© 2012, Megin E. Hughes
Megin E. Hughes – author
Copyright is not claimed in any material secured from official U.S. government sources.
All Rights Reserved
No part of this book may be reproduced or transmitted in any form or by any means, electronic or
mechanical, including photocopying, recording, or by any storage or retrieval system without permission
in writing from the author.
Printed in the U.S.A. March 2012
Table of Contents
1.0 The Basics .......................................................................1
2.0 The Fundamentals ...........................................................7
3.0 Income, Part 1 ...............................................................15
4.0 Standard Deduction & Exemptions ................................22
5.0 Credits ...........................................................................33
6.0 Income, Part 2 ...............................................................49
7.0 Itemized Deductions, Part 1 ..........................................56
8.0 Itemized Deductions, Part 2 ..........................................66
9.0 Tax Benefits of Education ..............................................73
10.0 The Sole Proprietor .....................................................80
11.0 Overview of Depreciation .............................................96
12.0 Depreciation, Part 2 ...................................................108
13.0 Retirement Income ....................................................115
14.0 Individual Retirement Arrangements (IRAs) ..............121
15.0 Capital Gains and Losses ..........................................128
16.0 Rental Income and Expenses ....................................134
17.0 Amended Returns & Estimated Payments ................139
18.0 Professional Practice & Responsibility ......................144
Quick Study 1.0 .................................................................152
Quick Study 2.0 .................................................................154
Quick Study 3.0 .................................................................156
Quick Study 4.0 .................................................................158
Quick Study 5.0 .................................................................160
Quick Study 6.0 .................................................................162
Quick Study 7.0 .................................................................164
Quick Study 8.0 .................................................................166
Quick Study 9.0 .................................................................168
Quick Study 10.0 ...............................................................170
Quick Study 11.0 ................................................................173
Quick Study 12.0 ...............................................................175
Quick Study 13.0 ...............................................................177
Quick Study 14.0 ...............................................................179
Quick Study 15.0 ...............................................................181
Quick Study 16.0 ...............................................................183
Quick Study 17.0 ...............................................................186
Quick Study 18.0 ...............................................................187
Study Questions ................................................................190
1.0 The Basics
1.1 Accounting Periods. An accounting period is a specific interval of time over which income and
expenses are recorded. The annual accounting period for an income tax return is called a tax year.
Most individuals use a calendar tax year, which is 12 consecutive months beginning January 1 and
ending December 31. A taxpayer must use a calendar year if any of the following apply:
• They keep no books;
•
They have no annual accounting period;
•
Their present tax year does not qualify as a fiscal year; or
•
Use of a calendar year is required under the Internal Revenue Code or Income Tax Regulations.
Unless the taxpayer has a required tax year, they adopt a tax year by filing their first income tax return
using that tax year.
The alternative to a calendar year tax year is a fiscal tax year. A fiscal tax year is any 12 consecutive
months ending on the last day of any month except December. An example of a fiscal tax year would
be the twelve months beginning on June 1 and ending on May 31. A 52-53 week tax year is a fiscal tax
year that varies from 52 to 53 weeks but does not have to end on the last day of the month.
The taxpayer must maintain books and records and report income and expenses using the same tax
year.
Once a taxpayer chooses an accounting period, they generally must request IRS approval to change
their tax year. See the instructions for Form 1128, Application To Adopt, Change, or Retain a Tax Year
for additional information.
1.2 Accounting Methods. An accounting method is a set of rules which determines when the taxpayer
reports income and expenses. There are two primary methods of accounting: the cash method and the
accrual method. The majority of taxpayers use the cash method of accounting.
Under the cash method of accounting, income is included in gross income when the taxpayer actually
or constructively receives all items of income.
Constructive receipt – A taxpayer constructively receives income when an amount is credited to
their account or made available to them without restriction. They do not actually have to have
possession of the money itself. For example, interest is credited to a bank account at the end of
2011. The taxpayer is considered to have constructively received the income even if they do not
withdraw the money. Receipt of a valid check by the end of the tax year is also considered
constructive receipt, even if the taxpayer does not deposit the check until the following year.
For a cash basis taxpayer, expenses are generally deductible when actually paid. However if a
taxpayer pays certain expenses in advance, they can take a deduction only for the year for which the
expense applies.
Example – A calendar year cash basis taxpayer pays $2,000 in 2011 for a liability insurance
policy effective from July 1, 2011 to June 30, 2012. They can deduct $1,000 in 2011 and the
remaining $1,000 in 2012.
If the taxpayer uses the accrual method of accounting, amounts are included in gross income when
they are earned; expenses are deducted in the year incurred whether or not they have actually been
paid. The purpose of an accrual method of accounting is to match income and expenses in the correct
year.
Example – An accrual basis, calendar year taxpayer performs services on December 15, 2011 for
which he bills his customer $500. He did not receive payment until January 5, 2011. He must
include the $500 received in his 2011 income.
1.0 The Basics
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© 2012, Megin E. Hughes, EA. Copyright is not claimed in any material secured from official U.S. government sources. All rights reserved.
A taxpayer can use any combination of cash, accrual and special methods of accounting if they use it
consistently and it clearly shows their income and expenses. However the following restrictions apply:
• If the taxpayer maintains an inventory, they generally must use an accrual method for purchases
and sales. They may choose to use the cash method for all other items of income and
expenses. We will talk more about inventories in the chapter about sole proprietors.
• If the cash method is used to figure income, it must be used to report expenses.
•
If the accrual method is used to figure expenses, it must be used to report income.
Once a taxpayer is in business and has been using an accounting method, they must generally get IRS
approval before they can change to another method. A change in accounting method includes either an
overall change in method (from cash to accrual) or a change in the treatment of any material item.
For more information see the instructions for Form 3115, Application for Change in Accounting Method.
1.3 Taxpayer Identification Numbers. Generally, every individual listed on the tax return –
taxpayer, spouse, dependents, etc. – must have a valid identification number. For most individuals
that would be their Social Security Number (SSN).
Social Security numbers were first issued in November 1936. To date, over 415 million different
numbers have been issued.
When a tax return is filed with the Internal Revenue Service, they match the Social Security Number
and last name (and possibly birth year) as shown on the return with the information on file at the
Social Security Administration (SSA). If the information does not match, the return could be rejected.
If the taxpayer has changed their name because of a marriage, divorce, etc., they should notify the
Social Security Administration as quickly as possible so that the name on their tax return is the same
as the one on file at the SSA.
If the taxpayer is not eligible for a Social Security number, but still needs to file a tax return, they may
apply for an Individual Taxpayer Identification Number (ITIN). This number would then be entered on
the tax return whenever a Social Security Number is required. To obtain an ITIN, complete Form W-7,
Application for IRS Individual Taxpayer Identification Number.
Examples of individuals who need ITINs include:
•
Non-resident alien filing a U.S. tax return and not eligible for an SSN
•
U.S. resident alien (based on days present in the United States) filing a U.S. tax return and not
eligible for an SSN
•
Dependent or spouse of a U.S. citizen/resident alien
•
Dependent or spouse of a non-resident alien visa holder
Note: An ITIN is valid for tax reporting only. It does not entitle the holder to any benefits or change their
employment or immigration status. In addition, some credits or tax benefits may not be available to
those individuals filing a return with an ITIN. If they are eligible for a Social Security Number they
should obtain one.
If the taxpayer is in the process of adopting a child and cannot get a Social Security number for the
child until the adoption is final, they can apply for an ATIN.
An ATIN is an Adoption Taxpayer Identification Number issued by the Internal Revenue Service as a
temporary taxpayer identification number for the child in a domestic adoption where the adopting
taxpayers do not have and/or are unable to obtain the child's Social Security Number (SSN). The ATIN
is to be used by the adopting taxpayers on their Federal Income Tax return to identify the child while
final domestic adoption is pending.
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© 2012, Megin E. Hughes, EA. Copyright is not claimed in any material secured from official U.S. government sources. All rights reserved.
The taxpayer should file Form W-7A, Application for Taxpayer Identification Number for Pending U.S.
Adoptions if all of the following are true:
• The adoption is a domestic adoption.
•
The child is legally placed in their home for adoption by a authorized adoption agency/agent.
•
The adoption is not yet final, and they are unable to obtain the child's existing SSN or they are
unable to apply for a new SSN for the child pending the finalization of the adoption.
•
They qualify to claim the child as a dependent.
After the adoption is final, the taxpayers should then apply for a regular Social Security Number for the
child. They cannot continue using the ATIN.
1.4 Recordkeeping. The IRS requires records to be kept for as long as they are important for the
administration of the Tax Code. Generally this means that the records should retained until the statute
of limitations for that return expires. The statute of limitations is the period of time in which the return
can be amended to claim an additional refund or credit or the IRS can assess any additional tax.
The Statue of Limitations, Generally
If
The statute of limitations is:
(3)
The taxpayer owes no additional tax and (2), (3),
or (4) do not apply
Income shown on return is understated by 25%
or more
A fraudulent return is filed
No limit
(4)
No return is filed
No limit
(5)
Time for filing a claim for refund or credit
(6)
Time for filing a claim for a loss on a worthless
security
(1)
(2)
3 years
6 years
Later of 2 year after the tax was
paid or 3 years
7 years
The number of years refers to the period of time after the return was filed. Returns filed before the due date
are treated as having been filed on the due date of the return.
Good records will help the taxpayer prepare their return properly, reduce the possibility of errors and
provides support for any item questioned by the IRS. The IRS does not require the taxpayer to keep
records in any particular manner. Records should be kept in a neat and organized fashion in a safe
place. If the taxpayer uses a computerized system of keeping records, they will also need to keep
receipts, checks and other documents that prove the amounts shown in their records.
Basic recordkeeping documents include:
• Form(s) W-2, 1099 or K-1
•
Bank statements, brokerage statements, mutual fund statements
•
Sales slips, invoices, receipts, cancelled checks
•
Closing statements, insurance records
•
Copies of tax returns
Employees that receive a Form W-2 should keep Copy C until they begin receiving social security
benefits. This will help protect those benefits in case there is a question about earnings in a particular
year. Workers over age 25 should receive an annual Social Security Statement which is a concise,
easy-to-read personal record of the earnings on which they have paid Social Security taxes during your
working years and a summary of the estimated benefits they and their family may receive as a result of
those earnings.
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© 2012, Megin E. Hughes, EA. Copyright is not claimed in any material secured from official U.S. government sources. All rights reserved.
For additional information on the kinds of records to keep, see IRS Publication 552, Recordkeeping for
Individuals or Publication 583, Starting a Business and Keeping Records.
1.5 Tax Return Due Dates. Calendar year taxpayers must file an income tax return and pay any tax
due by April 15 of the following year. Fiscal year taxpayers must file a return and pay any tax due by the
15th day of the 4th month after the close of their fiscal year. If the due date for filing a return falls on a
Saturday, Sunday or legal holiday, the due date is delayed until the next business day.
1.6 Filing The Tax Return. There are two main ways of filing a tax return – on paper (by mail) or
electronically. If the taxpayer does not qualify for electronic filing (or chooses to mail their return), the
address for the appropriate IRS service center should be used.
1.6a Paper Returns. A mailed paper return is considered to be filed on time if it is mailed in an
envelope that is properly addressed, has enough postage and is postmarked by the due date. If the
return is sent by registered mail, the date of the registration is the postmark date. If the return is sent by
certified mail, the date on the receipt is the postmark date. The postmarked certified mail receipt is
evidence that the return was delivered.
Taxpayers should mail their returns to the address specified in the instructions for the form they are
using.
A non-electronic alternative to the U.S. Postal Service is the use of a designated private delivery
service. The following have been designated by the IRS to be acceptable private delivery services:
• Airborne Express (Airborne): Overnight Air Express Service, Next Afternoon Service, and
Second Day Service
• Federal Express (FedEx): FedEx Priority Overnight, FedEx Standard Overnight, FedEx 2 Day,
FedEx International Priority and FedEx International First.
• United Parcel Service (UPS): UPS Next Day Air, UPS Next Day Air Saver, UPS 2nd Day Air, UPS
2d Day Air A.M., UPS Worldwide Express Plus and UPS Worldwide Express.
The postmark date of an item sent via private delivery service is the date that the private delivery
service records in its database or marks on the mailing label.
1.6b Electronic filing (e-filing) involves filing a paperless return using one of two methods:
• Use of an authorized IRS e-file provider; or
•
Use of tax preparation software or a tax preparation website.
An electronically filed return is considered filed on time if the authorized electronic return transmitter
“postmarks” the return by the due date. The date and time in the taxpayers time zone controls whether
your electronically filed return is timely.
1.6c Refund Anticipation Loans (RALs). A RAL is a bank loan against the amount of the taxpayer’s
tax refund as shown on their return. The taxpayer receives all or part of their refund amount in as little
as 1 minute after their tax return has been electronically filed. The lending bank authorizes a check (or
direct deposit) for all or part of the refund amount in exchange for a fee. The IRS then deposits the
taxpayer’s refund to the lending bank which repays the loan. Before agreeing to such a loan, the
taxpayer should be aware of all the facts and should consider the potential high cost in light of the short
refund repayment period.
1.6d Mandatory Electronic Fling. A new law requires many paid tax return preparers to electronically
file federal income tax returns prepared and filed for individuals, trusts, and estates starting Jan. 1,
2011.
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© 2012, Megin E. Hughes, EA. Copyright is not claimed in any material secured from official U.S. government sources. All rights reserved.
The e-file requirement will be phased in over two years. As a result of the new rules, preparers will be
required to start using IRS e-file beginning:
•
January 1, 2011— for preparers who anticipate filing 100 or more Forms 1040, 1040A, 1040EZ
and 1041 during the year; or
•
January 1, 2012— for preparers who anticipate filing 11 or more 1040, 1040A, 1040EZ and
1041 during the year.
The rules require members of firms to compute the number of returns based on the total number of
returns that they reasonably expect to file as a firm. If that number is 100 or more in calendar year 2011
(11 or more in 2012 and thereafter), then all members of the firm must e-file the returns they prepare
and file. This is true even if a member prepares and files fewer than the threshold on an individual
basis.
Specified tax return preparers may request an undue hardship waiver from the new e-file requirement
using Form 8944, Preparer e-file Hardship Waiver Request. Notification of approval or denial of the
waiver requests will not be made until final regulations and a final revenue procedure are issued in
early 2011. For calendar year 2011, Forms 8944 generally must be submitted to the IRS no later than
April 1, 2011.
1.6e Electronic Return Signatures. To file a return electronically, the taxpayer should sign the return
electronically using a Self-Select PIN or a Practitioner PIN. A Self-Select PIN is any combination of five
digits except five zeroes. To verify their identity they will need to enter their AGI from their originally filed
2010 return (not an amended return or as corrected by the IRS). If the taxpayer filed electronically the
previous year, they may use a prior year PIN to verify their identity rather than their AGI. The
Practitioner PIN method does not require the taxpayer to provide their prior year AGI or PIN.
Taxpayers who use the Practitioner PIN method and enter their own PINs in the electronic return record
after reviewing the completed return must still sign the signature authorization form.
1.7 Other Types of Taxes. In addition to an income tax, there are other assorted taxes that may be
imposed on individuals or businesses. Here are some of the most common:
1.7a Estate and gift taxes. The estate tax in the United States is a tax imposed on the transfer of the
"taxable estate" of a deceased person, whether such property is bequeathed by a will or according to
state law. Generally property left to a spouse or a charitable organization is exempt from estate tax as
are many life insurance payments. The estate tax is one part of the Unified Gift and Estate Tax system
in the United States. The other part of the system, the gift tax, imposes a tax on transfers of property
during a person's life; the gift tax prevents avoidance of the estate tax should a person want to give
away his/her estate just before dying.
In IRS terms, a “gift” is any transfer to an individual, either directly or indirectly, where full consideration
(measured in money or money's worth) is not received in return. The general rule is that any gift is a
taxable gift. However, there are many exceptions to this rule. Generally, the following gifts are not
taxable gifts.
1. Gifts that are not more than the annual exclusion for the calendar year ($13,000 for 2011);
2. Tuition or medical expenses paid for someone (the educational and medical exclusions);
3. Gifts to a spouse; or
4. Gifts to a political organization for its use.
1.7b Real and personal property taxes. In the U.S., tax on real estate is usually assessed by local
government, at the city or county level. The assessment is made up of two components—the
improvement or building value, and the land or site value. In some states, personal property such as
boats and vehicles are also taxed. The tax assessor’s office determines the value of real property for
the purpose of apportioning the tax levy.
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1.7c Sales Tax. A sales or “consumption tax” is imposed at the point of purchase of an item and is
usually calculated as a percentage of the purchase price. Sales tax is generally set at the state and
local level, paid by the consumer and remitted to the proper regulating agency via the merchant. Sales
taxes in the United States are assessed by every state except Alaska, Delaware, Montana, New
Hampshire and Oregon. Hawaii has a similar tax although it is charged to businesses instead of
consumers. While there is no national sales tax in the United States, the Fair Tax Act, which would
replace most federal taxes with a sales tax and monthly rebate, has attracted a great deal of interest.
1.7d Excise taxes. A type of tax charged on certain goods produced within the U.S. (as opposed to
customs duties, charged on goods from outside the country) and imposed generally on the producer of
the goods. Typical examples of excise duties are taxes on tobacco, alcohol and gasoline.
1.7e Sin taxes. Taxes imposed on substances or activities considered “sinful” or harmful imposed, in
part, to regulate behavior. A sin tax would generally be imposed on items such as tobacco, alcohol or
gambling activities.
1.7f Employment taxes. If a person is classified as an employee, their employer must calculate
certain employment taxes from each paycheck the employee receives. These taxes include:
• Federal, state and local taxes;
• The employee’s share of social security and Medicare tax withheld from their pay;
• The employer’s share of social security and Medicare tax; and
• Federal and state unemployment taxes.
Federal, state and local taxes, plus the employee’s share of social security and Medicare are generally
withheld from an employee’s check. An employer is also required to calculate and remit a matching
portion of social security and Medicare taxes, plus any required federal and state unemployment taxes.
Self-employed individuals are also required to calculate and pay self-employment social security taxes
on their net earnings.
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2.0 The Fundamentals
2.1 Tax Form Basics. There are three basic tax forms that can be used to file a federal return. There is
Form 1040EZ (very simple), Form 1040A (average) and Form 1040 (the “long form”). The easier forms
(1040EZ and 1040A) cannot be used in all situations – certain income items, deductions and credits
cannot be taken on the simpler forms. Any taxpayer may use Form 1040, but the use of Form 1040A or
1040EZ is limited to taxpayers with shorter, easier returns.
2.1a Schedules, Forms, Worksheets and Statements. Sometimes when completing a tax return,
additional information or calculations are necessary. Schedules and forms are usually official Internal
Revenue Service documents. They are used to report various types of income, deductions or credits.
After the taxpayer completes the schedule or form, the total is carried to the appropriate line on Form
1040 (or 1040A). Schedules and forms are considered to be part of the tax return and are submitted to
the taxing authority along with the base Form 1040 or 1040A. Statements may or may not be official
IRS documents. Usually they are included as part of the tax return to explain items found on the tax
return, e.g. a type of income or deduction. Worksheets are not included with the submitted tax return.
They may be provided by the IRS or a third party. They are used to calculate or determine information
such as a taxable amount of income or filing status. Worksheets are usually kept with the file copy of
the tax return.
2.1b Tax Return Assembly. Depending on the form filed and the items stated on the tax return, there
may be items that need to be attached to the return when filed.
Form W-2 or Form 1099-R should be attached to Form 1040EZ, Form 1040A or Form 1040 as
described below.
•
Form W-2, Wage and Tax Statement is a form given to employees by their employer detailing
the amount of wages paid and taxes withheld (it may also contain additional information – that
will be covered in a later chapter). A Form W-2 from each employer should be attached to the
front page of the return in the place indicated.
•
Form 1099R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs,
Insurance Contracts, etc. should be attached to the front page of the return in the place
indicated only if there is an amount shown for federal income tax withholding.
•
Form 1040EZ. There are no additional forms or schedules to be used with Form 1040EZ.
Attach a copy of each applicable Form W-2 to the front of the return.
•
Form 1040A. If there are any additional forms or schedules they should be placed behind the
1040A in order by number. Schedule EIC, if applicable, should be placed last. Attach a copy of
each applicable Form W-2 or 1099-R where indicated on the first page of Form 1040A.
•
Form 1040. Any forms or schedules are included behind Form 1040 in the order of the
“Attachment Sequence Number” shown in the upper right hand corner of the form or schedule.
Include any other required statements or attachments in the same order as the forms and
schedules that they relate to and attach them last. Attach a copy of each applicable Form W-2
or Form 1099-R where indicated on the first page of Form 1040.
2.2 Age and marital status for tax purposes. Your age for tax purposes is determined at the end of
they year, but if your 65th birthday is on January 1 of the following year, you are treated as being age 65
for tax purposes.
The age of a decedent is determined as of the date of death.
2.2a Marital Status. The marital status of a taxpayer forms the basis of determining the filing status of
a taxpayer. Marital status (married or unmarried) is determined on the last day of the tax year or, for a
deceased taxpayer, as of the date of death.
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For tax purposes, marriage means a legal union of a man and woman as husband and wife.
Unmarried – A taxpayer is considered unmarried for the whole year if on the last day of the tax
year, they are unmarried or legally separated from their spouse under a divorce or degree of
separate maintenance according to the law of the state in which they reside.
Married – A taxpayer and spouse are considered to be married for the whole year if on the last
day of the tax year they meet one of the following tests:
•They are married and living together as husband and wife;
•They are married and living apart, but not legally separated under a decree of divorce or
separate maintenance;
•They are separated under an interlocutory (not final) decree of divorce; or
•They are living together in a recognized common law marriage (discussed below).
If the taxpayer’s spouse dies during the year, they are considered married for the entire year for tax
purposes.
2.2b Common Law Marriage. A taxpayer and spouse are considered to be married for tax purposes if
they are living together and have entered into a common law marriage in a state which legally
recognizes the union. Their marital status for tax purposes does not change if they move to a state
which does not recognize common law marriages.
As of the end of 2011, nine states and the District of Columbia currently recognize common law
marriages, plus seven other states have recognized common law marriages in the past. It is not the job
of the tax professional to determine if a common law relationship is valid for tax purposes however the
following information is provided for your reference.
To be valid, common law marriages must meet the following four legal standards:
•Both individuals must have the legal capacity to marry;
•They must have the intent to be husband and wife and they must communicate this intent to each
other;
•They must live together as husband and wife; and
•The couple must publicly present themselves as husband and wife.
There is no such thing as a common law divorce. A couple united under a common law marriage must petition
their state for a divorce as any other married couple would.
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States that currently recognize
common law marriages
States that have previously recognized common law marriages
Florida – if the marriage began on or before December 31, 1967
Georgia – if the marriage began before January 1, 1997
Alabama, Colorado, Iowa,
Kansas, Montana, Rhode Island,
South Carolina, Texas, Utah and
the District of Columbia
Idaho – if the marriage began before January 1, 1996
New Hampshire – for inheritance purposes only
Ohio – if the marriage began before October 10, 1991
Oklahoma – if the union began before January 1, 1994
Pennsylvania – entered into prior to September 1, 2003
2.2c Same sex relationships. Generally at this time, individuals in a same sex domestic partnership
(or a marriage recognized by state law) will not be considered to be married for tax purposes.
2.2e Divorced taxpayers. If a taxpayer is divorced under a final decree of divorce by the last day of the
tax year, they are considered to be unmarried for the whole year.
2.2e Considered unmarried. Under certain circumstances, a married taxpayer can be considered to
be unmarried for tax purposes. An “abandoned spouse” with a child is an example of a taxpayer who
fits this scenario. A taxpayer is considered unmarried on the last day of the tax year of all of the
following tests are met:
•They file a separate return from their spouse;
•They paid more than half the cost of keeping up their home for the tax year;
•Their spouse did not live in the home at any time during the last six months of the tax year. A
temporary absence, such as a separation due to school, work, military service, etc. does not
qualify;
•Their home was the main home of their child, stepchild, adopted child, or eligible foster child for
more than half the year; and
•They must be able to claim an exemption for the child (unless the child’s noncustodial parent is
allowed to claim the exemption for the child).
It is important to remember the distinction between “unmarried” (single, not married) and “considered
unmarried” (married, but meets the conditions above).
2.2f Annulled marriages. A court decree of annulment holds that no valid marriage ever existed. A
couple that obtains an annulment is considered to have never been married, even if they filed joint
returns for earlier years. They must file amended returns (Form 1040X, Amended U.S. Individual
Income Tax Return) claiming single or head of household status for all tax years affected by the
annulment that are not closed by the statute of limitations.
2.2g Decedent taxpayers. Even if a taxpayer dies, they may still be required to file a tax return. The
same filing requirements that apply to all taxpayers will determine if a final income tax return is required
for the decedent. The final return for the taxpayer should show only the items of income (or deductions)
that the decedent actually received, that were credited to him, or that were made available to him
without restriction before his death. If the taxpayer receives income after their death, their estate may
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be required to file a return. Get Publication 559, Survivors, Executors, and Administrators for more
information or see the filing requirements for Form 1041, U.S. Income Tax Return for Estates and
Trusts.
The final return for a decedent should have the word “Deceased,” the decedent’s name and the date of
death written across the top of the return. If the person filing the return is not a surviving spouse, they
must generally also complete and file Form 1310, Statement of Person Claiming Refund Due a
Deceased Taxpayer with the return. Court appointed or certified personal representatives filing an
original return do not need Form 1310, but must attach a copy of the court certificate showing the
appointment.
If a personal representative has been appointed, they must sign the return. If it is a joint return, the
surviving spouse also must sign the return and write in the signature area, “Filing as surviving spouse.”
If there is no surviving spouse and no personal representative has been appointed, the person in
charge of the decedent’s property must file an sign the return as “personal representative.”
2.3 The five filing statuses. Determining the correct filing status for a taxpayer is the first step in
preparing a tax return (or determining whether a return must be filed). The filing status must be known
before looking up filing requirements, the standard deduction or correct tax liability. It is also crucial in
determining if the taxpayer is eligible to claim certain credits and deductions.
It is possible for a taxpayer to qualify for more than one filing status. Generally the filing status that will
give them the lowest tax liability should be used.
The first step in deciding the filing status of a taxpayer is to determine whether they are married or
unmarried at the end of the tax year, and if unmarried, whether they maintain a household for a
qualifying dependent.
Filing Status for Unmarried Taxpayers
2.3a Single. A taxpayer may use the Single filing status if on the last day of the year they are not
married or legally separated from their spouse under a divorce or separate maintenance decree. If the
taxpayer is unmarried they will usually use the Single filing status unless they meet the tests for Head
of Household or Qualifying Widow(er).
If a taxpayer is married they cannot use the Single filing status (even if they qualify as unmarried for tax
purposes).
2.3b Head of Household. A taxpayer may use the Head of Household filing status if they meet all of
the following requirements:
•They are single or considered unmarried for tax purposes (as discussed previously);
•They paid more than half the cost of keeping up a home for the year;
•They have a qualifying individual who lived with them for more than half the year.
The taxpayer must be a U.S. citizen or resident for the entire year to qualify for the Head of Household filing
status.
Keeping up a home. To qualify for the Head of Household filing status, the taxpayer must have paid
more than half the cost of keeping up a home for the year. Costs of keeping up a home include
mortgage interest, rent, property taxes, utilities, maintenance and repair costs, insurance, food eaten in
the home, etc. Keeping up a home does not include any money spent on clothing, education, vacations
or transportation Also, do not include the rental value of the taxpayer’s home or the value of any
services provided by the taxpayer or other member of the household.
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Qualifying individual. Generally a qualifying individual for Head of Household filing status purposes
must be a relative of the taxpayer, they must live with the taxpayer for more than half the year, and they
must be a dependent of the taxpayer. The table on the following page will help determine who can be
considered a qualifying individual. Unless otherwise noted, the table assumes that the qualifying
individual lived with the taxpayer for over half the year.
Exceptions to the rule. As always in taxation, exceptions to the rules do exist. Below are the exceptions
to keep in mind when determining Head of Household filing status.
•A parent does not have to live with the taxpayer to qualify them for the Head of Household filing
status. If the taxpayer pays more than half the cost of keeping up a home that was the main home
for the entire year for their father or mother (including the cost of a rest home or other home for
the elderly), the parent will be considered a qualifying individual.
•The taxpayer’s single child does not have to qualify as a dependent if they lived with the taxpayer
for more than half the year.
•The taxpayer’s married child does not have to qualify as a dependent if they lived with the taxpayer
for more than half the year and the taxpayer could claim an exemption for the child except that
the child’s other parent claims the exemption under the special rules for a noncustodial parent.
A person cannot qualify more than one person to use the Head of Household filing status.
Temporary absences. When determining Head of Household filing status, temporary absences are
disregarded when calculating the amount of time the qualifying individual has lived with the taxpayer.
An absence is considered temporary if it is reasonable to expect the qualifying individual to return to the
taxpayer’s household and the taxpayer continues to maintain the household during the individual’s
absence. Examples of temporary absences include those due to illness, business trips, vacations,
military service, school, etc.
Relationship
Qualifying relative who is the
taxpayer’s father or mother
Qualifying child (such as the
taxpayer’s son, daughter or
grandchild who lived with the
taxpayer over half the year and
meets all of the other requirements)
Dependent exemption
Dependent exemption can be
claimed*
Dependent exemption cannot be
claimed
Dependent exemption cannot be
claimed
Child is single*
Child is married and dependent
exemption can be claimed
Child is married and dependent
exemption cannot be claimed*
Qualifying/Non-qualifying
Individual is a qualifying person
Individual is not a qualifying person
Individual is a qualifying person
Individual is not a qualifying person
Lived with the taxpayer for more than
half the year and dependent
Individual is a qualifying person
exemption can be claimed
Qualifying relative, not a parent
(such as a grandparent, brother or
sister) who meets certain other tests Did not live with the taxpayer more
than half the year
Individual is not a qualifying person
Taxpayer cannot claim an exemption
for the person
* An exception exists. See the notes on the preceding page.
** For additional information on qualifying child or qualifying relative, see Session 4.0
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2.3c Qualifying Widow(er). This filing status is available to taxpayers with a dependent child for two
years following the death of their spouse. For example, if the spouse died in 2011, the taxpayer can use
the Qualifying Widow(er) status for 2012 and 2013.
This filing status gives the taxpayer the ability to take advantage of the higher standard deduction
amounts and tax rates available to married taxpayers filing a joint return. Use of the Qualifying Widow
(er) status does not entitle the taxpayer to file a joint return.
Providing they haven’t remarried, the surviving spouse would file a joint (or separate) return with their
deceased spouse for the year of death.
To be eligible for the Qualifying Widow(er) filing status, the taxpayer must meet all of the following
criteria:
•They were entitled to file a joint return with their spouse for the year that the spouse died whether
or not they actually filed a joint return;
•They did not remarry before the end of 2011;
•They have a child, stepchild, adopted child or foster child for whom they can claim an exemption;
and
•They paid more than half the cost of keeping up a home that is the main home for the taxpayer
and qualifying child for the entire year. Temporary absences are disregarded.
Filing Status for Married Taxpayers
2.3d Married Filing Jointly. A taxpayer and spouse can choose to file a joint return if they are married
and both agree to file a jointly. They would then report all their income, expenses, deductions and
credits on the same return. A joint return is allowed even if one spouse had no income or deductions.
Generally filing joint return results in a lower tax liability, however in certain circumstances filing
separately may be more advantageous. The table on the following page gives some of the specific
advantages and disadvantages of married filing jointly versus married filing separately.
If one spouse is a nonresident alien, the taxpayer and spouse may file jointly only if they elect to be
taxed on their worldwide income.
A surviving spouse of a taxpayer who died during the year is considered to be married for the entire
year and they can elect to file a joint return with their deceased spouse for the year of death.
2.3e Married Filing Separately. A taxpayer and spouse can also choose to file separate returns. This
filing status may be beneficial to the taxpayer(s) if they want to be separately responsible for the tax
shown on their returns or if it results in a lower tax liability than a joint return.
If a taxpayer and spouse cannot agree to file a joint return, they may have to file separate returns.
Generally when a taxpayer files a separate return they would report only their own income, exemptions,
deductions or credits. However special rules apply in community property states.
Community property. In a community property state, the income and property acquired by a taxpayer
and spouse during their marriage is generally considered to be held equally by each spouse. Property
owned before marriage generally remains separate property and property received by a spouse during
the marriage as a gift or inheritance is generally separate property. If a husband and wife file separate
returns in a community property state, each spouse must report all of their separate income plus onehalf of the community income.
The nine community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico,
Texas, Washington and Wisconsin.
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Why choose Married Filing Jointly instead of Married Filing Separately?
•
•
•
•
•
•
•
•
•
Generally Married Filing Jointly results in a smaller tax liability for married taxpayers.
The tax rate for Married Filing Jointly is lower than Married Filing Separately;
Generally, taxpayers must file jointly to claim various credits such as the Child and
Dependent Care Credit, Credit for the Elderly and Disabled, the Hope of Lifetime
Learning Credit, the Adoption Credit or the Earned Income Credit;
Taxpayers cannot take a deduction for student loan interest or the tuition and fees
deduction if filing separate returns;
Roth IRA contributions generally cannot be made if filing separate return because of
low phase-out amounts;
The taxpayer cannot make a contribution to a spousal IRA for a non-working spouse
unless they file a joint return;
If they lived together at any time during the year, the taxpayers cannot convert a
traditional IRA to a Roth IRA unless filing jointly;
Also if they lived together at any time, they will probably need to include in income
more social security or railroad retirement benefits received than if they were to file a
joint return;
Other deductions or credits may be limited when using the Married Filing Separate
filing status.
Why choose Married Filing Separately instead of Married Filing Jointly?
•
•
•
•
•
•
In certain circumstances filing separate returns may result in a lower tax liability.
Filing separately may sometime allow taxpayers to avoid part or all of a reduction in
exemption amounts or certain itemized deductions due to income levels;
On a joint return, both taxpayers may be held responsible, jointly and individually, for
the tax and any interest or penalty due. One spouse may be held responsible for all
the tax due even if all the income was earned by the other spouse;
If the taxpayer and spouse have different tax years for reporting purposes;
One spouse is a nonresident alien and they do not make an election to be taxed on
their worldwide income;
If a couple has filed separate returns, they have three years from the due date of the
return (without regard to extensions) to change to a joint return. If a joint return is
originally filed, they may not change to separate returns after the due date has
passed
If a joint return is filed and one spouse owes a back tax debt, part or all of the refund
from the joint return can be taken to repay that dept, even if the only spouse that
worked had no debt. However, the taxpayers may elect to file Form 8379, Injured
Spouse Claim and Allocation to protect all or part of the refund.
2.4 The Presidential Election Campaign Fund. Beginning with tax year 1972, taxpayers have had the
opportunity to designate if part of their tax liability should go to a fund to help pay for presidential
election campaigns. The intent was to allow presidential candidates to access a large base of small
donors. However the participation rates have been low and steadily declining (from a high of 28.7% on
1980 returns to 10.6% in 2003). Through 1995 $894.1 million had been designated through the
checkmark program.
For taxpayers, checking the box doesn’t change their tax liability. Checking “yes” doesn’t add to their
balance due (or decrease their refund). Checking “no” doesn’t increase their refund (or reduce their
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balance due). Answering “yes” will simply earmark three dollars of their tax to be used in the campaign
fund.
2.5 Tax Preparer Filing Responsibilities. A tax preparer may rely in good faith upon information
furnished by the taxpayer or another adviser or third party, and is not required to independently verify or
review the items reported on tax returns to determine if they are likely to be upheld if challenged by the
IRS. However, according to the Internal Revenue Service, the tax return preparer must make
"reasonable inquiries" if the information appears to be incorrect or incomplete. A benchmark standard
for rules governing paid preparers is Treasury Department Circular 230, Regulations Governing the
Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries, and Appraisers
before the Internal Revenue Service. (See also Publication 470, Limited Practice without Enrollment).
Circular 230 also provides guidance on preparer responsibilities on retaining client records, preparer
penalties due to negligence or intentional disregard of rules. As of this writing, Circular 230 was being
substantially revised by the IRS.
2.6 Preparer Tax Identification Numbers (PTINs). Paid Tax Preparers must provide an identifying
number (social security number) on all tax returns prepared. In today’s society where identity theft is a
concern, individuals may apply for a Preparer Tax Identification Number (PTIN) if you are a paid tax
return preparer and you do not want to disclose your Social Security Number (SSN) on returns they
prepare. A PTIN meets the requirement of furnishing an identifying number on returns prepared. The
PTIN cannot be used in place of the Employer Identification Number (EIN) of the tax preparation firm.
Form W-7P, Application for Preparer Tax Identification Number is used to apply for a PTIN.
2.7 IRS Preparer Registration. IRS now requires that (almost) all paid professional preparers register
with IRS. In the future there will also be a competency exam administered by a third-party.
The steps to register with the IRS are as follows:
•
Step 1: Apply for or renew your PTIN.
•
Step 2: Pass a proficiency exam
•
Step 3: Complete Continuing Education Credits
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3.0 Income, Part 1
3.1 Income, Generally. In general, income is defined as money or other compensation that is received
as a result of work or investment. For federal income tax purposes, all income is subject to income tax
and is reported on the tax return unless specifically exempt or excluded by law.
3.2 Gross income. For tax purposes, gross income includes total worldwide income received in the
form of money, goods, property or services that is not specifically exempt from tax.
3.2a Earned income. Earned income is generally received for work or other services performed.
Examples of earned income include wages, tips, salaries, commissions, bonuses, etc. In this
chapter we will primarily be discussing earned income. Amounts earned by a child are taxable to the
child.
3.2b Unearned income. Unearned income is income that is not earned income. Examples of
unearned income include interest, dividends, pensions, royalties, alimony, unemployment
compensation, etc. Unearned income will be discussed later in the text.
Differentiating between earned income and unearned income is important when determining the
amount of certain credits or deductions.
3.2c Nontaxable income. Some income is specifically exempt from tax by law. Examples of
nontaxable income include child support, welfare benefits, worker’s compensation, gifts, certain military
benefits and allowances, etc. Generally nontaxable income is not reported on the tax return; however it
may be included in calculations to determine support of a dependent, household maintenance or the
amount of certain other types of income to be included in income.
3.2d Community income. If a taxpayer is married and lives in a community property state, half of any
income defined by state law as community income may be considered income of the spouse. Property
that is held separately before marriage generally remains separate property. Also, property that is
received during the marriage by one spouse as a gift or inheritance is generally considered to be
separate property.
3.3 Form W-2 – Wage and Tax Statement. Form W-2, Wage and Tax Statement is used by employers
to provide to their employees a record of their taxable compensation, plus other items such as federal
and state withholding, taxable fringe benefits, deferred compensation amounts, etc. Wages from Form
W-2 are usually reported on Form 1040, line 7. Except for some tax-free fringe benefits, almost
everything that an employee receives is taxable, including cash, property or services. Taxable
compensation includes (but is not limited to) wages, tips, salaries, vacation pay, severance pay, sick
pay, prizes or awards, commissions, bonuses, back pay, value of taxable fringe benefits, etc.
3.3a Constructive receipt of year-end paychecks. Employees use the cash method of accounting,
meaning they report all income in the year it is received and all expenses in the year that they are paid.
Constructive receipt of a paycheck means that the employee is required to report income that is
received, even if it has not yet been credited to their account. So if the employee received a paycheck
on December 31, 2011 they must report the income on their 2011 return, even if they received the
check after banking hours and could not cash or deposit the check. The income from the December 31
check should be reported on the 2011 Form W-2.
3.3b Substitute Form W-2. Employers are required to mail their employees a copy of their Form W-2
by January 31 of each year. If the taxpayer does not receive their W-2 within two or three days they
should contact their employer. If they still have not received their Form W-2 by February 15, they should
contact the Internal Revenue Service. They can then complete IRS Form 4852, Substitute for Form
W-2, Wage and Tax Statement. The form is completed and then copies should be made for each taxing
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authority that would get a copy of Form W-2. The taxpayer should sign the form after the photocopies
have been made so each copy has an original signature.
3.4 Other Types of Income. A taxpayer is required to include on their tax return all income received in
the form of money, property and services unless specifically excluded by law.
3.4a Alimony. Alimony is a payment to or for a former spouse under a divorce or separation
agreement. It does not include voluntary payments. To be alimony, a payment must meet certain
requirements. The table below summarizes the conditions that generally must be met for a payment to
qualify as alimony. Note: different rules apply to payments as part of a divorce agreement entered into
before 1985.
Alimony received is included in income by reporting it on Form 1040, line 11. (Money received as child
support is non-taxable.) Alimony that is paid is deductible by the payer as an adjustment to income on
Form 1040, line 31. Transfers between spouses incident to a divorce usually have no immediate
taxable consequences.
Alimony Requirements (Instruments Executed After 1984)
Payments ARE alimony if all of the following are Payments are NOT alimony if any of the following
true:
are true:
Payments are required by a divorce or separate Payments are not required by a divorce or separate
maintenance agreement.
maintenance agreement.
Payer and recipient spouse do not file a joint return Payer and recipient file a joint return together.
together.
Payment is in cash (including checks or money orders).Payment is:
• Not in cash
• A noncash property settlement
• Spouse’s part of community income, or
• To keep up the payer’s property
Payment is not designated in the divorce or separation Payment is designated in the instrument as not
agreement as not alimony.
alimony.
Spouses legally separated under a decree of divorce or Spouses legally separated under a decree of divorce or
separate maintenance are not members of the same separate maintenance are members of the same
household.
household.
Payments are not required after the death of the Payments are required after the death of the recipient
recipient spouse.
spouse.
Payment is not treated as child support.
Payment is treated as child support.
These payments are deductible by the payer and These payments are neither deductible by the payer
includible in income by the recipient.
nor includible in income by the recipient.
3.4b Allocated tips. Represents the difference between the reported tips of an employee and their
share of an amount figured by subtracting the reported tips of all employees from 8% of food and drink
sales. The employee’s share was figured based upon an agreed upon method or a method provided by
IRS regulations based on employees’ sales or hours worked.
Any amount of allocated tips shown in Box 8 must be reported on the employee’s tax return unless:
•The employee kept a daily tip record which was complete and accurate; or
•The employee’s tip record is incomplete; however it shows that their actual tips were more than the
tips reported to their employer plus the allocated tips.
If either scenario applies, the employee should report the actual amount of tips received on their return.
Any tips reported to their employer should already be included in the amount of wages shown in Box 1
of Form W-2.
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If the employee did not keep a daily tip record or if the amount reported to their employer plus the
allocated tips is less than their tip record, the difference must be added to the amount in Box 1 of Form
W-2 and included as wages on Line 7, Form 1040. Tips should be reported to the employer by the 10th
of the following month.
3.4c Social Security and Medicare tax on tips. Employees may also be responsible for paying any
Social Security and Medicare tax that remains uncollected at the end of the year. If the employee
reports their tips to their employer, the employer will attempt to withhold all the taxes owed on their
regular (hourly) wage plus any reported tips. Sometimes since the hourly wage of some tipped
employees is fairly low, the regular wage of a tipped employee is not enough to cover all the taxes
owed. Any uncollected taxes on wages or reported tips will be shown in Box 12 of Form W-2 with the
codes A (for uncollected Social Security tax) or B (uncollected Medicare tax). These amounts should be
included in the total tax amount on Line 61, Form 1040 and “uncollected tax” or “UT” should be written
on the dotted line.
If the employee is including unreported tips or allocated tips in addition to their Box 1 wages, they are
also responsible for paying the required Social Security and Medicare tax on these amounts. Form
4137, Social Security and Medicare Tax on Unreported Tip Income, is used to figure these taxes.
3.4d Bartering. If a taxpayer provides services in return for other goods or services, they must include
in income the fair market value of the property received. If the parties in the exchange have agreed in
advance as to the value of the services, that amount will be accepted unless it can be proved
unreasonable.
3.4e Bribes. Bribes received are includable in income.
3.4f Child support. Child support payments received are generally not required to be included in
income.
3.4g Court awards. Whether or not a court award must be included in income depends on why the
settlement was received. The following is a partial list of court awards that must be included on the tax
return as ordinary income:
•
Compensation for lost wages
•
Damages for patent or copyright infringement
•
Damages in a breach of contract suit
•
Back pay and damages for emotional distress settled under Title VII of the Civil Rights Act of
1964
•
Punitive damages
If the settlement is includible in income, any associated attorney fees and court costs awarded are also
taxed as ordinary income.
A court award of compensatory damages for physical injury or illness is nontaxable. If the taxpayer
receives money for emotional distress, they must include in income any amount awarded that was not
associated with a physical injury or illness. For example, if the taxpayer receives an award for
emotional distress that is due to employment discrimination, they must include that amount in income.
3.4h Debt cancellation. Generally if a taxpayer is relieved of an obligation to pay a debt, the amount
forgiven or cancelled must be included in income. However, several exceptions to this rule exist
including some debt cancelled in a Chapter 11 bankruptcy, qualified farm debt, or qualified real property
business debt. In addition the cancellation of debt attributable to certain student loans or to the extent a
taxpayer is insolvent may be excludible.
3.4i Direct seller party sales. Direct sellers will be covered later in the text, however if the taxpayer
hosts a party at which sales are made, the fair market value of any gifts received is taxable income. Any
related out-of-pocket expenses may be deductible as miscellaneous deductions on Schedule A (subject
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to the 2% limit). These expenses are also subject to the 50% limit for meal and entertainment expenses
and can only be deducted up to the amount of income received for giving the party.
3.4j Foster care payments. Payments received by a taxpayer from a government agency, or a
qualified foster care placement agency for providing foster care in their home are generally not
includible in income. However if the payment were received for the care of more than five individuals
age 19 or older and certain “difficulty of care” payments may be taxable. See Publication 17 for
additional information.
3.4k Found property. Found money or property that has been lost or abandoned is taxable to the
finder at its fair market value in the first year it is the taxpayer’s undisputed property.
3.5l Fringe benefits. Employer-provide fringe benefits may be taxable or tax-exempt depending on
circumstances. The most common tax-free employee benefits are highlighted below:
• Child or dependent care plans – The value of day care services provided or reimbursed by an
employer under a written, nondiscriminatory plan is tax free up to $5,000 ($2,500 if MFS).
Expenses are excludable if they qualify for the dependent care credit (discussed later in the text).
• De minimis fringe benefits – Minor benefits such as occasional employee meals, company parties,
or minor employee awards such as movie or sporting event tickets are tax free, as are discounts on
company products and services as long as the employer does not incur additional cost in providing
them to the employee.
• Education benefits – Up to $5,250 in employer financed undergraduate and graduate level courses
may be excluded from income.
• Employee achievement awards – Taxable unless they qualify for special rules for length of service
or safety awards.
• Group term life insurance – Not taxed if the policy coverage is $50,000 or less.
• Health and accident plans such as HSAs – Premiums paid by an employer are tax free. For 2012
employer contributions to a health savings account (HSA) are tax free up to $3,100 for individual
coverage or $6,250 for family coverage. Benefits under an employer plan are also generally tax
free.
• Transportation benefits – Within certain limits, employer provided parking benefits and
transportation passes such as bus passes are tax free.
• Working condition fringe benefits – Benefits provided by the employer that would be deductible if
paid by the employee are considered to be tax free working condition fringe benefits. Examples
include a company car or employer paid business subscriptions or dues.
3.4m Gambling Income. Gambling winnings are taxable. Losses that the taxpayer incurs in an
attempt to win are deductible only up to the extent that they report gambling winnings. Generally,
they cannot have a “loss” from gambling. Non-professional gamblers should include gambling
income on Form 1040, line 21 as “other income.” Allowed gambling losses are deducted on
Schedule A as a miscellaneous deduction not subject to the 2% income. Gambling winnings over a
certain amount may have taxes withheld and be reported on Form W-2G.
3.4n Gifts. Money or property received as a gift is generally not taxable to the recipient. However any
subsequent income generated by the property (such as interest, dividends or rent) would be considered
taxable income. Special rules and gift taxes may be imposed on the “giver” however.
3.4o Income from illegal sources. Generally income from illegal activities must be reported as income
on line 21, Form 1040, or on Schedule C if the activity is considered self-employment.
3.4p Inheritances. Money or property received as an inheritance is generally not taxable. However any
subsequent income generated by the property (such as interest, dividends or rent) would be considered
taxable income.
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3.4q Jury duty pay. Jury duty pay should be reported as income on Form 1040, line 21. If the taxpayer
must turn over their jury duty pay to their employer because their employer continues to pay their
regular salary while they serve on the jury, they may make an adjustment on line 36, Form 1040 for the
amount given to the employer. Enter “Jury Pay” and the amount on the dotted line next to line 36.
3.4r Life insurance proceeds. Life insurance proceeds received because of the death of the insured
person are generally not taxable unless the policy was turned over to the taxpayer for a price. If the
amount of the proceeds exceeds the amount payable at the time of the death of the insured, or for
additional information, see the section on Life Insurance Proceeds Publication 525.
3.4s Prizes. Prizes or awards received as a result of a lottery, drawing, quiz program, contest, etc.
must generally be reported as income on line 21, Form 1040. If the taxpayer refused to accept a prize,
the value is not included in income.
3.4t Rebates. Cash rebates received are generally not includible in income. However the basis of the
property purchased is reduced by the amount of the rebate.
3.4u Rent of personal property. Income received for the rent of personal property must be reported
on the tax return. If the taxpayer is in the business of renting personal property, they must generally
compete and file Schedule C, Form 1040 to report income and expenses. If the taxpayer is not in the
business of renting personal property, they must report any income on line 21, Form 1040. Any
expenses may be listed on line 36, Form 1040. Enter the amount and “PPR” on the dotted line next to
line 36. However, the amount of expenses deducted can not exceed the amount of income reported.
3.4v Royalties. Royalties are payments for the use of patents or copyrights or for the use of mineral
and gas deposits. Generally, royalties are taxable as ordinary income and are reported on Schedule E.
If the taxpayer is a self-employed writer/artist or owns an operating oil, gas or mineral interest, use
Schedule C rather than Schedule E.
3.4w Scholarships and fellowships. A candidate for a degree can exclude amounts received as a
qualified scholarship or fellowship. A qualified scholarship or fellowship is any amount received for:
• Tuition and fees; or
• Fees, books, supplies and equipment required for courses at the school.
Amounts received for room and board are generally not conceded to be excludible from income.
3.4x Sick Pay. Sick pay that an employee receives from their employer is generally considered to be
wages and is included in Box 1 of Form W-2. Sick pay received under an accident or health plan is
generally nontaxable.
3.4y Statutory Employee Earnings. A statutory employee is a special type of employee whose
earnings are subject to Social Security and Medicare withholding, but not to income tax withholding.
The amount of wages and any related expenses are reported on Schedule C, Profit or Loss From
Business. Certain life insurance salesmen are the most common examples of statutory employees.
3.4z Stolen property. The fair market value of property must be reported as income for the year of the
theft unless it is returned to its rightful owner in the same year. (Really)
3.4aa Stock options. If the taxpayer receives an option to buy or sell stock or other property as
payment for their services, they may have income when they receive the option (the grant), when they
exercise the option (use it to buy or sell the stock or other property), or when they sell or otherwise
dispose of the option or property acquired through exercise of the option. The timing, type, and amount
of income inclusion depend on whether they receive a non-statutory stock option or a statutory stock
option. Their employer can tell them which kind of option they hold. Generally for qualified incentive
stock options (ISOs), taxable income is not determined until the stock acquired from exercising the ISO
is sold. Different rules apply to nonstatutory (nonqualified) stock options.
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3.4bb Strike benefits. If a taxpayer receives cash or property from a union as payment of strike or
lockout benefits, they must include the value received in income unless they can show that the union
intended them as gifts.
3.4cc Unemployment Compensation. Generally all unemployment benefits received from a state or
federal agency are treated as taxable income. The taxpayer should receive Form 1099-G, Certain
Government Payments showing the amount of benefits received. Report the amount of unemployment
benefits on Line 19 of Form 1040, Line 13 of Form 1040A, or Line 3 of Form 1040EZ.
If the benefits are supplemental benefits paid from an employer-financed plan, the amount is treated as
wages and not reported as unemployment compensation. Benefits to a voluntary plan such as a private
or union fund are taxable as other income but only if the amount of benefits received exceed the
taxpayer’s contributions to the fund.
Repaid Unemployment Benefits. If the taxpayer received benefits and paid a portion of them back in
the same year, the amount of benefits repaid should be subtracted from the total received. The
difference is reported on the tax return as stated above. Include on the dotted line the word “repaid” and
the amount repaid.
If the taxpayer repaid unemployment compensation received and included in income in a previous year
the tax treatment depends on the dollar amount repaid.
•If the repayment was $3,000 or less, the amount is deducted on Line 23 of Schedule A, Itemized
Deductions. We will discuss Schedule A later in the course.
•If the repayment was more than $3,000 the taxpayer has the option of deducting the amount on
Schedule A, line 28 or they can choose to take a tax credit for the year of repayment if they
included the income under a claim of right. A claim of right means that at the time they included
the income it seemed that they had an unrestricted right to it. Figure the tax using both methods
and use the one that results in the least amount of tax.
•To determine the amount of the tax claiming a credit for the repaid amount:
1) Figure the tax for 2011 without deducting the repaid amount;
2) Refigure the tax from the earlier year without including in income the amount repaid in
2011;
3) Subtract the refigured tax from Step 2 from the original tax on the return for the original
year;
4) Subtract the difference (the amount of the credit) from the refigured tax in Step 1.
•If the credit results in a lower tax, the taxpayer should write the amount of the credit on Line 68 of
Form 1040 and write “IRC 1341” on the dotted line.
3.4dd Utility rebates. Generally the amount of any rate reduction or nonrefundable credit received
from a utility company is not taxable.
3.4ee Veterans benefits. Benefits paid under any law, regulation or administrative practice by the
Department of Veterans affairs are non taxable, including (but not limited to) education or training
allowances, disability compensation, grants for homes designed for wheelchair living, VA insurance and
dividends paid either to a veteran or beneficiary, interest on insurance dividends on deposit with the VA
or payments made under the compensated work therapy program. For more information on nontaxable
veterans benefits, see Publication 17.
3.4ff Workers’ Compensation. If payment for a work-related illness or injury is received under a
workers’ compensation act, the proceeds are fully tax exempt. This includes payments received by the
injured worker or, in the event of death, their survivors. However the exclusion does not apply to
retirement benefits based on age, length of service, or prior contributions, even if they were received
because the taxpayer retired because of a work-related illness or injury. Also, if any part of the workers’
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compensation benefits received reduces the taxpayer’s Social Security (or equivalent railroad
retirement benefits) received, that part is considered to be Social Security and may be taxable as such.
3.5 Moving Expenses. If the taxpayer moved due to a change in their job or business because they
started a new job, they may be able to deduct their moving expenses. To qualify for the moving
expense deduction, the taxpayer must satisfy two tests. Under the first test, the "distance test", their
new job must be at least 50 miles farther from their old home than their old job location was from their
old home. If they had no previous workplace, the new job must be at least 50 miles from their old home,
or if they are a member of the armed forces and the move was due to a permanent change of station
they also may qualify.
The second test is the "time test". If the taxpayer is an employee, they must work full-time for at least
39 weeks during the 12 months right after starting their new job. If the taxpayer is self-employed, they
must work full time for at least 39 weeks during the first 12 months and for a total of at least 78 weeks
during the first 24 months after starting their new job. There are exceptions to the time test in case of
death, disability and involuntary separation, among other things. For more information on qualifying to
deduct moving expenses please refer to Publication 521, Moving Expenses.
Moving expenses are figured on Form 3903 and deducted as an adjustment to income on Form 1040.
The taxpayer cannot deduct any moving expenses that were reimbursed by their employer.
3.6 Excess Social Security and Tier 1 RRTA Tax Withheld. If the taxpayer or spouse had more than
one employer for 2011 and total wages of more than $106,800, too much social security or tier 1
railroad retirement tax may have been withheld. They may take a credit on Line 67, Form 1040 for the
amount over $4,485.60. But if any one employer withheld more than $4,485.60, the taxpayer cannot
claim the excess on their tax return. The employer should refund the excess. If the employer does not
adjust the overwithheld amount, the taxpayer can file a claim for refund using Form 843.
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4.0 Standard Deduction & Exemptions
4.1 The Standard Deduction. The standard deduction is a dollar amount, based on filing status, age,
and blindness, which is subtracted from income when calculating the amount of tax liability. When
completing their return, a taxpayer generally has the option of taking their standard deduction or
itemizing their deductions. Itemized deductions are detailed on Schedule A and include medical
expenses, taxes, mortgage interest, charitable contributions, employee business expenses, etc. We will
be talking more about itemized deductions later in this course.
A taxpayer should generally choose the larger of their standard or their itemized deductions.
4.1a Standard Deduction Amounts. The standard deduction amount is based on the taxpayer’s filing
status. This amount may be increased if the taxpayer is age 65 or older or blind (add $1,450 each). Or
the amount may be lower if the taxpayer is claimed as a dependent on another person’s return. Each
year the standard deduction amounts are adjusted for inflation. For 2011 the standard deduction
amounts are:
•
Single or married Filing Separately - $5,800
•
Married Filing Jointly or Qualified Widow(er) - $11,600
•
Head of Household - $ 8,500
4.1b Not Eligible for Standard Deduction. Certain individuals are not eligible for the standard
deduction. Their standard deduction is considered to be zero and they should complete Schedule A and
itemize their deductions regardless of the amount.
Persons not eligible for the standard deduction include:
•
Taxpayers who are married, filing separate returns, and their spouse itemizes deductions;
•
Taxpayers who are filing a tax return for a short tax year because of a change in accounting
periods; or
•
Taxpayers who are nonresidents or dual-status aliens during the year.
4.1c Blindness, Defined. For the purposes of the higher standard deduction amount, a taxpayer will
qualify if they are totally or partly blind. If the taxpayer is partly blind, they must get a certified statement
from an eye doctor or registered optometrist that:
•
They cannot see better than 20/200 in the better eye with glasses or contact lenses; or
•
Their field of vision is not more than 20 degrees.
If their vision can be correct better than these limits only be wearing contact lenses that cause pain,
infection or ulcers, the taxpayer can take the higher standard deduction if they otherwise qualify.
4.1d Standard Deduction for Dependents. A person who can be claimed as a dependent on another
person’s tax return can not use the regular standard deduction. Their deduction is limited to the greater
of:
•
$950; or
•
The dependent’s earned income for the year, plus $300, not to exceed the regular standard
deduction amount, usually $5,800.
4.2 Personal Exemptions. Exemptions are subtracted from gross income before calculating tax.
exemption Generally, for 2011 a taxpayer can subtract $3,700 for each eligible exemption. A taxpayer
may take an exemption for himself (if no one else can claim him as a dependent), a spouse, and for
each person they may claim as a dependent. However, part of the dollar amount of these exemptions
may be lost if the taxpayer’s adjusted gross income is above a certain amount
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4.2a Taxpayer’s Exemption. A taxpayer may take an exemption for themselves unless someone else
is able to claim them as a dependent. If someone else qualifies to claim the taxpayer as a dependent,
they may not take a personal exemption for themselves, even if the other person chooses not to claim
them.
4.2b Spouse’s Exemption. On a joint return, the taxpayer may claim one exemption for
themselves and one exemption for their spouse. The spouse is never considered to be a dependent.
When filing a separate return, a taxpayer can claim an exemption for their spouse only if the spouse
had no gross income, is not filing a return, and can not be claimed as a dependent by another
person. If the taxpayer qualifies to use the head of household filing status, they may take an
exemption for their spouse as long as the same qualifications are met.
Death of a Spouse. If the taxpayer’s spouse died during they year they may generally still be
able to claim an exemption for the spouse, as long as the previous rules have been met.
However, if the taxpayer remarries during the year, they may not take an exemption for the deceased
spouse.
Interesting. If the taxpayer is a surviving spouse without gross income and they remarry in the year
that their spouse died, they can be claimed as an exemption on both the final separate return of
their deceased spouse and the separate return of their new spouse for that year. If they choose to
file a joint return with their new spouse, they can be claimed as an exemption only on that return.
Divorced or Separated Spouse. If the taxpayer obtained a final decree of divorce or separate
maintenance by the end of the year, they cannot take their former spouse’s exemption, even if they
provided all of the former spouse’s support.
4.2c Nonresident Aliens. Generally if the taxpayer is a nonresident alien (other than a resident
of Canada or Mexico, or certain residents of India or Korea), they can only qualify for a personal
exemption for themselves. They cannot claim exemptions for a spouse or dependents. However, this
rule does not apply if the taxpayer is a nonresident alien married to a U.S. citizen (or resident alien) and
they have chosen to be treated as a resident of the U.S. For more information on exemptions for
nonresident aliens, see chapter 5 in publication 519.
4.3 Dependent Exemptions. A taxpayer is allowed one exemption for each person they claim as a
dependent. They can claim an exemption for a dependent even if that dependent files a tax return. The
term "dependent" means either a "qualifying child" or a "qualifying relative."
4.3a Three Initial Tests. There are three initial tests that must be met when determining if a person can
be claimed as a dependent - either a qualifying child or qualifying relative.
1. Dependent Taxpayer Test. If the taxpayer (or spouse, if filing a joint return) can be claimed as a
dependent by another person, they cannot claim anyone else as a dependent.
2. Joint Return Test. Generally a married person cannot be claimed as a dependent if they files a joint
return. The joint return test does not apply if the proposed dependent and spouse file a return only to
get a refund and no tax liability would exist for either spouse on separate returns.
3. Citizen or Resident Test. To qualify as a dependent, a person must be a U.S. citizen or resident alien,
U.S. national or a resident of Canada or Mexico (an exception exists for certain adopted children).
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Overview of the Rules for Claiming a Dependent
•
A taxpayer can not claim an exemption for a dependent if they (or their spouse if filing a joint return)
could be claimed as a dependent by another.
•
A taxpayer cannot claim a married person who files a joint return as a dependent unless the joint
return is filed only to claim a refund and neither spouse would have a tax liability if they filed separate
returns.
•
A person cannot be claimed as a dependent unless, for some part of the year, they are a
U.S. citizen, U.S. resident, U.S. national or a resident of Canada or Mexico.
Tests for a Qualifying Child
Relationship. The child must be the taxpayer’s
son, daughter, stepchild, eligible foster child, brother,
sister, half-brother, half-sister, stepbrother, stepsister, or a
descent of any of the above.
Tests for a Qualifying Relative
Relationship or Member of Household. The
person must either be related to the taxpayer in
any of the ways listed under Relatives That Do
Not Have to Live With The Taxpayer or have lived
with the taxpayer all year as a member of their
household.
Age. The child must either be under age 19 at
Gross Income. The person’s gross income for
the end of the year and younger than the taxpayer (and
the year must be less than $3,700.
spouse if MFJ); under age 24 at the end of the year, a fulltime student and younger than the taxpayer (and spouse
if MFJ); or any age if permanently and totally disabled.
Support. The taxpayer must have provided
over half of the child’s support.
Support. The taxpayer must have provided
over half of the person’s total support for the year
(except in the case of a Multiple Support
Agreement).
Member of Household. The child must have
lived with the taxpayer for more than half the year,
excluding temporary absences.
Qualifying Child. The person cannot be the
taxpayer’s qualifying child or the qualifying
child of anyone else.
Qualifying Child of More Than One Person. If
the child meets the rules to be a qualifying child for more
than one person, the taxpayer must be the person
entitled to claim the child
4.3b Qualifying Child. Once the first three tests have been met, there are additional tests to further
determine if a person can be claimed as a dependent. If the following five tests are met, a person
can be considered a qualifying child and claimed as a dependent on the taxpayer’s return.
Q C 1 . Relationship. The child must be the taxpayer’s son, daughter, stepchild, eligible foster
child, brother, sister, half-brother, half-sister, stepbrother, stepsister or a descendent of any of them.
An adopted child is always treated as the taxpayers own child. The term “adopted child”
includes a child who was lawfully placed with the taxpayer for adoption.
An eligible foster child is a child who has been placed with the taxpayer by an authorized
placement agency, or by judgment, decree or order of the court.
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QC2. Age. The child must have been:
• Under age 19 at the end of the year and younger than the taxpayer (and spouse if the taxpayer is
filing a joint return);
• Under age 24 at the end of the year and a full-time student (and younger than the taxpayer and
spouse if the taxpayer is filing a joint return); or
• Any age if permanently and totally disabled at any time during the year.
A full-time student is a student who is enrolled for the number of hours, credits or courses that the
school considers to be full-time for any five calendar months of the year. To qualify, a school can
be an elementary, junior or senior high school, college, university or technical/trade school. It can not
be an on-the-job training course, correspondence school or internet school.
Permanently and totally disabled means that the child cannot engage in any substantial gainful activity
because of a physical and mental condition and a doctor has determined that the condition has lasted
or can be expected to last continuously for at least a year or can lead to death.
QC3. Support. The child cannot have provided more than half of their own support for 2011. To
help determine support, a worksheet is provided at the end of the chapter. (Note that the support
test for a qualifying child and the support test for a qualifying relative differ.)
QC4. Member of household. The child must have lived with the taxpayer for more than half of
2011. A child who was born or died during 2011 is considered to have lived with the taxpayer for
the entire year if they lived with the taxpayer for the entire time he or she was alive. Temporary
absences such as school, vacation, hospitalization count as time lived at home.
Children of divorced or separated parents. In most cases, because of the residency test, a
child of divorced or separated parents will be a qualifying child of the custodial parent.
For tax purposes, the custodial parent is the parent with whom the child lived for the greater
number of nights during the year. The other parent is the noncustodial parent. If the parents
divorced or separated during the year and the child lived with both parents before the separation,
the custodial parent is the one with whom the child lived for the greater number of nights during
the rest of the year.
A child is treated as living with a parent for a night if the child sleeps:
•
At that parent’s home, whether or not the parent is at home; or
•
In the company of the parent, when the child does not sleep at that parent’s home (for
example, if they are on vacation).
Same number of nights. If the child lived with each parent for an equal number of nights during
the year, the parent with the higher adjusted gross income is considered to be the custodial
parent.
Parent works at night. If, due to a parent’s nighttime work schedule, a child lives for a greater
number of days but not nights with the parent who works at night, that parent is treated as the
custodial parent. On a school day, the child is treated as living at the primary residence registered
at the school.
Temporary absences. If a child did not stay with either parent on a particular night (for example,
a sleep-over at a friend’s house or a summer camp), the child is treated as living with the parent
with whom they generally would have stayed for the night, except for the absence. If it cannot be
determined which parent the child would have been with, the child is treated as not living with
either parent that night.
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A child will be treated as the qualifying child of their noncustodial parent if all of the following are true:
1. The parents:
a. Are divorced or legally separated under a decree of divorce or separate maintenance;
b. Are separated under a written separation agreement; or
c. Lived apart at all times during the last six months of the year.
2. The child received over half of his or her support for the year from their parents.
3. The child is in the custody of one or both parents for more than half the year.
4. Either of the following applies:
•
The custodial parent signs Form 8332 or similar statement stating that he or she will not
claim the child as a dependent for the year and the noncustodial parent attaches it to their
return; or
•
A pre-1985 decree of divorce or separate maintenance or written separation agreement
between the parents that applies to 2011 states that the noncustodial parent can claim the
child as a dependent, and the noncustodial parent provided at least $600 for support of the
child during 2011.
Post-1984 and pre-2009 divorce decree or separation agreement. If the divorce decree or
separation agreement went into effect after 1984 and before 2009, the noncustodial parent may
be able to attach certain pages from the decree or agreement instead of Form 8332. The decree
or agreement must state all three of the following.
a. The noncustodial parent can claim the child as a dependent without regard to any
condition, such as payment of support.
b. The custodial parent will not claim the child as a dependent for the year.
c. The years for which the noncustodial parent, rather than the custodial parent, can claim
the child as a dependent.
The noncustodial parent must attach all of the following pages of the decree or agreement to his
or her tax return.
•
The cover page (write the other parent's social security number on this page).
•
The pages that include all of the information identified in items (1) through (3) above.
•
The signature page with the other parent's signature and the date of the agreement.
Post-2008 divorce decree or separation agreement. Beginning with 2009 tax returns, the
noncustodial parent can no longer attach pages from the decree or agreement instead of Form
8332 if the decree or agreement went into effect after 2008. The noncustodial parent will have to
attach Form 8332 or a similar statement signed by the custodial parent and whose only purpose
is to release a claim to exemption.
The noncustodial parent must attach the required information even if it was filed with a return in
an earlier year.
Revocation of release of claim to an exemption. For 2009 and 2010, new rules allow the
custodial parent to revoke a release of claim to exemption that the custodial parent previously
released to the noncustodial parent on Form 8332 or a similar statement. If the custodial parent
provides, or makes reasonable efforts to provide, the noncustodial parent with written notice of
the revocation in 2009, the revocation can be effective no earlier than 2010. The custodial
parent can use Part III of Form 8332 for this purpose and must attach a copy of the revocation
to his or her return for each tax year he or she claims the child as a dependent as a result of the
revocation.
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QC5. Qualifying Child of More Than One Person. Sometimes a child meets all of the tests to be
considered the qualifying child of more than one person. However, only one person may take
advantage of the tax benefits of a qualifying child. Additionally, that person should take all of the
benefits of claiming the child; they cannot be divided among more than one taxpayer.
When one or more individuals are eligible to claim a qualifying child, they may decide themselves
who will claim the child. If they are unable to decide, or more than one taxpayer files a return
claiming the same child, the IRS will disallow all but one of the claims using the tie-breaker rules
described in the chart below.
If:
Tie-Breaker Rule – When more than one person can claim a qualifying child
Then:
Only one of the persons is the child’s parent
Two of the persons are parents of the child,
and they do not file a joint return together
Two of the persons are parents of the child,
they do not file a joint return together, and the
child lived with each parent the same amount
of time during the year
None of the persons are the child’s parent
Only the parent can treat the child as a
qualifying child
The parent with whom the child lived with the
longest during the year can treat the child as a
qualifying child
The parent with the highest adjusted gross
income (AGI) can treat the child as a qualifying
child
The person with the highest AGI can treat the
child as a qualifying child
4.3c Qualifying Relative. If an individual does not meet the requirements to be a qualifying child,
the taxpayer may still claim a dependent exemption for them if they meet the tests to be considered
a qualifying relative. Note that unlike a qualifying child, a qualifying relative can be any age. There
is no age test for a qualifying relative.
There are four tests that must be met in order for a person to be a taxpayer’s qualifying relative:
1. The “not a qualifying child” test;
2. The member of household or relationship test;
3. The gross income test; and
4. The support test.
QR1. Not a Qualifying Child. A child cannot be a qualifying relative of the taxpayer if they are a
qualifying child of the taxpayer or anyone else. So a 22-year old daughter, who is a full-time
student, lives with the taxpayer and meets all of the other tests to be a qualifying child, cannot be
the qualifying relative of the taxpayer or any other person. However, a 30-year old child who lives
with the taxpayer may be a qualifying relative since they do not meet the age
requirements to be a qualifying child.
A child who lives in Canada or Mexico may be a qualifying relative of the taxpayer and they
may be able to claim the child as a dependent. If the child does not live with the taxpayer, they
do not meet the residency test to be a qualifying child. If the person(s) with whom the child
does live are not U.S. citizens and have no U.S. gross income, they are not “taxpayers” so the
child is not a qualifying child of any other individual and may be considered the qualifying relative of
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the taxpayer if the other tests are met. The taxpayer cannot claim as a dependent a child who lives in
a foreign country other than Mexico or Canada unless the child is a U.S. citizen, U.S. resident
alien, or U.S. national for some part of the year.
QR2. Member of Household or Relationship. The individual must have either been a member
of the taxpayer’s household for the entire year or be related to the taxpayer (or spouse) in one of
ways below.
Persons who do not have to live with the taxpayer to be a Qualifying Relative
• Child, stepchild, eligible foster child, or a descendent of any of them
• Brother, sister, half-brother, half-sister, stepbrother, or stepsister
• Father, mother, grandparent, or other direct ancestor, but not foster parent
• Stepfather or stepmother
• The son or daughter of the taxpayer’s brother or sister
• A brother or sister of the taxpayer’s father or mother
• Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, sister-in-law
If the taxpayer files a joint return, the person can be related to either the taxpayer or spouse. The
person does not need to be related to the spouse who provides the support.
QR3. Gross Income Test. To be considered a qualifying relative, a person must have gross income
for the year of less than $3,700.
Gross income, defined. Gross income includes all income in the form of money, property and services
that is not exempt from tax.
Gross income from rental property are gross receipts. Expenses such as taxes, repairs, etc. are not
deducted when determining gross income. Gross income from manufacturing, merchandising, or
mining is total net sales minus the cost of goods sold plus any miscellaneous income from the
business.
Gross income also includes unemployment compensation and certain scholarships (if required to be
reported as income). It does not include tax- exempt income such as most social security benefits.
Q R 4 . Support Test (Qualifying Relative). The taxpayer generally must provide over half of
the total support of a person during the year. If two or more persons provided support, but no one
person provided over half, the persons who provided support can agree that one of them who
provided over 10% of the persons support can claim an exemption for the exemption. To do this,
each of the others must sign a multiple support declaration. Form 2120 can be used for this purpose.
See also Multiple Support Agreement at the end of this chapter.
Total Support. Total support includes amounts spent to provide food, lodging, clothing, education,
medical and dental care, recreation, transportation and other similar necessities. Generally, the
amount of an item of support is the amount of the expenses incurred in providing the item. For
lodging, the amount of support is the fair rental value of the home, including a reasonable allowance for
the use of furniture and appliances plus any amount for gas, electricity and other utilities that are
provided. Any expenses that are not directly related to any one member of the household (such as
the cost of the food for everyone) must be divided among the members of the household.
Fair Rental Value is considered to be the amount that the taxpayer could reasonably expect to receive
from a stranger for the same kind of lodging. A person living in their own home is considered to have
contributed the fair rental value of the home toward their own support.
Medical Benefits Received including basic and supplemental. Medicare benefits are not considered
to be support.
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Child Care Expenses paid by the taxpayer can be included in the amount provided for the support of
a child or disabled dependent even if they claim a credit for these payments.
Do Not Include in Total Support: The following are not included in total support:
Federal, state and local income taxes paid by persons out of their own income
•
Social security and Medicare taxes paid by persons out of their own income
•
Life insurance premiums
•
Funeral expenses
•
Scholarships received by a child if the child is a full-time student
•
Survivors’ and Dependents’ Educational Assistance payments used for the support of the
child who receives them.
A qualifying relative’s own funds are not support unless they are actually spent for support. For
example, the taxpayer’s mother received $2,400 in social security benefits and $300 in interest income.
She paid $2,000 for housing and $400 for recreation. The $300 remained in her savings account. Even
though the mother received a total of $2,700, she spent only $2,400 for her support. If the taxpayer
spent more than $2,400 for her support and no other support was received, the taxpayer paid more
than half of her support.
Also, when determining support, include tax-exempt income, savings and borrowed amounts used to
support that person (even though tax-exempt income is not used to determine if the gross income test
has been met).
Social security benefits. If a husband and wife each receive benefits that are paid by one check
made payable to both of them, half of the total amount paid is considered to be for the support of each
spouse unless they can show otherwise.
If a child received social security benefits and uses them toward his or her support, the benefits
are considered to be paid by the child.
Benefits provided by the state to a needy person (such as food stamps, housing, welfare, etc.) are
generally considered to be support provided by the state unless it can be shown that part of the
payments were not used for that purpose.
Foster care payments. Payments that the taxpayer receives for the support of a foster child from a
child placement agency are considered to be support provided by the agency. Support received for the
support of a foster child from a state or county are considered support paid by the state or county.
If the taxpayer is not in the trade or business of providing foster care and their unreimbursed out-ofpocket expenses in caring for a foster child were mainly to benefit an organization qualified to
receive deductible charitable contributions, the expenses are deductible as a charitable contribution.
Any amount considered to be a charitable contribution is not considered to be support provided by
the taxpayer.
4.4 Multiple Support Agreements. Sometimes no one person provides more than half of the
support of a person. Instead, two or more persons (who each provide more than 10% of total
support) together provide more than half of the person’s total support. Each must be able to take the
exemption except for the support test.
When this happens, the individuals who provide the support can agree that any of them who
individually provides more than 10% of the person’s support can claim the exemption for the
individual. Each of the others must sign a statement agreeing not to claim the exemption for that
year. The person who claims the exemption must keep these signed statements for their records.
Form 2120 Multiple Support Declaration or similar statement identifying each of the others who
4.0 Standard Deduction & Exemptions
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agreed not to claim the exemption must be attached to the return of the person claiming the exemption.
Example: The taxpayer, a sister and two brothers provides most of the support for their mother for
the year. The taxpayer provides 45%, the sister provides 35% and the brothers each provide 5%.
Both the taxpayer and the sister qualify to claim the mother’s exemption, except for the support test.
One of them can claim the exemption; one of them must sign a statement agreeing not to take an
exemption for the mother. Since neither brother provides more than 10% of the support, neither can
take the exemption and neither has to sign the statement.
4.5 Exemption Phase-out. New for 2010, the taxpayer will not lose part/all of their deductions for
personal exemptions and itemized deductions no matter how high their adjusted gross income is.
4.6 Filing Requirements for Most People. Generally, a person must file a federal income tax return if
they are a citizen or resident of the United States or a resident of Puerto Rico and they meet the
minimum filing requirements. Most individuals determine their minimum filing requirements based on
their filing status and age. However, special rules apply for dependent taxpayers, children under age
18, self-employed persons and aliens.
4.6a Individuals, generally. A taxpayer who is a U.S. resident must file a tax return if their gross
income exceeds the minimum filing requirements based on their filing status and age. The table below
illustrates these general filing requirements for 2011.
Filing Status
Single
Age at the end of 2011
Gross income at least
Under age 65
$9,500
65 or older
$10,950
Both spouses under 65
$19,000
One spouse 65 or older
$20,150
Both spouses 65 or older
$21,300
Married filing a separate return
Any age
$3,700
Head of household
Under age 65
$12,200
65 or older
$13,650
Under age 65
$15,300
65 or older
$16,450
Married filing a joint return
Qualifying widow(er)
Note that basically a taxpayer must file a return if their gross income exceeds their standard deduction plus their
exemption amounts.
4.6b Dependent taxpayers, generally. If the taxpayer is a dependent, see the table on the following
page to determine if they must file a return. Generally a child is responsible for filing their own tax return
and for paying any tax on the return. But if a dependent taxpayer cannot file for any reason (including
age), then a parent, guardian or legally responsible person must file the return. If the child cannot sign
the return, the parent or guardian must sign the child’s name, followed by the words “By (parent’s
signature), parent for minor child.”
4.6c Self-employed individuals. An individual who is self-employed must file a return if their gross
income is at least as much the filing requirement amount for their filing status and age as shown above.
Also, they must file Form 1040 and Schedule SE if their net earnings from self-employment were $400
or more. Self-employed taxpayers and Schedule SE will be discussed in greater detail later in this
course.
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4.6d Other situations where a taxpayer should file a return. Even if a taxpayer is not required to file
a return, they may file to get money back if any of the following apply:
• They had federal income tax withheld or made estimated tax payments.
• They qualify for the Earned Income Credit.
• They qualify for the Additional Child Tax Credit.
• They qualify for the refundable American Opportunity education credit
• They qualify for the Health Coverage Tax Credit.
• They qualify for the Refundable Credit for Prior Year Minimum Tax.
4.6e Other situations where a taxpayer must file a 2011 return. If any of the four conditions apply
listed below, the taxpayer must file a federal tax return, even if their income is less than the minimum
filing requirements.
1. They owe any special taxes, such as:
a. Social security or Medicare tax on tips not reported to their employer.
b. Social security or Medicare tax on wages received from an employer who did not
withhold these taxes.
c. Uncollected social security, Medicare or railroad retirement taxes on tips reported to their
employer.
d. Uncollected social security, Medicare or railroad retirement taxes on group term life
insurance (shown in Box 12 of Form W-2)
e. Alternative minimum tax
f.
Additional tax on a qualified retirement plan or IRA.
g. Additional tax on an Archer MSA or health savings account
h. Additional tax on a Coverdell ESA or qualified tuition program
i.
Recapture of an investment credit or low-income housing credit
j.
Recapture tax on the disposition of a home purchased with a federally subsidized
mortgage
k. Recapture of the electric vehicle credit
l.
Recapture of an education credit
m. Recapture of the Indian employment credit
n. Recapture of the new markets credit
2. They received any advance earned income credit (usually shown in box 9 of Form W-2)
3. They had net earnings from self-employment of at least $400
4. They had wages of $108.28 or more from a church or qualified church-controlled organization
that is exempt from employer social security and Medicare tax
4.7 Alternative Minimum Tax. The tax law gives special treatment to some kinds of income and allows
special deductions and credits for certain expenses. Taxpayers who benefit from tax law may have to
pay at least a minimum amount of tax through an additional (supplemental) tax called the Alternative
Minimum Tax (AMT). The taxpayer may be subject to AMT if their taxable income for regular tax
purposes, combined with certain adjustments and tax preference items is more than $37,225 (MFS),
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$48,450 (S, HH), or $74,450 (MFJ or QW). The Alternative Minimum Tax is calculated on Form 6251.
Those taxpayers subject to AMT may qualify for a tax credit in the following tax year.
4.8 Members of the Clergy. Special rules apply for certain income and expense items for members of
the clergy or religious orders such as social security calculation and housing allowances. For more
information, see our seminar on Clergy Income or IRS Publication 517, Social Security and Other
Information for Members of the Clergy and Religious Workers.
4.9 Penalties for Delinquency or Failure to File. The IRS can (and will!) impose a penalty on late or
non-filed returns or returns with a substantial understatement. Additional penalties may be assessed for
understating a reportable transaction, an erroneous claim or refund or credit, filing a frivolous return or
failure to provide a SSN or individual taxpayer identification number. If the taxpayer provides fraudulent
information on their return, they may also face criminal or civil fraud penalties.
• Filing late – Returns not filed by the due date (including extensions) may be subject to a penalty of
5% for each month or part of a month the return is late, but not more than 25%. The penalty is
based on the tax not paid by the due date (not including extensions). If the return is more than 60
days after the due date or extended due date, the minimum penalty is the smaller of $100 or 100%
of the unpaid tax. A failure to file due to fraud is subject to a penalty of 15% for each month or part
of a month the return is late, up to a maximum of 75%.
• Paying late – A failure to pay penalty of ½ of 1% (.50%) is imposed on unpaid taxes for each
month, or part of a month after the due date that the tax is not paid. The penalty does not apply
during the automatic 6-month extension of time to file period if at least 90% of the actual tax liability
was paid on or before of the due date and the balance was paid when the return was filed. The
monthly rate is reduced in half (.25%) if an installment agreement is in effect for that month. The
return must have been filed by the due date (including extensions) for the reduced penalty to apply.
o
Increased penalties may be imposed if a notice of intent to levy is issued or a notice and
demand for immediate payment is issued.
o
If both the failure to file and failure to pay penalties both apply in the same month, the
5% (or 15%) penalty for failure to file is reduced by the failure to pay penalty.
• Accuracy related penalties – The taxpayer may be subject to penalties if they were negligent or
intentionally disregard the tax laws or they substantially understate their tax. An understatement of
tax is substantial if it is more than the larger of 10% of the correct tax or $5,000. However
exceptions to the understatement penalties apply to the extent that the understatement is due to
substantial authority or the taxpayer has adequately disclosed their position and has a reasonable
basis for such position. The penalty is equal to 20% of the underpayment.
• Frivolous tax positions – The taxpayer may have to pay a penalty of $5,000 if they file a frivolous
tax return. A frivolous return is one that does not include enough information to figure the correct
tax or that contains information clearly showing that the tax reported is incorrect.
• Fraud – Any underpayment of tax due to fraud may be subject to a penalty of 75% of the
underpayment.
• Failure to supply an identifying number – If the taxpayer does not include their SSN or SSN of
other person required on a return they will be subject of a $50 penalty for each failure. They will
also be subject to a $50 penalty if they do not give their SSN to another person when it is required
on a return, statement or other tax document. In addition, if they do not provide their SSN to an
institution such as a bank, they may be subject to “backup” withholding of income tax.
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5.0 Credits
5.0 Credits vs. Deductions. A deduction reduces taxable income, while a credit reduces the
taxpayer’s tax itself dollar for dollar. A $500 credit however can potentially save the taxpayer up to $500
in tax. Occasionally a taxpayer may not get the full benefit of a credit, such as in the case of a
nonrefundable credit when the tax liability has already been reduced to zero.
5.1 Nonrefundable vs. Refundable Credits. A nonrefundable credit can reduce the taxpayer’s tax
liability only to zero. The taxpayer will not get an increased refund if the amount of the credit is greater
than their tax liability. Most credits are nonrefundable.
A refundable credit is treated in the same way as tax payments. If the amount of the refundable credits
(plus any other tax withheld) is greater than the tax liability, the excess will be refunded to the taxpayer.
Refundable credits include the Earned Income Credit, the Additional Child Tax Credit, Excess Social
Security Tax Withheld, the Credit for Federal Tax Paid on Fuels, and the Health Coverage Tax Credit
and credit for certain taxes paid by regulated investment companies (RICs) or real estate investment
trusts (REITs).
5.2 The Earned Income Tax Credit. The earned income credit (EITC or EIC) is a tax credit for certain
people who work and have earned income under $49,078 MFJ in 2011. In order for the taxpayer to
receive their EIC, they must qualify for the credit and file a return even if they are otherwise not required
to file.
5.2a Rules for Everyone. To claim the Earned Income Credit, the taxpayer must meet certain rules.
They must meet all of the rules below, then depending on whether or not the taxpayer has a qualifying
child (discussed later), they must meet other rules detailed later.
EIC1. Adjusted Gross Income. The taxpayer must have adjusted gross income (AGI) less than:
•
$43,998 ($49,078 married filing joint) if the taxpayer has three or more qualifying children;
•
$40,964 ($46,044 married filing joint) if the taxpayer has two or more qualifying children;
•
$36,052 ($41,132 married filing joint) if the taxpayer has one qualifying child; or
•
$13,660 ($18,740 married filing joint) if the taxpayer does not have a qualifying child.
EIC2. Social Security Number. The taxpayer must have a valid social security number. In addition,
any qualifying children listed on the return must have a valid social security number. If the taxpayer’s
social security card says “not valid for employment” the taxpayer is not eligible for the earned income
credit. If the card reads “Valid for work only with INS authorization” or “Valid for work only with DHS
authorization,” the taxpayer has a valid SSN.
If the taxpayer is eligible for an SSN, they may apply for one by filing Form SS-5 with the Social
Security Administration. If the taxpayer is eligible for, but does not have a number by the filing deadline,
they have two choices:
•
They can file the return on time without claiming the EIC and submit an amended return when
they get a SSN; or
•
They can request an extension of time to file a return (Form 4868) and file the original return
when they get a SSN.
EIC3. Filing Status. The taxpayer cannot use the Married Filing Separate filing status. Remember, if
the taxpayer is married and did not live with their spouse any time during the last six months of the
year, they may possibly qualify for the head of household filing status.
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EIC4. Residency. The taxpayer must be a U.S. citizen or resident alien for the entire year. The
taxpayer cannot claim the earned income credit if they are a nonresident alien for any part of the year
unless they are married to a U.S. citizen or resident alien and choose to be treated as a resident for all
of 2011 by filing a joint return. For more information, see Publication 519, U.S. Tax Guide for Aliens.
EIC5. Foreign Income. The taxpayer cannot file Form 2555 (Foreign Earned Income) or Form 2555EZ (Foreign Earned Income Exclusion). For more information on these forms, see Publication 54, Tax
Guide for U.S. Citizens and Resident Aliens Abroad.
EIC6. Investment Income. The taxpayer cannot have more than $3,150 in investment income.
Generally, investment income is the total of taxable interest, tax-exempt interest, dividend income plus
net income from capital gains. If the taxpayer has income or loss from the rent of personal property or is
filing Schedule E, Form 8814 or Form 4797, they will need to complete Worksheet 1 shown at the end
of the chapter to determine their investment income.
EIC7. Earned Income. The taxpayer (or spouse, if filing a joint return) must work and have earned
income. It is not necessary for both spouses to have earned income to qualify for the credit.
5.2b How to Determine Earned Income. Earned income generally includes wages, tips and other
taxable employee income, or net income from self-employment. Earned income of an employee is
generally taxable and does not include nontaxable employee items such as certain dependent care
benefits, adoption benefits or contributions to a deferred compensation plan.
Special rules apply to those taxpayers who are self-employed, statutory employees or members of the
clergy or church employees who file Schedule SE. Those taxpayers are required to complete a special
worksheet to determine the amount of their earned income credit.
5.2c Nontaxable Combat Pay and the EIC. A taxpayer may elect to have their nontaxable combat pay
considered to be earned income for the purposes of the EIC. Figure the credit both with and without the
combat pay amount before making the election. If a taxpayer and spouse both have nontaxable combat
pay, they may each make their own election. However, if they make the election they must include all
the nontaxable combat pay as earned income. Nontaxable combat pay should be shown on Form W-2,
box 12, code Q.
Electing to include nontaxable combat pay in earned income may increase or decrease the EIC.
Whether the election increases or decreases your EIC depends on total earned income, filing status,
and number of qualifying children.
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For the purposes of the EIC, earned income includes the following:
Earned Income
Unearned Income
Wages, salaries, tips and other income earned as an
employee
Interest and dividends
Net earnings from self-employment
Pensions and annuities
Gross income earned as a statutory employee
Long-term disability benefits received prior to minimum
retirement age (unless the taxpayer paid the premiums for
the policy)
The rental value of a home or a housing allowance
provided to a minister as part of the minister’s pay.
Exception, if the minister has an approved Form 4361 or
Form 4029 the amount of his/her housing allowance is not
considered earned income for the purposes of the EIC.
Social security and railroad retirement benefits
Union strike benefits paid by a union to its members
Workers’ compensation benefits
Nontaxable combat pay*
Unemployment compensation
Alimony and child support
In a community property state, earned income for
the purposes of the EIC does not include any
amounts earned by a spouse even though the
taxpayer may be required to report this amount
as income when filing a separate return.
Nontaxable foster care payments
Veterans’ benefits including VA rehabilitation
payments
Amounts received for work performed while an
inmate in a penal institution
Welfare or workfare payments benefits
Nontaxable military pay such as combat pay*, the
Basic Allowance for Housing (BAH), and the
Basic Allowance for Subsistence (BAS).
* See the discussion about nontaxable combat pay above.
5.2d Rules if the Taxpayer has a Qualifying Child. If the taxpayer has met all of the rules in Part 1
and the taxpayer has a qualifying child (discussed below), they must meet all of the following rules to
be eligible for the EIC.
5.2e Qualifying child, defined. A child may be considered to be a qualifying child for the purposes of
the EIC if they meet three tests:
1. Relationship;
2. Age; and
3. Residency
EIC1. Relationship. To be a qualifying child, a child must be the taxpayer’s:
•
Son, daughter, stepchild, eligible foster child or a descendent of any of the above; or
•
Brother, sister, half brother, half sister, stepbrother, stepsister, or a descendent of any of the
above.
For the purposes of the EIC, a child is an eligible foster child if they have been placed with the
taxpayer by an authorized placement agency or by court order.
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If the taxpayer’s child was married at the end of the year, they do not meet the relationship test
unless:
•
The taxpayer claims the child’s exemption; or
•
The taxpayer is eligible to claim the child as a dependent, but does not because they
gave the right to the child’s other parent.
A legally adopted child is treated as the taxpayer’s own child.
EIC2. Age. To be a qualifying child, the taxpayer’s child must fall under one of the following three
categories:
• They are under age 19 at the end of 2011 and younger than the taxpayer (or spouse if married filing
jointly).
• They are a full-time student under age 24 at the end of 2011 and younger than the taxpayer (or
spouse if married filing jointly). A full-time student is a student who is enrolled for the number of
hours or courses that the school considers full-time during some part of any five months during the
year. The five months do not have to be consecutive.
A school can be an elementary school, junior or senior high school, college, university, technical, trade
or mechanical school. However, on-the-job training courses, correspondence schools and schools
offering courses only through the internet do not count as schools for the purposes of the Earned
Income Credit.
• Permanently and totally disabled at any time during 2011 (regardless of age). To be considered
permanently and totally disabled, the child cannot be able to engage in any substantial gainful
activity because of a physical or mental condition and a doctor has determined the condition has
lasted or can be expected to last continuously for at least a year or can lead to death.
EIC3. Residency. To be a qualifying child, the child must have lived with the taxpayer in the United
States more than half of 2011. The United States includes all 50 states plus the District of Columbia. It
does not include Puerto Rico or U.S. possessions.
If the child is away from home on a temporary absence due to a special circumstance, that time is
considered time lived with the taxpayer. Examples include illness, school, business, vacation, military
service or detention in a juvenile facility.
5.2f. The qualifying child cannot be used by more than one person to claim the EIC. If more than
one person has the same qualifying child, they must decide who will take all of the following benefits
associated with that qualifying child:
•
The child’s exemption
•
The child tax credit
•
Head of household filing status
•
The credit for child and dependent care expense, and
•
The earned income credit.
They cannot “mix and match” individual benefits of claiming the child. For example, one person cannot
claim the exemption for the child and the other claim the child tax credit.
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If more than one person has the same qualifying child and they cannot agree on who will claim the tax
benefits associated with the child, the “tie-breaker rule” will apply. The following chart details the tiebreaker rules.
Tie-Breaker Rule – When more than one person can claim a qualifying child
If:
Then:
Only one of the persons is the child’s parent
Only the parent can treat the child as a qualifying child
Two of the persons are parents of the child, and
they do not file a joint return together
Two of the persons are parents of the child, they do
not file a joint return together, and the child lived
with each parent the same amount of time during
the year
None of the persons are the child’s parent
The parent with whom the child lived with the longest during
the year can treat the child as a qualifying child
The parent with the highest adjusted gross income (AGI) can
treat the child as a qualifying child
The person with the highest AGI can treat the child as a
qualifying child
5.2g Special rules for divorced or separated parents. Special rules apply for claiming exemptions
and credits when the qualifying child’s parents are divorced or separated. For additional information see
Publication 17, Chapter 36 for more information.
5.2h The taxpayer cannot be a qualifying child of anyone else. If the taxpayer is the qualifying child
of another, they cannot claim the EIC, even if the person for whom they are a qualifying child cannot (or
chooses not) to claim the credit. Put “NO” beside line 64, Form 1040 if this situation applies. The
taxpayer is a qualifying child of another if they meet the relationship, age and residency tests specified
in Part 2.
5.2i Rules if the Taxpayer Does Not Have a Qualifying Child. The taxpayer must meet all four of the
following rules to claim the EIC if they do not have a qualifying child.
EIC1. Age test. The taxpayer (or spouse, if filing a joint return) must be at least age 25 but under age
65. The taxpayer (or spouse, if filing a joint return) must be at least age 25 but less than age 65 at the
end of 2011. If filing a joint return, it does not matter which spouse meets the age test as long as one of
them does.
EIC2. Dependent Taxpayer test. The taxpayer (and spouse, if filing a joint return) cannot be the
dependent of another person. If the taxpayer (and spouse, if filing a joint return) can be claimed as a
dependent of another, they cannot claim the EIC. This is true even if the other person is eligible to claim
the taxpayer but chooses not to.
EIC3. Not a Qualifying Child test. The taxpayer (and spouse, if filing a joint return) cannot be the
qualifying child of another person. If the taxpayer is the qualifying child of another, they cannot claim the
EIC, even if the person for whom they are a qualifying child cannot (or chooses not) to claim the credit.
The taxpayer is a qualifying child of another if they meet the relationship, age and residency tests
specified in Part 2.
EIC4. Residency test. The taxpayer (and spouse, if filing a joint return) must have lived in the United
States for more than half of the year.
If any of the previous statements are true, the taxpayer cannot claim the earned income credit. Put
“NO” next to line 64a, Form 1040.
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5.2j EIC Claimed Improperly in Prior Year. If the taxpayer had their earned income credit denied or
reduced for a reason other than a math or clerical error for any year after 1996, they may need to
complete an additional form to claim the EIC.
Form 8862. If the taxpayer’s EIC was denied or reduced for any year after 1996 for any reason other
than a math or clerical error, the taxpayer must complete and attach Form 8862 to their next return to
be able to claim the Earned Income Credit. However, the taxpayer does not have to file Form 8862 if
either of the below are true:
1. After their EIC was reduced or disallowed in the earlier year, they:
a. Filed Form 8862 in a later year and they received their EIC in the later year; and
b. Their EIC has not been reduced or disallowed again for any other reason other than a
math or clerical error.
2. They are taking the EIC in the current year without claiming a qualifying child and the only
reason their EIC was reduced or disallowed in the earlier year was because the IRS determined
that a child listed on Schedule EIC was not a qualifying child.
If the taxpayer is required to attach Form 8862 to their return and does not, their claim will be
automatically denied.
If the IRS denies the EIC for the taxpayer and it is determined that the error was due to “reckless or
intentional disregard” of the rules, the taxpayer will not be able to claim the credit for the next two tax
years. If the error was due to fraud, the taxpayer cannot claim the credit for the subsequent 10 years.
5.2k Advance Earned Income Credit Payments. After 2010, the taxpayer can no longer get advance
payments of the credit in their pay during the year as they could in 2010 and earlier years. However, if
the taxpayer is eligible, they will still be able to claim the credit on their return.
5.2l Paid Preparer Responsibilities and the Earned Income Credit. Paid tax preparers who do
returns or claims for refund involving the Earned Income Credit must meet due diligence requirements
in determining if the taxpayer is eligible for, and the amount of, the EIC. Failure to do so could result in
a penalty of $500 per return. Form 8867 was designed to ensure that the paid preparer considered all
the requirements necessary when preparing an EIC return. It contains 19 questions which the preparer
is expected to ask their client when preparing the return.
The IRS actually considers paid preparers to be partners in helping families claim the correct amount of
EIC. The number of families that claim EIC is high, and the number of erroneous claims is also high.
The IRS estimates an error rate of 23 to 28 percent, or $11 to $13 billion paid out in error.
There are four due diligence requirements for tax professionals. Generally if you prepare returns with
the EITC, you must not only ask all the questions to get the information required on Form 8867, but you
must also ask additional questions when the information your client gives you seems incorrect,
inconsistent or incomplete.
The four due diligence requirements are:
•
Complete and submit Form 8867, Paid Preparer’s Earned Income Credit Checklist
•
Calculate the amount of the EITC
•
The “Knowledge” Requirement
•
The “Recordkeeping” Requirement
The Paid Preparer Due Diligence Requirements are discussed in greater detail at the end of this
chapter.
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5.3 The Child Tax Credit. The child tax credit is a credit that can reduce the amount of tax by up to
$1,000 per child. This credit is a nonrefundable credit, so if the taxpayer has a zero tax liability they will
not be able to take advantage of this credit. However, they may qualify for the additional child tax credit,
discussed later in this chapter.
To claim the child tax credit, the taxpayer must have a qualifying child.
5.3a Qualifying Child for the Child Tax Credit. To be considered a qualifying child for the purposes of
the child tax credit, a person must meet the following five requirements:
CTC1. Relationship. The child must be the taxpayer’s son, daughter stepchild, foster child, brother,
sister, stepbrother, stepsister or a descendent of any of them.
CTC2. Age. The child must have been under age 17 at the end of 2011.
CTC3. Support. The child did not provide more than half of their own support for 2011.
CTC4. Member of household. The child must have lived with the taxpayer for more than half of 2010.
A child who was born or died during 2011 is considered to have lived with the taxpayer for the entire
year if they lived with the taxpayer for the entire time he or she was alive. Temporary absences such as
school, vacation, hospitalization count as time lived at home.
CTC5. Residency. The child must have been a U.S. citizen, a U.S. national, or a resident of the United
States for the year 2011.
5.3b Credit Limitations. The amount of the child tax credit is $1,000 per qualifying child. However, the
taxpayer may not be able to take the full amount of the credit if:
•
The amount of their tax on line 46, Form 1040 is less than the amount of the credit. This is
because the child tax credit is nonrefundable. However, they may qualify for the additional child
tax credit, discussed next.
•
The taxpayer’s modified adjusted gross income (MAGI) is above $110,000 if married filing a joint
return, $55,000 if married filing a separate return, or $75,000 for all other filing statuses.
5.4 The Additional Child Tax Credit. If the taxpayer is not able to use the full amount of their child tax
credit, they may be eligible for the Additional Child Tax Credit. This credit is a refundable credit.
The maximum amount of the additional child tax credit for taxpayers with one or two children is the
lesser of:
•
The disallowed portion of the regular child tax credit; or
•
15% of the taxpayer’s earned income in excess of $3,000.
The maximum amount for taxpayers with three or more children is the lesser of:
•
The disallowed portion of the regular child tax credit; or
•
The larger of:
o
15% of earned income over $3,000
o
FICA and Medicare tax paid minus the earned income credit.
5.4a Calculating the Credit. To calculate the amount of the credit, the taxpayer will need to complete
and file Form 8812.
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5.5 Child and Dependent Care Credit. If the taxpayer paid someone to care for a child under age 13
or a qualifying spouse or dependent so they could work or look for work, they may be able to reduce
their tax by claiming the Child and Dependent Care Credit on their federal income tax return. To qualify,
their spouse, children age 13 or older, and other dependents must be physically or mentally incapable
of self-care.
The credit is a percentage of the amount of work-related child and dependent care expenses the
taxpayer paid to a care provider. The credit can be up to 35 percent of qualifying expenses, depending
upon the taxpayer’s income.
For 2011, the taxpayer may use up to $3,000 of the expenses paid in a year for one qualifying
individual, or $6,000 for two or more qualifying individuals. These dollar limits must be reduced by the
amount of any dependent care benefits provided by their employer that they excluded from income.
To claim the credit for child and dependent care expenses, the taxpayer must meet certain conditions
including:
• Income – The taxpayer must have earned income from wages, salaries, tips, other taxable
employee compensation, or net earnings from self-employment (one spouse may be considered as
having earned income if they were a full-time student or physically or mentally not able to care for
himself or herself)
• Payee - The payments for care cannot be paid to someone the taxpayer can claim as a dependent
on their return or to the taxpayer’s child who is under age 19, even if he or she is not the taxpayer’s
dependent
• Filing Status – The taxpayer’s filing status must be single, married filing jointly, head of
household, or qualifying widow(er) with a dependent child
• Care - The care must have been provided for one or more qualifying persons
• Home - The qualifying person must have lived with the taxpayer for more than half of 2011
• Identifying Number – The taxpayer must provide the taxpayer identification number (usually the
social security number) of the qualifying person
• Other Information – The taxpayer must report the name, address, and taxpayer identification
number, (either the social security number, or the employer identification number) of the care
provider on their return. If the care provider is tax exempt, the taxpayer needs only to report the
name and address on their return. Form W-10, Dependent Care Provider's Identification and
Certification, can be used to request this information from the care provider. If the taxpayer does
not provide information regarding the care provider, they may still be eligible for the credit if it is
shown that they exercised due diligence in attempting to provide the required information.
To calculate and claim the credit, complete and file Form 2441, Child and Dependent Care Credit.
5.6 Adoption Credit. For 2010 and 2011, a substantial change was made to the adoption credit. The
taxpayer may now be able to take a refundable tax credit for qualifying expenses paid to adopt an
eligible child (including a child with special needs). This means that they could qualify for a tax refund
even if they did not have federal income tax withheld. For tax years prior to 2010, the adoption credit is
not refundable.
Under new Adoption Credit Rules for the 2011 tax year, the taxpayer must attach one or more adoptionrelated documents (identified in the form instructions) with the completed Form 8839 (PDF), Qualified
Adoption Expenses, and attach the form to their Form 1040 or Form 1040A return, to claim the adoption
credit or income exclusion. The required documents are different if the adoption is foreign, or domestic,
final or not final and if the adoption is for a special-needs child.
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For expenses paid prior to the year the adoption becomes final, the credit generally is allowed for the
year following the year of payment. For expenses paid in and after the year the adoption becomes final,
the credit is allowed in the year of payment. The adoption credit is not available for any reimbursed
expense. In addition to the credit, certain amounts paid by the taxpayer’s employer for qualifying
adoption expenses may be excludable from their gross income.
A taxpayer who paid qualifying expenses in the current year for an adoption which became final in the
current year, may be eligible to claim the credit for the expenses on the current year return, in addition
to credit for expenses paid in a prior year.
For both the credit or the exclusion, qualifying expenses include reasonable and necessary adoption
fees, court costs, attorney fees, traveling expenses (including amounts spent for meals and lodging
while away from home), and other expenses directly related to and for which the principal purpose is
the legal adoption of an eligible child. An eligible child must be under 18 years old, or be physically or
mentally incapable of caring for himself or herself. The adoption credit or exclusion cannot be taken for
a child who is not a United States citizen or resident unless the adoption becomes final.
In the case of an adoption of a special-needs child, the taxpayer may be eligible for a certain amount of
credit or exclusion regardless of actual expenses paid or incurred. A child has special-needs if (1) the
child otherwise meets the definition of eligible child, (2) the child is a United States citizen or resident,
(3) a state determines that the child cannot or should not be returned to his or her parent's home, and
(4) a state determines that the child probably will not be adopted unless assistance is provided. The
credit and exclusion for qualifying adoption expenses are each subject to a dollar limit and an income
limit.
The amount of the adoption credit or exclusion is limited to the dollar limit for that year for each effort to
adopt an eligible child. If the taxpayer can take a credit and exclusion, this dollar amount applies
separately to each. For example, if the dollar limit for the year is $13,360 and the taxpayer paid $10,000
in qualifying adoption expenses for a final adoption, while their employer paid $4,000 of additional
qualifying adoption expenses, the taxpayer may be able to claim a credit of up to $10,000 and also
exclude up to $4,000.
The dollar limit for a particular year must be reduced by the amount of qualifying expenses taken into
account in previous years for the same adoption effort.
The income limit on the adoption credit or exclusion is based on their modified adjusted gross income
(MAGI). If the taxpayer’s MAGI is below the beginning phase out amount for the year, the income limit
will not affect their credit or exclusion. If their MAGI is more than the beginning phase out amount for
the year, their credit or exclusion will be reduced. If their MAGI is above the maximum phase out
amount for the year, their credit or exclusion will be eliminated.
Generally, if the taxpayer is married, they must file a joint return to take the adoption credit or exclusion.
If their filing status is married filing separately, they can take the credit or exclusion only if they meet
special requirements.
To take the credit or exclusion, complete Form 8839, Qualified Adoption Expenses, and attach the form
to Form 1040.
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Paid Preparer Responsibilities and the Earned Income Credit
Paid tax preparers who do returns or claims for refund involving the Earned Income Credit must meet
due diligence requirements in determining if the taxpayer is eligible for, and the amount of, the EIC.
Failure to do so could result in a penalty of $500 per return. Form 8867 was designed to ensure that the
paid preparer considered all the requirements necessary when preparing an EIC return. It contains 19
questions which the preparer is expected to ask their client when preparing the return.
The IRS actually considers paid preparers to be partners in helping families claim the correct amount of
EIC. The number of families that claim EIC is high, and the number of erroneous claims is also high.
The IRS estimates an error rate of 23 to 28 percent, or $11 to $13 billion paid out in error.
There are four due diligence requirements for tax professionals. Generally if you prepare returns with
the EITC, you must not only ask all the questions to get the information required on Form 8867, but you
must also ask additional questions when the information your client gives you seems incorrect,
inconsistent or incomplete.
Requirement 1: Complete and submit Form 8867, Paid Preparer’s Earned Income Credit
Checklist
•
The preparer must complete the checklist based on information provided by the client(s).
•
For returns and claims for refund not filed electronically, Form 8867 must be completed and
submitted with any paper return.
Requirement 2: Calculate the amount of the EITC
•
The preparer must complete the EITC worksheet from the Form 1040 instructions or from
Publication 596, or a document with the same information. The worksheet shows what is
included in the computation. Most tax preparation software has the computation worksheet
available.
Requirement 3: The “Knowledge” Requirement
•
The preparer must know the law and ensure that they are asking the client(s) the right questions
to get all relevant facts.
•
The preparer must take into account both what the client says and what they know about the
client.
•
The preparer must not know, or have any reason to know any information used to determine the
client’s eligibility for the EITC is incorrect, inconsistent or incomplete or that the amount of the
EITC is correct.
•
The preparer must make additional inquiries if a reasonable and well-informed tax return
preparer would know the information is incomplete, inconsistent or incorrect.
•
The preparer must document any additional questions asked and the client’s answer at the time
of the interview.
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Requirement 4: Recordkeeping
•
The preparer must keep a copy of the Form 8867 and EIC worksheet, and a record of any
additional questions asked of the client to comply with the due diligence requirements and the
client's answers to those questions.
•
The preparer must keep copies of any documents the client provides that is used to determine
eligibility for, or the amount of the EITC.
•
The preparer must verify the identity of the person giving the return information and keep a
record of who provided the information and when it was obtained.
•
The preparer must keep their records in either paper or electronic format, but must be sure they
can be produced if IRS asks for them.
•
The preparer must keep these records for 3 years from the latest date of the following that
apply:
•
The original due date of the tax return (This does not include any extension of time for
filing.), or
•
If they electronically file the return or claim for refund and sign it as the return preparer,
the date the tax return or claim for refund is filed, or
•
If the return or claim for refund is not filed electronically and they sign it as the return
preparer, the date they present the tax return or claim for refund to their client for
signature; or
•
If they prepare part of the return or claim for refund and another preparer completes and
signs the return or claim for refund, they must keep the part of the return they were
responsible to complete for 3 years from the date they submit it to the signing tax return
preparer.
If the IRS examines the EITC claims prepared, and they find the preparer did not meet all four due
diligence requirements, they can get:
•
A $500 penalty for each failure to comply with EITC due diligence requirements for returns
required to be filed after December 31, 2011. The penalty amount was increased from $100 to
$500 in October, 2011.
•
An employer or employing firm may also be penalized if an employee fails to comply with the
EITC due diligence requirements. (There are only specific times when an employer is subject to
the due diligence penalty).
•
A minimum penalty of $1,000 if they prepare a client return and IRS finds any part of the
amount of taxes owed is due to an unreasonable position.
•
A minimum penalty of $5,000 if they prepare a client return and IRS finds any part of the amount
of taxes owed is due to reckless or intentional disregard of rules or regulations.
Depending on the circumstances, the preparer can face additional IRS sanctions including suspension
or disbarment from practice and imprisonment.
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IRS Compliance Visits
The IRS has been conducting Preparer Compliance Program which are educational visits to preparers.
A revenue agent and criminal investigator visit preparers who filed EITC claims with a high chance of
error. The visits are educational. The goal is to help preparers understand the errors and how to avoid
them.
During these outreach and education visits, agents
•
Talk about the errors on the claims;
•
Offer tips and tools for improving accuracy;
•
Answer any questions; and
•
Explain the potential costs of not improving accuracy.
The IRS does not charge these preparers penalties because of these visits. But, they do monitor the
claims they file to find out if accuracy improves. If a preparer's claims do not show improvement, they
may do a due diligence audit.
Due Diligence Audits
Audits for compliance with EITC due diligence requirements are another tier of the IRS’ EITC Preparer
Compliance Program. They look at returns with a high chance of errors completed by the same
preparer. They use that information to select preparers for audits.
What Happens During the Audit? During these audits, the IRS will review at least 25 EITC returns.
They look at the return and the following for each return:
• the preparer's due diligence records,
• the probing questions asked and the client's responses, and
• all questionnaires, checklists, and worksheets.
They specifically look for evidence the preparer met the knowledge standard. To meet the knowledge
standard preparers must:
• Know the law;
• Ask the right questions, especially when the client gives information that appears incorrect,
inconsistent, or incomplete;
• Document the questions asked and the responses given by the client; and
• Get all the facts to make sure your client truly qualifies for EITC.
What Happens if Records Don't Show the Preparer Met the EITC Due Diligence Requirements?
The IRS does charge penalties when they find the preparer did not comply with EITC Due Diligence
requirements. They have greatly improved their audit selection process to find a high potential for a
preparer to be filing returns with EITC errors. Using this new process, they penalized over ninety
percent of the preparers audited. They charge most of the penalties to preparers who did not meet the
knowledge standard. The penalties range from $100 to $5,000 per incident so can be substantial.
What if the Preparer Doesn’t Agree with the Penalties?
If the IRS proposes or charges penalties and the preparer doesn’t agree, they have the right to request:
• An informal managerial hearing,
• Request abatement of the penalties,
• Appeal the assessments, or
• File Form 6118, Claim for Refund of Income Tax Return Preparer and Promoter Penalties, within
three years from the date the penalties are paid
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Examples
The IRS has cited the following examples of when additional questions may be necessary:
Example 1.
A 22 year-old taxpayer wants to claim two sons, ages 10 and 11, as qualifying children for purposes of
the EIC. Preparer A must make additional reasonable inquiries regarding the relationship between the
taxpayer and the children as the age of the taxpayer appears inconsistent with the ages of the children
claimed as sons.
Example 2.
An 18 year-old female taxpayer with an infant has $3,000 in earned income and states that she lives
with her parents. Taxpayer wants to claim the infant as a qualifying child for the EIC. This information
appears incomplete and inconsistent because the taxpayer lives with her parents and earns very little
income. Preparer B must make additional reasonable inquires to determine if the taxpayer is the
qualifying child of her parents and, therefore, ineligible to claim the EIC.
Example 3.
Taxpayer asks Preparer C to prepare his tax return and wants to claim his niece and nephew as
qualifying children for the EIC. Preparer C should make reasonable inquiries to determine whether the
children meet EIC qualifying child requirements and ensure possible duplicate claim situations involving
the parents or other relatives are properly considered.
Example 4.
Taxpayer asks Preparer D to prepare her tax return and tells D that she has a Schedule C business,
that she has two qualifying children and that she wants to claim the EIC. Taxpayer indicates that she
earned $10,000 from her Schedule C business, but that she has no expenses. This information
appears incomplete because it is very unlikely that someone who is self-employed has no business
expenses. D must make additional reasonable inquiries regarding taxpayer’s business to determine
whether the information regarding both income and expenses is correct.
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Sample Questions
Scenario 1: A client informs you she is separated from her spouse and her 7 year old
child lives with her. She would like to claim the Earned Income Credit.
Issues That Should Be Questioned
•
Her Filing Status
✓ If the client is separated from her spouse, what exactly does that mean?
✓ Ask questions to determine whether she must use a “married” filing status (married filing
jointly or married filing separately) or if she qualifies for head of household or single
✓ Ask questions to determine if she is legally separated or did not live with her spouse for the
last 6 months of the year (which would allow her to be “unmarried for tax purposes”)
•
The Qualifying Child Requirement
✓ Find out whether the child lived with the client for more than half the year
✓ Determine if there is a possibility the father might claim the child as well. The preparer has a
responsibility to inform the client what happens if both parents claim the child and how the
IRS applies the tie-breaker rules
Sample Q&A:
Q: Are you still married?
A: Yes, I’m still married but separated
•
If she is still married, you know she must use a married status unless she qualifies for Head
of Household. If she files Married Filing Separate she cannot claim EIC.
Q: When did you separate from your husband?
A: January of last year
•
It may be possible for her to file Head of Household. Clarify what “separated” means to her legally separated? Living separately?
Q: Did you live in separate homes, and if so, when?
A: Yes, in January of last year.
•
The client meets the requirement of not living together for the last 6 months of the year and
so may be “considered unmarried” and qualify for Head of Household if the other
requirements are met
Q: How long during the year did your child live with you?
A: My child lived with me every day except every other weekend and two weeks during the summer
•
The child lived with her for more than half the year
Q: Did anyone else live with you and your child
A: No.
•
She will not have a problem qualifying for the cost of keeping up the home
It looks like the client may qualify for the EITC. Complete the rest of the questions to be sure.
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Scenario 2: A client informs you she is 18 years old and has a 2-year old daughter. She
has never been married, lives with her parents and has earnings of $3,000 from a parttime job. She would like to claim the Earned Income Credit.
Issues That Should Be Questioned
•
Can the client be claimed by her parents for the EITC?
✓ Since she is 18 years old, she meets the age requirement to be claimed as a qualifying child
by her parents
✓ She also meets the relationship requirement since she is their daughter
•
The grandchild may also be the qualifying child for the grandparents for the EITC
Sample Q&A:
Q: When did you move in with your parents?
A: November of last year
•
The client is probably not a qualifying child for her parents for EITC, but you still need to ask
more questions...
Q: Did your daughter live with you all year?
A: No, she lived with my parents
•
The client’s daughter is not her qualifying child since she had to live with her for more than
half the year.
Scenario 3: A client informs you that he is 22 years old and has two sons, ages 10 and 11. He
would like to claim the Earned Income Credit.
Issues That Should Be Questioned
•
The children’s ages appear to be inconsistent with the client’s age, although there may be a
logical explanation
Sample Q&A:
Q: Could you clarify your relationship with these children?
A: They are my girlfriend’s sons, but I paid all the bills.
•
The children don’t seem to meet the relationship test, but you need to be sure. More
questions.
Q: Were you ever married to the mother?
A: No.
•
You can eliminate stepsons as a possible relationship. One more question.
Q: Were the children placed in your home for adoption or as foster children by a court or authorized
agency?
A: No.
Sorry. The client does not qualify for the EITC because the children do not meet the
relationship test.
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Scenario 4: A client informs you that she is Head of Household and has two children ages 13
and 14. She is a self-employed house cleaner, earned $12,000 and has no expenses. She would
like to claim the Earned Income Credit.
Issues That Should Be Questioned
•
Even though the client informs you that she is Head of Household, you will still need to ask the
proper questions to make the determination
•
It is unlikely that someone who is self-employed has no business expenses, you will need to ask
further questions.
•
Does the client truly have a business? As the preparer you may get the feeling that the client is
not being truthful about the “business”
Sample Q&A:
Q: Do you have a record of the money you received for cleaning houses?
A: No, but I know what I earned.
•
You will still need to ask more questions to find out how she came up with the $12,000
Q: How much did you charge to clean a house?
A: $60 per house
•
Still not enough information to come up with the $12,000 income
Q: How many houses did you clean?
A: I don’t know, it wasn’t always the same houses
•
Still a doubt as to her $12,000 income
Q: Who provided the cleaning supplies?
A: The homeowners provide everything
•
This is possible.
You will need to gather more information to determine how the client came up with her
information. Tell the client that the IRS requires a written record of earnings and expenses copies of receipts, invoices, etc.
Additional tip: According to the IRS, a self-employed individual is required to report all income and
deduct all expenses. Revenue Ruling 56-407 addressed the issue of whether taxpayers may
disregard allowable deductions in computing net earnings from self- employment for selfemployment tax purposes. Under § 1402(a), every taxpayer (with the exception of certain farm
operators) must claim all allowable deductions in computing net earnings from self- employment for
self-employment tax purposes. Because the net earnings from self-employment included in earned
income for EIC purposes are defined by cross-reference to the definition of net- earnings from selfemployment under I.R.C. §1402(a), this ruling applies equally to the EIC.
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6.0 Income, Part 2
6.1 Interest Income. Interest is income paid for the use of money. Sources of interest income include
(but is not limited to) banks, credit unions, government agencies, life insurance policies, and other
individuals. In general, any interest that the taxpayer receives is taxable income.
6.1a When to report interest income. When the taxpayer will report their interest income depends on
whether they use the cash method or an accrual method to report income. Most taxpayers use the cash
method of reporting income. In this situation a taxpayer would report their interest income in the same
year that they actually or constructively receive the funds. Exceptions to this rule will be discussed later
in this chapter.
Constructive receipt. A taxpayer is considered to have constructively received interest income when it is
credited to their account; they do not necessarily have to have physically received the funds. For
example, a taxpayer is considered to have received interest on a savings account when the money is
credited to the account and made available for withdrawal.
The taxpayer constructively receives income even if they must:
•
Make withdrawals in multiples of even amounts;
•
Give a notice to withdraw before making the actual withdrawal;
•
Withdraw all or part of the money in the account to withdraw the earnings; or
•
Pay a penalty on early withdrawals, unless the interest received on an early withdrawal or
redemption is substantially less than the interest that would be payable at maturity.
An accrual basis taxpayer reports taxable interest income when they have earned it, whether or not
they have received it. Interest is earned over the term of a debt instrument.
6.1b Form 1099-INT. Form 1099-INT or a similar statement is used by banks, savings and loans, and
other payers to report interest income to taxpayers. Form 1099-INT is required whenever interest of
over $10 is paid by an institution, or over $600 of interest paid in connection with a trade or business.
This form should be kept with the taxpayer’s records. It is not required to be filed with the tax return.
6.1c Where to report interest income. Generally all taxable interest income is reported on line 8a of
Form 1040 or Form 1040A (line 2 of Form 1040EZ). Taxpayers may also be required to complete and
file Schedule B, Form 1040 or Schedule 1, Form 1040A.
6.2 Different types of taxable interest. Taxable interest income includes interest received from bank
accounts, life insurance policies, loans made and other sources. Following are some other sources of
taxable interest.
6.2a Dividends that are actually interest – Certain distributions which are commonly called dividends
are actually interest. Any “dividends” from the following are reportable as interest income:
•
Cooperative banks
•
Credit unions
•
Domestic or federal savings and loan associations
•
Domestic building and loan associations
•
Mutual savings banks
6.2b Money market funds – Generally, any amounts received from money market funds are reportable
as dividends, not interest.
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6.2c Gifts for opening accounts – For deposits of less than $5,000, any non-cash gift or service
valued at more than $10 must be reported as interest. For deposits of $5,000 or more, gifts or services
of more than $20 must be reported as interest. The value of the gift or service is the cost to the financial
institution.
6.2d Insurance dividends – Interest on insurance dividends left on deposit at an insurance company
is taxable in the year credited to the taxpayer’s account. However if the taxpayer can only withdraw it
only on a specified date, the interest is taxable in the year that date occurs.
6.2e U.S. obligations – Interest on U.S. obligations such as Treasury bills, notes and bonds is taxable
for federal income purposes (but generally exempt from state and local tax).
Treasury bills – Treasury bills are issued at a discount (purchase price less than face value) in multiples
of $1,000. The difference between the discounted price paid and the value at maturity is considered
interest income. Generally this interest is reported at maturity.
Treasury notes and bonds – Treasury notes have maturity periods from one to ten years. Maturity
periods for bonds are generally longer than 10 years. Both generally pay interest every six months
which is reported in the year paid.
6.2f Interest on tax refunds – Interest received on a tax refund is taxable income.
6.2g Interest from frozen deposits – Interest from frozen deposits is usually not included in income.
A frozen deposit means the taxpayer cannot withdraw funds because:
•
The financial institution is bankrupt or insolvent; or
•
The state where the institution is located has placed limits on withdrawals because other
financial institutions in the state are bankrupt or insolvent.
6.2h U.S. Savings Bonds. A U.S. savings bond is issued by the U.S. Treasury or an authorized agent
showing that money has been loaned to the U.S. Government and is payable to the person to whom it
is registered. The bond is a contract between the Government and the bond owner. Savings bonds are
not negotiable instruments, and cannot be transferred to anyone at will. Interest paid on these bonds is
exempt from state and local taxes, and may also be exempt from federal tax if the taxpayer uses the
funds to pay for qualified higher education expenses.
Series H and HH Bonds. Series HH bonds are issued at face value. Interest on these bonds is paid
twice a year and, if the taxpayer is a cash basis taxpayer, must be reported as income in the year
received. Series HH bonds were offered between 1980 and 2004, Series H bonds were issued prior to
1980. Series H bonds have a maturity period of 30 years. Series HH bonds have a maturity period of 20
years.
Series EE and Series I Bonds. Series EE bonds were first offered in July 1980, they mature in 30 years
(before 1980, Series E bonds were issued). Paper series EE bonds are offered at a discount and at
maturity the face value amount is paid. The difference between the face value and the purchase price is
considered to be taxable interest. Electronic series EE bonds are issued at face value, their face value
plus accrued interest is payable at maturity. Series I bonds, first issued in 1988, are inflation-indexed
bonds that mature in 30 years. The face value, plus accrued interest is paid at maturity.
Cash basis taxpayers can report the interest income from series EE, series E, and series I bonds in one
of two ways:
1. Report the interest in the earlier of the year that they cash in the bonds or the year that they
mature; or
2. Report the interest income as accrued each year.
Taxpayers must use the same method for all series E, EE and I bonds owned.
Accrual basis taxpayers report interest each year as it accrues.
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6.2i Discount Bonds. Bonds issued at a discount may be referred to as Original Issue Discount bonds
(OID). Any time the bond is issued for a price that is less than its stated redemption price at maturity
may be an OID bond. The OID is the difference between the stated redemption price at maturity and
the original issue price. A taxpayer should generally include the OID in their income as it accrues over
the term of the debt instrument, whether or not they receive any payments from the issuer. If the
discount is less than one-fourth of 1% (.0025) of the stated redemption price at maturity multiplied by
the number of full years from the original issue to maturity can be treated as zero interest. This small
discount is referred to as “de minimis” OID. The taxpayer should receive a Form 1099-OID in this
situation.
6.2j Nontaxable Municipal Bonds. Interest on bonds used to finance government operations generally
is not taxable if the bond is issued by a state, the District of Columbia, a possession of the U.S. or any
of their political subdivisions. These bonds are generally known as municipal bonds. Even though these
types of bonds are non-taxable, if the taxpayer must file a tax return, any tax exempt interest must still
be shown on the return. Non-taxable interest income is shown on Form 1099-INT, Box 8. Report the
Box 8 amount on Line 8b of Form 1040. If the taxpayer is required to file Schedule B, also report the
tax-exempt interest in Part 1 of Schedule B, but subtract it from a subtotal interest so that is not
included in the amount shown on Line 2 of Schedule B.
6.2k Education Savings Bond Program. Taxpayers may be able to exclude from income all or part of
the interest received when redeeming qualified U.S. savings bonds if they pay higher educational
expenses during the same year.
To qualify for the exclusion a taxpayer must meet the following conditions.
•
They pay qualified education expenses for themselves, a spouse, or a dependent for whom they
claim an exemption on their return.
•
Their modified adjusted gross income (MAGI) is less than $85,100 ($135,100 if filing a joint
return).
•
Their filing status is not married filing separate.
Qualified expenses. Qualified higher educational expenses included tuition and fees for the taxpayer,
spouse or dependent (for whom the taxpayer can claim an exemption) to attend an eligible education
institution. An eligible institution includes most public, private and nonprofit universities, colleges and
vocational schools that are accredited and eligible to participate in student aid programs run by the
Department of Education. Qualified expenses also include contributions to a qualified tuition program
(QTP) a Coverdell education savings account.
Qualified expenses must be reduced by any of the following tax-free benefits.
•
Tax-free part of scholarships and fellowships.
•
Expenses used to figure the tax-free portion of distributions from a Coverdell ESA.
•
Expenses used to figure the tax-free portion of distributions from a QTP.
•
Any tax-free payments (other than gifts or inheritances) received as educational assistance,
such as:
•
o
Veterans' educational assistance benefits;
o
Qualified tuition reductions, or
o
Employer-provided educational assistance.
Any expenses used in figuring the Hope and lifetime learning credits.
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Qualified U.S. savings bonds. Qualified bonds include series I bonds or series EE bonds issued after
1989. The bonds must be issued either to the taxpayer as a sole owner or the taxpayer and spouse as
co-owners. Additionally, to qualify for the exclusion the person purchasing the bonds must be at least
24 years of age. A bond purchased by a parent and issued in the name of their child under age 24 does
not qualify for the exclusion.
Taxpayers using the Married Filing Separate filing status do not qualify for this exclusion.
Modified Adjusted Gross Income. For the purposes of excluding higher educational expenses, MAGI is
calculated by adding the following back into income:
•
Foreign earned income exclusion
•
•
Foreign housing exclusion and deduction
•
Exclusion for employer adoption assistance program
benefits
Deduction for tuition and fees
•
Exclusion of income for American Samoans
•
Deduction for student loan interest
•
Exclusion of income from Puerto Rico
•
Deduction for domestic production activities
6.3 Dividends and Other Types of Corporate Distributions. A dividend is a taxable payment
declared by a company's board of directors and given to its shareholders out of the company's current
or retained earnings, usually quarterly. Dividends are usually given as cash (cash dividend), but they
can also take the form of stock (stock dividend) or other property. Dividends provide an incentive to own
stock in stable companies even if they are not experiencing much growth. Companies are not required
to pay dividends.
Dividends, whether in the form of cash or stock, are usually taxable, although different types of
dividends may be taxed at different rates. Dividends are reported to the taxpayer on Form 1099-DIV.
The most common types of dividends are ordinary dividends and qualified dividends.
Two other common corporate distributions reported on Form 1099-DIV include capital gain distributions
and nontaxable distributions.
6.3a Form 1099-DIV. Most corporations or brokerages use Form 1099-DIV or a similar statement to
show the type and amount of distributions received by a taxpayer during the year. Form 1099-DIV is
kept with the taxpayer’s records and is not required to be filed with the tax return.
6.3b Ordinary Dividends. Ordinary dividends are the most common type of distribution from a
corporation. They are paid out of the earnings and profits of the corporation and are considered to be
ordinary income to the recipient. Ordinary dividends are taxed at the same rate as the taxpayer’s
wages and other ordinary (non-capital gain) income.
6.3c Qualified Dividends. Qualified dividends are ordinary dividends that qualify for the special 0% or
15% maximum capital gains tax rate. The 0% rate applies if the taxpayer’s regular tax rate is lower than
25%. If the regular tax rate that would apply is higher than 25%, the 15% capital gains rate would apply.
To figure their tax, the taxpayer needs to complete either the Qualified Dividends and Capital Gain
worksheet in the Form 1040 instructions or the Schedule D tax worksheet whichever applies.
For a dividend to be considered a qualified dividend (eligible for the 0% or 15% tax rate) all of the
following requirements must be met:
•
The dividends must have been paid by a U.S. corporation or a qualified foreign corporation;
•
The stock must have been held for more than 60 days during the 121-day period that begins 60
days before the ex-dividend date. Firms pay dividends to those individuals who are
shareholders on a certain date. The next day is called the ex dividend date. In the case of
preferred stock, the taxpayer must have held the stock for more than 90 days during the 181day period that begins 90 days before the ex-dividend date.
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•
The stock cannot be of the type listed below:
o
A capital gain distribution
o
Dividends paid on deposits with mutual savings banks, cooperative banks, credit unions,
U.S. savings and loan or building and loan associations, federal savings and loan
associations or similar financial institutions (these amount are usually reported as
interest)
o
Dividends from a corporation that is a tax exempt organization or farmer’s cooperative
o
Dividends paid by a corporation on employer securities which are held by an employee
stock ownership program (ESOP) maintained by the corporation
o
Dividends to the extent that the taxpayer is obligated to make related payments for
positions in substantially similar or related property (such as a short sale)
o
Payments in lieu of dividends if the taxpayer knew or had reason to know that the
payments were not qualified dividends
o
Payments shown in Form 1099-DIV, box 1b from a foreign corporation, to the extent that
the taxpayer knew or had reason to know that the payments were not qualified dividends
6.4 Capital Gain Distributions. Capital gain distributions are paid by mutual funds and real estate
investment trusts (REITs). These distributions are reported in box 2a of Form 1099-DIV.
Capital gain distributions are always considered long term, regardless of how long the taxpayer owned
shares in the mutual fund or REIT.
Certain mutual funds and REITs keep their long-term capital gains and pay tax on them. The taxpayer
must report their share of these gains as if they actually received them. However, they are not included
on Form 1099-DIV; instead they are reported on Form 2439, Notice to Shareholders of Undistributed
Long-Term Capital Gains.
6.5 Nondividend Distributions. A nondividend (nontaxable) distribution is a distribution that is not paid
out of the earnings and profits of a corporation. It is a return of the taxpayer’s investment in the stock of
the company. The taxpayer is required to reduce the basis of their stock by the amount of the
nontaxable distribution received. When the basis of the taxpayer’s stock has been reduced to zero, any
additional nondividend distributions are reported as a long-term or short-term capital gain depending on
how long the taxpayer has held the stock. Nondividend distributions are reported on Form 1099-DIV,
box 3. If the taxpayer does not receive such a statement they should report the distribution as ordinary
income.
6.6 Liquidating Distributions. Liquidating distributions (or liquidating dividends) are received during a
partial or complete liquidation of a corporation. The taxpayer will receive a Form 1099-DIV from the
corporation with the amount of the liquidating distribution in box 8 or 9. For more information on
liquidating distributions, see chapter 1 of Publication 550.
6.7 How To Report Dividend Income. Generally, the taxpayer can use either Form 1040 or 1040A to
report their dividend income. Form 1040EZ cannot be used. However, if the taxpayer received any
nondividend distributions, the taxpayer must use Form 1040, Form 1040A cannot be used.
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6.8 Kiddie Tax. If a child has substantial investment income, the following two rules may apply:
1. If the child’s interest and dividend income (including capital gains distributions) total less than
$9,500, the child’s parent(s) may be able to elect to include that income on the parent’s return
rather than filing a return for the child. (Form 8814, Parents’ Election to Report Child’s Interest
and Dividends). A parent can choose to do this if all of the following conditions are met:
1. At the end of the tax year, the child was under age 19 or under age 24 and a full-time
student.
2. The child would be required to file a return unless the parent makes this election.
3. The child had income only from income, dividends and capital gain distributions
4. The child’s interest and dividend income was less than $9,500 for 2011
5. No estimated payments were made for the tax year and no prior year’s overpayment
was applied to the current year under the child’s name and SSN.
6. No federal income tax was withheld from the child’s income under backup withholding
7. The parent is the correct person whose return must be used when applying the special
tax rules for children with investment income
8. The child does not file a joint return for 2011
2. If the child’s interest, dividends, and other investment income total more than $1,900, part of
that income may be taxed at the parent’s tax rate rather than the child’s rate. (Form 8615, Tax
for Children Under Age 18 With Investment Income of More Than $1,900). These rules apply if:
1. The child meets one of the following age requirements:
1. They were under age 18 at the end of the tax year
2. They were under age 19 at the end of the tax year and the child’s earned income
does not exceed one-half of the child’s support for the year, or
3. The child was a full-time student who was under age 24 at the end of the tax year
and the child’s earned income does not exceed one-half of the child’s support for
the year (excluding any scholarships)
2. At least one of the child’s parents was alive at the end of the tax year
3. The child’s investment income for the year was more than $1,900
4. The child is required to file a tax return for the year, and
5. The child does not file a joint return for the year.
The general purpose of these rules is to prohibit the transferring of income between a parent and child
for the sole purpose of reducing the amount of tax paid (assuming the child would have a lower tax rate
than the parent).
6.9 Foreign Tax Credit. The foreign tax credit is intended to reduce the double tax burden that would
otherwise arise when foreign source income is taxed by both the United States and the foreign country
from which the income is derived.
Generally, only income taxes paid or accrued to a foreign country or a U.S. possession, or taxes paid or
accrued to a foreign country or U.S. possession in lieu of an income tax, will qualify for the foreign tax
credit.
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Qualified foreign taxes do not include taxes that are refundable to you or income taxes paid or accrued
to any country if the income giving rise to the tax is for a period (the sanction period) during which:
• The Secretary of State has designated the country as one that repeatedly provides support for acts
of international terrorism,
• The United States has severed or does not conduct diplomatic relations with the country, or
• The United States does not recognize the country's government, unless that government is eligible
to purchase defense articles or services under the Arms Export Control Act.
A taxpayer can choose to take the amount of any qualified foreign taxes paid or accrued during the year
as a foreign tax credit or as an itemized deduction. To choose the deduction, the taxpayer must itemize
deductions on Form 1040, Schedule A. To choose the foreign tax credit they generally must complete
Form 1116 and attach it to their Form 1040, or Form 1040NR.
The taxpayer can claim the credit for qualified foreign taxes without filing Form 1116 if all of the
following requirements are met:
1. All of their foreign source income is passive income, such as interest and dividends,
2. All of their foreign source income and the foreign taxes are reported to them on a qualified payee
statement, such as Form 1099-INT or Form 1099-DIV, and
3. The total of their qualified foreign taxes is not more than the limit given in the Form 1040 Instructions
for the filing status they are using, or in the Form 1040-NR Instructions if they file Form 1040-NR.
If the taxpayer claims the credit directly on Form 1040 or Form 1040-NR without filing Form 1116, they
cannot carry back or carry over any unused foreign tax to or from this year.
If the taxpayer uses Form 1116 to figure the credit, their foreign tax credit will be the smaller of the
amount of foreign tax paid or accrued, or the amount of United States tax attributable to their foreign
source income. This limit is computed separately for each type of foreign income.
If the taxpayer cannot use the full amount of qualified foreign taxes paid or accrued, they may be
allowed a carryback and/or carryover of the unused foreign tax. For more information on this topic see
Publication 514.
The taxpayer may not take either a credit or a deduction for taxes paid or accrued on income they
exclude under the foreign earned income exclusion or the foreign housing exclusion. There is no
double taxation in this situation because the income is not subject to United States tax.
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7.0 Itemized Deductions, Part 1
7.1 Itemized Deductions, Generally. Generally, a taxpayer has the ability to choose between a
standard deduction and itemized deductions. They should opt for whichever method benefits them the
most, i.e. largest refund or lowest tax owed. Itemized deductions are calculated by completing and filing
Schedule A, Itemized Deductions, with the tax return.
7.1a When to Itemize. A taxpayer may benefit from itemizing deductions on Schedule A under the
following circumstances:
•
They do not qualify for the standard deduction or the amount they can claim is limited
o
The taxpayer is married, using the married filing separate filing status and the spouse
itemizes deductions (even if the other spouse is using the head of household filing
status)
o
They are filing a tax return for a short tax year because of a change in accounting
periods
o
The taxpayer is a nonresident or dual status alien during the year who does not choose
to be treated as a U.S. resident
•
The taxpayer (or spouse, if filing a joint return) had large amounts of unreimbursed medical and
dental expenses during the year
•
They paid interest and taxes on a main home
•
They had large amounts of unreimbursed business expenses or other miscellaneous expenses
•
They had large uninsured casualty or theft losses
•
They made large contributions to qualified charities
7.2 Medical Expenses. Medical expenses include costs for the diagnosis, cure, treatment or
prevention of disease. They include costs for equipment, supplies, prescription drugs, hospitalization,
insurance and transportation to get medical care. They also include amounts paid for qualified longterm care services and some amounts paid for long-term care insurance. Deductible medical expenses
may include amounts paid to dentists, opticians, psychiatrists, chiropractors, acupuncturists, and
facilities for in-patient alcohol or drug rehab. The chart on the following page details some of the
medical expenses that are allowed and not allowed.
7.2a Whose Medical Expenses Are Deductible? Generally, medical expenses paid for the taxpayer,
spouse, or dependents. To include expenses for a spouse or dependent, the person must be the
spouse/dependent of the taxpayer either at the time the expenses were incurred or at the time they
were paid for.
For purposes of the medical expenses deduction, a person qualifies as a dependent if:
• The person was a qualifying child or relative; and
• The person was a U.S. citizen or national, or a resident of the United States, Canada or
Mexico.
Adopted children. A legally adopted child (or a child legally placed with the taxpayer for adoption) is
treated as the taxpayer’s own child. If the taxpayer is a U.S. citizen or national, the child does not have
to meet the citizenship or residency test above if they lived with the taxpayer as a member of their
household for 2011.
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Medical and Dental Expenses Checklist
Deductible
Not Deductible
• Bandages
• Maternity clothes
•
• Medical insurance included
in a car insurance policy
• Non-prescription drugs or
medicine
•
•
•
• Meals and lodging provided • Baby sitting and child care
by a hospital during
treatment
Birth control pills prescribed • Medical insurance premiums • Bottled water
by a physician
• Oxygen equipment and
• Contributions to Archer
Capital expenses for
equipment or home
oxygen
MSAs
improvement if required for
medical care
Certain fertility treatments • Part of life-care fee paid to a • Diaper service
retirement home designated
for medical care
• Prescription medicine and • Expenses for general health
Certain treatments for
weight-loss
insulin
• Diagnostic devices
• Psychiatric and
psychological treatment
• Nursing care for a healthy
baby
• Prescriptions drugs
purchased in another
country
• Flex spending accounts if • Nutritional supplements,
contributions were made
vitamins, etc. unless
with pre-tax dollars
prescribed by a medical
practitioner as treatment for
a specific condition
• Funeral, burial or cremation • Surgery for cosmetic
expenses
reasons
• Expenses of an organ donor • Special items (artificial
limbs, false teeth, glasses,
hearing aids, etc.)
• Eye surgery to correct vision • Special education for
•
mentally or physically
disabled persons
• Guide dogs/animals
• Stop-smoking programs (not •
including over-the-counter
patches or gum)
• Hospital expenses
• Taxes (employment) paid for •
a worker providing medical
care
• Lead-based paint removal • Transportation for medical
care
• Legal abortion
• Treatment at a drug or
alcohol rehab facility
• Legal operations to prevent • Wages paid for nursing
conception
services
• Long-term care contracts
(limited)
Health savings account
payments for medical
expenses
Illegal operations or
treatment
• Toothpaste and other
toiletries
Life insurance or income
protection policies
• Weight-loss expenses not
for the treatment of obesity
or other disease
• Teeth whitening
Children of Divorced or Separated Parents. A child of divorced or separated parents can be treated as a
dependent of both parents and either (or both) parent can include the medical expenses he or she pays
for the child, even if the other parent claims the exemption for the child, if:
• The child is in the custody of one or both parents for more than half of the year;
• The child receives over half of his or support during the year from his or her parents; and
• The child’s parents are:
o
Divorced or legally separated under a decree of divorce or separate maintenance
o
Separated under a written separation agreement, or
o
Live apart during the last six months of the year
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However, this does not apply if the child’s exemption is being claimed under Multiple Support
Agreement.
7.2b When Are Medical Expenses Deductible? Medical expenses can be deducted when paid,
regardless of when the services were provided. The table below outlines when an expense becomes
deductible, depending on the form of payment used.
When Are Medical Expenses Deductible?
How paid?
When deductible
Cash
Date of payment
Check
Date the check is mailed or delivered
Pay-by-phone or online payment
Date the financial institution reports the payment
Credit card
Date the charge was made
Capital expenditures. The taxpayer can include as an expense amounts paid for special equipment or
improvements added to a home if its main purpose is for the medical care of the taxpayer, spouse or
dependents. However, this deduction is limited to the difference between the increase in fair market
value of the home (because of the addition) and the cost of the equipment or improvement.
Lodging. Expenses paid for the cost of meals and lodging at a hospital or other institution are
deductible if the primary purpose for being there is for medical care. Additionally the taxpayer may be
able to deduct up to $50 per day per person for the cost of lodging not in a hospital or similar institution
if all of the following requirements are met:
• The lodging is primarily for and essential to medical care
• The medical care is provided by a doctor in a licensed hospital or equivalent
• The lodging would not be considered lavish or extravagant
• There is no significant element of personal pleasure or recreation in the travel away from
home
Lodging for the person receiving the care and for a person traveling with the person receiving medical
care is deductible. For example, a parent and a sick child traveling away from home could include up to
$100 per night for lodging. When traveling away from home, only lodging is potentially deductible,
meals are not included.
Medicare A. If the taxpayer is covered under social security (or a government employee who paid
Medicare tax), the payroll tax paid is not deductible. However if the person is not covered under social
security and chooses to voluntarily enroll in Medicare A, the premiums paid are deductible.
Medicare B. Medicare B is supplemental medical insurance. Generally premiums paid for Medicare B
are deductible as a medical expense.
Long-Term Care Expenses. Expenses paid for long-term care are deductible for qualified individuals if
the expenses are required by a chronically ill individual and provided pursuant to a plan of care
prescribed by a licensed health care practitioner.
A person is considered to be chronically ill if, within the previous 12 months, a licensed health care
practitioner has certified that the individual in questions meets one of the two qualifications below:
• The person is unable to perform at least two activities of daily living without substantial
assistance from another individual for at least 90 days. Activities of daily living include eating,
toileting, transferring, bathing, dressing and continence; or
• The person requires substantial supervision to be protected from threats to health or safety
due to severe cognitive impairment.
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Long-Term Care Insurance – A qualified long-term care insurance policy provides only coverage of
long-term care services. The contract must:
• Be guaranteed renewable
• Not provide for a cash surrender value that can be paid, assigned, pledged or borrowed
• Provide that refunds and dividends under the contract must be used only to reduce future
premiums or increase future benefits (except in the case of refunds on the death of the
insured or complete surrender of the contract)
• Generally not pay or reimburse expenses that would be reimbursed under Medicare (except
where Medicare is a secondary payer), or the contract makes per diem or other periodic
payments without regard to expenses
The amount of qualified long-term care insurance premiums that can be deducted is limited and is
based on age:
• Age 40 and under – up to $340
• Age 41 to 50 – up to $640
• Age 51 to 60 – up to $1,270
• Age 61 to 70 – up to $3,390
• Age 71 and older – up to $4,240
Transportation. The taxpayer can deduct, as a medical expense, costs of transportation primarily for, as
essential to, medical care. Deductible amounts include bus, train, taxi, plane fares or amounts paid for
an ambulance. The cost of transportation for a parent traveling with a sick child are deductible as are
the expenses of a nurse or other person who can give injections, medicines or other treatment to a
patient who is traveling to get medical care and is unable to travel alone.
The taxpayer can include costs for gas and oil, but cannot include depreciation, insurance, or other
repair or maintenance expense. Instead of keeping track of actual expenses, the taxpayer can use a
standard mileage rate to determine the amount of deductible medical expense. Generally the standard
mileage rate will change each year. The standard mileage rate allowed for operating expenses for a car
when you use it for medical reasons is:
• 19 cents per mile from January 1–June 30, and
• 23.5 cents per mile from July 1–December 31, 2011.
7.2c Medical Expense Deduction Limits. Medical expenses are deductible only if the amount is more
than 7.5% of the taxpayer’s adjusted gross income as shown on line 38, Form 1040.
7.3 Deductible Taxes. There are four types of deductible non-business taxes:
•
Real estate taxes (state, local and foreign);
•
Personal property taxes (state and local);
•
Income taxes (state, local and foreign)
•
General sales taxes (state and local);
•
Qualified motor vehicle taxes.
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To be deductible, the tax must be imposed on the taxpayer and must have been paid during the tax
year. Generally the taxpayer must be the property owner to deduct real estate or personal property
taxes paid. If the taxpayer’s spouse owns the property the taxes are deductible on their joint return or
the spouse’s separate return.
Schedule A - Deductible and Nondeductible Taxes
Type of Tax
Income Tax
General Sales Tax
Real Estate Tax
Deductible
• State and local income taxes*
• Foreign income taxes
• Mandatory employee contributions to certain
state benefit funds
• State and local general sales tax*
Nondeductible
• Federal income taxes
• Employee contributions to voluntary
or private disability plans
• State and local real estate taxes
• Foreign real estate taxes
• Taxes for local benefits**
• Trash and garbage pickup fees**
• Tenant’s share of real estate taxes paid by a
cooperative housing corporation
• Rent increase due to higher real
estate taxes
• Homeowners association fees
Personal Property Tax • State and local personal property tax
• Import duties
* The taxpayer has the option to deduction their state and local income tax paid or their state and local general
sales tax paid.
**For exceptions to these rules, see the text.
7.3a Income Taxes. The taxpayer may elect to deduct either their state and local income taxes paid or
their state and local general sales tax paid, whichever gives them the greater tax benefit.
State and Local Taxes. The taxpayer can deduct state and local income taxes paid or withheld during
2011. They cannot deduct state taxes paid on income that is exempt from federal tax (except taxexempt interest). Deductible state taxes include:
• State and local taxes withheld from wages and reported on Form W-2. For 2011, these would include
amounts reported in Box 17 or Box 19.
• State and local taxes withheld from other compensation such as those reported on Form W-2G (Box
14), Form 1099-MISC (Box 16) or Form 1099-R (Box 10 and Box 13).
• Estimated tax payments made during the year as long as the taxpayer had a reasonable basis for
making these payments. Any payments made when the taxpayer had no basis to believe they had
any additional state tax liability are not deductible.
• If the taxpayer had any portion of their prior year refund applied to their 2011 estimated tax liability,
they may include the applied amount on Schedule A.
Contributions to State Benefit Funds. Employees may deduct mandatory contributions to state benefit
funds that provide protection against loss of wages.
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Payments to the following are deductible as state taxes paid on Schedule A, line 5:
• California Nonoccupational Disability Benefit Fund
• New Jersey Nonoccupational Disability Benefit Fund
• New Jersey Unemployment Compensation Fund
• New York Nonoccupational Disability Benefit Fund
• Rhode Island Temporary Disability Fund
• Washington State Supplemental Worker’s Compensation Fund
• West Virginia Unemployment Compensation Fund
Employee contributions to private or voluntary plans are not deductible.
7.3b General Sales Taxes. Instead of deducting their state and local taxes paid or withheld, taxpayers
may choose to deduct their state and local general sales taxes paid. Generally they can use either their
actual expenses or the optional sales tax tables provided by the IRS. An example of the sales tax tables
is provided on the top of the next page.
If the taxpayer elects to deduct their state and local general sales taxes they must check box b on line 5
of Schedule A.
Actual Expenses. The taxpayer can deduct the actual state and local sales taxes paid in 2011 if the tax
rate was the same as the amount of the general sales tax rate. Sales taxes paid on food, clothing,
medical supplies and motor vehicles can be deducted even if the tax rate was less than the general
rate. Sales taxes on motor vehicles are also deductible, up to the amount of the general rate, even if
the actual tax rate was more.
If the taxpayer chooses to deduct their actual sales tax paid, they must keep their receipts showing the
amounts paid.
Optional Sales Tax Tables. Instead of using their actual expenses, taxpayers may choose to use the
optional sales tax tables provided by the IRS to figure their deduction. In addition, they may be able to
add any state and local general sales tax paid on any of the following items:
• A purchased or leased motor vehicle, including cars, trucks, motorcycles, motor homes, RVs
and off-road vehicles. Include only amounts up to the general sales tax rate.
• An aircraft or boat if the tax rate was the same as the general sales tax rate.
• A home or major addition/renovation to a home but only if the tax rate was the same as the
general rate and any of the following apply:
o
The taxpayer’s state or locality imposes a sales tax on the purchase or
renovation of a home
o
The taxpayer purchased the materials to build or renovate a home and paid the
sales tax directly
o
Under state law, the taxpayer’s contractor is considered to be their agent in the
construction/renovation of a home and their contract specifically states that the
contractor is authorized to act in the taxpayer’s name and follow the taxpayer’s
direction. In these circumstances the taxpayer is considered to have purchased
any items subject to sales tax.
Real Estate Taxes. Include on line 6 any amounts paid on real estate that the taxpayer owns that is not
used for business, but only if the taxes are based on the assessed value of the property and made
uniformly throughout the community and used for general community or government purposes.
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Do not include any of the following amounts as deductible real estate taxes:
• Itemized charges for services such as a $20 charge for trash collection or a $5 charge for
every 1,000 gallons of water consumed.
• Charges for improvements that generally increase the value of property, such as an
assessment to build a new sidewalk. The cost of these property improvements is added to the
basis of the property. However a charge to maintain or repair an existing sidewalk is
deductible.
If the taxpayer’s real estate taxes are paid through their mortgage company they may include as a
deduction any amount the mortgage company actually paid in 2011, not any amount held in reserve.
Personal Property Taxes. Enter any personal property taxes paid, but only if the tax is based solely on
the value of the property and it is charged on a yearly basis. For example, include on this line the yearly
fee paid for registration of a vehicle, but only the part of the fee that is based on the value of the car.
Other Taxes. Enter on line 8 any income tax paid to a foreign country or U.S. possession. However the
taxpayer may want to take a credit for the foreign tax rather than the deduction.
7.4 Deductible Interest. Interest is the amount paid for the use of borrowed money. The types of
interest deductible on Schedule A include home mortgage interest, certain points paid in connection
with a loan and investment interest. Other personal interest, such as the interest paid on a credit card
balance or car loan is not deductible (unless used for business).
7.4a Home Mortgage Interest. Home mortgage interest is any interest paid on a loan secured by the
taxpayer’s main home or second home. Mortgage loans include a loan to buy a home, a second
mortgage, a line of credit, or a home equity loan.
Mortgage interest is deductible if the taxpayer meets all of the following conditions:
• They must file Form 1040 and itemize deductions on Schedule A
• They must be legally liable for the amount of the loan
• The mortgage must be secured by a main home or second home
Home mortgage interest is generally deductible in full; however under certain circumstances the
amount of the taxpayer’s deduction is limited. Whether the taxpayer can deduct all or part of the
interest depends on the date the mortgage originated, the amount of the mortgage and the use of the
proceeds. If all of the taxpayer’s mortgages fit into one or more of the following categories at all times
during the year, all of the interest is deductible. If any one mortgage fits into more than one category,
add the debt that fits in each category to the taxpayer’s other debt in that same category.
• Mortgages taken out on or before October 13, 1987 (grandfathered debt)
• Mortgages taken out after October 13, 1987 to buy, build or improve the home (acquisition
debt) but only if through all of 2005 the total of these mortgages plus any grandfathered debt
totaled $1 million or less ($500,000 or less if married filing separately)
• Mortgages taken out after October 13, 1987 other than to buy, build or improve the home
(home equity debt) but only if through 2005 these mortgages totaled $100,000 or less
($50,000 or less if married filing separately) and totaled no more than the fair market value of
the home reduced by any grandfathered debt or acquisition debt.
The dollar limits in the second and third categories (acquisition debt and home equity debt) apply to the
combined mortgages on the taxpayers main home and second home.
If the taxpayer has any interest on a mortgage that does not fit into one of the three categories above,
get Publication 936 to determine the amount of deductible interest.
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Late Payment Charges. If the taxpayer has incurred a late payment charge, not in connection with a
specific service performed, the amount is deductible as home mortgage interest.
Mortgage Prepayment Penalty. If the taxpayer pays off a mortgage early and incurs a mortgage
prepayment penalty, the amount is deductible as interest only if the penalty is not in connection with a
specific service performed in connection with the loan.
Prepaid Interest. Any interest paid for a period beyond the current tax year is deductible only in the year
to which it applies. For example, a taxpayer decides to make his January and February, 2007 house
payments in the month of December, 2006. The amount of interest in the payments for January and
February will not be deductible until 2007.
7.4b Points. The term “points,” also known as loan origination fees, loan charges, loan discount fees,
or discount points, is used to describe charges paid by a borrower to obtain a home loan.
Points are usually deductible ratably over the life of the loan. However if the taxpayer meets all of the
following conditions, their points may be deducted in full in the year paid:
1. The loan is secured by their main home (the one they live in the majority of the time)
2. Paying points is an established business practice in the area the loan was made
3. The points paid were not more than points generally paid in the area
4. The taxpayer uses the cash method of accounting
5. The points were not paid in place of amounts that are usually stated separately on a
settlement statement such as appraisal fees, inspection fees, title fees, attorney fees, etc.
6. The funds that the taxpayer provided at or before closing plus any amounts that the seller
paid were at least as much as the points paid, whether or not the amounts were applied to
the points charged. The taxpayer cannot have borrowed the funds to pay the points from the
lender
7. The loan was used to buy or build the taxpayer’s main home
8. The points were computed as a percentage of the amount of the loan
9. The amount is clearly shown on the settlement statement as points.
Home Improvement Loans. The taxpayer can fully deduct points paid on a home improvement loan to
improve their main home if tests 1-6 above are met.
Refinance. Points paid to refinance a mortgage are not deducible in full in the year paid unless part of
the refinanced mortgage proceeds are used to improve the taxpayer’s main home. If tests 1-6 above
are met, the taxpayer may fully deduct the part of the points paid related to the improvement in the year
paid. The remainder is deductible over the life of the loan.
Seller Paid Points. During the sale of a home if the seller pays points in connection with a loan, the
seller cannot deduct the points as interest. They are a selling expense and increase the basis of the
home. The buyer reduces the basis of the home by the amount paid and may deduct the points if all of
the nine conditions described earlier are met.
Second Home. The taxpayer cannot fully deduct points paid in connection with a second home. These
points are deductible only over the life of the loan.
7.5 Mortgage Interest Credit. The taxpayer may be able to claim a mortgage interest credit if they
were issued a mortgage credit certificate (MCC) by a state or local government. Figure the credit on
Form 8396, Mortgage Interest Credit. If they take this credit, they must reduce their mortgage interest
deduction by the amount of the credit. See Form 8396 and Publication 530 for more information on the
mortgage interest credit.
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7.6 Investment Interest. If the taxpayer borrows money to buy property for investment, the interest
paid is considered to be investment interest. Investment interest paid is generally deductible up to the
amount of net investment income. Interest that is not deductible because of this limit can be carried
over to the following tax year and treated as investment interest paid or incurred in that next year.
Investment property includes property that produces interest, dividends, annuities or royalties not in
connection with the taxpayer’s trade or business.
Interest expense paid to produce tax-exempt interest is not deductible.
Form 4952, Investment Interest Expense Deduction, is generally used to figure the taxpayer’s
deduction for investment interest. If the taxpayer meets the three conditions below, their investment
interest is deductible on Schedule A and Form 4952 is not required:
• Their investment expense is not more than investment income from interest and ordinary
dividends minus any qualified dividends
• The taxpayer has no other deductible investment expenses
• They have no carryover of disallowed expenses from the prior tax year.
7.7 First-time Homebuyer Credit - 2011. Most people will not qualify for the first-time homebuyer
credit in 2011. However, certain members of the uniformed services and Foreign Service and certain
employees of the intelligence can claim the credit.
7.7a First-time Homebuyer Credit Recapture. Homebuyers who purchased a home in 2008, 2009 or
2010 may have taken advantage of the first-time homebuyer credit. If they claimed and received the
one-time credit in 2008, they must repay the credit as an additional tax on their return (special rules
apply if the home stops being their main home). The IRS calls the repayment period the “recapture
period.” The amount repaid each year is one-fifteenth, or 6 2/3%, of the credit for each taxable year in
the recapture period. To find out how much the taxpayer owes each year, take the amount of the credit
and divide by 15. The maximum amount of the credit in 2008 was $7,500. Taxpayers who received the
credit in 2008 should enter the repayment on their 2011 Form 1040, line 59b.
Taxpayers who claimed the credit in 2009 or 2010are required to repay the credit only if they disposed
of the home or it ceased to be their main home during the 36 months following the purchase date.. In
that case they generally must repay the entire credit in 2011. To repay the credit the taxpayer must
attach a completed Form 5405 to their tax return.
If the taxpayer received the credit for a home purchased in 2008, 2009 or 2010 and the home stops
being their main home, they may need to add the entire remaining credit amount to their income tax on
their next return.
The home stops being the taxpayer’s main home when:
•
They sell the home
•
They transfer the home to a spouse or former spouse in a divorce settlement
•
They convert the entire home to a rental or business property
•
They convert the home to a vacation or second home
•
They no longer live in the home for the greater number of nights in a year
•
The home is destroyed or condemned
•
They lose the home in foreclosure
•
They die
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There are exceptions to when the taxpayer may not have to repay the full amount of the credit:
•
If the taxpayer must transfer the house as part of a divorce settlement and the former spouse is
fully responsible for making all of the remaining repayments
•
If the home is destroyed or condemned and the taxpayer purchases a replacement home within
two years, they can continue to repay the credit in installments
•
If they lose their home in a foreclosure sale, the taxpayer must repay the credit only up to the
amount of the gain
•
If the taxpayer dies, no further repayments are due. If the amount was claimed on a joint return,
the surviving spouse pays only his or her half of the remaining credit repayment amount
•
If the taxpayer sells their main home to an unrelated person, they must repay the credit only up
to the amount of gain on the sale. When calculating gain or loss on the main home, the taxpayer
must reduce their basis in their home on any remaining amount of the credit.
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8.0 Itemized Deductions, Part 2
8.1 Charitable Contributions. A charitable contribution is a donation (gift) of money or property to, or
for the use of a qualified charitable organization. In order to be considered a charitable contribution, the
donation must be voluntary and made without the getting, or expecting to get anything in return. To be
considered a qualified charity, most organizations must file an application and supporting
documentation to the IRS and have a certification letter issued under IRS Code section 501(c) (3).
Qualified organizations include:
•
Churches, temples, synagogues, mosques and other religious organizations
•
Most nonprofit charitable organizations such as the Red Cross or the United Way
•
Most nonprofit educational organizations including the Boy and Girl Scout, colleges, and
museums
•
Nonprofit hospitals and medical research organizations
•
Nonprofit volunteer fire companies
•
Public parks and recreation facilities (but not entry fees or usage fees)
•
Civil defense organizations
Charitible contributions are deducted on lines 15 through 18 of Schedule A.
If the taxpayer receives a benefit as a result of making a charitable contribution, they can only deduct
the portion of the contribution that is over and above the value of the benefit received.
8.1a Contributions of Property. When the taxpayer makes a non-cash charitable contribution, the fair
market value of the property is usually the amount of the deduction. Fair market value is the price at
which property would change hands between a willing buyer and willing seller, neither one having to
buy or sell, and both having reasonable knowledge of all the facts in the transaction.
However, if the property has increased in value, some additional research is necessary.
8.1b Cars, Boats and Planes. For donations of cars (or any motor vehicles made primarily for use on
public roads and highways), boats and planes donated to a qualified organization after December 31,
2004, the following rules apply.
For deductions of more than $500. The taxpayer is required to submit with their tax return written
acknowledgement of the donation from the receiving charity. The charity must provide such written
acknowledgement within 30 days. Form 1098-C or a similar statement may be given to the taxpayer.
The taxpayer is required to attach the statement to their return when claiming the deduction. If they do
not attach Form 1098-C or similar statement, they cannot take the deduction.
If the qualified organization sells the vehicle, and the deduction is more than $500, the taxpayer may
claim a deduction for the smaller of:
• The vehicle’s fair market value on the date of the contribution; or
• The gross proceeds from the sale of the vehicle by the organization.
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There are two exceptions to the previous:
Exception 1 – The vehicle was used or significantly improved by the organization. If the charity
used or materially improved the vehicle before selling it, the taxpayer should deduct the fair
market value of the vehicle on their return.
Exception 2 – The vehicle was given or sold below market value to a needy individual. If the
charity gives or sells the vehicle for a price well below market value, the taxpayer should deduct
the fair market value of the vehicle on their return.
If either of the above exceptions apply, the qualified organization will reflect the correct information on
Form 1098-C or similar statement.
For deductions of less than $500. If the qualified organization sells the vehicle for $500 or less and the
two exceptions listed above do not apply, the taxpayer may deduct the smaller of:
• The vehicle’s fair market value on the date of the contribution; or
• $500.
Schedule A – Deductible and Nondeductible Charitable Contributions
Deductible
Nondeductible
Money or property given to:
Money or property given to:
• Churches, synagogues, temples, mosques and other • Civic leagues, social or sports clubs, labor unions and
religious organizations
chambers of commerce
• Federal, state and local governments if the contribution is • Most foreign organizations
solely for public purposes
• Nonprofit schools and hospitals
• Groups that are run for personal profit
•
•
•
Public parks and recreation facilities (but not entry or •
usage fees)
Salvation Army, Red Cross, CARE, Goodwill, United Way, •
Boy Scouts, Girl Scouts, Boys & Girls club
•
Veterans groups
•
Groups whose primary purpose is political lobbying
Homeowners’ associations
Individuals
Political groups or candidates
Costs paid for a student living with the taxpayer, sponsored by Noncharitable payments to federal, state and local
a qualified organization
governments
Out-of-pocket expenses when serving as a volunteer at a Costs of raffle, bingo or lottery tickets
qualified organization
Dues or other amounts paid to country clubs, lodges, fraternal
orders, or similar groups
Tuition
Value of the taxpayer’s time or services
8.1c Form 8283. If the amount of the taxpayer’s deduction for noncash items is more than $500, they
must complete and include Form 8283 with their return.
If the taxpayer claims a total deduction of $5,000 or less for all contributed property, they must only
complete Section A of Form 8283. If they claim a deduction of more than $5,000 for an item or a group
of similar items, they generally need to complete Section B of Form 8283 which requires, in most
cases, an appraisal by a qualified appraiser.
8.1d Recordkeeping. The taxpayer is required to keep records to prove the amount of cash and
noncash contributions made during the year. The kind of records they must keep depends on the type
and amount of the contribution.
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Cash contributions. The taxpayer cannot deduct any cash contributions, regardless of the
amount, unless they have one of the following:
•
A bank record that shows the name of the qualified organization, the date of the contribution,
and the amount of the contribution. Bank records include canceled checks, bank statements
or credit card statements.
•
A receipt or letter from the qualified organization showing the name of the organization, the
date of the contribution, and the amount of the contribution.
Cash contribution of $250 or more. If the taxpayer makes a single cash contribution of $250 or
more, they must have a written acknowledgement of their contribution by the receiving charity.
The acknowledgment must meet the following tests:
• It must be in writing;
• It must include the amount, and if the taxpayer received any goods or services as a result of
the contribution, a description and estimate of the value of such goods and services;
• The statement must be received by the earlier of the date the taxpayer files their return for
the year; or the due date, including extensions, for filing the return.
If the acknowledgement does not show the date of the contribution, they taxpayer must also have a
bank record or receipt as mentioned previously. If the acknowledgement from the qualified charity does
show the date of the contribution, and meets the other tests as described, the taxpayer does not need
any additional records.
When figuring whether the taxpayer has made a contribution of $250 or more, do not combine separate
contributions. For example, if the taxpayer attends a weekly church service and contributes $25 per
week, the payments are not combined. Each payment is a separate contribution.
Noncash contribution of less than $250. If the taxpayer makes a noncash contribution of less
than $250, they must get and keep a receipt from the charity showing the name of the
organization, the date and location of the contribution, and a description of the property.
Noncash contribution of at least $250, but not more than $500. For contributions of at least
$250, but not more than $500, the taxpayer is required to get confirmation from the receiving
organization that shows the name of the organization, the date and location of the contribution,
and a description of the property, plus:
• It must be in writing;
• It must include the amount, and if the taxpayer received any goods or services as a result of
the contribution, a description and estimate of the value of such goods and services;
• The statement must be received by the earlier of the date the taxpayer files their return for
the year; or the due date, including extensions, for filing the return.
Noncash contributions of over $500. If the taxpayer makes a single contribution of over $500,
additional information is required. See Records to Keep in Publication 561, Charitable
Contributions for more information.
8.1e Limits on Charitable Contributions. The taxpayer’s deductible charitable contributions may be
limited depending on the type of property donated and the type of charity receiving the donation.
If the taxpayer’s total contributions for the year total less than 20% of their adjusted gross income, no
limitations apply.
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Contributions limited to 50% of AGI. The taxpayer cannot take a charitable contribution
deduction of more than 50% of their adjusted gross income. This limit applies to all charitable
contributions made during the year, whether by cash, check or property.
Contributions to the following organizations are limited to 50% of AGI:
• Churches and conventions or associations of churches
• Educational organizations with a regular faculty and enrolled student body
• Hospitals
• Publicly supported charities
• Private operating foundations
• Private nonoperating foundations that make qualifying distributions of 100% of contributions
within 2½ months following the year they receive the contributions
• Certain private foundations whose contributions are pooled in a common fund, the income
and principal of which are paid to public charities
For a more in depth list of 50% charities, see Publication 78, Cumulative List of Organizations
described in Section 170(c) of the Internal Revenue Code of 1986.
Contributions limited to 30% of AGI. The taxpayer is limited to a deduction of no more than 30%
of their AGI when donating property to any organization not specifically stated to be a 50%
organization. This includes donations to the following:
•
Veterans’ organizations
•
Fraternal societies
•
Nonprofit cemeteries
•
Certain nonoperating foundations
•
Expenses paid for a student living with the taxpayer, such as an exchange student (not the
taxpayer’s relative or dependent). For more information, see Publication 17
Special limits for capital gain property. Property is capital gain property if its sale at fair market value on
the date of the contribution would have resulted in long-term capital gain. Capital gain property includes
capital assets held more than 1 year. Capital assets include most items of property that owned and
used for personal purposes or investment. Examples of capital assets are stocks, bonds, jewelry, coin
or stamp collections, and cars or furniture used for personal purposes.
If the taxpayer donates capital gain property to a 50% organization, a special 30% limit on the
deduction applies. Donations of capital gain property to a 30% organization are limited to 20% of the
taxpayer’s AGI.
8.1f Carryovers. Any charitable contributions that the taxpayer cannot deduct in the current year
because they exceeded the adjusted gross income limits can be carried over to the next five tax years.
Deductions that are not used with the five year time period are lost. Contributions that are carried over
are subject to the same percentage limits in the year to which they are carried. For example,
contributions subject to the 20% limit in the year in which they are made are 20% limit contributions in
the year to which they are carried.
For each category of contributions (50%, 30%, 20%), the taxpayer should deduct carryover
contributions only after deducting all allowable contributions in that category for the current year. If they
have carryovers from two or more prior years, the carryovers from the earlier year are used first.
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8.2 Casualty Losses (non-business). For tax purposes, a casualty is the damage, destruction or loss
of property resulting from an event that is sudden, unexpected or unusual. Casualty losses can include
losses from car accidents, earthquakes, fires, floods, theft or vandalism.
A casualty loss is not deductible if the damage or loss is caused by the following:
• Accidental breakage under normal conditions
• Damage by a family pet
• Damage that is willfully done by the taxpayer or someone the taxpayer hired
• Progressive deterioration due to normal wear and tear
Amount of Loss. If the taxpayer’s property is not completely destroyed or stolen, determine the loss
from a casualty by first figuring the decrease in fair market value of the property as a result of the
casualty event. To do this, determine the fair market value of the property both immediately before and
immediately after the casualty (an appraisal is the best way to make this determination). Compare the
decrease in fair market value with the adjusted basis of the property. From the smaller of these two
amounts, subtract any insurance or other reimbursement the taxpayer receives or expects to receive.
The result is the amount of loss from the casualty.
Adjusted basis. The adjusted basis of property is usually the cost of the property increased or
decreased by various events such as improvements and casualty losses. We will discuss
adjusted basis in greater detail later in the course.
Fair Market Value (FMV). The fair market value of property is the price at which property would
change hands between a willing buyer and willing seller, neither one having to buy or sell, and
both having reasonable knowledge of all the facts in the transaction.
The cost of replacing stolen or destroyed property is not considered when determining the amount of a
casualty loss for tax purposes.
Insurance and other reimbursements. If the taxpayer receives, or expects to receive, an insurance
payment or other type of reimbursement, the amount of the reimbursement must be subtracted when
figuring the amount of their casualty loss. The amount of loss must be reduced even if the taxpayer
does not expect to receive a reimbursement until a later tax year.
If the taxpayer receives a reimbursement greater than their adjusted basis in the property, they may
have a taxable gain, even if the decrease in the FMV of the property is smaller than their adjusted
basis. For more information on the gain from a casualty loss, consult Publication 547.
If the taxpayer includes an amount for an expected reimbursement when deducting a casualty loss, but
instead receives a different amount than reported, they will need to make an adjustment on the tax
return for the year the reimbursement is received. If they receive less than expected, they will have a
loss in the year the reimbursement is received. If they receive more than expected, they may have to
include the extra amount in income for the year received. For more information, see Publication 17.
8.2a The $100 Rule. For each personal casualty or theft, the amount of loss must be reduced by $100.
This rule applies to each individual event, not each individual piece of property. For example, a tornado
damages the taxpayer’s car and garage. Combine the calculated loss on the car and garage before
subtracting $500.
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$100 Rule
Generally
Single Event
More Than One Event
Each casualty or theft is reduced by $100
when figuring any deduction. This rule is
applied after figuring the amount of the
loss
This rule is applied only once, even if
more than one piece of property is
involved
Apply to the loss from each event
More Than One Person with a loss
from the event (other than a couple Apply separately to each person
filing MFJ)
Married Couple – MFJ
Apply as if one person
Married Couple – not MFJ
Apply separately to each spouse
More Than One Owner other than a Apply to each owner
married couple MFJ
10% Rule
Reduce the total casualty of theft loss by
10% of AGI after reducing each loss by
the $100 rule
This rule is applied only once, even if
more than one piece of property is
involved
Apply to the total of all losses from all
events
Apply separately to each person
Apply as if one person
Apply separately to each spouse
Apply to each owner
8.2b The 10% Rule. The total of all casualty and theft losses on personal-use property for the year
must be reduced by 10% of the taxpayer’s AGI. The 10% rule is applied to the total of all losses for the
year after the $100 rule has been applied to each casualty or theft.
8.2c Presidentially Declared Disaster Areas. Special rules apply to casualty losses that result from
disasters in a Presidentially declared disaster area. The taxpayer can choose to deduct the loss in the
year the disaster occurred or on an amended return for the year preceding the year the disaster
occurred.
8.2d Form 4684. Form 4684 is used to report a deductible loss from a casualty or theft. If the taxpayer
has more than one casualty or theft for the year, a separate Form 4684 is completed for each event.
The totals are then reported on a combined Form 4684. The calculated loss for the year is then carried
to Schedule A, line 19.
8.3 Miscellaneous Itemized Deductions. In addition to the deductions discussed previously, there are
certain other miscellaneous deductions that the taxpayer may benefit from. Most of these itemized
deductions must be reduced by 2% of the taxpayer’s adjusted gross income.
8.3a Deductions Subject to the 2% Limitation. Deductions that fall under the 2% limit fall under three
categories:
• Unreimbursed employee business expenses (Schedule A, line 20). Include such items as union
dues, uniforms, education, etc.
• Tax preparation fees (Schedule A, line 21); and
• Other expenses (Schedule A, line 22).
Tax preparation fees (line 21). The fees the taxpayer pays to have their tax return prepared are
deductible in the year paid. So, for their 2011 return, the taxpayer can deduct the amount they paid to
have their individual 2010 return prepared. These fees can include the amount the taxpayer paid to a
tax professional or CPA. They also can include any fees paid for software or publications to help them
prepare their own return. The amount deductible includes fees paid to electronically file their return, but
fees paid in connection with a refund anticipation loan or a convenience charge by a credit card
company cannot be deducted.
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Fees paid in connection with schedules or forms relating to a business (Schedule C or C-EZ), rental
(Schedule E) or farm income (Schedule F) should be deducted on the appropriate schedule relating to
the activity. The remainder of the personal portion of the return is deductible on Schedule A.
Other expenses (line 22). Deduct on line 22 other expenses subject to the 2% AGI limitation. These
include expenses paid for:
• Production or collection of taxable income (investment expenses), including:
o
Accounting fees for keeping records of investment income,
o
Fees to set up and administer an IRA billed separately from the regular IRA contribution
o
Fees for an investment planner
o
Legal costs involved in collecting taxable income
o
Other fees and costs incurred in producing taxable income. For more information, see
IRS Publication 550, Investment Income and Loss
• Fees paid to determine, contest, pay or claim a refund of any tax.
8.3b Deductions Not Subject to the 2% Limitation. The items below can be deducted as
miscellaneous deductions not subject to the 2% limitation. They are reported on Schedule A, line 27.
• Amortizable premium on taxable bonds
• Casualty and theft losses from income producing property
• Federal estate tax paid on income in respect of a decedent
• Gambling losses up to the amount of gambling winnings
• Impairment-related work expenses of persons with disabilities
• Loss from other activities from Schedule K-1 (Form 1065-B), box 2
• Repayments of more than $3,000 under a claim of right
• Unrecovered investment in an annuity
8.4 Form 2106. Use Form 2106 if for employees deducting ordinary and necessary expenses for their
job. An ordinary expense is one that is common and accepted in their field of trade, business, or
profession. A necessary expense is one that is helpful and appropriate for their business. An expense
does not have to be required to be considered necessary.
8.4a Form 2106-EZ. The taxpayer may be able to file Form 2106-EZ, Unreimbursed Employee
Business Expenses, provided they:
• Use the standard mileage rate (if claiming vehicle expense), and
• Were not reimbursed by their employer for any expense (amounts the employer included in box
1 of Form W-2 are not considered reimbursements for this purpose).
8.4b Recordkeeping. An employee cannot deduct expenses for travel (including meals unless they
used the standard meal allowance), entertainment, gifts, or use of a car or other listed property, unless
they keep records to prove the time, place, business purpose, business relationship (for entertainment
and gifts), and amounts of these expenses. Generally, the taxpayer must also have receipts for all
lodging expenses (regardless of the amount) and any other expense of $75 or more.
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9.0 Tax Benefits of Education
9.1 Education Credits. There are two education credits available: the lifetime learning credit and the
American opportunity tax credit. These credits apply only to expenses paid for higher educational
expenses. The lifetime credit is nonrefundable; the American opportunity credit may be partially
refundable.
9.2 The American opportunity tax credit (AOC). For tax years 2009-2011, the previous Hope credit
has been expanded and modified. The modified credit is called the American opportunity tax credit
(AOC). Generally, the taxpayer can claim the American opportunity credit if all four of the following
requirements are met.
•
•
•
They pay qualified education expenses of higher education.
They pay the education expenses for an eligible student.
The eligible student is the taxpayer, their spouse, or a dependent for whom they claim an
exemption on your tax return.
Overview of the American Opportunity Credit
Maximum credit
Limit on modified adjusted
gross income (MAGI)
Refundable or nonrefundable
Number of years of
postsecondary education
Number of tax years credit
available
Type of degree required
Number of courses
Felony drug conviction
Qualified expenses
Up to $2,500 credit per eligible student
$180,000 if married filling jointly; $90,000 if single, head of household, or
qualifying widow(er)
40% of credit may be refundable; the rest is nonrefundable
Available ONLY for the first 4 years of postsecondary education
Available ONLY for 4 tax years per eligible student (including any year(s) Hope
credit was claimed)
Student must be pursuing an undergraduate degree or other recognized
education credential
Student must be enrolled at least half time for at least one academic period
that begins during the tax year
No felony drug convictions on student's records
Tuition and fees required for enrollment. Course-related books, supplies, and
equipment do not need to be purchased from the institution in order to qualify.
Payments made in 2011 for academic periods beginning in 2011 and in the
Payments for academic periods first 3 months of 2012
If the taxpayer pays qualified education expenses for more than one student in the same year, they can
choose to take the American opportunity and lifetime learning credits on a per-student, per-year basis.
This means that, for example, they can claim the American opportunity credit for one student and the
lifetime learning credit for another student in the same year.
9.2a Qualified Education Expenses. Generally the American Opportunity credit (and the lifetime
learning credit) is allowed if the taxpayer pays qualified education expenses for higher education. The
credit is allowed for expenses paid in 2011 for an academic period (semester, quarter, trimester, or
summer session, etc.) beginning in 2011 or in the first three months of 2012. Qualified education
expenses include tuition and enrollment fees. Other expenses may include "course materials" such as
books, supplies and equipment needed for a course. These are qualified expenses whether or not the
materials are purchased from the institution as a condition of enrollment or attendance.
If the taxpayer pays for qualified educational expenses with certain tax-free funds, such as a tax-free
scholarship, Pell grant, VA education assistance, employer provided educational assistance, etc., can
not be used to claim the American Opportunity credit. The taxpayer’s educational expenses must be
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reduced by any of the above before calculating the credit. However, if the taxpayer pays with funds
received as a tax-free gift, loan or inheritance, the expenses will still qualify for the credit.
Qualified vs. Nonqualified Expenses (AOC)
Qualified Expenses
• Tuition and fees
• Course related books*
Nonqualified Expenses
• Insurance
• Student health fees
• Course or lab related supplies*
• Course or lab related equipment*
• Room and board
• Transportation
• Other personal or living expenses
9.2b Eligible educational institution. An eligible educational institution includes most colleges,
universities, vocational schools and other postsecondary educational institutions. It includes almost all
accredited public, nonprofit and privately owned postsecondary institutions. If in doubt, the taxpayer
should ask the institution if they are considered to be an eligible educational institution for the purposes
of the educational tax credits.
If the taxpayer receives a refund of the qualified expenses before filing their tax return for that year, they
must reduce the amount of qualified expenses paid by the amount refunded. However, if the taxpayer
receives a refund of qualified fees paid after filing their tax return for the year, they may have to
recapture or pay back some of the credit claimed
9.2c Eligible student. To claim the American Opportunity credit, the qualified educational expenses
must have been paid for an eligible student. To be an eligible student, an individual must meet the
following requirements:
•
The student did not have expenses that were used to figure an American Opportunity (or Hope)
credit in any four earlier tax years.
•
The student has not completed the first four years of postsecondary education (generally a
freshman, sophomore, junior and senior year) before 2011.
•
The student was enrolled at least half-time in a program leading to a degree, certificate or other
recognized credential for at least one academic period beginning in 2011.
•
The student had no felony convictions for possessing or distributing a controlled substance as of
the end of 2011.
9.2d Expenses Paid for a Dependent. If the taxpayer pays for qualified educational expenses for a
dependent, they may claim the American Opportunity credit if they claim an exemption for that
individual on the first page of Form 1040. If the taxpayer (or anyone else) does not claim an exemption
for the student, only the dependent can include any expenses paid by the taxpayer when figuring their
American Opportunity credit. If the dependent paid expenses for qualified higher education, and the
taxpayer claims an exemption for them on their tax return, the taxpayer may also treat any expenses
paid by the dependent as if they were paid by the taxpayer when calculating their credit.
Determining the Amount of the American Opportunity Credit. The amount of the credit (for each eligible
student) is the sum of:
• 100% of the first $2,000, plus
• 25% of the next $2,000.
The maximum amount of the credit that the taxpayer can claim in 2011 is $2,500 times the number of
eligible students. However the credit may be reduced if the taxpayer’s modified adjusted gross income
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(MAGI) is between $80,000 and $90,000 ($160,000 and $180,000 if MFJ). For most taxpayers, their
MAGI will be their adjusted gross income. However if they have any foreign income, including income
from American Samoa or Puerto Rico, additional research is indicated.
To claim the credit, the taxpayer must complete Parts I and III of Form 8863, Education Credits
(American Opportunity and Lifetime Learning Credits) and include the form with their tax return.
9.2e Refundable Part of the American Opportunity Credit. Forty percent of the American
Opportunity credit is refundable for most taxpayers. However, if the taxpayer was under age 24 at the
end of 2010 and the following conditions apply, the taxpayer cannot claim any part of the credit as a
refundable credit.
1. The taxpayer was:
•
Under age 18 at the end of 2011, or
•
Age 18 at the end of 2011 and their earned income was less than one-half of
their support, or
•
A full-time student over age 18 and under age 24 at the end of 2011 and their
earned income was less than one-half of their support
2. At least one of their parents was alive at the end of 2011.
3. The taxpayer is filing a return as single, head of household, qualifying widow(er) or
married filing separately for 2011.
9.3 The Lifetime Learning Credit. The Lifetime Learning credit is a credit of up to $2,000 for qualified
educational expenses paid for students enrolled in eligible educational institutions. The amount of the
credit is 20% of the total qualified expenses for all eligible students on the tax return. The maximum
amount of expenses allowed per tax return is $10,000; the maximum amount of the credit is $2,000 per
return.
9.3a Qualified Education Expenses. Like the American Opportunity credit, the lifetime learning credit
is allowed if the taxpayer pays qualified education expenses for higher education. The credit is allowed
for expenses paid in 2011 for an academic period (semester, quarter, trimester, or summer session,
etc.) beginning in 2011 or in the first three months of 2012. Qualified education expenses include tuition
and certain related expenses required for enrollment or attendance at an eligible educational institution.
9.3b Eligible educational institution. As with the American Opportunity credit, an eligible educational
institution for the purposes of the lifetime learning credit includes most colleges, universities, vocational
schools and other postsecondary educational institutions including almost all accredited public,
nonprofit and privately owned postsecondary institutions.
9.3c Eligible student. To claim the lifetime learning credit, the qualified educational expenses must
have been paid for an eligible student. To be an eligible student, the individual must be enrolled in one
or more courses at an eligible educational institution. There is no requirement that the student attend
courses on at least a half-time basis. For example, a businessman may claim the credit for courses to
improve his job skills taken at an eligible educational institution, even if he takes only one course.
9.3d Expenses Paid for a Dependent. If the taxpayer pays for qualified educational expenses for a
dependent, they may claim the credit if they claim an exemption for that individual on the first page of
Form 1040. If the taxpayer (or anyone else) does not claim an exemption for the student, only the
dependent can include any expenses paid by the taxpayer when figuring their credit. If the dependent
paid expenses for qualified higher education, and the taxpayer claims an exemption for them on their
tax return, the taxpayer may also treat any expenses paid by the dependent as if they were paid by the
taxpayer when calculating their credit.
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9.3e Determining the Amount of the Lifetime Learning Credit. The amount of the credit (for each
eligible student) is 20% of the first $10,000 of qualified education expenses paid for all eligible students
The maximum amount of the credit that the taxpayer can claim in 2011 is $2,000. However the credit
may be reduced if the taxpayer’s modified adjusted gross income (MAGI) is between $51,000 and
$61,000 ($102,000 and $122,000 if MFJ). For most taxpayers, their MAGI will be their adjusted gross
income. However if they have any foreign income, including income from American Samoa or Puerto
Rico, additional research is indicated.
To claim the credit, the taxpayer must complete Parts II and III of Form 8863, Education Credits and
include the form with their tax return.
9.4 Recapture of Education Credits. If, after filing their tax return, the taxpayer receives tax-free
educational assistance or a refund of an expense used to figure an education credit on their return, they
may have to repay all or part of the credit. They must figure their education credit for 2011 as if the
assistance or refund was received in 2011. Subtract the amount of the refigured credit from the amount
of the original credit. The result is the amount the taxpayer must repay. The taxpayer should add the
repayment (recapture) to their tax liability for the year in which they receive the assistance or refund.
Their original tax return for 2011 does not change.
Overview of the Lifetime Learning Credit
Maximum credit
Up to $2,000 credit per return
Limit on modified adjusted
gross income (MAGI)
$122,000 if married filling jointly;
$61,000 if single, head of household, or qualifying widow(er)
Refundable or nonrefundable
Nonrefundable—credit limited to the amount of tax you must pay on your
taxable income
Number of years of
postsecondary education
Available for all years of postsecondary education and for courses to acquire
or improve job skills
Number of tax years credit
available
Available for an unlimited number of years
Type of degree required
Student does not need to be pursuing a degree or other recognized education
credential
Available for one or more courses
Felony drug convictions are permitted
Number of courses
Felony drug conviction
Qualified expenses
Tuition and fees required for enrollment (including amounts required to be paid
to the institution for course-related books, supplies, and equipment).
Payments made in 2011 for academic periods beginning in 2011 and in the
Payments for academic periods first 3 months of 2012
9.5 Student Loan Interest Deduction. Generally, personal interest paid is not deductible on a tax
return. However, the taxpayer may take an adjustment to income for certain student loan interest
expenses paid. The taxpayer can take a deduction of up to $2,500 even if they do not itemize their
deductions.
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9.5a Qualified Student Loan. A qualified student loan is a loan taken out solely to pay qualified
educational expenses that were:
• Paid for the taxpayer, spouse or a person who was the taxpayer’s dependent when they took out
the loan
• Paid or incurred with a reasonable period of time before or after the taxpayer took out the loan; and
• Paid for education provided during an academic period for an eligible student.
Loans from a related person or from a qualified employer plan do not qualify for the student loan
interest deduction.
9.5b Eligible Student. An eligible student for the purposes of the student loan interest deduction is a
degree candidate carrying at least a half-time course load. The student may be the taxpayer, the
taxpayer’s spouse, or someone claimed as the taxpayer’s dependent in the year the education was
furnished.
Also, for the purposes of the student loan interest deduction, there exist the following exceptions to the
general rules for dependents:
• The person would be the taxpayer’s dependent, however the taxpayer is a dependent of another;
• The person would be the taxpayer’s dependent, however the individual files a joint return with their
spouse;
• The person would be the taxpayer’s dependent, however the individual has gross income that was
equal to or greater to $3,700 for 2011 (the exemption amount).
9.5b Qualified Education Expenses. For the purposes of the student loan interest deduction, qualified
education expenses include the total costs of attending an eligible institution, including graduate school.
They include tuition and fees, room and board, books and supplies and other necessary expenses such
as transportation.
The room and board qualifies to the extent that the larger of the allowance for room and board,
determined by the educational institution, or the actual amount charged.
9.5c Amounts Includible as Interest. In addition to the simple interest on the loan, the following can
be deductible as well (as long as all of the other requirements are met):
• Loan origination fee for the use of money, accrued over the time of the loan
• Unpaid interest on a student loan that is added by the lender to the outstanding principal balance
of the loan
• Interest on revolving lines of credit (including credit cards) if the borrower uses the like of credit
only to pay qualified education expenses
• Interest on refinanced student loans. If the taxpayer refinanced the loan for a greater amount than
the original loan and the taxpayer used the additional amount for anything other than qualified
education expenses, they cannot deduct any interest paid on the refinanced loan
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9.5d Amounts Not Includible as Interest. Amounts that cannot be deducted as student loan interest
include:
• Interest paid on a loan that the taxpayer is not legally obligated to repay
• Loan origination fees that are payments for property or services, such as a processing fee
• Interest paid to the extent that the payments were made through the taxpayer’s participation in the
National Health Service Corps (NHSC) Loan Repayment Program or certain other state loan
repayment programs.
9.3e Who Can Claim The Deduction? Generally a taxpayer may claim a deduction for student loan
interest if the following requirements are met:
• They use any filing status except Married Filing Separately;
• No one else is claiming an exemption for the taxpayer; and
• The taxpayer paid qualified student loan interest;
In addition, the taxpayer may deduct interest paid on a student loan for their dependent in the following
circumstances:
• The taxpayer is legally obligated to make the interest payments;
• The taxpayer actually made the payments during the tax year; and
• The taxpayer claims an exemption for the dependent on their tax return.
9.3f Determining the Amount of the Deduction. The taxpayer’s deduction for student loan interest for
2011 is generally the smaller of $2,500 or the amount actually paid in 2011. However, the actual
amount of the deduction may be reduced if the taxpayer’s Modified Adjusted Gross Income (MAGI)
exceeds a phase out amount based on their filing status.
9.3g Calculating the Phase Out. To determine the amount of the allowed reduced deduction, multiply
the amount of the deduction before the phase out (the smaller of $2,500 or the amount paid) by the
following fraction:
MAGI - $60,000 ($120,000 MFJ)
$15,000 ($30,000 MFJ)
Subtract the result from the amount of interest paid to arrive at the allowed deduction.
9.4 Tuition and Fees Deduction. The tuition and fees deduction can reduce the amount of the
taxpayer’s taxable income by up to $4,000. Like the student loan interest deduction, the tuition and fees
deduction is taken as an adjustment to income, meaning that the taxpayer can benefit even if they do
not itemize deductions. Form 8917 is used to figure and take the deduction for tuition and fees
expenses paid in 2010.
9.4a Who Can Take The Deduction? Generally the taxpayer may claim the tuition and fees deduction
if all of the following requirements are met:
• The taxpayer paid qualified higher education expenses;
• The expenses were paid for an eligible student; and
• The eligible student is the taxpayer, the taxpayer’s spouse or a dependent for whom the taxpayer
claims an exemption on their tax return.
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The taxpayer cannot take a deduction for tuition and fees if they are using the married filing separate
filing status or if they are claimed as a dependent on the tax return of another.
9.4b Eligible Student, Defined. For the purposes of the tuition and fees deduction, an eligible student
must be enrolled in one or more courses at an eligible educational institution (as defined in the
discussions on the education credits). The student must have either a high school diploma or a General
Educational Development (GED) credential.
9.4c Expenses Paid For A Dependent. In order to claim the tuition and fees deduction for a
dependent, the taxpayer must have paid the expenses and claim an exemption for the dependent.
The chart below will help determine who may claim the tuition and fees deduction for the expenses of a
dependent.
Maximum Amounts for the Tuition and Fees Deduction
Filing status
MAGI is
Maximum tuition deduction is
Single
Not more than $65,000
More than $65,000 but not more than
$80,000
More than $80,000
$4,000
$2,000
Not more than $130,000
$4,000
More than $130,000 but not more than
$160,000
More than $160,000
$2,000
Head of household
Qualifying widow
Married filing jointly
$0
$0
Who May Claim The Tuition and Fees Deduction for a Dependent’s Expenses
If the taxpayer…
And…
Then…
The taxpayer paid qualifying education
expenses for the dependent
Claims an exemption for the
The dependent paid their own education
dependent
expenses
The taxpayer paid qualifying education
expenses for the dependent
Is eligible to claim an exemption The dependent paid their own education
for the dependent but chooses expenses
not to
The taxpayer paid qualifying education
expenses for the dependent
Is not eligible to claim the
The dependent paid their own education
exemption for the dependent
expenses
9.0 Tax Benefits of Education
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Only the taxpayer may claim the
deduction
No one may claim the deduction
No one may claim the deduction
No one may claim the deduction
Only the dependent may claim the
deduction
Only the dependent may claim the
deduction
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10.0 The Sole Proprietor
10.1 Definition of Sole Proprietor. A Sole Proprietor is an individual who is in business for himself or
herself. All income and expenses for a sole proprietor are reported on Schedule C (or Schedule C-EZ)
and carried to the form 1040 of the owner of the business. A sole proprietorship is the most basic form
of business ownership.
10.2 Husband and Wife Businesses. Generally speaking, if two or more people engage in a business
together in order to share profits, the activity is considered a partnership rather than a soleproprietorship. However there is an exception for a husband and wife who operate a business together.
Their business may qualify as dual sole-proprietors if:
•
The only members of the business are the husband and wife;
•
Both spouses materially participate in the business;
•
They file a joint return for the year; and
•
Both spouses agree to have the rule apply.
In this event, each spouse would file a separate Schedule C and account for his or her share of the
business income. All the items of income and expenses are divided between the spouses according to
their interest in the business. This election will generally not increase the total tax owed, but it does give
each spouse credit for social security earnings on which retirement benefits are based and for
Medicare coverage.
However, if one of the spouses has a greater investment in time, labor, and/or money, the business is
considered to belong to that spouse. The other spouse may be considered an employee of the sole
proprietorship and would receive wages reported on Form W-2. This scenario may be beneficial for tax
purposes – see Family Owned Business later in the text.
If a husband and wife wholly own an unincorporated business in a community property state, they may
treat the business either as a partnership or a sole proprietorship.
10.3 Business Income vs. Hobby Income. The taxpayer must be involved in a for-profit business in
order to report their income and expenses on Schedule C. A hobby is an activity engaged in for fun and/
or enjoyment and not necessarily with a profit motive. It may be that a hobby shows a profit, however it
is the intent to make a profit which is important. The same holds true for the reverse – a for-profit
business may lose money, however the intent is to show a profit. The determination of an activity as a
hobby or a for-profit activity is important as it impacts both where on the tax return the income/
expenses are reported and how much of a loss (if any) is deductible. See the chart below.
Hobby vs. Business
Hobby
For-profit sole proprietor
Line 21, Form 1040
Schedule C
Income subject to SE tax?
No
Yes
Expenses reported where?
Schedule A, subject to
2% limitation
Schedule C
Income reported where?
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Hobby expenses are allowed only to the extent of the income produced by the activity and then only on
Schedule A, subject to the 2% AGI limitation. Allowable expenses are deducted in the following order:
1. Expenses that are deductible without regard to profit motive (for example, real estate taxes;
2. Expenses that would be deductible in a for profit activity other than depreciation or
amortization (for example, advertising, office supplies, etc.); and then
3. Expenses that would be deductible in a for-profit activity that result in a basis adjustment
(depreciation or amortization).
10.3a Safe Harbor Rule. A “safe harbor” rule exists and, if met, the IRS will not attempt to reclassify
the business as a hobby unless there are extenuating circumstances. To meet the safe harbor test, an
activity must generate a profit in at least three of the five years ending with the tax year in question (two
of seven years for activities involving horse racing, breeding, or showing). Note: The IRS can invalidate
the safe harbor rule by proving that the activity is not engaged in for profit.
Applying the Safe Harbor Rule
Year 1
Year 2
Year 3
Profit / Loss
Loss
Loss
Profit
Year 4
Loss
Year 5
Year 6
Year 7
Profit
Profit
Loss
Safe harbor applies?
No – business has not yet shown a profit.
No – business has not yet shown a profit.
In this scenario, the safe harbor period begins in Year 3 since the
business has shown a profit three out of next five years. Had the
business not shown a profit in Year 6 or 7, the safe harbor period would
not apply.
Although this loss year is within the 5-year period, the losses incurred
are not protected because the safe harbor applies only after a taxpayer
has a third profitable year in a five year period.
This would be the second profitable year.
This would be the third profitable year.
This would be the only year covered by the safe harbor rule.
The safe harbor period does not begin until the first profitable year of the business and applies only for
the third (or second for horse racing, etc.) profitable year and all subsequent years within a five (or
seven) year period.
A taxpayer can elect to postpone the determination of whether or not an activity is engaged in for profit
until after the close of the fourth year (sixth year for breeding, training, etc. of horses) following the first
tax year that the activity is conducted. This election allows the taxpayer to presume the activity is
engaged in for profit in advance of actual results.
The advantage of this election is that losses from the activity during the five-year period are tentatively
allowed during that period and reported on Schedule C. However if the election is made and the
taxpayer fails the three-out-of-five test, the taxpayer may be faced with a substantial tax deficiency for
all years involved. The election also automatically extends the statute of limitations for all years in the
postponement period until two years after the due date (without extensions) of the return for the last tax
year in the five/seven year period. The statute is extended only for items related to the activity and
other items on the return that would be directly affected. To make an election, the taxpayer must file
Form 5213 (Election To Postpone Determination).
The following factors should be considered when making a determination of a profit-motive. This is not
an all inclusive list of factors, the facts and circumstances of each individual case must be taken into
account. The answer “yes” in answer to the questions indicates a profit motive.
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1. Is there a legitimate profit or gain motive?
2. Does the taxpayer maintain accurate and complete business books and records?
3. Does the taxpayer have expertise in the type of business he/she is involved in?
4. Has the taxpayer consulted business advisers in regards to his/her business?
5. Does the taxpayer rely on this business for a substantial portion of his/her income or do they
have other sources of income?
6. Do business/profit concerns outweigh personal enjoyment factors of the business?
7. Has the business shown a profit in the past?
10.4 Start-Up Costs. Start-up expenses are costs incurred before a trade or business begins. They are
generally connected to setting up a business; researching the creation of a business; or investigating
the purchase of a business. Since they were not incurred in the actual “business of doing business,”
start-up costs are not always deductible in full in the year the expenses are incurred.
To qualify as start-up expenses, the costs must meet the following two tests:
•
The expenses would have been deductible if they were paid in conjunction with an operating
trade or business;
•
The expenses must have been paid (or incurred) before the trade or business actually began
operating.
Start-up expenses are classified as “capital expenses.” Capital expenses are considered to be
investments in or assets of a business. There are, generally, three types of costs that must be
capitalized:
•
Start-up expenses
•
Business assets
•
Improvements
A taxpayer can elect to deduct up to $5,000 of organizational costs and up to $5,000 of business startup costs as a deduction in the year the trade or business begins. The $5,000 is reduced dollar for dollar
by the amount the total organizational or start-up expenses exceed $50,000. Any expenses that are not
currently deductible are amortized over 180 months (15 years). Note: Sole proprietors do not usually
have organizational expenses. They are usually incurred by start-up corporations or partnerships.
Organizational costs include state filing fees to establish a new entity, the initial costs of holding a
shareholder's meeting to elect a new board of directors, obtaining the corporate kit and share
certificates, etc.
Start-up costs include (but are not limited to) the following:
•
Analysis or surveys of potential markets, products, labor supply, transportation facilities, etc.
•
Advertisements for the opening of the business.
•
Salaries and wages for employees who are being trained and their instructors.
•
Travel and other necessary costs for securing prospective distributors, suppliers or customers
•
Salaries and fees for executives and consultants or for similar professional services.
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If the taxpayer elects to currently deduct their start-up costs, the amount should be entered in Part V –
Other Expenses of Schedule C. To claim a deduction for amortization of the balance of your start-up
costs, they will need to file Form 4562 - Depreciation and Amortization. The amortization of business
start-up costs and the costs of organizing a corporation or partnership is reported in Part VI of Form
4562.
If they taxpayer attempts to go into business and is not successful in starting the business, the
expenses fall into two categories:
•
“Investigatory expenses” - costs associated with reviewing a prospective business prior to a final
decision to go into business. These expenses are personal and non-deductible.
•
Start-up expenses incurred after a decision to go into business has been made, but before the
business actually begins to operate are deductible as a capital loss.
The taxpayer elects to deduct the start-up or organizational costs by claiming the deduction on the tax
return (filed by the due date including extensions) for the tax year in which the business started. If the
taxpayer filed a timely return without making the election, they can still make the election by filing an
amended return within 6 months of the due date of the return (including extensions). Clearly indicate
the election on the amended return and write “Filed pursuant to section 301.9100-2.” File the amended
return at the same address as the original return.
10.5 Schedule C, Part I - Income. A self-employed taxpayer should report their gross receipts from
sales or services on Line 1 of Schedule C. If they do not produce or sell items, they will not have an
inventory or cost of goods sold, but should report only their receipts from services. Line 1 of Schedule C
does not include any amount received for the sale of property used in a business or profession (Form
4797).
Many self-employed individuals receive Forms 1099-MISC showing income to be reported on Schedule
C. If the taxpayer received a Form 1099-MISC indicating nonemployee compensation, but believes they
received this form in error (were actually an employee) see the section at the end of this chapter.
10.5a Returns and Allowances, Line 2. Line 2 of Schedule C should only be used by accrual based
taxpayers who have previously included an amount as income when earned, but subsequently did not
get paid. Cash basis taxpayers should never have any amount on this line.
10.5b Cost of Goods Sold. If the taxpayer makes or buys goods to sell, they can deduct the cost of
goods sold from their gross receipts on Schedule C. However, to determine these costs, they must
value their inventory at the beginning and end of each tax year. If they must account for an inventory in
your business, they must generally use an accrual method of accounting for purchases and sales.
Beginning inventory is the cost of merchandise on hand at the beginning of the year that is available for
sale to customers. If the taxpayer is a manufacturer or producer, it includes the total cost of raw
materials, work in process, finished goods, and materials and supplies used in manufacturing the
goods. Opening inventory usually will be identical to the closing inventory of the year before. The
taxpayer must explain any difference in a schedule attached to the return.
Purchases include either the total cost of all merchandise bought for sale or the cost of all raw materials
or parts purchased for manufacture into a finished product.
Labor, materials and supplies, plus other costs are included in cost of goods sold only if they are
directly associated with and an integral part of the item being sold. If they are not directly related to
inventory, they must be taken as a general business expense.
Subtract the value of the taxpayer’s closing inventory (including, as appropriate, the allocatable parts of
the cost of raw materials and supplies, direct labor, and overhead expenses) from line 40. Inventory at
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the end of the year is also known as closing or ending inventory. The ending inventory will usually
become the beginning inventory of the next tax year.
10.6 Overview of Deductible Expenses on Schedule C. Note: If the Sole Proprietor is also an
employee performing similar duties for another and receiving a Form W-2, the expenses must be
allocated between Schedule C and Form 2106. If certain expenses cannot be matched to specific
income, they must be allocated between Schedule C and Form 2106 based on gross income from each
activity.
10.6a Advertising. Include on this line ordinary and necessary expenses of promoting a business,
such as newspaper, television or radio ads; flyers and the cost of distributing them; business cards;
promotional items, etc. Advertising to influence political legislation is not deductible.
10.6b Bad debts from sales or services. A business bad debt is a loss from an uncollectible debt that
was created, acquired or closely related to the business. A taxpayer can take a deduction for a bad debt
only if the amount was previously included in income. Cash basis taxpayers generally cannot take a
deduction for a bad debt on their tax return.
10.6c Car and truck expenses. Taxpayers using an automobile in a trade or business can deduct
expenses for the vehicle using either the standard mileage rate or the actual costs. Whichever method
is chosen, the taxpayer should keep a log of their business mileage to substantiate any deduction
taken. The taxpayer does not have to write down their mileage every time they use their car for
business (although that is certainly acceptable), however the IRS does require some method of
recordkeeping at or near the time of the use of the vehicle.
Standard Mileage Rate. In order to use the standard mileage rate for expenses, the taxpayer must
generally use that method in the year the car is placed in service. If the vehicle is owned, the taxpayer
may switch to the actual expense method in later years, but there are specific rules about calculating
depreciation after the standard mileage rate has been used. If the vehicle is leased, the election to use
the standard mileage rate must be for the entire lease period of the auto. The standard mileage rate
encompasses most expenses incurred in the operation of a vehicle.
Expenses not included in the standard mileage rate that may also be deductible include:
•
Business parking fees and tolls;
•
The business portion of state and local personal property taxes; and
•
The business portion of interest on an auto loan.
For tax year 2010 the standard mileage rate is 50¢ per mile.
Actual Expenses. The taxpayer can deduct the business-use percentage times the actual cost of
running the automobile. Actual expenses include (but are not limited to) the expenses listed above
under standard mileage rate. Depreciation is listed separately on line 13 of Schedule C and rent or
lease payments for a business automobile on line 20a. The taxpayer must use the actual expense
method if more than one vehicle is used at the same time in the business.
10.6d Commuting Expenses. Auto expenses between the taxpayer’s home and office are considered
to be personal commuting expenses and are not deductible. If the taxpayer does not have a regular
office, the mileage between home and their first business stop is considered to be commuting to work
mileage and it is not deductible. Additionally the mileage between their last business stop and their
home is commuting mileage. However, if the taxpayer qualifies for an office-in-the-home, all of their
business mileage outside the home office is deductible.
10.6e Commissions and fees. Payments to independent contractors for services provided. Do not
include on this line any amounts paid to employees for wages, salaries or commissions. If $600 or more
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is paid to any one individual, Form 1099-MISC (and 1096) must be filed. The independent contractor
must receive a copy of Form 1099-MISC by January 31.
10.6f Depletion. Depletion is the cost recovery of the basis of natural resources as the resource is
extracted and sold. Natural resources include oil or gas wells, mines, timber and exhaustible natural
deposits. For additional information see IRS Publication 535 (Business Expenses).
10.6g Depreciation and section 179 expense. Depreciation is the process by which the cost of
business property is written off over a period of years.
10.6h Employee benefit programs. This line includes the amounts paid by an employer for employee
benefit programs such as accident; health and group term life insurance. The sole proprietor cannot
deduct contributions made to any type of benefit plan on his or her own behalf on Schedule C.
However, he/she may be able to deduct a portion of the amount paid on the first page of Form 1040.
Employee benefit programs include the following:
•
Accident and health plans
•
Adoption assistance
•
Cafeteria plans
•
Dependent care or educational assistance
•
Group-term life insurance coverage
•
Welfare benefit funds
10.6i Credit for small employer health insurance premiums. Millions of small employers received
postcards from the IRS beginning in April 2010 that alerted them to the new small business health care
tax credit and encouraged them to check their eligibility. Even if the taxpayer didn't receive a postcard,
their business still may be eligible.
Eligibility Rules
•
Providing health care coverage. A qualifying employer must cover at least 50 percent of the
cost of health care coverage for some of its workers based on the single rate.
•
Firm size. A qualifying employer must have less than the equivalent of 25 full-time workers (for
example, an employer with fewer than 50 half-time workers may be eligible).
•
Average annual wage. A qualifying employer must pay average annual wages below $50,000.
•
Both taxable (for profit) and tax-exempt firms qualify.
Amount of Credit
•
Maximum Amount. The credit is worth up to 35 percent of a small business' premium costs in
2010 (25% for tax-exempt employers). On Jan. 1, 2014, this rate increases to 50 percent (35
percent for tax-exempt employers).
•
Phase-out. The credit phases out gradually for firms with average wages between $25,000 and
$50,000 and for firms with the equivalent of between 10 and 25 full-time workers.
Small employers, whether businesses or tax-exempt organizations, will use new Form 8941, Credit for
Small Employer Health Insurance Premiums, to calculate the small business health care tax credit.
Small businesses will include the amount of the credit as part of the general business credit on their
income tax returns.
If the taxpayer’s line 14 expenses include the cost of providing health insurance coverage to their
employees, they must reduce their line 14 amount by any credit claimed on Form 8941. See the Form
8941 instructions for further details.
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10.6j Insurance. Premiums paid for business insurance are deductible on line 15.
Deductible
Non-deductible
Fire, theft, flood insurance
Self-insurance reserve funds
Liability insurance
Insurance for loss of earnings
Workers’ compensation
insurance
Insurance to secure a loan
Malpractice insurance
Merchandise and inventory
insurance
10.6k Interest. Mortgage interest on real property used in a business is deducted on Line 16a with the
exception of an office in the home. Interest paid on a home office in a principal residence is deducted
on Form 8829. All other business interest paid is deducted on Line 16b, including:
•
Finance charges on credit card purchases for business purposes;
•
The business use percentage of interest paid on a vehicle loan; and
•
Borrowed funds used for business expenses.
10.6l Legal and professional services. Legal and professional services, such as those paid to
accountants or lawyers, that are ordinary and necessary expenses of operating a business are
deductible. Include tax preparation fees of a sole proprietor for the business portion of his/her tax
return, including charges for Schedule C, Schedule SE, Form 4562, Form 4797, Form 8829, etc.
Expenses that the sole proprietor incurs to resolve any tax issues related to Schedule C are also
deductible on this line.
10.6m Office expense. Office expenses include consumable office supplies such as pens, pencils,
receipt books, and supplies for office equipment (typewriter ribbons, toner for copy machines, cash
register tape, etc). Postage is also deductible as an office expense including stamps, certified mail
expenses and express mail services. Also deduct office expenses that are not includible on Form 8829,
Business Use of Home. Taxpayers who do not qualify to take an office in home deduction can still
deduct office expenses such as telephone, cleaning and extra insurance for the home office.
10.6n Pension and profit sharing plans. Contributions to pension, profit-sharing or annuity plans
made on behalf of employees are included on line 19. Amounts paid for the benefit of the sole
proprietor are not includible on this line; they are subtracted on the first page of Form 1040.
10.6o Rent or lease. Line 20a is the business portion of the cost of rented or leased vehicles,
machinery, or equipment. If the taxpayer leased a vehicle for a term of 30 days or more, they may have
to reduce the deduction by an inclusion amount. See IRS Publication 463 to figure the inclusion
amount. Line 20b is used for amounts paid to rent or lease other property such as office space in a
building.
Rent is deductible as an expense if the taxpayer does not ultimately receive title to the property. If rent/
lease payments are made under a conditional sales contract, it may be that the payments are
considered part of the purchase price of an asset. The cost of purchasing an asset is recovered through
depreciation rather than as an expense.
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Factors that may indicate a conditional sales contract include:
• The taxpayer can exercise an option to buy the asset at the end of the lease term for a small
amount of money;
• The contract designates a portion of each payment as principal or interest;
• Title to the property transfers to the taxpayer after a stated number of payments; or
• The rental/lease payments are much larger than the fair rental value of the asset.
If an asset can be purchased for a small fraction of its FMV at the end of the lease period, the lease is
actually a purchase and the lease payments must be treated as a loan payment. The cost of the asset
is recovered through depreciation rather than as an expense.
10.6p Repairs and maintenance. The taxpayer may deduct the cost of repairs and/or maintenance.
Include supplies, labor and any other items that do not add to the value of an asset; prolong the life of
an asset; or adapt the asset for use in another capacity. The cost of the labor of the sole proprietor is
not deductible.
10.6q Supplies. Include the cost of consumable supplies that are not included in the cost of inventory.
Included in this category are gift wrapping materials, security systems, and cleaning or maintenance
supplies.
10.6r Taxes and licenses. Licenses and fees paid annually to government or regulatory agencies are
deductible. Taxes directly attributable to a trade or business are deductible.
Deductible
Non-deductible
State and federal unemployment taxes
Federal income taxes
Real estate taxes on business property
Business use of home real estate taxes
Federal highway use tax
Taxes assessed to pay for improvements
State or local taxes imposed on gross income
State and local income taxes imposed on net income
(Schedule A)
Employees share of FICA and income taxes
Employer’s share of FICA taxes
Sales tax paid on purchased business assets
Sales taxes that seller collected are deductible only if the total collections were included in gross
10.6s Travel. Deductible expenses include amounts paid by the sole proprietor for him/herself or his/
her employees in connection with away from home travel for business related matters. An individual is
away from home if he or she is required to be away from his or her tax home substantially longer than
an ordinary days work and he or she needs to get sleep or rest to meet the demands of work while
away from home. Generally a tax home is defined as the taxpayer’s regular place of business,
regardless of where they maintain their family home. It includes the entire city or general area in which
the business is located.
In some cases it may be difficult to determine the taxpayer’s main place of business. In this case the
following three factors should be used to determine the taxpayer’s tax home:
1. The taxpayer conducts business in the area of their main home and lives in their main home
while doing business in the area.
2. The taxpayer has living expenses at a main home which are duplicated when at business.
3. The taxpayer has family members living at his main home and/or often uses the home for
lodging.
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If all three tests are met, the tax home is the place where the taxpayer regularly lives. If only two tests
are satisfied, a look at the other facts and circumstances is necessary to determine if the tax home is
where the taxpayer regularly lives. If only one test is met, the taxpayer is considered to be a “transient
worker.” The tax home of a transient worker is where there is work (consider for example, a migrant
farm worker). No travel expenses are deductible as the taxpayer is never considered to be away from
his tax home.
If a taxpayer’s regular place to live is different from their tax home, travel expenses between their tax
home and where they live are not deductible.
Temporary Assignments. If the taxpayer is away from home due to a temporary job assignment, the
taxpayer is considered to be away from their tax home for the entire time and their travel expenses are
deductible. A temporary assignment is one in a single location which lasts for one year or less. If the
assignment is expected to last for more than a year, the travel expenses are not deductible. If the
duration of the taxpayer’s temporary assignment is originally one year or less, but then circumstances
change, the expenses are deductible up until the time the facts indicate otherwise.
Transportation. If the trip is strictly for business, the taxpayer can deduct all of their travel related
expenses. If the trip is primarily for business but the taxpayer has some incidental personal activities, all
of their business related expenses are deductible including the costs of getting to and from their
business destination. If the trip is primarily for personal reasons but the taxpayer has some incidental
business to conduct, the trip is considered to be a nondeductible expense. None of the transportation to
and from the destination are deductible, however the taxpayer can deduct any directly related business
expenses while at their destination.
Special limitations apply for business travel outside the United States or travel by cruise ships or other
forms of luxury water transportation.
Taxis and commuter transportation. Deduct fares for transportation between the airport/train station
and the taxpayer’ hotel or between the hotel and the away from home work location.
Baggage and shipping. Deduct the cost of shipping luggage or work material (displays, samples)
between work locations.
Car or truck expenses. Deduct the costs of operating and maintaining a vehicle while away from
home on business travel using either actual expenses or the standard mileage rate. The taxpayer is
also entitled to a deduction for the business use portion of a rental car while on business.
Other deductible expenses. Deduct the costs of dry cleaning and laundry, business telephone and fax
machine costs, tips paid for any business expense.
Travel expenses for a spouse, dependent or any other person are not deductible unless the person is
an employee of the sole proprietor and the travel is for a bona fide business purpose.
Meals and entertainment. To be deductible, entertainment expenses must be directly related to or
associated with the active conduct of business. There must be more than a general expectation of
receiving income or other business benefit in the future. They must be directly related or associated
with business.
Directly related. The sole proprietor (or employee) does business with a person or persons
during a meal or activity related to entertainment.
Associated with. The sole proprietor (or employee) does business with a person or persons
directly before or after the meal or entertainment activity.
Generally the deduction for meals and entertainment is limited to 50% of the actual cost.
10.6t Utilities. Include on line 25 charges for business use electric, gas, telephone, water, sewer and
other ordinary and necessary utility charges. If the taxpayer qualifies to take an office-in-home
deduction, the amounts paid for utilities for the home are included on Form 8829. If the taxpayer uses
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Substantiation required for travel, entertainment and business gifts.
Travel
Amount
Time
Place
Description
Business Purpose
Business
Relationship
Entertainment
Business Gifts
Amount of each expense for Amount of each expense.
Cost of the gift.
transportation, lodging and
meals unless a per diem rate
is used.
Date the taxpayer left and
Date of entertainment and for Date of gift.
returned for each trip and the entertainment before or after a
number of days of business. business discussion, the
amount of time spent
discussing business.
Name of business travel
Name and address of
N/A
location
entertainment location. Type of
entertainment, Location of
business discussion, if
separate locale.
N/A
N/A
Description of gift
Business purpose for travel Business purpose or benefit
or benefit gained/expected to gained/expected to be gained.
be gained
N/A
Names, occupations and
business relationship of
persons entertained.
Business purpose of gift or
benefit gained/expected to
be gained.
Names, occupations and
business relationship of
recipients.
his/her home telephone for business use, the base cost of the first line in to the home is not deductible.
However any long distance charges are includible on this line.
10.6u Wages. Deduct the cost of ordinary and necessary compensation for employees of the sole
proprietor. The cost of payments made to the sole proprietor (the taxpayer) are not deductible as
wages, these payments are treated as nondeductible owner’s draw.
The taxpayer should include gross wages minus any employment credits claimed. Wages attributable
to the cost of goods sold should be included in Cost of Goods Sold.
10.6v Other expenses. Includes all ordinary and necessary business expenses not deducted
elsewhere on Schedule C. The type and amount of each expense are listed separately on the lines
provided.
10.7 Business use of home. To determine the deductible amount of business use of a taxpayer’s
home, complete and attach Form 8829, Business Use of Home.
10.8 Material Participation. Material participation means that the taxpayer is involved in the business
in a regular, continuous and substantial way. If the taxpayer does not materially participate in the
business, a loss from the business is considered a passive loss that can only be deducted against
passive income. The IRS tests for material participation are shown on the next page.
A taxpayer materially participates in a business if he/she meets one of the following tests:
•
The taxpayer participates in the activity for more than 500 hours.
•
The taxpayer’s participation represents substantially all participation in the activity by all
individuals.
•
The taxpayer participates for more than 100 hours and more than anyone else involved in
the activity.
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•
The taxpayer participates for more than 100 hours (but less than 500 hours) in two or more
activities and his/her total participation is more than 500 hours.
•
The taxpayer has materially participated in the activity for five of the preceding ten years.
•
The activity is a personal service activity in which the taxpayer has materially participated in
for any three preceding tax years.
•
The taxpayer has at least 100 hours of participation and facts and circumstances indicate
that the taxpayer participates in the activity on a regular, continuous and substantial basis.
10.9 Family Owned Business. A family business set up as a sole proprietorship can offer several tax
planning opportunities. Employing a spouse or a child can provide some tax benefits. However it is
important that the child or spouse actually provide services to the business. The IRS will make
determinations on whether or not the family member is actually a bona fide employee on a case by
case basis.
•
A child employed by a parent is exempt from FICA until age 18 and from FUTA until age 21.
•
A child employed by a parent ;for domestic work is exempt from both FICA and FUTA until
age 21. Domestic work includes baby sitting, cleaning and lawn mowing. However if the
child provides these services for other customers and provides their own supplies and
equipment, the child may be considered a sole proprietor of their own business, subject to
SE tax.
•
A parent employed by a child is exempt from FUTA.
•
A spouse employed by a spouse is exempt from FUTA.
If a child is employed by a parent it may also shift income from a higher tax bracket to a lower ax
bracket (assuming the parents are in a higher income tax bracket). Or the cost of travel expenses for a
family member employee may be a deductible expense when mixing business with vacation expenses.
If the family member is not an employee, their travel expenses would never be deductible, even if a trip
is 100% for business.
10.10 Employee-spouse health insurance premiums. Generally speaking, the health insurance
premiums for a self-employed individual are deductible on line 29 of Form 1040. While subtracted from
taxable income, these amounts paid from insurance do not reduce any SE tax that the taxpayer may be
subject to. However, if a sole proprietor employs a spouse and sets up a health insurance plan for all
their employees, it is possible to take a deduction for these amounts on Schedule C. The sole
proprietor spouse would be covered by the plan as a member of the employee-spouse's family. It is
important that the insurance be purchased in the name of the employee-spouse. If the insurance is
purchased in the name of the self-employed spouse, the deduction must be taken on the first page of
Form 1040 rather than on Schedule C.
10.11 Schedule SE. Schedule SE is used to calculate self-employment social security and Medicare
taxes which are usually calculated on the net profit from Schedule C. If the taxpayer has more than one
Schedule C, the business income/loss is combined for all businesses before calculating selfemployment tax. If a husband and wife both have separate Schedules C, each spouse must figure their
self-employment taxes separately on different Schedules SE. In a community property state, business
income is not treated as community property for self-employment tax purposes.
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A taxpayer is required to prepare and file Schedule SE if their net earnings from self-employment are
$400 or more in 2011. One-half of the total self-employment tax is also taken as an adjustment to
income on Line 27 of Form 1040.
The 2010 Tax Relief Act reduced the self-employment tax by 2% for self-employment income earned in
calendar year 2011. The self-employment tax rate for self-employment income earned in calendar year
2011 is 13.3% (10.4% for Social Security and 2.9% for Medicare). The Temporary Payroll Tax Cut
Continuation Act of 2011 extended the self-employment tax reduction of 2% for calendar year 2012 so
the rates for 2011 remain in effect for 2012. For self-employment income earned in 2010, the selfemployment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security (old-age,
survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).
For both 2010 and 2011, the first $106,800 of combined wages, tips, and net earnings are subject to
any combination of the Social Security part of self-employment tax, Social Security tax, or railroad
retirement (tier 1) tax. Income made after $106,800 will not be subject to the Social Security tax.
All combined wages, tips, and net earnings in the current year are subject to any combination of the
2.9% Medicare part of Self-Employment tax, Social Security tax, or railroad retirement (tier 1) tax.
The taxpayer can also reduce their net self-employment income by the amount of their self-employed
health insurance deduction on line 29 of Form 1040. If both husband and wife are self-employed, each
would subtract the appropriate amount of their health insurance deduction.
10.11a Who Must File Schedule SE. A taxpayer must file Schedule SE if:
•
Their net earnings from self-employment from other than church employee income were $400 or
more, or
•
They had church employee income of $108.28 or more.
10.11b More Than One Business If the taxpayer had two or more businesses, their net earnings from
self-employment are the combined net earnings from all of their businesses. If they had a loss in one
business, it reduces the income from another. Figure the combined SE tax on one Schedule SE.
10.11c Joint Returns. Show the name of the spouse with self-employment income on Schedule SE. If
both spouses have self-employment income, each must file a separate Schedule SE. Include the total
profits or losses from all businesses on Form 1040, as appropriate. Enter the combined SE tax on Form
1040, line 56.
10.11d Community Income. If any of the income from a business (including farming) is community
income, then the income and deductions are reported based on the following.
•
If only one spouse participates in the business, all of the income from that business is the selfemployment earnings of the spouse who carried on the business.
•
If both spouses participate, the income and deductions are allocated to the spouses based on
their distributive shares.
•
If either or both the taxpayer and spouse are partners in a partnership and should probably file a
partnership return.
10.12 Form 1099-MISC Received by Employee. If the taxpayer receives a Form 1099-MISC showing
non-employee compensation, but is actually an employee (rather than an independent contractor), they
may be able to reduce the amount of social security and Medicare tax paid with the tax return.
Occasionally, employers may pay their employees “under the table” and fail to withhold the required
employment taxes for their employees. In determining whether the person providing service is an
employee or an independent contractor, all information that provides evidence of the degree of control
and independence must be considered.
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10.12a Common Law Rules. Facts that provide evidence of the degree of control and independence
fall into three categories:
1. Behavioral: Does the company control or have the right to control what the worker does and how the
worker does his or her job?
2. Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things
like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan,
insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of
the business?
Businesses must weigh all these factors when determining whether a worker is an employee or
independent contractor. Some factors may indicate that the worker is an employee, while other factors
indicate that the worker is an independent contractor. There is no “magic” or set number of factors that
“makes” the worker an employee or an independent contractor, and no one factor stands alone in
making this determination. Also, factors which are relevant in one situation may not be relevant in
another.
The keys are to look at the entire relationship, consider the degree or extent of the right to direct and
control, and finally, to document each of the factors used in coming up with the determination.
10.12b Form SS-8. After reviewing the three categories of evidence, if the taxpayer is still unsure if a
worker is an employee or an independent contractor, the business can file Form SS-8, Determination of
Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding (PDF) with the
IRS. The form may be filed by either the business or the worker. The IRS will review the facts and
circumstances and officially determine the worker’s status.
If it is determined that a taxpayer who received a Form 1099-MISC is actually an employee, they may
use Form 4137 (used to calculate social security taxes on tips) to calculate what would properly be their
employee share of social security and Medicare taxes (instead of Schedule SE). The full amount from
Form 1099-MISC would be reported on Line 7, Form 1040 and Form 4137 and carried to page 2 of
Form 1040. Note: the IRS would likely then attempt to collect the employer share of social security and
Medicare taxes from the issuer of the Form 1099-MISC.
10.13 Income from Farming. Individuals with income from farming should use Schedule F, Profit or
Loss from Farming to calculate their net profit from farming activities. Schedule F is completed in much
the same manner as Schedule C, however there are certain income and deduction items specific to
farming that are included on the form.
10.14 Income from Partnerships, Trusts, Estates and S-Corporations. Individuals who receive
Schedule K-1 from a partnership, trust, estate or S corporation will generally complete Schedule E,
page 2 to report their income from these activities. Certain circumstances will also require the taxpayer
to calculate and pay self-employment tax on income shown on Schedule K-1. Additional research will
be necessary in these circumstances.
10.15 Retirement Plans for Self-Employed Individuals. Self-employed taxpayers may choose to put
money into a retirement plan in much the same manner as employees. SEPs and Simple IRAs are two
of the most common plans for self-employed individuals. A SEP is a Simplified Employee Pension. A
SIMPLE IRA plan is a Savings Incentive Match PLan for Employees. Because these are simplified
plans, the administrative costs should be lower than for other, more complex plans. Under a SIMPLE
IRA plan, employees and employers make contributions to traditional Individual Retirement
Arrangements (IRAs) set up for employees (including self-employed-individuals), subject to certain
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limits. It is ideally suited as a start-up retirement savings plan for small employers who do not currently
sponsor a retirement plan.
For more information on SEPs and Simple IRAs, see IRS Publication 560, Retirement Plans for Small
Businesses.
10.16 Business Use of Home - Form 8829. If a taxpayer uses part of their home for business, they
may be able to take a portion of the expenses related to the business portion of their residence if they
meet specific requirements.
For the purposes of this discussion, the term “home” includes a house, an apartment, condominium,
mobile home, boat or similar property which provides basic living accommodations. It does not include
any part of the property used exclusively as a hotel or inn.
To qualify to deduct expenses for business use of their home, the taxpayer must use part of their home:
•
Regularly and exclusively as their principal place of business;
•
Regularly and exclusively as a place where they meet with patients, clients or customers in the
normal course of their business;
•
In the case of a separate structure not attached to their home, in connection with their trade or
business;
•
On a regularly basis for certain storage use;
•
For rental use; or
•
As a daycare facility.
Note: Employees may be able to take a deduction for business use of their home if they meet all the
tests above and their business use is for the convenience of their employer.
10.16a Exclusive Use. To qualify as exclusive use, the specific area of the taxpayer’s home must be
used only for their trade or business. The area for business can be a room or other separately
identifiable space such as a desk. The space does not need to be marked off by a permanent wall. If
the taxpayer keeps an inventory or uses their home as a daycare, they may qualify for an exception to
the exclusive use rule.
10.16b Regular Use. To qualify under the regular use test, the taxpayer must use a specific area of
their home for business on a regular basis. Incidental or occasional business use is not regular use.
10.16c Principal Place of Business. The taxpayer can have more than one business location,
including their home, for a single trade or business. Facts to consider when determining whether the
home is the principal place of business include:
•
The relative importance of the activities performed at each place the taxpayer conducts
business; and
•
The amount of time spent at each place where they conduct business.
The taxpayer’s home office will qualify as their principal place of business if they:
•
Use it regularly and exclusively for administrative or management activities of the trade or
business; and
•
They have no other fixed location where they conduct substantial administrative or management
activities for the business.
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10.16d Place To Meet Patients, Clients or Customers. If the taxpayer meets or deals with patients,
clients or customers in their home in the normal course of business, they may be able to deduct their
home office even if they carry on business at another location. To qualify they must meet the following
criteria:
•
They physically meet with patients, clients or customers at their home;
•
Their use of their home is substantial and integral to the conduct of their business; and
•
That part of their home is used regularly and exclusively for business.
Using a home for occasional meeting and telephone calls does not qualify the taxpayer to deduct
expenses for the business use of their home.
10.16e Separate Structure. A taxpayer can deduct expenses for a separate free-standing structure
such as a studio, garage or barn if they use it regularly and exclusively for business. The structure does
not have to be a principal place of business or a place to meet patients, clients or customers.
10.16f Business Percentage. To determine the business percentage of the office in home, compare
the size of the part of home used for business to the whole house. The resulting percentage is used to
determine the business part of expenses for the entire home. The taxpayer can use any reasonable
method to determine the business percentage. The two most commonly used methods are:
•
Divide the area (length x width) used for business by the total square footage of the home.
•
If the rooms in the home are about the same size, divide the number of rooms used for business
by the total number of rooms in the home.
10.16g Deduction Limit. If the taxpayers gross income from the business use of home equals or
exceeds their total business expense (including depreciation) they can deduct all business expenses
related to the use of their home. If their gross income from the business use of their home is less than
their total business expenses, the deduction for certain expenses for the business use of their home is
limited. If their deductions are greater than the current year’s limit, they can carry over the excess to the
next year. They are subject to the deduction limit for that year, whether or not they live in the same
home during that year.
Their deduction of otherwise nondeductible expenses such as insurance, utilities and depreciation that
are allocable to the business is limited to the gross income from the business use of the home minus
the sum of the following:
•
The business part of expenses the taxpayer could deduct even if they did not use their home for
business (for example, mortgage interest or real estate taxes deductible on Schedule A)
•
The business expenses that relate to the business activity in the home (such as business
phone, supplies and depreciation on equipment), but not to the use of the home itself.
10.16h Types of Expenses. The part of a home operating expense the taxpayer can use to figure their
deduction depends on both of the following:
•
Whether the expense is direct, indirect or unrelated.
•
The percentage of the home used for business.
Direct Expenses. Direct expenses of the home relate only to the business part of the home, such as
painting or repairs on the business portion of the home. These expenses are deductible in full (except
in a daycare facility).
Indirect Expenses. Indirect expenses include those for keeping up and running the entire home, such
as insurance, utilities, and general repairs. These expenses are deductible based on the percentage of
the home used for business.
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Unrelated Expenses. These include expense only for the parts of the home not used for business, such
as lawn care or painting a room not used for business. Unrelated expenses are not deductible.
10.16i Mortgage Interest. To figure the business part of the taxpayer’s deductible mortgage interest,
multiply the interest by the percentage of home used for business. This includes interest on a second
mortgage (subject to the same limits as the taxpayer’s Schedule A deduction).
10.16j Real Estate Taxes. To figure the business part of deductible real estate taxes, multiply the taxes
by the percentage of business use of the home.
10.17k Casualty Losses. Casualty losses may be direct expenses, indirect expenses or unrelated
expenses depending on what property is affected.
10.17l Insurance. The taxpayer can deduct the cost of insurance that covers the business part of the
home. However, if the insurance premium gives the taxpayer coverage for a period that extends past
the end of the tax year, they can only deduct the portion that covers the current tax year. The taxpayer
can deduct the business percent of the part that applies to the following year in that year.
10.17m Rent. If the taxpayer rents the home they live in and meets the requirements for business use
of the home, they can deduct part of the rent that they pay. To figure the deduction, multiply the rent
payments by the percentage of the home used for business.
10.17n Telephone. The basic local telephone charge for the first phone line into the taxpayer’s home is
a nondeductible personal expense. However, charges for business long-distance calls on that line, as
well as the cost of a second line into the home are deductible business expenses.
Do not deduct these costs as part of the office in home deduction; instead deduct them separately on
the appropriate form or schedule, such as Schedule C.
10.17o Utilities. The taxpayer can deduct a portion of utilities and services, such as electricity, gas,
trash removal based on the business portion of the office in home.
10.17p Depreciation. If the taxpayer owns their home and qualifies to deduct expenses for its business
use, they can claim a deduction for depreciation. The depreciation deduction does not include the cost
or value of the land. To determine the depreciation for the office in home, the taxpayer should consider
the property to be 39-year nonresidential real property.
10.17q Where to Deduct. Self-employed persons should file Schedule C and compete and attach
Form 8829 to their return. Farmers filing Schedule F should report the entire deduction for business use
of the home from line 33 of the Worksheet To Figure the Deduction for Business Use of Your Home,
subject to the applicable limits. Employees will ultimately report their business use of home expenses
on Schedule A, line 21 (along with Form 2106 if necessary).
Landlords who use their home office to manage rental property or who use a separate storage facility
such a garage or barn to store equipment to maintain their rental may take a deduction on Schedule E.
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11.0 Overview of Depreciation
11.0 Depreciation, generally. Depreciation involves deducting the cost of an asset over a specified
length of time rather than in one lump-sum. For a sole proprietor, depreciation is calculated by
completing and attaching Form 4562 to the tax return. In this session, we’ll discuss basis of property
plus depreciation methods and conventions.
In order to determine the basis of property, we need to know how the property was acquired, the cost
and/or FMV of the property and the manner in which title to the property is held.
11.1 Basis of Purchased Property. The basis of property that is purchased is usually its cost. The
cost includes amounts paid with cash, credit, loans, traded property or services. The following amounts
are also included in the basis of property.
•
Sales tax
•
Freight
•
Installation and testing charges
•
Excise taxes
•
Capitalized legal and accounting fees
•
Revenue stamps
•
Recording fees
•
Real estate taxes assumed for the seller. If the taxpayer paid real estate taxes that the seller
owed and was not reimbursed, those taxes are added to the basis of the property. Do not
deduct them as real estate taxes paid. If the taxpayer reimbursed the seller for the taxes the
seller paid for them, those amounts are usually deducted as an expense in the year of sale. Do
not include those taxes in the basis of property.
11.1a Basis of Inherited Property. The basis of property that is inherited is generally the value of the
property for federal estate tax purposes:
•
FMV of the property on the date of decedent’s death; or
•
FMV of the property on the alternate date if an estate tax return is filed and an alternate
valuation date is elected; or
•
The value based on actual use if an estate tax return is filed and special-use valuation is
elected.
The manner in which the title to property is held also determines what happens to the basis of assets at
death. State law determines property ownership. In California, the most common ways of holding
property are:
•
An individual
•
Joint tenants
•
Tenants in common
•
Community property (husband and wife)
•
Community property with right of survivorship.
If title to property is held as an individual and the person is unmarried, the decedent’s will determines
who inherits an asset. If the decedent dies intestate (without a will) generally state laws control who
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inherits an asset. However, if title is held in the individual’s name alone and the person is married,
additional questions must be answered to determine the nature of the asset. If the asset in question
was acquired during marriage while the husband and wife lived in a community property state then the
asset is community property (see below).
In addition, “quasi-community property” is a concept recognized by some community property states.
Typically, such property is treated as if it were community property at the time of divorce or death of a
spouse, but in California, at least, property acquired while married and domiciled in a non-community
property jurisdiction does not become community property just because the married parties move to a
community property jurisdiction. It is the new event of divorce or death while domiciled in the
community property state that allows that state to treat such property as quasi-community property. As
of 2007, only Washington, California, New Mexico and Arizona have such laws
When title to property is taken in the name of two or more persons as joint tenants, the assets will
automatically pass to the surviving tenant(s) at death. Both parties are assumed to have an equal
(50/50) share in the property. Joint tenancy supersedes the deceased individual’s will, if any. If assets
are held by a husband and wife as joint tenants, then one-half of each asset gets a “stepped-up” basis
at the death of the first spouse. See the following example.
“Stepped Up” Basis – Joint Tenants
Assume that a husband and wife purchased a home for $80,000 twenty years ago. At the time of death of the
first spouse, the FMV of the home was $200,000. The surviving spouse has a basis in the house of $140,000.
(1/2 X the original cost $80,000) + (1/2 X the FMV value $200,000)
$40,000 + $100,000 = $140,000
When title to property is held as tenants in common, the parties involved do not have to have an equal
interest in the property. Each party can specify in his/her will their interest in the property. Holding
property as tenants in common is similar to sole ownership. None of the parties involved in holding
property as tenants in common have right of survivorship.
The Community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas,
Washington and Wisconsin. Alaska is an “opt-in” community property state.
11.1c Community property can refer both to the nature of assets held by a husband and wife during
the time of their marriage and a manner of holding property. When property is held as community
property there is no right of survivorship and the parties involved can will the property to whomever they
choose.
Recently, some states also allow a husband and wife to take title as community property with right of
survivorship. This allows a couple to hold property as community property, but allows the assets to
pass at death to the surviving spouse without a court or probate proceedings. A husband and wife must
both initial or sign the document making the transfer to indicate their desire to hold property in this
manner.
When a husband and wife hold property as community property or community property with right of
survivorship, both halves of the home get a stepped up basis as of the date of death of the first spouse.
Again, at the death of the first spouse, all of the property held as community property gets a new
valuation and there will be no tax due on the capital gains until that point.
If the title to a property is not stated implicitly and there is more than one person involved, the following
guidelines can be used:
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•
If the title document shows the parties to be husband and wife, title is treated as if it were
community property;
•
If the title document shows the parties to not be husband and wife, title is treated as tenants
in common with each party having an equal interest.
•
The title to property is never presumed to be joint tenancy.
11.1d Special Basis Rules for Assets Inherited from 2010 Decedents. The basis rules for inherited
assets explained above apply to assets inherited from individuals who die before or after 2010. A
special set of basis rules applies to assets inherited from decedents who die in 2010. Under the special
rules, the starting point for basis is the lower of: (1) the asset’s fair market value on the date of death or
(2) the decedent’s basis. For appreciated assets (those with date-of-death fair market value in excess
of the decedent’s basis), a limited basis step-up rule can be used at the discretion of the estate’s
executor. Under the limited basis step-up rule, the maximum allowable total basis step-up is generally
$1.3 million, but a surviving spouse is granted an additional step-up allowance of up to $3 million.
Bottom line: for larger estates of individuals who died in 2010, the limited basis step-up rule can result
in lower basis for inherited assets and higher capital gains taxes when those assets are sold. Under the
2010 tax act executors have the option of using the 2011 rules, which include a step up in basis, for
people who died in 2010. So taxpayers should check with the executor about the basis of property they
inherit from someone who died in 2010.
11.1e Basis of Property Received as a Gift. Generally, to determine the basis of property received as
a gift, it is necessary to have the following information:
•
The donor’s adjusted basis in the gift;
•
Any gift tax paid on the property; and
•
The FMV of the property at the time of the gift.
If the FMV of the property is higher than the donor’s adjusted basis (the item has appreciated in value),
the basis of the gift is the giver’s adjusted basis plus any gift tax paid on the property.
If the giver’s adjusted basis is higher than the FMV of the property (the item has decreased in value),
the basis depends on whether the recipient has a gain or a loss when they dispose of the property. The
recipient’s basis for determining a loss in the sale of the property is limited to the FMV at the time of the
gift. The basis for figuring a gain is the same as the donor’s adjusted basis. If the recipient uses the
donor’s adjusted basis for figuring a gain and gets a loss, and then uses the FMV for figuring a loss and
gets a gain, there is neither gain nor loss on the disposition of the property.
Other rules for determining basis apply depending on the specific method of acquiring property. The
chart on the next page summarizes the scenarios listed above, plus other common ways of receiving
property. For additional information on basis, get IRS Publication 551, Basis of Assets.
11.2 Adjusted Basis of Property. Before disposing of property and determining gain or loss, certain
adjustments must be made to determine the current or adjusted basis of the property. Generally
speaking, improvements, additions and certain fees paid in conjunction with property increase its basis.
Deductions or credits taken decrease the basis of property.
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Determining the Original Basis of Property
How property acquired?
Basis
Holding period begins
Purchase
Purchase price plus tax, freight,
installation, etc. charges
On the date of purchase
Gift property sold at a gain
Donor’s basis
Date donor’s holding period began
Gift property sold at a loss
Lesser of Donor’s basis or FMV at If the donor’s basis is used, date donor’s holding
the time of gift
period began is used. If FMV value is used,
holding period begins on the date of gift.
Inherited property (see exception for
2010 decedents in text above)
FMV on the date of the decedent’s On the date of decedent’s death or alternate
death (or alternate valuation date if valuation period. Note: Inherited property is
elected)
always considered to have been held long-term.
Acquired by taxable exchange
FMV at the time of exchange
Acquired by nontaxable exchange
Generally, basis of traded property The date the property that was traded was
plus any cash paid.
originally acquired.
On the date property was acquired
11.3 A Brief History of Depreciation. For tax purposes, depreciation is an annual deduction that
allows the taxpayer to recover the cost (or other basis) of property over an amount of time. It is an
allowance for the reasonable wear and tear of tangible property used in a business or for the production
of income. This chapter primarily covers the depreciation convention used most often today (MACRS)
and the Section 179 deduction. First however, we’ll briefly cover a short history of depreciation and the
methods used.
11.3a Pre-1981 Depreciation. Prior to 1981 taxpayers were allowed to use any reasonably consistent
method of cost-recovery as long as the deductions during the first two-thirds of the property’s useful life
did not exceed those using the double-declining balance method. An asset’s basis, useful life and
salvage value (estimated value of the property at the end of its useful life) were used to calculate
depreciation. The most commonly used methods were the straight-line and double-declining methods
followed by sum-of-the-years’ digits and units of production. We’ll talk shortly about straight-line and
declining balance methods, which are still used today.
11.3b The ACRS Years, January 1, 1981 – December 31, 1986. ACRS or Accelerated Cost Recovery
System is used to calculate deprecation or “cost recovery” for property placed in service after 1980 and
before 1987. The salvage value of an asset was no longer taken into account and specific class lives
and depreciation methods were assigned to property types.
ACRS provided prescribed percentages that were based on the 150, 175 and 200 percent declining
balance methods. There were four classes of personal property under the ACRS rules: 3-, 5-, 10-, and
15-year classes. Under ACRS, automobiles were in the 3-year class, and most other property (other
than public utilities properties) was in the 5-year class. ACRS recovery tables were based on the halfyear convention and the 150% declining-balance method with a switch to straight-line at the optimum
point.
The Section 179 and listed property rules were also in effect during the ACRS years, although differing
limits applied to both.
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11.4 MACRS – Modified Accelerated Cost Recovery System. MACRS (or Modified Accelerated Cost
Recovery System) generally applies to real and personal property placed in service after December 31,
1986. Taxpayers could also elect to use MACRS for property placed in service after July 31, 1986 and
before January 1, 1987.
Selecting a depreciation method and recovery period is one of the few post year-end planning
decisions a taxpayer can make. Generally, a taxpayer will want to elect the depreciation method that
results in the quickest recovery (biggest deduction) of an asset. In certain cases, however, choosing a
slower depreciation method (lower deduction) can be advantageous.
Before we begin to talk about MACRS, we need to understand the basics of how depreciation or cost
recovery is calculated.
11.5 Straight-Line Depreciation. Straight-line depreciation is the easiest and most constant method of
calculating cost recovery of an asset. There are two ways to calculate straight line depreciation as
shown below.
1) Number of Years
Ima Taxpayer has a piece of equipment that she would like to depreciate over five years using straight-line
depreciation. She purchased the equipment for $7500. The simplest way to calculate the annual depreciation is
divide the basis (cost) by the number of years.
$7500 ÷ 5 years = $1500 per year
2) Percentage Method
Using the same scenario as above, the percentage method will bring about the same result. The difference is
that we will calculate the percentage of cost to be recovered each year. To find the percentage, divide the
number one (1) by the total number of years.
1 ÷ 5 = .20 or 20%
Then multiply the depreciable basis by that percentage.
$7500 x 20% = $1500 per year
11.6 Declining Balance Method. The declining balance manner is the basis of the most common cost
recovery methods of MACRS. It provides for a larger depreciation deduction in the earlier years of the
assets life. The most common declining balance (DB) methods are 1) 150 DB, which means 1.5 times
the straight line amount is used as a multiplier; or 2) 200 DB or double-declining balance (DDB) which
means that twice the straight line amount is used.
“Declining balance” refers to the fact that each year the depreciable basis of the asset is adjusted to
account for the depreciation already claimed. Important! The reduction of the depreciable basis of an
asset is already taken into account when using the MACRS tables.
The following example illustrates how double-declining balance (or 200 DB) is calculated. Double
declining balance is most commonly used as “regular” MACRS to depreciate most tangible, personal
property.
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Calculating Declining Balance Depreciation, Half-Year Convention
Assume that the basis of an asset is $15,000 and that the taxpayer wishes to recover the cost over five years.
The method will be double declining balance or 200% declining balance using the half-year convention.
1) Calculate the straight line percentage:
1 ÷ 5 = .20 or 20%
2) Remember that the 200% means that you will use double the straight line percentage. The half year
convention means that in the first and last years you will get ½ the deduction actually calculated. We will be
discussing the half-year convention in more detail.
Straight Line
Double Declining
Balance of Asset
Year 1
$15,000 ÷ 66 X 12 = $2727
$15,000 X 20% = $3,000
$15,000 - $3,000 = $12,000
Year 2
$12,000 ÷ 54 X 12 = $2666
$12,000 X 40% = $4,800
$12,000 - $4,800 = $7,200
Year 3
$7,200 ÷ 42 X 12 = $2057
$7,200 X 40% = $2,880
$7,200 - 2,880 = $4,320
Year 4*
$4320 ÷ 30 X 12 = $1728
$4320 X 40% = $1728
$4320 - 1728 = $2592
Year 5
$2592 ÷ 18 X 12 = $1728
$2592 X 40% = $1037
$2592 – 1728 = $864
Year 6
Remaining $864
Note the switch to straight-line in
Year 4.
$864 – 864 = $0
Happily, there is generally no need for a taxpayer (or tax professional) to do these calculations
themselves. The MACRS tables have all of the percentages already calculated. Notice that in the
example above, dividing the depreciation calculated by the original basis of the asset produces the
same percentages as in the MACRS table for five-year property.
First, find the description of the asset
The center column gives the property class
for GDS or “regular” MACRS
The right-hand column gives the property
class for ADS or “alternative” MACRS
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11.6 Property Classes. The first thing to do when depreciating property is determine in which class the
property belongs. The class determines the recovery period, or for how long an asset is depreciated, for
most types of property. MACRS divides property into nine classes:
•
•
•
•
•
•
3-year property, which includes
o
Tractor units for over-the-road use
o
Any race horse over 2 years old when placed in service
5-year property
o
Automobiles, taxis, buses and trucks
o
Office machinery such as typewriters, calculators and copiers
o
Appliances, carpets, furniture, etc. used in a residential rental real estate activity
o
Breeding and dairy cattle
7-year property
o
Office furniture and fixtures such as desks, chairs and files
o
Agricultural machinery and equipment
o
Any property that does not have a class life and has not been designated by law as
being in any other class
10-year property
o
Barges, tugs and similar water transportation equipment
o
Any single purpose agricultural or horticultural structure
o
Any tree or vine bearing fruits or nuts
15-year property
o
Certain improvements made directly to land or added to it – including shrubs, fences,
roads and bridges
o
Any retail motor fuels outlet such as a convenience store
20-year property
o
•
25-year property
o
•
Water utility property that meets certain conditions
Residential rental property
o
•
Farm buildings other than single purpose agricultural or horticultural structures
Includes any building or structure in which 80% or more of its gross rental income for the
tax year is from dwelling units. It includes rental homes or mobile homes, but does not
include units in a hotel or motel where more than half the units are used on a transient
basis.
Nonresidential real property
o
Section 1250 property (we’ll discuss section 1250 property more in the seminar on sales
of business property) such as an office building, store or warehouse, which is neither
residential rental property nor property with a class life of less than 27.5 years.
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The Table of Class Lives and Recovery Periods (CLADR tables) published by the IRS can help identify
the property class of an asset. A complete copy of the tables can be found in IRS Publication 946. The
previous illustration shows the appropriate column to use when determining the class of a property.
As stated before, the property class determines the recovery period of an asset. As we’ll learn later,
once a depreciation method is chosen it must be used for all property in that class placed in service that
year (except nonresidential real and residential rental property).
Do not confuse property class and class life as the same thing.
For clarification purposes, Class life (the third column from the right in the illustration above) is the
suggested life, in years, as determined by the IRS. Based upon the class life of an asset, it is assigned
a MACRS property class (first and second columns from the right). The table below illustrates the
correlation between the class life of an asset and the MACRS property class. Nonresidential real and
residential rental property is not included.
If the class life in years is
The MACRS property class is
Four years or less
3-year property
More than 4, but less than 10
5-year property
10 or more but less than 16
7-year property
16 or more but less than 20
10-year property
20 or more but less than 25
15-year property
25 or more
20-year property
11.7 Depreciation Systems (GDS vs. ADS). Under MACRS there are two “systems” of depreciation
that can be used – the General Depreciation System (GDS) and the Alternative Depreciation System
(ADS).
11.7a General Depreciation System (GDS). The most commonly used MACRS system and is also
known as “regular” MACRS. Personal property is depreciated using the declining-balance method (200
or 150 percent, depending on the property class) with a switch to straight-line when that method results
in the larger deduction. Residential rental property is depreciated using the straight-line method over
27.5 years, and nonresidential real property is depreciated using the straight-line method over 39 years
(31.5 years for property placed in service before May 13, 1993).
Under the General Depreciation System, there are three methods of calculating cost recovery:
o
“Regular” MACRS – As outlined above, personal property is depreciated using the 200%
declining balance method (switch to straight-line when greater); real property is depreciated
using the straight-line method. This method provides for a greater deduction during the earlier
years of the asset’s life.
♦ Can be used for nonfarm 3-, 5-, 7-, and 10-year property.
o
150% declining balance method, GDS recovery period – For personal type property, a taxpayer
can elect to use 150% declining balance method (with a switch to straight-line) over the same
GDS recovery period. The taxpayer would make this election by entering “150 DB” under
column (f) method in Part III of Form 4562. This method provides for a larger deduction than
straight-line during the earlier years of the asset’s life, but not as large as 200% DB.
♦ Can be used for all farm property (except real property), all 15- and 20-year property, and all
nonfarm 3-, 5-, 7-, and 10-year property.
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o
Straight-line MACRS, GDS recovery period – A taxpayer can elect to use the straight-line
method of depreciation over the GDS recovery period. This method provides for equal yearly
deductions over the life of the asset (except for the first and last years). The taxpayer would
make this election by entering “S/L” under column (f) method in Part III of Form 4562.
•
Can be used for residential and nonresidential real property; trees or vines bearing fruit or nuts;
water utility property; all 3-, 5-, 7-, 10-, 15- and 20-year property.
When the election to use a specific depreciation method is made for one item in a property class, it
must be used for all property in that class placed in service in that year (excepting real property).
11.7b Alternative Depreciation System (ADS). “Alternate” MACRS involves using the straight-line
method of depreciation over the ADS recovery period. The ADS straight-line method provides for equal
yearly deductions and is elected by completing line 20 in part III of Form 4562.
In addition, ADS is required for certain property, such as imported property, foreign-use property, taxexempt use property, tax-exempt bond financed property, and luxury automobiles and other listed
property used 50% or less for business (we’ll be discussing listed property later).
The ADS recovery period is found here
11.8 Depreciation Conventions. The third thing to determine when using MACRS is the proper
convention to use. MACRS has three conventions used to determine when the property is considered
to have been placed in service.
11.8a Half-year convention. The half-year convention treats all personal-type property as being placed
in service (or disposed of) on the midpoint of the tax year. Since the property is treated as being in
service for a half-year, half the usual deduction is claimed in both the first and last years of the recovery
period. Remember that the example of calculating double declining balance depreciation on page 6
used the half year convention. Note that the half-year convention also means than since only ½ the
usual deduction is taken in the first and last years, the cost of the asset is actually recovered over one
more year than the recovery period, i.e. the cost of 5-year property is actually recovered over six years,
etc. If a taxpayer sells or otherwise disposes of an asset using the half-year convention before the end
of its normal recovery period, only one-half the usual amount of depreciation is allowed in the year of
disposition. No deduction is allowed if the property is placed in service and disposed of in the same
year.
The half-year convention is used for all property except real property and property subject to the midquarter convention.
11.8b Mid-quarter convention. When more than 40% of the total depreciable basis of personal-type
MACRS property is placed in service during the last quarter (three months) of the year, the mid-quarter
convention is used. For the assets placed in service during the last quarter, the depreciation deduction
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is smaller than what it would be using the half-year convention. Under this convention, property is
considered to have been placed in service (or disposed of) at the midpoint of the quarter.
Note that with the mid-quarter convention, property placed in service in the first half of the year receives
more than a half-year’s worth of depreciation and property placed in service during the last quarter of
the year receives only one-eighth of a year’s worth of depreciation.
The cost used to determine the 40 percent is the depreciable basis of property. The basis of the
property is reduced by any Section 179 deduction taken. So the taxpayer can elect to take the Section
179 deduction for all or part of property placed in service during the last quarter of the year to reduce
depreciable basis and reduce the percentage of fourth quarter property.
Example of Using Section 179 to Avoid the Mid-Quarter Convention
In 2004 for his small business, Dave purchased Property A for $8000 in May. Business was going well so Dave purchased
Property B for $10,000 in November.
As it stands, Dave is subject to the mid-quarter convention since more than 40% of the depreciable basis of property has
been placed in service in the last quarter. However, Dave can take the Section 179 deduction for at least $5000 of Property
B and be subject instead to the half-year convention.
The depreciable basis of Property B has been reduced to $5000, making the total basis of property placed in service to
$13,000.
13,000 x 40% = $5200.
Since the basis of property placed in service in the last quarter is now $5000, Dave can use the half-year convention.
Be careful however, since the reverse of the previous scenario is also true. If the depreciable basis of
property placed in service in the first three-quarters is reduced too much, the mid-quarter convention
may be applied when the property originally qualified for the half-year convention.
When determining if the mid-quarter convention applies, be sure to:
•
Exclude any Section 179 property
•
Exclude any property placed in service and disposed of in the same year
•
Exclude any property that has been excluded from MACRS
•
Use only the business portion of an asset’s basis
11.8c Mid-month convention. This convention is used for all nonresidential real property and
residential rental property. Under the mid-month convention, property is considered to have been
placed in service (or disposed of) at the midpoint of the month.
11.9 Calculating the MACRS Deduction. To figure depreciation using MACRS the following
information is needed:
•
Depreciation system (GDS or ADS), property class & recovery period
•
Date placed in service
•
Basis amount
•
Convention (half-year, mid-quarter, mid-month)
•
Depreciation method (200 DB, 150 DB, S/L)
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GDS 200 DB
GDS 150 DB
GDS S/L
ADS S/L
Year 1
$2143.50
$1606.50
$1071.00
$750.00
Year 2
$3673.50
$2869.50
$2143.50
$1500.00
Year 3
$2623.50
$2254.50
$2143.50
$1500.00
Year 4
$1873.50
$1837.50
$2142.00
$1500.00
Year 5
$1339.50
$1837.50
$2143.50
$1500.00
Year 6
$1338.00
$1837.50
$2142.00
$1500.00
Year 7
$1339.50
$1837.50
$2143.50
$1500.00
Year 8
$669.00
$919.50
$1071.00
$1500.00
Year 9
-
-
-
$1500.00
Year 10
-
-
-
$1500.00
Year 11
-
-
-
$750.00
Example: A taxpayer places in service a $15,000 machine which he purchased on June 1, 2004. The
table above shows the depreciation each year using the various depreciation methods available. Notice
how the depreciation amounts vary from year to year and from method to method. The taxpayer should
take into account their income in the current year as well as projected income in future years before
selecting a depreciation method.
11.10 Using the MACRS Tables. To help you figure depreciation deductions under MACRS, the IRS
has kindly developed percentage tables that incorporate the applicable conventions and depreciation
methods.
Things to keep in mind when using the tables:
♦ The percentages in the tables are applied to the property’s unadjusted basis. Any
Section 179 deduction claimed is subtracted from the basis, but no other depreciation
deduction taken previously is taken into account.
♦ The tables cannot be used for a short tax year.
♦ Once the percentage tables are used to depreciate property, they generally must be
used for the entire recovery period of the property.
♦ The tables can no longer be used if the basis of the property is adjusted for any other
reason other than depreciation allowed or allowable or additions or improvements that are
depreciated as a separate item of property.
If the basis of property is adjusted due to a casualty loss, the percentage tables can no longer be used.
Depreciation is calculated by hand using the property’s adjusted basis at the end of the year.
11.11 Other Things To Keep In Mind. In order for a taxpayer to take a depreciation deduction for
property, it must meet all of the following requirements:
•
Generally, the taxpayer must own the property.
•
The taxpayer may also depreciate any capital improvements for property the taxpayer leases.
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•
A taxpayer must use the property in business or in an income-producing activity. If a taxpayer
uses a property for both business and personal purposes, they can only take a depreciation
deduction for the business portion of the property.
•
The property must have a determinable useful life of more than one year.
Even if the taxpayer meets the above requirements, they cannot depreciate the following:
•
Property that is placed in service and disposed of in the same year.
•
Equipment used to build capital improvements. In this case, a taxpayer must add the otherwise
allowable depreciation amount to the basis of the improvements.
Most types of tangible property such as buildings, machinery, vehicles, furniture and equipment is
depreciable. Land is not depreciated. Certain intangible property such as patents, copyrights and
computer software is also depreciable.
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12.0 Depreciation, Part 2
12.1 The Section 179 Deduction. Under Section 179 (thus the name) of the Internal Revenue Code,
all or part of the cost of certain qualifying properties can be recovered by deducting it in the year the
property was placed in service. The amount of the Section 179 deduction is subject to a maximum
dollar limit ($500,000 for 2011) and a business income limit (discussed later). If more than one item of
qualifying Section 179 property is placed in service during the year, the $500,000 limit can be allocated
between the properties in any way as long as the total deduction is not more than $500,000.
Section 179 property is generally any tangible property that can be depreciated under MACRS that was
purchased for use in the active conduct of a trade or business. The Section 179 election is made on an
item by item basis for eligible property and does not have to be used on all eligible property placed in
service in the current year. However the election must be made in the tax year the property is first
placed in service and it must be made on the original tax return filed for the year the property was
placed in service. The only time that the Section 179 deduction can be taken on an amended return is if
the amended return was filed by the due date (including extensions) for the return for the year the
property was placed in service.
The election to use the Section 179 deduction is made by completing Part I of Form 4562 (and Part V
for listed property). Once the election is made, it cannot be revoked without IRS approval. The IRS will
grant approval only in extraordinary circumstances. For more information on how to revoke the election
get IRS Publication 946, How to Depreciate Property.
The Section 179 deduction can be beneficial to the taxpayer by reducing business income or escaping
the mid-quarter convention for depreciation purposes. However the election may also reduce or
eliminate eligibility to claim certain credits and deductions (such as the Earned Income Credit) and
reduce coverage under Social Security.
12.1a Section 179 property defined. To qualify for the section 179 deduction, the property must meet
all of the following requirements:
•
It must be eligible property
•
It must be acquired for business use
•
It must have been acquired by purchase
•
It must not be property specifically excluded from being section 179 property
12.1b Eligible Property. Section 179 property must be one of the following types of property:
•
Tangible personal property
•
Other tangible property (except buildings and their structural components) used as:
a. An integral part of manufacturing, production, extraction of, or furnishing transportation,
communications, electricity, gas, water or sewage disposal services
b. A research facility used in connection with any activities listed in (a) above
c. A facility used in connection with any of the activities in (a) for the bulk storage of
fungible commodities
•
Single purpose agricultural (livestock) or horticultural structures
•
Storage facilities (except buildings and their structural components) used in connection with
distributing petroleum or any primary product of petroleum
•
Off-the-shelf computer software
•
Qualified real property (described next)
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12.1c Tangible Personal Property. Any tangible property that is not real property including machinery
and equipment, property contained in or attached to buildings, and livestock. Examples of tangible
personal property include refrigerators, grocery store counters, office equipment, signs, horses, cattle,
goats, etc.
12.1d Off-the-shelf Computer Software. Software that is readily available for purchase by the general
public, is subject to a nonexclusive license, and has not been substantially modified. It includes any
program designed to cause a computer to perform a desired function.
12.1e Qualified Real Property. New for 2010 & 2011. The taxpayer can elect to treat certain qualified
real property placed in service during the tax year as section 179 property. If this election is made, the
term “section 179 property” includes any qualified real property that is:
•
Qualified leasehold improvement property
•
Qualified restaurant property
•
Qualified retail improvement property.
The maximum section 179 expense deduction that can be elected for qualified section 179 real
property is $250,000 of the maximum deduction of $500,000 for 2011. To make an election to take a
section 179 deduction for qualified real property, To make the election, attach a statement indicating
you are “electing the application of section 179(f) of the Internal Revenue Code” with either of the
original 2011 tax return, whether or not it is filed timely or an amended return for 2011 filed within the
time limits. The statement should indicate the taxpayer’s election to expense certain qualified real
property under section 179(f). It must specify one or more or more of the three types of qualified
property to which the election applies, the of each such type, and the portion of the cost of each such
property to be taken into account.
If qualifying property is purchased with cash and a trade-in, its cost for the purposes of the Section 179
deduction is limited to the cash paid.
Property that does not qualify for the section 179 deduction is property that is:
•
•
•
•
•
•
Held only for the production of income – investment property, rental property (if property rental is
not the trade or business) or property that produces royalties;
Used outside the United States;
Used by certain tax-exempt organizations;
Certain property for lease to others;
Property used by certain government agencies or foreign persons or entities; or
Air conditioning or heating units.
12.1f The Dollar Limit. The maximum amount that can be deducted under section 179 for 2011is
$500,000 ($535,000 for qualified enterprise zone property and qualified renewal community property).
However the $500,000 limit is reduced dollar for dollar (but not below zero) by the amount that the cost
of qualifying property placed in service exceeds $2,000,000 in 2011. If the cost of section 179 property
placed in service during 2011 is $2,500,000 or more, no section 179 deduction is available.
For qualified zone property, only 50% (instead of 100%) of the cost of qualified property is taken into
account when figuring the reduced dollar amounts for costs exceeding $2,000,000.
For married taxpayers filing separate returns, they are treated as one taxpayer for the dollar limit,
including any reduction of costs over $2,000,000. The spouses can allocate any percentages between
them as long as the total does not exceed 100%. If the percentages do not equal 100%, 50% percent
will be allocated to each spouse. If after filing separate returns, the taxpayers decide to file a joint return
after the due date of filing the returns, the dollar limit on the joint return is the lesser of:
•
•
The total dollar limit for the year (including any reduction for property over $2,000,000.)
The total cost of section 179 property expensed on the separate returns.
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12.1g Sport Utility and Certain Other Vehicles. The taxpayer cannot elect to expense more than
$25,000 of the cost of any heavy sport utility vehicle (SUV) and certain other vehicles placed in service
during the year. This rule applies to any 4-wheel vehicle primarily designed or used to carry passengers
over public streets, roads or highways that is rated at more than 6,000 pounds gross vehicle weight and
not more than 14,000 pounds gross vehicle weight. However, the $25,000 limit does not apply to any
vehicle:
•
Designed to seat more than nine passengers
•
Equipped with a cargo area at least six feet in interior length that is not readily accessible from
the passenger compartment, or
•
That has an integral enclosure fully enclosing the driver compartment and load carrying device,
does not have seating behind the driver’s seat and has no body section protruding more than 30
inches ahead of the windshield.
12.1h Taxable or Business Income Limit. The Section 179 deduction is also limited to the taxpayer’s
(and spouse, if applicable) taxable income from any trade or business without regard to any expensed
amounts. For the purposes of the Section 179 deduction, taxable income from a trade or business
includes:
•
Wages, salaries, tips and other employee compensation;
•
Income as a sole proprietor;
•
Ordinary net income from a partnership or S corporation;
•
Section 1231 gains (or losses);
•
Section 1245 and 1250 depreciation recapture; and
•
Interest earned from working capital related to a trade or business
Taxable income is not reduced by any Section 179 deduction, any NOL carryover or carryback or the
deduction for ½ of SE taxes.
Any Section 179 deduction limited by taxable income can be carried forward indefinitely. The deduction
is claimed as the taxpayer earns sufficient trade or business income. The carryover can be allocated to
a specific asset (or assets) selected by the taxpayer in the year the assets are placed in service. If no
allocation is made, the carryover is prorated equally between the expensed properties.
If business use of property for which the Section 179 deduction has been taken drops below 50% at
any time before the end of its recovery period, part of the expensed amount may have to be
“recaptured.” If the expensed property is disposed of and a carryover of the Section 179 deduction is
outstanding, the basis of the property is increased by the amount of the carryover.
12.2 Listed Property. Certain property eligible for depreciation and the Section 179 deduction is
classified as listed property. Generally, listed property includes property that is likely to be used for
personal purposes, including computers, automobiles, video cameras, cell phones, etc. These items
are on a special IRS list (hence the name) to ensure that no depreciation is taken for personal use of
these items - special rules for depreciation and recordkeeping exist. Special recordkeeping, business
use and dollar limitation rules are placed upon listed property.
Property on the IRS list includes:
•
Passenger automobiles – A passenger automobile includes any four-wheeled vehicle made
primarily for use on public streets, roads, etc. and having a gross vehicle weight of 6,000
pounds or less unloaded for cars (6,000 pounds or less including cargo and passengers for
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trucks and vans). Passenger automobiles do not include ambulances, hearses or vehicles used
to transport persons or property for hire (taxis and similar vehicles).
•
Other property used for transportation including trucks, boats, busses, airplanes motorcycles
and like vehicles used to transport persons or goods. This category also includes passenger
automobiles having a gross vehicle weight rating over 6,000 pounds. However, property that
due to its nature is not likely to be used for personal purposes is excepted from the list of
property, including:
o
Clearly marked police and fire vehicles;
o
Combines, cranes and forklifts;
o
Qualified moving vans;
o
School or passenger buses; or
o
Tractors and other special purpose farm vehicles.
•
Computers and peripheral equipment – Computers and peripheral equipment is considered
listed property unless it is used exclusively at a regular place of business. An office in home that
is used regularly and exclusively for business qualifies as a regular place of business.
•
Property generally used for entertainment, recreation or amusement including photographic,
phonographic, audio or video recording or communication devices. As with computers, property
that is used regularly and exclusively at a business establishment is not considered listed
property.
12.3 Business Use Test. To be eligible for the Section 179 deduction and regular MACRS, listed
property must be used more than 50 percent for business use. To determine if this test is met, use must
be allocated if the item is used for more than one purpose during the year.
Qualified business use does not include:
•
Lease of the property to any 5% owner or related party;
•
Use of property as pay for the service of 5% owner or related person; or
•
Use of property as pay for the service of any person not a 5% owner or related person, unless
the value of the use in that person’s gross income.
•
Use of the property to produce investment income. However, investment use is included when
figuring the depreciation deduction for the asset.
If the business use test is not met any time during the assets recovery period (the use is 50% or less):
•
The property is not eligible for the Section 179 deduction. If the deduction has been previously
claimed, all or part of the expensed amount must be recovered.
•
The property is not eligible for regular MACRS and depreciation must be calculated using the
straight-line method over the ADS recovery period. If accelerated depreciation was previously
claimed, excess depreciation must be recaptured. In addition, the taxpayer must continue to use
the straight-line method over the ADS recovery period even if the business use percentage
increases to over 50%.
For more information on the business use test, see IRS Publication 946, How To Depreciate Property.
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12.4 Dollar Limitations for Passenger Automobiles. The maximum depreciation deduction (including
the Section 179 deduction and Liberty Zone allowance) that can be claimed for a passenger automobile
is limited. Note that for the purposes of the dollar limitations, passenger automobiles includes only fourwheel vehicles used primarily on public streets and roads, having a gross vehicle rating of 6,000
pounds or less. The maximum dollar limitation is higher for trucks and vans. See Publication 946 for
limits.
The maximum depreciation deduction for passenger automobiles are based on the year the vehicle
was placed in service. The table below shows the maximum amounts for 2011.
2011
1st year
2nd year
3rd year
4th year and later
$11,0601
$4,900
$2,950
$1,1775
If the business/investment use is less than 100%, the maximum deduction amount is reduced
proportionately.
If the depreciation deductions for a passenger automobile are limited in any year, there will be an
unrecovered basis in the vehicle at the end of its recovery period. The taxpayer can continue to claim
depreciation in succeeding years until the full basis of the automobile has been recovered. The
unrecovered basis in the vehicle is calculated assuming the vehicle had been used 100% for business,
even if actual business use was less.
The cost used to determine the 40 percent is the depreciable basis of property. The basis of the
property is reduced by any Section 179 deduction taken. So the taxpayer can elect to take the Section
179 deduction for all or part of property placed in service during the last quarter of the year to reduce
depreciable basis and reduce the percentage of fourth quarter property.
Example of Using Section 179 to Avoid the Mid-Quarter Convention
In 2011 for his small business, Dave purchased Property A for $8000 in May. Business was going well so Dave purchased
Property B for $10,000 in November.
As it stands, Dave is subject to the mid-quarter convention since more than 40% of the depreciable basis of property has
been placed in service in the last quarter. However Dave can take the Section 179 deduction for at least $5000 of Property
B and be subject instead to the half-year convention.
The depreciable basis of Property B has been reduced to $5000, making the total basis of property placed in service to
$13,000.
13,000 x 40% = $5200.
Since the basis of property placed in service in the last quarter is now $5000, Dave can use the half-year convention.
Be careful however, since the reverse of the above scenario is also true. If the depreciable basis of
property placed in service in the first three-quarters is reduced too much, the mid-quarter convention
may be applied when the property originally qualified for the half-year convention.
12.5 Recordkeeping. No depreciation deduction or Section 179 expense can be claimed for the use of
listed property unless the taxpayer can prove business/investment use with adequate records.
Generally business-use records must be written, such as an account book, log, detailed calendar or
other documents to establish each element of use. The records of business use must support the
following:
•
•
•
•
Cost and related expenses such as capital improvements, lease payments, etc.;
The amount of each business and investment use (can be mileage for vehicles or time for other
listed property);
The date of expense or use;
The business or investment purpose for expense or use.
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These records must be kept for as long as any excess depreciation can be recaptured.
Information about listed property is entered in Part V of Form 4562, Section A (and Section B for
vehicles).
12.6 Enterprise Zone Businesses. An increased section 179 deduction is available to enterprise zone
businesses and renewal community businesses for qualified zone property or qualified renewal
property placed in service in an empowerment zone or renewal property. For more information see
Publication 946, How to Depreciate Property and Publication 954, Tax Incentives for Distressed
Communities.
12.7 Disaster Assistance Property. An increased section 179 deduction is available for qualified
property placed in service in a federally declared disaster area in which the disaster occurred after
December 31, 2007 and before January 1, 2010. The property must be placed in service on or before
the date which is the last day of the third calendar year following the federally declared disaster date. A
list of federally declared disaster areas is available at the FEMA website at www.fema.gov. For qualified
property the dollar limit on the section 179 deduction is increased by the smaller of:
•
$100,000, or
•
The cost of qualifying section 179 Disaster Assistance property placed in service during the tax
year.
The amount for which the taxpayer can make an election is reduced if the cost of all section 179
property placed in service during the tax year exceeds $2,000,000, increased by the smaller of:
•
$600,000, or
•
The cost of qualified section 179 Disaster Assistance property placed in service during the tax
year.
For more information on what property qualifies for an increased section 179 Disaster Assistance
deduction, see Chapter 3 of Publication 946, How to Depreciate Property.
12.8 Special Depreciation Allowance. There is a bonus depreciation rate for qualified property placed
in service during 2011. The allowance applies only for the first year the property is placed in service.
For 2011, the taxpayer may be able to take an additional 50% (or 100% in certain circumstances) for
qualified property. Claiming the special depreciation allowance reduces the basis for regular
depreciation.
Property qualified for the special depreciation allowance includes the following:
•
Qualified Gulf Opportunity Zone (GO Zone) property
•
Qualified reuse and recycling property
•
Qualified cellulosic biofuel plant property
•
Qualified disaster assistance property
•
Certain qualified property placed in service after December 31, 2007
For more information on what property qualifies, and what property qualifies for the 100% special
depreciation allowance, see Publication 946, How to Depreciate Property.
The special depreciation allowance is claimed after any Section 179 deduction but before calculating
regular depreciation of the property.
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Taxpayers may elect out of bonus depreciation entirely by attaching an election statement to their
return. If the election is made for a property, it applies to all property of the same class placed in service
during the year. To make the election a taxpayer must attach a statement to his return indicating the
class of property for which the election is being made. Once the election is made, it cannot be revoked
without IRS consent.
12.9 Amortization. Amortization is similar to straight line depreciation except that it involves recovering
the cost of an intangible asset over a fixed time period. Items that can be amortized include the costs of
starting a business, goodwill, patents, copyrights, etc.
12.10 Section 197 Intangibles. IRC § 197 is generally in effect for intangible property acquired after
August 10, 1993. Taxpayers may amortize Section 197 property over a 15-month period beginning with
the month the intangible was acquired. To qualify as a Section 197 property, the asset must be used by
the taxpayer in a trade or business (or for the production of income). Section 197 intangibles include:
•
Goodwill
•
Going concern value
•
Patents, copyrights, workforce in place, an information base or any customer/supplier based
intangible.
•
Covenants not to compete
•
Franchises, trademarks or trade names
•
Licenses, permits or other rights granted by the government
The Section 197 rules generally do not apply to an intangible created by the taxpayer, so a taxpayer
cannot amortize the goodwill or going concern value of a business they started. Rather, the rules apply
to purchased businesses where part of the purchase price has been allocated to one of the above
intangibles.
Computer software is generally excluded from Section 197 intangibles unless it has been substantially
modified and acquired in connection with the purchase of a business.
Amortization is reported in Part VI of Form 4562, lines 42 through 44. Line 42 is completed only for
amortization beginning in the current tax year. After completing Part VI, report the total amortization on
the “Other Expenses” or “Other Deductions” line of the applicable tax form. A sole proprietor would
report amortization on Schedule C. If the taxpayer is reporting amortization of costs that began before
the current year and is not required to file Form 4562 for any other reason, report the amortization on
the appropriate form or schedule (i.e., Schedule C).
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13.0 Retirement Income
13.0 Pensions and Annuities, Generally. Generally speaking, a pension is a series of payments
made to the taxpayer after retirement from work. These payments are usually made regularly (monthly)
and are based on factors such as years of service and earnings.
An annuity is a series of payments under a contract made at regular intervals over a period of more
than one year. Annuity payments can either be a fixed or variable amount. The amounts of a variable
annuity may vary depending on such things as the profits earned by the annuity fund, cost-of-living
increases or earnings from a mutual fund. A taxpayer may receive an employment related annuity or
they may have purchased the contract alone.
13.1 Qualified employee plan. A qualified employee plan is an employer’s stock, pension or profitsharing plan that meets specific IRS requirements. It qualifies for special tax benefits such as tax
deferral of employer contributions, certain capital gain treatments or the 10-year tax options for lumpsum distributions. To determine if a taxpayer’s plan is a qualified plan, the employee should check with
their employer or plan administrator.
Distributions from pensions and annuities are generally reported to the taxpayer on Form 1099-R and
included in income on line 16 of Form 1040. A taxpayer may elect to have federal and/or state tax
withheld from their pension.
Special rules (discussed later) apply to taxpayers who retire on disability.
13.2 Taxation of Pensions and Annuities. When a taxpayer participates in a retirement plan or
annuity their distributions may include amounts that they contributed, amounts the pension fund
earned, plus any employer contributions. The part of the distribution that is treated as a recovery of the
taxpayer’s contribution is tax free. The first step in determining how much of a distribution is taxable is
to determine the amount of the taxpayer’s investment in the pension or annuity.
Generally the amount of the taxpayer’s investment in the pension or annuity is determined as of the
date of the pension start date (or the date of the distribution, if earlier). The taxpayer’s cost includes the
amount of the taxpayer’s after-tax contributions, amounts their employer contributed that were taxable
at the time paid. It does not include any before-tax contributions or any amounts contributed for health
and accident benefits.
There are two methods generally used to determine the taxable portion of a distribution: the General
Rule or the Simplified Method. The General Rule (beyond the scope of this course) is used for
nonqualified plans and qualified plans if the starting date is before November 19, 1996. Under the
General Rule, the tax-free portion is based on the ratio of the cost of the contract to the total expected
return. To figure the amount of expected return, life expectancy tables prescribed by the IRS must be
used. For more information on the General Rule, get Publication 939, General Rule for Pensions and
Annuities.
13.2a The Simplified Method. Under the Simplified Method, the tax-free part of each payment is
figured by dividing the taxpayer’s cost by the total number of anticipated monthly payments. For an
annuity that is based on the lives of the recipients, this number is based on the ages of the recipients
and is determined from a table. For any other annuity, the number is the number of monthly payments
under the contract.
13.3 Disability Pensions. A taxpayer who has retired on disability must generally include in their
income any amount received under a plan that is paid for by their employer. Instead of reporting their
disability pension on line 16, Form 1040, taxable amounts are reported on Line 7 of Form 1040 until the
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taxpayer reaches minimum retirement age. Minimum retirement age is generally the age at which the
taxpayer can first receive a pension or annuity if they are not disabled. After the taxpayer has reached
minimum retirement age, any taxable payments are reported as usual on line 16, Form 1040.
13.4 Lump-Sum Distributions. A lump–sum distribution is the payment in one tax year of the
taxpayer’s total balance from all of their employer’s plans of one kind (for example, the distribution of
the total balance from a taxpayer’s profit sharing plan, pension or stock option plan). A distribution from
a non-qualified plan cannot qualify as a lump-sum distribution. Form 4972 is used to calculate special
tax options available if the taxpayer receives a lump-sum distribution.
If “Total Distribution” is checked in Box 2b of Form 1099-R, the taxpayer may have a lump-sum
distribution that qualifies for special tax treatment. However, just because the box is checked does not
mean the distribution automatically qualifies.
If the taxpayer receives a lump-sum distribution from a qualified plan, and the plan participant was born
before January 2, 1937, they may be able to elect optional methods of figuring their tax on the
distribution. The part from active participation in the plan before 1974 may qualify to be taxed as a
capital gain subject to a 20% tax rate (usually shown in Box 3 of Form 1099-R). Any part before 1974
that does not qualify for the capital gains rate, plus any part from after 1974 is taxed as ordinary
income. However the taxpayer may be able to use the 10-year tax option. Form 4792 is used to figure
the tax on lump-sum distributions using one of the optional methods described above. When using
Form 4972, the amount of the lump-sum distribution is not included in taxable income on the front page
of Form 1040. The tax on the lump-sum distribution is computed separately and added to the regular
tax figured on the taxpayer’s other income.
13.4a Distributions that do not qualify for lump-sum treatment. The following do not qualify for
either the special capital gain treatment or the 10-year tax treatment:
• Any distribution that is partially rolled over to another qualified plan or IRA
• Any distribution if the taxpayer had made an earlier election to use either the 5- or 10-year option
after 1986
• Any distribution made during the first five tax years that the participant was in the plan, unless the
distribution was made because the plan participant died
• A distribution from an IRA
• A distribution from a tax-sheltered annuity
• A distribution from a qualified plan if the participant (or surviving spouse) previously received a
distribution from the same (or similar) plan and the previous distribution was rolled over tax-free to
another qualified plan or IRA
• A distribution from a qualified plan that received a rollover after 2001 from an IRA (other than a
conduit IRA), a government section 457 plan or a section 403(b) plan
• A corrective distribution of excess deferrals or excess contributions.
For less common situations that do not qualify for lump-sum treatment, see IRS Publication 575,
Pension and Annuity Income.
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Tax Treatment Options for Lump-sum Distributions
Option
Where to Report
• Report the entire taxable part of the distribution as • Report on lines 16a and 16b, Form 1040
ordinary income on the tax return
• Roll over all or part of the distribution. No tax is due • Report the total amount of the distribution
on the part of the distribution; any part not rolled over
on line 16a, Form 1040. Report any part not
is taxed as ordinary income
rolled over on line 16b, and write “Rollover”
next to the line
• Report the part of the distribution from participation • Use Part II of Form 4972 to calculate the tax
before 1974 as a capital gain and the part from
on the capital gain portion. Report the
participation after 1973 as ordinary income
ordinary income part on lines 16a and 16b
of Form 1040
• Report the part of the distribution from participation • Use Part II of Form 4972 to calculate the
before 1974 as a capital gain and the part from after
capital gain portion and Part III of Form
1973 using the 10-year tax option
4972 to calculate the 10-year tax option
• Use the 10-year tax option to figure the tax on the • Use Part III of Form 4972 to calculate the
total taxable amount of the distribution
10-year tax option amount
13.4b The 10-year Tax Option. The 10-year tax option is calculated using a special formula “as if” the
taxpayer received the distribution over a ten year time period. However, the tax is paid only in one year
not over the next ten years. The taxpayer should complete Part III of Form 4972 to elect the 10-year tax
option. Special tax rates shown in the instructions for Part III are used to figure the tax.
13.5 Rollovers. If a taxpayer receives cash or other assets from a qualified retirement plan in a
qualified distribution, they can defer tax on the distribution by “rolling it over” to another qualified
retirement plan or traditional IRA. Any amount rolled over is not included in income until it is distributed
from the new plan without being rolled over.
For the purposes of rollovers, a qualified retirement plan includes:
• A qualified employer plan
• A qualified employee annuity
• A tax-sheltered annuity plan (403(b) plan)
• An eligible state or local government section 457 deferred compensation plan
If a taxpayer rolls over a distribution to a traditional IRA, they cannot deduct the amount rolled over as
an IRA contribution.
Also, when the funds are later withdrawn from the IRA, they cannot use the optional methods of
taxation discussed earlier under Lump Sum Distributions.
Special rules apply if the taxpayer is rolling over amounts to or from a Roth IRA. Roth IRAs will be
discussed in more detail in the next chapter.
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13.5a Distributions Eligible to be Rolled Over. Distributions that can be rolled over include a
complete or partial distribution of a qualified retirement plan except:
• Any series of substantially equal distributions paid at least once a year over;
o
The lifetime (or life expectancy) of the taxpayer;
o
The joint lives (or life expectancies) of the taxpayer and beneficiary; or
o
A period of 10 years or more
• A required minimum distribution
• A hardship distribution
• A corrective distribution of excess contributions or deferrals
• Most loans treated as a distributions
• Dividends on employer securities, and
• The cost of life insurance coverage.
Also, distributions to a beneficiary of a plan participant are generally not treated as an eligible rollover
distribution. However the distribution may be eligible for roll over if the distribution is made as a result of
a Qualified Domestic Relations Order or if the distribution is made to a surviving spouse.
If the taxpayer rolls over only part of a distribution that includes both taxable and nontaxable amounts,
the amount rolled over is treated as coming first from the taxable part of the distribution.
13.5b Rollover Options. There are two options for rollover contributions:
1. The funds are directly rolled over.
2. The funds are paid directly to the taxpayer and then deposited to another retirement plan
(indirect rollover).
Both options have tax consequences detailed below.
13.5c Direct Rollovers. A direct rollover occurs when any part or all of an eligible distribution is paid
from one plan directly to another qualified retirement plan or to a traditional IRA. At no time does the
taxpayer receive any funds.
There is an automatic rollover requirement for mandatory distributions made after March 27, 2005. A
mandatory distribution is one made without the taxpayer’s consent and before they reach the later of
age 62, or normal retirement age. The automatic rollover requirement applies if the distribution is more
than $1,000, is an eligible rollover distribution and the taxpayer does not specify whether the funds
should be paid directly to them or rolled over. If no choice is made, the plan administrator will
automatically roll over the distribution into an IRA of a designated trustee or issuer.
13.5d Indirect Rollovers. Instead of having the funds directly deposited with a new plan, the taxpayer
may elect to receive the funds themselves and then deposit the money into a new plan. In this case,
20% of the amount will usually be withheld for federal taxes. If the taxpayer intends to roll over the
distribution, they must make up the withheld amount from personal funds, or they will have to pay tax
(plus penalties, if applicable) on the withheld amount.
Generally a rollover transaction must be completed by the 60th day following the day on which the
taxpayer receives the distribution from their employer’s plan. The IRS may waive the 60-day
requirement when imposing the penalty would not be fair to the taxpayer, such as in the event of a
casualty, disaster or other event beyond the taxpayer’s control.
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Comparison of Direct vs. Indirect Rollovers
Indirect Rollover
(paid to the taxpayer)
Withholding
Additional tax
When reported as income
Direct Rollover
The payer must withhold 20% in
There is no withholding.
federal taxes.
If the taxpayer is under age 59 1/2, a
10% penalty may apply to the taxable There is no penalty.
distribution.
Any taxable part not rolled over
Any taxable part is not considered
(including the taxable portion of any income to the taxpayer until it is
withholding) is income to the taxpayerdistributed to the taxpayer from the
in the year paid.
new plan.
13.6 Tax on Early Distributions. If the taxpayer receives a distribution from a retirement plan or IRA,
and they are under age 59 ½, a 10% penalty is generally imposed on the taxable portion of the
distribution. The penalty is not imposed if the distribution meets one of the following requirements:
• Made as a part of a series of substantially equal periodic payments for the life (or life expectancy)
of the taxpayer or the taxpayer and beneficiary.
• Made because the taxpayer is totally and permanently disabled.
• Made on or after the death of the plan participant.
Additionally, the following exceptions to the penalty exist for distributions from qualified retirement plans
(not IRAs):
• Made after the taxpayer has separated from service in or after the year they reach age 55;
• Made to an alternate payee under a Qualified Domestic Relations Order (QDRO);
• Made to the extent that the taxpayer has deductible medical expenses. This means the taxpayer’s
medical expenses must exceed 7.5% of their adjusted gross income. The taxpayer does not need
to itemize deductions in order to qualify for this exception
• Made from an employer plan under a written election that provides a specific schedule for
distribution if, as of March 1, 1986, the taxpayer had separated from service and had begun
receiving payments;
• Made from an employee stock ownership plan for dividends on employer securities held by the
plan; or
• Made from a qualified retirement plan due to an IRS levy of the plan.
Form 5329 is used to calculate any penalty on the early distribution of retirement benefits.
13.7 Social Security and Equivalent Railroad Retirement Benefits. As a taxpayer has worked
through the years, they have made contributions to social security and Medicare. When they retire, they
can apply to receive social security benefits. Social security benefits as used in this chapter also
include monthly survivor and disability benefits. They do not include supplemental security income
(SSI) payments, which are not taxable.
Equivalent tier 1 railroad retirement benefits are the part of tier 1 benefits that a railroad employee or
beneficiary would have been entitled to receive under the social security system. They are often called
the social security equivalent benefits (SSEB).
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The Social Security Administration (SSA) reports social security benefits on Form SSA-1099 and Form
SSA-1042S. The Railroad Retirement Board (RRB) issues Form RRB-1099 and Form RRB-1042S.
13.7a How to Determine When Social Security Benefits (or RRB) Are Taxable. To determine if any
of the taxpayer’s social security benefits are taxable, the following information is needed:
• The taxpayer’s filing status
• One-half of the social security benefits (plus one-half of the spouse’s benefits, if filing a joint return)
• The total of the taxpayer’s other income, including any tax exempt interest (plus the spouse’s other
income, if filing a joint return).
If the sum of the one-half of the social security benefits plus the total of the other income exceeds the
base amount (shown below) for the taxpayer’s filing status, some of the social security benefits will be
taxable.
Base Amounts. The base amount for each filing status is shown below.
• Single, head of household or qualifying widow(er) - $25,000
• Married filing separately and lived apart from spouse all year - $25,000
• Married filing a joint return - $32,000
• Married filing separately and lived with spouse any time during the year - $0
How much of the benefits are taxable depends on the total amount of the taxpayer’s benefits and other
income. Generally, the higher the total amount of income, the greater the taxable amount of benefits.
Usually up to 50% of the taxpayer’s benefits will be taxable. However if either of the following situations
apply, up to 85% of the benefits can be taxable:
• The total of one-half of the benefits and all of the taxpayer’s other income is greater than $34,000
($44,000 if married filing jointly); or
• The taxpayer is married filing separate and lived with their spouse any time during the year.
The worksheet included on page 10 can be used to determine the amount of taxable benefits.
The person who has the legal right to receive the benefits must determine whether the benefits are
taxable. For example, if a parent and child receive benefits, but the check is made out in the taxpayer’s
name, the taxpayer should use only their part of the benefits to determine whether any benefits are
taxable. One-half of the child’s portion of the benefits should be added to the child’s other income to
determine whether any of these benefits are taxable to the child.
13.7b Lump-sum Distribution of Benefits. Generally the taxpayer should use their 2011 income to
determine the taxability of benefits received in 2011. However if the taxpayer receives a distribution in
2011 of benefits from an earlier year, they may be able to figure the taxable part of the payment for a
previous year using the income from the earlier year. For additional information, see IRS Publication
915, Social Security and Equivalent Railroad Retirement Benefits.
13.7c How to Report Social Security Benefits. Net social security benefits (Box 5, Form SSA-1099)
are reported on line 20a of Form 1040. The taxable portion of any benefits received is included on line
20b, Form 1040. If the taxpayer is married filing separately and lived apart from their spouse for all of
2011, also enter “D” to the right of the word “benefits” on line 20a. If none of the benefits are taxable, do
not report any of them on the tax return.
13.7d Repayment of Benefits. If the taxpayer repaid benefits in 2011, the amount of benefits repaid
must be subtracted from the gross benefits they received in 2011, even if the repayment was for
benefits received in a prior year.
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14.0 Individual Retirement Arrangements (IRAs)
14.0 Overview of IRAs. Congress created the traditional IRA in 1974. The benefits of an IRA include
the fact that the earnings in the IRA are not taxed until the taxpayer begins withdrawing the money,
presumably when they retire. In addition, the taxpayer may also be able to take a deduction for the
amount of their contributions to the IRA.
The Roth IRA was created in 1997. Unlike a traditional IRA, the earnings in a Roth IRA are not taxed
(as long as they are withdrawn appropriately). However, contributions to a Roth IRA are never
deductible.
The third type of IRA is the Education IRA or Coverdell Education Savings Account. A Coverdell ESA is
an account created as an incentive to help parents and students save for education expenses. If the
beneficiary uses the funds for qualified education expenses at an eligible institution, there is no tax on
the distributions.
14.1 Traditional IRAs. According to official IRS publications, a traditional IRA is defined as any IRA that
is not a Roth IRA or a SIMPLE IRA. The traditional or “original” or “regular” IRA has two advantages:
1. The taxpayer may be able to deduct some or all of their contributions to an IRA, depending on
their circumstances.
2. Generally, amounts in a traditional IRA, including earnings and gains, are not taxed until
distributed.
14.1a Who Can Set Up a Traditional IRA? A person can set up and make contributions to a traditional
IRA if they receive taxable compensation and were not age 70 ½ at the end of the year. Compensation
includes income from working such as wages, salaries, commissions and tips. It also includes income
from self-employment. And for IRA purposes, compensation includes any taxable alimony and separate
maintenance payments received under a decree of divorce or separate maintenance.
Compensation does not include earnings from investment property such as rental property, interest or
dividends. It also does not include pension or annuity income, compensation payments postponed from
a previous year or income from a partnership for which the taxpayer does not provide services that are
a material income-producing factor.
A traditional IRA can be set up at any time. However the time for making contributions for any specific
year is limited.
14.1b Traditional IRA Contribution Limit. There are rules about the amount of money that can be
contributed to a traditional IRA. The contribution limit should not be confused with the amount that can
be deducted on the tax return, which will be discussed later. For 2011, the most that can be contributed
to a traditional IRA (or the total of all traditional IRAs) is the smaller of the following:
• $5,000 ($6,000 if the taxpayer is age 50 or older); or
• The amount of the taxpayer’s taxable compensation for the year.
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14.1c Spousal IRA Contribution Limit. If the taxpayer files a joint return and their taxable contribution
is less than that of their spouse, the most that can be contributed for the year to a traditional IRA is the
smaller of the following:
• $5,000 ($6,000 if the taxpayer is age 50 or older); or
• The total compensation included in the gross income of the taxpayer and spouse, reduced by the
total of the following two amounts:
1. The amount of the spouse’s traditional IRA contribution for the year, and
2. The amount of the spouse’s Roth IRA contribution for the year.
If the taxpayer makes too large of a contribution to a traditional IRA, they can apply the excess
contribution to a later year if the contribution for that later year is less than the maximum allowed for
that year. However, a penalty of additional tax may apply. See Publication 590, Individual Retirement
Arrangements (IRAs).
14.1d Qualified reservist repayments. If the taxpayer was a member of a reserve component and
they were ordered or called to active duty after September 11, 2001, they may be able to contribute
(repay) to an IRA amounts equal to any qualified reservist distributions received. They can make these
repayment contributions even if they would cause their total contributions to the IRA to be more than
the general limit on contributions. To be eligible to make these repayment contributions, they must have
received a qualified reservist distribution from an IRA or from a section 401(k) or 403(b) plan or a
similar arrangement. For more information on qualified reservist repayments, see Publication 590.
14.1e Traditional IRA Contribution Time Limits. Contributions can be made to a traditional IRA any
year that the taxpayer has taxable compensation, as long as they have not reached age 70 ½. The
taxpayer is considered to reach age 70 ½ on the date that is six calendar months after the 70th
anniversary of their birth.
Contributions can be made to a traditional IRA at any time during the calendar year or by the due date
for filing the tax return for that year, not including extensions. For example, contributions for 2011 must
be made by April 17, 2012 (because April 15, 2012, falls on a Sunday and Emancipation Day, a legal
holiday in the District of Columbia, falls on Monday, April 16, 2012). Contributions made to a traditional
IRA between January 1 and April 16, 2012 can be designated as being for 2011 or 2012. If the taxpayer
does not tell the IRA provider which year the contribution is for, the provider can assume that the
contribution is for the year in which it was received.
14.1f Traditional IRA Deduction Limits. The amount of their traditional IRA contribution that a
taxpayer can deduct may be limited if the taxpayer or spouse was covered by an employer provided
retirement plan at anytime during the year.
If the taxpayer (and spouse) was not covered at any time during the year, the amount of their deductible
contribution is the lesser of:
• The actual contribution to the traditional IRA for year; or
• The general limit for contributions discussed above.
If the taxpayer (or spouse) was covered by an employer provided retirement plan, the amount of their
contribution may be subjected to further limits depending on their income and filing status.
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Traditional IRA Deduction Limits (Individual Covered by Retirement Plan)
Filing status
Modified AGI is
Deduction amount is
Single or head of household
$56,000 or less
Full deduction
More than $56,000 less than $66,000
Partial deduction
$65,000 or more
No deduction
$90,000 or less
Full deduction
More than $90,000 less than 110,000
Partial deduction
$110,000 or more
No deduction
Less than $10,000
Partial deduction
$10,000 or more
No deduction
Married filing joint/Qualified widow(er)
Married filing separately*
*If the taxpayer did not live with their spouse at any time during the year, for the purposes of IRA deduction limits, their
filing status is considered to be Single.
For the purposes of the IRA deduction limits described in the table above, Modified AGI is calculated by
starting with the taxpayer’s AGI on page 1 of Form 1040 and refiguring without taking into account any
of the following amounts:
• IRA deductions
• Student loan interest deduction
• Tuition and fees deduction
• Domestic production activities deduction
• Foreign earned income deduction
• Foreign housing exclusion or deduction
• Exclusion of qualified savings bond interest shown on Form 8815
• Exclusion of employer-provided adoption benefits shown on Form 8839.
14.2 Who is Covered by an Employer Plan? Whether or not an individual is covered by an employer
plan depends on whether the plan is a defined contribution plan or a defined benefit plan.
A defined contribution plan is a plan that provides for a separate account for each person covered by
the plan. Types of defined contribution plans include profit-sharing plans, stock bonus plans, and
money purchase pension plans. An individual is considered to be covered by a defined contribution
plan for a tax year if amounts are contributed or allocated to their account for the plan year that ends
with or within that tax year. The taxpayer is considered covered even if they are not vested in the plan
at the time of allocation.
A defined benefit plan is any plan that is not a defined contribution plan. Defined benefit plans include
pension plans and annuity plans. A taxpayer is considered covered by a plan if at any time during the
year they are eligible to participate in the employer plan.
This rule applies even if the employee:
• Declined to participate in the plan,
• Did not make a required contribution,
• Did not perform the minimum service required to accrue a benefit for the year
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Traditional IRA Deduction Limits (Individual Not Covered by Retirement Plan)
Filing status
Modified AGI is
Deduction amount is
Single or head of household
Any amount
Full deduction
Married filing joint or separate/spouse who is Any amount
not covered by a plan at work
Married filing joint/spouse covered by a plan at $169,000 or less
work
More than $169,000 less than 179,000
Married filing separate/spouse covered by a
plan at work
Full deduction
Full deduction
Partial deduction
$179,000 or more
No deduction
Less than $10,000
Partial deduction
$10,000 or more
No deduction
As with a defined contribution plan, the taxpayer is considered covered even if they are not vested (do
not have a legal right to) the amount accrued or allocated to the plan.
A taxpayer who is covered under social security or railroad retirement is not considered to be covered under an
employer retirement plan.
14.3 Nondeductible Contributions. Although the taxpayer’s deductible IRA contribution may be
limited, they may still choose to make the full amount of allowable contribution. The difference between
the total allowable contribution and their total deductible contribution is considered to be a
nondeductible contribution.
The taxpayer may choose to designate deductible contributions as nondeductible.
When they taxpayer has a nondeductible IRA contribution, Form 8606 must be filed. Form 8606 must
be filed even if the taxpayer is not required to file a tax return for the year. If the taxpayer does not
report their nondeductible contributions, all of their contributions to the traditional IRA will be treated as
deductible and all distributions from the IRA will be taxed unless the taxpayer can show that
nondeductible contributions were made.
14.4 Traditional IRA Distributions. In general, distributions from a traditional IRA are taxable in the
year received. Traditional IRA distributions may be fully taxable or partly taxable depending on whether
the taxpayer made any nondeductible IRA contributions.
If only deductible contributions were made, the taxpayer is considered to have no “basis” in their
traditional IRA. Any distributions are fully taxable when received.
If the taxpayer made any nondeductible contributions to their IRA they have a “basis” or investment in
the IRA equal to the amount of their nondeductible contributions. The nondeductible contributions are
not taxed when distributed to the taxpayer. If the taxpayer receives an IRA distribution and made
nondeductible contributions, Form 8606 must be filed.
14.5 Early Distributions. Generally, if the taxpayer is under age 59 ½ and they receive an IRA
distribution, they must pay a 10% penalty on any taxable amounts. Like early pension and annuity
distributions, there are several exceptions to the age 59 ½ rule. However, not all of the exceptions are
the same:
• The taxpayer has unreimbursed medical expenses that are more than 7.5% of their adjusted gross
income.
• The distributions are not more than the cost of the taxpayer’s medical insurance.
• The taxpayer is disabled.
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• The taxpayer is the beneficiary of a deceased IRA owner.
• The taxpayer is receiving distributions in the form of an annuity.
• The distributions are not more than the taxpayer’s qualified higher education expenses.
• The taxpayer uses the distributions to buy, build, or rebuild a first home.
• The distribution is due to an IRS levy of the plan.
In addition, distributions that are timely and properly rolled over, as discussed under pensions and
annuities, are not subject to either regular tax or penalty.
Form 5329 is used to figure any additional 10% tax owed on a premature IRA distribution.
14.6 Roth IRAs. A Roth IRA is an individual retirement plan that is subject to the same rules that apply
to traditional IRAs, except for the exceptions discussed in this chapter. To be a Roth IRA, the account or
annuity must be designated as a Roth IRA when it is set up, although it is possible to convert amounts
from a traditional IRA to a Roth IRA.
Generally a taxpayer can contribute to a Roth IRA if they have taxable compensation and their modified
AGI is less than:
• $179,000 for married filing jointly or qualifying widow(er)
• $10,000 for married filing separately and the taxpayer lived with their spouse at any time during the
year, and
• $122,000 for single, head of household or married filing separately and the taxpayer did not live
with their spouse at any time during the year.
However, depending on the amount of their income, the amount of the contribution may be limited. The
table on the next page outlines whether the taxpayer’s contribution to a Roth IRA is affected by the
taxpayer’s modified AGI.
14.6a Roth IRA Contribution Limit Reduction. If the taxpayer’s Roth IRA contribution must be
reduced, figure the reduced contribution by using a worksheet found in Publication 590.
14.6b Roth IRAs and traditional IRAs. If the taxpayer makes contributions to both a Roth IRA and a
traditional IRA, the contribution limit for the Roth IRA is generally the same as their limit would be if the
contribution was made only to a Roth IRA. However the contribution limit is reduced by all other
contributions for the year other than Roth IRAs.
14.6c Conversions and rollovers to Roth IRAs. If in 2011, the taxpayer converts a traditional IRA to
a Roth IRA, any amount they must include in income as a result of the conversion is generally included
in equal amounts over a 2-year period, beginning in 2012. This means they include one half of the
amount in income in 2012 and the other half in income in 2013. They must file Form 8606 to report a
conversion from a traditional IRA to a Roth IRA
14.6d Election not to use 2-year period. They can elect to include the total amount of the conversion
in income in 2011 rather than in equal amounts over the 2-year period (2012 and 2013). They make the
election on Form 8606. If you make this election, they cannot change it after the due date (including
extensions) for their 2011 tax return.
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Roth IRA Contribution Limits
Filing status
Modified AGI is
Contribution amount is
Single or head of household or married
Less than $107,000
Up to $5,000 ($6,000 if
filing separately and did not live with their
age 50 or older)
spouse at any time during the year
More than $107,000 less than $122,000 Contribution limited
$122,000 or more
Married filing joint/Qualified widow(er)
No contribution
Less than $169,000
Up to $5,000 ($6,000 if
age 50 or older)
More than $169,000 less than $179,000 Contribution limited
$179,000 or more
Married filing separately and lived with Zero $0
their spouse at any time during the year
More than $0 less than $10,000
$10,000 or more
No contribution
Up to $5,000 ($6,000 if
age 50 or older)
Contribution limited
No contribution
14.7 Coverdell Education Savings Accounts/Education IRAs. A Coverdell Education Savings
Account is an account created as an incentive to help parents and students save for education
expenses.
The total contributions for the beneficiary of the account cannot be more than $2,000 in any year, no
matter how many accounts have been established. A beneficiary is someone who is under age 18 or is
a special needs beneficiary.
The beneficiary of the account will not owe any tax on the distributions if they are less than their
qualified education expenses at an eligible institution. The benefit applies to higher education expenses
as well as elementary and secondary education expenses.
14.7a Contribution Limits. There are two yearly limits on Coverdell ESAs:
1. The total amount that can be contributed for each designated beneficiary in any year cannot be
more than $2,000 no matter how many individuals contribute or how many Coverdell ESAs are
set up for the beneficiary.
2. Generally a taxpayer can contribute up to $2,000 for each designated beneficiary for 2011.
However the contribution limit may be reduced if the taxpayer’s modified AGI is between
$95,000 and $110,000 ($190,000 and $220,000 if MFJ).
14.7b Additional Tax on Taxable Distributions. If the taxpayer receives a taxable distribution from a
Coverdell ESA, generally they also must have to pay a 10% penalty on the amount included in income.
However, the following exceptions apply to the 10% additional tax:
• It was paid to a beneficiary on or after the death of the designated beneficiary.
• It was made because the beneficiary is disabled.
• It was included in income because the designated beneficiary received one of the following:
1. A tax-free scholarship or fellowship
2. Veterans’ education assistance
3. Employer-provided education assistance
4. Any other nontaxable payments received as educational assistance, other than gifts or
inheritances
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• Made because the designed beneficiary attends a U.S. military academy such as West Point, to
the extent that the amount of the distribution does not exceed the costs of advanced education
• Included in income only because the qualified education expenses were taken into account in
determining the Hope or lifetime learning credit
• A distribution made before June 1, 2012 because of an excess 2011 contribution.
14.8 Retirement Savings Contributions Credit (aka, The Saver’s Credit). The taxpayer may be able
to take a tax credit if they make eligible contributions to a qualified retirement plan or IRA. The credit is
up to $1,000 ($2,000 if married filing a joint return).
If the taxpayer makes eligible contributions, they may claim the credit if all of the following apply:
• They were born before January 2, 1994
• They are not a full-time student
• No one else claims an exemption for the taxpayer
• Their AGI is not more than $56,500 MJF; $42,375 head of household, $28,250 for single, MFS or
qualifying widow(er).
The amount of the credit is based on the amount of contributions made and the taxpayer’s credit rate.
The credit rate ranges from 10% to 50% and is based on the taxpayer’s income and filing status. To
figure the amount of the taxpayer’s Retirement Savings Contribution Credit, complete and attach Form
8880. Report the credit on line 51, Form 1040.
For more information on the Retirement Savings Contributions Credit, see Publication 590, Individual
Retirement Arrangements.
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15.0 Capital Gains and Losses
15.0 Capital Assets, Generally. The U.S. Tax Code defines capital assets by giving a list of items that
are not capital assets and says that everything else is considered to be a capital asset. In general a
capital asset is an item held for personal or investment purposes. A list of things that are not capital
assets includes:
• Inventory or stock-in-trade
• Depreciable personal or real property used in a trade or business
• Accounts receivable or notes receivable acquired in the ordinary course of a trade or business
• Copyrights, written, musical or artistic property created by personal efforts and produced for the
taxpayer
Capital assets include stocks, bonds, home furnishings, collectibles, cars, gold, silver, etc.
15.1 Capital Gains and Losses. When a taxpayer sells or exchanges a capital asset, they may have a
gain or loss. The gain or loss from the sale or exchange is the difference between the gross sales price
and the adjusted basis of the asset plus any expenses of the sale. If the sales price is more than the
adjusted basis plus the expenses of the sale, the taxpayer has a gain on the sale. If the adjusted basis
plus expenses of the sale is more than the gross sales price, the result is a loss.
When the taxpayer has a gain on the sale or exchange of almost any property, the result is a taxable
gain. If the taxpayer has a loss on the sale or exchange of investment or business property, they may
have a deductible loss. Losses on the sale or exchange of personal-use property are not deductible.
The tax rates that apply to net capital gains are generally lower than the tax rates that apply to the
taxpayer’s other income. For 2011 the maximum capital gains rates are 0%, 15%, 25% or 28%.
For 2011, Form 8949 is new. Many transactions that, in previous years, would have been reported on
Schedule D (Form 1040) or D-1 must be reported on Form 8949 if they occur in 2011. Complete all
necessary pages of Form 8949 before completing line 1, 2, 3, 8, 9, or 10 of Schedule D (Form 1040)
15.2 Long-term or short-term. The term “holding period” refers to the length of time an asset has
been owned by the taxpayer. In general, assets held more than one year before being sold are
considered to be held long-term. Assets that the taxpayer has owned for one year or less are
considered to be held short-term. It is important to correctly determine the holding period of assets
because the maximum capital gains rate mentioned above generally applies to assets held long-term,
not short-term
If the taxpayer has more than one capital transaction in a year, short-term and long-term gains or
losses are determined separately. Short-term gains and losses are added together for a short-term
total. Long-term gains and losses are netted together to come up with a long-term total.
15.3 Reporting Gains or Losses. If the taxpayer sold property, such as stock or bonds, through a
broker, they should receive Form 1099-B or the equivalent. This form will contain information necessary
to complete Form 8949 and Schedule D.
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Maximum Capital Gain Rates for 2011
If the taxpayer’s net capital gain is from
Then the maximum rate is
Collectibles gain
28%
Gain on qualified small business stock minus the section 1202 exclusion
28%
Unrecaptured section 1250 gain
25%
Other gain and the regular tax rate that would apply is 25% or higher*
15%
Other gain and the regular tax rate that would apply is lower than 25%*
0%
* Other gain means any gain that is not collectibles gain, small business stock gain or unrecaptured section 1250 gain. This applies to most taxpayers.
15.3 Capital Gains Tax Rates. The regular individual income tax rates for 2011 are 10, 15, 25, 28, 33
and 35%. Normally to calculate their tax, an individual will determine his tax from the Tax Tables or the
Tax Rate Schedules. However, individuals with qualified dividends and long-term capital gains can have
reduced tax rates on these items. For 2011, the maximum capital gain tax rates are 0, 15, 25 or 28%.
The Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet is used to
figure the tax if the taxpayer has qualified dividends or net capital gains. There are net capital gains if
Schedule D, lines 15 and 16, are both gains.
Schedule D Tax Worksheet. The taxpayer must use the Schedule D Tax Worksheet if:
• They are required to file Schedule D; and
• Schedule D, line 18 (28% rate gain) or line 19 (unrecaptured Section 1250 gain) is more than zero.
Qualified Dividends and Capital Gain Tax Worksheet. If the taxpayer does not have to use the Schedule
D Tax Worksheet as described above, and any of the following apply, they should complete the
Qualified Dividends and Capital Gain Tax Worksheet to calculate their tax.
• They received qualified dividends;
• They do not have to file Schedule D and they received capital gain distributions; or
• Schedule D, lines 15 and16 are both more than zero.
15.4 Capital Losses and Carryovers. If the taxpayer has capital losses that total more than their
capital gains, they can claim a capital loss deduction. The deduction is reported on line 13, Form 1040,
enclosed in parentheses.
The maximum net amount of the capital loss deduction in any year is the lesser of:
• $3,000 ($1,500 if married filing a separate return), or
• The amount of the total net loss as shown on line 16 of Schedule D.
If the taxpayer has a total net loss on line 16 of Schedule D that is more than the yearly limit discussed
above, they can carry over the unused part to the next year and treat it as if the loss was incurred in
that next year. If part of the loss is still unused, the taxpayer can continue to carry it over to later years
until it is completely used up.
When a capital loss is carried over, it retains the character of the original loss: long-term or short-term.
A long-term capital loss carried over to the next year will reduce that year’s long-term capital gains
before it reduces short-term gains and vice versa.
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When figuring the amount of capital loss carryover, the short-term capital losses are always used first,
even if they were incurred after a long-term capital loss. If the taxpayer has not reached the limit on the
capital loss deduction after using all of the short-term capital losses, the long-term losses can be used
until the limit is reached.
15.5 Non-Business Bad Debts. If the taxpayer is owed money that they cannot collect, they have a
bad debt. They may be able to deduct the amount owed when they figure their tax for the year the debt
becomes worthless. Any bad debts that did not come from operating a trade or business are
nonbusiness ( personal) bad debts and are deductible as short-term capital losses (no matter the length
of time the debt was owed). To be deductible, a personal bad debt must be genuine (arising from a true
debtor-creditor relationship) and be uncollectible. To deduct the bad debt, complete Schedule D, Part 1,
line 1 and enter the name of the debtor and “statement attached” in column a. The amount of the bad
debt is listed in parentheses in column f. Attach a statement containing the amount and due date of the
debt, the name of the debtor and any relationship, the efforts made by the taxpayer to collect the debt
and why the taxpayer decided the debt was worthless.
15.6 Sale of Personal Residence. If the taxpayer sold their main home in 2011, they may be able to
exclude from income any gain up to $250,000 ($500,000 married filing jointly). If the taxpayer is able to
exclude all of the gain they do not need to report the gain on their tax return. Any gain that can not be
excluded is taxable and should be reported on Schedule D. A loss from the sale of a personal residence
is not deductible.
15.6a Main Home, Defined. A main home is usually defined as the home that the taxpayer lives in
most of the time. A main home can be a:
• House,
• Houseboat,
• Mobile home,
• Condominium, or
• Cooperative apartment
To exclude gain on the sale of a main home, the taxpayer generally must have owned and lived in the
property as their main home for at least two years during the five-year period ending on the date of
sale.
15.6b Determining Gain or Loss. To figure the amount of gain or loss, compare the amount realized
with the adjusted basis of the home.
Amount Realized. The amount realized on the sale of a home is the selling price minus any expenses
of sale.
Adjusted Basis of Home. The adjusted basis of a home is the taxpayer’s original basis in the home
(usually it’s cost) increased or decreased by certain amounts.
Increases to basis. The taxpayer’s basis in a main home is increased by:
• Certain settlement fees or closing costs paid when purchasing the property,
• Additions and other improvements that have a useful life of more than 1 year,
• Special assessments for local improvements, and
• Amounts spent after a casualty to restore damaged property.
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Decreased to basis. These include:
• Gain postponed from the sale of a previous main home before May 7, 1997,
• Deductible casualty losses,
• Insurance payments received for casualty losses,
• Depreciation allowed or allowable,
• Certain other credits and payments benefiting the taxpayer. For details, see Publication 17,
Chapter 15, Selling Your Home.
Repairs to maintain a home in good conditions but do not add to its value or prolong its life are not
added to the basis of the property.
The taxpayer should keep records to prove their home’s adjusted basis. Ordinarily the taxpayer should
keep records for three years after the due date for filing the return for the tax year in which they sold
their home. However if the taxpayer sold a home before May 7, 1997 and postponed the tax on any
gain, the basis of that old home affects the basis of the new home purchased. Keep records proving the
basis of both homes as long as they are needed for tax purposes.
15.6c Excluding the Gain. The taxpayer may qualify to exclude from their income all or part of any
gain from the sale of their main home. This means that, if they qualify, they will not have to pay tax on
the gain up to the limits described. To qualify, the taxpayer must meet the ownership and use tests.
Ownership and Use Tests. During the five year period ending on the date of sale the taxpayer must
have:
• Owned the home for at least two years (the ownership test); and
• Lived in the home as their main home for at least two years (the use test).
15.6d Reduced Exclusion. Even if the taxpayer did not meet the ownership and use tests, they may
be able to claim a reduced exclusion if either of the following is true:
• They did not meet the ownership or use tests, but the reason they sold their home was:
o
A change in place of employment or health;
o
Unforeseen circumstances that the taxpayer could not have reasonably anticipated
before buying and occupying their main home.
• Their exclusion would have been disallowed because they sold more than one home during the
two-year period ending on the date of the sale and excluded all or part of the gain, but the reason
they sold their second home was one of the reasons listed above.
In these circumstances the taxpayer may be able to claim a reduced exclusion amount. Get Publication
523, Selling Your Home for more information.
The required ownership and use tests do not have to be at the same time, nor do they have to be
continuous. The taxpayer can meet the tests if they can show that they owned or lived in the property
as their main home for either 24 full months or 730 days (365 x 2) during the 5-year period ending on
the date of sale.
If the taxpayer files a joint return for the year of sale, they can exclude the gain if either spouse meets
the ownership and use tests.
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15.6e Maximum Exclusion. The taxpayer can exclude up to $250,000 of the gain on the sale of their
main home if all of the following are true:
• They meet the ownership test.
• They meet the use test.
• During the 2-year period ending on the date of sale, they did not exclude gain from the sale of
another home.
The taxpayer can exclude up to $500,000 of the gain on the sale of their main home if all of the
following are true:
• They are married and file a joint return.
• Either the taxpayer or spouse meets the ownership test
• Either the taxpayer or spouse meets the use test.
• During the 2-year period ending on the date of sale, neither the taxpayer nor spouse excluded
the gain from the sale of another home.
If the taxpayer is an unmarried widow or widower on the date of sale, they may qualify to exclude up to
$500,000 of any gain from the sale or exchange of their main home. The taxpayer must meet all of the
following requirements, plus the ownership and use tests described earlier in order to exclude up to
$500,000 gain.
• The sale or exchange must have taken place after 2007
• The sale or exchange took place no more than 2 years after the date of death of their spouse.
• The taxpayer must not have remarried.
• The taxpayer and spouse met the use and ownership test at the time of the spouse’s death.
• Neither the taxpayer nor the spouse excluded gain from the sale of another home during the last
2 years before the date of death.
15.7 Nonqualified Use. Gain from the sale or exchange of the main home is not excludable from
income if it is allocable to periods of nonqualified use. Generally, nonqualified use means any period in
2010 or later where neither the taxpayer nor their spouse (or former spouse) used the property as a
main home with certain exceptions (see below).
A period of nonqualified use does not include:
1. Any portion of the 5-year period ending on the date of the sale or exchange that is after the last
date the taxpayer (or spouse) use the property as a main home;
2. Any period (not to exceed an aggregate period of 10 years) during which the taxpayer (or
spouse) is serving on qualified official extended duty:
a. As a member of the Uniformed Services;
b. As a member of the Foreign Service of the United States, or
c. As an employee of the intelligence community; and
3. Any other period of temporary absence (not to exceed an aggregate period of 2 years) due to
change of employment, health conditions, or such other unforeseen circumstances as may be
specified by the IRS.
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15.7a Calculation. To figure the portion of the gain that is allocated to the period of nonqualified use,
multiply the gain by the following fraction:
The total time of nonqualified use during the period the property was owned by the taxpayer
The period of time the taxpayer owned the property
15.8 Recapture of 2008 first-time homebuyer credit. If the taxpayer claimed the 2008 first-time
homebuyer credit when they purchased their home, they may have to recapture all or a portion of the
amount claimed. The 2008 first-time homebuyer credit is intended to be repaid by the taxpayer over a
period of 15 years, starting in 2010. If the home ceases to be the taxpayer’s main home before the 15year period has elapsed, they must include all remaining annual installments as additional tax on the
tax return for that year. Their home ceases to be their main home if they sell the home, convert the
home to business or rental property use, or the home is destroyed, condemned, or disposed under the
threat of condemnation. In the event of a sale or other conversion they will need to file Form 5405,
First-Time Homebuyer Credit and Repayment of the Credit, with their tax return.
15.9 Installment Sales. An installment sale is a sale of property at a gain where at least one payment
is to be received after the tax year in which the sale occurs. A taxpayer is required to report the sale on
the installment method unless they "elect out" in the year of the sale. If they elect out, they report all the
gain as income in the year of the sale. Installment sale rules do not apply to losses. A taxpayer cannot
use the installment method to report gain from the sale of inventory or stocks and securities traded on
an established securities market.
Under the installment method, a taxpayer should include in income each year only part of the gain they
receive, or are considered to have received. Use Form 6252, Installment Sale Income, to report
installment income each year.
In general, interest should be charged on an installment sale. If interest is not charged or the interest
rate is too low, there is a minimum amount of interest the seller is considered to have received. This
"imputed" or "unstated" interest is taxable.
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16.0 Rental Income and Expenses
16.0 Rental Income. Rental income is received for the use or occupation of property – either real or
personal property. If the taxpayer is in the business of renting out personal property, Schedule C should
be completed and filed. Generally if the taxpayer is renting out real property, they should complete and
file Schedule E. Supplemental Income and Loss. However, if the taxpayer provides services in addition
to just a room (such as a bed and breakfast or a boarding house), the income and expenses should be
reported on Schedule C and SE rather than Schedule E. Note that income from rents reported on
Schedule E is not considered earned income for the purposes of the Earned Income Credit, the
additional child tax credit or for the purposes of making a contribution to an IRA.
16.1 When to Report Income. When the taxpayer should report rental income depends partly on
whether or not the taxpayer is a cash basis or accrual basis taxpayer. A cash basis taxpayer will report
income when received (and expenses when paid); an accrual basis taxpayer will report income when
earned (and expenses when incurred). However if a taxpayer receives advanced rent (rent for a period
of time in the future), they must report the income when received no matter if they are a cash basis or
accrual basis taxpayer.
A cash basis taxpayer should not report in income any uncollected rent. Since it is not includible in
income, no deduction should be taken. For an accrual basis taxpayer, the rental income is reported
when earned. If the taxpayer is then unable to collect the amount due they may be able to deduct it as
a bad debt.
16.2 Security Deposits. If a taxpayer receives an amount of money as a security deposit, and they
plan to return it to their tenant at the end of the lease, it should not be included in income. If a landlord
makes a decision to keep all or a portion of a security deposit because their tenant has not lived up to
the terms of their lease, it should be included in income at that time. A security deposit is different from
money received as first and last months rent (which is includible in income).
16.3 Expenses Paid by a Tenant. If a tenant pays any expenses of the landlord, the payments are
rental income and the landlord must include them in income. The taxpayer may then take a deduction
for the expense, if it is an allowable expense.
The value of services provided by the tenant in exchange for rent or the value of improvements made
by the tenant is also considered to be rental income.
16.4 Rental Expenses. Generally the taxpayer may deduct the ordinary and necessary expenses paid
to produce rental income. If the taxpayer rents part of their property and uses part for personal use, the
expenses must be prorated between rental and personal use.
16.5 Repairs vs. Improvements. It is important to differentiate between a repair and an improvement
because the tax treatment is different. The taxpayer can deduct the cost of a repair to their property;
they cannot deduct the cost of improvements. The cost of improvements is recovered by taking a
depreciation deduction. The recovery period for depreciable property used in a rental activity is
generally the same as if it was used for any other business property and can be determined by looking
at the Class Lives Tables discussed in the chapter on depreciation.
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Some common General Depreciation System recovery periods include:
Appliances such as stoves and refrigerators
7 years
Furniture used in rental property
5 years
Shrubbery and fences
15 years
Residential rental structures and components
27.5 years
A taxpayer can begin to depreciate rental property when it is ready and available for rent.
Additions and improvements, such as a new roof for a rental house have the same recovery period as
that of the property to which the addition or improvement was made, determined as if the property were
placed in service at the same time as the addition or improvement. They are treated as separate
property for depreciation purposes. For example, the taxpayer owns a residential rental house that they
have been renting out since 1986 and are depreciating the house under ACRS. They replace the roof
on the house in 2011. They will use MACRS for the roof and the GDS recovery period is 27.5 years.
Additions
Bedroom
Bathroom
Deck
Garage
Porch or Patio
Examples of Improvements
Lawn & Grounds
Landscaping
Driveway or walkway
Sprinkler system
Fence or retaining wall
Swimming Pool
Heating & Air Conditioning
Heating system
Central air conditioning
Furnace
Filtration system
Duct work
Plumbing
Septic system
Water heater
Soft water system
Filtration system
Interior Improvements
Built-in appliances
Kitchen modernization
Flooring
Wall-to-wall carpeting
Miscellaneous
New roof
Security system
Satellite dish
Wiring upgrades
A repair keeps property in good operating condition but does not materially add to the value of the
property or prolong its life. Repainting property, fixing gutters, fixing leaks, plastering, and replacing
broken windows are examples of repairs.
Other Common Expenses. In addition to depreciation and repairs, most other ordinary and necessary
expenses of renting out property can be subtracted from rental income. Some of the more common
expenses include:
•
Advertising for tenants
•
Cleaning and maintenance such as trash pickup
•
Utility expenses paid by the landlord
•
Mortgage interest
•
Property taxes. However, charges for local benefits that increase the benefit of the property,
such as charges for putting in streets or water and sewer systems are not deductible. They are
considered non-depreciable capital assets, the cost of which is added to the taxpayer’s basis in
the property. Local taxes for maintaining, repairing or paying interest charges for the benefits
are deductible.
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•
Insurance premiums. However if the taxpayer pays an insurance premium in advance for more
than one year, they can only deduct the part of the premium payment that applies to the current
year.
•
Commissions paid to a real estate agent or property management company
•
Tax return preparation fees paid for forms and schedules pertaining to rental income
•
Travel expenses. The taxpayer can deduct the ordinary and necessary expenses of traveling
away from home if the primary purpose of the trip is to collect rental income or to manage,
conserve or maintain rental property. If trip is partly for business and partly for personal reasons,
the travel expense must be allocated between rental and nonrental activities. Travel expenses
are not deductible if the primary purpose of the trip was for the improvement of property. As with
all travel and transportation expenses, landlords must keep written records to substantiate their
travel and transportation expenses.
16.6 Property Not Rented for Profit. If the taxpayer does not rent their property to make a profit, they
can deduct their expenses only up to the amount of their rental income. Any rental expenses greater
than rental income cannot be carried forward. In this case, do not complete and file Schedule E.
Instead report the income on line 21, Form 1040. If the taxpayer uses the property as their main home
or second home, mortgage interest and real estate taxes can be deducted as usual on Schedule A.
Other rental expenses will be included as miscellaneous deductions on line 22 of Schedule A, subject
to the 2% limitation.
16.7 Renting Part of Property. If the taxpayer rents only part of their property and uses part for
personal use, they must divide up certain expenses incurred. Expenses directly related to the rental
portion of the property are deductible in full. For example, the expense for painting or wallpapering a
room used strictly for rental purposes is deductible in full. However those expenses paid for the entire
property may need to be divided up between rental and personal use. The taxpayer can use any
reasonable method for dividing the expenses. It may be easiest to divide certain expenses based on
the number of people involved (such as certain utility items). The two most common methods for
dividing expenses are one based on the number of rooms in the property and one based on the square
footage of the property.
16.8 Rental of Vacation Homes or Other Personal Use Dwellings. If a vacation home or other
dwelling unit is used by the taxpayer for personal use part of the time and also rented at fair rental
value for 15 days or more during the year, the expenses must be prorated. A dwelling unit includes a
house, apartment, mobile home, boat, apartment or other similar property.
The taxpayer uses a dwelling unit as a home during the tax year if they use it for personal purposes
more than the greater of:
•
14 days; or
•
10% of the total days it is rented to others at a fair rental price.
Personal use by the taxpayer includes any day that the unit is used by any of the following:
• The taxpayer or any other person who has an interest in the property, unless it is rented to the
other owner as his main home under a shared equity financing agreement.
• A member of the taxpayer’s family (or family member of another owner) unless that person uses
the dwelling as their main home and pays a fair rental price. For the purposes of this discussion,
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family includes brothers, sisters, half-brothers, half-sisters, spouses, ancestors (parents,
grandparents) and lineal descendents (children, grandchildren)
• Anyone under an arrangement that lets the taxpayer use another dwelling unit; or
• Anyone that pays the taxpayer less than a fair rental price for the dwelling unit
If the taxpayer uses a dwelling unit as a home and rents it fewer than 15 days during the year, they are
not required to include that rental income on their tax return. However they cannot deduct any
expenses as rental expenses.
If the dwelling is used as a residence and also rented for 15 days or more, some expenses are
deductible in full; some expenses are deductible only to the extent of the income reported. Any
expenses that cannot be deducted in the current year because of the rental income limit can be carried
over to the following year.
Expenses are deductible in the following order:
1. The rental portion of interest, taxes and casualty losses. The rental portion is deductible on
Schedule E. The personal portion will be deductible on Schedule A if the taxpayer itemizes
deductions.
2. Rental expenses not directly related to the dwelling unit, such as advertising, related travel,
commissions, fees, office supplies, etc. These items are fully deductible.
3. Expenses directly related to the dwelling unit such as repairs, maintenance, trash pickup, lawn
care, etc.
4. Depreciation
If items (1) and (2) exceed the gross rent, a loss may be claimed on the vacation home. If operating
expenses (3) exceed gross rent minus items (1) and (2), they must be carried forward to the next year.
16.9 Limits on Rental Losses. Rental real estate activities are generally considered passive activities
and the amount of loss that the taxpayer can deduct is limited. Generally a loss from rental real estate
activities is not deductible unless the taxpayer has income from other passive activities. However, if the
taxpayer “actively” or “materially” participates in the rental activity, they may be able to deduct some of
the losses.
16.9a Active Participation. A taxpayer actively participates in a rental real estate activity if they owned
at least 10% of the rental property and made significant management decisions. Management
decisions include approving new tenants, deciding on rental terms, approving expenditures, etc.
16.9b Material Participation. A taxpayer materially participates in an activity if they were involved in its
operations on a regular, continuous and substantial basis during the year.
If the taxpayer actively participated in the rental activity and their rental losses are less than $25,000,
generally they are allowed to deduct the full amount of the loss. However If the taxpayer’s modified
adjusted gross income is more than $100,000 ($50,000 MFS), they will not be able to deduct the full
amount of the $25,000. If their modified adjusted gross income is $150,000 or more ($75,000 MFS)
they generally cannot deduct a loss at all.
If the taxpayer is married filing a separate return, and lived apart from their spouse all year, their special
allowance cannot be more than $12,500. If they are filing a separate return and lived with their spouse
for any part of the year, they cannot use the special allowance to reduce their nonpassive income or tax
on nonpassive income.
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16.10 Modified Adjusted Gross Income (MAGI) for Rental Real Estate Activities. For the purposes
of this discussion the taxpayer MAGI is their adjusted gross income from line 38, Form 1040
disregarding the following items:
• Taxable social security
• Deductible contributions to an IRA or similar plan
• The exclusion for qualified U.S. savings bond interest used to pay higher education expenses
• The exclusion for employer provided adoption benefits
• Any passive activity income or loss included on Form 8582
• Any passive income or loss or loss allowable because of the real estate professional exception
• Any overall loss from a publicly traded partnership (PTP)
• The deduction for one-half of self-employment tax
• The deduction allowed for interest on student loans
• The deduction for qualified tuition and related expenses
• The deduction for income attributable to domestic activities
16.11 Rental Real Estate Professionals. Rental activities in which the taxpayer materially participates
are not passive activities if, for that year, the taxpayer was a real estate professional.
A taxpayer qualifies as a real estate professional for the year if they meet both of the following
requirements:
1. More than half of the personal services they performed in all trades or businesses during the
year were performed in real property trades or businesses in which the taxpayer materially
participated
2. They performed more than 750 hours of services during the tax year in real property trades or
businesses in which they materially participated.
16.12 Reporting Rental Income and Expenses. Unless the taxpayer is reporting rental income for a
not-for-profit activity or provides significant services primarily for the tenant’s convenience (discussed
earlier), file and complete Part 1, Schedule E, Form 1040, listing total income, expenses and
depreciation for each property.
If the taxpayer has more than three rental properties, compete and attach additional Schedules E as
needed. Complete lines 1 and 2 for each property. Fill in the “Totals” column on only one Schedule E.
The figure in the “Totals” column on that one Schedule E should be the total of all Schedules E.
16.13 Treatment of rental property expense payments. If the taxpayer makes payments of $600 or
more for certain rental property expenses, the payments are to be reported in box 7 on Form 1099MISC, Miscellaneous Income.
16.14 Other Schedule E Items. Page 1 of Schedule E is used to report income/loss from royalties
received from sources such as oil and gas wells, or other natural resources. Page 2 of Schedule E is
used to report income or loss from partnerships, S corporations, estates, trusts, and real estate
mortgage investment conduits.
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17.0 Amended Returns & Estimated Payments
17.0 Amended Returns. In this chapter we’ll discuss what can be done if the taxpayer discovers that
they have made an error when completing their original tax return. It may be that they have overlooked
a deduction or credit, resulting in an additional refund amount. Or they could have forgotten to report an
item of income, resulting in additional tax due. Form 1040X, Amended U.S. Individual Income Tax
Return can be completed and filed to correct errors or omissions on an original tax return.
17.1 When To File Form 1040X. Form 1040X should be filed only after the taxpayer has filed an
original return. Generally, for the taxpayer to receive an additional refund, Form 1040X must be filed
within three years after the date the original return was filed or within two years after the date the tax
was paid, whichever is later. A return that was filed before April 15 is considered to be filed on the due
date.
Taxpayers that find that they have an additional balance due should be aware that the IRS has three
years to audit a return and assess any additional taxes. The three year period starts on the day the
original return was filed or April 15, whichever was later. For example, the three year time period for a
return filed on April 1, 2006 begins on April 15, 2006. On April 16, 2009 the IRS cannot audit that tax
return unless there was a suspicion of fraud.
The IRS also has 10 years to collect outstanding tax liabilities, measured from the day a tax liability has
been finalized. A finalized liability can be a balance due on an original return or an additional
assessment from an audit or change to the return. From the day that the liability has been finalized the
IRS has ten years to collect the full amount plus penalties and interest. If the IRS doesn’t collect the full
amount in the 10-year period, they cannot collect the remainder (except again in the case of fraud).
Please note that the two above examples of the statute of limitations assumes that the taxpayer has
filed an original return. If the taxpayer does not file a return, the statute of limitations on any balance
due amounts does not apply. Additionally the time period in which the IRS may legally collect any
balance due amounts, plus any penalties and interest may be extended in the event of fraud or
substantial underpayment of tax.
17.1a Completing Form 1040X. When preparing Form 1040X, be sure to use the laws, deduction
amounts and tax rates from the tax year being amended. The taxpayer will also need to include any
form, schedule or supporting statement that changes because of the amendment or that had not been
included with the original return.
17.2 Estimated Taxes. Estimated tax payments are used by taxpayers to pay tax on income that is not
subject to withholding or not subject to enough withholding. This includes income from self-employment
(Schedule C), interest or dividends (Schedule B), rental income (Schedule E), capital gains (Schedule
D), plus income from alimony, prizes or awards.
If the taxpayer does not pay enough tax throughout the year, either through withholding or estimated
tax payments, they may be subject to a penalty.
17.2a When to Pay Estimated Taxes. For estimated tax purposes, the calendar tax year is divided into
four payment periods. Each period has a specific due date. If the taxpayer does not pay enough tax by
the due date of each period, they may be charged a penalty even if they get a refund when they file
their tax return.If the due date for an estimated tax payment falls on a Saturday, Sunday or legal
holiday, it will be considered on time if it is made on the next business day. If the taxpayer files their
2011 tax return by January 31, 2012 and pays their tax due, they do not need to make their January 15
estimated tax payment.
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Estimated Tax Payment Due Dates
For income earned in the period of:
The due date for an estimated tax payment is:
January 1 – March 31
April 15
April 1 – May 31
June 15
June 1 – August 31
September 15
September 1 – December 31
January 15 of next year
17.2b Who Is Not Required to Pay Estimated Taxes? If the taxpayer earns a salary or a wage, they
can avoid paying estimated taxes by asking their employer to withhold more federal tax from their pay.
They can do this by filing a new Form W-4 with their employer.
A taxpayer is not required to pay estimated taxes for 2012 if they meet all of the following conditions:
•
They had no tax liability for 2011 (total tax was zero or not required to file a return)
•
They were a U.S. citizen or resident for the whole year
•
Their 2011 tax year covered a 12-month period
17.2c Who Must Pay Estimated Taxes? If the taxpayer had a tax liability for 2011, they may have to
make estimated payments for 2012. Generally, a taxpayer must pay estimates for 2012 if both of the
following apply:
•
They expect to have a balance due of at least $1,000 in tax for 2012, after subtracting
withholding and credits
•
They expect their withholding and credits to be less than the smaller of
o
90% of the tax shown on their 2012 return, or
o
100% of the tax shown on their 2011 return, which covers 12 months.
If all of the taxpayer’s income is subject to withholding, they probably do not need to make estimated
payments.
17.2d Higher Income Taxpayers. If the taxpayer’s adjusted gross income for 2011 was more than
$150,000 ($75,000 if MFS), they must pay at least 90% of their 2012 tax or 110% of the tax shown on
their 2011 return.
Remember though, even though a taxpayer may not be required to make estimated payments, if they
expect to have a large balance due it may be easier for them to make estimated payments rather than
to have one lump sum payment on April 15.
Special rules apply to taxpayers who were married filing a joint return in 2011 and filing separate
returns in 2012 and vice versa. Taxpayers with at least two-thirds of their income from farming and
fishing also have different rules regarding the need to make estimated payments. For additional
information on these scenarios, see Publication 505.
17.2e How To Figure Estimated Tax. To help calculate the amount of their estimated taxes, a taxpayer
needs to know their expected adjusted gross income, taxable income, taxes, deductions and credits for
the year. The 2011 amounts for these figures can be used as a good starting point.
There are estimated tax worksheet on which can be used to help calculate the amount of required
quarterly tax payments.
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The taxpayer is not required to make estimated tax payments until after they have income on which to
owe the tax. If they have income during the first payment period (January 1 through March 31) they
must make an estimated tax payment by April 15. They can choose to pay all of their estimated taxes
by the due date of the first payment, or they can opt to make installments.
After figuring the amount of estimated tax required for the year, it is necessary to determine how much
must be paid by the due date of each payment period. If the taxpayer does not pay enough during any
payment period, they may owe a penalty even though they receive a refund when they file their tax
return.
Regular Installment Method. If the taxpayer’s income is basically the same throughout the year, they
will probably find it easiest to use the Regular Installment Method. If their first estimated payment is due
April 15, they can figure the required payment for each period by dividing the required annual amount
by four.
Annualized Income Installment Method. If the taxpayer does not receive their income evenly throughout
the year (for example, a tax professional who earns most of their money from January through April)
their required estimated tax payment for one or more periods may be different than the amount figured
using the Regular Installment Method. A complete discussion of this method of determining estimated
payments is beyond the scope of this course. For additional information, see Publication 505.
17.2f How To Pay Estimated Taxes. There are five ways to pay estimated tax.
•
By crediting an overpayment on your 2011 return to your 2012 estimated tax.
•
By sending in your payment with a payment voucher from Form 1040-ES.
•
By paying electronically using the Electronic Federal Tax Payment System (EFTPS).
•
By electronic funds withdrawal if you are filing Form 1040 or Form 1040A electronically.
•
By credit card using a pay-by-phone system or the Internet.
17.2g Crediting An Overpayment. If the taxpayer receives a refund, they can apply part or all of it to
their estimated tax for 2012. On line 74 of Form 1040, or line 46 of Form 1040A, enter the amount they
want credited to their estimated tax rather than refunded. The amount they have credited should be
taken into account when figuring their remaining estimated tax payments.
17.2h Using the Payment Vouchers. Each payment of estimated tax must be accompanied by a
payment voucher, Form 1040-ES. If the taxpayer made estimated tax payments in the previous tax
year, the IRS will mail them a copy of the 2012 Form 1040-ES in the mail. It will have payment
vouchers preprinted with their name, address, and social security number. Using the preprinted
vouchers will speed processing, reduce the chance of error, and help save processing costs.
17.2i Electronic Federal Tax Payment System (EFTPS). EFTPS is a free tax payment system that all
individuals and businesses can use. The taxpayer can make payments online or by phone.
17.2j Payment by Electronic Funds Withdrawal. The taxpayer can make a 2012 estimated tax
payment when they electronically file their 2011 Form 1040 or Form 1040A by authorizing an electronic
funds withdrawal from their checking or savings account. They can also schedule a one-time estimated
tax payment for April 15, 2012, June 15, 2012, or September 15, 2012. Do not send in a Form 1040-ES
payment voucher when making an estimated tax payment by electronic funds withdrawal.
17.2k Payment by Credit Card. A taxpayer can use an American Express® Card, Discover® Card,
MasterCard® card, or Visa® card to make estimated tax payments. They may call or access by Internet
one of the service providers listed below and follow the instructions of the provider. Each provider will
charge a convenience fee based on the amount you are paying.
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17.3 Interest on Overpayments or Underpayments. The Internal Revenue Service is required to
collect interest on balance due amounts not paid timely and to pay interest on overpayments. Under the
Internal Revenue Code, the rate of interest is determined on a quarterly basis. For taxpayers other than
corporations, the overpayment and underpayment rate is the federal short-term rate plus 3 points.
Beginning January 1, 2012 the rates will be:
• three (3) percent for overpayments [two (2) percent in the case of a corporation];
• three (3) percent for underpayments;
• five (5) percent for large corporate underpayments; and
• one-half (0.5) percent for the portion of a corporate overpayment exceeding $10,000.
17.4 Form W-4 & Tax Withholding. Taxpayers should try to have their withholding match your actual
tax liability. If not enough tax is withheld, they will owe tax at the end of the year and may have to pay
interest and a penalty. If too much tax is withheld, they will lose the use of that money until they get
their refund.
A taxpayer should always check their withholding if there are personal or financial changes in their life
or changes in the law that might change your their liability. See the next page for examples of when a
taxpayer might want to check their withholding.
Another sign that the taxpayer might want to check their withholding is a large refund or balance due
when they file their tax return. The earlier in the year they check their withholding; the easier it is to get
the right amount of tax withheld. A taxpayer can change the amount of their withholding by submitting a
new Form W-4 to their employer. They must give their employer a new Form W-4 to adjust their
withholding within 10 days of any event that decreases the number of withholding allowances they can
claim, such as a divorce if they are claiming married status.
Factor
Examples
Lifestyle change
Marriage
Divorce
Birth or adoption of child
Loss of an exemption
Purchase of a new home
Retirement
Wage income
Taxpayer or spouse start or stop working, or start or stop a
second job
Increased or decreased income not subject to
Interest income
withholding
Dividends
Capital gains
Self-employment income
IRA (including Roth IRA)
distributions
Increased or decreased adjustments to income IRA deduction
Student loan interest deduction
Alimony expense
Increased or decreased itemized deductions or Medical expenses
tax credits
Taxes
Interest expense
Gifts to charity
Job expenses
Education credit
Child tax credit
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17.5 Taxpayer Needs to Increase Withholding. If the taxpayer has a large balance due, there are two
ways to increase their withholding. They can:
• Decrease the number of allowances they claim on Form W-4, line 5, or
• Enter an additional amount that they want withheld from each check on Form W-4, line 6.
17.6 Taxpayer Needs to Decrease Withholding. If the taxpayer has a large refund, there are two
ways to decrease their withholding. They can:
•
Decrease the number of allowances they claim on Form W-4, line 5, or
•
Decrease an additional amount that they are having withheld from each paycheck on Form W-4,
line 6.
If the change is for the current year, the taxpayer’s employer must put the new Form W-4 into effect no
later than the start of the first payroll period ending on or after the 30th day after the day on which they
give their employer a revised Form W-4.
If the change is for next year, the new Form W-4 will not take effect until next year.
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18.0 Professional Practice & Responsibility
18.0 Circular 230. Treasury Department Circular No. 230 contains rules governing the recognition of
attorneys, certified public accountants (CPAs), enrolled agents (EAs), enrolled retirement plan agents,
registered tax return preparers (RTRPs), and other persons representing taxpayers before the Internal
Revenue Service.
Subpart A of Circular 230 outlines rules relating to the right to practice before the Internal Revenue
Service; Subpart B describes the duties and restrictions of practice before the Internal Revenue
Service; Subpart C prescribes the sanctions for violating regulations; Subpart D contains rules relating
to disciplinary proceedings; and Subpart E outlines general provisions relating to the availability of
official records.
18.1 Office of Professional Responsibility. The Office of Professional Responsibility (OPR) has
responsibility for matters relating to tax professional conduct and discipline, including any disciplinary
proceedings and sanctions. OPR processes all applications for enrollment to practice before the IRS
and oversees competency testing and continuing education.
18.2 Practice before the Internal Revenue Service. Practice before the Internal Revenue Service
includes all matters connected with a presentation to the Internal Revenue Service relating to a
taxpayer’s rights, privileges, or liabilities. Such presentations include, but are not limited to, preparing
documents; filing documents; correspondence and communication with the Internal Revenue Service;
providing written advice with regard to any entity, transaction, plan or arrangement; and representing
clients at conferences, hearings, and meetings.
18.3 Who May Practice. The following are individuals who may be recognized to practice before the
Internal Revenue Service.
18.3a Attorneys. Any attorneys who are not currently under suspension or disbarment from practice
may file with the IRS a written declaration that the attorney is currently qualified as an attorney and is
authorized to represent the party or parties. Attorneys who are not currently under suspension or
disbarment from practice are not required to file a written declaration before rendering certain written
advice, but their rendering of this advice is practice before the Internal Revenue Service.
18.3b Certified Public Accountants. Any certified public accountants who are not currently under
suspension or disbarment from practice before the service may file with IRS a written declaration that
the CPA is currently qualified as a certified public accountant and is authorized to represent the party or
parties. CPAs who are not currently under suspension or disbarment from practice are not required to
file a written declaration before rendering certain written advice, but their rendering of this advice is
practice before the Internal Revenue Service.
18.3c Enrolled Agents. An enrolled agent who is not currently under suspension or disbarment from
practice before the IRS may practice before the Internal Revenue Service.
18.3d Enrolled Actuaries. Any individual who is enrolled as an actuary by the Joint Board for the
Enrollment of Actuaries who is not currently under suspension or disbarment from practice may file a
written declaration that they are currently qualified as an enrolled actuary and is authorized to represent
the party or parties. Practice as an enrolled actuary is limited to representation with respect to areas
generally covering employee plans and associated areas. See Circular 230, Section 10.3 (d) for more
specifics.
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18.3e Enrolled Retirement Plan Agents. Any individual who is enrolled as a retirement plan agent
who is not currently under suspension or disbarment from practice may be recognized with respect to
issues involving certain Employee Plan programs. In addition, enrolled retirement plan agents are
generally permitted to represent taxpayers with respect to IRS forms under the 5300 and 5500 series
which are filed by retirement plans and plan sponsors, but not with respect to actuarial forms or
schedules.
18.3f Registered Tax Return Preparers. Individuals designated as a registered tax return preparer
who is not currently under suspension or disbarment from practice may practice before the Internal
Revenue Service limited to preparing and signing tax returns and claims for refund, and other
documents for submission to the Internal Revenue Service.
An RTRP may represent taxpayers before revenue agents, customer service representatives, or similar
officers and employees of the IRS (including the Taxpayer Advocate Service) if the RTRP signed the
return or claim for refund for the tax year or period under examination. Unless otherwise permitted by
law, an RTRP cannot represent individuals before appeals officers, revenue officers, Counsel or similar
officers or employees of the IRS or Treasury Department. An RTRP also cannot provide tax advice to a
client or any other person except as necessary to prepare a tax return, claim for refund, or other
documents intended to be submitted to the Internal Revenue Service.
18.4 Eligibility. The following outlines eligibility to become an enrolled agent or registered tax return
preparer:
18.4a Enrolled Agents. To become an enrolled agent, an applicant must be eighteen years or older,
must demonstrate special competence in tax matters by passing a written exam administered under the
Internal Revenue Service, possess a valid tax preparer identifying number, and not have engaged in
any conduct that would justify suspension or disbarment of the practitioner.
18.4b Registered Tax Return Preparers. To become an RTRP, an applicant must be eighteen years
or older, must demonstrate competence in Federal tax return preparation matters and pass a written
exam administered under the Internal Revenue Service, possess a valid tax preparer identifying
number, and not have engaged in any conduct that would justify suspension or disbarment of the
practitioner.
18.4c Former IRS Employees. Individuals who, by virtue of past service and technical experience has
demonstrated that they are qualified for such enrollment and who has not engaged in any conduct that
would justify the suspension or disbarment of any practitioner may be granted enrolled agent or
enrolled retirement plan agent status. For more details on the specific requirements on length and
scope of service, see Treasury Department Circular 230, Section 10.4(d).
18.5 Application and Suitability. Individuals wishing to become an enrolled agent, enrolled retirement
plan agent, or registered tax return preparer must apply, pay a fee and pass compliance and suitability
checks.
18.5a Form; Address. An applicant must apply by proper execution of required forms including any
under oath or affirmation. The address on the application will be the address under which the
successful applicant is enrolled or registered and to which all correspondence will be sent.
18.5b. Fee. A reasonable, nonrefundable fee may be charged for each application.
18.5c Compliance Check. As a condition of enrollment or registration, the IRS may conduct a federal
tax compliance check and suitability check. The tax compliance check will be limited to an inquiry
regarding whether an applicant has filed all required individual or business tax returns and whether the
applicant has failed to pay, or make suitable arrangements for any federal tax debt.
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18.5d Suitability Check. The suitability check will be limited to an inquiry regarding whether an
applicant has engaged in any conduct that would justify suspension or disbarment of any practitioner.
18.5e Failure to Pass Compliance or Suitability Checks. If the applicant does not pass the
compliance or suitability check, the applicant may reapply if they become current with respect to their
tax liabilities.
18.6 Term and Renewal. Individuals recognized to practice before the IRS must renew their status with
the Internal Revenue Service to maintain eligibility to practice. Failure to receive notification from the
Service of the renewal requirement will not be justification for the individual’s failure to satisfy this
requirement.
18.6a Change of Address. Enrolled agents, enrolled retirement plan agents, or registered tax return
preparers must send notification of any change of address to the Internal Revenue Service with 60
days of the actual change of address. Notification must include the individual’s name, prior address,
new address, tax identification number(s) (including a preparer tax identification number) and the date
the change is effective. Unless the notification is sent, the address for the purposes of any IRS
correspondence will be the address shown on the most recent application or renewal of enrollment or
registration.
18.6b Renewal Period for Enrolled Agents. Enrolled agents who have a social security or tax
identification number that ends with the numbers 0, 1, 2, or 3, except for those individuals who received
their initial enrollment after November 1, 2003 must have applied for renewal between November 1,
2003 and January 31, 2004. The renewal will be effective April 1, 2004.
Enrolled agents having a social security or tax identification number that ends with 4, 5 or 6 except for
those individuals who received their initial enrollment after November 1, 2004 must have applied for
renewal between November 1, 2004 and January 31, 2005. The renewal is effective April 1, 2005.
Enrolled agents with a social security number ending in 7, 8, or 9 except for those individuals who
received their initial enrollment after November 1, 2005 should have applied for renewal before
November 1, 2005 and January 31, 2006. The renewal is effective April 1, 2006.
Thereafter renewal application are required between November 1 and January 31 of every third year
according to the individual’s social security number or tax identification number. Individuals who receive
initial enrollment after November 1 and before April 2 of the applicable renewal period will not need to
renew their enrollment before the first full renewal period following their initial enrollment.
18.6c Renewal Period for Registered Tax Return Preparers. Registered tax return preparers must
renew their preparer tax identification number (PTIN) by December 31 for the coming tax season.
18.7 Continuing Education. In order to maintain their status, enrolled agents and registered tax return
preparers are required to complete a minimum number of qualified continuing education hours.
18.7a Requirements for Enrolled Agents. A minimum of 72 hours of continuing education credit,
including six hours of ethics or professional conduct must be completed during each enrollment cycle,
with a minimum of 16 hours of continuing education, including two hours of ethics or professional
conduct completed each enrollment year.
18.7b Enrolled Agent Initial Enrollment During Enrollment Cycle. In general, an enrolled agent who
receives their initial enrollment during an enrollment cycle must complete two hours of qualifying
continuing education for each month enrolled during the enrollment cycle. Enrollment for any part of a
month is considered enrollment for the entire month. Additionally they must complete two hours of
ethics or professional conduct for each enrollment year. Enrollment for any part of a year is considered
enrollment for the entire year.
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18.7c Requirements for Registered Tax Return Preparers. A minimum of 15 hours of continuing
education, including two hours of ethics or professional conduct, three hours of Federal tax law
updates, and 10 hours of federal tax law topics must be completed during each registration year.
18.7d Qualified Continuing Education. To qualify for continuing education credit, a course of learning
must be designed to enhance professional knowledge in federal taxation or federal tax related matters
(including accounting, tax return preparation software, taxation, or ethics) and be consistent with the
Internal Revenue Code and effective tax administration. Qualified continuing education can be a formal,
instructor led course or a correspondence course.
Individuals can also get continuing education credit for serving as an instructor, discussion leader or
speaker. One hour of continuing education will be given for each contact hour completed plus a
maximum of two hours for preparation time for each contact hour of speaking. The maximum amount of
continuing education credit for instruction and preparation may not exceed four hours annually for
registered tax return preparers and six hours annually for enrolled agents.
18.7e Recordkeeping. Individuals applying for renewal must keep records of qualifying education for
four years following the date of renewal. Such information should include the name of the sponsoring
organization, location of the program, title of the course, course number and description of its content,
course outlines and materials, dates of attendance, credit hours claimed, name of the instructor plus a
certificate of completion or signed statement of attendance.
18.7f Waiver. A waiver from continuing education requirements may be given for health reasons, active
military duty, work-related absence from the United States or other valid reason which will be decided
by the IRS on a case-by-case basis. A waiver must be in writing with accompanying documentation and
filed to later than the last day of the renewal period.
18.8 Representation. An individual who is not a practitioner may represent the following before the IRS
even if the taxpayer is not present:
• An individual may represent a member of his immediate family
• A regular full-time employee of an individual employer may represent the employer
• A general partner or a regular full-time employee of a partnership may represent the
partnership
• An officer or regular full-time employee of a corporation may represent the corporation,
association or organized group
• A regular full-time employee of a trust, receivership, guardianship,or estate may represent
those entities.
An individual who is under suspension or disbarment from practice before the Internal Revenue Service
may not engage in limited practice before the Service.
18.9 Information to be Furnished to the Internal Revenue Service. When lawfully requested, a
practitioner must promptly submit records or information in any matter before the Internal Revenue
Service unless the practitioner believes in good faith and on reasonable grounds that the records or
information are privileged.
If the records are unavailable, the practitioner must inform the requesting officer/employee of the
Internal Revenue Service and provide any information as to the whereabouts of the records.
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18.10 Knowledge of Client’s Omission. A practitioner who has been retained by a client with respect
to a matter before the Internal Revenue Service and who knows that the client has not complied with
the tax laws or has made an error or omission from a return or other document submitted to the IRS,
must promptly advise the client of the noncompliance. The practitioner must advise the client of the
consequences as provided by the Tax Code or regulations.
18.11 Due Diligence. In general a practitioner must exercise due diligence in the following:
• Preparing or assisting in the preparation of, approving, and filing tax returns, documents,
affidavits and other papers relating to Internal Revenue Service matters.
• Determining the correctness of oral or written representations made by the practitioner to the
Department of the Treasury.
• Determining the correctness of oral or written representations made to clients with reference to
any matter administered by the Internal Revenue Service.
Generally a practitioner will be presumed to have exercised due diligence if they rely on the work
product of another person and the practitioner used reasonable care in engaging, supervising, training
and evaluating the person, taking into account the nature of the relationship between the practitioner
and the other person.
18.12 Miscellaneous. A practitioner must follow the following:
• A practitioner may not unreasonably delay the prompt disposition of any matter before the
Internal Revenue Service.
• A practitioner may not knowingly accept assistance from or assist any person who is under
disbarment or suspension from practice before the Service if the assistance relates to a matter
constituting practice before the Service.
• A practitioner may not take acknowledgments, administer oaths, certify papers, or perform any
official act as a notary public with respect to any matter administered by the Service for which
he/she is employed as counsel, attorney, or agent, or in which they may be in any way
interested.
18.13 Fees. A practitioner may not charge an unconscionable fee in connection with any matter before
the Service.
18.13a Contingent Fee. Generally a practitioner may not charge a contingent fee for services rendered
in connection with the preparation of an original or amended return. A contingent fee is any fee that is
based, in whole or in part, on whether or not a position avoids challenge or is sustained if challenged.
A contingent fee also included a fee that is based on a percentage of the refund shown on the return or
a percentage of the taxes saved or that otherwise depends on a specific result attained.
A practitioner can charge a contingent fee for services rendered in connection with a claim for credit or
refund filed only in connection with determination of statutory interest or penalties or in connection with
any judicial proceeding arising under the Internal Revenue Code.
18.14 Return of Client’s Records. In general, when asked, a practitioner must promptly return any
and all records of the client that are necessary for the client to comply with his or her federal tax
obligations. The practitioner may retain copies of the records returned. The existence of a dispute over
fees does not relieve the practitioner of his or her responsibility. However if state law allows or permits
the retention of a client’s records by a practitioner in the case of a dispute of fees, the practitioner must
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return only those records that must be attached to the return. They must however provide the client with
reasonable access to review and copy any additional records retained that are necessary for the client
to comply with his or her federal tax obligations.
18.15 Conflict of Interest. In general, a practitioner should not represent a client before the Internal
Revenue Service if the representation creates a conflict of interest. A conflict of interest exists if the
representation of one client will be directly adverse to another client or there is a significant risk that the
representation of one client will be materially limited by the practitioner’s responsibilities to another
client, a former client, a third person, or by a personal interest of the practitioner.
The practitioner may represent a client if they reasonably believe that they will be able to provide
competent and diligent representation to each affected client, the representation is not prohibited by
law, and each client waives the conflict of interest and gives timely, written consent.
18.16 Advertising and Solicitation. Circular 230 also spells out a number of restrictions on advertising
and solicitation for practitioners.
18.16a False or Misleading Statements. A practitioner may not use false, or misleading statements
when describing their professional designation. Enrolled agents or registered tax return preparers may
not use the term “certified” or imply an employer/employee relationship with the Internal Revenue
Service. Acceptable descriptions include “enrolled or admitted to practice before the Internal Revenue
Service” for enrolled agents or “designated as a registered return preparer by the Internal Revenue
Service.
18.16b Solicitation. Practitioners may not, directly or indirectly, make an uninvited written or oral
solicitation of employment if the solicitation violates federal or state laws or other applicable rules. Any
lawful solicitation must clearly identify the solicitation as such and, if applicable, identify the source of
information used in choosing the recipient.
18.16c Fees. A practitioner may publish a written schedule of fees including fixed fees for services,
hourly rates, a range of fees for services, etc. The practitioner may not charge more than any published
fees for at least 30 calendar days after the last date on which the schedule of charges was published.
Fee information may be published in telephone directories, print media, print or electronic mail, fax,
flyers radio, television, etc., but the practitioner must retain copies of the advertising (along with a list of
recipients, if appropriate) for at least 36 months after the last published date. Any method of advertising
fees must not be untruthful or deceptive, and the practitioner may not persist in attempting to contact a
prospective client if they have made it known that he or she does not wish to be solicited.
18.17 Miscellaneous.
18.17a Negotiation of Taxpayer Checks. A practitioner who prepares tax returns may not endorse or
otherwise negotiate any check issued to a client by the government in respect to a federal tax liability.
18.17b Best Practices for Tax Advisors. Tax advisors should provide clients with the highest quality
representation, including the following practices:
• Communicating clearly with the client regarding the terms of the advice or assistance to be
rendered.
• Establishing and determining relevant facts, relating the applicable law and arriving at a
conclusion supported by the law and the facts.
• Advising the client regarding the any conclusions reached.
• Acting fairly and with integrity in practice before the Internal Revenue Service.
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18.17c Professional Standards with Respect to Tax Matters. A practitioner may not willfully,
recklessly, or through gross incompetence sign a return or claim for refund that the practitioner knows
(or reasonably should know) lacks reasonable basis, is unreasonable or is a willful attempt by the
practitioner to understate liability or an intentional disregard of rules or regulations.
A practitioner must inform a client of any penalties that are reasonably likely to apply in a position or
document submitted to the Internal Revenue Service if the practitioner advised the client with regard to
the position or prepared or signed the document or return. They must also inform the client of any
opportunity to avoid any such penalties and of the requirements for adequate disclosure.
18.17d Relying on Information Furnished by Clients. A practitioner advising a client to take a
position on a return or other information submitted to the Internal Revenue Service or preparing or
signing a tax return generally may rely in good faith and without proof upon information given by the
client. However the practitioner must make reasonable inquiries if the information as furnished appears
to be incorrect, inconsistent with facts or incomplete.
18.18 Incompetence and Disreputable Conduct. A practitioner may be sanctioned for incompetence
and disreputable conduct including (but not limited to):
• Conviction of any criminal offense under the federal tax laws;
• Conviction of any criminal offense involving dishonesty or breach of trust;
• Conviction of any felony under federal or state law for which the conduct involved renders the
practitioner unfit to practice before the Internal Revenue Service;
• Giving false or misleading information in any way to the Department of the Treasury;
• Solicitation of employment using false or misleading representations with the intent to
deceive;
• Willfully failing to file federal tax laws or attempting to illegally evade any assessment or
payment of federal tax;
• Willfully assisting, counseling or encouraging clients (or prospective clients) to illegally evade
any assessment or payment of federal tax;
• Misappropriation of funds received from a client for the purposes of payment of taxes or other
federal obligations;
• Directly or indirectly attempting to influence any member of the Internal Revenue Service by
the use of threats, false promises, duress or by the bestowing of any gift, favor or thing of value;
• Disbarment or suspension from practice as an attorney, certified public accountant, etc.
• Knowingly aiding and abetting another person to practice before the Internal Revenue Service
during a period of suspension, disbarment or ineligibility;
• Disreputable conduct in practice before the Internal Revenue Service including abusive
language, making false accusations, or circulating malicious or libelous material;
• Knowingly, recklessly or through gross incompetence, giving a false opinion;
• Willfully failing to sign a tax return when required by federal tax laws unless the failure is due
to reasonable cause and not due to willful neglect;
• Willfully disclosing or otherwise using a tax return or tax return information in an unauthorized
manner;
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• Willfully failing to file on magnetic or other electronic media a tax return prepared by the
practitioner when they are required to do so, unless the failure is due to reasonable cause and
not due to willful neglect;
• Willfully preparing all of, or substantially all of, or signing a tax return or claim for refund when
the practitioner does not possess a current, valid preparer tax identifying number;
• Willfully representing a taxpayer before the Internal Revenue Service unless they are
authorized to do so.
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Quick Study 1.0
•
Accounting Period. A specific interval of time over which income and expenses are recorded.
•
Calendar Year. An accounting period from January 1 to December 31.
•
Fiscal Year. Any accounting period that is any 12 consecutive months ending on the last day of
any month except December.
•
Accounting Method. A set of rules that determines when the taxpayer reports income and
expenses.
•
Cash Method of Accounting. Income is included in gross income when received; expenses
are deductible when paid.
•
Accrual Method of Accounting. Income is included in gross income when earned; expenses
when incurred.
•
Constructive Receipt. A taxpayer is considered to have received income when an amount is
credited to their account or made available without restriction.
•
A taxpayer can generally use any combination of cash, accrual or special methods of
accounting if they use it consistently and it clearly shows income and expenses.
•
A taxpayer who maintains an inventory must use an accrual method for purchases and sales
(they may use a cash method for all other items of income and expenses).
•
If the cash method is used to figure income, it must be used to report expenses. If the accrual
method is used to figure expenses, it must used to report income.
•
Once established, a taxpayer must get IRS approval before they can change their accounting
method.
•
Every individual listed on a tax return must have a identification number of some sorts - for most
individuals this is a Social Security number.
•
A taxpayer not eligible for a Social Security number may apply for an Individual Taxpayer
Identification Number (ITIN) by completing Form W-7, Application for IRS Individual Taxpayer
Identification Number.
•
Taxpayers who are in the process of adopting a child may complete a W-7A, Application for
Taxpayer Identification Number for Pending U.S. Adoptions and apply for an Adoption Taxpayer
Identification Number (ATIN) to identify a child while the final domestic adoption is pending.
•
IRS requires records to be kept for as long as they are important for the administration of the
Tax Code - usually until the statute of limitations expires.
•
Generally the statute of limitations is 3 years.
•
If the income shown on a return is understated by 25% or more, the statute of limitations is 6
years.
•
When a fraudulent return is filed or no return is filed, there is no limit on the statute of limitations.
•
The time for filing a claim for refund or credit is the later of 3 years from the due date of the
return of 2 years after the tax was paid.
•
The time for filing a claim for a loss on a worthless security is 7 years.
•
A calendar year taxpayer must generally file an income tax return and pay any tax due by April
15 of the following year.
•
Fiscal year taxpayers must file a return and pay any tax due by the 15th day of the 4th month
after the close of their fiscal year.
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•
If the due date for filing a return falls on a Saturday, Sunday or legal holiday, the due date is
delayed until the next business day.
•
A paper return is considered to be filed on time if it is mailed in an envelope that is properly
addressed, has enough postage and postmarked by the due date.
•
For registered mail or certified mail, the date of registration or the date on the receipt is the
postmark date.
•
An electronically filed return is considered to be timely if the authorized electronic return
transmitter "postmarks" the return by the due date.
•
The date and time in the taxpayer's time zone controls whether a return is timely filed.
•
A Refund Anticipation Loan (RAL) is a bank loan against the amount of the taxpayer's refund
shown on their return.
•
Starting January 1, 2011 tax preparers who anticipate filing 100 or more Forms 1040, 1040A,
1040EZ and 1041 during the year must use IRS e-file.
•
Starting January 1, 2012 tax preparers who anticipate filing 11 or more Forms 1040, 1040A,
1040EZ and 1041 during the year must use IRS e-file.
•
For the purposes of mandatory electronic filing, if a tax business expects to exceed the
threshold, all members of the firm must e-file the returns they prepare even if a specific preparer
complete less than the threshold on an individual basis.
•
When filing electronically, a taxpayer should sign their return electronically using a Self-Select or
Practitioner PIN.
•
To use a Self-Select PIN, the taxpayer must know their prior year Self-Select PIN or the AGI
from their original last years return.
•
A Practitioner PIN does not require a prior year PIN or AGI, but the taxpayer must sign an
authorization form.
•
An estate tax is a tax imposed on the transfer of the taxable estate of a deceased person.
•
A gift tax may be imposed on any transfer of money or property to an individual where full
consideration is not received in return.
•
Generally a gifts under the annual exclusion for the year ($13,000 for 2011) are not subject to
the gift tax.
•
Various other types exist, including real and personal property taxes, sales and excise taxes or
employment taxes.
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Quick Study 2.0
•
The three basic tax forms are the Form 1040EZ, 1040A and 1040 (long form).
•
Schedules and forms are usually official IRS documents and are submitted along with the tax
return.
•
Statements may or may not be official documents but are generally included as part of the
return to explain items found on the return.
•
Worksheets are used to calculate or determine figures on the return and are not filed with the
return but kept with the file copy.
•
A Form W-2 from each employer should be included with the return in the place indicated on the
front page of Form 1040.
•
Any Forms 1099-R should only be submitted with the tax return if there is an amount shown for
federal income tax withholding.
•
Additional forms or schedules should be included with the base tax return in order by sequence
number.
•
Any other worksheets should be in the same order as the form or schedule they relate to and
attached last.
•
Your age for tax purposes is determined at the end of the year.
•
You are considered a year older the day before your birthday.
•
The age of a decedent is determined as of the date of death.
•
Marital status is determined on the last day of the tax year or as of the date of death for a
decedent.
•
For tax purposes, marriage means a legal union of a man and a woman as husband and wife.
•
A taxpayer is considered unmarried if on the last day of the tax year, they are unmarried or
legally separated from their spouse under a divorce or decree of separate maintenance.
•
Married taxpayers not separated from their spouse under a divorce or decree of separate
maintenance on the last day of the tax year are considered married for tax purposes.
•
Common law marriages are recognized for tax purposes if the man and woman are living
together and have entered into a common law marriage in a state which recognizes the union.
•
At this time, same sex domestic partnerships or marriages are not recognized for tax purposes.
•
A taxpayer divorced under a final decree of divorce is unmarried for the whole year.
•
A married taxpayer may be considered unmarried for tax purposes if:
o
They file a separate return from their spouse
o
The spouse did not live in the home any time during the last 6 months
o
They paid for more than half the cost of keeping up their home
o
Their home was the main home for their child, stepchild, adopted child, or foster child for
whom they claim an exemption.
•
Individuals who have had a marriage annulled must file amended returns for all tax years that
are not closed by the statute of limitations.
•
A return should be filed for a decedent if the income that the decedent had made available to
him before his death exceeds the filing requirements.
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•
Form 1310, Statement of Person Claiming Refund Due a Deceased Taxpayer should be filed
with a decedents return if the person filing the return is not a surviving spouse or a court
appointed or certified personal representative.
•
The five filing statuses are Single, Married Filing Jointly, Married Filing Separately, Head of
Household and Qualifying Widow(er) with Dependent Child.
•
To qualify for the Head of Household filing status, the taxpayer must:
o
Be single or considered unmarried for tax purposes
o
Have paid more than half the cost of keeping up a home for the year
o
Have a qualifying individual who lived with them for more than half the year
•
A parent does not have to live with the taxpayer to qualify them for the Head of Household filing
status provided all the other requirements are met.
•
The taxpayer's single child does not have to be the taxpayer's dependent to qualify them for the
Head of Household filing status provided all the other requirements are met.
•
A person cannot qualify more than one person to use the Head of Household filing status.
•
The Qualifying Widow(er) filing status is available for taxpayers with a dependent child for two
year following the death of their spouse (provided they do not remarry).
•
In a community property state, the income and property acquired by a taxpayer and spouse
during their marriage is generally considered to be held equally by each spouse.
•
Treasury Department Circular 120, Regulations Governing the Practice of Attorneys, Certified
Public Accountants, Enrolled Agents, Enrolled Actuaries, and Appraisers before the Internal
Revenue Service outlines rules governing paid tax preparers.
•
Paid tax preparers must obtain a Preparer Tax Identification Number (PTIN) by completing Form
W-7P.
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Quick Study 3.0
•
All income is subject to income tax and is reported on the tax return unless specifically exempt or
excluded by law.
•
Gross income includes total worldwide income received in the form of money, goods, property or
services that is not specifically exempt from tax.
•
Earned income is generally received for work or other services performed.
•
Unearned income is income that is not earned income.
•
Nontaxable income is specifically exempt from tax by law.
•
In a community property state, property and income acquired during marriage is considered to be
owned 50/50 by each spouse unless specifically stated to be separate property.
•
Form W-2, Wage and Tax Statement is used by employers to provide to their employees a record of
their taxable compensation, plus other items such as federal and state withholding, taxable fringe
benefits, deferred compensation amounts, etc.
•
Employers are required to mail their employees a copy of their Form W-2 by January 31 of each
year.
•
Employees who have not received a Form W-2 by February 15 may complete IRS Form 4852,
Substitute for Form W-2, Wage and Tax Statement after contacting their employer and the IRS.
•
Alimony is a payment to or a former spouse under a divorce or separation agreement.
•
Alimony that is paid is subtracted from taxable income; alimony that is received is taxable.
•
Money that is paid as child support is not deductible from income; money that is received as child
support is not taxable.
•
Allocated tips are reported on a Form W-2 of an employee who worked in a restaurant, bar, etc.
who reported tips of less than their share of 8% of food and drink sales.
•
Allocated tips must be reported on the tax return in addition to wages unless the employee kept a
daily tip record.
•
Social security and Medicare taxes must be calculated and paid on allocated tips by completing
Form 4137, Social Security and Medicare Tax on Unreported Tip Income.
•
If a taxpayer provides services in return for other goods or services, they must include in income the
fair market value of the property received.
•
Generally if a taxpayer is relieved of an obligation to pay a debt, the amount forgiven or cancelled
must be included in income. Exceptions apply in certain bankruptcies or primary home loans or to
the extent that the taxpayer is insolvent.
•
Gambling winnings are taxable.
•
Gambling losses are deductible only up to the extent of reported gambling winnings and are
deducted on Schedule A as a miscellaneous deduction not subject to the 2% income limit.
•
Money or property received as a gift is generally not taxable to the recipient.
•
Money or property received as an inheritance is generally not taxable to the recipient.
•
Jury duty pay should be reported as income on Form 1040, line 21. Any money repaid to an
employer should be subtracted as an adjustment to income on line 36.
•
Prizes, awards or lottery winnings should be reported as income on Form 1040, line 21.
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•
A statutory employee is a special type of employee whose earnings are subject to social security
and Medicare withholding but not income tax withholding. Statutory employee wages shown on
Form W-2 should be reported on Schedule C with any related expenses.
•
Unemployment benefits are considered to be taxable income.
•
If the taxpayer moved due to a change in job, they may deduct their moving expenses if they satisfy
the "distance" test and the "time" test.
•
Moving expenses are figured on Form 3903 and deducted as an adjustment to income.
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Quick Study 4.0
•
The standard deduction is a dollar amount, based on filing status, age, and blindness, which is
subtracted from income when calculating the amount of tax liability.
•
The taxpayer generally has the option of taking their standard deduction or itemizing their
deductions.
•
Itemized deductions are calculated on Schedule A.
•
Taxpayers who are married filing separate and their spouse itemizes deductions are not eligible
for the standard deduction.
•
Taxpayers who are blind or age 65 or older are eligible for an increase in their standard
deduction.
•
A dependents standard deduction is limited to the greater of $950 or the dependents earned
income for the year plus $300 (not to exceed the regular standard deduction amount).
•
Taxpayers may also qualify for an increased standard deduction if they paid sales or excise tax
on a qualified new vehicle purchase or had a disaster loss from a federally declared disaster
area.
•
For 2011 a taxpayer can subtract $3,700 for each exemption.
•
The three initial tests for determining if someone can be claimed as a dependent: Dependent
Taxpayer test, Joint Return test, Citizen or Resident test.
•
Dependent Taxpayer test - A taxpayer cannot claim an exemption for a dependent if they (or
their spouse if filing a joint return) can be claimed as a dependent by another.
•
Joint Return test - A taxpayer cannot claim a married person who files a joint returns as a
dependent unless their joint return is filed only to claim a refund and neither spouse would have
a tax liability if they filed separate returns.
•
Citizen or Resident test - A person cannot be claimed as a dependent unless for some part of
the year they are a U.S. citizen, resident, national or a resident of Canada or Mexico.
•
The five additional tests to determine if someone is a qualifying child: Relationship, Age,
Support, Member of Household, More Than One Person/Tie-Breaker Rule.
•
Relationship test -The child must be the taxpayer's son, daughter, stepchild, eligible foster child,
brother, sister, half-brother, half-sister, stepbrother, stepsister or a descendent of any of them.
•
Age test -The child must have been under age 19 at the end of the year and younger than the
taxpayer (and spouse if the taxpayer is filing a joint return); under age 24 at the end of the year
and a full-time student (and younger than the taxpayer and spouse if the taxpayer is filing a joint
return); or any age if permanently and totally disabled at any time during the year.
•
Support test - The child cannot have provided more than half of their own support.
•
Member of Household test- The child must have lived with the taxpayer for more than half the
year.
•
More Than One Person test - If a child meets all the tests to be considered the qualifying child
of more than one person they can decide themselves who may claim the child. If they are
unable to decide they must use the Tie-Breaker Rules.
•
The five additional tests to determine if someone is a qualifying relative: Relationship of Member
of Household; Gross Income; Support; Qualifying Child.
•
Relationship or Member of Household test - The person must be either related to the taxpayer
or lived with the taxpayer all year as a member of their household.
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•
Gross Income test - The persons gross income for the year must be less than $3,700
(exemption amount).
•
Support test - The taxpayer must have provided over half the persons total support for the year
except in the case of a Multiple Support Agreement.
•
Qualifying Child test - The person cannot be the taxpayer's qualifying child or the qualifying child
of anyone else.
•
Generally a taxpayer must file a tax return if their gross income exceeds their standard
deduction plus their own personal exemption amount.
•
Additionally, a self-employed individual must file a tax return if their net earnings from selfemployment were $400 or more.
•
Even if a taxpayer is not required to file a return, they should file if they expect to get a refund.
•
The IRS can impose penalties for filing late, paying late, accuracy, frivolous tax positions, fraud
or failure to supply an identifying number.
Quick Study 4.0
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Quick Study 5.0
•
A deduction reduces taxable income, while a credit reduces the taxpayer’s tax itself dollar for
dollar.
•
A nonrefundable credit can reduce the taxpayer’s tax liability only to zero. The taxpayer will not
get an increased refund if the amount of the credit is greater than their tax liability.
•
A refundable credit is treated in the same way as tax payments. If the amount of the refundable
credits (plus any other tax withheld) is greater than the tax liability, the excess will be refunded
to the taxpayer.
•
The earned income credit (EITC or EIC) is a tax credit for certain people who work and have
earned income under $49,078 (for 2011).
•
To qualify for the EIC, every taxpayer must meet 7 tests: The AGI test, the SSN test, the Filing
Status test, the Residency test, the Foreign Income test, the Investment Income test, the
Earned Income test.
•
AGI Test. The taxpayer must have AGI under $49,078.
•
SSN test. The taxpayer/spouse and all qualifying children must have a valid social security
number.
•
Filing Status test. The taxpayer cannot use the Married Filing Separate filing status.
•
Residency test. The taxpayer must be a U.S. citizen or resident alien for the entire year.
•
Foreign Income test. The taxpayer cannot file Form 2555 or 2555-EZ.
•
Investment Income test. The taxpayer cannot have more than $3,105 in investment income.
•
Earned Income test. The taxpayer (or spouse if filing a joint return) must work and have earned
income.
•
For the purposes of EIC a child may be a qualifying child if they meet the Relationship, Age and
Residency tests.
•
Relationship test. To be a qualifying child, a child must be the taxpayer’s son, daughter,
stepchild, eligible foster child or a descendent of any of the previous; or brother, sister, half
brother, half sister, stepbrother, stepsister, or a descendent of any of the previous.
•
Age test. To qualify for EIC, the child must be under age 19 and younger than taxpayer (and
spouse); a full-time student under age 24 and younger than the taxpayer (and spouse) or any
age if permanently and totally disabled.
•
Residency test. To be a qualifying child, the child must have lived with the taxpayer in the
United States more than half of 2011.
•
A qualifying child cannot be used by more than one person to claim the EIC.
•
If more than one person has the same qualifying child, they must decide who will take all the
benefits associated with the qualifying child including the child's exemption, the child tax credit,
the head of household filing status, the credit for child and dependent care expenses and the
EIC. If they cannot decide the tie-breaker rules will apply.
•
To claim the EIC the taxpayer cannot be a qualifying child of anyone else.
•
If the taxpayer does not have a qualifying child they must meet the Age test, the 'Not a
Dependent' test, the 'Not a Qualifying Child' test, and the Residency test.
•
Age test. The taxpayer or spouse must be at least age 25 but under age 65 at the end of the
year.
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•
'Not a Dependent' test. If the taxpayer can be claimed as a dependent of another they cannot
claim the EIC (even if the other person chooses not to claim them as a dependent).
•
''Not a Qualifying Child' test. If the taxpayer is the qualifying child of another, they cannot
claim the EIC, even if the person for whom they are a qualifying child cannot (or chooses not) to
claim the credit.
•
Residency test. The taxpayer (and spouse) must have lived in the United States for more than
half the year.
•
If the taxpayer had their earned income credit denied or reduced for a reason other than a math
or clerical error for any year after 1996, they may need to complete Form 8862 to claim the EIC.
•
The taxpayer can no longer get advance payments of the credit in their pay during the year as
they could in 2010 and earlier years.
•
Paid tax preparers who do returns or claims for refund involving the Earned Income Credit must
meet due diligence requirements in determining if the taxpayer is eligible for, and the amount of,
the EIC.
•
Failure to meet EIC due diligence requirements could result in a penalty of $500 per return.
•
Form 8867 was designed to ensure that the paid preparer considered all the requirements
necessary when preparing an EIC return.
•
The child tax credit is a nonrefundable credit that can reduce tax by up to $1,000 per child.
•
To be a qualifying child for the Child Tax Credit, a person must meet five requirements: the
Relationship, Age, Support, Member of Household and Residency tests.
•
Relationship test. The child must be the taxpayer’s son, daughter stepchild, foster child,
brother, sister, stepbrother, stepsister or a descendent of any of them.
•
Age test. The child must have been under age 17 at the end of 2011.
•
Support test. The child did not provide more than half of their own support for 2011.
•
Member of household test. The child must have lived with the taxpayer for more than half of
2011.
•
Residency test. The child must have been a U.S. citizen, a U.S. national, or a resident of the
United States for the year 2011.
•
If the taxpayer is not able to use the full amount of their child tax credit, they may be eligible for
the refundable Additional Child Tax Credit.
•
The Additional Child Tax Credit is calculated on Form 8812.
•
The Child and Dependent Care Credit is a percentage of work-related child and dependent care
expenses the taxpayer paid to a care provider so they could work or look for work.
•
For 2011 the taxpayer may use up to $3,000 in expenses paid in a year for one qualifying
individual or $6,000 for two or more qualifying individuals. The credit can be up to 35% of
expenses depending on the taxpayer's income.
•
For 2010 and 2011, the taxpayer may take a refundable tax credit for qualifying expenses paid
to adopt an eligible child.
•
Form 8839 is used to calculate any credit for adoption expenses.
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Quick Study 6.0
•
Interest is income paid for the use of money.
•
Cash basis taxpayers report interest income in the same year they actually or constructively
receive the funds.
•
Constructive receipt. A t taxpayer is considered to have constructively received interest income
when it is credited to their account; they do not necessarily have to have physically received the
funds.
•
An accrual basis taxpayer reports taxable interest income when they have earned it, whether or
not they have received it.
•
Form 1099-INT or a similar statement is used by banks, savings and loans, and other payers to
report interest income to taxpayers.
•
Form 1099-INT is required whenever interest of over $10 is paid by an institution, or over $600
of interest paid in connection with a trade or business.
•
“Dividends” from the following are reportable as interest income: cooperative banks, credit
unions, domestic or federal savings and loan associations, domestic building and loan
associations and mutual savings banks.
•
Interest on U.S. obligations such as Treasury bills, notes and bonds is taxable for federal
income purposes (but generally exempt from state and local tax).
•
Interest received on a tax refund is taxable income.
•
Bonds issued at a discount may be referred to as Original Issue Discount bonds (OID).
•
Interest on bonds used to finance government operations generally is not taxable if the bond is
issued by a state, the District of Columbia, a possession of the U.S. or any of their political
subdivisions (municipal bonds).
•
Taxpayers may be able to exclude from income all or part of the interest received when
redeeming qualified U.S. savings bonds (including series I bonds or series EE bonds issued
after 1989) if they pay higher educational expenses during the same year.
•
A dividend is a taxable payment declared by a company's board of directors and given to its
shareholders out of the company's current or retained earnings, usually quarterly.
•
Dividends are usually given as cash (cash dividend), but they can also take the form of stock
(stock dividend) or other property.
•
Dividends, whether in the form of cash or stock, are usually taxable, although different types of
dividends may be taxed at different rates.
•
Dividends are reported to the taxpayer on Form 1099-DIV.
•
The most common types of dividends are ordinary dividends and qualified dividends.
•
Ordinary dividends are paid out of the earnings and profits of the corporation and are
considered to be ordinary income to the recipient. Ordinary dividends are taxed at the same rate
as the taxpayer’s wages and other ordinary (non-capital gain) income.
•
Qualified dividends are ordinary dividends that qualify for the special 0% or 15% maximum
capital gains tax rate. The 0% rate applies if the taxpayer’s regular tax rate is lower than 25%. If
the regular tax rate that would apply is higher than 25%, the 15% capital gains rate would apply.
•
Two other common corporate distributions reported on Form 1099-DIV include capital gain
distributions and nontaxable distributions.
•
Capital gain distributions are paid by mutual funds and real estate investment trusts (REITs).
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•
Capital gain distributions are always considered long term, regardless of how long the taxpayer
owned shares in the mutual fund or REIT.
•
A nondividend (nontaxable) distribution is a distribution that is not paid out of the earnings and
profits of a corporation and is a return of the taxpayer’s investment in the stock of the company.
•
The taxpayer is required to reduce the basis of their stock by the amount of the nontaxable
distribution received. When the basis of the taxpayer’s stock has been reduced to zero, any
additional nondividend distributions are reported as a long-term or short-term capital gain
depending on how long the taxpayer has held the stock.
•
Kiddie tax. If a child has substantial investment income, part of a child's investment income
may be taxed at the parent's rate by using Form 8615, Tax for Certain Children With Investment
Income of more than $1,900 or the parent may be able to elect to include the income on the
parent's return by including Form 8814, Parents' Election to Report Child's Interest and
Dividends.
•
The foreign tax credit is intended to reduce the double tax burden that would otherwise arise
when foreign source income is taxed by both the United States and the foreign country from
which the income is derived.
•
A taxpayer can choose to take the amount of any qualified foreign taxes paid or accrued during
the year as a foreign tax credit (Form 1116) or as an itemized deduction on Schedule A.
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Quick Study 7.0
•
Generally, a taxpayer has the ability to choose between a standard deduction and itemized
deductions and should opt for whichever method benefits them the most, i.e. largest refund or
lowest tax owed.
•
Itemized deductions are calculated by completing and filing Schedule A, Itemized Deductions,
with the tax return.
•
A taxpayer who is married, using the married filing separate filing status and whose spouse
itemizes deductions is assumed to have a standard deduction of $0 and should itemize their
deductions.
•
Generally, medical expenses include costs for the diagnosis, cure, treatment or prevention of
disease and are deductible if the amount is more than 7.5% of the taxpayer's adjusted gross
income.
•
Generally, medical expenses paid for the taxpayer, spouse, or dependents are deductible.
•
Medical expenses can be deducted when paid, regardless of when the services were provided.
•
The taxpayer can include as an expense amounts paid for special equipment or improvements
added to a home if its main purpose is for the medical care of the taxpayer, spouse or
dependents. However, this deduction is limited to the difference between the increase in fair
market value of the home (because of the addition) and the cost of the equipment or
improvement.
•
Generally premiums paid for Medicare B are deductible as a medical expense.
•
The taxpayer can use a standard mileage rate to determine the amount of deductible medical
expense. For 2011 the medical standard mileage rate is 19 cents per mile from January 1–June
30, and 23.5 cents per mile from July 1–December 31, 2011.
•
The taxpayer may elect to deduct either their state and local income taxes paid or their state
and local general sales tax paid, whichever gives them the greater tax benefit.
•
State and local taxes paid include those withheld from wages or other compensation such as
those reported on Form W-2G, Form 1099-MISC or Form 1099-R; estimated tax payments
made during the year as long as the taxpayer had a reasonable basis for making these
payments; a state balance due paid and any portion of their prior year refund applied to their
2011 estimated tax liability.
•
Deduct personal property taxes paid, but only if the tax is based solely on the value of the
property and it is charged on a yearly basis (for example the yearly fee paid for registration of a
vehicle)
•
Interest deductible on Schedule A include home mortgage interest, certain points paid in
connection with a loan and investment interest.
•
Personal interest, such as the interest paid on a credit card balance or car loan is not deductible
(unless used for business).
•
Home mortgage interest is any interest paid on a loan secured by the taxpayer’s main home or
second home including a loan to buy a home, a second mortgage, a line of credit, or a home
equity loan.
•
To deduct mortgage interest, he taxpayer must be legally liable for the amount of the loan and
the mortgage must be secured by a main home or second home.
•
Late payment charges or prepayment penalties (not in connection with a specific service
performed) are deductible as home mortgage interest.
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•
The term “points,” also known as loan origination fees, loan charges, loan discount fees, or
discount points, is used to describe charges paid by a borrower to obtain a home loan.
•
Points are usually deductible ratably over the life of the loan, however if the taxpayer meets
certain conditions, their points may be deducted in full in the year paid.
•
If the taxpayer borrows money to buy property for investment, the interest paid is considered to
be investment interest and is generally deductible up to the amount of net investment income.
•
Homebuyers who purchased a home in 2008 and claimed first-time homebuyer credit must now
begin repaying the credit as an additional tax on their return (special rules apply if the home
stops being their main home); if the home stops being their main home, they may need to add
the entire remaining credit amount to their income tax on their next return.
•
Homebuyers who purchased a home in 2009 or 2010 and claimed the first-time homebuyer
credit must repay the credit if they sell the home or stop using it as their main home in the 36months following the date of purchase.
Quick Study 7.0
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Quick Study 8.0
•
A charitable contribution is a donation (gift) of money or property to, or for the use of a qualified
charitable organization.
•
In order to be considered a charitable contribution, the donation must be voluntary and made
without the getting, or expecting to get anything in return.
•
Charitible contributions are deducted on lines 15 through 18 of Schedule A.
•
If the taxpayer receives a benefit as a result of making a charitable contribution, they can only
deduct the portion of the contribution that is over and above the value of the benefit received.
•
Fair market value is the price at which property would change hands between a willing buyer
and willing seller, neither one having to buy or sell, and both having reasonable knowledge of all
the facts in the transaction.
•
When the taxpayer makes a non-cash charitable contribution, the fair market value of the
property is usually the amount of the deduction.
•
If a taxpayer donates a car, boat or plane worth more than $500 to a charity, they should receive
a Form 1098-C from the charity and attach it to their return when they file.
•
If the amount of the taxpayer’s deduction for noncash items is more than $500, they must
complete and include Form 8283 with their return.
•
The taxpayer is required to keep records to prove the amount of cash and noncash
contributions made during the year.
•
If the taxpayer makes a single cash contribution of $250 or more, they must have a written
acknowledgement of their contribution by the receiving charity.
•
Generally a deduction for charitable contribution is limited to 50% of the taxpayer's AGI, but
deductions to certain organizations may be limited to 30 or 20% of the taxpayer's AGI.
•
Any charitable contributions that the taxpayer cannot deduct in the current year because they
exceeded the adjusted gross income limits can be carried over to the next five tax years.
Deductions that are not used with the five year time period are lost.
•
For tax purposes, a casualty is the damage, destruction or loss of property resulting from an
event that is sudden, unexpected or unusual.
•
A casualty loss is not deductible if the damage or loss is caused by: accidental breakage under
normal conditions, damage by a family pet, damage that is willfully done by the taxpayer or
someone the taxpayer hired or progressive deterioration due to normal wear and tear.
•
The taxpayer's loss from a casualty is the smaller of the decrease in fair market value of the
property compared to the adjusted basis of the property (minus any reimbursement the taxpayer
has received).
•
The cost of replacing stolen or destroyed property is not considered when determining the
amount of a casualty loss for tax purposes.
•
If the taxpayer receives a reimbursement greater than their adjusted basis in the property, they
may have a taxable gain.
•
The $100 Rule. For each personal casualty or theft, the amount of loss must be reduced by
$100 (each individual event, not each individual piece of property).
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•
The 10% Rule. The total of all casualty and theft losses on personal-use property for the year
must be reduced by 10% of the taxpayer’s AGI. The 10% rule is applied to the total of all losses
for the year after the $100 rule has been applied to each casualty or theft.
•
In a Presidentially declared disaster area the taxpayer can choose to deduct a casualty loss in
the year the disaster occurred or on an amended return for the year preceding the year the
disaster occurred.
•
Form 4684 is used to report a deductible loss from a casualty or theft. The loss is then carried to
Schedule A.
•
A taxpayer may deduct certain other miscellaneous items - most of these itemized deductions
must be reduced by 2% of the taxpayer’s adjusted gross income - such as unreimbursed
employee business expenses, tax preparation fees, fees for an investment planner, a safety
deposit box or other fees and costs incurred in producing taxable income.
•
Certain other deductions can be subtracted on Schedule A, not subject to the 2% limit, including
gambling losses up to the amount of gambling winnings, impairment-related work expenses of
persons with disabilities, unrecovered investment in an annuity, etc.
•
Form 2106 is for employees deducting ordinary and necessary expenses for their job.
•
An ordinary expense is one that is common and accepted in their field of trade, business, or
profession. A necessary expense is one that is helpful and appropriate for their business. An
expense does not have to be required to be considered necessary.
•
For 2011, there is no overall limit on itemized deductions.
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Quick Study 9.0
•
There are two education credits available: the lifetime learning credit and the American
opportunity tax credit.
•
The lifetime credit is nonrefundable; the American opportunity credit may be partially refundable.
•
The maximum amount of the American opportunity credit is $2,500 per student (100% of the
first $2,000 and 25% of the second $2,000 in expenses).
•
The AOC can be claimed for qualified tuition and related expenses for the first four years of a
student's post-secondary degree or certificate program.
•
Generally, up to 40% of the AOC is now refundable.
•
The lifetime learning credit is a credit of up to $2,000 per family (20% for up to $10,000 in
expenses).
•
Both the AOC and the lifetime learning credit are subject to phaseout when the taxpayer's AGI
reaches certain amounts.
•
The AOC and the lifetime learning credit are allowed for expenses paid in 2011 for an academic
period (semester, quarter, trimester, or summer session, etc.) beginning in 2011 or in the first
three months of 2012.
•
For both credits an eligible educational institution includes most colleges, universities,
vocational schools and other postsecondary educational institutions including almost all
accredited public, nonprofit and privately owned postsecondary institutions.
•
If, after filing their tax return, the taxpayer receives tax-free educational assistance or a refund of
an expense used to figure an education credit on their return, they may have to repay all or part
of the credit. They must figure their education credit for 2011 as if the assistance or refund was
received in 2011. Subtract the amount of the refigured credit from the amount of the original
credit. The taxpayer should add the repayment (recapture) to their tax liability for the year in
which they receive the assistance or refund. Their original tax return for 2011 does not change.
•
The AOC and the lifetime learning credit can only be claimed once for each eligible student in
each tax year - both credits cannot be claimed for the same student.
•
The taxpayer may take an adjustment to income for certain student loan interest expenses paid
up to $2,500.
•
The tuition and fees deduction can reduce the amount of the taxpayer’s taxable income by up to
$4,000. It is calculated on Form 8917 and taken as an adjustment to income.
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Page 79 of 87 of Publication 970
10:44 - 8-MAR-2012
The type and rule above prints on all proofs including departmental reproduction proofs. MUST be removed before printing.
Appendix B. Highlights of Education Tax Benefits for Tax Year 2011
This chart highlights some differences among the benefits discussed in this publication. See the text for definitions and
details. Do not rely on this chart alone.
Caution: You generally cannot claim more than one benefit for the same education expense.
Scholarships,
Fellowships,
Grants, and
Tuition
Reductions
What is your
benefit?
Amounts received
may not be taxable
American
Opportunity Credit
Lifetime Learning
Credit
Student Loan
Interest Deduction
Tuition and Fees
Deduction
Credits can reduce
the amount of tax
you have to pay.
Credits can reduce
amount of tax you
must pay
Can deduct interest
paid
Can deduct
expenses
40% of the credit
may be refundable
(limited to $1,000 per
student).
What is the annual
limit?
None
$2,500 credit per
student
$2,000 credit per tax
return
$2,500 deduction
$4,000 deduction
What expenses
qualify besides
tuition and required
enrollment fees?
Course-related
expenses such as
fees, books,
supplies, and
equipment
Course-related
books, supplies, and
equipment
Amounts paid for
required books, etc.,
that must be paid to
the educational
institution, etc., ARE
required fees
Books
Supplies
Equipment
None
Room & board
Transportation
Other necessary
expenses
What education
qualifies?
Undergraduate &
graduate
Undergraduate and
graduate
Undergraduate &
graduate
Undergraduate &
graduate
No other conditions
Must have been at
least half-time
student in degree
program
Cannot claim both
deduction &
education credit for
same student in
same year
$80,000 – $90,000
$51,000 – $61,000
$60,000 – $75,000
$65,000 – $80,000
$160,000 –
$180,000 for joint
returns
$102,000 –
$122,000 for joint
returns
$120,000 –
$150,000 for
joint returns
$130,000 –
$160,000 for
joint returns
K – 12
What are some of
the other
conditions that
apply?
Must be in degree or
vocational program
Payment of tuition
and required fees
must be allowed
under the grant
Undergraduate &
graduate
Courses to acquire
or improve job skills
Can be claimed for
only 4 tax years
(which includes
years Hope credit
claimed)
Must be enrolled at
least half-time in
degree program
No felony drug
conviction(s)
Must not have
completed first 4
years of
postsecondary
education before end
of preceding tax
year.
In what income
range do benefits
phase out?
No phaseout
(Continued)
Publication 970 (2011)
Page 79
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Quick Study 10.0
•
A Sole Proprietor is an individual who is in business for himself or herself.
•
All income and expenses for a sole proprietor are reported on Schedule C (or Schedule C-EZ)
and carried to the form 1040 of the owner of the business.
•
Generally speaking, if two or more people engage in a business together in order to share
profits, the activity is considered a partnership rather than a sole-proprietorship. However there
is an exception for a husband and wife who operate a business together if the spouses are the
only members of the business, they materially participate, file a joint return for the year and
agree to file separate Schedule Cs to account for their share of the business income.
•
The taxpayer must be involved in a for-profit business in order to report their income and
expenses on Schedule C.
•
A hobby is an activity engaged in for fun and/or enjoyment and not necessarily with a profit
motive.
•
Hobby income is reported on Form 1040, line 21; losses (up to the extent of income) are
reported on Schedule A, subject to the 2% limitation.
•
Hobby income is not subject to self-employment tax.
•
Start-up expenses are costs incurred before a trade or business begins and are generally
connected to setting up a business; researching the creation of a business; or investigating the
purchase of a business.
•
A taxpayer can elect to deduct up to $5,000 of organizational costs and up to $5,000 of
business start-up costs as a deduction in the year the trade or business begins.
•
Any start up expenses that are not currently deductible are amortized over 180 months.
•
Cash basis taxpayers should never have any returns and allowances.
•
If the taxpayer makes or buys goods to sell, they can deduct the cost of goods sold from their
gross receipts on Schedule C.
•
Advertising to influence political legislation is not deductible.
•
A taxpayer can take a deduction for a bad debt only if the amount was previously included in
income - cash basis taxpayers generally cannot take a deduction for a bad debt on their tax
return.
•
Taxpayers using an automobile in a trade or business can deduct expenses for the vehicle using
either the standard mileage rate or the actual costs.
•
In order to use the standard mileage rate for expenses, the taxpayer must generally use that
method in the year the car is placed in service.
•
The standard mileage rate for 2011 was 51 cents a mile from January 1 to June 30 and 55.5
cents a mile for all business miles driven from July 1, 2011, through Dec. 31, 2011.
•
Auto expenses between the taxpayer’s home and office are considered to be personal
commuting expenses and are not deductible.
•
If the taxpayer does not have a regular office, the mileage between home and their first
business stop is considered to be commuting to work mileage and it is not deductible as is the
mileage between their last business stop and their home.
•
If the taxpayer qualifies for an office-in-the-home, all of their business mileage outside the home
office is deductible.
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•
If $600 or more is paid to any one independent contractor for services rendered, Form 1099MISC (and 1096) must be filed.
•
Depreciation is the process by which the cost of business property is written off over a period of
years.
•
The sole proprietor cannot deduct contributions made to any type of benefit plan on his or her
own behalf on Schedule C but he/she may be able to deduct a portion of the amount paid on the
first page of Form 1040.
•
In 2011, small business owners who provide health care coverage for their employees may be
eligible for a credit worth up to 35% of their premium costs.
•
Generally a tax home is defined as the taxpayer’s regular place of business, regardless of
where they maintain their family home. It includes the entire city or general area in which the
business is located.
•
Deductible travel expenses include amounts paid by the sole proprietor for him/herself or his/her
employees in connection with away from home travel for business related matters.
•
An individual is away from home if he or she is required to be away from his or her tax home
substantially longer than an ordinary days work and he or she needs to get sleep or rest to meet
the demands of work while away from home.
•
If a taxpayer’s regular place to live is different from their tax home, travel expenses between
their tax home and where they live are not deductible.
•
If the taxpayer is away from home due to a temporary job assignment (one in a single location
which lasts for one year or less), the taxpayer is considered to be away from their tax home for
the entire time and their travel expenses are deductible.
•
If a trip is strictly for business, the taxpayer can deduct all of their travel related expenses.
•
If a trip is primarily for business but the taxpayer has some incidental personal activities, all of
their business related expenses are deductible including the costs of getting to and from their
business destination.
•
If a trip is primarily for personal reasons but the taxpayer has some incidental business to
conduct, the trip is considered to be a nondeductible expense and none of the transportation to
and from the destination are deductible, however the taxpayer can deduct any directly related
business expenses while at their destination.
•
To be deductible, entertainment expenses must be directly related to or associated with the
active conduct of business and there must be more than a general expectation of receiving
income or other business benefit in the future.
•
Generally the deduction for meals and entertainment is limited to 50% of the actual cost.
•
Material participation means that the taxpayer is involved in the business in a regular,
continuous and substantial way.
•
If the taxpayer does not materially participate in the business, a loss from the business is
considered a passive loss that can only be deducted against passive income.
•
Schedule SE is used to calculate self-employment social security and Medicare taxes which are
usually calculated on the net profit from Schedule C.
•
If the taxpayer has more than one Schedule C, the business income/loss is combined for all
businesses before calculating self-employment tax.
•
If a husband and wife both have separate Schedules C, each spouse must figure their selfemployment taxes separately on different Schedules SE.
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•
A taxpayer is required to prepare and file Schedule SE if their net earnings from selfemployment are $400 or more.
•
One-half of the total self-employment tax is also taken as an adjustment to income on Line 27 of
Form 1040.
•
The self-employment tax rate in 2011 was 13.3% (10.4% for Social Security and 2.9% for
Medicare).
•
Individuals with income from farming should use Schedule F, Profit or Loss from Farming to
calculate their net profit from farming activities.
•
Individuals who receive Schedule K-1 from a partnership, trust, estate or S corporation will
generally complete Schedule E, page 2 to report their income from these activities.
•
SEPs and Simple IRAs are two of the most common retirement plans for self-employed
individuals.
•
If the taxpayer uses their home for business, they should complete and attach Form 8829 to
determine the deductible amount of expenses.
•
To qualify to deduct expenses for business use of their home, the taxpayer must use part of
their home regularly and exclusively for business.
•
To qualify as exclusive use, the specific area of the taxpayer’s home must be used only for
their trade or business.
•
To qualify under the regular use test, the taxpayer must use a specific area of their home for
business on a regular basis (incidental or occasional business use is not regular use).
•
To determine the business percentage of the office in home expense, compare the size of the
part of home used for business to the whole house - the resulting percentage is used to
determine the business part of expenses for the entire home.
•
Direct expenses of the home (relating only to the business part of the home) are deductible in
full; indirect expenses (those for the entire home) are deductible based on the percentage of
business use; unrelated expenses are not deductible.
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Quick Study 11.0
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Depreciation involves deducting the cost of an asset over a specified length of time rather than
in one lump-sum.
•
Generally, depreciation is calculated by completing and attaching Form 4562 to the tax return.
•
The basis of property that is purchased is usually its cost including amounts paid with cash,
credit, loans, traded property or services.
•
Sales tax, freight, installation and testing charges, etc. are added to the basis of property.
•
The basis of property that is inherited is generally the value of the property for federal estate tax
purposes, generally the FMV of the property on the decedent's date of death unless an alternate
valuation date is elected.
•
For the basis of property received as a gift - If the FMV of the property is higher than the donor’s
adjusted basis (the item has appreciated in value), the basis of the gift is the giver’s adjusted
basis plus any gift tax paid on the property. If the giver’s adjusted basis is higher than the FMV
of the property (the item has decreased in value), the basis depends on whether the recipient
has a gain or a loss when they dispose of the property.
•
Adjusted basis of property. Generally speaking, improvements, additions and certain fees
paid in conjunction with property increase its basis. Deductions or credits taken decrease the
basis of property.
•
ACRS or Accelerated Cost Recovery System was used to calculate deprecation or “cost
recovery” for property placed in service after 1980 and before 1987.
•
MACRS (or Modified Accelerated Cost Recovery System) generally applies to real and personal
property placed in service after December 31, 1986.
•
Straight-line depreciation - the basis of property is deducted ratably over the life of the property.
•
Declining balance method - provides for a larger depreciation deduction in the earlier years of
the asset's life.
•
The property class determines the recovery period, or for how long an asset is depreciated, for
most types of property.
•
Once a depreciation method is chosen it must be used for all property in that class placed in
service that year (except nonresidential real and residential rental property).
•
Half-year convention. The half-year convention treats all personal-type property as being
placed in service (or disposed of) on the midpoint of the tax year - half the usual deduction is
claimed in both the first and last years of the recovery period.
•
If a taxpayer sells or otherwise disposes of an asset using the half-year convention before the
end of its normal recovery period, only one-half the usual amount of depreciation is allowed in
the year of disposition.
•
No deduction is allowed if the property is placed in service and disposed of in the same year.
•
When more than 40% of the total depreciable basis of personal-type MACRS property is placed
in service during the last quarter (three months) of the year, the mid-quarter convention is
used.
•
Under the mid-quarter convention, property is considered to have been placed in service (or
disposed of) at the midpoint of the quarter.
•
Mid-month convention. This convention is used for all nonresidential real property and
residential rental property. Under the mid-month convention, property is considered to have
been placed in service (or disposed of) at the midpoint of the month.
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Most types of tangible property such as buildings, machinery, vehicles, furniture and equipment
is depreciable.
•
Land is not depreciated.
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Quick Study 12.0
•
The Section 179 deduction allows for all or part of the cost of certain qualifying properties to be
recovered by deducting it in the year the property was placed in service.
•
The amount of the Section 179 deduction is subject to a maximum dollar limit ($500,000 for
2011) and a business income limit.
•
Section 179 property is generally any tangible property that can be depreciated under MACRS
that was purchased for use in the active conduct of a trade or business.
•
The Section 179 election must be made in the tax year the property is first placed in service and
it must be made on the original tax return filed for the year the property was placed in service.
•
Once the election is made, it cannot be revoked without IRS approval.
•
The only time that the Section 179 deduction can be taken on an amended return is if the
amended return was filed by the due date (including extensions) for the return for the year the
property was placed in service.
•
To qualify for the section 179 deduction, the property must be eligible property, purchased for
business use and not specifically excluded from being section 179 property.
•
The maximum section 179 expense deduction that can be elected for qualified section 179 real
property is $250,000 of the maximum deduction of $500,000 for 2011.
•
For the purposes of the Section 179 deduction, qualified real property is qualified leasehold
improvement property, qualified restaurant property or qualified retail improvement property.
•
If qualifying property is purchased with cash and a trade-in, its cost for the purposes of the
Section 179 deduction is limited to the cash paid.
•
The $500,000 maximum dollar limit is reduced dollar for dollar (but not below zero) by the
amount that the cost of qualifying property placed in service exceeds $2,000,000 in 2011.
•
The taxpayer cannot elect to expense more than $25,000 of the cost of any heavy sport utility
vehicle (SUV) and certain other vehicles placed in service during the year.
•
The Section 179 deduction is also limited to the taxpayer’s (and spouse, if applicable) taxable
income from any trade or business without regard to any expensed amounts.
•
Any Section 179 deduction limited by taxable income can be carried forward indefinitely.
•
If business use of property for which the Section 179 deduction has been taken drops below
50% at any time before the end of its recovery period, part of the expensed amount may have to
be “recaptured.”
•
If the expensed property is disposed of and a carryover of the Section 179 deduction is
outstanding, the basis of the property is increased by the amount of the carryover.
•
Generally, listed property includes property that is likely to be used for personal purposes,
including computers, automobiles, video cameras, cell phones, etc.
•
Special recordkeeping, business use and dollar limitation rules are placed upon listed property.
•
To be eligible for the Section 179 deduction and regular MACRS, listed property must be used
more than 50 percent for business use.
•
If the business use test is not met any time during the listed properties recovery period (the use
is 50% or less) the property is not eligible for the Section 179 deduction.
•
If a Section 179 deduction has been previously claimed for listed property and business use
drops to 50% or less, all or part of the expensed amount must be recovered.
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No depreciation deduction or Section 179 expense can be claimed for the use of listed property
unless the taxpayer can prove business/investment use with adequate records.
•
An increased section 179 deduction is available to enterprise zone businesses and renewal
community businesses for qualified zone property or qualified renewal property placed in
service in an empowerment zone or renewal property.
•
An increased section 179 deduction is available for qualified property placed in service in a
federally declared disaster area in which the disaster occurred before January 1, 2010.
•
For 2011, the taxpayer may be able to take an additional 50% bonus depreciation (or 100% in
certain circumstances) for qualified property.
•
Amortization is similar to straight line depreciation except that it involves recovering the cost of
an intangible asset over a fixed time period. Items that can be amortized include the costs of
starting a business, goodwill, patents, copyrights, etc.
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Quick Study 13.0
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A pension is a series of payments made to the taxpayer after retirement from work usually made
regularly and based on factors such as years of service and earnings.
•
An annuity is a series of payments under a contract made at regular intervals over a period of
more than one year and can either be a fixed or variable amount.
•
Distributions from pensions and annuities are generally reported to the taxpayer on Form 1099R and included in income on line 16 of Form 1040.
•
When a taxpayer participates in a retirement plan/annuity their distributions may include
amounts contributed, amounts the pension fund earned, and any employer contributions.
•
The part of the distribution that is treated as a recovery of the taxpayer’s contribution is
generally tax free.
•
There are two methods generally used to determine the taxable portion of a pension distribution:
the General Rule or the Simplified Method.
•
Under the Simplified Method, the tax-free part of each payment is figured by dividing the
taxpayer’s cost by the total number of anticipated monthly payments.
•
A taxpayer who has retired on disability must generally include in their income any amount
received under a plan that is paid for by their employer on line 16, Form 1040, taxable amounts
are reported on Line 7 of Form 1040 until the taxpayer reaches minimum retirement age.
•
A lump–sum distribution is the payment in one tax year of the taxpayer’s total balance from all of
their employer’s plans of one kind.
•
Form 4972 is used to calculate special tax options available if the taxpayer receives a lump-sum
distribution, including the 10-year tax option.
•
The 10-year tax option is calculated using a special formula “as if” the taxpayer received the
distribution over a ten year time period - however the tax is paid only in one year.
•
If a taxpayer receives cash or other assets from a qualified retirement plan in a qualified
distribution, they can defer tax on the distribution by “rolling it over” to another qualified
retirement plan or traditional IRA.
•
Any pension distribution amount rolled over is not included in income until it is distributed from
the new plan without being rolled over.
•
A direct rollover occurs when any part or all of an eligible distribution is paid from one plan
directly to another qualified retirement plan or to a traditional IRA. At no time does the taxpayer
receive any funds.
•
An indirect rollover is when the taxpayer elects to receive the funds themselves and then
deposits the money into a new plan. In this case, 20% of the amount will usually be withheld for
federal taxes. Generally they will have to pay tax (plus penalties, if applicable) on the withheld
amount unless the taxpayer makes up the withheld amount from personal funds.
•
Generally to receive special tax treatment, a rollover transaction must be completed by the 60th
day following the day on which the taxpayer receives the distribution from their employer’s plan.
•
If the taxpayer receives a distribution from a retirement plan or IRA, and they are under age 59
½, a 10% penalty is generally imposed on the taxable portion of the distribution.
•
Form 5329 is used to calculate any penalty on an early distribution.
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•
The penalty is not imposed if the distribution meets one of the following requirements:
o
Made as a part of a series of substantially equal periodic payments for the life (or life
expectancy) of the taxpayer or the taxpayer and beneficiary.
o
Made because the taxpayer is totally and permanently disabled.
o
Made on or after the death of the plan participant.
Additionally, the following exceptions to the penalty exist for distributions from qualified
retirement plans (not IRAs):
o
Made after the taxpayer has separated from service in or after the year they reach age
55;
o
Made to an alternate payee under a Qualified Domestic Relations Order (QDRO);
o
Made to the extent that the taxpayer has deductible medical expenses. This means the
taxpayer’s medical expenses must exceed 7.5% of their adjusted gross income. The
taxpayer does not need to itemize deductions in order to qualify for this exception
o
Made from an employer plan under a written election that provides a specific schedule
for distribution if, as of March 1, 1986, the taxpayer had separated from service and had
begun receiving payments;
o
Made from an employee stock ownership plan for dividends on employer securities held
by the plan; or
o
Made from a qualified retirement plan due to an IRS levy of the plan.
•
If the sum of the one-half of the social security benefits plus the total of the other income
exceeds the base amount for the taxpayer’s filing status, some of the social security benefits will
be taxable.
•
The base amount for single, head of household, qualifying widower or married filing separately
and lived apart from spouse all year is $25,000. The base amount for married persons filing a
joint return is $32,000. The base amount for persons married filing separately who lived together
at any time during the year is $0.
•
Usually the maximum amount of social security benefits that will be taxed is 50% of the total
benefits will be taxable. However if the total of one-half of the benefits and all of the taxpayer’s
other income is greater than $34,000 ($44,000 if married filing jointly) or the taxpayer is married
filing separate and lived with their spouse any time during the year, up to 85% of the benefits
can be taxable.
•
If the taxpayer receives a distribution in 2011 of benefits from an earlier year, they may be able
to figure the taxable part of the payment for a previous year using the income from the earlier
year.
•
If the taxpayer repaid benefits in 2011, the amount of benefits repaid must be subtracted from
the gross benefits they received in 2011, even if the repayment was for benefits received in a
prior year.
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Quick Study 14.0
•
Generally earnings in an IRA are not taxed until the taxpayer begins withdrawing the money,
presumably when they retire.
•
The taxpayer may also be able to take a deduction for the amount of their contributions to a
traditional IRA.
•
The earnings in a Roth IRA are not taxed (as long as they are withdrawn appropriately) but
contributions to a Roth IRA are never deductible.
•
A person can set up and make contributions to a traditional IRA if they receive taxable
compensation and were not age 70 ½ at the end of the year.
•
The taxpayer is considered to reach age 70 ½ on the date that is six calendar months after the
70th anniversary of their birth.
•
For 2011, the most that can be contributed to a traditional IRA (or the total of all traditional IRAs)
is the smaller of $5,000 ($6,000 if the taxpayer is age 50 or older) or the taxpayer’s taxable
compensation for the year.
•
If the taxpayer makes too large of a contribution to a traditional IRA, they can apply the excess
contribution to a later year if the contribution for that later year is less than the maximum allowed
for that year, however, a penalty of additional tax may apply.
•
Contributions can be made to a traditional IRA at any time during the calendar year or by the
due date for filing the tax return for that year, not including extensions.
•
If the taxpayer (and spouse) was not covered by a pension plan at any time during the year, the
amount of their deductible contribution is the lesser of the actual contribution to the traditional
IRA for year or the general limit for contributions.
•
If the taxpayer (or spouse) was covered by an employer provided retirement plan, the amount of
their contribution may be subjected to further limits depending on their income and filing status.
•
Although the taxpayer’s deductible IRA contribution may be limited, they may still choose to
make the full amount of allowable contribution. The difference between the total allowable
contribution and their total deductible contribution is considered to be a nondeductible
contribution.
•
When they taxpayer has a nondeductible IRA contribution, Form 8606 must be filed even if the
taxpayer is not required to file a tax return for the year.
•
In general, distributions from a traditional IRA are taxable in the year received.
•
If only deductible contributions were made, the taxpayer is considered to have no “basis” in their
traditional IRA and any distributions are fully taxable when received.
•
If the taxpayer made any nondeductible contributions to their IRA they have a “basis” or
investment in the IRA equal to the amount of their nondeductible contributions and Form 8606
must be filed to determine how much of the IRA distribution is taxable.
•
Generally, if the taxpayer is under age 59 ½ and they receive an IRA distribution, they must pay
a 10% penalty on any taxable amounts unless an exception applies.
•
Form 5329 is used to figure any additional 10% tax owed on a premature IRA distribution.
•
If in 2011, the taxpayer converts a traditional IRA to a Roth IRA, any amount they must include
in income as a result of the conversion is generally included in equal amounts over a 2-year
period, beginning in 2012 or they can elect to include the total amount of the conversion as
income in 2011.
•
Form 8606 is used to report a conversion from a traditional IRA to a Roth IRA
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•
A Coverdell Education Savings Account is an account created as an incentive to help parents
and students save for education expenses.
•
The total contributions for the beneficiary of a Coverdell Account cannot be more than $2,000 in
any year, no matter how many accounts have been established.
•
The beneficiary of the Coverdell Account will not owe any tax on the distributions if they are less
than their qualified education expenses at an eligible institution either for higher education
expenses or elementary and secondary education expenses.
•
The taxpayer may be eligible for a Retirement Savings Contribution Credit (Saver's Credit) of up
to $1,000 if they make eligible contributions to a qualified retirement plan or IRA.
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Quick Study 15.0
•
In general a capital asset is an item held for personal or investment purposes including stocks,
bonds, home furnishings, collectibles, cars, gold, silver, etc.
•
When a taxpayer sells or exchanges a capital asset, they may have a taxable gain or loss.
•
The gain or loss from the sale or exchange is the difference between the gross sales price and
the adjusted basis of the asset plus any expenses of the sale.
•
When the taxpayer has a gain on the sale or exchange of almost any property, the result is a
taxable gain. If the taxpayer has a loss on the sale or exchange of investment or business
property, they may have a deductible loss.
•
Losses on the sale or exchange of personal-use property are not deductible.
•
For 2011 the maximum capital gains rates are 0%, 15%, 25% or 28%.
•
Capital gains or losses are reported on Schedule D, Capital Gains and Losses, and then
generally transferred to line 13 of Form 1040.
•
The term “holding period” refers to the length of time an asset has been owned by the taxpayer.
•
In general, assets held more than one year before being sold are considered to be held longterm, assets that the taxpayer has owned for one year or less are considered to be held shortterm.
•
If the taxpayer has capital losses that total more than their capital gains, they can claim a capital
loss deduction.
•
The maximum net amount of the capital loss deduction in any year is the lesser of $3,000
($1,500 if married filing a separate return), or the amount of the total net loss as shown on line
16 of Schedule D.
•
If the taxpayer has a total net loss on line 16 of Schedule D that is more than the yearly limit,
they can carry over the unused part to the next year and treat it as if the loss was incurred in
that next year.
•
When a capital loss is carried over, it retains the character of the original loss: long-term or
short-term.
•
When figuring the amount of capital loss carryover, the short-term capital losses are always
used first.
•
If the taxpayer is owed money that they cannot collect, they have a bad debt which they may be
able to deduct when they figure their tax for the year the debt becomes worthless.
•
Any bad debts that did not come from operating a trade or business are nonbusiness ( personal)
bad debts and are deductible as short-term capital losses no matter the length of time the debt
was owed.
•
If the taxpayer sold their main home in 2011, they may be able to exclude from income any gain
up to $250,000 ($500,000 married filing jointly).
•
If the taxpayer is able to exclude all of the gain from the sale of a personal residence, they do
not need to report the gain on their tax return.
•
A main home is usually defined as the home that the taxpayer lives in most of the time. and can
be a house, houseboat, mobile home, condominium, or cooperative apartment.
•
To exclude gain on the sale of a main home, the taxpayer generally must have owned and lived
in the property as their main home for at least two years during the five-year period ending on
the date of sale.
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The required ownership and use tests do not have to be at the same time, nor do they have to
be continuous. The taxpayer can meet the tests if they can show that they owned or lived in the
property as their main home for either 24 full months or 730 days (365 x 2) during the 5-year
period ending on the date of sale.
•
Gain from the sale or exchange of the main home is not excludable from income if it is allocable
to periods of nonqualified use.
•
If the taxpayer claimed the 2008 first-time homebuyer credit when they purchased their home,
they may have to recapture all or a portion of the amount claimed beginning in 2010.
•
An installment sale is a sale of property at a gain where at least one payment is to be received
after the tax year in which the sale occurs.
•
Under the installment method, generally a taxpayer should include in income each year only
part of the gain they receive, or are considered to have received.
•
In general, taxable interest should be charged on an installment sale. If interest is not charged
or the interest rate is too low, there is a minimum amount of interest the seller is considered to
have received.
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Quick Study 16.0
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Rental income is received for the use or occupation of property – either real or personal
property.
•
If the taxpayer is in the business of renting out personal property, Schedule C should be
completed and filed.
•
Generally if the taxpayer is renting out real property, they should complete and file Schedule E.
Supplemental Income and Loss.
•
If the taxpayer provides services in addition to just a room (such as a bed and breakfast or a
boarding house), the income and expenses should be reported on Schedule C and SE rather
than Schedule E.
•
If a taxpayer receives advanced rent (rent for a period of time in the future), they must report the
income when received no matter if they are a cash basis or accrual basis taxpayer.
•
A cash basis taxpayer should not report in income any uncollected rent and since it is not
includible in income, no deduction should be taken.
•
For an accrual basis taxpayer, the rental income is reported when earned and if the taxpayer is
then unable to collect the amount due they may be able to deduct it as a bad debt.
•
If a taxpayer receives an amount of money as a security deposit, and they plan to return it to
their tenant at the end of the lease, it should not be included in income.
•
If a landlord makes a decision to keep all or a portion of a security deposit because their tenant
has not lived up to the terms of their lease, it should be included in income at that time.
•
Money received as first and last months rent is includible in income when received.
•
If a tenant pays any expenses of the landlord, the payments are rental income and the landlord
must include them in income.
•
The value of services provided by the tenant in exchange for rent or the value of improvements
made by the tenant is also considered to be rental income.
•
Generally the taxpayer may deduct the ordinary and necessary expenses paid to produce rental
income.
•
If the taxpayer rents part of their property and uses part for personal use, the expenses must be
prorated between rental and personal use.
•
A taxpayer can begin to depreciate rental property when it is ready and available for rent.
•
Additions and improvements, such as a new roof for a rental house have the same recovery
period as that of the property to which the addition or improvement was made, determined as if
the property were placed in service at the same time as the addition or improvement and are
treated as separate property for depreciation purposes.
•
A repair keeps property in good operating condition but does not materially add to the value of
the property or prolong its life and is generally considered an expense.
•
An improvement generally adds to the value of the property or prolongs its life and its cost is
recovered through depreciation.
•
If the taxpayer pays an insurance premium in advance for more than one year, they can only
deduct the part of the premium payment that applies to the current year.
•
If the taxpayer does not rent their property to make a profit, they can deduct their expenses only
up to the amount of their rental income. Any rental expenses greater than rental income cannot
be carried forward.
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If the taxpayer does not rent their property for profit any income should be reported on Form
1040, line 21 and any expenses on Schedule A.
•
If the taxpayer rents only part of their property and uses part for personal use, they must divide
up certain expenses incurred. Expenses directly related to the rental portion of the property are
deductible in full; expenses paid for the entire property may need to be divided up between
rental and personal use.
•
If a vacation home or other dwelling unit is used by the taxpayer for personal use part of the
time and also rented at fair rental value for 15 days or more during the year, the expenses must
be prorated.
•
The taxpayer uses a dwelling unit as a home during the tax year if they use it for personal
purposes more than the greater of 14 days; or 10% of the total days it is rented to others at a
fair rental price.
•
Personal use by the taxpayer includes any day that the unit is used by any of the following:
o
The taxpayer or any other person who has an interest in the property, unless it is rented
to the other owner as his main home under a shared equity financing agreement.
o
A member of the taxpayer’s family (or family member of another owner) unless that
person uses the dwelling as their main home and pays a fair rental price. For the
purposes of this discussion, family includes brothers, sisters, half-brothers, half-sisters,
spouses, ancestors (parents, grandparents) and lineal descendents (children,
grandchildren)
o
Anyone under an arrangement that lets the taxpayer use another dwelling unit; or
o
Anyone that pays the taxpayer less than a fair rental price for the dwelling unit.
•
If the taxpayer uses a dwelling unit as a home and rents it fewer than 15 days during the year,
they are not required to include that rental income on their tax return but they cannot deduct any
expenses as rental expenses.
•
If the dwelling is used as a residence and also rented for 15 days or more, some expenses are
deductible in full; some expenses are deductible only to the extent of the income reported.
•
Any expenses that cannot be deducted in the current year because of the rental income limit
can be carried over to the following year.
•
Rental real estate activities are generally considered passive activities and the amount of loss
that the taxpayer can deduct is limited to the amount of income from other passive activities.
However, if the taxpayer “actively” or “materially” participates in the rental activity, they may be
able to deduct some of the losses.
•
A taxpayer actively participates in a rental real estate activity if they owned at least 10% of the
rental property and made significant management decisions.
•
A taxpayer materially participates in an activity if they were involved in its operations on a
regular, continuous and substantial basis during the year.
•
If the taxpayer actively participated in the rental activity and their rental losses are less than
$25,000, generally they are allowed to deduct the full amount of the loss (subject to income
limitations).
•
If the taxpayer is married filing a separate return, and lived apart from their spouse all year, their
special allowance cannot be more than $12,500. If they are filing a separate return and lived
with their spouse for any part of the year, they cannot use the special allowance to reduce their
nonpassive income or tax on nonpassive income.
Quick Study 16.0
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•
Page 1 of Schedule E is also used to report income/loss from royalties received from sources
such as oil and gas wells, or other natural resources. Page 2 of Schedule E is used to report
income or loss from partnerships, S corporations, estates, trusts, and real estate mortgage
investment conduits.
•
If the taxpayer makes payments of $600 or more for certain rental property expenses, the
payments are to be reported in box 7 on Form 1099-MISC.
Quick Study 16.0
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Quick Study 17.0
•
Form 1040X, Amended U.S. Individual Income Tax Return can be completed and filed to correct
errors or omissions on an original tax return.
•
Form 1040X should be filed only after the taxpayer has filed an original return.
•
Generally, for the taxpayer to receive an additional refund, Form 1040X must be filed within
three years after the date the original return was filed or within two years after the date the tax
was paid, whichever is later.
•
The IRS also has 10 years to collect outstanding tax liabilities, measured from the day a tax
liability has been finalized.
•
When preparing Form 1040X, be sure to use the laws, deduction amounts and tax rates from
the tax year being amended.
•
When amending a return, the taxpayer will also need to include any form, schedule or
supporting statement that changes because of the amendment or that had not been included
with the original return.
•
Estimated tax payments are used by taxpayers to pay tax on income that is not subject to
withholding or not subject to enough withholding, including income from self-employment,
interest, dividends, pensions, rental income, capital gains, etc.
•
If the taxpayer does not pay enough tax throughout the year, either through withholding or
estimated tax payments, they may be subject to a penalty.
•
For estimated tax purposes, the calendar tax year is divided into four payment periods each with
a specific due date (April 15, June 15, September 15, January 15).
•
If the taxpayer does not pay enough tax by the due date of each period, they may be charged a
penalty even if they get a refund when they file their tax return.
•
If the due date for an estimated tax payment falls on a Saturday, Sunday or legal holiday, it will
be considered on time if it is made on the next business day.
•
If the taxpayer files their 2011 tax return by January 31, 2012 and pays their tax due, they do not
need to make their January 15 estimated tax payment.
•
A taxpayer is not required to pay estimated taxes for 2012 if they meet all of the following:
o They had no tax liability for 2011 (total tax was zero or not required to file a return),
o
They were a U.S. citizen or resident for the whole year, and
o
Their 2011 tax year covered a 12-month period.
•
Generally, a taxpayer must pay estimates for 2012 if both of the following apply:
o They expect to have a balance due of at least $1,000 in tax for 2012, after subtracting
withholding and credits and
o They expect their withholding and credits to be less than the smaller of 90% of the tax
shown on their 2012 return, or 100% of the tax shown on their 2011 return ( which
covers 12 months).
•
If the taxpayer’s adjusted gross income for 2011 was more than $150,000 ($75,000 if MFS),
they must pay at least 90% of their 2012 tax or 110% of the tax shown on their 2011 return.
•
Electronic Federal Tax Payment System (EFTPS) is a free tax payment system that all
individuals and businesses can use.
•
A taxpayer can change the amount of their withholding by submitting a new Form W-4 to their
employer.
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Quick Study 18.0
•
Treasury Department Circular No. 230 contains rules governing the recognition of persons
representing taxpayers before the Internal Revenue Service.
•
The Office of Professional Responsibility (OPR) has responsibility for matters relating to tax
professional conduct and discipline, including any disciplinary proceedings and sanctions.
•
Practice before the Internal Revenue Service includes all matters connected with a presentation
to the Internal Revenue Service relating to a taxpayer’s rights, privileges, or liabilities.
•
Individuals able to practice before the IRS include attorneys, CPAs, Enrolled Agents, Enrolled
Actuaries, Enrolled Retirement Plan Agents and Registered Tax Return Preparers.
•
Generally, registered tax return preparers may practice before the Internal Revenue Service
limited to preparing and signing tax returns and claims for refund, and other documents for
submission to the Internal Revenue Service.
•
An RTRP may represent taxpayers before revenue agents, customer service representatives, or
similar officers and employees of the IRS (including the Taxpayer Advocate Service) if the
RTRP signed the return or claim for refund for the tax year or period under examination.
•
Individuals wishing to become an enrolled agent, enrolled retirement plan agent, or registered
tax return preparer must be eighteen years or older, possess a valid tax preparer identification
number, apply, pay a fee and pass compliance and suitability checks.
•
A tax compliance check will be limited to an inquiry regarding whether an applicant has filed all
required individual or business tax returns and whether the applicant has failed to pay, or make
suitable arrangements for any federal tax debt.
•
The suitability check will be limited to an inquiry regarding whether an applicant has engaged in
any conduct that would justify suspension or disbarment of any practitioner.
•
If the applicant does not pass the compliance or suitability check, the applicant may reapply if
they become current with respect to their tax liabilities.
•
For enrolled agents, renewal applications are required between November 1 and January 31 of
every third year. Individuals who receive initial enrollment after November 1 and before April 2 of
the applicable renewal period will not need to renew their enrollment before the first full renewal
period following their initial enrollment.
•
Registered tax return preparers must renew their preparer tax identification number (PTIN) by
December 31 for the coming tax season.
•
Enrolled agents must complete a minimum of 72 hours of continuing education credit, including
six hours of ethics or professional conduct must be completed during each enrollment cycle,
with a minimum of 16 hours of continuing education, including two hours of ethics or
professional conduct completed each enrollment year.
•
An enrolled agent who receives their initial enrollment during an enrollment cycle must complete
two hours of qualifying continuing education for each month enrolled during the enrollment
cycle. Enrollment for any part of a month is considered enrollment for the entire month.
Additionally they must complete two hours of ethics or professional conduct for each enrollment
year. Enrollment for any part of a year is considered enrollment for the entire year.
•
Registered tax return preparers must complete a minimum of 15 hours of continuing education,
including two hours of ethics or professional conduct, three hours of Federal tax law updates,
and 10 hours of federal tax law topics during each registration year.
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•
To qualify for continuing education credit, a course of learning must be designed to enhance
professional knowledge in federal taxation or federal tax related matters (including accounting,
tax return preparation software, taxation, or ethics).
•
Qualified continuing education can be a formal, instructor led course or a correspondence
course.
•
Individuals can also get continuing education credit for serving as an instructor, discussion
leader or speaker. One hour of continuing education will be given for each contact hour
completed plus a maximum of two hours for preparation time for each contact hour of speaking.
The maximum amount of continuing education credit for instruction and preparation may not
exceed four hours annually for registered tax return preparers and six ours annually for enrolled
agents.
•
Individuals applying for renewal must keep records of qualifying education for four years
following the date of renewal. Such information should include the name of the sponsoring
organization, location of the program, title of the course, course number and description of its
content, course outlines and materials, dates of attendance, credit hours claimed, name of the
instructor plus a certificate of completion or signed statement of attendance.
•
An individual who is not a practitioner may represent the following before the IRS even if the
taxpayer is not present:
• An individual may represent a member of his immediate family
• A regular full-time employee of an individual employer may represent the employer
• A general partner or a regular full-time employee of a partnership may represent the
partnership
• An office or regular full-time employee of a corporation may represent the corporation,
association or organized group
• A regular full-time employee of a trust, receivership, guardianship,or estate may represent
those entities.
•
General a practitioner must exercise due diligence in basically all tax matters. A practitioner will
be presumed to have exercised due diligence if they rely on the work product of another person
and the practitioner used reasonable care in engaging, supervising, training and evaluating the
person, taking into account the nature of the relationship between the practitioner and the other
person.
•
A practitioner may not knowingly accept assistance from or assist any person who is under
disbarment or suspension from practice before the Service if the assistance relates to a matter
constituting practice before the Service.
•
A practitioner may not take acknowledgments, administer oaths, certify papers, or perform any
official act as a notary public with respect to any matter administered by the Service for which
he/she is employed as counsel, attorney, or agent, or in which they may be in any way
interested.
•
A practitioner may not charge an unconscionable fee in connection with any matter before the
Service.
•
A practitioner may not charge a contingent fee for services rendered in connection with the
preparation of an original or amended return. A contingent fee is any fee that is based, in whole
or in part, on whether or not a position avoids challenge or is sustained if challenged. A
contingent fee also included a fee that is based on a percentage of the refund shown on the
return or a percentage of the taxes saved or that otherwise depends on a specific result
attained.
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•
Generally when asked, a practitioner must promptly return any and all records of the client that
are necessary for the client to comply with his or her federal tax obligations. The practitioner
may retain copies of the records returned.
•
If state law allows or permits the retention of a client’s records by a practitioner in the case of a
dispute of fees, the practitioner must return only those records that must be attached to the
return. They must however provide the client with reasonable access to review and copy any
additional records retained that are necessary for the client to comply with his or her federal tax
obligations.
•
A practitioner should not represent a client before the Internal Revenue Service if the
representation creates a conflict of interest.
•
A practitioner may not use false, or misleading statements when describing their professional
designation. Enrolled agents or registered tax return preparers may not use the term “certified”
or imply an employer/employee relationship with the Internal Revenue Service.
•
Practitioners may not, directly or indirectly, make an uninvited written or oral solicitation of
employment if the solicitation violates federal or state laws or other applicable rules. Any lawful
solicitation must clearly identify the solicitation as such and, if applicable, identify the source of
information used in choosing the recipient.
•
A practitioner who prepares tax returns may not endorse or otherwise negotiate any check
issued to a client by the government in respect to a federal tax liability.
•
A practitioner may not willfully, recklessly, or through gross incompetence sign a return or claim
for refund that the practitioner knows (or reasonably should know) lacks reasonable basis, is
unreasonable or is a willful attempt by the practitioner to understate liability or an intentional
disregard of rules or regulations.
•
A practitioner must inform a client of any penalties that are reasonably likely to apply in a
position or document submitted to the Internal Revenue Service if the practitioner advised the
client with regard to the position or prepared or signed the document or return.
•
A practitioner advising a client to take a position on a return or other information submitted to the
Internal Revenue Service or preparing or signing a tax return generally may rely in good faith
and without proof upon information given by the client. However the practitioner must make
reasonable inquiries if the information as furnished appears to be incorrect, inconsistent with
facts or incomplete.
•
A practitioner may be sanctioned for incompetence and disreputable conduct.
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Study Questions
1. A(n) ___________________ is a specific interval of time over which income and expenses are recorded.
a. Year
b. Calendar tax year
c. Accounting period
d. Accounting method
2. True or False? A calendar year must begin on January 1 and end on December 31.
a. True
b. False
3. A taxpayer must use a calendar year if the following applies:
a. They have no annual accounting period
b. They keep no books
c. Their present tax year does not qualify as a fiscal year
d. All of the above
4. Unless they have a required tax year, a taxpayer adopts a tax year by:
a. Filing Form 1128, Application to Adopt, Change or Retain a Tax Year
b. Filing their first income tax return using that tax year
c. Having an attorney fill out the required forms
d. Filing with the Secretary of State
5. A fiscal tax year can be:
a. A calendar year
b. An alternative to a calendar tax year
c. Any 12 consecutive months ending on the last day of any month but December
d. Both b and c
6. A(n) _______________________ is a set of rules which determines when a taxpayer reports income and
expenses.
a. Fiscal tax year
b. Constructive receipt
c. Accounting method
d. Accounting period
7. True or False? Under the cash method of accounting, income is included in gross income when it is earned by
the taxpayer.
a. True
b. False
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8. An example of constructive receipt is:
a. The taxpayer has actual possession of cash
b. Interest is credited to the taxpayer’s bank account at the end of the year, but they have not withdrawn the
funds
c. A taxpayer has received a check in payment for services rendered, but has not cashed the check or
deposited it to their bank account
d. Both b and c
9. If a calendar year, cash basis taxpayer prepays $5,000 for a liability insurance policy effective from July 1,
2011 to June 30, 2012, they can deduct:
a. The entire $5,000 in 2011
b. The entire $5,000 in 2012
c. $2500 in 2011 and $2500 in 2012
d. They can deduct the balance in the amounts they choose in 2011 and 2012, as long as the total amount
does not exceed $5,000
10. If a taxpayer maintains an inventory, they generally must use the _____________ for purchases and sales.
a. Cash method of accounting
b. Accrual method of accounting
c. First-in, first-out method of accounting
d. Combination of cash and accrual methods, as long as they use it consistently
11. When a tax return is filed with the IRS, they match the Social Security number and __________________ with
the information on file at the Social Security Administration.
a. Taxpayer’s last name
b. Master file record
c. Taxpayer’s first and last name
d. ITIN
12. True or False? When a taxpayer’s name has changed because of a marriage or divorce, they should notify the
Social Security Administration as quickly as possible.
a. True
b. False
13. If a taxpayer is not eligible for a Social Security number, they may apply for a(n):
a. Resident alien card
b. ITIN
c. ATIN
d. They must wait until they are eligible to apply for a Social Security number
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14. If a taxpayer owes no additional tax and files all tax returns correctly and on time, the statute of limitations is:
a. 3 years
b. 5 years
c. Later of 2 years after the tax was paid or 3 years
d. 7 years
15. True or False? If a taxpayer uses a computerized system of keeping records (such as Quicken or
QuickBooks), they do not need to keep receipts, cancelled checks, etc.
a. True
b. False
16. A mailed paper return is considered to be filed on time if:
a. It is postmarked by the due date, but did not have sufficient postage
b. It is postmarked by the due date, but the taxpayer inadvertently put an incorrect address on the envelope
c. It is mailed by April 30, & the taxpayer uses a designated private delivery service
d. It is postmarked by the due date, has sufficient postage and is correctly addressed
17. An electronically filed return is considered to be filed on time if:
a. It is “postmarked” by midnight EST on April 15
b. It is acknowledged by the IRS by midnight in the taxpayer’s time zone
c. It is “postmarked” by midnight in the senders time zone
d. An electronically filed return is always considered filed on time
18. The IRS generally acknowledges receipt of an electronically filed return within:
a. Five minutes
b. 24 – 48 hours
c. One week
d. Two or three weeks
19. Which of the following is true regarding estate and gift taxes?
a. Gifts are always taxable to the recipient
b. Gifts are never taxable to the recipient
c. Gifts to a spouse are usually taxable
d. Gifts more than $13,000 may be taxable
20. All of the following are additional types of taxes, except:
a. Sales tax
b. Real and personal property taxes
c. Excise taxes
d. All are additional types of taxes
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21. A sin tax would generally be imposed on all of the following items, except:
a. Tobacco
b. Alcohol
c. Books
d. Gambling activities
22. All of the following are types of employment taxes, except:
a. State and federal unemployment taxes
b. Social security and Medicare tax
c. A state disability insurance payment
d. A sales tax
23.The three basic federal tax forms are:
a. The 1040 2EZ, the 1040 EZ and the 1040
b. The 1040 EZ, the 1040 X and the 1040
c. The 1040 EZ, the 1040 A and the 1040
d. The 1040 X, the 1040 A and the 1040
24.__________________ are usually considered to be a part of the tax return and are submitted to the IRS along
with the base tax form.
a. Schedules and forms
b. Statements
c. Worksheets
d. Both a and b
25.True or False? If your 65th birthday was on January 1, 2012, you are considered to be age 65 for tax purposes
in 2011.
a. True
b. False
26.The marital status of a taxpayer is determined ___________________________.
a. As of April 15
b. As of the last day of the tax year
c. As of the date of death for a deceased taxpayer
d. Both b and c
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27.A taxpayer and spouse are considered to be married for the whole year if on the last day of the tax year:
a. They are married and living together as husband and wife
b. They are married and living apart, but not legally separated under a decree of divorce or separate
maintenance
c. They are separated under a interlocutory (not final) divorce decree
d. Any one of the above
28.To be valid, a common law marriage must meet all of the following requirements except:
a. Both individuals must have the legal capacity and intent to marry and communicate this intent to each other
b. They must live together as husband and wife
c. They must publish their common law marriage intention in a newspaper
d. They must publicly present themselves as husband and wife
29.True or False? If a taxpayer is divorced under a final decree of divorce by the last day of the tax year, they are
considered to be unmarried for the entire year.
a. True
b. False
30.To be considered unmarried for tax purposes, a married taxpayer must meet all of the following conditions,
except:
a. They file a joint return with their spouse
b. They paid more than half the cost of maintaining their home for the year
c. Their spouse did not live in the home any time during the last six months of the tax year
d. Their home was the main home for their child, stepchild or adopted child for more than half the year
31.True or False? If a taxpayer obtains an annulment, they must file amended returns claiming single or head of
household filing status for all tax years affected by the annulment that are not closed by the statue of
limitations.
a. True
b. False
32. The five filing statuses for federal and state tax purposes are:
a. Single, Married Filing Jointly, Unmarried, Head of Household, Qualifying Widow(er)
b. Single, Married Filing Jointly, Married Filing Separately, Dependent, Qualifying Widow(er)
c. Single, Married Filing Jointly, Married Filing Separately, Head of Household, Qualifying Widow(er)
d. Single, Married, Divorced, Dependent, Widow(ed)
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33. Costs included in computing “keeping up a home” for the purposes of the Head of Household filing status
include all of the following except:
a. Mortgage interest paid
b. The fair rental value of a home
c. Actual rent paid
d. Food eaten in the home
34.A ___________________ does not have to live with the taxpayer to qualify them for Head of Household filing
status.
a. Qualifying child
b. Foster child
c. Married child
d. Parent
35. A taxpayer and spouse can choose to file a joint return only if:
a. They are married
b. They agree to file jointly
c. The taxpayer and spouse both have incomes
d. Both a and b
36. True or False? A surviving spouse of a taxpayer who has not remarried must file a tax return using the Married
Filing Separate status.
a. True
b. False
37. All of the following are valid reasons a taxpayer should choose Married Filing Jointly instead of Married Filing
Separately, except:
a. Married Filing Jointly usually results in a lower tax liability for married taxpayers
b. Certain deductions or credits may be limited when using the Married Filing Separate filing status
c. The tax rate for Married Filing Jointly is lower than the Married Filing Separate status
d. The taxpayers wish to conserve paper and so file only one return
38. All of the following are reasons a taxpayer should choose the Married Filing Separate filing status instead of
Married Filing Joint, except:
a. The taxpayer and spouse have different tax years for reporting purposes
b. One (or both) spouse chooses not to be responsible for all the tax due
c. The spouses have not lived together all year
d. One spouse has a back tax debt and the spouses do not wish to have all of their refund withheld
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39. True or False? If the taxpayer checks the box indicating a desire to contribute to the Presidential Election
Campaign fund it will decrease the amount of their refund or increase their balance due.
a. True
b. False
40. Which of the following is true regarding a Preparer Identification Number?
a. A PTIN can be used in place of an EIN for a tax preparation firm
b. A preparer can apply for a PTIN by completing Form W4-P
c. A PTIN is for paid preparers who do not wish to disclose their social security numbers on the returns they
prepare
d. A PTIN can be used in place of the primary social security number when a paid preparer files their own tax
return
41. Among other things, Circular 230 outlines preparer responsibilities and penalties including all of the following,
except:
a. Retention of records of returns prepared
b. Preparer penalties due to negligence
c. Preparer penalties due to intentional disregard of rules
d. Circular 230 covers all of the above
42.True or False? For federal income tax purposes, all income is subject to tax and is reported on the tax return
unless specifically exempt or excluded by law.
a. True
b. False
43.Income earned by a child is taxable to ___________.
a. The child
b. The child’s parents
c. The child’s court appointed financial advisor
d. Income earned by a child is nontaxable
44.Examples of earned income include all of the following, except:
a. Salaries
b. Commissions paid
c. Tips
d. Pensions
45.Examples of unearned income include all of the following, except:
a. Interest
b. Unemployment compensation
c. Alimony
d. Bonuses
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46.Examples of nontaxable income include all of the following, except:
a. Certain scholarships or fellowships
b. Worker’s compensation
c. Alimony
d. Certain debt discharges such as bankruptcy
47.Taxable compensation includes all of the following, except:
a. Wages and salaries
b. Vacation pay and sick pay
c. Back pay
d. All of the above are considered taxable compensation
48.True or False? An Employer Identification Number (EIN) is not required anywhere on the employee’s tax
return. Nor is it needed if a tax return is electronically filed.
a. True
b. False
49.If an employee’s social security number is incorrect as shown on their Form W-2, they should:
a. Do nothing as long as the income amounts shown on the form are correct
b. Cross out the incorrect number and write in the correct number before sending the form to the IRS with the
tax return
c. Have their employer issue a corrected W-2 so the correct information is sent to the Social Security
Administration
d. Contact the Social Security Administration and have their old number changed to the new number as
shown on the Form W-2
50.Amounts included in Box 1 of Form W-2 include all of the following, except:
a. Amounts paid into all deferred compensation plans
b. Certain scholarship and fellowship grants
c. Non-cash payments of wages or salaries
d. Taxable prizes or awards
51.A statutory employee is a special type of employee _____________________________.
a. Whose earnings are subject to Social Security and Medicare withholding, but not income tax withholding
b. Whose wages and related expenses are reported on directly on line 12, Form 1040
c. Whose earnings are not subject to federal tax
d. All of the above are true about statutory employees
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52.Which of the following statements is true about a substitute Form W-2?
a. If a taxpayer does not receive their original Form W-2 by January 15, they may file a tax return using a
substitute Form W-2
b. If a taxpayer does not receive their original Form W-2 by January 31, they should contact the IRS
c. A taxpayer can use Form 4852, Substitute for Form W-2, Wage and Tax Statement whenever they do not
have an original Form W-2
d. If a taxpayer does not receive their original Form W-2 within the first few days of February, they should first
contact their employer. If they do not receive their Form W-2 by February 15, they should contact the IRS
and may then complete a substitute W-2.
53.Allocated Tips represent:
a. The amount of tips reported by an employee to their employer
b. The employees share of eight percent of the food and drink sales of a restaurant
c. The difference between 8% of the food and drink sales of a restaurant and the amount of tips reported by
an employee
d. An amount for information purposes only. It does not need to be reported on the tax return
54.True or False? If an employee does not keep a daily tip record, the amount of Allocated Tips must be included
as wages on line 7, Form 1040.
a. True
b. False
55.If an employee is including unreported tips or allocated tips on line 7, Form 1040, they must also:
a. Calculate social security and Medicare tax on the unreported or allocated tips
b. Include Form 4137 with their tax return
c. Both a and b
d. Neither a nor b
56.Schedule U is _____________________________________________.
a. To calculate the amount of unemployment contributions owed on allocated tips
b. To calculate the amount of social security and Medicare taxes owed on allocated tips
c. To transmit the amount of unreported tips to the Social Security Administration to correct the employee’s
earnings record
d. Detached and mailed to the Social Security Administration before filing Form 4137 with an employee’s tax
return
57.Which of the following is false in regards to unemployment benefits?
a. Generally, all employment benefits received from a government agency are taxable
b. Generally, all employment benefits received from a government agency are nontaxable
c. If the benefits are supplemental benefits paid from an employer-financed plan, the amount is treated as
wages and not reported as unemployment compensation
d. Unemployment benefits are reported on line 19 of Form 1040
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58.True or False? If the taxpayer received unemployment benefits and repaid all or some of them back in the
same tax year, only the net amount is reported as income on the tax return.
a. True
b. False
59.If a taxpayer repaid more than $3,000 in unemployment compensation, the taxpayer may:
a. Deduct the amount on line 28 of Schedule A, Itemized Deductions
b. Take a tax credit for the year of repayment if they included the income under a claim of right
c. Either a or b, whichever results in a lower tax
d. Neither a nor b
60.All of the following are true regarding Workers’ Compensation, except:
a. If a payment for a work-related injury is received under a workers’ compensation act, the proceeds are tax
exempt
b. If a payment for a work-related death is received by the survivors of an employee, the proceeds are taxable
c. If any part of workers’ compensation benefits reduced the taxpayer social security benefits received, that
part may be taxable as social security
d. If the taxpayer receives benefits based on age, length of service or prior contributions, the worker’s
compensation benefits received may be taxable
61.True or False? If a taxpayer finds a $20 bill lying on the ground, they should report that as taxable income on
their tax return.
a. True
b. False
62.Which of the following is not true about gifts received?
a. Money received as a gift is generally not taxable
b. The fair market value of property received as a gift is generally not taxable
c. Any income generated by a gift (such as rent) is generally not taxable
d. Interest on money received as a gift is taxable
63.True or False? Income from illegal sources, such as bribes or illegal drug sales must be reported as other
income on the tax return and the taxpayer may need to file Schedule C if the activity is considered selfemployment.
a. True
b. False
64.Generally, all of the following are considered nontaxable, except:
a. The fair market value of stolen property
b. A utility rebate
c. The fair market value of a prize, if the taxpayer refused to accept it
d. Life insurance proceeds received because the death of the taxpayer
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65.Income received for the rent of personal property is:
a. Nontaxable
b. Always reported on Schedule C, Form 1040
c. Always reported on Line 21, Form 1040
d. Reported on Schedule C if the taxpayer is in the business of renting such property, otherwise reported on
Line 21, Form 1040
66.Gambling winnings and withholding are usually reported on Form ______________.
a. 1099-G
b. W-2G
c. W-4G
d. Gambling winnings are nontaxable
67.When an employee receives a stock option, they may have to recognize income
a. When they receive the option
b. When they exercise the option
c. When they dispose of the property received in the option
d. Any of the above depending on the circumstance
68.Compensation for sickness or injury from an employer may include:
a. Sick pay and medical expense reimbursement
b. Medical and disability insurance premiums paid by the employer
c. Workman’s compensation
d. All of the above
69.Nontaxable employee benefits include:
a. Certain meals and lodging provided by the employer
b. Certain dependent care benefits from the employer such as babysitting
c. Certain employee fringe benefits such as a company car, employee discounts, free travel for airline
employees, van pool and free coffee
d. All of the above
70.True or False? Up to $5,250 in employer financed undergraduate and graduate level courses may be excluded
from income.
a. True
b. False
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71.All of the following are considered separate property in a community property state except:
a. Property that is held separately before marriage
b. Property that is received during the marriage by one spouse as a gift
c. Property that is received during the marriage by one spouse as an inheritance
d. All of the above are considered separate property
72.All of the following are considered to be taxable income, except:
a. Bartering income
b. Royalty income
c. Gifts
d. A recovery of a previously deducted amount
73.Which of the following items is generally includible in income?
a. Alimony
b. A property settlement
c. Child support payments
d. Welfare benefits
74.Which of the following is considered earned income?
a. Alimony
b. Property settlement
c. Welfare benefits
d. None of the above
75.Moving expenses are reported on ____________________.
a. Form 2106
b. Form 3903
c. Form 4868
d. Form 2601
76.To meet the distance test, the taxpayer’s new job must be at least ________ farther from their old home than
their old job location was from their old home.
a. 50 miles
b. 25 miles
c. 100 miles
d. None of the above
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77.Which of the following is false regarding the standard deduction?
a. The standard deduction is a dollar amount based on filing status, age and blindness.
b. A taxpayer has the option of taking a standard deduction or itemizing deductions.
c. The standard deduction is subtracted from income when calculating tax liability.
d. All of the above are true regarding the standard deduction.
78.True or False? A taxpayer must always take the larger of their standard deduction or their itemized deductions.
a. True
b. False
79.Taxpayers not eligible for the standard deduction include all of the following, except:
a. Taxpayers who are married filing separate returns and their spouse itemizes deductions
b. Retired taxpayers
c. Taxpayers who are filing a tax return for a short tax year because of a change in accounting periods
d. Taxpayers who are nonresidents or dual-status aliens during the year
80.The standard deduction amount for a blind taxpayer, under 65, using the Head of Household filing status is:
a. $6,250
b. $7,300
c. $8,800
d. $9,950
81.To be considered legally blind for the purposes of the larger standard deduction, the taxpayer must get a
certified statement that they cannot see better than __________in the better eye with glasses or contact
lenses.
a. 20/20
b. 20/50
c. 20/100
d. 20/200
82.All of the following are true regarding the standard deduction amount for a dependent, except:
a. A dependent’s standard deduction cannot be greater than the regular standard deduction amount for their
filing status
b. A person claimed as a dependent on another person’s tax return cannot automatically use the regular
standard deduction
c. A dependent’s standard deduction is $900
d. A dependent’s deduction is limited to the greater of $950 or their earned income plus $300 (not to exceed
$5,700)
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83.The personal exemption amount for 2011 is:
a. $800
b. $2,300
c. $3,700
d. $5,000
84.True or False? When filing a joint return, a taxpayer’s spouse is considered to be a dependent.
a. True
b. False
85.The three tests that must be met to claim an exemption for either a qualifying child or a qualifying relative are:
a. The dependent taxpayer test, the support test and the citizen or resident test
b. The dependent taxpayer test, the citizen or resident test and the member of household test
c. The joint return test, the citizen or resident test and the support test
d. The dependent taxpayer test, the joint return test and the citizen or resident test
86. True or False? A person who files a joint return can never be claimed as a dependent by anyone else.
a. True
b. False
87. Each of the following will fulfill the citizen or resident test for the purposes of claiming a qualifying child or
qualifying relative, except:
a. A person who is a U.S. citizen
b. A person who is a resident of Mexico or Canada
c. A person who is a U.S. resident or national
d. Any of the above will fulfill the test
88. To be claimed as a dependent, any of the following would satisfy the relationship test for a qualifying child,
except:
a. The taxpayer’s parent
b. The taxpayer’s half-brother
c. The taxpayer’s grandchild
d. The taxpayer’s eligible fosterchild
89. To be claimed as a dependent, a qualifying child must be:
a. Under age 19 at the end of the year
b. Under age 24 at the end of the year and a full-time student
c. Either a or b
d. Neither a nor b
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90. A child will be treated as the qualifying child of a noncustodial parent if all of the following are true, except:
a. The parents are legally separated
b. The child lived with one or both parents for more than half the year and received over half of his or her
support from their parents
c. A divorce degree or written separate maintenance agreement states that the noncustodial parent can claim
the child as a dependent or the custodial parent signs Form 8332
d. The noncustodial parent files a tax return before the custodial parent
91. If all of the other qualifications are met, the tax benefits of a qualifying child include:
a. The earned income credit
b. The child and dependent care credit
c. The child tax credit and the additional child tax credit
d. All of the above
92. True or False? Taxpayers may divide the benefits of a qualifying child between custodial and noncustodial
parents.
a. True
b. False
93. If more than one individual is eligible to claim a qualifying child, and they cannot decide between them, they
must:
a. Use the tie-breaker rules
b. Split the benefits of the qualifying child
c. Take the qualifying child in alternate years
d. Neither can take an exemption for the qualifying child
94. Which of the following is false regarding the tie-breaker rules:
a. If only one of the persons is the child’s parent, then the parent can treat the child as a qualifying child
b. If both persons are the child’s parents (they do not file a joint return), the parent with the lowest AGI can
treat the child as a qualifying child
c. If both persons are the child’s parents (they do not file a joint return), the person with whom the child lived
with the longest can treat the child as a qualifying child
d. If neither of the persons is the child’s parent, the person with the highest AGI can treat the child as a
qualifying child
95. The four tests that must be met in order for an individual to be considered a qualifying relative, include all but:
a. The “not a qualifying child” test
b. The “file a joint return” test
c. The member of household or relationship test
d. The gross income test
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96. Persons who do not have to live with the taxpayer in order to be considered a qualifying relative include all of
the following, except:
a. A stepfather or stepmother
b. A son-in-law or daughter-in-law
c. A foster parent
d. A brother of the taxpayer’s parent
97. To be considered a qualifying relative, a person must have gross income for the year of less than
______________.
a. $800
b. $2,300
c. $3,700
d. $5,000
98. For the purposes of the gross income test, gross income includes all of the following, except:
a. Social security benefits
b. Unemployment compensation
c. Gross income from rental property
d. Total net sales from manufacturing, minus the cost of goods sold plus any miscellaneous income
99. All of the following are included in total support for a qualifying test, except:
a. Scholarships of a full-time student
b. Federal taxes paid by the person out of their own income
c. Funeral expenses
d. None of the above are included in total support
100. For taxpayers filing a joint return, the exemption amount is reduced when the taxpayer’s AGI exceeds
__________.
a. $145,950
b. $250,200
c. $108,475
d. For 2011 there is no exemption phase out
101. For taxpayers filing a return as single, the exemption amount is reduced when the taxpayer’s AGI exceeds
______________.
a. $166,800
b. $234,600
c. $108,475
d. For 2011 there is no exemption phase out
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102. For 2011, a single taxpayer under age 65 who was not self-employed (nor a dependent of another) must file
a tax return if their gross income was at least:
a. $9,500
b. $10,950
c. $3,700
d. $900
103. True or False? A self-employed taxpayer must file a tax return if their gross income from self-employment
was at least $400.
a. True
b. False
104. Taxpayers who benefit from tax law must generally pay a minimum amount of tax under a system called the
a. Alternative minimum tax
b. Additional minimum tax
c. Supplemental minimum tax
d. Extra supplemental tax
105. An additional penalty may be imposed by the IRS in all of the following cases except:
a. Substantial understatement of tax
b. Late filing of a return
c. Negligence
d. The IRS may impose a penalty in all of the above circumstances
106. Special rules for __________ exist for income and expenses such as social security and housing
allowances.
a. Clergy
b. Tipped employees
c. Highly compensated individuals
d. No special rules exist for social security and housing allowances
107.A deduction reduces _____________________, while a credit reduces _______________.
a. Taxable income; tax itself
b. Tax itself; taxable income
c. Adjusted gross income; taxable income
d. Taxable income; estimated taxes
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108.Which of the following is true regarding nonrefundable credits?
a. Nonrefundable credits can reduce the taxpayer’s tax liability below zero.
b. Nonrefundable credits can reduce the taxpayer’s tax only to zero.
c. If the credit is greater than the taxpayer’s tax liability, they will get a larger refund.
d. None of the above is true
109.Which of the following is true regarding refundable credits?
a. Refundable credits can reduce the taxpayer’s tax liability below zero.
b. Refundable credits can reduce the taxpayer’s tax only to zero.
c. If the credit is greater than the taxpayer’s tax liability, they will get a larger refund.
d. Both a and c are true.
110.Refundable credits include all of the following, except:
a. The earned income credit
b. The child tax credit
c. The additional child tax credit
d. The credit for federal tax paid on fuels
111.True or false? A taxpayer must have earned income in order to qualify for the earned income credit.
a. True
b. False
112.Which of the following is false regarding social security numbers and the earned income credit?
a. The taxpayer must have a valid social security number
b. Any qualifying children must have a valid social security number
c. If the social security card says “not valid for employment’ the taxpayer is still eligible for the earned income
credit
d. All of the above are true
113.A taxpayer can be any filing status, except ______________________ and be eligible for the earned income
credit.
a. Single
b. Married Filing Jointly
c. Married Filing Separate
d. Head of Household
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114.A taxpayer cannot have more than __________________ in investment income to qualify for the earned
income credit.
a. $600
b. $2,600
c. $3,150
d. $2,750
115.All of the following are considered earned income for the purposes of the EIC, except:
a. Gross income earned as a statutory employee
b. Union strike benefits paid by a union to its members
c. Tips
d. Alimony
116.A qualifying child for the purposes of the earned income credit can be any of the following, except:
a. Son or daughter
b. Grandson or granddaughter
c. Half-brother or half-sister
d. The child of the taxpayer’s significant other who lived with them all year
117.To be a qualifying child for the purposes of the earned income credit, the taxpayer’s child must be:
a. Under age 19 at the end of 2011
b. Under age 24 and a full-time student
c. Permanently and totally disabled
d. Any of the above
118.True or false? Assume that the taxpayer is the qualifying child of another person. If the other person does not
qualify for the Earned Income Credit because their income is too high, the taxpayer may claim the credit
themselves.
a. True
b. False
119.All of the following are true regarding the EIC if the taxpayer does not have a qualifying child, except:
a. The taxpayer must be at least age 25 but under age 65
b. If the taxpayer and spouse are filing a joint return, both must be at least age 25 but under age 65
c. The taxpayer (and spouse, if filing a joint return) cannot be the dependent of another person
d. The taxpayer (and spouse, if filing a joint return) cannot be the qualifying child of another person
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120.If the taxpayer had their earned income credit denied for a reason other than a math or clerical error for any
year after 1996, they ________________________________________.
a. Can claim the credit as usual if they are eligible
b. Cannot claim the credit for the next two tax years
c. Cannot claim the credit for the next ten tax years
d. Must attach a completed Form 8862 to their tax return to claim the credit
121.Which of the following is true, regarding the advance earned income credit?
a. The advanced earned income credit will be available in 2012.
b. As long as the taxpayer was eligible for the credit in 2010, they can submit a Form W-5 to their employer,
even if they expect that they will not qualify for the credit in 2012.
c. The advanced earned income credit will not be available in 2012.
d. The amount of any advance earned income payments will be reported on the taxpayer’s Form W-2.
122.True or false? Any refund received because of the EIC and any advance EIC payments received will not be
considered income when determining whether the taxpayer is eligible for the following benefit programs - SSI,
food stamps, low income housing. However, if the amounts received are not spent within a certain period of
time, they may count as an asset (or resource) and affect their eligibility.
a. True
b. False
123.Which of the following is false regarding Preparer Due Diligence & the EITC?
a. A preparer may be fined $500 for each failure to use due diligence
b. A preparer must ask all the questions on Form 8867
c. A preparer can prepare a return based solely on the client’s information, even if he/she has reason to
believe the information is incorrect
d. The preparer must retain records for 3 years after the June 30th following the date the return or claim was
presented for signature
124.Which of the following is true regarding the Child Tax Credit?
a. The Child Tax Credit is a refundable credit.
b. To claim the credit, the taxpayer must have a qualifying child
c. The credit can reduce the amount of taxable income by up to $1,000 per child
d. None of the above is true
125.To be considered a qualifying child for the purposes of the child tax credit, a person must meet all of the
following requirements, except:
a. The qualifying child must satisfy the relationship and member of the household tests
b. The qualifying child must satisfy the age and residency tests
c. The qualifying child must satisfy the support test
d. The qualifying child cannot have any earned income
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126.The taxpayer may not be able to take the full amount of the child tax credit, if:
a. The amount of their tax is less than the amount of the credit.
b. The taxpayer’s modified adjusted gross income (MAGI) is above $110,000 if married filing a joint return
c. The taxpayer’s MAGI is above $55,000 if married filing a separate return, or $75,000 for all other filing
statuses
d. Any of the above are true
127.All of the following are true regarding the Additional Child Tax Credit, except:
a. If the taxpayer is not able to use the full amount of their child tax credit, they may be eligible for the
Additional Child Tax Credit.
b. The Additional Child Tax Credit is a refundable credit.
c. The taxpayer may complete Form W-5 and get an Advance Child Tax Credit amount from their employer
d. To calculate the amount of the credit, the taxpayer will need to complete and file Form 8812.
128.The Child and Dependent Care Credit is calculated on ________________.
a. Form 2441
b. Form 4221
c. Schedule A
d. There is no Child and Dependent Care Credit
129.For the purposes of the Child and Dependent Care Credit, in 2011, the taxpayer may use up to __________
of the child care expenses paid in a year for one qualifying individual.
a. $2,000
b. $2,500
c. $3,000
d. $6,000
130.New for 2010 and 2011, the adoption credit has changed to become ____________________.
a. Phased out
b. Refundable
c. Unavailable to married taxpayers
d. Unavailable to single taxpayers
131.Generally a cash basis taxpayer would report their interest income _________________________________.
a. In the year received
b. In the year earned
c. When the funds are withdrawn from their account
d. The later of the year received or the year earned
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132.A taxpayer is considered to have constructively received interest income ____________________________.
a. When they withdraw the interest from their account
b. On December 31
c. When the funds are credited to their account
d. When they withdraw the interest and principal from their account
133.The taxpayer constructively receives interest income even if they must:
a. Make withdrawals in even amounts
b. Pay an early withdrawal penalty
c. Give a notice to withdraw before the actual withdrawal
d. All of the above
134.Generally an accrual basis taxpayer would report their interest income ______________________________.
a. In the year received
b. In the year earned
c. When the funds are withdrawn from their account
d. The later of the year received or earned
135.______________________ or similar statement is used by banks, savings and loans and other payers to
report interest income to taxpayers.
a. Form 1099-INT
b. Form 1099-DIV
c. Schedule B
d. Schedule 1
136.If a taxpayer does not provide a Taxpayer Identification Number (TIN) to the payer of interest in a timely
manner, they will be subject to backup federal tax withholding at a _________ rate.
a. 10%
b. 15%
c. 25%
d. 28%
137.True or False? If a taxpayer has taxable interest income of $1,000 they are required to use Schedule B to
report their interest.
a. True
b. False
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138.Any “dividends” from _________________________ are usually reportable as interest income.
a. Credit unions
b. Domestic or federal savings and loan associations
c. Mutual savings banks
d. All of the above
139.True or False? For deposits of more than $5,000, a gift of $10 for opening an account must be reported as
interest income.
a. True
b. False
140.Interest on insurance dividends left on deposit at an insurance is taxable in the year credited to the taxpayer’s
account, except if ______________________.
a. The taxpayer is deceased
b. The taxpayer can only withdraw it on a specific date
c. The taxpayer cancels their insurance policy
d. The funds are received by the taxpayer’s heirs
141.When a note or bond is issued at a discount (OID bonds), the interest income is:
a. Reported when the note or bond is purchased
b. Reported as accrued
c. Reported at maturity
d. There is no interest income when a note or bond is issued at a discount
142.If a taxpayer uses the cash method of accounting, the interest from series HH bonds is reported as income
______________________________.
a. Never
b. When the bonds are purchased
c. When the bonds mature
d. In the year received
143.If a taxpayer uses the cash method of accounting, the interest from series EE bonds is reported as income
______________________________.
a. Never
b. In the earlier of the year that they cash in the bonds or the year that they mature
c. As accrued
d. Either b or c
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144.To qualify for the exclusion a taxpayer must meet the following conditions:
a. They pay qualified education expenses for themselves, a spouse, or a dependent for whom they claim an
exemption on their return.
b. Their modified adjusted gross income (MAGI) is less than $85,100 ($135,100 if filing a joint return).
c. Their filing status is not married filing separate.
d. All of the above
145.True or False? If a taxpayer purchases EE bonds and has them issued in the name of their 8-year old child,
the purchase will qualify for the education savings bond interest exclusion.
a. True
b. False
146._________________ is a payment declared by a company’s board of directors and given to its shareholders
out of the company’s current or retained earnings.
a. Interest
b. A dividend
c. A return of capital
d. A gift
147.______________________ or similar statement is used by banks, savings and loans and other payers to
report interest income to taxpayers.
a. Form 1099-INT
b. Form 1099-DIV
c. Schedule B
d. Schedule 1
148.Ordinary dividends are taxed at _________________.
a. 0% or 15%
b. 25%
c. The taxpayer’s regular tax rate
d. Ordinary dividends are a return of capital and therefore not taxed
149.Qualified dividends are taxed at _________________.
a. 0% or 15%
b. 25%
c. The taxpayer’s regular tax rate
d. Ordinary dividends are a return of capital and therefore not taxed
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150.Capital gain distributions are always considered to be ______________.
a. A return of capital and therefore not taxable
b. Ordinary income
c. Held short term regardless of how long the taxpayer owned shares in the mutual fund or REIT
d. Held long term regardless of how long the taxpayer owned shares in the mutual fund or REIT
151.If the child’s interest and dividend income (including capital gains distributions) total less than $9,500, the
child’s parent(s) may be able to elect to include that income on the parent’s return rather than filing a return for
the child by using Form _________.
a. 8814
b. 8453
c. 8812
d. 8615
152.Nontaxable interest received is shown on _______________________.
a. Form 1099-INT, Box 1
b. Form 1099-INT, Box 8
c. Form 1099-N-INT Box 1
d. It is never reported on Form 1099-INT
153.Municipal bonds are issued by:
a. A state
b. The District of Columbia
c. A possession of the U.S. or any of their political subdivisions
d. Any of the above
154.______________________ or similar statement is used to report dividend income to taxpayers.
a. Form 1099-INT
b. Form 1099-DIV
c. Schedule B
d. Schedule 1
155.Entries reported on Form 1099-DIV include amounts for:
a. Capital gain distribution
b. Nontaxable distributions
c. Other information from a mutual fund
d. All of the above
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156.Interest forfeited due to an early withdrawal of money from a time deposit before maturity (an early withdrawal
penalty) is deducted on ______________:
a. Line 30, Form 1040
b. Schedule B
c. Form 1099-DIV
d. None of the above
157.To choose the foreign tax credit the taxpayer generally must complete ___________ and attach it to their
Form 1040, or Form 1040NR.
a. Form 1116
b. Form 4868
c. Schedule B
d. Schedule D
158.All of the following are true regarding itemized deductions, except:
a. The taxpayer has the ability to choose between a standard deduction and itemized deductions
b. The taxpayer should opt for whichever method benefits them the most
c. Itemized deductions are calculated by completing and attaching Schedule A
d. If the taxpayer itemizes deductions in one year, he/she must continue to itemize deductions for all
subsequent years
159.In which of the following circumstances is the taxpayer’s standard deductions limited or not allowed:
a. The taxpayer is married, using the married filing separate filing status and the spouse itemizes deductions
b. The taxpayer is filing a tax return for a short tax year because of a change in accounting periods
c. The taxpayer is a nonresident or dual status alien during the year who does not choose to be treated as a
U.S. resident
d. The taxpayer’s standard deduction is limited or not allowed in all of the above
160.True or False? Deductible medical expenses include amounts paid for qualified long-term care services and
some amounts paid for long-term care insurance.
a. True
b. False
161.Which of the following is not deductible as a medical expense?
a. Lead-based paint removal
b. Prescription drugs purchased in another country
c. Stop-smoking programs, not including over-the-counter patches or gum
d. Insulin
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162.True or False? To include medical expenses for a dependent or spouse, the person must be the spouse/
dependent of the taxpayer either at the time the expenses were incurred or at the time they were paid for.
a. True
b. False
163.Which of the following statements is incorrect?
a. Medical expenses paid in cash are deductible as of the date of payment
b. Medical expenses paid by check are deductible when the check is cashed
c. Medical expenses paid online are deductible when the financial institution reports the payment
d. Medical expenses paid with a credit card are deductible on the date the charge was made
164.The medical expense deduction for capital expenditures is limited to ________________________.
a. The amount paid for the expense
b. The increase in fair market value of the home
c. The difference between the increase in fair market value of the home because of the improvement and the
cost of the improvement
d. A medical expense deduction for capital expenditures is not allowed
165.The requirements that must be met in order for the taxpayer to take a deduction for medical lodging include
all of the following, except:
a. The lodging is primarily for and essential to medical care
b. The medical care is provided by a doctor in a licensed hospital or equivalent
c. The lodging would not be considered to be lavish or extravagant
d. The lodging must be within the continental United States
166.All of the following are true regarding medical lodging, except:
a. Lodging for the person receiving care and a person traveling with the person receiving care is deductible
b. When traveling away from home, lodging and meals are both includible as deductions
c. The taxpayer may be able to deduct up to $50 per day for the cost of lodging.
d. Expenses paid for the cost of meals and lodging at a hospital is deductible if the primary purpose for being
there is for medical care
167.True or False? Both Medicare A and Medicare B premiums are always deductible.
a. True
b. False
168.To be deductible, a qualified long-term care insurance policy must ________________.
a. Be guaranteed renewable
b. Not provide for a cash surrender value that can be paid, assigned, pledged or borrowed
c. Generally, provide that refunds and dividends under the contract must be used only to reduce future
premiums or increase future benefits
d. All of the above are true
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169.All of the following are deductible non-business taxes, except:
a. State and local real estate taxes
b. State and local personal property taxes
c. Federal income taxes
d. State income taxes
170.Deductible state and local taxes include all of the following, except:
a. An estimated state tax payment the taxpayer makes solely to increase the amount of their federal tax
refund
b. State and local taxes reported on Form W-2
c. A prior year state tax refund applied to a 2011 estimated tax liability
d. State and local taxes withheld and reported on Form 1099-MISC
171.Taxpayers using the optional sales tax tables may be able to add in any state and local sales tax paid on any
of the following items, except:
a. A leased motor vehicle
b. A motor home
c. An off-road vehicle
d. All of the following can be added to the amount calculated using the sales tax tables
172.True or False? The taxpayer may deduct the amount their mortgage company holds in reserve to pay their
real estate taxes at a later date.
a. True
b. False
173.Interest that is includible on Schedule A includes all of the following, except:
a. Home mortgage interest paid on a second home
b. Certain points paid in connection with a loan
c. Interest paid on credit card debt
d. Investment interest
174.Mortgage interest is deductible if the taxpayer meets all of the following conditions, except:
a. They must file Form 1040 and itemize deductions
b. The interest must be on a main home only
c. The taxpayer must be legally liable for the amount of the loan
d. The taxpayer must have actually paid the interest
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175.Mortgages taken out after October 13, 1987 to buy, build or improve the home are considered to be
__________________________________.
a. Grandfathered debt
b. Acquisition debt
c. Home equity debt
d. Origination debt
176.Mortgages taken out after October 13, 1987 other than to buy, build or improve the home are considered to
be ____________________________________.
a. Grandfathered debt
b. Acquisition debt
c. Home equity debt
d. Origination debt
177.True or False? A late payment charge, not incurred in connection with a specific service performed, is
deductible as home mortgage interest.
a. True
b. False
178.True or False? Points paid to refinance a mortgage are never deductible in full in the year paid.
a. True
b. False
179.All of the following are true regarding seller paid points are true, except:
a. The seller can deduct the points as interest
b. The cost is considered to be a selling expense and increase the basis of the home
c. The buyer reduces the basis of the home by the amount paid
d. The buyer may deduct the point if all of the conditions to deduct points are met
180.Which of the following is not true regarding investment interest paid?
a. Interest paid when a taxpayer borrows money to buy property for investment is investment interest
b. Investment interest paid is generally deductible up to the amount of net investment income
c. Interest that is not deductible because of the net investment income limit cannot be carried over to the
following year
d. Investment property includes property that produces interest or dividends or royalties not in connection with
the taxpayer’s business
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181._________ is generally used to figure the taxpayer’s deduction for investment interest.
a. Form 4952
b. Form 4972
c. Form 4562
d. Form 4886
182.If the taxpayer itemizes deductions and includes their state income taxes paid as an itemized deduction, the
following year they must:
a. Include their state tax refund as income
b. Return their state tax refund to the state
c. Amend their tax return
d. They do not need to take any action
183.If the taxpayer was issued a mortgage credit certificate (MCC) by a state or local government they may be
able to take the ______________________________.
a. Mortgage Interest Credit
b. Mortgage Credit Deduction
c. Local Mortgage Credit
d. Earned Income Credit
184.True or False? In order to be considered a charitable contribution, the donation must be voluntary and made
without the getting, or expecting to get anything in return.
a. True
b. False
185.To be considered to be a qualified charity, most organizations must file an application and have a certification
letter issued under IRS Code Section:
a. 502(c) (3)
b. 503 (b)
c. 401 (k)
d. 501 (c) (3)
186.Qualified organizations include all of the following, except:
a. The Red Cross
b. Nonprofit hospitals
c. Labor unions
d. Nonprofit volunteer fire companies
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187.Nondeductible charitable contributions include money or property given to all of the following, except:
a. The Boy Scouts
b. Political groups
c. Chambers of Commerce
d. Civic leagues
188.If a taxpayer receives a benefit as a result of making a charitable contribution, they can:
a. Still deduct the entire amount of the charitable contribution
b. Deduct the portion of the contribution that is over and above the value of the benefit received
c. Not deduct any of the contribution
d. Defer the deduction until the following tax year
189.When the taxpayer makes a contribution of property, the amount of the deduction is usually:
a. The adjusted basis of the property
b. The fair market value of the property
c. The larger of the fair market value or the taxpayer’s adjusted basis
d. Determined by appraisal
190.True or False? The fair market value is the price at which property would change hands between a willing
buyer and willing seller, neither one having to buy or sell, and both having reasonable knowledge of all the
facts in the transaction.
a. True
b. False
191.If the taxpayer donates a vehicle and the charitable organization sells the vehicle for more than $500, the
taxpayer may claim a deduction for:
a. The fair market value of the vehicle on the date of the contribution
b. The adjusted basis of the vehicle on the date of the contribution
c. The gross proceeds from the sale of the vehicle
d. The smaller (a) or (c)
192.If the amount of the taxpayer’s deduction for noncash items is more than ________, they must complete and
attach Form 8283 with their return.
a. $250
b. $500
c. $1,000
d. $2,500
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193.If a taxpayer makes a cash contribution of less than $250, any of the following can be used to substantiate
their deduction, except:
a. A cancelled check
b. A letter from the charity showing the name of the organization, plus the date and amount of the contribution
c. A notarized statement by the taxpayer
d. An account statement that shows the check number (if applicable), date posted, amount and to whom the
funds were paid
194.True or False? If the taxpayer makes weekly contributions of $25 for 52 weeks, they must meet the
substantiation records for contributions of $250 or more.
a. True
b. False
195.For noncash contributions of at least $250, but not more than $500, the taxpayer is required to get
confirmation from the receiving organization that shows the name of the organization, date and location of the
contribution, a description of the property, plus all of the following must apply, except:
a. It must be in writing
b. It must state if the taxpayer received any goods or services as a result of the contribution
c. It must be received by the earlier of the date the taxpayer files their return for the year or the due date
(including extensions) for filing the return
d. It must include all of the above
196.Percentage limitations on charitable may include all of the following, except:
a. 20%
b. 25%
c. 30%
d. 50%
197.A casualty loss resulting from any of the following is deductible, except:
a. Damage by a family pet
b. Car accidents
c. Theft
d. Earthquakes
198.To determine the amount of a casualty loss, the taxpayer must know all of the following, except:
a. The decrease in fair market value
b. The taxpayer’s adjusted basis right before the casualty
c. The amount of any insurance reimbursement
d. The taxpayer must know all of the above
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199.Which of the following is true about the 10% rule?
a. The 10% rule is applied to every property damaged or lost to a casualty
b. The 10% rule is applied before the $100 rule
c. The 10% rule refers to the fact that the taxpayer gets a deduction for 10% of the total casualty losses for
the year
d. The 10% rule refers to the fact that the taxpayer must subtract 10% of their AGI from the total of all
casualty and theft losses from personal use property for the year
200.________________ is used to report a deductible loss from a casualty or theft.
a. Form 4684
b. Form 4562
c. Form 6484
d. Form 4886
201.Most miscellaneous deductions must be reduced by ___________ of the taxpayer’s adjusted gross income.
a. 2%
b. 5%
c. 7.5%
d. 10%
202.The taxpayer can take a deduction for tax preparation fees for all of the following expenses, except:
a. Fees paid to a professional tax preparer
b. Fees paid to electronically file a tax return
c. Fees paid to obtain a refund anticipation loan
d. Fees paid for self-preparation tax software
203.Other miscellaneous deductions include all of the following, except:
a. Depreciation on a home computer used to produce taxable income
b. Hobby expenses
c. Money spent for investment advice
d. Legal fees paid to collect nontaxable income
204.Deductions not subject to the 2% limitation include all of the following, except:
a. Tax preparation fees
b. Gambling losses up to the amount of gambling winnings
c. Federal estate tax paid on income in respect to a decedent
d. Repayments of more than $3,000 under a claim of right
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205.Deductions nondeductible on Schedule A include all of the following, except:
a. Burial or funeral expenses
b. Unrecovered investment in an annuity
c. Parking tickets
d. Political contributions
206.True or False? If an employee has reimbursed employee business expenses, they may use Form 2106-EZ to
report their expenses.
a. True
b. False
207.Generally, when an employer pays for your expenses, the payments should not be included in box 1 of your
Form W-2 if, within a reasonable period of time, the employee:
a. Accounted to their employer for the expenses, and
b. Was required to return, and did return, any payment not spent (or considered not spent) for business
expenses
c. Both (a) and (b)
d. Neither (a) nor (b)
208.Fees for an investment planner can be deducted on ________________________.
a. Schedule B
b. Schedule A as a miscellaneous itemized deduction subject to the 2% limitation
c. Schedule A as a miscellaneous itemized deduction not subject to the 2% limitation
d. They cannot be deducted
209.True or False? Both the American Opportunity credit and the lifetime learning credit apply only to expenses
paid for higher educational expenses, and both of these credits are refundable.
a. True
b. False
210.The American Opportunity credit is a credit of up to $___________ for qualified educational expenses paid
for each eligible student.
a. $1,000
b. $2,500
c. $2,000
d. $2,650
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211.True or False? The American opportunity tax credit can be claimed in 2011 if the taxpayer paid qualified
education expenses in 2011 but the academic period did not begin until February, 2012.
a. True
b. False
212.All of the following may be considered eligible expenses for the purposes of the AOC, except:
a. Tuition
b. Enrollment fees
c. Room and board
d. All of the above are considered eligible expenses
213.If the taxpayer pays for qualified educational expenses with certain tax-free funds such as tax-free
scholarships, Pell grants or employer provided educational assistance, they must:
a. Declare the amounts as income on their tax return
b. Reduce the amount of their qualified expenses before calculating the credit
c. Increase the amount of their qualified expenses before calculating the credit
d. The taxpayer is not required to perform any action if they receive tax-free educational assistance
214.To be an eligible student for the purposes of the American Opportunity credit, which of the following must be
true:
a. The student has no felony drug convictions
b. The student was enrolled in at lease one course in a qualified educational institution
c. The student is studying for a Master’s degree
d. The student has claimed the American Opportunity/Hope credit for the previous four tax years
215.Which of the following is true concerning the American Opportunity credit and expenses paid for a
dependent?
a. The dependent may claim the credit if they are claimed as an exemption on the return of another
b. If the dependent paid qualified expenses and the taxpayer claims them as an exemption on their return, the
taxpayer may claim the credit
c. If no one claims an exemption for the dependent, the taxpayer may claim the credit
d. If the dependent paid qualified expenses and the taxpayer claims them as an exemption on their return, the
dependent may claim the credit
216.The amount of the American Opportunity credit (for each eligible student) is:
a. The sum of 100% of the first $2,000 plus 100% of the next $2,000
b. The sum of 50% of the first $2,000 plus 100% of the next $2,000
c. The sum of 100% of the first $2,000 plus 100% of the next $2,000
d. The sum of 100% of the first $2,000 plus 25% of the next $2,000
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217.The lifetime learning credit is a credit of up to _______________ for qualified educational expenses paid for
students enrolled in eligible educational institutions.
a. $1,000
b. $1,500
c. $2,000
d. $2,500
218.Which of the following is false regarding eligibility for the lifetime learning credit?
a. The student cannot have a felony drug conviction
b. The student can be enrolled in at lease one course in a degree program
c. The student can be in their junior year in a state university
d. The student can be taking a course to increase their job skills
219.To claim the education credits the taxpayer must complete ____________:
a. Form 8812
b. Form 8863
c. Form 8453
d. Form 1040 only
220.True or False? A student who is at least a half-time student at an eligible educational institution may include
room and board as qualified educational expenses for purposes of the American Opportunity credit (subject to
limitation).
a. True
b. False
221.The taxpayer can take a deduction of up to __________ for certain student loan interest paid.
a. $1,000
b. $1,500
c. $2,000
d. $2,500
222.True or False? The taxpayer must itemize their deductions to take advantage of the student loan interest
deduction.
a. True
b. False
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223.Student loan interest paid for the expenses all of the following individuals may qualify the taxpayer for the
deduction, except:
a. The taxpayer themselves
b. A person who would be the taxpayer’s dependent except their gross income is too high
c. A person who would be the taxpayer’s dependent except they file a joint return with their spouse
d. A person who lives with the taxpayer but is a claimed as a dependent on another’s return
224.All of the following are includible as student loan interest, except:
a. Loan origination fees accrued over the time of the loan
b. Interest on a credit card if the taxpayer used it only for qualified educational expenses
c. Interest on a credit card if the taxpayer used it only for qualified educational expenses plus a trip to
Jamaica
d. Interest on a refinanced student loan if the new loan was the same amount as the old loan
225.All of the following requirements must be met for the taxpayer to claim a deduction for student loan interest,
except:
a. They use any filing status except married filing separately
b. No one else is claiming an exemption for the taxpayer
c. The taxpayer paid the student loan interest
d. All of the above are requirements that must be met
226.In which of the following situations is the taxpayer’s student loan interest deduction phased out completely?
a. The taxpayer is single with a MAGI of $27,000
b. The taxpayer is married filing a joint return with a MAGI of $110,000
c. The taxpayer is filing as head of household with a MAGI of $75,000
d. The taxpayer is single with a MAGI of $60,000
227.True or False? The taxpayer must itemize their deductions to take advantage of the deduction for tuition and
fees.
a. True
b. False
228.The maximum amount of the tuition and fees deduction can be any of the following amounts, except:
a. $0
b. $1,500
c. $2,000
d. $4,000
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229.Which of the education credits can be taken for graduate level courses?
a. None of them can be taken for graduate level classes
b. The American Opportunity Credit
c. The Lifetime Learning Credit
d. Either of them can be taken for graduate level courses
230.Which of the education credits can be claimed for more than four years?
a. None of them can be claimed for more than four years
b. The American Opportunity Credit
c. The Lifetime Learning Credit
d. Either of them can be taken for more than four years
231.Which of the education credits can be claimed by a single taxpayer with income of $75,000 (assuming all
other conditions are met)?
a. The American Opportunity Credit
b. The Lifetime Learning Credit
c. Either credit can be taken
d. None of them can be taken by the taxpayer
232.Which of the education credits can be claimed by a student with a felony drug conviction (assuming all other
requirements are met)?
a. No credit can be taken
b. The American Opportunity Credit
c. The Lifetime Learning Credit
d. Either of them can be taken by the student
233.True or False? A sole proprietor is one individual who is in business for himself or herself.
a. True
b. False
234.True or False? If a hobby shows a profit it is automatically be considered a business.
a. True
b. False
235.The income from a hobby is reported on _______________________.
a. Schedule C
b. Line 7, Form 1040
c. Line 21, Form 1040
d. Schedule A
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236.True or False? Taxpayers who do not itemize deductions may report their hobby expenses as a negative
amount on Line 21, Form 1040
a. True
b. False
237.All of the following are true about the “safe harbor” rule as applied to hobbies, except:
a. An activity must generate a profit in at least three of the five years ending with the tax year in question (two
of seven for activities involving horse racing, breeding or showing).
b. The safe harbor period begins the first year the business is in operation.
c. The IRS can invalidate the safe harbor rule by proving that the activity is not engaged in for profit.
d. A taxpayer can elect to postpone the determination of whether or not an activity is engaged in for profit.
238.Taxpayers can elect to amortize start up costs over no less than _____________ (not including any amount
currently deductible).
a. 12 months
b. 36 months
c. 48 months
d. 180 months
239.True or False? Some start up expenses may be deductible even if the taxpayer decides not to go into
business.
a. True
b. False
240.True or False? If the Sole Proprietor is also an employee performing similar duties for another and receiving a
Form W-2, the expenses must be allocated between Schedule C and Form 2106.
a. True
b. False
241.All of the following may be deductible as advertising expenses except:
a. Television or radio ads
b. The cost of distributing flyers
c. The cost of advertising to influence political legislation
d. Business cards
242. All of the following are true about business bad debts except:
a. It can result from an uncollectible debt closely related to the business
b. A cash basis taxpayer can usually take a deduction for a bad debt on their tax return
c. A taxpayer can take a deduction only if the amount was previously included in income
d. A debt acquired with a business
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243. Taxpayers using an automobile in a trade a business can deduct expenses for the vehicle using either the
standard mileage rate or _______________.
a. The actuarial tables
b. Depreciation
c. Actual expenses
d. Amortization
244. If a sole proprietor pays ____________ or more to any one individual, Form 1099-MISC (and 1096) must be
filed.
a. $10
b. $500
c. $600
d. $1000
245. Employee benefit programs include:
a. Adoption assistance plans
b. Dependent care assistance plans
c. Group-term life insurance coverage
d. All of the above
246. All of the following types of business insurance premiums are deductible on Schedule C, Line 15 except:
a. Insurance for loss of earnings
b. Flood insurance
c. Workers’ compensation insurance
d. Liability insurance
247. _______________________ is an example of business interest deductible on Line 16b, Schedule C.
a. Finance charges on credit card purchases of business items
b. Business use percentage of interest paid on a vehicle loan
c. Interest paid on borrowed funds used for business expenses
d. All of the above
248. True or False? The business portion of tax preparation fees for a sole proprietor is deductible on Schedule C.
a. True
b. False
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249. All of the following are deductible as an expense except:
a. The cost of supplies to maintain an asset
b. The cost of labor to repair an asset
c. The cost of the labor of the sole proprietor
d. All of the above are deductible
250. All of the following taxes are deductible on Schedule C except:
a. Federal highway use tax
b. State and federal unemployment benefits
c. The employer’s share of FICA taxes
d. The employee’s share of FICA taxes
251. True or False? A tax home is defined as the taxpayer’s regular place of business regardless of where they
maintain their family home.
a. True
b. False
252. Deductible travel expenses include:
a. The cost of travel by airplane, train, bus or car between the taxpayer’s home and business destination.
b. The cost of shipping luggage or work material between work locations
c. Dry cleaning and laundry while traveling
d. All of the above
253.______________ is used to calculate self-employment (SE) tax for individuals.
a. Schedule C
b. Schedule S
c. Schedule SE
d. Schedule E
254.Calculations for cost of goods sold include entries for:
a. Beginning inventory
b. Ending inventory
c. Purchases
d. All of the above
255.Cost of goods sold is _____________ gross income of a sole proprietor.
a. Added to
b. Subtracted from
c. Disregarded when calculating
d. None of the above
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256.To qualify as a deduction, a home office must be used :
a. Regularly
b. Exclusively
c. For a business purpose
d. All of the above
257.A home office can be taken as a deduction when:
a. Used as storage
b. Used to manage rental income
c. Used by a doctor to see patients
d. All of the above
258.Self-employed persons can deduct as an adjustment to income health insurance premiums paid for:
a. Themselves
b. A spouse
c. A dependent
d. All of the above
259.A self-employed person reports a deduction for their own health insurance premiums on:
a. Schedule A
b. Line 29, Form 1040
c. Schedule C
d. A self-employed person is not entitled to a deduction for health insurance
260.Self-employment taxes are calculated on:
a. Schedule C
b. Form 1040 as an adjustment to income
c. Form 1040 as a payment
d. Schedule SE
261.If a self-employed person expects to owe more than $1,000, they should:
a. Do nothing, the IRS will bill them
b. Pay their taxes by Electronic Funds Transfer (EFT)
c. Pay their taxes by December 31 of the current tax year
d. Make estimated payments
262.True or False? A self-employed individual will be required to pay self-employment tax if they have a net loss
on all of their Schedules C.
a. True
b. False
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263._________________ is used to report income from farming.
a. Schedule C
b. Schedule D
c. Schedule E
d. Schedule F
264.If an employee gets a Form 1099-MISC instead of a Form W-2, they may file ___________ to pay the correct
amount of social security tax.
a. Schedule SE
b. Form 1099-C
c. Form 4137
d. They cannot do anything
265.In the scenario in question 32, the income from Form 1099-MISC would be reported on:
a. Form 1040, line 12
b. Form 1040, line 7
c. Schedule C
d. It would not be reported on the return
266.___________________ are two of the most common plans for self-employed individuals.
a. SEPs and SIMPLE IRAs
b. SEPs and CEPs
c. SIMPLE and COMPLEX IRAs
d. Money market funds and the stock exchange
267.The basis of property that is purchased is usually:
a. Zero
b. It’s fair market value
c. It’s cost
d. None of the above
268.The following amounts are usually included in the basis of purchased property:
a. Sales tax
b. Freight
c. Installation charges
d. All of the above
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269.When title to property is taken in the name of two or more persons as ___________________, both parties
are assumed to have an equal (50/50) share in the property.
a. Individuals
b. Joint tenants
c. Tenants in common
d. None of the above
270.In California ____________________ refers both to the nature of assets held by a husband and wife during
the time of their marriage and a manner of holding property.
a. Community property
b. Joint tenancy
c. Tenants in common
d. Share and share alike
271.Generally, to determine the basis of property received as a gift, it is necessary to have the following
information.
a. The donor’s adjusted basis in the gift
b. Any gift tax paid on the property
c. The FMV of the property at the time of the gift.
d. All of the above
272.If the FMV of the property is higher than the donor’s adjusted basis (the item has appreciated in value), the
basis of the gift is _______________________________.
a. The FMV of the property
b. The donor’s adjusted basis
c. The original cost of the property
d. The giver’s adjusted basis plus any gift tax paid on the property
273.Generally speaking, improvements, additions and certain fees paid in conjunction with property
_______________________ its basis.
a. Increase
b. Decrease
c. Have no effect on
d. Equal
274.MACRS stands for:
a. Making A Cost Recovery Selection
b. Modified Accelerated Cost Recovery System
c. Modified Adjusted Cost Recovery System
d. My! Accelerated Cost Recovery is Simple
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275. _______________________ is the easiest and most constant method of calculating cost recovery of an
asset.
a. ACRS
b. MACRS
c. Straight-line depreciation
d. The Section 179 deduction
276. Using the percentage method, the percentage used to calculate straight line depreciation for an asset for five
years is:
a. 5%
b. 10%
c. 20%
d. 25%
277. _____________________________ provides for a larger depreciation deduction in the earlier years of an
assets life.
a. The declining balance method
b. The reclining balance method
c. Straight line depreciation
d. None of the above
278. ________________________ refers to the fact that each year the depreciable basis of an asset is adjusted
to account for the depreciation already claimed.
a. Adjusted basis
b. Half-year convention
c. Declining balance
d. Cost recovery
279. Automobiles are considered to be in the __________ MACRS property class.
a. Three year
b. Five year
c. Seven year
d. Ten year
280. Office furniture is considered to be in the ________ MACRS property class.
a. Three year
b. Five year
c. Seven year
d. Ten year
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281. True or False? Class life and property class mean the same thing.
a. True
b. False
282. The General Depreciation System (GDS) is also referred to as:
a. Regular MACRS
b. ACRS
c. The Section 179 deduction
d. Straight line depreciation
283. True or False? When the election to use a specific depreciation method is made for one item in a property
class, it must be used for all property in that class placed in service that year (excepting real property).
a. True
b. False
284. The Alternative Depreciation System (ADS) involves using ___________ over the ADS recovery period.
a. Sum-of-the-years digits
b. Straight line
c. 200 DB
d. regular MACRS
285. MACRS has _________ conventions used to determine when the property is considered to have been
placed in service.
a. Two
b. Three
c. Five
d. Twelve
286.When more than ______ of the depreciable basis of personal-type MACRS property is placed in service
during the last quarter of the year, the mid-quarter convention applies
a. 25%
b. 40%
c. 50%
d. 80%
287.The maximum Section 179 deduction amount for 2011 is:
a. $50,000
b. $100,000
c. $500,000
d. $2,000,000
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288.Section 179 allows a sole proprietor to fully expense tangible property ______________ (within limitations).
a. In the year it is purchased
b. Over the length of its recovery period
c. Up to 110% of its purchase price
d. None of the above
289.True or False? A taxpayer may take a Section 179 deduction for property the second year after it was first
placed in service.
a. True
b. False
290.The election to use the Section 179 deduction for non-listed property is made by completing ___________.
a. Schedule C
b. Part I of Form 4562
c. Part II of Form 4562
d. Part V of Form 4562
291.Property that does not qualify for the Section 179 deduction includes:
a. Investment property
b. Rental property if renting property is not the trade or business of the taxpayer
c. Property used outside the United States
d. All of the above
292.For 2011, the $500,000 limit for the Section 179 deduction is reduced dollar for dollar by the amount that the
cost of qualifying property exceeds __________________.
a. $175,000
b. $400,000
c. $2,000,000
d. $5,000,000
293.For the purposes of the Section 179 deduction limits, taxable income from a trade or business includes all of
the following, except:
a. Wages, salaries and tips
b. Income as a sole proprietor
c. Royalty income
d. Ordinary income from a partnership
294.For the purposes of the Section 179 deduction limits, taxable income is not reduced by:
a. A NOL carryover
b. The Section 179 deduction itself
c. The deduction for ½ of self-employment taxes
d. Taxable income is not reduced by any of the above
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295.Any Section 179 deduction limited by taxable income _________________________.
a. Is lost and cannot be deducted
b. Carried forward for the next 5 years
c. Carried forward for the next 10 years
d. Carried forward indefinitely
296.If business use of property for which the Section 179 deduction has been taken drops below ___________
any time before the end of its recovery period, part of the expensed amount may need to be recaptured.
a. 100%
b. 75%
c. 50%
d. 10%
297.Listed property includes all of the following, except:
a. Computers
b. Passenger autos
c. Office equipment
d. All of the above are considered listed property
298.To be eligible for the Section 179 deduction and regular MACRS, listed property must be used more than
________ for business use.
a. 50%
b. 75%
c. 25%
d. 25%
299.The maximum depreciation deduction for passenger automobiles for 2011 is:
a. $11,060
b. $4,700
c. $2,850
d. $10,610
300.True or False? If the depreciation deduction for a passenger automobile is limited in any year, the taxpayer
can continue to claim depreciation in succeeding years until the full basis of the vehicle has been recovered,
even if actual business use was less than 100%.
a. True
b. False
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301.Record keeping for business use of listed property must include all of the following, except:
a. The cost and date of the expense
b. The amount of each business or investment use
c. The business or investment purpose
d. Good record keeping includes all of the above
302.Information about listed property is entered in __________________________.
a. Part I, Form 4562
b. Part II, Form 4562
c. Part IV, Form 4562
d. Part V, Form 4562
303.Certain property is eligible for ____________________ bonus depreciation.
a. 25%
b. 30%
c. 50%
d. 60%
304.Qualified property for the special (bonus) depreciation allowance must be:
a. Qualified disaster assistance property
b. GO Zone property
c. Qualified reuse and recycling property
d. Any of the above
305.Certain qualified property for the special (bonus) depreciation allowance must be placed in service:
a. Before January 1, 2006
b. Before December 31, 2006
c. After December 31, 2007
d. None of the above
306.Section 197 intangibles include all of the following, except:
a. Goodwill
b. Patents
c. Trademarks
d. It includes all of the above
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307.True or False? An annuity is a series of payments under a contract made at regular intervals over a period of
more than a year.
a. True
b. False
308.Distributions from pensions and annuities are reported to the taxpayer on:
a. Form 1099-INT
b. Form 1099-SSA
c. Form 1099-R
d. Form W-2
309.The part of a distribution from a pension that is attributed to the taxpayer’s contributions is
______________________________.
a. Taxable
b. Nontaxable
c. Recovered first
d. Reported as wages on the tax return
310.The two methods for determining the taxable portion of a pension distribution are:
a. The Simple and Not-So-Simple Methods
b. The Simplified Method and the 10-year Rule
c. The Simplified Method and the General Rule
d. The General Rule and the 10-year Rule
311.A disability pension received by a taxpayer before minimum retirement age is reported on:
a. Line 7, Form 1040
b. Line 16, Form 1040
c. Line 21, Form 1040
d. It is not reported on the tax return
312.True or False? A distribution from a non-qualified plan can still qualify for the special tax considerations of a
lump-sum distribution.
a. True
b. False
313.____________ is used to calculate special tax options available if the taxpayer received a lump-sum
distribution.
a. Form 4797
b. Form 4562
c. Schedule D
d. Form 4972
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314.Distribution that do not qualify for lump-sum treatment include all of the following, except:
a. A distribution from an IRA
b. A distribution from a qualified plan if the taxpayer previously made an earlier election to use either the 5year or 10-year option after 1986
c. A distribution due to the disability of the taxpayer before minimum retirement age
d. A distribution that is partially rolled over to another qualified plan or IRA
315.True or False? The 10-year tax option for lump-sum distributions must be calculated and included in the
taxpayer’s returns for the next 10 years after receiving the distribution.
a. True
b. False
316.If a taxpayer receives a lump-sum distribution and chooses to report the entire amount as ordinary income,
they should report the amount on _________________.
a. Lines 16 a and b, Form 1040
b. Schedule D, Form 1040
c. Form 4972
d. Form 1099-R
317.For the purposes of rollovers, a qualified retirement plan includes all of the following, except:
a. A qualified employer plan
b. A tax-sheltered annuity plan
c. An eligible state or local government section 457 plan
d. All of the above are considered to be qualified retirement plans
318.True or False? If a taxpayer rolls over a distribution from a pension to a traditional IRA, they may take a
deduction for the amount rolled over.
a. True
b. False
319.If a taxpayer rolls over only part of a distribution that includes both taxable and nontaxable amounts, the
amount rolled over _________________________.
a. Is treated as coming first from the taxable part of the distribution
b. Is treated as coming first from the nontaxable part of the distribution
c. Is always treated as a taxable distribution
d. The taxpayer cannot choose to roll over only part of a distribution
320.If a taxpayer chooses to receive the funds from a distribution from a retirement plan, _____ of the amount will
usually be withheld for federal taxes.
a. 10%
b. 15%
c. 20%
d. It varies depending on the filing status of the taxpayer
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321.If the taxpayer receives a distribution from a retirement plan or IRA before reaching age 59 ½, there may be a
______ penalty imposed on the taxable portion of the distribution.
a. 10%
b. 15%
c. 20%
d. It varies depending on the filing status of the taxpayer
322._________ is used to report the penalty on the early distribution of retirement benefits.
a. Form 4972
b. Form 1099-ED
c. Form 5329
d. Form 1099-R
323.Potentially taxable social security benefits include all of the following, except:
a. Social security retirement benefits
b. Equivalent tier 1 railroad retirement benefits
c. Monthly survivor and disability benefits
d. Supplemental security income (SSI)
324.To determine if any of the taxpayer’s social benefits are taxable, all of the following information is needed,
except:
a. The taxpayer’s filing status
b. One-half of the social security benefits received
c. The number of exemptions claimed by the taxpayer
d. The total of the taxpayer’s other income, including any nontaxable interest
325.The base amount for determining the taxable amount of social security benefits for a person married filing
separately who lived with spouse during 2011 is:
a. $0
b. $15,000
c. $25,000
d. $32,000
326.The taxable portion of social security benefits received in 2011 is reported on _____________.
a. Line 7, Form 1040
b. Line 15, Form 1040
c. Line 20, Form 1040
d. Social security benefits are always nontaxable
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327.All of the following are true regarding traditional IRAs, except:
a. Congress created the traditional IRA in 1974
b. Earnings in the IRA are taxed at the time they are earned
c. Earnings in the IRA are taxed at the time the money is withdrawn
d. The taxpayer may be able to take a deduction for the amount of their contribution
328.True or False? A taxpayer may make a deductible contribution to a Roth IRA.
a. True
b. False
329.All of the following are true regarding Education IRAs, except:
a. They are better known as Coverdell Education Savings Accounts
b. It is an account created as an incentive to help parents and students save for education
c. If the beneficiary uses the funds for qualified education expenses, there is no tax on the distributions
d. All of the above are true
330.A person can set up and make contributions to a traditional IRA if they were not age ___________ at the end
of the year.
a. 50 /12
b. 55
c. 59
d. 70 1/2
331.For the purposes of an IRA, compensation does not include ___________________:
a. Earnings from investment property
b. Interest or dividends
c. Pension or annuity income
d. Compensation does not include any of the above
332.For 2011, the most that can be contributed to a traditional IRA is
a. $2,000 ($2,500 if age 50 or older)
b. $2,500 ($3,000 if age 50 or older)
c. $4,000 ($5,000 if age 50 or older)
d. $5,000 ($6,000 if age 50 or older)
333.True or False? Contributions can be made to a traditional IRA at any time during the tax year or by the due
date for filing the tax return for the year, including extensions.
a. True
b. False
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334.A single taxpayer with a modified AGI of $45,000, covered by an employer provided retirement plan can take
_______________ for a traditional IRA contribution.
a. A full deduction
b. A partial deduction
c. No deduction
d. The taxpayer cannot make an IRA contribution
335.Defined contribution plans include all of the following, except:
a. Profit sharing plans
b. Stock bonus plans
c. Money purchase plans
d. All of the following are defined contribution plans
336.A taxpayer is considered to be covered by a plan if at any time during the year they are eligible to participate
in a defined benefit plan, except when:
a. They declined to participate in the plan
b. They did not make a required contribution
c. They were not vested in the plan
d. The taxpayer is considered to be covered by a plan in all of the above scenarios
337.True or False? A taxpayer who is covered under social security is considered to be covered under an
employer retirement plan.
a. True
b. False
338.When a taxpayer has a nondeductible IRA contribution, they must file Form ________.
a. 5329
b. 8606
c. 8800
d. 1099-R
339.All of the following are exceptions to the early distribution penalty for IRA distributions, except:
a. The taxpayer needed the money to pay high interest credit card debt
b. The taxpayer is receiving the distributions in the form of an annuity
c. The distributions are not more than the taxpayer’s qualified higher education expenses
d. The taxpayer uses the distribution to buy, build or rebuild a main home
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340.A taxpayer using the married filing joint status with a modified AGI of less than ____________________ may
make a full contribution of up to $5,000 to a Roth IRA.
a. $95,000
b. $110,000
c. $159,000
d. $179,000
341.A ______________________ is an account created as an incentive to help parents and students save for
education expenses.
a. A traditional IRA
b. A Roth IRA
c. A Coverdell Education Savings Account
d. A Roth Education Savings Account
342.The total contributions for a beneficiary of a Coverdell ESA cannot be more than ________ in any year, no
matter many accounts have been established.
a. $1,500
b. $2,000
c. $4,000
d. $4,500 if the beneficiary is age 50 or older
343.The beneficiary of a Coverdell ESA will not owe any tax on a distribution if the funds are less than their
qualified education expenses at _________________.
a. A college or university
b. An elementary school
c. A secondary school
d. All of the above
344.All of the following exceptions apply to the 10% additional tax on a taxable distribution from a Coverdell ESA,
except:
a. It was made because the beneficiary is disabled
b. It was included in income because the designated beneficiary received a tax-free scholarship
c. It was included in income because the taxpayer received tax-free educational assistance as a gift
d. All of the above are exceptions
345.A taxpayer may be able to take a tax credit of up to ________ if they make eligible contributions to a
retirement plan.
a. $1,000 ($2,000 MFJ)
b. $1,500 ($2,000 MFJ)
c. $2,000 ($2,500 MFJ)
d. $4,000 ($4,500 MFJ)
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346.To figure the amount of the taxpayer’s Retirement Savings Contribution Credit, complete and attach
______________.
a. Form 1040
b. Form 5329
c. Form 8606
d. Form 8880
347.The maximum a taxpayer can contribute to a spousal IRA is:
a. $5,000 ($6,000 if age 50 or older)
b. $2,500
c. $3,000
d. $10,000
348.True or False? A taxpayer and spouse can make contributions to both a regular and a spousal IRA in the
same year.
a. True
b. False
349.All of the following are capital assets, except:
a. Stocks and bonds
b. Collectibles
c. Depreciable personal property used in a business
d. Gold and silver
350.The gain or loss from the sale or exchange is the____________________________.
a. Difference between the gross sales price and the adjusted basis minus any expenses of the sale
b. Difference between the gross sales price and the adjusted basis plus any expenses of the sale
c. Amount realized
d. Cash received
351.True or False? A loss on the sale or exchange of personal use property is not deductible:
a. True
b. False
352.The sale of capital assets are reported on ___________________.
a. Schedule A
b. Schedule B
c. Schedule C
d. Form 8949 and Schedule D
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353.Assets held for ______________________________ are considered to be held long-term.
a. One year or more
b. More than one year
c. Five years or more
d. More than five years
354.True or False? The trade date rather than the date of payment is used as the date of sale for stocks and
bonds.
a. True
b. False
355.All of the following are capital gains tax rates, except:
a. 5%
b. 15%
c. 25%
d. 28%
356.The ____________________________ will be used to figure the tax if the taxpayer has qualified dividends
or net capital gains
a. The Qualified Dividends and Capital Gain Tax Worksheet
b. The Schedule D Tax Worksheet
c. The Tax Tables or Tax Rate Schedules
d. Either (a) or (b) depending on the circumstances
357.The amount of the capital loss deduction in any year is:
a. The lesser of $3,000 ($1,500 if married filing separately) or the amount of the total net loss on line 16 of
Schedule D
b. The greater of $3,000 ($1,500 if married filing separately) or the amount of the total net loss on line 16 of
Schedule D
c. Reported on line 15, Form 1040
d. All of the following are true of the capital loss deduction
358.When figuring the amount of capital loss carryovers, the ________________________ are always used first:
a. Short-term capital losses
b. Long-term capital losses
c. Oldest losses
d. Most recent losses
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359.All of the following are true about non-business bad debts, except:
a. To be deductible a personal bad debt must arise from a true debtor-creditor relationship
b. They are always considered to be short-term capital losses
c. Personal bad debts come from operating a trade or business as a sole proprietor
d. The taxpayer may be able to take a deduction for the debt in the year the debt becomes worthless
360.If the taxpayer sold a main home in 2011, they may be able to exclude gain up to:
a. $150,000 ($300,000 MFJ)
b. $200,000 ($400,000 MFJ)
c. $250,000 ($500,000 MFJ)
d. The amount realized
361.True or False? It is possible under certain circumstances for the taxpayer to deduct the loss from the sale of a
personal residence.
a. True
b. False
362.A main home can be all of the following, except:
a. A houseboat
b. A mobile home
c. A condominium
d. A hotel room
363.To exclude the gain on the sale of their main home, the taxpayer generally must have owned and lived in the
property for at least _______ during the __________ period ending on the date of sale
a. Two years; Four years
b. Two years; Five years
c. Five years; Seven years
d. Five years; Ten years
364.The __________________________ is the selling price minus any expenses of sale.
a. Net gain
b. Amount recognized
c. Amount realized
d. Adjusted basis
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365.All of the following are increases to the taxpayer’s basis in their main home, except:
a. Certain closing costs paid when purchasing the property
b. Additions and other improvements with a useful life of more than one year
c. Amounts spent after a casualty to restore damaged property
d. A deductible casualty loss
366.All of the following are decreases to the taxpayer’s basis in their main home, except:
a. Postponed gain from the sale of a previous main home before May 7, 1997.
b. Depreciation allowed or allowable
c. Insurance payments received for casualty losses
d. All of the above are decreases to the taxpayer’s basis
367.True or False? The taxpayer may add repairs to maintain a home to their basis in their main home
a. True
b. False
368.Even if they do not meet the ownership and use tests, a taxpayer may claim a reduced exclusion on the gain
of the sale of their personal residence if
a. The reason they sold their home was due to a change in place of employment
b. The reason they sold their home was due to a change in health
c. The reason they sold their home was due to unforeseen circumstances that the taxpayer could not have
reasonable anticipated before buying and occupying their home
d. All of the above
369.A __________________________ is a sale of property at a gain where at least one payment is to be
received after the tax year in which the sale occurs.
a. Installment sale
b. Nontaxable sale
c. Cash sale
d. Wash sale
370.The taxpayer must use the Schedule D Tax Worksheet if all of the following are true, except:
a. They are required to file Schedule D
b. Schedule D, line 18 (28% rate gain) is more than zero
c. Line 19 (unrecaptured Section 1250 gain) is more than zero
d. They expect to have no tax liability
371.True or False? Income from the rental of a vacation home should be reported on Schedule E.
a. True
b. False
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372.Rental income is not considered earned income for the purposes of:
a. The Earned Income Credit
b. The Additional Child Tax Credit
c. Making an IRA contribution
d. All of the above
373.If a cash basis taxpayer receives advance rent for a period of time in the next tax year, they should:
a. Wait until the next tax year to report the income
b. Report the income in both the current and the next tax year
c. Report the income in the current tax year only
d. Not report the income at all
374.If a taxpayer receives a security deposit from a tenant and they plan to return it to the tenant at the end of the
lease, ____________________________________.
a. It should be reported as income when received
b. It should be considered first and last months rent
c. It should not be included in income unless the landlord makes a decision to keep all or part of the funds
d. None of the above
375.If a tenant pays any expenses of the landlord, the payments are considered to be
______________________.
a.
b.
c.
d.
Rental income for the landlord
A deduction for the landlord if it is an allowable expense
An incidental benefit to the landlord, thus not includible in income
Both (a) and (b)
376.Which of the following statements is true concerning repairs and improvements?
a. The taxpayer can deduct the cost of an improvement
b. A repair materially adds to the value of the property
c. The cost of improvements is recovered by taking a depreciation deduction
d. A repair and an improvement are considered to be the same for tax purposes
377.True or False? Additions and improvements have the same recovery period as that of the property to which
the addition or improvement was made, determined as if the property were placed in service at the same time.
a. True
b. False
378.All of the following are examples of repairs, except:
a. Repainting the exterior of a rental house
b. Fixing plumbing leaks
c. Replacing an old roof
d. Replacing broken windows
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379.All of the following are true of local benefit property taxes, except:
a. They are deductible
b. The cost should be added to the taxpayer’s basis in the property
c. They include charges for putting in streets or water and sewer systems
d. All of the above are true
380. True or False? If a taxpayer pays an insurance premium in advance for more than one year, they can deduct
the full amount of the premium paid in the current tax year.
a. True
b. False
381. If a taxpayer does not rent their property to make a profit, _________________.
a. They should complete Schedule E
b. They should complete Schedule C
c. They should report their income on line 21, Form 1040
d. The income is not considered to be taxable
382. If taxpayer rents only part of their property and uses part for personal use, _________________________.
a. They must compete Schedule C
b. All of their expenses are considered nondeductible
c. All of their expenses are considered deductible
d. Expenses directly related to the rental portion of the property are deductible in full.
383. A dwelling unit includes __________________________________.
a. A mobile home
b. An apartment
c. A boat
d. All of the above
384. A taxpayer is considered to use a dwelling unit as a main home if they use it for personal purposes more
than the greater of _____________________________.
a. 14 days or 10% of the total days it is rented to others at a fair rental price
b. 15 days or 10% of the total days it is rented to others at a fair rental price
c. 14 days or 15% of the total days it is rented to others at a fair rental price
d. 10 days or 15% of the total days it is rented to others at a fair rental price
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385.Personal use by the taxpayer includes all of the following, except:
a. Use by the taxpayer themselves
b. Use by a member of the taxpayer’s brother
c. Use by anyone that pays the taxpayer less than a fair rental price
d. Any of the above
386.Which of the following statements is false if the taxpayer rents a dwelling for 15 days or more and also uses it
for a residence?
a. Some expenses are deductible in full; some are deductible only to the extent of the income reported
b. Expenses that cannot be deducted in the current year cannot be carried over
c. Rental expenses not directly related to the dwelling unit, such as advertising, commissions, etc. are
deductible in full
d. The rental portion of interest and taxes is deductible on Schedule E; the personal portion is deductible on
Schedule A if the taxpayer itemizes
387. A taxpayer actively participates in a rental real estate activity if they owned at least ___________ of the
property and made significant management decisions.
a. 10%
b. 15%
c. 25%
d. 51%
388. If a taxpayer actively participates in a rental activity, they will generally be able to deduct the full amount of
their rental loss if it is less than __________________.
a. $15,000
b. $25,000
c. $50,000
d. $100,000
389. True or False? If a taxpayer is considered to be a real estate professional, rental activities in which the
taxpayer materially participates are not considered passive activities.
a. True
b. False
390.Items that may be included as income for a landlord include all except:
a. Advance rent
b. Deposits kept by the landlord
c. Payment of expenses by the tenant
d. All of the above
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391. Page 2 of Schedule E is used to report:
a. Income or loss from partnerships
b. Income or loss from S corporations
c. Income or loss from estates or trusts
d. All of the above
392.For the purposes of a vacation rental, days used by the taxpayer includes any day that the unit is used by:
a. The taxpayer or any other person who has an interest in the property, unless it is rented to the other owner
as his main home under a shared equity financing agreement.
b. A member of the taxpayer’s family (or family member of another owner) unless that person uses the
dwelling as their main home and pays a fair rental price. For the purposes of this discussion, family
includes brothers, sisters, half-brothers, half-sisters, spouses, ancestors (parents, grandparents) and
lineal descendants (children, grandchildren)
c. Anyone under an arrangement that lets the taxpayer use another dwelling unit
d. Any of the above
393.True or False. A landlord must keep written records of their travel and transportation expenses.
a. True
b. False
394.A taxpayer may want to file an amended return because___________________.
a. They omitted an item of income
b. They overlooked a deduction
c. They want to change their address with the IRS
d. (a) or (b)
395.True or False? A taxpayer may file an original return using Form 1040X.
a. True
b. False
396.For a taxpayer to receive an additional refund, an amended return must be filed
____________________________.
a. Within 10 years of filing the original return
b. Within 5 years of filing the original return or 3 years after paying the tax, whichever is later
c. Within 3 years after the original return was filed or 2 year after paying the tax, whichever is earlier
d. Within 3 years after the original return was filed or 2 year after paying the tax, whichever is later
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397.The IRS has __________ to collect outstanding tax liabilities, measured from the day a tax liability has been
filed (except in the event of fraud).
a. 5 years
b. 7.5 years
c. 10 years
d. The IRS can collect outstanding tax liabilities at any time
398.Which of the following is false regarding filing status and an amended return?
a. The filing status on the amended return is shown on Page 1, Line A
b. A taxpayer may use the same filing status on an original and amended return
c. The taxpayer cannot change from a separate return to a joint return after the due date of the return
d. The taxpayer cannot change from a joint return to a separate return after the due date of the return
399.A change to a taxpayer’s AGI may affect all of the following, except__________?
a. The taxpayer’s home mortgage interest deduction
b. The taxpayer’s miscellaneous itemized deductions
c. The amount of the taxpayer’s child and dependent care credit
d. The amount of the taxpayer’s taxable social security benefits
400.Which of the following is not an abbreviation for the method used to figure the tax shown in column C of Form
1040X?
a. Table
b. TCW
c. IRA
d. QDCGTW
401.True or False? If the taxpayer has not received a refund (overpayment) shown on their original return, they
should not list the amount on the amended return. The IRS will process both refunds together.
a. True
b. False
402.A taxpayer may want to make estimated tax payments if they have income from:
a. Self-employment
b. Rental property
c. Capital gains
d. All of the above
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403. If a taxpayer does not pay enough tax throughout the year, either through withholding or estimated tax
payments _________________.
a. They may be subject to a penalty
b. They may be subject to backup withholding
c. The IRS will audit their tax return
d. They will need to file a tax return twice a year in the future
404.To change their withholding with their employer, an employee should file Form ________.
a. W-7
b. W-4
c. W-4P
d. W-2
405. Which of the following is not a payment period for the purposes of making an estimated tax payment?
a. January 1 – March 31
b. April 1 – June 30
c. June 1 – August 31
d. September 1 – December 31
406. True or False? A taxpayer can avoid paying estimated taxes by increasing their withholding by filing Form
W-4 with their employer.
a. True
b. False
407. Each of the following requirements must be met if the taxpayer is to be considered not required to make
estimated tax payments in 2012, except:
a. They had no tax liability for 2011
b. They were a U.S. citizen for the whole year
c. They filed a Form 1040A not Form 1040
d. Their 2011 tax return covered a 12-month period
408. True or False? If all of a taxpayer’s income is subject to withholding, they probably do not need to make
estimated payments.
a. True
b. False
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409. Higher income taxpayers must pay at least _____________________ in order to be not required to make
estimated tax payments
a. 90% of their 2012 tax; 100% of their 2011 tax
b. 100% of their 2012 tax; 100% of their 2011 tax
c. 100% of their 2012 tax; 110% of their 2011 tax
d. 90% of their 2012 tax; 110% of their 2011 tax
410. The taxpayer should know all of the following in order to help calculate the amount of their estimated taxes,
except:
a. Their expected adjusted gross income
b. Their expected deductions
c. Their expected credits
d. They should know all of the above
411. True or False? If a taxpayer does not pay enough estimated taxes during any payment period, they may owe
a penalty even if they get a refund on their tax return.
a. True
b. False
412. If the taxpayer’s income is basically the same throughout the year, they will probably find it easiest to use
____________________ to calculate their estimated taxes.
a. the Regular Installment Method
b. the Irregular Installment Method
c. the Annualized Income Installment Method
d. Form 1040-ES
413. If the taxpayer does not receive their income evenly throughout the year, they will probably find it necessary
to use ____________________ to calculate their estimated taxes.
a. the Regular Installment Method
b. the Irregular Installment Method
c. the Annualized Income Installment Method
d. Form 1040-ES
414. The taxpayer may use all of the following methods to pay their estimated taxes, except:
a. Crediting a overpayment on the previous year’s return
b. By sending in a payment with a payment voucher
c. By using a credit card or electronic funds withdrawal
d. Any of the above can be used
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415.Which of the following is true?
a. A taxpayer is not required to pay interest on a late balance due payment
b. The IRS is required to pay interest on an overpayment not made timely
c. The interest rate is different for overpayments and underpayments for individuals
d. The interest rate for an overpayment is 5% for an individual
416.Circular ________contains rules governing the recognition of attorneys, CPAs, EAs, enrolled retirement plan
agents, RTRPs and other persons representing taxpayers before the Internal Revenue Service.
a. 230
b. 320
c. 1040
d. 1116
417.The ______________________________ has responsibility for matters relating to tax professional conduct
and discipline.
a. Secretary of State
b. Audit and Appeals Division
c. Office of Professional Responsibility
d. Board of Accountancy
418.“Practice before the Internal Revenue Service” includes all of the following except ________________.
a. Preparing documents
b. Correspondence and communication with the IRS
c. Representing clients at conferences, hearings, and meetings
d. All of the above are included in “practice before the IRS"
419.Which of the following are not recognized to practice before the IRS.
a. Attorneys
b. Certified Public Accountants
c. Enrolled Agents
d. Bookkeepers
420.A Registered Tax Return Preparer may represent a taxpayer before a revenue agent if ____________.
a. The RTRP and the client have signed a nondisclosure agreement
b. If the RTRP signed the return for the tax year or period under examination
c. If they posses a valid PTIN
d. An RTRP can never represent a taxpayer before a revenue agent
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421.True or False? An RTRP cannot provide tax advice to a client or other person except as necessary to
preparer a tax return.
a. True
b. False
422.Which of the following is not required to become an enrolled agent?
a. Must be eighteen years of age or older
b. Must pass a written exam administered under the Internal Revenue Service
c. Must possess a valid tax preparer identifying number
d. Must be a former IRS agent
423.Which of the following is not required to become a Registered Tax Return Preparer?
a. Must be eighteen years of age or older
b. Must pass a written exam administered under the Internal Revenue Service
c. Must possess a valid tax preparer identifying number
d. Must be licensed by the state in which they reside
424.An individual wishing to become an enrolled agent,enrolled retirement plan agent, or registered tax return
preparer must:
a. Apply and pay a fee
b. Pass a compliance check
c. Pass a suitability check
d. All of the above
425. A tax compliance check is limited to an inquiry regarding whether an applicant has _______________.
a. Filed all required individual or business tax returns and paid (or made suitable arrangements to pay) any
federal tax debt
b. Ever been convicted of a felony
c. Lived in the United States for at least five years
d. None of the above
426. A suitability check is limited to an inquiry regarding whether an applicant has _______________.
a. Filed all required individual or business tax returns and paid (or made suitable arrangements to pay) any
federal tax debt
b. Ever been convicted of a felony
c. Lived in the United States for at least five years
d. None of the above
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427. True or False? Failure to receive notification from the Internal Revenue Service about a renewal requirement
will be justification for an individuals failure to renew.
a. True
b. False
428. Applications for EA renewal are required between November 1 and January 31 of every ______ year.
a. Second
b. Third
c. Fifth
d. Seventh
429. Registered tax return preparers must renew their preparer tax identification by _______________ for the
coming tax season.
a. January 15
b. April 15
c. September 30
d. December 31
430. Enrolled agents must complete a minimum of ______ hours of continuing during each enrollment cycle.
a. 60
b. 72
c. 90
d. 120
431. Enrolled agents must complete a minimum of _______ hours of continuing each enrollment year.
a. 16
b. 20
c. 24
d. 36
432. Enrolled agents must complete a minimum of _____ hours of ethics or professional conduct during each
enrollment cycle.
a. 6
b. 9
c. 10
d. 16
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433. Enrolled agents must complete a minimum of _____ hours of ethics or professional conduct during each
enrollment year.
a. 1
b. 2
c. 6
d. They are not required to complete ethics every year
434. An enrolled agent who receives their initial enrollment during an enrollment cycle must complete ____ hour
(s) of continuing education for each month enrolled during the enrollment cycle.
a. 1
b. 2
c. 3
d. 4
435. An enrolled agent who receives their initial enrollment during an enrollment cycle must complete ____ hour
(s) of ethics or professional conduct education for enrollment year.
a. 1
b. 2
c. 3
d. 4
436. A registered tax return preparer must complete a minimum of _______ hours of continuing education during
each registration year.
a. 5
b. 10
c. 15
d. 16
437. A registered tax return preparer must complete a minimum of _______ hours of ethics or professional
conduct education during each registration year.
a. 1
b. 2
c. 3
d. 4
438. A registered tax return preparer must complete a minimum of _______ hours of federal tax update education
during each registration year.?
a. 1
b. 2
c. 3
d. 4
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439. A registered tax return preparer must complete a minimum of _______ hours of federal tax law topics during
each registration year?
a. 5
b. 10
c. 15
d. 16
440. Individuals can get continuing education credit for __________________________________.
a. Attending an instructor led class
b. Completing a correspondence course
c. Serving as an instructor
d. Any of the above
441. Individuals applying for renewal must keep records of qualifying education for __________________.
a. Two years from the date of renewal
b. Three years from the date of renewal
c. Four years from the date of renewal
d. Five years from the date of renewal
442. An individual who is not a practitioner may represent any of the following before the IRS even if the taxpayer
is not present except:
a. An individual may represent a member of his immediate family
b. A regular full-time employer of an individual employer may represent the employer
c. An officer of a corporation may represent the corporation
d. An individual may represent any individual who has signed a consent form
443. True or False? An individual who is under suspension or disbarment from practice before the Internal
Revenue Service is eligible to engage in limited practice before the Service.
a. True
b. False
444. A practitioner who has been retained by a client with respect to a matter before the Internal Revenue Service
and who knows that the client has not complied with the tax laws or has made an error or omission from a
return or other document submitted to the IRS, must:
a. Promptly advise the client of the noncompliance and advise them of the consequences
b. Terminate their relationship with the client
c. Refer the client to a qualified tax attorney
d. The practitioner must do all of the above
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445. In general, a practitioner must exercise due diligence in the following:
a. Preparing or assisting in the preparation of documents, affidavits and other papers related to IRS matters
b. Determining the correctness of oral or written representations made by the practitioner to the Department
of the Treasury
c. Determining the correctness of oral or written representations made to clients with respect to any matter
administered by the IRS
d. A practitioner must exercise due diligence in all of the above situations
446. True or False? A practitioner may not knowingly accept assistance from or assist any person who is under
disbarment or suspension from practice before the Service if the assistance relates to a matter constituting
practice before the Service.
a. True
b. False
447. True or False? A practitioner may not take acknowledgments, administer oaths, certify papers, or perform
any official act as a notary public with respect to any matter administered by the Service for which he/she is
employed as counsel, attorney, or agent, or in which they may be in any way interested.
a. True
b. False
448. Which of the following is false about contingent fees?
a. A practitioner may charge a contingent fee for services rendered in connection with the preparation of a tax
return if the amount is deemed reasonable
b. A fee that is based on whether or not a position avoids challenge by the IRS is considered a contingent fee
c. A fee based on a percentage of the refund shown on the return is considered to be a contingent fee
d. A fee that depends on a specific result being attained is a contingent fee
449. Which of the following statements is false about retaining client records?
a. Generally when asked, a practitioner must promptly return all records of the client that are necessary for
the client for comply with his federal tax obligations unless state law allows otherwise
b. The practitioner may retain copies of the records returned
c. The practitioner may refuse to return the client’s records if there is a dispute of fees over $500
d. The practitioner must at least provide the client with reasonable access to review and copy an additional
records retained that are necessary for the client for comply with his federal tax obligations
450. In general, a practitioner is prohibited from representing a client before the IRS if:
a. The representation would be directly adverse to another client
b. There is significant risk that the representation of one client will be materially limited by the practitioner’s
responsibility to another client
c. There is significant risk that the representation of a client will conflict with a personal interest of the
practitioner
d. The practitioner should not represent a client in any of the above scenarios
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451. Which of the following is true with regards to statements describing a professional designation by the IRS?
a. An RTRP may use the term “certified” when describing their professional designation
b. An enrolled agent may use the term “certified” when describing their professional designation
a. An RTRP may use the phrase “admitted to practice before the IRS”
b. An enrolled agent may use the phrase “admitted to practice before the IRS”
452. True or False? Any lawful solicitation by a practitioner must identify the solicitation as such and, if applicable,
identify the source of information used in choosing the recipient.
a. True
b. False
453. With regard to their fees, which of the following statements is false?
a. A practitioner may publish a written schedule of fees including fixed fees for services
b. Fee information may be published in a telephone directory but the practitioner must retain a copy for at
least 36 months after the last published date
c. A practitioner may change their published fees after 15 days after the last date on which the schedule of
charges was published
d. Any method of advertising fees must not be untruthful or deceptive
454. True or False? A practitioner who prepares tax returns may endorse and/or cash a check issued to a client
by the government in respect to a federal tax liability.
a. True
b. False
455. True or False? A practitioner generally may rely in good faith and without proof upon information given by the
client. However the practitioner must make reasonable inquiries if the information as furnished appears to be
incorrect, inconsistent with facts or incomplete.
a. True
b. False
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