"FEDERAL INCOME TAX"
1 FEDERAL INCOME TAX 1) GROSS INCOME a) Defined: Gross income includes any economic benefit or any clearly realized accession to wealth b) Realization: Increased or decreased value of an asset is not taken into account for tax purposes until it is realized through the sale or other disposition of the asset. c) Non-Cash Receipts: Gross income includes the fair market value of any property received and the fair market value of any services received (e.g., baseball tickets from employer) d) Claim of Right i) Defined: Property received without restriction as to use or disposition—free use of the property or funds (e.g., you can commingle funds) ii) Rule: Must be reported for tax purposes even though the taxpayer may later be required to return the property, funds, or its equivalent iii) Example: Judgment in Year 1 for 100,000. Report it. plans to appeal. Doesn’t matter. If judgment is reversed in Year 2, you get a deduction. e) Illegally Acquired Property: must be reported as taxable income f) Tax Benefit Rule: Where a taxpayer deducts in one year and later recovers the amount deducted, the recovery is a tax benefit income (e.g., state income tax refund) g) Federal Income Tax Refund: Never a tax benefit h) Alimony: Unless otherwise provided in the written agreement, alimony is taxable to the receiving spouse and deductible to the paying spouse i) Writing—divorce or separation agreement ii) Not living together iii) Liability to pay ceases at or before death iv) Payments must be cash or its equivalent i) Child Support: Child support is not taxable to the receiving spouse and not deductible to the paying spouse j) Child Support in Disguise: Payment reduced upon a contingency relating to a child, the amount of the reduction is considered child support i) Example: Agreement provides that H will pay W $100,000 until Child reaches 21. At that time, support reduced to $70,000. ii) Result: The $30,000 reduction is considered child support—not taxable to W and not deductible by H. k) Combination of Alimony & Child Support: Where payments for both fall short, the payments are considered first to meet the child support obligation (i.e., not taxable; not deductible) l) Prizes and Awards: Gross income includes the value of cash, property, or services received as a prize, award, or windfall. (raffle prizes, gambling or lottery winnings, and treasure trove). m) Life Insurance Provided by Employer: Taxpayer may exclude the value of the first $50,000. Gross income includes the value of the excess. 2 n) Cancellation of Indebtedness i) General Rules: (1) Borrower: Borrower has no gross income upon the initial receipt of borrowed funds. If debt is cancelled or discharged at less than the full amount, taxpayer has income to the extent of the difference between the full amount of the obligation and the amount paid in satisfaction of the debt. (2) Lender: Lender has no income from principal. Lender has income from interest. ii) Exceptions: (RIGed) (1) Reduction in Purchase Price (a) Discharge of debt is reduction in purchase price with the sale of goods (b) Ex: $20,000 car; defects; dealer agrees to take $15,000 in full satisfaction. No income. (2) Insolvency (a) Discharge occurs when the taxpayer is insolvent or bankrupt, no income. (b) Ex: $20,000 car; Buyer goes bankrupt; dealer agrees to take $15,000 in full satisfaction. No income. (3) Gift (a) If the lender intends the discharge as a gift, no income (b) Ex: Parents give you a school loan for $30,000. As a gift, they agree to take 20,000. No income. 2) EXCLUSIONS FROM GROSS INCOME a) Life Insurance Proceeds: Gross income does not include proceeds paid by reason of death of the insured. If proceeds are paid in installments, any interest paid will be taxable. b) Inheritances: Gross income does not include amounts received by bequest, devise, or inheritance c) Gifts i) Defined: Transfer made out of detached and disinterested generosity (employer to employee is never a gift) ii) Rule: gross income does not include amounts received by gift d) Tort Awards i) Gross income does not include damages received on account of physical personal injury or sickness ii) Punitive damages received in connection with personal injuries are taxable e) Receipts from Health and Accident Insurance: Premiums paid by the employer are excluded f) Other Tax-Free Fringe Benefits to Employees i) De minimus ii) No additional cost to employer iii) Qualified employee discounts iv) Contributions to qualified pension plans v) Employee safety or length of service award g) Qualified Scholarships: i) Qualified: Not payment for past or future services (i.e., employer sends employee to school) ii) Rule: Qualified scholarships for tuition and related expenses are excluded from gross income h) Meals and Lodging: Employer provided meals and lodging excluded if convenience to the employer; in kind; and on the employer’s premises 3 3) DEDUCTIONS a) General Rules i) Above the Line (1) Alimony (2) Ordinary and necessary business expenses (a) Business interest (b) Business taxes except federal taxes (c) Bad debts (3) Depreciation (4) Capital Losses (5) Moving Expenses (6) School loan interest ii) Choice of Itemized or Standard Deductions (1) Mortgage interest on mortgages of up to $1 Million on principal personal residence and second residence (2) State and local taxes (3) Unreimbursed casualty losses (great losses) (4) Unreimbursed medical expenses (great losses) b) Personal Expenses i) Personal expenses are not deductible ii) Legal fees in the personal setting are not deductible c) Legal Fees for Divorce i) General Rule: Legal fees in the divorce setting are personal and not deductible ii) Exceptions (1) Attributable to tax device will be deductible (2) Recipient spouse can exclude legal fees necessary in generating taxable alimony d) Business Expenses: Legal fees in the business setting are deductible e) Exemptions i) General Rule: taxpayers are entitled to one exemption for themselves and one for each dependent ii) Divorce: custodial parent gets the exemption for children of the marriage 4) ALLOCATION OF INCOME (Whose Income) a) Rule One: Income must be taxed to he or she who earns the income. (―Assignment of Income Rule‖) b) Rule Two: Income from property investment (investment income) is taxed to he or she who owns the property 5) ACCOUNTING (What Tax Year) a) Cash Method of Accounting i) Reports when payment received ii) Deduction when payment is made b) Constructive Receipt: When funds or property are i) Credited ii) Set apart iii) Otherwise made available so that she may draw upon them 4 c) Accrual Method (Businesses) i) Reports (1) when all events have occurred (2) Fix the right to receive (3) Amount can be determined with reasonable certainty ii) Deducts (1) All events have occurred (2) Establish the fact of liability (3) Amount can be determined with reasonable certainty 6) GAINS AND LOSSES ON DISPOSITION OF PROPERTY a) Terminology i) Realization: Sale, disposition, or exchange of asset ii) Recognition: Reporting of gain or loss for tax purposes b) General Rule: Whenever a gain is realized it must be recognized c) Formula: Amount Realized (AR) – Adjusted Basis (AB) = Gain (or Loss) i) Amount Realized: money received, plus fair market value of property or services received, plus mortgages or liabilities to which the property sold is subject or which buyer assumes ii) Cost Basis Rule: Total cost of the property (including any loans to purchase the property) d) Divorce Property Settlements: Transfer between ex-spouses incident to the divorce is not taxable. Recipient will always have the same basis as the donor spouse. (No loss exception) e) Basis in Gift Property i) Gain Rule: Recipient of a gift takes the donor’s basis ii) Loss Exception: When property has lost value in the donor’s hands, the recipient takes the fair market value on the date of the gift as the basis f) Basis in Inherited Property: Fair market value of property at the date of decedent’s death g) Like-Kind Exchanges: No gain or loss is recognized when a taxpayer exchanges business or investment property for like-kind property held for productive use in business or for investment h) Involuntary Conversion: no gain when lost, damaged, or stolen property is replaced with ―similar or related‖ property i) Sale of Principal Residence: up to $250,000 of gain from sale of principal residence can be excluded if property has been used and owned as principal residence for a total of two years in the first five years after sale j) Ordinary Income v. Capital Gains i) Capital Gains: Investment assets ii) Ordinary Income: salary, rents, interest, royalties, dividends