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Federal Income Tax – Individuals

Steps in Determining Tax Liability
1) Determine Gross Income
2) Subtract “above the line deductions” to determine adjusted gross income (AGI)
3) Subtract standard deduction or itemized deductions to determine taxable income (TI)
4) Multiply by tax rate = tentative tax liability
5) Subtract any available credits = final tax liability
Gross Income
gross income includes any economic benefit or any clearly realized accession to your wealth (all income from whatever source derived)
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
Non-cash Receipts
Gross income includes the fair market value of any property received and the fair market value of any services received
* Barter – housepainter paints atty’s house in return for legal services (cost of housepainter’s services is income to atty and atty’s cost of services is income to housepainter)
Claim of Right
Rule: property or funds received under a claim of right must be reported for tax purposes even though the taxpayer may later be required to return the property, funds or their equivalent

Definition: the taxpayer has received property or funds under a “claim of right” when they are received without restriction as to use or disposition

Tax Benefit Rule
If a TP takes a deduction in one year and recovers the property that gave rise to the deduction in a later tax year, the TP has tax benefit income, to the extent that the earlier deduction provided a tax savings or a tax benefit

*When answering question – “Assuming he got a tax benefit…”

Alimony
unless otherwise provided in the written agreement, alimony is taxable to the receiving spouse and deductible to the paying spouse (ordinary income taxed at ordinary income rates)

Elements of Alimony
* 1) writing – pursuant to a written divorce or separation instrument or decree
* 2) living together disallowed – cannot be members of same household
* 3) cease at or before death – liability to make payments must cease at or before death (written agreement should specify this)
* 4) cash – payments must be in cash (or its equivalent – check)

Child Support
child support is NOT taxable to receiving spouse and is NOT deductible to paying spouse
Child Support In Disguise Rule
if a payment is reduced upon a contingency relating to a child, the amount of the reduction is considered child support (anything in child’s life triggers this rule)
Payments for Child Support/Alimony Fall Short
Where total payments for alimony and child support fall short, the payments are considered first to meet the child support obligation
Prizes and Awards
Gross income includes the value of cash, property, or services received as a prize, award, or windfall. Examples of taxable prizes or awards: raffle prizes, gambling, lottery winnings, treasure trove.
Cancellation of Indebtedness
The borrower has no gross income upon the initial receipt of borrowed funds. However, a taxpayer whose debt is cancelled or discharged at least than the full amount, has discharge of indebtedness income to the extent of the difference between the full amount of the obligation and the amount paid in satisfaction of the debt.

Exceptions
1) Reduction/Renegotiation in purchase price: If the apparent discharge of debt is really a reduction in purchase price in connection with the sale of goods, discharge of indebtedness rules will not apply

2) Insolvency: If the discharge occurs when the TP is insolvent or bankrupt, there is no immediate discharge of indebtedness income

3) Gift: If lender intends the discharge as a gift, the discharge of indebtedness rules will not apply

Life Insurance Proceed – Exclusion
Gross income does not include proceeds paid by reason of death of the insured. However, when proceeds are paid in installments, any interest paid will be taxable
Inheritances – Exclusion
Gross income does not include amounts received by bequest, devise, or inheritance (ESTATE AND GIFT TAX MAY STILL APPLY)
Gifts – Exclusion
* Gross income does not include amounts received by gifts
* Definition of Gift: a gift is a transfer made out of detached and disinterested generosity (love, affection, charity)
Tort Awards
Rule 1: Gross income does not include damages received on account of physical personal injury or sickness
* Inclues medical expenses; lost wages if underlying physical tort claim

Rule 2: By themselves, damages for emotional distress are not considered damages received on account of physical injury
* BUT emotional distress excluded if UNDERLYING PHYSICAL TORT CLAIM
* If no physical injuries and emotional distress ONLY – taxable

Rule 3: Punitive damages received in connection with personal injuries are taxable

Reimbursement for Property Damages
Amounts received to compensate for damage or loss to property are excluded from gross income to the extent of the basis or investment in the property (if above basis, taxable; if below basis, not taxable)
*Damages to a business of lost profits are taxable
Qualified Scholarships
Qualified scholarships for tuition, fees, and related expenses are excluded from gross income. To be “qualified” must not be payment for past or future services. Must also be primarily for the benefit of the individual.
* NOT room and board
* NOT if employer gives to advance past or future services
Receipts from Health and Accident Insurance – Employee Exclusions
* Value of employer provided health or accident insurance coverage, i.e. the premiums paid by the employer, are excluded from gross income (coverage itself)

* Health insurance reimbursements for medical expenses actually incurred also are excluded from gross income (use the coverage)

Life Insurance Provided by or Through Employer – Employee Exclusions
Taxpayers may exclude the value of the first $50k of employer-provided group term life insurance. Gross income includes the value of any excess life insurance coverage provided by the employer
Meals & Lodging – Employee Exclusions
Employer provided meals and lodging excluded if

* 1) provided for convenience of employer;
* 2) in-kind (actually provide the meal or lodging, not a cash supplement to help pay); and
* 3) on the employer’s premises

Tax-Free Fringe Benefits – Employees
* 1) De minimus (pens, coffee, donuts)
* 2) No additional cost to the employer (employer offers service at no additional cost – airline employees can take open seat w/o cost and tax income if on stand-by)
* 3) Qualified employee discounts (work at clothing store)
* 4) Contributions to qualified pension plans (when employer puts $ in; taxed when take money out later)
* 5) Employee safety or length of service award (retirement watch or safest employee of the year)
* Can be cash, can’t be more than $400, and has to be presented in a meaningful ceremony
Above-the-line Deductions
1) Ordinary & Necessary Business Expense
a) Business Interest
* Prepaid interest is not deductible
b) Business Taxes, except federal taxes (state and local)
c) Business Bad Debts – customers won’t pay what they owe

Exception: Excessive portion of excessive salaries is not deductible – above $1M

Exception: Illegal kickbacks or bribes – can’t take deduction but illegally acquired income is taxable)

2) Depreciation – one for an asset wasting over time; spreading out deduction over time (only business, not personal)

3) Capital Losses – up to a max of $3000 (includes non-business bad debts)
* Losses offset gains

4) Alimony

5) Moving Expenses – work related (not house hunting trips, meals; if reimbursement, can exclude)

6) Limited deduction for school loan interest

Itemized (Non-Business- Deduction
1) Home Mortgage Interest Rule: TP may deduct home mortgage interest on mortgages of up to $1M (in the aggregate) on a principal and a second personal residence (acquisition debt – mortgage itself)
* TP may also deduct interest on a “home equity loan” of up to $100k
* Use home as collateral for a home equity loan and deduct the interest on that loan
* Credits cards, vacation, use it however want
* Personal, i.e., consumer, interests is not deductible

2) State and Local Taxes: Taxes paid to state and local governments are deductible, with the exception of sales tax
* Business – state, local, and sales tax

3) Unreimbursed (Not Insurance, D) Casualty Losses: unreimbursed casualty losses if
* 1) the loss is greater than $100;
* 2) the loss is sudden and unexpected; and
* Fire, storm, shipwreck
* 3) only to the extent that losses (in the aggregate) exceed 10% of AGI

4) Unreimbursed Medical Expenses: unreimbursed medical expenses are deductible to the extent that they (in aggregate) exceed 10% of AGI

5) Charitable Contributions: TP may deduct the FMV of property and the amount of cash contributed to a qualified charities
* E.g. $1000 donation to charity; in exchange, get dinner for 2 at restaurant worth $250
* Can deduct $750
* If quid pro quo – e.g. kid get admitted to school – may jeopardize deduction all together

6) Miscellaneous Deductions: TP may deduct eligible miscellaneous deductions to the extent that (in the aggregate) they exceed of 2% AGI
* Examples – unreimbursed employee business expenses, certain educational expenses (those necessary to maintain and improve skills needed in the TP’s current trade or business – CLEs, not bar reviews even if already licensed)

7) Personal v. Business Expenses: personal expenses (housing, meals) are not deductible; expenses incurred in a or investment setting are deduction
* Legal Fees: Generally, legal fees incurred in a personal setting are not deductible but legal fees incurred in a business or investment setting are deductible
* Legal Fees in Divorce: legal fees incurred in a divorce or separation matter that are generally considered personal so fees are not deductible
* Exceptions
* Portion of legal fee to either party in a divorce or separation case that is attributable to tax advice will be deductible
* Recipient spouse may exclude legal fees necessary in generating taxable alimony

* Investment Fees or Expenses: TP may deduct the fees or expense that were necessary to generate taxable income
* Example – broker fees, settlement expenses in a successful lottery dispute

Exemptions
(also below the line – don’t need to itemize, everyone gets)

Rule: TP are entitled to one exemption for themselves, spouse, and one for each dependent
* Dependent = member of the household for whom you provide more than 1/2 their financial support
* Custodial Parent Rule – unless the other parent signs a written release, the general rule after a divorce is that the custodial parent gets the exemption for children of the marriage (doesn’t matter who provides the financial support)

Allocation of Income
TO WHOM IS IT INCOME

Rule 1 “Assignment of Income” Rule: Income must be taxed to he or she who it earns it
* Associates gives tix to dad that associate earned by billing most hours
* Income still to son; gift to dad

Rule 2: Income from property (investment income) is taxed to he or she who owns the property

Cash Method of Accounting
a cash method TP reports income when she receives (receive check, even if not cashed) payment and takes deductions for eligible expenses when she makes payment (even if put on credit card)

* Constructive Receipt – a TP has “constructive receipt” when funds or property are credited to her account, set apart, or otherwise made available so that she may draw upon them

Accrual Method of Accounting
Income: an accrual method TP reports income when all events have occurred that fix the right to receive it, and when the amount can be determined with reasonable accuracy
* All events have occurred – provided all legal services even if haven’t been paid

Deductions: an accrual method TP takes a deduction when all events have occurred that establish the fact of liability, and when the amount can be determined with reasonable accuracy

* All events have occurred – delivered report (fact of liability established)

* **Congress may have some exceptions to all events test (if looks really out there)

Gains and Losses – General Principles
Realization: sale, disposition, or exchange of an asset

Recognition: reporting the gain or loss for tax purposes

General Rule: Unless a specific statutory or common law exception applies, whenever a gain is realized, it must also be recognized for tax purposes
* Involuntary sale is taxable under the same principles as a voluntary sale (bank foreclosure)
* Any realized gain from an installment sale can be reported as payments are received
* If the seller fails to charge interest on an installment sale, interest will be imputed at the “applicable federal rate”
* Seller will be treated as receiving interest and the buyer will be treated as paying interest

Basic Sale Formula
Amount Realized (AR) – Adjusted Basis (AB) = Gain or Loss
* Amount realized = money received plus FMV of property or services received plus mortgages or liabilities to which the property is subject or which the buyer assumes
* For basis – see next slide
Basis – Different Rules
1) Cost Basis Rule = a TP’s basis in property acquired by purchase is generally the cost of the property, including money paid and borrowing incurred in connection with the purchase
* Borrowing isn’t taxed but included in basis
* “Adjusted basis” – add value to property or depreciation
* Property fully depreciated – basis = $0

2) Tax Cost Basis = If the TP receives property in a taxable transaction, basis in the property received is the FMV of the property that was reported for tax purposes
* **If the TP sells only a portion of her property, only that portion’s allocable basis is subtracted in computing gain or loss

3) Sale at a discount: a bargain sale of property may be treated as part sale/part gift

4) Divorce Property Settlements: a transfer of property between spouses or ex-spouse that is incident to divorce is not taxable to either party.
* Substituted Basis Rule: The spouse receiving the property will have the same basis that the donor spouse had

5) Basis in Gift Property: receipt of a gift takes the DONOR’s basis (substituted basis)
* Loss Exception: when property has lost value while in the donor’s hands, the recipient of the gift takes FMV as her basis for the purpose of determining loss
* **Doesn’t apply to transfers between spouses; receiving spouse always take the donor’s basis

6) Basis in Inherited Property: recipient’s basis in inherited property is the FMV of the property at the date of decedent’s death (step up basis)

7) Property Held by H & W As Joint Property: when spouses hold join title to property, the surviving spouse will get the fair market value basis (stepped up basis) only on the half of the property received through inheritance of intestacy; half originally owned by the surviving spouse will retain its basis

8) Like-Kind Exchanges: no gain or loss is recognized when a TP exchanges property held for productive use in a business or for investment (not stock) for like-kind property also held for productive use in business or for investment
* Gain or loss is realized but NOT recognized
* Real estate for real estate is fine, as long as business or investment (house for farm)
* Basis = takes basis in property as had in YOUR property exchanged

9) Basis in Inherited Property: recipient’s basis in inherited property is the FMV of the property at the date of decedent’s death (step up basis)

10) Property Held by H & W As Joint Property: when spouses hold join title to property, the surviving spouse will get the fair market value basis (stepped up basis) only on the half of the property received through inheritance of intestacy; half originally owned by the surviving spouse will retain its basis

11) Like-Kind Exchanges: no gain or loss is recognized when a TP exchanges property held for productive use in a business or for investment (not stock) for like-kind property also held for productive use in business or for investment
* Gain or loss is realized but NOT recognized
* Real estate for real estate is fine, as long as business or investment (house for farm)
* Basis = takes basis in property as had in YOUR property exchanged

12) Involuntary Conversion: no gain or loss is recognized if property involuntarily lost or damaged due to theft, fire, seizure, requisition, or condemnation is converted into property that is “similar or related in service or use”
* If property lost or damaged is converted to money, gain or loss is not recognized if the TP purchases replacement property that is “similar or related in service or use” within 2 years from the date of involuntary conversion
* Gain or loss will be recognized, however, to the extent that the money received exceeds the cost of the replacement property

13) Sale of a Principal Residence: up to $250k (or $500k for joint returns) of gain from the sale of a principal residence can be excluded if the property has been used and owned as the TP’s principal residence for periods aggregated 2 years out of the 5 year period ending on the date of the sale
* Exclusion is not available if the TP has used this exclusion within 2 years

Ordinary Income v. Capital Gains
Capital assets = generally invest assets except (most dividends to SHs of domestic corps are eligible for tax at capital gain rates) “DAY TO DAY BUSINESS PROPERTY – NOT CAPITAL ASSET” – real or stock held for investment as long as not a stock or real estate broker who regularly sells to customers
* inventory
* property held primary for sale to customers
* depreciable property
* copyrights

(long-term capital assets – held for more than 12 mo)

Ordinary income = salary, rents, interest, royalties

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