Lesson 2 of Income Tax Planning: Basic Income Tax Flashcards
Introduction to Individual Income Taxation
Basic Tax Formula
Accounting Periods and Methods
Taxable Year
Filing Status
Personal & Dependency Exemptions (repealed under TCJA)
Standard Deductions
Qualifying Child
Children of Divorced or Seperated Parents
Qualifying Relative
Multiple Support Agreements - Personal amd Dependency Exemptions Repealed (TCJA 2017)
Tax Payment Procuedures
What is the Basic Tax Formula
Accounting Periods and Methods
Taxpayers are either (1) cash basis taxpayers or (2) accrual basis taxpayers
Cash-Basis Recognition of Income
The Doctrine of Constructive Receipts
Business and Personal Items Use Different Accounting Methods
Taxpayers are either
(1) cash basis taxpayers
or
(2) accrual basis taxpayers
Cash-basis taxpayers recognize income when it is received (or set aside). Most individuals and some businesses are cash-basis taxpayers.
Accrual-basis taxpayers recognize income when it is earned. Most businesses are accrual-basis taxpayers.
Under accrual-basis accounting, taxpayers report an amount in their gross income on the earliest of the following dates:
-When payment is received,
-When the income amount is due to the taxpayer,
-When the taxpayer earns the income.
Cash-Basis Recognition of Income
A cash-basis taxpayer is deemed to receive income when it is credited to the taxpayer’s account, set apart for the taxpayer, or made available to be taken into the taxpayer’s possession.
Under the cash method, you include in your gross income all items of income you actually or constructively receive during the tax year. If you receive property and services, you must include their fair market value in income.
Recognition of income must be consistent with the constructive receipt doctrine.
The Doctrine of Constructive Receipts
The doctrine of constructive receipt states that when income is readily available to the taxpayer, and that income is not subject to substantial limitations or restrictions, that income is deemed to be constructively received and should be taxed (unless subject to another exception).
-Income that is subject to substantial limitations or restrictions is not constructively received. Substantial limitations or restrictions include:
–Any substantial limitation or restriction on either the time or manner of payment, and
–If the financial condition of the debtor makes payment of the income in question impossible, there is no constructive receipt.
Business and Personal Items Use Different Accounting Methods
You can account for business and personal items using different accounting methods.
For example, you can determine your business income and expenses under an accrual method, even if you use the cash method to figure personal items.
Examples (3)
Examples 1:
Jonas has an account at New Birmingham Bank. Ten thousand dollars of his account balance is invested in a certificate of deposit (CD). When interest is paid on the CD and added to Jonas account balance, that interest must be included in Jonas income even if he does not withdraw the interest from his account. The interest is includable in Jonas’ income because, even though he has not withdrawn it, it has been constructively received. The interest is constructively received because it is readily available to Jonas and is not subject to any substantial limitations or restrictions
Examples 2:
Edward owns 100 shares of Bulldog Company stock, On December 31, YRI, Bulldog Company mails dividend checks to all of its shareholders. Edward did not receive his dividend check until January 3, YR2. Edward is not required to include the dividends in his income until YR2 because the dividends were not readily available to Edward in YRI
Example 3:
George O’Malley, an agent for Seattle Mutual Insurance Company, assigns his renewal commissions to his 25-year-old daughter, Callie. Although George has assigned some of his commissions to his daughter, George would still be taxed on the commissions. Under the assignment of income doctrine, George cannot assign the tax liability on income that he has earned to another party.
Taxable Year
A taxable year is an annual accounting period for keeping records and reporting income and expenses.
-For most taxpayers, the taxable year is the 12-month period comprising the calendar year.
-Some taxpayers, however, choose a fiscal year.
A fiscal year is a 12-month period ending on the last day of a month other than December.
-A fiscal year can be elected if adequate records are maintained.
-Individuals that want to change their tax year must generally file Form 1128 to get IRS approval either under the automatic approval procedures or the ruling request procedures.
Filing Status
There are 5 tax filing categories for individuals:
Single
Married Filing Jointly
Married Filing Separately
Head of Household
Qualifying Widower with Qualified Child
Single
If you are single you file as a single person.
Married Filing Jointly
In order to file as married filing jointly, the taxpayer and his her spouse must have been married as of the last day of the year.
If the taxpayer’s spouse died during the year and the taxpayer did not remarry, the taxpayer may still file a joint return with that spouse for the year of death.
Married Filing Separately
If you are married you can file separately.
Head of Household
This filing status is allowed for individuals who are either unmarried or are considered unmarried as of the last day of the taxable year.
-A taxpayer is considered unmarried if he filed a separate return, paid more than half the cost of keeping up his home, the taxpayer’s spouse did not live in the taxpayer’s home during the last six months of the year (i.e. abandoned spouse), the taxpayer’s home was the main home of the taxpayer’s child for more than half of the year, and the taxpayer is eligible to claim a credit for that child.
The taxpayer is also required to have paid more than half the cost of keeping up a home during the taxable year.
Also, a “qualifying person” generally must have lived with the taxpayer for more than half of the
year
-The following chart from IRS Publication 501 summarizes “Who Is a Qualifying Person
Qualifying You To File as Head of Household?”
Chart of Who Is a Qualifying Person
Qualifying You To File as Head of Household?
Qualifying Widower with Qualified Child
A taxpayer is eligible to file as a qualifying widower with qualified child for two years following the year in which the taxpayer’s spouse died if all of the following apply:
-The taxpayer was eligible to file a joint return with his or her spouse in the year in which the taxpayer’s spouse died,
-The taxpayer has not remarried,
-The taxpayer has a child or stepchild for whom the taxpayer can claim as qualified,
-The child lived in the taxpayer’s home all year, and
-The taxpayer paid more than half the cost of keeping up a home during the year.
Example
Mario’s wife died in YR1. Mario has not remarried. During YR2 and YR3, Mario has continued to maintain a home for himself and his child, for whom Mario is eligible to claim as a dependent. In YR1, Mario is eligible to file a joint return for himself and his deceased wife (married filing jointly). For YR2 and YR3, Mario may file as a qualifying widower with a qualifying child.
After YR3, Mario may file as a head of household, if he qualifies.
Personal & Dependency Exemptions (repealed under TCJA)
Personal & Dependency Exemptions were repealed under Tax Cut Jobs Act 2017. The number is still indexed as it used as the income determination for dependency of children and family members
-2023 is $4,700
Standard Deductions
Chart
Additional Standard Deduction Amounts
Certain taxpayers are not eligible for standard deductions.
A taxpayer who is claimed as a dependent of another taxpayer will have a limited standard deduction.
Special rules apply to a person who can be claimed as a dependent by another taxpayer.
Personal and dependency exemptions.
Standard Deduction Chart
Additional Standard Deduction Amounts
Taxpayers age 65 or older or blind are entitled to an increased standard deduction.
-$1,850 for individuals not married and not filing as a qualifying widow(er).
-$1,500 for all other taxpayers.
*If you are single, and head of household = $1,800.
Taxpayers age 65 or older and blind are entitled to two additional standard deductions.
-Taxpayers who are blind must file to receive the additional standard deduction. The IRS does have age on file, but not blindness.
The additional standard deduction for blind will be the $1,850 if you are single and head of household.
Example
Albert is single, blind, and 67 years old. What is Albert’s standard deduction?
Albert is entitled to a standard deduction of $17,550. This deduction is calculated by adding the basic standard deduction for a single taxpayer ($13,850) and two additional standard deductions for a blind and elderly single taxpayer ($1,850 + $1,850).
Exan Question
Bob and Barbara are married and file a joint tax return. Bob is 68 years old and Barbara is 67 years old. Barbara is legally blind. What is Bob and Barbara’s standard deduction?
a) $27,700
b) $29,200
c) $30,700
d) $32,200
Answer: D
Bob and Barbara are entitled to a standard deduction of $32,200. They are entitled to the basic standard deduction for taxpayers married filing jointly ($27,700), plus one additional deduction for Bob since he is age 65 or older ($1,500 and two additional deductions for Barbara since she is age 65 or older and blind ($1,500 + $1,500).
Certain taxpayers are not eligible for standard deductions.
Married filing separately when other spouse itemizes deductions. If one spouse itemizes deductions (as opposed to taking the standard deduction), the other spouse must also itemize.
Nonresident aliens.
Individuals filing returns for tax year of less than 12 months.
Explanation of Itemized Deudction. When a spouse itemizes deductions, it means they are listing and claiming individual tax-deductible expenses, such as mortgage interest, medical expenses, or charitable contributions, on their income tax return instead of taking the standard deduction. This allows them to potentially reduce their taxable income by the total amount of qualified expenses they’ve incurred during the tax year. Standard deduction is a predetermined amount.
A taxpayer who is claimed as a dependent of another taxpayer will have a limited standard deduction.
A taxpayer who is claimed as a dependent of another taxpayer will have a limited standard deduction. A dependent’s standard deduction is equal to the greater of:
-$1,250 (2023), OR
- $400 plus earned income (but not exceeding the normal standard deduction).
- -If the dependent is age 65 or older and/or blind, however, the standard deduction may be higher.
Example (3)
Example 1:
Amy, who is single, blind, and 18 years old, is a dependent of her parents. Amy had earned income of $200 during 2023. Amy is entitled to a total standard deduction of $1,250. (the greater of earned income plus $400 or $1,250)
Example 2:
Brett has $1,500 of earned income and is a dependent of his parents. Brett is not blind or age 65 or older. Brett is entitled to a standard deduction of $1,900 ($1,500 + $400. Note that Brett’s earned income plus $400 is greater than $1,250.
Example 3:
Carla has $10,000 of earned income and is claimed by her parents as a dependent. Carla is not blind or age 65 or older, Carla is entitled to a standard deduction of $10,400. Carla’s earned income plus $400 equals $10,400, not to exceed $13,850.
Special rules apply to a person who can be claimed as a dependent by another taxpayer.
Special rules apply to a person who can be claimed as a dependent by another taxpayer.
Such a person:
(1) may have a reduced basic standard deduction, and
(2) is required to file a tax return based on different rules from the gross income test used by taxpayers who are not dependents.
An overview of these issues is presented in the section on calculating the standard deduction of a dependent.
Personal and Dependency Exemptions
Personal and dependency exemptions were repealed for 2018 through 2025.
Quaifying Child
A Qualifying child must meet:
Rules for a qualifying child related to the defintion of a child for purposes of head of household filing status
Relationship Test
Abode Test
Age Test
Support Test
Tie-Breaker Rules
A Qualifying child must meet:
In addition to the joint return test and the citizenship or residency test (discussed later), a qualifying child must meet all four tests:
A relationship test,
An abode test,
An age test,
A support test.
Must also Meet: (discussed later)
-Joint Return test
-Citizenship or Residency Test
Rules for a qualifying child related to the defintion of a child for purposes of head of household filing status:
These rules for a qualifying child relate to the definition of a child for purposes of head of household filing status, the earned income tax credit, the child tax credit, and the credit for child and dependent care expenses.
Note there are different age requirements for the child tax credit and the child and dependent care expense.
Relationship Test
In order to satisfy the relationship test, a qualifying child of a taxpayer must be:
-The taxpayer’s child.
-A descendant of the taxpayer’s child,
-The taxpayer’s brother, sister, stepbrother, stepsister, half brother, half sister, or
-A descendant of the taxpayer’s brother, sister, stepbrother, stepsister, half brother, or half sister.
Stated differently, a qualifying child is a descendant of the taxpayer, the taxpayer’s sibling, or a descendant of the taxpayer’s sibling. Note that a cousin is not a qualifying child.
A taxpayer’s child may be a natural child, a stepchild, an adopted child, or an eligible foster child.
Example
Elizabeth and Warren McConkie have a remarkably diverse family. In addition to Elizabeth and Warren, the family includes:
- Matt, Elizabeth’s 10-year-old son from a prior marriage,
- Amy, Elizabeth’s 15-year-old sister,
- Andrei, their 6-year-old son adopted from Russia,
- Zoe, their 4-year old daughter, and
- Carlos, a 2-year-old foster child placed with them by a state agency.
All five children meet the relationship test as a qualifying child of Elizabeth.
Adobe Test
To meet the abode test, a qualifying child must live with the taxpayer for more than half the year.
The taxpayer and the dependent are considered to occupy the household even during temporary absences due to special circumstances such as illness, education, business, vacation, or military service.
Example
The 18-vear-old son of William and Belinda Bates lived at home during the first five months of the year and then entered military service. Since military service is considered to be a temporary absence due to special circumstances, the son meets the abode test for the year.
Age Test
A full time qualifying child must either be under the age of 19 as of the end of the calendar year or a student under the age of 24 as of the end of the calendar year in order to satisfy the age test.
To be considered a student, the child must be a full-time student at an educational institution during five months of the calendar year. Most primary and secondary schools, colleges, universities and similar educational institutions are acceptable for this purpose
Example
Marilyn’s 21-year-old son finished his third year of college in May of this year. He spent the remainder of the year serving as a volunteer in a program to assist the victims of a flood. If the son was a full-time student during the first five months of the year, he meets the age test.
Support Test
The support test is satisfied if a qualifying child does not provide more than one-half of his or her own support during the year. If a child is the taxpayer’s child and is a full-time student, amounts received as scholarships are not considered to be support.
If more than one person is eligible to claim another person as a dependent under the qualifying child rules, the tie-breaker rules shown below apply:
Example
Frank and Alice provide $10,000 toward the support of their son, Edward. Edward provides $2,000 toward his own support and receives a scholarship worth $12,000 from the university he attends. Edward is not considered to provide more than one-half of his own support because the scholarship is not considered to be support provided by Edward.
Tie Breaker Rules
Children of Divorced or Separated Parents
Abode Test and the Custodial Parent
Form 8332
Abode Test and Custodial Parent
Because of the abode test, a child of divorced or separated parents is normally the qualifying child of the custodial parent. If all four of the following requirements are met, however, the child will be treated as the qualifying child of the noncustodial parent.
- The parents are divorced or legally separated under a decree of divorce or separate maintenance, are separated under a written separation agreement, or they lived apart at all times during the last six months of the year;
- The child receives over one-half of his support for the year from his parents;
- The child is in the custody of the parents for more than half the year; and
- The custodial parent signs a statement that she will not claim the child for the year, and the noncustodial parent attaches the statement to his return (may use Form 8332).
Custodial Parent: Is the parent that the child resides with after a divorce or seperation.
Form 8332
For the signed statement or written declaration in requirement four above, the custodial parent may use Form 8332 or a similar statement that contains the same information. The statement may apply to the current year, several years, or to all future years. For divorce or separation agreements after 1984, the requirement for a signed statement can be met by attaching certain pages from the decree or agreement to the tax return of the noncustodial parent. If pages from the decree or agreement are used, they must specify that the noncustodial parent can claim the child the years for which the noncustodial parent is allowed to claim the child. Different rules apply to divorce decrees and separation agreements before 1985.
Example
Edward and Janet were divorced three years ago. Janet was given custody of their daughter, Jes-sica, and Edward was given visitation rights on alternate weekends and other specified times. The divorce decree states that Edward will be allowed to claim Jessica for the child credit each year. Edward will be able to claim Jessica, but he will be required to attach pages from the divorce decree to his income tax return each year. If the right to claim Jessica for the credit had not been given to Edward in the divorce decree, Janet could allow him to claim Jessica by giving him a signed Form 8332 to attach to his tax return
Qualifying Relative
In addition to the joint return test and the citizenship or residency test (discussed later), a qualifying relative must the following four tests to qualify as a dependent of a taxxpayer for the child tax credit:
Relationship Test
Gross Income Test
Support Test
Not a Qualifying Child Test
Must also Meet: (discussed later)
-Joint Return test
-Citizenship or Residency Test
There is ALSO: Additional Test for Qualifying Child and Qualifying Relative
Relationship Test
To satisfy the relationship test for a qualifying relative, the potential dependent of the taxpayer must be:
-The taxpayer’s child or a descendant of a child (grandchildren, etc.),
-The taxpayer’s brother, sister, stepbrother, or stepsister,
-The taxpayer’s father, or mother, or an ancestor (grandparent, etc.),
-The taxpayer’s stepfather or stepmother,
-A son (nephew) or daughter (niece) of a brother or sister of the taxpayer,
-A brother (uncle) or sister (aunt) of the father or mother of the taxpayer,
-A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law of the taxpayer, or
-Any other individual (may be a totally unrelated person) who, for the taxable year of the taxpayer, has the same principal place of abode as the taxpayer and is a member of the taxpayer’s household. A person who was married to the taxpayer during part of the year does not qualify.
A child of the taxpayer who does not meet the requirements to be a qualifying child may still meet the requirements to be a qualifying relative of the taxpayer.
Note that not all relatives of a taxpayer (a cousin, for example) meet this relationship test. Significantly, individuals who are not actually related to the taxpayer may meet the relationship test if they live with the taxpayer as a member of the taxpayer’s household.
An unrelated person does not qualify in certain limited circumstances (for example, if the relationship violates state law).
Gross Income Test
To meet the gross income test, a dependent’s gross income must be less than the personal exemption amount ($4,700 for 2023 even though the personal exemption was repealed) for the year.
This contrasts with a qualifying child, for whom there is no such test.
Example
Phillip provides more than half the support of his son, David. David is a 25-year-old doctoral student at a university. David’s only income is a $12,000 fellowship to pay tuition. Even though David is not under 24 years of age and is therefore not a qualifying child, he may be claimed as a qualifying relative if he meets the gross income test.
Since a fellowship or scholarship is normally excluded from gross income, Phillip is allowed to claim David as a dependent.
Support Test
To satisfy the support test, the taxpayer must provide more than one-half of the support of a dependent. Support normally includes providing housing, food, clothing, education, and medical treatment, among other things. Income received by a dependent does not count as support provided by the dependent unless it is actually expended for that purpose.
For example, if income earned by an elderly parent is deposited in a savings account rather than expended for his own support, it does not count as support provided by the parent.
Not a Qualifying Child Test
In order to be claimed as a qualifying relative, a person cannot be a qualifying child of any taxpayer for the tax year.
Additional Tests for Qualifying Child and Qualifying Relative
In addition to the four tests for a qualifying child or the four tests for a qualifying relative, anyone who may be claimed as a dependent under the qualifying child or qualifying relative classifications must meet the following two tests:
-A joint return test, and
-A citizenship or residency test.
Joint Return Test
To satisfy the joint return test, a married dependent must not file a joint return with a spouse unless a tax return is filed only to claim a refund for tax withheld, if neither spouse is otherwise required to file a tax return, and if no tax liability would exist for either taxpayer on separate returns.
Example
George and Francesca wish to claim their married daughter, Elena, as a qualifying dependent.
They met all of the tests to claim her except the joint return test.
Elena and her husband filed a joint tax return for the year to reduce their income tax liability. They owed money on their joint return and each would have owed money on a separate return. George and Francesca are not eligible to claim Elena as a qualifying dependent.
Citizenship or Residency Test
A dependent must be a citizen or national of the United States or a resident of the United States, Canada, or Mexico during some part of the year. This test does not apply for certain adopted children.
Summary for Tests that apply for a Qualitive Dependent Child and a Qualifying Dependent Relative
Multiple Support Agreements - Personal amd Dependency Exemptions Repealed (TCJA 2017)
The personal exemption for 2023 is repealed.
The phaseout of the Personal Exemption (PEASE) was repealed by ICJA 2017.
Tax Payment Procedures
Federal income tax is a Pay-As-You-Go system
Taxpayers Who Receive Income That Is Not Subject to Withholding, Make Estimated Payments
Avoiding Penalties
Pay As You Go System
The federal income tax is a pay-as-you-go system.
As a taxpayer earns wages, the taxpayer pays federal income tax by having it withheld from his or her paycheck.
Estimated Payments Not Withholding
Taxpayers who receive income that is not subject to withholding or whose employers do not withhold a sufficient amount may be required to make estimated payments.
-If a taxpayer is required to estimate, the payments will be due quarterly on April 15, June 15, September 15, and January 15 of the following year.
-If the due date of the estimated tax payment falls on a Saturday, Sunday, or legal holiday, it will be considered on time if it is paid on the next business day.
Avoid Penalties
In order to avoid penalties, taxpayers must pay estimated tax for 2023 if both of the following apply.
-The taxpayer expects to owe at least $1,000 in tax for 2023, after subtracting withholding and credits.
-The taxpayer expects his withholding and credits to be less than the smaller of:
–90% of the tax to be shown on your 2023 tax return, or
–100% of the tax shown on your prior year’s tax return. Your prior year’s tax return must cover all 12 months.
Example
Paula, who files as head of household, has the following tax information:
-Expected AGI for 2023: $78,725
-AGI for 2022: $73,700
-Tax shown on 2022 return: $10,504.
-Tax expected to be shown on 2023 return: $11,501
-Tax expected to be withheld in 2023: $10,400
Paula is trying to determine whether she needs to make estimated payments for 2023. Paula expects to owe at least $1,000 for 2023 after subtracting her withholding from her expected tax ($11,501 - $10,400 - $1,101). Paula expects her income tax withholding ($10,400) to be at least 90% of the tax to be shown on her 2023 return ($11,501 × 90% = $10,351). Therefore, Paula does not need to pay estimated tax
Individual Income Taxes are Reported on Form
Individual Income Taxes are reported on Form 1040.
Front of Form 140
Back of Form 140
Gross Income
Definition of Gross Income
Sources of Income
Items Specifically Included in Gross Income
Definition of Gross Income
Under IRC Section 61, gross income is defined as “all income from whatever source derived.”
This broad definition of income includes accretions to wealth from money, property, or barter, UNLESS the IRC contains a specific provision excluding a particular item from income.
Gross income includes both earned and unearned income, regardless of whether or not it is taxable.
Sources of Income
Personal Services
Income from Property
Income from Partnerships, S corporations, trusts and estates
Income in community property states
Personal Services
When a taxpayer performs services for which he is compensated, the taxpayer has income as a result of those services.
Income from Property
Income from property (i.e., dividends or interest) must be included in the gross income of the owner of the property.
Income from Partnerships, S corporations, trusts and estates
Partnerships and S corporations are pass-through entities. Therefore, any income from a business whose legal form is a partnership or S corporation will be passed through to the owners of the business.
The income of a trust or estate is generally taxable to the beneficiary, unless the income is not distributed, in which case it will be taxable to the trust or estate.
Income in community property states
In community property states, one-half of the earnings of each spouse is considered owned by the other spouse.
In other words, one-half of the husband’s salary is considered to be owned by the wife. Similarly, one-half of the wife’s salary is considered to be owned by the husband.
Items Specifically Included in Gross Income
The Following Items are Specifically Included in Gross Income
Taxation of Annuity Payments
Distributions From Retirement Plans
Social Security Benefits
Below Market Loans
The Following Items are Specifically Included in Gross Income
Annuity payments,
Compensation for services (including certain fringe benefits),
Gross income derived from business,
Gains derived from dealings in property,
Interest & dividends,
Rents & royalties,
Alimony and separate maintenance payments for divorce decrees finalized by 12/31/18 (repealed for divorce decrees after 12/31/2018),
Income from life insurance and endowment contracts,
Pensions,
Discharge of indebtedness,
Distributive share of partnership gross income,
Income in respect of a decedent, and
Income from an interest in an estate or trust.
Taxation of Annuity Payments
An annuity is a contract under which the taxpayer makes a lump-sum payment or series of payments to the seller of the annuity. In return, the seller of the annuity agrees to make periodic payments to the taxpayer beginning immediately or at some future date.
An annuity is the systematic liquidation of principal and interest over a specified period of time. Each annuity payment includes:
-a return of capital (pro rata portion of premiums), which is received tax free, and
-Interest, which is taxable.
The Exclusion Ratio determines the portion of each payment excluded from taxation and is calculated at the starting date of the annuity.
Exclusion Ratio Formula
Exclution Ratio =
Investment in the contract
÷
Expected Total Return
Example
Distributions from Retirement Plans
Distributions from Qualified retirement plans
Distributions from Traditional IRA
Distributions from Qualified Retirement Plans
Distributions from qualified retirement plans are generally subject to ordinary income tax because the plans usually contain both contributions and earnings that have never been subjected to income tax.
-However, a participant will have an adjusted basis in distributions received from a qualified plan if either of the following have occurred
–The participant made after-tax contributions to a contributory qualified plan, or
–The participant was taxed on the premiums for life insurance held in the qualified plan.
-If the participant has an adjusted basis in the distributions, then at least part of the distribution will be a non-taxable return of capital.
-Amounts distributed as an annuity are taxable to the participant of a qualified plan in the year in which the annuity payments are received.
–Like any other annuity payment, each annuity payment is considered a partially tax-free return of adjusted basis and partially ordinary income using an inclusion/exclusion ratio.
–Once the participant has recovered the entire cost basis of the annuity, all future monthly payments will be fully taxed.
–Distributions that are not lump sum and are not part of an annuity are taxed pro rata to the account balance in comparison to the pre-taxed portion
Exclusion Ratio for Annuity Payments with Distributions from Qualified Retirement Plans Formula
Exclusion Ratio =
Cost Basis in the Annuity
÷
Total Expected Benefit
Exam Question
On April 30, Ava, age 60, received a distribution from her qualified plan of $150,000. She had an adjusted basis in the plan of $500,000 and the fair market value of the account as of April 30 was $625,000. Calculate the taxable amount of the distribution without regard to any applicable penalty.
a) Not taxable.
b) $30,000 taxable.
c) $120,000 taxable.
d) $150,000 taxable.
Answer: B
To calculate the amount of the distribution that is return of adjusted basis, the adjusted basis in the plan is divided by the fair market value of the plan as of the day of the distribution. This ratio is then multiplied times the gross distribution amount. As such, $120,000 ($500,000 - $625,000) x $150,000 of the $150,000 distribution is return of adjusted taxable basis. Accordingly, $30,000 ($150,000 - $120,000) will be subject to income tax.
Distributions from Traditional IRA’s
Distributions from Traditional IRAs are also generally taxed as ordinary income.
Like distributions from qualified plans, the exception is for distributions consisting of a combination of tax-deferred earnings and the return of adjusted basis that results from either nondeductible IRA contributions or rollovers of contributions from qualified plan balances that included after-tax contributions (such as thrift plans).
In such cases, each distribution will consist of a combination of return of Adjusted Basis (AB and ordinary income. The ratio of return of AB is equal to the ratio of the total AB of the account before the withdrawal to the fair market value of the total account balance.
-In addition, taxable distributions before the age of 59½ will generally be subject to a 10 percent early withdrawal penalty, subject to certain exceptions. See Retirement Planning and Employee Benefits Pre-Study Materials for more information on this topic.
Ratio of AB Formula
AB before Withdrawal
÷
FMV of account at withdrawal
Social Security Benefits
Up to 85% of an individual’s Social Security benefits may be taxable.
The taxability of an individual’s Social Security benefits is based on taxpayer’s Modified AGI (MAGI).
For purposes of Social Security, MAGI is equal to the taxpayer’s adjusted gross income (not including Social Security benefits) plus:
-tax-exempt interest;
-interest earned on savings bonds used for higher education;
-amounts excluded from the taxpayer’s income for employer-provided adoption assistance ()
-amounts deducted for interest paid for educational loans ()
-income earned in a foreign country, a US possession, or Puerto Rico, that is excluded from income.
-items marked with an () are the least likely to be tested on this list.
How to Calculate the Taxable Portion of the Social Security Benefit
To calculate the taxable portion of the Social Security benefits, MAGI plus one-half of the taxpayer’s Social Security benefits must be compared to the hurdle amounts, which are listed in the following chart.
If MAGI plus one-half of Social Security exceeds the first hurdle but not the second
If MAGI plus one-half of Social Security benefits exceeds the first hurdle but not the second, the taxable amount of Social Security benefits is the lesser of:
50% Social Security Benefits or
50% [MAGI + 0.50 (Social Security Benefits) -Hurdle 1].
Do not forget it is MINUS Hudle 1
Example
Sammy and Tammy are married and have interest income of $18,000 and Social Security benefits of $20,000. What amount of their Social Security benefits must be included in their taxable income?
Because MAGI and 50% Social Security benefits is below hurdle 1 they do not need to include any of their benefits ($18,000 + (50% × $20,000) = $28,000, which is less than $32,000.
This is Calculating to see if it exceeds 1st hurdle.
Exam Question
Uli and Violet are married and have $30,000 of income. In addition, they have Social Security benefits of $20,000. What amount of their Social Security benefits must be included in their taxable income?
a) $0
b) $4,000
c) $10,000
d) $20,000
Answer: B
Uli and Violet must include the lesser of
0.50 ($20.000) = $10,000, or
0.50 [$30,000 + 0.50 ($20,000) - $32,0001 = $4,000
Therefore, they would have $4,000 of Social Security benefits included in taxable income,
If MAGI plus one-half of Social Security exceeds the second hurdle
If MAGI plus one-half the Social Security benefits exceeds the second hurdle, the taxable amount of Social Security benefits is the lesser of:
85% Social Security Benefits, or
85% [MAGI + 0.50 (Social Security Benefits) - Hurdle 2], plus the lesser of:
-$6.000 for MFJ or $4,500 for all other taxpayers, or
-The taxable amount calculated under the 50% formula and only considering Hurdle 1.
Example
Wendy and Xavier, a married couple, have income of $60,000 and Social Security benefits of $20,000. What amount of their Social Security benefits must be included in their taxable income?
Wendy and Xavier must include the lesser of
.85 ($20,000) = $17,000, or
.885 ($60,000 + $10,000 - $44,000 = $22,100 plus the lesser of.
$6,000, or
50 ($60,000 + $10,000 - $32,000) = $19,000.
Therefore, Wendy and Xavier must include $17,000 of their Social Security benefits in their taxable income
Exam Question
Yanni and Zelda, a married couple, have income of $45,000 and Social Security benefits of $20,000. What amount of their Social Security benefits must be included in their taxable income?
a) $9.350
b) $11,500
c) $15,350
d) $17,000
Answer: C
Yanni and Zelda must include the lesser of:
85 (S20,000) = $17,000, or
85 ($45,000 + $10,000 - $44,000) = $9,350 plus
the lesser of:
$6,000,
or 50 ($45,000 + $10,000 - $32,000) = $11,500.
Therefore, Yanni and Zelda must include $15,350 ($9,350 + $6,000) of their Social Security benefits in their taxable income.
Below Market Loans
NEED MORE WORK ON THIS.
Below-market loan rules apply to term or demand loans that are gift loans, or tax avoidance loans. Below-market loans have special income tax treatment that requires the lender to impute the interest income that would have been earned had the lender made a bona fide interest-bearing market loan.
The interest, also known as phantom interest income, is included in income even though the lender did not actually receive any money.
The lender is also considered to have made a gift to the borrower in the amount of the imputed interest.
Whatever the amount the lender (donor) must impute as interest income for income tax purposes is also the amount of the gift from the donor (lender) to the donee borrower. Note that the amount of the gift may be eligible for the annual gift tax exclusion.
The following chart outlines the rules for imputing interest in below - market loans.
Example
Exam Question
Aidan loans $11,000 to his sister, Avril. Why would interest not be imputed on this loan?
a) Interest would not be imputed because the loan is less than the amount of the annual exclusion.
b) Interest would not be imputed because loans of $100,000 or less are exempt from both income tax and gift tax consequences.
c) Interest would not be imputed if Avril has unearned income of $500.
d) Interest would not be imputed if Avril’s earned income is less than $1,000
Answer: C
Answer A is incorrect because gift loans do not qualify for the annual exclusion. Answer B is incorrect; loans of less than $10,000 are exempt from both income tax and gift tax consequences. Answer D is incorrect because whether interest is imputed on this loan is based on Avril’s level of unearned income, not earned income.
The following chart exhibit is the graphical illustration of the tax consequences of a below-market rate loan
In addition to the basic below-market loan rules, certain types of below-market loans have additional tax consequences.
Below-market rate loans by a corporation to a shareholder in that corporation are treated as a dividend to shareholder. As the shareholder makes loan payments, the payments are treated by the corporation as interest income
Below-market rate loans from an employer to an employee are treated as paid compensation for the employee and are subject to employment taxes. As the employee makes loan payments, the employer must treat the payments as taxable interest income.
Exclusions! (IRC Section 101 - 150) Subheadings
Items Specifically Excluded In Income
Gifts and Inheritances
Life Insurance Proceeds
Scholarships
Gain on Sale of Personal Residence
Distributions from Roth IRAs and Roth 401(k)/403(b) Plans
Compensation for Injuries and Sickness
Employer-Sponsored Accident and Health Plans
Meals and Lodging
Other Employee Fringe Benefits
Foreign Earned Income
Interest on Certain State and Local Government Obligations
Discharge of Indebtedness
Items Speifically Excluded from Income
Gifts and Inheritances
Life Insurance Proceeds
Scholarships
Gain on Sale of Personal Residence (Up to Specific Limits)
Qualified Distributions from Roth Accounts
Compensation for Injuries and Sickness
Employer-Sponsored Accident and Health Plans
Child Support Payments Received
Gifts and Inheritances
IRC Section 102
A Note about Exclusion
Elements of a Gift
Gift Definition
Payment or GIft Determined by Motive
In General
Property Received by Gift or Bequest is Not Taxed
IRC Section 102
IRC Section 102 excludes from Gross Income amounts received by gift, bequest, devise, or inheritance.
A Note about Exclusions for Gifts and Inheritances
Note that this exclusion applies only to property, not income that is later generated on that property.
Elements of a Gift Are:
The donor must have the intent to make a voluntary transfer.
The donor must be competent to make the gift.
The donee must be capable of receiving the gift.
The donee must take delivery.
The donor must actually part with dominion and control over the gifted property.
Gift Definition
Gratuitous transfer of property.
Donor acted out of a “detached and disinterested generosity made out of affection, respect, admiration, charity, or like impulses.
Payment or Gift Determined by Motive
Whether something is a payment or a gift is determined by motive, or whether the transfer was made as the result of:
-detached and disinterested generosity, or
-from “constraining force of any moral or legal duty” or from the “incentive of anticipated benefit” of an economic nature.
In General
In general, amounts transferred by an employer to an employee will not be treated as gifts.
Property Received by Gift or Bequest is Not Taxed
Property received by gift or bequest is not taxed.
-A bequest of specific property or a sum of money is exempt from income tax even if it is paid out of income.
-Income earned on the property, however, is subject to tax. Similarly, a bequest of the income on property is subject to income taxation in the beneficiary’s hands.
-A gift or bequest of a specific amount paid in more than three installments is taxable to the extent it is actually paid from the income of the estate.
Life Insurance Proceeds
Life Insurance Proceeds paid on account of the death
When a Life Insurance Policy is Cashed
When a Life Insurance Policy is Transferred
Amounts Received as Part of a Viatical Settlement
Modified Endowment Contracts
Life Insurance Proceeds Paid on Account of Death
Life insurance proceeds paid on account of the death of the insured are not included in the gross income of the beneficiary.
-Note: That if the proceeds are received in installment payments, any interest component of the payments taxable to the beneficiary
When a Life Insurance Policy is Cashed
When a life insurance policy is cashed-in prior to the insured’s death, the owner of the policy must recognize any cash received in excess of what the owner paid in premiums.
-Losses are not deductible.
Formula?
The Following Table Summarizes the Maximum Deduction for Various Types of Property and Various Types of Charities
Example
Example
Note on QBI: QBI is not a business expense against revenue. It is a deduction on pass through income of the owners. It is taken at the individual level and is a below the line deduction.
AMT Formula Is?
Chart Summarizing Deductions That Are Lost Under the AMT
Rental Losses Are Subject to Passive Loss Rules
