TaxSpot

A QUESTION & ANSWER BLOG

Amounts last updated for tax year 2021. Please Note: TaxSpot blog helps start tax conversations. It does not constitute tax advice or legal advice.

Q: How does a tax preparer figure out how much I owe? What determines my refund amount?

A: To determine the proper tax liability, you must claim the appropriate filing status, elect the available deductions or credits, and comply with the necessary filing requirements. 

Prior to filing your return, the preparer must collect documents and ask you questions to gather information. 

For example, the preparer should obtain a copy of your prior year return, which will help prevent significant math errors and identify major changes. 

The accuracy of the prior year’s return affects the accuracy of the current year’s return in areas in which the prior year is relied upon, such as state taxes. It also increases the efficiency of completing the current year return. 

Certain items from the prior year return such as a state income tax refund, the AMT, or loss carryover may be needed to complete the current year return. Your previous correspondence with the IRS should also be reviewed. 

Your personal information, such as date of birth, age, marital status and dependents is used to verify your identity and the identities of your related dependents. 

Your age determines whether you qualify for items such as additional deductions, retirement distributions, and dependency status. 

Regarding filing status, you may be eligible to choose between more than one. It is important that you select the status the most favorable status for your financial circumstances. For example, married filing jointly status often increases beneficial dollar limits to deductions and credits. 

Your immigration status of citizenship is another important factor. Aliens, that is persons who are not US citizens, are considered nonresident aliens unless they meet either the green card test or substantial presence test for that calendar year. 

If you don’t meet either of those tests, you may be able to be treated as a US resident for part of the year, that is as a dual-status alien. 

This usually occurs in the year that you arrive in and depart from the US. If you are a non-US citizen if you are typically denied a social security number. 

Q: Can I file a tax return without a social security number?

A: If you are required to have a US taxpayer identification number, but you don’t have or you aren't eligible to obtain a social security number, an Individual Taxpayer Identification Number (ITIN) by the IRS. 

Q: What is an ITIN?

A: The ITIN is used to comply with tax laws and to process and account for tax returns and payments. ITINs are issued regardless of immigration status. Your return preparer will determine if you as a taxpayer  are considered an individual or business entity. 

Q: What expenses are not usually deductible?

A: Personal, living and family expenses are not deductible unless the code specifically provides otherwise. Nondeductible expenses include rent and insurance premiums paid for your own dwelling, insurance premiums paid by the insured, upkeep of a personal automobile, personal interests, and payments for food, clothing, or domestic help. 

Q: Can a preparer make sure prior returns were filed accurately?

A: The preparer will also affirm that all prior tax returns have been filed. That includes income tax, estimated tax, FICA and FUTA, the AMT, Estate tax, Gift tax, and Generation-Skipping transfer tax. 

Q: What other things determine if a return needs to be filed?

A: For purposes of determining whether you must file a return, gross income includes any income that can be excluded as foreign-owned income or as a foreign housing amount. 

If you are a US citizen or resident alien, the rules for filing income, estate and gift tax returns and for paying estimated tax are generally the same whether you are in the US or abroad. Income, filing status, and age generally determine whether an income tax must be filed. 

Q: Are residents and non-residents taxed differently?

A: In general, if you are a US citizen or resident alien, you are taxed on your worldwide income, but if you are a nonresident alien, you are only taxed on US source income. 

Generally, if you are a US citizen, resident, or person who has a business in the US and you have an ownership interest in, or authority over, any financial account in a foreign country with an aggregate value in excess of $10,000 at any time during the calendar year, you must file a report of foreign bank and financial accounts. 

This is commonly referred to as an FBAR. If you fail to file an FBAR, you are subject to both civil and criminal penalties. You must file the FBAR online with the Financial Crimes Enforcement Network by 4/15 each year. 

Q: When is my personal income tax return due?

A: Your return is due on the 15th day of the fourth month after the end of the tax year. But you may be allowed an automatic two-month extension. 

Q: What is the amount of my standard deduction?

A: The amount of your standard deduction and your applicable tax rates will vary depending on your filing status.

Q: What are the five filing statuses?

A: The five filing statuses that you may choose from are: 

1) Married filing a joint return, 

2) married filing separate returns, 

3) qualified surviving spouse, 

4) head of household, and 

5) single. 

Q: Who is required to file an income tax return with the IRS?

A: You must file a federal income tax return if income is above a certain threshold, net earnings  from self-employment is $400 or more or you are a dependent with more gross income than the standard deduction or unearned income over $1,100. 

The gross income amount, generally, is the standard deduction. That excludes any amount for being blind. If you are married and choose to file separately, you are not allowed to include the standard deduction in the threshold computation.

Also, if your spouse itemizes their deductions, you must also itemize on your return. When computing gross income, you must add back any gain from the sale of your home, known as residence disposition gain that you excluded. Also, you must also add back any foreign earned income that you excluded. 

Finally, you may be required to file if certain conditions apply to you, your spouse, or your dependents. For example, you may be liable for the Alternative Minimum Tax (AMT) or if you received wages from a church. 

Q: Should I file a return if not required to?

A: Even if you aren't required, you should file to obtain a refund and possibly to establish record and trigger running of statutes of limitations. You, your spouse, and your return preparer must all sign the completed return. 

Q: Why do I have to review the return before signing it?

A: The preparer must declare under penalty of perjury that you have examined the return and the accompanying statements and schedules and to the best of their knowledge and belief, the return and schedules are true, correct, and complete. 

Q: When is an individual’s income tax return due?

A: Your income tax return must be filed and postmarked no later than the 15th day of the fourth month following the close of the tax year. If you are a calendar year taxpayer, that date is April 15th. 

If that day falls on a Saturday, Sunday, or legal holiday, your due date is the next date that is not a Saturday, Sunday or legal holiday. 

Q: Do I qualify for an income tax filing extension?

A: You may obtain an automatic six-month extension if possible, but you must file form 4868 or you must use a credit card to make your required tax payment on or before the initial due date. 

Q: Do members of the military qualify for an income tax extension?

A: If you are a US citizen or resident who is on military or naval duty outside the US or Puerto Rico on April 15th, you will have an automatic two-month extension without having to file form 4868. 

If you file that form during that two-month extension, you will only get an additional four-month extension. 

Q: When is the due date for the final return of a decedent?

A: The due date for the final return of a decedent, someone who has passed away, is the date that the return would have been due if they had not passed away. 

Q: When must a nonresident alien file a personal income tax return?

A: If you are a nonresident alien, you must file your return by the 15th day of the sixth month after the close of the tax year. 

However, if you are a nonresident alien and your wages are subject to withholding, you must file your tax return on the 15th day of the fourth month after the close of the tax year. 

You must pay your tax liability on your return’s original due date. Just because you have chosen to automatically extend the filing due date, does not mean that you have also extended the time for payment. 

Q: If I file an income tax extension, do I still have to pay penalties?

A: You will be charged interest starting at your return’s original due date. Your penalty for failing to file your return is five percent per month up to twenty-five percent of your unpaid tax liability. 

In general, a failure to pay penalty is imposed from the due date for your taxes, other than estimated taxes, shown on your return. 

Q: Do I have to pay a penalty for not paying my income taxes by the due date?

A: Your penalty will be one half percent per month of the tax not paid up to twenty-five percent. The failure to pay penalty may offset the failure-to-file penalty. 

When your extension is timely requested, you may avoid a failure to pay penalty by paying an estimate of your unpaid tax due. 

Q: How much should I pay with my income tax extension to avoid some penalties?

A: You must include that with your extension request. But your payment must be no less than ninety percent of your actual tax liability due. 

Also, you must pay the balance of tax due when you file your return. Exceptions and adjustments to these rules do apply in unique situations. 

Q: What records should I save along with my income tax return?

A: Books of account or records sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown in any tax or information return must be kept. 

Q: How long do I have to keep bookkeeping records for my business?

A: You must maintain records as long as the contents are material in the administration of any tax law. 

If you are an employer, you must keep records of employment taxes for at least four years after the due date of your return or the date that you paid your tax. 

If you are required to report employment taxes or give tax statements to employees, you must have an Employer Identification Number (EIN). 

This is a nine-digit number, similar to a social security number, that the IRS issues to identify the tax accounts of employers. 

You will be subject to a penalty if, as an employer, you fail to make a required deposit of taxes on time. 

You will not be subject to penalties if your failure to make the deposit was due to reasonable cause, but not willful neglect. 

Q: Can I claim exemptions for myself and my dependents?

A: Until 2018, taxpayers were allowed to take personal exemptions reducing their adjusted gross income for themselves and any of their qualified dependents. 

For 2018-2025 exemption amount is $0. In essence, the personal exemption has been eliminated during these years. 

Q: Can I claim my child as a dependent?

A: Dependency status affects certain tax credits as well as the head of household filing status. To qualify as a dependent, the individual must be a qualifying child or qualifying relative. To be a qualifying child, four tests must be met. 

Q: What tests must be met to be a qualifying child?

A: A qualifying child has met the relationship, age, residence, and support tests.

1) Relationship: The child must be your son, daughter, step-son, step-daughter, brother, sister, step-brother, step-sister, or any descendent of any such relative. Adopted individuals and eligible foster children also meet the relationship test. 

2) Age: The child must be under the age of 19 or a full time student under the age of 24. 

3) Principal residence: The child must have the same principal residence as you do for more than half of the year. 

4) Not self-supporting: Your child must not have provided over half of their own support. 

Q: Can I claim my relative as a dependent?

A: To be a qualifying relative a different set of four tests must be met. 

1) An individual must satisfy either a relationship or a residence requirement to qualify as a dependent. The relationship requirement is satisfied by the existence of an extended relationship by blood or an immediate relationship by adoption or marriage. 

The residence requirement is satisfied by any individual who merely resides with you for the entire tax year. 

2) The gross income of the individual claimed as your dependent must be less than $4,300. 

3) The person who may claim an individual as a dependent must provide more than fifty percent of the economic support of the individual for the year. 

4) The individual must not be the qualifying child of the taxpayer or any other taxpayer. 

There are also special rules that apply to individuals qualifying as a dependent: 

1) If an individual meets the requirements to be classified as a dependent on another person’s tax return, the individual will be treated as having no dependents for the tax year. 

2) An individual does not qualify as a dependent on another’s return if the individual is married and files a joint return. 

However, the individual can qualify as a dependent if he or she files a joint return solely to claim a refund of withheld tax without regard to the citizenship test. 

3) To qualify as a dependent  an individual must be for any part of the year a US citizen, resident, or national or a Canadian or Mexican resident. 

4) The taxpayer must provide the correct taxpayer identification number of the dependent on the income tax return.  

Q: What is a dependent’s unearned income?

A: The standard deduction for a dependent with unearned income is limited to the greater of $1,100 or the amount of earned income plus $350. 

Net unearned income of a dependent under age 19, or 24 for college students, at the close of the tax year, is taxed at the parents’ marginal rate. 

This is referred to as the Kiddie Tax. The tax on a dependent is the greater of the results of two calculations. 

Q: What are non-residents and dual-status aliens?

A: An individual is considered a dual-status alien if the person is both a nonresident and resident alien during the year. 

Generally, a person is considered a resident if he or she meets either the green card test or the substantial presence test. 

Even if the individual does not meet either of these tests, he or she may be able to choose to be treated as a US resident for part of the year. 

Under the green card test, a person is considered a resident for tax purposes if he or she was a lawful permanent resident of the United States at any time during the year. 

Under the substantial presence test, a person is considered a US resident if he or she was physically present in the United States for at least 31 days during the current year and a set number of days the period covering the three most recent years. 

If one spouse was a nonresident or dual-status alien married to a US citizen or resident at the end of the year, the spouses can choose to file a joint return. 

If a joint return is filed, the two taxpayers are both treated as US residents for the entire tax year. If both choose to be treated as US residents, both are taxed on their worldwide income. 

A taxpayer is considered unmarried for head of household purposes if the person’s spouse was a nonresident alien at any time during the year and the taxpayer does not choose to treat the nonresident spouse as a resident alien. 

However, the spouse is not a qualifying person for head of household purposes.The taxpayer must have another qualifying person and meet the other tests to be eligible for filing as head of household. 

Even if a taxpayer is considered unmarried for head of household purposes as the result of being married to a nonresident alien, the taxpayer is still considered married for purposes of the earned income credit. 

The taxpayer is not entitled to the credit unless he or she files a joint return with his or her spouse and meets other qualifications. 

Nonresident aliens can deduct certain itemized deductions if they receive income effectively connected with a US trade or business. 

These deductions include state and local income taxes, charitable contributions to US organizations, and casualty and theft losses. 

A nonresident alien who is married to a US citizen or resident at the end of the year and chooses to be treated as a US resident can take the standard deduction. 

A nonresident alien is not eligible for the credit for the elderly and the education credits unless he or she elects to be treated as a US resident. 

Nonresident aliens are required to file a return if they earn wages effectively connected with a US trade or business. 

Most types of US-source income received by a foreign taxpayer are subject to a tax rate of thirty percent. 

A scholarship, fellowship, or grant received by a nonresident alien for activities conducted outside the US is treated as foreign-source income. 

Q: What does the IRS count as income?

A: The Internal Revenue Code (IRC) defines gross income as all income from whatever source derived, except as otherwise provided. 

The most common sources of income are:

1) Compensation for services, including fees, commissions, and fringe benefits, 

2) gross income derived from a business, 

3) gains derived from dealings in property, 

4) interest, dividends, rents, royalties, annuities, and pensions, 

5) alimony and separate maintenance payments executed before 2019, 

6) income from life insurance and endowment contracts, 

7) income from discharge of indebtedness, 

8) distributive share of partnership gross income, 

9) income in respect of a decedent (income earned, but not received before death), and

10) income received from an interest in an estate or trust. 

Q: How do I know when to report income to the IRS?

A: Items are included in income based on the method of accounting used by the taxpayer. The cash method of accounting includes income when constructively received. 

The accrual method of accounting reports income when: 

1) All events have occurred fixing the right to receive the income, and 

2) The amount can be determined with reasonable accuracy. 

Q: What method of accounting should I use for my business?

A: The accrual method is required when the taxpayer holds inventories. The hybrid method allows a business to use the cash method for the portion of the business that is not required to be on the accrual method. 

Q: Do I have to pay taxes on money if I don’t actually have it yet?

A: Income, even though it is not actually in the taxpayer’s possession, is constructively received in the taxable year during which it is credited to his or her account, set apart for him or her, or otherwise made available so that he or she may draw upon it at any time. 

Income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. 

A taxpayer receiving payment under a claim of right and without restrictions on its use or disposition includes the payment in income in the year received, even though the right to retain the payment is not yet fixed or the taxpayer may later be required to return it. 

If payment is not received, it is not included in income. All compensation for personal services is gross income. The form of payment is irrelevant. 

If services are paid for in property, its fair market value at the time of receipt is gross income and becomes the basis in the property. 

Gross income of an employee includes any amount paid by an employer for a liability or expense of an employee. 

Income from self-employment is included in gross income. Reported and unreported compensation, such as tips, is gross income. 

Virtual currency such as Bitcoin is treated as property for IRS purposes. This means that payment to employees with virtual currency is treated as income and uses the fair market value of the coin at the date received. 

Q: When do I have to report and pay taxes on prepaid income paid in advance?

A: Prepaid income is taxable in the year received, whether the taxpayer is on the cash or accrual method of accounting. A taxpayer cannot avoid tax liability by assigning his or her income to another person. 

This doctrine imposes the tax on income on those who earn it, produce the right to receive it, enjoy the benefit of it when paid, or control property that is its source. 

Royalties are payments to an owner from those using a right belonging to that owner. They constitute ordinary gross income. They are not a return of capital. 

Q: Can I carry forward a rental income loss to future years?

A: Rent is income from an investment, not from the operation of a business. Cash, or the fair market value of property or services received for the use of personal property is taxable as rental income. 

If property is not rented to make a profit, taxpayers can deduct their rental expenses, but only up to the amount of their rental income. 

A taxpayer cannot deduct a loss or carry it forward to the next year if rental expenses are more than rental income for the year. 

Q: Is alimony deductible by the payor or included in the gross income of the recipient?

A: For divorces executed before the 2019, alimony and separate maintenance payments are included in the gross income of the recipient and are deducted from the gross income of the payor. 

Alimony is not deductible by the payor and is not included in the gross income of the recipient if: 

1) The divorce is finalized after 2018, or 

2) A pre-2019 divorce is modified after 2018, where that modification expressly provides for exclusion from income. 

Q: Are child support payments taxable?

A: Child support payments are not alimony. They are excluded from the gross income of the recipient and may not be deducted by the payor. 

Property settlements are not treated as alimony. The portion of the amounts received under an annuity contract for which a statute does not provide an exclusion is gross income. 

Taxpayers are permitted to recover the cost of the annuity, that is the price paid, tax-free. Employer contributions to 401(k) plans are generally excluded from the income of the employee. 

Proceeds received from a life insurance contract are generally excluded from gross income. However, any interests paid on the proceeds of a policy that is paid out over time is gross income to the beneficiary. 

Q: Do I have to pay taxes on a canceled debt or a discharged loan?

A: A discharge of indebtedness can result in gross income. Gross income includes the cancellation of indebtedness when a debt is canceled in whole or part for consideration. There are certain exceptions. 
The most important of which are that gross income does not include discharges that occur in bankruptcy or when the debtor is insolvent. Another exception involves student loans. 

Federal, state, and/or local government loan indebtedness may be discharged and excluded from income if the former student engages in certain employment. 

For example, in a specified location for a specified period, or for a specified employer or the discharge is due to death and total or permanent disability. Social security benefits are generally not taxable unless additional income is received. 

Q: Do I have to report my scholarship or fellowship on my income tax return?

A: The gross income inclusion is dependent upon the provision of relation to the base amount and adjusted base amount. 

Amounts received by an individual as scholarships or fellowships are excluded from gross income to the extent that the individual is a candidate for a degree from a qualified educational institution. 

Amounts must be used for required tuition or fees, books, supplies or equipment. Not for personal expenses such as room and board. 

Most prizes and awards are included in gross income. If the prize is in a form other than money, the amount of gross income is the fair market value of the property. 

An honoree may avoid inclusion by rejecting a prize or award. Some prizes and awards are excludable, however. 

For instance, certain employee achievement awards may apply for exclusion from gross income de minimis fringe benefit. 

Unemployment benefits received under a federal or a state program, as well as company financed supplemental plans, are included in gross income. Also, strike benefits received from a union are excluded. 

Q: Do I have to report my disability or personal injury payments on my income tax return?

A: Gross income does not include benefits received in the form of disability pay, health, or accident insurance proceeds, worker’s compensation awards or other compensation for personal physical injury or physical sickness. 

Two significant items excluded from gross income are damages received for personal physical injury or physical sickness and payments received for emotional distress. 

If an injury has its origin in a physical injury or physical sickness, exclusion is allowed regardless of whether the damages are received by a lawsuit or an agreement or as lump sums or as periodic payments. 

However, punitive damages received are included, even if in connection with a physical injury or physical sickness. An amount for both actual and punitive damages must be allocated. 

Compensation for slander of personal, professional, or business reputation may not be excluded from gross income. 

Wrongful death damages can be excluded to the extent they were received on account of a personal injury or sickness.
But damages received soley for emotional distress are included in gross income. These damages include amounts received for claims such as employment or age discrimination. 

Benefits received by an employee under an accident or health plan for which the employer paid the premiums, or contributed to an independent fund, are excluded from the gross income of the employee. 

Proceeds from disability insurance policies are tax-free if paid for by the employee and prorated into taxable and nontaxable if paid for by the employer. 

Q: Can types of payments be excluded from reporting on my income tax return?

A: Up to $5,000 of dependent care provided by an employer is excluded from income. Proceeds of a life insurance policy for which the employer paid the premiums are excluded from the employee’s gross income. 

However, certain premiums paid by the employer are taxable to the employee. The cost of group term life insurance up to a coverage amount of $50,000 is excluded from the employee’s gross income. 

The amount included is the premiums representing excess coverage over $50,000 less any amounts paid by the employee on the insurance policy. 

Contributions by an employer to an employee’s long-term care coverage are nontaxable employee benefits. The rules for pensions are similar to the rules for annuities. 

Employees are able to recover their costs tax-free. The investment in the contract is the amount contributed by the employee in after-tax dollars. 

Amounts withdrawn early are treated as a recovery of both the employee’s contributions, which are excluded from gross income, and the employer’s contributions, which are included in gross income.  

After all of the employee’s contributions are recovered, additional withdrawals are included in gross income. 

All death benefits received by the beneficiaries or the estate of an employee from or on behalf of an employer are included in gross income. 

This inclusion is not to be confused with the exclusion of death benefits of a life insurance plan provided by an employer. 

Ministers may exclude from gross income the rental value of a home or a rental allowance to the extent the allowance is used to provide a home, even if deductions are taken for home expenses paid with the allowance. 

However, a minister should include in gross income any offerings given directly to him or her for church-related functions such as marriages. 

Military officers may exclude compensation up to an amount equal to the highest rate of basic pay at the highest pay grade that enlisted personnel may receive, plus any hostile fire or imminent danger pay. 

The exclusion applies only to compensation received while serving in a combat zone or while hospitalized as a result of wounds, disease, or injury incurred in a combat zone. 

Military personnel below officer level, that is enlisted, are allowed the same exclusion. The internal revenue code provides for exclusion from the gross income of the recipient the value of property acquired by gift or inheritance. 

A gift is a transfer for less than full or adequate consideration that results from the detached and disinterested generosity of the transferor. 

Gift transfers include inter vivos gifts, that is gifts between the living, and gifts by bequest, devise, and inheritance. 

A treasure trove is gross income for the tax year for which it is indisputably in the taxpayer’s possession. 

Q: Do I have to report gambling winnings, awards, or prizes on my income tax return?
A: All gambling winnings are included in gross income. Gambling losses are deductible only to the extent of winnings as an “other” itemized deduction. 

Gambling losses over winnings for the taxable year cannot be used as a carryover or carryback to reduce gambling income from other years. 

Q: What else do I have to include in income?

A: The tax benefit rules require the inclusion in gross income of items such as bad-debt write-offs for which the taxpayer received a tax benefit in a prior year. 

Q: What can I exclude from income?

A: Qualified reimbursements for moving expenses incurred by members of the military on active duty are excluded from gross income. 

Qualified adoption expenses paid to a third party, or reimbursed to an employee by an employer, are excludable from the employee’s gross income. 

Insurance payments received by a taxpayer whose residence is damaged or destroyed, and who must temporarily occupy another residence, are excluded, limited to the excess of actual living expenses over normal living expenses. 

Reimbursed employee expenses are excludable if reimbursements equal expenses and the employee makes an accounting of expenses to the employer. 

Employee housing at an educational institution, including an academic health center, is excluded from income if the rent paid by the employee exceeds five percent of the fair market value of the housing. 

Q: Can I exclude my fringe benefits from income?

A: An employee’s gross income does not include the cost of any fringe benefits supplied or paid for by the employer that qualifies as a:

1)  no-additional-cost-service, 

2) qualified employee discount, 

3) working condition fringe, 

4) de minimis fringe, 

5) qualified transportation fringe, 

6) qualified moving expense reimbursement (for active military only), or 

7) employer provided educational assistance. 

A no-additional-cost fringe is a service or product that the employer offers for sale to customers in the ordinary course of business in which the employee performs substantial services. 

The employer must not incur any substantial additional cost in providing the service to the employee and the fringe benefits must be available to employees on a non-discriminatory basis. 

For example, benefits available only to executives must be included in their gross income. 

Certain employee discounts on the selling price of qualified property or services, meaning those that are offered in the ordinary course of business, are excluded from gross income as long as they are purchased by the employee for his or her own use. 

The discounts must be available to employees on a nondiscriminatory basis. The fair market value of property or services provided to an employee by an employer as a working condition fringe benefit is excludable by the employee to the extent the employer can deduct the cost as an ordinary and necessary business expense. 

Property or services provided to an employee qualify as a working condition fringe benefit only if: 

1) The employee’s use of the property or services relates to the employer’s trade or business, 

2) The employee would have been entitled to a business expense deduction if the property or services that were provided by the employer had been purchased by the employee, and 

3) The employee maintains the required records, if any, with respect to the business use of the property or service or services provided by the employer. 

The value of property or services provided to an employee is excludable as a de minimis fringe benefit if the value is so minimal that accounting for it would be unreasonable or impractical. 

Examples include occasional use of company copy machines, occasional company parties or picnics, and coffee. 

Up to $270 per month may be excluded for the value of employer-provided parking, except residential transit passes, and for transportation in an employer-provided commuter highway vehicle, between the employee’s residence and place of employment. 

A commuter highway vehicle must seat six adults, with eighty percent of the mileage used for employee commuting, when the vehicle is at least one half full. 

Up to $5,250 may be excluded by the employee for employer-provided educational assistance. 

This rule does not apply to graduate teaching or research assistants who receive tuition reduction, tools, or supplies that the employee retains after the course, or meals, lodging, or transportation. 

Under the Cares Act, payments of up to $5,250 made between March 27, 2020 and January 1, 2026 by an employer to an employee or lender on any qualified educational loan incurred by the employee for his or her education may be excluded by the employer from the employee’s taxable wages. 

Q: What other income can be excluded?

A: Up to $108,700 of foreign earned income and a statutory housing cost allowance are excludable by those who qualify. 

A limited foreign housing allowance is excluded for reimbursement in excess of a base amount. The base amount is sixteen percent of the maximum foreign earned income exclusion. 

A rebate to the purchaser is treated as a reduction of the purchase price. It is not included in gross income. 

Business taxpayers must determine the correct classification for each worker. A statutory employee is a worker who straddles the divide between being self-employed and being considered a regular employee. 

That is to say a person who is in business for him or herself, or who works primarily or wholly for a specific company.  

Q: What is interest income?

A: Interest is the value received or accrued for the use of money. Interest is reported under the doctrine of constructive receipt when the taxpayer’s account is credited with the interest. All interest is gross income for tax purposes unless an exclusion applies. 

Q: What is imputed interest?

A: Imputed interest is the use of money at below market interest rates. It is the economic equivalent of a receipt of income in the amount of foregone interest expense. Thus, interest must be imputed on below-market-rate loans. 

Q: When do imputed interest rules apply?

A: Imputed interest rules apply to:

1) Any below market loan that is a gift loan, 

2) a loan between a corporation and a shareholder,

3)  a compensation related loan between an employer and an employee, or 

4) a loan that has tax avoidance as one of its principal purposes. 

There are certain exceptions: No interest is imputed for any day for which the total loans between borrower and lender are below certain amounts. 

If the loan is between individuals and is for $10,000 or less, there is no interest imputation unless the loan was made to acquire income producing assets. 

If the loan is between a corporation and a shareholder and is for $10,000 or less, there is no interest imputation unless the loan’s principal purpose is tax avoidance. Certain loans without a significant tax effect are excluded from these rules. 

Q: What is original issue discount?

A: Original issues discount on debt is the excess, if any, of the stated redemption price maturity over the issue price included in income based on the effective rate method of amortization.

If a taxpayer redeems Series EE US savings bonds to pay qualified higher education expenses during the year, all or a part of the interest received on the redemption of bonds may be excluded. The bonds must meet certain qualifications regarding issue date and ownership. 

If qualified expenses are less than the total amount of the principal and interest redeemed, the interest is multiplied by an exclusion rate to determine the amount excludable.

The exclusion rate is qualified expenses divided by the total of principal and interest. Payments to a holder of debt obligations of local governments such as municipal bonds are generally exempt from federal income tax. 

Exclusion of interest received is allowable even if the obligation is not evidenced by a bond. For example, in the form of an installment purchase agreement or an ordinary commercial debt. 

Interest on state, local, and federal tax refunds must be included in income. All interest, whether exempt or not, must be reported on the taxpayer’s federal income tax return.

Q: What is income from securities?

A: Amounts received as dividends are ordinary gross income. Qualified dividends are dividends from corporations or a qualified foreign corporation and are taxed at a zero percent, fifteen percent, or twenty percent rate depending on filing status and taxable income. 

For purposes of taxable income, a dividend is generally any distribution of money or other property made by a corporation to its shareholders out of earnings and profits. 

Any distribution in excess of earnings and profits is considered a recovery of capital and is therefore not taxable but it does reduce basis. 

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

Distributions by credit unions and savings and loan associations are considered interest not dividends for purpose of inclusion in gross income. 

Whether mutual fund distributions are excludable depends on the character of the income source. 

For example, distributions or dividends from a fund investing in tax exempt securities will be tax exempt interest. 

A dividend reinvestment plan allows a taxpayer to use his or her dividends to buy more shares of stock in the corporation instead of receiving the dividends in cash. 

The basis of stock received as a result of a dividend reinvestment is fair market value. Even if it was purchased at a discounted price. 

The general rule regarding stock dividends is that a stockholder does not include in gross income the value of a stock dividend or the right to acquire stock declared on its own shares. 

The term nonstatutory stock options refers to those options that are not qualified stock options, incentive stock options, employee stock purchase plans, or restricted stock options. 

An employee may not recognize income when an incentive stock option is granted or exercised, depending upon certain restrictions. 

The employee recognizes long-term capital gain if the stock is sold two years or more after the option was granted and one year or more after the option was exercised. 

Otherwise, the excess of the stock’s FMV  on the date of exercise option price is ordinary income to the employee when the stock is sold. 

An employee stock option plan is generally one permitting employees to buy stock in the employer corporation at a discount. 

Options issued under an employee stock option purchase plan qualify for special tax treatment. No income is recognized under such a plan when the option is granted. Recognition is deferred until stock acquired under the plan is disposed of. 

Q: What is income in respect of a decedent?

A: The filer of a decedent’s income tax and estate tax returns is required to make the appropriate allocation of income related to the decedent during the year of death. 

Income in respect of a decedent is all amounts that the decedent was entitled to as gross income, but were not includible in taxable income on the final return.

An example of income in respect of a decedent is salary earned prior to but not received before the death of a cash method taxpayer.

Income in respect of a decedent is reported by the person receiving the income as if the recipient were the decedent. It is taxable as income to the recipient and is includable in the gross estate.

Q: What are business deductions?

A: Two key amounts in the computation of federal tax liability to individuals are gross income and adjusted gross income, usually referred to as AGI. 

Deductions under the tax code are divided into two broad categories. The first category consists of what are referred to as deductions for AGI, and are commonly called above the line deductions. 

This group of deductions is subtracted from gross income to arrive at AGI. The second broad category consists of what are referred to as deductions from AGI and are commonly called below the line deductions. 

The governing rule for deductions is that no amount can be deducted from gross income unless specifically allowed by the internal revenue code. 

Q: What are business expenses:?

A: A deduction from gross income is allowed for all ordinary and necessary expenses paid or incurred during a tax year in carrying on a trade or business. The deduction is allowed for sole proprietorships, partnerships, and corporations. 

A trade or business is a regular and continuous activity that is entered into with the expectation of making a profit. 

Regular means the taxpayer devotes a substantial amount of business time to the activity. An activity that is not engaged in for a profit is deemed a hobby. 

An activity is presumed not to be a hobby if it results in a profit in any three of five consecutive tax years. Two out of seven for the breeding and racing of horses. 

Expenses related to a hobby are not deductible, but any income is included in gross income. An expense must be both ordinary and necessary to be deductible. 

An expense is ordinary if it normally occurs or is likely to occur in connection with businesses similar to the one operated by the person claiming the deduction. 

The expenditures need not occur frequently. Necessary implies that an expenditure must be appropriate and helpful in developing or maintaining the trade or business. 

Implicit in the ordinary and necessary requirement is a requirement that the expenditures be reasonable. 

For example, if the compensation paid to a shareholder exceeds that ordinarily paid for similar services, the excessive payment may constitute a nondeductible dividend. 

Only the portion of an expenditure that is attributable to business activity is deductible. A reasonable method of allocation may be used. 

Cash and the fair market value of property paid to an employee are deductible by an employer. 

Advanced rental payments may be deducted by the lessee only during the tax period in which the payments apply. While away from home overnight on business, travel expenses are deductible. 

No deduction is allowed for travel that is primarily personal in nature, except for directly related business expenses while at a destination, a taxpayer’s spouses’ travel expenses, unless there is a bonafide business purpose for the spouse’s presence, the spouse is an employee, and the expenses would be  otherwise deductible. 

Attending investment meetings, or travel engaged in as a form of education. Generally travel expenses, including meals and lodging of a taxpayer who travels outside of the United States away from home must be allocated between the time spent on the trip for business and time spent for pleasure. 

For automobile use, actual expenses, such as service, repairs, gasoline, depreciation,    insurance, and licenses are deductible. 

Alternatively, the taxpayer may deduct the standard mileage rate plus parking fees, tolls, etc. 

If the taxpayer switches from using the standard mileage rate to actual expenses, the depreciation deduction must be computed using the straight line method. 

Travel expenses to attend a convention are deductible if it can be shown that the attendance relates to the taxpayer’s trade or business. 

Expenses for travel to a convention in connection with investments, financial planning, or other income-producing property are not deductible. 

Transportation expenses include taxi fares, automobile expenses, tolls and parking fees and airfare. 

These expenses are treated as travel expenses if the taxpayer is away from home overnight. Otherwise, they are transportation expenses. 

Commuting costs are never deductible. A self-employed individual who uses an automobile to transport tools to work will be allowed a deduction for transportation expenses only if additional costs are incurred, such as renting a trailer. 

Actual automobile expenses may be used for the deduction, or the taxpayer may use the standard mileage rate. 

Actual expenses must be allocated between business use and personal use of the automobile. A deduction is allowed only for the business portion. 

Actual automobile expenses include the following: 

1) gas and oil, 

2) lubrication and washing, 

3) repairs, 

4) garage and parking fees, 

5) insurance, 

6) tires and supplies, 

7) tolls, 

8) interest expense, 

9) leasing fees, 

10) licenses, and 

11) depreciation. 

The following are used to determine a taxpayer’s home for travel purposes: 

1) The taxpayer performs part of his or her business in the area surrounding his or her main home and uses that home for lodging while doing business in the area, 

2) The taxpayer has living expenses at his or her main home that are duplicated because his or her business requires him or her to be away from that home, and 

3) The taxpayer has not abandoned the area in which both his or her traditional place of lodging and his or her main home are located. 

Members of his or her family live in his or her main home or he or she often uses that home for lodging. 

Ordinary or necessary trade or business insurance expense paid or incurred during the tax year is deductible. A cash method taxpayer may not deduct a premium before it is paid. 

Prepaid insurance must be apportioned over the period of coverage. A bad debt deduction is allowed only for bonafide debt arising from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money. 

Worthless debt is deductible only to the extent of adjusted basis in the debt. A cash method taxpayer has no basis in accounts receivable and generally has no deduction for bad debts. 

A business bad debt is one incurred or acquired in connection with a taxpayer’s trade or business. 

Partially worthless business debts may be deducted to the extent they are worthless and specifically written off. A business bad debt is treated as an ordinary loss. 

A nonbusiness bad debt is a bad debt other than one incurred or acquired in connection with a taxpayer’s trade or business. 

Worthless corporate securities are not considered bad debts. They are generally treated as a capital loss. 

The loss on deposits can occur when a bank, credit union, or other financial institution becomes bankrupt or insolvent. 

The individual may treat the nonbusiness account loss as a personal casualty loss which is nondeductible. 

Alternatively, the individual can elect to treat the loss as the nonbusiness ordinary loss arising from a transition entered into for profit. 

If no election is made the classification for the nonbusiness bad debt is a short-term capital loss to a $3,000 annual limit. 

Expenditures for business gifts are deductible as long as they are ordinary and necessary. 

Deduction for business gift expenditure is only allowed if the taxpayer substantiates by adequate records the cost of the gift. 

A description of the gift, the gift’s business purpose and the business relation of the recipient to the taxpayer. 

Deduction is limited to $25 per recipient per year for items excludable from income. The $25 limit does not apply to incidental items costing the giver not more than $4 each and other promotional materials including signs and displays. 

An employee achievement award is tangible personal property awarded to an employee as part of a meaningful presentation for a safety achievement or length of service. 

Up to $400 of the cost of employee achievement awards is deductible by an employer for all nonqualified awards. Deduction of qualified plan awards is limited to $1,600 per year. 

A qualified plan award is an employee achievement award provided under an established written program that does not discriminate in favor of highly compensated employees. 

If the average cost of all employee achievement awards is greater than $400, it is not a qualified plan award. Depreciation can be an expense of any business. 

Taxpayers may elect to deduct up to $5,000 of startup costs and $5,000 of organizational expenditures in the year when the trade or business begins. 

The remaining expenses are amortized over an 180 month time period. These amounts may be reduced, but not below zero, by the cumulative cost of the startup or organizational expenditures that exceed $50,000. 

Up to $10,000 of costs for reforestation may be expensed in the current year.

Interest and taxes on vacant land are deductible. If a structure is demolished, demolition costs, undepreciated basis and losses sustained are not deductible that are allocated to the land. 

A loss is deductible in the year in which the assets are actually abandoned with no claim for reimbursement. 

The amount of the loss is the adjusted basis in the abandoned property. Costs of goods sold is deducted before arriving at gross income. 

The cost of a medical reimbursement plan for employees is deductible by the employer. Contributions to a political party or candidate are not deductible. 

However, up to $2,000 of direct cost of lobbying activity at the state or federal level is deductible. If total direct costs exceed $2,000, this de minimis exception is not available. 

Payment of a debt of another party is generally not ordinary for a trade or a business. Thus, it is not deductible. 

However, if the debt constitutes a legal obligation, or definite business requirement, such as being required by suppliers to stay in business, the payment can be deductible. 

The costs of intangibles are generally capitalized. Amortization is allowed if the intangible has a determinable useful life. 

For example, a covenant not to compete, or if a code section specifically so provides. An expenditure related to producing tax exempt income is not deductible. 

For example, interest on a loan used to purchase tax exempt bonds. A trade or a business expenditure that is ordinary, necessary, and reasonable may be nondeductible if allowing the deduction would frustrate public policy. 

Some examples are fines and penalties paid to the government for violation of the law, illegal bribes and kickbacks, two thirds of damages for violations of federal antitrust laws, and expenses of dealers in illegal drugs. 

Expenses of a disabled individual for attendant care services at his or her place of employment and other expenses connected with his or her place of employment necessary for the individual to work are deductible expenses. 

The expenses are claimed under other itemized deductions for the individual’s return. Miscellaneous ordinary and necessary business expenses are deductible. 

Examples include costs of office supplies, advertising, and professional fees. Penalties on the early withdrawal of interest income are deductible as “above the line” deductions. 

Employers who reimburse and the self-employed may deduct expenses incurred for the use of a person’s home for business purposes, but only if certain requirements are met. 

A deduction is allowed only for the portion of expenses attributable to that part of the residence used exclusively and regularly as the taxpayer’s place of business. 

In addition, one of the following conditions must be met: 

1) The home office is the principal location of that business, 

2) It is used for patients, clients or customers in meeting or dealing with the person in the normal course of the person’s trade or business, 

3) It is used in connection with the taxpayer’s trade or business, and the office is separate and not attached to the home, 

4) It is used for administrative or management activities, 

5) It is used for storage of inventory or product samples used in the trade or business of selling products at retail or wholesale, 

6) It is for rental use, or 

7) It is used as a daycare facility. 

The exclusive use test is strictly applied. Use of the business portion of a home by the taxpayer or members of his or her family for nonbusiness purposes results in complete disallowance of the deductions. 

A retailer or wholesaler whose sole location of his or her business is his or her home need not meet the exclusive use test. 

In such a case, the ordinary and necessary allocable to an identifiable space used regularly for inventory or product sample storage are deductible. 

If the business portion of a home is used to offer qualifying daycare, the exclusive use test need not be met. 

A home office deduction may be taken for the portion of the home that is used to provide daycare on a regular basis for children, the elderly over 65 years of age, and/or those who are physically or mentally unable to care for themselves, even if the space is used for nonbusiness purposes. 

Deduction for business use is limited to gross income derived from the use minus deductions allocable to the trade or business for which the home office is used that are not home office expenses and deductions allocable to such use that are allowable regardless of use, such as interest or taxes.

Q: What are business meals?

A: Business meals include food and beverages provided to a business associate. A business associate is defined as a person with whom the taxpayer could reasonably expect to engage or deal in the active conduct of the taxpayer’s trade or business, such as the taxpayer’s:

1) Customer, 

2) client, 

3) supplier, 

4) employee, 

5) agent, 

6) partner, or 

7) professional advisor.

These rules apply regardless of whether the relationship is established or prospective. 

Meal expenses are not deductible if neither the taxpayer nor an employee of the taxpayer is present at the meal. 

Meals purchased from a restaurant are fully deductible, however, there is a fifty percent limit to deductible amounts for other allowable meal expenses, such as meals not provided by a restaurant and related expenses, such as taxes, tips and parking fees. 

No deduction is allowed for meals or any portion thereof that are lavish or extravagant under the circumstances. Meals while traveling for business are also fifty percent deductible. 

The IRS has denied deductions for any meal expense over seventy-five dollars for which the claimant did not provide substantiating evidence such as documented dates, amounts, location, purpose, and business relationship. 

Most entertainment expenses are no longer deductible, however entertainment expenses for recreational, social, or similar activities for the benefit of employees, such as an annual company holiday party are one hundred percent deductible. 

Expenses in connection with the use of an entertainment facility that the taxpayer owns are not deductible. 

Any property that a taxpayer rents, owns, or uses for entertainment purposes is considered to be an entertainment facility. 

Swimming pools, cars, hotel suites, and yachts are all examples of entertainment facilities. 

Q: What are above the line deductions?

A: Above the line deductions are deducted from gross income to arrive at adjusted gross income. 

They are contrasted with below the line deductions, which are deducted from AGI, to arrive at taxable income. 

Q: What are educator expenses?

A: Primary and secondary school educators may claim an above the line deduction for up to $250 annually in unreimbursed expenses paid or incurred for books and supplies used in the classroom. 

Books, supplies, computer equipment, including related software and services and other equipment, and supplementary materials used in the classroom qualify for the deduction. 

An eligible educator is an individual who, for at least 900 hours during the school year, is a kindergarten through grade twelve teacher, instructor, counselor, principal, or aide. 

The term school is defined as one that provides elementary or secondary education as determined under state law. 

Q: What is a health savings account?

A: A health savings account is a tax exempt trust or custodial account in which money is set aside exclusively for future medical expenses. This account must be used in conjunction with a high deductible health plan. 

The amount that may be contributed to a taxpayer’s health savings account depends on the nature of the taxpayer’s coverage and his or her age. 

For self only coverage, the taxpayer, or his or her employer can contribute up to $3,600 or $4,600 for taxpayers aged 55 to 64. 

For family coverage the taxpayer, or his or her employer, can contribute up to $7,200, or $8,200 for taxpayers aged 55 to 64. 

Contributions are not allowed for taxpayers aged 65 and over. A taxpayer is not required to have the insurance for the whole year to contribute the full amount. 

Q: What are self-employment deductions?

A: A self-employed person is allowed a deduction for the employer’s portion of the FICA taxes paid to arrive at AGI. 

The deduction for the employer’s share is equal to fifty percent of the self-employment tax or 6.2 percent of the first $142,800 of net self-employment income, plus 1.45 percent of net self-employment income. 

Net self-employment income is total net self-employed profits multiplied by 92.35 percent. 

The 0.9 percent additional medicare tax is on the employee’s portion of FICA taxes. Therefore the 0.9 percent tax is not deductible. 

A self-employed individual can deduct specified amounts paid to a qualified retirement or profit-sharing plan, such as a SEP or SIMPLE plan. 

For a SEP plan, the maximum annual contribution is limited to the lessor of 25 percent of the self-employed earnings or $58,000. 

Self-employed earnings are reduced by the deductible part of self-employment taxes, and contributions to the plan are subtracted from net earnings to calculate self-employed earnings. 

Since this creates a circular computation, a standard rate of twenty percent is used to calculate the allowed deduction. 

Self-employed individuals can deduct one hundred percent of payments made for health insurance coverage for the individual and his or her spouse and dependents. 

The deduction is limited to the taxpayer’s earned income derived from the business for which the insurance plan was established. No deduction is allowed when the taxpayer is eligible for an employer-sponsored plan. 

Q: How is alimony treated by the tax code?

A: For divorces executed before 2018, alimony and separate maintenance payments are gross income to the recipient and deductible by the payor. 

For divorces executed 2019 and later, alimony is nondeductible to the payor and not included in the gross income of the recipient. 

For divorces executed before 2019, to qualify, the payment must be made in cash or equivalent. The payment must be received by or on behalf of a spouse under a divorce or a separation agreement. 

The payee spouse and payor spouse must not be members of the same household at the time of payments. 

The payor spouse must not be liable for any payments after the death of the payee spouse. And the spouses must not file joint returns with each other. 

If the divorce or separation instrument states that the taxpayer must pay expenses for a home owned by the taxpayer and his or her former spouse, some of the payments may be alimony. 

Child support payments and any part of an alimony payment designated as child support are not deductible. 

If any amount of an alimony payment is to be reduced based on a contingency relating to a child, such as the attainment of a certain age or graduation, the amount of the specified reduction is treated as child support. 

Q: Are retirement savings contributions deductible?

A: Subject to certain qualifying rules and limitations, an individual who is not an active participant in an employer-maintained retirement plan may make contributions to an individual retirement account, or IRA. 

These IRA contributions are fully deductible up to the lesser of $6,000, $7,000 for taxpayers aged 50 or older or one hundred percent of his or her includable compensation. 

Contributions must be made by the due date of the return, without regard to extensions. Compensation includes earned income, but not pensions, annuities, or other compensation distributions. 

An additional $6,000 may be contributed to the IRA for the taxpayer’s nonworking spouse if a joint return is filed. 

The combined IRA contributions by both spouses may not exceed their combined compensation for the year. 

If a taxpayer meets both of the following conditions, the IRA deduction is proportionally reduced over a phase-out range: 

1) An active participant in an employer-sponsored retirement plan, and 

2) has modified AGI of over $105,000, ($66,000 for single or head of household taxpayers and $0 for married filing separately taxpayers). 

However, the deduction is fully phased out at $125,000. 

If an individual has reached age 50 before the close of the tax year, the regular contribution limit is increased by $1,000. 

Excessive contributions, that is those over the deductible limit, may be subject to a six percent excise tax. 

Calendar year taxpayers owning an IRA must begin receiving distributions by April first of the year following the later of the year in which the employee attains age 72 or the year in which the employee retires. 

Under the Cares Act, all required minimum distributions in 2020 from defined contribution plans, certain annuity plans, traditional IRAs and Roth IRAs are waived. 

The waiver applies regardless of whether the taxpayer has been impacted by the Covid 19 pandemic. 

IRA distributions made before age fifty-nine and a half for a reason other than death or disability, are subject to taxation, as well as a ten percent penalty tax, unless an exception applies. Contributions to a Roth IRA are nondeductible, but income can be accumulated tax free.

The contribution amount for a Roth IRA is the same amount as for a deductible, traditional IRA, and the total contribution to both deductible and nondeductible IRAs in any given taxpayer cannot exceed $6,000 per taxpayer, $7,000 if age 50 or older. 

Q: What are higher education deductions?

A: Taxpayers may deduct up to $2,500 of interest paid on qualified educational loans. This deduction is subject to income limits. 

The phaseout range begins with MAGI, without regard to this deduction, exceeds $70,000 or $140,000 for joint filers, and ends at $85,000 or $170,000 for joint filers. 

Q: Are there any additional above the line deductions?

A: Performing artists qualify to deduct employee business expenses as an adjustment to gross income if all of the following requirements are met: 

1) The performing arts services where performed as an employee for at least two employers, 

2) At least $200 was received from each of any two of these employers, 

3) Related performing arts business expenses are more than ten percent of total gross income from the services, and 

4) AGI is not more than $16,000 before deducting these expenses. 

The deduction for job-related relocation, that is moving expenses, has been removed until 2026, except for military service persons on active duty who move pursuant to a military order and due to a permanent change of station. 

A deduction is allowable for an early withdrawal of funds from certificates of deposit or other time savings accounts. 

A deduction is taken in the year the penalty is incurred. Individuals who are self-employed or employed by a small employer, and who are covered by a high deductible health insurance plan, may make tax-deductible contributions to an Archer medical savings account, most commonly called an Archer MSA, and use those funds accumulated to pay medical expenses. 

The deduction for an Archer MSA is not included with other medical expenses and is not subject to the 7.5 percent limitation. 

Earnings generated by the plan and distributions from an Archer MSA used to pay medical expenses are nontaxable. 

Distributions not used for medical expenses are taxable and subject to a twenty percent penalty tax unless made after age 65 or upon death or a disability. 

Contributions to an Archer MSA are subject to an annual limitation, which is a percentage of the deductible of the required high deductible health plan. 

An Archer MSA can be rolled into a health savings account tax free. Jury duty pay, returned to an employer, is deductible to the employee from gross income. 

Expenses from the nonbusiness rental of personal property are not deductible. An above the line charitable contribution deduction of up to $300 is allowed for individual taxpayers who do not itemize. 

A qualified contribution is any charitable cash contribution for which a deduction is allowed that is made to a:

1) Church, or association of churches, 

2) nonprofit educational organization, or 

3) nonprofit medical or hospital care organization (including one for medical education or medical research).

Q: What are loss limitations?

A: A taxpayer’s loss is limited by three different rules. The loss is limited: 

1) To the amount of a taxpayer’s basis in the activity, 

2) By the at-risk-rules, and 

3) By the passive activity rules. 

The deductible loss is the smallest amount of the three limitations. 

The amount of a loss allowable as a deduction is limited to the amount a person has at risk in the activity from which the loss arose. The loss is any excess of the allowable deductions over gross income. 

The rules apply to individuals, partners and partnerships, members in limited liability companies, shareholders of S corporations, trusts, estates, and closely held C corporations. 

Personal holding companies, foreign personal holding companies, and personal services corporations are not subject to at-risk-rules. 

The at risk rules are applied separately to each trade or business or income-producing activity. A person’s amount at risk in an activity is determined at the close of the tax year. 

The person at risk for a particular amount is the one who bears the economic risk of its loss or the one who will pay or lose the amount at risk if the activity fails. 

A person’s initial at risk amount includes money contributed, the adjusted basis of property contributed, and borrowed amounts. 

A person’s at risk amount includes amounts borrowed only to the extent that for the debt the person has either personally liable or has property pledged as security, that is recourse debt. 

Nonrecourse debt is generally excluded from the amount at risk. The amount at risk in the activity of holding real property includes qualified nonrecourse financing. 

The amount of loss attributable to a person’s passive activities is allowable as a deduction or credit only against and to the extent of gross income or tax attributable to those passive activities in the aggregate. The excess is deductible or creditable in a future year subject to the same limits. 

The passive activity rules apply to individuals, trusts, personal service corporations, and closely held corporations. 

Although passive activity rules do not apply to grantor trusts, partnerships, and S corporations directly, they do apply to the owners of these entities. 

A passive activity is either the trade or business in which the person does not materially participate or any rental activity. 

Material participation must be regular, continuous, and substantial and is determined separately for each activity. 

Generally, to be considered to be materially participating in an activity during a tax year, an individual must specify any one of a specific list of tests. Passive activity rules do not apply to: 

1) Active income loss or credit,   

2) Portfolio income loss or credit, 

3) Casualty or theft losses, 

4) vacation of home rental, 

5) qualified home mortgage interest, or 

6) business use of a home. 

All rental activity is passive. Material participation is irrelevant except for certain taxpayers who materially participate in real property trade or businesses. 

However, a person who actively participates in rental real estate activity is entitled to deduct up to $25,000 of losses from the passive activity from other than passive income. 

This exception to the general passive activity loss limitation rule applies to a person who:

1) Actively participates in the activity, 

2) Owns ten percent or more of the activity for the entire year, and

3) Has modified AGI of less than $150,000. 

Active participation is a less stringent requirement than material participation. Active participation is met by participating in management decisions or arranging for others to provide services such as repairs. 

The passive activity loss rules do not apply to taxpayers who are involved in real property trades or businesses.

An individual may avoid passive activity loss limitations in a rental real estate activity if two requirements are met: 

1) More than 50 percent of the individual’s personal services performed during the year are performed in the real property trades or businesses in which the individual materially participates, and 

2) The individual performs more than 750 hours of service in the real property trades or businesses in which the individual materially participates. 

This provision also applies to a closely held C corporation if fifty percent of gross income receipts for the tax year are from real property trades or businesses in which the corporation materially participated. 

A passive activity loss not allowable in the current tax year is carried forward indefinitely. It is treated as the deduction in subsequent tax years. 

If an activity is passive and produces a loss, the loss continues to be treated as a passive activity loss, even after the activity ceases to be passive in a subsequent tax year, except that it may also be deducted against income from that activity.

Suspended and current year losses from a passive activity become deductible in full in the year the taxpayer completely disposes of all interest in the passive activity. 

The loss is deductible first against net income or gain from the taxpayer’s other passive activities. The remainder of the loss, if any, is then treated as nonpassive. 

Losses from wash sales are not deductible. A wash sale occurs when a taxpayer sells or trades an asset at a loss and within thirty days before the sale the taxpayer does the following: 

1) Purchases a substantially identical asset, 

2) acquires a substantially identical asset in a taxable trade, or 

3) acquires a contract or option to buy a substantially identical asset. 

The unrecognized loss is added to the basis of the asset that caused  the wash sale. The holding periods of the original asset and the substantially identical asset are added together. 

Q: What are below the line deductions?

A: Below the line deductions are all the deductions that may be subtracted from gross income or AGI to arrive at taxable income. 

Each below the line deduction is an itemized, standard or qualified business income deduction. 

Q: What are qualified medical expenses?

A: Amounts paid for qualified medical expenses that exceed 7.5 percent of AGI may be deducted. 

To qualify for a deduction an expense must be paid during the taxable year for the taxpayer, the taxpayer’s spouse or a dependent and must not be compensated for by insurance or otherwise reimbursed during the taxable year. 

The deduction is allowed for a person who is either a spouse or a dependent at the time medical services were rendered, or at the time the expenses were actually paid. 

Thus, medical expenses charged on a credit card are deductible in the year the expenses were incurred, not when the credit card bill is paid. 

Q: How does an individual qualify as a dependent?

A: To qualify as a dependent, an individual must: 

1) Have over half of his or her support for the year paid for by the taxpayer, 

2) Fall within a family relationship, including adopted children, and 

3) Be a citizen, national or resident of the US, Canada, or Mexico during a portion of the tax year. 

However, the individual need not satisfy the gross income test or the joint return test. A child of divorced parents is treated as a dependent of both parents. 

Q: What are deductible medical expenses?

A: Deductible medical expenses are amounts paid for:

1) Diagnosis, 

2) cure, 

3) mitigation, 

4) treatment or prevention of disease, or 

5) for the purpose of affecting any structure or function of the body. 

Medical insurance, qualified long-term care premiums and services, and smoking cessation programs and prescribed drugs designed to alleviate nicotine withdrawal. 

Deductible medical expenses include amounts paid to physicians, surgeons, dentists, chiropractors, osteopaths, chiropodists, podiatrists, psychiatrists, psychologists, etc. solely in their professional capacity. 

A medical expense deduction is not allowed for amounts paid for any activity or treatment designed merely to improve an individual's general health or sense of wellness, even if recommended by a physician. 

For example, participation in a health club or a weight loss institute generally does not qualify as a deductible medical expense unless prescribed by a physician who provides a written statement that participation is necessary to alleviate a physical or a mental defect or illness. 

The cost of inpatient hospital care, including meals and lodging, is deductible as a medical expense. 

If the principal reason an individual is in an institution other than a hospital, such as a special school for the disabled or a rest home, is the need for and availability of the medical care furnished by that institution. 

Then the full cost of meals, lodging, and medical care are deductible. Only medicines and drugs that require a prescription are qualified medical expenses. 

Expenditures for obtaining items such as eye glasses, a seeing eye dog, a wheelchair, crutches, or artificial limbs are included as deductible medical expenses. 

The costs of special beds, air conditioning, and dehumidifying equipment, are also included as deductible medical expenses. 

Expenditures for new building construction, or for permanent improvements to existing structures, primarily for medical care, may be deductible in part as a medical expense. 

Amounts paid for transportation essential to and primarily for medical care are deductible. Included is the transportation cost of traveling to a warm climate on a doctor’s order to alleviate a specific chronic ailment. 

Expenditures for lodging are deductible up to $50 per night per individual, but the cost of meals is not deductible. 

Premiums paid for medical insurance that reimburses medical care expenses are deductible. Premiums paid on a policy that merely pays the insured a specified amount per week etc. are not deductible. 

The basic cost of medicare insurance part A is not deductible unless voluntarily paid by the taxpayer for coverage. 

However, the extra cost of medicare part B is deductible. If a decedent's medical expenses are paid by his or her estate within one year after the decedent’s death, the expenses may be deducted on the decedent's tax return for the year incurred. Alternatively, the estate can deduct medical expenses as a claim against the estate. 

The amount paid by an adopting parent for medical expenses rendered directly to a child before his or her placement in the adopting parents’ home constitutes a medical expense provided that: 

1) The child qualifies as a dependent, 

2) The medical expenses are paid by the adopting parent, and are not reimbursements, and 

3) The adopting parent can substantiate that any deduction claimed is directly attributable to the medical care of the child.

Q: Are taxes paid deductible on my return?

A: A taxpayer who itemizes deductions is permitted to deduct the full amount of certain taxes that are paid and incurred during the taxable year, subject to the $10,000 limit on total state and local taxes. 

State and local real property taxes are deductible by the person upon whom they are imposed in the year in which they were paid or accrued. 

If real property is bought or sold during the year, the real property tax is apportioned between the buyer and the seller on the basis of the number of days that each held the property real property tax year. 

The purchaser is presumed to own the property on the date of sale. Any taxes paid by an owner for a period in which someone else owned the property are not deductible, but are added to the basis of the property. 

Taxes paid to a financial institution and held in escrow are deductible when the financial institution disburses the funds to the taxing body. 

However, special assessments for local improvements increase the basis of the property and are not deductible. 

Ad valorem and personal property taxes are deductible, but only if the tax is substantially in proportion to the value of the property imposed on an annual basis, and actually imposed. State and local income taxes are deductible. 

Foreign income taxes paid are deductible unless the foreign tax credit is claimed. Individual taxpayers may claim an itemized deduction for general state and local sales taxes in lieu of state income tax. 

Taxpayers can deduct either actual sales tax amounts or a predetermined amount from an IRS table. 

The following taxes are not deductible: 

1) Federal taxes on income, estates, gifts, inheritances, legacies, and successions, 

2) state taxes on:

a. cigarettes and tobacco, 

b. alcoholic beverages, 

c. gasoline, 

d. licensing or registration, 

e. estates, gifts, inheritances, legacies and successions, 

f. licensing and registration fees of highway motor vehicles (if they are based on the weight instead of the value of the vehicle), and 

g. sales taxes on business property which are added to the basis of the acquired property.

Q: Can personal interest expense be deducted?

A: The general rule is that no personal interest may be deducted. 

Personal interest includes interest on:

1) Credit card debt, 

2) revolving charge accounts and lines of credit, 

3) car loans, 

4) medical fees and premiums, and 

5) home acquisition debt greater than the allowed deduction limit. 

Personal interest also includes any interest on underpaid tax liabilities. Personal interest does not include qualified residence interest, student loan interest, trade or business debt, passive activity interest, investment interest, or interest on the unpaid portion of certain estate taxes. 

The internal revenue code allows the deduction of a limited amount of investment interest as an itemized deduction. 

Investment interest is interest paid or incurred on debt to purchase or carry property held for investments. 

Generally, investment interest includes the following: 

1) Interest allocable to portfolio income under the passive activity loss rules, 

2) Any interest derived from an activity involving a trade or business in which the taxpayer does not materially participate (and which is not treated as a passive activity under the passive activity loss rules), and 

3) Any deductible amount in connection with personal property used in a short sale. 

Passive activity interest is includable in passive activities and deductible within passive loss rules. 

Deductible investment interest does not include:

1) Qualified residence interest, 

2) interest for generating tax exempt income, or

3) passive activity interest. 

Investment interest may be deducted only to the extent of net investment income. 

Net investment income is any investment income in excess of investment income over investment expenses other than interest expense. 

Disallowed investment interest is carried forward indefinitely. It is deductible to the extent of investment income in subsequent tax years. 

Q: What is qualified residence interest?

A: Qualified residence interest is deductible on no more than $750,000 of the sum of acquisition and home equity indebtedness, $375,000 if married filing separately. 

Acquisition indebtedness is debt incurred acquiring, constructing, or substantially improving a qualified residence. 

The debt must be secured by the residence. Qualified residence interest is interest paid or accrued during the tax year on acquisition or home equity indebtedness that is secured by a qualified residence.

A qualified residence is the principal residence of the taxpayer and any one other residence owned by the taxpayer and used for personal purposes for the greater of 14 days, or ten percent of the number of days during the year in which it is rented.

A taxpayer who has more than two residences may select each year the residences used to determine the amount of qualified residence interest. 

Home equity indebtedness is all debt other than acquisition debt that is secured by a qualified residence to the extent it does not exceed the fair market value of the residence reduced by any acquisition indebtedness. 

For tax years 2018 to 2025, the home equity debt must be used to buy, build, or substantially improve the qualified residence. 

The prior allowance to use the funds for other personal expenses is suspended until 2026. Points paid by the homebuyer are prepaid interest which is typically deductible over the term of the loan. 

Points paid by the seller are selling expenses that reduce the amount realized on the sale. 

The purchaser can elect to deduct points on the acquisition indebtedness of a principal residence by reducing the basis by the amount of the points. 

Qualified mortgage insurance premiums are deductible as interest expense for policies issued from 2007 to 2021. 

To compute interest deductions, individuals must allocate interest expenditures as:

1) Investment interest, 

2) personal interest, 

3) trade or business interest, 

4) portfolio interest, or 

5) interest connected to passive activities. 

It is allocated by tracing: 

1) The disbursement of the proceeds of the debt to which it relates to, and

2) the expenditure for which the proceeds are used.

Q: When are charitable contributions deductible?

A: Charitable contributions are deductible only if they are made to qualified organizations. 

In general, a deduction for a charitable contribution is allowed in the year a cash contribution is paid, including amounts charged to a bank credit card and in the year all rights and interests to noncash property is transferred. 

Qualified organizations can be either public charities or private foundations. Generally, a public charity is one that receives more than one third of its support from its members and the general public.

Qualified organizations include: 

1) Corporations, trusts, community chest funds or foundations that are created or organized in the US and operated exclusively for religious, charitable, scientific, literary, or educational purposes or for the prevention of cruelty to children or animals, 

2) Posts or organizations of war veterans, and 

3) Domestic, fraternal societies, orders, or associations, only if the contribution is to be used exclusively for religious, charitable, scientific, literary, or educational purposes or for the prevention of cruelty to children or animals. 

Donated clothing and household items must be in good condition. The exception to this rule is that a single item donation in less than good condition, but that still has more than a $500 value, is deductible with a qualified appraisal. 

Cash or cash equivalent donations require a bank record, receipt, letter, etc. from the donee organization regardless of the amount. 

Donations of $250 or more require substantiation by a contemporaneous written receipt from the organization. 

The bank record alone is insufficient. If a donation is in the form of property, the amount of the donation depends on the type of property and the type of organization that receives the property. 

Capital gain property is property on which a long-term capital gain would be recognized if it were sold on the date of the contribution. 

Ordinary income property is property on which ordinary income or short-term capital gain would be recognized if it were sold on the date of the contribution. 

There are basically two types of charitable organizations:
1) Those classified as fifty percent limit organizations, and 

2) all others that are classified as non fifty percent limit organizations. 

The majority of charitable organizations are fifty percent limit organizations. Examples include churches, educational organizations, hospitals, and certain medical research organizations. 

Organizations that are:

Operated only to receive, hold, invest, and administer property and to make expenditures to or for the benefit of:

1) State and municipal colleges and universities, 

2) the United States or any state, the District of Columbia, 

3) a US possession, including Puerto Rico, 

4) a political subdivision of a state or US Possession, or 

5) a Native American tribal government, 

6) private operating foundations, and

7) private nonoperating foundations 

Private nonoperating foundations make qualifying distributions of one hundred percent of contributions within two and a half months following the year they receive the contribution. 

Non fifty percent limit organizations include all other qualified charities that are not designated as fifty percent limit organizations. 

Charitable contribution deductions are subject to limitations. The overall limitation on charitable deductions is fifty percent of AGI, applicable to the total of all charitable contributions during the year. 

The limit is one hundred percent for cash contributions. Certain contributions may be individually limited to thirty or twenty percent of AGI, depending on the type of contribution given.

Any donations that exceed this limitation can be carried forward and deducted in the following five tax years. 

Additional limitations includes: 

1) The regular thirty percent limitation, which applies to gifts to all qualified charitable organizations other than fifty percent limit organizations, 

2) The special thirty percent limitation for capital gain property which applies to gifts of capital gain property given to fifty percent limit organizations, and 

3) The twenty percent limitation, which applies to capital gain property donated to non-fifty percent limit charities. 

In carrying over excess contributions to subsequent tax years, the excess must be carried over to the appropriate limitation categories.

If a contribution in the thirty percent category is in excess of the limit, the excess is carried over and subject to the thirty percent limitation in the following year. The value of services provided to a charitable organization is not deductible. 

However, out of pocket unreimbursed expenses incurred in rendering the service, such as uniforms or equipment are deductible.

Travel expenses incurred while performing the services away from home for the charitable organization are deductible if no significant element of personal pleasure, recreation, or vacation exists. 

For example, if an attorney provides pro-bono legal services to a charitable organization, the value of the services is not deductible, but the travel expenses incurred traveling to the charitable organization are deductible. 
The value of a ticket to a charitable event is deductible to the extent the purchase price exceeds the fair market value of admission.

Q: What are personal casualty losses?
A: Historically, taxpayers who itemized could deduct a limited amount for casualty losses to nonbusiness property arising from theft, fire, storm, shipwreck, or another casualty. 

However, for tax years 2018 to 2025, this personal deduction is only allowed for federally declared disasters. 

Only the amount of each loss over $100 is deductible and only the aggregate amount of all losses over $100, each in excess of ten percent of AGI, is deductible. 

If the loss was covered by insurance, timely filing of an insurance claim is required to take the deduction. 

The portion of the loss not covered by insurance, usually the deductible, is not subject to this rule. 

The amount of a loss is the lesser of the decrease in fair market value of the property due to the casualty or the property’s adjusted basis minus any insurance reimbursements.

Regardless of the ten percent of AGI floor, casualty losses are deductible against casualty gains. 

A taxpayer may claim personal casualty losses to the extent of personal casualty gain, even if the personal casualty losses are not attributable to federally declared disasters. 

If the net amount of all personal casualty gains and losses after applying the $100 limit, but before the AGI threshold is positive, each gain or loss is treated as a capital gain or loss. 

If the net amount is negative, the excess over ten percent of AGI is deductible as either an itemized deduction, or an addition to the standard deduction.

The cost of appraising a casualty loss is treated as a cost to determine tax liability for which there is no deduction. The cost of insuring a personal asset is a nondeductible personal expense. 

Additionally, for a loss in a federally declared disaster area disaster loss treatment is available when a personal residence is rendered unsafe due to a disaster and is ordered to be relocated or demolished by the state or local government.

The taxpayer may deduct the loss either on the return for the year on which the loss actually occurred or on a prior year’s return by filing an amended return. Although net operating losses are typically associated with businesses and not individuals, items such as personal casualty losses may create an individual net operating loss.

Q: Are there any additional itemized deductions?

A: Certain expenses are deductible as other itemized deductions on schedule A of Form 1040. They are:

1) Amortizable premium on taxable bonds, 

2) casualty and theft losses from income-producing property, 

3) federal estate tax on income on respect of a decedent, 

4) gambling losses up to gambling winnings, 

5) impairment-related work expenses of persons with disabilities, 

6) repayments of under $3,000 under a claim of right, and 

7) unrecovered investment in a pension.

Q: What is the qualified business income deduction?

A: When congress passed the Tax Cuts and Jobs Act, it reduced the C corporation tax rate to twenty-one percent. 

To avoid a disadvantage for owners of passthrough entities, the qualified business income deduction, or QBID, was created. 

The QBID is the last deduction before determining a taxpayer’s taxable income.

It is based on determining qualified business income. For this deduction, congress divided pass-through entities into two categories: 

1) Specified service trades or businesses, and 

2) Qualified trades or businesses. 

In general, a specified service trade or business is any trade or business in which the principal asset is the reputation or skill of one or more of its employees. 

For example, in the fields of health care, law, accounting, and the performing arts. 

A specified service trade or business also includes any business wherein a principal earns income for any of the following activities: 

1) Endorsing products or services, 

2) Use of the principal’s likeness, image, or name, or 

3) Appearance fees for an event or media performance. 

Trades and businesses that are specifically not included are architects, engineers, real estate agents and brokers, and insurance agents and brokers.

In general, a qualified trade or business is any passthrough entity that is not considered a specified service trade or business. 

A passthrough entity can be identified as a qualified trade or business if it has qualified business income. 

To calculate the QBID, there are four steps: 

1) Determine each pass-through entity’s qualified business income, 

2) Test the sum of each pass-through entity's qualified business income against the taxpayer’s taxable income. 

3) Determine the applicable combined QBID by adding together the allowed QBID amount for each respective entity to arrive at total QBID, 

4) Apply the overall limitation to the total QBID to determine the correct amount to deduct. This amount is then reported in form 1040. 

If the taxpayer is in the phaseout range or upper threshold, the QBID for each respective pass-through entity is reduced or limited by the IRS. 

The reduction is the allowed amount of QBID for each respective passthrough entity. 

The overall limitation is the lesser of twenty percent times qualified business income or twenty percent times the difference between taxable income and net capital gains.

Q: What is the alternative minimum tax?

A: For individuals, the alternative minimum tax, or AMT, is an income tax in addition to the regular income tax. 

Alternative minimum taxable income, known as AMTI, is based on taxable income. AMTI is taxable income after amounts are added or subtracted for tax preferences, adjustments, and loss limitations. 

The AMT base is AMTI reduced by an exemption amount and any AMT net operating loss carryover. Tentative AMT is determined by multiplying a rate times the AMT base after a reduction for the AMT foreign tax credit.

A two-tiered graduated rate schedule applies. A twenty six percent rate applies to the first $199,900, $99,950 if married filing separately of AMTI. 

A twenty eight percent rate applies to any excess. AMT is the excess tentative AMT over regular income tax. AMT must be reported and paid at the same time as regular tax liability. 

Estimated payments of AMT are required. A credit is allowed for the amount AMT exceeds the regular for a tax year. 

The credit carries forward indefinitely. Tax preference items generate tax savings by reducing the taxpayer’s taxable income. Therefore, they must be added back to taxable income when computing AMTI.

The first tax preference item under the AMT is section 1202 stock. When computing taxable income, noncorporate taxpayers may exclude up to one hundred percent of gain realized on the sale or exchange of qualified small business stock acquired after Sept 27, 2010 and held for more than five years.

The exclusion percentage drops to 75 percent for stock acquired after Feb. 17, 2009 and before Sept 28, 2010. 

It drops to fifty percent for stock acquired before Feb. 18, 2009. Generally seven percent of the exclusion is a tax preference item for AMT. 

However, stock purchased after Sept. 27, 2010 is excluded from tax preference treatment. The second tax preference item is private activity bonds. 

To compute AMT, add any tax exempt interest, minus expenses, including interest attributable to earning it. 

Bonds issued in 2009 and 2010 are excluded from tax preference treatment. In regards to percentage depletion, any excess deduction claimed over adjusted basis must be added back, such as Intangible drilling costs or IDC. 

Any excess of IDC amortized over ten years over 65 percent of net income from oil, gas, and geothermal properties must be added back. 

Usually, adjustments eliminate time value tax savings from accelerated deductions or deferral of income. 

An adjustment is an increase or a decrease to taxable income in computing ATMI. 

Adjustments include:

1) Installment sales, 

2) long-term contracts, 

3) certified pollution control facilities, 

4) mining exploration and development, 

5) net operating loss adjustments, 

6) distributions from a trust or estate, 

7) research and experimental expenditures, 

8) the standard deduction, certain itemized deductions, 

9) circulation expenditures, and 

10) incentive stock options. 

The AMT net operating loss is technically an adjustment to taxable income. After tax preferences have been computed and added to taxable income and all other adjustments have been computed and made, one of the two AMT net operating loss adjustment steps is performed: 

1) The net operating loss year or the profit year. An exemption is allowed that reduces AMTI to produce the AMT base, or

2) The basic exemption is phased out at twenty-five cents for each dollar of AMTI above a threshold (all members of a control group must share the exemption amount).

Q: What are employment FICA and FUTA taxes?

A: Both employers and employees are required to pay FICA tax based on the employee’s wages. An employee’s wages include all remuneration for employment including the value of noncash wages. 

The employer must pay 6.2 percent of the first $142,800 of wages paid for old age, survivors, and disability insurance, commonly referred to as social security, plus 1.45 percent of all wages for the hospital insurance percentage, commonly referred to as medicare. This tax applies to all wages with no cap. 

An additional medicare tax of 0.9 percent applies to wages, compensation, and self-employment income above a specified threshold amount. 

Failure by the employer to withhold the additional 0.9 percent results in the employee being personally responsible for the tax. 

All investment income in excess of deductions allowable for such income and income from passive activities are subject to a 3.8 percent tax. 

The tax imposed is on the lesser of an individual’s net investment income or any excess of modified adjusted gross income for the tax year over a specified threshold. 

For self-employed persons, the FICA tax liability is imposed on net earnings from self-employment at twice the rate that applies to an employer. 

That is at the rate of 15.3 percent. Unemployment or FUTA tax is imposed only on employers. The tax is six percent of the first $7,000 of wages paid to each employee. Unlike FICA, the employee does not pay any portion of FUTA. 

Q: Are there any other tax reporting requirements to be aware of?
A: A taxpayer is subject to the household employee tax if he or she paid one household employee cash wages of $2,300 or more during the year, withheld federal income tax at the request of the employee, or paid total cash wages of $1,000 or more in any calendar quarter to household employees. 
Between April 8, 2008 and May 1, 2010, a credit for qualifying first time homebuyers was available. 

Taxpayers who claimed the credit after 2008 did not have to repay the credit once they lived in the home for three years. Taxpayers who claimed it in 2008 continue to repay it over fifteen years. 

For taxpayers with a financial interest in or signature authority over a foreign financial account exceeding certain thresholds, the bank secrecy act may require them to report the account yearly by electronically filing a report of foreign bank accounts, or FBAR. 

Taxpayers with specified foreign financial assets that exceed certain thresholds must report those assets on form 8938 with their tax return. 

This form is in addition to the FBAR filing requirement, despite the chance of duplication of reported items.

Q: What are tax credits?

A: A one dollar credit reduces gross tax liability by one dollar. Various refundable and nonrefundable tax credits are available.
Most credits are nonrefundable, meaning that once tax liability reaches zero, no more credits can be taken to produce refunds. 

Nonrefundable personal credits include the following: 

1) Foreign tax credit, 

2) Lifetime Learning credit, 

3) retirement savings contribution credit, 

4) credit for other dependents, 

5) credit for the elderly or disabled, 

6) adoption credit, 

7) residential mortgage interest credit, 

8) minimum tax credit, 

9) family and medical leave credit, and 

10) residential energy credit. 

Refundable credits are treated as payments and can result in refunds to the taxpayer. 

Refundable credits include the following: 

1) American Opportunity tax credit, 

2) child and dependent care credit, 

3) child tax credit, additional child tax credit, 

4) earned income credit, and 

5) health insurance premium tax credit.

A taxpayer may either elect a nonrefundable credit or a deduction to taxes paid to other countries or US Possessions. 

Generally, the foreign tax credit or FTC is applied against gross tax liability after nonrefundable personal credits and before all other credits. The FTC, as modified, may offset AMT liability. 

The FTC is not credible against accumulated earnings tax or the personal holding company tax. 

Pass-through entities apportion the foreign taxes among the partners, shareholders for an S corporation, or beneficiaries of an estate. 

The taxpayers then elect and compute a credit or deduction on their personal returns. Qualified foreign taxes include foreign taxes on income, war profits, and excess profits. 

Qualified foreign taxes must be based on a form of net annual income, including gains. Foreign taxes paid on foreign earned income or housing costs excluded as excessive may neither be credited nor deducted. 

The maximum account of tax that may be credited is the amount of US income tax, times the percentage that foreign source taxable income represents, of worldwide taxable income. 

The limit must be applied separately to nonbusiness interest income and all other income. 

Two tax credits may be elected by low and middle income individuals for education expenses incurred by students pursuing college or graduate degrees or vocational training. 

The American Opportunity credit provides a maximum tax credit of $2,500 per student for each of the first four years of postsecondary education. 

The $2,500 per year is the sum of one hundred percent of the first $2,000 of qualified expenses and the next twenty-five percent of the next $2,000 of qualified expenses. 

The credit applies to the first four years of higher education received by the taxpayer, the taxpayer’s spouse, and/or the taxpayer’s dependents. 

The credit applies to tuition and tuition-related fees, books and other required course materials. 

The Lifetime Learning credit provides a credit of twenty percent of qualified tuition expenses paid by the taxpayer for any year in which the American Opportunity credit or an above the line education expense deduction is not claimed. 

The maximum credit allowed per year is $2,000. This is based on up to twenty percent of $10,000 of qualified tuition and fees paid for the taxpayer, the taxpayer’s spouse, and/or the taxpayer’s dependents. 

The credit is figured on a per taxpayer basis and applies to any number of years of higher education. 

Eligible expenses for the Lifetime Learning credit include tuition and fees required for enrollment. 

Neither the American Opportunity credit nor the Lifetime Learning credit may be used for:

1) Room and board, 

2) activity fees, 

3) athletic fees, 

4) insurance expense, or 

5) transportation. 

The credit for other dependents is a $500 nonrefundable credit for dependents other than a qualifying child or for a qualifying child without the required social security number. 

Nonrefundable means that any credit for other dependents is not included in the child tax credit when calculating the additional child tax credit. 

The child and dependent care credit is a refundable credit that a taxpayer is eligible for if: 

1) Child and dependent care expenses are incurred to enable the gainful employment of the taxpayer, and, 

2) The taxpayer provides more than half the cost of maintaining a household for a dependent under age 13 (or a physically or mentally incapacitated spouse or dependent). 

The required child and dependent care expenses may be incurred while the claimant is employed or actively seeking employment. 

The allowable household expenses may include household services such as babysitting, housekeeping, and nursery. 

Outside services such as daycare. The cost of sending a child to school if the child is below kindergarten, and payments to a relative for the care of a qualifying individual. Total child and dependent care expenses cannot exceed the taxpayer’s earned income. 

For married taxpayers, the income for this limitation is the smaller income of the two. Child and dependent care expenses are limited to $8,000 for one qualifying individual and $16,000 for two or more individuals, less excludable employer dependent care assistance program payments. 

The credit is equal to fifty percent of the child and dependent care expenses. This credit of fifty percent is reduced by one percent for each $2,000, or part thereof, by which AGI exceeds $125,000. The minimum credit is twenty percent. 

Therefore, taxpayers with AGI over $183,000, but no more than $400,000, will have a credit of twenty percent. 

The rate again, reduces by one percent, but not below zero percent for each $2,000, or part thereof, by which AGI exceeds $400,000. 

Taxpayers must provide each dependent’s taxpayer identification number to claim the credit, as well as the identifying number of the service provider. 

Taxpayers with qualifying children are entitled to the child tax credit of $3,600 per qualifying child under the age of six and $3,000 per qualifying child under the age of 18. 

Qualifying child is defined as:

1) A child, descendent, step-child, eligible foster child, sibling, or descendent of sibling, who is 

2) a US citizen for whom the taxpayer claims a dependency exemption, and 

3) who is less than 18 years old as of the close of the tax year. 

The credit is only allowed for tax years consisting of twelve months.

The phase-out begins when modified AGI equals $150,000 for married filing jointly, $112,500 for head of household, and $75,000 for single, married filing separately taxpayers. 

Taxpayers affected by the new phaseout rules can elect to claim the $2,000 credit under the prior rules until AGI reaches $400,000 for married filing jointly and $200,000 for all other taxpayers.

The credit is reduced by $50 for each $1,000 by which the taxpayer’s AGI exceeds the threshold. For certain individuals who get less than the full amount of the child tax credit, the additional child tax credit may result in a refund.

The credit is refundable up to fifteen percent of earned income in excess of $2,500. The refund is capped at the per child amount of $1,400. 

In general, the retirement savings contributions credit or saver’s credit may be claimed for an eligible contribution to an eligible retirement plan. 

Unlike most other tax topics allowing a credit or deduction, this nonrefundable credit is an addition to the exclusion or deduction from gross income. 

Rollover contributions are money that the taxpayer moved from another retirement plan or IRA are not eligible for the saver’s credit. 

Additionally, eligible contributions may be reduced by any recent distributions the taxpayer received from a retirement plan or IRA. 

An individual may be eligible for the nonrefundable credit for the elderly or disabled if he or she was aged 65 before the close of the tax year or retired before the close of the tax year due to a total and permanent disability.

The credit is equal to fifteen percent times an initial base amount, which is $5,000, $7,500 for married filing joint return with both spouses aged 65 or older, $3,750 for married filing separately, and limited to disability income if under age 65.

This initial base amount is reduced by tax exempt social security benefits, pension or annuity benefits excluded from gross income and one half the excess of AGI over $7,500, $10,000 for married filing jointly, $5,000 for married filing separately. 

A married person filing separately who lives with the spouse for any time during the year may not claim this credit. 

A nonrefundable adoption credit is allowed for qualified adoption expenses. An eligible child must be under 18 years of age or must be physically or mentally incapable of self-care. 

Qualified adoption expenses are reasonable and necessary expenses, including adoption fees, court costs, attorney fees, and other directly related expenses. 

Expenses that are not eligible for the adoption credit include:

1) Costs associated with the surrogate parenting arrangement, 

2) expenses incurred in violation of state or federal law, 

3) expenses incurred in connection with the adoption of the child of the taxpayer’s spouse, and

4)infant care supplies. 

The residential mortgage interest credit is allowed for taxpayers who use a mortgage credit certificate when privately financing the first purchase of a principal residence. 

This nonrefundable credit equals the interest paid during the year multiplied by the rate stated on the mortgage credit certificate. 

Any credit disallowed by the limit may be carried forward for three years. The credit taken reduces the mortgage interest deduction. 

A credit is allowed for alternative minimum tax paid in a tax year against regular tax liability in subsequent tax years. 

For individuals, the minimum tax credit or MTC amount is the alternative minimum tax that would have been computed if the only adjustments made to taxable income in computing alternative minimum taxable income were those for tax favored items that result in deferral as opposed to exclusion of income. 

To compute the MTC amount on form 8801, recompute the most recent year’s AMT without adjustment for the following exclusion items and add carryover MTC. 

The exclusion items are: 

1) The standard deduction, 

2) tax exempt interest on private activity bonds (except ones issued in 2009 or 2010), 

3) interest expense, 

4) depletion, and 

5) taxes. 

The MTC allowable is limited to current year gross regular tax, reduced by certain credits, minus current year tentative minimum tax. Any MTC amount beyond the current limit may be carried forward indefinitely. 

The earned income credit, or EIC, is refundable and is available to individuals who have earned income and gross income below certain thresholds. 

Earned income includes:

1) Wages, 

2) salaries, 

3) tips, and 

4) net earnings from self-employment. 

It does not include nontaxable compensation such as:

1) Military allowances, 

2) welfare benefits, 

3) veteran’s benefits, 

4) pensions, 

5) annuities, 

6) unemployment compensation, and 

7) scholarships. 

Disqualified income includes:

1) Interest, 

2) dividends, 

3) capital gain net income, 

4) positive passive income, and 

5) nonbusiness rents or royalties. 

The amount of disqualified income that causes a taxpayer to become ineligible for the EIC is $10,000. 

A $545 penalty is imposed for failure to comply with due diligence requirements when claiming the EIC. 

Individuals who improve the energy consumption of their residence may take the residential energy efficient property credit for installing qualified alternative energy property or the nonbusiness energy property credit for installing qualified energy efficient improvement property. 

Taxpayers who obtain health insurance through the health insurance marketplace may be eligible for the health insurance premium tax credit.

Generally, a taxpayer is eligible if all of the following criteria are met: 

1) He or she purchased the insurance through the marketplace, 

2) Is ineligible for coverage through employer or government plan, and 

3) Has the filing status other than married filing separately (with the exception for victims of domestic abuse or spousal abandonment) and 

4) Is not claimed as the dependent of another taxpayer.

Q: What are estimated payments of income tax?

A: The internal revenue code is structured to obtain at least 90 percent of the final income tax through withholding and estimated tax payments. 

Individuals who earn income not subject to withholding must pay estimated tax on that income in quarterly installments. 

Dates are adjusted for weekends and holidays. Underpayment of the fourth installment does not result in penalty if on or before January 31st of the following tax year an individual both files a return and pays the amount computed payable on that return. 

Each of the following is treated as payment of estimated tax: 

1) The election to apply an overpayment of tax in a prior tax year, which has not been refunded, to the following year’s tax return. 

2) The amount of federal income tax withheld by an employer from wages, direct payment by the individual, and 

3) Excess FICA withheld when an employee has two or more employers during a tax year who withheld, in the aggregate, more than the ceiling on FICA taxes. 

Each quarterly installment must be twenty-five percent of the least of the following amounts: 

1) 100 percent of the prior year’s tax, 

2) 90 percent of the current year’s tax, or 

3) 90 percent of the annualized current year’s tax. 

Taxpayers whose prior year tax returns showed AGI in excess of $150,000, $75,000 for married filing separately, must apply the safe harbor rule. 

This rule requires the taxpayer to make estimated payments of the lesser of 110 percent of the prior tax liability or 90 percent of the current tax liability. 

A taxpayer is not required to make a payment until the first period in which there is income. Tax refers to the sum of the regular tax, AMT, self-employment tax, and household employee tax. 

A penalty is imposed if by the quarterly payment date, the total of estimated tax payments and income tax withheld is less than twenty-five percent of the required minimum payment for the year. 

The penalty will not be imposed if any of the following apply: 

1) Actual tax liability shown on the return for the tax year, after the reduction for amounts withheld by employers, is less than $1,000, 

2) no tax liability was incurred in the prior tax year, or 

3) the IRS waives it for reasonable cause shown. 

Farmers or fishermen who expect to receive at least two-thirds of their gross income from farming or fishing activities, or did in the prior tax year, may pay estimated tax in one installment. 

An employer must deduct and withhold social security tax on an employee’s first $142,800 of wages. 

The withholding rate is 6.2 percent. When the maximum withholding is exceeded due to the correct withholding of two or more employers, the excess may be obtained only by claiming a credit for the amount. The credit is computed separately for each spouse on a joint return. 

When an employer incorrectly withholds social security taxes on more than the maximum amount, a credit may not be claimed for the excess. The employer should refund the overcollection to the employee. 

Taxpayers have a limited amount of time in which to file a claim for a credit or refund. A claim for refund is filed on form 1040X with the internal revenue service center where the original return was filed. 

A separate form is filed for each year or period involved. An explanation must be included of each item of income, credit, or deduction on which the income item is based. 

Generally, taxpayers must file a claim for credit or refund within three years from the date the original return was due or two years from the year in which the tax was paid, whichever is later.

Q: Why should I care about the basis of my property?

A: The concept of basis is important in federal income taxation. Generally, basis is the measurement of a taxpayer’s investment in property, which the taxpayer is entitled to have returned without tax consequences. 

A property’s basis is generally used determining the gain or loss associated with the property. 

The basis of an asset is generally its cost, but it may be adjusted over the course of time due to various events. 

The basis of property must be increased by capital expenditures and decreased by capital returns. 

Increases in basis have the effect of reducing the amount of gain realized or increasing the amount of realized loss. 

Decreases in basis have the effect of increasing the amount of realized gain or decreasing the amount of loss.

Q: What is cost basis?

A: When a taxpayer acquires property, his or her basis in the property is initially one of five bases: 

1) Cost, 

2) substituted, 

3) transferred, 

4) exchanged, or 

5) converted basis. 

Cost basis is the sum of capitalized acquisition costs. Substituted basis is computed by reference to basis in the other property. 

Transferred basis is computed by reference to basis in the same property in the hands of another.

Exchanged basis is computed by reference to basis in other property previously held by the person. Converted basis is when personal use property is converted to business use. 

The basis of the property is the lower of its basis or the fair market value on the date of conversion. Initial basis in purchased property is the cost of acquiring it. 

Only capital costs are included, that is those for acquisition, title acquisition, and major improvements. 

Common capitalized costs include:

1) Brokerage commissions, 

2) pre-purchased taxes, 

3) sales tax on purchase, 

4) title transfer taxes, 

5) title insurance, 

6) recording fees, 

7) attorney fees, 

8) document review and preparation, 

9) appraisal fees, 

10) freight, 

11) installation, 

12) testing, 

13) new roof, 

14) new gutters, 

15) extending water line to property, and 

16) demolition costs and losses. 

Costs of maintaining and operating property are not added to basis, for instance interest on credit related to the property, insurance, and ordinary maintenance or repairs. 

Costs for construction of real or tangible personal property to be used in trade or business are capitalized. 

All costs necessary to prepare the property for its intended use are capitalized, including both direct and most allocable indirect costs.
For example, permits, materials, equipment rent, compensation for services and architect fees. 

Construction period interest and taxes must be capitalized as part of building costs. Cost basis includes the fair market value of property given up.

If it is not determinable with reasonable certainty, use fair market value of property received.

Capital acquisition expenditures may be made by cash, by cash equivalent, in property, by liability, or by services. 

A rebate to the purchaser is treated as a reduction of the purchase price. It is not included in basis or in gross income. 

Uniform capitalization rules do not apply if property is acquired for resale and the company’s annual gross receipts do not exceed $26 million for the past three years. 

Acquisition basis is increased for notes to the seller and for liabilities to which the acquired property is subject. 

The fair market value of property received in exchange for services is income to the provider when it is not subject to a substantial risk of forfeiture and not restricted as to transfer. 

The property acquired has a tax cost basis equal to the fair market value of the property. Sale of restricted stock to an employee is treated as gross income to the extent any price paid is less than the stock’s fair market value. 

While restricted, the basis is any price paid other than by services. 

Upon lapse of the restriction, the recipient has ordinary gross income in the amount of the spread between fair market value on that date and any amounts otherwise paid. Basis is increased by that same amount. 

The transferee may elect to include the fair market value, minus the cost spread in gross income, when the stock is purchased. 

Basis includes price spread, but no subsequent deduction is allowed if the stock is forfeited by operation of the restriction. 

When more than one asset is purchased for a lump sum, the basis of each is computed based on the relative fair market value of each asset. 

Alternatively, the transferor and the transferee may agree in writing as to the allocation of fair market value. 

The agreement is binding on the parties, unless the IRS deems it as improper, then the residual method may be applied. 

To compute gain realized on the sale of stock, specific identification of the stock sold is used if possible, otherwise FIFO is assumed. 

Costs and losses associated with demolishing a structure are allocated to the land. 

The costs include the remaining basis of the structure, not its fair market value, and demolition costs.

Q: What is property received by gift?

A: The donee’s basis in property acquired by gift is the donor’s basis, increased for any gift tax paid attributable to appreciation. 

The donor’s basis is increased by the gift tax paid times a ratio of the fair market value at the time of the gift, less the donor’s basis, divided by the difference between the fair market value at the time of the gift and the annual exclusion. 

If the fair market value at the time of the gift is less than the donor’s basis, the donee has a dual basis for the property, which minimizes the gain or loss recognized on a subsequent transfer. 

If the property is later transferred at a loss, the basis used is the fair market value at the date of the gift. 

If the property is later transferred at a gain, the donor’s basis is used. If the property is later transferred for more than fair market value at the date of the gift, but for less than the donor’s basis at the date of the gift, no gain or loss is recognized. 

If gift property is immediately used as business property, the basis for depreciation is the donor’s adjusted basis. 

If gift property is later converted from personal to business use, the adjusted basis is the lower of a transferor’s adjusted basis or the fair market value on the date of conversion.

Q: What is property received for services?

A: All compensation for personal services is considered gross income. The form of payment is irrelevant. 

If property is received for services, gross income is the fair market value of the property received, minus any cash or other property given. 

Basis in property received is the amount included in income, plus any cash or other property given. 

Gross income includes any amount paid by an employer for a liability, including taxes, or an expense of the employee.

Q: What is inherited property?

A: Basis is the fair market value on the date of death. However, if the executor elects the alternate valuation date for the estate tax return, the basis of the assets is the fair market value six months after the decedent’s death. 

If the executor elects the alternate valuation date, but sells or distributes the assets within the first six months after death, the basis equals fair market value on the sale or distribution date. 

The fair market basis rule also applies to the following property: 

1) One half of community property interests, 

2) Property acquired by form of ownership, such as by right of survivorship, and 

3) Property received prior to death, without full and adequate consideration, if a life estate was retained in it or subject to a right of revocation. 

The fair market value rule does not apply to income in respect to a decedent, or to appreciated property given to the decedent within one year of death. 

A shareholder must report his or her ratable share of any income, that is income in respect to a decedent, as if he or she had received it directly from the decedent. 

For example, the shareholder’s basis in the inherited S corporation stock is its fair market value on the date of death, reduced by the ratable share of any income from the stock.

Q: What are stock dividends?

A: A corporation recognizes no gain or loss on transactions involving its own stock and a proportionate distribution of stock issued by the corporation is generally not gross income to the shareholders. 

A shareholder allocates the aggregate adjusted basis in the old stock to the old and new stock in proportion to the fair market value of the old and new stock.

Basis is apportioned by relative fair market value to different classes of stock if applicable. 

The holding period of the distributed stock includes that of the old stock. Earnings and profits are not altered for a tax-free stock dividend. 

A distribution of stock rights is treated as a distribution of the stock. Basis is allocated based on the fair market value of the rights. 

Basis in the stock rights is zero, if their aggregate fair market value is less than fifteen percent of the fair market value of the stock on which they were distributed, unless the shareholder elects to allocate. 

Basis in the stock, if the right is exercised, is any basis allocated to the right, plus the exercise price. 

The holding period of the stock begins on the exercise date. No deduction is allowed for basis allocated to stock rights that lapse. 

Basis otherwise allocated remains in the underlying stock. Distributions of stock are subject to tax. 

The amount of a distribution subject to tax is the fair market value of distributed stock or stock rights. 

If a shareholder has the option to choose between a distribution of stock and a distribution of other property, the amount of the distribution is the greater of the fair market value of stock or the cash or fair market value of other property. 

When convertible preferred stock is distributed, the effect is to change the shareholder’s proportionate stock ownership. 

Constructive stock distributions also change proportionate interests. Earnings and profits are reduced by the fair market value of the stock and property distributed. 

Basis in the underlying stock does not change. Basis in the new stock or stock rights is the fair market value. 

The holding period for the new stock begins on the day after the distribution date. A stock split is not a taxable distribution. 

The basis of the old stock is divided by the number of new shares. The holding period of the new stock includes that of the old stock.

Q: What are adjustments to asset basis?

A: Initial basis is adjusted for tax relevant events. Certain expenditures subsequent to acquisition are property costs and they increase basis. An example is legal fees to defend title or title insurance premiums. 

Basis must be increased for expenditures that substantially prolong the life of the property by at least one year or materially increase its value, such as a new roof or zoning changes. 

An increase to basis may result from a liability to the extent it is secured to real property and applied to extend its life. 

Depreciation taken on business property will decrease the basis. The base for MACRS depreciation is the cost. 

All assets depreciated under the general depreciation system under MACRS must be included in a class of depreciation, such as five, seven, or twenty year property. 

Basis must be reduced by the larger of the amount of depreciation allowed or allowable, even if not claimed. 

Section 179 expense is treated as a depreciation deduction. A shareholder does not recognize gain on the voluntary contribution of capital to a corporation. 

The shareholder’s stock basis is increased by the basis in the contributed property. The corporation has a transferred basis in the property. 

Distributions out of earnings and profits are taxable as dividends. Dividends are taxable and therefore do not reduce basis. 

When a corporation makes a distribution that is not out of earnings and profits, it is a nontaxable return of capital until basis is reduced to zero. Distributions in excess of basis are treated as capital gain. 

The basis of stock acquired in a nontaxable distribution, such as stock rights, is allocated a portion of the basis of the stock upon which the distribution was made. 

The basis is allocated in proportion to the fair market value of the original stock and the distribution as of the date of distribution. 

If the fair market value of the stock rights is less than fifteen percent of the fair market value of the stock upon which it is issued, the rights have a zero basis. 

Basis adjustment is required for certain specific items that represent a tax benefit, namely, casualty losses, discharge of indebtedness, and credit on asset purchases. 

When property is partially disposed of, the basis of the whole property must be equitably apportioned among the parts. 

Relative fair market value is generally used. When personal use property is converted into business use, the basis for depreciation is the lesser of the fair market value of the property at the conversion date or the adjusted basis at conversion.

Generally, lessors do not report income when a lessee makes leasehold improvements, or when the leasehold improvements revert to the lessor at the termination of the lease. Thus, the lessor has a zero basis in the leasehold improvements.

Q: What is a holding period?

A: The holding period of an asset is measured in calendar months, beginning on the date after acquisition and including the disposal date. The holding period may include that of the transferor. 

If the property is held for one year or less, it is considered short-term, if it is held for more than one year, it is long-term.

Q: What are capital gains and losses?

A: A capital gain or loss is realized on the sale or exchange of a capital asset. All property is characterized as a capital asset, unless expressly excluded. 

The following types of property are not capital assets: 

1) Inventory (not including property held primarily for sale to customers in the ordinary course of a trade or business), 

2) real or depreciable property used in a trade or business, 

3) accounts or notes receivable acquired in the course of ordinary trade or business for services rendered, 

4) copyrights and artistic compositions held by the person who composed them, and 

5) certain US government publications acquired at reduced cost. 

Property held either for personal use or for the production of income is a capital asset, but dealer property is not. 

Examples of capital assets are:

1) Personal homes, 

2) furnishings, 

3) automobiles, 

4) stocks, 

5) bonds, 

6) commodities, 

7) partnership interests, 

8) land, 

9) internally generated goodwill, 

10) contract rights, 

11) patents, 

12) trade secrets, and 

13) collectibles. 

Goodwill is a capital asset when generated within the business, however goodwill acquired with the purchase or trade of a business is an amortizable, intangible asset.

This ability to amortize characterizes acquired goodwill as a section 1231 asset rather than a capital asset. 

An option is treated the same as the underlying property. Stocks, bonds, commodities and the like are capital assets unless they are dealer property. 

A dealer holds an asset primarily for sale to customers in the ordinary course of his or her trade or business. 

But a dealer may identify particular assets as held for investment, by the close of the business day of acquisition. Such assets are capital. 

Land held primarily for investment, which is then subdivided, may be treated as converted to property held for sale in a trade or business. 

But mere subdivision for sale or land held by other than a C corporation does not establish that it is held for sale in a trade or business. 

The subdivided land is treated as a capital asset if particular conditions are satisfied. For example, if no substantial improvements have been made to the land while held by the person. 

Generally, under section 1001 all gains on the sale or exchange of property are realized. 

This includes sales or exchanges that are required in characterizing a realized gain or loss as capital. A sale is a transfer of property in exchange for money or a promise to pay money. 

While an exchange is a transfer of property in return for other property or services. For real property, a sale or exchange occurs on the earlier of the date of conveyance, or the date that the burdens of ownership pass to the buyer. 

Also, liquidating distributions and losses on worthless securities are treated as sales or exchanges. 

All realized gains must be recognized unless the code expressly provides otherwise. Conversely, no deduction is allowed for a realized loss unless the code expressly provides for it. 

For individuals, net capital gain is the excess of net long-term capital gain over net short-term capital loss. Net short-term capital gain is not included in net capital gain. 

Net short-term capital gain is treated as ordinary income for individuals. Net capital gain rates do not apply to net short-term capital gains. 

For individuals, net short-term capital gain is taxed as ordinary income, and capital transactions involving long-term holding periods, assets held for over twelve months, are grouped by tax rates. 

The maximum capital gains rates, referred to as baskets, are zero percent, fifteen percent, twenty percent, twenty five percent, or twenty eight percent. The thresholds for the application of the capital gains rates are adjusted for inflation. 

The capital gains rate is twenty five percent on unrecaptured section 1250 gains. The capital gains rate is twenty eight percent on gains and losses from the sale of collectibles and gains from section 1202 stock. 

After gains and losses are classified in the appropriate baskets, losses for each long-term basket are first used to offset any gains from within that basket. 

If a long-term basket has a net loss, the loss will be used first to offset net gain for the highest long-term rate basket, then to offset the next highest rate basket and so on. 

A carryover of a net long-term capital loss from a prior year is used first to offset any net gain in the twenty eight percent basket. 

Then, to offset any net gain in the twenty five percent basket. Finally, to offset any net gain in the fifteen percent basket. 

Likewise, net short-term capital loss is also used first to offset net gain for the highest long-term basket and so on. 

For corporations, all capital gains, short or long-term, are taxed at the corporation’s regular tax rate. 

An individual may offset a net capital loss with net capital gains. If the individual does not have net capital gains, he or she recognizes a net capital loss in the current year.

That amount is up to the lessor of $3,000, $1,500 for married filing separately, or ordinary income. An individual may carry forward any excess net capital losses indefinitely. 

The carry forward is treated as a capital loss incurred in the subsequent year. Net capital loss is treated as having been deductible in the preceding year, before net long-term capital loss. 

There can be no carryover from a decedent to his or her estate. A corporation may use capital losses only to offset capital gains each year. 

A corporation must carry the excess capital loss back three years and forward three years, and characterize all carryovers as short-term capital losses, regardless of character. 

Capital gains and/or losses on the sale or disposition of capital assets are computed on schedule D of form 1040. 

The individual transactions are first listed on form 8949 before being summarized on the schedule D. 

Under certain conditions, individuals may be able to report capital gain distributions directly on schedule one of form 1040. 

Liabilities discharged in bankruptcy are treated as a short-term loss on schedule D to a creditor who is an individual. The loss is short-term regardless of how long the debt was in the hands of the creditor.

Q: What are capital gains on sales of stock?

A: Gains and losses from the disposition of securities are generally determined and taxed like gains and losses from the disposition of other property. Securities held by investors are capital assets. 

A return of capital distribution reduces basis and becomes a capital gain when a shareholder’s basis in the stock reaches zero. 

Undistributed capital gains earned in a mutual fund are taxed as capital gains in the current period. A credit is allowed by any tax paid by the mutual fund on behalf of the taxpayer. 

Generally, positions in regulated futures contracts, foreign currency contracts, non equity options and dealer equity options in an exchange using the mark to market system are treated as if they were sold on the last day of the year. 

Any capital gains and losses arising under this rule are treated as if they were sixty percent long-term and forty percent short-term, without regard to the holding period.

Q: What are Sections 1202 and 1244 stock?

A: Taxpayers may exclude fifty percent of the gain from the sale or exchange of qualified small business stock, or QSB stock. 

The stock must have been issued after Aug. 10, 1993, and held for more than five years. 

For section 1202 stock acquired after Feb. 17, 2009 and before Sept. 28, 2010, the exclusion is seventy five percent. 

For section 1202 stock acquired after Sept. 27, 2010, the exclusion increases to one hundred percent. QSB stock must be that of a domestic C corporation with aggregate gross assets not exceeding $50 million. 

The corporation must have at least eighty percent by value of its assets used in the active conduct of a qualified business.

That includes any business other than one of the following: 

1) The performance of personal services, such as banking, financing, and leasing, 

2) any farming business, 

3) any extractive industry, and 

4) hospitality businesses. 

The aggregate annual gain for which a taxpayer may qualify under section 1202 is limited to the greater of $10 million or ten times the adjusted tax basis of qualified stock disposed of by the taxpayer during the year. 

Section 1202 stock qualifying for the fifty percent or seventy five percent exclusions is taxed at the twenty eight percent rate. 

An alternative minimum tax preference is equal to seven percent of the excluded gain. 

Since this is an exclusion preference, no minimum tax preference is allowed. For stock acquired after Sept. 27, 2010, there is no alternative minimum tax preference. 

Individuals are allowed to roll over capital gains from the sale of section 1202 stock if other small business stock is purchased within sixty days after the date of sale. 

The small business stock must have been held for more than six months. The normal rules of nontaxable exchange apply to the gain being deferred, the basis of the small business stock acquired and the holding period for the acquired stock. 

Qualified small business stock held through passthrough entities qualifies for the rollover rules.

If a person has more than one sale of QSB stock in a tax year that qualifies for the rollover election, the person may make the rollover election for one or more of those sales. 

An individual may deduct as an ordinary loss, a loss from the sale or exchange, or from the worthlessness of small business stock, that is section 1244 stock, issued by a qualifying small business corporation. 

A corporation qualifies if the amount of money and other property it receives as a contribution to capital does not exceed $1 million. This determination is to be made at the time the stock is issued. 

The shareholder must be the original owner of the stock. The maximum amount deductible as an ordinary loss in any year is $50,000, $100,000 on a joint return. 

If a taxpayer makes capital investments in the corporation without receiving stock, the loss must be allocated between the investments when stock was received and investments when stock was not received. Losses from investments without receiving stock are not eligible for section 1244. 

Q: What are related parties, business property, and installment sales?

A: Special rules prevent taxpayers from receiving unwarranted tax benefits. Losses on sales to related parties are disallowed, except for sales in corporate liquidation rules. Depreciation is recaptured on the sale of business property.

In order to prevent taxpayers from taking depreciation deductions, and then receiving capital gain treatment when the property is sold, when payments are received after the year of sale, gain recognition is deferred for each payment until the payment’s corresponding tax year.

Q: What are related party sales?

A: These rules limit tax avoidance between related parties. Gain recognized on an asset transferred to a related person, in whose hands the asset is depreciable, is ordinary income. 

Loss realized on a sale or exchange of property to a related person is not recognized. 

The transferee takes a cost basis, there is no adding of holding periods. Gain realized on a subsequent sale to an unrelated party is recognized only to the extent it exceeds the previously disallowed loss. 

Loss realized on a subsequent sale to a third party is recognized. But the previously disallowed loss is not added to it. 

For property purchased on or after Jan. 1, 2016 and later sold to an unrelated party, a new rule precludes the recognition of the disallowed loss if the original transferor is a tax indifferent party. Tax indifferent parties are those not subject to federal income tax. 

Examples of tax indifferent parties include non US persons, tax exempt organizations, and government entities. 

Related parties generally include: 

1) Ancestors, 

2) lineal descendents, 

3) spouses and siblings, 

4) trusts and beneficiaries, and 

4) controlled entities, that is fifty percent ownership (constructive ownership rules between family members apply). 

Loss on a sale or exchange of property between a partnership and a person owning more than fifty percent of the capital or profit interest in the partnership is not recognized.

An employee is not a related party to the employer for purposes of the related party sale rules. 

However, when an employer sells assets to an employee at less than fair market value, the difference between fair market value and the sales price is considered compensation to the employee. 

Since the employee pays tax on the compensation, his or her basis in the new property will be fair market value. 

No gain or loss is recognized on the transfer of property between spouses, or incident to a divorce, on transfer of property to a former spouse. 

The transferee takes a carryover basis in the property. These rules apply whether the transfer is a gift, a sale, or an exchange.

Q: What is business property?

A: Sections 1231, 1245, and 1250 recharacterize gain or loss. Sections 1245 and 1250 also accelerate recognition of certain installment gain that would otherwise be deferred. We will discuss each type of property in turn. 

Section 1245 property, generally, is depreciable personal property. It is tangible or intangible, depreciable or amortizable personal property, such as equipment or patent. 

Recovery property, including specified real property and tax benefit property, such as qualified section 179 expense property. 

Other tangible property, excluding a building or its structural components, includes property used in a trade or business, for instance, manufacturing or production equipment. 

Intangible, amortizable personal section 1245 property examples include:

1) Leaseholds of section 1245 property, 

2) professional athletic contracts such as in major league baseball, patents, livestock, and 

3) good will acquired in connection with the acquisition of a trade or business. 

A realized gain on the disposition of section 1245 property is ordinary income to the extent of depreciation or amortization taken. Amounts expensed under section 179 are considered depreciation deductions. 

Depreciation deductions may be taken for the taxable year the business property is placed in service. 

The property is considered placed in service when it is ready and available for a specific use. 

Also, the downward basis adjustment for a general business credit is considered a deduction allowed for depreciation and is subject to recapture. 

The realized gain in excess of depreciation taken may be treated as a gain from the sale or exchange of section 1231 property. 

Section 1250 property is all depreciable real property that is not section 1245 property, such as a building or its structural components. Subject 1250 property is subject to its own recapture rules. 

For the three items described here, the aggregate gain recognized on the sale or disposition of section 1250 property is ordinary income: 

1) The excess of accelerated depreciation taken over straight line depreciation is ordinary income, 

2) For corporations, the gain must be computed under both section 1245 and section 1250 (If a section 1245 gain is larger than section 1250 gain, then twenty percent of the difference is characterized as ordinary income), and 

3) For property held one year or less, any depreciation recaptured is ordinary income. 

For example, Mary purchases a building for $1 million. She takes $600,000 of depreciation. 

Straight line depreciation would have been $450,000. She sells the building for $1.2 million. Mary has a gain on the sale of the building of $800,000. 

The excess of accelerated depreciation over straight line depreciation of $150,000 is recaptured as ordinary income. 

The remaining unrecaptured depreciation of $450,000 is taxed at a maximum capital gains rate of twenty-five percent. 

The remaining gain of $200,000 is treated as a section 1231 gain. Section 1250 property includes depreciable real property not listed in section 1245 that is: 

1) Acquired prior to 1981 or after 1986, or 

2) Acquired during 1981 through 1986 

AND

1) Is either residential property, or 

2) property depreciated using the straight line method. 

Recapture as ordinary income of post 1986 residential rental property and nonresidential real property is not required because straight-line depreciation must be used. 

Examples of section 1250 property include: 

1) Shopping malls, 

2) an apartment or office building,

3) low-income housing, 

4) rented portions of residences, and 

5) escalators or elevators. 

Income received or accrued for more than one asset is allocated to each asset by agreement by fair market value or by the residual method. 

To compute section 1245 and 1250 ordinary income, an amount realized allocable to an asset must be further allocated each tax year for an asset that has both business and personal uses. 

Apportionment is on the basis of relative time or amount of asset usage. For example, five percent of automobile usage for business, or one half of a house used as rental property. 

All gain realized from a disposal of recapture property in an installment sale is characterized as ordinary income by section 1245 or section 1250 and must be recognized in the period of sale. 

Excess gain over section 1245 or section 1250 ordinary income is accounted for using the installment method. Neither section 1245 nor section 1250 applies to a gift disposition.
Any gain realized by the donee upon a subsequent taxable disposition is subject to section 1245 and section 1250 characterization, up to the sum of any potential section 1245 and section 1250 ordinary income at the time of the gift.

Furthermore, any section 1245 and section 1250 ordinary income potential arising between gift and subsequent disposition. 

Neither section 1245 nor section 1250 applies to a disposition by bequest, devise, or intestate succession. 

Except that section 1245 and section 1250 ordinary income is recognized to a transfer at death to the extent to any income in respect to a decedent.

In addition, section 1245 ordinary income results from depreciation allowed to a decedent, because the depreciation does not carry over to the transferee.

In a section 351 trade for stock, there is generally no gain recognized upon an exchange of property for all the stock of a newly formed corporation. 

Section 1245 and section 1250 ordinary income is limited to any amount of gain recognized in a section 351 transaction. 

Unlike the recapture provisions in sections 1245 and 1250, section 1231 is beneficial to the taxpayer. 

When section 1231 property gains exceed losses, each gain or loss is treated as being from the sale or loss of a long-term capital asset. 

However, if section 1231 property losses exceed gains, each gain or loss is considered ordinary. 

Section 1231 property is property held for more than one year, and includes: 

1) All real or depreciable property used in a trade or business, or

2) Involuntarily converted capital assets held in connection with a trade or business or in a transaction entered into for profit. 

Examples of section 1231 property include apartment buildings, parking lots, manufacturing equipment, and involuntarily converted investment artwork. 

Examples that are not section 1231 property include personal use property and inventory. 

Section 1231 has a two step test: 

1) Determine the net gain or loss from all casualties or thefts of section 1231 property for the tax year. 

Gain or loss from involuntary conversions by other than casualty or theft is included in step two, not step one. 

If the result is a net loss, each gain or loss is treated as ordinary income or loss. 

If the result is a net gain, each gain or loss is included in step two: 

2) Determine the net gain or loss from all dispositions from section 1231 property for the year, including the property included in step one, only if step one resulted in a net gain. If the result is a net loss, each gain or loss is treated as ordinary income or loss. 

If the result is a net gain, each gain or loss is treated as a long-term capital gain or loss, subject to the recapture rules. 

Allocation is required when section 1245 or section 1250 property is also section 1231 property. And only a portion of gain recognized is section 1245 or section 1250 ordinary income. 

The net gain on section 1231 property is treated as ordinary income to the extent of unrecaptured net section 1231 losses from preceding tax years. 

Unrecaptured net section 1231 losses are the total of net section 1231 losses for the last five tax years reduced by net section 1231 gains, characterized as ordinary income. 

Section 1245 and 1250 recapture is computed before section 1231 recapture. But section 1231 recapture is computed before steps one and two. Section 1231 merely characterizes a gain or loss. 

Any section 1231 gain that is recharacterized as capital gain will first consist of twenty-eight percent gain, then twenty-five percent gain, and finally, fifteen or twenty percent gain.

Q: What are installment sales?

A: The installment method must be used to report installment sales, unless the election is made to not apply the method. 

An installment sale is a disposition of property in which at least one payment is to be received after the close of the tax year in which the sale occurs. 

Installment sales do not apply to:

1) Dispositions of inventory personal property sales, 

2) revolving credit personal property sales, 

3) dealer dispositions, 

3) including dispositions of personal property or real property, 

4) securities (generally, if publicly traded), or 

5) sales on agreement to establish an irrevocable escrow account. 

Not excluded from installment sale deferral are certain sales of residential lots or timeshares subject to interest on the deferred tax, and property used or produced in a farming business. 

The amount of realized gain to be recognized in a tax year is based on the amount of payments received in the current year.

The gross profit percentage is the ratio of the gross profit to the total contract price. The gross profit is the sales price reduced by any selling expenses, including debt cancellation and adjusted basis. 

When the selling price is reduced in a future year, the gross profit on the sale will also be reduced. 

Therefore, the gross profit percentage must be recalculated for the remaining periods by using the reduced sales price and subtracting the gross profit already recognized. Gross profit includes the unrecognized gain on sale of a personal residence. 

The sales price is the sum of any cash received, liability relief, and installment notes from the buyer. It does not include imputed interest. 

The total contract price is the amount that will be collected. The character of the gain recognized depends on the nature of the property in the transferor’s hands. 

The full amount of section 1245 and section 1250 ordinary gain, that is the depreciation recapture, must be recognized in the year of sale even if it exceeds payments received. The gain is added to basis before further applying the installment method. 

An anti-avoidance rule applies to an installment sale of property to a related party. On a second disposition by the related party transferee of the first sale payments received must be treated as a payment received by the person who made the first installment sale to a related party. 

A second disposition by gift is included. The fair market value is treated as the payment. Death of the first disposition seller or buyer does not accelerate recognition. 

The seller of personal property recognizes as gain or loss any difference between the fair market value of repossessed property and the adjusted basis of an installment sale satisfied by the repossession. 

If real property, the taxpayer recognizes the lesser of cash and other property received in excess of gain already recognized or gross profit in remaining installments less repossession costs. 

Interest is imposed on deferred tax on receivables from non dealer installments sales of more than $150,000 outstanding at the close of the tax year. 

This interest is applied if the taxpayer has nondealer installment receivables of over $5 million over the tax year from installment sales of over $150,000 that occurred during the year. 

Excess of the fair market value over the adjusted basis of an installment obligation is generally recognized as income if it is transferred. 

Fair market value is generally the amount realized. If a gift, the face value of the obligation is used. The character of the disposition is the same as if the installment obligation was sold. 

A disposition of the installment obligation is deemed to occur when the obligation is transferred by gift, is forgiven, or becomes unenforceable. 

Disposition of obligations by the following events can result in the transferee treating payments as the transferor would: 

1) Transfers to a controlled corporation, 

2) Corporate reorganizations and liquidations, 

3) Contributions to capital of or distributions from partnerships, 

4) Transfer between spouses incident to divorce, and 

5) Transfer upon death of the obligee.

Q: What are nonrecognition property transactions?

A: Generally, a taxpayer recognizes a gain on an exchange of property when the fair market value of the property received is greater than the adjusted basis of the property given up. Situations occur in which there may be nonrecognition of the gain or loss. 

This nonrecognition can be temporary, as in the deferral of gain in a like-kind exchange of real property, or it can be permanent, as in the exclusion of the gain on the sale of a principal residence.

Q: Is there an exclusion on income from the sale of a principal residence?

A: Section 121 provides an exclusion upon the sale of a principal residence. No loss may be recognized on the sale of a personal residence.
The exclusion is available if the individual owned and occupied the residence for an aggregate of at least two of the five years before the sale. 

Nonqualified use after 2008 requires the gain to be reduced for the period of nonqualified use. 

The exclusion may be used only once every two years. A taxpayer may exclude up to $250,000 of realized gain on the sale of a principal residence. 

The exclusion is increased to $500,000 for married individuals filing jointly if: 

1) Either spouse meets the ownership test, 

2) both spouses meet the use test, and 

3) neither spouse is ineligible for the exclusion due to a sale or exchange of the residence within the last two years. 

A surviving spouse can qualify for the $500,000 exclusion If the residence is sold within two years of the other spouse’s death. The exclusion is determined on an individual basis.

Therefore, for married couples who do not share a principal residence, but file joint returns, a $250,000 exclusion is available for a qualifying sale or exchange of each spouse’s principal residence. 

If a single individual eligible for the exclusion marries a person who used the exclusion within two years before marriage, the individual is entitled to a $250,000 exclusion. 

Even though the individual’s spouse used the exclusion within the past two years, an individual may not be prevented from claiming the $250,000 exclusion. 

If a residence is transferred to a taxpayer incident to a divorce, the time during which the taxpayer’s spouse or former spouse owned the residence is added to the taxpayer’s period of ownership. 

Also, a taxpayer who owns a residence is deemed to use it as a principal residence while the taxpayer’s spouse or former spouse is given use of the residence under the terms of a divorce or separation. 

A widowed taxpayer’s period of ownership of residence includes the period during which the taxpayer’s deceased spouse owned the residence. 

If an individual becomes physically or mentally incapable of self-care, the individual is deemed to use a residence as a principal residence during the time in which the individual owns the residence and resides in a licensed care facility. 

In order for this rule to apply, the individual must have owned and used the residence for at least one year during the five years preceding the sale or exchange. 

The exclusion amount may be prorated if the use, ownership, or prior sale tests are not met. The prorated exclusion is the total exclusion multiplied by the ratio of the number of months used divided by twenty four months. 

However, the prorated exclusion is allowed only if the sale is due to a change in place of employment, health, or unforeseen circumstances. The exclusion on the sale must be prorated between qualified and nonqualified use. 

Nonqualified use includes periods that the residence was not used as the principal residence of the taxpayer, and does not include use before 2009. Section 121 excludes realized gain on the sale of a principal residence only. 

Therefore, gain may need to be recognized on the portion of the property that is not considered a personal residence. 

For example, use of a guest facility as rental property. The portion of the principal residence that is business use property, for example a home office for the taxpayer’s business, may not qualify for gain exclusion. 

If the business use property is within your home, the part of any gain equal to any depreciation allowed or allowable, after May 6, 1997, is included in income. 

If the business use property is a separate party of the property, any gain associated with it is not eligible for the principal residence exclusion and must be reported on form 4797. 

Realized gain may qualify for exclusion even if the entire property is used as rental property or business use property at the time of sale. 

For example, the entire property is subject to gain exclusion as long as the individual owned and occupied the entire residence as a principal evidence for at least two of the five years before the sale. 

Deductions, other than depreciation, that relate solely to the rental or business use portion of the property, such utilities and insurance, do not reduce the basis of the principal residence portion. 

Any selling expenses incurred in selling the personal residence reduce the amount realized by the seller. Any gain equal to depreciation allowed or allowable may not be excluded. 

Any capital improvements made to the personal residence are added to the adjusted basis of the house. Basis in a purchased home is its cost. 

If the residence was acquired in a section 1031 like-kind exchange in which any gain was not recognized in the prior five years, then the section 121 exclusion for gain on sale or exchange of a principal residence does not apply. 

If the amount of the realized gain is less than the maximum exclusion amount, the gain need not be reported on the individual’s income tax return.

Q: What are like-kind exchanges?

A: Section 1031 defers the recognition of gain or loss to the extent that real property productively used in a trade or business, or held for income, is exchanged for property of like-kind. 

Realized gain or loss is the gain or loss from the sale or exchange. Recognized gain or loss is the amount reported on the tax return. 

Only real property qualifies for like-kind treatment for transfers after 2017. Like-kind real property is alike in nature or character, but not necessarily in grade or quality. 

Properties are like-kind if each is within a class of like nature and character, without regard to differences in use. 

For example business or investment. Improvements, for example bare land or house. Location, for example city or rural, or proximity. 

Real property located within the United States is like-kind with all other real property in the US. Foreign real estate is like-kind with other foreign real estate. 

US real estate and foreign real estate are not like-kind. Boot is all non-qualified property transferred in an exchange transaction. 

Gain recognized is the lesser of gain realized or boot received. Boot received includes cash, liability relief, and other nonqualified property at fair market value. 

Liabilities are treated as money paid or received. If each party assumes a liability of another, only the net liability given or received is treated as boot. 

Liabilities include mortgages on property. Qualified property received in a like-kind exchange has an exchanged basis adjusted for boot and gain recognized. 

If a qualified property is exchanged, loss realized with respect to qualified property is not recognized, but loss on boot given may be recognized. 

In a qualified exchange accommodation agreement, the property given up, or the replacement property, is transferred to a qualified intermediary, also referred to as an exchange accommodation titleholder or facilitator. 

The qualified intermediary is considered the beneficial owner of the property. This allows a transfer in which a taxpayer acquires replacement property, before transferring relinquished property, to qualify as a tax-free exchange. 

An exchange of like-kind real properties must be completed within the earlier of 180 days after the transfer of the exchanged property, or the due date, including extensions, for the transferor’s tax return for the taxable year in which the exchange took place. 

The taxpayer has 45 days from the date of the transfer to identify the like-kind real property received in the exchange. The replacement property must be clearly described in a signed, written document. 

The document then must be delivered to the other person involved in the exchange. The identification of multiple replacement properties is permitted. The replacement property must be received within 180 days from the date of transfer. 

Exchange expenses are subtracted from the total of any cash paid to the taxpayer by the other party, the fair market value of other, not like-kind received by the taxpayer, if any, and net liabilities assumed by the other party. 

In a like kind exchange between related parties, the taxpayer cannot dispose of the property within two years as of the date of the last transfer that was part of the exchange, to avoid recognizing any gain on the initial exchange.

Multiple party transactions qualify as like-kind exchanges. A taxpayer must substantiate the existence of a like-kind exchange. Section 1031 like-kind exchanges are reported annually on form 8824. 

If property received in an exchange has the same basis in whole or in part as that of the property given, and if the property given is a capital asset, or a section 1231 asset, the holding period of the property received includes the period for which the property given was held.

Q: What are individual retirement accounts?

A: An individual retirement account, or IRA, is a personal savings plan that offers tax advantages to individuals who set money aside for retirement.

Two advantages include the deductibility of contributions and the tax exemption of IRA earnings until they are distributed. 

An IRA can be set up with most banks and similar savings institutions, mutual funds, stock brokerage firms, and insurance companies.

Any individual who receives taxable compensation during the year may set up an IRA. An individual may set up a spousal IRA for a spouse provided a joint return is filed. 

Compensation is defined as earned income. It includes:

1) wages and salaries, 

2) commissions, 

3) self-employment income, and 

4) taxable alimony and separate maintenance payments. 

Compensation does not include earnings and profits from property such as rental income, interest income, dividend income, or pension and annuity income, S corporation income, and deferred compensation distributions. 

There are five kinds of individual retirement accounts: 

1) The individual retirement account, 

2) the individual retirement annuity, 

3) the employer and employee association trust accounts, 

4) the simplified employee pension or SEP, and 

5) the savings incentive match plans for employees or SIMPLE. 

An IRA must be fully vested at all times. The assets of the trust cannot be commingled with other property except in a common trust fund or common investment fund, and no part of the trust funds can be used to purchase life insurance contracts. 

Generally, IRAs and Roth IRAs are not permitted to hold S corporation stock. However, if the IRA or Roth IRA held bank stock on or after Oct. 22, 2004, the IRA or Roth IRA is permitted to hold this stock and the owner of the plan is considered the shareholder.

Q: How much can I contribute to an IRA?

A: Once an IRA is set up, a taxpayer may make contributions each year in which he or she qualifies. To qualify to make contributions, a taxpayer must have received compensation. However, a taxpayer is not required to make a contribution each year. 

Contributions must be made by the due date of the year, not including extensions. The maximum contribution that can be made during any year is the lesser of the compensation received or $6,000. Individuals aged 50 or older at the end of the year can contribute an additional $1,000. 

SIMPLE plans allow small employers to make matching contributions to employee’s traditional IRAs. The maximum employee contribution to a SIMPLE plan is $13,500. 

For employees aged 50 and over, an additional $3,000 may be contributed. SEP plans also allow employers to contribute to employee’s traditional IRAs, but the employer contributions are not matching contributions. 

The maximum contribution allowed is up to twenty five percent of the employee’s income limited to an annual ceiling of $50,000. 

A person may deduct contributions made to an inherited IRA only if the IRA was inherited from a spouse. 

An IRA is included in the estate of the decedent who owned it. When an IRA is inherited from a person other than the spouse, the IRA cannot be treated as though it is owned by the taxpayer who inherited it. 

In addition, the taxpayer cannot contribute more to the IRA or roll the IRA into a Roth IRA. If a joint return is filed and the taxpayer makes less than his or her spouse, the taxpayer may still contribute the lesser of the sum of his or her compensation and the taxable compensation of the spouse, reduced by the amount of the spouse’s IRA contributions or $6,000. 

Thus, the total combined contributions to an IRA and a spouse’s IRA can be as much as $12,000 for the year, plus an additional $1,000 for each spouse aged 50 and over. 

If a taxpayer has more than one IRA, the limit applies to the total contributions made to the IRAs for the year. Generally, a deduction is allowed for contributions that are made to an IRA. 

If neither spouse was covered for any part of the year by an employer retirement plan, the entire contribution may be deducted. If a taxpayer is not covered by an employer plan but the taxpayer’s spouse is, the taxpayer may still deduct the full amount of the contribution, however the deduction is reduced if the adjusted gross income on the joint return is greater than $196,000, but less than $206,000. 

The deduction is eliminated if the income is greater than $206,000. If a taxpayer is covered by a retirement plan at work, the IRA deduction will be phased out or eliminated if a taxpayer’s modified AGI is between $65,000 and $75,000 for a single individual.

That amount is between $104,000 and $124,000 for a married couple filing a joint return and between $0 and $10,000 for a married individual filing a separate return. 

The phase-out amount is subtracted from the maximum allowable deduction to arrive at the allowable deductible amount. Round up to the next highest multiple of ten dollars to find the allowable deduction. 

Deductible contributions to an IRA must be made in cash and not any other property. Unlike contributions to traditional IRAs, contributions to SEP IRAs are excluded from an employee’s income rather than deducted from it. 

Any excess employer contributions must be included in income without any offsetting deduction. 

Generally, a rollover is a tax-free distribution of cash or other assets from one retirement plan to another retirement plan. 

A rollover from one qualified plan must be to another qualified plan. Sometimes, the taxpayer does not make a direct transfer of assets from one retirement plan to another, but instead withdraws assets from the plan.

In that case, the taxpayer must deposit the assets into another qualified plan within sixty days of the withdrawal in order to avoid taxes and penalties. Rollover contributions are not deductible. 

Distributions that are not qualified distributions eligible for rollover include the following: 

1) Required minimum distributions, 

2) hardship distributions, 

3) any series of substantially periodic distributions, 

4) corrective distributions due to excess contributions, 

5) a loan treated as a distribution, 

6) dividends on employee securities, 

7) the cost of life insurance coverage, and 

8) a distribution to the plan participant’s beneficiary. 

If a taxpayer withdraws assets from an IRA, rolls over part of it tax-free, and keeps the rest, ordinary income must be recognized.

Also, he or she may be subject to the ten percent tax on premature distributions. The same property that was received from an old IRA may be rolled over into a new IRA. 

If an individual inherits a traditional IRA from anyone other than a deceased spouse, the inheritor is not permitted to treat the IRA as his or her own, that is he or she cannot begin making direct contributions. 

The inherited IRA will generally not have tax assessed on the IRA assets until distributions are received. The basis of a traditional IRA, because of nondeductible contributions, remains with the IRA. 

Distributions from an inherited IRA must either begin by the end of the year following the death of the original IRA holder or the IRA must be completely distributed by the end of the fifth year following death. 

When transferring an IRA account to a spouse, or an ex-spouse pursuant to a domestic relations order, taxes and penalties may be avoided by changing the name on the IRA account or transferring the IRA assets into another qualified plan. 

Distributions from a SIMPLE IRA can be rolled over to another IRA two years after the first contribution is made. Rollovers to tax sheltered annuities are not tax-free. 

Generally, an IRA is prohibited from investing in collectibles, however an IRA may hold platinum coins, as well as gold, silver or platinum bullion. 

A taxpayer may not engage in the following transactions with a traditional IRA: 

1) Sell property to it, 

2) use it as security for a loan, or 

3) buy property with it for the taxpayer’s personal use. 

The taxpayer has a cost basis in a traditional IRA if he or she made any nondeductible contributions.

The cost basis is the sum of the nondeductible contributions to the IRA minus any withdrawals or distributions of nondeductible contributions. 

The difference between the total permitted contributions and the IRA deduction, if any, is the nondeductible contribution. 

Up to $100,000 of a distribution may be excluded from income if distributed directly by the trustees of the IRA to a qualified charitable organization. 

Only otherwise includable portions of the distribution are considered qualified charitable distributions or QCDs. 

An IRA is subject to tax on unrelated business income if it carries on an unrelated trade or business. 

An unrelated trade or business means any trade or business regularly carried on by the IRA or by a partnership of which it is a member and it is not substantially related to the performance of the exempt purpose or function.

Q: Will I incur a penalty for contributing too much to my retirement plan?
A: Generally an excess contribution is the amount contributed to an IRA that is more than the lesser of compensation received or $6,000, $7,000 for a taxpayer aged 50 or older. 

For SIMPLE plans, the limit is $13,500 or $16,500 for taxpayers aged 50 and older. For SEP plans, the limit is the lesser of twenty five percent of the employee’s income or $57,000. 

An excess contribution could be the result of a taxpayer’s contribution, a spouse’s contribution, an employer’s contribution or an improper rollover contribution. 

A six percent excise tax is imposed each year on excess contribution amounts that remain in an IRA account at the end of each tax year. 

The tax can be avoided if the excess contribution and the interest earned on it are withdrawn by the due date, including extensions of the tax return. 

The interest earned on the excess distribution qualifies as a premature distribution that is subject to an additional tax of ten percent on that distribution. 

The taxpayer may treat the unused excess contributions from a previous year as having been made in the current year to the extent that the allowable contribution limit exceeds the actual contributions for the current year. 

Premature distributions are amounts withdrawn from an IRA or annuity before a taxpayer reaches age fifty nine and a half. 

The additional tax on premature distributions is equal to ten percent of the amount of the premature distribution that must be included in gross income. This tax is in addition to any regular income tax that is due. 

In certain circumstances, the additional tax does not apply to distributions to an IRA even if they are made before a taxpayer reaches age fifty nine and a half. 

If a taxpayer borrows money against an IRA, the fair market value of the IRA, as of the first day of the tax year, must be included in gross income. 

The taxpayer may also be subject to the ten percent penalty tax. An individual may withdraw all or part of the assets of a traditional IRA.

An individual may exclude the withdrawals from income if they transfer it to another traditional IRA or returns it to the same IRA within sixty days after the withdrawal. 

A distribution from a SIMPLE IRA, within two years after the first contribution is made, is subject to a twenty five percent tax. 

Generally, a taxpayer must begin receiving distributions by April 1st of the year following the year in which he or she reaches age seventy two or seventy and a half for years before 2020. 

If distributions are less than the required minimum distribution for the year, a fifty percent excise tax will be imposed on the amount not distributed. 

Under the Cares Act, no minimum distribution is required for calendar year 2020 from an IRA. 

The provision waives the 2020 distribution requirement for lifetime distributions to IRA owners. The next required minimum distribution for these plans will be for calendar year 2021. 

Loans from a qualified plan, such as a 401k, will not be treated as a distribution to the extent the loans do not exceed the lesser of $50,000 or the greater of one half of the present value of the employee’s vested accrued benefit under such plans, or $10,000. 

Loans must be repaid within five years, on at least a quarterly basis, unless the funds are used to acquire a principal residence.

Q: What are Roth IRAs?

A: A tax-free IRA, referred to as a Roth IRA, has been available since the beginning of 1998. Contributions to the Roth IRA are nondeductible, but income can be accumulated tax-free. 

To be treated as a Roth IRA, the account must be designated as such when it is established. Roth IRAs are subject to income limits.
The maximum yearly contribution that can be made to a Roth IRA is phased out for single taxpayers with a modified AGI between $124,000 and $139,000.

For joint filers, modified AGI falls between $196,000 and $206,000 and for a married taxpayer filing separately with a modified AGI between $0 and $10,000. 

Modified AGI is determined by subtracting any income resulting from a conversion of a traditional IRA to a Roth IRA and any minimum required distributions from a qualified retirement plan, including an IRA, from adjusted gross income. 

The contribution amount is the same as the amount for a deductible IRA and the total contribution to both deductible and nondeductible IRAs cannot exceed $6,000 per taxpayer, $7,000 for individuals who will be fifty years old by the end of the year. 

Like deductible IRAs, individuals are allowed to make contributions to the Roth IRA at any age. 

Qualified distributions from a Roth IRA are not included in the taxpayer’s gross income and are not subject to the ten percent additional early withdrawal tax. 

To be a qualified distribution, the distribution must satisfy a five year holding period and must meet one of four additional requirements. To satisfy the five year holding period, the 

Roth IRA distribution may not be made before the end of the five tax year period beginning with the first tax year for which the individual made a contribution to the Roth IRA. 

The five year holding period begins to run when the tax year to which the contribution relates, not the year in which the contribution is actually made. 

Thus, a contribution made in April of year two, designated as a year one contribution, may be withdrawn tax-free in year six, if it is otherwise a qualified distribution. 

Once the five-year holding period is met, taxpayers must meet one of the following four requirements for a tax-free distribution: 

1) The distribution must be made on or after the date on which the individual attains age fifty nine and a half, 

2) The distribution must be made to a beneficiary, or the individual’s estate on or after the individual’s death, 

3) The distribution must be attributed to the individual being disabled, or 

4) The distribution must be distributed to pay for qualified first time homebuyer expenses. 

Distributions are treated as made from contributions first, thus, no portion of a distribution is treated as attributable to earnings, or includable in gross income, until the total of all distributions from the Roth IRA exceeds the amount of contributions. 

Nonqualified distributions are included in income after recovery of contribution, and they are subject to the ten percent early withdrawal penalty. 

Distributions from one Roth IRA can be rolled over or converted tax-free to another Roth IRA. Amounts in a Traditional IRA that was not inherited from a person other than a spouse can be rolled into a Roth IRA. 

If a taxpayer has both deductible and nondeductible IRAs, and only a portion of IRAs are converted into a Roth IRA, any amount rolled into a Roth IRA will be considered to have been drawn proportionally from both the deductible and nondeductible IRAs and will be taxed accordingly. 

Once a taxpayer has begun periodic distributions of a traditional IRA, he or she is able to convert his or her traditional IRA into a Roth IRA and resume the periodic payments.

In addition, the ten percent penalty on early distributions will not apply to non qualified distributions. 

Once amounts from a traditional IRA have been rolled over, or converted to a Roth IRA, they may not be recharacterized back to a traditional IRA. 

Amounts carried in a SIMPLE IRA may be converted to a Roth IRA, assuming the required two year participation requirement has been met. Distributions from Roth IRAs are required only upon death.

Q: What are section 529 qualified tuition programs?

A: Under a section 529 qualified tuition program, a taxpayer can establish an account for the benefit of a designated beneficiary to provide for that beneficiary’s qualified higher education expenses at an eligible educational institution. In other words, college, university, or vocational school. 

There is no dollar limitation for the contributions, though the contributions are not deductible for federal income tax purposes, the earnings are not taxable. 

Generally, withdrawals from a section 529 plan must be made during the same calendar year that the expenses are paid.  

Q: What is gift tax?

A: The gift tax is a wealth transfer tax that applies if a property transfer occurs during a person’s lifetime. The property transferred may be real, personal, tangible, or intangible. 

Both the gift tax and the estate tax are part of a unified transfer tax system under which gratuitous transfers of property between persons are subject to taxation.

Q: When do I have to file a gift tax return?

A: A donor is required to file a gift tax return, form 709, for any gifts, unless they are excluded. 

Exclusions include the annual $15,000 exclusion, the exclusion for qualified charitable gifts, or the deduction for qualified transfers to the donor’s spouse. 

These exclusions apply for gifts of present interests only. Any gift of a future interest requires the filing of form 709. Gift splitting does not excuse the donor from the requirement to file. 

A gift tax return is due on the fifteenth of April following the calendar year in which a gift was made. But a gift tax return for the year of death is due no later than the estate tax return due date. 

A calendar year taxpayer who receives an extension for filing his or his income tax return automatically receives the same extension of time for filing his or her gift tax return for that same year. 

A taxpayer does not have to file a gift tax return to report gifts to his or her spouse. However, this rule does not apply if the spouse is not a US citizen and the total gifts the taxpayer makes to the spouse during the year exceeds $157,000.

Also, the rule does not apply if the taxpayer makes any gift of a terminable interest that does not meet the power of appointment exception. 

If the only gifts a taxpayer makes during a year are deductible as gifts to charities, the taxpayer is not required to file a return provided that the taxpayer transferred the entire interest in the property to a qualified charity. If only a partial interest was transferred, a return must be filed. 

If the taxpayer is required to file a return to report non-charitable gifts and gifts were also made to charities, all the charitable gifts must be included on the return. 

The charitable gifts are not however subject to the gift tax. If the total value of gifts of present interest to any donee is more than $15,000 in a calendar year, the taxpayer must report all such gifts made during the year to or on behalf of that donee, including gifts excluded under the annual exclusion. 

If the total is $15,000 or less, the taxpayer need not report on form 709 schedule A any gifts except gifts of future interest that were made to that donee.

Q: What is gift tax?

A: The gift tax is a tax on the transfer imposed on the donor. Any excess of fair market value of transferred property over the fair market value of consideration for it is a gift. In other words, the amount of a gift is the fair market value of what is given. 

A gift is complete when the donor has given over dominion and control such that he or she is without legal power to change its disposition. 

For example, Robert opens a joint bank account with Irene with Robert the only depositor to the account. Robert or Irene may withdraw money. 

However, a gift is complete only when Irene withdraws money. Gifts completed when the donor is alive, called Inter Vivos gifts, are the only ones subject to gift tax. 

Transfers made in trust are included. Property passing by will or inheritance is not included. 

To the extent credit is extended with less than sufficient stated interest, the code imputes that interest is charged. 

If the parties are related, the lender is treated as having made a gift of the imputed interest to the borrower each year the loan is outstanding. Gift loans are excluded if the aggregate outstanding principal is not more than $10,000. 

Basis in a gift is basis in the hands of the donor, plus gift tax attributable to appreciation. The first $15,000 of gifts of present interest to each donee is excluded from taxable gift amounts. The $15,000 exclusion applies only to gifts of present interest. 

A present interest in property includes an unrestricted right to the immediate possession or enjoyment of the property or to the income from property. Gifts of future interests in property do not qualify for the annual exclusion. 

Excluded from taxable gifts are amounts paid on behalf of another individual as tuition to an educational organization or for medical care. 

The payment must be directly to the third party, for instance the medical provider or the educational organization. 

Amounts paid for room, board, and books are not excluded. Transfers that represent support of a former spouse or child are not gifts. 

Political contributions are not subject to gift tax. The amount of a gift transfer to a spouse is deducted in computing taxable gifts. 

For example, Sid gave his wife Mary a diamond ring valued at $20,000 and cash gifts of $30,000. Sid is entitled to a $15,000 exclusion with respect to the gifts to Mary. His marital deduction is $35,000. 

The marital deduction is not limited as long as it is not less than the amount includable as taxable gifts. Donor and donee must be married at the time of the gift and the donee must be a US citizen. The fair market value of property donated to a qualified charitable organization is deductible. 

Like the marital deduction, the amount of the deduction is the amount of the gift reduced by the $15,000 exclusion with respect to the donee. Qualified tuition programs, or QTIPs, are also known as 529 plans. 

Payments to this type of plan are not to be confused with the excludable tuition payments discussed earlier. 

A taxpayer may elect to treat up to $75,000 of a contribution made to a QTIP during a tax year as if made ratably over a five year period. 

By making this election, up to $15,000 of the contribution will be excluded from taxable gifts over the five year period. 

Any contribution in excess of the $75,000 limit is reported in the year the contribution was made and is not apportioned over five years. 

Contributions to QTIPs do not qualify for the education exclusion. Tentative tax is the sum of taxable gifts to each person for the current year and for each preceding year times the gift tax rate. 

Taxable gifts to a person are the total gift amounts in excess of exclusions and the marital and charitable deductions for the calendar year. 

The unified transfer tax rates are used. Current year applicable rates are applied to both current and preceding years taxable gifts. 

The rate is eighteen percent for taxable gifts up to $10,000. The rates increase in small steps, for example two or three percent, over numerous brackets. 

The maximum rate is forty percent on cumulative gifts in excess of $1 million. The tentative gift tax is reduced by the product of prior years’ taxable gifts and current year rates. 

Tentative tax may also be reduced by any unified credit, also called the applicable credit amount or ACA. The ACA is a $4,625,800 base amount, reduced by amounts allowable as credits for all preceding tax years.This excludes the first $11.7 million of taxable gifts.

Q: What is gift splitting?

A: If both spouses consent, married couples may consider a gift made by one spouse to any person other than the other spouse as made one half by each spouse. 

A married couple is not allowed gift splitting if the couple is not married at the time of the gift, the couple divorces after the gift, and a spouse remarries before the end of the calendar year, or one of the spouses is a nonresident alien. 

A joint gift tax return does not exist.

Each spouse must file his or her own gift return, however a spouse may simply give his or her consent to gift splitting by signing the donor spouse’s return if all of the requirements of either of the following exceptions are met: 

1) Only one spouse made any gifts, and 

2) the total value of these gifts did not exceed $30,000, 

OR 

1) One spouse made gifts of more than $15,000, but less than $30,000, and 

2) the only gifts made by the other spouse are gifts of not more than $15,000. 

If the couple elects to split its gifts they must split all gifts made to third party donees. The only exception is if one spouse gave the other a general power of appointment over gifts made. 

If a married couple does elect to split gifts, both spouses are jointly and severally liable.

Q: What is estate tax?

A: Estate taxes are wealth transfer taxes that apply to dispositions of property that occur as a result of the transferor’s death. 

The tax base for the federal estate tax is the total of the decedent’s taxable estate and adjusted taxable gifts. The taxable estate is the gross estate minus allowable deductions. 

Current year applicable rates are applied to both current and preceding years’ taxable gifts. The minimum rate is eighteen percent and is applied to cumulative gifts of up to $10,000. 

The maximum rate is forty percent on cumulative taxable gifts and estates in excess of $11.7 million.

Q: What is included in the gross estate?

A: A decedent’s gross estate includes the fair market value of all property, real or personal, tangible or intangible, to the extent the decedent owned a beneficial interest at the time of death. 

Special tax avoidance rules are established for US citizens or residents who surrender their US citizenship or long-term US residency. 

Included in the gross estate are such items as:

1) Cash, 

2) personal residence and effects, 

3) securities, and other investments such as real estate and collector items, and 

4) other personal assets such as notes and claims and business interests, such as partnership interests. 

Liabilities of the decedent generally do not affect the amount of the gross estate, unless the estate actually pays them. The gross estate includes the value of the surviving spouse’s interest in property as dower or curtesy. 

Dower and curtesy are common law rights recognized in some states, usually in modified form. Dower entitles a surviving wife to a portion of lands her husband owned and possessed during their marriage. 

Curtesy entities a surviving husband to a life estate in all of his wife’s land if they had children. 

The gross estate includes the full value of property held as joint tenants with a right of survivorship, except to the extent of any part shown to have originally belonged to the other person and for which adequate and full consideration was not provided by the decedent. 

The gross estate includes fifty percent of property held as joint tenants by spouses, or as tenants by the entirety, regardless of the amount of consideration provided by each spouse. 

The value of property interests over which the decedent had a general power of appointment is included in the gross estate. 

A power of appointment is a power exercisable in favor of the decedent, his or her estate, his or her creditors, or the creditors of his or her estate. 

Bonds, notes, bills and certificates of indebtedness of federal, state, and local governments are included in the gross estate, even if interest on them is exempt from income tax. 

The gross estate includes insurance proceeds on the decedent’s life if either the proceeds are payable to or for the estate. 

Or if the decedent had any incident of ownership in the policy at death, such as the rights to change beneficiaries or terminate the policy. 

The proceeds of insurance policies given to others by the decedent within three years of death are also included in the estate. 

The gross estate includes the value of any annuity receivable by a beneficiary by reason of surviving the decedent if either: 

1) The annuity was payable to the decedent, or 

2) If the decedent had the right to receive the annuity or payment either alone or in conjunction with another or for his or her life. 

Medical insurance reimbursements due the decedent at death are treated as property in which the decedent had an interest. 

The gross estate includes gift taxes paid on gifts within three years before death. The gross estate includes Inter Vivos transfers. 

Inter Vivos transfers are assets transferred during life in which the decedent retained, at death, any of the following interests: 

1) A life estate, and income interest, possession or enjoyment of assets, or the right to designate who will enjoy the property, 

2) A five percent or greater reversionary interest, if possession was conditioned on surviving the decedent, 

3) The power to alter, amend, revoke, or terminate the transfer, or 

4) An interest in a qualified terminable interest property trust. 

The value of the gross estate is the fair market value of the property, unless a special valuation rule is used. Real property is usually valued at its highest and best use.

A transfer of interest in a corporation or partnership to a family member is subject to estate tax freeze rules. 

Generally, the retained interest is valued at zero. The executor may elect to value the estate at either the date of death or the alternate valuation date, which is six months after the decedent’s death. 

Electing the alternate valuation date is irrevocable. Assets sold or distributed before the alternate valuation date are valued on the date of sale or distribution. 

Assets, the value of which is affected by mere lapse of time, are valued as of the date of the decedent’s death. But adjustment is made for a change in value by other than mere lapse of time.

Q: What are gross estate deductions and credits?

A: Deductions from the gross estate in computing the taxable estate include the following expenses, claims and taxes: 

1) Expenses for selling estate property to pay estate liabilities, preserve the estate, or affect distribution; 

2) administration and funeral expenses; 

3) claims against the estate, including debts of the decedent; 

4) unpaid mortgages on property if the value of the decedent’s interest is included in the gross estate; 

5) state inheritance taxes; 

6) casualty or theft losses deemed deductible and incurred during the settlement of the estate if they were not deducted on the estate’s income tax return; 

7) charitable contributions; and 

8) marital transfers. 

In lieu of the deductions from the gross estate, a deductible amount may be allowed against gross income on the decedent's final income tax return, only if the right to deduct them from the gross estate is waived. 

There are four credits available to offset federal estate tax liability: 

1)The applicable credit amount is a $4,625,800 base amount not reduced by amounts allowable as credits for gift tax for all preceding tax years. 

It offsets the estate tax liability that would be imposed on a taxable estate of up to $11.7 million, computed at current rates. 

Also, any amount unused by a deceased spouse may be used by the surviving spouse in addition to the surviving spouse’s own exclusion amount.

2) A credit is allowable for death taxes paid to foreign governments. 

3) A credit is allowable on gift tax paid on gifts made before 1977 and included in the gross estate. 

4) A credit is allowed for taxes paid on transfers by or from a person who died ten years before and two years after the decedent’s death. 

Beneficiaries may take a deduction for the estate tax paid on income in respect of a decedent, which is income earned before death but received after the decedent’s death.

Q: When do I have to file an estate tax return?

A: The executor is required to file form 706, United States Estate Tax return, if the gross estate at the decedent’s death exceeds $11.7 million. Adjusted taxable gifts made by the decedent during his or her lifetime reduce the threshold.

The estate tax return is due within nine months after the date of the decedent’s death and an extension of up to six months may be granted. The time for payment may be extended for a period of one year past the due date. 

For reasonable cause, the time for payment may be extended up to ten years. The general period for assessment of estate tax is three years after the due date for a timely filed form 706. 

The assessment period is extended one additional year on transferees for tranfers from an estate. 

Estate tax is charged to estate property. If the tax on part of the estate distributed is paid out of other estate property, equitable contribution from the distributee beneficiary is recoverable. The executor is ultimately liable for payment of the taxes. 

An estate that includes a substantial interest in a closely held business may be allowed to delay payment of part of the estate tax if that tax exceeds thirty five percent of the gross estate.

Q: What are generation-skipping transfers?

A: The Generation-skipping transfer tax, or GSTT, is imposed separately, and in addition to gift and estate taxes on transfers directly to or in trust for the sole benefit for a person at least two generations younger than the transferor. GSTT is generally imposed on each generation skipping transfer. 

There are three types of generation skipping transfers: 

1) Direct skips, 

2) Taxable distributions, and 

3) Taxable terminations. 

A direct skip is a transfer of an interest in property, subject to the estate or gift tax, to a skip person. 

The transferor is liable for the tax. A skip person is a natural person assigned to a generation that is two or more generations below the transferor. For a property in trust, the interests are held entirely by skip persons. 

A taxable distribution is a distribution from a trust to a skip person of income or principal other than a distribution that is a direct skip or taxable termination. The transferee is liable for the tax. 

A taxable termination is a termination of an interest in property held in trust. A taxable termination has not occurred if: 

1) Immediately after the termination, a non-skip person has an interest in the property, or 

2) if the distributions are not permitted to be made to a skip person at any time following the termination. 

The GSTT approximates the maximum federal estate tax that would have applied to the transfer on the date of the transfer. 

The generation skipping transfer exemption is allowed in determining the GSTT. The exemption is $11.7 million for each transferor. Gift splitting applies. It is typically allocated at the time of filing the transferor’s estate return. 

For example, the parent dies, leaving $3.5 million in trust to a child and the remainder to grandchildren. The entire $3.5 is allocated to property held in trust. 

The child dies twenty five years later and the property held in trust is now worth $10 million. No GSTT is imposed. 

The GSTT is computed by multiplying the taxable amount by the applicable rate. The applicable rate is the maximum federal rate multiplied by the inclusion ratio. 

The maximum federal rate is forty percent. The GSTT does not apply when neither the federal estate tax nor the federal gift tax applies. 

General power of appointment includes the trust and the estate, thus it is not subject to GSTT. The generation skipping termination tax arises when a non-skip person terminates by reason of death, expiration of time or other reason and the skip person becomes the recipient of the trust property. 

For example, under a parent’s will, a trust is created with income to a child for life and corpus to a grandchild. The child’s death is an event that terminates the child’s interest in the trust and results in a taxable termination. 

The grandchild is a skip person two generations below the parents. The generation skipping distribution transfer tax, or GSTD, applies to trust distributions out of income or corpus to a beneficiary at least two generations below the grantor, while an older generation beneficiary has an interest in the trust. 

For example, a trust is created by a parent for a child. The trust allows for distributions to the grandchild during the child’s lifetime. A taxable distribution occurs when a distribution is made from the trust to the grandchild. 

The distributee is entitled to a federal income tax deduction for GSDT imposed on current distributions of trust income. The basis of property is increased by the proportion of GSDT imposed. 

The distributee reports and pays the GSDT. A trustee’s payment of GSDT is deemed to be an additional distribution to the beneficiary. 

A direct skip occurs when one or more generations are bypassed altogether and property is transferred directly to or in trust for a skip person. 

The direct skip gift tax is imposed on gifts by an individual to a beneficiary who is a third generation or below. The tax applies only to the fair market value of the property given. 

Only the gift tax annual exclusion and the generation skipping tax exemption apply. The donor is liable for both the gift tax and the direct skip gift tax. 

The direct skip estate tax applies when there is a bequest by an individual to a third generation or below beneficiary. 

The donor estate is liable for the estate tax and the direct skip estate tax. Any unallocated $11.7 million generation skipping exemptions are used to reduce taxable direct skip requests. 

Basis is fair market value at the date of death. It is not increased by direct skip estate tax. 

Q: What is a partnership?

A: Partnerships are collaborative ventures governed by the partnership agreement. Ownership interest in a partnership is determined by contributions to the partnership and the operations of the partnership, including any assumptions of liabilities. 

Despite the flow-through nature of partnerships, filing requirements do exist, with the required tax year determined by several guidelines. 

Q: How is a partnership defined for income tax purposes?

A: A partnership is the relationship between two or more entities who joined together to carry on a trade or business. 

An entity, when used in this context, may refer to an individual, a corporation, a trust, an estate, or another partnership. 

For tax purposes, the term partnership includes a syndicate, group, pool, or joint venture that is carrying on a trade or business and is not classified as a trust, estate, qualified joint venture, or corporation. 

Per se corporations, such as insurance companies and tax exempt organizations cannot be classified as partnerships. 

An agreement to share expenses does not constitute a partnership. And co ownership of rental property is not a partnership unless services are provided to the tenants. 

A partnership that is essentially an operating agreement or that exists for investment purposes only, and not for the active conduct of a business, is excluded from treatment as a partnership if all partners elect. 

Each partner must separately include his or her share of income and deductions. Also, a single member domestic limited liability company is eligible to file an election to be taxed as a disregarded entity or a corporation. 

A partnership agreement includes the original agreement that determines the partner’s share of income, gains, losses, deductions, and credits. The agreement must be agreed to by all partners. 

The agreement must have substantial economic effect. Otherwise, the allocation will be made with respect to the partner’s interest in the partnership. 

The partner to whom an allocation is made actually receives the economic benefit or burden corresponding to that allocation. 

A family partnership is one consisting of a taxpayer and his or her spouse, ancestors, lineal descendents, or trusts for the primary benefit of any of them. 

Siblings are not treated as members of the taxpayer’s family for these purposes. Family members will be recognized as partners only if one of two sets of conditions is met: 

1) The first set of conditions is when capital is a material income producing factor,  

2) the family members acquired their capital interest in a bonafide transaction (even if by gift or purchase from another family member) actually own the partnership interest, and 

3) they actually control the interest. 

The alternative set of conditions is when:

1) Capital is not a material income producing factor, and 

2) the family members joined together in good faith to conduct a business, 

3) agreed that contributions of each entitled them to a share of the profits, and 

4) each has provided some capital or service. 

A services partnership is one in which capital is not a material income producing factor. An example is a partnership of tax accountants. 

In a family partnership, a family member is treated as a services partner only to the extent he or she provides services that are substantial or vital to the partnership. 

On the other hand, a family member is treated as a partner in a partnership in which capital is a material income producing factor. 

However, the partnership agreement is disregarded to the extent a partner receives less than reasonable compensation for services. 

Spouses filing a joint return may elect out of partnership treatment by choosing to be a qualified joint venture. 

Each spouse will be treated as a sole proprietor, allowing both to receive social security benefits. 

Special rules apply for attribution of ownership between related parties when there is loss or gain on a sale of property between a partnership and a person with direct or indirect capital interest. 

An individual is treated as owning the interest owned by his or her spouse, brothers and sisters, children, grandchildren, and parents. 

If a capital or profits interest in a partnership is owned, directly or indirectly, by or for any person, that person is considered to own the interest owned directly or indirectly by or for his or her partnership in the proportion that the value of the interest that he or she owns bears to the value of all of the interests in the partnership. 

Q: What are the partnership return filing requirements?

A: The partnership tax return is due by the 15th day of the third month following the close of the tax year; March 15th for calendar year partnerships. The extension period is six months after the original due date of the return. 

If certain monetary floors are not reached, qualifying partnerships are not required to file a tax return, or at least not required to file a balance sheet per books. 

A reconciliation of book income to return income, or an analysis of a partnership’s capital accounts. The partnership’s tax year is determined in respect to the partner’s tax years. 

For example, assume that a partnership has a fiscal year end of January 31st. A calendar year partner reports his or her share of the partnership’s February 1st year end through January 31st year two income on his or her year two tax return which is due March 15th year three. 

Unless an exception applies, the partnership must file using a required tax year. Discussion of the required year and the two exceptions follows: 

The required tax year is the first of the following three that applies. The first option is the majority interest tax year, which is the tax year of the partners in the same tax year who own more than 50 percent of partnership capital and profits. 

The second option is the principal tax year. A principal partner is any partner owning 5% or more in capital or profits. As with the majority interest tax year, all principal partners must have the same tax year. 

The third option is the least aggregate deferral tax year, which is a compound calculation determined by multiplying each partner's ownership percentage by the number of months of income deferral for each possible partnership tax year and then selecting the tax year that produces the smallest total tax deferral. 

A year other than the required three may be adopted for a business purpose with IRS approval. Two possibilities are the natural business year and the fiscal year. 

Accounting for a natural business year, for instance, in a seasonal line of business, can be an acceptable business purpose. 

A seasonal line of business is any 12 month period when at least 25 percent of annual gross receipts were received during the last two months of each of the preceding three years. 

Under section 444, a partnership may elect a tax year that is neither the required year nor a natural business year. 

The year elected may result in no more than three months' deferral between the end of a tax year elected and the end of the required tax year. 

If one or more than one qualifying tax year is also the partnership’s existing tax year, the partnership must maintain its existing tax year. 

Every existing partnership must file form 1065 unless it neither receives income nor incurs any expenses treated as deductions or credits for federal income tax purposes. 

Schedules K1 are filed with the return and furnished to the partners on or before the due date for the partnership return.

Q: What are contributions to a partnership?

A: Generally, no gain or loss is recognized on contributions of property in exchange for a partnership interest. 

However, gain or loss is recognized when the following situations occur:

1) The contributed property is distributed to a different partner within 7 years of the contribution date, 

2) when a partner contributes property to a partnership and immediately receives a distribution, the transaction is essentially a sale, 

3) when a partner who contributed property receives a distribution of a different property, other than money, within 7 years of his or her contribution, and 

4) when a partner acts in an individual capacity in an action with the partnership. 

The basis of contributed property is the same in the hands of the partnership as it was in the hands of the partner. The holding period is carried over as well. 

The value of a capital interest in a partnership that is transferred to a partner in exchange for services is taxable as ordinary income. 

The income recognized is added to the basis of the partnership interest. When a partner contributes property subject to a liability, or the partnership assumes a liability of a contributing partner, the partner is treated as receiving a distribution of money from the partnership in the amount of the liability. Distribution reduces the partner’s basis in the partnership interest. 

Once a partner’s interest in the partnership basis is reduced to zero, any partner liability assumed by the partnership is recognized gain to that partner. 

Note that a partner still bears responsibility for his or her share of the liabilities assumed by the partnership. 

That is, if Sam has a 25% partnership interest in the Advisors Group partnership, which assumed a $100,000 loan from Sam, he still bears the responsibility, the economic risk of loss: $25,000 of the loan.

Q: What is a partnership interest?

A: The original basis of a partner’s interest acquired in exchange for contributions of property is the sum of the money contributed, the adjusted basis of property contributed, and the amount of any recognized gain by the partner on the contribution. 

The assumption of liabilities by the partner is treated as a contribution of money to the partnership and increases basis. 

However, as mentioned earlier, the amount of liabilities assumed by the partnership is treated as a distribution to the contributing partner and reduces basis. 

In a cash basis partnership, accrued but unpaid expenses and accounts payable are not included in the basis of a partner's interest. 

A partner includes a liability only to the extent that the partner bears the economic risk of loss. A partnership realizes neither gain nor loss when it receives contributions of money or property in exchange for partnership interests. 

The partnership’s basis in contributed property is equal to the contributing partner’s adjusted basis in the property, immediately before contribution, increased by any gain recognized by the partner. 

Generally, it is not adjusted for liabilities. The holding period of the partner’s interest includes the holding period of contributed capital and section 1231 assets. 

However, if the partnership interest was received in exchange for ordinary income property or services, the holding period starts the day following the exchange. 

The partnership’s holding period in contributed property includes the partner’s holding period, even if the partner recognized gain. 

The basis in a partnership interest purchased from a partner is its cost, which is the sum of the purchase price and the partner’s share of partnership liabilities. 

The partnership may elect to adjust the basis in its assets by the difference of the transferee’s basis in his or her partnership interest and his or her proportionate share of the partnership’s adjusted basis in its assets.

Q: What are partnership operations?

A: A partnership is a business organization, other than a corporation, a trust, or an estate, which is co-owned by two or more persons and operated for a profit. 

It’s important to remember that different types of persons, such as individuals, corporations, trusts, estates, or even other partnerships, may participate in partnership, and each is subject to different treatment for income and deductions. 

A partnership is an untaxed flow through entity that reports its taxable income or loss as separately stated items. 

An individual partner must consider his or her distributive share of the partnership’s taxable income or loss, and every other separately stated item for the partnership. 

That is the case regardless of whether or not the distributive share was made from the partnership or the partner. Income tax rules for partnerships are similar to those for S corporations. 

Be prepared to classify a payment to a partner as a guaranteed payment, a distributive share, or an unrelated third party payment and the effect of the classification. For example, how a deduction to the partnership passes through ratably to all partners. 

A partner’s share of partnership liabilities affects the partner’s basis in his or her partnership interest. There are recourse and nonrecourse liabilities. 

A liability is a recourse liability if the creditor has a claim for payment against the partnership or any partner if the partnership defaults. Partners generally share recourse liabilities based on their ratio for sharing losses. 

For example, if Amy and Mary’s partnership closes and Mary who is insolvent pays less than her share of debt owed then Amy can take a bad debt deduction for any payment she makes towards Mary’s share. 

In the course of nonrecourse liabilities, the creditor has no claim against the partnership or any partners. 

However, the creditor may have a claim against a particular secured item of partnership property. In general, a partner's share in nonrecourse liabilities is based on their ratio for sharing profits. 

If a taxpayer has income because debt is canceled, forgiven, or discharged for less than the amount the taxpayer must pay, the amount of the canceled debt is taxable.

The taxpayer must report the canceled debt on the tax return for the year the cancellation occurs. 

A capital account is maintained for each partner at the partnership level. A partner’s initial capital account balance is the fair market value of the assets that he or she contributed to the partnership, reduced by any liabilities assumed by the partnership. 

It is separate from the partner’s adjusted basis in his or her partnership interest, which is equal to his or her capital account, plus the partner’s share of the partnership liabilities. 

Partnership taxable income is determined in the same way as for individuals, except that certain deductions are not allowed for a partnership. 

Other items are required to be separately stated and business interest expenses limited.
Each partnership item of income, gain, loss, deduction, or credit that may affect partners differently must be separately stated. 

Items that must be separately stated include the following: 

1) Section 1231 gains and losses, 

2) net short or net long term capital gain 

3) loss from the sale or exchange of capital assets, 

4) guaranteed payments, 

5) interest and dividend income, 

6) royalties, 

7) tax exempt income and related expenses, 

8) investment income and related expenses, 

9) rental activities and related expenses,

10) portfolio income and related expenses, 

11) cancellation of debt, 

12) recovery items such as prior taxes and bad debts, 

13) charitable contributions, 

14) foreign income taxes paid or accrued, 

15) depletion on oil and gas wells, 

16) section 179 deductions, 

17) distributions, and

18) qualified items of income, gain, and loss for the QBI deduction. 

Each partner may be entitled to a deduction for his or her distributive share of these separately stated items in computing his or her personal tax liability. Certain elections regarding credits or deductions are made by the partner. 

For example, the decision to claim a credit or take a deduction for foreign taxes paid by the partnership is made by each partner. Another such election is for basis reduction following discharge of indebtedness. 

Other elections that are made at the partnership level apply equally among all partners and include the methods of accounting and computing depreciation. 

Ordinary income for a partnership consists of all taxable items of income, gain, loss, or deduction that are not separately stated. 

The computation of ordinary income includes such items as gross profit, administrative expenses, and employee salaries. 

Ordinary income is different from taxable income. In general, taxable income is the sum of all taxable items, including the separately stated items and the partnership ordinary income or loss. 

Contributions made for employees for retirement accounts may be deducted, subject to limitations. 

Each partner is taxed on his or her share of partnership income, regardless of whether it is distributed. 

A partner’s distributive share of any partnership item is allocated by the partnership agreement, as long as the allocation has substantial economic effect, which means the allocation is not for tax avoidance. 

For example, the allocation of equal amounts of tax exempt income to one partner and taxable interest to another partner in a lower tax bracket has no substantial economic effect. It is motivated by tax avoidance. 

If the partnership agreement does not allocate a partnership item, the item must be allocated to partners according to their interests in the partnership. 

To the extent of gain not recognized on the contribution of property to the partnership, any precontribution gain or loss subsequently recognized on the sale or exchange of an asset by the partnership must be allocated to the contributing partner. 

On the other hand, post contribution gain or loss is allocated among partners.

Q: Who is allowed to represent taxpayers before the IRS?

A: When a dispute or disagreement over tax issues arises, a taxpayer may have to appear before the IRS. Enrolled agents, CPAs, attorneys, and other individuals authorized to practice before the IRS may represent taxpayers.

Q: What is authority to practice?

A: Practice before the internal revenue services means presenting to the IRS, or any of its officers or employees, any matter relating to a client’s rights, privileges, or liabilities under laws and regulations administered by the IRS. 

A person is practicing before the IRS if he or she:

1) Communicates with the IRS for a taxpayer, 

2) represents a taxpayer at conferences, hearings, or meetings with the IRS, 

3) prepares necessary documents and files them with the IRS for a taxpayer, or 

4) renders written advice. 

Not included in practice are: 

1) Preparing a tax return, an amended return, or a claim for refund, 

2) furnishing requested information to the IRS, and 

3) appearing as a witness for the taxpayer. 

Only the following authorized persons may practice before the IRS: 

1) Attorneys, 

2) CPAs, 

3) enrolled agents, 

4) enrolled actuaries, 

5) enrolled retirement plan agents, 

6) annual filing season program participants, 

7) appraisers, and 

8) unenrolled individuals if specifically permitted. 

To practice before the IRS, an attorney or a CPA must file a written declaration for each party he or she represents that he or she is qualified and has been authorized to represent the party and must not be suspended or disbarred. 

An enrolled agent is an individual other than an attorney or a CPA who is eligible, qualified, and authorized to represent another in practice before the IRS. 

An enrolled agent may not appear in a representative capacity unless he or she is recognized to practice before the IRS and presents satisfactory identification. 

Recognition must be evidenced when the enrolled agent appears for the initial meeting with the IRS in which he represents the taxpayer. 

The IRS may authorize any person to represent another in a particular matter without enrollment. 

Situations in which representation by an individual without enrollment has been authorized include the following: 

1) An individual may represent, without compensation, an immediate family member; 

2) an employee may represent his or her regular full time employer; 

3) a general partner or full time partnership employee may represent the partnership; 

4) an officer, or a regular full time corporate employee may represent the corporation; 

5) a trustee, a receiver, a guardian, an administrator, or an executor may represent the trust, receivership, guardianship, or estate;

6) an individual may provide representation to any individual or entity if the representation takes place outside the US; and

7) a practitioner, properly authorized by the taxpayer, who signed a return for the taxpayer. 

A student can apply for permission to practice before the IRS by virtue of his or her status as a law student or a CPA student and an individual may be authorized by the commissioner of the IRS to represent others in a particular matter. 

Certain persons may not practice: 

1) A member of congress in connection for any matter for which he or she directly or indirectly receives, agrees to receive, or seeks any compensation, 

2) an officer or employee of a US legislative, executive, or judicial branch, or its agencies, 

3) an individual convicted of any offense involving dishonesty or breach of trust, and 

4) a state employee who investigates, passes upon, or otherwise deals with state tax matters, if he or she may disclose information applicable to federal tax matters. 

Any practitioner who is an unenrolled return preparer may only represent clients before revenue agents and customer service representatives.

Such an individual may only represent clients for the tax return the practitioner signed and/or prepared. 

Oversight of practice is performed by the commissioner of internal revenue which is abbreviated as the Commissioner. 

The Commissioner:

1) Acts on applications for enrollment, 

2) makes inquiries respecting matters under the Commissioner’s jurisdiction, 

3) institutes and provides for the conduct of disciplinary proceedings related to practitioners, and 

4)performs duties as prescribed by the secretary of the treasury. 

Only natural persons may be enrolled agents, and US citizenship is not required. Enrollment is available to, but not required of attorneys and CPAs. They are automatically entitled to practice before the IRS. 

Enrollment is precluded by conduct that justifies suspension or disbarment from practice. A person who passes the IRS special enrollment exam may be enrolled. 

Past service in the IRS and technical experience are bases for enrollment. A properly executed application for enrollment is necessary. 

Filing additional information and submitting to a written or oral examination under oath may be required. 

An applicant may file a written appeal to the secretary of the treasury within thirty days after the receipt of a notice of denial. 

Temporary recognition to practice may be granted to the applicant only in unusual circumstances, if the application is regular on its face and properly executed. 

An enrollment card is issued to each approved applicant. Any individual who for compensation prepares or assists with the preparation of all or substantially all of a federal tax return or claim for refund must have a preparer tax identification number or PTIN. Tax preparers can sign up for a PTIN online or by paper application. 

Q: What is the conduct of practicing?

A: Rules for conduct of an attorney, a CPA, or an enrolled agent in practicing before the IRS are provided in the applicable sections of part ten of circular 230. In the examples that follow, the term practitioner includes anyone preparing a tax return. 

For example, an attorney, a CPA, or an enrolled agent, unless otherwise indicated. The person representing the taxpayer before the IRS must be qualified. 

For example the person could be an enrolled agent. The duty may not be delegated to an employee of the qualified agent and the power of attorney or written authorization from the taxpayer is insufficient. 

Furthermore, a written declaration that the representative is both qualified and authorized to represent the particular principle must be filed with the IRS. 

A practitioner advising a client to take a position on a tax return or other documents admitted to the IRS or preparing a tax return as a preparer generally may rely in good faith without verification upon information furnished by the client. 

However, the preparer may not ignore the implications of the information and must make reasonable inquiries if the information appears inaccurate or incomplete. 

The preparer should also make appropriate inquiries of a taxpayer about the existence of documentation for deductions. 

A conflict of interest exists if the representation of one client will adversely impact another client or there is a significant risk that the representation of one or more clients will be materially limited by the practitioner’s responsibilities to another client, to a former client or third person, or by a personal interest of the practitioner. 

A practitioner may represent conflicting interests before the IRS only if:

1) All directly affected parties provide informed, 

2) written consent at the time the existence of the conflict is known by the practitioner, 

3) the representation is not prohibited by law, and 

4) the practitioner reasonably believes that he or she can provide competent and diligent representation to each client. 

Copies of the written consents must be retained by the practitioner for at least thirty six 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 IRS upon request. 

A former government employee who participated in a transaction may not represent or knowingly assist any party who is or was a specific party to that transaction. 

A former IRS employee who participated in a matter administered by the IRS may not represent or assist anyone in that matter. 

However, members of a former IRS employee’s current firm may represent or assist a specific party to such a matter if certain conditions are satisfied. 

A practitioner may not administer oaths or certify papers as a notary public in connection with matters in which he or she is employed as an agent or in which he or she may be in any way interested before the IRS. 

Diligence must be exercised in preparing and in assisting in preparing, approving, and filing returns, documents, and other papers relating to IRS matters. 

Due diligence must also be exercised in determining the correctness of oral or written representations made by the practitioner. 

Diligence is presumed if the practitioner relies upon the work product of another person and if he or she uses reasonable care in engaging, supervising, training, and evaluating that person. 

If the practitioner engages a specialist, the focus is on engaging the specialist and when delegating to an employee the focus is on training, supervising, and evaluating the employee. 

Information or records properly and lawfully requested by the IRS must be promptly submitted. 

However, if a reasonable basis exists for a good faith belief that the information is privileged, or that the request is not proper and lawful, the practitioner is excused from submitting the requested information. 

A practitioner is also required to provide information about the identity of persons that he or she reasonably believes may have possession or control of the requested information, if the practitioner does not have the information. 

This requires only that the practitioner make a reasonable inquiry of his or her client to determine this information and does not require independent verification of the client’s statement. 

In practice before the IRS, a practitioner may not accept assistance from or give assistance to a person suspended or disbarred from practice before the IRS. 

A practitioner must not negotiate, including by endorsement, any tax income check issued to a client. 

A practitioner who knows that a client has not complied with the revenue laws of the US is required to promptly advise the client of noncompliance, as well as the consequences of noncompliance under the code and regulations. 

Circular 230 does not require the practitioner to notify the IRS or to advise the client to correct the error. 

A practitioner may not charge an unconscionable fee in connection with any practice before the IRS. 

If an agent publishes a fee schedule, he or she must abide by it for the longer of a reasonable time or thirty days. 

A practitioner may not charge a contingent fee in relation to any matter before the IRS except for:

1) Examination of returns, 

2) claims for credit or refund, and 

3) judicial proceedings. 

A practitioner must return a client’s records on request, regardless of any fee dispute. 

Records deemed returnable for purposes of this requirement are those records necessary for a client to comply with his or her federal tax obligations. 

Returns or other documents prepared by the practitioner, that the practitioner is withholding pending payment of a fee are not included. 

Circular 230 allows advertising and solicitation. An enrolled agent may use the phrase ‘Enrolled to practice before the IRS.’ 

A temporarily recognized person may not use the phrase. False, fraudulent, misleading, deceptive, or coercive statements or claims are not allowed. Claims must be verifiable. 

A practitioner may advertise the practice is limited to certain areas. Radio or television advertising must be recorded. 

A recording of the audio transmission must be retained. Copies of communications must be retained by the practitioner for at least thirty six months from the date of the last transmission or use. 

Uninvited solicitation, direct or indirect, of employment in matters related to the IRS is not allowed if the solicitation violates federal or state law or other applicable rule. 

Each of the following may be advertised: 

1) Fixed fees for specific routine services, 

2) a range of fees for particular services, 

3) the fee for an initial consultation, 

4) hourly rates, and 

5) the availability of a written fee schedule. 

Enrolled agents may not indicate an employer-employee relationship with the IRS or use the term certified while describing their professional designation. 

Finally, a practitioner may not assist or accept assistance from any person or entity that the practitioner knows has obtained clients in violation of circular 230’s advertising and solicitation rules. 

Q: What are best practices for tax advisors?

A: Tax advisors should provide clients with the highest quality representation concerning tax issues by adhering to best practices in providing advice and in preparing or assisting in the preparation of a submission to the IRS. 

Best practices include communicating clearly with the client regarding:

1) The terms of the engagement, 

2) establishing the facts, 

3) determining which facts are relevant, 

4) evaluating the reasonableness of any assumptions or representations, 

5) relating applicable law to the relevant facts, 

6) arriving at a conclusion supported by the law and the facts,  and

7) advising a client regarding the importance of the conclusions reached.

These also include, for example, whether the taxpayer may avoid accuracy related penalties if the taxpayer acts on reliance on the advice, and acting fairly and with integrity in practice before the IRS. 

Tax advisors with responsibility for overseeing a firm’s practice of providing advice concerning federal tax issues, or of preparing or assisting in the preparation of submissions to the IRS should take reasonable steps to confirm the firm’s procedures for all members, associates, and employees are consistent with best practices.

Q: What is supervisor responsibility?

A: Any practitioner who has principal authority and responsibility for overseeing a firm’s practice of preparing tax returns, claims for refunds, or other documents for submission to the IRS, must take reasonable steps to ensure the firm has adequate procedures in effect for all members, associates, and employees for purposes of complying with Circular 230.

Q: What are sanctions and disciplinary proceedings?

A: An attorney, a CPA, or an enrolled agent may be reprimanded, suspended, or disbarred from practice before the IRS for willful violations of any of the regulations contained in Circular 230. 

The secretary of the treasury may censure, suspend, or disbar from practice before the IRS any attorney, CPA or enrolled agent who:

1) Is shown to be incompetent or disreputable, 

2) refuses to comply with the rules and regulations relating to practice before the IRS, or 3) willfully and knowingly with intent to defraud deceives, misleads, or threatens any client. 

Circular 230 lists conduct that may result in suspension or disbarment. 

Examples include: 

1) Being convicted of an offense involving dishonesty or breach of trust; 

2) providing false or misleading information to the treasury department, including the IRS; 

3) negotiating a client’s refund check or not promptly remitting a refund check; 

4) circulating or publishing matter related to practice before the IRS deemed libelous or malicious or using abusive language; 

5) performing or maintaining a partnership to practice tax law or accounting with a person suspended disbarred from practice before the IRS; 

6) violating a Circular 230 rule; 

7) filing a complaint against IRS personnel if the practitioner knows the complaint to be false; 

8) advancing a argument or claim that the practitioner knows is frivolous; 

9) conviction of any felony involving conduct that renders the practitioner unfit to practice before the IRS; 

10) attempting to influence the official action of any IRS employee by bestowing a gift, favor, or thing of value; 

11) failing to electronically file when required to do so; 

12) preparing all or substantially all of or signing a tax return without a preparer tax identification number; 

13) unauthorized representation of a taxpayer before the IRS; 

14) failing to remit funds from a client to the IRS for payment of tax or other obligations; 

15) failing to make a federal tax return in violation of federal tax laws; 

16) intimating the ability to obtain special consideration from the IRS or instituting or maintaining proceedings primarily for delay. 

The Commissioner may confer with a practitioner on allegations of misconduct, whether or not a proceeding for suspension or disbarment has been instituted. 

A proceeding is instituted by filing a complaint that names the respondent and is signed by an authorized representative of the IRS. 

The complaint should contain a clear and concise statement of the allegations that constitutes the basis of the proceeding. 

The complaint must be served on the practitioner by delivery in person, private delivery service, certified mail or first class mail if a certified letter is not accepted by the agent. 

A proceeding is not instituted until the complaint is received and until the agent is provided the opportunity to show or achieve compliance with all lawful requirements. 

A practitioner may offer consent to suspension to avoid institution of a suspension or debarment proceeding. 

However, the IRS is not bound to accept the offer. The practitioner must file an answer to the complaint in writing within the specified period. 

The practitioner must have at least thirty days from the date of service to file his or her answer. An extension may be granted if application is made to the administrative law judge or ALJ. 

If an answer is not filed, the ALJ may treat the respondent as if he or she admitted each allegation and waived a hearing, not require proof by evidence at a hearing, and decide against the respondent practitioner by default. 

The answer must contain a statement of facts that constitutes the grounds for defense and admit or deny each allegation set forth in the complaint or state that he or she lacks sufficient information to form a belief. 

The practitioner may not deny a material allegation that he or she knows to be true or state that he or she lacks sufficient information to form a belief when he or she has such information. 

Special matters of defense may be affirmatively stated. Each allegation not denied is treated as admitted and proved. 

The IRS may request for suspension or disbarment any person to provide information for violation of the rules and to testify at a proceeding. 

The practitioner is required to honor the request unless, with a reasonable basis, he or she believes in good faith and on reasonable grounds that the information is privileged. An ALJ presides at hearings on complaints for sanctions. 

If either party, after due notice of a hearing has been sent, fails to appear, he or she is treated as having waived the right to a hearing and the ALJ may enter a decision against him or her by default. The hearing should occur within 180 days after the time for filing the answer. 

A respondent may appear in person, be represented by a practitioner, or be represented by an attorney who has not filed a declaration to practice before the IRS. The representative need not be an Enrolled Agent. 

Hearings must be stenographically recorded and transcribed and testimony of witnesses must be taken under oath or affirmation. An ALJ does not necessarily file rules of evidence applied in courts of law and equity. 

If the sanction sought is censure or a suspension of less than six months, the standard approved for Circular 230 proceedings is preponderance of the evidence. 

If the sanction sought is a monetary penalty, a suspension of more than six months, or disbarment, the standard of proof is clear and convincing evidence. 

The ALJ must allow the parties reasonable opportunity to submit proposed findings and conclusions and reasons supporting them. 

Either party may appeal the ALJ’s decision to the Secretary of the Treasury within thirty days of the decision. A suspended practitioner is not allowed to practice before the IRS while a suspension is in effect. 

Those receiving the issuance of a notice of disbarment or suspension from practice before the IRS include IRS employees, interested departments and agencies of the federal government, and the appropriate state authorities.

Five years after disbarment, the IRS may consider a petition for reinstatement. The IRS must be satisfied that the petitioner’s conduct will comply with rules and regulations governing practice before the IRS. 

The Secretary of the Treasury is also authorized to issue public reprimands to practitioners who violate the rules of practice. 

Censured practitioners may also be subject to conditions imposed for a reasonable period in light of the gravity of the violation. 

The IRS will make available for public inspection the roster of all persons who are enrolled to practice, censured, suspended, or disbarred from practice before the IRS and on the roster of all disqualified appraisers. 

Other records of the Director may be disclosed upon specific request in accordance with the applicable disclosure rules of the IRS and the treasury department as contained in Circular 230.

Q: What are the renewal requirements for Enrolled Agents?

A: To maintain active enrollment to practice before the IRS, Enrolled Agents must renew enrollment every third year after initial enrollment is granted. 

Application for renewal is based on the last digit of the Enrolled Agent’s social security number or tax identification number. 

Currently, renewals are divided into three groups over a three year cycle. Application for renewal is required to maintain active renewal status. 

Failure to receive notice of the renewal requirement by the IRS does not justify circumventing the requirement. 

A non complying Enrolled Agent will be given an opportunity to state the basis for the noncompliance with the possible consequence of being placed on the roster of inactive Enrolled Agents for a three year enrollment period. 

Renewal is conditioned on completing a minimum or 72 hours of continuing education credits during the three year enrollment cycle, including at least sixteen hours in each of the three years. 

Two hours per month of CE credit is required of an individual whose initial enrollment begins during a cycle. 

A course of learning may qualify for CE credit if it is a program that is designed to enhance professional knowledge in federal tax law, federal tax matters, qualified retirement plan matters or tax related ethics. 

For those who teach a qualifying program, two hours of CE credit is awarded for actual   preparation time and one hour as instructor, discussion leader, or speaker. The maximum credit for instruction and preparation may not exceed six hours annually. 

Each individual applying for renewal must retain the documentation required with regard to qualifying continuing education credit hours for a period of four years following the date of renewal of enrollment.

Q: What is identity theft?
A: Identity theft occurs when someone uses another person’s personal information, such as name, social security number, or other identifying information without permission to commit fraud or other crimes. 

Usually an identity thief uses a legitimate taxpayer’s identity to fraudulently file a tax return and claim a refund. Taxpayers subject to identity theft will need to fill out the IRS identity theft affidavit. 

Taxpayers should be aware that 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. 

Q: Who is considered a tax return preparer?
A: A tax return preparer does not have to be a CPA, an attorney, an Enrolled Agent, or any other person authorized to practice before the IRS in order to prepare tax returns. 

A tax preparer is subject to Circular 230 only if he or she is also a practitioner. However, all tax return preparers are subject to preparer penalties. 

The penalties include penalties for understatement of a taxpayer’s liability due to unreasonable positions or willful or reckless conduct, for disclosing taxpayer information, and for promoting abusive tax shelters.

A tax return preparer is any person who prepares for compensation or employs one or more persons to prepare for compensation any return of tax or claim for refund, or substantial portion thereof, under the code. 

A person who furnishes to a taxpayer or other preparer sufficient information and advice, so that completion of a return is simply a mechanical matter, is considered a tax return preparer. 

But a person who only gives advice only on specific issues is generally not considered to be a preparer. 

The regulations define specific parameters regarding what constitutes an insubstantial portion of the return, whereby the individual is generally not considered to be a preparer. 

If more than one tax return preparer is involved in preparing a return or claim for refund, the one with primary responsibility for the overall substantive accuracy is considered the only preparer for purposes of the signing requirement. 

The tax preparer with primary responsibility cannot relieve themselves of that responsibility by sharing any specified functional tasks.

Q: What are the penalties for disclosure of taxpayer information?

A penalty is imposed on any tax return preparer who discloses or uses any tax return information without the consent of the taxpayer other than for the specific purpose of preparing, assisting in preparing, or providing services in connection with the preparation of any tax return of the tax return taxpayer. 

The penalty is $250 per disclosure, with a maximum is $10,000 per year. If convicted of knowingly or recklessly disclosing the information, a preparer would be guilty of a misdemeanor, and subject to up to $1,000 in fines and up to a year in prison. 

The penalty for disclosure is not imposed of the disclosure was made:

1) Pursuant to other provisions of the code; 

2) to a related taxpayer, provide the taxpayer had not expressly prohibited a disclosure; 

3) pursuant to a court order; 

4) by one officer, employee, or partner to another officer, employee, shareholder, or partner; 

5) to provide information for educational purposes; 

6) to solicit tax return preparation services; 

7) or for the purpose of a conflict, quality, or peer review. 

The taxpayer’s consent must be a written, formal consent, authorizing the disclosure for a specific purpose. 

The taxpayer must authorize a preparer to disclose the information to additional third parties. Or disclose the information in connection with another person’s return. 

The confidentiality privilege is extended to certain other non attorneys. In non criminal tax proceedings before the IRS, a taxpayer is entitled to the same common law protections of confidentiality in respect with the tax advice given by an federally authorized tax practitioner as a taxpayer would have, if the advising individual were an attorney. 

Privilege also applies in any noncriminal proceeding in federal court, brought by or against the United States. 

A federally authorized tax practitioner includes any non attorney who is authorized to practice before the IRS, such as an Enrolled Agent, enrolled actuary, or CPA. 

Tax advice is defined as advice given by an individual in respect to matters that are within the scope of an individual’s authority to practice before the IRS. 

The privilege may not be asserted to prevent the disclosure of information to any regulatory body other than the IRS.
Also, the privilege does not apply to any written communication between a federally authorized tax practitioner and any:

1) director, 

2) shareholder, 

3) officer, 

4) employee, 

5) agent, or 

6) representative of a corporation

in connection with the promotion of any tax shelter in which the corporation is a direct or indirect participant.

Q: What is a tax shelter? 

A: A tax shelter is a legal method of minimizing or decreasing an investor’s taxable income and therefore tax liability. 

Q: What does a tax benefit include?

Tax benefit includes:

1) Deductions, 

2) exclusions from gross income, 

3) nonrecognition of gain, 

4) tax credits, 

5) adjustments to the basis of property, 

6) status as an entity exempt from federal income taxation, and 

7) any other tax consequences that may reduce a taxpayer’s federal tax liability by

affecting the:

1) Amount, 

2) timing, 

3) character, or 

3) source

of any item of income, gain, expense, loss or credit. 

The IRS considers certain tax shelters potentially improper tax shelter activity. Taxpayers are required to disclose reportable transactions. 

Five major categories of reportable transactions include: 
1) Listed transactions, 

2) confidential transitions, 

3) transactions with contractual protection, 

4) loss transitions, and 

5) transactions of interest. 

Tax return preparers are subject to a penalty for promoting abusive tax shelters, equal to the lessor of $1,000 for each sale or organization of an abusive arrangement or plan, or 100 per cent of the income derived from the activity.