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FUNDAMENTALS OF INCOME TAXATION
LEARNING OBJECTIVES
1. Identify how the federal income tax differs from other types of federal taxes.
2. Determine the steps in computing a taxpayer's federal income tax liability.
3. Differentiate tax consequences for terms commonly used for the federal income tax, such as "adjusted gross income," “qualifying child,” “tax credits,” “filing status,” and “kiddie tax.”
4. Recognize how an individual's standard deduction is determined.
LEARNING OBJECTIVES
5. Explain differences in the tax for ordinary income, capital gains, and qualified dividend income.
6. Discuss the difference between the cash and accrual method, and the correct period in which taxpayers must recognize income and/or deductions.
7. Identify deadlines for filing income tax returns and estimated taxes and how to obtain an extension of time for filing a return.
WHO MUST FILE
WHO MUST FILE? (1 OF 2)
For taxpayers under 65, must file if gross income exceeds
following levels even if no tax due (2019 thresholds):
Single $12,200
MFJ $24,400
Surviving Spouse $24,400
Married living separately $ 0
Head of Household $18,350
WHO MUST FILE? (2 OF 2)
Taxpayer must still file even if gross income below threshold if:
1. Taxpayer rec’d advance payments of EIC.
2. Taxpayer has self-employment income > $400.
3. Taxpayer who is claimed as a dependent by another AND unearned income > $1,100 or gross income > standard deduction.
4. Taxpayer owes 0.9% Additional Medicare tax or 3.8% Net Investment Income Tax.
CALCULATING THE FEDERAL TAX LIABILITY
BASIC FORMULA FOR CALCULATING INCOME TAX
Total Income
Less: Exclusions
Gross Income
Less: Deductions for Adjusted Gross Income
Adjusted Gross Income (“The Line”)
Less: Itemized Deductions/Standard Deductions
Taxable income
Tax liability calculated per table
Less: Any credits or prepayments
Equals: Net tax payable or refunds
FORM 1040, PAGE 1
FORM 1040, PAGE 2
FORM 1040, SCHEDULE 1
ALTERNATIVE MINIMUM TAX (“AMT”)
Ensures taxpayers pay a “fair” share of taxes irrespective of exclusions, deductions, and credits.
Must calculate every year.
Pay greater of “regular” tax or AMT.
AMT FORMULA (1 OF 2)
Regular Taxable Income or Loss
+ Tax Preference Items
+/− AMT Adjustment Items
Alternative Minimum Taxable Income (“AMTI”)
− Exemption for AMT
TAX BASE
AMT FORMULA (2 OF 2)
Tax Base
× AMT Tax Rates
Tentative Minimum Tax
− Regular Income Tax
ALTERNATIVE MINIMUM TAX
TAX RATES AND EXEMPTIONS
2019 AMT Rates
26% on first $194,800.
28% on AMTI over $194,800.
AMT Exemption Amount = Basic exemption amount – 25% (AMTI – threshold).
ADDITIONAL FEDERAL TAXES
OASDI 12.4% rate is limited to the first $132,900 of net SE earnings
(2019)
“Net SE Earnings” = 92.35% of SE income.
Medicare 2.9% rate is imposed on all net SE earnings without limit.
Can deduct “For” AGI ½ FICA tax- Schedule 1, Line 27.
Additional surtax is levied on taxpayers with income > $200,000
(individuals) / $250,000 (MFJ).
These individuals will need to pay an additional 3.8% on investments and
0.9% on wages and SE income.
EXAMPLE: SELF-EMPLOYMENT TAX CALCULATION
Crystal has earned self-employment income of $100,000 net of expenses. Her self-employment taxes will be calculated as follows:
Net SE income ($100,000 x 92.35%) $92,350
Times: 15.3% (12.4% OASDI + 2.9% Medicare) X 15.3%
Total SE Taxes $14,130
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Amount that can be deducted For AGI (50% SE taxes) $ 7,065
TYPES OF TAX YEARS
Calendar Year End
Fiscal Year End
52-53 week year end
RECOGNITION OF INCOME AND DEDUCTIONS
ASSIGNMENT OF INCOME
Individual providing services is required to recognize income even though he/she may have assigned the right to receive the income to another.
Income from property (e.g., interest or rent income) should be taxable to the owner of the property.
ACCOUNTING METHODS
Governs what year the taxpayer’s income and expenses are recognized.
Tax accounting methods must be generally the same as the taxpayer’s financial accounting method.
OVERALL ACCOUNTING METHODS
Cash
Accrual
Hybrid
CASH METHOD – GENERAL RULE
Income recognized when cash is received or constructively received.Constructive receipt = taxpayer has right to the cash but chose not to exercise possession.
No constructive receipt if taxpayer has substantial limitations in power to access income.
Generally income recognized when actually or constructively received, not when earned.
Income can be in form of cash, property, or services.
CASH METHOD – GENERAL RULE
Non-cash items are valued at FMV.
Expenses recognized when cash is paid.
Capital assets must be capitalized and depreciated.
CONSTRUCTIVE RECEIPT EXAMPLE
Mikayla is a calendar year taxpayer. Jane’s client gives her a check the morning of Wednesday, December 31, 2019. She decides not to deposit the check until the following week. Mikayla will be deemed to have constructively received the funds in 2019 and will have to recognize income that year.
PREPAID EXPENSES – CASH BASIS
Generally, prepaid expenses are not deductible when paid.
Exception: prepaid rent can be deducted when paid if:
1. Period covered by prepayment ≤ 1 year;
2. Prepayment is required by the lease.
CASH METHOD
Prepaid expenses must be capitalized and amortized as goods or services are used if life of asset extends substantially beyond the end of tax year (“one-year rule”).
No one-year rule available for prepaid interest expense unless the amounts are points paid on the mortgage to purchase or improve a personal residence.
CASH METHOD
Checks and credit cards = cash payment.
Taxpayer’s note is not equivalent cash payment; therefore no deduction until note is paid.
ACCRUAL METHOD – INCOME (1 OF 2)
Income recognized when earned (e.g., when goods and services have been provided).
All Events Test – “Earned” =
All events have occurred to fix the right to receive the income; and
Amounts can be determined with reasonable accuracy.
ACCRUAL METHOD – INCOME (2 OF 2)
Exception – Prepaid income recognized when received.
Exception to Exception:
Can defer recognition for prepayment of goods if tax accounting = financial accounting.
Can defer recognition if prepaid for services.
Must recognize revenue associated with services provided in Year 1.
Remainder must be recognized in Year 2 irrespective of whether services are provided.
EXAMPLE: RECOGNITION OF INCOME ACCRUAL BASIS
Jeff is a videographer who has adopted a calendar year end and is on the accrual basis. Jeff is paid $8,000 on December 1, 20X1 for an event he will video on January 1, 20X2. He performs no services in December. He will not need to recognize income until 20X2 even though he received a prepayment in 20X1 because his is providing services which did not occur until 20X2.
ACCRUAL METHOD – DEDUCTIONS (1 OF 2)
Can deduct expenses only if both test are met:
1.All Events Test; AND
2. Economic Performance Test
All Events Test – Can deduct if:
a.All events have occurred to establish the fact of the liability; and
b.Amount of expense can be determined with reasonable accuracy.
ACCRUAL METHOD – DEDUCTIONS (2 OF 2)
Economic Performance Test:
Economic performance occurs when property or services are actually provided by the taxpayer or the other party.
EXAMPLE: PREPAYMENT OF SERVICES
Deborah is an accrual-basis taxpayer who has adopted a calendar year end. She pays $360 on December 1, 20X1 of the current tax year as a prepayment of a 24 month policy insurance coverage. She can only deduct one month of the pro-rated premium in the 20X1 tax year since economic performance has not occurred.
DEEMED OCCURRENCE OF ECONOMIC PERFORMANCE – ALL MUST OCCUR
INCOME AND EXCLUSIONS
TOTAL INCOME
Any “income from whatever source derived.” IRC Sec. 61.
Includes both taxable and non-taxable income.
Does NOT include return of capital (basis) of property sold.
Example: Bob sells a piece of property for $1,000. He has a cost
basis of $700. Bob will include $300, not $1,000, in total income.
GROSS INCOME ITEMS PER § 61
Wages
Business Gross Inc.
Gains from Property Sales
Interest
Rents
Royalties
Dividends
Alimony through 12/31/2018
GROSS INCOME ITEMS PER § 61 (CONT’D)
Annuities
Life Insurance Proceeds
Pensions
Cancellation of Debt Income
Partnership Income
Income in Respect of a Decedent
Trust/Estate Income
EXCLUSIONS (1 OF 2)
Gifts
Life Insurance
Welfare
Certain Scholarships
Certain Payments for Injury
Certain Employee Benefits
Certain Foreign Income
EXCLUSIONS (2 OF 2)
Tax-Exempt Interest
Series EE Bond Interest
Leasehold Improvements
Meritorious Achievement Awards
Certain Divorce Payments
Gain from Sale of Home
Roth IRA Distributions
GIFTS AND INHERITANCES
Generally, gifts are not taxable to the recipient.
Any income derived after the donee takes title to the property is taxable to the donee.
Prizes are not considered gifts, but are income.
Any bonuses paid by an employer to an employee are not considered a gift, but are taxable wages.
LIFE INSURANCE PROCEEDS (1 OF 3)
Generally, face value of life insurance proceeds paid upon death are not taxable income to recipient.
Exception: if taxpayer purchases a policy insuring another, then tax-free portion limited to purchase price plus additional premiums paid.
Also, if amounts received are greater than face value, then the excess is taxable income.
DEDUCTIONS
“FOR” VS. “FROM” AGI“For” AGI – e.g., business deductions, moving expenses, IRAs, SE health insurance.
“From” AGI – e.g., greater of: itemized deductions or standard deduction.
AGI = “THE LINE”
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DEDUCTIONS “FOR” AGI = § 62
Trade and Business Deductions
Reimbursed Employee Expenses
Loss from Property Sales
Rent/Royalty Deductions
Retirement Plan Contributions
Penalties from Savings Accounts
One-half Self-Employment Taxes
DEDUCTIONS “FOR” AGI - § 62 (CONT’D)
Self-employed Health Insurance Premiums
Alimony for agreements executed prior to 2019
Moving Expenses
Repayments of Unemployment Compensation
Certain Jury Duty Pay
Interest on Student Loans
Medical Savings Account Contributions
HOBBY LOSSES
The taxpayer is presumed to have a profit motive if he/she
can show a profit for 3 out of 5 consecutive years. The IRS
then will have burden of proof to disprove the taxpayer’s
position.
If activity considered a hobby, then taxpayer can deduct
expense only up to amount of gross income.
FILING STATUS
FACTORS AFFECTING FILING STATUS
Marital status – determined by December 31 of the tax year. Taxpayer must file either MFJ or MFS.
If taxpayer is unmarried, whether he/she has dependents. This will affect whether the taxpayer can file as Single or Head of Household.
Most favorable tax brackets are MFJ and Head of Household.
DETERMINING FILING STATUS (1 OF 2)
DETERMINING FILING STATUS (2 OF 2)
SURVIVING SPOUSE CRITERIA
Year 1
If not remarried, can claim MFJ.
Can use MFJ tax schedule and MFJ standard deduction.
Year 2
Cannot be remarried by end of Year 2.
Must be a US citizen or resident.
Must have a dependent living at home with taxpayer paying over
½ expenses of home.
DEPENDENCY EXEMPTIONS – QUALIFICATION
Note: Individual must meet both Tier 1 and Tier 2 criteria to qualify as the taxpayer’s dependent.
Yes
No
TIER 1 CRITERIA FOR DEPENDENCY EXEMPTION
ID # – Each dependent must have a SSN.
Citizenship – Must be US citizen, US national, or legal resident.
Separate return test:
Generally, dependent cannot file joint return with spouse.
Exception: dependent files joint return only to obtain refund of tax withheld.
TIER 2 CRITERIA – DEPENDENT IS A QUALIFYING CHILD (1 OF 3)
Relationship Test – Eligible individuals:
Taxpayer’s natural, adopted, foster, and step-children.
Taxpayer’s siblings, half-siblings, and step-siblings.
Any descendants of the above.
Adoption = legal adoptions or child being legally placed in home for adoption.
TIER 2 CRITERIA – DEPENDENT IS A QUALIFYING CHILD (2 OF 3)
Age Test – Must fall within at least one category:
Under age 19; OR
Permanently and totally disabled (any age); OR
Full-time student under age 24.
Considered full-time student if dependent is enrolled at qualifying institution for at least 5 months and carries a full course load.
TIER 2 CRITERIA – DEPENDENT IS A QUALIFYING CHILD (3 OF 3)
Abode Test – Must have same principal abode as the taxpayer for > ½ the year.
Non-custodial parent meets Abode test if custodial parent agrees in writing.
Support Test – Dependent can’t provide more than ½ of his/her support.
TIER 2 CRITERIA – OTHER QUALIFYING INDIVIDUALS (1 OF 2)
Relationship Test – Must fall within at least one category:
Related to the taxpayer.
Does not have to live with taxpayer.
Can be a qualifying child, parents (including parents’ ancestors and siblings), step-parents, or certain in-laws.
Taxpayer’s cousins do not qualify under this category.
Resides in taxpayer’s home the entire year.
Dependent needs only to be related to one spouse in a joint return. Relationship is not terminated by death or divorce once established.
TIER 2 CRITERIA – OTHER QUALIFYING INDIVIDUALS (2 OF 2)
Gross Income Test – Dependent’s taxable gross income must be < $4,200 in 2019.
Support Test – Taxpayer must provide more than ½ of dependent’s financial support.
Include non-taxable amounts spent except scholarships.
Include FMV of items in support calculation including imputed rent.
Do not include FMV of personal services rendered by taxpayer to dependent.
EXAMPLE: DEPENDENCY DEDUCTION
Tony’s wife dies in December, 20X1. Their son, Joe, is 28 but had quit his job and moved home with his parents during 20X1 to help Tony during his mother’s illness. Joe remains with Tony during most of 20X2 to help settle his mother’s affairs. Joe does not earn income during 20X2, and Tony continues to pay for housing, food and all expenses for Joe throughout 20X2.
Tony is able to claim MFJ status for 20X1as a surviving spouse. Tony would normally claim Single filing status for 20X2, but since he is supporting Joe, Tony may claim Head of Household status. Head of Household and MFJ status will provide Tony with a larger Standard Deduction and more favorable tax brackets.
PARENTAL RELEASE
Generally, exemption is awarded to custodial parent.
Exception – Non custodial parent can claim exemption if other parent signs Form 8332.
STANDARD DEDUCTIONS VS. ITEMIZED DEDUCTIONS
DEDUCTIONS “FROM” AGI
Taxpayer can deduct greater of: Itemized Deductions OR
Standard Deduction.
Amount of Standard Deduction is affected by filing status.
STANDARD DEDUCTIONS (2019 AMOUNTS)
Single = $12,200
Head of Household = $18,350
Married Filing Separately = $12,200
Married Filing Jointly = $24,400
Add $1,300 to the Standard Deduction ($2,600 if both elderly
AND blind). Max increase of $5,200 for MFJ.
ITEMIZED DEDUCTIONS
Medical Expenses
Taxes – Property, Real Estate, and State
Charitable Contributions
Mortgage Interest
ITEMIZED DEDUCTIONS – NOT SUBJECT TO THRESHOLDS (1 OF 2)
Mortgage Interest – limited to $750,000 mortgage incurred 12/16/2017 and later (limit is $1 million mortgage incurred before 12/16/2017).
Charitable Contributions – limited to 60% AGI.
Property, State, and Real Estate Taxes – limited to $10,000 ($5,000 MFS).
Investment Interest – limited to net investment income.
ITEMIZED DEDUCTIONS – NOT SUBJECT TO THRESHOLDS (2 OF 2)
Miscellaneous Deductions:
Estate taxes for Income in Respect of a Decedent.
Gambling losses to the extent of gambling income.
Amortization of bond premium.
Amounts restored under claim of right.
ITEMIZED DEDUCTIONS – SUBJECT TO FLOORS
Medical Expenses – Can only deduct amounts over 7.5%
AGI.
COMMON TAX CONCEPTS
EARNINGS OF MINOR CHILDREN
Income earned by minor child is taxed to the child, not the parents.
This applies to wages or investment income earned by child.
Child’s investment income may be subject to the “kiddie tax.”
CHILDREN WITH UNEARNED INCOME (1 OF 2)
Children with earned or unearned income are required to file own tax return if otherwise over filing threshold.
Standard deduction is limited to greater of:
$1,100; OR
Dependent’s earned income + $350.
CHILDREN WITH UNEARNED INCOME (2 OF 2)
“Kiddie Tax” – If child is under 18 (24 in some cases), some of child’s unearned income is taxed at parent’s marginal rate.
If less than 18, “kiddie tax” applies to unearned income > $2,200.
If 18, “kiddie tax” if:
Earned income ≤ 1/2 support; AND
Unearned income > $2,200.
If 19 but less than 24, “kiddie tax” if:
Full-time student; AND
Earned income ≤ 1/2 support; AND
Unearned income > $2,200.
USE AND IMPORTANCE OF TAX CREDITS (1 OF 2)
Refundable Personal Credits
Earned Income Credit
Overpayment of Social Security Taxes
Taxes withheld from wages and other income.
Premium Tax Credit
Nonrefundable Personal Credits
Adoption Credit
Child Tax Credit
Child and Dependent Care Credit
Elderly/Disabled Credit
Educational Credits
Retirement Savings Credit
Residential Energy Credit
CHILD CREDITS – § 24
Can claim $2,000 credit for each qualifying child or $500 for each
other dependent. Partially refundable.
Qualifying child = same definition as for dependency exemption
except < 17 years.
Credit is reduced $50 for every $1,000 (or part thereof) over $200,000 ($400,000 MFJ).
Partially refundable. Refund is limited to the lesser of: (1) 15% of the taxpayer’s earned income in excess of $2,500 or (2) $1,400 (if the taxpayer has one or two qualifying children).
CAPITAL GAINS AND LOSSES
TREATMENT OF CAPITAL GAINS/LOSSES
Capital gains and capital losses derive from sale or exchange of capital assets. Capital assets are general trade, business, or investment property that are not inventory.
Net long-term capital gains are taxed at a lower rate than ordinary income.
Net short-term capital gains are taxed as ordinary income.
Net capital losses are deductible only up to $3,000. Excess capital losses can be carried forward.
MAXIMUM NET CAPITAL GAIN RATES
Capital Gains can be taxed at the following maximum rates depending on the taxpayer’s AGI:
0% for AGI < $39,375 – single ($78,750 – MFJ).
15% for AGI > $39,375, but < $434,550 – single($78,750/488,550 – MFJ).
20% for AGI > $434,550 – single ($488,850 – MFJ).
NETTING REALIZED CAPITAL GAIN OR LOSS
DIVIDENDS
Dividends generally includable into gross income.
C Corps can exclude between 50-100% of dividends under the dividends-received deduction (“DRD”).
Individuals – Dividend rates are capped.
DUE DATES
Individuals – April 15
C Corporations – 15th day of the 4th month after close of tax year.
Partnership and S Corporations – 15th day of the 3rd month after close of tax year.
If due date falls on weekend or national holiday, due date is moved to the first business day following.
Extensions – 6 months for Individuals, Partnership, and S Corporations. 6, or 7 months for Corporations.
TAXABILITY OF DIVORCE PAYMENTS
Type of Payment Payor Payee
Alimony Not Deductible Not Includable
(agreement. post 12/31/18)
Alimony Deductible Includable
(agreement prior to 1/1/19)
Property Settlement Not Deductible Not Includable
Child Support Not Deductible Not Includable
OTHER ITEMS IN GI (1 OF 2)
Life Insurance – Face value of insurance proceeds received incident to death is non-taxable to the recipients.
Discharge of Indebtedness – The forgiven amount of a loan is taxable income.
Pass-through Income – Generally, taxable to the recipient. Examples: partnership income, IRD, trust income, S Corp distributions.
OTHER ITEMS IN GI (2 OF 2)
Prizes, Awards, Treasure Trove, Lottery & Gambling Winnings– All considered taxable income.
Illegal Income – Amounts are taxable.
Unemployment Compensation – Creates taxable income.
CALCULATING TAXABLE SOCIAL SECURITY INCOME
ESTIMATED PAYMENTS
CREDITS AGAINST TAX LIABILITY
Withholding from wages
Quarterly estimated payments
Application of prior year’s tax return refund to current year liability
QUARTERLY PAYMENT DUE DATES FOR INDIVIDUALS
1st Quarter – April 15
2nd Quarter – June 15
3rd Quarter – September 15
4th Quarter – January 15
REQUIRED ESTIMATED TAX PAYMENTS – MUST BE GREATER THAN OR EQUAL TO ANY OF FOLLOWING:
CREDITS
CREDITS - GENERALLY
Dollar-for-dollar reductions on tax liability.
Refundable vs. non-refundable.
Taxpayers are usually better off having a credit instead of a deduction.
USE AND IMPORTANCE OF TAX CREDITS
General Business Credits
Business Energy Credit
Disabled Access Credit
Employer-Provided Child Care Cr.
Rehabilitation Expenditures Credit
Research Credit
Miscellaneous Credits
Foreign Tax Credit
Questions?
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