R1: Individual Taxation - Gross Income

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Gross Income (in general):

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The first step in determining tax liability is to compute gross income.

Gross income means all income from whatever source derived, unless specifically excluded

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Computation of Income - General Rule:

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Except in the cases of gain derived from dealings in property, income is determined by the amount of cash, property (FMV), or services obtained. In cases of noncash income, the amount of the income is the FMV of the property or services received.

Event Income Basis

Taxable = FMV FMV

Nontaxable = NONE NBV

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Realization and Recognition:

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In order to be taxable, the gain must be both realized and recognized.

Realization - requires the accrual or receipt of cash, property, or services, or a change in the form or nature of the investment (a sale or exchange)

=Real world

Recognition - means that a realized gain must be included on the tax return

=Record (on the records when you recognize)

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Accrual Method:

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=GAAP

Recognition occurs according to the rules of GAAP. That is, revenue is taxed when earned

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Cash Method:

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For individuals (b/c it's easier and more practicable).

Recognition occurs in the period the revenue is actually or constructively received in cash or (FMV) property.

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Characterization of Income:

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1. Ordinary - salaries and wages, alimony, self-employment income, unemployment compensation

2. Portfolio - interest and dividends. Earnings on portfolio of assets

3. Passive - rental activity. An activity in which a taxpayer did not actively participate. Only passive losses may offset passive income, and net passive loss is not deductible on the tax return (it is suspended and carried forward until passive income exists to offset it)

4. Capital - sales of capital assets create capital gains and losses. A capital asset is generally any property (personal or business), but there are some exceptions

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Salaries and Wages:

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1. Money

2. Property - FMV

3. Cancellation of Debt (COD)

4. Bargain purchases

5. Partially taxable fringe benefits - portion of life insurance premiums

-Premiums above the first $50K of coverage are taxable to the recipient and normally included in the W-2

6. Nontaxable fringe benefits

-Life insurance proceeds

-Accident, medical, and health insurance (employer paid)

-De Minimis fringe benefits

-Meals and lodging

-Employer payment of employee's educational expenses (up to $5,250 may be excluded from gross income) (applies to undergrad and grad)

-Qualified tuition

- Qualified pension, profit-sharing, and stock bonus plans

a) Payments made by employer (nontaxable)

b) Benefits received (taxable) -> you get money

-Flexible Spending Arrangements (FSAs)

a) Pretax deposits into employee's account - employees have the ability to elect to have part of their salary (generally up to $2,550 for 2016) deposited pretax into a FSA designated for them

b) Forfeit funds not used within 2.5 months after year-end - funds not used within 2.5 months after the year-end or not claimed within a period of time (usually 6 months) are forfeited

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Interest Income:

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Schedule B

1. Taxable Interest Income

-GR: all interest income is taxable, unless it is specifically excluded

-Premiums received for opening a savings account (ex. prizes and awards) are included at FMV

-Interest paid by the FEDERAL or STATE govt. for late payment of a tax refund is taxable

2. Tax-Exempt Interest Income (reportable but not taxable)

-State and Local govt. BONDS/obligations

-Series EE (U.S. savings bond) (Educational Expenses)

a) Exempt when it is used to pay for higher education (reduced by tax-free scholarships) of the taxpayer, spouse, or dependents

b) Phase-out starts when modified AGI exceeds an indexed amount

3. Unearned Income of a child under 18 ("kiddie tax")

-The net unearned income of a dependent child under 18 years of age (or, age 18-24 who does not provide over half of his/her own support and is a full-time student) is taxed at the parent's higher tax rate

4. Forfeited interest (adjustment) - penalty on withdrawing from savings (see R2)

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Dividend Income:

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3 categories of dividends:

1. Taxable dividends - all dividends that represent distributions of a corporation's earnings and profits are included in gross income

a) Taxable amount (to shareholder receiving)

Cash = amount received

Property = FMV

b) Special (lower) tax rate

Qualified dividends holding period

c) Tax rates (2016)

15% - most taxpayers

0% - low income taxpayers

20% - high income taxpayers

2. Tax-free distributions - the following items are exempt from gross income:

a) Return of capital

b) Stock split (the shareholder will allocate the original basis over the total number of shares held after the split)

c) Stock dividend (unless cash or other property option / taxable FMV)

d) Life insurance dividend

3. Capital gain distribution - distributions by a corp. that has no earnings and profits, and for which the shareholder has recovered his/her entire basis, are treated as taxable gross income

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State and Local Tax Refunds:

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The receipt of state or local income tax refund in a subsequent year is not taxable if the taxes paid did not result in a tax benefit in the prior year.

1. Itemized in prior year = state or local refund is taxable

2. Standard deduction used in prior year = nontaxable state or local refund

If exam says "1040EZ" - it was a standard deduction

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Payments Pursuant to a Divorce:

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1. Alimony/Spousal support (income/adjustment)

-Income to the spouse receiving the payments, and are deductible as an adjustment to arrive at AGI by the contributing spouse

-To be deemed alimony under the tax law:

a) Payments must be legally required pursuant to a written divorce agreement

b) Payment must be in case or its equivalent (pay credit card bills, pay college fees)

c) Payments cannot extend beyond the death of the payee-spouse

2. Child Support

-Nontaxable (to spouse receiving the $)

-Payment applies first to child support, then alimony

-"Loses adjustment for alimony"

3. Property settlements (nontaxable)

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Business Income or Loss:

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Schedule C or C-EZ

"Self-employed"

Gross business income

(Business expenses)

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Profit or Loss

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Schedule C - Gross Income:

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Those items that would normally be revenue in a trade or business or other self-employed activity are included as party of gross income on Schedule C.

-Cash = amount received (cash basis)

-Property = FMV

-Cancellation of Debt (COD)

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Schedule C - Expenses:

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-COGS (inventory is expensed when sold)

-Salaries and commissions paid to others (NOT to yourself)

-State and local business taxes paid

-Office expenses

-Business meal and entertainment expenses at 50%

-Depreciation of business assets

-Interest expense on business loans (interest expense paid in advance by a cash basis taxpayer cannot be deducted until the tax year/period to which the interest relates) (must be incurred and paid)

-Bad debts actually written off for an accrual basis taxpayer only (the direct write off method, not the allowance method, is used for tax purposes)

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Schedule C - Nondeductible Expenses:

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-Salaries paid to the sole proprietor (they are considered a "draw")

-Federal income tax

-Personal portion of:

Automobile, meals and entertainment, interest expense, state and local tax expense, health insurance of a sole proprietor

-Bad debt expense of a cash basis taxpayer (who never reported the income)

-Charitable contributions (report as an itemized deduction on Schedule A)

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Schedule C - Net Business Income or Loss:

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1. Net business income is taxable

-2 taxes on net business income:

a) Income tax

b) Federal self-employment tax (social security) (allowed as an adjustment later, see R2)

2. Net taxable loss

-A business with a loss may deduct the loss against other sources of income

-When the loss exceeds these amounts, the excess net operating loss is permitted as a carryover:

a) 2-year carryback

b) 20 year- carryforward

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Schedule C - Uniform Capitalization Rules:

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1. Costs required to be Capitalized as Inventory

-DM

-DL

-Indirect costs / Factory overhead

2. Costs not required to be capitalized - period expenses

-Selling

-General

-Administrative

-Research and Development

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Schedule C - Long-Term Contracts:

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A long-term contract is generally defined as a contract that is incomplete at the end of a tax year in which it was started.

1. Percentage-of-Completion Method required for tax for nonexempt long-term contracts

-Report income on a % basis

-Exceptions (may use other methods, like completed contract method - deferring all income until the job is done)

a) Small contractors

b) Home construction contractors

c) Services performed by architects, engineers, designers, construction MGMT advisors, and software implementation personnel related to the long-term project

d) Services performed under warranty and maintenance agreements related to the long-term contract

2. Cost allocation rules required for tax for long-term contracts

-Uniform capitalization rules

3. Production period defined

-Start date - the date on which the contractor incurs costs

-End date - the date on which the work under the contract is complete

4. Calculation for percentage-of-completion method income recognition

a) Cost-to-cost method (to determine percentage)

b) Gross income recognition calculation

5. Miscellaneous impacts

a) Corporate earnings and profits (R3) must be calculated using the percentage-of-completion method

b) Change in accounting method - cannot be changed for the contract without the consent of the IRS

c) "Unique" rules for personal property contracts - an item that is made specifically for a customer and could not be sold to others, is not generally part of a taxpayer's normal inventory, and requires significant pre-production costs

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Farming Income:

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Schedule F

1. Most farmers use the cash basis

-Inventories of produce, livestock, etc. are not considered

2. The accrual method is required for certain corporate and partnership farmers as well as for farming tax shelters

-Inventories must be used and maintained

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Gains and Losses on Disposition of Property:

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R4:

Amount Realized

(Adjusted basis of assets sold)

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Gain or loss realized

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IRA Income:

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Withdrawing funds from an IRA.

GR: taxable when withdrawn

Generally, retirement money cannot be withdrawn until the individual reaches the age of 59.5

Regular tax:

-Ordinary income (traditional deductive IRA distributions)

-Distributions/benefits from nondeductible IRAs

a) Roth IRA - all qualified benefits received from a Roth IRA are nontaxable

b) Traditional Nondeductible IRA

Principal - nontaxable

Accumulated earnings - taxable (when withdrawn)

Penalty Tax

-In addition to regular income tax

-10%

Exception to penalty tax (but still subject to ordinary income tax). Withdrawings used to pay:

"HIM DEaD"

-1st time Home buyer

-Insurance (medical)

-Medical expenses in excess of 10% of AGI

-Disability

-Education

-and

-Death

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Annuities:

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Treat like depreciation.

Factor is based on the age of the annuitant at the start of the payout period.

Live longer than actuarial payout period - further payments are fully taxable (entire amount)

Death before full recovery - unrecovered portion is a miscellaneous itemized deduction on the annuitant's final income tax return

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Rental Income:

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Schedule E

Passive Activity (income/loss)

Formula:

Gross rental income

Prepaid rental income

Rent cancellation payment

Improvement in-lieu-of rent

(Rental expenses)

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Net rental income/loss

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Rental of Vacation Home:

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1. Rented less than 15 days per year

-It is treated as a personal residence

-The rental income is excluded from income

2. Rented 15 or more days per year

-It is treated as a personal/rental residence

-Expenses must be prorated between personal and rental use

-Rental use expenses are deductible only to the extent of rental income (no rental loss allowed)

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Passive Activity Losses (PALs):

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GR: all rental activity = passive activity

1. Deductibility - a net passive activity loss may NOT be deducted against wages, salaries, and other active income or against portfolio income

2. Nondeductible PALs - carry forward without any time limit unused passive activity losses held in suspension

a) Suspended losses are used to offset passive income in future years

b) If still unused, suspended losses become fully tax deductible in the year the property is disposed of (sold)

3. PAL (disallowed net loss) exceptions

a) Mom and Pop Exception

-$25K and active - taxpayers may deduct up to $25K per year of net passive losses attributable to rental real estate annually if the individuals are actively participating/managing

-Carryforward - any excess carried forward indefinitely

-Phase-out - The $25K allowance is reduced by 50% of the excess of the taxpayer's AGI over $100K. The allowance is eliminated completely when AGI exceeds $150K

b) Real Estate Professional (not passive activity)

-Taxpayer can fully deduct losses from the rental activity against other income if:

-More than 50% of the taxpayer's personal services during the year are performed in real property businesses; and

-The taxpayer performs more than 750 hours of service in real property businesses during the year

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Unemployment Compensation:

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A taxpayer must include in gross income the full amount received for unemployment compensation.

*Compare: Worker's compensation is tax free

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Social Security Income:

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1. Low income = no social security benefits are taxable (income below: single $25K / MFJ $32K)

2. Upper income = 85% of social security benefits are taxable (income over: single $34K / MFJ $44K)

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Prizes and Awards:

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Taxable at FMV.

-Exclusions are where the winner is selected for the award without entering into a contest (ex. Nobel Peace Price) and assigns the award directly to a governmental unit or charitable organization

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Gambling Winnings and Losses:

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-Winnings - included in gross income-Losses - may only be deducted to the extent of gambling wins. The allowable amount of these gambling losses are deductible on Schedule A as an itemized deduction. but the amount is not subject to the 2% of AGI limitation on miscellaneous itemized deductions

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Business Recoveries:

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If a damage award is compensation for lost profit, the award is income.

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Punitive Damages:

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Are fully taxable as ordinary income if received in a business context or for loss of personal reputation.

Punitive damages received by an individual in a personal injury case are also taxable except in wrongful death cases where state law has limited wrongful death awards to punitive damages only.

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Partially Taxable - Degree-Seeking Students:

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Scholarships and fellowship grants are excludable only up to amounts actually spent on tuition, fees, books, and supplies (NOT room and board), provided:

1. The grant is made to a degree-seeking student

2. No services are to be performed as a condition to receiving the grant

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Nontaxable Miscellaneous Items:

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1. Life insurance proceeds

-However, the interest income element on deferred payout arrangements is fully taxable

2. Gifts and inheritances (for recipient)

3. Medicare benefits

4. Worker's compensation

5. Personal (physical) injury or illness award

6. Accident insurance - premiums paid by taxpayer