Chapter 3: Fundamentals of Income Taxation

Original Issue Discount (OID) Bond

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.

Net Unearned Income (NUI) -NUI is equal to the unearned income of the child, less $1,150 (the basic standard deduction of a dependent) and the greater of $1,150 or the amount of the deductions allowed in producing the unearned income (2022 threshold)

The amount of unearned income of a child that is subject to tax at the parent's marginal tax rate.

the close [last day] of the tax year

The determination of whether a taxpayer is married is normally made as of...

Marginal Tax Rate

The highest tax bracket in which the taxpayer falls. This is the rate that will apply to the next dollar of income earned.

Phantom Income

The income produced each year from Original Issue Discount (OID) Bond [aka Zero Coupon Bond]. It is not received by the bond holder but it has to be recorded each year.

Original Issue Discount (OID) Bond [aka Zero Coupon Bond]

The interest that accrues on the bond each year, is deemed to be constructively received by the taxpayer, and is included in the taxpayer's income. It is phantom income but it is recorded each year. [determined by a financial calculation that takes into consideration the difference between maturity value of the bond and its purchase price]

Illness, education, business, vacation, military service or a custody agreement

To meet the abode test, a qualifying child must live with the tax payer for more than 1/2 the year. What the exceptions to the abode test?

two preceding tax years -also have to pay more than 1/2 the cost of a household that has a dependent child as their principal place of residence [son, stepson, daughter, or stepdaughter], has not remarried, and the taxpayer and spouse were eligible to file a joint return for the spouse's year of death.

To qualify as a surviving spouse, the spouse of the taxpayer must have dies within what time frame?

True

True or False Tax credits are available for child and dependent care expenses.

False- Tax credits decrease the amount that the taxpayer owes.

True or False Tax credits increase the amount that the taxpayer owes.

False- The determination of whether a taxpayer is married is made as of the close [last day] of the tax year. However, if a taxpayer's spouse dies during the year, the marital status of the taxpayer is determined on the date of the spouse's death.

True or False The determination of whether a taxpayer is married is made as of the beginning of the year.

True

True or False The kiddie tax only affects children with unearned income greater than $2,300 [2022]

True

True or False Two commonly used tax accounting methods are the cash method and the accrual method.

accrual method - commonly used in businesses

What accounting method is income [revenue] is normally reported when it is earned, and expenses are normally deducted when they are incurred.

Zero Coupon Bond

A bond that is sold at a deep discount, makes no interest payments, and is redeemable for its face value at maturity.

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.

The doctrine of constructive receipt

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

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.

Dependency Exemption -While the dependency cannot be used in calculating taxable income for 2018-2025, it is still used when determining dependency status to qualify for Head of Household filing status

A deduction from adjusted gross income that is allowed for each person who is a qualifying child or relative of the taxpayer for tax years before 2018 and after 2025.

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.

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 Separate Filing Status

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

Married Filing Jointly (or) Married Filing Separately Married filing jointly is the better option, it doubles the standard deduction, has broader tax brackets and makes the couple eligible for the American Opportunity Tax Credit

A married person normally has two filing status options: Which filing status is better?

Qualifying Child

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

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.

1. relationship test 2. abode test 3. age test 4. support test

A qualifying child must meet all the requirements of four tests:

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.

Kiddie Tax

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

Effective Tax Rate

A taxpayer's average tax rate is the average rate of tax paid, factoring in the payments at various marginal brackets.

Marginal Tax Rate (MTR)

A taxpayer's highest tax bracket in which they fall. This is the rate that will apply to the next dollar of income earned.

Gross Income

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

Accrual Method

An accounting method under which income is reported when it is earned rather than when it is received in cash, and expenses are reported when they are incurred rather than when they are paid.

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.

Hybrid Method

An accounting method, other than the accrual or cash receipts and disbursements methods, that is permitted by the IRC and regulations as long as it is deemed to clearly reflect income

Tax Credit

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

The hybrid method of accounting [completed contract method or percentage-of completion method are also common hybrids]

Any other method of reporting that is permitted by the IRC and regulations as long as it is deemed to clearly reflect income. A common method is using accrual for inventories and property, plant and equipment and the cash method for everything else.

20% of qualified business income

Beginning in 2018, a new below-the-line deduction is allowed for taxpayers with qualified business income. Subject to certain limitations the deduction equals...

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.

Married filing jointly with Johnny or married filing separately [but that's not advantageous]

Daniel died in April. His surviving spouse, Ali remarried Johnny in November. Ali will be able to file as what filing status?

Married Filing Separately

Daniel died in April. His surviving spouse, Ali remarried Johnny in November. Daniel's final income tax will be able to file as what filing status?

taxable income

Deductions are subtracted from gross income, either below-the-line or above-the-line, in order to arrive at __________ ________.

Above-the-Line Deductions

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

Below the Line 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 20% qualified business income deduction for flow through entities introduced in the TCJA 2017 is a also a deduction that is below-the-line but is taken regardless of whether the taxpayer itemizes deductions.

Deductions from adjusted gross income. Also known as itemized deductions.

Taxable Income

Determined by subtracting allowable deductions from gross income.

$1,700 $4,000 Interest Income -$2,300 [2x Standard Deduction $1,150] =$1,700 of Net Unearned Income

Diana is 16years old. She earned $3,000 during 2022 working at an ice cream store. She earned $4,000 in interest income this year. Diana is claimed as a qualified dependent by her parents. How much of Diana's income will be taxed at her parents' highest marginal tax rate?

$7,000

Diana is 16years old. She earned $3,000 during 2022 working at an ice cream store. She earned $4,000 in interest income this year. Diana is claimed as a qualified dependent by her parents. What is Diana's gross income?

At her parents' highest marginal tax rate.

Diana is 16years old. She earned $4,000 in interest income this year, so her NUI is $1,700 ($4,000-$2,300) [2x Standard Deduction $1,150]. Diana is claimed as a qualified dependent by her parents. At what tax rate will the $1,700 be taxed?

Single filing status only. [he cannot claim head of household because the son is filing a joint tax return]

Frederick who is unmarried allows his 18 year old son Nick to live in his basement with the son's wife, Serena. Nick files a joint tax return with his wife. What filing status can Frederick use?

Adjusted Gross Income

Gross income less above-the-line deductions.

The taxpayer must maintain [pay more than half the cost of] a household as their home, which is also the principal place of residence for more than half the year for: - a qualifying child of the taxpayer who may by claimed as a qualifying dependent of the taxpayer. -an unmarried qualifying child who lives with the taxpayer but is not a dependent of the taxpayer [example a child or grandchild who live with the taxpayer but may be claimed as a dependent of another person] -a qualifying relative who: (1) is claimed as a qualifying dependent of the taxpayer; and (2) is actually related to the taxpayer

Head of household filing status can be used by an unmarried taxpayer who is not a surviving spouse and who meets the following requirements:

NO. You can only claim head of household if your married child isn't filing with their spouse and they meet a citizenship or residency test

If a married child of a taxpayer live with the taxpayer but cannot be claimed as a dependent of the either because the child files a joint return with their spouse or fails to meet a citizenship or residency test can the taxpayer still use the head of household filing status?

1. surviving spouse, [most favorable as is has same deductions as married filing jointly] {AKA qualifying widow(er)} 2. head of household, or 3. single filing status [least favorable]

If a person is not married on the final day of the tax year, then they may qualify for what filing statuses in order of tax favorability are:

surviving spouse, head of household, or single filing status

If a person is not married, then they may qualify for what filing statuses?

date of the spouse's death

If a taxpayer dies during the year, the marital status of the taxpayer is determined on what date?

No, Cash received with an obligation to repay is an exception in the cash receipts and disbursement accounting method

If cash is received, but there is an obligation to repay the money later [landlord taking a security deposit] is that reported as gross income?

a full-time student at an educational institution for at least 5 months of the calendar year. [most primary and secondary institutions qualify]

In order to satisfy the age test a qualifying child must be under the age of 19 and younger than the taxpayer as of the end of the calendar year; or A student under the age of 24 and younger than the taxpayer as of the end of the calendar year. But what constitutes a student?

Under the age of 19 and younger than the taxpayer as of the end of the calendar year; or A student under the age of 24 and younger than the taxpayer as of the end of the calendar year.

In order to satisfy the age test a qualifying child must be how old?

1. taxpayer's child 2. a decedent of the taxpayer's child 3. the taxpayer's brother, sister, stepbrother, stepsister, half brother, or half sister 4. a decedent of of the taxpayer's brother; sister; stepbrother; stepsister; half brother or half sister. [A qualifying child is a taxpayer's sibling, decedent of the taxpayer or the decedent's sibling. NOTE not a cousin]

In order to satisfy the relationship test, a qualifying child of a taxpayer must be: (4 things)

Phantom Income

Income imputed to taxpayers without a corresponding receipt of cash.

borrowed money or a return of invested dollars.

Income is the total amount of money, property, services, or other accretion to wealth received, but it does not include ______________ or __________________.

Exclusions

Income items that are specifically exempted from income tax.

Deductions

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

Yes, she is a qualifying relative because the relationship includes unrelated persons sharing the same abode. No, qualifying child has a different relationship test which Hannah does not pass until she is adopted. [They also are not related for Head of Household filing status purposes until she is adopted]

Janine is unmarried. She maintains a household in which she and her best friend's daughter, Hannah live. Hannah's parents died two years prior and requested that Janine raise their daughter. Does Hannah meets the definition of qualified relative? Does Hannah meets the definition of qualified child?

Single filing status [It's not head of household because they are not related. If Janine adopts Hannah she would get the better deductions]

Janine is unmarried. She maintains a household in which she and her best friend's daughter, Hannah live. Hannah's parents died two years prior and requested that Janine raise their daughter. Since Hannah meets the definition of qualified relative, Janine can claim her as a dependent. What filing status should Janine use?

Married Filing Jointly (or) Married Filing Separately

Javi married Darlene on December 31st of this year. What are their possible filing statuses for the year?

Head of household [even though she does not claim her as a dependent, she does maintain the house for her]

June, who is divorced, rents an apartment for herself and for her 14 year old daughter who lives with her most of the year: Under the terms of Junes divorce decree, her daughter is claimed as a dependent by her father. What filing status should June use?

Head of household [because he claimed him as a dependent and he is related to Luke]

Luke, who is unmarried, maintains a home in which he and his uncle live. He properly claims his uncle as a dependent. What filing status should Luke use?

Each of the 5 children meets the relationship test as a qualifying child.

Mike and Carol have a remarkably diverse family. In addition to Mike and Carol the family includes: 1. Greg, Carol's 10 y/o son from a prior marriage 2. Marcia, Carol's 15 y/o sister 3. Andrei, their 6 y/o adopted son 4. Cindy, their 4 y/o daughter 5. Brady, a 2 y/o foster child placed by the state Who meets the relationship test as a qualifying child?

Head of household [Even though Moira's son did not live with her for more than 1/2 the year Moira can use Head of Household status because it is considered temporary like illness, education, business, vacation, military service or a custody agreement]

Moira is not married. She rents a home for herself and her dependent son. Moira's son lives with her for 3 months in the summer and attends college the rest of the year. She should use what filing status?

Tax Year

Normally a period of 12 months.

Head of household

Omar who is not married, rents a home for himself and his two young children who he cares for all year. He should use what filing status?

Estimated Tax Payments

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

surviving spouse [2022 and 2023] head of household [2024]

Sam died in 2021. His wife, Diane, filed a joint return with Sam for 2021. Diane did not remarry in 2022, 2023, or 2024 but she maintained a home for herself and her two minor children during those years. During 2022 and 2023 she is eligible to use the _________ filing status. During 2024 she will probably be eligible to use the __________ filing status.

allowable deductions from gross income.

Taxable income is determined by subtracting __________ from __________.

(1) the greater of the standard deduction or the taxpayer's itemized deductions and (2) the QBI or Section 199A deduction [qualified business income deduction]

Taxable income is the tax base upon which the income tax is calculated. It is determined by reducing the taxpayer's adjusted gross income [AGI] by what 2 things?

Head of Household filing status

The ability to claim a qualifying dependent is important for taxpayers wishing to claim what status?

1. the cash receipts and disbursements method [cash method] 2. the accrual method 3. the hybrid method

There are 3 accounting methods that are available for reporting income and deductions:

1. prepaid income 2. advance payment for goods 3. advance payment for services 4. the claim-of-right doctrine

There are several exceptions to the accrual method of accounting. Some of the more common exceptions that apply are: (4)

Effective [or average] tax rate

This is the average rate of tax paid, factoring in the payments at various marginal tax brackets.

1. The taxpayer must be married; 2. Must file a separate tax return from the spouse; 3. Must maintain as their home a household which for more than one-half of the taxable year is the principal place of abode of a child who can be claimed as a dependent; 4. Must furnish over 1/2 of the cost of maintaining the household; and 5. The spouse must not be a member of the household during the last six months

To be eligible for a married person to file as head of household the tax payer must meet the following five requirements:

False- return of capital is not included in the definition of income.

True or False "Income" includes a return of invested capital.

False- A nonresident alien taxpayer is NOT allowed to use the standard deduction. They must itemize their deductions.

True or False A nonresident alien taxpayer is allowed to use the standard deduction.

True

True or False A qualifying child must live with the taxpayer for more than half of the year.

True

True or False A qualifying relative, unlike a qualifying child, is subject to a gross income test.

True

True or False A surviving spouse must not have remarried in order to use the surviving spouse filing status.

False- Multiple requirements must be met in order to claim a dependent exemption for someone who lives in the taxpayer's house.

True or False A taxpayer is entitled to claim as a dependent anyone who lives in the taxpayer's house.

False- An automatic 6-month extension of time to file a return is normally available to an individual taxpayer who files a Form 4868 by the due date of the return.

True or False An automatic one-year extension to file a return may be obtained by an individual taxpayer.

False- Prior to 2018, personal and dependency exemptions were allowed as deductions from AGI. This was repealed by TCJA 2017 for years after 2017 and before 2026.

True or False For tax years 2018-2025, personal and dependency exemptions are deducted from AGI.

True

True or False For the purposes of calculating NUI, unearned income does not include the wages received by the child as a result of their own personal efforts.

False - Although most individual taxpayers report their income and expenses on a calendar year basis, individuals are permitted to choose another tax year under certain circumstances.

True or False Only businesses may choose a tax year other than the calendar year.

True

True or False Property obtained by inheritance is not included in gross income.

Illness, education, business, vacation, military service or a custody agreement

What are some of the common exceptions to the head of household requirement that the dependent's "principal place of residence for more than half the year" must be the residence of the taxpayer? [abode test exceptions for qualified child]

1. Your spouse died within the two preceding tax years 2. You pay more than 1/2 the cost of a household that has a dependent child as their principal place of residence [son, stepson, daughter, or stepdaughter], 3. You have not remarried, 4. You and your spouse were eligible to file a joint return for the spouse's year of death.

What are the requirements to file as surviving spouse? (4 requirements)

A permanently and totally disabled child.

What child meets the age test regardless of age?

1. The doctrine of constructive receipt 2. Original issue discount bonds [zero coupon bonds] 3. Cash received with an obligation to repay

While cash method taxpayers normally recognize income when it is received in cash or cash equivalent, exceptions do apply. What are the 3 most common exceptions?