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G e r a l d e . W h i t t e n b u r G

S t e v e n l . G i l l

San Diego State University

Fundamentals Income Tax 2020

Australia ● Brazil ● Mexico ● Singapore ● United Kingdom ● United States

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Income Tax Fundamentals, 2020 Edition Gerald E. Whittenburg and Steven L. Gill

Senior Vice President, Higher Ed Product, Content, and Market Development: Erin Joyner

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Printed in the United States of America Print Number: 01 Print Year: 2019

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I ncome Tax Fundamentals 2020 Edition is designed as a self-contained book for an intro-ductory course in individual income taxation. We take pride in the concise, current, and practical coverage of the income tax return preparation process. Income Tax Fundamentals continues to be the market-leading textbook with a tax forms-based approach that is a reliable choice, with an experienced author team that offers a commitment to accuracy. The workbook format of the textbook presents materials in practical sections with multiple examples and review problems. The presentation of the material does not assume that the reader has taken a course in accounting, making it appropriate for use as a self- study guide to federal income tax. Income Tax Fundamentals adopters tell us:

Great text. I have used it for years mostly because of its simple and straightfor- ward approach to the basic income tax elements.

— Jerold K. Braun, Daytona State College

This text provides an excellent overview for community tax classes. The software gives these students good hands-on experience with the concepts.

— Jay Wright, New River Community College

I love this book with all its comprehensive problems that progress from easy to difficult. — LoAnn Nelson, PhD, CPA, Lake Region State College

The layout of the chapters is well-thought out. — James Hromadka, San Jacinto College

I enjoy using the Whittenburg text...it is the best I have found. — Jana Hosmer, Blue Ridge Community College

Whittenburg and Gill’s hallmark “Forms Approach” allows students to practice filling out tax returns right in the book while also having the option to download tax forms online. Income Tax Fundamentals has been redesigned to follow the new Form 1040 and supporting Schedules 1 through 3. Every attempt to align the concepts with the schedules has been made so students can follow from the detailed form to the schedule and eventu- ally to Form 1040.

Each individual tax form required to complete the problems in the textbook is included within Income Tax Fundamentals and within the complimentary Intuit ProConnect Online. ProConnect Online is an industry-leading tax preparation

software that is hosted on the cloud and provides robust tax content and easy navigation. The Intuit website offers community and knowledge-based content, view alerts, and FAQ articles. All of the 2019 individual income tax return problems in the textbook may be solved using the Intuit software, or students may prepare the tax returns by hand.

Income Tax Fundamentals’ Winning Forms Approach Is Time-Tested

ConCise, Current, & PraCtiCal!

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Income Tax Fundamentals

Evolves Each Year to Benefit You

new to this edition The Tax Cuts and Jobs Act (TCJA) of 2017 Although most of the new tax law became effective at the start of 2018, a significant amount of administrative tax guidance has followed in the last 24 months. New IRS notices, revenue rulings, and procedures have been reviewed and analyzed with the new material being included in this edition when appropriate. Improved clarity on the qualified business income deduction and the lapse of the individual shared responsibility for health care are notable changes that are covered.

A New Form 1040 and Schedules (again) Never leave well enough alone. The postcard-size Form 1040 and six schedules have been replaced by a more sizable Form 1040 and three schedules. In addition, a new Form 1040-SR has been introduced for taxpayers age 65 and older. All of these form changes, plus new qualified business income deduction forms, are covered in the same seamless forms-based approach in previous editions.

Introduction of additional real-life source documents We continue to include commonly used source documents in the exercises and tax return problems such as Form W-2, a myriad of Forms 1099, Form 1095-A, and additional accounting schedules such as trial balances and income statements in an effort to replicate the tax return preparation process more closely. Information that is not relevant to the problem is included to encourage students to use analytical and critical-thinking skills to deal with less structured problems.

Latest Tax Law is included Compared to 2018, the degree of tax law changes has been small, but Income Tax Fundamentals continues to monitor all changes through October 2019. Recent guidance on the qualified business income deduction and bonus depreciation is covered in this edition.

uPdated Cumulative software Problem The cumulative software problem included as Group 5 questions at the end of Chapters 1–8 have been updated to include more source documents (Form W-2s, 1099s, etc.) and include extraneous information to encourage students to think more critically about the relevance of certain items when preparing tax returns.

a ComPlete learning system—Cengagenowv2 CengageNOWv2 for Taxation takes students from motivation to mastery. It elevates think- ing by providing superior content designed with the entire student workflow in mind. Students learn more efficiently with the variety of engaging assessments and learning tools. For instructors, CengageNOWv2 provides ultimate control and customization and a clear view into student performance that allows for the opportunity to tailor the learning experience to improve outcomes.

Motivation Many instructors find that students come to class unmotivated and unprepared. To help with engagement and preparedness, CengageNOWv2 for Whittenburg offers the following feature:

Self-Study Questions based on the information presented in the textbook help students prepare for class lectures or review prior to an exam. Self-Study Questions provide ample practice for the students as they read the chapters, while providing them with valuable feed- back and checks along the way, as the solutions are provided conveniently in Appendix E of the textbook.

Application Students need to learn problem-solving skills in order to complete taxation problems on their own. However, as students try to work through homework problems, sometimes they become stuck and need guidance. To help reinforce concepts and keep students on the right track, CengageNOWv2 for Whittenburg offers the following:

● End-of-chapter homework: Group 1 and 2 problems ● Algorithmic versions of end-of-chapter homework are available for at least 10–15 problems per chapter.

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Income Tax Fundamentals

● Detailed feedback for each homework question. Homework questions include enhanced, immediate feedback so students can learn as they go. Levels of feedback include an option for “check my work” prior to submission of an assignment. Then, after submitting an assignment, students receive even more extensive feedback explaining why their answers were incorrect. Instructors can decide how much feedback their students receive and when, including providing the full solution, if they wish.

● Built-in Test Bank for online assessment. For students who need additional support, CengageNOWv2’s Adaptive Study Plan is complete with quizzes, an eBook, and more.

● It is designed to help give students additional support and prepare them for the exam.

Mastery Finally, students need to make the leap from memorizing concepts to critical thinking. They need to be able to connect multiple topics and master the material. To help students grasp the big picture of taxation, tax return preparation, and achieve the end goal of mastery, CengageNOWv2 for Whittenburg offers the following:

Comprehensive Problems allow students to complete the tax return problems by entering the relevant information on tax forms and schedules in the Intuit ProConnect Online tax software or by manually preparing the tax forms and schedules provided within each chapter.

Cengage Learning Testing Powered by Cognero®

Cognero® is a flexible, online system that allows instructors to:

● author, edit, and manage test bank content from multiple Cengage Learning solutions ● create multiple test versions in an instant ● deliver tests from your LMS, your classroom or wherever you want Cognero® possesses the features necessary to make assessment fast, efficient, and effective:

● Simplicity at every step. A desktop-inspired interface features drop-down menus and familiar, intuitive tools. ● Full-featured test generator. Choose from 15 question types (including true/false, multiple choice, and essay). Multi-language

support, an equation editor, and unlimited metadata help ensure your tests are complete and compliant.

● Cross-compatible capability. Import and export content into other systems. CL Testing Powered by Cognero® is accessible through the instructor companion site, www.cengage.com/login.

Key Terms Key Terms with page references are located at the end of all of the chapters and reinforce the important tax terms introduced in each chapter.

Key Points Following the Key Terms is a brief summary of the learning objective highlights for each chapter to allow students to focus quickly on the main points of each chapter.

To access tax law information after the publication of this textbook, please visit www.cengage.com. At the home page, input the ISBN of your textbook (from the back cover of your book). This will take you to the product page where free companion resources are located.

Solutions Manual The manual contains detailed solutions to the end-of-chapter problems in the textbook, Chapter Outlines and Suggested Minimum Assignments, and the Additional Comprehensive Problems that are located in Appendix D.

Comprehensive Instructor Companion Website This password-protected site contains instructor resources: the Solutions Manual, the Test Bank, Cognero® testing tools, Solutions to the Cumulative Tax Return Problems, Intuit ProConnect Online software solutions and instructions, PowerPoints, and more: www.cengage.com/login.

reliable instruCtor resourCes are Convenient

as we go to Press

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The practical, step-by-step format in Income Tax Fundamentals 2020 Edition builds from simple to complex topics. The authors are careful to lead students down a path of understanding rather than overwhelming them with excessive detail and multiple Internal Revenue Code references.

Step-by-Step Format Builds Student Confidence

● The Quick Tax Reference Guide on the inside of the back cover of the textbook includes the Tax Equation.

● Learning Objectives help organize information and are referenced by the end-of-chapter exercises.

Q u i c k T a x R e f e r e n c e 2 0 1 9

Child Tax CreditAmount per child under 17 $2,000

Credit reduction of $50 per $1,000 of modified AGI: joint filers, in excess of

$400,000

all other taxpayers, in excess of $200,000Standard DeductionsSingle

$12,200

Married Filing Jointly or Qualifying Widow(er) $24,400

Married Filing Separately $12,200

Head of Household

$18,350

Additional for 65 and Older or Blind—Married $1,300

Additional for 65 and Older or Blind—Unmarried $1,650

(per individual and for each situation: age or blind) The basic standard deduction for employed dependents cannot exceed the greater of: $1,100 or the individual’s earned income plus $350The Personal/Dependent Exemption has been suspended for taxable

years beginning in 2018.

Auto Standard Mileage AllowancesBusiness: $0.58 Charity Work: $0.14 Medical/Moving: $0.20

Traditional IRA Deduction If neither individual nor spouse is a participant in another plan, the maximum deduction is $6,000 if under age 50, or $7,000 if age 50 or over

If the individual is an active participant in another plan: Married/Joint AGI Single AGI Max. Deduction Up to $103,000 Up to $64,000 $6,000 (under 50)

$7,000 (50 or over)

$103,001–$122,999 $64,001–$73,999 Phased-out $123,000 and Over $74,000 and Over No deduction If the individual is not an active participant in a qualified

retirement plan (but spouse is), allowable contributions are fully deductible up to $193,000 and phased out at $203,000 of joint income

Roth IRA Requirements Individuals and spouses can contribute a maximum $6,000 plus $1,000 for taxpayers age 50 or over Contribution amount is phased out when AGI is between: – $193,000 and $203,000 for joint filers – $122,000 and $137,000 for all other filers Contributions are not tax-deductible Like traditional IRAs, contributions are limited to amount

of earned income

The Tax Formula for Individuals Gross Income – Deductions for Adjusted Gross Income = Adjusted Gross Income – Greater of Itemized Deductions or the Standard Deduction – Qualified Business Income Deduction = Taxable Income x Tax Rate (using appropriate tax tables or rate schedules)

= Gross Tax Liability – Tax Credits and Prepayments = Tax Due or Refund

Social Security, Medicare & Self-Employment Taxes Social Security Medicare Total Employer

6.20% 1.45% 7.65% Employee

6.20% 1.45%(a) 7.65% Self-Employed 12.40% 2.90%(a) 15.30% Wage Base for Social Security and Self-Employment Tax $132,900 Wage Base for Medicare

No limit2019 Federal Tax Rate Schedule If Taxable Income Is Over: But Not Over:

The Tax Is:

Single Individual $0

$9,700

10% of taxable income *

$9,700

$39,475

$970.00 + 12% of the excess over $9,700 *

$39,475

$84,200

$4,543.00 + 22% of the excess over $39,475 *

$84,200

$100,000

$14,382.50 + 24% of the excess over $84,200 *

$100,000

$160,725

$14,382.50 + 24% of the excess over $84,200

$160,725

$204,100

$32,748.50 + 32% of the excess over $160,725

$204,100

$510,300

$46,628.50 + 35% of the excess over $204,100

$510,300

$153,798.50 + 37% of the excess over $510,300

Married Filing Jointly or Qualifying Widow(er)

$19,400

10% of taxable income *

$19,400

$78,950

$1,940.00 + 12% of the excess over $19,400 *

$78,950

$100,000

$9,086.00 + 22% of the excess over $78,950 *

$100,000

$168,400

$9,086.00 + 22% of the excess over $78,950

$168,400

$321,450

$28,765.00 + 24% of the excess over $168,400

$321,450

$408,200

$65,497.00 + 32% of the excess over $321,450

$408,200

$612,350

$93,257.00 + 35% of the excess over $408,200

$612,350

$164,709.50 + 37% of the excess over $612,350

Married Filing Separately $0

$9,700

10% of taxable income *

$9,700

$39,475

$970.00 + 12% of the excess over $9,700 *

$39,475

$84,200

$4,543.00 + 22% of the excess over $39,475 *

$84,200

$100,000

$14,382.50 + 24% of the excess over $84,200 *

$100,000

$160,725

$14,382.50 + 24% of the excess over $84,200

$160,725

$204,100

$32,748.50 + 32% of the excess over $160,725

$204,100

$306,175

$46,628.50 + 35% of the excess over $204,100

$306,175

$82,354.75 + 37% of the excess over $306,175

Head of Household $0

$13,850

10% of taxable income *

$13,850

$52,850

$1,385.00 + 12% of the excess over $13,850 *

$52,850

$84,200

$6,065.00 + 22% of the excess over $52,850 *

$84,200

$100,000

$12,962.00 + 24% of the excess over $84,200 *

$100,000

$160,700

$12,962.00 + 24% of the excess over $84,200

$160,700

$204,100

$31,322.00 + 32% of the excess over $160,700

$204,100

$510,300

$45,210.00 + 35% of the excess over $204,100

$510,300

$152,380.00 + 37% of the excess over $510,300

* For taxable income below $100,000, the IRS requires use of the Tax Tables presented in Appendix A.

(a) – Plus an additional 0.9% Medicare tax on earnings above $200,000 ($250,000 MFJ)

1-1

L E A R N I N G O B J E C

T I V E S

After completi ng this chapte

r, you should be able to:

LO 1.1 E xplain the his

tory and obje ctives of U.S.

tax law.

LO 1.2 D escribe the d

ifferent entitie s subject to t

ax and repor ting requirem

ents.

LO 1.3 A pply the tax

formula for in dividuals.

LO 1.4 Id entif y individ

uals who mus t file tax retu

rns.

LO 1.5 D etermine filin

g status and understand th

e calculation of tax accor

ding to filing status.

LO 1.6 D efine qualif yi

ng dependen ts.

LO 1.7 C alculate the c

orrect standa rd or itemize

d deduction amount for ta

xpayers.

LO 1.8 C ompute basic

capital gain s and losses.

LO 1.9 A ccess and us

e various Inte rnet tax resou

rces.

LO 1.10 D escribe the b

asics of elect ronic filing (e

-filing).

1-1

O V E R V I E W

T his chapter intr

oduces the U.S . individual

income tax sys tem. Important

elements of

the individual tax formula ar

e covered,

including the tax calculation

, who must

file, filing statu s, and the inte

raction of item ized

deductions an d the standar

d deduction. The

chapter illustra tes all the step

s required for com-

pletion of a ba sic Form 1040

. Also included is

a discussion o f reporting and

taxable entitie s.

An introduction to capital ga

ins and losses

is included to provide a bas

ic understandin g of

capital transac tions prior to th

e detailed cove rage

in Chapter 4. An overview

of tax informa tion

available at th e Internal Rev

enue Service (IRS)

website and o ther helpful ta

x websites is also

included. A dis cussion of the p

rocess for electr onic

filing (e-filing) o f an individual

tax return comp letes

the chapter.

● The short Learning Objective sections within each chapter offer numerous examples, supported by the “Self-Study Problems” throughout. The Self-Study Problems encourage students to answer a series of short questions in a fill-in-the-blank or multiple-choice format. The solutions to the Self-Study Problems are provided at the end of the textbook, offering immediate solutions to students to help build confidence.

1-16 Chapter 1 ● The Individual Income Tax Return

out of the year. The opportunity to claim the child as a dependent can be shifted to the

noncustodial parent if the custodial parent signs IRS Form 8332, and the form is attached to

the noncustodial parent’s tax return. Figure 1.4 illustrates the interaction of the qualifying child dependency tests described

on the previous page.

1-6c Qualifying Relative A person who is not a qualifying child can be a qualifying relative if the following 5-part

test is met. A child of a taxpayer who does not meet the tests to be a qualifying child can

still qualify as a dependent under the qualifying relative tests described below. 1. Relationship or Member of Household Test

The individual must either be a relative of the taxpayer or a member of the household.

The list of qualifying relatives is broad and includes parents, grandparents, children,

grandchildren, siblings, aunts and uncles by blood, nephews and nieces, “in-laws,” and

adopted children. Foster children may also qualify in certain circumstances. If the potential

dependent is a more distant relative, additional information is available at the IRS website

(www.irs.gov). For example, cousins are not considered relatives for this purpose. In addition to the relatives listed, any person who lived in the taxpayer’s home as a

member of the household for the entire year meets the relationship test. A person is not

considered a member of the household if at any time during the year the relationship

between the taxpayer and the dependent was in violation of local law. EXAMPLE Scott provides all of the support for an unrelated family friend who lives with

him for the entire tax year. He also supports a cousin who lives in another state. The family friend can qualify as Scott’s dependent, but the cousin can- not. The family friend meets the member of the household test. Even though the cousin is not considered a relative, he could have been a dependent if he met the member of the household part of the test. ♦

2. Gross Income Test The individual cannot have gross income equal to or above the exemption amount

($4,200 in 2019). Although exemptions are no longer deductible, the exemption amount

will continue to be updated by the IRS. Gross income does not include any income

exempt from tax (for example, tax-exempt interest or exempt Social Security benefits).

3. Support Test The dependent must receive over half of his or her support from the taxpayer or a group

of taxpayers (see multiple support agreement below). Unlike the gross income test, income

exempt from tax and earned by the potential dependent is considered for the support test.

4. Joint Return Test The dependent must not file a joint return unless it is only to claim a refund of taxes.

5. Citizenship Test The dependent must meet the citizenship test discussed above.

EXAMPLE A taxpayer has a 26-year-old son with gross income less than the exemption amount who receives more than half his support from his parents. The son fails the test to be a qualifying child based on his age, but passes the test to be a dependent based on the qualifying relative rules. ♦

Figure 1.5 illustrates the qualifying relative tests described above. As long as the dependency tests are met, a person who was born or died during the

year, such as a baby born before or on December 31, can be claimed as a dependent.

Taxpayers must provide a Social Security number for all dependents. If a dependent is supported by two or more taxpayers, a multiple support agreement

may be filed. To file the agreement, the taxpayers (as a group) must provide over 50 percent

of the support of the dependent. Assuming that all other dependency tests are met, the

group may give the dependent to any member of the group who provided over 10 percent

of the dependent’s support.

● Helpful examples within each chapter provide realistic scenarios for students to consider.

08239_fm_ptg01.indd 6 10/31/19 7:48 PM

● Interesting tax facts within “Would You Believe?” sections grab students’ attention with interesting asides, including captivating facts and stories about tax laws and preparation.

● Real-world examples within Tax Break segments provide actual, effective examples of tax-planning strategies that clearly illustrate the concepts discussed throughout the book and cover nearly every basic tax-planning technique used by tax preparers.

● The “Would You Sign This Tax Return?” feature places readers in the office of a tax preparer with interesting and sometimes humorous real- world tax ethics questions that will intrigue students. Many of these features are inspired by the authors’ own experi- ences working with various clients in tax preparation. As part of each scenario, students decide if they would sign the tax return. The instructor can use the cases to spark group discussions on basic tax preparation ethics.

● New Tax Law boxes throughout the textbook draw students’ attention to specific areas affected by new tax legislation.

11-27 11-8 Corporate Accumulations89 percent (85 of 95 shares) of the stock after the transfer. B’s stock is not

considered because it was received in exchange for services. 1. A has a realized gain of $15,000 ($40,000 2 $25,000), but no recognized gain since no boot was received. 2. B’s recognized income is $10,000, since she performed services in exchange for the stock, and stock received for services does not fall within the nonrecognition provisions. 3. C’s realized gain is $40,000 ($45,000 1 $5,000 2 $10,000), but only $5,000 of the gain is recognized, the amount of boot received.

4. A’s basis in the stock is $25,000 ($25,000 2 $0 1 $0 2 $0), B’s basis in the stock is $10,000 ($0 2 $0 1 $10,000 2 $0), and C’s basis in the stock is $10,000 ($10,000 2 $5,000 1 $5,000 2 $0).

5. Hornbeam Corporation’s basis in the property contributed by A is $25,000 ($25,000 1 $0). The corporation’s basis in the property contributed by C is $15,000 ($10,000 1 $5,000 gain recognized). ♦

11-8 Corporate aCCumulationsIn many cases, taxpayers have established corporations to avoid paying income taxes at the

shareholder level by allowing earnings to be accumulated by the corporations, rather than

paid out as taxable dividends. To prevent that practice, Congress has enacted two special

taxes which may be applied to certain corporations: the accumulated earnings tax and the

personal holding company tax.

11.8 learning objective Describe the rules for the accumulated earnings tax and the personal holding company tax.

self-study problem 11.7 See Appendix E for Solutions to Self-Study Problems Tammy has a business which she decides to incorporate. She transfers to the new corporation, real estate with a basis of $75,000 and subject to a $34,000 mortgage in

exchange for all of its stock. The stock is worth $125,000.What is Tammy’s realized gain? $

What is Tammy’s recognized gain? $

What is Tammy’s basis in her stock? $

What is the corporation’s basis in the real estate? $

11-8a accumulated earnings tax The accumulated earnings tax is designed to prevent the shareholders of a corporation from

avoiding tax at the shareholder level by retaining earnings in the corporation. The tax is a pen-

alty tax imposed in addition to the regular corporate income tax. The tax is imposed at a rate of

20 percent on amounts that are deemed to be unreasonable accumulations of earnings. For all

corporations except service corporations, such as accounting, law, and health care corporations,

the first $250,000 in accumulated earnings is exempt from tax. Service corporations will not be

taxed on their first $150,000 of accumulated earnings. Even if the accumulated earnings of a

The TCJA made no direct changes to the accumulated earnings tax or the personal holding

company tax; however, the significant decrease in the corporate tax rate makes deferring income

without distributing the earnings and profits of a corporation considerably more attractive from

a tax planning perspective. Undoubtedly, this will increase both the use of this strategy and the

IRS’ sensitivity to this matter.

New Tax Law!

1-13

1-5 Filing Status and Tax Computation Divorcing couples may save significant taxes if one or both of the spouses qualify as an

“abandoned spouse” and can use the head of household filing status. The combination of head

of household filing status for one spouse with married filing separately filing status for the other

spouse is commonly seen in the year (or years) leading up to a divorce. In cases where each

spouse has custody of a child, the separated taxpayers may each claim head of household status.

TAX BREAK

1-5e Qualifying Widow(er) with Dependent Child A taxpayer may continue to benefit from the joint return rates for 2 years after the death

of his or her spouse. To qualify to use the joint return rates, the widow(er) must pay over

half the cost of maintaining a household where a dependent child, stepchild, adopted child,

or foster child lives. After the 2-year period, these taxpayers often qualify for the head of

household filing status.

1-5f Tax Computation For 2019, there are seven income tax brackets (10 percent, 12 percent, 22 percent, 24 percent,

32 percent, 35 percent, and 37 percent). Individuals with taxable income below $100,000 are

required to use the tax tables presented in Appendix A. Taxpayers with income equal to or

more than $100,000 use the tax rate schedules (also presented in Appendix A). An example

of the single tax rate schedule is presented below. Certain high-income taxpayers are subject

to additional taxes discussed in Chapter 6.

The tax rates applicable to net long-term capital gains currently range from 0 percent

to 31.8 percent depending on the taxpayer’s tax bracket and the kind of capital asset. The

calculation of the tax on capital gains is discussed in detail in Chapter 4, and the applicable

tax rates are discussed in LO 1.8 of this chapter. The tax rates for qualifying dividends, discussed in detail in Chapter 2, range from 0

percent to 23.8 percent in 2019. EXAMPLE Carol, a single taxpayer, has adjusted gross income of $120,000 and

taxable income of $105,000 for 2019. Her tax is calculated using the 2019 tax rate schedule from Appendix A as follows: $19,374.50 5 $14,382.50 1 [24% 3 ($105,000 2 $84,200)] ♦ EXAMPLE Meg is a single taxpayer during 2019. Her taxable income for the year is

$27,530. Using the tax table in Appendix A, her gross tax liability for the year is found to be $3,109. ♦

6-19 6-6 Self-Emp

loyment Tax

6-6 Self-emp loyment tax

The Federal Ins urance Contrib

utions Act (FIC A) imposes Soc

ial Security (Ol d Age, Survivor

and Disability I nsurance (OAS

DI)) and Medic are taxes. As di

scussed in Cha pter 9, employ-

ees and their em ployers are both

required to pay FICA taxes. Em

ployers withho ld a specified

percentage of e ach employee’s

wages up to a maximum bas

e amount, mat ch the amount

withheld with an equal amou

nt, and pay the total to the So

cial Security Ad ministration.

Self-employed individuals pa

y self-employm ent taxes inste

ad of FICA ta xes. Since

these individua ls have no em

ployers, the en tire tax is paid

by self-emplo yed individuals

Like the FICA taxes to whi

ch employees and their emp

loyers are sub ject, the self-

employment ta x also consists

of two parts, Social Security

and Medicare . The maximum

base amount o f earnings subj

ect to the Socia l Security porti

on of the self-e mployment tax

is $132,900 in 2 019. All earning

s are subject to the Medicare p

ortion of the se lf-employment

tax. The Social Security tax rat

e is 12.4 percen t and the Medi

care tax rate is 2.9 percent. Th

self-employme nt tax rates and

the maximum base amounts f

or 5 years are il lustrated in the

following table :

6.6 learning object ive

Calculate and r eport

the self-employm ent tax

(both Social Sec urity and

Medicare portio ns) for

self-employed ta xpayers.

Year Maximum $ Ba

se for 12.4% Maximum $ Ba

se for 2.90%*

2015 118,500

Unlimited

2016 118,500

Unlimited

2017 127,200

Unlimited

2018 128,400

Unlimited

2019 132,900

Unlimited

*A 0.9 percent additional Med

icare tax on sel f-employment

income over $2 00,000 single a

nd head of

household ($25 0,000 married fi

ling jointly). Se e LO 6.8 for m

ore information .

If a self-emplo yed individual

also receives w ages subject to

FICA taxes du ring a tax

year, the Social Security tax m

aximum base a mount for self-

employment ta xes is reduced b

the amount of wages. Therefo

re, the total am ount of earning

s subject to the Social Security

tax portion of b oth FICA and s

elf-employmen t tax for 2019 c

annot exceed $ 132,900.

The self-empl oyment tax is

imposed on net earnings

of $400 or m ore from

self-employme nt. Net earning

s from self-em ployment inclu

de gross incom e from a trade

or business les s trade or busin

ess deductions , the distributiv

e share of part nership income

Your client, Will iam Warrant, w

as hired for a m anagement posi

tion at an Intern et com pany

planning to start a website called

“indulgedanima ls.com” for dogs

, cats, and other pets. When

he was hired, W illiam was given

an incentive sto ck option (ISO)

worth $500,000 , which he

exercised during the year. Exerc

ise of the ISO c reates a tax pre

fer ence item for alternative

minimum tax (AM T) and causes hi

m to have to pa y substantial add

itional tax when combined

with his other tax items for the ye

ar. He is livid ab out the extra tax

and refuses to fi le the AMT

Form 6251 with his tax return bec

ause the AMT ta x is “unfair” and

“un-American” a ccording to

him. Would you sign this tax retur

Would You

Sign This

Tax Return?

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om .

Real-World Applications Keep Students Engaged

7-37 7-7 Adoption

Expenses

final, the credit is allowed for

that year. The f ull $14,080 cre

dit is allowed i n special-need

adoptions rega rdless of the am

ount of qualifie d adoption exp

enses paid.

EXAMPLE In c onnection with t

he adoption of a n eligible child w

ho is a U.S. citiz en

and is not a chi ld with special n

eeds, a taxpaye r pays $6,000 o

f qualified

adop tion expen ses in 2018 and

$8,600 of qua lified adoption e

xpenses in

2019. The adop tion is not finaliz

ed until 2020. T he $6,000 of ex

penses

paid or incurred in 2018 would

be allowed in 2 019, and $8,08

0 of the

$8,600 paid or incurred in 201

9 would be allo wed in 2020. O

n the other

hand, if the ado ption were finali

zed in 2019, th en $14,080 of

qualified

expenses would be allowed in 2

019 (the maxim um credit permit

ted as

of 2019). ♦

7-7c Foreign M ultiyear Adop

tions

In the case of the adoption o

f a child who i s not a U.S. cit

izen or residen t of the United

States, the cre dit for qualifie

d adoption ex penses is not

available unles s the adoption

becomes final. Qualified ado

ption expenses paid or incurr

ed before the t ax year in whic

the adoption b ecomes final a

re taken into a ccount for the

credit as if the expenses were

paid or incurre d in the tax yea

r in which the adoption beco

mes final. Ther efore, the cred

for qualified a doption expen

ses paid or inc urred in the ta

x year in whic h the adoption

becomes final, or in any ear

lier tax year, i s allowed only

in the tax yea r the adoption

becomes final.

EXAMPLE In 2 017 and 2018,

a taxpayer pay s $3,000 and $

6,000, respectiv ely,

of qualified ado ption expenses i

n connection wi th the adoption

of an

eligible child wh o is not a U.S. c

itizen or residen t of the United S

tates.

In 2019, the ye ar the adoption

becomes final, t he taxpayer pay

s an

additional $3,0 00 of qualified

expenses. The ta xpayer may clai

m a credit

of $12,000 on his or her incom

e tax return for 2 019 (the year th

e adoption

becomes final). Note: If a foreig

n adoption does not become fina

l, no credit

is allowed. ♦

7-7d Employer -Provided Ad

option Assist ance

An employee may exclude f

rom W-2 earn ings amounts

paid or expen ses incurred b

his or her emp loyer for quali

fied adoption expenses conn

ected with the adoption of a

child by the em ployee, if the a

mounts are fu rnished under

an adoption a ssistance pro-

gram. The tota l amount exclu

dable per child is the same as

the adoption credit amount

($14,080). The phase-out is

calculated in t he same man

ner as the ph ase-out for th

adoption credi t. An individua

l may claim bo th a credit and

an exclusion in connection

with the adop tion of an eligi

ble child, but m ay not claim b

oth a credit an d an exclusion

for the same e xpense.

The following qu otation is often a

ttributed to Albe rt Einstein: “The

hardest thing in the

world to understa nd is the income

tax.”

Would You

Believe?

vii

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ey _P

op ov

/S hu

tte rs

to ck

.c om

08239_fm_ptg01.indd 7 10/30/19 3:20 PM

Income Tax Fundamentals Delivers Proven End-of-Chapter Strengths ● The pages are perforated, allowing students to complete end-of-chapter problems and

submit them for homework. Students can also tear out tax forms as needed. ● Several question types ensure a variety of assignment options:

● Multiple-Choice Questions ● Problems ● Writing Assignments ● Comprehensive Problems ● The Cumulative Software Problem provided in Chapters 1–8 gives students the flexibility to

use multiple resources, such as the tax forms within the book, Intuit ProConnect Online or alternative tax preparation software.

Digital Tools Enhance Student Understanding CengageNOWv2 is a powerful online homework tool. This online resource includes an interactive eBook, end-of- chapter homework, detailed student feedback and interactive quizzing, that covers the most challenging topics, a lab guide

for using the Intuit ProConnect Online software, flashcards, and much more. The student companion website offers—at no additional costs—study resources for students.

Go to www.cengage.com, and input the ISBN number of your textbook (from the back cover of your book). This will take you to the product page where free companion resources are located.

Intuit ProConnect Online access is included with each textbook. A detailed reference lab guide will help the student use the software for solving end-of-chapter problems.

For students who are new to the Intuit ProConnect product, we have placed tips throughout the textbook providing guidance to assist students with the transition from a paper form to using the tax software.

viii

08239_fm_ptg01.indd 8 10/30/19 3:21 PM

This book includes many examples to help illustrate learning objectives. After reading each section, including the examples, answer the corresponding Self-Study Problems. You can find the solutions to the Self-Study Problems at the end of the textbook in Appendix E to check your accuracy. Use your performance to measure your understanding, and re-read the Learning Objectives section if needed. Many key tax terms are defined in each chapter, which will help improve your overall comprehension.

USING TAx SOFTWARE Numerous tax return problems in the textbook can be solved using either tax preparation software or hand preparation. The popular software, Intuit ProConnect Online, is available with the textbook. Helpful tips for using ProConnect have been placed throughout the book so that students can more easily train on the software and prepare the tax returns included in each of the first eight chapters. A student guide to Intuit ProConnect Online is provided at the companion website. Your college may offer additional tax preparation software, such as Intuit’s ProSeries®, but remember that you can always prepare the solutions manually on the chapter-provided tax forms, schedules and worksheets.

USING ThE FEATURE “WOULD YOU SIGN ThIS TAx RETURN?” A practitioner who knows when to say “I cannot sign this tax return,” even if it means losing a client, is exercising the most basic ethical wisdom. Most chapters contain a “Would You Sign This Tax Return?” case reflecting a common client issue. Each issue corresponds to an obvious concept illustrated in the previous section. However, the approach to advise the client is not obvious. The art of explaining tax rules to a client who does not understand them, or, worse, wants to break them, requires not only a good understanding of the rules, but also good interpersonal skills and sometimes the gift of persuasion. The news in the last several years has shown reports of respected CPA firms with members who failed to say the simple words, “I cannot sign this tax return,” demonstrating that simple ethical practice is not always easy. We hope instructors will use these cases to spark group discussions or contemplation, and, perhaps, add examples from their own experience.

USING ThE CUMULATIvE SOFTWARE PROBLEM The Cumulative Software Problem can be found at the end of Chapters 1–8. The case information provided in each chapter builds on the information presented in previous chapters, resulting in a lengthy and complex tax return by the conclusion of the problem in Chapter 8. Your instructor may have you work in groups to prepare each of the tax returns. The groups can follow the real-world accounting firm model using a preparer, a reviewer, and a firm owner who takes responsibility for the accuracy of the return and signs it. All of the issues in the problem are commonly seen by tax preparers and are covered in the textbook. The full return is difficult to prepare by hand, so tax software is recommended. If the problem is prepared using tax software, the data should be saved so the additional information in the succeeding chapters can be added without duplicating input from previous chapters.

Note to Students: Maximize Your Reading Experience

M ar

c Ro

m an

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08239_fm_ptg01.indd 9 10/30/19 3:21 PM

Gerald E. Whittenburg On March 8, 2015, we unexpectedly lost our dear friend and co-author Gene Whittenburg. As the original author of Income Tax Fundamentals, Gene was critical in designing the forms-based approach that the book has used successfully for over two decades. Gene started his life in a small town in Texas, entered the Navy, served his country in Vietnam, earned a Bachelor’s, Master’s, and PhD degrees, and served as a distinguished faculty at San Diego State University for almost 40 years. We intend to continue to honor Gene by committing to uphold his standard of publishing excellence.

Steven L. Gill is an associate professor of accounting and taxation in the Charles W. Lamden School of Accountancy at San Diego State University. He also serves as the Director of Graduate Programs at the Fowler College of Business at SDSU. Steve received a BS in Accounting from the University of Florida, an MS in Taxation from Northeastern University, and a PhD in Accounting from the University of Massachusetts. Prior to entering academia, he worked for almost 12 years in the field of tax and accounting, including roles in public accounting, internal audit, corporate accounting, and, ultimately, vice president of finance. Although currently in inactive status, Steve holds a Certified Public Accountant designation. He has published a wide variety of articles in various academic and practitioner journals, and has taught at both the undergraduate and graduate levels, including taxation and financial and management accounting. Steven also serves as an author on Cengage’s Federal Tax Research series.

About the Authors

Janice Akao, Butler Community College Sandra Augustine, Hilbert College George Barbi, Lanier Technical College Lydia Botsford, DeAnza College Mike Bowyer, Montgomery Community College Jerold Braun, Daytona State College Lindy Byrd, Augusta Technical College Greg Carlton, Davidson County Community College Diana Cescolini, Chaffey College John Chappell, Northland Community and Technical College Marilyn Ciolino, Delgado Community College Diane Clugston, Cambria-Rowe Business College Tonya Coates, Western Piedmont Community College Thomas Confrey, SUNY Orange Amy Conley, Genesee Community College Eric DaGragnano, Western Governors University Geoffrey Danzig, Miami Dade College – Hialeah Campus Richard Davis, Susquehanna University Susan Davis, Green River Community College Vaun Day, Central Arizona College Ken Dennis, San Diego City College Kerry Dolan, Great Falls College Montana State University Vicky C. Dominguez, College of Southern Nevada Lisa Farnam, College of Western Idaho John Fasler, Whatcom Community College Brian Fink, Danville Area Community College

Brenda Fowler, Central Carolina Community College George Frankel, San Francisco State University Alan Fudge, Linn-Benton Community College Gregory Gosman, Keiser University Nancy Gromen, Blue Mountain Community College Jeffery Haig, Copper Mountain College Tracie Hayes, Randolph Community College Michael Heath, River Parishes Community College Cindy Hinz, Jamestown Community College Rob Hochschild, Ivy Tech Community College Japan Holmes, Jr., Savannah Technical College Jana Hosmer, Blue Ridge Community College James Hromadka, San Jacinto College Carol Hughes, Asheville Buncombe Technical

Community College Norma Hunting, Chabot College, Hayward, California Adrian Jarrell, James Sprunt Community College Paul Johnson, Mississippi Gulf Coast Community College Jessica Jones, Mesa Community College Dieter Kiefer, American River College Christopher Kinney, Mount Wachusett Community College Angela Kirkendall, South Puget Sound Community College Mark Klamrzynski, Phoenix College Raymond Kreiner, Piedmont College William Kryshak, University Wisconsin-Stout Linda Lane, Walla Walla Community College

reviewers

08239_fm_ptg01.indd 10 10/30/19 3:21 PM

Christie Lee, Lanier Technical College Anna Leyes, Ivy Tech Community College Jeannie Liu, Rio Hondo College Susan Logorda, Lehigh Carbon Community College Heather Lynch, Northeast Iowa Community College Diania McRae, Western Carolina University Deanne Michaelson, Pellissippi State Community College Jennifer Morton, Ivy Tech Community College Sharon O’Reilly, Gateway Technical College Mike Prockton, Finger Lakes CC John Ribezzo, Community College of Rhode Island Lance Rodrigues, Ohlone College Hanna Sahebifard, Golden West College Larry Sayler, Greenville University James Shimko, Jackson Community College Barry Siebert, Concordia University–Saint Paul Kimberly Sipes, Kentucky State University Amy Smith, Pearl River Community College Thomas Snavely, Yavapai College

Joanie Sompayrc, UT-Chattanooga Barbara Squires, Corning Community College Todd Stowe, Southwest Florida College Gracelyn Stuart-Tuggle, Palm Beach State College Robert L. Taylor, C.P.A. Lees-McRae College Teresa Thamer, Brenau University Craig Vilhauer, Merced College Stan Walker, Georgia Northwestern Technical School Teresa Walker, Greensboro College Joe Welker, College of Western Idaho Jean Wells, Howard University Mary Ann Whitehurst, Southern Crescent Technical College Sharon Williams, Sullivan University Douglas Woods, Wayne College Patty Worsham, Chaffey College Jay Wright, New River Community College Douglas Yentsch, South Central College James Zartman, Elizabethtown PA College Jane Zlojutro, Northwestern Michigan College

The authors wish to thank all of the instructors who provided feedback for the 2020 edition via surveys as well as the following supplement authors and verifiers for their most valuable suggestions and support:

In addition, gratitude is expressed to Susan Gill, Kathleen Smith, and Steve Smith for their expert assistance reviewing chapters of this textbook. We would also like to thank Janice Stoudemire, and Wendy Shanker on their work of reviewing and verifying the content in CengageNOWv2 including the end-of-chapter items and Test Bank problems. We would also like to extend our thanks to the Tax Forms and Publications Division of the Internal Revenue Service for their assistance in obtaining draft forms each year.

We appreciate your continued support in advising us of any revisions or corrections you feel are appropriate.

Steven L. Gill

Acknowledgments

D. Elizabeth Stone Atkins—High Point University, High Point, NC David Candelaria—Mt. San Jacinto College, Menifee, CA Jim Clarkson—San Jacinto College South, Houston, TX

Pennie Eddy—Appalachian Technical College, Jasper, GA Paul Shinal—Cayga Community College, Auburn, NY Lisa Swallow—University of Montana, Missoula, MT

xixi

08239_fm_ptg01.indd 11 10/30/19 3:21 PM

the AnnotAted 1040 mAp

The annotated 1040 map is an expanded tax formula, illustrating where each piece of the tax formula is covered in the textbook.

The 1040 map helps you understand how all of the elements of the textbook and the tax formula fit together. Use this as a refer-

ence and bookmark this page.

xii

LO 1-5

LO 1-7

LO 1-6, 7-1

LO 2-10 LO 2-9 LO 5-3 LO 2-7

LO 2-16

LO 2-2 LO 2-9 LO 2-9 LO 5-3 LO 2-7

LO 2-16 LO 4-1 to 4-6

LO 1-7, 5-6 to 5-10

LO 4-10

08239_fm_ptg01.indd 12 10/30/19 3:21 PM

xiii

LO 1-7, 7-1

LO 2-2, 9-1

LO 7-2 LO 7-1

LO 7-5

LO 1.5, 2.9, 4.4, 6.4

08239_fm_ptg01.indd 13 10/30/19 3:21 PM

LO 5-7 LO 2-13

Chapter 3

LO 8-8 LO 4-7, 4-8

LO 2-15

LO 2.6, 2.12

LO 5-5

LO 5-5 LO 5-1 LO 5-5 LO 6-6 LO 5-4 LO 5-2 LO 2-9

LO 2-13

LO 5-3 LO 5-8

LO 6-5 LO 7-4

LO 6-6

LO 6-7

LO 6-8

xiv

08239_fm_ptg01.indd 14 10/30/19 3:21 PM

LO 7-6 LO 7-3 LO 7-5 LO 7-9 LO 7-8

LO 9-2 LO 7-4 LO 1-4

08239_fm_ptg01.indd 15 10/30/19 3:21 PM

ta b l e o f c o n t e n t s

chapter 1 The Individual Income Tax Return lO 1.1 history and objectives of the tax system 1-2 lO 1.2 Reporting and taxable entities 1-3 lO 1.3 the tax Formula for Individuals 1-6 lO 1.4 Who must File 1-8 lO 1.5 Filing status and tax Computation 1-11 lO 1.6 Qualifying dependents 1-14 lO 1.7 the standard deduction 1-21 lO 1.8 a Brief overview of Capital Gains and losses 1-22 lO 1.9 tax and the Internet 1-25 lO 1.10 electronic Filing (e-Filing) 1-27 Questions and Problems 1-30

chapter 2 Gross Income and Exclusions lO 2.1 the nature of Gross Income 2-2 lO 2.2 salaries and Wages 2-4 lO 2.3 accident and health Insurance 2-7 lO 2.4 meals and lodging 2-7 lO 2.5 employee Fringe Benefits 2-8 lO 2.6 Prizes and awards 2-12 lO 2.7 annuities 2-13 lO 2.8 life Insurance 2-17 lO 2.9 Interest and dividend Income 2-18 lO 2.10 municipal Bond Interest 2-25 lO 2.11 Gifts and Inheritances 2-26 lO 2.12 scholarships 2-27 lO 2.13 alimony 2-27 lO 2.14 educational Incentives 2-30 lO 2.15 unemployment Compensation 2-33 lO 2.16 social security Benefits 2-34 lO 2.17 Community Property 2-38 Questions and Problems 2-42

chapter 3 Business Income and Expenses lO 3.1 schedule C 3-2 lO 3.2 Inventories 3-7 lO 3.3 transportation 3-11 lO 3.4 travel expenses 3-14 lO 3.5 meals and entertainment 3-16 lO 3.6 educational expenses 3-17 lO 3.7 dues, subscriptions, and Publications 3-20 lO 3.8 special Clothing and uniforms 3-20

xvi

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08239_fm_ptg01.indd 16 10/30/19 3:22 PM

xviitable of Contents

lO 3.9 Business Gifts 3-21 lO 3.10 Bad debts 3-22 lO 3.11 office in the home 3-24 lO 3.12 hobby losses 3-27 Questions and Problems 3-31

chapter 4 Additional Income and the Qualified Business Income Deduction

lO 4.1 What Is a Capital asset? 4-2 lO 4.2 holding Period 4-3 lO 4.3 Calculation of Gain or loss 4-3 lO 4.4 net Capital Gains 4-8 lO 4.5 net Capital losses 4-10 lO 4.6 sale of a Personal Residence 4-19 lO 4.7 Rental Income and expenses 4-22 lO 4.8 Passive loss limitations 4-25 lO 4.9 net operating losses 4-29 lO 4.10 Qualified Business Income (QBI) deduction 4-34 Questions and Problems 4-46

chapter 5 Deductions For and From AGI lO 5.1 health savings accounts 5-2 lO 5.2 self-employed health Insurance deduction 5-7 lO 5.3 Individual Retirement accounts 5-8 lO 5.4 small Business and self-employed Retirement Plans 5-13 lO 5.5 other for aGI deductions 5-16 lO 5.6 medical expenses 5-18 lO 5.7 taxes 5-21 lO 5.8 Interest 5-28 lO 5.9 Charitable Contributions 5-32 lO 5.10 other Itemized deductions 5-37 Questions and Problems 5-46

chapter 6 Accounting Periods and Other Taxes lO 6.1 accounting Periods 6-2 lO 6.2 accounting methods 6-3 lO 6.3 Related Parties (section 267) 6-5 lO 6.4 unearned Income of minor Children

and Certain students 6-8 lO 6.5 the Individual alternative minimum tax (amt) 6-14 lO 6.6 self-employment tax 6-19 lO 6.7 the nanny tax 6-23 lO 6.8 special taxes for high-Income taxpayers 6-24 Questions and Problems 6-36

08239_fm_ptg01.indd 17 10/30/19 3:22 PM

xviii table of Contents

chapter 7 Tax Credits lO 7.1 Child tax Credit 7-2 lO 7.2 earned Income Credit 7-5 lO 7.3 Child and dependent Care Credit 7-17 lO 7.4 the affordable Care act 7-21 lO 7.5 education tax Credits 7-27 lO 7.6 Foreign exclusion and tax Credit 7-34 lO 7.7 adoption expenses 7-36 lO 7.8 energy Credits 7-38 lO 7.9 low-Income Retirement Plan Contribution Credit 7-41 Questions and Problems 7-47

chapter 8 Depreciation and Sale of Business Property lO 8.1 depreciation 8-2 lO 8.2 modified accelerated Cost Recovery system (maCRs) and Bonus depreciation 8-3 lO 8.3 election to expense (section 179) 8-10 lO 8.4 listed Property 8-14 lO 8.5 limitation on depreciation of luxury automobiles 8-15 lO 8.6 Intangibles 8-17 lO 8.7 section 1231 Gains and losses 8-18 lO 8.8 depreciation Recapture 8-20 lO 8.9 Business Casualty Gains and losses 8-25 lO 8.10 Installment sales 8-27 lO 8.11 like-Kind exchanges 8-30 lO 8.12 Involuntary Conversions 8-32 Questions and Problems 8-36

chapter 9 Payroll, Estimated Payments, and Retirement Plans

lO 9.1 Withholding methods 9-2 lO 9.2 estimated Payments 9-11 lO 9.3 the FICa tax 9-12 lO 9.4 Federal tax deposit system 9-14 lO 9.5 employer Reporting Requirements 9-19 lO 9.6 the Futa tax 9-22 lO 9.7 Qualified Retirement Plans 9-25 lO 9.8 Rollovers 9-26 Questions and Problems 9-29

chapter 10 Partnership Taxation lO 10.1 nature of Partnership taxation 10-2 lO 10.2 Partnership Formation 10-3 lO 10.3 Partnership Income Reporting 10-5 lO 10.4 Current distributions and Guaranteed

Payments 10-15

An dy

D ea

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ot og

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08239_fm_ptg01.indd 18 10/30/19 3:22 PM

Please contact the Cengage Learning Taxation publishing team if you have any questions:

Jonathan Gross, Associate Product Manager: [email protected] Chris Walz, Marketing Manager: [email protected] Tricia Hempel, Senior Content Manager: [email protected]

Questions

xix

lO 10.5 tax Years 10-16 lO 10.6 transactions Between Partners and the Partnership 10-16 lO 10.7 Qualified Business Income deduction for Partners 10-17 lO 10.8 the at-Risk Rule 10-19 lO 10.9 limited liability Companies 10-20 Questions and Problems 10-23

chapter 11 The Corporate Income Tax lO 11.1 Corporate tax Rates 11-2 lO 11.2 Corporate Gains and losses 11-2 lO 11.3 special deductions and limitations 11-4 lO 11.4 schedule m-1 11-6 lO 11.5 Filing Requirements and estimated tax 11-7 lO 11.6 s Corporations 11-15 lO 11.7 Corporate Formation 11-17 lO 11.8 Corporate accumulations 11-27 lO 11.9 the Corporate alternative minimum tax 11-28 Questions and Problems 11-31

chapter 12 Tax Administration and Tax Planning lO 12.1 the Internal Revenue service 12-2 lO 12.2 the audit Process 12-6 lO 12.3 Interest and Penalties 12-11 lO 12.4 statute of limitations 12-15 lO 12.5 Preparers, Proof, and Privilege 12-16 lO 12.6 the taxpayer Bill of Rights 12-19 lO 12.7 tax Planning 12-22 Questions and Problems 12-27

Appendices appendix a tax Rate schedules and tax table a-1 appendix B earned Income Credit table B-1 appendix C Withholding tables C-1 appendix d additional Comprehensive tax Return Problems d-1 appendix e solutions to self-study Problems e-1 Glossary of tax terms G-1 Index I-1 list of Forms l-1 list of schedules l-2 list of Worksheets l-2

xixtable of Contents

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vi ta

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C h a p t e r 1

The Individual Income Tax Return

08239_ch01_ptg01.indd 2 10/30/19 11:48 AM

1-1

L E A R N I N G O B J E C T I V E S

After completing this chapter, you should be able to: LO 1.1 Explain the history and objectives of U.S. tax law. LO 1.2 Describe the different entities subject to tax and reporting requirements. LO 1.3 Apply the tax formula for individuals. LO 1.4 Identif y individuals who must file tax returns. LO 1.5 Determine filing status and understand the calculation of tax according to filing status. LO 1.6 Define qualif ying dependents. LO 1.7 Calculate the correct standard or itemized deduction amount for taxpayers. LO 1.8 Compute basic capital gains and losses. LO 1.9 Access and use various Internet tax resources. LO 1.10 Describe the basics of electronic filing (e-filing).

1-1

O V e r V I e W

T his chapter introduces the U.S. individual income tax system. Important elements of the individual tax formula are covered, including the tax calculation, who must

file, filing status, and the interaction of itemized deductions and the standard deduction. The chapter illustrates all the steps required for com- pletion of a basic Form 1040. Also included is a discussion of reporting and taxable entities.

An introduction to capital gains and losses is included to provide a basic understanding of capital transactions prior to the detailed coverage in Chapter 4. An overview of tax information available at the Internal Revenue Service (IRS) website and other helpful tax websites is also included. A discussion of the process for electronic filing (e-filing) of an individual tax return completes the chapter.

08239_ch01_ptg01.indd 1 10/30/19 11:48 AM

1-2 Chapter 1 ● The Individual Income Tax Return

1-1 hISTORy ANd OBJECTIVES Of ThE TAx SySTEm 1-1a Tax Law history and Objectives The U.S. income tax was established on March 1, 1913 by the Sixteenth Amendment to the Constitution. Prior to the adoption of this amendment, the U.S. government had levied various income taxes for limited periods of time. For example, an income tax was used to help finance the Civil War. The finding by the courts that the income tax law enacted in 1894 was unconstitutional eventually led to the adoption of the Sixteenth Amendment. Since adoption of the amendment, the constitutionality of the income tax has not been questioned by the federal courts.

Many people inaccurately believe the sole purpose of the income tax is to raise sufficient revenue to operate the government. The tax law has many goals other than raising revenue. These goals fall into two general categories—economic goals and social goals— and it is often unclear which goal a specific tax provision was written to meet. Tax provisions have been used for such economic motives as reduction of unemployment, expansion of investment in productive (capital) assets, and control of inflation. Specific examples of economic tax provisions are the limited allowance for expensing of capital expenditures and the bonus depreciation provisions. In addition to pure economic goals, the tax law is used to encourage certain business activities and industries. For example, an income tax credit encourages businesses to engage in research and experimentation activities, the energy credits encourage investment in solar and wind energy businesses, and a special deduction for soil and water conservation expenditures related to farm land benefits farmers.

Social goals have also resulted in the adoption of many specific tax provisions. The child and dependent care credit, the earned income credit, and the charitable contribution deduction are examples of tax provisions designed to meet social goals. Social provisions may influence economic activities, but they are written primarily to encourage taxpayers to undertake activities to benefit themselves and society.

An example of a provision that has both economic and social objectives is the provision allowing the gain on the sale of a personal residence up to $250,000 ($500,000 if married) to be excluded from taxable income. From a social standpoint, this helps a family afford a new home, but it also helps achieve the economic goal of ensuring that the United States has a mobile workforce.

The use of the income tax as a tool to promote economic and social policies has increased in recent years. Keeping this in mind, the beginning tax student can better understand how and why the tax law has become so complex.

1-1b The Tax Cuts and Jobs Act of 2017 Although the tax laws often change in some way each year, significant overhauls of the tax code are actually quite rare. However, in December 2017, The Tax Cuts and Jobs Act or TCJA (PL 115-97) was signed into law. For budgetary reasons, many of the provisions of the tax law are set to expire over the next decade. Many of the more important expiring provisions are listed below along with the chapter in this textbook in which they are discussed.

Summary of Major Tax Provisions Scheduled to Expire TCJA Provision Expires Chapter

Reduction of individual tax rates 2025 1 Increased standard deduction 2025 1 Suspension of personal exemptions 2025 1 Qualified business income deduction 2025 4 Suspension of itemized deduction phase-out 2025 5 Temporary cap on state and local taxes 2025 5 Suspension of miscellaneous itemized deductions subject to 2 percent floor 2025 5 Suspension of moving expense deduction 2025 5 Reduced limits on mortgage interest deduction 2025 5

Learning Objective 1.1

Explain the history and objectives of U.S. tax law.

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1-31-2 Repor ting and Taxable Entities

Self-Study Problem 1.1 See Appendix E for Solutions to Self-Study Problems

Which of the following is not a goal of the income tax system?

a. Raising revenue to operate the government. b. Providing incentives for certain business and economic goals, such as higher

employment rates, through business-favorable tax provisions. c. Providing incentives for certain social goals, such as charitable giving, by

allowing tax deductions, exclusions, or credits for selected activities. d. All the above are goals of the income tax system.

1-2 REPORTING ANd TAxABLE ENTITIES Under U.S. tax law, there are five basic tax reporting entities. They are individuals, corpo- rations, partnerships, estates, and trusts. The taxation of individuals is the major topic of this textbook; an overview of the taxation of partnerships and corporations is presented in Chapters 10 and 11, respectively. Taxation of estates and trusts is a specialized area not covered in this textbook.

1-2a The Individual The most familiar taxable entity is the individual. Taxable income for individuals gener- ally includes income from all sources such as wages, salaries, self-employment earnings, rents, interest, and dividends. Most taxpayers will file Form 1040. The Form 1040 has been redesigned again for 2019. A small number of the items that were relegated to Schedules 1 through 6 in 2018 are back on the face of the Form 1040 in 2019 (e.g., capital gains and losses from Schedule D). Although the Form 1040 does not fill an entire page, it also is no longer “postcard” sized. There is a new Form 1040-SR for taxpayers over the age of 65.

1.2 Learning Objective Describe the different entities subject to tax and reporting requirements.

TCJA Provision Expires Chapter

Restrictions on personal casualty losses 2025 5 Increased AMT exemption and phase-out 2025 6 Changes to kiddie tax 2025 6 Increased child tax credit 2025 7 100 percent bonus depreciation Phases out 8 starting 2023

It remains uncertain if these provisions will be either extended or made permanent; how- ever, when appropriate, the textbook includes background on the pre-TCJA law in the event those provisions return.

Also, Form 1040 underwent additional changes since the 2018 design change and a new Form 1040-SR for taxpayers over age 65 has been introduced. As a “forms-based” textbook, the design changes have been implemented throughout the textbook.

Most taxpayers know they can deduct contributions of cash to qualified charities but may not deduct the value of their time or services. However, taxpayers may be able to deduct mileage ($0.14 per mile) associated with the provision of services to a qualified charity.

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1-4 Chapter 1 ● The Individual Income Tax Return

Form 1040-SR is almost identical to Form 1040 except for larger print size and some ad- ditional disclosure on the standard deduction presented on the face of the form.

The number of schedules has been reduced to three (Schedules 1, 2, and 3) by combining many of the elements of the previous six schedules:

Schedule Primary Purpose

1 Additional forms of income other than wages, interest, dividends, distributions from qualified retirement plans such as IRAs and pensions, Social Security benefits, and capital gains and losses. Schedule 1 also reports many of the deductions for adjusted gross income.

2 Additional taxes beyond the basic income tax such as the alternative minimum tax, repayments of excess advance premium tax credit, self- employment taxes, and household employment taxes.

3 Credits and payments other than withholding including education credits, the credit for child and dependent care expenses, residential energy credit, estimated tax payments, excess Social Security taxes withheld, and the net premium tax credit.

In addition to Schedules 1–3, certain types of income and deductions must be reported on specific schedules that are included with the Forms 1040 or 1040-SR.

Schedule Primary Purpose

A Itemized deductions such as medical expenses, certain taxes, certain interest, charitable contributions, and other miscellaneous deductions

B Interest income (over $1,500) or ordinary dividend income (over $1,500) C Net profit or loss from a sole proprietor trade or business, other than farm

or ranch activities D Capital gains and losses E Rental, royalty, and pass-through income from partnerships, S corporations,

estates, and trusts F Farm or ranch income

These tax forms and schedules and some less common forms are presented in this textbook.

The origin of the Form 1040 has been rumored to be associated with the year 1040 b.c. when Samuel warned his people that if they demanded a king, the royal leader would be likely to require they pay taxes. However, in the early 1980s, the then-Commissioner of the IRS, Roscoe Eggers indicated that the number was simply the next one in the control numbering system for federal forms in 1914 when the form was issued for taxpayers for the tax year 1913. About 350,000 people filed a 1040 for 1913. All the returns were audited. In 2018, less than 1 percent of the approximately 150 million individual tax returns were audited.

Would You

Believe?

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1-51-2 Repor ting and Taxable Entities

1-2b The Corporation Corporations are subject to the U.S. income tax and must report income annually on Form 1120. Corporations are taxed at a flat rate of 21 percent for all corporations re- gardless of income level.

Some corporations may elect S corporation status. An S corporation does not generally pay regular corporate income taxes; instead, the corporation’s income passes through to the shareholders and is included on their individual returns. S corporations must report tax information annually on Form 1120S. Chapter 11 covers the basics of corporate taxation, including a discussion of S corporations.

1-2c The Partnership The partnership is not a taxable entity; instead it is a reporting entity. Generally, all income or loss of a partnership is included on the tax returns of the partners. However, a partnership must file Form 1065 annually to report the amount of the partnership’s total income or loss and show the allocation of the income or loss to the partners. The partners, in turn, report their share of ordinary income or loss on their tax returns. Other special gains, losses, income, and deductions of the partnership are reported and allocated to the partners separately, since these items are given special tax treatment at the partner level. Capital gains and losses, for example, are reported and allocated sepa- rately, and the partners report their share on Schedule D of their income tax returns. See Chapter 10 for a discussion of partnerships, including limited partnerships and limited liability companies.

Summary of major Tax formS and ScheduleS Form or Schedule Description 1040 Individual income tax return Schedule 1 Additional income and adjustments to income Schedule 2 Additional taxes Schedule 3 Additional credits and payments Schedule A Itemized deductions Schedule B Interest and dividend income Schedule C Profit or loss from business (sole proprietorship) Schedule D Capital gains and losses Schedule E Supplemental income and loss (rent, royalty, and pass-

through income from Forms 1065, 1120S, and 1041) Schedule F Farm and ranch income 1041 Fiduciary (estates and trusts) tax return 1120 Corporate tax return 1120S S corporation tax return 1065 Partnership information return Schedule K-1 (Form 1065) Partner’s share of partnership results

All of the forms listed here, and more, are available at the IRS website (www.irs.gov).

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1-6 Chapter 1 ● The Individual Income Tax Return

1-3 ThE TAx fORmuLA fOR INdIVIduALS Individual taxpayers calculate their tax in accordance with a tax formula. Understanding the formula is important, since all tax determinations are based on the result. The formula is:

Gross Income 2 Deductions for Adjusted Gross Income 5 Adjusted Gross Income 2 Greater of Itemized Deductions or the Standard Deduction 2 Qualified Business Income Deduction 5 Taxable Income 3 Tax Rate (using appropriate tax tables or rate schedules) 5 Gross Income Tax Liability and Additional Taxes 2 Tax Credits and Prepayments 5 Tax Due or Refund

Learning Objective 1.3 Apply the tax formula for individuals.

Self-Study Problem 1.2 See Appendix E for Solutions to Self-Study Problems

Indicate which is the most appropriate form or schedule(s) for each of the following items. Unless otherwise indicated in the problem, assume the taxpayer is an individual.

ITEm form or Schedule

1. Bank interest income of $1,600 received by a taxpayer who itemizes deductions

2. Capital gain on the sale of AT&T stock 3. Income from a farm 4. Estate income of $850 5. Partnership reporting of an individual partner’s share of

partnership income 6. Salary of $70,000 for a taxpayer under age 65 who

itemizes deductions 7. Income from a sole proprietorship business 8. Income from rental property 9. Dividends of $2,000 received by a taxpayer who does not

itemize deductions 10. Income of a corporation 11. Partnership’s loss 12. Charitable contribution deduction for an individual who

itemizes deductions 13. Single individual, age 67, with no dependents whose only

income is $18,000 (all from Social Security) and who does not itemize deductions or have any credits

The IRS released data in mid-2019 that reflects 2018 individual tax returns filed by mid-May (any extended but unfiled tax returns are not included). The data show that on average, taxpayers had lower effective tax rates than in 2017 for all income brackets. Taxpayers with incomes over $1 million represented less than 1 percent of the returns filed, about 7 percent of the taxable income, and about 14 percent of the tax liability.

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1-71-3 The Tax Formula for Individuals

1-3a Gross Income The calculation of taxable income begins with gross income. Gross income includes all income, unless the tax law provides for a specific exclusion. The exclusions from gross income are discussed in Chapter 2. Gross income from wages, interest, dividends, pensions, Social Security, and capital gains and losses are reported directly on Form 1040 (interest and dividends and capital gains and losses may first flow through Schedules B and D, respectively). All other forms of income are reported on Schedule 1.

1-3b deductions for Adjusted Gross Income The first category of deductions includes the deductions for adjusted gross income. These deductions include certain trade or business expenses, certain reimbursed employee business expenses paid under an accountable plan, pre-2019 alimony payments, student loan interest, the penalty on early withdrawal from savings, contributions to qualified retirement plans, and certain educator expenses. Later chapters explain these deductions in detail. Deductions for gross income are reported on Schedule 1.

1-3c Adjusted Gross Income (AGI) The amount of adjusted gross income is sometimes referred to as the “magic line,” since it is the basis for several deduction limitations, such as the limitation on medical expenses. A taxpayer’s adjusted gross income is also used to determine limits on certain charitable contributions and contributions to certain individual retirement accounts.

1-3d Standard deduction or Itemized deductions Itemized deductions are personal expense items that Congress has allowed as tax deduc- tions. Included in this category are medical expenses, certain interest expenses, certain taxes, charitable contributions, certain casualty losses, and a small number of miscella- neous items. Taxpayers should itemize their deductions only if the total amount exceeds their standard deduction amount. The following table gives the standard deduction amounts for 2019.

Filing Status Standard Deduction

Single $ 12,200 Married, filing jointly 24,400 Married, filing separately 12,200 Head of household 18,350 Qualifying widow(er) 24,400

Taxpayers who are 65 years of age or older or blind are entitled to an additional standard deduction amount. For 2019, the additional standard deduction amount is $1,650 for unmarried taxpayers and $1,300 for married taxpayers and surviving spouses. Taxpayers who are both 65 years of age or older and blind are entitled to two additional standard deduction amounts. See LO 1.7 for a complete discussion of the basic and additional standard deduction amounts.

Talk Show Host Stephen Colbert’s Tax Tip: Be extremely wealthy … all kinds of breaks for guys like that!

Colbert Report, April 3, 2006

Would You

Believe?

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1-8 Chapter 1 ● The Individual Income Tax Return

1-3e Exemptions Prior to the TCJA, taxpayers received a deduction called an exemption for themselves, spouse (if married filing jointly), and dependents. Exemptions were suspended by the TCJA starting in 2018. The suspension is scheduled to expire at the end of 2025.

1-3f The Gross Tax Liability A taxpayer’s gross tax liability is obtained by reference to the tax table or by use of a tax rate schedule. Tax credits and prepayments are subtracted from gross tax liability to calculate the net tax payable to the government or the refund to the taxpayer.

Self-Study Problem 1.3 See Appendix E for Solutions to Self-Study Problems

Bill is a single taxpayer, age 27. In 2019, his salary is $29,000 and he has interest income of $1,500. In addition, he has deductions for adjusted gross income of $2,200 and he has $6,500 of itemized deductions. Calculate the following amounts:

1. Gross income $ 2. Adjusted gross income $ 3. Standard deduction or itemized deduction amount $ 4. Taxable income $

1-4 WhO muST fILE Several conditions must exist before a taxpayer is required to file a U.S. income tax return. These conditions primarily relate to the amount of the taxpayer’s income and the taxpayer’s filing status. Figures 1.1 through 1.3 summarize the filing requirements for taxpayers in 2019. If a taxpayer has any nontaxable income, the amount should be excluded in determin- ing whether the taxpayer must file a return.

Taxpayers are also required to file a return if they have net earnings from self- employment of $400 or more, or owe taxes such as Social Security taxes on unreported tips. When a taxpayer is not required to file but is due a refund for overpayment of taxes, a return must be filed to obtain the refund.

A taxpayer who is required to file a return should mail the return to the appropriate IRS Campus Processing Site listed on the IRS website (www.irs.gov) or electronically file the return as discussed in LO 1.10. Generally, individual returns are due on the fifteenth day of the fourth month of the year following the close of the tax year. For a calendar year individual taxpayer, the return due date is generally April 15. If the 15th falls on a weekend or holiday, returns are due the next business day. However, there are two exceptions: (1) In Maine and Massachusetts, Patriots’ Day is celebrated on the third Monday of April. When Patriots’ Day is on April 15 or the first business day after April 15, the tax filing deadline is deferred for an additional day for residents of Maine and Massachusetts. (2) The second exception is a result of Emancipation Day, a holiday observed in the District of Columbia.

Learning Objective 1.4 Identify individuals who must file tax returns.

Taxpayers may provide information with their individual tax return authorizing the IRS to deposit refunds directly into their bank account. Taxpayers with a balance due may also pay their tax bill with a credit card, subject to a fee.

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1-91-4 Who Must File

FIGURE 1.1 WhO muST fILE

FIGURE 1.2

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1-10 Chapter 1 ● The Individual Income Tax Return

FIGURE 1.3

Emancipation Day is observed on April 16; however, when the 16th is a Saturday, the holiday is celebrated on the prior Friday and when the 16th is Sunday, the holiday is celebrated on the following Monday. In 2020, April 15 is a Wednesday, Patriots’ Day is Monday the 20th and Emancipation Day is Thursday the 16th, thus the filing deadline will be Wednesday, April 15th.

April 15, 2020 will be the first time since 2015 that all individual taxpayers will be required to file on April 15. Going back to the 2016 filing season (for 2015 tax returns), either the Emancipation Day or Patriots’ Day holidays affected all or some taxpayers and provided a day or two delay in the filing deadline. Procrastinators take notice!

Would You

Believe? A six-month extension of time to file may be requested on Form 4868 by the April due

date. Regardless of the original filing deadline, the extension is until October 15 unless that day falls on a weekend or holiday in which case the extended due date is the following business day. However, all tax due must be paid by the April due date or penalties and interest will apply.

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1-111-5 Filing Status and Tax Computation

Self-Study Problem 1.4 See Appendix E for Solutions to Self-Study Problems

Indicate by a check mark whether the following taxpayers are required to file a return for 2019 in each of the following independent situations:

filing Required? yes No

1. Taxpayer (age 45) is single with income of $10,000. 2. Husband (age 67) and wife (age 64) have an income of

$25,000 and file a joint return. 3. Taxpayer is a college student with a salary from a part-time

job of $6,500. She is claimed as a dependent by her parents. 4. Taxpayer has net earnings from self-employment of $4,000. 5. Taxpayers are married with income of $15,900 and file a

joint return. They expect a refund of $600 from excess withholding.

6. Taxpayer is a waiter and has unreported tips of $450. 7. Taxpayer is a qualifying widow (age 48) with a dependent

son (age 18) and income of $22,800.

1-5 fILING STATuS ANd TAx COmPuTATION An important step in calculating the amount of a taxpayer’s tax is the determination of the taxpayer’s correct filing status. The tax law has five different filing statuses: single; married filing jointly; married filing separately; head of household; and qualifying widow(er). A tax table that must be used by most taxpayers, showing the tax liability for all five statuses, is provided in Appendix A. The tax table must be used unless the taxpayer’s taxable income is $100,000 or more or the taxpayer is using a special method to calculate the tax liability. If taxpayers cannot use the tax table to determine their tax, a tax rate schedule is used. Each filing status has a separate tax rate schedule as presented in Appendix A.

1-5a Single filing Status A taxpayer who does not meet the definition of married, qualifying widow(er), or head of household status must file as single. This status must be used by any taxpayer who is unmarried or legally separated from his/her spouse by divorce or separate maintenance decree as of December 31 of the tax year. State law governs whether a taxpayer is married, divorced, or legally separated. If a taxpayer’s spouse dies during the year, the taxpayer’s status is married for that year.

1-5b married filing Jointly Taxpayers are considered married for tax purposes if they are married on December 31 of the tax year. Also, in the year of one spouse’s death, the spouses are considered married for the full year. In most situations, married taxpayers pay less tax by filing jointly than by filing separately. Married taxpayers may file a joint return even if they did not live together for the entire year.

1.5 Learning Objective Determine filing status and understand the calculation of tax according to filing status.

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1-12 Chapter 1 ● The Individual Income Tax Return

1-5c married filing Separately Married taxpayers may file separate returns and should do so if it reduces their total tax liability. They may file separately if one or both had income during the year. If separate returns are filed, both taxpayers must compute their tax in the same manner. For example, if one spouse itemizes deductions, the other spouse must also itemize deductions. Each taxpayer reports his or her income, deductions, and credits and is responsible only for the tax due on his or her return. If the taxpayers live in a community property state, they must follow state law to determine community income and separate income. The community property states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. See Chapter 2 for additional discussion regarding income and losses from community property.

A legally married taxpayer may file as head of household (based on the general filing status rules) if he or she qualifies as an abandoned spouse. A taxpayer qualifies as an abandoned spouse only if all of the following requirements are met:

1. A separate return is filed, 2. The taxpayer paid more than half the cost (rent, utilities, etc.) to maintain his or her

home during the year, 3. The spouse did not live with the taxpayer at any time in the last 6 months of the year, and 4. For over 6 months during the year the home was the principal residence for a depen-

dent child, stepchild, or adopted child. Under certain conditions, a foster child may qualify as a dependent.

In certain circumstances, married couples may be able to reduce their total tax liability by filing separately. For instance, since some itemized deductions, such as medical expenses and casualty losses, are reduced by a percentage of adjusted gross income (discussed in Chapter 5), a spouse with a casualty loss and low separate adjusted gross income may be better off filing separately.

1-5d head of household If an unmarried taxpayer can meet special tests or if a married taxpayer qualifies as an aban- doned spouse, he or she is allowed to file as head of household. Head of household rates are lower than rates for single or married filing separately. A taxpayer qualifies for head of household status if both of the following conditions exist:

1. The taxpayer was an unmarried or abandoned spouse as of December 31 of the tax year, and

2. The taxpayer paid more than half of the cost of keeping a home that was the principal place of residence of a dependent child or other qualifying dependent relative. An unre- lated dependent or a dependent, such as a cousin, who is too distantly related, will not qualify the taxpayer for head of household status. If the dependent is the taxpayer’s parent, the parent need not live with the taxpayer. In all cases other than dependent parents, who may maintain a separate residence, the qualifying dependent relative must actually live in the same household as the taxpayer. A divorced parent who meets the above require- ments, but has signed an IRS form or a qualifying legal agreement shifting the dependency deduction to his or her ex-spouse, may still file using head of household status.

Head of Household is a filing status that can be difficult to understand but comes with some substantial tax benefits if a taxpayer qualifies. Single parents should carefully analyze their situation since Head of Household provides lower tax rates and higher standard deductions than Single filing status. This benefit is not just limited to single parents. All unmarried taxpayers that maintain a household and provide support for another person should consider whether they qualify for this tax-advantageous status.

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1-131-5 Filing Status and Tax Computation

Divorcing couples may save significant taxes if one or both of the spouses qualify as an “abandoned spouse” and can use the head of household filing status. The combination of head of household filing status for one spouse with married filing separately filing status for the other spouse is commonly seen in the year (or years) leading up to a divorce. In cases where each spouse has custody of a child, the separated taxpayers may each claim head of household status.

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1-5e Qualifying Widow(er) with dependent Child A taxpayer may continue to benefit from the joint return rates for 2 years after the death of his or her spouse. To qualify to use the joint return rates, the widow(er) must pay over half the cost of maintaining a household where a dependent child, stepchild, adopted child, or foster child lives. After the 2-year period, these taxpayers often qualify for the head of household filing status.

1-5f Tax Computation For 2019, there are seven income tax brackets (10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent). Individuals with taxable income below $100,000 are required to use the tax tables presented in Appendix A. Taxpayers with income equal to or more than $100,000 use the tax rate schedules (also presented in Appendix A). An example of the single tax rate schedule is presented below. Certain high-income taxpayers are subject to additional taxes discussed in Chapter 6.

The tax rates applicable to net long-term capital gains currently range from 0 percent to 31.8 percent depending on the taxpayer’s tax bracket and the kind of capital asset. The calculation of the tax on capital gains is discussed in detail in Chapter 4, and the applicable tax rates are discussed in LO 1.8 of this chapter.

The tax rates for qualifying dividends, discussed in detail in Chapter 2, range from 0 percent to 23.8 percent in 2019.

ExAmPLE Carol, a single taxpayer, has adjusted gross income of $120,000 and taxable income of $105,000 for 2019. Her tax is calculated using the 2019 tax rate schedule from Appendix A as follows:

$19,374.50 5 $14,382.50 1 [24% 3 ($105,000 2 $84,200)] ♦

ExAmPLE Meg is a single taxpayer during 2019. Her taxable income for the year is $27,530. Using the tax table in Appendix A, her gross tax liability for the year is found to be $3,109. ♦

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1-14 Chapter 1 ● The Individual Income Tax Return

Taxpayers considering marriage may be able to save thousands of dollars by engaging in tax planning prior to setting a wedding date. If the couple would pay less in taxes by filing as married rather than as single (which will frequently happen if one spouse has low earnings for the year), they may prefer a December wedding. They can take advantage of the rule that requires taxpayers to file as married for the full year if they were married on the last day of the year. On the other hand, if filing a joint return would cause the couple to pay more in taxes (which frequently happens if both spouses have high incomes), they may prefer a January wedding.

TAX BREAK

Self-Study Problem 1.5 See Appendix E for Solutions to Self-Study Problems

Indicate the filing status (or statuses) in each of the following independent cases, using this legend:

A – Single d – Head of household B – Married, filing a joint return E – Qualifying widow(er) C – Married, filing separate returns

Case filing Status

1. The taxpayers are married on December 31 of the tax year. 2. The taxpayer is single, with a dependent child living in her home. 3. The taxpayer is unmarried and is living with his girlfriend. 4. The taxpayer is married and his spouse left midyear and has

disappeared. The taxpayer has no dependents. 5. The unmarried taxpayer supports her dependent mother, who

lives in her own home. 6. The taxpayer’s wife died last year. His 15-year-old dependent son

lives with him.

1-6 QuALIfyING dEPENdENTS 1-6a dependents Prior to 2018, taxpayers were able to deduct approximately $4,000 each for themselves, their spouse (if married filing jointly), and any dependents. The TCJA eliminated the personal and dependency exemptions in lieu of a larger standard deduction; however, dependents remain important for other reasons. For example, head of household filing status, the child tax credit, and the earned income tax credit all depend on having a qualified dependent. Lastly, the suspension of personal and dependency exemptions is scheduled to expire after 2025 which means, exemptions may yet return. A dependent is an individual who meets the tests dis- cussed on the following page to be considered either a qualifying child or a qualifying relative.

Learning Objective 1.6 Define qualifying dependents.

tIp In ProConnect, much of the input is controlled by the left-hand margin. Filing status is part of Client Information under the General heading. By clicking on Filing Status, a dropdown appears in the main window to allow the preparer to select the taxpayer’s filing status. For married filing jointly and separately statuses, the Live With Spouse box should be checked if it applies.

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1-151-6 Qualifying Dependents

1-6b Qualifying Child For a child to be a dependent, he or she must meet the following tests:

1. Relationship Test The child must be the taxpayer’s child, stepchild, or adopted child, or the taxpayer’s brother or sister, half-brother or half-sister, or stepsibling, or a descendant of any of these. Under certain circumstances, a foster child can also qualify. The child must be younger than the person claiming him or her unless the child is permanently disabled.

2. Domicile Test The child must have the same principal place of abode as the taxpayer for more than half of the taxable year. In satisfying this requirement, temporary absences from the household due to special circumstances such as illness, education, and vacation are not considered.

3. Age Test The child must be under age 19 or a full-time student under the age of 24. A child is considered a full-time student if enrolled full-time for at least 5 months of the year. Thus, a college senior graduating in May or June can qualify in the year of graduation.

4. Joint Return Test The child must not file a joint return with his or her spouse. If neither the spouse nor the child is required to file, but they file a return merely to claim a refund of tax, they are not considered to have filed a return for purposes of this test.

5. Citizenship Test The dependent must be a U.S. citizen, a resident of the United States, Canada, or Mexico, or an alien child adopted by and living with a U.S. citizen.

6. Self-Support Test A child who provides more than one-half of his or her own support cannot be claimed as a dependent of someone else. Support includes expenditures for items such as food, lodging, clothes, medical and dental care, and education. To calculate support, the taxpayer uses the actual cost of the above items, except lodging. The value of lodging is calculated at its fair rental value. Funds received by students as scholarships are excluded from the support test.

In the event that a child satisfies the requirements of dependency for more than one taxpayer, the following tie-breaking rules apply:

● If one of the individuals eligible to claim the child is a parent, that person will be allowed to claim the dependent.

● If both parents qualify (separate returns are filed), then the parent with whom the child resides the longest during the year prevails. If the residence period is the same or is not ascertainable, then the parent with the highest AGI (Adjusted Gross Income) prevails.

● If no parents are involved, the taxpayer with the highest AGI prevails.

ExAmPLE Bill, age 12, lives in the same household with Irene, his mother, and Darlene, his aunt. Bill qualifies as a dependent of both Irene and Darlene. Since Irene is Bill’s mother, she has the right to claim Bill as a dependent. The tie-breaking rules are not necessary if the taxpayer who can claim the dependent does not claim the dependent. Hence, Darlene can claim Bill as a dependent if Irene does not claim him. ♦

In the case of divorced or legally separated parents with children, the ability to claim a qualifying child belongs to the parent with whom the child lived for more than 6 months

The IRS started requiring the disclosure of Social Security numbers for each dependent claimed by a taxpayer to stop dishonest taxpayers from claiming extra dependents or even claiming pets. Before this change, listing phony dependents was one of the most common forms of tax fraud. Reportedly, 7 million dependents disappeared from the tax rolls after Congress required taxpayers to include dependents’ Social Security numbers on tax returns.

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1-16 Chapter 1 ● The Individual Income Tax Return

out of the year. The opportunity to claim the child as a dependent can be shifted to the noncustodial parent if the custodial parent signs IRS Form 8332, and the form is attached to the noncustodial parent’s tax return.

Figure 1.4 illustrates the interaction of the qualifying child dependency tests described on the previous page.

1-6c Qualifying Relative A person who is not a qualifying child can be a qualifying relative if the following 5-part test is met. A child of a taxpayer who does not meet the tests to be a qualifying child can still qualify as a dependent under the qualifying relative tests described below.

1. Relationship or Member of Household Test The individual must either be a relative of the taxpayer or a member of the household. The list of qualifying relatives is broad and includes parents, grandparents, children, grandchildren, siblings, aunts and uncles by blood, nephews and nieces, “in-laws,” and adopted children. Foster children may also qualify in certain circumstances. If the potential dependent is a more distant relative, additional information is available at the IRS website (www.irs.gov). For example, cousins are not considered relatives for this purpose.

In addition to the relatives listed, any person who lived in the taxpayer’s home as a member of the household for the entire year meets the relationship test. A person is not considered a member of the household if at any time during the year the relationship between the taxpayer and the dependent was in violation of local law.

ExAmPLE Scott provides all of the support for an unrelated family friend who lives with him for the entire tax year. He also supports a cousin who lives in another state. The family friend can qualify as Scott’s dependent, but the cousin can- not. The family friend meets the member of the household test. Even though the cousin is not considered a relative, he could have been a dependent if he met the member of the household part of the test. ♦

2. Gross Income Test The individual cannot have gross income equal to or above the exemption amount ($4,200 in 2019). Although exemptions are no longer deductible, the exemption amount will continue to be updated by the IRS. Gross income does not include any income exempt from tax (for example, tax-exempt interest or exempt Social Security benefits).

3. Support Test The dependent must receive over half of his or her support from the taxpayer or a group of taxpayers (see multiple support agreement below). Unlike the gross income test, income exempt from tax and earned by the potential dependent is considered for the support test.

4. Joint Return Test The dependent must not file a joint return unless it is only to claim a refund of taxes.

5. Citizenship Test The dependent must meet the citizenship test discussed above.

ExAmPLE A taxpayer has a 26-year-old son with gross income less than the exemption amount who receives more than half his support from his parents. The son fails the test to be a qualifying child based on his age, but passes the test to be a dependent based on the qualifying relative rules. ♦

Figure 1.5 illustrates the qualifying relative tests described above. As long as the dependency tests are met, a person who was born or died during the

year, such as a baby born before or on December 31, can be claimed as a dependent. Taxpayers must provide a Social Security number for all dependents.

If a dependent is supported by two or more taxpayers, a multiple support agreement may be filed. To file the agreement, the taxpayers (as a group) must provide over 50 percent of the support of the dependent. Assuming that all other dependency tests are met, the group may give the dependent to any member of the group who provided over 10 percent of the dependent’s support.

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1-171-6 Qualifying Dependents

Yes

NO DEPENDENCY

DEPENDENCY

Yes

Was the domicile test met?

Was the relationship

test met?

Was the joint return test met?

Is the child under 19 or a full-time

student under 24?

START

U.S. citizen or resident of U.S.,

Mexico, Canada?

Was the support test met?

FIGURE 1.4 dEPENdENCy TESTS fLOW ChART fOR QuALIfyING ChILd

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1-18 Chapter 1 ● The Individual Income Tax Return

FIGURE 1.5 dEPENdENCy TESTS fLOW ChART fOR QuALIfyING RELATIVE

Yes

NO DEPENDENCY

DEPENDENCY

Yes

Was the support test met?

U.S. citizen or resident of U.S., Mexico, Canada?

Was the joint return test

met?

Was the relationship or member of house-

hold test met?

Is gross income less than the exemption amount

($4,200 in 2019)?

START

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1-191-6 Qualifying Dependents

1-6d Credits for dependents Although deductions for personal exemptions are no longer permitted from 2018 through 2025, dependent status is important for claiming a number of individual tax credits such as the child tax credit, the credit for other dependents, and the earned income tax credit. Many of these tax credits are covered in Chapter 7; however, due to the relatively large number of taxpayers that are eligible for the child tax credit and the credit for other dependents, an overview is provided here.

A tax credit differs from a tax deduction. A tax deduction serves to lower the taxable income of the taxpayer.

ExAmPLE Emily’s adjusted gross income is $50,025. She is eligible for a $12,200 standard deduction. This lowers her taxable income to $37,825 ($50,025 2 $12,200). If Emily is single, her 2019 tax liability is $4,345. ♦

A tax credit lowers the tax liability dollar for dollar. A credit is generally more advantageous than a deduction.

ExAmPLE Emily (from the previous example) is also eligible for a $500 tax credit. Rather than reduce her taxable income, the tax credit reduces the tax itself to $3,845 ($4,345 2 $500). ♦

In 2019, the child tax credit is $2,000 per child. To qualify for the credit, the child must be a qualifying child under the age of 17 and have a Social Security number at the time the tax return is filed. Additional requirements are covered in Chapter 7.

The credit for other dependents is $500 per dependent. An “other dependent” need not be a child but must qualify as either a qualifying child or qualifying dependent. Additional requirements are covered in Chapter 7.

ExAmPLE Bruce and Demi Mehr have two children, Anna (age 12) and Clark (age 18). Both Anna and Clark qualify as qualifying children under the dependent rules. Assuming all other requirements are met, the Mehrs may claim a $2,000 child tax credit for Anna and a $500 other dependent credit for Clark (as he is not under age 17). ♦

Spouse information is entered under Client Information and is just under Taxpayer Information on the left-hand margin. Dependents are a new category under General. Be sure and input date of birth and other fields. Typically, the Child Tax Credit and the Earned Income Credit should be set to When Applicable to permit the software to make the correct determination based on input. New dependents can be added by clicking the [1] tab at the top of the main window for Dependents.

tIp

ProConnect is designed to automatically compute the child tax credit and other dependent credit based on the information input in the Dependent window. If no such credit is being shown, it could be due to missing information (for example, birthdate) or the credits were inadvertently suppressed in the Dependent window. The child tax credit and other dependent credit can be overridden under Credits/EIC, Residential Energy, Oth Credits in the left-hand margin but this is generally not a good idea.

tIp

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1-20 Chapter 1 ● The Individual Income Tax Return

Self-Study Problem 1.6 See Appendix E for Solutions to Self-Study Problems

Indicate in each of the following situations whether the taxpayer has a dependent in 2019.

yes No

1. Betty and Bob, a married couple, had a new baby in December 2019.

2. Charlie, age 25, supports his 26-year-old brother, who is not a full-time student. His brother lives with Charlie all year. His brother’s gross income is $4,500 from a part-time job.

3. Donna and her sister support their mother and provide 60% of her support. If Donna provides 25% of her mother’s support and her sister signs a multiple support agreement, can Donna claim the mother as a dependent?

4. Frank is single and supports his son and his son’s wife, both of whom lived with Frank for the entire year. The son (age 20) and his wife (age 19) file a joint return to get a refund, reporting $2,500 ($2,000 earned by the son) on gross income. Both the son and daughter-in-law are full-time students.

5. Gary is single and provides $5,000 toward his 19-year-old daughter’s college expenses. The remainder of her support is provided by a tax-exempt $9,500 tuition scholarship. The daughter is a full-time student.

6. Helen is 50 years old and supports her 72-year-old mother, who is blind and has $5,000 of Social Security benefits that are not taxable.

Your clients, Adam and Amy Accrual, have a 21-year-old daughter named April. April is single and is a full-time student studying for her bachelor’s degree in accounting at California Poly Academy (CPA) in Pismo Beach, California, where she lives with her roommates year-round. Last year, April worked at a local bar and restaurant four nights a week and made $18,000, which she used for tuition, fees, books, and living expenses. Her parents help April by sending her $300 each month to help with her expenses at college. This is all of the support given to April by her parents. When preparing Adam and Amy’s tax return, you note that they claim April as a dependent for tax purposes. Adam is insistent that they can claim April because of the $300 per month support and the fact that they “have claimed her since she was born.” He will not let you take April off his return as a dependent. Would you sign the Paid Preparer’s declaration (see example above) on this return? Why or why not?

Would You Sign This

Tax Return?

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08239_ch01_ptg01.indd 20 10/30/19 11:49 AM

1-211-7 The Standard Deduction

1-7 ThE STANdARd dEduCTION The standard deduction was placed in the tax law to provide relief for taxpayers with few itemized deductions. The amount of the standard deduction is subtracted from adjusted gross income by taxpayers who do not itemize their deductions. If a taxpayer’s gross income is less than the standard deduction amount, the taxpayer has no taxable income. The 2019 standard deduction amounts are presented below:

Filing Status Standard Deduction

Single $ 12,200 Married, filing jointly 24,400 Married, filing separately 12,200 Head of household 18,350 Qualifying widow(er) 24,400

1.7 Learning Objective Calculate the correct standard or itemized deduction amount for taxpayers.

1-7a Additional Amounts for Old Age and Blindness Taxpayers who are 65 years of age or older or blind are entitled to an additional standard deduction amount. For 2019, the additional standard deduction amount is $1,650 for un- married taxpayers and $1,300 for married taxpayers and qualifying widows or widowers. Taxpayers who are both at least 65 years old and blind are entitled to two additional stan- dard deduction amounts. The additional standard deduction amounts are also available for the taxpayer’s spouse, but not for dependents. An individual is considered blind for pur- poses of receiving an additional standard deduction amount if:

1. Central visual acuity does not exceed 20/200 in the better eye with correcting lenses, or 2. Visual acuity is greater than 20/200 but is limited to a field of vision not greater than

20 degrees.

ExAmPLE John is single and 70 years old in 2019. His standard deduction is $13,850 ($12,200 plus an additional $1,650 for being 65 years of age or older). ♦

ExAmPLE Bob and Mary are married in 2019 and file a joint return. Bob is age 68, and Mary is 63 and meets the test for blindness. Their standard deduction is $27,000 ($24,400 plus $1,300 for Bob being 65 years or older and another $1,300 for Mary’s blindness). ♦

1-7b Individuals Not Eligible for the Standard deduction The following taxpayers cannot use the standard deduction, but must itemize instead:

1. A married individual filing a separate return, whose spouse itemizes deductions 2. Most nonresident aliens 3. An individual filing a short-period tax return because of a change in the annual

accounting period

ExAmPLE Ann and Ed are married individuals who file separate returns for 2019. Ann itemizes her deductions on her return. Ed’s adjusted gross income is $12,000, and he has itemized deductions of $900. Ed’s taxable income is calculated as follows:

Adjusted gross income $ 12,000 Itemized deductions (900) Taxable income $ 11,100

Since Ann itemizes her deductions, Ed must also itemize deductions and is not entitled to use the standard deduction amount. ♦

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1-22 Chapter 1 ● The Individual Income Tax Return

1-7c Special Limitations for dependents The standard deduction is limited for the tax return of a dependent. The total standard deduc- tion may not exceed the greater of $1,100 or the sum of $350 plus the dependent’s earned income up to the basic standard deduction amount in total (e.g., $12,200 for single taxpayers), plus any additional standard deduction amount for old age or blindness. The standard deduc- tion amount for old age and blindness is only allowed when a dependent files a tax return. It is not allowed to increase the standard deduction of the taxpayer claiming the dependent.

ExAmPLE Penzer, who is 8 years old, earned $17,000 as a child model during 2019. Penzer is claimed as a dependent by his parents on their tax return. Penzer is required to file a tax return, and his taxable income will be $4,800 ($17,000 less $12,200, the standard deduction amount). If Penzer had earned only $9,000, his standard deduction would be $9,350 [the greater of $1,100 or $9,350 ($9,000 1 $350)], and he would not owe any tax or be required to file a return. ♦

ExAmPLE Geoffrey, who is 4 years old and claimed as a dependent on his parents’ tax return, earned $6,500 of interest income on a large bank account left to him by his grandmother. He had no earned income. His standard deduction is $1,100 (the greater of $1,100 or $350). His taxable income will be $5,400 ($6,500 less $1,100, the standard deduction amount). Dependent children may be taxed at trust income tax rates when their taxable income is made up of unearned income, such as interest. The special “kiddie tax” calculations are covered in Chapter 6. ♦

Self-Study Problem 1.7 See Appendix E for Solutions to Self-Study Problems

Indicate in each of the following independent situations the amount of the standard deduction the taxpayers should claim on their 2019 income tax returns.

1. Adam is 45 years old, in good health, and single. 2. Bill and Betty are married and file a joint return. Bill is 66 years old, and

Betty is 60. 3. Charlie is 70, single, and blind. 4. Debbie qualifies for head of household filing status, is 35 years old, and

is in good health. 5. Elizabeth is 9 years old, and her only income is $3,600 of interest

on a savings account. She is claimed as a dependent on her parents’ tax return.

6. Frank and Frieda are married with two dependent children. They file a joint return, are in good health, and both of them are under 65 years of age.

1-8 A BRIEf OVERVIEW Of CAPITAL GAINS ANd LOSSES When a taxpayer sells an asset, there is normally a gain or loss on the transaction. Depending on the kind of asset sold, this gain or loss will have different tax consequences. Chapter 4 of this textbook has detailed coverage of the effect of gains and losses on a taxpayer’s tax liability. Because of their importance to the understanding of the calculation of an individual’s tax liability, a brief overview of gains and losses will be discussed here.

Learning Objective 1.8 Compute basic capital gains and losses.

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1-231-8 A Brief Over view of Capital Gains and Losses

The amount of gain or loss realized by a taxpayer is determined by subtracting the adjusted basis of the asset from the amount realized. Generally, the adjusted basis of an asset is its cost less any depreciation (covered in Chapter 8) taken on the asset. The amount realized is generally what the taxpayer receives from the sale (e.g., the sales price less any cost of the sale). The formula for calculating the gain or loss can be stated as follows:

Gain (or loss) realized 5 Amount realized 2 Adjusted basis

Most gains and losses realized are also recognized for tax purposes. Recognized gains and losses are those that are included in the taxpayer’s taxable income. The exceptions to this general tax recognition rule are discussed in Chapter 4.

ExAmPLE Lisa purchased a rental house a few years ago for $100,000. Total depreciation to date on the house is $25,000. In the current year she sells the house for $155,000 and receives $147,000 after paying selling expenses of $8,000. Her gain on the sale is $72,000, calculated as follows:

Amount realized ($155,000 2 $8,000) $ 147,000 Adjusted basis ($100,000 2 $25,000) (75,000) Gain realized $ 72,000

This gain realized will be recognized as a taxable gain. ♦

1-8a Capital Gains and Losses Gains and losses can be either ordinary or capital. Ordinary gains and losses are treated for tax purposes just like other items of income such as salaries and interest, and they are taxed at ordinary rates. Capital gains and losses receive special tax treatment.

A capital gain or loss arises from the sale or exchange of a capital asset. In general, a capital asset is any property (either personal or investment) held by a taxpayer, with certain exceptions as listed in the tax law (see Chapter 4). Examples of capital assets held by individual taxpayers include stocks, bonds, land, cars, boats, and other items held as investments or for personal use. Typical assets that are not capital assets are inventory and accounts receivable.

The tax rates on long-term (held more than 12 months) capital gains are summarized as follows:

Income Level 2019 Long-term capital gains rate*

Married filing jointly

$0–$78,750 0% $78,751–$488,850 15% .$488,850 20% Single $0–$39,375 0% $39,376–$434,550 15% .$434,550 20% Head of household $0–$52,750 0% $52,751–$461,700 15% .$461,700 20% Married filing separately $0–$39,375 0% $39,376–$244,425 15% >$244,425 20%

*Special higher rates for “high-income” taxpayers are covered in Chapter 6.

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1-24 Chapter 1 ● The Individual Income Tax Return

Gain from property held 12 months or less is deemed to be short-term capital gain and is taxed at ordinary income rates. Capital gains from the sale of assets that have been depreciated, or capital gains from “collectibles,” may be taxed at higher rates as discussed in Chapter 4.

ExAmPLE In the current year, Chris, a single taxpayer, sells AT&T stock for $25,000. He purchased the stock 5 years ago for $15,000, giving him an adjusted basis of $15,000 and a long-term gain of $10,000. Chris’ taxable income without the sale of the stock is $140,000, which puts him in the 24 percent tax bracket. The tax due on the long-term capital gain would be $1,500 (15% 3 $10,000) instead of $2,400 (24% 3 $10,000) if the gain on the stock were treated as ordinary income. ♦

When calculating capital gain or loss, the taxpayer must net all capital asset transactions to determine the nature of the final gain or loss (see Chapter 4 for a discussion of this calculation). If an individual taxpayer ends up with a net capital loss (short-term or long- term), up to $3,000 per year can be deducted against ordinary income. The net loss not used in the current year may be carried forward and used to reduce taxable income in future years (see Chapter 4 for a discussion of capital losses). Losses from capital assets held for personal purposes, such as a nonbusiness auto or a personal residence, are not deductible, even though gains on personal assets are taxable.

Taxpayers may wish to postpone the sale of capital assets until the holding period is met to qualify for the preferential long-term capital gains rate. Of course, there is always the risk that postponing the sale of a capital asset such as stock may result in a loss if the price of the stock decreases below its cost during volatile markets. The economic risks of a transaction should always be considered along with the tax benefits.

TAX BREAK

ExAmPLE Amy purchased gold coins as an investment. She paid $50,000 for the coins. This year she sells the coins to a dealer for $35,000. As a result, Amy has a $15,000 capital loss. She may deduct $3,000 of the loss against her other income this year. The remaining unused loss of $12,000 ($15,000 2 $3,000) is carried forward and may be deducted against other income in future years. Of course, the carryover is subject to the $3,000 annual limitation in future years. ♦

Volunteer Income Tax Assistance (VITA) Program The Volunteer Income Tax Assistance (VITA) program offers free tax help to people who generally make $55,000 or less, persons with disabilities, the elderly and limited English-speaking taxpayers who need assistance in preparing their own tax returns. IRS-certified volunteers provide free basic income tax return preparation with electronic filing to qualified individuals. VITA sites are generally located at community and neighborhood centers, libraries, schools, shopping malls, and other convenient locations across the country. Many universities and colleges operate VITA sites in conjunction with their accounting programs. This is a small but vital part of the VITA program run by the IRS. The majority of the VITA sites are not run by schools, but rather by community groups, such as churches, senior groups (AARP), military bases, etc. If a student has a chance to participate in a VITA program, he or she should do so if at all possible. The experience provides valuable insight into preparing tax returns for others. Please see the IRS website www.irs.gov to locate the nearest VITA site and for more information.

TAX BREAK

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1-251-9 Tax and the Internet

Self-Study Problem 1.8 See Appendix E for Solutions to Self-Study Problems

Erin purchased stock in JKL Corporation several years ago for $8,750. In the current year, she sold the same stock for $12,800. She paid a $200 sales commission to her stockbroker.

1. What is Erin’s amount realized? $ 2. What is Erin’s adjusted basis? $ 3. What is Erin’s realized gain or loss? $ 4. What is Erin’s recognized gain or loss? $ 5. How is the gain or loss treated for tax purposes (if any)?

The IRS recommends considering the following when getting married: ● Social Security numbers on the tax return need to match the Social Security Administration’s (SSA) records. Be sure and report any name changes to the SSA.

● Taxpayers may want to consider changing their withholding, especially if both spouses work.

● Marriage is likely to trigger a “change in circumstance” if a taxpayer is receiving advance payments on the premium tax credit. The appropriate health insurance marketplace should be notified.

● Change of address with the U.S. Postal Service (online) and with the IRS (Form 8822). ● Change in filing status to married filing jointly or separately should be considered.

TAX BREAK

1-9 TAx ANd ThE INTERNET Taxpayers and tax practitioners can find a substantial amount of useful information on the Internet. Government agencies, businesses, organizations, and groups (e.g., the IRS, AICPA, and Cengage) maintain sites that contain information of interest to the public.

The information available on various websites is subject to rapid change. Discussed below are some current Internet sites that are of interest to taxpayers. Taxpayers should be aware that the locations and information provided on the Internet are subject to change by the site organizer without notice.

1-9a The IRS Website, www.irs.gov One of the most useful websites containing tax information is the one maintained by the IRS. The IRS site has a search function to assist users in locating information. A number of common tasks are available at the home page such as refund status or making a tax pay- ment. The Forms and Publications search function is particularly useful and allows the user to locate and download almost any tax form, instructions, or publication available from the IRS. A Help function is available to aid users of the IRS website. Online and telephone as- sistance from the IRS is provided for users who have questions or want to communicate with the IRS. The IRS has also launched a YouTube video channel, an iTunes podcast, and a Twitter, Tumblr, and Facebook page. The YouTube channel has numerous educational videos covering a number of tax-related topics, including how to check on a refund and how to file a tax return extension. The IRS news feed on Twitter, @IRSnews, is also a good source of tax information. The IRS also offers IRS2GO—a mobile phone application.

A 2019 screenshot of the IRS website (www.irs.gov) is presented in Figure 1.6.

1.9 Learning Objective Access and use various Internet tax resources.

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1-26 Chapter 1 ● The Individual Income Tax Return

FIGURE 1.6 IRS WEBSITE

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1-9b Intuit’s ProConnect Tax Online Intuit offers a line of tax preparation products such as ProConnect Tax, Lacerte, and the well-known Turbo Tax. Many of the Intuit products have training and support available online at no charge. You can find ProConnect help at http://accountants-intuit.com /proconnect-tax-online-us-en and more general tax help at http://blog.turbotax.intuit .com/.

The IRS issues warnings to taxpayers each year about identity theft scams via e-mail known as “phishing” scams. The e-mails look official and may even have a link to a bogus website that looks almost identical to www.irs.gov (and may even mention USA.gov or IRS.gov). The fake e-mails may also appear to have been sent by the IRS Taxpayer Advocate’s Office. Taxpayers who get these messages should not respond to the e-mail or click on the links. Although the IRS maintains Twitter and Facebook accounts, the IRS does not initiate contact with taxpayers by e-mail, texting, or any social media.

Would You

Believe?

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1-271-10 Electronic Filing (E-Filing)

Self-Study Problem 1.9 See Appendix E for Solutions to Self-Study Problems

Indicate whether the following statements are true or false by circling the appropriate letter.

t F 1. Taxpayers can download tax forms and IRS publications from the IRS website.

t F 2. A help function is available to aid users of the IRS website. t F 3. The IRS has a mobile phone app.

1-10 ELECTRONIC fILING (E-fILING) Electronic filing (e-filing) is the process of transmitting federal income tax return informa- tion to the IRS Service Center using a device with Internet access. For the taxpayer, elec- tronic filing offers faster processing and generally a faster refund. The fastest refund can be obtained through a direct deposit to the taxpayer’s bank account (however, the taxpayer can also choose to be paid by check). IRS statistics show an error rate of less than 1 percent on electronically filed returns, compared with more than 20 percent on paper returns.

Two methods of e-filing of individual income tax returns are available with the IRS. The first e-filing method is using a personal computer device and tax preparation software such as Intuit’s ProConnect Tax Online, which is included as part of this textbook. Individual taxpayers may transmit their returns from their homes, workplaces, libraries, retail outlets, or, in some limited situations, a mobile phone app. The IRS website contains detailed information on this process as the IRS is constantly working to make e-filing more user-friendly and widely available. The IRS provides free tax preparation and e-filing software to individuals with income below certain thresholds (see www.irs.gov/freefile). Individuals with higher income may still e-file free, using IRS fill-in forms (see www .freefilefillableforms.com). The fillable forms program performs calculations but will not provide the tax preparation guidance that standard tax software programs provide.

The second e-filing option is to use the services of a tax professional, including certified public accountants, tax attorneys, IRS-enrolled agents, and tax preparation businesses qualifying for the IRS tax professional e-filing program.

Electronic filing represents a significant growth area in computerized tax services. More than 90 percent of all individual taxpayers now e-file. Mandatory electronic filing is currently in the process of being phased in for the professional tax return preparation industry. In the future, electronic filing will likely be required for most tax returns filed.

1.10 Learning Objective Describe the basics of electronic filing (e-filing).

In 2006, General Electric Co. (GE) electronically filed their corporate tax return. If printed, it was estimated at 24,000 pages and expected to stack up to 8 feet tall. In 2010, GE enjoyed a 7 percent effective tax rate but filed a federal income tax return estimated at a whopping 57,000 pages or 19 feet tall.

Would You

Believe?

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1-28 Chapter 1 ● The Individual Income Tax Return

Self-Study Problem 1.10 See Appendix E for Solutions to Self-Study Problems

Indicate whether the following statements are true or false by circling the appropriate letter.

t F 1. Compared to paper returns, electronic filings significantly reduce the error rate for tax returns filed.

t F 2. Individuals may not use electronic filing for their own personal tax returns, but must engage a tax professional if they wish to e-file.

t F 3. Taxpayers who e-file generally receive faster refunds. t F 4. Taxpayers who e-file can only request their refund in the form of a check.

K e y t e r m s

Individual, 1-3 Form 1040, 1-3 Corporation, 1-5 Partnership, 1-5 tax formula for individuals, 1-6 gross income, 1-7 adjusted gross income, 1-7 standard deductions, 1-7

itemized deductions, 1-7 exemptions, 1-8 single filing status, 1-11 married filing jointly, 1-11 married filing separately, 1-12 head of household, 1-12 qualifying widow(er), 1-13 dependent, 1-14

qualifying child, 1-15 qualifying relative, 1-16 tax deduction, 1-19 tax credit, 1-19 capital assets, 1-23 capital gains and losses, 1-23 e-filing, 1-27

Learning Objectives Key points

LO 1.1:

Explain the history and objectives of U.S. tax law.

● The income tax was established on March 1, 1913 by the Sixteenth Amendment to the Constitution.

● In addition to raising money to run the government’s programs, the income tax is used as a tool for enacting economic and social policies.

● Examples of economic tax provisions are the limited allowance for expensing capital expenditures and bonus depreciation provisions. The charitable contribution deduction is an example of a social tax provision.

● The Tax Cuts and Jobs Act (TCJA) has a number of significant individual tax provisions that expire in 2025.

LO 1.2:

Describe the different entities subject to tax and reporting requirements.

● Individual taxpayers file Form 1040 or 1040-SR (if age 65 or older) and any supplemental schedules required.

● Corporations must report income annually on Form 1120 and pay taxes. ● An S corporation generally does not pay regular corporate income taxes; instead, the corporation’s income or loss passes through to its shareholders and is included in their individual tax returns. S corporations file on Form 1120S.

● A partnership files Form 1065 to report the amount of partnership income or loss and to allocate the items of income, loss, deduction, and credit to the partners. Generally, all income or loss of a partnership is included in the tax returns of the partners.

K e y p O I N ts

08239_ch01_ptg01.indd 28 10/30/19 11:49 AM

1-29

LO 1.3:

Apply the tax formula for individuals.

● AGI (adjusted gross income) is gross income less deductions for adjusted gross income.

● AGI less the larger of itemized deductions or the standard deduction and less the qualified business income deduction equals taxable income.

● Appropriate tax tables or rate schedules are applied to taxable income to calculate the gross tax liability.

● The gross income tax liability plus additional taxes less credits and prepayments equals the tax due or refund.

LO 1.4:

Identify individuals who must file tax returns.

● Conditions relating to the amount of the taxpayer’s income must exist before a taxpayer is required to file a U.S. income tax return.

● Taxpayers are also required to file a return if they have net earnings from self- employment of $400 or more, or owe taxes such as Social Security taxes on unreported tips.

LO 1.5:

Determine filing status and understand the calculation of tax according to filing status.

● There are five filing statuses: single; married filing jointly; married filing separately; head of household; and qualifying widow(er).

● Tax is calculated using the appropriate tax table or tax rate schedule for the taxpayer’s filing status.

LO 1.6: Define qualifying dependents.

● Personal exemptions were suspended by the TCJA for tax years 2018–2025. ● Dependents are still important for determining filing status and certain credits. ● A dependent is an individual who is either a qualifying child or qualifying relative.

LO 1.7:

Calculate the correct standard or itemized deduction amount for taxpayers.

● The standard deduction was placed in the tax law to provide relief for taxpayers with few itemized deductions.

● For 2019, the standard deduction amounts are: Single $12,200; Married, filing jointly $24,400; Married, filing separately $12,200; Head of household $18,350; Qualifying widow(er) $24,400.

● Taxpayers who are 65 years of age or older or blind are entitled to additional standard deduction amounts of $1,650 for unmarried taxpayers and $1,300 for married taxpayers and surviving spouses in 2019.

LO 1.8:

Compute basic capital gains and losses.

● The amount of gain or loss realized by a taxpayer is determined by subtracting the adjusted basis of the asset from the amount realized.

● Gains and losses can be either ordinary or capital. ● Ordinary gains and losses are treated for tax purposes like other items such as salary and interest.

● Capital gains and losses result from the sale or exchange of capital assets. ● Common capital assets held by individual taxpayers include stocks, bonds, land, cars, boats, and other items held as investments.

● Gain from property held 12 months or less is deemed to be short-term capital gain and is taxed at ordinary income tax rates.

● Gain from property held more than 12 months is deemed to be long-term capital gain and is taxed at preferential income tax rates.

● The long-term capital gain rates for 2019 vary between 0, 15, and 20 percent, depending on the taxpayer’s income.

● If an individual taxpayer ends up with a net capital loss (short-term or long-term), up to $3,000 per year can be deducted against ordinary income. Any excess capital loss is carried forward to subsequent tax years. Losses from personal-use assets are not deductible.

Key Points

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1-30 Chapter 1 ● The Individual Income Tax Return

LO 1.9:

Access and use various Internet tax resources.

● Taxpayers and tax practitioners can find a substantial amount of useful information on the Internet.

● Useful websites containing tax information include the IRS (www.irs.gov) and the Intuit websites.

LO 1.10:

Describe the basics of electronic filing (e-filing).

● Electronic filing (e-filing) is the process of transmitting federal income tax return information to the IRS Service Center using a device with Internet access.

● Electronic filing offers a faster refund through a direct deposit to the taxpayer’s bank account or the taxpayer can request the refund be sent by check.

GrOUp 1:

muLTIPLE ChOICE QuESTIONS

1. Which of the following recent tax changes is not scheduled to expire after 2025? a. Suspension of personal exemptions b. General lowering of individual tax rates c. Restrictions on the deduction of casualty and theft losses d. Reduction of corporate tax rates to 21 percent

2. Which of the following tax forms are used by individuals in 2019? a. 1040A b. 1040-EZ c. 1040-SR d. 1120

3. Partnership income is reported on: a. Form 1040 b. Form 1120 c. Form 1040X d. Form 1065

4. On which of these would wage income be reported? a. Schedule 1 b. Schedule 2 c. Schedule 3 d. Form 1040

5. Which of the following is a deduction for adjusted gross income in 2019? a. Personal casualty losses b. Medical expenses c. Student loan interest d. Charitable contributions e. None of the above

6. All of the following are itemized deductions in 2019 except: a. Charitable contributions b. Alimony payments c. State and local taxes d. Medical expenses e. All of the above are itemized deductions

LO 1.1

LO 1.2

LO 1.3

Q U es t I O Ns a n d prO B L e m s

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1-31Questions and Problems

7. Ramon, a single taxpayer with no dependents, has adjusted gross income for 2019 of $98,000 and his itemized deductions total $19,000. What taxable income will Ramon show in 2019? a. $74,950 b. $74,850 c. $79,000 d. $85,800 e. $87,650

8. Ben is a single taxpayer with no dependents and is 32 years old. What is the minimum amount of income that he must have to be required to file a tax return for 2019? a. $4,200 b. $12,700 c. $12,000 d. $12,200 e. None of the above

9. Joan, who was divorced in 2019, had filed a joint tax return with her husband in 2018. During 2019, she did not remarry and continued to maintain her home in which her five dependent children lived. In the preparation of her tax return for 2019, Joan should file as: a. A single individual b. A qualifying widow(er) c. Head of household d. Married, filing separately e. None of the above

10. Glenda, a single taxpayer from Kansas, paid for more than one-half of the support for her mother, Dorothy. Dorothy did not live with Glenda in Kansas, but rather has lived in a nursing home in an adjacent state since Dorothy’s husband died three years ago. Glenda’s filing status should be: a. Single b. Married filing separately c. Qualifying widower d. Head of household e. Parental dependent

11. Margaret and her sister support their mother and together provide 85 percent of their mother’s support. If Margaret provides 40 percent of her mother’s support: a. Her sister is the only one who can claim their mother as a dependent. b. Neither Margaret nor her sister may claim their mother as a dependent. c. Both Margaret and her sister may claim their mother as a dependent. d. Margaret and her sister may split the dependency exemption. e. Margaret may claim her mother as a dependent if her sister agrees in a multiple

support agreement.

12. Margaret, age 65, and John, age 62, are married with a 23-year-old daughter who lives in their home. They provide over half of their daughter’s support, and their daughter earned $4,100 this year from a part-time job. Their daughter is not a full-time student. The daughter can/cannot be claimed as a dependent because: a. She cannot be claimed because she is over 19 and not a full-time student. b. She can be claimed because she is a qualifying child. c. She can be claimed because she is a qualifying relative. d. She cannot be claimed because she fails the gross income test.

LO 1.3

LO 1.4

LO 1.5

LO 1.6

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1-32 Chapter 1 ● The Individual Income Tax Return

13. Yasmine and her spouse Carlos, who file married filing jointly, provide all the support for their 17-year-old son, Miguel. If Miguel qualifies as a qualifying child under the dependent rules, Yasmine and Carlos will be able to claim a. $0 b. $500 c. $1,000 d. $2,000 e. $2,500

14. Robin and Howie file married filing jointly and have a 13-year-old daughter. They also provide all the support for Howie’s 82-year-old mother, who lives in a nursing home nearby. The amount of the combined child tax credit and other dependent credit for Robin and Howie is: a. $0 b. $1,000 c. $1,500 d. $2,000 e. $2,500

15. Arthur is 65 years old and single. He supports his father, who is 90 years old, blind, and has no income. What is Arthur’s standard deduction? a. $12,200 b. $13,850 c. $15,500 d. $18,350 e. $20,000

16. Taxpayers who are 65 or older get the benefit of: a. An additional exemption b. An additional amount added to their standard deduction c. An additional amount added to their itemized deductions d. None of the above

17. Taxpayers who are blind get the benefit of: a. An additional exemption b. An additional amount added to their standard deduction c. An additional amount added to their itemized deductions d. None of the above

18. Which of the following is not a capital asset to an individual taxpayer? a. Stocks b. A 48-foot sailboat c. Raw land held as an investment d. Inventory in the taxpayer’s business e. All of the above are capital assets

19. Jayne purchased General Motors stock 6 years ago for $20,000. In the current year, she sells the stock for $35,000. What is Jayne’s gain or loss? a. $15,000 long-term gain b. $15,000 short-term gain c. $15,000 ordinary loss d. $15,000 extraordinary gain e. No gain or loss is recognized on this transaction

20. Alexis purchased a rental house 3 years ago for $290,000. Her depreciation to date is $35,000. Due to a decrease in real estate prices, she sells the house for only $280,000 in 2019. What is her gain or loss for tax purposes? a. $0 b. $10,000 loss c. $10,000 gain

LO 1.6

LO 1.7

LO 1.8

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1-33

d. $35,000 loss e. $25,000 gain

21. Shannon, a single taxpayer, has a long-term capital loss of $7,000 on the sale of bonds in 2019 and no other capital gains or losses. Her taxable income without this transaction is $47,000. What is her taxable income considering this capital loss? a. $40,000 b. $44,000 c. $47,000 d. $55,000 e. Some other amount

22. Access the Internet and go to www.irs.gov and select “Search Forms & Instructions.” Enter “4868” into the search box. What is Line 6 of the Form 4868? a. Total payments b. Balance due c. Your name d. Estimate of total tax liability e. Your social security number

23. Access the Internet and go to www.irs.gov and select “News” in the upper right hand corner (on mobile devices, select “Menu” in the upper right hand corner and select “News”). Select “IRS Guidance” (on mobile devices, hit the plus on “more News,” then scroll down until you see “IRS Guidance”) and then select “IRS Guid- ance in Plain English.” Which of the following is a written statement issued to a taxpayer that interprets and applies tax laws to the taxpayer’s specific set of facts? a. Private letter ruling b. Revenue ruling c. Revenue procedure d. Notice e. Regulation

24. Electronically filed tax returns: a. May not be transmitted from a taxpayer’s home computer b. Constitute more than 90 percent of the returns filed with the IRS c. Have error rates similar to paper returns d. Offer larger refunds than paper returns

LO 1.8

LO 1.9

LO 1.10

Questions and Problems

1. List three major purposes the tax system is meant to serve: a. b. c.

2. Jason and Mary are married taxpayers in 2019. They are both under age 65 and in good health. For 2019 they have a total of $41,000 in wages and $700 in interest in- come. Jason and Mary’s deductions for adjusted gross income amount to $5,000 and their itemized deductions equal $18,700. They have two children, ages 32 and 28, that are married and provide support for themselves. a. What is the amount of Jason and Mary’s adjusted gross income?

b. What is the amount of their itemized deductions or standard deduction?

c. What is their taxable income?

LO 1.1

LO 1.3

GrOUp 2:

PROBLEmS

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1-34 Chapter 1 ● The Individual Income Tax Return

3. Leslie is a single taxpayer who is under age 65 and in good health. For 2019, she has a salary of $24,000 and itemized deductions of $1,000. Leslie allows her mother to live with her during the winter months (3–4 months per year), but her mother pro- vides all of her own support otherwise. a. How much is Leslie’s adjusted gross income?

b. What amount of itemized or standard deduction(s) should she claim?

c. What is the amount of Leslie’s taxable income?

4. In 2019, Lou has a salary of $53,300 from her job. She also has interest income of $1,600 and dividend income of $400. Lou is single and has no dependents. During the year, Lou sold silver coins held as an investment for a $7,000 loss. Calculate the following amounts for Lou: a. Adjusted gross income

b. Standard deduction

c. Taxable income

5. Diego, age 28, married Dolores, age 27, in 2019. Their salaries for the year amounted to $47,230 and they had interest income of $3,500. Diego and Dolores’ deductions for adjusted gross income amounted to $2,000, their itemized deductions were $16,000, and they have no dependents. a. What is the amount of their adjusted gross income?

b. What is the amount of their itemized deductions or standard deduction? $

c. What is the amount of their taxable income?

d. What is their tax liability for 2019?

6. Ulysses and Penelope are married and file separate returns for 2019. Penelope itemizes her deductions on her return. Ulysses’ adjusted gross income was $17,400, his itemized deductions were $2,250. Neither have any dependents. Calculate Ulysses’ income tax liability assuming the couple does not live in a community property state.

7. Alicia, age 27, is a single, full-time college student. She earns $13,200 from a part- time job and has taxable interest income of $1,450. Her itemized deductions are $845. Calculate Alicia’s taxable income for 2019. (Please note: Chapter 6 will cover the com- putation of tax credits for dependent college students under age 24.)

LO 1.3

LO 1.3 LO 1.8

LO 1.3 LO 1.5 LO 1.7

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1-35

8. Jonathan is a 35-year-old single taxpayer with adjusted gross income in 2019 of $46,300. He uses the standard deduction and has no dependents. a. Calculate Jonathan’s taxable income. Please show your work. ��

b. When you calculate Jonathan’s tax liability are you required to use the tax tables or the tax rate schedules, or does it matter?

��

c. What is Jonathan’s tax liability? ��

9. Jim, age 50, and Martha, age 49, are married with three dependent children. They file a joint return for 2019. Their income from salaries totals $49,500, and they received $10,125 in taxable interest, $5,000 in royalties, and $3,000 in other ordinary income. Jim and Martha’s deductions for adjusted gross income amount to $3,200, and they have itemized deductions totaling $18,200. Calculate the following amounts: a. Gross income

b. Adjusted gross income

c. Itemized deduction or standard deduction amount

d. Taxable income

e. Income tax liability (Do not consider the alternative minimum tax covered in Chapter 6 or any credits.)

10. Frank, age 35, and Joyce, age 34, are married and file a joint income tax return for 2019. Their salaries for the year total $84,800 and they have taxable interest income of $3,900. They have no deductions for adjusted gross income. Their itemized deductions are $24,700. Frank and Joyce do not have any dependents. a. What is the amount of their adjusted gross income?

b. What is their deduction for personal exemptions?

c. What is the amount of their taxable income?

11. Christine is a single 50-year-old taxpayer with no dependents. Her only income is $40,750 of wages. Calculate her taxable income and her tax liability. Please show your work.

LO 1.3 LO 1.5 LO 1.7

LO 1.3 LO 1.5 LO 1.6 LO 1.7

LO 1.3 LO 1.5 LO 1.7

Questions and Problems

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1-36 Chapter 1 ● The Individual Income Tax Return

12. Nicoula is a server at a La Jolla restaurant. Nicoula received $1,200 in unreported tips during 2019 and owes Social Security and Medicare taxes on these tips. Her total income for the year, including the tips, is $4,300. Is Nicoula required to file an income tax return for 2019? Why or why not?

13. For each of the following situations (none of the taxpayers claim dependents), indicate whether the taxpayer(s) is (are) required to file a tax return for 2019. Explain your answer. a. Helen is a single taxpayer with interest income in 2019 of $8,750.

b. Joan is a single college student who is claimed as a dependent by her parents. She earned $1,550 from a part-time job and has $1,150 in interest income.

c. Leslie, age 64, and Mark, age 66, are married and file a joint return. They received $17,800 in interest income from a savings account.

d. Ray, age 60, and Jean, age 57, are married and file a joint tax return. Their only income is $14,700 in interest income.

e. Harry, a 19-year-old single taxpayer, had net earnings from self-employment of $1,500.

14. Determine from the tax table in Appendix A the amount of the income tax for each of the following taxpayers for 2019:

Taxpayer(s) Filing Status Taxable Income Income Tax

Allen Single $21,000 $�� Boyd MFS 24,545 $�� Caldwell MFJ 35,784 $�� Dell H of H 27,450 $�� Evans Single 45,000 $��

15. For each of the following cases, indicate the filing status for the taxpayer(s) for 2019 using the following legend:

A—Single D—Head of household B—Married filing a joint return E—Qualifying widow(er) C—Married filing separate returns

Case Filing Status

a. Linda is single and she supports her mother (who has no income), including paying all the costs of her housing in an apartment across town.

b. Frank is single and he has a dependent child living in his home.

LO 1.4

LO 1.5

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1-37

c. Arthur is single and he supports his 30-year-old brother, who lives in his own home.

d. Leslie’s final decree of divorce was granted on June 18, 2019. She has no dependents.

e. Tom and Carry were married on December 31, 2019.

16. Melissa and Aaron are married taxpayers with taxable income of $105,000. a. When you calculate their tax liability, are you required to use the tax tables or the

tax rate schedules, or does it matter?

b. What is their 2019 tax liability?

17. Jessica and Carl were married on July 1, 2019. What are their options for filing status for their 2019 taxes?

18. Maggie is single and supports her 85-year-old parents who have no income and live in a home rented for them by Maggie. What is Maggie’s filing status and why?

19. List each alternative filing status available to unmarried individual taxpayers and the circumstances under which the alternatives can be used.

20. Mary is single and supports her 30-year-old son who has income of $2,000 and lives in his own apartment. a. Can she claim him as a dependent? b. Can she claim head of household filing status? Why or why not?

21. In each of the following situations, determine whether the taxpayer(s) has/have a dependent and if so, the total amount of child tax credit and other dependent credit (assuming no limitations apply).

a. Donna, a 20-year-old single taxpayer, supports her mother, who lives in her own home. Her mother has income of $1,350.

b. William, age 43, and Mary, age 45, are married and support William’s 19-year-old sister, who is not a student. The sister’s income from a part-time job is $4,200.

c. Devi was divorced in 2018 and receives child support of $250 per month from her ex-husband for the support of their 8-year-old son, John, who lives with her. Devi is 45 and provides more than half of her son’s support.

d. Wendell, an 89-year-old single taxpayer, supports his son, who is 67 years old, lives with him, and earns no income.

e. Wilma, age 65, and Morris, age 66, are married. They file a joint return.

LO 1.5

LO 1.5 LO 1.6

LO 1.6

Total Child and Other Dependent Credit

Dependent? (Yes/No)

Questions and Problems

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1-38 Chapter 1 ● The Individual Income Tax Return

22. What is the total dollar amount of personal and dependency exemptions which a married couple with two children (ages 11 and 14, both of which are qualified children) and $80,000 of adjusted gross income would deduct in 2019? What is the total child and other dependent credit that could be claimed (before any limitations)

23. If Charles, a 16-year-old child model, earns $50,000 a year and is completely self- supporting even though he lives with his parents, can his parents claim him as a dependent? Why or why not?

24. Marc’s brother, Phillip, who is a 20-year-old French citizen, lives in France for the full year. Marc supports Phillip while he attends college. Can Marc claim Phillip as a de- pendent? Why or why not?

25. Describe the difference between the standard deduction and itemized deductions. How should a taxpayer decide whether to take the standard deduction or claim item- ized deductions?

26. Go to the IRS website (www.irs.gov/newsroom) and note the name of the most recent news release.

27. Go to the IRS website (www.irs.gov) and print out a copy of the most recent Schedule F of Form 1040.

28. Go to the Turbo Tax Blog (http://blog.turbotax.intuit.com/) and search the blog for an article on the deduction of student loan interest. What is the maximum deduction that can be taken in a year?

LO 1.6

LO 1.7

LO 1.9

1. Jerry, age 23, a full-time student and not disabled, lives with William and Sheila Carson. Jerry is William’s older brother. Jerry is single, a U.S. citizen, and does not provide more than one-half of his own support. William and Sheila are both 21 and file a joint return. Can William and Sheila claim Jerry as a qualifying child?

Required: Go to the IRS website (www.irs.gov) and review Publication 501. Write a letter to William and Sheila stating if they can claim Jerry as a qualifying child.

2. Jason and Mary Wells, friends of yours, were married on December 30, 2019. They know you are studying taxes and have sent you an e-mail with a question concerning their filing status. Jason and Mary would each like to file single for tax year 2019. Jason has prepared their taxes both as single and married filing jointly, and he has real- ized that the couple will get a larger combined refund if they each file single. Jason argues “that it’s not as if we were married for very long in 2019.” Prepare an e-mail to respond to Jason and Mary’s inquiry.

RESEARCH

ETHICS

GrOUp 3:

WRITING ASSIGNmENTS

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1-39

1A. Patty Banyan is a single taxpayer (birthdate May 18, 1992) living at 543 Space Drive, Houston, TX 77099. Her Social Security number is 466-33-1234. For 2019, Patty has no dependents, and her W-2, from her job at a local restaurant where she parks cars, contains the following information:

GrOUp 4:

COmPREhENSIVE PROBLEmS

Instructions for working all Group 4 Comprehensive Tax Return Problems in the textbook are as follows:

Birthdays: If using the tax software, create birthdates for taxpayers and dependents. Adult taxpayers should have ages between 25 and 64 unless a different age is specified.

Wages: Assume the wages subject to income tax in the problems are the same as Social Security wages and Medicare wages. Create employer names and other information which may be required by your tax software package.

Missing Data: Please make realistic assumptions about any missing data. Decide whether taxpayers contribute to the Presidential Election Campaign, which does not affect tax liability.

Tax Forms: Tax forms to complete the problems are found at the end of each chapter. Additional copies can be found on the IRS website (www.irs.gov).

Questions and Problems

These wages are Patty’s only income for 2019.

Required: Complete Form 1040 for Patty Banyan for the 2019 tax year.

1B. Using the information from Problem 1A, assume Patty’s birthdate is May 18, 1952 and complete Form 1040-SR for Patty Banyan for the 2019 tax year.

2A. Hardy and Dora Knox are married and file a joint return for 2019. Hardy’s Social Secu- rity number is 466-47-3311 and her birthdate is January 4, 1975. Dora’s Social Security number is 467-74-4451 and her birthday is July 7, 1974. They live at 143 Maple Street,

466-33-1234

33-1235672

Burger Box 1234 Mountain Road Houston, TX 77099

Patty Banyan 543 Space Drive Houston, TX 77099

20,051.12 1,197.78

20,051.12

1,243.17

290.74

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1-40 Chapter 1 ● The Individual Income Tax Return

467-74-4451

33-0711111

Grocery City 1700 Harding Valley Street Knoxville, TN 37932

Dora Knox 143 Maple Street Knoxville, TN 37932

50,994.12

3,067.52

3,161.64

739.41

676-73-3311

31-1575142

DFAS Cleveland Center PO Box 998002 Cleveland, OH 44199

Abigail Boxer 3456 S Career Avenue Sioux Falls, SD 57107

59,364.23

4,996.00

3,680.58

860.78

Hardy and Dora have a 20-year-old son named Fort (Social Security number 552-52-5552), who is a dependent that lives with them, is not a full-time student, and generates $5,200 of gross income for himself.

Required: Complete Form 1040 for Hardy and Dora for the 2019 tax year.

2B. Abigail (Abby) Boxer is a single mother (birthdate April 28, 1981) working as a civilian accountant for the U.S. Army. Her Social Security number is 676-73-3311 and she lives at 3456 S Career Avenue, Sioux Falls, SD 57107. Helen, Abby’s 18-year-old daughter (Social Security number 676-73-3312 and birthdate April 16, 2001), is a dependent child living with her mother, and she does not qualify for the child tax credit due to her age but does qualify for the other dependent credit of $500. Abby’s Form W-2 from the U.S. Department of Defense shows the following:

Knoxville, TN 37932. For 2019, Hardy did not work, and Dora’s W-2 from her butcher’s job showed the following:

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1-41

1. Albert Gaytor and his wife Allison are married and file a joint return for 2019. The Gaytors live at 12340 Cocoshell Road, Coral Gables, FL 33134. Captain Gaytor is a charter fishing boat captain but took 6 months off from his job in 2019 to train and study for his Masters Captain’s License.

In 2019, Albert received a Form W-2 from his employer, Coconut Grove Fishing Charters, Inc.:

GrOUp 5:

CumuLATIVE SOfTWARE PROBLEm

Questions and Problems

Abby also has taxable interest from Sioux Falls Savings and Loan of $300 and tax-exempt interest from bonds issued by the state of South Dakota of $127.

Required: Complete Form 1040 for Abigail for the 2019 tax year.

266-51-1966

60-3456789

Coconut Grove Fishing Charters 2432 Bay Blvd. Coconut Grove, FL 33133

Albert T. Gaytor 12340 Cocoshell Road Coral Gables, FL 33134

67,023.67

5,634.12

4,155.47

971.84

Name Social Security Number Date of Birth

Albert T. Gaytor 266-51-1966 09/22/1970 Allison A. Gaytor 266-34-1967 07/01/1971 Crocker Gaytor 261-55-1212 12/21/2002 Cayman Slacker 261-11-4444 03/13/2001 Sean Slacker 344-23-5656 05/01/2000

The Gaytors have a 17-year-old son, Crocker, who is a full-time freshman at Brickell State University. The Gaytors also have an 18-year-old daughter, Cayman, who is a part-time student at Dade County Community College (DCCC). Cayman is married to Sean Slacker, who is 19 years old and a part-time student at DCCC. Sean and Cayman have a 1-year-old child, Wanda Slacker (Social Security number 648-99-4306). Sean, Cayman, and Wanda all live in an apartment up the street from Albert and Allison during the entire current calendar year. Sean and Cayman both work for Sean’s wealthy grandfather as apprentices in his business. Their wages for the year were a combined $50,000, which allowed them to pay all the personal expenses for themselves and their daughter.

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1-42 Chapter 1 ● The Individual Income Tax Return

Vizcaya National Bank 9871 Coral Way Miami, FL 33134

Albert T Gaytor

60-7654321 266-51-1966

337.54

Coral Gables, FL 33134

12340 Cocoshell Road

Required: Use a computer software package such as Intuit ProConnect to complete Form 1040 for Albert and Allison Gaytor for 2019. Be sure to save your data input files since this case will be expanded with more tax information in later chapters. Make assumptions re- garding any information not given.

Albert and Allison have a savings account and received the following Form 1099-INT for 2019:

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1-43Questions and Problems

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1-44 Chapter 1 ● The Individual Income Tax Return

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1-45Questions and Problems

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1-46 Chapter 1 ● The Individual Income Tax Return

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1-47

Student Name

Class/Section

Date

K e y n um b e r ta x r e t u r n sum m a ry

CHAPTER 1

Comprehensive Problem 1A

Adjusted Gross Income (Line 8b)

Taxable Income (Line 11b)

Total Tax (Line 16)

Tax Refund (Line 21a)

Comprehensive Problem 1B

Adjusted Gross Income (Line 8b)

Standard Deduction or Itemized Deductions (Line 9)

Total Tax (Line 16)

Tax Refund (Line 21a)

Comprehensive Problem 2A

Adjusted Gross Income (Line 8b)

Standard Deduction or Itemized Deductions (Line 9)

Tax (Line 12b)

Amount Overpaid (Line 20)

Comprehensive Problem 2B

Adjusted Gross Income (Line 8b)

Standard Deduction or Itemized Deductions (Line 9)

Credit for Other Dependents (Line 13a)

Total Tax (Line 16)

Amount Overpaid (Line 20)

Questions and Problems

08239_ch01_ptg01.indd 47 10/30/19 8:37 PM

G lo

w Im

ag es

/G et

ty Im

ag es

C h a p t e r 2

Gross Income and Exclusions

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2-1

L E A R N I N G O B J E C T I V E S

After completing this chapter, you should be able to: LO 2.1 Apply the definition of gross income. LO 2.2 Describe salaries and wages income reporting and inclusion in gross income. LO 2.3 Explain the general tax treatment of health insurance. LO 2.4 Determine when meals and lodging may be excluded from taxable income. LO 2.5 Identif y the common employee fringe benefit income exclusions. LO 2.6 Determine when prizes and awards are included in income. LO 2.7 Calculate the taxable and nontaxable portions of annuity payments. LO 2.8 Describe the tax treatment of life insurance proceeds. LO 2.9 Identif y the tax treatment of interest and dividend income. LO 2.10 Describe the tax treatment of municipal bond interest. LO 2.11 Identif y the general rules for the tax treatment of gifts and inheritances. LO 2.12 Describe the elements of scholarship income that are excluded from tax. LO 2.13 Describe the tax treatment of alimony and child support. LO 2.14 Explain the tax implications of using educational savings vehicles. LO 2.15 Describe the tax treatment of unemployment compensation. LO 2.16 Apply the rules governing inclusion of Social Security benefits in gross income. LO 2.17 Distinguish between the different rules for married taxpayers residing in community

property states when filing separate returns.

2-1

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2-2 Chapter 2 ● Gross Income and Exclusions

2-1 ThE NATuRE Of GROSS INCOmE Gross income is the starting point for calculating a taxpayer’s tax liability. The tax law states that gross income is:

… all income from whatever source derived, including (but not limited to) the following items:

Learning Objective 2.1 Apply the definition of gross income.

The definition of gross income as “all income from whatever source derived” is perhaps the most well-known definition in the tax law. Under this definition, unless there is an exception in the law, the U.S. government considers all income taxable. Therefore, prizes and awards, cash and noncash payments for goods and services, payments made in trade or barter (such as car repairs traded for tax preparation services), and illegal income not generally reported to the IRS are all still taxable income.

Table 2.1 provides an expanded list of items that are included in gross income. When in doubt, the general rule is that everything a taxpayer receives must be included in gross income unless specifically excluded. Any noncash items must be included in gross income at the fair market value of the items received.

The tax law provides that certain items of income are exempt from taxation; these items are referred to as exclusions. The exclusions include items such as life insurance proceeds, gifts, and veterans’ benefits. A more complete list of exclusions from gross income is provided in Table 2.2.

O V e r V I e W

T his chapter starts with the definition of gross income. Tables 2.1 and 2.2 list the common inclusions in and exclusions from gross income. Detailed coverage is provided for

inclusions and exclusions that may present unique issues for taxpayers. The coverage includes the special tax treatment for interest and dividends, ali- mony, prizes and awards, annuities, life insurance

proceeds, and gifts and inheritances. Coverage of exclusions from gross income includes scholar- ships, accident and health insurance benefits, certain meals and lodging, municipal bond inter- est, and the special treatment of Social Security benefits. The elements of gross income discussed here represent much of what is included in the first line of the individual tax formula.

● Compensation for services, including fees, commissions, fringe benefits, and similar items

● Gross income derived from business ● Gains derived from dealings in property ● Interest ● Rents ● Royalties ● Dividends ● Annuities

● Income from life insurance and en- dowment contracts

● Pensions ● Income from discharge of indebtedness ● Distributive share of partnership gross

income ● Income in respect of a decedent ● Income from an interest in an estate

or trust

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2-32-1 The Nature of Gross Income

Alimony (excluded after 2018) Amounts recovered after being deducted

in prior years Annuities Awards Back pay Bargain purchase from employer Bonuses Breach of contract damages Business income Clergy fees and contributions Commissions Compensation for services Contributions received by members

of the clergy Damages for nonphysical personal injury Death benefits Debts forgiven Directors’ fees Dividends Embezzled funds Employee awards (except certain service awards) Employee benefits (except certain fringe benefits) Employee bonuses Employee stock options Estate and trust income Farm income Fees Gains from illegal activities

Gains from sale of property Gambling winnings Group-term life insurance premiums paid by

employer for coverage over $50,000 Hobby income Incentive awards Interest income Jury duty fees Living quarters, meals (unless furnished for employer’s convenience, etc.) Military pay (unless combat pay) Notary fees Partnership income Pensions Prizes Professional fees Punitive damages Rents Retirement pay Rewards Royalties Salaries Scholarships (room and board) Severance pay Strike and lockout benefits Supplemental unemployment benefits Tips and gratuities Unemployment compensation Virtual currency (such as Bitcoin) paid for services Wages

TABLE 2.1 2019 INCLuSIONS IN GROSS INCOmE—PARTIAL LIST

Accident insurance proceeds Alimony (excluded after 2018) Annuities (to a limited extent) Bequests Casualty insurance proceeds Child support payments Damages for physical personal injury

or sickness Disability benefits (generally,

but not always) Gifts Group-term life insurance

premiums paid by employer (coverage not over $50,000)

Health insurance proceeds

Inheritances Life insurance proceeds Meals and lodging (furnished for

employer’s convenience, etc.) Military allowances (including G.I. bill benefits) Minister’s dwelling rental value allowance Municipal bond interest Olympic medals and cash awards given

to athletes Relocation payments Scholarships (tuition and books) Social Security benefits (with limits) Veterans’ benefits Welfare payments Workers’ compensation

TABLE 2.2 2019 EXCLuSIONS fROm GROSS INCOmE—PARTIAL LIST

In 2016, the Chicago Cubs won the Major League Baseball World Series for the first time in 108 years. Interestingly, a large number of betting slips were never turned in. Reports indicated that Cubs fans preferred to keep the uncashed slips as souvenirs of the long-awaited occasion. Once the slip expires, it has no value for redemption and so taxpayers do not have any taxable income in spite of winning. If the souvenir is later sold at a gain, income would be recognized.

Would You

Believe?

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2-4 Chapter 2 ● Gross Income and Exclusions

Self-Study Problem 2.1 See Appendix E for Solutions to Self-Study Problems

Indicate whether each of the items listed below should be included in gross income or excluded from gross income in 2019.

Included Excluded

1. Prizes and awards 2. Embezzled funds 3. Child support payments 4. Alimony 5. Pensions 6. Inheritances 7. Welfare payments 8. Bequests 9. Jury duty fees

10. Royalties 11. Life insurance proceeds paid at death 12. Hobby income 13. Rewards 14. Partnership income 15. Casualty insurance proceeds 16. G.I. Bill benefits 17. Scholarships for room and board 18. Business income 19. Gifts

2-2 SALARIES ANd WAGES Serving as an employee of a company is the most common way to earn income in the United States. More than 80 percent of all individual income tax returns include some amount of wage income, and wages represent approximately 70 percent of the adjusted gross income reported. Payments in almost any form, including salaries and wages, from an employer to an employee are considered income. The primary form of reporting wages to an employee is through Form W-2. An employee should receive a Form W-2 from an employer providing information about the wages paid to that employee during the year (the employer’s responsi- bilities with Form W-2 are examined in Chapter 9). Figure 2.1 presents a Form W-2 for 2019.

Box 1 of Form W-2 is where employers should report taxable wages, salary, bonuses, awards, commissions, and almost every other type of taxable compensation. In most instances, the amount in Box 1 is reported directly on Line 1 of Form 1040, Wages, salaries, tips, etc. If a taxpayer receives more than one Form W-2 or is jointly filing with a spouse having their own Form W-2, the amounts in Box 1 are combined before entering on Line 1 of Form 1040.

EXAmPLE Bonnie and Clyde are married and file jointly. In 2019, Bonnie received two Forms W-2 from two separate employers reporting $34,000 of wages on one and $16,500 on the other. In addition, Clyde also received a Form W-2 reporting wages of $23,000 in Box 1. Bonnie and Clyde should report $73,500 ($34,000 1 $16,500 1 $23,000) on Line 1 of Form 1040 (or Form 1040-SR, if Bonnie or Clyde are age 65 or older). ♦

Learning Objective 2.2

Describe salaries and wages income reporting and inclusion in gross income.

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2-52-2 Salaries and Wages

Box 2 of Form W-2 reports the amount of federal income tax withheld from the taxpayer’s wages by the employer for the year. This amount is reported in a fashion similar to that of Box 1 except on Line 17 of Forms 1040 and 1040-SR.

Boxes 3 through 6 report information related to the amount of wages subject to Social Security and Medicare taxes and the related taxes withheld. The amounts generally do not impact the income tax reporting by a taxpayer, although as discussed in Chapter 9, when a taxpayer has multiple employers and the amount of Social Security tax withheld exceeds the annual limits of Social Security taxable wages, the excess is treated as an additional tax payment. Note that the amounts in Box 1 and Boxes 3 and 5 often agree but they are not always the same for all taxpayers. For example, if an employee contributes part of their salary to a qualified retirement plan such as a 401(k) plan, the contribution is not generally subject to income tax but is subject to employment taxes. The amount of taxable wages in Box 1 would be lower than the amounts reported in Boxes 3 and 5 by the retirement plan contribution amount. In addition, wages are subject to Social Security tax up to a limit ($132,900 in 2019) and therefore, Box 3 will not exceed the annual limit.

Box 8 reports allocated tips for amounts not included in Box 1 taxable wages. Box 10 is where flexible spending contributions to a dependent care program are reported (see LO 2.5 for more information). Box 12 is for reporting a variety of different forms of compensation such as reimbursed parking, health care premiums paid by the employer, and other fringe benefits. The type of compensation is identified by the code provided adjacent to the amount in Box 12, as described in the instructions to the Form W-2. Commonly used codes are:

Code Explanation

C Taxable group life insurance D Elective deferral into 401(k) plans E Elective deferral into 403(b) plans G Elective deferral into 457(b) plans V Income from nonstatutory stock options W Contributions to a health savings account DD Cost of employer-sponsored health care

FIGURE 2.1 fORm W-2

791-51-4335

12-3456789

Ivy Technologies Inc. 436 E. 35 Ave. Gary, IN 46409

Eric Hayes 555 E. 81st Street Merrillville, IN 46410

134,627.00 15,184.00

132,900.00 8,239.80

5,000.00

C 127.00

D 8,000.00

DD 12,345.00

142,627.00 2,068.09

IN 00122231001 134,627.00 4,956.00 134,627.00 987.00 LAKE

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2-6 Chapter 2 ● Gross Income and Exclusions

The retirement plan box in Box 13 will be checked if the taxpayer is eligible to participate in a retirement plan [and thus may limit the amount of deductible IRA (individual retirement account) contributions]. Box 14 is designated to report other forms of compensation as needed.

State and local tax information is reported at the bottom of Form W-2 in Boxes 15 through 20. This includes the taxable wages for state tax purposes and the amount of state income tax withheld which is generally part of the state and local tax itemized deduction (see Chapter 5).

Self-Study Problem 2.2 See Appendix E for Solutions to Self-Study Problems

Based on Summer’s Form W-2, determine the following amounts:

a. Taxable wages to report on Line 1 b. Federal tax payments withheld to report on Line 17 c. The amount that Summer contributed to her company’s 401k plan

232-11-4444

12-9876543

QBI Company 4512 Lake Drive Grand Rapids, MI 49503

Summer Sandborne 134 Bostwick Ave NE Grand Rapids, MI 49503

56,000.00

61,000.00

3,456.00

3,782.00

884.50

D 5,000.00

DD 8,700.00

MI 56,000.00 1,145.00

tIp Entering wages from a Form W-2 is one of the most common data entry points for a tax preparer. Predictably, wages are entered under the Income section, more specifically, under Wages, Salaries, Tips (W-2). When selecting the Wages subheading, the entire entry screen for the W-2 is presented in the main window. The subheadings on the left- hand margin slide the entry form up and down for easier entry. Any additional W-2s can be added using the [+] tab at the top of the main window. Although the fictional textbook employers do not have import access, using ProConnect, many W-2s can be imported directly from an employer’s payroll system. Enter the employer’s identification number and click the circular arrow to import wages data.

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2-72-4 Meals and Lodging

2-3 ACCIdENT ANd hEALTh INSuRANCE Many taxpayers are covered by accident and health insurance plans. These plans pay for the cost of medical care of the taxpayer and any dependents who are insured under the plan. The taxpayer may pay the total premiums of the plan, or his or her employer may pay part or all of the premiums. Taxpayers are allowed liberal exclusions for payments received from these accident and health plans. The taxpayer may exclude the total amount received for payment of medical care. This exclusion applies to any amount paid for the medical care of the taxpayer, his or her spouse, or dependents. The payment may be made to the doctor, the hospital, or the taxpayer as reimbursement for the payment of the expenses. In addition, any premiums paid by a taxpayer’s employer are excluded from the taxpayer’s income, and the premium payments may be deducted by the employer.

Most accident and health care policies also pay fixed amounts to the insured for loss of the use of a member or function of the body. These amounts may also be excluded from income. For example, a taxpayer who receives $25,000 because he or she is blinded in one eye may exclude the $25,000 from income.

EXAmPLE Bob is a married taxpayer. His employer pays a $750 per month premium on a policy covering Bob and his family. Jean, Bob’s wife, is sick during the year and her medical bills amount to $6,500; the insurance company paid $6,000 for the bills. Bob and Jean may exclude from income the $750 per month premium paid by Bob’s employer and the $6,000 paid by the insurance company. The $500 not paid by the insurance company is deductible on Bob and Jean’s return, subject to the medical expense deduction limitations (see Chapter 5). ♦

2.3 Learning Objective Explain the general tax treatment of health insurance.

Self-Study Problem 2.3 See Appendix E for Solutions to Self-Study Problems

Marjorie, a single taxpayer, is an employee of Big State Corporation. Big State Corporation pays premiums of $3,000 on her health insurance for the current year. Also, during the current year, Marjorie has an operation for which the insurance company pays $5,000 to her hospital and doctor. Of the above amounts, how much must Marjorie include in her gross income? $

2-4 mEALS ANd LOdGING If certain tests are met, employers may exclude the value of meals and lodging from an employee’s taxable income. The exclusion is granted for any meals and lodging furnished by the employer for the convenience of the employer, but only if:

1. The meals are furnished on the business premises of the employer during working hours because the taxpayer must be available for emergency calls or the employer limits the employee to short meal periods, and

2. The lodging is on the business premises and must be accepted as a requirement for employment.

To exclude the value of lodging provided by the employer, the employee must be required to accept the lodging to perform the duties of the job properly. For example, a taxpayer who receives lodging on an offshore oil rig may exclude the value of the lodging from income, since the employee cannot go home at night. The exclusion for lodging also includes the value of utilities such as electricity, water, heat, gas, and similar items that make the lodging habitable.

2.4 Learning Objective Determine when meals and lodging may be excluded from taxable income.

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2-8 Chapter 2 ● Gross Income and Exclusions

The value of meals or lodging provided by the employer in other situations, and cash allowances for meals or lodging, must be included in the employee’s gross income. Starting in 2018, the business that pays the costs for meals provided for the convenience of an employee may only deduct 50 percent of those costs (the deduction is eliminated after 2025).

Self-Study Problem 2.4 See Appendix E for Solutions to Self-Study Problems

In each of the following independent cases, indicate whether the value of the meals or lodging should be included in or excluded from the taxpayer’s income.

Included Excluded

1. A waiter is required to eat lunch, furnished by his employer, on the premises during a busy lunch hour.

2. A police officer receives a cash allowance to pay for meals while on duty.

3. A worker receives lodging at a remote construction site in Alaska.

4. A taxpayer manages a motel and, although the owner does not require it, she lives at the motel rent free.

5. A bank teller is furnished meals on the premises to limit the time she is away during busy hours.

2-5 EmPLOyEE fRINGE BENEfITS The tax law provides that all fringe benefits must be included in the employee’s gross income, unless specifically excluded by law. The primary types of fringe benefits that may be excluded from gross income are described below.

2-5a flexible Spending Accounts Many employers create formal plans that allow employees to contribute pre-tax money to a special account from their wages to pay for one or more of the expenses listed below. If all the requirements of the plan are met and the employee provides receipts for the expenses incurred, the full amount of expenses reimbursed out of the employee’s account will be treated as a tax-free reduction in salary. These accounts may provide significant tax savings for employees, with only a small administrative cost to employers.

EXAmPLE In 2019, Dina has wage income of $43,000 and elects to defer $2,000 into a health care flexible spending account. She uses all $2,000 of the money for qualifying medical expenses in 2019. Dina’s taxable income will be $41,000. The $2,000 is excluded from her income as long as she uses the funds for qualifying medical expenses. ♦

Employees must be aware, however, of the “use-it-or-lose-it” rule for flexible spending accounts (e.g., any balance remaining in the employee’s account at December 31 is lost). For health care flexible spending accounts, employers have the option to allow $500 of the unused medical spending account to carry over to the next year or to offer a 21Y

2 -month

grace period after year-end to incur additional medical expenses before the employee loses the balance in the account.

Learning Objective 2.5 Identify the common employee fringe benefit income exclusions.

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2-92-5 Employee Fringe Benefits

Dependent Care Flexible Spending Accounts Employers may offer dependent care flexible spending accounts (FSAs) in which employees may set aside up to $5,000 of their salary each year to cover the costs of caring for a dependent child or aging parent. Such costs may include day care, day camp, in-home care and preschool. Dependent care benefits paid will be reported in Box 10 of Form W-2 and are reported on Form 2441 with the Child and Dependent Care Credit. See Chapter 7 for more information.

Health Care Flexible Spending Accounts Employers may offer health care flexible spending accounts in which employees can set aside up to $2,700 from their 2019 salary to cover medical expenses that they anticipate incurring during the year. These expenses may include eyeglasses, laser-eye surgery, neces- sary dental work, and health insurance copayments. Amounts used from a health care FSA may not also be deducted as an itemized deduction for medical expenses (see Chapter 5). Health care FSAs should not be confused with Archer medical spending accounts (MSAs) or health savings accounts (HSAs) which are covered in Chapter 5.

Public Transportation, Parking at Work, and Bicycle Commuting Employees can exclude from gross income payments from employers of up to $265 per month in 2019 (the maximum exclusion is adjusted for inflation) to cover the cost of public transportation to, or parking for, work. However, starting in 2018, employers may not deduct these payments to the extent they are excluded from the employee’s income; thus effectively removing transportation and parking as a qualified fringe benefit. In cases where the employee is being reimbursed transportation or parking costs that are necessary to ensure the safety of the employee, those costs remain deductible. The bi- cycle commuter fringe is suspended until 2025. Employers may continue to establish a plan whereby an employee’s own pre-tax salary is used to pay for public transportation costs and parking up to the exclusion limits. By doing so, these costs are paid for by the employee using pre-tax dollars as the withheld wages used to cover these costs are not subject to income or employment taxes.

2-5b Group Term Life Insurance Employers may pay for up to $50,000 of group term life insurance for employees as a tax- free fringe benefit. Providing group term life insurance to employees must not favor officers, shareholders, or highly compensated personnel.

Internal Revenue Code §79 was first passed in 1964 and provided the exclusion of employer paid group term life insurance premiums up to $50,000. The $50,000 limit has not been adjusted since originally passed into law. In today’s dollars, you would need almost $400,000 to equal $50,000 in 1964. The National Funeral Directors Association estimated the average cost of a funeral in 1965 as $790 and almost $7,400 in 2017.

Would You

Believe? 2-5c Education Assistance Plans Employers may provide up to $5,250 of excludable annual tuition assistance under an educational assistance plan. The exclusion requires an employer to have a written plan and the educational assistance can be paid to an employee or former employee. Assis- tance over $5,250 is included in the taxpayer’s wages unless otherwise excludable as a working condition benefit that would have been deductible as a business expense (see Chapter 3).

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2-10 Chapter 2 ● Gross Income and Exclusions

2-5d No-Additional-Cost Services This category of fringe benefits includes services that are provided to employees and their families at little or no additional cost to the employer, and which would otherwise have remained unused. An airline employee who is allowed to fly at no cost on a standby basis is an example. The value of the airfare may be excluded from the employee’s gross income.

Employees are only allowed to receive tax-free services in the major line of business in which they are employed. For example, if an airline company also owns a rental car agency, the employees working in the airline division would not be entitled to the tax-free use of rental cars.

2-5e Qualified Employee discounts The value of employee discounts may be excluded from gross income if the discounts are available on a nondiscriminatory basis. That is, the discounts must be available to substan- tially all full-time employees. The item being discounted must be from the line of business in which the employee is engaged. The discount exclusion also does not apply to discounts on real estate or personal property held for investment. For services provided at a discount, the exclusion is limited to 20% of the typical customer price. For merchandise, the exclusion is limited to the employer’s gross markup on the goods.

EXAmPLE R.J. works for an auto parts store chain. R.J. purchases a new water pump for her car at the employee discounted price of $26. Normally, the part would be sold for $41. R.J.’s employer’s cost for the part is $26. Because R.J.’s cost is not less than the cost of the part to her employer, the discount is within the exemption and is not taxable to R.J. ♦

2-5f Working Condition fringe Benefits An employee may exclude the value of property or services provided by an employer to the extent that the cost of the property or services would be a deductible expense of the employee. Examples of this type of exclusion include the use of a company car for busi- ness (not personal) purposes and a subscription to a tax journal paid for by a CPA firm. The working condition fringe benefit rules also allow several expenses which would not be deductible if paid by the employee. These include the value of certain employer-provided education and certain use of demonstrator autos by automobile salespeople.

2-5g de minimis fringe Benefits The value of small fringe benefits may be excluded from an employee’s gross income if ac- counting for the benefits would be impractical. Examples of this type of exclusion include occasional personal use of an office copy machine, personal letters typed by a company administrative assistant, a company picnic for the employees, and small non-cash holiday gifts provided to employees (e.g., a Christmas turkey).

If an employer provides a subsidized lunchroom for its employees, the value of the meals may be excluded from the employees’ income if (1) the facility is on or near the employer’s place of business, (2) the revenue from the lunchroom normally exceeds direct operating costs, and (3) the meals are provided without discrimination to all employees. Starting in 2018, the tax law limits the employer’s deduction related to the eating facility to only

Section 127 of the Code introduced the education assistance plan in 1979. In 1985, the $5,000 exclusion limit was increased to $5,250. According to the College Board, average tuition and fees for a public four-year college in the 1985–1986 school year was $1,318. In 2018–2019, that amount had increased to $9,980. Today’s exclusion is unlikely to pay for even a single year of college tuition. Source: www.collegeboard.org

Would You

Believe?

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2-112-5 Employee Fringe Benefits

50 percent of the cost. Upon the expiration of the provision in 2025, the tax law permits no deduction for such costs.

Cell phones provided to employees primarily for business purposes are considered tax-free de minimis fringe benefits. Examples of cell phones which qualify include those provided to allow employees to communicate with clients, or to allow employers to contact employees in the field or at home.

2-5h Tuition Reduction All employees of educational institutions may exclude from their income the value of a tuition reduction, if the plan is for an undergraduate education and available to all employ- ees. The exclusion applies to the employees, their spouses, and their dependents. The value of a graduate education tuition reduction plan may only be excluded by graduate students of the institution who are teaching or doing research at that institution.

2-5i Athletic facilities Employees may exclude from gross income the value of the use of an athletic facility located on the premises of their employer. The facility must be used primarily by employees.

2-5j Retirement Planning fringe Benefit Qualified retirement planning services constitute a fringe benefit that is excluded from income. This change was made to encourage employers to provide retirement planning services for their employees to assist them in preparing for retirement. Qualified retirement planning services are any retirement planning services provided to an employee and his or her spouse by an employer maintaining a “qualified employer plan.” The exclusion also applies to advice and information on retirement income planning for an individual and his or her spouse, including how the employer’s plan fits into the individual’s overall retirement income plan. The exclusion, however, does not apply to services that may be related to tax preparation, accounting, legal, or brokerage services.

EXAmPLE As part of its qualified plan, Linda’s employer provides retirement planning services. Linda has a meeting with a financial planner to review her retirement plan. The cost of the meeting ($600) is paid for by her employer’s qualified plan. The $600 is not income to Linda and is deductible to the employer. ♦

A summary of various fringe benefits is provided in Table 2.3.

Self-Study Problem 2.5 See Appendix E for Solutions to Self-Study Problems

Indicate in each of the following cases whether the value of the employee fringe benefit is included (I) in or excluded (E) from the employee’s gross income.

1. An employee of a railroad receives a free train-trip pass. 2. An employee of a department store receives a 25 percent discount on a shirt.

The department store’s markup is 15 percent. 3. An employee attends a New Year’s party paid for by her employer. 4. An employee of a stock brokerage firm receives a subscription to a financial

newsletter paid for by his employer. 5. An employee’s wife regularly uses a company car to go shopping. 6. An airline employee receives a 50 percent discount at a hotel chain owned by

her employer while traveling on vacation. 7. An employee uses the company’s employee fitness room.

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2-12 Chapter 2 ● Gross Income and Exclusions

Type of fringe Summary of Treatment Learning Objective Accident and Health Benefits Exempt except for long-term care provided through a flexible spending

arrangement 2.3, 2.5

Achievement Awards Exempt up to $1,600 for qualified plan awards ($400 for nonqualified) 2.6 Adoption Assistance Exempt up to $14,080 7.7 Athletic Facilities Exempt if substantially all use is by employees and families

and operated on employer’s premises 2.5

De Minimis Benefits Exempt if property or service provided to employee has so little value that accounting for it would be unreasonable or administratively impracticable (never cash and cash equivalents)

2.5

Dependent Care Assistance Exempt up to $5,000 2.5 Educational Assistance Exempt up to $5,250 2.5 Employee Discounts Exempt with certain limits 2.5 Employee Stock Options Beyond scope of textbook Employer-provided cell phones Exempt if primarily for business purposes 2.5 Group-term Life Insurance Exempt up to $50,000 2.5 Health Savings Accounts (HSA) Exempt up to certain limits 5.1 Lodging on Business Premises Exempt if for convenience as a condition of employment 2.4 Meals Exempt if furnished on premises for convenience or de minimis 2.4 Moving Expenses Exempt if otherwise deductible and related to military service 5.5 No-additional-cost Services Exempt 2.5 Retirement Planning Services Exempt 2.5 Transportation (Commuting)

Benefits Exempt up to $265 per month for parking and transit passes and

exempt if de minimis 2.5

Tuition Reduction Exempt if undergraduate or if graduate and employee performs teaching or research

2.5

Working Condition Benefits Exempt 2.5

Source: Adapted from IRS Publication 15-B.

TABLE 2.3 SummARy Of fRINGE BENEfITS

2-6 PRIzES ANd AWARdS Prizes and awards are taxable income to the recipient. Winnings from television or radio shows, door prizes, lotteries, and other contest winnings are income to taxpayers. In addi- tion, all other awards are generally taxable, even if they are awards given for accomplish- ments and with no action on the part of the taxpayer. Even a Nobel prize is taxable. If the prize or award is received in property instead of cash, the fair market value of the property is included in the taxpayer’s income. For example, the gift bags given to the attendees at the Academy Awards include items such as expensive jewelry and vacations worth more than $100,000. The value of these gift bags is included in taxable income. Taxpayers may refuse a prize and exclude its value from income.

An exception is provided for certain employee achievement awards in the form of tangible personal property, such as a gold watch for 25 years of service. If the award is made in recognition of length of service or safety achievement, the value of the property may be excluded from income. Generally, the maximum amount excludable is $400. However, if the award is a “qualified plan award,” the maximum exclusion is increased to $1,600. The definition of tangible personal property with respect to employee achievement awards excludes cash, cash equivalents, gift cards, gift coupons, gift certificates, vacations, meals, lodging, tickets to theater or sporting events, stocks, bonds, other securities, and other similar items.

Learning Objective 2.6 Determine when prizes and awards are included in income.

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2-132-7 Annuities

EXAmPLE Van enters a drawing and wins a new automobile. The automobile has a sticker price of $20,200. The fair market value of the prize should be included in Van’s gross income, but the fair market value is probably not the sticker price; instead, it is the price at which a similar car normally would be sold. ♦

In late 2013, a Washington state resident won the largest single-day game show prize—an Audi R8 sports car valued at $157,000. Assuming a California tax rate of 9.3 percent (the show is filmed in Los Angeles, and Washington state has no individual income tax) and a federal rate of 26 percent (adjusted for state taxes), the income tax bill alone is over $55,000. The estimate to pay taxes to register the car in her home town are almost $15,000 for a total tax bill of $70,000. The taxes can make the price feel not quite so right!

Would You

Believe?

Self-Study Problem 2.6 See Appendix E for Solutions to Self-Study Problems

For each of the following independent cases, indicate the amount of gross income that should be included on the taxpayer’s return.

Gross Income

1. Helen enters a radio contest and wins $2,000. $ 2. Professor Deborah wins an award of $10,000

for a book on literature she published 4 years ago. The award was presented in recognition of her past literary achievements. $

3. Bill is a professional baseball player. Because he has hit 50 home runs this season, he was given a new wrist watch worth $2,500. $

4. John is an employee of Big Corporation. He is awarded $5,000 for a suggestion to improve the plant layout. $

5. Martha received a desk clock worth $350 from her employer in recognition of her 15 years of loyal service as an employee. $

2-7 ANNuITIES When taxpayers consider retirement, they often purchase annuities. An annuity is a type of investment in which the taxpayer purchases the right to receive periodic payments for the remainder of his or her life. The amount of each periodic payment is based on the annuity purchase price and the life expectancy of the annuitant. Standard mortality tables, based on the current age of the annuitant, are used to calculate the annuity amount.

2.7 Learning Objective Calculate the taxable and nontaxable portions of annuity payments.

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2-14 Chapter 2 ● Gross Income and Exclusions

2-7a The Simplified method Individual taxpayers generally must use the “simplified” method to calculate the taxable amount from an annuity for annuities starting after November 18, 1996. Nonqualified plan annuities and certain annuitants age 75 or older must still use the general rule discussed below.

To calculate the excluded amount, the IRS provides the following worksheet.

Simplified method WorkSheet 1. Enter total amount received this year. 1. 2. Enter cost in the plan at the annuity starting date. 2. 3. Age at annuity starting date

Enter 55 or under 360 56–60 310 61–65 260 3. 66–70 210 71 or older 160

4. Divide line 2 by line 3. 4. 5. Multiply line 4 by the number of monthly payments this 5.

year. If the annuity starting date was before 1987, also enter this amount on line 8, and skip lines 6 and 7. Otherwise, go to line 6.

6. Enter the amount, if any, recovered tax free in prior years. 6. 7. Subtract line 6 from line 2. 7. 8. Enter the smaller of line 5 or 7. 8. 9. Taxable amount this year: Subtract line 8 from line 1. Do 9.

not enter less than zero.

Note 1: The denominators provided in step 3 above are effective for annuity starting dates after November 18, 1996. For annuity starting dates prior to November 18, 1996, see the IRS website.

Note 2: When annuity benefits with starting dates after 1997 are paid over two lives (joint and survivor annuities), a different set of denominators must be used in step 3.

Combined Age Number of of Annuitants Payments 110 or under 410 111–120 360 121–130 310 131–140 260 141 or older 210

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2-152-7 Annuities

EXAmPLE Joey, age 67, began receiving benefits under a joint and survivor annuity to be paid over the joint lives of himself and his wife Jody, who is 64. He received his first annuity payment in March of the current year. Joey contributed $38,000 to the annuity and he had no distributions from the plan before the current year. The monthly payment to Joey is $1,700.

Joey must use the simplified method to calculate his taxable amount. Using the worksheet, Joey’s taxable amount for the current year would be:

Simplified method WorkSheet 1. Enter total amount received this year. 1. $17,000.00 2. Enter cost in the plan at the annuity 2. $38,000.00

starting date. 3. Combined age at annuity starting date

Enter 110 or under 410 111–120 360 121–130 310 3. 260 131–140 260 141 or older 210

4. Divide line 2 by line 3. 4. $ 146.15 5. Multiply line 4 by the number of monthly 5. $ 1,461.50

payments this year. 6. Enter the amount, if any, recovered tax free in 6. $ 0.00

prior years. 7. Subtract line 6 from line 2. 7. $38,000.00 8. Enter the smaller of line 5 or 7. 8. $ 1,461.50 9. Taxable amount this year: Subtract line 8 from 9. $15,538.50

line 1. Do not enter less than zero. ♦

The exclusion ratio (the result on line 4 of the Simplified Method Worksheet) is calculated at the start of the annuity and remains constant. For annuities starting after 1986, the maximum amount excludable is limited to the taxpayer’s investment in the annuity. After the taxpayer’s investment is recovered, all additional amounts received are fully taxable. If the taxpayer dies before the entire investment is recovered, any unrecovered amount is permitted as a miscellaneous itemized deduction (not subject to the 2 percent floor) at the time of the annuitant’s death. For annuities starting before 1987, the exclusion ratio is used for the life of the annuitant, even after full recovery of the investment. For these earlier annuities, if the annuitant dies prior to recovering the entire investment, the unrecovered portion is lost.

2-7b The General Rule Prior to implementation of the Simplified Method discussed above, the General Rule was used for most annuities. Rather than use the denominators provided in Step 3 of the Sim- plified Method Worksheet, the life expectancy of the annuitant was determined based on mortality tables provided by the IRS. The excluded amount under the general rule can be calculated as follows:

Amount Excluded 5 Investment in Contract

Annual Payment 3 Life Expectancy 3 Amount Received

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2-16 Chapter 2 ● Gross Income and Exclusions

2-7c Employee Annuities Many employees participate in retirement plans organized by their employers. Employers generally make periodic payments to the plans on behalf of their employees. If the payments are made to qualified retirement plans, contributions by the employer are not taxable to the employees in the current year. Since the contributions are not taxable when made, they are not consi dered part of the employee’s investment in the contract when calcu- lating the exclusion ratio.

Self-Study Problem 2.7 See Appendix E for Solutions to Self-Study Problems

Part a Phil retired in January 2019 at age 63. His pension is $1,500 per month from a retirement plan to which Phil contributed $42,500. Phil’s life expectancy is 21 years, and this year he received eleven payments for a total pension income of $16,500. Calculate Phil’s taxable income from the annuity in the current year, using the general rule. $

Part b Calculate Phil’s taxable income using the following Simplified Method Worksheet.

Simplified method WorkSheet 1. Enter total amount received this year. 1. 2. Enter cost in the plan at the annuity starting date. 2. 3. Age at annuity starting date

Enter 55 or under 360 56–60 310 61–65 260 3. 66–70 210 71 or older 160

4. Divide line 2 by line 3. 4. 5. Multiply line 4 by the number of monthly payments this 5.

year. If the annuity starting date was before 1987, also enter this amount on line 8, and skip lines 6 and 7. Otherwise, go to line 6.

not enter less than zero.

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2-172-8 Life Insurance

2-8 LIfE INSuRANCE Life insurance proceeds are excluded from gross income based on the premise that it would be inappropriate in a time of need to tax the proceeds from a life insurance policy. Therefore, a major exclusion from gross income is provided for life insurance proceeds. To be excluded, the proceeds must be paid to the beneficiary by reason of the death of the insured. If the proceeds are taken over several years instead of a lump sum, the insurance company pays interest on the unpaid proceeds. The interest is generally taxable income.

Early payouts of life insurance, also called accelerated death benefits or viatical settlements, are excluded from gross income for certain terminally or chronically ill taxpayers. The taxpayer may either collect an early payout from the insurance company or sell or assign the policy to a viatical settlement provider. A terminally ill individual must be certified by a medical doctor to have an illness which is reasonably expected to cause death within 24 months. A chronically ill individual must be certified by a medical doctor as unable to perform daily living activities without assistance. Chronically ill taxpayers may only exclude gain on accelerated death benefits to the extent proceeds are used for long-term care.

If an insurance policy is transferred to another person for valuable consideration, all or a portion of the proceeds from the life insurance policy may be taxable to the recipient. For example, taxable proceeds result when a policy is transferred to a creditor in payment of a debt. When a transfer for value occurs, the proceeds at the death of the insured are taxable to the extent they exceed the cash surrender value of the policy at the time it was transferred, plus the amount of the insurance premiums paid by the purchaser. There is an exception to the rule that policies transferred for valuable consideration result in taxable proceeds. Transfers to a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is an officer or a shareholder do not cause the policy proceeds to be taxable.

EXAmPLE Howard dies on January 15, 2016, and leaves Wanda, his wife, a $50,000 insurance policy, the proceeds of which she elects to receive as $10,000 per year plus interest for 5 years. In the current year, Wanda receives $12,200 ($10,000 1 $2,200 interest). She must include the $2,200 of interest in income. ♦

EXAmPLE David owns a life insurance policy at the time he is diagnosed with a terminal illness. After his diagnosis, he sells the policy to Viatical Settlements, Inc., for $100,000. David is not required to include the gain on the sale of the insurance in his gross income. ♦

EXAmPLE Amy transfers to Bill an insurance policy with a face value of $40,000 and a cash surrender value of $10,000 for the cancellation of a debt owed to Bill. Bill continues to make payments, and after 2 years Bill has paid $2,000 in premiums. Amy dies and Bill collects the $40,000. Since the transfer was for valuable consideration, Bill must include $28,000 in taxable income, which is equal to the $40,000 total proceeds less $10,000 value at the time of transfer and $2,000 of premiums paid. If Amy and Bill were partners in the same partnership, the entire proceeds ($40,000) would be tax free. ♦

2.8 Learning Objective Describe the tax treatment of life insurance proceeds.

Self-Study Problem 2.8 See Appendix E for Solutions to Self-Study Problems

On March 19, 2014, Karen dies and leaves Larry an insurance policy with a face value of $100,000. Karen is Larry’s sister, and Larry elects to take the proceeds over 10 years ($10,000 plus interest each year). This year Larry receives $13,250 from the insurance company. How much income must Larry report for the current year? $

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2-18 Chapter 2 ● Gross Income and Exclusions

2-9 INTEREST ANd dIVIdENd INCOmE Any interest or dividend income a taxpayer receives or that is credited to his or her account is taxable income, unless it is specifically exempt from tax such as state or municipal bond interest (discussed further in LO 2.10). If the interest or dividends total more than $1,500, the taxpayer is required to file Schedule B of Form 1040, which instructs the taxpayer to list the amounts and sources of the income.

The fair market value of gifts or services a taxpayer receives for making long-term deposits or opening accounts in savings institutions is also taxable interest income. Interest is reported in the year it is received by a cash basis taxpayer.

Learning Objective 2.9 Identify the tax treatment of interest and dividend income.

2-9a u.S. Savings Bonds The U.S. government issues three basic types of savings bonds to individuals: Series EE Bonds, Series HH Bonds, and Series I Bonds. Series EE Bonds, whether sold at a discount (before 2012) or at face value, increase in value over their life, and the increase in redemption value is generally taxable when the bond is redeemed and the interest is paid. The second type of sav- ings bond, Series HH Bond, was issued at face value and pays interest twice a year. Interest on Series HH Bonds is reported in the year received by a cash basis taxpayer. (Note: As of August 31, 2004, the Treasury stopped issuing Series HH bonds. HH bonds sold before August 31, 2004, are still outstanding and paying interest.) Series I Bonds, like Series EE Bonds, do not pay interest until maturity, but earnings are adjusted for inflation on a semiannual basis.

Cash basis taxpayers report the increase in redemption value (interest) on a Series EE Bond or a Series I Bond using one of the following methods:

1. The interest may be reported in the year the bonds are cashed or in the year they ma- ture, whichever is earlier (no election is required to use this method), or

2. The taxpayer may elect to report the increase in redemption value each year.

If the taxpayer wants to change from method (1) to method (2), he or she may do so without the permission of the IRS. In the year of change, all interest earned to date and not previously reported must be reported on all Series EE Bonds and Series I Bonds held by the taxpayer. Once method (2) is selected, the taxpayer must continue to use it for all Series EE Bonds currently held or acquired in the future. Taxpayers cannot change back to method (1) without permission of the IRS.

Taxpayers may defer reporting interest income on a bank certificate of deposit (CD) if the CD has a maturity of 1 year or less and there is a substantial penalty for early withdrawal. For example, assume an investor purchases a 6-month CD on September 1, 2019, which matures on March 1, 2020, and the bank charges a penalty equal to 2 months of interest in the event of early withdrawal. In this case, the 4 months of interest earned on the account during 2019 will not have to be reported until the investor’s 2020 tax return is filed.

When a taxpayer withdraws funds early from a CD and must pay a penalty as described above, the full amount of the interest is reported as income and the penalty may be deducted on Form 1040 as a deduction for adjusted gross income.

TAX BREAK

Schedule B of Form 1040 has been around for a long time—the first version appeared as part of the Form 1040 in 1950. The dollar threshold of interest or dividends to require a Schedule B was at $400 in 1974. It was changed to $1,500 in 2002 and remains at that same amount today. Using the Consumer Price Index Inflation Calculator (www.bls.gov/data/inflation_calculator.htm), you would need about $2,100 to equal the purchasing power of $400 in 1974.

Would You

Believe? 08239_ch02_ptg01.indd 18 10/30/19 12:01 PM

2-192-9 Interest and Dividend Income

2-9b dividends Dividends are a type of distribution paid to a shareholder by a corporation. Taxpayers may receive the following types of distributions from a corporation:

1. Ordinary and qualified dividends 2. Nontaxable distributions 3. Capital gain distributions

Ordinary dividends are by far the most common type of corporate distribution. They are paid from the earnings and profits of the corporation. Ordinary dividends are also qualifying dividends if the stock is held for a certain amount of time (generally 60 days) and the dividend is issued by a U.S. corporation. If the ordinary dividends are not qualifying dividends, then instead of being taxed at the lower long-term capital gains rate, they will be taxed at the ordinary income rate. Corporations issuing dividends and brokerage companies holding stock investments for taxpayers are required to classify and report the amount of qualifying dividends to investors.

Nontaxable distributions are a return of invested capital and are not paid from the earnings and profits of the corporation. They are considered a return of the taxpayer’s investment in the corporation and are not included in the taxpayer’s income. Instead, the taxpayer’s basis in the stock is reduced by nontaxable distributions until the basis reaches zero.1 After the stock has reached a zero basis, distributions that represent a return of capital are taxed as capital gains. Capital gain distributions are reported on Line 6 of Forms 1040 or 1040-SR or Schedule D, Line 13 (if required otherwise).

2-9c Current Tax Rates for dividends For years, experts have argued that corporate dividends are taxed twice, once when the corporation pays tax on profits, and once when the dividend is received by the shareholder. To provide some tax relief for individual taxpayers who receive corporate dividends, the tax rates on qualifying dividends are lower than the rates for ordinary income.

Income level Qualified dividends and long-term

capital gains rates*

Married filing jointly $0–$78,750 0% $78,751–$488,850 15% .$488,850 20% Single $0–$39,375 0% $39,376–$434,550 15% .$434,550 20% Head of household $0–$52,750 0% $52,751–$461,700 15% .$461,700 20%

*An additional 3.8 percent Medicare tax on net investment income, including qualifying dividends, applies to high-income taxpayers with income over certain thresholds. Please see Chapter 6 for further details.

1A taxpayer’s basis in an investment is usually the cost of the investment. The basis is used to determine the gain or loss when the investment is sold.

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2-20 Chapter 2 ● Gross Income and Exclusions

Note that the break points between 0 and 15 percent for qualified dividends and long- term capital gains rates are similar to but not the same as the ordinary rate brackets for the same filing status. For example, the single ordinary income rate bracket breaks between 12 and 22 percent at $39,475; whereas the dividend/capital gain rate breaks at $39,375.

EXAmPLE Sandra is a single taxpayer with wage income of $42,000 and qualified dividends of $1,000 in 2019. Assume Sandra has no other deductions or income except the standard deduction. Sandra’s taxable income is:

Wage income $42,000 Qualified dividends 1,000 Standard deduction (12,200) Exemption (suspended by TCJA) 0 Taxable income $30,800

Sandra’s income now must be separated into the ordinary and qualified dividends portions:

Taxable income $30,800 Qualified dividends (1,000) Ordinary income $29,800

The 2019 tax on $29,800 of ordinary income is $3,385. As Sarah’s taxable income of $30,800 including the long-term gain is below $39,375, the threshold for 0 percent qualified dividend and long-term capital gains for a single taxpayer in 2019, her dividend tax rate is 0 percent and thus her total tax liability is $3,385. ♦

EXAmPLE Dee is a single taxpayer with wage income of $44,000 and qualified dividends of $8,000 in 2019. Assume Dee has no other deductions or income except the standard deduction. Dee’s taxable income is

Wage income $44,000 Qualified dividends 8,000 Standard deduction (12,200) Exemption (repealed by TCJA) 0 Taxable income $39,800

Dee’s income now must be separated into the ordinary and qualified dividend and long-term capital gain portions:

Taxable income $39,800 Qualified dividends (8,000) Ordinary income $31,800

The 2019 tax on $31,800 of ordinary income is $3,625. Dee’s taxable income without the qualified dividends is below the 15 percent threshold of $39,375 for a single taxpayer in 2019, but her taxable income with qualified dividends of $39,800 is above the threshold; thus a part of the qualified dividend will be taxed at 0 percent and a part at 15 percent. Of her $8,000 qualified dividends, $7,575 is below the $39,375 threshold and is taxed at 0 percent while $425 is above the $39,375 threshold and is taxed at 15 percent for an additional tax of $64 to bring Dee’s total tax liability to $3,689. The treatment of Dee’s ordinary and qualified dividend income is presented in Figure 2.2.

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2-212-9 Interest and Dividend Income

In order to assist with the calculation of preferential taxes on qualified dividends and long-term capital gains, the IRS provides the Qualified Dividends and Capital Gain Tax Worksheet as part of the Form 1040 instructions. This worksheet is presented on Page 2-24. ♦

2-9d Reporting Interest and dividend Income Generally, interest or dividend income in amounts greater than $10 must be reported by the payor to the recipient on a Form 1099-INT or Form 1099-DIV. These two forms are presented as part of Self-Study Problem 2-9.

On the Form 1099-INT, most taxable interest is reported in Box 1. The penalty for early withdrawal from a deposit account is reported in Box 2 and is generally deductible as a for AGI deduction (see Chapter 5). Because states may not tax interest from U.S. government obligations such as Treasury Bills, Treasury Bonds, and U.S. savings bonds, interest from these items is reported in Box 3. Tax-exempt interest is reported in Box 8 and to the extent the payor withheld income tax, that amount is reported in Box 4 and should be included with the total withholding on Line 17 of Form 1040. Taxable interest from each payor is reported on Schedule B (shown on Page 2-23) if interest totals more than $1,500 or is simply totaled on Line 2b of Form 1040. Tax-exempt interest is reported on Line 2a of Form 1040 (but not on Schedule B).

Form 1099-DIV reports total ordinary dividends in Box 1a. Box 1b reports the amount of qualified dividends included in Box 1a. These amounts are entered on to Schedule B (if more than $1,500 in total) or directly on to Lines 3a and 3b of Form 1040. Mutual fund investments, and to a lesser degree, corporate stock investments, can also pay capital gain dividends, which are reported in Box 2a of Form 1099-DIV. Unlike ordinary and qualified

FIGURE 2.2 TAX RATES fOR QuALIfIEd dIVIdENdS ANd LONG-TERm CAPITAL GAINS

Ordinary income

Qualified dividends below threshold

Qualified dividends above threshold

$39,800

$39,375

$31,800

$7,575 taxed at 0%

$425 taxed at 15%

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2-22 Chapter 2 ● Gross Income and Exclusions

dividends which are reported by the taxpayer on Schedule B or Form 1040 as described above, capital gain dividends are reported on Schedule D of Form 1040 (see Chapter 4) or if a taxpayer has only capital gain distributions reported on Form 1099-DIV, the amount can be reported on Line 6 of Form 1040.

Self-Study Problem 2.9 See Appendix E for Solutions to Self-Study Problems

Victor and Grace Alito received the following Forms 1099-INT and 1099-DIV during 2019:

In addition, the Alitos also received $400 of tax-exempt interest. The Alitos file jointly and have taxable income, including interest and dividends of $42,000.

Complete Schedule B of Form 1040 and the Qualified Dividends and Capital Gain Tax Worksheet on Pages 2–23 and 2–24 for the Alito’s 2019 tax year.

Mango Savings and Loan 600 Tausick Way Walla Walla, WA 99362

13-2122333 313-44-5454

Victor Alito

1112 Constitution Ave, NW

Washington, DC 20224

1,780.00

Grape Large Cap Index Fund 21251 Stevens Creek Road Cupertino, CA 95014

24-1234567 313-44-5454

Victor and Grace Alito

1112 Constitution Avenue, NW

Washington, DC 20224

1,658.00

1,600.00

200.00

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2-232-9 Interest and Dividend Income

Self-Study Problem 2.9

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2-24 Chapter 2 ● Gross Income and Exclusions

Self-Study Problem 2.9

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2-252-10 Municipal Bond Interest

2-10 muNICIPAL BONd INTEREST In 1913 when the Sixteenth Amendment was enacted, Congress questioned the constitu- tionality of taxing the interest earned on state and local government obligations. Congress provided an exclusion from taxpayers’ income for the interest on such bonds. To qualify for the exclusion, the interest must be from an obligation of a state, territory, or possession of the United States, or a political subdivision of the foregoing or of the District of Columbia. For example, Puerto Rico bonds qualify for the exclusion. Federal obligations, such as trea- sury bills and treasury bonds, do not qualify.

The interest exclusion allows high-income taxpayers to lend money to state and local governments at lower interest rates (discounts).

EXAmPLE Rigby is considering two different bond investments. This first option is a corporate taxable bond that yields a pre-tax return of 8.4 percent. The second option is a tax-exempt municipal bond that yields 6.5 percent. If Rigby is in the 35 percent tax bracket, the after-tax return of the taxable bonds can be computed as:

After-tax return 5 Pre-tax return 3 (1 2 tax rate) 5.46% 5 8.4% 3 (1 2 0.35)

Since the tax-exempt bond is not subject to tax, the after-tax return is 6.5 percent and thus is preferable. Using a re-arranged version of the same formula can determine what the equivalent yield on a taxable bond would need to be to make Rigby indifferent between the two bonds (all other terms being equal):

After-tax return 5 Tax-free return / (1 2 tax rate) 10.0% 5 6.5%/(1 2 0.35) ♦

Typically, interest rates on municipal bonds reflect the after-tax return that compensates for higher income tax rates (35 or 37 percent) and thus tax-exempt bonds will often have a lower after-tax yield than a taxable bond in the hands of a lower-income investor.

EXAmPLE Mordecai is also considering the same bonds as Rigby in the previous example; however, Mordecai is in the 22 percent tax bracket. The after- tax return on the corporate bond is 6.55 percent [8.4% 3 (1 2 0.22)]. In Mordecai’s situation, the after-tax return on the taxable corporate bond is greater than the tax-exempt return of 6.5 percent on the municipal bond. ♦

2.10 Learning Objective Describe the tax treatment of municipal bond interest.

Taxpayers in low tax brackets are likely to find that they earn a higher overall return investing in taxable bonds rather than comparable tax-free municipal bonds. This is because the smaller tax benefit from the municipal bonds does not make up for the reduced interest rate paid on municipal bonds. Municipal bonds are also generally not appropriate investments for IRAs or other retirement accounts since income on these accounts is excluded from tax until withdrawn.

TAX BREAK

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2-26 Chapter 2 ● Gross Income and Exclusions

Self-Study Problem 2.10 See Appendix E for Solutions to Self-Study Problems

Calculate the taxable interest rate that will provide the equivalent after-tax return in the cases that follow. 1. A taxpayer is in the 24 percent tax bracket and invests in a San Diego City Bond

paying 7 percent. What taxable interest rate will provide the same after-tax return? % 2. A taxpayer is in the 32 percent tax bracket and invests in a New York State Bond

paying 6.5 percent. What taxable interest rate will provide the same after-tax return? %

2-11 GIfTS ANd INhERITANCES Taxpayers are allowed to exclude from income the fair market value of gifts and inheritances received, but income received from the property after such a transfer is generally taxable. Normally, the gift tax or estate tax is paid by the donor or the decedent’s estate; such prop- erty is, therefore, usually tax free to the person receiving the gift or inheritance.

One tax problem that may arise concerning a gift is the definition of what constitutes a gift. The courts define a gift as a voluntary transfer of property without adequate consideration. Gifts made in a business setting are suspect since they may be disguised payments for goods or services. The courts are likely to rule that gifts in a business setting are taxable income, even if there was no obligation to make the payment. Also, if the recipient renders services for the gift, it will be presumed to be income for the services performed.

EXAmPLE In January of the current year, Richard inherits shares of Birch Corporation stock worth $22,000. After receiving the stock, he is paid $1,300 in dividends during the current year. His gross income from the inheritance in the current year would be $1,300. The $22,000 fair market value of the stock is excluded from gross income. ♦

Learning Objective 2.11 Identify the general rules for the tax treatment of gifts and inheritances.

Self-Study Problem 2.11 See Appendix E for Solutions to Self-Study Problems

Don is an attorney who supplied a list of potential clients to a new attorney, Lori. This list aided in the success of Lori’s practice. Lori was very pleased and decided to do something for Don. In the current year, Lori gives Don a new car worth $40,000. Lori was not obligated to give this gift to Don, and she did not expect Don to perform future services for the gift. How much income, if any, should Don report from this transaction? Explain your answer. Income $ Explain

tIp Interest and dividends are both common forms of income in addition to wages. The way the two items are reported is slightly different and not always intuitive. Tax-exempt interest (which is entered on Line 2a of Form 1040) is not included as part of taxable interest (Line 2b). Qualified dividends (line 3a), however, are included as part of ordinary dividends (Line 3b). Interest and Dividends are both located in ProConnect under Income and have a Quick Entry and a 1099 entry screen (with Box numbers presented) available. Quick Entry handles most Forms 1099- INT and Forms 1099-DIV; however, should one wish to use the detailed entry screens, they will appear in the left-hand margin when Quick Entry is open. One can always return to Quick Entry using the link at the top of the detail entry form (especially if there is a need to add more 1099s).

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2-272-13 Alimony

2-12 SChOLARShIPS A scholarship is an amount paid or awarded to, or for the benefit of, a student to aid in the pursuit of his or her studies. Scholarships granted to degree candidates are taxable income, with the exception of amounts spent for tuition, fees, books, and course-required supplies and equipment. Therefore, scholarship amounts received for items such as room and board are taxable to the recipient.

EXAmPLE In 2019, Diane receives a $5,000 scholarship to study accounting at Big State University. Diane’s expenses for tuition and books amount to $1,200 during the fall semester; therefore, she would have taxable income of $3,800 ($5,000 2 $1,200) from the scholarship. ♦

Payments received by students for part-time employment are not excludable; they are taxable as compensation. For example, students in work–study programs must include their compensation in gross income. Some scholarships will be reported on Form 1098-T. This form is discussed further in Chapter 7.

2.12 Learning Objective Describe the elements of scholarship income that are excluded from tax.

Self-Study Problem 2.12 See Appendix E for Solutions to Self-Study Problems

Indicate whether each item below would be included in or excluded from the income of the recipient in 2019.

Included Excluded

1. A $2,000 National Merit Scholarship for tuition 2. A basketball scholarship for room and board 3. Payments under a work–study program 4. Salary for working at Beech Research Laboratory 5. A scholarship for $10,000 to cover qualified

costs of $7,600. 6. Payment received from an employer while on

leave working on a research project

2-13 ALImONy The term alimony, for income tax purposes, includes separate maintenance payments or similar periodic payments made to a spouse or former spouse. Payments must meet certain requirements to be considered alimony.

1. The payments must be in cash and must be received by the spouse (or former spouse). 2. The payments must be made under a decree of divorce or separate maintenance or

under a written instrument incident to the divorce. 3. The payor must have no liability to make payments for any period following the death

of the spouse receiving the payments. 4. The payments must not be designated in the written agreement as anything other than

alimony. 5. If the parties are divorced or legally separated, they must not be members of the same

household at the time the payments are made.

2.13 Learning Objective Describe the tax treatment of alimony and child support.

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2-28 Chapter 2 ● Gross Income and Exclusions

Disguised child support payments may not be treated as alimony. Payments contingent on the status of a child, such as the age or marital status of the child, are not considered alimony.

EXAmPLE Under a 2013 divorce agreement, Sam has agreed to pay his former spouse, Silvia, $1,000 per month. The payments meet all the tests for classification as alimony, but they will be reduced to $600 per month when their child, in Silvia’s custody, becomes 18 years of age. In this situation, $400 of each payment must be treated as nondeductible child support and cannot be considered alimony. ♦

Under previous tax law, alimony was deductible by the payer and includable in income by the recipient. However, the alimony provisions were repealed and these amounts are neither includable nor deductible for divorce and separation agreements entered after December 31, 2018. For alimony paid pursuant to a divorce or separation instru- ment executed on or before December 31, 2018, alimony is deductible by the payor and included by the recipient unless the agreement is modified and the modification expressly provides that the new tax law applies to such modification.

EXAmPLE Brad and Jen were married in 2015. The relationship did not work out and they divorced in 2016. The divorce decree required Brad to pay Jen alimony of $1,000 per month. Because this divorce was effective prior to 2019, the alimony is deductible by Brad and is gross income to Jen. ♦

EXAmPLE Miley and Liam were married in 2018. The relationship did not work out and they divorced in 2019. Miley is required to pay Liam alimony of $1,000 per month. The alimony is neither deductible to Miley nor included in Liam’s gross income. ♦

2-13a Property Transfers A spouse who transfers property in settlement of a marital obligation is not required to recognize any gain as a result of the property’s appreciation. Thus, if in a divorce settlement, a wife transfers property with a fair market value of $10,000 and a tax basis of $3,000 to her husband, she will not be required to recognize the gain of $7,000 ($10,000 2 $3,000). Of course, the husband would be required to assume the wife’s tax basis ($3,000) in the property. The transfer of property in settlement of a divorce is not considered alimony and there is no deduction by the spouse who transfers the property, nor is it income to the recipient.

2-13b Child Support Payments made for child support are not deductible by the taxpayer making them, nor are they income to the recipient. However, they may be an important factor in determining which spouse is entitled to claim the dependent child (see Chapter 1). Child support pay- ments must be up to date before any amount paid may be treated as alimony. That is, if a taxpayer is obligated to pay both child support and alimony, he or she must first meet the child support obligation before obtaining a deduction for alimony payments. Payments for child support include payments designated as such in the marital settlement agreement, plus any alimony payments that are contingent upon the status of a child.

EXAmPLE Jim is required under a 2012 divorce decree to pay $400 in alimony and $250 in child support per month. Since the decree separately states that $250 is child support, only $400 per month is deductible by Jim and counts as income to his ex-wife. ♦

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2-292-13 Alimony

Income from alimony, when applicable, is reported in the Income section under SS Benefits, Alimony, Misc. Income (SS Bene., Misc. Inc.). Once this heading is clicked, Alimony and Other Income will be presented as a subheading. Deductible alimony paid, when applicable, is reported under Deductions. Once Adjustments to Income is clicked, a series of subheadings is presented including Alimony Paid.

tIp

Self-Study Problem 2.13 See Appendix E for Solutions to Self-Study Problems

A taxpayer (payor ex-spouse) is required to pay an ex-spouse (recipient ex-spouse) alimony of $12,000 per year. Determine how much alimony is deductible by the payor ex-spouse and how much alimony is recognized as income by the recipient ex-spouse based on the following information:

Details Deductible by

payor Includable by

recipient

a. The payments are made in 2019 as part of a divorce decree executed in 2018. The divorce decree is modified in 2019 to explicitly apply the provisions of the TCJA.

b. The payments are made in 2019 as part of a divorce decree executed in 2016.

c. The payments are made in 2019 as part of a divorce decree executed in 2019.

For the last 10 years, you prepared the joint tax returns for Dominic (husband; age 40) and Dulce (wife; age 35) Divorcio. In 2018, they got a divorce and remained as your separate tax clients. Under the dissolution decree, Dominic has to pay Dulce $2,500 per month alimony, which he does for the current year. You have completed Dominic’s tax return for the current year and you deducted the required alimony payments to Dulce on Dominic’s Form 1040. Dulce came in to have you prepare her tax return and refused to report her alimony received as income. She stated, “I am not going to pay tax on the $30,000 from Dominic.” She views the payments as “a gift for putting up with him for all those years of marriage.” Dulce will not budge on excluding this alimony from income. Would you sign the Paid Preparer’s declaration (see example above) on this return? Why or why not?

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08239_ch02_ptg01.indd 29 10/30/19 12:02 PM

2-30 Chapter 2 ● Gross Income and Exclusions

2-14 EduCATIONAL INCENTIVES

2-14a Qualified Tuition Programs (QTP) A Qualified Tuition Program (more commonly referred to as a Section 529 tuition plan) allows taxpayers (1) to buy in-kind tuition credits or certificates for qualified higher educa- tion expenses (a prepaid tuition plan) or (2) to contribute to an account established to meet qualified higher education expenses (a savings-type plan). Such Qualified Tuition Programs may be sponsored by a state government or a private institution of higher learning. Section 529 plans permit tax-free distributions if the distribution is used for qualified higher educa- tion expenses. Qualified higher education expenses include tuition, fees, books, supplies, and equipment required for the enrollment or attendance at an eligible educational institu- tion. In addition, reasonable room and board costs, subject to certain limitations, are also qualified expenses allowed to be paid from the Section 529 tuition plan. Qualified higher education expenses also include tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school. The use of the specific term “tuition” excludes other types of qualifying education expenses such as books, supplies, and equipment for elementary or secondary students. The maximum exclusion for elementary or secondary education (i.e., K-12) is $10,000 per beneficiary per year.

EXAmPLE Walt and Skyler Blanco have two children, Jesse and Jane, and established 529 plans for each of them many years ago. Jesse is now in his second year of college at Albuquerque Community College and Jane is a junior at Albuquerque High School for Math and Science, a private high school. In 2019, the Blancos have $3,500 distributed from the 529 plan with Jesse as the named beneficiary to pay for his community college tuition, books, and course-related supplies. Jane’s private school tuition is much higher and the Blancos distribute $12,000 from the 529 plan for which she is the beneficiary. $11,000 of the distribution is used to pay for tuition, $550 for books, and $450 for her private school uniforms. The Blancos may exclude $13,500 of the distributions. Jesse’s $3,500 distribution meets the definition of qualified higher education expenses. Only $10,000 of Jane’s distribution meets the definition of qualified higher education expenses. The remaining $1,000 of tuition is in excess of the annual limit and the books and uniform costs do not qualify. ♦

The earnings portion of QTP distributions that are not used for qualified tuition expenses are includable in the distributee’s gross income under the annuity income rules and are subject to a 10 percent early withdrawal penalty.

Unlike Educational Savings Accounts, discussed later in this section, there is no income limit on the amount of contributions to a Qualified Tuition Program. Like an Educational Savings Account, however, the contributions are not deductible. Any contributions are gifts, and thus subject to the gift tax rules. In addition, most programs impose some form of overall maximum contribution for each beneficiary based on estimated future higher education expenses.

EXAmPLE Bill has AGI of $275,000 and has two children. He chooses to contribute $9,000 (he is allowed to contribute any amount up to the limit imposed by his state’s law) to a QTP for each of his children in 2019, even with his high AGI. The $18,000 is not deductible to Bill. Any earnings on the contribution accumulate tax free and are excluded from gross income if used for future qualified higher education expenses. ♦

A taxpayer may claim an American Opportunity credit or lifetime learning credit (discussed in detail in Chapter 7) for a tax year and exclude from gross income amounts distributed (both the principal and the earnings portions) from a qualified tuition program on behalf of the same student. This is true as long as the distribution is not used for the same

Learning Objective 2.14 Explain the tax implications of using educational savings vehicles.

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2-312-14 Educational Incentives

expenses for which a credit was claimed. However, the amount of qualified higher education expenses for a tax year for purposes of calculating the exclusion from income must be reduced by scholarships, veterans’ benefits, military reserve benefits, employer-provided educational assistance amounts, and the tuition amounts used to generate the American Opportunity and lifetime learning credits.

EXAmPLE In 2019, Sammy receives $15,000 from a qualified tuition program. He uses the funds to pay for his college tuition and other qualified higher education expenses. Sammy also claims an American Opportunity credit of $1,500 for the year, using the expenses paid from the QTP funds. For purposes of the QTP exclusion calculation, the $15,000 must be reduced to $13,500 ($15,000 2 $1,500). ♦

The tax law provides that if the total distributions from a qualified tuition program and from an educational savings account exceed the total amount of qualified higher education expenses, the taxpayer will have to allocate the expenses among the distributions for purposes of determining how much of each distribution is excludable.

There are billions of dollars invested in the increasingly popular Section 529 Qualified Tuition Programs across the country. The plans offered by different states vary significantly and it is possible for a taxpayer to invest in the plan of a state other than the state that he lives in. The following two websites offer information comparing state plans and answers to questions regarding plan operations: www.collegesavings.org and www.savingforcollege.com.

TAX BREAK

2-14b Educational Savings Accounts Taxpayers are allowed to set up educational savings accounts, also known as Coverdell Edu- cation Savings Accounts, to pay for qualified education expenses. The maximum amount a taxpayer can contribute annually to an educational savings account for a beneficiary is $2,000. Contributions are not deductible and are subject to income limits. Contributions can- not be made to an educational savings account after the date on which the designated ben- eficiary becomes 18 years old. In addition, contributions cannot be made to a beneficiary’s educational savings account during any year in which contributions are made to a qualified state tuition program on behalf of the same beneficiary. The educational savings account ex- clusion for distributions of income is available in any tax year in which the beneficiary claims the American Opportunity credit or the lifetime learning credit (see Chapter 7), provided the distribution is not used for the same expenses for which the credit was claimed.

Contributions to educational savings accounts are phased out between AGIs of $95,000 and $110,000 for single taxpayers and $190,000 and $220,000 for married couples who file a joint return (these limits are not adjusted annually for inflation). Like regular and Roth IRAs, contributions applied to the current tax year must be made by April 15 (or the next business day, if April 15 falls on a weekend or holiday) of the following year.

EXAmPLE Joe, who is single, would like to contribute $2,000 to an educational savings account for his 12-year-old son. However, his AGI is $105,000, so his contribution is limited to $667, calculated as follows:

($110, 000 upper limit 2 $105,000 AGI)

$15,000 3 $2,000 5 $667 contribution

$15,000 is the difference between the upper ($110,000) and lower ($95,000) phase-out limits. ♦

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2-32 Chapter 2 ● Gross Income and Exclusions

For parents with income above the allowable limit, a gift may be made to a child and the child may make the contribution to an educational savings account. There is no requirement that the contributor have earned income as there is for IRAs.

TAX BREAK

Amounts received from an educational savings account are tax free if they are used for qualified education expenses. Qualified education expenses include tuition, fees, books, supplies, and related equipment for private, elementary, and secondary school expenses as well as for college. Room and board also qualify if the student’s course load is at least 50 percent of the full-time course load. If the distributions during a tax year exceed quali- fied education expenses, part of the excess is treated as a return of capital (the contribu- tions), and part is treated as a distribution of earnings. The distribution is presumed to be pro rata from each category. The exclusion for the distribution of earnings is calculated as follows:

Qualified education expenses

Total distribution 3 Earnings 5 Exclusion

EXAmPLE Amy receives a $2,000 distribution from her educational savings account. She uses $1,800 to pay for qualified education expenses. Immediately prior to the distribution, Amy’s account balance is $5,000, $3,000 of which are her contributions. Because 60 percent ($3,000/$5,000) of her account balance represents her contributions, $1,200 ($2,000 3 60%) of the distribution is a tax-free return of capital and $800 ($2,000 3 40%) is a distribution of earnings. The excludable amount of the earnings is calculated as follows:

$1,800 $2,000

3 $800 5 $720 is excludable (thus, the amount taxable is $80, or $800 2 $720).

Amy’s adjusted basis for her savings account is reduced to $1,800 ($3,000 2 $1,200). ♦

2-14c higher Education Expenses deduction Please note that at the time we go to print, the higher education expense deduction has expired and is no longer available. Because this deduction has previously been extended a number of times, a summary of the 2017 material remains in this textbook. Be sure and check the textbook companion website or www.irs.gov for changes.

In 2017, taxpayers were allowed a for AGI or “above-the-line” deduction for qualified tuition and related expenses incurred during the tax year. The deduction was allowed for qualified tuition and related expenses for enrollment at an institution of higher education during the tax year. In addition, the deduction was allowed for qualified expenses paid during a tax year if those expenses are in connection with an academic term beginning during the tax year or during the first 3 months of the next tax year. The tuition expense deduction is currently expired.

EXAmPLE Jerry pays $2,000 for his son’s college tuition in November 2017 for the spring 2018 term. The spring term starts in January 2018. The $2,000 is deductible in 2017, even though it is for education provided in a later tax year. ♦

The deduction cannot exceed a specified annual amount. The deduction was $4,000 for single and head of household taxpayers with modified AGI below $65,000 and for married filing jointly taxpayers with modified AGI below $130,000. The amount was $2,000 for single

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2-332-15 Unemployment Compensation

taxpayers with modified AGI between $65,000 and $80,000 and for married joint filers with modified AGI between $130,000 and $160,000. Taxpayers with AGI exceeding the limits were not allowed a deduction.

Self-Study Problem 2.14 See Appendix E for Solutions to Self-Study Problems a. Abby has a distribution of $10,000 from a qualified tuition program, of which

$3,000 represents earnings. The funds are used to pay for her daughter’s qualified higher education expenses. How much of the $10,000 distribution is taxable to the daughter?

b. During 2019, Henry (a single taxpayer) has a salary of $85,000 and interest income of $4,000. Henry has no other income or deductions. Calculate the maximum contribution Henry is allowed for an educational savings account.

2-15 uNEmPLOymENT COmPENSATION Unemployment compensation payments are fully taxable. Unemployment compensation is generally reported on a Form 1099-G.

EXAmPLE Genny was unemployed for several months during 2019 and received unemployment compensation of $4,000. The $4,000 is included in Genny’s taxable income for 2019. ♦

2.15 Learning Objective Describe the tax treatment of unemployment compensation.

Self-Study Problem 2.15 See Appendix E for Solutions to Self-Study Problems

Anthony was unemployed during part of 2019 and received the following Form 1099-G:

How much unemployment compensation is included in Anthony’s gross income?

3,000.00Florida Dept of Econ Opportunity 107 E. Jefferson St. Tallahassee, FL 32399

12-7654321 313-22-1212

Anthony Starky

103 Brickell Ave.

Miami, FL 33101

0.00

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2-34 Chapter 2 ● Gross Income and Exclusions

2-16 SOCIAL SECuRITy BENEfITS Some taxpayers may exclude all of their Social Security benefits from gross income. How- ever, most middle-income and upper-income Social Security recipients may have to include up to 85 percent of their benefits in gross income. The formula to determine taxable Social Security income is based on modified adjusted gross income (MAGI). Generally, MAGI is the taxpayer’s adjusted gross income (without Social Security benefits) plus any tax-free inter- est income. On rare occasions, taxpayers will also have to add back unusual items such as the foreign earned income exclusion, employer-provided adoption benefits, or interest on education loans. If MAGI plus 50 percent of Social Security benefits is less than the base amount shown below (base amounts are not adjusted for inflation), benefits are excluded from income.

Base Amounts Applies To

$32,000 Married filing jointly 0 Married taxpayers who did not live apart for the

entire year and still filed separate returns 25,000 All other taxpayers

The formula for calculating the taxable amount of Social Security is complex and time- consuming. Many taxpayers rely on tax-preparation software to perform the calculation. For preparation by hand, the Form 1040 Instructions include a full-page worksheet that takes taxpayers through the calculation one step at a time.

EXAmPLE For the 2019 tax year, Nancy, a single taxpayer, receives $7,000 in Social Security benefits. She has adjusted gross income of $20,000, not including any Social Security income, and receives $10,000 of tax-exempt municipal bond interest. Nancy must include $3,500 of her Social Security benefits in income. The amount included in gross income is determined as follows:

Simplified taxable Social Security WorkSheet (for moSt people) 1. Enter the total amount of Social Security income. 1. $ 7,000 2. Enter one-half of line 1. 2. 3,500 3. Enter the total of taxable income items on Form 1040 except 3. 20,000

Social Security income. 4. Enter the amount of tax-exempt interest income. 4. 10,000 5. Add lines 2, 3, and 4. 5. 33,500 6. Enter all adjustments for AGI except for student loan interest, the domestic 6. –0–

production activities deduction, and the tuition and fees deduction. 7. Subtract line 6 from line 5. If zero or less, stop here, none of the 7. 33,500

Social Security benefits are taxable. 8. Enter $25,000 ($32,000 if married filing jointly; $0 if married 8. 25,000

filing separately and living with spouse at any time during the year). 9. Subtract line 8 from line 7. If zero or less, enter –0–. 9. 8,500

Note: If line 9 is zero or less, stop here; none of your benefits are taxable. Otherwise, go on to line 10.

Learning Objective 2.16 Apply the rules governing inclusion of Social Security benefits in gross income.

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2-352-16 Social Security Benefits

10. Enter $9,000 ($12,000 if married filing jointly; $0 if married filing 10. 9,000 separately and living with spouse at any time during the year).

11. Subtract line 10 from line 9. If zero or less, enter –0–. 11. –0– 12. Enter the smaller of line 9 or line 10. 12. 8,500 13. Enter one-half of line 12. 13. 4,250 14. Enter the smaller of line 2 or line 13. 14. 3,500 15. Multiply line 11 by 85% (.85). If line 11 is zero, enter –0–. 15. –0– 16. Add lines 14 and 15. 16. 3,500 17. Multiply line 1 by 85% (.85). 17. 5,950 18. Taxable benefits. Enter the smaller of line 16 or line 17. 18. $ 3,500

♦

EXAmPLE Linda, a widow, is retired and receives Social Security benefits of $14,000 in 2019. She has MAGI of $47,000. Linda must include $11,900 of her Social Security benefits in income. The amount included in income is determined as follows:

Simplified taxable Social Security WorkSheet (for moSt people) 1. Enter the total amount of Social Security income. 1. $14,000 2. Enter one-half of line 1. 2. 7,000 3. Enter the total of taxable income items on Form 1040 except 3. 47,000

Social Security income. 4. Enter the amount of tax-exempt interest income. 4. –0– 5. Add lines 2, 3, and 4. 5. 54,000 6. Enter all adjustments for AGI except for student loan interest, the 6. –0–

domestic production activities deduction, and the tuition and fees deduction.

7. Subtract line 6 from line 5. If zero or less, stop here, none of the 7. 54,000 Social Security benefits are taxable.

8. Enter $25,000 ($32,000 if married filing jointly; 8. 25,000 $0 if married filing separately and living with spouse at any time during the year).

9. Subtract line 8 from line 7. If zero or less, enter –0–. 9. 29,000

Note: If line 9 is zero or less, stop here; none of your benefits are taxable. Otherwise, go on to line 10.

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2-36 Chapter 2 ● Gross Income and Exclusions

filing Status

mAGI 1 50% SS

Amount of SS That Is Included in Taxable Income

Single, HOH, Surviving Spouse, MFS (Living apart)

Under $25,000 No SS benefits included in taxable income

$25,000–$34,000 The lesser of: 50% of SS benefits, or 50% of (MAGI 1 50%SS, over $25,000)

Over $34,000 The lesser of: 85% of SS benefits, or (lesser of box above or $4,500) 1 85% of (MAGI 1 50%SS, over $34,000)

Married Filing Jointly Under $32,000 No SS benefits included in taxable income

$32,000–$44,000 The lesser of: 50% of SS benefits, or 50% of (MAGI 1 50%SS, over $32,000)

Over $44,000 The lesser of: 85% of SS benefits, or (lesser of box above or $6,000) 1 85% of (MAGI 1 50%SS, over $44,000)

Note: The Social Security income inclusion formulas in the table above are shown for information only. No problems in the textbook will require the use of these formulas.

TABLE 2.4 SOCIAL SECuRITy INCOmE INCLuSION fORmuLAS

A summary of the tax treatment of Social Security benefits is presented in Table 2.4.

10. Enter $9,000 ($12,000 if married filing jointly; 10. 9,000 $0 if married filing separately and living with spouse at any time during the year).

11. Subtract line 10 from line 9. If zero or less, enter –0–. 11. 20,000 12. Enter the smaller of line 9 or line 10. 12. 9,000 13. Enter one-half of line 12. 13. 4,500 14. Enter the smaller of line 2 or line 13. 14. 4,500 15. Multiply line 11 by 85% (.85). If line 11 is zero, enter –0–. 15. 17,000 16. Add lines 14 and 15. 16. 21,500 17. Multiply line 1 by 85% (.85). 17. 11,900 18. Taxable benefits. Enter the smaller of line 16 or line 17. 18. $11,900

♦

tIp Social Security benefits are entered under the same heading in Income as alimony discussed in LO 2.13.

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2-372-16 Social Security Benefits

Self-Study Problem 2.16 See Appendix E for Solutions to Self-Study Problems

For the 2019 tax year, Kim and Edward are married and file a joint return. They have Social Security benefits of $13,000 and their adjusted gross income is $20,000, not including any Social Security income. They also receive $30,000 in tax-free municipal bond interest. How much, if any, of the Social Security benefits should Kim and Edward include in gross income? Use the worksheet below to compute your answer.

Simplified taxable Social Security WorkSheet (for moSt people) 1. Enter the total amount of Social Security income. 1. $ 2. Enter one-half of line 1. 2. 3. Enter the total of taxable income items on Form 1040 except 3.

Social Security income. 4. Enter the amount of tax-exempt interest income. 4. 5. Add lines 2, 3, and 4. 5. 6. Enter all adjustments for AGI except for student loan interest, 6.

the domestic production activities deduction, and the tuition and fees deduction.

7. Subtract line 6 from line 5. If zero or less, stop here, none of 7. the Social Security benefits are taxable.

8. Enter $25,000 ($32,000 if married filing jointly; $0 if 8. married filing separately and living with spouse at any time during the year).

9. Subtract line 8 from line 7. If zero or less, enter –0–. 9.

Note: If line 9 is zero or less, stop here; none of your benefits are taxable. Otherwise, go on to line 10.

10. Enter $9,000 ($12,000 if married filing jointly; $0 if 10. married filing separately and living with spouse at any time during the year).

11. Subtract line 10 from line 9. If zero or less, enter –0–. 11. 12. Enter the smaller of line 9 or line 10. 12. 13. Enter one-half of line 12. 13. 14. Enter the smaller of line 2 or line 13. 14. 15. Multiply line 11 by 85% (.85). If line 11 is zero, enter –0–. 15. 16. Add lines 14 and 15. 16. 17. Multiply line 1 by 85% (.85). 17. 18. Taxable benefits. Enter the smaller of line 16 or line 17. 18. $

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2-38 Chapter 2 ● Gross Income and Exclusions

2-17 COmmuNITy PROPERTy When married couples file separate income tax returns, a special problem arises. Income derived from property held by a married couple, either jointly or separately, as well as wages and other income earned by a husband and wife, must be allocated between the spouses. State law becomes important in making this allocation.

The law in nine states is based on a community property system of marital law. In these states, the property rights of married couples differ from the property rights of married couples residing in the remaining common law states. The nine states that are community property states are:

Arizona Louisiana Texas California Nevada Washington Idaho New Mexico Wisconsin

Note: In Alaska, spouses may elect to treat income as community income.

Under the community property system, all property is deemed to be either separate property or community property. Separate property includes property acquired by a spouse before marriage or received after marriage as a gift or inheritance. All other property owned by a married couple is presumed to be community property. For federal income tax purposes, each spouse is automatically taxed on half of the income from community property.

The tax treatment of income from separate property depends on the taxpayer’s state of residence. In Idaho, Louisiana, Texas, and Wisconsin, income from separate property produces community income. Thus, just as each spouse is taxed on half of the income from community property, each spouse is also taxed on half of the income from separate property. In the other five community property states, income on separate property is separate income and is reported in full on the tax return of the spouse who owns the property. Income such as nontaxable dividends or royalties from mineral interests assumes the classification of the asset from which the income is derived. Capital gains also retain their classification based on the classification of the property from which the gain arises.

EXAmPLE John and Marsha are married and live in Texas. John owns, as his separate property, stock in AT&T Corporation. During the year, John receives dividends of $4,000. Assuming John and Marsha file separate returns, each of them must report $2,000 of the dividends. On the other hand, if John and Marsha lived in California, John would report the entire $4,000 of the dividends on his tax return and Marsha would not include any of the divi dend income on her tax return. ♦

In all of the community property states, income from salary and wages is generally treated as having been earned one-half by each spouse.

EXAmPLE Robert and Linda are married but file separate tax returns. Robert receives a salary of $30,000 and has interest income of $500 from a savings account which is in his name. The savings account was established with salary earned by Robert since his marriage. Linda collects $20,000 in dividends on stock she inherited from her father. The amount of income which Linda must report on her separate income tax return depends on the state in which Robert and Linda reside. Three different assumptions are presented below:

Learning Objective 2.17 Distinguish between the different rules for married taxpayers residing in community property states when filing separate returns.

State of Residence

Common Law Linda’s Income: Texas California States Salary $15,000 $15,000 $ 0 Dividends 10,000 20,000 20,000 Interest 250 250 0 Total $25,250 $35,250 $20,000

♦

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2-392-17 Community Proper ty

2-17a Spouses Living Apart To simplify problems that could arise when married spouses residing in a community prop- erty state do not live together, the tax law contains an exception to the above community property rules. Under this special provision, a spouse will be taxed only on his or her actual earnings from personal services. For this provision to apply, the following conditions must be satisfied:

1. The individuals must live apart for the entire year, 2. They must not file a joint return, and 3. No portion of the earned income may be transferred between the spouses.

EXAmPLE Bill and Betty, both residents of Nevada, are married but live apart for the entire year. Bill has a salary of $30,000 and Betty has a salary of $35,000. Normally, Bill and Betty would each report $32,500. However, if the required conditions are met, Bill and Betty would each report their own salary. If Bill and Betty had any unearned income, such as dividends or interest, the income would be reported under the general community property rules. The special provision applies only to earned income of the spouses. ♦

Another provision addresses the problem of spouses who fail to qualify for the above special exception because they do not live apart for the entire year. In certain cases, a spouse who fails to include in income his or her share of community income, as required by the community property laws, may be relieved of any liability related to this income. To be granted relief, the taxpayer must not know of or have reason to know of the omitted com- munity property income.

Self-Study Problem 2.17 See Appendix E for Solutions to Self-Study Problems

Tom and Rachel are married and living together in California. Their income is as follows:

Tom’s salary $40,000 Rachel’s salary 30,000 Dividends (Tom’s property) 5,000 Dividends (Rachel’s property) 3,000 Interest (community property) 4,000

Total $82,000

a. If Rachel files a separate tax return, she should report income of:

b. If Tom and Rachel lived in Texas, what should Rachel report as income?

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2-40 Chapter 2 ● Gross Income and Exclusions

K e y t e r m s

gross income, 2-2 barter, 2-2 inclusions – gross income, 2-3 exclusions – gross income, 2-3 employee fringe benefits, 2-8 flexible spending accounts, 2-8 dependent care flexible spending

accounts, 2-9 health care flexible spending

accounts, 2-9 group term life insurance, 2-9 education assistance plans, 2-9 no-additional-cost services, 2-10 qualified employee discounts, 2-10 working condition fringe benefit, 2-10

de minimis fringe benefits, 2-10 tuition reduction, 2-11 retirement planning fringe

benefit, 2-11 qualified plan award, 2-12 annuities, 2-13 the simplified method, 2-14 the general rule, 2-15 employee annuities, 2-16 accelerated death benefits, 2-17 viatical settlements, 2-17 interest income, 2-18 Schedule B, 2-18 U.S. savings bonds, 2-18 dividends, 2-19

municipal bond interest, 2-25 gift, 2-26 scholarship, 2-27 alimony, 2-27 property transfers, 2-28 qualified tuition programs

(Section 529 tuition plan), 2-30 educational savings account

(Coverdell Education Savings Accounts), 2-31

modified adjusted gross income (MAGI), 2-34

community property, 2-38 separate property, 2-38

Learning Objectives Key points

LO 2.1: Apply the definition of gross income.

● Gross income means “all income from whatever source derived.” ● Gross income includes everything a taxpayer receives unless it is specifically excluded from gross income by the tax law.

LO 2.2: Describe salaries and wages income reporting and inclusion in gross income.

● The primary form of reporting wages to an employee is through Form W-2. ● Employers should report the employee’s taxable wages, salary, bonuses, awards, commissions, and almost every other type of taxable compensation in Box 1 of the Form W-2.

● If a taxpayer receives more than one Form W-2 or is jointly filing with a spouse having their own Form W-2, the amounts in Box 1 are combined before entering the total on Line 1 of the Form 1040.

● Other Form W-2 information such as federal taxes paid will also be reported by the taxpayer on the Form 1040.

LO 2.3: Explain the general tax treatment of health insurance.

● Taxpayers may exclude health insurance premiums paid by their employer. ● Taxpayers are allowed an exclusion for payments received from accident and health plans. The taxpayer may exclude the total amount received for payment of medical care, including any amount paid for the medical care of the taxpayer, his or her spouse, or dependents.

LO 2.4: Determine when meals and lodging may be excluded from taxable income.

● Meals and lodging are excluded from gross income provided they are for the convenience of the employer and they are furnished on the business premises. Lodging must be a condition of employment to be excluded.

LO 2.5: Identify the common employee fringe benefit income exclusions.

● Certain fringe benefits provided to employees may be excluded from the employees’ gross income. These include dependent care and health care flexible spending accounts, group term life insurance (up to $50,000), education assistance plans, and others.

K e y p O I N ts

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2-41

LO 2.6: Determine when prizes and awards are included in income.

● Amounts received from prizes and awards are normally taxable income unless refused by the taxpayer.

● Certain small prizes (generally under $400) for length of service and safety achievement are excluded from gross income. If the award is a “qualified plan award,” then up to $1,600 of the value of the award may be excluded.

LO 2.7: Calculate the taxable and nontaxable portions of annuity payments.

● Annuity payments received by a taxpayer have an element of taxable income and an element of tax-free return of the original purchase price.

● The part of the payment that is excluded from income is the ratio of the investment in the contract to the total expected return.

● The total expected return is the annual payment multiplied by the life expectancy of the annuitant, based on mortality tables provided by the IRS.

● Individual taxpayers generally must use the “simplified” method to calculate the taxable amount from a qualified annuity starting after November 18, 1996.

LO 2.8: Describe the tax treatment of life insurance proceeds.

● Life insurance proceeds are generally excluded from gross income. If the proceeds are taken over several years instead of in a lump sum, any interest on the unpaid proceeds is generally taxable income.

● Early payouts of life insurance are excluded from gross income for certain terminally or chronically ill taxpayers.

● All or a portion of the proceeds from a life insurance policy transferred to another person for valuable consideration may be taxable to the recipient.

LO 2.9: Identify the tax treatment of interest and dividend income.

● Interest income is taxable except for certain state and municipal bond interest. ● Interest or dividend income exceeding $1,500 per year must be reported in detail on Schedule B of Form 1040.

● Series EE and Series I Savings Bond interest is taxable in the year the bonds are cashed unless a taxpayer elects to report the interest each year as it accrues.

● Series HH Savings Bond interest is taxable each year as it is paid to the taxpayer. ● Ordinary dividends are taxable in the year received. ● Qualified dividends are taxed at rates ranging from 0 percent to 20 percent and possibly included in the 3.8 percent net investment income tax.

LO 2.10: Describe the tax treatment of municipal bond interest.

● Interest from an obligation of a state, territory, or possession of the United States, or of a political subdivision of the foregoing, or of the District of Columbia, is excluded from gross income.

LO 2.11: Identify the general rules for the tax treatment of gifts and inheritances.

● The receipt of gifts and inheritances is usually excludable from gross income. Income received from the property after the transfer may be taxable to the recipient.

LO 2.12: Describe the elements of scholarship income that are excluded from tax.

● Scholarships granted to degree candidates are excluded from gross income if spent for tuition, fees, books, and course-required supplies and equipment. Amounts received for items such as room and board are taxable to the recipient.

LO 2.13: Describe the tax treatment of alimony and child support.

● Alimony paid in cash is taxable to the person who receives it and is deductible to the person who pays it, for divorce agreements dated prior to January 1, 2019.

● Child support is not alimony and therefore is not taxable when received, nor deductible when paid.

● A spouse who transfers property in settlement of a marital obligation is not required to recognize any gain as a result of the property’s appreciation. The receiving spouse assumes the tax basis of the property.

● The TCJA repealed the alimony provisions and these amounts are neither included nor deducted in taxable income beginning with divorce or separation agreements after December 31, 2018.

Key Points

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2-42 Chapter 2 ● Gross Income and Exclusions

LO 2.14: Explain the tax implications of using educational savings vehicles.

● A Qualified Tuition Program (Section 529 plan) allows taxpayers (1) to buy in-kind tuition credits or certificates for qualified higher education expenses or (2) to contribute to an account established to meet qualified higher education expenses. Distributions from the account are not taxable if the account is used for qualified higher education expenses.

● Qualified higher education expenses include tuition, fees, books, supplies, and equipment required for the enrollment or attendance at an eligible educational institution. In addition, taxpayers are allowed reasonable room and board costs, subject to certain limitations.

● The maximum exclusion for elementary or secondary education (K-12) for tuition only, is $10,000 per beneficiary per year.

● The maximum amount a taxpayer can contribute annually to an educational savings account for a beneficiary is $2,000. The contribution is not deductible, and if the amounts received are used for qualified education expenses, the distributions are not taxable.

LO 2.15: Describe the tax treatment of unemployment compensation.

● Unemployment compensation is taxable.

LO 2.16: Apply the rules governing inclusion of Social Security benefits in gross income.

● Taxpayers with income under $25,000 ($32,000 for Married Filing Jointly) exclude all of their Social Security benefits from gross income.

● Middle-income and upper-income Social Security recipients, however, may have to include up to 85 percent of their benefits in gross income.

● Calculating the taxable amount of Social Security is complex and most easily done using a worksheet, such as the one provided in this chapter, or a tax program such as Intuit ProConnect Tax Online.

LO 2.17: Distinguish between the different rules for married taxpayers residing in community property states when filing separate returns.

● Income derived from community property held by a married couple, either jointly or separately, as well as wages and other income earned by a married couple, must be allocated between the spouses, if filing separately.

● Nine states use a community property system of marital law. These states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. In Alaska, spouses may elect to treat income as community property.

● In general, in a community property state, income is split one-half (50 percent) to each spouse. There are exceptions for certain separate property (e.g., property owned prior to marriage, etc.).

GrOUp 1:

muLTIPLE ChOICE QuESTIONS

1. The definition of gross income in the tax law is: a. All items specifically listed as income in the tax law b. All cash payments received for goods provided and services performed c. All income from whatever source derived d. All income from whatever source derived unless the income is earned illegally

2. Which of the following is not taxable for income tax purposes? a. Prizes b. Severance pay c. Gifts d. Partnership income e. All of the above are taxable

LO 2.1

Q U es t I O Ns a n d prO B L e m s

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2-43Questions and Problems

3. All of the following items are taxable to the taxpayer receiving them, except: a. Life insurance proceeds b. Unemployment compensation c. Embezzled funds d. Prizes e. Gambling winnings

4. Which of the following types of income is tax exempt? a. Unemployment compensation b. Income earned illegally c. Dividends from foreign corporations d. Municipal bond interest e. Dividends from utility corporations’ stock

5. Which of the following is included in gross income? a. Loans b. Scholarships for room and board c. Worker’s compensation d. Health insurance proceeds e. None of the above

6. Which of the following items would be included in the gross income of the recipient? a. Insurance payments for medical care of a dependent child b. Insurance payments for loss of the taxpayer’s sight c. Season tickets worth $2,000 given to a son by his father d. Payments to a student for working at the student union food court e. Lodging provided to a worker on a remote oil rig

7. Malin is a married taxpayer and has three dependent children. Malin’s employer offers health insurance for employees and Malin takes advantage of the benefit for her entire family (her spouse’s employer also offers health insurance but they opt out). During the year, Malin paid $1,200 toward her family’s health insurance premiums through payroll deductions while the employer paid the remaining $9,200. Malin’s family visited health care professionals numerous times during the year and made total co- payments toward medical services of $280. Malin’s daughter had knee surgery due to a soccer injury and the insurance company paid the hospital $6,700 directly and reim- bursed Malin $400 for her out-of-pocket health care expenses related to the surgery. How much gross income should Malin recognize related to her health insurance? a. $0 b. $9,200 c. $14,020 ($9,200 1 $6,700 2 $1,200 2 $280 2 $400) d. $8,000 ($9,200 2 $1,200) e. None of the above

8. George works at the Springfield Nuclear Plant as a nuclear technician. The plant is located 15 miles from the town of Springfield. George likes to eat his lunch at the plant’s cafeteria because he is required to be available for nuclear emergencies during his shift. Unsurprisingly, there are no other eating establishments located near the plant. George estimates the value of the meals he was provided during the current year as $1,300. He estimates the cost for him to have prepared those lunches for him- self as about $560. The cost of the meals to the power company was $470. How much income does George need to recognize from the meals? a. $1,300 b. $560 c. $470 d. $830 ($1,300 2 $470) e. None of the above

LO 2.1

LO 2.3 LO 2.4 LO 2.11 LO 2.12

LO 2.3

LO 2.4

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2-44 Chapter 2 ● Gross Income and Exclusions

9. Which of the following is a fringe benefit excluded from income? a. A mechanic at Denise’s employer, a car rental company, provides $1,000 of repair

services to Denise’s personal car for free b. Alfa-Bet, a high-tech corporation, pays for each employee’s membership at the

24 Hour Biceps Gym closest to each Alfa-Bet office c. Quickchat Inc. gives each employee a $10 giftcard to the local coffee shop on

National Coffee Day d. Hedaya, a doctoral student at Ivy University, receives a full tuition waiver while

serving as research assistant

10. Which of the following will result in the recognition of gross income? a. Gail’s employer allows her to set aside $4,000 from her wages to cover the cost of

daycare for Gail’s four-year-old daughter. Gail’s daycare costs are $4,300 for the year.

b. Hannah purchases a new sofa from her employer, Sofas-R-Us, for $1,200. The cost of the sofa to the furniture store is $1,100 and the sofa normally sells for $1,700.

c. Jayden’s employer purchases her commuting pass for the subway at a cost of $225 per month.

d. Havana is a lawyer. The law firm she works for pays for her subscription to Lawyer’s Weekly, a trade magazine for attorneys.

e. None of the above will result in recognition of gross income.

11. Which of the following prizes or awards is taxable? a. Professional sports awards b. Prizes from a television game show c. Awards for superior performance on the job d. A one-acre lot received as a prize e. All of the above are taxable

12. Huihana receives a watch for achieving 20 years of employment with her employer. The watch cost the employer $225 and has a market value of $250 on the date awarded. Huihana is in the highest tax bracket for single taxpayers. How much gross income will Huihana recognize on the receipt of the watch? a. $250 b. $200 c. $25 d. $0 e. $50 or $59.50 including the net investment income tax

13. A 64-year-old taxpayer retires this year and receives the first payment on an annu- ity that was purchased several years ago. The taxpayer’s investment in the annuity is $97,500, and the annuity pays $1,000 per month for the remainder of the taxpayer’s life. Based on IRS mortality tables, the taxpayer is expected to live another 20 years. If the taxpayer receives $4,000 in annuity payments in the current year, the nontaxable portion calculated using the simplified method is: a. $0 b. $1,500 c. $1,400 d. $4,000 e. None of the above

14. Amara has an annuity and over time has recovered her entire investment but it continues to pay her $450 per month. Amara should recognize how much of each monthly payment as gross income? a. $0 b. Some amount greater than $450 c. Some amount between $0 and $450 d. $450

LO 2.5

LO 2.6

LO 2.7

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2-45Questions and Problems

15. Which of the following might result in life insurance proceeds that are taxable to the recipient? a. A life insurance policy in which the insured is the son of the taxpayer and the

beneficiary is the taxpayer b. A life insurance policy transferred by a partner to the partnership c. A life insurance policy transferred to a creditor in payment of a debt d. A life insurance policy purchased by a taxpayer insuring his or her spouse e. A life insurance policy purchased by a corporation insuring an officer

16. Harry’s wife Lila passes away in January of the current year. Fortunately, Lila had a $1 million life insurance policy. Harry elects to receive all $1 million in the current year and spends $200,000 of it on a luxury around-the-world trip with his new girlfriend. Harry’s gross income from the life insurance is: a. $0 b. $200,000 c. $800,000 d. $1,000,000

17. Nomi is in the highest individual tax bracket and receives $500 in qualified dividends from Omega Corp. Nomi’s tax liability (not including any net investment income tax) with respect to these dividends is: a. $0 b. $277.20 c. $100.00 d. $75.00 e. $50.00

18. Rebecca, a single taxpayer, owns a Series I U.S. Savings Bond that increased in value by $46 during the year. She makes no special election. How much income must Rebecca recognize this year? a. $0 b. $46 c. $23 d. $0 if in first 5 years or $46 thereafter

19. Interest from which of the following types of bonds is included in federal taxable income? a. State of California bond b. City of New Orleans bond c. Bond of the Commonwealth of Puerto Rico d. U.S. Treasury Bond e. All of the above are excluded from income

20. Which of the following gifts would probably be held to be taxable to the person re- ceiving the gift? a. One thousand dollars given to a taxpayer by his or her father b. An acre of land given to a taxpayer by a friend c. A car given to a loyal employee by her supervisor when she retired to recognize

her faithful service d. A Mercedes-Benz given to a taxpayer by his cousin e. An interest in a partnership given to a taxpayer by his or her uncle

21. Kelly receives a $40,000 scholarship to Ivy University. She uses $30,000 on tuition and books, $5,000 for a used car, and $5,000 for rent while at school. Kelly will recognize _______ gross income. a. $0 b. $5,000 c. $10,000 d. $30,000 e. $40,000

LO 2.8

LO 2.9

LO 2.10

LO 2.11

LO 2.12

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2-46 Chapter 2 ● Gross Income and Exclusions

22. Hillary gets divorced in 2016 and is required to pay her ex-spouse $200 per month until her son reaches 18 years of age in 7 years and $120 per month thereafter. How much of her 2019 payments are deductible as alimony? a. $0 b. $2,400 c. $1,440 d. $960

23. Ivanka and Jared are divorced in the current year. As part of the divorce settlement, Ivanka transfers a plot of land in Long Island, NY to Jared. Ivanka’s basis in the property was $20,000 and the market value of the property was $250,000 when transferred. Jared holds the property through the end of the year and in hopes of building a residence on it. How much income do Ivanka and Jared recognize in the current year? a. $0 for Ivanka and $20,000 for Jared b. $230,000 for Ivanka and $20,000 for Jared c. $230,000 for Ivanka and $0 for Jared d. $0 for both Ivanka and Jared e. $0 for Ivanka and $250,000 for Jared

24. Gina receives a $2,900 distribution from her educational savings account. She uses $1,500 to pay for qualified higher education expenses and $1,400 on a vacation. Immediately prior to the distribution, Gina’s account balance is $5,000, $3,000 of which is her contributions. What is Gina’s taxable income (after any exclusion) from the distribution? a. $1,400 b. $560 c. $840 d. $0 e. Some other amount

25. Which of the following is correct for Qualified Tuition Programs? a. Contributions are deductible, and qualified educational expense distributions are

tax free. b. Contributions are not deductible, and qualified educational expense distributions

are tax free. c. Contributions are deductible, and qualified educational expense distributions are

taxable. d. Contributions are not deductible, and qualified educational expense distributions

are taxable.

26. In 2019, Amy receives $8,000 (of which $3,000 is earnings) from a qualified tuition program. She does not use the funds to pay for tuition or other qualified higher edu- cation expenses. What amount is taxable to Amy? a. $0 b. $8,000 c. $3,000 d. $11,000

27. For married taxpayers filing a joint return in 2019, at what AGI level does the phase- out limit for contributions to Qualified Tuition Programs start? a. $110,000 b. $190,000 c. $220,000 d. There is no phase-out limit on QTP contributions

LO 2.13

LO 2.14

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2-47Questions and Problems

28. Which of the following is not true with respect to education incentives? a. The contributions to qualified tuition programs (Section 529 plans) are not

deductible. b. The contributions to educational savings accounts (Coverdell ESA) are not

deductible. c. Tuition paid by a taxpayer earning $300,000 of income is not deductible. d. Married taxpayers must have income less than $100,000 to contribute to a

qualified tuition program (Section 529 plan).

29. During 2019, Carl (a single taxpayer) has a salary of $91,500 and interest income of $11,000. Calculate the maximum contribution Carl is allowed for an educational savings account. a. $0 b. $400 c. $1,000 d. $2,000 e. Some other amount

30. George receives a $1,500 distribution from his educational savings account. He uses $1,200 to pay for qualified higher education expenses. Immediately prior to the distri- bution, George’s account balance is $5,000, $3,000 of which is his contributions. What is George’s tax-free return of capital from the distribution? a. $1,500 b. $1,200 c. $900 d. $750 e. $600

31. Alicia loses her job part way through 2019. Her employer pays her wages of $15,450 up through her date of termination. After that, she received $3,400 of unemployment compensation from the state until she gets a new job for which she is paid wages of $3,000 through year end. Based on this information, Alicia’s gross income for 2019 is: a. $0 b. $3,000 c. $6,400 d. $18,450 e. $21,850

32. For 2019, the minimum percentage of Social Security benefits that could be included in a taxpayer’s gross income is: a. 0% b. 25% c. 50% d. 75% e. 85%

33. Generally, modified adjusted gross income (MAGI) is adjusted gross income (without Social Security benefits): a. Less tax-exempt interest b. Less personal and dependency exemptions c. Less itemized deductions d. Less tax-exempt interest plus any foreign income exclusion e. Plus tax-exempt interest income

LO 2.14

LO 2.15

LO 2.16

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2-48 Chapter 2 ● Gross Income and Exclusions

GrOUp 2:

PROBLEmS

1. Indicate whether each of the items listed below would be included (I) in or excluded (E) from gross income for the 2019 tax year.

a. Welfare payments b. Commissions c. Hobby income d. Scholarships for room and board e. $300 set of golf clubs, an employee award for length of service f. Severance pay g. Ordinary dividend of $50 h. Accident insurance proceeds received for personal bodily injury i. Inheritances j. Gifts k. Tips and gratuities

2. Jane is a roofing contractor. Jane’s friend needed a new roof but did not have the cash to pay. Jane’s friend instead paid with a used truck that Jane could use in her roofing business. The truck had originally cost the friend $17,500 but it was gently used and only worth $6,000. Jane did not actually need the truck and ended up selling it to a used car dealer for $5,200 a few months later. Explain what amount of gross income Jane must recognize as a result of the truck payment and why.

3. Larry is a tax accountant and Sheila is a hairdresser. Larry prepares Sheila’s tax return for free and Sheila agrees to style Larry’s hair six times for free in return for the tax return. The value of the tax return is approximately $300 and the hair styling work is approximately $300. a. How much of the $300 is includable income to Larry? Why?

b. How much of the $300 is includable income to Sheila? Why?

LO 2.1

34. Dana and Larry are married and live in Texas. Dana earns a salary of $45,000 and Larry has $25,000 of rental income from his separate property. If Dana and Larry file separate tax returns, what amount of income must Larry report? a. $0 b. $22,500 c. $25,000 d. $47,500 e. None of the above

35. Which of the following conditions need not be satisfied in order for a married tax- payer, residing in a community property state, to be taxed only on his or her separate salary? a. The husband and wife must live apart for the entire year. b. A minor child must be living with the spouse. c. The husband and wife must not file a joint income tax return. d. The husband and wife must not transfer earned income between themselves. e. All of the above must be satisfied.

LO 2.17

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2-49Questions and Problems

4. Kerry and Jim have a successful marijuana farm in the woods around Humboldt County, California. Growing marijuana is illegal for federal purposes. Are Kerry and Jim required by law to report the income from their farm on their tax return? Why?

5. Kristen, a single taxpayer, receives two 2019 Forms W-2 from the two employers she worked for during the year. One Form W-2 lists her wages in Boxes 1, 3, and 5 as $18,700. Her other employer’s Form W-2 has $43,000 in Box 1 but only $46,500 in both Box 3 and Box 5. Kristen participated in the second employer’s 401(k) plan. She also received health care from her second employer. Lastly, her second employer pro- vided $30,000 of group term life insurance to Kristen. a. What amount should Kristen report as taxable wages in 2019? b. What could explain the difference between Box 1 wages and Boxes 3 and 5 on her

second employer’s W-2?

6. Skyler is covered by his company’s health insurance plan. The health insurance costs his company $9,500 a year. During the year, Skyler is diagnosed with a serious illness and health insurance pays $100,000 for surgery and treatment. How much of the insurance and treatment payments are taxable to Skyler?

7. Ellen is a single taxpayer. Ellen’s employer pays $150 per month ($1,800 this year) for her health insurance. During the year, Ellen had medical expenses of $3,500 and the insurance company paid $2,000 of the expenses. How much of the above amounts, if any, must be included in Ellen’s gross income?

$ Why?

8. a. Milton is a nurse whose employer provided meals for him on the employer’s premises, since he is given only 30 minutes for lunch. Is the value of these meals taxable income to Milton?

Explain

b. Mary is a San Diego ambulance driver. The city provides Mary with meals while she is working so she will be available for emergencies. Is the value of these meals taxable income to Mary?

Explain

c. Indigo is the head of security at a casino. The casino operator frequently provides meals from the casino buffett to Indigo as a gesture of goodwill for the great job she is doing. Is the value of these meals taxable income to Indigo? Explain

9. Linda and Richard are married and file a joint return for 2019. During the year, Linda, who works as an accountant for a national airline, used $2,100 worth of free passes for travel on the airline; Richard used the same amount. Linda and Richard also used $850 worth of employee discount coupons for hotel rooms at the hotel chain that is also owned by the airline. Richard is employed at State University as an accounting clerk. Under a tuition reduction plan, Richard saved $4,000 in tuition fees during 2019. He is studying for a master’s degree in business at night while still working full-time. Richard also had $30 worth of personal typing done by his administrative assistant at the University. What is the amount of fringe benefits that should be in- cluded in Linda and Richard’s gross income on their 2019 tax return?

LO 2.1

LO 2.2

LO 2.3

LO 2.4

LO 2.5

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2-50 Chapter 2 ● Gross Income and Exclusions

Group 2, Problem 13 continued on Page 2-51.

10. Ellen’s tax client, Tom, is employed at a large company that offers health care flexible spending accounts to its employees. Tom must decide at the beginning of the year whether he wants to put as much as $2,700 of his salary into the health care flexible spending account. He expects that he will have to pay for at least $8,000 of medical expenses for his family during the year since his wife is seeing a psychiatrist every week and his daughter and son are both having their teeth straightened. Tom does not itemize deductions. Should Ellen recommend that Tom put the maximum amount in his health care flexible spending account, and if so, why?

11. How much of each of the following is taxable? a. Cheline, an actress, received a $6,400 gift bag for attending the Academy Awards

Ceremony during 2019. b. Jon received a gold watch worth $660 for 25 years of service to his accounting firm

(not a qualified award). c. Kerry won $1,000,000 in her state lottery. d. Deborah is a professor who received $30,000 as an award for her scientific

research from the university that employs her.

12. For each of the following independent cases, indicate the amount of gross income that must be included on the taxpayer’s 2019 income tax return. a. Malchia won a $4,000 humanitarian award.

b. Rob won a new automobile (with a sticker price of $15,700 and a market value of $14,500) for being the best junior tennis player in 2019.

c. George received a $3,500 tuition and fees scholarship to attend Western University. $

13. Lola, age 67, began receiving a $1,000 monthly annuity in the current year upon the death of her husband. She received seven payments in the current year. Her husband contributed $48,300 to the qualified employee plan. Use the Simplified Method Worksheet below to calculate Lola’s taxable amount from the annuity.

Simplified method WorkSheet 1. Enter total amount received this year. 1. 2. Enter cost in the plan at the annuity starting date. 2. 3. Age at annuity starting date

Enter 55 and under 360 56–60 310 61–65 260 3. 66–70 210 71 and older 160

4. Divide line 2 by line 3. 4.

LO 2.5

LO 2.6

LO 2.6 LO 2.12

LO 2.7

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2-51Questions and Problems

5. Multiply line 4 by the number of monthly payments this year. If the annuity starting date was before 1987, also enter this amount on line 8, and skip lines 6 and 7. Otherwise, go to line 6. 5.

6. Enter the amount, if any, recovered tax free in prior 6. years.

7. Subtract line 6 from line 2. 7. 8. Enter the smaller of line 5 or 7. 8. 9. Taxable amount this year: Subtract line 8 from line 9.

1. Do not enter less than zero.

14. Sharon transfers to Russ a life insurance policy with a cash surrender value of $27,000 and a face value of $100,000 in exchange for real estate. Russ continues to pay the premiums on the policy until Sharon dies 7 years later. At that time, Russ has paid $12,000 in premiums, and he collects the $100,000 face value. How much of the proceeds is taxable to Russ?

$ Why?

15. Greg died on July 1, 2019, and left Lea, his wife, a $45,000 life insurance policy which she elects to receive at $9,000 per year plus interest for 5 years. In the current year, Lea receives $9,500. How much should Lea include in her gross income?

16. David is certified by his doctor as terminally ill with liver disease. His doctor certifies that he cannot reasonably be expected to live for more than a year. He sells his life insurance policy to Viatical Settlements, Inc., for $250,000. He has paid $20,000 so far for the policy. How much of the $250,000 must David include in his taxable income?

17. Helen receives a $200,000 lump sum life insurance payment when her friend Alice dies. How much of the payment is taxable to Helen?

18. How are qualified dividends taxed in 2019? Please give the rates of tax which apply to qualified dividends, and specify when each of these rates applies.

19. Describe the methods that an individual taxpayer that holds Series I Bonds can use to recognize interest.

LO 2.8

LO 2.9

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2-52 Chapter 2 ● Gross Income and Exclusions

20. Sally and Charles Heck received the following Form 1099-DIV in 2019:

The Hecks also received the following dividends and interest in 2019 (Forms 1099-DIV not shown):

Sally Charles Jointly Qualifying dividends: Altus Inc. $2,000 Buller Corp. $350 Gene Corporation $3,100 Interest: Porcine Bank 1,245 River Bank 650 City of New York Bonds 100

Assuming the Hecks file a joint tax return, complete Schedule B of Form 1040 (on Page 2-53) for them for the 2019 tax year. Do not attempt to complete the Qualified Dividends and Capital Gain Tax Worksheet.

21. Vandell is a taxpayer in the 25 percent tax bracket. He invests in Otay Mesa Water District Bonds that pay 4.5 percent interest. What interest on a taxable bond would provide the same after-tax return to Vandell?

22. Karen is a wealthy retired investment advisor who is in the 35 percent tax bracket. She has a choice between investing in a high-quality municipal bond paying 5 percent or a high-quality corporate bond paying 7 percent. What is the after-tax return of each bond and which one should Karen invest in? Explain your answer.

23. In June of 2019, Kevin inherits stock worth $125,000. During the year, he collects $5,600 in dividends from the stock. How much of these amounts, if any, should Kevin include in his gross income for 2019?

$ Why?

LO 2.9

LO 2.10

LO 2.11

Devona Corporation 33133 Hilltop Drive Alpine, CA 91901

850.00

694.00

27-1234567 313-13-1313

Sally Heck

1420 Pasadena Blvd.

Carrollton, TX 75007

0.00

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2-53Questions and Problems

08239_ch02_ptg01.indd 53 10/30/19 12:02 PM

2-54 Chapter 2 ● Gross Income and Exclusions

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2-55Questions and Problems

24. Gwen is a tax accountant who works very hard for a large corporate client. The client is pleased and gives her a gift of $10,000 at year-end. How much of the gift is taxable to Gwen?

25. Charlene receives a gift from her boyfriend of $10,000. He knows she is having financial problems and wants to help her. How much of the gift is taxable to Charlene?

26. Robbie receives a scholarship of $20,000 to an elite private college. $8,000 of the scholarship is earmarked for tuition, and $12,000 covers his room and board. How much of the scholarship, if any, is taxable to Robbie?

27. Answer the following questions: a. Under a 2017 divorce agreement, Joan is required to pay her ex-husband, Bill, $700

a month until their daughter is 18 years of age. At that time, the required pay- ments are reduced to $450 per month.

1. How much of each $700 payment may be deducted as alimony by Joan? $

2. How much of each $700 payment must be included in Bill’s taxable income? $

3. How much would be deductible/included if the divorce agreement were dated 2019?

b. Under the terms of a property settlement executed during 2019, Jane transferred property worth $450,000 to her ex-husband, Tom. The property has a tax basis to Jane of $425,000.

1. How much taxable gain must be recognized by Jane at the time of the transfer? $

2. What is the amount of Tom’s tax basis in the property he received from Jane? $

28. Arlen is required by his 2019 divorce agreement to pay alimony of $2,000 a month and child support of $2,000 a month to his ex-wife Jane. What is the tax treatment of these two payments for Arlen? What is the tax treatment of these two payments for Jane?

Arlen

Jane

29. As part of the property settlement related to their divorce, Cindy must give Allen the house that they have been living in, while she gets 100 percent of their savings accounts. The house was purchased for $90,000 20 years ago in Southern California and is now worth $700,000. How much gain must Cindy recognize on the transfer of the house to Allen? What is Allen’s tax basis in the house for calculating tax on any future sale of the house?

Cindy

Allen

LO 2.11

LO 2.12

LO 2.13

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2-56 Chapter 2 ● Gross Income and Exclusions

30. Jose paid the following amounts for his son to attend Big State University in 2019:

Tuition $6,400 Room and board 4,775 Books 772 A car to use at school 1,932 Student football tickets 237 Spending money 4,000

How much of the above is a qualified higher education expense for purposes of his Qualified Tuition Program?

31. In 2019, Van receives $20,000 (of which $4,000 is earnings) from a qualified tuition program. He uses the funds to pay for his college tuition and other qualified higher education expenses. How much of the $20,000 is taxable to Van?

32. Lydia, a married individual, was unemployed for a few months during 2019. During the year, she received $3,250 in unemployment compensation payments. How much of her unemployment compensation payments must be included in gross income?

33. During the 2019 tax year, Brian, a single taxpayer, received $7,400 in Social Security benefits. His adjusted gross income for the year was $14,500 (not including the Social Security benefits) and he received $30,000 in tax-exempt interest income and has no for-AGI deductions. Calculate the amount of the Social Security benefits that Brian must include in his gross income for 2019.

Simplified taxable Social Security WorkSheet (for moSt people) 1. Enter the total amount of Social Security income. 1. 2. Enter one-half of line 1. 2. 3. Enter the total of taxable income items on Form 1040 except 3.

Social Security income. 4. Enter the amount of tax-exempt interest income. 4. 5. Add lines 2, 3, and 4. 5. 6. Enter all adjustments for AGI except for student loan interest, 6.

the domestic production activities deduction, and the tuition and fees deduction.

7. Subtract line 6 from line 5. If zero or less, stop here, none of 7. the Social Security benefits are taxable.

8. Enter $25,000 ($32,000 if married filing jointly; $0 if 8. married filing separately and living with spouse at any time during the year).

9. Subtract line 8 from line 7. If zero or less, enter –0–. 9.

Note: If line 9 is zero or less, stop here; none of your benefits are taxable. Otherwise, go on to line 10.

10. Enter $9,000 ($12,000 if married filing jointly; $0 if 10. married filing separately and living with spouse at any time during the year).

LO 2.14

LO 2.15

LO 2.16

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2-57Questions and Problems

34. Please answer the following questions regarding the taxability of Social Security:

a. A 68-year-old taxpayer has $20,000 in Social Security income and $100,000 in tax-free municipal bond income. Does the municipal bond income affect the amount of Social Security the taxpayer must include in income?

b. A 68-year-old taxpayer has $20,000 in Social Security income and no other taxable or tax-free income. How much of the Social Security income must the taxpayer include in taxable income?

c. A 68-year-old taxpayer has $20,000 in Social Security income and has significant other taxable retirement income. What is the maximum percentage of Social Security that the taxpayer might be required to include in taxable income?

LO 2.16

1. Vanessa Lazo was an amazing high school student and so it was no great surprise when she was accepted into Prestige Private University (PPU). To entice Vanessa to attend PPU, the school offered her a reduced tuition of $13,000 per year (full-time tuition would typically be $43,000 per year). PPU also has a scholarship program thanks to a large donation from William Gatos. Vanessa was the Gatos Scholarship winner and will receive a scholarship for $20,000. Vanessa is required to use the scholarship first to pay her $13,000 tuition and the remainder is to cover room and board at PPU. Lastly, PPU also offered Vanessa a part-time job on the PPU campus as a student lab assistant in the Biology Department of PPU for which she is paid $1,500.

Required: Go to the IRS website (www.irs.gov) and locate Publication 970. Review the section on Scholarships. Write a letter to Vanessa Lazo stating how much of the PPU package for Vanessa is taxable. (An example of a client letter is available at the website for this textbook, located at www .cengage.com.)

RESEARCH

GrOUp 3:

WRITING ASSIGNmENT

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2-58 Chapter 2 ● Gross Income and Exclusions

1. Beverly and Ken Hair have been married for 3 years. Beverly works as an accoun- tant at Cypress Corporation. Ken is a full-time student at Southwest Missouri State University (SMSU) and also works part-time during the summer at Cypress Corp. Ken’s birthdate is January 12, 1993 and Beverly’s birthdate is November 4, 1995. Bev and Ken’s earnings and income tax withholdings are reported on the following Form W-2s:

GrOUp 4:

COmPREhENSIVE PROBLEmS

31-1238967

Cypress Corp. 1234 E. Chestnut Parkway Spring�eld, MO 65802

3567 River Street Spring�eld, MO 63126

Ken Hair

2,700.00 0.00

167.40

39.152,700.00

2,700.00

2,700.00 0.00

465-57-9934

465-74-3321

31-1238967

Cypress Corp. 1234 E. Chestnut Parkway Spring�eld, MO 65802

Beverly Hair 3567 River Street Spring�eld, MO 63126

51,000.00 4,790.00

51,000.00

3,162.00

739.50

MO 51,000.00 680.00

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2-59Questions and Problems

Green Corporation 900 South Orange Ave. Spring eld, MO 63126

33-11223344 465-57-9934

300.00

Ken Hair

3567 River Street

Spring eld, MO 63126

The Hairs have interest income of $1,000 on City of St. Louis bonds. Beverly and Ken also received the following Form 1099-INT and 1099-DIV:

651.76

33-1234566 465-74-3321

Spring�eld, MO 63126 300 City Avenue Boatman’s Bank

Beverly and Ken Hair

3567 River Street

Spring�eld, MO 63126

Ken is an excellent student at SMSU. He was given a $1,750 scholarship by the university to help pay educational expenses. The scholarship funds were used by Ken for tuition and books.

Last year, Beverly was laid off from her former job and was unemployed during January 2019. She was paid $1,825 of unemployment compensation until she started work with her current employer, Cypress Corporation.

Ken has a 4-year-old son, Robert R. Hair, from a prior marriage that ended in di- vorce in 2014. During 2019, he paid his ex-wife $300 per month in child support. Robert is claimed as a dependent by Ken’s ex-wife.

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2-60 Chapter 2 ● Gross Income and Exclusions

During 2019, Ken’s aunt died. The aunt, in her will, left Ken $15,000 in cash. Ken deposited this money in the Boatman’s Bank savings account.

Required: Complete the Hairs’ federal tax return for 2019 on Form 1040, Schedule 1, and the Qualified Dividends and Capital Gain Tax Worksheet.

2A. Ray and Maria Gomez have been married for 3 years. Ray is a propane salesman for Palm Oil Corporation and Maria works as a city clerk for the City of McAllen. Ray’s birthdate is February 21, 1991 and Maria’s is December 30, 1993. Ray and Maria’s earnings are reported on the following Form W-2s:

469-21-5523

21-7654321

Palm Oil Corporation 11134 E. Pecan Blvd. McAllen, TX 78501

Ray Gomez 1610 Quince Avenue McAllen, TX 78701

30,415.00 3,070.00

30,415.00

1,885.73

441.02

444-65-9912

23-4444321

City of McAllen 1300 W. Houston Ave. McAllen, TX 78501

Maria Gomez 1610 Quince Ave. McAllen, TX 78701

32,402.00 2,654.00

32,402.00

2,008.92

469.83

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2-61Questions and Problems

McAllen State Bank 3302 N. 10th Street McAllen, TX 78501

34-7657651 444-65-9912

Maria Gomez

1610 Quince Avenue

McAllen, TX 78701

673.12

Ray and Maria have interest income as reported on the following 1099-INT:

In addition, they own U.S. Savings bonds (Series EE). The bonds had a value of $10,000 on January 1, 2019, and their value is $10,700 on December 31, 2019. They have not made an election with respect to these bonds.

Ray has an ex-wife named Judy Gomez. Pursuant to their January 27, 2014 divorce decree, Ray pays her $450 per month in alimony. All payments were made on time in 2019. Judy’s Social Security number is 566-74-8765.

During 2019, Ray was in the hospital for a successful operation. His health insur- ance company reimbursed Ray $4,732 for all of his hospital and doctor bills.

In June of 2019, Maria’s father died. Under a life insurance policy owned and paid for by her father, Maria was paid death benefits of $25,000. She used $7,800 to cover a portion of the funeral costs for her father.

Maria bought a Texas lottery ticket on impulse during 2019. Her ticket was lucky and she won $4,025. The winning amount was paid to Maria in November 2019, with no income tax withheld.

Palm Oil Corporation provides Ray with a company car to drive while he is work- ing. The Corporation spent $5,000 to maintain this vehicle during 2019. Ray never uses the car for personal purposes.

Required: Complete the Gomez’s federal tax return for 2019 on Form 1040 and Schedule 1.

2B. Carl Conch and Mary Duval are married and file a joint return. Carl works for the Key Lime Pie Company and Mary is a homemaker after losing her job in 2018. Carl’s birth- date is June 14, 1974 and Mary’s is October 2, 1974. Carl’s earnings are reported on the following Form W-2:

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2-62 Chapter 2 ● Gross Income and Exclusions

Carl and Mary received the following Forms 1099:

Coral Reef Bank 3102 Simonton Street Key West, FL 33040

31-1234444 633-65-7912

Mary Duval and Carl Conch

1234 Mallory Sq. Apt 64

Key West, FL 33040

369.91

835-21-5423

61-7654321

Key Lime Pie Company 223 Key Deer Blvd.

Carl Conch 1234 Mallory Square, Apt. #64 Key West, FL 33040

67,894.88 6,650.00

67,894.88

4,209.48

984.48

C 240.00

Parking $1,680.00

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2-63Questions and Problems

Mary is divorced and she pays her ex-husband (Tom Tortuga) child support. Pur- suant to their 2016 divorce decree, Mary pays Tom $500 per month in child support. All payments were made on time in 2019.

In June 2019, Mary’s father gave her a cash gift of $75,000. Mary also received un- employment compensation as shown on the following Form 1099-G:

Southwest Corporation PO Box 36611 Dallas, TX 75235

74-1536241 835-21-5423

Carl Conch

1234 Mallory Square #64

Key West, FL 33040

234.00

0.00

Florida Dept of Econ Opportunity 107 E. Jefferson St. Tallahassee, FL 32399

21- 5556666 3633-65-7912

Mary Duval

170 .00

1234 Mallory Sq. #64

Key West, FL 33040

2,989.00

Mary won a $775 prize in a women’s club raffle in 2019. No income tax was withheld from the prize.

The Key Lime Pie Company provides Carl with a company car to drive while he is working. The Company spent $6,475 to maintain this vehicle during 2019. Carl never uses the car for personal purposes. The Key Lime Pie Company also provides a cafete- ria for all employees on the factory premises. Other restaurants exist in the area and so Carl is not required to eat in the cafeteria, but he typically does. The value of Carl’s meals is $650 in 2019.

Required: Complete Carl and Mary’s federal tax return for 2019 on Form 1040 and Schedule 1.

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2-64 Chapter 2 ● Gross Income and Exclusions

1. The following additional information is available for the family of Albert and Allison Gaytor.

In 2019, Albert received a Form W-2 from his employer, Coconut Grove Fishing Charters, Inc. (hint: slightly modified from Chapter 1):

GrOUp 5:

CumuLATIVE SOfTWARE PROBLEm

60-3456789

266-51-1966

Coconut Grove Fishing Charters 2432 Bay Blvd. Coconut Grove, FL 33133

Albert T. Gaytor 12340 Cocoshell Road Coral Gables, FL 33134

67,023.67

5,634.12

4,155.47

971.84

8,400.00

Parking $1,440

In addition to the interest from Chapter 1, Albert and Allison also received three Forms 1099:

Florida Electric Company 100 Palm Boulevard Jupiter, FL 33458

Albert T. Gaytor

59-0247776 266-51-1966

682.41

Coral Gables, FL 33134

12340 Cocoshell Road

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2-65Questions and Problems

The Gaytors also received interest of $751 from bonds issued by the Miami-Dade County Airport Authority (Form 1099 not shown).

Everglades Bank Corporation 1500 S. Krome Avenue Homestead, FL 33034

Allison Gaytor

12340 Cocoshell Road

Coral Gables, FL 33134

57-4443344 266-34-1967

1,031.00

0.00

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2-66 Chapter 2 ● Gross Income and Exclusions

Albert had no other gambling income or losses for the year. In February, Allison received $50,000 in life insurance proceeds from the death of her

friend, Sharon. In July, Albert’s uncle Ivan died and left him real estate (undeveloped land) worth $72,000. Five years ago, Albert and Allison divorced. Albert married Iris, but the marriage did not

work out and they divorced a year later. Under the July 1, 2015 divorce decree, Albert pays Iris $11,500 per year in alimony. All payments were on time in 2019 and Iris’ Social Security number is 667-34-9224. Three years ago, Albert and Allison were remarried.

Coconut Fishing Charters, Inc. pays Albert’s captain’s license fees and membership dues to the Charter Fisherman’s Association. During 2019, Coconut Fishing paid $1,300 for such dues and fees for Albert.

Allison was laid off from her job on January 2, 2019. She received a Form 1099-G for unemployment benefits:

Florida Dept of Econ Opportunity 107 E. Jefferson St. Tallahassee, FL 32399

4,050.00

155.00266-34-196721-5556666

Allison Gaytor

12340 Cocoshell Rd

Coral Gables, FL 33134

Albert and his family are covered by an employee-sponsored health plan at his work. Coconut Fishing pays $700 per month in premiums for Albert and his family. During the year, Allison was in the hospital for appendix surgery. The bill for the surgery was $10,100 of which the health insurance reimbursed Albert the full $10,100.

Coconut Fishing also pays for Albert’s parking at the marina. The monthly cost is $120.

Required: Combine this new information about the Gaytor family with the information from Chapter 1 and complete a revised 2019 tax return for Albert and Allison. Be sure to save your data input files since this case will be expanded with more tax information in later chapters.

Mikkosukee Resort and Gaming 1321 Tamiami Hwy. Miami, FL 33194

22-7777777 305-555-1212

Albert Gaytor

12340 Cocoshell Rd.

Coral Gables, FL 33134

6,022.00

1,600.00

266-51-1966

DF124562

Albert went to the casino on his birthday and won big, as reflected on the following Form W-2G:

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2-67Questions and Problems

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2-68 Chapter 2 ● Gross Income and Exclusions

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2-69Questions and Problems

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2-70 Chapter 2 ● Gross Income and Exclusions

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2-71Questions and Problems

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2-72 Chapter 2 ● Gross Income and Exclusions

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2-73Questions and Problems

Student Name

Class/Section

Date

K e y N Um B e r ta x r e t U r N sUm m a ry

ChAPTER 2

Comprehensive Problem 1

Adjusted Gross Income (Line 8b)

Taxable Income (Line 11b)

Total Tax (Line 16)

Amount Overpaid (Line 20)

Comprehensive Problem 2A

Adjusted Gross Income (Line 8b)

Taxable Income (Line 11b)

Total Tax (Line 16)

Amount Overpaid (Line 20)

Comprehensive Problem 2B

Adjusted Gross Income (Line 8b)

Taxable Income (Line 11b)

Total Tax (Line 16)

Amount Overpaid (Line 20)

08239_ch02_ptg01.indd 73 10/30/19 12:02 PM

H er

o Im

ag es

/G et

ty Im

ag es

Business Income and Expenses

C h a p t e r 3

08239_ch03_ptg01.indd 2 10/30/19 12:04 PM

O V e r V I e W

T his chapter covers Schedule C, “Profit or Loss from Business (Sole Proprietorship),” and many of the common business ex- penses allowed as deductions in arriving

at net taxable business income. Schedule C is filed by self-employed taxpayers, such as accoun- tants, doctors, lawyers, architects, consultants, small manufacturers, restaura teurs, store owners,

L E A R N I N G O B J E C T I V E S

After completing this chapter, you should be able to: LO 3.1 Complete a basic Schedule C (Profit or Loss from Business). LO 3.2 Describe the tax treatment of inventories and cost of goods sold. LO 3.3 Identif y the requirements for deducting transportation expenses. LO 3.4 Identif y the requirements for deducting travel expenses. LO 3.5 Determine the requirements for deducting meals. LO 3.6 Identif y the requirements for claiming business education expenses. LO 3.7 Identif y the tax treatment of dues and subscriptions. LO 3.8 Determine which clothing and uniforms may be treated as tax deductions. LO 3.9 Explain the special limits for business gift deductions. LO 3.10 Explain the tax treatment of bad debt deductions. LO 3.11 Ascertain when a home office deduction may be claimed and how the deduction is computed. LO 3.12 Apply the factors used to determine whether an activity is a hobby, and understand

the tax treatment of hobby losses.

3-1

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3-2 Chapter 3 ● Business Income and Expenses

gardeners, event planners, bookkeepers, and other small businesses. This form is one of the most commonly used tax forms and, for many taxpayers, the net income reported on Schedule C is the primary component in their adjusted gross income. With the TCJA’s introduction of the qualified business income (QBI) deduction, the sole proprietorship, along with income from rental properties (Chapter 4), partnerships (Chapter 10), and S corporations (Chapter 11), enjoy a reduction in tax rate in an attempt to match the new 21 percent corporate rate also introduced in 2018. The QBI deduction is covered in detail in Chapter 4.

The business expenses discussed in this chapter include travel, transportation, bad debts, inventory, home office, meals and entertainment, business educa- tion, dues, subscriptions, publications, special clothing, uniforms, and business gifts. While these expenses are often associated with Schedule C (sole proprietorship income), they may also be reported with rental and royalty income on Schedule E, or farm and ranch income on Schedule F. In addition, some of these expenses might be incurred by employees in connection with their employment. Employee business expenses are covered in Chapter 5.

3-1 SChEduLE C A taxpayer who operates a trade or business or practices a profession as a sole proprietor ship must file a Schedule C with the Form 1040, reporting his or her taxable income or loss from the activity. Schedule C is similar to the income statement in financial account ing. Taxable income from a business or profession is reported on either Schedule C or Schedule F (a specialized version of Schedule C for farmers and ranchers).

3-1a Trade or Business The term trade or business is not formally defined, although the term is used often in the Internal Revenue Code (the Code). For example, Section 162 of the Code states that a tax payer is allowed to deduct all the ordinary and necessary expenses in carrying on a trade or business. Generally, a “trade or business” for tax purposes is any activity engaged in for profit. Note that a taxpayer does not have to actually make a profit, but he or she should be seek ing to make a profit through regular and continual effort. Intermittent activities (e.g., casual craft sales) or leisure pursuits (e.g., wine making) do not always rise to the level of a trade or business and may require reporting under the hobby loss rules discussed later in this chapter.

3-1b Tests for deductibility Expenses must meet several general tests to qualify as a tax deduction. Listed below are three common tests for deductibility. These tests give guidelines for deductibility, but often in practice it is a matter of judgment as to whether an expense is considered a deductible business expense. Taxpayers and IRS agents frequently disagree as to whether specific ex penses pass the following tests, and many court cases have been devoted to resolving these dis agreements. The tests below overlap and an expense may fail more than one test.

● The Ordinary and Necessary Test: Under the tax law, for trade or business expenses to be deductible they must be ordinary and necessary. Generally, this means that the expense is commonly found in the specific business, and is helpful and appropriate in running the business. For example, Rob is a CPA who goes to a “tax boot camp” which offers intensive training on tax return preparation every year. Rob also hires a trainer at his local gym to work out with him to help him maintain the strength and endurance needed to handle the rigors of tax season. The cost of the “tax boot camp” would be deductible. The cost of the personal trainer is not a common or ordinary expense of CPA firms and is not necessary for preparing tax returns and therefore would not be deductible.

Learning Objective 3.1 Complete a basic Schedule C (Profit or Loss from Business).

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3-33-1 Schedule C

● The Business Purpose Test: Expenses must have a legitimate business purpose to be considered deductible. Larry is an independent consultant who maintains an office in his home, although he always meets with clients at their place of business. He spent $75,000 upgrading his office to include a large attached glass sunroom and a display area for his orchid collection. This home office upgrade would likely be considered to serve no business purpose, so the expenses related to the improvements would not be allowed.

● The Reasonableness Test: The tax law requires that deductions be reasonable to be de ducted. For example, Derek owns a small business and takes one of his clients, who is also a friend, to an expensive business dinner every week. They enjoy a variety of restaurants and fine wines, and always spend some time talking about their joint business interests. The yearly cost of the meetings and meals is $20,000, and Derek generates $15,000 of fees from his friend each year. This lavish and extravagant business entertainment would likely not be considered reasonable given the circumstances. If they had met for pizza and a business discussion every week, the expense would likely be considered reasonable and deductible.

The IRS and courts have taken a fairly permissive perspective on the deduction of business expenses; however, the Code does restrict the deduction of certain expenses such as the following:

● Personal, living, and family expenses (although see itemized deductions in Chapter 5) ● Capital expenditures (see Chapter 7) ● Expenses related to taxexempt income ● Expenditures related to the sale of illegal drugs ● Illegal bribes and kickbacks ● Fines, penalties, and other payments to governments related to the violation of law ● Lobbying and political expenditures ● Settlement or attorney fees related to sexual abuse or harassment if subject to a non

disclosure agreement

Taxes are specifically excepted from the restriction on fines and penalties as are payments made to bring the taxpayer into compliance with the law or as restitution.

EXAMPLE Maria owns and operates a small pizza shop in the city. The City Council is considering new zoning laws that would permit the creation of a large hotel and theme park next to Maria’s restaurant which she expects would increase her business significantly. She pays $10,000 to have a study prepared to show the economic benefits of the new zoning to the City Council at a future meeting. Maria also has been a Republican since she was old enough to vote and makes a $1,000 contribution to the Republican National Committee. The $10,000 fee and her contribution to the RNC are not deductible. ♦

Much has been made of the Supreme Court’s Citizens United decision in 2010 which allowed for unlimited corporate spending on political activities. Those opposed to the decision can take some comfort knowing that most of such expenditures will not be tax deductible.

Would You

Believe? 3-1c Schedule C Schedule C is used by sole proprietors to report profit or loss from their businesses (Sched ule CEZ is no longer available). The first section (lines A to J) of Schedule C requires disclo sure of basic information such as the business name and location, the accounting method (cash, accrual, or other, as covered in Chapter 6), material participation in the business (for passive activity loss classification purposes, see Chapter 4), and whether the business was started or acquired during the year.

Schedule C requires the taxpayer to provide a principal business or professional activity code (see Figure 3.1). These codes are used to classify sole proprie torships by the

08239_ch03_ptg01.indd 3 10/30/19 12:04 PM

3-4 Chapter 3 ● Business Income and Expenses

FIGURE 3.1 PRINCIPAL BuSINESS OR PROFESSIONAL ACTIVITY COdES EXCERPT

FIGURE 3.2 SChEduLE C INCOME (PART I)

3-1d Schedule C Income (Part I) Part I of Schedule C (Figure 3.2) contains the calculation of the taxpayer’s gross income from the business or profession. The calculation starts with gross receipts or sales (line 1). Returns and allowances (line 2) and cost of goods sold (line 4) are subtracted to arrive at the gross profit from the activity. Other related income from the business (line 6) is added to the gross profit to produce the Schedule C gross income (line 7).

type of business activity. For example, a fullservice restaurant is code 722511, as shown in Figure 3.1.

3-1e Schedule C Expenses (Part II) The taxpayer reports the expenses from his or her business or profession in Part II of Schedule C (Figure 3.3). Expenses such as advertising, insurance, interest, rent, travel, wages, and utilities are reported on lines 8 through 27. Some expenses such as depreciation may require additional supporting information from another schedule. The expenses are totaled on line 28 and subtracted from gross income (line 7) to arrive at the tentative profit from the activity (line 29). An expense for business use of a taxpayer’s home (see LO 3.11) is computed on Form 8829 or using the simplified method. The deductible portion of home office expenses is entered on line 30 and subtracted from tentative profit, resulting in the net profit or loss (line 31) from the activity. Common business expenses are covered in detail later in this chapter.

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3-53-1 Schedule C

FIGURE 3.3 SChEduLE C EXPENSES (PART II)

3-1f Schedule C Cost of Goods Sold (Part III) The calculation of cost of goods sold is reported in Part III (Figure 3.4) of Schedule C. In Part III lines 33 and 34, taxpayers must answer questions about the methods used to cal culate inventory. Cost of goods sold (line 42) is equal to the beginning inventory (line 35) plus purchases (line 36), labor (line 37), materials and supplies (line 38), and other costs (line 39) less ending inventory (line 41). Please see LO 3.2 for a more detailed discussion of inventories.

3-1g Schedule C Vehicle Information (Part IV) If a taxpayer uses a car or truck in his or her sole proprietorship, then Part IV of Sched ule C (Figure 3.5) must be completed to provide the IRS with supplemental vehicle infor mation. In Part IV, a taxpayer should provide the date the vehicle was placed in service for business use, (line 43), the business miles driven (line 44a), the commuting miles driven (line 44b), and other miles driven (line 44c). On lines 45 to 47 of Part IV, taxpayers must answer questions relevant to obtaining a deduction for business use of a vehicle.

3-1h Schedule C Other Expenses (Part V) The expenses section of Schedule C (Part II), line 27 contains an entry for other miscella neous expenses. These other expenses must be itemized in Part V of Schedule C and include deductible items which do not have specific lines already assigned in the expenses section (Part II). Expenses for business gifts, education, professional dues, and consulting fees are commonly listed.

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FIGURE 3.5 VEhICLE INFORMATION (PART IV)

3-1i Self-Employment Tax Selfemployed taxpayers, sole proprietors, and independent contractors with net earnings of $400 or more, many of whom report income on Schedule C, must pay a selfemployment tax calculated on Schedule SE with their Form 1040. For new business owners, the self employment tax may come as a particularly unpleasant and costly surprise if they are not aware of its existence.

The selfemployment tax is made up of two taxes, the Social Security tax, which is meant to fund old age and disability insurance payments, and the Medicare tax. For 2019, the Social Security tax rate of 12.4 percent applies to the first $132,900 of net selfemployment

FIGURE 3.4 COST OF GOOdS SOLd (PART III)

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3-73-2 Inventories

To report profits from a sole proprietorship in ProConnect, Under Income use Business Income (Schedule C) to enter information. Additional businesses can be added using the [1] tab at the top of the main window. tIp

income, while the Medicare tax rate of 2.9 percent applies to all net selfemployment income, with no ceiling. Half of the selfemployment tax is allowed as a deduction on Line 14 of Schedule 1 of Form 1040 in arriving at adjusted gross income. A similar tax is levied on employees partly through payroll withholding and partly through employer contributions, so it is not actually paid with Form 1040 as it is for selfemployed taxpayers. Selfemployed Social Security and Medicare taxes, including the 0.9 percent additional Medicare tax, are covered in detail in Chapter 6.

Self-Study Problem 3.1 See Appendix E for Solutions to Self-Study Problems

Teri Kataoka is self-employed as a professional golf instructor. She uses the cash method of accounting and her Social Security number is 466-47-8833. Her principal business code is 812990. Teri’s business is located at 1234 Pinecrest Dr., Kennesaw, GA 30152. During 2019, Teri had the following income and expenses:

Fees from golf lessons $40,125 Expenses: Car mileage (5,234 business miles) 3,036 Business liability insurance 475 Office expense 660 Rent on office space 2,700 City business license 250 Travel expense 3,000 Meals (deductible portion) 985 Utilities 1,015

Teri bought her car on January 1, 2019. In addition to the business miles listed above, she commuted 1,200 miles and she drove 5,000 miles for nonbusiness purposes.

Complete Schedule C on Pages 3-8 and 3-9 for Teri showing her net income from self-employment. Make realistic assumptions about any missing data.

3-2 INVENTORIES Inventory is the stock of goods or materials that a business holds for the purpose of resale to generate a profit. The cost of inventory a taxpayer owns has a significant impact on the taxable income of the taxpayer. The deduction for the cost of goods sold of a retail business is a direct function of the amount of the beginning and ending inventories. Cost of goods sold, which is the larg est single deduction for many businesses, is calculated as follows:

Beginning inventory $ 75,000 Add: purchases 250,000 Costs of goods available for sale 325,000 Less: ending inventory (100,000) Cost of goods sold $ 225,000

3.2 Learning Objective Describe the tax treatment of inventories and cost of goods sold.

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3-8 Chapter 3 ● Business Income and Expenses

Self-Study Problem 3.1

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3-93-2 Inventories

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Valuation of inventories used in calculating the cost of goods sold is necessary to clearly reflect the income of the taxpayer.

To calculate cost of goods sold, the taxpayer must value the beginning and ending inventories of the business. He or she must determine the cost of the items on hand. This process is not as easy as it seems, since the taxpayer will often have paid different prices during the year for the same item. There are two common methods of inventory valuation used by taxpayers: first in, first out (FIFO) and last in, first out (LIFO). The FIFO method is based on the assumption that the first merchandise acquired is the first to be sold. Accordingly, the inventory on hand consists of the most recently acquired goods. Alterna tively, when the taxpayer uses the LIFO method, it is assumed that the most recently acquired goods are sold first and the inventory on hand consists of the earliest purchases. FIFO and LIFO are simply calculation assumptions; the goods that are actually on hand do not have to correspond to the assumptions of the method selected. In addition to the LIFO and FIFO methods which are commonly used by taxpayers in valuing beginning and ending inventories, taxpayers may specifically identify the goods that are sold and the goods that are in ending inventory. However, the process of specifically identifying items sold and on hand is not a practical alternative for most taxpayers.

EXAMPLE Paige made the following purchases of a particular inventory item during the current year:

March 1 50 units at $120 per unit $ 6,000 August 1 40 units at $130 per unit 5,200 December 1 25 units at $140 per unit 3,500 Total $14,700

If the ending inventory is 60 units, it is valued under the FIFO method as illustrated below:

25 units at $140 each $3,500 35 units at $130 each 4,550 Ending inventory $8,050

Assuming that Paige had no beginning inventory of the item, the same ending inventory (60 units) would be valued using the LIFO method as follows:

50 units at $120 each $6,000 10 units at $130 each 1,300 Ending inventory $7,300

The cost of goods sold for both the FIFO and LIFO methods are presented below:

FIFO LIFO Beginning inventory $ 0 $ 0 Add: purchases 14,700 14,700 Cost of goods available for sale $14,700 $14,700 Less: ending inventory (8,050) (7,300) Cost of goods sold $ 6,650 $ 7,400

Notice that taxable income will be $750 more when the FIFO method is used instead of the LIFO method. During periods of rising inventory prices, taxpayers have lower taxable income and pay less tax if they use the LIFO inventory valuation method. ♦

A taxpayer may adopt the LIFO method by using it in a tax return and attaching Form 970 to make the election. Once the election is made, the method may be changed only with the consent of the IRS. Also, if the LIFO election is made for reporting taxable income, taxpayers must use the same method for preparing their financial statements. In other words, a taxpayer may not use LIFO for his or her tax return and use FIFO for financial statements presented to a bank. This rule is strictly enforced by the IRS.

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Generally, if a taxpayer produces, purchases, or sells merchandise as part of the business, inventory must be kept and the accrual method for purchases and sales of merchandise must be used. However, taxpayers with gross receipts of less than $25 million (calculated over 3 years) are not required to keep inventory on the accrual method. In addition, a “safeharbor” is provided if the business either treats inventory as nonincidental materials and supplies or treats inventory the same as on the business’ financial statements or books and records. The tax accounting rules for nonincidental materials and supplies permit a taxpayer to deduct the cost of such supplies in the tax year in which the supplies are first used or paid for, whichever is later.

Additionally, prior tax law required the capitalization of certain indirect costs into inventory under Section 263A, sometimes known as the UNICAP rules. Businesses with gross receipts of no more than $25 million are not required to apply the UNICAP rules. The details of the UNICAP rules are beyond the scope of this textbook.

Self-Study Problem 3.2 See Appendix E for Solutions to Self-Study Problems

Kelly owns a small retail store. During the year, Kelly purchases $180,000 worth of inventory. Her beginning inventory is $62,500 and her ending inventory is $68,400. Also, she withdrew $1,250 in inventory for her personal use during the year. Use Part III of Schedule C below to calculate Kelly’s cost of goods sold for the year.

3-3 TRANSPORTATION Certain transportation expenses for business purposes are deductible by taxpayers. Deducti ble expenses include travel by airplane, rail, and bus, and the cost of operating and main taining an automobile. Meals and lodging are not included in the transportation expense deduction; those expenses may be deducted as travel expenses (see LO 3.4). Transportation expenses may be deducted even if the taxpayer is not away from his or her tax home.

Deductible transportation costs do not include the normal costs of commuting. Commuting includes the expenses of buses, subways, taxis, and operating a private car between home and the taxpayer’s principal place of work, and is generally a nondeductible personal expense. The cost of transporta tion between the taxpayer’s home and a work

3.3 Learning Objective Identify the requirements for deducting transportation expenses.

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location is generally not deductible, except in the three sets of circumstances described below:

1. A taxpayer is allowed to deduct daily transportation expenses incurred in going be tween the taxpayer’s residence and work locations outside the metropolitan area where the taxpayer lives and normally works.

2. If the taxpayer has a regular place of business, daily expenses for transportation be tween the taxpayer’s home and temporary work locations are deductible.

3. A taxpayer may deduct daily expenses for transportation between the taxpayer’s home and other regular or temporary work locations if the taxpayer’s residence is the tax payer’s principal place of business, based on the home office rules, which are dis cussed later in this chapter.

In all cases, the additional costs of hauling tools and instruments are deductible. For example, the cost of renting a trailer to haul tools to a job site is deductible.

If the taxpayer works at two or more jobs during the same day, he or she may deduct the cost of going from one job to the other or from one business location to another. The deductible expense is based on the cost of travel by the shortest, most nor mally traveled route, even if the taxpayer uses another route. If the taxpayer works at a second job on a day that he or she does not work at the first job, the commuting expenses to the second job are not deductible.

EXAMPLE Walter is a self-employed CPA working full-time Monday through Friday. On Tuesday night he teaches an accounting class at a local university. Walter leaves the office at 5:30 p.m. on his class day and, after dinner at a local cafe, teaches his class from 7:00 p.m. to 10:00 p.m. The distance from Walter’s home to his office is 12 miles, the distance from his office to the university is 15 miles, and the distance from the university to his home is 18 miles. If Walter teaches the class thirty-two times a year, his mileage deduction is based on 480 miles (32 3 15 miles). While he is traveling from home to the office (12 miles) and from the university to home (18 miles), he is commuting and the mileage is not deductible. If Walter taught the class in the afternoon and returned to his regular job before going home, he could claim a deduction based on the round-trip mileage from his office to and from the university, 30 miles (2 3 15 miles). Alternatively, if he taught the course on a day (Saturday) when he did not work at his full-time job, Walter would not be entitled to any mileage deduction. ♦

Taxpayers may deduct the actual expenses of transportation, or they may be entitled to use a standard mileage rate to calculate their deduction for transportation costs. The stand ard mileage rate for 2019 is 58 cents per mile. Most costs associated with the operation of an automobile, such as gasoline, oil, insurance, repairs, and maintenance, as well as depreci ation, are built into the standard mileage rate. The deduction for parking and toll fees related to business transportation (not commuting) and the deduction for interest on car loans and state and local personal property taxes on the automobile are determined sepa rately. Selfemployed taxpayers deduct the business portion of the state and local personal property taxes and interest on automobile loans on Schedule C or F. To use the standard mileage method, the taxpayer must:

1. own or lease the automobile, 2. not operate a fleet of automobiles, using five or more at the same time, 3. not have claimed depreciation on the automobile using any method other than

straightline depreciation, and 4. not have claimed Section 179 (expense election) depreciation or bonus depreciation on

the automobile (see Chapter 8 for a complete discussion of depreciation).

If the taxpayer is entitled to use either the actual cost or the standard mileage method, he or she may select the method that results in the largest tax deduction for the first year. If

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the taxpayer does not use the standard mileage method in the first year, the method is not available for any subsequent year. A change to the actual cost method can be made any year. If, after using the standard mileage method, the taxpayer uses actual costs to determine the automobile expense deduction, depreciation on the automobile must be calculated using straightline depreciation (see Chapter 8). The standard mileage method may be used for a car for hire, such as a taxi, if the automobile meets the other requirements for use of this method.

Taxpayers who use the actual cost method to calculate their transportation deductions must keep adequate cost records. The deductible portion of the total automobile expenses is based on the ratio of the number of business miles driven during the year to the total miles driven during the tax year multiplied by the total automobile expenses for the year. The businessuse percentage is applied to the total automobile expenses for the year, including depreciation, but excluding any expenses which are directly attributable to business use of the automobile, such as business parking fees and tolls. The deduction for interest and personal property taxes is also separately computed.

EXAMPLE T.J. is a new salesman who drove his automobile 22,500 total miles during the 2019 tax year. The business use of the automobile was 80 percent of the total miles driven. The actual cost of gasoline, oil, repairs, depreciation, and insurance for the year was $10,000. The automobile expense deduction is calculated as follows:

1. Standard mileage method: Business mileage 5 18,000 miles (22,500 miles 3 80%) 18,000 miles 3 58 cents/mile $10,440

2. Actual cost method: 80% 3 $10,000 (total actual cost) $8,000

Since the deduction is larger using the standard mileage method, T.J. should deduct that amount. ♦

Self-Study Problem 3.3 See Appendix E for Solutions to Self-Study Problems

Marc Lusebrink, sole proprietor of Oak Company, bought a used automobile and drove it 13,120 miles for business during 2019 and a total (including business miles) of 16,000 miles. His total expenses for his automobile for the year are:

Gasoline $2,061 Oil changes 92 Insurance 1,030 Tires 225 Repairs 620 Total $4,028

The automobile cost $20,000 on January 1, and depreciation expense for the year, including business use, was $4,000. His business parking and toll fees for business amount to $327. Calculate Marc’s transportation expense deduction for the year.

Vehicle expenses are reported on Form 2106 and are carried over to Schedule C or other forms. To enter deductions associated with a business vehicle, go to Vehicle/Employee Business Expense (2106) under the general Deductions item in the left margin. The deduction can be connected to the appropriate Schedule C or other business using a dropdown box.

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3-4 TRAVEL EXPENSES Travel expenses are defined as ordinary and necessary expenses incurred in traveling away from home in pursuit of the taxpayer’s trade or business. These expenses are deductible as long as they can be substantiated and are not lavish or extravagant. Transportation expenses incurred while not away from home such as business gifts are not included as travel ex penses, although these items may be separately deductible, subject to cer tain limitations. Expenses included as part of the travel deduction include the cost of such items as meals, lodging, taxis, tips, and laundry. Most travel expenses are fully deductible, but Congress de cided that a portion of the cost of meals is a personal expense. Therefore, only 50 percent of the cost of meals is deductible. If an employer reimburses an employee for the cost of meals, then the 50 percent limitation applies to the employer so that the employer can deduct only 50 percent of the expense.

To deduct travel expenses, a taxpayer must be away from home “overnight.” Overnight does not literally mean 24 hours; it is a period of time longer than an ordinary work day in which rest or relief from work is required. Also, the taxpayer must be away from his or her “tax home” to be on travel status. A tax home is the taxpayer’s principal place of business or employment, and not necessarily the same location as his or her family residence. If the taxpayer has two or more places of business, the taxpayer’s tax home is at the principal place of business. Factors that determine the principal place of business include total time spent in each location, the degree of business activity, and the relative amount of income from each location.

Expenses of a temporary assignment are deductible if it is not practical to return home at the end of each day’s work or if the employer requires the employee’s attendance at a business meeting, training activity, or other overnight business function. If the assignment is for a long period of time or indefinite (generally more than 1 year), the new location may be considered the taxpayer’s new tax home and he or she may lose the travel deduction. If the travel deduction is lost, an employee must include as income any reimbursements of travel expenses.

Taxpayers who make a combined business and pleasure trip within the United States may deduct all of the costs incurred in traveling to and from the business destination (for example, airfare) pro vided the trip is primarily for business. Once at the destination, only the business portion of the travel costs for meals, lodging, local transportation, and incidental expenses may be deducted; any costs which are not associated with the taxpayer’s business are not deductible. If a taxpayer makes a trip which is primarily for pleasure, the travel expenses to and from the destination are not deductible even though the taxpayer engages in some business activity while at the destination. Although the traveling expenses to and from the destination are not deductible, any expenses incurred while at the destination that are related to the taxpayer’s business are deductible.

Special rules and limitations apply to combined business and pleasure travel outside the United States. Even though a trip is primarily for business, if the trip has any element of pleasure, the cost of traveling to and from the destination must be allocated between the business and personal portions of the trip. The travel expenses for transportation to and from the destination must be allocated based on the number of business days compared to the total number of days outside the United States. The rules for travel costs to and from the destination where the trip is primarily for pleasure are the same as the rules for travel within the United States; none of the travel costs are deductible. Once at the destination, the taxpayer’s expenses directly related to the taxpayer’s business are deductible. For a com plete explanation of travel outside the United States, see IRS Publication 463.

No deduction for travel expenses is allowed unless the taxpayer keeps proper expense records. Taxpayers must substantiate the following:

1. The amount of each separate expenditure, such as airfare and lodging. Expenses such as meals and taxi fares may be accumulated and reported in reasonable categories. As an alternative to reporting actual expenses, a per diem method may be used in certain circumstances.

Learning Objective 3.4 Identify the requirements for deducting travel expenses.

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2. The dates of departure and return for each trip and the number of business days on the trip.

3. The destination or locality of the travel described by the name of the city or town. 4. The business reason for the travel or the business benefit expected to be gained

from the travel.

EXAMPLE During 2019, Susan travels from Los Angeles to Hawaii for a 3-day business trip and pays $450 for the airfare. While in Hawaii, Susan spends 3 days on business and an additional 2 days on vacation. The lodging and meal costs are $300 and $120, respectively, for the business portion of the trip. The total cost of meals and lodging for the personal portion of the trip is $260. Susan may deduct $450 for the airfare, $300 for the business lodging, and $60 (50 percent of $120) for the business meals. None of the $260 of personal expenses is deductible. ♦

3-4a Per diem Substantiation Instead of requiring actual expense records, employers who reimburse employees for travel expenses can choose a per diem method of substantiation. The primary advantage of using a per diem method to substantiate expenses is that it eliminates much of the record keep ing usually associated with travel expenses. The IRS has approved two per diem methods to substantiate travel expenses: (1) the standard per diem method and (2) the highlow per diem method. Employers can use per diem for all travel expenses including lodging, meals, and incidentals or an employer can use per diem for only meals and incidentals. Selfemployed taxpayers may only use per diem for meals and incidentals.

1. The Standard Federal Rate Method. Under this method, the employee is allowed a per diem amount for travel equal to the current federal per diem rate which varies based on the travel location. A complete list of the regular per diem rates in effect for each area of the United States is available at the U.S. General Services Administration website (www.gsa.gov). The GSA also offers a downloadable app.

2. The High-Low Method. The highlow method provides a simplified way of computing the federal per diem rate for travel within the United States. This method avoids the need to keep a current list of the per diem rates for all localities in the United States. Under this method a small number of locations are designated as highcost localities and all other locations are deemed to be lowcost areas. In 2019, the highcost allow ance is $287 per day and the lowcost amount is $195 per day. If an employer uses this method to reimburse an employee any time during a calen dar year, this method must be used for all travel for that employee in the same calendar year.

Under either the standard method or the highlow method, the employee can use a current per diem amount for M&IE only. Actual cost records are required for lodging expenses. The M&IE rate may be taken from the standard per diem rate tables or the high low method may be used. For 2019, the M&IE allowance using the highlow method is $71 per day for highcost localities and $60 per day for lowcost localities. Employees and selfemployed taxpayers who do not incur meal expenses when traveling are allowed an incidental expense allowance of $5 per day.

Per diem rates are revised on October 1 every year with additional revisions made for specific locations throughout the year. For purposes of illustration and problems, the rates above are assumed to be chosen for the full year. Different rates than those shown above may apply.

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Self-Study Problem 3.4 See Appendix E for Solutions to Self-Study Problems

Byron is a certified public accountant who is self-employed. He is required to make a 5-day business trip to Salt Lake City for an audit. Since he is going to be in Utah, Byron decides to stay for the weekend and go skiing. His expenses for the trip are as follows:

Airfare to Salt Lake City and return $ 480 Hotel while on the audit (5 nights at $165 per night) 825 Deductible portion of meals while on the audit 168 Laundry in Salt Lake City 22 Taxi fares in Salt Lake City 72 Transportation from Salt Lake City to and from Park City ski resort 100 Lodging at Park City ski resort 380 Lift tickets 99 Ski rental 89 Meals at Park City 182 Total $2,417

If Byron has proper records to substantiate the above expenses, how much may he deduct as travel expenses for the 7-day trip?

3-5 MEALS ANd ENTERTAINMENT Starting in 2018, there is no deduction for (1) an activity generally considered to be en tertainment, amusement, or recreation, (2) membership dues for any club organized for business, pleasure, recreation, or other social purposes, or (3) a facility used in connection with any of the above items. Entertainment costs related to a recreation, social, or similar activities for the benefit of employees remain deductible.

EXAMPLE Dee Skotech operates a small business and hosted two parties at a local night club during 2019. The first was a party for all of her clients to celebrate a great year and to thank them for their loyalty. The second party was a holiday celebration for all the employees in Dee’s company. The costs associated with the client party are nondeductible entertainment costs. The costs for the employee holiday party are 100 percent deductible. ♦

Because meals and entertainment are often closely aligned, taxpayers should be cautious in attempting to deduct meals associated with an entertainment event. Client meals in which business is conducted (and the taxpayer or taxpayer’s employee is present) and which are not lavish or extravagant remain 50 percent deductible. An entertainmentrelated meal such as one associated with a cocktail party, theatre, golf outing, or other entertainment event is only deductible if the meal is purchased separately.

EXAMPLE Beau Gee is a salesperson for Hamilton Company. Beau has a meeting with an important customer at a local diner. Business is conducted at the meal as Beau and the customer discuss pricing, delivery dates, and other particulars, although no sale is actually closed. After the meal, Beau suggests they play a round of golf at the local golf course. After playing a round of golf, Beau and the customer stop in the golf club’s “19th hole” and

Learning Objective 3.5 Determine the requirements for deducting meals.

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have a drink or two and some appetizers. Because business was conducted at the diner, the cost of the first meal is 50 percent deductible; however, the golf is entertainment and is not deductible. If the drinks and appetizers are separately purchased, the cost is 50 percent deductible. ♦

In addition to celebratory meals such as holiday parties and company picnics, other meals remain either 50 or 100 percent deductible:

Type of meal Deductible

Meals for the convenience of the employer

50 percent (see Chapter 2) until after 2025 and then not deductible

Water, coffee, and other office snacks

50 percent deductible

Meals provided for inoffice meetings with employees

50 percent deductible

Meals during business travel 50 percent deductible Meals offered for free to the public (e.g., a free seminar)

100 percent deductible

Although entertainmentrelated club dues are nondeductible, dues paid to professional organizations, such as bar or medical organizations, are deductible. Dues paid to civic or public organizations, such as Chambers of Commerce, Kiwanis, and Rotary, are also al lowed as legitimate business deductions. These clubs do public service work and are not organizations like country clubs which are entertainment or pleasure driven. Many business people belong to clubs such as Kiwanis or Rotary to network, meet potential clients, and increase their visibility in the community, but the club must do significant service work for the members’ dues to qualify as deductions.

Self-Study Problem 3.5 See Appendix E for Solutions to Self-Study Problems

Milly operates a small business and incurs the following expenses:

Annual dues Tampa Bay Golf Club $2,000 Meals with clients after golf 500 Meals with clients at the Club’s dining

room where business was conducted 600 Greens fees (personal and with clients) 700 Meals (personal) 250 Total $4,050

Calculate the portion of the $4,050 that Milly can deduct. $

3-6 EduCATIONAL EXPENSES Please note: Educational incentives such as qualified tuition programs and educa- tional savings accounts are discussed in LO 2.14. The deduction for education loan interest is discussed in LO 5.7. Education tax credits are discussed in LO 7.5. Because there are numerous education incentives, the tax law in this area has become very complex. There may be more than one tax option for treating a particular education

3.6 Learning Objective Identify the requirements for claiming business education expenses.

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expense. This section deals primarily with the deduction of continuing education expenses incurred by self-employed taxpayers. The suspension of the deduction for miscellaneous expenses subject to 2 percent of AGI has effectively eliminated the deduction of unreimbursed educational costs for employees.

There are two tests related to the deduction of edu cational expenses, at least one of which must be met to deduct the expenses. The tests are:

1. the educational expenses must be paid to meet the requirements of the taxpayer’s employer or the requirements of law or regulation for keeping the taxpayer’s salary, status, or job, or

2. the educational expenses must be paid to maintain or improve existing skills required in performing the duties of the taxpayer’s present work.

Educational expenses meeting one of the above tests, which have a bona fide business purpose, may be deducted even if the education leads to a college degree.

Educational expenses are not deductible, even if one of the above tests is met, if (1) the education is required to meet the minimum requirements for the taxpayer’s current job, or (2) the education is part of a program that will lead to a new trade or business even if the taxpayer does not intend to enter that new trade or business.

3-6a Education Required by Employer or Law Taxpayers who are required to meet educational standards beyond minimum requirements may deduct the expenses of the education. However, the expenses must be paid for educa tion to maintain the taxpayer’s current job, not to meet the minimum requirements for that job. If the education qualifies the taxpayer for a new trade or business, the expenses are not deductible.

EXAMPLE Jenny is a high school teacher working under a temporary teaching certificate. The state in which she teaches requires a master’s degree to receive a permanent certificate, and Jenny only has a bachelor’s degree. Her expenses to obtain a master’s degree are not deductible even though the degree is required by her school district, since she has not yet met the minimum educational requirements to be a permanent teacher.

However, Jenny may qualify for the lifetime learning credit discussed in LO 7.5. ♦

3-6b Maintaining or Improving Existing Skills Expenses that are paid by a taxpayer for education to maintain or improve existing skills are deductible. Expenses deductible under this category include the costs of continuing educa tion courses and academic work at a college or university. However, the education must not lead to qualification in a new trade or business. The deduction of a review course for the CPA exam and bar exam is consistently disallowed by the IRS.

EXAMPLE John is a certified public accountant (CPA) in practice with a CPA firm. He decides a law degree would be helpful to him in his present job since he does a lot of income tax planning for clients. He enrolls in a night program at a local law school. John’s educational expenses are not deductible since the program leads to a new trade or business, the practice of law. Whether or not John plans to practice law is not relevant. However, John may qualify for the lifetime learning credit discussed in LO 7.5. ♦

EXAMPLE Kenzie recently completed her degree in accounting and went to work for a local CPA firm. She spends $1,000 for a CPA exam review course to help her pass the exam. The $1,000 is not deductible since passing the CPA exam leads to a new trade or business, that of being a licensed CPA as

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opposed to an accountant. Depending on whether Kenzie takes this course at a qualified institution of higher education, and other circumstances, she may qualify for the lifetime learning credit discussed in LO 7.5. ♦

3-6c Expenses of Travel for Educational Purposes Travel expenses incurred while away from home for trips that are primarily to obtain quali fying education are also deductible. For example, a taxpayer may deduct travel expenses for attending a continuing education course in a distant city. Whether a trip is primarily personal or primarily educational depends on the relative amount of time devoted to each activity. If the trip qualifies as primarily for educational purposes, the cost of transportation to and from the destination is fully deductible. The lodging and meal expenses directly con nected with the educational activity are also deductible. As is the case with travel expenses, the cost of meals is only 50 percent deductible. Expenses for “travel as a form of education” are not deductible.

EXAMPLE Jay is a doctor who attended a continuing education seminar in New York. His expenses related to attendance at the program are as follows:

Lodging in New York $ 350 Transportation 700 Meals 150 Fee for the course 250 Total $1,450

Jay’s educational expense deduction for the seminar would be $1,375 including lodging of $350, transportation of $700, meals of $75 (50 percent of the cost of the meals), and the course fee of $250. ♦

EXAMPLE Natalie is an instructor of Japanese at Big State University. She spends the summer traveling in Japan to improve her understanding of the Japanese language and culture. Although Natalie arranges her trip to improve her ability to teach the Japanese language, no education deduction is allowed for the travel expenses. ♦

Self-Study Problem 3.6 See Appendix E for Solutions to Self-Study Problems

Nadine is a self-employed attorney. Her expenses for continuing legal education are as follows:

Lodging in Tempe, Arizona $1,200 Transportation 350 Meals 200 Books 175 Tuition 550 Weekend trip to the Grand Canyon 175 Total $2,650

Calculate Nadine’s educational expense deduction for the current year. Assume Nadine’s household income is too high for her to qualify for the lifetime learning credit discussed in LO 7.5.

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3-20 Chapter 3 ● Business Income and Expenses

Self-Study Problem 3.7 See Appendix E for Solutions to Self-Study Problems

Indicate which of the following dues, subscriptions, and publications are deductible (D) and which are not deductible (ND) by circling the correct answer.

1. Dues to the American Medical Association paid by a self-employed D ND physician.

2. A subscription to a tax journal paid for by an accounting professor. D ND 3. Dues to a health spa paid by a lawyer. D ND 4. Union dues paid by a carpenter that works for a large construction D ND

company. 5. Subscription to Motor Trend magazine paid for by a registered D ND

nurse.

3-7 duES, SuBSCRIPTIONS, ANd PuBLICATIONS Doctors, lawyers, accountants, engineers, teachers, and other professionals who are self employed or are employers may deduct certain dues and the cost of certain subscriptions and publications. Included in this category of deductions are items such as membership to the local bar for a lawyer, dues to the American Institute of Certified Public Accountants (AICPA) for an accountant, and the cost of subscriptions to any journal that is directly related to the taxpayer’s profession. Due to the suspension of miscellaneous deductions subject to 2 percent of AGI through 2025, only selfemployed taxpayers can deduct dues and subscriptions. Employees can no longer deduct these costs; however, if the dues or subscription costs are reimbursed by the employer, the employer can deduct those costs.

EXAMPLE Hal is a federal law enforcement officer who pays $200 per year for a sub- scription to the official agency work manual. The agency provides a manual in the office for its employees, but Hal spends a lot of time on the road away from the office. As an employee, Hal may not deduct the cost of the subscription. If Hal were self-employed, the cost would be deductible. ♦

Learning Objective 3.7 Identify the tax treatment of dues and subscriptions.

3-8 SPECIAL CLOThING ANd uNIFORMS Selfemployed individuals are allowed a deduction for the costs of special work clothing or uniforms. The deduction is not allowed for the general cost and upkeep of normal work clothes; the clothing must be specialized. To be deductible, the clothing or uniforms must (1) be required as a condition of employment, and (2) not be suitable for everyday use. Both conditions must be met for the deduction to be allowed. It is not enough that the taxpayer is required to wear special clothing if the clothing can be worn while the taxpayer is not on the job. The costs of protective clothing, such as safety shoes, hard hats, and rubber boots, required for the job are also deductible. If the clothing or uniforms qualify, the costs of pur chase, alterations, laundry, and their maintenance are deductible. Any uniforms purchased by an employer for its employees are deductible by the employer.

The suspension of miscellaneous deductions subject to 2 percent of AGI has severely limited the deduction of uniforms and related costs by employees. In the past, uniforms worn by police officers, firefighters, nurses, and letter carriers would have qualified as an unreimbursed employee business expense. Because of the suspension of these miscellaneous deductions, taxpayers that serve in these roles as an employee are no longer permitted to

Learning Objective 3.8 Determine which clothing and uniforms may be treated as tax deductions.

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3-213-9 Business Gifts

deduct uniform costs. To the extent they serve as an independent contractor or are self employed, qualifying uniform costs may be deducted. Similar to dues and subscriptions, if the employer reimburses the employee for qualifying uniform costs, the employer may deduct the costs. Selfemployed taxpayers deduct special clothing and uniforms on Schedule C.

Self-Study Problem 3.8 See Appendix E for Solutions to Self-Study Problems

Steve has his own business as an installer for the light company, and he wears regular work clothes that cost $400 during the year. Also, Steve must wear safety shoes and an orange neon vest on the job that cost $650 this year, and he purchased pole-climbing equipment, spikes, and a safety belt that cost $275. What is Steve’s deduction on Schedule C for these items.

In his book, Bjorn Ulvaeus, one of the founders of 1970s megahit band Abba, states that the costumes that the band wore were intended to be so outrageous that they could not be considered suitable for general attire and thus garner a Swedish tax deduction (the tax laws are very similar to those in the U.S. on uniforms). Lady Gaga’s “meat dress” worn at the 2010 Video Music Awards was likely to qualify for a deduction as well.

Would You

Believe?

3-9 BuSINESS GIFTS Within limits, taxpayers are allowed a deduction for business gifts. Salespersons and other taxpayers may deduct up to $25 per year per donee. For purposes of this limitation, a hus band and wife count as one donee. Thus, the maximum that a taxpayer could deduct for gifts to a client or potential client and his or her spouse is a total of $25 per year, unless the spouse is also a client, in which case the spouse may receive a separate $25 gift. Incidental expenses such as gift wrapping and shipping may be excluded from the limitation and are fully deductible.

There is no limitation for small business gifts costing up to $4 each that have the taxpayer’s name or company name imprinted on them, such as pencils and calendars, and no limitation on promotional materials, such as signs and display racks. Also, the cost of gifts of tangible personal property made to employees for length of service on the job and safety achievement may be deducted up to a limit of $400 per employee per year. If the gift is made in conjunction with a “qualified plan,” the limit is raised to $1,600. Gifts made to a taxpayer’s supervisor (or individuals at a higher employment level) are not deductible. Those gifts are considered nondeductible personal expenses.

EXAMPLE Marc is a salesperson who gives gifts to his clients. During the year, Marc gives Mr. Alford a gift costing $20 and Mrs. Alford (not a client) a gift costing $15. He also gives Ms. Bland a gift that cost $24 plus $2 for wrapping. Marc may deduct a total of $25 for the two gifts to Mr. and Mrs. Alford, and $26 for the gift to Ms. Bland. The $2 gift-wrapping charge is not included as part of the $25 limitation on the gift to Ms. Bland. ♦

3.9 Learning Objective Explain the special limits for business gift deductions.

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3-22 Chapter 3 ● Business Income and Expenses

3-9a Substantiation Requirement To deduct meals and business gifts, taxpayers must be able to substantiate the deduction. The four items that must be substantiated to deduct meals expenses and gifts are the:

1. Amount of the expense, 2. Date and description, 3. Business purpose, and 4. Business relationship.

If any of the above information is not available, the IRS will disallow the deduction for meals expenses or gifts.

Self-Study Problem 3.9 See Appendix E for Solutions to Self-Study Problems

Carol makes the following business gifts during the tax year:

Donee Amount Deduction

1. Mr. Jones (a client) $ 20 $ 2. Mr. Brown (a client) 32 3. Mrs. Green (a client) 15 4. Mr. Green (the nonclient husband of Mrs. Green) 18 5. Ms. Gray (Carol’s supervisor) 45 6. Mr. Edwards (a client receiving a display rack 75

with Carol’s company name on it) 7. Various customers (receiving ball point pens with 140

the company name on them) Total business gift deduction $

Calculate Carol’s allowed deduction for each business gift and her total allowed deduction.

3-10 BAd dEBTS When a taxpayer sells goods or services on credit and the accounts receivable subsequently become worthless (uncollectible), a bad debt deduction is allowed to the extent that income arising from the sales was previously included in income. Taxpayers must use the specific chargeoff method and are allowed deductions for bad debts only after the debts are deter mined to be partially or completely worthless.

A taxpayer who uses the specific chargeoff method must be able to satisfy the IRS requirement that the debt is worthless and demonstrate the amount of the worthlessness. For a totally worthless account, a deduction is allowed for the entire amount of the taxpayer’s basis in the account in the year the debt becomes worthless. The taxpayer’s basis in the debt is the amount of income recognized from the recording of the debt, or the amount paid for the debt if it was purchased.

Learning Objective 3.10 Explain the tax treatment of bad debt deductions.

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3-233-10 Bad Debts

EXAMPLE Todd owns a small retail store. During the current tax year, Todd has $8,500 worth of uncollectible accounts receivable. Assuming he reported $7,800 in sales income from the accounts, that amount is his basis in the accounts receivable. Therefore, Todd’s deduction for bad debts is limited to $7,800 for the year. ♦

Business and Nonbusiness Bad debts Bad debts fall into two categories, business bad debts and nonbusiness bad debts. Debts that arise from the taxpayer’s trade or business are classified as business bad debts, while all other debts are considered nonbusiness bad debts. The distinction between the two types of debts is important, since business bad debts are ordinary deductions and non business bad debts are shortterm capital losses. Shortterm and longterm capital gains may be offset by shortterm capital losses. If there are net capital losses, only $3,000 of net capital losses may be deducted against ordinary income in any one tax year. Unused shortterm capital losses are carried forward and may be deductible in future years, sub ject to the $3,000 annual limitation. The treatment of capital gains and losses is discussed in Chapter 4.

EXAMPLE Robert loaned his friend, Calvin, $5,000 to start a business. In the current year, Calvin went bankrupt and the debt became completely worthless. Since the debt is a nonbusiness debt, Robert may claim only a $3,000 short-term capital loss deduction this year (assuming no other capital transactions). The $2,000 unused deduction may be carried forward to the next year. This is not a business bad-debt deduction, because Robert is not in the business of loaning funds. ♦

Self-Study Problem 3.10 See Appendix E for Solutions to Self-Study Problems

Indicate whether the debt in each of the following cases is a business or nonbusiness debt.

Business Nonbusiness

1. Accounts receivable of a doctor from patients 2. A father loans his son $2,000 to buy a car 3. A corporate president personally loans

another corporation $100,000 4. Loans by a bank to its customers 5. A taxpayer loans her sister $15,000 to start a business

Nonbusiness bad debts are treated as short-term capital losses. To report these items, use the Schedule D/4797/etc., item under Income. Drill down into the Schedule D entry form and select the Nonbusiness Bad Debt button after entering the other relevant information. tIp

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3-24 Chapter 3 ● Business Income and Expenses

Your clients, Tom (age 48) and Teri (age 45) Trendy, have a son, Tim (age 27). Tim lives in Hawaii, where he studies the effects of various sunscreens on his ability to surf. Last year, Tim was out of money and wanted to move back home and live with Tom and Teri. To prevent this, Tom lent Tim $20,000 with the understanding that he would stay in Hawaii and not come home. Tom had Tim sign a formal note, including a stated interest rate and due date. Tom has a substantial portfolio of stocks and bonds and has generated a significant amount of capital gains in the current year. He concluded that Tim is a deadbeat and the $20,000 note is worthless. Consequently, Tom wants to report Tim’s bad debt on his and Teri’s current tax return and net it against his other capital gains and losses. Tom is adamant about this. Would you sign the Paid Preparer’s declaration (see example above) on this return? Why or why not?

Would You Sign This

Tax Return?

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3-11 OFFICE IN ThE hOME Some taxpayers operate a trade or business in their homes and qualify for home office de ductions. The tax law imposes strict limits on the availability of the deduction. In fact, the deduction for an office in the home is allowed by exception. The general rule for a home office deduction states that a taxpayer will not be allowed a deduction for the use of a dwell ing unit used by the taxpayer as a residence. The law provides four exceptions to the general rule under which a deduction may be allowed.

Under the first exception, a deduction is allowed if the home office is used on a regular basis and exclusively as the selfemployed taxpayer’s principal place of business. To meet the exclusive use test, a specific area of the home must be used only for the trade or business. If the area is used for both business and personal purposes, no home office deduction is allowed. With the suspension of miscellaneous deductions subject to 2 percent of AGI, employees may no longer deduct home office expenses.

A second exception states that a deduction is allowed if the home office is used exclu sively and on a regular basis by patients, clients, or customers in meetings or dealings with the tax payer in the normal course of a trade or business. This exception allows doctors and salespeople to deduct home office expenses even though they maintain another office away from their residence, and even though the office is not the selfemployed taxpayer’s principal place of business.

Under the third exception, the deduction of home office expenses is allowed if the home office is a separate structure not attached to the dwelling unit and is used exclusively and on a regular basis in the taxpayer’s trade or business.

The fourth and final exception to the rule allows a deduction of a portion of the cost of a dwelling unit if it is used on a regular basis for the storage of business inventory or prod uct samples held for use in the selfemployed taxpayer’s trade or business of selling products. Under this fourth exception, the taxpayer’s home must be the taxpayer’s sole place of business.

Learning Objective 3.11 Ascertain when a home office deduction may be claimed and how the deduction is computed.

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3-253-11 Office in the Home

3-11a The Income Limitation The home office deduction may not reduce the net income from the business below zero, except for mortgage interest and property taxes allocable to the office, which are generally tax deductible anyway. The other costs of operating a home, which are included in the home office allocation, include rent, home insurance, repairs, cleaning, utilities and other services, homeowners’ association dues, and depreciation on the cost of the home. Depreciation expense is considered only after all other expenses have been allowed. These expenses are typically allocated to the home office on the basis of the square footage of the office to the total square footage of the home. Any unused deductions may be carried over to offset income in future years.

EXAMPLE Jane, an accounting professor, maintains an office in her apartment where she conducts a small tax practice. Jane properly allocates $1,500 in rent to the home office, and during the year she collects $1,400 in fees from various clients. Assuming Jane has no other expenses associated with her practice, only $1,400 of the rent may be claimed as a home office deduction, since she may not show a loss from the practice due to the gross income limitation. The unused portion is carried over to the next taxable year. ♦

EXAMPLE Assume the same facts as those in the previous example, except Jane owns her home. She has real estate taxes of $100, mortgage interest of $600, maintenance expenses of $200, and depreciation of $1,000 attributable to the home office. Her deduction for home office expenses is calculated as follows:

Gross income from tax practice $1,400 Less: mortgage interest and real estate taxes (700) Balance 700 Less: maintenance expense (200) Balance 500 Depreciation (maximum allowed) (500) Net income from tax practice $ 0

Please note that the only way the home office can generate an overall business loss for Jane is if her home office mortgage interest and taxes exceed her gross business income. The unused portion of depreciation is carried over to the next taxable year. ♦

If a home office is used for both business and personal purposes, no deduction is allowed. For example, Professor Jane in the previous example would not be allowed a deduction for any expenses associated with the office in her home if the office was also used for personal activities, such as watching television.

3-11b The home Office Allocation The calculation of home office expenses involves the allocation of the total expenses of a selfemployed taxpayer’s dwelling between business and personal use. This alloca tion is usually made on the basis of the number of square feet of business space as a percentage of the total number of square feet in the residence, or on the basis of the number of rooms devoted to business use as a percentage of the total number of rooms in the dwelling.

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3-26 Chapter 3 ● Business Income and Expenses

EXAMPLE Lois operates a hair-styling salon in her home. The salon occupies 400 square feet of her residence, which has a total of 1,600 square feet. Her expenses for her residence are presented below and allocated as shown.

Expenses Total Amount Business

Percentage* Business Portion

Rent $10,000 25% $2,500

Utilities 4,000 25% 1,000

Cleaning 2,000 25% 500 *400 sq. ft./1,600 sq. ft.

Selfemployed taxpayers filing Schedule C and claiming a deduction for home office expenses are required to file Form 8829, Expenses for Business Use of Your Home.

3-11c Optional Safe harbor Method In an effort to reduce the complexity of the home office deduction, the IRS has introduced a simplified method. Under the simplified method, the selfemployed taxpayer may de duct home office expenses at the applicable rate ($5 in 2019) multiplied by the number of square feet used in the home office, up to a maximum of 300 square feet, thus limiting the home office deduction to $1,500 in 2019. The deduction is still limited to the net profit from the business. Any deduction in excess of the income limit may not be carried forward. The same home office qualifications apply but no allocations are required. A taxpayer that uses the simplified method may deduct mortgage interest and property taxes as itemized deduc tions (see Chapter 5) without having to allocate a portion to the home office.

♦

EXAMPLE Martha operates a business that generates $6,700 of income before the home office deduction. She has a qualifying home office of 350 square feet in her home. She properly allocates $1,200 of household expenses to her home office. Under the safe harbor method, Martha’s home office deduction is $1,500 ($5 per square foot 3 maximum 300 square feet). Martha probably elects the larger safe harbor home office deduction. ♦

The simplified method may hold advantages that extend beyond ease of use. One possible advantage is that no depreciation is deducted from the basis of a taxpayer’s home and thus “depreciation recapture” (see LO 8.8) can be avoided and the exclusion of the gain on the sale of a principal residence (see LO 4.6) can still apply. A second advantage is that the property taxes and interest allocated to the small business can still be deducted on Schedule A as an itemized deduction (Chapter 5).

TAX BREAK

tIp Similar to auto expenses, the home office deduction is not entered into Schedule C directly, but rather under Deductions and then Business Use of the Home. The interaction between the cap on taxes (Chapter 5) and the allocation of property taxes can create complexity in this area for certain taxpayers.

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3-273-12 Hobby Losses

Self-Study Problem 3.11 See Appendix E for Solutions to Self-Study Problems

Terry is a self-employed lawyer who maintains an office in her home. The office is used exclusively for client work, and clients regularly visit her home office. The mortgage interest and real estate taxes allocated to the business use of the home amount to $2,100, and maintenance, utilities, and cleaning service allocable to the business use of the home total $1,400. If gross billings of Terry’s practice are $2,900 for this year and Terry has no other expenses allocable to the business, calculate the net income or loss she may report from the practice.

3-11d home Office deduction for an Employee Under certain circumstances, an employee was eligible to take a home office deduction. One of the most important requirements was that the use of the home office was for the convenience of the employer. The TCJA, however, suspended unreimbursed employee busi ness expenses as an itemized deduction through 2025.

3-12 hOBBY LOSSES If a taxpayer enters into an activity without a profit motive, the tax law limits the amount of tax deductions available. Under the hobby loss provisions, a taxpayer may not show a loss from an activity that is not engaged in for profit. For example, the breeding of race horses is an activity which might not be considered a trade or business when carried on by a fulltime dentist. The IRS might contend that the activity was for personal enjoyment and disallow any loss for tax purposes. Despite the limitation on losses, any profits from hobbies must be included in tax able income. Hobby income is reported on Line 8, Other Income on Schedule 1 of Form 1040.

3-12a Operational Rules Individual taxpayers (or S corporations) can avoid the hobby loss rules if they can show that the activity was conducted with the intent to earn a profit. To determine whether the activ ity was engaged in for profit, the IRS will look at the following factors:

1. carrying on the activity in a businesslike manner, 2. the time and effort put into the activity indicate an intent to make it profitable, 3. dependence on the income for the taxpayer’s livelihood, 4. whether the losses are due to circumstances beyond control (or are normal in the

startup phase of this type of business), 5. attempts to change methods of operation to improve profitability, 6. the taxpayer or advisors have the knowledge needed to carry on the activity as a suc

cessful business, 7. success in making a profit in similar activities in the past, 8. the activity makes a profit in some years, and 9. the activity is expected to make a future profit from the appreciation of the assets used

in the activity.

The tax law provides a rebuttable presumption that if an activity shows a profit for 3 of the 5 previous years (2 of the 7 previous years for activities involving horses), the activity is engaged in for profit. For example, if an activity shows a profit for 3 of the previous 5 years, it is presumed to be a trade or business, and the IRS has the burden to prove that it is a hobby.

3.12 Learning Objective Apply the factors used to determine whether an activity is a hobby, and understand the tax treatment of hobby losses.

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3-28 Chapter 3 ● Business Income and Expenses

3-12b Loss Limitations Historically, the deduction of hobby expenses have been limited. Hobby expenses were deductible to the extent of hobby income (unless otherwise deductible such as mortgage interest and property taxes) and claimed as a miscellaneous itemized deduction subject to the 2 percent of AGI floor. Thus, they were only available to deduct if the taxpayer itemized deductions.

The miscellaneous expense deduction for items subject to the 2 percent of AGI floor is suspended through 2025; thus, no miscellaneous hobby expenses are deductible. Hobby expenses associated with other allowable itemized deductions (e.g., taxes or interest) are deductible subject to the limitations on those items (see Chapter 5). The income, net of cost of goods sold, must still be reported as other income on Schedule 1, Line 8.

EXAMPLE Fred, the president of a bank, decides that he wants to be a famous wine maker. He has the following expenses related to this activity:

Costs attributable to the wine sold $2,000 Personal property taxes on equipment 2,500 Advertising costs 4,600

During the year, Fred sells 200 cases of wine for $7,500. If the activity is not a hobby, then Fred may take a loss, against his other income, of $1,600 ($7,500 2 $2,000 2 $2,500 2 $4,600). However, if the activity is deemed to be a hobby, Fred would potentially be allowed to deduct the property taxes of $2,500 as an itemized deduction. The cost of the wine sold can be netted against the revenue. The remaining advertising expenses are not deductible. ♦

Self-Study Problem 3.12 See Appendix E for Solutions to Self-Study Problems

Kana is a CPA who loves chinchillas. She breeds chinchillas as pets (she currently owns thirteen of them) and every so often sells a baby chinchilla to a suitable family to keep as a pet. In the current year, she sells $250 worth of chinchillas and incurs the following expenses:

Chinchilla cages $ 300 Advertising for chinchilla sales $2,500

This activity is considered a hobby. Kana has adjusted gross income of $72,000. What is the amount of income and expense Kana recognizes (assume she itemizes deductions) associated with her chinchilla hobby?

Income $ Deduction $

tIp Hobby income can be entered under Income and then Alimony and Other Income. Be sure and net the cost of goods sold against gross income when reporting this amount. Hobby expenses are not deductible.

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3-29

K e y t e r m s

Schedule C, 32 trade or business, 32 cost of goods sold, 35 selfemployment tax, 36 inventories, 37 first in, first out (FIFO), 310 last in, first out (LIFO), 310

standard mileage rate, 312 standard mileage method, 312 actual cost method, 313 tax home, 314 per diem substantiation, 315 standard federal rate method, 315 highlow method, 315

business gifts, 321 business and nonbusiness bad

debts, 323 home office, 324 hobby losses, 327

Learning Objectives Key points

LO 3.1: Complete a basic Schedule C (Profit or Loss from Business).

● Taxpayers who operate a business or practice a profession as a sole proprietorship must file a Schedule C to report the net profit or loss from the sole proprietorship.

● Deductions taken on Schedule C must be ordinary and necessary, reasonable, and have a business purpose.

● Schedule C filers such as sole proprietors and independent contractors with net earnings of $400 or more must pay a self-employment tax calculated on Schedule SE with their Form 1040.

LO 3.2: Describe the tax treatment of inventories and cost of goods sold.

● Cost of goods sold, which is the largest single deduction for many businesses, is calculated as follows: beginning inventory 1 purchases 2 ending inventory.

● There are two common methods of inventory valuation used by taxpayers: first in, first out (FIFO) and last in, first out (LIFO).

LO 3.3: Identify the requirements for deducting transportation expenses.

● Deductible transportation expenses include travel by airplane, rail, bus, and automobile. Normal commuting costs to and from the taxpayer’s place of regular employment are not deductible.

● If the taxpayer works at two or more jobs during the same day, he or she may deduct the cost of going from one job to the other or from one business location to another.

● The standard mileage rate for 2019 is 58 cents per mile.

LO 3.4: Identify the requirements for deducting travel expenses.

● Travel expenses are defined as ordinary and necessary expenses incurred in traveling away from home in pursuit of the taxpayer’s trade or business.

● Deductible travel expenses include the cost of such items as meals, lodging, taxis, tips, and laundry.

● A taxpayer must be away from home “overnight” in order to deduct travel expenses. Overnight is a period of time longer than an ordinary work day in which rest or relief from work is required. Also, the taxpayer must be away from his or her “tax home” to be on travel status.

● Taxpayers must substantiate the following: the amount of each separate expenditure, the dates of departure and return for each trip and the number of business days on the trip, the destination or locality of the travel, and the business reason for the travel.

● As an alternative to reporting actual expenses, a per diem method may be used in certain circumstances.

K e y p O I N ts

Key Points

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3-30 Chapter 3 ● Business Income and Expenses

LO 3.5: Determine the requirements for deducting meals.

● Self-employed taxpayers and employees are allowed deductions for 50 percent of the cost of meals at which business is conducted.

● Generally, entertainment costs are not deductible. ● Certain meals and entertainment costs are deductible when celebratory for all employees.

LO 3.6: Identify the requirements for claiming business education expenses.

● To be deductible as a business expense, education expenditures must be paid to meet the requirements of the taxpayer’s employer or the requirements of law or regulation for keeping the taxpayer’s salary, status, or job, or the expenses must be paid to maintain or improve existing skills required in performing the duties of the taxpayer’s present work.

LO 3.7: Identify the tax treatment of dues and subscriptions.

● Self-employed professionals may deduct dues and the cost of subscriptions and publications. Included are items such as membership to the local bar for a lawyer, dues to the AICPA for an accountant, and the cost of subscriptions to any journal that is directly related to the self-employed taxpayer’s profession. Employees may no longer deduct these costs due to the suspension of miscellaneous deductions subject to the 2 percent of AGI through 2025.

LO 3.8: Determine which clothing and uniforms may be treated as tax deductions.

● In order to be deductible, clothing or uniforms must (1) be required as a condition of employment, and (2) not be suitable for everyday use.

LO 3.9: Explain the special limits for business gift deductions.

● Taxpayers are allowed a deduction for business gifts up to $25 per year per donee. For purposes of this limitation, a husband and wife count as one donee, unless the husband and wife are both clients.

LO 3.10: Explain the tax treatment of bad debt deductions.

● Bad debts are classified as either business bad debts or nonbusiness bad debts. Debts arising from a taxpayer’s trade or business are classified as business bad debts, while all other debts are considered nonbusiness bad debts.

● Business bad debts are treated as ordinary deductions and nonbusiness bad debts are treated as short-term capital losses, of which only $3,000 can be deducted against ordinary income each year.

LO 3.11: Ascertain when a home office deduction may be claimed and how the deduction is computed.

● A home office is generally not deductible. However, there are four exceptions to the general rule.

● A home office deduction is allowed if the home office is used on a regular basis and exclusively as the self-employed taxpayer’s principal place of business.

● A home office deduction is allowed if the home office is used exclusively and on a regular basis by patients, clients, or customers in meetings or dealings with the self-employed taxpayer in the normal course of a trade or business.

● The deduction of home office expenses is allowed if the home office is a separate structure not attached to the dwelling unit and is used exclusively and on a regular basis in the taxpayer’s trade or business.

● A home office deduction of a portion of the cost of a dwelling unit is allowed if it is used on a regular basis for the storage of business inventory or product samples.

● The home office deduction is limited by the amount of net income from the associated trade or business.

● Employees may no longer deduct a home office, even when at the convenience of his or her employer, due to the TCJA suspension of the miscellaneous business expense deduction.

● A simplified home office deduction is also available at $5 per square foot up to a maximum of $1,500 in 2019.

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3-31

LO 3.12: Apply the factors used to determine whether an activity is a hobby, and understand the tax treatment of hobby losses.

● Under the hobby loss provisions, a taxpayer may not show a loss from an activity that is not engaged in for profit.

● To determine whether the activity was engaged in for profit, the IRS will look at numerous factors including whether the activity is conducted like a business.

● Hobby expenses are no longer deductible due to the TCJA suspension of miscellaneous itemized deductions subject to the 2 percent of AGI floor.

GrOUp 1:

MuLTIPLE ChOICE QuESTIONS

1. Which of the following is not a test for the deductibility of a business expense? a. Ordinary and necessary test b. Expectation of profit test c. Reasonableness test d. Business purpose test

2. In the current year, Mary started a profitable housekeeping business as a sole proprietor. She has ten housekeepers working for her and spends her time selling their services and coordinating her employees’ time. Mary made $50,000 in her first year of operations. In addition to filing a Schedule C to report her business earnings, Mary must also file a. Schedule A b. Schedule F c. Schedule B d. Schedule SE e. None of the above

3. Daniel is a selfemployed consultant. Until this year he was always an employee. He comes to discuss his new business with you. As his tax accountant, you should: a. Discuss setting up a good recordkeeping system for his new business b. Discuss the substantiation requirements for meals c. Discuss the selfemployment tax, as well as the income tax, on business earnings

in order to help Daniel estimate what he might owe in taxes for the year d. Discuss the rules for deducting automobile expenses e. Discuss all of the above

4. Which of the following formulas represents the proper method of calculating cost of goods sold? a. Beginning inventory 1 Ending inventory 2 Purchases b. Ending inventory 2 Purchases 2 Beginning inventory c. Purchases 2 Beginning inventory 2 Ending inventory d. Beginning inventory 1 Purchases 2 Ending inventory e. None of the above

5. If a taxpayer has beginning inventory of $45,000, purchases of $175,000, and ending inven tory of $25,000, what is the amount of the cost of goods sold for the current year? a. $155,000 b. $180,000 c. $175,000 d. $195,000 e. None of the above

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Q U es t I O Ns a n d prO B L e m s

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3-32 Chapter 3 ● Business Income and Expenses

6. Which of the following taxpayers may use the standard mileage method of calcula ting transportation costs? a. A taxi driver who owns a fleet of six cars for hire b. A taxpayer who used accelerated depreciation on his automobile c. A business executive who claimed bonus depreciation in the first year she used

the car d. An attorney who uses his European sports car for calling on clients e. None of the above

7. Heather drives her minivan 953 miles for business purposes in 2019. She elects to use the standard mileage rate for her auto expense deduction. Her deduction will be a. $510 b. $515 c. $519 d. $553 e. $953

8. Which of the following taxpayers is entitled to a travel expense deduction? a. An employee, who worked in the Salt Lake City plant of a company, who is

assigned to the Denver plant of the company for 4 years b. An employee who travels between several business locations within the same city

each day c. A manager of a chain of department stores who works in the main store

3 weeks out of every month and visits distant branch locations on overnight trips during the remainder of the month

d. An employee who resigns from his current job and accepts a new job in a city 500 miles away from his current residence

e. A bank employee who travels to a branch office for a couple of hours of work and decides to stay overnight to attend a play

9. Which of the following expenses incurred while the taxpayer is away from home “overnight” is not included as a travel expense? a. Laundry expenses b. Transportation expenses c. Meal expenses d. Business gifts e. Lodging expenses

10. Under the highlow method, the federal per diem amount is a. The same in every city in the U.S. b. Different for every city in the U.S. c. The same for most cities but higher in certain locations d. An average of the highest and lowest costs for that city e. The boundary for expenses incurred in a city (never higher than the high amount

but never lower than the low amount)

11. Joe is a selfemployed information technology consultant from San Francisco, CA. He takes a weeklong trip to Chicago primarily for business. He takes two personal days to go to museums and see the sights of Chicago. How should he treat the expenses related to this trip? a. One hundred percent of the trip should be deducted as a business expense

since the trip was primarily for business. b. Fifty percent of the trip should be deducted as a business expense since the IRS

limits such business expenses to 50 percent of the actual cost.

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c. The cost of all of the airfare and the business days should be deducted, while the cost of the personal days are not deductible.

d. None of the expenses are deductible since there was an element of personal enjoyment in the trip.

12. Which of the following expenses is deductible as an entertainment expense? a. The depreciation on an airplane used to entertain customers b. The cost of a hunting camp used to entertain customers c. The dues of a racquet club used to keep in shape d. The cost of a paintball party for clients paid for by a computer salesman at a

computer fair e. None of these are deductible

13. Which of the following is not likely to be a deductible expense? a. The cost of tickets to a stage play for a client and the taxpayer. b. The cost for Rosa to take a potential customer to lunch to describe a new service

Rosa’s company is offering. Unfortunately, the customer explains that they are not interested in the service.

c. The cost of a party for all of Dan’s employees to celebrate a recordbreaking profits year.

d. The dues for Charles Coke to join the City Chamber of Commerce to generally improve the reputation of his business in the community.

e. None of the above are deductible expenses.

14. Which of the following taxpayers may not deduct their educational expense? a. A CPA who attends a course to review for the real estate agents’ exam b. An independent sales representative who attends a customer relations course at a

local university c. A selfemployed attorney who attends a course on computing legal damages d. An independent real estate broker who attends a college course on real estate law e. All of the above are deductible

15. Which of the following is likely a deductible business educational expense? a. Leah is a selfemployed tax preparer. The State Board of Taxation requires Leah to

attend federal and state taxation training each year to maintain her tax preparation licence.

b. Mike is an auto mechanic. He decides he wants to be a high school math teacher but the state Department of Education requires Mike to earn a bachelor’s degree in education.

c. John teaches European History at Ridgemont High School. In order to better understand the material he teaches, John takes a summer trip with American Geographic magazine to tour Western Europe.

d. Becca is an auto mechanic. She sees that the local community college is offering courses in jet engine repair which would prepare her to work for one of the airlines. Becca would like to work for an airline because they let employees fly for free.

16. Which of the following is not deductible by the selfemployed taxpayer? a. A subscription to The CPA Journal by a CPA b. A subscription to The Yale Medical Journal by a doctor c. A subscription to Financial Management by a financial planner d. A subscription to The Harvard Law Review by a lawyer e. All of the above are deductible

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3-34 Chapter 3 ● Business Income and Expenses

17. Which of the following selfemployed taxpayers are most likely permitted to deduct the cost of their uniform? a. A lawyer who wears a business suit b. A furnace repairman who must wear overalls while on the job c. A nurse who can wear casual clothes while on duty d. A pair of stainless steel safety gloves for a butcher

18. Which of the following business gifts are fully deductible? a. A gift to a client that cost $35 b. A gift to an employee, for 10 years of continued service, costing $250 c. A gift to a client and her nonclient spouse costing $45 d. A gift to an employee paid under a qualified plan, for not having an onthejob

injury for 25 years, costing $1,650 e. None of the above are fully deductible

19. Loren loaned a friend $9,000 as financing for a new business venture. In the current year, Loren’s friend declares bankruptcy and the debt is considered totally worthless. What amount may Loren deduct on his individual income tax return for the current year as a result of the worthless debt, assuming he has no other capital gains or losses for the year? a. $9,000 ordinary loss b. $9,000 shortterm capital loss c. $3,000 shortterm capital loss d. $3,000 ordinary loss e. $6,000 shortterm capital loss

20. Kathy is a selfemployed taxpayer working exclusively from her home office. Before the home office deduction, Kathy has $3,000 of net income. Her allocable home office expenses are $5,000 in total (includes $2,000 of allocated interest and property taxes). How are the home office expenses treated on her current year tax return? a. All home office expenses may be deducted, resulting in a business loss of $2,000. b. Only $3,000 of home office expenses may be deducted, resulting in net business

income of zero. None of the extra $2,000 of home office expenses may be carried forward or deducted.

c. Only $3,000 of home office expenses may be deducted, resulting in net business income of zero. The extra $2,000 of home office expenses may be carried forward and deducted in a future year against home office income.

d. None of the home office expenses may be deducted since Kathy’s income is too low.

21. Which of the following taxpayers qualifies for a home office deduction? a. An attorney who is employed by a law firm and has a home office in which to

read cases b. A doctor who has a regular office downtown and a library at home to store

medical journals c. An accounting student who maintains a home office used exclusively for her

business preparing tax returns d. A nurse who maintains a home office to pay bills and read nursing journals e. A corporate president who uses his home office to entertain friends and

customers

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22. Carol maintains an office in her home where she conducts a dressmaking business. During the year she collects $4,000 from sales, pays $1,300 for various materials and sup plies, and properly allocates $2,500 of rent expense and $500 of her utilities expense to the use of her home office. What amount of the rent and utilities expense may Carol deduct in the current year in computing her net income or loss from the dressmaking business? a. $0 b. $500 c. $2,500 d. $2,700 e. $3,000

23. Which of the following factors is not considered by the IRS in determining whether an activity is a hobby? a. Whether the activity is conducted like a business b. The time and effort expended by the taxpayer c. Whether there have been changes in the methods of operation in an attempt to

improve profitability d. Income and loss history of the activity e. All of the above are considered to determine if an activity is a hobby

24. Stewie, a single taxpayer, operates an activity as a hobby. Brian, a different taxpayer, operates a similar activity as a bona fide business. Stewie’s gross income from his activity is $5,000 and his expenses are $6,000. Brian’s gross income and expenses are coincidentally the same as Stewie. Neither Stewie nor Brian itemize, but both have other forms of taxable income. What is the impact on taxable income for Stewie and Brian from these activities? a. Stewie will report $0 income and Brian will report a $1,000 loss. b. Stewie will report $5,000 income and $0 deduction and Brian will report a

$1,000 loss. c. Stewie and Brian will report $0 taxable income. d. Stewie and Brian will report a $1,000 loss. e. Stewie will report a $1,000 loss and Brian will report $5,000 income.

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Questions and Problems

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3-36 Chapter 3 ● Business Income and Expenses

GrOUp 2:

PROBLEMS

1. Scott Butterfield is selfemployed as a CPA. He uses the cash method of account ing, and his Social Security number is 644477833. His principal business code is 541211. Scott’s CPA practice is located at 678 Third Street, Riverside, CA 92860. Scott’s income statement for the year shows the following:

LO 3.1 LO 3.3 LO 3.5 LO 3.7

Scott also mentioned the following: ● The expenses for dues and subscriptions were his country club membership

dues for the year. ● $300 of the charitable contributions were made to a political action committee. ● Scott does not generate income from the sale of goods and therefore does not

record supplies and wages as part of cost of goods sold. ● Scott placed a business auto in service on January 1, 2016 and drove it 3,792

miles for business, 3,250 miles for commuting, and 4,500 miles for nonbusiness purposes. His wife has a car for personal use.

Complete Schedule C on Pages 337 and 338 for Scott showing Scott’s net taxable profit from selfemployment.

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3-37Questions and Problems

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3-39

2. Margaret started her own business in the current year and will report a profit for her first year. Her results of operations are as follows:

Gross income $45,000 Travel 1,000 Contribution to Presidential Election Campaign 100 Transportation 5,380 miles, using standard mileage method ? Entertainment in total 4,200 Nine gifts at $50 each 450 Rent and utilities for apartment in total 10,500 (25% is used for a home office)

What is the net income Margaret should show on her Schedule C? Show the cal culation of her taxable business income.

Gross income

Expenses (describe each)

Taxable business income

3. Lawrence owns a small candy store that sells one type of candy. His beginning inventory of candy was made up of 10,000 boxes costing $1.50 per box ($15,000), and he made the following purchases of candy during the year:

March 1 10,000 boxes at $1.60 $16,000 August 15 20,000 boxes at $1.70 34,000 November 20 10,000 boxes at $1.80 18,000

At the end of the year, Lawrence’s inventory consisted of 15,000 boxes of candy. a. Calculate Lawrence’s ending inventory and cost of goods sold using the FIFO

inventory valuation method.

Ending inventory $ Cost of goods sold $

b. Calculate Lawrence’s ending inventory and cost of goods sold using the LIFO inventory valuation method.

Ending inventory $ Cost of goods sold $

4. Kevin owns a retail store, and during the current year he purchased $610,000 worth of inventory. Kevin’s beginning inventory was $67,000, and his ending inventory is $77,200. During the year, Kevin withdrew $1,780 in inventory for his personal use. Use Part III of Schedule C below to calculate Kevin’s cost of goods sold for the year.

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Questions and Problems

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3-40 Chapter 3 ● Business Income and Expenses

5. Business with gross receipts of $25 million or less may treat inventory as non incidental materials and supplies. Find Regulation Section 1.1623 and read paragraphs (a)(1) and (a)(2) to help answer the following:

Frank owns an auto repair shop that serves a particular model of auto and so he tends to purchase parts in bulk. Frank is eligible to treat inventory as nonincidental materials and elects to do so. In December of 2019 he purchases 24 oil filters. He uses one to repair an auto in January 2020, and then about 2 per month and ends 2020 with 14 filters. Explain how Frank will treat his oil filter inventory.

6. Teresa is a civil engineer who uses her automobile for business. Teresa drove her automobile a total of 11,965 miles during 2019, of which 80 percent was business mileage. The actual cost of gasoline, oil, depreciation, repairs, and insurance for the year was $6,440. Teresa is eligible to use the actual or standard method. a. How much is Teresa’s transportation deduction based on the standard

mileage method? $

b. How much is Teresa’s transportation deduction based on the actual cost method? $

c. Which method should Teresa use to calculate her transportation deduction?

Why?

7. Art is a selfemployed installer of home entertainment systems, and he drives his car frequently to installation locations. Art drove his car 15,000 miles for business pur poses and 20,000 miles in total. His actual expenses, including depreciation, for oper ating the auto are $10,000 since he had to have the car repaired several times. Art has always used the actual cost method in the past. How much is Art’s deductible auto expense for the year?

8. Martha is a selfemployed tax accountant who drives her car to visit clients on a reg ular basis. She drives her car 4,000 miles for business and 10,000 for commuting and other personal use. Assuming Martha uses the standard mileage method, how much is her auto expense for the year? Where in her tax return should Martha claim this deduction?

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9. Joan is a selfemployed attorney in New York City. Joan took a trip to San Diego, CA, primarily for business, to consult with a client and take a short vacation. On the trip, Joan incurred the following expenses:

Airfare to and from San Diego $ 478 Hotel charges while on business 340 Meals while on business 260 Car rental while on business (she drove 240 miles) 110 Hotel charges while on vacation 460 Meals while on vacation 290 Car rental while on vacation 180 Total $2,118

Calculate Joan’s travel expense deduction for the trip, assuming the trip was made in 2019.

10. Go to the U.S. General Services Administration (GSA) website. For the month of September 30, 2019, what is the per diem rate for each of the following towns: a. Flagstaff, AZ b. Palm Springs, CA c. Denver, CO

11. Bob is a selfemployed lawyer and is required to take a week of continuing legal education every year to maintain his license. This year he paid $1,150 in course fees for his continuing legal education in a different city. He also paid $354 for airfare and a hotel room and paid $234 for meals. What is the total amount he can deduct on his Schedule C related to these expenses?

12. Grace is a selfemployed sales consultant who spends significant time entertaining potential customers. She keeps all the appropriate records to substantiate her entertainment. She has the following expenses in the current year:

Meals where business was conducted $5,000 Greens fees (all business) 500 Tickets to baseball games (all business) 500 Country Club dues (all business use) 6,000

What are the taxdeductible meals and entertainment expenses Grace may claim in the current year? On which tax form should she claim the deduction?

13. Marty is a sales consultant. Marty incurs the following expenses related to the entertainment of his clients in the current year:

Dues to a country club $4,500 (The country club was used for business 25 days of the total 75 days that it was used.) Business meals at the country club not associated with golf or tennis 1,200 Dues to a tennis club 1,000 (The club was used 75 percent for directly related business.) Tennis fees (personal use) 260 Business meals at various restaurants 1,844

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3-42 Chapter 3 ● Business Income and Expenses

a. How much is Marty’s deduction for meals and entertainment expenses for the current year? $

b. For each item listed above that you believe is not allowed as a deduction, explain the reason it is not allowed.

14. a. Loren is a secretary in a lawyer’s office. Since he often deals with legal matters, Loren feels that a law degree will be beneficial to him. May Loren deduct his educational expenses for law school?

Explain

b. Alicia is an employee in the sales department for an international firm. She wishes to learn Spanish to improve her ability to communicate with foreign clients. May Alicia deduct her educational expenses for language school as a miscellaneous itemized deduction?

Explain

c. Joan is a practicing lawyer. She enrolls in a local medical school and works toward a medical degree in her spare time. May Joan deduct her educational expenses for the medical classes?

Explain

15. Carey opens a law office in Chicago on January 1, 2019. On January 1, 2019, Carey purchases an annual subscription to a law journal for $170 and a 1year legal reference service for $1,500. Carey also subscribes to Chicago Magazine for $54 so she can find great places to take client’s to dinner and review the Best 50 Lawyers in Chicago list published each year. Calculate Carey’s deduction for the above items for the 2019 tax year.

16. Cooper and Brandy are married and file a joint income tax return with two separate Schedule Cs. Cooper is an independent security specialist who spent $395 on uniforms during the year. His laundry expenses for the uniforms were $175 for this year, plus $65 for altering them. Brandy works as a drill press operator and wears jeans and a work shirt on the job, which cost $175 this year. Her laundry costs were $50 for the work clothes. Brandy is also required by state regulators to wear safety glasses and safety shoes when working, which cost a total of $115. a. How much is Cooper’s total deduction on his Schedule C for special clothing and

uniforms? $

b. How much is Brandy’s total deduction on her Schedule C for special clothing and uniforms? $

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3-43Questions and Problems

17. Sam owns an insurance agency and makes the following business gifts during the year. Calculate Sam’s deduction for business gifts.

Donee Amount Amount Allowed

Ms. Sears (a client) $35, plus $4 shipping $

Mr. Williams (a tennis partner, not a business prospect or client)

Mr. Sample (a client) 22

Mrs. Sample (nonclient wife of Mr. Sample)

Various customers (calendars costing $3 each with the company name on them)

300

Mr. Shiver (an employee gift, a watch, for 25 years of continuous service)

175

Total business gift deduction $

18. Steinar loaned a friend $9,500 to buy some stock 3 years ago. In the current year the debt became worthless. a. How much is Steinar’s deduction for the bad debt for this year? (Assume he has

no other capital gains or losses.) $

b. What can Steinar do with the deduction not used this year?

19. Sharon is an orthopedic surgeon. She performed a surgery 2 years ago and billed $10,000 to her patient. After 2 years of attempting to collect the money, it is clear that Sharon will not be able to collect anything. Sharon reports income on her tax return on the cash basis, so she only reports the income she actually receives in cash each year. Can she claim a bad debt deduction for the $10,000?

20. Carrie loaned her friend $4,500 to buy a used car. She had her friend sign a note with repayment terms and set a reasonable interest rate on the note because the $4,500 was most of her savings. Her friend left town without a forwarding address, and no body Carrie knows has heard from her in the last year. How should Carrie treat the bad loan for tax purposes?

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3-44 Chapter 3 ● Business Income and Expenses

21. Cindy operates a computerized engineering drawing business from her home. Cindy maintains a home office and properly allocates the following expenses to her office:

Depreciation $1,500 Utilities 500 Real estate taxes 325 Mortgage interest (100 percent deductible) 500

a. Assume that Cindy earns income of $4,400 from her business for the year before deducting home office expenses. She has no other expenses associated with the business. Calculate Cindy’s deduction for home office expenses. $

b. Assume that Cindy earns income of $2,600 from her business during the year before deducting home office expenses. Calculate Cindy’s deduction for home office expenses. $

22. Pete qualifies for a home office deduction. The amount of space devoted to business use is 300 square feet of the total 1,200 square feet in his apartment. Pete’s total rent for the year is $9,600, and he pays utilities (other than telephone) of $2,500 for the year. Calculate Pete’s deduction for home office expenses before the gross income limitation.

Rent $ Utilities other than telephone Total home office expenses $

23. Randi qualifies for a home deduction. The amount of space devoted to business use is 400 square feet of the total 2,000 square feet of her home. Randi’s mortgage interest and property taxes in total are $1,600. Other deductions properly allocated to the home office total $300. In addition, Randi purchases and uses business supplies costing $200 during the year. Assume Randi earns income of $3,400 for the year be fore deducting any home office or supplies deduction. Calculate the largest deduction Randi can take for her home office (ignore selfemployment taxes).

24. Ann is a selfemployed restaurant critic who does her work exclusively from a home office. Ann’s income is $25,000 before the home office deduction this year. Her office takes up 200 square feet of her 1,000squarefoot apartment. The total expenses for her apartment are $6,000 for rent, $1,000 for utilities, $200 for renter’s insurance, and $800 for pest control and other maintenance. What is Ann’s home office deduction? Please show your calculations.

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GrOUp 3:

WRITING ASSIGNMENT

25. Lew is a practicing CPA who decides to raise bonsai as a business. Lew engages in the activity and has the following revenue and expenses:

Sales $ 5,000 Depreciation on greenhouse 10,000 Fertilizer, soil, pots 1,500

a. What are the factors that the IRS will consider when evaluating whether the activity is a business or a hobby?

b. If the activity is deemed to be a regular business, what is the amount of Lew’s loss from the activity?

c. If the activity is deemed to be a hobby, what is the amount of Lew’s expenses (if any) from the activity that may be deducted?

LO 3.12

1. Robert, a new client of yours, is a selfemployed caterer in Santa Fe, New Mexico. Robert drives his personal van when delivering catered meals to customers. You have asked him to provide the amount of business miles driven using his vehicle. You are planning on using the standard mileage method to calculate Robert’s deduction for transportation costs. Robert has responded by saying, “Well, I don’t really keep track of my miles. I guess I drove around 3,000 miles last year for the business.” What would you say to Robert?

2. Your supervisor has asked you to research a potential tax deduction for a client, Randall Stevens. Randall is a bank loan officer that lives in Portland, Maine. His specialty is marine loans; in particular, loans for the renovation of classic boats. Over the years, Randall has developed a very unique expertise in valuation of classic boats and is considered a global expert in the field. In 2019, Randall is hoping to attend the North American Classic Marine Boat Show that takes place in Zihuatanejo, Mexico. Randall attends the show more or less every year in order to stay current on classic boat valuations. Interested parties from around the world attend the show in the quaint Mexican coastal town. Randall’s costs to attend are $800 for show registra tion, $1,750 for airfare from Portland to Zihuatanejo, $2,400 for lodging. Meals are estimated at $600. Please prepare a letter for Randall that describes the issues he will face when attempting to deduct the cost of attending the show. Use IRS Publication 463 (available at www.irs.gov) to assist you.

(An example of a client letter is available at the website for this textbook located at www.cengage.com.)

research

ETHICS

Questions and Problems

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3-46 Chapter 3 ● Business Income and Expenses

1. Ken (birthdate July 1, 1988) and Amy (birthdate July 4, 1990) Booth have brought you the following information regarding their income, expenses, and withholding for the year. They are unsure which of these items must be used to calculate taxable income.

Income: Ken’s salary (salesman) $28,500 Amy’s wages (parttime nurse) 17,500 Insurance reimbursement for repairs from an 500

auto accident Gift from Uncle George 2,000 Interest income from Lodge State Bank 840 Federal income taxes withheld: From Ken’s salary 2,600 From Amy’s wages 650

Amy owns and operates a computer bookstore named “The Disk Drive.” The store is located at 2000 Broadway Street, Menomonie, WI 54751. The business EIN is 27 1234567 and the principal business code for bookstores is 451211. During 2019, Amy had the following income and expenses:

Sales of books $321,000 Expenses Store rental 16,000 Office expense 6,000 Advertising 11,700 City business license 1,020 Payroll 83,550 Payroll taxes 8,400 Utilities 8,050 Other 3,000 Cost of inventory sold 185,000

Amy treats inventory as nonincidental materials and supplies. This year, Amy loaned a friend $10,000 so that he could make an investment.

Instead of making the investment, the friend lost all the money gambling and left for parts unknown. Amy has no hope of ever collecting on this bad debt.

Ken, who ordinarily never gambles, won $20,000 at a casino birthday party for one of his friends.

The Booths provide the sole support for Ken’s parents, Rod (Social Security num ber 124809050) and Mary (Social Security number 489376676) Booth, who live in their own home. Ken and Amy live at 2345 Wilson Avenue, Menomonie, WI, 54751, and their Social Security numbers are 343753456 (Ken) and 123457890 (Amy). Ken and Amy can claim a $500 other dependent credit for each parent.

Required: Complete the Booths’ federal income tax return for 2019 on Form 1040, Schedule 1, Schedule C, Schedule D, and Form 8949. A statement is required to be attached to a return for a nonbusiness bad debt, but this requirement may be ignored for this problem. Assume no 1099B is filed in association with the bad debt when filling out Form 8949.

GrOUp 4:

COMPREhENSIVE PROBLEMS

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3-47Questions and Problems

2A. Russell (birthdate February 2, 1968) and Linda (birthdate August 30, 1973) Long have brought you the following information regarding their income and expenses for the current year. Russell owns and operates a landscaping business called Lawns and Landscapes Unlimited (EIN: 321456789). The business is operated out of their home, located at 1234 Cherry Lane, Nampa, ID 83687. The principal business code is 561730. Russell’s bookkeeper provided the following income statement from the landscaping business:

The bookkeeper provided the following additional information: ● Donations expense is a $600 donation to the Campaign to ReElect Senator

Ami Dahla. ● Training includes $575 for an educational seminar on bug control. It also in

cludes the cost for Russell to attend an online certificate program in landscaping in order to improve his skills and advertise his designation as a certified land scaper. The tuition, fees, and books cost $1,400. He also drove his personal car 57 miles round trip to Boise to take exams three times for a total of 171 miles.

● No business gift exceeded $22 in value. ● The subscription is for a trade magazine titled Plants Unlimited.

The business uses the cash method of accounting and has no accounts receivable or inventory held for resale.

In addition to the above expenses, the Longs have set aside one room of their house as a home office. The room is 160 square feet and their house has a total of 1,600 square feet. They pay $13,200 per year rental on their house, and the utilities amount to $1,800 for the year.

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The Longs also have the following interest income for the year:

Interest from Idaho Bank and Trust bond portfolio $44,000

The Longs have two dependent children, Bill (Social Security number 123237654) and Martha (Social Security number 345678654). Both Bill and Martha are fulltime high school students, ages 17 and 18, respectively, and each can be claimed for the $500 other dependent credit. Russell’s Social Security number is 664985678 and Linda’s is 554 983946. They made an estimated tax payment to the IRS of $2,500 on December 31, 2019.

Required: Complete the Longs’ federal tax return for 2019 on Form 1040, Schedule 1, Schedule 3, Schedule B, Schedule C, and Form 8829. Do not complete Form 4562 (depreciation).

2B. Christopher Crosphit (birthdate April 28, 1977) owns and operates a health club called “Catawba Fitness.” The business is located at 4321 New Cut Road, Spartanburg, SC 29303. The principal business code is 812190 and the EIN is 123456789. Chris had the following income and expenses from the health club:

Income $216,000 Expenses: Business insurance 3,600 Office supplies 3,300 Payroll 98,900 Payroll taxes 9,112 Travel 2,420 Equipment & club maintenance 10,720 Cleaning service 8,775 Equipment rent 22,820 Utilities (electric, water, gas) 13,975 Telephone 2,778 Rent 32,600 Advertising 5,200 Special workout clothing and boxing gloves 780 Subscription to Biceps Monthly magazine 120 Educational seminar on weight training 770 Other expenses 1,830

The business uses the cash method of accounting and has no accounts receivable or inventory held for resale.

Chris has the following interest income for the year:

Upper Piedmont Savings Bank savings account $13,000 Morgan Bank bond portfolio interest 12,075

Chris also dabbles as a broker of antique and rare books. He acquires and scav enges for books and then sells them on the Internet. He generated $4,000 of sales in 2019 and the books he sold cost $3,500. He also incurred $7,600 in travel and other expenses related to this activity. Chris has never turned a profit in the book business, but he loves books and book selling and does not mind losing money doing it.

Chris has been a widower for 10 years with a dependent son, Arnold (Social Security number 276233954), and he files his tax return as head of household. Arnold (birthdate July 1, 2001) is a high school student; he does not qualify for the child tax credit but does qualify for the $500 other dependent credit. They live next door to the health club at 4323 New Cut Road. Chris does all the administrative work for the health club out of an office in his home. The room is 171 square feet and the house has a total of 1,800 square feet. Chris pays $20,000 per year in rent and $4,000 in utilities.

Chris’ Social Security number is 565126789. He made an estimated tax payment to the IRS of $500 on April 15, 2019.

Required: Complete Chris’ federal tax return for 2019 on Form 1040, Schedule 1, Sched ule 3, Schedule B, Schedule C, and Form 8829. Do not complete Form 4562 (depreciation).

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3-49Questions and Problems

1. The following additional information is available for the Albert and Allison Gaytor family from Chapters 1 and 2. On September 1, Allison opened a retail store that specializes in sports car accessories.

The name of the store is “Toge Pass.” The store is located at 617 Crandon Boulevard, Key Biscayne, FL 33149. The store uses the cash method of accounting for everything except inventory which is kept on an accrual basis. The store’s EIN is 987321654. Allison purchased inventory in August and thus started her business on September 1 with $40,100 of inventory. The Toge Pass accountant provided the following financial information:

GrOUp 5:

CuMuLATIVE SOFTWARE PROBLEM

A review of the expense account detail reveals the following: ● The travel expense includes the costs Allison incurred to attend a seminar on sports car

accessories. She spent $300 on airfare, $400 on lodging, $90 on a rental car, and $150 on meals. Allison has proper receipts for these amounts.

● The gift account details show that Allison gave a $30 gift to each of her six best suppliers.

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3-50 Chapter 3 ● Business Income and Expenses

● The supplies expense account detail reflects the purchase of 250 pens with the “Toge Pass” logo inscribed on each pen. Allison gave the pens away to suppliers, customers, and other business contacts before the end of the year.

● Uniforms expense reflects the cost to purchase polo shirts Allison provided for each employee (but not herself). The shirts have the Toge Pass logo printed on the front and back and are the required apparel while working but otherwise are just like any other polo shirts.

● The license and fee account includes a $600 fine Toge Pass paid to the state of Wash ington for environmental damage resulting from an oil spill.

Allison drove her 2011 Ford Explorer 1,700 miles for business related to Toge Pass. The Explorer was driven a total of 11,450 miles for the year. Included in the total 11,450 miles is 5,000 miles spent commuting to the store. Allison has the required substantiation for this business mileage. She uses the standard mileage method.

In July, Albert loaned a friend $7,000 so he could buy a car. Albert’s friend lost his job in 2019 and stopped making payments on the loan. He plans to start making payments again, however, with additional interest as soon as he has new employment.

In late 2019, Albert started to mount and stuff some of his trophy fish to display in his “man cave” at the Gaytor’s home. Some of his friends liked Albert’s taxidermy work and asked him to prepare a couple of trophy fish for them as well. Although he doubts he will ever sell any more stuffed fish, he received $150 and had no expenses related to this activity in 2019.

Required: Combine this new information about the Gaytor family with the information from Chapters 1 and 2 and complete a revised 2019 tax return for Albert and Allison. Be sure to save your data input files since this case will be expanded with more tax information in later chapters.

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3-51Questions and Problems

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3-52 Chapter 3 ● Business Income and Expenses

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3-53Questions and Problems

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3-54 Chapter 3 ● Business Income and Expenses

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3-55Questions and Problems

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3-56 Chapter 3 ● Business Income and Expenses

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3-57Questions and Problems

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3-58 Chapter 3 ● Business Income and Expenses

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3-59Questions and Problems

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3-60 Chapter 3 ● Business Income and Expenses

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3-61Questions and Problems

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3-62 Chapter 3 ● Business Income and Expenses

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3-63Questions and Problems

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3-64 Chapter 3 ● Business Income and Expenses

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3-65Questions and Problems

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3-66 Chapter 3 ● Business Income and Expenses

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3-67

Student Name

Class/Section

Date

K e y N Um B e r ta x r e t U r N sUm m a ry

ChAPTER 3

Comprehensive Problem 1

Adjusted Gross Income (Line 8b)

Standard Deduction (Line 9)

Taxable Income (Line 11b)

Total Tax (Line 16)

Comprehensive Problem 2A

Adjusted Gross Income (Line 8b)

Tentative Profit or (Loss), Schedule C (Line 29)

Allowable Expenses for Business Use of Your Home, Form 8829 (Line 36)

Total Tax (Line 16)

Amount Overpaid (Line 20)

Comprehensive Problem 2B

Adjusted Gross Income (Line 8b)

Tentative Profit or (Loss), Schedule C (Line 29)

Allowable Expenses for Business Use of Your Home, Form 8829 (Line 36)

Total Tax (Line 16)

Amount Overpaid (Line 20)

Questions and Problems

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M ai

ca /E

+/ G

et ty

Im ag

C h a p t e r 4

Additional Income and the Qualified Business Income Deduction

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4-1

O V e r V I e W

C hapter 4 covers additional important elements of income and expense which enter into the calculation of adjusted gross income (AGI). The first part of

this chapter includes capital gains and other items reported through Schedule D. The second part covers the tax rules for rental properties and

other business activities including limitations on passive activities reported through Schedule E. This chapter concludes with the new qualified business income deduction introduced for 2018 by the TCJA. The business income and expenses included in this chapter are all part of the calcula- tion of a taxpayer’s AGI.

L E A R N I N G O B J E C T I V E S

After completing this chapter, you should be able to: LO 4.1 Define the term “capital asset.” LO 4.2 Apply the holding period for long-term and short-term capital gains and losses. LO 4.3 Calculate the gain or loss on the disposition of an asset. LO 4.4 Compute the tax on capital gains. LO 4.5 Describe the treatment of capital losses. LO 4.6 Apply the exclusion of gain from personal residence sales. LO 4.7 Apply the tax rules for rental property and vacation homes. LO 4.8 Explain the treatment of passive income and losses. LO 4.9 Describe the basic tax treatment of deductions for net operating losses. LO 4.10 Compute the qualified business income (QBI) deduction.

4-1

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4-2 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

4-1 WhAT IS A CApITAL ASSET? When taxpayers dispose of property, they must calculate any gain or loss on the transac- tion and report the gain or loss on their tax returns. The gain or loss realized is equal to the difference between the amount realized on the sale or exchange of the property and the taxpayer’s adjusted basis in the property. How gains and losses are reported is depen- dent on the nature of the property and the length of time the property has been owned. Gains and losses on the sale of capital assets are known as capital gains and losses and are classified as either short-term or long-term. For a gain or loss on the sale of a capital asset to be classified as a long-term capital gain or loss, the taxpayer must have held the asset for the required holding period.

The tax law defines a capital asset as any property, whether used in a trade or business or not, other than:

1. Stock in trade, inventory, or property held primarily for sale to customers in the ordi- nary course of a trade or business;

2. Depreciable property or real property used in a trade or business (Section 1231 assets); 3. A patent, invention, model or design (whether or not patented), a secret formula or

process, a copyright, a literary, musical, or artistic composition, a letter or memoran- dum, or similar property, if the property is created by the taxpayer;

4. Accounts or notes receivable; and 5. Certain U.S. government publications.

The definition of a capital asset is a definition by exception. All property owned by a taxpayer, other than property specifically noted as an exception, is a capital asset. Depreci- able property and real estate used in a trade or business are referred to as Section 1231 assets and will be discussed in Chapter 8 because special rules apply to such assets.

Learning Objective 4.1 Define the term “capital asset.”

Self-Study problem 4.1 See Appendix E for Solutions to Self-Study Problems

Indicate, by circling your answer, whether each of the following properties is or is not a capital asset.

Property Capital Asset?

1. Shoes held by a shoe store Yes No 2. A taxpayer’s personal residence Yes No 3. A painting held by the artist Yes No 4. Accounts receivable of a dentist Yes No 5. A copyright purchased from a company Yes No 6. A truck used in the taxpayer’s business Yes No 7. IBM stock owned by an investor Yes No 8. AT&T bonds owned by an investor Yes No 9. Land held as an investment Yes No

10. A taxpayer’s television Yes No 11. Automobiles for sale owned by a car dealer Yes No 12. A taxpayer’s sailboat Yes No

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4-34-3 Calculation of Gain or Loss

Self-Study problem 4.2 See Appendix E for Solutions to Self-Study Problems

Indicate whether a gain or loss realized in each of the following situations would be long-term or short-term by putting an “X” in the appropriate blank.

Date Acquired Date Sold Long-Term Short-Term

1. October 16, 2018 May 30, 2019 2. May 2, 2018 October 12, 2019 3. July 18, 2018 July 18, 2019 4. August 31, 2017 March 1, 2019

4-2 hOLdING pERIOd Assets must be held for more than 1 year for the gain or loss to be considered long-term. A capital asset sold before it is owned for the required holding period results in a short-term capital gain or loss. A net short-term capital gain is treated as ordinary income for tax pur- poses. In calculating the holding period, the taxpayer excludes the date of acquisition and includes the date of disposition.

EXAMpLE Glen purchased stock as an investment on March 27, 2018. The first day the stock may be sold for long-term capital gain treatment is March 28, 2019. ♦

To satisfy the long-term holding period requirement, a capital asset acquired on the last day of a month must not be disposed of before the first day of the thirteenth month following the month of purchase.

EXAMpLE If Elwood purchases a painting on March 31, 2018, the first day the painting may be sold for long-term capital gain treatment is April 1, 2019. ♦

4.2 Learning Objective Apply the holding period for long-term and short-term capital gains and losses.

4-3 CALCuLATION Of GAIN OR LOSS A taxpayer must calculate the amount realized and the adjusted basis of property sold or exchanged to arrive at the amount of the gain or loss realized on the disposition. The tax- payer’s gain or loss is calculated using the following formula:

Amount realized 2 Adjusted basis 5 Gain or loss realized

4-3a Sale or Exchange The realization of a gain or loss requires the “sale or exchange” of an asset. The term “sale or exchange” is not defined in the tax law, but a sale generally requires the receipt of money or the relief from liabilities in exchange for property, and an exchange is the transfer of ownership of one property for another property.

EXAMpLE Maggie sells stock for $8,500 that she purchased 2 years ago for $6,000. Maggie’s adjusted basis in the stock is its cost, $6,000; therefore, she realizes a long-term capital gain of $2,500 ($8,500 2 $6,000) on the sale. ♦

4.3 Learning Objective Calculate the gain or loss on the disposition of an asset.

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4-4 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

EXAMpLE Art owns a home which has increased in value during the tax year. If Art does not sell the home, there is no realized gain during the tax year. ♦

4-3b Amount Realized The amount realized from a sale or other disposition of property is equal to the sum of the money received, plus the fair market value of other property received, less the costs paid to transfer the property. If the taxpayer is relieved of a liability, the amount of the liability is added to the amount realized.

EXAMpLE During the tax year, Ted sells real estate held as an investment for $75,000 in cash, and the buyer assumes the mortgage on the property of $120,000. Ted pays real estate commissions and other transfer costs of $11,000. The amount realized on the sale is calculated as:

Cash received $ 75,000 Liabilities transferred 120,000 Total sales price 195,000 Less: transfer costs (11,000) Amount realized $ 184,000 ♦

4-3c Adjusted Basis The adjusted basis of property is equal to the original basis adjusted by adding capital (major) improvements and deducting depreciation allowed or allowable, as illustrated by the following formula:

Adjusted basis 5 Original basis 1 Capital improvements 2 Accumulated depreciation

The original basis of property is usually its cost. The cost is the amount paid in cash, debt obligations, other property, or services. The original basis also includes amounts you pay for the sales tax, freight, installation and testing, excise taxes, revenue stamps, recording fees, and real estate taxes if you assume the liability of the seller. If the acquired asset is real property, certain fees and other expenses are part of the cost basis in the property such as the settlement fees and closing costs you paid for buying the property but does not include fees and costs for getting a loan on the property.

The following are some of the settlement fees or closing costs included in the basis of real property:

● Charges for installing utility services ● Legal fees (including fees for the title search and preparation of the sales contract

and deed) ● Recording fees ● Survey fees ● Transfer taxes ● Owner’s title insurance ● Any amounts the seller owes that you agree to pay, such as back taxes or interest, re-

cording or mortgage fees, charges for improvements or repairs, and sales commissions

The following are some of the settlement fees and closing costs that cannot be included in the basis of property:

● Amounts placed in escrow for the future payment of items such as taxes and insurance ● Casualty insurance premiums ● Rent for occupancy of the property before closing ● Charges for utilities or other services related to occupancy of the property before closing

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4-54-3 Calculation of Gain or Loss

● Charges connected with getting a loan, such as points (discount points, loan origina- tion fees), mortgage insurance premiums, loan assumption fees, cost of a credit report, and fees for an appraisal required by a lender

Capital improvements are major expenditures for permanent improvements to or restora- tion of the taxpayer’s property. These expenditures include amounts which result in an in- crease in the value of the taxpayer’s property or substantially increase the useful life of the property, as well as amounts which are spent to adapt property to a new use. For example, architect fees paid to plan an addition to a building, as well as the cost of the addition, must be added to the original basis of the asset as capital improvements. Ordinary repairs and maintenance expenditures are not capital expenditures.

EXAMpLE Alan and his wife purchased a house on September 15, 2019. Their closing statement for the purchase is illustrated on Pages 4-6 and 4-7. Their original tax basis in the house is equal to the purchase price of $130,000 plus the incidental costs of the owner’s title insurance (not lender’s), government recording fees, and transfer taxes. Therefore, their original basis is $130,740 ($130,000 1 $500 1 $50 1 $190). The loan origination fee represents “points” on the mortgage loan. If the house is their principal residence, the points are deductible as interest in the year of payment. The prorated interest and taxes affect their deductions for interest and taxes, as described in Chapter 5. The homeowners’ insurance is a nondeductible personal expense, assuming the house is their personal residence. ♦

EXAMpLE Paul acquired a rental house 4 years ago for $91,000. Depreciation claimed on the house for the 4 years totals $14,000. Paul installed a new patio at a cost of $2,500. The adjusted basis of the house is $79,500, as calculated below:

Adjusted basis 5 original basis 1 capital improvements 2 accumulated depreciation

$79,500 5 $91,000 1 $2,500 2 $14,000 ♦

If property is received from a decedent (as an inheritance), the original basis is generally equal to the fair market value at the decedent’s date of death. For property acquired as a gift, the amount of the donee’s basis depends on whether the property is sold for a gain or a loss by the donee. If a gain results from the disposition of the property, the donee’s basis is equal to the donor’s basis. If the disposition of the property results in a loss, the donee’s basis is equal to the lesser of the donor’s basis or the fair market value of the property on the date of the gift. When property acquired by gift is disposed of at an amount between the basis for gain and the basis for loss, no gain or loss is recognized. Note that the basis for gain and the basis for loss will be different only where the gifted property has a fair market value, on the date of the gift, that is less than the donor’s adjusted basis in the property.

EXAMpLE Ron received AT&T stock upon the death of his grandfather. The stock cost his grandfather $6,000 forty years ago and was worth $97,000 on the date of his grandfather’s death. Ron’s basis in the stock is $97,000. ♦

EXAMpLE Jane received a gift of stock from her mother. The stock cost her mother $9,000 five years ago and was worth $6,500 on the date of the gift. If the stock is sold by Jane for $12,000, her gain would be $3,000 ($12,000 2 $9,000). However, if the stock is sold for $5,000, the loss would be only $1,500 ($5,000 2 $6,500). If the stock is sold for an amount between $6,500 and $9,000, no gain or loss is recognized on the sale. ♦

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4-6 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

× ×

Alan & Julie Young 66 W. 2nd Street, Apt. 3F Peru, IN 46970

68 W. Canal Street Peru, IN 46970

Chris and Fiona Everett 89 Payson Street Denver, IN 46926

2nd Farmers Bank 120 N. Broadway Peru, IN 46970

$130,000.00

$4,354.40

$1,000.0010/1/2019 12/31/2019 10/1/2019 12/31/2019

$135,354.40

$1,000.00

$104,000.00

$130,000.00

$1,000.00

$131,000.00

$8,240.00

$105,000.00

$135,354.40

$30,354.40

$8,240.00

$131,000.00 $8,240.00

$122,760.00

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4-74-3 Calculation of Gain or Loss

$7,800

3,900.00

ABC Realtor

XYZ Realtor

incl. origination points (1% or $1,040.00) 1,040.00

9/15/19 10/31/19 11.40

1 ($600 P.O.C.)

50.00

100.00

50.00

200.00

Title Company, Inc.

130,000.00 130,000.00

25.00 25.00 15.00

130.00

60.00

Pest Inspection

Home warranty

75.00 100.00

$4,354.40 $8,240.00

$100.00

$75.00

$15.00

$50.00

$190.00

$500.00

$1,350.00

Title Company Inc

Underwriter

300.00

75.00

500.00

100.00 $250.00

$250.00

$524.40

$1,040.00

$400.00

$50.00

$7,800.00

Appraisers R Us

Equifacts

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4-8 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

Self-Study problem 4.3 See Appendix E for Solutions to Self-Study Problems

Supply the missing information in the following blanks:

Original Cost Accumulated Depreciation

Capital Improvements Adjusted Basis

1. $15,000 $5,000 $1,000 $ 2. 15,000 8,000 9,000 3. 30,000 2,000 17,000 4. 9,000 4,000 18,000

4-4 NET CApITAL GAINS In recent years, the tax rates on long-term and short-term capital gains have become complex. Short-term capital gains are taxed as ordinary income, while there are various different preferential long-term capital gains tax rates. The 2019 capital gains tax rates are as follows:

Learning Objective 4.4 Compute the tax on capital gains.

The application of the typical long-term capital gains rates of 0, 15, or 20 percent depends on the taxable income and filing status of the taxpayer. Formerly, the different rates applied to a taxpayer depending on which ordinary tax bracket the taxpayer was in (e.g., a taxpayer in the 12 percent tax bracket would pay tax on long-term gains at 0 percent since 15 per- cent is not preferential). The current long-term capital gains tax rates do not align perfectly with the existing ordinary income tax rates. For 2019, typical long-term capital gains (and dividends as discussed in Chapter 2) are taxed as follows:

Income level Long-term capital gains rate*

Married filing jointly $0–$78,750 0% $78,751–$488,850 15% .$488,850 20%

Single $0–$39,375 0% $39,376–$434,550 15% .$434,550 20%

Type of Gains Tax Rate*

Short-Term Capital Gains Taxed at ordinary income rates consistent with filing status

Typical Long-Term Capital Gains Taxed at 0, 15, or 20 percent depending on level of other taxable income (see Chapter 2)

Long-Term Unrecaptured Section 1250 Gain (see Chapter 8)

Capped at 25 percent

Long-Term Collectibles Gains (Art, Gems, Coins, Stamps, etc.)

Capped at 28 percent

*The 3.8 percent Medicare tax on net investment income, including qualifying dividends, applies to high-income taxpayers with income over certain thresholds. Please see Chapter 6 for further details.

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4-94-4 Net Capital Gains

Head of household $0–$52,750 0% $52,751–$461,700 15% .$461,700 20%

Married filing separately $0–$39,375 0% $39,376–$244,425 15% .$244,425 20% *Special higher rates for “high-income” taxpayers are covered in Chapter 6.

The 2019 break points between the ordinary rates and the typical long-term capital gains rates differ by minor amounts. For example, a single taxpayer moves from an ordinary in- come tax rate of 12 percent to 22 percent at $39,475; whereas the same taxpayer moves from a 0 percent to 15 percent long-term capital gains tax rate at $39,375.

EXAMpLE Dee is a single taxpayer with wage income of $44,000 and long-term capital gains of $8,000 in 2019. Assume Dee has no other deductions or income except the standard deduction. Dee’s taxable income is

Wage income $44,000 Long-term capital gains 8,000 Standard deduction (12,200) Exemption (repealed by the TCJA) 0 Taxable income $39,800

Dee’s income now must be separated into the ordinary and long-term capital gain portions:

Taxable income $39,800 Long-term capital gains (8,000) Ordinary income $31,800

The 2019 tax on $31,800 of ordinary income is $3,625. Dee’s taxable income without the long-term gain is below the 15 percent threshold of $39,375 for a single taxpayer in 2019, but her taxable income with the long-term gain is above the threshold; thus a part of the long-term gain will be taxed at 0 percent and a part at 15 percent. Of her $8,000 long-term capital gain, $7,575 is below the threshold and taxed at 0 percent while $425 is above the threshold and is taxed at 15 percent for an additional capital gains tax of $64 to bring Dee’s total tax liability to $3,689. The Qualified Dividends and Capital Gain Tax Worksheet introduced in Chapter 2 can be used to calculate the ordinary and long-term capital gains tax. ♦

4-4a Ordering Rules for Capital Gains Since there are multiple kinds of capital gains on which to calculate tax, an ordering system is necessary to know which capital gains to tax at what rates. The various kinds of gains are included in taxable income in the following order:

1. Short-term capital gains 2. Unrecaptured Section 1250 gains on real estate 3. Gains on collectibles 4. Long-term capital gains

If taxpayers (or tax practitioners) have several different types of capital gains that interact with each other, the calculation may become very complex. A good tax preparation software will provide the calculation along with supporting worksheets for further review. The rules for the taxation of capital gains are exceptionally complex, and a complete discussion of them is beyond the scope of this textbook.

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4-10 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

Taxpayer Net LT Capital Gain or (Loss)

Net ST Capital Gain or (Loss)

Net Capital Position

Taxable LT Gain

Taxable ST Gain

A. $10,000 $ 0 $ 10,000 $10,000 $ 0 B. 10,000 (4,000) 6,000 6,000 0 C. 0 20,000 20,000 0 20,000 D. 0 (20,000) (20,000) 0 0 E. 10,000 8,000 18,000 10,000 8,000 F. (8,000) 12,000 4,000 0 4,000 G. (8,000) (6,000) (14,000) 0 0

♦

EXAMpLE The net capital gain computation is illustrated in the following table:

Self-Study problem 4.4 See Appendix E for Solutions to Self-Study Problems

In October 2019, Jack, a single taxpayer, sold IBM stock for $12,000, which he purchased 4 years ago for $4,000. He also sold GM stock for $14,000, which cost $17,500 3 years ago, and he had a short-term capital loss of $1,800 on the sale of land. If Jack’s other taxable income (salary) is $78,000, what is the amount of Jack’s tax on these capital transactions?

4-5 NET CApITAL LOSSES

4-5a Calculation of Net Capital Losses The computation of an individual taxpayer’s net capital loss is accomplished in a manner similar to the computation of a net capital gain. A net capital loss is incurred when the total capital losses for the period exceed the total capital gains for the period.

EXAMpLE Connie has net long-term capital gains of $6,500 and a short-term capital loss of $8,000. The net short-term capital loss is $1,500 ($6,500 2 $8,000). ♦

Learning Objective 4.5 Describe the treatment of capital losses.

4-4b Calculation of a Net Capital position If a taxpayer has a “net long-term capital gain” (net long-term capital gain in excess of net short-term capital loss), the gain is subject to a preferential tax rate as discussed above. Thus, a taxpayer has to net all of the long-term and short-term capital transactions that take place during a year to calculate tax liability. In calculating a taxpayer’s net capital gain or net capital loss, the following procedure is followed:

1. Capital gains and losses are classified into two groups, long-term and short-term. 2. Long-term capital gains are offset by long-term capital losses, resulting in either a net

long-term capital gain or a net long-term capital loss. 3. Short-term capital gains are offset by short-term capital losses, resulting in a net short-

term capital gain or a net short-term capital loss. 4. If Step 2 above results in a net long-term capital gain, it is offset by any net short-term

capital loss (Step 3), resulting in either a net long-term capital gain (net long-term capital gain exceeds net short-term capital loss) or a net short-term capital loss (net short-term capital loss exceeds net long-term capital gain). If Step 2 above results in a net long-term capital loss, it is offset against any net short-term capital gain (Step 3), resulting in either a net long-term capital loss (net long-term capital loss exceeds net short-term capital gain) or ordinary income (net short-term capital gain exceeds net long-term capital loss).

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4-114-5 Net Capital Losses

EXAMpLE Delvin has net long-term capital losses of $8,000 and a short-term capital gain of $4,500. The net long-term capital loss is $3,500 ($4,500 2 $8,000). ♦

4-5b Treatment of Net Capital Losses Individual taxpayers may deduct net capital losses against ordinary income in amounts up to $3,000 per year. Unused capital losses in a particular year may be carried forward indefi- nitely. Capital losses and capital loss carryovers first offset capital gains using the ordering rules discussed on the next page. Any remaining net capital loss may be used to offset ordinary income, subject to the $3,000 annual limitation.

EXAMpLE Carter has a net long-term capital loss of $15,000 and other taxable income for the year of $25,000. He may deduct $3,000 of the loss against the $25,000 of other taxable income. The remaining capital loss of $12,000 ($15,000 2 $3,000) is carried forward to future years. ♦

When unused capital losses are carried forward, they maintain their character as either long-term or short-term. If a taxpayer has both net long-term losses and net short-term losses in the same year, the net short-term losses are deducted first.

EXAMpLE Frances has a long-term capital loss of $7,000 and a $2,000 short-term capital loss in Year 1. For that year, Frances may deduct $3,000 in capital losses, the $2,000 short-term capital loss, and $1,000 of the long-term capital loss. Her carryforward would be a $6,000 long-term capital loss. If Frances has no capital gains or losses in Year 2, she would deduct $3,000 in long-term capital losses and carry forward $3,000 ($6,000 2 $3,000) to Year 3. Assuming she has no other capital gains and losses, the deduction of losses by year can be summarized as follows:

Year 1 Year 2 Year 3 Long-term capital loss $7,000 $6,000 $3,000 Short-term capital loss 2,000 0 0 Deduction 3,000 3,000 3,000 Long-term capital loss used 1,000 3,000 3,000 Carryforward, long-term capital loss 6,000 3,000 0 ♦

4-5c personal Capital Losses Losses from the sale of personal capital assets are not allowed for tax purposes. For in- stance, the sale of a personal automobile at a loss or the sale of a personal residence at a loss does not generate a tax-deductible capital loss for individual taxpayers.

EXAMpLE Rose moved to a nursing home in 2019 and sold both her personal auto and her principal residence. She originally purchased her auto for $20,000 and sold it for $10,000. She originally purchased her residence for $125,000 and sold it for $100,000. The losses on these sales are not tax deductible to Rose because the assets were personal-use assets. ♦

Taxpayers who have recognized a large capital loss during the year may wish to sell stock or other property to generate enough capital gains prior to year-end to use up all but $3,000 of the capital loss. This way, the capital loss in excess of $3,000 will be used in the current period rather than carried forward, and the capital gains will be fully sheltered from tax.

TAX BREAK

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4-12 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

4-5d Ordering Rules for Capital Losses When a taxpayer ends up with net capital losses, the losses offset capital gains using the following ordering rules:

● Net short-term capital losses first reduce 28 percent gains, then 25 percent gains, then regular long-term capital gains.

● Net long-term capital losses first reduce 28 percent gains, then 25 percent gains, then any short-term capital gains.

As with the ordering rules for capital gains, the ordering calculation may become quite complex when different classes of capital assets are present. A detailed discussion is beyond the scope of this textbook.

Self-Study problem 4.5 See Appendix E for Solutions to Self-Study Problems

During 2019, Louis Winthorp, who is single, received the following Form 1099-B:

He also received the following information (1099-B not shown):

Description Date Acquired Date Sold Selling Price Cost Basis

100 shs. 04/18/19 12/07/19 $12,000 $19,200 Rose stock 50 shs. 12/18/11 10/02/19 25,000 21,000 Blue stock

The basis was reported to the IRS for all sales. His taxable income is $59,000 (including gains and losses from above). Calculate Louis’ net capital gain or loss and tax liability using Schedule D of Form 1040, Parts I, II, and III; Form 8949, Parts I and II; and the Qualified Dividends and Capital Gain Tax Worksheet on Pages 4-13 to 4-17.

Duke Brothers Brokerage 135 S. Broad Street Philadelphia, PA 19103

08/15/20196/21/2010

18,000.00 12,500.00

100 sh. Purple Corp.

Box D

34-9876543 123-44-3214

Louis Winthorp

2014 Delancey Street

Philadelphia, PA 19103

0.00

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4-134-5 Net Capital Losses

Self-Study problem 4.5

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4-14 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-154-5 Net Capital Losses

Self-Study problem 4.5

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4-16 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-174-5 Net Capital Losses

Self-Study problem 4.5

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4-18 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-194-6 Sale of a Personal Residence

4-6 SALE Of A pERSONAL RESIdENCE

4-6a Sales After May 6, 1997 For gains on the sale of a personal residence after May 6, 1997, a seller who has owned and used a home as a principal residence for at least 2 of the last 5 years before the sale can exclude from income up to $250,000 of gain ($500,000 for joint return filers). In general, this personal residence exclusion can be used only once every 2 years. A personal residence includes single-family homes, mobile homes, houseboats, condominiums, cooperative apartments, duplexes, or row houses.

EXAMpLE Joe, a single taxpayer, bought his home 22 years ago for $25,000. He has lived in the home continuously since he purchased it. In November 2019, he sells his home for $300,000. Therefore, his realized gain on the sale of his personal residence is $275,000 ($300,000 2 $25,000). Joe’s recognized taxable gain on this sale is $25,000, which is his total gain of $275,000 less the exclusion of $250,000. ♦

A seller otherwise qualified to exclude gain on a principal residence who fails to satisfy the 2-year ownership and use requirements may calculate the amount of excluded gain by prorating the exclusion amount if the residence sale is due to an employment-related move, health, or unforeseen circumstances. Unforeseen circumstances include death, divorce or separation, a change in employment that leaves the taxpayer unable to pay the mortgage, multiple births from the same pregnancy, and becoming eligible for unemployment compensation. The $250,000 or $500,000 exclusion amount is prorated by multiplying the exclusion amount by the length of time the taxpayer owned and used the home divided by 2 years.

EXAMpLE John is a single taxpayer who owns and uses his principal residence for 1 year. He then sells the residence due to an employment-related move at a $100,000 gain. Because he may exclude up to one-half (1 year divided by 2 years) of the $250,000 exclusion amount, or $125,000, none of his gain is taxable. ♦

4-6b Married Taxpayers Taxpayers who are married and file a joint return for the year of sale may exclude up to $500,000 of gain realized on the sale of a personal residence. The full $500,000 for a mar- ried couple can be excluded if:

1. Either spouse owned the home for at least 2 of the 5 years before the sale, 2. Both spouses used the home as a principal residence for at least 2 of the last 5 years, and 3. Neither spouse has used the exclusion during the prior 2 years.

EXAMpLE Don and Dolly have been married for 20 years. At the time they were married, they purchased a home for $200,000 and have lived in the home since their marriage. Don and Dolly sell their home for $800,000 and retire to Arizona. Their realized gain on the sale is $600,000 ($800,000 2 $200,000), of which only $100,000 is taxable because of the $500,000 exclusion. ♦

The $500,000 exclusion for married taxpayers has been extended to spouses who sell the residence within 2 years of their spouse’s death. If a portion of the sale of a residence is taxable, then it should be reported (e.g., Form 8949 using Code H and Schedule D). If no portion is taxable, then no reporting is generally required.

Beginning in 2009, Congress closed a loophole in the residence gain exclusion laws, which was used effectively by some owners of multiple rental properties. Under the residence gain exclusion laws in operation prior to 2009, taxpayers with multiple rental properties could move into a previously rented property every 2 years, reside in the property for the required 2-year period, and then sell the property using the $250,000 or $500,000 gain exclusion. Over a period of 10 years, a married couple could theoretically exclude $2.5 million of taxable gain on five separate properties. Beginning in 2009, taxpayers who rent their residence prior to their

4.6 Learning Objective Apply the exclusion of gain from personal residence sales.

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4-20 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

2 years of personal use are generally limited to an exclusion smaller than the full $250,000 or $500,000 amounts. For details, examples, and exceptions to the law, visit www.irs.gov.

4-6c Sales Before May 7, 1997 Please note: The law below no longer applies to sales of principal residences. How- ever, because many taxpayers still own residences with “rollover” basis determined under this law, it is important to understand how the law operated.

For sales of a personal residence before May 7, 1997, taxpayers did not have to recognize gain on the sale if they rolled the gain into a new house with a cost as high as the adjusted sales price of the old residence. The adjusted sales price was the amount realized on the sale less any qualified fixing-up expenses. Fixing-up expenses must have been incurred within 90 days prior to the date of sale and paid within 30 days after the date of sale. In addition, the purchase of the new residence had to be within 2 years of the date of sale of the old residence to qualify for nonrecognition of the gain. The adjusted basis of the new residence was reduced by any gain not recognized on the sale of the old residence.

EXAMpLE Mary sold her personal residence for $60,000 in 1994 and paid selling expenses of $3,600. Mary had fixing-up expenses of $1,400, and the basis of her old residence was $40,000. If Mary purchased a new residence within 2 years for $85,000, her recognized gain and the basis of the new residence was calculated as follows:

1. Sales price $ 60,000 Less: selling expenses (3,600) Amount realized 56,400 Adjusted basis of the old residence (40,000) Gain realized on the sale $ 16,400

2. Amount realized $ 56,400 Less: fixing-up expenses (1,400) Adjusted sales price 55,000 Less: cost of the new residence (85,000) Gain recognized $ 0

3. Gain realized $ 16,400 Less: gain recognized (0) Gain not recognized (deferred) $ 16,400

4. Cost of the new residence $ 85,000 Less: gain deferred (16,400) Basis of the new residence $ 68,600 ♦

EXAMpLE Assume instead that Mary paid only $50,000 for a new residence. The gain and basis of the new residence are calculated as follows:

1. Adjusted sales price (from above) $ 55,000 Less: cost of new residence (50,000) Gain recognized $ 5,000

2. Gain realized (from above example) $ 16,400 Less: gain recognized (5,000) Gain not recognized (deferred) $ 11,400

3. Cost of the new residence $ 50,000 Less: gain deferred (11,400) Basis of the new residence $ 38,600 ♦

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4-214-6 Sale of a Personal Residence

The calculations on the previous page show that a taxpayer who sold one or more principal residences over a period of years and has a “rollover” basis under the old law may have a principal residence basis that is far lower than the cost of the taxpayer’s residence. Because the current law does not require rollover treatment, taxpayers receive a fresh basis in a newly purchased residence which is equal to the purchase price.

Self-Study problem 4.6 See Appendix E for Solutions to Self-Study Problems

Mike, a single taxpayer, purchased a house 20 years ago for $30,000. He sells the house in December 2019 for $350,000. He has always lived in the house.

a. How much taxable gain does Mike have from the sale of his personal residence? $

b. Assume Mike married Mary 3 years ago and she has lived in the house since their marriage. If they sell the house in December 2019 for $350,000, what is their taxable gain on a joint tax return?

$ c. Assume Mike is not married and purchased the house only 1 year ago for

$200,000, and he sells the house for $350,000 due to an employment-related move. What is Mike’s taxable gain?

The IRS has ruled that, in certain cases, a yacht may qualify as a taxpayer’s principal residence.

Would You

Believe?

Ivy Tower (age 45), a history professor at Coastal State University, recently purchased a house near the beach. In the current year, she accepted an offer from a buyer who wants to make the house into a bed and breakfast. Ivy sold her personal residence for a $100,000 gain. She owned the house 11 months as of the date of sale. After the sale closed, she discovered that the $100,000 is taxable as a short-term taxable gain (i.e., ordinary income) because she had not lived there the 2 years required for exclusion of gain on the sale of a residence. She is upset that she will have to pay substantial tax on the sale. Her best friend’s husband is an M.D. who signed a letter that Ivy had to move due to the dampness and humidity at the beach. She is not a regular patient of the doctor and Ivy has no history of respiratory problems. Ivy claims she meets the medical extraordinary circumstances exception and therefore refuses to report the gain on her Form 1040. If Ivy were your tax client, would you sign the Paid Preparer’s declaration (see example above) on her return? Why or why not?

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Would You Sign This

Tax Return?

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4-22 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

4-7 RENTAL INCOME ANd EXpENSES The net income from rental property is taxable income to the taxpayer. In most cases, rental income is reported with the related expenses on Part I of Schedule E. If services are provided to the tenant beyond those customarily provided, such as cleaning and maid services, the income is reported on Schedule C and is subject to the self-employment tax. Expenditures deductible as rental expenses include real estate taxes, mortgage interest, insurance, com- missions, repairs, and depreciation.

EXAMpLE June Sanchez owns a house that she rents to a tenant for $600 per month. The following are her expenses for the year:

Real estate taxes $ 800 Mortgage interest 2,000 Insurance 200 Rent collection commissions 432 General repairs 350

June bought the property on July 1, 2003, and her original basis for depreciation of the house is $55,000. She uses straight-line depreciation with a 27.5 year life.

In 2019, June bought a new stove for the rental house that cost $500. The stove has a 5-year life, and 20 percent of the stove’s cost is depreciated this year. June’s net rental income for the year is calculated as follows:

Rental income ($600 3 12) $ 7,200 Less expenses: Real estate taxes $ 800 Mortgage interest 2,000 Insurance 200 Commissions 432 General repairs 350 Depreciation: House ($55,000/27.5) $ 2,000 Stove ($500 3 20%) 100 Total expenses (5,882) Net rental income $ 1,318

Please note that depreciation is an advanced topic which will be covered in detail in Chapter 8. ♦

4-7a Vacation homes Many taxpayers own residences which they use personally as part-year residences and rent during the remainder of the year. Such part-year rental properties are often referred to as “vacation homes.” The tax law limits the deduction of expenses associated with the rental of vacation homes.

EXAMpLE Jean owns a condo in Vail, Colorado. The condo is rented for 3 months during the year and is used by Jean for 1 month. If there were no vacation home limitations, Jean could deduct 11 months’ worth of depreciation, maintenance, and other costs associated with the property. The resulting loss could then be deducted against Jean’s other taxable income. ♦

To prevent taxpayers from claiming a deduction for expenses effectively personal in nature (associated with a personal residence), the tax law limits the deductions a taxpayer can claim for expenses associated with a vacation home. Deductions attributable to

Learning Objective 4.7 Apply the tax rules for rental property and vacation homes.

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4-234-7 Rental Income and Expenses

vacation homes used primarily as personal residences are limited to the income generated from the rental of the property. In general, only profit or breakeven (no loss) tax situations are allowed on the rental of vacation homes.

The expenses associated with the rental of a residence used for both personal and rental purposes are subject to three possible tax treatments. The tax treatment depends on the period of time the residence is used for personal versus rental purposes.

1. Primarily Personal Use If a residence is rented for fewer than 15 days during the year, the rental period is dis- regarded and it is treated as a personal residence for tax purposes. The rental income is not taxable and the mortgage interest and real estate taxes may be allowed as itemized deductions. Other expenses, such as utilities and maintenance, are considered nonde- ductible personal expenses.

EXAMpLE Glenn owns a lake home. During the year he rented the home for $1,800 for 2 weeks, lived in the home for 3 months, and left the home vacant during the remainder of the year. The expenses for the lake home included $5,000 in mortgage interest, $700 in property taxes, $2,100 in utilities and maintenance, and $3,000 in depreciation. Since the lake home was rented for fewer than 15 days, Glenn would not report the $1,800 of income and would deduct only the interest and property taxes as itemized deductions on Schedule A. The other expenses are nondeductible personal expenses. ♦

2. Primarily Rental Use If the residence is rented for 15 days or more and is used for personal purposes for not more than 14 days or 10 percent of the days rented, whichever is greater, the residence is treated as rental property. The expenses must then be allocated between the personal and rental days. If this is the case, the rental expenses may exceed the rental income, and the resulting loss would be deducted against other income, subject to the passive loss rules. (See LO 4.8 for further details.)

EXAMpLE Assume the same facts as in the preceding example except that the $1,800 rental fee is for 20 days and Glenn uses the lake home for only 10 days during the year. Since the lake home is now rented for 15 days or more and Glenn’s use of the home is not more than 14 days (or 10 percent of the days rented, if greater), the property is treated partially as rental property and partially as a personal residence. Allocation of expenses associated with the home is based on the number of days of rental or personal use compared to the total number of days of use. Glenn’s personal use percentage is 33.33 percent (10 days/30 days) and the rental portion is 66.67 percent (20 days/30 days). For tax purposes, the rental income or loss is calculated as follows:

Rental Personal (66.67%) (33.33%)

Income $ 1,800 $ 0 Interest and taxes (3,800) (1,900) Utilities and maintenance (1,400) (700) Depreciation (2,000) (1,000) Rental loss $ (5,400) $ 0

The interest and taxes allocable to Glenn’s personal use of the property may be deductible as itemized deductions on Schedule A (see Chapter 5). The personal portion of utilities, maintenance, and depreciation are nondeductible personal expenses. ♦

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4-24 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

3. Rental/Personal Use If the residence is rented for 15 days or more and is used for personal purposes for more than 14 days or 10 percent of the days rented, whichever is greater, allocable rental expenses are allowed only to the extent of rental income. Allocable rental expenses are deducted in three separate steps: first, the interest and taxes are deducted; second, utilities and maintenance expenses are deducted; and third, depreciation expense is deducted. For utilities, maintenance, and depreciation expenses to be deductible, there must be positive income following the deduction of items in the preceding step(s). In addition, the expenses, other than interest and taxes, are only deductible to the extent of that positive income. Expenses are allocated between the rental and personal days before the limits are applied. The IRS requires that the allocation be on the basis of the total days of rental use or personal use divided by the total days of use.

EXAMpLE Assume Glenn rents the lake home for $2,500 for 20 days and uses it for personal purposes for 60 days. Assume Glenn has the same operating expenses as in the previous examples. Since the lake home is rented for 15 days or more and Glenn uses the home for personal purposes for more than 14 days (or 10 percent of the days rented, if greater), the property is subject to the vacation home limitations. Glenn’s personal use percentage is 75 percent (60 days/80 days) and the rental portion is 25 percent (20 days/80 days). The IRS requires that the rental income or loss be calculated as follows:

Gross rental income $ 2,500 Less: interest and taxes ($5,700 3 25%) (1,425) Balance 1,075 Less: utilities and maintenance ($2,100 3 25%) (525) Balance 550 Less: depreciation ($3,000 3 25%, limited to $550) (550) Net income $ 0

It should be noted that the U.S. Tax Court has allowed taxpayers to use 365 days for the allocation of interest and taxes. Under the Tax Court rules, the interest and taxes allocable to the rental use of the property in the above example would be 5.5 percent (20 days/365 days) instead of 25 percent (20 days/80 days). The allocation of utilities and maintenance would remain unchanged, while a full $750 of depreciation (25% of $3,000) would be allowed. The remaining interest and taxes (345 days/365 days) would be included in itemized deductions.

tIp Rental activity is entered under Income and then Rental and Royalty Income (Schedule E). Key fields to consider are the Type of Property (dropdown), the number of days rented, the number of days of personal use (located below the expenses fields), and the number of days owned (if the Tax Court method is to be used).

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4-254-8 Passive Loss Limitations

Self-Study problem 4.7 See Appendix E for Solutions to Self-Study Problems

Janet Randolf lives in a duplex that she owns at 14 Lancaster Drive, Salem, OR 97305. Janet rents one-half of her duplex and lives in the other half. Her rental income for the year is $6,000. Janet’s basis for depreciation in the rental portion is $15,000, and she uses straight- line depreciation with a 27.5 year useful life. On the whole duplex, real estate taxes are $1,200, interest on the mortgage is $3,400, utilities are $1,800, and insurance is $450. Use Part I of Schedule E on Page 4-27 to report Janet’s income from rental of part of the duplex.

4-8 pASSIVE LOSS LIMITATIONS Because of past abuses primarily involving tax shelters and loss deductions from rental real estate, Congress enacted legislation limiting the deduction of certain “passive” losses from other taxable income. A passive activity is a trade or business in which the taxpayer does not materially participate and most rental real estate activity. Because the most common passive loss seen on tax returns is from ordinary real estate rental activities, many taxpayers with an investment in a real estate rental property are affected by these rules. In establishing the limitations, the tax law classifies individual income into three categories. These catego- ries are (1) active income (e.g., wages, self-employment income, and salaries), (2) portfolio income (e.g., dividends and interest), and (3) passive income and losses (e.g., rental real estate income and loss, and income and loss passed through from limited partnerships and other ventures in which the taxpayer has minimal or no involvement).

Generally, passive losses cannot be used to offset either active or portfolio income. Also, any tax credits derived from passive activities can only offset income taxes attributable to passive income. Any unused passive losses and credits are carried over and may be used to offset future passive income or taxes attributable to such income, respectively. Generally, losses remaining when the taxpayer disposes of his or her entire interest in the passive activity may be used in full; however, the taxpayer can only use remaining credits to offset the income tax arising from any gain recognized on the disposition of the activity.

EXAMpLE Mike’s income items for 2019 are:

Salary $40,000 Sales commissions 15,000 Dividends on Microsoft stock 2,000 Rental income from real estate 5,000 Loss from limited partnership (9,000) Interest on savings account 4,000

Mike’s active income for the year is $55,000 ($40,000 1 $15,000), his portfolio income is $6,000 ($2,000 1 $4,000), and his passive loss is $4,000 ($5,000 2 $9,000). Mike must report gross income of $61,000 ($55,000 1 $6,000), since the passive loss cannot be used to offset his active or portfolio income. The net passive loss of $4,000 will be carried over to 2020. ♦

Under the passive loss rules, real estate rental activities are specifically defined as passive, even if the taxpayer actively manages the property and even if the activity is not conducted as a partnership. Individual taxpayers, however, may deduct up to $25,000 of rental property losses against other income, if they are actively involved in the management of the property and their income does not exceed certain limits. The $25,000 loss deduction is phased out when the taxpayer’s modified adjusted gross income (adjusted gross income before passive losses and Individual Retirement Account deductions) exceeds $100,000. The $25,000 is reduced by 50 cents for each $1.00 the taxpayer’s modified adjusted gross income

4.8 Learning Objective Explain the treatment of passive income and losses.

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4-26 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

exceeds that amount. Therefore, no deduction is allowed when the taxpayer’s modified adjusted gross income reaches $150,000 (this threshold is not adjusted for inflation). Special limitations apply to taxpayers filing as Married, Filing Separately and claiming a deduction for real estate rental losses under this special rule.

EXAMpLE Mary has modified AGI before passive losses of $120,000. In addition, she has a rental house that she actively manages which shows a loss of $18,000 for the year. She may deduct only $15,000 ($25,000 2 50% of $20,000) of the loss because of the phase-out of the $25,000 allowance for passive rental losses where modified AGI is over $100,000. ♦

4-8a Real Estate Rental as Trade or Business Taxpayers heavily involved in real estate rental activities may qualify as having an active business rather than a passive activity. If so, the income and losses from qualified rental activities are not subject to passive loss limitations. For a real estate rental to be considered active, the taxpayer must materially participate in the activity. An individual will satisfy this requirement if both of the following are met:

1. More than 50 percent of the individual’s personal service during the tax year is per- formed in real property trades or businesses, and

2. The individual performs more than 750 hours of service during the tax year in the real property trade or business in which he or she claims material participation.

EXAMpLE In 2019, Allan owns eighteen rental houses and spends 100 percent of his personal service time (1,800 hours in 2019) managing them. Allan spends his 1,800 hours of management time doing repairs, gardening, collecting rents, cleaning and painting vacant houses, advertising for and interviewing new tenants, doing bookkeeping, and purchasing/installing new appliances, drapes, carpets, and toilets. He keeps a log to prove how many hours he works on his property in case he is audited. Since both the above tests are met, Allan’s real estate rental activity is not a passive activity. If Allan has an overall loss of $40,000 on the real estate rentals, he can deduct the entire loss on his tax return as an active business, not a passive loss. ♦

The Tax Reform Act of 1986 (TRA 86) introduced the concept of a passive loss limitation. TRA 86 also introduced the active management exception of $25,000 with a phase-out starting at $100,000 of AGI. These amounts have not been adjusted since. For tax year 1987, about 2 million individual income tax returns (about 2 percent) had adjusted gross income of $100,000 or more. In the 2016 tax year (most recent complete year released by the IRS), 18 percent of individual tax returns reported AGI of $100,000 or more. Clearly, far fewer taxpayers are eligible for the exception today.

Would You

Believe? tIp

ProConnect assumes that a rental property is actively managed and will apply the appropriate phase-out based on the modified AGI information entered elsewhere. There is a box on the General Information page of the rental property section to indicate otherwise.

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4-274-8 Passive Loss Limitations

Self-Study problem 4.7

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4-28 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-294-9 Net Operating Losses

Income from passive activities can be used by taxpayers to absorb passive losses that would otherwise be disallowed. The passive loss limitations are very complex. Certain oil and gas investments are not subject to the passive loss limitations, and special rules apply to investments in qualified low-income housing.

Self-Study problem 4.8 See Appendix E for Solutions to Self-Study Problems

Sherry Moore has a limited partnership investment in a commercial rental project in which she has no personal involvement. During 2019, her share of the partnership loss equals $15,000. Sherry also has a rental house that she actively manages, and this activity generated a $21,000 loss for 2019. Sherry had no passive loss carryover from prior years. If Sherry’s modified adjusted gross income before passive losses is $102,000, calculate the deduction amounts for Sherry’s 2019 tax return using Form 8582 on Page 4-32.

4-9 NET OpERATING LOSSES Under the U.S. tax law, taxpayers are required to file an annual tax return. The pattern of a taxpayer’s income, however, can lead to inequities among taxpayers with the same total amount of taxable income over a number of years. To alleviate this problem, Congress enacted the Net Operating Loss (NOL) provision.

The NOL provision is primarily designed to provide relief for trade or business losses. Generally, only losses from the operation of a trade or business and casualty and theft losses can generate a net operating loss. Thus, individual taxpayers with only wages, itemized deductions (except casualty losses), and personal exemptions (although currently suspended) cannot generate a net operating loss.

The tax law is designed to permit individuals to deduct business NOLs and prevent the deductions of nonbusiness NOLs. Thus, the NOL computation for individual taxpayers requires the categorization of items of income, deductions, gains, and losses as either business or nonbusiness related. The NOL is not simply the total taxable loss shown on page 1 of Form 1040. In general, when calculating a current net operating loss, the following tax items should be considered:

● No personal or dependency exemptions (exemptions are suspended after 2017) ● No deduction for an NOL from a different year ● Capital losses in excess of capital gains are not allowed ● “Nonbusiness” capital losses (those arising outside of a trade or business, or employ-

ment) can only be used against “nonbusiness” capital gains. Excess capital losses can- not increase the NOL

● “Business” capital losses can only be used against “business” capital gains, except that they can be used to offset a net nonbusiness capital gain if one exists

● “Nonbusiness” deductions (e.g., charitable donations, deductible medical expenses, mort- gage interest, alimony, etc.) can only be used against “nonbusiness” income (interest, dividends, etc.). However, if nonbusiness capital gains exceed nonbusiness capital losses (see above), “excess” nonbusiness deductions can be offset against these gains. (Note that casualty losses are treated as “business deductions” for NOL purposes.)

EXAMpLE Yujian, a single taxpayer, has completed her 2019 Schedule C and her net loss is $70,000. She also has wages of $45,000 and interest income

4.9 Learning Objective Describe the basic tax treatment of deductions for net operating losses.

Rental real estate is a common form of passive income and is input through the Rental and Royalty Income (Sch E) window. Another source of passive income is from partnerships, LLCs or S corporations. As discussed in Chapters 10 and 11, these entities report income to individual owners through a Schedule K-1. K-1 income is input under Income in the left margin and the applicable Partnership K-1 or S Corporation K-1 input.

tIp

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from her savings of $500. Her business sold property during the year and generated a $3,000 ordinary gain and a separate $5,000 long-term capital gain. Yujian also had several capital gains and losses from the sale of stock investments. Her net results are a $17,000 short-term capital gain and a $6,000 long-term capital loss from these stock sales. Yujian itemizes her deductions and her Schedule A reports the following:

Taxes paid $ 8,500 Mortgage interest 6,000 Charitable gifts 500 Casualty loss (federal disaster area loss) 2,500 Total itemized deductions $ 17,500

Yujian calculates her taxable income as follows: Wages $ 45,000 Interest income 500 Business loss (70,000) Capital gains1 16,000 Other gains 3,000 Total income (loss) and AGI (5,500) Itemized deductions (17,500) Taxable income (loss) $(23,000) To compute Yujian’s NOL, we need to categorize business and non-

business items: Business Nonbusiness

Wages $ 45,000 Interest income $ 500 Business loss (70,000) Capital gains 5,000 11,000 Other gains 3,000 Itemized deductions (2,500) (15,000) Total $(19,500) $ (3,500)

Using the above information, we can modify taxable income to compute the NOL.

Step 1: Excess nonbusiness capital losses cannot exceed nonbusiness capital gains.

Since the $6,000 nonbusiness capital losses do not exceed $17,000 of nonbusiness capital gains, no adjustment is required. In addition, we can use the $11,000 “excess” nonbusiness capital gain to absorb any nonbusiness deductions in the next step.

Step 2: Nonbusiness deductions cannot exceed nonbusiness income. Nonbusiness deductions $15,000 2 Nonbusiness income $500 5 Net

nonbusiness deductions $14,500 However, as previously mentioned, net nonbusiness deductions can also

offset any net nonbusiness capital gains. Thus $11,000 of the nonbusiness deductions can be used; however, the remaining $3,500 ($14,500 2 $11,000) are not deductible and must be added back to the tentative NOL $(23,000) 1 $3,500 5 $(19,500).

1$1,000 long-term capital loss ($5,000 long-term capital gain from business less $6,000 long-term capital loss from stocks) netted against $17,000 short-term capital gain from stocks.

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4-314-9 Net Operating Losses

Step 3: The business capital (casualty) loss of $2,500 can only be offset by business capital gains of $5,000. There is no excess loss and thus no adjustment is needed.

This agrees to the business category total loss of $19,500 above which is consistent with the NOL representing only business losses.

Yujian may carryforward (or under previous tax law, carryback) the NOL of $19,500 to offset future income. ♦

4-9a NOL 80 percent Limitation The use of an NOL generated after December 31, 2017 is limited to 80 percent of the current year’s taxable income (without regard to the NOL deduction) when used (NOLs generated prior to January 1, 2018 continue to be used 100 percent necessitating tracking of different NOL periods). In addition, the carryback provisions are repealed and NOLs may only be carried forward; however, the carryforward period is now indefinite. The previous 2 year carryback and 20 year forward rules continue to apply to NOLs generated prior to January 1, 2018. Unlike many other recent changes, the changes to NOLs are not subject to expiration in 2025.

EXAMpLE In 2017, Desiree has a net operating loss of $10,000. She elects to forego any carryback and instead carries the NOL forward to 2018. In 2018, Desiree generates taxable income of $1,000 eligible to be offset by her 2017 NOL without regard to the new 80 percent of taxable income limitation. Desiree’s 2018 taxable income is $0 and she has $9,000 of NOL to carryforward into 2019. If her 2019 taxable income is $12,000, she can utilize the entire NOL (again, without regard to the 80 percent limitation since the NOL was created prior to 2018). ♦

EXAMpLE In 2019, Rusty has a net operating loss of $10,000. He is not eligible to carry the loss back and must carry it forward to 2020. In 2020, Rusty generates taxable income of $12,000. Rusty’s use of the 2019 NOL is limited to 80 percent of his 2020 taxable income or $9,600 ($12,000 3 80%). Rusty’s 2020 taxable income after NOL is $2,400 ($12,000 2 $9,600). Rusty may carryforward the remaining $400 NOL indefinitely. ♦

4-9b Overall Business Loss Limitation To reduce the potential for large business losses being claimed in a single year, the tax law places a $510,000 annual limitation on noncorporate business losses for married filing jointly taxpayers ($255,000 for all others) in 2019. The loss limitation is indexed for inflation. Any excess business loss limited under these rules becomes part of the NOL for future years.

EXAMpLE Bettina is a single taxpayer with wages of $20,000 and a business with income of $5,000. In addition, Bettina is disposing of a passive loss activity for which she has accumulated suspended losses of $280,000 (including her share of the current year loss). Bettina’s excess business loss is $275,000 ($280,000 2 $5,000) less the single threshold for 2019 of $255,000 yielding an excess loss of $20,000. This amount will become part of Bettina’s net operating loss and subject to the NOL limitation and carryforward rules. ♦

When a taxpayer creates a net operating loss (NOL), no specific entry is required by the preparer. Instead, supplemental schedules that track the NOL will be created automatically by the software. tIp

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4-32 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

Self-Study problem 4.8

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4-34 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

Self-Study problem 4.9 See Appendix E for Solutions to Self-Study Problems

Indicate whether the following statements are true or false by circling the appropriate letter.

T f 1. 2019 NOL deductions are first carried back 2 years and then forward 20 years.

T f 2. The itemized deduction for home mortgage interest can generate an NOL for an individual taxpayer.

T f 3. An individual taxpayer’s NOL is equal to the net taxable loss from page 1 of Form 1040.

T f 4. Individual taxpayer’s total business losses can be limited. T f 5. There is no limitation for using a 2019 NOL against the taxable income of

the following year.

Mark (age 44) and Mary (age 41) Mower are your tax clients. They have two children, Matthew (age 20) and Mindy (age 17), who live at home. Mindy is a senior in high school and Matthew commutes to a local college where he is studying soil management. Mark owns and operates a successful lawn maintenance and landscaping business. He has 6 employees and 3 pick-up trucks used for transportation to the job sites. The business has a credit card in its name for use by the employees and Mark, who fills the trucks with gas almost daily. Mark gave a business credit card to Mary, Matthew, and Mindy and told them to use it to buy gas for their automobiles used for shopping, going to school, and short trips. In the current year, his wife and children put $5,210 of gasoline in their automobiles using the business credit card. Mark is adamant that the $5,210 be deducted on his Schedule C. He feels the amount is small compared to the business gas purchases of approximately $28,000. Mark says the amounts charged are spread throughout the credit card statements and would be very difficult for the IRS to detect in an audit. Would you sign the Paid Preparer’s declaration (see example above) on this return? Why or why not?

Would You Sign This

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4-10 QuALIfIEd BuSINESS INCOME (QBI) dEduCTION The Qualified Business Income (QBI) deduction was introduced in 2018 and applies to tax years through 2025. The QBI deduction is a deduction for individual taxpayers report- ing business income from a passthrough entity such as a sole proprietorship, partner- ship, limited liability company, or S corporation. It is also referred to as the Section 199A deduction, the passthrough deduction, or the QBI deduction. The QBI deduction requires no additional outlay or investment of funds but is simply granted as a function of legis- lative grace. A discussion of the QBI deduction related specifically to partnerships and S corporations is covered in Chapters 10 and 11, respectively.

The QBI deduction is available to individual taxpayers as a “below the line” deduction (after adjusted gross income) and is also available to taxpayers who take the standard

Learning Objective 4.10

Compute the qualified business income (QBI) deduction.

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4-354-10 Qualified Business Income (QBI) Deduction

deduction. The deduction is generally 20 percent of a taxpayer’s qualified business income (QBI) from a partnership (including LLC if so treated), S corporation, or sole proprietorship.

4-10a definition of Qualified Business Income Qualified business income for a tax year is the net amount of qualified items of income, gain, deduction, and loss relating to any qualified trade or business of the taxpayer in the United States (foreign income is not considered). QBI excludes the following:

● Short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss

● Dividend income ● Interest income other than interest income that is properly allocable to a trade or

business ● Commodity transaction income or foreign currency gain or loss ● Any item of income, gain, deduction, or loss relating to certain notional principal

contracts ● Amounts received from an annuity that is not received in connection with the trade or

business ● Any item of deduction or loss properly allocable to an amount described in any of the

preceding items in this list (e.g., interest expense associated with investment income)

Reasonable employee compensation paid to the taxpayer by the qualified trade or business and guaranteed payments to a partner are not QBI and therefore the QBI deduction is not applicable to such income.

EXAMpLE Princess is a single taxpayer and operates a small business as a sole proprietor. In 2019, her business generates $80,000 of gross business income, $50,000 of business expenses, $3,000 of interest income, and a $2,000 capital gain. Princess’ QBI is $30,000 ($80,000 2 $50,000). The interest and capital gains are excluded from QBI. ♦

With respect to the QBI deduction, the term “qualified trade or business” means any trade or business other than a specified service trade or business, or the trade or business of performing services as an employee. Unfortunately, “trade or business” is not defined in the tax law. The regulations interpret trade or business to be consistent with the same phrase in Internal Revenue Code Section 162 related to the deduction of trade or business expenses. This does not provide an exceptional level of guidance for many businesses but certainly hobby activities (Chapter 3) would not qualify. The tax law provides a safe-harbor under which income from rental real estate (even if treated as passive) can qualify as qualified business income. The requirements are:

1. 250 hours or more are spent by the taxpayer with respect to the rental activity 2. Contemporaneous records of the time are maintained 3. Separate books and records for the rental activity are maintained

Note that 250 hours per year amounts to an average of over 20 hours per month. Time spent related to the rental activity on advertising, negotiating with tenants, verifying applications, daily operation, repair and maintenance, purchase of materials, and supervision of employees all count toward the required 250 hours. Time spent purchasing or financing the acquisition of the property and time spent traveling to and from the property do not generally qualify.

4-10b QBI deduction Taxable Income Limitation The QBI deduction is subject to a number of limitations and exceptions. A limitation that applies to all taxpayers is that the QBI deduction cannot exceed 20 percent of the taxpayer’s taxable income (excluding net long-term capital gains and qualified dividend income).

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EXAMpLE Alice operates a small accounting business that generates $60,000 of qualified business income. She also operates a separate investment advising business that focuses on providing crypto-currency investment advice that lost $20,000. Both of Alice’s businesses are sole proprietorships. Her pre- limitation QBI deduction is $8,000 [($60,000 2 $20,000) 3 20%]. Alice also earned $5,000 in net capital gains but had no other forms of income and elects the standard deduction. In 2019, Alice’s taxable income subject to the 20 percent limit is $27,800 ($40,000 of business income less her standard deduction of $12,200; capital gains are excluded from this calculation). Her QBI deduction is limited to $5,560 ($27,800 3 20%). ♦

4-10c Wage Limitation The two additional limitations on the QBI deduction are (1) the wage limitation and (2) the specified service business limitation. These limitations apply to taxpayers that have taxable income (total taxable income not just business income and including long-term capital gains or qualified dividends) above the threshold amounts, which in 2019 are $321,400 for mar- ried filing jointly $160,725 for married filing separately, and $160,700 for all other taxpayers. These threshold amounts are indexed for inflation each year. The limitations are computed before considering the QBI deduction.

For taxpayers with income below the thresholds, the QBI deduction is as described above. For taxpayers with taxable income above the threshold amounts, the two limitations apply and subject to a complex phase-out.

The wage limit is the greater of: ● 50 percent of the allocable share of W-2 wages with respect to the business (the “wage

limit”) or ● 25 percent of the allocable share of W-2 wages with respect to the business plus

2.5 percent of the unadjusted basis of all qualified business property (the “wage and capital limit”)

W-2 wages are defined as wages paid to employees (not independent contractors) including deferrals into Section 401(k) plans and the like. The term allocable share pertains to the allocation of wages similar to that associated with the allocation of partnership income (see further discussion of allocation of wages in Chapter 10). Because the tax law was designed to encourage investment in employees and business capital investment, the wage and capital limit includes a percentage of the unadjusted basis (basis prior to any depreciation) of business property.

EXAMpLE Pat operates a sole proprietorship which generates $200,000 of qualified business income that includes the deduction for wages of $66,000 that Pat pays to employees. Pat’s business has invested $20,000 in qualified business property. Pat has no other sources of income and files as a single taxpayer and elects the standard deduction. Pat’s initial QBI deduction is $200,000 3 20% or $40,000 which is limited to 20 percent of Pat’s taxable income [$187,800 ($200,000 2 standard deduction of $12,200) 3 20% 5 $37,560]. Furthermore, since Pat’s income exceeds the $160,700 threshold, the wage limits apply. The wage limit is the greater of 50 percent of the wages ($66,000 3 50% 5 $33,000) or the wage and capital limit of 25 percent of the wages ($66,000 3 25% 5 $16,500) plus 2.5 percent of the unadjusted basis of qualified business property ($20,000 3 2.5% 5 $500) which totals $17,000. The greater of the two wage limit amounts applies and thus Pat’s QBI deduction is limited to $33,000. Pat’s final taxable income will be $154,800 ($200,000 2 $33,000 2 $12,200). Recall that the wage

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limit applies if the taxpayer’s taxable income before the QBI deduction exceeds the threshold. ♦

Qualified business property for purposes of the wage and capital limit is defined as tangible property subject to depreciation (i.e., not inventory or land) for which the depreciable period has not ended before the close of the taxable year, held by the business at year end, and used at any point during the year in the production of QBI. If the “depreciation period” for a property ended in any prior tax year, that property is not included in the calculation of tangible property. The depreciable period is defined as starting when the property was placed in service and ending on the later of (1) 10 years or (2) the last day in the last year of the property’s regular depreciation.

EXAMpLE Josh, a single taxpayer, operates a sole proprietorship. He qualifies for the QBI deduction and his taxable income subjects him to the wage and capital limitations. Josh has purchased and placed in service the following property (all of which is currently being used in 2019):

Year 5-year recovery

period 39-year recovery

period

2008 $20,000 $600,000

2009 0 0

2010 4,000 0

2011 0 0

2012 0 0

2013 0 0

2014 25,000 0

2015 0 0

2016 10,000 0

2017 2,000 0

2018 50,000 0

2019 13,000 0

Total $124,000 $600,000

Qualified business property still within recovery period

In determining qualified business property for purposes of the QBI wage limit in 2019, Josh’s property must still be within the depreciable period which ends on the later of the last full year of the recovery period or 10 years. The 2008–2014 five-year property is fully depreciated BUT only the property placed in service before 2010 is no longer qualified; thus Josh has $104,000 of qualified five-year property. In spite of being placed in service more than 10 years ago, all of the building in the 39-year category is qualified as it is still being depreciated. Josh’s total qualified property under the wage and capital limit for the QBI deduction is $704,000 ($104,000 1 $600,000). ♦

Recall that the wage limitations apply only if the taxpayer’s taxable income exceeds the threshold amount ($321,400 or $160,700). As is typical in the tax law, a taxpayer’s opportunity to use the QBI deduction does not cease entirely if the threshold is exceeded. Instead, the QBI deduction is subject to a phase-out up to an excess of $100,000 for married filing jointly taxpayers and $50,000 for all others. First, the QBI

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deduction is computed as if no wage limitation applies. The next step is to compute the QBI deduction including the wage limitation. The excess of the QBI deduction with no limitation over the QBI deduction with limitation is known as the “excess amount.” The excess amount is subject to a pro rata phase-out based on the taxpayer’s income over the threshold amount.

EXAMpLE Phil is a single taxpayer with a QBI eligible small business and his taxable income as measured for the QBI deduction is $177,500 and thus exceeds the $160,700 threshold. Phil’s QBI is $150,000 and his business paid wages of $42,000 in 2019 and has qualified business property of $660,000.

Phil’s QBI deduction with no limitation 5 $30,000 ($150,000 3 20%) Wage limitation is $27,000 which is the greater of:

$21,000 ($42,000 wages 3 50%) or $27,000 [($42,000 3 25%) 1 ($660,000 3 2.5%)]

Phil’s QBI deduction is limited to $27,000; however, Phil is not subject to the entire wage limitation as his income is not $50,000 or more over the threshold amount. Thus, the wage limitation is “phased-in.”

Phil’s taxable income for QBI deduction purposes $177,500 Phil’s threshold amount (single taxpayer) 160,700 Excess $ 16,800 Excess divided by the phase-out range $16,800/$50,000 5 33.6%

Thus Phil will lose 33.6 percent of his “excess amount” of $3,000 ($30,000 QBI deduction without limit less $27,000 QBI deduction with limit) or $1,008. Phil’s QBI deduction is $28,992 ($30,000 2 $1,008). ♦

To summarize thus far, the QBI deduction is 20 percent of qualified business income, which is the income of a business held in any form but corporate form. QBI excludes forms of “portfolio” income such as interest, dividends, and gains. For taxpayers below the income thresholds ($321,400 married filing jointly and $160,700 for single and head of household), there are no explicit limitations other than the taxable income limit. For those with taxable income above the thresholds, the QBI deduction is limited by the wage limitation and also by the specified service business limitation (which is covered below).

4-10d Specified Service Business Limitation For taxpayers with income in excess of the threshold, certain types of businesses are not eligible for the QBI deduction:

1. a taxpayer whose business is being an employee, and 2. a specified service trade or business.

A specified service trade or business is defined as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its owners or employees. Also, specified service businesses include those involved in investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

To be clear, recall that a taxpayer in a specified service business is not necessarily prohibited from the QBI deduction but rather is not eligible for the QBI deduction if the taxpayer’s taxable income exceeds the aforementioned thresholds. The same phase-out for the wage limitation also applies to a specified service business (i.e., the with and without comparison of the QBI deduction and pro-rata reduction of the excess amount). However, the phase-out applies in a two-step process that is almost certainly better left to tax software.

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EXAMpLE Jenny and Jason file jointly in 2019. Jenny is a physician and works for her pass-through business that has QBI of $310,000 in 2019. The S corporation paid Jenny wages of $80,000 and her employee wages of $40,000 in 2019. Jenny and Jason’s taxable income before any QBI deduction is $385,000. Jenny’s S corporation has qualified business property of $300,000.

Jenny’s QBI without any limits would be $62,000 ($310,000 3 20%). However, Jenny and Jason exceed the threshold income by $63,600 ($385,000 2 $321,400). The excess income of $63,600 is 63.6 percent of the phase-out range of $100,000 for married filing jointly taxpayers and thus Jenny is eligible for only 36.4 percent of the benefits from the deduction. This eligible share is applied to each of the limits as follows:

QBI is $310,000 3 36.4% 5 $112,840 W-2 wages of $120,000 3 36.4% 5 $43,680 Qualified business property $300,000 3 36.4% 5 $109,200

Using this information, Jenny’s tentative QBI deduction under the general rules is

20% of QBI: $22,568 ($112,840 3 20%) Or the greater of Wages limit: $21,840 ($43,680 3 50%) or Wages and capital limit: $13,650 [($43,680 3 25%) 1

$109,200 3 2.5%]

Under the first step, the QBI deduction would be $21,840. But now, the phase-out associated with income over the threshold must be applied based on these amounts. Jenny’s QBI would be $22,568 with no limitation and $21,840 with limitation or an excess QBI deduction of $728. As previously calculated, Jenny and Jason’s income exceeds the threshold by $63,600 or 63.6 percent of the phase-out range of $100,000. Thus, Jenny is going to lose $463 of the QBI deduction (63.6% of the excess QBI deduction of $728).

As a result of the above steps, Jenny’s QBI deduction for 2019 is $22,105 ($22,568 2 $463). ♦

If a taxpayer has net QBI from one or more businesses that is less than zero, no QBI deduction is permitted and the QBI loss is carried over to the following year.

EXAMpLE Alice operates a small business that generates $20,000 of qualified business income. She also operates a separate business that lost $60,000. Both of Alice’s businesses are sole proprietorships. Alice’s total net QBI is less than $0 ($40,000 net loss). As a result, Alice is not permitted a QBI deduction in the current year and will carry the QBI loss forward in next year. ♦

The regulations that cover the QBI deduction are complex and the calculation of the QBI deduction can become unwieldy when a taxpayer subject to the limitations has multiple businesses eligible for the QBI deduction and some of these businesses operate at a loss and others generate income. These computations are beyond the scope of this textbook.

4-10e Reporting the QBI deduction In 2019, the IRS introduced Forms 8995 and 8995-A for reporting the QBI deduction. Form 8995 is for taxpayers whose taxable income before the QBI deduction does not ex- ceed the phase-out thresholds ($321,400 for married filing jointly and $160,700 for single and head of household in 2019). Otherwise, taxpayers must use Form 8995-A. As the complexity of the QBI deduction increases, taxpayers may also need to use four schedules (A–D) that are part of Form 8995-A. These are beyond the scope of this textbook.

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Self-Study problem 4.10 See Appendix E for Solutions to Self-Study Problems

Determine whether the following taxpayers are eligible for the QBI deduction and the deduction amount, if any.

Taxpayer

Eligible for QBI deduction

(Y/N)?

QBI deduction amount

a. Aretha is a married taxpayer filing jointly and a shareholder in Soul Corporation (not an S corporation). She owns 10 percent of the outstanding stock and the corporation generates $700,000 of taxable income from its business operations and distributes a $70,000 dividend to Aretha. Her total taxable income before the QBI deduction is $92,000.

b. Barbara Jones is a single taxpayer and sole proprietor that operates a small chain of hair salons called The Bee Hive that specialize in obscure hair colors. Her business has no employees since all the stylists operate as independent contractors. The taxpayer identification number of the Bee Hive is 317-65-4321. Barbara’s business generated business income of $120,000 in 2019. Her taxable income before any QBI deduction is $132,500. Use Form 8995 on Page 4–41 to determine her QBI deduction.

c. Alice Delvecchio is married and files a joint return with her spouse, Chris Delvecchio. Alice operates a small family restaurant called D’s Pizza as a sole proprietor (taxpayer identification number 565-22-4321). She pays wages of $36,000, has qualified property with a basis of $67,000, and the QBI from the restaurant is $100,000. Chris has wages of $250,000 and their joint taxable income before the QBI deduction is $364,000 and includes $12,000 of qualified dividends. Use Form 8995-A on Pages 4–42 and 4-43 to determine their QBI deduction amount.

tIp All of the different entry points for information for a tax return are located on the left-hand margin of ProConnect. At the top of that list are two tabs: All and In Use. The All tab shows all of the possible data entry points and aids in the prevention of overlooking a tax item while preparing the return. For reviewing a return, the In Use tab hides the areas not in use and can be very useful.

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4-41

Self-Study problem 4.10b

4-10 Qualified Business Income (QBI) Deduction

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4-42 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

Self-Study problem 4.10c

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4-43 4-10 Qualified Business Income (QBI) Deduction

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4-44 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

K e y t e r m s

capital asset, 4-2 capital gain or loss, 4-2 Section 1231 assets, 4-2 holding period, 4-3 “sale or exchange,” 4-3 adjusted basis, 4-4 capital improvements, 4-5 net capital gains, 4-8

net capital losses, 4-10 capital loss carryovers, 4-11 personal residence exclusion, 4-19 vacation homes, 4-22 primarily personal use, 4-23 primarily rental use, 4-23 passive activity, 4-25 passive income and losses, 4-25

net operating loss (NOL), 4-29 business loss limitation, 4-31 qualified business income (QBI)

deduction, 4-34 wage limitation, 4-36 wage and capital limit, 4-36 qualified business property, 4-37 service business limitation, 4-38

Learning Objectives Key points

LO 4.1: Define the term “capital asset.“

● A capital asset is any property, whether or not used in a trade or business, except: (1) inventory, (2) depreciable property or real property used in a trade or business, (3) patents, inventions, models or designs, secret formulas or processes, copyrights, literary, musical, or artistic compositions, letters or memorandums, or similar property if the property is created by the taxpayer, (4) accounts or notes receivable, and (5) certain U.S. government publications.

LO 4.2: Apply the holding period for long-term and short-term capital gains and losses.

● Assets must be held for more than 1 year for the gain or loss to be considered long-term.

● A capital asset held 1 year or less results in a short-term capital gain or loss. ● A net short-term capital gain is treated as ordinary income. ● In calculating the holding period, the taxpayer excludes the date of acquisition and includes the date of disposition.

LO 4.3: Calculate the gain or loss on the disposition of an asset.

● The taxpayer’s gain or loss is calculated using the following formula: amount realized 2 adjusted basis 5 gain or loss realized.

● The amount realized from a sale or other disposition of property is equal to the sum of the money received, plus the fair market value of other property received, plus any liabilities relieved, less the costs paid to transfer the property.

● The adjusted basis of property 5 the original basis 1 capital improvements 2 accumulated depreciation.

● In most cases, the original basis is the cost of the property at the date of acquisition, plus any costs incidental to the purchase, such as title insurance, escrow fees, and inspection fees.

● Capital improvements are major expenditures for permanent improvements to or restoration of the taxpayer’s property.

LO 4.4: Compute the tax on capital gains.

● Short-term capital gains are taxed as ordinary income, while there are various different preferential long-term capital gains tax rates.

● Net long-term capital gains may be subject to rates ranging from 0 percent to 28 percent (an additional 3.8 percent Medicare tax on net investment income applies to high-income individuals).

● Special rates apply to long-term gains on collectibles (e.g., art, stamps, gems, coins, etc.) and depreciation recapture on the disposition of certain Section 1250 assets.

K e y p O I N ts

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4-45Key Points

LO 4.5: Describe the treatment of capital losses.

● Individual taxpayers may deduct net capital losses against ordinary income in amounts up to $3,000 per year with any unused capital losses carried forward indefinitely.

● When a taxpayer ends up with net capital losses, the losses offset capital gains as follows: (1) net short-term capital losses first reduce 28 percent gains, then 25 percent gains, then regular long-term capital gains, and (2) net long-term capital losses first reduce 28 percent gains, then 25 percent gains, then any short-term capital gains. Personal capital losses are not deductible for tax purposes.

LO 4.6: Apply the exclusion of gain from personal residence sales.

● Taxpayers who have owned their personal residence and lived in it for at least 2 of the 5 years before the sale can exclude from income up to $250,000 of gain ($500,000 for joint return filers).

LO 4.7: Apply the tax rules for rental property and vacation homes.

● Rental income and related expenses are reported on Schedule E. ● Rental expenses include real estate taxes, mortgage interest, insurance, commissions, repairs, and depreciation.

● If a residence is rented for fewer than 15 days during the year, the rental income is disregarded and the property is treated as a personal residence for tax purposes.

● If the residence is rented for 15 days or more and is used for personal purposes for not more than 14 days or 10 percent of the days rented, whichever is greater, the residence is treated as a rental property.

● If the residence is rented for 15 days or more and is used for personal purposes for more than 14 days or 10 percent of the days rented, whichever is greater, allocable rental expenses are allowed only to the extent of rental income.

LO 4.8: Explain the treatment of passive income and losses.

● The tax law defines three categories of income: (1) active income, (2) portfolio income, and (3) passive income and losses.

● Normally, passive losses cannot be used to offset either active or portfolio income. Passive losses not used to offset passive income are carried forward indefinitely.

● Generally, losses remaining when the taxpayer disposes of his or her entire interest in a passive activity may be used in full.

● Under the passive loss rules, real estate rental activities are specifically defined as passive, even if the taxpayer actively manages the property.

● Individual taxpayers may deduct up to $25,000 of rental property losses against other income, if they are actively involved in the management of the property and their income does not exceed certain limits.

● Taxpayers heavily involved in real estate rental activities may qualify as running an active trade or business rather than a passive activity and fully deduct all rental losses.

LO 4.9: Describe the basic tax treatment of deductions for net operating losses.

● Net operating losses (NOL) allow taxpayers to “smooth out” their income. ● Computation of an individual taxpayer NOL requires classification of income and deductions as business and nonbusiness.

● An NOL generated after 2017 may only be carried forward and its use is limited to 80 percent of the future year’s taxable income.

● An NOL generated in 2017 or before may be carried back 2 years and forward 20 years.

● Total business losses are limited after 2017.

LO 4.10: Compute the qualified business income (QBI) deduction.

● Flow-through entities are eligible for a deduction of 20 percent of QBI subject to limitations.

● QBI is business income only and generally does not include interest, dividends, or capital gains.

● Tax law provides a safe-harbor under which income from rental real estate can qualify as QBI if it meets the necessary requirements.

● The QBI deduction may not exceed 20 percent of taxable income. ● If taxable income exceeds $321,400 (MFJ) or $160,700 (single and head of household), the QBI deduction is limited by the wage limitation or the wage and capital limitation, whichever is greater.

● QBI from service-related business may also be subject to limitation if income thresholds are surpassed.

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4-46 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

GrOUp 1:

MuLTIpLE ChOICE QuESTIONS

1. All of the following assets are capital assets, except: a. A personal automobile b. IBM stock c. A child’s bicycle d. Personal furniture e. Used car inventory held by a car dealer

2. Which of the following is a capital asset? a. Account receivable b. Copyright created by the taxpayer c. Copyright (held by the writer) d. Business inventory e. A taxpayer’s residence

3. Yasmeen purchases stock on January 30, 2018. If she wishes to achieve a long-term holding period, what is the first date that she can sell the stock as a long-term gain? a. January 20, 2019 b. January 31, 2019 c. February 1, 2019 d. July 31, 2018 e. July 30, 2018

4. Vijay sells land and receives $5,000 cash, a motorcycle worth $1,600, and two tickets to the Super Bowl with a total face value (cost) of $800 but worth $1,200. In addition, the buyer assumes the mortgage on the land of $12,000. What is Vijay’s amount re- ceived in this transaction? a. $5,000 b. $7,800 c. $8,200 d. $19,800 e. $20,200

5. Bob sells a stock investment for $35,000 cash, and the purchaser assumes Bob’s $32,500 debt on the investment. The basis of Bob’s stock investment is $55,000. What is the gain or loss realized on the sale? a. $10,000 loss b. $10,000 gain c. $12,500 gain d. $22,500 loss e. $22,500 gain

6. In 2019, what is the top tax rate for individual long-term capital gains and the top tax rate for long-term capital gains of collectible items assuming that the Medicare tax does not apply. a. 10; 20 b. 20; 28 c. 15; 25 d. 25; 28

LO 4.1

LO 4.2

LO 4.3

LO 4.4

Q U es t I O Ns a n d prO B L e m s

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4-47Questions and Problems

7. In November 2019, Ben and Betty (married, filing jointly) have a long-term capital gain of $54,000 on the sale of stock. They have no other capital gains and losses for the year. Their ordinary income for the year after the standard deduction is $72,500, making their total taxable income for the year $126,500 ($72,500 1 $54,000). In 2019, married taxpayers pay 0 percent on long-term gains up to $78,750. What will be their 2019 total tax liability assuming a tax of $8,315 on the $72,500 of ordinary income? a. $8,322 b. $15,717 c. $15,478 d. $19,712

8. Harold, a single taxpayer, has $30,000 of ordinary income after the standard deduc- tion, and $10,000 in long-term capital gains, for total taxable income of $40,000. For 2019, single taxpayers pay 0 percent on long-term gains up to $39,375. Assuming a tax of $3,409 on the $30,000 of ordinary income, what is Harold’s tax? a. $3,413 b. $3,503 c. $3,623 d. $4,094 e. $4,815

9. In 2019, Tim, a single taxpayer, has ordinary income of $29,000. In addition, he has $2,000 in short-term capital gains, long-term capital losses of $10,000, and long-term capital gains of $4,000. What is Tim’s AGI for 2019? a. $26,000 b. $27,000 c. $29,000 d. $32,000

10. Oscar, a single taxpayer, sells his residence of the last 10 years in January of 2019 for $190,000. Oscar’s basis in the residence is $45,000, and his selling expenses are $11,000. If Oscar does not buy a new residence, what is the taxable gain on the sale of his residence? a. $145,000 b. $134,000 c. $45,000 d. $9,000 e. $0

11. Jim, a single taxpayer, bought his home 20 years ago for $25,000. He has lived in the home continuously since he purchased it. In 2019, he sells his home for $300,000. What is Jim’s taxable gain on the sale? a. $0 b. $25,000 c. $125,000 d. $275,000

12. Susan, a single taxpayer, bought her home 25 years ago for $30,000. She has lived in the home continuously since she purchased it. In 2019, she sells her home for $200,000. What is Susan’s taxable gain on the sale? a. $0 b. $20,000 c. $250,000 d. $170,000

LO 4.4

LO 4.4 LO 4.5

LO 4.6

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4-48 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

13. Kevin purchased a house 20 years ago for $100,000 and he has always lived in the house. Three years ago Kevin married Karen, and she has lived in the house since their marriage. If they sell Kevin’s house in December 2019 for $425,000, what is their taxable gain on a joint tax return? a. $0 b. $75,000 c. $125,000 d. $250,000

14. Gene, a single taxpayer, purchased a house 18 months ago for $350,000. If Gene sells his house due to unforeseen circumstances for $550,000 after living in it for a full 18 months, what is his taxable gain? a. $0 b. $12,500 c. $50,000 d. $200,000

15. Which of the following is true about the rental of real estate? a. Depreciation and maintenance expenses for an apartment complex are deductible. b. A vacation home is a home that is rented for 15 days or more and is used by the

taxpayer for personal use for more than the greater of 14 days or 10 percent of the days it is rented for fair value during the year.

c. If a home is rented for less than 15 days a year, the rent is not taxable. d. Repairs on rental property are deductible by the taxpayer. e. All of the above.

16. John owns a second home in Palm Springs, CA. During the year, he rented the house for $5,000 for 56 days and used the house for 14 days during the summer. The house remained vacant during the remainder of the year. The expenses for the home included $5,000 in mortgage interest, $850 in property taxes, $900 for utilities and maintenance, and $3,500 of depreciation. What is John’s deductible rental loss, before considering the passive loss limitations? a. $200 b. $875 c. $2,500 d. $3,200 e. $0

17. Helen, a single taxpayer, has modified adjusted gross income (before passive losses) of $126,000. During the tax year, Helen’s rental house generated a loss of $15,000. Assuming Helen is actively involved in the management of the property, what is the amount of Helen’s passive loss deduction from the rental house? a. $0 b. $3,000 c. $10,000 d. $12,000 e. $15,000

18. Which of the following is not classified as portfolio income for tax purposes? a. Interest income on savings accounts b. Dividends paid from a credit union c. Net rental income from real estate partnership d. Dividend income from stock e. All of the above are classified as portfolio income

LO 4.6

LO 4.7

LO 4.8

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4-49Questions and Problems

19. Which of the following types of income is passive income? a. Net rental income from real estate limited partnership investments b. Dividends from domestic corporations c. Wages d. Interest income from certificates of deposit e. None of the above

20. Which of the following is classified as active income? a. Self-employment income from a small business b. Interest income c. Limited partnership income d. Dividend income from a mutual fund e. a. and d.

21. Nancy has active modified adjusted gross income before passive losses of $75,000. She has a loss of $5,000 on a rental property she actively manages. How much of the loss is she allowed to take against the $75,000 of other income? a. None b. $2,500 c. $5,000 d. $10,000

22. Ned has active modified adjusted gross income before passive losses of $250,000. He has a loss of $15,000 on rental property he actively manages. How much of the loss is he allowed to take against the $250,000 of other income? a. $15,000 b. $10,000 c. $5,000 d. None

23. Norm is a real estate professional with a real estate trade or business as defined in the tax law. He has $80,000 of business income and $40,000 of losses from actively managed real estate rentals. How much of the $40,000 in losses is he allowed to claim on his tax return? a. $40,000 b. $25,000 c. $20,000 d. None

24. Bonita earns $31,000 from her job, and she has $1,000 of interest income. She has itemized deductions of $35,000. There are no casualty or theft losses in the itemized deductions. What is Bonita’s net operating loss for the current year? a. $0 b. $1,000 c. $3,000 d. $4,000 e. Some other amount

25. Jim has a net operating loss in 2019. If he does not make any special elections, what is the first year to which Jim carries the net operating loss? a. 2015 b. 2016 c. 2017 d. 2018 e. 2020

LO 4.8

LO 4.9

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4-50 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

26. The qualified business income deduction is unavailable to which of the following businesses: a. A sole proprietor dental practice that generates about $70,000 in income each year b. An incorporated small tools manufacturer c. A partnership operated by a husband and wife that sells wood carvings over the

Internet d. A S corporation that owns and operates a restaurant. The S corporation has six

different owners. e. The QBI deduction is available to all of the above.

27. Qualified business income does not include which of the following: a. Income from sales of goods b. Deductions related to cost of goods sold c. Deductions for business expenses such as rent d. Interest income from an investment in bonds

28. In 2019, Tracy generates a $10,000 loss from an otherwise qualified business activity. Fortunately, she also works as an employee and has taxable income of $40,000. Tracy’s 2019 QBI deduction is a. $0 b. $2,000 c. $8,000 d. $6,000

LO 4.10

GrOUp 2:

pROBLEMS

1. Martin sells a stock investment for $26,000 on August 2, 2019. Martin’s adjusted basis in the stock is $15,000. a. If Martin acquired the stock on November 15, 2018, calculate the amount and the

nature of the gain or loss. $

b. If Martin had acquired the stock on September 10, 2017, calculate the amount and nature of the gain or loss.

2. During 2019, Tom sold Sears stock for $10,000. The stock was purchased 4 years ago for $13,000. Tom also sold Ford Motor Company bonds for $35,000. The bonds were purchased 2 months ago for $30,000. Home Depot stock, purchased 2 years ago for $1,000, was sold by Tom for $2,500. Calculate Tom’s net gain or loss, and indicate the nature of the gain or loss.

3. Charu Khanna received a Form 1099-B showing the following stock transactions and basis during 2019:

LO 4.1 LO 4.2 LO 4.3

LO 4.1 LO 4.2 LO 4.3 LO 4.5

LO 4.1 LO 4.2 LO 4.3 LO 4.5 Stock

Date Purchased Date Sold

Sales Price ($)

Cost Basis ($)

4,000 shares Green Co. 06/04/08 08/05/19 12,000 3,000

500 shares Gold Co. 02/12/19 09/05/19 54,000 62,000

5,000 shares Blue Co. 02/04/09 10/08/19 18,000 22,000

100 shares Orange Co. 11/15/18 07/12/19 19,000 18,000

None of the stock is qualified small business stock. The stock basis was reported to the IRS. Calculate Charu’s net capital gain or loss using Schedule D and Form 8949 on Pages 4-51 through 4-54.

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4-51 Questions and Problems

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4-52 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-53 Questions and Problems

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4-54 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-55

4. Jocasta owns an apartment complex that she purchased 6 years ago for $750,000. Jocasta has made $50,000 of capital improvements on the complex, and her depreciation claimed on the building to date is $128,700. Calculate Jocasta’s adjusted basis in the building.

5. Chrissy receives 200 shares of Chevron stock as a gift from her father. The stock cost her father $9,000 10 years ago and is worth $10,500 at the date of the gift. a. If Chrissy sells the stock for $12,500, calculate the amount of the gain or loss on

the sale. $

b. If Chrissy sells the stock for $4,600, calculate the amount of the gain or loss on the sale.

6. In 2019, Michael has net short-term capital losses of $1,500, a net long-term capital loss of $27,000, and other ordinary taxable income of $45,000. a. Calculate the amount of Michael’s deduction for capital losses

for 2019. $

b. Calculate the amount and nature of his capital loss carryforward. $

c. For how long may Michael carry forward the unused loss?

7. Larry Gaines, a single taxpayer, age 42, sells his personal residence on November 12, 2019, for $151,200. He lived in the house for 7 years. The expenses of the sale are $9,072, and he has made capital improvements of $10,150. Larry’s cost basis in his residence is $86,750. On November 30, 2019, Larry purchases and occupies a new residence at a cost of $150,000. Calculate Larry’s realized gain, recognized gain, and the adjusted basis of his new residence. a. Realized gain $ b. Recognized gain $ c. Adjusted basis of new residence $

8. On July 1, 2019, Ted, age 73 and single, sells his personal residence of the last 30 years for $368,000. Ted’s basis in his residence is $48,776. The expenses associated with the sale of his home total $22,080. On December 15, 2019, Ted purchases and occupies a new residence at a cost of $175,000. Calculate Ted’s realized gain, recognized gain, and the adjusted basis of his new residence. a. Realized gain $ b. Recognized gain $ c. Adjusted basis of the new residence $

9. Dick owns a house that he rents to college students. Dick receives $800 per month rent and incurs the following expenses during the year:

Real estate taxes $1,250 Mortgage interest 1,500 Insurance 425 Repairs 562 Association dues 1,500

LO 4.3

LO 4.4 LO 4.5

LO 4.6

LO 4.7

Questions and Problems

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4-56 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

Dick purchased the house in 1979 for $48,000. The house is fully depreciated. Calculate Dick’s net rental income for the year, assuming the house was rented for a full 12 months.

Rental income $ Expenses:

Net rental income $

10. Sherry rents her vacation home for 6 months and lives in it for 6 months during the year. Her gross rental income during the year is $6,000. Total real estate taxes for the home are $950, and interest on the home mortgage is $3,000. Annual utilities and maintenance expenses total $1,800, and depreciation expense is $4,500. Calculate Sherry’s net income or loss from the vacation home for this tax year.

11. Walter, a single taxpayer, purchased a limited partnership interest in a tax shelter in 1993. He also acquired a rental house in 2019, which he actively manages. During 2019, Walter’s share of the partnership’s losses was $30,000, and his rental house generated $20,000 in losses. Walter’s modified adjusted gross income before passive losses is $130,000. a. Calculate the amount of Walter’s allowable loss for rental house activities

for 2019. $

b. Calculate the amount of Walter’s allowable loss for the partnership activities for 2019.

c. What may be done with the unused losses, if anything?

12. Clifford Johnson has a limited partnership investment and a rental condominium. Clifford actively manages the rental condominium. During 2019, his share of the loss from the limited partnership was $11,000, and his loss from the rental condo was $17,000. Assuming Clifford’s modified adjusted gross income is $124,000 for 2019, and he has no prior year unallowed losses from either activity, complete Form 8582 on Page 4-58.

13. Tyler, a single taxpayer, generates a net operating loss of $12,000 in 2017 and elects to forego any carryback. He also generates a net operating loss of $6,000 in 2018. Finally, in 2019, Tyler’s business turns a corner and he generates taxable income of $17,000. a. How much of Tyler’s 2017 NOL is carried forward to 2020? b. How much of Tyler’s 2018 NOL is carried forward to 2020?

14. Julie, a single taxpayer, has completed her 2019 Schedule C and her net loss is $40,000. Her only other income is wages of $30,000. Julie takes the standard deduction of $12,200 in 2019. a. Calculate Julie’s taxable income or loss.

$ b. Calculate the business and nonbusiness portions of her taxable income or loss.

Business $ Nonbusiness $

c. Determine Julie’s 2019 NOL. $

LO 4.7

LO 4.8

LO 4.9

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4-57

15. Sanjay is a single taxpayer that operates a curry cart on the streets of Baltimore. The business is operated as a sole proprietorship with no employees (Sanjay does every- thing). Sanjay’s Schedule C reports income of $87,000. His taxable income is $80,000 and includes no capital gains. Compute Sanjay’s QBI deduction.

16. Rob Wriggle operates a small plumbing supplies business as a sole proprietor. In 2019, the plumbing business has gross business income of $421,000 and business expenses of $267,000, including wages paid of $58,000. The business sold some land that had been held for investment generating a long-term capital gain of $15,000. The business has $300,000 of qualified business property in 2019. Rob’s wife, Marie, has wage income of $250,000. They jointly sold stocks in 2019 and generated a long-term capital gain of $13,000. Rob and Marie have no dependents and in 2019, they take the standard deduction of $24,400. a. What is Rob and Marie’s taxable income before the QBI deduction? b. What is Rob and Marie’s QBI? c. What is Rob and Marie’s QBI deduction? d. Complete Form 8995-A on Pages 4-59 and 4-60 to report Rob’s QBI deduction.

LO 4.10

You recently received the following e-mail from a client and friend:

Hey Great Student,

I cannot believe it is almost year end! Only a few days before it’s 2020.

As you recall, I was lucky enough to win big at the casino back on New Year’s Day earlier this year (thanks for celebrating with me). I took the $3,000 I won and bought 100 shares of stock in that cool new smartphone app company, TriviaAddiction. I just love playing that game. Anyway, the stock has done well, and I am thinking of selling before year end now that the price has reached $240 per share. Since you are my tax adviser, I thought I’d ask a couple of questions:

1. Is there any reason to wait and sell later?

2. If I don’t sell, the price might go down (TriviaMaster seems to be replacing TriviaAd- diction as the “hot” new game). I’m thinking the price might be as low as $220 by early next year.

My taxable income this year and next year is expected to be $40,000 (not including the stock sale). I think that puts me in the 12 percent tax bracket? Any suggestions on what I should do?

Thanks!

Sue

Prepare an e-mail to your friend Sue addressing her questions. Be certain to include estimates of the different after-tax outcomes she is suggesting. Sue is a single taxpayer and not a tax expert and so your language should reflect her limited understanding of tax law and avoid technical jargon. Although Sue is your friend, she is also a client and your e-mail should maintain a professional style.

research

GrOUp 3:

WRITING ASSIGNMENT

Questions and Problems

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4-58 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-59 Questions and Problems

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4-60 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-61

1. Skylar and Walter Black have been married for 25 years. They live at 883 Scrub Brush Street, Apt. 52B, Las Vegas, NV 89125. Skylar is a stay-at-home parent and Walt is a high school teacher. Skylar’s Social Security number is 222-43-7690 and Walt’s is 700-01-0002. Neither are age 65 or older. The Blacks provide all the support for Skylar’s mother, Rebecca Backin (Social Security number 411-66-2121), who lives in a nursing home in Reno, NV and has no income. Walter’s father, Alton Black (Social Security number 343-22-8899), lives with the Blacks in Las Vegas. Although Alton received Social Security benefits of $7,600 in 2019, the Blacks provide over half of Al- ton’s support. Skylar and Walt claim a $500 other dependent credit each for Rebecca and Alton. Walt’s earnings from teaching are:

GrOUp 4:

COMpREhENSIVE pROBLEMS

51,200.00

31-1239867

700-01-0002

4,310.00

3,174.40

742.40

$7,900.00DD

Las Vegas School District 2234 Vegas Valley Drive Las Vegas, NV 89169

Walter Black 883 Scrub Brush Street, Apt 52B Las Vegas, NV 89125

The Blacks moved from Maine to Nevada. As a result, they sold their house in Maine on January 4, 2019. They originally paid $76,000 for the home on July 3, 1994, but managed to sell it for $604,000. They spent $13,000 on improvements over the years. They are currently renting in Las Vegas while they look for a new home.

Questions and Problems

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4-62 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

The Blacks received the following 1099-DIV from their mutual fund investments:

Cyber Funds Equities Fund 41 Wall Street New York, NY 10005

Skylar B. Black

883 Scrub Brush Street #52B

Las Vegas, NV 89125

17-1234326 222-43-7690

1,425.00

1,002.00

6,540.34

Form 1099-DIV

2019 Dividends and Distributions

Copy B For Recipient

Department of the Treasury - Internal Revenue Service

This is important tax information and is being furnished to the IRS. If you are

required to �le a return, a negligence

penalty or other sanction may be

imposed on you if this income is taxable

and the IRS determines that it has

not been reported.

OMB No. 1545-0110

CORRECTED (if checked) PAYER’S name, street address, city or town, state or province, country, ZIP or foreign postal code, and telephone no.

PAYER’S TIN RECIPIENT’S TIN

RECIPIENT’S name

Street address (including apt. no.)

City or town, state or province, country, and ZIP or foreign postal code

FATCA �ling requirement

Account number (see instructions)

1a Total ordinary dividends

$ 1b Quali�ed dividends

$ 2a Total capital gain distr.

$ 2b Unrecap. Sec. 1250 gain

$ 2c Section 1202 gain

2d Collectibles (28%) gain

$ 3 Nondividend distributions

$ 4 Federal income tax withheld

$ 5 Section 199A dividends

$ 6 Investment expenses

$ 7 Foreign tax paid

8 Foreign country or U.S. possession

9 Cash liquidation distributions

$ 10 Noncash liquidation distributions

$ 11 Exempt-interest dividends

12 Speci�ed private activity bond interest dividends

$ 13 State 14 State identi�cation no. 15 State tax withheld

$ $

Form 1099-DIV (keep for your records) www.irs.gov/Form1099DIV

The Blacks own a ski condo located at 123 Buncombe Lane, Brian Head, UT 84719. The condo was rented for 185 days during 2019 and used by the Blacks for 15 days. The rental activity does not rise to the level to qualify for the QBI deduction. Pertinent information about the condo rental is as follows:

Rental income $12,100 Mortgage interest reported on Form 1098 8,600 Homeowners’ association dues 5,200 Utilities 1,200 Maintenance 3,800 Depreciation (assume fully depreciated) 0

The above amounts do not reflect any allocation between rental and personal use of the condo. The Blacks are active managers of the condo.

Required: Complete the Black’s federal tax return for 2019. Use Form 1040, Schedule 1, Schedule D, Form 8949, Schedule E (page one only), Form 8582 (page one only) and the Qualified Dividends and Capital Gain Tax Worksheet to complete their tax return.

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4-63

Dr. Beeper owns a rental house located at 672 Lake Street, Spokane, WA 99212. The house rents for $1,000 per month and was rented for the entire year. The following are the related expenses for the rental house:

Real estate taxes $ 5,850 Mortgage interest 14,521 Insurance 2,215 Depreciation (assume fully depreciated) 0 Repairs 550 Maintenance 1,976

The house was purchased on July 5, 1984. Dr. Beeper handles all rental activi- ties (e.g., rent collection, finding tenants, etc.) himself. He spends about 10 hours per month on the rental.

In 2019, Dr. Beeper sold his primary residence as he wished to move to an apart- ment to avoid the maintenance and upkeep of a single-family home. Dr. Beeper’s home sold on February 12, 2019 for $345,000 net after commissions. He acquired the home on June 3, 2001 for $260,000 and had made improvements of $10,000.

Dr. Beeper was divorced on January 1, 2013. The divorce decree requires Dr. Beeper to pay his ex-wife, Meredith Gray (Social Security number 333-45-1234), $800 per month. Dr. Beeper made all his monthly alimony payments in 2019.

Required: Complete Dr. Beeper’s federal tax return for 2019. Determine if Form 8949 and Schedule D are required. If so, use those forms and Form 1040, Schedule E (page one only), and Form 8582 (page one only) to complete this tax return. Do not complete Form 4562 for reporting depreciation.

2A. Dr. George E. Beeper is a single taxpayer born on September 22, 1971. He lives at 45 Mountain View Dr., Apt. 321, Spokane, WA 99210. Dr. Beeper’s Social Security number is 775-88-9531. Dr. Beeper works for the Pine Medical Group, and his earnings and income tax withholding for 2019 are:

36-1389676

775-88-9531

133,900.00 21,045.00

8,239.80

1,941.55

DD 5,800.00

132,900.00

133,900.00

Pine Medical Group 800 W. 7th Ave. Spokane, WA 92204

George Beeper 45 Mountain View Drive, Apt 321 Spokane, WA 99210

Questions and Problems

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4-64 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

1. The following additional information is available for the Albert and Allison Gaytor family. The Gaytors own a rental beach house in Hawaii. The beach house was rented for the

full year during 2019 and was not used by the Gaytors during the year. The Gaytors were active participants in the management of the rental house but the activity is not eligible for a QBI deduction. Pertinent information about the rental house is as follows:

Address: 1237 Pineapple St., Lihue, HI 96766 Gross rental income $20,000 Mortgage interest 7,900 Real estate taxes 2,175 Utilities 1,500 Cleaning 2,400 Repairs 675

The house is fully depreciated so there is no depreciation expense.

GrOUp 5:

CuMuLATIVE SOfTWARE pROBLEM

2B. In 2019, Professor Patricia (Patty) Pâté retired from the Palm Springs Culinary Arts Academy (PSCAA). She is a single taxpayer and is 62 years old. Patty lives at 98 Colan- der Street, Apt. 206D, Henderson, NV 89052. Professor Pâté’s Social Security number is 565-66-9378. In 2019, Patty had just a few months of salary from her previous job:

Wages $9,800 Federal tax withheld 450 State tax withheld 0

Patty owns a rental condo located at 392 Spatula Way, Mount Charleston, NV 89124. The condo rented for two months of 2019 for $850 a month but a mold prob- lem was discovered in the condo, her renters moved out, and she was unable to rent the apartment after the repairs (although she vigorously pursued new tenants). Patty actively manages the property herself. The following are the related expenses for the rental house:

Real estate taxes $3,900 Mortgage interest 9,100 Insurance 561 Depreciation (assume fully depreciated) 0 Homeowners’ Association dues 1,260 Repairs 1,195 Gardening 560 Advertising 1,200

The condo was purchased on August 31, 1980. Professor Pâté handles all rental activities (e.g., rent collection, finding tenants, etc.) herself.

In 2019, Patty sold her beloved home for almost 30 years for $380,000 on February 27, 2019. Her basis in the home was $120,000 and she acquired the home sometime in July of 1989 (she could not remember the day).

Required: Complete Professor Pâté’s federal tax return for 2019. Use Form 1040, Schedule D, Form 8949, Schedule E, and Form 8582 (page one only) to complete this tax return. Also, to compute Patty’s net operating loss carryforward, prepare only Schedule A of Form 1045.

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4-65

Albert and Allison received the following combined statements 1099-DIV and 1099-B from their investment manager:

IMPORTANT TAX DOCUMENT 2019 Form 1099-DIV

Dividends and Distributions

RECIPIENT’S TIN: 266-51-1966 Fortress Securities

Albert T. Gaytor PO Box 1300 Allison A Gaytor Gaithersburg, MD 20877 JT TEN WROS Copy B for Recipient 12340 Cocoshell Rd Coral Gables, FL 33134

Fund Name

Total Ordinary Dividends

Qualified Dividends

Capital Gain

Distrib Unrecap

1250 Gain Nondividend

Distrib Fed Tax

Withheld

Exempt- Interest

Dividends State Tax Withheld

Peach Fund 0.00 0.00 450.00 0.00

2019 Form 1099-B Proceeds from Broker and Barter Exchange Transactions

Descript. Date Acq Date Sold Proceeds Cost Fed Tax

Withheld

Proceeds Reported

to IRS

Basis Reported

to IRS

100 shs. Orange Co 02/11/2001 04/16/2019 $3,000.00 $2,175.00 $0.00 Net Yes

100 shs. Banana Co. 07/17/2005 07/31/2019 2,100.00 4,200.00 0.00 Net Yes

100 shs Grape Corp 12/18/2018 09/25/2019 9,050.00 10,500.00 0.00 Net Yes

5 $1,000 Par Value Bonds due 4/2019

12/30/2009 01/02/2019 5,200.00 5,415.00 0.00 Net Yes

5,011.23 shs. Peach Mutual Fund

05/30/2010 10/22/2019 60,100.00 56,000.00 0.00 Net Yes

On January 12, 2019, Albert and Allison sold their personal residence for $715,200 and purchased a new house for $725,000. This was their personal residence before and after the divorce (they have lived in it together for three years since remarrying). The old house cost $120,000 back in January of 2007 and they added on a new bedroom and bathroom a few years ago for a cost of $20,000. They also built a pool for a cost of $60,000. They moved into the new house on January 19, 2019.

Required: Combine this new information about the Gaytor family with the information from Chapters 1–3 and complete a revised 2019 tax return for Albert and Allison. Be sure to save your data input files since this case will be expanded with more tax information in later chapters.

Questions and Problems

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4-66 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-67 Questions and Problems

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4-68 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-69 Questions and Problems

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4-70 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-71 Questions and Problems

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4-72 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-73 Questions and Problems

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4-74 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-75 Questions and Problems

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4-76 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-77 Questions and Problems

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4-78 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-79 Questions and Problems

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4-80 Chapter 4 ● Additional Income and the Qualified Business Income Deduction

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4-81

Student Name

Class/Section

Date

K e y N Um B e r ta x r e t U r N sUm m a ry

ChApTER 4

Comprehensive problem 1

Capital Gain or (Loss) (Line 6)

Rental Real Estate (Schedule 1, Line 5)

Adjusted Gross Income (Line 8b)

Total Tax (Line 16)

Amount Overpaid (Line 20)

Comprehensive problem 2A

Rental Real Estate (Schedule 1, Line 5)

Adjusted Gross Income (Line 8b)

Total Tax (Line 16)

Amount Overpaid (Line 20)

Comprehensive problem 2B

Capital Gain or (Loss) (Line 6)

Rental Real Estate (Schedule 1, Line 5)

Adjusted Gross Income (Line 8b)

Total Tax (Line 16)

Net Operating Loss (Form 1045, Schedule A, Line 25)

Questions and Problems

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ze ns

to ck

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tt er

st oc

k. co

Deductions For and From AGI

C h a p t e r 5

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5-1

L E A R N I N G O B J E C T I V E S

After completing this chapter, you should be able to: LO 5.1 Explain how Health Savings Accounts (HSAs) can be used for tax-advantaged

medical care. LO 5.2 Describe the self- employed health insurance deduction. LO 5.3 Explain the treatment of Individual Retirement Accounts (IRAs), including Roth IRAs. LO 5.4 Explain the general contribution rules for small business and self- employed

retirement plans. LO 5.5 Describe other adjustments for adjusted gross income. LO 5.6 Calculate the itemized deduction for medical expenses. LO 5.7 Calculate the itemized deduction for taxes. LO 5.8 Apply the rules for an individual taxpayer’s interest deduction. LO 5.9 Determine the charitable contributions deduction. LO 5.10 Describe other itemized deductions.

O V e r V I e W

D eductions related to a business (for example, Schedule C in Chapter 3) or the production of income or invest- ment (for example, Schedules D and

E in Chapter 4) represent deductions that are for AGI (above the line). The business deductions are

generally reported on the separate schedules. However, the tax law permits additional for AGI deductions that may be associated with busi- ness activity or, in some instances like the student loan interest deduction, as simply a matter of legislative grace for individual taxpayers. These

5-1

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5-2 Chapter 5 ● Deductions For and From AGI

additional deductions are now reported on the bottom half of Schedule 1 of the Form 1040 and include one-half of self-employment taxes, deductible contributions to an individual retirement account, and others.

Deductions that occur after AGI (from AGI deductions) include the standard deduction discussed in Chapter 1. Chapter 5 will also introduce Schedule A itemized deductions. Itemized deductions fall into six categories: medical and dental expenses, state and local taxes, interest expenses, charitable contributions, casualty and theft losses, and miscellaneous deductions.

Recall from Chapter 1, that when calculating taxable income, individuals determine their standard deduction and their allowable itemized deductions and use the larger of the two. For example, if a taxpayer’s standard deduction is $12,200 and her itemized deductions are $18,100, she would use her itemized deductions in calculating taxable income. On the other hand, if her itemized deductions were $9,500, she would use the larger standard deduction of $12,200 in computing taxable income.

Starting in 2018, a number of limitations were placed on itemized deductions. One example is the $10,000 limit on state and local taxes. For federal budget reasons, many of these limitations only suspend, rather than repeal the deduction. The suspensions are largely scheduled to end after 2025. As a result, brief explanations of the pre-limitation deductions are provided.

5-1 HEALTH SAVINGS ACCOuNTS There are four types of tax-favored medical spending plans available to taxpayers:

1. Health care flexible spending arrangements or FSAs (covered in Chapter 2) in which employees can set aside money to cover medical expenses and exclude the funds from gross income.

2. Health Reimbursements Arrangements (HRAs) in which the employer funds an ac- count that may be used by employees for medical expenses (these do not generally affect an individual taxpayer’s taxable income and thus are not covered in detail in this textbook).

3. Medical Savings Accounts (MSAs or Archer MSAs) which permit (limited) deductions for amounts contributed to an account established to cover medical expenses for small business and self-employed individuals. Effective January 1, 2008, no new MSA accounts may be established and thus these are not covered in detail in this textbook. Note that an Archer MSA can be rolled over into an HSA.

4. Health Savings Accounts (HSAs) are a type of savings account which may be estab- lished for the purpose of paying unreimbursed medical expenses by taxpayers who carry qualifying high-deductible medical insurance.

Contributions to HSAs are a deduction for AGI and are limited to certain dollar amounts depending on age and whether the high-deductible insurance covers an individual or a family. Earnings and unused contributions accumulated in an HSA are not taxed, and dis- tributions to cover medical expenses are not taxed or penalized.

Health insurance with a high deductible is less expensive than standard health insurance since the issuing insurance company does not have to pay any of the taxpayer’s medical expenses until a certain threshold (the deductible plus any other required out- of-pocket medical costs) is reached. The funds contributed to the HSA may then be used by the taxpayer to pay medical expenses not covered by health insurance. This popular

Learning Objective 5.1 Explain how Health Savings Accounts (HSAs) can be used for tax- advantaged medical care.

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5-35-1 Health Savings Accounts

combination of tax benefits and less expensive insurance is designed to encourage taxpayers to carry health insurance.

5-1a Deductions for Contributions to HSAs The following table shows the contribution limits for HSA deductions for 2019. The table also shows the additional “catch-up” contributions allowed for individuals beginning at age 55 and ending at age 65, the age for Medicare eligibility. Individuals are not allowed to make contributions to HSAs once they attain the age of 65 and qualify for Medicare cover- age. Finally, the table shows the lower and upper deductible and out-of-pocket medical expense limits (excluding the actual cost of insurance) required for insurance to qualify as a high-deductible health plan.

Although the out-of-pocket limits under the Affordable Care Act (ACA) are slightly higher than those listed above, the IRS limits determine tax compliance for HSAs. Contributions to HSAs must generally be made by April 15 of the year following the year for which the contribution is made. IRS Form 8889 is used to provide information to the IRS regarding HSA deductions claimed on Line 12 of Schedule 1 of Form 1040 and to compute the deduction amount.

EXAMPLE Gary is 35 years old and carries self-only coverage in a qualifying high- deductible health insurance plan during 2019. Gary may contribute up to $3,500 to his HSA account and deduct this amount for AGI. Gary may use some or all of the contribution to pay medical expenses he has incurred. Any amount he leaves in the HSA account will accumulate earnings tax free and carry forward to be used for qualifying medical expenses in the future. ♦

5-1b Distributions Distributions from HSAs are free of tax when used to pay for qualified medical expenses. Distributions which are not used to pay for qualified medical expenses are subject to both in- come tax and a 20 percent penalty. Once a taxpayer is 65 years old, distributions may be taken for nonmedical expenses and will be subject to income tax, but not the 20 percent penalty. Distributions from an HSA are reported on Form 1099-SA (see Self-Study Problem 5.1). The amount of the distribution is reported in Box 1 and codes indicating the proper treatment are provided in Box 3. A normal distribution is coded 1.

2019 Limits for HSAs

Family Self-Only

Contribution limit

Additional catch-up contribution for taxpayer age 55 or older

Minimum health insurance deductible

Maximum health insurance out-of-pocket

$ 7,000

1,000 per qualifying spouse

2,700

13,500

$ 3,500

1,000

1,350

6,750

To report HSA information and complete a Form 8889, the input area can be found in the left-hand margin under Deductions/Adjustments to Income. The input area is conveniently called Health Savings Account (Form 8889). tIp

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5-4 Chapter 5 ● Deductions For and From AGI

Self-Study Problem 5.1 See Appendix E for Solutions to Self-Study Problems a. Give the deductible HSA amount for each of the following taxpayers for 2019:

1. Amy is 40 years old, has a qualifying high-deductible health plan, carries family coverage, and contributes the maximum amount to her family HSA. Deductible HSA amount: $

2. Cary is 60 years old, has self-only health insurance with no deductible, and contributes $1,200 to an HSA. Deductible HSA amount: $

3. Annabelle is 52 years old and contributes $2,000 to her HSA. She has qualifying self-only coverage in a high-deductible health plan. Deductible HSA amount: $

4. Lucille is 70 years old and is covered by Medicare. She contributes $3,050 to her HSA. Deductible HSA amount: $

b. Alex Morton is a single taxpayer, age 34. She is part of a qualifying high-deductible health plan. In 2019, Alex made contributions of $2,700 to her HSA. Alex’s employer reported making $300 of contributions to her HSA in Box 12 of her Form W-2 (code W). Alex spent $2,500 on qualified medical expenses. Alex received the following Form 1099-SA from her HSA administrator:

Form 1099-SA

2019 Distributions

From an HSA, Archer MSA, or

Medicare Advantage MSA

Copy B For

Recipient

Department of the Treasury - Internal Revenue Service

This information is being furnished

to the IRS.

OMB No. 1545-1517

CORRECTED (if checked) TRUSTEE'S/PAYER'S name, street address, city or town, state or province, country, ZIP or foreign postal code, and telephone number

PAYER'S TIN RECIPIENT'S TIN

RECIPIENT'S name

Street address (including apt. no.)

City or town, state or province, country, and ZIP or foreign postal code

Account number (see instructions)

1 Gross distribution

$ 2 Earnings on excess cont.

$ 3 Distribution code 4 FMV on date of death

$ 5 HSA

Archer MSA

MA MSA

Form 1099-SA (keep for your records) www.irs.gov/Form1099SA

Heritage Health Partners PO Box 12345 Dallas, TX 75621

13-0080072

Alex Morton

1921 S. Orange Ave.

Orlando, FL 32806

213-21-3121 1,783.00

Prepare Form 8889 (page 1 only) on Page 5-5 to determine Alex’s HSA deduction and taxable HSA distribution.

EXAMPLE Debbie is 66 years old and has $30,000 in her HSA. She can withdraw the $30,000 to purchase a new car, but will have to pay income tax on the distribution. If she takes the distribution to pay medical expenses, no income tax will be due. If Debbie were 55 years old and took a distribution from her HSA to buy a car, she would owe both income tax and a 20 percent penalty on the distribution. ♦

5-1c Guidance The rules governing HSAs are more detailed and lengthy than the summaries above. IRS Publication 969 is a good source of information on a range of additional issues related to HSAs and their operation.

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5-55-1 Health Savings Accounts

Self-Study Problem 5.1

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5-6 Chapter 5 ● Deductions For and From AGI

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5-75-2 Self-Employed Health Insurance Deduction

5-2 SELf-EMPLOyED HEALTH INSuRANCE DEDuCTION Self-employed taxpayers are allowed an above-the-line deduction for the cost of providing health insurance for themselves and their families. This deduction is meant to give self- employed taxpayers the same tax treatment available to employees who are offered health insurance as a tax-free benefit of employment. Deductible insurance includes the following:

● Medical and dental insurance paid to cover the self-employed taxpayer, spouse, and dependents;

● Medical and dental insurance paid for children under the age of 27 who are not dependents;

● Medicare premiums; ● Long-term care insurance paid for the taxpayer and the family of the taxpayer, within

certain dollar limitations shown below.

EXAMPLE Joe has a barbershop and earns $60,000 in 2019 which he reports on Schedule C. Joe pays $10,000 in health and dental insurance costs for him- self, his unemployed wife, and his 10-year-old daughter. The full $10,000 is a deduction for Joe’s AGI. ♦

5-2a Special Rules The following special rules limit the treatment of health insurance as a deduction for AGI:

● Other Health Care Plan Available: The self-employed health insurance deduction is not allowed for any months in which the taxpayer is eligible to participate in a subsidized health care plan offered by an employer of either the taxpayer or the spouse of the taxpayer.

● Earned Income Limitation: The deduction for self-employed health insurance is only allowed to the extent of the taxpayer’s net self-employed earned income. For example, a taxpayer with a Schedule C business loss would not be allowed to claim a self- employed health insurance deduction even though he or she paid for health insurance. The deduction would instead be allowed as an itemized medical deduction subject to the limits discussed in LO 5.6.

● Long-Term Care Premium Limitation: The individual limitations on the deduction of long-term care premiums are as follows:

5.2 Learning Objective Describe the self- employed health insurance deduction.

● Definition of Self-Employment: Taxpayers with income reportable on Schedule C are generally considered self-employed. However, taxpayers with earnings from certain partnerships, S corporations, LLCs, and farm businesses may also be considered self- employed and may be allowed the above-the-line deduction for self-employed health insurance. Taxpayers with income from these sources sometimes present more complex health insurance deduction issues which should be researched as they appear.

● Deductible Portion: Self-employed taxpayers that receive advance premium tax credits under the ACA may deduct only the portion paid out of pocket, not the portion covered by the premium tax credit.

Attained Age Before the Close of the Taxable Year

2019 Limitation on Premiums

40 or less More than 40 but not more than 50 More than 50 but not more than 60 More than 60 but not more than 70 More than 70

$ 420 790 1,580 4,220 5,270

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5-8 Chapter 5 ● Deductions For and From AGI

EXAMPLE Candace is a 55-year-old massage therapist who earns $40,000 of net self- employment income in 2019. She pays $6,000 for medical insurance and $1,600 for long-term care insurance. Candace can take $7,580 ($6,000 1 $1,580) as a deduction for AGI. ♦

Self-Study Problem 5.2 See Appendix E for Solutions to Self-Study Problems

During the 2019 tax year, Gwen supports her family as a physical therapist. She reports $90,000 of earned income on her Schedule C and paid the following insurance premiums:

● Family health insurance: $15,000 ● Family dental insurance: $2,000 ● Health insurance for her 24-year-old son who is not a dependent: $3,000 ● Long-term care insurance for her 49-year-old husband: $800

What is Gwen’s self-employed health insurance deduction for 2019? $

5-3 INDIVIDuAL RETIREMENT ACCOuNTS There are two principal types of IRAs in the United States. One is the traditional IRA and the other is the Roth IRA. Generally, annual contributions to a traditional IRA are deductible, and retirement distributions are taxable. Annual contributions to a Roth IRA are not deductible, but retirement distributions are nontaxable. Earnings in both types of IRAs are not taxable in the current year.

EXAMPLE Gene has $30,000 in his IRA in 2019. The earnings for the year on this IRA are $1,600. These earnings are not taxed to Gene in the current year. ♦

5-3a IRA Annual Contributions There are annual contribution limits for both traditional and Roth IRAs. In 2019, the maxi- mum annual contribution that may be made to either type of IRA is equal to the lesser of (1) 100 percent of the taxpayer’s compensation or self-employment income (earned in- come) or (2) $6,000 (or $12,000 if an additional $6,000 is contributed to a spouse’s IRA, and the spouse has no earned income). The maximum contribution to a spouse’s IRA may not exceed $6,000. In 2019, an additional $1,000 annual “catch-up” contribution is allowed for taxpayers and spouses age 50 and over, increasing the maximum contribution to $7,000.

EXAMPLE Quincy, age 31, works for Big Corporation and has a salary of $40,000 for 2019. Quincy is eligible to contribute the maximum $6,000 to his traditional or Roth IRA for 2019. If Quincy has a spouse who does not work, he could also contribute $6,000 into her IRA or Roth IRA. If Quincy is 55 years old instead of 31 years old, he could contribute $7,000 to his traditional or Roth IRA, and $6,000 or $7,000 for his spouse, depending on whether she is old enough to qualify for the $1,000 “catch-up” contribution. ♦

Learning Objective 5.3 Explain the treatment of Individual Retirement Accounts (IRAs), including Roth IRAs.

tIp To enter self-employed health insurance and many of the other for-AGI deductions, go to Deductions/Adjustments to Income. There is a long input page, and a number of subheadings are available in the left-hand margin.

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5-95-3 Individual Retirement Accounts

If a taxpayer contributes to both a traditional IRA and a Roth IRA, the combined contributions cannot exceed the normal annual limit ($6,000 or $7,000 if age 50 or older in 2019).

The IRA limitation calculations discussed below are quite complex and change every year. Most taxpayers and tax preparers use tax software to assist them in calculating allowable IRA deductions. It is a standard belief in the tax community that computer software has paved the way for the enormous complexity we see in today’s tax law. Although it is important to understand the rules for calculating IRA contributions, please take solace in the fact that these calculations, as well as many others shown in this textbook, are not often done by hand in practice.

TAX BREAK

The annual deduction maximums above are reduced for traditional IRAs if the taxpayer is an active participant in another qualified retirement plan. The annual contribution allowed for a Roth IRA is reduced for all taxpayers over certain income levels, but is not affected by whether the taxpayer or spouse is an active participant in another retirement plan. In each case, the maximum annual contribution is phased out proportionately between certain adjusted gross income ranges, as shown below.

2019 AGI Phase-Out Ranges for Deductible Traditional IRA Contributions

Type of Taxpayer Phase-Out Range

Single or HOH, not a plan participant Single or HOH, active plan participant Married, Joint, both active participants Married, Joint, neither active plan participants Married, Joint, one an active participant: Active participant spouse Nonactive participant spouse

No phase-out $64,000–$74,000 $103,000–$123,000 No phase-out (See Note 1 below) $103,000–$123,000 (Joint AGI) $193,000–$203,000 (Joint AGI)

Note 1: When one spouse is an active participant in a retirement plan and the other is not, two separate income limitations apply. The active participant spouse may make a full deductible IRA contribution unless the $103,000–$123,000 phase-out range applies to the couple’s joint income. The spouse who is not an active participant may make a full deductible IRA contribution unless the higher $193,000–$203,000 phase-out range applies to the couple’s joint income.

2019 AGI Phase-Out Ranges for Roth IRA Contributions

Filing Status AGI Phase-Out Range

Single or HOH Married, Joint

$122,000–$137,000 $193,000–$203,000

Note: Active plan participation status is not relevant to the Roth IRA phase-out calculation. Special rules apply to married filing separate taxpayers.

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5-10 Chapter 5 ● Deductions For and From AGI

A nondeductible traditional IRA contribution may be made by taxpayers with income over the phase-out ranges shown above. Although the taxpayer cannot deduct the contribution, all income earned in the IRA account is sheltered from tax until the earnings are withdrawn. When there have been nondeductible IRA contributions, the calculation of the taxable portion of the withdrawn IRA money is calculated similar to the treatment of annuities discussed in Chapter 2. Many high-income taxpayers make nondeductible traditional IRA contributions each year because of the deferral of tax on the earnings of the IRA.

EXAMPLE Ed, age 31, is single and is covered by a retirement plan. If his modified adjusted gross income is $68,000, Ed’s maximum deductible traditional IRA contribution is $3,600. With income of $68,000, his $6,000 contribution is proportionately phased out by dividing the amount remaining in his phase- out range, $74,000 2 $68,000, or $6,000, by the $10,000 phase-out range (the difference between the bottom and top of the $64,000 and $74,000 phase-out range) and multiplying this by the $6,000 maximum IRA deduction as follows:

s$74,000 2 $68,000d $10,000

3 $6,000 5 $3,600 allowed IRA deduction

Ed may choose to contribute the $6,000 maximum to a traditional IRA, but the remaining $2,400 will not be deductible. Alternatively, he may contribute the remaining $2,400 to a Roth IRA since his income is below the phase-out range for Roth IRA contributions. He could also choose to ignore the allowed traditional IRA contribution and contribute the full $6,000 to a Roth IRA. In any event, he cannot contribute more than $6,000 in total to IRAs, and his maximum allowed tax deduction for a traditional IRA contribution will be $3,600. ♦

EXAMPLE Ann, who is 36 and single, would like to contribute $6,000 to her Roth IRA. However, her AGI is $125,000, so her contribution is limited to $4,800 calculated as follows:

s$137,000 2 $125,000d $15,000

3 $6,000 5 $4,800 allowed Roth IRA

The $15,000 denominator in the calculation above is the amount of the phase-out range between $122,000 and $137,000. If she were 50 or older and wanted to contribute $7,000, her contribution would be limited to $5,600. ♦

EXAMPLE Paul and Lucy are married and are both 36 years old. Lucy is covered by a retirement plan and earns $64,000. Paul is not covered by a retirement plan and earns $60,000. Lucy cannot make a deductible contribution to a traditional IRA since the income on their joint tax return is greater than the $123,000 maximum phase-out range for married couples. Paul, however, can make a fully deductible IRA contribution of $6,000 since Paul and Lucy’s AGI is below the $193,000–$203,000 phase-out range used when one spouse is an active participant in a plan and the other is not. Lucy could still choose to make a $6,000 contribution to a Roth IRA since their joint income is below the Roth IRA phase-out range for married couples. Paul would have a choice between making a $6,000 deductible contribution to a traditional IRA or a contribution of $6,000 to a Roth IRA or some combination thereof, not greater than $6,000. ♦

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5-115-3 Individual Retirement Accounts

An IRA contribution may be made at any time before the original due date of the tax return for the year in which the deduction is to be claimed. This means, for example, that an individual can contribute to an IRA as late as the filing deadline of April 15, 2020, and still deduct the amount on the 2019 tax return.

5-3b Roth IRA Conversions Taxpayers may benefit from a rule allowing conversions of traditional IRAs into Roth IRAs. Although the income generated by the conversion is subject to current income tax, tax- payers with certain factors in their favor such as many years to retirement, a low current tax bracket, or a high expected tax bracket in retirement may wish to convert. Also, taxpayers with negative taxable income due to large personal deductions may wish to convert enough of their regular IRAs to Roth IRAs to bring taxable income to zero. This way the conversion can be done with no tax cost since deductions which would otherwise be lost are used to offset the taxable IRA income.

For tax years 2010 and beyond, a rule that required taxpayers to have $100,000 or less in AGI to convert regular IRA accounts to Roth IRA accounts was eliminated. Congress expects that many high-income taxpayers will take advantage of this opportunity and pay income tax due up-front on conversions.

5-3c Traditional IRA Distributions Money removed from a traditional IRA is taxable as ordinary income and may be subject to a 10 percent penalty for early withdrawal. To avoid the 10 percent penalty, distributions from an IRA generally cannot begin before age 59½. However, penalty-free withdrawals from IRAs may be made by taxpayers under age 59½ who are:

1. Disabled 2. Using a special level payment option 3. Using the withdrawals for unreimbursed medical expenses in excess of 10 percent

of their AGI 4. The recipients of at least 12 weeks of unemployment compensation and to the extent

they are paying medical insurance premiums for their dependents 5. Paying the costs of higher education, including tuition, fees, books, and room and board

for the taxpayers or their spouses, children, or grandchildren 6. Withdrawing up to $10,000 for first-time home-buying expenses 7. Beneficiaries due to the death of the IRA owner 8. Withdrawing funds due to an IRS levy 9. A qualified reservist

While withdrawals made by these taxpayers are penalty free, they are still subject to income taxes. Also, taxpayers must start taking minimum annual distributions from their IRA at age 70½. The IRS provides tables for calculating the required minimum annual distributions based on the taxpayer’s life expectancy.

EXAMPLE Tomas is 48 years old and has a midlife crisis and decides he must have a red sports car. He withdraws $35,000 from his traditional IRA to purchase the car. Tomas does not qualify for any of the penalty-free withdrawals listed earlier. The $35,000 is taxable to Tomas as ordinary income and he is subject to a $3,500 (10% 3 $35,000) penalty for removing the funds before age 59½. ♦

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5-12 Chapter 5 ● Deductions For and From AGI

5-3d Roth IRA Distributions A taxpayer can make tax-free withdrawals from a Roth IRA after a 5-year holding period if any of the following requirements are satisfied:

1. The distribution is made on or after the date on which the participant attains age 59½. 2. The distribution is made to a beneficiary (or the participant’s estate) on or after the

participant’s death. 3. The participant becomes disabled. 4. The distribution is used to pay for qualified first-time home-buyer’s expenses.

EXAMPLE Bob establishes a Roth IRA at age 50 and contributes to the Roth each year for 10 years. The account is now worth $61,000, consisting of $35,000 of nondeductible contributions and $26,000 in earnings that have not been taxed. Bob may withdraw the $61,000 tax-free from the Roth IRA because he is over age 59½ and has met the 5-year holding period requirement. ♦

The distributions may be taxable if the taxpayer receives distributions from a Roth IRA and does not satisfy the above requirements. The part of the distributions that represents a return of capital is tax free, and the part that represents a payout of earnings is taxable. Under the ordering rules for Roth IRA distributions, distributions are treated as first made from contributions (return of capital) and then from earnings.

EXAMPLE Assume the same facts in the previous example, except that Bob is only age 56 and receives distributions of $10,000. Assume his adjusted basis for the Roth IRA is $12,000 (contributions made of $2,000 3 6 years). The distribution is tax free and his adjusted basis is reduced to $2,000 ($12,000 2 $10,000). ♦

A gift to a Roth IRA for a child or grandchild with a summer job can grow into a very large gift over time. The amount that may be contributed to a child’s Roth IRA is the lesser of $6,000 or the child’s earnings. A child with $6,000 in a Roth IRA at age 16 will have well over $100,000 at age 65 if the Roth IRA investment earns 7 percent annually.

TAX BREAK

Self-Study Problem 5.3 See Appendix E for Solutions to Self-Study Problems a. During 2019, George (a 24-year-old single taxpayer) has a salary of $46,000, dividend

income of $14,000, and interest income of $4,000. In addition, he has rental income of $1,000. George is covered by a qualified retirement plan. Calculate the maximum regular IRA deduction that George is allowed.

$ b. During 2019, Irene (a single taxpayer, under age 50) has a salary of $115,500 and

dividend income of $10,000. Calculate Irene’s maximum contribution to a Roth IRA.

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5-135-4 Small Business and Self-Employed Retirement Plans

5-4 SMALL BuSINESS AND SELf-EMPLOyED RETIREMENT PLANS

The tax law provides employees, employers, and the self-employed with an incentive to plan for retirement through qualified retirement plans. Under the tax law, favorable tax treatment is granted to contributions, by or for employees, to qualified retirement plans. Employers may claim a deduction in the current year for contributions to qualified retire- ment plans on the employees’ behalf, while the employees do not include the employer contributions in income until the contributed amounts are distributed (generally during their retirement years). Tax on earnings on the amounts contributed to the plan is also de- ferred. This deferral of income taxation is a significant benefit to most taxpayers.

EXAMPLE In the current year, Polly’s employer makes a $2,000 contribution to a qualified plan for Polly’s retirement. The $2,000 is deductible to the employer in the current year and is not taxable to Polly until she withdraws the money from the plan. Any earnings on the money contributed to the plan are also taxable only upon withdrawal from the plan (usually many years later). ♦

The tax code provides for a number of different types of plans for taxpayers to save for retirement. Most retirement plans have a number of requirements in order to be classified as “qualified” and thus extend the tax benefits described previously:

● Funding requirements: Most require that the benefit be extended to all employees and not favor only the highly compensated (nondiscriminatory)

● Fiduciary responsibility: Most require a separate account to hold the retirement assets, typically handled by a bank or financial institution

● Early withdrawals: Most penalize or prohibit early distributions from the plan with limited hardship exceptions

● Vesting requirement: Some require immediate “vesting” of contributions (i.e., the con- tributions are immediately set aside for an employee and will not be returned to the employer even if the employee leaves)

The retirement plan area has become one of the most complex areas of the tax law. Many tax accountants refer taxpayers to a specialist for help in choosing a plan and for guidance through the ongoing employee coverage, tax reporting, and contribution requirements. The coverage in this textbook is meant to give a simple overview of several common options available to taxpayers for tax-deferred retirement plans, which remain one of the best completely legal tax shelters available. Retirement plans for small businesses are covered here while large plans, which are generally operated by larger employers, are covered in Chapter 9.

5-4a Self-Employed and Small Business Retirement Plan Options

Although available to small businesses, complex retirement plans such as defined-benefit plans or employee stock ownership plans are generally used by only large companies due to their complexity and cost to operate (see Chapter 9). However, over time, the tax law has created a number of retirement plans directed at the small business owner or even a self-employed sole proprietor.

5-4b SEP or SEP IRA, SIMPLE IRA, and Payroll Deduction IRA

A Simplified Employee Pension (SEP or SEP IRA) is a retirement plan available to any em- ployer (including a self-employed individual). These plans are simple to set up–the IRS even provides a one-page Form 5305-SEP that can be used. SEPs have flexible funding require- ments in case funding the plan with consistent contribution amounts might be an issue for the underlying business. The amount of contributions can change from year-to-year and can

5.4 Learning Objective Explain the general contribution rules for small business and self- employed retirement plans.

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5-14 Chapter 5 ● Deductions For and From AGI

be zero. Participants in SEPs must meet requirements for minimum age and years of service. An employer must cover employees if the employees meet the requirements for coverage.

SEP contributions and deductions are limited under different rules for employees versus the self-employed business owner. The maximum contribution made for an employee and the related deduction cannot exceed the lesser of 25 percent of the employee’s compensation or $56,000 in 2019. For the self-employed business owner, the contribution maximum is the same as for employees; however, the deduction limit considers the net self-employment income after consideration of the deduction for the contribution to the SEP. As a result, the deduction available for the self-employed will be slightly lower than that of an employee and is derived by taking the plan contribution rate and dividing by one plus the contribution rate; thus effectively lowering the maximum contribution rate to 20 percent (0.25 4 1.25).

EXAMPLE Dan is a self-employed doctor. His net earned income (Schedule C net income less one-half of self-employment tax) from his practice is $125,000. Under the terms of his SEP plan, Dan contributes 20 percent of compensation (up to the maximum allowable) to the plan for his employees. Dan’s maximum deduction is calculated as follows:

Dan’s self-employed rate is 0.20 4 1.20 5 0.1666 or 16.667 percent. His maximum deduction is $20,834, which is the lesser of 16.667% 3 $125,000 ($20,834) or $56,000. ♦

To avoid penalties, taxpayers generally may not receive distributions from a SEP prior to age 59½ and must start drawing amounts by the age of 70½.

In the past, a plan similar to a current SEP, known as a SARSEP, was available. SARSEPs could not be created after January 31, 1996 and although some plans were grandfathered in, many are no longer in operation.

A Payroll Deduction IRA is probably the easiest type of plan to offer. Contributions are withheld from an employee’s pay and directed into a traditional IRA account. No plan set- up is necessary other than having the employee direct the payroll withholding to the IRA custodian. Contribution limits are the same as the traditional IRA limits.

A SIMPLE IRA is available to any employer with 100 or fewer employees (including a self-employed individual). SIMPLE IRAs are also easy to set up (Form 5304-SIMPLE or 5305-SIMPLE) and administer. Both the employee and the employer are eligible to contribute with an annual limit of $13,000 ($16,000 for taxpayers age 50 or older) in 2019. However, unlike a SEP, a SIMPLE IRA requires certain contributions must be made by the employer (match employees of the first 3 percent of compensation (with some flexibility) or 2 percent of each eligible employee’s compensation.

5-4c Self-Employed 401(k), Solo 401(k), Safe Harbor, and Traditional 401(k) Plans

One of the more popular qualified retirement plans is the Section 401(k) plan, which per- mits an employee to choose to receive a direct payment of compensation in cash or to defer the amount through an employer contribution on behalf of the employee to a profit-sharing or stock bonus plan. Such a plan may be structured as a salary reduction agreement. The agreement may allow the employee to reduce his or her compensation or forgo an increase in compensation, with the amount contributed to the qualified retirement plan, thereby de- ferring tax on the compensation. Employees choose the percentage of their pay which will be withheld and contributed to the plan. Some employers match employee contributions up to a certain percentage in order to encourage participation.

In all 401(k) plans, contributions are limited in two ways: (1) for 2019, an employee may elect to make an annual contribution up to $19,000 ($25,000 for taxpayers age 50 or older) to a Section 401(k) plan, and (2) the amount of any contributions made to the Section 401(k) plan are also subject to the limitations applicable to all qualified plans (25 percent of compensation subject to a limit of $56,000, $62,000 if over age 50).

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5-155-4 Small Business and Self-Employed Retirement Plans

Any matching amount contributed to the plan by the employer on behalf of the employee is excluded from the employee’s gross income. The contributions and the earnings on the amounts invested in the plan are taxable only when withdrawn.

A self-employed 401(k) or solo 401(k) is designed for self-employed individuals with no employees (spouse is permitted). Setup and maintenance of the plan are relatively inexpensive and easy.

A traditional 401(k) plan can be used by any type of company but is generally thought to be more appropriate for business with at least 20 employees due to the cost to establish and maintain the plan. An annual reporting of the plan assets is required (Form 5500) and special IRS testing is required to ensure that the plan does not favor highly-compensated employees.

The annual maximum ($19,000, or $25,000 if age 50 or over, in 2019) is reduced dollar for dollar by amounts contributed as a result of the employee’s participation in other salary reduction plans of any employer. Contributions in excess of the maximum allowed may be subject to a 10 percent excise tax imposed on the employer. Also, if the excess contributions are not withdrawn within a specified time period, the plan will lose its status as a qualified arrangement.

Finally, Section 401(k) plans must meet certain requirements in addition to the general qualification requirements for all qualified plans. The amount deferred must be 100 percent vested and may be distributed only upon retirement, death, disability, or other separation from service, attainment of age 59½, or hardship.

EXAMPLE Carol, age 48, participates in a Section 401(k) plan. Carol’s salary is $30,000 per year and she chooses to contribute 15 percent to the 401(k) plan. The maximum amount she may contribute on a tax-deferred basis to the Section 401(k) plan under a salary reduction agreement is $4,500 (15% 3 $30,000, not to exceed $19,000, in 2019). ♦

For small businesses with employees, a safe harbor 401(k) plan operates like other 401(k) plans with one important distinction: it must provide for employer contributions that are fully vested when made. These contributions may be employer-matching contributions, limited to employees who defer, or employer contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals. The safe harbor 401(k) plan is not subject to the complex annual nondiscrimination tests that apply to traditional 401(k) plans.

Beginning in 2006, employers were allowed to set up Roth 401(k)s for their employees. The amounts allowed to be set aside are the same as for regular 401(k)s, but the dollars paid in do not reduce the employees’ taxable income, which is similar to the tax treatment of Roth IRAs. Withdrawals, including earnings, are generally tax-free based on rules similar to those for Roth IRA withdrawals. Roth 401(k)s are popular because they allow a significantly higher Roth contribution than a Roth IRA and because there is no AGI limitation, they may be used by high-income taxpayers.

Different types of tax-advantaged retirement plans have developed over many years. Plans such as these tend to have long lifetimes as an employee may contribute early in their working career and then wait 40 years or more before reaching retirement age. The plans, once created, are slow to disappear. The result is a jumbled selection of plans to consider. In the previous few pages ten different plans were mentioned: SEP, SARSEP, SEP IRA, SIMPLE IRA, Payroll Deduction IRA, Self-Employed 401(k), Solo 401(k), Safe harbor 401(k), traditional 401(k), and Roth 401(k) plans. This list does not even consider the other “large” qualified plans such as traditional pension plans (defined contribution and defined benefit), profit-sharing plans, stock bonus plans, and Employee Stock Ownership Plans (ESOPs); not to mention the individual retirement opportunities available in an IRA or Roth IRA. If a taxpayer is confused about which retirement savings plan might be best for him or her, some solace can be taken in that there is probably a plan that will suit their individual situation!

Would You

Believe? 08239_ch05_ptg01.indd 15 10/30/19 12:34 PM

5-16 Chapter 5 ● Deductions For and From AGI

Self-Study Problem 5.4 See Appendix E for Solutions to Self-Study Problems a. Lewis, a self-employed individual, has net earned income of $50,000 in 2019. If

Lewis has no employees, calculate the maximum contribution to a SEP plan that he may deduct from his adjusted gross income.

$ b. During 2019, Linda, age 32, has a salary of $40,000. She participates in a Section

401(k) plan and chooses to defer 25 percent of her compensation. i. What is the maximum amount Linda can contribute to the Section 401(k) plan on a

tax-deferred basis? $ ii. If Linda’s salary was $125,000, instead of $40,000, what is the maximum

amount that she could contribute to the Section 401(k) plan on a tax-deferred basis? $

5-5 OTHER fOR AGI DEDuCTIONS There are a number of other deductions for AGI available under the tax law. Because of the limited nature of these deductions, a less detailed description is provided. The deduction for one-half of self-employment tax, which affects almost all self-employed taxpayers, is described in Chapter 6.

5-5a Educator Expenses Eligible educators may deduct up to $250 for the unreimbursed cost of classroom materials such as books, supplies, computer equipment, and supplementary materials as a deduction in arriving at AGI. An eligible educator is a kindergarten through grade 12 teacher, instruc- tor, counselor, principal or aide for at least 900 hours a school year in a school that provides elementary or secondary education. If a married filing jointly couple are both eligible educa- tors, the total deduction is up to $500 but not more than $250 for either spouse.

EXAMPLE Glen and Iris Holland are a married couple that files jointly and both are high school teachers. In 2019, Glen and Iris spent $270 and $120 on various school supplies, respectively. The Hollands are eligible for a $370 ($250 1 $120) educator expense deduction. ♦

5-5b unreimbursed Business Expenses for Performing Artists and Others

As discussed later in this chapter, employees that incur business expenses typically were permitted to deduct those costs as an itemized deduction subject to a 2 percent of AGI floor. Certain employee taxpayers, however, are eligible to take a for AGI deduction for unreimbursed employee costs and thus are not required to itemize to deduct these costs. The deduction has become even more significant since the suspension of unreimbursed employee costs by the TCJA.

Learning Objective 5.5 Describe other adjustments for adjusted gross income.

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5-175-5 Other for AGI Deductions

There are three different types of taxpayers eligible for this deduction (and the rules are different for each one):

1. Performing artists who worked for two or more employers during the year 2. National Guard or Reserve member 3. Fee-based government officials

Performing artists may deduct employee business expenses as a for AGI deduction if they meet the following qualifications:

1. The taxpayer was paid for providing performing arts as an employee for at least two employers.

2. The taxpayer received at least $200 each from any two of these employers. 3. The related performing-arts business expenses are more than 10 percent of gross

income from the performance of those services, and 4. AGI is not more than $16,000 before deducting these business expenses.

Members of a reserve component of the Armed Forces of the United States that travel more than 100 miles away from home in connection with services in the reserves can deduct travel expenses. The travel expense deduction is limited to the regular federal per diem rate (for lodging, meals, and incidental expenses) and the standard mileage rate (for car expenses) plus any parking fees, ferry fees, and tolls. Per diems are discussed in Chapter 3.

Certain fee-basis officials can claim their employee business expenses. Fee-basis officials are persons who are employed by a state or local government and who are paid in whole or in part on a fee basis.

EXAMPLE Sally is a building inspector for the city of Hickory, Indiana. Sally is compensated solely from fees paid directly to her by clients and is not considered an employee of Hickory. Sally’s travel and other business expenses can be deducted as a for AGI deduction. ♦

Unreimbursed business expenses that are deductible are claimed on Form 2106.

5-5c Moving Expenses In the past, the tax law provided a deduction for moving expenses to help relieve taxpay- ers of a portion of the financial burden of moving from one job location to another. The TCJA suspended the deduction for moving expenses (through 2025) for all taxpayers except members of the Armed Forces of the United States on active duty whose move is pursuant to a military order and incident to a permanent change of station.

Starting in 2018, reimbursements to an employee from an employer for qualified moving costs are no longer excluded from the employee’s income.

Under the former law, taxpayers (except for those in the Armed Forces) had to meet three tests in order to deduct moving costs:

1. The taxpayer must change job sites. 2. The taxpayer must move so that the distance from the taxpayer’s former residence to

the new job location must be at least 50 miles more than the distance from the former residence to the former job location.

3. The taxpayer must remain at the new job location for a certain period of time, gener- ally, 39 weeks. Taxpayers who were self-employed had to work at least 78 weeks at the new location.

Taxpayers in the Armed Forces are not required to meet the time or distance tests. For the members of the military that qualify, moving expenses are reported on

Form 3903.

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5-18 Chapter 5 ● Deductions For and From AGI

Self-Study Problem 5.5 See Appendix E for Solutions to Self-Study Problems

For each of the following situations, determine whether a deduction for AGI is permitted for the taxpayer.

a. Professor Hill teaches at Bunker Hall Community College. In 2019, he spent $267 on supplies for his classroom and was not reimbursed.

b. Jackie Rights played the lead role in two different plays in 2019 in the local community theatre. Two different production companies sponsored the plays and so she was an employee of both in 2019 and was paid the same by both employers: $4,000 per play. Jackie spent $1,100 in business expenses such as new business cards, personal management fees, and new head-shots for her portfolio. Her 2019 AGI was $15,200 (she also generated income as a shared-ride vehicle driver).

c. Lieutenant Dan of the U.S. Army was stationed in Fort Bragg, NC. In 2019, his permanent post was moved from Bragg to Fort Jackson. The unreimbursed moving costs for he and his wife are $4,500.

5-6 MEDICAL EXPENSES Medical expenses are the first itemized deduction listed on Schedule A. Taxpayers are allowed a deduction for the medical expenses paid for themselves, their spouse, and depen- dents. Unreimbursed medical expenses can only be deducted to the extent that they exceed 10 percent of the taxpayer’s AGI. The formula for calculating a taxpayer’s medical expense deduction is as follows:

Prescription medicines and drugs, insulin, doctors, $ xxx dentists, hospitals, medical insurance premiums Other medical and dental expenses, such as lodging, xxx transportation, eyeglasses, contact lenses, etc. Less: insurance reimbursements (xxx) Subtotal xxx Less: 10 percent of adjusted gross income (xxx)

Excess expenses qualifying for the medical deduction $ xxx

5-6a What Qualifies as a Medical Expense? Expenses that are deductible as medical expenses include the cost of items for the diagno- sis, cure, mitigation, treatment, and prevention of disease. Also included are expenditures incurred that affect any structure or function of the body. Therefore, amounts for all of the following categories of expenditures qualify as medical expenses:

Prescription medicines and drugs and insulin Fees for doctors, dentists, nurses, and other medical professionals Hospital fees Hearing aids, dentures, prescription eyeglasses, and contact lenses Medical transportation and lodging Medical aids, such as crutches, wheelchairs, and guide dogs Birth control prescriptions Acupuncture Psychiatric care Medical insurance premiums, including Medicare premiums Certain capital expenditures deemed medically necessary by a doctor Nursing home care for the chronically ill (e.g., Alzheimer’s disease care)

Learning Objective 5.6 Calculate the itemized deduction for medical expenses.

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5-195-6 Medical Expenses

The IRS has allowed a deduction for the following unusual medical expenses: ● Long-distance phone calls made to a psychological counselor ● Hair transplants for premature baldness ● A wig prescribed by a psychiatrist for a taxpayer upset by hair loss ● A cell phone for a taxpayer who may need instantaneous medical help ● Treatments provided by a Native American medicine man

Would You

Believe? Certain medical expenses are not deductible. For example, the cost of travel for the general

improvement of the taxpayer’s health is not deductible. The expense of a swimming pool is not deductible unless the pool is designed specially for the hydrotherapeutic treatment of the taxpayer’s illness. No deduction is allowed for the cost of weight-loss programs (unless prescribed by a doctor; diet foods do not qualify) or marriage counseling. Medical expenses for unnecessary cosmetic surgery or similar procedures are not deductible. Cosmetic surgery is considered unnecessary unless it corrects (1) a congenital abnormality, (2) a personal injury resulting from an accident or trauma, or (3) a disfiguring disease. In general, unnecessary cosmetic surgery is any procedure which is directed at improving the patient’s appearance and does not meaningfully promote the proper function of the body or prevent or treat illness or disease.

Taxpayers that do not spend medical expenses greater than 10 percent can still enjoy the tax benefit associated with the deduction by using the medical flexible spending account discussed in Chapter 2. By excluding up to $2,700 from gross income, the after-tax savings is basically identical to taking the medical expense deduction for the same amount.

TAX BREAK

5-6b Medical Insurance Medical insurance includes standard health policies, whether the benefits are paid to the taxpayer or to the provider of the services directly. In addition, the premiums paid for mem- bership in health maintenance plans are deductible as medical insurance, as are supple- mental payments for optional Medicare coverage. Insurance policies that pay a specific amount each day or week the taxpayer is hospitalized are not considered medical insurance and the premiums are not deductible. Premiums paid for qualified long-term care insurance policies are also deductible medical expenses up to specified limits which change each year and are based on the age of the taxpayer.

Self-employed taxpayers are allowed, subject to certain limitations, a deduction for adjusted gross income for the medical insurance premiums paid for themselves and their families. Long-term care insurance premiums, up to a specified amount based on the taxpayer’s age, are considered health insurance for this purpose. These deductions are covered earlier in this chapter. If a deduction is taken for these items in arriving at AGI, then these same expenses are excluded from the medical expense deduction on Schedule A. However, if the self-employed insurance deduction is limited by net self-employment income, the excess medical insurance expenses can be included on Schedule A.

5-6c Medicines and Drugs Prescription medicines and drugs and insulin are the only drugs deductible as medical expenses. No deduction is allowed for drugs purchased illegally from abroad, including Canada and Mexico. Nonprescription medicines such as over-the-counter antacids, allergy medications, and pain relievers, even if recommended by a physician, are not deductible as a medical expense.

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5-20 Chapter 5 ● Deductions For and From AGI

5-6d Capital Expenditures Payments for capital improvements purchased and installed in the taxpayer’s home for medical reasons may also be deductible. Examples include support railings, lowering kitchen cabinets, and medically necessary swimming pools. Unlike other capital expen- ditures, allowable amounts are deducted fully in the year the item is purchased. If the expenditure is for an improvement that increases the value of the taxpayer’s property, the deduction is limited to the amount by which the expenditure exceeds the increase in the value of the property. If the value of the property does not increase as a result of the expenditure, the entire cost is deductible. The cost of upkeep and operation of an item, the cost of which qualified as a medical expense, is also deductible, provided the medical reason for the improvement or special equipment still exists. To take advantage of this deduction, the taxpayer must show the improvement is used primarily for and directly related to medi- cal care. A doctor’s recommendation is an important factor in supporting the deduction.

EXAMPLE A taxpayer has a heart condition and installs an elevator in his home at a cost of $6,000. The value of the home is increased by $4,000 as a result of the improvement. The taxpayer is allowed a deduction of $2,000 ($6,000 2 $4,000), the excess of the cost of the equipment over the increase in the value of the taxpayer’s home. ♦

5-6e Transportation Transportation expenses primarily and necessary for medical care are deductible, including amounts paid for taxis, trains, buses, airplanes, and ambulances. Taxpayers may also claim a deduction for the use of their personal automobile for medical transportation. However, only out-of-pocket expenses such as the cost of gas and oil are deductible. Maintenance, insurance, general repair, and depreciation expenses are not deductible. If the taxpayer does not wish to deduct actual costs of transportation by personal automobile, the standard mileage rate for medical care purposes is 20 cents per mile for 2019. In addition to the de- duction for actual automobile costs or the standard mileage amount, parking and toll fees for medical transportation are deductible medical expenses. If the transportation expenses are for the medical care of a dependent child, the amounts are deductible by the parent.

5-6f Lodging for Medical Care Taxpayers may deduct the cost of lodging up to $50 per night, per person, on a trip primarily for and essential to medical care provided by a physician or a licensed hospital. The deduc- tion is allowed for the patient and an individual accompanying the patient, such as the parent of a child. However, no deduction is allowed if the trip involves a significant element of recreation or vacation. No deduction is allowed for meal costs.

A Las Vegas dentist admitted he provided free dental work to an IRS revenue officer in exchange for reductions of his $100,000 tax debt. Both men were indicted on conspiracy and bribery charges.

Would You

Believe? tIp

Itemized deductions are located under Deductions/Itemized Deductions (Schedule A). Subheadings for each of the itemized deductions will be found in the left-hand margin.

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5-215-7 Taxes

Self-Study Problem 5.6 See Appendix E for Solutions to Self-Study Problems

During the 2019 tax year, Frank (age 65) and Betty (age 63) paid the following medical expenses:

Medical insurance $ 425 Prescription medicines and drugs 364 Hospital bills 2,424 Doctor bills 725 Prescription Eyeglasses for Frank’s dependent mother 75 Doctor bills for Betty’s sister, who is claimed 220

as a dependent by Frank and Betty

In addition, during 2019, they drove 700 miles for medical transportation in their personal automobile. Their insurance company reimbursed Frank and Betty $1,420 during the year for the medical expenses. If their adjusted gross income for the year is $25,400, calculate their medical expense deduction. Use Schedule A of Form 1040 on Page 5-23.

5-7 TAXES Taxpayers are allowed to deduct certain state, local, and foreign taxes paid during the year. The purpose of the deduction for taxes is to relieve the burden of multiple taxation of the same income. However, the tax law distinguishes between a “tax” and a “fee.” A tax is im- posed by a government to raise revenue for general public purposes, and a fee is a charge with a direct benefit to the person paying the fee. Taxes are generally deductible; fees are not deductible. For example, postage, fishing licenses, and dog tags are considered fees that are not deductible as taxes.

Pre-TCJA, tax law provided for an itemized deduction for the following taxes: ● State, local, and foreign income taxes ● Sales taxes (in lieu of state and local income taxes) ● State, local, and foreign real property taxes ● State, local, and foreign personal property taxes

After the TCJA, these taxes largely remain deductible; however, foreign property taxes are only deductible if incurred in carrying on a business or for the production of income (e.g., rental activity). In addition, the aggregate amount of the deduction for state and local real property taxes, state and local personal property taxes, state and local, and foreign, income taxes, and general sales taxes (if elected) for any tax year is limited to $10,000 ($5,000 for married filing separately). But, the $10,000 aggregate limitation rule does not apply to (i) foreign income taxes; (ii) state and local, and foreign real property taxes; and (iii) state and local personal property taxes, if these taxes are paid or accrued in carrying on a business or for the production of income. In other words, taxes deductible on an individual’s Schedule C, Schedule E, or Schedule F remain fully deductible and are not subject to the limitation. Note that state and local income taxes are not included in the business-related exclusion from the limitation as these taxes have always been deductible as an itemized deduction on an individual’s Schedule A. These provisions (the loss of the foreign property tax deduction and $10,000 deduction limitation) apply through 2025.

EXAMPLE Britney and Brad are married taxpayers filing jointly. In 2019, Britney has $7,800 in state income taxes withheld by her employer from her wages. Brad operates a sole proprietorship that owns a building and pays property

5.7 Learning Objective Calculate the itemized deduction for taxes.

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taxes of $2,300. Brad also pays estimated state income tax payments on his business of $4,000. Lastly, in 2019 Brad and Britney pay property taxes on their home of $1,600. The $2,300 of property taxes associated with the business building are deductible on Schedule C as a business deduction. The $13,400 of itemized deduction for taxes includes Britney’s state income taxes ($7,800), Brad’s estimated tax payments ($4,000), and the property taxes on their home ($1,600). However, the itemized deduction for taxes is limited to $10,000 in 2019. ♦

The following taxes are not deductible: ● Federal income taxes ● Employee portion of Social Security taxes ● Estate, inheritance, and gift taxes (except in unusual situations not discussed here) ● Excise taxes and gasoline taxes (except when business-related) ● Foreign income taxes if the taxpayer elects a foreign tax credit

5-7a Income Taxes and Sales Taxes Taxpayers may elect to deduct either state and local sales and use taxes or state and local in- come taxes as itemized deductions. The election to deduct state and local sales tax instead of income tax primarily benefits taxpayers in states with no income taxes or low income tax rates.

For taxpayers electing to deduct state and local income taxes paid during 2019, the amount of the deduction is the total amount of state and local taxes withheld from wages plus any amounts actually paid during the year, even if the tax payments are for a prior year’s tax liability. If the taxpayer receives a refund of taxes deducted in a previous year, the refund must generally be included in gross income (e.g., Line 1 on Schedule 1 of the Form 1040) in the year the refund is received. Taxes which did not provide any tax benefit (reduction in taxes) in the year paid are not required to be included in income in the year received as a refund. For example, a taxpayer claiming the standard deduction in the year taxes are paid does not receive a tax benefit for the payment and is not required to include in income a tax refund received the following year.

EXAMPLE For 2019, Mary deducts state income taxes rather than state sales taxes as an itemized deduction. Mary has $1,800 of state income taxes withheld from her wages during 2019. In April of 2019, she paid an additional $250 for taxes due on her 2018 state income tax return. Mary’s deduction for state income taxes is $2,050 ($1,800 1 $250). Her state income tax return reflects a liability for the 2019 year of $1,650, resulting in a $150 refund ($1,800 2 $1,650) that was received in 2020. The $150 refund is reported as income in the 2020 return, assuming Mary received a benefit from the state tax deduction for 2019. ♦

EXAMPLE Damone paid state income and property taxes of $10,250 in 2019. Damone claimed total itemized deductions of $12,500, including the $10,000 limit on state and local taxes. In 2020, Damone received a state income tax refund of $1,000. If Damone had deducted the actual amount of state taxes in 2019, he would have deducted on $9,250 ($10,250 paid in 2019 less $1,000 refund). His adjusted total itemized deductions would have been $11,750. As a result, Damone would have elected the standard deduction of $12,200 in 2019. The difference between his 2019 claimed itemized deductions ($12,500) and his properly adjusted standard deduction ($12,200) is $300. Thus, he received a $300 benefit from the overpayment of taxes, and Damone must include $300 in his 2020 income.

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5-235-7 Taxes

Self-Study Problems 5.6, 5.7, 5.8, 5.9, and 5.10

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5-255-7 Taxes

For taxpayers electing to deduct sales taxes in 2019, the deduction is calculated by using either (a) actual sales taxes paid or (b) estimated sales taxes from IRS tables. Actual sales and use tax expenses are based on a “general sales tax,” which is a tax imposed at one rate with respect to the retail sale of a broad range of classes of items. To the extent a higher sales tax rate than the general rate applies to motor vehicles, that excess amount is specifically excluded from the deduction amount.

The actual sales taxes paid method requires a taxpayer to maintain extensive records to substantiate the sales and use taxes paid during the year. To ease the burden on taxpayers, the tax law also permits taxpayers to use estimated state sales tax tables to calculate the deduction. Taxpayers using the estimation tables may add the sales taxes paid on items that include motor vehicles (car, truck, van, motor home, recreational vehicle), aircraft, boats, a home or a substantial addition or renovation to a home. The estimated state sales tax tables are based on the taxpayer’s adjusted gross income modified by adding back certain tax-exempt sources of income such as tax-exempt interest, workers compensation, and the nontaxable parts of Social Security or qualified retirement plan distributions. The estimated sales tax also differs by the number of dependents a taxpayer has. The following is a portion of the sales tax estimation table:

Because a number of states permit localities to also charge a general sale tax, a local sales tax table for some of the states is provided to assist with that calculation. Because the esti- mation method is fairly complex, the IRS provides a worksheet to assist with the deduction calculation and most tax preparation software will compute the amounts as well.

*The 2019 version of the Optional State Sales Tax Tables was not available as we went to print. Please check the IRS website (www.irs.gov) for updates to the instructions for Form 1040 Schedule A.

When it comes to entering state tax deduction information, much of the work will be done elsewhere. For example, income taxes withheld are generally input as part of the W-2 input. Estimated payments are input under the primary heading Payments, Penalties, and Extensions. Lastly, Intuit ProConnect has the state sales tax calculator built in and does not require the manual completion of the state and local sales tax worksheet.

tIp

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5-275-7 Taxes

The IRS also provides an online sales tax deduction calculator at www.irs.gov.

EXAMPLE Jason and Tina Sterling are married filing jointly taxpayers and residents of Rock Hill, South Carolina (zip code 29732). They have no dependents and their AGI for 2019 is $85,000. Rock Hill has a 7 percent sales tax that includes 6 percent for the state portion and 1 percent for the local portion. The Sterlings paid no sales tax on specified items during the year.

The state sales tax table for South Carolina provides a general sales tax amount for income between $80,000 and $90,000 for married filing jointly as $964. South Carolina permits a local general sales tax, and thus the Sterlings use the Local Sales Tax Table for income between $80,000 and $90,000 with two family members to derive a local sales tax estimate of $151. Using the sales tax deduction worksheet, the local amount of $151 is multiplied by 1 to yield a total local sales tax amount of $151. Thus the total sales tax deduction is $1,115. ♦ This example uses 2018 state and local general sales tax estimates as the 2019 amounts were not available as we went to print.

When a married couple files separately, if one spouse uses the optional sales tax tables, the other spouse must use the optional sales tax tables as well.

5-7b Property Taxes Taxes that are levied on state and local real property for the general public welfare are de- ductible. However, special assessments charged to provide local benefit to property own- ers are not deductible; these amounts increase the basis of the taxpayer’s property. Also, service fees, such as garbage fees and homeowner association fees, are not deductible as property taxes.

If real estate is sold during the year, the taxes must be allocated between the buyer and the seller, and the division must be made according to the number of days in the year that each taxpayer held the property. The seller is generally responsible for the property taxes up to, but not including, the date the house was sold.

EXAMPLE Sally sells her home to Patty on March 3, 2019. The taxes for 2019 are paid by Patty and they total $1,825, or $5.00 per day ($1,825/365 days). The purchaser is treated as the owner on the day of sale. Sally is entitled to deduct 61 days of real property taxes or $305 (61 days 3 $5.00 per day). Patty deducts $1,520 (304 days 3 $5.00 per day). ♦

Generally, the escrow company or closing agent handling the sale of the property will make the allocation of taxes between the buyer and the seller and the result will be reflected in the settlement charges on the transfer of the title. These amounts are itemized on closing statements for the sale, which are provided to the buyer and the seller.

EXAMPLE William purchased a new residence from John in 2019. William’s closing statement shows that he receives a credit for $299.80 in taxes that he will pay later in the year on behalf of the seller. Assuming that William pays $525.00 in total taxes on the property later in 2019, his property tax deduction for 2019 would be $225.20 ($525.00 2 $299.80). John, the seller, would be allowed a deduction for $299.80 plus any other taxes he paid during the year prior to selling the property. ♦

5-7c Personal Property Taxes To be deductible as an itemized deduction, personal property taxes must be levied based on the value of the property. Taxes of a fixed amount, or those calculated on a basis other than

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value, are not deductible. For example, automobile fees that are calculated on the basis of the automobile’s weight are not deductible.

EXAMPLE Rich lives in a state that charges $20 per year plus 2 percent of the value of the automobile for vehicle registration. If Rich pays $160 [$20 1 (2% 3 $7,000)] for his automobile registration, he may deduct only $140, the amount that is based on the value of the automobile. ♦

Self-Study Problem 5.7 See Appendix E for Solutions to Self-Study Problems

Sharon is single, lives in Idaho, and has adjusted gross income of $21,150 for 2019. Sharon deducts state income tax rather than state sales tax. The tax withheld from her salary for state income taxes is $1,050, and in May of 2019 she received a $225 refund on her state income tax return for the prior year. Sharon paid real estate taxes on her house of $825 for the year and an automobile registration fee of $110, of which $25 is based on the weight of the automobile and the balance on the value of the property. Use the Taxes You Paid section of Schedule A on Page 5-23 to report Sharon’s deduction for state and local taxes.

5-8 INTEREST Taxpayers are allowed a deduction for certain interest paid or accrued during the tax year. Interest is defined as an amount paid for the use of borrowed funds. The type and amount of the deduction depend on the purpose for which the money is borrowed. Interest on loans for business, rent, and royalty activities is deducted for adjusted gross income. Certain interest on loans for personal purposes is deductible as an itemized deduction. The follow- ing types of personal interest are deductible:

Qualified residence interest (mortgage interest) Mortgage interest prepayment penalties Investment interest Certain interest associated with a passive activity

Interest on other loans for personal purposes which do not fall into one of the above categories is generally referred to as consumer interest and is not deductible. Consumer interest includes interest on any loan, the proceeds of which are used for personal purposes, such as credit card interest, finance charges, and automobile loan interest. Interest on loans used to acquire assets generating tax-exempt income is also not deductible.

The following items are not considered “interest” and, therefore, are not deductible as an itemized deduction for interest:

Service charges Credit investigation fees Loan fees other than “points” discussed later under Prepaid Interest Interest paid to carry single premium life insurance Premium on convertible bonds

Many lenders require that home mortgage borrowers purchase private mortgage insurance (PMI) to protect the lender. Although similar to interest, PMI is not deductible in 2019.

Learning Objective 5.8 Apply the rules for an individual taxpayer’s interest deduction.

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5-295-8 Interest

EXAMPLE Fred and Betty Pebblestone, married filing jointly taxpayers, acquired their principal residence in 2014. At the time of the mortgage, the lender required that the Pebblestones acquire private mortgage insurance. In 2019, the Pebblestones paid PMI premiums of $1,700. The Pebblestones may not include the PMI premiums as an itemized deduction for interest in 2019. ♦

As we go to print, it is unknown whether Congress will revive the PMI deduction in 2019.

5-8a Taxpayer’s Obligation To deduct interest on a debt, the taxpayer must be legally liable for the debt. No deduction is allowed for payments made for another’s obligation, where the taxpayer is not liable for payment. Also, both the lender and the borrower must intend for the loan to be repaid.

EXAMPLE Bill makes a payment on his son’s home mortgage since his son is unable to make the current payment. The interest included in the mortgage payment is not deductible by Bill since the mortgage is not his obligation. Bill’s son cannot deduct the interest since he did not make the payment. ♦

EXAMPLE Mary loans her daughter $50,000 to start a business. The daughter is 19 years old and unsophisticated in business. No note is signed and no repayment date is mentioned. Mary would be surprised if the daughter’s business venture is a success. In all likelihood, a true debtor-creditor relationship is not created. ♦

A taxpayer who assumes the benefits and burdens of ownership, and is considered to es- sentially be an owner under state law, may be allowed to deduct mortgage interest on a residence even if not directly liable on the mortgage. This situation is not typical and the deduction is allowed only on a case-by-case basis.

5-8b Prepaid Interest Cash basis taxpayers are required to use the accrual basis for deducting prepaid interest. Prepaid interest must be capitalized and the deduction spread over the life of the loan. This requirement does not apply to points paid on a mortgage loan for purchasing or improving a taxpayer’s principal residence, provided points are customarily charged and they do not exceed the normal rate. Such points paid on a mortgage for the purchase or improvement of a personal residence may be deducted in the year they are paid. Points paid to refinance a home mortgage are not deductible when paid, but must be capitalized and the deduction spread over the life of the loan. Points charged for specific loan services, such as the lender’s appraisal fee and other settlement fees, are not deductible.

EXAMPLE On November 1, 2019, Allen, a cash basis taxpayer, obtains a 6-month loan of $500,000 on a new apartment building. On November 1, Allen prepays $36,000 interest on the loan. He must capitalize the prepaid interest and deduct it over the 6-month loan period. Therefore, his interest deduction for 2019 is $12,000 ($36,000/6 months 3 2 months). ♦

5-8c Qualified Residence, Home Equity, and Consumer Interest

No deduction is available for consumer (personal) interest, such as interest on credit cards and loans for personal automobiles. Qualified residence interest, however, is a type of personal interest specifically allowed as a deduction. The term “qualified residence interest”

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EXAMPLE Klaus and Len file jointly in 2019. They purchased their primary residence in New Jersey in January 2016 using a 30-year mortgage of $1,000,000. In 2019, Klaus and Len decide to refinance the amount of their $950,000 mortgage balance. Because the refinanced amount is the same or less than the mortgage balance at the time of the refinancing, the interest on the entire $950,000 balance will remain deductible. ♦

EXAMPLE Meredith and Scott file jointly in 2019. They purchase their primary residence in Palo Alto, CA in January 2019 using a 30-year mortgage of $1,000,000. In 2019, Meredith and Scott pay interest of $38,000 and make no payments toward loan principle and thus the average loan balance is $1,000,000. Because Meredith and Scott’s 2019 mortgage exceeds $750,000, the interest deduction will be limited to $28,500 ($38,000 3 $750,000/$1,000,000). ♦

The previously permitted deduction of interest on up to $100,000 of home equity debt has been suspended through 2025 (unless the home equity debt is qualified acquisition debt). Unlike the qualified mortgage debt, no provision is made for grandfathering in existing home equity loans.

EXAMPLE Michael and Jeanette Stern file jointly in 2019. In 2003, the Sterns purchased a home using a mortgage of $400,000. In 2016, when the mortgage balance was $50,000, the Sterns used a $300,000 home equity loan to build a substantial addition to their home. The home equity loan is treated as acquisition financing and thus is treated as qualified mortgage debt and the interest remains deductible. The Sterns could also have used the home equity to refinance the original mortgage debt and retained the deduction of interest. ♦

is the interest paid on “qualified residence acquisition debt. ” The term “qualified residence acquisition debt” is defined as debt secured by the taxpayer’s principal or second residence in acquiring, constructing, or substantially improving that residence. Qualified residence acquisition debt can include the original mortgage, home equity debt, or refinanced debt. Refinanced debt is treated as acquisition debt only to the extent it does not exceed the principal amount of acquisition debt immediately before the refinancing.

The limit on the amount of interest has changed under the TCJA. The interest deduction pre-TCJA has been available to qualified mortgage debt up to $1 million ($500,000 married filing separately). Through 2025, the TCJA has lowered the amount of qualified mortgage debt to $750,000. For qualified mortgage debt incurred on or before December 15, 2017, the $1 million limit remains in place (thus “grandfathering” existing mortgage debt).

After 2025, the qualified mortgage debt limit returns to $1 million, regardless of the date of the mortgage. Refinancing of pre-TCJA qualified mortgage debt retains the $1 million limit as long as the refinanced debt does not exceed the debt balance at the time of the refinancing.

In order to take a home mortgage interest deduction, debt must be secured by a qualified home (primary residence or second home). A “home” includes a house, condominium, cooperative, and mobile home. A home also includes house trailer, boat, or similar property that has sleeping, cooking, and toilet facilities.

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5-315-8 Interest

EXAMPLE Barb is a single taxpayer. In 2019, she uses a home equity loan of $46,000 to pay for a new car and part of her nephew’s college tuition. Barb may not deduct any of the interest on the home equity loan. ♦

5-8d Education Loan Interest Taxpayers are allowed a deduction for adjusted gross income (above the line) for certain interest paid on qualified education loans. The deduction is limited to $2,500 for 2019, and is phased out for single taxpayers with modified AGI of $70,000 to $85,000 and for married taxpayers with modified AGI of $140,000 to $170,000. Qualified higher education expenses include tuition, room and board, and related expenses.

EXAMPLE Sam graduated from college in 2018, taking a job with a salary of $55,000 per year. During 2019, he pays $2,500 interest on qualified education loans. Because his income is below the $70,000 phase-out amount for individual taxpayers, he can deduct the full $2,500 of the interest in arriving at adjusted gross income on his 2019 tax return. If he had paid more than $2,500 in interest, the excess would be considered nondeductible consumer interest. ♦

5-8e Investment Interest To prevent abuses by taxpayers, the Internal Revenue Code includes a provision limiting the deduction of investment interest expense. This provision limits the amount of deductible interest on loans to finance investments. The investment interest deduction is limited to the taxpayer’s net investment income. Net investment income is income such as dividends and interest, less investment expenses other than interest. Special rules apply to dividends and capital gains included as investment income due to their preferential tax rates. The general rule is that they may only be included as investment income if the taxpayer chooses to calculate tax on them at ordinary income rates. Any disallowed interest expense is carried over and may be deducted in succeeding years, but only to the extent that the taxpayer’s net investment income exceeds investment interest expense for the year. The investment interest deduction is reported on Form 4952.

EXAMPLE Karen borrows $150,000 at 12 percent interest on January 1, 2019. The proceeds are used to purchase $100,000 worth of raw land and a $50,000 Certificate of Deposit (CD). During 2019, the CD pays interest of $1,500. Karen incurs expenses attributable to the investment property of $500. Of the $18,000 (12% of $150,000) interest expense incurred in 2019, $1,000 is deductible due to being limited by the total net investment income in 2019. The deduction is computed as follows:

Investment income $1,500 Less: investment expenses (500)

Net investment income $1,000 Interest deductible in 2019 $1,000

The unused deduction of $17,000 ($18,000 2 $1,000) is carried forward and may be used as an interest deduction in future years, subject to the net investment income limitation. ♦

If the sum of mortgage interest and other itemized deductions is less than the standard deduction, no tax benefit is received from the mortgage interest payments. In this case, a taxpayer may wish to pay the mortgage off as quickly as possible if the taxpayer believes its investments will generate an after-tax rate of return less than the interest rate on the home mortgage.

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Self-Study Problem 5.8 See Appendix E for Solutions to Self-Study Problems

Dorothie paid the following amounts during the current year:

Interest on her home mortgage (pre-12/16/17) $9,250 Service charges on her checking account 48 Credit card interest 168 Auto loan interest 675 Interest from a home equity line of credit (HELOC) 2,300 Interest from a loan used to purchase stock 1,600 Credit investigation fee for loan 75

Dorothie’s residence has a fair market value of $250,000. The mortgage is secured by the home at the time of purchase and has a balance of $180,000. Dorothie used the same home to secure her HELOC with a balance of $50,000. Dorothie used the proceeds of her HELOC to pay for college and to buy a new car. Dorothie has $1,000 of net investment income. Compute Dorothie’s interest deduction in the following scenarios:

a. Use the Interest You Paid section of Schedule A on Page 5-23 to calculate Dorothie’s interest deduction for 2019. $

b. Same as part a, and Dorothie used the HELOC proceeds to add a new bedroom to her home. $

c. Same as part a, but Dorothie’s home is valued at $1.2 million and her mortgage balance is $900,000. $

5-9 CHARITABLE CONTRIBuTIONS To encourage individuals to be socially responsible, the Internal Revenue Code allows a de- duction for charitable contributions. To be deductible, the donation must be made in cash or property; the value of free use of the taxpayer’s property by the charitable organization does not qualify. In addition, out-of-pocket expenses related to qualified charitable activities are deductible as charitable contributions. For example, a taxpayer who drives his car 200 miles during 2019 to take a church group to a meeting out of town would be allowed a charitable deduction of $28 (200 miles 3 14 cents per mile).

EXAMPLE Lucille allows the Red Cross to use her building rent-free for 8 months. The building normally rents for $600 per month. There is no deduction allowed for the free use of the building. ♦

To be deductible, the donation must be made to a qualified recipient as listed in the tax law, including:

1. the United States, a state, or political subdivision thereof, if the donation is made for exclusively public purposes (such as a contribution to pay down the federal debt);

2. domestic organizations formed and operated exclusively for charitable, religious, educa- tional, scientific, or literary purposes, or for the prevention of cruelty to children or animals;

3. church, synagogue, or other religious organizations; 4. war veterans’ organizations; 5. civil defense organizations; 6. fraternal societies operating under the lodge system, but only if the contribution is used

for one or more of the charitable purposes listed in (2) above; and 7. certain nonprofit cemetery companies.

Learning Objective 5.9 Determine the charitable contributions deduction.

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5-335-9 Charitable Contributions

The following contributions are not deductible:

1. Gifts to nonqualified recipients, for example, needy individuals, social clubs, labor unions, international organizations, and political parties;

2. Contributions of time, service, the use of property, or blood; 3. Contributions where benefit is received from the contribution, for example, tuition at

a parochial school; and 4. Wagering losses, such as church bingo and raffle tickets.

If a taxpayer has doubt as to the deductibility of a payment to a specific organization, he or she should review the IRS’s online search tool called “Tax Exempt Organization Search.”

If cash is donated, the deduction is equal to the amount of the cash. For donated property other than cash, the general rule is that the deduction is equal to the fair market value of the property at the time of the donation. The fair market value is the price at which the property would be sold between a willing buyer and seller. There is an exception to this general rule for property that would have resulted in ordinary income or short-term capital gain had it been sold on the date of the contribution. In that situation, the deduction for the contribution is equal to the property’s fair market value less the amount of the ordinary income or short-term capital gain that would have resulted from sale of the property. If the sale of the property would have produced a long-term capital gain, the deduction is generally equal to the fair market value of the property. However, the fair market value is reduced by the amount of the potential long-term capital gain, if the donation is made to certain private nonoperating foundations or the donation is a contribution of tangible personal property to an organization that uses the property for a purpose unrelated to the organization’s primary purpose.

EXAMPLE Jeano B. donates a painting acquired 5 years ago at a cost of $4,000 to a museum for exhibition. The painting’s fair market value is $12,000. If Jeano had sold the painting, the difference between the sales price ($12,000) and its cost ($4,000) would have been a long-term capital gain. The deduction is $12,000, and it is not reduced by the amount of the appreciation, since the painting was put to a use related to the museum’s primary purpose. If the painting had been donated to a hospital, the deduction would be $4,000, which is $12,000 less $8,000 ($12,000 2 $4,000), the amount of the long- term capital gain that would have resulted if the painting had been sold. ♦

5-9a Percentage Limitations Generally, a taxpayer may not deduct total contributions in excess of 50 percent of the taxpayer’s adjusted gross income. This 50 percent limitation applies to donations to all public charities, all private operating foundations, and private nonoperating foundations if they distribute their contributions to public charities within a specified time period. The TCJA increased the 50 percent limit to a 60 percent limit for contributions of cash to pub- lic charities and other 50 percent organizations. Contributions of other than cash remain subject to the 50 percent limit. Gifts to other qualified organizations, such as certain pri- vate nonoperating foundations, fraternal societies, and veterans’ organizations, as well as gifts for the use of an organization, are limited to 30 percent of adjusted gross income. Special rules apply to contributions of long-term capital gain property. If the full fair mar- ket value of a gift of long-term capital gain property is deducted, and the contribution is to a 50 percent organization, the contribution is subject to the 30 percent limit. Taxpayers

Rather than donate cash, taxpayers may wish to donate appreciated stock or other appreciated property to charity. If the gift is properly structured, a full deduction may be taken for the fair market value of the donated property, while tax on the appreciation is avoided completely.

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may avoid the 30 percent limit on contributions of long-term capital gain property by electing to reduce the value of the property by the appreciation that would otherwise be a long-term capital gain, in which case the 50 percent limitation applies. Long-term capital gain property donated to other than a 50 percent organization is subject to a 20 percent of adjusted gross income limitation.

EXAMPLE In 2019, Tim gave $11,000 to his church. Tim’s adjusted gross income is $21,000. Tim’s cash donation is subject to the 60 percent limit of $12,600 and thus is deductible. ♦

EXAMPLE Carol donates publicly traded stock worth $15,000 to a qualified 50 percent charity. The original purchase price of the stock, 10 years ago, was $10,000. Because the stock is a gift of long-term capital gain property, Carol’s deduction is limited to 30 percent of her adjusted gross income. Given that Carol’s AGI is $20,000, she may take a deduction for $6,000 (30% of $20,000) and may carry the remaining $9,000 ($15,000 2 $6,000) forward to the following year. Alternatively, Carol may deduct the original $10,000 cost of the stock using the 50 percent of AGI rule, which would give her a $10,000 deduction in the current year. Even though she would have a larger deduction in the current year, she would lose $5,000 of her potential charitable contribution deduction by choosing this alternative. ♦

Generally, contributions to 50 percent organizations are deducted first, followed by contributions subject to the 30 percent and 20 percent limitations, respectively. Contributions subject to the 30 percent and 20 percent of adjusted gross income limitations are allowed only to the extent that they do not exceed 50 percent of adjusted gross income reduced by the amount of contributions subject to the 50 percent limitation.

In general, any contributions not allowed due to the adjusted gross income limitations may be carried forward for 5 years. The contributions may be deducted in the carryover years subject to the same percentage of income limitations which were applicable to the contributions in the year they originated. Contribution carryovers are allowed only after taking into account the current year contributions in the same category.

EXAMPLE In March of 2019, Grace contributes $15,000 in cash to a public university. In addition, at the same time she donates $7,000 in cash to an organization subject to the 30 percent of adjusted gross income limitation. Grace has adjusted gross income in 2019 of $35,000. Her contribution deduction is determined as follows:

Adjusted gross income $35,000 360% 60% limitation 21,000 Allowable 60% limitation contributions (15,000) Excess 60% limitation 6,000 Maximum 30% contributions: Lesser of $6,000 or 30% of adjusted gross income, $10,500 6,000 Total deductible contributions: 60% contributions 15,000 30% contributions 6,000 Total $21,000

$1,000 of the $7,000 subject to the 30 percent limitation can be carried forward to 2020. ♦

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5-355-9 Charitable Contributions

Another change made by the TCJA is that no charitable contribution deduction is permitted for a payment to a college or university in exchange for the right to purchase tickets or seating at an athletic event. Pre-TCJA law permitted an 80 percent deduction for such amounts.

EXAMPLE In 2017, Marco donated $5,000 to Big State University in exchange for the right to purchase 2017 season tickets to Big State football games. Marco deducted $4,000 ($5,000 3 80%) of this donation, which was subject to the 50 percent AGI limit. In 2019, Marco donates $5,000 to Big State University in exchange for the right to purchase 2019 season tickets to Big State football games. Marco may not deduct any of the $5,000 payment. ♦

A tax lawyer pleaded guilty to tax evasion in Federal District Court for substantially overstating his charitable contributions. He told an IRS agent that he put $500 in cash into the church collection basket each week. His pastor, however, said that the church never received more than $500 in currency at all of its weekly church services combined.

Would You

Believe? 5-9b Substantiation Rules Taxpayers should keep records, receipts, cancelled checks, and other proof of charitable contributions. For gifts of property, for example clothes and household goods given to the Salvation Army, totaling over $500, the taxpayer must attach a Form 8283 to his or her re- turn giving the name and address of the donee, the date of the contribution, a description of the property, the approximate date of acquisition of the property, and certain other required information. For large gifts of property worth $5,000 or more, the donor must also obtain and submit an appraisal.

No charitable deduction is allowed for contributions of $250 or more unless the taxpayer substantiates the contributions with written acknowledgments from the recipient charitable organizations. The acknowledgments must contain this information:

● The amount of cash and a description (but not the value) of property other than cash contributed.

● Whether the charitable organization provided any goods or services in consideration, in whole or in part, for any property contributed. (If a payment is partly a gift and partly in consideration for goods or services provided to the donor, it is a “quid pro quo contribution” and special rules apply.)

● A description and good-faith estimate of the value of any goods or services pro- vided by the donor, or, if the goods and services consist solely of intangible religious benefits, a statement to that effect. Intangible religious benefits are any benefits provided by organizations formed exclusively for religious purposes and not gener- ally sold in a commercial setting. For example, attendance at church is considered an intangible religious benefit while attendance at a private religious school is not. Therefore, a donation made at a church service is generally considered a charitable contribution while tuition paid to a private religious school is not considered a charitable contribution.

Taxpayers donating amounts of cash smaller than the $250 limit are required to keep a bank record (cancelled check) or a written communication from the charity. Taxpayers who itemize deductions should use checks instead of cash for church and similar cash donations.

Gifts of clothing and household items (including furnishings, electronics, appliances, and linens) must be in “good” condition or better to qualify for a deduction. Also, charitable deductions may be denied for contributions of items with minimal value, such as used socks and undergarments. The rules for noncash contributions were enacted because some taxpayers significantly overstated the value of noncash contributions deducted.

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No particular form is prescribed for the written acknowledgment, nor does the donor’s tax identification number have to be contained on the acknowledgment. It may be a receipt, letter, postcard, or computer form. The acknowledgment must be obtained on or before the date on which the tax return for the tax year of the contribution is filed, or by the due date (plus extensions) if it is earlier than the actual filing date.

Taxpayers donating used vehicles to charity cannot claim a deduction greater than the amount for which the charity actually sells the vehicle. The charity is required to provide the resale information on Form 1098-C to taxpayers donating vehicles. The same rule also applies to boats and planes donated to charity. Taxpayers must attach Form 1098-C to their tax return to substantiate the deduction. Taxpayers may claim an estimated value for the automobile if the charity does not sell it but rather uses it or gives it to a needy individual. The charity must certify that an exception applies if no resale amount is provided on Form 1098-C.

For quid pro quo contributions (donations involving the receipt of goods or services by the donee), written statements (disclosures) are required from the charitable organization to donors making contributions of more than $75. The disclosures need not be individual letters to donors; they simply provide the donors with good-faith estimates of the value of the goods or services and inform the donors that only the amounts of the contributions in excess of the value of the goods or services are deductible for federal income tax purposes.

A charitable organization knowingly providing false written acknowledgments is subject to penalty (generally $1,000) for aiding and abetting in the understatement of tax liability. A penalty of $10 per contribution per event, capped at $5,000, may be imposed on charities failing to make the required disclosures for quid pro quo contributions.

Self-Study Problem 5.9 See Appendix E for Solutions to Self-Study Problems

In 2019, Eric gave $11,000 to his church. He donated $75 to Boy Scouts of America and $125 to the Mexican Red Cross. Eric gave the Salvation Army used clothes in good condition worth $150 (original cost $1,700). Eric donated $500 to Rhode Island State University (his alma mater) for the right to buy season tickets to the Fightin’ Nutmeggers basketball games. Eric’s adjusted gross income is $21,000. Use the Gifts to Charity section of Schedule A on Page 5-23 to report Eric’s deduction for the current year.

A cash basis taxpayer may charge year- end expenses on a credit card and still deduct the expenses even when payment on the credit card is not made until the next year. Instead of paying medical bills, charitable contributions, or even property taxes by check at year- end, the taxpayer may prefer to charge the expense. Note, however, that the credit card may not be one issued by the company supplying the deductible goods or services, but must be a card issued by a third party.

TAX BREAK

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5-10 OTHER ITEMIzED DEDuCTIONS The final portion of this chapter discusses the significant changes that the TCJA made to other miscellaneous deductions and to the casualty and theft losses. In addition to these changes, the TCJA also suspended the phase-out of itemized deductions for high income taxpayers (the “Pease” phase-out).

5-10a Casualty and Theft Losses Taxpayers are allowed deductions for certain casualty and theft losses. The deductions may be itemized deductions or, if related to a business, deductions for adjusted gross income. A casualty is a complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected, or unusual nature. Examples of casualties include property damage from storms, floods, shipwrecks, fires, automobile accidents, and vandalism. For damage from weather conditions to be deductible, the condition must be unusual for the particular region. To qualify as a casualty, an automobile accident must not be caused by the taxpayer’s willful act or willful negligence.

EXAMPLE A taxpayer has an automobile that he decides is a lemon, and he wants to get rid of it. He drives the automobile to the top of a cliff and pushes it off. There is no casualty loss deduction since the act is willful. ♦

Many events do not qualify as casualties. For example, progressive deterioration from rust or corrosion and disease or insect damage are usually not “sudden” enough to qualify as casualties. The IRS has held that termite damage is not deductible as a casualty; however, several courts have in the past allowed the deduction. Indirect losses, such as losses in property value due to damage to neighboring property, also are not deductible.

If the taxpayer can establish that theft occurred, theft losses are deductible. It is important to show that the item was not simply misplaced. Theft losses are deductible in the year the theft is discovered, not in the year the theft took place. This is important in cases of embezzlement, where the theft has gone on over many years and the statute of limitations has run out on earlier years, otherwise preventing the taxpayer from amending returns for those years.

As a general rule, casualty losses are deductible in the year of occurrence, but there is an exception for federally declared disaster area losses. Taxpayers may elect to treat the losses in a disaster area as a deduction in the year prior to the year the casualty occurred. If a return has already been filed for the prior year, an amended return may be filed and a refund claimed for the prior year’s taxes paid. This provision is designed to provide taxpayers with cash on a more timely basis when they have suffered severe casualties.

EXAMPLE In May of 2019, Amy’s house is damaged by flooding. Shortly thereafter, the president of the United States declared the region a disaster area. The damage to the house is $6,000 and the loss may be deducted in 2018 or 2019, even if the 2018 return has already been filed. If Amy elects to take the deduction in 2018, she may immediately file an amended tax return for that year and collect a refund of previously paid taxes. ♦

5-10b Measuring the Loss The amount of the casualty or theft loss is measured by one of the following two rules:

Rule A— The deduction is based on the decrease in fair market value of the property, not to exceed the adjusted basis of the property.

Rule B—The deduction is based on the adjusted basis of the property.

5.10 Learning Objective Describe other itemized deductions.

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5-38 Chapter 5 ● Deductions For and From AGI

Rule A applies to the partial destruction of business or investment property and the partial or complete destruction of personal property, while Rule B applies to the complete destruction of business and investment property. The cost of repairs is usually used for the measurement of loss from automobile damage. Repair costs may also be used to measure losses involving other types of property, but it is not controlling. Indirect costs, such as cleanup costs, are part of the loss, provided the payments do not restore the property to better than its previous condition.

EXAMPLE A taxpayer purchased his house 15 years ago for $25,000. Today it is worth $160,000, and heavy rains cause the house to slide into a canyon and be completely destroyed. The taxpayer’s casualty loss deduction under Rule A is the decrease in fair market value ($160,000 2 $0) not to exceed the taxpayer’s basis ($25,000). Thus, the deduction is limited to $25,000. ♦

5-10c Deduction Limitations The TCJA suspended the allowable loss for personal casualty losses except when the loss is attributable to a federally declared disaster. Such losses are subject to a $100 floor per casualty and must exceed 10 percent of AGI to be deducted. The restriction to a federally declared disaster applies to tax years 2018 to 2025. If a taxpayer has a net casualty gain, the declared disaster restriction does not apply to the extent of the gain. If related to business property, there is no adjusted gross income limitation or dollar reduction applicable to ca- sualty and theft losses; such losses are deductions for adjusted gross income.

EXAMPLE In 2019, Wanda incurs a loss due to a complete destruction of her personal use car due to a casualty event not attributable to a federally declared disaster. Her adjusted basis in the car was $19,000 and the fair market value at the time of the loss was $8,000. Wanda’s AGI is $55,000. Wanda was not insured for this type of loss and received no reimbursement. Wanda will not be able to deduct any of her loss as it was not attributable to a federally declared disaster.

If instead Wanda’s loss was attributable to a federally declared disaster, she can deduct $8,000 less the $100 floor and also less 10 percent of her AGI:

$2,400 5 $8,000 2 $100 2 $5,500 ♦

EXAMPLE Cosmo incurs two personal losses during 2019. His car was stolen and destroyed by the thieves. His basis in the car was $22,000 and the fair market value at the time of the theft was $16,000. Cosmo also lost a family heirloom watch worth $4,000 in a different theft. Neither of these losses is attributable to a federally declared disaster. Cosmo’s insurance covered the auto and reimbursed him $22,000 but the loss of the watch was not covered. Cosmo’s casualty gain on the auto is $6,000 ($22,000 2 $16,000) and his loss on the watch is $3,900 ($4,000 2 $100 floor). Because Cosmo experienced a net casualty gain of $2,100, he may deduct the casualty loss against the gain despite the loss not being attributable to a federally declared disaster. ♦

Certain disasters can be deemed “qualified” federal disasters and were eligible for additional relief. For example, certain areas affected by Hurricanes Harvey, Irma, and Maria as well as the California wildfires were declared qualified federal disaster areas. The rules for qualified federal disasters require the taxpayer to use a $500 floor (instead of $100) but do not subject the casualty loss to the 10 percent AGI limitation. In addition, taxpayers that do not itemize were permitted to add the qualified federal disaster area loss to the standard deduction. At the time we go to print, areas affected by Hurricane Dorian were declared a

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5-395-10 Other Itemized Deductions

federal disaster area and eligible for personal casualty losses, but were not declared qualified federal disaster areas extending additional loss benefits.

A casualty or theft loss is reported on Form 4684 and then the deductible amount is generally taken as an itemized deduction on Schedule A.

Entering the loss from a casualty is input on the left navigation menu. Select Income and then Schedule D/4797/etc. Scroll down to Casualties and Thefts (4868). tIp

5-10d Miscellaneous Expenses Miscellaneous itemized deductions are categorized into two types: (1) those subject to the 2 percent of AGI floor and (2) those not subject to the 2 percent of AGI floor.

The TCJA suspended the deduction of all miscellaneous itemized deductions subject to the 2 percent of AGI rule; thus, these items will no longer be deductible for tax years 2018 to 2025. The most common deductions subject to the 2 percent of AGI rule are:

● Unreimbursed employee business expenses and employee expenses reimbursed under a nonaccountable plan

● Investment expenses ● Other miscellaneous expenses including the all-important tax preparation fees

The most common unreimbursed employee expenses are included in the following list:

2 Business bad debt of an employee. 2 Business liability insurance

premiums. 2 Damages paid to a former employer

for breach of an employment contract.

2 Depreciation on a computer your employer requires you to use in your work.

2 Dues to a chamber of commerce if membership helps you do your job.

2 Dues to professional societies. 2 Educator expenses. 2 Home office or part of your home

used regularly and exclusively in your work.

2 Job search expenses in your present occupation.

2 Laboratory breakage fees. 2 Legal fees related to your job. 2 Licenses and regulatory fees.

2 Malpractice insurance premiums. 2 Medical examinations required by an

employer. 2 Occupational taxes. 2 Passport for a business trip. 2 Repayment of an income aid payment

received under an employer’s plan. 2 Research expenses of a college

professor. 2 Rural mail carriers’ vehicle expenses. 2 Subscriptions to professional journals

and trade magazines related to your work.

2 Tools and supplies used in your work. 2 Travel, transportation, meals,

entertainment, gifts, and local lodging related to your work.

2 Union dues and expenses. 2 Work clothes and uniforms if required

and not suitable for everyday use. 2 Work-related education.

The repeal of miscellaneous deductions subject to the 2 percent floor could result in an employee being subject to additional tax liability when receiving reimbursement from an employer without an accountable plan. Since changing from an employee to an independent contractor is generally not possible without a significant change in the relationship between the individual and the business (this is a matter of law, not a choice by either the employee or employer), taxpayers that are employees in this situation may want to inquire if an accountable plan can be implemented by their employer going forward.

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Miscellaneous itemized deductions not subject to the 2 percent floor were not affected by the TCJA. This category of expenses includes the following items:

2 Amortizable premium on taxable bonds. 2 Casualty and theft losses from income-producing property. 2 Federal estate tax on income in respect of a decedent. 2 Gambling losses up to the amount of gambling winnings. 2 Impairment-related work expenses of persons with disabilities. 2 Loss from other activities from Schedule K-1 (Form 1065-B), Box 2. 2 Losses from Ponzi-type investment schemes. 2 Repayments of more than $3,000 under a claim of right. 2 Unrecovered investment in an annuity.

Gambling losses are not subject to the 2 percent limitation and are not directly limited. Because gambling losses are only deductible for taxpayers that itemize deductions and the TCJA increased the standard deduction and limited itemized deductions for many taxpayers, fewer taxpayers may itemize and therefore fewer taxpayers may be eligible to deduct gambling losses. Gambling winnings must be reported as other income on Form 1040 and losses may be deducted on Schedule A only to the extent of winnings.

5-10e Phase-out of Itemized Deductions Prior to 2018, certain high-income taxpayers were subject to limits on the amount of itemized deductions. Certain AGI limits for different filing status triggered a reduction in itemized deductions by the lesser of 3 percent of the excess of the taxpayer’s AGI over the threshold amount or 80 percent of itemized deductions excluding the deductions for medi- cal expenses, investment interest expense, casualty and theft losses, and gambling losses to the extent of gambling income. The TCJA suspended the phase-out.

Self-Study Problem 5.10 See Appendix E for Solutions to Self-Study Problems

During 2019, Robert (a single taxpayer) is an employee and has AGI of $35,000. He lives in Jupiter, FL 33477.

a. Robert’s community was struck with a hurricane. During the storm a tree blew over and destroyed his car. The storm was declared a federal disaster (FEMA Code EM-5566). The market value of the car on the date of destruction was $14,000. Robert purchased the car in July 2016 at a cost of $18,500. Robert’s car was only partially covered for this type of loss and his insurance paid him $5,000. Calculate Robert’s casualty or theft loss on Form 4684 on Page 5-41 and carry any deductible amount to the Casualty and Theft Losses section of the Schedule A on Page 5-23.

b. Robert also incurs the following expenses:

Safe-deposit box rental (for investments) $ 25 Tax return preparation fees 450 Professional dues 175 Trade journals 125 Bank trust fees 1,055 Qualifying job hunting expenses 1,400 Total $3,230

Robert also had a big day at the casinos and won $1,400. Over the year, he had substantiation for $1,700 in gambling losses. Assuming Robert is not self-employed, calculate any miscellaneous deductions and enter them in the Other Itemized Deductions section of Schedule A on Page 5-23.

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5-415-10 Other Itemized Deductions

Self-Study Problem 5.10

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5-43

K e y t e r m s

Health Savings Accounts (HSAs), 5-2 traditional IRA, 5-8 Roth IRA, 5-8 annual contribution limits, 5-8 “catch-up” contribution, 5-8 nondeductible traditional IRA, 5-10 Roth IRA conversions, 5-11 early withdrawal, 5-11 distributions, 5-11 SEP IRA, 5-13 Payroll Deduction IRA, 5-14 SIMPLE IRA, 5-14 Section 401(k) plan, 5-14

Self-employed or Solo 401(k), 5-15 Safe harbor 401(k), 5-15 Roth 401(k), 5-15 tax, 5-21 fee, 5-21 estimated sales tax tables, 5-25 consumer interest, 5-28 prepaid interest, 5-29 qualified residence interest

(mortgage interest), 5-29 qualified residence acquisition

debt, 5-30 home equity debt, 5-30

investment interest, 5-31 charitable contributions, 5-32 qualified recipient, 5-32 nonqualified recipients, 5-33 Tax Exempt Organization Search,

5-33 50 percent limitation, 5-33 30 percent limitation, 5-33 20 percent limitation, 5-34 substantiation rules, 5-35 casualty, 5-37 “qualified” federal disasters, 5-38

Key Points

Learning Objectives Key points

LO 5.1: Explain how Health Savings Accounts (HSAs) can be used for tax-advantaged medical care.

● Health Savings Accounts (HSAs) are used for the purpose of paying unreimbursed medical expenses.

● HSAs have an annual age-based contribution dollar limitation for deductions for individuals ($3,500) and families ($7,000). There is an additional $1,000 “catch-up” contribution allowed for individuals beginning at age 55 and ending at age 65, the age for Medicare eligibility. 3

● Distributions from HSAs are tax-exempt when used to pay for qualified medical expenses. Distributions which are not used to pay for qualified medical expenses may be subject to income tax and a 20 percent penalty.

● Once a taxpayer is 65 years old, distributions may be taken for nonmedical expenses and will be subject to income tax, but not the 20 percent penalty.

LO 5.2: Describe the self-employed health insurance deduction.

● Deductible health insurance includes: (1) medical and dental insurance paid to cover the self-employed taxpayer, spouse, and dependents; (2) medical and dental insurance paid for children under the age of 27 who are not dependents; (3) Medicare premiums; and (4) long-term care insurance paid for the taxpayer and the family of the taxpayer.

● Taxpayers with income reportable on Schedule C are generally considered self-employed.

● Taxpayers with earnings from certain partnerships, S corporations, LLCs, and farm businesses may also be considered self-employed and may be allowed the deduction for self-employed health insurance.

● The deduction for self-employed health insurance is only allowed to the extent of the taxpayer’s net self-employed income.

K e y p O I N ts

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LO 5.3: Explain the treatment of Individual Retirement Accounts (IRAs), including Roth IRAs.

● Generally, annual contributions to a traditional IRA are deductible and retirement distributions are taxable, while annual contributions to a Roth IRA are not deductible and retirement distributions are nontaxable.

● Earnings in both types of IRAs are not taxable in the current year. ● In 2019, the maximum annual contribution that may be made to either type of IRA is equal to the lesser of (1) 100 percent of the taxpayer’s compensation or self- employment income (earned income) or (2) $6,000 (plus an additional $6,000 which may be contributed on behalf of a spouse with no earned income). An additional catch-up $1,000 annual contribution is allowed for taxpayers age 50 and over.

● The tax deduction for contributions to traditional IRAs is limited for taxpayers who are active participants in qualified retirement plans and have income over certain limits. Contributions to Roth IRAs are limited for taxpayers with income over certain limits, but they are not affected by taxpayer participation in other retirement plans.

● Taxpayers may benefit from a rule allowing conversions of traditional IRAs into Roth IRAs.

● Generally, money distributed from a traditional IRA is taxable as ordinary income and may be subject to a 10 percent penalty for early withdrawal (before age 59½). Some types of early withdrawals may be made without penalty.

● A taxpayer can make tax-free withdrawals from a Roth IRA after a 5-year holding period if the distribution is made on or after the date on which the participant attains age 59½. Other tax-free withdrawals may also apply.

LO 5.4: Explain the general contribution rules for small business and self-employed retirement plans.

● Employers may claim a deduction in the current year for contributions to qualified retirement plans on employees’ behalf. The employees do not include the employer contributions in income until the contributed amounts are distributed.

● For 2019, contributions to retirement plans by self-employed taxpayers are generally limited to the lesser of 20 percent of their net earned income before the contribution deduction or $56,000.

● For 2019, the maximum employee contribution to a SEP is the lesser of 25 percent of compensation or $56,000.

● For 2019, an employee may elect to make an annual contribution up to $19,000 ($25,000 for taxpayers age 50 or older) to a Section 401(k) plan. In addition, any matching amount contributed to the plan by the employer on behalf of the employee is excluded from the employee’s gross income.

LO 5.5: Describe other adjustments for adjusted gross income.

● Eligible educators may deduct up to $250 for the unreimbursed cost of classroom materials.

● Certain performing artists, reservists, and fee-based government officials can deduct unreimbursed employee expenses as a for AGI deduction.

● Starting in 2018, moving expenses are only deductible for members of the Armed Forces pursuant to a military order and permanent change of station.

LO 5.6: Calculate the itemized deduction for medical expenses.

● Taxpayers are allowed an itemized deduction on Schedule A for medical expenses paid for themselves, their spouse, and their dependents.

● Qualified medical expenses are deductible only to the extent they exceed 10 percent of a taxpayer’s adjusted gross income.

● Qualified medical expenses include such items as prescription medicines and drugs, insulin, fees for doctors, dentists, nurses, and other medical professionals, hospital fees, hearing aids, dentures, prescription eyeglasses, contact lenses, medical transportation and lodging, crutches, wheelchairs, guide dogs, birth control prescriptions, acupuncture, psychiatric care, medical and Medicare insurance premiums, and various other listed medical expenses.

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5-45Key Points

LO 5.7: Calculate the itemized deduction for taxes.

● The following taxes are deductible on Schedule A: state and local income taxes or state and local sales taxes, real property taxes (state and local), and personal property taxes (state and local).

● The itemized deduction for taxes is limited to $10,000. ● Nondeductible taxes include the following: federal income taxes, employee portion of Social Security taxes, estate, inheritance, and gift taxes (except in unusual situations), gasoline taxes, excise taxes, and foreign taxes if the taxpayer elects a foreign tax credit.

● If real estate is sold during the year, the taxes must be allocated between the buyer and seller based on the number of days in the year that each taxpayer held the property to determine each party’s deductible amount.

● To be deductible, personal property taxes must be levied based on the value of the property. Personal property taxes of a fixed amount, or those calculated on a basis other than value, are not deductible.

LO 5.8: Apply the rules for an individual taxpayer’s interest deduction.

● Deductible personal interest includes qualified residence interest (mortgage interest), mortgage interest prepayment penalties, investment interest, and certain interest associated with a passive activity.

● Nondeductible consumer interest includes interest on any loan, the proceeds of which are used for personal purposes, such as credit card interest, finance charges, and automobile loan interest.

● “Qualified residence interest” is the sum of the interest paid on “qualified residence acquisition debt.”

● Taxpayers are allowed a deduction for AGI for certain interest paid on qualified education loans.

● Deductible investment interest is limited to the taxpayer’s net investment income, which is investment income such as dividends and interest, less investment expenses other than interest.

LO 5.9: Determine the charitable contributions deduction.

● To be deductible, the donation must be made in cash or property. ● Donations must be made to a qualified recipient. ● The following contributions are not deductible: gifts to needy individuals, social clubs, labor unions, international organizations, and political parties; contributions of time, service, the use of property, or blood; contributions where benefit is received from the contribution, for example, tuition at a parochial school; and wagering losses, such as church bingo and raffle tickets.

● For donated property other than cash, the general rule is that the deduction is equal to the fair market value of the property at the time of the donation.

● Donations are limited to 60, 50, 30, or 20 percent of AGI in certain cases.

LO 5.10: Describe other itemized deductions.

● Starting in 2018, a loss from a personal casualty such as property damage from storms, floods, shipwrecks, fires, automobile accidents, and vandalism is only deductible if associated with a federally declared disaster.

● For the partial destruction of business or investment property and the partial or complete destruction of personal property, the deduction is based on the decrease in fair market value of the property, not to exceed the adjusted basis of the property.

● For the complete destruction of business and investment property, the deduction is based on the adjusted basis of the property.

● The amount of each personal casualty loss attributable to a federally declared disaster, is reduced by $100 and only the excess over 10 percent of the taxpayer’s AGI is deductible.

● Starting in 2018, the deduction for miscellaneous expenses subject to the 2 percent of AGI limit is suspended until 2025.

● Miscellaneous expenses not subject to the 2 percent of AGI limit such as gambling losses to the extent of gambling winnings, handicapped “impairment- related work expenses,” certain estate taxes, amortizable bond premiums, and unrecovered annuity costs at death remain deductible.

● The phase-out of itemized deductions for high-income taxpayers has been suspended.

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GrOUp 1:

MuLTIPLE CHOICE QuESTIONS

1. Which of the following is a false statement about Health Savings Accounts (HSAs)? a. Taxpayers who contribute to an HSA must carry qualifying high-deductible health

insurance. b. HSAs are available to any taxpayer using a health plan purchased through the

state or federal exchange under the Affordable Care Act. c. Distributions from HSAs are not taxable when used to pay qualifying medical expenses. d. Taxpayers must contribute to the HSA by April 15 of the year following the tax

year for which they want the deduction. e. Distributions from HSAs which are not used to pay qualifying medical expenses

are generally subjected to a 20 percent penalty as well as income taxes.

2. Charlene has self-only coverage in a qualifying high-deductible health insurance plan. She is 47 years old and wishes to contribute the maximum amount to her HSA. How much is she allowed to contribute and deduct in 2019? a. $1,000 b. $1,300 c. $3,450 d. $3,500 e. $4,600

3. Which type of insurance is not deductible as self-employed health insurance? a. Medical insurance b. Disability insurance c. Dental insurance d. Long-term care insurance e. Spousal medical insurance

4. Which of the following is true about the self-employed health insurance deduction? a. The deduction can be claimed when a subsidized employer health insurance plan

is also available. b. The deduction can be claimed if the taxpayer has an overall business loss from

self-employment. c. Long-term care premiums may not be deducted within specified dollar limitations

based on age. d. The self-employed health insurance deduction is a for AGI deduction. e. Dental insurance is not included as deductible self-employed health insurance.

5. Lyndon, age 24, has a nonworking spouse and earns wages of $36,000 for 2019. He also received rental income of $5,000 and dividend income of $900 for the year. What is the maximum amount Lyndon can deduct for contributions to his and his wife’s individual retirement accounts for the 2019 tax year? a. $11,000 b. $5,500 c. $6,000 d. $12,000 e. None of the above

LO 5.1

LO 5.2

LO 5.3

Q U es t I O Ns a n d prO B L e m s

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5-47

6. Martha and Rob, a married couple, under 50 years of age, have adjusted gross income on their 2019 joint income tax return of $45,000, before considering any IRA deduction. Martha and Rob have no earned income. What is the amount of Martha’s maximum deductible IRA contribution? a. $2,700 b. $3,500 c. $5,500 d. $11,000 e. $0

7. Donna, age 42 and a single taxpayer, has a salary of $104,500 and interest income of $20,000. What is the maximum amount Donna can contribute to a Roth IRA? a. $5,000 b. $3,850 c. $6,000 d. $5,500 e. Some other amount

8. Mary has a Roth IRA held more than 5 years to which she has contributed $30,000. The IRA has a current value of $62,000. Mary is 55 years old and she takes a distribution of $38,000. How much of the distribution will be taxable to Mary? a. $0 b. $8,000 c. $10,000 d. $40,000 e. Some other amount

9. Marge has a Roth IRA held more than 5 years to which she has contributed $30,000. The IRA has a current value of $62,000. Marge is 65 years old and she takes a distri- bution of $38,000. How much of the distribution will be taxable to Marge? a. $0 b. $8,000 c. $30,000 d. $38,000 e. Some other amount

10. Mindy has a Roth IRA held longer than 5 years to which she has contributed $30,000. The IRA has a current value of $62,000. Mindy is 55 years old and she takes a distribution of $38,000 after retiring on disability. How much of the distribution will be taxable to Mindy? a. $0 b. $8,000 c. $30,000 d. $38,000 e. Some other amount

11. What is the deadline for making a contribution to a traditional IRA or a Roth IRA for 2019? a. April 15, 2020 b. April 17, 2019 c. December 31, 2019 d. October 15, 2020

12. Which of the following statements with respect to a qualified retirement plan is accurate? a. Self-employed individuals are not eligible to be members of a SEP. b. Contributions to SIMPLE IRAs are limited to 15 percent of the taxpayer’s net

earned income or $100,000, whichever is greater. c. “Net earned income” includes the taxpayer’s wages from employment. d. Taxpayers must begin receiving distributions from a qualified plan by the age of 65. e. None of these statements are accurate.

LO 5.3

LO 5.4

Questions and Problems

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5-48 Chapter 5 ● Deductions For and From AGI

13. What is the maximum tax-deferred contribution that can be made to a Section 401(k) plan by an employee under age 50 in 2019? a. $19,000 b. $20,000 c. $18,500 d. $18,000 e. $56,000

14. Paul, age 37, participates in a Section 401(k) plan which allows employees to contribute up to 15 percent of their salary. His annual salary is $125,000 in 2019. What is the maximum he can contribute, on a tax-deferred basis under a salary reduction agreement, to this plan? a. $24,000 b. $20,500 c. $18,500 d. $18,000 e. None of the above

15. Eliza is a kindergarten teacher for Alexander Hamilton Elementary School. Eliza decorates her classroom with new artwork, posters, bulletin boards, etc. In 2019, she spends $470 on materials and supplies for her classroom. The school reimburses her $100 (the annual reimbursement limit). Eliza can deduct for AGI and

from AGI. a. $0 for and $0 from AGI b. $370 for and $0 from AGI c. $250 for and $120 from AGI d. $250 for and $0 from AGI e. $0 for and $370 from AGI

16. Jessica is a U.S. Army Reservist and in 2019 traveled 130 miles each way to serve duty at a local military installation. She was required to report four times in 2019. Her normal route from home to the base included a $1.75 toll each way. Jessica’s for AGI deduction for these costs is: a. $0 b. $617.20 c. $122.00 d. $566.80 e. $580.80

17. The cost of which of the following expenses is not deductible as a medical expense on Schedule A, before the 10 percent of adjusted gross income limitation? a. A psychiatrist b. Botox treatment to reduce wrinkles around eyes c. Acupuncture d. Expense to hire and train a guide dog for a visually-impaired taxpayer

18. The cost of which of the following is deductible as a medical expense? a. Travel to a warm climate b. Birth control pills c. A disability insurance policy that pays $200 for each day the taxpayer is in the hospital d. Liposuction to reduce waist size

19. Which of the following is not considered a deductible medical expense? a. Once daily multivitamin b. Prescription eyeglasses c. Acupuncture d. Filling a tooth cavity

LO 5.4

LO 5.5 LO 5.10

LO 5.5

LO 5.6

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5-49

20. Which of the following taxes may be deducted as itemized deduction? a. State gasoline taxes b. Local property taxes c. Federal income taxes d. Social Security taxes e. Medicare taxes

21. In April 2019, Fred paid $60 of state income tax that was due when he filed his 2018 income tax return. During 2019, Fred’s employer withheld $1,500 of state income tax from his pay. In April 2020, Fred determined that his 2019 state tax liability was on $1,200 and received his state income tax refund of $300 in May 2020. Assuming Fred itemizes, how much state income tax deduction should he report on his 2019 federal income tax return? a. $1,200 b. $1,260 c. $1,500 d. $1,560 e. $900

22. Antonio is a small business owner and files jointly with his spouse. In 2019, he gener- ates $100,000 of net profits from his business. His spouse, Maria, has $4,000 of state income tax withheld from her wages in 2019. They also pay $4,500 in property taxes on their home. Antonio determines that their state income taxes associated with his business are about $5,600 and makes estimated state income tax payments of that amount in 2019. How much should Antonio and Maria deduct for state taxes? a. Itemized deductions of $9,500 and deduct $5,600 for taxes on Antonio’s Schedule

C for his business b. Itemized deductions of $10,000 and deduct $5,100 for taxes on Antonio’s Schedule

C for his business c. Itemized deductions of $10,000 d. Itemized deductions of $4,000 and deduct $5,600 for taxes on Antonio’s Schedule

C for his business

23. The itemized deduction for state and local taxes in 2019 is a. Total taxes less 10 percent of AGI b. Limited to no more than $10,000 c. Unlimited d. Only deductible if the taxes are business related e. Deductible if your home value is less than $750,000

24. Which of the following is deductible as interest on Schedule A? a. Fees for having the home’s value assessed by the bank for purposes of getting a

mortgage b. Fees for having a new home inspected prior to purchase c. Interest of $32,000 on a mortgage of $967,000 for a primary residence that was

purchased in 2016 d. Interest on loans to finance tax-exempt bonds e. None of the above are deductible as interest

25. Carrie, a single taxpayer, finished h3er undergraduate degree using money from a student loan. She earned $126,000 her first year and paid $2,600 in interest in 2019. She can take a deduction for student loan interest in the amount of: a. $2,600 b. $2,500 c. $1,500 d. $0 e. None of the above

LO 5.7

LO 5.8

Questions and Problems

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5-50 Chapter 5 ● Deductions For and From AGI

26. Which of the following interest expense amounts is not deductible in the current year? a. Education loan interest of $2,000, assuming the taxpayer has income of $30,000. b. Home equity loan interest of $6,000, on a loan of $90,000, the proceeds of which

were used to add a new bedroom and bathroom to an existing primary residence. c. Investment interest expense of $10,000, assuming the taxpayer has no investment

income. d. Qualified residence interest of $70,000 on a $730,000 loan used to purchase a

luxury apartment in downtown San Diego.

27. Which of the following donations are not deductible as a charitable contribution? a. A donation of clothing to Goodwill Industries b. A cash contribution to a church c. A contribution of stock to a public university d. A contribution of a taxpayer’s time picking up trash on the beach e. A painting contributed to a museum

28. Stanley donates a hotel to a university for use as a conference center. The building was purchased 3 years ago for $1,500,000 and has a fair market value of $1,900,000 on the date the contribution is made. If Stanley had sold the building, the $400,000 difference between the sales price and cost would have been a long-term capital gain. What is the amount of Stanley’s deduction for this contribution, before considering any limitation based on adjusted gross income? a. $2,300,000 b. $1,500,000 c. $1,900,000 d. $0 e. The amount cannot be determined from the information given

29. In March of 2019, Thomas makes a $5,000 cash contribution to a public university. In that month, he also donates $20,000 to an organization subject to the 30 percent limitation. Thomas has adjusted gross income for 2019 of $30,000. What is the amount of Thomas’s 2019 charitable contribution deduction? a. $5,000 b. $23,000 c. $14,000 d. $15,500 e. None of the above

30. Which of the following gifts is a deductible contribution? a. A gift of $100 to a homeless person b. A $500 gift to the Democratic National Committee c. $1,000 spent on church bingo games d. A $200 contribution to your child’s public elementary school

31. Which of the following would typically be deductible as a casualty loss in 2019? a. Long-term damage to a home from termites b. An automobile accident during the daily commute c. A theft of a big screen television d. Dropping your smartphone in the pool e. None of the above

32. Which of the following is not a possible limitation on the deduction of a personal casualty loss? a. The lesser of the fair market value of the property or the adjusted basis at the time

of the loss b. A $100 floor for each casualty event c. A 10 percent of AGI floor for all casualty losses during the year d. A personal casualty not associated with a federally declared disaster e. All of the above are possible limitations on a personal casualty loss

LO 5.8

LO 5.9

LO 5.10

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5-51

33. Which of the following is deductible as a miscellaneous itemized deduction in 2019? a. Tax preparation fees b. Gambling losses in excess of gambling winnings c. Losses from Ponzi-type schemes d. Job-hunting expenses subject to the 2 percent of AGI floor e. None of the above are deductible as a miscellaneous itemized deduction.

34. Which of the following items is deductible as a miscellaneous deduction on Schedule A? a. Investment expenses b. Gambling losses to the extent of gambling winnings c. Unreimbursed business expenses d. Subscriptions to professional publications e. Charitable contributions

LO 5.10

1. Evan participates in an HSA carrying family coverage for himself, his spouse, and two children. In 2019, Evan has $100 per month deducted from his paycheck and contrib- uted to the HSA. In addition, Evan makes a one-time contribution of $2,000 on April 15, 2020 when he files his tax return. Evan also receives a 2019 Form 1099-SA that re- ports distributions to Evan of $3,200 which Evan used for medical expenses. Compute the effect of the HSA transactions on Evan’s adjusted gross income.

2. Serena is a 38-year-old single taxpayer. She operates a small business on the side as a sole proprietorship. Her 2019 Schedule C reports net profits of $15,624. Her employer does not offer health insurance. Serena pays health insurance premiums of $7,545 in 2019. Serena also pays long-term care insurance premiums of $600 in 2019. Calculate Serena’s self-employed health care deduction.

3. Karen, 28 years old and a single taxpayer, has a salary of $33,000 and rental income of $33,000 for the 2019 calendar tax year. Karen is covered by a pension through her employer. a. What is the maximum amount that Karen may deduct for contributions to her IRA

for 2019? $

b. If Karen is a calendar year taxpayer and files her tax return on August 15, what is the last date on which she can make her contribution to the IRA and deduct it for 2019?

4. Phil and Linda are 25-year-old newlyweds and file a joint tax return. Linda is covered by a retirement plan at work, but Phil is not. a. Assuming Phil’s wages were $27,000 and Linda’s wages were $18,500 for 2019

and they had no other income, what is the maximum amount of their deductible contributions to an IRA for 2019?

Phil $ Linda $

b. Assuming Phil’s wages were $55,000 and Linda’s wages were $70,000 for 2019 and they had no other income, what is the maximum amount of their deductible contributions to an IRA for 2019?

Phil $ Linda $

LO 5.1

LO 5.2

LO 5.3

GrOUp 2:

PROBLEMS

Questions and Problems

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5-52 Chapter 5 ● Deductions For and From AGI

5. What is the maximum amount a 45-year-old taxpayer and 45-year-old spouse can put into a Traditional or Roth IRA for 2019 (assuming they have sufficient earned income, but do not have an income limitation and are not covered by another pension plan)?

6. What is the maximum amount a 55-year-old taxpayer and 52-year-old spouse can put into a Traditional or Roth IRA for 2019, assuming they earn $70,000 in total and are not participants in pension plans?

7. Barry is a single, 40-year-old software engineer earning $190,000 a year and is not covered by a pension plan at work. How much can he put into a Roth IRA in 2019?

8. Bob is a single, 40-year-old doctor earning $190,000 a year and is not covered by a pension plan at work. What is the maximum deductible contribution into a Tradi- tional IRA in 2019?

9. Dori is 58 years old and retired in 2019. She receives a pension of $25,000 a year and no other income. She wishes to put the maximum allowed into an IRA. How much can she contribute to her IRA?

10. During 2019, Jerry is a self-employed therapist, and his net earned income is $160,000 from his practice. Jerry’s SEP Plan, a defined contribution plan, states that he will contribute the maximum amount allowable. Calculate Jerry’s contribution.

11. Tony is a 45-year-old psychiatrist who has net earned income of $300,000 in 2019. What is the maximum amount he can contribute to his SEP for the year?

12. Anthony, a self-employed plumber, makes a maximum contribution to a SEP for his employee, Debra. Debra’s compensation is $50,000 for the year. How much is he allowed to contribute to the plan for Debra?

13. During 2019, Jill, age 39, participated in a Section 401(k) plan which provides for maximum employee contributions of 12 percent. Jill’s salary was $80,000 for the year. Jill elects to make the maximum contribution. What is Jill’s maximum tax-deferred contribution to the plan for the year?

14. Linda installed a special pool for the hydrotherapeutic treatment of severe arthritis, as prescribed by her doctor. The cost of installing the pool was $20,000, and her insurance company paid $5,000 toward its cost. The pool increased the value of Linda’s house by $7,000, and it has a useful life of 10 years. How much of a deduction is Linda entitled to in the year of installation of the pool?

Explain

LO 5.3

LO 5.4

LO 5.6

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5-53

15. In 2019, Margaret and John Murphy (both over age 65) are married taxpayers who file a joint tax return with AGI of $26,100. During the year they incurred the following expenses:

Medical insurance premiums $1,300 Premiums on an insurance policy that pays $100 per 400

day for each day Margaret is hospitalized Medical care lodging (two people, one night) 65 Hospital bills 2,100 Doctor bills 850 Dentist bills 200 Prescription drugs and medicines 340 Psychiatric care 350

In addition, they drove 80 miles for medical transportation, and their insurance company reimbursed them $800 for the above expenses. On the following segment of Schedule A of Form 1040, calculate the Murphy’s medical expense deduction.

LO 5.6

16. Janet needs an elevator seat attached to her stairs since she has a medical condi- tion that makes her unable to climb the stairs in her house. The $10,000 spent on the elevator seat does not increase the value of her house according to a local ap- praiser. How much of the capital asset is deductible in Janet’s tax return as a medical expense?

17. Lyndon’s employer withheld $10,100 in state income taxes from Lyndon’s wages in 2019. Lyndon obtained a refund of $1,700 this year for overpayment of state income taxes for 2018. State income taxes were an itemized deduction on his 2018 return. His 2019 liability for state income tax is $8,700. Indicate the amount of Lyndon’s deduc- tion for state income taxes on his federal tax return assuming he elects to deduct state income taxes for 2019.

18. Mike sells his home to Jane on April 2, 2019. Jane pays the property taxes covering the full calendar year in October, which amount to $2,500. How much may Mike and Jane each deduct for property taxes in 2019?

Mike’s deduction $ Jane’s deduction $

LO 5.6

LO 5.7

Questions and Problems

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5-54 Chapter 5 ● Deductions For and From AGI

20. Mary paid $2,000 of state income taxes in 2019. She paid $1,500 of state sales tax on the purchase of goods and she also purchased a car in 2019 and paid sales tax of $3,000. How should Mary treat the taxes paid on her 2019 tax return?

21. Mary’s mother defaults on a home loan and Mary pays $600 in loan payments, includ- ing $175 in interest. Mary is not legally obligated on the loan and has no ownership interest in her mother’s home. a. What amount, if any, may Mary claim as an itemized deduction for the current

tax year?

b. Why?

22. Matthew borrows $250,000 to invest in bonds. During the current year, his interest on the loan is $30,000. Matthew’s taxable interest income from the bonds is $10,000. This is Matthew’s only investment income. a. Calculate Matthew’s itemized deduction for investment interest expense for this year.

b. Is Matthew entitled to a deduction in future years? Explain

23. Ken paid the following amounts for interest during 2019:

Qualified interest on home mortgage $5,322 Auto loan interest 850 “Points” on the mortgage for acquisition of his 400 personal residence Service charges on his checking account 40 Mastercard interest 300

LO 5.7

LO 5.8

19. Laura is a single taxpayer living in New Jersey with adjusted gross income for the 2019 tax year of $35,550. Laura’s employer withheld $3,410 in state income tax from her salary. In April of 2019, she pays $550 in additional state taxes for her prior year’s tax return. The real estate taxes on her home are $1,800 for 2019, and her personal property taxes, based on the value of the property, amount to $400. Also, she paid $80 for state gasoline taxes for the year. Complete the taxes section of Schedule A below to report Laura’s 2019 deduction for taxes assuming she chooses to deduct state and local income taxes.

LO 5.7

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5-55

24. Janet and James purchased their personal residence 15 years ago for $300,000. For the current year, they have an $80,000 first mortgage on their home, on which they paid $5,750 in interest. They also have a home equity loan to pay for the children’s college tuition secured by their home with a balance throughout the year of $150,000. They paid interest on the home equity loan of $9,000 for the year. Calculate the amount of their deduction for interest paid on qualified residence acquisition debt and qualified home equity debt for the current year.

Qualified residence acquisition debt interest $ Qualified home equity debt interest $

25. Helen paid the following amounts of interest during the 2019 tax year:

Mortgage interest on Dallas residence (loan balance $50,000) $1,600 Automobile loan interest (personal use only) 440 Mortgage interest on Vail residence (loan balance $50,000) 3,100 Visa and Mastercard interest 165

Calculate the amount of Helen’s itemized deduction for interest (after limitations) for 2019.

26. At the end of 2019, Mark owes $250,000 on the mortgage related to the 2016 purchase of his residence. When his daughter went to college in the fall of 2019, he borrowed $20,000 through a home equity loan on his house to help pay for her education. The interest expense on the main mortgage is $15,000, and the interest expense on the home equity loan is $1,500. How much of the interest is deductible as an itemized deduction and why?

LO 5.8

Questions and Problems

Calculate Ken’s itemized deduction for interest on the following portion of Schedule A.

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5-56 Chapter 5 ● Deductions For and From AGI

27. Barbara donates a painting that she purchased three years ago for $8,000, to a university for display in the president’s office. The fair market value of the painting on the date of the gift is $14,000. If Barbara had sold the painting, the difference between the sales price and her cost would have been a long-term capital gain. a. How much is Barbara’s charitable contribution deduction for this donation?

$ b. Explain

28. Jerry made the following contributions during 2019:

His synagogue (by check) $1,100 The Republican Party (by check) 180 The American Red Cross (by check) 200 His fraternal organization for tickets to a holiday party 100

In addition, Jerry donated used furniture to the Salvation Army that he purchased years ago for $400 with a fair market value of $200. Assuming Jerry has adjusted gross income of $45,000, has the necessary written acknowledgments, and itemizes deductions, complete the Gifts to Charity section of Schedule A below to show Jerry’s deduction for 2019.

LO 5.9

29. Richard donates publicly traded Gold Company stock with a basis of $1,000 and a fair market value of $15,000 to the college he attended, which is considered a public char- ity. Richard has owned the shares for 10 years. How is this contribution treated on Richard’s tax return?

30. In June of 2019, Maureen’s house is vandalized during a long-term power failure after a hurricane hit the city. The president of the United States declares Maureen’s city a disaster area as a result of the wide-scale vandalism. In which tax year may Maureen take her casualty loss deduction?

Explain:

31. On January 3, 2019, Carey discovers his diamond bracelet has been stolen. The bracelet had a fair market value and adjusted basis of $7,500. Assuming Carey had no insurance coverage on the bracelet and his adjusted gross income for 2019 is $45,000, calculate the amount of his theft loss deduction.

LO 5.9

LO 5.10

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5-57Questions and Problems

32. Kerry’s car is totaled in an auto accident. The car originally cost $18,000, but is worth $7,500 at the time of the accident. Kerry’s insurance company gives her a check for $7,500. Kerry has $30,000 of adjusted gross income. How much can Kerry claim as a casualty loss on her tax return? Please explain.

33. During the 2019 tax year, Irma incurred the following expenses:

Union dues $244 Tax return preparation fee 150 Brokerage fees for the purchase of stocks 35 Uniform expenses not reimbursed by her employer 315

If Irma’s adjusted gross income is $23,000, calculate her miscellaneous deductions.

LO 5.10

1. While preparing Massie Miller’s 2019 Schedule A, you review the following list of possible charitable deductions provided by Massie:

Cash contribution to a family whose house burned down $1,000 Time while working as a volunteer at Food Bank (5 hours @ $50/hour) 250 Cash contribution to United Methodist Church (receipt provided) 800 Cash contribution to Salvation Army (note from Massie: “I can’t

remember exactly the amount that I gave and I can’t find the receipt. I think it was around $500.”) 500

Total $2,550

What would you say to Massie regarding her listed deductions? How much of the deduction is allowed for charitable contributions?

2. In 2019, Gale and Cathy Alexander hosted an exchange student, Axel Muller, for 9 months. Axel was part of International Student Exchange Programs (a qualified orga- nization). Axel attended tenth grade at the local high school. Gale and Cathy did not claim Axel as a dependent but paid the following items for Axel’s well-being:

Food and clothing $1,500 Medical care 200 Fair market value of lodging 2,700 Entertainment 100 Total $4,500

Gale and Cathy have asked for your help in determining if any of the $4,500 can be deducted as a charitable contribution.

Required: Go to the IRS website (www.irs.gov) and locate Publication 526. Write a letter to Gale and Cathy answering their question. If they can claim a deduc- tion, be sure to include in your letter the amount that can be deducted and any sub- stantiation requirements. (An example of a client letter is available at the website for this text located at www.cengage.com.)

ETHICS

research

GrOUp 3:

WRITING ASSIGNMENT

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5-58 Chapter 5 ● Deductions For and From AGI

1. John Williams (birthdate August 2, 1976) is a single taxpayer. John’s earnings and withholdings as the manager of a local casino for 2019 are reported on his Form W-2:

GrOUp 4:

COMPREHENSIVE PROBLEMS

Lucky Ace Casino 700 N. Sierra Street Reno, NV 89503

196,000.00

132,900.00

196,000.00

31-1459656

555-94-9358

John Williams 1324 Skyewalker Drive Reno, NV 89501

25,000.00

8,239.80

2,842.00

John’s other income includes interest on a savings account at Nevada National Bank of $13,691.

John pays his ex-wife, Sarah McLoughlin, $3,900 per month in accordance with their February 12, 2013 divorce decree. When their 12-year-old child (in the ex-wife’s custody) reaches the age of 18, the payments are reduced to $2,800 per month. His ex- wife’s Social Security number is 554-44-5555.

In 2019, John purchased a new car and so he kept track of his sales tax receipts during the year. His actual sales tax paid is $3,700, which exceeds the estimated amount per the IRS tables.

John participates in a high-deductible health plan and is eligible to contribute to a health savings account. His HSA earned $75 in 2019.

During the year, John paid the following amounts (all of which can be substantiated):

Credit card interest $1,760 Auto loan interest 4,300 Auto insurance 900 Contribution to IRA 6,000 Property taxes on personal residence 2,700 Contributions to HSA 2,850 Income tax preparation fee 900 Charitable contributions (all cash): Boy Scouts 1,350 St. Matthews Church 3,100 U. of Nevada (Reno) Medical School 27,000 Nevada Democratic Party 250 Fund-raising dinner for the Reno Auto Museum 100 (value of dinner is $25)

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5-59Questions and Problems

John also received the following Form 1098:

Reno Bank & Trust 49 Commerce Street Reno, NV 89501

33-1234569 555-94-9358

John Williams

1324 Skyewalker Drive

Reno, NV 89501

19,003.41

591,786.32 3/01/2003

Required: Complete John’s federal tax return for 2019. Use Form 1040, Schedule 1, Schedule A, Schedule B, and Form 8889 to complete this tax return. Make realistic assumptions about any missing data.

2A. Bea Jones (birthdate March 27, 1984) moved from Texas to Florida in December 2018. She lives at 654 Ocean Way, Gulfport, FL 33707. Bea’s Social Security number is 466-78-7359 and she is single. Her earnings and income tax withholding for 2019 for her job as a manager at a Florida shrimp-processing plant are:

Earnings from the Gulf Shrimp Co. $44,000 Federal income tax withheld 4,600 State income tax withheld 0

Bea’s other income includes interest on a savings account at Beach National Bank of $1,200 and $600 per month alimony from her ex-husband in accordance with their August 2011 divorce decree.

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5-60 Chapter 5 ● Deductions For and From AGI

Granny Smith Apple Co. 200 Ahtanum Road Yakima, WA 98903

77,300.00

34-7654321

571-78-5974

John Fuji 468 Bonnie Doon Avenue Yakima, WA 98902

8,100.00

4,792.60

1,120.85

Bea’s employer operates a 401(k) plan, and although she is eligible, Bea does not participate.

During 2019, Bea paid the following amounts (all of which can be substantiated):

Home mortgage interest (1098 not shown) $8,800 Auto loan interest 2,300 State sales tax 820 Property taxes on personal residence 3,233 Unreimbursed hospital bills 3,275 Doctor bills 2,612 Other deductible medical expenses 720 Income tax preparation fee 600 Job-hunting expenses 925 Contribution to IRA 2,300

In September 2019, Tropical Storm Yuri struck Gulfport and a tree fell on Bea’s home. Bea acquired the home in February 2012 for $110,000. The estimated loss in mar- ket value from damage was equal to her repair charge of $7,800. The damage caused by TS Yuri was declared a federal disaster (code EM-1212). Bea’s deductible was quite high and her insurance company only reimbursed her $1,200.

Required: Complete Bea’s federal tax return for 2019. Use Form 1040, Schedule A, and Form 4684 (if needed) to complete this tax return. Make realistic assumptions about any missing data.

2B. John Fuji (birthdate June 6, 1981) moved from California to Washington in December 2018. His earnings and income tax withholding for 2019 for his job as a manager at a Washington apple-processing plant are:

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5-61

John’s other income includes interest on a Certificate of Deposit reported on a Form 1099-INT:

Questions and Problems

Braeburn National Bank 1600 W. Nob Hill Blvd. Yakima, WA 98902

John Fuji

54-9019016 571-78-5974

1,433.00

0.00

Yakima, WA 98902

468 Bonnie Doon Ave.

Form 1099-INT

2019 Interest Income

Copy B

For Recipient

Department of the Treasury - Internal Revenue Service

This is important tax information and is

being furnished to the IRS. If you are

required to �le a return, a negligence

penalty or other sanction may be

imposed on you if this income is

taxable and the IRS determines that it has

not been reported.

OMB No. 1545-0112

CORRECTED (if checked) PAYER’S name, street address, city or town, state or province, country, ZIP or foreign postal code, and telephone no.

PAYER’S TIN RECIPIENT’S TIN

RECIPIENT’S name

Street address (including apt. no.)

City or town, state or province, country, and ZIP or foreign postal code

FATCA �ling requirement

Account number (see instructions)

Payer's RTN (optional)

1 Interest income

$ 2 Early withdrawal penalty

$ 3 Interest on U.S. Savings Bonds and Treas. obligations

$ 4 Federal income tax withheld

$ 5 Investment expenses

$ 6 Foreign tax paid

$ 7 Foreign country or U.S. possession

8 Tax-exempt interest

9 Speci�ed private activity bond interest

$ 10 Market discount

11 Bond premium

$ 12 Bond premium on Treasury obligations

$ 13 Bond premium on tax-exempt bond

$ 14 Tax-exempt and tax credit

bond CUSIP no. 15 State 16 State identi�cation no. 17 State tax withheld

$ $

Form 1099-INT (keep for your records) www.irs.gov/Form1099INT

Also, in accordance with the January 2019 divorce decree he paid $500 per month alimony to his ex-wife (Dora Fuji, Social Security number 573-79-6075) starting with February 2019.

John received the following Form 1098 reporting mortgage interest and property taxes:

Braeburn National Bank 1600 W. Nob Hill Blvd. Yakima, WA 98902

54-9019016 571-78-5974

Yakima, WA 98902

1 Prop. Taxes $2,100

John Fuji

255,321.78

7,775.13

12/1/2017

468 Bonnie Doon Ave.

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5-62 Chapter 5 ● Deductions For and From AGI

During 2019, John paid the following amounts (all of which can be substantiated):

Auto loan interest 1,575 Credit card interest 655 State sales tax 1,285 Assisted living charges for Gala 5,250 Doctor bills 2,550 Other deductible medical expenses 760 Income tax preparation fee 500 Job-hunting expenses 925 Cash charitable donation to the Jonagold Research Center 400

John’s employer offers a retirement plan, but John does not participate. Instead, he made a $4,000 contribution to a Roth IRA.

John also provides 100 percent of the support for his mother, Gala Fuji (Social Se- curity number 323-11-4455). Gala is chronically ill and lives in an assisted living facility in Yakima. Her only income is interest of about $400 on a modest savings account. John can claim the $500 other dependent credit for Gala.

Required: Complete John’s federal tax return for 2019. Use Form 1040, Schedule 1, and Schedule A as needed to complete this tax return. Make realistic assumptions about any missing data.

1. The following information is available for the Albert and Allison Gaytor family in addition to that provided in Chapters 1– 4. Albert and Allison received the following form:

GrOUp 5:

CuMuLATIVE SOfTWARE PROBLEM

Vizcaya National Bank 9871 Coral Way Miami, FL 33134

60-7654321 266-51-1966

Coral Gables, FL 33134

Albert and Allison Gaytor

317,034.44

11,345.08

03/01/2005

12340 Cocoshell Road

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Albert and Allison paid the following in 2019 (all by check or can otherwise be substantiated):

Contributions to Perpetual Perpetuity Catholic Church $ 510 Tuition to Perpetual Perpetuity Catholic School for Crocker 6,000 Clothes to Salvation Army (10 bags in good condition) 275 Contributions to George Kerry’s Congressional campaign 250 Psychotherapy for Allison 2,298 Prescription eyeglasses for Crocker 413 Prescription medication and drugs 1,903 Credit card interest 1,345 Interest on Albert’s college loans 3,125 Actual state sales tax (including sales tax on new auto of $2,000) 3,202 Investment interest expense on stock margin account 345 Auto loan interest reported on Form 1098 (not shown here; 860 auto was paid for by a home equity loan on residence) Auto insurance 1,600 Cosmetic surgery for Albert 4,500 Dave Deduction, CPA, for preparation of last year’s tax return 765 Safe-deposit box for storage of stocks and tax data 100 Contribution to an educational savings account for Crocker 1,000 Home property taxes 4,888 Unreimbursed business expense (seminar on dealing with 700 hijacking at sea)

In August 2019, Crocker was on an out-of-town field trip with the university band and his appendix burst. He required immediate surgery which was considered “out of network” for the Gaytor’s health plan resulting in hospital and doctor’s fees of $3,150 not covered by insurance. In addition, Allison drove 300 miles round trip to be with Crocker after the surgery and drive him home after he recovered. She spent two nights in a hotel at a cost of $140 per night.

In June, Albert purchased a new professional digital SLR camera for $7,950. While the Gaytors were on vacation in August, someone broke into their residence and stole the camera. Albert’s homeowners’ insurance did not reimburse him for any part of the loss since he declined the special premium add-on for high value items required by his policy.

For the 2019 tax year, on April 15, 2020, Albert contributes $6,000 to a traditional IRA for himself and $6,000 to a traditional IRA for his wife. He is not covered by a qualified retirement plan at work.

Albert managed to gather his gambling loss documentation and can substantiate gambling losses of $4,502 in 2019 (refer back to Chapter 2 for gambling winnings).

Required: Combine this new information about the Gaytor family with the information from Chapters 1–4 and complete a revised 2019 tax return for Albert and Allison. Be sure to save your data input files since this case will be expanded with more tax information in later chapters.

5-63Questions and Problems

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5-64 Chapter 5 ● Deductions For and From AGI

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5-65Questions and Problems

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5-66 Chapter 5 ● Deductions For and From AGI

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5-67Questions and Problems

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5-68 Chapter 5 ● Deductions For and From AGI

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5-69Questions and Problems

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5-70 Chapter 5 ● Deductions For and From AGI

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5-71Questions and Problems

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5-72 Chapter 5 ● Deductions For and From AGI

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5-73Questions and Problems

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5-74 Chapter 5 ● Deductions For and From AGI

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5-75

Student Name

Class/Section

Date

K e y N Um B e r ta x r e t U r N sUm m a ry

CHAPTER 5

Comprehensive Problem 1

Adjusted Gross Income (Line 8b)

Standard or Itemized Deductions (Line 9)

Taxable Income (Line 11b)

Total Tax (Line 16)

Amount Overpaid (Line 20)

Comprehensive Problem 2A

Adjusted Gross Income (Line 8b)

Standard or Itemized Deductions (Line 9)

Casualties and Thefts (Form 4684, Line 18)

Total Tax (Line 16)

Amount Overpaid (Line 20)

Comprehensive Problem 2B

Adjusted Gross Income (Line 8b)

Standard or Itemized Deductions (Line 9)

Child Tax Credit/Credit for Other Dependents (Line 13a)

Total Tax (Line 16)

Amount Overpaid (Line 20)

Questions and Problems

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Ph ot

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H /S

hu tt

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oc k.

co m

C h a p t e r 6

Accounting Periods and Other Taxes

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L E A R N I N G O B J E C T I V E S

After completing this chapter, you should be able to: LO 6.1 Determine the different accounting periods allowed for tax purposes. LO 6.2 Determine the different accounting methods allowed for tax purposes. LO 6.3 Determine whether parties are considered related for tax purposes, and classif y the

tax treatment of certain related-party transactions. LO 6.4 Apply the rules for computing tax on the unearned income of minor children and

certain students (the “kiddie tax”). LO 6.5 Calculate a basic alternative minimum tax. LO 6.6 Calculate and report the self- employment tax (both Social Security and Medicare

portions) for self- employed taxpayers. LO 6.7 Apply the special tax and reporting requirements for household employees (the “nanny tax”). LO 6.8 Compute the special taxes for high-income taxpayers.

6-1

O V e r V I e W

T axpayers operating a business, whether professional, rental, manufacturing, or an- other activity, should have an understanding of the accounting periods (calendar, fiscal,

or short-period tax years) and accounting methods (cash, accrual, or hybrid methods) allowed. Trans- actions involving related parties often have different rules for inclusion or exclusion of income and de- ductions. This chapter begins by addressing how and when individual, partnership, and corporate taxpayers should report taxable income.

In addition to the typical income tax, a number of other taxes are also reported through the individual income tax return. On the 2019 Form 1040, Schedule 2 is the primary reporting mechanism for additional taxes. This chapter covers the computation of taxes such as the “kiddie tax,” the “nanny tax,” alternative minimum tax, self-employment tax, the net investment income tax, and the additional Medicare tax.

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6-2 Chapter 6 ● Accounting Periods and Other Taxes

6-1 ACCOuNTING PERIOdS

6-1a Individual Tax Years Almost all individuals file tax returns using a calendar-year accounting period. Individuals reporting for tax purposes on a fiscal year other than a calendar year are extremely rare since the tax system is set up to accommodate calendar-year taxpayers. However, there are no restrictions on an individual taking a tax year other than a calendar year. The choice to file on a fiscal year basis must be made with an initial tax return, and books and records must be kept on that basis. An individual may also request IRS approval to change to a fiscal year if certain conditions are met.

6-1b Partnership and Corporation Tax Years Many individual tax returns include the pass-through of income from partnerships, limited liability companies, S corporations, and personal service corporations. The income or loss from partnerships and S corporations is passed through on Schedule K-1 to the owners and taxed on the owners’ personal tax returns. Partnerships and S corporations are not taxable entities, only reporting entities. Similarly, wages are passed through to doctors, lawyers, accountants, actuaries, and other professionals from personal service corporations owned by them. Many individuals carry on businesses in partnerships which comprise a large part of the income shown on their tax returns. Other individuals make investments, including the operation of real estate rental activities, in these pass-through entities. Because the pass-through of income and loss from partnerships and S corporations plays a large role in the taxation of many individuals, it is important to understand the rules governing the allowed accounting periods for these entities.

Partnerships and corporations had a great deal of freedom in selecting a tax year in the past. However, Congress decided that this freedom often resulted in an inappropriate deferral of taxable income. For example, if an individual taxpayer has a calendar tax year and receives income from a partnership with a tax year ending September 30, the taxpayer is able to defer 3 months of partnership income for an indefinite period of time. Therefore, the tax law was changed to include provisions that specify the required tax year for many partnerships and certain corporations, reducing the opportunities for deferring income.

Corporations have much more flexibility and can generally choose any fiscal year-end for tax purposes. The primary restriction on choosing a fiscal year-end for a corporation is that its books and records must also be maintained on the same fiscal year-end. Fiscal year-ends must always occur on the last day of a month unless the taxpayer adopts a 52-53- week year, which permits the year-end to always fall on the same day of the week. That day of the week must be the one closest to the last day of the month.

Most partnerships, S corporations, and personal service corporations owned by individual taxpayers now conform to the same calendar-year reporting used by almost all individuals. These entities are allowed a September, October, or November year-end if the owners make an annual cash deposit on behalf of the entity or perform other required calculations to assure the IRS that they are not using the fiscal year to defer the payment of federal taxes. The details of the complex requirements which must be met by entities filing non-calendar tax years are beyond the scope of this textbook.

6-1c Short-Period Taxable Income If taxpayers have a short year other than their first or last year of operations, they are re- quired to annualize their taxable income to calculate the tax for the short period. The tax liability is calculated for the annualized period and allocated back to the short period. With the introduction of a flat 21 percent corporate tax rate, the annualization method is some- what simplified.

Learning Objective 6.1 Determine the different accounting periods allowed for tax purposes.

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6-36-2 Accounting Methods

EXAMPLE Omoto Corporation obtains permission to change from a calendar year to a tax year ending August 31. For the short period, January 1 through August 31, 2019, the corporation’s taxable income was $40,000. Omoto Corporation’s tax for the short period is calculated as follows:

Step 1: Annualize the income $40,000 3 12/8 5 $60,000 Step 2: Tax on annualized income 21% 3 $60,000 5 $12,600 Step 3: Short period tax $12,600 3 8/12 5 $ 8,400

With a flat rate, this is equivalent to $40,000 3 21 percent. ♦

Self-Study Problem 6.1 See Appendix E for Solutions to Self-Study Problems

For the following taxpayers, determine the choice of year-end and place an X in the correct column.

Taxpayer

1. Individual with no separate books and records

2. Partnership for which all the partners are calendar year-end individuals

3. A corporation that keeps in book and records on a fiscal year ending June 30

4. An S corporation for which all shareholders are calendar year-end individuals

Calendar year-end

Fiscal year-end

Fiscal year-end but some

restrictions

6-2 ACCOuNTING METhOdS The tax law requires taxpayers to report taxable income using the method of accounting regularly used by the taxpayer in keeping his or her books, provided the method clearly reflects the taxpayer’s income. The cash receipts and disbursements method, the accrual method, and the hybrid method are accounting methods specifically recognized in the tax law.

The cash receipts and disbursements method of accounting (commonly referred to as the cash method or cash basis) is used by most individuals for their overall method of accounting. Generally, wages, interest and dividend income, capital gains, and personal deductions are accounted for on the cash basis for individuals. Individuals may choose to account for a particular business, such as a sole proprietorship reported on Schedule C, using the accrual or hybrid method of accounting. If a taxpayer has two businesses, a different method of accounting may be used for each. The choice of a tax accounting method is a general rule which will be overridden by tax laws for some items of income and expense. For example, individuals reporting on a cash basis may deduct IRAs or pension contributions which are paid in cash in the year following the deduction, the income from savings bonds may be included in taxable income even though it is not received in cash, and prepaid interest may not be allowed as a deduction in the year paid.

The cash method generally results in the recognition of income when it is actually or constructively received; deductions are recognized in the year of payment. Taxpayers on the accrual basis generally recognize income when it is earned, regardless of when it is received, and generally recognize deductions when they are incurred, regardless of

6.2 Learning Objective Determine the different accounting methods allowed for tax purposes.

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6-4 Chapter 6 ● Accounting Periods and Other Taxes

when they are paid. Cash basis taxpayers may not use the cash method for all expenses. Tax rules require cash basis taxpayers to always use the accrual basis for prepayments of interest. Other business expenses such as rent must also follow the accrual method if the prepayment extends substantially (generally 12 months) beyond the end of the tax year. Conversely, accrual basis taxpayers who receive certain types of prepaid income, such as rent in advance, must generally recognize the income on the cash basis.

EXAMPLE On December 1, 2019, Carol entered into a lease on a building for use in her business for $2,000 per month. Under the lease terms, Carol pays 18 months’ rent ($36,000) in advance on December 1. Carol may deduct only 1 month’s rent ($2,000) for the calendar year ended December 31, 2019 because the prepayment extends substantially beyond the end of the tax year, even though she is a cash basis taxpayer. The remainder of the prepaid rent is deducted at $2,000 per month in 2020 and 2021. The taxpayer receiving the rent must report all $36,000 as income even if he or she is an accrual basis taxpayer. ♦

The accrual method of accounting requires that income be recognized when (1) all events have occurred which fix the right to receive the income, and (2) the amount of income can be estimated with reasonable accuracy. An expense is deductible in the year in which all events have occurred that determine a liability exists and the amount can be estimated with reasonable accuracy. Also, “economic performance” must occur before an accrual basis deduction can be claimed. Economic performance means that all activities related to the incurrence of the liability have been performed. For example, economic performance occurs for the purchase of services when the taxpayer uses the services.

A hybrid method of accounting involves the use of both the cash and accrual methods of accounting. The tax law permits the use of a hybrid method, provided the taxpayer’s income is clearly reflected by the method. An example of a hybrid method is the use of the accrual method for cost of products sold by the business and the use of the cash method for income and other expenses.

Taxpayers make an election to use an accounting method when they file an initial tax return and use that method. To change methods, taxpayers must obtain permission from the IRS.

The cash method allows a certain amount of flexibility in tax planning. Payment of business expenses may be accelerated before year-end to generate additional deductions, if desired. In addition, billings for services may be postponed at year-end so payment will not be received and included in income until the following year. Some itemized deductions such as property taxes, state income taxes, and charitable contributions may also be paid before year-end for an immediate deduction.

TAX BREAK

Self-Study Problem 6.2A See Appendix E for Solutions to Self-Study Problems

Melaleuca, Inc., is an accrual basis taxpayer with the following transactions during the calendar tax year:

Accrual business income (except rent and interest) $63,000 Accrual business expenses (except rent) 42,000 Three months’ rent received on a leased building on

November 1 of this year 9,000 Prepaid interest for 1 year received on a note on July 1 of

the current year 12,000 Six months’ rent paid on December 1 for business property 7,200 Calculate Melaleuca, Inc.’s, net income for this year. $

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6-56-3 Related Par ties (Section 267)

6-2a Restrictions on the use of the Cash Method The tax law contains certain restrictions on the use of the cash method of accounting. Regular corporations, partnerships that have a regular corporation as a partner, and tax- exempt trusts with unrelated business income are generally prohibited from using the cash method. However, this requirement does not apply to farming businesses, qualified personal service corporations, and entities with average annual gross receipts of $26 mil- lion or less in 2019.

EXAMPLE Orange Associates is a manufacturer of light bulbs with gross receipts of $27 million. Orange would not be allowed to use the cash method of accounting for tax purposes. ♦

Self-Study Problem 6.2B See Appendix E for Solutions to Self-Study Problems

Indicate whether or not each of the following entities may use the cash method for tax purposes during 2019.

Yes or No

1. A corporation engaged in orange farming. 2. A dentist with a personal service corporation. 3. A corporate car dealer with sales of $28 million per year. 4. A corporation engaged in certified public accounting.

The IRS will pay informants cash rewards based on the value of the information they furnish and the amount recovered from the target of the investigation. In 2014, 2015, and 2016 the IRS paid 101, 99, and 418 whistleblowers $52 million, $103 million, and $61 million, respectively. Over the last three years, the amount of tax collected by the IRS as a result of whistleblowers was almost $1.2 billion.

Would You

Believe?

6-3 RELATEd PARTIES (SECTION 267) When taxpayers who are related to of each other engage in transactions, there is poten- tial for abuse of the tax system. To prevent this abuse, the tax law contains provisions that govern related-party transactions. Under these rules, related parties who undertake certain types of transactions may find the timing of income or deduction recognition differs from typical rules.

There are two types of transactions between related parties restricted by Section 267 of the tax law. These transactions are:

1. Sales of property at a loss 2. Unpaid expenses and interest

6-3a Losses Under the tax law “losses from sale or exchange of property . . . directly or indirectly” are disallowed between related parties. When the property is later sold to an unrelated party, any disallowed loss may be used to offset gain on that transaction.

6.3 Learning Objective Determine whether parties are considered related for tax purposes, and classify the tax treatment of certain related-party transactions.

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6-6 Chapter 6 ● Accounting Periods and Other Taxes

EXAMPLE Mary sells IBM stock with a basis of $10,000 to her son, Steve, for $8,000, resulting in a disallowed loss of $2,000. Three years later, Steve sells the stock to Kim, an unrelated party, for $13,000. Steve has a gain on the sale of $5,000 ($13,000 2 $8,000). However, only $3,000 ($5,000 2 $2,000) of the gain is taxable to Steve since the previously disallowed loss can reduce his gain. ♦

EXAMPLE Assume the same facts as in the example above, except the IBM stock is sold for $9,500 (instead of $13,000). None of the gain of $1,500 ($9,500 2 $8,000) would be taxable, because the disallowed loss would absorb it. $500 of Mary’s disallowed loss is not available to her son. ♦

EXAMPLE Assume the same facts as in the example above, except Steve sells the IBM stock 3 years later for $7,000 (instead of $9,500). Steve now has a $1,000 realized loss, which can be deducted subject to any capital loss limitations. Because there is no gain on this transaction, the tax benefit of Mary’s $2,000 disallowed loss is not available to her son. ♦

6-3b unpaid Expenses and Interest Under Section 267, related taxpayers are prevented from engaging in tax avoidance schemes in which one taxpayer uses the cash method of accounting and the other taxpayer uses the accrual method.

EXAMPLE Ficus Corporation, an accrual basis taxpayer, is owned by Bill, an individual who uses the cash method of accounting for tax purposes. On December 31, Ficus Corporation accrues interest expense of $10,000 on a loan from Bill, but the interest is not paid to him. Ficus Corporation may not deduct the $10,000 until the tax year in which it is actually paid to Bill. This rule also applies to other expenses such as salaries and bonuses. ♦

6-3c Relationships Section 267 has a complex set of rules to define who is a related party for disallowance purposes. The common related parties under Section 267 include the following:

1. Family members. A taxpayer’s family includes brothers and sisters (whole or half), a spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.).

2. A corporation or an individual who directly or indirectly owns more than 50 percent of the corporation.

3. Two corporations that are members of the same controlled group. 4. Trusts, corporations, and certain charitable organizations. They are subject to a complex

set of relationship rules.

EXAMPLE Kalmia Corporation is owned 70 percent by Jim and 30 percent by Kathy. Jim and Kathy are unrelated to each other. Since Jim owns over 50 percent of the corporation, he is deemed to be a related party to the corporation. As a result, if Jim sells property to the corporation at a loss, the loss will be disallowed. Since Kathy is not related to the corporation, the rules of Section 267 do not apply to Kathy. ♦

Related-party rules also consider constructive ownership in determining whether parties are related to each other. Under these rules, taxpayers are deemed to own stock

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6-76-3 Related Par ties (Section 267)

owned by certain relatives and related entities. The common constructive ownership rules are as follows:

1. A taxpayer is deemed to own all the stock owned by his or her spouse, brothers and sisters (whole or half), ancestors, and lineal descendants.

2. A taxpayer is deemed to own his or her proportionate share of stock owned by any partnership, corporation, trust, or estate in which he or she is a partner, shareholder, or beneficiary.

3. A taxpayer is deemed to own any stock owned directly or indirectly by a partner.

EXAMPLE ABC Corporation is owned 40 percent by Andy, 30 percent by Betty, and 30 percent by Chee. Betty and Chee are married to each other. For purposes of related-party rules, Andy is not a related party to the corporation since he does not own more than 50 percent of the corporation. Betty is a related party because she is a 60 percent shareholder (30 percent directly and 30 percent from her husband, Chee). Using the same rule, Chee is also a related party since he also owns 60 percent (30 percent directly and 30 percent from his wife, Betty). ♦

EXAMPLE Robert owns 40 percent of R Corporation and 40 percent of T Corporation. T Corporation owns 60 percent of R Corporation. Since Robert is deemed to own 64 percent of R Corporation, he is a related party to R Corp. The 64 percent is calculated as 40 percent direct ownership and 24 percent (40% 3 60%) constructive ownership. ♦

There are other sets of related-party and constructive ownership rules in the tax law, which differ from the related-party rules discussed in this section and should not be confused with the Section 267 related-party provisions.

Self-Study Problem 6.3 See Appendix E for Solutions to Self-Study Problems

EFG Corporation is owned 40 percent by Ed, 20 percent by Frank, 20 percent by Gene, and 20 percent by X Corporation. X Corporation is owned 80 percent by Ed and 20 percent by an unrelated party. Frank and Gene are brothers. Answer each of the following questions about EFG under the constructive ownership rules of Section 267.

1. What is Ed’s percentage ownership? % 2. What is Frank’s percentage ownership? % 3. What is Gene’s percentage ownership? % 4. If EFG sells property to Ed for a $15,000 loss, what amount of that loss can be

recognized for tax purposes? $

Tax cuts and tax reform do not always represent the same change. Tax cuts often involve temporary provisions designed to stimulate the economy. The cuts are often paid for with the expiration of many of the favorable tax provisions toward the end of the budget window. Tax reform represents a long-term change in the method by which taxes are applied or calculated. Parts of the TCJA passed in 2017 are consistent with reform (permanent cut in corporate tax rates to 21percent) while other parts more closely resemble a temporary cut (the bevy of provisions expiring after 2025).

Would You

Believe?

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6-8 Chapter 6 ● Accounting Periods and Other Taxes

6-4 uNEARNEd INCOME OF MINOR ChILdREN ANd CERTAIN STudENTS

Many parents have found it beneficial from a tax-planning standpoint to give income earn- ing assets, such as stocks, bonds, bank certificates of deposit, and mutual funds, to their minor children. Since the children are generally in a lower income tax bracket, the income earned from these assets such as interest, dividends, and capital gains on stock sales has traditionally been taxed at a lower rate than the parents’ rate.

EXAMPLE Don and Melanie are high-income taxpayers in the 37 percent income tax bracket. They would like to shift income to their 11-year old son Boris. Don and Melanie gift Boris some investments over a few years and Boris ends up with $100,000 of investments that generate taxable income of $5,000 during the year. Boris is in the 10 percent tax bracket. The tax savings from the income shift would be $1,350 [$5,000 pretax income 3 (37% 2 10%)]. ♦

To prevent an income-shifting strategy such as that presented in the previous example, the child must compute tax on unearned income using the trust and estate tax rates. As shown in the following table, the 2019 trust and estate tax rates are extremely progressive:

Over But not over Tax is: Of the excess over

$ 0 $ 2,600 - 110% $ 0 2,600 9,300 260.00 124% 2,600 9,300 12,750 1,868.00 135% 9,300 12,750 3,075.50 137% 12,750

The tax on a child’s unearned income (commonly referred to as the “kiddie tax”) applies to dependent children who are ages 18 or younger and full-time students ages 19 through 23 at the end of the year, who have at least one living parent, and who have “net unearned income” of more than $2,200 for 2019. Although there is no statutory definition for a parent, the term is generally considered to mean a parent or step-parent of the child.

6-4a Computation of Tax on Child’s Taxable Income The computation of the tax on a child’s unearned income remains a complex, multi-step process. Taxable income is bifurcated into earned income and unearned income. The kiddie tax is assessed using rates that apply to trusts and estate on the portion of taxable income that consists of net unearned income and that exceeds the unearned income threshold of $2,200 (in 2019).

Step 1: Compute taxable income

Taxable income is equal to the child’s total (earned and unearned) income less the child’s standard deduction. The standard deduction for an individual that can be claimed as a de- pendent is the greater of $1,100 or the sum of the individual’s earned income and $350. The standard deduction cannot exceed the statutory standard deduction for that filing status (for example, single, $12,200).

EXAMPLE A Alice is a single child under 18 with $3,200 of interest income and no earned income. Her standard deduction is $1,100 (the greater of $1,100 or earned income of $0 1 $350). Alice’s taxable income is $2,100 ($3,200 2 $1,100). ♦

Learning Objective 6.4 Apply the rules for computing tax on the unearned income of minor children and certain students (the “kiddie tax”).

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6-96-4 Unearned Income of Minor Children and Cer tain Students

EXAMPLE B Boris is a single child under 18 with $3,200 of interest income and $5,000 of earned income. His standard deduction is $5,350 (the greater of $1,100 or $5,000 1 $350). Boris’ taxable income is $2,850 ($3,200 1 $5,000 2 $5,350). ♦

EXAMPLE C Carol is a single child under 18 with $12,500 of interest income and $12,400 of earned income. Her standard deduction is $12,200 ($12,400 1 $350 exceeds the standard deduction for a single taxpayer). Carol’s taxable income is $12,700 ($12,500 1 $12,400 2 $12,200). ♦

Step 2: Compute Net Unearned Income (NUI)

Net unearned income is generally defined as unearned income less $2,200 (a child with large itemized deductions associated with the unearned income may be different). Unearned income is income that is not derived from wages, salaries, or similar compensa- tion or income from a trade or business. More generally, unearned income is thought of as investment income such as interest, dividends, and capital gains.

EXAMPLE A Alice is a single child under 18 with $3,200 of interest income and no earned income. Alice’s NUI is $1,000 ($3,200 2 $2,200). ♦

EXAMPLE B Boris is a single child under 18 with $3,200 of interest income and $5,000 of earned income. Boris’ NUI is $1,000 ($3,200 2 $2,200). ♦

EXAMPLE C Carol is a single child under 18 with $12,500 of interest income and $12,400 of earned income. Carol’s NUI is $10,300 ($12,500 2 $2,200). ♦

Step 3: Compute Earned Taxable Income (ETI)

Earned taxable income is the residual amount of taxable income after reduction by NUI (in other words, taxable income less NUI).

EXAMPLE A Alice is a single child under 18 with $3,200 of interest income and no earned income. Alice’s ETI is $1,100 ($2,100 2 $1,000). ♦

EXAMPLE B Boris is a single child under 18 with $3,200 of interest income and $5,000 of earned income. Boris’ ETI is $1,850 ($2,850 2 $1,000). ♦

EXAMPLE C Carol is a single child under 18 with $12,500 of interest income and $12,400 of earned income. Carol’s ETI is $2,400 ($12,700 2 $10,300). ♦

The above steps effectively bifurcate taxable income into two parts (NUI and ETI).

Step 4: Calculate the tax

The tax on the NUI is calculated at trust and estate rates and the tax on ETI is calculated at the rates applicable to the child’s filing status. (In these examples, taxes are calculated using tax rate structures. For ETI below $100,000, the tax tables are required).

EXAMPLE A Alice is a single child under 18 with $3,200 of interest income and no earned income. Alice’s tax is $210 [$1,000 3 10% (NUI taxed as a trust) 1 $1,100 3 10% (taxed as a single taxpayer)]. ♦

EXAMPLE B Boris is a single child under 18 with $3,200 of interest income and $5,000 of earned income. Boris’ tax is $285 [$1,000 3 10% (NUI taxes as a trust) 1 $1,850 3 10% (taxed as a single taxpayer)]. ♦

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6-10 Chapter 6 ● Accounting Periods and Other Taxes

EXAMPLE C Carol is a single child under 18 with $12,500 of interest income and $12,400 of earned income. Carol’s tax is $2,458 [($2,218 of trust tax on $10,300 [$1,868 1 (($10,300 2 $9,300) 3 35%)] 1 $2,400 3 10% (taxed as a single taxpayer)]. ♦

The kiddie tax is reported on Form 8615 as presented on Page 6-11. Most of the complexity of the kiddie tax is revealed in the Line 7 tax computation worksheet in the instructions to Form 8615.

The taxation of a child’s unearned income is made even more complex in situations where the child’s earned income is unusually high (over approximately $70,000) or where the unearned income is subject to preferential rates such as qualified dividends or long- term capital gains. These situations are beyond the scope of this textbook.

Self-Study Problem 6.4 See Appendix E for Solutions to Self-Study Problems

Bill and Janet are a married couple filing jointly in 2019 and have one child, Robert, who is 9 years old. Robert has interest income of $3,000 in 2019. Bill and Janet’s taxable income in 2019 is $46,550 and they take the standard deduction as the only from AGI deduction. Calculate Robert’s tax liability for 2019, assuming

a. Bill and Janet do not make the election to include Robert’s income on their tax return. $

b. Bill and Janet make the election to include Robert’s income on their tax return. $

6-4b Election to Include a Child’s unearned Income on Parents’ Return

If certain conditions are met, parents may elect to include a child’s gross income on the parents’ tax return. The election eliminates the child’s return filing requirements and saves the parents from the trouble of filing the special calculation on Form 8615 for the “kiddie tax.” To qualify for this election, the following conditions must be met:

1. The child’s gross income is from interest and dividends only. 2. The gross income is more than $1,100 and less than $11,000 (or 10 times the lower

amount). 3. No estimated tax has been paid in the name of the child and the child is not subject to

backup withholding.

EXAMPLE Sam Jackson is 12 years old and has $2,300 of interest from a savings account established for him by his grandparents. This is Sam’s only income for the year. Instead of completing Form 8615 and paying the kiddie tax on his $2,300 in income, Sam’s parents, Michael and Janet, may elect to include the $2,300 on their tax return, thereby eliminating Sam’s filing requirement. The election to include the income of a minor child on the parents’ return is made on Form 8814, as illustrated on Page 6-13. ♦

Although the computation of the kiddie tax is complex, having ProConnect compute the kiddie tax requires no extra input on the part of the preparer. If the taxpayer is noted as being claimed as a dependent, fits the age requirements, and unearned income that exceeds the threshold is input (for example, form Forms 1099-INT or 1099-DIV), the software will automatically generate and populate the Form 8615 and calculate the kiddie tax.

tIp

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6-116-4 Unearned Income of Minor Children and Cer tain Students

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6-12 Chapter 6 ● Accounting Periods and Other Taxes

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6-136-4 Unearned Income of Minor Children and Cer tain Students

Michael and Janet Jackson

Sam Jackson

2,300

100

1,200

110

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6-14 Chapter 6 ● Accounting Periods and Other Taxes

6-5 ThE INdIVIduAL ALTERNATIVE MINIMuM TAX (AMT) A small number of individual taxpayers are subject to two parallel tax calculations, the regular tax and the alternative minimum tax (AMT). The AMT was designed in the 1960s to ensure that wealthy taxpayers could not take advantage of special tax write-offs (tax preferences and other adjustments) to avoid paying tax. In general, taxpayers must pay the alternative minimum tax if their AMT tax liability is larger than their regular tax liability.

The AMT is calculated on Form 6251, using the following formula simplified for pur- poses of this textbook:

Regular taxable income (before exemptions (suspended in 2018) and standard deduction)

6 Plus or minus AMT preferences and adjustments 5 Equals alternative minimum taxable income (AMTI) 2 Less AMT exemption (phased out to zero as AMTI increases) 5 Equals amount subject to AMT 3 Multiplied by the AMT tax rate(s) 5 Equals tentative minimum tax 2 Less regular tax 5 Equals amount of AMT due with tax return, if a positive amount

6-5a Common AMT Adjustments and Preferences The terms “AMT adjustments” and “AMT preferences” are often used interchangeably, though they have slightly different meanings. In general, adjustments are timing dif- ferences that arise because of differences in the regular and AMT tax calculations (e.g., depreciation timing differences), while preferences are special provisions for the regular tax that are not allowed for the AMT (e.g., state income taxes). Both terms refer to items which adjust regular taxable income to arrive at income which is subject to alternative minimum tax. There are over twenty different types of adjustments and preferences used in the calculation of AMT on Form 6251. Some of the common adjustments and prefer- ences are as follows:

● The standard deduction allowed for regular tax is not allowed for AMT. ● The deductions for property tax, state income tax, and other taxes allowed as

itemized deductions for regular tax are not allowed for AMT. ● Depreciation is generally calculated over a longer life for AMT, sometimes using a dif-

ferent method. ● Net operating losses are calculated differently for AMT and often result in an adjust-

ment when they are present. ● State income tax refunds are not considered income for AMT since the state income tax

deduction is not allowed for AMT. ● Interest from specified private activity bonds is not taxed for regular tax purposes, but

is taxable for AMT. ● Other less commonly seen AMT differences include such items as the calculations

related to incentive stock options, oil and gas depletion, research and development expenses, gains on asset sales such as rental real estate, passive losses, and the gain exclusion for small business stock and other items.

Learning Objective 6.5

Calculate a basic alternative minimum tax.

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6-156-5 The Individual Alternative Minimum Tax (AMT)

The actual details of the calculation of several of the AMT tax preferences and adjust- ments are complex and infrequently seen in practice. For further information, please con sult the IRS website, a tax service, or an advanced tax textbook.

6-5b AMT Exemption To reduce the chances of subjecting a greater number of taxpayers to the AMT, an exemp- tion amount is permitted as a deduction against AMT income. The 2019 AMT exemptions and thresholds are:

Married filing jointly

Single and H of H

Married filing separately

Exemption amount $ 111,700 $ 71,700 $ 55,850 Threshold 1,020,600 510,300 510,300

The exemption amount is phased out (reduced) 25 cents for each dollar by which the taxpayer’s alternative minimum taxable income exceeds the threshold amounts.

EXAMPLE Abby, a single taxpayer, has AMTI of $126,000 in 2019. Her AMT exemption is $71,700 as she has not reached the threshold for phase-out. ♦

EXAMPLE Damon and Tiffany are married and file jointly. They have AMTI of $1,234,000 in 2019. Their AMT exemption is $58,350 [$111,700 2 (($1,234,000 2 $1,020,600) 3 25%)]. ♦

The exemption amounts and phase-out thresholds are both indexed for inflation, but the amounts are scheduled to be reduced significantly after 2025.

6-5c Alternative Minimum Tax Rates For 2019, the alternative minimum tax rates for calculating the tentative minimum tax are 26 percent of the first $194,800 ($97,400 for married taxpayers filing separately), plus 28 percent on amounts above $194,800 (amounts above $97,400 for married filing sepa- rately). These rates are applied to the taxpayer’s alternative minimum tax base from the formula above. The alternative minimum tax rate for capital gains and dividends is limited to the rate paid for regular tax purposes (e.g., capital gain or qualified dividends taxed at 15 percent for regular tax purposes will also be taxed at a 15 percent alternative minimum tax rate).

EXAMPLE Teddy has alternative minimum taxable income after the exemption deduction of $270,000, none of which is from capital gains. His tentative minimum tax is $71,704, which is calculated as (26% 3 $194,800) 1 (28% 3 [$270,000 2 $194,800]). ♦

The increase in the AMT exemption amount and exemption phase-out threshold in conjunction with the limitation on the itemized deduction for state and local taxes and the suspension of miscellaneous itemized deduction subject to the 2 percent floor results in many fewer taxpayers being subject to the AMT than prior to the enactment of the TCJA.

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6-16 Chapter 6 ● Accounting Periods and Other Taxes

Self-Study Problem 6.5 See Appendix E for Solutions to Self-Study Problems

Harold Brown, a single taxpayer, has adjusted gross income of $600,000. He has a deduction for home mortgage interest of $23,000, cash contributions of $11,000, state income taxes of $10,000, and private activity bond interest income of $100,000. Assuming Harold’s regular tax liability is $170,708, use Form 6251 on Page 6-17 to calculate the amount of Harold’s net alternative minimum tax.

EXAMPLE Gram and Sally are married taxpayers who file a joint tax return. Their taxable income and regular tax liability can be calculated as follows:

2019

Adjusted gross income $200,000 Itemized deductions: State income tax 10,000 Home mortgage interest 20,000 Contributions 1,906 Total itemized deductions (31,906) Taxable income $168,094

Tax from rate schedule $ 28,698

Gram and Sally have $30,000 of private activity bond interest which is taxable for AMT but not for regular tax. The AMT is calculated as follows (same format as the Form 6251 presented on Page 6-17):

2019

Taxable income $168,094 Interest on private activity bonds 30,000 Add back: Taxes 10,000 Alternative minimum taxable income 208,094 AMT exemption (111,700) AMT Base 96,394 Tentative minimum tax 25,062 AMT $ 0

Because the regular tax exceeds the tentative minimum tax in 2019, no AMT is due. ♦

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6-176-5 The Individual Alternative Minimum Tax (AMT)

Self-Study Problem 6.5

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6-18 Chapter 6 ● Accounting Periods and Other Taxes

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6-196-6 Self-Employment Tax

6-6 SELF-EMPLOYMENT TAX The Federal Insurance Contributions Act (FICA) imposes Social Security (Old Age, Survivors, and Disability Insurance (OASDI)) and Medicare taxes. As discussed in Chapter 9, employ- ees and their employers are both required to pay FICA taxes. Employers withhold a specified percentage of each employee’s wages up to a maximum base amount, match the amount withheld with an equal amount, and pay the total to the Social Security Administration.

Self-employed individuals pay self-employment taxes instead of FICA taxes. Since these individuals have no employers, the entire tax is paid by self-employed individuals. Like the FICA taxes to which employees and their employers are subject, the self- employment tax also consists of two parts, Social Security and Medicare. The maximum base amount of earnings subject to the Social Security portion of the self-employment tax is $132,900 in 2019. All earnings are subject to the Medicare portion of the self-employment tax. The Social Security tax rate is 12.4 percent and the Medicare tax rate is 2.9 percent. The self-employment tax rates and the maximum base amounts for 5 years are illustrated in the following table:

6.6 Learning Objective Calculate and report the self-employment tax (both Social Security and Medicare portions) for self-employed taxpayers.

Year Maximum $ Base for 12.4% Maximum $ Base for 2.90%*

2015 118,500 Unlimited

2016 118,500 Unlimited

2017 127,200 Unlimited

2018 128,400 Unlimited

2019 132,900 Unlimited

*A 0.9 percent additional Medicare tax on self-employment income over $200,000 single and head of household ($250,000 married filing jointly). See LO 6.8 for more information.

If a self-employed individual also receives wages subject to FICA taxes during a tax year, the Social Security tax maximum base amount for self-employment taxes is reduced by the amount of wages. Therefore, the total amount of earnings subject to the Social Security tax portion of both FICA and self-employment tax for 2019 cannot exceed $132,900.

The self-employment tax is imposed on net earnings of $400 or more from self-employment. Net earnings from self-employment include gross income from a trade or business less trade or business deductions, the distributive share of partnership income

Your client, William Warrant, was hired for a management position at an Internet com pany planning to start a website called “indulgedanimals.com” for dogs, cats, and other pets. When he was hired, William was given an incentive stock option (ISO) worth $500,000, which he exercised during the year. Exercise of the ISO creates a tax prefer ence item for alternative minimum tax (AMT) and causes him to have to pay substantial additional tax when combined with his other tax items for the year. He is livid about the extra tax and refuses to file the AMT Form 6251 with his tax return because the AMT tax is “unfair” and “un-American” according to him. Would you sign this tax return?

Would You Sign This

Tax Return?

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6-20 Chapter 6 ● Accounting Periods and Other Taxes

from a trade or business, and net income earned as an independent contractor. Gains and losses from property transactions, except inventory transactions, and other unearned income are not considered self-employment income. In arriving at net earnings for purposes of computing the self-employment tax, self-employed taxpayers are allowed a deduction for AGI of one-half of the otherwise applicable self-employment tax. A shortcut to arriving at the self-employment income subject to self-employment tax is to multiply the net earnings from self-employment by 92.35 percent. This shortcut is used on Schedule SE as illustrated below.

EXAMPLE Norman is a self-employed accountant in 2019. From his practice, Norman earns $136,000, and has wages subject to FICA from a part-time job of $9,100. Norman’s self-employment tax is calculated as follows:

Step 1:

Net earnings from self- employment, before the self- employment tax deduction $136,000

3 92.35% Tentative net earnings from self- employment after deduction for self-employment tax $125,596

Step 2:

Social Security Medicare

Maximum base for 2019 $132,900 Unlimited Less: FICA wages (9,100) Not Applicable Maximum self-employment tax base $123,800 Unlimited Lesser of net earnings from self-employment after deduction for self-employment tax or maximum base $123,800 $125,596 Self-employment tax rate 12.4% 2.9% Self-employment tax for 2019 $ 15,351 $ 3,642

Norman’s total self-employment tax for 2019 is $18,993 ($15,351 1 $3,642). On his 2019 income tax return, Norman will report net earnings from self-employment of $136,000, a deduction for adjusted gross income of $9,497 (50% 3 $18,993), and a self-employment tax liability of $18,993. ♦

The calculation in this example is reported on page 2 of Schedule SE, Part I, and must be included with a taxpayer’s Form 1040. See Page 6-22 which shows the same calculation on Schedule SE.

Self-Study Problem 6.6 See Appendix E for Solutions to Self-Study Problems

Joanne Plummer is self-employed in 2019. Her Schedule C net income is $36,600 for the year, and Joanne also had a part-time job and earned $4,400 that was subject to FICA tax. Joanne received taxable dividends of $1,110 during the year, and she had a capital gain on the sale of stock of $9,100. Calculate Joanne’s self-employment tax using Schedule SE (page one only) of Form 1040 on Page 6-21.

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6-216-6 Self-Employment Tax

Self-Study Problem 6.6

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6-22 Chapter 6 ● Accounting Periods and Other Taxes

Norman

136,000 136,000 125,596

125,596

9,100

123,800 15,351 3,642

18,993

9,497

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6-236-7 The Nanny Tax

6-7 ThE NANNY TAX Over the years, the taxation and reporting of household employees’ wages has caused many problems for taxpayers and the IRS. The threshold for filing was low ($50 per quar- ter of wages), and the tax forms to be completed were complex. As a result, many taxpay- ers ignored the reporting of household workers’ wages and taxes. Congress addressed this problem by enacting what are commonly referred to as the “nanny tax” provisions. These provisions simplified the reporting process for employers of domestic household workers.

Household employers are not required to pay FICA taxes on cash payments of less than $2,100 paid to any household employee in a calendar year. If the cash payment to any household employee is $2,100 or more in a calendar year, all the cash payments (including the first $2,100) are subject to FICA taxes (see LO 9.3). The $2,100 threshold is adjusted for inflation each year. Household employers must also withhold income taxes if requested by the employee and are required to pay FUTA (Federal Unemployment Tax Act) tax (see LO 9.6) if more than $1,000 in cash wages are paid to household employees during any calendar quarter. The federal unemployment tax rate is 6 percent of an employee’s wages up to $7,000.

A taxpayer is a household employer if he or she hires workers to perform household services, in or around the taxpayer’s home, that are subject to the “will and control” of the taxpayer. Examples of household workers include:

● Babysitters ● Caretakers ● Cooks ● Drivers ● Gardeners ● Housekeepers ● Maids

If the household worker has an employee-employer relationship with the taxpayer, it does not matter if the worker is called something else, such as “independent contractor.” Also, it does not matter if the worker is full-time or part-time. The household employer is responsible for the proper reporting, withholding, and payment of any taxes due.

The following workers are not subject to FICA taxes on wages paid for work in the home: ● The taxpayer’s spouse ● The taxpayer’s father or mother ● The taxpayer’s children under 21 years of age ● Anyone who is under age 18 during the year, unless providing household services is his

or her principal occupation (being a student is considered an occupation for purposes of this requirement)

EXAMPLE Allison is a 17-year-old high school student. During the year, she earns $2,200 by babysitting for a neighbor with four children. Any amount she earns is exempt from FICA requirements. However, if Allison is not a student and works full-time as a nanny, she will be subject to the general FICA withholding requirements under the nanny tax rules. ♦

Under the nanny tax provisions, household employers only have to report FICA, federal income tax withholding, and FUTA tax once a year. The taxpayer com pletes Schedule H and files it with his or her individual Form 1040. Taxpayers who have nonhousehold worker(s) in addition to household worker(s) can elect to report any FICA taxes and withholding on Forms 941 and 940 with their regular employees. Also, at the close of a tax year, taxpayers must file Form W-2 (Copy A) and Form W-3 with the Social Security Administration for each household employee who earned $2,100 or more in cash wages subject to FICA tax or had federal income taxes withheld from wages. For complete details on reporting the wages of household employees, see IRS Publication 926.

6.7 Learning Objective Apply the special tax and reporting requirements for household employees (the “nanny tax”).

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6-24 Chapter 6 ● Accounting Periods and Other Taxes

6-8 SPECIAL TAXES FOR hIGh-INCOME TAXPAYERS There are two separate Medicare taxes for certain high-income taxpayers to help cover the cost of the Affordable Care Act (ACA). The first is the 3.8 percent Net Investment Income tax. The second is a 0.9 percent additional Medicare tax on wages and self-employment income.

6-8a The 3.8 Percent Medicare Tax on Net Investment Income

The ACA imposes a 3.8 percent Medicare tax on the net investment income of individuals with modified AGI over $250,000 for joint filers ($125,000 if married filing separate), and $200,000 for single filers (note that these amounts are not adjusted for inflation). Modified AGI is adjusted gross income increased by certain foreign earned income amounts not cov- ered in this textbook. Investment income subject to the additional 3.8 percent tax includes the following:

● Interest and dividends ● Royalties ● Annuities ● Net rental income, with some exceptions ● Passive activities ● Most gains on the sale of capital and other assets

Learning Objective 6.8 Compute the special taxes for high-income taxpayers.

Self-Study Problem 6.7 See Appendix E for Solutions to Self-Study Problems

Susan Green lives in Virginia and hires Helen in February 2019 to clean her house for $80 per week. Susan does not withhold income taxes from Helen’s wages. Helen’s quarterly wages are as follows:

1st quarter $ 480 ($80 3 6 weeks) 2nd quarter 1,040 ($80 3 13 weeks) 3rd quarter 1,040 ($80 3 13 weeks) 4th quarter 1,040 ($80 3 13 weeks) Total $3,600

Assume Susan pays her state unemployment of $194 to the state of Virginia during the year. Complete her 2019 Schedule H (Form 1040) on Pages 6-25 and 6-26, using the above information.

In 1993, shortly after he was elected, President Bill Clinton nominated Zoë Baird as U.S. Attorney General. Her nomination was derailed in what would become known as “Nannygate” when it was discovered that Baird had hired household employees and not paid taxes. During that time, the level of scrutiny on this type of arrangement increased significantly and some Americans were being asked if they had a “Zoë Baird problem.” Based on a 2006 study, some of the fear of Nannygate has subsided as filing rates for Schedule H have dropped on average across the United States. Interestingly, the filing rate for Schedule H was more than three times greater if you lived in or around Washington, DC.

Would You

Believe?

Taxes for household employees are input in ProConnect under Taxes. There is a separate subheading for Household Employment Taxes (Schedule H).

tIp

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6-256-8 Special Taxes for High-Income Taxpayers

Self-Study Problem 6.7

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6-26 Chapter 6 ● Accounting Periods and Other Taxes

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6-276-8 Special Taxes for High-Income Taxpayers

Income not subject to the 3.8 percent tax includes the following: ● Tax-exempt interest ● Excluded gain on the sale of a principal residence ● Distributions from retirement plans and individual retirement accounts ● Wages and self-employment income (earned income); however, this income may be

subject to a 0.9 percent Medicare tax

Deductions allowed in arriving at net investment income subject to tax include: ● State income taxes reasonably allocated to the investment income ● Investment interest expense

The $3,000 net deduction allowed for capital losses in excess of capital gains for regular tax purposes and net operating losses are not allowed to reduce net investment income. Addi- tional rules govern which income and deductions are included in calculating net investment income. The net investment income tax is reported on Form 8960 shown on Page 6-29.

EXAMPLE Consider each of the following single taxpayers:

Taxpayer A B C

Investment Income $ 50,000 $ 80,000 $ 80,000 Modified AGI 190,000 220,000 340,000

The 3.8 percent Net Investment Income tax would be calculated in each case as follows:

Taxpayer A B C

Modified AGI $190,000 $220,000 $340,000 Threshold 200,000 200,000 200,000 Excess over Threshold n/a 20,000 140,000 Investment Income 50,000 80,000 80,000 Lesser of Excess or Investment Income n/a 20,000 80,000 Tax Rate 3.8% 3.8% 3.8% Net Investment Income Tax $ 0 $ 760 $ 3,040

6-8b The 0.9 Percent Additional Medicare Tax on Earned Income

In addition to the 3.8 percent Medicare tax on net investment income, the ACA imposed a 0.9 percent Medicare tax on high-income taxpayers’ earned income such as salaries, wages, and self-employment income. The 0.9 percent tax applies to high-income taxpayers defined as taxpayers with earned income from wages, compensation, and self-employment income over the following thresholds (which are not adjusted for inflation each year):

a. $250,000 for joint filers b. $125,000 if married filing separately c. $200,000 for single filers (including head of household and qualifying widow(er)s)

The ordinary Medicare tax is 2.9 percent of earned income with no upper limitation. Employees split the cost of this tax with employers, with the employee paying 1.45 percent through withholding, and the employer paying 1.45 percent directly. Self-employed individuals pay the full 2.9 percent as calculated on Schedule SE with their Form 1040

♦

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6-28 Chapter 6 ● Accounting Periods and Other Taxes

income tax return. There is no employer match for the 0.9 percent tax. The 0.9 percent Medicare tax is reported on Form 8959 (see Page 6-31).

6-8c Employees The 0.9 percent Medicare tax must be withheld from each employee with a salary in ex- cess of $200,000, whether single or married. Married couples must combine their earned income and compare the total with the $250,000 threshold for married taxpayers to deter- mine if they owe the 0.9 percent Medicare tax. Depending on the income of each spouse, the couple may owe more 0.9 percent Medicare tax when computing the 0.9 percent Medi- care tax on their Form 1040 to make up for amounts not fully withheld, or they may treat the excess amount withheld as an additional tax payment. The withholding is reported on each individual’s Form W-2 along with other Medicare withholding.

EXAMPLE Will and Karen are married. Will earns $225,000 in 2019 and Karen does not work. They have no other income in 2019. Will’s employer must withhold $225 [0.9% 3 ($225,000 2 $200,000)], from his wages. Because Will and Karen do not have earned income in their joint return in excess of the $250,000 threshold for joint filers, the $225 withholding will be treated as an additional payment when they file their Form 1040 income tax return for 2019. ♦

EXAMPLE Fran and Steve are married and each has wages of $150,000. Because they each earn less than $200,000, their employers are not required to withhold the 0.9 percent Medicare tax. However, when they file their 2019 Form 1040, they will be required to pay $450 (0.9% 3 $50,000) with their tax return since their $300,000 in joint earnings exceeds the $250,000 threshold for married taxpayers filing jointly. ♦

EXAMPLE Johnny is single and changes jobs during 2019. His wages are $175,000 from each job for a total of $350,000 of wage income. Johnny’s employers are not required to withhold any 0.9 percent Medicare tax from his wages since he does not reach the $200,000 threshold in either job. Johnny must pay $1,350 (0.9% 3 $150,000, the excess of $350,000 over the $200,000 single threshold amount) with his tax return for 2019. ♦

6-8d Self-Employed Taxpayers Self-employed taxpayers generally report earnings on Schedule C, Schedule F, and Schedule E in the case of earned royalty income and partnership income passed through on Schedule K-l. The 0.9 percent Medicare tax for self-employed taxpayers must be paid with Form 1040. The following additional rules apply to high-income, self-employed taxpayers:

a. The 0.9 percent Medicare tax is not allowed as part of the computation of the deductible self-employment tax adjustment for AGI shown on the front page of Form 1040.

b. A loss from self-employment may offset gains from another self-employment enterprise by the same individual. In the case of married individuals, a loss incurred by one spouse may offset the income earned by the other self-employed spouse for purposes of the 0.9 percent Medicare tax. This is not true for the 2.9 percent Medicare tax on self-employment income because the 2.9 percent Medicare tax of each spouse is required to be computed separately.

c. Losses from self-employment are not allowed to offset salary or wages for purposes of the 0.9 percent Medicare tax.

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6-296-8 Special Taxes for High-Income Taxpayers

Self-Study Problem 6.8A.

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6-30 Chapter 6 ● Accounting Periods and Other Taxes

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6-316-8 Special Taxes for High-Income Taxpayers

Self-Study Problem 6.8B.

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6-32 Chapter 6 ● Accounting Periods and Other Taxes

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6-336-8 Special Taxes for High-Income Taxpayers

EXAMPLE In 2019, Barry is single and earns $500,000 from his construction business, and has a loss of $100,000 from his commercial nursery business. Both businesses are reported on Schedule C in his income tax return. His net self- employment earnings of $400,000 exceed the single individual threshold by $200,000. He must pay $1,800 with his 2019 Form 1040 (0.9% 3 $200,000) to cover his 0.9 percent Medicare tax. None of the $1,800 is allowed as part of the computation of the self-employment tax adjustment included with his deductions for AGI. ♦

Self-Study Problem 6.8 See Appendix E for Solutions to Self-Study Problems

A. Ronald Trunk is single and independently wealthy. In 2019, Ronald’s investment income is $110,000 (all interest) and his adjusted gross income is $380,000. He has no investment expenses associated with this income, no foreign earnings exclusion, and lives where there is no state income tax. Complete Form 8960 on Page 6-29 to calculate Ronald’s 2019 net investment income tax.

B. Meng and Eang Ung are married. Meng is self-employed and generates self-employment income of $130,000. Eang is a physician at a local hospital and earns Social Security (Box 5) wages of $265,000. Her Medicare withholding (Box 6) is $4,427.50. Eang and Meng have no other earned or unearned income. Complete Form 8959 on Page 6-31 to determine how much 0.9 percent additional Medicare tax on earned income Meng and Eang must pay with their joint tax return in 2019 and what 0.9 percent additional Medicare tax withholding will they report?

● Taxpayers may want to consider changing their withholding, especially if both spouses work.

● Change of address with the U.S. Postal Service (online) and with the IRS (Form 8822). ● Change in filing status to married filing jointly or separately should be considered.

TAX BREAK

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6-34 Chapter 6 ● Accounting Periods and Other Taxes

K e y t e r m s

accounting periods, 6-2 fiscal year, 6-2 short-period taxable income, 6-2 annualized period, 6-2 accounting methods, 6-3 cash method, 6-3 accrual method, 6-4 economic performance, 6-4 hybrid method, 6-4

Section 267, 6-5 related parties, 6-6 constructive ownership, 6-6 “kiddie tax,” 6-8 net unearned income (NUI), 6-9 earned taxable income (ETI), 6-9 alternative minimum tax (AMT), 6-14 AMT adjustments, 6-14 AMT preferences, 6-14

AMT exemption, 6-15 alternative minimum tax rates, 6-15 self-employment tax, 6-19 nanny tax, 6-23 household workers, 6-23 net investment income tax, 6-24 0.9 percent additional Medicare

tax, 6-27

Learning Objectives Key points

LO 6.1: Determine the different accounting periods allowed for tax purposes.

● Almost all individuals file tax returns using a calendar-year accounting period. ● Partnerships and corporations had a great deal of freedom in selecting a tax year in the past. However, Congress set limits on this freedom when it resulted in an inappropriate deferral of taxable income.

● A personal service corporation is a corporation whose shareholder-employees provide personal services (e.g., medical, legal, accounting, actuarial, or consulting services) for the corporation’s patients or clients. Personal service corporations generally must adopt a calendar year-end.

● If taxpayers have a short year other than their first or last year of operations, they are required to annualize their taxable income to calculate the tax for the short period.

LO 6.2: Determine the different accounting methods allowed for tax purposes.

● The tax law requires taxpayers to report taxable income using the method of accounting regularly used by the taxpayer in keeping his or her books, provided the method clearly reflects the taxpayer’s income.

● The cash receipts and disbursements (cash) method, the accrual method, and the hybrid method are accounting methods specifically recognized in the tax law.

LO 6.3: Determine whether parties are considered related for tax purposes, and classify the tax treatment of certain related- party transactions.

● The two types of disallowed related-party transactions are (1) sales of property at a loss and (2) unpaid expenses and interest.

● Any loss or deduction arising from transactions between related parties are disallowed by Section 267.

● The common related parties under Section 267 include brothers and sisters (whole or half ), a spouse, ancestors (parents, grandparents, etc.), lineal descendants (children, grandchildren, etc.), and a corporation or an individual shareholder who directly or constructively owns more than 50 percent of the corporation.

● Related-party rules also consider constructive ownership in determining whether parties are related to each other (e.g., taxpayers are deemed to own stock owned by certain relatives and related entities).

K e y p O I N ts

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6-35Key Points

LO 6.4: Apply the rules for computing tax on the unearned income of minor children and certain students (the “kiddie tax”).

● The tax law contains provisions that limit the benefit of shifting income to certain dependent children.

● The net unearned income of dependent children may be taxed using trust and estate rates. ● The trust tax rates apply to dependent children who are ages 18 or younger or are students ages 19 through 23 at the end of the year, who have at least one living parent, and who have “net unearned income” of more than $2,200 for 2019.

● If certain conditions are met, parents may elect to include a child’s gross income on the parents’ tax return. The election eliminates the child’s return filing requirements including the special calculation on Form 8615 for the “kiddie tax.”

LO 6.5: Calculate a basic alternative minimum tax.

● The AMT was designed in the 1960s to ensure that wealthy taxpayers could not take advantage of special tax write-offs (tax preferences and other adjustments) to avoid paying tax. In general, taxpayers must pay the AMT if their AMT liability is greater than their regular tax liability.

● Adjustments are timing differences that arise because of differences in the regular and AMT tax calculations (e.g., depreciation timing differences), while preferences are special provisions for the regular tax that are not allowed for the AMT (e.g., state income taxes).

● For 2019, the AMT exemption allowance is $111,700 for married taxpayers filing joint returns, $71,700 for single and head of household taxpayers, and $55,850 for married taxpayers filing separate returns. The AMT exemption allowance amount is phased out for high-income taxpayers.

● For 2019, the alternative minimum tax rates for calculating the tentative minimum tax are 26 percent of the first $194,800 ($97,400 for married taxpayers filing separately), plus 28 percent on amounts above $194,800 applied to the taxpayer’s alternative minimum tax base.

● The increases in the AMT exemptions and thresholds coupled with the limitations or suspension of certain itemized deduction are expected to reduce the number of taxpayers subject to the AMT.

LO 6.6: Calculate and report the self- employment tax (both Social Security and Medicare portions) for self-employed taxpayers.

● Self-employed individuals pay self-employment (SE) taxes instead of FICA taxes and, since these individuals have no employers, the entire tax is paid by the self- employed individuals.

● For 2019, the Social Security (OASDI) tax rate is 12.4 percent and the Medicare tax rate is 2.9 percent with a maximum base amount of earnings subject to the Social Security portion of $132,900. All earnings are subject to the Medicare portion.

● If an individual, subject to self-employment taxes, also receives wages subject to FICA taxes during a tax year, the individual’s maximum base amount for SE taxes is reduced by the amount of the wages when calculating the SE taxes.

● Net earnings from self-employment include gross income from a trade or business, less trade or business deductions, the distributive share of partnership income from a trade or business, and net income earned as an independent contractor.

● Self-employed taxpayers are allowed a deduction for AGI of one-half of the self- employment tax.

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6-36 Chapter 6 ● Accounting Periods and Other Taxes

LO 6.7: Apply the special tax and reporting requirements for household employees (the “nanny tax”).

● The “nanny tax” provisions provide a simplified reporting process for employers of household workers.

● Household employers are not required to pay FICA taxes on cash payments of less than $2,100 paid to any household employee in a calendar year.

● If the cash payment to any household employee is $2,100 or more in a calendar year, all the cash payments (including the first $2,100) are subject to Social Security and Medicare taxes.

● If more than $1,000 in cash wages are paid to household employees during any calendar quarter, employers are required to pay FUTA taxes.

● A taxpayer is a household employer if he or she hires workers to perform household services, in or around the taxpayer’s home, that are subject to the “will and control” of the taxpayer (e.g., babysitters, caretakers, cooks, drivers, gardeners, housekeepers, and maids).

● Certain workers are not subject to Social Security and Medicare taxes on wages paid for work in the home. These workers include the taxpayer’s spouse, the taxpayer’s father or mother, the taxpayer’s children under 21 years of age, and anyone who is under age 18 during the year, unless providing household services is his or her principal occupation.

● Under the nanny tax provisions, a household employer must report Social Security and Medicare taxes, federal income tax withholding, and FUTA tax once a year by filing Schedule H with his or her individual Form 1040.

● At the close of the tax year, household employers must also file Form W-2 (copy A) and Form W-3 for each household employee whose income is reflected on Schedule H or had federal income tax withheld from wages.

LO 6.8 Compute the special taxes for high-income taxpayers.

● The Affordable Care Act (ACA) added a 3.8 percent Medicare tax on net investment income and a 0.9 percent additional Medicare tax on earned income for certain high-income taxpayers.

● The 3.8 percent Net Investment Income tax applies to the net investment income of individuals with modified AGI over $250,000 for joint filers ($125,000 if married filing separate), and $200,000 for single filers.

● The 0.9 percent Medicare tax is imposed on earned income from salaries, wages, and self-employment income of joint filers with earned income over $250,000 ($125,000 if married filing separate) and single taxpayers with earned income over $200,000.

● Employers are required to withhold the 0.9 percent Medicare tax when a taxpayer’s salary exceeds $200,000.

● Self-employed taxpayers must pay the tax with their individual income tax returns.

GrOUp 1:

MuLTIPLE ChOICE QuESTIONS

1. E Corporation is a subchapter S corporation owned by three individuals with calendar year-ends. The corporation sells a sports drink as its principal product and has similar sales each month. What options does E Corporation have in choosing a tax year? a. E Corporation may choose any month end as its tax year. b. Because the owners of E Corporation have tax years ending in December,

E Corporation must also choose a December year-end. c. E Corporation may choose an October, November, or December tax year-end. d. E Corporation may choose a tax year ending in September, October, or

November, but only if the corporation also makes an annual cash deposit and adjusts the amount every year depending on the income deferred.

LO 6.1

Q U es t I O Ns a n d prO B L e m s

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6-37Questions and Problems

2. Income and loss from which of the following entities is passed through and taxed on the individual’s personal tax returns? a. S corporation b. Partnership c. Sole proprietor d. All of the above

3. Which of the following entities is likely to have the greatest flexibility in choosing a year-end other than a calendar year-end? a. Sole proprietor b. General partnership c. Corporation d. S corporation

4. Which of the following is an acceptable method of accounting under the tax law? a. The accrual method b. The hybrid method c. The cash method d. All of the above are acceptable e. None of the above

5. Which of the following entities is required to report on the accrual basis? a. An accounting firm operating as a Personal Service Corporation. b. A manufacturing business with $30 million of gross receipts operating as a regular

C corporation. c. A corporation engaged in tropical fruit farming in Southern California. d. A partnership with gross receipts of $13 million and all of the partners are

individuals with a December year-end.

6. Pekoe sold stock to his sister Rose for $12,000, its fair market value. Pekoe bought the stock 5 years ago for $16,000. Also, Pekoe sold Earl (an unrelated party) stock for $6,500 that he bought 3 years ago for $9,500. What is Pekoe’s recognized gain or loss? a. $7,500 loss b. $4,000 gain c. $3,000 loss d. $2,000 loss e. $1,000 gain

7. B Corporation, a calendar year-end, accrual basis taxpayer, is owned 75 percent by Bonnie, a cash basis taxpayer. On December 31, 2019, the corporation accrues inter- est of $4,000 on a loan from Bonnie and also accrues a $15,000 bonus to Bonnie. The bonus is paid to Bonnie on February 1, 2020; the interest is not paid until 2021. How much can B Corporation deduct on its 2019 tax return for these two expenses? a. $0 b. $4,000 c. $15,000 d. $19,000 e. $12,000

8. Using the same facts as in Question 7, how much can B Corporation deduct on its 2020 tax return? a. $0 b. $4,000 c. $15,000 d. $19,000 e. $12,000

LO 6.1

LO 6.2

LO 6.3

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6-38 Chapter 6 ● Accounting Periods and Other Taxes

9. BJT Corporation is owned 40 percent by Bill, 30 percent by Jack, and 30 percent by the Trumpet Partnership. Bill and Jack are father and son. Jack has a 10 percent interest in Trumpet Partnership. What is Jack’s total direct and constructive ownership of BJT Corporation under Section 267? a. 30 percent b. 70 percent c. 100 percent d. 73 percent e. 33 percent

10. Which of the following is not required to subject a taxpayer to the tax on unearned income of minors (kiddie tax) in 2019? a. Must be claimed as a dependent b. 18 years of age or younger (full time student up to age 23) c. Both parents must be living d. Net unearned income must exceed $2,200 e. All of the above are required

11. Generally, the tax rate that applies to the unearned income of a minor under the kiddie tax in 2019 is: a. The same as the parents’ tax rate b. The same as the single taxpayer rate c. The same as the head of household rate d. The same as the trust and estate rate e. The unearned income of a minor is not taxed

12. The alternative minimum tax exemption: a. Is a direct reduction of the tentative minimum tax b. Is a reduction of alternative minimum taxable income for certain taxpayers c. Permits certain taxpayers to elect to treat AMT as a reduction of tax d. Is subject to carryback and carryforward provisions e. Increases the effects of tax preference items

13. For 2019, Roberta is a self-employed truck driver with earnings of $47,000 from her business. During the year, Roberta received $2,500 in interest income and dividends of $500. She also sold investment property and recognized a $1,500 gain. What is the amount of Roberta’s self-employment tax (Social Security and Medicare taxes) liability for 2019? a. $7,277 b. $6,641 c. $6,358 d. $6,885 e. $7,191

14. Which of the following is not subject to self-employment tax? a. Gain on the sale of real estate held for investment b. Net earnings of a self-employed lawyer c. Distributive share of earnings of a partnership d. Net earnings of the owner of a shoe store e. Net earnings of the owner of a dry cleaner

15. Bob employs a maid to clean his house. He pays her $1,040 during the current year. What is the proper tax treatment of the Social Security and Medicare tax for the maid? a. Bob is not required to pay or withhold Social Security and Medicare taxes on the

$1,040. b. The $1,040 is subject to the Medicare tax, but not the Social Security tax. c. $500 is subject to the Social Security and Medicare tax. d. Bob is required to withhold Social Security and Medicare taxes on the entire $1,040.

LO 6.3

LO 6.4

LO 6.5

LO 6.6

LO 6.7

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6-39Questions and Problems

16. Which of the following employees would not be exempt from Social Security and Medicare taxes on wages paid for household work? a. The taxpayer’s 16-year-old daughter b. The taxpayer’s wife c. The taxpayer’s 20-year-old sister d. The 14-year-old babysitter from down the street

17. Individual taxpayers may pay withholding taxes due with their individual income tax returns using Schedule H for each of the following workers except: a. A nanny hired to watch their children b. A maid hired to clean house and cook every day c. An attorney with her own business, hired to handle a legal dispute with the

taxpayers’ neighbor d. An unlicensed caregiver for a disabled spouse

18. The 3.8 percent Medicare tax on net investment income applies to: a. Tax-exempt interest income b. Interest and dividends c. IRA distributions d. Wages

19. Skylar is single and earns $410,000 in salary during 2019. What is the amount of 0.9 percent Medicare tax for high-income taxpayers that his employer must withhold from his wages? a. $1,890 b. $1,800 c. $1,440 d. $900

20. Christine and Doug are married. In 2019, Christine earns a salary of $250,000 and Doug earns a salary of $50,000. They have no other income and work for the same employers for all of 2019. How much 0.9 percent Medicare tax for high-income taxpayers will Christine and Doug have to pay with their 2019 income tax return? a. $450 b. $900 c. $2,700 d. None

LO 6.7

LO 6.8

1. Explain why the tax law prefers flowthrough entities like partnerships and S corpora- tion to have a year-end that matches the year-end of its owners.

2. Yolanda is a cash basis taxpayer with the following transactions during the year:

Cash received from sales of products $70,000 Cash paid for expenses (except rent and interest) 40,000 Rent prepaid on a leased building for 18 months 48,600 beginning December 1 Prepaid interest on a bank loan, paid on 5,000 December 31 for the next 3 months

LO 6.1

LO 6.2

GrOUp 2:

PROBLEMS

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6-40 Chapter 6 ● Accounting Periods and Other Taxes

Calculate Yolanda’s income from her business for this calendar year.

Sales income $ Expenses: Other than rent and interest $ Rent $ Interest $ Net income $

3. Geraldine is an accrual basis taxpayer who has the following transactions during the current calendar tax year:

Accrued business income (except rent) $220,000 Accrued business expenses (except rent) 170,000 Rental income on a building lease for the next 6 months, received on December 1 21,000 Prepaid rent expense for 6 months, paid on December 1 9,000

Calculate Geraldine’s net income from her business for the current year.

Income: Other than rental $ Rental $ Expenses: Other than rental $ Rental $ Net income $

4. Amy is a calendar-year taxpayer reporting on the cash basis. Please indicate how she should treat the following items for 2019: a. She makes a deductible contribution to an IRA on April 15, 2020.

b. She has made an election to accrue the increase in value of savings bonds even though the increase is not received in cash.

c. She prepays half a year of interest in advance on her mortgage on the last day of 2019.

d. She pays all of her outstanding invoices for standard business expenses in the last week of December.

e. She sends out a big bill to a customer on January 1, 2020, even though she did all of the work in December of 2019.

5. JBC Corporation is owned 20 percent by John, 30 percent by Brian, 30 percent by Charlie, and 20 percent by Z Corporation. Z Corporation is owned 80 percent by John and 20 percent by an unrelated party. Brian and Charlie are brothers. Answer each of the following questions about JBC under the constructive ownership rules of Section 267:

a. What is John’s percentage ownership? % b. What is Brian’s percentage ownership? % c. What is Charlie’s percentage ownership? % d. If Brian sells property to JBC for a $6,000 loss,

what amount of that loss can be recognized for tax purposes (before any annual limitations)?

LO 6.2

LO 6.3

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6-41Questions and Problems

6. You have a problem and need a full-text copy of the Related Party Code Section 267. Go to the Office of the Law Revision Counsel of the United States House of Rep- resentatives website (uscode.house.gov) and enter Title 26 (the Internal Revenue Code) and Section 267 in the Jump To boxes. Print out a copy of Section 267(a).

7. Explain the purpose of the provision in the tax law that taxes unearned income of certain minor children at their parents’ tax rates.

8. Brian and Kim have a 12-year-old child, Stan. For 2019, Brian and Kim have taxable income of $52,000, and Stan has interest income of $4,500. No election is made to include Stan’s income on Brian and Kim’s return. a. For purposes of the tax on a child’s unearned income, calculate Stan’s

taxable income. $____________ b. Calculate Stan’s net unearned income. $____________ c. Calculate Stan’s earned taxable income. $____________ d. Calculate Stan’s tax for 2019. $____________

9. Refer to the previous problem 8. If Stan’s parents elected to report Stan’s income on his parents’ return, what would the tax on Stan’s income be?

10. Explain the two different ways that the tax on unearned income of minor children, or “kiddie tax,” can be reported.

11. Does the tax on unearned income of minor children, or “kiddie tax,” apply to wages earned by minors in summer and other jobs?

12. Otto and Monica are married taxpayers who file a joint tax return. For the current tax year, they have AGI of $80,300. They have excess depreciation on real estate of $67,500, which must be added back to AGI to arrive at AMTI. The amount of their mortgage interest expense for the year was $25,000, and they made charitable contributions of $7,500. If Otto and Monica’s taxable income for the current year is $47,800 determine the amount of their AMTI.

13. List two common deductions which are allowed for regular tax purposes but are not deductible for AMT purposes.

14. What are the two tax rates which are used to calculate AMT, ignoring the special treatment of dividends and capital gains?

LO 6.3

LO 6.4

LO 6.5

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6-42 Chapter 6 ● Accounting Periods and Other Taxes

15. Show the simplified formula for calculating AMT. Do not show tax rates or an exemption amount.

16. Stewart Beauf is a self-employed surfboard maker in 2019. His Schedule C net income is $126,503 for the year. He also has a part-time job and earns $16,100 in wages subject to FICA taxes. Calculate Stewart’s self-employment tax for 2019 using Schedule SE on Pages 6-43 and 6-44.

17. Sally hires a maid to work in her home for $280 per month. The maid is 25 years old and not related to Sally. During 2019, the maid worked 9 months for Sally. a. What is the amount of Social Security tax Sally must pay as the maid’s employer?

b. What is the amount of Medicare tax Sally must pay as the maid’s employer? $

c. What is the amount of Social Security and Medicare tax which must be withheld from the maid’s wages?

18. Ann hires a nanny to watch her two children while she works at a local hospital. She pays the 19-year-old nanny $170 per week for 42 weeks during the current year. a. What is the employer’s portion of Social Security and Medicare tax for the nanny

that Ann should pay when she files her Form 1040 for 2019? $

b. What is the nanny’s portion of the Social Security and Medicare tax? $

19. Rachel is single and has wages of $150,000 and dividend income of $90,000. She has no investment expenses. Calculate the amount of the 3.8 percent net investment income tax she must pay.

20. Married taxpayers Otto and Ruth are both self-employed. Otto earns $352,000 of self- employment income and Ruth has a self-employment loss of $13,500. How much 0.9 percent Medicare tax for high-income taxpayers will Otto and Ruth have to pay with their 2018 income tax return?

LO 6.5

LO 6.6

LO 6.7

LO 6.8

Charlie’s Green Lawn Care is a cash basis taxpayer. Charlie Adame, the sole proprietor, is considering delaying some of his December 2019 customer billings for lawn care into the next year. In addition, he is thinking about paying some of the bills in late December 2019, which he would ordinarily pay in January 2020. This way, Charlie claims, he will have “less income and more expenses, thereby paying less tax!” Is Charlie’s way of thinking acceptable?

ETHICS

GrOUp 3:

WRITING ASSIGNMENT

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6-43Questions and Problems

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6-44 Chapter 6 ● Accounting Periods and Other Taxes

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6-45

1. Richard and Christine McCarthy have a 19-year-old son (born 10/2/2000; Social Security number 555-55-1212), Jack, who is a full-time student at the University of Key West. Years ago, the McCarthys shifted a significant amount of investments into Jack’s name. In 2019, Jack received Forms 1099-INT and 1099-DIV that reported the following:

Tandy Corporation Bonds interest $11,300 Tandy Corporation ordinary dividends 3,400

The dividends are not qualified dividends. In addition, Jack works part-time as a waiter in an upscale seafood restaurant in Miami, FL. His 2019 Form W-2 reported:

Wages $12,800 Federal withholding 1,080

In spite of his fairly large income, the McCarthys provide over 50 percent of his sup- port and claim Jack as a dependent in 2019. Jack’s mailing address is 100 Duval Street, Apt. #B12, Key West, FL 33040. Richard’s Social Security number is 100-10-9090. Use Form 1040, Schedule B, Form 8615, and the Tax Computation Worksheet from the Form 8615 instructions to compute Jack’s 2019 income tax.

2A. Richard McCarthy (born 2/14/1965; Social Security number 100-10-9090) and Christine McCarthy (born 6/1/1967; Social Security number 101-21-3434) have a 19-year-old son (born 10/2/2000 Social Security number 555-55-1212), Jack who is a full-time student at the University of Key West. The McCarthys also have a 12-year- old daughter (Social Security number 444-23-1212), Justine, that lives with them. The McCarthys can claim a $2,000 child tax credit for Justine and a $500 other dependent credit for Jack. Richard is the CEO at a paper company. His 2019 Form W-2:

GrOUp 4:

COMPREhENSIVE PROBLEMS

100-10-9090

32-5656567

Mufflin-Dunder Paper 302 Lackawanna Ave. Scranton, PA 18503

Richard McCarthy 32 Sleepy Hollow Rd. Clarks Summit, PA 18411

PA 1234824 230,500.00

230,500.00

132,900.00

230,500.00

56,000.00

8,239.80

3,616.75

13,800.00

Questions and Problems

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6-46 Chapter 6 ● Accounting Periods and Other Taxes

Christine is an optometrist and operates her own practice (“The Eyes of March”) in town as a sole proprietor. The shop address is 1030 Morgan Highway, Clarks Summit, PA 18411 and the business code is 621320. Christine keeps her books on the accrual basis and her bookkeeper provided the following information:

Gross sales $270,541 Returns 8,994 Inventory: Beginning inventory $ 24,000 Purchases 120,000 Ending inventory 30,000 Rent 24,000 Insurance 11,019 Professional fees 2,998 Payroll 37,113 Payroll taxes 2,877 Utilities 3,961 Office expenses 1,995 Depreciation 5,000

The McCarthys have a nanny/housekeeper they paid $12,600 during 2019. They did not withhold income or FICA taxes. The McCarthys paid Pennsylvania state unemploy- ment tax of $378 in 2019.

Christine received a 2019 Form 1099-INT from the National Bank of Scranton that listed interest income of $23,467. Note that McCarthys reasonably allocate $761 to state income tax expense for purposes of the Net Investment Income tax.

The McCarthys received a Form 1099-G from Pennsylvania that reported a $451 state income tax refund from 2018. The McCarthys itemized deductions in 2018 and had $14,223 of state income tax expense that was limited to $10,000.

The McCarthys paid the following in 2019:

Home mortgage interest $15,661 Property taxes 5,436 Estimated state income tax payments 2,400 Estimated Federal income tax payments 10,500 Charitable contributions (all cash) 7,600

Required: Complete the McCarthys’ federal tax return for 2019. Use Form 1040, Schedule 1, Schedule 2, Schedule 3, Schedule A, Schedule B, Schedule C, Schedule H, Schedule SE, Form 8959, and Form 8960 to complete this tax return. Make realistic assumptions about any missing data and ignore any alternative minimum tax. Do not complete Form 4952, which is used for depreciation.

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6-47Questions and Problems

798-09-8526

43-4321567

Dragon Lady Corp. 1670 Eisenhower Pkwy. Macon, GA 31206

Warner Robins 638 Russell Parkway Macon, GA 31207

GA 5643E25 152,450.00

152,450.00

132,900.00

152,450.00

7,200.00

8,239.80

2,210.53

4,000.00

Georgia National Bank 520 Walnut Street Macon, GA 31201

23-8787878 445-81-1423

Augustine and Warner Robins

638 Russell Parkway

Macon, GA 31207

532.12

300.00

2B. Warner and Augustine Robins, both 33 years old, have been married for 9 years and have no dependents. Warner is the president of Dragon Lady Corporation located in Macon. The Dragon Lady stock is owned 40 percent by Warner, 40 percent by Augustine, and 20 percent by Warner’s father. Warner and Augustine received the following tax documents:

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6-48 Chapter 6 ● Accounting Periods and Other Taxes

Georgia National Bank 520 Walnut Street Macon, GA 31201

23-8787878 798-09-8526

Macon, GA 31207

Warner & Augustine Robins

870,000.00

35,373.23

10/13/2011

638 Russell Parkway

1 Prop Tax $6,650.00

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6-49Questions and Problems

Macon Museum of Arts 3231 Vineville Ave. Macon, GA 31204

Employer Identification Number 22-1234567 Macon Museum of Arts is a registered 501(c)(3) corporation

November 23, 2019

Mr. and Mrs. Warner and Augustine Robins 628 Russell Parkway Macon, GA 31207

Dear Mr. and Mrs. Robins:

Thank you for your contribution of the original album cover art for the Almond Sisters Band to the Macon Museum of Arts.

This gift supports the Macon Museum’s efforts to bring original and locally-sourced art work to Macon. This continuing support will guarantee our ability to display Almond Sister art work for many years to come.

We have attached a copy of the appraiser’s market valuation. Her analysis estimates the value of the painting at $34,505.

Please keep this written acknowledgement of your donation for your tax records. As a token of our appreciation for your support, we have mailed you the Macon Museum tote bag. We estimate the value of the tote bag to be $5. We are required to inform you that your federal income tax deduction for your contribution is the amount of your contribution less the value of the tote bag. Thank you for your continuing support for our important work in this field!

Please retain this letter as proof of your charitable contribution.

Thank you for helping us to help veterans.

Sincerely,

Jack T. Mann Art Development Officer

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6-50 Chapter 6 ● Accounting Periods and Other Taxes

The Robins paid the following amounts (all can be substantiated):

General state sales tax 2,120 Auto loan interest 4,800 Medical insurance 11,345 Income tax preparation fee 750 Charitable contributions in cash: Church 2,665 Tree Huggers Foundation (a qualified charity) 3,000 Central Georgia Technical University 5,000 Safe-deposit box 200

The tax basis for the donated painting is $25,000 and the painting has been owned by Warner and Augustine for 5 years.

Dragon Lady does not cover health insurance for its employees. In addition to Warner and Augustine’s health insurance premiums shown above, Augustine required surgery which cost $6,654 for which only $3,002 was covered by insurance. Warner had to drive Augustine 150 miles each way to a surgical center.

On January 1, 2019, Warner sold land to Dragon Lady Corporation for $75,000. He acquired the land 5 years ago for $160,000. No Form 1099-B was filed for this transaction.

Dragon Lady Corporation does not have a qualified pension plan or Section 401(k) plan for its employees. Therefore, Warner deposited $12,000 ($6,000 each) into traditional IRA accounts for Augustine and himself (neither are covered by a qualified plan at work).

Required: Complete the Robins’ federal tax return for 2019. Use Form 1040, Schedule 1, Schedule A, Schedule D, and Form 8949 to complete this tax return. Make realistic as- sumptions about any missing data and ignore any alternative minimum tax. Do not complete Form 8283, which is used when large noncash donations are made to charity.

1. The following information is available for the Albert and Allison Gaytor family in addition to that provided in Chapters 1–5. Allison discovered a bookkeeping error in her business records. The revenues from

Toge Pass should have been $85,100 (not the $64,050 originally recorded). Albert owned 1,000 shares of Behemoth Airline stock with a basis of $30 per share.

The stock was purchased 6 years ago on June 10. Albert sells 500 shares of Behemoth stock to his uncle Seth and 500 of the shares to his sister Sara for $5 per share on December 31, 2019.

Required: Combine this new information about the Gaytor family with the information from Chapters 1–5 and complete a revised 2019 tax return for Albert and Allison. Be sure to save your data input files since this case will be expanded with more tax information in the next chapter.

GrOUp 5:

CuMuLATIVE SOFTWARE PROBLEM

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6-51Questions and Problems

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6-52 Chapter 6 ● Accounting Periods and Other Taxes

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6-53Questions and Problems

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6-54 Chapter 6 ● Accounting Periods and Other Taxes

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6-55Questions and Problems

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6-56 Chapter 6 ● Accounting Periods and Other Taxes

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6-57Questions and Problems

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6-58 Chapter 6 ● Accounting Periods and Other Taxes

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6-59Questions and Problems

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6-60 Chapter 6 ● Accounting Periods and Other Taxes

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6-61Questions and Problems

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6-62 Chapter 6 ● Accounting Periods and Other Taxes

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6-63Questions and Problems

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6-64 Chapter 6 ● Accounting Periods and Other Taxes

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6-65Questions and Problems

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6-66 Chapter 6 ● Accounting Periods and Other Taxes

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6-67Questions and Problems

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6-68 Chapter 6 ● Accounting Periods and Other Taxes

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6-69Questions and Problems

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6-70 Chapter 6 ● Accounting Periods and Other Taxes

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6-71Questions and Problems

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6-72 Chapter 6 ● Accounting Periods and Other Taxes

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6-73Questions and Problems

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6-74 Chapter 6 ● Accounting Periods and Other Taxes

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6-75Questions and Problems

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6-76 Chapter 6 ● Accounting Periods and Other Taxes

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6-77Questions and Problems

Student Name

Class/Section

Date

K e y N Um B e r ta x r e t U r N sUm m a ry

ChAPTER 6

Comprehensive Problem 1

Form 8615, Net Unearned Income (Line 3)

Form 8615, Taxable Earned Income (Line 6)

Form 8615, Tax (Line 7)

Form 1040, Taxable Income (Line 11b)

Form 1040, Amount You Owe (line 23)

Comprehensive Problem 2A

Schedule C, Net Profit or (Loss) (Line 31)

Schedule SE, Self-Employment Tax (Line 5)

Schedule H, Household Employment Taxes (Line 26)

Form 1040, Taxable Income (Line 11b)

Form 1040, Total Tax (Line 16)

Comprehensive Problem 2B

Total Income (Line 7b)

Adjusted Gross Income (Line 8b)

Itemized Deductions (Line 9)

Total Tax (Line 16)

Amount Overpaid (Line 20)

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Tax Credits

C h a p t e r 7

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L E A R N I N G O B J E C T I V E S

After completing this chapter, you should be able to: LO 7.1 Calculate the child tax credit. LO 7.2 Determine the earned income credit (EIC). LO 7.3 Compute the child and dependent care credit for an individual taxpayer. LO 7.4 Calculate the premium tax credit available under the Affordable Care Act. LO 7.5 Apply the special rules applicable to the American Opportunity tax credit and lifetime

learning credit. LO 7.6 Compute the foreign income exclusion and tax credit. LO 7.7 Determine the proper use and calculation of the adoption credit. LO 7.8 Recognize the basic individual credits for energy efficiency. LO 7.9 Calculate the low-income Retirement Plan Contribution Credit.

7-1

O V e r V I e W

T his chapter covers the most common tax credits. Credits differ from deductions. A credit is a direct reduction in tax liabil- ity instead of a deduction from income.

Credits are used because they target tax relief to certain groups of taxpayers. Because of the progressive rate structure of the income tax, a de- duction pro vides greater benefit to higher-income taxpayers, while a tax credit provides equal benefit, regardless of the taxpayer’s income level. Many credits exist in the tax law that are not

covered here, such as the credit for research and development, the Work Opportunity Tax Credit, and the credit for the elderly and disabled.

A deduction reduces taxable income by the amount of the deduction and thus results in a tax savings equal to the deduction multiplied by the tax rate. A credit is a dollar-for-dollar reduction of the taxpayer’s tax liability. If a taxpayer has a choice between a credit or a deduction of equal amounts, generally the credit will result in greater tax savings.

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7-2 Chapter 7 ● Tax Credits

7-1 ChILd TAx CREdIT The child tax credit permits individual taxpayers to take a tax credit based on the number of their dependent children. The child tax credit comes in two parts, the nonrefundable child tax credit and the refundable additional child tax credit. Most tax credits are limited to the amount of total tax liability that a taxpayer has and thus are “nonrefundable.” Certain credits allow taxpayers to claim the credit even when the amount of the credit exceeds their tax liability – these are known as refundable credits since they result in a “refund” of taxes that were never actually paid by the taxpayer.

ExAMPLE Sandy is a taxpayer who files as head of household, with taxable income of $16,125 and a tax liability of $1,658 before any tax credits. Sandy has total tax payments (including withholding) of $2,200. Sandy has a daughter and is eligible for a child tax credit of $2,000. Sandy’s refund is calculated as follows if the credit is refundable versus nonrefundable:

Nonrefundable Refundable Total tax before credits $1,658 $1,658 Tax credit 1,658 (2,000) Tax after credits 0 (342) Tax payments (2,200) (2,200) Total refund $(2,200) $(2,542)

The refundable credit increases Sandy’s refund to an amount in excess of her taxes paid. ♦

The TCJA made three significant, but temporary, changes to the child tax credit that apply in 2019: (1) increased the credit per child to $2,000, (2) increased the threshold for which the phase-out starts, and (3) increased the refundable amount of the credit for taxpayers whose credit is limited by their pre-credit tax liability. In addition, the TCJA added a new qualifying dependent credit of $500 for certain dependents.

To qualify for the child tax credit, the child must be under age 17, a U.S. citizen or U.S. resident alien, claimed as a dependent on the taxpayer’s return, and meet the definition of “qualifying child” as discussed in Chapter 1. Thus the child must meet the six tests outlined in LO 1.6: (1) relationship test, (2) domicile test, (3) age test (except in the case of the child tax credit, the child must be under age 17), (4) joint return test, (5) citizenship test, and (6) self- support test. All qualifying children must have a Social Security number at the time of filing.

Learning Objective 7.1

Calculate the child tax credit.

ExAMPLE Gordon is a single taxpayer. His 2019 taxable income is $60,000 placing him in the 22 percent tax bracket for ordinary income. His income tax liability is $9,064. Not included in the $60,000 of taxable income is a choice between a $1,000 deduction or a $1,000 credit.

Deduction Credit Taxable income $60,000 $60,000 Deduction (1,000) n/a Revised taxable income 59,000 60,000 Tax on revised income 8,844 9,064 Tax credit n/a (1,000) Tax after credits 8,844 8,064 Original tax 9,064 9,064 Tax savings $ 220 $ 1,000

Gordon saves $1,000 (a dollar-for-dollar reduction in tax liability) with the credit. He saves on $220 ($1,000 3 22% tax rate) for the deduction. ♦

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7-37-1 Child Tax Credit

The maximum credit is $2,000 per qualifying child; however, the available credit begins phasing out when AGI reaches $400,000 for joint filers and $200,000 for all other taxpayers. The credit is phased out by $50 for each $1,000 (or part thereof) of AGI above the threshold amounts. Since the maximum credit available depends on the number of qualifying children, the income level at which the credit is fully phased out also depends on the number of children qualifying for the credit. The phase-out thresholds for the child tax credit are currently not adjusted for cost-of-living increases.

ExAMPLE Donna and Chris Howser are married and file a joint tax return. They have two children, ages 5 and 7, that are qualifying children under the dependency rules. All members of the family are U.S. citizens with Social Security numbers. In 2019, their AGI was $120,006. In 2019, both children qualify for the child tax credit of $2,000; thus, the maximum credit is $4,000. Because the phase-out for married filing jointly taxpayers in 2019 starts at $400,000, the Howsers are eligible for the maximum credit of $4,000. ♦

ExAMPLE Fiona and Kris Everest are married and file a joint return. They have one child aged 13. Each member of the Everest family has a Social Security number and their 2019 AGI is $409,800. The maximum child tax credit in 2019 is $2,000 per child; however, the Everest’s AGI exceeds the $400,000 threshold. The phase-out amount is $500.

$409,100 2 $400,000 5 $9,100 $9,100/$1,000 5 9.1 rounded to 10 10 3 $50 5 $500

The Everest’s child tax credit is $1,500 ($2,000 2 $500). ♦

Since a portion of the child tax credit is nonrefundable, that portion is limited to the amount of tax liability before taking the child tax credit. Because taxpayers may be eligible for other tax credits that also reduce tax liability, the tax law prescribes a “pecking order” to prevent taxpayers from claiming more than one nonrefundable tax credit and creating a refundable credit.

ExAMPLE Eugene has a tax liability of $2,200 before any tax credits. Eugene has determined he is eligible for an education credit of $400 and a child tax credit of $2,000. Because his two nonrefundable credits exceed his tax liability, Eugene will take a $400 education credit and his nonrefundable child tax credit will be limited to $1,800 ($2,200 2 $400). ♦

The refundable portion of the child tax credit is the amount of child tax credit that was limited by the taxpayer’s tax liability.

ExAMPLE Eugene in the previous example, was eligible for a total child tax credit of $2,000; however, he could only take a credit of $1,800 due to the tax liability limitation. The $200 unclaimed child tax credit may be refundable.

If the taxpayer has fewer than three children that are eligible for the child tax credit, the refundable portion of the child tax credit is subject to two additional limitations. The first limitation is that the additional child tax credit cannot exceed $1,400 per child. The second limitation is that the refundable child tax credit cannot exceed 15 percent of the taxpayer’s earned income less $2,500. The lower of these two amounts will apply.

ExAMPLE In 2019, Mike and Laura, married filing jointly taxpayers, have two qualifying children, AGI of $72,000 (all earned income) and tax liability before any credits of $1,043. As a result, their child tax credit of $4,000 is limited to $1,043. Mike and Laura can claim the refundable portion of child tax credit of $2,800; the lesser of the unclaimed child tax credit $2,957 ($4,000 2 $1,043) or 15 percent of earned income less $2,500 [($72,000 2 $2,500) 3 15% 5 $10,425] limited to $2,800 ($1,400 per qualifying child). ♦

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7-4 Chapter 7 ● Tax Credits

For taxpayers with three or more qualifying children, the child tax credit amount in excess of tax liability is subject to limitations. The same overall $1,400 limit per child applies. The refundable child tax credit is also limited by the greater of (1) 15 percent of earned income over $2,500 or (2) the amount of Social Security and Medicare taxes paid up to the unclaimed child tax credit. For purposes of the refundable child tax credit, Social Security and Medicare taxes are the amounts withheld for the employee and 50 percent of self-employment taxes.

ExAMPLE Molly and Sam are married, file a joint tax return, have five qualifying children and earned income of $6,000. The children are qualifying children for purposes of the child tax credit, but do not qualify under the earned income tax credit. Molly and Sam had $459 of Social Security and Medicare taxes withheld by their employers. Their pre-credit tax liability is $0. Because their pre-credit tax liability is $0, Molly and Sam are not eligible for the $10,000 ($2,000 3 5 children) child tax credit. The refundable portion of the child tax credit is $525 which starts at $10,000 but is first limited to $7,000 ($1,400 3 5) and then further limited to the greater of $459 or $525 [($6,000 2 $2,500) 3 15%]. ♦

No form is required for the nonrefundable child tax credit. It is simply claimed on Line 13a of Form 1040. The child tax credit can be computed using the Child Tax Credit Worksheet included as part of Form 1040 Instructions and included on Pages 7-6 and 7-7. Fortunately, tax software is proficient at calculating the child tax credit. The refundable child tax credit is available to taxpayers whose child tax credit was limited by their tax liability and requires completion of Form 8812 (see Page 7-8). The amount from Form 8812 is carried over to Form 1040 Line 18b.

The $400,000 and $200,000 income thresholds are not adjusted for inflation while the $1,400 limit on the refundable portion is adjusted for inflation. Both of these provisions are scheduled to expire after 2025.

The child tax credit also includes a $500 “other dependent credit” for each qualifying dependent other than qualifying children under the child tax credit. For example, a dependent parent or dependent child age 17 or older can still be eligible dependents for the other dependent credit. The qualifying relative test for purposes of the other dependent credit requires the individual must be a U.S. citizen, a U.S. national, or a U.S. resident in order to be eligible for the credit. A Social Security number is not required for the other dependent credit and the credit is nonrefundable. The other dependent credit is reported in combination with the child tax credit on Line 13a of Form 1040.

ExAMPLE Alex is a single taxpayer with a 15-year-old child. Alex also takes care of her elderly mother who qualifies as a dependent. Alex is eligible for a $2,000 child tax credit and an additional $500 other dependent credit for her mother. ♦

ExAMPLE Marty is a single taxpayer with a dependent 21-year-old child who is a full- time student. Marty also takes care of his elderly mother who qualifies as a dependent. Marty is eligible for an additional $1,000 other dependent tax credit for her child and her mother. ♦

A taxpayer who erroneously claims the child tax credit due to reckless or intentional dis- regard of rules or regulations is ineligible to claim the credit for a period of two tax years. If the IRS determines the claim for the credit was fraudulent, the ineligibility window is extended to ten years.

If the IRS rejects a child tax credit for any reason other than a math or clerical error, the taxpayer must complete a Form 8862 in a year after a rejection. Form 8862 is also used for claiming an earned income credit or American Opportunities credit after rejection. Tax preparers that prepare returns on which the child tax credit is claimed will be required to complete Form 8867, a due diligence checklist that was previously used for only the earned income credit.

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7-57-2 Earned Income Credit

The IRS will not issue refunds for any tax returns that claim a child tax credit (or earned income credit) until February 15 of the year following the tax year. This tax provision is intended to provide the IRS with additional time to review refund claims that stem from refundable child tax credit claims.

Self-Study Problem 7.1 See Appendix E for Solutions to Self-Study Problems a. Jose and Jane are married and file a joint tax return claiming their three children,

ages 4, 5, and 18, as dependents. Their AGI for 2019 is $125,400 and their pre- credit tax liability is $13,937. They are not claiming any other tax credits in 2019. Complete the Child Tax Credit Worksheet Parts 1 and 2 on Pages 7-6 and 7-7 to determine Jose and Jane’s child tax credit for 2019.

b. Herb and Carol are married and file a joint tax return claiming their three children, ages 4, 5, and 18, as dependents. Their AGI for 2019 is $405,600 and their pre-credit tax liability is about $84,000. What is Herb and Carol’s child tax credit for 2019?

c. Marie and Pierre Curry are married and file a joint tax return claiming their three children, ages 4, 5, and 16, as dependents. Their AGI for 2019 is $36,400 (all wage income) and their pre-credit tax liability is $383. Marie and Pierre’s employers withheld $2,785 in Social Security and Medicare taxes in 2019. They are not claiming any other tax credits. Complete the Child Tax Credit Worksheet Parts 1 and 2 on Pages 7-6 and 7-7 and Form 8812 on Page 7-8 to determine Marie and Pierre’s child tax credit and additional child tax credit, if any, for 2019.

7-2 EARNEd INCOME CREdIT The earned income credit (EIC or sometimes EITC) is available to qualifying individuals with earned income and AGI below certain levels. The earned income credit is meant to assist the working poor by reducing their tax burden and to supplement wage income through a refundable credit when earnings are less than the taxpayer’s maximum income for their filing status. Qualifying taxpayers can receive a refundable EIC even in situations when they have no filing requirement, owe no tax, and had no income tax withheld. Similar to the refundable child tax credit, the refundable EIC can in effect produce a “negative” income tax.

Proper calculation of the EIC requires a taxpayer to answer three important questions: (1) Does the taxpayer qualify for the EIC? (2) Does the taxpayer have a qualifying child? (3) What is the amount of the EIC?

7.2 Learning Objective Determine the earned income credit (EIC).

The child tax credit is handled by ProConnect in an almost seamless fashion. By entering the dependent birthdate and status (e.g., full time student) the software will automatically compute the child tax credit, other dependent credit, and additional child credit. A number of dropdown boxes are available under the Dependent entry screen that permit overrides and other options for these credits. You will not find any child tax credit or related information under the Credits input.

tIp

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7-6 Chapter 7 ● Tax Credits

7-2a does the Taxpayer Qualify? There are seven rules that all taxpayers must meet in order to claim the EIC and the tax- payer must meet all seven rules. Failure to meet just one precludes the taxpayer from claim- ing the EIC. The seven rules fall into the following categories:

1. AGI limit–AGI limits are indexed for inflation and can change each year. In addition, the AGI limits vary based on filing status and number of qualifying children. The EIC phases out for taxpayers with income over the limits. For 2019, the limits are:

Other than joint filers Joint filers

Qualifying Phase-out Phase-out Phase-out Phase-out Children Begins Ends Begins Ends None $ 8,650 $15,570 $14,450 $21,370 1 19,030 41,094 24,820 46,884 2 19,030 46,703 24,820 52,493 3 or more 19,030 50,162 24,820 55,952

The phase-out percentages vary; however, only the IRS EIC Tables (Appendix B) may be used to calculate the EIC amount.

2. Social Security numbers – The taxpayer (and spouse, if filing jointly) plus any qualifying children, must all have valid Social Security numbers.

3. Married filing separate not allowed. 4. U.S. citizenship or resident alien status is required for the entire tax year. 5. Foreign income exclusion not allowed – tax law provides for certain taxpayers to ex-

clude income earned overseas (reported on Form 2555 or Form 2555-EZ). The foreign income exclusion is beyond the scope of this textbook.

6. Investment income limit – generating a certain amount of “disqualified” income ($3,600 in 2019) precludes claiming the EIC. Disqualified income includes most typi- cal forms of investment income such as interest, dividends, net income from rents and royalties and most forms of capital gains.

7. Earned income requirement – Since the design of the EIC is to assist the working poor, an obvious requirement is that the taxpayer (or spouse, if filing jointly) have earned income. For self-employed taxpayers, earned income includes income reported on Schedule SE. The earned income limits for 2019 are:

Other than joint filers Joint filers

Qualifying Children

Minimum Earned Income

Maximum Earned Income

Minimum Earned Income

Maximum Earned Income

None $1 $15,570 $1 $21,370 1 1 41,094 1 46,884 2 1 46,703 1 52,493

3 or more 1 50,162 1 55,952

ExAMPLE Doug is married but files separately in 2019. Married filing separately taxpayers do not qualify for the EIC. ♦

ExAMPLE In 2019, Jane has income of $7,000, is single, has a valid Social Security number, and is not a qualifying child of another taxpayer. Her income includes $4,500 of interest on a corporate bond. Jane is not eligible for the EIC because her investment income exceeds $3,600. ♦

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7-77-2 Earned Income Credit

Self-Study Problem 7.1, Parts a and c

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7-8 Chapter 7 ● Tax Credits

Self-Study Problem 7.1, Parts a and c

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7-97-2 Earned Income Credit

Self-Study Problem 7.1, part c

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7-10 Chapter 7 ● Tax Credits

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7-117-2 Earned Income Credit

ExAMPLE In 2019, Eddie and Lindsey had a new baby. Their earned income and AGI in 2019 was $12,500, they filed jointly, lived in the United States, and had no investment income. Eddie and Lindsey have Social Security numbers but have not had the time to get a Social Security number for the baby yet. Eddie and Lindsey may claim an EIC in 2019 but only with no qualifying child since the baby does not have a valid Social Security number. They should consider applying for a Social Security number by the filing deadline. ♦

ExAMPLE In 2019, Jerry earns wages of $16,000 from his job and has no adjustments or other forms of income. He has no qualifying children and no investment income. Even if Jerry meets all the other requirements (Social Security number, U.S. residence, etc.), he will not be eligible for the EIC as his AGI exceeds the threshold amount for an unmarried taxpayer with no qualifying children ($15,570 in 2019). ♦

7-2b does the Taxpayer have a Qualifying Child? Determining whether the taxpayer has a qualifying child is important because the eligibility rules differ based on whether a qualifying child is claimed or not. Because the rules defining a qualifying child for the EIC are similar to the rules for claiming a dependent, a review of the rules in Chapter 1 is suggested.

7-2c Taxpayer with No Qualifying Child If the taxpayer does not have a qualifying child, the previous seven rules must be met along with four additional rules:

1. Taxpayer’s age – the taxpayer or the spouse (but not both) must be at least 25 years of age by the end of the tax year but less than 65 years of age. For 2019, the taxpayer (or spouse) must have been born after December 31, 1954 but before January 2, 1995.

2. Dependency status – the taxpayer (or spouse, if filing jointly) must not be eligible to be claimed as a dependent on another taxpayer’s return, whether they are claimed or not.

3. Cannot be a qualifying child – the taxpayer claiming the EIC may not be the quali- fying child of another taxpayer. Note the qualifying child definition discussed in Chapter 1 applies here with two notable exceptions: (1) the child need not meet the support test, and (2) the child must live in a U.S. home for more than one-half of the year (a slight extension of the domicile test).

4. U.S. home – the taxpayer must have lived in the United States for more than one-half of the tax year.

ExAMPLE Marco and Llewelyn are married and file jointly with no qualifying children in 2019 and meet the general rules to claim the EIC. Marco turns 65 on December 14, 2019 and Llewelyn turns 64 on April 3, 2019. Marco and Llewelyn qualify to claim the EIC because Llewelyn is under age 65 at the end of the tax year. ♦

ExAMPLE Monica is a 23-year-old single taxpayer with no qualifying children in 2019. She is a full-time student at State College and generates enough income to live on from her nontaxable scholarships and a job on campus; however, she lets her father claim her as a dependent as the scholarship money is not included in her support test. Even if Monica meets the seven general rules, because she is claimed as a dependent by another taxpayer, she is not eligible to claim the EIC. ♦

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7-12 Chapter 7 ● Tax Credits

7-2d Taxpayer with a Qualifying Child To claim an EIC with a qualifying child, three additional rules must be considered:

1. Qualifying child tests – the child must meet the qualifying child tests. These are the same tests as discussed in Chapter 1 with two notable exceptions: (1) the child need not meet the support test, and (2) the child must live in a U.S. home for more than one-half of the year (a slight extension of the domicile test).

2. Qualifying child cannot be claimed by more than one person–only one taxpayer may claim a qualifying child for the EIC. If the child meets the definition of a qualifying child for more than one taxpayer, tiebreaker rules similar to those discussed in Chapter 1 must be applied.

3. Taxpayer cannot be a qualifying child of another taxpayer–see rule 3 under taxpayer with no qualifying child at Section 7-2c.

With so many qualification rules, it is no wonder that taxpayers and tax preparers have been known to make numerous errors when determining the EIC. Numerous checklists and aids have been prepared to assist taxpayers with preparing the EIC calculation. IRS Publication 596 contains an EIC Eligibility Checklist as shown on Page 7-15.

In addition to checklists, the IRS has implemented some additional procedural steps to ensure the EIC is not being abused by taxpayers. Similar to the child tax credit rules, taxpayers claiming an earned income credit must have a Social Security number for the taxpayer, spouse (if married), and each qualifying child by the due date (including extensions) of the return.

If the IRS rejects an earned income credit for any reason other than a math or clerical error, the taxpayer must complete a Form 8862 in order to claim the earned income credit in a future year.

In addition, a taxpayer who erroneously claims the earned income credit due to reckless or intentional disregard of rules or regulations is ineligible to claim the credit for a period of two tax years. If the IRS determines the claim for the credit was fraudulent, the ineligibility window is extended to ten years.

The IRS will not issue refunds for any tax returns that claim an earned income credit until February 15th of the following year to provide the IRS with additional time to review refund claims that stem from refundable earned income credit claims.

To assist tax preparers with the accurate completion of the EIC (and the child tax credit and American Opportunities tax credit), Form 8867 (see Pages 7-13 and 7-14) must be prepared and filed with the tax return and a copy retained by the tax preparer. If a taxpayer is claiming more than one of the credits covered by Form 8867, only one form is required to be filed. Failure to file Form 8867 could result in a $530 penalty.

7-2e What Is the Amount of the EIC? Taxpayers are required to have some earned income to qualify for the EIC; however, too much earned income renders the taxpayer ineligible for the EIC (see Rule 7 under the gen- eral rules on Page 7-9). As stated previously, the EIC amount must be derived from the EIC Tables in Appendix B and should not be calculated using the statutory credit percentages to avoid rounding issues. To find the correct amount of EIC in the EIC Tables, the taxpayer must compare the EIC Table amount based on the taxpayer’s earned income with the EIC Table amount associated with the taxpayer’s AGI. The taxpayer is required to claim the smaller of the two EIC amounts.

Part of the complexity of the EIC is that a number of the thresholds, amounts, and limits change each year. As a result, new EIC tables must be used each year. The EIC is reported on Line 18a of Form 1040. Similar to the child tax credit, a specific form to support the EIC computation is not always required to be prepared and filed. Instead, a series of supporting worksheets found within the instructions to the Form 1040 are available to assist with preparation. Worksheet A is used for taxpayers with wage income only and Worksheet B is used by taxpayers with self-employment income. For taxpayers claiming a qualifying child for the EIC, Schedule EIC must also be filed.

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7-137-2 Earned Income Credit

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7-14 Chapter 7 ● Tax Credits

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7-157-2 Earned Income Credit

1. Is your AGI less than: ● $15,570 ($21,370 for married filing jointly) if you do not have a qualifying child, ● $41,094 ($46,884 for married filing jointly) if you have one qualifying child, ● $46,703 ($52,493 for married filing jointly) if you have two qualifying children, or ● $50,162 ($55,952 for married filing jointly) if you have more than two qualifying children?

2. Do you and your spouse each have a valid SSN (by the due date of your return including extensions)?

3. Is your filing status married filing jointly, head of household, qualifying widow(er), or single? 4. Answer “Yes” if you are not filing Form 2555 or Form 2555-EZ. Otherwise, answer “No.” 5. Is your investment income $3,600 or less? 6. Is your total earned income at least $1 but less than:

● $15,570 ($21,370 for married filing jointly) if you do not have a qualifying child, ● $41,094 ($46,884 for married filing jointly) if you have one qualifying child, ● $46,703 ($52,493 for married filing jointly) if you have two qualifying children, or ● $50,162 ($55,952 for married filing jointly) if you have more than two qualifying children?

7. Answer “Yes” if (a) you are not a qualifying child of another taxpayer or (b) you are filing a joint return. Otherwise, answer “NO.”

8. Does your child meet the relationship, age, residency, and joint return tests for a qualifying child and have a Social Security number received by the due date of the tax return (including extensions)?

9. Is your child a qualifying child only for you? Answer “Yes” if (a) your qualifying child does not meet the tests to be a qualifying child of any other person or (b) your qualifying child meets the tests to be a qualifying child of another person but you are the person entitled to treat the child as a qualifying child under the tiebreaker rules. Answer “No” if the other person is the one entitled to treat the child as a qualifying child under the tiebreaker rules.

10. Were you (or your spouse if filing a joint return) at least age 25 but under age 65 at the end of 2019?

11. Answer “Yes” if (a) you cannot be claimed as a dependent on anyone else’s return or (b) you are filing a joint return. Otherwise, answer “No.”

12. Was your main home (and your spouse’s if filing a joint return) in the United States for more than half the year?

PERSONS WITh A QUALIFYING ChILd: If you answered “Yes” to questions 1 through 9, you can claim the EIC. Remember to fill out Schedule EIC and attach it to your Form 1040. If you answered “Yes” to questions 1 through 7 and “No” to question 8, answer questions 10 through 12 to see if you can claim the EIC without a qualifying child. PERSONS WIThOUT A QUALIFYING ChILd: If you answered “Yes” to questions 1 through 7, and 10 through 12, you can claim the EIC. If you answered “No” to any questions that applies to you: You cannot claim the EIC.

Yes No

Yes No Yes No Yes No Yes No Yes No

Yes No

EIC Eligibility Checklist

ExAMPLE Ying and Michael are married filing jointly taxpayers with earned income and AGI of $23,200 in 2019. They have two children ages 3 and 5. All members of the family have Social Security numbers, are U.S. citizens, and lived together in the United States all year. Ying had $820 of tax withheld from her wages during the year. Michael did not work. Ying and Michael can claim the EIC as they meet all the tests for taxpayers with a qualifying child. Based on earned income of $23,200, filing jointly with two qualifying children, their EIC per the 2019 table (Appendix B) is $5,828. ♦

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7-16 Chapter 7 ● Tax Credits

Self-Study Problem 7.2 See Appendix E for Solutions to Self-Study Problems

Dennis and Lynne have a 5-year-old child. Dennis has a salary of $16,200. Lynne is self-employed with a loss of $400 from her business. Dennis and Lynne receive $100 of taxable interest income during the year. Their earned income for the year is $15,800 and their adjusted gross income is $15,900 ($16,200 2 $400 1 $100). Use the worksheet below and calculate their earned income credit from the EIC table in Appendix B. $________________

Wages, salaries

Adjusted gross income

tIp ProConnect determines whether the earned income credit applies based on the information that the preparer inputs (most importantly income and dependent information). However, if the earned income credit is not computing and the preparer believes the taxpayer is eligible, the earned income credit worksheets can be produced by ProConnect to allow for the review the calculation. To produce the EIC worksheets, click on the Credits section and on EIC, Residential Energy, Other Credits screen, expand the Earned Income Credit section and scroll down to the bottom to select the box Force Earned Income Credit Worksheets.

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7-177-3 Child and Dependent Care Credit

7-3 ChILd ANd dEPENdENT CARE CREdIT Congress enacted tax laws to provide benefits to taxpayers with dependents who must be provided with care and supervision while the taxpayers work. Taxpayers are allowed a credit for expenses for the care of their children and certain other dependents. To be eligible for the child and dependent care credit, the dependent must either be under the age of 13 or be a dependent or spouse of any age who is incapable of self-care. If a child’s parents are divorced, the child need not be the dependent of the taxpayer claiming the credit, but the child must live with that parent more than he or she lives with the other parent. For exam- ple, a divorced mother with custody of a child may be entitled to the credit even though the child is a dependent of the father.

7-3a Qualified Expenses The expenses that qualify for the credit include amounts paid to enable both the taxpayer and his or her spouse to be employed. Qualified expenses include amounts paid for in- home care, such as a nanny, as well as out-of-home care, such as a day care center. Over- night camps do not qualify for the credit, nor do activities providing standard education such as kindergarten. Day camps such as soccer camps, music camps, math camps, and dinosaur camps do qualify for the credit since they are not considered standard education. Payments to relatives are eligible for the credit, unless the payments are to a dependent of the taxpayer or to the taxpayer’s child who is under the age of 19 at the end of the tax year. To claim the credit, the taxpayer must include on his or her tax return, the name, address, and taxpayer identification number of the person or organization providing the care.

7-3b Allowable Credit For taxpayers with AGI of less than $15,000, the child and dependent care credit is equal to 35 percent of the qualified expenses. For taxpayers with AGI of $15,000 or more, the amount of the percentage of qualified expenses is reduced as income increases. See Line 8 on Form 2441 on Page 7-19 for the applicable credit percentage (these amounts are not adjusted for inflation). In determining the credit, the maximum amount of qualified expenses to which the applicable percentage is applied is $3,000 for one dependent and $6,000 for two or more dependents. Form 2441 is used to calculate and report the credit for child and dependent care expenses.

Married taxpayers must file a joint return to claim the child and dependent care credit, and the qualifying dependent care expenses are limited to the lesser of either spouse’s earned income. For example, if a taxpayer makes $22,000 and the spouse earns $1,500, and they spend $1,900 on child care, the maximum qualifying expenses are $1,500. A special rule applies when a taxpayer or spouse is a full-time student or disabled. Full-time students or disabled taxpayers with little or no income are deemed to have earned income of $250 per month for one dependent and $500 per month for two or more dependents for purposes of calculating this limitation. For example, if a taxpayer’s spouse is a full-time student for 9 months of the year and has no income, the maximum amount of the qualifying expenses for the care of one dependent is $2,250 ($250 per month 3 9 months).

7.3 Learning Objective Compute the child and dependent care credit for an individual taxpayer.

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7-18 Chapter 7 ● Tax Credits

ExAMPLE Harry and Molly Grant are married and file a joint return. They have one child and pay $4,000 for child care expenses during the year. Harry earns $16,000 and Molly earns $8,500 during the year, resulting in adjusted gross income of $24,500. The Grant’s child care credit is calculated as follows:

Qualified expenses $4,000 Maximum for one dependent 3,000 Credit percentage from Form 2441 3 30% Credit allowed $ 900

♦

ExAMPLE Assume the same facts as in the example above, except the qualified expenses are $2,100 (instead of $4,000). The credit is 30 percent of $2,100, or $630. ♦

Self-Study Problem 7.3 See Appendix E for Solutions to Self-Study Problems

Julie Brown (Social Security number 456-23-6543) has been widowed for 5 years and has one dependent child, Chuck Brown (Social Security number 123-33-4444). Julie’s adjusted gross income and her earned income are $90,000. Julie’s employer withheld $2,000 in the dependent care flexible spending account (see Chapter 2). This amount was excluded from her wage income. Assume her taxable income is $45,500, and her regular tax is $5,186 (line 10 on Form 2441). Julie paid child care expenses of $1,500 to Ivy Childcare (1 Sunflower Street, Terre Haute, IN 47803, EIN 56-7654321) and expenses for the care of her disabled dependent mother, Devona Neuporte (Social Security number 214-55-6666), of $2,400 paid to De Anza Adult Care (13 Fort Harrison Rd., Dewey, IN 47805, EIN 43-1234567). Calculate Julie’s child and dependent care credit for 2019 using Form 2441 on Pages 7-19 and 7-20. Make realistic assumptions about any missing data.

Congress’ choice to not adjust certain thresholds or amounts for inflation has over time, slowly reduced the advantage of a deduction or tax benefit. The last update to the deemed value placed on the earned income of a spouse that is a full-time student was in 2002 (for tax year 2003) and increased from $200 to $250 ($400 to $500 for two qualified dependents). Using inflation from the consumer price index, the value of $250 in 2003 would be $333 today. According to National Center for Education Statistics, the average cost of a university education in 2003 was $12,953 per year. In 2017 (the most current data available), the cost had increased to $23,091.

Would You

Believe?

tIp The child and dependent care credit is a function of two entry points in ProConnect. The first is the input in Dependents as discussed in Chapter 1 and in the other credits mentioned earlier in this chapter. The second important input occurs under Credits/Ind Qualifying for Dependant Care Cr. This screen and the Persons and Expenses Qualifying for the Dependant Care Credit are where you identify the dependant for which the expenses were incurred. The provider of the care is entered in the Provider of Dependent Care screen.

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7-197-3 Child and Dependent Care Credit

Self-Study Problem 7.3

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7-20 Chapter 7 ● Tax Credits

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7-217-4 The Affordable Care Act

7-4 ThE AFFORdABLE CARE ACT The Affordable Care Act (also called the “ACA” or “Obamacare”) contains a number of differ- ent provisions that affect a taxpayer’s income tax liability and reporting. The Net Investment Income tax of 3.8 percent and 0.9 percent Medicare tax (both discussed in Chapter 6) are additional taxes for certain high income taxpayers.

Changes to the tax law now leave only one significant tax provision that relates to individuals from the ACA: health insurance premium tax credits. The other previous provision, the individual shared responsibility, was repealed starting in 2019.

7-4a Premium Tax Credit Under the ACA, eligible taxpayers may receive a tax credit intended to lower the cost of health care. To be eligible, a taxpayer must meet all of the following requirements:

● Health insurance is purchased through one of the state exchanges or the federal exchange ● The taxpayer is not eligible for coverage through an employer or government plan ● The taxpayer’s income falls below certain limits ● The taxpayer does not file Married Filing Separately except under very limited conditions ● The taxpayer cannot be claimed as a dependent by another

The income eligibility is based on household income where modified AGI requires the add-back of tax-exempt interest and any nontaxable Social Security benefits. The maximum household income is 400 percent of the federal poverty line for the taxpayer’s family size. Taxpayers below the federal poverty line are eligible for Medicaid and thus not eligible for the credit.

Calculating the premium tax credit is similar to the EIC in that specific tables are required to compute the allowable credit. The credit is intended to take the form of the lesser of (1) actual health care premiums paid or (2) silver plan premiums less the amount the taxpayer is expected to contribute to health care. To calculate the premium tax credit, the following steps are required:

Step 1. Calculate modified AGI for all members of the household. This is AGI for all individuals claimed as a dependent (dependent’s income is includable if they are required to file a tax return) adjusted for a number of items including tax-exempt interest and nontaxable Social Security benefits.

Step 2. Compare the household income to the previous year’s federal poverty line (FPL). Under the ACA, the FPL is set in the previous year during open enrollment (around October). The FPL is defined in three ways: (a) the 48 contiguous states and the District of Columbia, (b) Alaska, or (c) Hawaii. The FPL selected is based on the household’s state of residence (see FPL amounts below).

Persons in Family/Household 2019 FPL for 48 States and DC

1 $12,140 2 16,460 3 20,780 4 25,100 5 29,420 6 33,740 7 38,060 8 42,380 Each additional person 1$ 4,320

7.4 Learning Objective Calculate the premium tax credit available under the Affordable Care Act.

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7-22 Chapter 7 ● Tax Credits

The household income is then expressed as a percentage of the FPL.

Step 3. The amount of income deemed appropriately spent on health care premiums is then identified on the 2019 Applicable Figure Table shown on Page 7-23. The applicable figure is designed to represent the maximum percentage of income a household will spend on health care premiums.

ExAMPLE Ed and Milly are married with two children under the age of 21. Household income is $50,200. Ed and Milly’s household income is at 200 percent of the FPL ($50,200 4 $25,100 5 2.0 or 200%). For household income of 200 percent of the FPL, the applicable figure is 0.0654; thus the intended or deemed to be paid for health care premiums is $50,200 3 6.54% or $3,283.08. ♦

Step 4. The amount of the credit is based on comparing the cost of premiums for a designated silver plan in the taxpayer’s state with the deemed premium cost cal- culated above. For example, if the deemed premium to be paid is $3,283 and the cost of a silver plan for that household is $10,000 then the premium tax credit is $6,717 ($10,000 2 $3,283). For households that did not have coverage for the entire year, the credit is prorated based on the number of months coverage was maintained.

Step 5. Lastly, the amount calculated in steps 1–4 is compared to the actual premiums paid and the lesser of the two is the premium tax credit (i.e., the credit cannot exceed the actual premiums paid).

The premium tax credit can be obtained at two different times: (1) in advance (i.e., as a direct reduction in the monthly health care premiums) or (2) at the end of the year when the tax return is filed. If the taxpayer elects to have the credit paid in advance, the exchange will automatically adjust the premiums to reflect an estimated credit based on estimated household income. Since the actual premium tax credit is not known until household income can be computed after the end of the tax year, Form 8962, shown on Page 7-25, provides a reconciliation of the estimated credit and the actual credit. If the actual credit is greater than the estimated credit, the difference between the two amounts is a refundable credit on the taxpayer’s tax return. If the estimated credit taken throughout the year is greater than the actual credit, the difference is treated as addi- tional tax due on the taxpayer’s tax return. However, as long as the household income remains below 400 percent of the FPL, the repayment amount of the credit is limited:

Single Taxpayers Other

Than Single Less than 200% $ 300 $ 600 At least 200% but less than 300% 800 1,600 At least 300% but less than 400% 1,325 2,650 At least 400% No limit No limit

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7-237-4 The Affordable Care Act

2019 Applicable Figure Table

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7-24 Chapter 7 ● Tax Credits

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7-257-4 The Affordable Care Act

Self-Study Problem 7.4

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7-26 Chapter 7 ● Tax Credits

Self-Study Problem 7.4

12-3456999 XXX Covered California

Tracy Brigantine 123-44-5555 07/01/1967

124-55-6666 09/22/1971

01/01/2019 12/31/2019 317 Kendra Lane

Poway CA 92064

123-44-5555 07/01/1967 01/01/2019 12/31/2019

124-55-6666 09/2/21971 01/01/2019 12/31/2019

503-11-2222 04/28/2005 01/01/2019 12/31/2019

867-53-0922 01/28/2003 01/01/2019 12/31/2019

957.00

11,484.00

825.00

9,900.00

487.00

5,844.00

Marco Brigantine

Tracy Brigantine

Marco Brigantine

Alex Brigantine

Bryan Brigantine

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Form 1095-A reports the taxpayer’s actual premiums paid, the cost of the silver plan, and any advance credits received during the year from the exchange on which they purchased the insurance.

Self-Study Problem 7.4 See Appendix E for Solutions to Self-Study Problems

Marco and Tracy Brigantine live in California, are married filing jointly, under age 65, and have three children ages 14, 16, and 26. However, the oldest child is not claimed as a dependent and does not live at home. Tracy’s adjusted gross income is $44,040 and Marco’s is $22,000 and both are self-employed. They also have $2,000 in interest income from tax-exempt bonds. The Brigantines are enrolled in health insurance for all of 2019 through their state exchange and elected to have the credit paid in advance. Using the Brigantine’s 2019 Form 1095-A on Page 7-26, complete the Form 8962 on Page 7-25 to determine the following:

1. The actual premium tax credit (Line 24). 2. The net premium tax credit to be claimed on the return, if any (Line 26) or the excess

advance payment, if any (Line 27). 3. The repayment amount required, if any.

7-5 EdUCATION TAx CREdITS The tax law contains a number of provisions that are intended to reduce the cost of edu- cation for taxpayers. Educational credits represent the last of these provisions covered in this textbook:

Educational Tax Benefit Learning Objective

Exclusion from gross income for scholarships 2.12 Employer-provided education assistance plans 2.5 Tuition reduction for school employees 2.5 Deduction of business educational expenses 3.6 Student loan interest deduction 5.8 Qualified tuition programs (529 plans) 2.14 Coverdell educational savings accounts 2.14 Tuition deduction (currently expired) 2.14 American Opportunity tax credit 7.5 Lifetime learning credit 7.5

7-5a American Opportunity Tax Credit The American Opportunity tax credit (AOTC) is an education credit available to help quali- fying low-income and middle-income individuals defray the cost of higher education.

The AOTC is a credit for students in their first 4 years of postsecondary education. The AOTC may be claimed for the expenses of students pursuing bachelor’s or associate’s degrees or vocational training. To be eligible, the student must meet all of the following:

● Pursuing a degree or recognized credential, ● Enrolled at least half-time for one semester, quarter, trimester, etc. starting during the

tax year, ● Received a Form 1098-T from the eligible education institution, ● Not have completed the first four years of higher education at the start of the tax year, ● The AOTC has not been claimed for more than four years, and ● Has not been convicted of a felony drug conviction.

7.5 Learning Objective Apply the special rules applicable to the American Opportunity tax credit and lifetime learning credit.

7-277-5 Education Tax Credits

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7-28 Chapter 7 ● Tax Credits

Meeting either of the following criteria precludes claiming the AOTC: ● Married filing separate status, or ● Taxpayer is listed as a dependent on another’s return.

ExAMPLE Alice is a single parent filing as head of household. Alice has been taking nursing classes at night to help her improve her job performance at the hospital. Alice has a 19-year-old daughter, Melanie, who is a second year full- time student at Wake Tech Community College pursing her associate degree in accounting. She might go on to pursue a four-year degree at some later date. Alice claims Melanie as a dependent but Melanie files her own tax return to report the income she earns from her part-time job. Alice claimed the AOTC for Melanie last year. As Melanie is enrolled in school at least half-time, is pursuing a degree, and has not claimed the AOTC for more than 4 years, she is an eligible student for the AOTC. Although Alice’s school expense does not qualify for the AOTC, since she is not pursuing a degree or certification, she may qualify for the lifetime learning credit (LLC) discussed below. ♦

Like many other education tax benefits, the AOTC depends on an accurate computation of “qualified higher education expenses.” The table below shows how qualified educational expenses can differ across some of the common education benefits:

Qualifying expenses for the AOTC can be paid on behalf of the taxpayer, his or her spouse, or dependents. As noted previously, expenses paid for room and board, nonacademic fees or for expenses that are not related to the student’s course of instruction, do not qualify. Also, expenses for courses that involve sports, games, and hobbies do not qualify for the credit unless the course is part of a degree program. Expenses paid from a gift or inheritance (which is tax-free) do qualify for credits.

Cost Scholarship AOTC LLC

Student Loan

Interest Coverdell QTP

(529 Plan)

Employer Provided

Education Assistance

Plan

Business Deduction for Work-

related Education

Tuition and enrollment fees

X X X X X X X X

Course-related Books

X X Xa X X X X X

Course-related supplies and equipment

X X Xa X X X X X

Room and board

X X X

Transportation X X

Certain K-12 education costs

X X

Other necessary expenses including special needs services

X X X X

a Only if required to be paid to educational institution

Qualified Educational Expenses

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7-297-5 Education Tax Credits

ExAMPLE Trinity’s grandmother paid her $4,000 tuition directly to the university. Assuming Trinity meets the qualifying requirements for the AOTC otherwise, Trinity’s parents may include the $4,000 as a qualifying expense when calculating the AOTC. ♦

Qualifying expenses must be reduced by any tax-free scholarships, grants or other education assistance. Taxpayers claiming the AOTC must have received a Form 1098-T (shown below) and must report the employer identification number of the educational institution on the Form 8863.

ExAMPLE Alice’s daughter Melanie is an eligible student for the AOTC. Melanie received a 2019 Form 1098-T from Wake Tech that reported $4,000 in Box 1 and $1,000 in Box 5. Additionally, Alice paid $400 for course-related books and materials related to Melanie’s school in 2019. Qualified education expenses for the AOTC are $3,400 ($4,000 of tuition and fees less $1,000 of tax-free scholarships plus $400 for books). ♦

The AOTC is calculated as 100 percent of the first $2,000 of qualified expenses paid, and 25 percent of the next $2,000, for a maximum annual credit of $2,500 per student. For 2019, the AOTC is phased out ratably for joint return filers with income between $160,000 and $180,000 and for single, head of household, or qualifying widow(er) filers with income between $80,000 and $90,000 (these amounts are not adjusted for inflation). The AOTC is 40 percent refundable, so up to $1,000 (40 percent of $2,500) may be refunded to the taxpayer if the credit exceeds the taxpayer’s tax liability.

Many college students earn income and provide some of their own support. As a result, many parents of college-age students start to consider the consequences of claiming a child as a dependent versus allowing the child to claim themselves as a dependent on the student’s own tax return (of course, the support test and others discussed in Chapter 1 generally dictate whether a full-time college student can be claimed by their parents). In order to prevent abuse of the AOTC by students attempting to maximize the credit by filing their own tax return, there are special rules related to the refundable portion of the AOTC. If a student under the age of 24, with at least one parent still living and not filing a joint return, is filing his or her own tax return and any of the following apply, they may not claim the refundable portion of the AOTC:

● Under age 18 at end of 2019, or ● At age 18 and earned income is less than one-half of support, or ● Over age 18 and a full-time student and earned income is less than one-half of support

ExAMPLE Vance Wilder is a single, 20-year-old full-time student at Harrison College. Van earned $11,000 from his part-time accounting job and in 2019, provided over one-half of his own support. As a result, his parents no longer claim him as a dependent. Although Vance has a living parent and is not filing a joint return, because he is over age 18 and a full-time student whose earned income is over one-half of his support, he is eligible for the refundable portion of the AOTC. ♦

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7-30 Chapter 7 ● Tax Credits

ExAMPLE Jenny graduates from high school in June 2019. In the fall, she enrolls for twelve units at Gwinett University. Gwinett University considers students who take twelve or more units to be full-time students. Jenny’s father pays her tuition and fees of $2,300. The American Opportunity tax credit for Jenny is $2,075 [(100% 3 $2,000) 1 (25% 3 $300)]. ♦

ExAMPLE Jason, a single father, has AGI of $85,000 in 2019. In 2019, he pays $5,000 in qualified tuition for his son, who just started at Alamance University. Without any limitations, Jason would be entitled to a maximum American Opportunity tax credit of $2,500. However, after applying the AGI limitations, Jason’s American Opportunity tax credit is reduced by $1,250 ($2,500 3 ($90,000 2 $85,000) / $10,000), resulting in a credit of $1,250. ♦

Qualifying expenses must be paid during the tax year for education during an academic year beginning within that tax year. If tuition expenses are paid during the tax year for an academic period beginning during the first 3 months of the following tax year, the expenses may be claimed during the payment year.

Similar to the child tax credit rules, a taxpayer identification number (Social Security number or individual tax identification number) is required for each AOTC qualifying student by the due date of the return (including extensions).

If the IRS rejects an AOTC for any reason other than a math or clerical error, the taxpayer must complete Form 8862 used for claiming an earned income credit in a year after a rejection.

In addition, a taxpayer who erroneously claims the AOTC due to reckless or intentional disregard of rules or regulations is ineligible to claim the credit for a period of two tax years. If the IRS determines the claim for the credit was fraudulent, the ineligibility window is extended to ten years.

Unlike the child tax credit and EIC, no time restriction was placed on the IRS issuing refunds for any tax returns that claim an AOTC.

Form 8867, a due diligence checklist for tax preparers previously required for only the earned income credit, has been expanded to include steps to be taken for returns that include a child tax credit or the AOTC. Failure to file Form 8867 could result in a $530 penalty.

7-5b Lifetime Learning Credit Taxpayers can elect a nonrefundable tax credit of 20 percent of qualified expenses of up to $10,000 in 2019, for a maximum credit of $2,000. The lifetime learning credit is available for qualified expenses paid for education of the taxpayer, his or her spouse, and dependents. The credit is available for undergraduate, graduate, or professional courses at eligible edu- cational institutions. The student can be enrolled in just one course and still get the credit. There is no limit on the number of years a taxpayer can claim the credit. The credit is not subject to felony drug offense restrictions. The purpose of this credit is to encourage taxpay- ers to take courses at eligible institutions to acquire or improve job skills.

ExAMPLE In September 2019, Scott pays $1,200 to take a course to improve his job skills to qualify for a new position at work. His lifetime learning credit for 2019 is $240 (20% 3 $1,200). ♦

The lifetime learning credit is phased out at different levels than the American Oppor- tunity tax credit. Married taxpayers with income between $116,000 and $136,000, and single, head of household, or qualifying widow(er) taxpayers with income between $58,000 and $68,000, must phase the credit out evenly over the phase-out range for 2019.

ExAMPLE During 2019, Jason, a single father with AGI of $85,000, paid $2,500 of tui tion for a master’s degree program in fine arts which he has been attend ing with the hope of eventually becoming a writer. Without any limitations, Jason would be entitled to a maximum lifetime learning credit of

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7-317-5 Education Tax Credits

$500 (20% 3 $2,500). However, due to the income phase-out ranges for the life time learning credit, none of the credit may be claimed on his tax return. ♦

7-5c Using Both Credits Taxpayers cannot take both the American Opportunity tax credit and the lifetime learn- ing credit for the same student in the same tax year. An American Opportunity tax credit can be claimed for one or more students, and the lifetime learning credit can be claimed for other students in the same tax year. Also, the choice in one year does not bind the taxpayer for future years. For example, a taxpayer can claim the American Opportunity tax credit for a stu dent in one tax year and take the lifetime learning credit for the same stu- dent the following year. Taxpayers should claim the credit or combination of credits that provides the best tax benefit. Both the AOTC and the lifetime learning credit are claimed using Form 8863 (see Pages 7-32 and 7-33).

Self-Study Problem 7.5 See Appendix E for Solutions to Self-Study Problems a. Judy Estudiante graduates from high school in June 2019. In the fall, she enrolls for

twelve units in Southwest University and receives the following Form 1098-T.

Judy’s parents, Santiago and Sophia Estudiante, pay her tuition and fees, have AGI of $170,000, have pre-credit tax liability of over $20,000, are claiming no other tax credits, and claim Judy as a dependent. Judy has never been arrested or convicted of any crimes. Complete Form 8863 on Pages 7-32 and 7-33 to determine what is the refundable and nonrefundable American Opportunity tax credit Judy’s parents can claim for Judy if they file a joint return.

Refundable American Opportunity tax credit $____________________

Nonrefundable American Opportunity tax credit $____________________

b. In September 2019, Gene pays $5,200 to take a course to improve his job skills at work. Gene’s AGI is $35,000 for 2019. What is Gene’s lifetime learning credit for 2019?

$____________________

Southwest University 1234 Cleveland Ave. El Paso, TX 79925

12-7652311

Judy Estudiante

12 Fannin Street

Van Horn, TX 79855

434-11-7812

5,923.00

Education credits are input under Credits/Education Tuition (1098-T). The typical starting point would be to enter the information on the student’s 1098-T. tIp

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7-32 Chapter 7 ● Tax Credits

Self-Study Problem 7.5 part a

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7-337-5 Education Tax Credits

Self-Study Problem 7.5 part a

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7-34 Chapter 7 ● Tax Credits

7-6 FOREIGN ExCLUSION ANd TAx CREdIT Some of the most sweeping changes to the tax law under the TCJA are related to the taxation of international income but virtually all of these changes were directed at U.S. corporations; with little applying specifically to individuals. However, there are two main provisions related to U.S. taxation of international income that apply to individuals: (1) the foreign income exclusion and (2) the foreign tax credit.

7-6a Foreign Income Exclusion Certain taxpayers working and living outside the U.S. are eligible to exclude a certain por- tion of their foreign income from taxable income under the foreign income exclusion. In addition, certain foreign housing can also be excluded or deducted. To qualify, the taxpayer must have a bona fide tax home outside the U.S. for a certain number of days. The exclu- sion limit in 2019 is $105,900.

ExAMPLE John Adams, a single U.S. citizen, is an employee of a large multinational corporation and works at the company’s Mexican subsidiary. He has established a bona fide tax home in Mexico. During the year, John spent 355 days in Mexico and 10 days vacationing in Hawaii. His employer paid him wages of $107,000 in 2019. John excludes $105,900 of his wages from U.S. taxable income. John will not be eligible to claim a foreign tax credit (see below) on the wages excluded. ♦

The foreign income exclusion is claimed on Form 2555. Form 2555-EZ has been discontinued by the IRS after 2018. Use of the foreign income exclusion precludes the use of certain credits or deductions (for example, the EITC). In addition, a number of provisions that require the computation of modified taxable income require the foreign income exclusion to be added back (for example, the limits for a deduction for contributions to an IRA).

Employees and self-employed taxpayers that qualify for the foreign income exclusion are also eligible for a housing exclusion or deduction. The foreign housing exclusion is an additional exclusion designed to represent the incremental cost of housing in a foreign country above a base amount. The details are beyond the scope of this textbook.

7-6b Foreign Tax Credit An individual will typically incur foreign taxes under two possible scenarios: (1) they have engaged in work outside the United States as either an employee or as self-employed indi- vidual (expats) or (2) as a result of foreign investments either directly or through an invest- ment portfolio such as a mutual fund or exchange-traded fund. Although the tax treatment of expats is beyond the scope of this textbook, aside from the benefit available for many expats under the foreign income exclusions described above, an expat may use a foreign tax credit for foreign taxes paid to reduce their U.S. income tax liability. The same is true of an investor whose income is subject to foreign taxes. In both cases, the amount of the credit is limited to the U.S. tax that applies to that income.

ExAMPLE Thomas Jefferson, a single U.S. citizen, works for his employer in France and he is not eligible to use the foreign income exclusion. In 2019, Thomas paid income taxes in France of $3,500 on his income of $50,000. This was his only income during the year (U.S. or otherwise). Thomas claims the standard deduction. Thomas’ foreign-sourced income is $37,800 ($50,000 less standard deduction of $12,200). His U.S. income for purposes of the foreign tax credit limitation is also $37,800. Thomas calculates his U.S.

Learning Objective 7.6

Compute the foreign income exclusion and tax credit.

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7-357-6 Foreign Exclusion and Tax Credit

income tax liability before any credits as $4,345. His foreign tax credit limit in this case is:

Net foreign income $37,800 U.S. taxable income $37,800

3 U.S. tax liability $4,345 5 $4,345

Thomas’ actual foreign taxes paid are $3,500; thus, his foreign tax credit is not limited and he is eligible for a $3,500 foreign tax credit. ♦

ExAMPLE Alexander Hamilton held shares in the Federalist International Stock Fund, a mutual fund with extensive foreign holdings. Alexander’s earnings of $2,300 from the fund and foreign taxes paid of $632 were reported to him on a Form 1099-DIV. This was Alexander’s only portfolio income during the year. Alexander’s taxable income was $75,950 and his tax liability before the credit was $12,573 including Alexander’s U.S. tax liability associated with dividend income of $345. Alexander’s limitation is calculated as

Net foreign income $2,300 U.S. taxable income $75,950

3 U.S. tax liability $12,573 5 $381

As a result, Alexander’s foreign tax credit is limited to $381. The unused credit of $251 ($632 foreign taxes paid less $381 limitation) can be carried back one year or forward for up to 10 years. ♦

A number of simplifications were used in the above examples and the actual computation of the limit can be considerably more complex. Different rules apply to income earned in a U.S. possession. The foreign tax credit is typically claimed on Form 1116 and the rules are explained in the instructions to Form 1116.

A simplified foreign tax credit that does not require the completion of Form 1116 is available if you meet all of the following requirements:

1. All of the foreign-sourced gross income was “passive category income” (which includes most interest and dividends).

2. All the income and any foreign taxes paid on it were reported on a qualified payee statement such as a Form 1099-DIV, Form 1099-INT, Schedule K-1, or similar substi- tute statements.

3. Total creditable foreign taxes aren’t more than $300 ($600 if married filing a joint return).

If the Form 1116 is not used, the foreign tax credit is entered directly on Schedule 3 of Form 1040, Line 1. The foreign tax credit is nonrefundable and thus limited to the pre-credit tax amount. Use of the simplified method precludes a carryback of any limited foreign tax credit but the unused credit can be carried forward up to 10 years.

As a reminder, this is just an overview of these areas which are, in most instances, extremely complex. Useful publications are IRS Publication 54, Form 1116 and instructions, and Form 2555 and instructions.

One of the most common ways to pay foreign taxes is through an investment in a mutual fund that happens to hold some international investments and pays foreign taxes at the fund level. The foreign tax payments are generally reported on the taxpayer’s Form 1099-DIV and are entered into ProConnect as part of recording the dividend income.

tIp

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7-36 Chapter 7 ● Tax Credits

Self-Study Problem 7.6 See Appendix E for Solutions to Self-Study Problems

Benny Franklin receives a Form 1099-DIV from his investment manager that lists foreign taxes paid of $432 and Benny’s foreign investment earnings of $1,500. Benny had no other investment earnings and his total taxable income for the year is $58,000. Benny’s tax liability before any foreign taxes is $8,624. Calculate the amount of the foreign tax credit.

$_______________

7-7 AdOPTION ExPENSES Taxpayers are allowed two tax breaks for adoption expenses. A tax credit is allowed for qualified adoption expenses paid by taxpayers, and an exclusion from W-2 income is al- lowed for qualified adoption expenses paid by taxpayers’ employers.

7-7a Adoption Credit Individuals are allowed a nonrefundable income tax credit for qualified adoption expenses (defined below). Form 8839 is used to calculate and report the adoption credit. The total expense that can be taken as a credit for all tax years with respect to an adoption of a child is $14,080 for 2019. The credit is the total amount for each adoption and is not an annual amount (i.e., there is only one $14,080 credit per adopted child). The amount of the credit allowable for any tax year is reduced for taxpayers with AGI over $211,160 and is fully phased out when AGI reaches $251,160. The amount of the credit is reduced (but not below zero) by a factor equal to the excess of the taxpayer’s AGI over $211,160 divided by $40,000. In some cases, beyond the scope of this textbook, AGI must be modified prior to calculating the adoption credit phase-out. For addi tional information on calculating modi- fied adjusted gross income (MAGI) with respect to the adoption credit, see the IRS website at www.irs.gov.

ExAMPLE Ben and Beverly pay $5,000 of qualified adoption expenses in 2019 to adopt a qualified child. Their AGI is $214,160 for 2019, which causes an adoption credit reduction for 2019 of $375 [$5,000 3 ($214,160 2 $211,160) / $40,000)]. Thus, Ben and Beverly’s allowable adoption credit for 2019 is $4,625 ($5,000 2 $375). ♦

The credit is not refundable; however, the unused portion may be carried forward for 5 years. To claim the credit, married individuals must file jointly, and the taxpayer must include (if known) the name, age, and taxpayer identification number (TIN) of the child on the return.

7-7b domestic Multiyear Adoptions In the case of the adoption of an eligible child who is a U.S. citizen or resident of the United States at the time the adoption commenced, the credit for qualified adoption ex- penses is allowed for the tax year that follows the year during which the expenses are paid or incurred, unless the expenses are paid or incurred in the tax year the adoption becomes final. If the expenses are paid or incurred during the tax year in which the adoption becomes

Learning Objective 7.7 Determine the proper use and calculation of the adoption credit.

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7-377-7 Adoption Expenses

final, the credit is allowed for that year. The full $14,080 credit is allowed in special-needs adoptions regardless of the amount of qualified adoption expenses paid.

ExAMPLE In connection with the adoption of an eligible child who is a U.S. citizen and is not a child with special needs, a taxpayer pays $6,000 of qualified adop tion expenses in 2018 and $8,600 of qualified adoption expenses in 2019. The adoption is not finalized until 2020. The $6,000 of expenses paid or incurred in 2018 would be allowed in 2019, and $8,080 of the $8,600 paid or incurred in 2019 would be allowed in 2020. On the other hand, if the adoption were finalized in 2019, then $14,080 of qualified expenses would be allowed in 2019 (the maximum credit permitted as of 2019). ♦

7-7c Foreign Multiyear Adoptions In the case of the adoption of a child who is not a U.S. citizen or resident of the United States, the credit for qualified adoption expenses is not available unless the adoption becomes final. Qualified adoption expenses paid or incurred before the tax year in which the adoption becomes final are taken into account for the credit as if the expenses were paid or incurred in the tax year in which the adoption becomes final. Therefore, the credit for qualified adoption expenses paid or incurred in the tax year in which the adoption becomes final, or in any earlier tax year, is allowed only in the tax year the adoption becomes final.

ExAMPLE In 2017 and 2018, a taxpayer pays $3,000 and $6,000, respectively, of qualified adoption expenses in connection with the adoption of an eligible child who is not a U.S. citizen or resident of the United States. In 2019, the year the adoption becomes final, the taxpayer pays an additional $3,000 of qualified expenses. The taxpayer may claim a credit of $12,000 on his or her income tax return for 2019 (the year the adoption becomes final). Note: If a foreign adoption does not become final, no credit is allowed. ♦

7-7d Employer-Provided Adoption Assistance An employee may exclude from W-2 earnings amounts paid or expenses incurred by his or her employer for qualified adoption expenses connected with the adoption of a child by the employee, if the amounts are furnished under an adoption assistance pro- gram. The total amount excludable per child is the same as the adoption credit amount ($14,080). The phase-out is calculated in the same manner as the phase-out for the adoption credit. An individual may claim both a credit and an exclusion in connection with the adoption of an eligible child, but may not claim both a credit and an exclusion for the same expense.

The following quotation is often attributed to Albert Einstein: “The hardest thing in the world to understand is the income tax.”

Would You

Believe?

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7-38 Chapter 7 ● Tax Credits

Self-Study Problem 7.7 See Appendix E for Solutions to Self-Study Problems

James and Michael Bass finalized the adoption of their daughter Allison in October 2019, one month after her birth. Allison is a U.S. citizen and is not a child with special needs. Her Social Security number is 466-47-3311. In 2019, James and Michael paid $17,000 in qualified adoption expenses. In addition, Michael’s employer paid $4,000 directly to an adoption agency as an employer-provided adoption benefit. The Bass’ AGI for 2019 is $219,160 (assume adjusted gross income and modified adjusted gross income are the same for purposes of this problem). The Bass’ tax liability is $22,332 and they are not using tax credits except the adoption credit. Use Form 8839 on Pages 7-39 and 7-40 to calculate the Bass’ adoption credit and the amount of any employee adoption exclusion.

7-8 ENERGY CREdITS Over the past decade, the tax law has included a number of personal tax credits associated with energy-efficient products. These credits have been slowly expiring. By design, many tax credits are temporary additions to the tax law and are designed to create short-term or limited changes in taxpayer behavior as mentioned in Chapter 1. The current status of many of these credits is presented below:

Credit IRC Section Status Electric vehicle credit 30D Active Nonbusiness energy property credit

25C Expired 2017

Residential energy efficient property (REEP) credit

25D Active

Qualified fuel cell motor vehicle credit

30B Expired 2017

Qualified alternative fuel vehicle refueling property

30C Expired 2017

Because credits are often retroactively extended, be sure and check www.irs.gov for any changes that may have occurred after we went to print.

Two of the remaining credits are discussed here.

7-8a Plug-In Electric Vehicle Credits Taxpayers are allowed a credit for the purchase of plug-in electric drive vehicles used for either business or personal purposes. The credit, which ranges between $2,500 and $7,500 for light-duty vehicles, varies depending on the weight of the vehicle and the kilowatt hour of battery capacity. The Hyundai Kona, Nissan Leaf, Honda Clarity, and numerous other new electric vehicles qualify for the full $7,500 credit. The credit phases out for each car manufacturer when they reach a total of 200,000 electric cars sold for use in the United States (e.g., the Toyota Prius Plug-In). More information on federal and state electric vehicle tax incentives may be found at www.fueleconomy.gov.

7-8b Credits for Residential Energy-Efficient Property (REEP Credit)

Taxpayers may claim a credit of 30 percent of the amount paid for qualified solar electric property (property which uses solar power to generate electricity in a home), qualified solar water-heating property, qualified fuel cell property, qualified small wind energy prop- erty, and qualified geothermal heat pump property. The REEP credit for all property types

Learning Objective 7.8 Recognize the basic individual credits for energy efficiency.

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7-397-8 Energy Credits

Self-Study Problem 7.7

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7-40 Chapter 7 ● Tax Credits

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7-417-9 Low-Income Retirement Plan Contribution Credit

except for qualified solar electric and water heating had expired at the end of 2017 but was extended through 2022. The credit percentage is reduced to 26 percent for property placed in service starting in 2020 and then further reduced to 22 percent in 2021.

The REEP credits described in the paragraph above may be claimed for both principal residences and vacation homes. No credit is allowed for installations used to heat swimming pools or hot tubs. The REEP credit is reported on Form 5695.

ExAMPLE In 2019, Mary buys $30,000 of solar electric property for her second (vaca- tion) home. The equipment is not used to heat her swimming pool or hot tub. She may claim a credit of $9,000 ($30,000 3 30%) for 2019. ♦

Self-Study Problem 7.8 See Appendix E for Solutions to Self-Study Problems Calculate the energy credit allowed for the following purchases:

a. Geoffrey purchases a Nissan Leaf in May of 2019.

Credit Allowed $_________________

b. Betty purchases a solar system to heat her hot tub for $2,000 and a second, certified, energy-efficient solar system to heat her home for $10,000 in 2019.

Credit Allowed $_________________

7-9 LOW-INCOME RETIREMENT PLAN CONTRIBUTION CREdIT

Certain low-income taxpayers may claim a nonrefundable “Low-Income Retirement Plan Contribution Credit,” also called the “Saver’s Credit,” to encourage them to participate in tax-saving retirement plans, including IRAs. The credit rate is 50 percent, 20 percent, or 10 percent depending on the taxpayer’s filing status and adjusted gross income. The credit is a direct deduction from income taxes otherwise payable, and the cash saved may be used to make part of the contribution to the plan. Taxpayers receive up to a 50 percent credit for contribution amounts up to $2,000 ($4,000 married filing jointly) or a maximum credit of $1,000 ($2,000 for married filing jointly). The credit phases out for adjusted gross income over certain income limits, as shown below.

7.9 Learning Objective Calculate the low- income Retirement Plan Contribution Credit.

Filing Status/Adjusted Gross Income for 2019—Saver’s Credit

Amount of Credit Joint Head of Household Single/Others

50% of first $2,000 ($4,000) deferred

$0 to $38,500 $0 to $28,875 $0 to $19,250

20% of first $2,000 ($4,000) deferred

$38,501 to $41,500 $28,876 to $31,125 $19,251 to $20,750

10% of first $2,000 ($4,000) deferred

$41,501 to $64,000 $31,126 to $48,000 $20,751 to $32,000

ExAMPLE In 2019, Teddy and Abby file a joint tax return with AGI of $29,000. Teddy contributes $1,500 to a Section 401(k) plan at work. Teddy and Abby are entitled to a $750 (50% 3 $1,500) Retirement Plan Contribution Credit. The credit is in addition to any deduction or exclusion allowed for the contribution. ♦

The Saver’s Credit is claimed on Form 8880. Because the Saver’s Credit is nonrefundable, the amount of the credit is limited to the income tax liability after reflecting any foreign tax credit, child and dependent care expense credit, educations credits, or credit for the elderly and disabled.

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7-42 Chapter 7 ● Tax Credits

Self-Study Problem 7.9 See Appendix E for Solutions to Self-Study Problems

Steve and Robin Harrington are married filing jointly taxpayers, both 61 years of age and semi-retired. Robin earns wages of $32,000 as a part-time school librarian and Steve sharpens knives as a hobby and their 2019 AGI is $39,500. Their tax liability before any credit is $1,510. The Harringtons are not eligible for any other tax credits. Neither Harrington is active in any other income deferral plans. Because the Harringtons have limited financial needs, they also made an IRA contribution of $12,000 ($6,000 each) trying to get ready for retirement. Use the Form 8880 on Pages 7-43 and 7-44 to determine the Harrington’s Saver’s Credit.

ExAMPLE In 2019, Whitney and Melissa file a joint tax return that reflects AGI of $37,100, income tax liability before any credits of $1,270, and a lifetime learning credit of $240. If Whitney and Melissa contribute $2,100 to an IRA, their Saver’s Credit is $1,030 calculated as the credit amount of $1,050 ($2,100 3 50%) limited to tax liability before the credit of $1,030 ($1,270 2 $240). ♦

Numerous tax credits may be claimed by taxpayers in addition to the tax credits discussed in this textbook. Several of the more common credits not covered here include:

● The Elderly or disabled Credit provides relief for low-income taxpayers who are not receiving substantial tax-free retirement benefits.

● The disabled Access Credit is 50 percent of eligible access expenditures up to a maximum credit of $5,000, and is meant to encourage small businesses to become more accessible to disabled individuals.

● The General Business Credit is made up of a number of credits which are bundled into one credit for carryback and carryforward purposes, including the credit for rehabilitation expenditures, the low-income housing credit, and the credit for employer-provided child care.

● The Small Employer health Insurance Credit provides small employers a credit for health insurance paid on behalf of workers who are not owners and who meet certain criteria.

● The Research Activities Credit is an incremental credit of 20 percent of expenditures in excess of a base amount, and is intended to encourage high-tech and energy research.

● The Work Opportunity Credit is limited to 40 percent of the first $6,000 of wages paid to each eligible employee. The purpose is to encourage employment of individuals in certain specified disadvantaged groups and has been extended through December 31, 2019.

Credits have a greater tendency to expire after a few years than do other tax code provisions. Be sure and check on the latest status of available individual and business credits at www.irs.gov/credits-deductions.

TAX BREAK

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7-437-9 Low-Income Retirement Plan Contribution Credit

Self-Study Problem 7.9

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7-44 Chapter 7 ● Tax Credits

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7-45

K e y t e r m s

child tax credit, 7-2 nonrefundable tax credit, 7-2 refundable tax credit, 7-2 qualifying dependent credit, 7-2 additional child tax credit, 7-3 earned income credit (EIC), 7-5 “negative” income tax, 7-5 child and dependent care credit, 7-17

Affordable Care Act (ACA), 7-21 premium tax credit, 7-21 federal poverty line (FPL), 7-21 American Opportunity tax

credit, 7-27 qualified higher education

expenses, 7-28 lifetime learning credit, 7-30

foreign income exclusion, 7-34 foreign tax credit, 7-34 adoption credit, 7-36 energy credit, 7-38 low-income Retirement Plan

Contribution Credit, 7-41 Saver’s Credit, 7-41

Learning Objectives Key points

LO 7.1:

Calculate the child tax credit.

● Credits are a direct reduction in tax liability instead of a deduction from income. ● The child tax credit is $2,000 per qualifying child. ● All qualifying children must have a Social Security number at the time of filing. ● The child tax credit begins phasing out when AGI reaches $400,000 for joint filers and $200,000 for all others.

● The additional child tax credit is available to certain taxpayers whose child tax credit was limited by their tax liability.

● The child tax credit also includes an “other dependent credit” of $500 for taxpayers with dependents that do not qualify for the child tax credit.

LO 7.2:

Determine the earned income credit (EIC).

● The earned income credit (EIC) is available to qualifying individuals with earned income and AGI below certain levels and is meant to assist the working poor.

● The EIC formula for calculating the credit is based on the AGI of the taxpayer and the number of qualifying children of the taxpayer.

● To compute the credit, the taxpayer must fill out a worksheet calculating the credit from the tables based on earned income from wages, salaries, and self-employment income.

● To be eligible for the credit with no qualifying children, a worker must be over 25 and under 65 years old and not be claimed as a dependent by another taxpayer.

LO 7.3:

Compute the child and dependent care credit for an individual taxpayer.

● To be eligible for the child and dependent care credit, the dependent must either be under the age of 13 or be a dependent or spouse of any age who is incapable of self-care.

● If a child’s parents are divorced, the child need not be the dependent of the taxpayer claiming the credit, but the child must live with that parent more than he or she lives with the other parent.

● The expenses that qualify for the credit include amounts paid to enable both the taxpayer and his or her spouse to be employed.

● For taxpayers with AGI of less than $15,000, the child and dependent care credit is equal to 35 percent of the qualified expenses. For taxpayers with AGI of $15,000 or more, the credit gradually decreases from 35 percent to 20 percent.

● In determining the credit, the maximum amount of qualified expenses to which the applicable percentage is applied is $3,000 for one dependent and $6,000 for two or more dependents.

● Full-time students with little or no income are deemed to have earned income of $250 per month for one dependent and $500 per month for two or more dependents for purposes of calculating this limitation.

K e y p O I N ts

Key Points

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7-46 Chapter 7 ● Tax Credits

LO 7.4:

Calculate the premium tax credit available under the Affordable Care Act.

● Certain lower income taxpayers may be eligible for a premium tax credit to offset some or all of the cost of health care purchased through an exchange.

● The premium tax credit can be paid in advance or at the time the tax return is filed. ● The advanced premium tax credit and the actual premium tax credit are reconciled at the time the tax return is prepared. Repayments may be limited.

LO 7.5:

Apply the special rules applicable to the American Opportunity tax credit and lifetime learning credit.

● The partially refundable American Opportunity tax credit is 100 percent of the first $2,000 of tuition, fees, books, and course materials paid and 25 percent of the next $2,000, for a total maximum annual credit of $2,500 per student.

● The American Opportunity tax credit is available for the first 4 years of postsecondary education.

● Taxpayers can elect a nonrefundable lifetime learning credit of 20 percent of the first $10,000 in qualified expenses for education.

● The American Opportunity tax credit is phased out for joint filers with income between $160,000 and $180,000 and for single and head of household filers with income between $80,000 and $90,000. The lifetime learning credit is phased out between $116,000 and $136,000 for joint filers, and between $58,000 and $68,000 for those single or head of household taxpayers.

● Taxpayers cannot take both the American Opportunity tax credit and the lifetime learning credit for the same student in the same tax year.

LO 7.6:

Compute the foreign income exclusion and tax credit.

● The foreign income exclusion amount for 2019 is $105,900. ● U.S. taxpayers are allowed to claim a foreign tax credit on income earned in a foreign country and subject to income taxes in that country.

● Generally, the foreign tax credit is equal to the amount of the taxes paid to foreign governments; however, there is an “overall” limitation on the amount of the credit, which is calculated as the ratio of net foreign income to U.S. taxable income multiplied by the U.S. tax liability.

● Unused foreign tax credits may be carried back 1 year and forward 10 years to reduce any tax liability in those years.

LO 7.7:

Determine the proper use and calculation of the adoption credit.

● Individuals are allowed an income tax credit for qualified adoption expenses. The maximum total expense that can be taken as a credit for all tax years with respect to an adoption of a child is $14,080 for 2019.

● The maximum exclusion from income for benefits under an employer’s adoption assistance program is $14,080.

● These amounts are phased out if modified AGI is between $211,160 and $251,160.

LO 7.8:

Recognize the basic individual credits for energy efficiency.

● A tax credit of up to $7,500 for the purchase of new plug-in electric drive vehicles is available.

● Taxpayers may claim a 30 percent credit of the amount paid for qualified property such as solar electric property and solar water-heating property.

LO 7.9:

Calculate the low-income Retirement Plan Contribution Credit.

● Certain low-income taxpayers may claim a nonrefundable low-income Retirement Plan Contribution.

● Credit, also called the “Saver’s Credit,” to encourage them to participate in tax- saving retirement plans.

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7-47Questions and Problems

GrOUp 1:

MULTIPLE ChOICE QUESTIONS

1. Russ and Linda are married and file a joint tax return claiming their three children, ages 4, 7, and 18, as dependents. Their adjusted gross income for 2019 is $415,300. What is Russ and Linda’s total child and other dependent credit for 2019? a. $500 b. $2,500 c. $3,700 d. $4,500 e. $4,700

2. Jennifer is divorced and files a head of household tax return claiming her children, ages 4, 7, and 17, as dependents. Her adjusted gross income for 2019 is $81,200. What is Jennifer’s total child and other dependent credit for 2019? a. $500 b. $2,500 c. $3,700 d. $4,500 e. $4,700

3. Assuming they all meet the income requirements, which of the following taxpayers qualify for the earned income credit in 2019? a. A married taxpayer who files a separate tax return and has a dependent child b. A single taxpayer who waited on tables for 3 months of the tax year and is

claimed as a dependent by her mother c. A single taxpayer who is self-employed and has a dependent child d. a and c above e. None of the above qualify for the earned income credit

4. Which of the following payments does not qualify as a child care expense for pur poses of the child and dependent care credit? a. Payments to a day care center b. Payments to the taxpayer’s sister (21 years old) for daytime babysitting c. Payments to a housekeeper who also babysits the child d. Payments to the taxpayer’s dependent brother (16 years old) for daytime babysitting e. All of the above qualify for the child and dependent care credit

5. Which of the following is not a requirement to receive the premium tax credit for health care? a. Health care through the employer is not available b. Health insurance is purchased through the state or federal exchange c. Income must be no greater than 200 percent of the federal poverty line d. The taxpayer cannot be claimed as a dependent

6. For purposes of determining income eligibility for the premium tax credit, household AGI is a. AGI for the taxpayer and spouse b. AGI for the taxpayer, spouse, and any other household members required to file a

tax return c. AGI for the taxpayer, spouse, and any other household members required to file a

tax return plus any tax-exempt income d. AGI for the taxpayer, spouse, and any other household members required to file a

tax return plus any tax-exempt income and untaxed Social Security benefits

LO 7.1

LO 7.2

LO 7.3

LO 7.4

Q U es t I O Ns a n d prO B L e m s

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7-48 Chapter 7 ● Tax Credits

7. The American Opportunity tax credit is 100 percent of the first of tuition and fees paid and 25 percent of the next . a. $600; $1,200 b. $1,100; $550 c. $2,000; $2,000 d. $1,100; $5,500 e. None of the above

8. Jane graduates from high school in June 2019. In the fall, she enrolls for twelve units at Big State University. Big State University considers students who take twelve or more units to be full-time. Jane’s father pays her tuition and fees of $2,500 for the fall semester and in December 2019 prepays $2,500 for the spring semester. In 2019, the American Opportunity tax credit for Jane’s tuition and fees before any AGI limitation is: a. $5,000 b. $2,500 c. $2,200 d. $1,800 e. Some other amount

9. Which of the following costs is not a qualified education expense for the American Opportunity tax credit? a. tuition b. room and board c. course-related books d. lab supplies required by the course

10. In September 2019, Sam pays $6,200 to take a course to improve his job skills to qualify for a new position at work. Assuming there is no phase-out of the credit, his lifetime learning credit for 2019 is: a. $220 b. $1,240 c. $2,500 d. $6,200 e. None of the above

11. In November 2019, Simon pays $1,000 to take a course to improve his job skills to qualify for a new position at work. Simon’s employer reimbursed him for the cost of the course. For 2019, Simon’s lifetime learning credit is: a. $200 b. $500 c. $1,000 d. $2,500 e. None of the above

12. John, a single father, has AGI of $81,000 in 2019. During the year, he pays $4,000 in quali fied tuition for his dependent son, who just started attending Small University. What is John’s American Opportunity tax credit for 2019? a. $0 b. $2,000 c. $2,250 d. $2,500 e. Some other amount

LO 7.5

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7-49Questions and Problems

13. Joan, a single mother, has AGI of $61,500 in 2019. In September 2019, she pays $5,000 in qualified tuition for her dependent son who just started at Big University. What is Joan’s American Opportunity credit for 2019? a. $0 b. $1,250 c. $2,125 d. $2,500 e. Some other amount

14. Becky, a college freshman, works part-time and pays $1,650 of her college tuition expenses. Although Becky files her own tax return, her parents claim her as a dependent on their tax return. Becky’s parents file jointly and have AGI of $50,000. What is the amount of American Opportunity tax credit her parents can claim on their tax return for the tuition Becky paid? a. $0 b. $495 c. $1,600 d. $1,650 e. Some other amount

15. Lucas, a single U.S. citizen, works in Denmark for MNC Corp during all of 2019. His MNC salary is $87,000. Lucas may exclude from his gross income wages of: a. $0 b. $40,000 c. $87,000 d. $105,900

16. Taxpayer L has income of $55,000 from Norway, which imposes a 40 percent income tax, and income of $45,000 from France, which imposes a 30 percent income tax. L has additional taxable income from U.S. sources of $200,000 and U.S. tax liability before credits of $105,000. What is the amount of the foreign tax credit? a. $16,500 b. $35,000 c. $35,500 d. $100,000 e. $45,000

17. John and Joan pay $16,500 of qualified adoption expenses in 2019 to finalize the adoption of a qualified child. Their AGI is $197,000 for 2019. What is their adop tion credit for 2019? a. $0 b. $16,500 c. $14,080 d. $13,810

18. In connection with the adoption of an eligible child who is a U.S. citizen and who is not a child with special needs, Sean pays $4,000 of qualified adoption expenses in 2018 and $3,000 of qualified adoption expenses in 2019. The adoption is finalized in 2019. There is no phase-out of the adoption credit. What are the adoption credits for both 2018 and 2019, respectively? a. $0; $7,000 b. $4,000; $1,000 c. $4,000; $3,000 d. $7,000; $0

LO 7.5

LO 7.6

LO 7.7

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7-50 Chapter 7 ● Tax Credits

19. If a taxpayer does not have enough tax liability to use all the available adoption credit, the unused portion may be carried forward for how many years? a. Two b. Three c. Five d. There is no carryforward

20. Barbara purchased a new Honda Clarity electric vehicle in 2019 for $36,000. Her federal tax credit will be: a. $0 b. $2,500 c. $5,000 d. $7,500 e. $10,000

21. Virginia and Richard are married taxpayers with adjusted gross income of $28,000 in 2019. If Virginia is able to make a $1,500 contribution to her IRA and Richard makes a $1,500 contribution to his IRA, what is the Saver’s Credit Virginia and Richard will be eligible for? a. $0 b. $1,500 c. $2,000 d. $3,000 e. $4,000

LO 7.7

LO 7.8

LO 7.9

1. Calculate the total child and other dependent credit for the following taxpayers. Please show your work. a. Jeremy is a single (head of household) father with $80,100 of AGI and has a

dependent 8-year-old son:

b. Jerry and Ann have $100,000 of AGI, file jointly, and claim two dependent preschool children:

c. James and Apple have AGI of $417,100, file jointly, and claim three dependent children (ages 7, 10, and 19):

2. How does the earned income credit produce a “negative” income tax?

3. List the 7 rules that all taxpayers must meet in order to claim the EIC.

4. List the rules that apply to taxpayers without a qualifying child in order to claim the EIC.

5. List the rules that apply to taxpayers with a qualifying child in order to claim the EIC.

LO 7.1

LO 7.2

GrOUp 2:

PROBLEMS

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7-51Questions and Problems

6. Diane is a single taxpayer who qualifies for the earned income credit. Diane has two qualifying children who are 3 and 5 years old. During 2019, Diane’s wages are $18,900 and she receives dividend income of $900. Calculate Diane’s earned income credit using the EIC table in Appendix B.

$_____________

7. Margaret and David Simmons are married and file a joint income tax return. They have two dependent children, Margo, 5 years old (Social Security number 316-31-4890), and Daniel, who was born during the year (Social Security number 316-31-7894). Margaret’s wages are $3,000, and David has wages of $14,000. In addition, they receive interest income of $200 during the year. Margaret and David do not have any other items of income and do not have any deductions for adjusted gross income. Assuming the Simmons file Form 1040 for 2019, complete Schedule EIC and the Earned Income Credit Worksheet A, on Pages 7-55 and 7-56. (The EIC table is in Appendix B.)

8. What is the maximum investment income a taxpayer is allowed to have and still be allowed to claim the earned income credit? Please speculate as to why there is an investment income limit in the tax law.

9. Calculate the amount of the child and dependent care credit allowed before any tax liability limitations or other credits for 2019 in each of the following cases, assuming the taxpayers had no income other than the stated amounts. a. William and Carla file a joint tax return. Carla earned $27,500 during the year,

while William attended law school full-time for 9 months and earned no income. They paid $3,500 for the care of their 3-year-old child, Carl.

$_____________

b. Raymond and Michele file a joint tax return. Raymond earned $32,500 during the year, while Michele earned $9,000 for the year from a part-time job. They paid $7,000 for the care of their two children under age 13.

$_____________

c. Beth is a single taxpayer who has two dependent children under age 5. Beth earned $25,500 in wages during the year and paid $6,700 for the care of her children.

$_____________

10. Clarita is a single taxpayer with two dependent children, ages 10 and 12. Clarita pays $3,000 in qualified child care expenses during the year. If her adjusted gross income (all from wages) for the year is $19,600 and she takes the standard deduction, calculate Clarita’s earned income credit and child and dependent care credit for 2019.

$_____________

11. Go to the IRS website (www.irs.gov) and redo Problem 10 above using the most recent Form 2441, Child and Dependent Care Expenses. Print out the completed Form 2441. Do not calculate the earned income credit here.

12. Mary and John are married and have AGI of $100,000 and two young children. John doesn’t work, and they pay $6,000 a year to day care providers so he can shop, clean, and read a little bit in peace. How much child and dependent care credit can Mary and John claim? Why?

13. Martha has a 3-year-old child and pays $10,000 a year in day care costs. Her salary is $45,000. How much is her child and dependent care credit?

LO 7.2

LO 7.3

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7-52 Chapter 7 ● Tax Credits

14. Marty and Jean are married and have 4-year-old twins. Jean is going to school full- time for 9 months of the year, and Marty earns $45,000. The twins are in day care so Jean can go to school while Marty is at work. The cost of day care is $10,000. What is their child and dependent care credit? Please explain your calculation.

15. Susan and Stan Collins live in Iowa, are married and have two children ages 6 and 10. In 2019, Susan’s income is $41,214 and Stan’s is $12,000 and both are self-employed. They also have $500 in interest income from tax-exempt bonds. The Collins enrolled in health insurance for all of 2019 through their state exchange but did not elect to have the credit paid in advance. The 2019 Form 1095-A that the Collins received from the exchange lists the following information:

Annual premiums $9,800 Annual premium for the designated silver plan in the state $10,800

Compute the Collins’ premium tax credit for 2019.

16. Using the information in the previous question, assume that the Collins’ Form 1095-A also indicated that the total advance payment of the premium tax credit was $9,200. Calculate the excess advance premium tax credit and the repayment amount for 2019.

17. What is the reason there are education tax credits in the tax law?

18. Please explain the difference between the types of education covered by the American Opportunity tax credit and the lifetime learning credit.

19. Janie graduates from high school in 2019 and enrolls in college in the fall. Her parents pay $4,000 for her tuition and fees. a. Assuming Janie’s parents have AGI of $170,000, what is the American Opportunity

tax credit they can claim for Janie?

b. Assuming Janie’s parents have AGI of $75,000, what is the American Opportu nity tax credit they can claim for Janie?

LO 7.3

LO 7.4

LO 7.5

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7-53Questions and Problems

20. Jasper is single and is a computer software consultant with a college degree. He feels that one of the reasons for his success is that he continually updates his knowledge by taking classes at the local college in various areas related to software design and information technology. This year he spent $2,000 on course tuition and fees. a. Assuming Jasper has AGI of $92,000, how much lifetime learning credit can Jasper

claim on his tax return? Would the answer be different if Jasper were married and supporting a wife who was not working?

b. Assuming Jasper has AGI of $45,000, how much lifetime learning credit can Jasper claim on his tax return?

21. Martha and Lew are married taxpayers with $400 of foreign tax withholding from dividends in a mutual fund. They have enough foreign income from the mutual fund to claim the full $400 as a foreign tax credit. Their tax bracket is 24 percent and they itemize deductions. Should they claim the foreign tax credit or a deduction for foreign taxes on their Schedule A? Why?

22. Carl and Jenny adopt a Korean orphan. The adoption takes 2 years and two trips to Korea and is finalized in 2019. They pay $7,000 in 2018 and $7,500 in 2019 for qualified adoption expenses. In 2019, Carl and Jenny have AGI of $150,000. a. What is the adoption credit Carl and Jenny can claim in 2019?

$______________ b. How much credit could they claim if the adoption falls through and is never

finalized?

c. How much credit could they claim if their AGI was $217,160?

23. Mike bought a solar electric pump to heat his pool at a cost of $2,500 in 2019. What is Mike’s credit?

$______________

24. In 2019, Jeff spends $6,000 on solar panels to heat water for his main home. What is Jeff’s credit for his 2019 purchases?

$______________

25. George and Amal file a joint return in 2019 and have AGI of $39,800. They each make a $1,600 contribution to their respective IRAs. Assuming that they are not eligible for any other credits, what is the amount of their Saver’s Credit?

$______________

LO 7.5

LO 7.6

LO 7.7

LO 7.8

LO 7.9

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7-54 Chapter 7 ● Tax Credits

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7-55Questions and Problems

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7-56 Chapter 7 ● Tax Credits

Wages, salaries

Adjusted gross income

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7-57

Your supervisor has asked you to research the following situation concerning Scott and Heather Moore. Scott and Heather are married and file a joint return. Scott works full-time as a wildlife biologist, and Heather is a full-time student enrolled at Online University. Scott’s earned income for the year is $36,000. Heather does not have a job and con centrates solely on her schoolwork. The university she is enrolled in offers courses only through the Internet. Scott and Heather have one child, Elizabeth (age 8), and pay $3,000 for child care expenses during the year.

Required: Go to the IRS website (www.irs.gov). Locate and review Publication 503. Write a file memorandum stating the amount of child and dependent care credit that Scott and Heather Moore can claim. (An example of a file memorandum is available at the website for this textbook located at www.cengagebrain.com.)

RESEARCH

GrOUp 3:

WRITING ASSIGNMENT

1. David and Darlene Jasper have one child, Sam, who is 6 years old (birthdate July 1, 2013). The Jaspers reside at 4639 Honeysuckle Lane, Los Angeles, CA 90248. David’s Social Security number is 577-11-3311, Darlene’s is 477-98-4731, and Sam’s is 589- 22-1142. David’s birthdate is May 29, 1986 and Darlene’s birthday is January 31, 1988. David and Darlene’s earnings and withholdings for 2019 are:

David: Earnings from Apple Company (office manager) $26,600 Federal income tax withheld 800 State income tax withheld 1,050 Darlene: Earnings from Rose Company (perfume tester) $25,500 Federal income tax withheld 1,050 State income tax withheld 1,000

Their other income includes interest from Pine Tree Savings and Loan of $1,900. Other information and expenditures for 2019 are as follows:

Interest: On home acquisition mortgage $11,312 Credit card 925 Taxes: Property taxes on personal residence 1,300 State income taxes paid in 2019 (for 2018) 315 Contribution (with written acknowledgement) to church 1,045 Medical insurance 675 Medical and dental expenses 6,175 Income tax return preparation fee paid in 2019 200 Actual general state sales tax for 2019 1,016 Payment of union dues 225 Contribution to David’s IRA 1,000

GrOUp 4:

COMPREhENSIVE PROBLEMS

Questions and Problems

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7-58 Chapter 7 ● Tax Credits

David and Darlene received the following letter from Sam’s daycare provider:

Required: Complete the Jaspers’ federal tax return for 2019. Use Form 1040, Schedule 1, Schedule 3, Schedule A, Schedule B, Form 2441, and Form 8880, as needed. Make realistic assumptions about any missing data.

2A. Steve Jackson (birthdate December 13, 1966) is a single taxpayer living at 3215 Pacific Dr., Apt. B, Pacific Beach, CA 92109. His Social Security number is 465-88-9415. In 2019, Steve’s earnings and income tax withholding as laundry attendant of a local hotel are:

Earnings from the Ocean View Hotel $21,900 Federal income tax withheld 219 State income tax withheld 100

Steve has a daughter, Janet, from a previous marriage. Janet is 11 years old (Social Security number 654-12-6543). Steve provides all Janet’s support. Also living with Steve is his younger brother, Michael (Social Security number 667-21-8998). Michael, age 47, is unable to care for himself due to a disability. On a reasonably regular basis, Steve has a care giver come to the house to help with Michael. He uses a company called HomeAid, 456 La Jolla Dr., San Diego, CA 92182 (EIN 17-9876543). Steve made

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7-59

payments of $1,000 to HomeAid in 2019. Janet receives free after-school care provided by the local school district.

Required: Complete Steve’s federal tax return for 2019. Use Form 1040, Schedule 3, Form 2441, Child Tax Credit Worksheet, Form 8812, EITC Worksheet A, and Schedule EIC.

2B. David Fleming is a single taxpayer living at 169 Trendie Street, Apartment 6B, La Jolla, CA 92037. His Social Security number is 865-68-9635 and his birthdate is September 18, 1974. David was employed as a delivery person for a local pizza restaurant. David’s W-2 showed the following:

865-68-9635

23-4567321

California Pizza Cafe 231 Foodie Street La Jolla, CA 92037

David Fleming 169 Trendie Street, Apt 6B La Jolla, CA 92037

CA D4567221 23,654.00 367.77

23,654.00

1,279.00

1,446.55

342.98

David’s only other source of income during the year was a prize he won appearing on a game show. The game show sent David home with a Form 1099-MISC:

Form 1099-MISC

2019 Miscellaneous Income

Copy B For Recipient

Department of the Treasury - Internal Revenue Service

This is important tax information and is being furnished to the IRS. If you are

required to �le a return, a negligence

penalty or other sanction may be

imposed on you if this income is

taxable and the IRS determines that it

has not been reported.

OMB No. 1545-0115

CORRECTED (if checked) PAYER’S name, street address, city or town, state or province, country, ZIP or foreign postal code, and telephone no.

PAYER’S TIN RECIPIENT’S TIN

RECIPIENT’S name

Street address (including apt. no.)

City or town, state or province, country, and ZIP or foreign postal code

Account number (see instructions) FATCA �ling requirement

1 Rents

$ 2 Royalties

$ 3 Other income

$ 4 Federal income tax withheld

$ 5 Fishing boat proceeds

6 Medical and health care payments

$ 7 Nonemployee compensation

8 Substitute payments in lieu of dividends or interest

$ 9 Payer made direct sales of

$5,000 or more of consumer products to a buyer (recipient) for resale

10 Crop insurance proceeds

$ 11 12

13 Excess golden parachute payments

14 Gross proceeds paid to an attorney

$ 15a Section 409A deferrals

15b Section 409A income

16 State tax withheld

$ $

17 State/Payer’s state no. 18 State income

$ $

Form 1099-MISC (keep for your records) www.irs.gov/Form1099MISC

Price is Accurate Studios, Inc. Studio 44 Studio City, CA 91604

21-8675309 865-68-9635

10,000.00 2,400.00

David Fleming

169 Trendie Street, Apt 6B

La Jolla, CA 92037

200.00 10,000.00

Questions and Problems

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7-60 Chapter 7 ● Tax Credits

1. The following information is available for the Albert and Allison Gaytor family in addition to that provided in Chapters 1–6. The Gaytors paid tuition and fees for both Crocker and Cayman to attend college.

Recall that Crocker is a freshman at Brickell State and Cayman is a part-time student in community college. Crocker received a $995 scholarship from Brickell State. Crocker’s Form 1098-T is shown below. The Gaytors paid tuition and fees of $1,400 for Cayman in 2019.

GrOUp 5:

CUMULATIVE SOFTWARE PROBLEM

He has no other adjustments to income or deductible expenses. Unfortunately, David’s employer did not provide health care to its employees but David signed up for coverage through his state’s health care exchange. The exchange sent him a Form 1095-A as shown on Page 7-61.

Required: Complete David’s federal tax return for 2019. Use Form 1040, Schedule 1, Schedule 2, and Form 8962. Make realistic assumptions about any missing data.

In December 2018, Albert’s 82 year-old aunt, Virginia Everglades (Social Security number 699-19-9000), was unable to support herself and moved in with the Gaytors. She lived with them for all of 2019. The Gaytors provided more than one-half of Aunt Virginia’s support. Virginia’s only source of income is a small annuity that paid her $3,100 in 2019. While Albert and Allison were working, the Gaytors hired a nanny service from time to time to take care of Aunt Virginia. The Gaytors paid $3,400 to Nannys R Us in 2019. Nannys R Us (EIN 34-1234123) is located at 80 SW 22nd Avenue, Miami, FL 33133.

Required: Combine this new information about the Gaytor family with the information from Chapters 1–6 and complete a revised 2019 tax return for Albert and Allison. Be sure to save your data input files since this case will be expanded and completed with more tax information in Chapter 8.

Brickell State University 605 Crandon Blvd. Key Biscayne, FL 33149

44-3421456 261-55-1212

Crocker Gaytor

12340 Cocoshell Rd

Coral Gables, FL 33134

4,750.00

995.00

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7-61

DO NOT FILE June 7, 2019

DRAFT AS OF

DO NOT FILE June 7, 2019

DRAFT AS OF

Form 1095-A 2019Department of the Treasury

Internal Revenue Service

Health Insurance Marketplace Statement ▶ Do not attach to your tax return. Keep for your records.

▶ Go to www.irs.gov/Form1095A for instructions and the latest information.

OMB No. 1545-2232VOID

CORRECTED

Part I Recipient Information

1 Marketplace identi�er 2 Marketplace-assigned policy number 3 Policy issuer’s name

4 Recipient’s name 5 Recipient’s SSN 6 Recipient’s date of birth

7 Recipient’s spouse’s name 8 Recipient’s spouse’s SSN 9 Recipient’s spouse’s date of birth

10 Policy start date 11 Policy termination date 12 Street address (including apartment no.)

13 City or town 14 State or province 15 Country and ZIP or foreign postal code

Part II Covered Individuals

A. Covered individual name B. Covered individual SSN C. Covered individual date of birth

D. Coverage start date E. Coverage termination date

Part III Coverage Information

Month A. Monthly enrollment premiums B. Monthly second lowest cost silver plan (SLCSP) premium

C. Monthly advance payment of premium tax credit

21 January

22 February

23 March

24 April

25 May

26 June

27 July

28 August

29 September

30 October

31 November

32 December

33 Annual Totals

For Privacy Act and Paperwork Reduction Act Notice, see separate instructions. Cat. No. 60703Q Form 1095-A (2019)

31-9876543 B1234TH Covered California

David Fleming 865-68-9635 09/18/1974

01/01/2019 12/31/2019 169 Trendie St. Apt 6B

La Jolla CA 92037

David Fleming 865-68-9635 09/18/1974 01/01/2019 12/31/2019

308.00

3,696.00

339.00

4,068.00

145.00

1,740.00

Questions and Problems

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7-62 Chapter 7 ● Tax Credits

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7-63Questions and Problems

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7-64 Chapter 7 ● Tax Credits

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7-65Questions and Problems

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7-66 Chapter 7 ● Tax Credits

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7-67Questions and Problems

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7-68 Chapter 7 ● Tax Credits

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7-69Questions and Problems

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7-70 Chapter 7 ● Tax Credits

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7-71Questions and Problems

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7-72 Chapter 7 ● Tax Credits

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7-73Questions and Problems

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7-74 Chapter 7 ● Tax Credits

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7-75Questions and Problems

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7-76 Chapter 7 ● Tax Credits

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7-77Questions and Problems

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7-78 Chapter 7 ● Tax Credits

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7-79

Wages, salaries

Adjusted gross income

Questions and Problems

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7-80 Chapter 7 ● Tax Credits

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7-81Questions and Problems

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7-82 Chapter 7 ● Tax Credits

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7-83Questions and Problems

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7-84 Chapter 7 ● Tax Credits

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7-85

Student Name

Class/Section

Date

K e y N Um B e r ta x r e t U r N sUm m a ry

ChAPTER 7

Comprehensive Problem 1

Adjusted Gross Income (Line 8b)

Taxable Income (Line 11b)

Total Nonrefundable Credits (Schedule 3, Line 7)

Child Tax Credit (Line 13a)

Amount Overpaid (Line 20)

Comprehensive Problem 2A

Adjusted Gross Income (Line 8b)

Taxable Income (Line 11b)

Credit for Child and Dependent Care Expenses (Schedule 3, Line 2)

Earned Income Credit (line 18a)

Amount Overpaid (Line 20)

Comprehensive Problem 2B

Adjusted Gross Income (Line 8b)

Taxable Income (Line 11b)

Excess Advance Premium Tax Credit Repayment (Schedule 2, Line 2)

Total Tax (Line 16)

Amount Overpaid (Line 20)

Questions and Problems

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A nd

y D

ea n

Ph ot

og ra

ph y/

Sh ut

te rs

to ck

.c om

C h a p t e r 8

Depreciation and Sale of Business Property

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8-1

L E A R N I N G O B J E C T I V E S

After completing this chapter, you should be able to: LO 8.1 Explain the concept of depreciation. LO 8.2 Calculate depreciation expense using the MACRS tables. LO 8.3 Identif y when a Section 179 election to expense the cost of property may be used. LO 8.4 Apply the limitations placed on depreciation of “listed property.” LO 8.5 Apply the limitations on depreciation of “luxury automobiles.” LO 8.6 Calculate the amortization of goodwill and certain other intangibles. LO 8.7 Classif y gains and losses from Section 1231 assets. LO 8.8 Apply the depreciation recapture rules. LO 8.9 Apply the general treatment of casualty gains and losses for business purposes. LO 8.10 Compute the gain on installment sales. LO 8.11 Calculate recognized and deferred gains on like-kind exchanges. LO 8.12 Calculate recognized and deferred gains on involuntary conversions.

8-1

O V e r V I e W

T he calculation of depreciation of business assets is an important issue for most busi- nesses. The Modified Accelerated Cost Recovery System (MACRS) is the tax depre-

ciation method currently in use under U.S. tax law. Many special depreciation provisions which are discussed in this chapter includ ing bonus depre- ciation and the election to expense (Section 179) were updated by the TCJA starting in 2018.

The chapter covers the tax treatment of goodwill, going-concern value, covenants not to compete, franchises, trademarks, and other intangibles. Also covered is the limitation on the deduction of losses realized in certain related- party transactions.

As discussed in Chapter 4, realized gains and losses are generally recognized for tax purposes unless there is a tax provision that specifically allows

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8-2 Chapter 8 ● Depreciation and Sale of Business Proper ty

8-1 DEpRECIATION Since many assets are used in the production of income over a number of years, accrual- based income is not properly measured if the entire cost of these assets is deducted in the year the assets are purchased. Depreciation is the accounting process of allocating and deducting the cost of an asset over a period of years. The term depreciation does not neces- sarily mean physical deterioration or loss of value of the asset. In fact, in some cases the value of the asset may increase while it is being depreciated. Certain assets, such as land, cannot be depreciated for tax purposes. Under U.S. tax law, land is considered an asset that is not subject to obsolescence. These assets remain on the taxpayer’s records at original cost.

It is important to distinguish maintenance expenses from depreciation. Depreciation expense is the deduction of a portion of the original cost of the asset, whereas maintenance expenses are those expenditures incurred to keep the asset in good operating condition. For example, a taxpayer who purchases a truck for use in his business depreciates the cost of the truck over a period of years. Maintenance costs such as tires and repairs are deducted in the year they are incurred.

The simplest method of depreciation is the straight-line method. Use of the straight-line method results in an equal portion of the cost being deducted in each period of the asset’s life. Straight-line depreciation expense is calculated by dividing the cost by the asset’s estimated useful life. The formula is:

Cost Estimated useful life

5 Depreciation for the period

EXAMpLE Wilson purchases an asset for use in his business. The asset cost $14,400 on October 1, 20X1, and has a 3-year (36-month) useful life. Depreciation is calculated as follows:

$14,400 36 months

5 $400 per month

The depreciation for each year is displayed in the following table:

Year Months Rate Depreciation Deduction

20X1 3 $400 $ 1,200 20X2 12 400 4,800 20X3 12 400 4,800 20X4 9 400 3,600 Total depreciation deduction $14,400

At the end of 36 months, the asset has a basis of $0. ♦

The calculation of depreciation expense for tax purposes involves certain conventions and limitations which are not reflected in the previous example. The example is intended to illustrate the concept of depreciation expense as an allocation of the cost of an asset over the asset’s estimated useful life. If more information is needed about depreciation, see any standard financial accounting textbook.

Learning Objective 8.1 Explain the concept of depreciation.

for a different treatment. This chapter focuses on business-related gains and losses. Transactions covered in this chapter include: 1. Section 1231 (business) gains and losses 2. Depreciation recapture on business assets 3. Installment sales 4. Like-kind exchanges 5. Involuntary conversions

Unlike capital gains and losses which are generally reported on Schedule D, many business asset sale transactions are reported on Form 4797, and installment sales are reported on Form 6252.

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8-38-2 Modified Accelerated Cost Recover y System (MACRS) and Bonus Depreciation

Self-Study problem 8.1 See Appendix E for Solutions to Self-Study Problems

On March 1, 20X1, Jack purchases office equipment for use in his business. The equipment cost $3,500 and has a 5-year (60-month) estimated useful life. Calculate the depreciation expense for the following years, assuming the regular straight-line depreciation method (used for financial accounting purposes or for pre-1981 assets) is used.

Year Depreciation Deduction

20X1 $ 20X2 $ 20X3 $ 20X4 $ 20X5 $ 20X6 $ Total $

8-2 MODIfIED ACCELERATED COST RECOVERy SySTEM (MACRS) AND BONuS DEpRECIATION

For tax years after 1980, modifications in the tax law were made to encourage capital invest- ment. As a major part of this tax law change, the Accelerated Cost Recovery System (ACRS) was enacted and later modified in 1986 to become the current tax depreciation system referred to as the Modified Accelerated Cost Recovery System (MACRS). The current MACRS allows taxpayers who invest in capital assets to write off an asset’s cost over a period designated in the tax law and to use an accelerated method for depreciation of assets other than real estate. The minimum number of years over which the cost of an asset may be deducted (the recovery period) depends on the type of the property and the year in which the property was acquired. The recovery periods are based on asset depreciation ranges (ADRs) as published by the IRS. A schedule of the recovery periods for assets acquired after 1986 is presented in Table 8.1.

8.2 Learning Objective Calculate depreciation expense using the MACRS tables.

Recovery period

3-year 5-year

7-year

10-year 15-year

20-year

27.5-year

39-year

Recovery Method 200% declining balance 200% declining balance

200% declining balance

200% declining balance 150% declining balance

150% declining balance

Straight-line

Assets ADR midpoint life of 4 years or less, excluding cars and light trucks. ADR midpoint life of more than 4 years but less than 10 years, cars and light trucks, office machinery, certain energy property, R&D property, computers, and certain equipment. ADR midpoint life of 10 years or more but less than 16 years and property without an ADR life (e.g., most business furniture and certain equipment). ADR midpoint life of 16 years or more but less than 20 years, including trees and vines. ADR midpoint life of 20 years or more but less than 25 years, including treatment plants and land improvements (sidewalks, roads, fences, and landscaping). ADR midpoint life of 25 years or more, other than real property with an ADR life of 27.5 years or longer and municipal sewers. Residential rental real estate, elevators, and escalators.

Other real property purchased generally on or after May 13,1993 (previously 31.5-year straight-line).

TABLE 8.1 RECOVERy pERIODS fOR ASSETS pLACED IN SERVICE AfTER 1986

The regular straight-line depreciation method described above may be used for financial accounting purposes and for calculating tax depreciation expense on assets acquired before 1981. The tax depreciation rules for assets acquired after 1980 are described in the following sections of this chapter.

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8-4 Chapter 8 ● Depreciation and Sale of Business Proper ty

The recovery period classification for assets acquired after 1980, but before 1987, differs from the recovery period classification presented in Table 8.1.

Under MACRS, taxpayers calculate the depreciation of an asset using a table which contains a percentage rate for each year of the property’s recovery period. The yearly rate is applied to the cost of the asset. The cost of the property to which the rate is applied is not reduced for prior years’ depreciation. For personal property (all property except real estate) the percentages in Table 8.2 apply.

EXAMpLE Assume a taxpayer acquires an asset (5-year class property) in 2019 with a cost basis of $15,000 and uses accelerated depreciation under MACRS. The depreciation expense deduction for each year of the asset’s life is calculated (using the percentages in Table 8.2) as follows:

Year Percent Cost Deduction 2019 20.00 3 $15,000 5 $ 3,000 2020 32.00 3 15,000 5 4,800 2021 19.20 3 15,000 5 2,880 2022 11.52 3 15,000 5 1,728 2023 11.52 3 15,000 5 1,728 2024 5.76 3 15,000 5 864 Total 100.00% $15,000

In the above example, note that even though the asset is a 5-year class property, the cost is written off over a period of 6 tax years. This is due to the convention under MACRS which provides for 6 months of depreciation during the year the asset is first acquired and 6 months of depreciation during the year the asset is fully depreciated, sold, or disposed. This convention is referred to as the half-year convention since only one-half of the year of depreciation is allowed in both the year of acquisition and the year of disposition, regardless of the actual acquisition and disposition dates. The half-year convention is built into the rates in Table 8.2.

♦

Accelerated Depreciation for personal property Assuming Half-year Convention (for property placed in Service after December 31, 1986)

1 ............... 33.33 20.00 14.29 10.00 5.00 3.750 2 ............... 44.45 32.00 24.49 18.00 9.50 7.219 3 ................14.81* 19.20 17.49 14.40 8.55 6.677 4 ................. 7.41 11.52* 12.49 11.52 7.70 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* 5.90* 4.888 8 ................................................................... 4.46 6.55 5.90 4.522

9 ........................................................................................ 6.56 5.91 4.462* 10 ........................................................................................ 6.55 5.90 4.461 11 ........................................................................................ 3.28 5.91 4.462 12 ............................................................................................................... 5.90 4.461 13 ............................................................................................................... 5.91 4.462 14 ............................................................................................................... 5.90 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

Recovery year

3-year (200% DB)

5-year (200% DB)

7-year (200% DB)

10-year (200% DB)

15-year (150% DB)

20-year (150% DB)

TABLE 8.2

*Switch to straight-line depreciation.

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8-58-2 Modified Accelerated Cost Recover y System (MACRS) and Bonus Depreciation

For property (other than real estate), a taxpayer may elect to use straight-line depreciation instead of the accelerated depreciation rates under MACRS. The taxpayer must use the straight-line MACRS tables for assets for which a straight-line election has been made. The annual percentage rates to be applied to the cost of an asset for which a straight- line election under MACRS has been made are presented in Table 8.3.

EXAMpLE On April 1, 2019, Lori purchased and placed in service a specialized computer for use in her business. The computer cost $18,000 and Lori elects to use straight-line depreciation over 5 years instead of accelerated depreciation under MACRS. The annual deduction for depreciation over the life of the computer is calculated below (the percentages are taken from Table 8.3).

Year Percent Cost Deduction

2019 10.00 3 $18,000 5 $ 1,800 2020 20.00 3 18,000 5 3,600 2021 20.00 3 18,000 5 3,600 2022 20.00 3 18,000 5 3,600 2023 20.00 3 18,000 5 3,600 2024 10.00 3 18,000 5 1,800 Total 100.00% $18,000

Note that Lori receives a deduction based on 6 months in the year of purchase (half-year convention), even though the asset was put into service on April 1. If the asset had been placed into service on September 1, Lori still would have received a deduction for 6 months of depreciation. ♦

Under MACRS, the same method of depreciation (accelerated or straight-line) must be used for all property in a given class placed in service during that year.

8-2a Mid-Quarter Convention When a taxpayer acquires a significant amount of assets during the last quarter of the tax year, the half-year convention, referred to in the above examples, is replaced by the mid-quarter convention. The mid-quarter convention must be applied if more than 40 percent of the total cost of a taxpayer’s property acquired during the year, other than real property, is placed in service during the last 3 months of the tax year. The mid-quarter

Straight-Line Depreciation for personal property, Assuming Half-year Convention* (for property placed in Service after December 31, 1986)

Recovery % first Other

Recovery years Last

Recovery years period Recovery year years % year %

3-year 16.67 2–3 33.33 4 16.67 5-year 10.00 2–5 20.00 6 10.00 7-year 7.14 2–7 14.29 8 7.14 10-year 5.00 2–10 10.00 11 5.00 15-year 3.33 2–15 6.67 16 3.33 20-year 2.50 2–20 5.00 21 2.50

*The official table contains a separate row for each year. For ease of presentation, certain years are grouped together in this table. In some instances, this will cause a difference of 0.01 percent for the last digit when compared with the official table.

TABLE 8.3

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8-6 Chapter 8 ● Depreciation and Sale of Business Proper ty

convention treats all property placed in service during any quarter of the tax year as being placed in service on the midpoint of the quarter. The mid-quarter convention, if applied in the year the asset is acquired, also applies upon the disposition of the asset. Assets placed in service and disposed of during the same tax year are not considered in determining whether the taxpayer meets the 40-percent test. An excerpt from the mid-quarter tables can be found in Table 8.4. Complete mid-quarter tables may be found at any of the major tax services (such as CCH IntelliConnect or Thomson Reuters Checkpoint).

EXAMpLE Jane, a calendar-year taxpayer, purchases the following property during 2019 for use in her business:

Placed in Original Recovery Service Property Cost Period

March 2 Office furniture $ 3,000 7 years July 31 Apartment building 200,000 27.5 years November 1 Automobile 18,000 5 years

Recovery year

3-year (200% DB)

5-year (200% DB)

7-year (200% DB)

first Quarter 1 58.33 35.00 25.00 2 27.78 26.00 21.43 3 12.35 15.60 15.31 4 1.54 11.01 10.93 5 11.01 8.75

Second Quarter 1 41.67 25.00 17.85 2 38.89 30.00 23.47 3 14.14 18.00 16.76 4 5.30 11.37 11.97 5 11.37 8.87

Third Quarter 1 25.00 15.00 10.71 2 50.00 34.00 25.51 3 16.67 20.40 18.22 4 8.33 12.24 13.02 5 11.30 9.30

fourth Quarter 1 8.33 5.00 3.57 2 61.11 38.00 27.55 3 20.37 22.80 19.68 4 10.19 13.68 14.06 5 10.94 10.04

*For ease of presentation, only 3-year, 5-year, and 7-year property and only depreciation rates for the first 5 years are provided. The official table also includes 10- ,15- , and 20-year property. See IRS Publication 946 for the complete table.

TABLE 8.4

Accelerated Depreciation for personal property Assuming Mid-Quarter Convention* (for property placed in Service after December 31, 1986)

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8-78-2 Modified Accelerated Cost Recover y System (MACRS) and Bonus Depreciation

Jane does not elect Section 179 and elects out of bonus depreciation. The cost of the automobile acquired during the last 3 months of the year represents 86 percent of the total cost of assets, other than real property, acquired during the tax year. Since more than 40 percent of Jane’s purchases, other than real property, were made during the last 3 months of the tax year, the mid-quarter convention would apply. Depreciation for 2019 on the furniture is $750 ($3,000 3 25%) and on the auto is $900 ($18,000 3 5%). ♦

8-2b Bonus Depreciation Because the cost recovery of long-lived assets occurs over many years, one way to lower the after-tax cost of capital expenditures is through accelerated depreciation. At times, the tax law has provided for “bonus depreciation,” which is the immediate deduction of all or some of the cost of otherwise slowly depreciated property. The TCJA increased the bonus depreciation percentage to 100 percent for qualified property acquired and placed in service after September 27, 2017 and through December 31, 2022 (certain long-lived assets have an addi tional year), but the 100 percent bonus depreciation phases out starting in 2023 as follows:

Year Bonus Percentage

2023 80 2024 60 2025 40 2026 20 2027 0

The bonus depreciation rules allow taxpayers purchasing property with a MACRS recovery period of 20 years or less (see Table 8.1), computer software, and certain leasehold improvements to directly write off up to 100 percent of the cost of the assets in the year placed in service. Bonus depreciation is presumed to apply unless the taxpayer elects out of the provision. The taxable income limits and thresholds associated with Section 179 (see LO 8.3) do not apply to bonus depreciation.

Both new and used property are generally eligible for bonus depreciation.

EXAMpLE Mary places a new 5-year MACRS-class machine costing $20,000 into service on March 1, 2019. She does not elect out of bonus depreciation on the machine. The bonus depreciation on the machine for 2019 is $20,000. The basis is reduced to $0 and no additional MACRS depreciation on the machine is deducted. ♦

Between bonus depreciation and the expanded immediate expensing under Section 179, small businesses are not likely to capitalize the cost of any non-real property unless they have a net operating loss or anticipate using larger depreciation deductions during higher tax bracket years in the future.

8-2c Real Estate For real estate acquired after 1986, MACRS requires the property to be depreciated using the straight-line method. The straight-line MACRS realty tables for residential realty (e.g., an apartment building) provide for depreciation over 27.5 years. Nonresidential realty (e.g., an office building) is depreciated over 39 years (31.5 years for realty acquired generally before May 13, 1993). The annual depreciation percentages for real estate under MACRS are shown in Table 8.5.

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8-8 Chapter 8 ● Depreciation and Sale of Business Proper ty

Straight-Line Depreciation for Real property Assuming Mid-Month Convention*

27.5-year Residential Real property

The applicable annual percentage is (use the column for the month in the first year the property is placed in service):

Recovery year(s) 1 2 3 4 5 6 7 8 9 10 11 12

1 3.485 3.182 2.879 2.576 2.273 1.970 1.667 1.364 1.061 0.758 0.455 0.152 2–18 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636

19–27 3.637 3.637 3.637 3.637 3.637 3.637 3.637 3.637 3.637 3.637 3.637 3.637 28 1.970 2.273 2.576 2.879 3.182 3.485 3.636 3.636 3.636 3.636 3.636 3.636 29 0.000 0.000 0.000 0.000 0.000 0.000 0.152 0.455 0.758 1.061 1.364 1.667

39-year Nonresidential Real property The applicable annual percentage is (use the column for the month in the first year the property is placed in service):

Recovery year(s) 1 2 3 4 5 6 7 8 9 10 11 12

1 2.461 2.247 2.033 1.819 1.605 1.391 1.177 0.963 0.749 0.535 0.321 0.107

2–39 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564

40 0.107 0.321 0.535 0.749 0.963 1.177 1.391 1.605 1.819 2.033 2.247 2.461

*The official tables contain a separate row for each year. For ease of presentation, certain years are grouped together in these two tables. In some instances, this will produce a difference of .001 percent when compared with the official tables.

TABLE 8.5

EXAMpLE Carlos purchases a rental house on September 3, 2019, for $90,000 (the land is accounted for separately). The house is already rented to a tenant. The annual depreciation expense deduction under MACRS for each of the first 4 years is illustrated below (the percentages are taken from Table 8.5, 27.5-Year Residential Real Property).

Year Percent Cost Deduction

2019 1.061 3 $90,000 5 $ 955 2020 3.636 3 90,000 5 3,272 2021 3.636 3 90,000 5 3,272 2022 3.636 3 90,000 5 3,272

Note that the percentages are taken from Table 8.5 under column 9, because the month of acquisition (September) is the ninth month of the year. ♦

Since 2018, most real property is not eligible for bonus depreciation or Section 179 immediate expensing (LO 8.3).

8-2d Mid-Month Convention For the depreciation of real property under MACRS, a mid-month convention replaces the half-year convention. Real estate is treated as placed in service in the middle of the month the property is placed in service. Likewise, a disposition during a month is treated as oc- curring on the midpoint of such month. For example, under the mid-month convention,

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8-98-2 Modified Accelerated Cost Recover y System (MACRS) and Bonus Depreciation

Self-Study problem 8.2 See Appendix E for Solutions to Self-Study Problems

During 2019, Mary Moser purchases the following items for use in her business:

Manufacturing equipment $ 12,000 (7-year property, placed in service August 1) Office furniture 4,000 (7-year property, placed in service December 15) Office building, land is accounted for separately 175,000 (placed in service March 30)

Assume that Mary uses the accelerated depreciation method under MACRS.

a. Use Form 4562 on Pages 8-11 and 8-12 to report Mary’s depreciation deduction for 2019 including bonus depreciation.

b. Calculate Mary’s depreciation (but do not complete Form 4562) assuming she elects out of bonus depreciation.

7-year property $

Office building $

c. Calculate Mary’s depreciation deduction on the assets for 2020 (Year 2). Compute amounts assuming bonus depreciation was taken in 2019.

year 2 Depreciation Deduction

7-year property $

Office building $

an asset purchased and placed in service on April 2 is treated as being placed in service on April 15. The mid-month convention is built into the first year’s rates in Table 8.5.

8-2e Reporting Depreciation Expense Depreciation expense is reported on Form 4562, Depreciation and Amortization. Individual taxpayers who have no current year asset additions and who are not reporting depreciation on listed property (see LO 8.4) are not required to file Form 4562 with their return.

Intuit ProConnect includes a powerful depreciation calculator included as part of the software. There are two ways to report depreciation. The first method is to enter the property details into the software. Property can be entered through either a quick entry or detail input screen. Both are located under Deductions. The first subheading in the left-hand margin is depreciation. The property is linked to a business (for example, Schedule C or Schedule E). Based on the type and cost of property placed in service, the software will automatically apply bonus depreciation (“SDA”) unless overridden in the detail screen. Section 179 immediate expensing can be input directly. The second method is to compute depreciation outside the ProConnect software and input the deduction as an override. There are screens for direct input located under the normal depreciation screens in the left-hand margin.

tIp

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8-10 Chapter 8 ● Depreciation and Sale of Business Proper ty

8-3 ELECTION TO EXpENSE (SECTION 179) As part of the landmark Tax Reform Act of 1986, Internal Revenue Code Section 179 was implemented to decrease the cost of investments in business property by permitting small businesses to expense the costs of certain property that would otherwise be capitalized and depreciated over time.

Under Section 179, taxpayers may elect to expense the acquisition cost of certain property, subject to certain limitations. This cost would otherwise have been deducted over a period of time using the regular cost recovery depreciation rules. Similar to bonus depreciation, the Section 179 deduction applies to both new and used property. To qualify for this limited expensing election, the property must be personal property (property other than real estate or assets used in residential real estate rental activities except for certain qualified improvement property, the treatment of which is beyond the scope of this textbook) placed in service during the year and used in a trade or business.

Section 179 places three limitations on the expensing election: (1) a maximum on the annual amount expensed, (2) a phase-out of the annual amount limit, and (3) the taxable income limit.

Originally, the maximum annual expensing amount was a modest $10,000. Over the years the amount was adjusted for inflation and also increased with economic stimulus in mind. As a result of the financial crisis, the annual maximum was increased to $250,000 in 2008 and then increased again to $500,000 in 2010. Although subject to repeated expiration and extension, the limit had remained at $500,000 until 2015 when it was made permanent and subject to inflation adjustment each year. The maximum annual amount that can be expensed under Section 179 is $1,020,000 in 2019.

The annual maximum expense amount is reduced dollar-for-dollar by the amount of Section 179 property acquired during the year in excess of a threshold amount. Similar to the annual limit, the Section 179 phase-out threshold amount has fluctuated over time. In 2019, the threshold is $2,550,000. As a result, a taxpayer that acquires $3,570,000 or more of Section 179 property during 2019 may not immediately expense under Section 179.

Lastly, the amount of acquired qualified property that may be expensed annually is limited to the taxpayer’s taxable income, before considering any amount expensed under the Section 179 election, from any trade or business of the taxpayer. Any amount which is limited due to the taxable income limitation may be carried over to succeeding tax years.

EXAMpLE During 2019, Bob buys used equipment that cost $1,520,000 for his factory. Bob’s business generates taxable income of well over $3,000,000 and he elects out of bonus depreciation. Bob’s Section 179 property placed in service is below $2,550,000 and thus is not subject to phase-out. With $3 million in taxable income, Bob’s Section 179 deduction is not subject to the income limitation. Bob may immediately expense $1,020,000 of his equipment. The remaining $500,000 of equipment cost will be depreciated over the recovery period under MACRS. ♦

EXAMpLE During 2019, Joe places in service used manufacturing equipment for use in his business. The machinery cost $1,030,000. Joe has taxable income (after considering any MACRS depreciation) from his business of $200,000. Under the annual maximum limitation, Joe can immediately expense up to $1,020,000 and would depreciate the remaining $10,000 under MACRS. However, the maximum amount under the taxable income limitation is only $200,000. The remaining $820,000 ($1,020,000 annual maximum less $200,000 permitted under the income limit) is carried forward to succeeding tax years. ♦

Learning Objective 8.3 Identify when a Section 179 election to expense the cost of property may be used.

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8-118-3 Election to Expense (Section 179)

Self-Study problem 8.2

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8-138-3 Election to Expense (Section 179)

EXAMpLE During 2019, Portia purchased $2,760,000 of new equipment for use in her business. Portia’s taxable income before considering immediate expensing is over $4 million. Because the amount of Section 179 property placed in service during the year exceeds the phase-out threshold of $2,550,000, Portia’s annual Section 179 expensing limit of $1,020,000 is reduced by the $210,000 phase-out ($2,760,000 2 $2,550,000) resulting in a maximum allowable expensing amount of only $810,000. ♦

A taxpayer who has made the Section 179 election to expense must reduce the basis of the asset by the amount expensed before calculating regular MACRS depreciation on the remaining cost of the asset. Even if the taxpayer is not able to deduct the full amount expensed in the current year due to the taxable income limitation, the basis must be reduced by the full amount of the Section 179 expense election.

When calculating depreciation on an asset, if an election to expense only part of the asset has been made, the amount of the Section 179 election to expense must be decided first. When a taxpayer decides to take only a portion of the cost of the asset as a Section 179 deduction, the rest of the cost of the asset must be depreciated. The depreciation must be deducted from taxable income to determine the income limitation for the Section 179 deduction.

EXAMpLE On August 1, 2019, Joan purchases a machine for use in her business. It is her only purchase of business property in 2019. The machine cost $1,050,000 and qualifies as 5-year MACRS property. Her business income before any cost recovery is $1,008,000. Joan elects to immediately expense the entire $1,020,000. She elects out of bonus depreciation, thus $30,000 of remaining basis is subject to MACRS depreciation of $6,000 ($30,000 3 0.20 depreciation factor). As a result of deducting MACRS depreciation of $6,000, Joan’s taxable income before Section 179 is reduced to $1,002,000. Joan may only immediately expense $1,002,000 due to the income limit. The excess $18,000 of Section 179 deduction will be carried forward to 2020. ♦

The effects of bonus depreciation, Section 179 and MACRS depreciation can combine to create substantially accelerated cost recovery. If a taxpayer elects Section 179 immediate expensing and uses bonus depreciation, the cost basis of the property is first reduced by the Section 179 deduction, then by bonus depreciation then lastly, by typical MACRS depreciation. With 100 percent bonus depreciation, the need to deduct Section 179 and then bonus depreciation is an unlikely occurrence since the entire cost of many types of property can be recovered under bonus depreciation without annual or income limits.

Self-Study problem 8.3 See Appendix E for Solutions to Self-Study Problems

On June 15, 2019, Chang purchases $2,837,000 of equipment (7-year property) for use in her business. It is her only purchase of business property in 2019. Chang has taxable income from her business of $2.5 million before any cost recovery.

a. Assuming Chang does not elect Section 179 and elects out of bonus depreciation, what is her total 2019 cost recovery?

b. Assuming Chang elects the maximum Section 179 deduction allowable and elects out of bonus depreciation, what is her total 2019 cost recovery?

c. Assuming Chang does not elect Section 179 deduction allowable and does not elect out of bonus depreciation, what is her total cost recovery?

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8-14 Chapter 8 ● Depreciation and Sale of Business Proper ty

8-4 LISTED pROpERTy Congress felt some taxpayers were using the favorable tax incentives of the accelerated cost recovery system and the limited expensing election to claim depreciation deductions on assets used for personal purposes. To curtail this perceived abuse of the tax system, Congress enacted special rules which apply to the depreciation of “listed property.” Listed property includes those types of assets which lend themselves to personal use, including the following:

1. Passenger automobiles, defined to include any four-wheeled vehicle manufactured primarily for use on public streets, roads, and highways, rated at 6,000 pounds or less unloaded gross vehicle weight. Specifically excluded from the definition of passenger automobiles are vehicles used directly in the trade or business of transporting persons or property, ambulances and hearses used in a trade or business, and certain trucks and vans not likely to be used more than a de minimis amount for personal purposes, including vehicles which display the company name or advertising.

2. Other property used as a means of transportation (trucks, buses, boats, airplanes, and motorcycles), except vehicles which are not likely to be used for personal purposes, such as marked police cars, school buses, and tractors, or vehicles used for transporting persons or cargo for compensation.

3. Property generally used for entertainment, recreation, or amusement (video recording equipment, communication equipment, etc.).

If listed property is used 50 percent or less in a qualified business use, any depreciation deduction must be calculated using the straight-line method of depreciation over an alternate recovery period, and the special election to expense under Section 179 and bonus depreciation are not allowed.

Qualified business use does not include investment use or the use of property owned by an employee in performing services as an employee, unless the use meets the convenience-of-employer and condition-of-employment tests. In addition, the excess depreciation allowed by reason of the property meeting the more-than-50-percent-use test must be included in income if property which meets the test in one year subsequently fails to meet the more-than-50-percent-use test in a succeeding year.

EXAMpLE Oscar has an automobile he uses 45 percent of the time for personal use and 55 percent of the time in his accounting business. Since Oscar’s business- use percentage of 55 percent exceeds 50 percent, Oscar is not required to use the straight-line method in calculating depreciation. The accelerated depreciation method and the election to expense may be used by Oscar. ♦

Learning Objective 8.4 Apply the limitations placed on depreciation of “listed property.”

Self-Study problem 8.4 See Appendix E for Solutions to Self-Study Problems

For each of the following independent situations, indicate with a Y (yes) or an N (no) whether or not the taxpayer is required to depreciate the property using the straight-line method over the alternate recovery period:

Straight Line Required?

1. Alvarez uses an automobile 80 percent for his business and 20 percent for personal reasons.

2. Laura has a truck she uses in her business 55 percent of the time, 15 percent for her real estate investment, and 30 percent for personal use.

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8-158-5 Limitation on Depreciation of Luxur y Automobiles

8-5 LIMITATION ON DEpRECIATION Of LuXuRy AuTOMOBILES

In addition to the limitations on the depreciation of passenger automobiles imposed by the listed property rules discussed in the preceding section, the depreciation of passenger auto- mobiles is subject to an additional limitation, commonly referred to as the “luxury automo- bile” limitation. Regardless of the method of depreciation used by the taxpayer, accelerated or straight-line, the election to expense, or bonus depreciation, the amount of depreciation expense that may be claimed on a passenger automobile is subject to an annual dollar limita- tion. The annual dollar limitations that apply to passenger automobiles acquired in 2019 are listed below. Any automobile which would have actual MACRS depreciation exceeding the limits is considered a “luxury automobile” by the IRS for purposes of the depreciation limitation rules.

AnnuAl Automobile DepreciAtion limitAtions Year of Use 2019 Limits 2018 Limits Year 1 $18,100* $18,000* Year 2 16,100 16,000 Year 3 9,700 9,600 Year 4 (and subsequent 5,760 5,760 years until fully depreciated)

*Additional bonus depreciation of $8,000 is included in this amount.

Separate higher depreciation limits apply for certain trucks and vans and also for electric automobiles.

Some sport utility vehicles fall outside of the definition of passenger automobiles and can be depreciated or expensed under Section 179 or the bonus depreciation rules without regard to the automobile depreciation limits. To qualify for the exception, the sport utility vehicle must have a gross vehicle weight rating above 6,000 pounds. Vehicles that meet the large sport utility vehicle exception are limited to $25,000 in Section 179 expensing but may depreciate using the 5-year MACRS percentages without the typical auto depreciation limitations.

The annual limitations must be reduced to reflect the actual business-use percentage where business use is less than 100 percent.

EXAMpLE Sally purchased a new car for $60,000 in September 2019 which she uses 75 percent for business. Sally elects out of bonus depreciation. Depreciation on the automobile is calculated as follows:

Total cost $60,000 3 0.75 Limited to business use $45,000 MACRS depreciation (half-year convention) $45,000 3 20% 5 $ 9,000 Maximum luxury automobile depreciation allowed $10,100 3 75% 5 $ 7,575

Because the luxury automobile limitation is less than the actual depreciation calculated, Sally’s depreciation deduction is limited to $7,575. ♦

EXAMpLE In September 2019, Joan purchased a passenger automobile which cost $60,000. The automobile is used 100 percent for business purposes and

8.5 Learning Objective Apply the limitations on depreciation of “luxury automobiles.”

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8-16 Chapter 8 ● Depreciation and Sale of Business Proper ty

Joan elects out of bonus depreciation. A comparison of MACRS, with and without the limitation, is as follows:

Five-Year MACRS Annual Limit

Year 1 $12,000 $10,100 Year 2 19,200 16,100 Year 3 11,520 9,700 Year 4 6,912 5,760 Year 5 6,912 5,760 Year 6 3,456 5,760 Year 7 5,760 Year 8 1,060

Note that, although the automobile is a 5-year property, it will take 8 years to recover the entire cost of the asset because of the annual dollar limits, assuming no election to expense under Section 179 or bonus depreciation. ♦

Self-Study problem 8.5 See Appendix E for Solutions to Self-Study Problems

On June 17, 2019, Donald purchased a passenger automobile at a cost of $56,000. The automobile is used 90 percent for qualified business use and 10 percent for personal purposes. Calculate the depreciation expense (without bonus depreciation) for the automobile for 2019, 2020, and 2021, assuming half-year convention and no Section 179 immediate expensing.

Taxpayers hoping to get around the luxury auto depreciation limits by leasing an auto should be aware that there is a rule designed to put them in the same economic position as if they had purchased the auto. The IRS issued tables for computation of an “income inclusion” which must be used to reduce the lease expense deduction for leased autos.

TAX BREAK

Bonus depreciation on autos is subject to annual depreciation limits also. For years after the first year, the unrecovered basis of the auto is subject to MACRS depreciation but remains limited by the auto limits.

EXAMpLE Sally purchased a new automobile for $60,000 in September 2019 which she uses 100 percent for business during the life of the auto. Assuming half-year convention, bonus depreciation and no Section 179 depreciation, Sally’s 2019 cost recovery is computed as follows:

Cost basis $60,000 Depreciation limit for autos, Year 1 18,100 Basis unrecovered at end of 2019 $41,900

In 2020, MACRS depreciation is $13,408 (unrecovered basis of $41,900 3 32%, which is the depreciation factor for the second year of 5-year property). The second year limit of $16,100 exceeds the deduction and thus does not apply. ♦

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8-178-6 Intangibles

Duncan Devious (age 52) is a self-employed attorney. Duncan loves to be noticed in public and, therefore, he drives a 7,000-pound, military-type, SUV, the only vehicle he owns. When you are preparing his tax return, you notice that he claims 90 percent of his total auto expenses as a business deduction on his Schedule C and 10 percent as personal use, with total miles driven in 2019 as 10,000. You note from his home and office addresses on his tax return that he lives approximately 15 miles from his office. The total of the expenses (i.e., gas, oil, maintenance, depreciation) he claims is $31,200. He does not have a mileage log to substantiate the business use of the SUV. Would you sign the Paid Preparer’s declaration (see example above) on this return? Why or why not?

Would You Sign This

Tax Return?

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8-6 INTANGIBLES The current tax guidance provides for two main categories of intangibles: (1) Section 197 intangibles and (2) non-Section 197 intangibles. Section 197 intangibles are those acquired by a taxpayer as part of the acquisition of a trade or business. Section 197 intangibles are am- ortized over a 15-year period, beginning with the month of acquisition. Amortization is a cost recovery method similar to depreciation in that it spreads the cost recovery over a fixed period of years. It differs from depreciation in that it is applied to intangible assets rather than tangi- ble personal or real property and does not include the half-year or mid-quarter conventions. The 15-year life applies regardless of the actual useful life of the intangible asset. No other amortization or depreciation method may be claimed on Section 197 assets. When acquired as part of a trade or business, the following are defined as qualified Section 197 intangibles:

● Goodwill ● Going-concern value ● Workforce in place ● Information bases including business books and records and operating systems ● Know-how ● Customer-based intangibles ● License, permit, or right granted by a governmental unit ● Covenant not to compete ● Franchise, trademark, or trade name

EXAMpLE In March 2019, Mary purchases a business from Bill for $250,000. Section 197 goodwill of $36,000 is included in the $250,000 purchase price. Mary amortizes the goodwill over a 15-year period at the rate of $200 per month, starting with the month of purchase. ♦

8-6a Exclusions Many intangible assets are specifically excluded from the definition of Section 197 intan- gibles. Examples of these Section 197 exclusions include items which are not generally amortizable:

● Interests in a corporation, partnership, trust, or estate ● Interests in land

8.6 Learning Objective Calculate the amortization of goodwill and certain other intangibles.

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8-18 Chapter 8 ● Depreciation and Sale of Business Proper ty

Section 197 exclusions that are generally amortizable: ● Computer software readily available for purchase by the general public ● Interests in films, sound recordings, video recordings, and similar property ● Self-created intangible assets

Non-Section 197 intangibles that are separately acquired are generally amortized over their remaining useful life using the straight-line method. For example, a patent could be acquired as part of the purchase of a business (Section 197 intangible) or a patent could be acquired separately (non-Section 197 intangible). A franchise, trademark, or tradename is treated as a Section 197 intangible whether acquired as part of a business or not.

EXAMpLE Sam purchases computer software sold to the general public for $20,000. The $20,000 is not a Section 197 intangible and therefore the amount would be amortized under regular amortization rules (typically 3 years). ♦

Self-Study problem 8.6 See Appendix E for Solutions to Self-Study Problems

Indicate by check marks whether the following items are generally amortizable over 15 years, amortized over their useful life, or not amortized.

15-Year Amortization Useful Life Not Amortizable

1. Patent acquired as part of a business

2. Separately acquired film rights 3. Computer software sold

at an office supply store 4. Goodwill 5. Franchise 6. Land 7. Trademark 8. Interest in a corporation

8-7 SECTION 1231 GAINS AND LOSSES The first part of this chapter has dealt with the acquisition and cost recovery of business property. The remaining sections deal with the sale, exchange, or disposal of business property. The tax rules on capital gains and losses covered in Chapter 4 continue to apply here, but the tax law has been crafted in a way to provide capital treatment for certain business gains and losses and ordinary treatment for others. Unlike much of the tax law covered elsewhere in this textbook, these tax concepts often refer to the Internal Revenue Code section number as the identifying name. For example, Section 1231 is used to describe property used in a trade or business and held for more than one year. Deprecia- tion recapture is commonly referred to as Section 1245 or Section 1250 recapture.

Learning Objective 8.7 Classify gains and losses from Section 1231 assets.

tIp Amortization is entered into the software in the Depreciation section. Select Non-recovery/ Straight-line as the depreciation method. The recovery period (e.g., 15 years for Section 197 intangibles) must be input. An amortization code is available in the detailed input screen.

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8-198-7 Section 1231 Gains and Losses

Section 1231 assets are not capital assets (see Chapter 4), but they are given special tax treatment. Gains on Section 1231 assets may be treated as long-term capital gains, while losses in some cases may be deducted as ordinary losses. Section 1231 assets include:

1. Depreciable or real property used in a trade or business; 2. Timber, coal, or domestic iron ore; 3. Livestock (not including poultry) held for draft, breeding, dairy, or sporting purposes;

and 4. Unharvested crops on land used in a trade or business.

Any property held 1 year or less, inventory and property held for sale to customers, and copyrights, paintings, government publications, etc., are not Section 1231 property.

The calculation of net Section 1231 gains and losses is summarized as follows:

Combine all Section 1231 gains and losses to compute net Section 1231 gains or losses. If the gains exceed the losses, the excess is a long-term capital gain. When the losses exceed the gains, all gains are treated as ordinary income, and all losses are fully deductible as ordinary losses.

EXAMpLE Frank Harper had the following business gains and (losses) on the sale of business property during August of 2019:

Sale of land held for 4 years $ 9,500 Sale of truck held for 3 years (2,100) Sale of inventory 6,000

Frank’s Section 1231 gains and losses would be calculated as follows:

Gain on land $ 9,500 Loss on truck (2,100) Net Section 1231 gain $ 7,400

The $7,400 net Section 1231 gain would be treated as a long-term capital gain and would be reported on Form 4797 and transferred to Line 11 of Schedule D of Form 1040. Inventory is not Section 1231 property and thus results in an ordinary gain. ♦

Self-Study problem 8.7 See Appendix E for Solutions to Self-Study Problems

Gary Farmer had the following sales of business property during the 2019 tax year:

1. Sold land acquired on December 3, 2008, at a cost of $24,000, for $37,000 on January 5, 2019. The cost of selling the land was $500, and there was no depreciation allowable or capital improvements made to the asset over the life of the asset.

2. Sold a business computer with an adjusted basis of $20,700 that was acquired on April 5, 2016. The original cost was $25,875, and accumulated depreciation was $5,175. The computer was sold on May 2, 2019, for $14,000, resulting in a $6,700 loss.

3. Sold equipment on July 22, 2019 for gross proceeds of $16,000. The equipment was acquired on October 21, 2018 at a cost of $25,000 and accumulated depreciation was $4,300 at the time of the sale. Gary used an equipment broker on this sale and paid a sales commission of $1,600.

Calculate Gary’s net gain or loss and determine the character as either capital or ordinary (ignore any depreciation recapture).

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8-20 Chapter 8 ● Depreciation and Sale of Business Proper ty

8-8 DEpRECIATION RECApTuRE Since long-term capital gains traditionally have been taxed at a lower rate than ordi- nary income, taxpayers have attempted to maximize the amount of income treated as capital gain. Congress enacted depreciation recapture provisions to prevent taxpayers from converting ordinary income into capital gains by claiming maximum depreciation deductions over the life of the asset and then selling the asset and receiving capital gain treatment on the resulting gain at the time of the sale. There are three major deprecia- tion recapture provisions: (1) Section 1245, which generally applies to personal prop- erty, (2) Section 1250, which applies to real estate, and (3) “unrecaptured depreciation” previously taken on real estate. The depreciation recapture provisions are extremely complex. Only a brief overview of the general provisions contained in the tax law is presented here.

8-8a Section 1245 Recapture Under the provisions of Section 1245, any gain recognized on the disposition of a Section 1245 asset will be classified as ordinary income up to an amount equal to the depreciation claimed. Any gain in excess of depreciation taken is classified as a Section 1231 gain. Sec- tion 1245 property is:

● Depreciable tangible personal property such as furniture, machines, computers, and automobiles

● Amortizable intangible personal property such as patents, copyrights, leaseholds, and professional sports contracts

● Other tangible property (except buildings) used as an integral part of manufacturing, production or extraction

● Single purpose agricultural or horticultural structures

Section 1245 recapture potential is defined as the total depreciation claimed on Section 1245 property. The amount of ordinary income recognized upon the sale of an asset under Section 1245 is equal to the lesser of (1) the recomputed basis less the adjusted basis, or (2) the amount realized less the adjusted basis. The recomputed basis of an asset is the adjusted basis of the property plus Section 1245 recapture potential. Any gain recognized in excess of the amount of ordinary income is a Section 1231 gain.

EXAMpLE On March 1 of the current year, Melvin sells Section 1245 property, which was purchased four years ago for $6,000. Melvin had claimed depreciation on the property of $2,500, and sold the property for $5,000. The recapture under Section 1245 is calculated below:

Section 1245 recapture potential $2,500 Adjusted basis ($6,000 2 $2,500) 3,500 Recomputed basis ($3,500 1 $2,500) 6,000 Gain realized ($5,000 2 $3,500) 1,500

The ordinary income is equal to the lesser of (1) $2,500, the recomputed basis ($6,000) less the adjusted basis ($3,500), or (2) $1,500, the amount realized ($5,000) less the adjusted basis ($3,500). The entire gain of $1,500 is subject to Section 1245 recapture and is taxed as ordinary income. ♦

Learning Objective 8.8 Apply the depreciation recapture rules.

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8-218-8 Depreciation Recapture

EXAMpLE Assume the same facts as in the previous example, except that the property is sold for $7,800. The recapture under Section 1245 is calculated below:

Section 1245 recapture potential $2,500 Adjusted basis ($6,000 2 $2,500) 3,500 Recomputed basis ($3,500 1 $2,500) 6,000 Gain realized ($7,800 2 $3,500) 4,300

The portion classified as ordinary income is equal to the lesser of (1) $2,500, the recomputed basis ($6,000) less the adjusted basis ($3,500), or (2) $4,300, the amount realized ($7,800) less the adjusted basis ($3,500). Of the $4,300 total gain, $2,500 is classified as ordinary income and the remaining $1,800 ($4,300 2 $2,500) is a Section 1231 gain. ♦

8-8b Section 1250 Recapture Section 1250 applies to the gain on the sale of depreciable real property, other than real prop- erty included in the definition of Section 1245 property. The amount of Section 1250 recapture potential is equal to the excess of depreciation expense claimed over the life of the asset under an accelerated method of depreciation over the amount of depreciation that would have been allowed if the straight-line method of depreciation had been used. If property is depreciated using the straight-line method, there is no Section 1250 recapture potential. Since the use of the straight-line method is required for real property acquired after 1986, there will be no Section 1250 recapture on the disposition of such property. In practice, Section 1250 recap- ture is rarely seen.

8-8c “unrecaptured Depreciation” on Real Estate—25 percent Rate

A special 25 percent tax rate applies to real property gains attributable to depreciation previously taken and not already recaptured under the Section 1245 or Section 1250 rules discussed above. Any remaining gain attributable to “unrecaptured depreciation” previously taken, including straight-line depreciation, is taxed at 25 percent rather than the long-term capital gain rate of 15 percent. When the taxpayer’s ordinary tax rate is below 25 percent, the depreciation recapture will be taxed at the lower ordinary tax rate to the extent of the remaining amount in the less than 25 percent bracket and then at 25 percent. The applica- tion of the 25 percent rate for “unrecaptured depreciation” is frequently seen in practice be- cause it applies to every rental property which is depreciated and then sold at a gain. If the 3.8 percent Net Investment Income tax discussed in Chapter 6 applies, the 25 percent rate will be increased to 28.8 percent and the 15 percent rate will be increased to 18.8 percent.

EXAMpLE Lew, an individual taxpayer, acquires an apartment building in 2009 for $300,000, and he sells it in October 2019 for $500,000. The accumulated straight-line depreciation on the building at the time of the sale is $45,000. Lew is in the 35 percent tax bracket for ordinary income. Lew’s gain on the sale of the property is $245,000 ($500,000 less adjusted basis of $255,000). $45,000 of the gain is attributable to unrecaptured depreciation and is taxed at 25 percent, while the remaining $200,000 gain is taxed at the 15 percent long-term capital gains rate. Lew may also be subject to the 3.8 percent Net Investment Income tax which is discussed in Chapter 6. If this is the case, his tax rates will increase to 28.8 percent and 18.8 percent, respectively. ♦

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8-22 Chapter 8 ● Depreciation and Sale of Business Proper ty

Self-Study problem 8.8 See Appendix E for Solutions to Self-Study Problems

The following information is from Self-Study Problem 8.7: Gary Farmer, an individual taxpayer, had the following sales of business property

during the 2019 tax year:

Add this new information:

4. Sold a building on October 7, 2019 for $340,000, net of sales commissions of $15,000. Gary acquired the building on December 3, 2008 at a cost of $320,000. Accumulated depreciation has been computed using the straight-line method since acquisition and totaled $126,050 at the time of the sale.

5. Sold furniture on October 7, 2019 for $7,600. The furniture was acquired on December 3, 2008 for $15,000 and accumulated depreciation was $15,000 at the time of the sale.

Gary’s employer identification number is 74-8976432. Use Form 4797 on Pages 8-23 and 8-24 to report the above gains and losses (hint: do not ignore depreciation recapture and complete Part III first).

The reporting of unrecaptured depreciation on 1250 property gains subject to the 25 percent rate is considerably complex. The amounts from the Form 4797 are reported on Schedule D and the use of the Unrecaptured Section 1250 Gain Worksheet from the Schedule D instructions is also suggested. Amounts from this worksheet are transferred to the Schedule D Tax worksheet (also part of the Schedule D instructions) which is similar to the Qualified Dividends and Capital Gain Tax Worksheet used in earlier chapters of this textbook.

tIp The sale of business property is entered on the Sale of Asset 4797/6252 screens under deductions.

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8-238-8 Depreciation Recapture

Self-Study problem 8.8

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8-24 Chapter 8 ● Depreciation and Sale of Business Proper ty

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8-258-9 Business Casualty Gains and Losses

8-9 BuSINESS CASuALTy GAINS AND LOSSES The treatment of casualty gains and losses differs depending on whether the property in- volved is held for personal-use or held for business or investment purposes. Therefore, a taxpayer’s business and investment casualty gains and losses are computed separately from personal casualty gains and losses. Deductions for personal casualty losses are restricted to those associated with a federally-declared disaster area. Since the casualty loss is an item- ized deduction, the rules for personal casualties are discussed in Chapter 5.

8.9 Learning Objective Apply the general treatment of casualty gains and losses for business purposes.

The Ninth Circuit Court decided that a man’s payment to a woman to keep her from revealing their extramarital affair was not a deductible casualty loss.

Would You

Believe? The amount of a business casualty or loss depends on whether the property was

completely or partially destroyed. If business property is completely destroyed, the loss is the adjusted basis of the property less any insurance reimbursement. If business property is partially destroyed, the loss is insurance proceeds less the lesser of the adjusted basis at the time of the casualty or the decrease in the property’s fair market value associated with the casualty.

EXAMpLE Joan’s business suffered two casualties in the current year. Theft 1: One of Joan’s employees stole a business vehicle and ended up abandoning the vehicle. The car was vandalized and damaged. The adjusted basis of the car was $14,000 at the time of the theft and the car was repairable but decreased in value $7,000 because of the damage. Theft 2: A car owned by Joan’s business was stolen. The thief was involved in a traffic accident and the car was totally destroyed. The basis of the car was $7,600 at the time of the theft and had fair market value of $5,000 before the crash. Joan’s insurance company reimbursed her $6,000 for the first theft and $4,000 for the second. Theft 1 is a partial destruction and the lesser of the decrease in market value or the adjusted basis is used to compute the loss. Theft 2 is a complete destruction and so the adjusted basis is used to compute the loss.

Theft 1 Partial

Destruction

Theft 2 Complete

Destruction

Insurance proceeds $ 6,000 $ 4,000 Adjusted basis 14,000 7,600 Decrease in FMV 7,000 n/a Loss $(1,000) $(3,600)

Business and investment property must be identified as a capital asset, trade or business property subject to an allowance for depreciation, or ordinary income property. The following rules apply to the treatment of business or investment property:

1. Property held for 1 year or less—gains from trade or business property (including property used in the production of rental or royalty income) and gains from invest- ment property are netted against losses from trade or business property, and the re- sulting net gain or loss is treated as ordinary income or loss. Losses from investment property are considered separately.

♦

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8-26 Chapter 8 ● Depreciation and Sale of Business Proper ty

2. Property held over 1 year—gains and losses from trade or business property and in- vestment property are netted.

a. Net gain—if the result is a net gain, the net gain is included in the calculation of the net Section 1231 gain or loss (the gains and losses are treated as Section 1231 gains and losses).

b. Net loss—if the result is a net loss, the gains and losses from business and invest- ment property are excluded from Section 1231 treatment. The tax treatment of the gains and losses depends on whether the property was used in the taxpayer’s trade or business or held for investment. Gains and losses from business-use assets are treated as ordinary income and ordinary losses, respectively.

If the taxpayer recognizes a gain as a result of a casualty, and the property involved is depreciable property, the depreciation recapture provisions may cause all or a part of the gain to be treated as ordinary income. A casualty involving business property is included in the definition of an involuntary conversion, so that gain realized may be eligible for deferral under the special involuntary conversion provisions discussed in LO 8.12 of this chapter. The interaction of Section 1231 and casualty gains and losses from business or investment property is complex. Taxpayers should follow the instructions included with Form 4684 and Form 4797. See the IRS website (www.irs.gov) for samples of these forms and instructions.

EXAMpLE Two pieces of manufacturing equipment used by Robert in his business are completely destroyed by fire. One of the pieces of equipment had an adjusted basis of $5,000 ($11,000 original basis less $6,000 accumulated depreciation) and a fair market value of $3,000 on the date of the fire. The other piece of equipment had an adjusted basis of $7,000 ($18,000 original basis less $11,000 of accumulated depreciation) and a fair market value of $10,000. Robert receives $3,000 from his insurance company to compensate him for the loss of the first piece of equipment, and he receives $8,000 for the second piece of equipment. As a result of the casualty, Robert’s casualty gain or loss is calculated as follows:

Item 1 Item 2

Insurance proceeds $ 3,000 $ 8,000 Basis of property (5,000) (7,000) (Loss) gain $(2,000) $ 1,000

The netting of the business casualty gains and losses results in a net loss of $1,000; thus, the gains and losses are excluded from Section 1231 treatment. Since the loss on Item 1 represents a loss arising from an asset used in the taxpayer’s business (not an asset held for investment), the loss is considered an ordinary loss. The $1,000 gain from Item 2 is treated as ordinary income under Section 1245 recapture. ♦

Self-Study problem 8.9 See Appendix E for Solutions to Self-Study Problems

Jonathan has the following separate casualties during the year:

Decrease in Fair Market Value

Adjusted Basis

Insurance Reimbursement

Holding Period

Business furniture $ 4,000 $ 5,000 $ 0 3 years Business machinery 15,000 14,000 10,000 3 years

The furniture was completely destroyed while the machinery was partially destroyed. Jonathan also sold business land for a Section 1231 gain of $10,000. Calculate the amount and nature of Jonathan’s gains and losses as a result of these casualties.

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8-278-10 Installment Sales

8-10 INSTALLMENT SALES Some taxpayers sell property and do not receive payment immediately. Instead, they take a note from the purchaser and receive payments over an extended period of time. It would be a financial hardship to require those taxpayers to pay tax on all of the gain on the sale of the property in the year of sale when they may not have received enough cash to cover the taxes. To provide equity in such situations, Congress passed the installment sale provision. The installment sale provision allows taxpayers to spread the gain (but not a loss) over the tax years in which payments are received. On an installment sale, the taxable gain reported each year is determined as follows:

Taxable gain 5 Total gain realized on the sale

Contract price 3 Cash collections during the year

Taxpayers who receive payments over a period of time automatically report gain on the installment method, unless they elect to report all the gain in the year of the sale. An election to report all the gain in the year of sale is made by including all the gain in income for the year of the sale. Taxpayers use Form 6252, Installment Sale Income, to report the installment sale gain on their income tax returns.

EXAMpLE Howard Scripp sells land with an adjusted basis of $20,000 for $50,000. He receives $10,000 in the year of sale, and the balance is payable at $8,000 per year for 5 years, plus a reasonable amount of interest. If Howard elects not to report under the installment method, the gain in the year of sale would be calculated in the following manner:

Cash $ 10,000 Note at fair market value 40,000 Amount realized 50,000 Less: the land’s basis (20,000) Taxable gain $ 30,000

EXAMpLE If, instead, Howard reports the gain on the installment method, the amount of the taxable gain in the year of sale is $6,000, which is calculated below.

Taxable gain 5 Total gain

Contract price 3 Cash collections

Taxable gain 5 $30,000 $50,000

3 $10,000 5 $6,000

Howard must complete Form 6252 as illustrated on Page 8-29.

If $8,000 is collected in the first year after the year of sale, the gain in that year would be $4,800, as illustrated below.

Taxable gain 5 $30,000 $50,000

3 $8,000 5 $4,800

Of course, any interest income received on the note is also included in income as portfolio income. ♦

Complex installment sale rules apply to taxpayers who regularly sell real or personal property and to taxpayers who sell certain business or rental real property. For example, any recapture under Section 1245 or Section 1250 must be reported in full in the year of sale, regardless of the taxpayer’s use of the installment method. Any remaining gain may be reported under the installment method. In addition, certain limitations apply where there is an installment sale between related parties.

8.10 Learning Objective Compute the gain on installment sales.

♦

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8-28 Chapter 8 ● Depreciation and Sale of Business Proper ty

8-10a The Contract price The contract price used in calculating the taxable gain is the amount the seller will ulti- mately collect from the purchaser (other than interest). This amount is usually the sale price of the property. However, the purchaser will occasionally assume the seller’s liability on the property, in which case the contract price is computed by subtracting from the selling price any mortgage or notes assumed by the buyer. If the mortgage or notes assumed by the buyer exceed the adjusted basis of the property, the excess is treated as a cash payment received in the year of sale and must be included in the contract price.

EXAMpLE Roger receives the following for an installment sale of real estate:

Cash $ 3,000 Roger’s mortgage assumed by the purchaser 9,000 Note payable to Roger from the purchaser 39,000 Selling price $ 51,000

Roger’s total gain is computed as follows:

Selling price $ 51,000 Less: selling expenses (1,500) Amount realized 49,500 Less: Roger’s basis in the property (30,000) Total gain $ 19,500

The contract price is $42,000 ($51,000 2 $9,000), and assuming the $3,000 is the only cash received in the year of sale, the taxable gain in the year of sale is $1,393 as shown below:

Taxable gain 5 $19,500 $42,000

3 $3,000 5 $1,393 ♦

Self-Study problem 8.10 See Appendix E for Solutions to Self-Study Problems

Brian acquired a rental house in 2003 for a cost of $80,000. Straight-line depreciation on the property of $26,000 has been claimed by Brian. In January 2019, he sells the property for $120,000, receiving $20,000 cash on March 1 and the buyer’s note for $100,000 at 10 percent interest. The note is payable at $10,000 per year for 10 years, with the first payment to be received 1 year after the date of sale. Calculate his taxable gain under the installment method for the year of sale of the rental house.

Gain reportable in 2019 $

Taxpayers may wish to elect out of the installment treatment for a sale which could qualify, and instead recognize all of the gain in the year of sale when they have low income and expect that the gain would be taxed at a higher rate if deferred to later years.

TAX BREAK

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8-298-10 Installment Sales

Land

Howard Scripp

50,000

20,000

0 50,000 20,000

20,000 0

30,000

0 30,000

50,000

.60

0 10,000 10,000

6,000

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8-30 Chapter 8 ● Depreciation and Sale of Business Proper ty

8-11 LIkE-kIND EXCHANGES Although a taxpayer realizes a gain or loss on the sale or exchange of property, the recogni- tion of the gain or loss may be deferred for tax purposes. One example of such a situation arises when a taxpayer exchanges real property for other real property of a like kind. Under certain circumstances, the transaction may be nontaxable. To qualify as a nontaxable ex- change, the property exchanged must be real property held for productive use in a trade or business or for investment. Exchanges of personal or intangible property used in a business or for investment such as machines, cars, trucks, patents, furniture, etc. do not qualify as like-kind. Property held for personal purposes, such as a taxpayer’s residence, also does not qualify for a like-kind exchange.

When the exchange involves only qualified like-kind property, no gain or loss is recognized. However, some exchanges include cash or other property in addition to the like-kind property. Even when the exchange is not solely for like-kind assets, the nontaxable treatment usually is not completely lost. Gain is recognized in an amount equal to the lesser of (1) the gain realized or (2) the “boot” received. Boot is money or the fair market value of other property received in addition to the like-kind property. Relief from a liability is the same as receiving cash and is treated as boot.

The basis of other property received as boot in an exchange is its fair market value on the date of the exchange. The basis of the like-kind property received is:

The basis of the like-kind property given up 1 Any boot paid 2 Any boot received 1 Any gain recognized Basis of property received

The holding period for property acquired in a like-kind exchange includes the holding period of the property exchanged. For example, if long-term capital gain property is exchanged today, the new property may be sold immediately, and the gain recognized would be long-term capital gain.

Taxpayers must file Form 8824, Like-Kind Exchanges, to report the exchange of property. This form must be completed even if no gain is recognized.

EXAMpLE Janis and Kevin exchange real estate held as an investment. Janis gives up property with an adjusted basis of $350,000 and a fair market value of $560,000. The property is subject to a mortgage of $105,000 which is assumed by Kevin. In return for this property, Janis receives from Kevin land with a fair market value of $420,000 and cash of $35,000. Kevin’s adjusted basis in the property he exchanges is $280,000.

1. Janis recognizes a gain of $140,000, equal to the lesser of the gain realized or the boot received as calculated below.

Calculation of gain realized: Fair market value of property received $ 420,000 Cash received 35,000 Liability assumed by Kevin 105,000 Total amount realized $ 560,000 Less: the adjusted basis of the property given up (350,000) Gain realized $ 210,000 Calculation of boot received: Cash received $ 35,000 Liability assumed by Kevin 105,000 Total boot received $ 140,000 Gain recognized: Lesser of gain realized or boot received $ 140,000

Learning Objective 8.11 Calculate recognized and deferred gains on like-kind exchanges.

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8-318-11 Like-Kind Exchanges

2. The basis of Janis’s property is calculated below.

Basis of the property given up $ 350,000 1 Boot paid 0 2 Boot received (140,000) 1 Gain recognized 140,000 Basis of the like-kind property received $ 350,000

3. Kevin’s recognized gain is equal to the lesser of the gain realized or the boot received. Since he received no boot, the recognized gain is zero.

Calculation of gain realized: Fair market value of the property received $ 560,000 Less: boot paid ($105,000 1 $35,000) (140,000) Less: adjusted basis of property given up (280,000) Gain realized $ 140,000 Boot received $ 0

4. The basis of Kevin’s new property is calculated below.

Basis of the property given up $ 280,000 1 Boot paid 140,000 2 Boot received 0 1 Gain recognized 0 Basis of the property received $ 420,000 ♦

8-11a Like-kind property The term “like-kind property” does not include inventory, stocks, bonds, or other securities or any personal property such as inventory, equipment, cars, trucks, machines, and furni- ture. Real property is more or less considered to be like-kind with any other real property so long as the original property and the new property are both used in a trade or business or held for investment.

Although the repeal of like-kind treatment for personal property does not permit the deferral of gains on that type of property, this may result in some favorable outcomes as well. The deferral on a like-kind exchange is not elective, it is required. One of the most common forms of exchange for a small business is the trade-in of a business auto. Because the market value of a used auto is almost always below its adjusted basis, the losses were not deductible under the previous like-kind exchange rules. Now that personal property is not eligible for like-kind treatment, these losses may be deductible.

TAX BREAK

Self-Study problem 8.11 See Appendix E for Solutions to Self-Study Problems

During the current year, Daniel James exchanges land used in his business for a new parcel of land. Daniel’s basis in the land is $18,000, and the land is subject to a mortgage of $8,000, which is assumed by the other party to the exchange. Daniel receives new land worth $22,000. Calculate Daniel’s recognized gain on the exchange and his basis in the new land.

Recognized gain $ Basis in the new land $

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8-32 Chapter 8 ● Depreciation and Sale of Business Proper ty

8-12 INVOLuNTARy CONVERSIONS Occasionally, taxpayers are forced to dispose of property as a result of circumstances be- yond their control. At the election of the taxpayer, and provided certain conditions are met, the gain on an involuntary conversion of property may be deferred. The provisions require that the property must be replaced and the basis of the replacement property reduced by the amount of the gain deferred. An involuntary conversion is defined as the destruction of the taxpayer’s property in whole or in part, or loss of the property by theft, seizure, req- uisition, or condemnation. Also, property sold pursuant to reclamation laws, and livestock destroyed by disease or drought, are subject to the involuntary conversion rules. To qualify for nonrecognition of gain, the taxpayer must obtain qualified replacement property. The replacement property must be “similar or related in service or use.” This definition is nar- rower than the like-kind rule; the property must be very similar to the property converted. Generally, a taxpayer has 2 years after the close of the tax year in which a gain was realized to obtain replacement property.

A realized gain on the involuntary conversion of property occurs when the taxpayer receives insurance proceeds or other payments in excess of his or her adjusted basis in the converted property. Taxpayers need not recognize any gain if they completely reinvest the proceeds or payments in qualified replacement property within the required time period. If they do not reinvest the total amount of the payments received, they must recognize a gain equal to the amount of the payment not reinvested (but limited to the gain realized). The basis of the replacement property is equal to the cost of the replacement property reduced by any gain not recognized on the transaction. The holding period of the replacement property includes the period the original property was held.

EXAMpLE Tammy’s office building, which has an adjusted basis of $600,000, is destroyed by fire in 2019. In the same year, Tammy receives $700,000 of insurance proceeds for the loss. She has until December 31, 2021 (2 years after the end of the taxable year in which the gain is realized), to acquire a replacement building. In 2020, Tammy replaces the building with a new building costing $680,000. Her realized gain on the involuntary conversion is $100,000 ($700,000 2 $600,000), and the gain recognized is $20,000, which is the $700,000 of cash received less the amount reinvested ($680,000). The basis of the new building is $600,000 ($680,000 2 $80,000), the cost of the new building less the portion of the gain not recognized. ♦

The involuntary conversion provision applies only to gains, not to losses. The provision must be elected by the taxpayer. In contrast, the like-kind exchange provision discussed previously applies to both gains and losses and is not elective.

Learning Objective 8.12 Calculate recognized and deferred gains on involuntary conversions.

Self-Study problem 8.12 See Appendix E for Solutions to Self-Study Problems Sam’s store is destroyed in 2019 as a result of a flood. The store has an adjusted basis of $70,000, and Sam receives insurance proceeds of $150,000 on the loss. Sam invests $135,000 in a replacement store in 2020.

1. Calculate Sam’s recognized gain, assuming an election under the involuntary conversion provision is made. $

2. Calculate Sam’s basis in the replacement store. $

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8-33

K e y t e r m s

depreciation, 8-2 straight-line depreciation, 8-2 Modified Accelerated Cost Recovery

System (MACRS), 8-3 recovery period, 8-3 asset depreciation ranges

(ADRs), 8-3 accelerated depreciation, 8-4 half-year convention, 8-4 mid-quarter convention, 8-5

bonus depreciation, 8-7 mid-month convention, 8-8 Section 179, 8-10 election to expense, 8-10 listed property, 8-14 intangibles, 8-17 Section 197 intangibles, 8-17 amortization, 8-17 goodwill and going-concern

values, 8-17

Section 1231 assets, 8-19 depreciation recapture, 8-20 Section 1245 recapture, 8-20 Section 1250 recapture, 8-21 installment sales, 8-27 like-kind exchange, 8-30 boot, 8-30 like-kind property, 8-31 involuntary conversion, 8-32 qualified replacement property, 8-32

Learning Objectives Key points

LO 8.1: Explain the concept of depreciation.

● Depreciation is the accounting process of allocating and deducting the cost of an asset over a period of years and does not necessarily mean physical deterioration or loss of value of the asset.

● The simplest method of depreciation is the straight-line method, which results in an equal portion of the cost of an asset being deducted in each period of the asset’s life.

LO 8.2: Calculate depreciation expense using the MACRS tables.

● The Modified Accelerated Cost Recovery System (MACRS) allows taxpayers who invest in capital assets to write off an asset’s cost over a period designated in the tax law and to use an accelerated method of depreciation for assets other than real estate.

● The minimum number of years over which the cost of an asset may be deducted (the recovery period) depends on the type of property and the year in which the property was acquired.

● Under MACRS, taxpayers calculate the depreciation of an asset using a table, which contains a percentage rate for each year of the property’s recovery period and includes the half-year convention for personal property and mid-month convention for real property.

● The mid-quarter convention must be applied if more than 40 percent of the total cost of a taxpayer’s tangible property acquired during the year, other than real property, is placed in service during the last quarter of the tax year.

● The bonus depreciation rules allow taxpayers purchasing property with a MACRS recovery period of 20 years or less (see Table 8.1), computer software, and certain leasehold improvements to directly write off 100 percent of the cost of the assets in the year placed in service.

● There are no taxable income limits or thresholds associated with bonus depreciation. ● For post-1986 acquired real estate, MACRS uses the straight-line method over 27.5 years for residential realty and 39 years for nonresidential realty (31.5 years for realty acquired generally before May 13, 1993).

K e y p O I N ts

Key Points

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8-34 Chapter 8 ● Depreciation and Sale of Business Proper ty

LO 8.3: Identify when a Section 179 election to expense the cost of property may be used.

● Qualified Section 179 property is personal property (property other than real estate or assets used in residential real estate rental activities) placed in service during the year and used in a trade or business.

● The maximum cost that may be expensed in the year of acquisition under Section 179 is $1,020,000 for 2019. The property may be new or used.

● The $1,020,000 maximum is reduced dollar for dollar by the cost of qualifying property placed in service during the year in excess of $2,550,000.

● The amount that may be expensed is limited to the taxpayer’s taxable income, before considering any amount expensed under this election, from any trade or business of the taxpayer.

● Section 179 expensed amounts reduce the basis of the asset before calculating any regular MACRS depreciation on the remaining cost of the asset.

LO 8.4: Apply the limitations placed on depreciation of “listed property.”

● Special rules apply to the depreciation of listed property. ● Listed property includes those types of assets which lend themselves to personal use. ● Listed property includes automobiles, certain other vehicles, and property used for entertainment, recreation, or amusement.

● If listed property is used 50 percent or less in a qualified business use, any depreciation deduction must be calculated using the straight-line method of depreciation over an alternate recovery period, and the special election to expense under Section 179 and bonus depreciation are not allowed.

LO 8.5: Apply the limitations on depreciation of “luxury automobiles.”

● The depreciation of passenger automobiles is subject to a limitation, commonly referred to as the luxury automobile limitation.

● For automobiles acquired in 2019, the maximum depreciation is $18,100 (Year 1), $16,100 (Year 2), $9,700 (Year 3), and $5,760 (Year 4 and subsequent years until fully depreciated). Bonus depreciation of $8,000 is included in the first year limit of $18,100.

LO 8.6: Calculate the amortization of goodwill and certain other intangibles.

● Section 197 intangibles are amortized over a 15-year period, beginning with the month of acquisition.

● Qualified Section 197 intangibles include goodwill, going-concern value, workforce in place, information bases, know-how, customer-based intangibles, licenses, permits, rights granted by a governmental unit, covenants not to compete, franchises, trademarks, and trade names.

● Examples of Section 197 exclusions are interests in a corporation, partnership, trust, or estate; interests in land; computer software readily available for purchase by the general public; interests in films, sound recordings, and video recordings; and self-created intangible assets.

LO 8.7: Classify gains and losses from Section 1231 assets.

● Section 1231 assets include (1) depreciable or real property used in a trade or business, (2) timber, coal, or domestic iron ore, (3) livestock (not including poultry) held for draft, breeding, dairy, or sporting purposes, and (4) unharvested crops on land used in a trade or business.

● If net Section 1231 gains exceed the losses, the excess is a long-term capital gain. When the net Section 1231 losses exceed the gains, all gains are treated as ordinary income, and all losses are fully deductible as ordinary losses.

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8-35Key Points

LO 8.8: Apply the depreciation recapture rules.

● Depreciation recapture provisions are meant to prevent taxpayers from converting ordinary income into capital gain by claiming maximum depreciation deductions over the life of the asset and then selling the asset and receiving capital gain treatment on the resulting gain at sale.

● Under Section 1245, any gain recognized on the disposition of a Section 1245 asset (generally personal property) will be classified as ordinary income up to an amount equal to the accumulated depreciation. Any gain in excess of depreciation taken is classified as a Section 1231 gain.

● Section 1250 real property recapture is the excess of depreciation expense claimed, using an accelerated method of depreciation, over what would have been allowed if the straight-line method were used.

● Since the straight-line method is required for real property acquired after 1986, there will be no Section 1250 recapture on the disposition of real property.

● A special 25 or 28.8 percent tax rate applies to real property gains attributable to depreciation previously taken and not already recaptured under Section 1245 or Section 1250.

LO 8.9: Apply the general treatment of casualty gains and losses for business purposes.

● The amount of a partial casualty loss from business property is insurance proceeds less the decrease in the value of the property or the adjusted basis, whichever is smaller.

● The amount of a casualty loss from a complete destruction of business property is the insurance proceeds less the adjusted basis of the property.

LO 8.10: Compute the gain on installment sales.

● On an installment sale, the taxable gain reported each year is determined as follows: taxable gain equals total gain realized on the sale, divided by the contract price, and multiplied by the payment received during the year.

LO 8.11: Calculate recognized and deferred gains on like-kind exchanges.

● To qualify as a nontaxable like-kind exchange, the property exchanged must be real property held for use in a trade or business or for investment, and exchanged for property of a like kind.

● Personal property no longer qualifies for like-kind exchange treatment. ● Like-kind gain is recognized in an amount equal to the lesser of (1) the gain realized or (2) the “boot” received. Boot is money or the fair market value of other property received in addition to the like-kind property.

● If a transaction qualifies as a like-kind exchange, the like-kind exchange provisions must be followed.

LO 8.12: Calculate recognized and deferred gains on involuntary conversions.

● A realized gain on the involuntary conversion of property occurs when the taxpayer receives proceeds in excess of his or her adjusted basis.

● Involuntary conversion gain is not recognized if the proceeds or payments are reinvested in qualified replacement property within the required time period and the taxpayer makes the proper election.

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8-36 Chapter 8 ● Depreciation and Sale of Business Proper ty

GrOUp 1:

MuLTIpLE CHOICE QuESTIONS

1. Alice purchases a rental house on August 22, 2019, for a cost of $174,000. Of this amount, $100,000 is considered to be allocable to the cost of the home, with the remaining $74,000 allocable to the cost of the land. What is Alice’s maximum depreciation deduction for 2019 using MACRS? a. $2,373 b. $1,970 c. $1,364 d. $1,061 e. $1,009

2. An asset (not an automobile) put in service in June 2019 has a depreciable basis of $30,000 and a recovery period of 5 years. Assuming half-year convention, no bonus depreciation, and no election to expense is made, what is the maximum amount of cost that can be deducted in 2019? a. $2,500 b. $5,000 c. $6,000 d. $30,000 e. None of the above

3. An asset (not an automobile) put in service in June 2019 has a depreciable basis of $40,000 and a recovery period of 5 years. Assuming bonus depreciation is used, half-year convention and no election to expense is made, what is the maximum amount of cost that can be deducted in 2019? a. $4,000 b. $20,000 c. $24,000 d. $28,000 e. $40,000

4. James purchased office equipment for his business. The equipment has a depreciable basis of $7,000 and was put in service on June 1, 2019. James decides to elect straight- line depreciation under MACRS for the asset over the minimum number of years (7 years), and does not use bonus depreciation or make the election to expense. What is the amount of his depreciation deduction for the equipment for the 2019 tax year? a. $2,000 b. $1,000 c. $500 d. $0 e. None of the above

5. Which of the following statements with respect to the depreciation of property under MACRS is incorrect? a. Under the half-year convention, one-half year of depreciation is allowed in the

year the property is placed in service. b. If a taxpayer elects to use the straight-line method of depreciation for property in

the 5-year class, all other 5-year class property acquired during the year must also be depreciated using the straight-line method.

LO 8.2

Q U es t I O Ns a n d prO B L e m s

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8-37Questions and Problems

c. In some cases, when a taxpayer places a significant amount of property in service during the last quarter of the year, real property must be depreciated using a mid-quarter convention.

d. Real property acquired after 1986 must be depreciated using the straight-line method.

e. The cost of property to which the MACRS rate is applied is not reduced for esti- mated salvage value.

6. Which of the following is not true about the MACRS depreciation system: a. A salvage value must be determined before depreciation percentages are applied

to depreciable real estate. b. Residential rental buildings are depreciated over 27.5 years straight-line. c. Commercial real estate buildings are depreciated over 39 years straight-line. d. No matter when during the month depreciable real estate is purchased, it is consid-

ered to have been placed in service at mid-month for MACRS depreciation purposes.

7. On July 20, 2019, Kelli purchases office equipment at a cost of $12,000. Kelli elects out of bonus depreciation but makes the election to expense for 2019. She is self- employed as an attorney, and, in 2019, her business has a net income of $6,000 before considering this election to expense. Kelli has no other income or expenses for the year. What is the maximum amount that Kelli may deduct for 2019 under the election to expense, assuming she elects to expense the entire $12,000 purchase? a. $24,000 b. $12,000 c. $6,000 d. $3,000 e. $1,000

8. Which of the following is not considered a limit on the immediate expensing election of Section 179? a. Fifty percent of qualified improvement property b. Total Section 179-eligible property acquired in excess of $3,570,000 c. The taxable income of the taxpayer considering all income and deductions except

for Section 179 immediate expensing d. An annual limit of $1,020,000 e. None of the above

9. In 2019, Ben purchases and places in service a new auto for his business. The auto costs $57,000 and will be used 60 percent for business. Assuming the half-year convention applies and Ben elects out of bonus depreciation and Section 179, what will depreciation on the auto be in 2019? a. $11,400 b. $6,840 c. $6,060 d. $6,000 e. None of the above

10. In 2019, Ben purchases and places in service a new auto for his business. The auto costs $57,000 and will be used 100 percent for business. Assuming the half-year convention applies and Ben does not elect out of bonus depreciation, what will depreciation on the auto be in 2018? a. $57,000 b. $18,000 c. $18,100 d. $10,000 e. None of the above

LO 8.2

LO 8.3

LO 8.5

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8-38 Chapter 8 ● Depreciation and Sale of Business Proper ty

11. The amortization period for Section 197 intangibles is: a. 5 years b. 7 years c. 10 years d. 15 years e. 40 years

12. Which of the following intangibles is defined as a Section 197 intangible asset? a. An interest in land b. A partnership interest c. An interest in a corporation d. A covenant not to compete acquired as part of a business e. A separately acquired sound recording

13. Which of the following is Section 1231 property? a. Land held for investment purposes b. A machine used in a business c. Accounts receivable d. Inventory e. Paintings owned by the artist

14. In 2019, Mary sells for $24,000 a machine used in her business. The machine was purchased on May 1, 2017, at a cost of $22,000. Mary has deducted depreciation on the machine of $6,000. What is the amount and nature of Mary’s gain as a result of the sale of the machine? a. $2,000 Section 1231 gain b. $8,000 ordinary income under Section 1245 c. $6,000 ordinary income and $2,000 Section 1231 gain d. $6,000 Section 1231 gain and $2,000 ordinary income under Section 1245 e. None of the above

15. During 2019, Paul sells residential rental property for $240,000, which he acquired in 1998 for $160,000. Paul has claimed straight-line depreciation on the building of $60,000. What is the amount and nature of Paul’s gain on the sale of the rental property? a. $140,000 ordinary income b. $80,000 “unrecaptured depreciation” and $60,000 ordinary gain c. $140,000 Section 1231 gain d. $80,000 Section 1231 gain, $60,000 “unrecaptured depreciation” e. None of the above

16. Jeanie acquires an apartment building in 2008 for $280,000 and sells it for $480,000 in 2019. At the time of sale there is $60,000 of accumulated straight-line depreciation on the apartment building. Assuming Jeanie is in the highest tax bracket for ordinary income and the Medicare tax on net investment income applies, how much of her gain is taxed at 28.8 percent? a. None b. $60,000 c. $200,000 d. $280,000 e. $260,000

17. Virginia has business property that is stolen and partially destroyed by the time it was recovered. She receives an insurance reimbursement of $6,000 on property that had a $14,000 basis and a decrease in market value of $10,000 due to damage caused by the theft. What is the amount of Virginia’s casualty loss? a. $14,000 b. $8,000 c. $10,000 d. $4,000 e. None of the above

LO 8.6

LO 8.7

LO 8.7 LO 8.8

LO 8.8

LO 8.9

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8-39Questions and Problems

18. Pat sells land for $25,000 cash and a $75,000 5-year note. If her basis in the property is $30,000 and she receives only the $25,000 down payment in the year of sale, how much is Pat’s taxable gain in the year of sale using the installment sales method? a. $0 b. $5,000 c. $17,500 d. $25,000 e. $75,000

19. Fred and Sarajane exchanged land in a qualifying like-kind exchange. Fred gives up land with an adjusted basis of $11,000 (fair market value of $16,000) in exchange for Sarajane’s land with a fair market value of $12,000 plus $4,000 cash. How much gain should Fred recognize on the exchange? a. $5,000 b. $4,000 c. $1,000 d. $0 e. None of the above

20. What is Sarajane’s basis in the equipment received in the exchange described in Question 19, assuming her basis in the equipment given up was $12,000? a. $0 b. $12,000 c. $14,000 d. $16,000 e. None of the above

21. Oscar owns a building that is destroyed in a hurricane. His adjusted basis in the building before the hurricane is $130,000. His insurance company pays him $140,000 and he immediately invests in a new building at a cost of $142,000. What is the amount of recognized gain or loss on the destruction of Oscar’s building? a. $0 b. $10,000 gain c. $8,000 gain d. $12,000 gain e. $2,000 loss

22. Using the information from Question 21, what is Oscar’s basis on his new building? a. $130,000 b. $132,000 c. $140,000 d. $142,000

LO 8.10

LO 8.11

LO 8.12

1. Is land allowed to be depreciated? Why or why not?

2. Is it possible to depreciate a residential rental building when it is actually increasing in value? Why?

LO 8.2

GrOUp 2:

pROBLEMS

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8-40 Chapter 8 ● Depreciation and Sale of Business Proper ty

3. Mike purchases a new heavy-duty truck (5-year class recovery property) for his deliv- ery service on March 30, 2019. No other assets were purchased during the year. The truck is not considered a passenger automobile for purposes of the listed property and luxury automobile limitations. The truck has a depreciable basis of $42,000 and an estimated useful life of 5 years. Assume half-year convention for tax. a. Calculate the amount of depreciation for 2019 using financial accounting straight-

line depreciation (not the straight-line MACRS election) over the truck’s estimated useful life.

b. Calculate the amount of depreciation for 2019 using the straight-line depreciation election, using MACRS tables over the minimum number of years with no bonus depreciation or election to expense.

c. Calculate the amount of depreciation for 2019, including bonus depreciation but no election to expense, that Mike could deduct using the MACRS tables.

d. Calculate the amount of depreciation for 2019 including the election to expense but no bonus depreciation that Mike could deduct. Assume no income limit on the expense election.

4. On March 8, 2019, Holly purchased a residential apartment building. The cost basis assigned to the building is $700,000. Holly also owns another residential apartment building that she purchased on October 15, 2019, with a cost basis of $400,000. a. Calculate Holly’s total depreciation deduction for the apartments for 2019

using MACRS. $

b. Calculate Holly’s total depreciation deduction for the apartments for 2020 using MACRS.

5. Give the MACRS depreciation life of the following assets: a. An automobile _____________________ b. Business furniture _____________________ c. A computer _____________________ d. Residential real estate _____________________ e. Commercial real estate _____________________ f. Land _____________________

6. Explain the use of the mid-quarter convention for MACRS depreciation:

7. Calculate the following: a. The first year of depreciation on a residential rental building costing $250,000

purchased June 2, 2019. $

b. The second year (2020) of depreciation on a computer costing $5,000 purchased in May 2019, using the half-year convention and accelerated depreciation consider- ing any bonus depreciation taken.

LO 8.2 LO 8.3

LO 8.2

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8-41Questions and Problems

c. The first year of depreciation on a computer costing $2,800 purchased in May 2019, using the half-year convention and straight-line depreciation with no bonus depreciation.

d. The third year of depreciation on business furniture costing $10,000 purchased in March 2017, using the half-year convention and accelerated depreciation but no bonus depreciation.

8. During 2019, William purchases the following capital assets for use in his catering business:

New passenger automobile (September 30) $54,000 Baking equipment (June 30) 7,000

Assume that William decides to use the election to expense on the baking equipment (and has adequate taxable income to cover the deduction) but not on the automobile, and he also uses the MACRS accelerated method to calculate depreciation but elects out of bonus depreciation. Calculate William’s maximum depreciation deduc- tion for 2019, assuming he uses the automobile 100 percent in his business.

9. On February 2, 2019, Alexandra purchases a personal computer. The computer cost $1,800. Alexandra uses the computer 85 percent of the time in her accounting business, and the remaining 15 percent of the time for various personal uses. Calculate Alexandra’s maximum depreciation deduction for 2019 for the computer, assuming half-year convention and she does not use bonus depreciation or make the election to expense.

10. On September 14, 2019, Jay purchased a passenger automobile that is used 75 percent in his accounting business. The automobile has a basis for depreciation purposes of $40,000, and Jay uses the accelerated method under MACRS. Jay does not elect to expense. Calculate Jay’s depreciation deduction for 2019 assuming bonus depreciation.

11. During 2019, Pepe Guardio purchases the following property for use in his calendar year-end manufacturing business:

Item Date Acquired Cost

Manufacturing equipment (7 year) June 2 $ 40,000 Office furniture September 15 6,000 Office computer November 18 2,000 Passenger automobile (used 90 percent for business) May 31 54,000 Warehouse June 23 Building 165,000 Land 135,000

Pepe uses the accelerated depreciation method under MACRS, if available, and does not make the election to expense or take bonus depreciation. Use Form 4562 on Pages 8-43 and 8-44 to report Pepe’s depreciation expense for 2019.

12. Go to the IRS website (www.irs.gov) and assuming bonus depreciation is used, redo Problem 11, using the most recent interactive Form 4562, Depreciation and Amortization. Print out the completed Form 4562.

LO 8.2 LO 8.3 LO 8.4 LO 8.5

LO 8.2 LO 8.4

LO 8.2 LO 8.4 LO 8.5

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8-42 Chapter 8 ● Depreciation and Sale of Business Proper ty

13. Tom has a successful business with $100,000 of taxable income before the election to expense in 2019. He purchases one new asset in 2019, a new machine which is 7-year MACRS property and costs $25,000. If you are Tom’s tax advisor, how would you advise Tom to treat the purchase for tax purposes in 2019? Why?

14. Derek purchases a small business from Art on June 30, 2019. He paid the following amounts for the business:

Fixed assets $180,000 Goodwill 40,000 Covenant not to compete 30,000 Total $250,000

a. How much of the $250,000 purchase price is for Section 197 intangible assets? $

b. What amount can Derek deduct on his 2019 tax return as Section 197 intangible amortization?

15. Annie develops a successful tax practice. She sells the practice to her friend Carol for $54,000 and moves to Florida to retire. The tax practice has no assets except intangible benefits such as the goodwill and going-concern value Annie has developed over the years. How should Carol treat the $54,000 cost of the tax practice she has purchased?

16. Nadia Shalom has the following transactions during the year: Sale of office equipment on March 15 that cost $20,000 when purchased on July 1, 2017. Nadia has claimed $3,100 in depreciation and sells the asset for $13,500 with no selling costs. Sale of land on April 19 for $125,000. The land cost $132,500 when purchased on February 1, 2008. Nadia’s selling costs are $6,500. Assume there were no capital improvements on either business asset sold. Nadia’s Social Security number is 924-56-5783. Complete Form 4797 on Pages 8-45 and 8-46 to report the above gains or losses.

17. Steve Drake sells a rental house on January 1, 2019, and receives $100,000 cash and a note for $50,000 at 7 percent interest. The purchaser also assumes the mortgage on the property of $25,000. Steve’s original cost for the house was $170,000 on January 1, 2011 and accumulated depreciation was $27,000 on the date of sale. He collects only the $100,000 down payment in the year of sale. a. If Steve elects to recognize the total gain on the property in the year of sale,

calculate the taxable gain. $

b. Assuming Steve uses the installment sale method, complete Form 6252 on Page 8-47 for the year of the sale.

c. Assuming Steve collects $5,000 (not including interest) of the note principal in the year following the year of sale, calculate the amount of income recognized in that year under the installment sale method.

LO 8.2 LO 8.3

LO 8.6

LO 8.7 LO 8.8

LO 8.8 LO 8.10

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8-43Questions and Problems

GrOUp 2:

pROBLEM 11

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8-44 Chapter 8 ● Depreciation and Sale of Business Proper ty

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8-45Questions and Problems

GrOUp 2:

pROBLEM 16

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8-46 Chapter 8 ● Depreciation and Sale of Business Proper ty

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8-47Questions and Problems

GrOUp 2:

pROBLEM 17

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8-48 Chapter 8 ● Depreciation and Sale of Business Proper ty

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8-49Questions and Problems

18. William sold Section 1245 property for $25,000 in 2019. The property cost $38,500 when it was purchased 5 years ago. The depreciation claimed on the property was $19,200. a. Calculate the adjusted basis of the property. $ b. Calculate the recomputed basis of the property. $ c. Calculate the amount of ordinary income under $

Section 1245. d. Calculate the Section 1231 gain. $

19. An office machine used by Josie in her accounting business was completely destroyed by fire. The adjusted basis of the machine was $8,000 (original basis of $14,000 less accumulated depreciation of $6,000). The machine was not insured. Calculate the amount and nature of Josie’s gain or loss as a result of this casualty.

Amount of gain or loss $ Nature

20. Carey exchanges land for other land in a qualifying like-kind exchange. Carey’s basis in the land given up is $115,000, and the property has a fair market value of $150,000. In exchange for her property, Carey receives land with a fair market value of $100,000 and cash of $10,000. In addition, the other party to the exchange assumes a mortgage loan on Carey’s property of $40,000. a. Calculate Carey’s recognized gain, if any, on the exchange. $ b. Calculate Carey’s basis in the property received. $

21. Teresa’s manufacturing plant is destroyed by fire. The plant has an adjusted basis of $270,000, and Teresa receives insurance proceeds of $410,000 for the loss. Teresa reinvests $420,000 in a replacement plant within 2 years of receiving the insurance proceeds. a. Calculate Teresa’s recognized gain if she elects to utilize the

involuntary conversion provision. $ b. Calculate Teresa’s basis in the new plant. $

LO 8.7 LO 8.8

LO 8.9

LO 8.11

LO 8.12

1. Your supervisor has asked you to research the following situation concerning Owen and Lisa Cordoncillo. Owen and Lisa are brother and sister. In May 2019, Owen and Lisa exchange land they both held separately for investment. Lisa gives up a 2 acre property in Texas with an adjusted basis of $2,000 and a fair market value of $6,000. In return for this property, Lisa receives from Owen a 1 acre property in Arkansas with a fair market value of $5,500 and cash of $500. Owen’s adjusted basis in the land he exchanges is $2,500. In March 2020, Owen sells the Texas land to a third party for $5,800.

Required: Go to the IRS website (www.irs.gov). Locate and review Publication 544, Chapter 1, Nontaxable Exchanges. Write a file memorandum stating the amount of Owen and Lisa’s gain recognition for 2019. Also determine the effect, if any, of the subsequent sale in 2020. (An example of a file memorandum is available at the website for this textbook located at www.cengage.com.)

research

GrOUp 3:

WRITING ASSIGNMENT

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8-50 Chapter 8 ● Depreciation and Sale of Business Proper ty

1. Trish Himple owns a retail family clothing store. Her store is located at 4321 Heather Drive, Henderson, NV 89002. Her employer identification number is 95- 1234321 and her Social Security number is 123-45-6789. Trish keeps her books on an accrual basis. The income and expenses for the year are:

Gross sales $352,000 Returns and allowances 4,000 Expenses: Beginning inventory (at cost) $ 85,000 Add: purchases 101,000 Cost of goods available for sale 186,000 Less: ending inventory (at cost) 75,000 Cost of goods sold $111,000 Rent 24,200 Insurance 1,800 Legal and accounting fees 5,600 Payroll 56,430 Payroll taxes 4,400 Utilities 2,100 Office supplies 750 Advertising 6,200

Trish’s bookkeeper has provided the following book-basis fixed asset rollforward:

GrOUp 4:

COMpREHENSIVE pROBLEMS

Himple Retail Fixed Asset Rollforward 12/31/2019 (book basis)

DEPR COST 2017 2018 2019 ACCUM NET BOOK ASSET IN SERVICE METHOD LIFE BASIS DEPR DEPR DEPR DEPR VALUE

CASH REGISTER 2/15/2017 SL 5 9,900.00 1,815.00 1,980.00 1,980.00 5,775.00 4,125.00 2017 TOTAL ADDITIONS 9,900.00 1,815.00 1,980.00 1,980.00 5,775.00 4,125.00

RETAIL FIXTURES 10/12/2018 SL 7 4,750.00 46.961 678.57 848.21 3,901.79 FURNITURE 10/12/2018 SL 7 3,900.00 92.931 557.14 696.43 3,203.57 2018 TOTAL ADDITIONS 8,650.00 - 308.93 1,235.71 1,544.64 7,105.36 TOTAL 18,550.00 1,815.00 2,288.93 3,215.71 7,319.64 11,230.36

DELIVERY TRUCK 6/1/2019 SL 5 37,500.00 00.573,4 4,375.00 33,125.00 DESK AND CABINETRY 6/1/2019 SL 7 11,900.00 76.199 991.67 10,908.33 COMPUTER 6/1/2019 SL 5 2,800.00 76.623 326.67 2,473.33 2019 TOTAL ADDITIONS 52,200.00 - - 5,693.34 5,693.34 46,506.66 TOTAL 70,750.00 1,815.00 2,288.93 8,909.05 13,012.98 57,737.02

The truck is not considered a passenger automobile for purposes of the luxury automobile limitations.

Trish also has a qualified home office of 250 sq. ft. Her home is 2,500 sq. ft. Her 2014 purchase price and basis in the home, not including land, is $100,000 (the home’s market value is $150,000). She incurred the following costs in 2019 related to the entire home:

Utilities $2,800 Cleaning 900 Insurance 1,100 Property taxes 2,000

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8-51Questions and Problems

Required: For tax purposes, Trish elected out of bonus depreciation in all years except 2019. She did not elect immediate expensing in any year. The tax lives of the assets are the same as the book lives shown in the fixed asset schedule above. Complete Trish’s Schedule C, Form 8829, and Form 4562 (as necessary). Make realistic assumptions about any missing data.

2. Lisa Kohl (birthdate 02/14/1953) is an unmarried high school principal. Lisa received the following tax documents:

Shawnee Mission School District 8200 W. 71st Street Shawnee Mission, KS 66204

56,640.00

59,000.00

56,640.00 1,150.00

56-1357924

467-98-9784

Lisa Kohl 212 Quivira Road Overland Park, KS 66210

6,100.00

3,658.00

855.50

9,800.00DD

2,360.00E

Olanthe National Bank 1240 E. Sante Fe Street Olanthe, KS 66061

Lisa Kohl

44-1352469 467-98-9784

203.88

Overland Park, KS 66210

212 Quivira Rd.

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8-52 Chapter 8 ● Depreciation and Sale of Business Proper ty

Big Brokerage Company 123 Wall Street New York, NY 10014

11-0010011

11/05/201912/13/2018

467-98-9784 17,200.00 35,600.00

Lisa Kohl

212 Quivira Rd.

Overland Park, KS 66210

100 shs. Johnson Corp.

Johnson Corporation 100 E. 49th Street New York, NY 10017

Lisa Kohl

212 Quivira Road

Overland Park, KS 66210

17-2468135 467-98-9784

4,122.40

0.00

During the year, Lisa paid the following amounts (all of which can be substantiated):

Home mortgage interest reported on Form 1098 (not shown) $9,540 KS state income tax payment for 2018 $475 MasterCard interest 550 Life insurance (whole life policy) 750 Property taxes on personal residence 1,525 Blue Cross medical insurance premiums 250 Other medical expenses 780 Income tax preparation fee 300 Charitable contributions (in cash) 750

Lisa’s sole stock transaction was reported to her on a Form 1099-B:

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8-53Questions and Problems

On January 28, 2019, Lisa sold land for $175,000 (basis to Lisa of $130,000). The land was purchased 6 years ago as an investment. She received $25,000 as a down payment and the buyer’s 10-year note for $150,000. The note is payable at the rate of $15,000 per year plus 8 percent interest. On January 28, 2020, the first of the ten prin- cipal and interest payments is due.

Lisa also helps support her father, Jay Hawke, who lives in a nearby senior facility. Jay’s Social Security number is 433-33-2121. Lisa provides over one-half of Jay’s sup- port but Jay also has a pension that paid him income of $14,000 in 2019. His Social Security benefits were $3,200 in 2019.

Required: Complete Lisa’s federal tax return for 2019. Use Form 1040-SR, Schedule A, Schedule B, Schedule D, Form 8949, the Qualified Dividends and Capital Gain Tax Worksheet, and Form 6252 as needed to complete this tax return. Make realistic assumptions about any missing data.

1. The following information is available for the Albert and Allison Gaytor family in addition to that provided in Chapters 1–7. On August 14, 2019, Allison purchased the building where her store is located. She

paid $335,000 for the building (including $100,000 for the land it is located on). Allison’s store is the only business in the building. The depreciation on the store needs to be reflected on Schedule C of the business.

Required: Combine this new information about the Gaytor family with the information from Chapters 1 to 7 and complete a revised 2019 tax return for Albert and Allison. This completes the Group 5 multichapter case.

GrOUp 5:

CuMuLATIVE SOfTWARE pROBLEM

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8-54 Chapter 8 ● Depreciation and Sale of Business Proper ty

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8-55Questions and Problems

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8-56 Chapter 8 ● Depreciation and Sale of Business Proper ty

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8-57Questions and Problems

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8-58 Chapter 8 ● Depreciation and Sale of Business Proper ty

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8-59Questions and Problems

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8-60 Chapter 8 ● Depreciation and Sale of Business Proper ty

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8-61Questions and Problems

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8-62 Chapter 8 ● Depreciation and Sale of Business Proper ty

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8-63Questions and Problems

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8-64 Chapter 8 ● Depreciation and Sale of Business Proper ty

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8-65Questions and Problems

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8-66 Chapter 8 ● Depreciation and Sale of Business Proper ty

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8-67Questions and Problems

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8-68 Chapter 8 ● Depreciation and Sale of Business Proper ty

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8-69Questions and Problems

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8-70 Chapter 8 ● Depreciation and Sale of Business Proper ty

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8-71Questions and Problems

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8-72 Chapter 8 ● Depreciation and Sale of Business Proper ty

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8-73Questions and Problems

Student Name

Class/Section

Date

K e y N Um B e r ta x r e t U r N sUm m a ry

CHApTER 8

Comprehensive problem 1

Form 4562, Special Depreciation Allowance (Line 14)

Form 4562, MACRS Deduction for Assets Placed in Service Before 2019 (Line 17)

Schedule C, Depreciation (Line 13)

Schedule C, Total Expenses (Line 28)

Schedule C, Net Profit or Loss (Line 31)

Comprehensive problem 2

Capital Gain or (Loss) (Line 6)

Adjusted Gross Income (Line 8b)

Standard Deduction or Itemized Deductions (Line 9)

Total Tax (Line 16)

Amount Overpaid (Line 20)

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zi m

m yt

w s/

Sh ut

te rs

to ck

.c om

C h a p t e r 9

Payroll, Estimated Payments, and Retirement Plans

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L E A R N I N G O B J E C T I V E S

After completing this chapter, you should be able to: LO 9.1 Compute the income tax withholding from employee wages. LO 9.2 Determine taxpayers’ quarterly estimated payments. LO 9.3 Compute the FICA tax. LO 9.4 Apply the federal deposit system to payroll withholding. LO 9.5 Prepare employer payroll reporting. LO 9.6 Compute the amount of FUTA tax for an employer. LO 9.7 Describe the general rules for qualified retirement plans. LO 9.8 Explain the pension plan rollover rules.

O V e r V I e W

T his chapter focuses on the payment and reporting of income and other taxes by employers, employees, and self- employed taxpayers. Payroll and other

tax topics covered include withholding methods for employees, estimated payments, the FICA tax (Social Security and Medicare taxes), the fed- eral tax deposit system, and employer reporting requirements. In addition, other payroll-related

topics such as retirement plans and pensions are covered.

The FICA tax is a combined Social Security (6.2 percent up to the annual wage limit, $132,900 in 2019) and Medicare tax (1.45 percent with no limit) that is paid by both employees and employers. The FICA tax is withheld from each employee’s paycheck, the tax is then matched by the employer, and the total amount is remitted to the IRS.

9-1

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9-2 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

The Federal Unemployment Tax Act (FUTA) tax is unemployment insurance with a joint state and federal payment plan to provide benefits for taxpayers when they become unemployed. The FUTA tax is paid only by employers, not employees.

9-1 WIThhOLdING METhOdS Employers are required to withhold taxes from amounts paid to employees for wages, in- cluding salaries, fees, bonuses, commissions, vacation and retirement pay. Employees com- plete Form W-4 to provide the information necessary for the employer to withhold income taxes at the prescribed amount. Although most taxpayers’ withholding should be adequate to result in an income tax refund at filing time, calculating withholding is more of an art than a science and is subject to the accurate estimation of income and deductions that are ultimately reported for the tax year.

Form W-4 was redesigned for 2019 but retains the typical elements of filing status and the number of withholding allowances an employee is claiming. Form W-4 is the key to the amount of the employee’s withholding for federal income taxes. As illustrated in the next part of this section, employers use the number of allowances to compute the amount of income tax withheld from each period’s pay.

The allowances are designed to be fairly straightforward for most taxpayers and are generally based on completion of the Personal Allowances Worksheet included as part of the Form W-4. Employees with less typical adjustments to income or additional deductions such as a second job, deductible alimony payments, a large amount of itemized deductions, or tax credits, may claim additional withholding allowances by completing one of the two additional worksheets included with Form W-4: (1) the Deductions, Adjustments, and Additional Income Worksheet and (2) the Two-Earners/Multiple Jobs Worksheet. The instructions are designed to allow employees to determine when either of these worksheets are required. Employees can authorize a set amount of additional income tax withheld from their wages each pay period using Line 6 of Form W-4. Also, exemption from withholding may be claimed on Form W-4 by employees who anticipate no federal tax liability for the current year. To be exempt from withholding, the employee must also have had no tax liability for the prior year. If an employee does not complete Form W-4, the employer is required to withhold as if the employee is single with no allowances.

Learning Objective 9.1 Compute the income tax withholding from employee wages.

In 1938, a wallet manufacturer used Hilda Schrader Whitcher’s Social Security number for a specimen card to show how nicely the card fit inside the wallet. At the time Hilda was an employee of the company. Although the fake card was not the correct size or color and had “specimen” reflected across the front, by 1943 over 5,000 people were using Hilda’s Social Security number and 10 were still doing so as late as 1970. Eventually, the Social Security Administration voided Hilda’s number and gave her a new one.

Would You

Believe?

EXAMPLE Tom Berry (Social Security number 555-12-1212) expects to earn $90,000 of wages from his new job. Tom’s spouse, Alicia, is a stay-at-home mom who operates a catering business on the side. Her business is expected to generate $10,000 of qualified business income (and a $2,000 QBI deduction) but they do not wish to make estimated payments and instead adjust Tom’s withholding. They live at 123 Main Street, Paris, TX 75460. The Berrys also expect interest income of $5,000 and qualified dividend income of $4,000. They have three kids ages 5, 15, and 17 at the end of 2019. Their 2019 itemized deductions are estimated at $27,000. Tom should claim four allowances as illustrated on Form W-4 on Pages 9-3 through 9-6. ♦

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9-39-1 Withholding Methods

Tom Berry 555-12-1212

123 Main Street

Paris, TX 75460

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9-4 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

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9-59-1 Withholding Methods

1 1

4 (a)

1 (b)

27,000

24,400

2,600

2,000 4,600 9,000 (c)

(4,400)

(1) 7

(a) - The Berrys have two children that qualify for the child tax credit and based on the information provided, will have total income between $103,351 and $345,850.

(b) - The Berrys have one child that is too old for the child tax credit. (c) - Interest and dividends total $9,000.

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9-6 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

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9-79-1 Withholding Methods

Single employees with only one job may claim one “special withholding allowance.” Married employees may also claim a “special withholding allowance” if one of the following conditions exists:

1. The employee has only one job and his or her spouse does not work, or 2. Annual wages earned from the employee’s second job, or wages earned by his or her

spouse, or the total of both are $1,500 or less.

The guidance on how an employer handles an unusual Form W-4 is somewhat contradictory. If an employer receives a W-4 from an employee that is known to be false based on oral or written statements made by the employee, the employer should notify the employee to file a corrected W-4. If the employee does not file a corrected W-4, the employer should withhold based on single with no allowances. However, employees do not have to provide proof to their employers that they are entitled to the number of allowances claimed on their Forms W-4. If an employee claims “exempt” and therefore requests no withholding, the employer is required to verify (1) that the employee was entitled to a full refund of all income taxes withheld because there was no income tax liability for the prior year, and (2) that the taxpayer expects a full refund during the current year because the taxpayer expects to have no tax liability. Employers are also instructed to carefully consider a large increase in withholding allowances, especially if the employee has otherwise had regular withholdings during the rest of the year.

An employee who claims withholding allowances on Form W-4 with no reasonable basis can be subject to fines of up to $500 plus underpayment of tax penalties. Willfully filing a fraudulent Form W-4 or failing to supply information that would increase the amount withheld can result in a fine of up to $1,000 or imprisonment for up to 1 year, or both. Employers must submit copies of Forms W-4 to the IRS only when directed to do so by written notice. Where there is significant underwithholding for a particular employee, the IRS may require the employer to withhold income tax at a higher rate and will notify the employer in writing (known as a “lock-in” letter). Employees are given the right to contest the IRS determination.

EXAMPLE Brianne is the payroll manager at her company and receives a Form W-4 from her employee, Mike. Mike has indicated that he is a married employee with two children and claims 10 allowances on his Form W-4. Brianne also noted that Mike did not list his “spouse” or children on his application or retirement plan paperwork and earlier mentioned that he was single. Based on both written and oral statements made by Mike, Brianne should ask Mike to prepare a corrected W-4. If he is unwilling to do so, she should withhold as if Mike is a single taxpayer with no allowances. ♦

EXAMPLE George works in the payroll department and receives a W-4 from a new employee, Beatrice. Beatrice indicates married status and two children and claims 10 allowances on her W-4. George notes that her married status is consistent with her other paperwork and Beatrice has provided no oral or written statements that would indicate she is not married and has two children. George is not required to verify the existence of Beatrice’s spouse and children. ♦

In 2020, the IRS has eliminated the “allowances” method of withholding reported on Form W-4 and used by employers for years. A new Form W-4, which replaces the allowance method with a standard withholding based on income and filing status only, is in draft as we go to print. The Form W-4 then provides dollar adjustments to reflect married filing jointly taxpayers that both work, a credit for dependents, multiple jobs, other forms of income, and itemized deductions. To assist taxpayers, an online withholding calculator will be available on the www.irs.gov website by the start of 2020.

New Tax Law!

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9-8 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

9-1a Computing Income Tax Withholding The amount of income tax to be withheld by the employer is based on gross taxable wages before deducting FICA taxes, pension payments, union dues, insurance, and other deduc- tions. An employer may elect to use any of several methods to determine the amount of the income tax withholding for each individual employee. Most commonly, withholding amounts are deter mined by use of the percentage method or by use of wage bracket tables. To compute the withholding amount under the percentage method, the employer should:

1. Multiply the number of allowances claimed by the employee (from Form W-4) by the allowance amount;

2. Subtract that amount from the employee’s gross taxable wages for the pay period; and 3. Apply the result in Step 2 to the applicable withholding table in Appendix C for the

appropriate marital status.

The allowance amounts used in Step 1 for 2019 for various pay periods are from IRS Publication 15, “(Circular E), Employer’s Tax Guide.” Although exemptions were repealed by the TCJA, allowance amounts remain based on what would have been the 2019 exemption amount of $4,200.

Pay Period 2019 Allowance Amount

Weekly $ 80.80 Biweekly 161.50 Semimonthly 175.00 Monthly 350.00 Quarterly 1,050.00 Semiannually 2,100.00 Annually 4,200.00

EXAMPLE Sharon is married, and her pay is $2,300 per month. On her Form W-4, Sharon claims married with a total of two allowances. Using the percentage method, the amount of withholding for Sharon is calculated as follows:

1. Allowances amount (monthly) $ 350.00 Number of allowances claimed 3 2 Total $ 700.00

2. Gross wages $2,300.00 Less: amount from above (700.00) Withholding income $1,600.00

3. Withholding from percentage tables in Appendix C: ($1,600.00 2 $983.00) 3 10% 5 $61.70 ♦

Under the wage bracket method of determining withholding, wage bracket tables are provided for weekly, biweekly, semimonthly, monthly, and daily payroll periods for both married and single taxpayers. The amount of withholding is obtained from the table for the appropriate payroll period and marital status, and is based on the total wages and the number of withholding allowances claimed. The monthly tables for single and married taxpayers are reproduced in Appendix C.

Although employers are not required to submit Forms W-4 to the Internal Revenue Service, that does not mean that new hires are not reported. In large part designed to assist with the enforcement of child support payments, the Personal Responsibility and Work Opportunity Reconciliation Act of 1996 (PRWORA) was passed requiring states to maintain a database of all new hires. Although many states use a specific form for reporting new hires, they will often also accept a completed Form W-4.

Would You

Believe?

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9-99-1 Withholding Methods

Tips are generally not paid directly by the employer to the employee and as a result, create a unique challenge for tax reporting for both the employee and employer. Additionally, tips are often paid in cash and thus capturing tips as income presents a challenge to the IRS.

To reduce the underreporting of tip income, the IRS requires employees to report tip income to their employers on Form 4070.

● Barber ● Hairdresser ● Parking attendant ● Porter ● Food and beverage servers ● Busser and others who share restaurant

tip pools

● Delivery driver ● Airport skycap ● Bartenders ● Hotel housekeepers ● Manicurists ● Taxi, Uber and Lyft drivers

The income tax withholding tables are constructed so that taxpayers that have completed their W-4 properly, will receive an income tax refund during tax filing season. Many taxpayers are satisfied with the resulting refund even though a tax refund represents an interest-free loan to the government. The overpayment of taxes serves as a “forced” savings account which provides the opportunity to purchase a big ticket item in late spring when the refund is received. Taxpayers should also be aware that interest is not charged symmetrically: underpayments of tax may result in penalties and interest (see LO 9.2), while overpayments are not usually credited with interest. Given the changes to the individual tax structure by the TCJA and the pending 2020 changes to the Form W-4, taxpayers should consider using the withholding calculator at www.irs.gov, complete an accurate Form W-4, and consider a mid-year review to ensure that the withholding amounts are proper given current income and other circumstances.

TAX BREAK

9-1b Pension and deferred Income Income tax withholding is also required on pension and other deferred income payments based on Form W-4P, Withholding Certificate for Pension or Annuity Payments, as completed and signed by the taxpayer. Financial institutions and corporations must withhold on the taxable part of pension, profit sharing, stock bonus, and individual retirement account payments. The rates used for withholding vary depending on the nature of the payment, as described below:

1. Periodic payments (such as annuities): Rates are based on the taxpayer’s Form W-4P or if no W-4P is filed, tax will be withheld as if the taxpayer were married and claiming three withholding allowances.

2. Nonperiodic payments: Withholding is deducted at a flat 10 percent rate, except for certain distributions from qualified retirement plans, which have a required 20 percent withholding tax rate. See LO 9.8 for a discussion of withholding on rollover distributions.

EXAMPLE Adam is a retired college professor and receives a pension of $775 per month. The payor should withhold on the pension, based on Adam’s signed W-4P, in the same manner as if it were Adam’s salary. ♦

9-1c Tip Reporting Tips are a significant part of the compensation received by employees in many types of jobs such as the following:

EXAMPLE Sharon’s withholding from the previous example may also be obtained from the wage bracket tables in Appendix C. For a wage payment of $2,300 with two allowances, using the married person’s monthly payroll period table, the amount of the withholding is found to be $62. ♦

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9-10 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

The employer uses the information from Form 4070 to properly withhold employment and income taxes on tip income. To provide some assurance that accurate tip income is being reported by employees in large food or beverage establishments, the employer must compare employee-reported tips to 8 percent of the employer’s sales. If the reported tips are less than 8 percent of sales, the employer must allocate the difference to each employee and report this amount on each employee’s Form W-2 in Box 8 (Allocated Tips). The allocation of tip income can be accomplished in one of three ways. The employer may allocate the amount based on (1) gross receipts per employee, (2) hours worked by each employee (available only to employers having fewer than the equivalent of twenty- five full-time employees), or (3) a good faith agreement as explained on Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips. For a detailed explanation of the allocation process, see the instructions for Form 8027. With the diversity of businesses and tipping customs, the IRS also permits employers to enter into the Tip Rate Determination Education Program, in which the employer and the IRS work out a tip rate and reporting system. For more information on tip reporting in general, see the IRS website (www.irs.gov) or a tax research service.

The IRS has created two programs to help employers in businesses in which employees are compensated with tips: Tip Rate Determination Agreement (TRDA) and Tip Reporting Alternative Commitment (TRAC). These two programs are designed to help employers and employees more accurately report tip income and simplify the process for reporting tips by employees and employers.

TAX BREAK

9-1d Backup Withholding In some situations, individuals may be subject to backup withholding on payments such as interest and dividends. The purpose of backup withholding is to ensure that income tax is paid on income reported on Form 1099. If backup withholding applies, the payor (e.g., bank or insurance company) must withhold 24 percent of the amount paid to the taxpayer. Payors are required to use backup withholding in the following cases:

1. The taxpayer does not give the payor his or her taxpayer identification number (e.g., Social Security number),

2. The taxpayer fails to certify that he or she is not subject to backup withholding, 3. The IRS informs the payor that the taxpayer gave an incorrect identification number, or

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9-119-2 Estimated Payments

Self-Study Problem 9.1 See Appendix E for Solutions to Self-Study Problems

For 2019, John earns $2,500 per month and has two dependent children. He is divorced and claims three allowances on his Form W-4. Calculate John’s withholding using:

1. The percentage method $ 2. The wage bracket method $

4. The IRS informs the payor to start withholding because the taxpayer has not reported the income on his or her tax return.

EXAMPLE Kamili earned $2,000 in interest income from Cactus Savings Bank. Kamili failed to certify that she was not subject to backup withholding. As a result, the bank must withhold taxes of $480 (24 percent of $2,000) from the interest payments to Kamili. ♦

Taxpayers who give false information to avoid backup withholding are subject to a $500 civil penalty and criminal penalties, including fines and/or imprisonment.

9-2 ESTIMATEd PAyMENTS Self-employed taxpayers are not subject to withholding; however, they must make quar- terly estimated tax payments. Taxpayers with large amounts of interest, dividends, and other income not subject to withholding are also generally required to make estimated payments. Payments are made in four installments on April 15, June 15, and September 15 of the tax year, and January 15 of the following year (or the first business day after if the dates fall on a weekend or holiday), based on the taxpayer’s estimate of the amount of the tax liability for the year. A taxpayer with self-employment income must begin making the payments when he or she first meets the filing requirements.

9.2 Learning Objective Determine taxpayers’ quarterly estimated payments.

Never write out a check to the “IRS.” The IRS issues this warning every year, because “IRS” may be easily changed to “MRS” plus an individual’s name if the check falls into the wrong hands. Checks must be made payable to the U.S. Treasury, as a reminder that the IRS is merely the collector of revenue for the federal government. Alternatively, individual taxpayers can draft their bank account using Direct Pay or, for a fee, pay using a debit or credit card. Both methods are available on the IRS website.

TAX BREAK

Any individual taxpayer who has estimated tax for the year of $1,000 or more, after subtracting withholding, and whose withholding does not equal or exceed the “required annual payment,” must make quarterly estimated payments. The required annual payment is the smallest of the following amounts:

1. Ninety percent of the tax shown on the current year’s return, 2. One hundred percent of the tax shown on the preceding year’s return (such return

must cover a full 12 months), or 3. Ninety percent of the current-year tax determined by placing taxable income, alterna-

tive minimum taxable income, and adjusted self-employment income on an annual- ized basis for each quarter.

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9-12 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

A special rule applies to individuals with adjusted gross income in excess of $150,000 for the previous year. These high-income taxpayers must pay 110 percent of the amount of tax shown on the prior year tax return for the current year estimated payments, instead of 100 percent, to meet the requirements in the second option on the previous page.

Estimated payments need not be paid if the estimated tax, after subtracting withhold- ing, can reasonably be expected to be less than $1,000. Therefore, employees who also have self-employment income may avoid making estimated payments by filing a new Form W-4 and increasing the amount of their withholding on their regular salary.

The IRS imposes a nondeductible penalty on the amounts of any underpayments of estimated tax. The penalty applies when any installment is less than the required annual payment divided by the number of installments that should have been made, which is usually four. Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts, is used for the calculation of the penalty associated with the underpayment of estimated tax.

Good tax planning dictates that a taxpayer postpone payment of taxes as long as no penalty is imposed. Unpaid taxes are equivalent to an interest-free loan from the government. Therefore, taxpayers should base their estimated payments on the method which results in the lowest amount of required quarterly or annual payment. For example, a taxpayer who expects his tax liability to increase might base his or her estimated payments this year on the amount of the tax liability for the prior year.

Self-Study Problem 9.2 See Appendix E for Solutions to Self-Study Problems

Ray Adams (Social Security number 466-47-1131) estimates his required annual payment for 2019 to be $8,140. He has a $365 overpayment of last year’s taxes that he wishes to apply to the first quarter estimated tax payment for 2019. Complete the first quarter voucher below for Ray for 2019 by assuming any additional information, such as Ray’s address.

9-3 ThE FICA TAX The Federal Insurance Contributions Act (FICA) imposes Social Security and Medicare taxes. It was passed by Congress in 1935 to provide benefits for qualified retired and disabled workers. If a worker should die, it would also provide the family of the worker with benefits. The Medicare program for the elderly is also funded by FICA taxes.

FICA taxes have two parts, Social Security (Old Age, Survivors, and Disability Insurance [OASDI]) and Medicare. Employees and their employers are both required to pay FICA

Learning Objective 9.3 Compute the FICA tax.

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9-13

Year Maximum $ Base for 6.2% (employee and employer)

Maximum $ Base for 1.45% (employee and employer)*

2015 118,500 Unlimited

2016 118,500 Unlimited

2017 127,200 Unlimited

2018 128,400 Unlimited

2019 132,900 Unlimited

*Employees pay a 0.9 percent Medicare tax on wages over $200,000 single and head of household ($250,000 married filing jointly). See Chapter 6 for more information.

taxes. Employers withhold a specified percentage of each employee’s wages up to a maximum base amount, match the amount withheld with an equal amount, and pay the total to the Social Security Administration.

The Social Security (OASDI) tax rate is 6.2 percent and the Medicare tax rate is 1.45 percent each for employees and employers in 2019. The original FICA tax in 1935 was 1 percent of the first $3,000 in earnings. The maximum wage subject to the Social Security portion of the FICA tax is $132,900 in 2019, and all wages are subject to the Medicare portion of the FICA tax. The maximum wages to which the rates apply have increased over the years as presented in the following table.

EXAMPLE Katherine earns $21,500 for 2019. The FICA tax on her wages is calculated as follows:

Katherine: Soc. Sec. 2 6.2% 3 $21,500 $1,333.00 Medicare 2 1.45% 3 $21,500 311.75 Total employee FICA tax $ 1,644.75 Katherine’s

employer: Soc. Sec. 2 6.2% 3 $21,500 $ 1,333.00 Medicare 2 1.45% 3 $21,500 311.75 Total employer FICA tax $1,644.75 Total FICA tax $ 3,289.50

♦

EXAMPLE Nora is an employee of Serissa Company. Her salary for 2019 is $138,000. Nora’s portion of the FICA tax is calculated as follows:

Soc. Sec. 2 6.2% 3 $132,900 $8,239.80 Medicare 2 1.45% 3 $138,000 2,001.00

Total employee FICA tax $10,240.80

The total combined FICA tax (employee’s and employer’s share) is $20,481.60. ♦

Taxpayers age 18 and older may request an online statement of Social Security benefits including estimates of projected retirement, survivors’, and disability benefits. The state- ment also shows the taxpayer’s Social Security earnings history, giving the taxpayer an opportunity to correct any errors or omissions. The personalized online statement is avail able at www.ssa.gov/myaccount. In some cases, the Social Security Administration will provide a paper version of this statement by mail.

TAX BREAK

9-3 The FICA Tax

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9-14 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

9-4 FEdERAL TAX dEPOSIT SySTEM Employers must make periodic deposits of the taxes that are withheld from employees’ wages. The frequency of the deposits depends on the total income tax withheld and the total FICA taxes for all employees. Employers are either monthly depositors or semiweekly depositors. Prior to the beginning of each calendar year, taxpayers are required to determine which of the two deposit schedules they are required to use. If income tax withholding and FICA taxes of $100,000 or more are accumulated at any time during the year, the depositor is subject to a special one-day deposit rule.

Monthly or semiweekly deposit status is determined by using a lookback period, con- sisting of the four quarters beginning July 1 of the second preceding year and ending June 30 of the prior year. If the total income tax withheld from wages and FICA taxes attributable to wages for the four quarters in the lookback period is $50,000 or less, employers are monthly

Learning Objective 9.4 Apply the federal deposit system to payroll withholding.

9-3a Overpayment of Social Security Taxes Taxpayers who work for more than one employer during the same tax year may pay more than the maximum amount of Social Security taxes. This occurs when the taxpayer’s total wages are more than the maximum base amount for the year. When this happens, the tax- payer should compute the excess taxes paid, and report the excess on Line 11 of Schedule 3 of Form 1040 as an additional payment against his or her tax liability. This way, the taxpayer is refunded the excess Social Security tax. Note that the employer is not entitled to a similar refund for the overpaid matching Social Security tax.

EXAMPLE Jerry worked for two employers during 2019. The first employer withheld and paid Social Security taxes on $80,000 of salary paid to Jerry, and the second employer withheld and paid Social Security taxes on $60,000 of salary paid to Jerry. The amount of Jerry’s excess Social Security taxes paid for 2019 is computed as follows: 6.2% (Social Security rate) 3 [$80,000 1 $60,000 2 $132,900 (maximum for Social Security portion of FICA tax)] 5 $440.20. Jerry receives credit against his 2019 income tax liability equal to the excess Social Security taxes of $440. No excess Medicare tax has been paid, as there is no upper limit on Medicare wages. ♦

Self-Study Problem 9.3 See Appendix E for Solutions to Self-Study Problems

Debbie earns $137,000 in 2019. Calculate the total FICA tax that must be paid by:

Debbie: Soc. Sec. $

Medicare $

Debbie’s employer: Soc. Sec. $

Medicare $

Total FICA tax $

FICA taxes are paid one-half by employees through withholding and one-half by employers. Since the employer portion of the tax increases the cost of employees, many economists believe that even the employer’s share of FICA tax is passed on to employees in the form of lower compensation. Thus, employees, like self-employed individuals, effectively bear both halves of FICA taxes.

Would You

Believe?

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9-159-4 Federal Tax Deposit System

depositors for the current year. Monthly depositors must make deposits of employment taxes and taxes withheld by the fifteenth day of the month following the month of withholding. New employers are automatically monthly depositors.

If the total income tax withheld from wages and FICA attributable to wages for the four quarters in the lookback period is more than $50,000, the employer is a semiweekly depositor for the current year. Taxes on payments made on Wednesday, Thursday, or Friday must be deposited by the following Wednesday; taxes on payments made on the other days of the week must be deposited by the following Friday. If a deposit is scheduled for a day that is not a banking day, the deposit is considered to be made timely if it is made by the close of the next banking day.

EXAMPLE Tom runs a small business with ten employees. During the lookback period for the current year, the total withholding and FICA taxes amounted to $40,000. Since this is less than $50,000, Tom is a monthly depositor. His payroll tax deposits must be made by the fifteenth day of the month following the month of withholding. ♦

Tax payments (monthly, semiweekly, or daily for large depositors) must be made by Electronic Federal Tax Payment System (EFTPS), or by another electronic transfer method. Generally, employers must file Form 941, Employer’s Quarterly Federal Tax Return, which reports the federal income taxes withheld from wages and the total FICA taxes attributable to wages paid during each quarter. Form 941 must be accompanied by any payroll taxes not yet deposited for the quarter. A special deposit rule allows small employers who accumulate less than $2,500 tax liability during a quarter to skip monthly payments and pay the entire amount of their payroll taxes with their quarterly Form 941. Form 941 must be filed by the last day of the month following the end of the quarter. For example, the first quarter Form 941, covering the months of January through March, must be filed by April 30. The Form 941 e-file program allows a taxpayer to electronically file Form 941 or Form 944.

Nearly a million very small employers with employment tax liability of $1,000 or less per year are allowed to file employment tax returns just once a year, instead of quarterly; for example, by January 31 of 2019 for 2018 employment taxes. Qualifying small employers receive written notification from the IRS that they should file using a Form 944 instead of the standard Form 941 used by most employers. The Form 944 is due annually, at the end of the month, following the taxpayer’s year end.

IRS Publication 15, “(Circular E), Employers Tax Guide,” covers the rules regarding the calculation and deposit of payroll taxes in detail and is an indispensable resource for those working in this complex area.

Self-Study Problem 9.4 See Appendix E for Solutions to Self-Study Problems

For the first quarter of 2019, Charlotte York has two employees. The payroll information for these two employees for the first quarter is as follows:

Mary Chris January February March January February March

Gross wages $2,000 $2,000 $2,100 $1,000 $1,000 $1,500 Federal income 230 230 235 60 60 180

tax withheld FICA tax 153 153 161 77 77 115

withheld

Charlotte deposited $750 on February 15, $750 on March 15, and $967 on April 15. Using this information, complete only page 1 of Charlotte’s Form 941, on Page 9-17, for the first quarter of 2019.

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9-16 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

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9-179-4 Federal Tax Deposit System

Self-Study Problem 9.4

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9-18 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

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9-199-5 Employer Repor ting Requirements

9-5 EMPLOyER REPORTING REquIREMENTS On or before January 31 of the year following the calendar year of payment, an employer must furnish to each employee two copies of the employee’s Wage and Tax Statement, Form W-2, for the previous calendar year. If employment is terminated before the end of the year and the employee requests a Form W-2, the employer must furnish the Form W-2 within 30 days after the last wage payment is made or after the employee request, whichever is later. Otherwise, the general rule requiring the W-2 to be furnished to the employee by January 31 applies. The original copy (Copy A) of all Forms W-2 and Form W-3 (Transmittal of Wage and Tax State- ments) must be filed by the employer with the Social Security Administration by January 31 of the year following the calendar year of payment. Copy B of Form W-2 is filed with the em- ployee’s federal tax return. Employers retain Copy D of Form W-2 for their records. Extra cop- ies of Form W-2 are prepared for the employee to use when filing state and local tax returns.

Form W-2 is used to report wages, tips, and other compensation paid to an employee. Form W-2 also provides the employee with additional supplemental information. Among the items which must be reported on the employee’s Form W-2 are the cost of employer- sponsored health coverage, employer contributions to a health savings account (HSA), excess group-term life insurance premiums, Roth contributions to an employer plan, and certain reimbursements of travel and other ordinary and necessary expenses.

Special rules apply to the reimbursement of travel and other ordinary and necessary employee business expenses. If an employee is reimbursed for travel and other ordinary and necessary business expenses, income and employment tax withholding may be required. If a reimbursement payment is considered to have been made under an accountable plan, the amount is excluded from the employee’s gross income and consequently is not required to be included on Form W-2, and no withholding is required. Alternatively, reim bursements of travel and other employee business expenses made under a nonaccountable plan must be included as wages on Form W-2, and the amounts are subject to withholding. Payments are considered made under a nonaccountable plan in the following circumstances: (1) the employee receives a reimbursement for expenses under an arrangement which does not require the employee to account adequately to the employer, or the employee receives advances under an arrangement which does not require the employee to return amounts in excess of substantiated expenses; or (2) the employee receives amounts under an arrange ment that requires the employee to substantiate reimbursed expenses, but the amounts are not substantiated within a reasonable period of time, or the employee receives amounts under a plan which requires excess reimbursements to be returned to the employer, but the employee does not return such excess amounts within a reasonable period of time. In the first case, the entire amount paid under the expense account plan is considered wages sub ject to withholding, whereas under the circumstances described in the second situation, only the amounts in excess of the substantiated expenses are subject to withholding.

9.5 Learning Objective Prepare employer payroll reporting.

The Social Security Administration permits employers to prepare and file up to 50 Forms W-2 using their online business services. Employers should go to www.ssa.gov to register for the service.

TAX BREAK

9-5a Form W-2G Gambling winnings are reported by gambling establishments on Form W-2G. Amounts that must be reported include certain winnings from horse and dog racing, jai alai, lot- teries, state-conducted lotteries, sweepstakes, wagering pools, bingo, keno, and slot machines. In certain cases, withholding of income taxes is required. Forms W-2G must be transmitted to the taxpayer no later than January 31 of the year following the calendar year of payment, and to the IRS along with Form 1096 by the last day of February of the year following the calendar year of payment. Requirements to file Form W-2G can differ

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9-20 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

between the type of wagering or gaming. The due date is March 31 if transmitting elec- tronically to the IRS. More information can be found in the instructions for Form W-2G.

9-5b Information Returns Taxpayers engaged in a trade or business are required to file Form 1099 for each recipi- ent of certain payments made in the course of their trade or business. Where applicable, federal income tax withheld with respect to the payment is also reported on Form 1099. The com mon types of payments and the related Form 1099 are summarized in Table 9.1.

Form used For 1099-B Payments of proceeds from brokers 1099-DIV Dividend payments 1099-G Certain government payments (state income tax refund) 1099-INT Interest payments 1099-K Merchant card and third-party network transactions 1099-MISC Miscellaneous payments 1099-R Payments of pension, annuity, profit sharing, retirement

plan, IRA, insurance contracts, etc. 1099-S Payments from real estate transactions

TABLE 9.1 1099 FORMS

If a taxpayer receives a Form 1099, the income reported on that form should be included on the tax return. The IRS is going to match the identification number on the Form 1099 to the taxpayer’s tax return and will likely notice if that income is missing. Form 1099s are not usually required to be attached to the taxpayer’s return; however, if tax was withheld on the payment reported, the Form 1099 should be attached as necessary.

TAX BREAK

Forms 1099 must be mailed to the recipients by January 31 of the year following the calendar year of payment. However, payors are allowed until February 15 of the year fol lowing the calendar year of payment to provide Forms 1099-B, 1099-S, and certain 1099-MISC forms. A separate Form 1096 must be used to transmit each type of 1099 to the appropriate IRS Campus Processing Site by the last day of February (or by January 31 if payments are reported in Box 7) of the year following the calendar year of payment. The due date is March 31 if transmitting electronically to the IRS.

Typically, nonemployee compensation has been reported in Box 7 on Form 1099-MISC. Nonemployee compensation is generally when an individual who does not qualify as an employee is paid for services provided. The IRS has released a draft Form 1099-NEC to begin reporting nonemployee compensation starting in 2020.

New Tax Law!

9-5c Form 1099-K Reporting Merchant Card and Third-Party Payments

Banks and online payment networks (“payment settlement entities”), such as PayPal, Venmo, VISA, and MasterCard, are required to use Form 1099-K to report credit card sales and other reportable sales transactions to the IRS and to the businesses making reportable sales. The reporting requirement is triggered for an entity when the total dollar amount of transactions for a particular merchant exceeds $20,000 and the total number of transactions exceeds 200.

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9-219-5 Employer Repor ting Requirements

Self-Study Problem 9.5 See Appendix E for Solutions to Self-Study Problems

Big Bank (P.O. Box 12344, San Diego, CA 92101; E.I.N. 95-1234567; California ID 800 4039250 092; and telephone number 800-555-1212) paid an employee, Mary Jones (6431 Gary Street, San Diego, CA 92115), wages of $16,150 for 2019. The federal income tax withholding for the year amounted to $2,422, and FICA withheld was $1,235.48 ($1,001.30 for Social Security tax and $234.18 for Medicare tax). State income tax withheld was $969.00. Mary’s FICA wages were the same as her total wages, and her Social Security number is 464-74-1132.

a. Complete the following Form W-2 for Mary Jones from Big Bank.

b. Mary also has a savings account at Big Bank, which paid her interest for 2019 of $461. Complete the following Form 1099-INT for Mary’s interest income.

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9-22 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

9-6 ThE FuTA TAX Please note: Employers in jurisdictions that have not repaid money borrowed from the federal government for unemployment benefits will have a higher FUTA tax than the 0.6 percent illustrated below. At the time we go to print, only the U.S. Virgin Islands may have a credit reduction in 2019. For purposes of the problems and examples in this textbook, assume that the employer does not reside in one of the jurisdictions where a higher FUTA tax applies.

The Federal Unemployment Tax Act (FUTA) instituted a tax that is not withheld from employees’ wages, but instead is paid in full by employers. The federal unemployment tax rate is 6 percent of an employee’s wages up to $7,000. A credit is allowed for state unemployment taxes of 5.4 percent. Therefore, the effective federal unemployment tax rate is only 0.6 percent if the state also assesses an unemployment tax.

EXAMPLE Karen has two employees in 2019, John, who earned $12,500 this year, and Sue, who earned $15,000. The FUTA tax is calculated as follows:

John’s wages, $12,500 (maximum $7,000) $ 7,000 Sue’s wages, $15,000 (maximum $7,000) 7,000 Total FUTA wages 14,000 FUTA tax at 0.6% $ 84 ♦

Employers report their FUTA liability for the year on Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return. Like federal income tax withholding and FICA taxes, federal unemployment taxes must be deposited by electronic funds transfer (EFTPS). A deposit is required when the FUTA taxes for the quarter, plus any amount not yet deposited for the prior quarter(s), exceed $500. If required, the deposit must be made by the last day of the month after the end of each quarter.

EXAMPLE Ti Corporation’s federal unemployment tax liability for the first quarter of 2019, after reduction by the credit for state unemployment taxes, is $255; for the second quarter, $200; for the third quarter, $75; and for the fourth quarter, $25. Ti Corporation must deposit $530, the sum of the first, second, and third quarters’ liability, by October 31, 2019. The remaining $25 may be either deposited or paid with Form 940. ♦

Because states administer federal-state unemployment programs, most of the unem- ployment tax is paid to the state. Employers must pay all state unemploy ment taxes for the year by the due date of the federal Form 940 to get full credit for the state taxes against FUTA.

Learning Objective 9.6 Compute the amount of FUTA tax for an employer.

Self-Study Problem 9.6 See Appendix E for Solutions to Self-Study Problems

The Rhus Company’s payroll information for 2019 is summarized as follows: Quarter 1 Quarter 2 Quarter 3 Quarter 4

Gross earnings of employees $25,000 $30,000 $26,000 $32,000 Individual employee earnings in excess of $7,000 None $ 4,000 $10,000 $ 8,000

Rhus Company (E.I.N. 94-0001112), located at 400 8th Street N., La Crosse, WI 54601, pays Wisconsin state unemployment tax. The company makes the required deposits of both federal and state unemployment taxes on a timely basis and had no overpayment in 2018. Complete Parts 1–5 of the Rhus Company’s 2019 Form 940 on Pages 9-23 and 9-24, using the above information.

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9-23

Self-Study Problem 9.6

9-6 The FUTA Tax

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9-24 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

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9-259-7 Qualified Retirement Plans

9-7 quALIFIEd RETIREMENT PLANS

9-7a qualified Plans For a retirement plan to be a qualified plan for income tax purposes, it must meet the fol- lowing general requirements:

1. A plan must be created by an employer for the exclusive benefit of employees or their beneficiaries.

2. The contributions and benefits under a plan must not discriminate in favor of highly compensated employees.

3. A plan must meet certain participation and coverage requirements. The plan must provide that all employees who are 21 years old and who have completed at least 1 year of service with the employer are eligible to participate. If the plan provides for 100 percent vesting of accrued benefits upon commencement of participation in the plan, the 1 year of service requirement may be replaced with a requirement that the employee has completed at least 2 years of service.

4. Minimum vesting requirements must be met with respect to both employee and employer contributions.

5. Uniform minimum distribution rules must be met.

9-7b Types of qualified Plans The tax law provides for several types of qualified plans: pension plans, profit-sharing plans, stock bonus plans, and Employee Stock Ownership Plans (ESOPs). The pension plan can take one of two forms: the defined contribution plan or the defined benefit plan. Under a defined contribution plan, the amount of contribution for the employee is determined by reference to a formula based on the employee’s current compensation. The employee’s retirement benefits will be dependent upon the accumulated contributions and earnings in the account at the time of retirement. Under a defined benefit plan, the future retirement benefits of the employee are specified, and a formula is used to determine the contributions necessary to provide for the defined benefit. Defined benefit plans are being used more sparingly by employers over the last three decades. Profit-sharing plans are structured to allow the employee to share in company profits through employer contributions from such profits. Under a stock bonus plan, employer contributions on behalf of the employee consist of stock of the employer company.

EXAMPLE Heather is an employee who earned $30,000 during the current year. Her employer contributed $1,200 (4 percent of Heather’s salary) to a qualified retirement plan. This plan is a defined contribution plan. ♦

EXAMPLE Alan works for an employer whose qualified retirement plan states that Alan will receive a retirement benefit at age 65 equal to 40 percent of his last year’s salary. The employer must make adequate contributions to the plan to enable the stated retirement benefit to be paid (a sufficient amount of money must be in the plan upon Alan’s retirement to pay for Alan’s defined retirement benefit). This plan is a defined benefit plan. ♦

9-7c Limitations on Contributions to and Benefits from qualified Plans

Employee and employer contributions to qualified plans are subject to certain dollar or percentage limitations. Under a defined contribution plan (including profit sharing plans), the annual addition to an employee’s account is generally not allowed to exceed the lesser of $56,000 (in 2019) or 25 percent of the employee’s compensation. Under a defined benefit plan, the annual benefit payable to an employee upon retirement is limited to the lesser of $225,000 (for 2019) or 100 percent of the employee’s average compensation for the highest three consecutive years of employment. The operational rules for qualified pension plans and the other types of qualified plans are complex.

9.7 Learning Objective Describe the general rules for qualified retirement plans.

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9-26 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

Self-Study Problem 9.7 See Appendix E for Solutions to Self-Study Problems

Jeannie is employed by a business that operates a qualified profit-sharing plan.

a. In 2019, when her compensation is $50,000, what is the maximum contribution the business can make for her?

$ b. If Jeannie’s salary was $250,000, what is the maximum contribution?

9-8 ROLLOVERS In many situations, taxpayers need to transfer assets from one retirement plan to another plan of the same or different type. For example, the taxpayer may change jobs, take early retirement, or simply seek a better retirement fund manager. There are two ways this trans- fer can be accomplished: (1) direct transfer, also known as a trustee-to-trustee transfer, and (2) rollover of the distribution, in whole or in part, to an IRA or other qualified plan. There are potentially different tax treatments for the two types of transfers.

9-8a direct Transfers In direct transfers, the taxpayer instructs the trustee of the retirement plan to transfer assets to the trustee of another plan. There are no current-year tax consequences for this transac- tion. Also, there is no limit to the dollar amount of the transfer or the number of times a taxpayer can do this in a single tax year.

EXAMPLE Juan has $90,000 in a Section 401(k) plan with his employer. He also has two IRAs, one with ABC Bank ($20,000) and one with XYZ Mutual Fund ($30,000). In March of 20XX, Juan instructs ABC Bank to make a direct transfer to XYZ Mutual Fund of all of his funds ($20,000). In August of 20XX, Juan quits his job and instructs the trustee of the Section 401(k) plan to transfer his $90,000 directly to XYZ Mutual Fund. On December 31, 20XX, Juan has $140,000 in his XYZ Mutual Fund IRA. Since the two transactions were direct transfers, there are no tax consequences to Juan in the current year. ♦

9-8b distribution Rollovers In a distribution rollover, the taxpayer receives a distribution of funds from a retirement plan and then transfers part or all of the funds to the new retirement plan trustee. The taxpayer has a maximum of 60 days in which to transfer funds to the new plan and avoid taxes and penalties. The 60-day rollover period may be waived in cases of casualty, disaster, and other events beyond the reasonable control of the taxpayer such as death, disability, incarceration, and postal error. The 60-day time limit is extended to 120 days for first-time home buyers.

The major drawback to distribution rollovers is that the trustee must withhold 20 percent of the amount distributed for federal income taxes, giving the taxpayer only 80 percent of the amount in his or her plan. However, the taxpayer must contribute 100 percent of the amount in the old plan to the new trustee within the required 60-day period to avoid tax on the distribution. Amounts that are not placed in a new plan within the required period are taxable as ordinary income in the current year. Also, if the taxpayer is under 59½ years old, the portion of the retirement plan distribution not transferred will be subject to a 10 percent penalty tax.

Learning Objective 9.8 Explain the pension plan rollover rules.

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9-279-8 Rollovers

The exception to mandatory withholding is a distribution from an IRA; such distributions are not subject to the 20 percent withholding tax. Also, taxpayers are allowed only one distribution rollover each year for transfers from one IRA to another IRA. There are many other complex rules concerning retirement plan rollovers.

EXAMPLE Bea is 50 years old, has worked for Gold Company for 25 years, and has $200,000 in her retirement plan. This year, Gold Company is purchased by Green Company. As a result of the takeover, Bea was laid off. Bea requests a distribution of her $200,000 from Gold Company’s retirement plan. The trustee of Gold’s retirement plan must withhold $40,000 (20% of $200,000) from the distribution. Bea only receives $160,000 from her retirement plan distribution. If Bea wants to roll her funds into an IRA and avoid taxes, she must contribute $200,000, even though she only received $160,000. If Bea has no other resources and cannot make up the $40,000, the amount not contributed to the IRA will be taxable income to her and subject to a 10 percent penalty. If Bea makes the total rollover contribution of $200,000 within the 60-day timeframe, then the distribution will be nontaxable. The $40,000 will be reported as taxes withheld on her tax return. ♦

Self-Study Problem 9.8 See Appendix E for Solutions to Self-Study Problems

Carol, age 40, has an IRA with Blue Mutual Fund. Her balance in the fund is $150,000. She has heard good things about the management of Red Mutual Fund, so she opens a Red Fund IRA. Carol requests her balance from the Blue Fund be distributed to her on July 1, 20XX. She opted to have no withholding on the distribution.

a. How much will Carol receive from the Blue Fund IRA? $

b. If the funds were distributed from a qualified retirement plan (not an IRA), how much would Carol receive?

$ c. When is the last day Carol can roll over the amount received into the Red Fund IRA and avoid

taxation in the current year?

$ d. Assuming the funds were distributed from a qualified retirement plan, not from an IRA, how

much will Carol have to contribute to the Red Fund IRA to avoid taxable income and any penalties?

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9-28 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

K e y t e r m s

Form W-4, 9-2 withholding allowances, 9-2 special withholding allowance, 9-7 IRS Publication 15, “(Circular E),

Employer’s Tax Guide,” 9-8 percentage method, 9-8 wage bracket method, 9-8 backup withholding, 9-10 estimated payments, 9-11 FICA, 9-12 Social Security, 9-12 Medicare, 9-12

OASDI, 9-12 monthly or semiweekly

depositors, 9-14 special one-day deposit rule, 9-14 EFTPS, 9-15 Form 941, 9-15 Form W-2, 9-19 Form W-3, 9-19 Form 1099, 9-20 Form 1099-K, 9-20 FUTA, 9-22 Form 940, 9-22

qualified plan, 9-25 pension plans, 9-25 profit-sharing plans, 9-25 stock bonus plans, 9-25 Employee Stock Ownership Plans

(ESOPs), 9-25 defined contribution plan, 9-25 defined benefit plan, 9-25 trustee-to-trustee transfer, 9-26 rollover, 9-26

Learning Objectives Key points

LO 9.1: Compute the income tax withholding from employee wages.

● Employers are required to withhold taxes from amounts paid to employees for wages, including salaries, fees, bonuses, commissions, vacation and retirement pay.

● Form W-4, showing the filing status and the number of withholding allowances an employee is claiming, is furnished to the employer by the employee.

● When using the percentage method of withholding, an employer (1) multiplies the number of allowances by a specified allowance amount, (2) subtracts that amount from the employee’s gross wages for the pay period, and (3) applies the result to the percentage method withholding tables.

● Under the wage bracket method, the amount of withholding is obtained from the wage bracket method witholding tables based on the total wages and the number of withholding allowances claimed for the appropriate payroll period and marital status.

● Tip income must be reported using one of several methods.

LO 9.2: Determine taxpayers’ quarterly estimated payments.

● Self-employed taxpayers are not subject to withholding; however, they must make quarterly estimated tax payments.

● Estimated payments are made in four installments on April 15, June 15, and September 15 of the tax year, and January 15 of the following year.

● Any individual taxpayer who has estimated tax for the year of $1,000 or more, after subtracting withholding, and whose withholding does not equal or exceed the “required annual payment,” must make quarterly estimated payments.

● The required annual payment is the smallest of three amounts: (1) 90 percent of the tax shown on the current year’s return, (2) 100 percent (or 110 percent at higher income levels) of the tax shown on the preceding year’s return, or (3) 90 percent of the current-year tax determined each quarter on an annualized basis.

LO 9.3: Compute the FICA tax.

● For 2019, the Social Security (OASDI) tax rate is 6.2 percent and the Medicare tax rate is 1.45 percent for employers and employees. The maximum wage subject to the Social Security portion of the FICA tax is $132,900 for 2019, and all wages are subject to the Medicare portion of the FICA tax.

● Taxpayers working for more than one employer during the same tax year may pay more than the maximum amount of Social Security taxes. If this happens, the taxpayer should compute the excess taxes paid, and report the excess on Schedule 3 of Form 1040 as a payment against his or her income tax liability.

K e y p O I n ts

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9-29Questions and Problems

LO 9.4: Apply the federal deposit system to payroll withholding.

● Employers must make periodic deposits of the taxes that are withheld from employees’ wages. Deposits must be made electronically.

● Employers are either monthly depositors or semiweekly depositors, depending on the total income taxes withheld from wages and FICA taxes attributable to wages. However, if withholding and FICA taxes of $100,000 or more are accumulated at any time during the year, the depositor is subject to a special one-day deposit rule.

LO 9.5: Prepare employer payroll reporting.

● On or before January 31 of the year following the calendar year of payment, an employer must furnish to each employee two copies of the employee’s Wage and Tax Statement, Form W-2, for the previous calendar year.

● The original copy (Copy A) of all Forms W-2 and Form W-3 (Transmittal of Wage and Tax Statements) must be filed with the Social Security Administration by January 31 of the year following the calendar year of payment.

● Forms 1099 must be mailed to the recipients by January 31 of the year following the calendar year of payment.

LO 9.6: Compute the amount of FUTA tax for an employer.

● The FUTA (Federal Unemployment Tax Act) tax is not withheld from employees’ wages, but instead is paid in full by employers.

● The federal unemployment tax rate is 6.0 percent of an employee’s wages up to $7,000. A credit of up to 5.4 percent is allowed if state unemployment taxes are paid, resulting in an effective federal unemployment tax rate of 0.6 percent.

LO 9.7: Describe the general rules for qualified retirement plans.

● In order to be qualified, retirement plans must meet certain requirements related to non-discrimination of lower compensated employees, participation eligibility, vesting requirements, and distribution rules.

LO 9.8: Explain the pension plan rollover rules.

● There are two ways to transfer assets from one retirement plan to another of the same or different type: (1) a direct transfer, also known as a trustee-to-trustee transfer, and (2) a rollover of an actual cash distribution, in whole or in part, to an IRA or other qualified plan.

● There are no current-year tax consequences for a direct trustee-to-trustee transfer. ● Distribution rollovers are subject to a 60-day time limit for completion and may also be subject to income tax withholding and tax penalties.

GrOUp 1:

MuLTIPLE ChOICE quESTIONS

1. Which of the following amounts paid by an employer to an employee is not subject to withholding? a. Salary b. Bonus c. Commissions d. Reimbursement of expenses under a non-accountable plan e. All of the above are subject to withholding

LO 9.1

Q U es t I O ns a n d prO b L e m s

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9-30 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

2. Abbe, age 56, is married and has two dependent children, one age 14, and the other a 21-year-old full-time student. Abbe has one job, and her husband, age 58, is not employed. If she expects to earn wages of $50,000, file jointly, and take the standard deduction, how many allowances should Abbe claim on her Form W-4? a. 4 b. 5 c. 7 d. 8 e. 9

3. Michele is single with no dependents and earns $23,000 this year. Michele claims sixteen allowances on her Form W-4. Which of the following is correct concerning her Form W-4? a. Michele may not under any circumstances claim sixteen allowances. b. Michele’s employer will require her to verify her right to claim sixteen allowances. c. Michele’s employer should ask her to prepare a corrected Form W-4. If Michele is

unwilling to update her Form W-4, then her employer should disregard her Form W-4 and withhold at the single taxpayer rate with no allowances.

d. Michele’s employer will submit a copy of her W-4 to the IRS if directed to do so by written notice.

e. None of the above is correct.

4. Flo is a server at a diner in Phoenix and earns a significant portion of her pay through tips from customers. Some of these tips are paid via credit card and others are paid in cash. Flo’s employer will: a. withhold employment taxes but no income taxes on the tips b. withhold both employment and income taxes on the cash tips but only employ-

ment taxes on the tips paid by credit card c. withhold both employment and income taxes on all tips d. not withhold any taxes on cash tips but will withhold both employment and in-

come taxes on credit card tips

5. The process for employee withholding involves: a. the employee computes the number of allowances on Form W-4 and the employer

uses the W-4 information to calculate income tax withholding b. the employee provides wage information and the employer completes Form W-4

and withholds based on employee instruction c. the employee provides filing status and the employer completes the Form W-4 and

submits to the IRS for proper withholding d. the employee completes most of the Form W-4 and the employer submits the

form to the IRS and awaits withholding instructions

6. Estimated payments for individual taxpayers are due on the following dates: a. Twice a year on April 15 and September 15 b. Four installments on April 15, June 15, September 15, and January 15 of the

next year c. Four times a year on April 15, July 15, September 15, and December 15 d. Twice a year on June 15 and December 15

7. Amy is a single taxpayer. Her income tax liability in the prior year was $5,178. Amy earns $50,000 of income ratably during the current year and her tax liability is $4,342. In order to avoid penalty, Amy’s smallest amount of required annual withholding and estimated payments is: a. $4,372 b. $3,935 c. $3,908 d. $4,660 e. $4,342

LO 9.1

LO 9.2

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9-31Questions and Problems

8. Jane is a single taxpayer with a current year AGI of $181,000 and current year income tax liability of $39,610. Her AGI in the prior year was $150,400 and prior year tax li- ability was $32,182. Jane earns her income ratably during the year. In order to avoid penalty, the smallest amount of required annual withholding and estimated payments is: a. $39,610 b. $32,182 c. $35,649 d. $35,400 e. $43,571

9. Which of the following is not true about FICA taxes? a. The FICA tax has two parts, Social Security (Old Age, Survivors, and Disability

Insurance) and Medicare. b. In 2019, the maximum wage base for Social Security tax withholding is $128,400. c. In 2019, there is no maximum wage base for Medicare tax withholding. d. When employees work for more than one employer and exceed the maximum

wage base for Social Security tax withholding in total, they are allowed a refund of excess tax withheld.

10. Terry worked for two employers during 2019. The amount of wages paid to Terry by both employers totaled $168,400 and the employers properly withheld both income and employment taxes. As a result of Terry’s two jobs: a. Terry will receive a credit against his employment taxes in 2020 from his employer b. Terry will request a refund of overpaid employment taxes from his second

employer c. Terry will claim a credit for excess Social Security taxes paid on his 2019 income

tax return d. Terry will claim a credit for excess Social Security and Medicare taxes on his 2019

income tax return e. Terry will file a Form 843 with the Social Security Administration to claim back

excess withheld employment taxes

11. Ran’s wage income is $47,350 in 2019. The combined employer and employee FICA tax rates that apply to Ran’s wages are: a. 15.3% for Social Security and Medicare b. 6.2% for Social Security and Medicare c. 1.45% for Medicare d. 7.65 for Social Security e. None of the above

12. Employers generally must file a quarterly tax return showing the amount of wages paid and the amount of income tax and FICA tax withholding due. This tax return is filed on: a. Form 944 or Form 945 b. Schedule H c. Schedule SE d. Form 941

13. Yamin operates a small business with a few part-time employees. Her annual employ- ment tax withholding in 2019 is $467.80. Yamin should file which employment tax reporting form? a. Form 944 b. Form 940 c. Form 941 d. Form 9000 e. Form 409

LO 9.2

LO 9.3

LO 9.4

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9-32 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

14. Which of the following forms is used to report wages, tips and other compensation paid to employees? a. Form W-4 b. Form W-2G c. Form W-2 d. Form 1099-R e. Form 1099-MISC

15. Which of the following forms is used to report government payments such as a state income tax refund? a. Form W-2G b. Form 1099-Casino c. Form 1099-G d. Form 1099-Lottery e. Form 1099-C

16. The FUTA tax is: a. An unemployment tax with a rate of 2.9 percent up to $132,900 of salary

per employee. b. A disability tax with a rate of 2.9 percent up to $7,000 of salary per employee. c. An unemployment tax with a rate as low as 0.6 percent on up to $7,000 of salary

per employee. d. A disability tax with a rate of 0.6 percent up to $132,900 of salary per employee.

17. Wei has four employees: Anna, Kenny, Stan, and Seth, who were paid $12,000, $5,000, $8,000, and $3,000, respectively. Assuming a full state credit, Wei’s FUTA taxable wages for the year are: a. $28,000 b. $21,000 c. $22,000 d. $186

18. Gail’s employer contributes $2,000 (5% of her $40,000 salary) to a qualified retirement plan for Gail. This pension plan is what kind of plan? a. Defined benefit plan b. Defined contribution plan c. Employee Stock Ownership Plan d. Profit-sharing plan e. None of the above

19. When taxpayers receive distributions from qualified retirement plans, how much time is allowed to roll over the amount received into a new plan to avoid paying taxes on the distribution in the current year, assuming there are no unusual events? a. 60 days b. 90 days c. 180 days d. 1 year e. There is no time limit

20. Tom quits his job with $150,000 in his employer’s qualified retirement plan. Since he is broke, Tom instructs the plan trustee to pay him the balance in his retirement account. How much will Tom receive when he gets his check from the retirement plan? a. $120,000 b. $100,000 c. $96,000 d. $24,000 e. Some other amount

LO 9.5

LO 9.6

LO 9.7

LO 9.8

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9-33Questions and Problems

21. Betty owns three separate IRA accounts with different banks. She wishes to consolidate her three IRAs into one IRA in 2019. How many distribution rollovers may Betty make in 2019? a. One b. Two c. Four d. Ten e. There is no limit

22. Bonnie is getting close to retirement and realizes she has three different IRA accounts at three different financial institutions. To make life simpler, Bonnie wishes to con- solidate her three IRAs into a single account in 2019 using trustee-to-trustee direct rollovers. How many rollovers of this type can Bonnie make in 2019? a. One b. Two c. Four d. Ten e. There is no limit

LO 9.8

1. Phan Mai is single with two dependent children under age 17. Phan estimates her wages for the year will be $42,000 and her itemized deductions will be $14,000. In the previous year, Phan had a small tax liability. Assuming Phan files as head of household, use Form W-4 on Pages 9-35 and 9-36 to determine the number of withholding allowances Phan should claim.

2. Ralph and Kathy Gump are married with one 20-year-old dependent child. Ralph earns a total of $98,000 and estimates their itemized deductions to be $29,500 for the year. Kathy is not employed. Use Form W-4 on Pages 9-35 and 9-36 to determine the number of withholding allowances that Ralph should claim.

3. Sophie is a single taxpayer. For the first payroll period in July 2019, she is paid wages of $2,200 monthly. Sophie claims one allowance on her Form W-4. a. Use the percentage method to calculate the amount of Sophie’s withholding for

a monthly pay period. $

b. Use the wage bracket method to determine the amount of Sophie’s withholding for the same period.

4. Cassie works at Capital Bank and is in charge of issuing Form 1099s to bank cus- tomers. Please describe for Cassie the 4 possible situations that require the bank to implement backup withholding on a customer.

LO 9.1

GrOUp 2:

PROBLEMS

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9-34 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

5. Sherina Smith (Social Security number 785-23-9873) lives at 536 West Lapham Street, Milwaukee, WI 53204, and is self-employed for 2019. She estimates her required annual estimated tax payment for 2019 to be $8,468. She had a $417 overpayment of last year’s taxes, which she will apply against her first quarter estimated payment. Complete the first quarter voucher below for Sherina for 2019.

LO 9.2

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9-35Questions and Problems

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9-36 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

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6. Kana is a single wage earner with no dependents and taxable income of $205,000 in 2019. Her 2018 taxable income was $155,000 and tax liability was $31,490. Calculate the following (note: this question requires the use of the tax tables in Appendix A):

Kana’s 2019 income tax liability $_______

Kana’s minimum required 2019 annual payment necessary to avoid penalty $_________

7. Lamden Company paid its employee, Trudy, wages of $52,000 in 2019. Calculate the FICA tax:

Withheld from Trudy’s wages: Social Security $ Medicare $ Paid by Lamden: Social Security $ Medicare $ Total FICA Tax $

8. Fiduciary Investments paid its employee, Yolanda, wages of $139,000 in 2019. Calculate the FICA tax:

Withheld from Yolanda’s wages: Social Security $ Medicare $ Paid by Fiduciary: Social Security $ Medicare $ Total FICA Tax $

9. Thuy worked as the assistant manager at Burger Crown through August 2019 and received wages of $79,000. Thuy then worked at Up and Down Burger starting in September of 2019 and received wages of $61,500. Calculate the amount of Thuy’s overpayment of Social Security taxes that she should report on her 2019 Form 1040.

10. Drew Freeman operates a small business and his payroll records for the first quarter of 2019 reflect the following:

Employee Matt D. Jack F. Avery F. Tiffany Y.

Gross wages $2,870.00 $1,400.00 $1,750.00 $4,200.00

Federal income tax withheld 37.00 18.00 24.00 191.00

FICA taxes 439.11 214.20 267.75 642.60 Drew’s employee identification number is 34-4321321 and his business is located at 732 Nob Hill Blvd. in Yakima, WA 98902. Drew is eligible to pay his withholding at the time he files his quarterly Form 941. Complete Form 941 located on Pages 9-39 and 9-40 for Drew for the first quarter of 2019.

11. For each of the following payments, indicate the form that should be used to report the payment: a. Interest of $400 paid by a bank b. Payment of $400 in dividends by a corporation to a shareholder c. Periodic payments from a retirement plan d. Salary as president of the company e. Las Vegas keno winnings of $25,000

LO 9.2

LO 9.3

LO 9.4

LO 9.5

9-37Questions and Problems

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9-38 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

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9-39Questions and Problems

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9-40 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

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12. Philcon Corporation created the following 2019 employee payroll report for one of its employees.

LO 9.5

Philcon Corpora�on Employee Payroll Report EIN: 12-3456789 2019 PO Box 4563 Anchorage, AK 99508

Period YTD Emp ID Name Wage Type Date Gross Pay Gross Pay W-4 Allow FIT w/h SS Tax w/h Med Tax w/h

A1246G Louise Chugach Monthly 1/31/2019 11,100.00 11,100.00 4 1,766.54 688.20 160.95 A1246G Louise Chugach Monthly 2/28/2019 11,100.00 22,200.00 4 1,766.54 688.20 160.95 A1246G Louise Chugach Bonus 3/15/2019 6,400.00 28,600.00 00.804,1 396.80 92.80 A1246G Louise Chugach Monthly 3/31/2019 11,100.00 39,700.00 4 1,766.54 688.20 160.95 A1246G Louise Chugach Monthly 4/30/2019 11,100.00 50,800.00 4 1,766.54 688.20 160.95 A1246G Louise Chugach Monthly 5/31/2019 11,100.00 61,900.00 4 1,766.54 688.20 160.95 A1246G Louise Chugach Monthly 6/30/2019 11,100.00 73,000.00 4 1,766.54 688.20 160.95 A1246G Louise Chugach Monthly 7/31/2019 11,100.00 84,100.00 4 1,766.54 688.20 160.95 A1246G Louise Chugach Monthly 8/31/2019 11,100.00 95,200.00 4 1,766.54 688.20 160.95 A1246G Louise Chugach Monthly 9/30/2019 11,100.00 106,300.00 4 1,766.54 688.20 160.95 A1246G Louise Chugach Monthly 10/31/2019 11,100.00 117,400.00 4 1,766.54 688.20 160.95 A1246G Louise Chugach Monthly 11/30/2019 11,100.00 128,500.00 4 1,766.54 688.20 160.95 A1246G Louise Chugach Monthly 12/31/2019 11,100.00 139,600.00 4 1,766.54 272.80 160.95 A1246G Louise Chugach YTD Total 139,600.00 84.606,22 8,239.80 2,024.20

Employee Mailing Address: Louise Chugach 5471 East Tudor Road Anchorage, AK 99508 SSN: 545-64-7745

Total Tax Net Pay 2,615.69 8,484.31 2,615.69 8,484.31 1,897.60 4,502.40 2,615.69 8,484.31 2,615.69 8,484.31 2,615.69 8,484.31 2,615.69 8,484.31 2,615.69 8,484.31 2,615.69 8,484.31 2,615.69 8,484.31 2,615.69 8,484.31 2,615.69 8,484.31 2,200.29 8,899.71

32,870.48 106,729.52

a. Complete the following Form W-2 for Louise Chugach from Philcon Corporation.

b. Philcon Corporation also paid $1,100 to Ralph Kincaid for presenting a management seminar. Ralph lives at 1455 Raspberry Road, Anchorage, AK 99508, and his Social Security number is 475-45-3226. Complete the Form 1099-MISC located on Page 9-42 for the payment to Ralph from Philcon Corporation.

9-41Questions and Problems

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9-42 Chapter 9 ● Payroll, Estimated Payments, and Retirement Plans

13. Thomas is an employer with two employees, Patty and Selma. Patty’s wages are $12,450 and Selma’s wages are $1,310. The state unemployment tax rate is 5.4 per- cent. Calculate the following amounts for Thomas: a. FUTA tax before the state tax credit $ b. State unemployment tax $ c. FUTA tax after the state tax credit $

14. Telly, age 38, has a $140,000 IRA with Blue Mutual Fund. He has read good things about the management of Green Mutual Fund, so he opens a Green Fund IRA. Telly asked for a distribution rollover and received his balance from the Blue Fund on May 1, 2019. Telly opted to have no withholding on the distribution. a. What amount will Telly receive from the Blue Fund IRA?

$ b. What amount must Telly contribute to the Green Fund IRA to avoid having taxable

income and penalties for early withdrawal? $

c. When is the last day Telly can roll over the amount received into the Green Fund IRA and avoid taxation in the current year, assuming no unusual circumstances?

$ d. What amount would Telly receive if the distribution were from his employer’s

qualified retirement plan? $

15. Allen (age 32) takes a distribution of $20,000 from his traditional IRA account which he plans to deposit into an IRA with a different bank. During the 60-day rollover period, he gambles and loses the entire IRA balance. What income and/or penalties must he show on his tax return related to the failed rollover?

LO 9.6

LO 9.8

Form 1099-MISC

2019 Miscellaneous Income

Copy B For Recipient

Department of the Treasury - Internal Revenue Service

This is important tax information and is being furnished to the IRS. If you are

required to �le a return, a negligence

penalty or other sanction may be

imposed on you if this income is

taxable and the IRS determines that it

has not been reported.

OMB No. 1545-0115

CORRECTED (if checked) PAYER’S name, street address, city or town, state or province, country, ZIP or foreign postal code, and telephone no.

PAYER’S TIN RECIPIENT’S TIN

RECIPIENT’S name

Street address (including apt. no.)

City or town, state or province, country, and ZIP or foreign postal code

Account number (see instructions) FATCA �ling requirement

1 Rents

$ 2 Royalties

$ 3 Other income

$ 4 Federal income tax withheld

$ 5 Fishing boat proceeds

6 Medical and health care payments

$ 7 Nonemployee compensation

8 Substitute payments in lieu of dividends or interest

$ 9 Payer made direct sales of

$5,000 or more of consumer products to a buyer (recipient) for resale

10 Crop insurance proceeds

$ 11 12

13 Excess golden parachute payments

14 Gross proceeds paid to an attorney

$ 15a Section 409A deferrals

15b Section 409A income

16 State tax withheld

$ $

17 State/Payer’s state no. 18 State income

$ $

Form 1099-MISC (keep for your records) www.irs.gov/Form1099MISC

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9-43Questions and Problems

Eric, your friend, received his Form W-2 from his employer (below) and has asked for your help. Eric’s 2019 salary was $145,200 and he does not understand why the amounts in Boxes 1, 3 and 5 are not $145,200? His final paycheck for the year included the following information:

– Eric contributed 5 percent of his salary to the company 401(k) plan on a pre-tax basis. – Eric is married with two children. He had $5,000 deducted from his wages for a Depen-

dent Care Flexible Spending Account. – Eric is enrolled in the company-sponsored life insurance program. He has a policy that

provides a benefit of $145,200. – Eric contributed $2,650 to the Health Care Flexible Spending Account (he keeps forget-

ting that the maximum deferral has increased over the years).

Using the information and Eric’s Form W-2, prepare an email to Eric reconciling his salary of $145,200 to the amounts in Boxes 1, 3, and 5.

ETHICS

GrOUp 3:

WRITING ASSIGNMENT

Ivy Technologies, Inc. 436 E. 35 Avenue Gary, IN 46409

Eric Hayes 555 E. 81st Street Merrillville, IN 46410

IN 00122231001 130,417.00 4,956.00 130,417.00 987.00 LAKE

12,345.00DD

7,260.00D

127.00

5,000.00

1,996.32

8,239.80

15,184.00

137,677.00

132,900.00

130,417.00

12-3456789

791-51-4335

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Partnership Taxation

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O V e r V I e W

T he partnership form allows taxpayers considerable flexibility in terms of con- tributions, income and loss allocations, and distributions. One of the primary

benefits of the partnership is that partnership income is only taxed at the partner level. Cor- porate taxpayers (other than S corporations) pay tax at the corporate level and often again at

the shareholder level (see Chapter 11), which results in corporate double taxation. Since a partnership’s income passes through to the part- ners, there is no federal income tax at the entity level, only at the partner level. Currently, the tax law permits an additional qualified business income deduction for pass-through entities like partnerships.

L E A R N I N G O B J E C T I V E S

After completing this chapter, you should be able to: LO 10.1 Define a partnership for tax purposes. LO 10.2 Describe the basic tax rules for partnership formation and operation. LO 10.3 Summarize the rules for partnership income reporting. LO 10.4 Describe the tax treatment of partnership distributions. LO 10.5 Determine partnership tax years. LO 10.6 Describe the tax treatment of transactions between partners and their partnerships. LO 10.7 Apply the qualified business income deduction to partners. LO 10.8 Apply the at-risk rule to partnerships. LO 10.9 Describe the tax treatment of limited liability companies (LLCs).

10-1

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10-2 Chapter 10 ● Par tnership Taxation

One of the disadvantages of partnerships over corporations has been the lack of limited liability for partners whereas corporate shareholders enjoy protection from liability to third parties (e.g., creditors of the corporation). The advent of the limited liability company (LLC) and the limited liability partnership (LLP) has provided partners this important legal benefit. Because LLCs and LLPs are taxed like partnerships, they are included in this chapter on partnership taxation.

This chapter will provide an understanding of the tax treatment of partnerships and the tax forms (Form 1065 and Schedule K-1) related to reporting partnership income or loss.

10-1 NATURE OF PARTNERSHIP TAXATION Partnership federal income tax returns are information returns only. Returns show the amount of income by type and the allocation of the income to the partners. Partnership income and other items are passed through to the partners, and each partner is taxed on the individual’s distributive share of partnership income. Partnership income is taxable to the partner even if he or she does not actually receive the income in cash.

Even though the partnership tax return is only informational, partnerships do have to make various elections and select accounting methods and periods. For example, partnerships must select depreciation and inventory methods. In addition, partnerships are legal entities under civil law, and in most states have rights under the Uniform Partnership Act.

10-1a What Is a Partnership? The tax law defines a partnership as a syndicate, group, pool, joint venture, or other unin- corporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not classified as a corporation, trust, or estate. The mere co-ownership of property does not constitute a partnership; the partners must engage in some type of business or financial activity.

Ordinary partnerships, or general partnerships as they are often called, may be formed by a simple verbal agreement or “handshake” between partners. In contrast, the formation of corporations, limited partnerships, limited liability companies (LLCs), and limited liability partnerships (LLPs) must be documented in writing and the entity must be legally registered in the state in which it is formed. Even though general partnerships may be formed by verbal agreement between partners, partners usually document their agreement in writing with the help of attorneys in the event disagreements arise during the course of operations.

General partners usually take on the risk of legal liability for certain actions of the partnership or debts of the partnership, as specified under state law. To limit some of the liability exposure of operating a joint business, many partnerships are created formally as limited partnerships, LLCs, or LLPs. LLPs are used for licensed professionals such as attorneys and accountants.

Entities generally treated as partnerships for tax law purposes include limited partner- ships, LLCs, and LLPs. Limited partnerships have one or more general partners and one or more limited partners. General partners participate in management and have unlimited liability for partnership obligations. Limited partners may not participate in management and have no liability for partnership obligations beyond their capital contributions. Many partnerships are formed as limited partnerships because the limited liability helps to attract passive investors. LLCs and LLPs are legal entities which combine the limited liability of corporations with the tax treatment of partnerships. LLCs and LLPs are discussed later in this chapter.

EXAMPLE Avery and Roberta buy a rental house which they hold jointly. The house is rented and they share the income and expenses for the year. Avery and Roberta have not formed a partnership. However, if they had bought and operated a store together, a partnership would have been formed. Although the ownership of real estate may not rise to the level of a business requiring a partnership return, co-owners of real estate frequently do choose to operate in a partnership, limited partnership, LLP, or LLC form. ♦

Learning Objective 10.1 Define a partnership for tax purposes.

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10-310-2 Par tnership Formation

10-2 PARTNERSHIP FORMATION Generally, there is no gain or loss recognized by a partnership or any of its partners when property is contributed to a partnership in exchange for an interest in the partnership. This rule applies to the formation of a partnership as well as any subsequent contributions to the partnership. However, there are exceptions to the nonrecognition rule. Income may be rec- ognized when a partnership interest is received in exchange for services performed by the partner for the partnership or when a partner transfers to a partnership, property subject to a liability exceeding that partner’s basis in the property transferred. In this situation, gain is recognized to the extent that the portion of the liability allocable to the other partners exceeds the basis of the property contributed. If a partner receives money or other property from the partnership, in addition to an interest in the partnership, the transaction may be considered in part a sale or exchange, and a gain or loss may be recognized.

EXAMPLE Dunn and Church form the Dunn & Church Partnership. Dunn contributes a building with a fair market value of $90,000 and an adjusted basis of $55,000 for a 50 percent interest in the partnership. Dunn does not recognize a gain on the transfer of the building to the partnership. Church performs services for the partnership for his 50 percent interest which is worth $90,000. Church must report $90,000 in ordinary income for the receipt of an interest in the partnership in exchange for services provided to the partnership. ♦

10.2 Learning Objective Describe the basic tax rules for partnership formation and operation.

Self-Study Problem 10.1 See Appendix E for Solutions to Self-Study Problems

Indicate, by placing a check in the appropriate blank, whether each of the following is or is not required to file a partnership return.

Yes No

1. Duncan and Clyde purchase and operate a plumbing ________ ________ business together.

2. Ellen and Walter form a corporation to operate a ________ ________ plumbing business.

3. George and Marty buy a duplex to hold as rental ________ ________ property, which is not considered an active business.

4. Howard and Sally (both single taxpayers) form a joint ________ ________ venture to drill for and sell oil.

5. Ted and Joyce, a married couple, purchase and operate ________ ________ a candy store.

For federal tax purposes, an unincorporated business operated by spouses is considered a partnership. As a result, a business co-run by spouses is generally required to comply with filing and record-keeping requirements for partnerships and partners. Married co-owners wishing to avoid the burden of partnership documentation can form a qualified joint venture. The election to do so is made by simply reporting each spouse’s share of income, losses, gains, and deductions on a Schedule C (along with other related forms) in respect of each spouse’s interest in the joint venture.

TAX BREAK

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10-4 Chapter 10 ● Par tnership Taxation

EXAMPLE Ann and Keith form the A&K Partnership. Ann contributes a building with a fair market value of $200,000 and an adjusted basis of $45,000 for a 50 percent interest in the partnership. The building is subject to a liability of $130,000. Keith contributes cash of $70,000 for a 50 percent interest in the partnership. Ann must recognize a gain on the transfer of the building to the partnership equal to $20,000, the amount by which the liability allocable to Keith, $65,000 (50% 3 $130,000), exceeds the basis of the building, $45,000. Keith does not recognize a gain on the contribution of cash to the partnership. ♦

A partner’s initial basis in a partnership interest is equal to the basis of the property transferred plus cash contributed to the partnership. If gain is recognized on the transfer, the partner’s basis in the partnership interest is increased by the gain recognized. The basis is reduced by any liabilities of the contributing partner assumed by the other partners through the partnership. For example, if a one-third partner is relieved of a $90,000 liability by the partnership, they would reduce by $60,000 ( 2@

3 of $90,000) their partnership interest

basis. After the initial basis in the partnership interest is established, the basis is adjusted for future earnings, losses, contributions to the partnership, and distributions from the partnership.

EXAMPLE Prentice contributes cash of $50,000 and property with a fair market value of $110,000 (adjusted basis of $30,000) to the P&H Partnership. Prentice’s basis in the partnership interest is $80,000 ($50,000 1 $30,000). ♦

EXAMPLE Assume that Prentice, in the example above, also received a partnership interest worth $15,000 for services provided to the partnership. She must recognize $15,000 as ordinary income, and her basis in the partnership interest is $95,000 ($80,000 1 $15,000). ♦

EXAMPLE Darnell contributes property with a fair market value of $110,000 and an adjusted basis of $30,000, subject to a liability of $20,000, to a partnership in exchange for a 25 percent interest in the partnership. Darnell’s basis in his partnership interest is $15,000 [$30,000 2 ($20,000 3 75%)]. ♦

The basis of a partner’s interest in a partnership changes due to partnership activities. A partner’s basis in their partnership interest is increased by the partner’s share of (1) additional contributions to the partnership, (2) net ordinary taxable income of the partnership, and (3) capital gains and other income of the partnership. Alternatively, a partner’s basis is reduced (but not below zero) by the partner’s share of (1) distributions of partnership property, (2) losses from operations of the partnership, and (3) capital losses and other deductions of the partnership. In addition, changes in the partner’s share of partnership liabilities affects the basis of a partner’s partnership interest.

EXAMPLE Reid has a 50 percent interest in the Reid Partnership. Her basis in her partner ship interest at the beginning of the tax year is $12,000. For the current tax year, the partnership reports ordinary income of $15,000, a capital gain of $3,000, and charita ble contributions of $700. The basis of Reid’s partnership interest, after con sidering the above items, would be $20,650 ($12,000 beginning basis 1 $7,500 share of partnership ordinary income 1 $1,500 share of partnership capital gain 2 $350 share of partnership charitable contributions). ♦

The partnership’s basis in property contributed by a partner is equal to the partner’s adjusted basis in the property at the time of the contribution plus any gain recognized by

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10-510-3 Par tnership Income Repor ting

Self-Study Problem 10.2 See Appendix E for Solutions to Self-Study Problems

John and Linda form the J&L Partnership. John contributes cash of $36,000 for a 40 percent interest in the partnership. Linda contributes equipment worth $54,000 with an adjusted basis of $17,500 for a 60 percent partnership interest.

1. What is John’s recognized gain or loss on the $_________________ contribution?

2. What is John’s basis in his partnership interest? $_________________ 3. What is Linda’s recognized gain or loss on the $_________________

contribution? 4. What is Linda’s basis in her partnership interest? $_________________ 5. What is J&L Partnership’s basis in the equipment $_________________

received from Linda?

10-3 PARTNERSHIP INCOME REPORTING A partnership is required to report its income and other items on Form 1065, U.S. Return of Partnership Income, even though the partnership entity does not pay federal income tax. The tax return is due on the fifteenth day of the third month following the close of the partnership’s tax year. When reporting partnership taxable income, certain transactions must be separated rather than being reported as part of ordinary income. The primary items that must be reported separately are capital gains and losses, Section 1231 gains and losses, dividends, interest income, tax-exempt income, retirement contributions, charitable contributions, and most credits. These items are listed as separate income or expenses, since they are often subject to special calculations or limitations on the tax returns of the partners.

After the special items are separated, the partnership reports the remainder of its ordinary income or loss. The ordinary income or loss of a partnership is calculated in the same manner as that of an individual, except the partnership is not allowed to deduct the standard deduction, foreign taxes paid, charitable contributions, net operating losses, or personal itemized deductions. Schedule K-1 of Form 1065 presents the allocation of ordinary income or loss, special income and deductions, and gains and losses to each partner. The partners report the amounts from their Schedules K-1 on their own tax returns.

A partner’s deductible loss from a partnership is limited to the basis of the partner’s partnership interest at the end of the year in which the loss was incurred. The partner’s basis is not affected by the qualified business income deduction. The partner’s partnership

10.3 Learning Objective Summarize the rules for partnership income reporting.

the partner. The transfer of liabilities to the partnership by the partner does not impact the basis of the property to the partnership. The partnership’s holding period for the property contributed to the partnership includes the partner’s holding period. For example, long-term capital gain property may be transferred to a partnership by a partner and sold immediately, and any gain would be long-term, assuming the property is a capital asset to the partnership.

EXAMPLE Clark contributes property to the Rose Partnership in exchange for a partnership interest. The property contributed has an adjusted basis to Clark of $45,000 and a fair market value of $75,000 on the date of the contribution. The partnership’s basis in the property is $45,000. ♦

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10-6 Chapter 10 ● Par tnership Taxation

basis cannot be reduced below zero. Any unused losses may be carried forward and reported in a future year when there is partnership basis available to be reduced by the loss.

Self-Study Problem 10.3 See Appendix E for Solutions to Self-Study Problems

Robert Conrad and Jan Springs are equal partners in the newly formed Malus Valley Partnership. During 2019, the partnership began operations and had the following income and expenses:

Gross income from operations $255,600 Deductions: Salaries to employees $168,000 Rent 12,000 Payroll taxes 6,100 Depreciation 9,250 Charitable contributions (to 50 percent organizations) 1,500 Cash withdrawals ($25,000 for each partner) 50,000

The partnership’s balance sheet is as follows:

Malus Valley Balance Sheet as of December 31, 2019

Assets: Cash $ 27,000 Accounts receivable 10,000 Land 115,000 Building $115,000 Less: accumulated depreciation (9,250) 105,750 Total Assets $257,750 Liabilities and Partners’ Capital: Accounts payable $ 29,750 Mortgage payable 187,750 Partners’ capital (includes $31,500 originally contributed, $15,750 by each partner) 40,250 Total Liabilities and Partners’ Capital $257,750

Complete Form 1065, Page 1, and Schedules K, L, M-1, and M-2 on Pages 10-7 to 10-11 for Malus Valley. Also, complete Schedule K-1 on Pages 10-13 and 10-14 for Robert.

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10-710-3 Par tnership Income Repor ting

Self-Study Problem 10.3

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10-8 Chapter 10 ● Par tnership Taxation

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10-910-3 Par tnership Income Repor ting

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10-10 Chapter 10 ● Par tnership Taxation

Self-Study Problem 10.3

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10-1110-3 Par tnership Income Repor ting

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10-12 Chapter 10 ● Par tnership Taxation

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10-1310-3 Par tnership Income Repor ting

Self-Study Problem 10.3

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10-14 Chapter 10 ● Par tnership Taxation

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10-1510-4 Current Distributions and Guaranteed Payments

10-4 CURRENT DISTRIBUTIONS AND GUARANTEED PAyMENTS

A partnership may make distributions of money or other property to the partners. A cur- rent distribution is defined as one which does not result in the complete termination of the partner’s interest in the partnership.

In a current distribution, no gain is recognized by the partner receiving the distribution unless the partner’s basis in the partnership has reached zero. In such a case, gain is recognized only to the extent that a distribution of money exceeds the partner’s basis in their partnership interest.

The distribution of money or other property reduces the partner’s basis in their partnership interest, but not below zero.

EXAMPLE Calvin is a partner in K&G Interests, and his basis in his partnership interest is $75,000. In the current tax year, Calvin receives a $45,000 cash distribution from the part nership. He does not recognize a gain or loss on the distribution, but his basis in his partnership interest is reduced to $30,000 ($75,000 2 $45,000). If the distribution of cash were $80,000 instead of $45,000, Calvin would have a taxable gain of $5,000 ($80,000 2 $75,000), and his basis in the partnership interest would be reduced to zero ($75,000 2 $80,000 1 $5,000). ♦

The basis of property received by a partner in a current distribution will generally be the same as the basis of the property to the partnership immediately prior to the distribution. An overall limitation is imposed which states that the basis of the assets distributed cannot exceed the partner’s basis in his partnership interest, reduced by any money distributed. In some cases, this overall limitation may require that the partner’s basis in the partnership interest be allocated among the assets received in the distribution.

10-4a Guaranteed Payments Payments made to a partner for services rendered or for use of the partner’s capital that are made without regard to the income of the partnership are termed guaranteed payments. Such payments are treated by the partnership in the same manner as payments made to a person who is not a partner. The payments are ordinary income to the partner and deductible by the partnership. Guaranteed payments are separately reported on Line 4 of Schedule K-1.

EXAMPLE Alexander and Bryant operate the A&B Partnership. Alexander, a 50 percent partner, receives guaranteed payments of $15,000 for the year. If A&B has net ordinary income (after guaranteed payments) of $53,000, Alexander’s total income from A&B is $41,500 ($15,000 1 50% of $53,000). Alexander’s Schedule K-1 would report $26,500 on Line 1 (ordinary business income) and $15,000 on Line 4 (guaranteed payments). ♦

A partnership may show a loss after deducting guaranteed payments. In that case, the partner reports the guaranteed payments as income and reports their share of the partnership loss.

10.4 Learning Objective Describe the tax treatment of partnership distributions.

Self-Study Problem 10.4 See Appendix E for Solutions to Self-Study Problems

Jim and Jack are equal partners in J&J Interests, which has ordinary income for the year of $32,000 before guaranteed payments. Jim receives guaranteed payments of $36,000 during the year. Calculate the total amount of income or loss from the partnership that should be reported by Jim and by Jack.

1. Jim should report total income (loss) of $ 2. Jack should report total income (loss) of $

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10-16 Chapter 10 ● Par tnership Taxation

10-5 TAX yEARS The tax law requires that each partner include in gross income for a particular tax year the individual’s distributive share of income, including guaranteed payments, from a partnership whose tax year ends with or within that partner’s tax year. For example, a calendar-year individual partner should report their income from a partnership with a tax year ending June 30, 2019, on his or her 2019 tax return. Since a partner reports only income reported by a partnership whose year ends with or within their tax year, it is possible to delay the reporting of partnership income and guaranteed payments for almost an entire year. This would happen, for example, if the partnership’s year-end is January 31, and the partner’s tax year is a calendar year. To prevent this deferral of income, rigid rules have been established regarding partnership tax years. Under these rules, unless a partnership can establish a business purpose for a fiscal year-end or meet certain tests, it must adopt the same taxable year as that of the majority partners. If such partners do not have the same tax year, then the partnership is required to adopt the tax year of all its principal partners. If neither of these rules can be met, the partnership must adopt a tax year based on the least aggregate deferral method (see IRS Publication 538 for more information).

Once established, a partnership will not close its tax year early unless the partnership is terminated. The tax year does not generally close upon the entry of a new partner, or the liquidation, sale, or exchange of an existing partnership interest. A partnership is terminated, and will close its tax year, if business activity by the partnership ceases.

Learning Objective 10.5 Determine partnership tax years.

Self-Study Problem 10.5 See Appendix E for Solutions to Self-Study Problems

R&S Associates is a partnership with a tax year that ends on August 31, 2019. During the partnership’s tax year, Robert, a partner, received $1,000 per month as a guaranteed payment, and his share of partnership income after guaranteed payments was $21,000. For September through December of 2019, Robert’s guaranteed payment was increased to $1,500 per month. Calculate the amount of income from the partnership that Robert should report for his 2019 calendar tax year.

10-6 TRANSACTIONS BETWEEN PARTNERS AND THE PARTNERSHIP

When engaging in a transaction with a partnership, a partner is generally regarded as an outside party, and the transaction is reported as it would be if the two parties were unre- lated. However, it is recognized that occasionally transactions may lack substance because one party to the transaction exercises significant influence over the other party. Therefore, losses are disallowed for (1) transactions between a partnership and a partner who has a direct or indirect capital or profit interest in the partnership of more than 50 percent, and (2) transactions between two partnerships owned more than 50 percent by the same partners. When a loss is disallowed, the purchaser may reduce a future gain on the disposi- tion of the property by the amount of the disallowed loss.

Learning Objective 10.6 Describe the tax treatment of transactions between partners and their partnerships.

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10-1710-7 Qualified Business Income Deduction for Par tners

Self-Study Problem 10.6 See Appendix E for Solutions to Self-Study Problems

Maxwell is a 50 percent partner in M&P Associates. Pam, Maxwell’s daughter, owns the other 50 percent interest in the partnership. During the current tax year, Maxwell sells ordinary income property to M&P Associates for $70,000. The property’s basis to Maxwell is $75,000. Also, Pam sells her personal Mercedes-Benz, with a basis of $25,000, for $40,000 to M&P Associates for use in the partnership’s business.

1. What is the amount of Maxwell’s recognized gain or loss on his transaction, and what is the nature of the gain or loss?

$ 2. What is the amount and nature of Pam’s gain or loss on her transaction with the

partnership?

EXAMPLE Kyle owns 55 percent of Willow Interests, a partnership. During the current year, Kyle sells property to the partnership for $60,000. Kyle’s adjusted basis in the property is $75,000. The $15,000 loss is disallowed, since Kyle is a more than 50 percent partner. If later the partnership sells the property for $80,000, realizing a $20,000 gain ($80,000 2 $60,000), only $5,000 of the gain is recognized, since the partnership can use Kyle’s disallowed loss to offset $15,000 of the gain. ♦

In a transaction between a partner and a partnership, a gain will be taxed as ordinary income if the partner has more than a 50 percent interest in the partnership and the property sold or transferred is not a capital asset to the transferee. The interest may be owned directly or indirectly. For example, a taxpayer indirectly owns the interests owned by their spouse, brothers, sisters, ancestors, and lineal descendants.

EXAMPLE Amy is a 50 percent partner in the A&B Partnership, and her brother, Ben, is the other 50 percent partner. Amy sells for $65,000 a building (with a basis of $50,000) to the partnership for use in its business. The property qualifies as a long-term capital asset to Amy. The gain of $15,000 ($65,000 2 $50,000), however, is ordinary income, since Amy is considered a 100 percent partner (50 percent directly and 50 percent indirectly) and the building is a Section 1231 asset to the partnership. ♦

10-7 QUALIFIED BUSINESS INCOME DEDUCTION FOR PARTNERS

The TCJA introduced a new qualified business income deduction available to individual owners of pass-through businesses such as partnerships and LLCs. The deduction in gen- eral is covered in Chapter 4. This section covers some of the items applicable specifically to partnerships.

Qualified business income (QBI) generally includes all items of ordinary business income; however, the tax law specifically excludes certain items including guaranteed payments to partners and payments made to partners by the partnership in situations in which the partner is not acting in their capacity as a partner.

10.7 Learning Objective Apply the qualified business income deduction to partners.

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10-18 Chapter 10 ● Par tnership Taxation

EXAMPLE Rigby is a 30 percent partner in Regular Partnership. In 2019, Regular has $50,000 of ordinary business income and no other separately stated items. In 2019, Rigby receives guaranteed payments of $10,000. Rigby also enters into a loan between himself and Regular and receives interest income from the partnership of $1,000. Rigby also receives a cash distribution from Regular of $5,000 and maintains a positive basis at year-end. The loan is treated as a transaction in which Rigby is not acting in his capacity as a partner and thus the guaranteed payment and the interest are both not included in Rigby’s QBI and thus Rigby’s QBI is $15,000 ($50,000 3 30%). ♦

Although guaranteed payments and payments to partners not acting as partners are not included in QBI, they are deductible by the partnership in computing ordinary business income (to the extent the items would be deductible otherwise).

Partners may want to reconsider a characterization away from guaranteed payments as part of a revision to the partnership agreement. Guaranteed payments and the allocation of business income to an individual partner are both generally subject to self-employment taxes; however, guaranteed payments are a deduction from ordinary business income while cash distributions from basis are not. In addition, guaranteed payments are not part of QBI. By treating former guaranteed payments instead as cash distributions, the partnership (and thus the partner) will have greater QBI eligible for the 20 percent QBI deduction. Of course, the “guarantee” of guaranteed payments will also be eliminated by the recharacterization.

TAX BREAK

For high income taxpayers, the QBI deduction is limited by W-2 wages or a combination of W-2 wages and qualified property. A partner must be allocated their share of these items in order to properly apply the limitations when applicable.

EXAMPLE Mordecai is a 50 percent partner in Park Partnership. In 2019, Mordecai’s taxable income is high enough to subject his QBI deduction to the wage limitation. Park pays W-2 wages of $70,000 and has qualified property of $300,000 in 2019. If these items are allocated in accordance with the partnership interest, Mordecai will be allocated $35,000 of W-2 wages ($70,000 3 50%) and $150,000 of qualified property ($300,000 3 50%) to compute his wage limitation. ♦

Self-Study Problem 10.7 See Appendix E for Solutions to Self-Study Problems

a. Dr. Marla Cratchitt is a single taxpayer and works as cardiologist. Marla is an investor in Salem Healthcare LLC, a business that manufactures stents for a variety of cardiovascular issues. Marla’s member’s interest in Salem is 20 percent and the LLC agreement calls for guaranteed payments to Marla of $75,000 per year. In 2019, Marla’s ordinary business income allocation from Salem is $200,000. Salem also allocated $5,000 of long-term capital gains to Marla. Salem paid wages to employees of $230,000 and has qualified property of $1,200,000. Marla has taxable income of $776,000 for purposes of the QBI limit. Compute Marla’s QBI deduction.

b. Assume that same facts as part a. except that Salem is a service business. Compute Marla’s QBI deduction.

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10-1910-8 The At-Risk Rule

10-8 THE AT-RISk RULE The at-risk rule is designed to prevent taxpayers from deducting losses from activities in excess of their investment in those activities. Although the at-risk rule applies to most tax- payers, it is discussed here because the rule is a common problem related to investments in partnerships. In general, the at-risk rule limits the losses from a taxpayer’s business activi- ties to “amounts at risk” (AAR) in the activity.

To understand the at-risk rule, it is necessary to understand two related terms, “nonrecourse liabilities” and “encumbered property.” A nonrecourse liability is a debt for which the borrower is not personally liable. If the debt is not paid, the lender generally can only repossess the property pledged as collateral on the loan. Encumbered property (also referred to as “collateral”) is property pledged for the liability. The property is said to be encumbered in the amount of the liability. Taxpayers are at risk in amounts equal to their cash and property contributions to the activities, borrowed amounts to the extent of the property pledged, liabilities for which the taxpayers are personally liable, and retained profits of the activity. For contributions of unencumbered property, the amount considered at risk is the adjusted basis of the property contributed to the activity. For encumbered property, the amount at risk is also the adjusted basis of the property to the taxpayer if he or she is personally liable for repayment of the debt. If there is no personal liability for the debt, the amount at risk is the difference between the adjusted basis of the property and the amount of the nonrecourse debt on the property.

EXAMPLE A taxpayer contributes property with an adjusted basis of $100,000, subject to a recourse liability of $25,000 and a nonrecourse liability of $40,000. The taxpayer’s AAR is the basis of the property less the amount of the nonrecourse liability, or $60,000 ($100,000 2 $40,000). ♦

Under the at-risk rule, taxpayers are allowed a deduction for losses allocable to a business activity to the extent of (1) income received or accrued from the activity without regard to the amount at risk, or (2) the taxpayer’s amount at risk at the end of the tax year. Any losses not allowed in the current year may be treated as deductions in succeeding years, with no limit on the number of years the losses may be carried forward. Remember that passive loss rules (discussed in Chapter 4) may also limit the taxpayer’s ability to deduct certain losses.

EXAMPLE A taxpayer contributes $100,000 to an activity. Her amount at risk is $100,000. In the current year, the activity incurs losses of $250,000. For the current year, the taxpayer is allowed a loss of $100,000, the amount at risk. ♦

While real estate acquired before 1987 is not subject to the at-risk rules, the at-risk rules do apply to real estate acquired after 1986. For real estate acquired after 1986, “qualified nonrecourse financing” on real estate is still considered to be an amount at risk. Qualified nonrecourse financing is debt that is secured by the real estate and loaned or guaranteed by a governmental agency or borrowed from any person who actively and regularly engages in the lending of money, such as a bank, savings and loan, or insurance company. A taxpayer is not considered at risk for financing obtained from sellers or promoters, including loans from parties related to the sellers or promoters.

EXAMPLE In the current tax year, Donna buys a real estate investment for a $20,000 cash down payment and she borrows $80,000 from a savings and loan company secured by a mortgage on the property. Donna has $100,000 at risk in this investment. If the mortgage were obtained from the seller, her amount at risk would be limited to her down payment of $20,000. ♦

10.8 Learning Objective Apply the at-risk rule to partnerships.

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10-20 Chapter 10 ● Par tnership Taxation

Self-Study Problem 10.9 See Appendix E for Solutions to Self-Study Problems

Indicate whether the following statements are true or false by circling the appropriate letter.

t F 1. A limited liability company is generally treated like a corporation for federal income tax purposes.

t F 2. A general partner is required for a limited liability company. t F 3. Tax attributes of an LLC transaction pass through to the owners of an LLC. t F 4. Owners of an LLC can participate in the management of the LLC business. t F 5. Limited liability debt is generally treated as recourse debt and thus included

in a member’s basis computations.

10-9 LIMITED LIABILITy COMPANIES A limited liability company (LLC) is a hybrid form of business organization having some at- tributes of a partnership and other attributes of a corporation. Each owner, referred to as a member, of an LLC has limited liability, which may be similar to a stockholder in a corpora- tion. However, an LLC is generally treated as a partnership for tax purposes. Because of this tax treatment, members of LLCs can have the tax advantages of a partnership and still have limited liability similar to a corporation. The benefits of LLCs have made them very popular as an entity choice for small business and LLCs are recognized legal entities in all 50 states and the District of Columbia. Many states prohibit certain licensed professionals such as at- torneys, architects, and accountants from forming LLCs but allow the formation of limited liability partnerships (LLPs) if they wish to operate in a partnership form with legal liability protection similar to LLCs.

For the most part, LLCs follow partnership taxation rules. For example, taxable income and losses pass through to members, thereby either avoiding the corporate tax or allowing the member to use the losses. An LLC may elect to be taxed like a corporation rather than a partnership, but very few do. Like partnerships, LLCs’ items of income and expense retain their tax attributes (e.g., capital gains and charitable contributions). However, LLCs are not required to have a general partner, unlike a limited partnership in which there has to be at least one general partner who does not have limited liability. Also, LLC members can participate in the management of the business. Because of the limited liability associated with LLCs, the debt of the LLC is generally treated as non-recourse. Lastly, LLCs may have a single member, whereas a partnership must have at least two partners. A single-member LLC is treated as a disregarded entity for tax purposes (i.e., the taxable income of the single-member LLC is reported directly on the tax return of its member, not on a separate Form 1065).

Learning Objective 10.9 Describe the tax treatment of limited liability companies (LLCs).

Self-Study Problem 10.8 See Appendix E for Solutions to Self-Study Problems

During the current tax year, Joe is a partner in a plumbing business. His amount at risk at the beginning of the year is $45,000. During the year, Joe’s share of loss is $60,000.

1. What is the amount of the loss that Joe may deduct $ for the current tax year?

2. If Joe has a profit of $31,000 in the following tax year, $ how much is taxable?

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K e y t e r m s

partnership, 10-2 general (ordinary) partnerships,

10-2 general partners, 10-2 limited partnerships, 10-2 limited partners, 10-2 initial basis, 10-4 basis, 10-4

Form 1065, 10-5 Schedule K-1, 10-5 current distribution, 10-15 guaranteed payments, 10-15 qualified business income deduction,

10-17 at-risk rule, 10-19 nonrecourse liabilities, 10-19

encumbered property (“collateral”), 10-19

qualified nonrecourse financing, 10-19

limited liability companies (“LLCs”), 10-20

limited liability partnerships (“LLPs”), 10-20

Learning Objectives Key points

LO 10.1: Define a partnership for tax purposes.

● A partnership is a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not classified as a corporation, trust, or estate.

● Partnership tax returns are information returns only, which show the amount of income by type and the allocation of the income to the partners.

● Partnership income is taxable to the partner even if that individual does not actually receive it in cash.

● Co-ownership of property does not constitute a partnership (e.g., owning investment property); the partners must engage in some type of business or financial activity.

● Limited partnerships, limited liability partnerships (LLPs), and limited liability companies (LLCs) are generally treated as partnerships for tax law purposes.

LO 10.2: Describe the basic tax rules for partnership formation and operation.

● Generally, there is no gain or loss recognized by a partnership or any of its partners when property is contributed to a partnership in exchange for an interest in the partnership.

● When a partner receives a partnership interest in exchange for providing services to the partnership, income is recognized by the partner.

● When a partner transfers property to a partnership in exchange for a partnership interest and that property is subject to a liability exceeding the partner’s basis, income may be recognized by the partner.

● A partner’s basis is increased by the partner’s contributions to the partnership, income and gains of the partnership, and increases in the partner’s share of partnership liabilities.

● A partner’s basis is decreased by distributions by the partnership, losses of the partnership, and decreases in the partner’s share of partnership liabilities.

LO 10.3: Summarize the rules for partnership income reporting.

● A partnership is required to report its income and other items on Form 1065, U.S. Return of Partnership Income, even though the partnership does not pay federal income tax.

● When reporting partnership taxable income, certain transactions must be separated rather than being reported as part of ordinary income. Separately reported items include capital gains and losses, Section 1231 gains and losses, dividends, interest income, tax-exempt income, retirement contributions, charitable contributions, and most credits.

● Schedule K-1 of Form 1065 presents the allocation of ordinary income or loss, special income and deductions, and gains and losses to each partner. The partners report the K-1 amounts on their own individual tax returns.

K e y p O I N ts

10-21Key Points

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10-22 Chapter 10 ● Par tnership Taxation

LO 10.4: Describe the tax treatment of partnership distributions.

● No gain is recognized by the partner receiving a current distribution unless the partner’s basis in the partnership has reached zero, in which case, gain is recognized to the extent that a distribution of money exceeds the partner’s basis in their partnership interest.

● Payments made to a partner for services rendered or for use of the partner’s capital that are made without regard to the income of the partnership are termed guaranteed payments.

● Guaranteed payments are treated by the partnership in the same manner as payments made to a person who is not a partner.

● Guaranteed payments are ordinary income to the partner and deductible by the partnership.

● A partnership may show a loss after deducting guaranteed payments, in which case, the partner reports the guaranteed payments as income and reports their share of the partnership loss.

LO 10.5: Determine partnership tax years.

● Each partner includes in gross income for a particular tax year their individual distributive share of income, including guaranteed payments, from a partnership whose tax year ends with or within that tax year.

● Unless a partnership can establish a business purpose for a fiscal year-end or meet certain tests, it must adopt the same taxable year as that of the majority partners.

● If the majority partners do not have the same tax year, then the partnership is required to adopt the tax year of all its principal partners; otherwise, the partnership must adopt a tax year based on the least aggregate deferral method.

● The tax year does not generally close upon the entry of a new partner, or upon the liquidation, sale, or exchange of an existing partnership interest.

● A partnership will not close its tax year early unless the partnership is terminated, which occurs when business activity by the partnership ceases.

LO 10.6: Describe the tax treatment of transactions between partners and their partnerships.

● Generally, in a transaction with a partnership, a partner is regarded as an outside party, and the transaction is reported as it would be if the two parties were unrelated.

● Losses, however, are disallowed for (1) transactions between a partnership and a partner who has a direct or indirect capital or profit interest in the partnership of more than 50 percent, and (2) transactions between two partnerships owned more than 50 percent by the same partners.

● When a loss is disallowed, the purchaser may reduce a future gain on the disposition of the property by the amount of the disallowed loss.

● A gain in a transaction between a partner and a partnership will be taxed as ordinary income if the partner has more than a 50 percent interest in the partnership and the property sold or transferred is not a capital asset to the transferee.

LO 10.7: Apply the qualified business income deduction to partners.

● Qualified business income does not include guaranteed payments or payments made to partners by the partnership in situations in which the partner is not acting in their capacity as a partner.

● Partners are allocated only their share of wages paid and qualified property of the partnership when computing the QBI deduction.

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LO 10.8: Apply the at-risk rule to partnerships.

● In general, the at-risk rule limits the losses from a taxpayer’s business activities to “amounts at risk” in the activity.

● Taxpayers are at risk in amounts equal to their cash and property contributions to the activities, borrowed amounts to the extent of the property pledged, liabilities for which the taxpayers are personally liable, and retained profits of the activity.

● Under the at-risk rule, taxpayers are allowed a deduction for losses allocable to a business activity to the extent of (1) income received or accrued from the activity without regard to the amount at risk, or (2) the taxpayer’s amount at risk at the end of the tax year.

● Any losses not allowed in the current year may be treated as deductions in succeeding years, with no limit on the number of years the losses may be carried forward.

LO 10.9: Describe the tax treatment of limited liability companies (LLCs).

● A limited liability company (LLC) is a hybrid form of business organization having some attributes of a partnership and other attributes of a corporation.

● Each member of an LLC has limited liability similar to that of a stockholder in a corporation and at the same time has the tax advantages of a partnership (e.g., no tax at the entity level, loss pass-through, etc.).

● Licensed professionals, such as attorneys, architects, and accountants, must often use limited liability partnerships (LLPs), which are similar in many respects to LLCs.

GrOUp 1:

MULTIPLE CHOICE QUESTIONS

1. Which of the following may not be treated as a partnership for tax purposes? a. Arnold and Willis operate a restaurant. b. Thelma and Louise establish an LLP to operate an accounting practice. c. Lucy and Desi purchase real estate together as a business. d. Jennifer and Ben form a corporation to purchase and operate a hardware store. e. All of the above are partnerships.

2. Which of the following is a partnership for tax purposes? a. Monica and Chandler form a corporation to acquire a trucking business. b. Jimmy and Stephen both purchase a small stock interest in a manufacturing

corporation as an investment. c. Emeril and Rachel purchase a food truck and sell prepared food dishes at various

spots around the city. d. Melissa purchases a shoe store and hires her sister, Whitney, to manage the store. e. None of the above.

3. A partner’s interest in a partnership is increased by: a. Capital losses of the partnership b. Tax-exempt interest earned by the partnership c. Losses of the partnership d. Distributions by the partnership e. None of the above

LO 10.1

LO 10.2

Q U es t I O Ns a n d prO B L e m s

10-23Questions and Problems

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10-24 Chapter 10 ● Par tnership Taxation

4. Abigail contributes land with an adjusted basis of $56,000 and a fair market value of $58,000 to Blair and Partners, a partnership. Abigail receives a 50 percent interest in Blair. What is Blair’s basis in the land? a. $0 b. $28,000 c. $29,000 d. $56,000 e. $58,000

5. Abigail contributes land with an adjusted basis of $56,000 and a fair market value of $58,000 to Blair and Partners, a partnership. Abigail receives a 50 percent interest in Blair. What is Abigail’s basis in her partnership interest? a. $0 b. $28,000 c. $29,000 d. $56,000 e. $58,000

6. Abigail contributes land with an adjusted basis of $56,000 and a fair market value of $58,000 to Blair and Partners, a partnership. Abigail receives a 50 percent interest in Blair. What is Abigail’s recognized gain or loss on the contribution? a. $0 b. $2,000 gain c. $2,000 loss d. $1,000 gain e. $1,000 loss

7. Abigail contributes land with an adjusted basis of $56,000 and a fair market value of $58,000 to Blair and Partners, a partnership. Abigail receives a 50 percent interest in Blair. What is Blair’s recognized gain or loss on the contribution? a. $0 b. $2,000 gain c. $2,000 loss d. $1,000 gain e. $1,000 loss

8. Blake and Ryan form the Poole Partnership. Blake contributes cash of $15,000. Ryan contributes land with an adjusted basis of $10,000 and a fair market value of $21,000. The land is subject to a $6,000 mortgage that Poole assumes. Blake and Ryan both receive a 50 percent interest in Poole. What is Ryan’s recognized gain or loss on the contribution? a. $4,000 b. $5,000 c. $11,000 d. $16,000 e. None of the above

9. Which of the following items do not have to be reported separately on a partnership return? a. Tax-exempt income b. Dividend income c. Interest expense on business loans d. Capital gains and losses e. Charitable contributions

LO 10.2

LO 10.3

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10. Which of the following items is generally reported separately on a partnership return? a. Ordinary income from the operations of the partnership business b. Bonus depreciation c. Interest expense on business debts d. Net rental income e. Factory rent expense

11. When calculating ordinary income, partnerships are not allowed which of the following deductions? a. Miscellaneous expenses b. Qualified business income deduction c. Depreciation d. Cost of goods sold e. Employee wages

12. Feela is a one-third partner in Alchemy LLC, which is taxed as a partnership. Her ba- sis prior to Alchemy paying Feela an $11,000 cash distribution is $27,000. How much income does Feela recognize from the distribution and what is her basis in her inter- est in Alchemy after the distribution? a. $11,000 income and $27,000 basis b. $0 income and $16,000 basis c. $11,000 income and $16,000 basis d. $0 income and $27,000 basis e. None of these choices

13. Which of the following items is generally reported separately on a partnership return? a. Ordinary income from the operations of the partnership business b. Typical MACRS depreciation c. Employee salaries expense d. Insurance expense e. Guaranteed payments to a partner

14. Khushboo’s basis in her 30 percent interest in the Rishi Partnership is $46,000 at the start of the current year. During the current year, Rishi reports ordinary business in- come of $70,000. Rishi also makes a $16,000 guaranteed payment and $10,000 cash distribution, both to Khushboo. What will Khushboo’s basis be at the end of the cur- rent year and how much income will Khushboo recognize from these transactions? a. Basis of $57,000 and income of $37,000 b. Basis of $41,000 and income of $47,000 c. Basis of $90,000 and income of $96,000 d. Basis of $57,000 and income of $21,000 e. Basis of $41,000 and income of $37,000

15. Which of the following circumstances will not cause a partnership to close its tax year early? a. The partnership terminates by agreement of the partners. b. The business activity of the partnership permanently ceases. c. All the partners decide to retire, permanently close their stores and stop conduct-

ing business. d. A new partner enters the partnership.

16. Joe, Ben, and Melissa are partners in Collins Partnership. All three use a calendar year-end for their individual taxes. Collins Partnership’s year-end is likely to be: a. October 31 since that is only three months prior to calendar year-end b. The end of any month during the year c. January 31 but only if Collins Partnership’s accounting year-end is January 31 d. December 31 e. None of the above

LO 10.3

LO 10.4

LO 10.5

10-25Questions and Problems

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10-26 Chapter 10 ● Par tnership Taxation

17. Kendra is an attorney and owns 60 percent of a law partnership. Kendra sells land to the partnership for $50,000 in the current tax year. She bought the land for $100,000 eight years ago when real estate prices were at their peak. How much gain or loss must Kendra recognize on the land sale to the partnership? a. No gain or loss b. $30,000 loss c. $50,000 loss d. $50,000 short-term capital loss, limited to $3,000 allowed per year

18. A loss from the sale or exchange of property will be disallowed in which of the following situations? a. A transaction between a partnership and a partner who owns 40 percent of the

partnership capital b. A transaction between a partnership and a partner who has a 40 percent profit in-

terest in the partnership c. A transaction between two partnerships owned 40 percent by the same partners d. A transaction between two partners with investments in the same partnership e. None of the above

19. In 2019, Gloria, a single taxpayer, receives a Schedule K-1 from a partnership she is invested in. The K-1 reports ordinary business income of $40,000, dividend income of $500, tax-exempt interest of $300, and a guaranteed payment to Gloria of $10,000. Gloria’s taxable income before the QBI deduction is $87,000. What is Gloria’s QBI deduction? a. $17,400 b. $10,160 c. $10,000 d. $8,160 e. $8,000

20. Jay is a 30 percent partner in the Closet Partnership. In 2019, Closet paid W-2 wages of $24,000 and held qualified property of $600,000. In 2019, Jay’s QBI deduction is subject to the wage limitation due to his income. If Closet allocates wages and quali- fied property in the same manner as income (based on percentage ownership), what is Jay’s wage and qualified property limit on the QBI deduction? a. $12,000 b. $3,600 c. $6,300 d. $4,500

21. Mike purchases a rental property for $200,000 and takes out a loan from a lending institution to finance half of the purchase, or $100,000. The loan is considered to be qualified nonrecourse financing. What is Mike’s at-risk amount? a. $300,000 b. $200,000 c. $100,000 d. $0

22. Gloria is a 30 percent general partner in the VH Partnership. During the year, VH bor- rows $40,000 from a bank to fund operations and is able to pay back $10,000 before year-end. VH also borrows $100,000 from Gloria’s wealthy retired uncle on a non- recourse basis using land held by the partnership as the collateral. How much does Gloria’s at-risk amount increase or decrease as a result of these transactions? a. $9,000 increase b. $30,000 decrease c. $12,000 increase d. $42,000 increase e. $42,000 decrease

LO 10.6

LO 10.7

LO 10.8

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10-27Questions and Problems

1. Debbie and Alan open a web-based bookstore together. They have been friends for so long that they start their business on a handshake after discussing how they will share both work and profits or losses from the business. Explain whether Debbie and Alan formed a partnership given that they have signed no written partnership agreement?

2. Martha, Steve, and Lew form a partnership to operate a grocery store. For each of the following contributions by the partners, indicate (1) the amount of income or gain recognized, if any, by the partner, and (2) the partner’s basis in the partnership interest immediately after the contribution including the allocation of liabilities. a. Martha contributes property with a basis of $45,000 and subject to a $75,000 liabil-

ity to the partnership for a one-third partnership interest worth $105,000. The partnership assumes the liability.

Income or gain recognized $ Her basis in the partnership interest $

b. Steve contributes property with a basis of $25,000 and a fair market value of $105,000 to the partnership for a one-third partnership interest.

Income or gain recognized $ His basis in the partnership interest $

c. Lew performs services valued at $105,000 for the partnership for his one-third interest in the partnership.

Income or gain recognized $ His basis in the partnership interest $

3. Nan contributes property with an adjusted basis of $60,000 to a partnership. The property has a fair market value of $75,000 on the date of the contribution. What is the partnership’s basis in the property contributed by Nan?

4. Elaine’s original basis in the Hornbeam Partnership was $30,000. Her share of the taxable income from the partnership since she purchased the interest has been $90,000, and Elaine has received $80,000 in cash distributions from the partnership. Elaine did not recognize any gains as a result of the distributions. Calculate Elaine’s current basis in her partnership interest. $

LO 10.1

LO 10.2

GrOUp 2:

PROBLEMS

23. Which of the following properly describes a difference between a partnership and an LLC? a. Partnerships pass income and losses through to the partners while LLCs generally

pay an entity level tax and owners pay tax on distributions. b. Partners are often personally responsible for the debts of the partnership while

LLC members are not liable for LLC debt. c. Partnerships may have only one partner but LLCs must have more than one

member. d. The tax attributes of income in a partnership are retained when included in the

partner’s income but LLC income is treated as capital income in all cases.

LO 10.9

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10-28 Chapter 10 ● Par tnership Taxation

5. Larry and Jessica form the L&J Partnership. Larry contributes property with an adjusted basis of $70,000, a fair market value of $200,000, and subject to a liability of $80,000 in exchange for a 40 percent interest in the partnership. Jessica receives a 60 percent interest in the partnership in exchange for services performed for the partnership, valued at $10,000, and cash of $170,000. a. What amount of gain or loss must Larry recognize as a result of his transfer of

the property to the partnership?

b. What is Larry’s basis in his partnership interest immediately after the formation of the partnership including allocation of partnership liabilities?

c. What is the partnership’s basis in the property contributed by Larry? $

d. What is Jessica’s basis in her partnership interest immediately after the formation of the partnership including allocation of partnership liabilities? $

e. How much income does Jessica recognize on the exchange? $

6. Jay contributes property with a fair market value of $16,000 and an adjusted basis of $5,000 to a partnership in exchange for an 8 percent partnership interest. a. Calculate the amount of gain recognized by Jay as a result of the transfer of the

property to the partnership. $

b. Calculate Jay’s basis in his partnership interest immediately following the contribution to the partnership.

7. Wilson has a 40 percent interest in the assets and income of the CC&W Partner- ship, and the basis in his partnership interest is $45,000 at the beginning of 2019. During 2019, the partnership’s net loss is $60,000 and Wilson’s share of the loss is $24,000. Also, Wilson receives a cash distribution from the partnership of $12,000 on June 30, 2019. a. Indicate the amount of income or loss from the partnership that should be

reported by Wilson on his 2019 individual income tax return.

b. Calculate Wilson’s basis in his partnership interest at the end of 2019.

8. Go to the IRS website (www.irs.gov) and print pages 1 and 2 of Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc. Review the different elements of income which must be passed through to each partner and be reported as separately stated items. Review the numerous codes on page 2 of Schedule K-1 which identify additional items that are required to be separately stated.

9. L&J Interests is a partnership with two equal partners, Linda and Joanne. The partnership has income of $75,000 for the year before guaranteed payments. Guaranteed payments of $45,000 are paid to Linda during the year. Calculate the amount of income that should be reported by Linda and Joanne from the partnership for the year.

Linda should report income of $ Joanne should report income of $

LO 10.2

LO 10.2 LO 10.4

LO 10.3

LO 10.4

08239_ch10_ptg01.indd 28 10/30/19 3:23 PM

10. Walter receives cash of $18,000 and land with a fair market value of $75,000 (adjusted basis of $50,000) in a current distribution. His basis in his partnership interest is $16,000 before the distribution. a. What amount of gain must Walter recognize as a result of the current distribution?

b. What amount of gain must the partnership recognize as a result of the distribution? $

c. What is Walter’s basis in his partnership interest immediately after the distribution? $

11. Quince Interests is a partnership with a tax year that ends on September 30, 2019. During that year, Potter, a partner, received $3,000 per month as a guaranteed pay- ment, and his share of partnership income after guaranteed payments was $23,000. For October through December of 2019, Potter received guaranteed payments of $4,000 per month. Calculate the amount of income from the partnership that Potter should report for his tax year ending December 31, 2019.

12. Louise owns 45 percent of a partnership, and her brother owns the remaining 55 percent interest. During the current tax year, Louise sold a building to the partnership for $160,000 to be used for the partnership’s office. She had held the building for 3 years, and it had an adjusted basis of $120,000 at the time of the sale. What is the amount and nature of Louise’s gain on this transaction?

13. Janie owns a 40 percent interest in Chang Partnership. Chang has W-2 wages of $50,000 and qualified property of $450,000 in 2019. a. When computing the W-2 wages limitation, what is the amount of wages that will

be allocated to Janie? $

b. What is the amount of qualified property that will be allocated to Janie? $

14. Van makes an investment in a partnership in 2019. Van’s capital contributions to the partnership consist of $30,000 cash and a building with an adjusted basis of $70,000, subject to a nonrecourse liability (seller financing) of $20,000. a. Calculate the amount that Van has at risk in the partnership immediately after

mak ing the capital contributions. $

b. If Van’s share of the loss from the partnership is $100,000 in 2019, and assuming that Van has sufficient amounts of passive income, how much of the loss may he deduct in 2019? $

c. What may be done with the nondeductible part of the loss in Part b?

15. Van makes an investment in an LLC in 2019. Van’s capital contributions to the LLC consist of $30,000 cash and a building with an adjusted basis of $70,000, subject to a nonrecourse liability (seller financing) of $20,000. Calculate the amount that Van has at risk in the LLC immediately after making the capital contributions.

16. Describe ways in which LLCs might differ from partnerships.

LO 10.4

LO 10.5

LO 10.6

LO 10.7

LO 10.8

LO 10.9

10-29Questions and Problems

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10-30 Chapter 10 ● Par tnership Taxation

Emily Jackson (Social Security number 765-12-4326) and James Stewart (Social Security number 466-74-9932) are partners in a partnership that owns and operates a barber shop. The partnership’s first year of operation is 2019. Emily and James divide income and expenses equally. The partnership name is J&S Barbers, it is located at 1023 Broadway, New York, NY 10004, and its Federal ID number is 95-6767676. The 2019 financial statements for the partnership are presented below.

J&S Barbers Income Statement for the Year Ending December 31, 2019

Gross income from operations $372,300 Deductions:

Salaries to employees 94,600 Payroll taxes 14,500 Supplies 9,000 Rent 41,000 Depreciation 5,100 Short-term capital loss 2,000 Charitable contributions 500

Net income $205,600 Partners’ withdrawals (each partner) $ 80,000

J&S Barbers Balance Sheet as of December 31, 2019

Assets: Cash $100,450 Accounts receivable 10,000 Equipment $32,000 Accum. depreciation (5,100) 26,900

$137,350 Liabilities and Capital:

Accounts payable $ 29,750 Notes payable 22,000 Partners’ capital ($20,000 contributed by each partner) 85,600

$137,350

Emily lives at 456 E. 70th Street, New York, NY 10006, and James lives at 436 E. 63rd Street, New York, NY 10012.

Required: Complete J&S Barbers’ Form 1065 and Emily and James’ Schedule K-1s. Do not fill in Schedule D for the capital loss, Form 4562 for depreciation, or Schedule B-1 related to ownership of the partnership. Make realistic assumptions about any missing data.

GrOUp 3:

COMPREHENSIVE PROBLEM

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10-31Questions and Problems

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10-32 Chapter 10 ● Par tnership Taxation

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10-33Questions and Problems

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10-34 Chapter 10 ● Par tnership Taxation

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10-35Questions and Problems

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10-36 Chapter 10 ● Par tnership Taxation

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10-37Questions and Problems

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10-38 Chapter 10 ● Par tnership Taxation

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10-39Questions and Problems

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10-40 Chapter 10 ● Par tnership Taxation

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Student Name

Class/Section

Date

K e y N Um B e r ta x r e t U r N sUm m a ry

CHAPTER 10

Comprehensive Problem

Ordinary Business Income (Loss) (Page 1, Line 22)

Net Income (Loss) (Page 5, Line 1)

Net Short-Term Capital Gain (Loss) (Page 4, Line 8)

Contributions (Page 4, Line 13a)

Net Income (Loss) per Books (Schedule M-2, Line 3)

10-41Questions and Problems

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C h a p t e r 1 1

The Corporate Income Tax

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11-1

L E A R N I N G O B J E C T I V E S

After completing this chapter, you should be able to: LO 11.1 Employ the corporate tax rates to calculate corporate tax liability. LO 11.2 Compute basic gains and losses for corporations. LO 11.3 Apply special corporate deductions to corporate taxable income. LO 11.4 Identif y the components of Schedule M -1 and how they are reported to the IRS. LO 11.5 Describe the corporate tax return filing and estimated tax payment requirements. LO 11.6 Explain how an S corporation operates and is taxed. LO 11.7 Describe the basic tax rules for the formation of a corporation. LO 11.8 Describe the rules for the accumulated earnings tax and the personal holding company tax. LO 11.9 Describe tax issues associated with the repeal of the alternative minimum tax.

11-1

O V e r V I e W

T here are many forms of organization which may be used by taxpayers to operate a business. These include the sole proprietor- ship (Form 1040, Schedule C, covered

in Chapter 3); the partnership, LLC, and LLP (Form 1065 covered in Chapter 10); and the regular C corporation and S corporation (covered in this chapter). Regular C corporations are taxed as sepa- rate legal taxpaying entities, and S corporations are taxed as flow-through entities similar to partnerships.

This chapter covers corporate tax rates, capital gains and losses, special deductions, the Schedule M-1, filing requirements, corporate formations, and corporate earnings accumulations. Additionally, basic coverage of the S corporation election and operating requirements are presented in this chapter.

This chapter provides a summary of corporate taxation and the tax forms (Form 1120, Form 1120S, and related schedules) associated with reporting C or S corporation income or loss.

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11-2 Chapter 11 ● The Corporate Income Tax

11-1 CORpORATE TAx RATES Prior to 2018, the U.S. corporate tax rate structure had eight tax brackets with progressive marginal tax rates ranging from 15 percent to 39 percent. Starting in 2018, corporations are subject to a flat income tax rate of 21 percent.

ExAMpLE Jasmine Corporation has taxable income of $175,000 for 2019. The corporation’s tax liability for the year is calculated as follows:

Taxable income $ 175,000 Corporate tax rate 21% Tax liability $ 36,750

♦

Personal service corporations are taxed at the same 21 percent tax rate on all taxable income. A personal service corporation is substantially employee-owned and engages in one of the following activities:

● Health ● Law ● Engineering ● Architecture ● Accounting ● Actuarial science ● Performing arts ● Consulting

ExAMpLE Elm & Ash, Inc., is a professional service corporation of CPAs. For the current tax year, the corporation has taxable income of $175,000. Elm & Ash will have a 21 percent tax rate like any other corporation and thus a tax liability of $36,750 (21% 3 $175,000). ♦

Learning Objective 11.1 Employ the corporate tax rates to calculate corporate tax liability.

Self-Study problem 11.1 See Appendix E for Solutions to Self-Study Problems

Maple Corporation has taxable income of $275,000 for the current tax year. Calculate the corporation’s tax liability, before tax credits. Tax liability $

11-2 CORpORATE GAINS ANd LOSSES If a corporation generates a net capital gain, the net gain is included in ordinary income and the tax is computed at the regular rate except under very rare circumstances. The tax law provides for a maximum rate of 21 percent on corporate capital gains. Thus, Congress intends the ordinary income and capital gains rates to be the same for corporations, so there is no tax rate benefit to having long-term capital gains in a corporation. Net short-term capital gains of a corporation are taxed as ordinary income.

11-2a Capital Losses Corporations are not allowed to deduct capital losses against ordinary income. Capital losses may be used only to offset capital gains. If capital losses cannot be used in the year they occur, they may be carried back 3 years and forward 5 years to offset capital gains in those years. When a long-term capital loss is carried to another year, it is

Learning Objective 11.2 Compute basic gains and losses for corporations.

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11-311-2 Corporate Gains and Losses

treated as a short-term capital loss, and may be offset against either long-term or short- term capital gains.

ExAMpLE In 2019, Eucalyptus Corporation incurs a long-term capital loss of $8,000, none of which may be deducted in that year. The loss is carried back to tax years 2016, 2017, and 2018, in that order. If the loss is not entirely used to offset capital gains in those years, it may be carried forward to 2020, 2021, 2022, 2023, and 2024, in that order. When the long-term loss is carried to another year, it is considered to be short-term, and may offset against either long-term or short-term capital gains. ♦

11-2b Net Operating Losses As discussed in Chapter 3, similar to individuals, corporations may also carryforward net operating losses (NOLs) to offset future taxable income. The TCJA made significant changes to carryback and carryforward of NOLs after 2017. The use of an NOL generated after December 31, 2017 is limited to 80 percent of the current year’s taxable income (with- out regard to the NOL deduction) when used. NOLs generated prior to January 1, 2018 continue to be used 100 percent necessitating tracking of different NOL periods. In addi- tion, for NOLs generated after December 31, 2017, the carryback provisions are repealed and NOLs may only be carried forward; however, the carryforward period is now indefinite. The previous 2-year carryback and 20-year carryforward rules continue to apply to NOLs generated prior to January 1, 2018. For a corporation with NOLs from both the pre-2018 period and the post-2017 period—although the tax law is not entirely settled—the pre- 2018 loss can be used to offset up to 100 percent of the current year income and then any income remaining is subject to the 80 percent limitation.

ExAMpLE In 2017, Dez Corp has a net operating loss of $10,000. Dez elects to forego any carryback and instead carries the NOL forward to 2018. In 2018, Dez generates taxable income of $12,000 eligible to be offset by the 2017 NOL without regard to the new 80 percent of taxable income limitation. Dez’s 2018 taxable income is $2,000. ♦

ExAMpLE In 2017, Rusk Corporation has a net operating loss of $10,000 that Rusk may only carry forward. In 2018, Rusk has a net operating loss of $12,000. In 2019, Rusk generates taxable income of $15,000. Rusk must first use the $10,000 2017 NOL leaving taxable income of $5,000. Rusk may use $4,000 ($5,000 3 80% limit) of the 2018 NOL and will report taxable income of $1,000 for 2019. The remaining 2018 NOL of $11,000 may be carried forward indefinitely, subject to the 80% income limitation each year. ♦

Self-Study problem 11.2 See Appendix E for Solutions to Self-Study Problems a. During the current tax year, Taxus Corporation has ordinary income of $110,000, a

long-term capital loss of $20,000, and a short-term capital loss of $5,000. Calculate Taxus Corporation’s tax liability.

b. In 2018, Maxus Corporation generates a net operating loss of $40,000. In 2019, Maxus generates taxable income of $45,000. What is the NOL carryforward to 2020, if any?

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11-4 Chapter 11 ● The Corporate Income Tax

11-3 SpECIAL dEduCTIONS ANd LIMITATIONS Corporations are allowed certain “special deductions,” including the dividends received deduction and the deduction for organizational expenditures and start-up costs. In addition, corporations are subject to limitations on the deduction of charitable contributions.

11-3a dividends Received deduction When a corporation owns stock in another corporation, income earned by the first corpora- tion could be taxed at least three times in the absence of a special provision. The income would be taxed to the first corporation when earned by the first corporation. Then it would be taxed to the corporation owning the stock in the first corporation when the income is distributed as dividend income. Finally, the income would be taxed to the shareholders of the second corporation when that corporation in turn distributes the earnings to its stockholders as dividends. To mitigate this potential for triple taxation of corporate earnings, corporations are allowed a deduction for all or a portion of dividends received from domestic corpora- tions. Corporations are entitled to a dividends received deduction based on their percentage of ownership in the corporation paying the dividend. The 2019 deduction percentages are described below:

Percent Ownership 2019 Dividends

Received Percentage

Less than 20 percent 50% 20 percent or more, but less than 80 percent 65% 80 percent or more 100%

The dividends received deduction is limited to the applicable deduction percentage times the corporation’s taxable income calculated before the dividends received deduction, the net operating loss deduction, and capital loss carrybacks. This taxable income limitation, however, does not apply if the receiving corporation has a net operating loss after reducing taxable income by the dividends received deduction. In other words, there is no taxable income limit if the dividends received deduction creates or increases a net operating loss.

ExAMpLE During 2019, Hackberry Corporation has the following income and expenses:

Gross income from operations $240,000 Expenses from operations 200,000 Dividend received from a 30 percent-owned domestic corporation 100,000

The dividends received deduction is equal to the lesser of $65,000 (65% 3 $100,000) or 65 percent of taxable income before the dividends received deduction. Since taxable income (for computing this limitation) is $140,000 ($240,000 2 $200,000 1 $100,000) and 65 percent of $140,000 is $91,000, the full $65,000 is allowed as a deduction. ♦

ExAMpLE Assume the same facts as in the previous example, except Hackberry Corporation’s gross income from operations is $190,000 (instead of $240,000). The dividends received deduction is equal to the lesser of $65,000 or 65 percent of $90,000 ($190,000 2 $200,000 1 $100,000), $58,500. Therefore, the dividends received deduction is limited to $58,500. Note that deducting the potential $65,000 dividends received deduction from taxable income does not generate a net operating loss. Accordingly, the taxable income limit is not avoided. ♦

Learning Objective 11.3 Apply special corporate deductions to corporate taxable income.

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11-511-3 Special Deductions and Limitations

11-3b Organizational Expenditures and Start-up Costs New businesses may incur organizational expenditures or start-up costs, or both, prior to starting a business. Organizational expenditures are incurred by partnerships, LLCs, and corporations in the process of forming an entity in which to operate a business. Start-up costs may be incurred by any business, including sole proprietorships reported on Schedule C, as well as the entities listed above.

Corporations amortize qualifying organizational costs over 180 months, and there is no upper limit to the amount of qualifying costs that can be amortized. Corporations can elect to deduct up to $5,000 of organizational costs in the year they begin business. The $5,000 amount is reduced by each dollar of organizational expenses exceeding $50,000. Costs not expensed as part of the first-year election to expense are amortized ratably over the 180-month period beginning with the month the corporation begins business. Generally, organizational expenditures that qualify for amortization include legal and accounting services incident to organization, expenses of temporary directors and organizational meetings, and fees paid to the state for incorporation. Expenses such as the cost of transferring assets to the corporation and expenses connected with selling the corporation’s stock are not organizational expenditures and, therefore, are not subject to amortization.

ExAMpLE In 2019, Coco Bola Corporation, an accrual-basis, calendar-year taxpayer, incurred $500 in fees to the state for incorporation, legal and accounting fees incident to the incorporation of $1,000, and temporary directors’ expenses of $300. Assuming the corporation does not make an election to expense in the first year, the total $1,800 ($500 1 $1,000 1 $300) may be amortized over 15 years at a rate of $10 per month ($1,800/180 months). If the corporation began operations on June 1, 2019, $70 ($10 per month 3 7 months) may be deducted for organizational expenditures for 2019. Alternatively, the corporation could elect to deduct the full $1,800 of organization costs in the first year of business. ♦

The start-up costs of a new business are given the same tax treatment as organizational costs, as illustrated in the previous paragraph and example. Start-up costs include both investigatory expenses and preopening costs. Investigatory expenses are expenses to investigate the potential success of a new business before the decision is made to actually pursue the business. Preopening costs are incurred after the taxpayer decides to start a new business but prior to the date the business actually begins. These expenses may include the training of new employees, advertising, and fees paid to consultants and professionals for advisory services.

11-3c Charitable Contributions Corporations are allowed a deduction for contributions to qualified charitable organiza- tions. Generally, a deduction is allowed in the year in which a payment is made. If, however, the directors of a corporation which maintains its books on the accrual basis make a pledge before year-end and the payment is made on or before the fifteenth day of the third month after the close of the tax year, the deduction may be claimed in the year of the pledge.

A corporation’s charitable contribution deduction is limited to 10 percent of taxable income, computed before the deduction for charitable contributions, net operating loss carrybacks, capital loss carrybacks, and the dividends received deduction. Any excess contributions may be carried forward to the 5 succeeding tax years, but carryforward amounts are subject to the 10 percent annual limitation in the carryover years, with the current year’s contributions deducted first.

ExAMpLE Zircote Corporation had net operating income of $40,000 for the current tax year and made a charitable contribution of $6,000 (not included in the operating income amount). Also not included in the operating income were dividends received of $10,000. The corporation’s charitable contribution

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11-6 Chapter 11 ● The Corporate Income Tax

Self-Study problem 11.3 See Appendix E for Solutions to Self-Study Problems

a. During 2019, Fraxinia Corporation has the following income and expenses: Gross income from operations, excluding dividends $ 90,000 Expenses from operations 100,000 Dividends received from a 25 percent-owned domestic corporation 70,000 Calculate the amount of Fraxinia Corporation’s dividends received deduction.

b. Boyce Inc., a calendar year corporation, incurred organizational costs of $13,000 and start-up costs of $52,000 in 2019. Boyce started business on August 3, 2019. What is the maximum deduction for organizational and start-up costs for Boyce in 2019 and what is Boyce’s 2020 deduction for the same costs?

c. Gant Corporation has income in 2019 of $95,000 before a dividends received deduction of $15,000 and a charitable contribution of $10,000. What is the deductible amount of the charitable contribution?

deduction is limited to 10 percent of $50,000 ($40,000 1 $10,000), or $5,000. Note that the dividends received deduction is not used in calculating taxable income for purposes of determining the limitation on the charitable contribution deduction. The $1,000 ($6,000 2 $5,000) of the charitable contribution that is disallowed is carried forward for up to 5 years. ♦

11-4 SChEduLE M-1 A corporation is required to report its income and other items on Form 1120, U.S. Corporation Income Tax Return. Because of various provisions in the tax law, a corpora- tion’s taxable income seldom is the same as its accounting income (commonly referred to as “book income” ). The purpose of Schedule M-1 of the Form 1120 corporate tax return is to reconcile a corporation’s book income to its taxable income, computed before the net operating loss and special deductions such as the dividends received deduction. On the left side of Schedule M-1 are adjustments that must be added to book income, and on the right side of the schedule are adjustments that must be subtracted from book income to arrive at the amount of taxable income. The amounts that must be added to book income include the amount of federal income tax expense, net capital losses deducted for book purposes, income recorded on the tax return but not on the books, and expenses recorded on the books but not deducted on the tax return. Alternatively, the amounts that must be deducted from book income are income recorded on the books but not included on the tax return, and deductions on the return not deducted on the books.

ExAMpLE For the current tax year, Wisteria Corporation, an accrual-basis taxpayer, has net income reported on its books of $44,975. Included in this figure are the following items:

Net capital loss $ 5,000 Interest income on tax-exempt bonds 9,000 Federal income tax expense 11,025 Depreciation deducted on the tax return, not deducted on the books 3,500 Interest deducted on the books, not deductible for tax purposes 4,000

Learning Objective 11.4 Identify the components of Schedule M-1 and how they are reported to the IRS.

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11-711-5 Filing Requirements and Estimated Tax

Self-Study problem 11.4 See Appendix E for Solutions to Self-Study Problems

Redwood Corporation has net income reported on its books of $115,600. For the current year, the corporation had federal income tax expense of $29,400, a net capital loss of $9,100, and tax-exempt interest income of $4,700. The company deducted depreciation of $17,000 on its tax return and $13,000 on its books. Using Schedule M-1 below, calculate Redwood Corporation’s taxable income, before any net operating loss or special deductions, for the current year.

44,975

4,000 65,000

interest

11,025 5,000 9,000

9,000

3,500 12,500 52,500

3,500

♦

11-5 FILING REquIREMENTS ANd ESTIMATEd TAx For all tax year-ends except for June 30, the due date for filing a corporate tax return is the fifteenth day of the fourth month after year-end. For June 30 year-end corporations, the filing due date is September 15 (fifteenth day of the third month). An extension provides an addi- tional 6 months; thus, a calendar year-end corporation has an initial filing deadline of April 15 and an extended deadline of October 15 (6 month extension). However, corporations with tax years ending on June 30 will have an extended filing deadline of April 15 (7 month extension). When the due date falls on a weekend or holiday, the due date is the next business day. To avoid penalties, a corporation must pay any tax liability by the original due date of the return.

Corporations must make estimated tax payments in a manner similar to those made by self-employed individual taxpayers. The payments are made in four installments due on the fifteenth day of the fourth, sixth, ninth, and twelfth months of the corporation’s tax year.

11.5 Learning Objective Describe the corporate tax return filing and estimated tax payment requirements.

Small corporations with less than $250,000 in gross receipts and less than $250,000 in assets do not have to complete Schedule L (Balance Sheet) or Schedules M-1 and M-2. The rule applies to both S and C corporations, and allows small businesses to keep records based on their checkbook or cash receipts and disbursements journal. This makes the reporting requirements for a small corporation similar to the reporting requirements for a Schedule C sole proprietorship.

TAX BREAK

Wisteria Corporation’s Schedule M-1, Form 1120, is illustrated below.

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11-8 Chapter 11 ● The Corporate Income Tax

Self-Study problem 11.5 See Appendix E for Solutions to Self-Study Problems

Aspen Corporation was formed and began operations on January 1, 2019. Aspen Corporation Income Statement

for the Year Ended December 31, 2019

Gross income from operations $ 285,000 Qualified dividends received from a 10 percent- owned domestic corporation 10,000 Total gross income 295,000 Cost of goods sold (80,000) Total income 215,000 Other expenses: Compensation of officers $90,000 Salaries and wages 82,000 Repairs 8,000 Depreciation expense for book and tax purposes 5,000 Payroll taxes 11,000 Total other expenses (196,000) Net income (before federal income tax expense) $ 19,000

Aspen Corporation Balance Sheet

as of December 31, 2019

Assets: Cash $ 35,000 Accounts receivable 10,000 Land 18,000 Building 125,000 Less: accumulated depreciation (5,000) Total assets $ 183,000 Liabilities and owners’ equity: Accounts payable $ 26,940 Common stock 140,000 Retained earnings 16,060 Total liabilities and owners’ equity $ 183,000

Aspen Corporation made estimated tax payments of $3,000. Based on the above information, complete Form 1120 on Pages 11-9 through 11-14.

Assume the corporation’s book federal income tax expense is equal to its 2019 federal income tax liability and that any tax overpayment is to be applied to the next year’s estimated tax. Schedule UTP, Form 4562, Form 1125-A, and Form 1125-E are not required. Make reasonable assumptions for any missing data.

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11-911-5 Filing Requirements and Estimated Tax

Self-Study problem 11.5

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11-10 Chapter 11 ● The Corporate Income Tax

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11-1111-5 Filing Requirements and Estimated Tax

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11-12 Chapter 11 ● The Corporate Income Tax

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11-1311-5 Filing Requirements and Estimated Tax

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11-14 Chapter 11 ● The Corporate Income Tax

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11-1511-6 S Corporations

11-6 S CORpORATIONS Qualified corporations may elect to be taxed under Subchapter S of the Internal Revenue Code in a manner similar to partnerships. An S corporation does not generally pay tax, and each shareholder reports his or her share of corporate income. The S corporation election is designed to relieve corporations of certain corporate tax disadvantages, such as the double taxation of income.

To elect S corporation status, a corporation must have the following characteristics:

1. The corporation must be a domestic corporation; 2. The corporation must have 100 or fewer shareholders who are either individuals,

estates, certain trusts, certain financial institutions, or certain exempt organizations; 3. The corporation must have only one class of stock; and 4. All shareholders must be U.S. citizens or resident aliens.

The S corporation election must be made during the prior year or the first two months and 15 days of the current tax year to obtain the status for the current year. Relief provisions may apply for elections that are filed late.

ExAMpLE Laurel Corporation is a calendar-year corporation that makes an S corporation election on November 2, 2019. The corporation does not qualify for any of the relief provisions for late S corporation elections for the 2019 tax year. The corporation is not an S corporation until the 2020 tax year; it is a regular C corporation for 2019. ♦

After electing S corporation status, the corporation retains the status until the election is voluntarily revoked or statutorily terminated. If the corporation ceases to qualify as an S corporation (e.g., it has 102 shareholders during the year), the election is statutorily terminated. Also, the election is terminated when a corporation receives 25 percent or more of its gross income from passive investments for 3 consecutive tax years and the corporation has accumulated earnings and profits at the end of each of those years. If a corporation experiences an involuntary termination of S corporation status, the election is terminated on the day the status changes. For example, the loss of S corporation status on June 1 causes the corporation to be a regular C corporation from that day on.

Upon consent of shareholders owning a majority of the voting stock, an S corporation election can be voluntarily revoked. If the consent to revoke the election is made during the first two months and 15 days of the tax year, the S corporation status will be considered voluntarily terminated effective at the beginning of that year. Shareholders may specify a date on or after the date of the revocation as the effective date for the voluntary termination of the S corporation election. If a prospective revocation date is not specified, and the consent to revoke the election is made after two months and 15 days of the tax year, the earliest that the S corporation status can be terminated is the first day of the following tax year.

ExAMpLE On January 20, 2019, Juniper Corporation, a calendar-year corporation, files a consent to revoke its S corporation election. No date is specified in the consent as the effective date of the revocation. The corporation is no longer an S corporation effective January 1, 2019. If the election were made after March 15, the corporation would not become a regular C corporation until the 2020 tax year. ♦

11-6a Reporting Income An S corporation is required to report its income and other items on Form 1120S, U.S. Income Tax Return for an S Corporation, even though the corporate entity does not pay federal income tax. The tax return is due on the fifteenth day of the third month following the close of the corporation’s tax year. S corporations may request a 6-month extension for filing its tax return. Each shareholder of an S corporation reports his or her share of

11.6 Learning Objective Explain how an S corporation operates and is taxed.

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11-16 Chapter 11 ● The Corporate Income Tax

corporate income based on his or her stock ownership during the year. The taxable income of an S corporation is computed in the same manner as a partnership.

Each shareholder of an S corporation takes into account separately his or her share of items of income, deductions, and credits on a per share per day basis. Schedule K-1 of Form 1120S is used to report the allocation of ordinary income or loss, plus all separately stated items of income or loss, to each of the shareholders. Each shareholder’s share of these items is included in the shareholder’s computation of taxable income for the tax year during which the corporation’s year ends. In the case of the death of a shareholder, the shareholder’s portion of S corporation items will be taken into account on the shareholder’s final tax return.

ExAMpLE Freda is the sole shareholder of the Freda Corporation, which has an S corpora- tion election in effect. During calendar year 2019, the corporation has ordinary taxable income of $100,000. Freda must report $100,000 on her individual income tax return for 2019 as income from the Freda Corporation. ♦

11-6b S Corporation Losses Losses from an S corporation also pass through to the shareholders. However, the amount of loss from an S corporation that a shareholder may report is limited to his or her adjusted basis in the corporation’s stock plus the amount of any loans from the shareholder to the corporation. Any loss in excess of the shareholder’s basis in the stock of the corporation plus loans is disallowed and becomes a carryforward loss. If a shareholder was not a shareholder for the entire tax year, losses must be allocated to the shareholder on a daily basis (the seller gets credit for the date of sale). This prevents a shareholder from selling losses late in the year to another taxpayer by selling the stock of an S corporation.

ExAMpLE Lawson and Mary are equal shareholders in L&M Corporation, an S corpora- tion. On December 1, 2019, Mary sells her interest to Connley for $15,000. Lawson’s basis in his L&M Corporation stock is $10,000. For the 2019 tax year, the corporation has a loss of $24,000. Lawson can deduct only $10,000 of his half of the loss ($12,000), since that is the amount of his stock basis. Even though she is not a shareholder at year-end, Mary may deduct $11,014 of the loss, which is 335/365 of $12,000, assuming her basis was at least that amount. Connley may deduct $986, 30/365 of $12,000. In leap years, the amounts would be $11,016 (336/366 3 $12,000) and $984 (30/366 3 $12,000) for Mary and Connley, respectively. ♦

11-6c pass-Through Items Certain items pass through from an S corporation to the shareholders and retain their tax attributes on the shareholders’ tax returns. The following are examples of pass-through items that are separately stated on the shareholders’ Schedule K-1:

● Capital gains and losses ● Section 1231 gains and losses ● Dividend income ● Charitable contributions ● Tax-exempt interest ● Most credits

11-6d qualified Business Income deduction Similar to partnerships, S corporations are flow-through entities that may generate quali- fied business income (QBI) and thus individual shareholders may be eligible for the QBI deduction. The same wage and service business limits apply as with other flow-through entities.

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11-1711-7 Corporate Formation

S corporations have a unique interaction between wages and qualified business income. The wages paid to an S corporation shareholder are not considered part of qualified business income; however, the wages count toward the wage limit, to the extent one applies to the taxpayer:

ExAMpLE Hogarth is a single taxpayer and the sole shareholder of Giant Corporation, which is an S corporation for tax purposes. Giant pays reasonable wages to Hogarth, the only employee, of $80,000 and allocates $100,000 of income. Hogarth’s taxable income is above the threshold for a single taxpayer and he is required to apply the wage limitation to his QBI deduction. Hogarth can include $40,000 ($80,000 3 50%) of wages in computing the wage limit for the QBI deduction but may not consider the $80,000 of wages as QBI, only the $100,000 of income allocated. ♦

11-6e Special Taxes S corporations are not subject to the corporate income tax on their regular taxable income. Under certain circumstances, an S corporation may be liable for tax at the corporate level. An S corporation may be subject to a tax on gains attributable to appreciation in the value of assets held by the corporation prior to the S corporation election, the built-in gains tax. In addition, a tax may be imposed on certain S corporations that have large amounts of passive investment income, such as income from dividends and interest. The rules for the application of these taxes are complex.

11-7 CORpORATE FORMATION When a taxpayer incorporates a business and transfers high-value, low-basis property to the corporation in exchange for corporate stock, a substantial gain is realized. This gain is measured at the value of the shares received less the basis of the property transferred. Favorable tax treatment is available in certain cases, which allows many taxpayers to defer the recognition of the gain in the year of formation. To defer the gain, the taxpayer must meet certain requirements, including:

1. The taxpayer must transfer property or money to the corporation, 2. The transfer must be solely in exchange for stock of the corporation, and 3. The shareholder(s) qualifying for nonrecognition must own at least 80 percent of the

corporation’s stock after the transfer.

When the above requirements are met, gains and losses are not recognized on the formation of the corporation.

11.7 Learning Objective Describe the basic tax rules for the formation of a corporation.

Self-Study problem 11.6 See Appendix E for Solutions to Self-Study Problems

Assume that Aspen Corporation in Self-Study Problem 11.5 is owned by Janet Nall, who is a 100 percent shareholder. Also, assume that the corporation has a valid S corporation election in effect for 2019 and is not subject to any special taxes. Assume no wages are included in Aspen’s cost of goods sold. Using the relevant information given in Self-Study Problem 11.5 and assuming the corporation’s retained earnings are $19,000, instead of $16,060, accounts payable are $24,000, rather than $26,940, and no estimated tax payments are made, complete Form 1120S on Pages 11–19 through 11–23 for Aspen Corporation, and complete Schedule K-1 on Pages 11–25 and 11–26 for Janet. Assume there were no cash distributions to Janet during the year.

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11-18 Chapter 11 ● The Corporate Income Tax

The shareholder must transfer property or cash to the corporation; performing services for corporate stock does not qualify for nonrecognition treatment. The shareholder performing services must recognize income in an amount equal to the value of the stock received. If the shareholder receives other property (boot) in addition to stock of the corporation in exchange for the transfer of cash or other property, the transaction may still qualify for partial nonrecognition treatment, provided the control requirement is met. However, realized gain must be recognized to the extent of the boot received.

11-7a Liabilities As a general rule, the assumption of shareholder liabilities by the corporation is not con- sidered boot. For example, if a shareholder transfers land to the corporation for stock and the land is subject to a liability that is assumed by the corporation, no gain would normally be recognized on the transfer. However, if there is no business purpose for transfer of the liability, or tax avoidance appears to be involved, the recognition of any realized gain is required. Also, when the total liabilities transferred to the corporation by a shareholder exceed the total basis of the property transferred by the shareholder, the excess amount is a gain that must be recognized without regard to whether gain is realized.

ExAMpLE Robusta Corporation is formed by Max, who contributes property with a basis of $12,000 in exchange for 100 percent of the company’s stock. On the date of the contribution, the property contributed has a fair market value of $120,000 and is subject to a liability of $20,000. Max must recognize a gain of $8,000 on the transfer of the property to the corporation since the liability transferred to the corporation exceeds his basis in the property transferred. ♦

11-7b Shareholder’s Stock Basis After the transfer, the shareholder’s basis in his or her stock is determined by the following formula:

Basis of the property transferred $ xxxx Less: boot received (xxxx) Plus: gain recognized xxxx Less: liabilities transferred (xxxx) Basis in the stock $ xxxx

11-7c Corporation’s Basis in property Contributed The corporation’s basis in the property received from a shareholder in a transaction to which nonrecognition treatment applies is the same as the basis of the property to the shareholder, increased by any gain recognized by the shareholder on the transfer.

ExAMpLE A, B, and C form Hornbeam Corporation. A contributes property with a basis of $25,000 in exchange for 40 shares of stock worth $40,000. B performs services for the corporation in exchange for 10 shares of stock worth $10,000. C contributes property with a basis of $10,000 in exchange for 45 shares of stock worth $45,000 and $5,000 cash. The stock described above is all of the outstanding stock of the corporation. A and C qualify for complete or partial nonrecognition treatment, since together they own

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11-1911-7 Corporate Formation

Self-Study problem 11.6

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11-20 Chapter 11 ● The Corporate Income Tax

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11-2111-7 Corporate Formation

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11-22 Chapter 11 ● The Corporate Income Tax

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11-2311-7 Corporate Formation

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11-24 Chapter 11 ● The Corporate Income Tax

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11-2511-7 Corporate Formation

Self-Study problem 11.6

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11-26 Chapter 11 ● The Corporate Income Tax

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11-2711-8 Corporate Accumulations

89 percent (85 of 95 shares) of the stock after the transfer. B’s stock is not considered because it was received in exchange for services.

1. A has a realized gain of $15,000 ($40,000 2 $25,000), but no recognized gain since no boot was received.

2. B’s recognized income is $10,000, since she performed services in exchange for the stock, and stock received for services does not fall within the nonrecognition provisions.

3. C’s realized gain is $40,000 ($45,000 1 $5,000 2 $10,000), but only $5,000 of the gain is recognized, the amount of boot received.

11-8 CORpORATE ACCuMuLATIONS In many cases, taxpayers have established corporations to avoid paying income taxes at the shareholder level by allowing earnings to be accumulated by the corporations, rather than paid out as taxable dividends. To prevent that practice, Congress has enacted two special taxes which may be applied to certain corporations: the accumulated earnings tax and the personal holding company tax.

11.8 Learning Objective Describe the rules for the accumulated earnings tax and the personal holding company tax.

Self-Study problem 11.7 See Appendix E for Solutions to Self-Study Problems

Tammy has a business which she decides to incorporate. She transfers to the new corporation, real estate with a basis of $75,000 and subject to a $34,000 mortgage in exchange for all of its stock. The stock is worth $125,000.

What is Tammy’s realized gain? $ What is Tammy’s recognized gain? $ What is Tammy’s basis in her stock? $ What is the corporation’s basis in the real estate? $

11-8a Accumulated Earnings Tax The accumulated earnings tax is designed to prevent the shareholders of a corporation from avoiding tax at the shareholder level by retaining earnings in the corporation. The tax is a pen- alty tax imposed in addition to the regular corporate income tax. The tax is imposed at a rate of 20 percent on amounts that are deemed to be unreasonable accumulations of earnings. For all corporations except service corporations, such as accounting, law, and health care corporations, the first $250,000 in accumulated earnings is exempt from tax. Service corporations will not be taxed on their first $150,000 of accumulated earnings. Even if the accumulated earnings of a

The TCJA made no direct changes to the accumulated earnings tax or the personal holding company tax; however, the significant decrease in the corporate tax rate makes deferring income without distributing the earnings and profits of a corporation considerably more attractive from a tax planning perspective. Undoubtedly, this will increase both the use of this strategy and the IRS’ sensitivity to this matter.

New Tax Law!

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11-28 Chapter 11 ● The Corporate Income Tax

corporation exceed the exemption amount, the tax will not be imposed on accumulations that can be shown to be necessary to meet the reasonable needs of the business.

ExAMpLE Alder Corporation is a manufacturing corporation that has accumulated earnings of $625,000. The corporation can establish reasonable needs for $450,000 of this accumulation. Alder Corporation would be subject to the accumulated earnings tax on $175,000 ($625,000 2 $450,000). The amount of the accumulated earnings tax is $35,000 (20% of $175,000). ♦

11-8b personal holding Company Tax Personal holding companies, which are corporations with few shareholders and with income primarily from investments, are subject to a 20 percent tax on their undistributed earnings. The tax is imposed in addition to the regular corporate income tax; however, a corporation cannot be subject to both the accumulated earnings tax and the personal holding company tax in the same year. If both taxes are imposed, the taxpayer pays only the personal holding company tax. The rules for the personal holding company tax are very complex.

Self-Study problem 11.9 See Appendix E for Solutions to Self-Study Problems

In 2019, Plum Corporation has regular income tax liability of $12,500. Plum has AMT credit carryforwards of $20,000 from prior years. What is Plum Corporation’s remaining AMT credit carryforward after applying the maximum credit against 2019? $

Self-Study problem 11.8 See Appendix E for Solutions to Self-Study Problems

Sugarbush Corporation, an accounting corporation, has accumulated earnings of $340,000, and the corporation cannot establish a reasonable need for any of that amount. Calculate the amount of accumulated earnings tax (if any) that will be imposed on Sugarbush Corporation.

11-9 ThE CORpORATE ALTERNATIVE MINIMuM TAx Unlike the individual alternative minimum tax (AMT), which remains in force, the corpo- rate AMT was repealed for tax years after 2017 by the TCJA. Under the prior corporate AMT regime, a corporation subject to AMT may have had unused AMT credits that can be carried over indefinitely to offset regular tax. Although beyond the scope of this textbook, under the TCJA, AMT credits may offset regular tax liability for any future tax year. Additionally, the AMT credit is a refundable credit for any tax year beginning after 2017 and before 2022 in an amount equal to 50 percent (100 percent for tax years beginning in 2021) of the excess AMT credits for the tax year, over the amount of the credit allowable for the year against regular tax liability.

ExAMpLE Lloyd Corporation, a calendar year C corporation, has unused AMT credits of $10,000 at the end 2017. In 2018, Lloyd has corporate income tax liability as $2,000 before any AMT credits. Lloyd may apply $2,000 of its AMT credit carryforward to reduce the 2018 income tax to $0. In addition, Lloyd is permitted to apply a refundable AMT credit of $4,000 (($10,000 2 $2,000) 3 50%). ♦

Learning Objective 11.9 Describe tax issues associated with the repeal of the alternative minimum tax.

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11-29

Learning Objectives Key points

LO 11.1: Employ the corporate tax rates to calculate corporate tax liability.

● The U.S. corporate tax rate is now a flat 21 percent regardless of income level. ● Qualified personal service corporations (health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting) are taxed at a flat 21 percent tax rate on all taxable income.

LO 11.2: Compute basic gains and losses for corporations.

● Corporate ordinary income and capital gains tax rates are the same, so there is no tax rate benefit to having long-term capital gains in a corporation.

● Net short-term capital gains of a corporation are taxed as ordinary income. ● Capital losses may be used only to offset capital gains. ● If capital losses cannot be used in the year they occur, they may be carried back 3 years and forward 5 years to offset capital gains in those years.

● When a long-term capital loss is carried to another year, it is treated as a short- term capital loss and may be offset against either long-term or short-term capital gains.

● Net operating losses generated after 2017 may only be carried forward to offset no more than 80 percent of the taxable income of the future year.

LO 11.3: Apply special corporate deductions to corporate taxable income.

● Corporations are allowed a dividends received deduction based on their percentage of ownership in the corporation paying the dividend.

● The dividends received deduction percentage is 50 percent (for ownership less than 20 percent), 65 percent (for ownership of 20 percent or more, but less than 80 percent), or 100 percent (for ownership of 80 percent or more).

● Corporations amortize qualifying organizational costs over 180 months, and there is no upper limit to the amount of qualifying costs that can be amortized.

K e Y p O I N tS

Key Points

K e Y t e r m S

corporate tax rates, 11-2 personal service corporation, 11-2 corporate capital gains and

losses, 11-2 net operating losses, 11-3 special deductions, 11-4 dividends received deduction, 11-4 organizational expenditures, 11-5 start-up costs, 11-5 corporate charitable contributions

deduction, 11-5

Form 1120, 11-6 Schedule M-1, 11-6 book income, 11-6 Schedule L (Balance Sheet), 11-7 S Corporation, 11-15 statutorily terminated, 11-15 Form 1120S, 11-15 Schedule K-1, 11-16 pass-through items, 11-16 built-in gains tax, 11-17 nonrecognition treatment, 11-18

boot, 11-18 stock basis, 11-18 corporation’s basis, 11-18 accumulated earnings tax, 11-27 personal holding company

tax, 11-28 corporate alternative minimum

tax, 11-28

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11-30 Chapter 11 ● The Corporate Income Tax

● Corporations can elect to deduct up to $5,000 of organizational costs and $5,000 of start-up costs in the year they begin business. The $5,000 amounts are reduced by each dollar of organizational expenses and start-up costs exceeding $50,000.

● A corporation’s charitable contribution deduction is limited to 10 percent of taxable income, computed before the deduction for charitable contributions, net operating loss carrybacks, capital loss carrybacks, and the dividends received deduction.

● Excess charitable contributions are carried forward to the 5 succeeding tax years, subject to the 10 percent annual limitation in the carryover years, with the current year’s contributions deducted first.

LO 11.4: Identify the components of Schedule M-1 and how they are reported to the IRS.

● The purpose of Schedule M-1 of the corporate tax return is to reconcile a corporation’s accounting “book” income to its taxable income.

● On the left side of Schedule M-1 are adjustments that must be added to book income, and on the right side of the schedule are adjustments that must be subtracted from book income to arrive at the amount of taxable income.

● The additions to book income include the amount of federal income tax expense, net capital losses deducted for book purposes, income recorded on the tax return but not on the books, and expenses recorded on the books but not deducted on the tax return.

● The amounts that must be deducted from book income include income recorded on the books but not included on the tax return, and deductions included on the return but not deducted on the books.

LO 11.5: Describe the corporate tax return filing and estimated tax payment requirements.

● The due date for filing a corporate tax return is the fifteenth day of the fourth month after year-end. An extension provides an additional 6 months; thus a calendar year-end corporation has an initial deadline of April 15 and an extended deadline of October 15.

● A corporation must pay any tax liability by the original due date of the return. ● Corporations must make estimated tax payments similar to those made by self-employed individual taxpayers. The payments are due on the fifteenth day of the fourth, sixth, ninth, and twelfth months of the corporation’s tax year.

LO 11.6: Explain how an S corporation operates and is taxed.

● Certain qualified corporations may elect to be taxed under Subchapter S of the Internal Revenue Code in a manner similar to partnerships.

● To elect S corporation status, a corporation must have the following characteristics: (1) be a domestic corporation; (2) have 100 or fewer shareholders who are either individuals, estates, certain trusts, certain financial institutions, or certain exempt organizations; (3) have only one class of stock; and (4) all shareholders must be U.S. citizens or resident aliens.

● Each shareholder of an S corporation reports his or her share of corporate income based on his or her stock ownership during the year.

● Schedule K-1 of Form 1120S is used to report the allocation of ordinary income or loss, and all separately stated items of income or loss, to each of the shareholders.

● Losses from an S corporation pass through to the shareholders, but the loss deduction is limited to the shareholders’ adjusted basis in the corporation’s stock plus the amount of any loans from the shareholder to the corporation.

● S corporation shareholders are eligible for the qualified business income deduction.

LO 11.7: Describe the basic tax rules for the formation of a corporation.

● If property is exchanged for stock in a corporation, the shareholders are in “control” of the corporation after the transfer, and the shareholders receive no boot, gain on the transfer is not recognized.

● Realized gain is recognized to the extent that the shareholder receives boot. ● The basis of the stock received by the shareholder is equal to the basis of the property transferred plus any gain recognized by the shareholder, less the fair market value of any boot received by the shareholder, less liabilities assumed by the corporation.

● The basis of property received by the corporation is equal to the basis in the hands of the transferor plus any gain recognized by the transferor.

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11-31

GrOUp 1:

MuLTIpLE ChOICE quESTIONS

1. Ironwood Corporation has ordinary taxable income of $65,000 in 2019, and a short- term capital loss of $15,000. What is the corporation’s tax liability for 2019? a. $7,500 d. $13,650 b. $5,250 e. None of the above c. $10,500

2. Tayla Corporation generated $400,000 of taxable income in the 2019. What is Tayla’s corporate tax liability? a. $71,400 b. $84,000 c. $115,600 d. $0 e. None of the above

3. Which of the following statements is false regarding corporate capital losses? a. Corporations may deduct $3,000 of net capital loss each year until the loss is

used up. b. Corporations may carry capital losses back 3 years and forward 5 years to offset

capital gains in those years. c. Corporations are not allowed to deduct capital losses against ordinary income. d. A long-term capital loss carried to another year is treated as a short-term capital loss.

4. Harrison Corporation generates capital gains/(losses) of $30,000, $2,000, ($40,000) in 2017, 2018, and 2019, respectively. Harrison started operating in 2017. What is Harrison’s capital loss carryforward into 2020? a. $0 b. $8,000 c. $10,000 d. $38,000 e. None of the above

LO 11.1

LO 11.2

Q U eS t I O NS a n d prO B L e m S

Questions and Problems

LO 11.8: Describe the rules for the accumulated earnings tax and the personal holding company tax.

● The accumulated earnings tax is a penalty tax, imposed in addition to the regular corporate income tax, at a rate of 20 percent on amounts that are deemed to be unreasonable accumulations of earnings.

● For all corporations, except personal service corporations such as accounting, law, and health care corporations, the first $250,000 in accumulated earnings is exempt from tax. The first $150,000 in accumulated earnings is exempt for personal service corporations.

● Personal holding companies, which are corporations with few shareholders and income primarily from investments, are subject to a 20 percent tax on undistributed earnings.

LO 11.9: Describe tax issues associated with the repeal of the alternative minimum tax.

● The corporate AMT was repealed for tax years after 2017. ● Any AMT credit carryforwards may be used to offset regular tax liability and are refundable up to 50 percent (100 percent for tax years beginning in 2021) of the remaining unused AMT credit carryforward amount.

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11-32 Chapter 11 ● The Corporate Income Tax

5. Mask Corporation generated a net operating loss of $24,000 in 2019 and taxable income of $10,000 in 2020. How much NOL can Mask use in 2020 to reduce taxable income? a. $8,000 b. $10,000 c. $19,200 d. $24,000

6. Walnut Corporation owns 6 percent of Teak Corporation, a domestic corporation. During the current year, Walnut Corporation received $20,000 in dividends from Teak Corporation. Assuming that Walnut’s taxable income for the current year before the dividends received deduction is $500,000, what is the amount of Walnut’s dividends received deduction for the current year? a. $10,000 b. $13,000 c. $16,000 d. $20,000 e. None of the above

7. Which of the following is not a corporate organizational expenditure that may be amortized? a. The cost of organizational meetings b. Fees paid to the state for incorporation c. Accounting fees incident to organization d. Legal fees incident to organization e. All of the above are organizational expenditures

8. The purpose of Schedule M-1 on the corporate tax return is to: a. Reconcile accounting (book) income to taxable income. b. Summarize the dividends received deduction calculation. c. List the officers of the corporation and their compensation. d. Calculate the net operating loss deduction.

9. Which of the following would not generally appear on the M-1 reconciliation? a. Federal income tax expense per books b. Tax-exempt interest income c. Excess tax over book depreciation d. Dividends received deduction

10. Which of the following statements is false regarding corporate tax return due dates? a. Corporate tax returns for 2019 calendar-year corporations are due April 15, 2020. b. Corporate tax returns may receive an automatic 6-month extension. c. Corporate taxes due must be paid no later than the extended due date of the tax

return. d. When an IRS due date falls on a weekend or holiday, the due date is the next

business day.

11. Mansfield Incorporated, a calendar year corporation, is expecting to have a current year tax liability of $100,000. Which best describes the tax payments Mansfield should make to avoid penalty? a. Make payments at the end of June and December of $40,000 each and $20,000

when filing the return on the original due date. b. Make no payments during the year but pay the entire balance on the extended

due date. c. Make no payments during the year but pay the entire balance on the original due

date. d. Make quarterly payments totaling $100,000, all during the current year. e. None of these will avoid penalty.

LO 11.2

LO 11.3

LO 11.4

LO 11.5

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12. Which of the following is not required for a corporation to be eligible to make an S corporation election? a. The corporation must have 100 or fewer shareholders. b. The corporation must be a domestic corporation. c. The corporation must have both common and preferred stock. d. The shareholders of the corporation must not be nonresident aliens. e. All shareholders must be either individuals, estates, certain trusts, or financial

institutions.

13. Which of the following items are passed through and separately stated on Schedule K-1 to share holders of an S corporation? a. Wages paid b. Typical MACRS depreciation c. Net long-term capital gains d. Advertising expense e. All of the above retain their character when passed through

14. Which of the following is true about S corporations? a. S corporations pay corporate taxes like other corporations. b. S corporations pay the alternative minimum tax for all income. c. S corporations cannot issue corporate stock. d. The S corporation status may be elected by stockholders only for corporations that

meet certain qualifications. e. None of the above.

15. Travis transfers land with a fair market value of $125,000 and basis of $25,000, to a corporation in exchange for 100 percent of the corporation’s stock. What amount of gain must Travis recognize as a result of this transaction? a. $0 d. $125,000 b. $25,000 e. None of the above c. $100,000

16. Carl transfers land with a fair market value of $120,000 and basis of $30,000, to a new corporation in exchange for 85 percent of the corporation’s stock. The land is subject to a $45,000 liability, which the corporation assumes. What amount of gain must Carl recognize as a result of this transaction? a. $0 b. $15,000 c. $30,000 d. $45,000 e. None of the above

17. What is the shareholder’s basis in stock of a corporation received as a result of the transfer of property to the corporation and as a result of which gain was recognized by the stockholder? a. The shareholder’s basis is equal to the basis of the property transferred less the gain. b. The shareholder’s basis is equal to the fair market value of the stock received, less

any liabilities transferred by the stockholder. c. The shareholder’s basis is equal to the basis of the property transferred to the

corporation, minus any liabilities transferred by the shareholder, plus the gain. d. The shareholder’s basis is equal to the basis of the property transferred to the

corporation, plus any liabilities transferred by the shareholder. e. None of the above.

18. Which of the following statements regarding personal holding companies is false? a. A personal holding company is one which has few shareholders. b. A personal holding company has income primarily from investments. c. A personal holding company operates a business which is a hobby for its owners. d. Personal holding companies are subject to a 20 percent tax on income that is left

undistributed.

LO 11.6

LO 11.7

LO 11.8

11-33Questions and Problems

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11-34 Chapter 11 ● The Corporate Income Tax

19. Boyce Industries, a manufacturing corporation, has accumulated earnings of $325,000 and cannot show any reasonable need for the accumulated earnings. What is Boyce’s accumulated earnings tax? a. $15,000 b. $0 c. $13,750 d. $75,000

20. Which of the following statements is true about the 2019 corporate alternative minimum tax? a. The corporate alternative minimum tax only applies to small corporations. b. The corporate alternative minimum tax preferences and adjustments are

exactly the same as those for individuals. c. The corporate alternative minimum tax was repealed for tax years after 2017. d. Corporations with alternative minimum taxable income greater than $310,000

receive no exemption.

21. Any corporate AMT credit carryovers that existed at the end of 2017: a. can be used to offset tax liability generated in 2018 and thereafter b. do not expire c. can generate a refundable credit of 50 percent of any unused AMT credits in 2019 d. all of the above

LO 11.8

LO 11.9

GrOUp 2:

pROBLEMS

1. Quince Corporation has taxable income of $485,000 for its calendar tax year. Calculate the corporation’s income tax liability for 2019 before tax credits.

2. Ulmus Corporation is an engineering consulting firm and has $1,120,000 in taxable income for 2019. Calculate the corporation’s income tax liability for 2019.

3. For its current tax year, Ilex Corporation has ordinary income of $260,000, a short-term capital loss of $60,000, and a long-term capital gain of $20,000. Calculate Ilex Corporation’s tax liability for 2019.

4. DeMaria Corporation, a calendar year corporation, generates the following taxable income (net operating losses) since its inception in 2016:

Year Taxable result

2016 40,000

2017 (15,000)

2018 (5,000)

2019 6,000

Assuming Demaria makes no special elections with regard to NOLs, what is DeMaria’s net operating loss carryforward into 2020?

5. Fisafolia Corporation has gross income from operations of $210,000 and operating expenses of $160,000 for 2019. The corporation also has $30,000 in dividends from publicly traded domestic corporations in which the ownership percentage was 45 percent. a. Calculate the corporation’s dividends received deduction for 2019.

LO 11.1

LO 11.1 LO 11.2

LO 11.2

LO 11.3

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b. Assume that instead of $210,000, Fisafolia Corporation has gross income from operations of $135,000. Calculate the corporation’s dividends received deduction for 2019. $

c. Assume that instead of $210,000, Fisafolia Corporation has gross income from operations of $158,000. Calculate the corporation’s dividends received deduction for 2019. $__________________

6. Beech Corporation, an accrual basis calendar year taxpayer, was organized and began business on July of the current calendar tax year. During the current year, the corporation incurred the following expenses:

State fees for incorporation $ 500 Legal and accounting fees incident to organization 4,150 Expenses for the sale of stock 2,100 Organizational meeting expenses 750

Assuming that Beech Corporation does not elect to expense but chooses to amortize organizational expenditures over 15 years, calculate the corporation’s deduction for its current calendar tax year.

7. In Year 1, Citradoria Corporation is a regular corporation that contributes $35,000 cash to qualified charitable organizations during the current tax year. The corporation has net operating income of $145,000, before deducting the contributions, and dividends received from domestic corporations (ownership in all corporations is less than 20 percent) in the amount of $25,000. a. What is the amount of Citradoria Corporation’s allowable deduction for charitable

contributions for Year 1? $

b. In Year 2, Citradoria contributes $5,000 to charitable organizations. The corpora- tion has net operating income of $150,000 before deducting the contributions, and no dividend income. What is the amount of Citradoria’s allowable deduction for charitable contributions for Year 2? $

c. If there is any carryover of the charitable contribution deduction from Year 2, what year will it expire (e.g., Year 3)?

8. The Loquat Corporation has book net income of $50,000 for the current year. Included in this figure are the following items, which are reported on the corporation’s Schedule M-1, Reconciliation of Income (Loss) per Books with Income per Return.

Federal income tax expense $ 7,500 Depreciation deducted on the books which is not deductible for tax purposes 10,000 Deduction for 50 percent of meals expense which is not allowed for tax purposes 5,500 Deduction for a tax penalty not allowed for tax purposes 2,000 Tax-exempt interest income included in book income but not in tax income 4,200

Calculate Loquat Corporation’s taxable income for the current year based on the information given. Show your calculations.

LO 11.3

LO 11.4

11-35Questions and Problems

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11-36 Chapter 11 ● The Corporate Income Tax

9. Caloundra Corporation has book income of $40,000. Included in the book income is $3,000 of tax-exempt interest, $7,000 of book income tax expense, and a $2,000 non- deductible fine. Also included in book income are $10,000 of dividends Caloundra re- ceived from a 30 percent owned corporation. Using this information and Form 1120, provide the amounts that go on each line on the form. a. Form 1120, Schedule M-1 Line 1 $ b. Form 1120, Schedule M-1, Line 10 $ c. Form 1120, Page 1, Line 28 $ d. Form 1120, Schedule C, Line 2(a) $ and 2(c) $ e. Form 1120, Schedule C, Line 24 $ f. Form 1120, Page 1, Line 29b $ g. Form 1120, Page 1, Line 30 $

10. Mallory Corporation has a calendar year-end. The corporation has paid estimated taxes of $10,000 during 2019 but still owes an additional $5,000 for its 2019 tax year. a. When is the 2019 tax return due?

b. If an automatic extension of time to file is requested, when is the 2019 tax return due?

c. If an extension of time to file is requested, when is the additional $5,000 of tax for 2019 due?

11. Cedar Corporation has an S corporation election in effect. During the 2019 calendar tax year, the corporation had ordinary taxable income of $200,000, and on January 15, 2019, the corporation paid dividends to shareholders in the amount of $120,000. How much taxable income, in total, must the shareholders of the corporation report on their 2019 tax returns?

Explain your answer

12. Bill and Guilda each own 50 percent of the stock of Radiata Corporation, an S corporation. Guilda’s basis in her stock is $21,000. On May 26, 2019, Bill sells his stock, with a basis of $40,000, to Loraine for $50,000. For the 2019 tax year, Radiata Corporation has a loss of $104,000. a. Calculate the amount of the corporation’s loss that may be deducted by Bill on his

2019 tax return. $

b. Calculate the amount of the corporation’s loss that may be deducted by Guilda on her 2019 tax return.

c. Calculate the amount of the corporation’s loss that may be deducted by Loraine on her 2019 tax return.

13. Karen, in forming a new corporation, transfers land to the corporation in exchange for 100 percent of the stock of the corporation. Karen’s basis in the land is $275,000, and the corporation assumes a liability on the property in the amount of $300,000. The stock received by Karen has a fair market value of $550,000. a. What is the amount of gain or loss that must be recognized by Karen on this transfer?

LO 11.4

LO 11.5

LO 11.6

LO 11.7

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1. Olive Corporation was formed and began operations on January 1, 2019. The corpora- tion’s income statement for the year and the balance sheet at year-end are presented below.

The Olive Corporation Income Statement for the Year Ended December 31, 2019

Gross income from operations $ 270,000 Qualified dividends received from a 35 percent- owned domestic corporation 20,000 Total gross income 290,000 Cost of goods sold (110,000) Total income 180,000 Other expenses: Compensation of officers $77,000 Salaries and wages 30,000 Bad debts (direct charge-offs) 9,000 Repairs 3,000 Depreciation for book and tax purposes 10,000 Advertising 2,000 Payroll taxes 16,000 Total other expenses (147,000) Net income (before federal income tax expense) $ 33,000

GrOUp 3:

COMpREhENSIVE pROBLEMS

11-37Questions and Problems

b. What is the amount of Karen’s basis in the corporation’s stock? $

c. What is the amount of the corporation’s basis in the land? $

14. Grevilla Corporation is a manufacturing company. The corporation has accumulated earnings of $950,000, and it can establish reasonable needs for $400,000 of that amount. Calculate the amount of the accumulated earnings tax (if any) that Grevilla Corporation is subject to for this year.

15. Cypress Corporation, a calendar year end corporation, has an AMT credit carryfor- ward from 2018 (the credit arose in 2017) in the amount of $43,000. In 2019, Cypress has $170,000 of taxable income. Assuming Cypress is not a personal service corpora- tion, what is the amount of refund Cypress can expect to receive from its 2019 tax return filing?

16. Go to the IRS website (www.irs.gov) and determine which IRS publication addresses the topic of corporate taxation. Print out the page with the Table of Contents of this IRS publication.

LO 11.8

LO 11.9

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11-38 Chapter 11 ● The Corporate Income Tax

The Olive Corporation Balance Sheet as of December 31, 2019

Assets: Cash $ 30,000 Accounts receivable 20,000 Inventory (at cost) 70,000 Equipment 90,000 Less: accumulated depreciation (10,000) Total assets $200,000 Liabilities and owners’ equity: Accounts payable $ 6,200 Note payable (due in 10 years) 85,000 Common stock 80,000 Retained earnings 28,800 Total liabilities and owners’ equity $200,000

The corporation made estimated tax payments of $5,000 and the corporation’s book federal income tax expense is equal to the federal tax liability. Complete Form 1120 for Olive Corporation on Pages 11-39 through 11-44.

2. Assume that Olive Corporation, in Comprehensive Problem 1, is an S corporation owned 50 percent by Linda Holiday and 50 percent by Ralph Winston. The corpora- tion is not subject to any special taxes and no wages are included in cost of goods sold. Using the relevant information given in Comprehensive Problem 1 and assuming the corporation’s retained earnings are $33,000 instead of $28,800, accounts payable are $2,000 instead of $6,200, and no estimated tax payments are made, complete Form 1120S for Olive Corporation and Schedule K-1 for Linda on Pages 11-45 through 11-52. Assume there were no cash distributions during the year.

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11-39Questions and Problems

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11-40 Chapter 11 ● The Corporate Income Tax

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11-41Questions and Problems

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11-42 Chapter 11 ● The Corporate Income Tax

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11-43Questions and Problems

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11-44 Chapter 11 ● The Corporate Income Tax

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11-45Questions and Problems

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11-46 Chapter 11 ● The Corporate Income Tax

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11-47Questions and Problems

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11-48 Chapter 11 ● The Corporate Income Tax

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11-49Questions and Problems

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11-50 Chapter 11 ● The Corporate Income Tax

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11-51Questions and Problems

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11-52 Chapter 11 ● The Corporate Income Tax

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11-53Questions and Problems

Student Name

Class/Section

Date

K e Y N Um B e r ta x r e t U r N SUm m a rY

ChApTER 11

Comprehensive problem 1

Total Income (Line 11)

Dividends Received Deduction (Line 29b)

Taxable Income (Line 30)

Total Tax (Line 31)

Overpayment (Line 36)

Comprehensive problem 2

Cost of Goods Sold (Line 2)

Total Income (Loss) (Line 6)

Ordinary Business Income (Loss) (Line 21)

Amount Owed (Line 25)

Qualified Dividends (Schedule K-1, Line 5b)

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Pg ia

m /i

St oc

k U

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ea se

d/ G

et ty

Im ag

C h a p t e r 1 2

Tax Administration and Tax Planning

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L E A R N I N G O B J E C T I V E S

After completing this chapter, you should be able to: LO 12.1 Identif y the organizational structure of the Internal Revenue Service (IRS). LO 12.2 Describe the IRS audit process. LO 12.3 Define the common penalties for taxpayers and be able to apply them to

specific situations. LO 12.4 Apply the general rule for the statute of limitations on tax returns and the important

exceptions to the general rule. LO 12.5 Describe the rules and penalties that apply to tax practitioners. LO 12.6 Describe the Taxpayer Bill of Rights. LO 12.7 Explain the basic concepts of tax planning.

12-1

O V e r V I e W

K nowing how the Internal Revenue Ser- vice (IRS) operates, and how and why the IRS audits certain tax returns, is extre mely important to tax practitioners.

This chapter covers thes