Federal Income Taxation

Question 1

Define gross income.

Answer 1

Gross income includes any economic benefit or any clearly realized accession to your wealth.

Question 2

What is realization?

Answer 2

The increased or decreased value of an asset is not taken into account for tax purposes until it is realized through the sale or disposition of the asset.

Question 3

What are non-cash receipts?

Answer 3

Gross income includes the fair market value of any property received and the fair market value of any services received.

Question 4

Define claim of right. What is the rule regarding claim of right?

Answer 4

Definition: The taxpayer has received property or funds under a “claim of right” when they are received without restriction as to use or disposition

Rule: Property or funds received under a claim of right must be reported for tax purposes even though the taxpayer may later be required to return the property, funds or their equivalent.

Question 5

Are stolen or illegally acquired funds or property considered taxable income?

Answer 5

Yes. Stolen, embezzled, or otherwise illegally acquired funds or property are considered taxable income.

Question 6

What is the tax benefit rule?

Answer 6

If a taxpayer takes a deduction in one tax year and receives the property that gave rise to the deduction in a later tax year, the taxpayer has tax benefit income, to the extent that the earlier deduction provided a tax savings or a tax benefit.

Question 7

What is the alimony rule regarding tax liability and deductions?

Answer 7

Unless otherwise provided in the written agreement, alimony is taxable to the receiving spouse and deductible to the paying spouse.

Question 8

What are the elements of alimony?

Answer 8

1. writing: must be pursuant to a written divorce or separation agreement;
2. living together disallowed: cannot be members of same household;
3. cease at or before death: liability to make payments must cease at or before death;
4. cash: payments must be cash (or its equivalent).

Question 9

What is the child support rule regarding tax liability and deductions?

Answer 9

Child support is NOT TAXABLE to receiving spouse and NOT DEDUCTIBLE to paying spouse.

Question 10

What is the “child support in disguise” rule for tax purposes?

Answer 10

If a payment is reduced upon a contingency relating to a child, the amount of the reduction is considered child support.

Question 11

In terms of determining one’s gross income, what is the effect of prizes and awards? What is the rule? Examples?

Answer 11

RULE: Gross income includes the value of cash, property, or services received as a prize, award, or Windfall

. Examples of taxable prizes or awards: raffle prizes, gambling or lottery winnings, and treasure trove.

Question 12

What is the rule regarding cancellation of indebtedness? What are the exceptions?

Answer 12

The borrower has no gross income upon the initial receipt of borrowed funds.

However, a taxpayer whose debt is cancelled or charged at less than the full amount, has discharge of indebtedness income to the extent of the difference between the full amount of the obligation and the amount paid in satisfaction of the debt.

EXCEPTIONS: The debt is RIGed.

1. _ R_eduction in purchase price: If the apparent discharge of debt is really a reduction in purchase price in connection with the sale of goods, discharge of indebtedness rules will not apply.
2. Insolvency: If the discharge occurs when the taxpayer is insolvent or bankrupt, there is no immediate discharge of indebtedness income.
3. Gift: If the lender intends the discharge as a gift, the discharge of indebtedness rules will not apply

Question 13

What is the rule regarding life insurance proceeds?

Answer 13

RULE: Gross income does not include proceeds paid by reason of death insured. (an exclusion)

However, when proceeds are paid in installments, any interest will be taxable.

Question 14

What is the rule regarding inheritance? Are inheritances included in gross income?

Answer 14

RULE: Gross income does NOT include amounts received by bequest, devise, or inheritance (an exclusion).

Question 15

When calculating gross income, does it include gifts? What is the definition of a gift?

Answer 15

Gross income does NOT include amounts received by gift.

A gift is a transfer made out of detached and disinterested (meaning love and affection) generosity?

NOTE: Employers do not give gifts.

Question 16

Does gross income include tort award damages?

Answer 16

RULE 1: Gross income does not include damages received on account of physical personal injury or sickness. (compensatory damages)

RULE 2: By themselves, damages for emotional distress are not considered damages received on account of physical injury.

Compare:
RULE 3: punitive damages received in connection with personal injuries are taxable.

Question 17

Are qualified scholarships included in gross income? What is required for a scholarship to be qualified?

Answer 17

RULE: Qualified scholarships for tuition and related expenses are excluded from gross income.

To be “qualified,” must not be payment for past or future services. Must also be primarily for the benefit of the individual.

Question 18

When something of value is not included in one’s gross income calculations, this is called?

Answer 18

An exclusion

Question 19

When calculating gross income, what is the rule regarding life insurance provided by or through an employer?

Answer 19

RULE: Taxpayers may exclude the value of the first $50,000 of employer- provided group term life insurance.

Gross income includes excess life insurance coverage provided by the employer.

Question 20

In determining an employee’s gross income, what is the rule regarding receipts from health and accident insurance?

Answer 20

RULE: Value of employer provided health or accident insurance coverage, i.e. the premiums paid by the employer, are excluded from gross income.

Health insurance reimbursements for medical expenses (and worker’s compensation) actually incurred also are excluded from gross income.

Question 21

In determining gross income of an employee, what is the rule regarding meals and lodging paid for by the employer?

Answer 21

Employer provided meals and lodging excluded if:

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

Question 22

Besides insurance, meals, and lodging, what are other common tax-free fringe benefits that employers provide to employees?

Answer 22

Other Tax-Free Fringe Benefits to Employees

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 award

Question 23

What are examples of above-the-line deductions?

Answer 23

EXAMPLES OF ABOVE-THE -LINE DEDUCTIONS

• Ordinary and Necessary Business Expenses. Examples: salaries to employees, rent for office space, office supplies
  
  • Business Interest
  • Business Taxes, except federal taxes
• Depreciation
• Capital Losses: up to a maximum of $3,000 Alimony
• Moving Expenses
• Limited deduction for school loan interest

The “subtotal” reached after subtracting above-the-line deductions is referred to as Adjusted Gross Income (AGI)

Question 24

What is the rule regarding home mortgage interest deductions?

Answer 24

RULE: Taxpayers may deduct home mortgage interest on mortgages of up to $1 million residence. (in the aggregate) on a principal and a second personal

Taxpayers may also deduct interest on a “home equity loan” of up to $100,000.

NOTE: Personal, i.e., consumer, interest is not deductible.

Question 25

What is the rule regarding state and local tax deductions?

Answer 25

Taxes paid to state and local governments are deductible, with the exception of sales tax.

Question 26

What is the rule regarding unreimbursed medical expenses?

Answer 26

RULE: Unreimbursed medical expenses are deductible to the extent that they (in aggregate) exceed10 percent

Question 27

What is the rule regarding charitable contributions?

Answer 27

Taxpayers generally may deduct the fair market value of property and the amount of cash contributed to qualified charities.

Cannot deduct for time spent volunteering.

Question 28

What is the rule pertaining to micellaneous deductions? Examples?

Answer 28

RULE: Taxpayers mat deduct eligible miscellaneous deductions to the extent that (in the aggregate) they exceed 2 percent of AGI.

Examples: Unreimbursed employee business expenses, certain educational expenses, e.g. those necessary to maintain and improve skills needed in the taxpayer’s current trade or business

Question 29

Are personal expenses deductible? What is the rule regarding legal fees for personal expenses and business expenses?

Answer 29

Personal expenses are not deductible.

Legal Fees - In General:

Legal fees incurred in a personal setting are not deductible.

Legal fees incurred in a business or investment setting are deductible.

Question 30

Are investment fees or expenses deductible? When may one deduct these expenses?

Answer 30

Yes. Taxpayers may deduct the fees or expenses that were necessary to generate taxable income.

Example: broker fees; advertising.

Question 31

What is the general rule regarding exemptions?

Answer 31

RULE: Taxpayers are entitled to one exemption for themselves and for one for each dependent.

Question 32

What is the rule regarding which partent gets a exemptions for dependents after divorce?

Answer 32

Unless the other parent signs a written release, the general rule after a divorce is that the custodial parent gets the exemption for children of the marriage.

Question 33

For the purposes of taxing, generally, how is income allocated (i.e. to whom is it income)?

How is income from property allocated?

Answer 33

Income must be taxed to he or she who earns it.

This is sometimes referred to as the “assignment of income” rule.

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

Question 34

What is the cash method of accounting?

Answer 34

A method used to determine when payment is income. A cash method taxpayer reports income when she receives payment takes deductions for eligible expenses when she makes payment.

Question 35

What is meant by constructive receipt?

Answer 35

A taxpayer has “constructive receipt” when funds or property are:

• credited to her account,
• set apart,

OR

• otherwise made available so that she may draw upon them.

Question 36

What is the accrual method of accounting? When does a taxypayer report income and when does she take a deduction?

Answer 36

An “accrual method” taxpayer reports income when all events have occurred that fix the right to receive it, and when the amount can be determined with reasonable accuracy.

An “accrual method” taxpayer takes deductions when all events have occurred that establish the fact of liability, and when the amount can be determined with reasonable accuracy.

Question 37

In terms of assessing gains and losses on disposition of property, what is meant by the term realization.

Answer 37

The moment of sale, exchange, or disposition of an asset.

Question 38

In terms of assessing the gains and losses on disposition of property, what is meant by recognition?

Answer 38

Reporting that gain or loss in a tax return

Question 39

What is the general rule regarding gains and losses on disposition of property?

Answer 39

Unless a specific statutory or common law exception applies, whenever a gain is realized, it must also be recognized for tax purposes.

Question 40

What is the basic sale formula for determining whether an amount is realized?

Answer 40

AMOUNT REALIZED includes money received, plus the fair market value of property or services received, plus mortgages or liabilities to which the property sold is subject or which the buyer assumes.

Question 41

What is the “cost basis” rule? What are the rules regarding adjustments?

Answer 41

A taxpayer’s basis in property acquired by purchase is generally the cost of the property, including money paid and borrowing incurred in connection with the purchase.

**1. Upward adjustments: ** A taxpayer’s basis in property is increased to reflect additional costs .

2. Downward adjustments: A taxpayer’s basis in property is decreased to reflect deductions previously taken for depreciation or other previous tax-free recoveries of basis.

Question 42

When determining gains and losses on the disposition of property, what is the rule regarding divorce property settlements? What type of rule is this?

Answer 42

A transfer of property between spouses or “ex-spouses” that is incident to divorce is not a taxable event to either party.

The spouse receiving the property will have the same basis that the donor spouse had.

This is known as a substituted (as opposed to a cost) basis rule.

Question 43

When determining gains and losses on the disposition of property, what is the general gain rule for basis in gift property? What type of rule is this?

Answer 43

The recipient of a gift takes the donor’s basis. This is also known as a substituted basis rule.

Question 44

When determining gains and losses on the disposition of property, what is the rule regarding the basis in inherited property?

Answer 44

The recipient’s basis in inherited property is the fair market value of the property at the date of decedent’s death.

Question 45

What is the rule regarding involuntary conversion when assessing gains and losses on the dispistion of property?

Answer 45

RULE: No gain or loss is recognized if property is involuntarily converted due to theft, fire, seizure, requisition or condemnation is converted into property that is “similar or related in service or use.”

If the property lost or damaged is converted to money, gain or loss is not recognized if the taxpayer purchases replacement property that is similar or related within two years from the date of involuntary conversion.

Gain or loss will be recognized, however, to the extent that the money received exceeds the cost of the replacement property.

Question 46

What is the rule regarding like-kind exchanges for determining gains and losses on disposition of property?

Answer 46

No gain or loss is recognized when a taxpayer exchanges property held for productive use in a business or for investment for like-kind productive use in business or for investment.

Question 47

What is the rule regarding the sale of a principal residence when calculating gains and losses on the disposition of property?

Answer 47

Up to $250,000 ($500,000 for joint returns) of gain from the sale of a principal residence can be excluded if the property has been used and owned as the taxpayer’s principal residence for periods aggregating two years during the five-year period ending on the date of the sale.

This exclusion generally is not available if the taxpayer has used it within two years.

Question 48

When choosing a business form for business planning purposes, what options are are available?

Answer 48

Options for Choice of Business Entity

Business activity may be conducted in the following forms:

• Sole proprietorship
• Generalpartnership
• Limited partnership
• C corporation
• S corporation
• Limited Liability company

Question 49

What factors should be considered when assessing what is the proper choice of business form.

Answer 49

An informed decision on the proper choice of entity for conducting a business requires consideration of both tax and non-tax factors.

_Non-Tax Factors: _

Perhaps the most important non-tax factor is the need or desire for limited liability.

Other important non-tax factors to consider are the need for flexibility in the business structure, and the ease of control and management.

Tax Factors:

The most important tax consideration is the income taxation of profits.

The sale of stock option can often provide the best of both worlds in that it offers limited liability while subjecting its investors to only a single tax.

Eligible unincorporated business entities may elect to be treated as either corporation or partnership for tax purposes under regulations popularly referred to as “check the box” regulations. Since unincorporated entities tend to prefer partnership classification, the I.R.S. considers unincorporated businesses as a partnership unless they explicitly elect otherwise.

Question 50

How does an eligible unincorporated business elect to be treated as a corporation or partnership for tax purposes?

Answer 50

Eligible unincorporated business entities may elect to be treated as either corporation or partnership for tax purposes under regulations popularly referred to as “check the box” regulations.

Since unincorporated entities tend to prefer partnership classification, the I.R.S. considers unincorporated businesses as a partnership unless they explicitly elect otherwise.

Question 51

What are the two types of income (character of income)?

Answer 51

Ordinary Income and Capital Gains

Question 52

What is the difference between ordinary income and capital gains?

Answer 52

The top marginal tax rate on most long-term capital gains is lower than the top marginal rate on ordinary income.

Capital assets: Generally investment assets.

Examples: stock or real estate held for investment. Capital assets do not include inventory, depreciable property, copyrights.

NOTE: Dividends to shareholders of domestic corporations are generally eligible for tax at capital gains rates

Ordinary income examples: salary, rents, interest, royalties

Question 53

In corporate tax, what is the basic double tax regime?

Answer 53

Corporations pay income tax upon profits.

In addition, shareholders pay a tax upon dividends received from the corporation.

Question 54

Under corporation tax law, how are gains and losses treated for the corporation?

Answer 54

There is no gain to a corporation upon the receipt of property upon formation/incorporation.

Question 55

Under corporation tax law, how are gains and losses treated for shareholders?

Answer 55

There is no gain or loss to the shareholders upon forming (incorporating) a corporation where:

1. the shareholder’s contribute property;
2. the shareholder’s receive stock in return for the exchange; AND
3. the shareholder’s are in control immediately after the exchange.

Question 56

When assessing how gains and losses are treated for shareholders, how is “control” defined?

Answer 56

“Control” means that the stockholders must have 80% of the outstanding corporate stock immediately after the exchange.

Question 57

Under corporate tax law, what is the rule for corporate distributions? Are shareholder taxable?

Answer 57

Shareholders are taxable on the dividends **they receive. A dividend is a corporate distribution made out of the corporation’searnings and profits**.

Most dividends paid by domestic corporations are now eligible for capital gains rates.

To the extent that a distribution is not made out of the corporation’s earnings and __profits, it is t*reated as a tax-free recovery *of the shareholder’s basis in her stock.

[Any excess received above the taxpayer’s basis is considered gain from the sale of a capital asset.]

Question 58

What is a dividend?

Answer 58

A dividend is a corporate distribution made out of the corporation’s earnings and profits.

Question 59

For pass-through business entities, what is the basic pass-through principle? What are examples of pass-through entities? How do pass-through entities differ from corporations?

Answer 59

The pass-through business entity itself pays no tax at the entity level.

Examples of pass-through entities include:

1) general partnerships;
2) limited partnerships;
3) Limited Liability Companies (“LLCs”); and
4) Subchapter S corporations (“S Corporations”).

Unlike the corporation, the pass-through entity is thus a single tax entity.

Question 60

In terms of profits and losses of pass-through entites, what it is the rule regarding investors?

Answer 60

Each partner, owner, investor, or shareholder of a pass-through entity generally reports his or her distributive share of income or loss on his or her individual tax return whether or not he actually receives it/ receives any distribution.

Subject to loss limitation rules, each partner, owner, investor, or shareholder of a pass-through entity is entitled to report his share of the entity’s loss.

Question 61

What is the rule regarding the formation of a pass-through entity?

Answer 61

The transfer of property to a general or limited partnership, an LLC, or a Subchapter S Corporation in return for a partnership interest, LLC interest, or stock in an S Corporation is not a taxable event.

Question 62

What is the rule for the formation and eligibility of a subchapter S Corporations?

Answer 62

An eligible regular corporation may become a pass-through Subchapter S corporation by making a Subchapter S election.

To be eligible, the corporation must have no more than 100 shareholders. (small business corporation).

Question 63

What are estate and gift taxes? What type of rate structure do they apply?

Answer 63

The estate and gift taxes are taxes imposed on the donor upon the transfer of wealth to another. These tax regimes are distinct from the federal income tax. (Some think of this as a double tax).

The estate and gift taxes apply a uniform rate structure and generally adopt similar tax prinicples and definitions.

Question 64

What is the general rule regarding gift taxes?

Answer 64

A gift tax is imposed on any completed or irrevocable donative transfer.

Examples of gifts include (think broadly):

• A bargain sale of property to a family member
• An interest free loan to a family member
• An interest in a joint bank account

Question 65

For gift taxes, what is the rule for annual exclusions?

Answer 65

Each taxpayer may exclude the first $13,000 (goes up to $14,000 next year) in gift transfers per donee.

Question 66

For gift taxes, what is the rule for marital deductions?

Answer 66

A gift transfer from one spouse to another is eligible for a 100% (unlimited) marital deduction.

Question 67

Under gift taxes, what is the rule regarding exemptions?

Answer 67

Taxpayers are entitled to a $5.25 million lifetime exemption for gift tax purposes.

To the extent that the taxpayer has used any of the lifetime gift exemption, it will reduce the available estate tax exemption.

Question 68

What is the general rule regarding estate taxes?

Answer 68

The decedent’s gross estate includes the value of all assets officially owned at the time of death as well as certain lifetime transfers.

The executor must file an estate tax return within nine months of the decedent’s death if the gross estate exceeds $5.25 million.

Virginia repealed its state-level estate tax in 2006.

Question 69

For estate taxes, what is the rule for lifetime transfers?

Answer 69

Even though the decedent transferred title to assets during lifetime, certain lifetime transfers will be included (“swept back in”) to the gross estate. Among the most important of these are:

1) transfers with a retained life estate and
2) transfers with a retained power to alter or revoke

In both instances, there are “strings attached.”

.

Question 70

For estate taxes, what is the rule regarding life insurance?

Answer 70

Proceeds of a life insurance policy on the decedent’s own life are included in the gross estate if either:

1) the proceeds are receivable by the executor; or
2) the decedent possessed any incidents of ownership at the time of death.

The most common incidents of ownership include: the right to change the beneficiary; a right to pledge against the policy; and a cash surrender value.

Question 71

Under an estate tax, what are the available exclusions and deductions?

Answer 71

1. Estate Tax Exemption - The decedent’s gross estate is entitled to an effective exemption of $5.25 million. Any gift tax exemption previously used by the decedent will count against the estate tax exemption.
2. Unlimited Marital Deduction -
   
   • Estate Passing to Spouse: The portion of the estate that passes to the surviving spouse is entitled to an unlimited (100%) marital deduction.
   • Terminable Interest Exception: Unless the executor makes a qualified
     (often referred to as a “Q-tip” terminable interest election), no marital deduction is allowed for transfers to a surviving spouse if the decedent spouse’s property or interest may ultimately be received by someone other than the surviving spouse. [NOTE:The same exception to the marital deduction applies to gift as well as estate transfers.]
3. New Estate Tax Exemption “Portability” Rules - If the decedent’s executor makes a proper, timely election, the decedent’s
   surviving spouse will be entitled to use any unused portion of the decedent’s estate tax exemption. Such an election effectively doubles the available estate tax exemption.
4. Other Deductions:
   
   • Funeral and administrative expenses
   • Debts owed by the decedent at death
   • Charitable contributions

Question 72

Under estate tax law, what is the estate tax exemption?

Answer 72

The decedent’s gross estate is entitled to an effective exemption of $5.25 million.

Any gift tax exemption previously used by the decedent will count against the estate tax exemption.

Question 73

Under an estate tax, what is the unlimited marital deduction? Wht is the exception?

Answer 73

_Unlimited Marital Deduction: _

Estate Passing to Spouse: The portion of the estate that passes to the surviving spouse is entitled to an unlimited (100%) marital deduction.

Terminable Interest Exception: Unless the executor makes a qualified (often referred to as a “Q-tip” terminable interest election), no marital deduction is allowed for transfers to a surviving spouse if the decedent spouse’s property or interest may ultimately be received by someone other than the surviving spouse.

[NOTE:The same exception to the marital deduction applies to gift as well as estate transfers.]

Question 74

Under an estate tax, what are the new estate tax exemption portability rules?

Answer 74

If the decedent’s executor makes a proper, timely election, the decedent’s surviving spouse will be entitled to use any unused portion of the decedent’s estate tax exemption. Such an election effectively doubles the available estate tax exemption.