Module 1: Income Tax Fundamentals and Calculations Flashcards
Types of Filing Status (5)
- Single
- Married Filing Jointly
- Married Filing Separately
- Head of Household
- Qualifying Widower with Dependent Child (also called surviving spouse)
Head of Household
Unmarried individuals who maintain a household for a qualifying child or relative under the tax law use this status and pay tax according to a schedule with rates somewhere between that of MFJ and Single. The taxpayer must put the dependents Social Security or taxpayer ID number on the return to use this status
Dependency Status (what must go on tax return)
The dependent’s social security number or taxpayer ID number must be on the return.
Dependency Status Qualifying
- Must be taxpayer’s: child, stepchild, foster child, brother, stepbrother, sister, stepsister, or a descendant of any previously listed and must have lived with the taxpayer for more than half of a year.
Dependency Status Age Test
- Under age 19 at the close of the tax year
- A full-time student and under age 24 at the close of tax year
- Totally and permanently disabled at any time during the tax year
Dependency Status Support Test (4 things)
- Individual must not have provided more than 50% of his own support (scholarships do not count)
- Individual cannot claim any other individual as dependent
- The individual may not file a joint return for the tax year (unless the only reason a return was filed was to obtain a refund of tax withheld)
- individual generally must also be a US citizens, national or a resident of the United States, Canada, or Mexico
Qualifying Relative
An individual who is not a qualifying child and bears a specific relationship to the taxpayer such as a parent, in-law, neice, nephew, aunt, uncle or is unrelated to the taxpayer but resided in the taxpayer’s principal home during the tax year. The taxpayer must have provided more than half of the person’s support for the tax year.
Overview of the Rules for Claiming a Dependent
- Cannot claim any dependents if you, or your spouse if filling jointy, could be claimed as a dependent by another taxpayer
- Cannot claim a married person who files a joint return as a dependent unless that return is filed only to claim a return of withheld income tax or estimated tax paid
- Cannot claim a person unless they are a US Citizen, Resident Alien, Nation, or a resident of Canada or Mexico
- Cannot claim a person as a dependent unless that person is your qualifying child or qualifying relative
Total Income
“All income from whatever source derived” unless specifically excluded. Items such as wages, commissions, tips, prizes and awards, unemployment compensation, honorariums, interest, dividends, sole properietorships income, rents, royalties, gambling income, jury duty fees received, and partnership income must all be recognized and included as total income for tax purposes.
Qualified Dividends (tax treatment and source?)
- Receive favorable income tax treatment, taxed at long-term capital gains rates.
- Eligible dividends from stock; interest earned from CDs, bonds and savings accounts are not eligible.
Alimony Received
Alimony payments arising as a result of divorce or separation decrees executed prior to 2019 are typically taxable to the recipient, as they are deductible by the payor.
- After 2019, the alimony payments are not includible as income, nor are they deductible by the payor.
Exclusions
- Do not have to be included as gross income.
- Examples: Life insurance proceeds received by reason of death of the insured, a gift or most inheritances received, interest received from muni bonds, and many employee fringe benefits like health insurance coverage, group term life insurance up to 50k, qualified employee discounts, and employee educational assistance.
Deductions and Adjustments
- Deductions are taken from AGI to determine taxable income. Can be standard or itemized.
- Adjustments reduce total income to arrive at AGI
- Both of them ultimately have the same effect of reducing taxes owed.
Gross Income
for federal income tax purposes, is defined as all income from whatever source derived. In addition, the financial planner must be aware that although some tax items are not taxable for regular income tax purposes, they may still be taxable for individual AMT purposes.
Deductions allowed in computing the total income on the 1040 (gross income minus this) - Capital Loss and other losses?
Net Capital Loss of up to 3000, allowable rental losses and losses from a sole properietorship
Inclusions
Items included in an individual’s gross income
“Other Income” (3)
gambling, winnings and hobby income
Self-Employment Income Rules for FICA Payroll Tax
- Individuals who are sole properietors or general partners, generate self-employment income. In turn, such individuals must pay both portions of the Federal Insurance Contributions Act (FICA) payroll tax, which is 15.3%.
FICA Tax Parts (referred to as the SE tax)
- Old Age, Survivors and Disability Insurance (OASDI) - also called social security insurance, which is a tax that is levied on earnings up to the taxable wage base of $142,800
- Medicare tax of 2.9% that is levied on all earnings with no income limit.
Additional Tax for Self Employed Individuals
.9% Medicare Tax if you have a combined income of greater than 200k or 250k MFJ
What income is the Additional Medicare Tax on?
- Levied on the net earnings from selfl-employment of the sole proprietor or partner and consists of:
- the gross income derived from any trade or business, less allowable deductions attributable to this trade of business (generally schedule C); or
- the taxpayer’s distributive share of the ordinary income or loss of a partnership (not an S corp) engaged in a trade or business (Schedule K-1)
FICA for Regular Wage Earners Deductibility
FICA is not deductible by the employee, but it is deductible by the employer
Where does a sole proprietor report net earnings from self-employment?
IRS Form 1040, Schedule C, so any income on Schedule C, you know that the individual reporting the income is self employed
Schedule F
Farming income and expenses, it is also considered self-employment income and is subject to self-employment taxes. So a seperate entry entitled “self-employment taxes” must be shown under the taxes section of cash outflows on the statement.
Self Employed “Investment Income”
If the SE invests some of the net income from the business in securities and receives dividends, that income is not reported on schedule C but is reported as though the taxpayer was not self-employed.
Self Employed “Partnership Income”
- is taxed to the general partner at his own individual rate. The partnership files an informational return FORM 1065 and provides each partner with a Schedule K-1 form indicating his share of the partnership income. The partner then reports this K-1 amount as income on Form 1040, Schedule E and pays self-employment tax on the same.
Shareholders of an S-Corp
Shareholder, rather than the corporation, pay taxes on an S corp’s income. Each shareholder is provided with a Schedule k-1 form indicating that shareholder’s share of the corporations income. It is not treated as self-employment income. These get passed on, after W-2 salary is paid, as dividends and capital gains.
Total Income vs. Gross Income
They are not the same, the biggest difference is that there are some subtractions allowed in computing total income on the tax return that are not deducted in computing gross income.
Total Income Adjustments for Schedule C
losses from certain unincorporated businesses (like sole proprietorships),
Adjusted Gross Income Deductions (business and individual)
- expenses related to carrying on a taxpayers business are a deduction in the calculation of AGI, however the deduction is not shown on the front page of 1040 like most other deductions, rather they are found on Schedule C.
- Most individual expenses that are deductible are only deductible as itemized and miscellaneous itemized deductions from AGI, subject to various limitations on some deductions.
Two cases in which the taxpayer may deduct some expenses from gross income in arriving at AGI (self-employed or passive income deductions)
- when the expenses are incurred in carrying on a trade or business (schedule C)
- When the expenses are incurred in connections with property held for the production of rents or royalties (schedule E)
Ordinary and Necessary expenses
To be deductible, expenses must be ordinary and necessary.
- an expense is ordinary if it is normal or customary.
- an expense is necessary when a prudent person would make the same expenditure in the same situation. The amount of the expenditure must also satisfy the reasonableness requirement for the expense to be deductible.
- ** IF the income generated is nontaxable, then the expenses incurred to generate that income are not deductible.
Accrual-basis vs. cash-basis timing
Cash Basis - a deduction is generally allowed for the tax year in which the expense is incurred.
Accrual basis - taxpayer receives a deduction when the expense is incurred.
Are capital gains considered taxable income?
Yes
Capital loss vs. Capital Gain Rules
Capital losses may be used to offset capital gains without limit, however if these losses exceed the gains, they may offset ordinary income only up to 3k per year, the excess loss may be carried forward to future years.
Maximum Net Capital Gains Rate on Collectibles
28% if they’re held for more than one year
Section 1250 Property Sale
the portion of the capital gain attributable to depreciation is subject to a maximum 25% tax rate, called the “unrecaputred Section 1250 income”.
3.8% Medicare Surcharge
This 3.8% is deemed the Net Investment Income (NII) tax, which will be discussed later in this course.
Provisional Income
MAGI + muni bond interest + 1/2 of the S.S
Imputed Interest Rules
In instances when a lender has engaged in a below-market-interest rate loan transaction, the lender may be required to impute (report) interest income even without receiving this interest. The borrower may receive an interest expense deduction.
Applicable Federal Rate
The rate that is used to judge if a lender has engaged in a below-market-interest rate loan transaction. It is the governments borrowing rate, compounded semiannually and adjusted monthly.
Types of “Below Market Loans”
- Gift loan
- Compensation-related loans
- Tax Avoidance Loans
Gift Loan
- can only occur between individuals, the lender has interest income, and the borrower has interest expense to the extent of the imputed interest.
- in addition, a gift has been made to the borrower (subject to federal gift tax) in the amount of imputed interest.
Gift Loan Exceptions
- No interest is imputed on total outstanding gift loans in the aggregate of $10k or less between individuals unless the proceeds of the loan are used to purchase income-producing property.
- For loans between individuals in an amount greater than $10,000 and less than or equal to $100,000, the imputed interest cannot exceed the borrower’s NII for the year
- If the borrowers NII for the year does not exceed $1,000, no interest is imputed on loans of $100k or less.
Compensation-related loans
- The employer makes a below-market loan to an employee. As a result, the lender-employer has interest income and compensation expense for the amount of the imputed interest.
- Like gift loans, there is also an exception for compensation related loans that are less than or equal to $10,000.
Tax Avoidance Loans
- these are below-market loans that significantly affect the borrower’s or lender’s federal income tax liability and are made primarily for the purpose of tax avoidance.
