Income Tax Planning Exam 1

16th Amendment

"The Congress shall have power to lay and collect taxes on income, from whatever source derived, without apportionment amount the several States, and without regard to any census or enumeration."

For Every Deduction, There Must be an Inclusion

- To be entitled to deduct something on a tax return, a taxpayer must have included that amount in income and - if a taxpayer claims a deduction, that deduction should be income (and therefore subject to income tax) on someone else's return.

Standard Deduction

A standard amount that is specified by Congress and includes inflation adjustments. Taxpayers may deduct the greater of the standard deduction or allowable itemized deductions.

Single Filing Status

A filing status used by an unmarried taxpayer who does not qualify as a surviving spouse or head of household.

Married Filing Separately Filing Status

A filing status used when married couples do not choose to file a joint return

Federal Insurance Contributions Act (FICA)

A law that dictates the amount to be withheld from an employee's pay for OASDI benefits

Determination Letter

A letter issued by a district director of the IRS advising a taxpayer on how to report a transaction for tax purposes

Kiddie Tax

A tax on the net unearned income of a child at the parent's highest marginal income tax rate.

Imputed Interest

A payment deemed to be made by the borrower to the lender when the interest rate on a loan is less than the applicable federal rate.

Failure to Pay Penalty

A penalty of 0.5 percent per month or part thereof that a taxpayer fails to pay tax that is owed

Accuracy-Related Penalty

A penalty of 20 percent of the underpayment amount imposed on taxpayers who file incorrect tax returns in certain situations.

Flexible Spending Account (FSA)

A type of cafeteria plan that is funded through employee salary reductions The health care FSA limit is $2,750 (2020).

Failure to File Penalty

A penalty of 5 percent of the unpaid tax balance for each month or part thereof that a tax return is late; subject to a minimum penalty of $435 or 100% of the tax due if more than 60 days late

Three Types of Assets

1. Capital Assets 2. Ordinary Income Assets 3. IRC Section 1231 Assets

Three Types of Final Regulations

1. Procedural Regulations 2. Interpretative Regulations 3. Legislative Regulations

Three Types of Administrative Rulings

1. Revenue Rulings 2. Private Letter Rulings 3. Determination Letters

Three Courts to Resolve Disputes

1. The U.S. Tax Court 2. The U.S. District Court 3. The U.S. Court of Federal Claims

Three Methods of Tax Planning

1. The advisor and client can legally avoid taxation. In addition, the advisor may be able to help clients: - Shift income to related taxpayers in lower income tax brackets, or - Realize income in a form that is taxed at lower tax rates (long-term capital gains or qualified dividends) 2. The advisor and client can deduct expenses to reduce taxable income and take tax credits to reduce taxes due. 3. The advisor and client can defer income and thus defer taxation

Three Tax Systems

1. The income tax system 2. The estate and gift tax system 3. The generation skipping transfer tax system

Qualifying Relative

A person who meets the relationship test, gross income test, support test, joint return test, and citizenship test; is not a qualifying child of any other taxpayer; and may be claimed as a dependent by the taxpayer.

Qualifying Child

A person who meets the relationship yes, abode test, age test, support test, joint return test, and citizenship test, and may be claimed as a dependent by the taxpayer.

Community Property

A regime in which married individuals own an equal, undivided interest in all of the property accumulated, using either spouse's earnings, during the marriage.

Alimony

A separate maintenance payment that is intended to replace income lost by one spouse as the result of a divorce and may be included in the gross income of the payee. Alimony will be included in income for divorce decrees signed prior to 2019.

Educational Assistance Program

A separate written plan that establishes a program through which an employer provides educational assistance to employees.

Tax Court

A special purpose court that sits in Washington, D.C. and only hears tax cases. The judges within the court travel throughout the U.S. to hear the cases.

Original Issue Discount Bond (OID)

A bond that is issued for a price that is less than its face amount or principal amount on which interest is usually paid only at maturity.

Zero Coupon Bond

A bond that is sold at a deep discount, pays no coupons (or periodic interest payments), and matures at its face value.

Doctrine of Constructive Receipt

A cash method taxpayer must report income when it is credited to the taxpayer's account or when it is made available without restriction.

Discriminant Inventory Function System

A computer program used by the IRS to identify tax returns for audit

Dependency Exemption

A deduction from adjusted gross income allowed for each person who is a qualifying child or relative of the taxpayer for tax years before 2018 and after 2025. While the dependency exemption cannot be used in calculating taxable income for tax years 2018-2025, it is still used when determining dependency status to qualify for Head of Household filing status

Personal Exemption

A deduction from adjusted gross income for the taxpayer and the taxpayers spouse for tax years before 2018 and after 2025. During the 2018-2025 period, however, the amount of the personal exemption may be relevant in determining whether a taxpayer qualifies for Head of Household filing status.

Dividend Income

A distribution of corporate earnings to shareholders, usually in cash

Surviving Spouse Filing Status

A filing status for a surviving spouse with a qualifying child that affords the same basic standard deduction and tax rates as the married filing jointly status.

Married Filing Jointly Filing Status

A filing status that allows married couples to combine their gross incomes and deductions.

Head of Household Filing Status

A filing status that provides a basic standard deduction and tax bracket sizes that are less favorable to the taxpayer than those for the surviving spouse status, but more favorable than those for the single filing status

Endowment Contract

A type of insurance contract that pays a specified death benefit to a beneficiary upon the death of the insured owner, but also pays a specified benefit (in lieu of the death benefit) to the owner of the policy if the insured person lives to a specified age or date.

Cafeteria Plan

A written plan under which an employee may choose to receive either cash or taxable benefits as compensation or qualified fringe benefits that are excludable from wages.

Health Savings Accounts (HSAs)

Accounts that allow individuals who have high deductible health insurance plans to save on a tax-free basis to fund their medical expenses.

Gross Income

All income from whatever source derived unless it is specifically excused by some provision of the Internal Revenue Code

Qualified Tuition Programs

Also known as 529 Plans, they permit taxpayers to save for elementary, secondary, and post-secondary education expenses of family members on a tax-favored basis through either a prepaid tuition program or a college savings plan.

Cash Receipts and Disbursements Method

An accounting method under which income items are reported for the tax year in which they are received in cash and expenses are deducted in the year in which they are paid with cash.

Tax Credit

An amount that reduces the calculated tax liability of the taxpayer.

Adoption Assistance Program

An employer plan that assists employees with the cost of adoption and may not discriminate in favor of highly compensated or key employees.

Bartering

An exchange of property and/or services for other property and/or services.

Substantial Omission

An omission from tax return of more than 25 percent of the gross income reported

Three Uses of Assets

Another factor that impacts the tax treatment associated with a sale or disposition of property is how that asset was used by the taxpayer: Individuals can use an asset in one of three ways: 1. They can use it for personal purposes (personal use assets) 2. They can use it in the active conduct of a trade or business (business assets), or 3. They can use it for the production of income (production of income assets).

Income

Broadly defined as the total amount of money, property, services, or other accretion to wealth received, but it does not include borrowed money or a return of invested dollars.

Three Anti-Abuse Provisions

Congress has imposed three sets of anti-abuse rules that limit the benefits that can be obtained from tax minimization planning. 1. The alternative minimum tax (AMT) 2. The at-risk rule limitations 3. The passive activity rules

U.S. Court of Federal Claims

Court that may preside over tax controversies and only hears cases in Washington, D.C.

Municipal Bonds

Debt instruments issued by states and their political subdivisions, the interest income from which is generally excluded from federal gross income

Above-the-Line Deductions

Deductions for adjusted gross income, also known as adjustments to income.

Below-the-Line Deductions

Deductions from adjusted gross income. Also known as itemized deductions. Personal and dependency exemption amounts are also deducted below-the-line. However, they have been suspended by the TCJA 2017 until 2026. In addition, the new 20% deduction for flow-through entities introduced in the TCJA 2017 is also a deduction that is below-the-line but is taken regardless of whether the taxpayer itemizes deductions.

Taxable Income

Determined by subtracting allowable deductions from gross income.

Qualified Dividends

Dividends subject to favorable tax rates.

Activities of Daily Living

Eating, bathing, dressing, toileting, transferring, and continence.

Qualified Education Expenses

Educational expenses that receive favorable tax treatment. Such expenses may vary depending on the type of program or tax benefit.

Health Reimbursement Arrangements (HRAs)

Employer funded plans that reimburse employees for medical expenses and allow employees to carry any unused balance forward to be used future years.

Accrual Method

Frequently used by larger businesses. Under the accrual method of accounting, income is taxed when it is earned (whether or not it has been received), and deductions are claimed when they are incurred (whether or not they have been paid).

De Minimis Fringe Benefit

Fringe benefits that are so small or insignificant that accounting for them would be unreasonable or administratively impracticable.

Interest Income

Gross income generated by a variety of debt instruments, including bank accounts, money market instruments, and bonds.

Adjusted Gross Income

Gross income less above-the-line deductions

Procedural Regulations

Housekeeping instructions indicating how the Treasury and IRS will conduct their affairs.

Fraud

Implies that the taxpayer intentionally disregarded tax rules or misstated information included on the return.

Three Types of Income

In the U.S. income tax system, there are three types of income: 1. Active (ordinary) income 2. Portfolio income 3. Passive income

Tax Formula

Income - Deductions = Taxable Income Taxable Income x Tax Rate = Tax Liability

Foreign Earned Income

Income earned by a qualifying citizen or resident of the United States in exchange for personal services rendered in a foreign country. The foreign earned income limit is $107,600.

Phantom Income

Income imputed to taxpayers without a corresponding receipt of cash.

Exclusions

Income items that are specifically exempted from income tax.

Deductions

Items are subtracted from gross income, either below- or above-the-line, in order to arrive at taxable income.

Compensatory Damages

Monetary award intended to compensate for damage to property, for recovery of expenses incurred, for income lost, or for personal injury.

Fringe Benefits

Non-cash benefits provided to an employee by an employer in addition to wages and salary.

Tax Year

Normally a period of 12 months.

Interpretive Regulations

Official interpretations of the Internal Revenue Code by the Treasury

Punitive Damages

Payments intended to punish the offending party.

Coverdell Education Savings Account

Plan similar to a college savings plan that allows taxpayers to contribute up to $2,000 per beneficiary per year to an account.

Disability Insurance

Provides benefits in the form of periodic payments to a person who is unable to work due to sickness or accidental injury.

Estimated Tax Payments

Quarterly payments that are paid to the IRS and may be claimed as a credit against tax.

Legislative Regulations

Regulations in which the Treasury determines the details of the law

Final Regulations

Regulations issued by the Treasury that have been adopted formally after compliance with the requirements of the Administrative Procedures Act.

Treasury Regulations

Regulations that are official interpretations of the Internal Revenue Code and give taxpayers insight as to how the Code will be enforced by the IRS

Proposed Regulations

Regulations that have been drafted by the Treasury, but have not yet been adopted.

Temporary Regulations

Regulations that have the same authority as final regulations and are issued when guidance must be provided quickly to taxpayers.

Bona Fide Resident Test

Requirement for the Foreign Earned Income exclusion that requires the taxpayer to generally intend to work and reside in the foreign country for an indefinite period of time.

Revenue Rulings

Rulings issued by the IRS based on a set of facts common to many taxpayers and binding on the IRS

Private Letter Ruling

Rulings issued by the IRS that are binding on the IRS only with respect to the transaction and the taxpayer that are the subject of the ruling.

Compensation

Salary, wages, and fringe benefits received in exchange for providing services to an employer

Revenue Procedures

Statements issued by the IRS which detail internal practices and procedures within the IRS and make important announcements to taxpayers.

Archer Medical Savings Accounts (MSAs)

Tax-favoured savings accounts for medical expenses that were established by HIPAA in 1996, but cannot be established after 2005.

Net Unearned Income (NUI)

The amount of unearned income of a child that is subject to tax at the parent's marginal tax rate. NUI is equal to the unearned income of the child, less $1,100 (the basic standard deduction of a dependent) and the greater of $1,100 or the amount of the deductions allowed in producing the unearned income (2020 threshold).

Original Issue Discount

The difference between the redemption price at maturity and the purchase price for debt instruments issued at a discount

Three Types of Tax Accounting

There are three methods of accounting that are used for federal income tax purposes: 1. Cash method 2. Accrual method 3. Hybrid method

Three Types of Rental Real Estate

There are three types of rental real estate activities: 1. Tax-free rental activities 2. ORdinary rental use activities 3. Mixed-use activities

Statue of Limitations

Three Years

Three Key Tax Principles

Three key tax principles underlie personal income taxation. They are: 1. The doctrine of constructive receipt 2. The economic benefit doctrine 3. The doctrine of the fruit and the tree

U.S. District Court

Trial court of the federal judicial system which has general jurisdiction and is the only option for tax controversies in which the taxpayer would like a jury trial.

Basic Rules of Income Taxation

Two primary rules can be used to determine the income tax consequences of a transaction: 1. All accretions to wealth, from whatever source derived, constitute income. 2. For every deduction taken for income tax purposes, there must be an inclusion in income. (But keep in mind there are exceptions even to these two rules.)

Cash Method

Used by most individuals and small businesses. Under the cash method, income is taxed when it is received, and allowable deductions are claimed when they are paid.

Hybrid Method

Used by some businesses to better reflect their economic income on their income tax returns.

Three Components for Classifying Gain

When property is sold, the manner of taxation will depend on: 1. The type of asset that was held 2. The use to which the asset was put 3. The holding period (how long the asset was held)

Annuitized

When regular periodic payments on an annuity contract begin for life or for a specified period of time in excess of one year.