Federal Income Tax

Question 1

Tax Liability Steps

Answer 1

Step 1: Determine Gross Income

Step 2: Subtract “above the line deductions” to determine Adjusted Gross Income

Step 3: Subtract standard deduction or itemized deductions to determine taxable income

Step 4: Multiply by tax rate

Step 5: Subtract any available credits

Question 2

Gross Income

Answer 2

Definition: Any economic benefit or any clearly realized accession to your wealth
- Change in value of asset does not affect taxes until realization (e.g., sale)

Includes:

• FMV of non-cash receipts
• Assets claimed under claim of right
• Stolen, embezzled funds or property
• Tax Benefit Rule

Special rules for:

1) Alimony
2) Child Support
3) Prizes and Awards
4) Cancellation of Indebtedness

Exclusions:

1) Life Insurance Proceeds
2) Inheritances
3) Gifts
4) Tort Awards
5) Employee-Related exclusions

Question 3

Claim of Right

Answer 3

Definition: If received without restriction as to use or disposition, even if taxpayer may later be required to return

If assets are later re-taken, taxpayer takes a deduction in Year 2.

Question 4

Tax Benefit Rule

Answer 4

Definition: If taxpayer takes a deduction one year, and then recovers the property that ave rise to the deduction, recovered property is taxable income.

Amount is judged as the amount of the prior deduction

Underlying assumption: that you benefitted from the giving in year 1

Question 5

Alimony

Answer 5

Rule: Unless otherwise agreed to, alimony is taxable income and a deductible payment

Requirements

1) writing
2) living together disallowed
3) cease at or before death
4) cash (or equivalent)

Question 6

Child Support

Answer 6

Rule: Not taxable income, and not deductible payment

Child Support in Disguise! If payment (e.g., alimony) is reduced based on contingency related to the child, the amount of reduction is considered child support

If total payments don’t satisfy both alimony and child support, payments are treated as first satisfying child support

Question 7

Prizes and Awards

Answer 7

Rule: Gross income includes the value of cash, property, or services received as a price, award, or windfall

But watch out! Bargain purchase (e.g., at a flea market) does not get treated as FMV

Question 8

Cancellation of Indebtedness

Answer 8

Rule: Borrower has no gross income upon the initial receipt of borrowed funds. But if debt is canceled or discharged at less than full amount, difference is income.

Exceptions – RIG
1) Reduction in purchase price: If apparent discharge of debt is really just a reduction in purchase price

2) Insolvency: If the discharge occurs when taxpayer is insolvent or bankrupt
3) Gift: If the lender intends the discharge as a gift

Question 9

Exclusions - Life Insurance Proceeds

Answer 9

Rule: GI does not include proceeds paid by reason of death of the insured.

But if paid in installments, any interest paid is taxable

Question 10

Exclusions - Inheritances

Answer 10

Rule: GI does not include amounts received by bequest, devise, or inheritance

Question 11

Exclusions - Tort Awards

Answer 11

Rule: GI does not include damages received on account of physical personal injury or sickness

Rule: By themselves, damages for emotional distress may be included

Rule: Punitive damages are taxable

Question 12

Exclusions - Gifts

Answer 12

Rule: GI does not include. Gifts are made out of detached and disinterested generosity

Irrebutable presumption that employers don’t make gifts

Question 13

Exclusions - Employee-Related Exclusions

Answer 13

Health Insurance: Premiums paid by employer and reimbursed medical expenses are excluded

Life Insurance: Can exclude the value of the first $50K

Meals and Lodging: Employer-provided meals and lodging are excluded if

1) provided for the convenience of the employer
2) in-kind
3) on the employer’s premises

Other Tax-Free Fringe Benefits:

1) De minimus
2) No additional cost to the employer
3) Qualified employee discounts
4) Contributions to qualified pension plans
5) Employee safety or length of service awards

Qualified Scholarship: For tuition and related expenses are excluded if primarily for the benefit of the individual

Question 14

Above-the-Line Deductions

Answer 14

Subtotal reached is referred to as Adjusted Gross Income (AGI)

Examples:

1) Ordinary and Necessary Business Expenses
2) Depreciation
3) Net Capital Losses (up to $3K)
4) Alimony
5) Net Gambling Losses
6) Moving Expenses
7) Limited Deduction for School Loan Interest

Question 15

Itemized Deductions

Answer 15

1) Home Mortgage Interest
2) State and Local Taxes
3) Unreimbursed Casualty Losses
4) Unreimbursed Medical Expenses
5) Charitable Contributions
6) Miscellaneous Deductions
7) Business Legal Expenses
8) Investment Fees or Expenses
9) Exemptions

Question 16

Itemized Deductions - Home Mortgage Interest

Answer 16

Can deduct home mortgage interest up to $1m (in the aggregate) on a principal and second personal residence

Can also deduct home equity loan up to $100K

Question 17

Itemized Deductions - State and Local Taxes

Answer 17

Deductible, with the exception of sales tax

Question 18

Itemized Deductions - Unreimbursed Casualty Losses

Answer 18

Deductible if:

1) loss is greater than $100
2) loss is sudden and unexpected
3) only to the extent that aggregated losses exceed 10% of AGI

Question 19

Itemized Deductions - Unreimbursed Medical Expenses

Answer 19

Deductible to the extent that aggregated losses exceed 10% of AGI

Question 20

Itemized Deductions - Charitable Contributions

Answer 20

Taxpayers can deduct FMV of contributions to qualified charities

Question 21

Itemized Deductions - Miscellaneous Deductions

Answer 21

Taxpayers may deduct eligible miscellaneous deductions to the extent that, aggregated, they exceed 2% of AGI

Look for expenses necessary to maintain and improve skills for taxpayer’s job

Question 22

Itemized Deductions - Investment Fees or Expenses

Answer 22

Can deduct fees or expenses necessary to generate taxable income (e.g., broker fees, advertising)

Question 23

Itemized Deductions - Exemptions

Answer 23

Entitled to one exemption for themselves, and one for each dependent

Question 24

Allocation of Income - To whom is it income?

Answer 24

Rule 1: Income is taxed to he or she who earns it. Assignment of income

Rule 2: Income from property (investment income) is taxed to he or she who owns the property

Question 25

Cash Method of Accounting

Answer 25

Reports when she receives PAYMENT and takes deductions when she makes PAYMENT

Constructive Receipt: Taxpayer receives payment when funds are credited to her account, set apart, or otherwise made available so she can draw on them

Question 26

Income in Respect of a Decedent

Answer 26

If a cash basis taxpayer is entitled to income, and payment is received after decedent’s death, executor must report on the estate’s income tax return

Question 27

Accrual Method of Accounting

Answer 27

Most businesses use this

Reports income when all events have occurred that fix the right to receive it, and when the amount can be determined with reasonable accuracy

Question 28

Basic Sale Formula

Answer 28

Amount Realized less Adjusted Basis = Gain/Loss

Amount Realized: includes money received, plus FMV, plus mortgages or liabilities to which the property sold is subject or buyer assumes

Cash Basis: Generally the cost of the property, including money paid and borrowing incurred to purchase. Adjusted based on later costs (e.g., renovations)

Question 29

Divorce Property Settlements

Answer 29

A transfer of property between spouses or ex-spouses that is incident to divorce is not taxable to either party. The spouse receiving has the same basis as the donor had. Substituted basis rule

Question 30

Basis in Gift Property

Answer 30

Recipient of a gift takes the donor’s basis. Substituted basis rule

Question 31

Basis in Inherited Property

Answer 31

FMV of the property at the date of decedent’s death

Question 32

Like-Kind Exchanges

Answer 32

No gain or less where taxpayer exchanges property held for productive use in a business or investment for like-kind property

Question 33

Sale of a Principle Residence

Answer 33

Up to $250K (500K for joint returns) of gain from sale can be excluded if the property has been used and owned as principle residence for periods aggregating 2 years during the 5-year period ending on date of sale