Fundamentals of Taxation for Individuals

GREGORY CARNES My love for education and learning began very early in life. I attended an excellent college prep school, Baylor, in Chattanooga, TN, which is where I discovered how to be curious and creative, and to push myself intellectually. My father majored in accounting in college, and worked in public accounting and industry his entire career. So, I first learned about accounting careers from him, and I decided I would give it a try at college. I had great accounting instructors at Lipscomb University, especially Dr. Axel Swang and Professor Charles Frasier. I worked at Charles Frasier's accounting firm during my senior year, which is when I decided that the tax route was best for me, and I would leave the audits to others. After graduation, I decided to specialize in taxation and began the Master of Science in Accounting with Tax Emphasis program at the University of Memphis. I received a very good foundation in the tax law, especially from Dr. Rodger Bolling, who would later be my colleague at Northern Illinois University. SUZANNE YOUNGBERG Being raised by hardworking parents who worked in corporate accounting, I was introduced to the field at an early age. After taking three high school accounting courses and being known as the penny-pincher of the family, I pursued my Bachelor of Science in Accountancy at Northern Illinois University. I was not a straight A student in college and worked very hard to earn my grades from outstanding professors who set a high bar. This early introduction to working hard to achieve my goals has carried through to all areas of my life. After working in taxation for a medium-sized public accounting firm in Chicago, passing the CPA Exam, and earning my Master of Science in Taxation from DePaul University, I was given the opportunity to teach one tax class at North Central College in Naperville, IL. I fell in love with teaching and have never looked back. Instructing students, understanding their difficulties in mastering the material, and celebrating their achievements were all extremely satisfying to me. When NIU asked me back to teach tax at my alma mater, I was thrilled!

Part I Introduction to Income Taxation

1 The Professional Practice of Taxation 1-1

1.1 The Basics of Tax Planning 1-4

The IRS: An Uninvited Third Party 1-4

The Goal of Tax Planning 1-5

Considering Tax Costs and Non-Tax Costs 1-6

1.2 Individual Income Tax Formula 1-7

1.3 Tax Compliance vs. Tax Planning 1-15

Closed vs. Open Transactions 1-16

Marginal Tax Rates, Average Tax Rates, and Effective Tax Rates 1-17

Tax Planning Opportunities 1-20

1.4 Tax Avoidance vs. Tax Evasion 1-28

Tax Evasion 1-28

Spotlight on the Law: Is the Tax Law Unconstitutional? 1-29

Tax Ethics 1-30

1.5 Tax Rules vs. GAAP 1-32

1.6 Goals of Tax Policymakers 1-33

Raise Revenue 1-34

Social Objectives 1-34

Economic Objectives 1-35

Equity Objectives 1-35

Political Objectives 1-37

1.7 Other Taxes Paid by Individuals 1-38

Other Federal Taxes 1-38

State and Local Taxes 1-39

Implicit Taxes 1-40

1.8 Professional Taxation as a Career 1-41

The Role of a Tax Professional 1-41

Characteristics of Successful Tax Professionals 1-42

2 Fundamentals of the Federal Income Tax System 2-1

2.1 Taxpayer Activities: Trade or Business, Investment, or Personal Use 2-4

Trade or Business 2-4

Investment Activities 2-5

Personal Activities 2-7

2.2 Classification of Assets 2-10

Ordinary, Section 1231, and Capital 2-10

Spotlight on the Law: Classification of an Asset: Sell Now or Later? 2-11

Realty vs. Personalty 2-12

Holding Period 2-13

2.3 Basis 2-14

What Is Basis? 2-14

Recovery of Basis 2-15

2.4 Foundations of Income 2-17

An All-Inclusive Definition of Income 2-18

Realization of Income 2-18

Income and Basis 2-19

2.5 Foundations of Deductions 2-21

Is an Expenditure Deductible? 2-21

Where Are Expenses Deductible? 2-23

2.6 Introduction to Property Transactions 2-24

Gains and Losses from Sales and Dispositions 2-24

Deferred Gains and Losses 2-26

Excluded Gains and Losses 2-31

3 Tax Authority, Research, Compliance Rules, and Professional Responsibilities 3-1

3.1 Sources of Tax Authority 3-5

Legislative Sources of Tax Authority 3-6

Administrative Sources of Tax Authority 3-8

Judicial Sources of Tax Authority 3-11

Spotlight on the Law: Impact of Filing a Petition Late 3-13

Secondary Sources of Tax Authority 3-16

3.2 Locating and Evaluating Authority 3-17

Weighting of Tax Authority 3-17

The Research Process 3-18

3.3 Compliance Responsibilities 3-20

Filing Requirements 3-20

Taxpayer Penalties 3-22

3.4 Tax Professional Responsibilities 3-31

Circular 230 3-31

Statements on Standards for Tax Services (ssts) 3-34

3.5 Tax Practice and Procedure 3-37

Audit Process 3-38

Appeals Process 3-40

Other Audit Issues 3-40

Signing a Return 3-41

4 Dependents and Filing Status 4-1

4.1 Dependents—Introduction and Qualifying Child 4-3

General Rules for Dependency 4-4

General Rules for Qualifying Child 4-4

Tiebreaker Rules 4-7

Unmarried Parents 4-8

Spotlight on the Law: Can I Claim My Dog as a Dependent? 4-10

4.2 Qualifying Relative and Other Dependency Rules 4-11

General Rules for Qualifying Relative 4-11

Other Dependency Rules 4-13

4.3 Filing Status—Introduction 4-16

General Rules for Married Filing Jointly (MFJ) and Single 4-17

Married Filing Separately (MFS) 4-19

Innocent Spouse Relief 4-20

4.4 Head of Household and Qualifying Widow(er) 4-21

General Rules for Head of Household Status 4-21

Qualifying Widow(er) 4-25

4.5 Dependent on Another Return and Kiddie Tax 4-28

Standard Deduction for a Dependent 4-28

Kiddie Tax 4-29

4.6 Filing Requirements 4-32

Part II Income

5 Framework for Income Recognition 5-1

5.1 All-Inclusive Approach to Income 5-4

Determining Income Recognition 5-5

Form of Receipt 5-5

Treasure Trove Principle 5-6

Spotlight on the Law: Great Catch but Beware of the Taxes! 5-7

5.2 Judicial Doctrines 5-8

Constructive Receipt Doctrine 5-9

Tax Benefit Rule 5-10

Claim of Right Doctrine 5-12

Assignment of Income Doctrine 5-13

5.3 Accounting Methods and Periods—Income 5-14

Cash vs. Accrual Method of Accounting 5-14

Recovery of Capital 5-16

Installment Sales 5-17

Income from Community Property 5-22

Change in Accounting Method 5-23

5.4 Business Income for Individuals 5-24

Sole Proprietorships and Single Member LLCs 5-25

Rental Real Estate 5-26

Royalty Income: Investment or Business? 5-27

Income from Other Pass-Through Entities: Partnerships, Limited Liability Companies (LLCs), and S Corporations 5-27

Advanced Topic—Drilling Down 5-28

5.5 Qualified Business Income Deduction 5-30

Qualified Business Income 5-30

Rental Real Estate 5-31

Determining the Qualified Business Income Deduction (Steps 1–5) 5-31

Determining the Qualified Business Income Deduction (Steps 6–7) 5-36

Determining the Qualified Business Income Deduction (Step 8) 5-38

Advanced Topics—Drilling Down 5-39

6 Income from Personal Activities 6-1

6.1 Income from Prizes, Awards, and Scholarships 6-6

Taxable Prizes and Awards 6-6

Exclusion for Awards for Recognition of Civic or Other Achievements 6-7

Exclusion for Olympic Medals 6-7

Scholarships 6-8

6.2 Divorces 6-10

Alimony 6-10

Child Support 6-12

Property Transfers 6-12

Inadequate Payments of Alimony or Child Support 6-13

6.3 Income and Basis Issues for Gifts and Inheritances 6-14

Income Tax Consequences of Gifts and Inheritances 6-15

Basis and Holding Period Issues for Property Received as Gift 6-16

Basis and Holding Period Issues for Inheritances 6-21

Basis and Issues for Property Converted from Personal Use 6-22

Advanced Topic—Drilling Down 6-24

6.4 Income from Injuries and Other Damage Awards 6-26

Determining the Tax Implications of Damage Awards: Key Questions 6-27

Legal Fees and Damage Awards 6-29

6.5 Income from Death of a Taxpayer 6-31

General Rule 6-31

Exceptions to the General Rule 6-32

Advanced Topic—Drilling Down 6-34

6.6 Forgiveness of Debt 6-35

Love or Generosity 6-36

Bankruptcy 6-36

Insolvency 6-38

Real Property Used in a Trade or Business 6-38

Other Debt Forgiveness 6-38

Spotlight on the Law: Is Debt Forgiveness Always Equitable? 6-39

6.7 Other Inclusions and Exclusions 6-40

Foster Child Payments 6-41

Government Assistance Program Payments (Welfare) 6-41

Parsonage 6-41

Income in Respect of a Decedent (IRD) 6-42

Jury Duty Pay 6-43

Unemployment Compensation 6-43

Advanced Topic—Drilling Down 7-45

7.7 Distribution Rules 7-47

Withdrawals from a Traditional IRA 7-47

Withdrawals from a Roth IRA 7-48

Distributions from Other Qualified Plans 7-49

Required Minimum Distributions 7-49

Rollovers 7-50

Annuities 7-50

7.8 Social Security Benefits 7-54

Spotlight on the Law: Taxation of Social Security Benefits 7-56

7.9 Foreign Earned Income 7-57

Part II (Ch. 5–7): Comprehensive Tax Return Problem

7 Income from Services 7-1

7.1 Wages and Tip Income 7-6

Wages 7-7

Tip Income 7-8

7.2 Income from Insurance-Related Fringe Benefits 7-9

Discrimination Rules 7-9

Employer-Purchased Health, Disability, and Long- Term Care Insurance 7-10

Life Insurance Premiums 7-12

Insurance Benefits Received 7-14

7.3 Income from Other Fringe Benefits 7-18

Personal Expenses Paid by Employer 7-18

Food and Lodging 7-19

Working Condition Fringe Benefits 7-20
De Minimis Fringe Benefits 7-21

No-Additional-Cost Services 7-21

Employee Discounts 7-22

Nominal Gifts 7-22

Safety and Length of Service Achievement Awards 7-22

Transportation and Parking 7-23

Other Fringe Benefits 7-23

Cafeteria Plans 7-25

7.4 Stock Options 7-27

Nonqualified Stock Options 7-29

Incentive Stock Options 7-29

Advanced Topics—Drilling Down 7-32

7.5 Reimbursement of Employee Business Expenses 7-34

Scenario 1: Accountable Plan 7-34

Scenario 2: Nonaccountable Plan 7-35

7.6 Retirement Plans 7-36

Section 401(k) Plans 7-36

Pension Plans 7-37

Self-Employed Plans 7-38

Individual Retirement Accounts 7-38

Part III Deductions

8 Framework for Deductions 8-1

8.1 Types of Activities 8-4

Trade or Business Activity 8-4

Investment/Production of Income Expenses 8-6

Personal Expenses 8-7

8.2 Disallowance of Deductions 8-8

Disallowed Expenses 8-8

Adequate Substantiation 8-11

Benefit of the Taxpayer 8-12

8.3 Types of Deductions 8-13

Spotlight on the Law: Insurance Fraud Payback: Deductible or Not Deductible? 8-14

8.4 Accounting Methods for Deductions 8-15

Prepaid Expenses 8-15

Prepaid Interest 8-16

All-Events Test and Economic Performance 8-17

Payments to a Related Party 8-19

Advanced Topic—Drilling Down 8-20

8.5 Capital Expenditure vs. Repair 8-22

8.6 Accounting for Inventories 8-24

Small Businesses 8-24

Large Businesses 8-25

9 Deductions for AGI and Itemized Deductions 9-1

9.1 Deductions for AGI 9-5

Educator Expenses 9-6

Health Savings Account 9-7

Moving Expenses 9-8

50% of Self-Employment Tax 9-8

Qualified Plan and IRA Contributions 9-9

Self-Employed Health Insurance Deduction 9-9

Penalty on Early Withdrawal of Savings 9-10

Alimony Paid 9-10

Student Loan Interest 9-10

Higher Education Tuition and Fees 9-11

Attorney’s Fees for Discrimination Lawsuits 9-11

Jury Duty Pay 9-12

Charitable Contributions 9-12

9.2 Deductions from AGI: Itemized Deductions vs. Standard Deduction 9-14

9.3 Medical Expenses 9-16

Qualified Medical Expenses 9-17

Other Medical Expense Rules 9-18

Medical Expense Calculation 9-19

9.4 Taxes 9-20

General Rules 9-20

$10,000 Limit 9-22

Spotlight on the Law: The Angst of the SALT Deduction Limitation 9-22

Sales Taxes 9-22

Taxes that Are Not Deductible 9-24

9.5 Interest 9-25

Home Mortgage Interest 9-25

Investment Interest Expense 9-28

Personal Interest 9-29

Other Rules Regarding Interest 9-30

9.6 Charitable Contributions 9-30

Was the Donation Made to a Qualified Charitable Organization? 9-31

Contribution of Services 9-31

Contributions of Cash or Property 9-33

Is There Appropriate Substantiation of the Donation? 9-35

Did the Donor Receive Anything of Value in Return for the Contribution? 9-35

What Limitations Apply to the Amount of the Donation? 9-36

Special Rules for Charitable Contributions 9-38

Nondeductible Contributions 9-38

9.7 Casualty Losses 9-42

Definition of a Casualty Loss 9-42

Casualty Loss Computation 9-42

Casualty Gains and Losses 9-43

9.8 Other Itemized Deductions 9-45

Deductible Other Expenses 9-45

Nondeductible Miscellaneous Expenses 9-45

Advanced Topic—Drilling Down 9-46

10 Business Expenses 10-1

10.1 Business Expense Requirements 10-4

Sole Proprietorship 10-4

Employee Business Expenses 10-4

New Business Investigation Expenses 10-6

10.2 Transportation and Travel Expenses 10-8

Transportation Mode vs. Travel Mode 10-8

Transportation Rules 10-8

Travel Expense Rules 10-9

Business Travel Mixed with Personal Travel 10-10

Travel When Not Away from Home 10-11

Other Travel-Related Limits 10-12

10.3 Entertainment and Education Expenses 10-14

Entertainment 10-14

Spotlight on the Law: Meals and Entertainment: Difference in Tax Treatment 10-15

Education 10-16

10.4 Business Interest 10-18

10.5 Bad Debts 10-21

Cash Method vs. Accrual Method 10-21

Business Bad Debts 10-21

Nonbusiness Bad Debts 10-22

10.6 Net Operating Losses 10-23

Pre-2018 NOLs 10-24

NOLs in 2018, 2019, and 2020 10-24

Post-2020 NOLs 10-24

NOL Computation 10-25

10.7 Excess Business Losses 10-29

11 Limitations on Business Losses and Expenses 11-1

11.1 Business Use of a Home 11-4

Qualification as a Home Office 11-4

Spotlight on the Law: The Home Office Rule 11-5

Evaluating Home Office Deductions 11-6

Simplified Method for Home Office Deduction 11-9

11.2 Hobby Losses 11-11

Definition of a Hobby 11-11

Evaluating the Tax Consequences of Hobbies 11-13

11.3 Vacation Homes 11-14

Personal Category for a Vacation Home 11-15

Rental Category for a Vacation Home 11-16

Personal/Rental Category for a Vacation Home 11-17

11.4 Basis and At-Risk Limitations 11-23

Basis Hurdle 11-23

At-Risk Hurdle 11-24

11.5 Passive Loss Rules 11-25

Tax Consequences of Passive Losses 11-25

Material Participation 11-27

Limited Partners and Rental Activities 11-29

Rental Real Estate 11-30

Selling an Activity with Suspended Passive Losses 11-31

Use of Suspended Losses at Death 11-31

Passive Credits 11-32

Advanced Topic—Drilling Down 11-33

11.6 Losses from Partnerships and S Corporations 11-34

Advanced Topics—Drilling Down 13-24

13.3 Amortization 13-26

Computing Tax Amortization 13-27

Defining Amortizable Intangible Assets 13-27

13.4 Depletion 13-29

Part III (Ch. 8–11): Comprehensive Tax Return Problem

Part IV Taxation of Property Transactions

12 Taxation of Investment Income 12-1

12.1 Interest Income 12-4

Municipal Interest Income 12-4

Series EE and Series I Bonds 12-6

Bond Premiums and Discounts 12-7

Spotlight on the Law: Is an Interest-free Loan Treated as a Loan or a Gift? 12-9

Advanced Topics—Drilling Down 12-10

12.2 Dividend Income 12-14

General Rules for Dividends 12-14

Qualified Dividend Income 12-15

Evaluating the Tax Consequences of Dividend Distributions 12-16

Stock Dividends 12-18

Constructive Dividends 12-20

12.3 Capital Gains and Losses 12-22

Capital Asset Definition 12-22

Netting Capital Gains and Losses 12-23

Long-Term Capital Gain Rates 12-27

Ordering Rule for Netting Capital Losses 12-29

Advanced Topics—Drilling Down 12-32

12.4 The 3.8% Net Investment Income Tax 12-36

Defining the Net Investment Income Tax 12-36

Computing the Net Investment Income Tax 12-37

13 Cost Recovery of Property 13-1

13.1 General MACRS Rules 13-5

Personalty (Personal Property) 13-5

Realty (Real Property) 13-12

Spotlight on the Law: Is It Ever Possible to Depreciate Land? 13-14

13.2 Additional Cost Recovery Rules 13-15

Bonus Depreciation 13-15

Section 179 Election 13-17

Automobile Depreciation 13-20

Other Depreciation Systems 13-24

14 Taxation of Assets Used in a Trade or Business 14-1

14.1 Distinguishing Section 1231 Assets from Ordinary and Capital Assets 14-4

Review of Ordinary and Capital Assets 14-4

Section 1231 Assets 14-4

14.2 Identifying Types of Section 1231 Assets 14-7

Spotlight on the Law: Impact of Identifying a Business Asset 14-9

14.3 Netting Section 1231 Gains and Losses 14-10

14.4 Section 1245 Depreciation Recapture 14-15

Defining Section 1245 Assets 14-16

Evaluating Section 1245 Depreciation Recapture 14-16

14.5 Section 1250 Depreciation Recapture 14-20

Defining Section 1250 Assets 14-21

Evaluating Section 1250 Depreciation Recapture 14-22

Reporting Sales of Business Assets: Form 4797 14-26

Advanced Topic—Drilling Down 14-27

15 Property Transactions: Nonrecognition of Gains and Losses 15-1

15.1 Related-Party Losses 15-4

Defining Related Party 15-4

Evaluating Related-Party Transactions 15-4

Advanced Topic—Drilling Down 15-8

15.2 Wash Sales 15-9

Defining a Wash Sale 15-9

Evaluating a Wash Sale 15-10

Spotlight on the Law: Do Wash Sale Rules Apply to Assets Held in an IRA? 15-15

15.3 Like-Kind Exchanges 15-15

Defining Like-Kind Exchanges 15-15

Evaluating Like-Kind Exchanges 15-16

Boot 15-19

Advanced Topics—Drilling Down 15-22

15.4 Involuntary Conversions 15-26

Defining an Involuntary Conversion 15-26

Evaluating an Involuntary Conversion 15-28

15.5 Loss on Sale of Personal Use Assets 15-32

15.6 Sale of Principal Residence 15-33

Defining a Principal Residence 15-33

Evaluating the Sale of a Principal Residence 15-36

Advanced Topics—Drilling Down 15-38

Part IV (Ch. 12–15): Comprehensive Tax Return Problem

Part V Other Individual Topics

16 Personal Tax Credits 16-1

16.1 Introduction to Personal Tax Credits 16-4

Credit vs. Deduction 16-5

Nonrefundable vs. Refundable Credits 16-5

16.2 Child Tax Credit 16-7

Refundability 16-8

Tax Compliance 16-9

16.3 Credit for Other Dependents (Family Tax Credit) 16-10

16.4 Child and Dependent Care Credit 16-11

Defining the Child and Dependent Care Credit 16-12

Computing the Child and Dependent Care Credit 16-14

16.5 Earned Income Tax Credit (EITC) 16-18

Defining a Qualifying Child 16-20

Other Rules for the EITC 16-21

Computing the Earned Income Tax Credit 16-21

Tax Compliance 16-23

16.6 Education Credits 16-25

General Guidelines for Education Tax Benefits 16-26

American Opportunity Tax Credit (AOTC) 16-26

Spotlight on the Law: Who Can Claim the American Opportunity Tax Credit? 16-28

Lifetime Learning Credit (LLC) 16-28

Comparison of the AOTC and the LLC 16-30

Tax Compliance 16-31

16.7 Other Personal Tax Credits 16-32

Adoption Credit 16-32

Retirement Savings Contributions Credit (Saver’s Credit) 16-34

Credit for the Elderly or the Disabled 16-35

Energy Credits 16-36

Premium Tax Credit 16-38

Foreign Tax Credit 16-38

17 Alternative Minimum Tax and Other Taxes 17-1

17.1 Alternative Minimum Tax (AMT) 17-4

Formula for Computing the AMT 17-5

Adjustments 17-7

Preferences 17-9

Reconciling Taxable Income and AMT Income 17-10

Other AMT Items 17-11

17.2 Social Security, Medicare, and Self-Employment Taxes 17-17

Independent Contractor vs. Employee 17-18

Self-Employment Income 17-18

Self-Employment Tax Computation 17-19

Social Security and Medicare Taxes for Employees and Employers 17-22

Excess Social Security Tax Credit 17-22

17.3 Other Taxes 17-24

Nanny Tax 17-24

Spotlight on the Law: The Nanny Tax 17-25

Additional Medicare Tax 17-26

Parts II–V (Ch. 4–17): Comprehensive Tax Return Problem

Part VI CPA Evolution: Core – Tax

18 Business Entity Topics: CPA Exam Core – Taxation and Regulation 18-1

18.1 Corporations: Taxable Income Computation and Special Deductions 18-5

Corporate Income Tax Formula 18-5

Corporate Deductions 18-8

Spotlight on Becoming a CPA 18-18

18.2 Other Corporate Tax Issues 18-19

Capital Gains and Losses 18-19

Accounting Methods and Periods 18-20

Reconciliation of Book Income and Taxable Income 18-21

Net Operating Losses 18-24

Reconciliation of Retained Earnings 18-26

Corporate Alternative Minimum Tax 18-27

18.3 Business Tax Credits 18-29

Foreign Tax Credit 18-29

General Business Credit 18-30

Business Energy Credits 18-38

18.4 S Corporations 18-40

What is an S Corporation? 18-40

S Corporations vs. C Corporations 18-42

Eligibility Rules for S Corporations 18-43

Election Requirements 18-45

Termination of the S Election 18-46

Taxation of S Corporation Income 18-48

Shareholder’s Basis In S Corporation Stock 18-54

Other S Corporation Issues 18-57

18.5 Partnerships and Limited Liability Companies 18-61

What is a Partnership? 18-61

Taxation of Partnership Income 18-65

Partner’s Basis in Partnership Interest 18-68

18.6 Tax-Exempt Organizations 18-71

Types of Tax-Exempt Organizations 18-71

Eligibility to be Tax-Exempt 18-72

Filing Requirements 18-72

Unrelated Business Income 18-72

Part VI (Ch. 18): Comprehensive Tax Return Problem

Appendix A Tax Formula Items A- 1

Appendix B Tax Forms B- 1

Glossary G- 1

Index I- 1