Unit 2 - Income and Assets Flashcards
Gross Income
Includes all forms of taxable compensation such as wages, salaries, commissions, tips, and self-employment income.
Non-monetary forms of compensation include goods, property, services, and taxable fringe benefits (interest, dividends, capital gains, and stock options)
Adjusted Gross Income (AGI)
Calculated by subtracting from gross income certain specific deductions or adjustments.
I.e. IRA contributions, certain expenses for self-employed individuals, deductible student loan interest and penalties paid to banks on early withdrawals of savings
** Helps determine eligibility for certain deductions and credits
Taxable Income
Calculated by subtracting additional deductions (standardized or itemized) from the AGI
How to Calculate Taxable Income and Tax Liability for Most Individuals
Earned Income
Received for services performed, such as wages, salaries, tips, professional fees, or self-employment income
Subject to Social Security and Medicare taxes (also called FICA taxes)
Unearned Income
Interest, dividends, retirement income, taxable alimony, and disability benefits
Investment income and other unearned income are generally not subject to FICA taxes
Constructive Receipt of Income
Requires that cash-basis taxpayers be taxed on income when it becomes available and is not subject to substantial limitations or restrictions, regardless of whether it is in their physical possession
If there are significant restrictions on the income, or if the income is not accessible to the taxpayer, it is not considered to have been constructively received.
Income is also not considered to have been “constructively received” if a taxpayer declines to accept an item, such as a prize or award, or if the prize is not received by the taxpayer
The “Claim of Right” Doctrine
If a taxpayer is required to pay back an amount over $3,000, which they included in income in a previous year, the taxpayer may claim a tax credit on schedule 3 (Form 1040) in the repayment year equal to the tax change caused by the income inclusion in the prior year if it results in less tax
If the repayment is $3,000 or less, repayment is generally deducted on the same form or schedule on which it was previously included. However, if the income was previously reported as wages, taxable unemployment compensation, or other nonbusiness ordinary income, and the repayment is less than $3,000, the repayment cannot be deducted.
**A taxpayer should not amend their reported gross income for the earlier year
Self-Employed Taxpayers
A taxpayer who has self-employment income of $400 or more in a year must file a tax return and report the earnings to the IRS.
Independent contractors usually receive Form 1099-NEC from their business customers showing the income they were paid for the year (if $600+)
Self-employed farmers report their earnings on schedule F
Self- Employment Income Includes…
- Income of ministers, priests, and rabbis for the performance of services such as baptisms and marriages
- The distributive share of trade or business income allocated by a partnership to its general partners or by an LLC to its members. The income is reported to the individual partners on schedule K-1
FICA Tax (Payroll Taxes)
The Federal Insurance Contributions Act (FICA) tax includes 2 separate taxes:
- Social Security Tax (currently 6.2% each for employee and employer)
- Medicare Tax (currently 1.45% each for employee and employer)
Applies up to $160,200 of a taxpayer’s combined earned income, including wages, tips, and 92.35% of net earnings from self-employment
If the taxpayer’s combined earned income exceeds $160,200 in 2023, a rate of 2.9%, representing only the
Medicare portion, applies to any excess earnings over the earned income threshold.
For certain high-income individuals, an additional Medicare surtax of 0.9% is applied to wages and self-employment income above certain thresholds.
Self-Employment Tax
Self-employed individuals are
responsible for paying the entire amount of Social Security and Medicare taxes applicable to their net
earnings from self-employment.
Tax.
If a taxpayer has wages in addition to self-employment earnings, the Social Security tax on the wages is paid first.
Self-Employment Tax Adjustments
There are two adjustments related to the self-employment tax that reduce overall taxes for a taxpayer with self-employment income
- The taxpayer’s net earnings from self-employment are reduced by 7.65%. Just as the employer’s share of Social Security tax is not considered wages to the employee, this reduction
removes a corresponding amount from the net earnings before the SE tax is calculated. - The taxpayer can deduct the employer-equivalent portion of his self-employment tax in determining his adjusted gross income
More than One Business
If a taxpayer owns more than one business, he must net the profit or
loss from each business to determine the total earnings subject to SE tax. However, married taxpayers cannot combine their income or loss from self-employment to determine their individual earnings subject to SE tax.
Employee Compensation
Wages, salaries, bonuses, tips, and commissions are compensation received by employees for services performed. Employee compensation is taxable income to the employee and a deductible expense for the employer.
Worker Classification
For federal tax purposes, the IRS classifies “workers” in two broad
categories: employees and independent contractors
These workers are taxed in different ways, and businesses must identify the correct classification for each individual to whom it makes payments for services.
Worker Classification - Employees
In general, a business must withhold and remit income taxes, Social Security and Medicare taxes (payroll taxes), and pay unemployment tax on salaries and wages paid to an employee. Employers are required by January 31 to issue Forms W-2, which shows the amounts of wages paid to employees for
the previous year.
Worker Classification - Independent Contractors
A business generally does not have to withhold or pay taxes on payments to
independent contractors, because the earnings of a person working as an independent contractor are subject to self-employment tax. The general rule is that an individual is an independent contractor if the payor has the right to control or direct only the result of the work, not what will be done and how
it will be done.
If a worker receives a Form 1099-NEC, but believes that they are an employee and should have received a Form W-2 instead, they can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding with the IRS, and if a determination is made that they are an employee, they will file Form 8919, Uncollected Social Security and Medicare Tax on
Wages, with their tax return.
Wages from Form 8919 also are reported on the Form 1040 on line 1g.
Advance Wages
If an employee receives advance wages, commissions, or other earnings, the employee must recognize the income in the year it is actually or constructively received. If the employee is later required to pay back a portion of the earnings, the amount would be deducted from
their taxable wages at that time.
Supplemental Wages
Supplemental wages are compensation paid to an employee in addition to his regular pay.
May include:
- Vacation pay
- Sick pay
- Bonuses, commissions, prizes
- Severance pay, back pay, and holiday pay
- Payment for nondeductible moving expenses
Garnished Wages
An employee may have their wages garnished for various reasons, such as when the employee owes child support, back taxes, or other debts.
State and federal law require employers to comply with various income-withholding orders for child support and other court-mandated obligations.
Regardless of the amounts garnished from the employee’s paycheck, the full amount of gross wages must be included in his taxable wages at year-end.
Property or Services “in Lieu” of Wages
Wages paid in any form other than cash are measured by their fair market value.
Wages paid in any form other than cash are measured by their fair market value. An employee who receives property for services performed must generally recognize the fair market value of the property when it is received as taxable income. However, if an employee receives stock or other
property that is restricted, the property is not included in income until it is available to the employee
without restriction.
Another common arrangement is when colleges offer tuition reduction and/or free on-campus housing in lieu of wages to student teachers. Any portion of a grant or scholarship that is compensation for services is taxable as wages.
Tip Income
An individual who receives $20 or more per month in tips must report the tip income to their employer.
An employee who receives less than $20 per month in tips while working
one job does not have to report the tip income to his employer. Tips of less than $20 per month are exempt from Social Security and Medicare taxes, but are still subject to federal income tax.
In situations where an employee works more than one job, the $20 tip reporting threshold applies on a per job basis, and not on an overall basis for the employee. An employee who does not report all their tips to their employer generally must report the tips and related Social Security and Medicare taxes on Form 1040. Form 4137, Social Security and Medicare Tax on Unreported Tip Income, is used to
compute the additional tax.
Taxpayers who are self-employed and receive tips must include their tip income in gross receipts on Schedule C.
Non-cash tips (for example, concert tickets, or other items) do not have to be reported to the employer, but they must be reported and included in the taxpayer’s gross income at their fair market value.
Taxable Fringe Benefits for Employees
The IRS considers fringe benefits to be
any additional cash, property, or service given to employees on top of their regular taxable wages. Employers often offer fringe benefits as part of a compensation package, with common examples being health insurance, retirement plans, and parking passes.
While most fringe benefits are not subject to taxes, there are some exceptions. Some taxable fringe benefits include:
* Off-site athletic facilities and health club memberships,
* Concert and athletic event tickets,
* The value of employer-provided life insurance over $50,000,
* Any cash benefit in the form of a credit card or gift card (an exception applies for occasional
meal money or transportation fare to allow an employee to work beyond normal hours),
* Transportation benefits exceeding the monthly maximum ($300 per month in 2023),
* Employer-provided vehicles, if they are used for personal purposes. There is an exception for
qualified nonpersonal use vehicles (i.e., police cars, school buses, transit buses, etc.).
Nontaxable Fringe Benefits for Employees - Retirement Plans
Employer contributions on behalf of their employees’ qualified retirement plans are not taxable to the employees when they are made. However, when an employee receives distributions from a retirement plan, the amounts received are taxable income.
Retirement plans may also allow employees to contribute part of their pre-tax compensation to the plan. This type of contribution is called an elective deferral and is excluded from taxable compensation for income tax purposes but is subject to Social Security and Medicare taxes.
Nontaxable Fringe Benefits for Employees - Cafeteria Plans
A cafeteria plan allows employees to receive certain benefits before taxes are taken out. Employees must be given the option to choose at least one taxable benefit (like cash) and one qualified benefit (nontaxable). Some examples of qualified benefits that can be offered in a cafeteria plan include
accident, dental, vision, and medical insurance (excluding Archer medical savings accounts and long-term care insurance), flexible spending accounts for health and dependent care, as well as adoption assistance and dependent care assistance.
Employee contributions are typically deducted through salary reduction agreements, meaning the money is taken directly from their paychecks and deposited into an account. These contributions do not count as taxable income and are not subject to employment taxes. Employers may also extend these benefits to employees’ spouses and dependents.
Nontaxable Fringe Benefits for Employees - FSA
An FSA is a form of cafeteria plan benefit that reimburses employees for expenses incurred for certain qualified benefits, such as health care and daycare expenses.
In 2023, employee salary reduction contributions to a Healthcare FSA are capped at $3,050. Both employer and employee may contribute to an employee’s Healthcare FSA, but contributions from all sources combined must not exceed the annual maximum
FSA benefits are subject to annual maximums and are typically subject
to an annual “use-it-or-lose-it” rule, with a short (two-and-a-half-months) grace period after year-end to claim subsequent year qualifying expenses against the prior plan year remaining balance.
Typically, Healthcare FSA funds that are not spent by the employee within the plan year are forfeited back to the employer. Cafeteria plans may offer employees a two-and-a-half-month grace period after the end of the year to spend down any remaining FSA funds. Employee plans can also offer
a carryover option, with the maximum amount that can be carried forward into the following year (if allowed by the employer) being 20% of the maximum available salary reduction for the year
Dependent Care FSA
Also known as a Dependent Care
Assistance Plan
Used to pay for dependent care
For unmarried taxpayers and married
couples filing jointly, the annual limit is $5,000. For married couples filing separately, the limit is $2,500.
The funds in a DCFSA can be used to pay for eligible daycare services, before or after school programs, and adult daycare for disabled dependents.
Adoption Assistance in a Cafeteria Plan
Although uncommon, adoption assistance benefits may be offered under a cafeteria plan and paid for entirely with pre-tax salary reductions. An employee can exclude amounts paid or reimbursed by an employer under a qualified adoption assistance program (up to a maximum of $15,930 for 2023).
Highly Compensated Employees (HCEs)
A cafeteria plan cannot have rules that favor eligibility for highly compensated employees to participate, contribute, or benefit from a cafeteria plan. If a benefit plan favors HCEs, the value of their benefits may become taxable. This is to discourage companies from offering excellent tax-free benefits to their top executives while ignoring the needs of lower-paid employees.
A “highly compensated
employee” is for 2023 is defined as:
* A company officer (i.e., company president, vice-president, treasurer).
* A 5% (or greater) shareholder in the current or prior year;
* An employee paid $150,000 or more for 2023,
* A spouse or close family member of one of the persons described above, regardless of salary level.
The IRS uses a process called “family attribution” in order to make the determination of who qualifies as an HCE, which means that an employee can be determined to be an HCE merely by familial relationship. An individual is attributed to interests owned by their spouse, siblings, and ancestors.
Employees that are hired in the middle of the year will not receive HCE status until the start of the following year, when they are eligible to collect the entirety of their salary.
A plan is considered to have improperly “favored” HCEs and key employees if more than 25% of all
the benefits are given to those employees. If a cafeteria plan or a retirement plan fails to pass IRS non-
discrimination testing, highly compensated employees and key employees may lose the tax benefits of
participating in the plan.
Key Employees
Employer-provided benefits also cannot favor “key employees.
“Key employees” are any of the following:
* A company officer having annual pay of more than $215,000 in 2023 (in this case, the officer
does not have to be an owner of the company).
* An employee who is either of the following:
o A 5% owner of the business, or;
o A 1% owner of the business whose annual pay is more than $150,000 in 2023.
Although the compensation threshold is lower for HCEs than Key Employees, an employee can be classified as a key employee without having any ownership in the company.
A plan is considered to have improperly “favored” HCEs and key employees if more than 25% of all
the benefits are given to those employees. If a cafeteria plan or a retirement plan fails to pass IRS non-
discrimination testing, highly compensated employees and key employees may lose the tax benefits of
participating in the plan. If this happens, then the plans can lose their tax-favored status, and the HCEs
or key employees must include the value of these benefits as taxable compensation. These types of
“corrections” often take the form of taxable distributions to plan participants.
Employee Fringe Benefits - Educational Assistance
An employer can offer employees educational assistance for the cost of
tuition, fees, books, supplies, and equipment. The payments may be for either undergraduate or graduate-level courses, and do not have to be work-related.
An employer may contribute up to $5,250 annually toward educational expenses, student loans, or a
combination of both. If an employer pays more than $5,250, the excess is generally taxed as wages to the employee.
The cost of courses involving sports, games, or hobbies is not covered unless they are related to the business or are required as part of a degree program. The cost of lodging, meals,
and transportation is also not included.
Employee Fringe Benefits - Tuition Reduction Benefits
A college or other educational institution can exclude the value of a
qualified undergraduate tuition reduction to an employee, his spouse, or a dependent child. A tuition reduction is “qualified” only if the taxpayer receives it from, and uses it at, an eligible educational institution. Graduate education only qualifies if it is for the education of a graduate student who performs teaching or research activities for the educational organization.
Employee Fringe Benefits - Employee-Provided Meals and Lodging
An employer may exclude the value of meals and lodging provided to employees if they are provided:
* On the employer’s business premises, and
* For the employer’s convenience.
Employee Fringe Benefits - Employee-Provided Lodging
For lodging, there is an additional rule: it must be required as a condition of employment. Lodging can be provided for the taxpayer, the taxpayer’s spouse, and the taxpayer’s dependents and still not be taxable to the employee. However, the exclusion from taxation does not apply if the employee can choose to receive additional pay instead of lodging.
Employee Fringe Benefits - Employee-Provided Meals
Meals may be provided to employees for the convenience of the employer on the employer’s business premises for several reasons, such as when:
* Police officers and firefighters need to be on call for emergencies during the meal period.
* The nature of the business requires short meal periods.
* Eating facilities are not available in areas near the workplace, such as in the case of remote or dangerous locations.
* Meals are furnished immediately after working hours because the employee’s duties prevented him from obtaining a meal during working hours.
Meals furnished to restaurant employees before, during, or after work hours are also considered
furnished for the employer’s convenience and are not taxable to the employee.
Transportation Fringe Benefits
Employers have the option to provide transportation benefits to their employees, such as transit passes, paid parking, or commuter passes (bus passes). These benefits are non-taxable for employees up to a certain amount.
Under the Tax Cuts and Jobs Act (TCJA), employers can no longer deduct these expenses. This does not affect the tax-exempt status of transportation benefits for employees.
Any expenses exceeding $300 per month in 2023 for transit and parking benefits will be added to the
employee’s taxable income as wages.
The use of a company car for commuting purposes or other personal use is generally a taxable
benefit. Thus, the value of using the vehicle for these reasons will be included in their taxable wages.
Transportation Fringe Benefits - EXCEPTION
There is an exception in IRS regulations that exempts the personal use of certain types of vehicles.
Qualified “nonpersonal use” vehicles, such as police or fire vehicles, school buses, and ambulances, are exempt from fringe benefit reporting, even if the vehicles are used for commuting purposes, as long as the employer requires their use for the employees to do their jobs.
Transportation Fringe Benefits - Cell Phones
Employer-provided cell phones can be excluded from an employee’s income.
The employer must have valid business-related reasons for providing the phone, such as the need to
contact the employee during work emergencies or to communicate with clients while away from the office.
Transportation Fringe Benefits - Group-Term Life Insurance Coverage
Up to $50,000 of life insurance coverage may be provided
as a nontaxable benefit to an employee.
The cost of insurance coverage on policies that exceed $50,000 is a taxable benefit. If an employer provides more than $50,000 of coverage, the amount included in
the taxpayer’s income is reported as part of their taxable wages on their Form W-2.
Transportation Fringe Benefits - Work-Related Moving Expense Reimbursements
Moving expenses are no longer deductible for most taxpayers, except for certain members of the armed forces. Therefore, moving expenses that are reimbursed or paid by an employer must be included in the employee’s taxable income as wages.
Transportation Fringe Benefits - No-Additional-Cost Services
Nontaxable fringe benefits also include services provided to employees that do not impose any substantial additional cost to the employer because the employer already offers those services in the ordinary course of doing business. Employees do not need to include these no-additional-cost services in their income. Typically, no-additional-cost services are excess capacity services, such as unused airline seat tickets for airline employees or open hotel rooms for hotel employees.
If an employee is provided with free or low-cost use of a health club on the employer’s premises, the value is not included in the employee’s compensation. The gym must be used primarily by employees, their spouses, and their dependent children. However, if the employer pays for a fitness program or use of a facility at an off-site location, the value of the program is included in the employee’s
compensation.
Transportation Fringe Benefits - Employee Achievement Awards
Employers may generally exclude from an employee’s taxable wages the value of awards given for length-of-service or safety achievement. The tax-free amount is limited to the following:
- $400 for awards that are not qualified plan awards.
- $1,600 for qualified plan awards. A qualified plan award is one that does not discriminate in favor of highly compensated employees, and that is established under a written plan.
- The exclusion for employee awards does not apply to awards of cash, gift cards, lodging, stocks, bonds, or tickets to sporting events.
Transportation Fringe Benefits - De Minimis (Minimal) Benefits
This is a property or service an employer provides that has so
little value that accounting for it would be impractical. Examples of de minimis benefits include the following:
- Occasional personal use of a company copying machine.
- Holiday gifts with a low fair market value (such as a holiday turkey or a gift basket)
- Flowers, fruit, books or similar property provided to employees under special circumstances, such as an employee’s birthday
- Beverages and snacks, such as coffee or doughnuts for employees
- Cash is not excludable as de minimis benefits unless they are for occasional meal money or transportation fare, and they are not given out on the basis of hours worked (for example, $1.50
per hour for each hour over 8 hours). In order to be non-taxable, the benefit must also be provided so that an employee can work an unusual, extended schedule.
Transportation Fringe Benefits - Employee Discounts
Employers may exclude the value of employee discounts from wages up to
the following limits:
- For services, a 20% discount of the price charged to nonemployee customers.
- For merchandise, the company’s gross profit percentage multiplied by the price nonemployee customers pay.
Accountable Plan Reimbursement of Employee-Business Expenses
When a company reimburses its workers for specific business-related costs, such as work travel and meals, the reimbursements are not considered taxable income if the employees meet all of the following requirements under an accountable plan:
- Have incurred the expenses while performing their duties as employees.
- Provide proper documentation for travel, meals, and lodging expenses.
- Supply evidence of their employee business expenditures, such as receipts or records.
- Return any surplus reimbursements within a reasonable timeframe.
Under an accountable plan, a company may give cash advances to employees. These advances must reasonably align with anticipated expenses and must be given within a reasonable timeframe. If any expenses reimbursed through this arrangement cannot be substantiated, they will be considered taxable income for the employee.
Accountable Plan Reimbursement of Employee-Business Expenses - Travel
Qualifying expenses for travel are excludable from an employee’s income if they are incurred for temporary travel on business away from the area of the employee’s tax home. Travel expenses paid in connection with an indefinite work assignment cannot be excluded from income. Any work assignment more than one year is considered “indefinite.”
Reimbursement for travel expenses may cover: expenses incurred while traveling to and from the designated business location (such as airfare and
mileage reimbursements), transportation costs during the trip (such as taxi fares), hotels, meals, and
other related costs, and dry cleaning, laundry, and any other miscellaneous expenses during the period spent away from home on assignment.
Taxation of Clergy Members
A clergy member’s salary is reported on Form W-2 and is taxable. For services in the exercise of the ministry, members of the clergy receive a Form W-2 but do not have social security or Medicare taxes withheld.
Offerings and fees received for performing marriages, baptisms, and funerals must be reported as self-
employment income on Schedule C.
Taxation of Clergy Members - Exemption from SE tax
A clergy member may apply for an exemption from self-employment tax if he is conscientiously opposed to public insurance because of religious principles. For a clergy member or a minister to claim an exemption from SE tax, the minister must file IRS Form 4029, Application for Exemption from Social Security and Medicare Taxes and Waiver of Benefits. Generally, this exemption is irrevocable.
The sect or religious order must also complete part of the form. The exemption does not apply to
federal income tax, only to self-employment tax. If the exemption is granted, the clergy member will
not pay Social Security or Medicare taxes on his earnings, and he will not receive credit toward those benefits in retirement. If a clergy member is a member of a religious order that has taken a vow of poverty, he is exempt from paying SE tax on his earnings for qualified services. The earnings are tax-free because they are considered the income of the religious order, rather than of the individual clergy
member
Taxation of Clergy Members - Housing Allowance for Clergy
A clergy member who receives a housing allowance may exclude
the allowance from gross income to the extent it is used to pay the expenses of providing a home. Only
taxpayers who are serving as clergy (ministers, priests, etc.) are eligible for a housing allowance. The exclusion is limited to the lesser of the following amounts:
- The amount officially designated as a housing allowance.
- The amount actually used to provide or rent a home.
- The fair market rental value of the home (including utilities, property taxes, insurance, etc.)
The housing allowance cannot exceed reasonable pay and must be used for housing in the year it
is received. Salary, other fees, and housing allowances must be included in income for purposes of
determining self-employment tax.
Combat Pay
Typically, military personnel’s regular wages are subject to taxes. However, there are specific exceptions and rules for military personnel regarding income that is taxable. For instance, combat zone wages or “combat pay” is not considered taxable income. Hazardous duty pay is also excludable for military personnel. Enlisted personnel who serve in a combat zone for any part of a month may exclude
their pay from tax. For officers, the pay is excluded up to a certain amount, depending on the branch of service.
Veterans Benefits
Similarly, veterans’ benefits paid by the Department of Veterans Affairs to a veteran or his family are not taxable if they are for education (the GI Bill), training, disability compensation, work therapy, dependent care assistance, or other benefits or pension payments given to the veteran because of disability.
Medicare Waiver Payments
“Difficulty-of-care” payments, also known as Medicare waiver payments, can be excluded from a taxpayer’s gross income. These payments are nontaxable to the caregiver if they are for in-home-care services provided to a disabled individual who resides in the same home. The exemption applies
to anyone providing care in their own home, regardless of who owns the home. It is also not necessary
for the caregiver to be related to the disabled individual, although this is often the case.
Qualified Medicare waiver payments may be excluded from income only when the care provider and the care recipient reside in the same home. When the care provider and the care recipient do not live together in the same home, the Medicare waiver payments may not be excluded from gross income.
Taxpayers who receive these payments may choose to include them in their income for purposes of the earned income credit (EITC) or the additional child tax credit (ACTC). In addition, under the SECURE Act, taxpayers can use this income to fund an IRA, but since the contributions come from
amounts excluded from tax, they are treated as nondeductible contributions.
Disability Payments
There are several types of disability payments, and the taxability of the income depends on several
factors. Some types of disability-related payments are given to workers that are not taxable at all.
Worker’s compensation is one such example. Worker’s compensation should not be confused with disability insurance, sick pay, or unemployment compensation; it is a type of benefit that only pays workers who are injured on the job.
Worker’s Compensation
Worker’s compensation is a type of mandatory business insurance, meaning most large and mid-
sized employers are required to have coverage for their employees. Worker’s compensation coverage can include wage replacement as well as rehabilitation services that help injured employees return to work when they are medically able to do so. Worker’s compensation is always exempt from tax.
Disability Retirement Benefits
Disability retirement benefits are unique. These benefits are taxable as wages if a taxpayer retired
on disability before reaching the minimum retirement age. The benefit is usually based on the employee’s final average earnings and their years of actual service. Once the taxpayer reaches retirement age (usually, this is age 62), the payments are no longer taxable as wages, they are taxable
as pension income.
This type of disability retirement benefit is offered to most Federal government workers and U.S.
Postal Service employees and is often called “FERS disability” because the disability retirement benefits are offered under the Federal Employees Retirement System (FERS).74 To apply for this benefit, the employee’s disability generally must have caused them to discontinue working.
Disability Insurance Benefits
A taxpayer may receive long-term disability insurance payments because of an insurance policy.
Generally, long-term disability payments from an insurance policy are excluded from income if the taxpayer pays the premiums for the policy. If an employer pays the insurance premiums, the employee must report the payments as taxable income.
If both an employee and the employer have paid premiums for a disability policy, only the
employer’s portion of the disability payments would be reported as taxable income.
Veterans Disability Benefits
Veterans’ disability benefits (also called VA Disability Compensation) are a type of disability benefit paid specifically to a veteran for disabilities that are service-connected, which means the injury or
disease is linked to their military service.
Veterans’ disability benefits are exempt from taxation if the veteran was terminated through separation or discharged under honorable conditions. The VA typically does not issue Form W-2, Form 1099-R, or any other tax-related document for veterans’ disability benefits.
Life Insurance Payments
Life insurance payouts generally are not taxable to a beneficiary if the payment was the result of
the death of the insured. This is true even if the proceeds were paid under an accident or health insurance policy. However, interest income received on life insurance proceeds is usually taxable.
Further, if a taxpayer surrenders a life insurance policy for cash, they must generally include in income
any proceeds that are more than the cost of the policy. However, an exception exists for when a terminally ill person receives a viatical settlement. In this case, the funds are tax-free. Sometimes, a taxpayer will choose to receive life insurance proceeds in installments rather than as a lump sum. In this case, part of the installment generally includes interest income.
If a taxpayer receives life insurance proceeds in installments (also called a life insurance annuity), they can exclude part of each installment from his income. To determine the excluded part, the amount held by the insurance company (generally the total lump sum payable at the death of the insured
person) is divided by the number of installments to be paid. The taxpayer would include any amount over this excluded portion as taxable interest income.
Real Property
Real estate, which includes land and anything permanently attached to it.
i.e. Buildings, farmland, residential homes, commercial properties,
rental properties, and subsurface mineral rights.
Gift for Opening a Bank Account
If the deposit is less than $5,000, any gifts or services valued at more than $10 must be reported. For deposits of $5,000 or more, gifts or services valued over $20 must be reported as interest. The financial institution determines the value of the gift based on its cost.
Rewards earned from credit and debit card purchases are typically not deemed as taxable income
Interest Earned on a Certificate of Deposit
Generally taxable when the taxpayer receives it or is entitled to receive it without incurring a penalty
The interest a taxpayer pays on funds borrowed from a financial institution to meet the minimum deposit required for a CD, and the interest a taxpayer earns on the CD are two separate items.
The taxpayer must include the total interest earned on the CD
in income. If the taxpayer chooses to itemize deductions, they can deduct the interest paid as investment interest, as long as it does not exceed their net investment income, by using “Form 4952,
Investment Interest Expense Deduction”
Tax-Exempt Interest
Interest earned on debt obligations of state and local governments (aka muni bonds or municipal bonds) is generally exempt from federal income tax but may be subject to income taxes by state and local governments.
Even if the interest on an obligation is nontaxable, the taxpayer may need to report a capital gain or loss when the investment is sold. The taxpayer’s Form(s) 1099-INT may include both taxable and tax-exempt interest. Tax-exempt interest must be reported on Form 1040, even though it is not taxable.
If a taxpayer borrows money to buy investments that generate tax-free income, the interest is not deductible as investment interest.
Interest on U.S. Treasury Bills, Notes, and Bonds
Interest on U.S. obligations, such as U.S. Treasury bills, notes, or bonds issued by any agency of the United States, is normally taxable for federal income tax purposes and exempt from state and local
income taxes
Individual taxpayers can generally report interest income
from a Series EE or Series I savings bond either:
* When the bond matures or is redeemed (whichever occurs first), or
* Each year as the bond’s redemption value increases (if the taxpayer makes an election).
However, taxpayers must use the same reporting method for all the Series EE and Series I bonds they own. When taxpayers redeem savings bonds, they should receive a Form 1099-INT from a bank
or another payor.
Series EE bond
Issued at a discount, and the difference between the purchase
price and the amount received when the bonds are later redeemed (or “cashed in”) is interest income.
Series I bonds
Issued at face value with a maturity period of thirty years. The face value and accrued interest are payable at maturity.
The Education Savings Bond Program
The program permits qualified taxpayers to exempt the interest earned upon redemption of eligible savings bonds, if they
are used to pay higher education expenses in the same year.
Series EE and I savings bonds are also called “educational savings bonds.”
The educational expenses must be for the taxpayer, a spouse, or dependents.
Interest earned on these bonds is usually exempt from state taxes as well.
The taxpayer must use both the principal and interest to pay for qualified education expenses. If the amount of savings bonds cashed during the year exceeds the amount of qualified educational expenses paid during the year, the amount of excludable interest is reduced.
In general, only tuition and fees are considered qualified expenses for the purposes of the savings bond exclusion. The costs of room and board, as well as required textbooks, are not eligible expenses.
However, the cost of required textbooks is a qualified educational expense for the purposes of the Lifetime Learning Credit and the American Opportunity Credit.
The amount of qualified expenses must be further reduced by the amount of any scholarships, fellowships, employer-provided educational assistance, and other forms of tuition reduction.
The Education Savings Bond Program Requirements
To exclude interest earnings on Series EE and Series I bonds:
- A taxpayer must be at least twenty-four years old before the bond’s issue date.
- The bonds must be purchased by the owner. They cannot be a gift, although the bond proceeds can be used to pay the tuition expenses of a dependent child.
- Qualified higher-education expenses must be reduced by scholarships and other tax-free benefits received and by expenses used to claim the American Opportunity and Lifetime Learning credits.
- The total interest received may be excluded only if the combined amounts of the principal and the interest received do not exceed the taxpayer’s qualified higher education expenses.
** Married taxpayers who file separately (MFS) do not qualify for the education savings bond interest exclusion. If a taxpayer cashes an education savings bond during the year and then files MFS, all the
interest would be taxable, regardless of whether the taxpayer had qualifying education expenses.
Dividend Income
if a taxpayer’s total dividend income is more than $1,500, it must
be reported on Schedule B, Interest and Ordinary Dividends.
Otherwise, the dividend income can be reported directly on Form 1040.
In 2023, the top rate on long-term capital gains and qualified
dividends is 20%. However, many higher-income taxpayers may also be subject to the Net Investment Income Tax (NIIT) on long-term capital gains and qualified dividends
Dividend
A dividend is a distribution of cash, stock, or other property from a corporation or a mutual fund.
Most large corporations pay dividends in cash. The payor will generally use Form 1099-DIV to report dividend income to its shareholders.
Ordinary Dividends
Ordinary dividends are corporate distributions in cash (as opposed to
property or stock shares) that are paid to shareholders out of earnings and profits.
They are taxed at ordinary income tax rates rather than at lower long-term capital gain rates.
Ordinary dividends are reported in Box 1a of Form 1099-DIV.
Qualified Dividends
Qualified dividends that meet certain requirements are taxed at lower capital gain rates if specific criteria are met. Short-term capital gains and ordinary dividends are taxed at ordinary income rates.
Qualified dividends are reported to the taxpayer in Box 1b of Form 1099-DIV.
Qualified Dividends Requirements
- The dividends must be paid by a U.S. corporation or qualified foreign corporation
- The taxpayer generally must have held the stock for more than sixty days during the 121-day period that begins sixty days before the ex-dividend date.
When figuring the holding period for qualified dividends, the taxpayer may count the number of days the stock was held, with the first day being the day after the stock was acquired (not including the holding period) and include the day the stock was sold.
A longer holding period may apply for dividends paid on preferred stock
Ex-dividend Date
The date a shareholder will no longer be entitled to receive the most recently declared dividend (typically the day following the record date).
Involuntary Conversions (Section 1033 Exchanges) - Longer Replacement Period
While a section 1031 exchange only has a 180-day exchange period,
a section 1033 exchange has a much longer time for completion. The replacement period for an involuntary conversion generally ends two years after the end of the first tax year in which any part of the gain is realized. There is no requirement under Section 1033 that a qualified intermediary be employed to hold the escrow funds or conversion proceeds.
If a taxpayer reinvests in replacement property similar to the converted property, the replacement property’s basis is the same as the converted property’s basis on the date of the conversion, subject to the certain adjustments.
The basis is decreased by any loss a taxpayer recognizes on the involuntary conversion, or any money a taxpayer receives that they do not spend on similar property. The basis is increased by any gain a taxpayer recognizes on the involuntary conversion and any additional costs of acquiring the replacement property.
Repairs vs. Improvements to Rental Property
A taxpayer can expense the cost of repairs to rental property but cannot currently expense the cost of substantial improvements. The IRS defines repairs and improvements in the IRS’ tangible property
regulations.
Unless the improvement qualifies for accelerated depreciation, a property owner must typically recover the cost of an improvement by taking depreciation deductions over the asset’s applicable recovery period.
