Regulation 1

Individual taxation – gross income

Non-taxable exchange (also called Like-Kind exchange): In a non-taxable exchange, you do not have to pay tax on any gain, and
you are not allowed to deduct a loss. A non-taxable exchange normally occurs when similar property is exchanged. This is
commonly referred to as a like-kind exchange. In order to qualify as a non-taxable exchange, both the property you transfer and the
property you receive must have been for business use. Any exchange expenses you have to pay, such as closing costs, are added
to the basis of the property you receive.

If you trade property and also pay money in a like-kind exchange, the basis of the property you receive is the basis of the property
you give up plus the money you pay, rather than the value of the replacement property. This would be the case when you trade in a
used vehicle for a new one, for example.

The Form 1040, U.S. Individual Income Tax Return, is the starting form for personal (individual) Federal income tax returns filed
with the Internal Revenue Service (IRS) in the United States.

Any full-time resident individual U.S. income taxpayer can use the standard Form 1040 (often referred to as the "long form" to
distinguish it from the other 1040 variants). Those with uncomplicated tax situations (for example, no itemized deductions, no capital
gain or loss, etc.) may be able to use the simplified Form 1040A (the "short form") or the even simpler Form 1040EZ (the "easy
form") instead of Form 1040. Some versions of Form 1040 are colored blue.

Income tax returns for individual calendar year taxpayers are due by April 15 of the next year.

Form 1040 consists of two full pages not counting attachments. The first page collects information about the taxpayer(s),
dependents, income items, and adjustments to income. The second page calculates the allowable deductions and credits, tax due
given the income figure, and applies funds already withheld from wages or estimated payments made towards the tax liability.

Form 1040 has 11 attachments, called "schedules" (Schedules A and B are printed on opposite sides of the same sheet), which
may need to be filed depending on the taxpayer. For 2009 and 2010 there is an addition form, Schedule M, due to the "Making Work
Pay" provision of the American Recovery and Reinvestment Act of 2009 ("the stimulus"):

• Schedule A itemizes allowable deductions against income; instead of filling out Schedule A, taxpayers may choose to take
a standard deduction of between $5,150 and $14,300, depending on age, filing status, and whether the taxpayer and/or
spouse is blind.
• Schedule B enumerates interest or dividend income, and is required if either interest or dividends received during the tax
year exceed $1,500 from all sources.
• Schedule C lists income and expenses related to self-employment, and is used by sole proprietors. (Schedule C has a
smaller version, the C-EZ, which is used for very simple self-employment situations.)
• Schedule D is used to describe capital gains and losses incurred during the tax year, and to calculate the tax amount due
given the special reduced tax rates applied to capital gains.
• Schedule E is used to report income and expenses arising from the rental of real property, royalties, or from pass-through
entities (like trusts, estates, partnerships, or S corporations).
• Schedule EIC is used to document a taxpayer's eligibility for the Earned Income Credit.
• Schedule F is used to report income and expenses related to farming.
• Schedule H is used to report taxes owed due to the employment of household help.
• Schedule J is used when averaging farm income over a period of several years.
• Schedule M (2009 and 2010) is used to claim the up to $400 "Making Work Pay" tax credit (6.2% earned income credit,
up to $400).[3]
• Schedule R is used to calculate the Credit for the Elderly or the Disabled.
 • Schedule SE is used to calculate the self-employment tax owed on income from self-employment (such as on a Schedule
C or Schedule F, or in a partnership).

In most situations, other Internal Revenue Service or Social Security Administration forms such as Form W-2 must be attached to
the Form 1040, in addition to the Form 1040 schedules. There are other, specialized forms that may need to be completed along
with Schedules and the Form 1040.

• United States Internal Revenue Service - includes downloadable forms and publications
• The Form 1040 lines that lead to the most mistakes - MarketWatch

1040A

The 1040A ("short form") is a shorter version of the Form 1040 U.S. individual income tax return. Use of Form 1040A is limited to
taxpayers with taxable income below $100,000 who take the standard deduction instead of itemizing deductions.

A taxpayer who uses the 1040A tax return can only have income from the following sources:

• Wages, salaries, and tips.

• Interest and ordinary dividends.
• Capital gains distributions.
• Taxable scholarships and fellowship grants.
• Pensions, annuities, and IRAs.
• Unemployment compensation.
• Taxable social security and railroad retirement benefits.
• Alaska Permanent Fund dividends.

1040EZ

The Form 1040EZ ("easy form"), Income Tax Return for Single and Joint Filers with No Dependents, is a simplified, six-section
Federal income tax return, issued by the United States' Internal Revenue Service. Its use is limited to taxpayers with taxable income
below $100,000 (as of tax year 2006) who take the standard deduction instead of itemizing deductions.

Other restrictions for 2005 include:

• Filing status must be single or married filing jointly.

• Filer must be under age 65 and not blind at the end of 2005.
• Filers must not claim any dependents (other than themselves).
• No adjustments to income can be claimed.
• The only credit that can be claimed is the Earned Income Tax Credit (EITC).
• The only income to report for the tax year consisted of wages, salaries, tips, taxable scholarship or fellowship grants,
unemployment compensation, or Alaska Permanent Fund dividends, and filer's taxable interest was not over $1,500.
But if the filer earned tips, including allocated tips, that are not included in box 5 and box 7 of your Form W-2, filer may
not be able to use Form 1040EZ.
• Filer did not receive any advanced EIC payments.

Specific Items of Income and Exclusions

A. Salaries & wages

  Money: all money received, credited, or available (constructive receipt)

 Property: FMV

 Cancellation of Debt: Income

 Bargain Purchases: employer sells property to employee for less than FV, the difference is income to
employee

 Taxable fringe benefits: FMV of a fringe benefit (not excluded by law) e.g.: employee’s personal use
of a company car is subject to employment taxes and withholding.

 Partially taxable fringe benefits: portion of life insurance premium. Premium paid by an employer on a
group-term life insurance policy covering employees are not income to employees for first $50,000.
Premiums above the first $50,000 of coverage are taxable income to the recipient and normally
included in W-2 wages.

 Non-taxable Fringe Benefits:

 Life Insurance Proceeds: proceeds paid because of death of the insured not taxed
(excluded from gross income) but interest income on deferred payout arrangement is fully
taxed.

 Accident, medical, and health insurance (employer paid): premium paid by employer are
excludable from employee’s income; amounts paid to employee under policy are
includable in employee’s income unless such amounts are reimbursement of medical
expenses incurred by employee or compensation for loss of use of part of body

 De Minimis Fringe Benefits: employee’s personal use of a company computer –excluded from income

 Meals & Lodging: for the convenience of employer on the employer’s premises – non-taxable

 Employer payment of employee’s educational expenses: up to $5,250 excluded from gross income

 Qualified employee discounts – excludable from income

 Qualified pension, profit-sharing, and Stock Bonus Plans

 Payment made by employer (non-taxable – at the time of contribution)

 Benefits received (taxable) – distribution

 Flexible Spending Arrangements (FSAs): pre-tax deposits into employee’s account

B. Interest Income – Schedule B (interest & ordinary dividend)

 General rule: all interest is taxable unless told is excludable.

 Taxable Interest:

 Federal Bonds

 Industrial Development Bonds

  Corporate Bonds

 Premiums received for opening a savings account (e.g. prizes and awards) are included at
FMV

 Part of the proceeds from installment sale is taxable as interest

 Interest paid by federal or state government for late payment of tax refund is taxable.

 Tax Exempt Interest (Reportable but Not Taxable)

 State and Local Government Bonds = Government Obligations (name on exam)

 Bonds of US possession (Puerto Rico, Guam, Virgin Islands)

 Series EE (US Savings Bond) - Saving money for Education Expense (EE) – interest on
these bonds is tax exempt when used to pay higher education; reduced by tax-free
scholarships, of the taxpayer, spouse, or dependents; taxpayer is over 24 when
issued/bought; they are acquired after 1989; phaseout starts when modified AGI > an
indexed amount (e.g., $100,650 MFJ)

 Interest on Veterans Administration Insurance

 Unearned Income (interest or dividend) of a Child Under 18 (“Kiddie Tax’): less than 900: no tax;
between 901-1800: child’s tax; over 1801: parent’s tax

 Forfeited Interest (Adjustment): Penalty on Withdrawal from Savings: forfeited interest is deductible
as an adjustment in the year incurred. (It was previously included in income when earned)

C. Dividend Income – Schedule B

 General Rule (Individual): All dividend income are taxed except…

 Three categories of dividends:

 Taxable dividends: all DVD that rep distributions of a corp’s earnings and profits (retained
earnings) are included in gross profits

 Taxable amount (to shareholder receiving)

 Cash: amount received

 Property: FMV

 Special (Lower) tax rate

 Holding period

 Disqualified DVD

 Tax rates (2008)

  15% - Most taxpayers

 0% - Low income taxpayers (10-15% income tax bracket)

 Tax-free distribution: Generally when corp has no earnings & profits

 return of capital – the taxpayer reduces (but not below zero) his basis in the
common stock held – the co distributes funds but has no earnings or profits.

 Stock split

 Stock DVD – Unless shareholder has the option to receive cash or other property
(which would then be taxable at the FMV of the dividend) – if you have the
option, even if you have accepted the stock dividend, then the stock dividend is
taxable (the option made the stock dividend taxable)

 Life insurance DVD: DVD caused by ownership of insurance with a Mutual

Company (premium return -> not taxed)

 Capital Gain Distribution: Distributions by a corporation that has no earnings and profits,
and for which the shareholder has recovered his or her entire basis, are treated as taxable
gross income. –> 15%

D. State and Local Tax Refunds

 State income tax refunds might be taxable income.

 Any state income tax refund you received last year might need to be included on your federal income
tax return. If you itemized your deductions on your federal tax return last year and you claimed a
deduction for State and Local Taxes, then you need to figure the taxable portion of your state refund.

 However, if you claimed the standard deduction on your federal tax return last year, your state tax
refund is not taxable. You can skip Form 1040 Line 10.

 Some short cuts to help you figure this out. If you filed Form 1040-A or 1040-EZ for the previous year,
then you took only the standard deduction. You can skip the part about taxable refunds.

 Prior year itemized = taxable state or local refund

 Prior year used standard deduction (examiner will say you used the 1040 EZ instead of saying you
have taken the standard deduction) = nontaxable state or local refund

E. Payment pursuant to a divorce

(Alimony = Spousal support (income); child support; property settlements (non-taxable)

 Alimony/ Spousal support (income): income for who gets it vs. deductible for who pays it: have to
be both the same amount. To be deemed alimony under the law, must be:

 Paid in cash (or its equivalent)– no property

  Paid pursuant to a written divorce or separation instrument

 Payment terminated at death of recipient

 Not paid to a member of the same household

 Must not be designated as anything else other than alimony and

 Not paid to a spouse with whom the taxpayer is filing a joint return

 Child support:

 Non taxable to receiving ex spouse

 For federal income tax purposes, child support payments you receive are not income – they are
tax free to you. The parent who makes the payments cannot deduct the amount as an expense
on his or her federal tax return. However, sometimes parents are able to negotiate higher
"alimony" (which is deductible by the parent making payments and taxable income to the
receiving parent) to generate tax savings.

 Payment applies first to child support until entire child support obligation is met and then to
alimony

 Property settlements (non-taxable)

 Asset (house) + liabilities (mortgage)

 Non-taxable to spouse who gets it, non-deductible for spouse who receive it

F. Business Income or Loss – Schedule C or C-EZ

 Net income from self-employment – Schedule C

 Self-employment tax – schedule SE

 Income from farming activities (like other business report on Sch. C), reported on Schedule F.
Definition of farmer: person or entity who operates or manages a farm with the intent of earning a
profit.

 Gross income:

 Cash = Amount Received (cash basis)

 Property = Fair Market Value

 Cancellation of Debt
 Expenses: no one can deduct estimated expenses/ losses vs. when performance is fixed you can
deduct. MUST BE INCURRED AND PAID TO HAVE THE DEDUCTION.

 COGS (inventory is expensed when sold)

 Salaries and commissions paid to others

 State and local business taxes paid

 Office expenses (including supplies, equipment, and rent)

 Actual automobile expense (business depreciation) or standard mileage rate (55 cents in
2009 and 50 cents in 2010)

 Business meal and entertainment expenses at 50% (where all proceeds go to charity,
100% deductible as an itemized deduction).

 Depreciation of business assets (business assets purchases are called capital expenses-
PPE – are capitalized and depreciated…)

 Interest expense on business loans – accrual basis (interest expense paid in advance by a
cash basis taxpayer cannot be deducted until the tax year/ period to which the interest
relates – BECAUSE IT HAD TO BE INCURRED AND PAID)

 Employee benefits

 Legal & professional services

 Bad debt actual written off for accrual basis taxpayer only (direct write off method, not the
allowance method, is used for tax purposes)

 Nondeductible expenses (on schedule C)

 Salaries paid to sole proprietorship (considered a “draw’ not a salary expense)

 Federal income tax

 Personal portion of anything – you can deduct business portion

 Bad debt expense of a cash basis taxpayer (who never reported the income)

 Charitable contribution (use Schedule A) – not deductable here but in itemized deduction

 PASSKEY: CPA exam attempts to confuse us by providing personal itemized deductions

as expenses of a sole proprietorship. We ONLY subtract business expenses from business
income. Itemized deductions and/or other adjustments are deducted elsewhere.

 Net business income or loss is taxable (Schedule C/F)

 Net Taxable Business Income (2 taxes on it)

 Income tax and

  Federal self-employed (SE) tax (= social security SE tax)

 As self employed = you both the boss & employee. (15.3%) The extra half of the
boss is an adjustment…

 See Books: Line 12 Sch. SE & Line 31 Schedule C.

 Net Taxable Loss

 A business with a loss may deduct the loss against other sources of income.
When loss> sources of inicome, the excess NOL:

 2-year carryback

 20-year carryforward

 Uniform Capitalization Rules (UNICAP): (QCM & Simulation – Research Question)

 In concept, the uniform capitalization (UNICAP) rules of the Internal Revenue Code Section
263A appear straightforward and not too difficult to understand: producers of tangible
property (except those specifically excluded) must include in inventory the indirect costs as
well as the direct costs of producing that inventory. The difficulty of the UNICAP rule arises
in its application: how to property allocate the additional indirect costs required to be
capitalized under Section 263A in a reasonable and consistent manner.

 Provide guidelines with respect to capitalizing or expensing certain costs

 Types of property

 Produced for Use: real or tangible personal property produced by taxpayer for
use in his/her trade or business.

 Produced for Sale: real or tangible personal property produced by taxpayer for
sale to his/her customer.

 Acquired for resale (RETAILERS): real or tangible personal property acquired

by taxpayer for resale (retailer’s inventory).

 However, UNICAP do not apply to (inventory) property acquired for

resale if the taxpayer’s average gross receipts for the last 3 years < $
10 million annually.

 PASSKEY: For inventory, even a sole proprietor will be required to apply the following
rules:
 Capitalized as Inventory Period Expense
Direct Materials Selling
Direct Labor General
Factory Overhead Administrative
Research & Development

Capitalized as Inventory:

Direct labor examples: compensation, vacation pay, and payroll taxes

Indirect Capitalized Expenses: utilities, warehousing costs, repairs, maintenance, indirect labor (e.g.
supervisory), rents, storage, depreciation, insurance, pension contributions, engineering and design,
repackaging, spoilage and administrative supplies

Period Expense:

Selling, Advertizing Expenses, Research, and officer compensation not attributed to production services

G. Gains or Losses on disposition of property (Sale or Exchange)

 Amount Realized – Adjusted Basis of Assets Sold = Gain or Loss Realized

Covered later

H. IRA Income
 General rule: retirement money cannot be withdrawn until the individual reaches the age of 59 ½ (but
see exceptions) or 10% penalty tax.

 Ordinary IRA: Invested with before tax money – tax-deductible, but when money is withdrawn
(distributions/benefits): principal – nontaxable vs. accumulated earnings: taxable (when withdrawn)

 Roth IRA: invested with after tax money i.e. contributions are not tax-deductible and qualified
distributions are tax free – better if you expect your tax rate to increase

 Exception (to penalty tax)

 Homebuyer (1st time): $10,000 max if used toward first home (within 120 days)

 Insurance (medical)

 Medical expenses in excess of 7.5% of AGI (deductible)

 Disability (permanent of indefinite disability, but not temporary disability)

  Education: college tuition, books, fees, etc.

 And

 Death

I. Annuities
 Annuity contract($60,000)/ factor in (260 months) = $230.77 portion excludible (threshold) of each
other the first 260 payments

 Non-taxable=< $230.77> taxable

 Live longer than actual payout period (260 months) = further payment fully taxable

 Death before Full Recovery: if dies before 260 payments are collected, the uncovered portion of the
$60,000 is a miscellaneous itemized deduction on the annuitant’s final income tax return not subject
to the 2% of AGI floor.

J. Rental Income (passive income) – Schedule E

Schedule E (supplemental Income & Losss) is used to compute supplement income and/ or loss from:

 Rental Real Estate

 Royalties

 Partnerships & LLC (from Schedule K-1)

 S-Corporations (from Schedule K-1)

 Estates (from Schedule K-1)

 Trusts (from Schedule K-1)

 Formula: Net Rental Income

Gross Rental Income

Prepaid Rental Income (Not refundable deposit)

Rent Cancellation Payment (Accelerated rent payment)

Improvement In-lieu-of Rent @ FMV

 <Rental Expenses> e.g. depreciation, repairs, operating expenses

Net Rental Income OR Net Rental Loss

 Rental Vacation Home

 Dwelling unit: place of residence – not for business purpose.

 Rented < 15 days = NO RENTAL – exclude from income

 Rented >= 15 days = If you receive rental income from renting to others, a dwelling unit,
such as a house or an apartment, you may deduct certain expenses. These expenses,
which may include interest, taxes, casualty losses, maintenance, utilities, insurance, and
depreciation, will reduce the amount of rental income that is taxed.

 Dwelling unit NOT AS HOME: If you are renting to make a profit and do not use
the dwelling unit as a home, your deductible rental expenses can be more than
your gross rental income, subject to certain limits.

 Your rental losses, however, may be limited by the "at-risk" rules and
the passive activity loss rules. For information on these limits, refer
to Publication 925, Passive Activities and At-Risk Rules.

 Dwelling unit AS HOME: You are considered to use a dwelling unit as a home if
you use it for personal purposes during the tax year for more than the greater of:
14 days or 10% of the total days it is rented to others at a fair rental price

 If you use the dwelling unit for both rental and personal purposes, you
generally must divide your total expenses between the rental use and
the personal use based on the number of days used for each purpose.
However, you will not be able to deduct your rental expense in excess
of your gross rental income. If you itemize your deductions on Form
1040, Schedule A, you may still be able to deduct mortgage interest,
property taxes, and casualty losses on that schedule.

 Home ownership benefit: itemized deduction – mortgage interest + real estate

tax

 SEE E1-36 (e.g.)

 Passive Activity Losses (PALs)

 Passive activity: not involved in management = rental activities, interests in

limited partnerships, S corporations, and most tax shelters

 can only be deducted to extent of passive activity income – cant be deducted

against earned income (w-2, Sch. C/F wages, salaries , other active income) or
against portfolio income (interest dividends, capital gains income).

 Passive activity losses (PALs) – can only be deducted to extent of passive

activity income
  Unlimited carryforward: suspended losses are used to offset passive income in
future years

 If sell asset and losses unused, losses become fully tax deductible in the year the
property is disposed

 PAL exceptions:

 Mom and Pop Exception

 25,000 and actively management of property

 Taxpayers may deduct up to $25,000 per year of net passive losses

attributable to rental real estate annually if the individuals actively
participate own > 10% of the rental activity – THIS 25,000 can be
offset against other form of income wages and salaries, interest and
dividend…

 Phase out – the 25,000 allowance is reduced 50% of excess of AGI

over $100,000 and eliminated when AGI exceeds $150,000

 Real Estate Professional (Not Passive Activity but business loss)

 >50% of taxpayer’s professional services during year are performed in

real property business

 > 750 hours of services in real property business (year)

K. Unemployment Compensation
 Unemployment compensation: taxable vs. worker’s compensation: nontaxable

 Workers' compensation laws are designed to ensure payment by employers for some part of the cost
of injuries, or in some cases of occupational diseases, received by employees in the course of their
work

 Unemployment compensation is money paid to workers who have lost their jobs. It is not paid to
those who leave voluntarily. Unemployment compensation is provided by states and is paid according
to formulas, for a specified period of time to those actively looking for work.

L. Social security income 91 45 08 38

 Low income (below S $25,000/ MFJ $32,000) – no social security benefits are taxable

 Upper income (above S $34,000/ MFJ $44,000) – 85% of social security are taxable
M.Taxable miscellaneous income
 Prizes and Awards: @ FMV is Taxable Income. Exclusion from income of certain prizes & awards if
assigns to governmental unit or charitable organization.

 Gambling Winnings & Losses: is Taxable Income (Losses: if you itemized your deductions –
Schedule A – but not subject to the 2% of AGI limitation on miscellaneous itemized deductions -
Gambling losses may be deducted to the extent of gambling winnings)

N. Partially taxable miscellaneous items: scholarships and

fellowships
 Scholarships & Fellowship

 Excludible: not taxed – amounts spent on tuition, fees, books and supplies

 Includible: taxed – room and board + service required

 Have to be candidate for a degree in qualified education institution (school)

 No service are to be performed as a condition to receiving grant

O. Nontaxable Miscellaneous items

 Life insurance proceeds (Nontaxable)

 Interest income element on deferred payout arrangements is fully taxable

 Gifts and Inheritances (Nontaxable)

 Medicare Benefits (Nontaxable)

 Workers’ Compensation (Nontaxable)

 Personal (Physical) Injury Award (Nontaxable)

 Accident Insurance – Premiums Paid by Taxpayer (Nontaxable)

 Foreign-Earned Income Exclusion