General Chapter 1 Tax Basics
● Tax = Tax Base × Tax Rate
● Marginal Tax Rate: the tax rate that applies to the next additional increment of a
taxpayer’s taxable income.
Average Tax Rate: the taxpayer’s average level of taxation on each dollar of taxable
income.
●
Effective Tax Rate: the taxpayer’s average rate of taxation on each dollar of total income
(both taxable and nontaxable).
Example:
○ Bill and Mercedes have $160,000 of taxable income and additional $10,000 of
nontaxable income. Using the 2018 married-joint tax rates, what is their tax due,
average tax rate, and effective tax rate? If they receive an additional $80,000 of
taxable income, what is their marginal tax rate on this income?
Answer:
○
Tax Due = $27,079, computed as:
$27,079 = $8,907 + 22% × ($160,000 − $77,400)
Average tax rate: 16.92% ($27,079 /160,000)
Effective tax rate: 15.93% ($27,079 /170,000)
Marginal tax rate: 23.88% ($46,179 − $27,079)/($240,000 − $160,000)
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Proportional Tax Rate (Flat Tax): imposes a constant tax rate throughout the tax base.
Progressive Tax Rate: imposes an increasing marginal tax rate as the tax base
increases.
Regressive Tax Rate: imposes a decreasing marginal tax rate as the tax base increases.
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Types of revenue forecasting:
Static: Forecasting revenue ignores how taxpayers might alter their activities in response
to a tax law change and to base projected tax revenues on the existing state of
transactions.
Dynamic: Forecasting which tries to predict possible responses by taxpayers to new tax
laws.
Income Effect: as tax rates go up, people will work harder to maintain same after-tax
income.
Substitution Effect: as tax rates go up, people will substitute non-taxable activities
because the marginal value of taxable ones has decreased.
●
Horizontal Equity: two taxpayers in similar situations pay the same tax.
Vertical Equity: taxpayers with greater ability to pay tax, pay more tax relative to
taxpayers with a lesser ability to pay tax.
Chapter 2
● All corporations must file a tax return, and estates and trusts must file if gross income
exceeds $600
● Not all individuals must file: depends on age, filing status, and income
● Gross income thresholds by status and age:
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Filing Date:
○ Individuals: 15th day of 4th month following end of tax year
C corporations: Generally 15th day of the 4th month following end of tax year
Partnerships and S corporations: 15th day of 3rd month following end of tax year
Due dates on a Saturday, Sunday, or holiday are extended to next
business day.
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Statute of Limitations: Generally ends 3 years from the later of (1) the date the tax return
was actually filed or (2) the tax return’s original due date
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Tax Law/ Sources
○ Primary Authorities: Official sources of tax law:
Statutory sources (e.g., Internal Revenue Code)
Judicial sources (the courts)
Administrative sources (IRS pronouncements)
Secondary Authorities: Unofficial tax authorities:
Tax services
Tax articles
○ How to Write Tax Sections:
●
Tax Research Steps:
○ Step 1: Understand facts
Step 2: Identify issues
Step 3: Locate relevant authorities
Step 4: Analyze tax authorities
Step 5: Document and communicate the results
Chapter 5: Income and Exclusions from Gross Income
Recognition of income:
● Cash basis taxpayers: when payment is received
● Accrual basis: when services are performed/ goods received
Tax Benefit Rule: Refunds of expenditures deducted in a prior year are included in gross
income to the extent that the refund reduced taxes in year of the deduction.
Example: Last year Courtney reported $9,550 in itemized deductions including $3,500
of state income taxes paid last year (the standard deduction last year was $9,350). In March of
this year, Courtney received a $420 refund of the $3,500 in state income taxes paid last year.
Under the tax benefit rule, how much of the $420 refund should Courtney include in her gross
income this year?
Answer: $200 because her itemized deductions were $200 above the standard
deduction, therefore cannot exclude the full refund
Constructive Receipt Rule: income recognized when the taxpayer has means to access this
income (Only applies to cash-basis taxpayers)
Fruit and Tree Doctrine: An individual may not assign income (fruit) from property or services to
another person without transferring full ownership of the underlying asset (tree) to the other
individual
Earned Income: income from services
Unearned Income: income from property (ex. Investment assets)
Dividend Income Recognition Example:
Capital Gains and Losses:
● Capital Gains: short-term if held for less than a year
○ Long-term gains taxed at preferred rates
● Capital Gain Tax Rates:
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● Capital Losses: deductible up to $3,000
Netting Capital Gains/Losses
● Step 1: Combine all short-term capital gains and losses for the year and any short-term
capital loss carryforward. If negative, it is a net short-term capital loss. If positive, it is a
net short-term capital gain.
Step 2: Combine all long-term capital gains and losses for the year and any long-term
capital loss carryforward. If negative, it is a net long-term capital loss. If positive, it is a
net long-term capital gain.
Step 3: If the results from steps 1 and 2 are both positive or negative, stop the netting
process. Otherwise, net the results from steps 1 and 2.
● If additional netting is required in Step 3, four outcomes are possible:
1. Net short-term capital gain if net short-term capital gains exceed net long-term capital
losses.
2. Net long-term capital gain (also referred to as net capital gain) if net long-term capital
gains exceed net short-term capital losses.
3. Net short-term capital loss if net short-term capital losses exceed net long-term capital
gains.
4. Net long-term capital loss if net long-term capital losses exceed net short-term capital
gains.
● Example: Gram has the following gains/losses:
Short-term capital gain: $13,000
Short-term capital loss: ($8,000)
Long-term capital gain: $3,000
Long-term capital loss: ($12,000)
What is the amount and character of Gram’s gains and/or losses for the year?
Answer: $3,000 long term capital loss recognized, netting process comes out to $4,000
long term loss, $1,000 can be carried forward to future years
Capital Loss Limitations:
- Related Parties (brothers, sisters, spouses, ancestors, and descendants)
- If you (or you along with related parties) own more than half of a corporation, that
corporation is also a related party
- Example: You sell stock (which you bought for $10,000) to your daughter at a fair market
value of $6,000
- She can recognize a loss if she sells for less than $6,000
- She can recognize a gain if she sells for more than $10,000
Wash Sale:
- When an investor sells or trades stocks/securities and within a 61 day period (30 days
before or after sale, including day of sale) buys identical stock/securities, they may not
recognize a loss from the sale (to the extent of the amount of shares purchased vs
shares sold)
Wash Sale and ch Examples:
Prizes and Awards: generally must be included in income
● 3 Exceptions:
○ 1. For scientific, literary, or charitable achievement and transferred to a
qualified charity (recipient must also be selected without taking action to enter
the contest, and the recipient must not be expected to perform any future service
due to the achievement recognition)
2. For employee length of service or safety achievement ($400 tangible property
limit per employee per year): Cash, cash equivalents, stocks, bonds, other
securities, meals, vacations, lodging, tickets to events, or similar items are
not excludible as this type of prize
3. To Team USA athletes from U.S. Olympic Committee on account of their
competition in Olympic and Paralympic games (AGI limit applies).
Social Security Benefits: Maximum of 85% of total benefits is taxable and included in gross
income
Imputed Interest Income
● Interest/Income deemed to be received due to a gift, loan, etc. (must be included in
income)
● ***If the loan does not exceed $10,000, it is not included in gross income
● capits not used to generate income are tax-free up to $100,000
● Examples:
Discharge of Indebtedness (Loan Forgiveness)
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If taxpayer is determined insolvent after the loan forgiveness, they may exclude this from
income
If they are solvent, they must recognize income amounting to how solvent they are as a
result of loan forgiveness (total assets exceeding liabilities)
Gains on the Sale of Personal Residence
Taxpayers may exclude up to $250,000 ($500,000 if married filing jointly) of gain on the sale of
their principal residence.
Must satisfy ownership and use tests (owned and used as personal residence for at least 2 of
previous 5 years)
Any excess gain generally qualifies as long-term capital gain.
Municipal Bond Interest is excluded from income
Fringe Benefits
● Qualified fringe benefits may be excluded from income
● Qualified Fringe Benefits:
Educational and Scholarships:
- Scholarships used to pay for required tuition, fees, books, and supplies may be excluded
from income
- Only applies if individual is not required to perform services in exchange for the
scholarship
Life Insurance Proceeds can generally be excluded from income
- Exception: if the proceeds are paid over multiple periods, some of the proceeds must be
included in income. Lump sum payments are excluded, though
Foreign income
- Must live in foreign country at least 11 months out of 12-month period (does not have to
be the same year (aka 330 out of 365 days)
- Max exclusion: $103,900
- Examples:
Personal Injury
● You may exclude compensation income related to a physical personal injury
(mental/emotional injuries are not excludible)
● You may exclude compensatory damages and emotional damages related to the
physical injury, but you may not exclude punitive damages
Deductions
Business / Investment activity deductions (business on top, investment on bottom)
●
Rent and Royalty expenses are deductible for AGI
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Loss on disposition is Deductible for AGI up to $3000 per year can be taken until loss
is fully deducted.
Expenses from flow-through entities are deductible for AGI
Losses from pass-through entities can be fully deducted if:
○ Sole proprietorship
■ If this criteria not met:
● Tax-basis rule: partner can only deduct up to their basis in the
partnership
● At-risk rule: partner can only deduct their “economic risk” in the
partnership (cash contributed)
● Passive activity: can only deduct passive losses to the extent of
passive income: Passive = not material participant
○ Material participant criteria:
■ More than 500 hours participated during year
■ Individual makes up almost all of overall
participation
■ Participates more than 100 hours and no one else
in partnership contributes over 100
■ Individual has over 500 hours of significant
participation activities during the year
● Significant participation activites = over 100
hours contributed. (5 of these = 500 hours)
■ Individual participated materially in any 5 of the
previous 10 taxable years
■ Individual participates on a continuous basis
(REAL ESTATE LOSSES DEDUCTION CALCULATION)
Excess Business Loss Deduction/Limitation:
Notes: $500,000 joint, $250,000 Single
Rental Use of Home Deduction/Limitation:
(FROM AGI Deduction)
(FOR AGI DEDUCTION)
(FOR AGI DEDUCTION)
Home office deduction:
Office in the home technicalities
Direct Expenses: Maintenance of room
Indirect Expense: maintenance of home
Examples: painting of room, repairs to room
Examples: insurance, utilties, rent, property
tax
Treatment: deductible in full as home office
expenses
Treatment: allocated to home and office
-rooms for business/total rooms in home
Or
-sq. Footage business/sq. Footage home
IRA CONTRIBUTION DEDUCTION:
Traditional & Roth:
**Distributions prior to age 59.5 result in 10% penalty (traditional)
Health Insurance Deduction (Self-emloyed): self-employed taxpayers are allowed to deduct
their own, their spouses, and their dependents (under age 27) health insurance premiums as a
for AGI deduction (only to the extent of self-employment income). **If taxpayer has access to an
employer-sponsored plan, they are disqualified from deduction
Self-employment tax deduction: self-employed taxpayers are allowed to deduct the employer
share of their social security and medicare taxes.
Early withdrawl deduction: Any penalty incurred for early withdrawal of funds can be deducted
for AGI
Student-loan interest deduction: Up to $2500 of qualifying educational debt interest can be
deducted for AGI.
From AGI Deductions
Itemized deductions
● Medical Expenses
■ Qualified medical expenses include any payment for the care, prevention,
diagnosis, or cure of injury, disease, or bodily function that are not reimbursed by
health insurance or paid for through a flexible spending account.
■ Common expenses include:
● Prescription medications, insulin, aids like eyeglasses, contact lenses and
wheelchairs. Non-prescription meds are general not deductible.
● Payments to medical care providers (doctors, dentists, nurses)
● Transportation for medical purposes
● Long term care facilities
● Health insurance premiums (if not deducted for AGI by self-employed
taxpayers)
■ Medical expenses for cosmetic surgery are NOT deductible.
■ Transportation to and from a doctor’s office and PT office to receive essential
medical care can be deducted. Mileage rate is 18 cents per mile.
■ Nursing Homes are deductible only when the principle purpose is for medical
care rather than convenience. Problem will tell you % of cost allocable to medical
care. Take yearly cost * % allocable.
■ Limitations
● 7.5% of taxpayer’s AGI.
● Example:
○ Courtney incurred $2,400 in unreimbursed medical expenses, her
AGI is $187,000, what can she itemize for medical expense?
○ Answer is $0.
■ $2,400 minus (7.5% * $187,000 [AGI]) = $2,400 - $14,025.
○ What if AGI was $20,000?
■ $2,400 - ($20,000 * 7.5%) = 2,400 - 1500 = $900
● Taxes
○ Can deduct tax payments for the following taxes:
■ State, local, and foreign income taxes, including state and local taxes
paid during the year through employer withholding, estimated tax
payments, and overpayments on the prior year return.
■ State and local real estate taxes on property held for personal or
investment purposes.
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Can elect to deduct state and local SALES taxes instead of deducting state and
local INCOME taxes.
■ Advantageous for states that don’t have an individual state income tax
○ Total itemized deduction for taxes is limited to $10,000 ($5,000 for married
separate)
○ Example:
■ Courtney paid $6700 state income tax through withholding, $2700 in real
estate (personal), $980 in real estate (investment), and $180 registration
fee.
● Answer: $10,000. (6700 + 2700 + 980, limited to $10,000).
■ What if she had $420 overpayment, $6700 state income tax withholding,
and $1500 real estate tax?
● Answer: $8,620 (6700 + 420 overpayment + 1500 real estate)
Interest
○ Subject to limitations, but individuals can deduct interest paid on debt that is
incurred in acquiring, constructing, or substantially improving the residence.
Highlighted yellow is the definition of ACQUISITION INDEBTEDNESS (AI).
■ Must be a qualified residence (taxpayer’s principal residence and one
other residence)
○ Home mortgage interest deduction
■ For AI incurred after 12/15/17, taxpayers can only deduct mortgage
interest up to $750,000 of AI, (375K if married filing separately).
■ For AI incurred before 12/16/17, mortgage interest limit is $1,000,000
($500,000 if married filing separate).
● Applies EVEN if debt is refinanced after 12/15/17.
○ Can deductira paid on loans used to purchase investment assets such as
stocks, bonds, or land.
■ Limited to taxpayer’s net investment income.
○ Examples:
■ Courtney acquired home for $300,000. Borrowed 260,000 and down
payment of 40,000. Courtney paid 15,800 in interest on the loan. How
much can she deduct?
● Answer: All $15,800. Because mortgage is secured by her home.
■ Courtney received investment income of $100 from stocks but paid $130
of interest expense on a $2000 loan to purchase the stock. How much
can she deduct?
● Answer: $100 because that was her investment income.
Contributions of Money
○ Can deduct in year paid, including donations of cash, check, electronic fund
transfers, credit card charges, payroll deductions.
○ Can deduct mileage for transportation costs and out of pocket costs providing
services for charitable purposes.
■ Rate is 14 cents per mile.
○ Cannot deduct value of services they provide.
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Gambling
○ Gambling expense and losses are deductible to the extent of gambling winnings
for the year.
Standard Deduction
● Standard deduction is the flat amount that individuals can elect to deduct instead of
deducting itemized deductions.
● Standard Deduction Amounts can be found in EXHIBIT 7-3 (copy and paste that).
● Additional standard deduction for age/blindness is $1300 for married & $1600 for not
married
○ Can do a double deduction if blind AND over 65.
○ Blind individual who is 65 years old and single can deduct $15,200 ($12,000 +
$1,600 + additional $1,600)
○ Married couple with one spouse over 65 and one spouse legally blind can deduct
$26,600 ($24,000 + $1,300 + additional $1,300).
Net Qualified Business Income
● Deduction is allowed in addition to either the taxpayer’s itemized or standard deduction.
● Can deduct the lesser of:
○ 20 percent of taxpayer’s qualified business income plus 20 percent of the
taxpayer’s qualified real estate investment trust dividends
○ 20 percent of the excess of taxable income over the taxpayer’s net capital gains.
● Qualified trade or business is any trade other than a specified service trade or
business or the trade of being an employee.
○ Architecture and engineering are excluded from being a specified service
trade.
● Any year where taxpayer’s taxable income is less than $157,500 ($315,000 if married
filing jointly), taxpayer can deduct for qualified business income.
○ Taxpayers above 157,500 have a shield of 50,000 (100,000 if joint), so the
exclusion applies with taxable income in excess of $207,500 ($415,00 if
married filing jointly).
● Examples:
○ Courtney performs architectural consulting services. Will her income be
considered qualified business income?
■ Yes because it is architecture.
○ Courtney decides to establish a sole proprietorship to perform investment
advising services. Reports $250,000 of taxable income, will this be considered
QBI?
■ No. Investment advisory services counts as a specified service or trade
business. Taxable income exceeds 207,500 as well so exclusion does not
reply.
○ What if the income is only $100,000?
■ Yes. Because her taxable income falls below $157,500
○ What if income is $187,500?
■
60% of her income would not be considered QBI. ($187,500 - 157,500) /
$50,000 phase out range = 60%. Remaining 40 percent will count as QBI
Charitable Contributions: AGI limits and breakdown by charity type
Example: Investment assets charitable contribution
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Ordinary Income Property:
○ Assets held for a year or less
○ Inventory sold in a trade or business
○ Assets that have declined in value and have a lower FMV than the basis (ex.
Investment assets, personal-use assets, etc.)
○ Certain Business assets (covered in a different area of the book, not on this test)
Capital gain property:
○ Investment assets that have not declined in value (ex. Stocks, bonds, land held
for investment, etc.)
○ Personal-use assets
○ Business Assets (that are not categorized as ordinary income- also probably not
needed to know for this test)
○ *If the donation is personal tangible property unrelated to the organization’s
purpose, the deduction is limited to the adjusted basis of the property
Cash Contributions: includes cash, check, credit card charges, electronic funds transfer,
or payroll deductions
Charitable Travel Mileage: deductible at 14 cents per mile
Individual income tax: computation and credits
Tax rate schedule:
Alternative Minimum Tax (AMT):
FICA Taxes:
**Withholding
calculation
Earned-income credit (Refundable):
Child tax credit (non-refundable):
Child and dependent care credit (non-refundable):
Credit application order:
Business Tax Credits (non-refundable):
● Examples:
○ Foreign Taxes paid
○ Work opportunity credit