Income Tax Formula

Chapter 5 and Related Chapters Lecture Notes

Chapter 4: Income Tax Formula

Chapter 5: Income and Exclusions

Chapter 12 (7), pt. 1: Investment Income and Character of Income

Handout 1 & Ch. 13: Employment-Related Deferrals and Exclusions

Chapter 6: For AGI Deductions

Chapter 7 & Ch. 12 (7), pt. 2 & Handout 2: From AGI Deductions

Chapter 8: Tax Computations and Credits

  1. Overview
    1. Overview:
      1. In Chapter 4, we discussed gross income in general terms. We learned that:
        1. Gross income is income that TPs realize and recognize (i.e., report) on their tax returns
        2. Gross (Recognized) income = Income realized – (exclusions + deferrals)
      2. In Chapter 5, we explain the requirements for TPs to recognize gross income and discuss the most common sources of gross income.
  1. Realization and Recognition of Income (pp.5-2 through 5-9)
    1. What is included in gross income?
      1. IRC §61:

All realized income – inclusions and deferrals

  1. TPs recognize income when three conditions are met. List and discuss each condition below.
    1. TPs recognize gross income when:
      1. There’s a transaction
  1. Measureable change in property rights
    1. When is income realized?
      1. Transaction
  1. Economic benefit
  1. Why is a transaction important?
    1. Agreed upon value to determine basis
  1. Gives taxpayer the ability to pay tax
  1. Economic benefit
    1. Better off because of transaction
  1. Other income concepts
    1. Does the form of receipt (i.e., cash, property, or services) affect the realization or recognition of income?
      1. No, cash, property, services, all count
  1. What is the return of capital principle?
    1. TP recovers cost in sale of property before calculating tax on the income
  1. Income (Gain or Loss) from asset sale = sales proceeds – tax basis

Amount realized – adjusted basis

  • What is the tax benefit rule (recovery of amounts previously deducted)?
    1. the refund is included in gross income to the extent that the prior deduction produced a tax benefit
  1. This can seem confusing! When applying the tax benefit rule, you often must consider both the standard deduction and itemized deductions.
  1. What determines the year in which realized income is recognized and included in gross income?
    1. A TP’s accounting method determines the year in which realized income is recognized and included in gross income.
      1. Accounting methods:
        1. Accrual
          1. Income à earned
          2. Expenses àincurred
  1. cash
    1. Income àreceived
    2. Expenses àpaid
  1. What judicial doctrines affect the timing of income recognition? Describe each.
    1. Constructive receipt
      1. Income is deemed realized if:
        1. Unconditionally available
        2. TP is aware of availability
        3. No restrictions on TPs control of income
  1. Claim of Right (in a claw back)
    1. Realized in year received
    2. Deducted in year clawed back
  1. Who recognizes the income?
    1. Based on the assignment of income doctrine:
      1. Income from services à whoever does the work
  1. Income from an income-producing asset à whoever owns the asset
  1. Special rules depending on whether TP lives in a community property or common law state (state law dictates sharing of income between spouses)
  1. What are the different types of income? List and discuss each type below. (pp.5-9 through 5-28)
    1. Income from services
      1. Also known as earned income
      2. Examples:

Barber, accountant

  1. Income from employee stock options (SKIP)
  1. Income from property
    1. Also known as unearned
  1. Examples:
    1. dividend
    2. interest
    3. rent
    4. annuities
    5. gain/loss on sale
  • Annuities. What is an annuity and how do you compute the taxable income from an annuity?
    1. Stream of equal future payments
      1. Exclude a portion based on net value
  1. Each annuity payment includes:
  1. What formula is used to compute the excluded income (i.e., the nontaxable return of capital)?
    1. Annuity exclusion Ratio

           

                        Original investment / expected value

  1. What is the expected value for a fixed annuity?
    1. Expected value = #of payments x amount of payments
  1. What is the expected value for a lifetime annuity?
    1. Expected value = expected return multiple x annual payment amount
  1. What formula is used to calculate the amount of included income (i.e., taxable income)?

Annual payment received – (exclusion ratio X APR)

  1. Property Dispositions. How do you compute the gain/loss on a property disposition?

Sales proceeds

- selling expenses

Amount realized
- adjusted basis

  1. Capital Gains and Losses
    1. The basics
      1. Recall from Ch. 4: Capital assets are typically investment-type assets and personal-use assets.
  1. What are the advantages of investing in capital assets from a tax perspective?
    1. Gains are deferred for tax purposes until the TP disposes of the assets.
  1. Gains are generally taxed at preferential rates.
  1. Realized gain (or loss) = Amount realized – Adjusted basis
    1. In general, FIFO method determines basis.
    2. TP may elect specific identification method to select high bases shares to sell (if adequate records are kept).
      1. This can be a very effective tax planning tool!
  1. Types of capital gains and losses
    1. What type of capital gains are generated when selling capital assets with the following holding periods?
      1. Holding period <= 1 year à Short term CG
      2. Holding period > 1 year à Long Term CG
  1. How are short-term capital gains taxed? Long-term capital gains?
    1. Short-term capital gains à ordinary rates
  1. Long-term capital gains (general rule) à Preferential Rates (0, 15, 20)
    1. Exceptions:
      1. Unrecaptured §1250 gains à max 25%
      2. Collectibles à max 28%
      3. If the ordinary rate is lower, these are all taxed at the lower rate
  1. Netting process for gains and losses
    1. What happens when multiple gains and/or losses are recognized in the same tax year?

Engage in the netting process

  1. The netting process (assuming no 25%/28% gains):
    1. Step 1à Net all short term gains or losses
  1. Step 2 à net all long term gains or losses
  • Step 3:
    1. If steps 1 and 2 both yield gains à

Recognize seperately

  1. If steps 1 and 2 both yield losses à

Recognize separately

  1. Otherwise à combine and recognize as largest absolute value
  1. How are the netted gains/losses taxed?
    1. Net long-term capital gains à preferential rates
  1. Net short-term capital gains à ordinary rates
  • Net capital losses àcan deduct up to 3000 annually
  1. Excess net capital losses à carried over indefinitely
  1. Do capital loss carryovers for individuals expire? NO
  1. Netting process is much more complex when a TP has gains taxed at the 25% and/or 28% rate. Review this netting process in the book (Appendix A). We will revisit it in Ch. 11.
    1. This looks complicated in the book!
    2. But when you go through it, keep in mind the rules are designed to favor the taxpayer:
      1. Short term or low rate losses are subtracted from the highest rate group (28%)
      2. If losses remain, they are moved down to the 25% group, etc.
  • If there are no losses, the process is simple, each rate group stays within its rate group
  1. What are the limitations on capital losses?
    1. General limitationà can deduct up to 3000 after netting
  1. Additional limitations:
    1. Losses on sale of personal use assets à not deductible

House or car depreciates, no deduction

If they appreciate, taxed on sale

  1. Losses on sales of capital assets between related parties à
    1. Note: The related party acquiring the asset may eventually be allowed to deduct all, a portion, or none of the disallowed loss on a subsequent sale.

Still in the same economic sphere

  • Losses incurred in a wash sale à
    1. What is a wash sale?

Selling stock at a loss within 30 day before or after purchase of substantial identical stock (61 day window)

  

  1. Other sources of income. List and discuss each source below.
    1. Income from flow-through entities.
      1. Income flows through to partners or shareholders. How do owners report income or deductions?
        1. As though they operated that portion of the business personally
      2. Common flow-through entities:

Partnerships

S corperations

  1. How is owners’ taxable income related to cash distributions of these entities?
    1. In proportion to ownership
  1. Alimony
    1. Tax treatment:

Receiver recognizes income, payer deducts

  1. A payment is alimony if the following conditions are met:
    1. Transfer of cash in written separation agreement
    2. Not decreed as not alimony
    3. Spouses don’t live together at time of payment
    4. Payments don’t continue after death of recipient
  1. Alimony is not:
    1. Property division
    2. Child support
    3. Can’t be disguised a child support (ends on child’s nth birthday) child support is not deductible
  • Prizes, Award, and Gambling Winnings
    1. Tax treatment: all included in income
  1. Exceptions:
    1. Award for scientific, literary, and charitable achievement (e.g., the Nobel Prize) are excluded from income if:
      1. The TP was selected without any action on his part to enter the contest of proceeding,
      2. The TP is not required to render substantial future services as a condition to receive the prize or award, and
  • The TP immediately transfers the award to a governmental unit or qualified charity
  1. Award for length of service or safety
    1. Unless an obviously concealed bonus
    2. Exempt up to 400$ of CASH ONLY, property is all included
  1. Social Security
    1. Partially taxable: Include up to 85% depending on the amount of the taxpayer’s social security benefits and the taxpayer’s Filing Status
      1. What is a taxpayer’ Modified AGI?
        1. Modified AGI = AGI (- social security benefits) + tax exempt interest income
      2. Complete the following chart summarizing when SS is included in income.

Income Level

Filing Status

Modified AGI + 50% Social Security benefits

Are Social Security benefits taxable?

Low

Single

Up to 25k

NO

Married

Up to 32K

High

Single

Above 25K and up to 34K

Lesser of (50% SSB) or (50% mAGI + 50% SSB -25k)
Up to 85%

Married

Above 32K and up to 44K

Medium

Single

Above 34k

Lesser of (50% SSB) or (50% mAGI + 50% SSB -34k)
Up to 50%

Married

Above 44k

  1. Imputed Income
    1. Taxpayers must recognize income tied to the indirect economic benefit resulting from:
      1. Bargin Purchases or corporate loans
        1. Definition:

Income from indirect benefit

  1. Tax treatment (employer/employee relationship):

Included in income

  1. Exception:

Product sale: above cost to seller

Service: above 80% of regular price

  • Tax treatment (shareholder/corporation relationship):

Taxable at dividend rates

  1. Tax treatment (family relationship):

Gift tax to be paid by giver

  1. Below market loans
    1. Loan given at reduced interest rates
  1. Lender and borrower must treat the transaction as if:
    1. The borrower paid the lender the difference between the applicable federal interest rate (compounded semiannually) and the actual interest paid (this difference is called imputed interest).
  1. The lender then returned the imputed interest to the borrower.
  • The deemed “payment” of the imputed interest in these transactions is treated as interest income to the lender and interest expense to the borrower
  1. The deductibility of the interest expense for the borrower depends on how she used the loan proceeds (for business, investment, or personal purposes).
  1. General rule: The relationship between the transacting parties governs the taxability
  1. Discharge of indebtedness
    1. Tax treatment when lender forgives debt à TP includes forgiven debt as income
      1. Exception: insolvent before or after forgiveness

CHAPTER 12 (7), PART 1

  1. Investments Overview (pp. 7-2)
    1. After-tax returns from investments depend on:
      1. Before-tax rate of return (ATR=PTR*(1-TR)).
      2. The timing of tax payments or tax benefits (i.e., when investment income is taxed or when investment losses are deducted). We will discuss this more in Ch. 3.
  • The tax rate applied to investment income (i.e., the rate at which investment income is taxed or deductible losses generate tax savings).
  1. Chapter 12 (7) outlines: 1) when various forms of investment income/losses are taxed and 2) the rates at which investment income/losses are taxed.
  • Portfolio Income: Interest and Dividends (pp. 7-2 through 7-7)
    1. Investment choices
      1. If a TP wants a steady stream of cash flows from her investment, what types of investments will she purchase?
        1. Interest from debt
  1. Examples:

Bonds, savings accounts

  1. Dividends
  1. Examples:

Stocks, mutual funds

  1. Interest
    1. The basics
      1. When do TPs recognize interest income from interest-paying investments?
  1. How would a TP compute a bond’s:
    1. After-tax rate of return =
    2. After-tax future value =
    3. Note: When computing after-tax future value here, r = ATR
    4. Note: For bonds, the formulas assume that the bonds are purchased at face value. Special rules apply for determining the timing and amount of interest from bonds when there is a bond discount or a bond premium (discussed below).
  1. Corporate and U.S. Treasury Bonds
    1. How often do Treasury bonds and Treasury notes pay interest?
  1. How often do corporate bonds pay interest?
  1. What are the two primary differences between Treasury and corporate bonds?
  1. When is interest income from corporate and U.S. Treasury bonds included in income?
    1. When the bond is issued at face value:
  1. When the bond is issued at a discount (subject to OID rules):
    1. TP will include in income:
  1. Note: This is particularly relevant for zero-coupon bonds.
  1. When the bond was issued at a premium:
    1. TP will include in income:
  1. When the bond was purchased in the secondary market at a discount:
    1. Interest payments are included in income as they are received.
    2. In addition:
      1. When the bond matures, the taxpayer treats the market discount as interest income.
      2. If the bond is sold prior to maturity, a ratable amount of the market discount (based on the number of days the bond is held over the number of days until maturity when the bond is purchased), called the accrued market discount, is treated as interest income on the date of sale.
    3. If the bond was purchased in the secondary market at a premium:
      1. Same as a bond originally issued at a premium.
      2. TP will include in income:
        1. Interest payments actually received during the year and
        2. The current year amortization of the premium (if TP elects to amortize the premium).

Example 13: At the beginning of his current tax year Brienne invests $12,000 in original issue U.S. Treasury bonds with a $10,000 face value that mature in exactly 10 years.  Brienne receives $700 in interest (i.e., stated annual interest rate of 7%; $350 every six months) from the Treasury bonds during the current year and the yield to maturity on the bonds is 5 percent.

  • How much interest income will Brienne report this year if she elects to amortize the bond premium?
  • How much interest will she report this year if she does not elect to amortize the bond premium?
  • U.S. Savings Bonds
    1. How often does the bond pay interest?
  1. When is the interest income recognized? What is the amount of interest income?
    1. Recognition occurs à
  1. Interest income =
  1. Exception to recognition of income:
  1. Summary – Timing of Interest Payments and Taxes (Exhibit 7-1)

General Rule

Exception

Exception

Interest Received Annually and Taxed Annually

Interest Received at Sale or Maturity and Taxed at Sale or Maturity

Interest Received at Sale or Maturity but Taxed Annually

  1. Dividends
    1. When are dividends taxed?
  1. What tax rate applies to dividends?
    1. Qualified dividends à
  1. Other dividends à
  • What requirements must be met for a dividend to be a “qualified dividend?”

Example 14: Sansa invests $10,000 in preferred shares with a dividend rate of 6%. The dividends are qualified dividends and her MTR is 35%. 

  • Assuming Sansa reinvests the after-tax dividend income in additional preferred shares, what is her accumulated balance in preferred shares after 3 years?
  • What is Sansa’s after-tax return in each year?
  • Assuming Sansa withdraws the after-tax dividend income each year, how much dividend income will she have earned after 3 years?

Read the Capital Gains Section (pp. 7-7 to 7-9) for additional info on Capital Gains

CONTINUE WITH CH. 5

  1. Exclusion Provisions (pp. 5-28 through 5-37)
    1. Why does Congress allow exclusions and deferrals?
      1. Subsidize or encourage behavior
      2. To be Fair
  1. What are some common exclusions? Discuss each below.
    1. Muni bond interest
  1. Gain on sale of personal residence
    1. Excludes up to $250,000 ($500,000 if MFJ); remaining gain taxed as Long term capital gains at preferential rates
    2. Must meet ownership test and use test
      1. ownership test à must have owned for two of last five years
  1. use test à primary residence for two of the last five years

if married, either can meet ownership, both must meet use

  • Fringe benefits
    1. See Exhibit 5-4 for examples.
  1. What are common educational-related exclusions?
    1. Education
      1. To be excluded à must pay for required materials or tuition for courses
  1. If scholarships > tuition, fees, books, etc. àexcess funds taxed as income
  1. If recipient is required to perform services in exchange for scholarship à

Treated as income

  1. Exception for: athletic scholarships, room and board only excluded if scholarship can’t be canceled for not participating
  1. 529 plans and Coverdell

Investment savings accounts for college, must be used to pay for school

Interest excluded

  1. Interest income earned from Series EE Bonds
    1. Must be spent on qualifying expenses
  1. Can be phased out
  1. What exclusions mitigate double taxation?
    1. Gifts and inheritances
      1. Gifts (definition): wealth transfers during life
  1. Inheritances (definition): after death
  1. Tax treatment: gift and estate tax, not income tax
  1. Life insurance proceeds
    1. Subject to estate tax, not income tax
  • Foreign earned income
    1. Income earned in a foreign country is generally taxed in that foreign country
  1. To prevent double taxation (by foreign country and the U.S.), the tax law allows:
    1. A maximum exclusion of $101,300
    2. An itemized deduction for foreign taxes paid (see Ch. 7), or
    3. A foreign tax credit for foreign taxes paid (see Ch. 8)
  1. What requirements must be met to qualify for the foreign earned income exclusion?
    1. Considered to be a resident of the foreign country, or
    2. Live in the foreign country for 330 days in a consecutive 12-month period
  1. Exclusion computed on a daily This means that the maximum exclusion is reduced pro rata for each day during the calendar year the taxpayer is not considered a resident of the country or does not actually live in the foreign country
  2. TP can also exclude housing costs provided by the employer that exceed 16% of foreign-earned income exclusion ($16,208 in 2016). Maximum exclusion is 14% of foreign-earned income exclusion ($14,182 in 2016).
    1. Also subject to proration.
  1. What are some common sickness and injury-related exclusions?
    1. Workers comp
      1. Received when unable to work
  1. Payment associated with personal injury or sickness
    1. Compensatory lawsuit payments
  1. Note:
    1. Damages paid for emotional distress that are associated with a physical injury are excluded; Other payments due to emotional distress are taxable
    2. Punitive damages (payments made to punish the person doing the harm) are taxable
  • Health Care Reimbursement
    1. Reimbursed from employer for med bills = non taxable
  1. Disability Insurance
    1. If TP pays the cost of the insurance, using money that has already been taxed à

Cost of policy and benefits excluded from gross income

  1. If TP’s employer purchases the insurance and:
    1. Premiums paid by employer are treated as nontaxable fringe benefits à

Disability benefits are included in gross income

HANDOUT #1

  1. Fringe Benefits
    1. Noncash benefits provided to employees

Payments on your behalf by employer, usually taxable

  1. Nontaxable Fringe Benefits (Exclusions)
    1. See Exhibit 12-2
    2. Group term life insurance
      1. Employees may exclude:

Premiums on policies up to $50,000 of insurance (Not benefits)

  1. Health and accident insurance benefits
    1. Premium payment by employer: excluded
    2. Reimbursements of covered expenses: excluded
  1. Meals/lodging for convienice of employer
    1. Requirements for exclusion:
      1. On employer premisis
  1. For convenience of employer
  1. Educational Assistance
    1. Maximum exclusion amount: $5250
  1. Dependent care benefits
    1. Exclude up to $5,000
    2. Generally, child must be < 13
  1. No-additional-cost services
    1. Exclude value of services that generate no substantial additional costs to employer
      1. Example: empty seat on plane for airline employee
  1. Qualified employee discounts (imputed)
    1. For goods:
      1. Above cost
  1. For services:
    1. No more than 20 percent discount
  1. Additional non-taxable fringe benefits
    1. De Minimis (basically, too small to be worth tracking)
    2. Qualified transportation fringe benefits: cost of transport/parking up to $255
  • Qualified moving expense reimbursement: if the employer reimburses expenses that are otherwise deductible (we will discuss in Ch. 6)
  1. Flexible Spending Accounts (FSA)
    1. Used to pay for: medical expenses
    2. Employee or employer contributions
  • May contribute up to:2550
  1. If not used within the plan year: money forfeited, some employers allow use within first 2.5 months of the year
  1. Deferrals (pp 5-38 to 5-42)
    1. Defer income to later period rather than excluding income permanently
    2. Skim these pages, focus on Ch. 13
    3. We will discuss additional deferrals in Chapter 11

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