amount generally charged
in that area.

The taxpayer uses the cash method of accounting. This means he


reports income in the year received and deduct expenses in the year
paid.

The points were not paid for items that usually are separately stated
on the settlement sheet such as appraisal fees, inspection fees, title
fees, attorney fees, or property taxes.

605

LESSON
PART II

19

STANDARD

AND

ITEMIZED

DEDUCTIONS

The taxpayer provided funds at or before closing that were at least


as much as the points charged, not counting points paid by the
seller. The taxpayer cannot have borrowed the funds from the lender
or mortgage broker in order to pay the points.

The taxpayer uses the loan to buy or build his main home.

The points were computed as a percentage of the principal amount


of the mortgage, and

The amount is clearly shown on the settlement statement.

606

LESSON
PART II

19

STANDARD

AND

607

ITEMIZED

DEDUCTIONS

LESSON
PART II

19

STANDARD

AND

ITEMIZED

DEDUCTIONS

Points that do not meet these requirements may be deductible over the life
of the loan.

TAX TIP

Year-End First Time Home Purchases


Some taxpayers will purchase their first home late in the year. When this
happens it is unlikely that they will accumulate enough deductions to
itemize because they will not have paid real estate taxes and mortgage
interest for most of the year. Consequently, they will get no benefit from
deducting the points in the year they paid them as they cannot itemize
their deductions. When this happens you can begin deducting the points
over the life of the loan starting the following year.

TAX PRACTICE TIP

Verifying Points Were Deducted


Be sure to review the settlement statement and tax return for the year of
a first home purchase of any new clients that are currently deducting
mortgage interest, to verify if the above situation occurred and whether
or not they ever deducted the points they paid. If they didn't you can
start deducting them over the life of the loan now.
Points paid for refinancing generally can only be deducted over the life of
the new mortgage. However, if the taxpayer used part of the refinanced
mortgage proceeds to improve his main home and he meets the first six
requirements stated previously, he can fully deduct the part of the points
related to the improvement in the year he paid them with his own funds.
Points charged for specific services, such as preparation costs for a
mortgage note, appraisal fees or notary fees are not interest and cannot be
deducted. Points paid by the seller of a home cannot be deducted as
interest on the seller's return, they are a selling expense which will reduce
the amount of gain realized. Points paid by the seller may be deducted by
the buyer provided the buyer subtracts the amount from the basis, or cost,
of the residence.
608

LESSON
PART II

19

STANDARD

AND

ITEMIZED

DEDUCTIONS

Points paid on loans secured by your second home, can be deducted only
over the life of the loan.
Beware of certain charges that some lenders call points. Remember: only
points paid for the use of money are considered interest.
Points paid in excess of those generally charged in the area can be
deducted over the life of a mortgage.
Deduct points reported to the taxpayer in box 2 of Form 1098 - Mortgage
Interest Statement...

Figure 19-1: Form 1098 - Mortgage Interest Statement with box 2 "Points paid on purchase
of principal residence" highlighted.

...on line 10 of Schedule A. Deduct points not reported on Form 1098 on


line 12 of Schedule A.

Figure 19-2: The Interest You Paid section of Form 1040 Schedule A - Itemized
Deductions with line 10 "Home mortgage interest and points reported to you on Form
1098" and line 12 "Points not reported to you on Form 1098" highlighted.

609

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DEDUCTIONS

TAX QUOTE

"Rich bachelors should be heavily taxed. It is not fair that some men should
be happier than others."
Oscar Wilde

Gifts to Charity
Taxpayers can deduct contributions to qualifying organizations that:

Operate exclusively for religious, charitable, educational, scientific, or


literary purposes, or

Work to prevent cruelty to children or animals, or

Foster national or international amateur sports competition if they


do not provide athletic facilities or equipment

Deduction Limits
There are limits on how much a taxpayer can deduct. However, unless the
taxpayer makes substantial donations in relation to his or her AGI the limits
are never met. The limit is 50% of AGI for cash contributions, but in some
cases a 30% of AGI limit applies. The limit is 30% of AGI for contributions of
property, but in some cases a 50% or 20% limit apply. A five year carryover
is allowed for contributions above the limit that are not currently deductible.
Use the following list for a quick check of charitable contributions you can
or cannot deduct on tax returns. Consult Publication 17 for more
information and additional rules or limitations that may apply.

Deductible as Charitable Contributions

NOT Deductible as Charitable


Contributions

Money or property for:

Money or property for:

A student living with you,


sponsored by a qualified
organization.

Churches, synagogues,

610

Civic leagues and associations,


business organizations, social
and sports clubs, labor unions,
and Chambers of Commerce.

LESSON
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DEDUCTIONS

NOT Deductible as Charitable


Contributions

Deductible as Charitable Contributions

temples, mosques and other


religious organizations.

ITEMIZED

Dues, fees, and assessments


paid to qualified organizations
above the value of benefits
received.

Raffle, bingo or lottery tickets.

Dues, fees, or bills paid to


country clubs, lodges, fraternal
orders, or similar groups.

Foreign organizations (except


certain Canadian and Mexican
charities).

Fair market value of used


clothing and furniture

Federal, state and local


governments, if your
contribution is solely for public
purposes (for example, a gift to
reduce the public debt.)

Groups that are run for


personal profit.

Groups whose purpose is to


lobby for law changes.

Homeowners' associations

Fraternal orders (if used for


qualified purposes)

Individuals

Nonprofit schools and


hospitals

Non-charitable payments to
federal, state, or local
governments

Nonprofit medical research


organizations

Political groups or candidates


for public office.

Out of pocket expenses when


you serve a qualified
organization as a volunteer.

Sickness or burial expenses for


members of a fraternal society.

Public parks and recreation


facilities.

Tuition

Value of blood given to a


blood bank or Red Cross...

Value of your time or services.

Salvation Army, Red Cross,


CARE, Goodwill Industries,
United Way, Boy Scouts, Girl
Scouts, Boys and Girls Clubs of
America, World Wildlife Fund,
etc.
The part of a contribution

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NOT Deductible as Charitable


Contributions

Deductible as Charitable Contributions

above the fair market value for


items such as merchandise and
tickets to charity balls or
sporting events

Un-reimbursed transportation
expenses that relate directly to
the services provided for the
organization

Upkeep of uniforms that have


no general use but must be
worn while performing services
donated to a charitable
organization

War veterans' groups and


certain cultural groups.

TAX TIP

Can taxpayers deduct contributions to foreign charities?


Ordinarily, direct contributions to foreign charitable organizations are not
tax deductible, except for certain Canadian and Mexican charities, and
some other limited exceptions. However, taxpayers may deduct
contributions to domestic charitable organizations that distribute funds
to foreign charities provided the domestic organization controls the
distribution of the funds overseas.
Transportation expenses that relate directly to the services the taxpayer
provided for an organization are deductible and include bus fare, parking
fees, tolls, and either the cost of gas and oil or a standard mileage
deduction in the table below:

612

LESSON
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Type of Mileage
Business*
Medical/Moving
Charitable

STANDARD

2012
55.5 per mile
23 per mile
14 per mile

AND

ITEMIZED

2013
56.5 per mile
24 per mile
14 per mile

DEDUCTIONS

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

If the taxpayer does volunteer work for a qualified organization the


following questions and answers may be helpful.
Question
I do volunteer work 6 hours a week
in the office of a qualified
organization. The receptionist is
paid $10 an hour to do the same
work I do. Can I deduct $60 a week
for my time?

I volunteer as a Red Cross nurse's


aide at a hospital. Can I deduct the
cost of uniforms that I must wear?

I pay a babysitter to watch my


children while I do volunteer work
for a qualified organization. Can I
deduct theses costs?

Answer
No, you cannot deduct the value of
your time or services.
Yes, you can deduct the costs of
gas and oil that are directly related
to and from the place where you
are a volunteer. If you don't want to
figure your actual costs, you can
deduct the Charitable Standard
Mileage Deduction for each mile.
Yes, you can deduct the cost of
buying and cleaning your uniforms
if the hospital is a qualified
organization, the uniforms are not
suitable for everyday use, and you
must wear them when volunteering.
No, you cannot deduct payments
for child care expenses as a
charitable contribution, even if they
are necessary so you can do
volunteer work for a qualified
organization. However, if you have
child care expenses so that you can
work for pay you may be able to
deduct them.

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DEDUCTIONS

Taxpayers can deduct donations for disaster relief if they make their
contributions to a qualified organization. Money or a gift given directly to a
person in need is not deductible. To be deductible, contributions must be
made to a qualifying organization, not an individual.
Gifts To Reduce The Public Debt
Taxpayers can make a tax deductible contribution (gift) to reduce the public
debt. If they wish to do so they should make out a separate check payable
to "Bureau of the Public Debt." Send the check to:
Bureau of the Public Debt
ATTN: Department G
P.O. Box 2188
Parkersburg, WV 26106-2188
Be sure not to add this gift to any check for tax owed to the IRS.
Taxpayers can also make a tax deductible contributions to state and local
governments, provided the contribution is used for public purposes.
Appraisal fees to determine the value of donated items are not deductible
as contributions but are deductible as miscellaneous expenses on line 23 of
Schedule A. They are subject to the 2% of AGI floor.

Figure 19-3: The Job Expenses and Certain Miscellaneous Deductions section of Form 1040
Schedule A - Itemized Deductions with line 23 "Other expenses - investment, safe deposit
box, etc." highlighted.

614

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TAX PLANNING TIP

Donations of Appreciated Property


Donations of appreciated property, such as art or collectibles, are tax
deductible for their fair market value provided the charity uses the items
in its main activity or tax exempt purpose. However. taxpayers should be
cautious and obtain a letter in advance from the charity stating that it
intends to use the property in such a way. If the taxpayer doesnt get such
a letter, and the charity subsequently sells the property, the taxpayer's tax
deduction is limited to his or her basis in the property.
When a charity sells or otherwise disposes of a property donation which
exceeded $5,000 within three (3) years of receiving the gift, the charity
must notify the IRS on Form 8282 - Donee Information Return and send
the taxpayer a copy. The taxpayer may have to recapture his prior tax
deduction.
The tax deduction for artworks created by the taxpayer are limited to the
taxpayers cost of materials, regardless of how the charity uses the
artwork.
Reporting Contributions
Qualified cash and check contributions are reported on line 16 of Schedule
A. Other contributions are entered on line 17.

Figure 19-4: The Gifts to Charity section of Form 1040 Schedule A - Itemized
Deductions.

Taxpayers:

Must keep records of their contributions


Must obtain a written acknowledgement from the organization for a
single contribution of $250 or more
615

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TAX PRACTICE TIP

Dont Forget to Include Donations Withheld from the Taxpayers


Paycheck
Employees who give to charities such as United Way via payroll
deductions at work frequently forget to include the deduction on their
tax return. The amount of any charitable contributions taken out of the
taxpayers salary should be shown in box 14 "Other" of the taxpayers W2 along with a description of the donation. However, some employers do
not include this information on the W-2. You can also usually find the
amount on the taxpayers last pay stub of the year.
Restrictions on Charitable Contributions made after August
17, 2006
Cash contributions
All cash contributions made in tax years beginning after August 17, 2006, to
any qualified charity must be supported by a dated bank record or a dated
receipt. The tax year for most individual taxpayers begins on January 1.
Clothing and household items
Beginning with contributions made after August 17, 2006, no deduction is
allowed for most contributions of clothing and household items unless the
donated property is in good used condition or better.

TAX PLANNING TIP

Bunching Charitable Contributions


Charitable contributions provide great flexibility for tax planning
purposes because taxpayers can make double contributions before
December 31st every other year thereby maximizing their tax
deductibility if they otherwise wouldnt be able to itemize their
deductions. And dont forget to bunch donations of clothing and other
non-cash items too.

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Casualty and Theft Losses


Losing personal or business property due to a casualty, i.e. fire, flood,
hurricane, or theft or other similar event is devastating, but some casualty or
theft losses can be recouped through income tax breaks on Schedule A line
20.

Figure 19-5: The Casualty and Theft Losses section of Form 1040 Schedule A Itemized Deductions.

The taxpayer may be entitled to a casualty or theft loss deduction. A


casualty loss is the damage, destruction, or loss of property resulting from
an identifiable event that is sudden, unexpected, or unusual in nature. It can
also be a government-ordered demolition or relocation of a home that's
unsafe because of a disaster.
Other examples of casualty losses include car accidents, fires, and vandalism.
If the taxpayers property is covered by insurance, he cannot deduct a
casualty or theft loss unless he files a timely insurance claim for
reimbursement. If insured, a claim must be filed even if no reimbursement is
expected.
To determine the amount of a loss on property used personally the IRS
requires that taxpayers use either the property's adjusted tax basis
immediately before the loss, or the property's decline in fair market value
due to the casualty, whichever is less. However, if the property was used as
business property or to produce income use the property's adjusted tax
basis after the loss minus any salvage value.
Costs associated with preventive measures, such as boarding up a home
before a hurricane, or installing burglar alarms and smoke detectors, are not
tax deductible when paid for personal residences. However, they may be
deductible when paid for rental property.
Some casualty or theft losses are not tax deductible, such as the ones
below:

Accidental loss of a ring


617

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A fire set on purpose by the owner


A well that goes dry
Carpet beetle damage
China plates broken by a pet
Damages to property caused by excavations on adjoining property
Damages for personal injuries or property damage to others caused
by the taxpayers negligence
Damage to a crop caused by plant diseases, insects, or fungi
Damage from rust or corroding of the understructure of a house
Damage to property from a government construction project
Damages to property from drought in an area where a dry spell is
normal and usual
Dry rot
Engine damage caused by failing to use anti-freeze
Expenses to move to, and rent for, temporary quarters
Eye glasses or a watch dropped on the ground
Injuries from tripping over a wire
Legal expenses for defending a suit regarding negligent operation of
a personal automobile
Legal expenses to recover personal property wrongfully seized by
the police
Loss of a valuable dog that strayed
Loss of a private liquor stock in an improper police seizure
Loss of a contingent interest in property because of the unexpected
death of a child
Loss of jointly held property taken by the other joint tenant
Loss of luggage aboard a ship
Loss of personal property while in storage or transit
Losses from natural phenomena
Loss of trees from diseases
Money paid to a public library for a damaged book
Moth damage
Sudden drop in the value of securities
Termite damage
Temporary fluctuations in value

Appraisers fees are not a part of any deductible casualty loss. However,
618

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DEDUCTIONS

they can be deducted as a miscellaneous itemized deductions on Schedule


A.
People who suffer a casualty or theft loss may be able to deduct the loss
when they itemize deductions. The amount of total casualty or theft losses
that exceed 10% of adjusted gross income (AGI), after subtracting the $100
floor for each occurrence, maybe deducted. It's basically a three step
process:

Calculate the decrease in the property's fair market value that is the
difference between the property's value immediately before and
immediately after the casualty loss. Compare this with the adjusted
basis of the property. Use the lower of these two amounts

Reduce this amount by any insurance or other reimbursements


received or expected

Reduce this figure twice, first by $100, and then by 10% of adjusted
gross income. What's left, if anything, is tax deductible as a casualty
or theft loss

These tax rules apply to a casualty or theft loss of non-business property.


$100 Rule
You must reduce each
casualty or theft loss by
$100 when figuring your tax
deduction. Apply this rule
after you reduce your loss
by any reimbursement.

10% Rule
You must reduce your total
casualty or theft loss by
10% of your adjusted gross
income. Apply this rule
after you reduce each loss
by any reimbursement and
by $100 (the $100 Rule).

Single Event

Apply this rule only once,


even if many pieces of
property are affected.

Apply this rule only once,


even if many pieces of
property are affected.

More Than One Event

Apply this rule to the loss


from each event.

Apply the rule to the total


of all your losses from all
events.

More Than One


Apply the rule separately
Person to each person.
With a loss from the
same event (other than
a married couple filing
jointly.)
Married Couple - with loss from the same event:

Apply the rule separately


to each person.

Definition of Rule

619

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STANDARD

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ITEMIZED

$100 Rule

DEDUCTIONS

10% Rule

Filing joint tax return

Apply this rule as if you


were one person.

Apply this rule as if you


were one person.

Filing separate tax


return

Apply this rule separately


to each spouse.

Apply this rule separately


to each spouse.

More Than One Owner

Apply this rule separately to


each owner of jointly owned
property.

Apply this rule separately


to each owner of jointly
owned property.

(other than a married


couple filing jointly.)

1040 ValuePak will perform these calculations automatically.

TAX TIP

Financial Institution Deposit Losses


If the taxpayer has funds on deposit in a financial institution that files for
bankruptcy or becomes insolvent, and the taxpayers loss exceeds the
amount of insurance (such as FDIC or SIPC) covering the loss, the
taxpayer may deduct the remaining loss as either a bad debt, a casualty
loss, or if none of the deposit was insured, as a miscellaneous itemized
deduction. A casualty loss deduction may not be claimed for lost deposits
in foreign financial institutions. If the taxpayer has other miscellaneous
itemized deductions that exceed 2% of Adjusted Gross Income his or her
best bet may be to claim the loss as a miscellaneous itemized deduction.
That way the loss wont be subject to the casualty loss 10% floor or the
bad debt (capital loss) limit of $3,000 (see Lesson 10). However, keep in
mind that miscellaneous itemized deductions are not allowed for
Alternative Minimum Tax purposes.
The table below shows when the casualty loss should be deducted:
IF you have a loss...
from a casualty
in a Presidentially declared disaster
from a theft

THEN deduct it in the year...


the loss occurred.
the disaster occurred or the year
immediately before the disaster.
the theft was discovered.

620

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STANDARD

IF you have a loss...


on a deposit treated as a:
casualty
bad debt
ordinary loss

AND

ITEMIZED

DEDUCTIONS

THEN deduct it in the year...


a reasonable estimate can be
made.
deposits are totally worthless.
a reasonable estimate can be
made.

Taxpayers must keep records of any casualty loss deductions taken and any
compensation received as they reduce the taxpayer's basis in the property
and the reduced basis will be used at the time of sale to determine any gain
or loss.
Some taxpayers casualty losses are very large and exceed their income for
the year. In those cases they may have a Casualty Loss related Net
Operating Loss (NOL) for the year. Taxpayers can carry back this NOL to a
previous year(s) and get a tax refund for that year(s).
Complete Form 4684 - Casualties and Thefts to claim a casualty or theft loss
and attach it to the tax return. A non-business casualty or theft loss may be
claimed only if the taxpayer itemizes deductions.

TAX TIP

Can taxpayers ever have a gain for tax purposes after suffering a
casualty loss of their home?
Yes. Most mortgage lenders require the borrowers to insure their homes
for the full replacement cost. These policies are called Replacement Cost
policies as compared to Actual Cash Value policies.
If the home's replacement cost has increased over the years and the
taxpayer is reimbursed for its replacement cost the taxpayer may have a
gain because for tax purposes the taxpayer can only claim the original
cost basis of the home, plus adjustments to basis, as a loss. Usually
taxpayers can avoid paying tax on the gain if they purchase a qualified
replacement property within two years.

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Involuntary Conversions
If property is stolen, destroyed, or condemned during the tax year (an
involuntary conversion), and a taxable gain is realized from insurance
proceeds or some other source, tax on the gain can be deferred by
reinvesting the proceeds in property similar to the property that was subject
to the involuntary conversion. Two full years after the close of the taxable
year in which the involuntary conversion occurs are allowed to make the
reinvestment. If the involuntary conversion property is not replaced within
the allowed time period, an amended tax return for the year of the
involuntary conversion must be filed.
Declared Disaster Areas
Casualty losses are generally tax deductible only in the tax year the casualty
loss occurred. However, if the taxpayer has a tax deductible casualty loss
from a disaster in an area that is officially designated by the President of the
United States as eligible for federal disaster assistance, a Declared Disaster
Area, the taxpayer can choose to deduct that casualty loss on the tax return
for the tax year immediately preceding the casualty loss tax year. In other
words, the taxpayer may treat the Declared Disaster Area loss as having
occurred in either the current tax year or the previous tax year, whichever
provides the best tax results. If the taxpayer has already filed the tax return
for the preceding tax year, the Declared Disaster Area casualty loss may be
deducted by filing an amended tax return, Form 1040X.
If the taxpayer has been impacted by a Presidentially declared disaster, the
IRS can help by delaying collection of any tax owed and by eliminating tax
penalties and interest if the disaster has caused the taxpayer to file a tax
return late or pay any tax late. The IRS can provide copies or transcripts of
previously filed tax returns free of charge.
For additional information refer to Publication 547 - Casualties, Disasters,
and Thefts.
Grants under the Disaster Relief Act of 1974
Grants under the Disaster Relief Act of 1974 to help victims of natural
disasters are not included in taxable income. They are treated as a
reimbursement that reduces their tax deductible loss. Taxpayers may not
deduct casualty losses or medical expenses that are specifically reimbursed
by these disaster relief grants.
622

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DEDUCTIONS

Disaster Unemployment Assistance


Disaster unemployment assistance payments under the Disaster Relief Act
of 1974 are unemployment benefits and are taxable.

Miscellaneous Deductions
Miscellaneous itemized deductions are expenses a taxpayer pays in order
to:

Produce or collect income


Manage, conserve, or maintain property held for producing income
Determine, contest, pay, or claim a refund of any tax

For some miscellaneous deductions, only the portion that exceeds 2% of


the taxpayer's AGI can be deducted. Other miscellaneous deductions are
deductible regardless of AGI.

TAX QUOTE

"What at first was plunder assumed the softer name of revenue."


Thomas Paine

Deductions subject to the 2% limit


Deductions subject to the 2% of AGI limit are reported on lines 21 through
27 of Schedule A.

Figure 19-6: The Job Expenses and Certain Miscellaneous Deductions section of Form
1040 Schedule A - Itemized Deductions.

623

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DEDUCTIONS

Job Expenses
Un-reimbursed employee business expenses can be deducted as a
miscellaneous itemized deduction subject to the 2% limitation. Examples
include:

union and professional dues


licenses
malpractice insurance
business cards
home office expense
uniforms not adaptable to general use
safety shoes, safety glasses and other protective clothing
small tools and supplies
briefcase, office decorations, office supplies
transportation (other than commuting)
50 % of meals and entertainment
professional books, magazines, and journals
employment-related educational expenses
expenses related to temporary out-of-town job assignments
business travel
expenses of looking for a new job
any other expense that relates to the taxpayers job

You will need to fill out Form 2106 Employee Business Expenses or Form
2106-EZ to deduct these items.

TAX TIP

Statutory Employees
Statutory employees may deduct their expenses on Schedule C and thus
avoid the 2% of AGI floor for miscellaneous itemized deductions. If the
taxpayer is a statutory employee box 13 of his or her W-2 will be checked.
Job Search Expenses
Job search expenses are deductible if the taxpayer is looking for a job in his
present line of work. No deduction can be taken if the taxpayer is looking
for his first job, changing to a job in a new line of work, or if he has been
624

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ITEMIZED

DEDUCTIONS

unemployed for a long period of time as taxpayers cannot deduct job


search expenses if there is a substantial break between the end of the last
job and the time the taxpayer begins looking for a new job. Deductible job
search expenses include resume costs, employment and outplacement
agency fees, automobile expenses, travel expenses, long-distance phone
calls, 50% of related meals and entertainment, and any other job hunting
expenses.
Taxpayers should provide you with receipts for expenses
documentation of travel to substantiate job search expenses.

and

TAX TIP

Can the taxpayer deduct attorney fees?


Some attorney fees are tax deductible. Is the taxpayers attorney charging
for advice about income taxes? If so, the attorney should prepare a bill
that breaks down the deductible tax advice and non-deductible charges.
Better yet, have your client get two separate bills. These fees are subject
to the 2% of AGI limitation. Tax preparation fees and tax preparation
guide books are also tax deductible and subject to the 2% of AGI
limitation.

TAX TIP

Deducting Clothing & Uniforms


Work clothing and uniforms, such as safety shoes, safety glasses, nurse's
uniforms, and bus driver's uniforms which are required for the taxpayers
job and that cannot also be used for general wear are deductible as a
miscellaneous itemized deduction. Laundry and cleaning expenses for
qualified clothing are also deductible. Any clothing that is suitable for use
off of the job, such as blue jeans or a business suit, is not deductible even
if the taxpayer only uses the jeans or suit for work.
Reservists Uniforms
Money spent by reservists in excess of their uniform allowance is
625

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DEDUCTIONS

deductible if they are prohibited from wearing the uniform off-duty.


Laundry and cleaning expenses are also deductible.
Clothing for Volunteer Work
Any qualified clothing that the taxpayer uses while volunteering for a
charitable organization, such as a boy scout uniform or a Santa Claus suit,
is deductible as a charitable contribution. The clothing cannot be suitable
for use other than for the volunteer work. Taking a charitable contribution
deduction avoids the miscellaneous itemized deduction 2% limitation.

SIDE BAR

What is the difference between dealers, traders, and investors in


securities?
Dealers buy and then re-sell securities to customers in the ordinary
course of a trade or business. Their sales result in ordinary gain or
ordinary loss and their deductible investment expenses are trade or
business expenses.
Traders buy and sell securities frequently but have no customers. Their
purchases and sales result in capital gain or capital loss, and their
deductible investment expenses are trade or business expenses.
However, see "Special Rules for Day Traders" at the end of Lesson 10.
Investors buy and sell securities for profit motivated reasons such as long
term capital appreciation, dividends and interest. Investors trade solely
for their own account and do not carry on a trade or business. Their
securities sales result in capital gain or capital loss and their tax
deductible investment expenses are itemized deductions.
The proper classification is important to determine how investment
income and investment expenses are to be reported on the tax return.
Whether the activities of an individual constitute a trade or business or an
investment is determined from the facts of each case. These distinctions
have been established through tax court cases. Be aware that the IRS
regularly audits and disputes tax returns (including going to court) of
626

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ITEMIZED

DEDUCTIONS

investors attempting to gain the tax benefits of being a trader.


Investment Expenses
The following investment expenses of investors are tax deductible as
Miscellaneous Itemized Deductions subject to the 2% of AGI floor:

Accounting fees for record keeping;

Expenses of proxy fights when legitimate corporate policies are


involved;

Fees for collecting taxable interest and dividends;

Fees shown in Box 5 of Form 1099-DIV;

Guardian fees of a minor incurred in collecting or producing income;

Investment manager and planner fees to the extent that they relate
to taxable income;

IRA setup and administration fees;

Legal fees;

Premiums for indemnity bonds for replacing missing securities;

Safe deposit box fees used exclusively to hold taxable income


generating securities and investments;

Salaries of persons hired to keep records of your taxable investment


income; and

Subscriptions to investment services.

The following investment expenses are not tax deductible:

costs of attending investment-related conventions


costs of attending investment-related seminars
expenses related to tax-exempt investments
transportation to stockholder meetings
627

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ITEMIZED

DEDUCTIONS

Expenses that relate to both taxable and tax-exempt investments must be


prorated between the two.

TAX PLANNING TIP

Bunching Miscellaneous Itemized Deductions


Taxpayers should consider prepaying their Miscellaneous Itemized
Deductions. Miscellaneous Itemized Deductions for investment expenses,
fees for tax preparation and advice, and un-reimbursed employee
business expenses count only to the extent they exceed 2% of Adjusted
Gross Income. If they can bunch these expenditures into a single tax year,
they may have a better chance of clearing the 2% threshold and getting
some tax write-offs. This strategy wont work for taxpayers subject to
Alternative Minimum Tax because Miscellaneous Itemized Deductions are
completely disallowed under the AMT rules.
Legal Fees
Legal fees are generally tax deductible if the dispute arose in the course of
the taxpayers business or employment or involves income producing
property. They are subject to the 2% limit. Legal fees for personal matters
are not tax deductible.

SIDE BAR

Are there any ways for taxpayers to protect their assets from
lawsuits?
Yes there are ways that taxpayers can arrange their affairs to provide at
least some protection from lawsuits. I addition to trusts, which taxpayers
can discuss with their attorney, they may also want to consider:

Liability insurance Both a personal liability umbrella policy, and if


the taxpayer has a business he or she should also consider
business related liability insurance, as business liabilities are not
covered under personal policies.
Declaring their home as a Homestead The amount of protection
628

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DEDUCTIONS

this affords is determined by state law, but in some states it is


100% protection
Dividing assets between spouses - Dividing assets between
spouses will not necessarily limit liability but it may limit the
amount of assets available for the satisfaction of any judgment or
claim.

Legal Fees to Collect Alimony


The portion of legal fees specifically paid to collect taxable alimony are
deductible as Miscellaneous Itemized Deductions subject to the 2% of
Adjusted Gross Income limitation. This is true for legal fees paid for the
original legal proceeding and for any subsequent legal proceeding to
increase the alimony or collect past due alimony.
The payer of alimony cannot deduct legal fees for resisting or defending
against his or her former spouses demands for alimony.
Legal Fees for Divorce
Legal fees for a divorce itself, and for property settlement, are not tax
deductible. However, legal fees incurred in a divorce action to retain
ownership of income-producing assets, such as rental property, increase
the basis of the property for purposes of figuring gain or loss upon its
sale.

Employee Business Expenses


Employees may be able to deduct un-reimbursed workrelated expenses as
an itemized deduction. These employee business expenses include the cost
of business travel away from home, local transportation, entertainment,
gifts, and other ordinary and necessary expenses related to the job.
Deductible travel expenses are the ordinary and necessary expenses of
temporarily traveling away from the taxpayers tax home overnight on
business. They include the cost of transportation, meals, lodging and other
expenses related to the taxpayers business travel.

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Although commuting costs are not deductible, some local transportation


expenses are. Deductible local transportation expenses include the ordinary
and necessary expenses of going from one workplace to another. Taxpayers
may deduct the cost of going between their residence and a temporary
work location outside of the metropolitan area where they live and normally
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work. A temporary work location is a location where the taxpayer


reasonably expects to work for one (1) year or less.
Transportation expenses include the cost of transportation by car, air, rail,
bus, taxi, etc.
The table below shows the travel expenses that may be tax deductible:
Expense
Transportation

Taxi, commuter,
bus & limousine

Baggage &
shipping
Car

Lodging

Meals

Cleaning
Telephone

Description
The cost of travel by airplane, train, bus, or car
between your home and your business
destination.
Fares for these and other types of transportation
between the airport or station and your hotel or
between the hotel and your work location away
from home.
The cost of sending baggage or display material
between your regular and temporary work
locations.
The cost of operating and maintaining your car
when traveling away from home on business. You
may deduct actual expenses or the standard
mileage rate, including business-related tolls and
parking on your tax return. If you lease a car while
away from home on business, you can deduct on
your tax return business-related expenses only.
The cost of lodging if your business trip is
overnight or long enough to require you to get
substantial sleep or rest to properly perform your
duties.
The cost of meals only if your business trip is
overnight or long enough to require you to get
substantial sleep or rest. Includes amounts spent
for food, beverages, taxes, and related tips.
Cleaning and laundry expenses while away from
home overnight.
The cost of business calls while on your business
trip, including business communication by fax
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Expense

Description
machine or other communication devices.

Tips
Other

Tips you pay for any expenses in this chart.


Other similar ordinary and necessary expenses
related to your business travel such as public
stenographer's fees and computer rental fees.

Business entertainment expenses and business gift expenses may be


deductible, but are subject to certain limits. For information on business
entertainment expenses refer to Publication 463 - Travel, Entertainment, Gift,
and Car Expenses. The taxpayer must keep contemporaneous records to
prove the expenses.
You must use Form 2106 - Employee Business Expenses or Form 2106-EZ Unreimbursed Employee Business Expenses to figure the taxpayers
deduction for employee business expenses, and attach it to Form 1040. This
is miscellaneous itemized tax deduction subject to the 2% limit.

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Accountable Plans
If the employer reimbursed the taxpayer or gave him an advance or
allowance for the business expenses, the payment(s) are usually treated as
paid under an "accountable plan", and the payment(s) will not be shown on
Form W-2. Do not include the payment(s) in the taxpayers income.
To be an accountable plan, the employer's reimbursement or allowance
arrangement must include all three of the following rules:

The taxpayer must have paid or incurred expenses that are


deductible while performing services as an employee

The taxpayer must adequately account to the employer for these


expenses within a reasonable time period, and

The taxpayer must return any excess reimbursement or allowance


within a reasonable time period

If the employer's reimbursement arrangement does not meet all three


requirements above, the payments were received under a "non-accountable
plan" should be included in wages shown on Form W2. The taxpayer must
report the payments as income, and must complete Form 2106 and itemize
deductions to deduct the expenses.
Reimbursed Employment Agency Fees
If an employer pays the taxpayer back in a later year for employment
agency fees the taxpayer must include the amount received from the
employer in gross income, up to the amount deducted in the earlier year.

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The table below shows where employers and employees report


reimbursements:
IF the type of reimbursement (or other expense allowance) arrangement is
under...
An accountable plan
THEN the employer
AND the employee
with:
reports on Form W-2:
reports on Form 2106
or 2106-EZ:
Actual expense
No amount.
No amount.
reimbursement:
Adequate accounting
made and excess
returned.
Actual expense
The excess amount as
No amount.
reimbursement:
wages in box 1.
Adequate accounting
and return of excess both
required but excess not
returned.
Per diem or mileage
No amount.
All expenses and
allowance up to the
reimbursements only if
federal rate:
excess expenses are
claimed. Otherwise,
Adequate accounting
form is not filed.
made and excess
returned.
Per diem or mileage
The excess amount as
No amount.
allowance up to the
wages in box 1. The
federal rate:
amount up to the federal
Adequate accounting up rate is reported only in
box 12-it is not reported
to the federal rate only
and excess not returned. in box 1.
Per diem or mileage
The excess amount as
All expenses (and
allowance exceeds the
wages in box 1. The
reimbursement reported
federal rate:
amount up to the federal on Form W-2, box 12)
only if expenses in
Adequate accounting up rate is reported only in
box
12
it
is
not
reported
excess of the federal
to the federal rate only
rate are claimed.
and excess not returned. in box 1.
Otherwise, form is not
required.
A non-accountable plan with:

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IF the type of reimbursement (or other expense allowance) arrangement is


under...
Either adequate
The entire amount as
All expenses.
accounting or return of
wages in box 1.
excess, or both, not
required by plan.
No reimbursement
The entire amount as
All expenses.
plan:
wages in box 1.

If the taxpayer was reimbursed for travel or transportation under an


accountable plan, but at a per diem or mileage rate that exceeds the Federal
rate, the excess should be included in wages on Form W2. If the taxpayers
actual expenses exceed the Federal rate, the taxpayer must itemize
deductions to deduct the excess.
Per diem tables published by the government show the federal per diem
travel rates for areas within the continental U.S., called CONUS locations,
and for areas outside the continental U.S. including Alaska and Hawaii,
called OCONUS locations. The CONUS federal per diem travel rates are in
Publication 1542 - Per Diem Rates.
You can also access the federal per diem rates for CONUS localities on the
Internet at CONUS. This website also provides a link to rates for OCONUS
localities.
Click here: http://www.gsa.gov
Publication 529 - Miscellaneous Deductions also discusses the 2% limit and
explains some of the other expenses that are deductible as employee
business expenses.

Deductions not subject to the 2% limit


Deductions that are not subject to the 2% limit are reported on line 28 of
Schedule A.

Figure 19-7: The Other Miscellaneous Deductions section (line 28) of Form 1040
Schedule A - Itemized Deductions.

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Examples include:

amortizable premiums on taxable bonds


federal estate tax that was paid on income in respect of a decedent
gambling losses, but only to the extent of gambling winnings
impairment-related work expenses of persons with disabilities, such
as attendant care services
repayments made of income reported in earlier years, if more than
$3,000
unrecovered investment in a pension

Gambling Losses
Gambling winnings are reported on Form W-2G.

Figure 19-8: Form W-2G - Certain Gambling Winnings.

Gambling winnings are taxable and taxpayers can deduct gambling losses
only if they itemize deductions and only to the extent of gambling winnings.
It is important that the taxpayer keeps an accurate diary or similar record of
gambling winnings and losses. To deduct gambling losses the taxpayer
must be able to provide receipts, tickets, statements or other records that
show the amount of both the gambling winnings and losses. Taxpayers
cannot carry forward a net gambling loss; even if the taxpayer is
professional gambler.

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Non-deductible Expenses
Some examples of non-deductible expenses include:

Burial or funeral expenses


Wedding expenses
Fees and licenses, such as car or marriage licenses and dog tags
Fines and penalties, such as parking tickets
Home repairs, insurance, and rent
Illegal bribes and kickbacks
Insurance premiums (except for medical insurance)
Losses from the sale of a taxpayer's home, furniture, or personal car
Lost or misplaced money or property
Personal legal expenses
Commuting expenses to and from work
Attorney fees for a will

TAX PLANNING TIP

Using Checks to Pre-pay Tax Deductible Expenses


Dating checks December 31st to pre-pay tax deductible expenses, such
as charitable contributions, medical bills, and interest does not
automatically entitle taxpayers to claim the deduction in the current year.
Whether an expense is tax deductible this year or next depends on a
checks date of delivery, not the date written on the face of a check. "Date
of delivery", however, for tax purposes, means that the checks must be
postmarked by midnight December 31st, even if the checks are not
deposited by the payee until after the first of the year. They have been
"delivered" by year end for tax purposes.
Its probably a good idea to have taxpayers send such checks, if for large
sums, by certified mail and get a receipt from the post office. The receipts
will support the deductions for payments made with checks that may not
clear the bank until after December 31st.
When a taxpayer uses his credit card to pay for tax deductible expenses
he gets to take the deduction in the year charged, even though he may
not pay the credit card bill until the following year. This is because with a
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credit card the taxpayer is taking a small loan from the bank each time he
makes a purchase. Its the same as if he actually went to the bank and
received a personal loan to pay the bills.
Keep in mind, however, credit cards and charge cards are two different
things. Tax deductions are not available when taxpayers use charge cards
issued by stores and are subsequently billed after the first of the year. No
deductions are allowed until the taxpayer pays the bill.

Lesson Summary
Lets take a moment to review what you have learned in this lesson:
Points are the charges paid by a borrower and/or seller to a lender to secure
a loan. If the taxpayer can deduct all of the interest on his mortgages, he
may also be able to deduct all of the points paid on the mortgage.
The taxpayer can deduct the points in full in the year they are paid, if all the
following requirements are met:

The taxpayers loan is secured by his main home (main home is the
one lived in most of the time).Paying points is an established
business practice in the area.

The points paid were not more than the amount generally charged
in that area.

The taxpayer uses the cash method of accounting. This means he


reports income in the year received and deduct expenses in the year
paid.

The points were not paid for items that usually are separately stated
on the settlement sheet such as appraisal fees, inspection fees, title
fees, attorney fees, or property taxes.

The taxpayer provided funds at or before closing that were at least


as much as the points charged, not counting points paid by the
seller. The taxpayer cannot have borrowed the funds from the lender
or mortgage broker in order to pay the points.
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The taxpayer uses the loan to buy or build his main home.

The points were computed as a percentage of the principal amount


of the mortgage, and

The amount is clearly shown on the settlement statement.

Taxpayers can deduct contributions to qualifying organizations that:

Operate exclusively for religious, charitable, educational, scientific, or


literary purposes, or

Work to prevent cruelty to children or animals, or

Foster national or international amateur sports competition if they


do not provide athletic facilities or equipment

The taxpayer may be entitled to a casualty or theft loss deduction. A


casualty loss is the damage, destruction, or loss of property resulting from
an identifiable event that is sudden, unexpected, or unusual in nature. It can
also be a government-ordered demolition or relocation of a home that's
unsafe because of a disaster.
If property is stolen, destroyed, or condemned during the tax year (an
involuntary conversion), and a taxable gain is realized from insurance
proceeds or some other source, tax on the gain can be deferred by
reinvesting the proceeds in property similar to the property that was subject
to the involuntary conversion.
If the taxpayer has a tax deductible casualty loss from a disaster in an area
that is officially designated by the President of the United States as eligible
for federal disaster assistance, a Declared Disaster Area, the taxpayer can
choose to deduct that casualty loss on the tax return for the tax year
immediately preceding the casualty loss tax year.
Miscellaneous itemized deductions are expenses a taxpayer pays in order
to:

Produce or collect income


Manage, conserve, or maintain property held for producing income
Determine, contest, pay, or claim a refund of any tax
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Employees may be able to deduct workrelated expenses as an itemized


deduction. These employee business expenses include the cost of business
travel away from home, local transportation, entertainment, gifts, and other
ordinary and necessary expenses related to the job.
If the employer reimbursed the taxpayer or gave him an advance or
allowance for the business expenses, the payment(s) are usually treated as
paid under an accountable plan, and the payment(s) will not be shown on
Form W-2. Do not include the payment(s) in the taxpayers income.
You must use Form 2106 - Employee Business Expense or Form 2106-EZ Unreimbursed Employee Business Expenses to figure the taxpayers
deduction for employee business expenses, and attach it to Form 1040. This
is miscellaneous itemized tax deduction subject to the 2% limit.
Gambling winnings are taxable and taxpayers can deduct gambling losses
only if they itemize deductions and only to the extent of gambling winnings.
Taxpayers who choose to itemize their deductions must file Form 1040 and
report them on Schedule A as follows:

Points paid only for the use of money (as a form of interest) can be
deducted on Schedule A.

Deductible contributions to qualifying organizations are reported on


lines 16 and 17. Taxpayers must keep records of their contributions
and must obtain a written acknowledgement for a single
contribution of $250 or more.

Casualty Losses may be tax deductible after applying certain


deductions and limitations. The amount of total casualty or theft
losses that exceed 10% of adjusted gross income (AGI), after
subtracting the $100 floor for each occurrence, maybe deducted.

Most qualified miscellaneous expenses are deductible if they exceed


2% of AGI; they are reported on lines 21 through 27. Line 28 is for
specific expenses that are deductible regardless of AGI.

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1040 ValuePak will compare the taxpayers total itemized deductions to


their standard deduction and enter the larger amount on line 40 of Form
1040.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify your 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

20
Lesson 20 - Alternative Minimum
Tax
In this lesson you'll learn about the Alternative Minimum Tax. The following
topics are discussed in this lesson:
Alternative Minimum Tax
(AMT)
Alternative Minimum Tax
Credit
Investment Expenses

Questions Taxpayers Ask...


Tax Shelters
Incentive Stock Options
The Tax Planning Process
Form 1040 Tax Credits

ore and more middle class families are finding that they are
subject to the Alternative Minimum Tax - which was originally
designed to charge an additional tax on certain tax preference
items commonly deducted by the rich.
The tax laws give preferential tax treatment to certain kinds of income and
allow special tax deductions and tax credits for some kinds of expenses. The
Alternative Minimum Tax attempts to ensure that all individuals who benefit
from these tax advantages will pay at least a minimum amount of tax.
The Alternative Minimum Tax eliminates many deductions and credits. It is a
separate, parallel, tax computation that, in effect, reduces the tax benefit of
certain deductions and credits, thus creating a tax liability for an individual
who would otherwise pay little or no tax. There are no "tests" to determine

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whether a taxpayer is subject to the Alternative Minimum Tax. Tax liability


must be calculated both ways.
The tentative minimum tax rates on ordinary income are percentages set by
law. For capital gains and certain dividends, the rates in effect for the regular
tax are used.
The Alternative Minimum Tax is particularly effective in ensuring people pay
some minimum amount of tax after they've taken advantage of tax credits
and deductions. Some middle income families may find the $1,000 Child
Tax Credit and college tax credits will force them to calculate, and pay,
Alternative Minimum Tax.
The taxpayer may have to pay the Alternative Minimum Tax if his taxable
income for regular tax purposes plus any adjustments and preference items
that apply are more than the Alternative Minimum Tax exemption amount.
The exemption amounts are set by law for each filing status and are listed in
the Form 6251 Instructions.
The following preference items are subject to the alternative minimum tax:

accelerated depreciation in excess of straight line depreciation


circulation expenses
depletion
foreign tax credit
income from long term contracts computed under the percentage of
income method
income from the exercise of incentive stock options
intangible drilling costs
installment sale income (certain types)
interest on home equity debt used for non-residential purposes
investment expenses
itemized tax deductions for tax, medical expenses, and miscellaneous
expenses
mining exploration and development costs
net operating loss tax deductions
passive income or loss tax deductions
personal tax exemptions
pollution control facility amortization
research and experimental expenses
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small business stock gains that qualify for the 50% tax exclusion
standard tax deduction
tax exempt interest from private activity bonds
tax shelter farm income or loss

The individual Alternative Minimum Tax rate is 26% on all alternative


minimum taxable income in excess of an exemption of up to $82,100 on a
joint tax return, $52,800 for a single or head of household person's tax
return, and $41,050 for married persons who file separate tax returns. The
rate is 28% starting at $182,501 ($91,251 for married persons who file
separate tax returns) of alternative minimum taxable income in excess of the
exemption.
1040 ValuePak will automatically calculate the taxpayers AMT liability, if any,
and add Form 6251 - Alternative Minimum Tax - Individuals.

TAX QUOTE

"The purse of the people is the real seat of sensibility. Let it be drawn upon
largely, and they will then listen to truths which could not excite them
through any other organ."
Thomas Jefferson

TAX PLANNING TIP

How To Avoid The Alternative Minimum Tax


The AMT was passed by Congress in 1969. Congress learned that 155
taxpayers with taxable incomes over $200,000 had paid no federal
income tax in 1966. It was intended to target those 155 high-income
households that had been eligible for so many tax deductions they owed
no income tax. This parallel income tax system was supposed to make
sure that even the rich pay their fair share.
The Tax Reform Act of 1986 broadened the AMT to the detriment of
home owners in high tax states. The AMT is not indexed for inflation, and
consequently an increasing number of middle-class taxpayers are
discovering they are subject to this tax. This is often quite a surprise at tax
time a surprise that may have been avoided had they done some tax
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planning.
In 1970, the year in which the AMT became effective, there were actually
20,000 households subject to the tax. By 2002 that number had grown to
400,000. By 2004 it rose to 2.5 million. If the AMT had been indexed for
inflation, along with the regular income tax in 1985, the number of
taxpayers affected by the AMT would have remained at about 400,000
through 2013.
Without the higher exemptions set by American Taxpayer Relief Act
(ATRA) of 2012, approximately 23 million Americans would have had to
pay the AMT in 2013 and that number would have grown to more than
50 million by 2023.
ATRA indexed three AMT parameters after 2012: the exemptions, the
AMT income above which the exemption phases out, and the start of the
28% AMT bracket.
ATRA permanently indexed the three AMT parameters, thereby
protecting millions of taxpayers from owing the additional tax simply
because of inflation. In 2013, an estimated 3.9 million taxpayers paid
$25.6 billion in AMT, an average of just over $6,600 each.
But ATRAs indexing will not prevent the number of taxpayers owing AMT
from growing. Growth of real incomes will increase the number of AMT
payers to more than 6 million in 2023.
Taxpayers who may be subject to the AMT should periodically review
their income and expenses to determine whether to postpone or
accelerate income and defer paying expenses. There are also certain
depreciation and amortization elections that can be made to avoid the
AMT. Taxpayers may want to consider postponing capital gains and
business income, selling property through an installment sale, and not
pre-paying state and local income and property taxes all of which effect
AMT.
If the taxpayers regular tax liability and AMT liability are about equal
from year to year they may be wise to maintain this equilibrium. If their
tax deductions are not regular or they tend to have large fluctuations in
income from year to year they may be able to shift some AMT-triggering
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items from the AMT years to a non-AMT years. Doing this can reduce
their liability in the non-AMT years to just below the point where they
become subject to the AMT.
This is where good tax planning pays off!

Alternative Minimum Tax Credit


If an alternative minimum tax liability occurs because of certain deductions
or tax credits not fully allowed for Alternative Minimum Tax purposes (nonexclusion preferences), the Alternative Minimum Tax credit can be used to
decrease regular tax liability in a later tax year. In most cases, this Alternative
Minimum Tax credit reduces the impact of the Alternative Minimum Tax by
effectively refunding some or all of the Alternative Minimum Tax paid. Thus,
in some cases, Alternative Minimum Tax planning may be a matter of
timing-payment of Alternative Minimum Tax now and reducing regular tax
on the taxpayers tax return in the future. If the taxpayer is not liable for
Alternative Minimum Tax this year, but paid Alternative Minimum Tax in one
or more previous years, he may be eligible to take the special minimum tax
credit against his regular tax this year. If the taxpayer is eligible, you should
complete and attach Form 8801 - Credit for Prior Year Minimum Tax Individuals, Estates and Trusts. The credit is carried over by 1040 ValuePak to
Form 1040 line 73d.

Figure 20-1: The Payments section of Form 1040 with line 73d "Credits from Form:"
highlighted.

For further information refer to Form 6251 - Alternative Minimum Tax.

Lesson Summary
The Alternative Minimum Tax eliminates many deductions and credits. It is a
separate, parallel, tax computation that, in effect, reduces the tax benefit of
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certain deductions and credits, thus creating a tax liability for an individual
who would otherwise pay little or no tax. There are no "tests" to determine
whether a taxpayer is subject to the Alternative Minimum Tax. Tax liability
must be calculated both ways.
The individual Alternative Minimum Tax rate is 26% on all alternative
minimum taxable income in excess of an exemption of up to $82,100 on a
joint tax return, $52,800 for a single or head of household person's tax
return, and $41,050 for married persons who file separate tax returns. The
rate is 28% starting at $182,501 ($91,251 for married persons who file
separate tax returns) of alternative minimum taxable income in excess of the
exemption.

TAX TIP

If a taxpayer checks the box at the top of the Form 1040 where it
asks if they want to contribute $3 to the Presidential Election
Campaign Fund are they charged?
Beginning with the 1973 tax year individual taxpayers were able to
designate $1 to be applied to the Presidential Election Campaign Fund. It
was subsequently increased to $3. The $3 is paid by the government. In
other words, checking the box causes the federal government to receive
$3 less in tax revenue for other spending than if the taxpayer hadn't
checked the box.

SIDE BAR

The Importance of a Last Will and Testament


Many people who pass away really werent expecting to die when they
got out of bed that morning. They looked "healthy as a horse" and they
felt great. This may be the reason that so many people die without a will,
or intestate.
When a taxpayer dies without a will his or her assets pass in accordance
with the states intestacy laws. These laws will often not pass the
decedents assets in accordance with his or her wishes. In other words,
the wrong person gets the money. Perhaps even someone that the
decedent didnt really like at all. Additionally, the lack of a will often
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results in the estate being burdened with unnecessary administrative


expenses and taxes.
When taxpayers make out a will they can also prepare a letter of
instruction. This is an informal document in which, among other things,
the taxpayer lists the location of his or her important personal papers and
assets.
Heirs need to know what and where the decedents assets are and how
to dispose of them. Some advance planning can help ensure that the
decedents intentions are carried out and that his or her heirs are not
taken advantage of by incompetent or dishonest advisers at a time when
they are vulnerable.
What are the benefits of a Last Will and Testament?
A properly drafted Last Will and Testament will determine:

Who inherits what property.

Who will care for the taxpayer's minor children. Taxpayers can
name a guardian and also a trustee who distributes income and
assets for the children until they are adults.

What happens if the taxpayer is incapacitated. A power of


attorney can give a person selected by the taxpayer legal authority
to make health care and financial decisions. Additionally, a Living
Will can provide a doctor with the taxpayers desires regarding life
sustaining procedures, artificial nourishment and organ donation.

How to minimize inheritance and estate taxes.

Who administers the will. The taxpayer can choose an executor.


Without one the Probate Court will appoint an administrator who
may be unfamiliar with the decedent's heirs.

What gets donated to charity.

Wills should be reviewed every three years to be sure they still fit the
taxpayer's present situation and conform to current state laws. In most
states marriage, divorce, and sometimes other events modify or revoke
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the Will automatically by operation of law.


What are the benefits of a Revocable Living Trust?
A Revocable Living Trust has three main benefits that a Last Will and
Testament cannot offer:

Privacy. Probate Court is a process that requires the filing of all


probate documents with the local court. This makes each probate
pleading a part of the public record that anyone can read including a list of beneficiaries and assets, and a breakdown of
who's getting what and how and when they're getting it. Some
dishonest advisers actually search the obituaries and court records
searching for their "marks." A Revocable Living Trust is not filed
with the court.

Mental Disability Planning. The trust can specify how the


taxpayer's mental incapacity should be determined, what care
should be given if the taxpayer does become disabled, and who
will be able to manage the taxpayers property in the event of a
disability. This keeps the taxpayer and his or her property outside
of a court-supervised guardianship or conservatorship.

Avoiding Probate. Avoiding probate is by far the most recognized


benefit of a Revocable Living Trust and usually the one that
convinces the majority of people to set one up. With a Revocable
Living Trust the taxpayer's assets are re-titled in the name of the
trust and they avoid probate. Only assets left out of the trust will
have to be probated.

Hand-written wills or kits are often not a good idea as they may not
conform to state laws. If you are starting a tax preparation business try to
team up with a good local attorney. One who you can make referrals to,
and who will make referrals to you. Dont be afraid to ask the attorney if
he is currently working with anyone like yourself and if hell make referrals
to you should you team up.

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TAX PLANNING TIP

Are "death bed" gifts a good idea?


Generally speaking, no, they are not a good idea. Remember, inherited
property receives stepped-up basis; i.e. the beneficiarys basis in the
property is its value on the decedents date of death. As a result, no
capital gains taxes are ever paid on the appreciation in the property while
the decedent was alive and the beneficiary only pays capital gains tax on
the appreciation that occurs after inheriting the property. Because of this,
gifts made during the decedents lifetime may be inadvisable for people
with sizeable untaxed gains in the property that they are considering
giving as the recipient wont be able to take advantage of stepped-up
basis. The recipient will have to use the gifts original carry-over basis as
his basis upon the sale of the property. But also consider that, by not
making the gift, the property will remain in the decedents estate for
inheritance and estate tax purposes. Balancing these conflicting issues will
require the skills of a good estate planning attorney.
Incidentally, in most cases healthy taxpayers shouldnt gift property that
has gone down in value since they bought it. Rather, they should sell it so
they can get the benefits of the capital loss.
However, keep in mind that if the taxpayer is dying any unused capital
loss carry forward after netting the loss against gains and deducting the
maximum $3,000 per year, will be lost upon the taxpayers death.

TAX QUOTE

"Today, it takes more brains and effort to make out the income tax form
than it does to make the income."
Alfred E. Neuman

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Questions Taxpayers Ask...


Question: "Can I take a deduction for a tax shelter?"
Answer: One of the Internal Revenue Service's priorities is to combat
abusive tax avoidance schemes and the individuals who promote them. To
reach the maximum audience, the IRS recognizes the importance of
partnering with external stakeholders. The IRS's external stakeholders, such
as the practitioner community, have an enormous reach as well as an
excellent relationship with U.S. taxpayers.
An "abusive tax shelter" is a marketing scheme that involves tax transactions
with little or no economic value. People invest money to make money. An
abusive tax shelter offers inflated tax savings based on large tax write offs
and credits. The tax write offs and credits are often out of proportion to the
investment. An abusive tax shelter exists solely to reduce tax, and thus there
is no real economic benefit. A legitimate tax shelter exists to reduce tax fairly
and also produce income. As in any investment, a real tax shelter involves
risks, while an abusive tax shelter often involves little risk, despite outward
appearances. An abusive tax shelter is often marketed in terms of how much
the taxpayer can write off in relation to how much he invests. This "tax write
off" ratio is frequently much greater than one-to-one. A series of tax laws
have been designed to halt the write off of abusive tax shelters.
Operators of tax shelters are required to keep a list of investors for seven (7)
years and provide the list to the IRS upon request.
The IRS may not pay the tax refund if the tax shelter claims are
questionable. Each IRS Service Center screens the returns of tax shelter
investors to determine the legitimacy of the deductible items on the
taxpayer's return.
If the taxpayer receives a letter from the IRS prior to filing a tax return
notifying the taxpayer that he cannot claim certain tax write offs from the
tax shelter and he claims them anyway, the tax refund will be withheld by
the IRS.
Question: "Do I have to pay tax on stock I purchased from my employer
upon its sale?"

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Answer: You generally treat gain or loss from the sale of the stock as a
capital gain or loss. However, you may have ordinary income to report if:

the option price of the stock was below the stock's fair market value
at the time the option was granted; or
you did not meet the holding period requirement explained below

You must hold the stock for more than two years from the time the stock
option is granted to you and for more than one year from when the stock
was transferred to you. If you meet the holding period requirement and the
option price was below the fair market value of the stock at the time the
option was granted, you report the difference as ordinary income when you
sell the stock.
However, this ordinary income that you report cannot be more than your
gain on the sale. If your gain is more than the amount you report as
ordinary income, the remainder is a capital gain reported on Form 1040,
Schedule D. If you sell the stock for less than the option price, your loss is a
capital loss.
Question: "Do I have to pay tax on illegally obtained money or property?"
Answer: Yes, you have to pay tax on illegally obtained money. Illegal
income, such as stolen or embezzled money or property, must be included
in your gross taxable income. You must also include in your taxable income,
kickbacks, bribes, side commissions, push money, or similar payments you
receive.
Question: "Do I have to pay tax on my job interview expense
reimbursements?"
Answer: If a prospective employer asks you to appear for a job interview
and pays you a job interview expense allowance, or reimburses you for your
job interview expenses including transportation and other travel expenses,
you include in taxable income on Form 1040 Line 21, Other Income only the
amount of job interview expense reimbursement you receive that is more
than your actual job interview expenses.
Question: "Do I have to pay tax on meals and lodging provided by my
employer?"
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Answer: Generally, no. Do not include in your taxable income the value of
meals and lodging provided to you and your family by your employer, if the
following conditions are met.
The meals must be:

Furnished on the business premises of your employer, and


Furnished for the convenience of your employer

The lodging must be:

Furnished on the business premises of your employer


Furnished for the convenience of your employer
A condition of your employment and you must accept it

Question: "Do I have to pay tax on a rebate?"


Answer: A cash rebate you receive from a dealer or manufacturer of an
item that you buy is not taxable income. However, you should reduce any
applicable tax deductible amount on your sales receipt by the amount of
the rebate.
You should reduce your basis used to figure taxable gain or loss upon sale
or exchange, or depreciation, on property used in a trade or business or in
an activity for the production of income; by the amount of the cash rebate.
Question: "Do I have to pay tax on my severance pay?"
Answer: Amounts you receive as severance pay are taxable and must be
reported on your tax return. A lump sum payment for cancellation of your
employment contract is taxable income in the year you receive it and must
be reported with your other salaries and wages on your tax return.

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TAX PLANNING TIP

The Tax Planning Process


A typical Tax Planning Review is outlined below. The best time for a review is usually
around the time the taxpayer files his tax return and again in October or November. A
review should also be conducted after any new tax laws have been passed.
Activity
When
1. Initial Interview/Review
January 2. Conduct a tax projection based upon established objectives
April
3. Develop recommendations/estimates for:

Income

Assess withholdings

Withholdings
Deductions
Investments
Business expenses

April & Oct.

Credits
Retirements (IRAs, 401(k), etc.)
Tax reduction ideas
Estimated payments (if required)

Long-term tax planning


4. Conduct a year-end review
Estimate year end situation

November

File quarterly estimates


Tax reduction ideas

5. Review any new tax laws or changes, and situational changes, as


required.

Ongoing

Table: The Tax Planning Process

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify your 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

21
Lesson 21 - Credit for Child and
Dependent Care Expenses
In this lesson you'll learn about the Credit for Child and Dependent Care
Expenses and how to claim the credit on Forms 1040A and 1040. A credit is a
dollar-for-dollar reduction of the taxpayers tax liability. This lesson includes
an overview of the eligibility tests that taxpayers must meet to claim the credit
and the forms used to figure and report the credit.

After completing this lesson, you will be able to:


Explain the Child and Dependent Care Tax Credit
Use the five eligibility tests to determine who is eligible for the credit
Explain the limits on work-related expenses that qualify for the credit
Calculate the credit and the dependent care benefits exclusion and
report the expenses on the correct form

The following topics are discussed in this lesson:


Qualifying Person Test
Children of Divorced or
Separated Parents
Earned Income Test
Work-Related Expense Test
Payments to Relatives
Joint Return Test
Legally Separated and
Divorced

Married and Living Apart


Provider Identification Test
Due Diligence
Provider Refusal
Limit on Expenses - General
Limit
Dependent Care Benefit Limit
Nonworking Spouse

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he child and dependent care credit is one of the most commonly


used credits. It allows qualified taxpayers to claim a credit for paying
for child and dependent care so that they can work or look for work.

A refundable credit can be greater than the tax due. With a refundable
credit taxpayers can not only have their income tax reduced to zero, they
can also receive a "refund" of the excess credit.
A non-refundable credit can also be greater than the tax, but the nonrefundable credit can only reduce the tax to zero. Therefore, taxpayers will
not receive a refund for any excess non-refundable credit.
The Child and Dependent Care Credit is a non-refundable credit that allows
taxpayers to claim a credit for paying someone to care for their qualifying:

Dependents under the age of 13


Spouses or dependents who are unable to care for themselves

This credit is a dollar-for-dollar reduction of the taxpayer's tax liability and


can be up to 35% of a taxpayer's qualifying child or dependent care
expenses. To qualify a taxpayer must pay these expenses in order to work or
look for work.

Figure 21-1: The Tax and Credits section of Form 1040 with line 49 "Credit for child
and dependent care expenses" highlighted.

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TAX TIP

Are tuition payments for a child tax deductible?


Technically no. However, preschool and nursery school costs, which are
tantamount to "tuition", count as child care expenses for the Child and
Dependent Care Credit. For students in first grade or above only the
amounts paid for actual daycare expenses are eligible for the Child and
Dependent Care Credit.

TAX PLANNING TIP

Should a taxpayer pay child care expenses directly to the provider,


or should she participate in her companys cafeteria plan and pay
them through the plan?
It depends on her income, income tax bracket, and which city, county and
state in which she lives.
The maximum Child and Dependent Care Credit ranges from 35% at the
lowest income level down to 20% at the highest income level. See the
table below.

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The table below shows the maximum allowable Child and Dependent
Care Tax Credit:
Adjusted Gross
Income

Credit
Percentage

One Dependent

Two or more
Dependents

$15,000 or less

35%

$1,050

$2,100

$15,001-$17,000

34%

$1,020

$2,040

$17,001-$19,000

33%

$990

$1,980

$19,001-$21,000

32%

$960

$1,920

$21,001-$23,000

31%

$930

$1,860

$23,001-$25,000

30%

$900

$1,800

$25,001-$27,000

29%

$870

$1,740

$27,001-$29,000

28%

$840

$1,680

$29,001-$31,000

27%

$810

$1,620

$31,001-$33,000

26%

$780

$1,560

$33,001-$35,000

25%

$750

$1,500

$35,001-$37,000

24%

$720

$1,440

$37,001-$39,000

23%

$690

$1,380

$39,001-$41,000

22%

$660

$1,320

$41,001-$43,000

21%

$630

$1,260

$43,001 and over

20%

$600

$1,200

The federal income tax rates range from 0% at the lowest income level to
39.6% at the highest income level. See the table below.
Below are 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
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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

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

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If the taxpayers tax bracket is higher than the Child and Dependent Care
Credit percentage shown above then the company's dependent care
program is a great deal because the payments into the cafeteria plan will
be deducted from her wages (and W-2), and thus deducted at her current
tax bracket rate. Be sure to include FICA in determining the taxpayer's
"tax bracket" as the lower wages will reduce any FICA tax too.
On the other hand, if the taxpayers tax bracket is lower than the credit
percentage shown above then she should pay the child care expenses
directly because the credit shell receive will be greater than the taxes she
would save making payments into the cafeteria plan by having them
deducted from her wages.
The expense limit for the Child and Dependent Care Credit ($3,000 or
$6,000) must be reduced by the amount of any tax free payments
received from a qualified employer dependent care plan.
Depending in which city, county and state she lives in can tilt the scales in
either direction in the above calculation as participating in the cafeteria
plan may also reduce her wages for her city, county and state income tax
if there are such taxes in her locality and they allow such a reduction.
Often youll be able to tell which way the taxpayer is better off just by
looking at the above tables, However, sometimes you'll have to do the
math. Especially if you have to factor in state and local tax effects.
How to do the math
After the taxpayer's tax return has been completed, e-filed, and
acknowledged by the IRS open the return, print it, and then adjust the W2 wages and the Child and Dependent Care Credit expenses to see which
way the taxpayer is better off. Don't forget to also look at any changes in
tax liability of any state and local tax return.
CAUTION: Be sure to switch the numbers back after you have made your
determination.
To qualify for Child and Dependent Care Credit, the taxpayer must satisfy all
five tests of eligibility, which include:

Qualifying Person Test


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Earned Income Test


Work-related Expense Test
Joint Return Test
Provider Identification Test

Taxpayers must submit one of two forms with their tax return to claim the
credit:

Schedule 2 for Form 1040A


Form 2441 for Form 1040

Some taxpayers receive employer-provided dependent care benefits.


Dependent care benefits include amounts the employer paid directly to the
taxpayer or to the care provider. These benefits can also include the fair
market value of care in a day-care facility provided or sponsored by the
employer. The taxpayer's salary may have been reduced to pay for these
benefits. Employer-provided benefits are reported on Form W-2 box 10.

Figure 21-2: Form W-2 - Wage and Tax Statement with box 10 "Dependent care benefits"
highlighted.

Taxpayers with an entry in box 10 of Form W-2 must fill out a Schedule 2 or
Form 2441 even if they do not claim the credit.
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TAX QUOTE

"I am thankful for the taxes I pay because it means that I'm employed."
Nancie J. Carmody

Five Eligibility Tests


To be able to claim the credit for child and dependent care expenses,
taxpayers must meet all five eligibility tests which are described below. You
will be able to use the five eligibility tests to determine who is eligible for
the child and dependent care credit.
Qualifying Person Test
To meet the qualifying person test, a taxpayer's child and dependent care
expenses must be for the care of at least one qualifying person. A qualifying
person is:

A child who was under the age of 13 when the care was provided
and for whom the taxpayer can claim a dependency exemption
(special rules apply, however, if the parents are divorced or
separated)
A dependent who was physically or mentally unable to care for
himself or herself and for whom the taxpayer can claim a
dependency exemption (or could be claimed except the person had
$3,950 or more of gross income)
A spouse who was physically or mentally unable to care for himself
or herself

A qualifying child must pass four tests which are based on the Working
Families Relief Act of 2004. This act established a uniform definition of
Qualifying Child to be used for the purposes of dependency exemptions
and other credits.
Children of Divorced or Separated Parents
Special rules apply to children of divorced or separated parents. Taxpayers
who are the custodial parents can treat the child as a qualifying person even
if they cannot claim the childs exemption.

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Taxpayers who are not the custodial parents cannot treat the child as a
qualifying person even if they can claim the childs exemption. The custodial
parent is the parent who has physical custody of the child for the longest
period of time during the year.
Physical custody (who the child lives with), not legal custody, determines
whether or not a taxpayer is eligible to claim the childcare credit. It is not
uncommon for physical custody to differ from legal custody.
This exception applies only if all the following are true:

One or both parents had custody of the child for more than half the
year

One or both parents provided more than half of the childs support
for the year, and

The custodial parent signed Form 8332 - Release of Claim to


Exemption for Child of Divorced or Separated Parents or a similar
statement agreeing not to claim the childs exemption for the year

Earned Income Test


The next test to claiming the child and dependent care tax credit is the
earned income test. The taxpayer (and spouse if married) must have earned
income during the year. Earned income includes:

Wages
Salaries
Tips
Other taxable employee compensation
Net earnings from self-employment
Strike benefits
Disability pay reported as wages

A taxpayer's spouse is treated as having earned income for any month he or


she is:

A full-time student, or
Physically or mentally unable to care for himself or herself

A full-time student is defined as enrolled and attending a school for the


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number of hours or classes the school considers full time. The taxpayer (or
spouse) must be a student for some part of five calendar months during the
year.
Only the taxpayer or the spouse can be treated as having earned income in
any one month.
Work-Related Expense Test
The next eligibility test is the work-related expense test. To qualify for the
credit, a taxpayer's child and dependent care expenses must be workrelated. Expenses are considered work-related only if both of the following
are true:

The expenses allow the taxpayer (and spouse if married) to work or


look for work (if the taxpayer or their spouse do not find a job and
have no income for the first year, they cannot take the credit), and

The expenses are for a qualifying persons care

To be considered work-related, the expenses must provide for the care,


well-being and protection of a qualifying person. Household services
required to run the home are considered work-related expenses because
they assist in providing for the care of the qualifying person. Household
services are services required to care for the qualifying person as well as to
run the home. They include services of a cook, maid, babysitter,
housekeeper, or cleaning person.
Expenses for care do not include amounts paid for food, clothing,
education, or entertainment. However, small amounts paid for these items
can be included if they are incident to, and cannot be separated from, the
cost of care. Examples of childcare expenses that do not qualify as work
related include:

Education, for example expenses to attend kindergarten or a higher


grade

The cost of sending a child to an overnight camp

Payments to Relatives
Payments to relatives do not qualify as work-related expenses. Do not count
amounts paid to:
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A dependent for whom the taxpayer (or spouse if married) can claim
as an exemption, or

The taxpayers child who is under age 19 at the end of the year, even
if he or she is not the taxpayers dependent

Joint Return Test


The next eligibility test is the joint return test. Married couples who wish to
take the credit for child and dependent care must file a joint return.
However, taxpayers who are legally separated or living apart from their
spouses may file separate returns and still take the credit.
Legally Separated and Divorced
Taxpayers are not considered married if they have a decree of legal
separation from their spouses. Taxpayers in this category are eligible to take
the credit on a separate return.
Married and Living Apart
Taxpayers who are married but live apart are eligible to take the credit if
they meet all of the following conditions listed below:

Filed a separate return


Lived apart from their spouse during the last six months of the year
Provided the home for the qualifying person for more than half the
year
Provided more than half the cost of keeping up the home

Provider Identification Test


Finally, the provider identification test requires that taxpayers provide the
name, address and taxpayer identification number of the person or
organization who provided the care for their child or dependent. This
information should be listed on Form 2441 or Form 1040A Schedule 2.
Taxpayers who are unable to provide this information or who have incorrect
information must show they used due diligence to obtain the information.
If the care provider is an individual, the taxpayer identification number is the
social security number or individual taxpayer identification number. If the
care provider is an organization, then it is the employer identification
number (EIN).
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Due Diligence
Taxpayers can show they used due diligence by obtaining and keeping any
of the following documents:

Form W-10 - Dependent Care Providers Identification and


Certification

Figure 21-3: Form W-10 - Dependent Care Providers Identification and


Certification.

A copy of the providers Social Security card

A copy of the providers drivers license if it includes the Social


Security Number

A copy of the providers Form W-4 if the provider is the taxpayers


household employee

A copy of the statement furnished by the taxpayers employer if the


provider is a dependent care plan

A letter or invoice from the provider if it shows the name, address,


and Employer Identification Number (EIN) or Social Security Number

Provider Refusal
If the care provider refuses to give the taxpayer the identifying information,
the taxpayer should report whatever information was obtained such as
name and address on Form 2441 or Schedule 2.

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Enter the explanation for the missing information which should include that
the information was requested, but that the care provider refused to
provide it.

TAX QUOTE

"Government's view of the economy could be summed up in a few short


phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops
moving, subsidize it."
Ronald Reagan (1911-2004) 40th President of the United States (19811989)

Limit on Expenses
General Limit
There is a limit on the amount of work-related expenses taxpayers can
include in figuring the child and dependent care credit. The limit is the
smallest of the following amounts for the year:

The lower paid spouses earned income (in the case of married
taxpayers)

The single taxpayers earned income

The actual expenses paid, or

The overall limit of $3,000 for expenses paid for one qualifying
person or $6,000 for two or more qualifying persons

Dependent Care Benefit Limit


Some taxpayers receive dependent care benefits from their employers. If so,
the overall limit of $3,000/$6,000 is reduced, dollar for dollar, by any
reimbursement excluded from the taxpayers income.
Dependent Care Fringe Benefits
Employers can provide a substantial amount of dependent care assistance
as a non-taxable fringe benefit to employees provided certain rules are met.
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AND

DEPENDENT

The most important rule is probably that the amount of non-taxable


assistance is limited to $5,000 per year (Publication 503) per family, or to
the amount of the lower-paid spouse's salary, whichever is less. If one
spouse is a student or totally disabled that spouse is treated as earning
$200 per month for one dependent or $400 per month for two dependents.
The expenses that may be covered by an employer's dependent care fringe
benefit plan are the same as those that would qualify for the Child and
Dependent Care Credit. The same rules apply to the employer-provided
fringe benefit program.
Employer-provided dependent care can be claimed by a married couple
filing separately, unlike the Child and Dependent Care Credit.
One difference between the two is important for those with only one child.
Under the Child and Dependent Care Credit taxpayers are only allowed to
count the first $3,000 they spend for the care of that child. However, under
an employer dependent care assistance plan taxpayers may count up to
$5,000, regardless of whether it's spent on one child or two.
The amount of dependent care benefits received is shown in box 10 of the
taxpayer's Form W-2.

Non-working Spouse
Married taxpayers usually must both work (have earned income) in order to
claim the credit. If a spouse is either a full-time student during any five
months of the year, or is not capable of caring for himself or herself for
some period during the year, a credit can still be claimed.
To figure the credit, the earned income for each month the spouse is either
a full-time student or disabled is considered to be at least:

$250 with one qualifying person in the home, or

$500 with two or more qualifying persons in the home

671

LESSON
CARE

21

CREDIT

FOR

CHILD

AND

DEPENDENT

SIDE BAR

Should parent(s) have life insurance?


Yes. A parent(s) income producing ability is relatively secure so long as
they are alive and healthy. Parent(s) and their children can enjoy the
lifestyle to which theyve become accustomed. However, most families
would face difficult economic times with only one or no income. Life
insurance can be used to pay for:

Burial expenses and funeral costs


Childcare
College education for the children
Credit Cards
Emergency expenses
Final monthly expenses
Housekeeping
Income replacement for a surviving spouse
Income replacement for the children
Loans
Mortgage balance
Nursery school
Unpaid medical bills

Taxpayers should ask themselves how these expenses will be paid


without life insurance. A life insurance agent can help determine if the
taxpayer is adequately covered at work on the company's group term life
insurance policy or if additional life insurance coverage is necessary.
Taxpayers should also consider that their employers group term life
insurance will terminate when their employment terminates. And at that
time they may be uninsurable.

Lesson Summary
The credit for child and dependent care expenses is a nonrefundable credit
that allows taxpayers to reduce their tax liability for a portion of the
expenses.

672

LESSON
CARE

21

CREDIT

FOR

CHILD

AND

DEPENDENT

The maximum credit rate is 35%. A taxpayer must satisfy the five tests to
qualify for the credit. The tests are the:

Qualifying person test


Earned income test
Work-related expense test
Joint return test
Provider identification test

This lesson also explained the limits on the amount of work-related


expenses that can be used in claiming the child and dependent care credit.
The limit is the smallest of the following amounts for the year:

The lower-paid spouses earned income (in the case of married


taxpayers)

The single taxpayers earned income

The actual expenses paid

The overall limit of $3,000 for expenses paid for one qualifying
person or $6,000 for two or more qualifying persons

The credit is calculated and reported on Form 2441 of Form 1040 or


Schedule 2 of Form 1040A.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify your 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.

673

LESSON

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TAX

ISSUES

Lesson

22
Lesson 22 - Child Tax Issues
In this lesson you'll learn about the Child Tax Credit, which allows taxpayers
to claim a credit of up to $1,000 per qualifying child on their tax returns. This
lesson also discusses the Additional Child Tax Credit, which is available to
taxpayers who are not able to claim the full amount of the Child Tax Credit,
and also available to certain taxpayers who can claim both the Child Tax
Credit and the Additional Child Tax Credit. Upon completing this topic, you
will be able to explain both Child Tax Credits and apply the general rules for
determining whether a child qualifies for the credits. In this lesson you'll also
learn about child tax returns (Kiddie Tax), student tax returns, adopting a
child, and the Adoption Credit.
The following topics are discussed in this lesson:
The Child Tax Credit
Qualifying Child
Eligible Descendant
Adopted Child
Eligible Foster Child
Exceptions for Children of
Divorced or Separated
Parents
Amount of Credit
Figuring the Credit

Additional Child Tax Credit


Child Tax Returns Kiddie
Tax
Tax Returns for Students
Penalties
Adopting a Child - Children
without SSNs
Adoption Credit
Employer Adoption
Assistance Exclusion

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ISSUES

The Child Tax Credit

he Child Tax Credit allows taxpayers to claim a tax credit of up to


$1,000 per qualifying child. It is in addition to the Credit for Child and
Dependent Care and the Earned Income Credit. The credit can be
claimed on either Form 1040 or Form 1040A. Taxpayers should check the
box in line 6(c) column 4 if their dependent children qualify for the Child
Tax Credit.

Figure 22-1: The Exemptions section of Form 1040 with box 4 " If child under age 17
qualifying for child tax credit" highlighted.

Qualifying Child
To qualify, the child must:

Be under age 17 at the end of the year


Have not provided over half of his or her own support for the year
Have lived with the taxpayer for more than half of the year
Be a citizen or resident of the United States
Be the taxpayer's:
o Son or daughter
o Stepson, stepdaughter, or adopted child
o Brother or sister
o Eligible descendent, or
o Eligible foster child

Eligible Descendent
For the purposes of the Child Tax Credit a descendant can be the taxpayer's
child, grandchild, great-grandchild, niece or nephew.

675

LESSON

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ISSUES

TAX QUOTE

"I owe the government $3,400 in taxes. So I sent them two hammers and a
toilet seat."
Michael McShane
Adopted Child
A child placed with a taxpayer by an authorized placement agency for legal
adoption is an adopted child for Child Tax Credit purposes, even if the
adoption is not yet final.
Eligible Foster Child
An eligible foster child qualifies for the Child Tax Credit if the child is placed
with the taxpayer by an authorized placement agency.
A child who was born or died during the tax year is considered to have lived
with the taxpayer for all of the tax year if the taxpayer's home was the child's
home for the entire time he or she was alive.
Exceptions for Children of Divorced or Separated Parents
There are exceptions for children of divorced or separated parents, as well
as children of parents who never married. In any of these cases, a child will
be treated as a qualifying child of his or her non-custodial parent if all of the
following apply:

The parents are divorced or legally separated or lived apart at all


times during the last 6 months of the year.

The child received over half of his or her support for the year from
the parents.

The child is in the custody of one or both of the parents for more
than half of the year.

A decree of divorce or separate maintenance or written separation


agreement for the year provides that (a) the non-custodial parent
can claim the child as a dependent, or (b) the custodial parent will
sign a written declaration that he or she will not claim the child as a
dependent for the year. If the divorce or separation agreement went
676

LESSON

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TAX

ISSUES

into effect before 1985, this requirement is met if the non-custodial


parent provides at least $600 for the support of the child for the
year.
Taxpayers must provide the name and social security number of each
qualifying child on their tax returns.

Amount of Credit
The amount of a taxpayer's Child Tax Credit depends on the taxpayer's tax
liability, modified adjusted gross income, and filing status. The credit is not
"refundable". A taxpayer's Child Tax Credit is reduced if the tax liability listed
on line 47 of Form 1040 is less than the $1,000 credit.

Figure 22-2: The Tax and Credits section of Form 1040 with line 47 highlighted.

If the tax liability is zero, the credit is zero because there is no tax to reduce.
Taxpayers who are not able to take the full amount of the Child Tax Credit
may be able to take the Additional Child Tax Credit which is discussed in the
next topic.
A taxpayer's Child Tax Credit may also be reduced if the taxpayer's Modified
AGI is above a certain amount for their filing status. For most taxpayers,
their Modified AGI is the same as their AGI. AGI is shown on line 37 of Form
1040.

677

LESSON

22

CHILD

TAX

ISSUES

Figure 22-3: The Adjusted Gross Income section of Form 1040 with line 37 "Adjusted
Gross Income" highlighted.

The table below shows the phase-out ranges for various deductions,
exemptions, and credits. They begin to phase-out at the lower amount,
and are completely phased out at the higher amount. Thus, once the
higher amount is reached there is no tax benefit to that item.

678

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Married filing Joint/


Qualifying Widower

Single or Head of
Household

Married filing
Separately

$197,880-$237,880

$197,880-$237,880

No Credit

$160,000-$180,000

$80,000-$90,000

No Credit

$156,500-$484,900

$117,300-$328,500

$78,250-$242,450

$110,000-$130,000

$75,000-$95,000

$55,000-$75,000

$190,000-$220,000

$95,000-$110,000

$95,000-$110,000

$15,000-$43,000

No Credit

$7,500-$17,500

$5,000-$12,500

$60,000-$70,000

$0-$10,000

$254,200 (s)
$279,650 (hoh)

$152,525

$54,000-$64,000

No Credit

Passive Activity Loss $100,000-$150,000

$100,000-$150,000

$50,000-$75,000

Personal Exemptions $305,050-$427,550

$254,200-$376,700 $152,525-$213,775

Retirement Savings
Credit

No limit

$18,000-$30,000 (s)
$27,000-$45,000
No limit

$181,000-$191,000

$114,000-$129,000

$0-$10,000

$113,950-$143,950

$76,000-$91,000

No Exclusion

$130,000-$160,000

$65,000-$80,000

No Deduction

$130,000-$160,000

$65,000-$80,000

No Deduction

$17,500

$17,500

$17,500

Benefit
Adoption Credit /
Exclusion
American
Opportunity Credit
AMT Exemption (1)
Child Tax Credit (1
child)
Coverdell ESA

Dependent Care
$15,000-$43,000
Credit
Elderly/Disabled
$10,000-$20,000
Credit
(if both eligible)
$10,000-$25,000
IRA Income Limit
$96,000-$116,000
with Pension
Itemized Deductions,
$305,050 +
beginning at
Lifetime Learning
$108,000-$128,000
Credit

Rollover to Roth IRA


Roth IRA Income
Limit
Savings Bond
Interest
Student Loan
Interest Ded.
Tuition & Fees
Deduction
401(k)/403(b)
Elective Def. (2)

$36,000-$60,000

(1) Phaseout applies to AMT income rather than AGI.


(2) Add $5,500 if age 50 or over.
Table: AGI Phase-out Ranges

679

$18,000-$30,000
No Limit

LESSON

22

CHILD

TAX

ISSUES

Figuring the Credit


Before figuring a taxpayer's Child Tax Credit amount for the year, perform
the following steps:

Make sure the taxpayer has a qualifying child for the credit
Make sure the box or boxes are checked in column 4 of line 6c on
Form 1040 for each qualifying child.
Ask the taxpayer the questions in the Child Tax Credit Worksheet.

Additional Child Tax Credit


Some taxpayers may be eligible to claim a refundable Additional Child Tax
Credit if their tax liability is less than the allowable Child Tax Credit. Like the
Child Tax Credit, the Additional Child Tax Credit allows eligible taxpayers to
claim $1,000 for each qualifying child. The credit is generally based on the
lesser of:

15% of the taxpayer's taxable earned income that is over $3,000, or


The amount of unused Child Tax Credit (caused when tax liability is
less than allowed credit)

Use Schedule 8812 to claim the Additional Child Tax Credit.

The Trade Preferences Extension Act of


2015
The Trade Preferences Extension Act of 2015 amends the Child Tax
Credit to provide that taxpayers who exclude foreign earned income
cannot claim the Child Tax Credit. This provision is effective for tax years
beginning after Dec. 31, 2014.

TAX PLANNING TIP

Are gifts to individuals ever tax deductible?


Unlike charitable contributions, taxpayers get no income tax deduction
for gifts to individuals. However, these gifts can be advantageous
because they can shift assets that produce investment income from the
taxpayer to other family members in lower tax brackets as well as reduce
the value of assets subject to inheritance and estate taxes upon the
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taxpayer's death. However, be aware of the "Kiddie Tax" limits, which are
discussed below.

Child Tax Returns Kiddie Tax


A tax return usually must be filed for a minor child whose income included
investment income, such as interest and dividends, and totals more than
$1,050 for 2015.
The minor child pays no tax on the first $1,050 of unearned income and
pays tax on the next $1,050 at his or her own (presumably 10%) tax rate. If
the minor child receives annual unearned income of more than $2,100 in
2015 and is under age 18, he or she will be liable for tax on amounts in
excess of $2,100 at the parent taxpayers maximum marginal tax rate. This
tax rule, commonly referred to as the "Kiddie Tax", reduces the appeal of
shifting income producing property to children under age 18.
A minor child is a taxpayer in his/her own right. If the tax laws require the
minor child to file a tax return but he/she is unable to file the tax return for
any reason the parent or guardian is required to file the tax return. If the
minor child cannot sign the tax return the parent should sign the child's
name on the tax return followed by "by [parent's signature], parent for
minor child".
If the child is under 18 and has gross income of more than $1,050, the
taxpayer should consider electing to include the child's tax liability on his tax
return. This option is available if the child's gross income is comprised only
of interest and dividends totaling $10,500 or less in 2015, no estimated tax
payments are were made, and the minor child is not subject to backup tax
withholding. Making this election requires including the child's gross
income in excess of $2,100 on the parents tax return.

TAX QUOTE

"If you are truly serious about preparing your child for the future, don't
teach him to subtract - teach him to deduct."
Fran Lebowitz

681

LESSON

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CHILD

TAX

ISSUES

The taxpayer may use Form 8814 to include a child's income on the parent's
tax return if all of the following conditions are met:

The child is under age 19 (or age 24 if a full-time student) on


1/1/2016.
The child is required to file a tax return.
The child has unearned income only.
The child's gross income is less than $10,500.
There were no withholding or estimated payments made for the
child.
The child does not file a joint tax return.

If the child is under age 19 and there is investment income of $2,100 or


more and Form 8814 is not filed, the child must file a tax return and include
Form 8615.

TAX TIP

Should taxpayers always claim their childs income on their tax


return?
Claiming the childs income on the parent's tax return may eliminate the
need to file two tax returns, thereby lowering tax preparation fees.
However, when determining whether or not to include the childs income
on the parents tax return, dont forget to consider the possible loss of
certain deductions, the possibility of loss from increased phase-outs, and
that the parents may have to pay more state and local income tax.

682

LESSON

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TAX

ISSUES

683

LESSON

22

CHILD

TAX

ISSUES

Flowchart: Include Childs Income

Flowchart: Use Form 8615

684

LESSON

22

CHILD

TAX

ISSUES

TAX PRACTICE TIP

Prepare The Parents Tax Return First


Because the parents taxable income and income tax liability are needed
to prepare Form 8615, you should always prepare their tax return first. If
the parents have to file Form 4868 and obtain an extension of time to file,
but the childs tax return must be filed by the April 15th deadline, you can
use estimates of the parents taxable income and income tax liability.
However, if it later turns out that the estimates for the parent's taxable
income and income tax liability were wrong youll need to file an
amended return for the child.
For each minor child for whom this election is made, an added tax equal to
the lesser of $100.00 or 10% of the excess of the minor child's income over
$1,050, which is on the parent's tax return. The minor child's holdings are
not depleted by paying tax, and the cost of preparing an additional tax
return is avoided.
Including the child's investment income on the parent's tax return may
allow the parent to deduct more investment interest expense - up to
$10,500 - because of the addition of the minor child's investment income
on the parents tax return. This could effectively shelter a portion of the
minor child's income from tax on the parent's tax return.
But be careful. The additional income could reduce available itemized tax
deductions on the parents tax return that are deductible based on a
percentage of Adjusted Gross Income. Additionally, the election could
increase the parents state income tax liability.
If the child has only earned income and no investment income a tax return
must be filed if the child's income is more than $6,200.
There are special tax rules that affect the tax on certain investment income
of a child under age 18.
The following table shows when a dependent must file a tax return for
2014:

685

LESSON

22

CHILD

TAX

ISSUES

Single Dependents NOT either age 65 or


older or blind

Must file a return if any of the following


apply:

Unearned income was more than $1,000


Earned income was more than $6,200
Total earned and unearned income was
more than the larger of $1,000 or earned
income up to $5,850 plus $350.
Single Dependents either age 65 or older or Must file a return if any of the following
blind
apply:

Married Dependents NOT either age 65 or


older or blind

Unearned income was more than $2,550


($4,100 if 65 or older or blind)
Earned income was more than $7,750
($9,300 if 65 or older or blind)
Gross income was more than the larger of
$2,550 ($4,100 if 65 or older or blind) OR
your earned income was $5,850 plus
$1,900 ($3,450 if 65 or older or blind)
Must file a return if any of the following
apply:

Married Dependents either age 65 or older


or blind

Gross income was at least $5 and the


spouse files a separate return and
itemizes deductions
Earned income was more than $6,200
Unearned income was more than $1,000
Total earned and unearned income was
more than the larger of $1,000 or earned
income up to $5,850 plus $350.
Must file a return if any of the following
apply:
Earned income was more than $7,400
($8,600 if 65 or older or blind)
Unearned income was more than $2,200
($3,400 if 65 or older or blind)
Gross income was at least $5 and your
spouse files a separate return and
itemizes deductions
Gross income was more than the larger of
$2,200 ($3,400 if 65 or older or blind) or
your earned income was $5,850 plus
$1,550 ($2,750 if 65 or older or blind)

Table: Dependent Filing

686

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ISSUES

For further information see Publication 929 - Tax Rules for Children and
Dependents.

TAX PLANNING TIP

Uniform Gifts to Minors Act (UGMA) Accounts


The Uniform Gifts to Minors Act is a law in some states that allows assets
such as bank accounts and securities to be held in a custodial account for
the benefit of the minor without the need for a trust to be established.
This allows a minor to have property set aside for his or her benefit and
may achieve some income tax savings for the child's parents. Once the
child reaches the age of majority the assets become the property of the
child directly and the child can use them for any purpose. These custodial
accounts permit annual contributions of up to $14,000 per child without
being affected by the gift tax.
Assets in the account are considered an irrevocable gift to the minor and
are taxed at the minors lower income tax bracket. These once popular
accounts have lost much of their appeal since the passage of the "Kiddie
Tax". However, they can still be used to shelter up to $2,100 in 2015
from the parents higher income tax rate.
In some states UGMA is known as the Uniform Transfers to Minors Act
(UTMA).

Tax Returns for Students


Whether a student has to file a tax return depends on the students filing
status, age, and gross income. Assuming the student is a U.S. citizen or
resident alien, and the student is not blind, the student must file a tax return
if he can be claimed as a dependent on another person's tax return, he had
any unearned income, such as taxable interest, dividends, capital gains, and
trust distributions, and his total income was more than $1,050.
A dependent with only earned income, such as wages, tips, and salaries,
must file a tax return only if his or her gross income is more than his or her
standard tax deduction amount.

687

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Penalties
If the student did not have enough tax withheld in 2015 he will not have to
pay a penalty if he did not owe tax for 2014.

Adopting a Child
If the taxpayer is in the process of a domestic U.S. adoption and doesnt
have or is unable to obtain the soon to be adopted child's Social Security
Number (SSN) then the taxpayer should request an Adoption Taxpayer
Identification Number (ATIN) in order to claim the soon to be adopted child
as a dependent on the tax return and (if eligible) to claim the child care tax
credit.

Figure 22-4: Form W-7A - Application for Taxpayer Identification Number for Pending U.S.
Adoptions.

Click this hyperlink to get Form W-7A - Application for Taxpayer


Identification Number for Pending U.S. Adoptions.
Taxpayers who have adopted their new spouses children, whose names
have changed, will need to update the children's names with the Social
Security Administration.
688

LESSON

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ISSUES

Adoption Credit
An Adoption Credit of up to $13,190 is allowed for the qualifying costs of
adopting a child under the age of 18, or a person who is physically or
mentally incapable of self care. There is a $13,190 adoption credit limit for
each effort to adopt a child and the Adoption Credit is allowed only if the
adoption is finalized. If the adoption isnt final, no credit can be taken. The
separate $13,190 limit applies for each child adopted. For tax years 2012
and after the Adoption Credit is a non-refundable credit.
A special needs adoption for Adoption Credit purposes is defined as the
adoption of a child who:

according to the state could not or should not be returned to the


home of the birth parents

due to a specific factor or condition (such as ethnic background, age,


membership in a minority group, or sibling group, medical condition,
or physical, mental or emotional handicap) could not be expected to
be adopted unless an adoption credit is provided

is a resident or citizen of the United States

Expenses that qualify for the Adoption Credit are:

reasonable and necessary adoption fees


court costs
travel expenses (including meals and lodging)
attorney's fees
other expenses directly related to, and whose principal purpose is
for, the legal adoption of an eligible child

If the taxpayer paid qualifying expenses but the adoption was not final at
the end of the tax year he may not claim the Adoption Credit. Qualified
expenses paid in one tax year are not taken into account for purposes of the
Adoption Credit until the next tax year, unless the expenses qualifying for
the Adoption Credit are incurred in the tax year the adoption becomes final.
The Adoption Credit is not allowed for expenses:

incurred in violation of state or federal law


incurred in carrying out any surrogate parenting arrangement
689

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ISSUES

incurred in connection with the adoption of a child of the taxpayer's


spouse
that are paid or reimbursed by a federal, state, or local grant
that are paid or reimbursed under an employer's adoption assistance
program

TAX QUOTE

"Day in and day out, your tax accountant can make or lose you more
money than any single person in your life, with the possible exception of
your kids."
Harvey Mackay
Employer Adoption Assistance Exclusion
In addition to an Adoption Credit, the tax law provides an Adoption
Assistance Exclusion from an employee's taxable income for up to $13,190
of employer provided adoption reimbursement for specified adoption
expenses incurred and paid pursuant to a written adoption assistance plan.
The $13,190 limit is applied against each child adopted, rather than on an
annual basis.
Taxpayers adopting children are eligible for both the Adoption Credit and
the Adoption Assistance Exclusion paid for through an employer's adoption
assistance plan. However, the same adoption expense cannot qualify for
both the credit and the exclusion.
For taxpayers whose Modified Adjusted Gross Income (MAGI) is between
$197,880 and $237,880 in 2014, both the Adoption Credit and the
Adoption Assistance Exclusion are subject to a ratable phase out. No
Adoption Credit or Adoption Assistance Exclusion is allowed if MAGI is
$237,880 or more in 2014. See the Table of AGI Phase-out Ranges above.
To qualify for either the Adoption Credit or the Adoption Assistance
Exclusion, the taxpayer must provide the IRS with the name, age and TIN of
each adopted child.
The Adoption Credit and Adoption Assistance Exclusion are both taken on
Form 8839. The total carries over to Form 1040 line 54c.
690

LESSON

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ISSUES

Figure 22-5: The Tax and Credits section of Form 1040 with line 54c "Other credits
from Form:" highlighted.

For more information about adoptions see the Top Ten Facts about
Adoption Tax Benefits.

Lesson Summary
Lets spend a few minutes and review what you have learned today.
The Child Tax Credit allows taxpayers to claim a tax credit of up to $1,000
per qualifying child. It is in addition to the credit for child and dependent
care and earned income credit.
To qualify, the child must:

Be under age 17 at the end of the year


Have not provided over half of his or her own support for the year
Have lived with the taxpayer for more than half of the year
Be a citizen or resident of the United States
Be the taxpayer's:
o Son or daughter
o Stepson, stepdaughter, or adopted child
o Brother or sister
o Eligible descendent, or
o Eligible foster child

The credit is not "refundable". A taxpayer's Child Tax Credit is reduced if the
691

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ISSUES

tax liability listed on line 46 of Form 1040 is less than the $1,000 credit. If the
tax liability is zero, the credit is zero because there is no tax to reduce.
Some taxpayers may be eligible to claim a refundable Additional Child Tax
Credit if their tax liability is less than the allowable Child Tax Credit. Like the
Child Tax Credit, the Additional Child Tax Credit allows eligible taxpayers to
claim $1,000 for each qualifying child.
A tax return usually must be filed for a minor child whose income included
investment income, such as interest and dividends, and totals more than
$1,050 in 2015.
The minor child pays no tax on the first $1,050 of unearned income and
pays tax on the next $1,050 at his or her own (presumably 10%) tax rate.
If the child is under 18 and has gross income of more than $1,050, the
taxpayer should consider electing to include the child's tax liability on his tax
return.
For each minor child for whom this election is made, an added tax equal to
the lesser of $100.00 or 10% of the excess of the minor child's income over
$1,050, which is on the parent's tax return. The minor child's holdings are
not depleted by paying tax, and the cost of preparing an additional tax
return is avoided.
The additional income could reduce available itemized tax deductions on
the parents tax return that are deductible based on a percentage of
Adjusted Gross Income. Additionally, the election could increase the
parents state income tax liability.
A dependent with only earned income, such as wages, tips, and salaries,
must file a tax return only if his or her gross income is more than his or her
standard tax deduction amount.
If the taxpayer is in the process of a domestic U.S. adoption and doesnt
have or is unable to obtain the soon to be adopted child's Social Security
Number (SSN) then the taxpayer should request an Adoption Taxpayer
Identification Number (ATIN). An Adoption Credit of up to $13,190 is
allowed for the qualifying costs of adopting a child under the age of 18, or a
person who is physically or mentally incapable of self care.
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The table below shows the provisions of the Adoption Credit:


The provisions below are similar for the credit and the income exclusion (Employer
provided assistance program - excluded income in Form W-2, Box 12 as "T").
Adoption expenses incurred in 2001 and before, used to determine the credit in a tax
year after 2001, are subject to the 2001 dollar limitations.
Rules:
a) Qualifying adoption expenses are specifically defined.
b) The child must be under 18 or physically mentally incapable of caring for
himself.
c) A special needs child is defined
d) Married taxpayers must file Married Filing Jointly, with exceptions.
Tax Year
2006
2007
2008
2009
2010
2011
2012
2013
2014

Maximum Credit and Exclusion Per Child


Special Needs Child
All Others
$10,960
$10,960
$11,390
$11,390
$11,650
$11,650
$12,150
$12,150
$13,170
$13,170
$13,360
$13,360
$12,650
$12,650
$12,970
$12,970
$13,190
$13,190

Phaseout Range- Modified AGI for All Filers


2013
Phaseout begins
$194,580
Complete phaseout
$234,580

2014
$197,880
$237,880

For adoptions finalized after 2001, the credit and exclusion maybe used for qualified
expenses. The year 2014 maximum limit is $13,190 per child.
Additional provisions - 1) The credit is nonrefundable; 2) A 5 year carry forward of any
unused credit is available; 3) The MAGI phaseout limits do not apply to the carryover; 4)
The credit offsets both the regular and AMT tax
Special Needs Adoption Provision:
1. $13,190 is the deemed credit/exclusion regardless of whether the taxpayer has
qualifying expenses.
2. For tax years after 2001, the credit is available as paid with the deemed residual up to
the indexed maximum in the year the adoption is finalized.
3. For tax years after 2002, the exclusion is available only in the year of finalization of the
adoption.
Table: Adoption Credit

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ISSUES

Any unused Adoption Credit may be carried forward to future tax returns
for up to five years.
Expenses that qualify for the Adoption Credit are:

reasonable and necessary adoption fees


court costs
attorney's fees
other expenses directly related to, and whose principal purpose is
for, the legal adoption of an eligible child

In addition to an Adoption Credit, the tax law provides an Adoption


Assistance Exclusion from an employee's taxable income for up to $13,190
of employer provided adoption reimbursement for specified adoption
expenses incurred and paid pursuant to a written adoption assistance plan.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify your 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

23
Lesson 23 - Credit for the Elderly or
Disabled
In this lesson you'll learn about the credit for the elderly or the disabled. At the
end of this lesson you will be able to determine whether a taxpayer is a
qualified individual for the credit for the elderly or the disabled and apply the
income limits to the qualified individual.
The following topics are discussed in this lesson:
Who Qualifies for the Credit?
Personal Qualifications for
the Credit
Physician Statements
Sheltered Employment

Income Limits for the Credit


Taking the Credit
Medicare
Eldercare
Questions Taxpayers Ask

Lesson 24 Primer: College Planning


Tomorrows Lesson, Education Credits and Programs is a very long Lesson.
Therefore, we have included some important information regarding College
Planning in this Lesson.
How Much Does a College
Education Cost?
College Savings
Requirements Worksheet
Financial Aid Calendar

How to Improve Your Client's


Chances of Getting Financial
Aid...
Key College Planning
Websites

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ew taxpayers qualify for this credit. Even individuals who meet the
personal qualifications may not be eligible due to the income limits
on their non-taxable social security, veterans' benefits, or other
excludable pension, annuity, or disability benefits.

Personal Qualifications for the Credit


Elderly individuals and individuals who are permanently and totally disabled
may be able to claim a special credit on their tax returns if they are U.S.
citizens or residents.
To be eligible for the credit, an individual must either be at least 65 years
old by the end of the year; or meet all of the following conditions:

Be retired on permanent and total disability by the end of the year


Have not reached mandatory retirement age before this year
Have received taxable disability income for this year

Mandatory retirement age is the age set by a taxpayer's employer at which


the taxpayer would have been required to retire, had the taxpayer not
become disabled. Generally, disability income comes from an employer's
disability insurance, health plan, or pension plan. The payments replace
wages for the time the taxpayer missed work because of the disability. The
plan must provide for disability retirement for the payments to be
considered disability income.
The following questions determine an individual's eligibility:

Are you a U.S. citizen or resident?


o If no, you are not eligible for the credit.
o If yes, then:
Were you 65 or older at the end of the year?
o If yes, you may be eligible for the credit, depending on your
income.
o If no, then:
Are you retired on permanent and total disability?
o If no, you are not eligible for the credit.
o If yes, then:
Did you reach mandatory retirement age before this year?
o If yes, you are not eligible for the credit.
o If no, then:
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Did you receive taxable disability benefits this year?


o If no, you are not eligible for the credit.
o If yes, you may be eligible for the credit, depending on your
income.

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TAX QUOTE

"There's nothing wrong with the younger generation that becoming


taxpayers won't cure."
Dan Bennett

Physician Statements
Permanent and total disability means that:

The taxpayer cannot engage in any substantial, gainful activity


because of a physical or mental condition, and

A physician has determined that the disability has lasted or can be


expected to last continuously for at least a year or can lead to death

Although the Physician's Statement that proves a taxpayer's disability is no


longer required to be attached to the return, it must be completed and kept
with the taxpayer's records. The statement form is provided in the
instructions for Schedule R.
Substantial activity is work of a productive (not "busy-work") nature. Gainful
activity is work for which the individual is paid at a rate at or above the
minimum wage.

Sheltered Employment
Certain work offered at qualified locations to persons with disabilities or
with mental retardation is considered sheltered employment. A person's
participation in sheltered employment is not proof of the person's ability to
engage in substantial, gainful activity, and therefore does not disqualify the
person for the credit. Sheltered employment projects offer paid working
positions to people with physical or mental disabilities and who are unable
to take employment on the open market.

Income Limits for the Credit


Taxpayers who qualify for the credit cannot take the credit if they exceed
the income limits for their filing status. Use the table below to determine
eligibility.
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Nontaxable:
Social Security,
Pensions,
Retirement
Disability less
than:

and AGI less


than:

Single (HH or Qual. Widower) Age 65 or older,


or under age 65 and retired or disabled

$5,000

$17,500

Married Joint - Both spouses age 65 or over

$7,500

$25,000

Married Joint - Both spouses under age 65,


one spouse retired or disabled

$5,000

$20,000

Married Joint - Both spouses under age


65, both spouses retired or disabled

$7,500

$25,000

Married Joint - One spouse age 65 or older,


other spouse under age 65 and retired or
disabled

$7,500

$25,000

Married Joint - One spouse age 65 or older,


other spouse under age 65 and NOT retired or
disabled

$5,000

$20,000

Married Separate - live apart all year, age 65


or older, or under age 65 and retired or
disabled.

$3,750

$12,500

Filing Status

AGI is the adjusted gross income entered on Form 1040A line 21, or Form
1040 line 37.

Figure 23-1: The Adjusted Gross Income section of Form 1040 with line 37 "Adjusted
Gross Income" highlighted.

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Taking the Credit


To take the credit, complete Schedule R which carries over to Form 1040
line 54c.

Figure 23-2: The Tax and Credits section of Form 1040 with line 54c "Other credits from
Form:" highlighted.

TAX PLANNING TIP

Are there any planning techniques or legal documents elderly


taxpayers should consider?
Yes, elderly taxpayers may wish to consider the following planning
techniques and legal documents:

Joint bank account ownership with their children


Durable Power of Attorney for finances
Health care Power of Attorney
Living Will regarding life sustaining medical treatment for terminal
conditions

SIDE BAR

What is the difference between a living trust and a living will?


A living trust is used to manage property in the event of incapacitation. A
living trust is a revocable trust that a grantor creates while alive. Property
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is transferred to the trust and the grantor is the trustee. The


grantor/trustee manages the property. When the grantor/trustee
becomes incapacitated a successor trustee who was previously selected
by the grantor/trustee steps in and continues managing the property.
Advance Directives refer to a variety of documents you can use to state
your wishes in advance of becoming too ill or too injured to make them
known.
A living will is used to make health care decisions in the event of
incapacitation. A living will isnt really a will at all, although it is usually
drafted by an attorney at the time the attorney drafts the person's will. It
is merely a legal document that becomes effective when a person
becomes so ill they cannot make appropriate health care decisions on
their own. It allows them to accept or decline certain medical treatment in
advance. An example would be a living will that stated "Do Not
Resuscitate" even thought that could result in death.
Not all states allow living wills. In some states a durable power of attorney
for health care, health-care proxy, or a Do Not Resuscitate order (a
doctors order informing other medical personnel not to perform CPR) is
used to accomplish the same thing.
It's a good idea to plan ahead for the possibility of incapacitation because
if the taxpayer(s) don't a relative or friend will have to ask a probate court
to appoint a guardian.

Medicare
Medicare is a federal government program that provides health insurance
to retired individuals. In 1965 Congress enacted the Medicare program
which provides for the medical needs of persons aged 65 or older. Social
Security Amendments subsequently created the Medicaid program which
provides medical assistance for people with low incomes and resources. In
1972 benefits were indexed for the cost of living.
What is covered by Medicare?
Medicare consists of four parts:

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Part A - Hospital Insurance: covers services performed for inpatient


hospital care, including charges for a hospital room, meals, and
nursing services in hospitals, skilled nursing facilities and psychiatric
hospitals, hospices, and home health care.

Part B - Medical Insurance: covers physician care, both inpatient, and


outpatient at a hospital, health-care facility, or doctor's office.
Laboratory tests, physical therapy, and ambulance services are also
covered.

Part C - Medicare Advantage: beneficiaries have the option to


receive their Medicare benefits through private health insurance
plans and health maintenance organizations (HMOs) instead of
through Medicare Parts A and B. These private health insurance
plans are required to offer benefits at least as good as Medicare
Parts A and B and must cover everything Medicare covers. However,
they do not have to cover every benefit in the same way. Private
health insurance plans use some of the excess payments they receive
from the federal government for each enrollee to offer supplemental
benefits.

Part D - Prescription Drug Coverage: beneficiaries can join a


Medicare prescription drug plan offered by insurers that are
approved by Medicare. These prescription drug plans vary in price
and benefits. Medicare Part D participation is voluntary.

How do taxpayers enroll in Medicare?


Individuals receiving Social Security monthly retirement benefits are
automatically enrolled in Parts A and B at age 65. They receive an
enrollment package by mail from the Social Security Administration three
months before their 65th birthday. Taxpayers not receiving Social Security
monthly benefits are automatically enrolled when they apply for benefits at
age 65. Taxpayers who decide to delay retirement must remember to enroll
in Parts A and B at age 65 because their enrollment won't be automatic.
Medigap Insurance
Medicare often doesnt cover all health care costs during retirement. Some
taxpayers purchase supplemental medical insurance policies sold by private
insurance companies known as Medigap policies. Medigap policies cover
costs not paid by Medicare.
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What's does Medigap insurance typically cover?


Under federal law, 12 standardized plans can be offered as Medigap
insurance. Massachusetts, Minnesota, and Wisconsin have their own
standardized plans. Each Medigap policy is identified with the letters A
through L. Plan A offers basic benefits and Plan J offers the most advanced
coverage. All plans cover the Medicare coinsurance amounts. Plans B
through J also offer some other benefits including coverage for Medicare
Parts A and B deductibles and preventive medical care. Plans K and L
provide protection against catastrophic expenses.
Medicaid
Medicaid provides full or partial coverage for low income adults and
children and people with certain disabilities including the following:

Inpatient and outpatient hospital care


Prescription drugs
Skilled care
Nursing home care
Transportation to medical treatments

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The table below shows Medicare Facts:


Medicare health insurance covers persons age 65 or older, certain disabled persons
under age 65, and End Stage Renal Disease patients.
Medicare has several parts:
Part A - Hospital Insurance which covers hospital, hospice, skilled nursing facility and
some home health care. Premium costs are based on quarters of Medicare covered
wages, as detailed in the table below:
Quarters of
Covered Wages
2014
2015
Under 30 quarters
$426 per month
$426 per month
30-39 quarters
$234 per month
$234 per month
40 or more quarters
No Cost
No Cost
Part B - Medical insurance which covers doctor, outpatient, physical and occupational
therapists and some home health care. 2014 Premium costs are based on Filing Status
and income, as detailed in the table below:
Married Filing
Married Filing
Single
Joint
Sep.
Premium
Prescriptions
$85,000 or less

$170,000 or less $85,000 or less


$170,001$85,001-$107,000
$214,000
$214,001$107,001-$160,000
$320,000
$320,001$85,001$160,001-$214,000
$428,000
$129,000
over $214,000
over $428,000
over $129,000

$104.90
$146.90

$12.30

$209.80

$31.80

$272.70

$51.30

$335.70

$70.80

Medicare Prescription Drug - Coverage is offered through private insurance companies.


Plans will vary based on state of residency, drugs covered, and premium cost. The next
enrollment period begins November 15, 2015.
Table: Medicare Facts

You can learn more about Medicare by obtaining a copy of Medicare &
You, the official U.S. Government Medicare Handbook. You can also obtain
additional information at the Medicare website, www.medicare.gov, or by
calling Medicare at 1-800-Medicare.

SIDE BAR

Popular Misconceptions About Medicare


There are two popular misconceptions that workers have about Medicare
that you should be aware of.
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The first is that Medicare pays 100% of the medical expenses for retired
people. As you just learned that is not the case. Often people enrolling in
Medicare are shocked to learn that it doesnt pay all of their medical
expenses. It never did. Medicare is a patch work of premiums,
deductibles, co-insurance payments, and medical expenses that simply
are not covered by the program. Typically Medicare Parts A & B pay up
to 80% of a participant's covered medical expenses.
One of the biggest drains on retirement savings is health care costs.
Medicare pays for just over half of the total health care expenses a typical
elderly person faces, according to the Employee Benefit Research
Institute. A couple who is 65 today will need nearly $270,000 to pay for
those uncovered health care expenses.
The second misconception is the "I paid my dues" misconception.
Workers saw Medicare taxes being withheld from their paychecks
throughout their working lives and thus believed they were "paying their
dues". They think, quite logically, that the amount being withheld from
their paychecks will be sufficient to cover their medical expenses in
retirement. However, the truth of the matter is, workers didnt "pay their
dues", or at least not the entire amount of their dues, regardless of how
much money they earned or how much tax they paid over the years.
Lets do the math. Tom, who was born in 1950, is retiring and enrolling in
Medicare today after working and paying Medicare tax for 49 years. Let's
assume Tom is an average guy and he earns an annual income of
$50,000 per year. Wages were much lower 49 years ago and Medicare
didn't tax all wages until 1994. See the table below. For the sake of this
example let's assume that Tom earned the Maximum Annual Covered
Earnings for Medicare until his income reached $50,000 a year. At that
point his income "topped out" at $50,000 a year.
The total Medicare tax rate today is 2.9%. Both the employee and the
employer pay 1.45%. But that wasn't the case years ago. In 1966, the year
that the Medicare program commenced, both the employee and the
employer paid 0.35% - for a total Medicare tax rate of 0.7%. To see the
Social Security and Medicare tax rates since the inception of the
programs click here.
So how much did Tom and his employer pay in Medicare tax? To find out
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see our paper Medicare Taxes Paid For An Average Employee Retiring
Today in Appendix P or by clicking here.
The $50,733 that Tom and his employer paid in Medicare tax over his
entire working lifetime wouldn't even cover the cost of one major
operation today. And yet Tom will probably live to be 86 years old and
receive medical care for the next 20 years.
Add to that the rising cost of health care and all of the new procedures,
medicines, and operations (think heart bypasses and transplants) that
weren't around when Medicare was enacted in 1965 and it's no wonder
that the Medicare system is heading for major financial trouble.

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

706

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

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Year
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

FOR

THE

ELDERLY

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
$106,800
$106,800
$110,100
$113,700
$117,000
$118,500

OR

DISABLED

Medicare Maximum
Annual Covered Earnings

Unlimited

TAX QUOTE

"I love America, but I can't spend the whole year here. I can't afford the
taxes."
Mick Jagger

Eldercare
There are a number of web sites dedicated to Eldercare. Some of the best
are below.
U.S. Department of Health & Human Services - Administration on Aging
offers a variety of information and materials for elders, their families, and
professionals about medical, care giving, housing, and services for senior
citizens.

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U.S. Department of Health & Human Services - Eldercare Locator - puts you
in touch with a local organization which recommends home health care
aides.
ElderWeb offers many resources for the elderly and their caregivers on
financial matters, health care, living arrangements, and social, mental, and
legal issues.
Leading Age - publishes free brochures on how to choose a nursing home
or assisted-living facility, a directory of continuing care retirement
communities, and information on long term care insurance.
Family Caregiver Alliance - offers newsletters, information on caregiver
concerns, and an online support group.
The National Alliance for Caregiving - offers information on eldercare
conferences, books, tips for caregivers, and training for professionals.
The National Association of Area Agencies on Aging - is an advocacy group
for local aging agencies.

TAX PRACTICE TIP

Missing Form W-2?


Is your client missing Form W-2? As you know, Form W-2 is essential to
filling out most individual tax returns. Employers have until January 31st
to provide or send Forms W-2 earnings statements either electronically or
in paper form. Taxpayers should allow two weeks to receive W-2s from
employers who send them by mail.
If your client does not receive his Form W-2, he must contact his
employer to inquire if and when the W-2 was mailed. If it was mailed, it
may have been returned to the employer because of an incorrect or
incomplete address. After contacting the employer, he should allow a
reasonable amount of time for the employer to resend or to issue the W2.
If your client still does not receive his W-2 by February 15th he should
contact the IRS for assistance at 800-829-1040. He should have the
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following information ready when he calls:

The employer's name, address, city, state, and zip code.

His name, address, city, state, zip code, and Social Security
number, and

An estimate of the wages he earned, the federal income tax


withheld, and the period he worked for that employer. The
estimate should be based on year-to-date information from his
final pay stub.

If your client misplaced the W-2 he should contact his employer. The
employer can replace the lost W-2 with a "reissued statement." The
employer is allowed to charge a fee for providing a new W-2.
Your client must still file his tax return on time even if he does not receive
Form W-2. If he does not receive the missing information in time to file,
you may use 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. Attach
Form 4852 to the return, estimating income and withholding taxes as
accurately as possible. You can use his final paystub to estimate the
amounts. There may be a delay in any refund due while the information is
verified by the IRS.
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. 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
Form 4852 is completed in accordance with the rules of that form. The IRS
DOES NOT allow Form 4852 to be filed until AFTER February 15th. E-filing
returns without W-2's will result in your termination from the IRS e-file
program.
On occasion your client may receive conflicting documents. He may
receive another Form W-2 or W-2C (corrected Form W-2) after you filed
his return using Form 4852, and the information differs from what you
reported on the return. If this happens, you must amend his return by
filing a Form 1040X - Amended U.S. Individual Income Tax Return. Dont
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forget to amend his state tax return too.

SIDE BAR

What are ABLE Accounts?


ABLE Accounts are tax-favored accounts for people with disabilities who
became disabled before his or her 26th birthday. The Achieving a Better
Life Experience (ABLE) account provision was signed into law in
December 2014. Recognizing the special financial burdens faced by
families raising children with disabilities, ABLE accounts are designed to
enable people with disabilities and their families to save for and pay for
disability-related expenses.
The new law authorizes any state to offer its residents the option of
setting up an ABLE account. Alternatively, a state may contract with
another state that offers such accounts. The account owner and
designated beneficiary of the account is the disabled individual. In
general, a designated beneficiary can have only one ABLE account at a
time.
Contributions up to the annual gift tax exclusion amount, currently
$14,000, can be made to an ABLE account annually, and distributions are
tax-free if used to pay qualified disability expenses. These are expenses
that relate to the designated beneficiarys blindness or disability and help
that person maintain or improve health, independence and quality of life.
They can include housing, education, transportation, health, prevention
and wellness, employment training and support, assistive technology and
personal support services and other expenses.
An ABLE account is not counted in determining the designated
beneficiarys eligibility for many federal means-tested programs, or in
determining the amount of any benefit or assistance provided under
those programs, although special rules and limits apply for Supplemental
Security Income (SSI) purposes.
The IRS has developed two new forms that ABLE account programs will
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use to report relevant account information to designated beneficiaries


and the IRS each year - Form 5498-QA for Contributions and Form 1099QA for Distributions.

Lesson Summary
Lets take a moment to review what you have covered in this lesson.
The credit for the elderly or the disabled is a nonrefundable credit which
allows taxpayers to reduce their tax liability.
Elderly individuals and individuals who are permanently and totally disabled
may be able to claim a special credit on their tax returns if they are U.S.
citizens or residents. However, qualified individuals cannot take the credit if
they exceed the income limits for their filing status. Due to the income
limitations, very few taxpayers are eligible to receive this credit.
The credit is based on filing status, age, and income. The credit is calculated
and reported on Form 1040 Schedule R, or Form 1040A Schedule 3.

Questions Taxpayers Ask...


Question: "Do I have to pay tax on a lump sum payment for cancellation
of employment?"
Answer: Yes. The lump sum payment is taxable income in the tax year
you receive it and must be reported with your other salary and wages.
This is true even if the payment was received (by suit or agreement) as
settlement under the Age Discrimination in Employment Act.
Question: "Do I have to pay tax on fees I received as an election
precinct official?"
Answer: Fees you receive for services as an election precinct official are
taxable income and you must include them on your tax return. Include
them in your gross income.
Question: "Do I have to pay tax on advance commissions?"
Answer: It is common, especially in the insurance industry, for agents to
receive advance commissions even though the premiums for the
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underlying policy haven't been paid by the policyholder yet. If you


receive advance commissions or other amounts for services to be
performed in the future, and you are a cash method taxpayer, you must
include these amounts as taxable income in the tax year received.
If you repay advance commissions or other amounts in the same tax year in
which you received them, you reduce the amount you include on your tax
return by the advance commissions repaid. The payer should report your
earnings this way.
However, if you repay the advance commissions or other amounts in a later
year, you can deduct the repayment on line 28 of Schedule A as a
miscellaneous itemized tax deduction.

Figure 23-3: The Other Miscellaneous Deductions section (line 28) of Form 1040
Schedule A - Itemized Deductions.

If the advance commissions repayment exceeds $3,000 it is not subject to


the 2% AGI floor. Because the tax law is not clear on whether amounts of
$3,000 or less are subject to the 2% AGI floor, if your advance commissions
repayment is $3,000 or less you should claim a credit against your prior tax
return by filing Form 1040X - Amended Tax Return for the prior tax year.
Question: "Do I have to pay tax on my bonus or award?"
Answer: Generally, a bonus or award paid to you for outstanding work is
taxable income shown on your Form W-2 that you must report on your tax
return.
Question: "Do I have to pay tax on a prize or award?"
Answer: If you win a prize or award in a lucky number drawing, television or
radio quiz program, beauty contest, or other event, you must include its fair
market value in your taxable income. For example, if you win a $50 prize or
award in a photography contest, you must report this taxable income on
line 21 of Form 1040.

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Figure 23-4: The Income section of Form 1040 with line 21 "Other income"
highlighted.

However, if your award or prize meets all of the following four tests it is not
taxable:

it is in recognition of religious, charitable, scientific, educational,


artistic, literary, or civic achievement

you do not have to perform any services

you were selected without any action on your part

you assign the prize or award to a government unit or tax exempt


charitable organization prior to your use of, or receipt of benefits
from, the award. You can't claim a charitable deduction for the
assignment.

If you receive merchandise for a prize or award, you must report the fair
market value of the prize or award as taxable income.
If you refuse to accept a prize or award, do not include it in taxable income.
Question: "Do I have to pay tax on my bartering income?"
Answer: Bartering income occurs when you exchange goods or services
without exchanging money; or the full amount of money. The goods or
services exchanged have a dollar or fair market value, and this value must
be included in the income of both parties as bartering income.

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If you exchanged goods or services through a barter exchange you'll receive


a Form 1099-B from the exchange for the bartering income that you must
report on your tax return.

Figure 23-5: Form 1099-B - Proceeds From Broker and Barter Exchange Transactions.

Question: "Do I have to pay tax on my back pay award?"


Answer: Court awards or settlements are generally taxable unless they are
compensation for a personal injury. Damages received after August 20,
1996 are tax free only if they are paid for physical injury or sickness.
Amounts you are awarded in a settlement or judgment for back pay,
including unpaid life insurance premiums and unpaid health insurance
premiums, must be included in your income.
They should be reported to you by your employer as taxable income on
Form W-2.

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TAX PRACTICE TIP

Professional Liability Insurance


In most states tax preparers are not required to carry professional liability
insurance, although you should if you prepare tax returns with large tax
liabilities (especially estate tax returns). Generally, you wont be preparing
those types of returns until you have been in the business for several
years. Provided youve prepared the tax return honestly, the worst that
would usually happen if you make an honest mistake is that you'd have
to pay a preparer penalty to the IRS. The taxpayer himself is responsible
for any tax liability and any taxpayer penalties and interest. The taxpayer
may ask you to pay the penalties and interest.
Most tax preparers do not carry professional liability insurance, but they
probably should. Many CPAs do. The foregoing is provided in the event
that you would like to carry professional liability insurance. We DO
recommend that you carry it.
EZ Insurance Solutions provides tax, accounting, and bookkeeping
services with professional liability insurance. Most of their insured's are
sole practitioners and small to mid-sized businesses. EZ Insurance
Solutions specializes in offering business insurance products designed
especially for tax preparers.
The basic policy includes coverage for the following services:

Tax return preparation


Client representation before the IRS or any governmental taxing
authority
Tax advice
Bookkeeping
Payroll processing
Notary Public
Data processing
Computer hardware/software recommendation, installation, client
training.

They offer a range of liability limits that provide limit of liability options
that include both a per claim limit and a higher annual aggregate limit.
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Liability limits available are:

$100,000/$250,000
$250,000/$500,000
$500,000/$1,000,000
$1,000,000/$2,000,000

Two annual aggregate deductibles are available: $500 and $1,000. One or
more of the CNA Insurance Companies provides the underlying
coverage. For further information visit: http://www.ezinssolutions.com/

Lesson 24 Primer: College Planning


How Much Does a College Education Cost?
With higher education costs climbing steadily upward nearly 6% per year
many families are particularly concerned about accumulating enough
money to put their children through college. College cost projections are
continually increasing. Based on the latest averages from The College Board
and recent average annual college cost increases, a child who entered
kindergarten in 2002 will face four-year college costs of $82,868 if he or
she chooses to attend a public college in 2015. For a private college, costs
will be $185,567.
The average annual cost of attending a four-year private university is
now $46,392 ($185,567 / 4), triple the price tag 25 years ago in 1990,
and the equivalent, after taxes are taken out, of almost a year's income
for a median household today. Even public schools now cost students
$20,717 ($82,868 / 4) per year on average, a more than 100 percent
increase over the last 25 years.

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The table below shows the projected cost of a college education:

Years Until
Child Starts
College
0
1
2
3
4
5
6
7
8
9

Projected Cost of
a 4-Year Education
Public
Private
$82,868
$185,567
$87,840
$196,701
$93,110
$208,503
$98,697
$221,013
$104,619
$234,274
$110,896
$248,331
$117,550
$263,230
$124,603
$279,024
$132,079
$295,766
$140,004
$313,512

Years Until
Child Starts
College
10
11
12
13
14
15
16
17
18
19

Projected Cost of
a 4-Year Education
Public
Private
$148,404
$332,322
$157,308
$352,262
$166,747
$373,397
$176,751
$395,801
$187,357
$419,549
$198,598
$444,722
$210,514
$471,405
$223,145
$499,690
$236,533
$529,671
$250,725
$561,451

Starting average cost is based on The College Board's Annual Survey of Colleges for the
2014-2015 school year. The Annual Survey of Colleges is a Web-based survey of nearly
4,000 accredited undergraduate colleges and universities in the U.S. The survey collects
information of use to high school students, parents, and school counselors about the
characteristics of each college including programs, costs, application requirements, and
deadlines.It includes tuition, fees, and room and board; but not transportation, books, or
other expenses. The figures do not account for any financial aid or other assistance. The
table assumes 6% annual increases in education costs.
Table: Projected Cost of a College Education

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College Savings Requirements Worksheet


The table below shows how to calculate how much money must be
saved for a college education:
1
Age
of
Student

2
Years
Until
College

3
Total
Estimated
Cost

4
Less:
Current
Savings

5
Less:
Financial /
Tax Aid

6
Equals:
Required
Savings

7
Annual
Savings
Required

How to use:
1. Age of Student - Enter the age of the student.
2. Years Until College - Enter the number of years until the first year of college.
3. Total Estimated Cost - Estimate the cost of college for four years and multiply the cost
times the factor below to adjust it for a 6% inflation rate.
Years Until
Cost
Years Until
Cost
Years Until
Cost
College
Factor
College
Factor
College
Factor
5
1.338
10
1.791
15
2.397
6
1.419
11
1.898
16
2.54
7
1.504
12
2.012
17
2.693
8
1.594
13
2.133
18
2.854
9
1.689
14
2.261
19
3.026
4. Current Savings - Take the current savings you have available times the same factor
above to assume savings will grow at the same rate as the costs.
5. Financial / Tax Aid - 50% of all students receive some form of scholarship, grant or
loan. You may wish to estimate that some of the cost will be handled this way. Also
include any Tax Aid (incentives).
6. Required Savings - This equals Total Estimated Cost (3) minus Current Savings (4)
minus Financial / Tax Aid (5).
7. Annual Savings Required - This equals Required Savings (6) divided by number of
Years Until College (2). This amount is in future dollars. The actual amount needed can
be reduced to account for any interest or gains in savings.
Table: College Savings Requirements Worksheet

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Financial Aid Calendar


Use the calendar below to advise your clients of the timing required for
their high school age children to keep on track for their first year in
college.
Pre-Senior Year

Visit Schools
Target scholarships and note deadlines
Position financial affairs for Free Application for Federal Student
Aid (FAFSA)
Conduct college financial planning review

September thru November: Senior Year

SAT/ACT preparation
Develop a calendar of deadlines for specific schools
If your clients are looking for early decisions from specific schools,
make sure all financial aid materials are sent to those schools
Fill out College Applications
Collect financial aid information from specific schools
Establish and revise tax strategy for while in college

December

Review the federal loan process


Set up FAFSA PIN if filing application on line
Start filling out and filing all applications
Review and pre-fill out FAFSA application
Collect and organize tax return information

January through March

File FAFSA application as soon as possible


Review financial aid programs
Continue filing applications
Follow up on any applications to ensure receipt

April through June

Acceptance and award packages received


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Determine the best aid packages


Ask for more aid from school if required
Identify other financial needs while at school (food, transportation,
etc.)
Select school
Shop for financial aid (talk to banks)

SIDE BAR

What are the different college financial aid programs?


The three major federal college financial aid programs are the Stafford,
Perkins, and PLUS Loan programs. College financial aid options include
the following:

College Work Study Programs - which provide employment to


students who have proven financial need.

Parent Loans for Undergraduate Students (PLUS) - which are


available to parents of dependent undergraduate students.

Pell Grants - which are awarded based solely on financial need.

Perkins Loans - which are made by the college or university to


qualifying students in need. Repayments are deferred until after
graduation.

Stafford Student Loans - which offer low interest rates and


deferred payment until after graduation.

Supplement Education Opportunity Grants - which provide


additional money to students in need who have already been
awarded financial assistance.

How to Improve Your Client's Chances of Getting Financial


Aid...
All federally funded college financial aid programs use a formula to
determine how much money a parent(s) must contribute toward a child's
education expenses before being eligible for college financial aid. This
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percentage is the Expected Family Contribution (EFC). The difference


between the EFC and the cost of the child's college education equals the
child's financial need. The greater the EFC the lower the child's financial
need and the less aid the child will get.
The EFC is a percentage of the parent(s) income and assets in the calendar
year (base year) before the year that the child applies for aid. Lowering the
parent(s) income and assets in the base year lowers the EFC and increases
the child's eligibility for financial aid.
The Free Application for Federal Student Aid (FAFSA) is the starting point for
determining eligibility for financial aid. Understanding this process will help
you to provide college planning assistance to your clients. Note that a
parent's assets are expected to be used less than the student's assets. See
the table below:
Parent's Contributions:

47% of a parent's income is assumed to be used as a payment for


college.

5.6% of a parent's assets are expected to be contributed.

Student's Contributions:

50% of student's income above $3,750 is expected to be used as a


payment for college.

35% of a student's assets are expected to be contributed.

FAFSA is a snapshot of your client's financial condition at a moment in


time. Lowering the parent(s) income and assets in the base year will
increase financial aid eligibility. Some ways to improve the chances of
receiving Student Financial Aid include the following:
13 Planning Guidelines for Parent's:
1. Sell stock early. Time the selling of stock saved for college to keep
capital gains out of the FAFSA base reporting year.
2. Sell losing stocks. Selling in the base year lowers income. Avoid
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selling stocks that will incur a capital gain in the base year.
3. Pay down credit card debt. It trims cash assets in the formula, saves
interest, and credit card debt does not count in the FAFSA
application.
4. Pay down your home mortgage. Home equity is not assessed by
FAFSA (it can be for private schools, however). Plus paying down
the mortgage reduces cash.
5. Contribute the maximum to retirement savings. It reduces income
and non-current year retirement funds are excluded from the
FAFSA calculation.
6. Don't take pension distributions. Avoid pension plan and IRA
distributions in the base year.
7. Deplete cash. Cash is counted against your client in the FAFSA
calculation. Deplete cash for planned purchases. But remember
your clients will still need assets to pay for their portion of the
payment for college.
8. Pay federal and state income taxes. Do this during the base year as
this reduces available cash.
9. Make large cash purchases. This will deplete available cash in the
base year.
10. Pay medical bills. Medical bills in the FAFSA reporting year are a
reduction in the income calculation.
11. Defer employment bonuses. Take them after December 31st.
12. Buy annuities. They are excluded from the FAFSA calculation.
13. Buy cash value life insurance. It's excluded from the FAFSA
calculation.
Planning Guidelines for Student's:
1. Delay gifts. Have planned college financial gifts given after the
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FAFSA application OR have the gifts paid directly to the school.


2. UGMA management. An UGMA (Uniform Gifts to Minors Act)
account should be managed to reduce the balance in the year
PRIOR to the FAFSA filing. Remember assets in the child's name are
more heavily weighted than the parent's assets.
3. The more the merrier. The more students in college with 6 credits
or more, the better the application will look for this student.

TAX PLANNING TIP

Can an UGMA or UTMA account lower a child's college financial aid?


Yes, an UGMA or UTMA account could entitle a child to less financial aid,
as can any asset owned by the child. Under the current financial aid
formula children must contribute 35% of their assets to college costs
each year before becoming eligible for financial aid.
Key College Planning Websites
Website

What is it?

What's there?

http://www.collegeboard.com

The College
Board is a nonprofit group
made up of
participating
schools.
U.S.
Department of
Education Free
Application for
Federal
Student Aid.

Tools for
college. Great
place to send
clients for more
information.

http://www.fafsa.ed.gov

http://ifap.ed.gov/IFAPWebApp/index.jsp U.S.
Department of
Education information for
financial aid
professionals

723

The required
application
necessary to
determine how
much financial
aid the student
is eligible to
receive.
Information on
the federal
calculation for
determining
amounts of
student aid.

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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. To view Part I see
Appendix F or click 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. To view Part II see Appendix G or click here.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify your 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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EDUCATION

CREDITS

AND

PROGRAMS

Lesson

24
Lesson 24 - Education Credits and
Programs
In this lesson you'll learn about the general rules that apply to both the
American Opportunity Credit and the Lifetime Learning Credit, two education
credits that are available to taxpayers who pay expenses for higher education.
You'll also learn about other tax-favored education benefits, such as Qualified
Tuition Programs (QTP's) and Coverdell Educational Savings Accounts (ESA's).
After completing this lesson, you will be able to:
Explain the American Opportunity Credit
Explain the Lifetime Learning Credit
Explain the general rules of eligibility for both education credits
Define "qualified expenses"
Apply the general rules for determining when taxpayers are eligible for
the American Opportunity Credit
Apply the general rules for determining when taxpayers are eligible for
the Lifetime Learning Credit
Define a "double benefit"

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The following topics are discussed in this lesson:


American Opportunity Credit
Eligible Student
Eligible Educational
Institution
Income Requirements
Modified Adjusted Gross
Income (MAGI)
Tuition and Fees
Related Expenses
Non-qualifying Expenses
Non-credit Courses
Prepaid Expenses
Payments with Borrowed
Funds
Expenses Paid by Others
What Is the American
Opportunity Credit?

Figuring the American


Opportunity Credit
What Is the Lifetime Learning
Credit?
Differences between the Two
Education Credits
No Double Benefits
Adjustments to Qualified
Expenses
Refunds
Qualified Tuition Programs
(QTPs) (Section 529 Plans)
Coverdell ESAs
Excludable U.S. Savings Bond
Interest
Educational Assistance Plans
Work Related Education
Expenses

he American Recovery and Reinvestment Act of 2009 enhanced the


existing Hope Credit in amount (from a maximum $1,800 to $2,500
per year) in scope (extending it to all four years of college and adding
course materials to qualifying expenses), and in minimum phase-out level
(to $80,000/$160,000 for joint filers). The new law renames the Hope
Credit the American Opportunity Credit and makes 40 percent of the
credit refundable. Under the new law, the maximum $2,500 per year would
be allowed on $4,000 in qualifying payments (100 percent of the first $2,000
and 25 percent of the next $2,000).

The Credits
Taxpayers who paid higher education expenses during the year for an
eligible student can generally claim an education credit, either the American
Opportunity Credit or the Lifetime Learning Credit, if they meet the general
requirements. They cannot claim both credits for the same student. The
Lifetime Learning Credit is non-refundable. Both credits can be claimed on
either Form 1040 or Form 1040A.
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Higher education refers to education beyond the high school level. Higher
education is also called "post-secondary education."
The American Opportunity Credit allows taxpayers to claim up to $2,500 for
qualified tuition and related expenses paid for each eligible student per tax
return, i.e. one (1) credit of up to $2,500 for each student on a tax return.
The Lifetime Learning Credit allows taxpayers to claim a maximum of
$2,000 for qualified tuition and related expenses paid for all other eligible
students listed on a tax return, i.e. only one (1) $2,000 credit is allowed per
tax return.
To be eligible for either of the education credits, taxpayers must:

Use any filing status other than Married Filing Separately

Have paid qualified tuition and related expenses for an eligible


student to an eligible education institution

Have a modified adjusted gross income (AGI) of less than $64,000


($128,000 if married filing jointly) for the Lifetime Learning Credit

Have a modified adjusted gross income (AGI) of less than $90,000


($180,000 if married filing jointly) for the American Opportunity
Credit

Form 8863 - Education Credits (American Opportunity, American


Opportunity, and Lifetime Learning Credits) is used to figure each credit, and
will be discussed in this lesson.

TAX QUOTE

"It's income tax time again, Americans: time to gather up those receipts, get
out those tax forms, sharpen up that pencil, and stab yourself in the aorta."
Dave Barry

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CREDITS

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PROGRAMS

The table below shows the Education Programs, Credits, and Benefits:
Name
Duration
American
4 years Post
Opportunity Credit Secondary

Lifetime Learning
Credit

Post Secondary

Coverdell ESA

Secondary, Post
Secondary,
Elementary

Student
Post Secondary
programs
Loan Interest
QTP (QSTP & 529s) State Programs Post Secondary

EE Savings Bonds Post Secondary

Tuition & Fees


Deduction

Post Secondary

Amount
Covered Expense
$2,500 per yr. per
Tuition, Fees, Books
student. (100% of the and supplies paid to
1st $2,000, 25% of
school. No room and
the next $2,000).
board.
40% of the credit is
refundable.
$2,000 for each
Tuition, Fees, Books
taxpayer and
and supplies paid to
dependent. 20% of
school. No room and
expenses.
board.
$2,000 per student
Tuition, Fees, Books,
per year.
Supplies, Equipment
Contributions are non- and Room and
deductible. Earnings Board. Must be
accrue tax free.
enrolled 1/2 the time.
$2,500 per year.

Qualified student loan


interest.

$14,000 - Same as
Gift Tax. Contributions are nondeductible. Earnings
accrue tax free if
used for college. Gift
taxes apply.
Unlimited interest
exclusion.

Tuition, Fees, some


Supplies and some
Room and Board

$4,000 per year.

Qualified Tuition and


Fees. Not room and
board.

Tuition and Fees. Not


Books and supplies.
Not room and board.

Table: Education Credits and Benefits

American Opportunity Credit Eligible


Student
To qualify for the credit, a taxpayer must have paid qualified tuition and
related expenses for an eligible student. The eligible student could be:

The taxpayer
The taxpayer's spouse
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EDUCATION

CREDITS

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The taxpayer's dependent for whom the taxpayer claims an


exemption on his or her tax return
In some circumstances the student may claim the education credit. If the
eligible student is the taxpayer's dependent, but the taxpayer does not
claim the dependency exemption, the student can claim the credit. Either
the taxpayer or the dependent, but not both, can claim an education credit
for that dependent's higher education expenses.

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Eligible Educational Institution


To claim an education credit, taxpayers must also have paid the higher
education expenses to an eligible educational institution. These are
generally any accredited post-secondary institutions eligible to participate in
the student aid programs administered by the Department of Education.
This includes public, nonprofit, or private (proprietary) institutions. Most
universities and colleges, including community colleges, meet these
requirements.

Income Requirements
Taxpayers must also meet income requirements to claim either the
American Opportunity or Lifetime Learning Credit. Taxpayers whose
modified AGI is $64,000 or more ($128,000 or more if married filing jointly)
are not eligible to take the Lifetime Learning Credit. Taxpayers whose
modified AGI is $90,000 or more ($180,000 or more if married filing jointly)
are not eligible to take the American Opportunity Credit.
The table below shows the phase-out ranges for various deductions,
exemptions, and credits. They begin to phase-out at the lower amount,
and are completely phased out at the higher amount. Thus, once the
higher amount is reached there is no tax benefit to that item.

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CREDITS

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PROGRAMS

Married filing Joint/


Qualifying Widower

Single or Head of
Household

Married filing
Separately

$197,880-$237,880

$197,880-$237,880

No Credit

$160,000-$180,000

$80,000-$90,000

No Credit

$156,500-$484,900

$117,300-$328,500

$78,250-$242,450

$110,000-$130,000

$75,000-$95,000

$55,000-$75,000

$190,000-$220,000

$95,000-$110,000

$95,000-$110,000

$15,000-$43,000

No Credit

$7,500-$17,500

$5,000-$12,500

$60,000-$70,000

$0-$10,000

$254,200 (s)
$279,650 (hoh)

$152,525

$54,000-$64,000

No Credit

Passive Activity Loss $100,000-$150,000

$100,000-$150,000

$50,000-$75,000

Personal Exemptions $305,050-$427,550

$254,200-$376,700 $152,525-$213,775

Retirement Savings
Credit

No limit

$18,000-$30,000 (s)
$27,000-$45,000
No limit

$181,000-$191,000

$114,000-$129,000

$0-$10,000

$113,950-$143,950

$76,000-$91,000

No Exclusion

$130,000-$160,000

$65,000-$80,000

No Deduction

$130,000-$160,000

$65,000-$80,000

No Deduction

$17,500

$17,500

$17,500

Benefit
Adoption Credit /
Exclusion
American
Opportunity Credit
AMT Exemption (1)
Child Tax Credit (1
child)
Coverdell ESA

Dependent Care
$15,000-$43,000
Credit
Elderly/Disabled
$10,000-$20,000
Credit
(if both eligible)
$10,000-$25,000
IRA Income Limit
$96,000-$116,000
with Pension
Itemized Deductions,
$305,050 +
beginning at
Lifetime Learning
$108,000-$128,000
Credit

Rollover to Roth IRA


Roth IRA Income
Limit
Savings Bond
Interest
Student Loan
Interest Ded.
Tuition & Fees
Deduction
401(k)/403(b)
Elective Def. (2)

$36,000-$60,000

(1) Phaseout applies to AMT income rather than AGI.


(2) Add $5,500 if age 50 or over.
Table: AGI Phase-out Ranges

731

$18,000-$30,000
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Modified Adjusted Gross Income (MAGI)


For most taxpayers, MAGI is the adjusted gross income AGI as figured on
their federal income tax return. On Form 1040A MAGI is the AGI on line 22.
On Form 1040 MAGI is the AGI on line 37, modified by adding back any:

Foreign earned income exclusion


Foreign housing exclusion
Exclusion of income for bona fide residents of American Samoa
Exclusion of income from Puerto Rico

Figure 24-1: The Adjusted Gross Income section of Form 1040 with line 37 "Adjusted
Gross Income" highlighted.

TAX TIP

Who should claim the education tax credit?


The tax law provides flexibility in allowing either the parent who pays the
tuition to claim the education tax credit or letting the student claim it. The
reason why this becomes an important choice is because of the Modified
Adjusted Gross Income limits that apply for the education tax credits.
These limits may preclude high income parents from taking the credit at
all, because it will be phased-out.
Provided the parent's credit would be phased-out, and the student
cannot be claimed as a dependent on the parents tax return (or the
parent waives the dependency exemption), the student should claim the
credit; provided however that the student has sufficient income to have a
tax liability for the credit to offset. This will avoid the phase-out that the
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higher income parent would incur.

Tuition and Fees


To qualify for the American Opportunity or Lifetime Learning Credit,
taxpayers must have paid higher education expenses that qualify as tuition
and related expenses. Tuition expenses are tuition and fees required for
enrollment or attendance at an eligible educational institution.
Related Expenses
Related expenses can include fees for:

Course-related books
Course-related supplies and equipment
Student activities

Related expenses are considered a qualifying expense only if the fees must
be paid to the institution as a condition of enrollment or attendance.
Non-qualifying Expenses
Qualified tuition and related expenses do not include the cost of:

Course-related books, supplies, activity fees and equipment that do


not have to be purchased as condition of enrollment

Insurance

Medical expenses including student health fees

Room and board

Transportation or similar personal, living, or family expenses even if


the fees must be paid to the institution as a condition of enrollment
or attendance

Non-credit Courses
The cost of noncredit courses is not considered a qualifying expense for the
American Opportunity Credit, but these expenses may be includable when
computing the qualified tuition and related expenses for the Lifetime
Learning Credit, if the student took the course to acquire or improve his or
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her job skills. Noncredit courses include courses for athletics, sports, games
or hobbies.
Prepaid Expenses
Other qualifying expenses for the American Opportunity and Lifetime
Learning Credit include prepaid expenses, payments with borrowed funds,
and expenses paid by others.
For example, taxpayers who prepaid qualified tuition and related expenses,
for example in November, for an academic period that begins in the first
three months of the following year can use the prepaid amount in figuring
the credit for the year paid. Prepaid expenses do not change the fact that
only payments made during the tax year can be used to claim an education
credit for that tax year.
Payments with Borrowed Funds
Taxpayers who paid qualified tuition and related expenses with loan
proceeds are eligible to claim the American Opportunity Credit and Lifetime
Learning Credit. Calculate the credit for the year in which the taxpayer paid
the expenses, not the year in which the loan is repaid.
Expenses Paid by Others
If someone other than the taxpayer, the taxpayer's spouse, or the
dependent (such as a relative or former spouse) makes a qualified tuition
payment directly to the eligible educational institution, the student is
treated as receiving the payment from the other person, and is considered
to have paid the expenses to the institution.

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Flowchart: Education Credit


(1)

Qualified education expenses paid by a dependent for whom the


taxpayer claims an exemption, or by a third party for that dependent, are
considered paid by by the taxpayer.
(2)
You cannot use the same expenses to claim both a Lifetime Learning
Credit and an American Opportunity Credit.
(3)
The education credits may be limited to the tax liability minus certain
credits. See Form 8863 for more details.

The Trade Preferences Extension Act of


2015
The Trade Preferences Extension Act of 2015 creates a requirement that
taxpayers receive a payee statement (Form 1098-T, Tuition Statement)
containing the information required in IRC Sec. 6050S(d)(2) before they
can claim an American Opportunity or Lifetime Learning Tax Credit or
take the deduction for Qualified Tuition and related expenses. These
changes are effective for tax years beginning after the acts date of
enactment.

What Is the American Opportunity Credit?


The American Opportunity Credit (American Opportunity Tax Credit) allows
taxpayers to claim a credit of up to $2,500 based on qualified tuition and
related expenses paid for each eligible student. To be eligible for the credit,
the student must be:

Enrolled in a program that leads to a degree, certificate or other


recognized educational credential

Taking at least one-half of the normal full-time workload for his or


her course of study for at least one academic period beginning
during the calendar year

Enrolled as a freshman or sophomore (in other words, has not


completed the first two years of post-secondary education)

Free of any felony conviction for possessing or distributing a


controlled substance

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Flowchart: Hope Credit

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(1)

Qualified education expenses paid by a dependent for whom you


claim an exemption, or by a third party for that dependent, are
considered paid by you.
Figuring the Credit
Use Form 8863 - Education Credits (American Opportunity and Lifetime
Learning Credits) to calculate the amount of the credit. The maximum
American Opportunity Credit is $2,500 per student for four taxable years of
his or her post-secondary education.
For each eligible student who qualifies for the American Opportunity Credit:

If the expenses are $2,000 or less, the credit is the amount of the
expenses

If the expenses are between $2,000 and $4,000 the credit is $2,000
plus one-quarter of the expenses over $2,000. For example, if the
expenses are $3,000 the credit is $2,250 ($2,000 plus one-quarter
of $1,000 which is $250)

If expenses are $4,000 or more the credit is $2,500.

The credit is reported on line 50 of Form 1040.

Figure 24-2: The Tax and Credits section of Form 1040 with line 50 "Education credits"
highlighted.

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TAX TIP

The American Opportunity Tax Credit and Foreign Students


The American Opportunity Tax Credit is available to help eligible
students and their parents offset the cost of higher education by
reducing the amount of the federal income tax they owe. If they dont
owe tax, the American Opportunity Tax Credit could result in a refund.
If a student is in the United States on an F1 Student Visa, the student
would generally be considered a nonresident alien for federal tax
purposes. A student who is a nonresident alien for any part of the tax
year is not eligible and cannot claim the American Opportunity Tax
Credit unless the student elects to be treated as a resident alien for
federal tax purposes.
To learn more about resident and nonresident alien status and
restrictions on claiming education credits, read American Opportunity
Tax Credit Information for Foreign Students:
http://www.irs.gov/irspup/Individuals/American-Opportunity-TaxCredit-Facts

What Is the Lifetime Learning Credit?


Taxpayers may claim a Lifetime Learning Credit of up to $2,000 based on
qualified tuition and related expenses paid for all eligible students enrolled
in eligible educational institutions.
The Lifetime Learning Credit is based on the total qualified education
expenses paid by the taxpayer and not on the number of eligible students.
Education expenses are qualified for the Lifetime Learning Credit if they are
for:

Courses taken as part of a post-secondary degree program, or

Courses that are not part of a post-secondary degree program, but


are taken to improve or acquire job skills

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Flowchart: Lifetime Learning Credit


(1)

Qualified education expenses paid by a dependent for whom you


claim an exemption, or by a third party for that dependent, are
considered paid by you.

TAX QUOTE

"People who complain about paying their income tax can be divided into
two types: men and women."
Anonymous

Differences between the Two Education


Credits
The Lifetime Learning Credit is different from the American Opportunity
Credit in the following ways:

It is allowed for one or more courses


Non-degree courses taken to improve job skills are eligible
Expenses related to noncredit courses are allowed
No limit to number of years credit can be claimed
Amount taxpayer can claim does not change based on the number
of students taxpayer pays for

The table below shows a comparison of the Education Credits:


American Opportunity Credit
Lifetime Learning Credit
up to $2,500 credit per eligible
Up to $2,000 credit per return.
student
Available for the first 4 years of post Available for all years of
secondary education are completed postsecondary education and for
courses to acquire or improve job
skills
Available only for 4 years per
Available for an unlimited number
eligible student
of years
Student must be pursuing an
Student does not need to be
undergraduate degree or other
pursuing a degree or other
recognized educational credential
recognized education credential.
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American Opportunity Credit


Student must be enrolled at least
half time for at least one academic
period beginning during the year.
No felony drug conviction on
student's record

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Lifetime Learning Credit


Available for one or more courses.

Felony drug conviction rule does


not apply.

No Double Benefits
Taxpayers cannot claim a double-benefit, which is two or more educationrelated benefits. For example, taxpayers cannot:

Deduct higher education expenses and claim a credit based on those


same expenses

Claim a American Opportunity Credit and a Lifetime Learning Credit


based on the same qualified education expenses

Claim a credit based on expenses paid with a tax-free scholarship,


grant, employer-provided educational assistance or a distribution
from a Coverdell ESA

Claim a credit for higher education expenses paid with tax-free funds

Claim a credit for higher education expenses for which they received
a refund

However, a taxpayer can claim a credit based on expenses paid with the
eligible student's earnings, loans, gifts, inheritances or personal savings.
The American Opportunity Credit will generally save the taxpayer more
money than the Lifetime Learning Credit. For taxpayers that dont qualify,
the Lifetime Learning Credit is the next best thing.

Adjustments to Qualified Expenses


Taxpayers who pay qualified higher education expenses with tax-free funds
cannot claim a credit for those amounts. Qualified expenses must be
reduced by the amount of any tax-free educational assistance taxpayers
receive. Tax-free educational assistance can include the following:

Scholarships
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Pell grants
Employer-provided educational assistance
Veteran's educational assistance
Any other nontaxable payments (other than gifts, bequests or
inheritances) received for education expenses

Refunds
Qualified tuition and related expenses do not include expenses for which
the taxpayer received a refund. If the refund or tax-free assistance is
received in the same year in which the expenses were paid or in the
following year before the tax return is filed, reduce the qualified expenses
by the amount received and figure the education credits using the reduced
amount of qualified expenses.
If the refund or tax-free assistance is received after the tax return is filed for
the year in which the expenses were paid, figure the amount by which the
education credits would have been reduced if the refund or tax-free
assistance had been received in the year for which the education credits
were claimed. Include that amount as an additional tax for the year the
refund or tax-free assistance was received. Enter the amount and "ECR"
(Education Credit Refund) on the tax return.

SIDE BAR

What is the CollegeSure CD?


A CollegeSure CD is an FDIC insured variable rate certificate of deposit
(CD) with an annual percentage rate based on the annual increase in
college costs as measured by the College Board's Independent College
500 Index (IC 500). For the past 10 years college cost inflation has
risen twice as fast as general inflation.
CollegeSure CDs pay interest annually on July 31st each year they remain
outstanding. The interest rate adjusts each year on July 31st. The interest
rate is equal to the prior years college inflation rate as measured by the
IC 500, less an issue margin, and is subject to a maximum interest rate
which is equal to the first years interest rate plus an interest rate cap.
CollegeSure CDs are offered in terms of 1 to 22 years. The term chosen
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usually coincides with the number of years until the child enters college.
As with all a certificates of deposit any interest earned on a CollegeSure
CD is taxable income.

Qualified Tuition Programs (QTPs) (Section


529 Plans)
Qualified Tuition Programs, also known as Section 529 Plans, are tax favored
programs established by a state. Many states have tax favored Qualified
Tuition Programs and more are in the approval process.
There's basically two types of tax favored Qualified Tuition Programs,
College Tuition Prepayment Plans and Savings Plan Trusts.
College Tuition Prepayment Plans are exactly what their name implies,
prepayment plans. Savings Plan Trusts are tax deferred accounts in which
the earnings build up tax free.
In general, earnings on Qualified Tuition Programs are free from tax within
the program or account. When withdrawals are made from a Qualified
Tuition Program, the earnings will be included in the student's taxable
income. However, to the extent that a distribution from a Qualified Tuition
Program is used to pay qualified tuition and fees, a American Opportunity
Tax Credit or Lifetime Learning Tax Credit with respect to such tuition and
fees will be available to the student or other qualified taxpayer (assuming
that the other requirements are satisfied and the modified AGI phase out
for those tax credits does not apply).
Contributions to Qualified Tuition Programs qualify for the annual $14,000
gift tax exclusion, and the taxpayer may elect to treat a contribution to a
Qualified Tuition Program as if made over a five year period for purposes of
the annual $14,000 gift tax exclusion.
For example, if the taxpayer transfers $30,000 to a Qualified Tuition Program
to benefit his child, the transfer is considered a gift that qualifies for the
annual $14,000 gift tax exclusion. In addition, the taxpayer may make an
election to treat the gift as if made over five years. If made, the taxpayer will
be deemed to have made a $6,000 gift ($30,000 divided by five years) that
qualifies for the annual gift tax exclusion in each of the five years.
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When a taxpayer receives a distribution from a Qualified Tuition Programs


he will receive a Form 1099-Q from the plan paying the distribution.

Figure 24-3: Form 1099-Q - Payments From Qualified Education Programs.

TAX TIP

Qualified Tuition Programs


Americans are putting billions of dollars into Section 529 Qualified Tuition
Programs and these contributions are expected to increase dramatically
in the coming years. Congress created Internal Revenue Code Section
529 in 1996. Section 529 was later amended in 1997, 2001, and 2006.
Some of the specific tax advantages of Section 529 plans are that the
earnings grow tax deferred and withdrawals are not taxed at all provided
they are used by the beneficiary for the purpose of a higher education.
However, there are some disadvantages and risks too:
Prepaid Tuition Plans allow for the purchase of tuition credits at todays
presumably lower rates for use in the future. The "return" is the difference
between how much was paid for the credit an how much it would cost
when the child enters college. One risk, although it seems remote, is that
the cost of a college education doesnt rise as much as expected. These
types of plans may also restrict school selection.
College Savings Plans consist of equity investments and any growth is
based upon market performance. The investments in such plans may
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perform well but if they dont the participant can lose money.
A Section 529 plan could lower the childs financial aid amount. Section
529 plans are treated as an asset of the parent for financial aid purposes
if the parent is the account owner. Accounts owned by grandparents
don't count at all for determining financial aid.
Qualified state tuition programs are great for high-income taxpayers and
people who want to invest large amounts for their child or grandchild's
education. Some states also offer tax breaks for residents of their state
too. Some states do not have very good qualified tuition programs,
however some state programs allow for nonresident participation. Thus,
taxpayers may be able to participate in a better out-of-state program.
http://www.SavingforCollege.com offers an analysis of all the different
state qualified tuition programs. Check it out!

Coverdell ESAs
A Coverdell ESA, formerly known as an Education IRA, is a tax advantaged
trust or custodial account set up in the United States solely for the purpose
of paying qualified education expenses for the cost of elementary, high
school, or higher education for the designated beneficiary of the account.
Qualified higher education expenses include expenses for tuition, fees,
books, supplies, and equipment required for enrollment or attendance. If
the designated beneficiary is enrolled at least half time at an eligible
educational institution, certain room and board expenses are qualified
education expenses. Expenses also include amounts contributed to a
qualified tuition program for the same designated beneficiary. Qualified
expenses include public, private and religious elementary and secondary
school expenses.
Coverdell ESAs are found at section 530 of the Internal Revenue Code. The
tax treatment of Coverdell ESA's are much the same as 529 plans with a few
important differences. Like a 529 plan, Coverdell ESA's allow money to grow
tax deferred and proceeds to be withdrawn tax free for qualified education
expenses at a qualified institution. However the definition of qualified
expenses in an ESA includes primary and secondary schools, not just
colleges and universities.
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The account must be designated as a Coverdell ESA at the time it is created


in order to be treated as a Coverdell ESA for tax purposes.
The designated beneficiary must be under the age of 18 when the account
is established. Any balance in a Coverdell ESA must be distributed within 30
days after the date the beneficiary reaches age 30. These age limits do not
apply to beneficiaries with special needs.
There is no limit to the number of Coverdell ESA's that can be established
for one beneficiary. However, total contributions made to all Coverdell ESA's
for any beneficiary in one tax year cannot be greater than $2,000.
The taxpayer must report contributions, including rollover contributions, to
any Coverdell ESA on Form 5498-ESA. If no reportable contributions were
made then no return is required.
In general, the designated beneficiary of a Coverdell ESA can receive tax free
distributions to pay qualified education expenses. The distributions are tax
free to the extent the amount of the distributions do not exceed the
beneficiary's qualified education expenses. If a distribution does exceed the
beneficiary's qualified education expenses, a portion of the distribution is
taxable. For information on how to determine the part of any distribution
that is taxable earnings, refer to Publication 970 - Tax Benefits for Education.
To qualify for the interest exclusion, the taxpayer's higher education
expenses may not include:

Expenses that the taxpayer used to claim American Opportunity or


Lifetime Learning Credits

Distributions from Coverdell ESA's that the taxpayer excluded from


income

Expenses paid with scholarships and fellowship distributions that the


taxpayer excluded from income

Expenses paid with any nontaxable payments received, other than


gifts, bequests, or inheritances

When a taxpayer receives a distribution from a Coverdell ESA he will receive


a Form 1099-Q from the plan paying the distribution.
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Question
What is a Coverdell ESA?

Where can it be established?

Who can have a Coverdell ESA?


Who can contribute to a Coverdell ESA?

Are distributions tax free?

Are contributions deductible?


Why should someone contribute to a
Coverdell ESA?
What is the annual contribution limit per
designated beneficiary?
What if more than one Coverdell ESA has
been opened for the same designated
beneficiary?

AND

PROGRAMS

Answer
A savings account that is set up to pay the
qualified education expenses of a
designated beneficiary.
It can be opened in the United States at any
bank or other IRS-approved entity that
offers Coverdell ESAs.
Any beneficiary who is under age 18 or is a
special needs beneficiary.
Generally, any individual (including the
beneficiary) whose modified adjusted gross
income for the year is less than $110,000
($220,000 in the case of a joint return).
Yes, if the distributions are not more than
the beneficiary's adjusted qualified
education expenses for the year.
No.
Earnings on the account grow tax free until
distributed.
$2,000 for each designated beneficiary.

The annual contribution limit is $2,000 for


each beneficiary, no matter how many
Coverdell ESAs are set up for that
beneficiary.
What if more than one individual makes
The annual contribution limit is $2,000 for
contributions for the same designated
each beneficiary, no matter how many
beneficiary?
individuals contribute.
Can contributions other than cash be made No.
to a Coverdell ESA?
When must contributions stop?
No contributions can be made to a
beneficiary's Coverdell ESA after he or she
reaches age 18, unless the beneficiary is a
special needs beneficiary.
Is a distribution from a Coverdell ESA to pay Generally, yes, to the extent the amount of
for a designated beneficiary's qualified
the distribution is not more than the
education expenses tax free?
designated beneficiary's adjusted qualified
education expenses.
After the designated beneficiary completes Yes. Amounts must be distributed when the
his or her education at an eligible
designated beneficiary reaches age 30
educational institution, can amounts
unless he/she is a special needs
remaining in the Coverdell ESA be
beneficiary. Also, certain transfers to the
distributed?
beneficiary's family members are permitted.
Does the designated beneficiary need to be No.
enrolled for a minimum number of courses
to take a tax-free distribution?
Table: Coverdell ESA

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TAX PLANNING TIP

Can a grandparent pay a grandchild's tuition directly to the college


or university without paying any gift tax?
Yes. An exception to the gift tax rules applies to medical and tuition
payments made directly to the institution. See Lesson 29. Any tuition
payments made directly to a qualifying educational institution are
exempt from federal gift tax even if such payments exceed the $14,000
annual gift tax exclusion. This unlimited exclusion does not cover books,
supplies, or room and board. In some states this type of gift may still be
subject to state gift tax.

Excludable U.S. Savings Bond Interest


Taxpayers may be able to exclude from income all or part of U.S. Savings
Bond interest if they paid for qualified higher education expenses the same
year the bonds were cashed.
The bonds must be either:

Series EE bonds issued after 1989, or


Series I bonds in the taxpayer's name or spouse's name

The individual in whose name the bonds were issued must be 24 years of
age or older before the bonds were issued.
To exclude U.S. Savings Bond interest from income, a married taxpayer
cannot file as "Married Filing Separately."
For purposes of the Savings Bond interest exclusion, qualified higher
education expenses include:

Tuition and fees paid to an eligible educational institution for the


bond owner, the bond owner's spouse, or the bond owner's
dependent for whom the bond owner claims an exemption

Room and board are not qualifying expenses.


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Any contribution to a qualified state tuition program or to a


Coverdell ESA. For more information, get Publication 970 - Tax
Benefits for Higher Education.

An eligible educational institution is any college, university, vocational


school, or other post-secondary educational institution eligible to
participate in a student aid program administered by the Department of
Education.
U.S. Savings Bond interest is reported in box 3 of Form 1099-INT.

Figure 24-4: Form 1099-INT - Interest Income with box 3 "Interest on U.S. Savings Bonds
and Treas. obligations" highlighted.

Excludable interest from US Savings Bonds is figured on Form 8815 and


then shown on Schedule B of Form 1040 or Schedule 1 of Form 1040A.

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Figure 24-5: Form 1040 Schedule B - Interest and Ordinary Dividends with Part I line 3
"Excludable interest on series EE and I U.S. savings bonds issued after 1989"
highlighted.

Educational Assistance Plans


An Educational Assistance Plan allows an employee to exclude from wages
up to $5,250 annually paid by his or her employer for educational
assistance. Only reimbursements for undergraduate-level course work
qualify for the educational assistance exclusion.
The tax law allows the employer to deduct the cost of these educational
assistance benefits.

Work Related Education Expenses


The taxpayer may be able to deduct work-related education expenses as
business expenses. To claim such a deduction, the taxpayer must:

Be working,

Itemize deductions on Schedule A if the taxpayer are an employee,

File Schedule C or Schedule C-EZ, or Schedule F if the taxpayer is


self-employed, and
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Have expenses for education that meet the requirements discussed


below.

What is the tax benefit of taking a business deduction for


work-related education?
If the taxpayer is an employee and able to itemize deductions, he may be
able to claim a deduction for the expenses he pays for work-related
education. The taxpayers deduction will be the amount by which his
qualifying work-related education expenses plus other job and certain
miscellaneous expenses is greater than 2% of his Adjusted Gross Income. If
the taxpayer is self-employed, he can deduct the expenses for qualifying
work-related education directly from his self-employment income. This
reduces the amount of his income subject to both income tax and selfemployment tax.
Qualifying Work-Related Education
The taxpayer can deduct the costs of qualifying work-related education as
business expenses. This is education that meets at least one of the following
two tests:

The education is required by the taxpayers employer or the law to


keep his present salary, status, or job. The required education must
serve a bona fide business purpose of the taxpayers employer.

The education maintains or improves skills needed in the taxpayers


present work. However, even if the education meets one or both of
the above tests, it is not qualifying work-related education if it:
o Is needed to meet the minimum educational requirements of
the taxpayers present trade or business, or
o Is part of a program of study that will qualify the taxpayer for
a new trade or business.

The taxpayer can deduct the costs of qualifying work-related education as a


business expense even if the education could lead to a degree.
Education Required by Employer or by Law
Once the taxpayer has met the minimum educational requirements for his
job, his employer or the law may require him to get more education. This
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additional education is qualifying work-related education if all three of the


following requirements are met:

It is required for the taxpayer to keep his present salary, status, or


job,

The requirement serves a business purpose of the taxpayers


employer, and

The education is not part of a program that will qualify the taxpayer
for a new trade or business.

When the taxpayer gets more education than his employer or the law
requires, the additional education can be qualifying work-related education
only if it maintains or improves skills required in his present work.
Education To Maintain or Improve Skills
If the taxpayers education is not required by his employer or the law, it can
be qualifying work-related education only if it maintains or improves skills
needed in his present work. This could include refresher courses, courses on
current developments, and academic or vocational courses.
Maintaining Skills vs. Qualifying for a New Job
Education to maintain or improve skills needed in the taxpayers present
work is not qualifying education if it will also qualify the taxpayer for a new
trade or business.
Temporary Absences
If the taxpayer stops working for a year or less in order to get education to
maintain or improve skills needed in his present work and then returns to
the same general type of work, his absence is considered temporary.
Education that the taxpayer gets during a temporary absence is qualifying
work-related education if it maintains or improves skills needed in his
present work.
Indefinite Absences
If the taxpayer stops work for more than a year, his absence from his job is
considered indefinite. Education during an indefinite absence, even if it
maintains or improves skills needed in the work from which he is absent, is
considered to qualify him for a new trade or business. Therefore, it is not
qualifying work-related education.
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Education To Meet Minimum Requirements


Education the taxpayer needs to meet the minimum educational
requirements for his present trade or business is not qualifying work-related
education. The minimum educational requirements are determined by:

Laws and regulations,


Standards of the taxpayers profession, trade, or business, and
The taxpayers employer.

Once the taxpayer has met the minimum educational requirements that
were in effect when he was hired, he does not have to meet any new
minimum educational requirements. This means that if the minimum
requirements change after he was hired, any education he needs to meet
the new requirements can be qualifying education.
Requirements for Teachers
States or school districts usually set the minimum educational requirements
for teachers. The requirement is the college degree or the minimum
number of college hours usually required of a person hired for that position.
If there are no requirements, the taxpayer will have met the minimum
educational requirements when he becomes a faculty member. The
taxpayer generally will be considered a faculty member when one or more
of the following occurs:

The taxpayer has tenure,


The taxpayers years of service count toward obtaining tenure,
The taxpayer has a vote in faculty decisions,
The taxpayers school makes contributions for him to a retirement
plan other than social security or a similar program.

Certification in a New State


Once the taxpayer has met the minimum educational requirements for
teachers in his state, he is considered to have met the minimum educational
requirements in all states. This is true even if the taxpayer must get
additional education to be certified in another state. Any additional
education he needs is qualifying work-related education. He has already
met the minimum requirements for teaching. Teaching in another state is
not a new trade or business.

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Education That Qualifies The Taxpayer for a New Trade or


Business
Education that is part of a program of study that will qualify the taxpayer for
a new trade or business is not qualifying work-related education. This is true
even if he does not plan to enter that trade or business. If the taxpayer is an
employee, a change of duties that involves the same general kind of work is
not a new trade or business.
Teaching and Related Duties
All teaching and related duties are considered the same general kind of
work. A change in duties in any of the following ways is not considered a
change to a new business:

Elementary school teacher to secondary school teacher,


Teacher of one subject, such as biology, to teacher of another
subject, such as art,
Classroom teacher to guidance counselor,
Classroom teacher to school administrator.

What Expenses Can Be Deducted


If the taxpayers education meets the requirements described earlier under
Qualifying Work-Related Education, he can generally deduct the his
education expenses as business expenses. If the taxpayer is not selfemployed, he can deduct business expenses only if he itemizes deductions.
He cannot deduct expenses related to tax-exempt or excluded income.
Deductible Expenses
The following education expenses can be deducted:

Tuition, books, supplies, lab fees, and similar items


Certain transportation and travel costs
Other education expenses, such as costs of research and typing
when writing a paper as part of an educational program.

Non-deductible Expenses
The taxpayer cannot deduct personal or capital expenses. For example, the
taxpayer cannot deduct the dollar value of vacation time or annual leave he
takes to attend classes. This amount is a personal expense.

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Unclaimed Reimbursement
If the taxpayer does not claim reimbursement that he is entitled to receive
from his employer, he cannot deduct the expenses that apply to the
unclaimed reimbursement.
Transportation Expenses
If the taxpayers education qualifies, he can deduct local transportation costs
of going directly from work to school. If he is regularly employed and goes
to school on a temporary basis, he can also deduct the costs of returning
from school to home.
Temporary Basis
The taxpayer goes to school on a temporary basis if either of the following
situations applies:

The taxpayers attendance at school is realistically expected to last 1


year or less and does indeed last for 1 year or less, or

Initially, the taxpayers attendance at school is realistically expected


to last 1 year or less, but at a later date his attendance is reasonably
expected to last more than 1 year. The taxpayers attendance is
temporary up to the date he determines it will last more than 1 year.

If the taxpayer is in either situation (1) or (2) above, the taxpayers


attendance is not temporary if facts and circumstances indicate otherwise.
Attendance Not on a Temporary Basis
The taxpayer does not go to school on a temporary basis if any of the
following situations apply:

His attendance at school is realistically expected to last more than 1


year. It does not matter how long he actually attends, or

Initially, his attendance at school is realistically expected to last 1 year


or less, but at a later date his attendance is reasonably expected to
last more than 1 year. The taxpayers attendance is not temporary
after the date the taxpayer determines it will last more than 1 year.

Deductible Transportation Expenses


If the taxpayer is regularly employed and goes directly from home to school
on a temporary basis, he can deduct the round-trip costs of transportation
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between his home and school. This is true regardless of the location of the
school, the distance traveled, or whether he attends school on non-work
days. Transportation expenses include the actual costs of bus, subway, cab,
or other fares, as well as the costs of using his car. Transportation expenses
do not include amounts spent for travel, meals, or lodging while he is away
from home overnight.
Using His Own Car
If the taxpayer uses his car (whether he owns or leases it) for transportation
to school, he can deduct his actual expenses or use the standard business
mileage rate to figure the amount he can deduct.
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

Whichever method the taxpayer uses, he can also deduct parking fees and
tolls.
Travel Expenses
The taxpayer can deduct expenses for travel, meals (subject to the 50%
limitation), and lodging if he travels overnight mainly to obtain qualifying
work-related education. Travel expenses for qualifying work-related
education are treated the same as travel expenses for other employee
business purposes.
Mainly Personal Travel
If the taxpayers travel away from home is mainly personal, he cannot
deduct all of his expenses for travel, meals, and lodging. He can deduct only
his expenses for lodging and 50% of his expenses for meals during the time
he attends the qualified educational activities. Whether a trips purpose is
mainly personal or educational depends upon the facts and circumstances.
An important factor is the comparison of time spent on personal activities
with time spent on educational activities. If the taxpayer spends more time
on personal activities, the trip is considered mainly educational only if he
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can show a substantial non-personal reason for traveling to a particular


location.
Cruises and Conventions
Certain cruises and conventions offer seminars or courses as part of their
itinerary. Even if the seminars or courses are work related, the taxpayers
deduction for travel may be limited. This applies to:

Travel by ocean liner, cruise ship, or other form of luxury water


transportation, and

Conventions outside the North American area.

50% Limit on Meals


The taxpayer can deduct only 50% of the cost of his meals while traveling
away from home to obtain qualifying work-related education. He cannot
have been reimbursed for the meals. Employees must use Form 2106 or
Form 2106-EZ to apply the 50% limit.
Travel as Education
The taxpayer cannot deduct the cost of travel as a form of education even if
it is directly related to his duties in his work or business.
No Double Benefit Allowed
The taxpayer cannot do any of the following:

Deduct work-related education expenses as business expenses if he


deducts these same expenses under any other provision of the law,
for example, as a tuition and fees deduction,

Deduct work-related education expenses paid with tax-free


scholarship, grant, or employer-provided educational assistance.

Adjustments to Qualifying Work-Related Education


Expenses
If the taxpayer pays qualifying work-related education expenses with certain
tax-free funds, he cannot claim a deduction for those amounts. He must
reduce the qualifying expenses by the amount of any tax-free educational
assistance he received.

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Tax-free Educational Assistance


This includes:

The tax-free part of scholarships and fellowships,


Pell grants,
Employer-provided educational assistance,
Veterans educational assistance, and
Any other non-taxable payments (other than gifts or inheritances)
received as educational assistance.

Amounts That Do Not Reduce Qualifying Work-related


Education Expenses
Do not reduce the qualifying work-related education expenses by amounts
paid with funds the student receives as:

Payment for services, such as wages,


A loan,
A gift,
An inheritance, or
A withdrawal from the students personal savings.

Also, do not reduce the qualifying work-related education expenses by any


scholarship or fellowship reported as income on the students return or any
scholarship which, by its terms, cannot be applied to qualifying work-related
education expenses.
How To Treat Reimbursements
How the taxpayer treats reimbursements depends on the arrangement he
has with his employer. There are two basic types of reimbursement
arrangements - accountable plans and non-accountable plans.
The taxpayer can tell the type of plan he is reimbursed under by the way the
reimbursement is reported on his Form W-2.
Note. The following rules about reimbursement arrangements also apply to
expense allowances received from the taxpayers employer.

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Accountable Plans
To be an accountable plan, the taxpayers employers reimbursement
arrangement must require the taxpayer to meet all three of the following
rules:

The taxpayers expenses must have a business connection that is,


the expenses must be deductible under the rules for qualifying workrelated education explained earlier,

The taxpayer must adequately account to his employer for the


expenses within a reasonable period of time, and

The taxpayer must return any reimbursement or allowance in excess


of the expenses accounted for within a reasonable period of time.

If the taxpayer is reimbursed under an accountable plan, his employer


should not include any reimbursement in income in box 1 of his Form W-2.
Accountable Plan Rules Not Met
Even though the taxpayer is reimbursed under an accountable plan, some
of his expenses may not meet all three rules for accountable plans. Those
expenses that fail to meet the three rules are treated as having been
reimbursed under a non-accountable plan.
Expenses Equal Reimbursement
Under an accountable plan, if the taxpayers expenses equal his
reimbursement, do not complete Form 2106 or 2106-EZ. Because the
taxpayers expenses and reimbursements are equal, the taxpayer does not
have a tax deduction.
Excess Expenses
If the taxpayers expenses are more than his reimbursements, he can deduct
the excess expenses.
Allocating the Taxpayers Reimbursements for Meals
Because the taxpayers excess meal expenses are subject to the 50% limit,
he must figure them separately from other expenses. If the taxpayers
employer paid him a single amount to cover both meals and other
expenses, he must allocate the reimbursement so that he can figure his
excess meal expenses separately. Make the allocation as follows:
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Divide the taxpayers meal expenses by the total expenses.

Multiply the taxpayers total reimbursement by the result from (1).


This is the allocated reimbursement for the taxpayers meal
expenses.

Subtract the amount figured in (2) from the taxpayers total


reimbursement. The difference is the allocated reimbursement for
the taxpayers other expenses of qualifying work-related education.

Non-Accountable Plans
The taxpayers employer will combine the amount of any reimbursement or
other expense allowance paid to the taxpayer under a non-accountable
plan with his wages, salary, or other pay and report the total in box 1 of his
Form W-2. The taxpayer can deduct his expenses regardless of whether they
are more than, less than, or equal to the reimbursement.
Reimbursements for Non-deductible Expenses
Reimbursements the taxpayer received for non-deductible expenses are
treated as paid under a non-accountable plan. The taxpayer must include
them in his income.
Self-Employed Persons
If the taxpayer is self-employed, he must report the cost of his qualifying
work-related education on Schedule C, C-EZ, or F. If the taxpayers
educational expenses include expenses for a car or truck, travel, or meals,
report those expenses the same way you report other business workexpenses for those items.
Employees
If the taxpayer is an employee, he can deduct the cost of qualifying workrelated education only if he:
1. Did not receive any reimbursement from his employer,
2. Was reimbursed under a non-accountable plan (the amount is
included in box 1 of Form W-2), or
3. Received reimbursement under an accountable plan, but the amount
received was less than his expenses.
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If either (1) or (2) applies, the taxpayer can deduct the total qualifying cost. If
(3) applies, the taxpayer can deduct only the qualifying costs that were more
than his reimbursement. In order to deduct the cost of the taxpayers
qualifying work-related education as a business expense, include the
amount with the taxpayers deduction for any other employee business
expenses on Schedule A line 21.

Figure 24-6: The Job Expenses and Certain Miscellaneous Deductions section of Form
1040 Schedule A - Itemized Deductions with line 21 "Unreimbursed employee expenses
- job travel, union dues, job education, etc." highlighted.

This deduction is subject to the "2% of Adjusted Gross Income" limit that
applies to most miscellaneous itemized deductions.
Form 2106 or 2106-EZ
To figure the taxpayers deduction for employee business expenses,
including qualifying work-related education, the taxpayer generally must
complete Form 2106 or 2106-EZ.
Form 2106 or 2106-EZ Not Required
Do not complete either Form 2106 or 2106-EZ if:

All reimbursements, if there were any, are included in box 1 of the


taxpayers Form W-2, and

The taxpayer is not claiming travel, transportation, meal, or


entertainment expenses

If the taxpayer meets both of these requirements, enter the expenses


directly on Schedule A line 21.
Using Form 2106-EZ
This form is shorter and easier to use than Form 2106. Generally, the
taxpayer can use this form if:
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All reimbursements, if there were any, are included in box 1 of the


taxpayers Form W-2, and

the taxpayer is using the standard mileage rate if he is claiming


vehicle expenses.

If the taxpayer does not meet both of these requirements use Form 2106.
Performing Artists and Fee-Basis Officials
If the taxpayer is a qualified performing artist, or a state (or local)
government official who is paid in whole or in part on a fee basis, he can
deduct the cost of his qualifying work-related education as an adjustment
to gross income rather than as an itemized deduction. Include the cost of
the taxpayers qualifying work-related education with any other employee
business expenses on Form 1040 line 24.

Figure 24-7: The Adjusted Gross Income section of Form 1040 with line 24 "Certain
business expenses of reservists, performing artists, and fee-basis government officials"
highlighted.

The taxpayer does not have to itemize his deductions on Schedule A, and,
therefore, the deduction is not subject to the "2% of Adjusted Gross
Income" limit.
Impairment-Related Work Expenses
If the taxpayer is disabled and has impairment-related work expenses that
are necessary for him to be able to get qualifying work-related education,
he can deduct these expenses on Schedule A line 28.

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Figure 24-8: The Other Miscellaneous Deductions section (line 28) of Form 1040
Schedule A - Itemized Deductions.

They are not subject to the "2% of Adjusted Gross Income" limit. To deduct
these expenses, the taxpayer must complete Form 2106 or 2106-EZ even if
he meets the requirements described earlier under "Form 2106 or 2106-EZ
Not Required".

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TAX PRACTICE TIP

Obtaining Copies of Prior Year Tax Returns


Your new client comes in to your office and looks troubled. He needs his
last three years tax returns to get approved for his bank loan and he only
has a copy of the return you just prepared last month. He doesnt have
the other two years and youd prefer not to send him back to his old tax
preparer if possible because hes your client now and you dont want to
risk losing his business. What can you do?
There are two easy ways to obtain free copies of the taxpayers federal tax
return information - tax return transcripts and tax account transcripts.
Both can be obtained by either phone or mail.
A tax return transcript shows most line items from the tax return and its
forms and schedules as it was originally filed. It does not reflect any
amendments or changes made after the return was filed. In most cases a
tax return transcript will meet the requirements of lenders. The taxpayer
will receive the tax return transcript within 10 working days from the time
the IRS receives the request.
A tax account transcript includes any amendments or changes made after
the tax return was filed. It shows basic data, including marital status, type
of return filed, adjusted gross income and taxable income. Allow 30
calendar days for delivery of a tax account transcript.
Transcripts are available for the current and the past three years. The IRS
does not charge a fee for either.
To request either transcript:

Phone: Call 800-829-1040 and follow the prompts in the recorded


message.

Mail: Complete Form 4506-T - Request for Transcript of Tax Return


and mail it to the IRS address listed on the form.

If the taxpayer needs an actual copy of a previously filed tax return, it will
cost him $57 per tax year and it will take a lot longer. Complete Form
4506, Request for Copy of Tax Return. Allow 60 calendar days for delivery
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of actual copies of tax returns. Copies are available for the current and the
past six years.
TIP: Be sure to check your client files. The taxpayer may have given you
his copies of the prior year's tax returns when you first met this season.

Lesson Summary
The American Opportunity and Lifetime Learning Credits are nonrefundable
credits that allow a taxpayer to claim all or a portion of qualified tuition and
related expenses paid for post-secondary education.
Generally, a taxpayer can claim the American Opportunity or Lifetime
Learning Credit if they pay qualified tuition and related expenses of higher
education for an eligible student who is either the taxpayer, the taxpayer's
spouse, or a dependent whom the taxpayer can claim an exemption on his
or her tax return.
A taxpayer cannot:

Deduct higher education expenses on his or her tax return and also
claim a American Opportunity or Lifetime Learning Credit based on
those same expenses

Claim a American Opportunity Credit and a Lifetime Learning Credit


based on the same qualified education expenses

Claim a credit based on expenses paid with a tax-free scholarship,


grant or employer-provided educational assistance

The American Opportunity and Lifetime Learning Credits are claimed on


Form 8863, which can be filed with either Form 1040 or Form 1040A.
Qualified Tuition Programs, also known as Section 529 Plans, are tax favored
programs established by a state.
There are two types of tax favored Qualified Tuition Programs, College
Tuition Prepayment Plans and Savings Plan Trusts.
A Coverdell ESA, formerly known as an Education IRA, is a tax advantaged
trust or custodial account set up in the United States solely for the purpose
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of paying qualified education expenses for the designated beneficiary of the


account.
The designated beneficiary must be under the age of 18 when the account
is established. Any balance in a Coverdell ESA must be distributed within 30
days after the date the beneficiary reaches age 30.
Total contributions made to all Coverdell ESA's for any beneficiary in one tax
year cannot be greater than $2,000.
The designated beneficiary of a Coverdell ESA can receive tax free
distributions to pay qualified education expenses.
When a taxpayer receives a distribution from a Qualified Tuition Programs
or Coverdell ESA he will receive a Form 1099-Q from the plan paying the
distribution.
Taxpayers may be able to exclude from income all or part of U.S. Savings
Bond interest if they paid for qualified higher education expenses the same
year the bonds were cashed.
An Educational Assistance Plan allows an employee to exclude from wages
up to $5,250 annually paid by his or her employer for educational
assistance. Only reimbursements for undergraduate-level course work
qualify for the educational assistance exclusion.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify your 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.

767

LESSON

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CREDIT

Lesson

25
Lesson 25 - The Earned Income
Tax Credit
In this lesson you'll learn about the Earned Income Tax Credit (EITC or EIC). At
the end of this lesson, you will be able to:
Determine which taxpayers are eligible for the EITC
Determine when a taxpayer can claim a child as a qualifying child for
the purposes of the EITC
Calculate and report the credit using the EITC Worksheet
The following topics are discussed in this lesson:

What Is the EIC?


Filing Requirements
Income Requirements
Taxpayer Identification
Numbers
Taxpayers With Qualifying
Children
Taxpayers Without
Qualifying Children
Earned Income
Income Not Considered
Earned Income for EIC
Household Employee Income
768

Qualifying Child
Relationship Test
Residency Test
Age Test
Qualifying Child of More
Than One Taxpayer
EIC Qualification Checklist
Schedule EIC
Disallowed EIC
Deficiency Procedures
Reasons for Disallowed EIC
EIC Certification

LESSON

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he Earned Income Credit provides a tax credit and, frequently, a cash


payment to low to moderate income workers who qualify. The
purpose of the EIC is to reduce tax burdens on working families with
lower earned income. The EIC is a refundable credit and eligible taxpayers
can receive a refund of this credit even if they owe no tax and had no
income tax withheld. Taxpayers must file a tax return to receive this credit.
This lesson explains how to determine whether a taxpayer meets the
general requirements for claiming the Earned Income Credit. At the end of
this lesson you will be able to determine which taxpayers are eligible to
claim the earned income tax credit.
To claim the Earned Income Credit, all taxpayers (and spouses, if filing a
joint return) must meet the general rules for filing, income, and
identification numbers. Other rules apply depending on whether the
taxpayer has a qualifying child. The EIC is claimed on Form 1040 line 66.

Figure 25-1: The Payments section of Form 1040 with line 66 "Earned Income Credit
(EIC)" highlighted.

Filing Requirements
The filing requirements for claiming the EIC are that a taxpayer must:

Have a valid social security number (SSN); on a joint return, both


spouses must have SSNs

Not use the Married Filing Separately filing status

Not be a nonresident alien, unless filing a joint return with a U.S.


citizen or resident

Have a tax return that covers a 12-month period, unless filing a short
period return because of an individual's death
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Not be the qualifying child of another person

TAX QUOTE

"If you get up early, work late, and pay your taxes, you will get ahead -- if
you strike oil."
J. Paul Getty

Income Requirements
The income requirements for claiming the EIC are that a taxpayer must:

Have earned income during the year


Not have investment income of more than $3,350
Not exclude from gross income any income earned in foreign
countries, or deduct or exclude a foreign housing amount (by filing
Form 2555 or Form 2555-EZ, Foreign Earned Income Exclusion)

If a taxpayer retires on disability the benefits received under the employer's


disability retirement plan are considered earned income until the taxpayer
reaches the minimum retirement age.
Investment income includes taxable interest and dividends, tax-exempt
interest, capital gain net income, net income from rents and royalties not
derived from a trade or business, and net income from passive activities.

Taxpayer Identification Numbers


To claim the EIC, the taxpayer (and spouse, if filing a joint return) must have
a valid social security number issued by the Social Security Administration.
Any qualifying child listed on Schedule EIC must also have a valid SSN. If a
social security card has a legend that says "Not valid for employment" and
the number was issued so that the taxpayer (or spouse or qualifying child)
could receive a federally funded benefit, such as Medicaid, the taxpayer
cannot claim the EIC. If a taxpayer has a social security card that contains the
legend "valid for work only with INS authorization," the taxpayer may claim
the EIC, assuming the taxpayer meets the other requirements. Individual
Taxpayer Identification Numbers (ITINs) and Adoption Taxpayer
Identification Numbers (ATINs) cannot be used when claiming the EIC.
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Taxpayers With Qualifying Children


If the taxpayer has a qualifying child, the taxpayer's earned income and
adjusted gross income (AGI) must each be less than:

$38,511 if the taxpayer has one qualifying child ($43,941 if Married


Filing Jointly)

$43,756 if the taxpayer has two qualifying children ($49,186 if


Married Filing Jointly)

$46,997 if the taxpayer has more than two qualifying child ($52,427
if Married Filing Jointly)

The taxpayer's Schedule EIC must include the name, age, and SSN for each
qualifying child.

Taxpayers Without Qualifying Children


If the taxpayer does not have a qualifying child:

The taxpayer's earned income and AGI must each be less than
$14,590 ($20,020 if Married Filing Jointly)

The taxpayer (or the taxpayer's spouse, if filing a joint return) must
be at least age 25 but under age 65 at the end of the year

Neither the taxpayer (nor the taxpayer's spouse if filing jointly) can
be eligible to be claimed as a dependent or a qualifying child on
another person's return

The principal place of abode of the taxpayer (and the taxpayer's


spouse, if filing jointly) must be in the United States for more than
half the year

Earned Income
Earned income includes:

Wages, salaries, tips, and other employee compensation, but only if


the amounts are includable in gross income

Net earnings from self-employment


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Taxable long-term disability benefits received prior to minimum


retirement age

Nontaxable combat pay

Income Not Considered Earned Income for EIC


Two types of income are not considered earned income for the purposes of
the EIC, but are considered earned income subject to federal income tax:

Taxable scholarships or fellowship grants not reported on Forms W-2


Income received for work performed while an inmate in a penal
institution

Some other types of "income" are also excluded for EIC purposes, such as:

Salary deferrals
Excludable dependent care benefits
Excludable education assistance

Household Employee Income


Household employers are not required to issue a W-2 to household
employees who earned less than $1,500. A household employee without a
W-2 should:

Include the income in the total on line 7 of Form 1040


Enter "HSH" and enter the amount not reported next to line 7 of
Form 1040

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LESSON

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Figure 25-2: The Income section of Form 1040 with line 7 "Wages, salaries, tips, etc."
highlighted.

The total entered for wages, salaries, and tips on line 7 of Form 1040
includes the PRI and HSH amounts.

Qualifying Child
This topic describes the three tests used to determine whether a child
qualifies a taxpayer for the EIC, and what to do when more than one
taxpayer can claim the EIC on the basis of the same child(ren).
At the end of this topic, you will be able to determine when a taxpayer can
claim a child as a qualifying child for the purposes of the EIC.
Three Tests for the EIC
For purposes of the Earned Income Credit, a taxpayer has a qualifying child
if the child meets all the following tests:

Relationship test
Residency test
Age test

Relationship Test
To meet the relationship test, the qualifying child must be the taxpayer's:

Son, daughter, stepson, stepdaughter, or a descendant of the


taxpayer's son, daughter, stepson, or stepdaughter

Brother, sister, stepbrother, stepsister, or a descendant of the


taxpayer's brother, sister, stepbrother, or stepsister

Foster child placed with the taxpayer by an authorized placement


agency

Married child who is claimed as a dependent by the taxpayer or


claimed by the child's other parent

The taxpayer must care for any of these children as his or her own child.
A child who is married at the end of the year will not meet the relationship
test unless the taxpayer can claim the child as a dependent, or would be
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able to claim the child's exemption if it wasn't being claimed by the other
parent under the Special Rule for Divorced or Separated Parents.
An adopted child is treated as a biological child of the taxpayer.
A descendant must be lineal descendant.
An authorized placement agency is an agency of a state or political
subdivision of a state, including a court, or tax-exempt organization licensed
by the state.
Residency Test
To meet the EIC residency test, the child must live with the taxpayer in the
United States for more than half of the tax year. The residency test is still
considered to be met even if the child was born or died during the year, as
long as the child lived with the taxpayer while the child was alive.
The taxpayer does not need to have a home for the child to meet the
residency test. It is sufficient if the taxpayer and child live together in a series
of homeless shelters or with friends or family members.
Age Test
To meet the EIC age test, the child must be:

Under age 19 at the end of the year, or

A full-time student under age 24 at the end of year, or

Permanently and totally disabled at any time during the tax year,
regardless of age

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Review of the Three Qualifying Child Tests for the EIC:

Qualifying Child of More Than One Taxpayer


One Child
If a child is a qualifying child of two or more taxpayers, the taxpayers may
choose which of them will claim the credit on the basis of that child. In
general, the taxpayer with the lower earned income will get a higher EIC.
However, if two or more taxpayers actually claim the credit on the basis of
the same qualifying child, the IRS applies the following tiebreaker rule which
says that the taxpayer who is entitled to the credit is:

The parent, if one taxpayer is a parent of the child

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The parent the child lived with longest during the tax year, if both
taxpayers are parents of the child

The parent with the higher AGI, if both taxpayers are parents of the
child and the child lived with both parents for the same length of
time during the tax year

The taxpayer with the higher AGI, if neither is a parent of the child

More Than One Child


If two or more children are qualifying children of the same taxpayers, the
taxpayers may agree that:

One will claim the credit on the basis of one (or more) child(ren), and
The other will claim the credit on the basis of the other child(ren)

EIC Qualification Checklist


You must first determine whether the taxpayer is eligible to take the credit
by completing the EIC eligibility questions on the 1040 ValuePak EIC
Qualification Checklist.

Schedule EIC
Qualifying Child Information
Schedule EIC - Earned Income Credit contains only information about
qualifying children. Only taxpayers who have a qualifying child must fill out
the schedule and attach it to Form 1040A or Form 1040.

Disallowed EIC
This topic explains how and when taxpayers whose EIC was previously
disallowed may claim the credit again. At the end of this topic, you will be
able to identify which taxpayers may use Form 8862 to claim the EIC again
after their EIC has been disallowed.
Deficiency Procedures
Taxpayers whose Earned Income Credit was disallowed for any year after
1996 as a result of the deficiency procedures cannot claim the Earned
Income Credit again unless they complete and attach Form 8862,
Information To Claim Earned Income Credit After Disallowance, to their
return. Without Form 8862, the EIC claim will be automatically denied.
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However, if the credit was disallowed in the earlier year merely because of a
mathematical or clerical error, the taxpayer should submit the EIC claim
without Form 8862.
A deficiency procedure occurs when the IRS questions the taxpayer's
eligibility for the Earned Income Credit for reasons other than a
mathematical or clerical error. For more information on deficiency
procedures, see Publication 596 - Earned Income Credit or Form W-5.
Reasons for Disallowed EIC
If the IRS has determined that a taxpayer has claimed the EIC:

With reckless or intentional disregard of rules or regulations, then


the taxpayer is ineligible to claim the EIC for a subsequent period of
two years

Fraudulently, then the taxpayer is ineligible to claim the EIC for a


subsequent period of ten years

EIC Certification
This topic discusses the purpose and use of the EIC certification process.
Pilot Initiative
The Internal Revenue Service is continuing an initiative with the balanced
goal of:

Providing better service and


Improving the integrity of the administration of the EIC

The twin objectives of the EIC certification process are to:

Reduce overpayments
Improve participation of eligible EIC customers

Using the Certification


If a taxpayer has received correspondence regarding EIC certification, offer
to review the information with the taxpayer. If the taxpayer has received a
determination letter, complete the return, relative to the EIC, as directed by
the letter. A determination letter is a letter issued by the IRS indicating that a
taxpayer meets the requirements for the EIC. Review the letter to see if the
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taxpayer's situation has changed. If the taxpayer's situation has changed


since receiving a determination letter, the qualifying rules still apply.

TAX QUOTE

"Why does a slight tax increase cost you two hundred dollars and a
substantial tax cut save you thirty cents?"
Peg Bracken

Earned Income Credit Summary


Earned income includes the following:
Wages, salaries, and tips
Commissions
Jury Duty pay
Union strike benefits
Long-term disability pensions received prior to minimum retirement
age
Net earnings from self employment
Earned income does not include the following:
Interest and dividends
Social security and railroad retirement benefits
Welfare benefits
Pensions or annuities
Veterans' benefits (including VA rehabilitation payments)
Workers' compensation benefits
Alimony
Child support
Unemployment compensation (insurance)
Taxable scholarship or fellowship grants that were not reported on
Form W-2
Variable housing allowance for the military
Earnings for work performed while an inmate at a penal institution.
A qualifying child must:
be a son, daughter, stepchild, adopted/foster child, brother, sister,
stepbrother, stepsister, or a descendent of any of them (i.e.
grandchild)
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be under age 19, or under age 24 and a full time student (enrolled
full time during any 5 months)

be any age if permanently disabled

not provide more than one-half of his or her own support

have lived with the taxpayer for more than 6 months in the United
States, except in the case of newborns and adoption. A full year is
required for foster care

have an SSN, unless the child was born and died during the tax year

be younger than the person claiming him/her

not have filed a joint tax return other than to claim a refund

To qualify all of the following tests must be met:


the taxpayer must have earned income
the taxpayer's filing status cannot be married filing separately
the taxpayer cannot be the qualifying child of another person
the taxpayer must include his SSN on the return, and if married, that
of his spouse
earned income and AGI must each be less than...
Number of children
No qualifying children
One qualifying child
Two qualifying children
More than two
qualifying child

Single
$14,590
$38,511
$43,756

Married Filing Jointly


$20,020
$43,941
$49,186

$46,997

$52,427

Disqualified income:
The taxpayer is not eligible for the earned income credit if he had
"disqualified income" exceeding $3,350. Disqualified income includes both
taxable and tax exempt interest, dividends, net rent and royalty income, net
capital gains, and net passive income that is not self employment income.

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Claiming the earned income credit without a qualifying child:


If the taxpayer does not have a qualifying child, then the taxpayer must

have earned income as detailed above

have a main home in the US for more than six months of the tax year

be at least 25 years old, but under age 65, at the end of the tax year.
On joint returns either spouse may satisfy this test

file a joint tax return if married, unless the taxpayers lived apart for
the last six months of the tax year, and this taxpayer qualifies to file
as Head of Household

not be the dependent or qualifying child of another taxpayer. This


rule includes a spouse

include his SSN on the return, and if married, that of his spouse

Tie-Breaker Rules:
If both parents are eligible to claim the credit for the same qualifying child
and they do not file a joint return the parent with whom the child resided
for the longer period of time during the tax year claims the credit. If the
child lived with each parent for the same amount of time the parent with
the higher AGI claims the credit.
If a parent and one or more non-parents are entitled to claim the child as a
qualifying child, only the parent may claim the credit. If none of the persons
entitled to claim the child are a parent the person with the higher AGI claims
the credit.
Married Children:
If the taxpayer's child was married at the end of the tax year, he or she can
be the taxpayer's qualifying child only if the taxpayer can claim an
exemption for the child.
Nonresident Aliens:
An individual who is a nonresident alien for any part of the tax year is not
eligible for the credit unless he or she is married and an election is made by
the couple to have all of their worldwide income subject to U.S. income tax.

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TAX PRACTICE TIP

Internal Revenue Code (IRC) 6695


Internal Revenue Code (IRC) 6695 regarding the Earned Income Tax
Credit (EITC) due diligence knowledge requirements became effective
January 1, 2009. On December 19, 2011 the IRS issued final due
diligence requirements which are imposed on tax return preparers
who prepare tax returns on which taxpayers claim the EITC. The final
regulations became effective December 20, 2011, and apply to returns
filed for tax years ending on or after December 31, 2011. Paid
preparers who file EITC returns or claims for refunds must meet these
due diligence requirements.
Tax return preparers who fail to comply with the IRC 6695 rules will
now be assessed a $500 penalty for each failure to comply. Example: If
you prepare 50 returns that do not comply with the due diligence
rules you will be fined $25,000 by the IRS.
The IRS now requires Form 8867 - Paid Preparer's Income Credit
Checklist to be filed electronically with the tax return. You must also
keep a copy of Form 8867 and any documentation the taxpayer
provided you upon which you relied to complete the form in your file,
or stored electronically, for three (3) from the latest of:

The return due date (without regard to extensions);


For a signing tax return preparer who is filing the return
electronically, the filing date;
For a signing tax return preparer who is not filing the return
electronically, the date the return or claim was presented to the
taxpayer for signature; or
For a non-signing tax return preparer, the date the preparer
submitted to the signing preparer the portion of the return or
claim that the non-signing preparer was responsible for.

You must have no knowledge that any of the information used to


determine the taxpayer's eligibility for the credit and the credit
amount is incorrect. You must make reasonable inquiries if a
reasonable and well-informed tax preparer, knowledgeable in the law,
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would conclude that the information furnished to you appears


incorrect.
You must also contemporaneously (i.e. simultaneously, concurrently)
document the reasonable inquiries made and the taxpayer's
responses to those inquiries. You must retain a record of how, when,
and from whom the information used to prepare the form and
worksheet(s) was obtained.
The new regulations subject firms to the same $500 penalty for each
failure as their preparers if:

One or more officers or managers of the firm or its branch


office participated in or, prior to the time the return was filed,
knew of the failure to comply with the due diligence
requirements;
The firm failed to establish reasonable and appropriate
procedures to ensure compliance; or
The firm had such procedures but disregarded them through
recklessness, willfulness, or gross indifference.

The EITC due diligence rule is being enforced. To receive the IRS's
EITC Brochure click here:
http://www.irs.gov/pub/irs-pdf/p4687.pdf
For further information click here:
http://www.irs.gov/individuals/article/0,,id=150528,00.html
Learn how to meet the requirements and avoid penalties with the
IRS's online EITC due diligence training module:
http://www.eitc.irs.gov/Tax-Preparer-Toolkit/main

SIDE BAR

What is an Enrolled Agent?


An Enrolled Agent (EA) is a tax practitioner who has been authorized to
practice before the Internal Revenue Service. Enrolled Agents, like
attorneys and Certified Public Accountants (CPAs), are unrestricted as to
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which taxpayers they can represent, what types of tax matters they can
handle, and which IRS offices they can practice before. Enrolled Agents
are authorized to represent taxpayers before all administrative levels of
the IRS for audits, collections, and appeals. Enrolled Agents advise,
represent, and prepare tax returns for individuals, partnerships,
corporations, estates, trusts, and other entities with tax reporting
requirements.
According to the National Association of Enrolled Agents there are
currently about 48,000 practicing Enrolled Agents in the United States.
History of Enrolled Agents
After the U.S. Civil War many citizens had problems collecting their claims
from the government for horses and other property that was confiscated
for use in the war effort. Additionally, the government had problems with
many of the claims as many were fraudulent. For instance, the Treasury
Department received more claims for reimbursements for horses taken
than there were horses in North America. In 1884 Congress required that
all persons submitting claims to the Treasury Department submit them
through an Enrolled Agent. When the federal income tax was passed in
1913 the role of Enrolled Agents expanded.
How do you become an enrolled agent?
There are two ways to become an enrolled agent - pass the IRS's
comprehensive Special Enrollment Examination; or have the required five
years experience as a former IRS employee in a position which regularly
interprets and applies the tax code and its regulations. Further details are
contained in Treasury Department Circular 230 - Regulations Governing
the Practice of Attorneys, Certified Public Accountants, Enrolled Agents,
Enrolled Actuaries, and Appraisers Before the Internal Revenue Service.
Enrollment via the Special Enrollment Examination method requires the
following:

Pass a written examination. You must demonstrate special


competence in tax matters by passing the written examination;
and

Pass a background check to ensure that you have not engaged in


any un-permitted conduct.
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Failure to timely file tax returns or pay tax due is un-permitted conduct
and thus grounds for denial of enrollment.
Continuing Professional Education (CPE)
In addition to comprehensive testing the IRS requires Enrolled Agents to
complete 72 hours of continuing professional education every three years
to maintain their Enrolled Agent status.
Ethical Standards
Enrolled Agents must comply with the provisions of the Circular 230.
Failure to do so results in suspension or disbarment.
Practice before the United States Tax Court
Enrolled Agents are not allowed to practice before the United States Tax
Court unless they pass the Tax Court Examination for non-attorneys.
Identification
Taxpayers may ask an enrolled agent to show his or her enrollment card.
Additionally, Enrolled Agents display their certificate evidencing Enrolled
Agent status prominently in their offices. Taxpayers seeking to confirm a
person's enrollment status can also contact the Detroit Office of
Practitioner Enrollment at (313)234-1280 or by email at epp@irs.gov.
If you have successfully completed our income tax course and have at
least two years of experience in the tax preparation business and you
think that you would like to become an Enrolled Agent let us know as we
have an Enrolled Agent Educational Assistance Plan for our third year and
later tax software users.

Lesson Summary
Lets take a moment to review what you have covered in this lesson. The EIC
is a refundable credit available to low to moderate income workers who
meet certain income, filing status, and residence requirements. The income
requirements depend on whether the taxpayer has zero, one, or more
qualifying children and/or files a joint return. Eligible taxpayers can receive a
refund of this credit even if they owe no tax and had no income tax
withheld.

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The EIC can be claimed on Form 1040EZ, Form 1040A, or Form 1040.
Taxpayers who claim the EIC based on qualifying children must use Form
1040A or Form 1040.
A taxpayer has a qualifying child for the EIC if the child meets the
relationship test, residency test, and age test.
If a taxpayer's EIC was disallowed as a result of the deficiency procedures,
not mathematical or clerical errors, the taxpayer must attach Form 8862 Information To Claim Earned Income Credit After Disallowance to the return
to claim the credit again.
The 1040 ValuePak EIC Qualification Checklist provides EIC eligibility
questions. Schedule EIC is required for entering qualifying child(ren)
information for Forms 1040 and 1040A.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify your 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

26
Lesson 26 - The Foreign Tax Credit
In this lesson you'll learn about the Foreign Tax Credit as it applies to U.S.
citizens and residents, including U.S. military personnel, who have paid or
accrued foreign taxes to a foreign country on foreign source income, and are
subject to U.S. tax on the same income. This lesson explains the steps for
completing Form 1116 - Foreign Tax Credit which taxpayers must complete in
order to claim the credit.
The following topics are discussed in this lesson:
What Is the Foreign Tax
Credit?
Qualifying Taxes
No Economic Benefit
Country Restrictions
Form 1116
Types of Income
Passive Income

High Withholding Tax


Interest
General Limitation Income
High Taxed Income
Completing Form 1116
Foreign Earned Income
Exclusion
Cash Basis vs. Accrual Basis
Taxpayers

axpayers who paid income, war profits, or excess profits taxes to any
foreign country or U.S. possession may be able to take a Foreign Tax
Credit (FTC) for taxes paid. The Foreign Tax Credit can only be
claimed using Form 1040.
Foreign Country includes any political subdivision, or agency or
instrumentality of the country or possession.
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U.S. citizens and residents compute their U.S. taxes based on their
worldwide income. This sometimes results in U.S. citizens having to pay tax
twice on the same income: once to the government of the foreign country
where the income was sourced and once to the U.S. government.
The Foreign Tax Credit was created to help taxpayers avoid this double
taxation. It allows taxpayers to take a tax credit for taxes paid to a foreign
government on foreign source income that is subject to U.S. tax.
To qualify for the credit, a taxpayer must:

Have income from a foreign country


Have paid taxes on that income to the same foreign country
Not have claimed the foreign earned income exclusion on the same
income

The Foreign Tax Credit is a dollar-for-dollar reduction in the amount of U.S.


tax. However, in some cases, not all taxes paid to a foreign government can
be used in the computation of the Foreign Tax Credit.

TAX QUOTE

"The government deficit is the difference between the amount of money the
government spends and the amount it has the nerve to collect."
Sam Ewing

Qualifying Taxes
In order to qualify for the Foreign Tax Credit, the foreign tax must:
Be paid to a foreign country on income derived from the foreign
country
Be similar to the U.S. income tax
Provide no economic benefit to the taxpayer paying the tax
A credit for foreign taxes can be claimed only for foreign tax imposed by a
foreign country or U.S. possession.

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Foreign taxes that qualify for the Foreign Tax Credit generally include taxes
on:

Wages
Dividends
Interest
Royalties
Annuities

Foreign taxes for which an individual may not take a credit include, among
other examples, taxes:

On excluded income
For which the taxpayer can take only an itemized deduction
On foreign oil-related income
On foreign mineral income

No Economic Benefit
In order to qualify for the credit, the foreign tax cannot provide specific
economic benefit for the taxpayer. This means that the tax cannot be a
payment that results in an individual receiving:

Goods
Services, or
The right to use certain properties that are not available to others
who are subject to the same income tax

A taxpayer is considered to receive a specific economic benefit if he or she


conducts a business transaction with a person who receives an economic
benefit from a foreign country, and under the terms and conditions of the
transaction, the taxpayer directly or indirectly receives some part of the
benefit.

Country Restrictions
There are certain countries to which a taxpayer may pay foreign income
taxes but cannot claim a Foreign Tax Credit. These countries include those
that the United States has designated as repeatedly providing support for
acts of international terrorism, and countries with which the United States

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has no diplomatic relations, or whose government the United States does


not recognize.
At the time of this writing, income taxes paid to the following countries are
not eligible for the Foreign Tax Credit:

Cuba
Iran
Libya
North Korea
Syria
Sudan

A waiver can be granted to a sanctioned country if the President of the


United States determines that granting a waiver is in the national interest of
the United States and will expand trade and investment opportunities for
U.S. companies in the sanctioned country. The country of Iraq used to be on
the list of countries not eligible for the Foreign Tax Credit. The sanctioned
period for Iraq ended June 27, 2004. A Presidential waiver was granted for
qualified income taxes paid to Libya arising after December 9, 2004.
The foreign income from sanctioned countries is still subject to U.S. tax. A
separate Form 1116 must be completed for foreign income from a
sanctioned country.

Form 1116
Generally, to claim the FTC, taxpayers are required to file Form 1116 Foreign Tax Credit (Individual, Estate, Trust, or Nonresident Alien Individual).
However, taxpayers do not have to file Form 1116 if they meet all of the
following requirements:

All of the taxpayers gross foreign source income is from interest and
dividends that are reported on Form 1099-INT or Form 1099-DIV (or
substitute statement)

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Figure 26-1: Form 1099-INT - Interest Income with box 6 "Foreign tax paid" and box 7
"Foreign country or U.S. possession" highlighted.

Figure 26-2: Form 1099-DIV - Dividends and Distributions with box 6 "Foreign tax
paid" and box 7 "Foreign country or U.S. possession" highlighted.

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If the taxpayer has dividend income from shares of stock, he or she


must have held those shares for at least 16 days

In addition, the taxpayer does not have to file Form 1116 if:

The taxpayer is not filing Form 4563 - Exclusion of Income for Bona
Fide Residents of American Samoa, or excluding income from sources
within Puerto Rico

The total of the taxpayers foreign taxes is less than or equal to $300
($600 if Married Filing Jointly)

All of the taxpayers foreign taxes were:


o Legally owed and not eligible for a refund, and
o Paid to countries that are recognized by the United States
and do not support terrorism

If the taxpayer meets all of the requirements listed above, Form 1116 is not
required. Enter the Foreign Tax Credit on line 48 of Form 1040.

Figure 26-3: The Tax and Credits section of Form 1040 with line 48 "Foreign tax credit"
highlighted.

For more information on the Foreign Tax Credit refer to Publication 514
Foreign Tax Credit for Individuals and the Instructions for Form 1116.

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Types of Income
At the top of Form 1116, Foreign Tax Credit, taxpayers are asked to indicate
the type of foreign income they received. There are three types of income
categories that are generally eligible for the Foreign Tax Credit:

Passive income
High withholding tax interest
General limitation income

A separate Form 1116 must be completed for each type of income. The
credits are eventually combined onto one form.
Passive Income
Passive income generally includes the following types of income, assuming
the income is from another country and the taxpayer has paid taxes on it:

Dividends
Interest
Royalties
Rents
Annuities

Indicate passive income by checking box A on Form 1116.


Wages and salaries are considered to be general limitation income, which is
discussed later in this topic.
High Withholding Tax Interest
High withholding tax interest income is interest income on which at least
5% foreign gross income tax was withheld. Banks in some foreign countries
may withhold as much as 27.5% of interest income as income tax. Since the
withholding rate is at least 5%, a taxpayer who maintains a bank account in
a foreign country with this high mandatory withholding rate would check
the box "high withholding tax interest."
General Limitation Income
The final income category on Form 1116 is the "general limitation income"
category. General limitation income consists of wages earned in a foreign
country that an individual does not exclude, or excludes only part of, under
the foreign earned income exclusion. Additionally, if a taxpayer has foreign
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income that does not come under any of the other categories on Form
1116, then that income can typically be included as general limitation
income.
High Taxed Income
For taxpayers who have passive income that is taxed by a foreign
government at a rate higher than the highest U.S. income tax rate, the
income is classified under the general limitation category.
In 2013, the highest U.S. individual income tax rate is 39.6%. Therefore, if a
taxpayer pays more than 39.6% on the foreign source passive income for
which he or she claimed the credit, the credit is computed under the
"general limitation" category.

TAX QUOTE

"A tax loophole is something that benefits the other guy. If it benefits you, it
is tax reform."
Russell B. Long

Completing Form 1116


The previous topic addressed the top portion of Form 1116 where you enter
the taxpayer's type of foreign income. This topic will explain how to
complete the rest of the form, which consists of three parts:

Part I: Used to figure the taxable income from foreign sources in


each income category

Part II: Addresses the amount of foreign taxes paid or that may be
owed (accrued)

Part III: Used to compute the Foreign Tax Credit

Part I is used to figure the taxable income from foreign sources in each
income category. For a taxpayer who has one type of foreign income that
comes from several foreign countries, you would use one Form 1116. Up to
three countries may be added to one Form 1116.

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Foreign Earned Income Exclusion


For taxpayers who have claimed the foreign earned income exclusion, you
would enter on line 1 only the amount of earned income not excluded. The
foreign earned income exclusion allows qualified taxpayers to exclude up to
$99,200 (for 2014) of their foreign earnings from their taxable income.
For example, a U.S. citizen living in England who earned $99,200 could
claim a foreign earned income exclusion of $99,200. The taxpayer would
enter only $0 on line 1 of Form 1116 ($99,200 earned income - $99,200
exclusion = $0).
Cash Basis vs. Accrual Basis Taxpayers
A cash basis taxpayer reports income when it is actually received, and
reports expenses when they are paid. Nearly all of people who file individual
income tax returns are cash basis taxpayers. Taxpayers who do not know
whether they are on a cash basis or accrual basis are probably on a cash
basis. Cash basis taxpayers have the option to take Foreign Tax Credit using
the cash or accrual method.
Accrual basis taxpayers compute income and deductions differently. They
compute income when they actually earn it or became entitled to it.
Therefore, their deductions are computed based on when those debts were
incurred, but not necessarily paid.
Taxpayers on a cash basis may choose to use the accrual method to
determine the Foreign Tax Credit. However, once this choice has been
made, the taxpayer must use the accrual method for the Foreign Tax Credit
on all future tax returns.
For additional information, see Publication 514 - Foreign Tax Credit for
Individuals.

Lesson Summary
In this lesson you learned that:

To qualify for a Foreign Tax Credit, income on which the taxes are
paid must be from a foreign source

The tax being paid must be similar to U.S. income tax

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The individual paying the tax cannot derive a specific economic


benefit and still claim the Foreign Tax Credit

The Foreign Tax Credit is computed on Form 1116. Taxpayers do not have
to file Form 1116 if they meet all of the following requirements:

All of the taxpayers gross foreign source income is from interest and
dividends that are reported on Form 1099-INT, or Form 1099-DIV (or
substitute statement)

If the taxpayer has dividend income from shares of stock, he or she


must have held those shares for at least 16 days

In addition, the taxpayer does not have to file Form 1116 if:

The taxpayer is not filing Form 4563, Exclusion of Income for Bona
Fide Residents of American Samoa, or excluding income from
sources within Puerto Rico

The total of the taxpayers foreign taxes is less than or equal to $300
($600 if Married Filing Jointly)

All of the taxpayers foreign taxes were:


o Legally owed and not eligible for a refund, and
o Paid to countries that are recognized by the United States
and do not support terrorism

Part I of Form 1116 is used to figure the taxable income from foreign
sources in each income category:

A separate Form 1116 must be completed for passive income,


interest income that is subject to a gross withholding rate of at least
5%, and other income that falls under the general limitation category

If passive income, minus allocations, is subject to tax at a rate that is


higher than 39.6%, then it falls into the general limitation category

If an individual claims the foreign earned income exclusion, the


excluded amount is not shown on line 1 of Part I of the Form 1116
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SIDE BAR

Extensions of Time to File


If taxpayer's dont file their tax returns and pay any tax due by the due
date they may have to pay a penalty. Keep in mind that your state filing
deadline may be different than the federal filing deadline. Check your
state Department of Revenue's web site or call them.
Penalties
If the taxpayer does not file by the deadline they'll face a failure-to-file
penalty. If they do not pay any tax due by the due date they'll also face a
failure-to-pay penalty. The failure-to-file penalty is generally more than
the failure-to-pay penalty. So if a taxpayer cannot pay all the taxes he
owes he should still file his tax return and explore the other payment
options described below.
The penalty for filing late is usually 5 percent of the unpaid taxes for each
month or part of a month that a return is late - up to a maximum of 25
percent of the unpaid taxes. If the tax return is filed more than 60 days
after the due date or extended due date, the minimum penalty is the
smaller of $135 or 100 percent of the unpaid tax.
The penalty for paying late is of 1 percent of the unpaid taxes for each
month or part of a month after the due date that the taxes are not paid up to a maximum of 25 percent of the unpaid taxes.
If both the failure-to-file penalty and the failure-to-pay penalty apply in
any month, the 5 percent failure-to-file penalty is reduced by the failureto-pay penalty. However, if the taxpayer files his return more than 60
days after the due date or extended due date, the minimum penalty is
the smaller of $135 or 100% of the unpaid tax.
Taxpayers will not have to pay a failure-to-file or failure-to-pay penalty if
they can show that they failed to file or pay on time because of
reasonable cause and not because of willful neglect.
Extensions
If a taxpayer can't meet the deadline to file their tax return they should
still file their tax return by the deadline and pay as much as they can to
avoid penalties and interest. Alternatively, they can get an automatic six
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month extension of time to file from the IRS. Most individuals and
businesses can request a full six-month filing extension, without a reason
or even a signature. Individuals use Form 4868, Application For Automatic
Extension of Time To File U.S. Individual Tax Return, to get an automatic
six-month extension of time to file. A reasonable estimate of tax liability
must be entered on Form 4868. The IRS can later invalidate an extension
if the tax is understated.
Keep in mind that a federal extension is NOT necessarily an automatic
state extension. You may still need to file a separate extension form with
your state. Check your state Department of Revenue's web site or call
them.
There is no penalty for failure to file a tax return if the taxpayer is due a
refund. However, taxpayers cannot obtain a refund without filing a tax
return. If the taxpayer waits too long to file he may risk losing the refund
altogether. The deadline for claiming refunds is generally three (3) years
after the tax return due date.
A filing extension DOES NOT extend the tax-payment deadline. Taxpayers
will owe interest on any amounts not paid by the deadline, plus a late
payment penalty if they have paid less than 90 percent of their total tax
due by that date.
United States citizens or residents whose home and main place of
business or post of duty is outside the United States and Puerto Rico on
the due date of their return are allowed an automatic extension until June
15th to file their return AND pay any tax due. This also applies to
taxpayers in military or naval service on duty outside the United States
and Puerto Rico. If the taxpayer uses this automatic extension, he must
attach a statement when he does file his return showing that he met the
requirements for the extension on the due date of the return.
If the taxpayer is serving in a combat zone, a qualified hazardous duty
area, or in a contingency operation (or is hospitalized as a result of an
injury received while serving in such an area or operation), he or she has
at least 180 days after he or she leaves the designated area to file and
pay taxes. Refer to Topic 301 for more information about extensions. Also
click here. Further information is in Publication 3 - Armed Forces' Tax
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Guide.
If the taxpayer is determined by the IRS to be affected by a Presidentially
declared disaster or a terroristic or military action, then the taxpayer may
have up to one year after the due date of the return to file and pay taxes,
depending on the deadline specified by the IRS.
If the taxpayers return is completed but they are unable to pay the tax
due, DO NOT request an extension. File the tax return on time and have
the taxpayers pay as much tax as they can. The IRS will send them a bill or
notice for the balance due. To apply for a payment agreement click here.
Also see Extensions of Time to Pay below.
Making Payments
Taxpayers can charge their taxes on their American Express, MasterCard,
Visa, and Discover cards - or by using their debit card. The debit card
must be a Visa Consumer Debit Card, or a NYCE, Pulse or Star Debit Card.
To pay by credit card contact one of the service providers at its telephone
number or web site. In the 1040 ValuePak Portal click Tax Preparation
Help > Go to IRS Help > Payments by Credit Card - or click here.
The service providers charge a convenience fee based on the amount the
taxpayer is paying. Do not add the convenience fee to the tax payment.
At the completion of the transaction, the taxpayer(s) will receive a
confirmation number for their records.
Extensions of Time to Pay
Based on the circumstances, a taxpayer could qualify for an extension of
time to pay. The IRS is willing to allow extensions of time to pay in order
to assist in tax debt repayment. A taxpayer can request an extension from
30 - 120 days depending on the specific situation. Taxpayers qualifying
for an extension generally will pay less in penalties and interest than if the
debt were repaid through an installment agreement. An additional
amount of time to pay can be requested through the Online Payment
Agreement application or by calling 800-829-1040.
Installment Agreements
The IRS may allow taxpayers to pay any remaining balance in monthly
installments through an Installment Agreement. They can apply for an
Installment Agreement using the IRSs Online Payment Agreement.
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This application allows eligible taxpayers or their authorized


representatives who owe $25,000 or less in combined tax, penalties and
interest to self-qualify, apply for, and receive immediate notification of,
approval.
Another alternative is to attach a Form 9465 - Installment Agreement
Request to the front of the tax return. The IRS charges a $120 fee for
setting up an installment agreement. The fee is only $52 if paid via direct
debit. If the taxpayers income is below a certain level (see Form 13844 Application For Reduced User Fee For Installment Agreements), they may
qualify for a $43 fee. They will also be required to pay interest plus a late
payment penalty on the unpaid taxes for each month or part of a month,
after the due date that the tax is not paid. To prepare Form 9465 in our
software simply click Your Forms and select Form 9465 from the Misc tab.
Mailing a Payment
If the taxpayer mails the payment, Form 1040-V is not required. The
taxpayer simply needs to write their Social Security number, daytime
telephone number, and 2011 Form 4868 on the check or money order.

TAX PRACTICE TIP

Amending Tax Returns


Oops! You or the taxpayer have discovered an error after a tax return has
been filed. What should you do now? Do not panic - you may need to
amend the tax return. You can correct a previously filed Form 1040,
1040A 1040EZ, 1040NR, or 1040NR-EZ by filing Form 1040X - Amended
U.S. Individual Income Tax Return. Here are six reasons to file an amended
return:

You did not include some income on the return,

You claimed deductions or credits that should not have been


claimed,

You did not claim deductions or credits that should have been
claimed,

You should have claimed a different filing status. Taxpayers who


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filed a joint return cannot choose to file separate returns for that
year after the due date of the return. However, an executor may
be able to make this change for a deceased spouse,

You want to claim an uninsured disaster loss that occurred this


year on the prior year tax return. Doing this will result in an
immediate refund. However, it may pay to wait until you know the
Adjusted Gross Income for the current year, to determine which
year will result in the largest tax savings,

You discover a bad debt or worthless security that you failed to


write off. You have 7 years from the due date of the return for the
year in which the debt or security became worthless to submit an
amended return.

The IRS usually automatically corrects math errors or requests forms that
were erroneously not attached to the tax return - such as W-2s or
schedules. In these instances, do not amend the tax return.
Also don't amend a return if you want to claim a net operating loss carryback. You can file for a quick refund using Form 1045 - Application for
Tentative Refund, which is simpler than filing an amended tax return.
Form 1040X is available from the Misc tab of the Your Forms section of
1040 ValuePak Professional. Before amending any return make sure you
have a saved .pdf and printed copy of the original return.
Form 1040X has an area on the front of the form to explain why you are
filing Form 1040X. Be sure to enter the year of the return you are
amending at the top of Form 1040X. If you are amending more than one
tax return, prepare a separate Form 1040X for each return and mail them
in separate envelopes to the IRS processing center(s). The 1040X
instructions list the addresses for the processing centers.
If the changes involve another schedule or form, attach it to Form 1040X.
For example, if you are filing a 1040X because of a qualifying child and
now want to claim the Earned Income Tax Credit, attach Schedule EIC to
show the qualifying person's name, year of birth, and Social Security
number.
If you are filing to claim an additional refund, wait until the taxpayer has
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received the original refund before filing Form 1040X. The taxpayer may
cash that check while waiting for any additional refund. If the taxpayer
owes additional tax, filing Form 1040X and paying the tax by the April
due date will avoid any penalties and interest.
Generally, to claim a refund, Form 1040X must be filed within three years
from the date the original return was filed or within two years from the
date the tax was paid, whichever is later. Form 1040X cannot be e-filed.
The IRS often takes two to three months to process Form 1040X.
If you file an amended return shortly before the three (3) year statute of
limitations expires and the amended return shows the taxpayer owes
additional tax the IRS has sixty (60) days from the date it receives the
amended return to assess any additional tax - even if the statute of
limitations has expired.
If you file an amended federal tax return and the taxpayer owes
additional tax, or is assessed additional tax by the IRS, he may also owe
additional state income tax. The IRS shares its information with most
states, and vice versa. You may be able to avoid interest and tax penalties
on the taxpayers state tax return by promptly amending the state return
too. The reverse is also true.
The IRS now has a tool that you can use to track the status of amended
returns, "Where's My Amended Return?" You'll find it at
http://www.irs.gov/Filing/Individuals/Amended-Returns-(Form-1040X)/Wheres-My-Amended-Return-1. You have to wait 3 weeks from filing
before you can use this tool.

SIDE BAR

Facts about IRS Publication 17


IRS Publication 17 - Your Federal Income Tax takes you step by step
through each part of an individual Federal Income tax return. Here are
the top things you should know about Publication 17.

The online version of Publication 17 contains electronic links that


make finding your answer simple. Both the downloadable PDF
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and online Publication 17 have thousands of helpful hyperlinks.

Publication 17 is packed with basic tax-filing information and tips


on what income to report and how to report it.

Publication 17 also includes information on figuring capital gains


and losses, claiming dependents, choosing the standard
deduction versus itemizing deductions, and how to claim valuable
tax credits.

Publication 17(SP) El Impuestos Federal sobre los Ingresos is


available in Spanish.

You can also order a hard copy of Publication 17 at the IRS web site by
calling 800-TAX-FORM (800-829-3676).

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify your 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

27
Lesson 27 - Miscellaneous Tax
Credits
In this lesson you'll learn about six miscellaneous tax credits: the credit for
qualified retirement savings, the residential energy credits, the electric
vehicle credit, the alternative motor vehicle credit, the mortgage interest
credit, and the health coverage credit.
The following topics are discussed in this lesson:
Qualified Retirement Savings
Contributions
Eligible contributions
Married Filing Jointly
Residential Energy Efficient
Property Credit
Alternative Motor Vehicle
Credit

Plug-in Electric Drive Vehicle


Credit
Mortgage Interest Credit
Health Coverage Tax Credit
General Business Credits

ederal tax credits can generally be divided into four categories:

Credits for investments in processes or equipment that benefit the


environment

Credits for investments believed of benefit to society

Credits for certain taxes already paid


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Credits for wages and investments of benefit to low income,


disabled, and disadvantaged people

This lesson deals primarily with credits available to individual taxpayers who
file Form 1040, although we do list the components of the General Business
Credit at the end of the lesson. Below is a list of the tax credits that are
available to individuals filing Form 1040.
Tax Credit
Adoption
Credit/Exclusion

IRS Form

IRS Pub.

8839

Topic 607

Phaseout
Modified AGI

Credit Applies to
Qualifying adoption
expenses. Certain
adoptions do not
require expenses.

American Opp. /
Lifetime
Learning Credit

8863

970

Modified AGI

Child and
Dependent Care
Credit

2441/8882

503

2441/AGI,
8882/Tax
liability

Child &
Additional Child
Tax Credit
Earned Income
Credit

8812/8901

972

Modified AGI

Qualifying post
secondary
education
expenses.
Working parent or
student spouse,
with dependent
children. Also,
separate employer
credit.
Taxpayers with
qualifying children.

EIC

596

AGI/Earned
income

Elderly/Disabled
Credit

Sch R

524

Modified AGI

Federal Tax Paid


on Fuels
Foreign Tax
Credit

4136
1116

514

Taxable
income

Health Coverage
Tax Credit

8885

502

None

None

804

Low income
taxpayers with
earned income.
Low income
taxpayers based
on age and/or
permanent
disability.
Federal tax paid for
specific fuel usage.
Foreign taxes
withheld. Election
to not file form
1116 is available.
Health insurance
premiums of
qualified persons.

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Tax Credit
General
Business
Credits

IRS Form

Prior Year AMT


Credit

8801

Mortgage
Interest Credit

8396

Residential
Energy Credits

5695

Retirement
Savings
Contribution
Credit

8880

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IRS Pub.
Phaseout
Credit Applies to
Many credits are available including (with form
number): Investment (3468), Work
Opportunity/Welfare to Work (5884), Research
(6765), Low Income Housing (8586), Oil
Recovery (8830), Disabled Access (8826),
Renewable Electric Production (8835), Indian
Employment (8845, Orphan Drug (8820), New
Markets (8874), Pension Start-Up Costs (8881),
and others.
Per filing
Taxpayers with
status
prior year AMT tax
liability.
Tax liability
Qualified Mortgage
530
Credit Certificate
holders in credit
certificate program.
Various limits

590-A

Modified AGI

Various
nonbusiness
property
improvements for
energy savings.
Contributions to
most qualifying
retirement plans by
lower income
taxpayers.

SIDE BAR

Make Sure Your Client Always Remits Payroll Taxes


Business owners and operators withhold and remit federal, state, and
local income taxes; Social Security and Medicare taxes; and, in some
states, disability insurance taxes. All of these payroll taxes must be
remitted to various government agencies. Additionally, employment tax
returns must be timely filed.
Business owners must be sure to always file payroll tax returns and remit
the payroll tax withheld when due. For payroll tax purposes, the business
owner is a trustee and dipping into payroll tax withholding is stealing the
employees income, social security, and Medicare taxes. If a business
owner is strapped for cash he should never dip into the withheld payroll
taxes. Its illegal. The IRS will assess large penalties and even shut down
the business if the payroll taxes are not remitted to them. Additionally,
any unpaid payroll taxes are the personal liability of the business owner
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or operator - even if the business is a corporation or limited liability


company. The IRS can and will seize personal assets (such as homes, cars,
and boats) of the business owner or operator to pay the payroll tax
liability. Business owners should consider using a payroll service such as
ADP.

Qualified Retirement Savings Contributions


This topic defines the Qualified Retirement Savings contributions credit. At
the end of this topic, you will be able to explain the credit for Qualified
Retirement Savings contributions.
Taxpayers should be asked about contributions to a retirement plan or IRA
in order to accurately report the credit. When a taxpayer is eligible for this
credit, the amount that can be reported is determined by the taxpayers:

filing status
adjusted gross income
qualified contributions

Taxpayers who contributed to a retirement plan or an IRA may be eligible


for the nonrefundable Qualified Retirement Savings contributions credit or
savers credit. The credit is reported on line 51 of Form 1040.

Figure 27-1: The Tax and Credits section of Form 1040 with line 51 "Retirement savings
contributions credit" highlighted.

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This credit may be claimed in addition to any IRA deduction.


Taxpayers may be eligible to claim the retirement savings credit if they (or
their spouses if filing jointly) made:

Contributions (other than rollover contributions) to a traditional or


Roth IRA

Elective deferrals to a 401(k), tax-sheltered annuity 403(b) plan,


governmental 457, salary reduction SEP, or SIMPLE IRA plan

Voluntary after-tax employee contributions to a qualified retirement


plan (as defined in section 4974(c), or

Contributions to a 501(c) (18) (D) plan

An employee contribution is considered voluntary if it is not required as a


condition of employment.
In addition, to be eligible for the credit the taxpayer:

Must be age 18 or older by the end of the tax year


Cannot be claimed on another person's tax return
Cannot be a full-time student, and
Cannot have an adjusted gross income of more than:
o $60,000 if Married Filing Jointly
o $45,000 if Head of Household
o $30,000 if Single, Married Filing Separately or Qualifying
Widow(er)

The table below shows the Retirement Savings Contribution Credit rates
for various Filing Statuses and Adjusted Gross Incomes:

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A nonrefundable credit is available for contributions to retirement savings plans. The


credit is in addition to the deduction (or income exclusion) of the contribution. The credit
is equal to the applicable percentage (based on income and filing status), times qualified
retirement plan contributions (not to exceed $1,000 of contributions).
Credit Phaseout - Modified Adjusted Gross Income
Credit Rate
Married Filing Joint Head of Household
Single
50%
$0 - $36,000
$0 - $27,000
$0 - $18,000
20%
$36,001 - $39,000
$27,001 - $29,250
$18,001 - $19,500
10%
$39,001 - $60,000
$29,251 - $45,000
$19,501 - $30,000
0%
Over $60,000
Over $45,000
Over $30,000
Contributions to many plans qualify including 401(k), SEP, SIMPLE, Keogh, IRA
(traditional and Roth), 403(b), and voluntary after-tax qualified plans. The contribution
used to calculate the credit must be offset by certain retirement plan distributions.
Contributions to a qualified retirement plan must be made by an eligible individual, defined
as:

At least 18 years of age at year end

Not a dependent of another taxpayer, and

Not a student (generally full time)


Table: Retirement Contribution Credit

A full-time student is anyone who attends school full time for some part of
each of five calendar months of the year. The five months need not be
consecutive. Students are considered full time if they are enrolled for the
number of hours or courses the school considers as full-time attendance.

TAX QUOTE

"A democratic government is the only one in which those who vote for a
tax can escape the obligation to pay it."
Alexis de Tocqueville
Eligible Contributions
Eligible contributions are determined by reducing the taxpayers Qualified
Retirement Savings contributions by the following distributions that were
received during the testing period:

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Any distribution, that is included in the taxpayers gross income, from


a qualified retirement plan, or from an eligible deferred
compensation plan

Any distribution from a Roth IRA that is not a qualified rollover


contribution

Further information is contained in Publication 590-B - Distributions from


Individual Retirement Arrangements.
The testing period includes:

The tax year


The two preceding tax years, and
The period between the end of the tax year and the due date of the
return (including extensions)

If the distributions received by the taxpayer are for loans or for excess IRA
contributions returned before the due date of the return, they are not used
to reduce the taxpayers Qualified Retirement Savings contributions.
In addition, distributions from a Military Retirement Plan are not used to
reduce the taxpayers qualified retirement savings contribution. The Military
Retirement Plan is a non-contributory plan that does not allow any
contributions by the military employee.
Married Filing Jointly
For taxpayers who are married filing a joint return, both spouses may be
eligible for a credit of up to 50% of the maximum annual contribution
amount of $2,000.
If the taxpayers file a joint return, the qualified contribution is reduced by
the taxable distributions received by the taxpayer or the taxpayers spouse
(if the taxpayers filed jointly for both):

The year a distribution was made, and


The year the credit is claimed

To take the retirement savings credit, complete Form 8880 - Credit for
Qualified Retirement Savings Contributions.
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Residential Energy Efficient Property Credit


The energy efficient residential energy credit is 30% of the cost of qualified
energy efficient property added to the taxpayers home in the United States.
This property includes photovoltaic property (solar panels), solar water
heating equipment, fuel cell power plans, qualified small wind energy
property costs, and qualified geothermal heat pump property. The cost
includes labor costs properly allocated to the onsite preparation, assembly,
or original installation of the property and piping or wiring to interconnect
the property to the home.
A home includes a house, houseboat, mobile home, cooperative apartment,
condominium, and certain manufactured homes. The taxpayer must reduce
the basis of their home by the amount of any credit allowed.
A Residential Energy Efficient Property Credit may be taken in the year when
the item is installed, or in the case of construction or reconstruction of a
building, when the original use of the constructed or reconstructed building
begins.
To assure customers that their energy efficient items will qualify for the tax
credit manufactures provide their customer with a certification statement.
In 2009 through 2016 there is no limitation on the credit amount for
qualified solar electric property costs, qualified solar water heating property
costs, qualified small wind energy property costs, and qualified geothermal
heat pump property costs. The limitation on the credit amount for qualified
fuel cell property costs is $500 for each half kilowatt of capacity.
Costs allocated to a swimming pool or hot tub do not qualify for the
Residential Energy Efficient Property Credit.
Form 5695 is used to claim these credits which are carried to Form 1040 line
53.

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Figure 27-2: The Tax and Credits section of Form 1040 with line 53 "Residential energy
credits" highlighted.

Alternative Motor Vehicle Credit


Taxpayers may be able to claim a tax credit for an alternative motor vehicle
placed in service for business or personal use after 2005 through 2014. An
alternative motor vehicle must meet certain requirements and a be new:

Advanced lean burn technology vehicle


Qualified alternative fuel vehicle
Qualified fuel cell vehicle
Qualified hybrid vehicle

Generally for a passenger car or light duty truck that is either a qualified
hybrid vehicle or an advanced lean burn technology vehicle, taxpayers can
rely on the manufacturers (or domestic distributors) certification that a
specific make, model, and model year vehicle qualifies for the credit and the
maximum amount of the credit for which it qualifies.
If the taxpayer purchases a qualified vehicle from a manufacturer who
previously sold at least 60,000 qualified vehicles, the credit may be phased
out. The manufacturer should give the taxpayer the information needed to
figure the phase-out percentage.
In addition to the certification, the following requirements must be met to
qualify for the credit:

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Vehicle was placed in service after 2005


Original use of the vehicle began with the taxpayer
Acquired for the taxpayers use or lease to others, and not for resale
Vehicle is used primarily in the United States

There are some exceptions for sellers of a new vehicle to a tax exempt
organization, governmental unit, or foreign person or entity.
If the vehicle no longer qualifies for the credit the taxpayer may need to
recapture all or part of the credit.
Form 8910 - Alternative Motor Vehicle Credit is used to claim this credit. Its
total is carried to Form 1040 line 54c.

Figure 27-3: The Tax and Credits section of Form 1040 with line 54c "Other credits
from Form:" highlighted.

Plug-in Electric Drive Vehicle Credit


ARRA modifies this credit for qualified plug-in electric drive vehicles
purchased after Dec. 31, 2009. The minimum amount of the credit for
qualified plug-in electric drive vehicles, which runs through 2014, is
$2,500 and the credit tops out at $7,500, depending on the battery
capacity. ARRA phases out the credit for each manufacturer after they
sell 200,000 vehicles.

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Mortgage Interest Credit


Taxpayers who hold qualified mortgage credit certificates (MCC's) under a
qualified state or local government program may claim a credit for
mortgage interest paid. The certificate must be for the taxpayers main
home. If the interest is paid to certain related parties (such as relatives) the
credit cannot be claimed. The Mortgage Interest Credit can only be claimed
using Form 1040.The MCC must be used in connection with the purchase,
qualified rehabilitation, or qualified home improvement of the certificate
holder's main home. The MCC shows the certificate credit rate taxpayers
should use to figure their credit.
Any mortgage interest credit that the taxpayer cannot use in the current
year can be carried forward for up to three tax years.
Taxpayers who were issued (and used) qualified mortgage credit certificates
after 1990 for a home may have to recapture (repay) all or part of the
benefit if they sell that home within 9 years. Use Form 8828 - Recapture of
Federal Mortgage Subsidy to figure the recapture.
For further information see Publication 530 - Tax Information for First-Time
Homeowners; and Publication 523 - Selling Your Home.
Use Form 8396 - Mortgage Interest Credit to claim the credit. 1040 ValuePak
will carry over the credit to Form 1040 line 54c.

Figure 27-4: The Tax and Credits section of Form 1040 with line 54c "Other credits
from Form:" highlighted.

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Health Coverage Tax Credit


The Health Coverage Tax Credit (HCTC) is a federal tax credit that was
established to assist workers who lose their jobs due to the effects of
international trade, provided the worker is be eligible for either certain
Trade Adjustment Assistance benefits or Alternative Trade Adjustment
Assistance. It also assists people who receive benefits from the Pension
Benefit Guaranty Corporation (PBGC) and are at least 55 years old.
Taxpayers who are potentially eligible for this credit will be notified by mail.
Shortly after the mailing, the HCTC Customer Contact Center will mail the
taxpayer a packet describing the program and eligibility requirements.
To claim the credit complete Form 8885 and attach it to Form 1040. The
credit is taken on Form 1040 line 73d.

Figure 27-5: The Payments section of Form 1040 with line 73d "Credits from Form:"
highlighted.

TAX QUOTE

"The tax collector must love poor people, he's creating so many of them."
Bill Vaughan

General Business Credits


The General Business Credit is a "catch all" for the many business credits
listed below. The titles of most of the credits explain what they are about, in
most cases. The General Business Credit is made up of the following credits:

advanced nuclear power facility production credit


agricultural chemicals security credit
alcohol fuels credit
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alternative fuel vehicle refueling property credit attributable to


depreciable property
alternative motor vehicle credit attributable to depreciable property
biodiesel fuels credit
carbon dioxide sequestration credit
disabled access credit
distilled spirits credit
employer social security credit for FICA tips
employer wage credit for employees who are active duty members
of the uniformed services
employer-provided child care credit
enhanced oil recovery credit
increasing research activities credit
Indian employment credit
investment tax credit including the rehabilitation credit, energy
credit, qualifying advance coal project credit, qualifying gasification
project credit, qualifying advanced energy project credit, and the
qualifying therapeutic discovery credit
low income housing credit
low sulfur diesel fuel production credit
mine rescue team training credit
new energy efficient home credit
new markets tax credit
non-conventional source production
orphan drug credit
qualified plug-in electric drive motor vehicle credit attributable to
depreciable property
railroad track maintenance credit
renewable resources electricity production credit
small employer health insurance credit
small employer pension plan startup costs credit
work opportunity credit

Lesson Summary
This lesson explained six miscellaneous tax credits: the credit for qualified
retirement savings, the residential energy credits, the electric vehicle credit,
the alternative motor vehicle credit, the mortgage interest credit, and the
health coverage tax credit.
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Taxpayers who contributed to a retirement plan or an IRA may be eligible


for the nonrefundable qualified retirement savings contributions credit or
savers credit if they (or their spouses if filing jointly) made:

Contributions (other than rollover contributions) to a traditional or


Roth IRA

Elective deferrals to a 401(k), tax-sheltered annuity 403(b) plan,


governmental 457, salary reduction SEP, or SIMPLE IRA plan

Voluntary after-tax employee contributions to a qualified retirement


plan (as defined in section 4974(c), or

Contributions to a 501(c) (18) (D) plan

Taxpayers who make energy efficient improvements to their main home


may be eligible for the residential energy credit.
Taxpayers who place an alternative motor vehicle into service for business
or personal use after 2005 may be eligible to claim the alternative motor
vehicle credit. To qualify for the credit the alternative motor vehicle must
meet certain criteria.
Taxpayers who hold qualified mortgage credit certificates (MCC's) under a
qualified state or local government program may claim a credit for
mortgage interest paid
The Health Coverage Tax Credit. Taxpayers who are potentially eligible for
this credit will be notified by mail.

TAX PRACTICE TIP

Form 8888 - Allocation of Refund


As you know, Form 8888 - Allocation of Refund is available for taxpayers
to direct the IRS to deposit their refund into multiple bank accounts or to
purchase U.S. Series I Savings Bonds.
Form 1040 Line 74a states "Amount of line 73 you want refunded to
you. If Form 8888 is attached, check here". Additionally, the instructions
for Form 8888 state "Purpose of Form - Use Form 8888 if: You want us to
directly deposit your refund (or part of it) to one or more accounts at a
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bank or other financial institution..."


The words you and your in the above paragraph refer to the taxpayer,
NOT the tax preparer. It is illegal for tax preparers to intercept or directly
receive from the IRS any part of a taxpayer's refund. Taxpayers may direct
the IRS to direct deposit their entire refund into one or more of their
bank account(s). The account(s) must be owned by the taxpayer, NOT the
tax preparer. Taxpayers may also direct the IRS to direct deposit their
refund into an account in their name at a tax refund processing bank.
Do not attempt to circumvent the law by having the taxpayer sign Form
8888 directing the IRS to deposit a part of their tax refund into their bank
account and your tax preparation fees into your bank account. The IRS
will eventually detect this when their computers see multiple partial
deposits from different taxpayers going to the same RTN and DAN. This
may, and probably will, result in your termination by the IRS, from the IRS
e-file program. Other civil and criminal penalties may also apply.

SIDE BAR

Exclusions from Electronic Filing


Do not be alarmed by the following list of exclusions! Historically, these
exclusions are for taxpayers in the upper income categories. Over 97% of
your clients will fall in the "wage earner" category and never fall under the
list below. Due to IRS guidelines, the following returns automatically are
mail-in returns because they are not acceptable for electronic filing:
1. Returns with a power of attorney currently in effect for the refund to be
sent to a third party.
2. Amended or corrected returns. Only one valid electronic return (the
original one) can be e-filed per taxpayer per season.
3. Returns containing forms or schedules not listed as e-fileable by the
IRS.
4. Returns for any tax period other than the current year.
5. Returns for taxpayers with foreign addresses.
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6. Returns with temporary social security numbers within the range of


900-00-0000 through 999-99-9998. (See Publication 1345 for valid
ranges).
7. Returns with dollars and cents entries (must use whole dollars only).
8. Returns with "applied for", "decedent", "F4029", "Amish", "Mennonite",
"SSA205(C)", "NRA", or missing social security numbers.
9. Returns containing more than 30 additional statements.
10. Returns, which contain Form 8283, where the Property type box
checked is equal to "Art More than $50,000".
11. Returns which require special consideration or procedures for
completion, such as returns for taxpayers who have formally requested
and received waivers from the IRS or returns for taxpayers who have
changed accounting methods.
12. Returns for taxpayers who want the IRS to complete the computation
of their return, e.g., figuring credits on Schedule EIC or Schedule R.
13. Returns containing Schedule D-1.

TAX PRACTICE TIP

Providing Bank Products


When providing bank products to taxpayers (discussed more fully in
Lesson 28) please be sure to do each of the following as the tax refund
processing bank requires these:
1. Explain Refund Options & Costs Review all refund options and costs
with the taxpayer.
2. Complete The Application Verify and input the required information.
3. Print Required Documents Print all disclosures and the Bank
Application and Agreement.
4. Review Printed Documents Give the customer ample time to review
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all of the printed documents and answer any additional questions.


5. Taxpayer(s) Signature(s) Taxpayer(s) must sign and date the Bank
Product Application and Agreement and any other required forms.
6. Taxpayer Copies Give the taxpayer(s) a copy of all the signed
documents.
7. Retain Documents Retain the signed signature page of the Bank
Product Application and Agreement and any other required forms in a
secure location for a period of at least five (5) years. Documents must be
retained in accordance with the Banks Data Security and Physical Security
requirements.
If anything changes with regards to the information printed on the Bank
Product Application and Agreement or any other required forms, you
must reprint the documents and have the taxpayer(s) sign and date the
revised documents. Keep BOTH the original and reprinted documents in
your files. DO NOT discard the old documents.
When printing checks, be sure that the check number in the software
matches the number on the check that you are actually printing. If these
numbers do not match, the check may not be able to be verified through
the automated check verification.

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify your 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

28
Lesson 28 - Electronic Filing and
Bank Products
In this lesson you'll learn about Electronic Filing and Bank Products. The
following topics are discussed in this lesson:
Introduction to Electronic
Filing
Electronic Filing
The History of IRS e-file
Security of IRS e-file
Why Offer IRS e-file to Your
Clients?
What's in it for Your Clients?
What is the Self-Select PIN?
State E-file Mandates
Refund Options
Straight Electronic Filing
(Direct Deposit)
Straight Electronic Fling
(Paper Check)
Mail in Return (Direct
Deposit)
Mail in Return (Paper Check)

820

How to get started with e-file


Bank Products
The key benefits of bank
products
Advent Financial
Federal Refund Anticipation
Loan (RAL)
RAL Product Features &
Benefits
Federal Electronic Refund
Check (ERC)
ERC Product Features &
Benefits
Federal Electronic Refund
Direct Deposit (ERDD)
State Electronic Refund Check
(SERC)
SRT Product Features &
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iling a federal tax return using IRS e-file is easier and more convenient
than ever before. Taxpayers can simultaneously e-file their Federal
and State tax returns. IRS e-file offers quick and easy filing options
over traditional paper returns, such as using direct deposit for refunds and
either a credit card or direct debit for payments. IRS e-file makes filing faster
and more accurate and allows taxpayers to receive their refunds in half the
usual time - even sooner with direct deposit.

SIDE BAR

e-file Extras
For a Glossary of Electronic Filing Terms click here.
For a copy of the IRS e-file Application and Participation Booklet click
here.
For a full size and printable copy of The Electronic Filing and Bank
Product Process shown below see Appendix Q or click here.

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TAX QUOTE

"The current tax code is a daily mugging."


Ronald Reagan (1911-2004) 40th President of the United States (19811989)

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Electronic Filing
IRS e-file offers the option to file electronically through an authorized tax
practitioner. This option allows the taxpayers to use direct deposit to a bank
account for any tax refunds, and either a credit card or direct debit from a
bank account to make tax payments.
If you've ever wondered how to get started in IRS e-file or take advantage
of convenient electronic payment options, then you're in the right place.
Since the 2012 filing season all tax return preparers that prepare eleven (11)
or more federal tax returns have been required to e-file all of their returns.
The History of IRS e-file
The IRS began its endeavor into the world of electronic services by
partnering with industry and the tax professional community. That
partnership has continued until today and has allowed the program to
expand to provide new services and to increase return volumes, reaching
more taxpayers than ever before.
The IRS e-file program for individual and business tax returns has come a
long way since its debut in 1986 with the transmission of 25,000 refund-only
individual income tax returns from five transmitters in three locations. These
returns were transmitted to the Cincinnati Service Center via a modem. Each
year since, the e-file system was been expanded to allow more and more
tax returns to be e-filed.
Today nearly all tax returns are electronically filed.
IRS e-file Historical Timeline
1986: Initial filing season pilot with 5 tax preparers in 3 cities; 25,000 returns
filed. The program could only accept simple returns that were due a refund.
1987: Pilot expanded to 7 cities; 78,000 returns filed. Direct Deposit was
added as a benefit.
1988: Pilot expanded to 16 IRS districts; 583,000 returns filed. The Form
1065 (partnerships) and Form 1041 (trusts) are added to the e-file list.
1989: Pilot expands to 36 states; 1.1 million returns filed.
1990: E-File expands nationwide; 4.2 million returns filed. Balance due
returns are accepted for processing for the first time.
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1991: the Federal/State electronic filing program begins, with South


Carolina participating in the pilot.
1992: Telefile pilot debuts for 1040-EZ filers to e-file via telephone. The IRS
begins to accept individual tax returns where tax is owed and checks can be
mailed via paper voucher.
1994: Approximately 98 percent of all individual tax returns can be e-filed.
Over 14 million individual and 1.7 million business returns are filed
electronically from over 39,000 transmitters - 15.7 million electronic returns
in all.
1998: Congress passes IRS RRA 98 containing a provision setting a goal of
an 80 percent e-file rate for all federal tax and information returns.
1999: Electronic payments through credit cards or direct debit introduced;
IRS pilots alternative programs to allow taxpayers to sign returns
electronically instead of mailing a signature form.
2002: IRS allows taxpayers to sign e-file returns using a Personal
Identification Number (PIN) which made the e-file process entirely
paperless.
2003: In a major step for businesses, e-file is expanded to the quarterly
Form 941 for employment taxes and the annual Form 944 for small
businesses. 37 states and the District of Columbia offer Federal/State e-file.
2004: Modernized e-File (MeF), the next generation of IRS e-file, makes its
debut, accepting business and information returns such as the Forms 1120,
1120-S and 990 series.
2005: E-filed returns cross the 50 percent threshold; 68.4 million returns
filed. Telefile ends after years of declining use as users migrated to tax
software and e-file..
2006: MeF becomes mandatory for businesses and exempt organizations
with assets of $50 million or more.
2007: MeF threshold for businesses and exempt organizations lowered to
assets of $10 million or more.

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2009: Congress passes a provision requiring tax preparers who file more
than 10 individual tax returns to file electronically; IRS phases in the
requirement, setting the threshold at 100 or more for 2011 and 11 or more
for 2012.
2010: MeF begins a roll out for the Form 1040 series and 23 related forms
which will take three or more years to make all the related forms available;
IRS stops mailing paper Form 1040 packages.
2011: E-filed returns cross the 100 million threshold in one filing season;
cumulative total exceeds 1 billion returns. Approximately three out of every
four individual tax returns were filed electronically.
2012: Electronic filing becomes mandatory for most professionally prepared
individual income tax returns.
Forms and Schedules Accepted for Electronic Filing
1040
1040A
2120
4684
6478
8615
Sch. A
Sch. 1
2210
4797
6765
8621
Sch. B
Sch. 2 2210-F
4835
6781
8689
Sch. C
Sch. 3
2290
4868
8082
8697

8839
8844
8845
8846

8880
8881
8882
8885

8911
8912
8917
8919

Sch. C-EZ 1040 EZ


Sch. D
Sch. E 1040-SS

9465

Sch. EIC
Sch. F
Sch. H
Sch. J

2350
2439
2441

1099-R
2555
W-2
2555-EZ
W-2G
3468
W-2GU
3800

Sch. K-1
970
Sch. M
982
Sch. O
1116
Sch. P
1310
Sch. R
2106
Sch. SE 2106-EZ

3903
4136
4137
4255
4562
4563

4952
4970
4972

8271
8275
8275-R

8801
8812
8814

8847
8853
8854

8886
8888
8889

5074
5329
5471
5695

8283
8379
8396
8582

8815
8820
8824
8826

8859
8860
8861
8862

8891
8896
8900
8901

8828
8829
8830
8833
8834
8835

8863
8864
8865
8866
8873
8874

8903
8906
8907
8908
8909
8910

5713 8582-CR
5884
8586
5884-A
8594
6198
8606
6251
8609-A
6252
8611

Table: Forms and Schedules Accepted

Security of IRS e-file


More than 1 billion tax returns have been filed electronically since 1986 with
no e-file security incidents.

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The IRS e-file System:

is not done over e-mail


has many built-in security features
employs multiple firewalls
uses state of the art virus and worm detection, and
meets or exceeds all government security standards

All Internet transmissions use SSL (Secure Sockets Layer) encrypted security
measures. IRS e-file transmissions are very secure because the IRS has been
extremely diligent in the design, development, analysis and testing of the
system.
What is the Self-Select PIN method?
The Self-Select PIN (Personal Identification Number) method allows
taxpayers to electronically sign their e-filed return by selecting a five-digit
PIN as their signature. The five-digit PIN can be any five numbers except all
zeros. The taxpayers will need to know their original prior year Adjusted
Gross Income or PIN from their prior year return (Tax Year 2014) and their
Date of Birth for verification purposes. It eliminates the requirement for a
taxpayer to sign (and mail) Form 8453 -U.S. Individual Income Tax
Declaration for an IRS e-file Return in most cases, making e-filing returns
truly paperless. Beginning with the 2008 filing season Forms 8453 were
eliminated in most cases. A new and revised Form 8453 is occasionally used
to send a few required documents to the IRS.
Nearly 90 percent of tax professionals use electronic signatures to sign
returns. You can e-file individual income tax returns only if the returns are
signed electronically using a PIN. Tax practitioners must use either the SelfSelect PIN or the Practitioner PIN methods to sign their client's tax return. A
Self-Select PIN allows taxpayers to electronically sign e-filed returns by
selecting a five-digit PIN. A Practitioner PIN is used when a taxpayer
authorizes an Electronic Return Originator (ERO) to input an electronic
signature on their behalf. Practitioner PINs require the use of Form 8879 IRS e-file Signature Authorization which you retain. The Practitioner PIN
method does not require taxpayers to enter their adjusted gross income or
PIN from the prior year. This method requires the taxpayer and Practitioner
to SIGN Form 8879 - IRS e-file Signature Authorization.

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Forms 8879 are to be SIGNED and retained in your records and should NOT
be sent to the IRS. The Andover and Austin Processing Campuses receive
thousands of these forms each year, and as a result, they must return them
to the ERO. The process of returning these forms to the EROs reduces the
time the IRS e-help Desk has to devote to your inquiries. Please help the IRS
by keeping these forms in your office files. You may electronically image
and store these forms using the guidelines in Revenue Procedure 97-22 Retention of Books and Records. Failure to have SIGNED Forms 8879
available for IRS inspection AT ANY TIME will result in your termination
from the IRS e-file program.

TAX PRACTICE TIP

What are the tax preparer e-file 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.
Also see 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.
State E-file Mandates
In 21 states electronic filing is mandatory. The following states have
mandated e-file:

Alabama
California
Connecticut
Florida (only for most corporate tax returns)
Indiana
Kansas
Louisiana
Maine
Massachusetts
Michigan
Minnesota
New Jersey
New Mexico
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New York
Oklahoma
Rhode Island
South Carolina
Utah
Virginia
West Virginia
Wisconsin

More and more states are requiring electronic filing, so be sure to check
with your state before the start of the tax season. Some states assess
substantial penalties for failure to e-file when required.

Refund Options
Straight Electronic Filing (Direct Deposit)
This is similar to electronic filing and receiving a paper check described
below except the IRS deposits the refund into the taxpayer's bank account
within 7-14 days. Make sure that you have the correct Depositor Account
Number (DAN) and Routing Transfer Number (RTN) on page 2 of the 1040
or the taxpayers may not receive their refund. You must collect your fees up
front because there is no bank product to withhold your fees from.
Straight Electronic Fling (Paper Check)
The taxpayer receives his refund directly from the IRS via paper check in 3-4
weeks. You must collect your fees up front because there is no bank
product to withhold your fees from.
Mail in Return (Direct Deposit)
The taxpayer receives his refund directly from the IRS in approximately 3045 days. You must collect your fees up front because there is no bank
product to withhold your fees from.
Mail in Return (Paper Check)
The taxpayer receives his refund directly from the IRS via paper check in 612 weeks. You must collect your fees up front because there is no bank
product to withhold your fees from.

How to Get Started with e-file


To register as an authorized IRS e-file provider contact us.
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TAX PRACTICE TIP

Checking Acknowledgements
As an Electronic Return Originator, one of the most important things that
youll do during the tax season is to verify that all tax returns that you
have e filed have been accepted by the IRS and state. When a tax return
has not been electronically acknowledged, it is the same as if no tax
return was ever filed at all. Obviously, this can cause you a great deal of
trouble later in the year, when the taxpayer is contacted by the taxing
authorities questioning why they failed to file a tax return.
You should ALWAYS verify that you have received acknowledgements for
all federal and state returns that you have transmitted. If a return was not
acknowledged you should re-transmit it. If the return was rejected by the
IRS or state then you should correct the return and re-transmit it. When
the IRS rejects a tax return the reason for the rejection is provided
through an Error Reject Code (ERC). If your return is rejected you will find
the ERC along with an explanation in our tax preparation software. The
most common codes are also in our Portal. As a last resort, if you cannot
get the IRS or state to accept the return, you should mail the return.

Bank Products
Bank Products provide taxpayers with their money today, when they need it,
not weeks from now. With 1040 ValuePak its easy to provide your clients
with Electronic Refund Checks (ERCs or Refund Transfers), putting money
into your clients hands very quickly! 1040 ValuePak smoothly integrates
premier bank products with electronic filing so you can quickly increase
your revenue! Your clients will appreciate the ability to electronically file
their tax return with no up-front, out-of-pocket expenses. When the IRS
deposits the taxpayer's refund into the authorized tax refund processing
bank's account your fees are deducted and sent via ACH to your account
the very next day. You wont need to charge the taxpayer their tax return
preparation and electronic filing fees up front.

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TAX PRACTICE TIP

Collecting Your Fees


If there is no bank product present you must collect your fees directly
from the taxpayer. In order to have your fees withheld the taxpayers
refund must pass through an authorized tax refund processing bank. To
have your fees withheld you must do a bank product.

TAX PRACTICE TIP

Receiving Taxpayer Refunds


Tax preparers ARE NOT authorized tax refund processing banks and are
PROHIBITED from receiving taxpayer refunds. It's illegal - so don't do it.
You WILL get caught several months or even a year or more down the
road when the IRS's computers determine that tax refunds for multiple,
different, unrelated taxpayers were deposited to the same bank account.
They determine this from the RTN and DAN deposit information.
NEW: As part of the ongoing IRS effort to combat fraud and identity
theft, beginning with the 2015 filing season, the IRS will limit the number
of refunds that may be electronically deposited into a single bank
account or pre-paid debit card to three (3).
The key benefits of our Bank Products include:

Our taxpayer approval ratio is among the highest in the industry


Competitively priced ERCs (Refund Transfers)
Faster refunds generally within 8-14 days
Direct deposit of your fees into your bank account
Direct deposit of taxpayer refunds into the taxpayers bank account
On-site check printing
24/7/365 hour internet transmission
Free check and debit card stock

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General Purpose Reloadable Prepaid Cards


In addition to the bank accounts that the national banks establish for
Refund Transfers, it is estimated that each year hundreds of thousands
of taxpayers receive a General Purpose Reloadable (GPR) Prepaid Card.
Prepaid cards are the most rapidly growing payment instrument. GPR
Prepaid Cards, in particular, have gained considerable traction especially
among the unbanked and under-banked.1
According to a 2010 Federal Reserve Payments Study, the growth rate of
prepaid cards was more than 20 percent between 2006 and 2009. The
industry expects this high growth rate to continue.
Among various types of prepaid cards, GPR Prepaid Cards are gaining
the most traction among consumers who do not have access to other
forms of electronic payments, such as debit or credit cards.
GPR cards carry at least one of the major payment card network brands
- American Express, Discover, MasterCard, Visa, or a PIN debit network and can be used to make purchases at any merchant that accepts that
card brand as well as to obtain cash at any ATM that connects to the
networks. Cardholders must load value onto their cards, such as their tax
refund, before they use them for purchases or cash withdrawals, and
they can reload value via electronic funds transfer or at a retail location
that participates in a reload network.
Financial institutions are interested in offering GPR Prepaid Cards. They
promote these cards not only to unbanked consumers but also to
banked consumers since their revenues from debit cards were reduced
by the recently implemented debit card regulation.2

According to the Federal Reserve Board (2013), about one in five U.S. consumers are either
unbanked or under-banked, conducting at least some of their financial transactions outside of
the mainstream banking system.
2

Regulation II, implemented by the Federal Reserve Board in 2011, caps debit card interchange
fees received by large financial institutions. Certain types of prepaid cards, such as reloadable
prepaid cards, are exempt from this interchange fee cap.

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Not surprisingly, federal expenditures on direct payments to individuals


other than for retirement and disability (e.g., food stamps and refunded
earned income tax credits) are positively correlated with prepaid card
penetration rates.
Why do taxpayers like GPR Prepaid cards? Consider the Facts:

The days of free checking accounts are pretty much gone.


Monthly minimums are now required on many traditional
checking accounts to avoid service fees.
Effective March 2013, the Federal Government has eliminated
paper benefit checks for Social Security and Supplemental
Security Income recipients, saving the government over $700
billion annually.
Many states no longer issue paper checks for tax refunds. They
require either a direct deposit, or they will mail the taxpayer a
card.
Nearly 4.5 million U.S. workers got their wages, totaling $34
billion, on a payroll card in 2012. Those numbers are expected to
more than double over the next four years.
Payroll cards offer unbanked workers an economical, safe and
convenient way to receive their wages. Payroll cards mean no
check cashing fees and greater security without the risk of
carrying cash.
1 in 3 consumers is now unbanked.3
30 million consumers have had their checking accounts closed
and are unable to open an account anywhere.4

GPR Prepaid Cards help not only the middle class, but also the working
poor. No credit checks are required. Account approval is granted upon
successful ID verification. This allows many people who are locked out of
the traditional banking system (due to prior bounced checks, or poor
3

Banks Tell 30 Million Troubled Customers to Get Lost - One in Three Consumers now
Unbanked - Problem Bank List. February 24, 2012.
4

GPR Cards Deliver Banking Services - The Prepaid Press. July 1, 2012.

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credit history) to participate in the banking system. For many, it is the


only option available to them.
With a GPR Prepaid Card account the cardholder can perform all of the
tasks that they might have performed had they opened an account at a
local bank, an option that often isn't available to them.
With GPR Prepaid Cards taxpayers can have an automatic deposit of
their tax refund, payroll or government benefits; they can add money
anytime at any participating Western Union, MoneyGram, Walmart
Rapid Reload or Green Dot Location5; or they can use their smart
phone to snap a picture of a check and load it to their card.
They can access their money by utilizing online bill pay (writing checks)
or in-store bill pay. They can also access their money at ATM machines,
get cash back with purchases at the Point-of-Sale for no charge at many
merchants, or they can use their card for online or in-store shopping at
tens of millions of merchants - wherever Debit Visa cards are accepted.
There are no minimum balance requirements and the taxpayer's funds are
FDIC Insured. Taxpayers receive text and email alerts and online Statements
at no charge. Mobile apps are commonly available at no charge for both the
iOS and Android Devices.
Our Refund Settlement Products
Our settlement products provide a way for you to serve your clients at tax
time and year round, ensuring you repeat business for next tax season. We
offer powerful revenue opportunities and rewards through a full suite of
refund settlement products. The taxpayers refund is disbursed in one of
three ways:

a check printed at your office


an ACH deposit into the taxpayers bank account, or
The TPSC VISA Prepaid Card issued to your client at your office on
their first visit.

Not all GPR Cards offer every one of these reload options.

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With the TPSC VISA card your


clients dont have to return to
your office to get their checks.
Theyll receive an email or text
message letting them know as
soon as their funds are available.

The TPSC VISA Card is a best-in-class, card-based banking and quasichecking account offered at tax time and used year round. Offering the
TPSC VISA Card provides your clients with a safe, secure and low-cost
solution that can address their everyday personal financial needs. The TPSC
VISA Card offers your clients all of the features of a mainstream bank
account at significantly lower cost and with strong safety features.
The TPSC VISA Card is a fully functional, FDIC-insured banking account
thats based on a debit card. With their TPSC VISA Card clients can do just
about anything with their money make purchases, get cash back with
purchases, get cash from ATMs, pay bills electronically, and much more.
The TPSC VISA Card is fully reloadable and can be used not only at tax time,
but year round as well. We built TPSC VISA Card from the ground up to
meet the needs of your taxpayers.
Our core tax-time settlement products, the Electronic Refund Check and
ACH Deposit, offer your clients an opportunity to receive their Federal and
State tax refund proceeds in 7-14 days or less. Your tax preparation fees are
deducted from the refund proceeds so that the client does not have to pay
any out-of-pocket money at the time the return is prepared. Refund checks
and ACH deposits are offered by TPSC Financial, drawn on, and payable at,
First Century Bank.

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A sample Electronic Refund Check is shown below:

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Check Cashing Alternatives


Participating Walmart locations will cash checks
under $1,000 for $3 and checks from $1,001 to
$5,000 for only $6. With over 4,000 stores
nationwide your clients are sure to find a
convenient location with a retailer they trust. To
find a Walmart location near you click here.
By revenue, Kroger is the country's largest
supermarket chain. Kroger is also the fifth
largest retailer in the world. Kroger operates,
either directly or through its subsidiaries, 2,424
stores in 31 states. Participating Kroger stores
will cash checks at store locations nationwide.
Check with store locations for fees and check
cashing limits.
Albertson's is a supermarket chain that had
1,075 supermarkets located in 29 U.S. states
under 12 different names. In July 2014, it
acquired Safeway Inc for $9.2 billion. The newly
merged company has more than 2,400 stores
and over 250,000 employees, which makes it
the second largest supermarket chain in North
America after Kroger. Participating Albertson's
stores will cash checks at store locations
nationwide. Check with store locations for fees
and check cashing limits.

See Albertson's above. The newly merged (with


Albertson's) company has more than 2,400
stores and over 250,000 employees, which
makes it the second largest supermarket chain
in North America after Kroger. Checks up to
$2,000 can be cashed at participating Safeway
grocery store locations nationwide. Safeway
owned stores are listed above.
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Piggly Wiggly is a supermarket chain operating


in the Midwestern and Southern regions of the
United States. More than 600 independently
owned Piggly Wiggly stores operate in 17
states, primarily in smaller cities and towns.
Participating Piggly Wiggly stores will cash
checks. Check with store locations for fees and
check cashing limits.
H-E-B is a supermarket chain based in San
Antonio, Texas, with more than 350 stores
throughout the state of Texas, as well as in
northern Mexico. Checks up to $9,500 can be
cashed at over 350 participating H-E-B grocery
stores throughout Texas. Check with store
locations for fees.
Citizen's Bank operates more than 1,300
branches and approximately 3,500 ATMs in 12
states in the north central and north eastern
U.S. Citizens is a wholly owned subsidiary of
The Royal Bank of Scotland Group (RBS).
Citizen's Bank will cash checks at it's branches.
Check with your local branch for fees and check
cashing limits.
With over 1,700 locations in 38 states, ACE Cash
Express provides a competitive check cashing
option for taxpayers. ACE will cash checks in
any amount. Click here to find an ACE Cash
Express location near you.
7-Eleven - Vcom: Taxpayers looking for
convenient and quick access to check cashing
services can now cash checks 24/7 at over 2,200
Vcom equipped 7-Eleven stores nationwide.
Checks up to $6,000 can be cashed for a fee of
just 0.99%. The Vcom check cashing kiosk is a
fully automated check cashing machine with
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touch screen technology in English and


Spanish.
Federal Refund Anticipation Loan (RAL)
Editors Note: At the present time Refund Anticipation Loans are largely
unavailable. We retained the following discussion of them in our
course for legacy purposes, in case they once again become available.
The RAL is the fastest method for your clients to receive money based upon
their federal tax refund. RALs are Refund Anticipation Loans. The key word is
loans. As a result there is a "loan underwriting process" just like with any
other loan. The taxpayer is borrowing the money from the bank. The loan is
secured by the anticipated tax refund which the IRS will forward to the bank.
Loan approval is subject to bank screening and RALs that are declined are
converted to ERCs. It normally takes about one to two days from the time
the tax return is electronically filed to receive the IRS acknowledgement. The
RAL check is funded within minutes AFTER IRS Acknowledgement. The loan
is for the taxpayers refundable income tax withholding and all or a portion
of the Earned Income Tax Credit (EITC). You'll print the bank cashier's check
in your office. The loan is paid off when the IRS wires the taxpayers refund
to the bank in 7-14 days. You'll print a second cashier's check payable to the
taxpayer if the funds received from the IRS are greater than the original
amount of the loan advanced, or if subsequent deposits are received by the
bank. These loans are expensive in terms of the interest rate, 200%-300%,
when stated as an annual percentage rate (APR). That's because it's a very
short term loan of only 7-14 days. The actual dollars paid for the loan are
small and depend on the amount of the loan. No upfront cash is required
from the taxpayer for the payment of your fees. All fees can be deducted
from the loan check.
Your client can choose from one or more of the following disbursement
methods to receive their RAL proceeds: Cashier's Check, Debit Card, or ACH
Direct Deposit into their bank account. Your fees are deducted from the RAL
and paid out on a daily basis to your bank account by ACH direct deposit.
Sample Bank Product Pricing:
RALs are priced using a fixed interest rate times the loan amount. For
traditional RALs between $300 and $3,999, the finance charge is typically
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2.5% of the loan amount. For RALs between $4,000 and $7,500, the fee is
typically $100. This is in addition to an account-handling fee of $32.00.
There is also a Transmitter Fee, Technology Access Fee, and a Service
Bureau Fee deducted from all RALs and ERCs. All fees are deducted from
the taxpayer's check. Please Note: The above prices are samples. Bank
product pricing changes each season and is announced in early January.
Military RAL Exclusion
Active military personnel and their spouses and dependents are not able to
apply for a RAL. The John Warner National Defense Authorization Act (the
"Act") prohibits offering active military personnel or their spouse and
dependents RALs with military APRs greater than 36%. The Act requires the
$29.95 account-handling fee to be included in the military APR calculation.
Including this fee increases the APR so much that RAL Banks cannot offer an
economically viable RAL that meets the military APR limitation.
RAL Product Features & Benefits

Consistently high loan approval rate.

Loan ranges from $300 to as high as $9,999.

No minimum federal tax withholding amount required to apply for a


RAL.

First time filers accepted - previous RAL experience is not necessary.

No Partial RALs! This means clients can get more full loans regardless
of previous bank experience.

"Overturn" review service for denied loan reconsideration can be


requested under certain conditions.

No out of pocket expenses for your clients.

Approved RAL refund amount available through a variety of


disbursement methods upon IRS acknowledgement.

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Federal Electronic Refund Check (ERC)


ERCs or Refund Transfers are funded in 7-14 days. When the IRS wires the
refund to the authorized tax refund processing bank the bank authorizes
you to print the check. They cost $34.95.
No upfront cash is required from the taxpayer for the payment of your fees.
All fees can be deducted from the ERC check. The fees are smaller than for
RALs because the bank has virtually no loan loss risk. Regardless of which
bank product you are providing to the taxpayer, always verify the amount of
the check prior to handing it to the taxpayer and confirm that your fees
have been withheld. Errors do happen!
The ERC is a quick and cost effective method for your client to receive their
federal tax refund. The federal tax refund is usually available within 21 days
from the time the client's tax return is electronically filed. When the IRS
deposits your client's refund with the authorized tax refund processing
bank, the bank deducts all applicable fees from the refund amount and
disburses the balance of the refund to your client. Your client can choose
one of the following disbursement methods to receive the refund proceeds:
Cashier's Check, Debit Card, or ACH Direct Deposit. Your fees are deducted
from the refund and deposited to your bank account within 24 hours after
the bank receives the IRS refund.

TAX QUOTE

"The invention of the teenager was a mistake. Once you identify a period of
life in which people get to stay out late but don't have to pay taxes,
naturally, no one wants to live any other way."
Judith Martin
ERC Product Features & Benefits
Most popular e-file bank product chosen by taxpayers.

A cost effective and convenient way for your clients to receive their
federal tax refund.

Your clients can receive their refund within 7-14 days after the IRS
acknowledges their tax return.
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No out of pocket expenses for your clients.

ERC refund amount available through a variety of disbursement


methods upon IRS funding.

Federal Electronic Refund Direct Deposit (ERDD)


This is similar to the Straight Electronic Filing in the IRS Refund Options
section above and also similar to the Federal ERCs above. However, there is
no check printed in your office. The taxpayer's refund is wired to the
authorized tax refund processing bank in 7-14 days, the bank withholds
your fees, and the remainder is directly deposited into the taxpayer's bank
account. ERDDs require that the taxpayer have a bank account. ERDDs cost
$34.95.
No upfront cash is required from the taxpayer for the payment of your fees.
All fees can be deducted from the ERDD check. The fees are smaller than for
RALs because the bank has virtually no loan loss risk and no cashier's check
is involved. Once again, regardless of which bank product you are providing
to the taxpayer, always verify the amount of the check prior to handing it to
the taxpayer and confirm that your fees have been withheld. Errors do
happen!
State Electronic Refund Check (SERC)
The SERC is similar to the federal ERC whereupon the client requests the
state taxing authority to deposit the client's state refund with the authorized
tax refund processing bank. Funding dates vary from state to state. You can
obtain the funding dates from your State Department of Revenue. When
the state refund is received by the bank they will deduct all applicable fees
from the state refund and disburse the balance of the refund to your client
using the same disbursement method the client selected to receive the ERC
proceeds. The SERC must be selected in addition to an ERC. This product is
not available in certain states.
SERC Product Features & Benefits
One stop shopping for your clients - the convenience of e-filing both
federal and state returns.

Low cost makes this e-file bank product a viable method for your
clients.

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Many states fund e-filed returns within 1 to 7 days

No out of pocket expense for your clients.

Additional measure of security to receive your fees (in case of no IRS


funding).

The taxpayer may only select one disbursement method. Once a


disbursement method has been selected, all additional disbursements to
the taxpayer will be made by the same disbursement method.
Product features and pricing are subject to change at the discretion of the
bank.

TAX PRACTICE TIP

Checking your Electronic Filing Identification Number (EFIN)


As you'll recall from Lesson 2, 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).
Occasionally, an EFIN can be compromised. This occurs when someone
steals or otherwise obtains an ERO's EFIN and uses it to efile tax returns
using the identity of the ERO. The tax returns are usually bogus.
You can protect yourself from this by logging into your IRS eServices
account regularly (we recommend monthly) and comparing the number
of electronically filed tax returns the IRS says they have received from you
against your records.
Say you've efiled 100 tax returns, but your IRS eServices account says
you've efiled 200 tax returns. That means that your EFIN has been
compromised.
Here's the steps:
1. Go to the IRS e-Services Login page:
http://www.irs.gov/Tax-Professionals/e-services---Online-Toolsfor-Tax-Professionals
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3.
4.
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Click the Login or Register button in the left border.


If you have multiple accounts, select your account.
Click Application and then click e-File Application.
If you have multiple accounts, select your account.
In the left border click EFIN Status.

In the lower half of the screen review the Electronic Return Originator
(ERO) Activity by EFIN/Return Type section. That section tells you the
number of Transmitted, Accepted, and Rejected efiles that IRS has
received with your EFIN.
That number may vary from your number a little to account for a few
returns that are being processed. But if it varies dramatically you should
call the IRS immediately and tell them that your EFIN has been
compromised. They can deactivate your current EFIN and assign you a
new one over the phone.

Lesson Summary
Lets take a few minutes and review what you learned in this lesson.
Filing a federal tax return using IRS e-file is easier and more convenient than
ever before. Taxpayers can simultaneously e-file Federal and State tax
returns.
IRS e-file offers quick and easy filing options over traditional paper returns,
including the option to file electronically through an authorized tax
practitioner. This option allows taxpayers to use direct deposit to a bank
account for any tax refunds, and either a credit card or direct debit from a
bank account to make tax payments.
More than 1 billion tax returns have been filed electronically since 1986 with
no e-file security incidents.
IRS e-file can help create loyal, satisfied clients. Preparers whove switched
to IRS e-file say it was well worth it. Theyve saved money on paper, printer
cartridges, postage, envelopes and staff wages. And, of course, in most
states they get to charge the taxpayer a fee for electronically filing the tax
return.
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Some of the benefits of IRS e-file include:

No mail loss of the tax return - IRS verifies receipt of the tax return
within 48 hours

Less processing time - tax returns are processed immediately;

Less paper - help save the ecology

Tax returns are more accurate when computer calculated and e-filed
with the IRS

Faster tax refunds - about 7-14 days.

The Self-Select PIN (Personal Identification Number) method allows


taxpayers to electronically sign their e-filed return by selecting a five-digit
PIN as their signature.
In some states electronic filing is mandatory.
IRS Refund Options include Straight Electronic Filing (Direct Deposit),
Straight Electronic Fling (Paper Check), Mail in Return (Direct Deposit), and
Mail in Return (Paper Check).
Bank Products provide taxpayers with their money today, when they need it,
not weeks from now. With 1040 ValuePak its easy it is to provide your
clients with ERCs, putting money into your clients hands, and yours, almost
instantly!
If there is no bank product present you must collect your fees directly from
the taxpayer. In order to have your fees withheld the taxpayers refund must
pass through an authorized tax refund processing bank. To have your fees
withheld you must do a bank product, i.e. RAL, ERC, or ERDD. To register as
an authorized IRS e-file provider contact you Instructor via email or our toll
free telephone number.

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Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify your 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

29
Lesson 29 - Finishing The Tax
Return
In this lesson you'll learn how to finish a taxpayer's tax return and prepare it
for submission to the IRS. At the end of this lesson, you will be able to:
Report federal income tax withheld from all sources
Determine the refund or amount due
Determine if estimated taxes should be paid
Determine whether to suggest changes to the taxpayer's Form W-4 or
Form W-4P
Determine who qualifies for an extension of the deadline
Complete the tax return
This lesson will explain how to calculate and report how much tax a taxpayer
owes or is owed based on federal income tax withholdings, estimated tax
payments, and refundable credits.
The following topics are discussed in this lesson:
Pay As You Earn
Income Tax Withholding
Estimated Income Tax
Payments

Option to Apply an
Overpayment
How to Make Payments
Forms W-4, W-4P, W-4V,
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Refundable Credits
Overpayment or Tax Due
Refunds
Direct Deposit
Payment by Check or Money
Order
Electronic Payment Options
Monthly Installment Options
Estimated Tax Penalty
Estimated Tax
Withheld Taxes
Who Must Pay Estimated Tax
When to Pay Estimated Tax

TAX

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and W-4S
How Much to Withhold
Multiple Incomes
Attaching Forms and
Schedules
Signatures
Deceased Taxpayers
Deceased Spouses
Third Party Designee
Ending the Interview
Checking on Refunds
Financial Management
Service

he federal government has a pay-as-you-earn tax system. The


payment section of the tax return has three sources:
Federal income tax withholdings from Forms W-2 and 1099
Estimated tax payments
Refundable credits

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Income Tax Withholding


Federal income tax withheld is reported to the taxpayer on:
Box 2 of Form W-2 - Wage and Tax Statement

Figure 29-1: Form W-2 - Wage and Tax Statement with box 2 "Federal income tax
withheld" highlighted.

Box 2 of Form W-2G - Certain Gambling Winnings

Figure 29-2: Form W-2G - Certain Gambling Winnings with box 2 "Federal income tax
withheld" highlighted.

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Box 4 of Form 1099-R - Distributions From Pensions, Annuities,


Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

Figure 29-3: Form 1099-R - Distributions From Pensions, Annuities, Retirement or


Profit-Sharing Plans, IRAs, Insurance Contracts, etc. with box 4 "Federal income tax
withheld" highlighted.

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Box 4 of Form 1099-INT - Interest Income

Figure 29-4: Form 1099-INT - Interest Income with box 4 "Federal income tax withheld"
highlighted.

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Box 4 of Form 1099-DIV - Dividends and Distributions

Figure 29-5: Form 1099-DIV - Dividends and Distributions with box 4 "Federal income
tax withheld" highlighted.

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Box 4 of Form 1099-OID - Original Issue Discount

Figure 29-6: Form 1099-OID - Original Issue Discount with box 4 "Federal income tax
withheld" highlighted.

Box 4 of Form 1099-G - Certain Government Payments

Figure 29-7: Form 1099-G - Certain Government Payments with box 4 "Federal income
tax withheld" highlighted.

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Box 6 of Form SSA-1099 - Social Security Benefit Statement

Figure 29-8: Form SSA-1099 - Social Security Benefit Statement with box 6 "Voluntary
Federal Income Tax Withheld" highlighted.

Box 10 of Form RRB-1099 - Payments by the Railroad Retirement Board

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Figure 29-9: Form RRB-1099 - Payments by the Railroad Retirement Board with box 10
"Federal income tax withheld" highlighted.

When entering federal income tax withheld from Box 2 of Form W-2 be
careful to never report the amounts in box 4 (Social Security tax) and box 6
(Medicare tax) as income tax withheld.
1040 ValuePak will automatically calculate, from the data you entered, a
taxpayer's federal income tax withholding by:

Adding all federal income tax withholding from all Forms W-2
received by the taxpayer for the year.

Adding all federal income tax withholding from all Forms 1099-INT,
1099-G, and 1099-OID received by the taxpayer for the year.

Determining the amount of income tax withheld from the taxpayer's


Alaska Permanent Fund Dividends, if any.

Adding all federal income tax withholding from all Forms 1099-R,
1099-DIV, SSA-1099, RRB-1099, and RRB-1099-R received by the
taxpayer for the year.

1040 ValuePak enters the total on Form 1040 line 64.

Figure 29-10: The Payments section of Form 1040 with line 64 "Federal income tax
withheld from Forms W-2 and 1099" highlighted.

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TAX QUOTE

"There's nothing wrong with the younger generation that becoming


taxpayers won't cure."
Dan Bennett

Estimated Income Tax Payments


Estimated tax is a method used to pay tax on income that is not subject to
withholding. Taxpayers may need to pay estimated taxes during the year
depending on what they do for a living and what type of income they
receive. If taxpayers have income from sources such as self-employment,
interest, dividends, alimony, rent, gains from the sales of assets, prizes or
awards, then they may have to pay estimated tax.
The second source of the tax return's payment section is estimated tax
payments. Some taxpayers have already paid some of their taxes by making:

Estimated tax payments during the tax year using Form 1040ES

Figure 29-11: Form 1040-ES - Estimated Tax.

A payment made from last year's overpayment which is shown on


last year's tax return

1040 ValuePak will automatically calculate, from the data you entered, a
taxpayer's estimated income tax payments, and, if this is a taxpayer
returning from last year, the amount of last year's overpayment that was
applied to this year.
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Figure 29-12: The Payments section of Form 1040 with line 65 "2014 estimated tax
payments and amount applied from 2013 return" highlighted.

The table below shows when tax returns, extensions, and estimated tax
payments are due:
Form 1040 Tax Return
Form 4868 Extension
Form 1040 Tax Return on Extension
Form 1040ES - Estimated tax - 1st Installment
Form 1040ES - Estimated tax - 2nd Installment
Form 1040ES - Estimated tax - 3rd Installment
Form 1040ES - Estimated tax - 4th Installment

4/15/2015
4/15/2015
10/15/2015
4/15/2015
6/15/2015
9/15/2015
1/15/2016

Table: Filing Due Dates

If the due date for making an estimated tax payment falls on a Saturday,
Sunday, or legal holiday the estimated tax payment must be made on the
next day that is not a Saturday, Sunday, or legal holiday.
Corporations
A corporations fourth installment is due on December 15th not January
15th of the following year, which is available only to individuals.
Farmers and Fishermen
Farmers and Fishermen have only one estimated tax payment due date January 15th - provided at least two-thirds of their income comes from
farming or fishing.

TAX PLANNING TIP

Adjusting Estimated Tax Payments


Taxpayers who choose to accelerate income or defer deductions for tax
planning purposes should make sure their estimated tax payments
and/or withholding cover any additional income tax this year to avoid
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estimated tax penalties.

Refundable Credits
The third source of the tax return's payment section is refundable credits
which are automatically calculated by 1040 ValuePak.

Figure 29-13: The Payments section of Form 1040 with line 66 "Earned Income Credit
(EIC)", line 67 "Additional child tax credit", and line 68 "American opportunity credit"
highlighted.

Overpayment or Tax Due


1040 ValuePak will automatically calculate, from the data you entered, a
taxpayer's overpayment or tax due.

Figure 29-14: The Refund section of Form 1040.

Refunds
For taxpayers who want their overpayment refunded to them:

Advise them that a check should be mailed within 6-8 weeks after
the return is filed

Inform them of the option to have the refund deposited directly into
a financial account

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Buying U.S. Series I Savings Bonds


Taxpayers can receive up to $5,000 of Series I Savings Bonds as part of their
income tax refund without setting up a Treasury Direct account in advance.
For more details see Form 8888.
Direct Deposit
Instead of getting a paper check taxpayers may choose to have their refund
deposited directly into their account or mutual fund at a bank, brokerage
firm, credit union, or other financial institution.
The account information, including bank routing number, account number,
and account type, are entered on the Federal Personal Information
Worksheet.
The routing number must be nine digits. The first two digits must be either
01 through 12 or 21 through 32. The account number can be up to 17
alphanumeric characters. It can include hyphens, but not spaces or special
symbols. The number should be entered from left to right with any unused
boxes left blank.

Figure 29-15: The Refund section of Form 1040 with line 76b "Routing number", line 76c
"Type", and line 76d "Account number" highlighted.

Form 8888 can be used to allow a taxpayer to split their refund into three
separate accounts.

Payment by Check or Money Order


If the tax payment total is less than the amount of tax liability then a tax
payment is due with the return no later than the deadline. Payments can be
submitted via check, money order, or electronically.
Remind taxpayers who pay with a check or money order to:

Make it payable to the "United States Treasury"

Make sure their name, address, social security number, daytime


phone number, and "2015 Form 1040 (or 1040A or 1040EZ)" are on
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the check or money order. If the taxpayers are married filing jointly
be sure to use the name and social security number of the spouse
who appears first on Form 1040. If you dont the IRS may not apply
the payment to the correct account.

Enclose the payment with their tax return but do not attach it to the
return

Taxpayers should not mail cash with their returns.


To help expedite payment processing the taxpayer should:

Enter the amount on the right side of the check with numbers of
uniform size, like this: $XXX.XX

Not use dashes or lines. For example, do not enter "$XXX" or


"$XXX XX/100"

Encourage taxpayers to send Form 1040-V - Payment Voucher with their


payment.

Figure 29-16: Form 1040-V - Payment Voucher.

1040 ValuePak provides instructions for completing the voucher.

Electronic Payment Options


Taxpayers can also pay electronically by authorizing an electronic funds
withdrawal from their checking or savings account no later than the
deadline, or by using their credit card.

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To pay by credit card, taxpayers must:

Call one of the service providers listed in the instructions for Forms
1040EZ, 1040A, or 1040 and follow the instructions

Enter the confirmation number (provided at the end of the call) on


page 1 of their tax return in the upper-left corner

Alternatively, you can click "Taxpayer Payments by Credit Card" in the Tax
Preparation Help section of the 1040 ValuePak Portal.
The credit card payment service provider (not the IRS) will charge a
convenience fee based on the amount of the tax payment. Do not include
the convenience fee as part of the tax payment.

Monthly Installment Options


Taxpayers who cannot pay the full amount owed, as shown on their return,
may ask permission to make monthly installment payments. Taxpayers will
be charged interest and a late payment penalty if the tax is not paid by the
filing deadline, even if their request to pay the tax in installments is granted.
Before requesting an installment agreement, taxpayers should consider less
costly alternatives, such as a bank loan.
Taxpayers should always file their tax returns on time, even if they cant pay
the tax due. They can attach to the front of the tax return either a
completed Form 9465 - Installment Agreement Request or their own written
request for a payment plan, specifying the amount of tax they can pay and
the date they can pay it each month. If the taxpayer has already mailed his
return and has received a notice or tax bill from the IRS requesting payment,
he should contact the IRS immediately by calling the telephone number
shown on the tax notice. The taxpayer may be eligible to establish an
installment agreement at that time by telephone.
To ask for an installment agreement, the taxpayer should file Form 9465,
Installment Agreement Request, with the tax return. Form 9465 can be filed
electronically. The IRS will let the taxpayer know, usually within 30 days,
whether his request for an installment agreement is approved or denied, or
if additional information is needed. If the installment agreement is
approved, a one-time user fee of $120 will be charged.

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If the taxpayer is unable to pay the tax due, and doing so would result in a
severe hardship, he can also apply for a special payment extension on Form
1127 - Application for Extension of Time for Payment of Tax. However, this
type of payment extension is rarely used because the legal requirements are
so strict. Read the conditions on the back of Form 1127 carefully before using
this method.
For more details on installment agreements refer to Publication 594 Understanding the Collection Process.

Estimated Tax Penalty


A taxpayer may owe a penalty for underpayment of estimated tax if the tax
owed is $1,000 or more, and it is more than 10% of the total tax liability
shown on the return. Total tax liability appears on line 63 of Form 1040.

Figure 29-17: The Other Taxes section of Form 1040, with line 63 "Total Tax"
highlighted.

Tax owed appears on line 78 of Form 1040.

Figure 29-18: The Amount You Owe section of Form 1040 with line 78 "Amount you
owe" highlighted.

Taxpayers who underpaid their previous tax year's estimated tax liability
may also owe the penalty.
Taxpayers who may owe the estimated tax penalty can either:

Use Form 2210 - Underpayment of Estimated Tax by Individuals,


Estates, and Trusts to find out if they owe the penalty, figure the
amount, and report the penalty on line 79 of Form 1040

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Figure 29-19: The Amount You Owe section of Form 1040 with line 79 "Estimated tax
penalty" highlighted.

or, leave the penalty line on the tax return blank, let the IRS figure
the penalty and send the taxpayer a bill.

1040 ValuePak will automatically create and calculate Form 2210 when it is
needed.
Refer to Form 2210 - Underpayment of Estimated Tax by Individuals, Estates,
and Trusts when viewing the flow chart below.

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Estimated Tax
This topic will help you identify taxpayers who should pay estimated taxes
and how much and when they should pay. Estimated tax is the amount a
taxpayer expects to owe for the year, after deducting any tax credits or
federal income tax withheld. In other words, estimated tax is what the
taxpayer expects to owe on the following year's federal income tax return.
Withheld Taxes
If a taxpayer is an employee, the employer generally must withhold income,
Medicare, and Social Security taxes on the wages paid. Also, most payers of
taxable pensions withhold income tax and pay it to the government.
Withheld taxes usually reduce either the likelihood of having to pay
estimated taxes or the amount of estimated tax due.

TAX TIP

Avoiding Estimated Tax Payments


The IRS treats federal tax payments made through payroll withholding as
having been made evenly throughout the year regardless of when the
withholding actually occurred. If the taxpayer is receiving a payroll check
he can avoid making estimated tax payments and use the money
throughout the year by arranging to have extra tax withheld from his
paycheck during December. This will also save him some interest and
penalties if he simply failed to make required estimated tax payments
earlier in the year.
Taxes Not Withheld
A taxpayer may receive taxable income that is not subject to having taxes
withheld, such as:

Interest and dividends


Alimony
Unemployment compensation
Prizes or awards
Self-employment income

As a result, taxpayers may find that they owe estimated tax.


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TAX TIP

Recovering Social Security Tax Overpayments


Employers must withhold Social Security tax from workers' wages. These
payments determine benefits when the employee retires. In 2015 the first
$118,500 of income is taxed. Because there is a limit on how much
income can be taxed each year, taxpayers with more than one employer
sometimes unintentionally overpay this tax. For instance, a taxpayer may
have two jobs with unrelated employers (or change employers during the
year) from which he earns $60,000 at each job. In this instance, both
employers, usually unaware of what the other employer withheld, would
have withheld Social Security tax on $60,000 of income ($60,000 x 2 =
$120,000 total). In these cases, the taxpayer can get his Social Security tax
overpayment refunded as a credit on his individual tax return.
If the taxpayer had only one employer but still had too much Social
Security tax withheld, he cannot claim the excess as a credit on Form
1040. Instead, he must ask his employer to refund the overpayment.
Who Must Pay Estimated Tax
Generally a taxpayer must make payments of estimated tax if the following
conditions are met:

The taxpayer owes $1,000 or more for the tax year after subtracting
federal income tax withheld and credits from taxable income, and

The taxpayer expects the tax withheld and credits on this year's tax
return to be less than the smaller of:
o 90% of the tax liability to be shown on this year's tax return,
or
o 100% of the tax liability shown on last year's tax return (which
must cover all 12 months)

Sole Proprietors, Partners and S Corporation shareholders, generally must


make estimated tax payments if they expect to owe $1,000 or more in tax
when they file their return.
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Corporations must make estimated tax payments if it expects its tax to be


$500 or more for the year. Corporations are subject to an underpayment
penalty if the estimated tax payments do not equal the lesser of:

100% of the tax shown on the corporations tax return for the prior
year, or

100% of the tax shown on the corporations tax return for the current
year

Married taxpayers can pay estimated tax either separately or jointly. Joint
estimated tax payments may be divided between the spouses if they later
choose to file separate returns. Married taxpayers cannot use 100% of the
tax liability shown on this year's return to figure the estimated tax payments
for next year's return if their joint adjusted gross income (AGI) exceeds:

$150,000, or
$75,000 if Married Filing Separately

110% of the prior year tax liability must be paid by these taxpayers. For
further information refer to Publication 505 - Tax Withholding and Estimated
Tax.
Estimated tax is paid by using Form 1040ES - Estimated Tax for Individuals.
1040 ValuePak automatically creates and calculates Form 1040ES when it is
needed.
However, the calculations are based on the current years tax return. Be sure
to:

Consider all available facts that will affect income, deductions, and
credits

Use last year's tax return as a starting point for estimations

Include all taxes, such as tax on lump-sum distributions and selfemployment tax

Be careful to make adjustments both for:


o Anticipated changes in the taxpayer's situation, and
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o Recent changes in the tax law


Taxpayers who are unsure about the accuracy of their estimate may want to
pay more than the required minimum of 90%. Taxpayers who do not pay
enough tax may be charged a penalty.
Generally, the simplest and safest procedure is to make sure that the total of
tax withheld plus the amount of estimated tax for each of the four payment
periods for the following year is at least one quarter of the tax shown on the
tax return for the prior year.

TAX PRACTICE TIP

Reviewing Estimated Tax Liability


Taxpayers, and especially business owners, must be aware of changes in
their estimated tax liability. Because their business income may increase
dramatically, business owners should evaluate their estimated tax liability
twice a year when they file their tax return and six months later. You
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should remind all taxpayers to let you know if they receive substantially
more income or gains from the sale of property.
Taxpayers that don't pay enough estimated tax on a quarterly basis may
have to pay a penalty for the estimated tax underpayment - even if they
wind up getting a refund when their tax return is filed.
The IRS provides a worksheet for calculating estimated taxes in the Form
1040-ES Booklet.
When to Pay Estimated Tax
There are four payment periods for making estimated tax installments. Each
period has a specific due date. Most of the taxpayers you assist will pay their
estimated tax in four equal installments. Taxpayers who do not pay enough
tax by the due date of each payment period may be charged a penalty,
even if the filed tax return shows a refund.
The table below shows when estimated tax payments are due:
For the period:
Due Date:
January 1st through March 31st
April 15th
April 1st through May 31st
June 15th
June 1st through August 31st
September 15th
September 1st through December 31st
January 15th next year
If the Due Date falls on a Saturday, Sunday, or holiday, then the payment
is due on the next business day.
What if the taxpayer receives new taxable income that he or she didn't have
last year?
Taxpayers do not have to make estimated tax payments until they have
received taxable income. Taxpayers who do not receive any taxable income
until after one or more payment periods have passed may begin making
payments for the period they first receive the income.
The table below shows when estimated tax payments for new taxable
income are due:

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If you first have new


income on which you
must pay estimated
tax:

THE

TAX

Make a payment
by:

Before April 1st

April 15th

April 1st - May 31st

June 15th

June 1st - August 31st

September 15th
January 15th next
year

After August 31st

RETURN

Make later
installments by:
June 15th
September 15th
January 15th next year
September 15th
January 15th next year
January 15th next year
(None)

Amount of Each Payment


Generally, the minimum payment due during the first pay period the
taxpayer receives taxable income is:

One quarter of the total estimated tax for the year, plus

An additional one quarter of the yearly total for each period that has
already passed

The taxpayer must then pay the balance of the estimated tax during the
remaining periods (one quarter of the yearly total for each remaining
period).
Taxpayers also have the option of paying all the estimated tax at once.
Instead of paying by installments, taxpayers may choose to pay the entire
amount by the due date of the period during which the income is received.
For example, some taxpayers choose to pay all of their estimated tax with
the first payment due April 15th. It alleviates the need for them to
remember to make the remaining payments.
Taxpayers who file their Form 1040 or Form 1040A by January 31 and pay
the entire amount of tax owed at that time are not required to make the
estimated tax payment due January 15th.
A taxpayer can pay in installments other than even amounts. However, if a
quarterly installment is less than one quarter of the total estimated tax, the
taxpayer risks an underestimated tax penalty.
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Taxpayers can always re-examine their tax liability or change their estimated
payments based on actual income.

Option to Apply an Overpayment


Taxpayers can apply all or part of an overpayment from this year's Form
1040 or Form 1040A to the estimated tax for this year (next year's return).
Make the election on the Form 1040-ES Additional Information Worksheet.
The overpayment amount to be credited will appear on Form 1040 line 77.

Figure 29-20: The Refund section of Form 1040 with line 77 "Amount of line 75 you
want applied to your 2015 estimated tax" highlighted.

How to Make Payments


Estimated tax payments can be sent to the IRS:

Electronically through the Electronic Federal Tax Payment System


from the taxpayer's checking or savings account or by credit card, or

By check, along with the appropriate payment voucher from Form


1040ES

Each voucher is inscribed with its due date. Be sure to use the correct
voucher for each payment.
Advise the taxpayer to:

Write his or her social security number and "2015 Form 1040ES" on
the check or money order - made payable to the "United States
Treasury"

Mail payment vouchers to the address shown in the Form 1040ES


instructions for the place where the taxpayer lives

DO NOT mail estimated tax payments to the address shown in Form 1040
or Form 1040A instructions. Instead, refer to the instructions for the 1040ES
for the correct address.
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Forms W-4, W-4P, W-4V, and W-4S


This topic discusses Forms W-4, W-4P, W-4V, and W-4S, the documents
taxpayers can use to adjust their tax withholding allowances. At the end of
this topic, you will be able to determine whether to suggest changes to the
taxpayer's Form W-4, Form W-4P, Form W-4V, or Form W-4S.
Form W-4
An employer withholds tax based on wages paid and information the
employee provides on Form W-4, Employee's Withholding Allowance
Certificate. The worksheets that come with Form W-4 use the employee's
expected income, deductions, adjustments to income, and credits to figure
the total withholding allowances to claim on Form W-4. In addition, an
employee can claim extra allowances in certain situations.

Figure 29-21: Form W-4 - Employee's Withholding Allowance Certificate.

Form W-4P
A taxpayer who receives distributions from a pension, an annuity, an IRA, a
stock bonus plan, or certain deferred compensation plans should use Form
W-4P, Withholding Certificate for Pension or Annuity Payments, to notify
the payer whether, and how much, income tax should be withheld.

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Figure 29-22: Form W-4P - Withholding Certificate for Pension or Annuity Payments.

Form W-4V
Taxpayers may have tax withheld from unemployment compensation and
federal government payments. Use Form W-4V, Voluntary Withholding
Request.

Figure 29-23: Form W-4V - Voluntary Withholding Request.

Form W-4S
Taxpayers may have tax withheld from sick pay. Submit a Form W-4S,
Request for Federal Income Tax Withholding From Sick Pay to the insurance
company.

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Figure 29-24: Form W-4S - Request for Federal Income Tax Withholding From Sick Pay.

How Much to Withhold


Income, deductions, and credits should be estimated carefully. Taxpayers
who do not have enough federal income tax withheld can be subject to
interest and penalties. Taxpayers who either have a very large refund or who
owe taxes should consider adjusting their withholding.
Some taxpayers want their withholding to be high enough to ensure that
they receive a tax refund rather than owe taxes. It is perfectly legal for
taxpayers to claim fewer allowances than the worksheets show they are
entitled to claim. If more tax than required is withheld each pay period, then
the taxpayer should be eligible for a refund of overpaid taxes at the end of
the year.

TAX TIP

Avoiding Underwitholding & Overwitholding


Taxpayers who work two jobs often dont have enough tax withheld from
their part-time earnings. As a result, they might wind up owing money at
tax time. To avoid this situation, increase the amount of money withheld
either from their main paycheck or from their second job paycheck.
Taxpayers who do not work for an employer for a full year, like an
employee that starts full time work for the first time on July 1st, are
subject to overwitholding. This is because the withholding calculations
used to determine how much is deducted from each paycheck is based
on income for a full year. To solve this problem, if the employee expects
to work 245 or fewer days throughout the year, he or she can ask the
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employer to calculate the withholding on a "part year" basis. Alternatively,


employees in this situation can claim extra withholding allowances on
Form W-4.
Taxpayers cannot claim more withholding allowances than they are entitled
to in order to increase their take-home pay unless they have a substantial
overpayment. You should warn taxpayers that there are penalties for
willfully supplying false information on Form W-4 to decrease the amount
withheld for taxes.
Completing Forms W-4 and W-4P
In addition to the Withholding Allowance Certificate, which goes to the
employer or pension payer, Form W-4 and Form W-4P packets also contain:

Instructions

Personal Allowances Worksheet

Deductions and Adjustments Worksheet

Two-Earner/Two-Job, Multiple Pension/More Than One Income


Worksheets

Tables

Employees should start with the Personal Allowances Worksheet, which will
direct them to any additional worksheets and tables that apply to them. The
worksheets incorporate the number of allowances, adjustments, deductions,
and credits that the employee expects on the next income tax return. The
employee will then use that information to complete the allowance
certificate.

TAX TIP

Should newly married taxpayers change their withholding?


Anytime there is a major life change, such as more income or deductions,
additional dependents, marriage, or divorce taxpayers should review their
withholding. Married taxpayers can take an additional allowance on their
Forms W-4, and keep more of their money in their pockets throughout
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the year.

TAX PRACTICE TIP

Social Security Administration Provides Online Service to Replace


SSA-1099 or SSA-1042-S
If your client receives Social Security benefits but did not receive, or
misplaced, either form SSA-1099 or SSA-1042S, he or she may now
view and print the form online by creating a my Social Security
account. Click here: http://www.socialsecurity.gov/myaccount/

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Flowchart: Exempt From Withholding

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Exemption From Withholding for Taxpayers Over Age 65 and/or


Blind
Caution: Use this worksheet only if, for 2014 the taxpayer had a right to a refund of all
federal income tax withheld because the taxpayer had no tax liability. This worksheet
does not apply if the taxpayer can be claimed as a dependent.
1. Check the boxes below that apply to the taxpayer:
65 or older
Blind
2. Check the boxes below that apply to the taxpayer's spouse if the taxpayer will claim
the spouse's exemption on his 2015 return:
65 or older
Blind
3. Add the number of boxes checked in 1 and 2 above. Enter the result here

The taxpayer can claim exemption from withholding if:


The taxpayer's filing
...and the
...and the taxpayer's 2015 total income
status is:
number on line will be no more than:
3 above is:
Single
$11,850
1
$13,400
2
Head of Household
$14,800
1
Married filing
separately for both
2013 and 2014

Other married status


(Include both spouses'
income whether the
taxpayers will file
separately or jointly .)
Qualifying widow(er)

$16,350

$11,550

2
3
4
1
2
3

$12,800
$14,050
$15,300
$21,850
$23,100
$24,350

$25,600

$17,850

$19,100

The taxpayer cannot claim exemption from withholding if his total income will be more
than the amount shown for his filing status.
Table: Exemption From Withholding Over 65

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Multiple Incomes
An employee should complete only one set of Form W-4 worksheets, even
if the employee has a working spouse or income from two jobs.
For employees with a working spouse or multiple jobs, complete the
worksheets for one Form W-4 using the combined expected income,
adjustments, deductions, and exemptions, then either:

Divide the number of total allowances from this Form W-4 among all
jobs, or

Claim zero allowances on all jobs except for the highest-paying one;
this is usually the more accurate option

Certain events can occur during the year that can change an employee's
marital status, exemptions, allowances, deductions or credits. When this
happens, employees may have to change their withholding allowances by
submitting a new Form W-4 to the employer. The original Form W-4
remains in effect until the employee submits a revised Form W-4.
For more information on withholding, refer to the IRS's Tax Withholding
web page.
Employees who are exempt from withholding do not use the worksheets,
but still fill out the Form W-4 - Withholding Allowance Certificate. See the
instructions for more information.
You can also select "Withholding Calculator" in the Tax Preparation Help >
IRS section of the 1040 ValuePak Portal.

Attaching Forms and Schedules


Attach forms and schedules behind Form 1040 according to the Attachment
Sequence Number shown in the upper-right corner of the form or schedule.
Items without an Attachment Sequence Number should be placed at the
end.

Figure 29-25: Form 1040 Schedule A with "Attachment Sequence No." highlighted.

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Attach Form(s) W-2 to the left margin of the return.


If any Form 1099 showed federal income tax withheld:

Make sure that amount was included in the Payments section of the
return

Attach a copy of the Form 1099 with the Form(s) W-2

Signatures
Before the taxpayer mails the return, make sure:

The taxpayer has signed and dated the return

Both spouses have signed a joint return, even if only one spouse had
income

Figure 29-26: The signature section of Form 1040.

Unsigned returns cannot be processed by the IRS and will be sent back to
the taxpayer.
Returns for Children
If the taxpayer is filing a return for his or her minor child he or she should
sign the child's name, and add "By (taxpayers signature), parent (or
guardian) for minor child." The parent who signs the child's return will be
authorized to deal with the IRS if any questions arise about the return.
Combat Zone
If the taxpayer's spouse is currently stationed in a combat zone or a
qualified hazardous duty area the stateside spouse can sign a joint tax
return for the serviceman or woman.

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As a paid tax return preparer you are required by law to sign the return in
the Paid Preparer's section and provide your Preparer Tax Identification
Number (PTIN).

Deceased Taxpayers
If a taxpayer died before filing a return for the tax year the person
responsible for signing and filing the decedent's final return is either the:

Executor this is a person named in the decedents will to wrap-up


the decedents affairs

Administrator who performs the same duties as an executor but is


appointed by a probate court when the decedent dies intestate
(without a will) or the executor named in the will is unable to serve

Personal Representative often this is the decedents spouse. Often


executors and administrators are referred to as personal
representatives too.

If no executor or administrator has been appointed by the tax return is due


date the surviving spouse is responsible for filing the final tax return. If there
is no surviving spouse then whoever is in charge of the decedent's property
must file the final tax return. The due date of the tax return is ordinarily the
same due date the deceased would have if he or she were still alive.
The person filing the final return must sign it and state his or her capacity
("Jane Doe, executor for the estate of John Q. Doe"). The spouse must also
sign in the space provided if the decedents final return is a joint return.
If the deceased taxpayer did not have to file a return but had tax withheld, a
return must be filed to get a refund.

TAX QUOTE

"I'm spending a year dead for tax reasons."


Douglas Adams

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The person who files the final return should enter "DECEASED," the
deceased taxpayer's name, and the date of death across the top of the
return.

Figure 29-27: Form 1040 with "Deceased" and the date of death highlighted.

TAX TIP

Can taxpayers get out of paying income tax by simply filing a "final
return" even though they are still alive?
No. That has been tried over the years and it never works. Payers of
income, such as employers, banks, and brokerage houses still file the W2's and 1099's with the IRS if there is any income. Additionally, the Social
Security Administration maintains a database of deceased citizens that is
available to the IRS. Eventually the IRS will catch up with the "deceased".
The table below shows where to report the decedent's income received
both before and after death.
Before Death
After Death
Final Form 1040
Income received
by the decedent.

Estate's Form 1041


Income in Respect of a Decedent (IRD) paid
to the probate estate.
Income paid on probate assets during
administration, such as interest, dividends,
rents, etc.
Sale of capital assets by the probate estate.
Beneficiary's Form 1040
Income in Respect of a Decedent (IRD) paid
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After Death

THE

directly to the beneficiary.


Income paid after death on assets received
directly from decedent.
Sale of capital assets received from decedent.

TAX TIP

Deducting Federal Estate Taxes Paid For IRD


Taxpayers who receive income in respect of a decedent can deduct the
portion of the decedent's federal estate tax that applied to this income as
a miscellaneous itemized deduction that is not subject to the 2% of AGI
floor.
Claiming the Decedent's Refund
A surviving spouse can claim a refund on a final joint tax return without
filing any extra forms. If the decedents final tax return is filed separately
then the person filing the final tax return must attach Form 1310 Statement of Person Claiming Refund Due a Deceased Taxpayer. An
executor, administrator, or other court appointed personal representative
can avoid filing this form by attaching a copy of the "Letters Testamentary"
or "Letters of Administration" issued by the court.
While a complete discussion of Federal Estate and Gift taxes is beyond the
scope of this course, we briefly provide some information below so that
you'll be aware of what they are.

Federal Estate Tax


The Federal Estate Tax is a tax on the decedent's right to transfer property at
his death. It consists of an accounting of everything he owned or had
certain interests in at the date of death. The fair market value of these items
is used, not necessarily what was paid for them or what their values were
when he acquired them. The total of all of these items is the decedents
"Gross Estate." The includible property may consist of cash and securities,
real estate, insurance, trusts, annuities, business interests and other assets.
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Once you have accounted for the Gross Estate, certain deductions (and in
special circumstances, reductions to value) are allowed in arriving at the
"Taxable Estate." These deductions may include mortgages and other debts,
estate administration expenses, property that passes to surviving spouses
and qualified charities. The value of some operating business interests or
farms may be reduced for estates that qualify.
After the net amount is computed, the value of lifetime taxable gifts
(beginning with gifts made in 1977) is added to this number and the tax is
computed. The tax is then reduced by the available unified credit. Presently,
the amount of this credit reduces the computed tax so that only total
taxable estates and lifetime gifts that exceed $5,430,000 will actually have
to pay tax.
In its current form, the estate tax only affects the wealthiest 2 percent of all
Americans. Only about 0.2 percent of the estates of people who die pay the
tax, down from 2.16 percent in 2000 and 6.47 percent in 1973, according to
the congressional Joint Committee on Taxation. As Congress has reduced
the tax, its become a less important piece of federal revenue. It made up
just 0.6 percent of tax collections in 2014, compared with a post-World War
II peak of 2.6 percent in 1972.
Most relatively simple estates (cash, publicly traded securities, small
amounts of other easily valued assets, and no special deductions or
elections, or jointly held property) do not require the filing of an estate tax
return. A filing is required for estates with combined gross assets and prior
taxable gifts exceeding $5,430,000.

TAX TIP

Closing Estates Promptly


Ordinarily the IRS has three (3) years from the filing of an estate tax return
to audit the return and/or assess additional taxes. However, if the
executor files Form 4810 - Request for Prompt Assessment Under Internal
Revenue Code Section 6501(d) the IRS has only eighteen (18) months to
audit the return and/or assess additional taxes. This will help the executor
in promptly closing the estate, as keeping estates open can be costly.

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The table below shows the Unified Estate Tax Credit Exemption
amounts:

Year
2002
2003
2004
2005
2006
2007-08
2009
2010
2011
2012
2013
2014
2015

Unified Credit Exemption


Amount
$1,000,000
$1,000,000
$1,500,000
$1,500,000
$2,000,000
$2,000,000
$3,500,000
Repealed
$5,000,000
$5,120,000
$5,250,000
$5,340,000
$5,430,000

Estate Tax rate


50%
49%
48%
47%
46%
45%
45%
Repealed
35%
35%
40%
40%
40%

Table: Estate Tax Credit

TAX TIP

Are inheritances taxable income?


Inheritances are ordinarily not taxable income. Taxpayers don't report
them on their income tax return unless one of the following exceptions
apply:

The taxpayer inherited a traditional IRA or a retirement account


such as a 401(k). In that case any distributions received from those
retirement accounts are reported as income on the beneficiarys
tax return unless the beneficiary rolls the distribution over. Then
beneficiary will have until her age 70 to begin distributions
from the IRA. The beneficiary will receive a Form 1099-R showing
the amounts of income to report.

If the taxpayer receives property such as shares of stock, a rental


property, or a home, the taxpayers cost basis in the property is the
fair market value of the property on the decedent's date of death.
Any post-death gain on the sale of the inherited property is
reported on the beneficiarys tax return on Schedule D. Post-death
gain or loss on the sale of inherited property is automatically a
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long-term gain or loss even if the taxpayer held the property for
one year or less.

TAX PLANNING TIP

How can taxpayers minimize estate taxes?


Thats where estate planning comes in. Taxpayers can minimize estate
taxes by reducing the value of their estate while they are still alive until it
is below the applicable exclusion amount. There are many ways this can
be accomplished. Gifts that do not trigger gift tax include the following:

Gifts made for tuition or medical expenses paid directly to the


institution

Gifts made that fall under the gift tax applicable exclusion amount.
However, any part of the gift tax applicable exclusion amount
used for lifetime gifts reduces the applicable exclusion amount
available for estate tax purposes

Gifts made to charities

Gifts made to U.S. citizen spouses

Gifts of up to $147,000 in 2015 made to non-U.S. citizen spouses

Gifts of up to the annual gift tax exclusion amount of $14,000

Another way to minimize estate taxes is to transfer assets to an


irrevocable trust. Trusts hold assets for the benefit of its beneficiaries.
Transfers to an irrevocable trust may be subject to gift tax, but the assets
and all future appreciation will be removed from the taxpayer's gross
estate. Be aware that an irrevocable trust cannot be revoked later.
Irrevocable trusts can:

Bypass the expense, delay, and public disclosure of probate


Minimize federal estate taxes
Minimize state inheritance taxes
Preserve assets for minors
Provide charitable benefits
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Shield assets from potential creditors


Shift income taxes to beneficiaries in lower tax brackets
Shield assets from judgments
Support the grantor in case of incapacity

Taxpayers with estate planning concerns should consult with a qualified


estate planning attorney.

SIDE BAR

Testamentary Trusts
Testamentary trusts are created by the taxpayers last will and testament
when the will is probated. Selected assets are placed in the trust.
Taxpayers can place just about any type of asset into a trust stocks,
bonds, cash, insurance policies or proceeds, real estate, etc. The trust
document controls how the assets in the trust are managed and
distributed to the beneficiaries. These trusts allow the deceased to have a
certain amount of control over how the assets are used after his death.
There are no income tax benefits from creating a testamentary trust.
However, assets in the trust will bypass the beneficiary's estates.

Federal Gift Tax


If the taxpayer gives someone money or property during his life, he may be
subject to the Federal Gift Tax. The Federal Gift Tax is a tax on the transfer of
property by one individual to another while receiving nothing, or less than
full value, in return. The tax applies whether the donor intends the transfer
to be a gift or not.
The gift tax applies to the transfer by gift of any property. Taxpayers make a
gift if they give property (including money), or the use of or income from
property, without expecting to receive something of at least equal value in
return. If the taxpayer sells something at less than its full value or if he
makes an interest-free or reduced-interest loan, he may be making a gift.
The table below shows the Estate and Gift Unified Tax Rate Schedule:

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If the taxable amount is:


Over
$0
$10,001
$20,001
$40,001
$60,001
$80,001
$100,001
$150,001
$250,001
$500,001
$750,001
$1,000,001

But not over The tax rate is:


$10,000
18%
$20,000
20%
$40,000
22%
$60,000
24%
$80,000
26%
$100,000
28%
$150,000
30%
$250,000
32%
$500,000
34%
$750,000
37%
$1,000,000
39%
...
40%

Minus
$0
$200
$600
$1,400
$2,600
$4,200
$6,200
$9,200
$14,200
$29,200
$44,200
$54,200

= The Tax
= The Tax
= The Tax
= The Tax
= The Tax
= The Tax
= The Tax
= The Tax
= The Tax
= The Tax
= The Tax
= The Tax

Gift Tax: The first $14,000 of gifts annually from a single donee is exempt from tax
($28,000 for both spouse's). The gift tax exclusion amount for 2015 is $5,430,000.
Gifts to a non-US citizen spouse are eligible for an annual gift tax exclusion of
$147,000 in 2015. Use the rates above for amounts in excess. There is an unlimited
exclusion for medical expense and tuition payments paid directly to an institution.
Table: Estate and Gift Unified Tax Rate Schedule

TAX PLANNING TIP

Year-End Gifts
If the taxpayer plans to make a gift by check at year end make sure the
recipient deposits the check in sufficient time for it to clear the taxpayers
bank account by December 31st. If the check doesnt clear by December
31st the gift will be treated by the IRS as a gift made in the following year,
thus reducing the $14,000 gift tax exclusion for next year. Alternatively,
the taxpayer can give the recipient a bank cashier's check, which
immediately removes the funds from the taxpayers account.
Who Must File Form 709?
Most gifts are not subject to gift tax and in most cases taxpayers do not
need to file Form 709 - United States Gift (and Generation-Skipping Transfer)
Tax Return. For example, there is usually no gift tax if the taxpayer makes a
gift to his spouse or to a charity. If the taxpayer makes a gift to someone
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else, the gift tax usually does not apply until the value of the gifts to that
person exceeds the $14,000 annual exclusion for the year.
Gift tax returns do not need to be filed unless the taxpayer gives someone,
other than his spouse, money or property worth more than the annual
exclusion. Generally, the person who receives the gift will not have to pay
any income tax on the value of the gift received.
Making a gift does not ordinarily affect the taxpayers federal income tax.
He cannot deduct the value of gifts he makes, other than gifts that are
deductible charitable contributions.
The general rule is that any gift is a taxable gift. However, there are many
exceptions to this rule. The following gifts are not taxable gifts:

Gifts that are not more than the annual exclusion for the calendar
year,

Tuition or medical expenses paid directly to a medical or educational


institution for someone,

Gifts to the taxpayer's spouse,

Gifts to a political organization for its use, and

Gifts to charities.

Gift Splitting
The taxpayer and spouse can make a gift up to $28,000 to a third party
without making a taxable gift. The gift can be considered as made one-half
by the taxpayer and one-half by the spouse. If they split a gift they made,
they must file a gift tax return to show that they agreed to use gift splitting even if half of the split gift is less than the annual exclusion.
Gift Tax Returns must be filed if any of the following apply:

The taxpayer gave gifts to at least one person (other than his spouse)
that are more than the annual exclusion for the year.

The taxpayer and spouse are splitting a gift.

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The taxpayer gave to someone other than his spouse a gift of a


future interest that he or she cannot actually possess, enjoy, or
receive income from until sometime in the future.

The taxpayer gave his spouse an interest in property that will


terminate due to a future event.

SIDE BAR

How can business owners determine the value of their business for
estate or gift tax purposes?
There are appraisers who specialize in businesses valuation. Many
different methods exist for determining the Fair Market Value of a closely
held business. Fair Market Value is defined by the federal tax regulations
as "the price at which the property would change hands between a
willing buyer and a willing seller, neither being under any compulsion to
buy or to sell and both having reasonable knowledge of relevant facts."
Some of the factors that might affect the value of a business include:

Book value and financial condition of the business


Dividend paying capacity
Earnings capacity
Goodwill or intangible value
Market value of stock in similar businesses
Nature of the business and its history
Outlook for the industry and economy

State Estate and Inheritance Tax


Twenty-two states and the District of Columbia also levy either an estate tax
or inheritance tax. The primary difference between inheritance tax and
estate tax is where the tax burden falls - that is, whether it must be paid by
an individual beneficiary, or by the estate itself. Unlike estate tax, inheritance
tax is levied by the states on the money and assets received by a beneficiary
from the estate of the decedent. Beneficiaries must pay taxes on the value
of whatever they inherit, though they can claim a number of exemptions to
reduce these taxes.
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The table below shows states with an estate or inheritance tax:


States with Estate or Inheritance Tax
Connecticut
Massachusetts

Pennsylvania

Illinois

Minnesota

Rhode Island

Indiana

New Jersey

Tennessee

Iowa

New York

Vermont

Kansas

North Carolina

Washington

Kentucky

Ohio

Wisconsin

Maine

Oklahoma

District of Colombia

Maryland

Oregon

Probate
Probate is the legal process of administering the estate of a deceased
person by resolving all claims and distributing the deceased person's
property according to the terms of the will. Probate Court interprets the
instructions of the deceased, appoints the executor as the personal
representative of the estate, and adjudicates the interests of heirs and other
parties who may have claims against the estate.
Below is a list of what property does and does not pass through the
probate estate.
Probate Assets
Pass to beneficiaries named in a will
or, if there is no will, according to
state intestacy law.

Non-probate Assets
Pass to new owners without going
through probate.

Assets owned solely by the


decedent
Decedent's share of assets
owned as tenant-incommon.

Assets that name the estate


as beneficiary.

Assets with no beneficiary or


a pre-deceased beneficiary
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Most joint tenancies.

Life insurance, IRAs,


retirement plans with living
beneficiaries.

Bank accounts Payable on


Death (POD) provided the
beneficiary is living...

Stock registered Transfer on


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Probate Assets
Assets that do not take joint
ownership or beneficiaries such as wages, tax refunds
of a Single filing status
taxpayer, other refunds, etc.

TAX

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Non-probate Assets
beneficiary is living.

Assets held in trust if the


trust instrument provides for
distributions at death.

Remainder interests.

Deceased Spouses
If a taxpayer's spouse died during the tax year and the taxpayer did not
remarry before the end of the year, the taxpayer can use either the Married
Filing Jointly status or the Married Filing Separately status for that year. A
joint return for a widowed taxpayer should show the deceased spouse's
income before death and the taxpayer's income for the entire tax year. The
taxpayer should enter "Filing as surviving spouse" in the area where the
spouse signs the return. If someone else is the personal representative, he
or she must also sign.

Figure 29-28: The signature section of Form 1040 with the "Spouses signature" line
highlighted.

The surviving spouse or personal representative should promptly notify all


payers of income, including financial institutions, of the taxpayer's death.
This will ensure the proper reporting of income earned by the taxpayer's
estate or heirs.
A deceased taxpayer's social security number should not be used for tax
years after the year of death, except for estate tax return purposes.

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SIDE BAR

Who Inherits The Decedent's Debts?


Inheriting assets is the easy part. But who pays the decedents debts?
Unfortunately some estates include large outstanding credit card bills
and houses with negative equity. So where does that leave the heirs?
What happens to the decedent's debts such as mortgages, car loans,
medical bills, and even student loans?
Generally, personal debts die with the decedent and are not passed
along to the heirs. However, there are exceptions. In some cases heirs
are jointly liable for the debts or they are guarantors. In those cases
that heir continues to be liable for the debt. Thats one of the reasons
people have to be careful about co-signing for loans. Ditto for joint
credit cards - even if the expenses weren't personally the heir's.
If the decedent's estate is solvent (i.e. his assets are greater than his
liabilities) the debts get deducted from the estate and the heirs get
whats left over. The executor of the estate will sell whatever assets
the decedent had and pay off the creditors to the extent possible. Any
shortfall gets written off as a loss. Debts of insolvent decedents
ordinarily get buried with them. Ordinarily heirs are not responsible
for making the creditors whole.
All debts must be paid before the estate can distribute any assets.
Creditors always collect their money before the heirs get anything.
Depending on state laws some assets may be excluded from probate.
That can include life insurance proceeds, retirement benefits and real
estate if the surviving spouse is a co-owner as a Joint Tenant with
Rights of Survivorship - provided the surviving spouse is listed on the
mortgage as a co-owner/debtor. A local probate attorney can advise
on specifics.
The rules related to debts are different for married decedents that live
in community property states - where all property and debts acquired
during a marriage are considered jointly owned and owed. A local
probate attorney can advise on specific state laws.
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Spouses may also be required to pay for the decedent's nursing home
expenses if he or she received Medicaid. Its common strategy for the
healthier spouse to invoke spousal refusal and refuse to pay for such
expenses incurred by the husband or wife. The spouse requiring the
nursing home care then claims no assets and Medicaid steps in with
financial assistance. The federal government may come after the
surviving spouse for payment.
If the surviving spouse has significant assets the government may sue
him or her to recover the amount paid. However, the government
usually would wait to collect from the proceeds of the sale of the
property after the second spouse passes away.
Student loans are another matter. Federal loans such as Perkins and
Stafford Loans offer loan forgiveness provisions if the student
borrower dies before the debt gets repaid.
Federal PLUS loans for parents are forgiven if the parent or student for
whom the parent is borrowing the money passes away with an
outstanding balance. But most private student loans, such as those from
a bank, are not forgiven.

Third Party Designee


If the taxpayer wants to allow a friend, family member, or other selected
person to discuss the tax return with the IRS, you should complete the Third
Party Designee information.

Figure 29-29: The Third Party Designee section of Form 1040.

Any five numbers the designee chooses can be used as his or her personal
identification number (PIN).
By appointing a designee, a taxpayer (and his or her spouse if filing a joint
return) is authorizing the IRS to call the designee to answer any questions
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that may arise during the processing of the return. The taxpayer is also
authorizing the designee to:

Give the IRS any information that is missing from the return

Call the IRS for information about the processing of the return or the
status of the taxpayer's refund or payment(s)

Receive copies of notices or transcripts related to the taxpayer's


return, upon request

Respond to certain IRS notices that the taxpayer has shared with the
designee about math errors, offsets, and return preparation

A taxpayer's third party designee is not authorized to:

Receive the taxpayer's refund check from the IRS


Bind the taxpayer to anything, including any additional tax liability
Otherwise represent the taxpayer before the IRS

The designee's authorization can be revoked before it ends by sending


the IRS a written statement of revocation indicating that the designee's
position is revoked and noting the affected tax return(s). Both the
taxpayer and the designee must sign the statement.
The authorization will automatically end no later than the due date (without
regard to extensions) for filing the taxpayer's return for the current year. For
example, on 2014 tax returns a third party designee's authorization will
automatically end on the due date for filing the 2015 tax return. This is
April 15, 2016 for most people.
A third party designee's authority can be expanded, for example to
grant the person a power of attorney to represent the taxpayer at a
conference with the IRS by filing Form 2848 - Power of Attorney and
Declaration of Representative.

Ending the Interview


Make sure the taxpayer keeps a copy of all Forms W-2 and 1099 with a copy
of the tax return. Advise the taxpayer to keep these copies for at least three
years. If you are providing an envelope or jacket for the taxpayer's records,
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place the copies into it. Advise the taxpayer to bring the return back next
year.

TAX TIP

Good Recordkeeping Pays


Good records are essential if the taxpayer is audited. In the case of tax
deductions the burden of proof is on the taxpayer to show that he or she
incurred and paid the expenses. If the taxpayer can't do so the IRS will
disallow the deductions. Taxpayers must prove:

that they actually incurred the expenses (invoices will prove that);

that they actually paid the invoices (canceled checks will prove
that), and

that the expenses in question were business-related, or tax


deductible for other reasons.

Checking on Refunds
Tax refund status information does not become available until it has been
six (6) weeks since the tax return was mailed or three (3) weeks if the tax
return was filed electronically. The fastest, easiest way to find out the status
of a tax refund is to either call the Automated Tax Refund Service at 1-800829-4477 (TDD: 1-800-829-4059) or use the "Wheres My Refund?" search
at http://www.irs.gov/. Just click the "Wheres My Refund?" on the IRSs
home page. The taxpayer should be sure to have a copy of the tax return
available since he will need to know the first social security number shown
on the return, the filing status on the return, and the exact whole dollar
amount of the refund.
If the taxpayer doesnt receive his refund within 28 days from the original
IRS mailing date shown on "Wheres My Refund?" he can start a refund
trace online. If "Wheres My Refund?" shows that the IRS was unable to
deliver the refund, he can change his address online. "Wheres My Refund?"
will prompt the taxpayer when these features are available for his situation.
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Financial Management Service


Under the law, state and federal agencies refer to the IRS the names of
taxpayers who are behind in their child support payments, tax, and loans.
The taxpayers refund may not be sent if the taxpayer is delinquent in child
support payments or has a past due federal debt, such as a student loan, or
taxes for a prior year. The Department of the Treasury's Financial
Management Service, which authorizes tax refunds, has been authorized by
Congress to conduct the Treasury Offset Program. Through this program, a
tax refund or tax overpayment that the taxpayer asked the IRS to apply to
next tax year's estimated tax, may be reduced by the Financial Management
Service and offset to pay any past-due child support or federal agency non
tax debts he may owe.
An offset will not occur until the IRS has verified the tax refund amount and
certified the tax refund for payment by the Financial Management Service.
The taxpayer will receive a notice if an offset occurs. The notice will reflect
the original refund amount, the offset amount, the agency receiving the
payment, and the address and telephone number of the agency.
He should contact the agency directly to determine if the debt was
submitted for an IRS tax refund offset. If the debt was submitted to the
Financial Management Service for a tax refund offset, as much of the tax
refund as is needed to pay off the debt will be taken by the Financial
Management Service and sent to the agency. Any portion of the tax refund
remaining after offset will be issued in a check, direct deposited, or credited
to next tax year's estimated tax as requested.
The taxpayer should contact the agency shown on the notice directly if he
believes he does not owe the debt or he is disputing the amount taken
from the tax refund. Contact the IRS only if the original refund amount
shown on the FMS offset notice differs from the refund amount shown on
the tax return that was filed.
If the taxpayer filed a joint return and is not responsible for the debt, but is
entitled to a portion of the refund, she may request her portion of the
refund by filing IRS Form 8379, Injured Spouse Allocation. See Injured
Spouse Relief in Lesson 30. The IRS will compute the injured spouse's share
of the joint refund.

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If a Offset Notice is not received contact the Financial Management Service


at (800) 3043107, Monday through Friday from 7:30 AM to 5 PM (Central
Time).

Lesson Summary
Lets take a moment to review what you have covered in this lesson.
The information for the Payments section of the return comes from:

Federal income tax withholdings from Forms W-2 and 1099

Estimated tax payments paid by the taxpayer (not reported on Form


1040EZ), and

Refundable credits

If a taxpayer has made more tax payments than the amount of tax liability,
this is considered an overpayment and the taxpayer can:

Receive a complete refund, or

Apply the overpayment to the next year's estimated tax, or

Receive a partial refund and apply the remainder of the overpayment


to next years estimated tax

Taxpayers may have to pay estimated tax if they:

Expect to owe $1,000 or more in tax for the tax year after subtracting
income tax withheld and credits, and

Expect the tax withheld and credits on this year's tax return to be less
than the smaller of:
o 90% of the tax to be shown on this year's tax return or,
o 100% of the tax shown on last year's tax return

Recap:
Pay at least 90% of current year tax - OR Pay 100% of prior year tax - OR -

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Pay 110% of prior year tax if Adjusted Gross Income is over $150,000 MFJ,
$75,000 Single.
Withholding allowances for employees are reported on Form W-4.
Allowances for pension or annuity recipients are reported on Form W-4P.
They are figured by taking into account:

Expected income
Deductions
Credits
Adjustments to income

To finish the return:

Click Review Return on the tax Return Toolbar to check each return
for completeness and accuracy

Assemble the return correctly, attaching any Forms W-2 and any
Forms 1099 showing federal income tax withholding

Have the taxpayer(s) sign and date the return

Tax refund status information does not become available until it has been
six (6) weeks since the tax return was mailed or three (3) weeks if the tax
return was filed electronically. The fastest, easiest way to find out the status
of a tax refund is to either call the Automated Tax Refund Service at 1-800829-4477 (TDD: 1-800-829-4059) or use the "Wheres My Refund?" search
at www.irs.gov.
The Department of the Treasury's Financial Management Service, which
authorizes tax refunds, has been authorized by Congress to conduct the
Treasury Offset Program. Through this program, a tax refund or tax
overpayment that the taxpayer asked the IRS to apply to next tax year's
estimated tax, may be reduced by the Financial Management Service and
offset to pay any past-due child support or federal agency non tax debts he
may owe.
If the taxpayer filed a joint return and is not responsible for the debt, but is
are entitled to a portion of the refund because he reported income,
payments, or credits on the return, he may request his portion of the refund
by filing Form 8379 - Injured Spouse Claim and Allocation.
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Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify your 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

30
Lesson 30 - IRS Audits
In this lesson you'll learn about IRS Audits. The following topics are discussed
in this lesson:
How long does the taxpayer
need to keep certain tax
records?
The taxpayer received a
notice from the IRS...
The taxpayer received a
notice from the IRS thats
wrong
What to do if there's Form
W-2 or Form 1099
discrepancies
What if the taxpayer hasn't
filed tax returns with the IRS
for several years.
What are the penalties and
interest and can they be
avoided?
Acting on bad advice from
the IRS
Honest mistakes
Disputing assessed tax
penalties
Taxpayer Advocate Helpline

IRS Directory
How to avoid an IRS audit
The High-Risk Tax Audit
Areas
How to prepare for an IRS
audit
What is an Offer in
Compromise?
Innocent Spouse Relief
Injured Spouse Relief
What are a taxpayers appeal
rights?
How does the Statute of
Limitations affect tax
collections?
Statute of Limitations on
Taxpayers to Claim a Tax
Refund
What is the Taxpayer Bill of
Rights?
How does the Bankruptcy
Code affect tax obligations?

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ome tax related time frames, such as the tax return filing deadline or
the due date to pay estimated tax payments, are clear-cut. But when
it comes to tax records and how long to keep tax records, the answer
is far from simple.
Tax records such as receipts, canceled checks, and other documents that
prove to the IRS an item of income or a tax deduction appearing on a tax
return should be kept until the statute of limitations expires for that tax
return. Usually this is three (3) years from the date the tax return was due or
tax return was filed, or two (2) years from the date the tax was paid,
whichever is later. This is the time period in which the IRS can question a tax
return - typically three years after it is filed. There is no statute of limitations
when a tax return is false or fraudulent or when no tax return was filed.
Taxpayers should keep some tax records indefinitely, such as tax records
relating to property, since they may need those tax records to prove to the
IRS the amount of gain or loss if the property is sold.
Exceptions to the three (3) year rule are listed below:

Retain documents verifying the basis of property (such as real estate


or stock) until recognition of gain or loss from sale of the property
plus the three-year statute of limitations on the tax return filed
reporting the sale

Keep copies of the actual tax returns filed indefinitely

Retain tax records relating to a claim for a refund or credit based on


bad debts or losses on worthless securities for at least seven years

Because a net operating loss (NOL) can be carried back two (2) years
and carried forward twenty (20) years, it is important to keep tax
records until all net operating losses are used to offset taxable
income and the carry forward term expires, plus the three-year
statute of limitations on the tax returns using the carry forward

The statute of limitations is extended to six years if the IRS finds that
gross income on a tax return was understated by more than 25%

Further, in cases where a fraudulent tax return has been filed, or no


tax return has been filed at all, assessment by the IRS may be made
at any time.
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Employers must keep all employment tax records for at least four (4) years
after the tax is due or paid, whichever is later. People in business often have
expenses for travel, entertainment, and gifts. The documentation they
should keep for each of these expenses can be found in Publication 463 Travel, Entertainment, Gift and Car Expenses.
For more details, refer to Tax Topic 305 - Recordkeeping.

TAX QUOTE

"If the IRS took 100 taxpayers at random and sent each an incorrect notice
that they owed an extra $92.35 in taxes and interest, more than two-thirds
would probably just send in a check without investigating further."
G. Guttman

The taxpayer received a notice from the


IRS
The IRS may send the taxpayer a letter or notice to request payment of tax,
or notify the taxpayer of a change to his tax account, or request additional
tax information. You should review the notice and tax information on the
entire tax return and compare it with the information in the IRSs letter or
notice. If the IRSs notice tells you that a tax correction was made to the
taxpayers account and you and the taxpayer agree a reply is not usually
needed unless a tax payment is due to the IRS. If you and the taxpayer do
not agree with the tax correction the IRS made it is important that you and
the taxpayer respond to the IRSs letter or notice as requested by the IRS.
Complete instructions will be contained in the letter or notice. You and the
taxpayer should write to the IRS and tell them why you disagree with the
letter or notice so any necessary action can be taken. If the taxpayer is due a
tax refund as a result of an adjustment, it will be sent to the taxpayer unless
the taxpayer owes other amounts the law requires the IRS to collect (for
example, related tax accounts, unpaid child support, student loans, etc.). IRS
tax notices and refund checks are sent from different locations. Any tax
refund issued as a result of a change or correction should be received within
six (6) weeks from the date of the IRSs notice.

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TAX TIP

How often is the IRS wrong?


Internal Revenue Code 6213(b)(1) allows the IRS to adjust tax returns for
math or clerical errors including computational errors, tax credit claims
that exceed allowable limits, and incomplete or incorrect supporting
information including missing or incorrect Social Security numbers and
missing documentation.
According to the Treasury Inspector General for Tax Administration
(TIGTA) the IRS's adjustments are wrong 17% of the time and the IRS is
late in resolving disputes 40% of the time.

TAX PRACTICE TIP

Always Use Certified Mail


Whenever you correspond with the IRS be sure to send the
correspondence certified mail, return receipt requested (the green card).
If the IRS loses your correspondence youll be able to prove that you sent
it.
The taxpayer received a notice from the IRS thats wrong.
If you believe the IRS made a mistake with the tax figures, or didn't consider
some important tax information, you (if you are a Third Party Designee on
the tax return) or the taxpayer should call the IRS at the phone number
listed on the notice to discuss the matter. If possible have a copy of both
the tax return and the IRSs notice when you call.
What to do if there's Form W-2 or Form 1099 discrepancies.
The IRS compares the income figures reported on the tax return with figures
supplied to them on Forms W-2 filed by the taxpayers employer and Forms
1099 filed by brokers, financial institution, and others who paid taxable
income. A discrepancy may result in a bill for the unpaid tax, interest, and a
penalty of 20%. If the taxpayer receives such a notice claiming a discrepancy
on the tax return you should be sure to double check the accuracy of the
tax information before having the taxpayer pay the IRS. It's possible that
one of the Form 1099's filed with the IRS was inaccurate, that the right
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IRS

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income was reported by the taxpayer in an incorrect manner on the tax


return, or that the IRS made an error. You or the taxpayer should promptly
respond in writing regardless of who is responsible for the error. If the
correct amount of taxable income has been reported, provide copies of the
necessary documentation to support your tax case. If you failed to report
taxable income the taxpayer should pay the IRS the tax owed.
You may be able to get the IRS to drop the 20% penalty if you can show
that your mistake was an honest error. Have the taxpayer send the IRS a
check for payment of the tax and interest along with a letter explaining how
the mistake was made and a request to eliminate the 20% penalty.

What if the taxpayer hasn't filed tax returns


for several years?
You should file them at this time. Prior years 1040 ValuePak software is
available for purchase. Contact your Sales Representative for further details.

TAX TIP

Eliminating Penalties and Interest


If the taxpayer is due a refund from a prior year you may be able to
reduce or even eliminate any penalties and/or interest in subsequent
year(s) by applying the refund due to the subsequent year(s) instead of
receiving a refund check and then having taxes due for the subsequent
year(s). Enter the amount to be applied to the subsequent year(s) on line
75 of Form 1040 as shown below.

Figure 30-1: The Refund section of Form 1040 with line 77 "Amount of line 75 you
want applied to your 2015 estimated tax" highlighted.

903

LESSON

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IRS

AUDITS

TAX QUOTE

Steve Martin's Defense


In 1978 comedian Steve Martin offered the following defense on Saturday
Night Live for taxpayers who fail to file their tax returns:
You can be a millionaire and never pay taxes! You can be a millionaire, and
never pay taxes! You say, Steve, how can I be a millionaire, and never pay
taxes? First, get a million dollars.
Now, you say, Steve what do I say to the tax man when he comes to my
door and says, You have never paid taxes? Two simple words. Two simple
words in the English language: I forgot!
How many times do we let ourselves get into terrible situations because we
dont say I forgot? Lets say youre on trial for armed robbery. You say to
the judge, I forgot armed robbery was illegal. Lets suppose he says back
to you, You have committed a foul crime. You have stolen hundreds and
thousands of dollars from people at random, and you say, I forgot? Two
simple words: Excuuuuuse me!!

TAX PRACTICE TIP

Getting Paid for Prior-Year Tax Return Preparation


When preparing prior-year(s) returns, presumably for new clients, it is
always best to get paid up front, in advance. If that is not possible be sure
to get paid prior to delivering the completed tax returns. Why? Because a
taxpayer that wasn't very concerned about the IRS's tax collections
certainly won't be very concerned about your attempts to collect your
fees after his tax returns have been filed.

What are the penalties and interest and


can they be avoided?
In 1989 the IRS revamped its penalty system. Before the reform, more than
150 overlapping penalties existed. Consequently, a single infraction could
result in multiple penalties. Below are the current penalties for various
infractions.
904

LESSON

30

IRS

AUDITS

Infraction:
Late Filing
(If the tax return is more than 60 days
late, the minimum penalty is the
smaller of $100 or 100% of the tax
owed.)
Late filing due to fraud

Penalty
5% per month of the net tax due
(maximum 25%)

Late tax payments

Negligence or disregard of tax rules


and regulations
Fraud
Substantial understatements of income
tax (tax underpayments that exceed
the greater of 10% of the correct tax
liability or $5,000)
Over valuations of 200% or more but
less than 400% of the correct amount
Over valuations of 400% or more of the
correct amount
Estate tax and gift tax under valuations
of 50% or more of the correct valuation
and if the tax underpayment exceeds
$5000
Estate tax and gift tax under valuations
of 75% or more of the correct valuation
and if the tax underpayment exceeds
$5000

15% per month of the net tax due


(maximum 75%)
0.5% per month of the unpaid tax due
(maximum 25%) The 0.5% rate
increases to 1% after the IRS issues a
notice of intent to levy.
20% of tax underpayment
75% of tax underpayment
20% of tax underpayment

20% of tax underpayment


40% of tax underpayment
20% of tax underpayment

40% of tax underpayment

905

LESSON

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AUDITS

Below are the interest rates for the last 20 years on the various infractions.
From
To
Interest Rate
07/01/12
12/31/14
3%
01/01/12
06/30/12
4%
10/01/11
12/31/11
3%
04/01/11
09/30/11
4%
01/01/11
03/31/11
3%
01/01/10
12/31/10
4%
04/01/09
12/31/09
4%
01/01/09
03/31/09
5%
10/01/08
12/31/08
6%
07/01/08
09/30/08
5%
04/01/08
06/30/08
6%
01/01/08
03/31/08
7%
07/01/06
12/31/07
8%
10/01/05
06/30/06
7%
04/01/05
09/30/05
6%
10/01/04
03/31/05
5%
07/01/04
09/30/04
4%
04/01/04
06/30/04
5%
10/01/03
03/31/04
4%
01/01/03
09/30/03
5%
01/01/02
12/31/02
6%
07/01/01
12/31/01
7%
04/01/01
06/30/01
8%
04/01/00
03/31/00
9%
04/01/99
03/31/00
8%
01/01/99
03/31/99
7%
04/01/98
12/31/98
8%
07/01/96
03/31/98
9%
04/01/96
06/30/96
8%
07/01/95
03/31/96
9%
04/01/95
06/30/95
10%
10/01/94
03/31/95
9%
07/01/94
09/30/94
8%
10/01/92
06/30/94
7%
04/01/92
09/30/92
8%
Table: Penalties - Interest Rates

906

LESSON

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IRS

AUDITS

For current interest rates go to News Releases and Fact Sheets and find the
most recent IRS release entitled Quarterly Interest Rates.
Acting on bad advice from the IRS
There is no tax penalty imposed if you relied on erroneous written advice
from an IRS official. You must show that you provided accurate tax
information to the IRS when you asked the IRS for the tax advice.
Honest mistakes
You may be able to get the IRS to drop the penalty if you can show that the
mistake was an honest error. Have the taxpayer send the IRS a check for
payment of the tax and any interest along with a letter explaining how the
mistake was made and a request to eliminate the penalty.
Disputing assessed tax penalties
Penalties can be avoided if the relevant facts affecting the item's tax
treatment are adequately disclosed in the tax return. However, disclosure
cannot be used to avoid incorrect valuation penalties.
Another way to dispute a penalty is to show that substantial authority exists
for your tax treatment of an item. To establish substantial authority for a
position, look to tax documents published in the Internal Revenue Bulletin,
tax court cases, private letter rulings issued by the IRS, and some
congressional reports. Authority supporting your tax position should be
substantial in relation to the weight of authority supporting contrary tax
treatment.
If a penalty is assessed by the IRS, the taxpayer can appeal. While the appeal
is under consideration, payment of the penalty is suspended. The taxpayer
also has a right to representation and can ask to have a meeting with the
IRS.
The tax penalty for filing a frivolous tax return is not based on tax liability
and will be assessed immediately and added to any other penalties.
For more details on penalties and interest refer to Publication 594 Understanding the Collection Process.

907

LESSON

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IRS

AUDITS

SIDE BAR

IRS Lien vs. IRS Levy - What's the Difference?


A lien is a legal claim to the taxpayer's property as security for the
payment of a tax debt. It is not a seizure. However, the IRS can seize
the property later if the taxpayer fails to pay the debt. A Notice of
Federal Tax Lien publicly notifies all of the taxpayer's creditors.
The IRS issues a lien after all of the following occur:

The IRS assesses the taxpayer's outstanding tax liability.


The IRS sends the taxpayer a Notice and Demand for Payment
The taxpayer neglects to, or refuses to pay the entire debt
within 10 days after being notified.

The IRS will send the taxpayer a Release of the Notice of Federal Tax
Lien within 30 days after the taxpayer either:

Pays the tax due, or


Make arrangements for payment within the allotted 10 days

A levy is a legal seizure of the taxpayer's property to pay a tax debt.


The IRS can seize and sell any type of real or personal property the
taxpayer owns or has an interest in.
The IRS won't seize the taxpayer's property until the taxpayer has
received and ignored both of these notices:

Final Notice of Intent to Levy


Notice of Your Right to a Hearing

Further information is available at IRS.gov which you can visit by clicking


here: http://www.irs.gov/businesses/small/article/0,,id=108339,00.html

908

LESSON

30

IRS

AUDITS

Taxpayer Advocate Helpline


Since October 1998 there has been a national toll-free Helpline, the IRS
Problem Resolution Hotline, with assistance available 24 hours a day, seven
days a week. You may reach the Helpline by calling 1-877-777-4778.
The Helpline should not be used as a substitute for normal IRS procedures;
most problems can be resolved through regular IRS channels. Some of the
situations that could qualify for help under the IRS Problem Resolution
Program are:

If the taxpayer must contact the IRS again on the same tax issue at
least 30 days after the first contact. Give the IRS 60 days to process
the original tax return or amended tax return or claim before
contacting the IRS the first time;

If the taxpayer must contact the IRS again because he has not
received a response by the date the IRS promised, including dates
promised on IRS forms and letters; or

Any time the IRS established systems fail.

There are some situations that do not qualify for IRS Problem Resolution
assistance. These areas include tax cases where an established IRS
administrative or formal appeal procedure is available and should be used.

909

LESSON

30

IRS

AUDITS

IRS Directory
The table below is an IRS directory:
Telephone Directory
Individual Taxpayer Assistance
Business Taxpayer Assistance

1(800)829-1040
1(800)829-4933

Taxpayer Assistance (TTY/TDD)


e-file Help Desk
Order Forms
TeleTax
Automated Refund Status
Disaster Relief Information
Pay by Phone-Pay 1040

1(800)829-4059
1(800)255-0654
1(800)829-3676
1(800)829-4477
1(800)829-4477
1(866)562-5227
1(888)658-5465

Pay by Phone-Official Pmts. Corp. 1(877)754-4413


Tax Refund Hotline
1(800)829-1954
Taxpayer Advocate
1(877)777-4778
Practitioner Priority Service
1(866)860-4259
Internet Directory
IRS Web Site
http://www.irs.gov
Where's my refund?
Forms and Publications
News Releases
Tax Professionals
Social Security Administration
State Efile Coordinators

https://sa2.www4.irs.gov/irfof/lang/en/irfofgetstatus.jsp

http://www.irs.gov/Forms-&-Pubs
http://www.irs.gov/uac/Latest-News

http://www.irs.gov/Tax-Professionals
http://www.ssa.gov/

http://www.irs.gov/Tax-Professionals/GovernmentSites

Make checks payable to: United States Treasury


Table: IRS Directory

How to avoid an IRS audit


Many taxpayers fear an IRS audit. No one wants to be audited. However,
anyone who files a tax return runs a small chance of being audited. The
odds of being audited do increase if the taxpayer falls into certain
categories.
If your client is selected for an audit, they will be notified by mail with a
letter that will tell them what type of audit will be conducted. The three
types of audits are:

Correspondence Audit - a request for more documentation to be


mailed to the IRS.
910

LESSON

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AUDITS

Office Audit - a meeting is scheduled at the local IRS office during


which time the client should bring all relevant paperwork.

Field Audit - an IRS examiner will actually visit the clients place of
business or home. This is not very common for most individuals and
usually reserved for medium and large business returns. The most
important key to any audit is preparation and ensuring that all
paperwork is properly organized.

This topic will give you some tips on avoiding an IRS audit in the first place,
or, if the taxpayer is already involved in an audit, surviving it with a
minimum loss. The IRS says that most taxpayers are selected for an audit
based on a computer analysis to determine which tax returns are most likely
to be in error.
Percentage wise, the IRS audits very few tax returns.

SIDE BAR

IRS Audit Rates


For complete details of IRS examination coverage click here.

TAX TIP

Should taxpayers attend their own audit?


Probably not. While taxpayers can attend the audit themselves, they can
also authorize an accountant, lawyer, or enrolled agent to attend for
them. The upside to having a professional attend the audit is that it will
prevent the auditor from escalating the audit beyond the original areas
the IRS questioned. Loose lips sink ships. Oftentimes taxpayers will say
too much, furnishing too much information in an audit and this will
open the door for the IRS to expand the audit into areas that previously
weren't even in question. Professionals are much less likely to make
statements that lead to more IRS questioning. Professionals also have the
benefit of being able to say "I don't know" to the auditor's questions and then offer to check with their client and get back to the auditor. This
gives the professional and client time to "frame" their answers correctly.

911

LESSON

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IRS

AUDITS

If the IRS requests that that the taxpayer meet face-to-face with an agent,
the taxpayer should try to have that meeting at his accountants office, or
on other neutral ground instead of at his home or workplace. That will
give the taxpayer more control over what information is introduced to
the IRS. For instance, the IRS agent wont be able to to talk to coworkers.
Business Audits
When business owners are subject to field audits of their business, it is
highly recommended that the business owner contact a tax professional.
It may not be necessary for the tax professional conduct all aspects of
audit, however engaging a tax professional offers numerous advantages,
such as:

Gauging the scope of the audit and possibly influencing the


scope of the audit
Assisting in quantifying areas of potential tax exposure
Becomming proactive in disclosing errors to avoid the
imposition of IRS penalties
Professionally asserting reasons why the owners treatment of
income and deductions is proper under the law
Identifying areas of missed opportunities where deductions
were inadvertently omitted, or alternatively where deductions
are capable of being accelerated, so no additional tax is due
Determining whether the auditors questions and requests are
reasonable or unreasonable

The IRS may also impose discretionary penalties, the most frequent of
which is the 20 percent negligence penalty. Most penalties can be
waived if the mistakes are attributable to reasonable causes, and a
professional is in the best position to make that argument.
Most tax returns singled out by the IRS for audit contain either tax
deductions that appear to be too high in relationship to the person's
income, items that are erroneous, items that require proof or an
explanation, or items that are on the IRS' list of hot tax issues. It is important
that the IRS audits tax returns effectively, and the IRS puts a general fear in
all taxpayers of being audited to encourage voluntary compliance with the
income tax laws. The U.S. tax system depends on voluntary compliance.
912

LESSON

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IRS

AUDITS

With today's computers there are now more ways than ever that the IRS can
monitor tax compliance.
Although the IRS audit targets change with the times, below you'll find
some helpful hints as to which tax areas have commanded the IRS' audit
attention in recent years. There are a host of strategies you can use to
ensure the taxpayer isnt selected for an audit.

TAX PLANNING TIP

Whats the difference between tax avoidance and tax evasion?


Tax avoidance, through planning, is completely legal. Tax evasion, on the
other hand, is illegal. Tax evasion involves the use of concealment, deceit,
and subterfuge. The IRS determines if there was fraudulent intent on the
taxpayers part by examining the following areas as indicators of fraud:

failure to report substantial amounts of income


claiming false or overstated deductions
falling to keep accurate records

The High-Risk Tax Audit Areas


The odds are low that a tax return will be picked for an audit. The IRS does
not have sufficient personnel and resources to examine every tax return, so
the IRS selects those tax returns which, upon preliminary inspection, have
high audit potential - those that are most likely to result in a substantial tax
deficiency. In recent years, less than 2% of all individual income tax returns
have been audited. However, the chances for an IRS audit are higher
depending upon certain types of income, certain amounts of income, the
taxpayers profession, the types of transactions, and the types of deductions
claimed on the tax return.
High Wages
Generally, as income increases, so does the chance of an IRS audit.
The chances of being audited are also greater if the taxpayer:

claims large amounts of itemized deductions that exceed IRS targets

claims large cash contributions to charities in relation to income


913

LESSON

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IRS

AUDITS

claims tax shelter investment losses

deducts mortgage interest of more than $50,000

had an informant give information to the IRS

has complex investment or business expenses

has complex tax transactions without explanations

has deductions or business expenses that are large in relation to


income

has losses on Schedule C for more than two years in a row

is a shareholder in an S corporation and received a large payout,


little or none of which was compensation for FICA tax purposes

is a shareholder or partner in an audited partnership or corporation

owns or works in a "cash cow" business which receives cash and/or


tips in the ordinary course of business

rental real estate that generates losses

was previously audited and the audit resulted in a tax deficiency

The taxpayer must report all income, and should take all available tax
deductions, even if they increase his chances of an audit. Don't be scared off
by these factors. However, also realize that the taxpayers chances of an
audit do increase with certain tax items, and prepare the tax return
accurately and completely.
Large Amounts of Itemized Deductions
If the taxpayers itemized deductions exceed a target range as set by the
IRS, the chances of being audited increase. The IRS doesn't disclose the
criteria by which it determines when tax deductions are excessive. This does
not mean that you should not take itemized deductions on the taxpayers
return that he is entitled to, but you should realize that the chances for an
audit increase if deductions exceed the averages for the taxpayers income
level. All deductions on a tax return should be amply backed up with proof.
914

LESSON

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IRS

AUDITS

Written documentation should be provided to you by the taxpayer for all


deductions he is claiming. The basic rule for deductions is quite simple. If
there is no receipt, there should be no deduction claimed on the income tax
return. Charitable contributions can be somewhat of a red flag, so once
again documentation is important. Documentation should be provided for
all charitable contributions which are claimed as a deduction. Charitable
contributions which appear to be particularly large in comparison to the
taxpayer's salary can be an automatic red flag for an audit.
High DIF
When a tax return is filed, IRS computers compare it against the national
Discriminate Information Function (DIF) system average. The IRS calculates
the DIF score by using a closely-guarded formula. Tax returns with the
highest DIF scores are scrutinized by experienced IRS examining officers
who determine which tax returns provide the best chance for collecting
additional taxes, interest, and tax penalties.
Unreported Taxable Income
Unreported taxable income is a common red flag. The IRS discovers
unreported taxable income when its computers match the taxable income
reported on a return with information gathered from banks and others. For
example, if the taxpayer failed to report the interest earned on his bank
savings account, the IRS typically will catch it when it matches the bank's
1099 forms against the tax return.
One good way to make sure you don't miss unreported taxable income is to
review last year's tax return to make sure you have all Form 1099's, etc. from
mutual funds, banks and other sources. Ask the taxpayer about any missing
ones. If this is the second year that youve prepared the taxpayers return
using the 1040 ValuePak and youve imported last year's information youll
see the payers, etc. right on your computer screen in the tax form. Dont just
delete any that you do not have Form 1099s for. Ask the taxpayer why
there is not a Form 1099 from that payer this year.
The IRS electronically matches, letter for letter, figure for figure, what you
report for dividends, interest, securities transactions and other taxable
income with tax information supplied by banks, brokerage firms, and other
payers. To avoid problems, it's best to report dividend and interest income
exactly as it appears on the 1099 forms and make adjustments on the tax
return if the numbers are incorrect. If a brokerage house files a single Form
915

LESSON

30

IRS

AUDITS

1099 for all dividends, don't list separate amounts on the tax return. By the
same token, if you receive separate Forms 1099, don't report the taxable
earnings in one lump sum.
Self Employment
Because the IRS believes most under-reporting of taxable income and
abuse of tax deductions occurs among those who are self employed, these
individuals are audited by the IRS far more frequently than employees
collecting a salary. The same holds true for bartenders, taxicab drivers,
waiters and waitresses, hairdressers, and others who traditionally receive
payment in cash. Also, the IRS will sometimes conduct tests of certain
individuals to determine if a taxpayer's reported taxable income can support
his or her lifestyle.
The IRS publishes manuals to familiarize its auditors with about 100
different businesses, particularly ones that have a high number of self
employed individuals. These Audit Techniques Guides, which are available
to the general public, can help you pinpoint what auditors are looking for
and how best to protect the taxpayer.
To learn if an Audit Techniques Guide is available for the taxpayers business
go to http://www.irs.gov and type "Audit Techniques Guides" in the search
box at the upper right.
Home Office Tax Deductions
Home office tax deductions have been targeted by the IRS since the tax
rules for deducting home office expenses are complicated. A good example
is claiming office space in the home. By claiming such an item, you increase
the chances for an audit. However, if the taxpayer clearly is entitled to claim
the office space in the home under the tax rules, then you should do it if it's
substantial enough to make a difference. However, if the tax savings are
minimal, then it may be wise not to claim the tax deduction at all.
Unreported Alimony
Over the years, the IRS has found that not all taxpayers report alimony
receipts as taxable income. As a result, the IRS now matches tax deductions
for alimony payments by one former spouse with the taxable alimony
income reported by the other. Thats why the payer is required to report the
recipients SSN on line 31b of Form 1040.
916

LESSON

30

IRS

AUDITS

Figure 30-2: The Adjusted Gross Income section of Form 1040 with line 31a "Alimony
paid" and 31b "Recipient's SSN" highlighted.

TAX QUOTE

"Worried about an IRS audit? Avoid what's called a red flag. That's
something the IRS always looks for. For example, say you have some
money left in your bank account after paying taxes. That's a red flag."
Jay Leno

TAX TIP

Three Tips to Minimize the Chances of an IRS Audit


Below are three tips to minimize the chances of an IRS audit:

Make sure the numbers on the tax return match the numbers
provided on Form(s) W-2 and 1099. If one of the forms is incorrect
have the issuer issue a corrected form. That way the IRS will have
the correct number when it's computer matches what the issuer
reported and what is on the tax return.

Enter every W-2 and 1099 separately on the tax return. Lumping
them together will cause a mismatch in the IRSs computers.

Attach a brief written explanation for any unusual item on the tax
return.

917

LESSON

30

IRS

AUDITS

Automobile Logs
One of the biggest and most commonly audited items by the IRS for
individuals in their own business, and employees of companies who use
their car in business, is the tax deduction for business transportation. It is
important that the taxpayer keeps good records of all tax deductible
automobile expenses and a daily mileage log showing business miles
driven. Ideally, such log would show the date, beginning and ending
odometer readings, the location, the business purpose, and the client. Such
detail is hard for today's business person to keep but it's important to have
something in writing in case of an audit.
The table below shows a sample vehicle expense log:

Date

Destination
(City,
Town, or
Area)

6/4/2008

Local (St.
Louis)

6/5/2008

Indianapolis

6/6/2008

Louisville

6/7/2008
6/8/2008
6/9/2008

Return to
St. Louis
Local (St.
Louis)
Local (St.
Louis)

Business
Purpose

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

Sales calls
Sales calls
See Bob
Smith
(Pot.
Client)

Sales calls

$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

8,914

9,005

91

8,097

9,005

846

6/10/2008
Weekly
Total
Total Year-to-Date

6,236

918

$167.50
$2,313.00

LESSON

30

IRS

AUDITS

Self-defense Pays Off


The taxpayer should take every tax deduction hes entitled to, and shouldnt
be frightened by the potential of an audit. However, exercise common
sense and weigh the risk you are taking by claiming certain deductions with
the reward that the taxpayer receives in terms of tax savings. Don't be
frightened by the chance for an audit since it is slight, but also don't
randomly increase the taxpayers chances for an audit with items that have
minimal tax benefit. Use your own judgment and common sense. The best
way to avoid an audit is to file a complete and accurate tax return. One for
which you can provide written documentation if the IRS requests it!

How to Prepare for an IRS Audit


The traditional view of an IRS audit is a face-to-face contact with an IRS
auditor. About one-third of IRS "tax audits" are in the form of letters asking
for explanations of various items on a return or asking for supporting
documentation. If the taxpayer receives an audit letter from the IRS,
examine the records to determine the nature of the issue. The IRS may want
to audit the entire tax return or could audit just a portion of it, for example,
meals and entertainment, or automobile and travel expenses. If the issue
concerns documenting a deduction or a tax credit send the IRS copies of
the appropriate documents. Do not send the IRS originals, as they may get
lost in the mail or at the IRS.
A satisfactory explanation can end the matter quickly. In any event, it is
important to respond to the IRS in writing. If only a portion of the tax return
is to be audited the taxpayer should bring only those tax records pertaining
to that part of the return being audited. A full audit will request all tax return
information for that tax year.
It is possible to avoid an IRS audit completely. If the taxpayer has been
audited for the same item in either of the two previous years, and the prior
audit resulted in no change in the tax bill, he may challenge the IRS on the
selection of his tax return with respect to the same tax issue. The IRS
procedure in such situations is to suspend the audit, examine the file and
make a re-determination whether to continue the audit or close out the
matter. The taxpayer should notify the IRS and ask them not to conduct the
audit.
919

LESSON

30

IRS

AUDITS

IRS audits are often prompted by large business losses over a period of
several years, raising the question of how the owner made a living during
that time. Large deductions for travel, entertainment, and automobile
expenses that don't appear to relate to the company's sales volume also can
trigger an audit. Only about 2% of small businesses' tax returns are audited
by the IRS nationwide.
An IRS Office Audit is where the taxpayer is invited to the IRS office to meet
with an IRS auditor. An IRS Field Audit is where the IRS comes out to the
taxpayer's place of business.
To prepare for an audit a business owner needs to recall the events of that
year, who was employed by the company at that time, and any problems
encountered that year. The best way to prepare for any audit is to do a
good job of record keeping during the tax year prior to filing the tax return.
Then, if the tax return is selected for an audit, the information needed to
answer the IRS agent's questions will be at hand.
Taxpayers can have an accountant, lawyer or enrolled agent admitted to
practice before the IRS represent them at an audit. Once the taxpayer has
chosen a representative, the IRS may not interview the taxpayer alone,
unless consent is given. The taxpayer doesnt need to be present, provided
he didn't receive a summons from the IRS. An accountant, lawyer or
enrolled agent admitted to practice before the IRS may be in a better
position to field questions because he may have to confer with the taxpayer
on some issues, delaying the progress of the audit. This may be a strategic
advantage for the taxpayer.
The attorney-client privilege has been extended under certain
circumstances to all non-attorney tax practitioners authorized to practice
before the IRS, including Certified Public Accountants, Enrolled Agents, and
Enrolled Actuaries.
If the taxpayer decides to go to the audit alone remind him not to volunteer
information not requested by the IRS. He should be cordial and polite, but
remember, "Loose lips sink ships".
In most cases the IRS audit notice will indicate which area of the tax return is
being questioned. The taxpayer should bring copies of all the
documentation relevant to the tax item(s) in question, so that the evidence
920

LESSON

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IRS

AUDITS

needed to support his tax case is available. However, he should bring only
documentation for tax items specified in the IRS audit notice.
Taxpayers can tape record the meeting at their own expense, but they have
to notify the IRS ten (10) days in advance of the audit. Likewise, the IRS may
record a conference if the taxpayer is informed 10 days in advance. At the
audit if the taxpayer feels the IRS auditor is not being fair, he can ask to
speak to his or her supervisor. A taxpayer can also suspend an IRS audit in
progress at any time to consult with his professional advisor.
At the end of the audit, the IRS agent will cite any problems with the tax
return. After the IRS agent informally advises the taxpayer of any
adjustments needed to the return, a formal report is filed.
If the taxpayer owes money on one tax issue and the IRS owes money on
another tax issue, the two tax amounts can be netted. In a small number of
tax cases, the audit results in a tax refund for the taxpayer.
If the IRS agent's tax decision is unsatisfactory, the taxpayer can appeal to
the IRS agent's supervisor, the Appeals Division of the IRS, and if necessary,
the U.S. Tax Court.
Taxpayers have appeal rights in IRS tax collection cases, such as tax liens,
levies and property seizures. For example, one possible reason to appeal a
tax lien is that the IRS lacks critical information about the taxpayers tax case.
The taxpayer can seek hardship relief from the IRS if a property seizure
would create a significant hardship. The IRS can waive tax penalties if the
taxpayer shows you acted in good faith on the incorrect advice of an IRS
worker.
For additional information, refer to Publication 556 - Examination of Returns.

TAX QUOTE

"What's the difference between a tax auditor and a rottweiler? A


rottweiler eventually lets go."
Anonymous

921

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AUDITS

What is an Offer in Compromise?


An Offer in Compromise (OIC) may be an alternative for resolving a tax
delinquency. The IRS accepts an offer in compromise for tax due to settle
unpaid tax accounts for less than the amount of tax owed when doubt
exists as to whether the taxpayer owes the liability or when there is doubt
that the tax liability can be collected in full and the offer in compromise
reasonably reflects the IRS's tax collection potential.
Should the IRS determine that a taxpayer is unable to pay the liability in a
lump sum or through an installment agreement and it has exhausted the
search for other payment arrangements the last option would be to file an
Offer in Compromise.
Taxpayers should use the checklist in the Form 656 - Offer in Compromise
package to determine if they are eligible for an offer in compromise. The
objective of the OIC program is to accept a compromise when it is in the
best interests of both the taxpayer and the government and promotes
voluntary compliance with all future payment and filing requirements. See
IRS Policy Statement P-5-100 for the complete OIC policy statement.
All taxpayers who submit a Form 656 "Offer in Compromise" must pay a
$186 application fee except in two instances:

The OIC is submitted based solely on "doubt as to liability;" or

The taxpayer's total monthly income falls at or below 250% of the


Department of Health and Human Services (DHHS) poverty income
levels, as shown in the table below. Please Note: The table below is a
Prior Year Sample. Refer to Form 656, Section 4 - Low Income
Certification (Individuals and Sole Proprietors Only) for the current
year amounts.

PRIOR YEAR SAMPLE: 250% of the DHHS poverty income levels:


Size of Family
Unit

48 Contiguous
States and D.C.

Hawaii

Alaska

$2,256

$2,596

$2,819

$3,035

$3,492

$3,794

$3,815

$4,388

$4,769

$4,594

$5,283

$5,744

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LESSON

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IRS

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$5,373

$6,179

$6,719

$6,152

$7,075

$7,694

$6,931

$7,971

$8,669

$7,710

$8,867

$9,644

For each additional


person, add

$779

$896

$975

Example: If the taxpayer resides in the 48 Contiguous States, and his Family
Unit Size is 4, and his total household monthly income is $3,000, then he is
exempt from the fee and payment because his income is less than the
$4,594 guideline amount.

923

LESSON

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IRS

AUDITS

Offer in Compromise - Application Fee and Payments Required


One
Two
person people
is liable are
liable
for one
joint
liability

Two
people
have joint
liabilities
but want
to file
separate
offers

Number
of Forms
656
Required

Number
of fees to
be sent
with the
Form
656*
Lump
Sum
Cash
Offer
amount
to be
sent with
the Form
656
Amount
to be
sent with
the Short
Term or
Deferred
Periodic
Payment
Offer

1-$186

1-$186

2-$186

Two
people
have joint
liabilities
and one
has joint
and
separate
liabilities
2
One with
the joint
and 2nd
with the
joint and
separate
liabilities
2-$186

20% of
the
amount
offered

20% of
the
amount
offered

20% for
each
amount
offered

20% for
each
amount
offered

First
payment
amount
shown in
Section
IV of the
Form
656

First
payment
amount
shown in
Section
IV of the
Form
656

First
payment
for each
offer that
is shown
in Section
IV of the
Form 656

First
payment
for each
offer that
is shown
in Section
IV of the
Form 656

2
Each will
show the
joint
liabilities

Table: Offer in Compromise - T01

924

Corporation is
proposing
an offer

Partnership is
proposing
an offer

Individual
and Corporate or
Partnership
liabilities

1-$186

1-$186

2-$186

20% of the 20% of the


amount
amount
offered
offered

First
payment
amount
shown in
Section IV
of the Form
656

First
payment
amount
shown in
Section IV
of the
Form 656

20% for
each
amount
offered

First
payment
for each
offer that
is shown
in Section
IV of the
Form 656

LESSON

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IRS

AUDITS

The IRS expects a taxpayer requesting an OIC to file all delinquent tax
returns and pay any required current estimated tax payment.
The statute of limitations for assessment and collection of a tax debt is
suspended while an OIC is "pending," or being reviewed.
In order to avoid defaulting on an OIC once accepted by the IRS, taxpayers
must remain in compliance in the filing and payment of all required taxes
for a period of five years or until the offered amount is paid in full,
whichever is longer. Failure to comply with these conditions will result in the
default of the OIC and the reinstatement of the tax liability.
If there is a Notice of Federal Tax Lien on record prior to filing Form 656, the
lien is not released until the OIC terms are satisfied, or until the liability is
paid, whichever comes first. A Notice of Federal Tax Lien may be filed during
the course of an OIC investigation regardless of the type of offer being
considered.
For further information go to http://www.irs.gov and type "Offer in
Compromise" in the search box at the upper right.

Spouse Relief
When the taxpayer files a joint income tax return, the law makes both
spouses responsible for the entire tax liability. This is called joint and several
liability. Joint and several liability applies not only to the tax liability shown
on the return but also to any additional tax liability the IRS determines to be
due, even if the additional tax is due to income, deductions, or credits of
only one spouse, or a former spouse.
Both taxpayers remain jointly and severally liable for the taxes, and the IRS
still can collect from either, even if they later divorce and the divorce decree
states that only one former spouse will be solely responsible for the tax
liability.
In some cases, a spouse, or former spouse, will be relieved of the tax liability,
interest, and penalties on a joint tax return. Three types of relief are available
to married persons who filed joint returns are:

Innocent Spouse Relief


Separation of Liability Relief
925

LESSON

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Equitable Relief

Married persons who did not file joint returns, but who live in community
property states, may also qualify for relief under Community Property Laws.
Innocent Spouse Relief
By requesting Innocent Spouse Relief, the taxpayer can be relieved of
responsibility for paying tax, interest, and penalties if his spouse, or former
spouse, improperly reported items or omitted items on a tax return.
Generally, the tax, interest, and penalties that qualify for relief can only be
collected from the spouse, or former spouse. However, the taxpayer is
jointly and individually responsible for any tax, interest, and penalties that
do not qualify for relief. The IRS can collect these amounts from either the
taxpayer or the spouse, or former spouse.
The taxpayer must meet all of the following conditions to qualify for
Innocent Spouse Relief:

The taxpayer filed a joint return.

There is an understated tax on the return that is due to erroneous


items of the spouse, or former spouse.

The taxpayer can show that when he signed the joint return he did
not know, and had no reason to know, that the understated tax
existed (or the extent to which the understated tax existed).

Taking into account all the facts and circumstances, it would be


unfair to hold the taxpayer liable for the understated tax.

A request for Innocent Spouse Relief will not be granted if the IRS proves
that the taxpayer and spouse, or former spouse, transferred property to one
another as part of a fraudulent scheme. A fraudulent scheme includes a
scheme to defraud the IRS or another third party, such as a creditor, exspouse, or business partner.
Additional rules apply so be sure to read Publication 971 - Innocent Spouse
Relief.

926

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Separation of Liability Relief


Under this type of relief, the understated tax, plus interest and penalties, on
the taxpayer's joint return is allocated between the taxpayer and the spouse,
or former spouse. The understated tax allocated to the taxpayer is generally
the amount he is responsible for. This type of relief is available only for
unpaid liabilities resulting from the understated tax. Refunds are not
allowed.

927

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IRS

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To request Separation of Liability Relief, the taxpayer must have filed a joint
return and meet either of the following requirements at the time he files
Form 8857:

He is no longer married to, or are legally separated from, the spouse


with whom he filed the joint return for which he is requesting relief.
Under this rule, he is no longer married if he is widowed.

928

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IRS

AUDITS

He was not a member of the same household as the spouse with


whom he filed the joint return at any time during the 12-month
period ending on the date he files Form 8857.

Additional rules apply so be sure to read Publication 971 - Innocent Spouse


Relief which includes a section on Separation of Liability Relief.
Equitable Relief
If the taxpayer does not qualify for Innocent Spouse Relief, Separation of
Liability Relief, or relief from liability arising from Community Property Law,
he may still be relieved of responsibility for tax, interest, and penalties
through Equitable Relief. Unlike Innocent Spouse Relief or Separation of
Liability Relief, he can get Equitable Relief from an understated tax or an
underpaid tax. An underpaid tax is an amount of tax he properly reported
on his return but he has not paid.
Conditions for Getting Equitable Relief
The taxpayer may qualify for Equitable Relief if he meets all of the following
conditions:

He is not eligible for Innocent Spouse Relief, Separation of Liability


Relief, or relief from liability arising from Community Property Law.

He has an understated tax or an underpaid tax.

He did not pay the tax.

He establishes that, taking into account all the facts and


circumstances, it would be unfair to hold him liable for the
understated or underpaid tax.

He and his spouse, or former spouse, did not transfer assets to one
another as a part of a fraudulent scheme. A fraudulent scheme
includes a scheme to defraud the IRS or another third party, such as
a creditor, ex-spouse, or business partner.

The spouse, or former spouse, did not transfer property to the


taxpayer for the main purpose of avoiding tax or the payment of tax.

He did not file or fail to file his return with the intent commit fraud.

929

LESSON

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IRS

AUDITS

The income tax liability from which he seeks relief must be


attributable to an item of the spouse, or former spouse, with whom
he filed the joint return, unless one of the following exceptions
applies:
o The item is attributable or partially attributable to the
taxpayer solely due to the operation of community property
law. If he meets this exception, that item will be considered
attributable to the spouse, or former spouse, for the purposes
of Equitable Relief.
o If the item is titled in the taxpayer's name, the item is
presumed to be attributable to him. However, he can rebut
this presumption based on the facts and circumstances.
o He did not know, and had no reason to know that funds
intended for the payment of tax were misappropriated by the
spouse, or former spouse, for his or her own benefit. If the
taxpayer meets this exception, the IRS will consider granting
Equitable Relief although the underpaid tax may be
attributable in part or in full to the taxpayer himself, and only
to the extent the funds intended for payment were taken by
the spouse, or former spouse.
o He establishes that he was the victim of spousal abuse or
domestic violence before signing the return, and that, as a
result of the prior abuse, he did not challenge the treatment
of any items on the return for fear of the spouses retaliation.
If he meets this exception, relief will be considered although
the understated tax or underpaid tax may be attributable in
part or in full to the taxpayer himself.

Additional rules apply so be sure to read Publication 971 - Innocent Spouse


Relief which includes a section on Equitable Relief.

930

LESSON

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IRS

AUDITS

931

LESSON

30

IRS

AUDITS

Questions and Answers About Applying for Relief


How does the taxpayer request relief?
File Form 8857 to ask the IRS for the types of relief discussed above. If the
taxpayer is requesting relief for more than three tax years, he must file an
additional Form 8857. The IRS will review Form 8857 and let the taxpayer
know if he qualifies.
When should Form 8857 be filed?
The taxpayer should file Form 8857 as soon as he becomes aware of a tax
liability for which he believes only his spouse or former spouse should be
held responsible, such as:

The IRS is examining his tax return and proposing to increase your
tax liability.

The IRS sends the taxpayer a notice.

Form 8857 must be filed no later than two years after the date on which the
IRS first attempted to collect the tax from the taxpayer.
Collection activities that may start the 2-year period are:

The IRS offsets the taxpayer's income tax refund against an amount
he owed on a joint return for another year and the IRS informed the
taxpayer about his right to file Form 8857.

The filing of a claim by the IRS in a court proceeding in which the


taxpayer is or was a party or the filing of a claim in a proceeding that
involves the taxpayer's property. This includes the filing of a proof of
claim in a bankruptcy proceeding.

The filing of a suit by the United States against the taxpayer to


collect the joint liability.

The issuance of a section 6330 notice, which notifies the taxpayer of


the IRS intent to levy and his right to a Collection Due Process (CDP)
hearing. The collection related notices include, but are not limited to,
Letter 11 and Letter 1058.
932

LESSON

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IRS

AUDITS

Where should Form 8857 be filed?


Use the address shown in the instructions for Form 8857.
What are "erroneous items"?
Erroneous items are any deductions, credits, or bases that are incorrectly
stated on the return, and any income that is not properly reported on the
return.
What is an "understated tax"?
The taxpayer has an understated tax if the IRS determined that his total tax
should be more than the amount actually shown on his tax return.
Will the taxpayer qualify for Innocent Spouse Relief in every situation
where there is an understated tax?
No. There are many situations in which the taxpayer may owe tax that is
related to his spouse, but not be eligible for Innocent Spouse Relief.
Why would a request for Separation of Liability Relief be denied?
Even if the taxpayer meets the requirements listed earlier, a request for
Separation of Liability Relief will not be granted in the following situations:

The IRS proves that the taxpayer and spouse transferred assets to
one another as part of a fraudulent scheme.

The IRS proves that at the time the taxpayer signed the joint return,
he had actual knowledge of any erroneous items giving rise to the
deficiency's that are allocable to the spouse.

The spouse, or former spouse, transferred property to the taxpayer


to avoid tax, or the payment of tax.

How do state community property laws affect the taxpayers ability to


qualify for relief?
The community property states are Arizona, California, Idaho, Louisiana,
Nevada, New Mexico, Texas, Washington, and Wisconsin. Generally,
community property laws require the taxpayers to allocate community
income and expenses equally between both spouses. However, community
property laws are not taken into account in determining whether an item
belongs to the taxpayer or to the spouse, or former spouse, for the
purposes of requesting any relief from liability.
933

LESSON

30

IRS

AUDITS

The taxpayer is currently undergoing an examination of his tax return.


How does he request Innocent Spouse Relief?
File Form 8857 at the address shown in the instructions for Form 8857. Do
not file it with the IRS employee assigned to examine the tax return.
What if the IRS has given the taxpayer notice that it will levy his account
for the tax liability and he decides to request relief?
Generally, the IRS has 10 years to collect an amount the taxpayer owes. This
is the "collection" statute of limitations. By law, the IRS is not allowed to
collect after the 10-year period ends. If the taxpayer requests relief for any
tax year, the IRS cannot collect for that year while the request is pending.
But interest and penalties continue to accrue. The request is generally
considered pending from the date the IRS receives Form 8857 until the date
the request is resolved. This includes the time the Tax Court is considering
the request. After the case is resolved, the IRS can begin or resume
collecting the tax. The 10-year period will be increased by the amount of
time the request for relief was pending, plus 60 days.
For additional information refer to Publication 971 - Innocent Spouse Relief.

Injured Spouse Relief


The terms Innocent Spouse Relief and Injured Spouse Relief are sometimes
used interchangeably - but they are not the same thing. The taxpayer is an
injured spouse if his or her share of the overpayment shown on a joint tax
return was, or is expected to be, applied (offset) against his or her spouses
legally enforceable past-due federal taxes, state income taxes, child or
spousal support payments, or a federal non-tax debt, such as a student
loan. Injured spouses may be entitled to receive a refund of their share of
the overpayment.The taxpayer is considered an injured spouse if she is not
legally obligated to pay the past-due amount, and she meets any of the
following conditions:

she made and reported tax payments (such as federal income tax
withholding or estimated tax payments).

she had earned income (such as wages, salaries, or self-employment


income) and claimed the earned income credit or the additional
child tax credit.

934

LESSON

30

IRS

AUDITS

she claimed a refundable tax credit, such as the health coverage tax
credit or the refundable credit for prior year minimum tax.

Injured spouses may be entitled to receive a refund of their share of the


overpayment by simply filing Form 8379 - Injured Spouse Claim and
Allocation. Form 8379 may be filed along with the original tax return or it
may be filed by itself after the taxpayer is notified of an offset. Form 8379
can be filed electronically. If the taxpayers file a paper return they can
include Form 8379 with the return and write "INJURED SPOUSE" at the top
left corner of the Form 1040, 1040A, or 1040EZ. The IRS will process the
allocation request before an offset occurs. If Form 8379 is being filed by
itself, it must show both spouses' social security numbers in the same order
as they appeared on the original income tax return. The "injured" spouse
must sign Form 8379. Do not attach the previously filed Form 1040 to Form
8379. Send Form 8379 to the Service Center where the taxpayer filed the
original tax return.
If the taxpayer's residence was in a community property state at any time
during the year special rules apply and she may file Form 8379 even if only
the first item above applies. For more information about the factors used to
determine whether the taxpayer is subject to community property laws see
Publication 555 - Community Property.

What are a taxpayers appeal rights?


The IRS has an appeals system for people who do not agree with the results
of an IRS examination or with other adjustments made to their tax liability.
If the taxpayer disagrees with the IRS about the amount of tax liability or
about proposed collection actions, he has the right to ask the IRS Appeals
Office to review his case.
Publication 1 - Your Rights as a Taxpayer explains some of the most
important taxpayer rights. During their contact with taxpayers, IRS
employees are required to explain and protect these taxpayer rights,
including the right to appeal.
The Appeals Office, which is independent of the IRS office that proposed
the disputed action, can work with taxpayers by correspondence, telephone,
or informal conferences.
935

LESSON

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IRS

AUDITS

Through Appeals procedures, taxpayers can settle most differences without


expensive and time-consuming court trials. However, if the taxpayer and the
Appeals Officer or Settlement Officer cannot reach agreement or if the
taxpayer prefers not to appeal within the IRS, in most cases, the taxpayer
may take his disagreement to federal court.
For more information about Appeals and its processes go to the IRS Web
site at IRS.gov and select the link to "Appeal a Tax Dispute", which is found
at the bottom of the page. The website assists the taxpayer in determining if
he are ready for Appeals, how to request an appeal, and what he can expect
from Appeals. The site also provides easy to use online self-help tools
designed to help the taxpayer focus on the area of dispute and to
determine if hell benefit from filing an appeal.
For additional information about Appeals, the IRS website contains
informative online video streams entitled "The Appeals Process
(Examination)" and "The Appeals Process (Collection)."
If the taxpayer is unable to resolve a problem with the IRS through regular
channels, he can seek relief through the IRS Taxpayer Advocate Office,
which acts like an ombudsman for taxpayers.
After receiving the IRS appeals decision the taxpayer will receive a ninety
(90) day letter from the IRS, which gives him ninety days to file a petition
with the U.S. Tax Court if he still disagrees with the IRS findings. There is a
simplified small tax case procedure if the case is $50,000 or less for any tax
period or tax year. A tax case settled under the simplified small tax case
procedure cannot be appealed.
If the taxpayer is not satisfied with the Tax Court result, or if he decides not
to go to Tax Court and wishes to go directly to U.S. District Court, then he
will almost certainly need to utilize an attorney, and the cost will go up
dramatically. Accordingly, it is usually wise to settle either at the IRS audit
level, the IRS appeals level, or the Tax Court level. However, the taxpayer
shouldnt be afraid to exercise his rights of appeal if he feels he is not being
treated fairly by the IRS or did not receive a just tax decision.
If the taxpayer wins a tax case against the IRS, he may be able to recover
legal fees and related expenses from the IRS. Taxpayers who contend they
are the target of an unauthorized IRS tax collection action can sue the IRS if
936

LESSON

30

IRS

AUDITS

they believe the agent recklessly or intentionally disregarded the tax law or
IRS regulations.
Information is also available in Publication 5 - Your Appeal Rights and How
to Prepare a Protest If You Don't Agree; Publication 556 - Examination of
Returns, Appeal Rights, and Claims for Refund; and Publication 1660 Collection Appeal Rights (for Liens, Levies, and Seizures).

SIDE BAR

Seven Important Facts about a Taxpayer's Appeal Rights


The IRS provides an appeals system for those who do not agree with the
results of a tax return examination or with other adjustments to their tax
liability. Here are the top seven things to know when it comes to a
taxpayer's appeal rights.
1. When the IRS makes an adjustment to a tax return, the taxpayer will
receive a report or letter explaining the proposed adjustments. This letter
will also explain how to request a conference with an Appeals office
should the taxpayer not agree with the IRS findings.
2. In addition to tax return examinations, many other tax obligations can
be appealed. Taxpayers may also appeal penalties, interest, trust fund
recovery penalties, offers in compromise, liens and levies.
3. Taxpayers are urged to be prepared with appropriate records and
documentation to support their position if they request a conference with
an IRS Appeals employee.
4. Appeals conferences are informal meetings. Taxpayers may represent
themselves or have someone else represent them. Those allowed to
represent taxpayers include Attorneys, Certified Public Accountants, or
Enrolled Agents (individuals enrolled to practice before the IRS).
5. The IRS Appeals Office is separate from - and independent of - the IRS
office taking the action the taxpayer disagrees with. The Appeals Office is
the only level of administrative appeal within the IRS.
6. If the taxpayer does not reach agreement with IRS Appeals or if the
taxpayer does not wish to appeal within the IRS, he may appeal certain
937

LESSON

30

IRS

AUDITS

actions through the courts.


7. For further information on the appeals process, refer to Publication 5 Your Appeal Rights and How To Prepare a Protest If You Don't Agree.

How does the Statute of Limitations affect


tax collections?
The table below shows the Statute of Limitations:
THEN the
period is...

If you...
1 Owe additional tax and (2), (3), and (4) do not
apply to you
2 Do not report income that you should and it is
more than 25% of the gross income shown on
your tax return
3 File a fraudulent tax return
4 Do not file a tax return
5 File a claim for credit or refund after you filed your
tax return
6 File a claim for a loss from worthless securities

3 years
6 years
No limit
No limit
Later of 3 years
or 2 years after
the tax was paid.
7 years

TAX TIP

So the IRS has either 3 or 6 years to audit a tax return, right?


Not exactly. In some situations the statute of limitations never runs.
Because an unsigned tax return is not considered a valid tax return, the
statute of limitations never runs. Ditto if a taxpayer alters the penalties of
perjury language directly above the signature box which says "Under
penalties of perjury, I declare that I have examined this return and
accompanying schedules and statements, and to the best of my knowledge
and belief, they are true, correct, and complete. Declaration of preparer
(other than taxpayer) is based on all information of which preparer has any
knowledge".
938

LESSON

30

IRS

AUDITS

When a U.S. shareholder owns part of a foreign corporation, it can trigger


reporting, including filing a Form 5471 - Information Return of U.S.
Persons With Respect To Certain Foreign Corporations. Failing to file Form
5471 means penalties, generally $10,000 per form - and a separate
$10,000 penalty can apply to each Form 5471 filed late, incomplete or
inaccurate. This penalty can apply even if no tax is due on the return.
That is harsh, but the rule about the statute of limitations is even harsher.
If the taxpayer fails to file a required Form 5471, his entire tax return
remains open for audit indefinitely. In fact, the IRS can make any
adjustments to the entire tax return, with no expiration until the required
Form 5471 is filed.
Statute of Limitations for Collecting Tax Already Assessed
The statute of limitations limits the time for IRS tax collection activities.
Generally, there is a 10-year statute of limitations for the IRS collecting tax
already assessed.
For assessments of tax or levy made after November 5, 1990, the IRS cannot
either collect or levy any tax 10 years after the date of assessment of tax or
levy. See Section 6502(a)(1) of the Tax Code and section 301.6502-1 of the
Tax Regulations. Court proceedings must also be started by the IRS within
the 10 year statute of limitations. Section 301.6502-1(a)(1) of the Tax
Regulations.
For assessments of tax or levy made on or before November 5, 1990, the
IRS cannot either collect or levy any tax 6 years after the date of assessment
of tax or levy. See section 6501(e) of the Tax Code. However, if the 6 year
period ends after November 5, 1990, the statute of limitations is 10 years. In
order to come under the 6 year statute of limitations, the 6 year period
must have ended prior to November 5, 1990.
The 10 year statute of limitations can be extended by agreement between
the taxpayer and the IRS provided the agreement is made prior to the
expiration of the 10 year period. See section 6501(c)(4) of the Tax Code and
section 301.6501(c)-1(d) of the Tax Regulations.
Make sure you understand the starting date for the running of the statute
of limitations, any exceptions to the tolling of the statute of limitations, the
939

LESSON

30

IRS

AUDITS

last day that the IRS can audit a tax return, and the last day that the IRS can
collect overdue tax on a tax return.

TAX TIP

Should the taxpayer grant the IRS more audit time?


Under the Statute of Limitations the IRS must ordinarily audit a tax return
within three years. However, often the IRS cannot get to the taxpayer's
return within the three years. What should a taxpayer do if two years and
nine months after he filed his tax return the IRS sends him a letter asking
to extend the Statute of Limitations?
Taxpayers often simply say no. That's the "knee-jerk" reaction. If they say
no the IRS will either commence the audit immediately or the taxpayer
will receive a notice assessing additional taxes. The notices are based on
the information the IRS has on hand. And the IRS is likely to resolve any
doubts in favor of higher taxes because that is what is in their best
interests. The theory is to assess the taxes now and later should it turn
out that the taxpayer can prove the IRS is wrong they can then withdraw
the assessment.
When the IRS asks for an extension of the Statute of Limitations it is
because they suspect something is wrong with the tax return. A better
option is for the taxpayer to agree to the requested extension for a
limited time, perhaps six months or a year, and limit the scope of the
audit to the particular area(s) of the tax return the IRS has a problem with.
Be as specific as possible.
For instance, say the IRS is questioning a charitable contribution
deduction. Offer to extend the Statute of Limitations for charitable
contributions only, for six months. That way, when the IRS gets around to
conducting the actual audit, provided the three years has expired, they
will not be able to question other areas of the tax return such as other
itemized deductions or Schedule C.
Be sure to send any correspondence to the IRS by certified mail, return
receipt requested. Also be sure to get any agreement with the IRS in
writing and signed.

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Statute of Limitations on Taxpayers to


Claim a Tax Refund
A taxpayer may file a claim for a tax refund of an overpayment of any tax
within 3 years from the time the tax return was filed or 2 years from the time
the tax was paid, whichever period is the last. If no tax return was filed with
the IRS, the claim may be made within 2 years from the date that the tax
was paid to the IRS. See section 6511(a) of the Tax Code.
Under section 6511(d)(1) of the Tax Code a taxpayer may file a claim within
7 years if the tax refund pertains to a bad debt under section 166 or 832(c)
or in connection with a loss from a worthless security under section 165(g).

What is the Taxpayer Bill of Rights?


No longer does the IRS have all the advantages in dealing with taxpayers.
The Taxpayer Bill of Rights, instituted in 1989, specifies the taxpayers rights
in dealing with the IRS. The Taxpayer Bill of Rights II, enacted in 1996, and
the Taxpayer Bill of Rights III, enacted in 1998, further expanded those
taxpayer rights. One aim of the Taxpayer Bill of Rights is to have the IRS
inform you of the effect of the tax action the IRS is taking and how you can
proceed and protect your rights.
IRS personnel must deal with taxpayers in a professional manner and must:

Provide the tax information and help that taxpayers need to comply
with the tax laws;

Ensure personal and financial confidentiality;

Treat taxpayers in a courteous manner;

Provide clear explanations in any tax notice or mail inquiries, and


provide additional information if requested. If the IRS sends the
taxpayer a notice of a tax deficiency or tax collection action, the IRS
must include a non-technical statement of taxpayer rights during an
audit and an explanation of IRS collection and tax appeals
procedures within the IRS and the courts;

Collect tax fairly (e. g., the IRS generally can't sell a taxpayers home
to collect tax). If the IRS threatens to seize a taxpayers property or
take some other tax collection measure that could cause a taxpayer
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significant hardship, then the taxpayer may apply for a Taxpayer


Assistance Order by filing Form 911 with an IRS Problem Resolution
Office in the IRS district where the taxpayer lives. While this is being
reviewed by the IRS, tax enforcement actions will be suspended;

The IRS must agree to a three (3) year installment payment schedule
for tax if a taxpayer who owes $10,000 or less, exclusive of interest
and tax penalties, requests an installment arrangement and certain
conditions are met;

The tax law generally requires an IRS supervisor's approval before a


notice of tax lien or tax levy may be issued to a taxpayer. Before the
IRS may enforce a tax lien by levy, the IRS must provide a notice to
the taxpayer within five (5) business days after the filing of a tax lien.
The notice must indicate the amount of tax owed and explain the
IRS's proposed action and the taxpayer's rights to a hearing within
thirty (30) days before an IRS appeals officer. The notice must also
explain the IRSs tax levy procedures, the availability of administrative
appeals and the IRS appeal procedures, the alternatives to the
proposed tax levy such as an installment agreement, and the tax
rules for obtaining a release of the tax lien.

Burden of Proof. Under certain circumstances the taxpayer may shift


the burden of proof in court to the IRS with respect to factual issues
relevant to determining tax liability.

Certain properties are exempt from IRS seizure. The weekly amount
of wages exempt from IRS seizure is equal to the taxpayers standard
deduction plus allowable personal exemptions divided by 52. The
amount of personal property exempt is $6,250 for fuel provisions,
furniture, and household effects. The exempt amount for tools,
books, machinery, or equipment used in a business or profession is
$3,125. Non-exempt business property may not be seized unless an
IRS District Director or IRS Assistant District Director determines that
the taxpayer's other assets are insufficient to satisfy the tax liability or
that the collection of tax is jeopardized. A personal residence is
exempt from seizure if the unpaid tax liability is $5,000 or less. If the
unpaid tax liability exceeds $5,000 the IRS must obtain written
approval from a U.S. District Court judge to seize the taxpayer's
personal residence. Before the IRS may seize property, it must give
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thirty (30) days notice so the taxpayer can contest the levy if it is
erroneous. (The IRS can freeze the assets during the waiting period).
The notice must clearly describe the levy procedures, the taxpayers
options for avoiding the levy, such as beginning installment
payments for overdue tax, and steps for redeeming property if it is
seized by the IRS. A bank will hold a taxpayers account for twentyone (21) days after receiving notice of an IRS levy before turning over
the money to the IRS. This freeze allows the taxpayer time to contact
the IRS. If the IRS attempts to levy property after the taxpayer has
paid the underlying tax liability or after the statute of limitations has
expired, or if the property is exempt under bankruptcy rules, then the
taxpayer should appeal to the IRS to release the levy. Send a written
statement to the IRS District Director of the IRS district in which the
tax lien was filed explaining your grounds for appeal;

Issue a tax refund of overpaid tax;

Provide 30 days notice prior to altering, modifying or terminating an


installment payment agreement;

Reasonable legal costs incurred during certain administrative


proceedings may be recovered if the taxpayer prevails in court
against the IRS.

Also see Publication 1 - Your Rights as a Taxpayer.

How does the Bankruptcy Code affect tax


obligations?
It is a common misconception that tax obligations can never be discharged
in a bankruptcy. If there is tax fraud involved, a tax return was not filed, or
the tax was not listed as a liability in the bankruptcy filing, then the tax
cannot be discharged in bankruptcy. However, if there was no tax fraud
involved and the tax return was filed then there is a point in time when tax
can be discharged in bankruptcy and when the IRS can no longer
commence tax collection proceedings.
As a result of Bankruptcy Code Sections 523 and 527 the following tax is
generally dischargeable:

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Tax penalties for non-filing, tax penalties for late payment, tax
penalties for late deposit, and tax penalties for late estimated
payments; and

Income tax, excise tax, and gift tax which is over three years old, has
been filed at least two years prior to the bankruptcy petition, and/or
has been assessed as an IRS tax audit deficiency for at least 240 days.

For further information see Publication 908 - Bankruptcy Tax Guide.

TAX PLANNING TIP

Tax Planning Conclusion


The tax planning tips in this course will apply differently to each taxpayer.
Changes to the taxpayers adjusted gross income from one year to the
next can have a negative impact in certain circumstances. For instance,
postponing an IRA distribution will reduce the taxpayers current taxable
income which is good, but it will increase the taxpayers next year's
income, which may be bad depending on the taxpayer's circumstances.
Higher income next year can increase the taxable amount of Social
Security benefits; reduce or eliminate the ability to make deductible IRA
contributions; "phase out" itemized deductions and personal exemptions;
and reduce or eliminate deductions for medical expenses, casualty losses,
charitable contributions and rental real estate.
Higher income could also reduce or eliminate the tax credits for
dependent children and college education expenses, Roth IRA
contributions, conversions of regular IRAs into Roth IRAs and college
education loan interest deductions. Youll need to consider the effects of
potential year-end tax breaks for both this year and next, and implement
only those ideas that will put the taxpayer ahead over the two-year
period.
Thats where tax planning comes in!

Lesson Summary
Lets take a few minutes and review what you learned in this lesson.
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Tax records such as receipts, canceled checks, and other documents that
prove to the IRS an item of income or a tax deduction appearing on a tax
return should be kept until the statute of limitations expires for that tax
return. Usually this is three (3) years from the date the tax return was due or
tax return was filed, or two (2) years from the date the tax was paid,
whichever is later.
Exceptions to the three (3) year rule are listed below:

Retain documents verifying the basis of property (such as real estate


or stock) until recognition of gain or loss from sale of the property
plus the three-year statute of limitations on the tax return filed
reporting the sale

Keep copies of the actual tax returns filed indefinitely

Retain tax records relating to a claim for a refund or credit based on


bad debts or losses on worthless securities for at least seven years

Because a net operating loss (NOL) can be carried back two (2) years
and carried forward twenty (20) years, it is important to keep tax
records until all net operating losses are used to offset taxable
income and the carry forward term expires, plus the three-year
statute of limitations on the tax returns using the carry forward

The statute of limitations is extended to six years if the IRS finds that
gross income on a tax return was understated by more than 25%

Further, in cases where a fraudulent tax return has been filed, or no


tax return has been filed at all, assessment by the IRS may be made
at any time.

Employers must keep all employment tax records for at least four (4) years
after the tax is due or paid, whichever is later.
You should review IRS notices and tax information on the entire tax return
and compare it with the information in the IRSs letter or notice.
If you believe the IRS made a mistake with the tax figures, or didn't consider
some important tax information, you (if you are a Third Party Designee on

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the tax return) or the taxpayer should call the IRS at the phone number
listed on the notice to discuss the matter.
If there is a W-2 or 1099 discrepancy you or the taxpayer should promptly
respond in writing regardless of who is responsible for the error.
It is possible to avoid an IRS audit completely. If the taxpayer has been
audited for the same item in either of the two previous years, and the prior
audit resulted in no change in the tax bill, he may challenge the IRS on the
selection of his tax return with respect to the same tax issue. The IRS
procedure in such situations is to suspend the audit, examine the file and
make a re-determination whether to continue the audit or close out the
matter. The taxpayer should notify the IRS and ask them not to conduct the
audit.
An IRS office audit is where the taxpayer is invited to the IRS office to meet
with an IRS auditor. An IRS field audit is where the IRS comes out to the
taxpayer's place of business.
Taxpayers can have an accountant, lawyer or enrolled agent admitted to
practice before the IRS represent them at an audit. Once the taxpayer has
chosen a representative, the IRS may not interview the taxpayer alone,
unless consent is given. The taxpayer doesnt need to be present, provided
he didn't receive a summons from the IRS.
An accountant, lawyer or enrolled agent admitted to practice before the IRS
may be in a better position to field questions because he may have to
confer with the taxpayer on some issues, delaying the progress of the audit.
This may be a strategic advantage for the taxpayer.
If the taxpayer decides to go to the audit alone remind him not to volunteer
information not requested by the IRS. He should be cordial and polite, but
remember, "Loose lips sink ships".
At the audit if the taxpayer feels the IRS auditor is not being fair, he can ask
to speak to his or her supervisor. A taxpayer can also suspend an IRS audit
in progress at any time to consult with his professional advisor.
An Offer in Compromise (OIC) may be an alternative for resolving a tax
delinquency. The IRS accepts an offer in compromise for tax due to settle
unpaid tax accounts for less than the amount of tax owed when doubt
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exists as to whether the taxpayer owes the liability or when there is doubt
that the tax liability can be collected in full and the offer in compromise
reasonably reflects the IRS's tax collection potential.
The IRS has an appeals system for people who do not agree with the results
of an IRS examination or with other adjustments made to their tax liability.
The statute of limitations limits the time for IRS tax collection activities.
Generally, there is a 10-year statute of limitations for the IRS collecting tax.
A taxpayer may file a claim for a tax refund of an overpayment of any tax
within 3 years from the time the tax return was filed or 2 years from the time
the tax was paid, whichever period is the last.
If there was no tax fraud involved and the tax return was filed then there is a
point in time when tax can be discharged in bankruptcy and when the IRS
can no longer commence tax collection proceedings.

TAX TIP

Conclusion
We hope that you enjoyed our income tax course and that you
learned a lot about taxes!

Important Reminders

Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify your 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.
Take the Final Exam - You must pass the Final Exam with a
grade of 70% or more in order to receive your Certificate of
Completion.

947

Glossary
10-Year Averaging - a special computation method to determine the tax on a qualified lump-sum
distribution for taxpayers born before 1936.
Accelerated Cost Recovery System (ACRS) - the system of depreciation mainly used for property
placed in service after 1980 and before 1987. The Modified Accelerated Cost Recovery System
(MACRS) replaced ACRS for assets placed into service after 1986.
Accelerated Depreciation method(s) of depreciation that yield larger tax deductions in the earlier
years of the life of an asset and smaller deductions at the end.
Accountable Plan - a plan for reimbursing employees for expenses such as meals, travel, and
transportation incurred for business purposes on behalf of the employer. Reimbursements are not
taxable and expenses are not deductible to the employee.
Accounting Method - a method under which income and expenses are determined for tax purposes.
Most individuals and small businesses use the cash method. Businesses that maintain inventory are
required to use the accrual method.
Accounting Period - the period (normally a calendar year) that a taxpayer uses to determine federal
income tax liability.
Accrual Method of Accounting a method by which income is reported in the tax year earned,
whether or not received, and deductions are claimed in the tax year incurred, whether or not paid.
Acknowledgement (ACK) - an official electronic notice from the IRS or a State tax authority that
evidences an electronically filled tax return was accepted and considered filed or rejected and
considered not filed.
Acquisition Debt - debt incurred to acquire, construct, or improve the taxpayer's principal or second
residence.
Active Participant - a taxpayer who is covered by an employer-maintained qualified retirement plan,
or a qualified self-employed retirement plan.
Active Participation - the level of involvement in the management of residential rental real estate
that allows the owner to deduct up to $25,000 annually of losses from the rental of the property.
Actual Expenses the regular method of deducting automobile expenses based on actual costs
incurred.
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Additional Child Tax Credit an additional credit for taxpayers with three or more qualifying
children who cannot take the full Child Tax Credit.
Adjusted Basis - the cost or other original basis of property reduced by depreciation allowed or
allowable and casualty losses, and increased by the cost of capital improvements, expenses of
purchase, and other adjustments. Used to determine the gain or loss upon the sale of the asset.
Adjustment to Income expenses that are subtracted from gross income to arrive at adjusted gross
income.
Adjusted Gross Income (AGI) - gross income reduced by adjustments to income.
Adoption Credit a nonrefundable credit for qualified adoption expenses incurred for each eligible
child.
Adoption Taxpayer Identification Number (ATIN) - the taxpayer identification number used for a
child while the child's adoption is pending.
Alternative Minimum Tax (AMT) a mandatory alternative method of computing tax which negates
or minimizes the effects of tax preference items and tax loopholes.
Alien - a person who is not a citizen of the country in question.
Amended Return - a tax return filed on Form 1040X used to correct errors or to claim more
advantageous ways of filing the prior original return.
Amortization - a deduction for certain capital expenses over a fixed period of time. Similar to
depreciation.
Amount Due - money that taxpayers must pay to the government when the total tax on their return
is greater than their total withholding and estimated tax payments.
Applicable Federal Rate (AFR) - a minimum interest rate that must be charged on transactions that
involve payments over a number of years. If the parties do not adhere to this rate the IRS imputes it.
At-Risk Rules rules limiting the amount of losses a taxpayer can claim on a business or investment
to the amount he actually has at risk to lose.
Audit - an IRS examination and verification of a taxpayer's return or other transactions.

949

Authorized IRS e-file Provider - a business authorized by the IRS to participate in the IRS e-file
Program.
Average Basis - a method of figuring basis that can be used only for sales of regulated investment
company (including mutual fund) shares.
Backup Withholding - a 28% tax withheld by the payer from investment income, such as interest and
dividends, to ensure that tax is collected on the income.
Bank Denial - a Refund Anticipation Loan (RAL) denial by a bank.
Bank Product - a RAL, Instant Loan, or Preferred Electronic Refund Check (PERC).
Basis - the amount of the taxpayers adjusted cost in an asset from which gain or loss is determined
for income tax purposes when the asset is sold.
Blind - for tax purposes, a taxpayer is blind if his vision with corrective lenses is no better than 20/200
in his best eye, or if he has a visual field not greater than 20 degrees.
Boot - cash or other property used in a sale or exchange to make the values of property traded equal.
Cafeteria Plan an employer plan that allows employees to select from a menu of taxable and
nontaxable benefits.
Capital Asset - an asset owned for investment or personal purposes, such as stocks and bonds.
Capital Expenditure - an expenditure made for an asset, with a useful life of more than one year, that
increases its value or extends its useful life.
Capital Gain - a gain from the sale or exchange of a capital asset.
Capital Gain Distributions ordinarily, amounts paid by a mutual fund resulting from the sale of
capital assets by the fund.
Capital Improvement - an improvement made to extend the useful life or add to the value of a
property.
Capital Loss - a loss from the sale or exchange of a capital asset.
Capital Loss Carryover - the amount of a capital loss not allowed as a deduction against ordinary
income in the current year and carried over to the next year.

950

Capitalize - to record an expense as an addition to an asset account and depreciate it, rather than
treating it as a deductible expense in the current year.
Carry Back - to use deductions or credits that cannot be taken in the current year to reduce tax
liability for a prior year(s).
Carry Forward to use deductions or credits that cannot be taken in the current year to reduce tax
liability for a later year(s).
Cash Method of Accounting a method of accounting under which income is reported in the tax
year actually or constructively received and expenses are deducted in the tax year paid.
Casualty Loss - the complete or partial destruction of property resulting from an identifiable event of
a sudden, unexpected, or unusual nature.
Certified Historic Structure - a structure listed on the National Register of Historic Places or located
in a designated historic area. The tax code provides tax incentives for the rehabilitation of such
structures.
Certified Public Accountant (CPA) - a person who has met state requirements for education and
work experience, passed a national exam, and met other licensing requirements.
Change in Accounting Method - a change from one accounting method to another, which ordinarily
requires prior approval from the IRS.
Change in Accounting Period - a change from one accounting period to another.
Charitable Contributions tax deductible money or property donated to a qualified tax-exempt
charitable organization.
Charitable Organization - a tax-exempt organization recognized by the IRS as a charity.
Child Tax Credit - A credit of up to $1,000 per eligible child under age 17 at the end of the tax year.
Child and Dependent Care Credit - a tax credit of 20-35 percent of employment-related child and
dependent care expenses incurred to enable the taxpayer to be gainfully employed.
Citizen or Resident Test - a test that allows taxpayers to claim a dependency exemption for persons
who are U.S. citizens for some part of the year or who live in the United States, Canada, or Mexico for
some part of the year; or an alien child whom you have adopted and who lived with you for the entire
year.

951

Combat Zone - a geographical area designated by the president of the United States from which
members of the armed forces can exclude military pay from their income tax return.
Common-Law State - a state in which the laws governing property rights are based on English
common law under which the property and income of each spouse belongs to him or her separately.
Community Income - income of a married couple in a community property state, that belongs
equally to each spouse, regardless of which spouse earned or received the income. The community
property states are Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington, and
Wisconsin.
Community Property property of a married couple in a community property state, that belongs
equally to each spouse.
Compulsory Payroll Tax - an automatic tax collected from employers and employees to finance
specific programs.
Constructive Receipt a tax rule that states the taxpayer receives taxable income when it is made
available to him, regardless of whether he actually takes possession of it.
Cost - cash and/or the value of property paid to acquire the property received.
Cost of Goods Sold the cost of obtaining and producing goods sold in a business.
Coverdell Education Savings Account (ESA) - a tax-favored educational savings plan.
Credits tax credits are similar to credits from a retail store, which are subtracted from tax liability.
Crop Method - a form of accounting used by farmers under which they deduct the entire cost of
producing a crop, including the expense of seed and young plants, in the year they realize income
from it.
Declaration Control Number (DCN) - a 14-digit number assigned by 1040 ValuePak to each
electronically filed return, which is used by the IRS or state tax authority to track the return.
Declining Balance Method of Depreciation - an accelerated method of depreciation under which
the depreciable basis for the following year is reduced by the depreciation deduction taken in the
current year.
Deduction - expenses that may be subtracted from taxable income.

952

Deferred Compensation a plan that allows an employee to receive part of a year's pay in a later
year and not be taxed in the year the money was earned.
Deficiency - the difference between the amount reported on a tax return and the amount assessed
by the IRS.
Deficit - the result of a government spending more money than it takes in.
Defined Benefit Plan - an employer-provided retirement plan in which contributions are based on
the retirement benefits to be paid.
Defined Contribution Plan an employer-provided retirement plan in which contributions are based
on a specific percentage of income.
Dependent - a qualifying child or relative, other than the taxpayer or spouse, who entitles the
taxpayer to claim a dependency exemption.
Dependent Exemption the amount a taxpayer can claim for a "qualifying child" or "qualifying
relative".
Depletion - a method similar to depreciation that allows the owner of natural resources to deduct a
portion of the cost of the asset during each year of its presumed productive life.
Deposit Account Number (DAN) - the deposit account number for a checking or savings account.
Depreciable Property - property with a useful life of more than one year that is used for your trade
or business.
Depreciation - the deduction for the reasonable allowance for the wear and tear of assets with a life
of more than one year used in a trade or business or held for the production of income.
Direct Deposit an electronic transfer of a tax refund directly into the taxpayer's bank account.
Disability Pension - a taxable pension from an employer-funded disability plan received by a
taxpayer who retired on disability and has not reached normal retirement age.
Disaster Area Loss - an un-reimbursed loss of property sustained in an area designated as a disaster
area by the President of the United States.
Disposition a sale or other disposal of property that causes a gain or a loss, including like-kind
exchanges and involuntary conversions.

953

Distribution - money or property a taxpayer receives from a retirement plan.


Dividend - a stockholder's share of the profits of a corporation.
Drain Times - cut-off times established by each IRS Service Center for processing electronically filed
returns.
Dual-status Taxpayer - an alien who is a resident part of the tax year and a nonresident the other
part of the tax year.
Early Withdrawal Penalty a penalty paid for withdrawing money from a savings plan, such as a
certificate of deposit (CD), before its maturity date.
Earned Income income for services rendered (i.e. wages, salaries, tips, and net earnings from selfemployment) versus income generated by property or other sources.
Earned Income Credit a refundable tax credit for certain low-income taxpayers who work, meet
certain requirements, and have earned income under a specified limit.
Education Expense - an expense that is eligible for an education tax deduction or credit.
Education IRA a type of savings plan for education expenses.
Electronic Filing (e-file) - the transmission of tax return information to the IRS using computers and
the Internet.
Electronic Filling Identification Number (EFIN) - a unique six-digit number assigned to a business
by the IRS so that the business can file tax returns electronically.
Electronic Return Originator (ERO) a tax preparer that originates the electronic submission of
income tax returns to the IRS.
Employer Identification Number (EIN) - a nine-digit number assigned by the IRS for businesses,
estates, and trusts.
Employment Expenses - ordinary and necessary expenses required to perform the duties for which
the taxpayer is employed.
Energy Tax Credit--Business Property a tax credit allowed for the purchase of certain business-use
property utilizing solar, geothermal, biomass, coal and gasification energy.

954

Energy Tax Credit--Residential Property - a tax credit allowed for the purchase of certain qualified
energy efficiency improvements (i.e. insulation, exterior windows, and exterior doors) and residential
energy property costs (i.e. qualified furnaces, water heaters, and heat pumps) and the cost of qualified
photovoltaic property, solar water heating property, and fuel cell property.
Entertainment Expenses - expenses which are deductible by employees and self-employed
taxpayers only if the expenses are directly related to or associated with a trade, business, or
profession.
Estate Tax - a tax based on the fair market value of the decedent's property at death, less his or her
liabilities.
Estimated Tax - quarterly tax payments paid to the IRS on April 15, June 15, September 15, and
January 15 if the total year's taxes will exceed $1,000 and the amount is not covered by withholding.
Excess Accelerated Depreciation - the difference between the total depreciation taken and the
depreciation that would have been taken using the straight-line depreciation method.
Excess Social Security Tax Withheld excess amounts withheld by multiple employers of the
taxpayer.
Excise Tax - a tax on the sale or use of specific products, transactions or property.
Exempt from Withholding to be free from withholding of federal income tax a person must meet
certain income, tax liability, and dependency criteria.
Excludable Amount of Pension - the portion of pension distributions that is not taxable.
Exemption - an deduction taxpayers can claim for themselves, their spouses, and eligible dependents
which reduces income subject to tax.
Expensing a term used when a taxpayer claims the Internal Revenue Code (IRC) Section 179
expense deduction and currently deducts certain expenditures that would ordinarily be required to be
depreciated.
Extension - a allowance of additional time to perform an act required by the tax law or by regulation.
Fair Market Value (FMV) - the amount at which property would change hands between a willing
buyer and a willing seller, neither being under compulsion to buy or sell and both having reasonable
knowledge of the relevant facts.
Federal Income Tax a tax levied on personal and corporate income.
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Federal Income Tax Withheld - the amount withheld from income and submitted by the payer to
the IRS as an advance payment of the taxpayer's federal income tax.
Federal Insurance Contributions Act (FICA) - a federal law that requires taxpayers to pay Social
Security taxes for Old-Age, Survivors and Disability Insurance (OASDI), and Medicare.
Federal Unemployment Tax Act (FUTA) - a cooperative effort between 53 possessions and states,
and the federal government for the administration of unemployment insurance. The IRS is responsible
for receiving and processing the Employers Annual Federal Unemployment Tax Return (Form 940).
Filing Extension - an additional amount of time to file a tax return.
File a Return - to mail or electronically transmit to an IRS service center the taxpayer's information, in
specified format, about income and tax liability.
Filling Center the computer data center which transmits electronically filed tax returns to the
appropriate IRS Service Center, as well as bank applications to the appropriate RAL bank, and sends
acknowledgements and other reports back to the Electronic Return Originator.
Filing Status - the five filing statuses are: single, married filing a joint return, married filing a separate
return, head of household, and qualifying widow(er) with dependent child.
Final Return for Decedent a tax return filed for the year in which the individual died.
First In, First Out (FIFO) a method of valuing inventory that assumes any inventory sold was from
the first inventory purchased.
First-year Expensing - a term used when a taxpayer claims the Internal Revenue Code (IRC) Section
179 expense deduction and currently deducts certain expenditures that would ordinarily be required
to be depreciated.
Fiscal Year - an accounting year ending on the last day of any month except December.
Fixing-up Expenses - expenses incurred to physically prepare a home for sale.
Flexible Spending Account - a method of paying for benefits under a cafeteria plan through salary
reductions.
Financial Management Service (FMS) - a bureau of the Department of the Treasury that provides
central payment services to federal agencies, operates the federal government's collections and

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deposit systems, provides government wide accounting and reporting services and manages the
collection of delinquent debt owed to the government.
Foreign Child - a child who is not a U.S. citizen or resident.
Foreign Earned Income Exclusion an amount of income that the taxpayer can exclude from
taxable income if he lived and earned income in a foreign country.
Foreign Housing Exclusion and Deduction - an exclusion or deduction available if the taxpayer lived
and earned income outside the United States and either his employer paid for his housing or he was
self-employed.
Foreign Tax Credit or Deduction - a credit or deduction available to a taxpayer who incurs or pays
income tax to a country other than the U.S., on income that is also subject to U.S. income tax.
Form 8633 the Application to Participate in the IRS e-file Program, which must be filed by anyone
who wants to participate in the IRS Electronic Filing program. Upon IRS acceptance the tax preparer is
assigned an EFIN.
Form 8879 - a form that allows taxpayers and preparers to sign a tax return using an electronic
signature by entering a five-digit PIN.
Form W-2 - the form employers send to workers and the IRS at the end of the year to report annual
wages, taxes withheld and other information.
Form W-4 the Employee's Withholding Allowance Certificate which is completed by the employee
and used by the employer to determine the amount of income tax to withhold from each paycheck.
Forms Method - a method of completing a tax return in 1040 ValuePak by completing the electronic
versions of the IRS forms and schedules.
Foster Child - a child placed with a taxpayer by an authorized placement agency or by court order.
Fringe Benefits - benefits received by an employee in addition to salary.
Full-Time Student - a dependent enrolled in a school for the number of hours or courses considered
by the school to be full-time during some part of at least 5 calendar months during the year.
Gain - the excess of the amount realized from a sale or exchange above the adjusted basis of the
property sold or exchanged.

957

Gain or Loss - the difference between the basis in an asset and the price received upon disposal of
the asset.
Gambling Income and Losses - income and losses from gambling, such as lotteries, bingo and racing.
General Depreciation System - the most commonly used method for computing MACRS
depreciation.
General Rule - the method of determining the taxable part of a pension when the taxpayer is not
eligible to use the simplified method.
Generation-Skipping Transfer Tax - a tax on gifts or death transfers of money or property that
would otherwise escape the once-per-generation transfer taxes that apply to gifts and estates.
Gift Tax a federal excise tax paid by donors on the value of gifts exceeding a specified amount.
Goodwill the value of a trade or business based on expected continued customer patronage due to
its name, reputation, and other factors.
Gross Dividends - the sum of ordinary dividends, capital gains distributions and nontaxable
distributions received during the tax year.
Gross Income total worldwide money, goods, services, and property a person receives that must be
reported on a tax return unless specifically exempt or excluded by law.
Gross Income Test - one of five tests that must be met for a taxpayer to claim someone as his or her
dependent.
Gross Receipts - the total of sales for a business during the year.
Head of Household Filing Status a filing status used by an unmarried taxpayer who pays over half
the cost of maintaining a home that is the principal residence for over half the tax year of his
qualifying child or a qualifying relative.
Hobby Loss - a nondeductible loss arising from a personal hobby which was not pursued for profit.
Holding Period - the period of time property has been owned for income tax purposes.
Home Equity Debt - debt secured by a principal residence or second home that does not include the
original acquisition debt.
Home Office - part of a home or other structure for which the taxpayer qualifies to take a deduction
for its business use.
958

Hope Scholarship Credit - a nonrefundable credit for tuition and fees paid for the first two years of
post-secondary education.
Household Employee - an individual who performs non-business services for a taxpayer in or around
the taxpayer's home.
Improvements - the expenses of permanently upgrading property versus maintaining or repairing it.
Imputed Interest - interest the IRS assumes has been paid on a loan if the stated interest is below
the minimum Applicable Federal Rate.
Inclusion Amount the amount a taxpayer must add back to income if the fair market value of his
leased car is above a certain amount.
Income - a gain derived from capital, labor, or a combination of the two.
Income Averaging - a method by which farmers may reduce tax liability by computing their income
tax as if their current farm income had been spread evenly over the preceding three years.
Income in Respect of a Decedent (IRD) - income a decedent earned or was entitled to receive
before death.
Income Taxes - taxes on both earned income (salaries, wages, tips, commissions) and unearned
income (interest, dividends).
Individual Retirement Arrangement (IRA) - a trust account established to receive retirement
contributions of individuals.
Individual Taxpayer Identification Number (ITIN) a taxpayer identification number for persons
(usually aliens) who do not qualify for a Social Security number.
Inflation a simultaneous increase in consumer prices and decrease in the value of money.
Information Returns forms such as Form W-2 and 1099, which report income and property
transactions to the IRS.
Innocent Spouse Rule - an exception to the general rule, under which a spouse may claim to not be
jointly liable if he or she did not know about errors in a tax return and did not benefit from them.
Installment Method - a method enabling a taxpayer to spread the recognition of gain on the sale of
property over the payment period.
959

Instant Loan - an immediate loan made by a RAL bank before the IRS has acknowledged the return,
for a portion of a taxpayers anticipated refund amount.
Interest Expense - the amount paid for borrowing money.
Interest Income - the amount received for lending money.
Internal Revenue Service (IRS) - a division of the U.S. Treasury Department responsible for collecting
taxes.
Inventory - items acquired for sale to customers in the regular course of a taxpayer's trade or
business.
Investment Interest Expense - deductible interest paid on funds borrowed for investment purposes,
which is limited to income generated from the investments.
Investment Income - interest, dividends, capital gains, certain rent and royalty income, and net
passive activity income.
Investment Tax Credit - tax credits which are allowed for rehabilitating a building or investing in
energy property for business purposes.
Involuntary Conversion a forced disposition of property due to a casualty, theft, condemnation or
the threat of condemnation.
IRS e-file - the preparation and transmission of tax return information to the IRS using a computer
and the Internet.
Itemized Deductions - personal expenses allowed by the Internal Revenue Code as deductions from
adjusted gross income.
Joint Return - a return combining the income, exemptions, credits, and deductions of a husband and
wife.
Joint Return Test - one of the five tests a person must pass to qualify as the taxpayers dependent
requiring that the person must not file a joint tax return with his or her spouse for the tax year in
which the taxpayer claims the person as a dependent.
Joint Tenancy a form of joint ownership under which two or more individuals each has an
undivided interest in the entire property.

960

Jointly Owned Property - property held in the name of more than one person.
Keogh Plan - a pension or profit-sharing retirement plan available to self-employed individuals and
their employees.
Kiddie Tax - the popular name for a 1986 law enacted to prevent parents from escaping taxes by
putting money in their children's names.
Last In, First Out (LIFO) a method of valuing inventory that assumes any inventory sold was from
the last inventory purchased.
Legally Separated - married couples living apart under a court order or separate maintenance
agreement.
Lien for Taxes - a lien on the property of a taxpayer who is delinquent in the payment of amounts
owed to the IRS.
Lifetime Learning Credit - a nonrefundable tax credit of a portion of qualified post-secondary higher
education tuition and fees paid on behalf of the taxpayer, his or her spouse, or his or her dependents.
Like-Kind Exchange - a tax-deferred exchange of similar property used in a trade or business or held
for investment, not including securities and other indebtedness or interests such as stocks and bonds.
Listed Property - passenger autos and other property used for transportation, property generally
used for purposes of entertainment, recreation, or amusement, computers, cellular telephones, and
other property specified by the IRS for which special rules apply to depreciation.
Long-Term Capital Gains and Losses - gains and losses on the sale or exchange of capital assets
that have been held for more than 12 months.
Lump-Sum Distribution - the payment of the entire balance in an individual's employer-provided
retirement plan account in one calendar year.
Luxury Automobile Limits - limits on the amount of depreciation that can be taken annually on an
automobile used for business purposes.
Luxury Tax - a tax paid on expensive goods and services considered by the government to be
nonessential.
Marital Deduction - a deduction that allows a taxpayer to transfer assets to his spouse estate and
gift tax free.

961

Married Filing Jointly Filing Status - a filing status that can be used by taxpayers who are married at
the end of the tax year.
Married Filing Separately Filing Status - a filing status that can be used by married taxpayers who
choose to declare their individual incomes, deductions, and credits on separate individual tax returns.
Material Participation a test used to determine if the taxpayer worked and was involved in a
business activity on a regular basis or if he was only an investor
Meals and Entertainment - expenses that may be 50% deductible in a business, such as the cost of
taking a client to a restaurant or a sporting event.
Medical Expenses - the reasonable and necessary un-reimbursed expenses relating to health care
(doctors, dentists, hospitals, prescriptions) for the taxpayer and his dependents.
Medical Savings Account (MSA) - a tax-exempt trust or custodial account established to save
money exclusively for future medical expenses that are not covered by health insurance.
Medicare Part A coverage for hospital and nursing home care.
Medicare Part B - coverage for a portion of doctor bills and outpatient services. The premium is
withheld from social security benefits and deductible on Schedule A.
Medicare Tax a tax used to provide medical benefits for workers, retired workers, and the spouses
of workers and retired workers that are eligible to receive Medicare benefits upon reaching age 65.
Medicare Tips - tips reported to an employer by an employee which are subject to Medicare Tax
withholding.
Medicare Wages - wages paid to an employee that are subject to Medicare tax not including
Medicare Tips, which are reported separately.
Miscellaneous Itemized Deductions - deductions reported on Schedule A which are usually jobrelated expenses or investment expenses.
Modified AGI (MAGI) - a figure used to calculate the limit on an exclusion or deduction.
Modified Accelerated Cost Recovery System (MACRS) - the depreciation system used for most
property, other than real estate, placed in service after December 31, 1986.

962

Mortgage Interest Credit - a certificate from a state or local government in connection with a new
mortgage for the purchase of a main home entitling taxpayers to claim a credit for a percentage of
their home mortgage interest.
Mortgage Interest Expense - interest paid on a loan secured by a home that is fully deductible up to
certain limits.
Moving Expenses - an adjustment to income permitted to employees and self-employed individuals
who move for work-related reasons, provided certain requirements are met.
Multiple Support Agreement a legal document that states who can claim a person as a dependent
when two or more people provide more than half of a dependent's support.
Net Operating Loss (NOL) a net loss for the year attributable to business or casualty losses
because expense deductions are more than income for the year.
Nominee Dividends - dividends received on behalf of another person.
Nominee Interest - interest received on behalf of another person.
Non-custodial Parent - the parent who does not have physical custody of the child, or who has
custody for the smaller part of the year.
Nonrefundable Credit - a credit that cannot exceed the taxpayer's tax liability.
Nonresident Alien - a person who is not a U.S. citizen and either does not live in the United States, or
lives in the United States and does not have a green card or meet the substantial presence test.
Nontaxable Distributions - stock dividend distributions that are not paid from earnings and are not
taxable - such as a return of capital, stock splits, and/or tax-free distributions.
Nontaxable Income - income that is exempt from tax by law.
Open Year - a tax year for which the statute of limitations has not yet expired.
Ordinary and Necessary Business Expenses - expenses that are fully deductible as current expenses,
as opposed to unnecessary expenses or capital expenditures.
Ordinary Dividends - fully taxable dividends that are distributions of a company's profits.
Ordinary Income - income that does not qualify as a capital gain, such as wages, interest, dividends
and net income from a business.
963

Ordinary Loss - a loss that is not a capital loss and that is fully deductible against ordinary income.
Original Issue Discount (OID) a discount that occurs when a bond is issued for a price less than its
face amount or principal amount.
Parsonage Allowance - a housing allowance for clergy, designated by the church or other employer
organization, for the expenses of providing and maintaining a home.
Passive Activity - an activity in which the taxpayer does not materially participate.
Passive Income - income from business activities in which the taxpayer does not materially
participate including most real estate rental activities.
Passive Loss losses from business activities in which the taxpayer does not materially participate.
Payment-in-Kind Wages wages paid to farm employees in the form of farm commodities, such
as livestock or food, instead of cash.
Payroll Tax - a tax based on wages, tips and salaries paid such as Social Security Tax, Medicare Tax,
unemployment compensation, workers compensation insurance and local transit.
Permanent and Total Disability - a disability that prevents an individual from engaging in any
substantial gainful activity because of a medically determined physical or mental impairment that is
expected to result in death, or that has lasted or is expected to last for a continuous period of not less
than 12 months.
Personal Exemption exemptions for the taxpayer and his spouse.
Personal Identification Number (PIN) - a five-digit self-selected number which allows taxpayers to
"sign" their tax returns electronically and ensures that electronically submitted tax returns are
authentic.
Physical Presence Test - one of the two residency tests a taxpayer can meet to qualify for the
Foreign Earned Income Exclusion and the Foreign Housing Exclusion and Deduction.
Placed in Service - the date an asset is ready for use for business purposes, which is usually the date
of purchase and which is used as the starting point for depreciation.
Points a loan-origination fee that a borrower may deduct as interest expense under certain
circumstances.

964

Portfolio Income - income such as interest, dividends, royalties, and gains or losses from
investments.
Power of Attorney - a legal document authorizing one person to act as another person's attorney or
agent.
Practitioner PIN - allows the Electronic Return Originator to sign a tax return using an electronic
signature by entering a five-digit PIN.
Preferred Electronic Refund Check (PERC) a quick and cost-effective way for taxpayers to receive
their tax refunds - usually in 7 to 14 days without paying any tax preparation fees up front.
Premature Distribution - a withdrawal from a qualified retirement plan before age 59 1/2.
Principal Place of Business - the main place where work is performed or business is transacted,
determined by how much of a taxpayers working time is spent there and the importance of the work
done there.
Principal Residence - generally the home in which a taxpayer lives most of the time, which can be a
house, condominium, cooperative apartment, townhouse, mobile home, or houseboat.
Profit-Sharing Plan a plan for distributing a predetermined percentage of a company's profits to
its employees' accounts.
Progressive Tax - a tax that takes a larger percentage of income from high-income groups than from
low-income groups.
Property Taxes - a tax levied by local governments, based on the value of property owned.
Publication 1345 - Handbook for Electronic Return Originators of Individual Income Tax Returns,
which provides information on electronic filing requirements and restrictions.
Publication 1345A - Filing Season Supplement for Authorized IRS e-file Providers, which is a
supplement to IRS publication 1345 that lists all IRS rejection codes for electronically filed returns.
Qualified Adoption Expenses - reasonable and necessary expenses for adopting a child, including
such expenses as adoption fees, attorney fees, and other expenses, but not including expenses paid
for a surrogate parenting arrangement or expenses paid to adopt a spouse's child.
Qualified Charitable Organization - usually an association or nonprofit corporation designed to
provide some form of public service and specifically approved by the U.S. Treasury as a recipient of
tax deductible charitable contributions.
965

Qualified Pension or Profit-Sharing Plan - an employer-sponsored plan that meets the


requirements of IRC Section 401 - such as who must be covered, the amount of benefits that are paid,
information that must be given to plan participants, etc.
Qualified Retirement Plan - a retirement plan approved by the IRS that allows for tax-deferred
accumulation of investment income.
Qualifying Child - a child who meets five tests: (1) Relationship, (2) Age, (3) Residency, (4) Support,
and (5) Special test for qualifying children of more than one person.
Qualifying Relative a relative who meets four tests: (1) Not a qualifying child, (2) Member of
household or relationship, (3) Gross income, and (4) Support.
Qualifying Widow(er) Filing Status - a filing status taxpayers may be able to use for two years after
the year a spouse died, allowing the taxpayer to use the same rates as if filing jointly.
Railroad Retirement Tax Act - the law that provides for railroad retirement benefits.
RAL Bank - a provider of bank products to taxpayers, for the electronic filing industry.
Real Estate Professional - a person who meets the qualifications to treat rental real estate losses as
non-passive losses and to use the losses to offset non-passive income.
Realized Gain or Loss - the difference between the amount received upon the sale or other
disposition of property and the adjusted basis of the property.
Recapture of Depreciation - inclusion of part or all of the depreciation deducted in prior years in this
year's taxable income.
Recapture - the reversal of a tax benefit if certain requirements are not met in future years.
Recognized Gain or Loss - the amount of gain or loss reported for income tax purposes.
Refund - money owed to taxpayers when their total tax payments are greater than the total tax.
Refundable Credit - a credit which is not limited by the amount of total tax and for which the IRS will
send the taxpayer a refund for any amount in excess of the taxpayer's tax liability.
Refund Anticipation Loan ( RAL) a fast way for taxpayers to receive money based on their
anticipated refund amount.

966

Regular Method - a deduction for business use of the taxpayer's vehicle based on actual cost of gas,
oil, repairs, tires, parking, etc. plus depreciation.
Relationship or Member of Household Test - one of the five tests to determine if the taxpayer can
claim someone as a dependent.
Resident Alien a permanent resident, but not a citizen, of the United States.
Return of Capital - a distribution received from an investment that is not income, but rather a return
of a portion of the original investment.
Rollover a tax-free transfer of an employer plan distribution to another employer plan or to a
traditional IRA, or the tax-free transfer from one IRA to another or to an eligible employer plan within
60 days.
Roth IRA a retirement account which features non-deductible contributions on which earnings
grow tax free and qualified withdrawals are also tax free.
Routing Transit Number (RTN) - a unique nine-digit identification number for a bank.
Royalty Income - payments for using of certain kinds of property, such as artistic or literary works
and patents.
S Corporation - a type of small business corporation with no more than 100 shareholders that elects
not to be taxed as a corporation and that generally pays no tax. Instead, shareholders of an S
corporation report their share of the corporation's income, gain, losses, and credits on their individual
returns.
Safe Harbor - tax regulations that allow a simpler method of determining a tax consequence than is
available following the precise language of the Code or regulations.
Salvage Value - the estimated amount an asset could be sold for at the end of its useful life.
Savings Incentive Match Plan for Employees (SIMPLE) - a simplified retirement plan that allows
employees of 100 or fewer employee businesses and self-employed individuals to make salaryreduction contributions to a retirement plan either one similar to a 401(k) plan or one that funds
IRAs for employees.
Schedules - official IRS forms used to report various types of income, deductions, and/or credits.
Section 1231 Gain or Loss - a net section 1231 gain is treated as long-term capital gain and a net
section 1231 loss is treated as an ordinary (fully deductible) loss.
967

Section 1231 Property - depreciable assets and real estate used in a trade or business and held for
more than one year, such as equipment, vehicles and rental real estate.
Section 1245 the section of the IRC that requires that when depreciable personal property, such as
business equipment and vehicles, are sold, gain must be recaptured as ordinary income up to the
amount of depreciation claimed.
Section 1250 - the section of the IRC that requires that when real property is sold, gain must be
recaptured as ordinary income up to the amount of depreciation claimed in excess of straight line
depreciation.
Section 179 Expense Deduction - a deduction allowed for up to the entire cost of certain
depreciable business assets, other than real estate, in the year purchased, which can be used as an
alternative to depreciating the asset over its useful life.
Section 457 Plan a deferred-compensation plan for employees of state and local governments and
tax-exempt organizations that allows for tax deferral of salary.
Self-Employment Tax - Social Security and Medicare tax paid by self-employed individuals on the
net income from their trade or business.
Separate Maintenance Payments - amounts paid to one spouse by the other under a court order or
agreement while they live apart.
Series EE Bonds - U.S. Savings Bonds issued after 1979.
Short Tax Year - a tax period less than 12 months, resulting from a business start-up or the transition
to a tax year ending on a different date.
Short Term Gain or Loss - gain or loss on the sale or exchange of a capital asset held one year or
less.
Simplified Employee Pension (SEP) - An retirement plan under which an employer makes
contributions to an employee's Individual Retirement Account (IRA), or a self-employed person
contributes to his own plan.
Simplified Method a method of computing the taxable portion of a pension received from a
qualified employer plan.

968

Single Filing Status a filing status used if on the last day of the year, the taxpayer is unmarried or
legally separated from his spouse under a divorce or separate maintenance decree and he does not
qualify for another filing status.
Sin Tax - a tax on goods such as tobacco and alcohol.
Social Security Number (SSN) a taxpayer identification number for most U.S. citizens.
Social Security Tax see Federal Insurance Contributions Act (FICA).
Social Security Tips - the amount of tips reported to an employer by an employee that is subject to
Social Security Tax.
Social Security Wages - wages paid to an employee that are subject to Social Security tax.
Special Needs Child - a child determined by the state to be difficult to adopt due to factors such as
racial or ethnic background, age, a condition that requires special care, mental, physical or emotional
handicaps, or whether the child is a member of a minority or sibling group.
Specific Use - a specific use for a power of attorney that is not recorded in the Centralized
Authorization File (CAF). Because the IRS does not record a power of attorney for specific use, the
person to whom you have given power of attorney must bring a copy of the power of attorney to
each meeting with the IRS.
Spousal IRA - an IRA established by a taxpayer whose spouse has little or no compensation - for the
benefit of that spouse.
Standard Deduction an deductible amount provided by the tax law in lieu of itemized deductions.
Standard Mileage Rate - a deductible fixed rate for each mile of qualified use of an automobile,
which is used instead of keeping track of actual costs, such as gas and maintenance..
State Non-Residents - an individual who temporarily resided and/or worked in a state at any time
during the tax year, although that state was not their state of residence.
State Part Year Residents - an individual who was a resident of a particular state for only part of the
tax year.
Statutory Employee - a worker who is treated as an employee for Social Security and Medicare tax
purposes and as self-employed for income tax purposes.

969

Step-by-Step Interview - a method of completing a tax return in 1040 ValuePak by answering a


series of simple interview questions.
Straight-Line Depreciation - a method of computing depreciation under which the depreciation
deduction is the same for each full year.
Student Loan Interest Deduction - an adjustment to income for interest paid during the year on
qualified higher-education loans.
SUB Pay - Supplemental unemployment benefits.
Support - costs of food, clothing, shelter, education, medical and dental care, recreation, and
transportation.
Support Test - one of the five tests to see if a taxpayer can claim someone as his dependent.
Tariff - a tax on products imported from foreign countries.
Taxable Income - Adjusted Gross Income reduced by itemized deductions or the standard deduction,
and by allowable personal and dependent exemptions.
Tax - required payments of money to governments.
Taxable Interest Income - interest income that is subject to income tax.
Tax Benefit Rule - a rule that provides that the amount of a deductible expense subsequently
recovered must be included in income in the year of the recovery to the extent the original expense
resulted in a tax benefit.
Tax Bracket - the rate at which income at a taxpayers top level is taxed.
Tax Code - the official body of tax laws and regulations.
Tax Court - the U.S. Tax Court is one of three trial courts of original jurisdiction that decide litigation
involving federal income, death, and gift taxes.
Tax Credit - a dollar-for-dollar reduction in the tax owed.
Tax Cut - a reduction in the amount of taxes taken by the government.
Tax Deduction a personal or business expense that reduces income subject to tax.

970

Tax Deferral - the postponement of taxes to a later tax year, usually accomplished by recognizing
income or a gain at a later time.
Tax Evasion - a failure to pay or a deliberate underpayment of taxes.
Tax-Exempt Income - income that is not subject to federal income tax by law.
Tax-Exempt Interest Income - interest income that is not subject to federal income tax by law.
Tax Exemption - a part of a taxpayers income on which no tax is imposed.
Tax-Free Exchange - transfers of property specifically exempt from federal income tax consequences
in the current year such as like-kind exchanges.
Tax Home - the taxpayers principal place of work or post of duty.
Tax Liability - the amount of tax the taxpayer must pay after deducting any credits and before taking
into account any advance payments such as withholding or estimated tax payments made by the
taxpayer.
Tax Preference Items - items such as accelerated depreciation, percentage depletion or certain taxexempt income that may result in the imposition of the alternative minimum tax.
Tax Rate Schedules - schedules published by the IRS for taxpayers with taxable income of more than
$100,000 to use to compute their income tax.
Tax Return Preparer - a person paid to prepare, review or assist in the preparation of the taxpayers
income tax return.
Tax Shelter - an investment that is designed to result in tax-favored treatment.
Tax-Sheltered Annuity - a retirement plan for employees of tax-exempt organizations and public
schools, also known as a Section 403(b) plan.
Tax Tables tables published by the IRS for taxpayers with taxable income of $100,000 or less to use
to compute their income tax.
Tax Year - the 12-month reporting period for which taxable income is computed.
Taxpayer Identification Number (TIN) in the case of an individual, the individuals Social Security
number. In the case of a business , the Employer Identification Number (EIN).

971

TeleTax - a phone number that taxpayers can call to hear recorded information on more than 100 tax
topics.
Third Party Designee an authorization electronically filed with a tax return that authorizes the IRS
to discuss the tax return with a third party.
Tip Income - gratuities received by the taxpayer for services rendered. Tips of $20 or more from any
one job during a calendar month must be reported to the taxpayer's employer.
Traditional IRA an IRA that is not a SIMPLE IRA or Roth IRA - to which an individual makes annual
contributions that may or may not be deductible depending on the individual's income and whether
the individual actively participates in an employer's retirement plan.
Transaction Taxes - taxes on economic transactions, such as the sale of goods and services.
Transmit - to send a tax return to the IRS electronically.
Transmission - the sending and receiving of tax returns, acknowledgements, and other files using
your computer and Internet connection.
Transportation Expenses - the cost of transportation incurred in the course of business or
employment when the taxpayer is not away from home traveling.
Travel Expenses - ordinary and necessary business expenses such as meals, lodging and
transportation expenses while away from home in the pursuit of a trade or business.
Unadjusted Basis - the basis of property used to figure a gain on the sale of the property, but
without reduction for any depreciation deductions.
Underpayment Penalty - a penalty for not paying enough total estimated tax and withholding.
Unstated Interest - interest the IRS assumes has been paid on a loan if the stated interest rate is
below a minimum, called the Applicable Federal Rate (AFR).
Useful Life - the number of years depreciable business property is expected to be productive and in
use.
Vacation Home - a second home used for recreational purposes that may also be rented out at times
to others.
Voluntary Compliance - a system of compliance that relies on individual citizens to report their
income freely and voluntarily, calculate their tax liability correctly, and file a tax return on time.
972

Wages - compensation received by employees for services performed.


Wash Sale - the sale and repurchase of stocks or securities within a short period of time - within 30
days before or after the sale.
Welfare to Work Credit - a tax credit for employers who hire workers currently on the welfare rolls.
Withholding - taxes deducted from wages or other income that are deposited in an IRS account.
Withholding Allowance an allowance claimed on Form W-4 for employers to use in calculating the
amount of income tax to withhold from employee paychecks.

973

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