Income Tax - Chapter 2 Key Points

Describe the tax treatment of alimony and child support.

Alimony paid in cash is taxable to the person who receives it and is deductible to the person who pays it. Child support is not alimony and therefore is not taxable when received, nor deductible when paid. A spouse who transfers property in settlement of a marital obligation is not required to recognize any gain as a result of the property's appreciation. The receiving spouse assumes the tax basis of the property. The TCJA repealed the alimony provisions and these amounts are neither included or deducted tin taxable income beginning with divorce or separation agreements after December 31, 2018.

Determine when prizes and awards are included in income.

Amounts received from prizes and awards are normally taxable income unless refused by the taxpayer. Certain small prizes (generally under $400) for length of service and safety achievement are excluded from gross income. If the award is a "qualified plan award," then up to $1,600 of the value of the award may be excluded.

Calculate the taxable and nontaxable portions of annuity payments.

Annuity payments received by a taxpayer have an element of taxable income and an element of tax-free return of the original purchase price. The part of the payment that is excluded from income is the ratio of the investment in the contract to the total expected return. The total expected return is the annual payment multiplied by the life expectancy of the annuitant, based on mortality tables provided by the IRS. Individual taxpayers generally must use the "simplified" method to calculate the taxable amount from a qualified annuity starting after November 18, 1996.

Identify the common employee fringe benefit income exclusions.

Certain fringe benefits provided to employees may be excluded from the employees' gross income. These include dependent care, health care flexible spending accounts, group term life insurance (up to $50,000), education assistance plans, and others.

Apply the definition of gross income.

Gross income means "all income from whatever source derived." Gross income includes everything a taxpayer receives unless it is specifically excluded from gross income by the tax law.

Explain the tax implications of using educational savings vehicles.

A Qualified Tuition Program (Section 529 plan) allows taxpayers (1) to buy in-kind tuition credits or certificates for qualified higher education expenses or (2) to contribute to an account established to meet qualified higher education expenses. Distributions from the account are not taxable if the account is used for qualified higher education expenses. Qualified higher education expenses include tuition, fees, books, supplies, and equipment required for the enrollment or attendance at an eligible educational institution. In addition, taxpayers are allowed reasonable room and board costs, subject to certain limitations. The maximum amount a taxpayer can contribute annually to an education savings account for a beneficiary is $2,000. The contribution is not deductible, and if the amounts received are used for qualified education expenses, the distributions are not taxable.

Describe the elements of scholarship income that are excluded from tax.

Scholarships granted to degree candidates are excluded from gross income if spent for tuition, fees, books, and course-required supplies and equipment. Amounts received for items such as room and board are taxable to the recipient.

Explain the general tax treatment of health insurance.

Taxpayers may exclude health insurance premiums paid by their employer. Taxpayers are allowed an exclusion for payments received form accident and health plans. The taxpayer may exclude the total amount received for payment of medical care, including any amount paid for the medical care of the taxpayer, his or her spouse, or dependents.

Apply the rules governing inclusion of Social Security benefits in gross income.

Taxpayers with income under $25,000 ($32,000 for Married Filing Jointly) exclude all of the Social Security benefits from gross income. Middle-income and upper-income Social Security recipients, however, may have to include up to 85 percent of their benefits in gross income. Calculating the taxable amount of Social Security is complex and most easily done using a worksheet, such as the one provided in this chapter, or a tax program such as Intuit ProConnect Tax Online.

Describe the tax treatment of unemployment compensation.

Unemployment compensation is taxable.

Distinguish between the different rules for married taxpayers residing in community property states when filing separate returns.

Income derived from community property held by a married couple, either jointly or separately, as well as wages and other income earned by a married couple, must be allocated between the spouses, if filing separately. Nine states use a community property system of marital law. These states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. In general, in a community property state, income is split one-half (50 percent) to each spouse. There are exceptions for certain separate property (e.g., property owned prior to marriage, etc.).

Describe the tax treatment of life insurance proceeds.

Life insurance proceeds are generally excluded from gross income. If the proceeds are taken over several years instead of in a lump sum, any interest on the unpaid proceeds is generally taxable income. Early payouts of life insurance are excluded from gross income for certain terminally or chronically ill taxpayers. All or a portion of the proceeds from a life insurance policy transferred to another person for valuable consideration may be taxable to the recipient.

Determine when meals and lodging may be excluded from taxable income.

Meals and lodging are excluded from gross income provided they are for the convenience of the employer and they are furnished on the business premises. Lodging must be a condition of employment to be excluded.

Describe the tax treatment of municipal bond interest.

Interest from an obligation of a state, territory, or possession of the United States, or of a political subdivision of the foregoing, or of the District of Columbia, is excluded from gross income.

Identify the tax treatment of interest and dividend income.

Interest income is taxable except for certain state and municipal bond interest. Interest or dividend income exceeding $1,500 per year must be reported in detail on Schedule B of Form 1040. Series EE and Series I Savings Bond interest is taxable in the year the bonds are cashed unless a taxpayer elects to report the interest each year as it accrues. Series HH Savings Bond interest is taxable each year as it is paid to the taxpayer. Ordinary dividends are taxable in the year received. Qualified dividends are taxed at rates ranging from 0 percent to 20 percent and possibly included in the 3.8 percent net investment income tax.

Describe salaries and wages income reporting and inclusion in gross income.

The primary form of reporting wages to an employee is through Form W-2. Employers should report the employee's taxable wages, salary, bonuses, awards, commissions and almost every other type of taxable compensation in Box 1 of the Form W-2. If a taxpayer receives more than one Form W-2 or is jointly filing with a spouse having their own form W-2, the amounts in Box 1 are combined before entering on Line 1 of the Form 1040. Other Form W-2 information such as federal taxes paid will also reported by the taxpayer on the Form 1040.

Identify the general rules for the tax treatment of gifts and inheritances.

The receipt of gifts and inheritances is usually excludable from gross income. Income received from the property after the transfer may be taxable to the recipient.