Unit 5 - Investment Income & Expenses

Question 1

1099-INT

Answer 1

Reports interest, income via financial institution or another payer

Given if the interest is $10 or more for the year

Even if you don’t receive the form, all interest income must be reported on your tax return

Question 2

Schedule B

Answer 2

Interest and ordinary dividends

Taxable interest that exceeds $1500 is reported on schedule B

Question 3

Gift for opening a bank account – deposit less than $5000

Answer 3

Gifts or services valued at more than $10 is reported as interest in income

Question 4

Gift for opening a bank account – deposit of $5000 or more

Answer 4

Gifts or services valued over $20 are reported as interest income

Question 5

Interest a taxpayer pays on funds borrowed from a financial institution to meet the minimum deposit required for a CD

Answer 5

This interest can only be deducted if the taxpayer chooses to itemize deductions

Deducted as investment interest

As long as it does not exceed their net investment income

Form 4952, investment interest expense, deduction

If the borrowed money generates tax-free income, it is not deductible as investment interest

Question 6

Municipal Bonds - muni bonds

Answer 6

Interest is tax exempt

Federal income tax is exempt, but maybe subject to income taxes by state and local governments

Still needs to be reported on the 1040 even if it’s not taxable

Question 7

Series EE bond

Answer 7

Issued at a discount

The difference between the purchase price and the amount received when the bonds are later redeemed or cashed in is interest income

Question 8

Series I Bonds

Answer 8

Issued at face value with a maturity period of 30 years

The face value and accrued interest are payable at maturity

Question 9

Interest on US treasury bills, notes, and bonds

Answer 9

Normally taxable for federal income tax, purposes and exempt from state and local income taxes

Question 10

When do you report interest income from a series, EE or series I savings bond

Answer 10

Either…

When the bond matures or is redeemed – whichever occurs first

Or each year as the bonds redemption value increases – if the taxpayer makes an election

Taxpayers must use the same reporting method for all the series EE and series I bonds they own

Question 11

The education savings bond program

Answer 11

Both series, EE and series high savings bonds are also called educational savings bonds

Special rule 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

Must be for the taxpayer, a spouse, or dependence

Interest earned on these bonds is usually exempt from state taxes as well

Must use both the principal and interest to pay for qualified education expenses does not include textbooks or room and board

Taxpayer must be at least 24 years old before the bonds issue date

Bonds must be purchased by the owner – cannot be a gift

Qualified higher education, expenses must be reduced by scholarships and other tax-free benefits, like the American opportunity and lifetime learning credits

If principal and interest received from the bond do not exceed the education expenses, the percentage of the education expense Used of the principal and interest is multiplied by the interest to pay tax on that remaining value

Married filing separately, do not qualify for the tax exemption

Question 12

Dividend income

Answer 12

A distribution of cash, stock, or other property from a corporation or a mutual fund

Form 1099 – DIV

If no form is received, the income must still be reported

If total dividend income is more than $1500, it must be reported on schedule be, interest, and ordinary dividends

Otherwise, the dividend income can be reported directly on form 1040

Question 13

Dividend income - top rate

Answer 13

20%

The maximum tax rate for qualified dividends is 20% regardless of the taxpayers individual tax bracket

However, higher income taxpayers may also be subject to the net investment income tax (NIIT) on long-term capital gains and qualified dividends

Question 14

Ordinary dividends

Answer 14

Are corporate distributions in cash that are paid to shareholders out of earnings and profits

At the taxpayers, ordinary income tax rates

Reported in box 1A form 1099 – DIV

Question 15

Qualify dividends

Answer 15

Dividends that meet certain requirements are taxed at lower capital gains rates if specific criteria are met

The tax rates are 0%, 15%, and 20%

Reported in box 1B of form 1099 – DIV

Question 16

Qualified dividend requirements

Answer 16

The dividend must be paid by a US corporation or qualified foreign corporation

And

The taxpayer must have held the stock for more than 60 days during the 121 day period that begins 60 days before the ex dividend date (date of purchase doesn’t count)

Question 17

Non-dividend distributions

Answer 17

Distributions that are not paid out of a corporations earnings and profits

Considered a recovery or return of capital and therefore our generally not taxable

The distributions reduce the taxpayers basis in the stock of the corporation

Once the basis is reduced to zero, any additional distributions are capital gains and are taxed as such

Reported in box 3 of form 1099 – DIV

Question 18

Money market funds

Answer 18

Money market funds pay dividends and are offered by non-bank financial institutions

Such as mutual funds and stock brokerage houses

Amount received should be reported as dividends, not as interest

Question 19

Stock dividend

Answer 19

A distribution of stock rather than money by a corporation to its own shareholders

Generally Non-taxable

If the shareholder has the option to receive cash instead of stock, the stock dividend is taxable in the year. It is distributed. - must include the fair market value of the newly issued stock in gross income

Question 20

The Education Saving Program (bonds) - MFS

Answer 20

They don’t qualify for the exemption

Question 21

Dividend Reinvestment Plans (DRIP)

Answer 21

Dividends are used to buy more stock instead of receiving dividends in cash

Must still report the dividends as income at FMV

Question 22

Mutual Fund

Answer 22

An investment vehicle that allows investors to pool their money to invest in stocks, bonds, and other securities

Managed by a portfolio manager

Combined holdings are the “portfolio”

Generally distribute all of their ordinary income to shareholders by the end of the year

Taxpayer will receive form 1099 – DIV, identifying the types of distributions received

Question 23

Mutual fund distribution may include…

Answer 23

Ordinary dividends
Qualify dividends
Capital gain distributions
Exempt interest dividends
Non-dividend distributions

Ordinary dividends are the most common type from a mutual fund - taxable as ordinary income

Question 24

Mutual fund – capital gain distributions
Short term or long term

Answer 24

Always treated as long-term, regardless of the actual period. The mutual fund investment is held.

Question 25

Mutual fund – tax exempt securities

Answer 25

Distributions are tax exempt interest, and retain their tax exempt character for the payee

But the taxpayer must report them on the tax return

Question 26

REIT

Answer 26

Real estate investment trust

Question 27

Mutual fund and REIT – declared dividends

Answer 27

If a mutual fund or real estate investment trust declares a dividend payable to shareholders in October November or December, but actually pays the dividend during January of the following year. The shareholder is considered to have received the dividend on December 31 of the prior tax year and must report the dividend in the year it was declared.

Regardless, if the dividend is withdrawn or reinvested

Question 28

Constructive distributions

Answer 28

Also called constructive dividends

Certain transactions between a corporation and its shareholders may be considered dividends – and therefore taxable to the shareholders and non-deductible to the corporation

6 Examples

Payment of personal expenses
Unreasonable compensation
Unreasonable rents
Cancellation of a shareholders debt
Property transfers for less than FMV
Below market or interest, free loans

Question 29

Constructive distributions – payment of personal expenses

Answer 29

Corporation pays personal expenses on behalf of an employee – shareholder

Amount it should be classified as a distribution rather than expense

Question 30

Constructive distributions – unreasonable compensation

Answer 30

Corporation pays an employee – shareholder and unreasonably high salary, considering the services performed

Excessive part of the salary may be treated as a distribution

Question 31

Constructive distributions – unreasonable rents

Answer 31

Corporation rents property from a shareholder, and the rent is unreasonably higher then the shareholder would charge an unrelated party

Excessive part of the rent may be treated as a distribution

If corporation rents property to a shareholder that is unreasonably low

The discounted portion could be treated as a distribution

Question 32

Constructive distributions – cancellation of a shareholders debt

Answer 32

Corporation cancels a shareholders repayment by the shareholder

Amount canceled may be treated as a distribution

Question 33

Constructive distributions – property transfers, for less than FMV

Answer 33

Corporation transfers, or sell property to a shareholder for less than fair market value

Excess may be treated as a distribution

Question 34

Constructive distributions – below market or interest, free loans

Answer 34

Corporation gives a loan to a shareholder on an interest-free basis or at a rate below the applicable federal rate

The uncharged interest may be treated as a distribution