Essentials of taxation 2016 cengage chapter 10

Alimony and Separate Maintenance Payments slide 3 of 3 • Child support payments – Payments made to satisfy legal obligation to support child of taxpayer – Nondeductible by payor and not

Chapter 10

Individuals: Income,

Deductions, and Credits

The Big Picture (slide 1 of 4)

• Donna and David Steele recently married and have come to

you for tax advice.

– They both are employed, and they expect to have combined wages of

$70,000 during the year

• Donna recently completed an internship with a CPA firm.

– The firm was pleased with her work and gave her a $1,500 bonus to

help with her graduate school expenses at State University.

• Because of Donna’s excellent academic record, the university

awarded her a graduate assistantship that waived her tuition of

$6,000 per semester and paid her $400 per month

– In exchange, Donna was required to teach a principles of accounting

course each semester

– Donna used the $400 per month for books and incidental fees.

The Big Picture (slide 2 of 4)

from her undergraduate years

of $10,000 from her grandmother.

– The couple earned $250 of interest on a savings

account they opened with the money

purchased two years ago for $5,000.

The Big Picture (slide 3 of 4)

• Late in the year, Donna was hit by a delivery van The driver

had a blood alcohol level of 12 Donna suffered a severe

injury to her right arm that required her to miss work for a

month or so

• The delivery company’s insurance company settled the case

by paying damages, itemized as follows:

Compensatory damages:

Medical expenses $ 30,000 Injury to Donna’s right arm 100,000 Pain and suffering 50,000 Loss of income 10,000 Legal fees 25,000 Punitive damages 160,000

The Big Picture (slide 4 of 4)

• This is David’s second marriage, and he pays alimony to his

ex-wife

–He has custody of his 15-year-old son, Stephen, who lives with Donna

and David for nine months each year

• The Steeles rent their home, paid $3,500 of state income taxes,

paid an $812 motor vehicle registration tax on their personal

car, incurred additional medical expenses of $25,000, and

made $2,500 of charitable contributions.

• Without calculating Donna and David’s tax liability, what are

the tax implications of the transactions noted above?

–Are there other tax deductions or credits for which they may qualify or

other tax issues about which they should be made aware?

Specific Inclusions Applicable To Individuals

individuals are covered in this chapter:

– Alimony and separate maintenance payments

– Prizes and awards

– Unemployment compensation

– Social Security benefits

Alimony and Separate Maintenance

Alimony and Separate Maintenance

Payments (slide 2 of 3)

– Transfer of property to former spouse

– No deduction or recognized gain or loss for

transferor

– No gross income and carryover of transferor’s

basis for transferee

Alimony and Separate Maintenance

Payments (slide 3 of 3)

• Child support payments

– Payments made to satisfy legal obligation to support child

of taxpayer

– Nondeductible by payor and not taxed to recipient (or

child)

• May be difficult to determine whether an amount

received is alimony or child support

– If amount of payment would be reduced due to some future

event related to the child (e.g., child reaches age 21), such

Alimony and Separate Maintenance

Payments (slide 3 of 3)

• Child support payments

– Payments made to satisfy legal obligation to support child

of taxpayer

– Nondeductible by payor and not taxed to recipient (or

child)

• May be difficult to determine whether an amount

received is alimony or child support

– If amount of payment would be reduced due to some future

event related to the child (e.g., child reaches age 21), such

reduction is deemed child support

Prizes and Awards

Prizes and Awards

Prizes and Awards

Unemployment Compensation

Social Security Benefits

amount, up to 85% of benefits may be taxable

Specific Exclusions Applicable To Individuals

individual’s income, including:

– Gifts and Inheritances

– Scholarships

– Certain damages

– Workers’ Compensation

– Accident and Health Insurance Benefits

– Interest on Educational Savings Bonds

Gifts and Inheritances

(slide 1 of 3)

– Transfer is voluntary without adequate

consideration, and

– Made out of affection, respect, admiration, charity,

or donative intent

Gifts and Inheritances

(slide 2 of 3)

taxable under normal rules

– Example: Father gifts corporate bond to daughter

Gift is excluded from daughter’s gross income, but

interest income earned after gift date is taxable to

her

Gifts and Inheritances

(slide 3 of 3)

qualify as excludible gifts

– May be excludible under other provisions, e.g.,

employee achievement awards

The Big Picture - Example 4

Gifts to Employees

• Return to the facts of The Big Picture on p 10-1.

firm was compensation for services rather than

a gift.

– The payment was most likely not motivated by the

employer’s generosity, but as a result of business

considerations

– Even if the payment had been made out of

generosity, because the payment was received from her employer, Donna could not exclude the “gift.”

Scholarships and Fellowships

student to aid in pursuing a degree at an

educational institution

– Nontaxable to extent of tuition and related

expenses (e.g., fees, books, supplies, and

equipment required for courses)

• Amounts received for room and board are taxable

Scholarships and Fellowships

student to aid in pursuing a degree at an

educational institution

– Nontaxable to extent of tuition and related

expenses (e.g., fees, books, supplies, and

equipment required for courses)

• Amounts received for room and board are taxable

The Big Picture - Example 5

Scholarships

• Return to the facts of The Big Picture on p 10-1

• State University waives tuition for all graduate

teaching assistants

– The tuition waived is intended as compensation for

services and is included in gross income

– Therefore, the $6,000 tuition waiver Donna received each

semester is compensation for her services

• The $400 she received each month also is

compensation for services

– The fact that she used the funds for educational expenses

does not change the tax treatment of the compensation.

Damages (slide 1 of 3)

– Depends on type of harm taxpayer experienced

– The taxpayer may seek damages for:

• Loss of income

• Expenses incurred

• Property destroyed

• Personal injury

Damages (slide 2 of 3)

– Loss of income

• Generally, taxed the same as the income replaced

– Exceptions exist related to personal injury

– Reimbursement for expenses incurred

• Not income, unless the expense was deducted

– Damages that are a recovery of the taxpayer’s previously

deducted expenses are generally taxable under the tax benefit rule

Damages (slide 3 of 3)

– Property damaged or destroyed

• Treated as an amount received in a sale or exchange of the property

– Thus, taxpayer has realized gain if damage payments exceed

property’s basis

– Personal injury

• Receives special treatment

Compensation for Injuries

and Sickness (slide 1 of 3)

– Compensatory damages received on account of

physical personal injury or physical illness are

excludible

• Includes amounts received for loss of income associated with the physical personal injury or physical sickness

– All other personal injury damages are taxable

• Compensatory damages for nonphysical injury

• All punitive damages

The Big Picture - Example 9

Damages

• Return to the facts of The Big Picture on p 10-1

a result of a physical personal injury

– Therefore, all of the compensatory damages can be

excluded

– Even the compensation for the loss of income of

$10,000 can be excluded

however, must be included in her gross

income.

Compensation for Injuries

and Sickness (slide 2 of 3)

– Although may be payment for loss of wages,

workers’ compensation is specifically excluded

from gross income

Compensation for Injuries

and Sickness (slide 3 of 3)

– Benefits received under policy purchased by

taxpayer are excludible

• Even if benefits are substitute for income

– Different rules apply if the accident and health

insurance protection was purchased by the

individual’s employer

Compensation for Injuries

and Sickness (slide 3 of 3)

– Benefits received under policy purchased by

taxpayer are excludible

• Even if benefits are substitute for income

– Different rules apply if the accident and health

insurance protection was purchased by the

individual’s employer

Educational Savings Bonds

be excluded from income if:

– Proceeds used to pay for qualified higher

educational expenses

– Bonds issued after 12/31/89, and

– Bonds issued to person at least 24 years old

exceeds threshold amount

Itemized Deductions

(slide 1 of 2)

AGI as itemized deductions include:

Itemized Deductions

(slide 2 of 2)

to extent that, in total, they exceed the standard deduction amount for the taxpayer

Medical Expenses

(slide 1 of 6)

unreimbursed medical expenses, in total,

exceed 10% of AGI

– For taxpayers age 65 and older, the threshold is

7.5% of AGI until 2017, when it increases to 10%

– Prior to 2013, the percentage threshold for regular

income tax purposes was 7.5% of AGI for all

taxpayers

– The purpose of affecting any structure or function

of the body of the taxpayer, spouse, or dependents

– Includes prescription drugs and insulin

Medical Expenses

(slide 5 of 6)

– Unnecessary cosmetic surgery

– General health items

– Nonprescription drugs

deductible as a medical expense

– Cosmetic surgery is necessary when it ameliorates

• A deformity arising from a congenital abnormality

• A personal injury, or

The Big Picture - Example 13

Medical Expenses

• Return to the facts of The Big Picture on p 10-1

accident were later reimbursed by the delivery

company’s insurance company.

– The Steeles had other qualifying medical expenses.

$200,000.

– They will need to itemize their deductions and have more

than $20,000 ($200,000 X 10%) in unreimbursed medical

Nursing Home Expenditures

medical, costs (including meals and lodging)

qualify

personal, only specific medical costs qualify

(no meals or lodging)

Capital Medical Expenditures

• May include a pool, air conditioners if they do not

become permanent improvements, dust elimination

systems, elevators, etc

• Must be medical necessity, advised by a physician,

used primarily by patient, and expense is reasonable

• Full amount of cost is medical expense in year paid

• Maintenance on capital expenditures also medical

expense

Capital Improvement to Home

exceeds increase in value of home

– Appraisal costs related to capital improvements are

also deductible, but not as medical expenses

home of handicapped are deemed to add no

value to home

– Thus, full amount is a medical expense

Medical Care of Spouse

and Dependents

spouse and dependents

– Dependents need not meet gross income or joint

return tests

– Medical expenses of children of divorced parents

can be deducted by non-custodial parent even

though child is claimed as dependent of custodial

parent

Medical Transportation

and Lodging

• Transportation costs to and from medical care are

deductible

– Mileage allowance of 23.5 cents per mile (in 2014) may be

used instead of actual out-of-pocket automobile expenses

• Lodging while away from home for medical care

– Allowable amount is $50 per person per night

• If parent and/or aide needs to accompany patient,

their expenses are also deductible

Medical Transportation

and Lodging

• Transportation costs to and from medical care are

deductible

– Mileage allowance of 23 cents per mile (in 2015) may be

used instead of actual out-of-pocket automobile expenses

• Lodging while away from home for medical care

– Allowable amount is $50 per person per night

• If parent and/or aide needs to accompany patient,

their expenses are also deductible

Medical Insurance Premiums

(slide 1 of 2)

deductible medical expenses

– If employer pays all or part of taxpayer’s medical

insurance premiums the amount paid by employer

is

• Not included in gross income by employee

• Not deductible by the employee as medical expense

Medical Insurance Premiums

(slide 2 of 2)

• For self-employed, 100% of insurance premiums are

deductible for AGI

– Includes amounts paid for taxpayer’s spouse and

dependents

– Not allowed if taxpayer is eligible to participate in a

subsidized health plan maintained by any employer of the

taxpayer or the taxpayer’s spouse

• Premiums paid for qualified long-term care insurance

are deductible medical expenses

Health Savings Accounts

• Used in conjunction with a high deductible medical

insurance policy

– Employee contributions to HSA are deductible for AGI and earnings on funds in account are not taxable

– Deductible contributions are limited to the sum of the

monthly limitations The monthly deductible amount is

limited to the lesser of one twelfth of:

• The annual deductible under a high deductible plan or

• $3,350 for self-only ($6,650 for family coverage) in 2015

– Withdrawals from HSA are excludible to the extent used

for qualified medical expenses

Taxes

(slide 1 of 4)

property taxes are deductible in the year paid

– Real property taxes do not include taxes assessed

for local benefits

• e.g., Special assessments for streets, sidewalks, curbing, and other similar improvements

on value (ad valorem) are deductible in the

Taxes

(slide 2 of 4)

deductible

– May be deductible if incurred in business or

production of income activity

Taxes

(slide 3 of 4)

be apportioned between the buyer and the

seller

– Failure to correctly apportion requires offsetting

adjustments to seller’s amount realized and buyer’s adjusted basis

• Estimated tax payments

• Amounts paid in current year for prior year’s liability

– For sales/use taxes, deduct either:

• Actual sales/use tax payments or

• Amount from an IRS table

– Table amount may be increased by sales tax paid on certain specific

items (e.g., Purchase of motor vehicles, boats, etc.)

The Big Picture - Example 17

Deductible Property Taxes

• Return to the facts of The Big Picture on p 10-1.

vehicle registration tax is 2% of the value of

the vehicle plus 40 cents per hundredweight

– The Steele’s car is valued at $20,000 and weighs

3,000 lbs

– Their annual registration tax is $412

• $400 (2% of $20,000) is deductible as a personal property tax if they itemize.

Interest Expense

– Interest on qualified student loans

Interest on Qualified

Student Loans

– Maximum deduction is $2,500 per year

– Deduction is phased out for taxpayers with

modified AGI (MAGI) between $65,000 and

$80,000 ($130,000 and $160,000 on joint returns)

– Not allowed for those claimed as a dependent or

for married filing separate returns

Investment Interest

are used to purchase investment property may

be deductible

– e.g., Investment property may include stock,

bonds, and land held for investment

limited to net investment income

Qualified Residence Interest

(slide 1 of 4)

principal residence and one other residence

(qualified residences)

home equity loans

Qualified Residence Interest

(slide 2 of 4)

acquire, construct, or substantially improve the qualified residences

– Interest paid on aggregate acquisition indebtedness

of $1 million or less ($500,000 for married, filing

separately) is deductible as qualified residence

interest