Professional Documents
Culture Documents
Volume
Federal Income
Tax Course 2015
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
Tariffs .............................................................................................................................................41
Value Added Tax (VAT) ............................................................................................................42
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 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
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
SIDE BAR
TAX TIP
TAX PLANNING
TIP
TAX PRACTICE
TIP
xxiii
$13,190
Up to $13,190
$82,100
$41,050
$52,800
26%
28%
0%
15%
20%
25%
28%
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
$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
Single
$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
$500,000
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
$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
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
LESSON
OUR
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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.
LESSON
OUR
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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
Cost
$200
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
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SYSTEM
Tax Quote
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OUR
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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.
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
LESSON
OUR
FEDERAL
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SYSTEM
LESSON
OUR
FEDERAL
TAX
SYSTEM
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
LESSON
OUR
FEDERAL
TAX
SYSTEM
earned their money and wealth was accumulated and dispensed with little
or no interaction with the federal government.
Side Bar
LESSON
OUR
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10
LESSON
OUR
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TAX
11
SYSTEM
LESSON
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SIDE BAR
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.
12
LESSON
OUR
FEDERAL
TAX
SYSTEM
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.
13
LESSON
OUR
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SYSTEM
14
LESSON
OUR
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TAX
SYSTEM
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:
Side Bar
LESSON
OUR
FEDERAL
TAX
SYSTEM
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
16
LESSON
OUR
FEDERAL
TAX
17
SYSTEM
LESSON
OUR
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TAX
SYSTEM
Side Bar
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.
18
LESSON
OUR
FEDERAL
TAX
SYSTEM
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;
Side Bar
LESSON
OUR
FEDERAL
TAX
SYSTEM
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
20
LESSON
OUR
FEDERAL
TAX
SYSTEM
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.
21
LESSON
OUR
FEDERAL
TAX
SYSTEM
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
22
LESSON
OUR
FEDERAL
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SYSTEM
Side Bar
23
LESSON
OUR
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SYSTEM
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.
LESSON
OUR
FEDERAL
TAX
SYSTEM
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
LESSON
OUR
FEDERAL
TAX
SYSTEM
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%.
26
LESSON
OUR
FEDERAL
TAX
SYSTEM
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%
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.
27
LESSON
OUR
FEDERAL
TAX
SYSTEM
LESSON
OUR
FEDERAL
TAX
SYSTEM
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)
29
LESSON
OUR
FEDERAL
TAX
SYSTEM
30
LESSON
OUR
FEDERAL
TAX
SYSTEM
31
LESSON
OUR
FEDERAL
TAX
SYSTEM
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
LESSON
OUR
FEDERAL
TAX
SYSTEM
LESSON
OUR
FEDERAL
TAX
SYSTEM
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.
LESSON
OUR
FEDERAL
TAX
SYSTEM
Combined, the two new laws include more than $400 billion in revenue
raisers and new taxes on employers and individuals.
a 20% capital gains and dividend tax rate for the aforementioned
taxpayers
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.
LESSON
OUR
FEDERAL
TAX
SYSTEM
36
LESSON
OUR
FEDERAL
TAX
SYSTEM
Tax Tip
SIDE BAR
37
LESSON
OUR
FEDERAL
TAX
SYSTEM
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
$353,141,112
11.52%
$2,575,871,018
84.06%
$8,611,877
0.28%
$5,953,524
0.19%
$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)
SIDE BAR
LESSON
OUR
FEDERAL
TAX
SYSTEM
39
LESSON
OUR
FEDERAL
TAX
SYSTEM
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.
40
LESSON
OUR
FEDERAL
TAX
SYSTEM
LESSON
OUR
FEDERAL
TAX
SYSTEM
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
LESSON
THE
TAX
RETURN
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
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.
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
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.
45
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
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
46
LESSON
THE
TAX
RETURN
47
PREPARATION
PRO CESS
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
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!
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.
48
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
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:
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:
Letting the other person take the time they need to express
themselves
Restating what the other person has said to ensure that you
understand
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
49
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
Avoid "leading" questions that make the taxpayer feel you have a
specific answer in mind.
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
50
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
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
53
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
SIDE BAR
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
Use all of these important components to take the guess work out of return
preparation.
Tax Tip
This is a complex return and Ill have it ready in a few days. Set a final
appointment.
"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.
55
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
Side Bar
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
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:
Throughout our course you'll see many tax planning tips. We've also
57
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
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.
58
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
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.
59
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
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:
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:
60
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
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 capital gain/loss, net operating loss, and similar records which
may form the basis of claims made on future tax returns indefinitely.
Expenses
Home
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
61
Brokerage
statements
Form(s) K-1
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
Check
Debit or Credit
Card
Electronic Funds
Transfer
Payroll Deduction
SIDE BAR
62
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
TAX TIP
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
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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LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
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:
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
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
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.
66
LESSON
THE
TAX
RETURN
PREPARATION
PRO CESS
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.
67
LESSON
TAXPAYER
IDENTIFICATION
NUMBERS
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
LESSON
TAXPAYER
IDENTIFICATION
NUMBERS
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:
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
LESSON
TAXPAYER
IDENTIFICATION
NUMBERS
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:
70
LESSON
TAXPAYER
IDENTIFICATION
NUMBERS
A nonresident alien required to file a U.S. tax return or filing a U.S. tax
return only to claim a refund
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
LESSON
TAXPAYER
IDENTIFICATION
NUMBERS
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
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."
72
LESSON
TAXPAYER
IDENTIFICATION
NUMBERS
Figure 3-1: Form W-9 - Request for Taxpayer Identification Number and Certification.
73
LESSON
TAXPAYER
IDENTIFICATION
NUMBERS
the taxpayer ignores notices from the IRS claiming that he has under
reported interest or dividend income
There are both civil and criminal penalties if for providing false information,
such as a fake taxpayer identification number, to avoid backup withholding.
LESSON
TAXPAYER
IDENTIFICATION
NUMBERS
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".
75
LESSON
TAXPAYER
IDENTIFICATION
NUMBERS
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.
Separate Property
Generally, separate property is:
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.
76
LESSON
TAXPAYER
IDENTIFICATION
NUMBERS
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:
LESSON
TAXPAYER
IDENTIFICATION
NUMBERS
78
LESSON
TAXPAYER
IDENTIFICATION
NUMBERS
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
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
TAXPAYER
IDENTIFICATION
NUMBERS
TAX QUOTE
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:
The ITIN is for tax purposes only. The issuance of an ITIN does not:
In general, to receive an ITIN, the taxpayer must file Form W-7 Application
for Individual Taxpayer Identification Number and supply documentation
80
LESSON
TAXPAYER
IDENTIFICATION
NUMBERS
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 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.
81
LESSON
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:
Dual-Status Aliens
Undocumented Aliens
Children Born Abroad Obtaining an SSN
Questions Commonly Asked
by or About Aliens
82
LESSON
ALIENS
Dual status: Is both a nonresident and resident alien for the tax year
83
LESSON
ALIENS
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:
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:
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
84
LESSON
ALIENS
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
85
LESSON
ALIENS
One of the spouses must be a U.S. citizen or resident alien on the last
day of the tax year
86
LESSON
ALIENS
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
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:
LESSON
ALIENS
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.
88
LESSON
ALIENS
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.
89
LESSON
ALIENS
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.
90
LESSON
ALIENS
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
91
LESSON
ALIENS
92
LESSON
ALIENS
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.
93
LESSON
ALIENS
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.
94
LESSON
ALIENS
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.
LESSON
ALIENS
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
96
LESSON
ALIENS
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.
Have the taxpayers employer pay out any bonuses after January
1st.
LESSON
ALIENS
December 31st.
LESSON
ALIENS
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.
Lesson Summary
An alien has one of the following statuses:
LESSON
ALIENS
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.
100
LESSON
ALIENS
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
101
LESSON
ALIENS
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.
102
LESSON 5 - FILING
A TAX RETURN
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:
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
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.
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
104
LESSON 5 - FILING
A TAX RETURN
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
105
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
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.
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:
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
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:
Tax Tip
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
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.
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
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.
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:
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
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 a spouse has died during the year and the personal representative
of the estate elects to file a separate return
110
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
Tax Tip
AND you...
Medical Expenses
111
LESSON 5 - FILING
A TAX RETURN
IF you paid...
STATUSES
AND
AND you...
Property Tax
Mortgage Interest
Casualty Loss
WHO
SHOULD
FILE
Tax Tip
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
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:
Welfare payments are not considered amounts that the taxpayer provides
to keep up a home.
113
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
Tax Tip
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:
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
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
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.
115
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
Must Be Taxpayer's
Dependent?
Qualifying child
Married child
Parent
No
Yes
Other relatives
Yes
116
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
Tax Tip
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
117
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
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
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.
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
119
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
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:
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 furnished over half the cost of keeping up the child's home for
the entire year
120
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
Filing
Status
Marital Status
Conditions
Single
Married
S
HH
MJ / MS
HH
Widowed
Divorced/Legally
Separated
MJ
HH / QW
QW
No dependents
HH
MJ / MS
HH
Tax Tip
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
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
123
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
Use either the Married Filing Jointly filing status or the Married Filing
Separately status
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):
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
Yes
Qualifying widow(er)
No
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
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:
status is:
was:
Single
under 65
$10,150
65 or older *
$11,700
$20,300
$21,500
filing jointly
*
both spouses 65 or
$22,700
older*
Married, living together any age
$3,950
$3,950
under 65
$13,050
65 or older *
$14,600
Qualifying widow(er)
under 65
$16,350
65 or older *
$17,550
126
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
However, dependents who are not required to file should file a return to
claim:
Figure 5-7: The Tax and Credits section of Form 1040 with the Age and Blindness
section highlighted.
Special taxes
127
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
If any of the four conditions listed below apply, a tax return must be filed.
1. The taxpayer owes any special taxes, such as:
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
LESSON 5 - FILING
A TAX RETURN
STATUSES
AND
WHO
SHOULD
FILE
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:
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
For the first and second years after the spouse's death, the widowed
taxpayer with dependent child(ren):
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
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
LESSON
PERSONAL
AND
DEPENDENCY
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
LESSON
PERSONAL
AND
DEPENDENCY
EXEMPTIONS
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.)
135
LESSON
PERSONAL
AND
DEPENDENCY
EXEMPTIONS
Your father, mother, grandparent, or other direct ancestor, but not foster
parent.
Any of these relationships that were established by marriage are not ended by
death or divorce.
1
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
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:
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.
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
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.
LESSON
PERSONAL
AND
DEPENDENCY
EXEMPTIONS
parent.
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:
143
LESSON
PERSONAL
AND
DEPENDENCY
EXEMPTIONS
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:
Stepmother or stepfather
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.
144
LESSON
PERSONAL
AND
DEPENDENCY
EXEMPTIONS
TAX TIP
Death of a Dependent
You can claim a deceased family member as a dependent if both if these
apply:
Also, if the deceased dependent let you qualify for these benefits, you
can still have the benefits in the year your dependent died:
TAX TIP
LESSON
PERSONAL
AND
DEPENDENCY
EXEMPTIONS
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:
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)
146
LESSON
PERSONAL
AND
DEPENDENCY
EXEMPTIONS
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
147
LESSON
PERSONAL
AND
DEPENDENCY
EXEMPTIONS
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 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:
LESSON
PERSONAL
AND
DEPENDENCY
EXEMPTIONS
child, and that the non-custodial parent can claim the exemption for
the child without regard to any condition
TAX TIP
LESSON
PERSONAL
AND
DEPENDENCY
EXEMPTIONS
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
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.
150
LESSON
PERSONAL
AND
DEPENDENCY
EXEMPTIONS
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
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.
151
LESSON
PERSONAL
AND
DEPENDENCY
EXEMPTIONS
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 only exception to the gross income test is for a disabled person in a
sheltered workshop.
152
LESSON
PERSONAL
AND
DEPENDENCY
EXEMPTIONS
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.
153
LESSON
INCOME
PART
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.
154
LESSON
INCOME
PART
Wages and other employment income are included on Form W-2, prepared
by the employer, and mailed to the taxpayer.
155
LESSON
INCOME
PART
Interest
Dividends
Refunds of state and local taxes
Alimony or separate maintenance payments received
Business income
Capital gains
Sale or conversion of property
156
LESSON
INCOME
PART
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:
157
LESSON
INCOME
PART
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
Inheritances
Insurance and certain other payments for physical injury and sickness
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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LESSON
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PART
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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LESSON
INCOME
PART
Figure 7-4: Copy C of Form 1099-LTC - Long-term Care and Accelerated Death Benefits.
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:
LESSON
INCOME
PART
SIDE BAR
TAX TIP
LESSON
INCOME
PART
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.
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:
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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LESSON
INCOME
PART
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.
LESSON
INCOME
PART
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:
Form 1040A
Taxpayers can use Form 1040A to report all the types of income that can be
reported on Form 1040EZ, plus:
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
164
LESSON
INCOME
PART
or below it.
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.
165
LESSON
INCOME
PART
Figure 7-7: Form W-2 - Wage and Tax Statement with box 1 "Wages, tips, other
compensation" highlighted.
LESSON
INCOME
PART
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
Exempt
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
Exempt
Exempt
Exempt
1
Exempt
Exempt
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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.
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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
LESSON
INCOME
PART
Other Rules:
LESSON
INCOME
PART
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.
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LESSON
INCOME
PART
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.
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INCOME
PART
TAX TIP
174
LESSON
INCOME
PART
Figure 7-8: The Other Taxes section of Form 1040 with line 60a "Household employment
taxes from Schedule H" highlighted.
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.
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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.
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
Any Form W-2 that is different from other Forms W-2 issued by the
same employer
177
LESSON
INCOME
PART
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:
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LESSON
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PART
TAX TIP
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 7-11: 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
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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:
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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'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:
LESSON
INCOME
PART
the employer. These tips are subject to social security and Medicare
tax.
A degree candidate
Tax free
Taxable
Tax free
Taxable
Tax free
Taxable
Tax free
183
LESSON
INCOME
PART
Taxable
Tax free
Taxable
Taxable
Taxable
Taxable
Taxable
A degree candidate
Taxable
Taxable
SIDE BAR
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
Figure 7-14: The income section of Form 1040 with line 8a "Taxable interest" highlighted.
185
LESSON
INCOME
PART
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.
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LESSON
INCOME
PART
TAX TIP
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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LESSON
INCOME
PART
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.
Series E
Bond Maturity
40
yrs. after issue
Date
Series E
Series EE
January 1980-present
Savings Notes
(Freedom Shares)
Series H
Series HH
January 1980-present
Series I Bonds
Present
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...
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LESSON
IF...
INCOME
PART
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.
189
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190
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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.
LESSON
INCOME
PART
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
LESSON
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PART
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:
LESSON
INCOME
PART
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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PART
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:
LESSON
INCOME
PART
Form 1040A
Taxpayers can use Form 1040A to report all the types of income that can be
reported on Form 1040EZ, plus:
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 different from other Forms W-2 issued by the
same employer
LESSON
INCOME
PART
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
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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LESSON
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PART
II
Figure 8-1: Form 1099-INT - Interest Income with box 1 "Interest Income" highlighted.
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.
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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LESSON
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PART
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
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,
203
LESSON
INCOME
PART
II
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:
LESSON
INCOME
PART
II
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
LESSON
INCOME
PART
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
Figure 8-4: The Income section of Form 1040 with line 8b "Tax-exempt interest"
highlighted.
LESSON
INCOME
PART
II
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
10%
15%
25%
28%
33%
35%
39.6%
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
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LESSON
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PART
II
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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PART
II
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.
Then in Part I double click again to drill down to the Interest Income
Worksheet.
209
LESSON
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PART
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
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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II
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
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II
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.
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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II
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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LESSON
INCOME
PART
II
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
215
LESSON
INCOME
PART
II
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:
216
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II
Figure 8-15: Form 1040 Schedule B, Part III, Foreign Accounts and Trusts.
the combined value of the accounts was $10,000 or less during the
year;
If these exceptions don't apply, check the "yes" box. Also check the "yes"
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LESSON
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PART
II
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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II
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.
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II
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PART
II
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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PART
II
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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II
...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
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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PART
II
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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II
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
Federal Employees'
LESSON
INCOME
PART
II
Type of Benefit
General Rule
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
Disability Benefits
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II
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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LESSON
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PART
II
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
LESSON
INCOME
PART
II
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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II
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:
The above payments are neither deductible by the payer nor includible in
income by the recipient.
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II
SIDE BAR
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...
income-producing
property (such as an
interest in a business,
rental property, stocks,
or bonds)
interest in a passive
activity with unused
passive activity losses
231
LESSON
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PART
II
THEN you...
investment credit
property with recapture
potential
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...
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LESSON
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II
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
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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LESSON
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PART
II
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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LESSON
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II
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
$420.00
The employer may also owe state unemployment tax. Employers who pay state
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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II
Figure 8-27: The Adjusted Gross Income section of Form 1040 with line 36
highlighted.
LESSON
INCOME
PART
II
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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II
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:
LESSON
INCOME
PART
II
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
LESSON
INCOME
PART
II
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.
Other Income
Line 21 of Form 1040 is used to report income from other sources, such as:
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TAX TIP
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
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PART
punitive damages
II
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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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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II
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II
Important Reminders
Take the Quiz - Taking each lesson's quiz promptly after lesson
completion will help you solidify you're understanding of the
most important lesson content, and will also help you pass the
Final Exam.
Do the Homework - While completing the homework is not
mandatory, we strongly recommend that you complete each
lesson's homework assignment. It will expand your knowledge
and understanding of the topics covered in this course.
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LESSON
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EMPLOYMENT
INCOME
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
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LESSON
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EMPLOYMENT
INCOME
Checklist
Summary of Employment
Taxes and Forms
General Business Credits
Business Tax Return Due
Dates
IRS Publications for 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:
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LESSON
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EMPLOYMENT
INCOME
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
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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EMPLOYMENT
INCOME
SIDE BAR
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.
LESSON
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EMPLOYMENT
INCOME
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
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INCOME
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.
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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:
Have each employee fill out IRS Form W-4, Employee's Withholding
Allowance Certificate, and keep them on file.
File IRS Form 941, Employer's Quarterly Federal Tax Return, after the
end of each quarter.
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INCOME
File a Form W-2 for each employee annually to report wages to the
IRS and state.
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...
Changed a bank
account
Changed a type of
organization
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
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EMPLOYMENT
INCOME
IF the applicant....
AND...
estate
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
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".
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INCOME
An independent contractor
A common-law employee
A statutory employee
A statutory nonemployee
LESSON
SELF
EMPLOYMENT
INCOME
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.
Services
Rendered
Personally
Hiring,
Supervising
and Paying
Assistance
Continuing
Relationship
Integration
Set Hour of
Work
Full Time
Required
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INCOME
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
Submits no reports.
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
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INCOME
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INCOME
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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INCOME
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 by:
15th day of 4th month
after end of the tax year.
Schedule SE
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LESSON
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EMPLOYMENT
INCOME
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)
Providing information on
Social Security and
Medicare taxes and
income tax withholding
January 31
Federal Unemployment
Tax (FUTA)
940
January 31
Excise Tax
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
See the form instructions if you go out of business, change the form of your
business, or stop paying wages.
LESSON
SELF
EMPLOYMENT
INCOME
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
LESSON
SELF
EMPLOYMENT
INCOME
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
Over $1
million
Over $25
million
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:
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INCOME
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.
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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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INCOME
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:
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
268
capital expenditures
charitable contributions by a
LESSON
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EMPLOYMENT
Deductible Expenses:
INCOME
Non-deductible Expenses:
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INCOME
Account statements
Canceled checks
Cash register tape receipts
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LESSON
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INCOME
SIDE BAR
TAX TIP
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INCOME
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.
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.
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INCOME
TAX TIP
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INCOME
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
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INCOME
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INCOME
Figure 9-2: The Income section of Form 1040 with line 12 "Business income or (loss)"
highlighted.
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
281
LESSON
SELF
EMPLOYMENT
INCOME
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.
LESSON
SELF
EMPLOYMENT
INCOME
Figure 9-3: Form W-2 - Wage and Tax Statement with box 13 "Statutory employee"
highlighted.
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
283
LESSON
SELF
EMPLOYMENT
INCOME
TAX TIP
LESSON
SELF
EMPLOYMENT
INCOME
LESSON
SELF
EMPLOYMENT
Expense
Home office
Rent on equipment and machinery
Interest
INCOME
LESSON
SELF
EMPLOYMENT
INCOME
The table below shows what information must be produced for business
expense tax deductions:
287
LESSON
IF you have
expenses for...
Travel
Entertainment
SELF
EMPLOYMENT
INCOME
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
EMPLOYMENT
INCOME
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.
LESSON
SELF
EMPLOYMENT
INCOME
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
SELF
Tax Treatment
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
Costs of Equipment
Obsolescence
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.
291
LESSON
SELF
EMPLOYMENT
INCOME
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
Deductible travel expenses while away from home include, but are
not limited to, the costs of:
LESSON
SELF
EMPLOYMENT
INCOME
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.
293
LESSON
SELF
EMPLOYMENT
INCOME
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.
294
LESSON
SELF
EMPLOYMENT
INCOME
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:
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:
295
LESSON
SELF
EMPLOYMENT
INCOME
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:
vehicles depreciated using any method other than straight line for
which the taxpayer claimed any special depreciation allowance
296
LESSON
SELF
EMPLOYMENT
INCOME
Amount
2007
2008
2009
2010
2011
2012 - 2013
2014
TAX TIP
TAX TIP
LESSON
SELF
EMPLOYMENT
INCOME
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:
LESSON
SELF
EMPLOYMENT
INCOME
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:
299
LESSON
SELF
EMPLOYMENT
INCOME
TAX TIP
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.
300
LESSON
SELF
EMPLOYMENT
INCOME
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:
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.
301
LESSON
SELF
EMPLOYMENT
INCOME
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.
302
LESSON
SELF
EMPLOYMENT
INCOME
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.
303
LESSON
SELF
EMPLOYMENT
INCOME
304
LESSON
SELF
EMPLOYMENT
INCOME
Flowchart: Schedule SE
305
LESSON
SELF
EMPLOYMENT
INCOME
They have filed Form 4361 - Application for Exemption From SelfEmployment Tax for Use by Ministers, Members of Religious Orders
and Christian Science Practitioners, and
306
LESSON
SELF
EMPLOYMENT
INCOME
The table below shows the Social Security and Medicare tax rates:
$118,500.00
6.20%
$7,347.00
6.20%
$7,347.00
12.40%
1
$14,694.00
Unlimited
1.45%
1.45%
2.90%
Footnotes:
Self employed persons are entitled to deduct one-half of their self
Figure 9-5: The Adjusted Gross Income section of Form 1040 with line 27 "Deductible part
of self-employment tax" highlighted.
307
LESSON
SELF
EMPLOYMENT
INCOME
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
308
LESSON
SELF
EMPLOYMENT
INCOME
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.
309
LESSON
SELF
EMPLOYMENT
INCOME
310
LESSON
SELF
EMPLOYMENT
311
INCOME
LESSON
SELF
EMPLOYMENT
INCOME
312
LESSON
SELF
EMPLOYMENT
INCOME
LESSON
SELF
EMPLOYMENT
INCOME
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
314
LESSON
SELF
EMPLOYMENT
INCOME
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
315
LESSON
SELF
EMPLOYMENT
INCOME
Personal Property
Inventory
LESSON
SELF
EMPLOYMENT
INCOME
cars and other vehicles (but not those exceeding 14,000 pounds or
those that are unlikely to be used for personal purposes)
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
317
LESSON
SELF
EMPLOYMENT
INCOME
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
LESSON
SELF
EMPLOYMENT
INCOME
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:
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.
5-year property:
Appliances, carpets, furniture, etc., used in a residential rental real estate activity.
7-year property:
319
LESSON
SELF
EMPLOYMENT
INCOME
Any natural gas gathering line placed in service after April 11, 2005.
10-year property:
15-year property:
Certain improvements made directly to land or added to it (such as shrubbery,
fences, roads, and bridges)
20-year property:
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.
320
LESSON
SELF
EMPLOYMENT
INCOME
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:
321
LESSON
SELF
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
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
322
LESSON
SELF
EMPLOYMENT
INCOME
323
LESSON
SELF
EMPLOYMENT
INCOME
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.
324
LESSON
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EMPLOYMENT
INCOME
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.
325
LESSON
SELF
EMPLOYMENT
INCOME
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
Typewriters
Calculators
Copiers
5 years
6 years
Automobiles
5 years
5 years
Light trucks
5 years
5 years
Stoves
Refrigerators
5 years
9 years
Carpets
5 years
9 years
5 years
9 years
7 years
10 years
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
326
LESSON
SELF
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.
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.
327
LESSON
SELF
EMPLOYMENT
INCOME
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.
328
LESSON
SELF
EMPLOYMENT
INCOME
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
329
LESSON
SELF
EMPLOYMENT
INCOME
TAX TIP
TAX TIP
LESSON
SELF
EMPLOYMENT
INCOME
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,
331
LESSON
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EMPLOYMENT
INCOME
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.
LESSON
SELF
EMPLOYMENT
INCOME
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.
LESSON
SELF
EMPLOYMENT
INCOME
Loss on sale of
small business
stock
1245
1250
1252
Gains from
personal business
assets and
commercial real
estate
Gain on certain
farmland held for
1-10 years
334
LESSON
SELF
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
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
335
LESSON
SELF
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:
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.
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.
336
LESSON
SELF
EMPLOYMENT
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%
LESSON
SELF
EMPLOYMENT
INCOME
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:
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
LESSON
SELF
EMPLOYMENT
INCOME
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
LESSON
SELF
EMPLOYMENT
INCOME
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
LESSON
SELF
EMPLOYMENT
INCOME
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
341
LESSON
SELF
EMPLOYMENT
INCOME
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.
342
LESSON
SELF
EMPLOYMENT
INCOME
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
LESSON
SELF
EMPLOYMENT
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
344
LESSON
SELF
EMPLOYMENT
INCOME
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.
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
LESSON
SELF
EMPLOYMENT
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
SelfEmployment
Taxes
Employment
Taxes
Information
Returns
346
LESSON
SELF
EMPLOYMENT
INCOME
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
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
Yes
An EIN must be
included on all
employment tax
returns.
348
LESSON
SELF
EMPLOYMENT
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
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
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.
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
IRS
Form
8846
8844
8908
8909
See
Chapter
2 of
Pub.
510
8864;
6478;
8896;
8907.
8941
8845
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
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
351
8881
334
8835
334
6765
5884;
8850.
LESSON
SELF
EMPLOYMENT
INCOME
SIDE BAR
(1)
Extension
Form 4768 for a
six month
extension.
April 15th
May 15th
April 15th
April 15th
March 15th
March 15th
S-Corporations &
LLCs taxed as SCorps
Forms 5500:
July 31st
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:
352
LESSON
SELF
EMPLOYMENT
(1)
INCOME
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
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
353
LESSON
SELF
EMPLOYMENT
INCOME
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.
354
LESSON
SELF
EMPLOYMENT
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.
355
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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
10
SALE
OF
INVESTMENT
PROPERTY
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:
Figure 10-1: Form 1099-B - Proceeds From Broker and Barter Exchange Transactions.
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.
357
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
Taxpayers should not file these items with the return; instead, they should
keep them with their records.
SIDE BAR
then the
maximum
tax rate is
28%
28%
25%
358
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
then the
maximum
tax rate is
20%
15%
0%
39.6%
60 days or more
20%
60 days or more
15%
60 days or more
0%
39.6%
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:
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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.
360
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
Figure 10-3: Form 1099-DIV - Dividends and Distributions with box 2a "Total capital
gain distr." highlighted.
SIDE BAR
361
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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.
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
SALE
OF
INVESTMENT
PROPERTY
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.
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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.
Non-taxable exchanges
Gifts
Real Property
Real Property (repossessed)
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
366
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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.
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.
367
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
TAX TIP
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
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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.
369
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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.
371
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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.
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.
372
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
shows stock sales and other types of distributions, such as dividends and
interest.
TAX TIP
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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.
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
TAX TIP
376
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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.
377
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
TAX TIP
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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."
379
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
TAX TIP
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.
380
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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:
384
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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.
385
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
The first tax year for which the election is effective; and
386
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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%
LESSON
10
SALE
OF
INVESTMENT
PROPERTY
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.
388
LESSON
11
SALE
OF
HOME
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.
Have sold the home that has been their main home
Meet the ownership and use test
389
LESSON
11
SALE
OF
HOME
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) :
(2)
TAX TIP
390
LESSON
11
SALE
OF
HOME
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
LESSON
11
SALE
OF
HOME
House
Houseboat
Mobile home
Cooperative apartment, or
Condominium
392
LESSON
11
SALE
OF
HOME
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
LESSON
11
SALE
OF
HOME
agreement, the other ex-spouse can continue to occupy the home for
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:
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
394
LESSON
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SALE
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HOME
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:
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:
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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.
396
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LESSON
11
SALE
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HOME
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
Casualty losses:
Restoring damaged
property
Legal fees:
Cost of defending title
Fees for reduction of and
assessment
Zoning costs.
TAX TIP
LESSON
11
SALE
OF
HOME
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
LESSON
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SALE
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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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LESSON
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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.
401
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LESSON
11
SALE
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HOME
403
LESSON
11
SALE
OF
HOME
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.
404
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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
405
LESSON
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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.
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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LESSON
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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:
LESSON
11
SALE
OF
HOME
SIDE BAR
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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INCOME
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
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INCOME
Taxation of Individual
Retirement Arrangements
Traditional IRA
Contributions
Pension Withholding and
Estimated Tax Payments
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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LESSON
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INCOME
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.
413
LESSON
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PENSION
INCOME
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.
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INCOME
SIDE BAR
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
LESSON
12
PENSION
INCOME
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:
TAX QUOTE
"The income tax has made more liars out of the American people than golf
has."
Will Rogers
416
LESSON
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PENSION
INCOME
417
LESSON
12
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
418
LESSON
12
PENSION
INCOME
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
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
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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INCOME
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INCOME
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)
LESSON
12
PENSION
INCOME
TAX TIP
Year of Birth
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
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LESSON
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PENSION
INCOME
Year of Birth
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
67
60
0.5
30
LESSON
12
PENSION
INCOME
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
LESSON
12
PENSION
INCOME
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.
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INCOME
RRA has two components. Tier 1 is the equivalent of social security benefits
and Tier 2 is like an employer's pension plan.
Form 1099-R
Form 1099-R is used by payers to report distributions from:
Pensions
Annuities
Retirement or profit sharing plans
IRAs
Insurance contracts
427
LESSON
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TAX TIP
LESSON
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INCOME
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.
LESSON
12
PENSION
INCOME
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.
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LESSON
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INCOME
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 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.
431
LESSON
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INCOME
432
LESSON
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INCOME
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
"Cliff" vesting which provides no vested benefit until the 3rd year.
After 3 years of participation 100% of the employer's contributions
are vested.
Traditional IRA
Savings Incentive Match Plans for Employees (SIMPLE) IRA
Simplified Employee Pension (SEP) IRA
Roth IRA
433
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
434
LESSON
12
PENSION
INCOME
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
435
LESSON
12
PENSION
INCOME
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.
436
LESSON
12
PENSION
INCOME
Filing Status
Base Income
$25,000
$32,000
$0
Base Income
none
$25,000 to $34,000
over $34,000
none
$32,000 to $44,000
over $44,000
more than $0
437
LESSON
12
PENSION
INCOME
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)
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.
438
LESSON
12
PENSION
INCOME
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.
LESSON
12
PENSION
INCOME
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.
LESSON
12
PENSION
INCOME
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.
441
LESSON
12
PENSION
INCOME
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
442
LESSON
12
PENSION
INCOME
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:
LESSON
12
PENSION
INCOME
Ten-year tax option to figure the tax on the total taxable amount
TAX TIP
444
LESSON
12
PENSION
INCOME
TAX TIP
LESSON
12
PENSION
INCOME
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 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:
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
446
LESSON
12
PENSION
INCOME
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.
LESSON
12
PENSION
INCOME
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.
448
LESSON
12
PENSION
INCOME
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).
449
LESSON
12
PENSION
INCOME
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.
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.
450
LESSON
12
PENSION
INCOME
TAX TIP
LESSON
12
PENSION
INCOME
LESSON
12
PENSION
INCOME
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
453
LESSON
12
PENSION
INCOME
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:
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.
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
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
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
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
TAX TIP
Multiply by the number of months the home was used for each
purpose
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
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
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
Is a capital expenditure
Increases the basis of the property
Must be depreciated
TAX TIP
462
LESSON
13
RENTAL
INCOME
AND
EXPENSES
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:
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:
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
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
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.
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:
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
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
468
LESSON
13
RENTAL
INCOME
AND
EXPENSES
Self-Employment Tax
TAX TIP
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:
470
LESSON
13
RENTAL
INCOME
AND
EXPENSES
Taxpayers with rental losses may be required to file Form 8582 - Passive
Activity Loss Limitations.
SIDE BAR
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
LESSON
14
FOREIGN
EARNED
INCOME
EXCLU SION
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
473
LESSON
14
FOREIGN
EARNED
INCOME
EXCLU SION
Eligibility Requirements
To claim the foreign earned income exclusion the taxpayer must:
"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.
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
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?
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:
LESSON
14
FOREIGN
EARNED
INCOME
EXCLU SION
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
478
LESSON
14
FOREIGN
EARNED
INCOME
EXCLU SION
TAX TIP
LESSON
14
FOREIGN
EARNED
INCOME
EXCLU SION
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.
480
LESSON
14
FOREIGN
EARNED
INCOME
EXCLU SION
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
481
LESSON
14
FOREIGN
EARNED
INCOME
EXCLU SION
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
482
LESSON
14
FOREIGN
EARNED
INCOME
EXCLU SION
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:
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
483
LESSON
14
FOREIGN
EARNED
INCOME
EXCLU SION
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.
484
LESSON
14
FOREIGN
EARNED
INCOME
EXCLU SION
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.
485
LESSON
14
FOREIGN
EARNED
INCOME
EXCLU SION
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.
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.
486
LESSON
14
FOREIGN
EARNED
INCOME
EXCLU SION
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.
LESSON
14
FOREIGN
EARNED
INCOME
EXCLU SION
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.
488
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
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)
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
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 15-2: The Adjusted Gross Income section of Form 1040 with line 29 "Self-employed
health insurance deduction" highlighted.
490
LESSON
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ADJUSTMENTS
TO
INCOME
PART
Figure 15-3: The Adjusted Gross Income section of Form 1040 with line 36
highlighted.
2015 Individual
$2,200
$3,300
$4,450
65% of deductible
2015 Family
$4,450
$6,650
$8,150
75% of deductible
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
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
492
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
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.
493
LESSON
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ADJUSTMENTS
TO
INCOME
PART
The interest or other earnings on the assets in the account are tax
free
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.
494
LESSON
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ADJUSTMENTS
TO
INCOME
PART
The table below shows the amount of HSA deductible contributions and
limits:
Qualifications:
taxpayer must not be covered under another health plan or enrolled in Medicare
Parts A or B
495
LESSON
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ADJUSTMENTS
TO
INCOME
PART
496
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
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.
497
LESSON
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ADJUSTMENTS
TO
INCOME
PART
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).
498
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
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.
499
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
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
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
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
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.
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
the entire
reimbursement
reported as wages in
box 1
no reimbursement
moving expenses
moving expenses
Employee Must:
claimed.
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
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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LESSON
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ADJUSTMENTS
TO
INCOME
PART
The table below shows the Social Security and Medicare maximum
wages subject to tax and the tax rates:
$118,500.00
6.20%
$7,347.00
6.20%
$7,347.00
12.40%
1
$14,694.00
Unlimited
1.45%
1.45%
2.90%
Footnotes:
Self employed persons are entitled to deduct one-half of their self
Figure 15-8: The Other Taxes section of Form 1040 with line 57 "Self-employment tax"
highlighted.
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
Publication 517 - Social Security and Other Information for Members of the
Clergy and Religious Workers.
SIDE BAR
Figure 15-9: The Adjusted Gross Income section of Form 1040 with line 28 "Self-employed
SEP, SIMPLE, and qualified plans" highlighted.
504
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
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
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
505
LESSON
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ADJUSTMENTS
TO
INCOME
PART
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.
506
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
$210,000
Traditional IRA
Roth IRA
SEP-IRA
SIMPLE IRA
October 1st
December 31st
December 31st
December 31st
401(k) Plan
December 31st
507
LESSON
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ADJUSTMENTS
TO
INCOME
PART
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
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:
508
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
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
509
LESSON
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ADJUSTMENTS
TO
INCOME
PART
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.
510
LESSON
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ADJUSTMENTS
TO
INCOME
PART
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.
511
LESSON
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ADJUSTMENTS
TO
INCOME
PART
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:
512
LESSON
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ADJUSTMENTS
TO
INCOME
PART
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:
The above payments are neither deductible by the payer nor includible in
income by the recipient.
TAX TIP
LESSON
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ADJUSTMENTS
TO
INCOME
PART
divorce
THEN you...
income-producing
property (such as an
interest in a business,
rental property, stocks,
or bonds)
interest in a passive
activity with unused
passive activity losses
investment credit
property with recapture
potential
includes an amount in
gross income when he or
she exercises the stock
options or when the
deferred compensation
is paid or made available
514
LESSON
15
ADJUSTMENTS
IF you transfer...
THEN you...
TO
INCOME
PART
TAX TIP
TAX TIP
TAX TIP
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
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:
516
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
The interest or other earnings on the assets in the account are tax
free
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.
517
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
518
LESSON
15
ADJUSTMENTS
TO
INCOME
PART
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.
519
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
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
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
Figure 16-1: The Adjusted Gross Income section of Form 1040 with line 32 "IRA
deduction" highlighted.
521
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
Figure 16-2: Form W-2 - Wage and Tax Statement with box 13 "Retirement plan"
highlighted.
522
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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
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
increments
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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 +
TAX QUOTE
524
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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)
525
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
Traditional IRA
Roth IRA
SEP-IRA
SIMPLE IRA
October 1st
December 31st
December 31st
December 31st
401(k) Plan
December 31st
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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.
The taxpayer meets the exceptions below and pays medical costs
The distribution is $10,000 or less and used for qualified first time
home buyer expenses
527
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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.
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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.
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:
529
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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
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:
530
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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
531
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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:
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
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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.
533
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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
$100,000-$150,000
$50,000-$75,000
$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
$36,000-$60,000
$18,000-$30,000
No Limit
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
534
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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
535
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
536
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
The deduction is not available for the same student in the year the
American Opportunity or Lifetime Learning Credit is taken.
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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
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.
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.
LESSON
16
ADJUSTMENTS
TO
INCOME
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.
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.
540
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
Figure 16-7: The Adjusted Gross Income section of Form 1040 with line 34 "Tuition
and fees" highlighted.
541
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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
Figure 16-9: The Income section of Form 1040 with line 21 "Other income"
highlighted.
542
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
Figure 16-10: The Adjusted Gross Income section of Form 1040 with line 36 highlighted.
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.
543
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
544
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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:
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
Figure 16-12: The Adjusted Gross Income section of Form 1040 with line 36
highlighted.
546
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
TAX TIP
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
547
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
Feature
Description
cannot be from a related person or made
under a qualified employer plan.
Student
qualifications
Time limit on
deduction
Phase-out
LESSON
16
ADJUSTMENTS
TO
INCOME
PART
II
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.
549
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
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
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
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
What is an IRA?
Roth IRA
SIMPLE IRA
Coverdell Education Savings Account (ESA)
TAX TIP
SIDE BAR
551
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
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
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
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
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
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
553
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
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.
554
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
555
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
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:
for
the
spouse
with
the
greater
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
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.
IRA Rollovers
Taxpayers can avoid additional taxes and penalties by rolling over funds to
their traditional IRA from the following retirement plans:
TAX TIP
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
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.
558
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
The 10% Early Withdrawal Penalty for withdrawals prior to age 59 1/2 does
not apply to the following taxable IRA Distributions:
Disability or Death.
559
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
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
560
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
TAX TIP
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
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:
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
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.
563
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
Figure 17-4: The Adjusted Gross Income section of Form 1040 with line 37 "Adjusted
Gross Income" highlighted.
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
17
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
No tax deduction
is allowed at...
$70,000 +
$116,000 +
$191,000 +
$10,000 +
LESSON
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
Figure 17-6: The Adjusted Gross Income section of Form 1040 with line 32 "IRA
deduction" highlighted.
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
17
INDIVIDUAL
RETIREMENT
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.
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
17
INDIVIDUAL
RETIREMENT
ACCOUNTS
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
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:
569
LESSON
17
INDIVIDUAL
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
PART I
18
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
571
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.
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
LESSON
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
$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
573
LESSON
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
The following taxpayers are not eligible to use the standard deduction:
those who are filing a tax return for a short tax year because they are
changing to a fiscal year
574
LESSON
PART I
18
STANDARD
AND
ITEMIZED
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
575
LESSON
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
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
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
Figure 18-3: The Medical and Dental Expenses section of Form 1040 Schedule A Itemized Deductions.
577
LESSON
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
TAX TIP
578
Diaper service
Diet foods
LESSON
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
Legal abortion
Maternity clothes
579
LESSON
PART I
18
STANDARD
AND
ITEMIZED
for details).
DEDU CTIONS
your car.
Nonprescription drugs or
medicines.
Toothpaste, toiletries,
cosmetics, etc.
580
LESSON
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
TAX TIP
LESSON
PART I
18
STANDARD
AND
ITEMIZED
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
582
LESSON
PART I
18
STANDARD
AND
ITEMIZED
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
LESSON
PART I
18
STANDARD
AND
ITEMIZED
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
Income Tax
You CANNOT
deduct the
following taxes
Federal income tax.
Employee
contributions to
LESSON
PART I
18
STANDARD
Tax
AND
ITEMIZED
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
DEDU CTIONS
You CANNOT
deduct the
following taxes
private or voluntary
disability plans.
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
Occupational tax.
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.)
LESSON
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
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
annuities
endowment contracts
municipal bonds
single-premium life insurance policies
straddle options
TAX TIP
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.
LESSON
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
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
TAX TIP
591
LESSON
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
Figure 18-6: Form 1098 - Mortgage Interest Statement with box 1 "Mortgage interest
received from payer(s)/borrower(s)" highlighted.
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
592
LESSON
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
TAX TIP
SIDE BAR
593
LESSON
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
TAX TIP
Appraisal fee for determining the value of the property for the
lender
Attorneys fees for preparing and reviewing the loan and closing
documents
LESSON
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
Recording fee payable to the city or county for recording the deed
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 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
597
LESSON
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
TAX TIP
AND your
home is...
Mortgage
Payments
(principal and
interest)
jointly owned
Real Estate
Taxes and
Home
held as tenants
in common
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
Insurance
home insurance
held as tenants
by the entirety
or in joint
tenancy
none of the
payments
TAX TIP
TAX TIP
599
LESSON
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
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
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:
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.
LESSON
PART I
18
STANDARD
AND
ITEMIZED
DEDU CTIONS
home equity debt does not exceed the lesser of $100,000 or the fair
market value of the home
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:
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
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:
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).
The points paid were not more than the amount generally charged
in that area.
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 uses the loan to buy or build his main home.
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
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.
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
LESSON
PART II
19
STANDARD
AND
ITEMIZED
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:
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.
Churches, synagogues,
610
LESSON
PART II
19
STANDARD
AND
DEDUCTIONS
ITEMIZED
Homeowners' associations
Individuals
Non-charitable payments to
federal, state, or local
governments
Tuition
611
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
Un-reimbursed transportation
expenses that relate directly to
the services provided for the
organization
TAX TIP
612
LESSON
PART II
19
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
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.
613
LESSON
PART II
19
STANDARD
AND
ITEMIZED
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
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
Figure 19-4: The Gifts to Charity section of Form 1040 Schedule A - Itemized
Deductions.
Taxpayers:
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
616
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
Figure 19-5: The Casualty and Theft Losses section of Form 1040 Schedule A Itemized Deductions.
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
Appraisers fees are not a part of any deductible casualty loss. However,
618
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
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 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
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
Definition of Rule
619
LESSON
PART II
19
STANDARD
AND
ITEMIZED
$100 Rule
DEDUCTIONS
10% Rule
TAX TIP
620
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
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.
621
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
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
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
Miscellaneous Deductions
Miscellaneous itemized deductions are expenses a taxpayer pays in order
to:
TAX QUOTE
Figure 19-6: The Job Expenses and Certain Miscellaneous Deductions section of Form
1040 Schedule A - Itemized Deductions.
623
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
Job Expenses
Un-reimbursed employee business expenses can be deducted as a
miscellaneous itemized deduction subject to the 2% limitation. Examples
include:
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
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
and
TAX TIP
TAX TIP
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
SIDE BAR
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
Investment manager and planner fees to the extent that they relate
to taxable income;
Legal fees;
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
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:
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
629
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
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
631
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
Expense
Description
machine or other communication devices.
Tips
Other
632
LESSON
PART II
19
STANDARD
AND
633
ITEMIZED
DEDUCTIONS
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
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:
634
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
635
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
Figure 19-7: The Other Miscellaneous Deductions section (line 28) of Form 1040
Schedule A - Itemized Deductions.
636
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
Examples include:
Gambling Losses
Gambling winnings are reported on Form W-2G.
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.
637
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
Non-deductible Expenses
Some examples of non-deductible expenses include:
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
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 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.
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
The taxpayer uses the loan to buy or build his main home.
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
Points paid only for the use of money (as a form of interest) can be
deducted on Schedule A.
641
LESSON
PART II
19
STANDARD
AND
ITEMIZED
DEDUCTIONS
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.
642
LESSON
20
ALTERNATIVE
MINIMUM
TAX
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
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
643
LESSON
20
ALTERNATIVE
MINIMUM
TAX
LESSON
20
ALTERNATIVE
MINIMUM
TAX
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
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
LESSON
20
ALTERNATIVE
MINIMUM
TAX
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
646
LESSON
20
ALTERNATIVE
MINIMUM
TAX
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!
Figure 20-1: The Payments section of Form 1040 with line 73d "Credits from Form:"
highlighted.
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
647
LESSON
20
ALTERNATIVE
MINIMUM
TAX
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
LESSON
20
ALTERNATIVE
MINIMUM
TAX
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.
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
649
LESSON
20
ALTERNATIVE
MINIMUM
TAX
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.
650
LESSON
20
ALTERNATIVE
MINIMUM
TAX
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
651
LESSON
20
ALTERNATIVE
MINIMUM
TAX
652
LESSON
20
ALTERNATIVE
MINIMUM
TAX
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?"
653
LESSON
20
ALTERNATIVE
MINIMUM
TAX
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:
654
LESSON
20
ALTERNATIVE
MINIMUM
TAX
Income
Assess withholdings
Withholdings
Deductions
Investments
Business expenses
Credits
Retirements (IRAs, 401(k), etc.)
Tax reduction ideas
Estimated payments (if required)
November
Ongoing
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.
655
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
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.
656
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
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:
Figure 21-1: The Tax and Credits section of Form 1040 with line 49 "Credit for child
and dependent care expenses" highlighted.
657
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
TAX TIP
658
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
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
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
659
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
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.
660
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
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
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
661
$0
$12,950
$49,400
$127,550
$206,600
$405,100
$432,200
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
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:
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
Taxpayers must submit one of two forms with their tax return to claim the
credit:
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.
663
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
TAX QUOTE
"I am thankful for the taxes I pay because it means that I'm employed."
Nancie J. Carmody
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.
664
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
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
Wages
Salaries
Tips
Other taxable employee compensation
Net earnings from self-employment
Strike benefits
Disability pay reported as wages
A full-time student, or
Physically or mentally unable to care for himself or herself
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
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:
Payments to Relatives
Payments to relatives do not qualify as work-related expenses. Do not count
amounts paid to:
666
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
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
LESSON
CARE
21
CREDIT
FOR
CHILD
668
AND
DEPENDENT
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
Due Diligence
Taxpayers can show they used due diligence by obtaining and keeping any
of the following documents:
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.
669
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
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
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 overall limit of $3,000 for expenses paid for one qualifying
person or $6,000 for two or more qualifying persons
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
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:
671
LESSON
CARE
21
CREDIT
FOR
CHILD
AND
DEPENDENT
SIDE BAR
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:
The overall limit of $3,000 for expenses paid for one qualifying
person or $6,000 for two or more qualifying persons
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
22
CHILD
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
674
LESSON
22
CHILD
TAX
ISSUES
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:
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
22
CHILD
TAX
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 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.
LESSON
22
CHILD
TAX
ISSUES
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
LESSON
22
CHILD
TAX
ISSUES
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
$100,000-$150,000
$50,000-$75,000
$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
$36,000-$60,000
679
$18,000-$30,000
No Limit
LESSON
22
CHILD
TAX
ISSUES
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.
LESSON
22
CHILD
TAX
ISSUES
taxpayer's death. However, be aware of the "Kiddie Tax" limits, which are
discussed below.
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
22
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:
TAX TIP
682
LESSON
22
CHILD
TAX
ISSUES
683
LESSON
22
CHILD
TAX
ISSUES
684
LESSON
22
CHILD
TAX
ISSUES
685
LESSON
22
CHILD
TAX
ISSUES
686
LESSON
22
CHILD
TAX
ISSUES
For further information see Publication 929 - Tax Rules for Children and
Dependents.
687
LESSON
22
CHILD
TAX
ISSUES
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.
LESSON
22
CHILD
TAX
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:
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:
LESSON
22
CHILD
TAX
ISSUES
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
22
CHILD
TAX
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:
The credit is not "refundable". A taxpayer's Child Tax Credit is reduced if the
691
LESSON
22
CHILD
TAX
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.
692
LESSON
22
CHILD
TAX
ISSUES
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
693
LESSON
22
CHILD
TAX
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:
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.
694
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
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
695
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
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.
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
697
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
TAX QUOTE
Physician Statements
Permanent and total disability means that:
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.
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
Nontaxable:
Social Security,
Pensions,
Retirement
Disability less
than:
$5,000
$17,500
$7,500
$25,000
$5,000
$20,000
$7,500
$25,000
$7,500
$25,000
$5,000
$20,000
$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.
699
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
Figure 23-2: The Tax and Credits section of Form 1040 with line 54c "Other credits from
Form:" highlighted.
SIDE BAR
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
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:
701
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
703
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
$104.90
$146.90
$12.30
$209.80
$31.80
$272.70
$51.30
$335.70
$70.80
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
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
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
705
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
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
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
23
CREDIT
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
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.
707
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
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.
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
His name, address, city, state, zip code, and Social Security
number, and
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
709
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
SIDE BAR
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
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.
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
Figure 23-3: The Other Miscellaneous Deductions section (line 28) of Form 1040
Schedule A - Itemized Deductions.
712
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
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:
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.
713
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
Figure 23-5: Form 1099-B - Proceeds From Broker and Barter Exchange Transactions.
714
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
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.
715
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
$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/
716
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
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
717
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
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
718
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
Visit Schools
Target scholarships and note deadlines
Position financial affairs for Free Application for Federal Student
Aid (FAFSA)
Conduct college financial planning review
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
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
SIDE BAR
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
Student's Contributions:
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
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
722
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
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.
LESSON
23
CREDIT
FOR
THE
ELDERLY
OR
DISABLED
SIDE BAR
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.
724
LESSON
24
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"
725
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
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.
726
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
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:
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
727
LESSON
24
EDUCATION
CREDITS
AND
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
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.
$14,000 - Same as
Gift Tax. Contributions are nondeductible. Earnings
accrue tax free if
used for college. Gift
taxes apply.
Unlimited interest
exclusion.
The taxpayer
The taxpayer's spouse
728
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
729
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
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.
730
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
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
$100,000-$150,000
$50,000-$75,000
$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
$36,000-$60,000
731
$18,000-$30,000
No Limit
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
Figure 24-1: The Adjusted Gross Income section of Form 1040 with line 37 "Adjusted
Gross Income" highlighted.
TAX TIP
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
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:
Insurance
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
733
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
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.
734
LESSON
24
EDUCATION
CREDITS
735
AND
PROGRAMS
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
736
LESSON
24
EDUCATION
CREDITS
737
AND
PROGRAMS
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
(1)
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)
Figure 24-2: The Tax and Credits section of Form 1040 with line 50 "Education credits"
highlighted.
738
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
TAX TIP
739
LESSON
24
EDUCATION
CREDITS
740
AND
PROGRAMS
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
TAX QUOTE
"People who complain about paying their income tax can be divided into
two types: men and women."
Anonymous
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
No Double Benefits
Taxpayers cannot claim a double-benefit, which is two or more educationrelated benefits. For example, taxpayers cannot:
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.
Scholarships
742
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
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
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
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.
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
TAX TIP
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
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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LESSON
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EDUCATION
CREDITS
AND
PROGRAMS
LESSON
24
EDUCATION
CREDITS
Question
What is a Coverdell ESA?
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.
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LESSON
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PROGRAMS
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:
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
Figure 24-4: Form 1099-INT - Interest Income with box 3 "Interest on U.S. Savings Bonds
and Treas. obligations" highlighted.
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LESSON
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PROGRAMS
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.
Be working,
LESSON
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AND
PROGRAMS
LESSON
24
EDUCATION
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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.
753
LESSON
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EDUCATION
CREDITS
AND
PROGRAMS
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:
754
LESSON
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EDUCATION
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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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LESSON
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PROGRAMS
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:
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
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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PROGRAMS
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LESSON
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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:
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
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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LESSON
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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:
LESSON
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EDUCATION
CREDITS
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PROGRAMS
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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LESSON
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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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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
765
LESSON
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EDUCATION
CREDITS
AND
PROGRAMS
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
LESSON
24
EDUCATION
CREDITS
AND
PROGRAMS
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
25
EARNED
INCOME
TAX
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:
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
25
EARNED
INCOME
TAX
CREDIT
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 tax return that covers a 12-month period, unless filing a short
period return because of an individual's death
769
LESSON
25
EARNED
INCOME
TAX
CREDIT
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:
LESSON
25
EARNED
INCOME
TAX
CREDIT
$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.
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
Earned Income
Earned income includes:
LESSON
25
EARNED
INCOME
TAX
CREDIT
Some other types of "income" are also excluded for EIC purposes, such as:
Salary deferrals
Excludable dependent care benefits
Excludable education assistance
772
LESSON
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EARNED
INCOME
TAX
CREDIT
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:
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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LESSON
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EARNED
INCOME
TAX
CREDIT
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:
Permanently and totally disabled at any time during the tax year,
regardless of age
774
LESSON
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EARNED
INCOME
TAX
CREDIT
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LESSON
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EARNED
INCOME
TAX
CREDIT
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
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)
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.
776
LESSON
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EARNED
INCOME
TAX
CREDIT
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:
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:
Reduce overpayments
Improve participation of eligible EIC customers
LESSON
25
EARNED
INCOME
TAX
CREDIT
TAX QUOTE
"Why does a slight tax increase cost you two hundred dollars and a
substantial tax cut save you thirty cents?"
Peg Bracken
LESSON
25
EARNED
INCOME
TAX
CREDIT
be under age 19, or under age 24 and a full time student (enrolled
full time during any 5 months)
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
not have filed a joint tax return other than to claim a refund
Single
$14,590
$38,511
$43,756
$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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LESSON
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EARNED
INCOME
TAX
CREDIT
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
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.
780
LESSON
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EARNED
INCOME
TAX
CREDIT
LESSON
25
EARNED
INCOME
TAX
CREDIT
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
LESSON
25
EARNED
INCOME
TAX
CREDIT
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:
LESSON
25
EARNED
INCOME
TAX
CREDIT
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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LESSON
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EARNED
INCOME
TAX
CREDIT
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.
785
LESSON
26
FOREIGN
TAX
CREDIT
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
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.
786
LESSON
26
FOREIGN
TAX
CREDIT
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:
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.
787
LESSON
26
FOREIGN
TAX
CREDIT
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
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
788
LESSON
26
FOREIGN
TAX
CREDIT
Cuba
Iran
Libya
North Korea
Syria
Sudan
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)
789
LESSON
26
FOREIGN
TAX
CREDIT
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.
790
LESSON
26
FOREIGN
TAX
CREDIT
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)
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.
791
LESSON
26
FOREIGN
TAX
CREDIT
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
LESSON
26
FOREIGN
TAX
CREDIT
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
Part II: Addresses the amount of foreign taxes paid or that may be
owed (accrued)
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.
793
LESSON
26
FOREIGN
TAX
CREDIT
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
794
LESSON
26
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)
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)
Part I of Form 1116 is used to figure the taxable income from foreign
sources in each income category:
LESSON
26
FOREIGN
TAX
CREDIT
SIDE BAR
LESSON
26
FOREIGN
TAX
CREDIT
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
797
LESSON
26
FOREIGN
TAX
CREDIT
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.
798
LESSON
26
FOREIGN
TAX
CREDIT
You did not claim deductions or credits that should have been
claimed,
LESSON
26
FOREIGN
TAX
CREDIT
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,
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
800
LESSON
26
FOREIGN
TAX
CREDIT
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
LESSON
26
FOREIGN
TAX
CREDIT
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.
802
LESSON
27
MISCELLANEOUS
TAX
CREDITS
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
LESSON
27
MISCELLANEOUS
TAX
CREDITS
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
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.
LESSON
27
MISCELLANEOUS
Tax Credit
General
Business
Credits
IRS Form
8801
Mortgage
Interest Credit
8396
Residential
Energy Credits
5695
Retirement
Savings
Contribution
Credit
8880
3800
TAX
CREDITS
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
LESSON
27
MISCELLANEOUS
TAX
CREDITS
filing status
adjusted gross income
qualified contributions
Figure 27-1: The Tax and Credits section of Form 1040 with line 51 "Retirement savings
contributions credit" highlighted.
806
LESSON
27
MISCELLANEOUS
TAX
CREDITS
The table below shows the Retirement Savings Contribution Credit rates
for various Filing Statuses and Adjusted Gross Incomes:
807
LESSON
27
MISCELLANEOUS
TAX
CREDITS
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:
808
LESSON
27
MISCELLANEOUS
TAX
CREDITS
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):
To take the retirement savings credit, complete Form 8880 - Credit for
Qualified Retirement Savings Contributions.
809
LESSON
27
MISCELLANEOUS
TAX
CREDITS
810
LESSON
27
MISCELLANEOUS
TAX
CREDITS
Figure 27-2: The Tax and Credits section of Form 1040 with line 53 "Residential energy
credits" highlighted.
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:
811
LESSON
27
MISCELLANEOUS
TAX
CREDITS
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.
812
LESSON
27
MISCELLANEOUS
TAX
CREDITS
Figure 27-4: The Tax and Credits section of Form 1040 with line 54c "Other credits
from Form:" highlighted.
813
LESSON
27
MISCELLANEOUS
TAX
CREDITS
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
LESSON
27
MISCELLANEOUS
TAX
CREDITS
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.
815
LESSON
27
MISCELLANEOUS
TAX
CREDITS
LESSON
27
MISCELLANEOUS
TAX
CREDITS
SIDE BAR
LESSON
27
MISCELLANEOUS
TAX
CREDITS
LESSON
27
MISCELLANEOUS
TAX
CREDITS
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.
819
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
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
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
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.
821
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
TAX QUOTE
822
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
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.
823
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
824
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
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
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
825
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
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.
826
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
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.
Alabama
California
Connecticut
Florida (only for most corporate tax returns)
Indiana
Kansas
Louisiana
Maine
Massachusetts
Michigan
Minnesota
New Jersey
New Mexico
827
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
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.
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
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.
829
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
830
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
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.
831
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
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.
832
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
Not all GPR Cards offer every one of these reload options.
833
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
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.
834
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
835
BANK
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
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
No Partial RALs! This means clients can get more full loans regardless
of previous bank experience.
839
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
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.
840
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
Low cost makes this e-file bank product a viable method for your
clients.
841
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
LESSON 28
PRODUCTS
2.
3.
4.
5.
6.
ELECTRONIC
FILING
AND
BANK
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.
843
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
No mail loss of the tax return - IRS verifies receipt of the tax return
within 48 hours
Tax returns are more accurate when computer calculated and e-filed
with the IRS
844
LESSON 28
PRODUCTS
ELECTRONIC
FILING
AND
BANK
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.
845
LESSON
29
FINISHING
THE
TAX
RETURN
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,
846
LESSON
29
FINISHING
THE
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
RETURN
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
847
LESSON
29
FINISHING
THE
TAX
RETURN
Figure 29-1: Form W-2 - Wage and Tax Statement with box 2 "Federal income tax
withheld" highlighted.
Figure 29-2: Form W-2G - Certain Gambling Winnings with box 2 "Federal income tax
withheld" highlighted.
848
LESSON
29
FINISHING
THE
TAX
RETURN
849
LESSON
29
FINISHING
THE
TAX
RETURN
Figure 29-4: Form 1099-INT - Interest Income with box 4 "Federal income tax withheld"
highlighted.
850
LESSON
29
FINISHING
THE
TAX
RETURN
Figure 29-5: Form 1099-DIV - Dividends and Distributions with box 4 "Federal income
tax withheld" highlighted.
851
LESSON
29
FINISHING
THE
TAX
RETURN
Figure 29-6: Form 1099-OID - Original Issue Discount with box 4 "Federal income tax
withheld" highlighted.
Figure 29-7: Form 1099-G - Certain Government Payments with box 4 "Federal income
tax withheld" highlighted.
852
LESSON
29
FINISHING
THE
TAX
RETURN
Figure 29-8: Form SSA-1099 - Social Security Benefit Statement with box 6 "Voluntary
Federal Income Tax Withheld" highlighted.
853
LESSON
29
FINISHING
THE
TAX
RETURN
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.
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.
Figure 29-10: The Payments section of Form 1040 with line 64 "Federal income tax
withheld from Forms W-2 and 1099" highlighted.
854
LESSON
29
FINISHING
THE
TAX
RETURN
TAX QUOTE
Estimated tax payments during the tax year using Form 1040ES
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.
855
LESSON
29
FINISHING
THE
TAX
RETURN
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
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.
LESSON
29
FINISHING
THE
TAX
RETURN
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.
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
857
LESSON
29
FINISHING
THE
TAX
RETURN
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.
LESSON
29
FINISHING
THE
TAX
RETURN
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
Enter the amount on the right side of the check with numbers of
uniform size, like this: $XXX.XX
859
LESSON
29
FINISHING
THE
TAX
RETURN
Call one of the service providers listed in the instructions for Forms
1040EZ, 1040A, or 1040 and follow the instructions
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.
860
LESSON
29
FINISHING
THE
TAX
RETURN
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.
Figure 29-17: The Other Taxes section of Form 1040, with line 63 "Total Tax"
highlighted.
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:
861
LESSON
29
FINISHING
THE
TAX
RETURN
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.
862
LESSON
29
FINISHING
THE
TAX
RETURN
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
LESSON
29
FINISHING
THE
TAX
RETURN
TAX TIP
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)
LESSON
29
FINISHING
THE
TAX
RETURN
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
Include all taxes, such as tax on lump-sum distributions and selfemployment tax
LESSON
29
FINISHING
THE
TAX
RETURN
LESSON
29
FINISHING
THE
TAX
RETURN
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:
867
LESSON
29
FINISHING
THE
TAX
Make a payment
by:
April 15th
June 15th
September 15th
January 15th next
year
RETURN
Make later
installments by:
June 15th
September 15th
January 15th next year
September 15th
January 15th next year
January 15th next year
(None)
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.
868
LESSON
29
FINISHING
THE
TAX
RETURN
Taxpayers can always re-examine their tax liability or change their estimated
payments based on actual income.
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.
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"
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.
869
LESSON
29
FINISHING
THE
TAX
RETURN
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.
870
LESSON
29
FINISHING
THE
TAX
RETURN
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.
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.
871
LESSON
29
FINISHING
THE
TAX
RETURN
Figure 29-24: Form W-4S - Request for Federal Income Tax Withholding From Sick Pay.
TAX TIP
LESSON
29
FINISHING
THE
TAX
RETURN
Instructions
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.
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the year.
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875
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$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.
Figure 29-25: Form 1040 Schedule A with "Attachment Sequence No." highlighted.
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Make sure that amount was included in the Payments section of the
return
Signatures
Before the taxpayer mails the return, make sure:
Both spouses have signed a joint return, even if only one spouse had
income
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:
TAX QUOTE
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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.
LESSON
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Before Death
FINISHING
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After Death
THE
TAX TIP
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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
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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
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long-term gain or loss even if the taxpayer held the property for
one year or less.
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
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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.
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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
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,
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.
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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:
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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.
LESSON
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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
RETURN
Non-probate Assets
beneficiary is living.
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.
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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.
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)
Respond to certain IRS notices that the taxpayer has shared with the
designee about math errors, offsets, and return preparation
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place the copies into it. Advise the taxpayer to bring the return back next
year.
TAX TIP
that they actually incurred the expenses (invoices will prove that);
that they actually paid the invoices (canceled checks will prove
that), and
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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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:
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:
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
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
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.
898
LESSON
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IRS
AUDITS
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?
899
LESSON
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IRS
AUDITS
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:
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%
LESSON
30
IRS
AUDITS
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
901
LESSON
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AUDITS
TAX TIP
LESSON
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IRS
AUDITS
TAX TIP
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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AUDITS
TAX QUOTE
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%)
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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
The IRS will send the taxpayer a Release of the Notice of Federal Tax
Lien within 30 days after the taxpayer either:
908
LESSON
30
IRS
AUDITS
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
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.
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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
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
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
LESSON
30
IRS
AUDITS
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
TAX TIP
911
LESSON
30
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:
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
30
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.
LESSON
30
IRS
AUDITS
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
30
IRS
AUDITS
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
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
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
30
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
921
LESSON
30
IRS
AUDITS
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
922
LESSON
30
IRS
AUDITS
$5,373
$6,179
$6,719
$6,152
$7,075
$7,694
$6,931
$7,971
$8,669
$7,710
$8,867
$9,644
$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
30
IRS
AUDITS
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
924
Corporation is
proposing
an offer
Partnership is
proposing
an offer
Individual
and Corporate or
Partnership
liabilities
1-$186
1-$186
2-$186
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
30
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:
LESSON
30
IRS
AUDITS
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 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).
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
LESSON
30
IRS
AUDITS
927
LESSON
30
IRS
AUDITS
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:
928
LESSON
30
IRS
AUDITS
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.
He did not file or fail to file his return with the intent commit fraud.
929
LESSON
30
IRS
AUDITS
930
LESSON
30
IRS
AUDITS
931
LESSON
30
IRS
AUDITS
The IRS is examining his tax return and proposing to increase your
tax liability.
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.
LESSON
30
IRS
AUDITS
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.
LESSON
30
IRS
AUDITS
she made and reported tax payments (such as federal income tax
withholding or estimated tax payments).
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.
LESSON
30
IRS
AUDITS
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
LESSON
30
IRS
AUDITS
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
LESSON
30
IRS
AUDITS
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
940
LESSON
30
IRS
AUDITS
Provide the tax information and help that taxpayers need to comply
with the tax laws;
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
941
LESSON
30
IRS
AUDITS
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;
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
942
LESSON
30
IRS
AUDITS
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;
943
LESSON
30
IRS
AUDITS
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.
Lesson Summary
Lets take a few minutes and review what you learned in this lesson.
944
LESSON
30
IRS
AUDITS
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:
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%
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
945
LESSON
30
IRS
AUDITS
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
946
LESSON
30
IRS
AUDITS
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.
948
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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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.
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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.
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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.
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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).
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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.
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