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ACC 331 Spring 2016
Individuals: Income, Deductions, and Credits
1-3. Income ? Inclusions and Exclusions
What gets reported to the IRS?
Gross Income ? all (worldwide) income from whatever source derived (legal or
illegal) except as otherwise provided (exclusions and deferrals)?..(IRC ?61)
All income is considered taxable unless the tax code specifically allows for exclusion
for deferral to a later tax period.
Examples of Items Specifically Included in Income
1) Alimony versus Child Support Payments
Alimony is taxable income to the recipient
Deductible by the payer (as a For AGI deduction),
To be treated as alimony, the following conditions must be satisfied:
o Payment must be in the form of cash
o There isn?t a written agreement that says the payment is something
other than alimony (e.g., divorce agreement)
o The ex-spouse cannot live in the same household (i.e., not living
o The payments must stop on death of recipient (payments can stop
Child support (i.e., maintenance payments) is NOT considered taxable
income; and is not deductible by the payer
Transfer of property under a divorce agreement is considered a division of
property can is NOT treated as taxable income or a gift to the recipient
(recipient assumes carry-over basis in the property acquired)
Bob pays Midge child support payments of $80,000 per year until their daughter, Donna, turns
18. Once Donna turns 18, Bob will pay Midge $50,000. How much of Bob?s $80,000 should be
treated as child support and how much as alimony?
Just because he thinks of this as child support, it is not because of how it is structured.
Substance ? over ? form doctrine
Structure of Bob and midge payments suggest the 50,000 is alimony. Balance of 30,000 is treated
as child support.
2) Prizes and Awards
A prize or award is gross income to recipient (valued at FMV); it is not treated
as a gift.
Exceptions: a taxpayer can exclude a prize/award under the following
If the award if for literary, scientific, or charitable achievement and
the award is transferred/donated to a government agency or a
qualified charitable organization. To qualify:
i. Taxpayer must transfer the entire award
ii. Taxpayer must not have taken any action to win the award
(e.g., submitting a project or paper to a competition
disqualifies the taxpayer)
Taxpayer must not receive any future services connected
with making the award
EXAMPLE ? Nobel Prize winner transfers monetary award to MSU, then
award is non-taxable.
Employment Achievement Awards are non-taxable if the award is:
Based on length of service or safety
Paid in the form of property (i.e., non-cash)
And below the following amount:
$400 / employee per year (non-qualified plan)
$1,600 / employee per year (qualified plan)
A qualified plan is a non-discriminatory award (i.e., open to all
EXAMPLE: A factory worker receiving a watch (FMV $350) for 30-years
of service to the firm
3) Unemployment Compensation
Unemployment benefits are taxable income (considered substitute income)
However, workman?s compensation, which is payment for injury on the job is
NOT taxable (considered a return of human capital)
4) Social Security Benefits
Portion of social security benefits are taxable if taxpayer has other sources of
income (?86). For example, single taxpayer:
o Mod AGI ? 25K => all social security benefits is non-taxable
o 25K < Mod AGI ? 34K => 50% of social security benefits is taxable
o Mod AGI > 34K => 85% of social security benefits is taxable
NOTE: Mod AGI is defined in the textbook.
Will be given Mod AGI in this class
Examples of Excluded (Non-Taxable) or Deferred Income
1) Gifts and Inheritances
Donates made during donor?s life (i.e., gifts); and transfers upon death of donor
(i.e., inheritances or bequests) are not taxable income to the recipient (?102).
Donor is potentially subject to gift or estate tax (recall from Chapter 1)
Note however that the income generated by the gift after it is transferred into the
hands of the recipient is taxable (e.g., future interest income earned on a bond
received as a gift)
Transfers from employer to employee generally does not qualify as a gift; instead
it is treated as compensation income (recall Imputed Income from Chapter 4)
If funds are used for tuition, fees, books, supplies, and other equipment required
for student?s course, then scholarship funds are non-taxable.
o Scholarship funds used for any other activities are taxable.
Payments made in exchange for services provided by the student are considered
compensation, not scholarships (e.g., stipend received by research or teacher
assistant). Special exception made for student athletes.
3) Damages and Compensation
Reimbursements for expenses incurred (e.g., employee travel expenses, medical
expenses from accident) or property destroyed (insurance proceeds) are nontaxable unless
o The reimbursement exceeds expense/damage suffered, then the excess
is taxable income; or
o If the taxpayer claims the expense/damage as a deduction on her tax
return, then the full reimbursement has to be included as income
Compensation for personal injury or sickness is non-taxable (e.g., in a car
accident), however, compensation for loss of income or award of punitive
damages is taxable income to the recipient.
4) Workers Compensation
Employer payments for specific job-related injuries are non-taxable
5) Accident and Health Benefits
Proceeds/benefits collected from an accident or health insurance policy purchased
by the taxpayer is non-taxable
Tax rules are more complex for employer purchased policies (covered in Ch. 11,
not covered in this course)
6) Educational Savings Bonds
Interest earned on U.S. Series EE bonds are non-taxable if the proceeds of the
bonds are used to pay for qualified higher education expenses.
The proceeds can be used to pay the higher education expense of the taxpayer, her
spouse, or a dependent
7) Foreign-earned income
The first $100,800 of foreign earnings are non-taxable, provided the taxpayer:
(i) Is a resident of foreign country; or
(ii) Lives in the foreign country for 330 days in a 12- month period.
Otherwise include total foreign income in gross income and
(i) Deduct income taxes paid to foreign gov?t as a from AGI deduction, or
foreign tax credit
8) Other Exclusions
Gain on sale of personal residence
o Single ? exclude the first $250,000 of gain ($500,000 ? MFJ)
o must live in residence for 2 of last 5 years
Roth retirement accounts ? all earnings from Roth accounts are tax exempted.
Gain/Loss on exchange-related disposals (where-withal to pay concept)
o Gains/Losses on Like-kind exchanges
o Gains on Involuntary conversions (e.g., property seized through eminent
o Gains/Losses on transfer of property to separate legal entities, e.g.,
formation of C-Corp (?351) or Partnership (?721) (See chapters 12 & 14)
o Gains on Installment sales
o Contributions to qualified retirement accounts
o Contributions under non-qualified deferred compensation plans
For each of the following independent situations, indicate the amount the taxpayer must include
in gross income and explain your answer:
a. Phil won $500 in the scratch-off state lottery. There is no state income tax.
The award is taxable
b. Ted won a compact car worth $17,000 in a TV game show. Ted plans to sell the
car next year for $15,000.
It is taxable in the year that he receives it.
c. Al Bore won the Nobel Peace Prize of $500,000 this year. Rather than take the
prize, Al designated that the entire award should go to Weatherhead Charity, a taxexempt organization.
No, because donated it to a tax-exempt organization
d. Jerry was awarded $2,500 from his employer, Acme Toons, when he was selected
most handsome employee for Valentine?s Day this year.
Its taxable because it is cash. Its not related to safety or length of service. Its over
the 1,600 limit. Fails all three test
e. Ellen won a $1,000 cash prize in a school essay contest. The school is a taxexempt entity, and Ellen plans to use the funds to pay her college education.
She has to report because she enters a contest. It is award. When she uses the
money for her education she can claim a deduction
f. Gene won $400 in the office March Madness pool.
4. Itemized Deductions
As discussed in Ch. 9, Congress allows for the deduction of specific expenses as a from AGI
deduction. Here are some examples
1) Medical Expenses
Medical expenses for care of taxpayer, spouse, and/or dependents that has not
been reimbursed by health insurance or other source.
Deductible medical expenses include any payments for the ? care, prevention,
diagnosis, cure, mitigation, treatment or prevention of disease. Including:
o health insurance premiums
o transportation and lodging for medical care
o nursing home care (stay must be primarily for medical care)
o medically necessary capital expenditure (e.g., renovating home to be
Medical expenses are subject to a 10% AGI floor (for taxpayers ? 65 years old the
AGI floor is reduce to 7.5%). That is, only the amount in excess of the 10% of
AGI is deductible on the tax return
Contributions to health savings account are a For AGI deduction;
Payments for cosmetic surgery, unless medically necessary (e.g., reconstructive
surgery after an accident), are generally not deductible.
2) Taxes (State, Local and Foreign)
To provide relieve from double-taxation, the following taxes are deductible:
Income taxes paid to state and/or local gov?t.
o Taxpayers can elect to deduct sales tax paid to the state instead of
income taxes (beneficial for taxpayers living in states without an
income tax, e.g., Florida).
Foreign income taxes paid (hardly done, in most cases claiming foreign
income taxes paid as a tax credit generates greater tax savings)
Property taxes on real property (both investment and personal-use property),
and ad-valorem taxes on personal property (e.g., taxes on motor vehicle)
Recall Tax benefit rule from Chapter 4 - refund of state, local and foreign taxes are
included as taxable income to the extent taxpayer?s taxable income would have been
higher had she not taken the excess deduction in the prior year(s).
You paid $3,000 in Michigan state income tax in 20x1 (this is your only itemized deduction).
Your standard deduction in 20x1 is $6,300. On April 15, 20x2 you claim a refund of $1,800 on
your state income tax return for 20x1. Rather than receive a check, you decide to have the tax
refund applied to your 20x2 state income tax return.
a) How much of the refund is included as income on your 20x2 tax return?
Michigan income tax
Standard Deduction 6,300 (would have claimed this)
Therefore, tax benefit 20x1 from overpaying state income taxes. No tax benefit,
so none of 1,800 is treated as income in 20x2
b) In addition to the $3,000 Michigan state income tax you also have charitable
contributions of $4,500. How much of the refund is included as income in your 20x2 tax
Michigan income tax 3,000
Charitable Contributions 4,300
Total 7,3000 (chose this one)
Tax benefit from overpaying by 1,800. Your taxable income 7,300-6,300= 1,000
lower because of overpayment so 1,000 is gross income in 20x2
If you had not overpaid
Mich. Income tax 1,200
Charitable contributions 4,300
3) Interest Expense
Mortgage Interest ?
o Mortgage interest on qualified residence (taxpayer?s principal residence
plus one other residence), and interest on ?home-equity? loans
o Mortgage interest limited to interest on the first $1 million of mortgage
o Home-equity interest limited to lesser of
(i) (FMV - acquisition debt) at time loan was executed; or
o To qualify as residence, the structure must have sleeping accommodations,
toilet and cooking facilities
o Mortgage proceeds must be used to acquire, construct or substantially
improve a qualified residence. There are no restrictions on the use of
Investment interest expense ? Deduction is limited to net investment income (NII)
NII =Investment income?Investment related Expense
o Excess investment interest expense is carried forward to deduct in next tax
Expenses related to Tax-Exempt Securities ? Interest expense on debt incurred to
purchase tax-exempted securities (e.g., interest expense on loan taken out to
purchase municipal bonds) are disallowed.
Interest on Qualified Student Loans - Taxpayers may be able to deduct up to
$2,500 of student loan interest as a For AGI deduction.)
This year Randy paid $28,000 of mortgage interest (Randy borrowed $450,000 to buy his
residence, and it is currently worth $500,000). Randy also paid $2,500 of interest on his car loan
and $4,200 of margin interest to his stockbroker (investment interest expense). How much of
this interest expense can Randy deduct as an itemized deduction under the following
a) Randy received $2,200 of interest income this year and had no other investment income
or expenses. His AGI is $75,000.
Mortgage interest 28,000 (loan <1M, the interest expense is fully deductible)
Car loan interest 2,500 (non-deductible, personal use asset)
Investment int expense 4,200 (can only deduct 2,200, cannot exceed investment income.
2,000 is carried forward?. Does not expire)
b) Randy had no investment income this year, and his AGI is $75,000.
Investment int expense deduction is now 0
4) Charitable Contributions
Donations (cash, ordinary income property or capital gain property) made to a
qualified domestic charity (?170) are deductible.
o If the donor receives any tangible benefits in return for the donation, then
the donation is not considered a charitable contribution (e.g., purchase of
raffle or bingo ticket is not deductible as a charitable contribution)
o Currently contribution of services/time does not qualify as a charitable
contribution (unable to accurately measure FMV of service/time)
Individual taxpayers are limited on how much charitable contributions can be
deducted in any one tax year. The limit depends on the type of charity and the
form of the contribution:
Summary of Charitable Contribution Limitation Rules
Form of Contribution
Cash/Ordinary Income property
Lesser of Basis or FMV Lesser of Basis or FMV
Capital gain property
* If public charity puts the donated property to non-charity use then the amount
deducted is limited to basis in property
** If donation is a publicly-traded stock the donor can deduct at FMV.
Excess charitable contributions are carried forward for 5 years.
Warren is contemplating making a charitable contribution of $20,000 cash to either a public
charity or a private non-operating foundation. Warren?s tax rate in 20x1 is 32% and in 20x2 it
will be 35%. The market rate of interest is 10%, Warren?s AGI is $50,000 each year and Warren
also has $18,000 in mortgage interest expense in both 20x1 and 20x2.
Should Warren make the donation to the public charity or the private non-operating foundation?
5) Casualty losses ? losses from a sudden, unexpected or unusual event (e.g., house fire,
theft of jewelry) of personal-use assets are deductible (losses from normal wear and
tear are not). Deduction for casualty losses are computed as follows:
o For each incident, loss is equal to the lesser of the decline in FMV or the
tax basis of asset
o The loss is reduced by any reimbursement received (e.g., insurance
o Amount deductible subject to two floors:
(i) First, reduce losses by $100 per incident (i.e., the first $100 of
losses is not deductible), and
(ii) Second, sum the remaining casualty losses for the year and reduce
by 10% of AGI (i.e., only the amount in excess of the 10% of AGI
6) Miscellaneous Itemized Deductions
There are two types of miscellaneous itemized deductions:
(i) Miscellaneous items subject to 2% AGI Floor - Miscellaneous items are
aggregated and the total is then subjected to the 2% AGI Floor, common examples
o Unreimbursed employee business expenses
o Hobby expenses (deduction cannot exceed income from hobby)
o Tax preparer fees
o Investment expenses (e.g., safe deposit box fees, subscriptions, advisory
o Professional dues, cost of uniforms (not suitable for normal wear),
o Job hunting expenses
(ii) Other Miscellaneous items NOT subject to 2% AGI Floor:
o Gambling losses, deduction cannot exceed amount of gambling winnings
o Casualty and theft losses on investment property
o Unrecovered capital invested in life-time annuity
o Impairment-related work expenses of a handicapped person
Phase-out of Itemized Deductions
Some itemized deductions are subject to phase-out for high income
o The following items are not subject to phase-out: medical expenses,
investment interest expense, gambling losses, non-business casualty and
(iv) Taxpayers with AGI that exceeds $258,250 ($309,900 for MFJ) - itemized
deductions are reduced by the lesser of:
o 3% * (AGI - $258,250) for single taxpayers; 3% * (AGI - $309,900) for
o 80% of the itemized deductions subject to phase-out.
5. Individual Tax Credits
Unlike tax deductions which reduce taxable income, tax credits reduce tax liability.
o A dollar of tax credit reduces tax liability by a dollar
o A dollar of deduction reduces tax liability by $1 * Marginal Tax Rate
Therefore a dollar of tax credit is more valuable than a dollar of tax deduction.
There are major types of tax credits:
1) Non-refundable tax credits ? These credits reduce tax liability to zero, but cannot
result in a tax refund. Any excess credit is either lost or carried forward to use in the
next tax year.
2) Refundable tax credits ? Unlike non-refundable tax credits, these tax credits result in
a tax refund if the tax credit is greater than the tax liability.
Examples of tax credits available to individuals:
Adoption Expenses Credit ? Provide tax relief/subsidy for the initial cost of adoption (e.g.
adoption fees, attorney fees, court costs, social service review costs, and transportation
costs). To qualify:
o Adopted child must be < 18 years old, or physically/mentally disable
o For 2015, the maximum credit is $13,400 per child; the credit is reduced for
taxpayers with AGI> $201,010.
o The credit is non-refundable, however excess credit can be carried forward up to
Child Tax Credit ? maximum of $1,000 per qualifying child
o Child must be < 17 years old, a U.S. citizen, and claimed as a dependent on the
taxpayer?s tax return
o The credit is phased-out by $50 for each $1,000 the taxpayer?s AGI exceeds
$75,000 ($110,000 for MFJ)
o The child tax credit is non-refundable and cannot be carried forward
Dependent Care Credit ? Provide tax subsidy/relief for working taxpayers with young
children. The credit encourages both parents to seek work outside of the home.
o Dependent must be < 13 years old; or
o Dependent/spouse who is physically or mentally incapable of caring for self and
lives with taxpayer for more than ? year
o Tax credit is a percentage (based on taxpayer?s AGI) of eligible care expenses
1 child ? max. eligible expenses $3,000
2 or more children ? max. eligible expenses $6,000
If MFJ, eligible expenses cannot exceed earned income of the taxpayer
with the lowest earned income
o Child care payments made to relatives < 19 years old are disallowed (e.g., cannot
claim amounts paid to your 15 yr. old niece for babysitting)
Education Tax Credits ? subsidize the cost of higher education and continuous learning.
Two types of educations tax credits:
1) American Opportunity Credit (AOC)
Available for the first four years of postsecondary education
Available per eligible student (taxpayer, spouse or dependent); student
must be at least half-time for one term/semester
Covers tuition, books and related course material
Tax credit is 100% of first $2,000 spent and then 25% of next $2,000
(i.e., maximum credit of $2,500 in 2015)
Subject to phase-out:
( ModAGI ?160 K )
( ModAGI ?80 K )
40% of allowable AOC is refundable
2) Lifetime Learning Credit
Covers postsecondary education or any course that acquires or
improves a taxpayer?s job skills (much broader than AOC).
Available per taxpayer unit (i.e., one credit for all members of
20% of the first $10,000 of qualifying expenses (tuition)
Subject to phase-out:
( ModAGI ?110 K )
( ModAGI?55 K )
o Taxpayer has to choose between claiming the education expense as a tax credit or
a for AGI deduction, not both.
o Expenses paid with tax-exempt income cannot be claimed (e.g., tuitions paid by
scholarships) or reimbursed by your employer.
o Cannot claim both AOC and Lifetime credits for the same expense/student
Tim and Mandy file married filing jointly and have a modified AGI of $116,000. They have
two children, Liz and Peter. Liz is a university sophomore and incurs $8,000 for tuition and
$500 for books for 2015. Peter is a senior at the university but is in his fifth year because he
changed majors. Peter?s expenses are $5,000 for tuition and $600 for books. Both children
live at home and are qualifying children on Tim and Mandy?s tax return.
What is Tim and Mandy?s education tax credit for 2015?
Earned Income Credit ? designed to help offset the effect of employment taxes (social
security and medicare) on the earned income of low-income taxpayers and encourage the
poor to seek employment.
o Qualifying individuals:
A taxpayer with at least one qualifying child; or
Taxpayer ? 25 but < 65, and not claimed as a dependent on someone else tax
o Taxpayers with investment income > $3,400 are not eligible
o Maximum earned income credit for 2015 (subject to phase-out)
(lower limit to get
Foreign Tax Credit (FTC) ? U.S. Citizens working abroad owe taxes abroad and at home
o Taxpayer can claim income taxes paid to foreign government as a tax credit (subject
o Taxpayer cannot claim credit if income is excluded
Live in country 330 days of year
Exclude up to $100,800 of income
o Taxpayer can choose to deduct foreign taxes paid as itemized (if foreign income is
included in gross income)
o FTC may only reduce taxpayer?s tax liability to zero. Excess FTC can be carried
back one year or forward up to 10 years.
Affordable Care Act (ACA) Provisions
ACA?s ?individual mandate? - requires all taxpayers to have health insurance,
otherwise taxpayer required to pay a tax penalty for each month they do not have
o Tax Penalty - Individual Share Responsibility Payment (ISRP) for 2015 is
the greater of:
1) $325 per adult plus $162.50 per child up to a maximum of $975; or
2) 2% of household income (measured as AGI ? standard deduction ?
o Taxpayers can apply for exemption from the ISRP on a variety of grounds
including financial hardship, religious objections, incarceration (see page
10-34 of text for list of factors).
Premium Tax Credit ? low-income taxpayers can receive a federal subsidy to
secure health insurance on the Health Insurance Marketplace.
o Household income must be between 100% - 400% of the federal poverty
o Tax credit ranges between 2.01% to 9.56% of household income
o Tax credit can be claimed in advance at the start of the year or claim as a
refund when filing tax return for the year (file on IRS Form 8962)
Aaron, age 45, had AGI of $40,000 for 2015. He was injured in a skiing accident and paid
$3,600 for hospital expenses and $1,400 for doctor bills. Aaron also incurred medical expenses
of $1,200 for his child, who lives with his former wife and is claimed as a dependent by her. In
2016, Aaron was reimbursed $1,300 by his insurance company for the medical expenses
attributable to the skiing accident.
a) Compute Aaron?s deduction for medical expenses in 2015.
b) Assume that Aaron would have elected to itemize his deductions even if he had no
medical expenses in 2015. How much, if any, of the $1,300 reimbursement must be
included in gross income in 2016?
c) Assume that Aaron?s other itemized deductions in 2015 were $8,000 and that he filed as a
head of household. How much of the $1,300 reimbursement must he include in gross
income in 2016?
Ross, who is single, purchased a personal resid...
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