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.).