Fundamentals of income taxation - my-CPE.com...TIER 2 CRITERIA –DEPENDENT IS A QUALIFYING CHILD (2...

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

======

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”

1-49

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?

Thank you!

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