Who Must File - TaxEase, LLC
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2013 60 Hour Federal and California “Become A Tax Preparer” Course TaxEase, LLC c/o Postal Annex 39270 Paseo Padre Pkwy #624 Fremont CA 94538 June 2013 877-829-2667 www.taxeaseed.com Fax: 510-779-5251 1 Objectives TaxEase’s objective is to: Assist in preparing accurate tax returns Give the convenience of studying in a comfortable setting. Supply material that will give a wealth of information to use in future reference. Offer services at an affordable cost The authors of this publication and TaxEase LLC are not engaged in rendering legal, accounting or other professional advice and assume no responsibility for its use. Throughout this publication, we refer to many reference websites and IRS publications. All tax situations differ we urge you to do additional research and refer to IRS publications This California Qualifying Education class is a CTEC-approved course of Federal and CA tax, which fulfills the 60-hour “qualifying education” requirements for tax preparers. A listing of additional requirements to register as a tax preparer may be obtained by contacting CTEC at P.O. Box 2890, Sacramento, CA, 95812-2890, by phone at (877) 850-2832, or on the Internet at www.ctec.org. TaxEase, LLC is an approved education provider, CTEC course number 3064QE-0025. 2 Assignments Although all the information to answer the questions is included in the TaxEase Study Guide, the following sources are recommended reading before taking the final exam and should be included in your library: IRS Pub. 17 Form 1040 IRS Pub. 334 IRS Pub. 547 IRS Pub. 553 CA 540 and 540A CA FTB Pub 1031 CA FTB Pub 1001 Your Federal Income Tax Instructions for Form 1040 Tax Guide for Small Business Casualties, Disasters, and Thefts Highlights of Tax Changes Personal Income Tax Booklet Guidelines for Determining Resident Status Supplemental Guidelines to California Adjustments Throughout the text, references have been made to other publications that will enhance the learning process. We strongly recommend that these publications be ordered and reviewed. The IRS and FTB form instructions give a wealth of information, which will be helpful in reviewing all aspects of tax return preparation. To receive Internal Revenue and California Franchise Tax Board publications call or visit their website: IRS: (800) 829-3676 www.irs.gov FTB: (800) 338-0505 www.ftb.ca.gov This text is for CA Tax Preparers who must meet the requirements of the California Tax Education Council (CTEC). This course does not qualify for Federal or CA continuing education. 3 Certification and Instructions 1. Gather the IRS and the FTB Publications before beginning The TaxEase Study Guide. 2. The test material has been integrated into the study material, we recommend taking the tests after reading each group of chapters. All tests are open book. 3. The study guides and tests are yours to keep for reference. 4. There is only one correct answer per question; all questions are True (A) / False (B) or multiple choices (A – E). Circle the correct question in your text for reference and enter the correct letter on our answer sheet provided with this material. 5. Complete all test sheets. Make sure your name and the date is on each answer sheet. Send the completed answer sheet, the personal information page and the evaluation to: Mail to: TaxEase, LLC c/o Postal Annex 39270 Paseo Padre Pkwy #627 Fremont CA 94538 Fax: 510-779-5251 6. TaxEase will grade the test, a score of 70% or better is passing. Upon successful passing of the test, we will email you a certificate, bonding information and instructions for registering with the California Tax Education Council to become a registered Tax Preparer in California. Allow 10 days to complete our grading process. Correct answers will not be provided. A paper certificate is available for an $8 charge. 7. If you do not pass the test the first time, you may retake the test within 30 days at no additional charge. 8. TaxEase is confident that you will find the information informative and helpful to your future tax practice. If you wish to return the product, a full refund will be issued upon return of all materials within 30 days of date ordered and prior to submission of any answer sheet for grading. The answer sheet, personal information form and evaluation form is included at the end of this text. Be sure your name is on each page of the answer sheet and the personal information sheet is complete. 4 TABLE OF CONTENTS OBJECTIVES..................................................................................................................................................................... 2 ASSIGNMENTS ................................................................................................................................................................ 3 CERTIFICATION AND INSTRUCTIONS ....................................................................................................................... 4 INTRODUCTION ............................................................................................................................................................ 11 PTINS FOR EVERYONE ............................................................................................................................................ 11 CHAPTER 1 - THE BASICS ........................................................................................................................................... 13 IRS PUBLICATIONS .................................................................................................................................................. 13 WHO MUST FILE? .................................................................................................................................................... 14 STANDARD DEDUCTION........................................................................................................................................... 14 WHERE TO FILE ADDRESSES FOR TAXPAYERS AND TAX PROFESSIONALS ............................................................... 16 FILING CLAIM FOR REFUND ..................................................................................................................................... 18 ACCOUNTING METHOD AND PERIODS ..................................................................................................................... 19 ACCOUNTING METHODS .......................................................................................................................................... 19 WHICH FORM TO FILE - FORM 1040EZ, FORM 1040A OR FORM 1040? ................................................................... 22 FORM 1040A ........................................................................................................................................................... 22 FORM 1040 .............................................................................................................................................................. 23 CHAPTER 2 – FORM 1040EZ ....................................................................................................................................... 24 FORM 1040EZ SCENARIO ........................................................................................................................................ 25 HIGHLIGHTS OF FORM 1040EZ RETURN .................................................................................................................. 25 CHAPTER 3 – FORM 1040A .......................................................................................................................................... 26 FORM 1040A SCENARIO .......................................................................................................................................... 26 HIGHLIGHTS OF THE FORM 1040A RETURN ............................................................................................................. 26 GENERAL FILING STATUS INFORMATION ................................................................................................................. 28 DEPENDENTS ........................................................................................................................................................... 30 PUB 17 – QUALIFYING CHILD/QUALIFYING RELATIVE CHART ................................................................................ 30 PERSONAL EXEMPTIONS .......................................................................................................................................... 31 DEPENDENT EXEMPTIONS........................................................................................................................................ 31 WAGES .................................................................................................................................................................... 31 FORM 1099-R .......................................................................................................................................................... 32 BOX 7: DISTRIBUTION CODES .................................................................................................................................. 33 STANDARD DEDUCTION........................................................................................................................................... 34 EXEMPTIONS ............................................................................................................................................................ 34 CHILD TAX CREDIT – REFER TO CHAPTER 14 FOR A COMPLETE DISCUSSION AND EXAMPLES. ................................ 36 CHAPTER 4 - FILING STATUS AND DEPENDENTS ................................................................................................ 37 FILING STATUS INFORMATION ................................................................................................................................. 37 QUALIFYING WIDOW(ER) ........................................................................................................................................ 37 COMMUNITY PROPERTY STATES ............................................................................................................................. 39 HEAD OF HOUSEHOLD FILING STATUS .................................................................................................................... 40 WORKSHEET FOR COST OF KEEPING UP A HOME ..................................................................................................... 40 PERSONAL EXEMPTIONS .......................................................................................................................................... 41 DEPENDENT EXEMPTIONS........................................................................................................................................ 41 QUALIFYING CHILD ................................................................................................................................................. 43 TIE-BREAKER RULES ............................................................................................................................................... 49 QUALIFYING RELATIVE ........................................................................................................................................... 49 MULTIPLE SUPPORT AGREEMENT ............................................................................................................................ 51 5 CHAPTER 5 – WHERE TO REPORT INCOME ............................................................................................................ 52 WHERE TO REPORT INCOME .................................................................................................................................... 52 FORM W-4 ............................................................................................................................................................... 53 WITHHOLDING ON TIPS............................................................................................................................................ 57 FORM W-2 ............................................................................................................................................................... 57 2012 - FORM 1040 ................................................................................................................................................... 60 CHAPTER 6 – WAGES, INTEREST AND DIVIDENDS .............................................................................................. 62 EMPLOYEE COMPENSATION..................................................................................................................................... 62 STATUTORY EMPLOYEE ........................................................................................................................................... 62 MISCELLANEOUS COMPENSATION ........................................................................................................................... 63 LIFE INSURANCE PROCEEDS .................................................................................................................................... 63 FRINGE BENEFITS .................................................................................................................................................... 64 EMPLOYEE BENEFITS ............................................................................................................................................... 66 WORKERS’ COMPENSATION .................................................................................................................................... 67 INTEREST INCOME ................................................................................................................................................... 67 DIVIDEND INCOME................................................................................................................................................... 70 NONTAXABLE DISTRIBUTIONS................................................................................................................................. 71 CHAPTER 7 – CANCELLATION OF DEBT, REFUNDS, ALIMONY AND INDEPENDENT CONTRACTOR ...... 73 CANCELLATION OF DEBT......................................................................................................................................... 73 QUALIFIED PRINCIPAL RESIDENCE INDEBTEDNESS.................................................................................................. 75 STATE TAX REFUND ................................................................................................................................................ 77 CHAPTER 8 - BUSINESS INCOME – SCHEDULE C .................................................................................................. 80 MAJOR ATTRIBUTES OF SCHEDULE C ...................................................................................................................... 80 PRINCIPAL BUSINESS OR PROFESSIONAL ACTIVITY CODES ..................................................................................... 83 TRAVEL, MEALS AND ENTERTAINMENT EXPENSES ................................................................................................. 87 PENSION PLANS ....................................................................................................................................................... 93 BUSINESS USE OF HOME .......................................................................................................................................... 93 SCHEDULE SE .......................................................................................................................................................... 95 HOBBY VS. BUSINESS INCOME ................................................................................................................................. 99 CHAPTER 9 - CAPITAL ASSETS ............................................................................................................................... 101 STOCKS, BONDS AND MUTUAL FUNDS .................................................................................................................. 103 SALE OF STOCK - 1099-B....................................................................................................................................... 103 SECURITIES SUBJECT TO REPORTING ..................................................................................................................... 104 FIRST-IN, FIRST-OUT METHOD OF IDENTIFICATION (FIFO) .................................................................................. 105 SPECIFIC IDENTIFICATION METHOD ....................................................................................................................... 105 AVERAGE COST BASIS, SINGLE CATEGORY METHOD (MUTUAL FUNDS) .............................................................. 106 AVERAGE COST BASIS, DOUBLE CATEGORY METHOD (MUTUAL FUNDS) ............................................................ 106 REPORTING ON FORM 8949 AND SCHEDULE D ...................................................................................................... 109 WASH SALES ......................................................................................................................................................... 112 BASIS REPORTING WHEN TRANSFERRING SECURITIES ........................................................................................... 113 ORGANIZATIONAL ACTIONS WHICH AFFECT BASIS .............................................................................................. 113 SALE OF BUSINESS PROPERTY (FORM 4797) AND INSTALLMENT SALES (FORM 6252) .......................................... 114 CHAPTER 10 - TYPES OF IRA’S AND EMPLOYER SPONSORED PENSION PLANS - DISTRIBUTIONS ....... 116 ROTH IRA CONVERSIONS ...................................................................................................................................... 116 REPORTING DISTRIBUTIONS .................................................................................................................................. 116 ROTH IRA DISTRIBUTIONS .................................................................................................................................... 117 REPORTING DISTRIBUTIONS .................................................................................................................................. 117 DISTRIBUTIONS ...................................................................................................................................................... 118 REQUIRED MINIMUM DISTRIBUTION ..................................................................................................................... 118 ROLLOVERS OF PENSIONS AND IRA’S ................................................................................................................... 119 6 FORM 1099-R ........................................................................................................................................................ 120 ADDITIONAL TAXES ON QUALIFIED PLANS (INCLUDING IRA’S) – FORM 5329 ...................................................... 123 EXCEPTIONS TO ADDITIONAL TAXES ON QUALIFIED RETIREMENT PLANS ............................................................ 125 CHAPTER 11 - RENTAL REAL ESTATE, K-1 INCOME AND LOSS, PASSIVE ACTIVITIES ............................. 126 RENTAL INCOME.................................................................................................................................................... 126 RENTAL EXPENSES ................................................................................................................................................ 126 DEPRECIATION (FORM 4562) ................................................................................................................................. 128 SPECIAL DEPRECIATION ALLOWANCE ................................................................................................................... 131 SCHEDULE E .......................................................................................................................................................... 131 ROYALTY INCOME ................................................................................................................................................. 133 COMPREHENSIVE SCHEDULE E EXAMPLE .............................................................................................................. 133 PASS-THROUGH INCOME FROM PARTNERSHIP, S-CORPORATION, ESTATE OR TRUST K-1’S .................................. 141 FARM INCOME ....................................................................................................................................................... 142 CHAPTER 12 - UNEMPLOYMENT COMPENSATION, SOCIAL SECURITY BENEFITS AND MISCELLANEOUS INCOME ........................................................................................................................................................................ 145 UNEMPLOYMENT COMPENSATION ......................................................................................................................... 145 SOCIAL SECURITY BENEFITS ................................................................................................................................. 146 COMPREHENSIVE EXAMPLE OF TAXABLE SOCIAL SECURITY INCOME ................................................................... 147 SOCIAL SECURITY.................................................................................................................................................. 147 MISCELLANEOUS INCOME ITEMS ........................................................................................................................... 149 CHAPTER 13- ADJUSTMENTS TO INCOME ........................................................................................................... 151 HEALTH SAVINGS ACCOUNT ................................................................................................................................. 152 IRC §401(K) .......................................................................................................................................................... 154 ALIMONY PAID ...................................................................................................................................................... 155 IRA ....................................................................................................................................................................... 156 ROTH IRA ............................................................................................................................................................. 158 CHAPTER 14 – ITEMIZED DEDUCTIONS ................................................................................................................ 161 STANDARD DEDUCTION VS. ITEMIZED DEDUCTIONS ............................................................................................. 161 ITEMIZED DEDUCTIONS ......................................................................................................................................... 162 TAXES ................................................................................................................................................................... 164 HOME MORTGAGE INTEREST ................................................................................................................................. 166 CHARITABLE CONTRIBUTIONS ............................................................................................................................... 169 EIGHT TIPS FOR DEDUCTING CHARITABLE CONTRIBUTIONS ................................................................................. 171 CASUALTY AND THEFT .......................................................................................................................................... 172 DEDUCTIONS SUBJECT TO 2% OF ADJUSTED GROSS INCOME ................................................................................ 173 FORM 2106 - EMPLOYEE BUSINESS EXPENSES ...................................................................................................... 174 DEDUCTIONS SUBJECT TO 2% OF ADJUSTED GROSS INCOME ................................................................................ 180 DEDUCTIONS NOT SUBJECT TO 2% LIMIT – SCHEDULE A, LINE 28........................................................................ 180 2013 ITEMIZED DEDUCTIONS LIMITATION WORKSHEET ....................................................................................... 182 CHAPTER 15 - TAXES AND CREDITS ...................................................................................................................... 183 TAX ....................................................................................................................................................................... 183 TAX ....................................................................................................................................................................... 183 “KIDDIE TAX” - TAX ON INVESTMENT INCOME OF CERTAIN MINOR CHILDREN .................................................... 184 REPORTING OF CHILD’S INTEREST AND DIVIDENDS AT PARENT’S TAX RATE ....................................................... 184 FORM 8814 ............................................................................................................................................................ 184 FORM 8615 – TAX FOR CERTAIN CHILDREN WHO HAVE INVESTMENT INCOME OF MORE THAN $1900 ................. 185 REASONS TO FILE A SEPARATE RETURN FOR THE CHILD: ........................................................................................ 186 ALTERNATIVE MINIMUM TAX ............................................................................................................................... 187 ADDITIONAL MEDICARE TAX ................................................................................................................................ 190 THE MEDICARE PAYROLL TAX .............................................................................................................................. 190 THE MEDICARE SURTAX ON NET INVESTMENT INCOME........................................................................................ 190 7 CREDITS ................................................................................................................................................................ 192 ADOPTION BENEFITS ............................................................................................................................................. 193 CHILD AND DEPENDENT CARE CREDIT .................................................................................................................. 193 CHILD TAX CREDIT -TEN QUICK FACTS ................................................................................................................ 199 FORM 8812, PART I DEPENDENTS WITH ITIN’S ..................................................................................................... 203 EDUCATION CREDITS (IRC SECTION 25(A)) .......................................................................................................... 205 QUICK REFERENCE CHART FOR EDUCATION CREDITS ........................................................................................... 205 RECAPTURE OF EDUCATION CREDIT ...................................................................................................................... 209 QTP AND COVERDELL ESA TERMINOLOGY .......................................................................................................... 209 COVERDELL ESA – SEE IRS PUB. 970 FOR MORE DETAILS................................................................................ 209 U.S. SAVINGS BONDS INTEREST EXCLUSION ......................................................................................................... 212 RETIREMENT SAVINGS CONTRIBUTION CREDIT ..................................................................................................... 214 GENERAL BUSINESS CREDIT .................................................................................................................................. 215 CHAPTER 16 - PAYMENTS, WITHHOLDING AND EARNED INCOME CREDIT ............................................... 218 WITHHOLDING ....................................................................................................................................................... 218 ESTIMATED TAX .................................................................................................................................................... 219 SAMPLE ES VOUCHER WORKSHEET ....................................................................................................................... 222 EXCESS SOCIAL SECURITY AND TIER 1 RRTA WITHHELD .................................................................................... 223 EARNED INCOME CREDIT ...................................................................................................................................... 223 EIC 2012 TAX YEAR ............................................................................................................................................. 224 CHAPTER 17 – REFUNDS, AMOUNT DUE, PTIN & ELECTRONIC FILING ........................................................ 233 REFUND ................................................................................................................................................................. 233 AMOUNT OWED ..................................................................................................................................................... 233 PREPARER REGISTRATION ..................................................................................................................................... 233 ELECTRONIC FILING - FEDERAL AND CALIFORNIA ................................................................................................ 235 ELECTRONIC RETURN ORIGINATOR ....................................................................................................................... 235 SIGNING AN ELECTRONIC RETURN ........................................................................................................................ 236 DIRECT DEPOSIT OF REFUND ................................................................................................................................. 237 IMPORTANT ITEMS REGARDING EFIN’S ................................................................................................................. 239 FORM 8879 ............................................................................................................................................................ 244 FORM 8888 ............................................................................................................................................................ 245 REQUIREMENTS FOR CA E-FILE PARTICIPATION: .................................................................................................. 248 ASSEMBLY OF CA RETURN FROM FORM 540 INSTRUCTIONS ................................................................................. 249 CHAPTER 18 – VARIOUS TAXES.............................................................................................................................. 250 GIFT AND ESTATE TAX .......................................................................................................................................... 250 GIFT AND ESTATE TAX .......................................................................................................................................... 250 FEDERAL AND STATE UNEMPLOYMENT TAX (FUTA AND SUI) ............................................................................ 251 CHAPTER 19 –CALIFORNIA TAX RETURNS .......................................................................................................... 252 WHO MUST FILE A CALIFORNIA TAX RETURN? .................................................................................................... 252 STANDARD DEDUCTION......................................................................................................................................... 253 2012 CALIFORNIA TAX RATES AND EXEMPTIONS ................................................................................................. 253 INDIVIDUAL TAX RATES ......................................................................................................................................... 253 2012 CALIFORNIA TAX RATE SCHEDULES ............................................................................................................. 254 EXEMPTION CREDITS 2012..................................................................................................................................... 255 PHASEOUT OF EXEMPTION CREDITS 2012 .............................................................................................................. 255 2013 ITEMIZED DEDUCTIONS LIMITATION WORKSHEET ....................................................................................... 259 FORM 540 2EZ, FORM 540A OR FORM 540 ........................................................................................................... 260 FILING STATUS ...................................................................................................................................................... 260 REGISTERED DOMESTIC PARTNERS ....................................................................................................................... 261 FEDERAL FORM 8958 – NEW FOR TAX YEAR 2012................................................................................................ 262 GENERAL RULES – PROPERTY INCOME: COMMUNITY OR SEPARATE? ................................................................... 263 HEAD OF HOUSEHOLD AUDIT PROCESS ................................................................................................................. 265 8 TIME/DATES QUALIFYING PERSON WAS IN THE HOME ......................................................................................... 266 HOH AUDIT LETTER .............................................................................................................................................. 267 GROSS INCOME ...................................................................................................................................................... 270 TYPES OF INCOME ................................................................................................................................................ 270 CHAPTER 20 - CA RESIDENCY/ NON-RESIDENCY/ELECTRONIC FILING ....................................................... 272 DETERMINING CA TAX AS A NONRESIDENT .......................................................................................................... 274 SCHEDULE CA (540NR), CALIFORNIA ADJUSTMENTS –NONRESIDENTS ............................................................... 274 SCHEDULE CA (540 NR) PAGE 1 AND 2 ................................................................................................................ 276 MULTIPLE SCENARIOS OF A FULL YEAR NONRESIDENT RETURN.......................................................................... 277 IRA DEDUCTIONS WHEN A NONRESIDENT WORKING IN CA ................................................................................. 278 STOCK OPTIONS..................................................................................................................................................... 279 SAFE HARBOR ....................................................................................................................................................... 280 INCOME FORM 540NR ........................................................................................................................................... 282 CA ELECTRONIC FILING ........................................................................................................................................ 283 NEW FOR 2012 ....................................................................................................................................................... 283 MANDATORY INDIVIDUAL ELECTRONIC FUNDS TRANSFER (EFT) ........................................................................ 284 MYFTB ACCOUNT FOR INDIVIDUALS .................................................................................................................... 284 DIFFERENCES BETWEEN THE IRS AND FTB E-FILE PROGRAMS ............................................................................. 286 FORM 8454 – E-FILE OPT OUT ............................................................................................................................... 288 FORM 8453 ............................................................................................................................................................ 293 CA FORM 8879 ...................................................................................................................................................... 295 CHAPTER 21 - CALIFORNIA CONFORMITY, SCHEDULE CA AND MILITARY ............................................... 297 CALIFORNIA DIFFERENCES NOTED IN SB 401: ....................................................................................................... 297 HEALTH COVERAGE FOR ADULT CHILDREN UP TO AGE 27 ................................................................................... 298 MILITARY .............................................................................................................................................................. 304 CA INCOME ........................................................................................................................................................... 306 CHAPTER 22 – AMT, CREDITS AND OTHER ITEMS ............................................................................................. 308 2012 CA ALTERNATIVE MINIMUM TAX – SCHEDULE P ........................................................................................ 308 KIDDIE TAX - CHILDREN UNDER THE AGE OF 14 WITH INVESTMENT INCOME....................................................... 308 EXCESS SDI OR VPDI WITHHELD ......................................................................................................................... 309 SAMPLE ES VOUCHER WORKSHEET ....................................................................................................................... 311 MENTAL HEALTH TAX .......................................................................................................................................... 312 UNDERPAYMENT PENALTIES EXCEPTIONS ............................................................................................................ 312 ORDERING OF CREDITS .......................................................................................................................................... 314 CA CHILD AND DEPENDENT CARE CREDIT - FORM 3506 ...................................................................................... 314 OTHER STATE TAX CREDIT ................................................................................................................................... 317 FORM 540, PAGE 2 – SPECIAL CREDITS ................................................................................................................. 322 SCHEDULE P, PAGE 2 ............................................................................................................................................. 323 INTEREST AND PENALTIES ..................................................................................................................................... 324 POWER OF ATTORNEY ........................................................................................................................................... 324 VOLUNTARY CONTRIBUTIONS ............................................................................................................................... 325 USE TAX ................................................................................................................................................................ 325 WHERE TO REPORT USE TAX ................................................................................................................................ 327 USE TAX WORKSHEET ........................................................................................................................................... 328 EXAMPLES REGARDING USE TAX ......................................................................................................................... 329 CHAPTER 23 ETHICS – FEDERAL AND CALIFORNIA.......................................................................................... 331 INTERNAL REVENUE CODE .................................................................................................................................... 331 CIRCULAR 230 ....................................................................................................................................................... 331 DISTRICT COURT INJUNCTION ............................................................................................................................... 331 PRACTICAL EXAMPLES .......................................................................................................................................... 334 § 10.21 KNOWLEDGE OF CLIENT’S OMISSION........................................................................................................ 334 DUE DILIGENCE ..................................................................................................................................................... 334 9 CONFLICT OF INTEREST ......................................................................................................................................... 337 § 10.30 SOLICITATION ........................................................................................................................................... 338 FINAL DECISIONS .................................................................................................................................................. 339 DISCLOSURE .......................................................................................................................................................... 340 INTERNAL REVENUE CODE §7216 ......................................................................................................................... 340 REVENUE PROCEDURE 2013-14 ............................................................................................................................. 341 § 10.27 - FEES. ....................................................................................................................................................... 344 SANCTIONS FOR THE VIOLATION OF REGULATIONS ............................................................................................... 344 §10.50 SANCTIONS ................................................................................................................................................ 344 CIRCULAR 230, SUBCHAPTER C §10.51- INCOMPETENCE AND DISREPUTABLE CONDUCT. .................................... 345 FORM 8275 ............................................................................................................................................................ 346 RETURN PREPARER PENALTIES UNDER IRC SECTION 6694 .................................................................................. 346 PREPARER PENALTIES UNDER IRC SECTION 6695 ................................................................................................ 347 NATIONAL TAXPAYER ADVOCATE – REPORT TO CONGRESS ................................................................................. 352 TRADE OR BUSINESS EXPENSES UNDER IRC § 162 AND RELATED SECTIONS........................................................ 353 DAMAGE AWARDS................................................................................................................................................. 357 DISCHARGE OF INDEBTEDNESS .............................................................................................................................. 357 STANDARDS WITH RESPECT TO TAX RETURNS AND DOCUMENTS ........................................................................... 358 § 10.36 – PROCEDURES TO ENSURE COMPLIANCE ................................................................................................. 359 SOME “DIRTY DOZEN” AND TAX LAW CASES ....................................................................................................... 360 IDENTITY THEFT .................................................................................................................................................... 360 PHISHING ............................................................................................................................................................... 361 RETURN PREPARER FRAUD .................................................................................................................................... 363 HIDING INCOME OFFSHORE ................................................................................................................................... 364 “FREE MONEY” FROM THE IRS & TAX SCAMS INVOLVING SOCIAL SECURITY ...................................................... 365 FALSE/INFLATED INCOME AND EXPENSES ............................................................................................................. 365 FALSE FORM 1099 REFUND CLAIMS ...................................................................................................................... 366 FRIVOLOUS ARGUMENTS ....................................................................................................................................... 367 FALSELY CLAIMING ZERO WAGES ........................................................................................................................ 367 ABUSE OF CHARITABLE ORGANIZATIONS AND DEDUCTIONS ................................................................................ 368 CALIFORNIA - CTEC ............................................................................................................................................. 370 TAX PREPARER CODE OF CONDUCT AND RESPONSIBILITIES.................................................................................. 370 PREPARER PENALTIES............................................................................................................................................ 372 APPENDIX .................................................................................................................................................................... 373 MEDICAL SAVINGS ACCOUNT (MSAS).................................................................................................................. 375 TAX DEDUCTION FOR LONG-TERM CARE INSURANCE........................................................................................... 376 ANNUAL EXCLUSION FOR GIFTS ............................................................................................................................ 376 COMMUNITY PROPERTY INCOME........................................................................................................................... 377 FORM 8958 – NEW FOR TAX YEAR 2012 ............................................................................................................... 377 GENERAL RULES – PROPERTY INCOME: COMMUNITY OR SEPARATE? ................................................................... 377 SAFE HARBOR METHOD FOR OFFICE IN HOME ...................................................................................................... 380 AFFORDABLE CARE ACT TAX PROVISIONS............................................................................................................ 384 ADDITIONAL MEDICARE TAX ................................................................................................................................ 384 THE MEDICARE PAYROLL TAX .............................................................................................................................. 384 THE MEDICARE SURTAX ON NET INVESTMENT INCOME........................................................................................ 385 REPORTING EMPLOYER PROVIDED HEALTH COVERAGE IN FORM W-2 ................................................................. 386 REQUIREMENT TO HAVE HEALTH INSURANCE ...................................................................................................... 387 HEALTH INSURANCE PREMIUM TAX CREDIT ......................................................................................................... 389 THE PREMIUM TAX CREDIT: .................................................................................................................................. 390 KEY FACTS ABOUT THE PREMIUM TAX CREDIT:.................................................................................................... 390 HOW THE PREMIUM TAX CREDIT WORKS ............................................................................................................. 391 DISCLOSURE OF TAX RETURN INFORMATION ........................................................................................................ 392 ETHICS .......................................................................................................................................................................... 395 REV. PROC. 2013-14 – DISCLOSURE OR USE PERMITTED ONLY WITH TAXPAYERS CONSENT .................................. 395 10 FINAL EXAM QUESTIONS 2013................................................................................................................................ 407 CHAPTER 9 QUESTIONS ............................................................................................................................................ 442 TAXEASE, LLC 2013 - 60 HOUR “BECOME A TAX PREPARER” EVALUATION ............................................. 520 Introduction PTINs for Everyone Beginning January 1, 2011, all paid preparers must have a Preparer Tax Identification Number before preparing returns. In addition, all enrolled agents are required to have a PTIN. You can sign up for your PTIN online or by paper application. It costs $64.25. To submit a first-time PTIN application, view this PTIN Application checklist to get started. Before you begin your PTIN application, be sure you have the following available: Social Security Number Personal information (name, mailing address, date of birth) Business information (name, mailing address, telephone number) Previous year’s individual tax return (name, address, filing status) Explanations for felony convictions (if any) 2 Explanations for problems with your U.S. individual or business tax obligations (if any) Credit or debit card for the $64.25 PTIN user fee If applicable, your supervisor’s PTIN If applicable, any U.S.-based professional certification information (CPA, attorney, enrolled agent, enrolled retirement plan agent, enrolled actuary, certified acceptance agent, or state license) including certification number, jurisdiction of issuance, and expiration date PTINs that were obtained for the prior filing season expire on December 31. Renewal costs are $63. To renew your PTIN online, just follow four easy steps: Access Your Account — if you do not remember your password or user ID, click the Forgotten Password or Forgotten User ID buttons. Renew Your PTIN — Complete the online renewal application. You must verify your personal information and answer a few new questions. View a checklist of what you need before you get started. Pay Your Fee — Pay the $63 renewal fee via credit card or direct debit. View Your Next Steps — Review your next steps, including any testing and continuing education requirements. Remember to renew your PTIN each calendar year. A PTIN must be obtained by all tax return preparers who are compensated for preparing or assisting in the preparation of, all or substantially all of any U.S. federal tax return, claim for refund, or other tax form submitted to the IRS except the following: Form SS-4, Application for Employer Identification Number; Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding; 11 Form SS-16, Certificate of Election of Coverage under FICA; Form W-2 series of returns; Form W-7, Application for IRS Individual Taxpayer Identification Number; Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding; Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Over assessment; Form 872, Consent to Extend the Time to Assess Tax; Form 906, Closing Agreement On Final Determination Covering Specific Matters; Form 1098 series; Form 1099 series; Form 2848, Power of Attorney and Declaration of Representative; Form 3115, Application for Change in Accounting Method; Form 4029, Application for Exemption From Social Security and Medicare Taxes and Waiver of Benefits; Form 4361, Application for Exemption From Self-Employment Tax for Use by Ministers, Members of Religious Orders and Christian Science Practitioners; Form 4419, Application for Filing Information Returns Electronically; Form 5300, Application for Determination for Employee Benefit Plan; Form 5307, Application for Determination for Adopters of Master or Prototype or Volume Submitter Plans; Form 5310, Application for Determination for Terminating Plan; Form 5500 series; Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips; Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests; Form 8288-B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests; Form 8508, Request for Waiver From Filing Information Returns Electronically; Form 8717, User Fee for Employee Plan Determination, Opinion, and Advisory Letter Request; Form 8809, Application for Extension of Time to File Information Return; Form 8821, Tax Information Authorization; Form 8942, Application for Certification of Qualified Investments Eligible for Credits and Grants Under the Qualifying Therapeutic Discovery Project Program 12 Chapter 1 - The Basics Note: All information presented in this course is based on 2012 tax year unless separately stated. IRS Publications On page 3 of this text, we recommend IRS Publications. Publication 17 and Form 1040 Instructions are extremely valuable when preparing returns. Publication 17 outlines the basics and gives references throughout of other publications for specific items. Form 1040 Instructions provide line-by-line instructions for filling out Form 1040 and makes reference to the other forms, which must be completed in a particular return. Pub.17 13 Who Must File? All US citizens, regardless of where they live, and resident aliens must determine whether they are required to file a tax return. The determination is based on the following three factors: 1. Gross Income1 (shown in the chart on the previous page) 2. Filing Status2 - Discussed in Chapter 4 of this text a. Single – unmarried in the tax year b. Married Filing Joint (MFJ) – married on the tax year and filing with their spouse c. Married Filing Separate (MFS) – married and filing a separate return from their spouse d. Head of Household (HOH) – unmarried or considered unmarried in the tax year and provides a home for a qualifying individual. (See chapter 4) e. Qualifying Widow(er) (QW) – filing status available for the first two years after the death of his or her spouse providing the taxpayer has paid over half the cost of keeping up the home; the taxpayer has a dependent child or stepchild who lived with them all of the tax year; and had filed joint with their deceased spouse 3. Age A return must be filed if any of the following four conditions below apply: 1. The taxpayer owes special taxes, such as Social Security or Medicare taxes on tips that were not reported to the employer, Alternative Minimum Tax, recapture taxes or tax on a qualified plan including IRA or other tax-favored account. 2. The taxpayer had earnings from self-employment of at least $400. 3. Any advanced earned income payments were received. 4. There are wages of $108.28 or more from a church that is exempt from employer social security and Medicare taxes. Standard Deduction The standard deduction is a dollar amount that reduces the amount of income on which the taxpayer is taxed. The standard deduction is allowed only if the taxpayer does not have itemized deductions. In general, the basic standard deduction is an amount relative to each tax year and varies according to the filing status. The standard deduction of an individual who can be claimed as a dependent on another person's tax return is the greater of: An amount specified by law, or The individual's earned income plus a specified amount up to the basic standard deduction for his or her filing status In some cases, the standard deduction can consist of two parts, the basic standard deduction and additional standard deduction amounts, for age, or blindness, or both. The additional amount is an amount specified by law and varies based on the filing status. 1 2 IRC §6012 IRC §2 14 The additional amount for age will be allowed if the taxpayer is age 65 or older at the end of the tax year. The taxpayer is considered 65 on the day before their 65th birthday. The additional amount for blindness will be allowed if the taxpayer is blind on the last day of the tax year. Certain individuals are not entitled to the standard deduction. They are: A married individual filing a separate return whose spouse itemizes deductions, An individual who was a nonresident alien or dual status alien during any part of the year, or An individual who files a return for a period of less than 12 months due to a change in his or her annual accounting cycle Standard Deduction 2012 Standard Tax Year Deductions 2012 S HH MFJ/QW MFS $5,950 $8,700 $11,900 $5,950 Standard Deduction 20133 Standard Tax Year Deductions 2013 $6,100 S $8,950 HH $12,200 MFJ/QW $6,100 MFS Additional Standard Deduction, Age 65 and Over or Blind $1,450 $1,450 $1,150 $1,150 Additional Standard Deduction, Age 65 and Over or Blind $1,500 $1,500 $1,200 $1,200 When to File? Tax returns for individual taxpayers are due by the 15th day of the fourth month after the close of the tax year (April 15 for calendar year taxpayers). If the return is filed after this date, it is subject to interest and penalties.4 If the taxpayer needs an extension of time Form 4868, requesting an automatic 6-month extension must be filed. If the return is due on April 15, the taxpayer will have until October 15 to file the return. The extension can be filed through electronic filing or on paper. If the taxpayer is a US Citizen and out of the country on the due date of the return an automatic 2-month extension is allowed without filing Form 4868. The extension of time is regarding filing not payment of tax. If the tax is not paid by the regular due date the taxpayer will owe interest and possibly penalties. The due date that falls on a Saturday, Sunday or legal holiday for filing tax forms is delayed until the next business day. 3 4 Rev. Proc 2013-15 IRC § 6651 15 Where to File Addresses for Taxpayers and Tax Professionals and you are filing a Form ... and you ARE NOT ENCLOSING A PAYMENT, then use this address ... and you ARE ENCLOSING A PAYMENT, then use this address ... 1040 Department of the Treasury Internal Revenue Service Fresno, CA 93888-0002 Internal Revenue Service P.O. Box 7704 San Francisco, CA 94120-7704 1040A Department of the Treasury Internal Revenue Service Fresno, CA 93888-0015 Internal Revenue Service P.O. Box 7704 San Francisco, CA 94120-7704 1040EZ Department of the Treasury Internal Revenue Service Fresno, CA 93888-0014 Internal Revenue Service P.O. Box 7704 San Francisco, CA 94120-7704 N/A Internal Revenue Service P.O. Box 510000 San Francisco, CA 94151-5100 N/A Internal Revenue Service P.O. Box 1300 Charlotte, NC 28201-1300 N/A Internal Revenue Service P.O. Box 7704 San Francisco, CA 94120-7704 1040X Department of the Treasury Internal Revenue Service Fresno, CA 93888-0422 Department of the Treasury Internal Revenue Service Fresno, CA 93888-0422 4868 Department of the Treasury Internal Revenue Service Fresno, CA 93888-0045 Internal Revenue Service P.O. Box 7122 San Francisco, CA 94120-7122 1040-ES 1040-ES(NR) 1040V If you live in CALIFORNIA ... 16 Paying the Amount Owed The taxpayer can pay online, by phone, or by check or money order. Estimated tax payments are made separately and should not be included. The taxpayer should make their check or money order payable to “United States Treasury” for the full amount due. They cannot send cash. They should not attach the payment to their return. The correct name, address, SSN, daytime phone number, and the tax year and form number on should be shown the front of the check or money order. If filing a joint return, the taxpayer must enter the SSN of the taxpayer shown first on the tax return. Bad check or payment. The penalty for writing a bad check to the IRS is $25 or 2% of the check, whichever is more. This penalty also applies to other forms of payment if the IRS does not receive the funds. 17 Interest Charged on Late Payments Interest will be charged on tax returns not paid by the due date, even if an extension of time is granted. Interest is also charged on penalties imposed for failure to file, negligence, fraud, substantial valuation misstatements, and substantial understatements of tax. Interest is charged on the penalty from the due date of the return (including extensions). The IRS will pay interest on overpayment of tax if the refund is not issued 45 days after the tax return is filed. If the refund is issued within 45 days of the filing, date there is no interest. The interest adjusts quarterly. Accepting a check from the IRS does not change the right of the taxpayer to claim an additional refund and interest. A claim for additional refund should be filed on Form 1040X. Filing Claim for Refund A claim for refund must be filed within three years after the date of the original return or within 2 years after the date the tax was paid, whichever is later. Returns filed before the due date (without regard to extensions) are considered filed on the due date (even if the due date was a Saturday, Sunday, or legal holiday). The following exceptions apply: Disability – The period of limitation for filing a claim for a refund is suspended while the taxpayer is unable to manage financial affairs due to disability. Bad Debts and worthless securities – the periods is extended seven years from the due date of filing the return for the year of worthlessness. Net Operating losses - If a claim for a refund relates to an overpayment attributable to an NOL carryback, the period for filing for a refund ends three years after the due date for the taxable year of the NOL. Agreements- Claim based on an agreement with the IRS extending the period for assessment of tax. Amended Returns Errors and omissions on a return can lead to additional refund or additional amount owed. The return should be corrected if: 1. Not all income was reported 2. Deductions and credits were claimed that should not have been claimed. 3. Deductions and credits were not claimed that should have been claimed. 4. The filing status claimed was incorrect. If Form 1040X is filed on or before the due date of the original return, the amended return is treated as the original return. Once an accounting method is chosen on an original return, the accounting method cannot be changed on Form 1040X even if the tax year is not closed. A separate Form 1040X must be filed for every year being changed. Interest and Penalties are not included on Form 1040X, the interest and penalties will be adjusted accordingly. It takes 8 to 10 weeks for an amended return to be processed. (Refer to Form 1040X instructions for further information). 18 Penalties Refer to Ethics Section of this text for additional information Late Filing and failure to file5: If the return is not filed by the due date (including extensions), the penalty is usually 5% of the amount due for each month or part of the month the return is late, unless there is a reasonable explanation. The explanation must be attached to the return. The penalty can be as much as 25% (more in some cases) of the tax due. If the return is more than 60 days, late the minimum penalty will be $100 or the amount of any tax owed whichever is smaller. Late Payment of Tax6: If the taxes owed are paid late the penalty is usually 1/2 of 1% of the unpaid amount for each month or part of the month the tax is not paid. This is known as the failure-to pay penalty. The penalty can be as much as 25% of the unpaid amount. It applies to any unpaid amount on the return. This penalty is in addition to interest charges on the late payments. The penalty does not apply during the automatic 6-month extension of time to file. Negligence and disregard7: The term negligence includes failure to make a reasonable attempt to comply with the tax law or to exercise ordinary and reasonable care in preparing the tax return and adequate books and records. This accuracy penalty includes any careless, reckless, or intentional disregard. Substantial understatement of income tax8: An understatement is considered substantial if it is more than the largest of 10% of the correct tax or $5,000. Negligence, disregard and substantial understatement of income are all considered accuracy related penalties. Accuracy related penalty is equal to 20% of the underpayment. Accounting Method and Periods Accounting Methods9 An accounting method is a set of rules used to determine when and how income and expenses are reported. The accounting method includes not only the overall method of accounting used, but also the accounting treatment used for any material item. The accounting method for the sole proprietorship is determined when the first income tax return is filed that includes a Schedule C for the business. After that, IRS approval is required for a change in accounting method. Kinds of methods: Generally, any of the following accounting methods can be used: Cash method. An accrual method. Special methods of accounting for certain items of income and expenses. Combination method using elements of two or more of the above. The same accounting method must be used to figure the taxable income and to keep the books. 5 IRC §6651(a) (1) IRC §6651(a)(2)/6651(h) 7 IRC §6662 8 IRC §6662 9 Rev. Proc 2011-14, Pub 538 6 19 Business and personal items: The taxpayer can account for business and personal items under different accounting methods. For example, the business can be computed using an accrual method, even if using the cash method to figure personal items. Two or more businesses: If the taxpayer has two or more separate and distinct businesses, they can use a different accounting method for each if the method clearly reflects the income of each business. They are separate and distinct only if they maintain complete and separate books and records for each business. Cash method: The cash method is the most common method of accounting. The major difference between cash and accrual is that a cash-method taxpayer recognizes income and expenses at the point in time that the money is actually received or paid. In contrast, an accrualmethod taxpayer generally reports income at the time the sale is made even if the customer does not pay at that time, and reports expenses as they become due rather than by the date that the expenses are paid. Fortunately, the IRS allows small service businesses that also sell related products and have average annual gross receipts under $10 million to use the cash method of accounting for their income and expenses. The major requirement to qualify for this relief is that the principal business activity (i.e., over half of the gross receipts) must be the provision of services. Under the cash method, include the gross income for all items of income actually or constructively received during the tax year. If property or services are received, they must include the fair market value in income. Constructive receipt: Constructive receipt of income is when an amount is credited to the taxpayer’s account or made available without restriction. The taxpayer does not need to have possession of it. Accrual basis taxpayers cannot delay recognition of income by not taking control of money that the taxpayer is entitled to receive. Under the cash method, income is recognized when it is actually or constructively received. Example: A customer pays the bill with a check on December 30, 2012. The sole proprietor has constructively received the money and must count it as income in 2012, even if the sole proprietor does not cash the check or deposit it into the bank account until sometime in January of 2013. The sole proprietor cannot hold checks or postpone taking possession of similar property from one tax year to another to avoid paying tax on the income. They must report the income in the year the property is received or made available without restriction. Receipt of a valid check by the end of the tax year is constructive receipt of income in that year, even if it is not cashed or deposited until the following year. Debts paid by another person or canceled by creditors, the sole proprietor may have to report part or all of this debt relief as income. If income is received in this way, the constructive receipt of the income is when the debt is canceled or paid. Debt relief of a business expense for a sole proprietorship is income and reported on the Schedule C. 20 Expenses Under the cash method, generally deduct expenses in the tax year in which they were actually paid, even if they were incurred in an earlier year. This includes business expenses for which the taxpayer contests liability. Expenses paid in advance: Deduct an expense paid in advance only in the year to which it applies. Accrual Method: Under the accrual method, the taxpayer records business income when a sale occurs, whether it is the delivery of a product or the rendering of a service, regardless of when the taxpayer is paid. The record of an expense is acknowledged when goods or services are received, even though the taxpayer may not pay for them until later. To be more precise, under the accrual method the taxpayer recognizes an item of income when all the events that establish their right to receive the income has happened, and when the amount of income received is known with reasonable accuracy. If the amount is estimated with reasonable accuracy and recorded it as income, and the amount eventually received differs from the estimate, the adjustment to income should be made in the year the taxpayer actually received the payment. Example: Jack uses QuickBooks to maintain his books. Jack purchases his dye, plastic in bulk and some of it was used in 2012, and the rest was kept in inventory. Since it is the first year for this business, the beginning inventory is -0-. Jack also purchased several materials that were used to create his pumpkins that was ordered and paid for in December 2012 and was received in January 2013. Jack uses the accrual method, so the materials ordered and paid for in December are taken as an expense in 2012. Ninety-five percent of Jack’s income is from Internet Sales, although he is working on getting the product into local specialty stores. All the money from sales is deposited directly into Jack’s bank within 24 hours. He has constructive receipt at the time the money is deposited from the sale because all deposits are available for immediate withdrawal. Sales made on December 31 would be included in 2013 because his clients can cancel or adjust the quantity of the sale until the sale is final when it is deposited. Calendar Year: If the first filed income tax return was filed using the calendar tax year and the taxpayer later begins business as a sole proprietor, the taxpayer must continue to use the calendar tax year unless they get IRS approval to change the accounting period. A sole proprietor using a calendar year must keep their records from January 1 through December 31. Fiscal tax year: A fiscal tax year is 12 consecutive months ending on the last day of any month except December. 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 a month. If the taxpayer adopts a fiscal year, they must 21 keep their books and records and report the income and expenses using the same tax year10. Example: A ski resort is open only during the months of December through March - the winter resort season. If the books are kept based on a calendar year, the accounting period would split the season, and distortion of income would result. Therefore, what would appear as a profit as of December 31, the close of the calendar year, may turn out to be a loss, or vice versa, when the entire season, December through March, is considered. The use of the calendar year would require the operators to take inventories and make other determinations in the middle of the season when they have the least amount of time available. The use of a fiscal year that included the entire season would make it possible to avoid these difficulties. Change in tax year: Generally, the taxpayer must file Form 1128, Application to Adopt, Change, or Retain a Tax Year, to request IRS approval to change the tax year. See the Instructions for Form 1128 for exceptions and for information about user fees if requesting a ruling. Which Form to File - Form 1040EZ, Form 1040A or Form 104011? The taxpayer can use Form 1040 EZ if the following is true: a) The filing status is single or married filing a joint return b) The taxpayer (and spouse if married filing joint) were under age 65 and not blind at the end of the year. c) There are no dependents on the return d) The taxable income is less than $100,000 e) The taxpayer did not claim any adjustments to income. f) The taxpayer did not claim any credit except EIC. g) The only income is from salaries, wages, tips, taxable scholarship or fellowship grants, unemployment compensation, Alaska Permanent Fund and the taxable interest is not over $1,500 Form 1040A The taxpayer can use Form 1040A if all of the following apply. 1. The income is only from: a) Wages, salaries, and tips, b) Interest, c) Ordinary dividends (including Alaska Permanent Fund dividends), d) Capital gain distributions* e) IRA distributions, f) Pensions and annuities, g) Unemployment compensation, h) Taxable social security and railroad retirement benefits, and i) Taxable scholarship and fellowship grants. *If the taxpayer receives a capital gain distribution that includes unrecaptured section 10 11 Pub 538 IRS Pub. 17 22 2. 3. 4. 5. 6. 7. 1250 gain, section 1202 gain, or collectibles (28%) gain, they cannot use Form 1040A. They must use Form 1040. The taxable income is less than $100,000. The adjustments to income are for only the following items. a) Educator expenses. b) IRA deduction. c) Student loan interest deduction. d) Tuition and fees. The taxpayer does not itemize their deductions. They claim only the following tax credits. a) The credit for child and dependent care expenses. b) The credit for the elderly or the disabled. c) The education credits. d) The retirement savings contribution credit. e) The child tax credit. f) The earned income credit. g) The additional child tax credit. The taxpayer did not have an alternative minimum tax adjustment on stock acquired from the exercise of an incentive stock option. The taxpayer can also use Form 1040A if they received employer-provided dependent care benefits or if they owe tax from the recapture of an education credit or the alternative minimum tax. Form 1040 If the taxpayer cannot use Form 1040EZ or Form 1040A, they must use Form 1040. The taxpayer must use Form 1040 if any of the following apply. a) The taxable income is $100,000 or more. b) The taxpayer itemizes deductions on Schedule A. c) Form W-2, box 12, shows uncollected employee tax (social security and Medicare tax) on tips or group-term life insurance. d) The taxpayer received $20 or more in tips in any 1 month and did not report all of them to their employer. e) They were a bona fide resident of Puerto Rico and exclude income from sources in Puerto Rico. f) The taxpayer owes the excise tax on insider stock compensation from an expatriated corporation. g) Form W-2 shows an amount in box 12 with a code Z. h) There is a qualified health savings account funding distribution from your IRA. i) The employer did not withhold social security and Medicare tax. j) The taxpayer has to file other forms with the return to report certain exclusions, taxes, or transactions. k) The taxpayer is in a bankruptcy case filed after October 16, 2005. l) The taxpayer must repay the first-time homebuyer credit. 23 Chapter 2 – Form 1040EZ Taxpayer & Spouse are under 65 and not blind. The taxable income is less than $100,000. The Samples take the standard deduction and there are no additional credits. This return can be filed on Form 1040EZ 24 Form 1040EZ Scenario John and Mary Sample live in Reno NV. John worked the entire year as a mechanic and earned $65,000 with Federal withholding of $7,250. Mary worked for seven months before being laid off. She earned $17,500 with Federal withholding of $2,400. Mary collected unemployment compensation of $10,000 with 10% withholding. Highlights of Form 1040EZ Return On Form 1040EZ the wages, salaries and tips are reported on Line 1. Unemployment compensation and any Federal tax withheld on that compensation are reported to the taxpayer on Form 1099G. The taxpayer includes that amount on Line 3 of Form 1040EZ. The entire amount reported is the amount received. The withholding is totaled with the other withholding on the return and reported on Line 7 of Form 1040 EZ On Form 1040EZ, Line 5 the exemption amount and the standard deduction are combined. There can only be a single filer who would deduct $9,750 ($3,800 exemption plus $5,950 standard deduction); or married filing joint, as in the above example, the deduction will be $19,500 (the exemption of $3,800 for the taxpayer and $3,800 for the spouse plus the standard deduction of $11,900). NOTE: The personal exemption amount for 2012 is $3,800. This amount is not changed by filing status or age (See phaseout of personal exemptions in tax year 2013 in a later chapter.) 25 Chapter 3 – Form 1040A Form 1040A Scenario Peter and Jane Employed lived in Reno, NV with their son Peter Jr. Peter who was born on January 23, 1962 and is employed as a technician. He earned $96,000. (See an example of his W-2 below). Jane was born on July 15, 1966 and is disabled. Jane received Social Security Benefits of $20,300 and had withholding of 15% ($3,045). The amount was reported to her on Form 1099-SSA. Peter Jr was born on June 10, 1995 his social security number is 666-22-3333. Peter’s father died in 2012 and Peter received his IRA of $4,400; see Form 1099R later in this chapter. Highlights of the Form 1040A Return Peter and Jane are filing a joint return. 26 27 General Filing Status Information Generally, the marital status on the last day of the year determines the filing status for the entire year. 28 If the taxpayer and spouse are married at the end of the year, they can use either the married filing joint filing status or the married filing separate filing status. Married Filing Joint Married at the end of the tax year, even if not living together. Both spouses agree to file joint Spouse died during the year and the taxpayer did not remarry Married Filing Separately – The taxpayer chose to file separate. Community property laws affect how the taxpayer figures income on their federal income tax return if they are married, live in a community property state or country, and file separate returns. For federal tax purposes, a marriage means only a legal union between a man and a woman as husband and wife and the word “spouse” refers only to a person of the opposite sex who is a husband or a wife. Form 8958 is used for married spouses in community property states who choose to file married filing separately. This form shows how the income is divided. If the taxpayer is unmarried, or is legally separated from the spouse under a divorce or separate maintenance decree according to state law, and the taxpayer does not qualify for another filing status, the filing status is single. Generally, to qualify for head of household status, the taxpayer must be unmarried and must have paid more than half the cost of maintaining a household that was the main home for a qualifying person for more than half the year. The taxpayer may also qualify for head of household status if, though married, the taxpayer filed a separate return, and the spouse was not a member of the household during the last six months of the tax year, and the taxpayer provided more than half the cost of maintaining the home as a household that was the main home for more than one half of the tax year of a qualifying person. If the taxpayer is married, the taxpayer and spouse may file a joint return or separate returns. If the spouse died and the taxpayer did not remarry in the year that the spouse died, the taxpayer may still file a joint return for that year. This is the last year for which the taxpayer may file a joint return with that spouse. The taxpayer may be able to file as a qualifying widow or widower for the two years following the year the spouse died. To do this, the taxpayer must meet all four of the following tests: A. The taxpayer is entitled to file a joint return with the spouse for the year he or she died. It does not matter whether the joint return was actually filed, B. The taxpayer did not remarry in the two years following the year the spouse died, C. There is a child, stepchild, or adopted child (a foster child does not meet this requirement) for whom the taxpayer can claim a dependency exemption, D. The taxpayer paid more than half the cost of maintaining a household that was the main home for the taxpayer and child the entire year. After the two years following the year in which the spouse died, the taxpayer may qualify for head of household status. 29 Refer to Chapter 4 for a complete discussion of filing status. Dependents Peter Jr. is under 17 years old at the end of 2012 and qualifies as a dependent child. A valid social security number, ITIN or ATIN must be entered for each dependent child. Peter Jr. qualifies for the Child Tax Credit, so an “X” is entered in column 4 of Line 6c. Pub 17 – Qualifying Child/Qualifying Relative Chart 30 Personal Exemptions12 The personal exemption amount for 2012 is $3800; the personal exemption amount for tax year 2013 is $3,900 and $4,000 for 2014. Personal Exemption phase-out (PEP) was revived in the American Taxpayer Relief Act starting in tax year 2013. The applicable income threshold level is as follows: $300,000 for married couples and surviving spouse; $275,000 for head of households; $250,000 for single taxpayers; and $150,000 for married taxpayers filing separately Under the phase-out, the total amount of exemptions that may be claimed by a taxpayer is reduced by two percent for each $2,500 or portion thereof ($1,250 for MFS) by which the taxpayers AGI exceeds the applicable threshold level. Phase-out examples are found later in this text Dependent Exemptions13 The exemption amount for 2012 is $3,800, 2013 is $3,900 and $4,000 for 2014. If the taxpayer is a U.S. citizen, U.S. resident alien, U.S. national or a resident of Canada or Mexico, the taxpayer may qualify for any of the exemptions discussed here. The dependent cannot be claimed as a dependent on another return. 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), the taxpayer can qualify for only one personal exemption for himself. The taxpayer cannot claim exemptions for a spouse or dependents. Wages The amount shown on Line 7, Form 1040 “Wages, salaries, tips, etc.” in the example is Box 1 of Peter’s W-2. Box 1 of Form W-2 may also include bonuses and awards; awards in a settlement or judgment for back pay; payments for damages, unpaid life insurance premiums; and unpaid health insurance premiums. Other common taxable items14 included on Line 7 of Form 1040 include: Excess reimbursements from Form 2106, Unreported tips from Form 4137- See Pub. 531 for more details. Taxable employer provided day care benefits in Box 10 of Form W-2 after exclusion reported on Form 2441. (“DCB” on the dotted line next to line 7.) Wages reported on Form 8919 “Uncollected Social Security and Medicare Tax on Wages”. Taxable Scholarships and Fellowships (refer to Pub 17) (“SCH” on the dotted line next to line 7.) All wages received as a household employee for which the taxpayer did not receive a 12 IRC §151 IRC §152 14 IRS Pub 525 13 31 Form W-2 because an employer paid less than $1,800 in 2012. (“HSH” on the dotted line next to line 7.) Employer-provided adoption benefits, Form W-2 with code T in Box 12. See Instructions for Form 8839 for part or all of the exclusion of adoption benefits. Refer to the instructions for Schedule SE later in this text for information regarding the Social Security Wages (W-2 Box 3) and Medicare Wages and Tips (W-2 Box 5). IRA Distribution15 Peter’s distribution from an IRA from his father is shown on Line 11b of Form 1040A. The only time there is an entry on 11a is if the amount received is different from the taxable amount. Form 1099-R The gross distribution before income tax or other deductions were withheld is shown in Box 1. Including direct rollovers, IRA rollovers to accepting employer plans, premiums paid by a trustee or custodian for the cost of current life or other insurance protection, including a recharacterization and a Roth IRA conversion. Also included in this box distributions to plan participants from governmental section 457(b) plans. However, in the case of a distribution by a trust representing certificates of deposit (CDs) redeemed early, report the net amount distributed. 15 IRC§ 408 32 Included in gross distributions are charges or payments for qualified long-term care insurance contracts under combined arrangements. Enter Code W in box 7. In addition to reporting distributions to beneficiaries of deceased employees, report as gross distributions are any death benefit payments made by employers that are not made as part of a pension, profit sharing, or retirement plan. These entries will have a Code 4 in box 7, as in this example. In addition to reporting distributions to beneficiaries of deceased employees, reported here are any death benefit payments made by employers that are not made as part of a pension, profit sharing, or retirement plan. Also, enter these amounts in box 2a; enter Code 4 in box 7. NOTE: A rollover is defined as a withdrawal of cash or other assets from a qualified retirement plan in an eligible distribution that can defer tax, by rolling it over to another qualified retirement plan or a traditional IRA. Taxable Amount: The following items usually reduce the gross amount reported in Box 1 of Form 1099-R to determine the amount in Box 2a: A direct rollover (other than a qualified rollover contribution under section 408A(e)) from a qualified plan (including a governmental section 457(b) plan) or section 403(b) plan, or a rollover from a designated Roth account into a Roth IRA, A traditional, SEP, or SIMPLE IRA directly transferred to an accepting employer plan, An IRA recharacterization, or A nontaxable IRC §1035 exchange of life insurance, annuity, or endowment contracts. A nontaxable charge or payment, for the purchase of a qualified long-term care insurance contract, against the cash value of an annuity contract or the cash surrender value of a life insurance contract. Box 7: Distribution Codes The following was taken from the 1099R instructions in reference to Box 7. 1. Early distributions, no known exception (in most cases, under 59 1//2). 2. Early distribution, exception applies 3. Disability 4. Death 5. Prohibition transaction 6. Section 1035 exchange (a tax free exchange of life insurance, annuity or endowment contracts) 7. Normal distribution 8. Excess contributions plus earnings/excess deferrals taxable in 2012 9. Cost of current life insurance protection A. May be eligible for 10-year tax option (Form 4972) B. Designated Roth account distribution C. N/A D. N/A E. Distributions under Employee Plans Compliance Resolution System F. Charitable gift annuity 33 G. H. I. J. K. L. M. N. O. P. Q. R. S. T. U. V. W. Direct rollover to a qualified plan, tax-shelter annuity, a governmental 457 (b) plan or an IRA Direct rollover of a designated Roth account distribution to a Roth IRA N/A Early distribution from a Roth IRA. N/A Loans treated as distributions under section 72(p). N/A Recharacterized IRA contribution made for 2010. N/A Excess contributions plus earnings/excess deferrals in 2010. Qualified distribution from a Roth IRA Recharacterized IRA contribution made for 2010. Early distribution from a SIMPLE IRA the first 2 years, no known exception Roth IRA distribution, exception applies. Dividend distributions from ESOP under sec 404(k). N/A Charges or payments for purchasing qualified long-term care insurance contracts under combined arrangements. Refer to Chapter 9 of this text for additional information regarding IRA’s and employer sponsored pension plans. Standard Deduction In our scenario, the Employed’s are married filing a joint return, the standard deduction for married filing joint is $11,900. Taxpayer’s using Form 1040A cannot itemize their deductions. Exemptions The Employed’s can deduct two personal exemptions, one for Peter, one for Jane and one dependent exemption for Peter Jr. The exemption amount shown on Line 26 of Form 1040A represents 3 times $3,800 (the exemption amount). Social Security benefits may be taxable. To find out whether any of the Social Security Benefits received are taxable compare one-half of the benefits plus all other income including tax-exempt with the base amount. The base amount is $25,000 if single, head of household or qualifying widow(er) $25,000 if married filing separately and lived apart from the spouse for the tax year $32,000 if married filing jointly, or -0- if married filing separately and lived with the spouse at any time during the year If one-half of the benefits plus all other income is less than the base amount, none of the social security benefits is taxable. If one-half of the benefits plus all other income is more than the base amount, some of the social security benefits are taxable. The total amount of social security benefits are reported on Line 14A of Form 1040A and the taxable amount are reported on Line 14b. 34 Form 1040A, Line 14a and 14b – Social Security Worksheet The worksheet below is found in Pub 17, for a complete set of worksheets refer to IRS Pub. 915, “Social Security and Equivalent Railroad Retirement Benefits”. Line A = $20,300 Line B = $10,150 Line C = $110,875 Line D = -0Line E = $110,875 Since Line E exceeds the base amount of $32,000 for MFJ return, the amount of taxable social security benefits must be computed. Completed Social Security worksheet below, additional examples found in Chapter 9 of this text. 35 Child Tax Credit – Refer to Chapter 14 for a complete discussion and examples. The Child Tax Credit is an important tax credit that may be worth as much as $1,000 per qualifying child depending upon the taxpayer’s income. 36 Chapter 4 - Filing Status and Dependents Filing Status Information Generally, the marital status on the last day of the year determines the filing status for the entire year. Single The filing status is single if on the last day of the year the taxpayer was unmarried or legally separated under a divorce decree and does not qualify for another filing status. The filing status of the taxpayer may be single if the taxpayer is a widow(er) before January 1 and did not remarry before the end of the year. Qualifying Widow(er) The qualifying widow(er) (QW) is available for the first two years following the year the spouse died if all the following requirements are met: The spouse died in 2010 or 2011 and the taxpayer did not remarry in 2012. The taxpayer has a child or stepchild that they can claim as a dependent. The child lived in the taxpayer’s home all of 2012. The taxpayer paid over half the cost of keeping up the home. The taxpayer filed married filing joint with the deceased spouse in the year of death or could have filed a joint return in that year. Example: Mary and her husband James are married and have a son, Drew, age 7. James passed away on November 19, 2010. Mary and James filed a joint return in 2010. Mary paid over half the cost of keeping up the home and claims Drew, who has continues to live with her, as her dependent on her tax return. Mary has not remarried. Can Mary file using the Qualifying Widow(er) filing status on her 2011 and 2012 tax return? Yes. She meets all the above requirements. James passed away in 2010 Mary has a son who lived with her all year and who she claims as a dependent child. Mary paid over half the cost of keeping up the home Mary and James filed a joint return in 2010 Mary has not remarried The QW filing status uses affects various tax rules in different ways depending on the rule. The following items are treated the same as Married Filing Joint filing status: Tax tables and tax rate tables Standard Deduction Phase-out of IRA deductions for active participation in employer plan Phase-out of Roth IRA Contributions AMT Exemption Phase-out of Exclusion of Interest of Series EE and US Savings Bonds Based on Modified AGI 37 The following items are treated as Single filing status: Social Security and railroad retirement benefits taxable when income exceeds a certain level Phase-out of Child Tax Credit based on AGI Child and Dependent Care Credit Eligibility to claim EIC Phase-out of EIC based on earned income Phase-out of Education Credits based on modified AGI Schedule R Phase-out of Student Loan Tuition and Fees Deduction limit Phase-out of contributions to Coverdell ESA Married Filing Joint (MFJ) Married at the end of the tax year, even if not living together. Both spouses agree to file joint Spouse died during the year and the taxpayer did not remarry A married couple reports combined income and deduct combined allowable expenses. Both the taxpayer and spouse may be held responsible jointly and individually for the tax or any interest or penalty due on the joint return. One spouse may be held responsible for all the tax due even if all the income was earned by the other spouse. Once a taxpayer files a joint return, they cannot choose to file separate returns for that year after the due date of the return. Exception. A personal representative for a decedent can change from a joint return elected by the surviving spouse to a separate return for the decedent. The personal representative has 1 year from the due date of the return (including extensions) to make the change. See Publication 559, Survivors, Executors, and Administrators, for more information on filing a return for a decedent. Married Filing Separately (MFS) – The taxpayer chose to file separate. Community property laws affect how the taxpayer figures income on their federal income tax return if they are married, live in a community property state or country, and file separate returns. For federal tax purposes, a marriage means only a legal union between a man and a woman as husband and wife and the word “spouse” refers only to a person of the opposite sex who is a husband or a wife. Form 8958 is used for married spouses in community property states who choose to file married 38 filing separately. This form shows how the income is divided. Unless the taxpayer is required to file married filing separately, the taxpayer should compare the married filing joint to the married filing separate for the lowest tax. When filing married, filing separately the taxpayer generally will pay more combined tax than married filing joint Limitations Regarding Married Filing Separate 50% of MFJ Standard Deduction, Tax Brackets, AMT Exemptions, Net Capital Loss Deduction ($1,500), Exclusion of Gain on Sale of Home §121, Home Mortgage Interest Limits Income limits Child Tax Credit, Retirement Savings Contribution Credit, Reduction of 50% of MFJ Itemized Deductions ($150,000-Tax Year 2013) Exemption phase-out ($150,000-$211,250 – Tax Year 2013) Credits Earned Income Credit, Elderly and Disable Credit (unless spouses lived apart disallowed all year), Child and Dependent Care Credit*, Adoption Expense Credit** Education Education Credits, Tuition and Fees Deductions, Exclusion of U.S. Savings benefits Bonds Interest, Student Loan Interest Deduction disallowed IRA’s Contributions phase-out is $10,000 (unless spouses lived apart all year) Social Security Is taxable at -0- unless spouses did not live together all year Rental Real Estate Deduction is $12,500 reduced at modified AGI over $50,000. No deduction Loss Limitations if spouses lived together any time during the year * An exception to this rule exists if the taxpayer’s spouse was not a member of the household for the last six months of tax year, and if the taxpayer paid over half the cost of maintaining the principal household during the year for him/herself and a qualifying individual. ** If the filing status is married filing separately in the year that particular qualified adoption expenses are first allowable, the taxpayer will never be eligible to claim the credit or exclusion for the particular expenses unless they amend the return and file a joint return for the year within the period of the statute of limitations If the taxpayer and spouse file separate returns generally, the filing status can be changed to a joint return within three years from the due date of the separate returns. In this situation, a separate return includes a return filed by the taxpayer or spouse using the filing status; married filing separate, single or head of household. NOTE: If the taxpayer filed a joint return, the taxpayer cannot amend the return to file a separate return for that year after the due date of the return. Community Property States Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin are community property states. Income in community property states may be considered separate or community depending on state law. Refer to Pub 555 for more information. Registered domestic partners (RDPs) and same-sex spouses for 2010 and following years, in Nevada, Washington, or California (or a person in California or Washing-ton who is married to a person of the same sex) generally must follow state community property laws and report half the combined community income of the individual and his or her RDP (or California or Washington same-sex spouse). These rules apply to RDPs in Nevada, Washington, and California in 2010 and following years because they have full community property rights in 2010. Nevada RDPs attained these rights as 39 of October 1, 2009. Washington RDPs attained them as of June 12, 2008, and California RDPs attained them as of January 1, 2007. For years prior to 2010, RDPs who reported income without regard to the community property laws may file amended returns to report half of the community income of the RDPs for the applicable periods, but are not required to do so. If one of the RDPs files an amended return to report half of the community income, the other RDP must report the other half. RDPs (and individuals in California and Washington who are married to an individual of the same sex) are not married for federal tax purposes. They can use only the single filing status, or if they qualify, the head of household filing status. Separate property is: Property owned separately by a spouse before marriage Property received separately as gifts or inheritances. Property purchased with separate property funds Money earned while domiciled in separate property states All property declared separate property in a valid agreement (pre-or-post nuptial) Separate property belongs to the spouse who owns it. The taxpayer must maintain the property separately. If they use the property for community purposes, or if they commingle it, it could lose the separate property character, overriding agreements. Head of Household Filing Status Head of Household – The taxpayer is unmarried or considered unmarried on the last day of the year. The taxpayer paid more than half the cost of keeping up a home for the year. Worksheet for Cost of Keeping up a Home Amount Taxpayer Paid Property Taxes Mortgage Interest Expense Rent Utilities Repairs/Maintenance Insurance on the Home Food Consumed in the Home Miscellaneous Home Expenses Total $ Amount Paid by Others Total Cost $ $ If the total amount paid is more than the amount others have paid, the requirement for paying more than half the cost of keeping up the home is met. The cost of keeping up the home for head of household is different from the cost for dependency; do not include the cost of anything not related to the home like clothing or education. One or more qualifying persons lived with the taxpayer in the home for more than half the year. There are two exceptions to the residency requirement, which are temporary absences and dependent parents. 40 Considered Unmarried The taxpayer must file a separate return than their spouse The taxpayer must have paid more than half the cost of keeping up the home for the tax year. The spouse did not live in the home for the last 6 months of the year. The taxpayers home is the home of their child for more than half of the year which they can claim the child as their dependent. The term considered unmarried is used for different items such as head of household filing status and EIC. There are several examples throughout this text. Personal Exemptions16 The personal exemption amount for 2012 is $3800; the personal exemption amount for tax year 2013 is $3,900 and $4,000 for 2014. Personal Exemption phase-out was revived in the American Taxpayer Relief Act starting in tax year 2013. The applicable income threshold level is as follows: $300,000 for married couples and surviving spouse; $275,000 for head of households; $250,000 for single taxpayers; and $150,000 for married taxpayers filing separately Under the phase-out, the total amount of exemptions that may be claimed by a taxpayer is reduced by two percent for each $2,500 or portion thereof ($1,250 for MFS) by which the taxpayers AGI exceeds the applicable threshold level. Phase-out examples are found later in this text. Personal Exemptions The taxpayer generally can take one for themselves and, if they are married, one for their spouse. If another taxpayer is entitled to claim this taxpayer as a dependent, they cannot take an exemption for themselves even if the other taxpayer does not actually claim this taxpayer as a dependent. Dependent Exemptions17 The exemption amount for 2012 is $3,800. If the taxpayer is a U.S. citizen, U.S. resident alien, U.S. national or a resident of Canada or Mexico, the taxpayer may qualify for any of the exemptions discussed here. Exemptions for Dependents The taxpayer generally can take an exemption for each of their dependents. If the taxpayer is entitled to claim an exemption for a dependent, that dependent cannot claim a personal exemption on his or her own tax return. 16 17 IRC §151 IRC §152 41 The taxpayer must list the social security number of any dependent for whom they can claim an exemption. The taxpayer can claim an exemption for a qualifying child or qualifying relative only if the dependent taxpayer, joint return, citizen or resident tests are met. The taxpayer must meet all three of the following tests. Dependent Taxpayer Test If the taxpayer could be claimed as a dependent by another person, the taxpayer cannot claim anyone else as a dependent. Even if the taxpayer has a qualifying child or qualifying relative, the taxpayer cannot claim that person as a dependent. If the taxpayer is filing a joint return and their spouse could be claimed as a dependent by someone else, the taxpayer and their spouse cannot claim any dependents on their joint return. Joint Return Test The taxpayer cannot claim a married person as a dependent if he or she files a joint return. An exception to the joint return test applies if the taxpayer’s child and his or her spouse file a joint return merely as a claim for refund and no tax liability would exist for either spouse on separate returns. Citizen or Resident Test The taxpayer cannot claim a person as a dependent unless that person is a U.S. Citizen, U.S. resident alien, U.S. national, or a resident of Canada or Mexico. An exception for an adopted child if the taxpayer is a U.S. citizen or U.S. national who has legally adopted a child who is not a U.S. citizen, U.S. resident alien, or U.S. national, this test is met if the child lived with the taxpayer as a member of their household all year. This exception also applies if the child was lawfully placed with the taxpayer for legal adoption. If the taxpayer was a U.S. citizen when their child was born, the child may be a U.S. citizen even if the other parent was a nonresident alien and the child was born in a foreign country. A taxpayer cannot claim an exemption for a foreign student placed in their home for a temporary period under a qualified international education exchange program. The foreign student generally is not considered a U.S. resident. U.S. nationals include American Samoans and Northern Mariana Islanders who chose to become U.S. nationals instead of U.S. Citizens. These are individuals who although are not U.S. citizens, they owe his or her allegiance to the United States. Spouse’s Exemption The spouse is never considered the taxpayers dependent. On a joint return the taxpayer can claim one exemption for themselves and one for their spouse. If the taxpayer and their spouse file separate returns, the taxpayer can claim an exemption for their spouse only if their spouse had no gross income, is not filing a return, and is not 42 the dependent of another taxpayer. This is true even if the other taxpayer does not actually claim the taxpayer’s spouse as their dependent. If the taxpayer’s spouse died during the year and the taxpayer and spouse filed a joint return, the taxpayer can generally claim the spouse’s exemption the year the spouse died. If the taxpayer’s spouse died during the year and the taxpayer and spouse filed separate returns, the taxpayer can claim the spouse’s exemption the year the spouse died only if their spouse had no gross income, was not going to file a return, and was not the dependent of another taxpayer. This is true even if the other taxpayer does not actually claim the taxpayer’s spouse as their dependent. The taxpayer cannot claim an exemption for their deceased spouse if they remarry during the year. If the taxpayer is a surviving spouse without gross income and they remarry in the year their spouse died, the taxpayer 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 the taxpayer files a joint return with their new spouse, the taxpayer can be claimed as an exemption only on that return. If the taxpayer obtained a final decree of divorce or separate maintenance by the end of the year, the taxpayer cannot take their former spouse’s exemption. This rule applies even if they provided all of their former spouse’s support. Qualifying Child18 There are five tests that must be met for a child to be a qualifying child. The five tests are: 1. Relationship, 2. Age, 3. Residency, 4. Support, and 5. Joint return. Relationship Test To meet this test, a child must be: A son, daughter, stepchild, foster child, or a descendant (for example, a grandchild) of any of them, or A brother, sister, half-brother, half-sister, stepbrother, stepsister, or a descendant (for example, a niece or nephew) of any of them. Adopted child: An adopted child is always treated as the taxpayer’s own child. The term “adopted child” includes a child who was lawfully placed with the taxpayer for legal adoption. Foster child: A foster child is an individual who is placed with the taxpayer by an authorized placement agency or by judgment, decree, or other order of any court of competent jurisdiction. Age Test To meet this test, a child must be: 18 IRC §2 43 Under age 19 at the end of the year and younger than the taxpayer (or spouse if filing jointly), A full-time student during some part of each of any 5 calendar months of the year (the 5 months do not have to be consecutive) under age 24 at the end of the year and younger than the taxpayer (or the spouse if filing jointly), or Permanently and totally disabled at any time during the year, regardless of age. Explanation of child younger than the taxpayer or spouse Samson’s 22-year-old brother, who is a full-time student and unmarried, lives with Samson and Delilah. He is not disabled. Both Samson and Delilah are 21 years old, and they file a joint return. The brother is not a qualifying child because he is not younger than Samson or Delilah. Assume the same facts as above except that Samson is 24 years old. Because Samson’s brother is younger than Samson and Samson and Delilah are filing a joint return, Samson’s brother is a qualifying child, even though he is not younger than Delilah.(If Samson was 21 and Delilah was 24, Samson’s brother would still meet the age test) Example: An unmarried son lived with his father all year and was 25 years old and his gross income was $5,000 at the end of the year. Because he does not meet the age test, the taxpayer’s son is not his qualifying child. As a result, he is not the taxpayer’s qualifying person for head of household purposes. Generally, the qualifying person must live with the taxpayer for more than half of the year. Special rule for parent. If the qualifying person is the father or mother of the taxpayer, the taxpayer may be eligible to file as head of household even if the father or mother does not live with the taxpayer. However, the taxpayer must be able to claim an exemption for his father or mother. In addition, the taxpayer must pay more than half the cost of keeping up a home that was the main home for the entire year for the father or mother. The taxpayer is assumed to be keeping up a main home for his father or mother if the taxpayer pays more than half the cost of keeping the parent in a rest home or home for the elderly. Example: The taxpayer is unmarried. Her mother, for whom she can claim an exemption, lived in an apartment by herself. She died on September 2. The cost of the upkeep of her apartment for the year until her death was $6,000. The taxpayer paid $4,000 and her brother paid $2,000. The brother made no other payments towards their mother's support. The mother had no income. Because the taxpayer paid more than half of the cost of keeping up her mother's apartment from January 1 until her death, and she can claim an exemption for her, she can file as a head of household. Residency Test To meet this test, the child must have lived with the taxpayer for more than half of the year. There are exceptions for temporary absences, children who were born or died during the year, kidnapped children, and children of divorced or separated parents. Temporary absences: The child is considered to have lived with the taxpayer during periods when one, or both, is temporarily absent due to special circumstances such as: 44 Illness, Education, Business, Vacation, or Military service. Children of divorced or separated parents or parents who live apart: In most cases, because of the residency test, a child of divorced or separated parents is the qualifying child of the custodial parent. However, the child will be treated as the qualifying child of the noncustodial parent if all four of the following statements 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 6 months of the year, whether or not they are or were married. 2. The child received over half of his or her support for the year from the parents. 3. The child is in the custody of one or both parents for more than half of the year. 4. Either of the following statements is true. A. The custodial parent signs a written declaration or uses Form 8332 that he or she will not claim the child as a dependent for the year, and the noncustodial parent attaches this written declaration to his or her return. (If the decree or agreement went into effect after 1984 and before 2009, see Post-1984 and pre-2009 divorce decree or separation agreement, in Pub. 17. If the decree or agreement went into effect after 2008, see Post-2008 divorce decree or separation agreement, in Pub 17.) B. A pre-1985 decree of divorce or separate maintenance or written separation agreement, that applies to 2012, states that the noncustodial parent can claim the child as a dependent, the decree or agreement was not changed after 1984 to say the noncustodial parent cannot claim the child as a dependent, and the noncustodial parent provides at least $600 for the child's support during the year. Custodial parent and noncustodial parent: 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 present, or In the company of the parent, when the child does not sleep at a parent's home (for example, the parent and child are on vacation together). Equal number of nights: If the child lived with each parent for an equal number of nights during the year, the custodial parent is the parent with the higher adjusted gross income (AGI). 45 December 31. The night of December 31 is treated as part of the year in which it begins. For example, December 31, 2012, is treated as part of 2012. Absences: If a child was not with either parent on a particular night (because, for example, the child was staying at a friend's house), the child is treated as living with the parent with whom the child normally would have lived for that night, except for the absence. However, if it cannot be determined with which parent the child normally would have lived or if the child would not have lived with either parent that night, the child is treated as not living with either parent that night. 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 with the school. Janice is the Custodial Parent of Grant for 2012, but agreed to release his exemption every other year until Grant started school and his father could move into the same school district. Grant will start school in 2013 and his father has moved into the district. Janice will no longer sign Form 8332 (shown below). Both parents will now keep track of the number of days Grant is with them and the Custodial Parent will claim his exemption. Example: Grant lived with Janice greater number of nights than her ex-husband. In 2012, Grant lived with Janice 210 nights and with Grant’s father, Maxwell 155 nights. Janice is considered the custodial parent. Example: Grant is away at camp. In 2013, Grant lives with each parent for alternate weeks. In the summer, he spends 6 weeks at summer camp. During the time he is at camp, he is treated as living with Janice for 3 weeks and with Maxwell her ex-spouse, for 3 weeks because this is how long Grant would have lived with each parent if he had not attended summer camp. Example: What if Grant lived same number of days with each parent? Grant lived with Janice 180 nights during the year and lived the same number of nights with his father Maxwell. Janice’s adjusted gross income with her husband is $119,000. Maxwell’s adjusted gross income is $85,000. Janice is treated as Grant’s custodial parent because she has the higher adjusted gross income. 46 47 Form 8332 above must be signed by the custodial parent Janice and filed by the noncustodial parent Maxwell. Maxwell electronically files his return Form 8332 should be attached to Form 8453, U. S. Individual Income Tax Transmittal for IRS efile Returns, and mailed to the IRS within three days of the acceptance of his electronically filed return. Support Test (To Be a Qualifying Child) To meet this test, the child cannot have provided more than half of his or her own support for the year. Example: The taxpayer provided $4,000 toward his 16-year-old son's support for the year. His son has a part-time job and provided $6,000 toward his own support. He provided more than half of his own support for the year. He is not the taxpayer’s qualifying child. Foster care payments and expenses. Payments received for the support of a foster child from a child placement agency are considered support provided by the agency. Similarly, payments received for the support of a foster child from a state or county are considered support provided by the state or county. If the taxpayer is not in the trade or business of providing foster care and the unreimbursed outof-pocket expenses in caring for a foster child were mainly to benefit an organization qualified to receive deductible charitable contributions, the expenses are deductible as charitable contributions but are not considered support provided by the taxpayer. For more information about the deduction for charitable contributions, see Publication 526. If the unreimbursed expenses are not deductible as charitable contributions, they are considered support provided by the taxpayer. Scholarships: A scholarship received by a child who is a full-time student is not taken into account in determining whether the child provided more than half of his or her own support Joint Return Test (To Be a Qualifying Child) To meet this test, the child cannot file a joint return for the year, except to claim a refund. This section applies to Federal return If the taxpayer was married as of the last day of the tax year or if the spouse died during the tax year, the taxpayer may be considered unmarried for head of household purposes. The taxpayer may be considered unmarried if they meet all of the following requirements: The qualifying person is the taxpayer’s birth child, stepchild, adopted child, or eligible foster child. The taxpayer filed a tax return separate from their spouse's tax return. The taxpayer paid more than one-half the cost of keeping up the home for the taxable year. The spouse did not live in the taxpayer’s home at any time during the last six months of the taxable year. The home was the main home for the taxpayer and the birth child, stepchild, adopted child, or eligible foster child for more than half the year. The taxpayer must be entitled to claim a dependent exemption credit for the child. The child must meet the requirements to be either a qualifying child or qualifying relative and 48 meet the joint return and citizenship tests. However, the taxpayer cannot claim a dependent exemption credit for the child if they can be claimed as a dependent by another taxpayer. Tie-Breaker Rules Under the tiebreaker rule, the child is treated as a qualifying child only by: The parents if they file a joint return; The parent, if only one of the persons is the child's parent; The parent with whom the child lived the longest during the tax year, if two of the persons are the child's parent and they do not file a joint return together. The parent with the highest AGI if the child lived with each parent for the same amount of time during the tax year, and they do not file a joint return together; The person with the highest AGI if no parent can claim the child as a qualifying child; or A person with the higher AGI than any parent who can also claim the child as a qualifying child but does not. Qualifying Relative Four tests must be met for a person to be a qualifying relative. The four tests are: 1. Not a qualifying child test, 2. Member of household or relationship test, 3. Gross income test, and 4. Support test. Age: Unlike a qualifying child, a qualifying relative can be any age. There is no age test for a qualifying relative. 1. Not a Qualifying Child Test A child is not a qualifying relative if the child is a qualifying child or the qualifying child of any other taxpayer. For example, if the taxpayers’ 19-year-old daughter; who is a student, lives with the taxpayer and meets all the tests to be their qualifying child, then she is not a qualifying relative. 2. Member of Household or Relationship Test To meet this test, a person must either: 1. Live with the taxpayer all year as a member of the household, or 2. Be related to the taxpayer in one of the ways listed below. If at any time during the year the person was the taxpayers’ spouse, that person cannot be the qualifying relative. Relatives who do not have to live with the taxpayer. A person related to the taxpayer in any of the following ways does not have to live with them all year as a member of their household to meet this test. The taxpayer’s child, stepchild, foster child, or a descendant of any of them (for example, a grandchild). 49 The brother, sister, half brother, half sister, stepbrother, or stepsister of the taxpayer. The father, mother, grandparent, or other direct ancestor, but not foster parent. The stepfather or stepmother. A son or daughter of the taxpayer’s brother or sister. A son or daughter of the taxpayer’s half brother or half sister. A brother or sister of the taxpayer’s father or mother. The taxpayer’s son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law. Any of the above relationships that were established by marriage are not ended by death or divorce. For example, the taxpayer and his wife began supporting the wife's mother, a widower, in 2006. The wife died in 2011. Despite the wife's death, the taxpayer’s mother-in-law continues to meet this test, even if she does not live with him. He can claim her as a dependent if all other tests are met, including the gross income test and support test. A cousin meets this test only if he or she lives with the taxpayer all year as a member of their household. A cousin is a descendant of a brother or sister of the taxpayer’s father or mother. 3. Gross Income Test To meet this test, a person's gross income for the year must be less than $3,800. Gross income is all income in the form of money, property, and services that is not exempt from tax. Tax-exempt income, such as certain social security benefits, is not included in gross income. 4. Support Test (To Be a Qualifying Relative) To meet this test, the taxpayer generally must provide more than half of a person's total support during the calendar year. This is done by comparing the amount contributed to that person's support by the taxpayer with the entire amount of support that person received from all sources. This includes support the person provided from his or her own funds. For example, the taxpayer’s grandmother received $2,700 in social security benefits and $200 in interest. She paid $2,200 for lodging, $300 for food and $200 for recreation. She put $200 in a savings account. Even though the taxpayer’s grandmother received a total of $2,900 ($2,700 + $200), she spent only $2,700 ($2,200 + $300 +$200) for her own support. If the taxpayer spent more than $2,700 for her support and no other support was received, the taxpayer provided more than half of her support. 50 Multiple Support Agreement Sometimes no one provides more than half of the support of a person. Instead, two or more persons, each of who would be able to take the exemption but for the support test, together provide more than half of the person's support. When this happens, the taxpayer and the others providing support can agree that any one of them who individually provides more than 10% of the person's support, but only one, can claim an exemption for that person as a qualifying relative. 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 his or her records. A multiple support declaration identifying each of the others who agreed not to claim the exemption must be attached to the return of the person claiming the exemption. See Form 2120, Multiple Support Declaration, below. In this example, the taxpayer, John Sample, and his brother Peter Johnson both provide the entire support of their mother for the year. John provides 45%, and Peter provides 55%. Either John or Peter can claim an exemption for their mother. The other must sign a statement agreeing not to take the exemption. Since John claims the exemption, he must attach Form 2120 to his return and must keep the statement signed by his brother for his records. 51 Chapter 5 – Where to Report Income Where to Report Income19 19 Pub. 525, IRC §61, 71-90, 101-139 52 Form W-4 Below are the instructions and a copy of Form W-4. Form W-4 includes four types of information the employer will use to figure withholding: Whether to withhold at a single rate or at the lower married rate. How many withholding allowances the taxpayer claims (each allowance lowers the amount withheld). 53 Whether the taxpayer wants an additional amount withheld Whether the taxpayer is claiming an exemption from withholding. o The taxpayer can claim an exemption from withholding only if both of the following situations apply: For 2012, the taxpayer had a right to a refund of all federal income tax withheld because they had no tax liability. For 2013, the taxpayer expects a refund of all federal income tax withheld because they expect to have no tax liability. o Student’s are not automatically exempt o An exemption is only good for one year and a new Form W-4 must be completed by Feb 15 each year to continue the exemption. Below is a completed W-4 for a single taxpayer. The taxpayer would complete the Form on page 1 and give it to the employer for withholding. The worksheet on page 2 of this form, included below is for taxpayers who itemize their deductions or have credits or adjustments to income that must be taken into account when computing their withholding. Backup Withholding20 Interest (including tax-exempt interest and exempt-interest dividends), dividends, rents, royalties, commissions, nonemployee compensation, and certain other may be subject to backup withholding at a 28% rate. If the payment is one of these reportable payments, backup withholding will apply if: 20 The payee fails to furnish his or her taxpayer identification number (TIN) to the issuer of the 1099, For interest, dividend, and broker and barter exchange accounts opened or instruments acquired after 1983, the payee fails to certify, under penalties of perjury, that the TIN provided is correct, The IRS notifies the issuer of the 1099 to impose backup withholding because the payee furnished an incorrect TIN, For interest and dividend accounts or instruments, the issuer of the 1099 is notified that the payee is subject to backup withholding, or For interest and dividend accounts opened or instruments acquired after 1983, the payee fails to certify to you, under penalties of perjury, that he or she is not subject to backup withholding.. IRC §3406(a)(1)(C 54 55 56 Withholding on Tips The tips a taxpayer receives while working are considered part of their pay. They must include the tips on their tax return on the same line as wages. However, tax is not withheld directly from tip income, as it is from the regular pay. Nevertheless, the employer will take into account the tips the taxpayer reports when figuring how much to withhold from the regular pay21. Taxable Fringe Benefits22 The value of certain noncash fringe benefits received from an employer is considered part of pay at their fair market value. . Sick Pay Sick pay is a payment to replace regular wages while the taxpayer is temporarily absent from work due to sickness or personal injury. Pay in lieu of wages is taxable and subject to withholding. Form W-2 Form W-2 provides information to employees, the Social Security Administration, the IRS, and state and local governments. Employers must file Forms W-2 for wages paid to each employee whom: Income, social security, or Medicare tax was withheld or Income tax would have been withheld if the employee had claimed no more than one withholding allowance or had not claimed exemption from withholding on Form W-4. 21 22 Pub 531 Pub 505 57 58 59 2012 - Form 1040 60 References to the forms in this chapter will be made throughout this syllabus. 61 Chapter 6 – Wages, Interest and Dividends Employee Compensation Refer to Form 1040 in Chapter 5 The wages shown on line 7 of Form 1040 are in Box 1 of Form W-2 for Thomas, the taxpayer in this scenario. Box 1 of Form W-2 may also include bonuses and awards; awards in a settlement or judgment for back pay; payments for damages, unpaid life insurance premiums; and unpaid health insurance premiums. Other common taxable items23 included on Line 7 of Form 1040 include: Excess reimbursements from Form 2106, Unreported tips from Form 4137- See Pub.531 for more details. Taxable employer provided day care benefits in Box 10 of Form W-2 after exclusion reported on Form 2441. (“DCB” on the dotted line next to line 7.) Wages reported on Form 8919 “Uncollected Social Security and Medicare Tax on Wages”. Taxable Scholarships and Fellowships (refer to Pub 17) (“SCH” on the dotted line next to line 7.) All wages received as a household employee for which the taxpayer did not receive a Form W-2 because an employer paid less than $1,800 in 2012. (“HSH” on the dotted line next to line 7.) Employer-provided adoption benefits, Form W-2 with code T in Box 12. See Instructions for Form 8839 for part or all of the exclusion of adoption benefits. Statutory Employee A worker who is not an employee under the common law rules may still be subject to employment taxes (common law rules and employment taxes are discussed in detail under “employees” later in this section). These four occupational categories24 are: Full-time life insurance agents Traveling salespersons Agent drivers, and Home workers Workers in these categories are employees for FICA purposes. Income and related expenses the taxpayer receives as a statutory employee is reported on Schedule C, the same as a self-employment business. The only difference is that with the statutory employee position, the taxpayer will not owe the self-employment taxes of Social Security and Medicare, as those have already been paid and deducted by the employer. 23 24 IRS Pub 525 IRC Section 3121(d)(3) 62 Statutory employee income and self-employee income must be reported on two separate Schedule Cs. The W-2 a statutory employee receives will have a check in Box 13 “Statutory Employee”. The income and expenses for that employee is reported on line 1 of Schedule C and check the box. Social Security and Medicare should have been withheld and reported on Form W-2; therefore, the taxpayer does not pay self-employment tax on these earnings. If the taxpayer has selfemployment income and statutory employee income, they must use two separate Schedule Cs. Miscellaneous Compensation Child-care providers, either in the taxpayer's home, the child's home, or another location, the pay must be included in income. If someone else does not employ the childcare provider, the provider is probably self-employed and must report the income on Schedule C. The same rule applies to babysitting as childcare. Advanced commissions received for services to be performed in the future, a cash taxpayer must report the income in the year received. Back pay awards are reported on a W-2 and entered on Line 7 of Form 1040. Bonuses or awards received for outstanding work are included in income and reported on Form 1040, line 7. Prizes such as vacation trips for meeting sales goals or awards in the form of goods or services are taxable at the fair market value. Stock appreciation rights granted by the employer are not included in income until they are exercised (use the right). When the right is used, a cash payment equal to the fair market value of the corporation’s stock on the date of use minus the fair market value on the date the right was granted is included in income in the year the right is used. Non-statutory options to buy or sell stock or other property, as payment for services, there will be income either when the option is received or exercised (used to buy or sell other stock or other property). The employer determines which type of option. (Refer to Pub 525). Life Insurance Proceeds Life insurance proceeds paid to the taxpayer because of the death of the insured person are not taxable unless the policy was turned over to the taxpayer for a price. This is true even if the proceeds were paid under an accident or health insurance policy or an endowment contract. Refer to “Life Insurance Proceeds” in Pub 525 for the taxable portion when the values of the proceeds exceed the value at the date of death or when paid in installments. Policy dividends paid during the taxpayer’s life are generally not taxable unless dividends withdrawn exceed the premiums paid. If a policy is surrendered for cash, the amount that exceeds the premium is taxable. 63 Fringe Benefits Fringe benefits received in connection with the performance of the services performed are included in income as compensation, usually not in the form of cash. They are not included in income if they are purchased at the fair market value or are specifically excluded by law. The value of accident and health plan benefits are generally not included in income, benefits from the plan may be taxable. Long-term care coverage contributions by the employer are generally not taxable. However, contributions made through a flexible spending or other similar arrangement must be included in income. This amount is usually included in Box 1 of form W-2 as wages. Archer MSA contributions made by the employer are not included in income. The total is included in Box 12 of W-2 with a code R. Deminimis benefits or a gift provided by the employer that is a product or service of minimal value is not included in income. However, if the employer gives a gift certificate or similar item that can be easily exchanged for cash the value of the gift should be included in salary or wages, regardless of the amount. No additional cost fringe benefits are those benefits offered to the taxpayer that are of no additional cost to the employer, or a service that is offered for sale to customers in the ordinary course of doing business. These benefits are not taxable. Qualified discounts on the purchase of the employer's goods or services are not taxable if the discount received is not greater than the gross profit percentage of the price the product is offered to the general public. The discount also cannot exceed 20% of the price at which the goods are offered to the public. The discount must be offered to all employees. Working condition fringe benefits are excluded from tax by the employee if it would have been deductible as an employee business expense if the employee had paid the amount out-of pocket. Educational assistance of qualified employer provided educational assistance could be excluded up to $5,250. The exclusion applies to undergraduate and graduate level courses. If the education is not required by the employer or the law, it can be qualifying work-related education only if it maintains or improves skills needed in the taxpayer’s present work. Refer to Pub 970 for additional information. Employer-provided vehicles are usually taxable non-cash fringe benefits. The employer must determine the actual value of this fringe benefit to include in income. A transportation fringe benefit can be excluded from income up to certain limits. A qualified transportation fringe benefit is: Commuter highway vehicle between home and work, or A transit pass, or Qualified parking 64 Cash reimbursement by the employer for these expenses under a bona fide reimbursement arrangement is also excludable. There is a $230 exclusion limit for commuter vehicle and transit pass and a $230 a month exclusion limit for parking, regardless of the value. Qualified moving expense reimbursements under a qualified plan may be excluded from income if the expenses are a deductible moving expense. If a nonqualified plan, the amount is included in income. (Refer to Form 3903) The cost of group term-life insurance is excludable from income if the coverage is less than $50,000. The cost of the employer provided insurance over $50,000 is included in income. If the taxpayer pays any portion of the premium, the taxable portion is reduced dollar for dollar. Scholarships or fellowships to someone who is a degree candidate is excluded from income, if the scholarship is used for tuitions, fees, books, supplies or equipment required by the financial institution. Clergy and Military A member of the clergy must include in income offerings and fees received for marriages, baptisms, funerals, masses, etc. in addition to the salary unless the offering or fee is to the religious organization. If the clergy donates offerings or fees received by the clergy to the religious institution it is still taxable to the clergy, but the clergy can take a charitable contribution deduction. Special rules apply for housing of the clergy. The rental value of the home or housing allowance is not included in income. The housing allowance is subject to self-employment tax; refer to Schedule SE or Publication 517. U.S. citizens working for a foreign government, an international organization, a foreign embassy or any foreign employer the income is included as salary. Social security and Medicare taxes are usually not withheld, but the income is subject to self-employment taxes. Amounts reported on a W-2 for a member of the military are generally taxable as wages except for retirement pay, which is taxed as a pension. Wages earned in a combat zone and other allowances are generally nontaxable. Military retirement pay based on age or length of service is generally taxable. Do not include any reduction in retirement or retainer pay to provide a survivor annuity for the spouse or children under the Retired Serviceman’s Family Protection Plan or the Survivor Benefit Plan. Do not include in income any veteran's benefits paid under any law, regulation or administrative practice administered by the Department of Veterans Affairs. The following amounts are not taxable: Education, training and subsistence allowances Disability compensation and pension payments for disabilities paid either to veterans or their families Grants for homes designed for wheelchair living Grants for motor vehicles for veterans who lost their sight or use of their limbs Veterans' insurance proceeds and dividends paid either to veterans or their beneficiaries, including the proceeds of a veteran's endowment policy paid before death Interest on insurance dividend left on deposit with the VA 65 VA payments to hospital patients and resident veterans for their services under VA therapeutic or rehabilitative programs are not treated as nontaxable veteran's benefits. Report these payments as income on line 21 of Form 1040. Volunteer workers for the Peace Corps receiving living allowances are exempt from tax. Taxable allowances included below are reported as wages: Allowances paid to the spouse or minor children while volunteer leader training in the United States Living allowances designated by the Director of the Peace Corps as basic compensation. These are allowances for personal items such as domestic help, laundry and clothing maintenance, entertainment and recreation, transportation, and other miscellaneous expenses Leave allowances Readjustment allowances or termination payments. These are considered received when credited to the account Employee Benefits Sick pay is a payment to replace regular wages while temporarily absent from work due to sickness or personal injury. To qualify as sick pay, it must be paid under a plan to which the employer is a party. Sick pay is taxable and subject to withholding when paid by the employer. If the sick pay is paid by a third party where the employer is not a party, the sick pay is generally not taxable. Health insurance coverage provided by the employer is usually not included as income. The insurance premiums would not be a Schedule A deduction, unless self-employed health insurance. Disability Insurance Benefits are taxable depending on who paid the premiums. If the employee pays the premium, the premium is not a qualified medical expense and is not deductible. The benefits received are excluded from income. Employer-paid premiums are deductible as employee benefits. The premiums are not included in taxable income of the employee. However, benefits from an employer-paid disability policy are generally taxable to employees to the extent the amounts exceed qualified medical expenses for the current year. Cafeteria Plans (or flexible benefit plan) allows employees to choose between receiving taxable compensation and funding one or more tax-free benefits. The employer for the benefit of the employees must maintain the plan; the plan must be written; the plan must be available to all employees; and the plan must include two or more benefits consisting of cash and qualified benefits. Qualifying benefits include: Group term-life insurance premium costs Disability income and accident insurance costs Health insurance premium costs Dental insurance premium costs Medical costs not covered by insurance Qualified dependent care benefits Qualified transportation costs Contribution to qualified 401(k)-pension plan 66 Workers’ Compensation Amounts received as workers’ compensation for an occupational sickness or injury are fully exempt from tax, the exemption does not apply to retirement plans based on age, length of service or prior contributions. The following compensation received for injury or sicknesses are not taxable: Compensatory damages received for physical injury or sickness, whether paid in a lump sum or in periodic payments Benefits received under an accident or health insurance policy on which either the taxpayer or the employer paid the premiums that were included in income Compensation received for permanent loss or loss of a part or function of the body, or for permanent disfigurement. This compensation must be based only on the injury and not on the period of absence from work. These benefits are not taxable even if the employer pays for the accident and health plan that provides these benefits Foreign Income Exclusion25 Limit on exclusion. For 2013, the annual limit is $97,600 per taxpayer. If both the taxpayer and spouse qualify for the exclusion, both of them can exclude up to $97,600 each. If the taxpayer qualifies for only part of the year, the maximum deduction is the lesser of $97,600 or the actual compensation received multiplied by the ratio of the qualifying days in the year to the number of days in the tax year. Choosing the exclusion must generally be made on one of the following. • A timely-filed return (including any extensions), • A return amending a timely-filed return, or • A return filed within one year from the original due date of the return (determined without regard for any extensions). The housing exclusion applies only to amounts considered paid for with employer-provided amounts. The housing deduction applies only to amounts paid with self-employment earnings. Interest Income26 Taxable interest includes interest received from bank accounts, certificate of deposits, loans to others and other sources. The following are sources of taxable interest: 1. Dividends that are actually interest must be reported as interest on accounts in: Cooperative banks Credit Unions Domestic building and loan associations Domestic savings and loan associations Federal savings and loan associations Mutual savings banks 2. Money market certificates, savings certificates and other deferred interest accounts. 3. Interest subject to penalty for early withdrawal – report the full amount of interest without subtracting the penalty on early withdrawal. 4. Gifts for opening an account - Gifts or services for deposits less than $5,000 valued at more than $10 or for deposits of $5,000 or more valued at $20 or more must be reported as interest. The value is 25 26 Form 2555 Pub550 67 determined by the financial institution and included on Form 1099-INT. 5. Interest on insurance dividends is taxable in the year the interest is received. 6. Interest on U.S. obligations is taxable for federal income tax purposes. 7. Municipal bonds or interest on obligations used to finance government is not taxable if issued by a state, the District of Columbia, a U.S. possession or any of their subdivisions. 8. Treasury Bills generally have a 4-week, 13-week, or 26-week maturity period. They are issued at a discount for $1,000 and multiples of $1,000. The difference between the discounted price paid for the bills and the face value received at maturity is interest income. The interest is generally reported at maturity. 9. Money market interest is taxable in the year it is received or credited to the taxpayers account and can be withdrawn without substantial penalty. Interest on the money market account is not taxable if the interest is not credited to the taxpayer's account until maturity and withdrawal or redemption would result in a substantial penalty. 10. OID - When a long-term debt instrument is issued at a price that is lower than its stated redemption value, the difference is called original issue discount (OID). Interest is reported on 1099-OID. Adjustments are sometimes needed for OID interest because the issuing company does not track the activity of the bond. 11. The interest from a bearer and coupon bond is taxable the year the bonds are due and payable regardless of when they are presented for collection. 12. Interest paid on money borrowed to invest (Form 4952) is a separate transaction from the money earned on the investment. The interest paid on the money borrowed is deductible if the taxpayer itemizes. 68 69 When to Report Interest Interest is reported depending on the method of accounting. Most individuals use the cash method of accounting. Generally, under the method the interest is reported in the year it is actually or constructively received. When interest is credited to an account or made available to the taxpayer, it is constructively received. If the taxpayer is using an accrual method of accounting the interest is taxable when it is accrued, whether or not the taxpayer has received it. How Interest is Reported to the Taxpayer? Taxable interest is reported to the taxpayer on Form 1099-INT in Box 1 except for U.S. savings bonds and Treasury obligations, and OID. All taxable interest must be reported whether or not Form 1099 is received. Which Form is used to Report Interest Income? The taxpayer may only use Form 1040EZ if the interest income is less than $1,500. If the taxpayer is filing form 1040 or 1040A, Schedule B (1040) must be completed if any of the following are true: 1. Taxable interest income exceeds $1,500. 2. The taxpayer is claiming the interest exclusion under the Education Savings Bond Program. 3. Seller-financed mortgage interest and the buyer used the property as a home. 4. The taxpayer received a 1099-INT for savings bond interest (Box 3). 5. The taxpayer received a 1099-INT for tax-exempt interest. 6. The taxpayer received as a nominee interest that was reported by someone else. If the taxpayer had interest from or authority over a foreign bank account, they must file Form 1040 and use Schedule B to report the interest. Interest is considered nominee interest when the registered owner receives a 1099-INT with interest income in his/her name, but the interest actually belongs to someone else. The full amount of interest must be reported. On a separate line below the total of all interest, reported label the nominee interest received as "Nominee Distribution" and subtract it from the total. Note: Form 1099-INT must be issued by the taxpayer (using the name of the taxpayer as the payer) reporting the nominee distribution to the actual owner of the interest. The Education Savings Bond Program allows interest received on Series EE Bonds issued after 1989 or a Series I Bond to a taxpayer over the age of 24 may exclude the interest income from that bond if during the year the taxpayer paid qualified higher education expenses to an eligible educational institution. Refer to Form 8815 for instructions and limitations. Dividend Income Dividends are distributions of money, stock or other property paid to the taxpayer by a corporation. Dividends may be received by a taxpayer through a partnership, an estate, a trust, or an association that is taxed as a corporation. 70 Ordinary dividends are the most common type of dividends and are paid out of earnings and profits of a corporation. Ordinary dividends are reported on Form 1099-DIV box 1a. Ordinary dividends that are not “qualified” are taxed as ordinary income. The American Taxpayer Relief Act of 2012 made the 0% and 15% capital gains rates permanent. A 20% rate becomes effective after 2012 for high-income taxpayers. Long-term capital gains and qualified dividends are taxed as follows: 0% for taxpayers in the 10% and 15% tax brackets 15% for taxpayers in the 25, 28, 33 and 25% bracket 20% (up from 15%) to the extent taxpayers are in the 39.6% income tax bracket ($400,000 for single filers; $450,000 for married filing joint and $425,000 for head of household filers) 25% on unrecaptured §1250 gain 28% on collectibles Qualified Dividends are shown in box 1b of Form 1099-DIV. The dividends must have been paid by a U.S. Corporation or a qualified foreign corporation. The dividends must meet the holding period. Ordinary dividend income that exceeds $1,500 must be reported on Schedule B when filing Form 1040. The amount from Schedule B is carried to the 1040, line 9a. The qualified dividends are reported on 9b. Qualified dividends are carried to page 2 of Schedule D, line 23. If the total interest and dividends are less than $1,500, Schedule B is not required and can be reported on Form 1040A. Dividends are not reported on Form 1040EZ. Ordinary dividends reinvested into stock through a dividend reinvestment plan must be reported in income. Regulated investment companies (mutual funds) and real estate investment trusts (REITs) pay capital gain distributions. These capital gain distributions are reported in Box 2a of Form 1099-DIV. If 1099DIV has only capital gain distributions in Box 2a and 2b the amount can be reported on line 13a and 13b of the 1040 and check the box on the line. When Schedule D is required in the return the capital gain distributions will net with the other capital gains on the Schedule D. Nontaxable Distributions A nontaxable distribution is a return of capital or a tax-free distribution of shares of stock or stock rights. It is a return of the investment in the stock of the company. Distributions by a corporation of its own stock are commonly known as stock dividends. Stock rights or options are distributions by a corporation of rights to acquire the corporation stock. Generally, these nontaxable distributions are not reported on the tax return. Dividends Used to Buy More Stock The corporation in which the taxpayer owns stock may have a dividend reinvestment plan. The dividend reinvestment plan purchases more stock at the fair market value with the dividends. Dividends used in a dividend reinvestment plan must be reported as the fair market value of the additional stock on the 71 dividend payment date. How to Report Dividend Income Dividends are reported to the taxpayer on Form 1099-DIV if they received more than $10 in dividends. Ordinary and qualified dividends are included in adjusted gross income. Taxpayers report dividends on Form 1040 or 1040A. Ordinary dividends are reported on Line 9a and qualified dividends on line 9b. Dividends are reported on Schedule B, Part II if the dividends earned are more than $1500 or if the taxpayer received dividends as a nominee. Expenses related to dividend income may be deducted on Schedule A as a miscellaneous deduction subject to 2% of the adjusted gross income. 72 Chapter 7 – Cancellation of Debt, Refunds, Alimony and Independent Contractor Cancellation of Debt A debt is considered canceled or discharged at the moment it becomes clear that the debt will never be repaid based on the likelihood of payment or the worthlessness of the debt27. A debt includes any indebtedness for which the taxpayer is liable or which attaches to property for which the taxpayer is liable. If the debt forgiven is $600 or more, a 1099-C is issued and the amount must be reported on Line 21 of Form 1040. Foreclosure and Repossession If the taxpayer does not make payments owed on a loan secured by property, the lender may foreclose on the loan or repossess the property. The foreclosure or repossession is treated as a sale from which the taxpayer may realize gain or loss. This is true even if they voluntarily return the property to the lender. If the outstanding loan balance was more than the FMV of the property and the lender cancels all or part of the remaining loan balance, the taxpayer also may realize ordinary income from the cancellation of debt. This cancellation of debt is income that is reported on their return unless certain exceptions or exclusions apply. The borrower’s gain or loss28 from a foreclosure or repossession is figured and reported the same way as gain or loss from a sale. The gain is the difference between the amount realized and the adjusted basis in the transferred property (amount realized minus adjusted basis). The loss is the difference between the adjusted basis in the transferred property and the amount realized (adjusted basis minus amount realized). Forms 1099-A and 1099-C. A lender who acquires an interest in a property in a foreclosure or repossession issues Form 1099-A, Acquisition or Abandonment of Secured Property, showing information needed to figure the gain or loss. However, if the lender also cancels part of the debt they must file Form 1099-C, the lender can include the information about the foreclosure or repossession on that form instead of on Form 1099-A. The lender must file Form 1099-C and send the taxpayer a copy if the amount of debt cancelled is $600 or more and the lender is a financial institution, credit union, federal government agency, or any organization that has a significant trade or business of lending money. These forms are due by to the taxpayer by February 1. Exceptions to the inclusion of cancelled debt29 as income. Student Loans: Certain student loans provide a provision that all or part of the debt incurred to attend the qualified institution will be forgiven if the taxpayer works for a certain period of time in certain professions or for a broad class of employers. Education Loan Repayment Assistance: Education loan repayments made to the taxpayer by the National Health Services Corps Loan Repayment program or state education loan 27 IRC §108(e)(2) Pub 544 29 Pub 4681 28 73 repayment program eligible for funds under the Public Health Services Act are not taxable if the taxpayer agrees to provide primary health services in health professional areas. Deductible Debt30: The taxpayer does not have income from cancellation of debt if the payment of the debt would have been deductible. The exception applies only if the taxpayer uses the cash method of accounting. Price Reduced After Purchase: Generally, if the seller reduces the amount of the debt the taxpayer owes for property purchased then the income from the reduction is not recognized. This is treated as a purchase price adjustment and reduces the basis. Excluded Debt: Do not include cancelled debt in income in the following instances: o The debt is cancelled in bankruptcy case under Title 11 of the U.S. Code. o The debt is cancelled when insolvent, up to the amount the taxpayer was insolvent. o The debt is qualified farm debt and is cancelled by a qualified person. Refer to Pub 225. o The debt is qualified real property business debt. Refer to Pub 334 o The cancellation is intended as a gift. o The debt is qualified principal residence debt. Refer to Pub 525 Cancellation of Debt reported on Form 1040 30 Pub 334 74 Cancellation of Debt derived from a sole proprietorship is reported on Schedule C, page 2 as a negative expense. Qualified Principal Residence Indebtedness31 The taxpayer can exclude canceled debt from income if it is qualified principal residence indebtedness. Qualified principal residence indebtedness is any mortgage taken out to buy, build, or substantially improve a main home, and must be secured by the main home. Qualified principal residence indebtedness also includes any debt secured by the main home that was used to refinance a mortgage taken out to buy, build, or substantially improve the main home, but only up to the amount of the old mortgage principal just before the refinancing. Exclusion limit. The maximum amount the taxpayer can treat as qualified principal residence indebtedness is $2 million ($1 million if married filing separately). They cannot exclude cancelled qualified principal residence indebtedness from income if the cancellation was for services performed for the lender or any other factor not directly related to a decline in the value of the home or to the financial condition. Ordering rule. If only a part of a loan is qualified principal residence indebtedness, the exclusion applies only to the extent the amount canceled is more than the amount of the loan (immediately before the cancellation) that is not qualified principal residence indebtedness. The remaining part of the loan may qualify for another exclusion. Reduction of Tax Attributes – Form 982 If the taxpayer excludes canceled debt from income, they must reduce certain tax attributes (but not below zero) by the amount excluded. Use Part II of Form 982 to reduce the tax attributes. The order in which the tax attributes are reduced depends on the reason the canceled debt was excluded from income. If the total amount of canceled debt excluded from income (line 2 of Form 982) was more than the total tax attributes, the total reduction of tax attributes in Part II of Form 982 will be less than the amount on line 2. If the taxpayer excludes canceled qualified principal residence indebtedness from income and they continue to own the home after the cancellation, they must reduce the basis of the home (but not below zero) by the amount of the canceled qualified principal residence indebtedness excluded from income. Enter the amount of the basis reduction on line 10b of Form 982. 31 Pub 4681, Form 982 75 76 State Tax Refund The following worksheet is from Form 1040 Instructions for Line 10 If the taxpayer received a refund, credit, or offset of state or local income taxes in 2012, they may be required to report this amount. A recovery is taxable only if tax was reduced by deducting the payment or claiming a credit on the amount paid. An increase to a carryover to the current year that resulted from the deduction or credit is considered to have reduced tax in the earlier year. If the taxpayer chose to apply part or all of the refund to the 2012 estimated state or local income tax, the amount applied is treated as received in 2012. If the refund was for a tax paid in 2011 and the taxpayer deducted state and local income taxes on line 5 of the 2011 Schedule A, use the State and Local Income Tax Refund Worksheet above to see if any of the refund is taxable. NOTE: None of the refund is taxable if, in the year the taxpayer paid the tax, they either (a) did not itemize deductions, or (b) elected to deduct state and local general sales taxes instead of state and local income taxes 77 Alimony Received32 Alimony, maintenance, separate maintenance payments, support and spousal support are interchangeable terms for federal tax purposes. Payments that qualify are deductible by the payer spouse and taxable to the payee spouse. Alimony received is reported on Line 11 of Form 1040. To qualify as alimony payments must be: 1. Cash (including checks and money orders) 2. Required by decree 3. Spouse cannot be of the same household 4. Payments may not be treated as child support 5. Payer's liability must cease at death 6. Parties may not file a joint return Payments that do not qualify: 1. Child support 2. Non-cash property settlements 3. Payments that are the spouse's part of community property 4. Payments for use of property 5. Payments to keep up the payer’s property. Independent Contractor vs. Employee The classification of workers is important for both the worker and the employer. If an employee is classified as an independent contractor then they are responsible for paying self-employment tax on their earnings. If the worker is classified as an employee the employer becomes responsible for: Employment taxes being withheld, such as FICA, federal and state income taxes Employers share of FICA State and federal unemployment taxes Retirement plan eligibility This definition is from IRS Publication 334. Common Law Rules33 are a set of factors arising out of Revenue Ruling 87-41 used to determine if a worker is an employee or an independent contractor: People such as doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, or auctioneers who are in an independent trade, business, or profession in which they offer their services to the general public are generally independent contractors. However, whether these people are independent contractors or employees depends on the facts in each case. The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. The earnings of a person who is working as an independent contractor are subject to SelfEmployment Tax. 1. Behavior control factor – An employer retains the right to control how the work is done. Usually an independent contractor retains control over the work 2. Financial control factor- An employer has the right to control how the business aspects of an 32 33 IRC §71, IRC §215, Pub 504 Pub 15-A 78 employee’s business are conducted. The employer would realize the profit or loss and make a significant investment in the business. An independent contractor controls his or her own business activities. 3. Relationship factor - An employer would have a continuing relationship with the employee, who would be an integral part of the business and as such provide benefits for the employee. An independent contractor would have a written agreement determining method of payment, handling of expenses and how and when the work is to be done, designating the worker as an independent contractor. 4. There are many other less important factors that are also weighed in determining the status, such as: The right to discharge a worker or the worker’s right to quit Part or full-time work requirement Work required at the employers location Setting hours and sequence of work 79 Chapter 8 - Business Income – Schedule C A trade or business is generally an activity carried on to make a profit. The facts and circumstances of each case determine whether or not an activity is a trade or business. The taxpayer does not actually need to make a profit as long as they have a profit motive. The taxpayer must make ongoing efforts to further the interests of the business. Major Attributes of Schedule C No requirements for formation; no franchise fee or license to obtain No formalities required for formation (no meetings or corporate filings) Complete management authority Owner personally liable for all debts and obligations of business All profits and losses are included in the owner’s personal income tax; the business is not recognized for tax purposes Business normally dies with owner Business or assets may be sold or transferred at the sole discretion of the owner Owner may decide to convert the business to a different type of entity All judicial proceedings occur in the name of the owner. The major advantages of the sole proprietorship is its simplicity, there are no mandatory meetings or filings and no franchise fees. It is easiest to organize and the owner receives all the profits. A sole proprietor may make decisions at any time and about any matter, with minimum legal restrictions. A sole proprietorship is easy to discontinue. Example: Jack Lantern created a small business in 2012 making plastic pumpkins for sale at Halloween. He makes all his own business decision; he keeps all his own books. Has a separate bank account from his personal banking. He files his business income and expenses on a Schedule C in his personal return. Refer to Schedule C later in this section to see how this is reported. The major disadvantages is that the owner has unlimited liability for the business and the employees actions in the scope of the business. Sole proprietorships usually have limited ability to raise capital. Fringe benefits are not provided to the owner tax-free and all business net income is subject to self-employment tax 80 81 82 Any income connected to a business is business income. A connection exists if it is clear that the payment of income would not have been made if the business did not exist. Income from work done in addition to a full time job can also be considered business income; the work does not have to be on a regular full-time basis. Business income from the sale of products or services is reported on Schedule C or C-EZ. Schedule C is designed to report income by a sole proprietor (single owner of a business). A Sole Proprietor is someone who owns an unincorporated business by himself or herself. Principal Business or Professional Activity Codes The Principal Business or Professional Activity classification code must be entered in Box B of Schedule C. The code must be selected from the category that best describes the sole proprietorship and then from the activity that best identifies the principal source of sales or receipts. All Schedule C income must be classified by their activity. An activity code based on the North American Industry Classification System must be entered in block B on Schedule C. All moneys received from business must be included in income unless excluded by law. Income from miscellaneous sources are reported on 1099-MISC, whether the income is reported on a 1099 or not it must be included in income. Accounting of gross receipts should be kept according to generally accepted accounting practices on a daily basis. Refer to Pub 583 for record keeping requirements. Employer Identification Number A sole proprietor is not required to have an EIN unless the sole proprietor has a qualified retirement plan, is a payer of gambling winnings or is required to file employment or excise tax returns. A sole proprietor may obtain an EIN to use instead of his or her own Social Security Number when opening a bank account or issuing 1099’s to subcontractors or vendors. If they must have an EIN, include it along with the SSN on the Schedule C. Qualified Joint Venture – Husband and Wife Business34 Qualified joint venture – exception: If the taxpayer and spouse each materially participate as the only members of a jointly owned and operated business, and file a joint return for the tax year, they can make a joint election to be treated as a qualified joint venture instead of a partnership By making the election, the taxpayer will not be required to file Form 1065 for any year the election is in effect and will instead report the income and deductions directly on the joint return. If the taxpayer and spouse filed a Form 1065 for the year prior to the election, the partnership terminates at the end of the tax year immediately preceding the year the election takes effect. Mere joint ownership of property that is not a trade or business does not qualify for the election. Making the election: To make this election, all items of income, gain, loss, deduction, and credit attributable to the business between the taxpayer and spouse in accordance with the respective interests in the venture. The taxpayer and spouse must each file a separate Schedule C. On each line of the separate Schedule C, they must enter their share of the applicable income, deduction, or loss. Each of them must also file a separate Schedule SE to pay self-employment 34 Pub 334 83 tax, as applicable. Once made, the election can be revoked only with the permission of the IRS. However, the election technically remains in effect only for as long as the spouses filing as a qualified joint venture continues to meet the requirements for filing the election. If the spouses fail to meet the qualified joint venture requirement for a year, a new election will be necessary for any future year in which the spouses meet the requirements to be treated as a qualified joint venture. Business Income The taxpayer must report on their tax return all income received from their business unless it is excluded by law. In most cases, business income will be in the form of cash, checks, and credit card charges. Business income can be in other forms, such as property or services. Generally if there is a connection between any income the owner receives and his business the income is business income. Enter the business income (gross receipts from trade or business, sale of products or services) on Schedule C. The taxpayer does not have to be involved in the business full-time to have business income. Include amounts reported on 1099 MISC in Box 7. If the amount from the total of Box 7 Form 1099-MISC is more than the total being reported on line 1 of Schedule C, a statement explaining the difference must be attached to the return. All income earned by the taxpayer is taxable to that taxpayer. Taxpayers cannot avoid tax by having it paid to a third party. In operating a business, the business owner must report certain payments on information returns (Form 1099, etc.). The recipient of these payments (the payee) must receive a statement showing the total amount paid during the year. The statement must include the payee's identification number and the business owner’s identification number. If the sole proprietor makes payments to someone who is not their employee and they must report the payments on an information return, they must get that person's SSN. If reporting payments to an organization, such as a corporation or partnership, they must get its EIN Other Kinds of Income 1. Bartering is an exchange of property for services. Bartering income must be included in gross receipts determined by the fair market value of the goods or services. Both people or companies involved in the exchange must report the income.(Barter income is reported on 1099-B) 2. Personal property renting (equipment, vehicle rental, formal wear) income must be included in gross receipts. 3. Income created from debt cancellation is business income if the debt is incurred in the business. 4. Other items of income reported on Schedule C: Restricted property Promissory notes Lost income payments Patent infringement Breach of contract Antitrust injury Kickbacks 84 Recovery of items previously deducted Recapture of depreciation: Listed property which falls below 50% business use (refer to Pub 926) Section 179 expense taken on property where the business percentage falls below 50% before the end of the recovery period. (refer to Pub 926) Sale or exchange of depreciable property at a gain (refer to Pub 544) Items that are Not Income 1. Loans 2. Sales tax 3. Appreciation 4. Leasehold improvements 5. Exchange of like-kind property 6. Consignments 7. Construction allowances 8. Short-term lease 9. Retail space 10. Qualified long-term real property Recovery of items previously deducted: If an individual recovers a bad debt or any other item deducted in a previous year, include the recovery in income on Schedule C. However, if all or part of the deduction in earlier years did not reduce the tax, exclude the part that did not reduce the tax. This rule does not apply to depreciation. Include with the return a computation showing how the exclusion was computed. Example: Clifford West, a sole proprietor, had gross income of $8,000, a bad debt deduction of $300, and other allowable deductions of $7,500 with a net profit of $200. He also had two personal exemptions for a total of $7,600. He would not pay income tax even if he did not deduct the bad debt. Therefore, he will not report as income any part of the $300 he may recover in any future year. Cost of Goods Sold If the business makes or buys goods to sell, the cost of goods sold can be deducted from gross receipts on Schedule C. To determine the cost of goods sold the inventory must be valued at the beginning and the end of each tax year. Inventory at Beginning of the Year The cost of merchandise on hand at the beginning of the year that is available to be sold to customers. Purchases less cost of items withdrawn for personal use – a merchant uses the cost of all merchandise, bought for sale; a manufacturer or producer includes the cost of all the raw materials or parts purchased for manufacture into the finished product. Trade discounts - The difference between the stated amount and the actual amount. The cost of purchases is the amount actually paid Cash discounts - Amount discounted from invoices for prompt payment, must be credited to either a separate account or subtracted from purchases Purchase returns and allowances - Must be deducted from purchases Merchandise withdrawn for personal use must be excluded from cost Cost of labor – Labor costs are usually an element of the cost of goods sold only in manufacturing and mining. 85 Materials and Supplies – some supplies such as hardware and chemicals used in manufacturing are charged to cost of goods sold. These can also be deducted as business expenses. Cost of Goods Sold = Cost of inventory on hand at the beginning of the year plus Cost of inventory acquired during the year plus Shipping costs to receive inventory (not the finished product) plus Direct cost of labor that produces inventory plus Depreciation on machinery that produces the inventory minus Inventory removed for personal use minus Cost of inventory on hand at the end of the year. Gross Receipts minus Cost of Goods Sold plus Other Income = Gross Income minus Business Expenses = Tentative Profit minus Business Use of Home = Net Profit or Loss Business Expenses35 – an ordinary expense is one that is common and accepted in the field of business. A necessary expense is one that is helpful and appropriate. Determining what is ordinary expense common and accepted in the particular field of business of the taxpayer, use the Schedule C and the Schedule C instructions as a guide. Here are some examples to assist in the determination of whether an item is an expense in the current year or a capital expenditure to be depreciated. Generally, repairs to a business machinery are an expense. However, if the taxpayer reconditions and overhauls a machine that is a capital expenses and are recovered through depreciation. Roads and driveways. The cost of building a private road on business property is a capital expense. The cost of maintaining a private road on business property is a deductible expense. Tools. Amounts spent for tools used in a business are deductible expenses if the tools have a life expectancy of less than 1 year or their cost is minor. Machinery parts. The cost of replacing short-lived parts of a machine to keep it in good working condition, but not add to its life, is a deductible expense. Heating equipment. The cost of changing from one heating system to another is a capital expense. Record keeping is an essential part of business. The tax practitioner should instruct the taxpayer to bring adequate records to the tax interview. To meet adequate recordkeeping requirements the taxpayer must maintain an account book, diary, log, statement of expense, trip sheet and/or similar record or other documentary evidence that together with the receipt is sufficient to establish each element of an expenditure or use. The information already shown on the receipt does not have to be repeated in the record; however the records should back up the receipts. An adequate record contains enough information on each element of every business or investment use. If an asset is being depreciated notes must be kept in regards to the basis. If Section 179 is claimed in the first year, all the information should not only be noted on the correct form in the tax returns, but in the record keeping, so the basis can easily be determined. 35 Pub 535 86 Travel, Meals and Entertainment Expenses36 The taxpayer may deduct 50% of costs for meals while traveling on business. The two ways to determine meal costs are: Actual costs for meals Use the standard IRS meal allowance With either method, the taxpayer must still keep receipts and track actual costs. The IRS publishes the standard meal allowance (called the "Meal and Incidental Expense" rate (M&IE)37 for most major U.S. cities in IRS Publication 1542. Meals and Entertainment are deductible only if they are directly related or associated with the active trade or business incurred while the taxpayer or his employee is present at a meal. A facility used for the meal cannot be deducted. Meals and entertainment expenses are taken at 50%.38 General Guidelines on Deducting Meal/Entertainment Expenses The expenses must be "ordinary and necessary" business expenses The expenses must meet one of two tests: o The directly related test applies if the taxpayer can show that the main purpose of the activity was business. For example, if they were meeting with clients in their office, meal expenses during the meeting would probably meet the "directly related" test. o The associated test applies if the expense is associated with (along with, in conjunction with) a "substantial" business discussion. For example, if they had a meeting with clients at a restaurant and then take the clients to the theater, this might satisfy the "associated" test. What May NOT Be Deducted The taxpayer may not deduct costs of meals and entertainment for personal reasons while traveling. If the trip is "primarily" business, most expenses will be considered as business expenses. If the trip is "primarily" personal and the taxpayer conducts some minimal business, only those costs directly related to the business conduct may be deductible. Travel: For business expenses while away from the tax home are deductible. The tax home is the main place business is conducted regardless of where the personal residence is located. Expenses for lodging and transportation connected with overnight travel for business while away from the tax home is a deduction. Generally, the tax home is the main place of business, regardless of where the family home is maintained. The expenses paid or incurred in connection with employment away from home if that period of employment exceeds 1 year cannot be deducted. The employer cannot deduct travel expenses for his spouse, dependent, or any other individual unless that person is an employee, the travel is for a bona fide business purpose, and the expenses would otherwise be deductible by that person. 36 Form 2106 Instructions Pub 1542 38 Pub 463 37 87 Instead of keeping records of the actual incidental expenses, an optional method for deducting incidental expenses can be used only if meal expenses were not incurred or paid on a day when traveling away from the tax home. Incidental expenses include fees and tips given to porters, baggage carriers, bellhops, hotel maids, stewards or stewardesses and others on ships, and hotel servants in foreign countries. They do not include expenses for laundry, cleaning and pressing of clothing, lodging taxes, or the costs of telegrams or telephone calls. Membership dues for any club organized for business, pleasure, recreation, or other social purpose cannot be deducted. This includes country clubs, golf and athletic clubs, airline and hotel clubs, and clubs operated to provide meals under conditions favorable to business discussion. Any expense paid or incurred for a facility (such as a yacht or hunting lodge) used for any activity usually considered entertainment, amusement, or recreation cannot be deducted. It does not include civic or public service organizations, professional organizations (such as bar and medical associations), business leagues, trade associations, chambers of commerce, boards of trade, and real estate boards, unless a principal purpose of the organization is to entertain, or provide entertainment facilities for, members or their guests. There are exceptions to these rules as well as other rules that apply to skybox rentals and tickets to entertainment events39. Expenses that cannot be deducted Generally, the following cannot be deducted as business expenses. Bribes and kickbacks. Charitable contributions. Demolition expenses or losses. Dues to business, social, athletic, luncheon, sporting, airline, and hotel clubs. Lobbying expenses. Penalties and fines paid to a governmental agency or instrumentality because the law was violated. Personal, living, and family expenses. Political contributions. Repairs that add to the value of property or significantly increased its life. Depreciation – if property acquired in a business is expected to last more than one year, generally the entire cost cannot be deducted in the year acquired. The process of spreading the cost over more than one year is depreciation. (Refer to depreciation in Pub. 946). What property can be depreciated? Owned property Property used in business or held to produce income Property must have a useful life that is substantially more than one year Property must have a determinable useful life, which means it must be something that wears out, decays, becomes obsolete or loses value The property cannot be property that is purchased and sold in the same year Section 179: The American Taxpayer Relief Act extends through 2013 enhanced Code Section 39 Pub 463 88 179 small business expensing. Section 179 of the IRS Code was enacted to help small businesses by allowing them to take a depreciation deduction for certain assets (capital expenditures) in one year, rather than depreciating them over a longer period of time. Taking a deduction on an asset in its first year is called a "Section 179 deduction." The taxpayer can see that there is a benefit to taking the full deduction for the cost of the item immediately, rather than being required to spread out the deduction over the item's useful life. For example, if the taxpayer buys a computer for the office, under Section 179 they can deduct the full cost of that computer in one year. This also makes sense, because we all know that computers have a short lifetime, or useful life. So what types of business property does Section 179 apply to? The IRS says it must be "tangible, depreciable, personal property which is acquired for use in the active conduct of a trade or business." Annual Limits on Section 179 deductions and bonus depreciation There are annual limits on the amount of Section 179 Deductions. For 2012 and 2013 the limits are: $500,000 maximum on new and used equipment and purchased computer software Your business can spend up to a maximum of $2 million on Section 179 equipment. The deduction is reduced above this amount. The rule allowing of-the-shelf computer software is also extended. Bonus Depreciation: The American Taxpayer Relief Act extends 50 percent bonus depreciation through 2013. Bonus depreciation is a method of accelerated depreciation, which allows a business to make an additional deduction of 50% of the cost of qualifying property in the year in which it is put into service. This special "bonus depreciation" allowance is available to all businesses and applies to most types of tangible personal property and computer software acquired and placed in service in [a particular year]. It allows taxpayers to deduct 50 percent of the cost of qualifying property in addition to the regular depreciation allowance that is normally available. The maximum bonus depreciation allowance for 2012 and 2013 is 50% of qualified assets purchased and put into service in the tax year. Bonus depreciation is not available for used equipment. It can be used to create a tax loss. 89 90 91 Listed property is any of the following: Most passenger automobiles Most other properties used for transportation Any property of a type generally used for entertainment, recreation or amusement Certain computer and related peripheral equipment For tax years beginning after 2009 cellular telephones and similar telecommunications equipment have been removed from the definition of listed property. Recordkeeping on a vehicle used for business must be kept in an adequate log, noting what is of business use. A mileage log is essential, not only if the standard mileage rate is to be used, but to determine the correct percentage of business use. Records should always be in written form, with dates and business purpose noted. If the business records are being kept for a route that is the same every day, the adequate mileage of the route and a log of any deviations will suffice. Home computers and other listed property should be detailed in the same way. With a home computer total number of hours on the computer and an adequate log being kept next to the computer for business use is adequate. Self-Employed Health Insurance Health insurance paid on behalf of employees is a business expense. Medical and dental insurance for the taxpayer and his/her family is an adjustment to income reported on Form 1040, line 29. 40 The business owner may be able to deduct premiums paid for medical and dental insurance and qualified long-term care insurance for themselves, their spouse, and their dependents if they are one of the following. A self-employed individual with a net profit reported on Schedule C (Form 1040), Profit or Loss from Business; Schedule C-EZ (Form 1040), Net Profit From Business; or Schedule F (Form 1040), Profit or Loss From Farming. A partner with net earnings from self-employment reported on Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, etc., box 14, code A. A shareholder owning more than 2% of the outstanding stock of an S corporation with wages from the corporation reported on Form W-2, Wage and Tax Statement. The insurance plan must be established, or considered to be established under the business. The self-employed health insurance cannot exceed the earned income from the business. For a selfemployed individuals filing a Schedule C, a policy can be either in the name of the business or in the name of the individual. Health coverage for an employee's children under 27 years of age is now generally tax-free to the employees and included in self-employed health insurance deduction on their federal income tax return All Medicare parts are eligible for the self-employed health insurance deduction. 40 Form 1040 instructions for the worksheet or Pub 535. 92 Pension Plans A small business can set up retirement plans for the taxpayer and employees SEP (Simplified Employee Pension) plans SIMPLE (Savings Incentive Match Plan for Employees) plans Qualified plans (including Keogh or H.R. 10) Contributions to a plan made for an employee can be deducted on Schedule C, if the contribution is for the taxpayer it is deducted on line 28 of Form 1040. (Refer to Pub. 560). Before computing the business use of home complete Schedule C through the tentative profit by subtracting the business expenses from the gross income. Business Use of Home (Refer to the Appendix of this document for information on the Safe Harbor Method taking affect in tax year 2013) To qualify to claim expenses for the business portion of a home specific requirement must be met: 1. Use of the business part of the home must be exclusive (a room or identifiable place), regular (continuing basis), for the specific business and 2. Must be one of the following: Principal place of business (can have more than one place of doing business, including the home) A place to meet and deal with patients, clients or customers in the normal course of doing business A separate structure used in the course of business If the gross income from the business use of the home equals or exceeds the total business expenses, the business expenses related to the office in the home are deductible. If the gross income from business use of the home is less than the total business expenses the deduction for the business use of the home is limited. The deduction of otherwise nondeductible items such as insurance, utilities, and depreciation (with depreciation taken last) 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 that could be deducted even if the home was not used for business (such as itemized deductions) The business activities that relate to the business activity on the home but not to the home itself (such as the telephone costs) Deduction limit: The business use of home deduction is limited to the tentative profit from the Schedule C (line 29) plus items listed on Form 8829, Line 8. If the business use of home expenses as calculated on Form 8829 is more than the tentative profit on Schedule C, the deduction for certain expenses for the business use of the home is limited. 93 Mortgage interest, real estate taxes and casualty losses times the business use percentage (Line 3, Form 8829) are deductible even if the business has a loss; the nonbusiness portion of these items may be allowable as itemized deductions on Schedule A (Form 1040). The other business expenses shown on Form 8829 (for example, insurance, utilities, and depreciation on the home), are not included if there is a loss on Schedule C. These amounts would be carried over to the next tax year. The net profit is computed by subtracting any office in home expense from the tentative profit. Refer to Form 8829 for limitations and instructions or Pub 587. 94 Schedule SE Use Schedule SE (Form 1040) to figure the tax due on net earnings from self-employment. The Social Security Administration uses the information from Schedule SE to figure the taxpayers Social Security Benefits under the social security program. Self-employment tax (SE tax) is a social security and Medicare tax primarily for individuals who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of most wage earners.41 If the taxpayer earned income as a statutory employee, they do not pay SE tax on that income. Social security coverage: Social security benefits are available to self-employed persons just as they are to wage earners. Payments of SE tax contribute to the taxpayer’s coverage under the social security system. Social security coverage provides the taxpayer with retirement benefits, disability benefits, survivor benefits, and hospital insurance (Medicare) benefits. The taxpayer must pay SE tax and file Schedule SE (Form 1040) if either of the following applies. A. The net earnings from self-employment (excluding church employee income) were $400 or more. B. The taxpayer had church employee income of $108.28 or more. The SE tax rules apply no matter how old the taxpayer and even if they are already receiving social security or Medicare benefits. SE tax rate: For 2012, the SE tax rate on net earnings was 13.3% (10.4% social security tax plus 2.9% Medicare tax). Only the first $110,100 of the combined wages, tips, and net earnings in 2012 is subject to any combination of the 10.4% social security part of SE tax, social security tax, or railroad retirement (tier 1) tax. All the combined wages, tips, and net earnings in 2012 are subject to any combination of the 2.9% Medicare part of SE tax, social security tax, or railroad retirement (tier 1) tax. If wages and tips received as an employee are subject to either social security or railroad retirement (tier 1) tax, or both, and total at least $110,100, the taxpayer does not pay the 10.4% social security part of the SE tax on any of the net earnings. However, the taxpayer must pay the 2.9% Medicare part of the SE tax on the total net earnings. Deduct the employer-equivalent portion of the SE tax as an adjustment to income on line 27 of Form 1040 Income. The form below is associated with the Schedule C shown earlier in this section for Jack Lantern. The first segment of Schedule SE is a flowchart, which shows when Schedule SE should be computed and which portion of the Form, should be completed. Schedule SE is only produced if the self-employment income when multiplied by .9235 is over $400 on line. 41 Pub 334 95 Example: Jack Lantern had a net income from his business. That net income is subject to self-employment tax. Jack uses the Short Schedule SE found on page 1 of the form because he does not have SE earnings over $110,100. 96 Reasons to use the Optional Methods of computing SE tax if there is a loss or a small net profit where filing Schedule SE is not required The taxpayer receives credit for social security benefit coverage The optional method may increase the earned income component for computing child or dependent care credit The optional method may increase the earned income component for computing an earned income credit The optional method may increase the earned income component for computing an additional child tax credit Self-employed people who are facing a year, in which they have lost money (expenses greater than income) or years in which their income is vastly lower, and who still want to build up Social Security credits towards their retirement or disability benefits, can use a special method to increase their self-employment tax. This is called the "Optional Method". It is important to remember that a self-employed person who is not a farmer or fisherman is limited to using this optional method only five times in their lifetime. Example: John is self-employed on a regular basis. His earnings in 2011 were $25,100 and 2012 was $14,500, which qualifies him as being self-employed on a regular basis, which meets the first requirement for the Optional Method of SE. John has never used this method before, so he qualifies for not using this method more than 5 times in his lifetime. John’s net nonfarm profits was $1,200 and gross income was $5,000 which is less than $4,894, and less than 72.189% of his gross nonfarm income. The S/E tax is the lesser of 2/3 of $5,000 that is his gross income ($3,333). Since John has a daughter he can use the $3,333 for the Earned Income Credit. More than one business: If the taxpayer has more than one trade or business, they must combine the net profit (or loss) from each business to figure their SE tax. A loss from one business will reduce the profit from another business. File one Schedule SE showing the earnings 97 from self-employment, but file a separate Schedule C for each business. Estimated Tax Self-employment tax and the profit from Schedule C are not subject to withholding. To avoid an underpayment of tax penalty, compute the estimated tax for the next year by starting with the current year income, deductions and credits, and use the ES worksheet. Make adjustments for changing situations. Standard due dates for estimated tax payments are Apr. 15, June 15, Sept 15 and Jan 15 of the next year. Refer to the Estimated Tax discussion later in this text. Use Form 1040-ES, Estimated Tax for Individuals, to figure and pay the estimated tax. For additional information, refer to Publication 505, Tax Withholding and Estimated Tax. 98 Hobby income or not-for-profit income is income that must be reported and accurate records must be kept, according to generally accepted accounting practices. Expenses are allowed to be deducted from this income. The expenses are limited to the amount of income. Refer to Pub 535 for information of whether income is not-for-profit and more information. Hobby vs. Business Income The Internal Revenue Service reminds taxpayers to follow appropriate guidelines when determining whether an activity is a business or a hobby, and to determine if an activity qualifies as a business and what limitations apply if the activity is not a business. Incorrect deduction of hobby expenses account for a portion of the overstated adjustments, deductions, exemptions and credits that add up to $30 billion per year in unpaid taxes, according to IRS estimates. In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business. An ordinary expense is an expense that is common and accepted in the taxpayer’s trade or business. A necessary expense is one that is appropriate for the business. Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit. In order to make this determination, taxpayers should consider the following factors: Does the time and effort put into the activity indicate an intention to make a profit? Does the taxpayer depend on income from the activity? If there are losses, are they due to circumstances beyond the taxpayer has control or did they occur in the start-up phase of the business? Has the taxpayer changed methods of operation to improve profitability? Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business? Has the taxpayer made a profit in similar activities in the past? Does the activity make a profit in some years? Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity? The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year — at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses. If an activity is not for profit, hobby losses42 from that activity may not be used to offset other income. An activity produces a loss when related expenses exceed income. The 42 IRC §183 99 limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations. Sometimes, a taxpayer does not realize when a taxpayer’s hobby turns into a business. How does the taxpayer and the tax preparer tell the difference, especially when the business involves buying and selling stuff, something that many people do as a hobby-such as selling antiques on eBay; breeding cats, dogs or other animals; making arts and crafts for sale at craft shows; publishing a newsletter; participating in various kinds of home party sales where the main objective is to get discounts on the products; and other activities where the primary objective is personal satisfaction rather than economic gain. Under a long-standing IRS rule, the activity is considered a "business" if the taxpayer made a profit in three of the past five years, including the current year. However, what if the taxpayer is just starting out and is likely to lose money this year? The activity may still be considered a "business" for tax purposes if it can be proven to the IRS that the taxpayer is taking the activities seriously and are treating them as a business with the primary goal of making a profit. To substantiate the business, at a minimum, the taxpayer should have a name for their business, some stationery, invoices, a separate bank account, separate books and records, a place in their home that is used only for this business activity, and some records to show that they are spending some time working on this activity on a regular basis. The taxpayer should also consider preparing a formal business plan showing the projected income and expenses over a five or ten-year period with some profit at the end of that period the taxpayer should educate themselves regarding finances as well as their chosen business. As soon as the taxpayer begins to have a profit the tax preparer should discuss the upcoming self-employment tax and paying an estimated voucher. There maybe Form 1099’s that has to be issued. Whether the taxpayer knew it or not, the taxpayer has started a business. 100 Chapter 9 - Capital Assets43 Most properties owned and used for personal purposes, pleasure or investment are capital assets, such as a personal residence, furniture, car, stocks and bonds. A capital asset is any property held by the taxpayer except: Stock in trade or other property included in inventory or held mainly for sale to customers Accounts or notes receivable for services performed in the ordinary course of trade or business Depreciable property used in trade or business Copyrights, literary, musical or artistic compositions, letters or memoranda or similar property (a) Created by the taxpayer’s personal efforts (b) Prepared or produced by the taxpayer (c) Received from someone who created them or for whom they were created, as mentioned in (a) or (b) in a way that entitled the taxpayer to the basis of the previous owner. U.S. Government record including the Congressional Record Certain commodities derivative financial instruments held by a dealer (Section 1221(a)(6)) Certain hedging transactions44 entered into in the normal course of trade or business. Supplies regularly used in the trade or business Basis of Property The basis of property bought is usually its cost. The cost is the amount paid in cash, debt obligations, other property or services. The cost also includes amounts paid for the following items: Sales tax Freight Installation and heating Excise taxes Legal and accounting fees (when they must be capitalized) Revenue stamps Recording fees Real estate taxes (if assumed for the seller) Real property, also called real estate, is land and generally anything built on, growing on, or attached to land. Land is not depreciable if the cost is a lump sum; allocate the cost according to the fair market value of the land and buildings at the time of purchase. Fair market value (FMV) is the price at which the property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the necessary facts. 43 44 IRC§1221, Pub 544 IRC §1221(a)(7) 101 Adjusted basis – before figuring gain or loss on a sale, exchange, or other disposition of property or figuring allowable depreciation, depletion or amortization, certain increases or decreases to the basis may be needed. The result of the increases or decreases is the adjusted basis. This chart is from Publication 17, Part 3, Gains and Losses. Basis other than cost is computed by using the fair market value or the adjusted basis. If property is received for services the property is included in income at the fair market value. This FMV becomes the basis. If an asset is purchased at bargain prices (less than the FMV) include the difference between the discounted cost and the FMV in income and the FMV becomes the basis. A taxable exchange is one in which the gain is taxable or the loss is deductible. A taxable gain and deductible loss is also known as a recognized gain or loss. The basis of property received in exchange for other property in a taxable exchange is usually the FMV at the time of the exchange. The most common taxable exchange is an involuntary conversion. If the taxpayer receives property due to an involuntary conversion, such as a casualty theft or condemnation, the basis of the replacement property is computed by using the basis of the converted property. If the property received is similar or related in service or use to the converted property, the new basis is the same as the converted property on the date of the conversion, with the following adjustments: Decreasing the basis by any loss recognized on the conversion and any money received that was not spent on similar property Increase the basis by any gain recognized on the conversion and any cost of acquiring the replacement property A nontaxable exchange is an exchange in which the taxpayer is not taxed on the gain and not able to deduct the loss. In the transactions the basis is generally the same as the property transferred. A like-kind exchange45 is an exchange of property for the same kind of property and is the most common type of nontaxable exchange. In a like-kind exchange the property traded and the property received must both be qualifying property and like-kind property. Qualifying property 45 IRC §1031 102 in an exchange must either be held for investment or for productive use in a trade or business. Like-kind property is property of the same nature and character, even if it differs in quality or grade. The exchange of real property for real property or personal property for personal property is an exchange of like property. A like kind exchange is reported on Form 8824 refer to these instructions for more information. The basis of property received as a gift is the FMV less the donor’s adjusted basis. To determine the amount the taxpayer must determine whether there is a gain or a loss when disposing of the property. The basis for figuring the gain is the donor has adjusted basis plus or minus any required adjustments to basis while the property was held. The basis for figuring a loss is the FMV when the gift was received plus or minus any required adjustments. (Refer to Pub 551.) Stocks, Bonds and Mutual Funds The basis of stocks or bonds generally is the purchase price plus any costs of purchase, such as commissions and recording or transfer fees. If the taxpayer receives stocks or bonds other than by purchase, the basis is determined by the fair market value or the previous owners’ adjusted basis. The basis is also adjusted by certain events that occur after purchase such as stock splits, where the number of the old and new shares must divide the basis of the old stock if the new stock received is identical to the old stock. Nontaxable distributions also reduce the basis. There are other methods of determining basis of stocks having to do with how the stocks were acquired. (Refer to Pub. 550.) The basis in mutual funds is determined in the same manner as stocks and bonds. If the taxpayer sells mutual fund shares at various times and prices the taxpayer can choose to use an average basis. (Refer to Pub 564.) Sale of Stock - 1099-B A broker or barter exchange must file Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, for each person: For whom the broker has sold (including short sales) stocks, bonds, commodities, regulated futures contracts, foreign currency contracts (pursuant to a forward contract or regulated futures contract), forward contracts, debt instruments, etc., for cash, Who received cash, stock, or other property from a corporation that the broker knows or has reason to know has had its stock acquired in an acquisition of control or had a substantial change in capital structure reportable on Form 8806, or Who exchanged property or services through a barter exchange. The Energy Improvement and Extension Act of 2008 amended the Internal Revenue Code to mandate that: Every broker required to file a return (Ex. Form 1099-B) with the IRS reporting gross proceeds from the sale of a covered security additionally report the adjusted basis the customer has in the security; and Whether any gain or loss on the sale is a short-term or long-term transaction. The amendments direct brokers to follow customers’ instructions and elections when determining adjusted basis. 103 When a broker transfers securities to another new broker before their sale, the transferring broker must furnish to the receiving broker a statement containing sufficient information about the transferred securities for the receiving broker to determine the adjusted basis the customer has in the security; and Whether any gain or loss on the sale is short-term or long-term when the transferred security is eventually sold. The amendments require issuers of securities to file a return with the IRS and furnish a statement to holders of the securities after taking a corporate action that affects the basis of the security to explain the corporate action and its quantitative effect upon the basis of the security Securities Subject to Reporting The types of securities covered by the legislation (referred to in the legislation as “specified securities”) include stock in a corporation, notes, bonds, debentures and other evidence of indebtedness, commodities, commodity contracts or derivatives, and any other financial instrument for which the Secretary determines reporting adjusted basis is appropriate. A security is a “covered security” and therefore subject to the basis reporting requirements if the security is acquired after its corresponding applicable date. For stock in a corporation, the applicable date is January 1, 2011, unless the stock is in a mutual fund or is acquired in connection with a dividend reinvestment plan (DRP), in which case the applicable date is January 1, 2012. For any other specified security, the applicable date is January 1, 2013, or a later date determined by the Secretary of the Treasury. Brokers therefore are not required to report basis for any securities acquired before 2011. 104 Under the new law every broker who is required to file Form 1099-B reporting the gross proceeds of a “covered security” must include the customer’s adjusted basis in the security. The term “covered security” means any “specified security” acquired on or after the applicable date if the security: Was acquired through a transaction in the account in which the security is held; or Was transferred to the account from an account in which the security was a covered security, but only if the broker received a statement under Code Sec. 6045A with respect to the transfer. Under this rule, securities acquired by gift or inheritance are not covered securities. The term “specified security” means: Any share of stock in a corporation; Any note, bond, or other evidence of indebtedness; Any commodity, or contract or derivative with respect to the commodity, if IRS determines that adjusted basis reporting is appropriate for purposes of the Code Sec. 6045(g) reporting requirements; and Any other financial instrument with respect to which IRS determines that adjusted basis reporting is appropriate for purposes of the Code Sec. 6045(g) reporting requirements. The term “applicable date” means: January 1, 2011, in the case of any specified security which is stock in a corporation (other than any stock described in item (ii), below); January 1, 2012, in the case of any stock for which an average basis method is permissible under; and January 1, 2013, or any later date IRS determines in the case of any other specified security. The deadline for furnishing these information statements to customers is on or before March 15 of the year following the calendar year for which the return was required to be made. Previously, this date was January 31. In general the basis of a security is its cost. Under the new law, in the case of the sale, exchange, or other disposition of a specified security on or after the applicable date (defined above), the determination of basis as prescribed by regulations under Sec. 1012 for determining adjusted basis (i.e., the FIFO, specific-identification, and average-cost conventions) will apply on an account-by-account basis. If the taxpayer has the same specified security with multiple brokers only the shares sold through that account can be identified as shares sold. First-In, First-Out Method of Identification (FIFO) Under this method it is assumed the first share sold in an account was first share bought. The basis is determined by the order the funds were purchased. The First In First Out method is referred to as FIFO. It is a straight- forward concept--the first shares bought are always the first shares sold. The IRS likes this method because in a generally rising stock market, it maximizes the capital gain tax that they will collect. Absent any action on the part of the investor, this is the method that brokerage firms will apply to the sale of a stock that has multiple tax lots. (It applies to bonds, too, but usually the difference in cost between bond tax lots is minor, unlike stocks, which can vary substantially over time.) Specific Identification Method The Specific Identification method is the most flexible in terms of controlling the tax 105 liability. The investor can pick and choose which tax lots they want to sell based on how much taxable gain or loss to be recognize. Identify the specific tax lot (meaning the purchase date of the shares that the investor wants to sell) and inform the broker before the trade is executed. This is called a "versus purchase" trade. It is often denoted by "VSP" with the original tax lot purchase date printed on the trade confirmation for the sale in order to document that the specific identification method was used. Average Cost Basis, Single Category Method (Mutual Funds) Calculate the average cost basis based on the price paid for each share bought, including any reinvested dividends and reinvested capital gains. The average cost basis is the total purchase price of all shares divided by the number of shares owned. When some shares are sold, it is assumed the shares are sold on a first-in, first-out basis. The capital gain is calculated using the holding period of the oldest shares being sold, even if the stocks being sold are a mixture of long-term and short-term shares. The Average Cost Single Category method is one of the most commonly used ones for mutual fund holdings with many tax lots. It is the one that most mutual fund companies use as the default method because it is easy to display a single number on an account statement It cannot be used if the taxpayer has any shares in physical certificate form. Average Cost Basis, Double Category Method (Mutual Funds) The Average Cost Double Category method is only available to use for mutual fund holdings and dividend reinvestment plans until 4/1/2011. It involves calculating the average cost separately for two buckets of tax lots--one short-term (less than one year since purchase) and the other longterm holdings. This method cannot be used if they have any shares in physical certificate form. Rafael sold the Apple Stock he had purchased in 1992 with the gift from his father. Rafael bought the stock but did not reinvest any of the dividends. He held the stock, which appreciated considerably for 10 years. On October 11, 2012 he sold the stock I computed Rafael’s tax using the Schedule D worksheet (see below). Rafael saved a significant amount because of the favorable capital gains rates. Capital Gain Distributions- are the result of a fund selling shares. If the fund manager decides to sell a stock due to the changing outlook for the stock, or even if the fund must simply raise cash for shareholder redemptions (if a shareholder sells shares of the fund), if the stock is trading higher than when the fund initially purchased it, the fund must distribute at least 95% of the gains to shareholders. The capital gains distribution is taxable to the fund shareholders unless the fund is owned in a tax-deferred account (IRA, 401k, etc.). Capital gains and losses are classified as long-term or short-term46. If the taxpayer holds the asset for more than one year before disposition, the capital gain or loss is long-term. If the taxpayer holds it one year or less, the capital gain or loss is short-term. To determine how long the asset is held, count from the date after the day acquired to and including the date of disposition of the asset. 46 Tax Topic 409 106 The American Taxpayer Relief Act of 2012 made the 0% and 15% capital gains rates permanent. A 20% rate becomes effective after 2012 for high-income taxpayers. Longterm capital gains and qualified dividends are taxed as follows: 0% for taxpayers in the 10% and 15% tax brackets 15% for taxpayers in the 25, 28, 33 and 25% bracket 20% (up from 15%) to the extent taxpayers are in the 39.6% income tax bracket ($400,000 for single filers; $450,000 for married filing joint and $425,000 for head of household filers) 25% on unrecaptured §1250 gain 28% on collectibles There are three exceptions where capital gains may be taxed at rates greater than 15%: 1. The taxable part of a gain from selling Section 1202 qualified small business stock is taxed at a maximum 28% rate. 2. Net capital gains from selling collectibles (such as coins or art) are taxed at a maximum 28% rate. 3. The portion of any unrecaptured Section 1250 gain from selling Section 1250 real property is taxed at a maximum 25% rate. Note: Net short-term capital gains are subject to taxation at the ordinary income tax rate of the taxpayer. If the capital losses exceed the capital gains, the amount of the excess loss that can be claimed is the lesser of $3,000, ($1,500 if married filing separately) or the total net loss. 107 108 Reporting on Form 8949 and Schedule D Form 8949 “Sale and Other Dispositions of Capital Assets” is used for dispositions since 2011. All sales and exchanges of capital assets, including stocks, bonds, etc. and real estate not reported on Forms 4684, 4797, 6252, 6781 or 8824 are reported on Form 8949. This includes dispositions even if a 1099-B or 1099-S was not received by the taxpayer. Form 8949 is for long and short-term transactions. 109 A separate Form 8949 must be issued for each short-term or long-term gain or loss that the taxpayer received a Form 1099-B (or substitute statement) that shows cost or other basis in Box 3 of Form 1099-B (Box A, Form 8949). A separate Form 8949 must be issued for each shortterm or long-term gain or loss that the taxpayer received a Form 1099-B (or substitute statement) that does not show cost or other basis in Box 3 of Form 1099-B (Box B, Form 8949). A separate Form 8949 must be issued for each short-term or long-term gain or loss where the taxpayer does not receive a Form 1099-B (or substitute statement) (Box C, Form 8949). Each transaction should be reported on a separate line and the combined totals from all the Forms 8949 are entered on Schedule D (see instructions for reporting). A statement can be attached if it contains all the same information as Form 8949. If electronic filing these statements can be attached to Form 8453 and mailed to the IRS. Completing Form 8949 The majority of Form 8949 is completed similarly to the 2010 Schedule D. Refer to the Schedule D instructions to find the instructions for Form 8949. 110 111 Wash Sales The addition of the date acquired and the cost or other basis on Form 1099-B is designed to increase the accuracy in the reporting of the gain or loss of stocks or mutual funds. It is important that the taxpayer verifies the accuracy of Form 1099-B as soon as possible. The date acquired and the date sold should be verified as well as the amounts. The new reporting requirements on Form 1099-B will increase the IRS tracking of wash sales. Generally, a wash sale occurs when the taxpayer sells stocks at a loss and buys substantially identical stocks within 30 days before or after the sale. The wash sale period for any sale at a loss consists of 61 days; the day of the sale, the 30 days before the sale and the 30 days after the sale (Calendar days not trading days) The wash sale rule has three consequences: The loss is not allowed to be claimed The disallowed loss is added to the basis of the replacement stock (this basically preserves the benefit of the disallowed loss) The holding period for the replacement stock includes the holding period of the stock sold. Wash sales only apply to losses. A gain can be washed out by buying back the same stock within 30 days. 112 Basis Reporting when Transferring Securities Every “applicable person” that transfers to a broker a “covered security” will have to furnish to that broker a written statement that will enable the broker to meet the new requirements. This means that the furnished statement must allow the new broker to satisfy the basis and holding period reporting requirements. The statement must be furnished no later than 15 days after the date of transfer. The “applicable person” is any person the IRS designates in the regulations. Organizational Actions Which Affect Basis Any issuer of a specified security will have to file an information return with the following information: A description of any organizational action that affects the basis of the specified security of the issuer; The quantitative effect on the specified security's basis resulting from the organizational action; and Any other information the IRS may prescribe. Stock splits, mergers, and acquisitions are examples of organizational changes that affect basis. The information return will have to be filed no later than the earlier of: 45 days after the date of the organizational action; or January 15 of the year following the calendar year during which the organizational action occurred. Sale of Personal Residence47 For sales of a personal residence after May 6, 1997, a homeowner may exclude from income up to $250,000 of gain and a married couple may exclude up to $500,000 of gain realized on the sale. The Section 121 exclusion requires individuals to meet the following conditions: Ownership and use test: The individual must have owned and used the home as a principal residence for at least two out of the five years prior to the sale (the two years do not have to be consecutive). The taxpayer must own the home directly not through an entity Frequency limitation: The exclusion applies to only one sale every two years The Section 121 exclusion requires married couple to meet the following conditions: Joint return: The married couples must file a joint return Ownership: Either or both spouse(s) must have owned and used the home as a principal residence for at least two out of the five years prior to the sale (the two years do not have to be consecutive). The taxpayer must own the home directly not through an entity Use: Both spouses must have used the residence as their principal residence for at least two out of five years prior to the sale Neither spouse may have sold a home more than once every two years 47 IRC §121, Pub. 544 113 Reduced exclusion: taxpayers who do not meet the two-year ownership and use test of Section 121 may qualify for a reduced exclusion if the taxpayer sold a home due to: Job relocation - The new job location must also be at least 50 miles farther from the residence sold than was the former place of employment Health - A sale is due to health if the primary reason for the sale is to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of disease, illness or injury of a qualified individual Unforeseen circumstances such as the following: Natural and man-made disasters or acts of war or terrorism resulting in a casualty to the residence. Death, loss of job, change in job status, divorce or legal separation, multiple births from the same pregnancy. Involuntary conversion of residence An event the IRS determines as an unforeseen circumstance. A prorated exclusion of gain based on the period of time the homeowner meets the ownership and use requirements, and the period of time between the most recent sale of home and current sale. Dispositions other than Sales The following excerpts from Pub 17 regarding foreclosure and repossession of personal residence. Refer to Pub 523 for more information regarding foreclosure and abandonment of a personal residence. Sale of Business Property (Form 4797) and Installment Sales (Form 6252) Installment sales48 are sales of real or personal property (other than inventory) for which the taxpayer will receive payments after the year of sale. Installment sales that result in a loss are not qualified for installment sale treatment even if a payment is made after the tax year. Each payment in an installment sale consists of three parts: 1. Interest 2. Gain on the sale 3. Recovery of basis Interest must be charged at a rate at least equal to the IRS minimum. The amount of interest is subtracted from the total of payments made and the remainder is split between gain on sale and recovery of basis. 48 Pub 544 114 In the year of sale the gross profit percentage is calculated for the installment sale to determine how much of each payment is profit. The gross profit percentage is calculated by dividing the amount of gross profit by the contract price. The contract price includes the total of all principal payments to be made by the buyer over the term of the installment sale. The gross profit percentage is calculated only in the year of sale and used for each subsequent year. The sale retains its characteristics of ordinary income, short or long-term capital gain. Use Form 4797 to report the following transactions: 1. The sale or exchange of property used in a trade or business; depreciable or amortizable property; oil, gas, geothermal or other mineral properties; Section 126 property. 2. Involuntary conversion (other than casualty and theft) of property used in a trade or business and capital assets held in connection with a trade or business or a transaction entered into for profit. 3. The disposition of noncapital assets. 4. The disposition of capital assets not reported on Schedule D. 5. The recapture of Section 179 for partners and S corporation shareholders from property dispositions by partnerships and S corporations. 6. The computation of recapture amounts under Section 179 and 280F (b) (2) when business use drops to 50% or less. The following code sections apply when business property and other depreciable and amortizable assets are sold and reported on Form 4797: IRC §1231 (Form 4797, Part I) Personal and real business assets Gains exceed the depreciation taken Gains are treated as long-term capital gain treatment and subsequently reported on Schedule D Gains are treated as short-term capital gain treatment and subsequently reported on Schedule D IRC §1245 (Part II or III) Refers to gains from personal business assets and certain commercial real estate Gains result from claimed or allowable depreciation Gains are treated as ordinary income IRC §1250 (Part III) Gains from real property ACRS depreciation recapture as ordinary income ACRS on residential building excess over straight line recaptured as ordinary income No recapture under MACRS because straight line depreciation always taken Unrecaptured §1250 gain-taxed as capital gains at 25% rate IRC §179 and §280(f) Recapture of excess depreciation when business use falls under 50% Recapture of IRC §179 or §280(f) expense deduction allowable if the IRC §179 or §280(f) expense had not been taken Gains from the disposition of assets as a result of IRC § 179 are considered ordinary income Depreciation Recapture – is a term that refers to the amount of gain that is treated as ordinary income upon the sale or disposition of property. Gain that is treated as capital gain is not depreciation recapture, even if it is attributable to prior depreciation deductions. 115 Chapter 10 - Types of IRA’s and Employer Sponsored Pension Plans - Distributions Refer to IRS Pub 590 for an explanation of each plan, limitations and allowed contributions. Roth IRA Conversions The Tax Increase Prevention and Reconciliation Act of 2005 had a provision that in taxable years beginning after December 31, 2009, the AGI limitation that prevented many taxpayers from converting traditional IRAs to Roth IRAs are eliminated. A taxpayer who made a conversion in 2010 was allowed to recognize all the income in 2010 or spread the income over the next two years. A taxpayer who did not elect to report the conversion income in 2010 must report half in 2011 and half in 2012. This is a onetime opportunity; if making the election in 2011 or later the taxpayer must recognize all the income in the year of conversion. Reporting Distributions The following are reported on Form 1040 Line 15a and 15b: 1. Traditional IRA 2. Roth IRA 3. Simplified Employee Pension (SEP) IRA 4. Savings Incentive Match Plan for Employees (SIMPLE) IRA Distributions from IRA’s are reported to the taxpayer on Form 1099-R, with an X in the IRA/SEP/SIMPLE check box. Distributions from a traditional IRA are fully or partially taxable in the year of distribution. If the taxpayer made only deductible contributions, distributions are fully taxable. The following are reported on Form 1040 Line 16a and 16b: Qualified pension, profit sharing, stock bonus, money-purchase, Keogh plans etc. Complies with special rules imposed by Internal Revenue Code and IRS regs. Contributions allowed by both the employer and employee It cannot discriminate between certain employees It must be permanent It must satisfy minimum vesting requirements Section 401(k) plans - employer controlled. Allows employee to defer compensation taxfree. Plans established by the United States, a state or political subdivision (does not include Section 457 plans). Section 457(b) plans available for certain state and local governments and entities tax exempt under Section 501. Allows employee deferred compensation. Tax-sheltered annuity plans Section 403(b) - Employee of a charitable, religious or educational organization. Allow employees to defer compensation tax-free. SEP plans Section 408 (k) - anyone with S/E income, contributions treated the same as an IRA. Distributions from a 401(k) plan may qualify for optional lump-sum distribution 116 treatment or rollover treatment as long as they meet the respective requirements Many 401(k) plans allow employees to make a hardship withdrawal because of immediate and heavy financial needs. Generally, hardship distributions from a 401(k) plan are limited to the amount of the employees' elective contributions only, and do not include any income earned on the deferred amounts. Hardship distributions are not treated as eligible rollover distributions. Roth IRA Distributions Qualified distributions from a Roth IRA are tax-free and are not included in gross income. To be a qualified distribution, the following requirements must be met: The distribution is made after the five-year period beginning with the first taxable year for which the contribution was made to a Roth IRA. The distributions is one of the following: o Made on or after age 59 ½ o Made because the taxpayer was disabled o Made to a beneficiary or an estate o Made to pay qualified first-time homebuyer amounts ($10,000 lifetime limit) Reporting Distributions The following are reported on Form 1040 Line 15a and 15b: Traditional IRA Roth IRA Simplified Employee Pension (SEP) IRA Savings Incentive Match Plan for Employees (SIMPLE) IRA Distributions from IRA’s are reported to the taxpayer on Form 1099-R, with an X in the IRA/SEP/SIMPLE check box. The following are reported on Form 1040 Line 16a and 16b: Qualified pension, profit sharing, stock bonus, money-purchase, Keogh plans etc. Complies with special rules imposed by Internal Revenue Code and IRS regs. Contributions allowed by both the employer and employee It cannot discriminate between certain employees It must be permanent It must satisfy minimum vesting requirements Section 401(k) plans - employer controlled. Allows employee to defer compensation taxfree. Plans established by the United States, a state or political subdivision (does not include Section 457 plans). Section 457(b) plans available for certain state and local governments and entities tax exempt under Section 501. Allows employee deferred compensation. Tax-sheltered annuity plans Section 403(b) - Employee of a charitable, religious or educational organization. Allow employees to defer compensation tax-free. SEP plans Section 408 (k) - anyone with S/E income, contributions treated the same as an IRA. 117 Distributions If the taxpayer did not pay any part of the employee pension or annuity and the employer did not withhold any part of the cost from their pay, then the amounts received each year are fully taxable. If part of the cost of an annuity represents a return of capital it is not taxable. The rest of the amount is taxable. Before age 59 ½ distributions from an IRA or qualified pension plan are taxable as ordinary income (except for the part that represents a return of capital) and are subject to a 10% penalty for early withdrawal. SIMPLE plans have a 25% early withdrawal penalty if the taxpayer has been in the plan less than 2 years. (Form 5329) When a taxpayer is between 59 ½ and 70 ½ distributions are taxable as ordinary income (except the portion that represents return of capital). There is no early withdrawal penalty. The plan participant has total control over the amounts of the distributions and the timing. No distribution is required. Form 5498 Form 5498 is document issued annually by a financial institution to report information about individual retirement accounts and other tax-preferred savings accounts. Form 5498 is filed with the Internal Revenue Service and a copy is also sent to the person who owns the account. Essentially, Form 5498 provides independent confirmation to the IRS of the amounts contributed to IRAs and other tax-preferred savings accounts. Required Minimum Distribution When a taxpayer is age 70½ distributions from Non-Roth IRA’s are required to begin. Distributions are taxable as ordinary income (except the portion that represents return of capital). Distributions can be lump sum or periodic as long as the required minimum distribution (RMD) is made in the year. The RMD can come from one account or several accounts. There is no penalty for taking distributions in excess of the RMD, but these amounts cannot be carried over to meet the next year requirement. For participants in qualified pension plans other than 5% owners the RMD rules do not apply until the participant reaches 70 ½ or retires whichever is later. If the employee starts the distributions later than 70 ½, the employee’s accrued benefit must be actuarially increased to reflect the value of the benefits the employee would have received if the distributions started at age 70 ½. Note: Required minimum distribution rules do not apply to Roth IRA’s. Distributions from Roth IRA’s are required after the death of the participant. The basic calculation of the RMD is determined by dividing the account balance by the distribution period. For years after the year of death the distribution period is generally the remaining life expectancy of the designated beneficiary. The distribution period is based on the age of the beneficiary as of his/her birthday in the year following the owner’s death, reduced by one year for each year that has elapsed since the owner’s death. If the beneficiary is the surviving spouse the distribution period is based on the age of the spouse as of his/her birthday in the year following the owner’s death, reduced by one year for each year that has elapsed since the owner’s death. If the owner died before he/she 118 reached 70 ½, the surviving spouse is not required to begin distributions until he/she reached 70 ½. (Refer to Pub 575). Refer to Life-expectancy tables in Pub 575. Rollovers of Pensions and IRA’s A rollover is taking receipt of assets for up to 60 days before reinvesting in a new retirement plan. A transfer is moving the assets directly from one custodian to another. Qualifying Rollovers 1. From one IRA to another IRA within the 60 day period with the taxpayer taking possession of the IRA during the 60 day period. IRA’s cannot be rolled over more than once in a 12-month period. 2. From an employer plan to an IRA within the 60-day period with the taxpayer taking possession of the distribution. The 60-day rule applies even if the distribution was in error. 3. A traditional IRA can be rolled into a qualified retirement plan. Nondeductible after tax dollars are not eligible to be rolled into an employer plan but can be rolled over from one IRA into another IRA. A SIMPLE IRA to a qualified retirement plan - the participant must be in the plan for 2 years. If the participant was not in the plan for 2 years the SIMPLE IRA can only be rolled into another SIMPLE IRA. 4. From a 457 plan to a qualified retirement plan. 5. From a 403(b) annuity plan to a qualified retirement plan 6. From a deceased spouse’s plan to the surviving spouse’s qualified plan 7. Rollover of after-tax contributions provided a direct trustee-to-trustee transfer is made. The taxpayer is responsible for tracking the basis on Form 8606. A Roth IRA can be rolled over to another Roth IRA but cannot be rolled over to a traditional IRA. Losses on the tax-deferred portion of IRA’s, pension plans and annuities are generally not deductible because the taxpayer has not paid tax on the money lost. The taxable portion of a pension or annuity is determined using the simplified method if the annuity starting date is after Nov. 18, 1996 and the participant is not 75 years or older. If the participant is in a nonqualified plan, age 75 or older on the annuity starting date refer to Pub 939. In order to determine the amount that is taxable under the Simplified Method the participants' cost must be established. The cost is everything the participant paid into the plan and taxable contributions by the employer. Cost does not include amounts excluded from income. Refunds of premiums, rebates, dividends, unpaid loans, or other tax-free amounts must be subtracted. The cost should be shown in Box 5 of Form 1099-R. Under the Simplified Method the tax-free part of each monthly annuity payment is computed by dividing the cost by the total number of expected monthly payments. For an annuity that is payable for the lives of the annuitants, this number is based on the annuitants ages on the annuity starting date and is determined from a table. For any other annuity the number is the number of monthly annuity payments in the contract. (Refer to Pub 17 or 590 for worksheet) 119 Form 1099-R 120 Distributions Codes – 1099 R Box 7 121 122 Lump-Sum Distributions ((Form 4972) (10-Year averaging)) is available for taxpayers born before 1936. See instructions for Form 4972 for qualifications and ten-year averaging tables. Additional Taxes on Qualified Plans (including IRA’s) – Form 5329 An additional tax is due if the taxpayer received an early distribution from a Roth IRA and Form 8606 line 21 is more than Form 8606 Line 23 (See Form 8606 instructions) or an early distribution from a qualified retirement plan other than a Roth IRA. An early distribution is before the participant reaches age 59 ½. The additional tax for early distributions from a qualified retirement plan is 10% unless the distribution is from a SIMPLE IRA within the first 2 years the participant is in the plan. In that case the penalty is 25%. If a contribution is more than the smaller of compensation or $4,000 ($5,000 if over 50), it is considered an excess contribution. A contribution made for the year a taxpayer turns 70 ½ or any later year, is also an excess contribution. There is a 6% excise tax each year on excess amounts that remain in an IRA. The excise tax will not apply if the excess is removed before the due date. Use Form 5329 to report additional taxes on: IRAs, Other qualified retirement plans, Modified endowment contracts, Coverdell ESAs, QTPs, Archer MSAs, or HSAs. The taxpayer must file Form 5329 if any of the following apply. The taxpayer received an early distribution from a Roth IRA. The taxpayer received an early distribution subject to the tax on early distributions from a qualified retirement plan (other than a Roth IRA). However, if distribution code 1 is correctly shown in box 7 of Form 1099-R, and the taxpayer owes the additional tax on each Form 1099-R, Form 5329 may not have to be filed. Instead, see the instructions for Form 1040, line 58, for how to report the additional 10% tax directly on that line. The taxpayer received an early distribution subject to the tax on early distributions from a qualified retirement plan (other than a Roth IRA), and met an exception to the tax on early distributions, and distribution code 1 is shown in box 7 of Form 1099-R. 123 The taxpayer received an early distribution subject to the tax on early distributions from a qualified retirement plan (other than a Roth IRA), and met an exception to the tax on early distributions from the list on page 3 but box 7 of Form 1099-R does not indicate an exception or the exception does not apply to the entire distribution. The taxpayer received taxable distributions from Coverdell ESAs or QTPs. The contributions for 2012 to a traditional IRAs, Roth IRAs, Coverdell ESAs, Archer MSAs, or HSAs exceed the maximum contribution limit. The taxpayer did not receive the minimum required distribution from their qualified retirement plan Form 5329, Line 2 The additional tax on early distributions does not apply to the distributions described below. Enter on line 2 the amount that can be excluded. In the space provided, enter the applicable exception number (01-12). 124 Exceptions to Additional Taxes on Qualified Retirement Plans49 01 Qualified retirement plan distributions if the taxpayer separated from service in or after the year they reach age 55 (does not apply to IRAs). Distributions made as a part of a series of substantially equal periodic payments (made at 02 least annually) for the taxpayer’s life or the joint lives of the taxpayer and their designated beneficiary (if from an employer plan, payments must begin after separation from service). 03 Distributions due to total and permanent disability. 04 Distributions due to death (does not apply to modified endowment contracts) Qualified retirement plan distributions up to (1) the amount the taxpayer paid for 05 unreimbursed medical expenses during the year minus (2) 7.5% of the adjusted gross income for the year. 06 Qualified retirement plan distributions made to an alternate payee under a qualified domestic relations order (does not apply to IRAs). 07 IRA distributions made to unemployed individuals for health insurance premiums. 08 IRA distributions made for higher education expenses. 09 IRA distributions made for the purchase of a first home (up to $10,000) 10 Distributions due to an IRS levy on the qualified retirement plan. 11 Qualified distributions to reservists while serving on active duty for at least 180 days. 12 Other (enter this code if more than one exception applies). 49 Form 5329 Instructions 125 Chapter 11 - Rental Real Estate, K-1 Income and Loss, Passive Activities Rental Income50 Rental income is any payment the taxpayer receives for the use or occupation of property or a dwelling unit. A dwelling unit includes apartments, condominiums, mobile home, boat, vacation home, or similar property. A dwelling unit has basic living accommodations such as sleeping space, a toilet and cooking facilities. Income from room rentals of a hotel or motel is not considered rental income and should be reported on a Schedule C. Included in rental income are the following items: Security deposits - that are kept by the property owner or landlord or used as the last months' rent, included in rent. Security deposits that are returned to the tenant are not income Advance rent is any amount received before the period that it covers. Include advance rent in rental income in the year it is received, regardless of the period it covers or the method of accounting used Payment for canceling a lease is included in income in the year received Expenses paid by the tenant are rental income and can be deducted as any other rental expense If property or services are received instead of money as part of the rent include the fair market value in income. If services are agreed upon at a specified price, that price is the fair market value If the tenant has a lease with an option to buy, the payments received under the agreement are usually rental income. If the tenant exercises the right the payments received after the date of sale are considered part of the selling price. Rental Expenses Ordinary and necessary expenses are deductible for managing, conserving or maintaining rental property from the time it is first available for rent. Accurate record keeping is mandatory for expenses to be deductible. Ordinary and necessary expense can be taken when a rental is vacant, but no losses can be deducted for the period the rental is vacant. Repairs are considered an expense and deductible in the year they are paid. Improvements add to the basis of the property and are depreciated. An improvement adds to the value of property, prolongs its useful life or adapts it to new uses. The cost of an improvement must be capitalized and can generally be depreciated as if the improvement was separate property. Repairs made within extensive remodeling or restoration of property are included as part of the improvement and capitalized. Work done on the rental property that does not add much to either the value of the house or the life of the property, but rather keeps the property in good condition is considered a repair, not an improvement. Repainting, fixing gutters, floors, or replacing broken windows are examples of repairs. 50 IRC §280A 126 The following is a list of common rental expenses: Advertising Cleaning and maintenance Utilities Insurance Taxes Interest Points Commissions Tax return preparation fees Local transportation costs Rental payments or leases on equipment Vacant property expenses are deductible beginning at the time the property is available for rent regardless of when rental income is actually received. Mortgage interest reported to the owner of the property on Form 1098 (if over $600) is a deductible expense. Points or “loan origination fees”, if any are charges solely for the use of the money and are considered interest. Insurance premiums paid in advance cannot be deducted in full in the year paid. The premium must be allocated to the period covered and deducted in that year. Local benefit taxes that increase the value of the property, such as charges for putting in sewers, streets or sidewalks are non-depreciable capital expenditures and are added to the basis only. The ordinary and necessary expenses of traveling are deductible if the primary purpose of the trip was to collect rents, or to manage, conserve, or maintain the rental property. The travel expenses must be properly allocated between rental and non-rental activities. (See Pub 463). The ordinary local transportation expenses to collect rents, or to manage, conserve, or maintain the rental property is deductible. Generally if the taxpayer uses his/her personal vehicle the expenses can be deducted using one of two methods: actual expense or standard mileage rate. In 2012 the standard mileage rate is $.555 per mile. (Refer to Pub 463) Condominiums and Cooperatives Special rules apply to the rental of a condominium or cooperative. A condominium is a dwelling in a multi-unit building. Along with owning the unit, the owner also owns some of the common elements of the structure such as land, lobbies, elevators, and service areas. The owners of the units may pay dues or assessments for the care of these common areas. If the condominium is a rental, expenses such as depreciation, repairs, upkeep, dues, interest, taxes and assessments for the care of the common parts of the structure are deductible. Any special assessments for improvements to the rental must be capitalized and depreciated. 127 All of the maintenance fees paid to cooperative housing authority for a cooperative apartment rented to others are deductible. Any payment for improvements or a capital asset cannot be deducted. The payment is added to the basis of the stock in the cooperative. In addition to the maintenance fees direct payments for repairs, upkeep and other rental expenses can be deducted. (Refer to Pub. 527) The personal use of a dwelling unit comes into play if a personal residence or any other property was changed to a rental at any time during the year other than the beginning of the tax year. The yearly expenses such as taxes and insurance must be divided between rental and personal use. For depreciation purposes, treat the property as being placed in service on the conversion date. If only part of a property is rented the expenses and depreciation must be divided between the rental and personal use. Direct expenses of the rental do not have to be divided. The cost of the first phone line cannot be deducted, but a portion of other utilities can be deducted. The most common way to divide the expenses is either by square footage or number of rooms. The tax treatment of rental income and expenses for a dwelling unit that is also used for personal purposes depends on whether it is used as a home. The dwelling unit is considered a home for tax purposes if during the year it is used for personal purposes more than the greater of: 1. 14 days …or 2. 10% of the total days it is rented to others at a fair rental price. If a home is rented fewer than 15 days during the year, none of the rental income or expenses is to be included. If the home is rented more than 15 days all the income and expense must be reported, including depreciation. All expenses and depreciation must be allocated between personal and rental use. (Refer to the passive section of this chapter for limitations of losses) Rental income, expenses and depreciation are reported on Part I of Schedule E. Depreciation (Form 4562) Depreciation is the annual deduction allowed to recover the cost or other basis of business or other investment property through yearly deductions. Depreciation reduces the basis through yearly tax deductions. Only the part of property used for business or rental purposes can be depreciated. Three basic factors determine how much depreciation can be deducted each year. 1. The basis in the property 2. The recovery period for the property 3. The depreciation method used. Depreciation starts when the property is first used in business or for the production of income. It ends when the property is taken out of service, deduct all depreciable cost or other basis, or no longer use the property in the business or for the production of income. 128 The basis of property must be reduced by the full amount of depreciation that could have been deducted, whether or not the depreciation was taken. The tax return can be amended if the proper amount of depreciation was not taken each tax year. Depreciation can be taken on property that meets all the following requirements: The taxpayer owns the property, even if there is debt on the property The property is used in a business or an income producing activity The property has a determinable useful life (something that wears out, decays, gets used up, becomes obsolete or loses value due to natural causes The property is expected to last more than one year The property is not property that is placed in service and disposed of in the same year or a Section 197 intangible Land can never be depreciated because land never wears out, becomes obsolete or gets used up. No deduction greater than basis may be taken. The total of the yearly deductions cannot be more than the cost or adjusted basis of the property. The total depreciation includes the depreciation deductions taken or was allowed to be claimed. The type of property and the date placed in service: 1. MACRS - Modified Accelerated Cost recovery System) for property placed in service after 1986. 2. ACRS - Accelerated Cost Recovery System for property placed in service after 1980 but before 1987. 3. Useful lives and either straight line or accelerated method of depreciation, such as declining balance method, for property placed in service before 1981 If property was placed in service before 2012 the same method of depreciation must be continued. To depreciate assets placed in service in 2012 the classification of the asset or recovery period must be determined: 3-year property includes (200% declining balance): A race horse that is more than 2 years old at any time it is placed in service Any horse other than a race horse that is more than 12 years old at the time it is placed in service Any qualified rent-to-own property 5-year property includes (200% declining balance): Automobiles Light general purpose trucks Typewriter, calculators, copiers etc. Any semi-conductor manufacturer Section 1245 property used in connection with research and experimentation Certain energy property Appliances, carpets, furniture, etc. 7-year property includes (200% declining balance): 129 Office furniture and equipment Railroad track Any property that does not have a class life and is not otherwise classified 10-year property includes (200% declining balance): Vessels, barges, tubs Any single purpose agricultural structure Any tree or vine bearing fruit 15-year property includes (150% declining balance): Any municipal wastewater treatment plant Any telephone distribution plant Any section 1250 property that is a retail motor fuels outlet 20-year property includes (150% declining balance): Farm buildings Municipal sewers not classified as 25 years 25-year property includes (straight-line method): Property that is an integral part of the gathering, treatment or commercial use of Municipal sewers Residential rental property – 27.5 years (straight-line method) Nonresidential real property – 39 years (straight line method) 50-year property – improvement to roadbed or right-of-way railroad track Report depreciation on Form 4562 and carry the deduction to the appropriate schedule. Use one Form 4562 per business or rental. Section 179-expense deduction is property described in Section 1245(a) (3) that was acquired by purchase for use in active conduct of the trade or business and is either Tangible property that can be depreciated under MACRS or Off-the-shelf computer software Section 179 does not include Property held for investment Property used mainly outside the United States Property used mostly to furnish lodging or in connection with the furnishing or lodging Property used by a tax-exempt organization Property used by a governmental unit or foreign person or entity Air conditioning or heating units Amortization is similar to the straight-line depreciation in that an annual deduction is allowed to recover certain costs over a fixed time period. Amortization can be taken on such items as the costs of starting up a business, goodwill and certain intangibles. 130 Listed property generally includes: Passenger automobiles weighing 6,000 pounds or less Any other property used for transportation of the nature that the property lends itself to personal use, such as motorcycles Any property used for entertainment or recreational purposes Computers or peripheral equipment Special Depreciation Allowance51 Special depreciation must be on original use property that started with the taxpayer. Purchase of used property does not qualify for Special depreciation treatment. Allowance Qualifying Property Placed in Service Date 50% Special Depreciation Allowance for Certain Property Acquired After December 31, 2007 and 100% Special Depreciation Allowance for Certain Property Acquired After September 8, 2010 IRC §168(k) New property only (cannot be used property). Must be one of the following: • MACRS property with a recovery period of 20 years or less. • Water utility property. • Off-the-shelf computer software that is not a section 197 intangible asset. • Qualified leasehold improvement property. • Certain transportation property and property with a recovery period of 10 years or more. Acquired and placed in service after 2007 and before 2014 (2014 for certain long life and transportation property). • Increased to 100% if placed in service after September 8, 2010 and before 2012 (2013 for certain long production period property 4 and transportation property). The 50% bonus depreciation and AMT depreciation relief are extended for most qualified property placed on service through December 31, 2013. The 100% bonus depreciation was not extended in the American Taxpayer Relief Act of 2012. Schedule E Schedule E is used to report the following income or losses: Real estate rental activities (Page 1) Royalty income and expenses from oil, gas or mineral properties (Page 1) Income or loss from partnership’s and LLC’s that are treated as partnerships Required unreimbursed partnership expenses Income/loss from an S-corporation Income or loss from estates or trusts Income or loss from REMIC Net farm rental income Classification of Activities 1. Passive activities - investment in a trade or business with no material participation (participated more than 100 hours in the tax year or more than a total of 500 hours), most rental activities, limited partnerships. There are limits on passive activity deductions and credits. Generally, income cannot 51 Pub 946, Form 4562 Instructions 131 be offset by passive losses (other than passive income). Nor can taxes be offset by income (other than passive income) with the credits resulting from passive activities. Any excess loss or credit is suspended to the next year Rental real estate activities are generally considered a passive activity and the amount of deduction allowed is limited. Active participation in rental real estate activity allows a taxpayer with an adjusted gross income of under $100,000 to deduct up to $25,000 ($12,500 if married filing separately) in passive losses against non-passive income. Taxpayers are considered actively participating if they own 10% of the rental activity and make management decisions in a significant and bona fide sense. Use Form 8582 to compute and track passive activities and suspended amounts from year to year 2. Non-passive activities - trade or business activate with material participation. Include wages and SE income. A person engaged in a trade or business is not subject to passive loss rules if material participation rules are met. Refer to Pub 925 for material participation criteria) 3. Portfolio Income - interest, dividends, and royalties from investments such as stocks, bonds and interest bearing accounts. If the taxpayer rented out a dwelling unit that was also used for personal purposes during the year, they may not be able to deduct all the expenses for the rental part. “Dwelling unit” (unit) means a house, apartment, condominium, or similar property. For each property listed on line 1, report the number of days in the year each property was rented at fair rental value and the number of days of personal use. A day of personal use is any day, or part of a day, that the unit was used by: The owner for personal purposes, Any other person for personal purposes, if that person owns part of the unit (unless rented to that person under a “shared equity” financing agreement), Anyone in the owners family (or in the family of someone else who owns part of the unit), unless the unit is rented at a fair rental price to that person as his or her main home, Anyone who pays less than a fair rental price for the unit, or Anyone under an agreement that lets the owner use some other unit. Do not count as personal use: Any day spent working substantially full time repairing and maintaining the unit, even if family members used it for recreational purposes on that day, or Any days the unit as the main home before or after renting it or offering it for rent, if the owner rented or tried to rent it for at least 12 consecutive months (or for a period of less than 12 consecutive months at the end of which it was sold or exchanged). Whether or not the taxpayer can deduct expenses for the unit depends on whether or not they used the property as a residence in 2012. It is considered a residence if the property was used as a residence more than the greater of: 14 days, or 10% of the total days it was rented to others at a fair rental price. 132 If the taxpayer did not use the property as a residence, they can deduct all the expenses for the rental part, subject to the At-Risk Rules and the Passive Activity Loss Rules explained later. If the taxpayer did use the property as a residence and rented the unit out for fewer than 15 days in 2012, do not report the rental income and do not deduct any rental expenses. If they itemize deductions on Schedule A, they can deduct allowable interest, taxes, and casualty losses. If the taxpayer did use the property as a residence and rented the unit out for at least 15 days in 2012, they may not be able to deduct all their rental expenses. They can deduct all the following expenses for the rental part on Schedule E. Mortgage interest. Real estate taxes. Casualty losses. Other rental expenses not related to the use of the unit as a home, such as advertising expenses and rental agents' fees. If any income is left after deducting these expenses, they can deduct other expenses, including depreciation, up to the amount of remaining income. They can carry over to 2012 the amounts they cannot deduct. Regardless of whether the taxpayer used the unit as a residence, expenses related to days of personal use do not qualify as rental expenses. The expenses must be allocated based on the number of days of personal use to total use of the property. Refer to Pub 527. QJV. Check the box for “QJV” if the taxpayer owned the property as a member of a qualified joint venture reporting income not subject to self-employment tax. Royalty Income Royalty from copyrights, patents and oil, gas and mineral properties are taxed as ordinary income, which is generally reported on Schedule E. If the royalties are received as a selfemployed writer, inventor or artist, report the royalties on Schedule C. Copyright and patent income is generally paid to the taxpayer for the right to use the taxpayer’s work over a period of time. Royalties from oil and gas are paid by a person or company who leases the property from the taxpayer. (Refer to Schedule E instructions for additional information). Comprehensive Schedule E Example Rental and royalty income are reported on Schedule E page 1, and the total is carried to page 2 line. The pass-through K-1’s are reported on page 2 of Schedule E. 133 John and Maria Sample own a rental and receive some royalties from an oil investment. They had been preparing their return each year using computer software. Normally they showed a gain on their rental. They came to see me because they did not understand why the software was not allowing the full loss on their property and they had some questions. I set them a consultation appointment where I looked over their return and explained the filing. They asked me if there was anything else they could deduct on their rental and I explained what was allowed. They produced receipts for several items they had not included. Rental income, expenses and depreciation are reported on Part I of Schedule E. In the course of our discussion, John and Maria asked me to prepare their return, which had not been filed. They agreed to electronically file the return. The Schedule E was straightforward we reported their rental income and expenses, entered their royalty income. I explained to them that even though they materially participated in the rental, there is a passive activity with special rules. Generally, losses from passive activities that exceed the income from passive activities are disallowed for the current year. Disallowed passive losses are carried forward to the next taxable year.52 Since John and Maria collect the rents and do all the work around the rental they meet the requirement for active participation in rental real estate. Since the taxpayer and spouse actively participated in a passive rental real estate activity, they can deduct up to $25,000 ($12,500 MFS) of loss from the activity, depending on their adjusted gross income. Modified adjusted gross income for this purpose is the adjusted gross income figured without the following. Taxable social security and tier 1 railroad retirement benefits. Deductible contributions to individual retirement accounts (IRAs) and section 501(c) (18) pension plans. The exclusion from income of interest from qualified U.S. savings bonds used to pay qualified higher education expenses. The exclusion from income of amounts received from an employer's adoption assistance program. Passive activity income or loss included on Form 8582. I told them, generally, they may deduct in full any previously disallowed passive activity loss in the year that they dispose of their entire interest in the activity. The Schedule E below shows a loss from rental real estate of $11,914 and an allowed passive loss of $4,114. I explained the Schedule E to John and Maria, we discussed the royalty income shown separately and how that was investment income and not passive income. 52 Pub 925 134 Adjusted gross income, modified as required Minus amount not subject to phase-out Amount subject to phase-out rule Multiply by 50% $141,773 $100,000 $41773 × 50% Required reduction to special allowance $20886 Maximum special allowance $25,000 Minus required reduction (see above) $20,886 Adjusted special allowance Passive loss from rental real estate $4,114 $11,914 Deduction allowable/Adjusted special allowance (see above) $4,114 Amount that must be carried forward $7,800 John and Maria Sample Modified Adjusted Gross Income Form 1040, Line 37 (AGI)…….$137,659 Plus Allowed Passive Activity Loss, Schedule E, Line 22 …….$ 4,114 Modified AGI..............................$141,773 Refer to Form 8582 below, Page 1, Part II regarding the Special Allowance for Rental Real Estate with Active Participation and Form 8582 Page 2 and 3 for the allowed loss and the unallowed loss. 135 136 . 137 138 139 140 Pass-through Income from Partnership, S-Corporation, Estate or Trust K-1’s Schedule E, Page 2 is where all pass-through K-1 income or loss is reported. Partners and S Corporation shareholders and estate or trust beneficiaries should get a separate Schedule K-1 (or substitute statement) of income, expenses, deductions and credits for each activity engaged in by the partnership or S-corporation. Every K-1 should have instructions regarding the correct reporting of the partner or shareholder’s share of the items. 141 Schedule K-1 is issued through the Partnership, S-Corporation or Estate and Trust. The income deductions or credits are reported on the individual tax return The Schedule K-1 is not attached to the individual return. The taxpayer may deduct unreimbursed ordinary and necessary expenses paid on behalf of the partnership if required to pay these expenses under the partnership agreement. The K-1 instructions will tell where the income or loss is to be reported. Ordinary or rental income or loss from a partnership, S-corporation or an estate or trust is reported on Schedule E, page 2. If the partner is classified as a limited partner (did not materially participate in the partnership), the income from the K-1 is passive. The loss is allowed up to the distributive share of income and is not subject to self-employment tax. If the partner is classified as a general partner (did materially participate in the partnership), the income from the K-1 is not passive. The loss is allowed. The partner is subject to selfemployment tax on guaranteed payments and the distributive share of income. A sale of a passive activity is considered to be a nonpassive transaction. Passive activity losses that have not been deducted in a prior year (suspended) are generally allowed in the year of disposition. This includes the current year loss and any losses suspended from a prior year. This rule applies if the entire entity is disposed of and the sale is not made to a related party. Farm Income Sources of Income Subject to SE Tax Sales of livestock and other items bought for resale Sales of livestock, produce, grains, etc. that the taxpayer raised Distributions received from cooperatives Agricultural program payments Custom hire work Federal and state fuel tax credits Accounting Methods for Farmers 1. Cash method - income is reported when actually received or constructively received. Expenses are deducted in the year paid. 2. Accrual method – required for certain farm corporations and partnerships, and for all tax shelters. Report income in the year in which it was earned and expenses in the year incurred. 3. Special methods of accounting for certain items of income and expenses. Crop method is a method used by farmers who do not complete harvesting and disposing of crops within the tax year they are planted. The entire cost of the crop is deducted in the year the income is realized. 4. Combination hybrid method using elements of 1, 2, and 3. 142 Section 179 Deductions - Farm Property Trade or business property that qualifies for a Section 179 deduction includes: Tangible personal property such as machinery and equipment, milk tanks, automatic feeders, barn cleaners and office equipment Livestock Single-purpose agricultural and horticultural structures such as greenhouse, hay storage, integrated hog raising facility Milk parlor Poultry house Depreciation - Three, five, seven and ten-year MACRS property used in a farming business must be depreciated using 150% declining-balance or SL method. Principal Agricultural Codes - are included on page 2 of Schedule F. An activity code must be included on all Schedule F’s to classify farms. These codes are based on the North American Industry Classification Industry. An election can be made to figure the tax by averaging over the previous three base years. Making this election may provide a lower tax if the current year tax is high and in one of the previous three years the tax is low. Farm averaging is computed on Schedule J (Refer to Schedule J instructions). 143 144 Chapter 12 - Unemployment Compensation, Social Security Benefits and Miscellaneous Income Unemployment Compensation The taxpayer must include in income all unemployment compensation received. The taxpayer should receive a Form 1099-G showing in box 1 the total unemployment compensation paid. Generally, enter unemployment compensation on line 19 of Form 1040, line 13 of Form 1040A, or line 3 of Form 1040EZ. Types of unemployment compensation. Unemployment compensation generally includes any amount received under an unemployment compensation law of the United States or of a state. It includes the following benefits: Benefits paid by a state or the District of Columbia from the Federal Unemployment Trust Fund. State unemployment insurance benefits. Railroad unemployment compensation benefits. Disability payments from a government program paid as a substitute for unemployment compensation. (Amounts received as workers' compensation for injuries or illness are not unemployment compensation) Trade readjustment allowances under the Trade Act of 1974. Unemployment assistance under the Disaster Relief and Emergency Assistance Act. Governmental program. If the taxpayer contributes to a governmental unemployment compensation program and the contributions are not deductible, amounts they receive under the program are not included as unemployment compensation until they recover those contributions. If the taxpayer deducted all of the contributions to the program, the entire amount received under the program is included in income. Tax withholding. The taxpayer can choose to have federal income tax withheld from unemployment compensation. To make this choice the taxpayer completes Form W-4V, Voluntary Withholding Request. NOTE: Unemployment compensation is not taxable to California 145 Social Security Benefits Social Security benefits may be taxable. To find out whether any of the Social Security Benefits received are taxable compare one-half of the benefits plus all other income including tax-exempt with the base amount. The base amount is $25,000 if single, head of household or qualifying widow(er) $25,000 if married filing separately and lived apart from the spouse for the tax year $32,000 if married filing jointly, or -0- if married filing separately and lived with the spouse at any time during the year If one-half of the benefits plus all other income is less than the base amount none of the social security benefits are taxable. If one-half of the benefits plus all other income is more than the base amount some of the social security benefits are taxable. The total amount of social security benefits are reported on Line 20A of Form 1040 and the taxable amount is reported on Line 20b. Year of Birth* Full Retirement Age 1937 or earlier 65 1938 65 and 2 months 1939 65 and 4 months 1940 65 and 6 months 1941 65 and 8 months 1942 65 and 10 months 1943--1954 66 1955 66 and 2 months 1956 66 and 4 months 1957 66 and 6 months 1958 66 and 8 months 1959 66 and 10 months 1960 and later 67 *If you were born on January 1st of any year you should refer to the previous year. Early retirement permanently reduces the amount of benefits. If receiving early retirement benefits there is an earnings limit on receiving benefits. For 2012 the earnings limit is $14,640, benefits are reduced by $1 for each $2 earned. 146 Delayed retirement is available for a worker over the full retirement age. At age 70 the worker automatically starts receiving benefits. Benefits are increased by a monthly percentage if the worker delays retirement. If a taxpayer, spouse or dependent does not have a Social Security Number refer to the Social Security Administration website at www.ssa.gov or phone 1-800-772-1213 to apply. (Refer to Pub 517) Comprehensive Example of Taxable Social Security Income Social Security Rafael Ramirez decided to retire from his daily job when he was 63 years of age, Jane, his wife also 63 years of age retired as well. His side business of carpentry was still viable; he had a profit of about $80,000 a year. Rafael and Jane decided not to start withdrawing from their retirement while he still had earnings from this business. He researched his and Janes’ Social Security Benefits online53 and realized that he should not start collecting his Social Security Benefits early since his earnings would lower his benefits by $1 for each $2 he earned, until he reached full retirement age. Workers planning for their retirement should be aware that retirement benefits depend on age at retirement. If a worker begins receiving benefits before his/her full retirement age, the worker will receive a reduced benefit. A worker can choose to retire as early as age 62, but doing so may result in a reduction of as much as 30 percent. Starting to receive benefits after normal retirement age may result in larger benefits. With delayed retirement they earn more credits and a person can receive his or her largest benefit by retiring at age 70. In the case of early retirement, a benefit is reduced 5/9 of one percent for each month before normal retirement age, up to 36 months. If the number of months exceeds 36, then the benefit is further reduced 5/12 of one percent per month. Example: If the number of reduction months is 60 (the maximum number for retirement at 62 when normal retirement age is 67), then the benefit is reduced by 30 percent. This maximum reduction is calculated as 36 months times 5/9 of 1 percent plus 24 months times 5/12 of 1 percent. Delayed retirement credit is generally given for retirement after the normal retirement age. To receive full credit, the taxpayer must be insured at the normal retirement age. No credit is given after age 69. Rafael decided to do more research so he would have a better idea of the amount that would be taxable when he did receive his benefits. If the only income the taxpayer received during the tax year was social security income or equivalent railroad retirement benefits, the benefits may not be taxable and they may not have to file a tax return. 53 www.SSA.gov 147 Since Rafael and his wife received other income, his benefits will be taxable since his modified adjusted gross income (MAGI) is more than the base amount for their filing status. Rafael would continue filing a tax return. The taxable benefits and MAGI are figured by completing the worksheet in Form 1040 instructions. The taxable benefits, if any, must be included in the gross income of the person who has the legal right to receive them. If the taxpayer and his child received benefits, but the check for the child was made out in the taxpayer’s name, the taxpayer only reports social security benefits he received.54 If the taxpayer is married and files a joint return, the taxpayer and spouse must combine their incomes, social security benefits, and equivalent railroad retirement benefits when figuring the taxable portion of their benefits. Even if the spouse did not receive any benefits, the spouse’s income must be added to the taxpayer’s when figuring if any of the benefits are taxable, if they file a joint return. The taxpayer should receive Form SSA-1099 or Form RRB-1099 by early February for the benefits paid in the prior calendar year. The form will show benefits paid to the person who has the legal right to receive them, and the amount of any benefits repaid. It will also show amounts by which the benefits were reduced because the taxpayer received workers' compensation benefits. The substitute workers' compensation benefits would be taxable to the same extent. For additional information, refer to Publication 915, Social Security and Equivalent Railroad Retirement Benefits. Taxable Social Security Benefits Social Security benefits are taxed depending on the total income from all sources. Here is how to calculate how much of the taxpayer’s Social Security benefits is taxable. If the total income, including tax-exempt income, plus half of the Social Security benefits is below the base amounts for the taxpayer’s filing status, then the Social Security benefits are completely non-taxable. If the total income, including tax-exempt income, plus half of the Social Security benefits is between the base amount and the additional amount, then half of the Social Security benefits over the base amount are taxable. If the total income, including tax-exempt income, plus half of the Social Security benefits is over the additional amount, then $4,500 (or $6,000 if Married Filing Jointly) plus 85% of the Social Security benefits over the additional amount are taxable. The taxable portion of Social Security benefits cannot exceed 85% of the total benefits. Example: Martin, age 68 and Harriett, age 63 are both collecting Social Security Benefits. Martin started collecting Social Security at full retirement age. Harriet started 54 Form 1040 Instructions 148 receiving benefits this year at age 63 when she retired – the following worksheet is an example of the worksheet found in Form 1040 Instructions Miscellaneous Income55 Items The following items are reported on Line 21 of Form 1040, for additional items refer to Pub 17, Form 1040 instructions or IRS Pub 525: Hobby income or not-for-profit income is income that must be reported and accurate records must be kept, according to generally accepted accounting practices. Expenses are allowed to be deducted from this income. The expenses are limited to the amount of income. Refer to Chapter 8 of this text for a discussion of Hobby vs. Business Income. Taxable distribution from Coverdell Education Savings Account (ESA) or a Qualified Tuition Program (QTP) – distributions from these accounts may be taxable if they exceed higher education expenses and were not included in a qualified rollover. Taxable distribution from a health savings account or an Archer MSA if the exceed unreimbursed qualified medical expenses and were not included in a qualified rollover. Gambling winnings reported on Form W-2G. Reimbursements or other amounts received for items deducted in a prior year. The value of cash, property, services, credits, or scrip the taxpayer received from exchanges during the taxable year. Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, or a similar statement from the barter exchange should be sent to the taxpayer and the IRS reporting the value. Canceled Debts - If a debt owed by the taxpayer is canceled or forgiven, other than as a gift or bequest, they must include the canceled amount in income. All nonbusiness canceled debt is reported on Line 21. The taxpayer will receive Form 1099-C if a Federal Government agency, financial institution, or credit union cancels or forgives a debt of 55 Pub 525 149 $600 or more. Income from an activity not engaged in for profit, such as hobby income. Income from rental of personal property if the taxpayer engaged in the rental for a profit but was not in the business of renting that property. Alaska Permanent Fund dividend income, the taxable amount is stated with each check and reported to the IRS. Net Operating Losses from a prior year (NOL). Credit Card Insurance – If the taxpayer receives benefits under a credit card disability or unemployment insurance plan where the minimum payment to the credit card is made for the taxpayer. The amount received in excess of the premiums. Executor or administrator of an estate income may be subject to self-employment tax. Kickbacks Jury duty fees not reported on Form W-2 Illegal income Prizes and awards Items not considered miscellaneous income for tax purposes Cash rebates – from manufacturers or dealers Casualty insurance and other reimbursements (refer to Pub 547) Damages received for emotional distress due to physical injury or sickness Foster care payments are generally not taxable 150 Chapter 13- Adjustments to Income Form 1040 Adjustments to Income If the taxpayer is an eligible educator, they can deduct up to $250 ($500 if married filing joint and both spouses are educators, but not more than $250 each) of any unreimbursed expenses [otherwise deductible as a trade or business expense] paid or incurred for books, supplies, computer equipment (including related software and services), other equipment, and supplementary materials that are used in the classroom. For courses in health and physical education, expenses for supplies are qualified expenses only if they are related to athletics. This deduction is for expenses paid or incurred during the tax year. The deduction is claimed on either line 23 of Form 1040 or line 16 of Form 1040A. If the taxpayer is an eligible teacher, instructor, counselor, principal or aide who worked at least 900 hours a school year in a school that provides elementary or secondary education (K-12), as determined under state law. Form 1040, line 24 is where an adjustment for certain business expenses of reservists, performing artists and fee-based government officials56 are reported. Reservists have now been added to the special rules allowing an adjustment for these expenses rather than an itemized deduction like other employee business expenses. These adjustments are computed on Form 2106 and have limitations due to AGI. The adjustment coming from Form 2106 for reservists, performing artists and fee-based government employees is claimed on Form 1040, line 24. 56 Pub 463, Form 2106 151 Health Savings Account A health savings account (HSA) is a tax-exempt trust or custodial account that is set up with a U.S. financial institution (such as a bank or an insurance company). Health Savings Accounts are designed to allow the taxpayer to save for current and post-retirement qualified medical expenses on a tax-free basis. This account must be used in conjunction with a high deductible health plan (HDHP). The adjustment for health savings account is claimed on Form 1040, line 25. The HSA can be established using a qualified trustee or custodian that is different from the HDHP provider. Contributions to an HSA must be made in cash or through a cafeteria plan. Contributions of stock or property are not allowed. Benefits of an HSA: The HSA is tax deductible even if the taxpayer is not itemizing Contributions made by the employer (including contributions through a cafeteria plan) may be excluded from gross income The contributions remain in the account from year to year until used The interest or other earnings on the assets in the account are tax free Distributions are tax free if used for qualified expenses An HSA is portable and stays with the taxpayer. Contributions to an HSA are generally limited to the maximum allowable deduction for the year or the HDHP annual deductible. Individuals age 55 or over are allowed catch up contributions. Moving expenses are reported on Form 3903. Moving costs are allowed for moving household goods and personal effects and travel expenses for one trip for the taxpayer and each member of the household. Household members do not have to travel together or at the same time. The standard mileage rate for moving expenses is 23 cents per mile for tax year 2012. The adjustment for moving expenses is claimed on Form 1040, line 26. To file Form 3903 the taxpayer must meet the following general rules: The taxpayer must move within the U.S. or be an U.S. citizen The distance test is met if the new place of work is at least 50 miles farther from the former home than the old main job location was The employee must work at the new job for at least 39 weeks to qualify, for married filing joint returns only one spouse needs to work 152 Deductible Part of Self-Employment Tax If there is any self-employment income compute Schedule SE first and then deduct the employer equivalent portion of self-employment income tax from Schedule SE. The deduction is 57.51% if the amount of self-employment tax is $14,643 or less; If self-employment tax is more than $14,643 the deduction is 50% times the amount of self-employment tax plus $1,100 in 2012. 153 IRC §401(k)57 A 401(k) plan is a qualified deferred compensation plan in which an employee can elect to have the employer contribute a portion of his or her cash wages to the plan on a pretax basis. Generally, these deferred wages (commonly referred to as elective contributions) are not subject to income tax withholding at the time of deferral, and they are not reflected on Form 1040 since they were not included in the taxable wages on Form W-2. However, they are included as wages subject to withholding for social security and Medicare taxes. In addition, employers must report the elective contributions as wages subject to federal unemployment taxes. The amount that an employee may elect to defer to a 401(k) plan is limited by the Internal Revenue Code. In addition, the elective contributions may be limited based on the terms of the 401(k) plan. Retirement Plan Contributions Reported on Line 28 of Form 1040 Type of Plan SEP SIMPLE IRA and SIMPLE 401(k) Last Date for Contribution 1 Smaller of $50,000 or 25% 25% of all of participant's participants' 2 2 compensation. compensation. Salary reduction contributions: 30 days after the end of the month for which the contributions are to be 4 made. Employee contribution: Salary reduction contribution up to $11,500, $14,000 if age 50 or over. Contributions generally When To Set Up Plan Any time up to the due date of employer's return (including extensions). Any time between 1/1 and 10/1 of the calendar year. Employer contribution: Same as maximum Either dollar-for-dollar contribution. Matching or matching contributions, up nonelective to 3% of employee's contributions: Due date compensation,3or fixed of employer's return nonelective contributions of 2 (including extensions). 2% of compensation. Qualified Plan: Defined Contribution Employer contribution: Plan Money Purchase or Profit Sharing: Due date of employer's return (including extensions). 57 1 Due date of employer's return (including extensions). Elective deferral: Due date of employer's return 4 (including extensions). Qualified Maximum Deduction Maximum Contribution For a new employer coming into existence after 10/1, as soon as administratively feasible. Employee contribution: Elective deferral up to $17,000, $22,500 if age 50 or over. Employer Contribution: Money Purchase: Smaller 1 of $50,000 or 100% of participant's 2 compensation. 1 25% of all participants' By the end of the tax 2 compensation , plus year. amount of elective deferrals made. Profit-Sharing: Smaller of 1 $50,000 or 100% of participant's 2 compensation. Amount needed to provide Based on actuarial Topic 424 154 By the end of the tax Plan: must be paid in quarterly Defined installments, due 15 Benefit Plan days after the end of each quarter. an annual benefit no larger assumptions and year. than the smaller of computations. $200,000 or 100% of the participant's average compensation for his or her highest 3 consecutive calendar years. 1 Net earnings from self-employment must take the contribution into account. 2 Compensation is generally limited to $250,000 in 2012. 3 Under a SIMPLE 401(k) plan, compensation is generally limited to $250,000 in 2012 4 Certain plans subject to Department of Labor rules may have an earlier due date for salary reduction contributions and elective deferrals A self-employed health insurance deduction is deductible if the taxpayer was self-employed and had a net profit or the taxpayer received wages from an S-corporation in which the taxpayer was a 2% shareholder. The insurance plan must be established under the business and there must be net profit equal to or more than the self-employed health insurance premiums. (Refer to Pub 535). The adjustment for self-employed health insurance is claimed on Form 1040, line 29. Premiums paid for health insurance covering the taxpayer, spouse and dependents generally qualify for this deduction. Premiums paid for coverage of an adult child under age 27 at the end of the year, for the time period beginning on or after March 30, 2010, also qualify for this deduction, even if the child is not the taxpayer’s dependent. As in previous years, the insurance plan must be set up under the taxpayer’s business, and the taxpayer cannot be eligible to participate in an employer-sponsored health plan. Details, including a worksheet, are in the instructions to Form 1040. Enter the penalty on early withdrawal from savings or certificate reported on Form 1099-INT or 1099-OID. This amount does not get deducted from taxable interest. The adjustment for penalty on early withdrawal is claimed on Form 1040, line 30. Alimony Paid Alimony is a payment to or for a spouse or former spouse under a divorce or separation instrument. It does not include voluntary payments not in the decree. Alimony is deductible by the payer and must be included in income by the payee. Payments not alimony: 1. Child Support 2. Noncash property settlement 3. Payments that are the spouses part of community property 4. Payment’s to keep up the payer’s property 5. Use of property Payments included as alimony Payments to a third party Life insurance premium Payments for a jointly-owned home Mortgage payments Taxes and Licenses 155 Only the taxpayers share (1/2) of payments for a jointly owned home, mortgage interest and taxes and licenses can be deducted as alimony. The spouse’s Social Security Number must be provided; there may be a $50 penalty and the deduction may be disallowed. The adjustment for alimony paid is claimed on Form 1040, line 31. (Refer to Pub 504) IRA58 IRA Contributions are reported on Line 32, Form 1040. An individual retirement arrangement, or IRA, is a personal savings plan, which allows the taxpayer to set aside money for retirement, while offering tax advantages. Different kinds of IRAs can be set up with a variety of organizations, such as a bank or other financial institution, a mutual fund, or a life insurance company. The original IRA is referred to as a "traditional IRA." A traditional IRA is any IRA that is not a Roth IRA or a SIMPLE IRA. The taxpayer may be able to deduct some or all of their contributions to a traditional IRA. The taxpayer may also be eligible for a tax credit equal to a percentage of their contribution. Amounts in the traditional IRA, including earnings, generally are not taxed until distributed to the taxpayer. IRAs cannot be owned jointly. However, any amounts remaining in an IRA upon death will be paid to a beneficiary or beneficiaries. Type of Plan Tax Year 2012 Tax Year 2013 Traditional IRA AGI Phase-out Range $58,000 - $68,000 (S/HH) $92,000 - $112,000 (M, Covered) $173,000 - $183,000 (M, Not Covered) $110,000 - $125,000 (S/HH) $173,000 - $183,000 (MFJ) $0 - $10,000 (MFS, Covered) $6,000 age 50 and over; $5,000 under age 50 $17,000/age 50 and over $22,500 $59,000 - $69,000 (S/HH) $95,000 - $115,000 (M, Covered) $178,000 - $188,000 (M, Not Covered) $112,000 - $127,000 (S/HH) $178,000 - $188,000 (MFJ) $0 - $10,000 (MFS, Covered) $6,500 age 50 and over; $5,500 under age 50 $17,500/age 50 and over $23,000 Roth IRA AGI Phaseout Range Contribution 401(k) Elective Contribution Limit To contribute to a traditional IRA, the taxpayer must be under age 70 1/2 at the end of the tax year. There must be taxable compensation, such as wages, salaries, commissions, tips, bonuses, or net income from self-employment. Taxable alimony and separate maintenance payments received by an individual are treated as compensation for IRA purposes. IRA Contributions are reported on Line 32, Form 1040. Qualifications for a traditional IRA include: Must not be over 70 ½ by the end of the tax year Must have earned income (if married filing jointly a spouse can make contributions based on the other spouse’s earned income - Spousal IRA) No gross income limitations for individuals who are not participating in a qualified plan If taxpayer is in a qualified plan (active participant in an employer retirement plan), 58 IRC §408 156 contribution is subject to phase out of modified adjusted gross income – see the excerpt from Pub 590. All distributions are taxable Qualifications for a Spousal IRA include: The spouse must not be over 70½ by the end of the tax year Must have earned income (spouse can make contributions based on the taxpayers income) No gross income limitations for individuals who are not participating in a qualified plan If working spouse is in a qualified plan (active participant in an employer retirement plan), the non-working spouse’s contribution is subject to phase out rules (See chart below) All distributions are taxable Distributions from Traditional IRA’s are taxable upon distribution, with Roth IRA’s only the interest earned is taxable. Roth IRA can convert to a traditional IRA, but is taxable upon conversion as ordinary income. After conversion all traditional IRA rules apply.59 Compensation does not include earnings and profits from property, such as rental income, interest and dividend income, or any amount received as pension or annuity income, or as deferred compensation. If the taxpayer is covered by a retirement plan at work, use this table to determine if the modified AGI affects the amount of the deduction.60 In addition, The Modified AGI Is... Then Take... $58,000 or less a full deduction up to the amount of the contribution limit. more than $58,000 but less a partial deduction. than $68,000 $68,000 or more no deduction. married filing jointly or $92,000 or less a full deduction up to the amount of qualifying widow(er) the contribution limit. more than $92,000 but less a partial deduction. than $112,000 $112,000 or more no deduction. married filing separately less than $10,000 a partial deduction. $10,000 or more no deduction. If the taxpayer files separately and did not live with the spouse at any time during the year, the IRA deduction is determined under the "single" filing status. If The Filing Status Is... single or head of household 59 60 Pub 590 Pub 575 157 If the taxpayer is not covered by a retirement plan at work, use this table to determine if the modified AGI affects the amount of the deduction. If The Filing Status Is... single, head of household, or qualifying widow(er) married filing jointly or separately with a spouse who is not covered by a plan at work married filing jointly with a spouse who is covered by a plan at work And The Modified AGI Is... any amount any amount $173,000 or less Then Take... a full deduction up to the amount of the contribution limit. a full deduction up to the amount of the contribution limit. a full deduction up to the amount of the contribution limit. a partial deduction. more than $173,000 but less than $183,000 $183,000 or more no deduction. married filing separately with a spouse less than $10,000 a partial deduction. who is covered by a plan at work $10,000 or more no deduction. If the taxpayer files separately and did not live with the spouse at any time during the year, the IRA deduction is determined under the "single" filing status. Roth IRA A Roth IRA is an individual retirement arrangement that except as explained below is subject to the rules that apply to a traditional IRA. Roth IRAs can be set up anytime during the year, generally the taxpayer can contribute to a Roth IRA if they have compensation during the year. The IRA can be either an account or annuity. Refer to the AGI limitations in the chart below. A Roth IRA61 differs from a traditional IRA in several respects: A Roth IRA does not permit a deduction at the time of contribution. with exception of the 70½ age rule for required distribution. The age rule does not apply to Roth IRA's. Regardless of the taxpayer’s age, they may be able to establish and make nondeductible contributions to a Roth IRA. The taxpayer does not report Roth contributions on their tax return. To be a Roth IRA, the account or annuity must be designated as a Roth IRA when it is set up. Roth IRA’s are not deductible. 61 Student Loan Interest is deductible (up to $2,500) if the taxpayer meets the following restrictions: The taxpayer cannot be a dependent on another return Not available for married filing separate taxpayers The taxpayer must have the primary obligation to repay the loan Interest on a loan from a related party does not qualify Topic 309 158 Loans made under a qualified employer plan do not qualify for the deduction The deduction is phased out for 2012 when modified AGI is $60,000 to $75,000 ($120,000 to $150,000 MFJ) Qualified loans are loans for tuition, fees, room and board, books, equipment and transportation paid for attendance at an eligible institution. The adjustment for student loan interest is be claimed on Form 1040, line 33. Tuition and fees deduction can be taken if all of the following apply: Qualified tuition and fees were paid for the taxpayer, spouse or dependent The filing status on the return is any filing status other that married filing separately The modified adjusted gross income is not more than $80,000 for single, head of household, qualifying widow(er); $160,000 if married filing joint The taxpayer cannot be claimed as a dependent on another return There cannot be an education credit for the same return The taxpayer must be a U.S. citizen Form 8917 is used to compute the allowable deduction and reported on Form 1040, Line 34. Qualified tuition and fees do not include the following: Room and board Course related books Any course involving sports, games or hobbies Qualified tuition and fees must be reduced by the following: Excludable U.S. series EE bonds Nontaxable qualified state tuition programs Nontaxable earnings from education savings account Any scholarship, educational assistance or other payment Taxpayers must file Form 1040 to take this deduction for up to $4,000 of tuition and fees paid to a post-secondary institution. It cannot be claimed on Form 1040A. The adjustment for tuition and fees is claimed on Form 1040, line 34 159 Domestic Production Activity Deduction – Form 8903 – Line 35 The American Jobs Creation Act of 2004 added the domestic production activities deduction, a tax benefit for certain domestic production activities. This deduction provides a tax savings against income attributable to domestic production activities. The Act created new Internal Revenue Code section 199 and is available to corporations, individuals, and pass-thru entities such as S Corporations, partnerships, estates and trusts. For the pass-thru entities, the deduction is applied at the individual partner, shareholder, or similar level. For 2012, the deduction equals 6% of the lesser of: (a) qualified production activities income; or (b) taxable income for the taxable year. However, the deduction for a taxable year is limited to 50 percent of the W-2 wages paid by the taxpayer during the calendar year that ends in such taxable year. Enter any other miscellaneous deductions and identify each deduction on the dotted line on line 36. Below is a list of some of these deductions with reference for additional information and identifiers required when filing: Archer MSA deduction (see Form 8853). Identify as “MSA.” Jury duty pay if the pay is given to the employer because the employer paid the taxpayer’s salary while they served on the jury. Identify as “Jury Pay.” Deductible expenses related to income reported on line 21 from the rental of personal property engaged in for profit. Identify as “PPR.” Reforestation amortization and expenses (see Pub. 535). Identify as “RFST.” Repayment of supplemental unemployment benefits under the Trade Act of 1974 (see Pub. 525). Identify as “Sub-Pay TRA.” Contributions to section 501(c) (18) (D) pension plans (see Pub. 525). Identify as “501(c) (18) (D).” Contributions by certain chaplains to section 403(b) plans (see Pub. 517). Identify as “403(b).” Attorney fees and court costs for actions involving certain unlawful discrimination claims, but only to the extent of gross income from such actions (see Pub. 525). Identify as “UDC.” Attorney fees and court costs the taxpayer paid in connection with an award from the IRS for information the taxpayer provided that helped the IRS detect tax law violations, up to the amount of the award includible in the gross income. Identify as “WBF.” 160 Chapter 14 – Itemized Deductions Standard Deduction vs. Itemized Deductions 161 Standard Deduction Enter the greater of itemized deductions or the standard deduction on Line 40 of Form 1040. Standard Deduction 2012 Standard Tax Year Deductions 2012 S HH MFJ/QW MFS $5,950 $8,700 $11,900 $5,950 Standard Deduction 201362 Standard Tax Year Deductions 2013 $6,100 S $8,950 HH $12,200 MFJ/QW $6,100 MFS Additional Standard Deduction, Age 65 and Over/ Blind $1,450 $1,450 $1,150 $1,150 Additional Standard Deduction, Age 65 and Over/ Blind $1,500 $1,500 $1,200 $1,200 Itemized Deductions Medical and Dental Expenses63 The AGI threshold for deducting medical expense increases from 7.5% to 10% for tax years beginning after December 31, 2012. NOTE: For taxpayers who have reached age 65 by the end of the year, the effective date of this provision is delayed until January 1, 2017. . The following are some examples of medical and dental expenses that can be deducted: Insurance premiums for medical and dental care qualified long-term care insurance policy covering qualified long-term care services Payments of fees to doctors, dentists, surgeons, chiropractors, psychiatrists, psychologists, and nontraditional medical practitioners Payments for in-patient hospital care or nursing home services, including the cost of meals and lodging charged by the hospital or nursing home Payments for acupuncture treatments or inpatient treatment at a center for alcohol or drug addiction, for participation in a smoking-cessation program and for drugs to alleviate nicotine withdrawal that require a prescription Payments to participate in a weight-loss program for a specific disease or diseases, including obesity, diagnosed by a physician. Payment of health club dues. 62 63 Rev. Proc 2013-15 IRC §213 162 Payment of food that exceed the normal diet if the food treats an illness and the food is not part of the normal nutritional needs and is substantiated by a physician. Payments for insulin and payments for drugs that require a prescription Payments for admission and transportation to a medical conference relating to a chronic disease that the taxpayer, spouse, or dependents have (if the costs are primarily for and essential to necessitated medical care). However, the taxpayer may not deduct the costs for meals and lodging while attending the medical conference Payments for false teeth, reading or prescription eyeglasses or contact lenses, hearing aids, crutches, wheelchairs, and for guide dogs for the blind or deaf Payments for transportation primarily for and essential to medical care that qualify as medical expenses, such as, payments of the actual fare for a taxi, bus, train, or ambulance or for medical transportation by personal car, the amount of the actual out-of-pocket expenses such as for gas and oil, or the amount of the standard mileage rate for medical expenses, plus the cost of tolls and parking fees Any insurance reimbursement must be subtracted from the expenses. Who is a Dependent? For medical purposes, a dependent includes anyone who could not otherwise be claimed as a dependent solely because of one of the following: The dependent received gross income of $3,800 or more during 2012 The dependent filed a joint return for 2012. In the case of divorced or separated parents, the child dependency exemption was assigned to the other parent. An adopted child lived with the U.S. Citizen as a member of the household for 2012, but the child is not a U.S. Citizen. The person paying the medical expense could be claimed as a dependent on someone else’s 2012 return. The taxpayer may not deduct funeral or burial expenses, over-the-counter medicines, toothpaste, toiletries, cosmetics, a trip or program for the general improvement of health, or most cosmetic surgery. No deduction is allowed for the amounts paid for nicotine gum and nicotine patches, which do not require a prescription. The taxpayer can only include the medical expenses paid by the taxpayer during the year. The total deductible medical expenses for the year must be reduced by any reimbursement of deductible medical expenses. It makes no difference if the reimbursement is paid directly to the taxpayer or if it is paid directly to the doctor, hospital, or other medical provider. Capital Expenses Deductible as Medical Expenses The cost of home improvements and special equipment are deductible as medical expenses if their main purpose is medical care. The cost is deductible to the extent it does 163 not increase the value of the home or other capital asset. The costs must be reasonable to accommodate a home for a person with a disability. Example: John adds a ramp to the front of his home to allow access for his wife who is confined to a wheelchair. The ramp cost $7,000 and according to an appraisal increased the value of the house by $4,000. John can deduct the $3,000 of the home improvement cost as a medical expense. Car specially equipped for medical reasons: the cost of special hand controls and other special equipment installed in a car for use be a person with a disability is deductible as a medical expense. The difference between the regular cost of the car and the specially equipped vehicle can be deducted as a medical expense. The cost of operating the specially equipped vehicle is not deductible. Taxes Individual taxpayers have the option of claiming deduction on Schedule A for either (1) general sales and local sales taxes; or (2) state and local income taxes. Sales taxes can be deducted either as Actual sales tax amounts (based on the taxpayer’s records); or Predetermined deduction amounts from IRS tables. State and local income taxes that may be deducted include the following: State and local income taxes withheld on Forms W-2’s or 1099’s State and local income taxes paid for a prior year State and local estimated tax payments made in the taxable year State and local tax refunds applied to the current year tax Mandatory contributions to State Disability Insurance (SDI) or Supplemental Workmen’s Compensation Fund Annual personal property taxes based on the value of the asset are deductible. For example car registration is generally assessed against the value of the vehicle and the weight. The portion that is based on value is deductible; the other portion based on weight is not deductible. Other taxes such as taxes paid to a foreign country or U.S. possession. List the type of the tax on line 8 of Schedule A. Deductible Nondeductible State and local income taxes State and local general sales tax Real estate taxes Personal property taxes Income tax paid to a foreign country or US possession Federal income and excise taxes Social Security, Medicare, FUTA and RRTA taxes State and local gasoline taxes Car inspection fee Special assessments for improvements to taxpayer’s property. Tax paid for someone else License fees, such as dog license, driver’s license or marriage license 164 Example: Since Alex and Sandra live in Nevada they do not have any state income tax. The provision allowing the deduction of state sales tax has been extended through 2013. The Dependables will take advantage of the Sales Tax Deduction. Real Estate Taxes (property taxes) from state, local or foreign sources based on the assessed value of the home are deductible in the year it is paid to the taxing authority. Do not include charges for improvements that increase the value of the property, they are an addition to the basis of the property. Do not include itemized charges for specific services. Real estate assessments are deductible if they are made uniformly on property throughout the community and if the proceeds are used for the general community. Annual personal property taxes based on the value of the asset are deductible. For example car registration is generally assessed against the value of the vehicle and the weight. The portion that is based on value is deductible; the other portion based on weight is not deductible. Charges for services, such as trash, water or sewer are not deductible. Special assessments may be part of the tax bill.64 Improvement assessments, which improve the value of the property, increase the basis of the property and are not deductible as real estate taxes. Maintenance assessments on existing public facilities already in service are deductible as real estate taxes; as well as interest charges regardless of the assessment purpose. Loan Origination Fees - Points Example: Having just purchased their home the Dependables paid points65 on their mortgage. Points are deductible in full if all of the following requirements are met: 1. The loan is secured by the taxpayer’s main home. 2. Paying points is an established business practice in the area. 3. The points paid were not more than the amount generally charged in that area. 4. The taxpayer uses the cash method of accounting. This means they report income in the year received and deduct expenses in the year paid. 5. The points were not paid for items that usually are separately stated on the settlement sheet such as appraisal fees, inspection fees, title fees, attorney fees, or property taxes. 6. The funds the taxpayer provided at or before closing, plus any points the seller paid, were at least as much as the points charged. The taxpayer cannot have borrowed the funds from the lender or mortgage broker in order to pay the points. 7. The loan is used to buy or build the taxpayer’s main or second home. 8. The points were computed as a percentage of the principal amount of the mortgage. 9. The amount is clearly shown as points on the settlement statement. 64 65 Pub 530 Topic 504, Form 1040, Schedule A Instructions 165 Other taxes such as taxes paid to a foreign country or U.S. possession. List the type of the tax on line 8 of Schedule A. Recoveries - A recovery is a refund of an amount that was deducted in a prior year. The most common recovery is the state tax refund, which was deducted in a prior year, discussed earlier. Recoveries must be reported up to the amount that the taxpayer received benefit. If the taxpayer paid back an item previously deducted that is also a recovery. Home Mortgage Interest A home mortgage is any loan that is secured by the taxpayer’s main home or second home. It includes first and second mortgages, home equity loans, and refinanced mortgages.66 A home can be a house, condominium, cooperative, mobile home, boat, or similar property. It must provide basic living accommodations including sleeping space, toilet, and cooking facilities. To be a secured debt, the home loan is recorded under state and local law, with the home as collateral for the debt. Debt not secured by the home is personal debt. Example: Money borrowed from parents or others for a down payment is unsecured debt, unless the loan is legally recorded with the home as collateral. Limit on home mortgage interest. If the mortgage was taken after October 13, 1987, the deduction may be limited. Any additional amounts borrowed after October 13, 1987; on an equity line-of-credit secured by the home the taxpayer had on that date is treated as a mortgage taken out after October 13, 1987. If the taxpayer refinanced a mortgage he had on October 13, 1987, treat the new mortgage as taken out on or before October 13, 1987. However, if the taxpayer refinanced for more than the balance of the old mortgage, treat the excess as a mortgage taken out after October 13, 1987. 66 Pub 936, IRC §16 166 Mortgage Insurance Premiums – Qualified mortgage insurance is mortgage insurance provided by the Department of Veterans Affairs, the Federal Housing Administration, or the Rural Housing Service, and private mortgage insurance.67 These fees can be deducted fully in 2012 if the mortgage insurance contract was issued in 2012. Mortgage insurance premiums are reported on Form 1098. The deduction is not available for taxpayers with an adjusted gross income is more than $109,000 ($54,500 if married filing separately) Limit of deduction of mortgage insurance premiums: If the adjusted gross income on Form 1040, line 38, is more than $100,000 ($50,000 if the filing status is married filing 67 §2 of the Homeowners Protection Act of 1998 as in effect on December 20, 2006). 167 separately), the amount of the mortgage insurance premiums that are otherwise deductible is reduced and may be eliminated. If the adjusted gross income is more than $109,000 ($54,500 if married filing separately), the taxpayer cannot deduct the mortgage insurance premiums. Form 1098. The mortgage interest statement received should show not only the total interest paid during the year, but also the mortgage insurance premiums paid during the year, which may qualify to be treated as deductible mortgage interest. Investment Interest68 Investment interest is interest paid by the taxpayer on money borrowed that is allocable to property held for investment. It does not include any interest allocable to passive activities or to securities that generate tax-exempt interest income. Investment interest is reported on Form 4952 and carried to Schedule A. The deduction applies to interest on money borrowed to buy property that will produce investment income -- interest, dividends, annuities or royalties -- or that the taxpayer expects to appreciate in value, allowing them to sell it at a gain in the future. However, the taxpayer cannot deduct interest when the property bought produces nontaxable income, such as tax-exempt bonds. The deduction for investment interest is limited to investment income. Investment income not allowed due to the deduction limit is carried forward to the following year. There is no limit on how long it can be carried over. Investment interest expense is compute on Form 4952 and the allowable amount is entered on Line 14 of Schedule A. Example: The taxpayer takes out a $5,000 loan on a personal credit card and uses the money to buy stock. The interest on that loan is investment interest. 68 Form 4952 168 Charitable Contributions69 For a contribution of cash, check, or other monetary gift (regardless of amount), the taxpayer must maintain as a record of the contribution a bank record or a written communication from the qualified organization containing the name of the organization, the date of the contribution, and the amount of the contribution. In addition to deducting cash contributions, generally the taxpayer can deduct the fair market value of any other property donated to qualified organizations. For any contribution of $250 or more (including contributions of cash or property), the taxpayer must obtain and keep a written acknowledgment from the qualified organization indicating the amount of the cash and a description of any property contributed. The acknowledgment must say whether the organization provided any goods or services in exchange for the gift and, if so, must provide a description and a good faith estimate of the value of those goods or services. The preparer should inquire whether these requirements were met by the taxpayer and if possible view these documents. Gifts that include a benefit to the taxpayer are deductible only to the extent of the donation. For example the taxpayer paid $70 for a charitable dinner; the dinner was valued at $40. The deductible portion of the $70 is $30. Gifts of $250 or more are deductible only if there is a statement issued by the charitable institution indicating the amount of the gift and whether the organization did or did not give any goods or services in return for the donation. In computing whether a charitable donation is over $250 treats each donation separately. For example, if the taxpayer gives a church $25 a week totaling $1,300 treat each $25 as a separate gift. (Refer to Pub 526) The mileage rate when using a personal vehicle for charitable purposes is 14 cents. Limits on charitable Contributions apply when the contributions exceed 50% of the adjusted gross income. Charitable organizations classified as 50% organizations are the most common charitable organizations. They include churches, religious organization hospitals, medical research, schools etc. A reduced limit of 30% (capital gain property and any organization not listed as a 50% organization such as veteran’s organizations) and 20% (capital gain property donated to an organization that is not a 50% organization). If a charitable donation exceeds the AGI limit in the current year the remaining portion must be carried over to each of the five subsequent years. Carryovers retain the original percentage limits and are deducted after deducting the contributions for the current year. Gifts other than by cash or check, of property such as clothing or furniture are deducted at the fair market value. The fair market value is what a willing buyer would pay a willing seller when neither has to buy or sell and both are aware of the condition of sale. (Refer to Pub 561). If the deduction is more than $500 the taxpayer is required to file form 8283. If the total deduction is over $5,000 appraisals on the value of the donation may be required. 69 IRC §170 169 Donated Goods Valuation Chart Women’s Clothing Men’s Clothing Blouse ($4 – $9) Shirt ($4 – $6) Sweater ($4 – $13) Sweater ($4 – $6) Pants ($4 – $23) Pants ($4 – $23) Dress ($6 – $28) 2pc Suit ($5 – $96) 2pc Suit ($10 – $96) Shoes ($3 – $30) Handbag ($2 – $10) Jacket ($10 – $45) Hat ($1 – $9) Overcoat ($3 – $9) Shoes ($3 – $30) Children’s Clothing Dry Goods Shirt ($2 – $10) Pillow ($2 – $5) Sweater ($2 – $10) Sheet ($2 – $9) Pants/Jeans ($2 – $10) Blanket ($3 – $14) Dress ($2 – $10) Curtain ($2 – $7) Shoes ($3 – $10) Drapes ($7 – $23) Boots ($6 – $10) Area Rug ($2 – $16) Snowsuit ($2 – $10) Books ($0.59 – $2) Furniture CD’s ($2 - $5) Appliances Floor Lamp ($8 – $34) Iron ($3 – $10) Sofa ($40 – $395) Vacuum Cleaner ($5 – $70) Table Lamp ($3 – $20) Coffee Maker ($5 – $10) Stuffed Chair ($10 – $75) Radio ($1 – $10) Kitchen Set ($35 – $135) Working Television ($5 – $50) End Tables ($10 – $75) DVD Player ($5 - $15) Coffee Table ($15 – $100) Sewing Machine $5 -$75) Bicycle ($5 - $80) Dresser ($20 – $80) Miscellaneous Battery Back-ups ($1.50 – $2) Computers ($5 - $50) Keyboards ($0.30 – $10) Laptops ($5- $15) Mice ($0.30 – $5.00) Printers ($1 – $10) Golf Clubs ($2 - $25) 170 Charitable Contributions of IRA Distributions70 Beginning in 2006 there has been an allowance from gross income for otherwise taxable IRA distributions from a traditional or Roth IRA if the money was directly transferred by the IRA trustee to a charitable organization. The exclusion was limited to $100,000 per taxpayer per year. Any amount excluded from income under this rule is not deductible as a charitable contribution. The taxpayer does not count the distribution as taxable income and did not deduct the contribution as a charitable contribution. Eight Tips for Deducting Charitable Contributions71 Charitable contributions made to qualified organizations may help lower the tax bill. The IRS has put together the following eight tips to help ensure taxpayer’s contributions are deductible. 1. The taxpayer must be giving to a qualified organization. The taxpayer cannot deduct contributions made to specific individuals, political organizations and candidates. See IRS Publication 526, Charitable Contributions, for rules on what constitutes a qualified organization. 2. To deduct a charitable contribution, the taxpayer must file Form 1040 and itemize deductions on Schedule A. 3. Benefits received as a result of a charitable contribution such as merchandise, tickets to a ball game or other goods and services, and then only the amount that exceeds the fair market value of the benefit received can be deducted. 4. Donations of stock or other non-cash property are usually valued at the fair market value of the property. Clothing and household items must generally be in good used condition or better to be deductible. Special rules apply to vehicle donations. 5. Fair market value is generally the price at which property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the relevant facts. 6. Regardless of the amount, to deduct a contribution of cash, check, or other monetary gift, the taxpayer must maintain a bank record, payroll deduction records or a written communication from the organization containing the name of the organization, the date of the contribution and amount of the contribution. For text message donations, a telephone bill will meet the record-keeping requirement if it shows the name of the receiving organization, the date of the contribution, and the amount given. 7. To claim a deduction for contributions of cash or property equaling $250 or more the taxpayer must have a bank record, payroll deduction records or a written acknowledgment from the qualified organization showing the amount of the cash and a description of any property contributed, and whether the organization provided any goods 70 71 IRC §408(d)(8) IRS Tax Tip 2011-57 171 or services in exchange for the gift. One document may satisfy both the written communication requirement for monetary gifts and the written acknowledgement requirement for all contributions of $250 or more. If the total deduction for all noncash contributions for the year is over $500, the taxpayer must complete and attach IRS Form 8283, Noncash Charitable Contributions, to the return. 8. Taxpayers donating an item or a group of similar items valued at more than $5,000 must also complete Section B of Form 8283, which generally requires an appraisal by a qualified appraiser. Casualty and Theft Losses incurred because of a casualty, disaster, or theft may be tax-deductible. Casualty and theft losses are reported on Form 4684 and Form 1040 Schedule A. For property held by the taxpayer for personal use, once they have subtracted any salvage value and any insurance or other reimbursement, they must subtract $100 from each casualty or theft event that occurred during the year. Then add up all those amounts and subtract 10% of their adjusted gross income from that total to calculate the allowable casualty and theft losses for the year. Casualty Losses A casualty is the loss of property (including damage and destruction) because of a sudden event. The event must be identifiable, unexpected, and unusual. Events that meet this criteria include: car accidents, disaster-related demolition, earthquakes, fires, floods, hurricanes, shipwrecks, storms, terrorist attacks, tornadoes, vandalism, and volcanic eruptions. Non-Deductible Casualty Losses Losses are not tax-deductible if the damage or destruction of the property is the result of: accidental breaking (such as dinnerware or glassware breaking), pet-related accidents (such as the cat knocking over a valuable object), arson committed by or on behalf of the taxpayer, car accidents that are willful or willfully negligent and that are caused by or on behalf of the taxpayer, or progressive deterioration. Progressive deterioration is damage that steadily occurs over a long period of time. Damage caused by termite infestation, dry rot, and wet rot are classic examples of nondeductible progressive deterioration losses. To be tax-deductible, the damage must be caused by a sudden event (such as a sudden natural disaster or a sudden infestation). 172 Theft Losses Loss of property because of theft may be tax-deductible. According to the IRS, “a theft is the taking and removing of money or property with the intent to deprive the owner of it. The taking of property must be illegal under the law of the state where it occurred and it must have been done with criminal intent.” The taxpayer may have a theft loss if they are the victim of blackmail, burglary, embezzlement, extortion, kidnaping for ransom, larceny, or robbery. Deductions Subject to 2% of Adjusted Gross Income72 Job Expenses and Other Miscellaneous Deductions Job expenses and other miscellaneous deductions must exceed 2% of the adjusted gross income. The following unreimbursed employee expenses may be deducted if they were paid or incurred during the tax year, for carrying on the trade or business of being an employee and the expenses were ordinary and necessary. Safety equipment Union dues Uniform required by employer Protective clothing Physical examinations required by employer Dues to professional organizations or chambers of commerce Legal fees related to the job Job search expenses Tools used for work Licenses and regulatory fees Malpractice Insurance premiums Medical examinations required by the employer Subscription to professional journals Fees to employment agencies when looking for a new job Certain business use of home Certain education expenses Unreimbursed employee business expenses include ordinary and necessary job expenses paid for by the taxpayer and not reimbursed. An ordinary expense is one common for the industry of employment of the taxpayer. If the taxpayer claims any travel, transportation, meal or entertainment expenses for the job or the employer paid for any job expenses Form 2106 is required. 72 2012 Pub 529 173 Form 2106 - Employee Business Expenses 174 The taxpayer cannot deduct ordinary expenses which are common and accepted for travel (including meals unless the standard meal allowance is used) entertainment, gifts, or use of the car or other listed property unless proper record keeping and journals of expenses are kept. 175 Generally receipts are required for all lodging expenses (regardless of the amounts) and any other expense of $75 or more. Special rules apply for qualified performing artists, fee-basis state or local government employees or reservists. Officials paid on a fee basis. Certain fee-basis officials can claim their employee business expenses whether or not they itemize their other deductions on Schedule A (Form 1040). Feebasis officials are persons who are employed by a state or local government and who are paid in whole or in part on a fee basis. They can deduct their business expenses in performing services in that job as an adjustment to gross income rather than as a miscellaneous itemized deduction. Expenses of certain performing artists. If the taxpayer is a performing artist, they may qualify to deduct employee business expenses as an adjustment to gross income rather than as a miscellaneous itemized deduction. To qualify, all of the following requirements must be met. During the tax year, the taxpayer performs services in the performing arts as an employee for at least two employers The taxpayer receives at least $200 each from any two of these employers 176 The related performing-arts business expenses are more than 10% of the gross income from the performance of those services The adjusted gross income is not more than $16,000 before deducting these business expenses Armed Forces reservists traveling more than 100 miles from home. If the taxpayer is a member of a reserve component of the Armed Forces of the United States and travels more than 100 miles away from home in connection with performance of services as a member of the reserves, the taxpayer can deduct travel expenses as an adjustment to gross income rather than as a miscellaneous itemized deduction. The amount of expenses which are deductible as an adjustment to gross income is limited to the regular federal per diem rate (for lodging, meals, and incidental expenses) and the standard mileage rate (for car expenses) plus any parking fees, ferry fees, and tolls Meals and entertainment are deductible if the meal or entertainment expense is directly related to or associated with the active conduct of a trade or business or for the production or collection of income. Meals with business partners are usually not deductible unless the taxpayer can establish a clear business purpose. Lavish and extravagant expenses are not allowed, the expenses must be reasonable according to the circumstances. The deduction for meals and entertainment is limited to 50% of the amounts that would otherwise be eligible. Taxes and tips, cover charges and parking are included in the 50% limit. The following items are not included in the 50% limit: De minimis fringe benefits Expenses for meals and entertainment that are treated as taxable compensation to the employee and fully deductible by the employer Promotional activities made available by the taxpayer to the general public Employer-provided expenses for the benefit of employees that are not highly compensated, such as company picnics Meals and entertainment sold to customers such as a restaurant Business gifts made in the course of a taxpayer’s trade or business are limited to $25 to any one individual per year. Exceptions to the $25 business gift rule includes items costing $4 or less containing and imprint; signs, displays, racks or other promotional items; incidental costs, such as engraving; awards of tangible property costing $400 or less given an employee for length of service. Travel away from the tax home expenses are 100% deductible if the taxpayer is away long enough that it cannot be reasonable to expect the taxpayer to complete the trip without sufficient sleep and rest. The tax home is determined by the taxpayer’s business being in the same general vicinity of the main residence; the taxpayer incurs duplicate expenses while on business travel; and the taxpayer has not changed his/her historic place of main residence. 177 Travel expenses include the following: Transportation Transportation to and from airports etc Baggage and shipping Car Lodging Meals (at 50%) Dry cleaning and laundry Telephone Tips Other similar, ordinary and necessary expense Expenses for temporary employment away from home are deductible, when the time of employment exceeds one year, it is considered permanent and is not deductible. Excess reimbursement to an employee must be included in income. There are two ways to compute the amount of vehicle expense taken on a return, either actual expenses or the standard mileage rate. Automobiles are listed property and are subject to rules under Internal Revenue Code Section 280(f). Regardless of which method the taxpayer uses to compute the automobile expenses the taxpayer must keep records of the following information: Total miles driven in the year Total business miles driven in the year The basis of the vehicle Date placed in service Instead of deducting actual costs, a taxpayer can use the standard mileage rate (SMR) method to calculate the amount deductible for business use of a vehicle. The deduction is calculated by multiplying the number of business miles driven by the applicable standard mileage rate. To choose the SMR for a vehicle it must be used in the first year the car is available for business. In later years the taxpayer can choose between either the standard mileage rate method or actual expenses, unless the vehicle was leased. Parking fees and tolls can be taken in addition to the standard mileage rate. Listed property should be documented in order to determine the percentage of business use. The documentation should account for the total usage of property and separate business and personal usage. Beginning on Jan. 1, 2012, the standard mileage rates for the use of a car (also vans, pickups or panel trucks) will be: 55.5 cents per mile for business miles driven 23 cents per mile driven for medical or moving purposes 14 cents per mile driven in service of charitable organizations 178 The 2013 standard mileage rates are set 56.5 cents per mile for business transportation or travel, 24 cents per mile for medical care, and 14 cents per mile for charity purposes. Type of Listed Property Cars and Trucks Computers and Peripherals Photographic and video items Suggested Documentation Mileage Log Time Logs Time Logs Actual car expenses include the following: Depreciation Garage Rent Gas Lease payments Licenses Oil Parking Fees Registration Fees Repairs Tires Tolls The actual expense method can be taken on lease vehicles. Lease payments can be deducted for business purposes. If the lease payment is for more than 30 days, an inclusion amount is required, refer to Pub 463 for inclusion tables. Recordkeeping Generally there must be documentary evidence to prove expenses, such as receipts, canceled checks, or bills to support the deduction. If there is an accountable plan through the employer evidentiary documentation is not required for the expense, other than lodging, if less than $75 or a transportation expense where a receipt is not readily available. An accountable plan is an employer reimbursement plan for an employee’s business expenses that are deductible to the employer and are not included in the employee’s income. The employee must substantiate the expenses and return any excess reimbursements in a reasonable amount of time. Documentary evidence ordinarily will be considered adequate if it shows the amount, date, place and essential character of the expense. A canceled check together with a bill from the payee establishes cost. The records should be kept in a timely method and provide a written statement of the business purpose. Form 2106 is completed and the total of the expenses are reported on Schedule A line 21 subject to 2% of adjusted gross income. Excess reimbursements are included on Line 7 of Form 1040. Business expenses for self-employed persons are reported on Schedule C and reduce the amount of self-employment tax. The same limits apply for automobiles and other business expenses as employee business expenses. Qualifying work-related education can be deducted as a business expense. The education must meet at least one of the following two tests: 179 The education is required by the employer or the law to keep the taxpayer’s present salary status 1. The required education must serve a bona fide business purpose of employment. 2. The education maintains or improves skills needed in the present work. Even if the education meets one or both of the above tests, it is not qualifying education if it: Is needed to meet the education requirements of the taxpayers present job Is part of a program of study that will qualify the taxpayer for a new trade or business? Deductions Subject to 2% of Adjusted Gross Income Income that is used to produce or collect income that must be included in gross income, to manage conserve or maintain property held for the production of income or to determine contest, pay or claim a refund of any tax are reported on Line 22 of Schedule A. The following items are subject to the 2% of adjusted gross income limitation: Tax preparation fees Excess deductions of an estate Fees to collect interest and dividends Hobby expenses Indirect deductions of pass-through entities Investment fees and expenses Legal expenses Loss on deposits Repayments of Income Repayments of Social Security benefits Trustee administrative fees for an IRA Deductions Not Subject to 2% limit – Schedule A, Line 28 Gambling losses up to the amount of gambling winnings reported on Form 1040, line 21. Amortizable bond premiums (the amount paid is greater than its stated interest the excess is the bond premium) Federal estate tax on income in respect of a decedent Unrecovered investment on annuity reported on final return of decedent Nondeductible Expenses Brokers commissions Adoption expenses Campaign expenses Check-writing fees Club dues Commuting expenses Fines or penalties Health Spas Home security system Homeowners insurance premiums Investment related seminars Life insurance premiums Lobbying expenses 180 2013 Itemized Deductions Limitation73 Phase Out Itemized deductions begin to phase out when modified AGI reaches: MFJ, QW $300,000 HOH $275,000 Single $250,000 MFS $150,000 The limitation of itemized deductions (known as “Pease” after the Congressman who helped create it) apply to taxpayers with AGI over a threshold amount: $250,000 (single), $300,000 (married filing jointly), $275,000 (head of household), or $150,000 (married filing separately). Deductions are reduced by 3% of the amount by which AGI exceeds the threshold. The maximum amount of reduction is 80%. Not all itemized deductions are subject to phase-out. The following deductions are not subject to the phase-out: Medical and dental expenses Investment interest expenses Casualty and theft losses from personal-use property Casualty and theft losses from income-producing property Gambling losses 73 § 68 181 Example of “PEASE”: Sally and Corey from the previous example, who had an AGI of $346,186 for 2013, exceed the threshold for a married couple by $46,186. Thus, they must reduce their itemized deductions subject to the phase-out by $1,386 (3% of $112,500), but the reduction must not exceed 80% of the deductions subject to the phaseout. For 2013, Sally and Corey had the following itemized deductions: Itemized Deductions $ 3,381 8,964 23,000 4,000 $39,345 Allowable Medical And Dental Expense* Taxes Paid Home Mortgage Interest Charitable Gifts Total *Total Medical and Dental expense is $38,000 less $34,619(10% (Sally and Corey are in their 40’s)) = $3,381 2013 Itemized Deductions Limitation Worksheet 1. Total Itemized Deductions for 2013 2. Itemized Deductions not subject to Phaseout $ 39,345 3,381 3. Subtract Line 2 from Line 1 4. Multiply Line 3 by 80% (.80) 5. 2013 AGI 6. Filing Status Threshold 7. Subtract Line 6 from Line 5 8. Multiply Line 7 by 3% 9. Enter the smaller of Line 4 or Line 8 10. Total Itemized Deductions Subtract Line 9 from Line 1 35,964 28,771 346,186 300,000 46,186 1,386 1,386 $ 37,959 182 Chapter 15 - Taxes and Credits The income tax is based on taxable income. After the income tax is computed subtract any tax credits and add any other taxes owed. The result is total tax. Compare the total tax with total payments to determine whether the taxpayer is entitled to a refund or there is an amount owed. Tax Most taxpayers use either the tax table or the tax rate schedule to figure their income tax. Tax Most taxpayers use either the tax table or the tax rate schedule to figure their income tax. The tax is computed on taxable income. Tax Rate Schedule 2012 Filing Status 10% 15% 25% 28% 33% 35% $0 $ 8,701 $ 35,351 $ 85,651 $178,651 $388,351 S $0 $ 12,401 $ 47,351 $122,301 $198,051 $388,351 HH $0 $ 17,401 $ 70,701 $142,701 $217,451 $388,351 MFJ/QW $0 $ 8,701 $ 35,351 $ 71,351 $108,726 $194,176 MFS Tax Rate Schedule 201374 Filing Status 10% $0 S $0 HH $0 MFJ/QW $0 MFS 15% $ 8,926 $ 12,750 $ 17,850 $ 8,925 25% $ 36,250 $ 48,600 $ 72,500 $ 36,250 28% $ 87,850 $125,450 $146,400 $ 73,250 33% $183,250 $203,150 $223,050 $111,525 35% $398,350 $398,350 $398,350 $199,175 39.6% $400,001 $425,000 $450,000 $225,001 However there are special methods if the taxpayer has any of the following items included in their return: 74 Qualified dividends taxed at capital gain rates - when there is a qualified dividend the tax is computed on Schedule D, page 2. Qualified dividends differ from capital gain distributions in as much as they do not net with capital gains and get included in the total of Schedule D. Qualified dividends are included in income on Schedule B and only affect the tax computation on Schedule D. Lump Sum Distributions-is a ten-year tax option used to compute the tax on the ordinary income portion of the lump sum distribution. The tax is paid only once in the year the lump-sum distribution is received. The special treatment can be elected only once for any plan participant and only if the participant was born before January 2, 1936 (and beneficiaries of such individuals) (Refer to Form 4972 instructions) Farm income averaging - allows farmers to average their income over a three-year period (the tax is paid in the current year). (Refer to Schedule J Instructions) Rev. Proc 2013-15 183 “Kiddie Tax” - Tax on Investment Income of Certain Minor Children When Pete was younger and his earnings from his brokerage account were less, his parents reported his income on their return by filing Form 8814. The Kiddie Tax Rule applies if a child’s unearned income (investment income) totals more than $1,900. The amount over $1,900 is taxed at the parent’s marginal tax rate if the rate is higher than the child’s.75 Investment income is generally all income other than salaries, wages and other amounts received as pay for work done. It includes taxable interest, dividends, capital gains, the taxable part of social security and pension payments, certain distributions from trusts. Investment income includes amounts produced by assets the child obtained with earned income. Earned income. Earned income includes wages, tips, and other payments received for personal services performed. It does not include investment income as defined later in this section. Support. A child’s support includes all amounts spent to provide the child with food, lodging, clothing, education, medical and dental care, recreation, transportation, and similar necessities. To figure the child's support, count support provided by the taxpayer, the child, and others. However, a scholarship received by the child is not considered support if the child is a full-time student. Reporting of Child’s Interest and Dividends at Parent’s Tax Rate Form 8814 The additional tax is computed on Form 8814 to figure the child’s interest, dividend or capital gain distribution on the tax return. Only the amount over $1,900 is added to the parent’s income. If there is more than one child, compute Form 8814 for each child. The total amount of income computed on Form 8814 is added to Line 21 of Form 1040. If the income includes capital gain distributions or qualified dividends a special worksheet must be used to compute the tax. Parents can elect to report the child’s income on their tax return if all of the following apply:76 The child was under age 19 (or under age 24 if a full-time student) at the end 2012. The child’s only income was from interest and dividends, including capital gain distributions and Alaska Permanent Fund dividends. The child’s gross income for the year was less than $9,500. The child is not required to file a return. The child does not file a joint return. There were no estimated tax payments for the child for the year. There was no federal income tax withheld from the child’s income. The election to report the income on the parent’s return avoids the filing of a return for the child, 75 76 IRC §1(g) IRS Pub. 929, Tax Rules for Children and Dependents 184 but the election can affect the parent’s return. For most taxpayer’s the tax difference between filing Form 8814 and filing a return for the child is minimal. For some taxpayers the difference can be significant if increased AGI reduces or eliminates deductions or credits or increases taxable Social Security. Tax rate may be higher The child does not get benefit of any of the following deductions: o Higher standard deduction for a blind child o The deduction for a penalty on early withdrawal of the child’s interest o Itemized deductions Reduced deduction of credits Penalty for underpayment of estimated tax May increase taxable Social Security The tax computed on Form 8814 is added to the tax computed on the taxpayer’s Form 1040. If there is more than one Form 8814 add the total of the computed tax to the taxpayer’s Form 1040. Part II of Form 8814 is used to figure the tax on the $1,900 of the child’s interest and dividends that does not get included in income. The additional tax is the smaller of: a. 10% X (the child’s gross income - minus - $950) or b. $95. NOTE: The unearned income amount for this test increases to $2,000 for 2013. The definition of a child for purposes of this provision in 2013 is defined the same as above. Qualified dividends. Any ordinary dividends that the child received are entered on Form 8814, line 2a. This amount may include qualified dividends. Qualified dividends are those dividends reported on Form 1040, line 9b, or Form 1040NR, lines 10a and 10b and are eligible for the lower tax rates that apply to a net capital gain. For detailed information about qualified dividends, see Publication 550. The child has qualified dividends that are added to the taxpayer’s (parents) income, which must be reported on Form 1040, lines 9a and 9b, lines 10a and 10b. These dividends are not included on Form 8814, line 12, or on line 21 of Form 1040. If the child received qualified dividends or capital gain distributions, the taxpayer may pay up to $95 more tax if the election to enter the child’s income on the parent’s return instead of filing a separate tax return for the child. This is because the tax rate on the child's income between $950 and $1,900 is 10% if the election to file Form 8814 is made. However, if Form 8615 for the child, the tax rate may be as low as 0% (zero per-cent) because of the preferential tax rates for qualified dividends and capital gain distributions Form 8615 – Tax for Certain Children who have Investment Income of More than $1900 Form 8615 must be filed for a child if all of the following statements are true77. 77 The child is subject to Kiddie Tax Form 8615 Instructions 185 The child's investment income was more than $1,900. The child is required to file a return for 2012. The child either: o Was under age 18 at the end of the year, o Was age 18 at the end of the year and did not have earned income that was more than half of his or her support, or o Was a full-time student over age 18 and under age 24 at the end of the year and did not have earned income that was more than half of his or her support. At least one of the child's parents was alive at the end of 2012. The child does not file a joint return for 2012. Investment income defined. Investment income is generally all income other than salaries, wages, and other amounts received as pay for work actually done. It includes taxable interest, dividends (including capital gain distributions), capital gains, the taxable part of social security and pension payments, and certain distributions from trusts. Investment income includes amounts produced by assets the child obtained with earned income (such as interest on a savings account into which the child deposited wages). Nontaxable income. For this purpose, investment income includes only amounts the child must include in total income. Nontaxable investment income, such as tax-exempt interest and the nontaxable part of social security and pension payments, is not included. Income from property received as a gift. A child's investment income includes all income produced by property belonging to the child. This is true even if the property was transferred to the child, regardless of when the property was transferred or purchased or who transferred it. A child's investment income includes income produced by property given as a gift to the child. This includes gifts to the child from grandparents or any other person and gifts made under the Uniform Gift to Minors Act. Reasons to file a separate return for the child: Parents qualify for the Earned Income Credit. The child’s investment income can reduce the credit. Income over $1,900 increases the parent’s AGI. All deductions and credits limited or phased out by AGI are affected (child tax credit, education credits, medical deductions, etc.) Taxable Social Security may increase. Some deductions can only be taken on the child’s return. o Higher standard deduction for child who is blind. o Child’s Itemized deductions o Penalty on early withdrawal of child’s savings o Child’s capital loss carryover. If the child has qualified dividends or capital gain distributions, tax is up to $95 lower on the child’s return 186 Child’s exempt interest from private activity bonds is included in the parent’s alternative minimum tax calculation. Child’s tax increases the parent’s estimated tax requirements. Refer to Pub 929, Form 8814 and 8615 instructions. Alternative Minimum Tax Alternative Minimum Tax (AMT) exists to make sure that taxpayers with substantial income are not able to avoid paying tax. The law limits the benefits a taxpayer can receive from favorable treatment of certain items. The AMT uses a separate accounting method with its own rules that govern the recognition and timing of income and expenses. The taxpayer is liable for either AMT or regular tax, whichever is more. AMT Permanent Patch78 - The Alternative Minimum Tax parallels the regular income tax: taxpayers whose AMT liability exceeds their regular tax liability pay the difference as AMT. The AMT replaces personal exemptions and some deductions (most notably, the standard deduction and the deduction of state and local taxes) with an AMT exemption and applies to two tax rates-26% on the first $175,000 and 28% on any excess-to the resulting AMT taxable income. The American Taxpayer Relief Act of 2012 indexed three AMT parameters after 2012: the exemptions, the AMT income above which the exemption phases out, and the start of the 28% AMT bracket. The most common exemptions and preferences include the following items: Addition of personal exemptions Addition of standard deduction Addition of itemized deductions claimed for state and local income taxes, certain interest, most miscellaneous deductions and part of medical expenses 78 American Taxpayer Relief Act of 2012 187 Subtraction of any refund of state and local taxes included in gross income Changes to accelerated depreciation of certain property Difference between gain or loss on the sale of property reported for regular tax purposes and AMT purposes Addition of certain income from incentive stock options Change in certain passive activity loss deductions Addition of certain depletion that is more than the basis of the property Addition of part of the deduction for certain intangible drilling costs, and Addition of tax-exempt interest on certain private activity bonds AMT Exemption Amounts for 201379 Indexed for inflation: $51,900 for single and head of household filers, $80,800 for married people filing jointly and for qualifying widows or widowers, and $40,400 for married people filing separately. AMT is computed using Form 6251; refer to the form instructions for further information. 79 Revenue Procedure 2013-15 188 189 Additional Medicare Tax A new Additional Medicare Tax goes into effect starting in 2013. The 0.9 percent Additional Medicare Tax applies to an individual’s wages, Railroad Retirement Tax Act compensation, and self-employment income that exceeds a threshold amount based on the individual’s filing status. The threshold amounts are $250,000 for married taxpayers who file jointly, $125,000 for married taxpayers who file separately, and $200,000 for all other taxpayers. An employer is responsible for withholding the Additional Medicare Tax from wages or compensation it pays to an employee in excess of $200,000 in a calendar year. The Medicare Payroll Tax In 2012, the Medicare payroll tax was 2.9%. It applied only to earned income, which includes wages that are paid by an employer, plus tips. The taxpayer share, 1.45%, was deducted automatically from the paycheck. The employer pays the other 1.45%. In 2013, high-wage earners will owe an additional 0.9% on earned income above $200,000 (single filers) or $250,000 (married filing jointly). Example 1: If the taxpayer is a single filer whose salary will be $225,000 in 2013, they will pay a 1.45% Medicare tax on the first $200,000, then 2.35% (1.45% plus 0.9%) on the next $25,000. The employer will be required to withhold the extra 0.9% once the taxpayer’s wages pass the $200,000 threshold for individuals. Example 2: There is a married couple filing a joint return. The taxpayer earns wages of $150,000 and the spouse earns wages of $175,000. Both employers withheld 1.45% Medicare tax because neither the taxpayer nor the spouse earned over $200,000. The couples’ total earnings is $325,000, they owe an additional $675 ($325,000 minus $250,000 = $75,000 x .9%). The couple can either pay this additional amount when they file their return or pay an estimated voucher. The Medicare Surtax on Net Investment Income. A 3.8% surtax will be due on the lesser of net investment income for the year, or the amount by which the taxpayer’s “modified adjusted gross income”—or MAGI—exceeds the income thresholds. Note that a taxpayer could be subject to both the additional 0.9% tax on earned income and this 3.8% tax. 190 Individuals will owe the tax if they have Net Investment Income and also have modified adjusted gross income over the following thresholds: Filing Status Threshold Amount Married filing jointly $250,000 Married filing separately $125,000 Single $200,000 Head of household (with qualifying person) $200,000 Qualifying widow(er) with dependent child $250,000 Taxpayers should be aware that these threshold amounts are not indexed for inflation. If the taxpayer is an individual that is exempt from Medicare taxes, they still may be subject to the Net Investment Income Tax if they have Net Investment Income and also have modified adjusted gross income over the applicable thresholds Example: Jack and Jill’s MAGI is $372,000, of which $330,000 is wages and $42,000 is net investment income. Their MAGI is $122,000 over the $250,000 threshold for married couples filing jointly. They will incur the 3.8% tax on they $42,000 of net investment income, because it is less than the amount they are over the MAGI threshold ($122,000). They will also owe 0.9% on the $80,000 that their wages are over the $250,000 earned income threshold for married couples filing jointly. Their total Medicare tax surcharge will be $2,316, which includes $1,596 (3.8% of $42,000) and $720 (0.9% on $80,000). In general, investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities, and businesses that are passive activities to the taxpayer (within the meaning of IRC section 469). The Net Investment Income Tax is subject to the estimated tax provisions. Individuals, estates, and trusts that expect to be subject to the tax in 2013 or thereafter should adjust their income tax withholding or estimated payments to account for the tax increase in order to avoid underpayment penalties 191 Credits After the income tax is determined, the tax credits are determined. There are two kinds of credit, refundable and nonrefundable. The nonrefundable credits can reduce the tax to zero but any excess is not refundable. The refundable credit is treated as payments and is refundable. The refundable credits are added to withholding and estimate payments. If this total is more than the total tax the excess is refunded to the taxpayer. Adoption Expense Credit80 After December 31, 2012, the refund ability of the adoption tax credit and the increase in the maximum credit amount and income exclusion that were in effect for 2010 and 2011 are repealed. The maximum adoption credit or exclusion for employer-provided adoption benefits has gone to $12,650. In order to claim either the credit or exclusion, the MAGI must be less than $189,710 (phase-out between AGI of $189,710 and $229,710). The adoption expense credit is no longer refundable for tax years after 2011. For taxable years beginning in 201381 The credit allowed for an adoption of a child with special needs is $12,970. For taxable years beginning in 2013, the maximum credit allowed for other adoptions is the amount of qualified adoption expenses up to $12,970. The available adoption credit begins to phase out under for taxpayers with modified adjusted gross income in excess of $194,580 and is completely phased- out for taxpayers with modified adjusted gross income of $234,580 or more. For taxable years beginning in 2013 the amount that can be excluded from an employee’s gross income82 for the adoption of a child with special needs is $12,970, and has the same phase-out provisions as above. Nonqualifying expenses: Any expenses that violates state or federal law The carrying out of a surrogate parenting arrangement The adoption of a spouse’s child Using funds paid from any state or Federal program Allowed as a deduction under any other federal income tax rule Paid or reimbursed by the employer or anyone else Eligible Child means: Under 18 years old or Physically or mentally handicapped A child with special needs means: He or she is a citizen or resident of the United States; and A state (including the District of Columbia) determines that the child cannot or should not be returned to his or her parents’ home and probably will not be adopted unless adoptive assistance is provided to the adoptive parents The credit can generally be taken in any year prior to the adoption becoming final. Use Form 80 IRC §23 IRC §23(a)(3) 82 IRC §137(b)(1) 81 192 8893. (Refer to Form 8893 instructions and Pub 968). If the full amount of the credit cannot be taken in the current year due to the tax liability, the credit can be carried forward five years. Adoption Benefits Amounts paid or expenses incurred by an employer for qualified adoption expenses under an adoption assistance program are not subject to federal income tax withholding and are not reportable in box 1, of Form W-2. However, these amounts (including adoption benefits paid from a section 125 (cafeteria) plan, but not including adoption benefits forfeited from a cafeteria plan) are subject to social security, Medicare, and railroad retirement taxes and must be reported in boxes 3 and 5. Also, the total amount must be reported in box 12 with code T. Child and Dependent Care Credit83 If the taxpayer pays someone to care for a dependent that is under the age of 13 or for the spouse or dependent that is not able to care for him or herself, the taxpayer may be able to claim a credit. The credit can be up to 35% of the expenses. The expenses must be so the taxpayer can work. To claim the credit the taxpayer must meet all of the following tests; 1. The care must be for one or more qualified person who is identified on Form 2441. 2. The taxpayer and the spouse if married must maintain the home of the qualifier for the credit. 3. The taxpayer and spouse if married must have earned income during the year. 4. The child and dependent care expenses must be so the taxpayer and spouse if married can work or look for work. 5. The person paid to care for a dependent cannot be a dependent of the taxpayer and must be 19 or older. 6. The filing status cannot be married filing separate. 7. The care provider must be identified with either a Social Security Number or a Federal Identification Number. 8. Dependent care benefits paid by the employer must be excluded from expenses before computing the credit. The credit is generally a percentage of the amount of work-related child and dependent care expenses paid to a care provider. The percentage depends on the taxpayer’s adjusted gross income. Work-related child and dependent care expenses qualifying for the credit are those paid for the care of a qualifying individual to enable the taxpayer to work or actively look for work for any period when there are one or more qualifying individuals. Expenses are paid for the care of a qualifying individual if the primary function is to assure the individual's well-being and protection. In general, amounts paid for services outside the household qualify for the credit if the care is provided for a qualifying individual who was the taxpayer’s qualifying child under age 13 and regularly spent at least 8 hours each day in the taxpayer’s household. 83 IRC §21 193 The taxpayer can include amounts paid for items other than the care of their child (such as food and schooling) only if the items are incidental to the care of the child and cannot be separated from the total cost. However, do not include the cost of schooling for a child in kindergarten or above. The taxpayer can include the cost of a day camp, even if it specializes in a particular activity, such as soccer. But cannot include any expenses for sending the child to an overnight camp, summer school, or a tutoring program This credit provides a percentage credit in the amount of the lesser of the taxpayer’s earned income (or spouse earned income), the actual expenses, or $3000 for one individual; $6000 for two individuals. For married couples, the higher of actual income or for each month a spouse is disabled or a full-time student, that spouse is deemed to have $250 in earned income (one qualifying individual), or $500 earned income for two or more qualifying individuals. The credit is intended to assist working taxpayers with dependent children. The requirements for the use of this credit are as follows: 1. Taxpayer Must Have Earned Income, except that for a married couple, living together, one spouse may be a student or disabled. Earned income includes employee pay and income earned from self-employment. If one spouse does not work, this bars use of the credit, except where the non-working spouse is incapable of self-care due to mental or physical disability, or where the non-working spouse is a full-time student at an educational institution at least some portion of five months out of the tax year. Earned income includes wages, salaries, tips, other taxable employee compensation, and net earnings from self-employment. A net loss from selfemployment reduces earned income. Earned income also includes strike benefits and any disability pay reported as wages. Nontaxable combat pay may also be included if the taxpayer finds it advantageous. (Unemployment compensation does not qualify) 2. Qualifying Individual.84 For purposes of the child and dependent care credit, a qualifying individual is: A. The taxpayer’s dependent qualifying child who is under age 13 when the care is provided, B. The taxpayer’s spouse who is physically or mentally incapable of self-care and who has the same principal place of abode as the taxpayer for more than half of the year, or An individual is physically or mentally incapable of self-care if, as a result of a physical or mental defect, the individual is incapable of caring for his or her hygiene or nutritional needs, or requires the full-time attention of another person for the individual's own safety or the safety of others. A noncustodial parent may not treat a child as a qualifying individual for purposes of the credit, even if the noncustodial parent may claim an exemption for the child. If a person is a qualifying individual for only a part of the tax year, only those expenses paid during that part of the year are included in calculating the credit. 84 Topic 602 194 4. Qualifying Expenses by the taxpayer necessary to ensure the welfare of the qualifying individual while the taxpayer works or searches for work. Non-qualifying expenses include transportation to and from a care facility, overnight camp expenses, and education expenses incurred for the education of the qualifying individual in the first grade or higher. Preschool costs are a qualifying expense. Payments that do not qualify: Amounts paid to the following for child or dependent care do not qualify: Taxpayer’s spouse Qualifying child’s parent Taxpayer’s dependent Taxpayer’s child who is under age 19 even if not a dependent The percentage depends on the adjusted gross income refer to Form 2441 instructions for the percentage. The amount of credit that can be claimed is limited to the amount of the regular tax (after reduction by any allowable foreign tax credit) that is multiplied by a percentage. This credit is not refundable and does not allow a carry forward. 195 Michael and Janice put Little John in childcare in July and incurred $4,200 of qualified expenses. Michael’s employer paid $1,500 in Dependent Care Benefits in 2012. 196 Flexible Spending Accounts (Dependent Care Benefits, or Cafeteria Plans/125 Plans): Allows an employer to provide for childcare for an employee. Such benefits are paid for by the employee out of his or her salary and are not taxed up to $5000 (or $2,500 if MFS and not considered unmarried). The amount in excess of these amounts is taxable. Such benefits provided by an employer are non-taxable only to the extent these limits are not reached, or up to the amount of the actual expenses, or the taxpayer’s earned income including the non-taxable earned income other than the dependent care benefits provided by the employer. When an employer provides these benefits, Part III of Form 2441 must be completed (See Below). 197 In the following example the expenses were limited by the earned income of the spouse. If the taxpayer or spouse’s earned income is less than $3,000 or the amount paid for childcare expense, the credit will be limited to earned income of that spouse. See lines 3, 4 and 5 below. 198 Child Tax Credit -Ten Quick Facts85 The Child Tax Credit is an important tax credit that may be worth as much as $1,000 per qualifying child depending upon the taxpayer’s income. Here are 10 important facts from the IRS about this credit and the necessary qualifications. 1. Amount - With the Child Tax Credit, the taxpayer may be able to reduce federal income tax by up to $1,000 for each qualifying child under the age of 17. Under The American Taxpayer Relief Act of 2012, this amount is permanently set at $1,000. 2. Qualification - A qualifying child for this credit is someone who meets the qualifying criteria of six tests: age, relationship, support, dependent, citizenship, and residence. 3. Age Test - To qualify, a child must have been under age 17 – age 16 or younger – at the end of the tax year. 4. Relationship Test - To claim a child for purposes of the Child Tax Credit, they must either be the son, daughter, stepchild, foster child, brother, sister, stepbrother, stepsister or a descendant of any of these individuals, which includes a grandchild, niece or nephew. An adopted child is always treated as a son or daughter. An adopted child includes a child lawfully placed with the taxpayer for legal adoption. 5. Support Test - In order to claim a child for this credit, the child must not have provided more than half of their own support. 6. Dependent Test – The taxpayer must claim the child as a dependent on their federal tax return. 7. Citizenship Test - To meet the citizenship test, the child must be a U.S. citizen, U.S. national, or U.S. resident alien. 8. Residence Test86 - The child must have lived with the taxpayer for more than half of the year. There are some exceptions to the residence test (see examples earlier in this section). 9. Limitations - The credit is limited if the modified adjusted gross income is above a certain amount. The amount at which this phase-out begins varies depending on filing status. For married taxpayers filing a joint return, the phase-out begins at $110,000. For married taxpayers filing a separate return, it begins at $55,000. For all other taxpayers, the phase-out begins at $75,000. In addition, the Child Tax Credit is generally limited by the amount of the income tax owed as well as any alternative minimum tax. 85 86 IRC §24 Pub 972 199 10. Additional Child Tax Credit - If any or all of the regular Child Tax Credit is reduced to zero before the entire credit is used, the portion disallowed may qualify for the Additional Child Tax Credit. The Additional Child Tax Credit is a refundable credit. For 2012, the maximum Additional Child Tax Credit for taxpayers with one or two children is the lesser of: The disallowed portion of the Child Tax Credit, or 15% of the taxpayer’s earned income in excess of $3,000 For 2012, the maximum Additional Child Tax Credit for taxpayers with three or more children is the lesser of: The disallowed portion of the Child Tax Credit, or The larger of: 15% of the taxpayer’s earned income in excess of $3,000, or Social Security tax paid minus the Earned Income Credit Under The American Taxpayer Relief Act of 2012, the Additional Child Tax Credit is permanent for one or two children and the $3,000 amount is extended for five years through the end of 2017. 200 The example below is of Bonnie Friend, age 51, lives with her grandchild, Marcy 7. Bonnie filed head of household in 2012. She worked in 2012, earned $22,000 for the first few months, and then became disabled. She received $6,400 in Social Security Benefits; she also had Municipal bonds, which yielded nontaxable interest of $1,300 and taxable interest of $100. 201 In the Section 1 was an example of her Earned Income Credit. The worksheet below shows the amount of child tax credit and then the Additional Child Tax Credit she is allowed. Note on the worksheet the child tax credit is limited because of her tax and the additional amount picked up on Form 8812. The taxpayer below had a disallowed portion of the child tax credit and qualifies for the Additional Child Tax Credit. 202 Form 8812, Part I Dependents with ITIN’s An Individual Taxpayer Identification Number (ITIN) is a tax processing number issued by the Internal Revenue Service. It is a nine-digit number that always begins with the number 9 and has a range of 70-88 in the fourth and fifth digit. Effective April 12, 2011, the range was extended to include 900-70-0000 through 999-88-9999, 900-90-0000 through 999-92-9999 and 900-94-0000 through 999-99-9999. IRS issues ITINs to individuals who are required to have a U.S. taxpayer identification number but who do not have, and are not eligible to obtain a Social Security Number (SSN) from the Social Security Administration (SSA).87 ITINs are issued regardless of immigration status because both resident and nonresident aliens may have a U.S. filing or reporting requirement under the Internal Revenue Code. Individuals must have a filing requirement and file a valid federal income tax return to receive an ITIN, unless they meet an exception. The IRS issues ITINs to foreign nationals and others who have federal tax reporting or filing requirements and do not qualify for SSNs. A non-resident alien individual not eligible for a SSN who is required to file a U.S. tax return only to claim a refund of tax under the provisions of a U.S. tax treaty needs an ITIN. Other examples of individuals who need ITINs include: • A nonresident alien required to file a U.S. tax return • A U.S. resident alien (based on days present in the United States) filing a U.S. tax return • A dependent or spouse of a U.S. citizen/resident alien • A dependent or spouse of a nonresident alien visa holder 87 www.irs.gov/Individuals/General-ITIN-Information 203 204 Education Credits (IRC Section 25(A)) The following three criteria must be met to take either the American Opportunity Credit or the Lifetime Learning Credit: i. The taxpayer pays the qualified education expenses for higher education ii. The tuition and related expenses are for an eligible student iii. The eligible student is the taxpayer, the spouse or a dependent that the taxpayer claims an exemption for on the return. Quick Reference Chart for Education Credits88 Caution. The taxpayer can claim both the American opportunity credit and the lifetime learning credit on the same return—but not for the same student. American Opportunity Credit Lifetime Learning Credit Maximum Up to $2,500 credit per eligible Up to $2,000 credit per return credit student Tuition, required enrollment fees, and course materials that Tuition and required enrollment the student needs for a course fees amounts required to be Qualified of study whether or not the paid to the institution for expenses materials are bought at the course-related books, supplies, educational institution as a and equipment. condition of enrollment or attendance $180,000 if married filing $124,000 if married filing Modified jointly; jointly; adjusted $90,000 if single, head of $62,000 if single, head of gross income household, or qualifying household, or qualifying (MAGI) limit widow(er) widow(er) At least a half-time student in Taking one or more courses program leading to a degree Undergraduate & graduate or Eligibility for the first 4 years of Courses to acquire or improve job postsecondary education skills Nonrefundable—credit limited 40% of credit may be Refundable/ to the amount of tax the refundable; the rest is nonrefundable taxpayer must pay on their nonrefundable taxable income Form Used Form 8863 Form 8863 As of the end of 2012, the Felony drug student had not been Felony drug convictions are convictionconvicted of a felony for permitted New for 2012 possessing or distributing a controlled substance Tuition and Fees Deduction Up to $4,000 deduction amount Tuition and required enrollment fees only $160,000 if married filing jointly; $80,000 if single, head of household, or qualifying widow(er) At least a half-time student in program as an undergraduate & graduate course Deduction on Form 1040, Line 34 Form 8917 Felony drug convictions are permitted Cannot claim both more than one education credit; or a deduction and a credit for same student in the same year Form 1098-T Tuition Statement is issued by an eligible educational institution (a college, university, vocational school, or other postsecondary educational institution that is described in section 481 of the Higher Education Act of 1965), reporting either payments received during the year or amounts billed during the year. When figuring the education credit use only the amount actually paid during the taxable year. Form 1098-T may also contain other information, such as adjustments from prior years, the amount of scholarships or grants, reimbursements or refunds and whether the student was enrolled 88 Form 8863 Instructions 205 at least half-time or as a graduate student. Form 8863- Education Credits requires the information found on Form 1098-T, review the form for Pete’s tax return below. Most students receive their Form 1098-T89 through their online accounts at the college or university. It is a common item, which is not presented by the taxpayer at the tax interview, it is essential that the taxpayer review this form to correctly complete the Education Credits the taxpayer is allowed to take. 89 Form 1098T Instructions 206 207 208 Recapture of Education Credit Taxpayers rarely remember receiving a refund in a situation like this and it is important we ask the right questions of our clients to meet our due diligence. Education credits are an area that takes a little more time and diligence to correctly prepare. The taxpayer cannot claim an education credit for 2012 if any of the following apply: The filing status is married filing separately The taxpayer is a dependent on another return American Opportunity Credit: The modified adjusted gross income is $90,000 ($180,000 if married filing jointly) Lifetime Learning Credit: The modified adjusted gross income is $60,000 ($120,000 if married filing jointly) The taxpayer is a nonresident alien in the tax year Expenses that are not considered to be qualified education expenses: o Room and board o Insurance o Medical (including student health fees) o Transportation If the qualified education expenses were paid from the proceeds of a loan, figure the credit for the year in which the education expenses are paid and not the year in which the loan is repaid. QTP and Coverdell ESA Terminology When dealing with QTPs and ESAs it is important to understand all terminology: A half-time student is a student who is enrolled for at least half the full-time academic workload for the course of study the student is pursuing. The school determines what is considered a fulltime workload for a particular course of study. Form1098-T Box 8 will be checked. Tax-free education assistance include: o The tax-free portion of a scholarship or fellowship – Form 1098-T, Box 5 o Veterans’ educational assistance o Pell grants - Form 1098-T, Box 5 o Employer-provided educational assistance o Any other tax-free payments received as educational assistance (except gifts or inheritances) A student or the student’s parent may claim the American Opportunity and Lifetime Learning Credits in the same year as a Coverdell ESA or a QTP distribution is taken as long as the same qualified expenses are not taken. Description COVERDELL ESA – See IRS Pub. 970 for more details A savings account that is set for This account can be set up with a a designated beneficiary to pay financial institution that is 209 for qualified education expenses. approved by the IRS to offer Coverdell ESA plans. There is no limit on the number of ESA accounts a beneficiary can have. Contributions to both Coverdell ESA and Qualified Tuition Programs are allowed Age Limit of The beneficiary must be under All remaining money must be removed designated 18 years old: from the account when the beneficiary beneficiary reaches age 30 unless the person is a When the account is special needs beneficiary. opened; and When contributions are made to the account for this beneficiary. Income Limit for The MAGI of the contributor The contribution limit is reduced for contributors must be less than: contributors with a MAGI between: $ 110,000 or $95,000 and $110,000 or $220,000 for couples $190,000 and $220,000 for who file a joint tax return couples who file a joint tax return Contribution Limit The maximum annual The maximum annual contribution limit contribution limit is $2,000 for is $2,000 per beneficiary. any one beneficiary. Regardless of the number of Coverdell ESA accounts the beneficiary has. Regardless of the number of contributors contributing to different Coverdell ESA’s for any one beneficiary. Excess Beneficiary may have to pay a Contribution 6% excise tax on excess Penalty contributions. Eligible Education Can be used for qualifying This includes: education expenses for Public, private, and religious beneficiaries attending schools that provides K-12 elementary, secondary, and education. postsecondary schools. Most all eligible education institutions (colleges, universities, vocational schools or other postsecondary institutions). Considered Higher Education: Tuition and fees Qualifying Expenses for room and board must be Books, supplies and Education incurred by students who are enrolled at equipment Expenses least half-time. Room and board Special needs services for K-12 Education: 210 Tax Treatment for ESA Distributions special needs beneficiaries Academic tutoring, uniforms, transportation, and extended day care (applies to K-12) Expenses for room and board, uniforms, transportation, and extended day care programs must be required or provided by the school in connection with attendance or enrollment at the school. To determine if the students total distributions are more than the amount of their adjusted qualifying expenses the student must subtract the amount of taxfree assistance they received from their total qualifying education expenses. Are not deductible Distributions are usually not taxed if the amount of the adjusted qualified education expense does not exceed the distribution amount. Coverdell Education Savings Account This account was created as an incentive to help parents and students save for education expenses. Unlike a QTP, a Coverdell ESA can be used to pay a student’s eligible K-12 expenses, as well as post-secondary expenses. On the other hand, income limits apply to contributors, and the total contributions for the beneficiary of this 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. Contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax free until distributed. The beneficiary will not owe tax on the distributions if less than a beneficiary’s qualified education expenses at an eligible institution. This benefit applies to qualified higher education expenses as well as to qualified elementary and secondary education expenses. Any amount that is distributed from a Coverdell ESA can be rolled over to another Coverdell ESA. A Coverdell ESA distribution can also be transferred to the name of a member of the same family, including the spouse, as long as the person is under age 30. In order for rollover or a transfer to be non-taxable it must be done within 60 days after the distribution. Please refer to IRS Publication 970 for a complete list of Members of the Beneficiary’s Family. Here are some things to remember about distributions from Coverdell accounts: Distributions are tax-free as long as they are used for qualified education expenses, such as tuition and fees, required books, supplies and equipment and qualified expenses for room and board. Room and board expenses qualifies to the extent that it is not more than the greater of the following two amounts: o The allowance for room and board, as determined by the eligible educational institution, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student. o The actual amount charged if the student is residing in housing owned or operated by the eligible educational institution. 211 There is no tax on distributions if they are for enrollment or attendance at an eligible educational institution. This includes any public, private or religious school that provides elementary or secondary education as determined under state law. Virtually all accredited public, nonprofit and proprietary (privately owned profit-making) post-secondary institutions are eligible. Education tax credits can be claimed in the same year the beneficiary takes a taxfree distribution from a Coverdell ESA, as long as the same expenses are not used for both benefits. If the distribution exceeds qualified education expenses, a portion will be taxable to the beneficiary and will usually be subject to an additional 10% tax. Exceptions to the additional 10% tax include the death or disability of the beneficiary or if the beneficiary receives a qualified scholarship. U.S. Savings Bonds Interest Exclusion If the taxpayer buys a paper Series EE U.S. Savings Bond, it is bought at a discount and receives the face value of the bond at maturity. When purchasing a Series I or electronic Series EE bond, the taxpayer pays the face value of the bond. It accrues interest until the bond matures. The difference between the purchase price and the redemption value is taxable interest income. The taxpayer can report interest income from Series E, EE, and I bonds in one of these ways: Report the interest in the year it is earned. Report the entire amount of interest earned when the bond matures or when it is redeemed whichever comes first. Interest Income Exclusion for Education90 The taxpayer can help defray college expenses by investing in bonds or by cashing in bonds previously purchased. The bond interest can be excluded from taxable income if both of these apply: The taxpayer redeems Series EE bonds purchased after 1989 or Series I bonds. The money is used to pay qualified education expenses. To qualify for this tax break: The bonds must be Series EE bonds purchased after 1989 or Series I bonds. The student cannot own the bonds. The bonds must be in one of these names: o Taxpayer’s name o Taxpayer’s spouse’s name o Both the taxpayer and the spouse’s names as co-owners The taxpayer must be at least age 24 in the month before the bond was issued. If the redemption amount of the bond is more than the total qualified education expenses, they can only exclude a portion of the interest. Use Form 8815 to figure the interest income that can be excluded from income. The interest income exclusion is phased out at higher income levels based on modified adjusted gross income (AGI). Use Form 8815 to figure the modified AGI. 90 IRC §135 212 For 2012, the exclusion phase-out is $72,850 - $87,850 for single filers, if married filing jointly or a qualifying widow(er), the exclusion phase-out is $109,250-$139,250. Married couples who file separate returns are not eligible for the exclusion. (See example below) Qualified educational expenses include: Tuition and fees (such as lab fees and other required course expenses). Expenses that benefit the taxpayer, spouse, or a dependent for which the taxpayer can claim an exemption. Expenses paid for any course required as part of a degree or certificate-granting program. Expenses paid for sports, games, or hobbies qualify only if part of a degree or certificate program. Note: The costs of books or room and board are not qualified expenses. The amount of qualified expenses is reduced by the amount of any scholarships, fellowships, employer-provided educational assistance, and other forms of tuition reduction (such as education credits). The taxpayer must apply both the principal and interest from the bonds to pay qualified expenses in order to exclude the interest from their gross income. If the amount of eligible bonds cashed during the year exceeds the amount of qualified educational expenses paid during the year, the amount of excludable interest is reduced pro rata. Foreign Tax Credit91 Generally any foreign income taxes paid or accrued are eligible for the Foreign Tax Credit, unless the income has been excluded from income on Form 2555. The credit is limited to the tax liability and multiplied by the following fraction: Taxable income from sources outside the United States Total taxable income from U.S. and foreign sources The foreign tax credit is reported on Form 1116 (Refer to Pub 514 for more information). Foreign taxes paid or accrued on dividends, interest or royalties less than $300 ($600 if married filing jointly) can be reported directly on Form 1040. If Form 1116 is used in the return and the full amount of the credit is not allowed due to the tax liability, the foreign tax credit can be carried back 1 year and carried forward for 10 years. Mortgage Interest Credit92 The mortgage interest credit is intended to help lower income individuals purchase a home. If the taxpayer qualifies they can receive a credit for part of the interest they paid. The deductible interest on Schedule A is reduced by the amount used to compute the credit. To qualify the taxpayer must be issued a certificate by state or local government. The credit rate on the certificate is multiplied by the interest allowed. If the credit rate is over 20%, the maximum 91 92 IRC §901(a) IRC §25 213 amount of the credit is $2,000. The credit is reported on Form 8396. If the credit is more than the tax liability, the excess can be carried forward for three years. Credit for Prior Year Minimum Tax This credit occurs if the taxpayer paid Alternative Minimum Tax generated by “deferral items” in the prior year. Adjustments required under AMT rules fall into two categories: Deferral items are AMT adjustments that do not cause a permanent difference in taxable income over time. Circulation costs Depreciation after 1986 Disposition of property Electing large partnerships Estates and trusts Exercise of incentive stock options Income from installment sale Intangible drilling costs Long-term contract Loss limitations Mining cost Passive activities Research and experimental costs Exclusion items are AMT adjustments that result in a permanent change in tax, such as itemized deduction adjustments. Depletion Interest from private bond activity Investment interest expense Medical and dental expense Miscellaneous deductions Qualified small business stock Tax refund Taxes The prior year minimum tax credit is reported on Form 8801 and can be carried forward indefinitely. The taxpayer can take the credit against regular tax if they: 1. Paid alternative minimum tax in the prior year. 2. Had an unused prior year credit Retirement Savings Contribution Credit93 The taxpayer may be able to take a credit of 10% - 50% of the eligible contributions up to $1,000 ($2,000 if married filing joint) if they the contributions to an employer sponsored retirement plans or an IRA. The credit is a percentage of the retirement contribution with highest credit for the lowest income taxpayers. 93 IRC §25(b) 214 Eligible contributions include contributions to: Traditional or Roth IRA’s Tax-exempt employee-funded pension plans (501)(c)(18)(D) Elective deferrals 401(k), 403(b) annuities, nonqualified deferred compensation plans Elective deferrals to SIMPLE’s or SARSEP’s Voluntary after tax employee contribution to any qualified retirement plan, annuity or IRA The amount of the credit depends on the amount of the adjusted gross income, filing status and eligible contributions. The credit is claimed on Form 8880. (Refer to Pub 590 for further information). The credit cannot be taken if the following apply: The amount of the taxpayer’s adjusted gross income is more than $28,750 ($43,125 for head of household and $57,500 for married filing joint) The taxpayer was not at least 18 by the end of the year. The taxpayer was claimed as a dependent on another return The taxpayer was a full-time student General Business Credit General Business Credit is a credit made up of several separate business related credits. The General Business Credit is calculated on Form 3800 and consists of carry forward from prior years plus the total of current year business credits. The following credits are part of the general business credit. Use this form to figure each credit below. The 2012 Form 3800 is included at the end of this section. Alcohol and cellulosic biofuel fuels credit (Form 6478): This credit consists of the alcohol mixture credit, alcohol credit, small ethanol producer credit, and cellulosic biofuel producer credit. For more information, see Form 6478. Biodiesel and renewable diesel fuels credit (Form 8864): This credit applies to certain fuel sold or used in the business. For more information, see Form 8864. Credit for employer social security and Medicare taxes paid on certain employee tips (Form 8846): This credit is generally equal to the (employer's) portion of social security and Medicare taxes paid on tips received by employees of the food and beverage establishment where tipping is customary. The credit applies regardless of whether the food is consumed on or off the business premises. For more information, see Form 8846. Credit for employer differential wage payments (Form 8932): This credit provides certain small businesses with an incentive to continue to pay wages to an employee performing services on active duty in the uniformed services of the United States for a period of more than 30 days. For more information, see Form 8932. Credit for employer-provided childcare facilities and services (Form 8882): This credit applies to the qualified expenses paid for employee childcare and qualified expenses the taxpayer paid for childcare resource and referral services. For more information, see Form 8882. Credit for increasing research activities (Form 6765): This credit is designed to encourage businesses to increase the amounts they spend on research and experimental activities, including energy research. For more information, see 215 Form 6765. Investment credit (Form 3468): The investment credit is the total of the following credits. For more information, see Form 3468. Rehabilitation credit. Energy credit. Qualifying advanced coal project credit. Qualifying gasification project credit. Qualifying advanced energy project credit. Low-income housing credit (Form 8586): This credit generally applies to each new qualified low-income building placed in service after 1986. For more information, see Form 8586. Orphan drug credit (Form 8820). This credit applies to qualified expenses incurred in testing certain drugs for rare diseases and conditions. For more information, see Form 8820. 216 Work opportunity credit (Form 5884).94 This credit provides businesses with an incentive to hire individuals from targeted groups that have a particularly high unemployment rate or other special employment needs. For more information, see Form 5884. Social Security and Medicare taxes on tips not reported to the employer are reported on Form 4137. If a taxpayer received $20 or more in cash or charge tips in a month from any one job and did not report all of those tips to the employer, the taxpayer must report the social security and Medicare taxes on the unreported tips as an additional tax on the return. Form 4137 is reported on Form 1040 on Line 58. Household Employment Tax: If the taxpayer pays someone to work in their home, the taxpayer may be a household employer. If the employee is self-employed or under the control of a third party, such as a placement agency, the taxpayer is not a household employer. If the taxpayer qualifies as a household employer, they must apply for an employer identification number (EIN) and determine whether employment taxes must be paid. Employment taxes include Social Security and Medicare taxes, federal unemployment taxes and federal income tax withholding. For more information refer to Pub 926 and Schedule H (Form 1040). The taxpayer may also have to pay state unemployment tax. A list of state employment tax agencies, including addresses and phone numbers are included in Pub 926. Schedule R is a nonrefundable credit the elderly US citizen over the age of 65 or under the age of 65 who is retired on total and permanent disability and received taxable disability payments. The taxpayer must supply a physician statement. The income requirements for this form are very low and it is only claimed by people with very little income. 94 IRC §51 217 Chapter 16 - Payments, Withholding and Earned Income Credit Withholding Generally an employer withholds taxes from an employee’s pay, tax may also be withheld from certain other income, including pensions, bonuses, and commissions and gambling winnings. In each case the amount withheld is paid to the IRS in the taxpayer’s name. If the tax is not paid through withholding or not enough tax is withheld, the taxpayer may have to pay estimated tax. Self-employed persons generally must pay their taxes through estimates. Income from interest and capital gains, rent and royalty also may be subject to withholding. Estimated tax is also used to pay self-employment tax and alternative minimum tax. The amount of income tax the employer withholds from regular pay depends on two things: 1. The amount the taxpayer earns 2. The information that is reported to the employer on Form W-4 Form W-4 includes three items the employer will need to withhold tax. 1. Whether to withhold at the single rate or at the lower married rate. 2. How many withholding allowances to claim (each allowance reduces the amount withheld) 3. Whether the taxpayer wants an additional amount withheld. If the taxpayer’s income is low enough that they will not have to pay income tax they may be exempt from withholding. Whenever the taxpayer starts a new job or changes jobs they must fill out a new W-4 form. There are worksheets to help the taxpayer compute how many allowances should be claimed. (Refer to Chapter 3 in this syllabus) Supplemental wages include bonuses, commissions, overtime pay and certain sick pay. The employer should figure withholding on certain wages using the same method used for regular wages. If these supplemental wages are identified separately the employer can withhold at a flat rate of 27%. There are penalties for falsely reporting information on Form W-4. Tips reported to the employer are included in income and are subject to withholding. The employer should not withhold tax on allocated tips, only on the taxpayer’s pay and reported tips. The employer must withhold on the value of fringe benefits included in income for the period the benefits are paid. Sick pay is a payment to replace the taxpayer’s wages while the taxpayer is temporarily absent from work. Paid by the employer and is subject to withholding. If sick pay is paid by a third party and the employer is party to it, such as an insurance company, the taxpayer should file Form W-4S with the company paying the sick pay. W-4S is a Request for Federal Income Tax Withholding from Sick Pay. 218 Gambling winnings subject to withholding are reported on Form W-2G showing the amount of winnings and the amount of withholding. Gambling winnings of more than $5,000 from the following sources are subject to income tax withholding: Any sweepstakes, wagering pool or lottery Any other wager, if the proceeds are at least 300 times the amount of the bet The taxpayer can choose to have voluntary withholding on unemployment compensation and other federal payments such as social security income. The taxpayer can choose withholding of 7, 10, 15, and 27% of each payment withheld. (Refer to Pub 505 for additional information on withholding and estimated tax). Estimated Tax Estimated tax is the method used to pay tax on income not subject to withholding. This includes income from self-employment, interest dividends, alimony, rent, gains from the sale of assets, prizes, awards and when withholding is not enough on salaries and pensions. If the taxpayer under withholds or does not pay enough estimated payments, they may be subject to a penalty. Estimated taxes are required if both the following apply: The taxpayer expects to owe at least $1,000 in tax after subtracting the withholding and credits The taxpayer expects the withholding and credits to be less than the smaller of 90% of the tax to be shown on the current year return (66 2/3 % for farmers and fishermen) 100% of the taxes shown on the prior year return (110% if the adjusted gross income was over $150,000 ($75,000 if MFS)) Estimated tax payments are not required if the taxpayer meets all of the following requirements: There was no tax liability for the prior year The taxpayer was a U.S. resident for the whole year The prior year return covered a full 12 months Compute the estimated tax for the next year by starting with the current year income, deductions and credits, and use the ES worksheet. Make adjustments for changing situations. Penalty for underpayment of tax is computed on the amount underpaid for the number of days the estimated payment is late. Standard due dates for estimated tax payments are Apr. 15, June 15, Sept 15 and Jan 15 of the next year. A taxpayer who underpays an estimated tax installment cannot avoid the underpayment penalty by overpaying the next installment. In contrast, an employee who has insufficient withholding midyear can eliminate an underpayment penalty by increasing withholding for the remainder of the year because withholding is generally considered to be paid in four equal installments. 219 There are five ways to pay estimated tax: 1. Credit the overpayment on the current year return to the next year. 2. Send a payment with the payment voucher from Form 1040-ES 3. Use the Electronic Federal Tax Payment System (EFTPS) 4. Electronic funds withdrawal 5. Credit card using pay by phone system or the Internet 220 CA Estimated Tax Requirements In 2012 California continues to have front-loaded estimated tax payments. The required payments include the 1% mental health surcharge for taxpayers with a taxable income $1,000,000 or more and AMT. The required percentages are: Quarter 1st 2nd 3rd 4th Percentage 30% 40% 0% 30% If the taxpayer and spouse/RDP paid joint estimated tax payments, but are now filing separate income tax returns, either of the taxpayer or spouse/RDP may claim the entire amount paid, or they may each claim part of the joint estimated payments. If the taxpayer wants the estimated tax payments to be divided, notify the FTB before they file the income tax returns so that the payments can be applied to the proper account. The FTB will accept in writing, any divorce agreement (or court ordered settlement) or a statement showing the allocation of the payments along with a notarized signature of both taxpayers. The statements should be sent to: JOINT ESTIMATE CREDIT ALLOCATION MS F225, TAXPAYER SERVICES CENTER, FRANCHISE TAX BOARD, PO BOX 942840, SACRAMENTO CA 94240-0040 The taxpayer is required to remit all their payments electronically once they make an estimate or extension payment exceeding $20,000 or they file an original return with a total tax liability over $80,000 for any taxable year that begins on or after January 1, 2009. Once the threshold is met, all subsequent payments regardless of amount, tax type, or taxable year must be remitted electronically. Individuals who do not send the payment electronically will be subject to a one percent noncompliance penalty. Electronic payments can be made using Web Pay on the Franchise Tax Board’s (FTB’s) website, electronic funds withdrawal (EFW) as part of the e-file return, or credit card 221 Sample ES Voucher worksheet 222 Excess Social Security and Tier 1 RRTA Withheld The maximum amount of social security tax withheld (FICA) for 2012 is $4,624. If the taxpayer’s employer withheld in excess of this amount the taxpayer should ask the employer to refund the excess. If the taxpayer has more than one employer the excess withheld can be claimed on the return. Figure the taxpayer and spouse separately. Earned Income Credit The earned income credit is a tax credit for certain people who work and have income under a certain amount. Everyone must meet all the following seven rules to qualify. Earned Income Credit95 – the Basics: EIC is a refundable credit. Investment income cannot be more than $3,200. The taxpayer must be a U.S. citizen or resident alien all year, or a nonresident alien married to a U.S. citizen or resident alien and filing a joint. The qualifying child must be U.S. Citizen. The taxpayer must meet the earned income, AGI and investment income limits (income limits change each year). The taxpayer cannot file Married Filing Separate. The taxpayer cannot file Form 2555 Foreign Income Exclusion. If the taxpayer does not have a qualifying child, they must: be age 25 but under 65 at the end of the year, live in the United States for more than half the year, and not qualify as a dependent of another person. Earned Income for EIC usually means taxable employee pay and self-employment income: Wages from Line 7, Form 1040 reduced by: o Taxable scholarships or fellowships grants not reported on Form W-2 o Work performed in a Penal Institution o Pension or annuity from nonqualified deferred compensation plan, or o Nongovernmental Section 457 plan Combat Pay (see below). Disability Pay reported on Line 7 of Form 1040. Net profit96 from self-employment income less one-half deduction for one-half of SE tax. Church employee income as computed on the Earned Income Worksheet97 Clergy Income reported on Line 7 of Form 1040 as computed on the Earned Income Worksheet 95 IRC §32 IRC §1402(a) 97 Pub 596, Earned Income 96 223 Items that are not Earned Income: Social Security and Railroad Retirement Benefits Worker’s Compensation Welfare Benefits Unemployment Compensation Nontaxable foster care payments Nontaxable workfare payments Veteran’s Benefits Nontaxable military payments (see examples of Combat pay below) Interest and Dividends Capital Gains Rental Income Royalty Income Pensions and Annuities EIC 2012 Tax Year98 Earned Income and adjusted gross income (AGI) must each be less than: $45,060 ($50,270 married filing jointly) with three or more qualifying children $41,952 ($47,162 married filing jointly) with two qualifying children $36,920 ($42,130 married filing jointly) with one qualifying child 98 www.irs.gov/Individuals/EIC-Income-Limits,-Maximum-Credit--Amounts-and-Tax-Law-Updates 224 $13,980 ($19,190 married filing jointly) with no qualifying children Tax Year 2012 maximum credit: $5,891 with three or more qualifying children $5,236 with two qualifying children $3,169 with one qualifying child $475 with no qualifying children Investment income must be $3,200 or less for the year. The importance of due diligence99 when preparing an earned income credit cannot be overstated. Congress has determined that noncompliance with the EIC rules poses a sufficiently significant problem to merit imposing unique due diligence requirements on the tax preparer. Failure to be diligent in determining eligibility for EIC is $500 per failure. Oddly enough this was signed into law by President Obama in a trade agreement with South Korea100 that increased the amount from $100 to $500 included in Sec. 6695(g) penalty for failure by preparers to exercise due diligence with respect to the earned income tax credit. The EIC penalty applies to each failure of a tax return preparer to exercise due diligence in determining taxpayer eligibility for, or the amount of, an EIC. The increased penalty amount will apply to returns required to be filed after Dec. 31, 2011. Publication 4687 on EIC due diligence identifies three common errors that account for more than 60% of erroneous claims. The first and most common form of EIC noncompliance is the improper claiming of a qualifying child. This error occurs when the taxpayer claims a child who does not meet the age, relationship, or residency requirements. The following are the Qualifying Child Rules.101 (See examples below) The child must have a Social Security Card and pass all the other requirements below: Relationship Son, daughter, adopted child, stepchild, foster child or a descendent of any of them such as a grandchild Brother, sister, half brother, half sister, step brother, step sister or a descendant of any of them such as a niece or nephew Age At the end of the filing year, the taxpayer’s child was younger than the taxpayer (or spouse if they file a joint return) and o younger than 19, or o younger than 24 and a full-time student At the end of the filing year, the child was any age and permanently and totally disabled 99 Sec. 6695(g) HR3080 101 Pub. 596 100 225 Residency Child must live with the taxpayer (or spouse if they file a joint return) in the United States for more than half of the year Joint Return The child cannot file a joint return for the year, unless the child and the child's spouse did not have a separate filing requirement and filed the joint return only to claim a refund. IMPORTANT: Only one person can claim the same child. If a child qualifies for more than one person and one of the persons is a parent or parents, the non-parent can claim the child only if their AGI is higher than the parent(s). If the child qualifies another relative and the parent AGI rules do not apply, the parent decides whether to allow the other relative to claim the child. Adopted Child. An adopted child is always treated as the taxpayer’s own child. It also includes a child lawfully placed with the taxpayer for adoption. Foster Child. For EIC, a child is the taxpayer’s foster child if the child is placed with the taxpayer by an authorized placement agency or by judgment, decree, or other order of any court of competent jurisdiction. (An authorized placement agency includes a state or local government agency or an Indian tribal government. It also includes a tax-exempt organization licensed by a state or an Indian tribal government.) Permanently and totally disabled. The child is permanently and totally disabled if both of the following apply: 1). The child cannot engage in any substantial gainful activity because of a physical or mental condition and 2). A doctor determines the condition has lasted or can be expected to last at least a year or lead to death. Tiebreaker Rules Under the tiebreaker rule, the child is treated as a qualifying child of: The parents if they file a joint return; The parent, if only one of the persons is the child's parent; The parent with whom the child lived the longest during the tax year, if two of the persons are the child's parent and they do not file a joint return together. The parent with the highest AGI if the child lived with each parent for the same amount of time during the tax year, and they do not file a joint return together; The person with the highest AGI if no parent can claim the child as a qualifying child; or 226 A person with the higher AGI than any parent who can also claim the child as a qualifying child but does not. If another person uses the qualifying child to claim EIC using the tiebreaker rule, the taxpayer can claim EIC only if they have another qualifying child. The taxpayer cannot take the credit using the rules for those with no qualifying child. If there is a qualifying child and the taxpayer does not claim EIC using that qualifying child, they cannot allow someone else to take EIC who do not have a qualifying child. The second most frequent mistake is when taxpayers file as Single or Head of Household when they are married. According to the IRS, many times this error is caused by taxpayers failing to understand the rules regarding the Head of Household filing status, but taxpayers also often improperly claim filing status of Single or Head of Household intentionally to qualify for or inflate the amount of EIC. The taxpayer can claim the Single filing status on their tax return if they are unmarried or "considered unmarried" on the last day of the year. This includes people who are legally separated or divorced at the end of the year. The filing status is single if, on the last day of the year, the taxpayer was unmarried or legally separated from their spouse under a divorce or separate maintenance decree, and they do not qualify for another filing status102 Considered Unmarried The taxpayer must file a separate return than their spouse The taxpayer must have paid more than half the cost of keeping up the home for the tax year. The spouse did not live in the home for the last 6 months of the year. The taxpayers home is the home of their child for more than half of the year which they can claim the child as their dependent. The third most common error made by taxpayers is the improper reporting of income. Taxpayers sometimes over or under report income to either qualify for or maximize the amount of EIC. Documentation is essential to EIC, be sure to ask questions and keep not only all the documents the taxpayer presents but notes of the questions asked and the answers. Exercise Due Diligence103 A tax return preparer must exercise due diligence in preparing a return claiming an EIC. There are four due-diligence requirements: 1. Completion and Submission of Form 8867 Complete checklist based on information provided by the client(s). 102 103 IRS Pub 501 Regs. Sec. 1.6695-2(b). 227 104 For returns or claims for refund filed electronically, submit Form 8867 to IRS electronically with the return. For returns or claims for refund not filed electronically, attach the completed form to any paper return prepared and filed. For returns or claims for refund prepared but do not submit directly to the IRS, provide completed Form 8867 to the taxpayer to send with the filed tax return or claim for refund. 2. Computation of the Credit Complete EIC worksheet104 from the Form 1040 instructions, Earned Income Credit, or a document with the same information. The worksheet shows what is included in the computation, that is, selfemployment income, total earned income, investment income, and adjusted gross income. 3. Knowledge Know the law and use your knowledge of the law to ensure you are asking your client the right questions to get all relevant facts. Take into account what your client says and what you know about your client. Not know or have reason to know any information used to determine your client's eligibility for, or the amount of, EIC is incorrect, inconsistent or incomplete. Make additional inquiries if reasonable and well-informed tax return preparer would know the information is incomplete, inconsistent or incorrect. Document any additional questions you ask and your client's answer at the time of the interview. The Treasury Regulations give examples of when to apply the knowledge requirement. Find the regulations for tax return preparer due diligence requirements on the Government Printing Office site. 4. Retention of Records Keep a copy of the Form 8867 and EIC worksheet, and a record of any additional questions that were asked during the interview client to comply with your due diligence requirements and your client's answers to those questions. Keep copies of any documents the client provides to determine eligibility for, or the amount of the EIC. Verify the identity of the person giving the return information and keep a record of who provided the information and the date received. 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 the date the tax return or claim for refund is electronically filed, or Publication 596 228 If the return or claim for refund is not filed electronically the date the preparer presents the tax return or claim for refund to the client for signature; or Keep the records in either paper or electronic format. All of the records should be in a format that can be given to the IRS if requested. The best approach as a tax return preparer to avoid incurring penalties due to unintended errors in conducting EIC due diligence is the enhancement tax knowledge and ask the pertinent questions of the taxpayer. Did the client provide satisfactory records of all income and expenses? Are the expenses being reported consistent with this type of business? In your opinion, is the amount of expenses being reported reasonable? Does anything seem to be missing? Is the income the taxpayer reporting seem sufficient to support the taxpayer and the qualifying children that are being claimed? Were school or doctors records supplied to verify the information claimed regarding the qualifying children? If the income reported is self-employment income, did you see the books? Did you note how the information was presented and substantiated? How long have you owned your business? Who maintains the business records for your business? Does the taxpayer have separate banking accounts for personal and business transactions? Have you been issued a 1099-MISC or 1099-K to support the income? 229 Note: The preparer’s Name and PTIN are required on Form 8867. 230 231 NOTE: Form 8867 is for the preparer not the taxpayer. The IRS wants to know that you are doing everything possible to meet the due diligence responsibility. To comply with the EIC knowledge requirement, you must not know or have reason to know that any information used to determine the taxpayer's eligibility for, and the amount of, the EIC is incorrect. You may not ignore the implications of information furnished to or known by you, and you must make reasonable inquiries if the information furnished appears to be incorrect, inconsistent, or incomplete. At the time you make these inquiries, you must document in your files the inquiries you made and the taxpayer's responses.105 105 Form 8867, Line 24 232 Chapter 17 – Refunds, Amount Due, PTIN & Electronic Filing Refund If there is withholding, estimated tax or a refundable credit in excess of the total tax liability, there is an overpayment, which can be refunded, unless there is unpaid child or spousal support, other federal debts or state tax judgment. The taxpayer can elect to have the refund directly deposited to either a savings or checking account in the taxpayer’s name. A bank account number and the routing number of the bank are required for direct deposit. The routing number should either be furnished by the bank or taken directly from a check. The amount of refund can also be applied to the next year’s tax. To check the status of a refund go the IRS website; click on the link “Where is my Refund?” Enter the taxpayer SSN, filing status, and refund amount. Amount Owed If the withholding or estimated tax payments were not enough to cover the tax liability there is an amount owed. Payments can be made in several ways: If payment is by check, make the check payable to the United States Treasury; write the SSN on the check and “2012 Form 1040”. Complete the payment voucher “1040V” and send that with the check loose on top of the return Credit Card payments can be made through service providers. The IRS accepts American Express, Master Card, Discover and Visa. The taxpayer will be charged a convenience fee The taxpayer can also make a direct deposit through their financial institution. The taxpayer will have to register first by going to www.eftps.gov Preparer Registration New regulations require all paid tax return preparers (including attorneys, CPAs, and enrolled agents) to apply for a Preparer Tax Identification Number (PTIN) — even if you already have one — before preparing any federal tax returns. A PTIN must be obtained by all tax return preparers who are compensated for preparing or assisting in the preparation of, all or substantially all of any U.S. federal tax return, claim for refund, or other tax form submitted to the IRS except the following: Form SS-4, Application for Employer Identification Number; Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding; Form SS-16, Certificate of Election of Coverage under FICA; Form W-2 series of returns; Form W-7, Application for IRS Individual Taxpayer Identification Number; Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding; Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Over assessment; Form 872, Consent to Extend the Time to Assess Tax; 233 Form 906, Closing Agreement On Final Determination Covering Specific Matters; Form 1098 series; Form 1099 series; Form 2848, Power of Attorney and Declaration of Representative; Form 3115, Application for Change in Accounting Method; Form 4029, Application for Exemption From Social Security and Medicare Taxes and Waiver of Benefits; Form 4361, Application for Exemption From Self-Employment Tax for Use by Ministers, Members of Religious Orders and Christian Science Practitioners; Form 4419, Application for Filing Information Returns Electronically; Form 5300, Application for Determination for Employee Benefit Plan; Form 5307, Application for Determination for Adopters of Master or Prototype or Volume Submitter Plans; Form 5310, Application for Determination for Terminating Plan; Form 5500 series; Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips; Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests; Form 8288-B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests; Form 8508, Request for Waiver From Filing Information Returns Electronically; Form 8717, User Fee for Employee Plan Determination, Opinion, and Advisory Letter Request; Form 8809, Application for Extension of Time to File Information Return; Form 8821, Tax Information Authorization; Form 8942, Application for Certification of Qualified Investments Eligible for Credits and Grants Under the Qualifying Therapeutic Discovery Project Program All federal tax return preparers, including those who obtained a PTIN prior to Sept. 28, 2010, need to register in the new system. All preparers need to be registered in the new system and have a PTIN prior to filing any return after Dec. 31, 2010. As long as the IRS can validate the ownership of the existing PTIN, the same number will be reassigned once the appropriate information is provided and the user fee is paid. A PTIN is an individual number and must be obtained by the individual preparer. Applicants must be 18 years of age and have a valid social security number. To prepare tax returns the applicant must wait until an online or paper application is submitted, the fee is paid, and they obtain (or renew) the PTIN. Exception: Certain individuals who have made a good faith effort to timely obtain a PTIN but experienced processing issues are being advised they may prepare returns during the interim period while their applications are pending. These notifications are being issued on the online system to people who make four unsuccessful attempts to register and in writing (email or letter) to individuals who have timely submitted paper applications and payments. Refer to Notice 2011-11 for additional information. Any individual who, for compensation, prepares, or assists in the preparation of, all or substantially all of a tax return or claim for refund after December 31, 2010 must have a PTIN. Failure to do so could result in the imposition of Internal Revenue Code section 6695 penalties, injunction, referral for criminal investigation, or disciplinary action by the IRS Office of Professional Responsibility. 234 Electronic Filing - Federal and California This section is designed starts with a scenario to help clarify the IRS rules for the taxpayer and the preparer regarding electronic filing. Pete Dreamer’s tax return has been electronically filed since he started filing. He said he would be moving out of the area and would find a local preparer in his new hometown. He asked the best way to find a preparer and to make sure they are approved by the IRS to electronically file his return. Last year, nearly 100 million taxpayers opted for the safest, fastest and easiest way to submit individual tax returns through IRS e-file. Since 1990, taxpayers have e-filed nearly 1 billion Form 1040 series tax returns safely and securely. E-file is the norm; it gives you an extra weapon in verifying Social Security Numbers for such items as EIC. Starting January 1, 2012, any tax return preparer who anticipates preparing and filing 11 or more Individual Forms 1040, 1040A, 1040EZ and/or Trust Form1041 during a calendar year must use IRS e-file (unless the preparer or a particular return is administratively exempt from the e-file requirement or the return is filed by a preparer with an approved hardship waiver, using Form 8944). Members of firms must count returns in the aggregate. If the number of applicable income tax returns is 11 or more, then all members of the firm generally must e-file the returns they prepare and file. This is true even if a member expects to prepare and file fewer than 11 returns on an individual basis. Those who are subject to the e-file requirement are referred to as "specified tax return preparers." A firm must apply to be an e-file provider. The authorization process generally takes about 45 days. Electronic Filing Identification Numbers are currently issued on a firm basis. All preparers in the firm are covered by one EFIN. Note that a sole proprietorship is considered a firm for EFIN purposes. A firm’s principals and at least one “responsible official” must be identified on the application106. Fingerprint cards are required to be submitted along with the application, with the exception of attorneys, CPA’s and Enrolled Agents who may submit evidence of current professional status. Electronic Return Originator The preparers who offer electronic filing to their clients generally function as an Electronic Return Originator (ERO). The most common way the ERO prepares the returns is by using a computer program, and then transmitting the return to the IRS either directly or through a software provider. Timely Filing An electronically filed return is not considered filed until the electronic portion of the return has been acknowledged by the IRS. However, if the return is successfully transmitted on or before the due date, and the provider complies with the requirements 106 www.irs.gov 235 for signing the return, the return will be considered timely filed. Signing an Electronic Return Self-Select PIN Method to Sign a Return Most taxpayers are eligible to use the Self-Select PIN Method. The taxpayer enters a personal identification number directly into the electronic return. Signature documents are not required. However, the taxpayer must provide the prior year AGI for use by the IRS to authenticate the taxpayer. Taxpayers ELIGIBLE to use the Self Select PIN method if:107 Taxpayers who are eligible to file 1040, 1040A, 1040EZ and 1040-SS (PR) for Tax Year 2012. Taxpayers who did not file for Tax Year 2010, but have filed previously. Taxpayers who are age 16 or older on or before December 31, 2012, who have never filed a tax return. Military personnel residing overseas with APO/FPO addresses. U.S. Citizens and resident aliens residing in the U.S. Possessions of the Virgin Islands, Puerto Rico, American Samoa, Guam and Northern Marianas, or with foreign country addresses. Taxpayers filing Form 4868 (extension of time to file), or Form 2350 (extension for certain U.S. citizens living abroad). Those who are filing on behalf of deceased taxpayers Taxpayers not eligible to use Self Select PIN method: Primary Taxpayers under age 16 who have never filed. Secondary Taxpayers (spouse) under age 16 who did not file in the immediate prior year Taxpayers required to file the following forms must attach Form 8453 (Form 8453 is a transmittal for an e-file return): Form 1098-C, Contributions of Motor Vehicles, Boats, and Airplanes (or acceptable documentation/required donor documentation) Form 8949, Sales and Other Dispositions of Capital Assets, (or a statement with the same information), if you elect not to report your transactions electronically on Form 8949. Form 2848, Power of Attorney and Declaration of Representative (or POA that states the agent is granted authority to sign the return) Form 8283, Non-Cash Charitable Contributions, If an appraisal is attached. Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents Form 3115, Application for Change in Accounting Method Form 3468, Computation of Investment Credit Form 4136, Credit for Federal Tax Paid on Fuels Form 5713, International Boycott Report Form 8858, Information Return of U.S. Persons with Respect to Foreign Disregarded Entities 107 www.irs.gov 236 Form 8864, Biodiesel and Renewable Diesel Fuels Form 8885, Health Coverage Tax Credit, and all required attachments Practitioner PIN Method The Practitioner PIN method does not require the taxpayer to provide their Prior Year AGI amount or Prior Year PIN. When using the Practitioner PIN Method, taxpayers must always appropriately sign a completed signature authorization form. Form 8879, IRS efile Signature Authorization. The tax practitioner must retain Form 8879 for three years from the return due date or the date the IRS received the return. whichever is later. Form 8879 is not required to be sent to the IRS unless requested by the IRS. Explain paper returns: Even if you are an authorized e-file provider, clients for whom you prepare one of the returns identified above may choose to file on paper if the return will be submitted to the IRS by the taxpayer. As described in Rev. Proc. 2011-25, tax return preparers in this situation should obtain and keep a signed and dated statement from the client. Also, in this situation and in the cases of administratively exempt returns or returns filed by a tax return preparer with an approved hardship waiver, specified tax return preparers generally should attach Form 8948, Preparer Explanation for Not Filing Electronically, to the client's paper return. The requirement applies to any return of income tax imposed by subtitle A of the Internal Revenue Code on individuals, estates, and trusts, such as Forms 1040, 1040A, 1040EZ, and 1041. Forms 1040NR, 1041QFT, and 990T (when the exempt organization is a trust subject to tax on unrelated business taxable income under section 511(b)) meet the definition of a return of income tax, but because these forms cannot be electronically filed at this time they are exempt from the e-file requirement, and will not count towards the 11-return threshold (100 or more returns in 2011 only). Direct Deposit of Refund Taxpayers often elect the Direct Deposit option because it is the fastest way of receiving refunds. Providers must accept any Direct Deposit election to any eligible financial institution designated by the taxpayer. The taxpayer may designate refunds for Direct Deposit to qualified accounts in the taxpayer’s name. Qualified accounts include savings, checking, share draft or consumer asset accounts (for example, IRA or money market accounts). The taxpayer may not designate refunds for Direct Deposit to credit card accounts. Qualified accounts are accounts held by financial institutions within the United States and established primarily for personal, family or household purposes. Qualifying institutions may be national banks, state banks (including the District of Columbia and political sub-divisions of the 50 states), savings and loan associations, mutual savings banks and credit unions. By completing Form 8888, Direct Deposit of Refund to More Than One Account, the taxpayer may split refunds between up to three qualified accounts. A qualified account can be a checking, savings, or other account such as an individual retirement arrangement (IRA), health savings account (HSA), Archer MSA, Coverdell education savings account (ESA), or Treasury Direct online account. Taxpayers may choose the refund splitting 237 option regardless of which Form 1040 series tax form they file. Providers should caution taxpayers that some financial institutions do not permit the deposit of joint individual income tax refunds into individual accounts. The IRS is not responsible if the financial institution refuses Direct Deposits for this reason. Taxpayers should verify their financial institution’s Direct Deposit policy before they elect the Direct Deposit option. Taxpayers who choose Direct Deposit must provide Providers with account numbers and routing transit numbers for qualified accounts. The annual tax packages show how to find and identify these numbers. The taxpayer can best obtain this information from official financial institution records, account cards, checks or share drafts that contain the taxpayer’s name and address. The provider must never charge a separate fee for Direct Deposit and must accept any Direct Deposit election by a taxpayer to any eligible financial institution. The Provider must advise taxpayers that they cannot rescind a Direct Deposit election and they cannot make changes to routing transit numbers of financial institutions or to their account numbers after IRS has accepted the return. Providers with repeat customers or clients should check to see if taxpayers have new accounts. Some software stores prior year’s information and reuses it unless it is changed. TaxEase strongly recommends that you highlight the information for the taxpayer to review before signing the return. If account information is not current, taxpayers do not receive Direct Deposit of their refunds. The Provider must not alter the Direct Deposit information in the electronic record after taxpayers have signed the tax return. On occasion when a taxpayer reviews a return, which was mailed or not signed in your office, the taxpayer may call after they have signed the filing forms and before you have electronically filed the return. If this occurs you should change the routing number and account number, send the corrected return to the taxpayer for review and get new signature documents before electronically filing. Documentation of the change is important for both the taxpayer and the tax preparer. Refunds that are not Direct Deposited because of institutional refusal, erroneous account or routing transit numbers, closed accounts, bank mergers or any other reason are issued as paper checks, resulting in refund delays of up to ten weeks. While the IRS ordinarily processes a request for Direct Deposit, it reserves the right to issue a paper check and does not guarantee a specific date for deposit of the refund into the taxpayer’s account. Treasury’s Financial Management Service (FMS) issues federal income tax refunds and offsets taxpayers’ refunds to pay off past-due child support or federal agency debts such as student loans. Neither the IRS nor FMS is responsible for the misapplication of a Direct Deposit that results from error on the part of the taxpayer, the tax preparer, ERO or financial institution.108 Stockpiling Returns An ERO must ensure that stockpiling of returns does not occur in their offices. 108 Pub 1345, The Handbook for Authorize IRS e-file Providers – Individual Returns 238 After the official acceptance to participate in IRS e-file, stockpiling refers to waiting more than three calendar days to submit the return to the IRS once the ERO has all necessary information for origination. The IRS does not consider returns held prior to the date that it accepts transmission of electronic returns stockpiled. This includes when the IRS is not able to accept specific returns, forms, or schedules until a date later than the start-up of IRS e-file due to constraints such as late legislation, programming issues, etc. EROs must advise taxpayers that it cannot transmit returns to the IRS until the date the IRS accepts transmission of electronic returns. Example: A tax practitioner has a large practice. He has taxpayers come in Monday through Friday, pick up their copy of the tax return; review and sign Form 8879. For the convenience of the tax practitioner he only transmits returns to the IRS from his computer on Sundays. The Form 8879’s that were signed earlier in the week (more than three days previously) is considered stockpiling and must be transmitted earlier. Important items regarding EFIN’s Preparer’s may get into the situation where they have a compromised EFIN, this can happen if an unauthorized user gets your EFIN and uses it to submits returns109. Check the EFIN status of your application at http://www.irs.gov/Tax-Professionals/e-services---Online-Tools-for-Tax-Professionals to make sure the summary of the volume of returns e-filed in the last two years matches your records. If it does not match, your EFIN may have been compromised. Call the ehelp desk at 866-255-0654 (6:30 AM to 8:00 PM Central) to report a possible compromised EFIN. If an EFIN is compromised, the IRS will disable it, issue a new one, and notify the firm in writing when they issue the new EFIN. If the use of the unauthorized EFIN was intentional, they will also review the situation to see if further action is needed. The IRS may also notify transmitters who are transmitting with the provider with a compromised EFIN. If your firm uses an associated third party provider you can verify that a provider is valid in two ways: Ask the provider to show you a summary of his/her IRS e-file application from eServices. Ask the provider to show you an authorized provider acceptance letter from the IRS, dated within the last year. The firm’s EFIN is not transferable and neither is a password. Even if the business is transferred either by sale, gift or other disposition, the business may not transfer the 109 www.irs.gov/for-Tax-Pros/Info-for-e-File-Providers/FAQs-About-Electronic-Filing-ID-Numbers- (EFIN) 239 firm’s EFIN. The principals of the business and the “responsible party” must protect the firm’s EFIN’S and passwords from unauthorized use. The following are examples of how an EFIN can be compromised: If you had an EFIN at your previous firm but moved to another firm, you cannot use the EFIN you had at your previous firm. If you have not used your EFIN to e-file in the last two years, you must apply for a new EFIN. If in doubt, call the e-help desk at 866-255-0654 (6:30 AM to 8 PM Central) to find out if your EFIN is still valid. If a deceased person is listed on the application and their death changes the structure of the business entity, the EFIN may be invalid for use. If you are unsure, call the e-help desk at 866-255-0654 (6:30 AM to 8 PM Central) to find out. Rejected Returns Rejected electronic individual income tax return data can be corrected and retransmitted without new signatures or authorizations if changes do not differ from the amount on the original electronic return by more than $50 to “Total income” or “AGI”, or more than $14 to “Total tax,” “Federal income tax withheld,” “Refund” or “Amount you owe.” The ERO must give taxpayers copies of the new electronic return data.110 A common example of a rejected return has to do with teenage dependents. As a common practice you ask your clients if their teenage dependents have a job and if so have they filed a return? You remind their parents that the child is dependent and must mark their return that they are a dependent on another return. This does not always happen. If the teenager files their return incorrectly, the teenager’s return must be amended and then the parent’s return filed. The teenager is not entitled to their own exemption. In my practice I do the children’s return for a nominal fee to be sure they are done properly. This is another area where TaxEase recommends documentation; reject notices and resolution as well as any documentation from the client should be kept in the file. The ERO must, at the request of the taxpayer, provide the Declaration Control Number (DCN) and the date the IRS accepted the electronic individual income tax return data. TaxEase recommends that an acknowledgement be sent to the taxpayer as a matter of practice. Most software programs supply an acknowledgement letter that can be sent. If the IRS rejects the electronic portion of a taxpayer’s individual income tax return for processing, and the ERO cannot rectify the reason for the rejection, the ERO must take reasonable steps to inform the taxpayer of the rejection within 24 hours. When the ERO advises the taxpayer that it has not filed the return, the ERO must provide the taxpayer with the reject code(s) accompanied by an explanation. If the taxpayer chooses not to have the electronic portion of the return corrected and transmitted to the IRS, or if the IRS cannot accept the return for processing, the taxpayer must file a paper return. In order to timely file the return, the taxpayer must file the paper return by the later of the due date of the return or ten calendar days after the date the IRS gives notification that it rejected the electronic portion of the return or that the return cannot be accepted for 110 Pub 1345 240 processing. Taxpayers should include an explanation in the paper return as to why they are filing the return after the due date. Practical Example of Electronic Filing Forms After answering Pete’s questions we completed his 2012 return and set him up to electronically file his returns as we had in the past. During 2012 Pete donated his 2005 Toyota and bought a new car. Pete brought Form 1098-C from the American Cancer Research Center where he had donated the vehicle. They had the fair market value of the Toyota Truck at $8,000, which Pete reported on Form 8283 in his return. When a vehicle is sold and Form 1099-C is received this document must be sent to the IRS and is one of the items listed on Form 8453 below. Note: The FMV of a donated vehicle111 is the same as the price listed in a used vehicle pricing guide for a private party sale only if the guide lists a sales price for a vehicle that is the same make, model, and year, sold in the same area, in the same condition, with the same or similar options or accessories, and with the same or similar warranties as the donated vehicle. Pete requested his refund be directly deposited into his checking and savings account. I asked him if his bank had changed since the prior year since I had his bank information stored in my computer records. He said he had moved his banking to the credit union. He had a bank statement and a check with him to verify the routing numbers and account numbers. I kept his voided check in the file for reference. 241 Form 8453 – The Individual Income Tax Transmittal for an IRS e-file return. Within 3 days after receiving an acknowledgement that the IRS has accepted the electronically filed return, this form must be filed. 242 Some forms cannot be electronically filed, each year the IRS allows more forms. In 2012 Forms 1040NR, 1041QFT, and 990T (when the exempt organization is a trust subject to tax on unrelated business taxable income under section 511(b)) meet the definition of a return of income tax, but these forms cannot be electronically filed at this time they are exempt from the e-file requirement, and do not count towards the threshold. This also includes amended income tax returns, such as Form 1040X, fiscal year returns for Form 1040, and fiscal year returns for Form 1041 In addition, some Forms 1040, 1040A, 1040EZ, and 1041 cannot be e-filed if they have attached forms, schedules, or documents that IRS does not accept electronically. However, if the form, schedule or document can be sent to the IRS separately using Form 8453 or 8453-F as a transmittal document, the rest of the return must be e-filed. Only the returns that cannot be e-filed are exempt from the requirement. See the instructions for Forms 8453 and 8453-F to identify which forms, schedules and documents apply. 243 Form 8879 EFIN 244 Form 8888 245 Taxpayers may independently choose to file a paper return. If a return is not electronically filed this form must be completed and attached to the paper return. In answer to Pete’s question regarding finding a new preparer I recommended the following: Check the person's qualifications. New regulations require all paid tax return preparers to have a Preparer Tax Identification Number (PTIN). In addition to making sure they have a PTIN, ask if the preparer is affiliated with a professional organization and attends continuing education classes. The IRS allows the following professionals to prepare taxes: o Tax Return Preparer – a tax return preparer who has valid Preparer Tax Identification Number (PTIN). o Enrolled Agent - EAs focus solely on taxes. They must have worked for the IRS for at least five years or passed exams on tax codes and calculations and must have a valid PTIN. 246 o o CPA – Certified Public Accountant who is authorized to do a variety of financial responsibilities and must have a valid PTIN, or; Attorney who also must have a valid PTIN to file a return for you Find out about their service fees. Avoid preparers who base their fee on a percentage of your refund or those who claim they can obtain larger refunds than other preparers. Also, always make sure any refund due is sent to you or deposited into an account in your name. Under no circumstances should all or part of your refund be directly deposited into a preparer’s bank account. Note to Preparer: If you are taking on new clients you should have a clear fee structure you can explain, and engagement letter and a list of documents you must review at the first interview. Documentation key to good preparation. Ask if they offer electronic filing. Any paid preparer who prepares and files more than 10 returns for clients must file the returns electronically, unless the client opts to file a paper return. More than 1 billion individual tax returns have been safely and securely processed since the debut of electronic filing in 1990. Make sure your preparer offers IRS e-file. Make sure the tax preparer is accessible. Make sure you will be able to contact the tax preparer after the return has been filed, even after the April due date, in case questions arise. Provide all records and receipts needed to prepare your return. I reminded him to bring the same documents he had brought to my office in the past; a copy of his prior year returns; identification (possibly including your Social Security Card) required by the new preparer. Since he was moving because of his job, I reminded him to keep track of moving expenses, the sale of his home and the purchase of his new home. Reputable preparers will request to see your records and receipts and will ask you multiple questions to determine your total income and your qualifications for expenses, deductions and other items. Never sign a blank return. Avoid tax preparers that ask you to sign a blank tax form. Do not use a preparer who is willing to electronically file your return before you receive your Form W-2 using your last pay stub. This is against IRS e-file rules. Review the entire return before signing it. Before you sign your tax return, review it and ask questions. Make sure you understand everything and are comfortable with the accuracy of the return before you sign it. Although the preparer signs the return, I reminded Pete he is responsible for the accuracy of every item on your return. Make sure the preparer signs the form and includes his or her preparer tax identification number (PTIN). A paid preparer must sign the return and include his or her PTIN as required by law. The preparer must also give you a copy of the return. 247 The items above are important for all preparers to keep in mind and to explain to new clients as part of your procedure in their first appointment. Requirements for CA E-file Participation: In order to be automatically enrolled in the CA e-file Program, the preparer needs to be an accepted participant in the IRS e-file program. The FTB receives confirmation from the IRS after they accept the preparer into their program. Use the IRS-assigned Electronic Filer Identification Number (EFIN) to e-file with the FTB. Comply with the guidelines in FTB Pubs. 1345, 1345B, 1346, 1346B, and 1346X. Mandatory e-file California law requires individual income tax returns prepared by certain income tax preparers to be e-filed unless the individual return cannot be e-filed due to reasonable cause. Reasonable cause includes a taxpayer's election to opt-out (choose not to e-file). If the preparer prepares more than 100 California individual income tax returns in any calendar year beginning January 1, 2003 or after and in the following calendar year prepare one or more using tax preparation software, they must e-file all acceptable individual returns in that following year and all subsequent calendar years thereafter. Federal Tax Return Assembly Federal returns that are not electronically filed must be assembled behind Form 1040 in the order of the “Attachment Sequence No.” shown in the upper right corner of the schedule. If there are supporting schedules or forms arrange them in the same sequence as the forms and attach them last. Correspondence should not be attached unless requested. Attach a copy of Forms W-2, W-2G and 2439 to the front of Form 1040; also attach Form 1099-R if tax was withheld. 248 Assembly of CA Return from Form 540 Instructions 249 Chapter 18 – Various Taxes Gift and Estate Tax Gift and Estate Tax A gift tax is a tax on transfers made without adequate payment during life. An estate tax is a tax on transfers of property after death. One set of rates apply to both gift and estate tax. The tax is generally imposed on the person transferring rather than the recipient. The annual gift tax exclusion is the amount that can be given away by a taxpayer in any one year to any number of people free from any federal gift tax consequences at all. In other words, a lump sum gift or even a series of smaller gifts made to the same person during the course of a year that don't exceed the annual gift tax exclusion aren't really considered gifts at all - they're simply considered "freebies" when it comes to federal gift taxes. For 2012, the annual gift tax exclusion is $13,000 and 2013 is $14,000. In contrast, the lifetime gift tax exemption is the amount that can be given away by a taxpayer over his or her entire lifetime to any number of people that will be free from gift taxes but will reduce the amount that can be given away by the taxpayer tax-free after death. In other words, the lifetime gift tax exemption is tied directly to the federal estate tax exemption such that if the taxpayer gifts away any amount of their lifetime gift tax exemption, then this amount will be subtracted from their estate tax exemption after death. For 2012, the lifetime gift tax exemption is $5,120,000, which is the same as the federal estate tax exemption A gift tax return is filed on Form 709 if the taxpayer makes any gifts over $13,000 to someone other than a spouse or charity. The annual exclusion of $13,000 is indexed for inflation and will change again when cost of living adjustments reach the next $1,000 multiple. The estate return is filed on Form 706. The gross estate includes all property owned by a decedent at the time of death. The estate can deduct funeral expenses, administrative expenses, claims paid, including debts and losses. The estate can also deduct property passing to qualified charities and to a surviving spouse. Gross Estate Gross estate includes the value of all property the taxpayer had an interest in at the time of death. The gross estate also includes the following: Life insurance proceeds payable to the estate or, if the decedent owned the policy, to the heirs; The value of certain annuities payable to the estate or the heirs; and The value of certain property transferred within 3 years of the decedent’s death. Taxable Estate The allowable deductions used in determining the taxable estate include: 250 Funeral expenses paid out of by the estate, Debts owed at the time of death, The marital deduction (generally, the value of the property that passes from the estate to the surviving spouse), The charitable deduction (generally, the value of the property that passes from the estate to the United States, any state, a political subdivision of a state, the District of Columbia, or to a qualifying charity for exclusively charitable purposes), and The state death tax deduction (generally any estate, inheritance, legacy, or succession taxes paid as the result of the decedent's death to any state or the District of Columbia. All taxable gifts made by a decedent during life are added to the gross estate. The estate received credit for gift tax paid by the decedent. Excise Tax An excise is an indirect tax, meaning that the producer or seller who pays the tax to the government is expected to try to recover the tax by raising the price paid by the buyer (that is, to shift or pass on the tax). Excise taxes are taxes paid when purchases are made on a specific good, such as gasoline. Excise taxes are often included in the price of the product. There are also excise taxes on activities such as on wagering or on highway usage by trucks. Excise tax has several general excise programs. One of the major components of the excise program is motor fuels. Federal and State Unemployment Tax (FUTA and SUI) The employer must pay a percentage of the first $7,000 of wages paid to each employee in a calendar year as FUTA tax and state unemployment insurance (UI). The Federal Unemployment Tax Act along with state unemployment compensation provides for payments of unemployment compensation to workers who have lost their job. FUTA tax is paid at 6.0% of the first $7,000 in 2012. The state rate may be different. Generally there is a credit against FUTA tax for the amounts paid to state unemployment tax. The credit cannot be more than 5.4% of taxable wages. If the maximum is paid, then the FUTA tax rate will be 0.6%. CA UI and SDI The Employment Training Tax (ETT) rate for 2012 is 0.1 percent. The UI and ETT taxable wage limit remains at $7,000 per employee per calendar year. The State Disability Insurance (SDI) withholding rate for 2012 is 1.0 percent. The taxable wage limit is $95,585 for each employee per calendar year. The maximum to withhold for each employee is $955.85 Sales Tax is charged on tangible personal property sold in California (and many other states). Tangible personal property includes include furniture, toys clothing, etc. The sales tax is collected by the retailer and paid to the state. There is no national sales tax. Purchases made from an out-of-state source or the Internet is also subject to tax. Use tax is charged on these items. Use tax and sales tax rates are the same. 251 Chapter 19 –California Tax Returns The 2012 Form 540 is 3 pages: Page One (Side 1) contains the scan band and the taxpayer and tax professional signature. Page 2 contains filing status, exemptions, taxable income, tax, credits, refund, balance due and use tax. Page 3 contains all voluntary contributions, amount due, interest, penalties, refund and bank information. Form 540NR is also three pages. Who Must File a California Tax Return? The federal tax returns (Form 1040, 1040a or 1040EZ) must be complete before beginning the California return. California tax returns start with federal adjusted gross income and primarily Schedule CA is used to make adjustments where the California law does not conform. California is commonly known as an AGI state. Standard deductions The standard deduction amounts for: Filing Status Deduction Amount Single or married/RDP filing separately $3,841 Married/RDP filing jointly, head of household, or $7,682 qualifying widow(er) The minimum standard deduction for dependents 252 $950 Standard Deduction California does not conform to the federal provisions that allow a taxpayer to increase the standard deduction for age or blindness (California provides an additional exemption credit). A taxpayer may itemize deductions on the federal return and use the standard deduction on the California return or vice versa. (R&TC §17024.5) Dependent’s standard deduction California conforms to the federal computation of a dependent’s standard deduction. For federal and California purposes, a dependent’s standard deduction is limited to the greater of $850, or the dependent’s earned income plus $300, or the current maximum standard deduction. 2012 California Tax Rates and Exemptions112 On Nov 6, 2012 CA voters passed Prop 30, which adds three new tax brackets at higher levels of income as shown below. The increase is effective on January 1, 2012 and will remain in effect for a period of seven years. Individual tax rates The maximum rate for individuals is 12.3% The AMT rate for individuals is 7% 112 www.ftb.ca.gov/forms/2012_California_Tax_Rates_and_Exemptions.html 253 2012 California Tax Rate Schedules Schedule X — Single or married/RDP filing separately If the taxable income is….. Over But Not Over Tax is Of Amount Over $0 $7,455 $0.00 plus 1.00% $0 $7,455 $17,676 $74.55 plus 2.00% $7,455 $17,676 $27,897 $278.97 plus 4.00% $17,676 $27,897 $38,726 $687.81 plus 6.00% $27,897 $38,726 $48,942 $1,337.55 plus 8.00% $38,726 $48,942 $250,000 $2,154.83 plus 9.30% $48,942 $250,000 $300,000 $20,853.22 plus 10.30% $250,000 $300,000 $500,000 $26,003.22 plus 11.30% $300,000 $500,000 AND OVER $48,603.22 plus 12.30% $500,000 Schedule Y — Married/RDP filing jointly, or qualifying widow(er) with dependent child If the taxable income is….. Over But Not Over Tax is Of Amount Over $0 $14,910 $0.00 plus 1.00% $0 $14,910 $35,352 $149.10 plus 2.00% $14,910 $35,352 $55,794 $557.94 plus 4.00% $35,352 $55,794 $77,452 $1,375.62 plus 6.00% $55,794 $77,452 $97,884 $2,675.10 plus 8.00% $77,452 $97,884 $500,000 $4,309.66 plus 9.30% $97,884 $500,000 $600,000 $41,706.45 plus 10.30% $500,000 $600,000 $1,000,000 $52,006.45 plus 11.30% $600,000 $1,000,000 AND OVER $97,206.45 plus 12.30% $1,000,000 254 Schedule Z — Head of household If the taxable income is….. Over But Not Over Tax is Of Amount Over $0 $14,920 $0.00 plus 1.00% $0 $14,920 $35,351 $149.20 plus 2.00% $14,920 $35,351 $45,571 $557.82 plus 4.00% $35,351 $45,571 $56,400 $966.62 plus 6.00% $45,571 $56,400 $66,618 $1,616.36 plus 8.00% $56,400 $66,618 $340,000 $2,433.80 plus 9.30% $66,618 $340,000 $408,000 $27,858.33 plus 10.30% $340,000 $408,000 $680,000 $34,862.33 plus 11.30% $408,000 $680,000 AND OVER $65,598.33 plus 12.30% $680,000 Exemption credits 2012 Filing Status/Qualification Exemption amount Married/Registered Domestic Partner (RDP) filing $208 jointly or qualifying widow(er) Single, married/RDP filing separately, or head of $104 household Dependent $321 Blind $104 Age 65 or older $104 Phaseout of exemption credits 2012 Higher-income taxpayers' exemption credits are reduced as follows: Filing Status Reduce each Credit For Each Federal AGI exceeds by: Single $6 $2,500 $169,730 Married/RDP filing separately $6 $1,250 $169,730 Head of household $6 $2,500 $254,599 Married/RDP filing jointly $12 $2,500 $339,464 Qualifying widow(er) $12 $2,500 $339,464 255 When applying the phaseout amount, apply the $6/$12 amount to each exemption credit, but do not reduce the credit below zero. If a personal exemption credit is less than the phaseout amount, do not apply the excess against a dependent exemption credit. Itemized deductions for California are subject to adjusted gross income limitations similar to the federal itemized deduction AGI limitation. Itemized Deductions must be reduced by the lesser of 6% of the excess of the taxpayer’s federal AGI over the threshold amount or 80% of the amount of itemized deductions otherwise allowed for the taxable year. Reduction in itemized deductions 2012 Itemized deductions must be reduced by the lesser of 6% of the excess of the taxpayer's federal AGI over the threshold amount or 80% of the amount of itemized deductions otherwise allowed for the taxable year. Filing Status AGI Threshold Single or married/RDP filing separately $169,730 Head of household $254,599 Married/RDP filing jointly or qualifying widow(er) $339,464 California makes an adjustment for State and local taxes deducted on the federal return. Also adjustments for law difference such as Section 179 over the CA limit of $25,000 for an employee business expense; or meals provided for the convenience of the employer the federal allows over the 50% CA did not conform. Comprehensive Example: Corey and Sally Quint have two children, Sally is legally blind, they file Married Filing Joint, and their Federal AGI is $348,750. The following is a worksheet showing the phaseout of their exemptions: A. Enter the amount from form 540, Line 13 $348,750. B. If the filing status is: Single or MFS $169,730 MFJ or Qualifying Widow(er) 339,464 Head of Household 254,599 Enter that amount here 339,464. C. Subtract line B from Line A 9,286. D. Divide Line C by $2,500 ($1,250 if Married Filing Separate) 4. E. Multiply Line D by $6 24. F. Add the numbers from the boxes on Form 540, Line 7, 8, and 9 3. G. Multiply Line E by Line F 72. H. Enter the total amount from Form 540, Line 7, 8, and 9 312. I. Subtract Line G from Line H 240. J. Enter the number from the box on Form 540 Line 10 (not the amount) 2. K. Multiply Line E by Line J 48. L. Enter the amount from Form 540, Line 10 642. M. Subtract Line K from Line L 594. N. Add Line I and Line M. Enter result here and on Form 540, Line 32 834. 256 NOTE: Line I above is the reduced amount for the personal exemptions, and Line M is the reduced amount for the dependents. If a personal exemption credit is less than the phaseout amount, do not apply the excess against a dependent exemption credit. Exemptions and education credit A parent may forgo claiming the child as a dependent so the child may take advantage of the federal education credits. Treas. Regs. §1.25A-1(g) allows a taxpayer to forgo claiming the federal dependency exemption for the purpose of shifting the American Opportunity Credit, which was extended to 2017, to the dependent. However, California requires the parent to claim the exemption if the dependency tests are met. There are two situations where this election benefits the taxpayer: • The parent’s income is too high to qualify for the credit; or • The child’s taxable income is greater than the parent’s, even though the parent still provides more than one-half of the support of the child. This federal election allows the parents to pass the credit to the student by not claiming the dependency exemption for which they are qualified. However, it does not allow the child to claim his or her personal exemption deduction. Example: John Smith is a college student at UCLA. His parents’ federal and California AGI is $190,000. His federal and California AGI is $22,000. He had $2,100 of expenses that qualify for education credits and exemptions. His parents’ income is too high to take advantage of these benefits, so they do not claim him as a dependent on their federal return. He does not claim his own exemption on his federal return, but takes the $1,550 American Opportunity Tax Credit. John’s parents claim his dependency exemption on the California return. 257 In this example of the $557 reduction of itemized deductions shown on Line 43 above. 258 Federal Itemized Deduction Limitation Worksheet CA Phase-Out of Itemized Deduction Sally and Corey from TaxEase Tax Update Course, who had an AGI of $346,186 for 2013, exceed the threshold for a married couple by $46,186. Thus, they must reduce their itemized deductions subject to the phase-out by $1,386 (3% of $112,500), but the reduction must not exceed 80% of the deductions subject to the phase-out. For 2013, Sally and Corey had the following itemized deductions: Allowable Medical And Dental Expense* Itemized Deductions $ 3,381 Taxes Paid Home Mortgage Interest Charitable Gifts CA does not conform to the Federal deduction of state, local or foreign tax or any of their political subdivisions such city or county taxes. CA does not tax the state lottery and as such does not allow a deduction on Schedule A. 8,964 23,000 4,000 $39,345 Total *Total Medical and Dental expense is $38,000 less $34,619 (10% (Sally and Corey are in their 40’s)) = $3,381 2013 Itemized Deductions Limitation Worksheet 1. Total Itemized Deductions for $ 39,345 2013 2. Itemized Deductions not subject to Phase-out 3. Subtract Line 2 from Line 1 4. Multiply Line 3 by 80% (.80) 5. 2013 AGI 6. Filing Status Threshold 7. Subtract Line 6 from Line 5 8. Multiply Line 7 by 3% 9. Enter the smaller of Line 4 or Line 8 10. Total Itemized Deductions Subtract Line 9 from Line 1 The Federal and CA phase-out of itemized deductions are very similar except the phaseout for CA is 6% not 3%. The phase-out amounts are the same as Federal and the reduction cannot exceed 80%. 1. Total Itemized Deductions for 2013 (Sch CA Line 41) $42,244 2. Add amounts (adj for CA) on Fed. Sch A 11,844 30,400 3,381 3.Subtract 2 from 1 4. Multiply Line 3 by 80% 35,964 5. Amount from Form 540, Line 13 348,750 6.CA Threshold amount 339,464 $24,320 28,771 346,186 300,000 46,186 1,386 7.Subtract Line 6 from Line 5 1,386 $ 37,959 259 8.Multiple Line 7 by 6% 9.Smaller of Line 4 or 8 10.Total CA Itemized Deductions (Subtract Line 9 from1 9,286 557 557 41,687 Form 540 2EZ, Form 540A or Form 540 Filing Status The taxpayer must use the same filing status on California as they did on the federal return, unless the taxpayer is in a same-sex marriage (SSM) or a registered domestic partnership (RDP). If the taxpayer is filing married filing joint for Federal purposes, they may file either separate if either spouse is active military or California nonresident with no California source income. California does not recognize common law marriage. Common law marriage is not the same as a registered domestic partner and is only recognized in 15 states. 260 Registered Domestic Partners A domestic partnership is a legal or personal relationship between two individuals who live together and share a common domestic life but are neither joined by marriage nor a civil union. According to the California Revenue and Taxation code a Registered Domestic Partnership113 is two persons who filed a Declaration of Domestic Partnership with the California Secretary of State. On September 4, 2003 the California legislature passed an expanded domestic partnership bill, extending nearly all the legal rights of married couples to people in same-sex partnerships. This erased all difference between California's domestic partnerships and civil unions passed in other states. California's comprehensive domestic partner policy was the first same-sex couple’s policy in the United States created by a legislature without court intervention. The policy became effective January 1, 2005. Registered Domestic Partners in CA must file Married Filing Joint or Married Filing Separately. Domestic partners cannot file a married filing joint or married filing separate tax return for tax years prior to 2007. A domestic partner is required to use the same filing status for state income tax purposes that was used or would have been used for federal income tax purposes. For taxable years beginning on or after January 1, 2007, domestic partners are required to use the same filing status available to married persons114. Earned income is not treated as community property for state income tax purposes for tax years prior to 2007. Married/RDP Filing Jointly Filing Status – A filing status for married couples who were married as of the last day of the tax year. If any of the following is true, the taxpayer may be able to file as Married/RDP Filing Jointly: The taxpayer was an RDP as of December 31, 2012, even if they did not live with their RDP at the end of 2012. The taxpayer RDP partner died in 2012 and the taxpayer did not re-register as an RDP or marry in 2012. The RDP died in 2013 before they filed a 2012 tax return. Married/RDP Filing Separately Filing Status – A filing status for married couples and RDPs who choose to report their respective incomes, exemptions, and deductions on separate tax returns. If one spouse lives in a state that is not a community property state and the other spouse lives in California, which is a community property state (defined below); when separate returns are filed the taxpayer and spouse must each report half of the community income plus all the separate income earned by that spouse. • Community property rules115 apply to the division of income if the taxpayer uses the 113 Cal. Rev. & Tax. Cd. §18521 Chief Counsel Advice (CCA) 2010210501 115 FTB Pub.1051A 114 261 married/RDP filing separately status. • The taxpayer cannot claim a personal exemption credit for the RDP even if the RDP had no income, is not filing a tax return, and is not claimed as a dependent on another person’s tax return. • The taxpayer may be able to file as head of household if the taxpayer’s child lived with the taxpayer and they lived apart from the RDP during the entire last six months of 2012. Federal Form 8958116 – New for Tax Year 2012 Use Form 8958 to determine the allocation of tax amounts between married filing separate spouses, California same-sex spouses, or registered domestic partners (RDPs) with community property rights. This form is acceptable for electronic filing, prior to the 2012 tax year when allocating income for CA RDP’s or same-sex spouses with community property rights the return could not be electronically filed. If a statement must be added listing the source of the item and the total plus the allocated amounts the name of the taxpayer and social security number (SSN) must be on the statements and attach those statements at the end of the return. Community property laws affect how the taxpayer figures income on their federal income tax return if they are married, live in a community property state or country, and file separate returns. For federal tax purposes, a marriage means only a legal union between a man and a woman as husband and wife and the word “spouse” refers only to a person of the opposite sex who is a husband or a wife. Note: Community property can be determined by a prenuptial or postnuptial agreement in which both spouses specifically agree that assets that otherwise would be considered community property are separately owned by one or the other. Form 8958 is used for married spouses in community property states who choose to file married filing separately. This form is also for RDPs who are domiciled in Nevada, Washington, or California and for individuals in California who, for state law purposes, are married to an individual of the same sex. For 2010 and following years, a RDP in Nevada, Washington, or California (or a California same-sex spouse) generally must follow state community property laws and report half the combined community income of the individual and his or her RDP (or California same-sex spouse). 116 Form 8958 Instructions 262 General Rules – Property Income: Community or Separate? Community property is property: That the taxpayer or spouse (or RDP/California or Washington same-sex spouse), or both acquire during the marriage (or registered domestic partnership/same-sex marriage in California or Washington) while they are domiciled in a community property state. (Includes the part of property bought with community property funds if part was bought with community funds and part with separate funds.) That the taxpayer and the spouse (or RDP/California or Washington same-sex spouse) agreed to convert from separate to community property. That cannot be identified as separate property Community income is income from: Community property. Salaries, wages, or pay for services of the taxpayer, the spouse (or RDP/California or Washington same-sex spouse), or both during the marriage (or registered domestic partnership/same-sex marriage in California or Washington). Real estate that is treated as community property under the laws of the state where the property is located. Separate property is: • Property that the taxpayer or spouse (or RDP/California or Washington same-sex spouse) owned separately before the marriage (or registered domestic partnership/same-sex marriage in California or Washington). • Money earned while domiciled in a noncommunity property state. • Property either the taxpayer or spouse received as a gift or inherited separately during the marriage (or registered domestic partnership/same-sex marriage in California or Washington). • Property bought with separate funds, or exchanged for separate property, during the marriage (or registered domestic partnership/same-sex marriage in California or Washington). • Property that the taxpayer and spouse (or RDP/California or Washington same-sex spouse) agreed to convert from community to separate property through an agreement valid under state law. • The part of property bought with separate funds, if part was bought with community funds and part with separate funds. Separate income is income from: Separate property, which belongs to the spouse who owns the property. Separate property, which belongs to the RDP/California or Washington same-sex spouse who owns the property. Mixing or commingling separate property with community property will change the separate property into community property unless the separate property component can be traced. If community property is used to assist in the purchase of a separate property asset, or if community property substantially benefits or improves separate property, a community property right to reimbursement is presumed. The right follows the attributes of appreciation, interest, and profits attributable to the community property contribution. It is generally not applicable for routine upkeep and living expenses, such as payment of 263 property taxes or maintenance. It often arises, for example, where one spouse owns a house prior to marriage, and after marriage, uses wages (a community property asset) to continue paying a mortgage. Commingled property becomes community property unless the separate property portion can be traced. Tracing is done by allocating withdrawals, deposits or payments between community property funds and separate property funds. The burden of proof is usually on the party attempting to rebut the community property presumption created under California law. RDPs (and California same-sex spouses) are not married for federal tax purposes. They can only use the single filing status, or if they qualify, the head of household filing status. Head of Household117 (HOH) Qualification Requirements The law allowing this filing status has very specific rules. The taxpayer must meet all of the following requirements: On the last day of the year, they must be either unmarried and not an RDP, or meet the requirements to be considered unmarried or considered not in a registered domestic partnership as outlined in the tables below (see Step 1 below). They must have paid more than one-half the cost of keeping up a home that was, for more than one-half of the year, the main home for the taxpayer and one of the specified qualifying persons described in the tables below (see Step 2 below). The qualifying person must have been a citizen or national of the U.S. or a resident of the U.S., Canada, or Mexico. The qualifying person must not have filed a joint federal or state return with his or her spouse/RDP. For head of household purposes the taxpayer must be unmarried and not an RDP (on the last day of the year) means one of the following: Never married and never registered as a domestic partner. By December 31, the taxpayer was divorced under a final decree or the registered domestic partnership was legally terminated. Legally separated under a final decree by December 31. Marriage or registered domestic partnership annulled under a final decree. Widowed (spouse/RDP died before January 1). Considered Unmarried or Considered Not in a Registered Domestic Partnership For head of household purposes, considered unmarried means the taxpayer was legally married as of December 31, but was ending the relationship and the taxpayer lived apart from the spouse at all times during the last six months of the year. Considered not in a registered domestic partnership means the taxpayer was still registered as a domestic partner as of December 31, but were ending the relationship and lived apart from the RDP at all times during the last six months of the year. 117 FTB Pub 1540 264 Qualifying Person Requirements for Individuals who are Unmarried and not an RDP. The qualifying person must be one of the following: The taxpayer’s birth child, grandchild, stepchild, adopted child, eligible foster child, brother, sister, half brother, half sister, stepbrother, stepsister, or a descendant of such an individual, who lived with the taxpayer for more than half of the year, who did not pay more than half of his or her own support during the year, and who: Did not reach the age of 19 by December 31, or Was a full-time student who did not reach the age of 24 by December 31, or The taxpayer’s birth child, grandchild, stepchild, adopted child, eligible foster child, or a descendant of such an individual, brother, sister, half brother, half sister, stepbrother, stepsister, parent, grandparent, stepparent, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law who lived with the taxpayer for more than half of the year; or was a blood-related uncle, aunt, nephew, or niece who lived with the taxpayer for more than half of the year. In addition: 1. The taxpayer must have provided more than half of the individual’s support for the year, and 2. The individual’s gross income for the year must be less than the federal exemption amount for the year. The qualifying person must be one of the following: The taxpayer’s birth child, stepchild, adopted child, or eligible foster child who lived with the taxpayer for more than half of the year, who did not pay more than half of his or her own support during the year, and who: 1. Did not reach the age of 19 by December 31, or 2. Was a full-time student who did not reach the age of 24 by December 31? OR The taxpayer’s birth child, stepchild, adopted child, or eligible foster child who lived with them for more than half of the year. In addition: 1. The taxpayer must have provided more than half of the individual's support for the year, and 2. The individual's gross income for the year must be less than the federal exemption amount for the year. Head of Household Audit Process The Franchise Tax Board reviews the tax returns of taxpayers who claim head of household filing status because this filing status is often misunderstood. They ask some taxpayers to provide information to determine if they qualify to use the head of household filing status. This is done through the Head of Household Audit Letter. The Head of Household Audit Letter asks specific questions in the form of an audit questionnaire. The answers to the questions in the questionnaire help the FTB determine if the taxpayer correctly used the head of household filing status. Even if the taxpayer decides they do not qualify, they must complete and submit the questionnaire by the date provided on the audit letter to avoid receiving a Notice of Proposed Assessment. 265 If the FTB receives incomplete or conflicting information, they will either contact the taxpayer by telephone or mail a letter to ask for clarification of incomplete or unclear answers. If the taxpayer electronically filed the tax return and included a completed questionnaire, they will only receive a Head of Household Audit Letter if the questionnaire contains incomplete or conflicting information. In such situations, the FTB will mail a letter requesting clarification for incomplete or unclear answers. If the answers on the questionnaire show the taxpayer qualifies for the head of household filing status, an acceptance letter will be issued. In the acceptance letter, the taxpayer is informed by the FTB that they met the qualification for the head of household filing status for the tax year specified. The FTB will send a Notice of Proposed Assessment disallowing the head of household filing status if the taxpayer does not qualify for the head of household filing status, or does not respond to the audit letter. If the taxpayer does not respond to the audit questionnaire, the FTB can impose a penalty of 25% of the additional tax owed. Each year the FTB reviews the returns of taxpayers who claim the HOH filing status because the qualifications for this filing status are commonly misunderstood. 118 Time/Dates Qualifying Person Was in the Home To claim the HOH filing status, the child must have lived with the taxpayer for more than 50 percent of the taxable year. If the taxpayer’s child did not live in his home more than half of the taxable year, he may qualify for the Credit for Joint Custody Head of Household. If And Then The taxpayer and the The taxpayer was spouse separated still married at the during the period end of the year January 1 to June 30 Count only half of the time that the taxpayer, spouse, and son lived together and all the time the taxpayer and son lived together without the spouse. If Then And The taxpayer and The taxpayer was spouse separated still married at the during the period July end of the year 1 to December 31 The taxpayer cannot qualify for HOH filing status because to be considered unmarried, must have lived apart from the spouse at all times during the last six months of the year. If Then And The taxpayer and The taxpayer was spouse separated legally separated during the year by the end of the year 118 The taxpayer can count half of the time that he, the spouse, and son lived together and all the time the taxpayer and son lived together without the spouse. www.ftb.ca.gov/aboutFTB/Public_Service_Bulletins/2012/Bulletin_1225_Attachment.shtml 266 These same rules apply to registered domestic partners HOH Audit letter The audit letter tells taxpayers: Why the FTB is reviewing their filing status information. How to obtain assistance with completing the questionnaire. How to return the completed questionnaire. The qualification requirements for HOH. Frequently asked questions about HOH. The letter also includes information about how to obtain assistance with completing the questionnaire for Spanish speaking taxpayers. A sample of the HOH audit letter is available on the FTB at: https://ftb.ca.gov/forms/2011/11_4803MEO.pdf Audit process HOH audit staff will: Review completed questionnaires to determine if taxpayers qualify for the HOH filing status. Call taxpayers or send follow up letters if responses are incomplete or contain conflicting information. Send an HOH acceptance letter to qualified taxpayers. Send a Notice of Proposed Assessment disallowing the HOH filing status to taxpayers who do not respond to the audit letter, or do not qualify for the HOH filing status based on their responses to the questionnaire. Assess a failure to furnish information penalty on all taxpayers who do not respond by the due date on the audit letter. Acceptance letters only apply to the specific tax year we examined and do not qualify taxpayers for any other year. Taxpayer who e-filed Taxpayers who filed electronically and claimed the head of household filing status had the option of completing and including an electronic HOH questionnaire (Schedule HOH/FTB 4803E) with their e-filed return. The FTB will not send an HOH audit letter to taxpayers who submitted this information with their return. However, they may still receive a follow up audit letter if the information they provided electronically was incomplete or conflicting. Taxpayers can get more information about HOH, view the FTB Pub. 1540, California Head of Household Filing Status, or access the HOH audit letter response application by visiting ftb.ca.gov and search for HOH filing status. 267 268 Taxpayer inquiries The FTB cannot give information over the telephone or in person. Inform the taxpayers to complete and return the audit letter questionnaire by the date specified on their letter. Taxpayers may: Respond using the HOH web Response Application. They will need their social security number and the FTB ID number listed at the top of the audit letter. Using this method of responding to the HOH Audit Letter will expedite the processing of the questionnaire. Return the questionnaire to the FTB by mail or fax. A list of frequently asked questions is included with the audit letters mailed to taxpayers. 269 Qualifying Widow(er) with Dependent Child RDPs qualify for this filing status if all five of the following apply: • The taxpayer’s RDP died in 2010 or 2011 and they did not marry or enter into another registered domestic partnership in 2012. • The taxpayer has a child, stepchild, adopted child, or foster child whom the taxpayer claim as a dependent. • This child lived in the taxpayer’s home for all of 2012. Temporary absences, such as for vacation or school, count as time lived in the home. • The taxpayer paid over half the cost of keeping up the home for this child. • The taxpayer could have filed a joint return with the RDP the year he or she died, even if they actually did not do so. Gross Income119 Personal Income Tax Law defines adjusted gross income as meaning gross income minus specified deductions, among which are those attributable to a trade or business carried on by the taxpayer. California conforms to IRC §61. As such, all items of income included for Federal purposes are included for California purposes, unless a specific exception is stated in CA statute. California taxes residents of California on their entire taxable income;120 California provides that gross income of nonresidents includes only income from California sources. The word "source" pertains to the place of origin121. Nonresidents are taxed only on taxable income derived from sources within California. Example: Unemployment benefits including paid family leave are taxable for Federal purposes, but are not taxable for CA purposes.122 Types of Income Specific types of income are treated as follows: Wages – have a source where the services are performed. Neither the location of the employer, nor where the payment is issued, nor the location when the taxpayer receives payment have an effect on the taxability of income Interest and dividends - generally have source where the taxpayer is a resident Business income - Nonresident income from California sources includes income from a business, trade, or profession carried on in California. If the nonresident business, trade or profession is carried on both within and outside of California. The part outside of California must be separate and distinct. Only the income from the part conducted within California is California source income. If there is no distinction between the business being done within and outside California, then the apportionment factor (as computed in corporations) must be used to determine source income Pensions and Keoghs (HR 10): Residents: Distributions from employersponsored and self-employment (Keogh) pension, profit sharing, stock bonus R&TC §17072 R&TC §Section 17041(a) and (c). 121 R&TC Section 17951 122 IRC §85, R&TC §17083 119 120 270 plans, and other deferred compensation arrangements are taxable by California regardless of where the services were performed. Nonresidents: Distributions are not taxable by California if received after December 31, 1995 IRA, Roth IRA, SIMPLE, SEP and Keogh distributions received after becoming a nonresident are not taxable by California if received after December 31, 1995 Alimony received and alimony paid are entered on Schedule CA (540NR) only if the alimony was not reported on the Federal return The gain or loss from the sale of real estate has a source where the property is located. If the taxpayer sells the property in California, whether or not a resident the sale is taxable to CA. The basis of the property must be reduced by the amount of depreciation that would have been allowed had the taxpayer filed a California return. Real Estate withholding may be required on real estate, which is California source income, report the withholding on Line 40 of Form 540. Effective January 1, 2003 the 3 1/3% withholding requirement of the sales price for transfer of California real property of California real property was expanded to include sales made by California residents. The sale of principal residences and sales that qualify for tax free exchange under IRC Section 1031 are exempt from withholding Partnership, S-Corporation and trust income when a partner is a part-year resident during any part of the taxable year, the part–year resident must divide his/her taxable year into two distinct periods. The taxpayer is taxed on all California source income for the period when the taxpayer was a resident or a nonresident, and all California nonsource income for the period when the partner was a resident. This also applies to shareholders and beneficiaries Sale of stock or bonds depends on the source at the time of distribution. If the taxpayer is a resident it is taxable regardless of source, if the taxpayer is a nonresident at the time of sale it is not taxable Installment sales received by a nonresident on the sale of California property are taxable by California. However the interest earned on the installment note is not taxable to the non-resident Moving expenses, which are reimbursed, are taxable to the state to which the taxpayer moves, regardless of the residency at the time. 271 Chapter 20 - CA Residency/ Non-Residency/Electronic Filing A resident is any individual who is: In California for other than a temporary or transitory purpose; or Domiciled in California, but outside California for a temporary or transitory purpose An individual domiciled in California who is outside California for temporary or transitory purpose remains a resident. Domicile is defined for tax purposes as the place where the taxpayer voluntarily establishes himself and his family, not merely for a special or limited purpose, but with the intention of making the domicile the true, fixed, permanent home. The domicile is a place where the intent is always to return. Presumption of residence-nine month rule. An individual who spends in the aggregate more than nine months of any taxable year in California is presumed to be a California resident. The presumption is not conclusive and may be overcome by satisfactory evidence that the individual is in California for temporary and transitory purposes. R&TC Section 17016 states: "Every individual who spends in the aggregate more than nine months of the taxable year within this state shall be presumed to be a resident. The presumption may be overcome by satisfactory evidence that the individual is in the state for a temporary or transitory purpose." Note: This is merely a presumption of residence. The presumption can be overcome. There are several court cases, which have overcome the section. CCR Section 17016 provides that presence within California for less than nine months does not constitute a presumption of nonresidency. On the contrary, a person may be a California resident even though not in this state during any portion of the year. A part-year resident is a taxpayer who meets both of the following conditions: 1. Is a resident of California during a portion of the tax year and 2. Is a nonresident of California during a portion of the tax year? A part-year resident computes income and deductions using nonresident rules for the period of time they are a nonresident and resident rules for the period of time they are a resident. Part-year residents file Form 540NR. Items such as income from a K-1 that has source and nonsource income must be computed according to the number of days as a resident and nonresident. A nonresident is any individual who is not a resident. 272 Presumption of nonresidence-six month rule123: An individual whose presence in CA does not exceed a total of six months within the taxable year; and who maintains a permanent home outside of the state; will be considered as being in California for temporary and transitory purposes, provided they do not engage in any activity or conduct within this state other than that of a seasonal visitor tourist or guest. This ruling is based on a 1964 court case where the court ruled the voluntary or physical presence in the state is a factor of greater significance than the mental intent or outward ties to another state. Residency is significant because: Residents of California are taxed on ALL income including income from sources outside California Nonresidents are taxed only on income from California sources; and Part-year residents are taxed on all income received while a resident, and only on income from California sources while a non-resident The underlying theory of residency is that the taxpayer is a resident of the place where they have the closest connections. The following list shows some of the factors the taxpayer can use to help determine the residency status. Since the residence is usually the place where the taxpayer has the closest ties, they should compare their ties to California with their ties elsewhere. In using these factors, it is the strength of their ties, not just the number of ties that determines residency. This is only a partial list of the factors to consider. No one factor is determinative. Consider all the facts of the particular situation to determine the residency status. Factors to consider are as follows: Amount of time spent in California versus amount of time spent outside California. Location of the spouse/RDP and children. Location of the principal residence. State that issued the driver’s license. State where the vehicles are registered. State in which the taxpayer maintain their professional licenses. State in which the taxpayer is registered to vote. Location of the banks where they maintain accounts. The origination point of the financial transactions. Location of medical professionals and other healthcare providers (doctors, dentists etc.), accountants, and attorneys. Location of the social ties, such as a place of worship, professional associations, or social and country clubs of which the taxpayer are a member. Location of the taxpayer’s real property and investments. Permanence of work assignments in California 123 Whittell v. Franchise Tax Board 231 Cal. App. 2d 278 (1964) 273 Determining CA Tax as a Nonresident For taxable years beginning on or after January 1 2002, if the taxpayer is a nonresident or a part-year resident, the taxpayer determined the California tax by multiplying their California taxable income by an effective tax rate. The effective tax rate is the California tax on all income as if the taxpayer were a California resident for the current taxable year and for all prior taxable years for any carryover items, deferred income, suspended losses, or suspended deductions, divided by that income. Use the following formula: Prorated tax = CA taxable income x Tax on total taxable income Total taxable income Schedule CA (540NR), California Adjustments –Nonresidents Refer to the example of Schedule CA on the following pages Determines California taxable income by doing the following124: Identify the domiciles and also, current and past residency information. o Part I, Line 4 shows the taxpayer and the spouse are a nonresident for the full year. o Part I, Line 6 shows the taxpayer own property in CA Enter the amounts of income and deductions reported on the federal tax return. o Column A in the example shows all the income from the Federal return. Adjust the income and deductions reported on the federal tax return for differences in California and federal law. o In the example there are no CA law adjustments (subtractions and additions), so there are no amount in Column B and C Determine the portion of income reported on the federal tax return that was earned or received while the taxpayer was a California resident. o The taxpayer was a nonresident for the entire year Determine the portion of income reported on the federal tax return that was earned or received from California sources while the taxpayer was a nonresident. o Column E shows the CA source income (wages, capital gains and rental income) while a nonresident and also there is the IRA deduction on line 32. Determine the allowable standard deduction or itemized deductions. o Part III Schedule CA 540NR below, line 38 shows the Fed Itemized Deductions. Line 39 through 41 shows the adjustments to itemized deductions due to CA law. o The itemized deductions were not reduced due to high income (line 43). 124 Schedule CA (540NR) Instructions 274 The deduction percentage is computed by dividing the CA Source income (Line 37, Column E by the amount of CA income under CA law (line 37,column D) 275 Schedule CA (540 NR) Page 1 and 2 276 Multiple Scenarios of A Full Year Nonresident Return In all the following situations the taxpayer is a full year Nonresident. A nonresident is only taxed on income derived from California sources. California taxes installment gains received by a nonresident from the sale of tangible property and intangible property on a source basis. California taxes real property based upon where the property is located. Installment gains from the sale of intangible property are generally sourced to the recipient’s state of residence at the time of the sale. California taxes residents on all income regardless of source. California taxes the installment proceeds received by a nonresident to the extent the income from the sale was from a California source Example The taxpayer has always been a nonresident of California but has owned rental property in CA for many years. On March 1, 2009, the taxpayer sold a California rental property in an installment sale. The installment proceeds received comprised of capital gain income and interest income. The capital gain income is taxable by California, because the property was located in California. The interest income is not taxable by California and has a source in the state 277 of residence. Example The taxpayer is a nonresident of California. A parcel of land located in Idaho was sold on an installment basis. The installment proceeds comprised of capital gain income and interest income. The capital gain income is not taxable by California because the source of the gain is Idaho. The interest income is not taxable by California and has a source in the state of residence. IRA Deductions When a Nonresident Working in CA If the taxpayer files a Long Form 540NR, the IRA deduction on Schedule CA (540NR)125, line 32, column E, is limited to the lesser of: • The IRA deduction allowed on the federal return. • The compensation reported on Schedule CA (540NR), column E. Example: The taxpayer is a nonresident of California who is under 50 years of age. During the year, he worked temporarily in California. California compensation is $1,000, which is reported on Schedule CA (540NR), column E. The federal compensation is $10,000. The allowable IRA deduction on the federal return is $5,000 in 2012. The allowable California IRA deduction that is report on Schedule CA (540NR), column E, is $1,000. This is the lesser of (1) the $4,000 IRA deduction allowed on the federal return, or (2) the $1,000 of compensation reported on Schedule CA (540NR), column E. California does not impose tax on retirement income received by a nonresident after December 31, 1995. For this purpose, retirement income means any income from any of the following: A qualified plan described in IRC Section 401. A qualified annuity plan described in IRC Section 403(a). A tax-sheltered annuity described in IRC Section 403(b). A governmental plan described in IRC Section 414(d). A deferred compensation plan maintained by a state or local government or an exempt organization described in IRC Section 457. An IRA described in IRC Section 7701(a) (37), including Roth IRA and SIMPLE. A simplified employee pension described in IRC Section 408(k). A trust described in IRC Section 501(c) (18). A military pension, even if the military service was performed in California 125 FTB Pub 1005 278 A private deferred compensation plan program or arrangement described in IRC Section 3121(v)(2)(C) only if the income is either of the following: 1. Part of a series of substantially equal periodic payments (not less frequently than annually) made over the life or life expectancy of the participant or those of the participant and the designated beneficiary or a period of not less than 10 years. 2. A payment received after termination of employment under a plan program or arrangement maintained solely to provide retirement benefits for employees in excess of the limitations on contributions or benefits imposed by the IRC. Any retirement or retainer pay received by a member or former member of a uniform service computed under Chapter 71 of Title 10, United States Code. Stock Options California taxes the wage income received by a nonresident from employee stock options on a source basis, whether the taxpayer was always a nonresident or was formerly a California resident.126 Example While a California resident, the taxpayer was granted nonstatutory stock options. He performed all of the services in California from February 1, 2007, to May 1, 2011, the date he left the company and permanently moved to Texas. On Jan 12, 2012, the taxpayer exercised the nonstatutory stock options. The income resulting from the exercise of the nonstatutory stock options is taxable by California because the income is compensation for services having a source in California, the state where all of the services were performed. CA Property Exchange for Property Out of State127 The taxpayer is a nonresident and exchanged real or tangible property located within California for real or tangible property located outside California, the realized gain or loss will be sourced to California. Taxation will not occur until the gain or loss is recognized. This requires the preparer and the taxpayer to keep track of the deferred California sourced gains and losses to report them to California in the year of sale or otherwise dispose of the property received in the exchange. Example As a resident of Texas, the taxpayer exchanged a condominium located in California for like-kind property located in Texas. The taxpayer realized a gain of $15,000 on the exchange that was properly deferred under IRC Section 1031. The taxpayer then sells the Texas property in a nondeferred transaction and recognized a gain of $20,000. The $15,000 deferred gain (the lesser of the deferred gain or the gain recognized at the time the taxpayer disposed of the Texas property) has a source in California 126 127 FTB Pub 1100 FTB Pub 1100 279 and is taxable by California. Property from Out of State Exchanged for CA Property The taxpayer exchanged real or tangible property located outside California for real or tangible property located within California, the gain recognized when he sells or otherwise disposes of the California property in a nondeferred transaction has a California source and is taxable by California. As a resident of Nevada, the taxpayer exchanged Nevada business property for like-kind California business property. They realized a $10,000 gain on the exchange that was properly deferred.128 The taxpayer then sold the California business property in a nondeferred transaction and recognized a gain of $50,000. Because the property is located in California, the $50,000 gain has a California source and is taxable by California. Safe Harbor Safe harbor is available for certain individuals leaving California under employment-related contracts. The safe harbor provision states that an individual domiciled in California who is outside of California for at least 546 consecutive days will be considered a nonresident unless: The individual has intangible income (stocks, bonds, notes, etc.) exceeding $200,000 in any taxable year during which the employment-related contract is in effect The principal purpose of the absence is to avoid personal income tax Return visits to California that do not exceed a total of 45 days during any taxable year covered by the employment contract are considered temporary. Individuals not covered by the safe harbor determine their residency status based on facts and circumstances. The determination of residency status cannot be solely based on an individual’s occupation, business, or vocation. Instead, consider all activities to determine residency status. For instance, students who are residents of California leaving this state to attend an out-of-state school do not automatically become nonresidents, nor do students who are nonresidents of California coming to this state to attend a California school automatically become residents. In these situations, individuals must determine their residency status based on their facts and circumstances. When the taxpayer is present in California for temporary or transitory purposes, they are a nonresident of California. For instance, if they come to California for a vacation, or to complete a transaction, or are simply passing through, the purpose is temporary or transitory. As a nonresident, they are taxed only on income from California sources. When in California for other than a temporary or transitory purpose, the taxpayer is a California resident. For instance, if an employer assigns an employee to an office in California for a long or indefinite period, if a taxpayer retires and comes to California with no specific plans to leave, or 128 IRC §1031 280 if the taxpayer is ill and in California for an indefinite recuperation period, the stay is other than temporary or transitory. As a resident, the taxpayer is taxed on income from all sources. Generally, the taxpayer is presumed to be a California resident for any taxable year in which they spend more than nine months in this state. An individual domiciled in California when entering the military is considered a: Resident while stationed in California Resident while stationed in California on Permanent Change of Station (PCS) orders and Temporary Duty (TDY) assignments outside California, regardless of duration Nonresident while stationed outside California on PCS orders129. Military members domiciled outside California are considered nonresidents for tax purpose even when stationed in California on PCS orders. Residents are taxed on all income from all sources. Nonresidents of California are taxed only on income from California sources. Nonresidents of California are not taxed on pensions (HR 10) received after December 31, 1995. Part-year residents are taxed on all income received while a resident and only on income from California sources while a nonresident. The difference between CA and Federal law (conformity) is shown on Schedule CA filed with the required CA return. (See Chapter 20 for an example of Schedule CA). File Form 540, 540A or 5402EZ to report income as a resident. The resident return deals with conformity issues by using Schedule CA. File Form 540NR if the taxpayer is a nonresident or a part-year resident and use Schedule CA (540NR). 129 FTB Pub 1032 281 Income Form 540NR 282 CA Electronic Filing California law requires individual income tax returns prepared by income tax preparers to be e-filed unless the individual return cannot be e-filed due to reasonable cause. Reasonable cause includes a taxpayer's election to opt-out (choose not to e-file). FTB e-Programs Customer Service: Available Monday through Friday, between 8 a.m. and 5 p.m. Phone: 916.845.0353 Fax: 916.845.0287 Email: e-file@ftb.ca.gov Send comments or suggestions regarding the California e-file Program or this publication to: e-file Coordinator, MS F-284 Franchise Tax Board PO Box 1468 Sacramento CA 95812-1468 Email: e-file.coordinator@ftb.ca.gov If the preparer prepares more than 100 California individual income tax returns in any calendar year beginning January 1, 2003 or after, and in the following calendar year prepare one or more using tax preparation software, then the taxpayer must e-file all acceptable individual returns in that following year and all subsequent calendar years thereafter. In order to be automatically enrolled in the e-file Program, the preparer needs to be an accepted participant in the IRS e-file program. The FTB receives confirmation from the IRS after they accept the preparer into their program. The preparer uses the IRS-assigned Electronic Filer Identification Number (EFIN) to efile with FTB. If the preparer transmits returns, use the IRS-assigned Electronic Transmitter Identification Number (ETIN) with FTB130. New for 2012 The FTB e-file program will not shut down after October 15th, but will continue year round and support previous year e filing once the new production year is implemented in January. Two New Forms allowed for electronic filing; Form 3811 Donated Fresh Fruits or Vegetable Credit Form 3541 CA Motion picture and Television Production 130 FTB Pub. 1345 2012 Handbook for Authorized e-file Providers 283 Mandatory Individual Electronic Funds Transfer (EFT) Individuals are required to remit all payments electronically once they make an estimate or extension payment exceeding $20,000 or the taxpayer files an original tax return with a total tax liability over $80,000 for any taxable year that begins on or after January 1, 2009. Once they meet this threshold, all subsequent payments regardless of amount, tax type, or taxable year must be remitted electronically. The first payment that would trigger the mandatory e-pay requirement does not have to be made electronically. Individuals that do not send the payment electronically will be subject to a one percent noncompliance penalty. Electronic payments can be made using Web Pay on Franchise Tax Board’s (FTB’s) website, electronic funds withdrawal (EFW) as part of the e-file return, or credit card. Web Pay can be used for the following transactions: Pay any personal income tax bill from us. Pay the balance due on the current-year tax return. Make an amended return payment (form FTB 540X). Make an extension payment (form FTB 3519). Pay any amount owed for prior years. Pay any notice of proposed assessment. Make a tax deposit for a pending audit payment Refund Splitting Taxpayers have the option of splitting their refund made by Direct Deposit (DDR) in up to two accounts. Taxpayers requesting their refund be split must request the total refund amount be electronically deposited between the two accounts. Taxpayers cannot receive part of their refund by DDR and part by paper check. Verifying Banking Information To avoid DDRs or EFWs being returned by taxpayer’s banks, we encourage the use of double entry or other techniques that require the taxpayer double-check the entered bank account and routing number information. This will help ensure the accuracy of the information that is entered or imported from previous requests, return filings, etc. MyFTB Account for Individuals131 This service allows taxpayers and their authorized representatives to change their address, view current year payment activity, the total balance due on the account, up to 25 estimated payments, and tax year summaries (tax computation) with payments applied. In addition, Wage and Withholding and FTB issued 1099G and 1099INT information is available. Taxpayers must complete a one-time registration process to access MyFTB 131 www.ftb.gov 284 Account. General Information e filing ensures more accurate returns because e-file software and the FTB e-file process verifies certain aspects of the return before they accept it for processing. Because of these checks, e-file returns have the lowest error rate of all returns filed. In addition, taxpayers and tax practitioners receive an acknowledgment for each e-file return. The FTB e-file program checks the return information for completeness and accuracy, as does the Federal program. When the e-file Program accepts the return, an acknowledgement showing it is accepted is sent. If the FTB’s e-file Program rejects the return, an ACK is sent identifying the problem(s) that caused the e-file Program to reject the return. The return must be corrected and retransmit the return for processing. The following electronic returns may be filed: Forms 540, 540NR Long, 540NR Short, 540 2EZ, 100, 100S, 100W, 100X, 199, 565, and 568 They are transmitted via a transmitter or directly to the FTB. Returns are transmitted via the Internet, using our Secure Web Internet File Transfer (SWIFT) system. A participant in California’s e-file Program is an “Authorized FTB e-file Provider.” The Authorized FTB e-file Provider categories are: An Electronic Return Originator (ERO) originates the electronic submission of income tax returns. EROs may originate the electronic submission of income tax returns they either prepared or collected from taxpayers. To be an ERO, the preparer must: o Be an accepted participant in the IRS’s e-file Program. o Receive an Electronic Filer Identification Number (EFIN) from the IRS. o Pass the FTB suitability check. Intermediate Service Providers receive tax return information from an ERO or a taxpayer, process the tax return information and either forward the information to a Transmitter or send the information back to the ERO (or taxpayer). Software Developers develop software for the purpose of formatting electronic tax return information according to FTB Publication 1346X, California Individual e-file Guide for Software Developers and Transmitters, or 1346B, Business e-file Guide for Software Developers and Transmitters. Transmitters transmit electronic tax return information directly to FTB. The Authorized FTB e-file Provider categories are not mutually exclusive. For example, an ERO can, at the same time, be a Transmitter, Software Developer, or Intermediate Service Provider, depending on the functions performed. All participants are responsible for adhering to the requirements of each category they may participate in. 285 Differences Between the IRS and FTB e-file Programs The FTB follows the e-file Program requirements found in IRS Publication 1345132, to the extent that they apply to FTB’s e-file Program. Transmit all state tax returns and attachments directly to FTB in Sacramento, California. Do not send paper documents to FTB. Unlike the IRS, the FTB allows ERO’s and online filers to use a pen on paper signature method (Form FTB 8453 series) in addition to electronic signature methods. EROs and taxpayers must retain forms FTB 8453, FTB 8453-OL, FTB 8453-C, FTB 8453-EO, FTB 8453-LLC, FTB 8453-P, or FTB 8879. Do not mail these to FTB. Individual taxpayers must retain forms W-2, W-2G, 1099-R, 592-B, and 593, along with a complete copy of the return. The FTB does not have an “offset” indicator. The FTB does not have an electronic signature option for business e-file returns. e filing is mandatory for certain preparers of individual income tax returns. Mandatory e-file (Individual e-file) e-file of individual returns is mandatory for returns prepared by certain income tax preparers. California law requires tax preparers who prepare more than 100 individual state income tax returns annually and prepare one or more using tax preparation software to e-file all current-year individual income tax returns. Note: The mandatory e-file law does not apply to the filing of business returns. For the purposes of this law, an “Income Tax Preparer” is defined as a person who prepares, in exchange for compensation, or who employs another person to prepare, in exchange for compensation, any return for the tax imposed. This means, even if a person in the preparer’s employ or one of the offices files less than 100 individual returns, if the total of all individual income tax returns prepared by multiple preparers or from multiple offices equals more than 100 and tax preparation software is used for one or more returns, all acceptable returns prepared are required to be e-filed. If the preparer resides or have an office outside California and they meet the requirements of the mandate, all California individual returns prepared are required to be e-filed. Note: There is no provision in the law that allows for a preparer waiver from the mandate. 132 IRS Revenue Procedure 2007-40, 2007-26 I.R.B. 1488 (or the latest update) and Publication 3112 286 What types of returns must be e-filed? All current year individual income tax returns are required to be e-filed. Prior year, fiduciary, amended, and business returns are not required to be e-filed under the mandate. A $50 per return penalty may be assessed for each return filed on paper that should have been e-filed. What if the taxpayer does not want their return e-filed? A taxpayer can elect not to e-file133. If the taxpayer elects not to e-file, the preparer should record that election on the e-file Opt-Out Record for Individuals (form FTB 8454). This form allows the preparer to record the taxpayer’s election not to e-file and should be retained with their records. 133 Rev. & Tax. Cd. §19170 287 Form 8454 – e-file Opt Out For individual e-file returns, if the taxpayer chooses to file a paper return, 288 The FTB suggests that they sign the e-file Opt-Out Record for Individuals (FTB 8454). The taxpayer must be allowed to review their completed tax return before signing the return. The preparer should always retain copies of all material furnished to the taxpayer. Any material exchanged or retained by the taxpayer or preparer can be exchanged electronically, provided copies of documents or information can be provided upon request. The preparer must comply with all the latest publications, forms, and notices governing the e-file Program individual e-file returns, if the taxpayer chooses to file a paper return, the FTB suggests that they sign the e-file Opt-Out Record for Individuals (FTB 8454). Suitability Check The FTB may perform a suitability check on all applicants, or perform suitability checks on an annual basis for continuing e-file Program participants. The purpose of the suitability check is to ensure that: All business entities are valid and licensed. All personal and business tax returns are timely filed. All liabilities are paid or current Fraud protection The potential for fraud is a concern both at the federal and state level. The FTB is committed to reducing the risk of fraudulent tax return filings. The tax preparer can help prevent and detect fraud by: Verifying the identity of new clients. Informing clients that the FTB verifies W-2 and Child and Dependent Care Expenses Credit information. Verifying supporting information for the nonrefundable Child and Dependent Care Expense Credit including: o Visually inspecting the social security card to verify the child’s name and social security number, o Obtaining proof of care provided, such as copies of cancelled checks, and o Reviewing taxpayer and spouse (if married) earned income to determine if they meet the Child and Dependent Care Expenses Credit requirements. Questioning Forms W-2 that appear altered or suspicious. Identifying similar W-2 information between clients, such as employers, wages, and withholding. Identifying similar return information between clients, such as refund amounts, number of dependents, and number of Forms W-2. Questioning refunds on different returns directed to the same address or post office box. Asking taxpayers for social security cards and other documents to avoid incorrect social security numbers (SSN’s) for taxpayers, spouses, and dependents on income tax returns. 289 Before preparing returns or accepting returns for electronic transmission, the tax preparer should review two pieces of identification (picture identifications are preferable) from each new client. One form of identification could include a picture reflecting at least the individual’s name and the current address, such as: Driver’s License State Identification Card Military Identification Alien Registration Card Passport Veteran’s Identification Card The second should include the same name and the SSN the individual is using to file the tax return, such as: Social security card Work pay stub A copy of this information should be retained in the files for four years from the due date of the return or four years from the date the return is filed, whichever is later. Suspension The FTB reserves the right to suspend the electronic filing privilege of any Authorized FTB e-file Provider who violates any provision of the requirements, specifications, and procedures stated in the electronic filing procedures or who does not consistently transmit error-free returns. The following reasons could lead to a warning letter and/or suspension of an Authorized FTB e-file Provider from the e-file Program. This list is not allinclusive: Conviction of any criminal offense arising from a violation of California tax statutes or revenue laws of the United States, or any offense involving dishonesty, or breach of trust Non-compliance with the provisions of California Business and Professions Code §22250-22259 (Tax Preparer Act)1 Failure to file timely and accurate returns, both business and personal Failure to pay business or personal tax liabilities Assessment of penalties under any of California’s tax statutes Suspension/disbarment from practice before the IRS or local tax agency Other facts or conduct of a disreputable nature that would adversely reflect on the e-file Program Misrepresentation on an enrollment form Unacceptable format quality of individual transmissions Unacceptable error rate Violation of advertising standards Unethical practices in return preparation Stockpiling returns prior to official acceptance into California’s e-file Program, or at any time while participating in California’s e-file Program Failure of Transmitters to provide preparer clients with acknowledgment files within 48 hours of receipt from the FTB 290 Significant complaints about an Authorized FTB e-file Provider Misuse of an Authorized FTB e-file Provider’s EFIN or ETIN Practices inconsistent with the FTB’s recommendations revealed during site visits Monitoring The FTB staff site visits to tax practitioners, including Authorized FTB e-file Providers who are participating in the e-file Program to monitor advertising and compliance with mandatory e-file law. During the filing season to ensure that you are following the e-file Program requirements134. The FTB may ask the preparer to: Produce a copy of the faxed or original signed form FTB 8453, FTB 8453-C, FTB 8453-EO, FTB 8453-LLC, FTB 8453-P, FTB 8454, or FTB 8879 for all e-filed returns. Demonstrate that copies of forms FTB 8453, FTB 8453-C, FTB 8453-EO, FTB 8453-LLC, FTB 8453-P, FTB 8454 and FTB 8879 are being stored in a secure manner. Produce any required e-file documentation maintained for the entire filing season. Demonstrate that copies of taxpayer returns are maintained if the ERO is also the tax preparer. Produce a letter of acceptance into California’s e-file Program. Produce a $5,000 surety bond and a Letter of Compliance from the California Tax Education Council (CTEC) if the preparer is a registered tax preparer. Produce record of clients who opted out of having their return e-filed. Disclosure of Electronic Return Information An ERO shall not disclose or use any tax return information for a purpose other than preparing, assisting in preparing, obtaining or providing services in connection with the preparation of tax returns. Disclosure among accepted participants in California’s e-file Program for preparing and transmitting the return information is permissible. For example, it is permissible for an ERO to pass on tax return information to a Transmitter for the purpose of having an electronic return formatted and transmitted to the FTB. However, the return information may not be disclosed or used in any other way. Signing the Electronic Return FTB offers pen-on-paper signature and e-Signature options. That will accept all signature methods for all California individual e-file return types (Forms 540, 540 2EZ, and 540NR Long and Short) throughout the duration of the e-file season. Like the IRS, ERO’s may sign forms FTB 8453, 8454, 8455 and 8879 by rubber stamp, mechanical device (such as signature pen) or computer software program135 134 135 FTB Pub 1345 IRS Notice 2007-79 291 Reminder: The taxpayer must be allowed to review their completed tax return before using any of the signature options. Also, the return must be signed before it is transmitted it to the FTB. Individual e-file Pen-on-Paper Signature Option – Form FTB 8453 Form FTB 8453, California e-file Return Authorization for Individuals, is used when the taxpayer and ERO sign using the pen on paper method. Form FTB 8453 serves to: Authenticate the return. Authorize the ERO to file the return on the taxpayer’s behalf. Authorize the ERO to transmit the tax return electronically to us either directly or through a third party Transmitter. Provide the taxpayer has written consent to have their refund directly deposited or their tax payment debited from their financial institution. Authorize the FTB to inform the taxpayer’s ERO or Transmitter that the taxpayer’s return has been accepted or rejected and when rejected, to identify the reason(s) for rejection. Authorize the FTB to inform the taxpayer’s ERO or Transmitter of the reason(s) for return processing delays or when the refund was sent. Remind taxpayers who are filing balance due returns, of their liability for paying taxes, and if applicable, any interest and penalties. Note: The ERO must provide the taxpayer with a copy of form FTB 8453, Forms W-2, W-2G, and 1099-R and a copy of Form 540, Short Form 540NR, Long Form 540NR, or Form 540 2EZ showing the electronic data transmitted to us. EROs must retain forms FTB 8453 at their place of business for four years from the due date of the return or four years from the date the return is filed, whichever is later. Failure to maintain forms FTB 8453 as required, or incomplete or erroneous forms may result in immediate suspension from California’s e-file Program. 292 Form 8453 293 e-Signature Options- Individual Only The FTB offers most of the same PIN methods as the IRS: the Self-Select PIN method, the Practitioner PIN method, and the ERO PIN. Practitioner PIN Method Form FTB 8879, California e-file Signature Authorization for Individuals, is used when the taxpayer signs using the Practitioner PIN Method. The Practitioner PIN method is an option only available for taxpayers who use an ERO to e-file their return. Form FTB 8879 serves to: Authenticate the return. Authorize the ERO to file the return on the taxpayer’s behalf. Authorize the ERO to enter the taxpayer’s PIN on the return on the taxpayer’s behalf. Authorize the ERO to transmit the tax return electronically to us either directly or through a third party Transmitter. Provide the taxpayer has written consent to have their refund directly deposited or their tax payment debited from their financial institution. Authorize the FTB to inform the taxpayer’s ERO or Transmitter that the taxpayer’s return has been accepted or rejected and when rejected, to identify the reason(s) for rejection. Authorize the FTB to inform the taxpayer’s ERO or Transmitter of the reason(s) for return processing delays or when the refund was sent. Remind taxpayers who are filing balance due returns, of their liability for paying taxes, and if applicable, any interest and penalties. Note: The ERO must provide the taxpayer with a copy of Forms W-2, W-2G, and 1099R and a copy of Form 540, Short Form 540NR, Long Form 540NR, or Form 540 2EZ showing the electronic data transmitted to us. EROs must retain forms FTB 8879 at their place of business for four years from the due date of the return or four years from the date the return is filed, whichever is later. California tax returns have an automatic extension to file to October 15th. Failure to maintain forms FTB 8879 as required, or incomplete or erroneous forms may result in immediate suspension from California’s e-file Program. To sign using this method, the taxpayer(s) must: Review the appropriate disclosure statements for their filing situation. Select a PIN consisting of any five numbers (except all zeros). Review and sign the California e-file Signature Authorization for Individuals (FTB 8879). When taxpayers are married filing jointly, each taxpayer must complete these steps. By signing form FTB 8879, the taxpayer(s) give the ERO a one-time authorization to enter their PIN for their individual e-file return. 294 CA Form 8879 295 The ERO PIN The ERO must use the ERO PIN when the taxpayer uses either the Self-Select PIN or Practitioner PIN method to electronically sign their individual e-file return. The ERO PIN is made up of two components: 1. The ERO’s six-digit electronic filer identification number (EFIN). 2. Any five numbers (except all zeros). Differences between the IRS & FTB e-Signature Programs The FTB follows the IRS electronic signature specifications to the extent that they apply to the Individual e-file Program. Key differences include: Shared secret – We require the original California AGI, rather than the federal AGI. Prior-year nonresidents – Taxpayers who filed a Form 540NR in the previous year may use any of the electronic signature methods for their current year return. Prior-year non-filers – Taxpayers who did not file (or did not need to file) a California individual income tax return in the previous year cannot sign their current year return using the Self-Select PIN method. These taxpayers must sign the California e-file Return Authorization for Individuals (FTB 8453) or use the Practitioner PIN method. Extension of time to file – there is an automatic six-month extension of time to file California individual income tax returns. No form or signature is required to receive this extension. Returns filed after cut-off – Taxpayers who filed their previous year’s California tax return after November 15th cannot sign their current California tax return using the Self-Select PIN method. e-Signature Taxpayer Eligibility Requirements Practitioner PIN: All taxpayers are eligible to sign electronically using the Practitioner PIN method, provided the ERO follows the fraud prevention procedures described in this publication. Self-Select PIN Method: Only taxpayers who filed a California individual income tax return (Form 540, 540A, 540 2EZ, or 540NR) on or before November 15th are eligible to use the Self-Select PIN method in the current year. Note: If a taxpayer is ineligible to sign electronically using the self-select PIN method, they may still e-file by signing the California e-file Return Authorization for Individuals (FTB 8453) or by using the Practitioner PIN method. 296 Chapter 21 - California Conformity, Schedule CA and Military In general, California law conforms to the Internal Revenue Code (IRC) as of January 1, 2005, creating the state and federal differences. California is commonly known as an AGI state. California does not conform to all the Federal rules, this creates nonconformity. The governor signed SB 401 on April 13, 2010, which partially conformed California to the federal Cancellation of Debt (COD) exclusion for principal residences, as well as numerous other changes enacted since January 1, 2005. While the partial COD conformity will be retroactive to taxable years beginning on or after January 1, 2009 and before January 1 2013, most of the other conformity items will not be effective until the 2010 taxable year. Like the federal exclusion for qualified principal residence debt, the exclusion will apply to discharges occurring on or after January 1, 2009, and before January 1, 2013. California differences noted in SB 401: Qualified principal residence indebtedness may be limited to $800,000 ($400,000 for married filing a separate return) instead of the federal $2 million ($1 million for married filing a separate return); and The maximum cancellation of debt income (COD) exclusion may be further limited to $500,000 ($250,000 for taxpayers married filing separately). Some of the other significant conformity provisions, most all of which take effect beginning with the 2010 taxable year, include: Surviving spouse may exclude up to $500,000 if sale of principal residence occurs within two years of death of the spouse; Gain from sale of principal residence attributable to nonqualified use can't be excluded; Increased penalty for failure to file partnership and S corporation returns (partial conformity); Increased minimum penalty for failure to file individual returns; Waiver of early withdrawal penalty for public safety employees and individuals called to active duty; Kiddie tax age increase; and Inflation-indexing for the active participation limitations on traditional IRA contributions; . 297 Health Coverage for Adult Children up to Age 27 California Assembly Bill (AB) 36 was enacted on April 7, 2011. This bill conforms California personal income tax law with federal income tax law by adopting a specified provision of the Affordable Care Act signed into law by the President in March 2010. (The Affordable Care Act refers to Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010.) AB 36 is effective immediately, and generally applies to the same taxable periods as federal law. The Patient Protection and Affordable Care Act requires benefit plans that provide coverage for family members to cover adult children of the employee, to age 26 whether or not they qualify as dependents for tax purposes. The Health Care and Education Reconciliation Act of 2010 extends the general exclusion for reimbursements for medical care expenses under an employer-provided accident or health plan to any child of an employee who has not attained age 27 as of the end of the taxable year. Impact on Income Tax – The Affordable Care Act amends federal income tax laws to exclude the value of an eligible adult child’s medical coverage from the taxable income of the parent-employee, even if the child is not a dependent. The law also allows selfemployed individuals a deduction for health insurance premiums for an adult child under age 27, even if the child is not a dependent. New California law – California personal income tax law, as amended by AB 36, conforms to the 2010 federal income tax rules which exclude the value of the medical coverage provided to nondependent adult children from California gross income and allow a deduction to self-employed individuals for health insurance premiums for nondependent adult children under age 27. 136 Any amount paid by an employee for such additional coverage is excluded from California taxable wages. California did conform to the federal provision that allows an exclusion from income for the cost of employer-provided medical insurance premiums for nondependent adult children (under age 27 at end of taxable year).136 No adjustment will be made for these benefits. R&TC §17021.7, 17024.5, 17131 298 299 Schedule CA Page 1 Wages are generally the same as the federal return if the taxpayer is a full-year resident, with the following exception: Active military pay on a taxpayer or spouse domiciled in community property state when the spouse is a California resident the spouse is entitled to an adjustment in wages Sick pay that is received under FICA or the Railroad Retirement Act is excluded in CA Foreign earned income excluded on the federal return (Form 2555) is taxable to CA and must be an addition to income California qualified stock option is not taxable if: o Earned income from the corporation is $40,000 or less o Market value of the options is $100,000 or less o The total number of shares is less than 1,000 o The corporation issuing the stock designates the stock as California Qualified Stock CA allows an exclusion from gross income for employer provided accident, health insurance and medical expense reimbursement for registered domestic partners and partners dependents if not previously deducted. Effective January 1, 2003 Interest from the following is not taxable to California U.S. savings bonds, treasury bills or any other bonds or obligations of the U.S. and its territories are not taxable to California. Federal tax-exempt interest attributable to nonCalifornia state bonds must be added back to CA income. Interest earned on qualified tax credit bonds Enterprise Zone business loans – net interest is excludable Interest that is taxable to California Bonds issued by other states HSA’s Canadian RSSP’s Children Age 14 and older must file their own return Dividends Dividends that relate to exempt interest is excludable if the mutual fund has at least 50% of its assets invested in tax exempt government obligations, Non-cash patronage dividends from farmers cooperative or mutual associations Controlled foreign corporation dividends – taxable in the year distributed rather than in the year earned. Distributions of pre 1987 earnings of from an S-Corporation are taxable by CA Undistributed capital gains from a regulated investment corporation are taxable by CA in the year distributed rather than earned Dividends from HSA’s invested in stocks or mutual funds are taxable by CA Children age 14 and older must file their own returns in CA 300 State Tax Refunds are not taxable to CA. Business/Farm Income California conforms to the federal: Mileage rates; Lease inclusion amounts; and Maximum allowable auto deduction — including autos with gross vehicle weight rating in excess of 6,000 pounds. California does not conform: CA and federal credits differ. Prior to 1999 and after 2002 Section 179 expense differed between Federal and CA could cause a depreciation or basis adjustment. The maximum amount allowed under California law as a Section 179 expense for 2012 is $25,000. 50% bonus depreciation not allowed for CA FTB Form 3885A is used only if there is a difference in depreciation between Federal and California. o Before 1/1/87 California did not allow depreciation under the Federal accelerated recovery class system (ACRS) and the taxpayer must continue to figure California depreciation in the same manner as prior years o On or after 1/1/87 – California provides special credits and accelerated write offs that affect the California basis of qualifying assets. California did not conform to all changes to federal law enacted in 1993 and this causes California basis of recovery periods to be different for some assets Amortization differences such as start up costs and research and development will create a different basis. Capital Gains/Losses can differ due to prior year differences, depreciation, amortization etc. There are many potential differences between federal and California capital gains and losses. It is not necessary to complete California Schedule D unless there is a difference between federal and California taxable amounts or capital loss carryover amounts. IRA/Pension/Annuity Distributions – the taxable amount may be less on CA due to basis differences pre 1987 law differences and AGI differences. These differences in basis make the amount taxable in 2012 different from the Federal and an adjustment is required on Sch CA. 1982 Through 1986 California law was different from federal law. The maximum federal deduction for an individual was $2,000, and was available to active participants in qualified or government retirement plans and to persons who contributed to tax-sheltered annuities. The California IRA deduction was the lesser of $1,500 or 15% of compensation with an additional deduction for a nonworking spouse, for a maximum deduction of $1,750. An IRA deduction was not allowed if you were an active participant in a qualified or government retirement plan or contributed to a tax-sheltered annuity. 301 1976 Through 1981 California law was the same as federal law. The IRA deduction for an individual was the lesser of $1,500 or 15% of compensation. An IRA deduction was not allowed if you were an active participant in a qualified or government retirement plan or contributed to a tax-sheltered annuity. 1975 California law was different from federal law. California did not allow an IRA deduction. Therefore, income earned in 1975 and 1976 on the 1975 contribution was taxable. Differences in the amount of IRA deduction the taxpayer could claim may have occurred prior to January 1, 1996 if there was a difference between the federal self-employment income and the California self-employment income. Rents/Royalties/Partnerships/Estates and Trusts Passive activity rules for real estate professionals – California does not conform to the federal law that treats real estate transactions by real estate professionals as nonpassive. Losses are suspended on Form 3801. Passive activities must be calculated separately, even though CA conforms due to differences in basis. Depreciation differences K-1 net income differences and state law differences Differences in accumulated distributions to beneficiaries The following items are not taxable to California State Tax Refund Unemployment Compensation Paid Family Benefits Social Security Benefits California Lottery Winnings Net operating loss in general conforms to federal as of January 2001. However there are continuing differences in law between the Federal and California. Therefore there are different NOL’s computed each year and different carryover amounts. Generally the carryover from 2005 to future years is 100% for 10 years. The following adjustments to income are not allowed in California Educator expense Tuition and fees deduction Self-employed health insurance paid in excess of 50% Student loan interest deduction for a spouse/RDP of a non-California domiciled military taxpayer residing in a community property state. Itemized deductions may differ between the federal and California return: Standard deduction on the Federal return and itemizing on CA State and local income tax (including prior year state taxes) and state disability payments (SDI), foreign taxes are not deductible as an itemized deduction on California. Mortgage interest may have to be increased if the taxpayer took a Mortgage Interest 302 Credit on the Federal return and the mortgage interest was on Form 1040 Schedule A was reduced by the amount of mortgage interest used to compute the federal credit. Difference is in teacher’s employee business expense due to nonconformity to the education expense deduction. Gambling losses – may be different since California lottery winnings are not taxable to CA. Schedule CA Pg 2 303 Military Active Duty Military – Generally, for tax purposes, the taxpayer is considered a resident of the state from which he entered the military. • A person shall not be deemed to have lost a residence or domicile in any state solely by reason of being absent there from in compliance with military orders. • A person shall not be deemed to have acquired a residence or domicile in any other state solely by reason of being there in compliance with military orders. • Compensation for military service is not considered to be from sources within the state where a member is stationed if that state is not the member’s domicile. Domicile is defined as the one place: • Where the taxpayer maintains a true, fixed home and a permanent establishment; • To where the taxpayer intends to return; and • Where the taxpayer intends to make his permanent home. For tax purposes, a member of the military is not considered a resident of California unless he or she is domiciled in California. An individual domiciled in California when entering the military is considered to be a: • Resident while stationed in California; • Resident while stationed in California on Permanent Change of Station (PCS) orders and Temporary Duty (TDY) assignments outside California, regardless of the duration; and • Nonresident while stationed outside California on PCS orders. Note: Military members domiciled outside of California are considered nonresidents for tax purposes even when stationed in California on PCS orders. Determining Resident Status Nonresident Example: A long time client and his wife came in for their appointment. He is a military service member who has been stationed in CA for the past three years. He had a permanent change of station (PCS) to Nevada on July 1st, his wife continued to reside and work in CA through the year. In the past they have always filed married filing joint, this year they do not know what income is taxable to CA and how they are to file. I advise them to continue to file married filing joint as they have in the past. This year rather than file Form 540, advise them to file Form 540NR. The taxpayer is considered a nonresident for tax purposes when domiciled on PCS orders outside of CA. The taxpayer earned $64,000 from the military, half of which was earned in CA. All of the spouse’s wages of $52,000 was earned in CA. Since there is no law differences Column B and C of Schedule CA (BR) below are blank, the source income is shown in Column E. 304 If the spouse of the military member remains in California, the spouse is considered a California resident. As a California resident, the spouse is subject to tax on all his or her separate income, regardless of where it is earned. If the military member retains a California domicile, the spouse is also subject to tax on his or her one-half community property share of all income, including the military member’s military pay. The spouse of a military member who is domiciled in California but leaves the state with the military spouse on PCS orders outside California becomes a nonresident upon leaving California. All income received or earned while a California resident is subject to tax. While a nonresident, only income from California sources is subject to tax. California Military Personnel in California – Military members whose domicile is California are residents of California and are subject to tax on all income, regardless of source, while stationed in California on permanent military orders. California Military Personnel Outside California – California military members who leave California under PCS orders become nonresidents of California for income tax purposes when they leave California. All income received or earned prior to departure is subject to tax by California. After departure, only income from California sources is subject to tax by California. Nonresidents are generally not taxed by California on income from intangibles, such as dividends from stocks or interest from bonds or bank accounts. California military members who leave California under a TDY assignment continue to be California residents even though absent from the state. California military members on a ship whose homeport is in California remain California residents while on sea duty, regardless of the ship’s location. Nonmilitary Spouse – If the spouse of the military member remains in California, the spouse is considered a California resident. As a California resident, the spouse is subject to tax on all his or her separate income, regardless of where it is earned. If the military member retains a California domicile, the spouse is also subject to tax on his or her onehalf community property share of all income, including the military member’s military pay. The spouse of a military member who is domiciled in California but leaves the state with the military spouse on PCS orders outside California becomes a nonresident upon leaving California. All income received or earned while a California resident is subject to tax. 305 While a nonresident, only income from California sources is subject to tax. Non-California Military Personnel – Military members who are domiciled outside California remain nonresidents, even though stationed in California, unless they establish a California domicile. Military Couples – Each member follows the above rules applicable to each of them as individual military members. California Source Income – California source income includes income from: • Real or tangible personal property located in California; • A trade or business located in California; and • Nonmilitary services performed in California such as salaries or wages from a second job held by a nonresident military member. CA Income • Income from intangible property (such as dividends from stocks or interest from bonds or bank accounts), regardless of the location of the payor, is sourced in the state of residence of the recipient. Therefore, intangible income is not taxable by California if received by a nonresident. • Military pay is not included in California source income unless the military member is domiciled in California and stationed in California. Income is allocated between spouses based upon whether the person receiving the income is domiciled in a community property or separate property state. • Military Retirement Pay - Military retirement pay is taxable by California if it is received by a California resident. This applies to all military pension income received while the retiree is a California resident regardless of where the retiree was stationed or domiciled while on active duty. Nonresidents of California are not taxed on military retirement pay or other qualified retirement income. Example: Peter and Dana Dreamer own a house in CA. They have been there since Peter was stationed there in 2009. Dana has a job in doctor’s office near the base. person In June 2012; he was transferred to VA for four months until he left for IRAQ. Dana took a leave of absence and went to VA with Peter. She did not work while she was there. Dana returned to CA when Peter left, Peter will return to CA when he returns. He earned $4,114 in wages and $27,992 nontaxable combat pay. Dana earned $45,000 in wages in CA. 306 The $4,114 of wages Peter earned and the $45,000 of Dana’s wages were taxable to CA. Military Spouses Residency Relief Act (MSRRA) If the military servicemember and nonmilitary spouse have the same state of domicile, the federal MSRRA provides: • A spouse shall not be deemed to have lost a residence or domicile in any state solely by reason of being absent to be with the servicemember serving in compliance with military orders. • A spouse shall not be deemed to have acquired a residence or domicile in any other state solely by reason of being there to be with the servicemember serving in compliance with military orders 307 Chapter 22 – AMT, Credits and Other Items 2012 CA Alternative Minimum Tax – Schedule P California tax law gives special treatment to some items of income and allows deductions and credits for some items of expense137. Many individuals who benefit from these provisions must pay at least a minimum amount of tax and/or limit the amount of their credits. Use Schedule P (540), Alternative Minimum Tax and Credit Limitations — Residents, to determine if: • The taxpayer owes AMT. • The taxpayer’s credits must be reduced or eliminated entirely. The credits may be limited even if they do not owe AMT, so be sure to complete Side 1 and Side 2 of Schedule P (540). AMT Exemption138 Filing Status Amount Married/RDP filing jointly or qualifying widow(er) $83,225 Single or head of household $62,420 Married/RDP filing separately, estates, or trusts $41,612 AMT Exemption Phaseout Filing Status Amount Married/RDP filing jointly or qualifying widow(er) $312,095 Single or head of household $234,072 Married/RDP filing separately, estates, or trusts $156,047 Kiddie Tax139 - Children Under the Age of 14 with Investment Income Like federal law (Chapter 14 of this text), California requires certain children with investment income above $1,900 to be taxed at the parent’s tax rate if the parent’s tax rate is higher. This law is commonly known as Kiddie Tax. The child’s investment income may be reported by using one of the following forms: FTB 3803, Parents' Election to Report Child's Interest and Dividends. The parents use this form to elect to include the child's interest and dividend income on their tax return. If the parents make this election, the child does not need to file a tax 137 Schedule P Instructions www.ftb.ca.gov/forms/2012_California_Tax_Rates_and_Exemptions.html 139 IRC §1(g) 138 308 return. The requirements for parents to elect to use FTB 3803 are different than the FTB 3800; review the instructions for both forms. FTB 3800, Tax Computation for Certain Children with Investment Income. When a child files a tax return, use this form to compute the tax on the child's investment income at the parent's tax rate. Note: The client is not required to report the same as federal. For example, if the taxpayer reported federal Kiddie Tax on the parent’s return, the client can choose to report it on the child’s return for California and vice versa. Schedule CA adjustments would be needed. Kiddie Tax is owed if all the following apply: The child is 18 and under or a student under age 24 at the end of the year. The child has investment income taxable by California of more than $1,900 At least one of the child's parents was alive at the end of the year. The child does not have earned income that exceeds over half of their support. If the child has an individual filing requirement, the Form 3800 can be attached to the child’s tax return to report the Kiddie Tax. In this case, the taxpayer should also verify whether or not the child can be claimed as a dependent by another person. A child who can be claimed as a dependent by another person cannot take a personal exemption on their own tax return. This is true even if the other person who can claim the exemption does not actually claim it. If the child has earned income that exceeds over half of their support, the Kiddie Tax is not applicable. Excess SDI or VPDI Withheld The maximum SDI withholding tax for 2012 is $955.85 ($95,585 x 1.0%). The taxpayer may be entitled to claim a credit for excess SDI (or VPDI) only if they meet all of the following conditions: They had two or more employers during 2012. They received more than $95,585 in wages. The amounts of SDI (or VPDI) withheld appear on Forms W-2. They may claim the excess SDI or (VPDI) on Form 540A, Form 540, or Long Form 540NR. The taxpayer cannot claim the excess SDI (or VPDI) on Form 540 2EZ or Short Form 540NR. Short Form 540NR filers must use Long Form 540NR to claim the credit. California withholding is reported on Form W-2, the Franchise Tax Board verifies all withholding with the Employment Development Department. The California withholding is found on Form W-2, Box 17; W-2G, Box 14; 1099MISC, Box 16; or 1099-R, Box 10. Report the withholding on Line 39 of Form 540 and attach the W-2 to the return. Refer to Chapter 16 in this text regarding the assembly of this return. 309 CA Estimated Tax Requirements In 2012 California continues to have front-loaded estimated tax payments. The required payments include the 1% mental health surcharge for taxpayers with a taxable income $1,000,000 or more and AMT. The required percentages are: Quarter 1st 2nd 3rd 4th Percentage 30% 40% 0% 30% If the taxpayer and spouse/RDP paid joint estimated tax payments, but are now filing separate income tax returns, either of the taxpayer or spouse/RDP may claim the entire amount paid, or they may each claim part of the joint estimated payments. If the taxpayer wants the estimated tax payments to be divided, notify the FTB before they file the income tax returns so that the payments can be applied to the proper account. The FTB will accept in writing, any divorce agreement (or court ordered settlement) or a statement showing the allocation of the payments along with a notarized signature of both taxpayers. The statements should be sent to: JOINT ESTIMATE CREDIT ALLOCATION MS F225, TAXPAYER SERVICES CENTER, FRANCHISE TAX BOARD, PO BOX 942840, SACRAMENTO CA 94240-0040 The taxpayer is required to remit all their payments electronically once they make an estimate or extension payment exceeding $20,000 or they file an original return with a total tax liability over $80,000 for any taxable year that begins on or after January 1, 2009. Once the threshold is met, all subsequent payments regardless of amount, tax type, or taxable year must be remitted electronically. Individuals who do not send the payment electronically will be subject to a one percent noncompliance penalty. Electronic payments can be made using Web Pay on the Franchise Tax Board’s (FTB’s) website, electronic funds withdrawal (EFW) as part of the e-file return, or credit card 310 Sample ES Voucher worksheet 311 Mental Health Tax The Mental Health Services Tax Rate140 is 1% for taxable income in excess of $1,000,000. Effective January 2005, applies to all filing status and without regard to credits. The funds collected under the Mental Health Services Tax are transferred to the CA Mental Health Services Fund. California imposes a surcharge of 1% on “a taxpayer’s taxable income in excess of $1 million.”(R&TC §17043) The additional tax: o Is added after all taxes except withholding, estimated tax, and overpayment of SDI; o May not be reduced by tax credits, including the credit for taxes paid to another state; o Is in addition to alternative minimum tax; o Must be included in estimated tax for purposes of the underpayment penalty; and o Includes a marriage penalty. The surcharge is imposed on, “a taxpayer’s taxable income in excess of $1 million.” Since a joint return is “a taxpayer,” a married couple filing jointly gets the use of only a single $1 million “exemption” before the surcharge takes effect. The same couple can get the benefit of two $1 million exemptions by filing separate (this tax is without regard to filing status). At 1%, that extra $1 million benefit can save the couple up to $10,000. Example: Jack Jones has an AGI $1,097,409, the amount of Mental Health Services Tax on his return will be $974 or $97,409 x 1%. This amount is reported on Line 62 of Form 540. California conforms to the following Federal provisions (using CA amounts) Underpayment Penalties Exceptions Generally, the taxpayer does not have to complete this form. If they owe a penalty, the Franchise Tax Board (FTB) figures the penalty for them and sends a bill after the taxpayer has filed their tax return. The taxpayer must pay the penalty within 15 days of the billing to avoid additional interest charges When figuring the required estimated tax payments, the taxpayer must pay the lesser of 100 percent of last year's tax or 90 percent of the current year's tax. However, a highincome individual must base their estimate tax payments on the following applicable percentages. If adjusted gross income is more than $150,000 ($75,000 if married filing a separate return) in the prior tax year: The required payment is the lesser of 90 percent of their tax for 2013 or 110 percent of their tax for 2012. If adjusted gross income is $1 million or more ($500,000 if married filing a separate 140 R&TC §17043 312 return) in the current tax year: The required payment is 90 percent of their tax for 2013. This rule does not apply to farmers or fishermen. To avoid an estimate penalty, the taxpayer must pay at least 30 percent in the first quarter, 40 percent in the second quarter, 0 percent (zero) in the third quarter, and 30 percent in the fourth quarter. Description Current CodeCode Credit California Motion Picture and Television Production – FTB 3541 Code 223 Description The credit, which is allocated and certified by the California Film Commission, is 20% of expenditures attributable to a qualified motion picture and 25% of production expenditures attributable to an independent film or a TV series that relocates to California. Child Adoption Costs – Worksheet on page 12 197 50% of qualified costs in the year an adoption is ordered Child and Dependent Care Expenses – FTB 3506 See the 232 Similar to the federal credit except that the California credit amount is based on a specified percentage of the federal credit. 209 20% of each qualified deposit made to a community development financial institution Obtain certification from: California Organized Investment Network (COIN), Department of Insurance, 300 Capitol Mall, Suite 1600, Sacramento CA 95814. Website: insurance.ca.gov. Must use married/RDP filing separately status and have a dependent parent instructions on page 57 Community Development Financial Institutions Investments – Certification Required Dependent Parent – See page 12 173 Disabled Access for Eligible 205 Similar to the federal credit but limited to $125 based on 50% of qualified expenditures that do not exceed $250 204 50% of the costs paid or incurred for the transportation of agricultural products donated to nonprofit charitable organizations 224 10% of the donation’s costs for qualified taxpayers who donate fresh fruits or fresh vegetables to a California food bank 203 One third of the similar federal credit and limited to qualified enhanced oil recovery projects located within California. 169 5% of wages from work in an enterprise zone 176 Business incentives for enterprise zone businesses Environmental Tax – FTB 3511 218 Five cents ($.05) for each gallon of ultra low sulfur diesel fuel produced during the taxable year by a small refiner at any facility located in this state First-Time Buyer – Pub. 3549 222 Joint Custody Head of Household – Worksheet on page 12 170 The lesser of 5% of the purchase price of a qualified principal residence or $10,000. The credit is taken equally over three years. 30% of tax up to $409 for taxpayers who are single or married/RDP filing separately, who have a child and meet the support test Local Agency Military Base Recovery Area (LAMBRA) Hiring 198 Business incentives for LAMBRAs Low-Income Housing – FTB 3521 172 Similar to the federal credit but limited to low-income housing in California Manufacturing Enhancement Area (MEA) Hiring – FTB 3808 211 Percentage of qualified wages paid to qualified disadvantaged individuals Natural Heritage Preservation – FTB 3503 213 55% of the fair market value of any qualified contribution of property donated to the state, any local government, or any nonprofit organization designated by a local government New Home (2010) – Pub. 3549 221 The lesser of 5% of the purchase price of a qualified principal residence or $10,000. The credit is taken equally over three years. Small Business – FTB 3548 Donated Agricultural Products Transportation – FTB 3547 Donated Fresh Fruits or Vegetables – FTB 3811 Enhanced Oil Recovery – FTB 3546 Enterprise Zone Employee – FTB 3553 Enterprise Zone Hiring & Sales or Use Tax – FTB 3805Z & Sales or Use Tax – FTB 3807 313 New Jobs – FTB 3527 220 Nonrefundable Renter’s None Other State Tax – Schedule S Prior Year Alternative Minimum Tax – FTB 3510 Description Current CodeCode Credit 187 188 Code Prison Inmate Labor – FTB 3507 162 Research – FTB 3523 183 Senior Head of Household – 163 Worksheet on page 12 Targeted Tax Area (TTA) Hiring & 210 $3,000 allowed for a qualified employer for each increase in qualified fulltime employees hired in the current taxable year. For California residents who paid rent for their principal residence for at least 6 months in 2012 and whose AGI does not exceed a certain limit Net income tax paid to another state or a U.S. possession on income also taxed by California Must have paid alternative minimum tax in a prior year and have no alternative minimum tax liability in 2012 Description 10% of wages paid to prison inmates Similar to the federal credit but limited to costs for research activities in California 2% of taxable income up to $1,251 for seniors who qualified for head of household in 2010 or 2011 and whose qualifying individual died during 2010 or 2011 Business incentives for TTA business Sales or Use Tax – FTB 3809 Ordering of Credits Net tax141 is the basic figure against which credits are applied. Credits are allowed against the net tax in the following order: A. Credits, which do not contain a carryover or refundable provision, except for credits, allowed reducing net tax below the tentative minimum tax.142 Form 540 Schedule P, Part III, Section B. (See example on the following pages) B. Credits, which contain carryover provisions but do not contain refundable provisions except after 2001 credits that may reduce net tax below the tentative minimum tax.143 C. Credits, which contain both carryover and refundable provisions. D. The minimum tax credit allowed. E. Credits that are allowed to reduce net tax below the tentative minimum tax. F. Credits for taxes paid to another state. G. Credits, which contain refundable provisions but do not contain carryover provisions. CA Child and Dependent Care Credit - Form 3506 141 CA Rev & Tax Code § 17504 CA Rev & Tax Code § 17063 143 CA Rev & Tax Code § 17062 142 314 This credit is claimed if taxpayer paid someone to care for their qualifying child under the age of 13, other dependent who is physically or mentally incapable of caring for him or herself, or spouse/RDP if physically or mentally incapable of caring for him or herself. The Child and Dependent Care Expenses Credit is a non-refundable tax credit. The credit is applied against the net tax liability. If the credit exceeds the net tax liability, the excess credit cannot be refunded. The credit is allowed for certain household and dependent care expenses incurred during the year that allowed the taxpayer to seek or maintain gainful employment. The taxpayer qualifies to claim this credit if they meet all of the following for the tax year: The Adjusted Gross Income is less than $100,000.00. They had at least as much earned income as was paid for child or dependent care. The taxpayer has a qualifying individual. A qualifying individual is one of the following: A dependent of the taxpayer who is under 13 years of age and for whom the taxpayer is entitled to a dependent exemption credit. The spouse of the taxpayer, if he or she is physically or mentally unable to care for him or herself. A dependent of the taxpayer who is physically or mentally unable to care for him or herself and for whom the taxpayer was entitled to a dependent exemption credit without regard to the gross income limitation Example: Michael and Janice Goodheart have two children in day care. Both Michael and Janice have earned income. They qualified for the federal Child and Dependent Care Credit on Form 2441. The taxpayer had $2,000 in Dependent Care Benefits in Box 10 of his W-2. The Goodhearts have an itemized receipt from the childcare provider itemizing the $8,000 in childcare expenses. Federal AGI on Line 13 of Form 540 is $79,685. Refer to page two of Form 3506 for the calculations. See the following pages for an example of FTB Form 3506. 315 CA not only requires the name, address, ID Number of the care provider, but the phone number is also required. 316 Other State Tax Credit California allows a credit for taxes paid to another state. The other state’s taxes must have been imposed on income derived from sources within the other state. CA considers the source of compensation for services is in CA or in the other state only to the extent, the services are actually rendered. The majority of the time the credit is taken on the resident return. A CA resident with income from Arizona, Guam, Indiana, Oregon and Virginia take the credit on the other state nonresident return. A CA resident takes any income from any other state or U.S. possession on the CA resident tax return. A CA nonresident where the taxpayer is a resident for Arizona, Guam, Indiana, Oregon and Virginia take the credit on the California nonresident return. A CA nonresident takes any income from any other state or U.S. possession on the other state resident tax return Nonresidents and part-year residents are allowed all credits except the renter’s credit, and a nonresident’s credit for taxes paid in the state of residence, in the same proportion as the ratio used to determine the basis for tax under CA law. When a joint return is filed in California, the entire amount of tax paid to the other state may be used in figuring the credit, regardless of which spouse/RDP paid the other state tax or whether a joint or separate return is filed in the other state. 317 When a joint return is filed in the other state and separate California returns are filed, the credit is allowed in proportion to the income reported on each California return. The definition of double-taxed144 income is for resident taxpayers claiming the credit to reflect only income that would be sourced to California to a nonresident. In other words, they cannot take the credit if the other state taxes the nonresident on the income, but California would not tax a nonresident on the same income. Calculation of Credit: Step 1: Calculate the amount of income taxable by both California and the other state. Typically, they will be the same, although they may vary because of depreciation or other laws Step 2: Calculate a percentage of the double-taxed income taxable by California divided by the California adjusted gross income. The percentage cannot exceed 100%. This percentage is multiplied by the California tax liability. Step 3: Calculate a percentage of the double-taxed income taxable by the other state divided by the other state’s adjusted gross income. The percentage cannot exceed 100%. This percentage is multiplied by the income tax paid to the other state for the same year the income is taxed by California. The credit is the lesser of the results of Step 2 or Step 3. Items excluded from the computation: • Taxes paid to any local government, such as a city or county. • Taxes paid to the federal government. • Taxes paid to any foreign country. • Any tax comparable to California’s alternative minimum tax paid to another state. • Tax on net passive income, built in gains tax, gross income tax, and any special tax paid to another state (S corporation). Example: Jack Perk went to Connecticut for four months to work. He is a resident of CA. He earned $38,000 in Connecticut. Jack’s CA adjusted gross income is $111,790. The $38,000 earned in CT is also taxable to CA since Jack is a resident and CA taxes all income from all source. See CA Schedule S below. 144 R&TC §18001 318 New Jobs Credit - Line 41 and Line 42 Qualified employers who had a net increase of qualified employees during the current taxable year or qualified employers who first commenced business in California during the current taxable year may be eligible to claim this credit. Use form FTB 3527, New Jobs Credit, to determine the amount of the credit available. Enter on line 41 the amount of the credit generated from form FTB 3527, line 18. Answer the following question to determine the amount of the credit the taxpayer can claim. Is the taxpayer required to complete Schedule P (540)? Yes Enter on line 42 the amount of the New Jobs credit claimed from Schedule P (540), Part III. No Use this worksheet to figure the credit. 1. Enter the amount from Form 540, line 35. _____________ 2. Enter the amount from form FTB 3527, line 21 _____________ 3. Enter the smaller of line 1 or line 2 here and on Form 540, line 42 * and form FTB 3527, line 22a _____________ * If the taxpayer has other credits with limited carryovers, they may want to apply those credits first on line 43 through line 45 before claiming the New Jobs credit on line 42. 319 Form 540 – Lines 43, 44 and 45 Qualified senior head of household credit 2% of California taxable income Maximum California AGI of $66,391 Maximum credit of $1,251 Joint custody head of household credit/dependent parent credit 30% of net tax Maximum credit of $409 If, under a joint custody arrangement, a child lives with the custodial parent for more than half the year, the noncustodial parent may be entitled to claim the Joint Custody Head of Household Credit. The noncustodial parent may claim the Joint Custody Head of Household Credit if he or she: Is unmarried and not an RDP on the last day of the tax year; or files a separate return and lives apart from his or her spouse/RDP for the entire year. Maintains his or her home as the main home for a birth child, stepchild, adopted child, or grandchild. Lives with the child for at least 146 days, but not more than 219 days of the tax year. Pays more than half the costs of keeping up his or her home for the year. Possesses one of the following documents that indicates the taxpayer's home was the child's main home for the above period: o A decree of dissolution of marriage or registered domestic partnership. o A decree of legal separation. o A written agreement entered into after a divorce, dissolution of registered domestic partnership, or legal separation proceeding began, but before the final decree was issued. Credit for Dependent Parent The taxpayer may not claim the Credit for Dependent Parent if they are using the single, head of household, qualifying widow(er), or married/RDP filing jointly filing status. The taxpayer can claim this credit only if all of the following apply: o The taxpayer was married/or an RDP at the end of 2012 and used the married/RDP filing separately filing status. o The spouse/RDP was not a member of the household during the last six months of the year. o The taxpayer furnished over one-half the household expenses for the dependent mother or father’s home, whether or not she or he lived in the taxpayer’s home. To figure the amount of this credit, use the worksheet above for the Credit for Joint Custody Head of Household in Form 540 instructions. If the taxpayer qualifies for the Credit for Joint Custody Head of Household and the Credit for Dependent Parent, they can claim only one. Select the credit that will allow the maximum benefit. 320 Credit for Senior Head of Household The taxpayer may claim this credit if they: • Were 65 years of age or older on December 31, 2012.* • Qualified as a head of household in 2010 or 2011 by providing a household for a qualifying individual who died during 2010 or 2011. • Did not have AGI over $66,391 for 2012. * If the taxpayer 65th birthday is on January 1, 2013, they are considered to be age 65 on December 31, 2012. If the taxpayer meets all the conditions listed above, they do not need to qualify to use the head of household filing status for 2012 in order to claim this credit. Use this worksheet to figure this credit using whole dollars only. 1. Enter the amount from Form 540, line 19 …………………………..1. ________ 2. Credit percentage — 2% ……………………………………………2.___x .02__ 3. Credit amount. Multiply line 1 by line 2. Enter the result or $1,251, whichever is less 3. _________ Credit for Child Adoption Costs For the year in which an adoption decree or an order of adoption is entered (e.g., adoption is final), claim a credit for 50% of the cost of adopting a child who was both: • A citizen or legal resident of the United States. • In the custody of a California public agency or a California political subdivision. Treat a prior unsuccessful attempt to adopt a child (even when the costs were incurred in a prior year) and a later successful adoption of a different child as one effort when computing the cost of adopting the child. Include the following costs if directly related to the adoption process: • Fees for Department of Social Services or a licensed adoption agency. • Medical expenses not reimbursed by insurance. • Travel expenses for the adoptive family. Note: This credit does not apply when a child is adopted from another country or another state, or was not in the custody of a California public agency or a California political subdivision. Any deduction for the expenses used to claim this credit must be reduced by the amount of the child adoption costs credit claimed. Use the worksheet below to figure this credit using whole dollars only. If more than one adoption qualifies for this credit, complete a separate worksheet for each adoption. The maximum credit is limited to $2,500 per minor child. 1. Enter qualifying costs for the child ……………………………………1. ___________ 2. Credit percentage — 50% ……………………………………..............2. ____x .50___ 3. Credit amount. Multiply line 1 by line 2. Do not enter more than $2,500 ……………….3. ___________ The allowable credit is limited to $2,500 for 2012. Carry over the excess credit to future years until the credit is used. 321 Line 46 - Nonrefundable Renter's credit145 If the taxpayer was a resident of California and paid rent on property in California, which was their principal residence, they may qualify for this credit. The taxpayer rented the home for at least half of 2012, on property (including a mobile home that the taxpayer owned on rented land) in California, which was the principal residence? This nonrefundable, non-carryover credit for renters is available for: Single or married/RDP filing separately with a California AGI of $36,337 or less. o The credit is $60. Married/RDP filing jointly, head of household or qualifying widow(er) with a California AGI of $72,674 or less. o The credit is $120. This credit is applied against the tax computed on the return after deducting all other credits. Form 540, Page 2 – Special Credits 145 Form 540 Instructions 322 Schedule P, Page 2 323 Mental Health Services Tax146 If the taxable income is more than $1,000,000, the Mental Health Services Tax is computed below: A. Taxable income from Form 540, line 19 . . . . . . . ___________ B. Less . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($1,000,000) _ C. Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ____________ D. Multiply line C by 1% . . . . . . . . . . . . . . . . . . . . . ______.01___ E. Mental Health Services Tax – Enter this amount here and on Form 540, line 35 . . . . . . . . . . . . . . ____________ Interest and Penalties Interest will be charged on any late filing or late payment penalty from the original due date to the date paid. In addition if other penalties are not paid within 15 days, interest will be charged from the date of the billing notice until the date of the payment. Interest compounds daily and the interest rate are adjusted twice a year. Late filing of return: The maximum total penalty is 25% for late filing. The minimum penalty for filing a return more than 60 days late is a $100 or 100% of the balance due, whichever is less. Underpayment of Estimated Tax – If the tax due is $500 or more and more than 20% of the tax shown on line 34 (excluding the tax on lump-sum distribution) or the estimated tax liability is underpaid for any quarter, a penalty may be due. Power of Attorney To obtain information from the Franchise Tax Board for a taxpayer use FTB Form 3520. Form 3520 grants the following: Receive and inspect confidential tax information Represent the taxpayer before the Franchise Tax Board Sign waivers to extend the statutory period for assessment and determination of taxes Execute settlement agreements Execute closing agreements Any specific instructions can be listed Power of Attorney forms do not need to be notarized. The form can be filled out through the FTB website www.ftb.ca.gov. 146 Proposition 63 324 Voluntary Contributions Voluntary contributions can be made in the amount of $1 or any whole dollar amount. The contribution will either reduce the amount of refund or increase the amount due. Voluntary contributions cannot be changed once the return is filed. Fund Names California Seniors Special Fund Alzheimer Disease/Related Disorders Fund California Fund for Senior Citizens Rare and Endangered Species Preservation Program State Children’s Trust Fund for the Prevention of Child Abuse California Breast Cancer Research Fund California Firefighters Memorial Fund Emergency Food for Families Fund California Peace Officer Memorial Fund California Sea Otter Fund Municipal Shelter Spay- Neuter California Cancer Research Fund ALS/Lou Gehrigs Disease Research Fund Child Victims of Human Trafficking Fund California YMCA Youth and Government Fund California Youth Leadership School Supplies for the Homeless Fund State Parks Protection/Park Pass Purchase Fund Use Tax147 California law requires tax on in-state purchases, and also requires tax on items purchased out-of-state for use in California. Recent legislation now requires a “qualified purchaser” under Revenue and Taxation Code section 6225 to be registered with Board of Equalization (BOE) to report and pay use tax owed. Under this legislation, a "qualified purchaser" means a person that meets all of the following conditions: The person receives at least $100,000 in gross receipts from business operations per calendar year. Note: Gross receipts are the total of all receipts from both instate and out-of-state business operations The person is not required to hold a seller's permit or certificate of registration for use tax (under section 6226 of the Revenue and Taxation Code) The person is not a holder of a use tax direct payment permit as described in section 7051.3 of the Revenue and Taxation Code The person is not otherwise registered with the BOE to report use tax Assuming other requirements are met registration applies to: Exempt organizations 147 Revenue and Taxation Code § 6225 325 Owner’s of rental property Schedule C and F filers; and All entities: corporations, partnerships, LLC and trusts The registration is not voluntary. In the first year the businesses must file an annual use tax return even if there is no use tax liability by April 15 of each year to report and pay use tax on untaxed purchases made in the preceding calendar year. When a qualified purchaser registers with the BOE they must file a Use Tax return for the past three years even if there is no tax liability. The extension of time to file that applies to Personal Income Tax does not apply to Use tax. The BOE may grant a one-month extension if the completed Use Tax return is filed with the Request for Extension of Time to File form (BOE-468). An extension is only granted after the BOE reviews the request with the return. In the fall of 2009 the BOE began sending initial contact letters to taxpayers informing them of the new registration and filing requirements, the letters continued through 2011. A business can register in one of two ways File Form BOE-404A; or The BOE may auto register the business based on prior year income tax returns. Even though the taxpayer has reported the use tax liability on their income tax return, as a qualified purchaser under section 6225 of the Revenue and Taxation Code they are required to register with the BOE. SB 86 allows the taxpayer to report use tax for single non-business purchases of $1,000 or less on their FTB return using either: The actual amount of tax due The amount shown on the look-up table, which would indicate an estimated amount of use tax due based on the person,’s AGI. The provision will apply for tax years beginning on or after January 1, 2011. Sales Tax vs. Use Tax: What is the Difference? Tax collected by the retailer here in California is called sales tax, and the retailer is responsible for reporting and paying the tax to the state. When an out-of-state or online retailer does not collect the tax for an item delivered to California, the purchaser may owe "use tax," which is simply a tax on the use, storage, or consumption of personal property in California. Exempt Items Items that are exempt from sales tax are exempt from use tax as well. Use tax liabilities are often created by internet or mail order purchases with out-of-state retailers not required to collect the tax. Be sure to review the receipts for internet and other out-ofstate purchases to determine if tax was charged. 326 Where to Report Use Tax The following taxpayers are required to report purchases subject to use tax directly to the State Board of Equalization and may not report use tax on their income tax return: • Individuals or businesses that have a California seller’s permit. • Businesses that are not required to hold a California sellers permit, but receive at least $100,000 in gross receipts. • Individuals or businesses that have a California consumer use tax account. If the taxpayer is not required to report purchases subject to use tax directly to the State Board of Equalization, they may report use tax on their income tax return. Report and pay any use tax owed on the following purchases directly to the State Board of Equalization, not on the income tax return. • Vehicles, vessels, and trailers that must be registered with the Department of Motor Vehicles. • Mobile homes or commercial coaches that must be registered annually as required by the Health and Safety Code. • Vessels documented with the U.S. Coast Guard. • Aircraft. • Leases of machinery, equipment, vehicles, and other tangible personal property. • Cigarettes and tobacco products when the purchaser is registered with the State Board of Equalization as a cigarette and/or tobacco products consumer. Report purchases of items that would have been taxable if purchased from a California retailer. For example, the taxpayer would include purchases of clothing, but not purchases of prescription medicine. • Include handling charges. • Do not include any other state’s sales or use tax paid on the purchases. • Enter only purchases made during the year that correspond with the tax return that is being filed. • If the taxpayer traveled to a foreign country and carried items back to California, generally the use tax is due on the purchase price of the goods listed on his U.S. Customs Declaration less the $800 per-person exemption. This $800 exemption does not apply to goods sent or shipped to California by mail or other common carrier. • If the filing status is “married/RDP filing separately,” the taxpayer may elect to report one-half of the use tax due or the entire amount on the income tax return. If taxpayer elects to report one-half, the spouse/RDP may report the remaining half on his or her income tax return or on the individual use tax return available from the State Board of Equalization. Failure to report and timely pay may result in the assessment of interest, penalties and fees. Use Tax Worksheet The taxpayer must use the Use Tax Worksheet on the next page to calculate use tax liability, if any of the following apply: 327 The taxpayer prefers to calculate the amount of use tax due based upon the actual purchases subject to use tax. The taxpayer owes use tax on non-business purchases of individual items with a purchase price of $1,000 or more. Use Tax Worksheet See Instructions Below Use whole dollars only. 1. Enter purchases from out-of-state sellers made without payment of California sales/use tax. If you are choosing the option to estimate the use tax due on individual, non-business items purchased for less than $1,000 each, only enter purchases of non-business items with a purchase price of $1,000 or more. ….________.00 2. Enter the applicable sales and use tax rate…………………… ___________ 3. Multiply line 1 by the tax rate on line 2. Enter result here…………………………………………………… ________.00 4. If you are choosing the option to estimate the use tax due on individual, non-business items purchased for less than $1,000 each, enter the use tax amount due from the Use Tax Table. If all of your purchases are included in line 1, enter -0-. ……………________.00 5. Add lines 3 and 4. ………………….This is your total use tax …. ________.00 6. Enter any sales or use tax you paid to another state for purchases included on line 1. See worksheet instructions below …...................$________.00 7. Subtract line 6 from line 5. This is the total use tax due. Enter the amount due on line 95. If the amount is less than zero, enter -0-. $________.00 Estimated Use Tax Table The taxpayer may use the Estimated Use Tax Table to estimate and report the use tax due on individual non-business items purchased for less than $1,000 each, instead of reporting the use tax liability determined using the Use Tax Worksheet. This option is only available if the taxpayer is permitted to report use tax on his income tax return and is not required to use the Use Tax Worksheet to calculate the use tax owed on the purchases of such items. Include the use tax liability that corresponds to the taxpayer’s California Adjusted Gross Income. The taxpayer may not use the Estimated Use Tax Table to estimate and report the use tax due on purchases of items for use in the taxpayer’s business or on purchases of individual non-business items purchased for $1,000 or more each. 328 Adjusted Gross Income (AGI) Range Less Than $10,000 $10,000 to $19,999 $20,000 to $29,999 $30,000 to $39,999 $40,000 to $49,999 $50,000 to $59,999 $60,000 to $69,999 $70,000 to $79,999 $80,000 to $89,999 $90,000 to $99,999 $100,000 to $124,999 $125,000 to $149,999 $150,000 to $174,999 $175,000 to $199,999 Use Tax Liability $ 2 $ 7 $12 $17 $22 $27 $32 $37 $42 $47 $56 $69 $81 $94 More than $199,999 – Multiply AGI by 0.050% Examples Regarding Use Tax 148 The taxpayer purchased a backpacking tent over the Internet from a company in Wyoming. The seller shipped the tent to the taxpayer’s home in California and did not charge any tax. This purchase is subject to use tax. The taxpayer ordered a large novelty basket filled with assorted specialty luncheon meats, cheeses, and crackers from a company based in Wisconsin. Does California use tax apply to this purchase? This purchase is not subject to use tax. Assuming the value of the novelty basket itself is merely incidental to the total value of the product (less than 10 percent of the retail value of the complete package); the taxpayer would not report the purchase of this item. Luncheon meats, cheeses, and crackers are food products and are exempt from sales and use tax. Last week, while visiting relatives in Maine, the taxpayer purchased $200 in stereo equipment for use in his Sacramento, California home. When he purchased the equipment, he was charged five percent Maine sales tax. Does he owe California use tax on this purchase? This purchase is subject to use tax, however,149 the taxpayer is allowed to take a credit for sales or use tax paid to another state. Therefore, a portion of the California use tax owed on the purchase is offset by the sales tax paid to the retailer in Maine. Since the sales and use tax rate in Sacramento at the time of purchase is 8.00%, use tax of $16.00 would be due on the purchase. However, after deducting the $10 in Maine sales tax when the taxpayer purchased the equipment, he would only owe $6.00 in California use tax on the purchase. Note: For each purchase, the taxpayer can only take a credit for sales tax paid to another state up to the amount of California use tax owed on that purchase. If the taxpayer paid an amount in excess of the California use tax due on a purchase, the taxpayer cannot use this additional tax paid to offset the tax due on another transaction. The taxpayer ordered a stove and refrigerator from a company based in New Hampshire. The taxpayer had them ship the items directly to his cabin in Idaho. He planned to install these items in the cabin when he visited there later in the year. 148 149 boe.ca.gov/taxprograms/usetax/requirements.html Revenue and Taxation Code § 6406 329 Does the taxpayer owe California use tax on this purchase? This purchase is not subject to use tax. The California use tax only applies to property used, consumed, given away or stored in this state. Since the stove and refrigerator were never stored or used within California, the taxpayer is not required to report or pay California use tax on this purchase. The taxpayer’s company assigned him to work in Portland, Oregon, for nine months. When he arrived in Portland, he purchased a personal computer and software from a local retailer. Oregon does not have a sales or use tax and he was not charged tax. Does he owe California use tax on the personal computer and software when he returns to California? This purchase is not subject to use tax. The taxpayer would not owe use tax on this purchase since the personal computer was used in Oregon for nine months. Tangible personal property (excluding vehicles, vessels, and aircraft) is not considered to have been purchased for use in this state when: A person uses the item outside of California for more than 90 days after the purchase, exclusive of any shipping or storage time; or A person first uses the item outside of California, brings it back into California within 90 days of purchase, and then uses the item outside of California for more than half the time during the next six months. 330 Chapter 23 Ethics – Federal and California Internal Revenue Code Congress writes the tax laws, which become part of the Internal Revenue Code (IRC). The tax code is amended every year. Congress has given the IRS the power to interpret the tax code through a series of IRS Regulations. These regulations are expanded versions of some tax code provisions with illustrations of how the law is applied in different situations. The regulations are about four times the length of the tax code itself. The IRS also publishes revenue rulings, revenue procedures, and letter rulings, as well as publications and instructions, which provide guidance in much the same manner as the regulations The IRS does not have the final say on interpreting the tax code. The federal court system composed of the U.S. Tax Court, federal district courts, the U.S. Court of Federal Claims, and U.S. bankruptcy courts, all have the power to decide, on a case-by-case basis, how Congress intended the tax laws to be applied. And if more than $50,000 is at stake, a taxpayer can appeal a tax court decision to a circuit court of appeal and in rare cases to the U.S. Supreme Court Our objective in this course is to show practical examples and court case decisions, which will show the practitioner a clear view of the ethics, discussed in these examples. Circular 230 The Treasury Department Circular 230 (Revised 8-2011) is the Regulations Governing Practice before the Internal Revenue Service. A copy of these new regulations can be found on the IRS website. Circular 230 is sometimes an incredibly complex document that addresses a broad range of topics. Treasury and the IRS have consistently maintained that tax practitioners must meet minimum standards of conduct and those who do not should be subject to disciplinary action, including suspension or disbarment. PTIN Beginning January 1, 2011, all paid preparers must have a Preparer Tax Identification Number (PTIN) before preparing returns. Tax Preparers can sign up for their PTIN online or by paper application. It costs $64.25. 150 Renewal cost is $63 per year and most preparers can renew online. Preparers who applied for their PTINs on paper will be able to renew either online or on paper. District Court Injunction On Friday, Jan. 18, 2013, the United States District Court for the District of Columbia enjoined the Internal Revenue Service from enforcing the regulatory requirements for registered tax return preparers. In accordance with this order, tax return preparers covered 150 www.irs.gov/taxpros 331 by this program are not required to complete competency testing or secure continuing education. The ruling does not affect the regulatory practice requirements for CPAs, attorneys, enrolled agents, enrolled retirement plan agents or enrolled actuaries. The case which was brought in U.S. District Court for the District of Columbia (Loving et al, 2013-1 USTC §50156). This case can be found online at the Government Printing Office151. The case is very interesting and should be read to have a clear understanding of the ruling. On Friday, February 1, the Court modified the order from Jan. 18th through a Memo Opinion filed in which the Court refused to stay its injunction and clarified the specifics of the injunction. The Injunction was modified to make it clear that the IRS is not required to suspend its PTIN program. A PTIN is required by statute not by regulation that is what allows the PTIN program to continue. Before the Loving case the PTIN was conditional upon testing and continuing education. The PTIN program now allows the tax preparer to receive a PTIN if they pay the fee they with no other conditions. In the Memo mentioned above, a meeting TaxEase has attended with IRS representatives, as well as group conference calls with IRS officials it is clear that mandatory required continuing education for the time being is gone. The designation of “RTRP” is also gone, but voluntary continuing education is allowed and encouraged. One item the memo from the Court of Appeals clearly states is that Congress specifically authorized the use of the Preparer Tax Identification Number (PTIN); therefore, the requirements for all tax professionals to obtain and use a PTIN continue. This means the IRS cannot require a preparer must pass the RTRP exam before obtaining a PTIN; however, they can require all those who prepare tax returns for compensation must obtain and use a PTIN. The IRS has indicated whenever TaxEase has been in contact with them and through releases of information that they have confidence in the appeal process and are awaiting the result. Tax professionals have differing levels of skills, education and expertise. There also are several different types of credentials. For 2013, any tax professional with an IRS Preparer Tax Identification Number is authorized to prepare federal tax returns. An important difference in the types of practitioners is “representation rights”. Here is guidance on each credential: UNLIMITED REPRESENTATION RIGHTS: Enrolled agents, certified public accountants, and attorneys have unlimited representation rights before the IRS this means they may represent their clients on any matters including audits, payment/collection issues, and appeals. 151 www.gpo.gov/fdsys/granule/USCOURTS-dcd-1_12-cv-00385/USCOURTS-dcd-1_12-cv-003851/content-detail.html 332 Enrolled Agents – People with this credential are licensed by the IRS and specifically trained in federal tax planning, preparation and representation. Enrolled agents hold the most expansive license IRS grants and must pass a suitability check, as well as a three-part Special Enrollment Examination, a comprehensive exam that covers individual tax, business tax and representation issues. An EA is required to complete 72 hours of continuing education every 3 years. This must be done by obtaining a minimum of 16 hours of continuing education (including 2 hours of ethics or professional conduct) each year. For more information on enrolled agents, see Publication 4693-A, A Guide to the Enrolled Agent Program. Certified Public Accountants – People with this credential (unlike Enrolled Agents) are licensed by state boards of accountancy, the District of Columbia, and U.S. territories, and have passed the Uniform CPA Examination. They also must meet education, experience, and good character requirements established by their boards of accountancy. In addition, CPAs must comply with ethical requirements as well as complete specified levels of continuing education in order to maintain an active CPA license. CPAs can offer a range of services; some CPAs specialize in tax preparation and planning. Attorneys – People with this credential are licensed by state courts or their designees, such as the state bar. Generally, requirements include completion of a degree in law, passage of an ethics and bar exam and on-going continuing education. Attorneys can offer a range of services; some attorneys specialize in tax preparation and planning. LIMITED REPRESENTATION RIGHTS: Preparers without any of the above credentials have limited practice rights and may only represent clients whose returns they prepared and signed and only at the initial audit level. NOTE: Registered Tax Return Preparers – Certain preparers became RTRPs under an IRS program that IRS is no longer able to enforce due to a District Court injunction. RTRPs passed an IRS competency test based on Form 1040 tax preparation. REMINDER: Everyone described above must have an IRS issued Preparer Tax Identification Number (PTIN) in order to legally prepare your tax return for compensation. All preparers should be sure to enter their PTIN on every return. 333 Practical Examples Practical Example 1: A first-time client comes in to your office for you to prepare their 2012 tax return. He supplies you with his W-2’S, 1099’s, Mortgage Interest Statement and a Brokers Statement. You verify his prior year information on his 2011 tax return he supplied and then begin to review his documents. While reviewing his documents you notice that the Brokers statement is from 2011 not 2012, furthermore you notice that there is a sale of stock and some interest on this statement that was not reported in 2011. You discuss the omission with the client, he tells you he opened the account in 2011 and noted he bought and sold some stock and had a gain on the sales of $2500. You advise the client to amend the 2011 return as soon as possible. After further discussion the client decides he would rather wait for the IRS to contact him and he does not want you to amend the prior year return. § 10.21 Knowledge of Client’s Omission The action taken in the above example is in accordance with § 10.21 Knowledge of Client’s Omission from Circular 230, it states that the preparer must advice the taxpayer immediately of any error or omission discovered in a tax return. A discussion of the remedy, which in this case would be the amending the 2011 return and the interest and penalties that may occur should be done immediately. Amended returns are sometimes confusing to a taxpayer, it is important that they understand all income from all sources should be reported on a return and as a preparer you believe the best course of action is the amended return. It is the decision of the taxpayer how to proceed and not to amend this return and the preparer must abide by that decision, even if they do not agree. Circular 230 does not require the preparer to inform the IRS of the omission NOTE: Although it is not required, if a taxpayer does not amend or correct an error or omission, it is recommended that the preparer advises the client in writing and notations be made in the file. In this example you advise the client that they must provide the Broker statement for 2012 before you can complete the return for the current year. Due Diligence152 There is no exact set of standards a tax preparer must apply in preparing a tax return. When a tax return is completed and ready for submission to the IRS, the taxpayer and the preparer signs a declaration. The declaration for the preparer includes the following “Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge153”. under penalties of perjury that the return is—to the best of the knowledge and belief—true, correct, and complete. A fundamental portion of preparer regulations has to do with the concept of reliance by the preparer. The general rule is that the preparer may rely in good faith and without verification upon information furnished by the taxpayer. The preparer is not required to 152 § 10.22 Diligence as to Accuracy 153 IRS 2012 Form 1040 334 audit, examine, or review books and records, business operations, documents, or other evidence to independently verify information provided by the taxpayer; however, the preparer may not ignore the implications of information furnished by the taxpayer. The preparer must make reasonable inquiries if the information as furnished appears to be incorrect or incomplete.154 Practical Example 2 It is the customary practice of your office to mail out tax organizers at the beginning of tax season to all of your clients. You request that they complete the organizer and return it to you, when they come in for their interview. Mr. Johnson came for his appointment and as is previous years he brought his completed organizer. You reviewed a series of questions that the tax software includes and asked a few questions you had notes on from the prior year. You then review his documents. Everything was complete and you kept a copy of his W-2. In reviewing his organizer he had all the same interest and dividends as in previous years, he did supply the 1099-INT or DIV and had answered the question that he had not sold any stock during the year. You completed the return and he came in the office the next week reviewed the return and signed Form’s 8879. A few months after filing the return he got a CP2000 from the IRS regarding missing dividends. You checked his organizer and everything seemed to be in order. You call Mr. Johnson and he says in December 2011 he purchased several additional shares of stock through E-trade, he had arranged for the dividends to be reinvested and the 1099-DIV is in his E-trade account and not with his other stock holdings. You advise him to pay the amount as soon as possible. As the preparer of the return you exercised due diligence by relying on his complete organizer and the interview. A definition of “due diligence” suggests for the purpose of tax preparation means the diligence or care that a reasonable tax return preparer would use under the same circumstances. While court cases relating to disciplinary or malpractice actions against preparers often refer to a preparer’s due diligence, they do not appear to define the term in any manner that is unique to tax preparers. 10.22 (b) of Circular 230 discusses that a practitioner would have exercised due diligence if the practitioner used reasonable care in evaluating the other practitioner and the work product they supplied. Practical Example 3 For many years you have rented an office in a small building that also has offices for another tax preparer, a chiropractor, and an attorney. Many times over the years the other preparer has asked for your assistance on some tax return issues and you have also asked his advice to determine if the issue on a particular return was being handled properly. He called your office on March 30th and indicated that he had 10 returns where he had done the interview and had completed the work papers (all information had been submitted), since we used the same software company, he asked if I would finish the returns sign them and answer any questions the taxpayer’s may have when they came to pickup the return. He contacted the clients, got permission to give me the information and 154 §6694 1(e)1 335 delivered the returns. I completed the returns, the work papers were complete, only one of the taxpayer has had any additional questions, which I noted in the file. Using my colleagues work papers met the standards for due diligence. Note: I could not have assisted my colleague with these returns if he had been under disbarment or suspension from practice before the Internal Revenue Service. A tax practitioner cannot accept assistance from or assist any person who is under disbarment or suspension if the assistance relates to a matter or matters constituting practice before the Internal Revenue Service. I could not have relied on his work papers; that would not have met the due diligence standard as described in §10.24. Practical Example 4 A client comes to your office when you are unavailable; he has a packet of documents, which he asks your secretary to give you. Your secretary asks the client if she can make an appointment for him to come in for his interview. He says the packet of documents should be sufficient and would like you to prepare the return from those documents. When you review the documents, you realize he had not completed the organizer and he did not have any interest or dividend statements in the package, which he did report in the previous year. You call him and he instructs you to prepare the return without that income, he fears he may owe tax and he will amend have you amend the return later. After a discussion regarding reporting all income. He says he will make an appointment soon, but he would like to pick up his documents and review them. According to Circular 230 § 10.28, at the request of a client, a tax preparer 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 to a client. Records of the client include: All documents or written or electronic materials provided to the practitioner, or obtained by the practitioner in the course of the practitioner’s representation of the client, that pre-existed the retention of the practitioner by the client. The documents include materials that were prepared by the client at any time and provided to the practitioner for tax preparation. Also included is any return, claim for refund, schedule, affidavit, appraisal or any other document prepared by the practitioner, or his or her employee or agent that was presented to the client with respect to a prior representation if such document is necessary for the taxpayer to comply with current Federal tax obligations. Practical Example 5: A client in prior years has mailed their tax organizer and all pertinent and required documents to your office for preparation of their tax returns, the client picked up and reviewed the tax return and signed Form 8879 for electronic filing. No payment was received at that time. Being a returning client you go ahead and electronically file his return. Even though you contacted the client many times that he never paid his fee. 336 This year, in late March, he sent in his documents and a letter of instruction asking you to complete the return as soon as possible, but there was no payment for the prior year return. You call the client and he feels the fee you charged in the prior year was too high and he does not intend to pay all of it and wants you to complete this year’s return and then discuss the matter. Since this is not your firms policy and you clearly explained that to the client, with no resolution, his documents and notes should be returned so he can meet the filing deadline. The fee dispute for the prior year should be handled separately. According to Circular 230 §10.28 the existence of a dispute over fees generally does not relieve the practitioner of his or her responsibility to return documents to the taxpayer. Nevertheless, if applicable state law allows or permits the retention of a client’s records by a practitioner in the case of a dispute over fees for services rendered, the practitioner need only return those records that must be attached to the taxpayer’s return. The practitioner, however, must provide the client with reasonable access to review and copy any additional records of the client retained by the practitioner under state law that are necessary for the client to comply with his or her Federal tax obligations. NOTE: A tax organizer prepared by the preparer and completed by the client is considered material prepared by the client and should be returned to the client in a fee tax dispute. Practical Example 6: For many years you have completed the joint tax return for Mr. Jones and Mrs. Jones. Much to your surprise they came to your office together, but they told you they have not lived together since May. They are not legally separated or divorced; they want to file as married filing separate. After a discussion with the Jones you realize they have some disagreements over their holdings and even though they are willing to waive any conflict of interest, you do not feel you can represent both of them to the best of your ability, Mrs Jones decides to retain another preparer, you provide her with a copy of the prior year return and complete the return with Mr. Jones. Conflict of Interest According to §10.29 a conflict of interest exists if the representation of one client will be directly adverse to another client (which in the circumstance above would be the case); or The tax preparer could represent the taxpayer, if — (1) The tax preparer reasonably believes that they will be able to provide competent and diligent representation to each affected client; (2) The representation is not prohibited by law; and (3) Each affected client waives the conflict of interest and gives informed consent, confirmed in writing by each affected client, at the time the existence of the conflict of interest is known by the practitioner. The confirmation may be made within a reasonable period of time after the informed consent, but not later than 30 days. Copies of the written consents must be retained by the practitioner for at least 36 months from the date of the conclusion of the representation of the affected clients, and the written consents must be provided to any officer or employee of the Internal Revenue Service on request. 337 Practical Example 6: A new client comes to your office and you prepare his tax return. After the preparation of the return, he tells you he has some stock he wants to sell in the current year and wants to know about the tax he may have to pay. He anticipates a gain of about $10,000. You had reviewed his prior year return and correctly picked up a $9,500 capital loss carryover. $3,000 of that loss was used on the return that you just prepared. You explain to him that he can use his carryover loss to offset $6,500 of his gain and the remainder would be taxed at 15% with his income. He then tells you that he would be willing to pay you for some advice on which stock he should buy and asks you to do some research on three different stocks. You do not accept his offer and explain that this kind of research is not directly related to the preparation of the tax return. Circular 230 §10.3(f)(3) the latest clarification from the IRS of this section suggests that tax return preparers are allowed to provide advice to a client that is reasonably necessary to prepare a tax return, claim for refund, or other document intended to be submitted to the Internal Revenue Service for a current or future tax period, regardless of whether the client has engaged the registered tax return preparer to prepare the tax return, claim for refund or other document for the tax period. In the example above the advice would not be related to a document intended to be submitted to the IRS. § 10.30 Solicitation (a) Advertising and solicitation restrictions. (1) A practitioner may not, with respect to any Internal Revenue Service matter, in any way use or participate in the use of any form of public communication or private solicitation containing a false, fraudulent, or coercive statement or claim; or a misleading or deceptive statement or claim. Enrolled agents, enrolled retirement plan agents, or registered tax return preparers, in describing their professional designation, may not utilize the term “certified” or imply an employer/employee relationship with the Internal Revenue Service 338 Practical Example 5: According to the Office of Professional Responsibility the majority of sanctions on preparers have been for failure to file their own tax returns Circular 230 §10.50 and §10.51 state that incompetence and disreputable conduct for which a practitioner may be sanctioned includes willfully not filing a Federal tax return and filing a Federal income tax return in an untimely manner. This section pertains to tax preparers as well as taxpayers. It is important that tax preparers who understand the tax rules as interpreted by the IRS follow them. Below is a chart from OPR V. Timothy L Baldwin Complaint No. 2010-08: Final Decisions The following website gives many examples of CPA’s, Attorneys, EA’s and Tax Return Preparers who have been sanctioned or disbarred from practice through cases brought by the Office of Professional Responsibility http://www.irs.gov/Tax-Professionals/Enrolled-Actuaries/Final-Agency-Decisions 339 Disclosure Internal Revenue Code §7216 On January 1, 2009, tax return preparers became subject to many additional rules regarding the use and disclosure of their clients’ tax return information. These new rules and restrictions create everyday problems by complicating a tax preparer’s ability to use or disclose return information. Basically these changes made it very difficult for any tax preparer to share tax return information with anyone other than the IRS without obtaining a clients consent. Disclosure regulations under Internal Revenue Code Section 7216 became effective January 1, 2009. The regulations give taxpayers greater control over their personal tax return information. The statute limits tax return preparers’ use and disclosure of information obtained while preparing a taxpayer’s return to activities directly related to the preparation. The regulations describe how preparers, with the informed written consent of taxpayers, may use or disclose return information for other purposes. The regulations also describe specific and limited exceptions that allow a preparer to use or disclose return information without the consent of taxpayers. Consents to disclose or a taxpayer’s tax return information – paper or electronic – must contain certain specific information. Every consent form must include: Tax preparer name and the taxpayer’s name The nature of the disclosure and intended purpose To whom the disclosures will be made Details on the information being disclosed The particular use authorized The product or service for which the tax return information will be used. Expansion of the definition of “return preparer” The new rules apply only to “return preparers.” Tax return preparers for this purpose are defined as persons who participate in the preparation of tax returns for taxpayers. These include, but are not limited to: Return preparers who are in business or hold themselves out as preparers. Casual preparers who are compensated for their services E-file providers Electronic return originators and electronic return transmitters Intermediate service providers Software developers Reporting Agents The definition of a “return preparer” also now extends to those who assist you in preparing returns, such as a tax preparers' employees who perform services in connection with the preparation of a tax return, and those individuals outside the office who perform services in connection with the preparation of return. 340 Revenue Procedure 2013-14155 Refer to the Appendix in this publication for a complete copy of Rev Proc. 2013-14. This Rev. Proc supercedes and modifies the rules issued in 2008-35 (effective Jan 14, 2013) The IRS has provided guidance to tax return preparers about the format and content of taxpayer consents to disclose and consents to use tax return information and modified the mandatory language required on each taxpayer consent. The guidance applies to individuals filing a return in the Form 1040 series. The revenue procedure also lists specific requirements for electronic signatures when a taxpayer executes an electronic consent to the disclosure or consent to the use of the taxpayer’s tax return information. In the revenue procedure, the IRS says that some taxpayers have expressed confusion over whether they must complete consent forms to engage a tax return preparer to perform tax return preparation services. The modified mandatory language required in consent forms clarifies that a taxpayer does not need to complete a consent form to engage a tax return preparer to perform only tax return preparation services. One example in the revenue procedure provides that if a tax return preparer makes provision of tax preparation services contingent on the taxpayer’s signing a consent, the consent is not valid because it is not voluntary. However, a taxpayer must complete a consent form as described in the revenue procedure to allow a tax return preparer to disclose or use tax return information in providing services other than tax return preparation. Sec. 7216 prohibits a tax return preparer from “knowingly or recklessly” disclosing or using tax return information. A violation could result in a preparer’s being charged with a criminal misdemeanor, involving a maximum penalty of $1,000 or one year in prison, or both, plus costs of prosecution Under the revenue procedure, each separate consent to disclosure or use of tax return information must be contained on a separate written document (either paper or electronic). The separate written document may be provided as an attachment to an engagement letter furnished to the taxpayer. The revenue procedure prescribes the required paper size and font size for consents on paper. For electronic consents, the revenue procedures requires the consent to appear on its own screen, prescribes the text size, and says there must be sufficient contrast between the text and background colors. The revenue procedure provides mandatory statements that must be included in a consent in various circumstances, including: 1. Consent to disclose tax return information in a context other than tax return preparation or auxiliary services; 2. Consent to disclose tax return information in the context of tax return preparation or auxiliary services; and 3. Consent to use tax return information. 155 Appendix Rev Proc 2013-14 341 All consents must also contain the following statement: If the taxpayer believes the tax return information has been disclosed or used improperly in a manner unauthorized by law or without their permission, they may contact the Treasury Inspector General for Tax Administration (TIGTA) by telephone at 1-800-3664484, or by email at complaints@tigta.treas.gov. The revenue procedure also provides mandatory language to be included in any consent to disclose tax return information to a tax return preparer located outside the United States. All consents must require the taxpayer’s affirmative consent to a tax return preparers' disclosure or use of tax return information. An “opt-out” consent, which requires the taxpayer to remove or deselect disclosures or uses that the taxpayer does not wish to be made, is not permitted. For an electronic consent to be valid, it must be furnished in a manner that ensures the taxpayers' affirmative, knowing consent to each disclosure or use. All consents to disclose or use tax return information must be signed by the taxpayer. For consents on paper, the taxpayer’s consent to a disclosure or use must contain the taxpayer’s handwritten signature. For electronic consents, a taxpayer must sign the consent by any method prescribed in Rev. Proc. 2013-14. (See Appendix) A tax return preparer may not alter a consent form after the taxpayer has signed the document; therefore, a tax return preparer cannot present a taxpayer with a consent form containing blank spaces for the purpose of completing the spaces after the taxpayer has signed the document. Practical Example 6: The taxpayer does not send a consent form to a taxpayer's retirement administrator when a draft of the taxpayer's Schedule C has to be sent to the administrator to determine the amount of retirement contribution that can be made by the taxpayer? The tax preparer did not meet any of the exceptions. Disclosure of tax return information to a taxpayer’s retirement administrator does not fit within any of the exceptions under the second revised regulation (301.7216-2) to the requirement of prior written consent. Accordingly, the taxpayer should have a signed consent form before making the disclosure Practical Example 7 : A clients email to his preparer reads: “I'm in the process of refinancing my home loan, and if the mortgage company calls, please provide him with whatever he needs”, should I require the client to send this in writing? The tax preparer prints the email and puts it in the clients file. When the mortgage lender calls a week later the preparer gives the information he requests. The preparer did not meet the requirements of §7216 or Rev Proc 2013-14. The preparer should have gotten the appropriate consent form and provide it to the taxpayer-client for signature. The preparer should not provide any tax return information to the third party 342 until he received the signed consent form from the client. A letter, email, or note is not sufficient. Adequate data protection safeguards A tax return preparer located within the United States, including any U.S. territory or possession, may disclose a taxpayer’s Social Security number to a tax return preparer located outside the United States or any U.S. territory or possession with the taxpayer’s consent only when both the tax return preparer located within the United States and the tax return preparer located outside the United States maintain an “adequate data protection safeguard” at the time the taxpayer’s consent is obtained and when making the disclosure. The revenue procedure describes an adequate data protection safeguard as a management-approved and implemented security program, policy, and practice that includes administrative, technical, and physical safeguards to protect tax return information from misuse, unauthorized access, or disclosure and that meets or conforms to one of the data security frameworks described in the revenue procedure. Electronic signatures 1. For electronic consents, the tax return preparer must obtain the taxpayer’s signature on the consent in one of the following ways: 2. Assign a personal identification number (PIN) that is at least five characters long to the taxpayer. 3. Have the taxpayer type in the taxpayer’s name and then hit “enter” to authorize the consent. (The software must not automatically furnish the taxpayer’s name so that the taxpayer only has to click a button to consent.) Any other manner in which the taxpayer affirmatively enters five or more characters unique to the taxpayer that the tax return preparer uses to verify the taxpayer’s identity. PENALTIES The new rules have criminal as well as civil penalties that can apply. Further, violations can be sanctioned by restriction on a practitioner’s right to practice before the IRS. A civil penalty is imposed under Code Sec. 6713(a) for unauthorized disclosures or uses of information furnished in connection with the preparation of an income tax return. The penalty for violating Code Sec. 6713 is $250 for each disclosure or use, not to exceed a total of $10,000 for a calendar year. Code Sec. 7216 imposes a criminal penalty on tax return preparers who knowingly or recklessly make an unauthorized use or disclosure of tax return information provided to them in connection with the preparation of an income tax return. A maximum $1,000 fine or imprisonment of no more than one year, or both, may be imposed for each violation. 343 § 10.27 - Fees. (a) In general. A practitioner may not charge an unconscionable fee in connection with any matter before the Internal Revenue Service. (b) Contingent fees —(1) Except as provided in paragraphs (b)(2), (3), and (4) of this section, a practitioner may not charge a contingent fee for services rendered in connection with any matter before the Internal Revenue Service. (2) A practitioner may charge a contingent fee for services rendered in connection with the Service’s examination of, or challenge to — (i) An original tax return; or (ii) An amended return or claim for refund or credit where the amended return or claim for refund or credit was filed within 120 days of the taxpayer receiving a written notice of the examination of, or a written challenge to the original tax return. (3) A practitioner may charge a contingent fee for services rendered in connection with a claim for credit or refund filed solely in connection with the determination of statutory interest or penalties assessed by the Internal Revenue Service. (4) A practitioner may charge a contingent fee for services rendered in connection with any judicial proceeding arising under the Internal Revenue Code. (c) Definitions. For purposes of this section — (1) Contingent fee is any fee that is based, in whole or in part, on whether or not a position taken on a tax return or other filing avoids challenge by the Internal Revenue Service or is sustained either by the Internal Revenue Service or in litigation. A contingent fee includes a fee that is based on a percentage of the refund reported on a return, that is based on a percentage of the taxes saved, or that otherwise depends on the specific result attained. A contingent fee also includes any fee arrangement in which the practitioner will reimburse the client for all or a portion of the client’s fee in the event that a position taken on a tax return or other filing is challenged by the Internal Revenue Service or is not sustained, whether pursuant to an indemnity agreement, a guarantee, rescission rights, or any other arrangement with a similar effect. (2) Matter before the Internal Revenue Service includes tax planning and advice, preparing or filing or assisting in preparing or filing returns or claims for refund or credit, and all matters connected with a presentation to the Internal Revenue Service or any of its officers or employees relating to a taxpayer’s rights, privileges, or liabilities under laws or regulations administered by the Internal Revenue Service. Such presentations include, but are not limited to, preparing and filing documents, corresponding and communicating with the Internal Revenue Service, rendering written advice with respect to any entity, transaction, plan or arrangement, and representing a client at conferences, hearings, and meetings. Sanctions for the Violation of Regulations §10.50 Sanctions Code §10.50 gives the OPR the authority to censure, suspend or disbar any practitioner from practice before the IRS, if they fail to comply with the conduct of standards. Monetary penalties may also be assessed to individuals and/or firms who violate these provisions. 344 Circular 230, SubChapter C §10.51- Incompetence and disreputable conduct. The following is an overview of §10.51 Incompetence and disreputable conduct for which a practitioner may be sanctioned, but is not limited to — Conviction of any criminal offense under the Federal tax laws. Giving false or misleading information to the Department of the Treasury or any officer or employee or facts or other matters contained in Federal tax returns, financial statements and any other document or statement, written or oral, are included in the term “information.” Failing to file a Federal tax return in violation of the Federal tax laws, or willfully evading or attempting to evade any assessment or payment of any Federal tax. Assisting, counseling, encouraging a client in violating, or suggesting to a client or prospective client to violate, any Federal tax law, or knowingly counseling or suggesting to a client or prospective client an illegal plan to evade Federal taxes or payment. Tax Law Case 10-243 - USA v. Mobley Tax preparer Alice Mobley, paid $10 to $20 per person to a friend to gather social security numbers to fraudulently use on tax returns. Those selling their information were paid $500 for adult numbers and $600 for childrens’ numbers. Mobley’s Preyear Tax and Check Cashing in Atmore, Mobley’s home and other business locations were raided by federal agents on March 4, 2010. Investigators found complete identification information on 536 people, including Social Security cards, Medicaid cards and other documents. Mobley also “split” dependents, using the identity of some children on one return to obtain Earned Income Credit, and on other returns to obtain Child Credit and Dependent Care Credits. Mobley’s firm also prepared returns, which claimed business tax deductions for business, which did not exist and farm tax deductions for clients who did not have farms. Failure to properly or promptly remit funds received from a client for the purpose of payment of taxes. Directly or indirectly attempting to influence the official action of any officer or employee of the Internal Revenue Service. Disbarment or suspension from practice. Knowingly aiding and abetting another tax professional to practice before the Internal Revenue Service during a period of suspension or disbarment. Giving a false opinion, knowingly, recklessly, or through gross incompetence, including an opinion which is intentionally or recklessly misleading. Failing to sign a tax return when the signature is required. Disclosing or otherwise using a tax return or tax return information in a manner not authorized by the Internal Revenue Code. 345 Failing to file on magnetic or other electronic media a tax return prepared by the practitioner when the practitioner is required to do so by the Federal tax laws unless the failure is due to reasonable cause and not due to willful neglect. Preparing or signing a tax return or claim for refund when the practitioner does not have a valid preparer tax identification number (PTIN) or other prescribed identifying number. Form 8275 Form 8275 is used by taxpayers and tax return preparers to disclose items or positions, except those taken contrary to a regulation, that are not otherwise adequately disclosed on a tax return to avoid certain penalties. The form is filed to avoid the portions of the accuracy-related penalty due to disregard of rules or to a substantial understatement of income tax for non-tax shelter items if the return position has a reasonable basis. It can also be used for disclosures relating to preparer penalties for understatements due to unreasonable positions or disregard of rules and the economic substance penalty.156 Form 8275 is designed to help the preparer and the taxpayer be thorough and careful regarding the information disclosed on the return. In every audit the IRS examiner addresses the question of whether preparer penalties apply. Not all preparers are aware of this form or should use this form. The fastest way to get to the attention of the IRS Office of Professional Responsibility is for a tax preparer is not to file their own return along with those who take improper positions on tax returns, or have patterns of conduct consistent with those positions. A preparer who files a return or claim for refund is subject to a penalty in an amount equal to the greater of $1,000 or 50 percent of the income derived by the tax return preparer, with respect to the return or claim, for taking a position which the preparer knew or reasonably should have known would understate any part of the liability if there is or was no substantial authority for the position. The penalty will not apply if it can be shown that there was reasonable cause for the understatement and that the preparer acted in good faith. Return Preparer Penalties Under IRC Section 6694 1. The definition of a tax return preparer for purposes of Sections 6694 and 6695 is provided in IRC 7701(a) (36) and Treasury Regulation 301.7701-15. 2. IRC 6694 penalties can only apply if there is an understatement of tax liability. 3. The IRC 6694(a) penalty is the greater of $1,000 or 50% of the income derived (or to be derived) by the tax return preparer with respect to each return, amended return or claim for refund prepared if there is an understatement on the return or claim due to an unreasonable position taken on the return or claim that the preparer knew or reasonably should have known about. A position is unreasonable if: A. There was not substantial authority for the position and the position was not disclosed. 156 Form 8275 instructions 346 4. 5. 6. 7. B. The position was disclosed but there was not reasonable basis for the position. C. The position is with respect to a tax shelter or reportable transaction under IRC 6662A and it is not reasonable to believe the position will be more likely than not sustained on the merits. See Notice 2009-5. Refer to IRM 20.1.6.4.10 for tax shelters and reportable transactions to which IRC 6662A applies. The IRC 6694(b) penalty is the greater of $5,000 or 50% of the income derived (or to be derived) by the tax return preparer with respect to returns, amended returns, and claims for refund prepared after May 25, 2007. The penalty may be imposed against a tax preparer if: A. There is an understatement of liability, on a return or claim for refund prepared by the preparer, which is due to a willful attempt in any manner to understate the tax liability by the preparer, or B. The preparer has recklessly or intentionally disregarded rules or regulations. Reduce the IRC 6694(b) penalty by the amount of the IRC 6694(a) penalty if both the IRC 6694(a) and (b) penalties are asserted against the preparer on the same return or claim. Because the IRC 6694(b) penalty involves willfulness, there is no statutory period for assessment of this penalty. On all other tax return preparer penalties, the three year statute of limitations for assessment begins to run on the statutory due date of the return or, if filed late, the filing date of the return. The statute of limitations on assessment for the section 6694(a) and 6695 penalties may be extended using a Form 872-D, Consent to Extend the Time on Assessment of Tax Return Preparer Penalty. IRC 6696(d) addresses periods of limitation. Refer to IRM 20.1.6.4, IRC 6694 Understatement of Taxpayer's Liability by Tax Return Preparer, for additional information. Preparer Penalties Under IRC Section 6695 1. The return preparer penalties under IRC 6695 are assessed against preparers who: A. Fail to provide the taxpayer with a copy of the return, $50 per failure per IRC 6695(a), B. Fail to sign the return, $50 per failure per IRC 6695(b), C. Fail to provide an identifying number, $50 per failure per IRC 6695(c), D. Fail to retain a copy of the return or a list of returns prepared, $50 per failure per IRC 6695(d), E. Fail to provide file correct information returns, $50 per failure per IRC 6695(e), F. Negotiate a refund check or misappropriate a refund via electronic means, $500 per failure per IRC 6695(f), or G. Fail to be diligent in determining eligibility for the Earned Income Tax Credit, $500 per failure per IRC 6695(g). 2. These penalties are generally processed under the pre-assessment penalty procedures. In cases where any part of the understatement of the liability is due to a willful attempt by the return preparer to understate the liability, or if the understatement is due to reckless or 347 intentional disregard of rules or regulations by the preparer, the preparer is subject to a penalty equal to the greater of $5,000 or 50 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim. This penalty shall be reduced by the amount of the penalty paid by such person for taking an unreasonable position, or a position with no reasonable basis. For purposes of the substantial understatement portion of the accuracy-related penalty, items that meet the requirements of a periodically updated revenue procedure are considered adequately disclosed on the return without filing Form 8275. Exception to filing Form 8275. Guidance is published annually in a revenue procedure in the Internal Revenue Bulletin157. The revenue procedure identifies circumstances when an item reported on a return is considered adequate disclosure for purposes of the substantial understatement aspect of the accuracy-related penalty and for avoiding the preparer's penalty relating to understatements due to unreasonable positions. Practical Example 8: Generally, the requirements of Rev. Proc. 97-56, 1997-52 I.R.B. 18 are met for adequate disclosure of a charitable contribution deduction if the preparer completes the contributions section of Schedule A, and the taxpayer supplies all required information. If the taxpayer makes a contribution of property other than cash, valued at $500 or more, Form 8283 must also be attached to the return. As stated above, preparers are now exposed to risk when signing tax returns. Preparers must therefore carefully review the penalty sections of the code and regulations.158 There are many questions regarding whether using Form 8275 may increase the chance of an audit. IRS officials say that inclusion of this form does not increase the chance of audit. Form 8275 offers considerable protection for both the preparer and taxpayer; the practitioner’s job is to get it right, with minimal risk. The United States relies on a voluntary system of compliance in which each citizen reports their income freely and voluntarily, calculates their tax liability correctly and files a tax return on time. The tax system is based on voluntary compliance that allows a taxpayer to take advantage of tax incentives made available through legislation. Voluntary does not mean that the tax laws do not apply. Not knowing the law is generally not an excuse for not complying with the law. The portion of the accuracy-related penalty attributable to the following types of misconduct cannot be avoided by disclosure on Form 8275. Negligence. Disregard of regulations. Any substantial understatement of income tax. Any substantial valuation misstatement under chapter 1. Any substantial overstatement of pension liabilities. Any substantial estate or gift tax valuation understatements. Any claim of tax benefits from a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law. 157 158 www.irs.gov §10.51 348 Any otherwise undisclosed foreign financial asset understatement. The accuracy related penalty can be assessed based on either mechanical or conduct based triggers. Mechanical triggers are set off when the understatement of tax exceeds the greater of (1) 10% of the tax required to be shown on the return or (2) $5,000 ($10,000 for corporate taxpayers). The conduct-based triggers include negligence and disregard of the rules and regulations. Negligence is not defined in Sec. 6662, but case law generally holds that negligence is failing to do what a reasonable an ordinary person would do under the same or similar circumstances. Disregard of rules and regulations occurs when the taxpayer does not exercise reasonable diligence to determine the correctness of a return position that is contrary to the rules and regulations. IRS regulations provide examples of negligent behavior that include failing to keep adequate books and records and failing to substantiate items properly. Both the court and the regulations recognize that a taxpayer’s experience and education are relevant in determining the reasonableness of his or her conduct. Taxpayers that are relatively unsophisticated and inexperienced in tax law are generally held to a lower standard; however, such lack of sophistication could also support a conclusion that the taxpayer was negligent in not seeking the advice of a qualified tax adviser. The purpose of tax penalties is to encourage voluntary compliance by supporting the standards of behavior expected by the Internal Revenue Code. The Supreme Court has recognized on numerous occasions that the tax law is complicated, accounting treatment of various items raises problems of great complexity, and innocent errors are numerous. The purpose of the penalties is not to penalize frank differences of opinion or innocent errors made despite the exercise of reasonable care. Sec. 6664 provides an affirmative defense to the proposed application of any Sec. 6662 penalty by requiring “no penalty shall be imposed under section 6662…with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.” The regulations state that the determination of whether the taxpayer acted with reasonable care and good faith will be made on a case-by-case basis, taking into account all pertinent facts and circumstances. The most important fact is making this determination is the extent of the taxpayer’s effort to assess the proper tax liability. Reliance on Advice of a Tax Professional as Reasonable Cause159 Another commonly litigated question was whether reliance on a tax professional established reasonable cause. The taxpayer’s education, sophistication, and business experience are relevant in determining whether his or her reliance on tax advice was reasonable. To prevail, a taxpayer must establish that: 1. The adviser was a competent professional who had sufficient expertise to justify reliance; 2. The taxpayer provided necessary and accurate information to the adviser; and 3. The taxpayer actually relied in good faith on the adviser’s judgment. 159 National Taxpayer Advocate Annual Report to Congress 2012 349 Cambell v. C.I.R. 658 F.3d 1255 (2011) United States Court of Appeals, Eleventh Circuit. September 28, 2011. An employee of a government contractor received an $8.75 million whistleblower award from the government as a result of two lawsuits against his employer. The employee/taxpayer paid attorneys $3.5 million for their assistance in his case but, without seeking any professional tax advice, excluded the entire award from his taxable income. The taxpayer disclosed the award on a Form 8275, Disclosure Statement, attached to his return but cited no authority for his assertion that the award was not taxable income After holding that the entire award was taxable income, the Tax Court, later affirmed by the Eleventh Circuit, upheld a substantial underpayment penalty. The Eleventh Circuit reasoned that the taxpayer was “sophisticated” and chose not to consult a tax professional. Further, the court held that the taxpayer did not make the tax return disclosure with reasonable cause or in good faith. Rather, the omission of income was “an overt and intentional act to underpay,” the court said. The Form 8275 he included with his tax return was ineffective, since Regs. Sec. 1.6662-4(e) (2) states that disclosure will have no effect in reducing an understatement if the position, even if disclosed, does not have a reasonable basis The regulations state that in order for the taxpayer’s reliance on advice to constitute reasonable cause and good faith, the reliance itself must be reasonable. The taxpayer’s education, sophistication and business experience are relevant factors. In the case of United States v. Boyle160, the Supreme Court held that: “When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in substantive advice of an accountant or attorney. To require the taxpayer to challenge the accountant or attorney, to seek a ‘second opinion,’ or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking advice of a presumed expert in the first place…’Ordinary business care and prudence’ does not demand such actions.” Seeking such advice after the fact does not constitute reasonable cause and good faith. In some cases, however, the IRS will abate accuracy related penalties when the taxpayer seeks representation to resolve a past matter and makes a commitment to work with a tax professional moving forward in order to avoid future issues. A preparer is not considered to have recklessly or intentionally disregarded a rule if a position is adequately disclosed and has a reasonable basis; which is why Form 8275 is a useful tool. Form 8275 must be discussed and the client must be informed about the use of it in their 160 (1985) 469 US 241 350 tax return. It is imperative that the taxpayer knows Form 8875 is in the return to meet the disclosure rules 351 National Taxpayer Advocate – Report to Congress The National Taxpayer Advocate’s Annual Report to Congress identifies the most serious problems facing taxpayers and recommends solutions to those problems. Section 7803(c)(2)(B)(ii) of the Internal Revenue Code requires the National Taxpayer Advocate to submit this report each year and in it, among other things, to identify at least 20 of the most serious problems encountered by taxpayers and to make administrative and legislative recommendations to mitigate those problems. As the national taxpayer advocate, Nina Olson’s job is to discover any way in which the IRS bureaucracy, or the tax laws passed by Congress, are harming taxpayers. And taxfiling season is when those ills are most easily detected. This year, Olson predicts many taxpayers will be particularly confused, since the lastminute fiscal cliff deal pushed the already delayed tax season back by days or weeks for some filers. An analysis of IRS data by the Office of the Taxpayer Advocate shows it takes U.S. taxpayers more than 6.1 billion hours to complete filings required by a tax code that contains almost four million words and that, on average, has more than one new provision added to it daily. Indeed, few taxpayers complete their returns without assistance. Nearly 60 percent of taxpayers hire paid preparers and another 30 percent rely on commercial software to prepare their returns. To inspire confidence and trust, the tax laws should be comprehensible and the computations of tax should be transparent and relatively simple, yet few taxpayers today can confidently say they understand the tax code or even that they have correctly computed their tax liabilities. The office is located within the IRS, but independent of its authority, the Taxpayer Advocate Service helps taxpayers with liens or delayed refunds navigate the IRS. Congress created the office of the National Taxpayer Advocate in 1996 as a resource for taxpayers with “significant hardship[s]” like extraordinary delays, legal threats or substantial costs. The advocate office’s current budget is $205 million. Olson says she is placing particular attention now on fraud. Only the most serious cases get elevated to Olson’s desk, and last year 26 of the “taxpayer assistance order” cases she saw focused on fraud, specifically tax preparer fraud. In the previous few years, she had a total of 10 cases elevated The Office of the Taxpayer Advocate also analyzes the most litigated issues each year. The Report to Congress discusses this litigation and shows the court cases that were analyzed. This gives unique insight to the tax preparer on how the IRS looks at different situations. The following is an overview of some of the litigated issues from National Tax Advocate’s Annual Report to Congress – 2012. 352 Accuracy Related Penalty There are many different circumstances that can result in an accuracy related penalty for the taxpayer or for the tax preparer. A common defense against the accuracy-related penalty is reliance on tax software The IRS and court decisions have sustained accuracy related penalties where the taxpayer or preparer relies on the software. In this case 66% of the time when the taxpayer or tax preparer blamed software for inaccuracy, the penalty was sustained by the court. The court and the IRS essentially followed the garbage-in and garbage-out philosophy. To blame the computer software the taxpayer or preparer needs to show it was a software error and not the taxpayer’s failure to enter the information in the proper manner161. Another example of an accuracy related penalty is Andrew Dean Shelton v. Commissioner162 the Tax Court considered whether a $25,000 cash payment made pursuant to a marital settlement agreement was alimony deductible by the petitioner. The divorce decree entered in 2007 by an Illinois Circuit Court stated that each party was barred from asserting any claim “for maintenance, formerly known as alimony.” The petitioner paid the $25,000 in 2007 and deducted the full amount as alimony. The IRS issued a statutory notice disallowing the deduction and asserted the accuracy –related penalty under section 6662(a). The court ruled that the payment was not deducible alimony,163 and as such not deductible. The court held that the Illinois divorce court did designate the payments as non-deductible/ non-taxable by stating in its order that each party was barred from asserting any claim for maintenance, formerly known as alimony. The court in Shelton upheld the accuracy-related penalty for negligence or intentional disregard of the rules or regulations. The court found based on the evidence that petitioner did not act with reasonable cause and in good faith. The court based is finding on the fact that the Illinois court explicitly stated that neither party was entitled to alimony, yet petitioner “proceeded to claim an alimony deduction.” Trade or Business Expenses Under IRC § 162 and Related Sections Internal Revenue Code § 162 allows deductions for ordinary and necessary trade or business expenses paid or incurred during the course of a taxable year. Rules regarding the practical application of IRC § 162 have largely come from case law. The IRS, the Department of the Treasury, Congress, and the courts continue to provide guidance about whether a taxpayer is entitled to claim certain deductions.164 In the following paragraphs we show many court cases, which demonstrate ordinary and necessary, and some of the evolution of the term. The majority of gross income cases this year involved taxpayers failing to report items of 161 Brenda F Bartlett v. Commissioner TC Memo 2012-254 T.C. memo 2011-266 163 Section 215(See section 71(b) (1) (B)). 164 Taxpayer Advocate ARC 2012 162 353 income, including some specifically mentioned in Internal Revenue Code (IRC) § 61 such as wages, interest, dividends, and annuities. Although “trade or business” is one of the most widely used terms in the IRC, neither the Code nor the Treasury Regulations provide a definition. The definition of a “trade or business” comes from common law, where the concepts have been developed and refined by the courts. The Supreme Court has interpreted “trade or business” for purposes of IRC § 162 to mean an activity conducted with “continuity and regularity” and with the primary purpose of earning income or making profit.165 IRC § 162(a) requires a trade or business expense to be both “ordinary” and “necessary” in relation to the taxpayer’s trade or business in order to be deductible. In Welch v. Helvering, the Supreme Court stated that the words “ordinary” and “necessary” have different meanings, both of which must be satisfied for a taxpayer to benefit from the deduction. The Supreme Court describes an “ordinary” expense as customary or usual and of common or frequent occurrence in the taxpayer’s trade or business. The Court describes a “necessary” expense as one that is appropriate and helpful for development of the business. Common law also requires that in addition to being ordinary and necessary, the amount of the expense must be reasonable for the expense to be deductible. In Commissioner v. Lincoln Electric Co., the Court of Appeals for the Sixth Circuit held there must be an element of reasonableness in the term ‘ordinary and necessary.’ The courts held that it was not the intention of Congress to automatically allow as deductions operating expenses incurred or paid by the taxpayer in an unlimited amount.166 A taxpayer is required to have receipts and be able to demonstrate its business use or relationship. The most prevalent issue was the substantiation of claimed trade or business expense deductions, which appeared in 13 cases. For example, in Lyseng v. Commissioner167, the Tax Court denied several deductions for lack of substantiation, including depreciation on a travel trailer, laundry services, vehicle permit costs, and towing expenses. The taxpayer provided no evidence to substantiate the laundry, vehicle, and towing expenses, and therefore the court disallowed the deductions. In regard to the depreciation deduction, the taxpayer provided no evidence substantiating the trailers' cost basis — no bill of sale, canceled check, or third-party corroborating testimony. The Tax Court did find that the taxpayer substantiated the deductions for unreimbursed automobile expenses and some union dues. The taxpayer kept a mileage record with the dates of travel and provided credible testimony regarding the business purpose of each trip he took for his employer. A pay stub from an employer, combined with credible taxpayer testimony, also convinced the court to partially allow some of the union dues. Even when the individual taxpayer maintains records to substantiate a deduction, he or she still has to prove the expense is ordinary and necessary to a trade or business. In Farias v. Commissioner168, the taxpayer was a teacher who claimed deductions for 165 Taxpayer Advocate ARC 2012 166 IRC § 104 (compensation for injuries or sickness); 105 (amounts received under accident and health plans); 108 (income from discharge of indebtedness); 6501(limits on assessment and collection, determination of “substantial omission” from gross income) 167 T.C. Memo. 2011-226. 168 T.C. Memo. 2011-248. 354 unreimbursed employee expenses for the purchase of a specialty chair, an adjustable headrest, a pillow, and ice/heat pads. The taxpayer claimed she purchased the items because she suffered a back injury when she moved her classroom. The taxpayer also taught fitness classes and claimed deductions for fitness items, including clothing. The IRS denied the deductions because the purchases were not ordinary and necessary to her teaching position. The Tax Court also disallowed the taxpayer’s deductions for fitness expenses because she failed to clearly describe the items purchased and to prove the clothing was ordinary and necessary in her trade or business. The court further determined the clothing deduction was not allowable because the clothing was suitable for general use Kennedy v. Commissioner169 shows the general rule is that where business clothes are suitable for general wear, a deduction for them is not allowable. Refer to Donnelly v. Commissioner,170 such costs are not deductible even when it has been shown that the particular clothes would not have been purchased but for the employment. The tax preparer should assist the taxpayer in determining whether their business expenses are ordinary and necessary under IRC § 162. The Internal Revenue Code defines business expenses as the ordinary and necessary expenses of carrying on a trade or business. Generally business expenses are tax deductible. However, the IRS does not provide a compendium of general business expenses, leaving it to the taxpayer to define from the criteria what is ordinary and necessary. In fact, the terms ordinary and necessary were not defined in the original statute establishing the Internal Revenue Code, leaving it to the tax courts to establish their meanings through case law. This case's interpretation of the word necessary is referenced again and again in subsequent court cases involving taxation. Welch v. Helvering171, references McCulloch v. Maryland in its assumption "that the payments to creditors were necessary for the development of the petitioner's business, at least in the sense that they were appropriate and helpful." In 1983, Rothner v. Commissioner172, adds that an expense need not be considered unnecessary "simply because the taxpayer could have avoided it by pursuing a different course of conduct", further reinforcing a less rigorous interpretation of its meaning. In Welch v. Helvering, the court also stated that the term ordinary has some constancy but is nonetheless a variable affected by time, place and circumstance" and does not mean it must be habitual. There is not one standard which defines ordinary. Accuracy-related penalties have been assessed for not giving adequate substantiation that expenses are ordinary and necessary. 169 T.C. Memo. 1970-58, affd. 451F.2d 1023 (3d Cir. 1971) 262 F.2d 411 (2d Cir. 1959), affg. 28 T.C. 1278 (1957) 171 Supreme Court 290 U.S. 111 (1933) 172 United States Tax Court, T.C. Memo. 1996-442, Docket No. 26134-93 170 355 In Deputy v. DuPont173 the Supreme Court defined ordinary as “normal, usual, or customary”, reaffirming Welch V. Helvering by explaining, that though an expense happen but once in the taxpayer's lifetime, if the transaction giving rise to it is of "common or frequent occurrence in the type of business involved", it is ordinary. It concludes that the kind of transaction of which the obligation arose in the particular business is crucial in determining whether the expense is ordinary and, deductible by the taxpayer. In Commissioner v. Heininger174defines the term "normal" as used in the prior two court opinions quoted above in their definition of ordinary, as an expense arising "from an action that is ordinarily to be expected of one in the taxpayer's position". The above court cases are summarized as definitions in Pub. 525: To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in their trade or business. A necessary expense is one that is helpful and appropriate for their trade or business. An expense does not have to be indispensable to be considered necessary. From this definition and the tax courts rulings, we can draw the following conclusions. Both criteria, ordinary and necessary, need to be met for the expense to be deductible. For an expenditure to be an ordinary expense, it must be a common or usual expense in one's business and an acceptable or customary expense for one's business. Practical Example 9: If a plumber claims the purchase of window curtains as a deduction on his tax return it would not be considered an ordinary and necessary expense. However, if an interior decorator purchases window curtains, they may be able to easily be a legitimate business deduction. Their purchase would be both a common and an acceptable expenditure in the conduct of their services teaching. The term necessary for tax purposes has a wider definition than that found in common usage today. As the tax cases illustrated above, the expense does not have to be "absolutely necessary" in the sense that it is "indispensable" to carrying on the business. It only needs to be helpful to one's business as well as appropriate for one's business. Practical Example 10: For instance, renting an office is certainly helpful to a tax preparer, providing a place for the preparer to meet with clients and for employees to work. However, renting an office is not absolutely necessary for a tax preparer to conduct his trade, since many sole proprietor’s or preparer’s work out of their home or provide their services at their clients' home or business. In addition, an office is very appropriate for a tax preparer, providing a workplace for him and his employees. 173 174 Supreme Court 308 U.S. 488, 495 (1940), Supreme Court, 320 U.S. 467 (1943) 356 The best advice the tax preparer can give a taxpayer regarding “ordinary and necessary” expenses is good record keeping. All taxpayers should have records and receipts. There are many ways a business taxpayer can keep and substantiate their records. Any recordkeeping system suited to their business that clearly shows the income and expense is acceptable. The books must show the gross income, as well as deductions and credits. For most small businesses, the business checkbook is the main source for entries in the business books.175 Damage Awards The taxation of damage awards continues to generate litigation. Damage awards fall under IRC § 104(a) (2). This year, at least ten taxpayers challenged the inclusion of settlement proceeds or arbitration awards in gross income, and the IRS won every case. The code specifies that damage awards and settlement proceeds are taxable as gross income unless the award was received “on account of personal physical injury or physical sickness.176” Congress added the “physical injury or physical sickness” requirement in 1996; until then, the word “physical” did not appear in the statute. A court cannot consider damage awards for emotional distress to be excludible from income, even if the emotional distress has resulted in “insomnia, headaches, or stomach disorders.” To justify exclusion from income under IRC §104, the taxpayer must show that settlement proceeds are in lieu of damages for physical injury or sickness. Settlements and judgments are taxed according to the item for which the plaintiff was seeking recovery (the "origin of the claim"). If the taxpayer is suing a competing business for lost profits, a settlement will be lost profits, taxed as ordinary income. If the taxpayer is laid off at work and sues for discrimination seeking wages and severance, the taxpayer will be taxed as receiving wages. If the taxpayer sues for damage to their condo by a negligent building contractor, the damages usually will not be income. Instead, the recovery will be treated as an expense to repair the condo and/or affect the basis of the condo. Legal Fees: If the taxpayer settles a suit for intentional infliction of emotional distress against a neighbor for $100,000 and the lawyer fee is $40,000. The $100,000 would be taxable and the $40,000 would be an itemized deduction, subject to 2% of AGI.177 Discharge of Indebtedness A taxpayer must include income from discharge of indebtedness when calculating gross income, but can exclude it in certain circumstances. In this regard, IRC §108(a) provides, subject to limitations, that a taxpayer may exclude income from the discharge of indebtedness if the discharge occurs in bankruptcy, or when the taxpayer is insolvent, or if the indebtedness is qualified farm or business real estate debt or qualified principal residence indebtedness. The creditor issues a Form 1099-C, Cancellation of Debt, to the taxpayer for canceled debts of $600 or more.178 175 176 177 178 IRS Publication 583 Pub. L. No. 104-188, § 1605(a), 110 Stat. 1755, 1838 (1996). Tc 1997-312 eFleur v Commissioner IRS, Instruction 1099-A & C, Instructions for Forms 1099-A and 1099-C 2 (2012). 357 Standards with respect to tax returns and documents 179 (a) Tax returns. (1) A practitioner may not willfully, recklessly, or through gross incompetence — (i) Sign a tax return or claim for refund that the practitioner knows or reasonably should know contains a position that — (A) Lacks a reasonable basis; (B) Is an unreasonable position as described in section 6694(a)(2) of the Internal Revenue Code (Code) (including the related regulations and other published guidance); or (C) Is a willful attempt by the practitioner to understate the liability for tax or a reckless or intentional disregard of rules or regulations by the practitioner as described in section 6694(b)(2) of the Code (including the related regulations and other published guidance). (ii) Advise a client to take a position on a tax return or claim for refund, or prepare a portion of a tax return or claim for refund containing a position, that — (A) Lacks a reasonable basis; (B) Is an unreasonable position as described in section 6694(a)(2) of the Code (including the related regulations and other published guidance); or (C) Is a willful attempt by the practitioner to understate the liability for tax or a reckless or intentional disregard of rules or regulations by the practitioner as described in section 6694(b)(2) of the Code (including the related regulations and other published guidance). (2) A pattern of conduct is a factor that will be taken into account in determining whether a practitioner acted willfully, recklessly, or through gross incompetence. (b) Documents, affidavits and other papers — (1) A practitioner may not advise a client to take a position on a document, affidavit or other paper submitted to the Internal Revenue Service unless the position is not frivolous. (2) A practitioner may not advise a client to submit a document, affidavit or other paper to the Internal Revenue Service — (i) The purpose of which is to delay or impede the administration of the Federal tax laws; (ii) That is frivolous; or (iii) That contains or omits information in a manner that demonstrates an intentional disregard of a rule or regulation unless the practitioner also advises the client to submit a document that evidences a good faith challenge to the rule or regulation. (c) Advising clients on potential penalties — (1) A practitioner must inform a client of any penalties that are reasonably likely to apply to the client with respect to — (i) A position taken on a tax return if — (A) The practitioner advised the client with respect to the position; or (B) The practitioner prepared or signed the tax return; and (ii) Any document, affidavit or other paper submitted to the Internal Revenue Service. 179 IRC §10.34 358 (2) The practitioner also must inform the client of any opportunity to avoid any such penalties by disclosure, if relevant, and of the requirements for adequate disclosure. (3) This paragraph (c) applies even if the practitioner is not subject to a penalty under the Internal Revenue Code with respect to the position or with respect to the document, affidavit or other paper submitted. (d) Relying on information furnished by clients. A practitioner advising a client to take a position on a tax return, document, affidavit or other paper submitted to the Internal Revenue Service, or preparing or signing a tax return as a preparer, generally may rely in good faith without verification upon information furnished by the client. The practitioner may not, however, ignore the implications of information furnished to, or actually known by, the practitioner, and must make reasonable inquiries if the information as furnished appears to be incorrect, inconsistent with an important fact or another factual assumption, or incomplete. § 10.36 – Procedures to Ensure Compliance (a) Requirements for covered opinions. Any practitioner who has (or practitioners who have or share) principal authority and responsibility for overseeing a firm’s practice of providing advice concerning Federal tax issues must take reasonable steps to ensure that the firm has adequate procedures in effect for all members, associates, and employees for purposes of complying with §10.35. Any such practitioner will be subject Consequences of Filing Incorrect Returns The consequences of preparing inaccurate returns can be severe and can extend to both the preparer and the client. These consequences may include any or all of the following: If the taxpayer’s returns are examined and found to be incorrect, the taxpayer may be subject to accuracy-related or fraud penalties plus accrued interest on any underpayment. Return preparers who prepare a client return for which any part of an understatement of tax liability is due to an unreasonable position taken on the return based on the preparer’s advice, can be assessed a minimum penalty of $1,000 (IRC section 6694(a)). Return preparers who prepare a client return for which any part of an understatement of tax liability is due to the return preparer’s willful, reckless or intentional disregard of rules or regulations by the tax preparer, can be assessed a minimum penalty of $5,000 (IRC section 6694(b)). The assessment of return-related penalties against a return preparer may result in: Assertion of applicable penalties; Suspension or expulsion of the return preparer’s firm from participation in IRS efile; Injunction barring the return preparer from preparing tax returns; Referral for criminal investigation; or Disciplinary action by the IRS Office of Professional Responsibility. 359 Some “Dirty Dozen” and Tax Law Cases The Dirty Dozen180 listing, compiled by the IRS each year, lists a variety of common scams taxpayers can encounter at any point during the year. But many of these schemes peak during filing season as people prepare their tax returns. It is important that tax preparers are aware of these scams and can advise the taxpayers The IRS works with the Justice Department to pursue and shut down perpetrators of these and other illegal scams. Promoters frequently end up facing heavy fines and imprisonment. Meanwhile, taxpayers who wittingly or unwittingly get involved with these schemes must repay all taxes due plus interest and penalties. Illegal scams can lead to significant penalties and interest and possible criminal prosecution. The IRS Criminal Investigation Division works closely with the Department of Justice to shutdown scams and prosecutes the criminals behind them. The following is the Dirty Dozen tax scams for 2012 and tax law cases involving violations by tax professionals. Identity Theft Topping this year’s list Dirty Dozen list is identity theft. In response to growing identity theft concerns, the IRS has embarked on a comprehensive strategy that is focused on preventing, detecting and resolving identity theft cases as soon as possible. In addition to the law-enforcement crackdown, the IRS has stepped up its internal reviews to spot false tax returns before tax refunds are issued as well as working to help victims of the identity theft refund schemes. Identity theft cases are among the most complex ones the IRS handles, but the agency is committed to working with taxpayers who have become victims of identity theft. The IRS is increasingly seeing identity thieves looking for ways to use a legitimate taxpayer’s identity and personal information to file a tax return and claim a fraudulent refund. An IRS notice informing a taxpayer that more than one return was filed in the taxpayer’s name or that the taxpayer-received wages from an unknown employer may be the first tip off the individual receives that he or she has been victimized. The IRS has a robust screening process with measures in place to stop fraudulent returns. While the IRS is continuing to address tax-related identity theft aggressively, the agency is also seeing an increase in identity crimes, including more complex schemes. In 2011, the IRS protected more than $1.4 billion of taxpayer funds from getting into the wrong hands due to identity theft. 180 “ Dirty Dozen” - IR-2012-23, Feb. 16, 2012 360 In January, the IRS announced the results of a massive, national sweep cracking down on suspected identity theft perpetrators as part of a stepped-up effort against refund fraud and identity theft. Working with the Justice Department’s Tax Division and local U.S. Attorneys’ offices, the nationwide effort targeted 105 people in 23 states. Anyone who believes his or her personal information has been stolen and used for tax purposes should immediately contact the IRS Identity Protection Specialized Unit. For more information, visit the special identity theft page at www.IRS.gov/identitytheft. Memphis Woman Sentenced on Tax Fraud Charges On Dec. 21, 2012, in Memphis, Tenn., Aundria Bryant-Branch was sentenced to 262 months in prison; three years supervised release, and ordered to pay $690,399 in restitution to the Internal Revenue Service. According to the indictment, Bryant-Branch orchestrated a tax refund scheme beginning in 2006 and continuing until approximately June 10, 2008. Bryant-Branch obtained stolen identification information and a stolen “Warrant Book” from the Memphis Police Department. This book listed individuals with outstanding arrest warrants. Bryant-Branch would give the stolen identification information to others, who then used it to prepare and electronically file false tax returns with the IRS claiming refunds without the taxpayer’s knowledge, These fraudulent returns generated either refund checks from the IRS or Refund Anticipation Loan (RAL) checks from the Bank and Trust of Santa Barbara Phishing Phishing is a scam typically carried out with the help of unsolicited email or a fake website that poses as a legitimate site to lure in potential victims and prompt them to provide valuable personal and financial information. Armed with this information, a criminal can commit identity theft or financial theft. An example of phishing was investigated by the Treasury Inspector General for Tax Administration (TIGTA) in which several individuals were deceived into providing their personal identification numbers and banking information to identity thieves who then defrauded them of over $1 million. The phishing scheme was designed to defraud numerous individuals through Internet solicitations and stealing the identities of those individuals. The subject of the investigation was sentenced to a total of 30 months of imprisonment and five years of supervised release for aggravated identity theft and conspiracy to commit wire fraud. He was also ordered to pay $1,741,822 in restitution to his victims181 If the taxpayer receives an unsolicited email that appears to be from either the IRS or an organization closely linked to the IRS, such as the Electronic Federal Tax Payment System (EFTPS), report it by sending it to phishing@irs.gov. It is important to keep in mind the IRS does not initiate contact with taxpayers by email to request personal or financial information. This includes any type of electronic communication, such as text messages and social media channels. 181 E.D.N.Y. Response to Defendant’s Sentencing Letter filed Dec. 19, 2011; E.D.N.Y. Judgment filed Aug. 9, 2012 361 362 Return Preparer Fraud About 60 percent of taxpayers will use tax professionals this year to prepare and file their tax returns. Most return preparers provide honest service to their clients. But as in any other business, there are also some who prey on unsuspecting taxpayers. The following are some of items the Tax Division of the Department of Justice routinely identify a fraudulent: Preparing phony tax-return forms with fabricated businesses and income; False education and homebuyer credits; False and inflated deductions; False filing status; False dependents; Selling deceptive loan products; Filing tax returns without customer consent or authorization; Preparing bogus W-2 forms, based on information from employee paystubs; Falsifying information on returns to claim inflated earned income tax credits; and Filing fraudulent tax returns using stolen taxpayer identities to obtain improper tax refunds. Some preparers try to conceal their fraud by not signing the returns they prepare and by using stolen or fake social security numbers or PTIN has to misidentify the paid preparer. In 2012, every paid preparer needs to have a Preparer Tax Identification Number (PTIN) and enter it on the returns he or she prepares. Tax Fraud Case182 A Montclair man, who was charged for his role in a scheme to unlawfully use the names and social security numbers of other people to file fraudulent federal income tax returns, has pleaded guilty to tax and identity theft charges. Specifically, Chibueze Chidozie Nwafor pleaded guilty to three criminal counts – presenting false claims to the United States, theft of government benefits, and aggravated identity theft. The charges are the result of an investigation by the IRS Criminal Investigation. Nwafor used the identification of other individuals who he knew to be real people, specifically the names and social security numbers of purported tax filers, in order to submit false tax returns. Nwafor knew the information contained in the false tax returns that he filed contained materially false information, including taxes withheld and wages received from a bogus corporation, California Mutual Life and Health (“CMLH”). Nwafor also misappropriated tax filer refunds to which he was not entitled for his own use. In 2009, Nwafor prepared tax returns for various individuals including a 2008 federal income tax return in the name of an unidentified victim claiming a tax refund of $7,773, 182 USA v Chibueze Chidozie Nwafor 363 which included Form W-2, which falsely claimed that the unidentified victim received $30,119 in wages from CMLH. The IRS issued a tax refund, which Nwafor stole and converted to his own use. For the 2010 tax year, Nwafor filed a fraudulent tax return on his own behalf claiming false deductions, which resulted in Nwafor receiving a refund check in the amount of $32,789 from the IRS. It is estimated that the attempted tax loss attributable to Nwafor from 2009 through 2011 is approximately $126,991. As a result of the guilty plea, Nwafor faces a sentence of 70 months in federal prison and a was ordered to pay $118,474 in restitution to the IRS. Hiding Income Offshore Over the years, numerous individuals have been identified as evading U.S. taxes by hiding income in offshore banks, brokerage accounts or nominee entities, using debit cards, credit cards or wire transfers to access the funds. Others have employed foreign trusts, employee-leasing schemes, private annuities or insurance plans for the same purpose. The IRS uses information gained from its investigations to pursue taxpayers with undeclared accounts, as well as the banks and bankers suspected of helping clients hide their assets overseas. The IRS works closely with the Department of Justice to prosecute tax evasion cases. While there are legitimate reasons for maintaining financial accounts abroad, there are reporting requirements that need to be fulfilled. U.S. taxpayers who maintain such accounts and who do not comply with reporting and disclosure requirements are breaking the law and risk significant penalties and fines, as well as the possibility of criminal prosecution. The IRS is in the middle of a major offensive against wealthy taxpayers who are hiding income overseas to avoid taxes. An estimated 19,000 American citizens were hiding taxable assets in the Swiss Bank UBS with the encouragement and assistance of the bank itself, the government alleges. UBS is now cooperating and has paid a $780 million fine to avoid prosecution. Bradley Birkenfeld, an American citizen who worked at UBS, voluntarily disclosed UBS documents that alerted the U.S. to a scheme "to defraud the United States by impeding the IRS," the Department of Justice alleges. Department of Justice went on to say that Swiss bankers made about 3,800 trips to the U.S. "to market Swiss bank secrecy to United States clients interested in attempting to evade United States income taxes." That prompted the IRS to establish a new unit, Offshore Voluntary Disclosure Program. Which allow the IRS to take a unified look at the entire web of business and economic entities controlled by high-wealth individuals. Finding the missing income was made easier when UBS agreed to turn over the names of U.S. citizens who have assets at the bank. 364 The IRS offered amnesty for those who came forward voluntarily, and so far, about 15,000 Americans have done so to avoid prosecution. At the beginning of this year, the IRS reopened the Offshore Voluntary Disclosure Program following continued strong interest from taxpayers and tax practitioners after the closure of the 2009 and 2011 programs. The IRS continues working on a wide range of international tax issues and follows ongoing efforts with the Justice Department to pursue criminal prosecution of international tax evasion. This program will be open for an indefinite period until otherwise announced. The IRS has collected $3.4 billion so far from people who participated in the 2009 offshore program, reflecting closures of about 95 percent of the cases from the 2009 program. On top of that, the IRS has collected an additional $1 billion from up front payments required under the 2011 program. That number will grow as the IRS processes the 2011 cases. “Free Money” from the IRS & Tax Scams Involving Social Security Flyers and advertisements for free money from the IRS, suggesting that the taxpayer can file a tax return with little or no documentation, have been appearing in community churches around the country. These schemes are also often spread by word of mouth as unsuspecting and well-intentioned people tell their friends and relatives. Scammers prey on low-income individuals and the elderly. They build false hopes and charge people good money for bad advice. In the end, the victims discover their claims are rejected. Meanwhile, the promoters are long gone. The IRS warns all taxpayers to remain vigilant. There are a number of tax scams involving Social Security. For example, scammers have been known to lure the unsuspecting with promises of non-existent Social Security refunds or rebates. In another situation, a taxpayer may really be due a credit or refund but uses inflated information to complete the return. A common tax scam against the elderly is convincing a Social Security Recipient who has not other income, that they can receive a refund by filing a tax return, the scammer then receives the Social Security Number of the recipient and prepares a fraudulent return. False/Inflated Income and Expenses Including income that was never earned, either as wages or as self-employment income in order to maximize refundable credits, is another popular scam. Claiming income they did not earn or expenses not paid in order to secure larger refundable credits such as the Earned Income Tax Credit could have serious repercussions. This could result in repaying the erroneous refunds, including interest and penalties, and in some cases, even prosecution. Additionally, some taxpayers are filing excessive claims for the fuel tax credit. Farmers and other taxpayers who use fuel for off-highway business purposes may be eligible for the fuel tax credit. But other individuals have claimed the tax credit when their 365 occupations or income levels make the claims unreasonable. Fraud involving the fuel tax credit is considered a frivolous tax claim and can result in a penalty of $5,000. Tax Fraud Case against Preparer Kenneth L. Barber Kenneth L. Barber has been convicted by a federal jury of wire fraud, preparing false returns, making a false statement to a bank and conspiracy to commit tax fraud. At trial, the government presented evidence that Barber ran and operated a local tax prep business where he encouraged preparers to falsify clients’ returns. Government agents testified that the scheme resulted in a loss of more than $700,000. Barber was also convicted of making false statements to a financial institution based upon evidence that he provided a bank with false information concerning his income in order to qualify for loans totaling more than $300,000. Records introduced at trial showed that personal and corporate returns he submitted to Wachovia Bank reflected substantially greater income than the returns the defendant filed with the IRS. Barber faces a maximum of five years in prison for conspiracy, three years in prison on each count of preparing fraudulent returns, 20 years in prison on each count of wire fraud and 30 years in prison on each count of making a false statement to a bank. False Form 1099 Refund Claims In this ongoing scam, the perpetrator files a fake information return, such as a Form 1099 Original Issue Discount (OID), to justify a false refund claim on a corresponding tax return. In some cases, individuals have made refund claims based on the bogus theory that the federal government maintains secret accounts for U.S. citizens and that taxpayers can gain access to the accounts by issuing 1099-OID forms to the IRS. Do not fall prey to people who encourage the taxpayer to claim deductions or credits to which the taxpayer is not entitled or willingly allow others to use information to file false returns. If the preparer is a party to such schemes, they could be liable for financial penalties or even face criminal prosecution. Tax Fraud Case using 1099-OID183 Karen A. Olson admitted she participated in a conspiracy that promoted a tax refund scheme across the United States from July 1, 2008, to Sept. 21, 2011. Conspirators received more than $3.5 million of the total $96 million in attempted fraudulent refunds. Olson, who has an associate’s degree in accounting, was formerly employed as a tax preparer and did taxes for people on the Air Force base where her husband was deployed while serving in the military. On Oct. 13, 2008, the Olsons submitted a 2007 joint income tax return, including fraudulent Forms 1099-OID. They received a refund of $171,806. In actuality, Olson admitted that they had never accrued any OID income from the banks and lenders listed on their Forms 1099-OID, nor had those entities issued the forms, nor had they paid any taxes on the Olsons’ behalf. 183 justice.gov/usao/mow/divisions/OIDfraud.html 366 People around the Olsons knew they had received a large refund from the process and began asking them for their help. They decided to charge $200 per person or couple to transmit their Forms 1099-OID and 1099-A through their tax preparation and submission company, FATR, LLC. The Olsons assisted approximately 10 individuals/couples in preparing their Forms 1040 using the 1099-OID process. Four returns that were based on fraudulent Forms 1099-OID claimed refunds totaling $825,907. Refunds totaling $408,693 were issued. Under federal statutes, Olson is subject to a sentence of up to 10 years in federal prison without parole, plus a fine up to $250,000 and an order of restitution. Frivolous Arguments Promoters of frivolous schemes encourage taxpayers to make unreasonable and outlandish claims to avoid paying the taxes they owe. The IRS has a list of frivolous tax arguments that taxpayers should avoid. These arguments are false and have been thrown out of court. While taxpayers have the right to contest their tax liabilities in court, no one has the right to disobey the law. The Internal Revenue Service released an 84-page document, The Truth About Frivolous Tax Arguments. The document explains many of the common frivolous arguments made in recent years and it describes the legal responses that refute these claims. It will help taxpayers avoid wasting their time and money with frivolous arguments and incurring penalties. The 2011 version of the IRS document released March 2013 includes numerous recently decided cases that continue to demonstrate that frivolous positions have no legitimacy. Frivolous arguments include contentions that taxpayers can refuse to pay income taxes on religious or moral grounds by invoking the First Amendment; that the only “employees” subject to federal income tax are employees of the federal government; and that only foreign-source income is taxable. irs.gov/Tax-Professionals/The-Truth-About-Frivolous-Tax-Arguments-Introduction Falsely Claiming Zero Wages Filing a phony information return is an illegal way to lower the amount of taxes an individual owes. Typically, a Form 4852 (Substitute Form W-2) or a “corrected” Form 1099 is used as a way to improperly reduce taxable income to zero. The taxpayer may also submit a statement rebutting wages and taxes reported by a payer to the IRS. Sometimes, fraudsters even include an explanation on their Form 4852 that cites statutory language on the definition of wages or may include some reference to a paying company that refuses to issue a corrected Form W-2 for fear of IRS retaliation. Taxpayers should resist any temptation to participate in any variations of this scheme. Filing this type of return may result in a $5,000 penalty. 367 NOTE: Tax preparers fraudulently use Line 21 of Form 1040 to subtract the income shown on a W-2, as well as using Miscellaneous Deductions on Schedule A. Unknown items shown in the Miscellaneous Deduction Section of Schedule A were not always allowed to be electronically filed in the 2012 Tax Season. Abuse of Charitable Organizations and Deductions IRS examiners continue to uncover the intentional abuse of 501(c) (3) organizations, including arrangements that improperly shield income or assets from taxation and attempts by donors to maintain control over donated assets or the income from donated property. The IRS is investigating schemes that involve the donation of non-cash assets – – including situations in which several organizations claim the full value of the same noncash contribution. Often these donations are highly overvalued or the organization receiving the donation promises that the donor can repurchase the items later at a price set by the donor. The Pension Protection Act of 2006 imposed increased penalties for inaccurate appraisals and set new standards for qualified appraisals. Subject to certain limitations, taxpayers can take a deduction from their adjusted gross income for contributions of cash or other property to charitable organizations.184 Taxpayers must contribute to certain qualifying organizations,185 and are required to substantiate contributions of $250 or more litigation generally arises over one of four issues: 1. Whether the organization receiving the contribution is charitable in nature; 2. Whether the property contributed qualifies as a charitable contribution; 3. Whether the amount deducted equals the fair market value of the property contributed; and 4. The extent to which the taxpayer has substantiated the contribution. Taxpayers can generally take a deduction for charitable contributions made within the taxable year.186 For individuals, these deductions are generally limited to 50 percent of the taxpayer’s contribution base (adjusted gross income computed without regard to any net operating loss carryback to the taxable year under IRC § 172). However, subject to certain limitations, individual taxpayers can carry forward unused charitable contributions in excess of the 50 percent base for up to five years. Corporate charitable deductions are generally limited to ten percent of the taxpayer’s taxable income. Taxpayers cannot deduct services that they offer to charitable organizations; however, incidental expenditures incurred while serving a charitable organization and not reimbursed may constitute a deductible contribution187. Deductions for charitable contributions of $250 or more are disallowed in the absence of a contemporaneous written receipt from the recipient. For cash contributions, taxpayers 184 IRC §170 IRC § 170(c)(2). 186 IRC § 170(a)(1). 187 Treas. Reg. § 1.170A-1(g). Meal expenditures in conjunction with offering services to qualifying organizations are not deductible unless the expenditures are away from the taxpayer’s home. IRC § 170(j). 185 368 must maintain receipts from the charitable organization, copies of canceled checks, or other reliable records showing the name of the organization, the date, and the amount contributed. For each contribution of property other than money, taxpayers generally must maintain a receipt showing the name of the recipient, the date and location of the contribution, and a description of the property. When property other than money is contributed, the amount of the allowable deduction is the fair market value of the property at the time of the contribution.188 188 Treas. Reg. § 1.170A-13 369 California - CTEC If a paid preparer prepares the return, that preparer must register with The California Tax Education Council unless that person meets one of the following exemptions: 1. 2. 3. 4. 5. Persons licensed with the State Board of Accountancy and their employees Persons who are active members of the State Bar of California and their employees Employees of certain Trust Companies. Persons enrolled to practice before the Internal Revenue Service and their employees. Companies and their employees of Financial Institutions regulated by state or federal government. The preparer must complete at least 60 hours of instruction in basic personal income tax law, theory and practice within the past 18 months. 20 hours of continuing education is required in all subsequent cycles. A paid preparer other than those mentioned above must acquire a tax preparer bond in the amount of $5,000. The California Business and Professions Code Section 22250 requires that a bond be acquired through a surety company admitted to do business in California and shall be maintained for each individual preparing returns for another person. The tax preparer is required to give the client prior to preparing the tax return, their name, address, telephone number and evidence of compliance with the bonding requirement. Tax preparers who violate the Business and Professions Code may be subject to a fine of up to $1,000, a civil penalty of up to $1,000 and up to one year in county jail. The tax preparer has a requirement to furnish and retain a copy of the return he has prepared. The return can be kept on magnetic media and shall be kept for a period of at least 4-years from the time the return was filed. The taxpayer must sign the return and use either an employer identification number, a social security number or a personal taxpayer identification number (PTIN). Tax Preparer Code of Conduct and Responsibilities Must register as a tax preparer with the California Tax Education Council (CTEC). Must maintain a $5,000 tax preparer bond issued by a surety company admitted to do business in California. A tax preparer shall provide to the surety company proof that he or she is at least 18 years of age before a bond can be issued. Must identify to the surety company all preparers employed or associated with the tax preparer securing the bond. Must file an amendment to the bond within 30 days of any change in the information provided in the bond. Must not conduct business without having a current surety bond in effect. 370 Must cease doing business as a tax preparer upon cancellation or termination of bond until a new bond is obtained. Must furnish evidence of a current bond upon the request of any state or federal agency or law enforcement agency. Must prior to rendering any tax preparation services, provide the customer, in writing, with the tax preparer’s name, address, telephone number, and evidence of compliance with the bonding requirement. Must not make fraudulent, untrue, or misleading statements or representations that are intended to induce a person to use their tax preparation services. Must not obtain the signature of a customer on a tax return or authorizing document that contains blank spaces to be filled in after it has been signed. Must not fail or refuse to give a customer, a copy of any document requiring the customer’s signature, within a reasonable time after the customer signs. Must not fail to maintain a copy of any tax return prepared for a customer for four years from the later of the due date of the return or the completion date of the return. May not engage in advertising practices that are fraudulent, untrue, or misleading, including assertions that the tax preparer bond in any way implies licensure or endorsement of a tax preparer by the State of California. Must not violate provisions of Section 17530.5 or 7216 of Title 26 of the United States Code prohibiting tax preparers from disclosing any information obtained in the business of preparing federal or state income tax returns unless (1) consented to, in writing, by the taxpayer in a separate document; (2) expressly authorized by law; (3) necessary for the preparation of the return; and, (4) pursuant to court order. Must not fail to sign a customer’s tax return when payment for services rendered has been made. Must not fail to return, upon demand by or on behalf of a customer, records or other data provided to the tax preparer by the customer. Must not give false or misleading bond information to a consumer or give false or misleading information to a surety company in obtaining their tax preparer bond. Must apply for their Certificate of Completion within 18 months after completing their 60 hours of qualifying education from an approved provider. Must complete, on an annual basis, not less than 20 hours of continuing education from an approved curriculum provider (12 hours federal, 4 hours California, and 2 hours ethics and 2 hours of either federal or California). 371 According to California Business & Professions Code Section 22253.2, and California Revenue & Taxation Code Section 19167, when a person prepares a tax return, for a fee, without the appropriate lawful designation, the Franchise Tax Board, pursuant to an agreement with the California Tax Education Council, will do the following: (1) The amount of the penalty under the subdivision for the first failure to register is two thousand five hundred dollars ($2,500). This penalty shall be waived if proof of registration is provided to the Franchise Tax Board within 90 days from the date of notice of the penalty, which is mailed, to the tax preparer. (2) The amount of the penalty for a failure to register, other than the first failure to register, is five thousand dollars ($5,000). Violators of other sections of the statute are guilty of a misdemeanor, which offense is punishable by a fine not exceeding $1,000, or by imprisonment in a county jail for not more than one year, or by both. If a CRTP fails to perform a duty specifically imposed upon him or her pursuant to this statute, any person may maintain an action for enforcement of those duties or to recover a civil penalty in the amount of $1,000, or for both enforcement and recovery. The Superior Court, in and for the county in which any person acts as a tax preparer in violation of the provisions of this statute, may, upon a petition by any person, issue an injunction or other appropriate order restraining the conduct. Preparer Penalties The following are some other penalties that can be assessed against tax preparers: Failure to furnish a copy of the return to the taxpayer - $50 per return up to $25,000. Failure to sign a return - $50 per return up to $25,000. Failure to furnish preparer’s identification number $50 per return up to $25,000. Failure to maintain copies of the return - $50 per return up to $25,000 Understatement of taxpayer’s liability due to unrealistic position - $250 per return. Understatement due to preparers' willful or reckless conduct - $1,000 per return. Failure to maintain records of preparers in office - $50 per preparer up to $25,000. Improper disclosure of return information - $250 for each disclosure up to $10,000. 372 Appendix Foreign Earned Income Exclusion The maximum exclusion for 2012 is $95,100; the maximum exclusion for 2013 is $97,600189. The following general rules apply to U.S. citizens and resident aliens. • Worldwide income from all sources is subject to federal income tax, regardless of where the taxpayer is living. • The same filing requirements apply whether the taxpayer is in the United States or abroad. • Resident aliens: A resident alien is an individual who is not a citizen of the United States and who meets either the green card test or the substantial presence test for the calendar year. • Green card test: A taxpayer is a U.S. resident if he or she was a lawful permanent resident of the United States at any time. • Substantial presence test: A taxpayer is considered to be substantially present in the U.S. if he or she is living in the U.S. for a minimum of 31 days during the current calendar year and a total of 183 days during the current calendar year and two preceding years. For purposes of counting 183 days, count all the days of physical presence in the current year, but only one-third the number of days of presence in the preceding year, and only one-sixth the number of days in the second preceding year. The following exclusions and deductions may be available to qualifying U.S. citizens and resident aliens in 2012.190 • Exclusion from gross income up to $95,100 (2012) or $97,600 (2013) foreign earned income. • Exclusion from gross income of a limited amount of employer-paid foreign housing expense that was reported as foreign earned income. • Deduction taken as an adjustment to gross income, of a limited amount of employeepaid foreign housing expense or foreign housing expense paid by a self-employed taxpayer. The exclusion of foreign earned income is for purposes of income tax. Selfemployed taxpayers who qualify to exclude foreign earned income are still subject to self-employment tax on net earnings from self-employment income. Qualifying for the exclusions and the deduction. The taxpayer must satisfy all three of the following requirements in order to qualify for the foreign earned income exclusion, foreign housing exclusion, or foreign housing deduction. • The tax home must be in a foreign country, and • The taxpayer must have foreign earned income, and • The taxpayer meets either the bona fide residence test or the physical presence test. 189 190 § 911(b)(2)(D)(i) Form 2555 373 Foreign Earned Income Earned income that meets the following two requirements is foreign earned income. 1) Income is earned while the taxpayer’s tax home is in a foreign country, and 2) Either the bona fide residence test or physical presence test is met. Note: Foreign earned income includes foreign housing allowances or reimbursements and the fair market value of employer-provided foreign housing. U.S. government employees: Amounts paid to employees by the U.S. government or any of its agencies are not foreign earned income for purposes of the exclusions or deduction. However, amounts paid to independent contractors may qualify. Bona Fide Residence Test: U.S. citizens and resident aliens who are nationals of a country with which the United States has a tax treaty may use the bona fide residence test. • The taxpayer must be a bona fide resident of a foreign country or countries. The IRS decides if the taxpayer qualifies as a bona fide resident based on information provided on Form 2555. • The period of residency in the foreign country or countries must be an uninterrupted period that includes an entire tax year (January 1 through December 31 for calendar year taxpayers). Temporary trips to the United States or elsewhere do not necessarily interrupt the qualifying tax year. Determination of bona fide residence is more difficult to satisfy than the physical presence test. . Physical Presence Test: Any U.S. citizen or resident alien may use the physical presence test. • The taxpayer must be physically present in a foreign country or countries for at least 330 full (24-hour) days during a period of 12 consecutive months. The 12-month period can start on any day of the month and end with the same calendar day a year later. • The 330 days need not be consecutive. Days abroad for any reason may be counted, including time spent on vacation. Days spent flying over international waters may not be counted. Example: Kelly accepted a job to teach English in Spain. She arrived in Spain on June 15, 2011 and immediately established a residence there. She took a vacation to England during December 2011. She returned to the U.S. on June 15, 2012. If, for any reason, Kelly was in the U.S. or over international waters for more than 36 days between June 15, 2011 and June 15, 2012, then she will not meet the physical presence test. Foreign Income Exclusion Limit on exclusion. For 2013, the annual limit is $97,600 per taxpayer. If both the taxpayer and spouse qualify for the exclusion, both of them can exclude up to $97,600 each. If the taxpayer qualifies for only part of the year, the maximum deduction is the lesser of $97,600 or the actual compensation received multiplied by the ratio of the qualifying days in the year to the number of days in the tax year. 374 Form 2555, Foreign Earned Income: File this form to claim a foreign earned income exclusion or housing allowance. Choosing the exclusion must generally be made on one of the following. • A timely-filed return (including any extensions), • A return amending a timely-filed return, or • A return filed within one year from the original due date of the return (determined without regard for any extensions). The housing exclusion applies only to amounts considered paid for with employerprovided amounts. The housing deduction applies only to amounts paid with selfemployment earnings. Standard Deduction for Meals191 – High Low Method (Per Day) This is a simplified method of computing the federal per diem rate for travel within the continental United States. It eliminates the need to keep a current list of the per diem rate for each city. Standard Deduction for Meals Tax Year 2012 and 2013 High Cost Localities $ 65 All Other Localities $ 52 Transportation Workers $ 59 Medical Savings Account (MSAs)192 High Deductible Health Plans 2013 2012 Self Family Self Family Annual Minimum Deductible $2,150 $4,300 $2,100 $4,200 Annual Maximum Deductible $3,200 $6.450 $3,150 $6,300 Out-of-pocket Expense $4,300 $7,8500 $4,200 $7,650 65% of deductible 75% of deductible 65% of deductible 75% of deductible Maximum Annual Deductible 191 192 To start a HSA or MSA, the taxpayer needs to have a high deductible health insurance plan (HDHP). Deposits can be made by the employer on a pretax basis, into the MSA or HSA. If the deposits are not through the employer, then the collections will be post-tax. There are limits to the amounts that can be deposited into each account, and these limits are set by the IRS (and listed above). Pub. 535 IRC §220 (c )(2)(A) 375 Any amounts exceeding the limits are considered excessive, and are not taxdeductible. However, once the money has been deposited it remains in the taxpayer’s account, and even if the taxpayer leave the employment and drops the HDHP, the account will remain theirs. Differences between and HSA and A MSA: Both HSA and MSA need a HDHP in order to open such an account, but there are two further particulars required for a MSA. Only persons, or their spouses, in the employ of a company with 50 or less workers qualify for a MSA. The taxpayer or spouse can be self-employed. With a MSA, the taxpayer cannot receive contributions from the employer and the taxpayer within the same year, while for a HSA, that is possible. HSA limitations are set by the IRS at a fixed amount per year, while for the MSA, it is determined by a percentage of the yearly income and annual deductibles. A MSA is limited by the amount earned in that year. Medical Expenses: The AGI threshold for deducting medical expenses for the taxpayer, spouse or dependents that are paid in the taxable year increases from 7.5% to 10%, if the taxpayer itemizes their deductions on Schedule A. Effective date: Tax years beginning after December 31, 2012. NOTE: For taxpayers who have reached age 65 by the end of 2013, the effective date of this provision is delayed until January 1, 2017. Tax Deduction for Long-Term Care Insurance193 The rates have steadily increased each year. The deductible limits are includable as a medical deduction on Schedule A. Age before Close of Taxable Year 40 or less More than 40 not more than 50 More than 50 not more than 60 More than 60 not more than 70 More than 70 2012 Deduction Limits 2013 Deduction Limits $350 $660 $1,310 $3,500 $4,370 $360 $680 $1,360 $3,640 $4,550 Annual Exclusion for Gifts For calendar year 2013, the first $14,000 of gifts to any person (other than gifts of future interests in property) is not included in the total amount of taxable gifts made during the year.194 193 194 IRC §213(d)(10) IRC §2503 376 Community Property Income Form 8958195 – New for Tax Year 2012 Use Form 8958 to determine the allocation of tax amounts between married filing separate spouses, California same-sex spouses, or registered domestic partners (RDPs) with community property rights. This form is acceptable for electronic filing, prior to the 2012 tax year when allocating income for CA RDP’s or same-sex spouses with community property rights the return could not be electronicaly filed. If a statement must be added listing the source of the item and the total plus the allocated amounts the name of the taxpayer and social security number (SSN) must be on the statements and attach those statements at the end of the return. Community property laws affect how the taxpayer figures income on their federal income tax return if they are married, live in a community property state or country, and file separate returns. For federal tax purposes, a marriage means only a legal union between a man and a woman as husband and wife and the word “spouse” refers only to a person of the opposite sex who is a husband or a wife. Form 8958 is used for married spouses in community property states who choose to file married filing separately. This form is also for RDPs who are domiciled in Nevada, Washington, or California and for individuals in California who, for state law purposes, are married to an individual of the same sex. For 2010 and following years, a RDP in Nevada, Washington, or California (or a California same-sex spouse) generally must follow state community property laws and report half the combined community income of the individual and his or her RDP (or California same-sex spouse). General Rules – Property Income: Community or Separate? Community property is property: That the taxpayer or spouse (or RDP/California or Washington same-sex spouse), or both acquire during the marriage (or registered domestic partnership/same-sex marriage in California or Washington) while they are domiciled in a community property state. (Includes the part of property bought with community property funds if part was bought with community funds and part with separate funds.) That the taxpayer and the spouse (or RDP/California or Washington same-sex spouse) agreed to convert from separate to community property. That cannot be identified as separate property Community income is income from: Community property. Salaries, wages, or pay for services of the taxpayer, the spouse (or RDP/California or Washington same-sex spouse), or both during the marriage (or registered domestic partnership/same-sex marriage in California or Washington). Real estate that is treated as community property under the laws of the state where the property is located. 195 Form 8958 Instructions 377 Separate property is: Property that the taxpayer or spouse (or RDP/California or Washington same-sex spouse) owned separately before the marriage (or registered domestic partnership/same-sex marriage in California or Washington). Money earned while domiciled in a noncommunity property state. Property either the taxpayer or spouse received as a gift or inherited separately during the marriage (or registered domestic partnership/same-sex marriage in California or Washington). Property bought with separate funds, or exchanged for separate property, during the marriage (or registered domestic partnership/same-sex marriage in California or Washington). Property that the taxpayer and spouse (or RDP/California or Washington same-sex spouse) agreed to convert from community to separate property through an agreement valid under state law. The part of property bought with separate funds, if part was bought with community funds and part with separate funds. Separate income is income from: Separate property that belongs to the spouse who owns the property. Separate property that belongs to the RDP/California or Washington same-sex spouse who owns the property. RDPs (and California same-sex spouses) are not married for federal tax purposes. They can only use the single filing status, or if they qualify, the head of household filing status. Allocation of Certain Tax Return Items196 Dividends, interest, and rents: Dividends, interest, and rents from community property are community income and must be evenly split. Example: If the taxpayer and the spouse, (or RDP/California or Washington same-sex spouse) buy a bond that is considered community property under state laws, half the bond interest belongs to the taxpayer and half belongs to the spouse. Both the taxpayer and spouse each must show the bond interest and the split of that interest on Form 8958, and report half the interest on their Form 1040. Attach Form 8958 to Form 1040. Alimony received: Alimony or separate maintenance payments made prior to divorce are taxable to the payee spouse only to the extent they exceed 50% (his or her share) of the reportable community income. This is so because the payee spouse is already required to report half of the community income Alimony paid: Payments that may otherwise qualify as alimony are not deductible by the payer if they are the recipient spouse's part of community income. They are deductible as alimony only to the extent they are more than that spouse's part of community income. 196 Pub 555 378 Example: The taxpayer lives in a community property state. Under a written agreement, the taxpayer pays the spouse $12,000 of the $20,000 total yearly community income. The spouse receives no other community income. Under state law, earnings of a spouse living separately and apart from the other spouse continue as community property. On their separate returns, each of them must report $10,000 of the total community income. In addition, the spouse must report $2,000 as alimony received. The taxpayer can deduct $2,000 as alimony paid. Civil service retirement: For income tax purposes, community property laws apply to annuities payable under the Civil Service Retirement Act (CSRS) or Federal Employee Retirement System (FERS). Exemptions When taxpayer’s file separate returns, they must claim their own exemption amount for that year. The taxpayer cannot divide the amount allowed as an exemption for a dependent between the taxpayer and the spouse (or RDP/California or Washington same-sex spouse). When community funds provide support for more than one person, each of whom otherwise qualifies as a dependent, the taxpayer and the spouse (or RDP/California or Washington same-sex spouse) may divide the number of dependency exemptions as explained in the following example. Example: Ron and Diane White have three dependent children and live in Nevada. If Ron and Diane file separately, only Ron can claim his own exemption, and only Diane can claim her own exemption. Ron and Diane can agree that one of them will claim the exemption for one, two, or all of their children and the other will claim any remaining exemptions. They cannot each claim half of the total exemption amount for their three children IRA deduction: Deductions for IRA contributions cannot be split between spouses (or RDPs/California or Washington same-sex spouses). The deduction for each spouse (or RDP/California or Washington same-sex spouse) is figured separately and without regard to community property laws. Personal expenses: Expenses that are paid out of separate funds, such as medical expenses, are deductible by the spouse who pays them. If these expenses are paid from community funds, divide the deduction equally between the taxpayer and the spouse Child tax credit: The taxpayer may be entitled to a child tax credit for each of the qualifying children. The taxpayer must provide the name and identification number (usually the social security number) of each qualifying child on their return.The credit is limited if the modified adjusted gross income (modified AGI) is above a certain amount. The amount at which the limitation (phase-out) begins depends on the filing status. Generally, the credit is limited to the tax liability unless there are three or more qualifying children. 379 Self-employment tax197: Although the self-employment tax rules contain a provision that overrides community income treatment in the case of spouses (IRC 1402(a)(5)), this provision does not apply to RDPs or California same-sex spouses. RDPs and California same-sex spouses split self-employment income from sole proprietorships and partnerships for self-employment tax purposes. The following rules apply only to persons married for federal tax purposes. Sole proprietorship: With regard to net income from a trade or business (other than a partnership) that is community income, self-employment tax is imposed on the spouse carrying on the trade or business. Partnerships: The entire distributive share of a married partner's income or loss from a partnership trade or business is attributable to the partner for computing any selfemployment tax, even if a portion of the partner's distributive share of income or loss is community income or loss that is attributable to the partner's spouse for income tax purposes. If both spouses are partners, any self-employment tax is allocated based on their distributive shares. Federal income tax withheld: If the taxpayer and the spouse file separate returns on which each of reports half the community wages, each is entitled to credit for half the income tax withheld on those wages. Likewise, each RDP/California same-sex spouse is entitled to credit for half the income tax withheld on those wages. Safe Harbor Method for Office in Home The IRS has developed a new optional safe harbor method198 for taxpayers claiming office-in-home expenses. This safe harbor method is an alternative to the calculation, allocation, and substantiation of actual expenses. For tax years beginning on or after January 1, 2013, taxpayers have two choices for deducting office-in-home expenses. • Continue to use the actual expense method, or • Use the new optional safe harbor method. General rule. Section 280A generally disallows any deduction that is otherwise allowable as a business expense if it is related to a dwelling unit that is used as a residence by the taxpayer during the year. This is true even if the dwelling unit is used in the taxpayer’s trade or business. An exception applies for mortgage interest, property taxes, and casualty losses, which are deductible regardless of whether the residence is used for business purposes. Another exception to the general rule is if the taxpayer uses the residence for business and meets all the following requirements. Exclusive use test: An area of the home is used exclusively for business and not for personal purposes. Exceptions to the exclusive use test include an area used for the storage of inventory or product samples and areas used as a day care facility. 197 198 Form 8958 IRC §280A 380 Regular use test: The area must be used on a regular basis. Incidental or occasional business use does not count. Trade or business test: The area used for business must be used in connection with a trade or business. A profit-seeking activity for investment purposes, such as buying and selling stocks or managing a rental unit, that is not conducted as a trade or business does not qualify. Principal place of business test: The trade or business can have more than one location. However, the area in the home used for business must be the principal place of business for that trade or business. For this purpose, an area used for administrative or management activities qualifies if there is no other fixed location where substantial administrative or management activities are conducted. Employee use: In addition to the above general rules, an employee can deduct office-in-home expenses if the home office is for the convenience of the employer, the employee is able to itemize deductions on Schedule A, and the employee is not renting the home office to his or her employer. Substantiation rules: As with any business expense deduction, the taxpayer must be able to substantiate the cost. For office-in-home deductions, the cost must also be allocated between the amount used for business and the amount used for personal purposes. For example, after adding up all the costs for home utilities, the taxpayer must use a reasonable method to determine how much of that cost is for business. A method comparing the square footage of the business area with total livable square footage in the home, and then multiplying total costs by that percentage, is one reasonable method for allocating costs. The IRS recognizes that the calculation, allocation, and substantiation of allowable deductions attributable to an office-in-home can be complex and burdensome for small business owners. Accordingly, the IRS has developed this optional safe harbor method to reduce the administrative, recordkeeping, and compliance burdens of determining the allowable deduction for business use of the home under section 280A. Optional safe harbor method for calculating office-in-home deduction To use the optional safe harbor method, the taxpayer must otherwise qualify for deducting office-in-home expenses under prior rules (exclusive use test, regular use test, business use test, etc). Under the new optional method, deductible expenses are calculated by multiplying the allowable square footage of the office-in-home by the prescribed rate. The allowable square footage is the area used for business, but not more than 300 square feet. • The prescribed rate is $5 per square foot (300 × $5 = $1,500 maximum deduction) Itemized deductions: In addition to the above method for calculating office-in-home expenses, a taxpayer who itemizes deductions can deduct mortgage interest paid, property taxes, and casualty losses without regard to whether there is a qualified business use of the home for the year. Such deductions are deducted in full on Schedule A, with none being 381 allocated to the business tax form (Schedule C or F, etc.). However, if the taxpayer also uses a portion of the home for a rental activity, then mortgage interest, taxes, etc. must continue to be allocated between Schedule A and the rental activity form (Schedule E) to the extent required under prior rules. Election: If the taxpayer elects to use the above method to calculate deductible costs, then the taxpayer cannot deduct any actual expenses related to the office-in-home. This optional method does not apply to an employee with a home office if the employee receives advances, allowances, or reimbursements for expenses related to the qualified business use of the home. The election to use the optional safe harbor method is made on a year-by-year determination. The election is made by using the optional method on a timely filed, original tax return. Once made, the election is irrevocable. A change from using the optional method one year to actual expenses in another year is not considered a change in an accounting method and does not require consent from IRS. Unrelated business expenses: Other expenses, such as advertising and office supplies, continue to be deductible in addition to this new optional method to the extent they are allowed as ordinary and necessary business expenses199. Depreciation: If the new optional method is used, no depreciation deduction for the office-in-home is allowed. Depreciation for the use of the home is deemed zero in that year. If actual expenses are used in a subsequent year, the taxpayer must calculate the depreciation deduction allowable using the depreciation tables200 as if the taxpayer used the actual expense method for the year the property was placed in service. Gross income limitation: Nothing in the optional method allows a taxpayer to bypass the gross income limitation for deducting office-in-home expenses. Thus, the deduction computed using the safe harbor method cannot exceed the gross income derived from the qualified business use of the home. Square footage: If the square footage varies throughout the year, such as a seasonal business or a business that increases or decreases the business square footage use during the year, then calculate the average square footage for the year and use that amount to determine the deduction under this safe harbor method. Married taxpayers: If each spouse uses a separate area for a qualified home office, each spouse, regardless of filing status, may use this safe harbor method for a qualified business use of the same home up to 300 square feet each of different portions of the home. However, if someone has more than one qualified business use of the same home, that individual is limited to a maximum of 300 square feet for all businesses. Sally, a manicurist, is a sole proprietor who uses a room in her residence regularly and exclusively to meet with customers in the normal course of her trade or business 199 200 IRC §162 IRS Pub 946 382 throughout 2013. Sally determines that the room is 350 square feet and the total square footage of her home is 1900 square feet. Sally bought the house in 2011 and placed the room in service in January 2012. Sally depreciated the room as nonresidential real property using the optional depreciation table that corresponds with the general depreciation system, the straight-line method of depreciation, a 39-year recovery period, and the mid-month convention. During 2013, Sally earns $9,000 of gross income from the business and pays the following business expenses. Supplies..................................................................................................................... $ 1,500 Advertising................................................................................................................ ...... 800 License fees……............................................................................................................. 300 Magazines/subscriptions........................................................................................... ...... 700 Postage...................................................................................................................... ...... 100 Total......................................................................................................................... $ 3,400 Sally also pays the following expenses related to her home in 2013. Mortgage interest................................................................................................. $ 10,000 Real property taxes................................................................................................... 3,000 Homeowners’ insurance........................................................................................... 1,500 Utilities..................................................................................................................... 2,400 Repairs...................................................................................................................... .. 900 Total.................................................................................................................... $ 17,800 Example 1: For 2013, Sally elects the safe harbor method. Sally determines the amount of her deduction for the qualified business use of her home is $1,500 (300 sq. ft. × $5). Sally deducts her mortgage interest ($10,000), and real property taxes ($3,000) as itemized deductions on her federal income tax return (Schedule A, Form 1040). Sally deducts her ordinary and necessary business expenses that are unrelated to the qualified business use of her home ($3,400) as trade or business expenses Schedule C, Form 1040)) to the extent otherwise allowed. Sally may not deduct any portion of the actual expenses related to the qualified business use of her home for 2013 (homeowners’ insurance, utilities, and repairs). Sally may not deduct any depreciation for the room on her federal income tax return for 2013, and the depreciation deduction allowable for the room for 2013 is deemed to be zero. 383 Example 2: For 2014, Sally has a profit on her manicure business of $16,000 and she does not elect the safe harbor method. Sally calculates and substantiates actual expenses for purposes of section 280A. Sally must use the appropriate optional depreciation table for determining the depreciation deduction allowable for the room for 2014. The appropriate optional depreciation table provides that the depreciation rate for year three is 2.033%. Sally computes depreciation for the room for 2014 as follows: (350 sq.ft divided by 1900 sq ft = 18.42%) x ($156,000 (the basis of the home) = $28,735 (The basis of the business portion of home) The 2014 depreciation using the 39-year recovery period is: $28,735 x 2.033% = $584. Assuming the same home expenses in tax year 2014 as in 2013, Sally’s deduction is: $17,800 x 18.42% = 3279 + $584 (depreciation) = $3862 Total Business Use of Home For purposes of disallowed expenses from prior years due to the gross income limitation, a taxpayer using the safe harbor method may not deduct in that year any disallowed amounts carried over from a prior taxable year. Such disallowed expenses may be carried over to a future year in which the actual expense method is used. Affordable Care Act Tax Provisions201 Additional Medicare Tax A new Additional Medicare Tax goes into effect starting in 2013. The 0.9 percent Additional Medicare Tax applies to an individual’s wages, Railroad Retirement Tax Act compensation, and self-employment income that exceeds a threshold amount based on the individual’s filing status. The threshold amounts are $250,000 for married taxpayers who file jointly, $125,000 for married taxpayers who file separately, and $200,000 for all other taxpayers. An employer is responsible for withholding the Additional Medicare Tax from wages or compensation it pays to an employee in excess of $200,000 in a calendar year. The Medicare Payroll Tax In 2012, the Medicare payroll tax was 2.9%. It applied only to earned income, which includes wages that are paid by an employer, plus tips. The taxpayer share, 1.45%, was deducted automatically from the paycheck. The employer pays the other 1.45%. In 2013, high-wage earners will owe an additional 0.9% on earned income above $200,000 (single filers) or $250,000 (married filing jointly). Example 1: If the taxpayer is a single filer whose salary will be $225,000 in 201 www.irs.gov/uac/Affordable-Care-Act-Tax-Provisions 384 2013, they will pay a 1.45% Medicare tax on the first $200,000, then 2.35% (1.45% plus 0.9%) on the next $25,000. The employer will be required to withhold the extra 0.9% once the taxpayer’s wages pass the $200,000 threshold for individuals. Example 2: There is a married couple filing a joint return. The taxpayer earns wages of $150,000 and the spouse earns wages of $175,000. Both employers withheld 1.45% Medicare tax because neither the taxpayer nor the spouse earned over $200,000. The couples’ total earnings is $325,000, they owe an additional $675 ($325,000 minus $250,000 = $75,000 x .9%). The couple can either pay this additional amount when they file their return or pay an estimated voucher. The Medicare Surtax on Net Investment Income. A 3.8% surtax will be due on the lesser of net investment income for the year, or the amount by which the taxpayer’s “modified adjusted gross income”—or MAGI—exceeds the income thresholds. Note that a taxpayer could be subject to both the additional 0.9% tax on earned income and this 3.8% tax. 385 Individuals will owe the tax if they have Net Investment Income and also have modified adjusted gross income over the following thresholds: Filing Status Threshold Amount Married filing jointly $250,000 Married filing separately $125,000 Single $200,000 Head of household (with qualifying person) $200,000 Qualifying widow(er) with dependent child $250,000 Taxpayers should be aware that these threshold amounts are not indexed for inflation. If the taxpayer is an individual that is exempt from Medicare taxes, they still may be subject to the Net Investment Income Tax if they have Net Investment Income and also have modified adjusted gross income over the applicable thresholds Example: Jack and Jill’s MAGI is $372,000, of which $330,000 is wages and $42,000 is net investment income. Their MAGI is $122,000 over the $250,000 threshold for married couples filing jointly. They will incur the 3.8% tax on they $42,000 of net investment income, because it is less than the amount they are over the MAGI threshold ($122,000). They will also owe 0.9% on the $80,000 that their wages are over the $250,000 earned income threshold for married couples filing jointly. Their total Medicare tax surcharge will be $2,316, which includes $1,596 (3.8% of $42,000) and $720 (0.9% on $80,000). In general, investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities, and businesses that are passive activities to the taxpayer (within the meaning of IRC section 469). The Net Investment Income Tax is subject to the estimated tax provisions. Individuals, estates, and trusts that expect to be subject to the tax in 2013 or thereafter should adjust their income tax withholding or estimated payments to account for the tax increase in order to avoid underpayment penalties Reporting Employer Provided Health Coverage in Form W-2 The Affordable Care Act requires employers to report the cost of coverage under an employer-sponsored group health plan on an employee’s Form W-2, Wage and Tax Statement, in Box 12, using Code DD. Many employers are eligible for transition relief for tax-year 2012 and beyond, until the IRS issues final guidance for this reporting requirement. The amount reported does not affect tax liability, as the value of the employer excludible contribution to health coverage continues to be excludible from an employee's income, and it is not taxable. This reporting is for informational purposes only, to show employees the value of their health care benefits. 386 Requirement to Have Health Insurance202 Why is this important to tax preparers? This is going to be talked about in many of your interviews with taxpayers, even if they are not directly affected since they have maintained their own health insurance and will continue to do so. Tax preparers are also involved because penalties and credits are going to be part the filing of a tax return. The more you know the better equipped you will be to answer the questions. Beginning January 1, 2014, all U.S. residents are required to maintain minimum essential Coverage. Statutory Exemption from Shared Responsibility 1. Religious conscience: The taxpayer is a member of a religious sect that is recognized as conscientiously opposed to accepting any insurance benefits. The Social Security Administration administers the process for recognizing these sects according to the criteria in the law. 2. Health care sharing ministry: The taxpayer is a member of a recognized health care sharing ministry. 3. Indian tribes: The taxpayer is a member of a federally recognized Indian tribe. 4. No filing requirement: The household income is below the minimum threshold for filing a tax return. The requirement to file a federal tax return depends on the filing status, age, and types and amounts of income. 5. Short coverage gap: The taxpayer went without coverage for less than three consecutive months during the year. In general, a gap in coverage that lasts less than three months qualifies as a short coverage gap. If an individual has two short coverage gaps during a year, the short coverage gap exemption only applies to the first or earlier gap. 6. Hardship: A Health Insurance Marketplace, also known as an Affordable Insurance Exchange, has certified that the taxpayer has suffered a hardship that makes it unable to obtain coverage. 7. Unaffordable coverage options: The taxpayer cannot afford coverage because the minimum amount they must pay for the premiums is more than eight percent of the household income. 8. Incarceration: the taxpayer is in a jail, prison, or similar penal institution or correctional facility after the disposition of charges. 9. Not lawfully present: The taxpayer is neither a U.S. citizen, a U.S. national, nor an alien lawfully present in the U.S. The individual shared responsibility provision goes into effect in 2014. The taxpayer will not have to account for coverage or exemptions or to make any payments until they are filing the 2014 federal income tax return in 2015. Information will be made available later about how the income tax return will take account of coverage and exemptions. Insurers will be required to provide everyone that they cover each year with information that will help them demonstrate they had coverage. 202 IRC§ 5000A(d) 387 Individuals are responsible for ensuring that they, and any dependent, are covered under minimum essential coverage. Minimum essential coverage includes: Government sponsored programs including: Medicare, Medicaid, Children’s Health Insurance Program coverage (CHIP), TRICARE, coverage through Veterans Affairs, and Health Care for Peace Corps volunteers; Employer-sponsored plans including governmental plans, grandfathered plans and other plans offered in the small or large group market; Individual market plans, including grandfathered plans; or Other coverage designated as minimum essential coverage by HHS and/or the Dept. of the Treasury. There are varying levels of coverage that can be purchased that would satisfy these requirements; for purposes of ACA, they are divided into four categories: bronze, silver, gold and platinum. The penalty will be paid as a federal tax liability on income tax returns and is enforced by the Treasury. The penalty is the greater of: For 2014, $95 per uninsured person or 1 percent of household income over the filing threshold, For 2015, $325 per uninsured person or 2 percent of household income over the filing threshold, and For 2016 and beyond, $695 per uninsured person or 2.5 percent of household income over the filing threshold. There is a family cap on the flat dollar amount (but not the percentage of income test) of 300 percent, and the overall penalty is capped at the national average premium of a bronze level plan purchases through an exchange. For individuals under 18 years old, the applicable per person penalty is one-half of the amounts listed above. Example: The flat dollar amount per individual is $95 in 2014; $325 in 2015 and $695 in 2016. After 2016, the flat dollar amount is indexed to inflation. The flat dollar penalty is capped at 300% of the flat dollar amount. A family of three (two parents and one child under 18) would have a flat dollar penalty of $1737 in 2016; A family of four (two parents and two children over 18) would have a flat dollar penalty of $2,085 in 2016 because the 300 % cap would apply. 388 Example: The percentage of taxable income is an amount equal to a percentage of a household income (as defined by the Act) that is in excess of the tax filing threshold (phased in at 1% in 2014; 2% in 2015; 2.5% in 2016). If an individual has a household income of $50,000, the percentage would be 1% of the difference between $50,000 and the tax threshold (which is $9,350 for an individual in 2010). Assuming the tax threshold is $10,000 in 2014. This individual would be subject to a percentage penalty of $400. Because this percentage penalty is greater than the flat dollar penalty for 2014 (which is $95), so the individual would pay the percentage penalty. Generally, the annual penalty is capped at an amount equal to the national average premium for qualified health plans that have a bronze level of coverage available through the state exchange. Beginning in 2017, the penalties will be increased by the cost-of-living adjustment. A penalty will not be assessed on individuals who: 1. Cannot afford coverage based on formulas contained in the law, 2. Have income below the federal income tax filing threshold, 3. Are members of Indian tribes, 4. Were uninsured for short coverage gaps of less than three months; 5. Have received a hardship waiver from the Secretary, or are residing outside of the United States, or are bona fide residents of any possession of the United States Individuals that fail to pay the penalty will not be subject to criminal penalties, liens or levies. Health Insurance Premium Tax Credit203 Starting in 2014, individuals and families can take a new premium tax credit to help them afford health insurance coverage purchased through an Affordable Insurance Exchange. Exchanges will operate in every state and the District of Columbia. The premium tax credit is refundable so taxpayers who have little or no income tax liability can still benefit. The credit also can be paid in advance to a taxpayer’s insurance company to help cover the cost of premiums. On May 18, 2012, the Treasury Department and the IRS issued final regulations that provide guidance for individuals who enroll in qualified health plans through Exchanges and claim the premium tax credit, and for Exchanges that make qualified health plans available to individuals and employers. Additionally, on Jan. 30, 2013, the Treasury Department and IRS released final regulations on the premium tax credit affordability test for related individuals. 203 Federal Register /Vol. 77, No. 100 389 The Premium Tax Credit: • Makes Coverage Affordable. Millions of Americans will be given help to purchase private health coverage through an Affordable Insurance Exchange. To assist in making coverage affordable, the level of support is tailored to individuals’ needs. • Provides a Substantial Benefit. The Congressional Budget Office estimates that, when the Affordable Care Act is fully phased in, individuals receiving premium tax credits will get an average subsidy of over $5,000 per year. • Builds on What is Best in the Existing Health Care System. The Affordable Care Act includes crucial safeguards to ensure that the coverage purchased on an Affordable Insurance Exchange with the premium tax credits will supplement – not supersede – existing employer- and government-sponsored health programs (including TRICARE). This allows Americans to keep the coverage they have. Key Facts about the Premium Tax Credit: • Broad Middle-Class Eligibility. The premium tax credit is generally available to individuals and families with incomes between 100% and 400% of the federal poverty level ($22,350 – $89,400 for a family of four in 2011), providing a crucial safety net for the middle class. The Congressional Budget Office estimates that, when the Affordable Care Act is fully phased in, the premium tax credit will help 20 million Americans afford health insurance. • Larger Tax Credits for Older Americans who Face Higher Premiums. The amount of the premium tax credit is tied to the amount of the premium, so that older Americans who face higher premiums will receive a greater credit. • Controls Health Care Costs by Incentivizing Families to Choose More CostEffective Coverage. The amount of the premium tax credit is generally fixed based on a benchmark plan (which may be age- adjusted within Affordable Care Act limitations), so families that choose to purchase coverage that is less expensive than the benchmark plan will pay less towards the cost of that coverage. • Credit Is Refundable So Even Families with Modest Incomes Can Benefit. The premium tax credit is fully refundable, so even moderate-income families who may have little federal income tax liability (but who may pay a higher share of their income towards payroll taxes and other taxes) can receive the full benefit of the credit. • Credit Is Advanceable to Help Families with Limited Cash-Flow. Since many moderate-income families may not have sufficient cash on hand to pay the full premium upfront, an advance payment of the premium tax credit will be made by the Department of the Treasury directly to the insurance company. This advance payment will assist families to purchase the health insurance they need. Later, the advance payment will be reconciled against the amount of the family’s actual premium tax credit, as calculated on the family’s federal income tax return. 390 How the Premium Tax Credit Works Eligibility • Household income must be between 100% and 400% of the federal poverty level. • Covered individuals must be enrolled in a “qualified health plan” through an Affordable Insurance Exchange. • Covered individuals must be legally present in the United States and not incarcerated. • Covered individuals must not be eligible for other qualifying coverage, such as Medicare, Medicaid, or affordable employer-sponsored coverage. Credit Amount • The credit amount is generally equal to the difference between the premium for the “benchmark plan” and the taxpayer’s “expected contribution.” • The expected contribution is a specified percentage of the taxpayer’s household income. The percentage increases as income increases, from 2% of income for families at 100% of the federal poverty level (FPL) to 9.5% of income for families at 400% of FPL. (The actual amount a family pays for coverage will be less than the expected contribution if the family chooses a plan that is less expensive than the benchmark plan.) • The benchmark plan is the second-lowest-cost plan that would cover the family at the “silver” level of coverage. • The credit is capped at the premium for the plan the family chooses (so no one receives a credit that is larger than the amount they actually pay for their plan). Special Rules • The credit is advanceable, with advance payments made directly to the insurance company on the family’s behalf. The advance payments are then reconciled against the amount of the family’s actual premium tax credit, as calculated on the family’s federal income tax return. Any repayment due from the taxpayer is subject to a cap for taxpayers with incomes under 400% of FPL. The caps range from $600 for married taxpayers ($300 for single taxpayers) with household income under 200% of FPL to $2,500 for married taxpayers ($1,250 for single taxpayers) with household income above 300% but less than 400% of FPL. • The proposed regulation provides that a taxpayer is not required to repay any portion of the advance payment if a family ends the year with household income below 100% of FPL after having received advance payments based on an initial Exchange determination of ineligibility for Medicaid. Individual Shared Responsibility Provision204 Starting in 2014, the Individual Shared Responsibility provision calls for each individual to either have minimum essential health coverage (minimum essential coverage) for each month, qualify for an exemption, or make a payment when filing his or her federal income tax return. • The provision applies to individuals of all ages, including children. The adult or married couple who can claim a child or another individual as a dependent for 204 www.irs.gov/uac/Questions-and-Answers-on-the-Individual-Shared-Responsibility-Provision 391 • • federal income tax purposes is responsible for making the payment if the dependent does not have coverage or an exemption The provision goes into effect on Jan. 1, 2014. It applies to each month in the calendar year. The amount of any payment owed takes into account the number of months in a given year an individual is without coverage or an exemption Most individuals in the United States have health coverage today that will count as minimum essential coverage and will not need to do anything more than continue the coverage that they have. For those who do not have coverage, who anticipate discontinuing the coverage they have currently, or who want to explore whether more affordable options are available, Health Insurance Marketplaces (also known as Affordable Insurance Exchanges) will open for every state and the District of Columbia in October of 2013. These Health Insurance Marketplaces will help qualified individuals find minimum essential coverage that fits their budget and potentially financial assistance to help with the costs of coverage beginning in 2014. The Health Insurance Marketplace will also be able to assess whether applicants are eligible for Medicaid or the Children’s Health Insurance Program (CHIP). For those who will become eligible for Medicare during 2013, enrolling for Medicare will also ensure that the taxpayer has minimum essential coverage for 2014 Disclosure of Tax Return Information TaxEase has included the following sections about the disclosure of tax return information to health care providers under the Affordable Care Act, to provide information to preparers when or if questions may arise. According to these regulations taxpayers will be providing tax return and financial information and the IRS will have the authority to provide this information, but tax preparers205 will not, they will be following the disclosure rules206 in place. For a thorough discussion of disclosure rules refer to the TaxEase 2013 Ethics course. In proposing regulations in the Federal Register on August 17, 2011, the Secretary of Health and Human Services concluded that a less burdensome and more reasonable eligibility process would not require an individual to provide an Exchange with specific income-related information, such as the individual’s MAGI. Final regulations published in the Federal Register on March 27, 2012207 limiting the information an individual needs to provide to an Exchange for purposes of income verification and allowing the Exchange to solicit information from the IRS through HHS with respect to the individual and his family members whose names and social security numbers, or adoption taxpayer identification numbers, are provided. The regulations also provide guidance on the eligibility determination process for enrollment in a Qualified Health Plan, advance payments of the premium tax credit and cost-sharing reductions, and other insurance affordability programs. Section 6103(l)(21) permits the disclosure of return information to assist Exchanges in performing certain functions set forth in section 1311 of the Affordable Care Act for 205 IRC §7216 IRC §6713 207 77 Federal Register 18310 206 392 which income verification is required (including determinations of eligibility for the insurance affordability programs described in the Affordable Care Act), as well as to assist State agencies administering a State Medicaid program under title XIX of the Social Security Act, Children’s Health Insurance Program, or a basic health program under section 1331 of the Affordable Care Act (if applicable). Section 6103(l)(21) identifies specific items of return information that will be disclosed and permits the disclosure of such other items prescribed by regulation that might indicate whether an individual is eligible for the premium tax credit under section 36B or cost-sharing reductions under section 1402, and the amount thereof. After an individual submits an application for financial assistance in obtaining health coverage provided208 to an Exchange or State agency, the IRS will disclose the available items of return information to the agency that is processing the application. Under section 6103(l)(21)(A), the IRS will disclose to HHS (including its contractor(s)) certain items of return information, as enumerated in the statute or by regulation, for any relevant taxpayer. For purposes of these regulations, a relevant taxpayer is defined to be any individual listed, by name and social security number or adoption taxpayer identification number (“taxpayer identity information”), on the application whose income may bear upon a determination of the eligibility of an individual for an insurance affordability program. For each relevant taxpayer, section 6103(l)(21) explicitly authorizes the disclosure of the following items of return information from the reference tax year: taxpayer identity information, filing status, the number of individuals for which a deduction under section 151 was allowed (“family size”), MAGI, and the taxable year to which any such information relates or, alternatively, that such information is not available. In some situations, the IRS will be unable to calculate MAGI. While uncommon, for certain relevant taxpayers who receive nontaxable social security benefits, the IRS may not have complete information from which to determine the amount of those benefits. If the IRS has information indicating that a relevant taxpayer received nontaxable social security benefits, but is unable to determine the amount of those benefits, the IRS will provide the aggregate amount of the other components used to calculate the relevant taxpayer’s MAGI, as well as information indicating that the amount of nontaxable social security benefits must still be taken into account to determine MAGI. Similarly, where MAGI is not available, the IRS will disclose the adjusted gross income, as well as information indicating that the other components of MAGI must still be taken into account to determine MAGI. Because the Affordable Care Act and HHS’s final regulations require that Exchanges use alternative means to verify income where information is not available from the IRS, these explanatory items may assist an Exchange in determining an individual’s eligibility for, and amount of, any advance payment of the premium tax credit or cost-sharing reductions. The proposed regulations further provide that, in certain instances, where some or all of the items of return information prescribed by statute or regulation is unavailable, the IRS will provide information indicating why the particular item of return information is not available. Where an individual jointly filed with a spouse who is not a relevant taxpayer 208 pursuant to Title I, subtitle E, of the Affordable Care Act 393 (that is, that spouse is not included on the application), the IRS will not disclose MAGI from the joint return because it cannot be appropriately allocated between the two spouses. Instead, the IRS will disclose that a joint return had been filed. This additional information may help individuals correct any errors or understand why they need to pursue alternative routes to verify their income. This information, therefore, also can assist Exchanges in determining whether an individual is eligible for advance payments of the premium tax credit or cost-sharing reductions. Additionally, the IRS may have information in its records indicating that a relevant taxpayer had been a victim of identity theft or that a relevant taxpayer has been reported as deceased. The proposed regulations provide that the IRS will disclose that, although a return for that taxpayer is on file, the information described under section 6103(l)(21) is not being provided because IRS records suggest that the Exchange should take additional steps to authenticate the identities of the relevant taxpayers and may need to use alternate means for income verification. Where an individual who is listed as a dependent on the application (for the tax year in which the premium tax credit will be claimed) filed a return in the reference tax year but did not have a tax filing requirement for that year (based upon the return filed), the IRS will provide information indicating the dependent listed did not have a filing requirement because the information is relevant to the Exchange’s computation of household income. NOTE: This is just the beginning of the information that will be available regarding the disclosure of information for the “Affordable Care Act”. The safest way to assist the taxpayer when they are researching health care options would be to provide the taxpayer with the information needed. They will then have the option of disclosing the information and the tax preparer will not be in violation of any disclosure rules. 394 Health Coverage for Older Children209 Health coverage for an employee's children under 27 years of age is now generally taxfree to the employee. This expanded health care tax benefit applies to various work place and retiree health plans. These changes immediately allow employers with cafeteria plans –– plans that allow employees to choose from a menu of tax-free benefit options and cash or taxable benefits –– to permit employees to begin making pre-tax contributions to pay for this expanded benefit. This also applies to self-employed individuals who qualify for the self-employed health insurance deduction on their federal income tax return. As a result of changes made by the recently enacted Affordable Care Act, health coverage provided for an employee's children under 27 years of age is now generally tax-free to the employee. Employers with cafeteria plans –– plans that allow employees to choose from a menu of tax-free benefit options and cash or taxable benefits –– are allowed to permit employees to begin making pre-tax contributions to pay for this expanded benefit. This expanded health care tax benefit applies to various workplace and retiree health plans. It also applies to self-employed individuals who qualify for the self-employed health insurance deduction on their federal income tax return. Employees who have children who will not have reached age 27 by the end of the year are eligible for the new tax benefit from March 30, 2010, forward, if the children are already covered under the employer’s plan or are added to the employer’s plan at any time. For this purpose, a child includes a son, daughter, stepchild, adopted child or eligible foster child. This new age 27 standard replaces the lower age limits that applied under prior tax law, as well as the requirement that a child generally qualify as a dependent for tax purposes. The notice says that employers with cafeteria plans may permit employees to immediately make pre-tax salary reduction contributions to provide coverage for children under age 27, even if the cafeteria plan has not yet been amended to cover these individuals. Plan sponsors then have until the end of 2010 to amend their cafeteria plan language to incorporate this change. In addition to changing the tax rules as described above, the Affordable Care Act also requires plans that provide dependent coverage of children to continue to make the coverage available for an adult child until the child turns age 26. The extended coverage must be provided not later than plan years beginning on or after Sept. 23, 2010. The favorable tax treatment described in the notice applies to that extended coverage. Ethics Rev. Proc. 2013-14 – Disclosure or use permitted only with taxpayers consent 26 CFR 301.7216-3: Disclosure or use permitted only with the taxpayer's consent. (Also: Sections 7216, 6713) 209 IRS Notice 2010-38 395 SECTION 1. PURPOSE This revenue procedure provides guidance to tax return preparers regarding the format and content of taxpayer consents to disclose and consents to use tax return information with respect to taxpayers filing a return in the Form 1040 series (e.g., Form 1040, Form 1040NR, Form 1040A, or Form 1040EZ) under section 301.7216-3 of the Regulations on Procedure and Administration (26 CFR Part 301). This revenue procedure also provides specific requirements for electronic signatures when a taxpayer executes an electronic consent to the disclosure or consent to the use of the taxpayer’s tax return information. This revenue procedure modifies and supersedes Revenue Procedure 2008-35, 2008-29 I.R.B. 132, to provide guidance pursuant to section 301.7216-3. SECTION 2. CHANGES This revenue procedure modifies the mandatory language required on each taxpayer consent to disclose or consent to use tax return information. This revenue procedure also explains the difference between tax return preparation services (or auxiliary services) and other financial or accounting services. Some taxpayers have expressed confusion regarding whether they needed to complete consent forms to engage a tax return preparer to perform tax return preparation services. The modified mandatory language required in consent forms clarifies that a taxpayer does not need to complete a consent form to engage a tax return preparer to perform only tax return preparation services. To allow a tax return preparer to disclose or use tax return information in providing services other than tax return preparation, however, a taxpayer must complete a consent form as described in this revenue procedure. Sections 5.04(1) (a) and (c) provide the modified language that must be included on each consent to disclose or consent to use tax return information. The examples in section 7 reflect the modified language provided in section 5.04. In addition, a few nonsubstantive changes have been made to the revenue procedure to promote clarity. SECTION 3. BACKGROUND .01 In general, section 7216(a) of the Internal Revenue Code imposes criminal penalties on tax return preparers who knowingly or recklessly make unauthorized disclosures or uses of information furnished in connection with the preparation of an income tax return. A violation of section 7216 is a misdemeanor, with a penalty of up to one-year imprisonment or a fine of not more than $1,000, or both, together with the costs of prosecution. Section 7216(b) establishes exceptions to the general rule in section 7216(a) and also authorizes the Secretary to promulgate regulations prescribing additional permitted disclosures or uses. 396 .02 Section 6713(a) prescribes a related civil penalty for unauthorized disclosures or uses of information furnished in connection with the preparation of an income tax return. The penalty for violating section 6713 is $250 for each disclosure or use, not to exceed a total of $10,000 for a calendar year. Section 6713(b) provides that the exceptions in section 7216(b) also apply to section 6713. .03 Section 301.7216-3 provides that, unless section 7216 or §301.7216-2 specifically permits the disclosure or use of tax return information, a tax return preparer may not disclose or use a taxpayer’s tax return information without obtaining a consent from the taxpayer. Section 301.7216-3(a) provides that consent must be knowing and voluntary. Section 301.7216-3(a) (3) (i) prescribes the form and content requirements that all consents to disclose or consents to use must include. Section 301.7216-3(b) provides timing requirements and other limitations upon consents to disclose or consents to use tax return information. Section 301.7216-3(b)(4) provides a limitation upon consents to disclose a taxpayer’s social security number to a tax return preparer located outside of the United States. .04 Section 301.7216-3(a) (3) (ii) provides that the Secretary may, by publication in the Internal Revenue Bulletin, prescribe additional requirements for tax return preparers regarding the format and content of consents to disclose and consents to use tax return information with respect to taxpayers filing a return in the Form 1040 series, as well as the requirements for a valid signature on an electronic consent under section 7216. Section 301.7216-3(b)(4)(ii) provides that the Secretary may require, by publication in the Internal Revenue Bulletin, additional consent format and content requirements for purposes of consents to disclose a taxpayer’s social security number. This revenue procedure defines an “adequate data protection safeguard” and describes the requirements of an adequate data protection safeguard for purposes of removing the limitation upon consents to disclose a taxpayer’s social security number to a tax return preparer located outside of the United States. SECTION 4. SCOPE This revenue procedure applies to all tax return preparers, as defined in §301.72161(b)(2), who seek consent to disclose or consent to use tax return information pursuant to §301.7216-3 with respect to taxpayers who file a return in the Form 1040 series. Taxpayers who are not filers of returns in the Form 1040 series may use language prescribed in this revenue procedure or consents whose formats and content do not conform to this revenue procedure as long as the consents otherwise meet the requirements of Treas. Reg. § 301.7216-3. SECTION 5. FORM AND CONTENT OF A CONSENT TO DISCLOSE OR A CONSENT TO USE FORM 1040 TAX RETURN INFORMATION .01 Separate Written Document. Except as provided by §301.7216-3(c)(1) (special rule for multiple disclosures or multiple uses within a single consent form), and described in section 5.05, below, a taxpayer’s consent to each separate disclosure or separate use of tax return information must be contained on a separate written document, which can be furnished on paper or electronically. For example, the separate written document may be 397 provided as an attachment to an engagement letter furnished to the taxpayer. .02 A consent furnished to the taxpayer on paper must be provided on one or more sheets of 8½ inch by 11 inch or larger paper. All of the text on each sheet of paper must pertain solely to the disclosure or use the consent authorizes, and the sheet or sheets, together, must contain all the elements described in section 5.04 and, if applicable, comply with section 5.06. All of the text on each sheet of paper must also be in at least 12-point type (no more than 12 characters per inch). .03 A consent furnished in electronic form must be provided on one or more computer screens. All of the text placed by the preparer on each screen must pertain solely to the disclosure or use of tax return information authorized by the consent, except for computer navigation tools. The text of the consent must meet the following specifications: the size of the text must be at least the same size as, or larger than, the normal or standard body text used by the website or software package for direction, communications, or instructions and there must be sufficient contrast between the text and background colors. In addition, each screen or screens, together, must: (1) contain all the elements described in section 5.04 and, if applicable, comply with section 5.06, (2) be able to be signed as required by section 6 and dated by the taxpayer, and (3) be able to be formatted in a readable and printer-friendly manner. .04 Requirements for every consent. In addition to the requirements provided in §301.7216-3, consents to disclose or use Form 1040 series tax return information must satisfy the following requirements: (1) Mandatory statements in the consent. The following statements must be included in a consent under the circumstances described below, except that a tax return preparer may substitute the preparer’s name where “we” or “our” is used. (a) Consent to disclose tax return information in a context other than tax return preparation or auxiliary services. Unless a tax return preparer is obtaining a taxpayer’s consent to disclose the taxpayer’s tax return information to another tax return preparer to perform services that assist in, or to provide auxiliary services (as defined in §301.72161(b) (2) (iii)) in connection with, the preparation of the taxpayer’s tax return, any consent to disclose tax return information must contain the following statements in the following sequence: Federal law requires this consent form be provided to you. Unless authorized by law, we cannot disclose your tax return information to third parties for purposes other than the preparation and filing of your tax return without your consent. If you consent to the disclosure of your tax return information, Federal law may not protect your tax return information from further use or distribution. You are not required to complete this form to engage our tax return preparation services. If we obtain your signature on this form by conditioning our tax return preparation services on your consent, your consent will not be valid. If you agree to the disclosure of your tax return information, your consent is valid for the amount of time that you specify. If you do not specify the duration of your consent, your consent is valid for one year from the date of signature. (b) Consent to disclose tax return information in tax return preparation or auxiliary services context. If a tax return preparer is otherwise required to obtain a taxpayer’s consent to disclose the taxpayer’s tax return information to another tax return preparer to 398 perform services that assist in the preparation of, or to provide auxiliary services (as defined in §301.7216-1(b) (2) (iii)) in connection with, the preparation of the taxpayer’s tax return, any consent to disclose tax return information must contain the following statements in the following sequence: Federal law requires this consent form be provided to you. Unless authorized by law, we cannot disclose your tax return information to third parties for purposes other than those related to the preparation and filing of your tax return without your consent. If you consent to the disclosure of your tax return information, Federal law may not protect your tax return information from further use or distribution. You are not required to complete this form. Because our ability to disclose your tax return information to another tax return preparer affects the tax return preparation service(s) that we provide to you and its (their) cost, we may decline to provide you with tax return preparation services or change the terms (including the cost) of the tax return preparation services that we provide to you if you do not sign this form. If you agree to the disclosure of your tax return information, your consent is valid for the amount of time that you specify. If you do not specify the duration of your consent, your consent is valid for one year from the date of signature. (c) Consent to use. All consents to use tax return information must contain the following statements in the following sequence: Federal law requires this consent form be provided to you. Unless authorized by law, we cannot use your tax return information for purposes other than the preparation and filing of your tax return without your consent. You are not required to complete this form to engage our tax return preparation services. If we obtain your signature on this form by conditioning our tax return preparation services on your consent, your consent will not be valid. Your consent is valid for the amount of time that you specify. If you do not specify the duration of your consent, your consent is valid for one year from the date of signature. (d) All consents must contain the following statement: If you believe your tax return information has been disclosed or used improperly in a manner unauthorized by law or without your permission, you may contact the Treasury Inspector General for Tax Administration (TIGTA) by telephone at 1800-366-4484, or by email at complaints@tigta.treas.gov. (e) Mandatory statement in any consent to disclose tax return information to a tax return preparer located outside of the United States. If a tax return preparer to whom the tax return information is to be disclosed is located outside of the United States, the taxpayer’s consent under §301.7216-3 is required prior to any disclosure. See §§ 301.7216-3(a) (3) (i) (D), 301.7216-2(c) and (d). (i) If the tax return information to be disclosed does not include the taxpayer’s social security number or if the social security number is fully masked or otherwise redacted, consents for disclosure of tax return information to a tax return preparer outside of the United States must contain the following statement: This consent to disclose may result in your tax return information being disclosed to a tax return preparer located outside the United States. (ii) If the tax return information to be disclosed includes the taxpayer’s social security number or if the social security number is not fully masked or otherwise redacted, pursuant to the limitations of §301.7216-3(b) (4) and section 5.07, consents for disclosure 399 of the taxpayer’s tax return information that includes a social security number to a tax return preparer outside of the United States must contain the following statement: This consent to disclose may result in your tax return information being disclosed to a tax return preparer located outside the United States, including your personally identifiable information such as your Social Security Number (“SSN”). Both the tax return preparer in the United States that will disclose your SSN and the tax return preparer located outside the United States that will receive your SSN maintain an adequate data protection safeguard (as required by the regulations under 26 U.S.C. section 7216) to protect privacy and prevent unauthorized access of tax return information. If you consent to the disclosure of your tax return information, federal agencies may not be able to enforce United States laws that protect the privacy of your tax return information against a tax return preparer located outside of the United States to whom the information is disclosed. (2) Affirmative consent. All consents must require the taxpayer’s affirmative consent to a tax return preparers' disclosure or use of tax return information. A consent that requires the taxpayer to remove or deselect disclosures or uses that the taxpayer does not wish to be made (i.e., an “opt-out” consent) is not permitted. (3) Signature. All consents to disclose or use tax return information must be signed by the taxpayer. (a) For consents on paper, the taxpayer’s consent to a disclosure or use must contain the taxpayer’s handwritten signature. (b) For electronic consents, a taxpayer must sign the consent by any method prescribed in section 6, below. (4) Incomplete consents. A tax return preparer shall not alter a consent form after the taxpayer has signed the document. Accordingly, a tax return preparer shall not present a taxpayer with a consent form containing blank spaces for the purpose of completing the spaces after the taxpayer has signed the document. .05 Special rule for multiple disclosures within a single consent form or multiple uses within a single consent form. Section 301.7216-3(c) (1) provides that a taxpayer may consent to multiple uses within the same written document or multiple disclosures within the same written document. Disclosure consents and use consents must be provided in separate documents. Multiple disclosure consents and multiple use consents must provide the taxpayer with the opportunity, within the separate written document, to affirmatively select each separate disclosure or use. Further, the taxpayer must be provided the information in section 5.04 for each separate disclosure or use. The mandatory statements required in section 5.04(1) relating to disclosure or use need only be stated once in a multiple disclosure or multiple use consent. .06 Disclosure of entire return. If, under §301.7216-3(c)(2), a consent authorizes the disclosure of a copy of the taxpayer’s entire tax return or all information contained within a return, the consent must provide that the taxpayer has the ability to request a more limited disclosure of tax return information as the taxpayer may direct. .07 Adequate data protection safeguard. Pursuant to §301.7216-3(b)(4), a tax return preparer located within the United States, including any territory or possession of the United States, may disclose a taxpayer’s SSN to a tax return preparer located outside of the United States or any territory or possession of the United States with the taxpayer’s consent only when both the tax return preparer located within the United States and the tax return preparer located outside of the United States maintain an adequate data 400 protection safeguard at the time the taxpayer’s consent is obtained and when making the disclosure. An adequate data protection safeguard is a management-approved and implemented security program, policy, and practice that includes administrative, technical, and physical safeguards to protect tax return information from misuse, unauthorized access, or disclosure and that meets or conforms to one of the following privacy or data security frameworks: (1) The United States Department of Commerce “safe harbor” framework for data protection (or a successor program); (2) A foreign law data protection safeguard that includes a security component (e.g., the European Commission’s Directive on Data Protection); (3) A framework that complies with the requirements of a financial or similar industry-specific standard that is generally accepted as best practices for technology and security related to that industry (e.g., the BITS, Financial Services Roundtable, Financial Institution Shared Assessment Program); (4) The requirements of the AICPA/CICA Privacy Framework; (5) The requirements of the most recent version of IRS Publication 1075, Tax Information Security Guidelines for Federal, State and Local Agencies and Entities; or (6) Any other data security framework that provides the same level of privacy protection as contemplated by one or more of the frameworks described in (1) through (5). SECTION 6. ELECTRONIC SIGNATURES .01 If a taxpayer furnishes consent to disclose or consent to use tax return information electronically, the taxpayer must furnish the tax return preparer with an electronic signature that will verify that the taxpayer consented to the disclosure or use. The regulations under §301.7216-3(a) require that the consent be knowing and voluntary. Therefore, for an electronic consent to be valid, it must be furnished in a manner that ensures affirmative, knowing consent of the taxpayer to each disclosure or use. .02 A tax return preparer seeking to obtain a taxpayer’s consent to the disclosure or consent to the use of tax return information electronically must obtain the taxpayer’s signature on the consent in one of the following manners: (a) Assign a personal identification number (PIN) that is at least 5 characters long to the taxpayer. To consent to the disclosure or consent to the use of the taxpayer’s tax return information, the taxpayer may type in the pre-assigned PIN as the taxpayer’s signature authorizing the disclosure or use. A PIN may not be automatically furnished by the software so that the taxpayer only has to click a button for consent to be furnished. The taxpayer must affirmatively enter the PIN for the electronic signature to be valid; (b) Have the taxpayer type in the taxpayer’s name and then hit “enter” to authorize the consent. The software must not automatically furnish the taxpayer’s name so that the taxpayer only has to click a button to consent. The taxpayer must affirmatively type the taxpayer’s name for the electronic consent to be valid; or (c) Any other manner in which the taxpayer affirmatively enters 5 or more characters unique to the taxpayer that the tax return preparer uses to verify the taxpayer’s identity. For example, entry of a response to a question regarding a shared secret could be the type of information by which the taxpayer authorizes disclosure or use of tax return information. SECTION 7. EXAMPLES .01 The application of this revenue procedure is illustrated by the following 401 examples: (1) Example 1. Preparer P offers tax preparation services over the Internet. P wishes to use information the taxpayer provides during tax preparation of the taxpayer’s Form 1040 to generate targeted banner advertisements (i.e., electronic advertisements appearing on the computer screen based on the taxpayer’s tax return information). In the course of advertising services and products, P also wishes to disclose to other third parties the information that the taxpayer provides. (a) P posts, in pertinent part, the following consent on the computer screen for taxpayers to indicate approval. If a taxpayer does not indicate approval, the tax return preparation software does not permit the taxpayer to use the software. PRIVACY STATEMENT Your privacy is very important to us at P. We are providing this statement to inform you about the types of information we collect from you, and how we may disclose or use that information in connection with the services we provide. This Privacy Statement describes the privacy practices of our company as required by applicable laws. . . . During the course of providing our services to you, we may offer you various other services that may be of interest to you based on our determination of your needs through analysis of your data. Your use of the services we offer constitutes a consent to our disclosure of tax information to the service providers. If at any time you wish to limit your receipt of promotional offers based upon information you provide, you may call us at the following. . . . (b) Beneath this Privacy Statement, the following acknowledgment line appears next to two button images stating “yes” and “no:” “I have read the Privacy Statement and agree to it by clicking here.” (c) If the taxpayer clicks “no,” a message appears on the screen informing the taxpayer that tax return preparation will not proceed without the taxpayer agreeing to the company’s Privacy Statement. (d) P has failed to comply with the requirements of §301.7216-3 and this revenue procedure. P has attempted to obtain consent from the taxpayer by making the use of the program (i.e., the provision of tax return preparation services) contingent on the taxpayer’s consent to P’s disclosure and use of the taxpayer’s tax return information for purposes other than tax preparation (e.g., for use in displaying targeted banner advertisement). Thus, the consent is not voluntary, as required by §301.7216-3(a). P has also failed to identify the tax return information that it will disclose or use, as required by §301.7216-3(a)(3)(C); to identify the purposes of the disclosures or uses, as required by section §301.7216-3(a)(3)(B); and, to the extent that P intends to disclose the entire return based on the consent, P’s consent form has not provided that the taxpayer has the ability to request a more limited disclosure of tax return information as the taxpayer may direct as required by section 5.06. The single document attempts to have the taxpayer consent to both disclosures and uses, in violation of section 5.05. P has not used the mandatory statements required by section 5.04(1). The consent is not signed by the taxpayer because P has not provided a means for the taxpayer to electronically sign the consent in a form authorized by section 6. Finally, the consent is not dated as required by section 5.03(2). (2) Example 2. Preparer Q offers tax preparation services over the Internet and wishes to use targeted banner advertisements during tax return preparation. Q contracts with 402 Bank A regarding the advertisement of Individual Retirement Accounts (IRAs). Preparer Q displays advertisements to the taxpayer only if the taxpayer’s tax return information indicates that the services are relevant to the taxpayer (e.g., targeted banner advertisements). A taxpayer using Q’s software must enter a password to begin the process of preparing a return. (a) Before the taxpayer starts providing tax return information, the following screen appears on Q’s tax preparation program. CONSENT TO USE OF TAX RETURN INFORMATION Federal law requires this consent form be provided to you. Unless authorized by law, we cannot use your tax return information for purposes other than the preparation and filing of your tax return without your consent. You are not required to complete this form to engage our tax return preparation services. If we obtain your signature on this form by conditioning our tax return preparation services on your consent, your consent will not be valid. Your consent is valid for the amount of time that you specify. If you do not specify the duration of your consent, your consent is valid for one year from the date of signature. For your convenience, Q has entered into arrangements with certain banks regarding the provision of Individual Retirement Accounts (IRAs). To determine whether this service may be of interest to you, Q will need to use your tax return information. If you would like Q to use your tax return information to determine whether this service is relevant to you while we are preparing your return, please check the corresponding box, provide the information requested below, and sign and date this consent to the use of your tax return information. � I, [INSERT NAME] authorize Q to use the information I provide to Q during the preparation of my tax return for 2006 to determine whether to offer me an opportunity to invest in an IRA. Signature: [INSERT SIGNATURE AS PRESCRIBED UNDER SECTION 6] Date: [INSERT DATE] If you believe your tax return information has been disclosed or used improperly in a manner unauthorized by law or without your permission, you may contact the Treasury Inspector General for Tax Administration (TIGTA) by telephone at 1-800-366-4484, or by email at complaints@tigta.treas.gov. (b) If the taxpayer selects the consent above, the taxpayer is directed to print the screen. Later, after the taxpayer has entered data to prepare his or her 2006 tax return, the following screen is displayed: CONSENT TO DISCLOSURE OF TAX RETURN INFORMATION Federal law requires this consent form be provided to you. Unless authorized by law, we cannot disclose your tax return information to third parties for purposes other than the preparation and filing of your tax return without your consent. If you consent to the disclosure of your tax return information, Federal law may not protect your tax return information from 403 further use or distribution. You are not required to complete this form to engage our tax return preparation services. If we obtain your signature on this form by conditioning our tax return preparation services on your consent, your consent will not be valid. If you agree to the disclosure of your tax return information, your consent is valid for the amount of time that you specify. If you do not specify the duration of your consent, your consent is valid for one year from the date of signature. You have indicated that you are interested in obtaining information on IRAs. To provide you with this information, Q must disclose your tax return information, as indicated below, to the bank that provides this service. If you would like Q to disclose your tax return information to the bank providing this service, please check the corresponding box for the service in which you are interested, provide the information requested below, and sign and date your consent to the disclosure of your tax return information. � I, [INSERT NAME], authorize Q to disclose to Bank A that portion of my tax return information for 2006 that is necessary for Bank A to contact me and provide information on obtaining an IRA or altering my contribution to an IRA for 2006. Signature: [INSERT SIGNATURE AS PRESCRIBED UNDER SECTION 6] Date: [INSERT DATE] If you believe your tax return information has been disclosed or used improperly in a manner unauthorized by law or without your permission, you may contact the Treasury Inspector General for Tax Administration (TIGTA) by telephone at 1-800-366-4484, or by email at complaints@tigta.treas.gov. If the taxpayer consents to the disclosure of the tax return information using the screen above, the taxpayer is directed to print the screen. Q will then transmit only that portion of the taxpayer’s tax return information for 2006 that is necessary for the bank authorized in the consent, Bank A, to provide the service. (c) These two consent forms, above, satisfy the requirements of §301.7216-3(c) and this revenue procedure for the disclosure or use of the information provided by the taxpayer for the specific purposes stated in the consent forms. (3) Example 3. Large corporation C employs 200 expatriated employees who work in Belgium. Preparer R, located in the United States, prepares individual income tax returns for C’s expatriated workers pursuant to a corporate plan for executive tax return preparation. Preparer R is affiliated with Preparer F, located in Belgium. Pursuant to the corporate plan for executive tax return preparation, Preparer R plans to provide the expatriated employees’ tax return information, including the expatriated employees’ SSNs, located on Preparer R’s US based data servers to Preparer F who then plans to meet with the expatriated employees to prepare those employees’ 2008 individual income tax returns. Preparer R obtains information electronically from various sources in anticipation of providing the information to Preparer F. Preparer R developed, adopted, and incorporated into its operations a data privacy program that meets the requirements 404 of the AICPA/CICA Privacy Framework. Preparer F also developed, adopted, and incorporated into its operations a data privacy program, which is subject to the European Commission’s Directive on Data Protection. The data privacy programs adopted by Preparer R and Preparer F are in operation at the time all consents to disclose are obtained by Preparer R and disclosures are made by Preparer R to Preparer F. (a) Before transmitting or sending any expatriated employee’s SSN to Preparer F, Preparer R provides the expatriated employee (taxpayer) with the following document. CONSENT TO DISCLOSURE OF TAX RETURN INFORMATION Federal law requires this consent form be provided to you. Unless authorized by law, we cannot disclose your tax return information to third parties for purposes other than the preparation and filing of your tax return and, in certain limited circumstances, for purposes involving tax return preparation without your consent. If you consent to the disclosure of your tax return information, Federal law may not protect your tax return information from further use or distribution. You are not required to complete this form. Because our ability to disclose your tax return information to another tax return preparer affects the tax return preparation service(s) that we provide to you and its (their) cost, we may decline to provide you with tax return preparation services or change the terms (including the cost) of the tax return preparation services that we provide to you if you do not sign this form. If you agree to the disclosure of your tax return information, your consent is valid for the amount of time that you specify. If you do not specify the duration of your consent, your consent is valid for one year from the date of signature. This consent to disclose may result in your tax return information being disclosed to a tax return preparer located outside the United States, including your personally identifiable information such as your Social Security Number (“SSN”). Both the tax return preparer in the United States that will disclose your SSN and the tax return preparer located outside the United States that will receive your SSN maintain an adequate data protection safeguard (as required by the regulations under 26 U.S.C. Section 7216) to protect privacy and prevent unauthorized access of tax return information. If you consent to the disclosure of your tax return information, Federal agencies may not be able to enforce US laws that protect the privacy of your tax return information against a tax return preparer located outside of the US to which the information is disclosed. If you agree to allow Preparer R to disclose your tax return information, including your SSN, to Preparer F for purposes of providing assistance in the preparation of your 2008 individual income tax return, please check the box below, provide the information requested below, and sign and date your consent to the disclosure of your tax return information. � I, [INSERT NAME], authorize Preparer R to disclose to Preparer F my tax return information, including my SSN, to allow Preparer F to assist in the preparation of my 2008 individual income tax return. Signature: Date: [INSERT DATE] 405 If you believe your tax return information has been disclosed or used improperly in a manner unauthorized by law or without your permission, you may contact the Treasury Inspector General for Tax Administration (TIGTA) by telephone at 1-800-366-4484, or by email at complaints@tigta.treas.gov. The taxpayer provides consent by checking the box and signing and dating the consent form. Preparer R then provides a copy of the signed and dated consent form to the taxpayer, and then transmits the taxpayer’s tax return information to Preparer F for processing of taxpayer’s 2008 individual income tax return. (b) The consent above satisfies the requirements of section 301.7216-3 and this revenue procedure for the disclosure of the information provided by the taxpayer for the specific purpose stated in the consent form. SECTION 8. EFFECT ON OTHER DOCUMENTS Rev. Proc. 2008-35, 2008-29 I.R.B. 132 is modified and superseded. SECTION 9. EFFECTIVE DATE This revenue procedure is effective on January 14, 2013. Prior to that date, tax return preparers may use the mandatory language provided in section 5.04 of this revenue procedure or the language provided in section 4.04 of Rev. Proc. 2008-35. Any consent obtained on or after January 14, 2013 must contain the mandatory language provided in section 5.04 of this revenue procedure. SECTION 10. DRAFTING INFORMATION The principal authors of this revenue procedure are Skyler Bradbury and Emily M. Lesniak of the Office of the Associate Chief Counsel (Procedure and Administration). For further information regarding this revenue procedure contact Emily M. Lesniak at (202) 622-4910 (not a toll free call). 406 Final Exam Questions 2013 Introduction and Chapter 1 1. Which of the following is true regarding IRS registration of tax preparers? A. Registration renewals and user fee payments are required every four years. B. Registration and PTIN requirements applies to volunteer or other uncompensated preparers. C. The IRS requires individuals who are required to sign a federal tax return as paid return preparer to register with the IRS and pay an annual user fee to maintain a PTIN. D. None of the above 2. Which of the following is not correct regarding filing a tax return? A. If the taxpayer did not live with the spouse at the end of 2012 and the taxpayers’ income was at least $3,800 they must file a return. B. If the taxpayer was born on or before January 1, 1948 they are considered 65 at the end of the year for filing purposes.. C. If filing married filing separate a taxpayer must file a return if there is any income regardless of the amount. D. All of the above are true statements 3. Gross income means all income received in the following forms, except: A. Money B. Goods C. Services D. Losses from the taxpayer’s business 4. Which of the following information regarding the standard deduction is false? A. The standard deduction is a dollar amount that reduces the amount of income on which the taxpayer is taxed. B. The basic standard deduction is an amount relative to each tax year and varies according to the filing status. C. The standard deduction is allowed whether or not the taxpayer has itemized deductions. D. The additional amount of standard deduction for age, or blindness or both is an amount specified by law and varies based on the filing status. 407 5. Which one of the following is not a determination of whether a person must file a tax return? A. Residency B. Filing status C. Gross Income D. Age 6. A single person age 65 or older must file a return for 2012 if their gross income is at least____________. A. $9,500 B. $11,200 C. $21,300 D. $16,450 7. For most people filing a return is required when: A. Gross income exceeds the standard deduction amount plus the exemption amount B. There is self-employment income of $400 or more. C. The taxpayer owes Alternative Minimum Tax D. Any of the above. 8. Form 1040 Instructions state that gross income means all income that is received in the form of the following, except: A. Money B. Property C. Services that are not tax exempt D. Real estate taxes paid 9. Which of the following is not a true statement? A. A taxpayer is considered to be 65 on the day before their birthday. B. The basic standard deduction is an amount relative to each tax year and varies according to the filing status C. A married individual filing a separate return whose spouse itemizes deductions is entitled to the standard deduction. D. The additional standard deduction for a single taxpayer who is under 65 and blind for 2012 is $1,450. 408 10. The tax return for a calendar year taxpayer is due on: A. The 15th day of the 4th month after the close of the taxable year. B. April 1st C. August 15th D. The 15th day of the 3rd month after the close of the taxable year. 11. Which of the following is a true statement? A. The taxpayer can request an automatic 6-month extension for time to file their tax return. B. If the return is due on April 15th the taxpayer will have until October 15th to file the return. C. The extension of time is regarding filing not payment of tax. If the tax is not paid by the regular due date the taxpayer will owe interest and possibly penalties. D. All of the above are correct 12. Form 4868 is used: A. To request an automatic 6-month extension of time to file the tax return. B. To report self-employment tax C. To report miscellaneous income D. To request an automatic 2-month extension of time to file the return.. 13. If the taxpayer is filing a paper return on their own, which of the following is correct? A. The taxpayer sends the return to the same filing location whether or not they file a Form 1040, 1040A or 1040EZ. B. The taxpayer sends the return to the same filing location whether or not they owe money with the return or they are due a refund. C. If the taxpayer is filing a Form 2555 and they owe tax they must send their tax return to Charlotte NC. D. Each state has one filing location at the IRS 14. All of the following are correct regarding making a payment to the IRS when filing a paper return, except: A. The taxpayer can pay online, by phone, or by check or money order. B. Estimated tax payments can be made with the payment for taxes owed on the tax return C. If filing a joint return, the taxpayer must enter the SSN of the taxpayer or spouse shown first on the tax return. D. The penalty for writing a bad check to the IRS is $25 or 2% of the check, whichever is more. 15. Which of the following is not an exception to the filing requirement for a claim for refund? A. Disability. B. Net Operating Loss C. A change in depreciation. D. Agreement with the IRS 409 16. A return should be amended for the following reasons, except: A. Not all income was reported B. Deductions and credits were claimed that should not have been claimed C. Deductions and credits were not claimed that should have been claimed D. Everything was reported correctly on the original return 17. Which of the following is not an accuracy related penalty? A. Negligence penalty B. Disregard penalty C. Penalty for substantial under reporting of income D. Penalty for late filing of the tax return. 18. Generally, if the return is not filed by the due date, the penalty is: A. 10% of the amount due for each month or part of the month the return is late B. 5% of the amount due for each month or part of the month the return is late. C. 15% of the amount due for each month or part of the month the return is late D. A $5.00 late fee 19. Which of the following is correct regarding the failure-to-file and the substantial underpayment penalty? A. If the return is not filed by the due date (including extensions), the penalty for failure to file is usually 5% of the amount due for each month or part of the month the return is late, unless there is a reasonable explanation. B. If the return is more than 60 days late the minimum penalty will be $100 or the amount of any tax owed whichever is smaller C. An understatement is considered substantial if it is more than the largest of 10% of the correct tax or $5,000. D. All of the above 20. If the return is more than 60 days late the minimum penalty will be: A. $75.00 or the amount of any tax owed, whichever is greater B. Equal to the amount of tax owed C. $100 or the amount of any tax owed whichever is smaller D. $150 21. The term for a tax return that is carelessly prepared and without adequate records is considered to be done with: A. Oversight or omission B. Inattention or neglect C. Negligence or disregard D. Indifference or disinterest 410 22. The taxpayer can use Form 1040EZ when the taxable income is less than: A. $75,000 B. $50,000 C. $100,000 D. $40,000 23. The taxpayer can use Form 1040A when reporting the following, except: A. Interest and ordinary dividends B. An IRA deduction C. Education Credits D. Distribution from a foreign trust 24. Which of the following is not a condition requiring form 1040 to be filed? A. The taxpayer owes alternative minimum tax B. The taxpayer receives social security benefits C. The taxpayer has self-employment earnings D. Received foreign earned income 25. Which of the following is not true regarding when the taxpayer can use Form 1040EZ? A. The filing status is single or married filing a joint return. B. The taxpayer (and spouse if married filing joint) were under age 65. C. There are no dependents on the return. D. The income must be less than $50,000. 26. Which of the following is not true regarding when the taxpayer can use Form 1040A? A. Income from wages, salaries, and tips are allowed B. Interest and dividend income are allowed C. Capital gain distributions are allowed D. Self-employment income is allowed 27. Which of the following is allowed on Form 1040A? A. Child tax credit B. Unemployment compensation C. Student loan interest deduction D. All of the above 28. All of the following is income that requires the taxpayer to File form 1040, except A. Interest and dividend income under $1500. B. Nontaxable distributions required to be reported as capital gains C. Tips not reported to the employer D. Income received as a shareholder in an S-Corporation. 411 29. Foreign earned income requires the taxpayer to file which of the following forms? A. Form 1040 B. Form 1040A C. Form 4562 D. Schedule C 30. If the taxpayer uses the cash method of accounting, which of the following statements are correct? A. Income is reported in the year received or constructively received B. Expenses are deducted in the year they are paid C. Income is reported when earned D. Both A and B 31. A regular fiscal year is a 12-month period that ends: A. December 31st B. The first day of any month other than December C. The last day of any month other than December D. Always on November 30th 32. Which of the following is not true regarding sources of gross income? A. Money B. Goods C. Property D. Only income earned in the United States 33. Which of the following is not one of the five filing status? A. Single B. Married filing a joint return C. Head of household D. Divorced 412 Chapter 2 Questions 34. Which of the following is not correct regarding Form 1040EZ A. The filing status must be single or married filing a joint return B. The taxpayer (and spouse if married filing joint) are under age 65 and not blind at the end of the year. C. Only one dependent is allowed on the return D. The taxpayer cannot claim any credit except EIC. 35. Which of the following is a true statement A. Taxpayers who qualify for the earned income credit can use Form 1040EZ. B. W-2’S are attached to the front of Form 1040EZ C. A refund on Form 1040EZ can be directly deposited. D. All of the above 413 Questions Chapter 3 36. Peter and Jane Employed can file form 1040A because; A. Their taxable income is less than $100,000 B. They are not itemizing their deductions C. They do not have self-employed income D. All of the above 37. Which of the following is a true sentence? A. To qualify for head of household status, the taxpayer must be unmarried and must have paid more than half the cost of maintaining a household that was the main home for a qualifying person for more than half the year. B. The taxpayer may be able to file as a qualifying widow or widower for the three years following the year the spouse died. C. Generally, the marital status on the first day of the year determines the filing status for the entire year. D. None of the sentences are true. 38. Which of the following is a qualifying child of all other requirements are met? A. The taxpayers’ son B. The taxpayers’ half sister C. The taxpayers’ brother D. The taxpayers’ spouse if the spouse is younger than the taxpayer. 39. Which of the following is not true regarding the residency of a qualifying child or relative? A. The child can be a resident of Mexico and live with the taxpayer. B. The child can live in Brazil for the entire year, if the child is a U.S. Citizen C. The child can be claimed as a dependent even though they were temporarily absent from the household while attending school D. None of the above 40. Which of the following is not included in box 12 of the W-2 form? A. Total wages B. Employee contributions to an Archer MSA C. Elective deferral contributions to a 401(k) plan D. Employer contributions for qualified long-term care services to the extent that such coverage is provided through a flexible spending or similar arrangement. 414 41. Which of the following can reduce the amount reported on Form 1099-R, Box 1? A. Direct Rollovers B. A SEP directly transferred to an accepting employer plan C. IRA recharacterization D. All of the above 42. A withdrawal of cash or other assets from a qualified retirement plan in an eligible distribution, that can defer tax, by rolling it over to another qualified retirement plan or a traditional IRA, is defined as which of the following? A. Death benefit payment B. Rollover C. Nontaxable exchange D. None of the above 43. Distribution code 4 in Box 7 of Form 1099R indicates which of the following? A. Early Distribution, no known exception B. Death C. Disability D. Early Distribution, exception applies 44. Which of the following is not correct regarding personal exemptions? A. Personal Exemption phase-out (PEP) was revived in the American Taxpayer Relief Act starting in tax year 2013 B. Taxpayers filing Married Filing Joint will have their exemption amount reduced by 6% for each $1250 by which the AGI exceeds the threshold level C. The amount of personal exemption will increase in 2014. D. All of the above statements are true 45. Which of the following meets the test to be a qualifying relative? A. The taxpayer’s niece who is a citizen of England but lives with the taxpayer B. The taxpayers’ mother who has an annual pension of $5,000 C. Both A and B D. Neither A nor B. 415 46. Which of the following forms can be attached to Form 1040A? A. Schedule B B. Schedule C C. Schedule D D. All of the above 47. Social Security Benefits are reported to the taxpayer on which form? A. 1099-R B. SSA-1099 C. SSA-W-2 D. None of the above 48. Which of the following statements are correct regarding Social Security Benefits? A. Tax Exempt interest is included when computing the taxable amount of Social Security? B. If one-half of the benefits plus all other income is less than the base amount, none of the social security benefits are taxable. C. If one-half of the benefits plus all other income is more than the base amount, some of the social security benefits are taxable. D. All of the above 49. Which of the following is the correct answer regarding wages the taxpayer received as a household employee who did not receive a W-2 because the wages were less than $1,800 in 2012? A. The wages are not reported on the tax return B. The wages are included on Line 7 with a notation of “HSH” plus the amount included on the dotted line next to Line 7 C. The amount is reported on Line 21 of Form 1040. D. None of the above 50. Which of the following is not included in Box 12 of Form W-2? A. Wages B. Dependent care benefits C. Employer provided adoption benefits D. Excess salary deferrals 51. Income received by childcare providers must be received in which of the following locations to be taxable? A. In the taxpayer’s home, B. The child’s home C. Any other location D. Any of the above 416 Chapter 4 Questions 52. Both the taxpayer and spouse may be held responsible jointly and individually for the tax or any interest or penalty due on the joint return. Which of the following may be relief for the liability? A. B. C. D. Innocent Spouse Relief Equitable Relief Separation of Liability All of the above 53. The following apply to Married Filing Joint taxpayer and spouse, except A. If a spouse dies during the tax year the other spouse can file Married Filing joint B. Once a taxpayer files a joint return, they cannot choose to file separate returns for that year after the due date of the return. C. A taxpayer and spouse report combined income and deduct combined allowable expenses. D. All of the above are correct. 54. In 2012, the IRS required Same Sex Married Couples to file as which of the following? A. Married filing jointly B. Married filing separately C. Single D. There were no specific filing requirements 55. The taxpayer may be able to file as a qualifying widow or widower for the two years following the year the spouse died. To do this, the taxpayer must meet all four of the following tests, except? A. The taxpayer is entitled to file a joint return with the spouse for the year he or she died. It does not matter whether the joint return was actually filed, B. The taxpayer did not remarry in the two years following the year the spouse died, C. There is a child, stepchild, or adopted child (a foster child does not meet this requirement) for whom the taxpayer can claim a dependency exemption, D. No dependent child is needed in order to use this filing status 56. Which of the following items related to Married Filing Separate filing status is incorrect? A. The taxpayer cannot take the child and dependent care expenses in most cases. B. The taxpayer cannot take the earned income credit. C. The taxpayer cannot take the exclusion or the credit for adoption expenses in most cases. D. The taxpayer can claim the education credits or student loan interest 417 57. In respect to Married Filing Separately, which of the following is true if the taxpayer lived with the spouse at any time during the tax year? A. The taxpayer cannot claim the credit for the elderly or the disabled B. The taxpayer will have to include in income more (up to 85%) of any social security income or equivalent railroad retirement benefits received. C. The taxpayer cannot rollover amounts from a traditional IRA to a Roth IRA D. All of the above 58. Which of the following is not a community property state? A. Arizona B. California C. New Mexico D. New York 59. Which of the following is not a definition of separate property in a community property state? A. Property owned separately by a spouse before marriage B. Property received by both the taxpayer and spouse as gifts or inheritances. C. Money earned while domiciled in separate property states D. All property declared separate property in a valid agreement (pre-or-post nuptial) 60. Which of the following is not true regarding separate property in a community property state? A. Separate property belongs to the spouse who owns it B. The taxpayer must maintain the property separately C. The taxpayer can commingle the separate property with the spouse D. Both A and B are not true 61. Which of the following are qualifications for the head of household filing status? A. The spouse did not live in the taxpayer’s home at any time during the last six months of the taxable year. B. The home was the main home for the taxpayer and the birth child, stepchild, adopted child, or eligible foster child for more than half the year. C. The taxpayer must be entitled to claim a dependent exemption for the child. The child must meet the requirements to be either a qualifying child or qualifying relative and meet the joint return and citizenship tests. D. All of the above 418 62. An ___________________________is a child placed with the taxpayer by an authorized placement agency or by a judgment, decree, or other order of a court of competent jurisdiction. Generally, formal placement ends when the child reaches the age of 19. A. Eligible foster child B. An adopted child C. A descendant D. None of the above 63. To qualify for head of household filing status, the eligible foster child must meet the requirements of a __________________________. A. Qualifying child and qualifying parent B. Qualifying child or a qualifying relative C. Qualifying adult and qualifying parent D. Qualifying niece and qualifying nephew 64. Generally, if two or more people keep up the same home, _________________ could pay more than half the costs and qualify for the head of household filing status. A. Both people B. Only one of the people C. Neither of the above D. Both of the above 65. Which of the following are correct regarding the dependent taxpayer test? A. If the taxpayer could be claimed as a dependent by another person, the taxpayer cannot claim anyone else as a dependent. B. If the taxpayer could be claimed as a dependent by another person, the taxpayer cannot claim anyone else as a dependent. Even if the taxpayer has a qualifying child or qualifying relative, the taxpayer cannot claim that person as a dependent. C. If the taxpayer is filing a joint return and their spouse could be claimed as a dependent by someone else, the taxpayer and their spouse cannot claim any dependents on their joint return D. All of the above 66. Which of the following qualifies as the time to claim head of household filing status that a child must live with a custodial parent? A. More than 5 months B. More than half the year (more than 183 days) C. More than 4 months D. More than 3 months 419 67. Form 8332 is which of the following? A. Release of Claim of Exemption for Child of Divorced or Separated Parents B. Depreciation and Amortization C. Sale of Business Property D. Moving Expenses 68. Which of the following is true regarding Form 8332? A. If the exemption is released for more than 1 year, the original release must be attached to the return of the noncustodial parent for the first year. B. The original Form 8332 is attached in the first year C. A copy of Form 8332 is attached in subsequent years after the first year D. All of the above 69. If the taxpayer was unmarried and if the qualifying person is the parent, the taxpayer may be eligible for the _______________________ even if the father or mother did not live with the taxpayer. A. Head of household filing status B. Married filing separate filing status C. Single filing status D. None of the above 70. Which of the following is not a test for qualifying child A. Residency B. Relationship C. Age D. Gender 71. If filing as a Qualifying Widow the following items will be treated the same as Married Filing a Joint return, except: A. Tax Tables B. AMT Exemption C. Phase-out of Student Loan D. Standard Deduction 72. Which of the following is a definition of an eligible foster child? A. A child who was lawfully placed with you for legal adoption B. An individual who is placed with you by an authorized placement agency or by judgment, decree, or other order of any court of competent jurisdiction. C. An individual enrolled for the number of hours or courses the school considers to be full-time attendance. D. The child is permanently and totally disabled 420 73. Which of the following are correct regarding custodial and noncustodial parents? A. The custodial parent is the parent with whom the child lived for the greater number of nights during the year B. 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. C. If a child was not with either parent on a particular night (because, for example, the child was staying at a friend's house), the child is treated as living with the parent with whom the child normally would have lived for that night, except for the absence D. All of the above 74. Which is a correct statement in order to be a qualifying relative? A. Unlike a qualifying child, a qualifying relative can be any age. B. In order to be a qualifying relative the person cannot be a qualifying child or a qualifying relative of another taxpayer. C. The qualifying relative’s gross income must be less than $3,800 in 2012. D. All of the above 75. Form 2120 is used to identify other eligible persons who paid over ____ of the support of a person claimed as a dependent, and indicates that the taxpayer has a signed agreement from each of the other eligible persons waiving his or her right to claim that person as a dependent. A. 10% B. 20% C. 25% D. 15% 76. Which of the following is a correct statement in order to be a qualifying child? A. The child must be under age 19 at the end of the year and younger than the taxpayer (or the spouse, if married filing jointly), or under age 24 at the end of the year, a full-time student, and younger than the taxpayer (or spouse, if married filing jointly), or any age if permanently and totally disabled. B. The child must be under age 18 at the end of the year and younger than the taxpayer (or the spouse, if married filing jointly), or under age 25 at the end of the year, a full-time student, and younger than the taxpayer (or spouse, if married filing jointly), or any age if permanently and totally disabled. C. The child must be under age 19 at the end of the year and younger than the taxpayer (or the spouse, if married filing jointly), or under age 24 at the end of the year, a full-time student, and younger than the taxpayer (or spouse, if married filing jointly), or under age 22 if permanently and totally disabled. D. The child must be under age 22 at the end of the year and younger than the taxpayer (or the spouse, if married filing jointly), or under age 28 at the end of the year, a full-time student, and younger than the taxpayer (or spouse, if married filing jointly), or any age if permanently and totally disabled. 421 77. Which of the following is correct in determining the custodial parent under the tiebreaker rules? A. The parent with whom the child lived the longest during the tax year, if two of the persons are the child's parent and they do not file a joint return together. B. The parent with the highest AGI if the child lived with each parent for the same amount of time during the tax year, and they do not file a joint return together; C. A person with the higher AGI than any parent who can also claim the child as a qualifying child but does not. D. All of the above 422 Chapter 5 Questions 78. Sales or redemptions of securities, future transactions, commodities and barter transactions are reported on which form? A. 1099-B B. 1098-T C. 1099-G D. 1099-MISC 79. Form 1098-T is used to report ____________________. A. Proceeds from Broker and Barter Exchange Transactions B. Contributions Statement C. Tuition Payments D. Mortgage Interest 80. Form W-2, the Wage and Tax Statement is required to be sent by the employer to which of the following? A. Mortgage lenders to verify employment B. IRS C. Social Security Administration D. State and local government 81. Abandonment of Secured Property is reported on which form? E. 1099-C F. 1099-INT G. 1099-A H. 1099-G 82. The due date to the recipient of Form W-2 is ___________________. A. The last day of February B. January 31st C. December 31st D. January 1st 83. Which of the following is a correct statement? A. W-2G reports certain gambling winnings B. Form 1098 reports Mortgage Interest reported on Schedule A C. Form 1098E reports Student Loan Interest paid D. All of the above 84. Contributions (including rollover contributions) to any IRA, including SEP, SIMPLE, Roth IRA and Ed IRA; conversions; recharacterizations; and the fair market value of the account is reported on the ______________________ form. A. Taxable distributions B. IRA Contribution Information C. Contribution Statement D. Dividends and Distributions 423 85. Which of the following is a true statement in regards to Form 1099-INT? A. Interest income is reported on Line 8a of Form 1040 B. Early penalty amounts are not reported on the tax return. C. Tax exempt interest is not shown on Form 1099-INT D. Both statements A and B are true 86. Which form is used to report student loan interest? A. 1098-E B. 1099-S C. 1098-T D. 1089-E 87. Form 1099-C is used to report _________________________. A. Qualified Student Tuition Program Payments B. Original Issue Discount C. Long Term Care and Accelerated Death Benefits D. Cancellation of Debt 88. Distributions from retirement or profit-sharing plans are reported on which form? A. 1099-S B. W-2 C. 1099-R D. 1099-MSA 89. Which of the following is true regarding withholding on tip income? A. The tips a taxpayer receives while working on are considered part of their pay. B. They must include the tips on their tax return on the same line as wages. C. Tax is not withheld directly from tip income, as it is from the regular pay. D. All of the above 90. The purpose of completing Form W-4 is for ___________________________. A. The employer to know if the employee is married. B. The employer to know the taxpayer’s address. C. The employer to withhold the correct amount of tax from the employee’s wages D. None of the above 91. Generally, the taxpayer may claim Head of Household filing status on Form W-4 if they are unmarried and pay more than ________% of the cost of keeping up the household for the taxpayer and the dependents. A. 10 B. 25 C. 30 D. 50 424 92. A new Form W-4 must be completed each year by ____________________. A. January 1 B. February 28 C. February 15 D. January 31 93. The taxpayer can claim an exemption from withholding on Form W-4 in which of the following circumstances? A. The taxpayer had a right to a refund of all federal income tax withheld because they had no tax liability. B. The taxpayer was allowed to be exempt in the previous tax year C. The taxpayer is a student D. None of the above 94. The taxpayer should take into account all the following items when completing the W-4 Personal Allowance Worksheet, except: A. Filing status B. Marital status C. Dependents D. All of the above 95. On the W-4 Personal Allowance Worksheet a “1” is entered on line B, if: A. The taxpayer is single and has only 1 job B. The taxpayer is married and has only one job and the spouse does not work C. The total of all the wages for the taxpayer and/or the spouse are $1500 or less D. All of the above 96. All of the following are subject to withholding, except: A. Sick pay B. Mortgage Interest payments made by the taxpayer to a lender C. Tips D. Taxable Fringe Benefits 97. Dependent care benefits are reported in _______ on the W-2? A. Box 9 B. Box 10 C. Box 18 D. Box 12a 98. A code V in Box 12 of the W-2 indicates for which of the following? A. Deferrals under a Section 409A nonqualified deferred compensation plan B. Nontaxable Sick Pay C. Designated Roth contribution D. Income from the exercise of nonstatutory stock options (included in Box 1 and 3 (up to the social security wage base). 425 Chapter 6 Questions 99. Which of the following are not true about statutory employees? A. Box 13 of the W-2 should be checked. B. Full-time life insurance salespeople can qualify as a statutory employee C. The wages shown in Box 1 of form W-2 is reported as income on Schedule C D. Statutory employee income is subject to self-employment tax. 100. Which of the following is considered taxable?. A. Life insurance proceeds paid to the taxpayer because of the death of the insured person B. Proceeds were paid under an accident or health insurance policy because of the death of the insured. C. A policy surrendered for cash when the amount that exceeds the premium D. None of the above 101. A cash basis taxpayer must report an advanced commission received for services to be performed in the future: A. In the tax year the service is actually performed B. In the tax year the income is received C. The tax year after the advance commission is received D. Never 102. Bonuses or awards received for outstanding work are: A. Reported as an adjustment to income B. Reported on Schedule A as a deduction to income C. Included in income and reported on Form 1040, line 7 D. None of the above 103. Which of the following are generally not included in an employee’s income? A. Long-term care coverage paid by the employer B. Accident and health insurance benefits paid be the employer C. MSA contributions paid by the employer D. All of the above 104. Which of the following payments received as a member of the military are not generally taxable? A. Wages except for retirement pay. B. Combat pay. C. Military retirement pay based on age or length of service. D. None of the above 426 105. Which of the following is true? A. Employees can exclude working condition fringe benefits from tax if it would have been deductible as an employee business expense. B. Sick pay is a payment to replace wages while temporarily absent from work due to sickness. Sick pay is taxable if paid by the employer C. Employer-provided vehicles are usually taxable non-cash fringe benefits. The employer must determine the actual value of this fringe benefit to include in income D. All of the above 106. Which of the following is not true regarding tax on the clergy? A. Offerings and fees from marriages must be included in income. B. If the clergy donates the fees from a marriage to the religious organization it is still taxable. C. The rental value of the housing for the clergy is not included in income. D. Clergy cannot take a charitable deduction for their donations. 107. Which of the following is true regarding scholarships or educational assistance? A. Scholarships or fellowships to someone who is a degree candidate is excluded from income, if the scholarship is used for tuitions, fees, books, supplies or equipment required by the financial institution. B. Scholarships and Fellowships are always taxable C. Educational assistance of qualified employer provided educational assistance are always taxable. D. None of the above 108. A. B. C. D. Which of the following is not a qualified benefits in a cafeteria plan? Disability income and accident insurance costs Dental insurance premium costs Worker’s compensation Contribution to qualified 401(k)-pension plan 109. Amounts received as _______ for an occupational sickness or injuries are fully exempt from tax. A. Self-employed B. Retirement pay C. Workers ‘compensation D. Wage earner 110. Which of the following is not taxable interest received? A. Interest on a bank account B. Interest on loans to others C. Capital gain distributions D. Interest from certificate of deposits 427 111. Generally, the _______ is used when the interest is reported in the year it is actually or constructively received. A. Accrual method B. Cash method C. Inventory method D. Weighing method 112. Which of the following is not a correct statement? A. For taxpayers using the accrual method of accounting the interest is taxable when it is accrued, whether or not the taxpayer has received it. B. Interest is considered nominee interest when the registered owner receives a 1099INT with interest income in his/her name, but the interest actually belongs to someone else C. If the taxpayer had interest from or authority over a foreign bank account, they can report it directly on Form 1040. D. All taxable interest must be reported whether or not Form 1099 is received. 113. Taxable interest from U.S. savings bonds are reported to the taxpayer using this form: A. Form 1099-DIV, box 4a B. Form Schedule B, box 2b C. Form 1098, box 3 D. Form 1099-INT box 3 114. Which of the following is an acceptable maturity period for Treasury Bills? A. 4-week, B. 15-week, C. 30-week D. None of the above 115. Dividends that really are interest come from the following sources, except A. Cooperative banks B. Credit Unions C. Domestic building and loan associations D. Mutual fund accounts 116. The difference between the discounted price the taxpayer pays for the bonds and the ________ received at maturity is interest income. A. Face value B. Original issue discount C. Cooperative amount D. None of the above 428 117. When a long-term debt instrument is issued at a price that is lower than its stated redemption value, the difference is called which of the following? A. Capital loss B. Discounted debt C. Original issue discount D. Ordinary dividend 118. The taxpayer is allowed to use Form 1040EZ if interest income is less than _______. A. $400 B. $1500 C. $1200 D. None of the above 119. If the taxpayer is filing form 1040 or 1040A, Schedule B, which of the following must be present to require Schedule B to be completed. A. Taxable interest income exceeds $1300. B. Taxpayer is not claiming the interest exclusion under the Education Saving Bond Program. C. Seller-financed mortgage interest and the buyer used the property as a home. D. Taxpayer received a 1098-INT for tax exempt interest. 120. Interest paid on money borrowed to invest is a separate transaction from the money earned on the investment. The interest paid on the money borrowed is deductible if the taxpayer itemizes. Report the investment interest on which form? A. Form 4952 B. Form 4562 C. Form 8801 D. Form 8814 121. Municipal Bonds are not taxable if issued by which of the following? A. District of Columbia B. U.S. Possession C. Any State D. All of the above 122. When the registered owner receives a 1099-INT, but the interest actually belongs to someone else it is considered: A. A mistake B. Nominee Interest C. Mortgage Interest D. None of the above 429 123. Form 1099-INT must be issued by the taxpayer reporting the nominee distribution to: A. The IRS. B. The actual owner of the interest in a certified letter C. The actual owner of the interest D. None of the above 124. Interest received on _______ issued after 1989 to a taxpayer over the age of 24 may exclude the interest income from that bond if during the year the taxpayer paid qualified higher education expenses to an eligible educational institution. A. Series II Bonds B. Series CC Bonds C. Series EE Bonds D. None of the above 125. _______ are distributions of money, stock or other property paid to the taxpayer by a corporation. A. Dividends B. Stocks C. Bonds D. Interest 126. Which of the following are not ways dividends may be received? A. Partnership B. Estate C. Corporation D. Fringe Benefits 127. The most common type of dividends paid out of earnings and profits of a corporation are called: A. Qualified Dividends B. Ordinary Dividends C. Standard Dividends D. Bank Dividends 128. Ordinary dividends are reported on form: A. 1099-MISC B. 1099-INT C. 1099-DIV D. 1098 430 129. Which statement below is incorrect about how to report dividends? A. Ordinary dividend income that exceeds $1,500 must be reported on Schedule B when filing Form 1040. B. The amount from Schedule B is carried to the 1040, line 9a. C. Dividends cannot be entered on Form 1040 without a Schedule B, being in the return. D. Qualified dividends are carried to page 2 of Schedule D, line 23 130. Tax on ______________is taxed at the same rate as long-term capital gains received in 2012 or 2013. A. Qualified Dividends B. Ordinary Dividends C. Adjusted Gross Income D. Schedule D 131. Ordinary dividends reinvested into stock through a dividend reinvestment plan must be reported as: A. Adjustment to income B. Income C. Credit on tax due D. Deduction 132. Regulated investment companies are commonly known as which of the following? A. Mutual Funds B. Dividends C. Returns of Capital D. Capital Gain Distribution 133. Which of the following is not an example of nontaxable distribution? A. Return of capital B. Stock rights C. Options D. Gift certificates 431 Chapter 7 Questions 134. The below statements describes Cancellation of Debt, except: A. A debt is considered cancelled or discharged at the moment it becomes clear that the debt will never be repaid based on the likelihood of payment or the worthlessness of the debt. B. If the debt forgiven is $600 or more the taxpayer should receive a 1099-C. C. Cancellation of Debt is not reported on the tax return D. The amount of debt cancelled on Form 1099-C, is reported on Line 21 of Form 1040 135. Which of the following is excluded from income when reporting cancelled debt? A. The debt is cancelled in bankruptcy case under Title 11 of the U.S. Code. B. The debt is cancelled when insolvent, up to the amount the taxpayer was insolvent. C. The debt is qualified farm debt and is cancelled by a qualified person. The debt is qualified real property business debt. D. All of the above 136. If a personal residence was foreclosed or repossessed, the taxpayer has A. A casualty loss B. A disposition C. An investment expense to report on Schedule A D. None of the above 137. Which of the following is not a true statement? A. Qualified principal residence indebtedness is any mortgage obtained to buy, build, or improve a main home. B. Equity loan used to pay off credit cards qualify as qualified principal residence indebtedness C. The exclusion limit on qualified principal residence indebtedness is 2 million dollars D. Qualified principal residence indebtedness must be secured by the main home. 138. A State Tax Refund from the prior year may be taxable in the current year if the taxpayer A. Paid state tax in the current tax year B. Itemized their deductions in the prior year C. Took the Standard Deduction in the prior year D. Contributed to an IRA account 432 139. Which of the following is an incorrect statement regarding a recovery? A. If the taxpayer received a refund, credit, or offset of state or local income taxes in 2012, they may be required to report this amount. B. A recovery is taxable only if tax was reduced by deducting the payment or claiming a credit on the amount paid. C. An increase to a carryover to the current year that resulted from the deduction or credit is considered to have reduced tax in the current year. D. None of the above 140. Form 1040 line 10 is used to report: A. Property tax B. Refunds from state or local taxing authorities C. Business tax D. Federal income tax refunds 141. Which of the following is not a qualification for alimony included in income by one spouse and deducted by the other? A. Payment must be in cash (check or money order) B. Required by decree C. Parties must include child support D. Payer’s liability must cease at death 142. Which of the following payments do not qualify as alimony? A. Child support B. Non-cash property settlements C. Payment that are the spouse’s part of community property D. All of the above 143. A set of factors used to determine whether a worker is an employee or an independent contractor is known as which of the following? A. Behavior Rules B. Contractor Rules C. Independent Rules D. Common Law Rules 144. When a worker is classified to be independent contractors, which of the following statements apply? A. The employer has the right to control how the business aspects of the contractor’s business are conducted. B. The employer must have a continuing relationship with the contractor C. The employer retains the right to control how the work is done D. None of the above 433 145. Which one of the following describes the three main factors for determining if a worker is an employee or a contractor? A. Behavior Control, Financial Control, Relationship B. Performance Control, Economic Control, Association C. Production Control, Industry Control, Companionship D. None of the above 146. Generally, if the seller reduces the amount of the debt the taxpayer owes for property purchased then the income from the reduction is not recognized. This is treated as ______________________. An increase to the basis A purchase price adjustment and reduces the basis A seller’s adjustment A purchase price adjustment and increases the basis A. B. C. D. 147. A. B. C. D. Do not include cancelled debt in income in the following instances: The debt is cancelled in bankruptcy case under Title 11 of the U.S. Code The debt is qualified farm debt and is cancelled by a qualified person. The cancellation is intended as a gift. All of the above 434 Chapter 8 Questions 148. Any income connected to a business is considered to be: A. B. C. D. Taxable income An adjustment to income Business income Personal Income 149. Use Schedule C or C-EZ when reporting income or loss from a business the taxpayer operates as a: A. Partnership B. Sole proprietor C. Sub Corporation D. Corporation 150. What is the responsibility of a sole proprietor who receives money that is not reported on a 1099-MISC? A. They do not have to report the money B. They can report it if they choose C. Report 50 percent of the money D. They must include the money in income, unless excluded by law 151. Which of the following is incorrect regarding a sole proprietorship? A. The sole proprietor has complete management authority B. The owner is personally liable for all debts and obligations of business C. Business normally continues after the owners death D. Business or assets may be sold or transferred at the sole discretion of the owner 152. Accounting of gross receipts; A. Is optional B. Should be kept according to generally accepted accounting practices on a daily basis C. Should be kept according to generally accepted accounting practices on a monthly basis D. None of the above 153. Which of the following is true regarding record keeping for the self-employed taxpayer? A. The information that is shown on a receipt does not have to be repeated in the record. B. Adequate records contain enough information on every element of every business. C. Notes on depreciable assets should be kept in respect to basis. D. All of the above 435 154. Other kinds of income reported on Schedule C or C-EZ include. A. Restricted property B. Promissory notes C. Patent infringement D. All of the above 155. Exchange of property for services is called? A. Switching B. Bartering C. Trading D. Borrowing 156. Barter income must be included in which of the following: A. Gross receipts B. Expenses C. Cost of goods sold D. Inventory 157. Which of the following personal property rental income must be included in gross receipts? A. Equipment B. Vehicle rental C. Formal wear D. All of the above 158. Cost of goods sold are: A. Added to the gross receipts B. Deducted from the gross receipts C. Neither A or B D. Both A and B 159. To determine the cost of goods sold the inventory must be valued; A. At the beginning of the previous year B. June 1st of the current tax year C. At the beginning and the end of the tax year D. December 31st of the current tax year 160. Cost of goods sold start with which of the following? A. Inventory at beginning of year B. Materials and supplies C. Cost of labor D. Inventory at the end of the year 436 161. Schedule C, line 36; merchandise withdrawn for personal use must be; A. Ignored B. Excluded from cost C. Listed on page 1 of Schedule C D. Included in cost 162. Gross receipts minus cost of goods sold plus other income equals which of the following: A. Net income B. Net profit or loss C. Gross income D. None of the above 163. Gross income minus business expenses equals which of the following: A. Tentative profit B. Cost of goods sold C. Gross receipts D. All of the above 164. Tentative profit minus business use of the home equals which of the following: A. Gross income B. Business Expenses C. Gross receipts D. Net profit or loss 165. Which of the following is considered an ordinary expense? A. An expense that is common and appropriate in that field of business B. An expense that is common and accepted in that field of business C. An expense that is helpful and common in that field of business D. A accepted expense in that field of business 166. Which of the following would be a definition of an expense? A. One that is common and accepted in the field of business B. A repair that does not increase the useful life of machinery C. A short-lived part D. All of the above 167. Which of the following describes the process of spreading the cost over more than one year of an acquired property? A. Appreciation B. Depreciation C. Depletion D. None of the above 437 168. Which of the following property cannot be depreciated? A. Owned property B. Property that has a useful life that is substantially more than one year C. Property that is purchased and sold in the same year D. Property used in business or held to produce income 169. A Section 179 deduction is the amount determined by code that can be expensed in _____________. A. The year of sale B. The year of purchase C. The third year that the property is owned D. None of the above 170. Which of the following is a definition of a tax home? A. The main place of business, regardless of where the family home is maintained B. Where the home is located regardless of the business C. Where the taxpayer is working at the present time D. None of the above 171. What is the maximum amount of Section 179 expense allowed in 2012? A. $500,000 B. $250,000 C. $125,000 D. $100,000 172. Which of the following is considered to be listed property? A. Most passenger automobiles B. Any property of a type generally used for entertainment, recreation or amusement C. Computer equipment D. All the above 173. Which of the following is no longer considered listed property? A. Cellular telephones B. Property used for entertainment C. Computer equipment D. None of the above 174. Which of the following would be an adequate recordkeeping method to track the basis of a business asset? A. Business ledger and the receipt B. Mileage log C. Receipt with notes on the back D. Information verbally given to a tax preparer. 438 175. Which of the following is correct regarding record keeping? A. Adequate record keeping must contain enough information on each element of every business or investment use. B. To meet adequate recordkeeping requirements the taxpayer must maintain an account book, diary, log, statement of expense, trip sheet and/or similar record or other documentary evidence that together with the receipt is sufficient to establish each element of an expenditure or use. C. The information already shown on the receipt does not have to be repeated in the record; however the records should back up the receipts D. All of the above are correct 176. Which of the following statements are true regarding travel and meals and entertainment? A. Meals and Entertainment are deductible only if they are directly related or associated with the active trade or business incurred while the taxpayer or his employee is present at a meal. B. A facility used for the meal cannot be deducted C. Travel for business expenses while away from the tax home are deductible. D. All of the above 177. Use ________ to report depreciation. A. Form 1040 B. Form 4562 C. Form 4797 D. Form 2210 178. If self-employed, medical and dental insurance for the taxpayer and their family is treated as which of the following? A. As a deduction on Schedule A B. As a expense on Schedule C C. As an adjustment to income reported on Form 1040 D. None of the above 179. Which of the following is correct regarding Self-employed health insurance? A. Premiums paid for health insurance established under the taxpayer’s business for a child who is 26 and the taxpayer’s dependent is eligible for the self-employed health insurance deduction. B. All Medicare parts are eligible for the self-employed health insurance deduction C. The insurance plan must be established, or considered to be established under the business. The self-employed health insurance cannot exceed the earned income from the business D. All of the above 439 180. A small business retirement plan for the taxpayer and their employees may include the following, except; A. SEP (Simplified Employee Pension) plans B. A traditional IRA C. SIMPLE (Savings Incentive Match Plan for Employees) plan D. Qualified plans (including Keogh or H.R. 10) 181. In order to qualify to claim expenses for the business portion of a home, which of the following requirements must be met? A. Business part of the home must be exclusive (a room or identifiable place) B. Business part of the home must be used on a regular (continuing basis) C. Business part of the home must be used for a specific business D. All of the above 182. Which of the following statements is incorrect regarding the business use of home? A. If the gross income from the business use of the home equals or exceeds the total business expenses, the business expenses related to the office in the home are deductible. B. A home that is rented as the taxpayer’s primary residence cannot be used for business use of home deduction. C. If the gross income from business use of the home is less than the total business expenses the deduction for the business use of the home is limited. D. Both A and C are correct 183. The net profit on Schedule C is computed by subtracting any office in home expense from the ___________. A. Gross receipts B. Gross income C. Other income D. None of the above 184. Self-employment tax (SE tax) is primarily for which of the following? A. Employees B. Sole proprietors C. Individuals who are not employed D. Individuals who do not want their employers to withhold social security and Medicare taxes from their pay. 185. All of the following are correct regarding self-employment income and tax, except: A. By not reporting all of the self-employment income from their business the taxpayer may cause the social security benefits to be lower upon retirement. B. The SE tax rules apply no matter how old the taxpayer and unless they are already receiving social security or Medicare benefits C. Self-employment tax (SE tax) is a social security and Medicare tax primarily for individuals who work for themselves D. All the combined wages, tips, and net earnings in 2012 are subject to any combination of the 2.9% Medicare part of SE tax, social security tax, or railroad retirement (tier 1) tax 440 186. Which of the following methods can be used to compute net earnings from selfemployment to compute SE tax? A. The regular method B. The nonfarm optional method C. The farm optional method D. All of the above 187. The taxpayer must pay _____________ for the Medicare portion of S/E taxes on all net earnings. A. 20% B. 15.3% C. 2.9% D. 12.40% 188. A. B. C. D. 189. A. B. C. D. How much of the SE tax is deducted as an adjustment to income on Form 1040 for 2012 if the taxpayer’s self-employment tax is less than $14,643? 33% 57.51% 50% None of the above How many times in a lifetime may a self-employed person who is not a farmer or fisherman use the “Option Method” to compute self-employment tax? 5 8 10 unlimited 190. A. B. C. Which of the following statements are correct? Schedule C profit is subject to withholding. Self-employment tax does not have to be paid until the return is filed. The profit from Schedule C and self-employment tax should be taken into consideration when determining whether estimated tax payments are required. D. None of the above 191. A. B. C. D. Which of the flowing is a true statement?: An activity that is done without the intent of a profit is a hobby Hobby expense can only be deducted up to the amount of hobby income The IRS presumes if a hobby makes a profit 3 out of 5 years it is a business All of the above 441 Chapter 9 Questions 192. Which of the following is a capital asset? A. Most properties owned and used for personal purposes B. Investments C. Raw land D. All of the above 193. The following are examples of a capital asset; except: A. Personal residence B. Furniture C. Supplies regularly used in the trade or business D. Car 194. Which of the following is not considered a capital asset? A. Stock or trade or other property included in inventory or held mainly for sale to customers. B. Depreciable property used in trade or business C. U.S Government record including the Congressional Record. D. All of the above 195. The basis of property bought is usually ________. A. The property current value B. The property’s cost C. The property current value less the cost D. All of the above 196. The cost of property does not include amounts paid for which the following? A. Warranty contract bought at the time of purchase B. Sales Tax C. Installation and heating D. Recording fees 197. Which of the following statements is not true? A. Real property is also called real estate. B. Real property is land and generally anything built on land. C. Real property is land and generally anything attached to land D. Land is depreciable 198. The price at which property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the necessary facts is the ________________ of the property. A. Cost or basis B. Adjusted basis C. Fair market value (FMV) D. Taxable exchange 442 199. The result of increases or decreases to the basis of property is which of the following? A. Fair Market Value B. Basis other than cost C. Adjusted basis D. None of the above 200. How does an improvement having a useful life of more than 1 year and increases the value of the property, lengthens the life of the property or adapts the property for a different use effect the basis? A. Increases the basis B. Decreases the basis C. Has no effect on the basis D. Either A or B 201. All the following is correct regarding the fair market value of an asset, except: A. If property is received for services the property is included in income at the fair market value. B. If an asset is purchased at bargain prices (less than the FMV) include the difference between the discounted cost and the FMV in income and the FMV becomes the basis C. The cost of an asset cannot be the fair market value D. Basis other than costis computed by using the fair market value of the adjusted basis. 202. Which of the following increases the basis of property? A. Capital improvements B. Casualty losses- restoring damaged property C. Zoning costs D. All of the above 203. The following decreases the basis of property, except; A. The section 179 deduction B. Alternative motor vehicle credit C. Legal fees D. Easements 204. Basis in mutual funds are determined in the same manner as_____________________. A. Transfer fees B. Land C. Real Estate D. Stocks or bonds 205. Which of the following describes a taxable exchange? A. When a gain is taxable or a loss is deductible B. When a gain is deductible and a loss is taxable C. Both of the above D. Neither of the above 443 206. A taxable gain or deductible loss is known as which of the following? A. Taxable exchange B. Recognized gain or loss C. Both of the above D. Neither of the above 207. The most common taxable exchange is which of the following? A. Voluntary conversion B. Involuntary exchange C. Voluntary exchange D. Involuntary conversion 208. A like-kind exchange is reported on which form? A. 8824 B. 4797 C. 4562 D. 2106 209. Which of the following is the most common nontaxable exchange? A. Bartering B. Like-kind exchange C. Exchange of different kinds of property D. None of the above 210. Qualifying property in a like-kind exchange must be held for which of the following reasons? A. Investment B. Productive use in a trade or business C. Either A or B D. Neither A or B 211. Which of the following is correct? A. If the taxpayer holds the asset for more than one year before disposition, the capital gain or loss is long-term. B. If the taxpayer holds it one year or less, the capital gain or loss is short-term. C. To determine how long the asset is held, count from the date after the day acquired to and including the date of disposition of the asset D. All of the above 212. The basis of stocks or bonds generally is which of the following? A. Fair Market Value B. Current value C. Purchase price plus any costs of purchase D. None of the above 444 213. When purchasing stocks or bonds, the cost of purchase can include which of the following? A. Commissions B. Recording Fees C. Transfer Fees D. All of the above 214. Which form is issued when stocks, bonds or certain commodities are sold through a broker? A. 1099-MISC B. 1098 C. 1099-INT D. 1099-B 215. Which of the following is not true regarding the information reporting on Form 1099-B? A. Under the law prior to January 1, 2011 every broker must file an information return (Form 1099-B) in accordance with IRS regulations. The return must show the name and address of each customer and the details concerning the gross proceeds and any other information the IRS required. B. Beginning on January 1, 2011, brokerage firms, mutual fund companies, banks and transfer agents will also be required to track and report the cost of securities to both the IRS and the investor. C. The date the security was purchased is a requirement of Form 1099-B D. The data reported to the taxpayer on Form 1099-B is not reported to the IRS. 216. The Energy Improvement and Extension Act of 2008, contained changes that apply to Form 1099-B reporting implemented in which of the following years? A. 2011, 2012 and 2013 B. 2008, 2009 and 2010 C. 2001, 2008 and 2009 D. None of the above. 217. Which of the following statements are not true regarding a “covered security”? A. The security was acquired through a transaction in the account in which the security is held B. The security was transferred to the account from an account in which the security was a covered security, but only if the broker received a statement under Code Sec. 6045A with respect to the transfer. C. Securities acquired by gift or inheritance are covered securities D. All stock acquired beginning in 2011 except stock in a regulated investment company for which the average basis method is available and stock acquired in connection with a dividend reinvestment plan. 445 218. If Box 1b, 1c 3 and 5 are blank and Box 6a is checked on Form 1099-B what kind of securities were sold? A. Noncovered security B. Covered security C. Specified security D. None of the above 219. Section 403 of the Energy Improvement and Extension Act of 2008, Div. B of Pub. L. No. 110-343, 122 Stat. 3765, enacted on October 3, 2008, added which sections to the Code? A. 6045(g). B. 6045A. C. 6045B D. All of the above 220. Which of the following information is reported on Form 1099-B? A. Date of sale or exchange B. State income tax withheld C. Wash sale loss disallowed. D. All of the above 221. Which of the following is true regarding a “specified security”? A. A share of stock in a corporation or any note bond or other evidence of indebtedness. B. Any commodity, or contract or derivative with respect to the commodity, if IRS determines that adjusted basis reporting is appropriate for purposes of the Code Sec. 6045(g) reporting requirements C. Any other financial instrument with respect to which IRS determines that adjusted basis reporting is appropriate for purposes of the Code Sec. 6045(g) reporting requirements. D. All of the above 222. What is the applicable date when a broker must report a specified security which is a stock in a corporation? A. January 1, 2009 B. January 1, 2011 C. January 1, 2012 D. January 1, 2013 223. For the 2012 tax year, the deadline for a broker to furnish Form 1099-B to customers is on or before ___________________________ following the calendar year for which the return was required to make. A. January 31, 2013 B. March 15, 2013 C. April 15, 2013 D. None of the above 446 224. Which of the following is not a method used in the determination of basis as prescribed by regulations under Sec. 1012? A. FIFO B. Specific Identification C. Average Cost Convention D. LIFO 225. The determination of basis as prescribed by regulations under Sec. 1012 for determining adjusted basis will apply on _____________________. A. An account by account basis B. Date basis only C. Comparison basis D. Specified basis 226. Absent of any instructions from an investor which of the following methods is used to determine basis? A. FIFO B. Specific Identification C. Average Cost Basis, Single Category Method D. Average Cost Basis, Double Category Method 227. Which of the following is a definition of a “versus purchase” trade? A. An investor can pick and choose which tax lots they want to sell based on how much taxable gain or loss to be recognize. B. The investor identifies the specific tax lot they want to sell and informs the broker before the trade is executed. C. Versus purchase trade is denoted by "VSP" with the original tax lot purchase date printed on the trade confirmation for the sale in order to document that the specific identification method was used D. All of the above 228. Which of the following is correct regarding mutual funds? A. The average cost basis methods apply to mutual funds only. B. If the investor has a physical certificate form the average cost basis method cannot be used. C. The average cost single category method is commonly used when the taxpayer has holdings with several lots. D. All of the above 229. Which of the following is not true regarding the consequences of wash sales? A. The loss is not allowed to be claimed B. The disallowed loss is added to the basis of the replacement stock (this basically preserves the benefit of the disallowed loss) C. The holding period for the replacement stock includes the holding period of the stock sold. D. A gain can be considered a wash sale with the same restrictions. 447 230. Every “applicable person” that transfers to a broker a “covered security” will have to furnish to that broker a written statement that will enable the broker to meet the new requirements. A statement must be furnished no later than _____ days after the date of transfer. A. 30 B. 45 C. 15 D. 60 231. All the following are correct regarding the gross profit percentage when computing an installment sale, except: A. The gross profit percentage is calculated by dividing the amount of gross profit by the contract price. B. The contract price includes the total of all principal payments to be made by the buyer over the term of the installment sale. C. The gross profit percentage is calculated only in the year of sale and used for each subsequent year. D. The sale is always a long-term capital gain when calculating an installment sale. 232. The 2012 sales and other dispositions of capital assets are reported on which of the following forms? A. Form 2476 B. Form 8949 C. Form 4797 D. Form 6198 233. Form 1099-A is issued in each of the following circumstances? A. Sale of Stock B. Acquisition or Abandonment of Secured Property C. Report Mutual Funds D. None of the above 234. Which of the following statements is not true regarding Form 8949? A. A separate Form 8949 must be issued for Form 1099-B with the basis reported to the IRS and a Form 1099-B where the basis is not reported to the IRS. B. A disposition reported on Form 4797 must also be included on Form 8949. C. The short-term dispositions and the long-term dispositions are reported in different parts of Form 8949. D. Totals from Form 8949 are included on Schedule D. 448 235. All of the following is true regarding Column G on Form 8949 except: A. Brokers fees and commissions are reported in column G B. If net sales are reported in Column E of Form 8949 also include the commissions in Column G C. A code must be entered in Column B if an amount is entered in Column G D. If more than one code is entered in Column B the net adjustment is entered in Column G. 236. Which of the following is not a correct statement regarding the codes entered in Column B of Form 8949? A. If code B is entered the basis shown in Box 3 of Form 1099-B is incorrect. B. Column B and G should be blank if none of the codes for Column B apply. C. No code is available if the type of gain or loss is incorrect on Form 1099-B. D. Code W is for a nondeductible loss from a wash sale. 237. If a fund manager of a mutual fund decides to sell a stock and the stock is trading higher than when the fund initially purchased it, the fund must distribute at least ____ of the gains to shareholders. A. 50% B. 75% C. 95% D. -0238. After May 6, 1997, a married couple, filing a joint return, can exclude ________ of the gain realized on the sale of their personal residence if they meet certain conditions. A. $250,000 B. $520,000 C. $500,000 D. None of the gain can be excluded 239. Which of the following are one of the three exceptions where capital gains may be taxed at rates greater than 15%: A. The taxable part of a gain from selling Section 1202 qualified small business stock is taxed at a maximum 28% rate. B. Net capital gains from selling collectibles (such as coins or art) are taxed at a maximum 28% rate. C. The portion of any unrecaptured Section 1250 gain from selling Section 1250 real property is taxed at a maximum 25% rate. D. All of the above 449 240. Which of the following is true regarding the exclusion from gross income of a discharge of personal residence indebtedness? A. The taxpayer must reduce the basis even if falls below -0B. Form 982 must be included in the return C. The exclusion applies from 2006 through 2020 D. None of the above 241. The Section 121 exclusion requires individual to meet certain conditions. Ownership and use test states which of the following? The individual must have owned and used the home as a principal residence for: A. At least two out of the five years prior to the sale B. No more than two out of the five years prior to sale C. At least three out of the five years prior to sale D. All five years prior to the sale 242. Installment sales are sales for which the taxpayer ________________________ A. Will receive payments of interest only B. Will receive payments after the year of sale C. Must get permission from the IRS D. Must include Form 6251 243. Each payment in an installment sale consists of: A. Interest B. Gain on the sale C. Recovery of basis D. All the above 244. Interest on an installment sale must be charged at a rate: A. Equal to the IRS maximum B. Decided by the seller C. At least equal to the IRS minimum D. Of 10 percent 245. On which of the following forms is the Sale of Business Property reported? A. Form 6252 B. Form 4797 C. Form 8582 D. None of the above 450 246. Involuntary conversion (other than casualty and theft) of property used in ________ and capital assets held in connection with _____________ or a transaction entered into for profit are reported on Form 4797. A. A trade or business B. As a non-profit asset C. Either A or B D. Neither A or B 247. Which of the following is a true statement? A. A like-kind exchange is an exchange of property for the same kind of property. B. A like-kind exchange is the most common type of taxable exchange C. Like-kind property has different nature and character. D. A like-kind exchange is reported on Form 8482. 248. Which of the following is a true statement? A. Redemption or retirement of bonds is considered a sale B. Redemption of stock is treated as a sale or trade and is subject to the capital gain or loss provisions unless the redemption is a dividend or other distribution on stock. C. The gross sales price of the item is shown in Box 2 of 1099-B. D. All of the above 451 Chapter 10 Questions 249. A taxpayer who made a conversion from a Roth IRA in 2010 was allowed to recognize all the income in 2010 or _____________________________. A taxpayer who did not elect to report the conversion income in 2010 must report half in 2011 and half in 2012. This is a one-time opportunity; if making the election in 2011 or later the taxpayer must recognize all the income in the year of conversion A. Spread the income over the next two years B. Defer the income for 5 years C. Include it income in either 2011 or 2012 D. Chose the year with the lowest other income 250. A qualified distribution from a _______ is nondeductible, and the interest earned is tax deferred. A. IRA B. Roth IRA C. SEP D. SIMPLE 251. The following are examples that are reported on Form 1040 line 16a and 16b except: A. SEP IRA plans Section 408 (k) B. Tax sheltered annuity plans Section 403(b) C. Qualified pension D. Interest from a bank 252. If the taxpayer did not pay any part of the employee pension, and the employer did not withhold any part of the cost from the pay, the amounts received each year are _______. A. Nontaxable B. Fully taxable C. Consider as Losses D. Nondeductible 253. Before age _______ distributions from an IRA are taxable as ordinary income and subject to an additional tax for early withdrawal (10%). A. 65 B. 55 ½ C. 59 ½ D. 60 254. When a taxpayer is age _____ distributions from non-Roth IRA’s are required to begin. A. 65 B. 70 ½ C. 59 ½ D. 60 452 255. The basic calculation of the required minimum distribution is determined by _______ the account balance by the distribution period. A. Subtracting B. Adding C. Dividing D. Multiplying 256. A _______ is taking receipt of assets for up to 60 days before reinvesting in a new retirement plan. A. Transfer B. Rollover C. Distributions D. None of the above 257. A _______ is moving the assets directly from one custodian to another. A. Rollover B. Distribution C. Transfer D. SEP 258. Losses on the tax-deferred portion of IRA’s pension plans and annuities are generally _______ because the taxpayer has not paid tax on the money lost. A. Taxable B. Not deductible C. Fully deductible D. Discounted 259. In order for rollover or a transfer to be non-taxable it must be done _______ days after the distribution.. A. Within 45 days B. Within 60 days C. Within 30 days D. Within 90 days 260. At what age must a taxpayer begin Required Minimum Distributions from Non-Roth IRA’s? A. 65 B. 59 ½ C. 70 ½ D. 62 453 261. Which of the following would be reported with a Code 2 in Box 7 on Form 1099-R? A. A conversion from a Roth IRA B. A distribution from an IRA due to an IRS levy C. A distribution from a government defined benefit plan to public safety employee who is 52 year old. D. All of the above 262. The additional tax for early distributions from a SIMPLE IRA within the first 2 years the participant is in the plan is ______________. A. 10% B. 25% C. 5% D. There is no additional tax. 263. Which code on Form 1099-R, Box 7, is used to identify a rollover from a qualified plan, tax shelter annuity, a governmental 457 (b) plan or an IRA? A. Code G B. Code 3 C. Code 1 D. Code 7 264. ______________ is document issued annually by a financial institution to report information about individual retirement accounts and other tax-preferred savings accounts. A. Form 4797 B. Form 1099-R C. Form 5498 D. None of the above 265. The following are exceptions to the additional tax on Form 5329, except: A. IRA distributions made for higher education B. Distribution due to death C. Distribution due to total and permanent disability D. IRA distributions made for purchase of a second home 266. Form 5329 is used to compute an additional tax in the following instances, except: A. Early withdrawal of funds from an IRA B. Excess contributions to an IRA account. C. Penalty for early withdrawal from savings D. None of the above 454 267. Which form will be used to report additional taxes on an IRA? A. Form 8606 B. Form 5498 C. Form 5329 D. None of the above 268. Which code would be found in Box 7 of Form 1099-R for the distribution of a Qualified Roth IRA? A. Code Q B. Code B. C. Code R D. None of the above 455 Chapter 11 Questions 269. The following are samples of dwelling units except: A. Apartments B. Houseboat C. Condominiums D. Hotel room 270. Which of the following is an example of rental income: A. Security deposit B. Expenses paid by the tenant C. Payment for canceling a lease D. All of the above 271. Which of the following is not a common rental expense: A. Interest B. Commissions C. Sale of land D. Insurance 272. Which of the following is a true statement? A. Depreciation is shown separately on each rental property. B. Improvements made on a rental are never depreciated. C. The basis of rental property can be taken as an expense if the taxpayer chooses. D. None of the above 273. Work done on the rental property that does not add much to either the value of the house or the life of the property, but rather keeps the property in good condition is considered a ___________. A. Repair B. Improvement C. A miscellaneous expense D. None of the above 274. Which of the following is correct regarding rental expenses? A. Insurance premiums paid in advance cannot be deducted in full in the year paid. The premium must be allocated to the period covered and deducted in that year. B. Vacant property expenses are deductible beginning at the time the property is available for rent regardless of when rental income is actually received C. Local benefit taxes that increase the value of the property, such as charges for putting in sewers, streets or sidewalks are non-depreciable capital expenditures and are added to the basis only. D. All of the above are correct 456 275. _______ is the annual deduction allowed to recover the cost or other basis of business or other investment property through yearly deductions. A. Depreciation B. Capital losses C. Utilities D. Real estate taxes 276. Depreciation starts___________________________________________. It ends when the property is taken out of service, and has fully deducted all depreciable cost or other basis, or no longer use the property in the business or for the production of income. A. The day the property is purchased B. When the property is first used in business or for the production of income C. On a date chosen by the owner D. None of the above 277. Which of the following are true statements regarding depreciation? A. No deduction greater than basis may be taken. B. The total of the yearly deductions cannot be more than the cost or adjusted basis of the property. C. The total depreciation includes the depreciation deductions taken or was allowed to claim. D. All of the above 278. Residential rental property placed in service in 2010 has a class life under MACRS of: A. 27.5 years – straight line B. 39 years – straight line C. 31.5 years straight line D. None of the above 279. 5-year property MACRS (200% declining balance) includes the following, except: A. Automobiles B. Office furniture C. Typewriter, calculators, copiers etc. D. Computers 280. Section 179-expense deduction is property described in Section 1245(a)(3) that was acquired by purchase for use in active conduct of the trade or business and is either tangible property that can be depreciated under MACRS, or: A. Off-the-shelf computer software B. Property held for investment C. Air conditioning and heating unit D. All of the above 457 281. Amortization is similar to the straight-line __________________________over a fixed time period. A. An annual deduction is allowed to recover certain costs B. Is like depreciation with double declining balance C. Both A and B D. Neither A nor B 282. depreciation in that Land can never be depreciated because of which of the following? A. Land never wears out B. Land never becomes obsolete or C. Land never gets used up. D. All of the above 283. Modified Accelerated Cost Recovery System is for property placed in service after _______ A. 1988 B. 1986 C. 1999 D. 1983 284. Which of the following is a true statement? A. Report depreciation on Form 4562 and carry the deduction to the appropriate schedule. B. Use one Form 4562 per business or rental. C. Section 179 does not include property used outside the US D. All of the above 285. Amortization is similar to which of the following? A. MACRS 5 year % B. MACRS 7 year % C. Straight-line depreciation D. None of the above 286. Which of the following is true regarding the special depreciation allowance? A. A used property qualifies for the special allowance B. The 100% bonus depreciation was extended in the American Taxpayer Relief Act of 2012 C. Property must be new property to qualify for the special allowance D. All of the above are correct 287. Which of the following is the standard mileage rate for 2012? A. The standard mileage rate is $.51 per mile, before 7/1 and after 6/30 is $.555 per mile. B. The standard mileage rate is $.555 per mile C. The standard mileage rate is $.52 per mile, before 7/1 and after 6/30 is $.56 per mile. D. None of the above 458 288. Which of the following are reported on Schedule E, Page 1? A. Rental income, B. Rental expenses C. Depletion D. All of the above 289. Which of the following is considered a home? A. A dwelling unit used 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. B. A dwelling unit rented fewer than 15 days during the year C. Both A and B D. Neither A nor B 290. _______ are an investment in a trade or business with no material participation, most rental activities, and limited partnerships. A. Passive activities B. Portfolio income C. Nonpassive activities D. All of the above 291. Which of the following is not included as a definition of a passive activity? A. Investment in a trade or business with no material participation B. Interest income C. Rental activities D. Limited partnerships 292. Which of the following statements are true about rental real estate activities? A. The amount of deduction allowed is limited B. Active participation in rental real estate activity allows a taxpayer with an adjusted gross income of under $100,000 to deduct up to $25,000 ($12,500 if married filing separately) in passive losses against non-passive income. C. Use Form 8582 to compute and track passive activities and suspended amounts from year to year. D. All of the above. 293. Royalty income is reported on which of the following? A. Schedule E, Page 1, Line 3b B. Schedule E, Page 1, Line 4a C. Schedule E, Page 2, Line 32 D. None of the above 459 294. Which of the following is not considered a day of personal use, or part of a day, when renting a single family dwelling? A. Any day spent working substantially full time repairing and maintaining the unit, even if family members used it for recreational purposes on that day Schedule E, B. Any days the unit as the main home before or after renting it or offering it for rent, if the owner rented or tried to rent it for at least 12 consecutive months (or for a period of less than 12 consecutive months at the end of which it was sold or exchanged). C. Either A or B D. None of the above 295. Portfolio income includes the following, except A. Interest B. Dividends C. Royalties D. Self-Employment Income 296. Which of the following entities issue a K-1 to a taxpayer? A. Partnership B. S-Corporation C. Estate and Trust D. All of the above 297. Which of the following information is included in the Schedule K-1? A. Income B. Expenses C. Deductions and credits D. All the above 298. The taxpayer may deduct unreimbursed ordinary and necessary expenses paid on behalf of the partnership if required to pay these expenses under the: A. Corporation agreement B. Partnership agreement C. Handshake agreement D. None of the above 299. Report ordinary income or loss from a partnership, S-corporation or an estate or trust on: A. Schedule E, page 1, Line 3 B. Schedule D C. Schedule E, page 2, Line 28 D. Schedule C 460 300. If a rental is a condominium any special assessments for improvements to the rental must be ________________________. A. Capitalized and depreciated B. Expensed C. Subtracted from the rental income D. None of the above 301. All of the following are reported on Schedule E, except: A. Royalty from copyrights, patents and oil, gas and mineral properties are taxed as ordinary income the income is generally reported on Schedule E. B. Royalties are received as a self-employed writer inventor or artist. C. Copyrights and patent income is generally paid to the taxpayer for the right to use the taxpayer’s work over a period of time. D. Royalties from oil and gas is paid by a person or company who leases the property from the taxpayer. 302. If the partner is considered a limited partner (did not materially participate in the partnership), the income from the Schedule K-1 is: A. Nonpassive B. Inactive C. Passive D. Submissive 303. All of the following is correct regarding Farm Income, except:. A. Farm income is reported on Schedule F B. Farm Income is not subject to self-employment tax C. The crop method of accounting allows the taxpayer to deduct the crop expenses in the year the income is realized. D. The is a special averaging method for farms over three years. 304. Which of the following is a source of income reported on Schedule F? A. Sales of livestock and other items bought for resale B. Sales of livestock that the taxpayer raised C. Agricultural program payments D. All of the above 305. Which farm property used in trade or business qualifies for a Section 179 deduction? A. Machinery and equipment B. Milk tanks C. Livestock D. All of the above 461 306. In a farming business, the 150% declining-balance or SL method must be used when depreciating the following, except: A. Three-year MACRS property B. Fifteen-year MACRS property C. Five-year MACRS property D. Seven-year MACRS property 307. Which of the following would not be considered a pass-through entity?. A. A Partnership B. A Schedule F C. An S-Corporation D. An Estate 308. When is the ordinary local transportation expense deductible for rental property? A. To collect rents B. To manage property C. To maintain property D. All of the above 462 Chapter 12 Questions 309. Which of the following is a type of unemployment compensation? A. Benefits paid by a state or the District of Columbia from the Federal Unemployment Trust Fund. B. State unemployment insurance benefits. C. Disability payments from a government program paid as a substitute for unemployment compensation. (Amounts received as workers' compensation for injuries or illness are not unemployment compensation) D. All of the above 310. The taxable amount of Social Security Benefits is reported on which line of Form 1040? A. 20a B. 19a C. 19b D. 20b 311. Which of the following is a true statement regarding unemployment compensation? A. Reported to the taxpayer on Form 1099-G and is not taxable. B. Reported to the taxpayer on Form 9910-G and is taxable. C. Reported to the taxpayer on Form 1099-G and is taxable. D. Unemployment compensation is never taxable. 312. All of the following is true regarding Social Security, except: A. Delayed retirement is available for a worker over the full retirement age. B. For a person born in 1937 the full retirement age is 65. C. At age 70 a worker loses social security benefits D. There is an earnings limit if a worker chooses early retirement. 313. A worker is eligible for early retirement benefits at: A. Age 59 1/2 B. Age 62 C. Age 63 D. Age 65 314. _________________________plus all other income including tax exempt income is compared to the base amount to determine whether any Social Security benefits are taxable: A. Interest B. One-half Social Security Benefits C. Wages D. Dividends 315. How does early retirement affect the amount of the Social Security benefits paid? A. Has no effect B. Permanently reduces the amount paid and places an earnings limit on receiving benefits C. Permanently reduces the amount paid, but allows you to earn income without effect D. Increases the amount of the benefit paid 463 316. A worker who was born in 1952 is eligible for full retirement benefits at what age? A. Age 62 B. Age 66 C. Age 63 D. Age 65 317. Hobby income is: A. Income that must be reported and accurate records must be kept B. Expenses are allowed up to the amount of income C. Not for profit income D. All of the above 318. Which of the following items is generally not taxable? A. Prizes and awards B. Jury duty C. Illegal income D. Foster care payments 319. Which of the following is a correct statement regarding credit card insurance? A. Report on Form 1040, Line 21 the total benefits the taxpayer receives during the year. B. Report on Form 1040, line 21, the amount of benefits received during the year that is more than the amount of the premiums paid during the year. C. Credit card insurance benefits received by the taxpayer are never taxable. D. Report on Form 1040, line 21, the amount of benefits received during the year that is less than the amount of the premiums paid during the year. 464 Chapter 13 Questions 320. An eligible educator can deduct _____________as an adjustment to income rather than as an itemized deduction. A. Mileage to and from school B. All expenses having to do with education C. Up to $250 of qualified expenses D. All of the above 321. How many hours a year must an eligible educator work in elementary or secondary education to qualify for education expense deduction? A. 700 hours B. 800 hours C. 900 hours D. None of the above 322. Certain business expenses reported on Line 24 of Form 1040 is for which of the following? A. Reservists B. Performing Artists C. Fee-based government officials D. All of the above 323. The Health Savings Account is designed to allow the taxpayer to save for current and post retirement _______________________ on a tax free basis A. Qualified medical expenses B. Charitable contributions C. Health insurance premiums D. None of the above 324. Which of the following is not true regarding contributions to an HSA A. Contributions may be made in cash B. Contributions may be made through a cafeteria plan C. Contributions may be made by contribution stock to the plan D. All of the above 325. Benefits of an HSA include all the following, except. A. The HSA is tax deductible even if the taxpayer is not itemizing B. Contributions made by the employer (including contributions through a cafeteria plan) may be excluded from gross income C. The contribution must be removed at the end of each year D. Distributions are tax free if used for qualified expenses 465 326. Deferred wages contributed to a Section 401 (k) plan is commonly known as which of the following? A. Employee contribution B. Elective contribution C. Employee compensation D. None of the above 327. A Health Savings Account (HSA) is set up with A. The employer B. The pharmacy C. A U.S. financial institution D. The health care provider 328. The 2012 standard mileage rate for moving expenses is A. 20 cents per mile B. 27.5 cents per mile C. 23 cents per mile D. 16 cents per mile 329. Which of the following is not true regarding moving expenses A. Travel expenses for moving are limited to two trips for each member of the household B. Household members do not have to travel together or at the same time. C. The taxpayer must move within the US or be a US citizen D. All of the above are correct 330. When filing Form 3903, the taxpayer must meet some general rules. Which rule is correct? A. The taxpayer must move within the U.S. or be a U.S. citizen B. The new job location is at least 50 miles farther from the former home than the old place of work C. The employee must work at the new job for at least 39 weeks. D. All of the above 331. Which of the following is the employer equivalent of self-employment income tax? A. The deduction is 57.51% if the amount of self-employment tax is $14,643 or less; B. If self-employment tax is more than $14,643 the deduction is 50% times the amount of self-employment tax plus $1,100 in 2012 C. Both A and B D. Neither A nor B 332. Which of the following is correct regarding a self-employed SEP IRA for 2012 A. The taxpayer can deduct the smaller of 25% of compensation or $50,000 B. The taxpayer can deduct 20% of self-employment income up to $42,000 C. The compensation limit is $175,000 D. None of the above are correct 466 333. Which of the following is correct for a 2012 SIMPLE IRA A. The employee elective deferral equals the lesser of $11,500 or earned income B. The employer must match up to 3% of wages C. If over 50 the lesser of $14,000 or earned income D. All of the above 334. Self-employed health insurance is deductible if A. The taxpayer has established an insurance plan under the business B. The business has a net profit of at least $500 C. The taxpayer was a 50% shareholder in an S-corporation D. The taxpayer is self-employed and the business had a net loss 335. Which of the following is incorrect regarding Self-employed health insurance? A. Premiums paid for health insurance established under the taxpayer’s business for a child who is 26 and the taxpayer’s dependent is eligible for the self-employed health insurance deduction. B. All Medicare parts are eligible for the self-employed health insurance deduction C. The insurance plan must be established, or considered to be established under the business. D. All of the above are correct 336. Which does not qualify as alimony? A. Child support B. Payments to keep up the payer’s property C. Use of property D. All of the above 337. Which qualifies as alimony? A. Noncash property settlement B. Use of property C. Life insurance premium D. None of the above 338. Which payments cannot be included as alimony? A. Payments to a third party B. Mortgage payments C. Taxes and licenses D. Use of property 339. The taxpayer can deduct as alimony one-half of A. Mortgage interest of a jointly owned home B. Mortgage principal of a jointly owned home C. Both of A and B D. Neither A or B 467 340. Qualifications for a spousal IRA include which of the following? A. All distributions are taxable B. A non-working spouse’s contribution is subject to phase out rules if the working spouse is in a qualified plan C. No gross income limitations apply if the other spouse is not in a qualified plan D. All of the above 341. Which of the following is correct ? A. A Roth IRA is an individual retirement arrangement that except as explained in this chapter is subject to the rules that apply to a traditional IRA with exception of the 70½ age rule for required distribution. B. Distributions from Traditional IRA’s are taxable upon distribution, with Roth IRA’s only the interest earned is taxable C. Both A and B D. Neither A nor B 342. Deductible traditional IRA contributions for 2012 are A. The lesser of $5,000 or taxable compensation B. The lesser $6,000 if age 50 or older or taxable compensation C. Both A and B above D. Neither A or B 343. Qualifications for a traditional IRA include A. Must be at least 55 years old B. Must not be over 65 years old C. Must not be over 70½ years old by the end of the tax year D. Must not be over 70½ years old by the filing due date 344. 2012 IRA contributions are subject to phase out rules if the taxpayer is in a qualified plan A. Phase out is between $92,000 and $112,000 for MFJ B. Phase out is between $58,000 and $68,000 for Head of Household C. Phase out is between $0 and $10,000 for married filing separate D. All of the above are true 345. Which of the following is not correct regarding the spousal IRA? A. The taxpayer must not be 70½ by the end of the tax year. B. Must have earned income (spouse can make contributions based on the taxpayers income) C. No gross income limitations for individuals who are not participating in a qualified plan D. All distributions are taxable 346. In a Roth IRA the A. Traditional IRA age rule does not apply B. Contribution is not deductible C. Distribution less interest is not taxable D. All of the above 468 347. Student loan interest is deductible for a single taxpayer if A. The taxpayer is not a dependent on another tax return B. Married filing separate C. The loan is from a relative D. The modified AGI is above $75,000 348. A qualified student loan is a loan for A. Equipment and school uniforms B. Transportation and meals C. Tuition and books D. None of the above. 349. Tuition and fees deduction cannot be taken if A. Filing status is Head of Household B. Modified AGI is $65,000 or less C. There is an education credit for the same return D. The qualified tuition and fees were paid for the taxpayer, spouse, or dependent 350. Qualified tuition and fees deduction is reduced by which of the following A. Excludable U.S. series EE bonds B. Nontaxable qualified state tuition programs C. Nontaxable earnings from education savings account D. All of the above 351. Which of the following is correct regarding deductions on line 36 of Form 1040? A. Deduction must be specific and identified B. More than one item can be deducted C. Both A and B D. Neither A nor B 352. Miscellaneous deductions for line 36 of Form 1040 include A. Jury Duty Pay (if not reimbursed by employer) B. Reforestation amortization C. Both A and B D. Neither A or B 353. Miscellaneous deductions on Line 36 of Form 1040 for Attorney Fees are limited to which of the following? A. The attorney fees B. Gross income from the award or claim C. Court costs D. None of the above 469 Chapter 14 Questions 354. In 2013 which medical and dental expenses qualify for itemized deductions for taxpayers under age 65? A. The unreimbursed expenses that exceed 2% of AGI B. The reimbursed expenses that exceed 5% of AGI C. The unreimbursed expenses that exceed 7.5% of AGI D. The unreimbursed expenses that exceed 10% of AGI 355. Medical and dental expenses include A. Surgery to improve vision B. Medical treatment for alcoholism C. Lodging expenses while away from home to receive medical care in a hospital D. All of the above 356. Which is not a medical expense? A. Nicotine Gum sold over the counter B. Weight loss programs not prescribed by a doctor C. Insurance premiums for medical and dental care D. Acupuncturist expenses 357. Which of the following are not deductible on Schedule A? A. Federal income tax B. Personal property tax C. State and local income taxes D. Real Estate Taxes 358. Which of the following are not deductible as taxes on Schedule A A. Foreign taxes B. State Disability Insurance C. Excise Taxes D. State income taxes 359. Which of the following is a true statement? A. A taxpayer can claim some sales tax and some state and local income tax on Schedule A. B. SDI cannot be claimed as a deduction on Schedule A. C. Personal property taxes based on the value of an asset are not deductible. D. Individuals can deduct the larger of either the general sales tax or state and local income tax. 360. Home mortgage interest is for any loan secured by A. The main home and second home B. The third home C. The second and third home D. None of the above 470 361. A home must provide basic living accommodations including A. Living space, cooking facilities, garage B. Cooking facilities, garage, sleeping space C. Garage, sleeping space, toilet D. Sleeping space, toilet, cooking facilities 362. Limits apply to home mortgages taken out A. After October 31st, 1987 B. After October 31st, 1988 C. After October 13th, 1987 D. After October 13th, 1988 363. Which of the following is not reported on Form 1098? A. Home mortgage interest paid B. Points paid on home acquisition C. Interest income D. Mortgage insurance premiums 364. Points charged when refinancing A. Are deductible over the life of the loan B. Are deductible (the remaining portion) when the mortgage is paid off C. Both A and B above D. Neither A or B above 365. Investment interest deduction allowed on Form 4952 includes which of the following? A. Interest on money borrowed to buy investment property B. Interest on money allocable to self-employment income C. Interest on money borrowed to purchase tax-exempt bonds D. None of the above 366. If a taxpayer drove to and from volunteer work A. He may deduct 14 cents per mile B. He may deduct parking and toll expenses C. He may deduct actual cost of gas and oil instead 14 cents per mile D. All of the above 367. Gifts of $250 or more are deductible A. If the charitable organization issues a statement for the amount B. To the extent of the donation C. Each donation is treated separately D. All of the above 471 368. Limits on charitable contributions for most common charitable organizations apply A. When the contributions exceed 10% of AGI B. When the contributions exceed 25% of AGI C. When the contributions exceed 35% of AGI D. When the contributions exceed 50% of AGI 369. The reduced limit for charitable contributions in the form of capital gain property donated to an organization that is not listed as a 50% organization is A. 15% B. 30% C. 25% D. 35% 370. Charitable contributions exceeding the AGI limit must be carried over to A. The next year B. To each of the five subsequent years C. The next three years D. To each of the seven subsequent years 371. Carryovers of charitable contributions A. Do not retain the original percentage limits B. Are deducted before current year’s contributions C. Retain the original percentage limits D. None of the above 372. Donations other than by check or cash A. Are deducted at fair market value B. Are deducted at the value a willing buyer would pay C. Are deducted at the value a willing seller would sell D. All of the above 373. Appraisals on the value of the donation may be required if the total donation is over A. $1,000 B. $2,500 C. $5,000 D. $7,500 374. Form 8283 is required if the deduction is more than A. $500 B. $1,000 C. $3,000 D. $5,000 472 375. Non-business casualties or thefts are deductible if the total amount of all losses during the year is more than A. 2% of AGI B. 5% of AGI C. 10% of AGI D. 12% of AGI 376. In 2012 for non-business casualties or thefts to be deductible each separate casualty or theft must exceed A. $500 B. $250 C. $100 D. $1000 377. Which of the following would qualify for a casualty or theft loss?. A. Car accident B. Shipwreck C. Vandalism D. All of the above 378. How is a casualty loss which happens from one event only reported? A. As a single event, one time only. B. Can reported in two taxable years C. Either A or B D. Neither A not B 379. Which of the following is correct regarding officials paid on a fee basis? A. Certain fee-basis officials can claim their employee business expenses whether or not they itemize their other deductions on Schedule A (Form 1040). B. Fee-basis officials are persons who are employed by a state or local government and who are paid in whole or in part on a fee basis. C. They can deduct their business expenses in performing services in that job as an adjustment to gross income rather than as a miscellaneous itemized deduction D. All of the above. 380. Ordinary and necessary expenses of an employee carrying on a trade or business include A. Fees to employment agencies when looking for a new job B. Dues to professional organizations C. Both A and B above D. Neither A or B above 473 381. Which is an ordinary and necessary expense of an employee carrying on a trade or business? A. Union Dues B. Protective clothing C. Tools used for work D. All of the above 382. Receipts are required for employee business lodging expenses A. Over $50 B. Over $75 C. Over $100 D. Any amount 383. If there is no accountable plan receipts for expenses other than lodging are generally required for expenses A. $50 or more B. $75 or more C. $100 or more D. Any amount 384. The deduction for meals and entertainment is limited to A. 80% of the amount that would otherwise be eligible B. 75% of the amount that would otherwise be eligible C. 50% of the amount that would otherwise be eligible D. Deminimis fringe benefits are included in the limit 385. Which of the following are included in the 50% deduction limit regarding meals and entertainment A. Meals and entertainment sold to customers such as a restaurant B. Taxes and tips C. Cover charges D. Parking 386. Business gifts made in the course of a taxpayer’s trade or business are limited to A. $50 to any one individual per year B. $401 to any individual per year C. $25 to any one individual per year D. None of the above 387. Exceptions to the $25 business gift rule includes which of the following items? A. An award costing $400 or less given to an employee for length of service B. Signs and displays C. Promotional items D. All of the above 474 388. Items costing $4 or less are A. Added until they reach the business gift limitation B. Exceptions from the gift limitation C. Considered to cost $5 D. None of the above 389. Travel away from home expenses are deductible at A. 50% B. 75% C. 80% D. 100% 390. Expenses for temporary employment are not deductible if A. The employment exceeds six weeks B. The employment exceeds four months C. The employment exceeds six months D. The employment exceeds one year 391. Excess reimbursement to an employee A. Must be returned B. Must be included in income C. Is taxable after the $250 D. Is taxable after $500 392. Which of the following can be taken as a deduction in addition to the standard mileage rate? A. Gasoline B. Parking fees and tolls C. Auto insurance D. All of the above 393. Which is not a record keeping requirement? A. Total business miles driven in a year B. The basis of the vehicle C. Date placed in service D. Annual finance charges 394. The form employee business expense is computed on which of the following forms? A. Form 2106, page 2 B. Form 1040, page 2 C. For 3903, page 2 D. None of the above 475 395. Actual car expenses include the following A. Depreciation B. Garage rent C. Gas D. All of the above 396. Union dues are deductible on which form? A. Schedule A, subject to 2% of the adjusted gross income. B. Form 1040 C. Form 4562 D. Form 1116 397. Which of the following is correct regarding vehicle lease payments? A. If a vehicle lease payments are for more than 30 days an inclusion amount is required. B. The inclusion amount is included if the taxpayer uses the actual expense method. C. Lease payments can be a business expense D. All of the above 398. All of the following is allowed regarding Armed Forces reservists traveling more than 100 miles from home, except? A. The amount of expenses are deductible as an adjustment to gross income B. The regular federal per diem rate for lodging, meals, and incidental expenses is allowed C. Either the standard mileage rate for car expenses is allowed or actual expenses D. Any parking fees, ferry fees, and tolls are allowed 399. Work related education is deductible if A. The education is required by the employer B. The education maintains or improves skills needed in present work C. The education is required by law D. All of the above 400. Which of the following is correct regarding itemized deductions allowed subject to 2% of adjusted gross income? A. Income that is used to produce or collect income that must be included in gross income B. To manage conserve or maintain property held for the production of income C. To determine contest, pay or claim a refund of any tax D. All of the above 401. Which of the following is not subject to the 2% AGI limitation? A. Tax preparation fees B. Hobby expenses C. Life insurance premiums D. Investment fees and expenses 476 402. Which of the following is subject to the 2% AGI limitation? A. Adoption expenses B. Legal expenses C. Home security system D. Investment related seminars 403. Casualty and Theft is computed on which form? A. Form 4684 B. Schedule C C. Form 4562 D. Schedule B 404. Employee business expenses are taken on Form _____________. A. 4562 B. 8824 C. 2106 D. 4797 405. Which of the following is not correct regarding the limitation of itemized deductions in tax year 2013? A. The limitation of itemized deductions apply to single taxpayers with AGI over a threshold amount of $300,000 B. Itemized deductions are reduced by 3% of the amount by which AGI exceeds the threshold. C. Itemized deductions for gambling losses are not subject to the limitation. D. The maximum amount of reduction is 80%. 406. Which of the following are subject to “Pease”? A. Mortgage Interest B. Medical Expenses C. Gambling losses D. Casualty losses 407. The maximum amount of reduction of itemized deductions is __________ A. 20% B. 80% C. 100% D. None of the above 408. Which of the following are incorrect regarding the phase out of itemized deductions? A. Not all itemized deductions are subject to phase-out B. Deductions are reduced by 3% of the amount by which AGI exceeds the threshold. C. The modified AGI phase-out amount for a Single taxpayer is $200,000 D. The modified AGI phase-out amount for a couple filing married filing joint is $300,000 477 Chapter 15 Questions 409. Which of the following is correct when determining a refund or amount owed A. After the income tax is computed subtract any tax credits and add any other taxes owed. The result is total tax. Compare the total tax with total payments to determine whether the taxpayer is entitled to a refund or there is an amount owed B. Use the adjusted gross income to compute the tax and compare the total tax with total payments to determine whether the taxpayer is entitled to a refund or there is an amount owed. C. Credits are not taken into account to determine a refund. D. Additional taxes are not taken into account to determine an amount due 410. Which of the following do taxpayers use to figure their income tax? A. Tax Table Chart B. Tax Rate Schedule C. Either A or B D. Neither A or B 411. Which of the following is not correct regarding qualified dividends?. A. Qualified dividends taxed at capital gain rates B. When there are qualified dividends in a return the tax is computed on Schedule D, page 2. C. Qualified dividends are added to other dividends and increase total dividends on Schedule B. D. Qualified dividends only affect the tax computation on Schedule D 412. When the parent elects to include the child's income on their tax return, how could it affect the parent's tax return? A. The tax rate may be higher B. Reduced deduction of credits C. Penalty for underpayment of estimated tax D. All of the above 413. Part of a child's investment income may be subject to tax at the parent's rate if the child is under the age of 18, required to file a tax return for 2012 and has investment income of: A. $1,900 B. $1,499 C. $1,200 D. $150 414. Alternative Minimum Tax exists so that taxpayers with substantial income: A. Can avoid paying tax B. Are not able to avoid paying tax C. Can receive favorable treatment on certain items D. All of the above 478 415. Which of the following is not one of the three paramenters indexed after 2012 in The American Taxpayer Relief Act of 2012? A. Exemptions B. The 28% AMT bracket C. Personal exemptions D. AMT income above which the exemption phases out 416. The taxpayer is liable for either AMT or regular tax, whichever: A. The taxpayer chooses B. Is less C. Is more D. None of the above 417. The taxpayer may have to pay AMT if the taxable income for regular tax purposes is over the exemption amount for regular tax combined with certain adjustments and preferences. The most common adjustments and preferences include the following, except: A. Addition of personal exemptions B. Addition of certain income from incentive stock options C. Addition of any refund of state and local taxes included in gross income D. Addition of tax-exempt interest on certain private activity bonds 418. Which of the following statements are correct regarding the Medicare Payroll Tax? A. A Single taxpayer with self-employment income between $100,000 and $200,000 is subject to the Medicare Payroll tax. B. The employer is not subject to the additional 0.9% Medicare Tax C. The employer is responsible for withholding the Additional Medicare Tax from wages or compensation it pays to an employee in excess of $50,000 in a calendar year. D. None of the above statements are correct. 419. All the following is incorrect regarding the new Additional Medicare Tax, except? A. The 0.9 percent Additional Medicare Tax applies to an individual’s wages, not self-employment income. B. The threshold amounts are $250,000 for married taxpayers who file jointly and the employer starts withholding at $250,000 C. The employer does not have to pay the additional .9%. D. None of the above 420. There are two kinds of credits: A. Favorable and unfavorable B. Refundable and nonrefundable C. Fortunate and unfortunate D. Useful and not useful 479 421. Which of the following is not correct regarding refundable and nonrefundable credits? A. Nonrefundable credits can reduce the tax to zero and any excess is refunded to the taxpayer. B. The refundable credit is treated as payments and is refundable. C. The refundable credits are added to withholding and estimate payments. D. If the total refundable credit is more than the total tax the excess is refunded to the taxpayer 422. The maximum tax credit that may be allowed for qualifying expense paid to adopt an eligible special needs child is: A. $12,650 B. $13,010 C. $1,016 D. None of the above 423. The following is a list of qualifying adoption expenses, except: A. Reasonable and necessary B. The adoption of a spouse's child C. Court costs D. Attorney fees 424. In an adoption, which of the following is an eligible child? A. Under 18 years old B. Physically or mentally handicapped C. Both A or B D. Neither A or B 425. A taxpayer pays someone to care for their spouse that is not able to care for him or herself so that the taxpayer can work. What is the maximum credit for the expenses that can be claimed? A. 35% B. 53% C. 25% D. 40% 426. In order to claim the Child and Dependent Care Credit, eight tests must be met. Which of the answers below is not one of the eight tests? A. The taxpayer and spouse, if married, must have earned income during the year B. The person paid to care for a dependent cannot be a dependent of the taxpayer and must be at least 19 years old C. The care provider must have a valid driver’s license D. The filing status cannot be married filing separate 427. The dollar limit for qualified expenses for the Child and Dependent Care Credit is A. $3,000 for one child and $6,000 for two or more qualifying persons B. $4,000 for one child or more 480 C. $2,500 for one child and $5,000 for more than one child D. None of the above. 428. Which of the following is incorrect regarding The Child and Dependent Care Credit? A. The credit is generally a percentage of the amount of work-related child and dependent care expenses paid to a care provider. B. All taxpayers who have child and dependent care expenses may take the credit regardless of the taxpayer’s adjusted gross income. C. Work-related child and dependent care expenses qualifying for the credit are those paid for the care of a qualifying individual to enable the taxpayer to work or actively look for work for any period when there are one or more qualifying individuals. D. Expenses are paid for the care of a qualifying individual if the primary function is to assure the individual's well-being and protection. 429. Which of the following is not true regarding Employer provided childcare? A. Flexible Spending Accounts (Dependent Care Benefits, or Cafeteria Plans/125 Plans) allows an employer to provide for childcare for an employee. B. The taxpayer can only take advantage of this plan 2 out of 5 years C. Benefits are paid for by the employee out of his or her salary and are not taxed up to $5000 (or $2,500 if MFS and not considered unmarried). D. Such benefits provided by an employer are non-taxable only to the extent these limits are not reached, or up to the amount of the actual expenses, or the taxpayer’s earned income including the non-taxable earned income other than the dependent care benefits provided by the employer 430. Which of the following is a true statement regarding The Child Tax Credit? A. The Child Tax Credit must be reduced by any advanced payments of Child Tax Credit. B. The Child Tax Credit is limited to the tax liability. C. The maximum Child Tax Credit is $1,000. D. All of the above 431. Which of the following is not a requirement for a qualifying child for child tax credit purposes: A. Under age 17 at the end of the tax year. B. A citizen or resident of the United States. C. Claimed as the taxpayer’s dependent. D. The child must be in public school 432. Which if the following is true regarding the Additional Child Tax Credit: A. This credit is for certain individuals who get less than the full amount of Child Tax Credit. B. This is a refundable credit that allows the credit whether or there is any tax liability. C. Complete the child tax credit before computing the additional child tax credit. D. All of the above 481 433. Which of the following is a correct statement regarding the Foreign Tax Credit? A. The credit equals the tax liability from sources outside the US divided by taxable income from US sources and foreign sources. B. The Foreign Tax Credit is computed on Form 2555 C. The Foreign Tax Credit can be carried back 5 years D. The Foreign Tax Credit is a refundable credit 434. Which of the following is not true about the Mortgage Interest Credit? A. The deductible interest on Schedule A is reduced by the amount used to compute the credit. B. To qualify the taxpayer must be issued a certificate by the IRS. C. The credit rate on the certificate is multiplied by the interest allowed. D. The mortgage interest credit is intended to help lower income individuals purchase a home. 435. What is the maximum amount of the Mortgage Interest Credit? A. $5,000 B. $2,000 C. $3,000 D. $1,500 436. The credit for _____________________________occurs if the taxpayer paid Alternative Minimum Tax generated by “deferral items” in the prior year. A. Alternative Minimum Tax B. Child Tax Credit C. Prior Year Minimum Tax D. Retirement Savers Credit 437. Adjustments required under AMT rules fall into two categories A. Deferral and exclusion items B. Deductions and credits C. Adjustments and taxes D. None of the above 438. Which of the following are deferral items that AMT adjustments do not cause a permanent difference in taxable income over time? A. Depreciation after 1986 B. Circulation costs C. Disposition of property D. All of the above 439. The taxpayer may be able to take the Retirement Savings Contribution Credit if they make eligible contributions to which of the following? A. A traditional IRA or Roth IRA. B. An employer sponsored retirement plan. 482 C. A money market savings account D. Both A and B above 440. Which of the following is not true regarding the Retirement Savings Contribution Credit? A. The credit is a percentage of the retirement contribution with highest credit for the lowest income taxpayers. B. The credit is being renamed to the Saver’s Credit C. Eligible contributions include contributions to an HSA D. The credit is claimed on Form 8880. 441. A. B. C. D. Which of the following are reported on Form 4137? Social Security and Medicare taxes on tips not reported to the employer Wages earned as a waitress Health insurance coverage paid by the employer All of the above 442. If the taxpayer pays someone to work in their home, the taxpayer may be subject to _______________. A. Household Employment Tax. B. Alternative Minimum Tax C. Self-Employment Tax D. “Kiddie” Tax 443. A. B. C. D. The maximum credit per eligible student for the American Opportunity Credit is: $2,500 $1,800 $2,000 $5,000 444. A. B. C. D. What percentage of the American Opportunity Credit may be refundable? 10% 25% 30% 40% 445. Students do not need to be pursuing a degree or other recognized education credentials in order for the taxpayer claim which credit? A. The Lifetime Learning Credit B. The Hope Credit C. The American Opportunity Credit D. None of the above 446. A. B. C. D. Which expenses are not considered to be qualified education expenses? Room and board Insurance Transportation All of the above 483 447. Complete the following sentence with the correct answer: The foreign tax credit can be _________________________. A. Carried back 1 year and carried forward for 10 years B. Carried back 3 years and carried forward for 7 years C. Carried back 10 years and carried forward for 1 years D. Carried back 5 years and carried forward for 10 years 484 Chapter 16 Questions 448. Which of the following is incorrect?. A. Estimated tax is used to pay self-employment tax B. A fund administrator usually withholds taxes on pensions C. Income from rentals is never subject to withholding D. Estimated tax is used to pay the tax on capital gains 449. Which of the following is generally an item on which the employer would withhold taxes from an employee’s pay? A. Wages B. Bonuses C. Commissions D. All of the above 450. The amount of income tax the employer withholds from regular pay depends on which of the following? A. The amount the taxpayer earns B. The information that is reported to the employer on Form W-4 C. Both A and B D. Neither A or B 451. Which of the following items are usually included when computing estimated tax vouchers? A. Alternative minimum tax B. Self-employed income. C. Income from interest and capital gains D. All of the above 452. A. B. C. D. Form W-4 includes which items the employer will need to withhold tax. Whether to withhold at the single rate or at the lower married rate. How many withholding allowances to claim Whether the taxpayer wants an additional amount withheld. All of the above 453. Which of the following is true about withholding and Form W-4? A. If the taxpayer’s income is low enough that they will not have to pay income tax they may be exempt from withholding. B. Whenever the taxpayer starts a new job or changes jobs they must fill out a new W-4 form. C. There are worksheets to help the taxpayer compute how many allowances should be claimed. D. All of the above 485 454. The following statements are true regarding withholding, except: A. Supplemental wages are identified separately the employer can withhold at a flat rate of 27%. B. Tips reported to the employer are included in income and are subject to withholding. C. The employer must withhold on the value of fringe benefits included in income for the period the benefits are paid. D. There are no penalties associated with the W-4 455. All of the following is true regarding withholding on gambling winnings, except? A. Gambling winnings of more than $5,000 from a wagers sweepstakes or lottery are reported on Form W-2G and subject to withholding. B. If the Gambling proceeds are at least 300 times the amount of the be they are subject to withholding and are reported on Form W-2G. C. The amount of winnings and the amount of withholding must be shown on Form W-2G. D. All of the above are true statements. 456. A taxpayer can choose to have voluntary withholding on Social Security benefits or unemployment benefits. Which of the following is an allowable voluntary withholding rate? A. 7% B. 10% C. 15% D. Any of the above 457. Estimated tax payments are not required if the taxpayer meets all of the following requirements, except: A. There was no tax liability for the prior year B. The taxpayer was a U.S. resident for the whole year C. If there are wages subject to withholding D. The prior year return covered a full 12 months. 458. A. B. C. D. Which of the following is an acceptable way to pay estimated tax? Credit the overpayment on the current year return to the next year. Send a payment with the payment voucher from Form 1040-ES Credit card using pay by phone system or the Internet All of the above 459. Which of the following is the correct percentage for the 2nd required CA installment payment? A. 10% B. 20% C. 30% D. 40% 486 460. Taxpayers are required to remit their payments electronically if they make an estimate or extension payment exceeding _________________ for the taxable year 2012. A. $20,000 B. $30,000 C. $80,000 D. -0461. Which of the following is correct regarding CA estimated tax payments? A. If the total tax liability shown on the original 2012 return exceeds $80,000 taxpayer’s are required to remit their payments electronically. B. Once the taxpayer meets the threshold all subsequent payments regardless of amount, tax type, or taxable year must be remitted electronically. C. Both A and B above D. Neither A and B above. 462. A. B. C. Rules everyone must follow for EIC, include the following, except: The taxpayer, spouse and qualifying child must all have valid Social Security Numbers. 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 file Form 2555 to exclude foreign income. D. The earned income credit cannot be claimed unless the taxpayer’s investment income is $5,000 or less. 463. If the taxpayer does not have a qualifying child for EIC purpose all the following rules are correct, except : A. The taxpayer must be at least 25 but under age 65 at the end of the year. If married filing a joint return, either the taxpayer or the spouse must be at least 25 but under 65 at the end of the year. It does not matter which spouse meets the age test, as long as one does. B. The taxpayer cannot be a dependent of another person, this applies to the taxpayer and the spouse if married filing joint. C. The taxpayer cannot be a qualifying child of another person D. The home of the taxpayer and spouse (if married filing joint) must have been in the United States for at least three months of the year. 464. Which of the following would not be included in earned income for the Earned income credit? A. Net profit from self-employment income B. Unemployment compensation C. Taxable scholarship D. Wages 487 465. Special penalties apply to fraudulently claiming Earned Income Credit, which of the following are true A. Taxpayers who fraudulently claim Earned Income Credit are disqualified from taking the credit for the next ten years. B. Taxpayers who improperly claim the EIC with a reckless disregard of the rules are disqualified for the next two years. C. Taxpayers must file Form 8862 to be reinstated for eligibility in the future D. All of the above 466. EITC due diligence are preparer requirements with respect to EIC, which of the following would be an example of noncompliance of due diligence A. The preparer does not inquire about documentation regarding purchase of equipment on Schedule C. B. The tax preparer does not verify the social security numbers of the taxpayer, spouse or dependents of new clients who otherwise qualify for EIC. C. The tax preparer assumes all children living with the taxpayer are qualifiers for EIC D. All of the above 467. The preparer must follow the following rules to protect themselves from the penalty. All the following are true except: A. The preparer must complete Form 8867 or the EIC eligibility checklist contained in Notice 97-65 B. The preparer must complete the EIC worksheet in Form 1040 instructions. C. The preparer must make reasonable inquiries if the information furnished to the preparer appears to be incorrect. D. The preparer must retain the above information, including a record of how and when the information was obtained and the identity of the person furnishing the information for ten years after June 30th following the date the return was presented to the taxpayer for signature. 468. Which of the following is true regarding Social Security Tax Withheld? A. The maximum amount of social security tax withheld from one employer for 2012 is $4,624. B. Excess Social Security Tax Withheld by one employer must be entered on Form 1040 for a refund. C. The taxpayer and spouse maximum social security tax is computed together. D. All of the above are true 488 Chapter 17 Questions 469. Which of the following is true regarding IRS registration of tax preparers? A. Registration renewals and user fee payments would be required every four years. B. Registration and PTIN requirements would apply to volunteer or other uncompensated preparers. C. The IRS intends to require individuals who are required to sign a federal tax return as paid return preparer to register with the IRS and pay a user fee. D. None of the above 470. Which of the following is not required to be electronically filed under the new regulations? A. Form 1040 B. Form 1041 C. Form 1040X D. Form 1040A 471. Which of the following is not true regarding the new electronic filing regulations? A. A tax preparer who files 150 returns must electronically file in 2010 and 2011 B. An explanation is required if the taxpayer refuses to electronically file. C. Form 8453 is filed with every electronically filed return. D. None of the above 472. Which of the following cannot be attached to Form 8453? A. Form 1098-C B. Form 8283 C. Form 8879 D. Form 4136 473. Which form is used to explain why a return is not being electronically filed? A. Form 1040 B. Form 8948 C. Form 8453 D. Form 8879 474. In order to be automatically enrolled in the CA e-file Program, the preparer needs to be an accepted participant in the _____________________. A. IRS e-file program B. Preparer Tax Identification Program C. IRS ERO provider program D. Enrolled agent program 489 475. Which of the following is not true regarding CA e-file program? A. CA preparers use their IRS-assigned Electronic Filing Identification Number B. California law requires individual income tax returns prepared by certain income tax preparers to be e-filed unless the individual return cannot be e-filed due to reasonable cause. C. Reasonable cause is never a taxpayer's election to opt-out (choose not to e-file). D. Comply with guidelines in FTB publications 476. E-file of individual returns is mandatory in CA for returns prepared by certain income tax preparers. CA law requires tax preparers who prepare more than 100 individual state income tax returns annually and prepare ___________________________________________. A. 50 tax returns the next year B. One or more using tax preparation software to e-file all current year individual income tax returns C. 100 tax returns the next year D. Ten or more using tax preparation software to e-file all current year individual income tax returns 477. Which form should the tax preparer retain in their office if the taxpayer chooses not to electronically file. A. FTB Form 8454 B. FTB Form 8879 C. FTB Form 8453 D. None of the above 478. Which of the following statements is true regarding the FTB mandatory e-file? A. A tax preparer who resides outside California may be required to e-file B. There is no provision in the law that allows for a preparer waiver from the FTB e-file mandate C. Prior year tax returns are not required to be e-filed D. All of the above 479. Which of the following is not true regarding Federal return assembly when the return is not electronically filed? A. Forms are attached behind Form 1040 in “Attachment Sequence Order”. B. Form W-2 is attached to the last page of the return. C. Correspondence should not be attached unless requested D. Form 1099-R should be attached to the front of the return if there is tax withholding. 480. Which of the following is not true regarding CA return assembly when the return is not electronically filed? A. Form 540A is a 2-sided form. B. Payments are stapled to the return C. If the return is a multi-state return a copy of the state return should be attached behind the Federal return. D. None of the above 490 Chapter 18 Questions 481. The amount that can be given away by a taxpayer in any one year to any number of people free from any federal gift tax consequences at all is known as which of the following? A. Annual gift tax exclusion B. Form 709 C. Lifetime gift tax exclusion D. None of the above 482. Gross estate includes the value of all property the taxpayer had an interest in at the time of death. The gross estate also includes the following: A. Life insurance proceeds payable to the estate B. The value of certain annuities payable to the estate C. The value of certain property transferred within 3 years of the decedent’s death. D. All of the above 483. A. B. C. D. The annual amount of the gift exclusion for 2012 is: $13,000 $12,000 $10,000 None of the above 484. A. B. C. D. Which of the following is true about gift and estate taxes? The gift tax return and estate tax have a different rate Gift tax is always paid yearly even if the exemption has not been met The gross estate includes all property owned by the decedent at the time of death Prior year gifts are not included in the total gift tax 485. A. B. C. D. Which of the following is not true regarding excise taxes? Excise taxes are paid when purchases are made on a specific good Excise tax is included on Form 1040. Excise taxes are often included in the price of the product Excise tax is included in the price of gasoline 486. The following statements are true about the CA State Unemployment Insurance (SUI) along with the Federal Unemployment Tax Act (FUTA), except: A. The employer must pay a percentage of the first $7,000 of wages paid to each employee in a calendar year as FUTA tax and state unemployment insurance (UI). B. The Federal Unemployment Tax Act along with states unemployment compensation provides for payments of unemployment compensation to workers who have lost their job. C. FUTA tax for 2012 is paid at 6.2% of the first $7,000. The state rate may be different. D. None of the above 491 487. Which of the following is true about Sales tax? A. Sales tax is charged on personal property sold in California and many other states B. The sales tax is collected by the retailer and paid to the state C. Use tax and sales tax rates are the same D. All of the above 488. Which of the following is a true statement? A. The State Disability Insurance (SDI) withholding rate for 2011 is 1 percent. B. The taxable wage limit is $95,585 for each employee per calendar year. C. An employee who has taxable wages of $30,000 will pay $300 in SDI D. All of the above are correct 492 Chapter 19 Questions 489. Which of the following statements are correct regarding California? A. The federal tax returns (Form 1040, 1040a or 1040EZ) must be complete before beginning the California return. B. Schedule CA is used to make adjustments where the California law does not conform C. California tax returns start with federal adjusted gross income D. All of the above 490. California is known as a federal ____________ state. A. AGI B. Taxable Income C. Interest D. Dividends 491. There are three factors that determine whether a taxpayer must file a return. Which of the following is not one of the three? A. Filing Status B. Age C. Investment Income D. Number of dependents. 492. In which of the following circumstances must a California return be filed? A. The California gross income or the California AGI is more than the amount shown for the taxpayers filing status, age and number of dependents. B. The taxpayer is considered a resident of CA but is unemployed C. The taxpayer spends seven months in CA going to college. D. None of the above 493. Which if the following is true regarding California Exemptions? A. California exemptions are the same for personal exemptions and dependent exemptions. B. California allows an extra exemption if the taxpayer or spouse is blind C. When applying the phaseout amount, apply the $6/$12 amount to each exemption credit, but do not reduce the credit below zero. D. All of the above 494. Which if the following is correct? A. The dependency exemption on Federal return is the same as the dependent exemption on CA. B. If a parent who provides over half the support for their child does not take an exemption on the Federal return they may not take a dependent exemption on CA C. If a personal exemption credit is less than the phaseout amount, do not apply the excess against a dependent exemption credit. D. All of the above 493 495. If the taxpayer is single and has earned income of $8,000 in 2012, the standard deduction for CA will be which of the following? A. $ 800 B. $3,841 C. $3,516 D. $6,140 496. All of the following are correct regarding the CA standard deduction and itemized deductions, except A. A taxpayer cannot itemize on the Federal or CA return and take the standard deduction on the other. B. Itemized deductions must be reduced by the lesser of 6% of the excess of the taxpayer's federal AGI over the threshold amount or 80% of the amount of itemized deductions otherwise allowed for the taxable year. C. CA does not conform to the Federal deduction of state, local or foreign tax or any of their political subdivisions such city or county taxes. D. CA does not tax the state lottery and as such does not allow a deduction on Schedule A. 497. Which of the following is not true regarding CA forms? A. File Form 540, 540A or 5402EZ to report income as a resident. B. The resident return deals with conformity issues by using Schedule CA. C. File Form 540NR if the taxpayer is a nonresident or a part-year resident and use Schedule CA (540NR). D. All of the above are true. 498. All the following statements are true, except? A. California does not recognize common law marriage. B. A common law marriage is not the same as a registered domestic partnership C. Common law marriage is not recognized in any state in the United States.. D. All of the above 499. Which of the following is a requirement for head of household filing status: A. The taxpayer was unmarried or considered unmarried on the last day of the taxable year. B. The taxpayer paid more than one-half the cost of keeping up the home C. For three months of the year the home was the main home for the taxpayer and another person who lived with the taxpayer. D. The other person was a qualifying relative 500. Which of the following is true about a community property state? A. Community property is all property that is acquired by the taxpayer and spouse while domiciled in a community property state B. Each spouse owns one-half of all community property C. When separate returns are filed the taxpayer and spouse must each report half of the 494 community income plus all the separate income earned by that spouse. D. All of the above 501. If one spouse lives in a state that is not a community property state and the other spouse lives in California which is a community property state; and, separate returns are filed ____________________________. A. The taxpayer and spouse must each report half of the community income plus all the separate income earned by that spouse B. The taxpayer reports only the income he or she earned. C. The spouse reports only the income he or she earned D. They both report only the community property income 502. Which of the following is considered separate property when filing married filing separate? A. Property that the taxpayer or spouse (or RDP/California or Washington same-sex spouse) owned separately before the marriage (or registered domestic partnership/same-sex marriage in California or Washington). B. Money earned while domiciled in a noncommunity property state. C. Property listed in a prenuptial agreement in which both spouses specifically agree that assets that otherwise would be considered community property are separately owned by one or the other. D. All of the above 503. A __________ is a legal or personal relationship between two individuals who live together and share a common domestic life but are neither joined by marriage nor a civil union. A. Domestic partnership B. Common Law Marriage C. Fiduciary D. Divorce 504. Which if the following is not true regarding registered domestic partners? A. Before 2002 a domestic partner is required to use the same filing status for state income tax purposes that was used or would have been used for federal income tax purposes. B. For taxable years beginning on or after January 1, 2007, domestic partners are required to use the same filing status available to married persons. C. Earned income is not treated as community property for state income tax purposes for tax years prior to 2007. D. No adjustments are ever required between Federal and CA for domestic partner’s. 495 505. Which of the following is true regarding the Community Property laws? A. Community property laws affect how the taxpayer figures income on their federal income tax return if they are married, live in a community property state or country, and file separate returns. B. For federal tax purposes, a marriage means only a legal union between a man and a woman as husband and wife and the word “spouse” refers only to a person of the opposite sex who is a husband or a wife. C. Form 8958 is used on the Federal return for RDPs who are domiciled in Nevada, Washington, or California and for individuals in California who, for state law purposes, are married to an individual of the same sex. D. All of the above are true 506. Community property used to assist in the purchase of a separate property asset, or if community property substantially benefits or improves separate property, is which of the following? A. Commingled Property B. Community Property C. Separate Property D. None of the above 507. Which of the following is true regarding CA adjusted gross income? A. California conforms to IRC §61. B. All items of income included for Federal purposes are included for California purposes, unless a specific exception is stated in CA statute. C. Unemployment compensation is included in CA adjusted gross income. D. All of the above 508. All of the following is true regarding CA source income, except? A. California taxes residents of California on their entire taxable income. B. California provides that gross income of nonresidents includes only income from California sources. C. Nonresidents are taxed only on taxable income derived from sources within California. D. All of the above. 496 Chapter 20 Questions 509. Every individual who spends in the aggregate more than nine months of the taxable year within this state shall be presumed to be a resident. The presumption may be overcome by satisfactory evidence that the individual is in the state for a temporary or transitory purpose. Which of the following is true? A. The above statement is known as the presumption of residence. B. A person who in CA less than nine months is assumed to be a nonresident. C. The taxpayer cannot be considered a resident if they are out of CA for the full year. D. All of the above 510. Which of the following is a factor in determining residency in CA? A. Where the driver’s license was issued; B. Where the vehicles are registered; C. Where the taxpayer maintains professional licenses D. All of the above 511. Which of the following is correct if taxpayer moves out of CA on September 11 of the tax year and establishes residency in Arizona? A. The taxpayer is considered a part-year resident and computes income and deductions using nonresident rules for the period of time they are a nonresident and resident rules for the period of time they are a resident. B. The taxpayer files Form 540NR. C. Items such as income from a K-1 which has source and nonsource income must be computed according to the number of days as a resident and nonresident. D. All of the above 512. The safe harbor provision states that an individual domiciled in California who is outside of California for at least ______consecutive days will be considered a nonresident. A. 546 B. 60 C. 90 D. 100 513. Jane Smith worked in an office in Los Angeles until May 1, 2012 when she moves to Texas. Her last paycheck is mailed to her in Texas on May 10. Jane now works in Texas. Which of the following is correct? A. Jane can file a resident return Form 540 for 2012 reporting only her CA income. B. Jane is a part-year resident of CA and files Form 540 including all income from CA and Texas. C. Jane is a part-year resident of CA and files Form 540NR and all of her wages are taxable to CA including the check she received from May 10. D. Jane does not have to file in CA since she moved out of state in the last half of the year. 497 514. Which of the following is a correct statement regarding the presumption of nonresidence? A. An individual whose presence in CA does not exceed a total of six months within the taxable year; and who maintains a permanent home outside of the state; may be considered as being in California for temporary and transitory purposes. B. Voluntary or physical presence in California is a factor of greater significance than the mental intent or outward ties to another state C. The taxpayer may only be a seasonal visitor, tourist or guest and may not conduct business in the state D. All of the above 515. Which of the following is true about an individual domiciled in California when entering the military? A. Resident while stationed in California B. Resident while stationed in California on Permanent Change of Station (PCS) orders and Temporary Duty (TDY) assignments outside California, regardless of duration. C. Nonresident while stationed outside California on PCS orders. Military members domiciled outside California are considered nonresidents for tax purpose even when stationed in California on PCS orders. D. All of the above. 516. Which of the following is correct regarding a taxpayer who comes to CA under an employment related contract? A. Working in CA automatically makes the taxpayer a resident. B. Return visits to California that do not exceed a total of 45 days during any taxable year covered by the employment contract are considered temporary. C. The determination of residency status is solely based on an individual’s occupation, business, or vocation. D. None of the above. 517. Which of the following is not a true statement? A. CA Residents are taxed on all income from all sources. B. Nonresidents of California are taxed only on income from non-California sources. C. Nonresident of California are not taxed on pensions received after December 31, 1995. D. Part-year residents are taxed on all income received while a resident and only on income from California sources while a nonresident. 518. Under which of the following circumstances would the taxpayer be considered a nonresident? A. A business executive who resides in Oklahoma with his family, several times each year he travels to California for business purposes. B. In December 2011, a taxpayer moved to California on an indefinite job assignment. He rented an apartment in California and continued to live and work in CA throughout 2012. C. Both A and B are nonresidents of California. D. Both A and B are residents of CA 498 519. Which of the following is not true regarding CA e-file program? A. CA preparers use their IRS-assigned Electronic Filing Identification Number B. California law requires individual income tax returns prepared by certain income tax preparers to be e-filed unless the individual return cannot be e-filed due to reasonable cause. C. Reasonable cause is never a taxpayer's election to opt-out (choose not to e-file). D. Comply with guidelines in FTB publications 520. E-file of individual returns is mandatory in CA for returns prepared by certain income tax preparers. CA law requires tax preparers who prepare more than 100 individual state income tax returns annually and prepare ___________________________________________. A. 50 tax returns the next year B. One or more using tax preparation software to e-file all current year individual income tax returns C. 100 tax returns the next year D. Ten or more using tax preparation software to e-file all current year individual income tax returns 499 Chapter 21 Questions 521. In general, California law conforms to the Internal Revenue Code (IRC) as of : A. December 31, 2004 B. January 2, 2005 C. January 1, 2008 D. January 1, 2005 522. For tax purposes, California is commonly known as A. The sunshine state B. An AGI state C. The golden state D. A conformity state 523. The partial COD conformity outlined in SB 401 is retroactive to taxable years beginning on or after _____________. A. January 1, 2008 and before January 12, 2014 B. January 1 2006 and before January 1, 2013 C. January 1 2009 and before January 1, 2013 D. None of the above 524. Qualified principal residence indebtedness may be limited to ________________ instead of the federal $2 million ($1 million for married filing a separate return). A. $2 million ($1 million for married filing separately) B. $500,000 ($250,000 for married filing separately) C. $800,000 ($400,000 for married filing separately) D. $100,000 ($50,000 for married filing separately) 525. Which statement is true regarding other significant conformity provisions included in SB 401? A. Surviving spouse may exclude up to $500,000 if sale of principal residence occurs within two years of death of the spouse B. Decreased maximum penalty for failure to file individual returns C. Gain from sale of principal residence attributable to nonqualified use can be excluded D. None of the above 526. Which of the following is not true regarding the Child and Dependent Care Expenses Credit for CA? A. For 3506 is used for the Child and Dependent Care Expenses Credit B. The Child and Dependent Care Expenses Credit is no longer a refundable credit. C. If the taxpayer’s AGI is less than $40,000 the Credit is not allowed D. None of the above 500 527. Which of the following is true regarding Assembly Bill (AB) 36? A. AB 36 conforms CA to Federal rules regarding self-employed health insurance and medical insurance on Schedule A for nondependent and dependent health insurance deductions. B. There is no longer a wage difference for employees whose employers provide health insurance for their nondependent adult children. C. AB 36 applies to the same periods as federal law. D. All of the above. 528. Which of the following are an addition (taxable) to CA and not taxable or a deduction to the Federal? A. Foreign Earned Income exclusion B. US Savings Bonds Interest C. Both A and B D. Neither A nor B 529. What is the maximum amount allowed for a Section 179 expense deduction under CA law? A. $35,000 B. $100,000 C. $25,000 D. $10,000 530. Which of the following is not a correct statement? A. California qualified stock option is not taxable if the earned income from the corporation is $40,000 or less B. California qualified stock option is not taxable if the market value of the options is $100,000 or less C. California qualified stock option is not taxable if the total number of shares is less than 900 D. California qualified stock option is not taxable if the corporation issuing the stock designates the stock as California Qualified Stock 531. Which of the following interest items are not taxable to CA? A. CA state bonds B. US Savings Bonds C. Treasury Bills D. All of the above 532. Dividends from HSA's invested in stocks or mutual funds are: A. Taxed by California B. Added back to California income C. Non-taxable by California D. Both answers A and B are correct 501 533. Which of the following items are not taxable to California? A. State Tax Refund B. Unemployment Compensation C. Social Security Benefits D. All of the above 534. Which of the following adjustments are allowed on a CA return?. A. Educator expense B. Tuition and fees deduction C. 50% of Self-employed health insurance paid. D. Student loan interest deduction for a spouse/RDP of a non-California domiciled military taxpayer residing in a community property state 535. Which of the following is a deduction to CA A. CA lottery losses B. Federal standard deduction C. Both A and B D. Neither A nor B 536. Which of the following is a true statement regarding wages in California? A. Wages have a source where the services are performed B. The location of the employer determines the source of the wages C. The location of the taxpayer at the time the wages are received determines the source of the wage. D. None of the above 537. Which of the following is incorrect regarding IRAs and pension distributions in CA? A. The taxable amount may be less on CA due to basis differences pre 1987 law differences and AGI differences B. CA amount of IRA deduction was different from the Federal amount in 1982 through 1986 C. CA law regarding IRA deductions was the same as Federal in 1975 D. Between 1976 and 1981 the IRA deduction in CA for an individual was the lesser of $1,500 or 15%. 538. Which of the following is a true statement? A. A CA part-year resident who sells stock while residing in CA is taxed on that stock. B. A CA resident is not taxed on stocks sold out of CA C. A CA resident is not taxed on stocks sold by a company located out of CA. D. All of the above 502 539. Which of the follow retirement income would not be taxed by CA if the taxpayer was nonresident of CA living in another State? A. A tax-sheltered annuity described in IRC Section 403(b). B. A deferred compensation plan maintained by a state or local government or an exempt organization described in IRC Section 457. C. An IRA described in IRC Section 7701(a) (37), including Roth IRA and SIMPLE. D. All of the above 540. Real estate, which is California _______________ may be subject to real estate withholding. A. Depreciable B. Land only C. Source Income D. None of the above 541. Which of the following is true about a real estate sale in California? A. The gain or loss from the sale of real estate has a source where the property is located. B. If the taxpayer sells the property in California, whether or not a resident the sale is taxable to CA. C. The basis of the property must be reduced by the amount of depreciation that would have been allowed had the taxpayer filed a California return. D. All of the above 542. Which of the following is not true? A. Sale of stock or bonds depends on the source at the time of distribution. B. If the taxpayer is a resident stocks are taxable regardless of source, if the taxpayer is a nonresident at the time of sale it is not taxable. C. Installment sales received by a nonresident on the sale of California property are taxable by California. D. Interest earned on the installment note is taxable to the non-resident. 503 Chapter 22 Questions 543. Which of the following is true regarding use tax? A. The extension of time to file that applies to Personal Income Tax and Use tax. B. The BOE may grant a one-month extension whether or not the completed Use Tax return is filed. C. An extension is only granted after the taxpayers individual CA income tax form is filed D. None of the above. 544. Which of the following is a component of alternative minimum tax? A. Deductions B. Exclusion C. Credits D. All of the above 545. Alternative Minimum Tax is computed on which of the following form for CA? A. Schedule P B. FTB 3885A C. FTB 3506 D. Form 540 546. Form 3800 and 3803 income for children with investments are the California counterpart to which Federal forms? A. Forms 8814 and 8615 B. 6178 and 6251 C. Schedule F and 4797 D. 8582 and 8582CR 547. In 2012, excess California State Disability Insurance (SDI) or Voluntary Plan Disability Insurance (VPDI) withheld from wages by a single employer, at more than 1% of the gross wages is recovered in which of the following manners? A. Contact the employer for a refund. B. Enter the excess amount on Form 540 C. Apply to the FTB for a refund by writing a letter D. None of the above 548. California withholding is not reported on which of the following forms? A. W-2G B. 1099 MISC C. FTB Form 3801 D. W-2 504 549. All of the following is correct regarding California estimated tax, except: A. California estimated tax is the tax the taxpayer expects to owe in the following tax year, subtracting the tax the taxpayer expects to have withheld and any credits the taxpayer plans to take. B. If the taxpayer and spouse/RDP paid joint estimated tax payments, but are now filing separate income tax returns, either of the taxpayer or spouse/RDP may claim the entire amount paid, or they may each claim part of the joint estimated payments is the tax the taxpayer expects to owe in the following tax year, subtracting the tax the taxpayer expects to have withheld and any credits the taxpayer plans to take. C. The taxpayer is required to remit all their payments electronically once they make an estimate or extension payment exceeding $20,000 D. The taxpayer must pay estimated tax in equal amounts each quarter 550. FTB Form 3520, Power of Attorney grants which of the following? A. Receive and inspect confidential tax information B. Execute settlement agreements C. Execute closing agreements D. All of the above 551. Which of the following items are not true about the CA Child and Dependent Care Expense Credit? A. California AGI must $100,000 or less B. The CA credit is a percentage of the Federal as modified by CA law C. The primary home must be in CA D. The CA credit is refundable 552. If, under a joint custody arrangement, a child lives with the custodial parent for more than half the year, the noncustodial parent may be entitled to claim the Joint Custody Head of Household Credit, under which of the following circumstances? A. The noncustodial parent maintains his or her home as the main home for a birth child, stepchild, adopted child, or grandchild. B. The noncustodial parent lives with the child for at least 146 days, but not more than 219 days of the tax year. C. The noncustodial parent possesses a decree of dissolution of marriage or registered domestic partnership that indicates the taxpayer's home was the child's main home for the above period D. All of the above 505 553. Which of the following is an incorrect statement regarding taxes paid to another state? A. Schedule S allows a credit for the tax paid to another state if the tax was on double taxed CA income. B. The other state’s taxes must have been imposed on income derived from sources within CA C. When a joint return is filed in California, the entire amount of tax paid to the other state may be used in figuring the credit, regardless of which spouse/RDP paid the other state tax or whether a joint or separate return is filed in the other state D. The taxpayer cannot take the credit if the other state taxes the nonresident on the income, but California would not tax a nonresident on the same income. 554. Which of the following is not a Voluntary Contribution Fund? A. California Seniors Special Fund B. Alzheimer Disease/Related Disorders Fund C. California Fund for Senior Citizens D. Mental Health Services Tax 555. The Mental Health Services Tax is computed on which of the following? A. Taxable income over $1,000,000 B. Taxable income over $250,000 C. AGI over $1,000,000 D. AGI over $250,000 556. Which of the following is not true about Voluntary Contributions to various funds on the CA return? A. Voluntary contributions can be made in the amount of $1 or any whole dollar amount. B. The contribution will either reduce the amount of refund or increase the amount due. C. Voluntary contributions can be change once the return is filed. D. CA Cancer Fund is one of many funds a taxpayer can contribute to. 557. Which of the following is incorrect regarding “Use Tax”? A. When an out-of-state or online retailer does not collect the tax for an item delivered to California, the purchaser may owe "use tax," which is simply a tax on the use, storage, or consumption of personal property in California. B. Use tax is administered by the “Board of Equalization” C. Registration into the Board of Equalization and the filing of Use Tax is voluntary D. Corporations must file Use Tax. 506 Chapter 22 Questions 558. The IRS clarified §10.3 (f)(3) as the following: The IRS interprets this provision to permit registered tax return preparers to provide advice to a client that is __________________ to prepare a tax return, claim for refund, or other document intended to be submitted to the Internal Revenue Service for a current or future tax period, regardless of whether the client has engaged the registered tax return preparer to prepare the tax return, claim for refund or other document for the tax period A. Reasonably necessary B. Exact and precise C. Ordinary and reasonable D. All of the above 559. The IRS recommends making all signing and non-signing tax return preparers subject to the provisions of ___________________, which will make them subject to discipline for unethical and unprofessional conduct. A. Treasury Department Circular 230 B. Publication 4832 C. Form 8453 D. Form 1040 560. Which of the following will be subject to the provisions of Circular 230 if they practice before the IRS? A. Registered Tax Preparers B. Enrolled Agents C. CPA’s D. All of the above 561. Which code section applies to a penalty if a tax preparer willfully understates a tax liability? A. Code § 6694(a) B. Code § 7206 C. Code § 6694(b) D. Code § 6695 562. The IRS will require all individuals who are required to sign a federal tax return as a paid tax return preparer to: A. Obtain a Preparer Tax Identification Number B. Obtain a Employers Federal Identification Number C. Obtain an Electronic Filing Identification Number D. None of the above 507 563. Which of the following would not be sustained position under IRC §6694(a)? A. There was not substantial authority for the position and the position was not disclosed. B. The position was disclosed but there was not reasonable basis for the position. C. The position is with respect to a tax shelter D. All of the above 564. Which of the following is a true statement regarding the IRC §6694(b) penalty? A. IRC §6694(b) penalty involves willfulness B. There is a strict statutory period for assessment of this penalty. C. The IRC 6694(b) penalty is the greater of $1,000 or 50% of the income derived (or to be derived) by the tax return preparer with respect to returns affected. D. None of the above 565. Which of the following tax return preparers are defined by IRC §7216 and must comply with the disclosure rules? A. Casual preparers who are compensated for their services B. People who advertise themselves as a tax preparer C. Electronic return originators and electronic return transmitters D. All of the above 566. Tax return information includes which of the following? A. Computations B. Worksheets C. Correspondence from IRS during the preparation D. All of the above 567. A tax preparer can disclose tax return information without the consent of the taxpayer to: A. An IRS auditor B. A relative of the taxpayer C. The taxpayers bank D. None of the above 568. Which of the following people is the tax preparer permitted to disclose information provided the first taxpayer's tax interest in the information is not adverse to the second taxpayer's tax interest in the information and the first taxpayer has not expressly prohibited the disclosure or use. A. Husband and wife, B. Grandchild and grandparent, partner and partnership, C. Trust or estate and beneficiary members of a controlled group of corporations as defined in §1563 D. All of the above 508 569. Which of the following is “Regulations Governing Practice before the Internal Revenue Service”? A. Publication 17 B. Circular 200 C. Circular 230 D. None of the above 570. The term “Matter before the Internal Revenue Service” includes all of the following, except? A. Tax planning and advice, B. A taxpayer keeping a mileage log for business purposes. C. Preparing or filing or assisting in preparing or filing returns or claims for refund or corresponding and communicating with the Internal Revenue Service, D. The filing of documents with the IRS 571. Which of the following is not true regarding written consents to represent clients to waive conflict of interest? A. Copies of the written consents must be retained by the practitioner for at least 24 months from the date of the conclusion of the representation of the affected clients B. Written consents must be provided to any officer or employee of the Internal Revenue Service on request. C. Each affected client must sign consent to waive conflict of interest. D. The confirmation of the consent must be made within a reasonable amount time after the informed consent, but in no event later than 30 days. 572. A practitioner may publish the availability of a written schedule of fees and disseminate which of the following information? A. Hourly rates B. Range of fees for particular services C. Fee for initial consultation D. All of the above 573. Which of the following is an acceptable description for a tax preparer for advertising purposes? A. Certified as a registered tax preparer by the IRS B. Designated as a registered tax preparer by the IRS C. Both a and b are correct D. None of the above is acceptable 509 574. The modified mandatory language required in consent forms clarifies that a taxpayer does not need to complete a consent form to engage a tax return preparer to perform only tax return preparation services. A. Release information to assist a client in getting a mortgage B. To engage a tax return preparer to perform only tax return preparation services. C. To discuss a tax return with the taxpayer’s financial advisor. D. All of the above 575. Which of the following is not correct? A. The “Dirty Dozen” is a group of tax scams B. Taxpayers who unwittingly get involved with tax scams must repay all taxes due plus interest and penalties C. Taxpayers who unwittingly get involved with tax scams must repay all taxes due but not the interest and penalties D. Illegal scams can lead to possible criminal prosecution 576. Which of the following is a common type of disclosure of tax information that requires taxpayer consent? A. Payment for tax preparation services B. Retention of records C. Disclosure to taxpayer’s fiduciary D. None of the above 577. Which of the following are consequences of preparing inaccurate returns which can be severe and can extend to both the preparer and the client? A. If the taxpayer’s returns are examined and found to be incorrect, the taxpayer may be subject to accuracy-related or fraud penalties plus accrued interest on any underpayment. B. Return preparers who prepare a client return for which any part of an understatement of tax liability is due to an unreasonable position taken on the return based on the preparer’s advice, can be assessed a minimum penalty of $1,000 (IRC section 6694(a)). C. Return preparers who prepare a clients return for which any part of an understatement of tax liability is due to the return preparer’s willful, reckless or intentional disregard of rules or regulations by the tax preparer, can be assessed a minimum penalty of $5,000 (IRC section 6694(b)). D. All of the above 510 578. All disclosure of tax return information from the tax preparer that is not specifically authorized, require: A. A verbal consent from the taxpayer B. That the taxpayer must sign and date a consent form which must contain certain language and warnings C. A signed post-it -note from the taxpayer D. IRS authorization of the disclosure 579. The following are true regarding deductions for a trade or business expenses paid or incurred during the course of a taxable year, except A. Rules regarding deduction have largely come from case law. B. Internal Revenue Code § 162 allows the deductions C. A business expense must be ordinary and necessary D. All of the above. 580. If no period is specified on the consent for the tax preparer to use tax return information, the consent will be effective for a period of ___________________ from the date the taxpayer signed the consent. A. 6 months B. 3 years C. 1 year D. 5 years 581. Which of the following is not a correct practice when a practitioner is exercising due diligence? A. Advising a client of the requirements of adequate disclosure B. Reliance on information furnished by others C. Making reasonable inquiries if information regarding the tax return appears incorrect D. Endorsing of tax refunds. 582. Which of the following is true according to Circular 230A §10.28 regarding the existence of a dispute over fees? A. Applicable state law allows or permits the retention of a client’s records by a practitioner B. A fee dispute does not relieve the preparer of the responsibility to return all records to a client at their request. C. A tax organizer prepared by the preparer and completed by the client is not material prepared by the client and should be retained by the preparer D. All of the above. 511 583. A practitioner may not sign a tax return as a preparer if the practitioner determines that the tax return contains a position that does not have a _____________________ of being sustained on its merits A. Assurance from the taxpayer B. Assurance from a colleague C. Realistic possibility D. None of the above 584. A practitioner advising a client to take a position on a tax return, or preparing or signing a tax return as a preparer, reasonably __________________________likely to apply to the client with respect to the position advised A. Must inform the client of the penalties B. Must consult with a colleague C. Both of the above D. Neither of the above 585. Which of the following is not correct regarding a practitioner advising a client to take a position on a tax return? A. The preparer, generally may rely in good faith without verification upon information furnished by the client. B. The practitioner may not, ignore the implications of information furnished to, or actually known by, the practitioner. C. The practitioner must make reasonable inquiries if the information as furnished appears to be incorrect, inconsistent with an important fact or another factual assumption, or incomplete. D. The practitioner may delay or impede the proceeding with the IRS to protect the taxpayer 586. Which of the following is not an exception to the requirement of registering annually with the California Tax Education Council? A. Persons who are registered with the State Board of Accountancy B. Persons who are active members of the State Bar of California C. Practitioners who have been registered previously with CTEC D. A financial institution that is regulated by the state or Federal government. 587. How many total hours of continuing education must be completed annually to renew your registration with CTEC? A. 20 hours B. 30 hours C. 60 hours D. 15 hours 512 588. The California Business and Professions Code Section 22250 requires that a bond be acquired through a surety company admitted to do business in California and shall be maintained for each individual preparing returns for another person. Which of the following is the required amount of the bond? A. $1,000 B. $5,000 C. $10,000 D. $12,000 589. Which of the following meet the CTEC exemption for registration? A. Persons licensed with the State Board of Accountancy and their employees B. Employees of certain Trust Companies. C. Persons enrolled to practice before the Internal Revenue Service and their employees. D. None of the above 590. A California tax preparer must maintain a copy of any tax return he/she prepared for a customer for at least _________________. A. 5 years B. 7 years C. 4 years D. 10 years 591. Which of the following is a true statement? A. A California tax preparer must furnish and retain a copy of the tax return he/she prepares B. A California tax preparer must electronically file the return if it meets the qualifications C. A California tax preparer must sign the return he/she prepares D. All of the above 592. Which of the following is a requirement of a registered CTEC preparer? A. Must identify the surety company all preparers employed or associated with the tax preparer securing the bond B. Must not conduct business without having a current surety bond in effect C. Must not make fraudulent, untrue or misleading statements or representations which are intended to induce a person to use their tax preparation services D. All of the above 593. A. B. C. D. Which of the following is not an item that a preparer can be assessed a penalty? Failure to furnish a copy of the return to the taxpayer. Failure to furnish preparer’s identification number. Failure to give the taxpayer an estimate of the tax during the interview. Understatement of taxpayer’s liability due to unrealistic position. 594. Which of the following best describes the California 20 hours of continuing education required annually? 513 A. 12 hours federal, 4 hours California, 2 hours either Federal or California, plus 2 hours ethics B. 16 hours federal and 4 hours California C. 20 hours federal D. None of the above 595. The late fee for not renewing a preparer’s CTEC registration after Nov 1, 2012 is which of the following? A. $15 B. $25 C. $55 D. $100 596. CRTP’s who do not renew their registration by January 15, 2013 and each year thereafter must: A. Re-take the 60 hour qualifying course and pass the competency test from an approved provider. B. Pay $500 to reinstate their registration C. Complete 40 hours of continuing education D. Will be barred from ever signing a tax return 597. The amount of the penalty under the subdivision for the first failure to register is which of the following amounts? A. $2,500 B. $5,000 C. $3,000 D. There is no monetary penalty. 598. The new grace period for CRTP to complete their continuing educations is which of the following? A. 10 weeks B. 10 months C. 12 months D. None of the above 599. A. B. C. D. Which of the following is correct? CTEC now requires on-line registration CTEC requires 15 hours of Federal education and no CA education. Both A and B Neither A or B 600. How many hours of Ethics does CTEC require each year for continuing education? A. 2 B. 4 C. 6 D. 8 514 Question 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 TaxEase, LLC Answer Sheet for 2013 – 60 Hour Qualifying Education Name: ______________________ Instructions in on the last answer sheet page Date: _______________________ A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D Question 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D Question 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 515 A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D Question 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D Name: ______________________ TaxEase, LLC Answer Sheet for 2013 – 60 Hour Qualifying Education Date: _______________________ Question 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198 199 200 A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D Question 201 202 203 204 205 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220 221 222 223 224 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D Question 241 242 243 244 245 246 247 248 249 250 251 252 253 254 255 256 257 258 259 260 261 262 263 264 265 266 267 268 269 270 271 272 273 274 275 276 277 278 279 280 516 A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D Question 281 282 283 284 285 286 287 288 289 290 291 292 293 294 295 296 297 298 299 300 301 302 303 304 305 306 307 308 309 310 311 312 313 314 315 316 317 318 319 320 A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D TaxEase, LLC Answer Sheet for 2013 – 60 Hour Qualifying Education Name: ______________________ Date: _______________________ Question 321 322 323 324 325 326 327 328 329 330 331 332 333 334 335 336 337 338 339 340 341 342 343 344 345 346 347 348 349 350 351 352 353 354 355 356 357 358 359 360 A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D Question 361 362 363 364 365 366 367 368 369 370 371 372 373 374 375 376 377 378 379 380 381 382 383 384 385 386 387 388 389 390 391 392 393 394 395 396 397 398 399 400 A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D Question 401 402 403 404 405 406 407 408 409 410 411 412 413 414 415 416 417 418 419 420 421 422 423 424 425 426 427 428 429 430 431 432 433 434 435 436 437 438 439 440 517 A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D Question 441 442 443 444 445 446 447 448 449 450 451 452 453 454 455 456 457 458 459 460 461 462 463 464 465 466 467 468 469 470 471 472 473 474 475 476 477 478 479 480 A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D Name: ______________________ TaxEase, LLC Answer Sheet for 2013 – 60 Hour Qualifying Education Date: _______________________ Question 481 482 483 484 485 486 487 488 489 490 491 492 493 494 495 496 497 498 499 500 501 502 503 504 505 506 507 508 509 510 511 512 513 514 515 516 517 518 519 520 A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D Question 521 522 523 524 525 526 527 528 529 530 531 532 533 534 535 536 537 538 539 540 541 542 543 544 545 546 547 548 549 550 551 552 553 554 555 556 557 558 559 560 A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D Question 561 562 563 564 565 566 567 568 569 570 571 572 573 574 575 576 577 578 579 580 581 582 583 584 585 586 587 588 589 590 591 592 593 594 595 596 597 598 599 600 518 A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B B C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C C D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D Answer Sheet Instructions Using ink mark an X in the column which reflects the correct answer. Example: Question 1 – How many inches are in a foot? A. 6 B. 3 C. 9 D. 12 Question 1 2 3 A A A A B B B B C C C C D X D D PERSONAL INFORMATION FORM This form must be completed and returned to TaxEase with your Answer Sheets in order for us to complete our grading process. Enter the last four digits. Example: Yhst-69000034383144-XXXX. Locate this number on your Confirmation Email from TaxEase. If you do not have your Confirmation Email, TaxEase will enter the order number upon submission. ORDER NUMBER: NAME (AS IT SHOULD APPEAR ON THE CERTIFICATE): PLEASE PRINT CLEARLY EMAIL ADDRESS (ALL CERTIFICATES ARE EMAILED): PLEASE PRINT CLEARLY DAYTIME PHONE NUMBER: LAST 6 DIGITS OF YOUR SOCIAL SECURITY NUMBER: TAXEASE REPORTS EDUCATION TO CTEC. IT IS THE STUDENT’S RESPONSIBILITY TO COMPLETE THEIR NEW PREPARER REGISTRATION WITH CTEC. HOW DID YOU HEAR ABOUT TAXEASE? USED PREVOUSLY INTERNET IRS WEBSITE CTEC WEBSITE OTHER PLEASE COMPLETE THE SECTION BELOW IF YOU WISH TO PURCHASE A PAPER CERTIFICATE FOR $8.00: CREDIT CARD NUMBER: CARD EXPIRATION DATE: NAME ON CARD: SIGNATURE OF THE CARD HOLDER: MAILING ADDRESS FOR THE CERTIFICATE: SUBMISSION INSTRUCTIONS: Be sure that your name and the date of submission are on the answer sheet. Complete the Personal Information Form above and the Evaluation Form EMAIL or FAX or MAIL the Answer Sheet, Personal Information Form, and Evaluation Form to: Email – support@taxeaseed.com Fax – (510) 779-5251 Mail: TAXEASE, LLC c/o POSTAL ANNEX 39270 PASEO PADRE PKWY., #624 FREMONT, CA 94538 519 TaxEase, LLC 2013 - 60 Hour “Become A Tax Preparer” Evaluation Please take a moment to let us know how we did… 1. Was the material effective in helping you learn the basic facts regarding tax return preparation? __________________________________________________________________________________________ __________________________________________ 2. Are the tax facts useful for the future? __________________________________________________________________________________________ __________________________________________ 3. Was the content relevant to you? __________________________________________________________________________________________ __________________________________________ 4. Was the material presented in an effective way? __________________________________________________________________________________________ __________________________________________ 5. Did the format aid in your studies? __________________________________________________________________________________________ __________________________________________ 520
