1040 TaxationByDanny C. SantucciThe author is not engaged by this text or any accompanying lecture or electronicmedia in the rendering of legal, tax, accounting, or similar professional services.While the legal, tax, and accounting issues discussed in this material have beenreviewed with sources believed to be reliable, concepts discussed can be affectedby changes in the law or in the interpretation of such laws since this text wasprinted. For that reason the accuracy and completeness of this information andthe author's opinions based thereon cannot be guaranteed. In addition, state orlocal tax laws and procedural rules may have a material impact on the generaldiscussion. As a result, the strategies suggested may not be suitable for every individual.Before taking any action, all references and citations should be checkedand updated accordingly.This publication is designed to provide accurate and authoritative informationin regard to the subject matter covered. It is sold with the understanding that thepublisher is not engaged in rendering legal, accounting, or other professionalservice. If legal advice or other expert advice is required, the services of a competentprofessional person should be sought.—-From a Declaration of Principles jointly adopted by a committee of theAmerican Bar Association and a Committee of Publishers and Associations.Copyright May 2009Danny Santuccii

TABLE OF CONTENTSCHAPTER 1 - Individual Tax Elements .......................................................1-1Federal Income Taxes: A Description........................................................................................................1-1Rates, Tables, & Statutory Amounts ..........................................................................................................1-3Standard Deduction ..............................................................................................................................1-4Dependent Limit...........................................................................................................................1-5Kiddie Tax ...............................................................................................................................1-5Election to Report on Parent’s Return .....................................................................................1-5AMT Exemption......................................................................................................................1-6Phaseout of Exemptions - 2% Haircut..................................................................................................1-6Overall Limitation on Itemized Deductions - 3% Haircut ....................................................................1-7Earned Income Credit - §32..................................................................................................................1-7Social Security & Self-Employment Earnings Base.............................................................................1-8Cents-Per-Mile Rates - Standard Mileage Rate ....................................................................................1-9Qualified Transportation Fringes..........................................................................................................1-9Passenger Automobile Depreciation Limits .........................................................................................1-9

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Expensing Deduction - §179 ................................................................................................................1-10Self-Employed Health Insurance Deduction ........................................................................................1-10Corporate Income Tax Rates ................................................................................................................1-10Withholding & Estimated Tax....................................................................................................................1-10Estimated Tax......................................................................................................................................1-13Filing Status ..............................................................................................................................................1-15Marital Status.......................................................................................................................................1-15Single Taxpayers ...........................................................................................................................1-15Divorced Persons .....................................................................................................................1-15Sham Divorce ..........................................................................................................................1-15Annulled Marriages .................................................................................................................1-16Married Taxpayers........................................................................................................................1-20Spouse’s Death ........................................................................................................................1-20Married Persons Living Apart .................................................................................................1-20Filing Jointly...........................................................................................................................1-21Joint Liability ......................................................................................................................1-21Innocent Spouse Exception .............................................................................................1-21Nonresident Alien................................................................................................................1-24Filing Separately.....................................................................................................................1-24Special Rules .......................................................................................................................1-25Joint Return after Separate Returns .....................................................................................1-25Separate Returns after Joint Return .....................................................................................1-25Exception ........................................................................................................................1-26Head of Household.......................................................................................................................1-26Advantages ..............................................................................................................................1-26Requirements of §2(b) .............................................................................................................1-26Considered Unmarried.........................................................................................................1-27Keeping Up a Home ............................................................................................................1-27Qualifying Person................................................................................................................1-27iiSummary.................................................................................................................................1-28Qualifying Widow(er) With Dependent Child ..............................................................................1-29Gross Income.............................................................................................................................................1-32Compensation ......................................................................................................................................1-33Fringe Benefits ....................................................................................................................................1-33Rental Income......................................................................................................................................1-33Advance Rent ...............................................................................................................................1-33Security Deposits..........................................................................................................................1-33Payment for Canceling a Lease .....................................................................................................1-34Social Security Benefits.......................................................................................................................1-34Taxability of Benefits ....................................................................................................................1-34Alimony & Spousal Support.................................................................................................................1-37Requirements................................................................................................................................1-37Recapture......................................................................................................................................1-38Child Support ...............................................................................................................................1-38Prizes & Awards - §74 & §274.............................................................................................................1-38Dividends & Distributions...................................................................................................................1-39Ordinary Dividends .......................................................................................................................1-39Money Market Funds...............................................................................................................1-39Dividends on Capital Stock .....................................................................................................1-39Dividends Used to Buy More Stock ........................................................................................1-39Qualified Dividends......................................................................................................................1-40Capital Gain Distributions.............................................................................................................1-40Undistributed Capital Gains.....................................................................................................1-40Form 2439 ...........................................................................................................................1-40

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Basis Adjustment .....................................................................................................................1-41Real Estate Investment Trusts (REITs)....................................................................................1-41Nontaxable Distributions...............................................................................................................1-41Return of Capital......................................................................................................................1-41Basis Adjustment .....................................................................................................................1-41Liquidating Distributions...............................................................................................................1-42Distributions of Stock and Stock Rights........................................................................................1-42Taxable Stock Dividends and Stock Rights.............................................................................1-42Discharge of Debt Income ....................................................................................................................1-46Exceptions from Income Inclusion................................................................................................1-46Reduction of Tax Attributes ..........................................................................................................1-47Order of Reductions.................................................................................................................1-47Foreclosure ...................................................................................................................................1-47Nonrecourse Indebtedness .......................................................................................................1-48Recourse Indebtedness.............................................................................................................1-49Mortgage Relief Act of 2007 ...................................................................................................1-49Bartering..............................................................................................................................................1-50Barter Exchange ............................................................................................................................1-51Backup Withholding................................................................................................................1-51Recoveries ...........................................................................................................................................1-55Itemized Deduction Recoveries.....................................................................................................1-56Recovery Limited to Deduction...............................................................................................1-57Recoveries Included in Income................................................................................................1-57Non-Itemized Deduction Recoveries.............................................................................................1-57Amounts Recovered for Credits ....................................................................................................1-58Tax Benefit Rule ...........................................................................................................................1-58iiiIncome Earned by Children ..................................................................................................................1-58Expenses.......................................................................................................................................1-58AMT for Children .........................................................................................................................1-58Unearned Income of Children under 19 - §1(i) [Form 8615] ...............................................................1-59Application ...................................................................................................................................1-59Definitions ....................................................................................................................................1-59Tax Computation Steps .................................................................................................................1-60Other Items & Situations ...............................................................................................................1-60Exclusions from Income............................................................................................................................1-63Educational Savings Bonds - §135 .......................................................................................................1-63Income Exclusion ..........................................................................................................................1-63Limitation .....................................................................................................................................1-64MAGI......................................................................................................................................1-64Notice 90-7...................................................................................................................................1-64Education Expenses .................................................................................................................1-64Excludable Interest ..................................................................................................................1-64Forms 8818 & 8815.................................................................................................................1-64Scholarships & Fellowships - §117 ......................................................................................................1-65Definitions ....................................................................................................................................1-65Scholarship Prizes .........................................................................................................................1-65Education Expenses.......................................................................................................................1-65Education Assistance Programs - §127....................................................................................1-66Employer Educational Trusts - §83 .........................................................................................1-66Qualified Tuition Programs (QTP).......................................................................................................1-66Gift & Inheritance Exclusion................................................................................................................1-66Subsequent Income........................................................................................................................1-66Divorce .........................................................................................................................................1-68Business Gifts...............................................................................................................................1-68

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Employees ....................................................................................................................................1-68Insurance..............................................................................................................................................1-68Exceptions ....................................................................................................................................1-68Purchase for Value...................................................................................................................1-68Installment Payments...............................................................................................................1-69Specified Number of Installments .......................................................................................1-69Specified Amount Payable ..................................................................................................1-69Installments for Life ............................................................................................................1-70Personal Injury Awards - §104 .............................................................................................................1-74Personal Injury ..............................................................................................................................1-74Emotional Distress...................................................................................................................1-74Punitive Damages.........................................................................................................................1-75Tax Benefit Rule - §111 .......................................................................................................................1-75Interest State & Local Obligations - §103 ............................................................................................1-75Foreign Earned Income Exclusion - §911 ............................................................................................1-75Nonbusiness & Personal Deductions..........................................................................................................1-75Itemized Deductions .............................................................................................................................1-76Limitation .....................................................................................................................................1-77Personal & Dependency Exemptions ...................................................................................................1-78Personal Exemptions .....................................................................................................................1-78Dependency Exemptions ...............................................................................................................1-78Before 2005 .............................................................................................................................1-79After 2004...............................................................................................................................1-79ivResidency Test ....................................................................................................................1-79Citizenship ......................................................................................................................1-79Relationship Test.................................................................................................................1-80Age Test ..............................................................................................................................1-80Joint Return Prohibition ......................................................................................................1-80Exception ........................................................................................................................1-80Phaseout of Exemptions...........................................................................................................1-81Interest Expense - §163 ........................................................................................................................1-81Personal Interest - §163(h)(1)........................................................................................................1-82Definition................................................................................................................................1-82Deductibility ............................................................................................................................1-82Investment Interest Expense - §163(d)..........................................................................................1-82Definitions ...............................................................................................................................1-82Net Investment Income Limitation ..........................................................................................1-83Qualified Residence Interest - §163(h)(3) [Form 8598] ................................................................1-83Definitions ...............................................................................................................................1-84Limitations..............................................................................................................................1-84Acquisition Indebtedness.....................................................................................................1-84Home Equity Indebtedness..................................................................................................1-85Refinancing.............................................................................................................................1-85Home Improvements ...............................................................................................................1-86Timing ................................................................................................................................1-86Alternative Minimum Tax .......................................................................................................1-87Points............................................................................................................................................1-88Home Purchase & Improvement Exception.............................................................................1-88Refinancing .........................................................................................................................1-89Huntsman Case................................................................................................................1-89Mortgage Interest Statement - R.P. 92-11................................................................................1-89Allocation of Interest Expense ......................................................................................................1-89Education Expenses.............................................................................................................................1-98Educational Transportation............................................................................................................1-99

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Educational Travel.........................................................................................................................1-101Meal Expenses..............................................................................................................................1-102Investment Seminars .....................................................................................................................1-102Tuition Deduction - §222 ..............................................................................................................1-102Classroom Expenses for Teachers - Expired .................................................................................1-103Medical Expense Deductions - §213 [Schedule A] ..............................................................................1-103Items Deductible...........................................................................................................................1-104Items Not Deductible.....................................................................................................................1-104Medical Insurance Premiums ........................................................................................................1-105Medicare A ..............................................................................................................................1-105Medicare B ..............................................................................................................................1-105Prepaid Insurance Premiums ...................................................................................................1-105Meals & Lodging..........................................................................................................................1-106Expenses of Transportation ...........................................................................................................1-106Permanent Improvements..............................................................................................................1-106Spouses, Dependents & Others .....................................................................................................1-107Reimbursement of Expenses .........................................................................................................1-107Long-Term Care Provisions ..........................................................................................................1-107Long-Term Care Payments......................................................................................................1-107Long-Term Care Premiums .....................................................................................................1-108vIRA Withdrawals for Certain Medical Expenses ..........................................................................1-108Charitable Contributions - §170 [Schedule A] .....................................................................................1-108Requirements for Deductibility .....................................................................................................1-108Qualified Organizations.................................................................................................................1-109Limitations on Contributions.........................................................................................................1-109Five-year Carryover.................................................................................................................1-110Contributions of Cash....................................................................................................................1-110Benefits Received ....................................................................................................................1-110Benefit Performances...............................................................................................................1-110Athletic Events.........................................................................................................................1-111Raffle Tickets, Bingo, Etc........................................................................................................1-111Dues, Fees, or Assessments .....................................................................................................1-111Contribution of Property................................................................................................................1-111Clothing & Household Goods..................................................................................................1-111Ordinary Income or Short-Term Capital Gain Type Property .................................................1-112Exception............................................................................................................................1-112Capital Gain Type Property .....................................................................................................1-112Exceptions ...........................................................................................................................1-113Conservation Easements......................................................................................................1-113Loss Type Property..................................................................................................................1-114Vehicle Donations ...................................................................................................................1-114Fractional Interests...................................................................................................................1-114Other Types of Contributions ........................................................................................................1-115Charitable Distributions from an IRA......................................................................................1-115Substantiation ...............................................................................................................................1-115Cash Contributions ..................................................................................................................1-115Contributions Less Than $250.............................................................................................1-116Contributions of $250 or More............................................................................................1-116Payroll Deduction Records..............................................................................................1-117Noncash Contributions ............................................................................................................1-117Deductions of Less Than $250 ............................................................................................1-117Additional Records..........................................................................................................1-118Deductions of At Least $250 But Not More Than $500......................................................1-118Deductions Over $500 But Not Over $5,000 ......................................................................1-119

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Deductions over $5,000.......................................................................................................1-120Contributions over $75 Made Partly for Goods or Services ....................................................1-120Deduction for Taxes - §164 [Schedule A] ............................................................................................1-121Income Taxes ...............................................................................................................................1-121Real Property Tax..........................................................................................................................1-121Accrual Method Taxpayers......................................................................................................1-121Standard Deduction for Real Property Taxes ..........................................................................1-121State & Local Sales Tax ................................................................................................................1-122Actual Expenses.......................................................................................................................1-122Sales Tax Deduction for Qualified Vehicles............................................................................1-122Personal Property Tax ...................................................................................................................1-123Other Deductible Taxes.................................................................................................................1-123Examples of Non-Deductible Taxes..............................................................................................1-124Casualty & Theft Losses - §165 [Schedule A] .....................................................................................1-130Definitions ....................................................................................................................................1-130Proof of Loss ................................................................................................................................1-130Amount of Loss .............................................................................................................................1-131viInsurance & Other Reimbursements..............................................................................................1-131Limitations....................................................................................................................................1-131Allocation for Mixed Use Property ...............................................................................................1-132Standard Deduction for Disaster Losses........................................................................................1-132Miscellaneous Deductions - §67 [Schedule A].....................................................................................1-133Deductions - Subject to 2% Limit .................................................................................................1-133Deductions Not Subject To 2% Limit ...........................................................................................1-133Nondeductible Expenses ...............................................................................................................1-134Moving Expenses - §217 ......................................................................................................................1-134Distance Test ................................................................................................................................1-135Time Test......................................................................................................................................1-135Time Test for Employees.........................................................................................................1-135Time Test for Self-employment...............................................................................................1-136Deductible Expenses .....................................................................................................................1-136Travel Expenses.......................................................................................................................1-137Travel by Car ...........................................................................................................................1-137Location of Move ..........................................................................................................................1-137Reporting......................................................................................................................................1-138Reimbursements ......................................................................................................................1-138Credits .......................................................................................................................................................1-142Child Care Credit - §21 [Form 2441] ...................................................................................................1-142Eligibility......................................................................................................................................1-143Employment Related Expenses .....................................................................................................1-143Qualifying Out-of-the-home Expenses ....................................................................................1-143Payments to Relatives..............................................................................................................1-143Allowable Amount ........................................................................................................................1-143Dependent Care Assistance - §129 ..........................................................................................1-143Reporting......................................................................................................................................1-144Earned Income Credit - §32 [Form 1040] ............................................................................................1-144Persons with One or More Qualifying Children............................................................................1-145Persons without a Qualifying Child...............................................................................................1-145Computation .................................................................................................................................1-146Phaseout .......................................................................................................................................1-146Advance Payment of Earned Income Credit..................................................................................1-147Adoption Credit & Exclusion - §23 & §137.........................................................................................1-147Exclusion from Income for Employer Reimbursements ...............................................................1-148Child Tax Credit - §24..........................................................................................................................1-151

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Credit Amount..............................................................................................................................1-151Qualifying Child ......................................................................................................................1-151Phase out ......................................................................................................................................1-151Refundable Child Care Credit Amount .........................................................................................1-152AMT & Child Tax Credit ..............................................................................................................1-152First-Time Homebuyer Credit ..............................................................................................................1-152“Making Work Pay” Tax Credit ...........................................................................................................1-153Hope & Lifetime Learning Credits.......................................................................................................1-154“American Opportunity” Education Tax Credit ............................................................................1-155Ministers & Military - §107 .......................................................................................................................1-156Clergy ..................................................................................................................................................1-156Rental Value of a Home ................................................................................................................1-156Members of Religious Orders........................................................................................................1-157Military & Veterans.............................................................................................................................1-157viiWages ...........................................................................................................................................1-157Nontaxable Income..................................................................................................................1-158Veterans’ Benefits .........................................................................................................................1-159

CHAPTER 2 - Expenses, Deductions & Accounting ...................................2-1Landlord's Rental Expense .........................................................................................................................2-1Repairs & Improvements.....................................................................................................................2-1Repairs..........................................................................................................................................2-2Improvements...............................................................................................................................2-2Salaries & Wages.................................................................................................................................2-2Rental Payments for Property & Equipment ........................................................................................2-2Insurance Premiums .............................................................................................................................2-2Local Benefit Taxes & Service Charges...............................................................................................2-3Travel & Local Transportation Expenses .............................................................................................2-3Tax Return Preparation........................................................................................................................2-3Other Expenses ....................................................................................................................................2-3Tenant's Rental Expense............................................................................................................................2-4Rent Paid in Advance ...........................................................................................................................2-4Lease or Purchase ................................................................................................................................2-4Determining the Intent...................................................................................................................2-5Taxes on Leased Property.....................................................................................................................2-5Cash Method.................................................................................................................................2-5Accrual Method............................................................................................................................2-5Cost of Acquiring a Lease ....................................................................................................................2-6Option to Renew - 75% Rule.........................................................................................................2-7Cost of a Modification Agreement ................................................................................................2-7Commissions, Bonuses, & Fees ....................................................................................................2-8Loss on Merchandise & Fixtures...................................................................................................2-8Improved Leased Property ............................................................................................................2-8Construction Allowances Provided To Lessees - §110 ........................................................................2-8Assignment of a Lease..........................................................................................................................2-9Capitalizing Rent Expenses ..................................................................................................................2-9Health Insurance Costs of Self-Employed Persons - §162(l) [Schedule C] ...............................................2-10Requirements for Eligibility .................................................................................................................2-13Amount Deductible..............................................................................................................................2-14Percentage............................................................................................................................................2-14Hobby Loss Rules - §183 [Schedule C] .....................................................................................................2-14Allowable Deductions ..........................................................................................................................2-14Limited Deductions ..............................................................................................................................2-15Profit Motive Presumptions..................................................................................................................2-16Special Rule for Horse Breeding .............................................................................................2-16

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Other Factors .......................................................................................................................................2-16Self-Employment Taxes .............................................................................................................................2-17Home Office Deduction - §280A [Schedule C] .........................................................................................2-17Requirements.......................................................................................................................................2-17Deductible Expenses............................................................................................................................2-18Employee's Home Leased To Employer...............................................................................................2-18Residential Phone Service ....................................................................................................................2-18Allocations...........................................................................................................................................2-19Room v. Square Footage ...............................................................................................................2-19viiiLimitations...........................................................................................................................................2-19Expanded Principal Place of Business Definition ................................................................................2-20Business & Investment Credits ..................................................................................................................2-23Business Credit Carryback & Carryforward Rules - §39(a) .................................................................2-24NOL Comparison ..........................................................................................................................2-24Travel & Entertainment.............................................................................................................................2-27Travel Expenses...................................................................................................................................2-28Determining a Tax Home - Travel Expenses........................................................................................2-28Tax Home .....................................................................................................................................2-28Regular Place of Abode in a Real & Substantial Sense.................................................................2-28Two Work Locations.....................................................................................................................2-29Temporary Assignment .................................................................................................................2-29Rigid One-Year Rule ...............................................................................................................2-30Away From Home - Travel Expenses...................................................................................................2-31Sleep & Rest Rule .........................................................................................................................2-31Substantial Period ....................................................................................................................2-31Business Purpose - Travel Expense ......................................................................................................2-32Categories of Expense ...................................................................................................................2-35Travel Costs............................................................................................................................2-35Costs at Destination .................................................................................................................2-35All or Nothing.........................................................................................................................2-35Time .............................................................................................................................................2-3651/49 Rule...............................................................................................................................2-36Foreign Business Travel ................................................................................................................2-36Personal Pleasure .....................................................................................................................2-36Primarily Business ...................................................................................................................2-36Full Deduction Exception ........................................................................................................2-36Limitations - Travel Expenses ..............................................................................................................2-36Meals & Lodging..........................................................................................................................2-37Domestic Conventions & Meetings...............................................................................................2-37Foreign Conventions & Meetings..................................................................................................2-37Cruise Ship Convention.................................................................................................................2-38Eligible Expenses - Entertainment........................................................................................................2-44Test #1 - "Directly Related" ..........................................................................................................2-45Test #2 - "Associated With" ..........................................................................................................2-45Test #3 - Statutory Exceptions.......................................................................................................2-47Expense for Spouses Of Out Of Town Business Guests ...............................................................2-47Entertainment Facilities.................................................................................................................2-48Home Entertainment Expenses................................................................................................2-48Limitations - Entertainment..................................................................................................................2-48Exceptions ....................................................................................................................................2-48Ticket Purchases...........................................................................................................................2-48Charitable Sports Events Exception.........................................................................................2-48Skyboxes ......................................................................................................................................2-49One Event Rule........................................................................................................................2-49

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Related Parties .........................................................................................................................2-49Food & Beverages ...................................................................................................................2-49Substantiation ......................................................................................................................................2-53Travel Expense Substantiation ......................................................................................................2-54Entertainment & Meal Expense Substantiation.............................................................................2-54Business Gifts Expense Substantiation....................................................................................2-55ixSubstantiation Methods .................................................................................................................2-55Adequate Records....................................................................................................................2-55Sufficiently Corroborated Statements......................................................................................2-56Exceptional Circumstances......................................................................................................2-56Retention of Records ...............................................................................................................2-56Exceptions to Substantiation Requirements.............................................................................2-57Employee Expense Reimbursement & Reporting ......................................................................................2-57When an Employee Needs to File Form 2106......................................................................................2-58Employee Expense Reimbursement & Reporting ................................................................................2-58Family Support Act of 1988 ..........................................................................................................2-58Remaining Above-The-Line Deduction ........................................................................................2-59Accountable Plans ...................................................................................................................2-64Reasonable Period of Time .................................................................................................2-65Adequate Accounting ..............................................................................................................2-66Per Diem Allowance Arrangements ....................................................................................2-66Federal Per Diem Rate ....................................................................................................2-67Related Employer............................................................................................................2-70Meal Break Out ...............................................................................................................2-71Partial Days of Travel .....................................................................................................2-71Usage & Consistency ......................................................................................................2-71Unproven or Unspent Per Diem Allowances ..................................................................2-71Travel Advance ...............................................................................................................2-72Reporting Per Diem Allowances .............................................................................................2-72Reimbursement Not More Than Federal Rate.....................................................................2-72Reimbursement More Than Federal Rate............................................................................2-72Nonaccountable Plans..............................................................................................................2-74Local Transportation .................................................................................................................................2-79Assignments within Work Area............................................................................................................2-79Old Revenue Ruling 90-23 (Superseded) ......................................................................................2-79Temporary Work Site Definition.............................................................................................2-80Reserve Units..........................................................................................................................2-80Revenue Ruling 99-7.....................................................................................................................2-81Automobile Deductions.............................................................................................................................2-81Eligible Expenses ................................................................................................................................2-81Apportionment of Personal & Business Use ........................................................................................2-82Actual Cost Method.............................................................................................................................2-82Depreciation & Expensing ............................................................................................................2-82Placed in Service......................................................................................................................2-82Half-year Convention ..........................................................................................................2-83Quarterly Convention Exception.....................................................................................2-83MACRS ..................................................................................................................................2-83Double Declining Balance Method .....................................................................................2-83Depreciation "Caps" ............................................................................................................2-83Temporary Increase in Depreciation Caps ......................................................................2-84Expensing Limit ..................................................................................................................2-84Predominate Business Use Rule ....................................................................................................2-88Qualified Business Use............................................................................................................2-88More Than 50% Use Test ........................................................................................................2-88

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Limitations..............................................................................................................................2-89Recapture ................................................................................................................................2-89ITC Recapture .....................................................................................................................2-89xExcess Depreciation Recapture ...........................................................................................2-89Leasing Restrictions ......................................................................................................................2-90Standard Mileage Method.....................................................................................................................2-90Limitations....................................................................................................................................2-90Alternating Use.............................................................................................................................2-91Switching Methods........................................................................................................................2-91Charitable Transportation..............................................................................................................2-91Medical Transportation .................................................................................................................2-91Gas Guzzler Tax........................................................................................................................................2-92Automobiles ........................................................................................................................................2-92Limousines ...................................................................................................................................2-92Vehicles Not Subject To Tax.........................................................................................................2-92Fringe Benefits ..........................................................................................................................................2-97Excluded Fringe Benefits .....................................................................................................................2-97Prizes & Awards - §74 ..................................................................................................................2-97Group Life Insurance Premiums - §79 ..........................................................................................2-97Personal Injury Payments - §104...................................................................................................2-98Employer Contributions to Accident and Health Plans - §106 & §105.........................................2-98Partnerships & S Corporations - R.R. 91-26............................................................................2-98Health Insurance & FICA - Announcement 92-16 ..................................................................2-99Meals & Lodging - §119 ...............................................................................................................2-99Cafeteria Plans - §125 ...................................................................................................................2-100Educational Assistance Programs - §127 ......................................................................................2-100Dependent Care Assistance - §129................................................................................................2-101No-Additional Cost Services - §132(b) .........................................................................................2-101Qualified Employee Discounts - §132(c) ......................................................................................2-101Working Condition Fringe Benefits - §132(d) ..............................................................................2-102Transportation in Unsafe Areas ...............................................................................................2-102De Minimis Fringe Benefits - §132(e)...........................................................................................2-103Employer Provided Automobile ...........................................................................................................2-103Annual Lease Value Method .........................................................................................................2-104Cents Per Mile Method..................................................................................................................2-104Commuting Value Method ............................................................................................................2-104Methods of Accounting - §446...................................................................................................................2-106Cash Method........................................................................................................................................2-110Constructive Receipt .....................................................................................................................2-110Accrual Method ...................................................................................................................................2-110Advance Payments ........................................................................................................................2-111Accrual Method Required .............................................................................................................2-111Other Methods of Accounting ..............................................................................................................2-111Hybrid Methods............................................................................................................................2-111Long Term Contracts - §460 .........................................................................................................2-111Percentage of Completion........................................................................................................2-112Percentage of Completion - Capitalized Cost Method.............................................................2-112Look-back Rule .......................................................................................................................2-112Uniform Capitalization - §263A....................................................................................................2-112Annual Sales Limit ..................................................................................................................2-112Artist Exception......................................................................................................................2-113Classification of Property ........................................................................................................2-113Costs .......................................................................................................................................2-113Self Constructed Assets ...........................................................................................................2-114

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xiAllocation Method ...................................................................................................................2-114Manufactured Products........................................................................................................2-114Interest ....................................................................................................................................2-114Change in Accounting Method.............................................................................................................2-119Accounting Periods..............................................................................................................................2-119Definitions ....................................................................................................................................2-119Taxable Years...............................................................................................................................2-120No Books Kept ........................................................................................................................2-120New Taxpayer.........................................................................................................................2-120Partnership ...............................................................................................................................2-120S Corporations .........................................................................................................................2-121Personal Service Corporations.................................................................................................2-122C Corporations........................................................................................................................2-122Business Purpose Exception ....................................................................................................2-122Section 444 Election ................................................................................................................2-122Partnerships & S Corporations ............................................................................................2-123Personal Service Corporations.............................................................................................2-123Tiered Structures .................................................................................................................2-123Expensing - §179.......................................................................................................................................2-123Placed In Service .................................................................................................................................2-123Qualifying Property ..............................................................................................................................2-124Purchase Restrictions....................................................................................................................2-124Section 1245 Property ...................................................................................................................2-124Property Used Primarily for Lodging ......................................................................................2-125Deduction Limit...................................................................................................................................2-126Maximum Dollar Limit .................................................................................................................2-126Investment Limit ...........................................................................................................................2-126Taxable Income Limit ...................................................................................................................2-126Carryover of Unallowable Deduction............................................................................................2-127Married Taxpayers Filing Separate Returns ..................................................................................2-127Passenger Automobiles .................................................................................................................2-127Partnerships ..................................................................................................................................2-128S Corporations..............................................................................................................................2-128Cost...............................................................................................................................................2-128Election................................................................................................................................................2-128Records.........................................................................................................................................2-129Revocation of Election ..................................................................................................................2-129Figuring the Deduction........................................................................................................................2-129Recapture of §179 Deductions..............................................................................................................2-130Dispositions ..................................................................................................................................2-130Installment Sales...........................................................................................................................2-130Depreciation & Cost Recovery - §167 & §168 ..........................................................................................2-130Personal Property.................................................................................................................................2-130ACRS - §168 ................................................................................................................................2-130Applicable Percentage .............................................................................................................2-131Straight-line Election ...............................................................................................................2-131MACRS........................................................................................................................................2-131Temporary Bonus Depreciation...............................................................................................2-132Qualifying Property.............................................................................................................2-133Coordination with §179.......................................................................................................2-133Elections .................................................................................................................................2-133xiiMACRS Conventions ..............................................................................................................2-134Mid-quarter Convention Exception .....................................................................................2-134

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Recapture - §1245 .........................................................................................................................2-13450% Bonus Depreciation ......................................................................................................................2-134Tables: ..........................................................................................................................................2-137Real Property.......................................................................................................................................2-142ACRS ...........................................................................................................................................2-142MACRS........................................................................................................................................2-149Leasehold Improvements.........................................................................................................2-149Qualified Leasehold Improvement Property........................................................................2-149Qualified Retail Improvement Property ..............................................................................2-150Restaurant Improvements - §168.............................................................................................2-151Recapture - §1250 & §1245..................................................................................................................2-156Section 1245.................................................................................................................................2-156Full Recapture.........................................................................................................................2-156Section 1250.................................................................................................................................2-156Partial Recapture......................................................................................................................2-156MACRS Recapture Exception for Real Property ..........................................................................2-156Alternative Depreciation System - §168(g) ..........................................................................................2-156Mandatory Application..................................................................................................................2-156Method .........................................................................................................................................2-157Amortization..............................................................................................................................................2-157Costs Eligible for Amortization............................................................................................................2-157Trademarks & Trade Names - §167(r) ..........................................................................................2-157Methods & Periods for Amortization ...................................................................................................2-157Partnership & Corporate Organization Costs - §709 & §248........................................................2-158Business Start-Up Costs - §195.....................................................................................................2-158Depletion - §613............................................................................................................................2-158Other Assets .................................................................................................................................2-158

CHAPTER 3 - Property Transfers & Retirement Plans .............................3-1Sales & Exchanges of Property ..................................................................................................................3-1Sale or Lease........................................................................................................................................3-1Easements ............................................................................................................................................3-1Capital Gains & Losses ........................................................................................................................3-2Capital Assets - §1221...................................................................................................................3-2Capital Gain Rates.........................................................................................................................3-3Holding Periods - (§1222 & §1223) ..............................................................................................3-3Capital Losses - §1211 ..................................................................................................................3-4Business Property ..........................................................................................................................3-4Basis of Property ...........................................................................................................................3-5Basis Adjustments ...................................................................................................................3-5Property Received as a Gift .....................................................................................................3-5Property Received by Inheritance............................................................................................3-6Changes in Property Usage......................................................................................................3-6Stocks & Bonds .......................................................................................................................3-6Sale of Personal Residence - §121........................................................................................................3-8Two-Year Ownership & Use Requirements..................................................................................3-11Tacking of Prior Holding Period..............................................................................................3-12Prorata Exception.....................................................................................................................3-12xiiiLimitations on Exclusion...............................................................................................................3-12Reduced Home Sale Exclusion................................................................................................3-13Surviving Spouse Home Sale Exclusion .......................................................................................3-13Installment Sales - §453 .......................................................................................................................3-14General Rules ...............................................................................................................................3-14Dealer Sales..................................................................................................................................3-14Unstated Interest...........................................................................................................................3-14

12

Related Parties - §453(e) ...............................................................................................................3-15Disposition of Installment Notes - §453B .....................................................................................3-17Determining Installment Income ...................................................................................................3-17Pledge Rule...................................................................................................................................3-19Escrow Account ............................................................................................................................3-19Depreciation Recapture .................................................................................................................3-19Like Kind Exchange ......................................................................................................................3-19Repossessions - §1038..........................................................................................................................3-23Personal Property ..........................................................................................................................3-24Non- Installment Method Sales ...............................................................................................3-24Basis of Installment Obligation ...........................................................................................3-24Gain or Loss on Repossession.............................................................................................3-25Installment Method Sales.........................................................................................................3-25Basis of Installment Obligation ...........................................................................................3-25Gain or Loss on Repossession.............................................................................................3-25Basis of Repossessed Personal Property..................................................................................3-26Bad Debt.................................................................................................................................3-27Real Property................................................................................................................................3-27Conditions...............................................................................................................................3-27Figuring Gain on Repossession .....................................................................................................3-28Limit on Taxable Gain.............................................................................................................3-28Repossession Costs..............................................................................................................3-28Indefinite Selling Price....................................................................................................3-30Character of Gain ................................................................................................................3-30Basis of Repossessed Real Property ........................................................................................3-30Holding Period for Resales ......................................................................................................3-31Bad Debt.................................................................................................................................3-32Seller’s Former Home Exception ..................................................................................................3-32Involuntary Conversions - §1033 .........................................................................................................3-35Condemnations.............................................................................................................................3-40Threat of Condemnation ..........................................................................................................3-40Reports of Condemnation....................................................................................................3-41Property Voluntarily Sold........................................................................................................3-41Easements ...............................................................................................................................3-41Condemnation Award..............................................................................................................3-42Amounts Withheld From Award .........................................................................................3-42Net Condemnation Award...................................................................................................3-42Interest on Award ................................................................................................................3-42Payments to Relocate ..........................................................................................................3-43Severance Damages .................................................................................................................3-43Treatment of Severance Damages .......................................................................................3-44Expenses of Obtaining an Award ............................................................................................3-44Special Assessment Withheld from Award .............................................................................3-44Severance Damages Included in Award ..................................................................................3-45xivGain or Loss from Condemnations................................................................................................3-46How to Figure Gain or Loss ....................................................................................................3-46Part Business or Part Rental ................................................................................................3-46Postponement of Gain ...................................................................................................................3-46Choosing to Postpone Gain......................................................................................................3-46Cost Test .................................................................................................................................3-47Replacement Period .................................................................................................................3-47Condemnation .....................................................................................................................3-47Replacement Property Acquired Before the Condemnation................................................3-47Extension............................................................................................................................3-47

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Time for assessing a deficiency...........................................................................................3-48At Risk Limits for Real Estate..............................................................................................................3-49Amount At Risk............................................................................................................................3-54Qualified Nonrecourse Financing ............................................................................................3-54Section 1031 Like Kind Exchanges......................................................................................................3-55Statutory Requirements & Definitions ..........................................................................................3-55Qualified Transaction - Exchanges v. Sales.............................................................................3-55Held for Productive Use or investment....................................................................................3-55Investment Purpose .............................................................................................................3-56Statutory Exclusions from §1031 ........................................................................................3-56Like Kind Property ..................................................................................................................3-56Nature or Quality of Property..............................................................................................3-56Real v. Personal Property ....................................................................................................3-57The Concept of “Boot”..................................................................................................................3-60Realized Gain...........................................................................................................................3-60Recognized Gain......................................................................................................................3-61Limitation on Recognition of Gain under §1031 .....................................................................3-61The Definition of “Boot” .........................................................................................................3-61The Rules of “Boot” ......................................................................................................................3-61Property Boot...........................................................................................................................3-61Mortgage Boot.........................................................................................................................3-61Netting “Boot” - The Rules of Offset ......................................................................................3-62Property Boot Given Offsets Any Boot Received ...............................................................3-62Mortgage Boot Given Offsets Mortgage Boot Received.....................................................3-62Mortgage Boot Given Does Not Offset Property Boot Received........................................3-62Revenue Ruling 72-456 & Commissions ............................................................................3-62Gain or Loss on Boot...............................................................................................................3-63Basis on Tax-Deferred Exchange ..................................................................................................3-63Allocation of Basis ..................................................................................................................3-63Installment Reporting of Boot .................................................................................................3-63Exchanges Between Related Parties ........................................................................................3-64Reporting an Exchange............................................................................................................3-64Types of Exchanges......................................................................................................................3-64Two-Party Exchanges ..............................................................................................................3-64Three-Party “Alderson” Exchange ..........................................................................................3-65Three-Party “Baird Publishing” Exchange ..............................................................................3-66Delayed Exchanges..................................................................................................................3-6745-Day Rule ........................................................................................................................3-67Method of Identification..................................................................................................3-67180-Day Rule ......................................................................................................................3-67Final Regulations for Delayed (Deferred) Exchanges ...................................................................3-70xvDeferred (Delayed) Exchange Definition ................................................................................3-72Identification Requirements.....................................................................................................3-72Identification & Exchange Periods......................................................................................3-72Method of Identification......................................................................................................3-72Property Description .......................................................................................................3-73Revocation..........................................................................................................................3-73Substantial Receipt ..............................................................................................................3-73Multiple Replacement Properties ........................................................................................3-73Actual & Constructive Receipt Rule........................................................................................3-74Four Safe Harbors ...............................................................................................................3-74Safe Harbor #1 - Security................................................................................................3-74Safe Harbor #2 - Escrow Accounts & Trusts ..................................................................3-74Safe Harbor #3 - Qualified Intermediary ........................................................................3-75

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Safe Harbor #4 - Interest .................................................................................................3-76Exchanges of Partnership Interests ..........................................................................................3-76Retirement Plans .......................................................................................................................................3-77Qualified Deferred Compensation........................................................................................................3-80Qualified v. Nonqualified Plans ....................................................................................................3-80Major Benefit ...............................................................................................................................3-82Current Deduction ...................................................................................................................3-82Timing of Deductions ..............................................................................................................3-82Part of Total Compensation .....................................................................................................3-82Compensation Base .......................................................................................................................3-82Salary Reduction Amounts ......................................................................................................3-83Benefit Planning ............................................................................................................................3-83Pension Protection Act of 2006.....................................................................................................3-84Corporate Plans .............................................................................................................................3-85Advantages ..............................................................................................................................3-85Current................................................................................................................................3-85Deferred..............................................................................................................................3-85Disadvantages ..........................................................................................................................3-85Employee Costs...................................................................................................................3-85Comparison with IRAs & Keoghs.......................................................................................3-85Basic ERISA Provisions................................................................................................................3-86ERISA Reporting Requirements..............................................................................................3-86Fiduciary Responsibilities........................................................................................................3-87Bonding Requirement..........................................................................................................3-87Prohibited Transactions ...........................................................................................................3-87Additional Restrictions........................................................................................................3-88Fiduciary Exceptions ...........................................................................................................3-88Loans ..................................................................................................................................3-88Employer Securities.................................................................................................................3-89Excise Penalty Tax ..................................................................................................................3-89PBGC Insurance ......................................................................................................................3-90Sixty-Month Requirement ...................................................................................................3-90Recovery Against Employer................................................................................................3-90Termination Proceedings .........................................................................................................3-90Plans Exempt from PBGC Coverage.......................................................................................3-90Basic Requirements of a Qualified Pension Plan .................................................................................3-95Written Plan..................................................................................................................................3-96Communication.......................................................................................................................3-96xviTrust .............................................................................................................................................3-96Requirements ...........................................................................................................................3-96Permanency ..................................................................................................................................3-97Exclusive Benefit of Employees....................................................................................................3-97Highly Compensated Employees.............................................................................................3-97Reversion of Trust Assets to Employer ...................................................................................3-97Participation & Coverage ..............................................................................................................3-98Age & Service.........................................................................................................................3-98Coverage.................................................................................................................................3-99Percentage Test....................................................................................................................3-99Ratio Test ............................................................................................................................3-99Average Benefits Test .........................................................................................................3-99Numerical Coverage............................................................................................................3-100Related Employers...............................................................................................................3-100Vesting .........................................................................................................................................3-101Full & Immediate Vesting .......................................................................................................3-101

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Minimum Vesting....................................................................................................................3-101Diversification Rights ..............................................................................................................3-103Nondiscrimination Compliance ...............................................................................................3-103Contribution & Benefit Limits ......................................................................................................3-103Defined Benefit Plans (Annual Benefits Limitation) - §415....................................................3-103Defined Contribution Plans (Annual Addition Limitation) - §415..........................................3-104Limits on Deductible Contributions - §404 .............................................................................3-104Assignment & Alienation ..............................................................................................................3-105Miscellaneous Requirements.........................................................................................................3-106Basic Types of Corporate Plans............................................................................................................3-106Defined Benefit .............................................................................................................................3-106Mechanics...............................................................................................................................3-106Defined Benefit Pension ..........................................................................................................3-107Defined Contribution....................................................................................................................3-107Mechanics...............................................................................................................................3-107Discretion................................................................................................................................3-107Favorable Circumstances.........................................................................................................3-108Types of Defined Contribution Plans ............................................................................................3-112Profit Sharing..........................................................................................................................3-112Requirements for a Qualified Profit Sharing Plan ...............................................................3-112Written Plan ....................................................................................................................3-113Eligibility ........................................................................................................................3-113Deductible Contribution Limit ........................................................................................3-113Substantial & Recurrent Rule..........................................................................................3-113Money Purchase Pension.........................................................................................................3-114Cafeteria Compensation Plan...................................................................................................3-115Thrift Plan...............................................................................................................................3-116Section 401(k) Plans ................................................................................................................3-116Death Benefits ...............................................................................................................................3-117Defined Benefit Plans ..............................................................................................................3-118Money Purchase Pension & Target Benefit Plans ...................................................................3-118Employee Contributions................................................................................................................3-118Non-Deductible.......................................................................................................................3-118Life Insurance in the Qualified Plan..............................................................................................3-119Return .....................................................................................................................................3-119xviiUniversal Life ..........................................................................................................................3-119Compare..................................................................................................................................3-119Plan Terminations & Corporate Liquidations................................................................................3-11910-Year Rule...........................................................................................................................3-120Lump-Sum Distributions .........................................................................................................3-120Asset Dispositions ...................................................................................................................3-120IRA Limitations .......................................................................................................................3-121Self-Employed Plans - Keogh ..............................................................................................................3-124Contribution Timing......................................................................................................................3-124Controlled Business.......................................................................................................................3-124General Limitations .................................................................................................................3-125Effect of Incorporation ..................................................................................................................3-125Mechanics...............................................................................................................................3-126Parity with Corporate Plans.................................................................................................3-126Figuring Retirement Plan Deductions For Self-Employed..................................................3-127Self-Employed Rate ........................................................................................................3-127Determining the Deduction...................................................................................................................3-128Individual Plans - IRA’s .......................................................................................................................3-129Deemed IRA.................................................................................................................................3-129

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Mechanics.....................................................................................................................................3-129Phase-out ................................................................................................................................3-129Special Spousal Participation Rule - §219(g)(1)......................................................................3-130Spousal IRA............................................................................................................................3-131Eligibility......................................................................................................................................3-131Contributions & Deductions..........................................................................................................3-132Employer Contributions...........................................................................................................3-132Retirement Vehicles ......................................................................................................................3-132Distribution & Settlement Options ................................................................................................3-133Life Annuity Exemption ..........................................................................................................3-133Minimum Distributions............................................................................................................3-133Required Minimum Distribution – Subject to 2009 Waiver................................................3-1342009 Waiver of Required Minimum Distribution Rules .................................................3-134Definitions......................................................................................................................3-135Distributions during Owner’s Lifetime & Year of Death after RBD..............................3-135Sole Beneficiary Spouse Who Is More Than 10 Years Younger ....................................3-137Distributions after Owner’s Death ..................................................................................3-137Inherited IRAs .........................................................................................................................3-139Estate Tax Deduction ..........................................................................................................3-140Charitable Distributions from an IRA .................................................................................3-140Post-Retirement Tax Treatment of IRA Distributions...................................................................3-141Income In Respect of a Decedent ............................................................................................3-141Estate Tax Consequences.........................................................................................................3-141Losses on IRA Investments .....................................................................................................3-141Prohibited Transactions .................................................................................................................3-142Effect of Disqualification.........................................................................................................3-142Penalties..................................................................................................................................3-142Borrowing on an Annuity Contract ...............................................................................................3-143Tax-Free Rollovers.......................................................................................................................3-146Rollover from One IRA to Another .........................................................................................3-147Waiting Period between Rollovers ......................................................................................3-147Partial Rollovers ..................................................................................................................3-147xviiiRollovers from Traditional IRAs into Qualified Plans ............................................................3-147Rollovers of Distributions from Employer Plans.....................................................................3-147Withholding Requirement ...................................................................................................3-147Waiting Period between Rollovers ......................................................................................3-148Conduit IRAs.......................................................................................................................3-148Keogh Rollovers..................................................................................................................3-148Direct Rollovers From Retirement Plans to Roth IRAs.......................................................3-148Rollovers of §457 Plans into Traditional IRAs........................................................................3-149Rollovers of Traditional IRAs into §457 Plans........................................................................3-149Rollovers of Traditional IRAs into §403(B) Plans ..................................................................3-149Rollovers from SIMPLE IRAs ................................................................................................3-150Nonspouse Rollovers ...............................................................................................................3-150Roth IRA - §408A.........................................................................................................................3-151Eligibility ................................................................................................................................3-152Contribution Limitation ...........................................................................................................3-152Roth IRAs Only...................................................................................................................3-152Roth IRAs & Traditional IRAs............................................................................................3-152Conversions .............................................................................................................................3-153AGI Limit Exception...........................................................................................................3-154Recharacterizations.................................................................................................................3-155Reconversions.........................................................................................................................3-155Taxation of Distributions .........................................................................................................3-155

17

No Required Minimum Distributions..................................................................................3-156Simplified Employee Pension Plans (SEPs) .........................................................................................3-156Contribution Limits & Taxation ..............................................................................................3-158SIMPLE Plans .....................................................................................................................................3-159SIMPLE IRA Plan.........................................................................................................................3-159Employee Limit .......................................................................................................................3-159Other Qualified Plan ................................................................................................................3-160Set up ......................................................................................................................................3-160Contribution Limits .................................................................................................................3-160Salary Reduction Contributions...........................................................................................3-160Employer Matching Contributions ......................................................................................3-161Deduction of Contributions .....................................................................................................3-161Distributions ............................................................................................................................3-161SIMPLE §401(k) Plan ...................................................................................................................3-161

CHAPTER 4 - Losses, AMT & Compliance .................................................4-1Passive Losses ...........................................................................................................................................4-1Prior Law.............................................................................................................................................4-1Passive Loss Rules...............................................................................................................................4-3Application ...................................................................................................................................4-3Active Losses ...............................................................................................................................4-4Credits ..........................................................................................................................................4-4Calculating Passive Loss ......................................................................................................................4-4Categories of Income & Loss ...............................................................................................................4-4Passive..........................................................................................................................................4-4Portfolio........................................................................................................................................4-5Material Participation ....................................................................................................................4-6Self-Charged Interest Regulations.................................................................................................4-6xixPassive Deduction - Portfolio Income .....................................................................................4-6Regulations ..............................................................................................................................4-6Suspension of Disallowed Losses.........................................................................................................4-12Fully Taxable Disposition .............................................................................................................4-12Abandonment & Worthlessness...............................................................................................4-12Related Party Transactions ......................................................................................................4-13Credits.....................................................................................................................................4-13Disallowance .......................................................................................................................4-13Increase Basis Election........................................................................................................4-13Entire Interest ...............................................................................................................................4-14Partnership ...............................................................................................................................4-14Grantor Trust ...........................................................................................................................4-14Other Transfers.............................................................................................................................4-14Transfer By Reason Of Death - §469(g)(2) .............................................................................4-14Transfer By Gift - §469(j)(6) ...................................................................................................4-14Installment Sale - §469(g)(3)...................................................................................................4-15Activity No Longer Treated As Passive Activity - §469(f)(1).................................................4-15Closely Held To Nonclosely Held Corporation- §469(f)(2) ....................................................4-16Nontaxable Transfer ................................................................................................................4-16Ordering of Losses ........................................................................................................................4-17Capital Loss Limitation ...........................................................................................................4-18Carryforwards...............................................................................................................................4-18Allocation of Suspended Losses....................................................................................................4-18Taxpayers Affected..............................................................................................................................4-18Noncorporate Taxpayers ...............................................................................................................4-19Regular Corporations....................................................................................................................4-19Personal Service Corporations.......................................................................................................4-19

18

Definition................................................................................................................................4-19Real Estate Professionals...............................................................................................................4-19Activities..............................................................................................................................................4-20Facts & Circumstances Test ..........................................................................................................4-20Relevant Factors ......................................................................................................................4-20Rental Activities ......................................................................................................................4-21Limited Partnership Activities .................................................................................................4-22Partnership & S Corporation Activities ...................................................................................4-22Consistency ..................................................................................................................................4-22Regrouping ...................................................................................................................................4-23Partial Dispositions.......................................................................................................................4-23Alternative Minimum Tax..........................................................................................................................4-28Computation ........................................................................................................................................4-28Exemption Amount - §55(d)..........................................................................................................4-29AMT Exemption Phaseout.......................................................................................................4-30Regular Tax Deduction - §55(c)....................................................................................................4-30Tax Preferences & Adjustments ....................................................................................................4-30Preferences & Adjustments for All Taxpayers ........................................................................4-30Preferences & Adjustments for Noncorporate Taxpayers Only...............................................4-31Preferences & Adjustments for Corporations Only.......................................................................4-31Adjustments - §56 .........................................................................................................................4-31Itemized Deductions ................................................................................................................4-31Standard Deduction .............................................................................................................4-32Medical Expenses................................................................................................................4-32xxTaxes ..................................................................................................................................4-32Interest................................................................................................................................4-32Personal Exemptions ...............................................................................................................4-33Depreciation............................................................................................................................4-33Alternative Depreciation System (ADS) .............................................................................4-33ADS Recovery Periods........................................................................................................4-33Asset Placed in Service After 1998 .....................................................................................4-34Mining Exploration and Development Costs...........................................................................4-35Basis ...................................................................................................................................4-35Election...............................................................................................................................4-35Long-Term Contracts...............................................................................................................4-36Home Construction Contracts .............................................................................................4-36Pollution Control Facilities......................................................................................................4-36Installment Sales......................................................................................................................4-36Circulation Expenditures .........................................................................................................4-37Incentive Stock Options...........................................................................................................4-37Credit for Prior Year Minimum Tax & ISOs.......................................................................4-37Research and Experimental Expenditures................................................................................4-38Passive Farm Losses ................................................................................................................4-38Definition ............................................................................................................................4-38Loss Disallowance...............................................................................................................4-38Allocation ............................................................................................................................4-39Same Activity Suspension...................................................................................................4-39Passive Activity Losses ...........................................................................................................4-39Business Untaxed Reported Profits (Pre-1990) .......................................................................4-41ACE Adjustment (Post-1989)..................................................................................................4-41Adjusted Current Earnings Regulations...................................................................................4-43Tax Preferences - §57....................................................................................................................4-44Depletion ................................................................................................................................4-44Intangible Drilling Costs..........................................................................................................4-45

19

Excess Drilling Costs ..........................................................................................................4-45Accelerated Depreciation.........................................................................................................4-45Real Property.......................................................................................................................4-45Personal Property ................................................................................................................4-46Private Activity Bond Interest .................................................................................................4-46Alternative Tax NOL Deduction ...................................................................................................4-46Carrybacks & Carryovers ........................................................................................................4-46Alternative Minimum Foreign Tax Credit.....................................................................................4-47Foreign Tax Credit Carryback or Carryover............................................................................4-47Tentative Minimum Tax................................................................................................................4-47Minimum Tax Credit ............................................................................................................................4-47Regular Income Tax Reduced .......................................................................................................4-48Carryforward of Credit ..................................................................................................................4-48Other Credits ................................................................................................................................4-48Compliance ...............................................................................................................................................4-55Reporting Requirements .......................................................................................................................4-55Real Estate Transactions [Form - 1099S]......................................................................................4-55Independent Contractors................................................................................................................4-57Cash Reporting [Form 8300].........................................................................................................4-58Exceptions ...............................................................................................................................4-60Recipient’s Knowledge............................................................................................................4-60xxiCash Reporting Rules - Attorneys ...........................................................................................4-60Sale of Certain Partnership Interests (Form 8308) ........................................................................4-61Tax Shelter Registration Number [Form 8271].............................................................................4-61Asset Acquisition Statement [Form 8594] ....................................................................................4-61Accuracy-Related Penalties.......................................................................................................................4-66Negligence...........................................................................................................................................4-67Substantial Understatement of Income Tax...................................................................................4-67Penalty on Carryover Year Return...........................................................................................4-68Substantial Valuation Overstatements...........................................................................................4-68Substantial Estate & Gift Tax Valuation Understatements............................................................4-69Final Regulations.................................................................................................................................4-69Negligence or Disregard of Rules .................................................................................................4-69Substantial Understatement Penalty ..............................................................................................4-70Adequate Disclosure.....................................................................................................................4-70Information Reporting Penalty Final Regulations......................................................................................4-71Penalty for Unrealistic Position..................................................................................................................4-73Realistic Possibility Standard ...............................................................................................................4-74Adequate Disclosure............................................................................................................................4-75Form 8275-R .......................................................................................................................................4-75Statute of Limitations for Assessments ......................................................................................................4-76Three Year Assessment Periods ...........................................................................................................4-76Six Year Assessment Period.................................................................................................................4-76No Statute Of Limitations....................................................................................................................4-76Extension of Statute Of Limitations .....................................................................................................4-76Examination of Returns.............................................................................................................................4-76How Returns Are Selected....................................................................................................................4-77Arranging the Examination...................................................................................................................4-77Transfers.......................................................................................................................................4-77Representation ...............................................................................................................................4-77Recordings....................................................................................................................................4-77Repeat Examinations ............................................................................................................................4-78Changes to Return ...............................................................................................................................4-78Appealing Examination Findings .........................................................................................................4-78

20

Appeals Office..............................................................................................................................4-78Appeals to the Courts ....................................................................................................................4-79Court Decisions .......................................................................................................................4-79Recovering Litigation Expenses ..............................................................................................4-79Other Remedies ...................................................................................................................................4-79Claims for Refund .........................................................................................................................4-79Cancellation of Penalties ...............................................................................................................4-80Reduction of Interest .....................................................................................................................4-80

Learning ObjectivesAfter reading the next chapter, participants will be able to:xxii1. Name federal revenue tax sources discussing the definitive role ofgross income, estimate a client’s tax liability using current rates, tables,and statutory amounts, and determine a client’s responsibility for withholdingand/or estimated taxes.2. Compare and contrast the various filing statuses pointing out advantagesand disadvantages and naming the filing requirements of each.3. Define gross income under §61 including the tax treatment of compensation,fringe benefits, rental income, Social Security benefits, alimony,prizes and awards, describe dividend and distribution types includingtheir tax differences, and explain how debt discharge can resultin taxable income.4. Discuss the mechanics of income exclusions including educationrelatedexclusions, gift and inheritance exclusions, insurance, personalinjury awards, interest state and local obligations, and the foreignearned income exclusion.5. Categorize income tax deductions and use such deductions to reducetax liability by:a. Identifying personal, spousal and dependency exemptions andreporting requirements including pre-2005 dependency rules;b. Determining the deductibility of five §163 interest categories,§162 educational expenses, §217 moving expenses, §165 casualty &theft losses, and §164 taxes along with their proper reporting andsubstantiation;c. Discussing four variables that impact the deductibility of charitablecontributions, and identifying qualified organizations, permissiblecontributions contribution limitations, their tax treatment,and substantiation requirements;d. Explaining the deductibility of medical care expenses includingmedical insurance, meals and lodging, transportation, home improvementsand lifetime care payments including the impact ofMedicare;e. Naming at least twelve deductions that are subject to the 2% ofAGI limitation, up to six deductions not subject to the 2% limit,and eleven nondeductible expenses.

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6. Compare several types of tax credits identifying the eligibility requirementsand applying the cited changes created by the AmericanRecovery and Reinvestment Act of 2009 to individual tax returns.After studying the materials in this chapter, answer the exam questions 1to 49.1-1

CHAPTER 1Individual Tax ElementsFederal Income Taxes: A DescriptionThe sources of federal tax revenue are individual income taxes; Social Securityand other payroll taxes; corporate income taxes; excise taxes; and estate and gifttaxes.Note: The individual income tax is the major source of federal revenues, followedclosely by Social Security and other payroll taxes. As a revenue source,the corporate income tax is a distant third. Estate and gift and excise taxesplay only minor roles as revenue sources.There are four main filing categories under the individual income tax: marriedfiling jointly, married filing separately, head of household and single individual.The individual income tax base is composed of wages, salaries, tips, taxable interestand dividend income, business and farm income, realized net capital gains,income from rents, royalties, trusts, estates, partnerships, taxable pension andannuity income, and alimony received.Note: Wage income of employees is taxed, although most contributions toemployee pension and health insurance plans and certain other employeebenefits are not included in wages subject to income tax. Employer contributionsto Social Security are also excluded from wages. When pensions are received,they are included in income to the extent that they represent contributionsoriginally excluded. If the taxpayer has the same tax rate when contributionsare made and when pensions are received, this treatment isequivalent to eliminating tax on the earnings of pension plans. Some SocialSecurity benefits are also subject to tax.1-2The tax base is reduced by adjustments to income, including contributions toKeogh and traditional IRAs, some interest paid on student loans, and alimonypayments made by the taxpayer. This step of the process produces adjusted grossincome (AGI), which is the basic measure of income under the federal income

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tax.The tax base is further reduced by certain deductions. Taxpayers can take astandard deduction or they may itemize their deductions. The elderly and blindare allowed an additional standard deduction. Itemized deductions are allowedfor home mortgage interest payments, state and local income taxes, state and localproperty taxes, charitable contributions, medical expenses in excess of 7.5%of AGI, and a few other items.The tax base is reduced further by subtracting personal and dependent exemptions.Personal exemptions are allowed for the taxpayer, his or her spouse, andeach dependent. For taxpayers with high levels of AGI, the personal and dependentexemptions are phased out.Taxable income equals AGI reduced by either the standard deductions or itemizeddeductions and personal and dependent exemptions. Taxable income is thebase on which federal income tax is assessed.The individual income tax has six marginal income tax rates: 10%, 15%, 25%,28%, 33%, and 35%. These marginal income tax rates are applied against taxableincome to arrive at a taxpayer’s gross income tax liability.Note: Long-term capital gains - that is, gain on the sale of assets held morethan 12 months - and qualified dividend income are taxed at lower tax rates.Tax credits are subtracted from gross tax liability to arrive at a final tax liability.The major tax credits include the earned income tax credit, the child tax credit,the education tax credit, the tax credit for the elderly and the disabled, and thecredit for child and dependent care expenses.Note: Tax credits offset tax liability on a dollar-for-dollar basis and have becomean increasingly popular method of providing tax relief and social benefitsin general. If a tax credit is refundable and it exceeds tax liability, a taxpayerreceives a payment from the government. If credits are not refundable,then they provide no benefit to many lower income individuals who have notax liability. The earned income credit is refundable, and the child tax creditis refundable for all but very low income families. Many credits are phasedout as income rises and thus do not benefit higher income individuals; thesephase-out points vary considerably.1-3

Rates, Tables, & Statutory AmountsUnder §1(f), tax rate schedules, exception amounts, and the standard deduction

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are to be adjusted on a straight-line percentage by the increase in the ConsumerPrice Index for All Urban Consumers (CPI-U).Note: Currently, a great site on the Internet to get updates on these amountsis http://www.smbiz.com/sbwref.html .The tax rate schedules for 2009 are:Filing Status Taxable Income RateSingle $1 to $8,350 10%$8,350 to $33,950 15%$33,950 to $82,250 25%$82,250 to $171,550 28%$171,550 to $372,950 33%Over $372,950 35%Head of Household $1 to $11,950 10%$11,950 to $45,500 15%$45,500 to $117,450 25%$117,450 to $190,200 28%$190,200 to $372,950 33%Over $372,950 35%Married, Joint $1 to $16,700 10%$16,700 to $67,900 15%$67,900 to $137,050 25%$137,050 to $208,850 28%$208,850 to $372,950 33%Over $372,950 35%Married, Separate $1 to$8,350 10%$8,350 to $33,950 15%$33,950 to $68,525 25%$68,525 to $104,425 27%$104,425 to $86,475 33%Over $86,000 475 35%The tax rate schedules for 2008 were:Filing Status Taxable Income RateSingle $1 to $8,025 10%$8,025 to $32,550 15%$32,550 to $78,850 25%$78,850 to $164,550 28%1-4$164,550 to $357,700 33%Over $357,700 35%Head of Household $1 to $11,450 10%$11,450 to $43,650 15%$43,650 to $112,650 25%$112,650 to $182,400 28%$182,400 to $357,700 33%Over $357,700 35%Married, Joint $1 to $16,050 10%

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$16,050 to $65,100 15%$65,100 to $131,450 25%$131,450 to $200,300 28%$200,300 to $357,700 33%Over $357,700 35%Married, Separate $1 to$8,025 10%$8,025 to $32,550 15%$32,550 to $65,725 25%$65,725 to $100,150 27%$100,150 to $178,850 33%Over $178,850 35%Standard DeductionThe standard deductions for 2008 and 2009 are:Filing Status 2009 2008Married Filing Separately $5,700 $5,450Single $5,700 $5,450Head of Household $8,350 $8,000Married Filing Jointly $11,400 $10,900Surviving Spouse $11,400 $10,900The additional standard deduction for the elderly and blind is increased as followsfor 2009:(1) Unmarried taxpayer: an additional $1,400 – up $100 from 2008 ($2,800for a taxpayer who is both elderly and blind); and(2) Married taxpayer: an additional $1,100 – up $50 from 2008 ($2,200 for ataxpayer who is both elderly and blind) (§63(f)).Real estate taxes. For 2008, taxpayers can claim an additional standard deduction,based on the state or local real-estate taxes paid in 2008. Taxes paid on foreignor business property do not count. The maximum deduction is $500 or$1,000 for joint filers.1-5Disaster losses. For 2008, a taxpayer can increase his standard deduction by thenet disaster losses suffered from a federally declared disaster.Dependent LimitIn 2009, if an individual may be claimed as a dependent on another taxpayer’sreturn then the standard deduction is limited to the lesser of:(1) The dependent’s earned income up to the basic standard deduction($5,700 in 2009), or(2) The greater of:(a) $950 (up from $900 in 2008), or(b) The dependent’s earned income plus $300 (no change from 2008)

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(§63(c)(5)).For 2009, if a child under age 19 (24 if a fulltime student) has net investmentincome exceeding $1,900 (i.e., double the basic standard deduction for dependents),the excess is subject to income tax at the parent’s highest marginalrate.Kiddie TaxThe rules regarding the age of a child whose investment income may betaxed at the parent's tax rate changed for 2008. These rules continue toapply to a child under age 18 at the end of the year but, beginning in 2008,also apply in certain cases to a child who either was:(1) age 18 at the end of 2008 and did not have earned income that wasmore than half of the child's support, or(2) a full-time student over age 18 and under age 24 at the end of 2008and did not have earned income that was more than half of the child'ssupport.A student is a child who during any part of 5 calendar months of the yearwas enrolled as a full-time student at a school, or took a full-time, onfarmtraining course given by a school or a state, county, or local governmentagency. A school includes a technical, trade, or mechanical school.It does not include an on-the-job training course, correspondence school,or school offering courses only through the Internet.Note: Previously, the tax only applied to children under age 18. Form 8615 isused to figure this tax.Election to Report on Parent’s ReturnIf a child’s gross income is less than a certain amount and consists only ofdividends and interest, the parent can elect to report the amount on theirreturn. For 2009, the interest and dividend income must be more than$950 and less than $9,500.1-6Remember that this income must consist solely of interest, dividends,capital gains distributions coming strictly from mutual funds (i.e., notstocks or other capital assets disposed of by the child directly) and Alaskandividends. Furthermore, no estimated taxes must have been paid onthis income in the SSN of the child. Finally, if the child has any earned income,this election is not available (i.e., then, the child's income wouldnot have consisted "solely" of the unearned income sources listed above;keep in mind that the assignment of income doctrine would prevent anyearned income from ever being taxed to another taxpayer except the personwho had actually performed the services justifying the payment of it).Note: Given how easy it normally is to produce a child's return using the taxprep software that we have today, it really doesn't make sense from a taxplanning standpoint to make this election thereby increasing a parent's AGIby up to $9,000 for each child for whom the election is made. Approximately20 different items on the parent's tax return can be impacted by a higherAGI number and this should be kept in mind when considering the election.

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AMT ExemptionFor taxable years beginning in 2009, for a child to whom the "kiddie tax"applies, the exemption amount under §§ 55 and 59(j) for purposes of thealternative minimum tax under § 55 may not exceed the sum of:(1) the child's earned income for the taxable year, plus(2) $6,700.Phaseout of Exemptions - 2% HaircutFor 2009, the personal exemption is $3,650 (up from $3,500 for 2008). However,phaseout of personal exemption for 2009 begins at:Married Filing Jointly $250,200 (up from $239,950 in 2008)Surviving Spouse $250,200 (up from $239,950 in 2008)Head of Household $208,500 (up from $199,950 in 2008)Single $166,800 (up from $159,950 in 2008)Married Filing Separately $125,100 (up from $119,975 in 2008)All exemption amounts claimed on a return are reduced by 2% (4% if marriedfiling separately) for each $2,500 (or fraction thereof) of AGI in excess of theabove threshold amount. As a result, exemption deductions are completelyeliminated when AGI exceeds the AGI threshold amount by more than $122,500($61,250 for married individual filing separately).Note: It takes 50 two-percent reductions to achieve a 100-percent reduction.Since 49 two-percent reductions would result from an excess of $122,500 (491-7x $2,500 = $122,500), any excess above $122,500 would be a fraction of a$2,500 amount and create the 50th two-percent reduction.Since 2006 is this phaseout is gradually being eliminated. The phaseout was reducedby one-third in 2006 and 2007, will be reduced two-thirds in 2008 and2009, and will be completely eliminated in 2010.Overall Limitation on Itemized Deductions - 3% HaircutTotal itemized deductions otherwise allowable are reduced by 3% of a taxpayer’sAGI in excess of specified threshold amounts. This overall limitation applies toitemized deductions after all other floors have been applied. After application ofthe 3% floor, the “net itemized deductions” remain.The threshold amount is $166,800 in 2009 (up from $159,950 in 2008) for all taxpayersexcept a married individual filing separately, where the threshold is$83,400 ($79,975 in 2008).The “minimum” amount of “net itemized deductions” is the medical expense,

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casualty and theft loss, and investment interest deductions plus 20% of the otheritemized deductions allowable.Since 2006, this overall limitation on itemized deductions is gradually being repealedor phased out. The gradual repeal is over a five year period. For tax yearsbeginning in 2006 and 2007, the limitation was reduced by one-third, and, for taxyears beginning in 2008 and 2009, the limitation will be reduced by two-thirds.After 2009, the repeal will be fully in effect and the limitation on itemized deductionswill no longer apply.Note: Thus, after the regular limitation is determined, taxpayers must takean additional step of multiplying the limitation by 2/3 for tax years beginningin 2006 and 2007 or by 1/3 for tax years beginning in 2008 and 2009.

Earned Income Credit - §32One in six taxpayers claim the EITC, which, unlike most tax breaks, is refundable,meaning that individuals can get it even if they owe no tax and even if notax is withheld from their paychecks.Scheduled increase. The earned income base amounts, credit percentages, andphase-out information were to be as follows for 2009:Earned Maximum Threshold CompletedType of Credit Income Amount Phaseout Phaseout PhaseoutTaxpayer Percentage Amount of Credit Percentage Amount Amount1 child 34 $8,950 $3,043 15.98 $19,540 $38,5832+ children 40 $12,750 $5,028 21.06 $19,540 $43,415No children 7.65 $5,970 $ 457 7.65 $10,590 $16,5601-8Note: Taxpayers are required to use the IRS tables to determine the amountof their earned income credit. While these tables are based on the inflationadjusted figures set out above, because the credit under the tables is thesame for everyone within a $50 range, there may be slight differences betweenthe credit under the tables and the credit the taxpayer would determineusing those inflation adjusted figures.Actual increase. However, for 2009 and 2010, the American Recovery & ReinvestmentAct increases the EITC credit percentage for families with three ormore qualifying children to 45 percent.ExampleIn 2009, taxpayers with three or more qualifying children mayclaim a credit of 45 percent of earnings up to $12,570, resultingin a maximum credit of $5,656.50.In addition, the Act increases the threshold phase-out amounts for married couplesfiling joint returns to $5,000 (indexed for inflation starting in 2010) abovethe threshold phase-out amounts for singles, surviving spouses, and heads of

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households) for 2009 and 2010.ExampleIn 2009, the maximum credit of $3,043 for one qualifying childis available for those with earnings between $8,950 and$16,420 ($21,420 if married filing jointly).The credit begins to phase down at a rate of 15.98 percent of earnings above$16,420 ($21,420 if married filing jointly). The credit is phased down to $0 at$35,463 of earnings ($40,463 if married filing jointly).Disqualified income. The amount of disqualified income (i.e., investment income)a taxpayer may have before losing the entire earned income tax credit increasesto $3,100 in 2009, up from $2,950 in 2008.Social Security & Self-Employment Earnings BaseThe social security contribution and benefit base for remuneration paid and selfemploymentincome earned in tax years beginning in 2009 is $106,800 (up from$102,000 in 2008).1-9Cents-Per-Mile Rates - Standard Mileage RateThe optional standard mileage rates used in computing the deductible costs paidor incurred, for operating a passenger automobile for business, charitable, medical,or moving purposes are:Year Business Mail Carrier Charitable Medical/Moving2009 55 47½ 14 242008 50½ 47½ 14 192007 48½ 47½ 14 202006 44½ 47½ 14 182005 40½/48½ 47½ 14 152004 37½ 47¼ 14 142003 36 47¼ 14 122002 36½ 47¼ 14 132001 34½ 47¼ 14 122000 32.5 47¼ 14 101999 32½ /31 47¼ 14 10Qualified Transportation Fringes“$60 vehicle/ ”155 parking"Tax Year transit" limitation limitation2009 $120 $2302008 $115 $2202007 $110 $2152006 $105 $2052005 $105 $2002004 $100 $195

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2003 $100 $1902002 $100 $1852001 $65 $1802000 $65 $1751999 $65 $175Passenger Automobile Depreciation Limits2009 2008 2007 2006 2005 20041st Year $2,960 $2,960 $3,060 $2,960 $2,960 $2,9602nd Year $4,800 $4,800 $4,900 $4,800 $4,700 $4,8003rd Year $2,850 $2,850 $2,850 $2,850 $2,850 $2,8504th Year $1,775 $1,775 $1,775 $1,775 $1,675 $1,6751-10Expensing Deduction - §1792008-9 2007 2006 2005 2004 2003 2002250,000 $125,000 $108,000 $105,000 $102,000 $100,000 $24,000Self-Employed Health Insurance Deduction2003-9 2002 2001 2000 1999 1998 1997100% 70% 60% 60% 60% 45% 40%Corporate Income Tax RatesTaxable Income Over Not Over Tax Rate$0 $50,000 15%$50,000 $75,000 25%$75,000 $100,000 34%$100,000 $335,000 39%$335,000 $10,000,000 34%$10,000,000 $15,000,000 35%$15,000,000 $18,333,333 38%$18,333,333 .......... 35%

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questions

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and then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.1-111. The federal tax revenue is comprised of excise taxes, estate and gift taxes,individual and corporate income taxes, and Social Security and other payrolltaxes. However, which of the following is the greatest source of federal revenues?a. corporate income taxes.b. estate and gift taxes.c. individual income taxes.d. Social Security and other payroll taxes.2. In 2009, Taxpayer A earned $40,000. What is Taxpayer A’s taxable incomerate if he files as head of household?a. 15%.b. 25%.c. 28%.d. 33%.3. A taxpayer may lose all of his earned income tax credit if he has disqualifiedincome. In 2009, what is the limit of investment income that a taxpayermay have?a. $2,900.b. $2,950.c. $3,100.d. $8,580.4. The purpose of automobile usage determines which optional standardmileage rate a taxpayer should use to compute the deductible costs paid orincurred for operating the vehicle. For 2009, what optional standard mileagerate is used to compute such costs if the passenger automobile was used forcharitable purposes?a. 14.b. 19.c. 47½.d. 50½.

Answers & Explanations1. The federal tax revenue is comprised of excise taxes, estate and gift taxes,individual and corporate income taxes, and Social Security and other payrolltaxes. However, which of the following is the greatest source of federalrevenues?

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a. Incorrect. Corporate income tax is the third greatest source of federalrevenue.1-12b. Incorrect. The most minor sources of federal revenue are the estate andgift taxes and the excise tax.c. Correct. The greatest source of revenue for the federal government is individualincome taxes.d. Incorrect. The second greatest revenue source for the United States governmentis Social Security and other payroll taxes. [Chp. 1]2. In 2009, Taxpayer A earned $40,000. What is Taxpayer A’s taxable incomerate if he files as head of household?a. Correct. The 2009 taxable income rate for a taxpayer who earns between$11,950 and $45,500 and is filing as head of household is 15%. Head ofhousehold is disproportionately favored under the Code and should not beoverlooked.b. Incorrect. The 2009 taxable income rate for a taxpayer who earns between$45,500 and $117,450 and is filing as head of household is 25%. Still, 25% is avery favorable rate for this amount of income.c. Incorrect. The 2009 taxable income rate for a taxpayer who earns between$117,450 and $190,200 and is filing as head of household is 28%. Not toolong ago 28% was the capital gain rate.d. Incorrect. The 2009 taxable income rate for a taxpayer who earns between$190,200 and $372,950 and is filing as head of household is 33%. Even at33%, this is the marginal rate not the effective rate. [Chp. 1]3. A taxpayer may lose all of his earned income tax credit if he has too muchdisqualified income. In 2009, what is the limit of investment income that ataxpayer may have?a. Incorrect. The figure $2,900 is the amount of investment income a taxpayerwas able to have in 2007 before he lost all of his credit.b. Incorrect. The limit of investment income increased to $2,950 for 2008.c. Correct. The limit of investment income increased to $3,100 for 2009.What this means is that a taxpayer’s earned income tax credit is lost if theamount of disqualified income surpasses this limit.d. Incorrect. The figure $8,585 is the 2008 earned income amount for a taxpayerwith one child. [Chp. 1]4. The purpose of automobile usage determines which optional standardmileage rate a taxpayer should use to compute the deductible costs paid or

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incurred for operating the vehicle. For 2009, what optional standard mileagerate is used to compute such costs if the passenger automobile wasused for charitable purposes?a. Correct. For 2009, the optional standard mileage rate used in computingthe deductible costs paid or incurred for operating a passenger automobilefor charitable purposes is 14. Charitable purpose automobile mileage has not1-13been particularly favored by Congress. This amount has rarely been adjustedto any large degree.b. Incorrect. The optional standard mileage rate used in computing the deductiblecosts paid or incurred for operating a passenger automobile formedical or moving purposes was 19 in 2008.c. Incorrect. For 2008, the optional standard mileage rate used in computingthe deductible costs paid or incurred for operating a passenger automobilefor mail carrier purposes was 47½. This is specialty rate and rarely applies tomost taxpayers.d. Incorrect. The optional standard mileage rate used in computing the deductiblecosts paid or incurred for operating a passenger automobile forbusiness purposes in 2008 was 50½. While this is a nice increase over previousyears, it is still better to use the actual cost method if you keep proper records.[Chp. 1]

Withholding & Estimated TaxWhen a taxpayer is an employee, their employer withholds income tax from theirpay. Tax may also be withheld from certain other income - including pensions,bonuses, commissions, and gambling winnings. In each case, the amount withheldis paid to the IRS in taxpayer’s name. The amount of income tax withhelddepends on two things:(1) Amount earned, and(2) Information given the employer on Form W-4.Estimated tax is used to pay not only income tax, but self-employment tax and alternativeminimum tax as well.Estimated TaxEstimated tax is the method used to pay tax on income that is not subject towithholding. This includes income from:(1) Self-employment,(2) Unemployment compensation,(3) Interest,

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(4) Dividends,(5) Alimony,1-14(6) Rent,(7) Gains from the sale of assets,(8) Prizes, and(9) Awards.To the extent that tax is not collected through withholding, taxpayers are requiredto make quarterly estimated payments of tax, the amount of which is determinedby reference to the required annual payment.Taxpayers also may have to pay estimated tax if the amount of income tax beingwithheld from their salary, pension, or other income is not enough. The Form1040-ES, Estimated Tax for Individuals, is used to figure and pay estimated tax.Prior to 2009, the required annual payment was the lesser of:(1) 90% of the tax shown on the return, or(2) 100% of the tax shown on the return for the prior taxable.When a taxpayer’s adjusted gross income for the prior year exceeded $150,000($75,000 for married filing separately) the safe harbor percentage was 110%.Effective February 17, 2009, the American Recovery & Reinvestment Act providesthat the required annual estimated tax payments of a qualified individualfor taxable years beginning in 2009 is not greater than 90% of the tax liabilityshown on the tax return for the preceding taxable year.Qualified individual. A qualified individual means any individual if the adjustedgross income shown on the tax return for the preceding taxable year is less than$500,000 ($250,000 if married filing separately) and the individual certifies thatat least 50% of the gross income shown on the return for the preceding taxableyear was income from a small trade or business.Small trade or business: For purposes of this provision, a small trade or businessmeans any trade or business that employed no more than 500 persons, on average,during the calendar year ending in or with the preceding taxable year.If an individual anticipates that income tax withheld during the year will be less

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than 90% of estimated tax liability, then he or she is required to make estimatedtax payments equal to 25% of the shortfall by each of the following dates:(i) April 15,(ii) June 15,(iii) September 15 of the current year, and(iv) January 15 of the following year (§6654(d)(1)(B)(i)).If a taxpayer does not receive their income evenly throughout the year, they maybe able to figure their estimated tax using the annualized income installmentmethod. Under this method, the required installment for one or more paymentperiods may be less than one-fourth of the required annual payment.1-15

Filing StatusFiling status is a category that identifies a taxpayer based on their marital andfamily situation. A taxpayer’s filing status is an important factor in determiningwhether they are required to file, the amount of their standard deduction, andthe correct amount of tax. Filing status is also important in determining whetherdeductions and credits may be taken (§6012; §1; §63).There are five basic filing statuses to choose from:(1) Single,(2) Married filing jointly,(3) Married filing separately,(4) Head of household, and(5) Qualifying widow(er) with dependent child.Note: There are different tax rates for different filing statuses. If more thanone filing status applies, one should choose the status resulting in the lowesttax.

Marital StatusFiling status depends on whether the taxpayer is considered single or married.Single TaxpayersA taxpayer is considered single for the whole year if, on the last day of the taxyear, they are unmarried or separated from their spouse by a divorce or aseparate maintenance decree (Reg. §1.6013-4(a)). State law governs whethera taxpayer is married, divorced, or legally separated under a decree of divorceor separate maintenance. However, since 1996 the federal Defense ofMarriage Act requires that for federal purposes a marriage must be between

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a man and a woman.Note: If a taxpayer is considered single, they may be able to file as a head ofhousehold or as a qualifying widow(er) with a dependent child.Divorced PersonsState law governs whether you are married, divorced, or legally separatedunder a decree of separate maintenance. If you are divorced under a finaldecree by the last day of the year, you are considered unmarried for thewhole year (Reg. §1.6013-4(a)).Sham DivorceIf taxpayers obtain a divorce in one year for the sole purpose of filing taxreturns as unmarried individuals, and at the time of divorce they intended1-16to remarry and did remarry each other in the next tax year, the taxpayersmust file as married individuals (R.R. 76-255).Annulled MarriagesWhen a taxpayer obtains a court decree of annulment, which holds thatno valid marriage ever existed, and the taxpayer does not remarry, theymust file as single or head of household, whichever applies, for that taxyear. They must also file amended returns claiming single or head ofhousehold status for all tax years affected by the annulment that are notclosed by the statute of limitations for filing a tax return. The statute oflimitations generally does not expire until 3 years after the original returnwas filed (Reg. §301.6501(a)-1; Reg. §301.6501(b)-1; R.R. 76-255).

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.5. Withholding applies to a variety of types of income including pensions, bonuses,and commissions. What other type of income is subject to withholding?

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a. gambling winnings.b. interest.c. alimony.d. prizes and awards.1-176. Certain taxpayers are required to pay estimated tax on income that is excludedfrom withholding. How may a taxpayer calculate estimated tax whenincome is received at irregular intervals throughout the year?a. using the annualized income installment method.b. using the income averaging method.c. using the accrual method.d. using the seasonal business year method.7. Based on marital and family factors, filing status determines which deductionsand credits an individual may claim. What else is determined by an individual’sfiling status?a. the due date of the income tax return.b. eligibility for Medicare.c. earned income credit eligibility.d. the standard deduction amount.8. A person’s filing requirement and correct tax is also determined by his orher filing status. What are the available federal filing statuses for an unmarriedtaxpayer?a. separate or individual.b. single or head of household.c. single or domestic partner.d. living together or head of household.9. When a marriage is annulled, the marriage is held to never have existed.As a result, what must the parties file?a. amended returns.b. Form 8379 as injured spouses.c. a request for innocent spouse relief.d. a request for abandoned spouse status.

Answers & Explanations5. Withholding applies to a variety of types of income including pensions, bonuses,and commissions. What other type of income is subject to withholding?a. Correct. Income tax withholding is required for large gambling winnings.b. Incorrect. Interest is not subject to income tax withholding but it can besubject to estimated tax.1-18

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c. Incorrect. While alimony is considered earned income for a variety of purposesincluding IRA contributions, it is not subject to income tax withholding.d. Incorrect. Prizes and awards are not subject to income tax withholding butcan be subject to estimated tax. [Chp. 1]6. Certain taxpayers are required to pay estimated tax on income that is excludedfrom withholding. How may a taxpayer calculate estimated tax whenincome is received at irregular intervals throughout the year?a. Correct. The annualized income installment method may be used to figuretheir estimated tax if a taxpayer does not receive their income evenlythroughout the year. Under this method, the required installment for one ormore payment periods may be less than one fourth of the normally requiredannual payment.b. Incorrect. Except for certain farmers and fishermen, the income averagingmethod no longer exists and even when it did, it did not apply to the calculationof estimated tax.c. Incorrect. The accrual method is a method for calculating income during atax year and is not used in determining estimated tax.d. Incorrect. Seasonal business year method is used to determine a fiscal yearfor certain businesses. It is not used to determine estimated tax liability.[Chp. 1]7. Based on marital and family factors, filing status determines which deductionsand credits an individual may claim. What else is determined by anindividual’s filing status?a. Incorrect. The due date for filing an income tax return does not vary basedon filing status.b. Incorrect. Medicare is a separate government entitlement program not dependentupon federal income tax filing status.c. Incorrect. The earned income credit is based upon certain earnings thresholdsand number of children not filing status.d. Correct. Filing status does determine a taxpayer's amount of standard deduction.Each filing status is entitled to a different standard deduction. [Chp.1]8. A person’s filing requirement and correct tax is also determined by his orher filing status. What are the available federal filing statuses for an unmarriedtaxpayer?a. Incorrect. Under the Code, there are no tax filing statuses for separate or

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individual.b. Correct. When a taxpayer is unmarried, their filing status is single or headof household. Practitioners should exercise care in using the single tax filing1-19status. In many cases, the taxpayer could also qualify for head of householdwhich is disproportionately favored under the Code.c. Incorrect. While some states have recognized a tax status as domestic partner,the federal government has not.d. Incorrect. Living together is not a tax filing status under the Code. [Chp. 1]9. When a marriage is annulled, the marriage is held to never have existed. Asa result, what must the parties file?a. Correct. Upon annulment, they must file amended returns claiming singleor head of household status for all tax years affected by the annulment thatare not closed by the statute of limitations for filing a tax return.b. Incorrect. The Form 8379 is used to prevent a spouse’s share of a tax refundon a joint return from being applied to a debt owed by their spouse. It isnot used upon an annulment.c. Incorrect. Requests for innocent spouse relief are filed by legitimatelymarried parties seeking relief from joint and several liability.d. Incorrect. Abandoned spouse status is only available to a married personliving apart from their spouse. [Chp. 1]1-20Married TaxpayersMarried taxpayers may file a joint return or separate returns. Taxpayers areconsidered married for the whole year if on the last day of the tax year theyare either:(1) Married and living together as husband and wife (Reg. §1.6013-4(a)),(2) Living together in a common law marriage that is recognized in thestate where they now live or in the state where the common law marriagebegan (R.R. 58-66),(3) Married and living apart, but not legally separated under a decree ofdivorce or separate maintenance (§7703(a)(2)-1(a)), or(4) Separated under an interlocutory (not final) decree of divorce (Reg.§1.6013-4(a); R.R. 57-368).Spouse’s DeathWhen a taxpayer's spouse dies during the year, the surviving taxpayer isconsidered married for the whole year for filing status purposes(§6013(d)). If the taxpayer has not remarried before the end of the taxyear, they may file a joint return for themselves and their deceasedspouse. In addition, for the next 2 years, the taxpayer may be entitled tothe special benefits as a qualifying widow(er) with dependent child (Reg.§1.2-2(a); Reg. §1.6013-1(d)).If the taxpayer has remarried before the end of the tax year, they may file

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a joint return with their new spouse. The deceased spouse’s filing status ismarried filing separately for that year (Reg. §1.6013-1(d)(2)).Married Persons Living ApartWhen a taxpayer lives apart from their spouse and meet certain tests, theymay be considered unmarried. Thus, a taxpayer may file as head of1-21household even though not divorced or legally separated. If a taxpayerqualifies to file as head of household instead of as married filing separately,their standard deduction will be higher. In addition, their tax maybe lower, and they may be able to claim the earned income credit(§63(c)(2); §7703(b); §32(c); §32(d)).Filing JointlyA taxpayer may choose married filing jointly as a filing status if marriedand both the taxpayer and their spouse agree to file a joint return. On ajoint return, married taxpayers report their combined income and deducttheir combined allowable expenses (Reg. §1.6013-4(b)).Note: Both married taxpayers must use the same accounting period, but mayuse different accounting methods (Reg. §1.6013-1(c)).Joint LiabilityA taxpayer may be held jointly and individually responsible for any tax,interest, and penalties due on a joint return filed before their divorce.This responsibility applies even if the divorce decree states that theformer spouse will be responsible for any amounts due on previouslyfiled joint returns (§6013(d); Pesch, 78 TC 100).Note: Under the new equitable relief exception, a factor to be takeninto consideration is the written agreement of the parties.One spouse may be held responsible for all the tax due even though allthe income was earned by the other spouse (§6013(d)(3); Reg.§1.6013-4(b)).Note: Under certain conditions, if a separate liability election is timelymade, liability can be limited to taxes generated by income attributableto that spouse.Innocent Spouse ExceptionThe RRA ‘98 made innocent spouse relief easier to obtain. The Acteliminated all understatement thresholds and requires only that theunderstatement of tax be attributable to an erroneous (and not just agrossly erroneous) item of the other spouse.A separate liability election is provided for a taxpayer who, at the timeof the election:(1) Is no longer married to,(2) Is legally separated from, or(3) Has been living apart for at least 12 months,from the person with whom the taxpayer originally filed a joint return(§6015(c)).1-22Such taxpayers may elect to have the liability for any deficiency limitedto the portion of the deficiency that is attributable to items allocable

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to the taxpayer. The election is not available if the IRS demonstratesthat assets were transferred between individuals filing ajoint return as part of a fraudulent scheme of the individuals or ifboth individuals had actual knowledge of the understatement of tax.Expanded innocent spouse relief and the separate liability electionmust be elected no later than two years after the date on which theIRS has begun collection activities with respect to the individualseeking the relief. The Tax Court has jurisdiction with respect to disputesabout innocent spouse relief.In addition, the IRS is authorized to relieve an individual of liabilityif relief is not available under the expanded innocent spouse rule orthe separate liability election, but it is inequitable to hold the individualliable for any unpaid tax or any deficiency (§6015(f), §66(c)).The expanded innocent spouse relief, separate liability election, andauthority to provide equitable relief apply to liabilities for tax arisingafter July 22, 1998 and any tax liability arising on or before July 22,1998 but remaining unpaid as of that date.Innocent Spouse GuidelinesThe IRS has issued permanent guidance (R.P. 2003-61) for individualsseeking equitable innocent spouse relief under §§6015(f)or 66(c).R.P. 2003-61 supersedes R.P. 2000-15 and the interim guidancecontained in Notice 98-61 and applies to spouses requesting equitablerelief for:(1) Tax liabilities arising after July 22, 1998, or(2) Any unpaid liability arising before that date.R.P. 2003-61 provides:(1) Threshold conditions for relief consideration;(2) Circumstances under which relief will usually be granted;and(3) A partial list of factors for determining whether it would beinequitable to hold an individual liable for a deficiency or unpaidliability.Under the revenue procedure, the IRS will consider granting equitablerelief under §6015(f) if the individual:(1) Seeks relief for a tax year in which a joint return was filed;(2) Is ineligible for relief under §§ 6015(b) or (c);1-23(3) Applies for relief no later than two years after the date theIRS initiates its first collection activity after July 22, 1998;(4) Did not transfer assets to or receive assets from the nonrequestingspouse as part of a fraudulent scheme;(5) Did not receive disqualified assets from the nonrequestingspouse; and(6) Did not file the joint return with fraudulent intent.Additionally, when the individual requests relief, the liability, with

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two exceptions, must be unpaid.If the individual meets the threshold requirements, the IRS willordinarily grant equitable relief under §6015(f) if:(1) The liability reported on the joint return was unpaid whenthe return was filed;(2) When the relief is requested, the individual is no longer marriedto, or is legally separated from the spouse with whom thejoint return was filed;(3) When the relief is requested, the individual hasn’t shared ahousehold with the nonrequesting spouse at any time during the12-month period preceding their request;(4) On filing the joint return, the individual didn’t know and hadno reason to know that the tax wouldn’t be paid; and(5) The individual would suffer economic hardship if relief werenot granted.Married individuals who file separate returns in community propertystates and request relief under §66(c) may qualify for relief, aswell as persons who meet the threshold requirements for §6015(f)relief yet would not ordinarily be granted relief under the notice.In determining whether it is inequitable to hold those individualsliable for the unpaid liability or deficiency, the IRS will take intoaccount all the facts and circumstances. Factors that the IRS willconsider include the individual’s marital status; whether they willsuffer hardship if relief isn’t granted; whether they have sufferedspousal abuse, not amounting to duress; and the nonrequestingspouse’s legal obligations under a divorce decree or agreement.The notice also provides factors that weigh against granting relief,including: unpaid liability that is attributable to the requestor; theindividual’s knowledge or reason to know of an unpaid liability;whether the individual has significantly benefited from the unpaidliability; the individual’s efforts to comply with federal income taxlaws in the tax years following the tax year in which the relief re1-24quest is made; and the individual’s legal obligation to pay the deficiencyunder a divorce decree or agreement.To apply for relief under the revenue procedure, interested individualsmust file Form 8857, Request for Innocent Spouse Relief(and Separation of Liability, and Equitable Relief) within two yearsof the first collection activity against the requesting spouse. Individualswho applied for relief under §§6015(b) or (c) need not fileanother application for relief under §§6015 or 66(c), as the IRSwill review those applications for possible equitable relief.Tax Court JurisdictionEffective for a liability for taxes arising or remaining unpaid on orafter Dec. 20, 2006, the Tax Court has jurisdiction to review theIRS's denial of equitable innocent spouse relief from joint liability

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even if no deficiency was asserted against the requestor of relief(§6015(e)(1)).Nonresident AlienA joint return generally cannot be made if either spouse is a nonresidentalien at any time during the tax year. However, if at the end of theyear one spouse was a nonresident alien or dual-status alien married toa U.S. citizen or resident, both spouses may choose to file a joint return(§6013(a)(1); §6013(g); §6013(h)).Filing SeparatelyA taxpayer may choose married filing separately as a filing status if married.This method may benefit a taxpayer if they want to be responsibleonly for their own tax or if this method results in less tax than a joint return.If married taxpayers do not agree to file a joint return, they mayhave to use this filing status.If a taxpayer lives apart from their spouse and meets certain tests, theymay be considered unmarried and file as head of household. This is trueeven though the taxpayer is not divorced or legally separated. If a taxpayerqualifies to file as head of household, instead of as married filingseparately, their tax may be lower, they may be able to claim the earnedincome credit, and their standard deduction will be higher. In addition,the head of household filing status allows a taxpayer to choose the standarddeduction even if their spouse chooses to itemize deductions.Note: Taxpayers will generally pay more combined tax on separate returnsthan they would on a joint return because the tax rate is higher for marriedpersons filing separately.1-25When a taxpayer files a separate return, they report only their own income,exemptions (they may not split an exemption), credits, and deductions.A taxpayer may file a separate return and claim an exemption fortheir spouse if the spouse had no gross income and was not a dependentof another person. However, if the spouse had any gross income or wasthe dependent of someone else, a taxpayer may not claim an exemptionfor him or her on their separate return (§1(d); §63; §151(b); §211; Reg.§1.151-1(a); R.R. 71-268; R.R. 72-79; R.R. 74-209).Special RulesIf a taxpayer files a separate return:(1) Their spouse should itemize deductions if the taxpayer itemizeddeductions, because he or she cannot claim the standard deduction(§63(c)(6)(A));(2) The taxpayer cannot take the credit for child and dependent careexpenses in most instances (§21(e)(2), (4));(3) The taxpayer cannot take the earned income credit (§32(d));(4) The taxpayer cannot exclude any interest income from series EEU.S. Savings Bonds that might be used for higher education expenses(§135(d)(2));(5) The taxpayer cannot take the credit for the elderly or the disabled

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unless they lived apart from their spouse for all of the tax year(§22(e)(1)); and(6) The taxpayer may have to include in income more of their socialsecurity benefits (or equivalent railroad retirement benefits) receivedthan on a joint return (§86(c)(3))).Joint Return after Separate ReturnsIf a taxpayer or their spouse files a separate return, the taxpayer maychange to a joint return any time within 3 years from the due date ofthe separate return (§6013(b); Reg. §1.6013-2; R.R. 83-183). This doesnot include any extensions. A separate return includes a return filed bya taxpayer or their spouse claiming married filing separately, single, orhead of household filing status. If the amount paid on the separate returnis less than the total tax shown on the joint return, the taxpayermust pay the additional tax due on the joint return when filed.Separate Returns after Joint ReturnOnce a joint return is filed, a taxpayer cannot choose to file a separatereturn for that year after the due date of the return (Reg. §1.6013-1(a)(1)).1-26ExceptionA personal representative for a decedent may change from a jointreturn elected by the surviving spouse to a separate return for thedecedent. The personal representative has one year from the duedate of the return to make the change (§6013(a)(3); Reg. §1.6013-1(d)(5)).Head of HouseholdThe head of household rules changed in 2005 as a result of the WorkingFamily Relief Tax Act of 2004. Under these rules, a taxpayer is able to file ashead of household if unmarried or considered unmarried on the last day ofthe year. In addition, the taxpayer must have paid more than half the cost ofkeeping up a home for themselves and a qualifying person for more than halfthe year (Reg. §1.2-2(b)(1); Reg. §1.2-2(c)).AdvantagesFiling as head of household has the following advantages:(1) a taxpayer can claim the standard deduction even if their spousefiles a separate return and itemizes deductions;(2) the standard deduction is higher than is allowed if taxpayer claimeda filing status of single or married filing separately;(3) the tax rate usually will be lower than it is if the taxpayer claimed afiling status of single or married filing separately;(4) the taxpayer may be able to claim certain credits (such as the dependentcare credit and the earned income credit) they cannot claim iftheir filing status were married filing separately; and(5) income limits that reduce your child tax credit, retirement savingscontributions credit, itemized deductions, and the amount claimed forexemptions will be higher than the income limits if the taxpayer

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claimed a filing status of married filing separately.Requirements of §2(b)A taxpayer is able to file as head of household if he or she:(1) is unmarried or “considered unmarried” on the last day of the year,(2) paid more than half the cost of keeping up a home for the year, and(3) had a “qualifying person” live with them in their home for morethan half the year (except for temporary absences, such as school).Note: If the “qualifying person” is your dependent parent, he or shedoes not have to live with you.1-27Considered UnmarriedA taxpayer is considered unmarried on the last day of the tax year ifthey meet all of the following tests:(1) The taxpayer files a separate return;(2) The taxpayer paid more than half the cost of keeping up theirhome for the tax year;(3) The taxpayer's spouse did not live in the taxpayer’s home duringthe last 6 months of the tax year; and(4) The taxpayer’s home was, for more than half the year, the mainhome of their child, stepchild, adopted child, or foster child whomthe taxpayer could claim as a dependent.Note: A taxpayer can still meet this last test if they cannot claim theirchild as a dependent because they state in writing to the noncustodialparent that he or she may claim an exemption for the child (§7703(b)).Keeping Up a HomeA taxpayer is keeping up a home only if they pay more than half of thecost of its upkeep (Reg. §1.2-2(d)). Costs include rent, mortgage interest,taxes, insurance on the home, repairs, utilities, and food eaten inthe home. Do not include the cost of clothing, education, medicaltreatment, vacations, life insurance, transportation, or the rental valueof a home. Also, do not include the value of taxpayer's services orthose of a member of the taxpayer’s household.Qualifying PersonEach of the following individuals is considered a qualifying person:(1) a “qualifying child” under the definition established by the WorkingFamily Relief Tax Act of 2004,Note: If the taxpayer is a noncustodial parent, the term “qualifyingchild” for head of household filing status does not include a child who istheir qualifying child for exemption purposes only because the custodialparent signs a written declaration that he or she will not claim the childas a dependent for the year. If you are the custodial parent and thoserules apply, the child is generally your qualifying child for head ofhousehold filing status even though the child is not a qualifying childfor whom you can claim an exemption.(2) a “qualifying relative” other than the taxpayer’s mother or fatherwho lives with the taxpayer more than half the year, an exemption istaken and is related in one of the following ways:Son Half brother

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Daughter Brother-in-law1-28Grandparent Sister-in-lawBrother Son-in-lawSister Daughter-in-lawStepbrother StepsisterStepmother If related by blood:Stepfather UncleMother-in-law AuntFather-in-law NephewHalf sister Niece, andNote: Any of these relationships that were established by marriage arenot ended by death or divorce.(3) a “qualifying relative” who is the taxpayer's father or mother forwhom an exemption may be claimed.Note: A taxpayer can be eligible to file as head of household even iftheir dependent parent does not live with them. The taxpayer must paymore than half the cost of keeping up a home that was the main homefor the entire year for their father or mother. A taxpayer is keeping upa main home for their dependent father or mother if they pay morethan half the cost of keeping their parent in a rest home or home forthe elderly (§2(b)(1)(B); R.R. 70-279).SummaryFor 2005 and thereafter, the requirements for head of household statusare affected by changes made by the Working Family Relief Tax Act of2004. As a result, an individual is considered a head of household if suchindividual is not married at the close of the taxable year, is not a survivingspouse, and either:(1) maintains a household which constitutes for more than half of thetaxable year the principal abode for:(a) a "qualifying child" of the individual (under the new unified definitionof a qualified child now contained in §152(c) but without regardto §152(e)), but not if such child:(i) is married at the close of the taxpayer's taxable year, and(ii) is not a dependent of such individual by reason of §152(b)(2)or §152(b)(3), or both, or(b) any other person who is a dependent of the taxpayer, if the taxpayeris entitled to a deduction for the taxable year for such personunder §151, or(2) maintains a household which constitutes for the taxable year the principalabode of the father or mother of the taxpayer, if the taxpayer is entitledto a deduction for such father or mother under §151.1-29Qualifying Widow(er) With Dependent ChildTaxpayers can be eligible to use qualifying widow(er) with dependent child as

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their filing status for 2 years following the year of death of their spouse. Forexample, if a taxpayer's spouse died in 2007, and the taxpayer has not remarried,they may be able to use this filing status for 2008 or 2009.Note: While this filing status entitles the taxpayer to use joint return tax ratesand the highest standard deduction amount, it does not authorize the taxpayerto file a joint return.To file as a qualifying widow(er) with dependent child, a taxpayer must meetall of the following tests:(a) The taxpayer was entitled to file a joint return with their spouse forthe year their spouse died;(b) The taxpayer did not remarry before the end of the tax year;(c) The taxpayer had a child, stepchild, adopted child, or foster child whoqualifies as their dependent for the year; and(d) The taxpayer paid more than half the cost of keeping up a home thatis the main home for the taxpayer and that child for the entire year, exceptfor temporary absences (Reg. §1.2-2(c)(1)).

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.1-3010. If two conditions are met, a married taxpayer filing a separate return mayactually claim an exemption for their spouse. What is one of these conditions?a. The other spouse assigns the exemption.b. The spouses are legally separated.c. The spouse has income less than the standard deduction.d. The spouse could not be claimed as a dependent of another taxpayer.

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11. Taxpayers may find it desirable to file as head of household. What is anadvantage of this filing status?a. The IRS may not take the nondebtor’s tax refunds for another’s olddebts.b. The taxpayer may claim the standard deduction regardless of whetherdeductions are itemized by the spouse on a separate return.c. The taxpayer takes the same standard deduction allowed on a single ormarried filing separate return.d. This filing increases the allowable amount of childcare tax credit.12. Due to the Working Family Relief Tax Act, the definition of head ofhousehold changed in 2005. Since 2005, when might an individual be considereda head of household?a. if he or she is not a surviving spouse.b. if he or she is married at the close of the taxable year.c. if he or she maintains a household which constitutes for the taxableyear the principal abode of the taxpayer’s parent who is not a dependent.d. if he or she maintains a household which constitutes for less than halfof the taxable year the principal abode for any dependent of the taxpayer,if the taxpayer is entitled to a deduction for such person.

Answers & Explanations10. If two conditions are met, a married taxpayer filing a separate return mayactually claim an exemption for their spouse. What is one of these conditions?a. Incorrect. Personal exemptions are non-assignable. However, in divorce,dependency exemptions for children can be transferred.b. Incorrect. The ability to claim an exemption for a spouse is not based uponlegal separation.c. Incorrect. If the spouse has any gross income, the taxpayer is disallowedfrom claiming the exemption.1-31d. Correct. As long as the other condition is met, a taxpayer may file a separatereturn and claim an exemption for a spouse who is not a dependent ofanother person. [Chp. 1]11. Taxpayers may find it desirable to file as head of household. What is an advantageof this filing status?a. Incorrect. An advantage of filing a separate return is that if one spouseowes such debts as back taxes from before the marriage or back child supportpayments, it may keep the nondebtor’s tax refunds from being taken by theIRS for the other’s old debts.

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b. Correct. An advantage of filing as head of household is that the standarddeduction can be claimed even if the other spouse itemizes deductions on aseparate return.c. Incorrect. An advantage of filing as head of household is that the standarddeduction is higher than that allowed on a single or married filing separate return.d. Incorrect. This filing does not increase the allowable amount of childcaretax credit under §21. This credit is based upon earnings and number of children.[Chp. 1]12. Due to the Working Family Relief Tax Act, the definition of head ofhousehold changed in 2005. Since 2005, when might an individual be considereda head of household?a. Correct. Since 2005, if all other requirements are met, an individual is considereda head of household if such individual is not a surviving spouse.b. Incorrect. Since 2005, if all other requirements are met, an individual isconsidered a head of household if they are not married at the close of thetaxable year.c. Incorrect. Since 2005, if all other requirements are met, an individual isconsidered a head of household if they maintain a household which constitutesfor the taxable year the principal abode of the father or mother of thetaxpayer, if the taxpayer is entitled to a deduction for such father or motherunder §151.d. Incorrect. Since 2005, if all other requirements are met, an individual isconsidered a head of household if they maintain a household which constitutesfor more than half of the taxable year the principal abode for any otherperson who is a dependent of the taxpayer, if the taxpayer is entitled to a deductionfor the taxable year for such person under §151. [Chp. 1]1-32

Gross IncomeSection 61 requires that gross income include all income from whatever sourcederived unless “otherwise provided.” The following is a list of items that are specificallyincluded in gross income per §61:(1) Compensation for services and other benefits,(2) Gross income derived from business,(3) Gains derived from dealing in property,(4) Interest,(5) Rents,

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(6) Royalties,(7) Dividends,(8) Alimony and separate maintenance payments,(9) Annuities,(10) Income from life insurance and endowment contracts,(11) Pension,(12) Income from discharge of indebtedness,(13) Distributive share of partnership gross income,(14) Income in respect of a decedent, and1-33(15) Income from an interest in an estate or trust.CompensationEmployee compensation is includible in gross income whether it is cash or otherassets. Compensation includes salary, commissions, bonuses, tips, vacation pay,and severance pay.Note: Unemployment compensation is included in gross income.

Fringe BenefitsIn addition to compensation, many employers provide fringe benefits to employees.Unless specifically exempted from taxation by law or the employee pays fairmarket value for them, the employer must include the value of these fringe benefitsin the employee’s gross income and withhold income taxes thereon.The amount includible as compensation is based on the fair market value of thebenefits. Reg. §1.61-21(b) requires that gross income include the fair marketvalue of a fringe benefit, less any payments by or on behalf of the recipient andany statutory exclusion.Rental IncomeRental income is any payment received for the use or occupation of property.Taxpayers must include in gross income all amounts received as rent. In additionto amounts received as normal rent payments, there are other amounts that maybe rental income.Advance RentAdvance rent is any amount received before the period that it covers. Advancerent is included in income in the year received regardless of the periodcovered or the method of accounting used.ExampleDan signs a 10-year lease to rent Ron’s property. In the first

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year, Ron receives $5,000 for the first year’s rent and $5,000as rent for the last year of the lease. Ron must include$10,000 in his income in the first year.Security DepositsA security deposit is not included in income if the taxpayer plans to return itto the tenant at the end of the lease. However, if during any year, the taxpayerkeeps part or all of the security deposit because their tenant does not1-34live up to the terms of the lease, the amount kept is included in income forthat year.Note: If an amount called a security deposit is to be used as a final paymentof rent, it is advance rent and includible in income when received.Payment for Canceling a LeaseIf a tenant pays a taxpayer to cancel a lease, the amount received is rent. Thepayment is included in income for the year received regardless of the taxpayer’smethod of accounting.Social Security BenefitsA portion of Social Security benefits received may be taxable (§86). If the taxpayer’sonly income received in a tax year was their social security benefits, thebenefits are not taxable. If the taxpayer received income other than the social securitybenefits, a portion of the benefits is taxable if provisional income, which ismodified adjusted gross income plus one-half of the net benefits, is greater thana base amount.Note: Social Security benefits are included in gross income only if the recipient’sprovisional income exceeds a specified amount, referred to as the “baseamount” or “adjusted base amount.”There are two tiers of benefit inclusion. A 50% rate is used to figure the taxablepart of income that exceeds the base amount but does not exceed the higher adjustedbasis amount. An 85% rate is used to figure the taxable part of incomethat exceeds the adjusted base amount.Taxability of BenefitsHere is how this complicated two-tier benefit inclusion system came into being.Prior to 1994, up to 50% of Social Security benefits were subject to incometax when a taxpayer’s modified adjusted gross income plus 50% of theirsocial security benefits exceeded:(1) $25,000 if the taxpayer filed as single, head of household, or qualifyingwidow(er) with dependent child,1-35

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(2) $25,000 if the taxpayer was married, did not file a joint return, and didnot live with their spouse at any time during the year,(3) $32,000 if the taxpayer was married and filed a joint return, or(4) $-0- if the taxpayer was married, did not file a joint return, and did livewith their spouse at any time during the year.“Modified adjusted gross income” is the sum of the taxpayer’s adjusted grossincome plus any tax-exempt interest received. “Adjusted gross income” is figuredwithout including any of the taxpayer's social security or equivalent railroadretirement benefits and without subtracting:(1) The interest exclusion for certain Series EE savings bonds redeemedfor “qualified educational expenses,”(2) The foreign earned income exclusion and the foreign housing exclusionor deduction,(3) The exclusion of income from U.S. possessions, or(4) The exclusion of income from Puerto Rico by bona fide residents ofPuerto Rico.OBRA ’93 made up to 85% of Social Security benefits subject to income taxfor taxable years beginning after December 1, 1993. However, the old law continuesto apply to a taxpayer whose modified adjusted gross income plus 50%of their social security benefits does not exceed $34,000 for unmarried individualsand $44,000 for married individuals filing joint returns.For taxpayers whose modified adjusted gross income plus 50% of social securitybenefits exceed these thresholds, gross income includes the lesser of:(l) 85% of the taxpayer's social security benefit, or(2) The sum of:(a) The smaller of(i) The amount included under old law; or(ii)$4,500 (for unmarried taxpayers) or $6,000 for married taxpayersfiling joint returns (one-half of the difference between the old andnew threshold amounts),Plus,(b) 85% of the excess of the taxpayer’s modified adjusted gross incomeplus 50% of their social security benefits over the applicable thresholdamounts.For married taxpayers filing separate returns, gross income includes the lesserof 85% of the taxpayer's social security benefits or 85% of the taxpayer’smodified adjusted gross income plus 50% of their social security benefits.Note: In addition to this increase in tax on Social Security benefits, Medicaidplanning strategies were severely restricted. One of the most popular tools,1-36the so-called Medicaid Trust is now completely disallowed. Taxpayers who

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have done “Medicaid planning” now need to have their plan reviewed.Taxpayers may use the following worksheet to compute the taxable portionof their social security benefits.Social Security Worksheetl. Modified adjusted gross income $___________2. Social security benefits $___________3. 85% of social security benefits $___________4. 50% of social security benefits $___________5. Sum of lines 1 and 4 $___________6. Enter $25,000 unmarried, $32,000 marriedjoint,$0 married separate if living together $___________7. Subtract line 6 from line 5 (if $0, benefitsare not taxable) $___________8. 50% of line 7 $___________9. Lesser of line 4 or line 8 $___________10. $4,500 unmarried, $6,000 married-joint $___________11. Lesser of lines 9 or 10 $___________12. Enter $34,000 unmarried, $44,000 married-joint,$0 married separate if living together $___________13. Line 5 less line 12 $___________14. 85% of line 13 $___________15. Sum of lines 11 and 14 $___________16. Taxable amount, lesser of lines 3 or 15 $___________ExampleSharon and Danny, a married couple filing a joint return,have modified adjusted gross income of $40,000 and receivesocial security benefits of $10,000. The taxable portionof their social security benefits is $5,850, calculated asfollows:l. Modified adjusted gross income $ 40,0002. Social security benefits $10,0003. 85% of social security benefits $8,5004. 50% of social security benefits $5,0005. Sum of lines 1 and 4 $45,0006. Enter $25,000 unmarried, $32,000 marriedjoint,$0 married separate if living together $32,0007. Subtract line 6 from line 5 (if $0, benefits1-37are not taxable) $13,0008. 50% of line 7 $6,5009. Lesser of line 4 or line 8 $5,00010. $4,500 unmarried, $6,000 married-joint $6,00011. Lesser of lines 9 or 10 $5,00012. Enter $34,000 unmarried, $44,000 marriedjoint,$0 married separate if living together $44,00013. Line 5 less line 12 $1,00014. 85% of line 13 $85015. Sum of lines 11 and 14 $5,85016. Taxable amount, lesser of lines 3 or 15 $5,850

Alimony & Spousal Support

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Payments of spousal support (sometimes called “alimony”) by a separated or divorcedspouse to the other spouse are taxable to the recipient and deductible tothe payor (§71(a) & §215). The payor deducts the payment in arriving at AGI(§62(13)).Note: The parties can agree in writing that otherwise taxable and deductiblepayments will not be alimony and therefore not taxable and deductible(§71(b)(1)(B)).Requirements1. The payment must be required by a divorce or separation instrument(§71(b)(1)(A)).Note: An instrument is a judicial decree of divorce or separate maintenanceor a decree of temporary support. An instrument also includes a writtenagreement incident to a divorce or written separation agreement(§71(b)(2)).2. A payment is not deductible to the payor or taxable to the payee if the partiesare living together in the same household after being legally divorced(§71(b)(1)(C)).3. Payments must cease upon death, and there cannot be any liability to makepayments after the recipient’s death as a substitute for payments stopped atdeath (§71(b)(1)(D)).4. Payments must be in cash (§71(b)(1)).5. The divorce or separation instrument must not designate the payment asnot alimony (§71(b)(1)(B).6. The payment must not be treated as child support ((§71(c)(1))).7. The spouses must not file a joint return ((§71(e)).1-38RecaptureIf the amount of alimony paid in the first year exceeds the average of the secondand third year payments by more than $15,000, the excess is recapturedin the third year. Also, if second year payments exceed third year paymentsby more than $15,000, the excess is recaptured in the third year. Recapturemakes the amount ordinary income to the payor and a deduction to thepayee.ExampleA divorce decree requires Dan to make payments to Bambi of$24,000 in 2006 and $1 per year in 2007 and 2008. Paymentsin year one exceed average payments in the secondand third years by $23,999. The excess over $15,000 (i.e.,$8,999) is recaptured as income in the third year (i.e., 2008).Thus, Dan has $8,999 of income in 2008, and Bambi has an$8,999 deduction.Child SupportChild support is not taxable to the recipient or the child, and is not deductibleby the payor (§71(c)(1)). Normally, child support is clearly designated in

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the instrument as for the support of the child. However, any amount that isreduced upon the happening of a contingency related to the child is deemedto be child support (§71(c)(2)).Prizes & Awards - §74 & §274Prizes won through a quiz show, lucky number drawing, beauty contest, etc. mustbe included in taxable income. In addition, employee cash awards or bonusesgiven by an employer for good work or suggestions must be included in incomewhen received.Prizes and awards in goods or services must be included in income at their fairmarket value. If taxpayer refuses to accept a prize, it is not included in income(Reg. §1.74-1(a)(2); R.R. 57-374).1-39If a salesperson receives “prize points” redeemable for merchandise, which areawarded by a distributor to employees of dealers, they must include their fairmarket value in income. The “prize points” are taxable in the year they are paidor made available, rather than in the year taxpayer redeems them for merchandise(R.R. 70-331).Dividends & DistributionsDividends are distributions of money, stock, or other property by a corporation.Dividends may also be received through a partnership, an estate, a trust, or anassociation that is taxed as a corporation. However, some amounts that arecalled dividends are actually interest income.Most distributions are paid in cash or by check. However, distributions may bereceived as additional stock, stock rights, other property, or services.Ordinary DividendsOrdinary (taxable) dividends are the most common type of distribution froma corporation. They are paid out of the earnings and profits of a corporationand are ordinary income to the recipient. Most dividends, whether on commonor preferred stock, are ordinary dividends unless the paying corporationstates otherwise (§316; Reg. §1.316-1(a); §61(a)(7); Reg. §1.61-9).Note: Since 2003 and until 2011, corporate dividends (defined as "qualifieddividends") paid to an individual are no longer taxed at ordinary incomerates; rather, they are taxed at the top rates for capital gains.Money Market Funds

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Amounts received from money market funds are reported as dividend income.These amounts generally are not interest income and should not bereported as interest.Dividends on Capital StockDividends on the capital stock of organizations, such as savings and loanassociations, are ordinary dividends. They are not interest (Reg. §1.116-(d)(1)).Dividends Used to Buy More StockA corporation may have a dividend reinvestment plan. Such a plan permitsthe use of dividends to buy more shares of stock in the corporationinstead of receiving the dividends in cash. Members of this type of plan,who use their dividends to buy additional stock at a price equal to its fairmarket value, must report dividends as income (R.R. 77-149).1-40Qualified DividendsQualified dividends receive special favorable tax treatment. Qualified dividendincome received by an individual between January 1, 2003, and December31, 2010, is taxed at rates substantially lower than ordinary income.Note: Dividends passed through to investors by a mutual fund or other regulatedinvestment company (RIC), partnership, real estate investment trust(REIT), or held by a common trust fund are also eligible for the reducedrate assuming the distribution would otherwise be qualified dividend incomeThe rate for such dividends is 15%, or 5% for those individuals whose incomesfall in the 10% or 15% rate brackets (§1(h)(11)). For 2008, 2009 and2010, a zero-percent rate applies to taxpayers in the 10% or 15% brackets."Qualified dividend income" is dividends received from a:(1) domestic corporation, or(2) qualified foreign corporation.In the alternative, taxpayers may elect to treat qualified dividend income asinvestment income under §163(d)(4) (B). A taxpayer makes this election onForm 4952, Investment Interest Expense Deduction.Capital Gain DistributionsRegulated investment companies, mutual funds, and real estate investmenttrusts pay these distributions or dividends from their net realized long-termcapital gains. A Form 1099-DIV or the mutual fund statement will tell theamount recipients are to report as a capital gain distribution.Capital gain distributions are reported as long-term capital gains regardlessof how long the stock in the mutual fund has been owned. Those distributionsthat are not derived in the ordinary course of a trade or business aretreated as portfolio income and are not considered as income from a passiveactivity (§852(b)(3)(B); Reg. §1.852-4(b)(1); Reg. §1.852-4(C); §854(a);§469(e)(1)).Undistributed Capital Gains

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Taxpayers must report as long-term capital gain any amounts that the investmentcompany or mutual fund credited to the taxpayer as capital gaindistributions, even though the taxpayer did not actually receive them(Reg. §1.852-4(b)(2); §852(b)(3)(D)).Form 2439Taxpayers can take a credit on their return for any tax that the investmentcompany or mutual fund has paid on the undistributed capitalgains. The company or fund will send a Form 2439, Notice to Shareholderof Undistributed Long-Term Capital Gains, showing the amount1-41of the undistributed long-term capital gain and the tax that was paid.Take this credit by entering the amount of tax paid and checking thebox on line 59, Form 1040. Attach Copy B of Form 2439 to the return(§852(b)(3)(D)(ii); Reg. §1.852-9(c)(2)).Basis AdjustmentBasis in the stock is increased by the difference between the amount ofundistributed capital gain reported and the amount of the tax paid by thefund. Keep Copy C of Form 2439 as part to show increases in the basis ofstock (§852(b)(3)(D)(iii)).Real Estate Investment Trusts (REITs)Taxpayers will receive a Form 1099-DIV or similar statement from theREIT showing the capital gain distributions includable in income. Regardlessof how long stock in the REIT has been owned, capital gain distributionsare reported as long-term capital gain (§857(b)(3)(B);§857(b)(3)(C)).Nontaxable DistributionsTaxpayers may receive a return of capital or a tax-free distribution of additionalshares of stock or stock rights. These distributions are not treated thesame as ordinary dividends or capital gain distributions.Return of CapitalA return of capital is a distribution that is not paid out of the earningsand profits of a corporation. It is a return of the taxpayer’s investment inthe stock of the company. Taxpayers should receive a Form 1099-DIV orother statement from the corporation showing what part of the distributionis a return of capital (§301(c)(2); Reg. §1.3011(a)).Basis AdjustmentA return of capital reduces stock basis and is not taxed until basis in thestock is fully recovered. If a taxpayer buys stock in a corporation in differentlots at different times, reduce the basis of the earliest purchases first(Reg. §1.1012-1(c)(1); Reg. §1.1016-5(a)(1)).When the stock basis has been reduced to zero, report any return of capitalreceived as a capital gain. Whether the gain is reported as a long-termcapital gain or short-term capital gain depends on how long the stock hasbeen held (§301(c)(3)).

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1-42ExampleYou bought stock in 2003 for $100. In 2005, you received areturn of capital of $80. You did not include this amount inyour income, but you reduced the basis of your stock. Yourstock now has an adjusted basis of $20. You receive a returnof capital of $30 in 2008. You use $20 of this amount to reduceyour basis to zero. You report the other $10 as a longtermcapital gain for 2008. You must report as a long-termcapital gain any return of capital you receive on this stock inlater years.Liquidating DistributionsLiquidating distributions, sometimes called liquidating dividends, are distributionsreceived during a partial or complete liquidation of a corporation.These distributions are, at least in part, one form of a return of capital. Theymay be paid in one or more installments. Taxpayers will receive a Form 1099-DIV from the corporation showing the amount of the liquidating distribution(§331; Reg. §1.331-1).Any liquidating distribution received is not taxable until the taxpayer has recoveredthe basis of their stock. After the stock basis has been reduced tozero, taxpayers must report the liquidating distribution as a capital gain (exceptin certain instances with regard to collapsible corporations under §341).Whether taxpayer reports the gain as a long-term capital gain or short-termcapital gain depends on how long the stock has been held (§341(a); Ludorff,40 BTA 32).Distributions of Stock and Stock RightsDistributions by a corporation of its own stock are commonly known as stockdividends. Stock rights (also known as “stock options”) are distributions by acorporation of rights to subscribe to the corporation’s stock. Generally, stockdividends and stock rights are not taxable to the recipient and are not reported(§305(a); Reg. §1.305-1(a)).Taxable Stock Dividends and Stock RightsDistributions of stock dividends and stock rights are taxable if:(1) Taxpayer or any other shareholder has the choice to receive cash orother property instead of stock or stock rights (§305(b)(1)),(2) The distribution gives cash or other property to some shareholdersand an increase in the percentage interest in the corporation’s assets orearnings and profits to other shareholders (§305(b)(2)),1-43(3) The distribution is in convertible preferred stock and has the sameresult as in (2), (§305(b)(5)),(4) The distribution gives preferred stock to some common stock

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shareholders and gives common stock to other common stock shareholders(§305(b)(3)), or(5) The distribution is on preferred stock (§305(b)(4); Reg. §1.305-5(a)).

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.13. When a tenant pays a landlord to use or occupy a property, the landlordreceives rental income. For income tax purposes, what is the tax treatment ofan amount paid by a tenant to a landlord to terminate a lease?a. as a security deposit.b. as advance rent.c. as excludible income.d. as rent.1-4414. In response to increasing pressure on the Social Security system, Congresshas responded in part by:a. making all Social Security benefits taxable.b. permitting participants to invest a portion of their account.c. reducing the normal retirement age.d. taxing recipients with provisional income exceeding specified amounts.15. Divorce or separation instruments may define child support payments asbeing for the support of a child. However, when does federal tax law deempayments to constitute child support?a. if other payments are patently insufficient to support the child.b. if they are decreased upon a contingency related to the child.

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c. if the other spouse waives spousal support.d. if the spouses execute Form 8332.

Answers & Explanations13. When a tenant pays a landlord to use or occupy a property, the landlordreceives rental income. For income tax purposes, what is the tax treatmentof an amount paid by a tenant to a landlord to terminate a lease?a. Incorrect. A security deposit is not included in income if the taxpayer plansto return it to the tenant at the end of the lease.b. Incorrect. Advance rent is any amount received before the period that itcovers. Advance rent is included in income in the year received regardless ofthe period covered or the method of accounting used.c. Incorrect. The payment for canceling a lease is included in income for theyear received regardless of the taxpayer’s method of accounting.d. Correct. If a tenant pays a taxpayer to cancel a lease, the amount receivedis rent. [Chp. 1]14. In response to increasing pressure on the Social Security system, Congresshas responded in part by:a. Incorrect. Under §86, not all individuals Social Security benefits are taxable.For example, those whose only income in a tax year is their Social Securitybenefits do not have to include the amounts in their gross income.b. Incorrect. While the ability of participants to invest a portion of their SocialSecurity account has been proposed and debated for years, Congress hasyet to approve of such action.1-45c. Incorrect. Congress' primary response to the financial problems of the SocialSecurity system has been to increase rather than decrease the normal retirementage.d. Correct. If a taxpayer received income other than the Social Security benefits,a portion of the benefits is taxable if provisional income, which is modifiedadjusted gross income plus one-half of the net benefits, is greater than abase amount. [Chp. 1]15. Divorce or separation instruments may define child support payments asbeing for the support of a child. However, when does federal tax law deempayments to constitute child support?a. Incorrect. The insufficiency of payments to support a child is not determinativein deeming certain payments to be child support for federal income taxpurposes. The sufficiency of child support payments is a matter of state law.

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b. Correct. Under §71, any amount that is reduced upon the happening of acontingency related to the child is deemed to be child support.c. Incorrect. Any waiver of spousal support has no bearing on other paymentsbeing deemed child support.d. Incorrect. The Form 8332 relates to the transfer of a child's dependencyexemption between former spouses. It does not result in any payments beingreclassified as child support. [Chp. 1]1-46Discharge of Debt IncomeIf a taxpayer’s debt is canceled or forgiven, other than as a gift, the taxpayer mustinclude the canceled amount in their gross income (§61(a)(12). A debt includesany indebtedness for which the taxpayer is liable or which attaches to propertyheld by the taxpayer (§108(d)(1); §108(e)(1); §61(a)(12)).ExampleDan obtained a mortgage loan on his personal residence severalyears ago at a relatively low rate of interest This year, inreturn for Dan paying off the loan early, the lending institutioncancels a part of the remaining principal. Dan must includethe amount canceled in his gross income (R.R. 82-202)Exceptions from Income InclusionDespite the general rule requiring inclusion of a canceled debt in gross income,taxpayers do not include a canceled debt in gross income if any of thefollowing situations apply:1. The cancellation takes place in a bankruptcy case under title 11 of theUnited States Code (§108(a)(1)(A)).Note: Income from debt discharged prior to the filing of a bankruptcy doesnot qualify for this exclusion (and may not be entitled to either the insolvencyor farm debt exclusion). Thus, for tax planning purposes, it is importantfor a debtor who will be involved in a bankruptcy to discharge all thedebt inside of the bankruptcy proceedings.2. The cancellation takes place when the taxpayer is insolvent. Here, theamount excluded is not more than the amount by which the taxpayer isinsolvent at the moment immediately prior to discharge (§108(a)(1)(B)).Note: If the taxpayer is insolvent before the cancellation but solvent after thecancellation, income is realized to the extent the transaction makes the taxpayersolvent. The amount of income realized would be equal to the amountby which the fair market value of the taxpayer’s assets is more than the liabilitiesafter the cancellation. If the taxpayer is insolvent before the cancel1-47lation, and remains insolvent or has no excess of assets over liabilities afterthe cancellation, no income is realized.3. The cancellation is a qualified farm debt discharged by an unrelated

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lender (§108(a)(1)(C)).4. The cancellation is real property business debt (§108(a)(1)(D)).5. The debt arises from certain student loans (§108(f)).Note: Many states make loans to students on the condition that the loan willbe forgiven if upon completion of study the student will practice a professionin the state. The amount of the loan that is forgiven is excluded from grossincome.6. Other circumstances enumerated in §108(e) such as purchase-moneydebt reduction and cancellation of deductible debt.Reduction of Tax AttributesThe amount of canceled debt that does not create income must reduce tax attributesby the amount of such canceled debt. Tax attributes include “basis”of certain assets, net operating losses, general business credit carryovers,minimum tax credits, capital losses, passive activity losses and credits, andforeign tax credit carryovers. Reducing the tax attributes effectively defersthe realization of the canceled debt instead of excluding it.Note: A bankrupt taxpayer may exclude the amount of discharge of indebtednessincome that exceeds their tax attributes.Order of ReductionsGenerally, the order for reducing tax attributes is:(1) Net operating losses,(2) General business credit carryover,(3) Alternative minimum tax credits,(4) Capital losses,(5) Property basis,(6) Passive activity loss and credit carryovers, and then(7) Foreign tax credit carryovers.The taxpayer may elect to reduce the basis of depreciable property beforereducing other tax attributes.ForeclosureIf the borrower (buyer) of property does not make payments due on a loansecured by property, the lender (mortgagee or creditor) may foreclose on themortgage or repossess the property. The foreclosure or repossession istreated as a sale or exchange from which the borrower may realize gain orloss. This is true even if the property is voluntarily conveyed to the lender.1-48The borrower’s gain or loss from the foreclosure or repossession is generallyfigured and reported in the same way as gain or loss from sales or exchanges.The gain or loss is the difference between the borrower’s adjusted basis ofthe transferred property and the amount realized.Note: The amount realized from a sale or other property disposition includesliabilities “discharged” in the sale or disposition (Reg. §1.1001-2(a)).Nonrecourse IndebtednessThis rule applies to nonrecourse debt regardless of the fair market valueof the property transferred. Thus, even if the property’s fair market value

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at time of transfer is less than the nonrecourse debt, the total amount ofsuch debt is included in the amount realized when determining the transferor’sgain or loss (Commissioner v. Tufts, 461 U.S. 300 (1983)).When the amount realized exceeds the mortgagor’s adjusted basis, thetaxpayer will recognize gain. If the adjusted basis exceeds the amount realized,then a loss will be recognized.ExampleDan purchased a new residence for $150,000. He paid$20,000 down and borrowed the remaining $130,000 fromthe bank. Under state law, Dan is not personally liable on theloan (nonrecourse), but the loan is secured by the home.Years later, the bank foreclosed on the home because hestopped making loan payments. The balance due after takinginto account the payments Dan made was $100,000. Thehome’s fair market value when foreclosed was $90,000. Theamount Dan realized on the foreclosure is $100,000. Thatamount is the debt canceled by the foreclosure, even thoughhe is not personally liable for the loan and the home’s fairmarket value is less than $100,000. Dan figures his gain orloss on the foreclosure by comparing the amount realized($100,000) with his adjusted basis ($150,000). He, therefore,has a $50,000 nondeductible loss.Typically, the borrower receives no consideration from the mortgageeother than the application of the proceeds towards the amount of thedebt. In such case, the amount realized by the mortgagor, will only includethe amount of debt satisfied by the foreclosure.Note: In a nonrecourse debt, the lending institution only looks to the propertyfor recovery of the mortgage, and cannot additionally look to the borrower’sother assets. In effect, the investor never owes more than the fairmarket value of the asset securing the loan. Therefore, the sales price is theentire nonrecourse debt, even if the fair market value is less than the amount1-49of the loan. The result is there will never be cancellation of indebtedness incomein a nonrecourse debt.Recourse IndebtednessIf the underlying indebtedness is recourse, Reg. §1.1001-2(a), Example 8provides for a different result.If the fair market value of the property transferred is less than the canceleddebt, the amount realized by the owner includes the canceled debtup to the fair market value of the property. The owner is treated as receivingordinary income from the canceled debt for that part of the canceleddebt not included in the amount realized. Such income may be realized,but not recognized by reason of the §108 bankruptcy, insolvency, orqualified farm debt exclusions.ExampleDan purchases the same new residence (see earlier example)for $150,000, paying $20,000 down and borrowing theremaining $130,000 from the bank. This time Dan is personally

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liable on the loan (recourse). Years later, when thebank forecloses, Dan still owed $100,000, but the home wasonly worth $90,000.In this case, the amount he realizes is $90,000. This is theamount of the canceled debt ($100,000) up to the home’s fairmarket value ($90,000). He is also treated as receiving ordinaryincome from cancellation of debt. That income is$10,000 ($100,000 minus $90,000). This is the part of thecanceled debt not included in the amount realized. Dan figureshis gain or loss on the foreclosure by comparing theamount realized ($90,000) with his adjusted basis ($150,000).He, therefore, has a $60,000 nondeductible loss.The income from cancellation of debt is in addition to the gain or lossfrom the sale or exchange (transfer of property). This ordinary incomefrom the cancellation of debt may arise if:(1) The borrower is personally liable for repayment of the debt securedby the property transferred to satisfy the debt, and(2) The fair market value (FMV) of the transferred property is lessthan the amount of canceled debt.Mortgage Relief Act of 2007Under the Mortgage Relief Act, effective for indebtedness discharged onor after Jan. 1, 2007 and before Jan. 1, 2013, taxpayers are allowed to excludeup to $2 million of mortgage debt forgiveness on their principal1-50residence. Specifically, the Mortgage Relief Act provides that gross incomedoes not include any discharge of "qualified principal residence indebtedness"(§108(a)(1)(E)).Qualified principal residence. Qualified principal residence indebtednessis acquisition indebtedness under §163(h)(3)(B) with respect to the taxpayer'sprincipal residence, but with a $2 million limit (i.e., instead of thenormal $1 million on qualified Acquisition indebtedness) ( §108(h)(2)).Principal residence. "Principal residence" has the same meaning as underthe homesale exclusion rules of §121 (§108(h)(5))Acquisition indebtedness. "Acquisition indebtedness" of a principal residenceis indebtedness incurred to build, buy or substantial improve an individual'sprincipal residence that is secured by the residence. It also includesrefinancing of debt to the extent the amount of the refinancingdoes not exceed the amount of the refinanced indebtedness (unless theproceeds of the financing are also used for one of these three purposesand the cumulative level of the such debt does not exceed the overall $1million cap). However, to the extent this exception is used to avoid CODincome, the basis of the taxpayer's principal residence is reduced (but notbelow zero) (§108(h)(1)).Bartering

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Bartering is an exchange of property or services. Taxpayers must include in income,at the time received, the fair market value of property or services receivedin bartering.If services are exchanged with another person and there is an agreement aheadof time as to the value of the services, that value will be accepted as fair marketvalue unless the value can be shown to be otherwise.ExampleDan is a self-employed attorney who performs legal servicesfor a client, a small corporation. The corporation gives Danshares of its stock as payment for his services. Dan must includethe fair market value of the shares in income on ScheduleC (Form 1040) in the year he received them.ExampleRalph is a self-employed accountant. Both Ralph and ahouse painter are members of a barter club. The organizationeach year gives its members a directory of members and the1-51services each member provides. Members get in touch witheach other directly and bargain for the value of the services tobe performed. In return for accounting services Ralph provided,the house painter painted his home. Ralph must reportas income on Schedule C (Form 1040) the fair market valueof the house painting services he received, and the housepainter must include in income the fair market value of theaccounting services Ralph provided.ExampleDan is a member of a barter club. The club uses “credit units”as a means of exchange. It adds credit units to his accountfor goods or services he provides to members, which Dancan use to purchase goods or services offered by othermembers of the barter club. The club subtracts credit unitsfrom Dan’s account when he receives goods or services fromother members. Dan must include in income the value ofcredit units that are added to his account, even though Danmay not actually receive goods or services from other membersuntil a later tax year.ExampleDan owns an apartment building and an artist gives Dan awork of art the artist created in return for 6 months’ rent-freeuse of an apartment. Dan must report as rental income onSchedule E (Form 1040) the fair market value of the artwork,and the artist must report as income on Schedule C (Form1040) the fair rental value of the apartment.Barter ExchangeIf property or services are exchanged through a barter exchange, taxpayersshould receive Form 1099-B, Statement for Recipients of Proceeds from Brokerand Barter Exchange Transactions, or a similar statement from the barter exchange.

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The statement should be received by January 31, and it should showthe value of cash, property, services, credits, or scrip received from exchangesduring the year. The IRS will get a copy of Form 1099-B.Backup WithholdingIncome received from bartering is generally not subject to regular incometax withholding. However, backup withholding will apply in certain circumstancesto ensure that income tax is collected on this income.1-52Under backup withholding, the barter exchange must withhold, as incometax, 20% of the income if:(i) The taxpayer does not give the barter exchange their identificationnumber (either a social security number or an employer identificationnumber), or(ii) The IRS notifies the barter exchange that the taxpayer gave it anincorrect identification number.Note: If a taxpayer joins a barter exchange, they must certify underpenalties of perjury that their social security or employer identificationnumber is correct and that they are not subject to backup withholding.If a taxpayer does not make this certification, backup withholding maybegin immediately. The barter exchange will give a Form W-9, Payer’sRequest for Taxpayer Identification Number and Certification, or a similarform, to make this certification.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.16. When must canceled debt be included in a taxpayer’s gross income?a. if income from debt is discharged before filing for bankruptcy.

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b. if the cancellation is a qualified farm debt by an unrelated lender.c. if the cancellation is real property business debt.d. if the debt arises from certain student loans.1-5317. There are many exceptions to the discharge of indebtedness inclusionrule. However, the use of most of these exceptions requires that the taxpayer:a. use the amount of the canceled debt to reduce tax attributes.b. not file for bankruptcy.c. is solvent at the time of the cancellation.d. receive cash management and debt counseling.18. When reducing tax attributes, taxpayers must follow a specific order.What should be reduced first when there is nonrecognition of debt dischargeincome?a. alternative minimum tax credits.b. passive activity losses.c. general business credit carryovers.d. net operating loss.19. The foreclosure rules vary for nonrecourse debt and recourse debt. Uponthe foreclosure of property subject to a recourse loan, how does the borrowertreat the canceled debt?a. as an amount realized regardless of the fair market value of the property.b. as ordinary income.c. as an amount realized up to the fair market value of the property.d. as fully protected by §121.

Answers & Explanations16. When must canceled debt be included in a taxpayer’s gross income?a. Correct. Income from debt discharged prior to the filing of a bankruptcydoes not qualify for the exclusion (and may not be entitled to either the insolvencyor farm debt exclusion). Taxpayers do not include a canceled debt ingross income if the cancellation takes place in a bankruptcy case under title11 of the United States Code.b. Incorrect. Taxpayers do not include a canceled debt in gross income if thecancellation is a qualified farm debt discharged by an unrelated lender.c. Incorrect. Taxpayers do not include a canceled debt in gross income if thecancellation is real property business debt.d. Incorrect. Taxpayers do not include a canceled debt in gross income if thedebt arises from certain student loans. Many states make loans to students onthe condition that the loan will be forgiven if upon completion of study the1-54student will practice a profession in the state. The amount of the loan that isforgiven is excluded from gross income. [Chp. 1]

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17. There are many exceptions to the discharge of indebtedness inclusion rule.However, the use of most of these exceptions requires that the taxpayer:a. Correct. Use of many of the exceptions to the discharge of indebtednessinclusion rule requires that the taxpayer reduce tax attributes by the amountof such canceled debt.b. Incorrect. Cancellation of a debt while in bankruptcy is specifically authorizedas an exception to the discharge of indebtedness inclusion rule.c. Incorrect. Insolvency is specifically authorized as an exception to the dischargeof indebtedness inclusion rule. However, the amount excluded is notmore than the amount by which the taxpayer is insolvent at the moment immediatelyprior to discharge.d. Incorrect. Cash management and debt counseling are requirements of thenew Bankruptcy act. They are not required for an exception to the dischargeof indebtedness inclusion rule. [Chp. 1]18. When reducing tax attributes, taxpayers must follow a specific order. Whatshould be reduced first when there is nonrecognition of debt discharge income?a. Incorrect. Generally, alternative minimum tax credits must be reducedthird when debt discharge income is not recognized.b. Incorrect. Generally, passive activity losses must be reduced sixth whendebt discharge income is not recognized.c. Incorrect. Carryovers in the order in which they arose must be reducedsecond when debt discharge income is not recognized.d. Correct. The net operating loss and capital losses for the current year arereduced first when debt discharge income is not recognized. [Chp. 1]19. The foreclosure rules vary for nonrecourse debt and recourse debt. Uponthe foreclosure of property subject to a recourse loan, how does the borrowertreat the canceled debt?a. Incorrect. This is the rule for nonrecourse debt. For such debts the entireamount canceled is treated as an amount realized.b. Incorrect. When recourse debt is canceled through foreclosure, there istypically a split between the amount realized and ordinary income basedupon the fair market value of the property.c. Correct. For recourse debt, if the fair market value of the property transferredis less than the canceled debt, the amount realized by the owner includesthe canceled debt up to the fair market value of the property. Theowner is only treated as receiving ordinary income from the canceled debt forthat part of the canceled debt not included in the amount realized.

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1-55d. Incorrect. While the amount realized on the foreclosure of a recourse debton a primary personal residence might be excluded from taxation by §121,the ordinary income portion would not receive such protection. [Chp. 1]RecoveriesA recovery is a return of an amount the taxpayer deducted or took a credit for inan earlier year. Generally, part or all of the recovered amounts must be includedin income in the year the recovery is received.The most common recoveries are refunds, reimbursements, and rebates of deductionsitemized on Schedule A (Form 1040). Non-itemized deduction recoveriesinclude such items as payments received on previously deducted bad debts,and recoveries on items previously claimed as a tax credit.If amounts are recovered which were deducted in a previous year that are attributableto itemized deductions and to non-itemized deductions, recompute taxableincome first as shown in the section below on Non-Itemized Deduction Recoveriesbefore determining the amount to include in income as shown in the sectionbelow on Itemized Deduction Recoveries.Note: Interest on any of the amounts recovered must be reported as interestincome in the year received.Recovery & Expense—Same Year: If the refund or other recovery and the deductibleexpense occur in the same year, the recovery reduces the deduction andis not reported as income.Note: Refunds of federal income taxes are not included in income becausethey are never allowed as a deduction from income.Recovery Attributable to 2 or More Years: If a refund or other recovery is foramounts paid in 2 or more separate years, the taxpayer must allocate, on a prorata basis, the recovered amount between the years in which it was paid.This allocation is necessary to determine the amount of recovery attributable toany earlier years and to determine the amount, if any, of allowable deduction forthis item for the current year.1-56ExampleDan paid a 2008 estimated state income tax liability of$4,000 in four equal payments. He made his fourth paymentin January 2008. Dan had no state income tax withheld during2008. In 2009, Dan received a $400 tax refund based onhis 2008 state income tax return. Dan claimed itemized deductionseach year on his federal income tax return.Dan must allocate the $400 refund between 2008 and 2009,

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the years in which he paid the tax on which the refund isbased. Since Dan paid 75% ($3,000 divided by $4,000) of theestimated tax in 2008, 75% of the $400 refund, or $300, is foramounts Dan paid in 2008 and is a recovery item. If all of the$300 is a taxable recovery item, Dan will include $300 on line10, Form 1040, for 2009, and attach a copy of his computationshowing why the amount on line 10 is less than theamount shown on the Form 1099-G, Statement for Recipientsof Certain Government Payments, Dan received from thestate.The balance ($100) of the $400 refund is for his January2009 estimated tax payment. When Dan figures his deductionfor state and local income taxes paid during 2009, he will reducethe $1,000 paid in January by $100. His deduction forstate and local income taxes paid during 2009 will include theJanuary net amount of $900 ($1,000 minus $100), plus anyestimated state income taxes paid in 2008 for 2009, any stateincome tax withheld during 2009, and any tax paid with hisstate income tax return filed in 2009.Itemized Deduction RecoveriesIf any amount is recovered that was deducted in an earlier year on ScheduleA (Form 1040), the taxpayer must determine how much, if any, of the recoveryto include in income1. To determine if amounts deducted in 2008 and recoveredin 2009 must be included in income, the taxpayer must know thestandard deduction for their filing status in 2008.Note: If a state or local income tax refund (or credit or offset) is received in2007, the taxpayer may receive Form 1099-G from the payer of the refund byJanuary 31, 2008. The IRS will receive a copy of Form 1099-G.1 If the taxpayer did not itemize deductions in the year for which they received the recovery, theydo not include any of the recovery amount in income.1-57ExampleIn 2008, Dan filed his income tax return on Form 1040A. In2009, Dan received a refund from his 2008 state income tax.Dan does not report any of the refund as income because hedid not itemize deductions in 2008.Recovery Limited to DeductionThe amount included in income is limited to the lesser of:(i) The amount deducted on Schedule A (Form 1040), or(ii) The amount recovered.Thus, any recovery amount that exceeds the amount deducted in the earlieryear is not included in income.ExampleDuring 2008, you paid $1,200 for medical expenses. Fromthis amount, you subtracted $1,000, which was 7.5% of youradjusted gross income. Your taxable income for 2008 was$9,000. Your actual medical expense deduction was $200. In2009, you received a $500 reimbursement from your medicalinsurance for your 2008 expenses. The only amount of the

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$500 reimbursement that must be included in your income in2009 is $200 - the amount actually deducted.Recoveries Included in IncomeAmounts deducted will be included in income if:(i) The recoveries are equal to or less than the amount by which itemizeddeductions exceeded the standard deduction for the filing status inthe earlier year, and(ii) Taxable income in the earlier year was zero or more2.However, under the tax benefit rule, recoveries included in income willnot be more than the amount deducted.Non-Itemized Deduction RecoveriesIf amounts recovered are due to both itemized deductions and non-itemizeddeductions taken in the same year, the taxpayer must determine the amountsto include in income as follows:2 If taxable income was a negative amount, reduce the includable recovery by the negativeamount.1-58(a) Figure the non-itemized recoveries,(b) Add the non-itemized recoveries to taxable income, and then(c) Figure itemized recoveries.This order is required because taxable income will change and the taxpayermust use taxable income to figure their itemized recoveries.Amounts Recovered for CreditsIf a recovery is received in the current tax year for an item claimed as a taxcredit in an earlier year, the current tax year’s tax must be increased to theextent the credit reduced tax in the earlier year. There is a recovery if there isa downward price adjustment or similar adjustment on the item for which acredit was claimed.Tax Benefit RuleIf an amount is recovered that the taxpayer deducted or took a credit for inan earlier year, include the recovery in income only to the extent the deductionor credit reduced tax in the earlier year.If a deduction reduced taxable income, but did not reduce tax because thetaxpayer either was subject to the alternative minimum tax or had tax creditsthat reduced tax to zero, they will need to recompute the earlier year’s tax todetermine whether they can exclude the recovery amount from income.Income Earned by ChildrenIncome earned by children is taxable to the child (§73). This is true even thoughthe income is paid to the parent rather than the child, and even if under state law

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such income may be the property of the parent rather than the child. However, ifa parent agrees to do a job, and puts the child to work on the job but does notpay the child a salary, the income is taxed to the parent, not to the child. The rationaleis that the third party contracted with the parent, not the child to do thework.ExpensesExpenditures made by the parent, related to the business or activity fromwhich the child’s income is derived, are treated as if made by the child andare deductible on the child’s tax return (§73(b)).Note: The parent has the responsibility to see that an income tax return isfiled on behalf of the child (§6201(c)).AMT for ChildrenA child whose tax is figured on Form 8615 may be subject to the alternativeminimum tax if he or she has certain items given preferential treatment un1-59der the tax law. These items include accelerated depreciation and certain taxexemptinterest income. The AMT may also apply if the child has passive activitylosses or certain distributions from estates or trusts.For taxable years beginning in 2009, for a child to whom the "kiddie tax" applies,the exemption amount under §§ 55 and 59(j) for purposes of the alternativeminimum tax under § 55 may not exceed the sum of:(1) the child's earned income for the taxable year, plus(2) $6,700 (R.P. 2008-66).Unearned Income of Children under 19 - §1(i) [Form 8615]For many years, a favorite tax-planning tool was to shift income-producing assetsfrom parents to their children to take advantage of the lower tax rates of thechildren. The Tax Reform Act of 1986 limited the usefulness of this strategy bytaxing the child’s net unearned income (commonly called investment income) atthe greater of the child’s normal tax rate or the parents’ tax rate.ApplicationA part of a child’s normal investment income may be subject to tax at theparent’s rate if:(1) The child has not reached age 19 (24 for students) at the close of thetax year,(2) Either parent is alive at the close of the year, and(3) The child’s investment income is more than $1,900 (in 2009) for theyear.Definitions

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Child - The term “child” includes a legally adopted child or stepchild, regardlessof whether the child is a dependent. A child is considered to be 18 on theday before his or her 19th birthday.Investment Income - Investment income includes all taxable income otherthan salaries, wages, professional fees, and amounts received as pay for workactually done. A child’s investment income includes investment income producedby property given as gifts to the child under the Uniform Gifts to MinorsAct or Uniform Transfers to Minors Act.Examples of investment income include:(1) Interest, dividend, and capital gains,(2) Income from property received as gifts or inheritances,(3) Certain distributions from trusts, and(4) The taxable portion of social security benefits.1-60Net Investment Income - Net investment income is total investment incomereduced by the sum of the following items:(1) Adjustments to income attributable to investment income (such as apenalty for early withdrawal of savings),(2) $950 (in 2009), and(3) The greater of $950 (in 2009) or the child’s itemized deductions thatare directly connected with the production of investment income (§1(g)).Directly-Connected Itemized Deductions - Directly-connected itemized deductionsare those expenses paid to produce or collect income or to manage,conserve or maintain income producing property that are in excess of the 2%limit on miscellaneous itemized deductions. These expenses include custodialfees, service charges, and investment counsel fees.Tax Computation Steps1. Compute the child’s net investment income.2. Compute the child’s tentative tax on net investment income at the parent’stax rate.a. Compute tax on parent’s taxable income plus child’s net investment income.b. Compute tax on parent’s taxable income without child’s net investmentincome.c. The difference between item a and item b is the tentative tax on thechild’s net investment income.3. Compute child’s income tax on taxable income.a. Compute tax on child’s total taxable income.b. Compute tax on child’s taxable income without net investment income.c. Add tentative tax on child’s net investment income computed in step

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2.c above to tax on child’s income less net investment income computedin step 3.b.d. The greater of step 3.a or step 3.c is the child’s income tax.Other Items & Situations1. Filing status of parentsa. If parents file a joint return for the year, the tentative tax is computedusing total taxable income for both parents.b. If parents are married and file separate returns, the tentative tax iscomputed using the return of the parent with the greater income.c. If parents are divorced, the tentative tax is computed using the incomeof the parent who has custody of the child.1-61ExamplePeter is twelve years old and last year his uncle Dan gavehim bonds that generated interest income of $5,000. Peter’sparents are divorced and he lives with his mother, Pat. Patmust pay income tax on $3,500 ($5,000 minus $1,500) of theinterest income.d. If the parent who has custody of the child has remarried, the tentativetax is computed using the total income of that parent and his or her newspouse.2. More than one childa. Net investment income for all children is added together to computethe tentative tax at the parents’ rate.b. The tentative tax is then allocated to each child based on the ratio ofeach child’s net investment income to net investment income for all thechildren.3. Recomputation of TaxThe child’s tax liability must be re-computed if:(i) The parent’s taxable income is subsequently adjusted, or(ii) More than one child uses the parent’s taxable income and a subsequentadjustment is made to any child’s net investment income.4. Information to compute tentative taxIf the child (or the child’s representative) is unable to obtain the necessaryinformation directly from the parent, the child may, upon written requestto the IRS, obtain sufficient information regarding the parent’s returnto properly prepare the child’s tax return.5. Election to Report Child’s Income on Parents’ ReturnParents may elect to include the child’s income in their return and thechild will not be required to file a return if:(1) The child’s gross income for the tax year is more than $950 and lessthan $9,500 (in 2009);(2) It consists solely of interest and dividends (including Alaska PermanentFund dividends);(3) No estimated tax payments are made for the year in the name andTIN of the child; and(4) No backup withholding has been made (§1(g)(7)(A)).

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Using Form 8814 and attaching it to the parents’ return makes the election.1-62While the election simplifies filing, it results in a higher tax as a familyunit. Since the electing parents increase their income by the amount ofthe child’s investment income above $1,900 (in 2009), their adjusted grossincome is increased affecting such other tax items as:(1) The amount of permissible deductions above the 7.5% floor on deductiblemedical expenses,(2) The 2% floor on miscellaneous itemized deductions,(3) The 10% floor on non-business casualty losses,(4) The phase-out of the deduction for personal exemptions,(5) The reduction of itemized deductions, and(6) Eligibility to make deductible IRA contributions.6. Capital LossesA child’s capital losses are taken into account in determining the child’sinvestment income. Capital losses are first applied against capital gains; ifthe capital losses are more than the capital gains, the difference is a netcapital loss. Net capital losses (up to $3,000) are then subtracted.7. Alternative Minimum TaxThe net unearned income of a child under age 18 that is taxed at the parent’srate is subject to alternative minimum tax in an amount no less thanthe minimum tax that the parents would pay on the income.In the following examples, assume that the child is under 18 and has at leastone parent alive at the end of the year.Example 1The child has the following income:Dividends 600Wages 2,300Taxable interest income 1,200Tax-exempt interest income 100Net capital gains 300Investment income would be $2,100, which is the total of thedividends ($600), taxable interest income ($1,200), and netcapital gains ($300).Example 2The child has investment income of $16,000 and an earlywithdrawal penalty of $100. Itemized deductions of $1,100(net of the 2% floor) are directly connected with the produc1-63tion of her investment income. The net investment income is$14,100 determined as follows:Total investment income 16,000Less:Adjustments to income attributableto investment income (100)$700 (in 2000) deduction (700)Greater of $700 or itemized

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deductions directly connected withthe production of investment income (1,100)Net investment income 14,100

Exclusions from IncomeMany exclusions are provided in §101 through §137, in addition to other sectionsscattered throughout the Code. Often, there is a reason for each exclusion. Someprevent double taxation, others provide incentives for certain activities, and othersprovide indirect welfare payments.Educational Savings Bonds - §135Since 1990, a tax exemption has been provided for intereston U.S. savings bonds used to finance the higher educationof taxpayers, their spouses, or their dependents. If the redemptionproceeds (principal and interest) exceed the educationalexpenses, only a prorata portion of the interest willqualify.Income ExclusionSection 135 allows a taxpayer to exclude from gross income the interestearned on certain Series EE U.S. savings bonds that are redeemed to payqualified higher education expenses. The interest exclusion does not apply tomarried taxpayers filing separately. The exclusion only applies to bonds issued:(i) After December 31, 1989, and(ii) To an individual who is at least 24 years old.Comment: The exclusion is only available to a purchaser who is also theowner of the bonds. The only exception is for bonds owned jointly with aspouse or bonds purchased by one spouse and owned by the other. Thus,1-64bonds purchased by a parent and put in the child’s name don’t qualify nor dobonds bought by a grandparent even if put in the parent’s name.LimitationFor 2009, the amount of your interest exclusion is phased out (gradually reduced)if your filing status is married filing jointly or qualifying widow(er)and your modified adjusted gross income (AGI) is between $104,900 and$134,900. You cannot take the exclusion if your modified AGI is $134,900 ormore.For all other filing statuses, your interest exclusion is phased out if yourmodified AGI is between $69,950 and $84,950. You cannot take the exclusionif your modified AGI is $84,950 or more.MAGIModified adjusted gross income is adjusted gross income without regardto the income earned abroad exclusion (§911) and the §931 and §933 exclusions,

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but after application of the partial inclusion of Social Securitybenefits under §86, the limitation of passive activity losses and credits,and adjustments for contributions to retirement savings (§219).Notice 90-7In Notice 90-7, the IRS issued guidance on educational savings bonds. To beeligible for the exclusion, the bonds must be issued in the name of the taxpayeror in the names of the taxpayer and his spouse. A taxpayer who buys aqualified bond may designate any individual, including a child, as a beneficiaryof the bond payable on death.Education ExpensesQualified higher education expenses are limited to tuition and required feesat eligible educational institutions, not including room and board. Theamount of qualified expenses must be reduced by scholarships, fellowships,veteran’s benefits, and other tax-exempt educational benefits.Excludable InterestThe amount of excludable interest is proportionate to the part of the redemptionproceeds used to pay qualified expenses during the same taxyear as the redemption.Forms 8818 & 8815Form 8818 is used to record the serial number, date of issue, face value,cost, and redemption proceeds when the bonds are redeemed. Taxpayerwill need the information in the Form 8818 to fill out the Form 8815,1-65which is used to figure the amount of interest that can be excluded fromincome.Scholarships & Fellowships - §117An amount received as a qualified scholarship is not included in gross income ifit is granted to a degree candidate at an “educational organization.” Only a candidatefor a degree may exclude amounts received as a qualified scholarshipfrom income (§117).DefinitionsScholarship - A scholarship is an amount to aid a student at an educationalinstitution in the pursuit of studies.Educational institution - An educational institution is one that normally maintainsa regular faculty and course of study and has a regularly enrolled bodyof students in attendance.Fellowship grant - A fellowship grant is an amount to aid a person in the pursuitof study or research.Qualified scholarship- A qualified scholarship is any amount received that is

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used according to the conditions of the grant for:(a) Tuition to enroll in or attend an educational institution, and(b) Fees, books, supplies and equipment required for courses at the educationalinstitution.Note: Amounts used for room and board do not qualify.Scholarship PrizesScholarship prizes won in a contest are not scholarships or fellowships if therecipient does not have to use the prizes for educational purposes. Recipientsmust include these amounts in their gross income whether or not used foreducational purposes (R.R. 65-58; R.R. 68-20).Education ExpensesWhere education expenses are those of a qualified performing artist or arereimbursed by the employer, deductible education expenses are fully deductedas an adjustment to gross income. Otherwise, education expenses areitemized deductions that (except for impairment-related work expenses) aremiscellaneous itemized deductions subject to the 2% of adjusted gross incomelimitation.1-66Education Assistance Programs - §127Employers can set up educational assistance programs under which anemployee may receive tax-free educational benefits of up to $5,250 peryear.Employer Educational Trusts - §83Where an employer contributes to a trust for the purpose of paying theexpenses of the employees’ children attending school, the employee includesthis benefit in income under the restricted property rules. Thus,the amount would be taxable to the employee when it is either transferableby the employee or not subject to a substantial risk of forfeiture.Qualified Tuition Programs (QTP)A distribution from a QTP can be excluded from income if the amount distributedis used for higher education.Gift & Inheritance ExclusionGifts and inheritances are generally excluded from the gross income of the recipient(§102(a)). The donor’s motive determines whether a gift has been made.The motive must be of “detached and disinterested generosity” and the gift mustbe made “out of affection, respect, admiration, charity or like impulses” (Commissionerv Duberstein (1960) 363 US 278).

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The gift transfer must have the following elements:(i) A donor who is competent to make the gift,(ii) A donee that is able to receive the gift,(iii) A clear intent by the donor to make the gift, and(iv) A vesting of legal title in the donee, without the donor’s power of revocation.The exclusion for inheritances applies to property actually received under a willor through intestate succession as well as any other property received that is referableto such inheritance. Will contest settlements are excluded inheritances. Abequest in consideration of past services, however, is taxable income. Executor’sfees are income, but an executor who waives his fees is not taxed on the value ofhis services even though he is also a legatee (R.R. 66-167).Subsequent IncomeAlthough property transferred as a gift or inheritance is excluded from grossincome, the income subsequently earned by the property is includible in therecipient’s gross income (§102(b)(1)). When a gift or inheritance is merely offuture income, then all such income is taxable to the recipient (§102(b)(2)).1-671-68DivorceA transfer of property incident to a divorce to a spouse or former spouse istreated as a tax-free gift. The transfer is incident to a divorce if it occurswithin one year after the parties cease to be married or if it is related to thedivorce (§1041(c)).Business GiftsThe deduction for business gifts is limited to $25 per person per year. Thisdoes not include advertising gifts each costing $4 or less with the taxpayer’sname on them, or any promotional material used in the recipient’s place ofbusiness (§274(b)).EmployeesTransfers of property by an employer to an employee rarely qualify as gifts.However, §132(e) permits holiday gifts to employees where the property is ofa low fair market value. This would include the cost of turkeys, hams, orother merchandise of nominal value distributed at holidays in order to promoteemployee goodwill.InsuranceAmounts paid under an insurance contract by reason of an insured’s death areexcluded from gross income (§101(a)). Life insurance proceeds are excluded regardlessof who paid the premiums. Moreover, the exclusion applies regardless

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that the proceeds are paid to the insured’s estate, family, creditors, or to thepartnership or corporation of which the insured was a member (Reg. §1.101(a)).The Code does not define life insurance, however, the Supreme Court has indicatedthat life insurance involves “risk-shifting and risk-distributing” (Helvering v.Le Gierse, 312 U.S. 531 (1941)). Thus, when a contract does not shift any risk ofpremature death to the insurance company, it is not life insurance (R.R. 65-57).ExceptionsPurchase for ValueThe exclusion for life insurance does not cover the purchase of an existingpolicy for consideration (§101(a)(2)). However, this exception does notapply if the purchaser is the insured himself, his partner or partnership, ora corporation in which the insured is a member or officer.1-69ExampleDan owns a policy on his own life and sells it to Bambi, thegold digger. Bambi pays the future premium payments. Dannow dies. The proceeds are taxed to Bambi, except Bambican recover her basis in the policy - i.e., the purchase priceplus subsequent premiums (§101(a)(2)).Installment PaymentsWhen the death benefits are payable by the insurer in installments, andthe unpaid balance bears interest, that portion of the installment representinginterest is taxable. The balance is exempt (§101(c) & (d)).To determine the excluded part, divide the amount held by the insurancecompany (generally the total lump sum payable at the death of the insuredperson) by the number of installments to be paid. Include anythingover this excluded part in income as interest.Specified Number of InstallmentsIf a taxpayer is entitled to receive a specified number of installmentsunder the insurance contract, figure the excluded part of each installmentby dividing the amount held by the insurance company by thenumber of installments to which the taxpayer is entitled3.ExampleThe face amount of the policy is $75,000, and as beneficiary,Dan chooses to receive 120 monthly installments of $1,000each. The excluded part of each installment is $625 a month($75,000 divided by 120) or $7,500 for an entire year. Therest of each payment, $375 a month (or $4,500 for an entireyear), is interest income.Specified Amount PayableIf each installment received under the insurance contract is a specificamount, figure the excluded part of each installment by dividing theamount held by the insurance company by the number of installments

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necessary to use up the principal and guaranteed interest in the contract.3 A secondary beneficiary is entitled to the same exclusion.1-70ExampleAs beneficiary, Dan chooses to receive $40,000 of proceedsin 10 annual installments of $4,000 plus $400 of guaranteedinterest each year. During the year Dan receives $4,400. Hecan exclude from gross income $4,000 ($40,000 divided by10) as a return of principal. The rest of the installment, $400,is taxable as interest income.Installments for LifeIf, as the beneficiary under an insurance contract, a taxpayer is entitledto receive the proceeds in installments for the rest of their life withouta refund or period-certain guarantee, figure the excluded part of eachinstallment by dividing the amount held by the insurance company bythe taxpayer’s life expectancy. If there is a refund or period-certainguarantee, the amount held by the insurance company for this purposeis reduced by the actuarial value of the guarantee.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.1-7120. Deductions for items taken in earlier years but later recovered typicallymust be included in income in the year of the recovery. However, the requiredrecomputation of income is complex and must be ordered basedupon:a. the filing status of the taxpayer.b. the regular and alternative minimum tax.c. the reduction in tax attribute rules.

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d. whether the deductions were itemized or non-itemized.21. As a result of the “kiddie” tax, parents will likely shift fewer incomeproducingassets to their children who are under age 19. The reasoning forthis is that these children’s net unearned income is taxed at the greater of:a. the child's highest tax rate or the parents' lowest tax rate.b. the child's alternative minimum tax rate or the parents' regular tax rate.c. the usual tax rate for the child or the tax rate of the parents.d. the child's tax rate for the previous year or the parents' tax rate for thecurrent year.22. Section 117 scholarships granted to qualified students are tax free to theextent they are used to cover qualified expenses. For example, scholarship incomecould be used to pay for:a. required books.b. research or clerical help.c. room and board.d. travel.23. A §529 qualified tuition program is an investment vehicle allowing individualsto make contributions to accounts for a beneficiary’s qualified educationalexpenses. What rule applies when qualified higher education expensesare paid using a distribution from a qualified tuition program?a. The contributions are deductible to the contributor at that time.b. The distribution is free from income tax.c. The earnings portion is subject to a 10% additional tax.d. The entire distribution is includible in beneficiary’s income.24. At least nine items are identified in the course material as exclusionsfrom income. Which of the following is one such item?a. wages and salary.b. inheritances.c. IRA distributions.d. royalties.1-72

Answers & Explanations20. Deductions for items taken in earlier years but later recovered typicallymust be included in income in the year of the recovery. However, the requiredrecomputation of income is complex and must be ordered basedupon:a. Incorrect. While the filing status of the taxpayer may determine theamount or the effect of the recovery, it does not dictate the ordering of therecovery computation.b. Incorrect. Recoveries may impact the recomputed regular and alternative

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minimum tax. However, these taxes do not affect the ordering of the recomputation.c. Incorrect. The reduction in tax attributes rules are applicable to debt cancellationand do not apply to the recomputation of income under the recoveryprovisions.d. Correct. Recovered itemized and non-itemized deductions have differentmethods for income recomputation. If amounts recovered were attributableto itemized deductions and to non-itemized deductions, taxable income mustbe first recalculated on the non-itemized deduction recoveries before determiningthe amount to include in income on the itemized deduction recoveries.[Chp. 1]21. As a result of the “kiddie” tax, parents will likely shift fewer incomeproducingassets to their children who are under age 19. The reasoning forthis is that these children’s net unearned income is taxed at the greater of:a. Incorrect. This "high-low" formula is not used in calculating a child's unearnedincome taxation.b. Incorrect. The competing alternative minimum tax and regular tax systemsare not compared in determining a child's unearned income taxation.c. Correct. For a child under age 19, their net unearned income (commonlycalled investment income) is taxed at the greater of the child’s normal tax rateor the parents’ tax rate. Investment income includes all taxable income otherthan salaries, wages, professional fees, and amounts received as pay for workactually done.d. Incorrect. This tax "straddle" formula and comparison of tax years is notused to calculate a child's unearned income taxation. [Chp. 1]22. Section 117 scholarships granted to qualified students are tax free to theextent they are used to cover qualified expenses. For example, scholarshipincome could be used to pay for:1-73a. Correct. Scholarships granted to qualified students are tax free to the extentthey are used to cover tuition, fees, and required books, supplies, andequipment.b. Incorrect. Grants for research or clerical help are taxable. This is consideredpayment for services and wages are salary.c. Incorrect. Grants for room and board are taxable. Such expenses are notincluded within the scholarship exemption.d. Incorrect. Grants for travel are taxable. Travel costs are not included

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within the scholarship exemption. [Chp. 1]23. A §529 qualified tuition program is an investment vehicle allowing individualsto make contributions to accounts for a beneficiary’s qualified educationalexpenses. What rule applies when qualified higher education expensesare paid using a distribution from a qualified tuition program?a. Incorrect. Contributions to a §529 qualified tuition account are not deductible.b. Correct. Under §529, when qualified higher education expenses are paidfrom a distribution from a qualified tuition program, no portion of the distributionis subject to income tax.c. Incorrect. When a distribution from a qualified tuition program is not usedto pay for qualified higher education expenses, the earnings portion is subjectto a 10% additional tax. However, certain exceptions to this rule apply.d. Incorrect. If a distribution from a qualified tuition program is not used topay for qualified higher education expenses, the earnings portion is subject tofederal income tax. Contributions are not includible in income of the designatedbeneficiary because they are made on an after-tax basis. [Chp. 1]24. At least nine items are identified in the course material as exclusions fromincome. Which of the following is one such item?a. Incorrect. Wages and salary are a form of taxable income.b. Correct. Amounts received in the form of gifts or inheritances are not includedin taxable income.c. Incorrect. A common example of a tax-deferred investment is the IRA,which allows many workers to invest money each year for their retirement.The amount they invest in the plan each year is a tax deduction. Further, theearnings on such funds are not taxed until withdrawn.d. Incorrect. Royalties are a type of taxable income. [Chp. 1]1-74Personal Injury Awards - §104Damages received on account of personal injury or illness are tax-free under§104. Damages received because of a physical injury or sickness, or in an actionbased on a claim that is attributable to a physical injury or sickness, are treatedas payments for physical injury or sickness under §104.Note: Those damages are excluded from income even if the person receivingthe damages is not the person injured.There are three main categories of damages related to personal injuries:(1) Damages on account of personal injury or illness,

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(2) Punitive damages, and(3) Interest on a personal injury award.Personal InjuryThe exclusion under §104 is available only if there is physical injury or illness.The statute does not define the term “personal injury,” so much controversysurrounds the taxation of this type of compensation. However, damage recoveriesfor nonphysical injuries are included in income.Emotional DistressEmotional distress is not considered a physical injury or physical sickness.However, damages awarded for a claim of emotional distress that resultsfrom a physical injury are excluded from income.1-75Punitive DamagesAll punitive damages for personal injury or sickness are includable income,whether or not related to a physical injury or physical sickness.Tax Benefit Rule - §111Income attributable to the recovery of an amount deducted in a prior year is notincluded in gross income to the extent such amount did not reduce the tax owedby the taxpayer. The recovery is included in gross income only to the extent thatthe taxpayer received a tax benefit (§111).Interest State & Local Obligations - §103Section 103, enables the federal government to subsidize state and local governmentsby excluding interest earned on the state and local obligations from tax.Thus, state and local governments can offer a lower interest rate, since investorsrequire a lower yield on tax-free investments than they do on taxable investments.Foreign Earned Income Exclusion - §911Worldwide income of a U.S. citizen is subject to U.S. tax. In addition, a foreigncountry can tax foreign income. Without any relief, the income could be subjectedto double taxation. The Code provides two relief provisions:(1) The foreign tax credit, which allows a taxpayer to claim a credit againstU.S. taxes for foreign taxes paid, and(2) The foreign earned income exclusion, which allows a taxpayer to excludeforeign earned income.Foreign earned income is compensation from personal services rendered in aforeign country during periods while the bona fide residence or 330-day test is

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satisfied. Section 911 requires that the bona fide resident status must be for anuninterrupted period that includes a full year.The exclusion is limited to $91,400 (in 2009) per year. If a husband and wife bothqualify for the foreign earned income exclusion, each has a separate exclusionavailable, and community property rules do not apply.Note: If the foreign earned income exclusion is elected, the foreign tax creditcannot be claimed for the foreign tax allocated to the excluded income.

Nonbusiness & Personal DeductionsThe income tax is a tax on net rather than gross income. Thus, after gross incomeis determined deductions from income must be calculated.1-76There are three categories of deductions:(1) Deductions related to a trade or business, including an employee’s business-related expenses (§162);(2) Nonbusiness deductions related to investments and to the production ofnonbusiness income (§212); and(3) Personal deductions specifically provided for by the Code.Note: Nonbusiness and personal deductions are deductible even though theyhave no connection to a trade or business.Deductions are either:(1) “Above the line” deductions, which are deducted from gross income, or(2) “Below the line” deductions, which are deducted from adjusted gross income(AGI).Section 62 lists the following fifteen “above the line” deductions available to arriveat AGI:(1) Trade and business deductions;(2) Reimbursed employee deductions and certain expenses of performingartists;(3) Losses from the sale or exchange of property;(4) Deduction attributable to rents and royalties;(5) Certain deduction of life tenants and income beneficiaries of property;(6) Pension, profit sharing, and annuity plans of self-employed individuals;(7) Retirement savings;(8) Certain portion of lump-sum distributions from pension plans taxed under§402(e);(9) Penalties forfeited because of premature withdrawal of funds from timesavingaccounts or deposits;(10) Alimony;

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(11) Reforestation expenses;(12) Certain required repayments of supplemental unemployment compensationbenefits;(13) Jury duty pay remitted to employer;(14) Deduction for clean fuel vehicles and certain refueling property; and(15) Moving expenses allowed as a deduction under §217.Itemized DeductionsTaxpayers may choose to claim itemized deductions or the standard deduction.If total itemized deductions are more than the standard deduction, itemize deductions.Taxpayers can benefit from itemizing deductions on Schedule A ofForm 1040 if they:1-77(1) Do not qualify for the standard deduction, or the amount they can claimis limited,(2) Had large uninsured medical and dental expenses during the year,(3) Paid interest and taxes on their home,(4) Had large unreimbursed employee business expenses or other miscellaneousdeductions,(5) Had large casualty or theft losses not covered by insurance,(6) Had large moving expenses,(7) Made large contributions to qualified charities, or(8) Have total itemized deductions that are more than the highest standarddeduction to which they otherwise are entitled.LimitationItemized deductions (after all other restrictions have been applied) are reducedby 3% of AGI in excess of certain amounts (§68).Otherwise allowable itemized deductions are reduced if adjusted gross incomein 2009 is more than:All Returns Except MFS $166,800 (up from $159,950 in 2008)Married Filing Separately $83,400 (up from $79,975 in 2008)Section 68 covers most deductions including those for home mortgage interest,state and local taxes, charitable donations, and miscellaneous itemizeddeductions such as tax-return preparation and employee business expenses.However, §68 does not affect medical expense, casualty and theft loss, andinvestment interest deductions.The limitation applies only to individual taxpayers and cannot reduce a taxpayer’sitemized deductions below the sum of his allowable medical expense,

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casualty and theft loss, investment interest deductions, plus 20% of the otheritemized deductions.Formula for Deductions AllowedTotal Itemized Deductions Otherwise AllowableLess the Sum of:(1) Medical Expenses (after 7.5% AGI floor)(2) Casualty Losses (after 10% AGI floor), and(3) Investment Interest Expense (after limitation)Equals:Itemized Deductions Subject to §68 Limit1-78Less the Lesser of:(1) 80% of Itemized Deductions Subject to §68 Allowed, or(2) 3% of AGI in Excess of the Threshold AmountEquals:Minimum Itemized Deductions Subject to §68 Ceiling AllowedPlus the Sum of:(1) Excess Medical Expenses(2) Excess Casualty Losses(3) Investment Interest ExpenseEquals:Net Itemized Deductions AllowedSince 2006, this overall limitation on itemized deductions is gradually beingrepealed or phased out. The gradual repeal is over a five year period. For taxyears beginning in 2006 and 2007, the limitation was reduced by one-third,and, for tax years beginning in 2008 and 2009, the limitation will be reducedby two-thirds. After 2009, the repeal will be fully in effect and the limitationon itemized deductions will no longer apply.Note: Thus, after the regular limitation is determined, taxpayers must takean additional step of multiplying the limitation by 2/3 for tax years beginningin 2006 and 2007 or by 1/3 for tax years beginning in 2008 and 2009.

Personal & Dependency ExemptionsThere are two types of exemptions:(1) Personal exemptions, and(2) Dependency exemptions (§151(b), (c)).While these are both worth the same amount, different rules apply to each type.Personal ExemptionsTaxpayers are allowed one exemption for themselves (unless they can beclaimed as a dependent by another taxpayer) and, if married, one exemptionfor their spouse (§151(d)(2)). These are called personal exemptions.If another is entitled to claim the taxpayer as a dependent, the taxpayer maynot take an exemption for himself or herself. This is true even if the othertaxpayer does not actually claim the exemption (§151(d)(2)).Dependency Exemptions

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Taxpayers are allowed one exemption for each person they can claim as adependent (§151(c)).1-79Before 2005Prior to 2005, a person was a dependent if all five of the following dependencytests were met:(1) Member of household or relationship test,(2) Citizenship test,(3) Joint return test,(4) Gross income test, and(5) Support test.After 2004Since 2005, the Working Family Relief Act of 2004 provides a unifieddefinition of a "qualified child" for purposes of the dependency exemption,child tax credit, earned income credit, dependent care credit, andhead of household status. In general, tests involving residency and relationshipwill be the same across-the-board. However, some provisions(e.g., child tax credit) will continue to use different ages.Note: If a potential dependent is not a "qualified child" they may be a "qualifiedrelative." For "qualifying relatives" the old gross income, support, jointreturn and citizenship/residency tests still exist. There are eight categories ofsuch "relatives." Non-relatives that live with the taxpayer during the entireyear also qualify.The "qualified child" definition is based on four tests:(1) residency (and citizenship),(2) relationship,(3) age, and(4) joint return prohibition.There is no support (unless the child provides more than half of their ownsupport) or gross income test. Instead, the child must have the same principalplace of abode as the claimant for more than half the year.Residency TestThe child must live with the claimant for more than half of the year.However, temporary absences due to education, business, vacation,military service or illness are not counted as absences. Thus, a studentat college is not necessarily absent.CitizenshipTo meet the citizenship test, a person must be a U.S. citizen or resident,or a resident of Canada or Mexico, for some part of the calendaryear in which the taxpayer’s tax year begins (§152(b)(3); Reg.§1.152-2(a)).1-80Relationship TestThe potential dependent must be related to the claimant as a:

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(1) child or descendent of a child,(2) brother, sister, stepbrother, stepsister, or a descendent of anysuch relative,(3) brother or sister by half blood,(4) foster child, or(5) adopted child.Note: Not all the above are necessarily biologically or legally children.Age TestThe potential dependent meets the age test if they are:(1) under age 19 at the close of the calendar year,(2) a full-time student (at least parts of five months during the year)under age 24 at the close of the calendar year, or(3) permanently and totally disabled.Joint Return ProhibitionEven if the other dependency tests are met, a taxpayer is not allowedan exemption for their dependent if he or she files a joint return(§151(c)(2)).ExampleDan supported his daughter for the entire year while her husbandwas in the Armed Forces. The couple files a joint return.Even though all the other tests are met, Dan may not take anexemption for his daughter.ExceptionIf the other dependency tests are met, a taxpayer may take an exemptionfor their married dependent who files a joint return if:(1) Neither the dependent nor the dependent’s spouse is requiredto file a return,(2) Neither the dependent nor the dependent’s spouse would havea tax liability if they filed separate returns, and(3) They only file a joint return in order to get a refund of tax withheld(§151(c)(2); Reg. §1.151-2(a); R.R. 65-34).1-81Phaseout of ExemptionsMost taxpayers can take personal exemptions for themselves and an additionalexemption for each eligible dependent. An individual who qualifiesas someone else’s dependent cannot claim a personal exemption, andthough personal and dependency exemptions are phased out for higherincometaxpayers, the phase-out rate for 2009 is slower than in past years.For 2009, the phaseout begins at:Married Filing Jointly $250,200 (up from $239,950 in 2008)Surviving Spouse $250,200 (up from $239,950 in 2008)Head of Household $208,500 (up from $199,950 in 2008)Single $166,800 (up from $159,950 in 2008)Married Filing Separately $125,100 (up from $119,975 in 2008)All exemption amounts claimed on a return are reduced by 2% (4% if

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married filing separately) for each $2,500 (or fraction thereof) of AGI inexcess of the above threshold amount. As a result, exemption deductionsare completely eliminated when AGI exceeds the AGI threshold amountby more than $122,500 ($61,250 for married individual filing separately).Note: It takes 50 two-percent reductions to achieve a 100-percent reduction.Since 49 two-percent reductions would result from an excess of $122,500 (49x $2,500 = $122,500), any excess above $122,500 would be a fraction of a$2,500 amount and create the 50th two-percent reduction.Since 2006 is this phaseout is gradually being eliminated. The phaseoutwas reduced by one-third in 2006 and 2007, will be reduced two-thirds in2008 and 2009, and will be completely eliminated in 2010.Interest Expense - §163The tax law creates several categories of interest expense including:1. Personal interest - Personal interest is nondeductible and thus, the least desirabletype of interest.2. Investment interest expense - Deductions for investment interest are limitedto net investment income. However, amounts disallowed are carried forwardto future years.3. Interest expense attributable to passive activities - Deductions related to passiveactivities are limited by complex passive loss rules. However, amountsdisallowed are carried forward to future years (§469).4. Qualified residence interest - Home mortgage interest is one of the mostpopular types of interest. In general, it is fully deductible subject to certainceiling limitations.1-825. Business interest - Business interest is attributable to a trade or businessand is normally fully deductible (§162).Personal Interest - §163(h)(1)DefinitionPersonal interest is all interest other than:(a) Interest on trade or business debt (other than the trade or businessof being an employee),(b) Qualified residence interest,(c) Investment interest,(d) Interest considered in computing income or loss from a passive activity,and(e) Interest on estate tax payments deferred because reversionary interestor closely held business interest is included in the estate.DeductibilityPersonal is not deductible. Starting in 1987, the deduction for personal interestwas phased-out over a four-year period ending in 1991:Taxable yearsbeginning in Deduction allowed

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1987 65%1988 40%1989 20%1990 10%1991 0%Examples of personal interest:a. Interest on a loan to purchase the family car (including an employeebusiness auto)b. Interest on individual income taxesc. Interest on credit cards used for personal expensesNote: Personal interest is also not deductible for alternative minimumtax purposes.Investment Interest Expense - §163(d)DefinitionsInvestment interest expense includes:(1) Interest expense incurred on indebtedness to purchase or carryproperty held for investment, including any amount allowable as a deductionin connection with personal property used in a short sale,1-83(2) Interest allocable to portfolio income under the passive loss rules,and(3) Interest allocable to an activity involving a trade or business, inwhich the taxpayer does not materially participate, if not treated aspassive under the passive loss rule.Net investment income is the excess of investment income over investmentexpenses.Investment income is the gross income from property held for investment,including any gain attributable to disposition of property held for investment,but only to the extent the gross income is not derived from the conductof a trade or business.Investment income also includes gross portfolio income under the passiveloss rule, and income from trade or business activities in which the taxpayerdoes not materially participate, if the activities are not treated aspassive under the passive loss rule.Note: The amount of passive loss allowed for rental real estate activity inwhich the taxpayer actively participates does not reduce investment income.Investment expenses are the deductible expenses, other than interest, directlyconnected with the production of investment income. These expensesare treated as miscellaneous itemized deductions subject to the2% of adjusted gross income floor and are deductible only to the extentthey exceed that floor. For such purposes, miscellaneous itemized deductionsother than investment expenses are taken into account first in determiningthe expenses disallowed by the 2% rule.Net Investment Income LimitationInvestment interest is deductible to the extent of net investment income.

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Investment interest expense disallowed is carried forward to subsequentyears. However, investment interest expense carried forward can be deductedonly against net investment income.Note: Prior to 1987, investment interest expense was deductible to the extentof net investment income plus $10,000 ($5,000 for marrieds filing separately).This additional $10,000 allowance was phased out from 1987 through1990.For purposes of the alternative minimum tax, investment interest expenseis also deductible only to the extent of net investment income.Qualified Residence Interest - §163(h)(3) [Form 8598]The Tax Reform Act of 1986 created numerous rules dealing with interestexpense paid on personal residences. These rules were further modified by1-84later legislation. Nevertheless, qualified residence interest is exempt from thelimitations on personal, investment, and passive activity interest.DefinitionsA qualified residence is the taxpayer’s principal residence and/or a secondresidence selected by the taxpayer for the taxable year. The taxpayer mustown the home in order for it to qualify. A home can include a house, cooperativeapartment, condominium, house trailer, or boat, provided it includesbasic living accommodations, including sleeping space, toilet, andcooking facilities.A principal residence is a residence that would qualify for nonrecognitionof gain on an old rollover sale (§1034 - now repealed). The taxpayer cannothave more than one principal residence at one time.A second residence is one that is not occupied, occupied part of the year,or rented out during the year. If the home was rented out during the year,it may qualify if the taxpayer uses the home the greater of 14 days or 10%of the number of days during the year that it was rented at a fair rental. Ifthe home was not rented out during the year, there is no usage requirementand the home can be considered a second residence.If the taxpayer has more than one residence that would qualify as a secondresidence, the taxpayer can select which home will be a qualified secondresidence. This selection is made each year without regard to thehome selected as a second residence in prior years. Generally, a taxpayercannot elect different residences as the second residence at differenttimes of the same tax year.Qualified residence interest is interest on debt that is secured by the taxpayer’sprincipal residence or second residence subject to certain limitations.In most states, the security must be recorded.LimitationsQualified residence interest includes acquisition indebtedness and homeequity indebtedness on a taxpayer’s principal and second residences.

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Note: Amounts not deductible as qualified residence interest due to the limitationsimposed are generally treated as personal interest. Form 8598 is usedto calculate amounts deductible as qualified residence interest.Acquisition IndebtednessAcquisition indebtedness is debt incurred in acquiring, constructing, orsubstantially improving principal or second residences. Aggregate acquisitionindebtedness cannot exceed $1,000,000 ($500,000 for marriedsfiling separately). Acquisition indebtedness is reduced as paymentsof principal are made and cannot be increased by refinancing.1-85However, if a taxpayer refinances the acquisition indebtedness, thenew debt is considered acquisition indebtedness to the extent of theold debt immediately before refinancing.Any debt incurred before October 14, 1987, which is secured by a qualifiedresidence on October 13, 1987 and at all times thereafter, is consideredacquisition indebtedness. This debt is also not limited by the$1,000,000 acquisition indebtedness limitation. However, the pre October14, 1987 debt does reduce the amount available under the$1,000,000 limitation on acquisition indebtedness.ExampleA pre October 14, 1987 debt of $1,500,000 would leave $-0-for acquisition indebtedness for the second home. A pre October14, 1987 debt of $600,000 would leave $400,000 leftthat could be used for the acquisition indebtedness for a secondhome.Home Equity IndebtednessHome equity indebtedness is debt other than acquisition indebtednesssecured by a qualified residence. Interest on home equity indebtednessis deductible regardless of the use of the proceeds. The aggregateamount of debt treated as home equity indebtedness cannot exceed$100,000 ($50,000 for marrieds filing separately). However, the aggregateamount of acquisition indebtedness and home equity indebtednesscannot exceed the fair market value of the residences.Note: There are no special limitations for debt incurred to pay expensesfor educational or medical purposes.RefinancingIf a taxpayer takes out a loan that qualifies as acquisition debt and, subsequently,takes out a second loan, which is used to refinance the first loan,the second loan will qualify as acquisition indebtedness up to the amountof the first loan. Any excess of the second loan over the first loan will betreated as home equity indebtedness, subject to the $100,000 limit on suchdebt.Exception: If the excess of the new debt over the old debt is used to makesubstantial improvements to the residence, the entire debt can be treated asacquisition indebtedness.1-86Home Improvements

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Expenses that qualify as home improvements can be used to determinethe amount of interest deductible as acquisition indebtedness. Generally,an improvement to the home adds to the value of the home, prolongs itsuseful life, or adapts it to new uses.Examples of Improvements:(1) Putting a recreation room in an unfinished basement,(2) Paneling a den,(3) Adding a bathroom or bedroom,(4) Putting decorative grillwork on a balcony,(5) Putting up a fence,(6) Putting in new plumbing or wiring,(7) Putting in new cabinets,(8) Putting on a new roof, and(9) Paving a driveway.The taxpayer should save all receipts and other records for any improvements,additions, and other items that affect the basis of the home for atleast three years after the home is sold or disposed of. In fact, it is a wisepractice to permanently retain records dealing with a property’s basis.TimingDebt incurred before the date the improvement is completed may betreated as acquisition indebtedness for the amount of expenditures forthe improvements that are made not more than twenty-four months afterthe date of the debt.Debt incurred after the improvement is completed may be treated asacquisition indebtedness if it is taken out within ninety days after completion.Additionally, the debt can only be for improvement costs thatare made within twenty-four months before the completion of the improvement.Debt is generally considered incurred on the date that loanproceeds are disbursed.ExampleOver a period of four months, you make a substantial improvementto your residence, paying cash. Within ninety daysafter completion, you take out a mortgage loan in the amountof the cost of the improvement. The loan qualifies as acquisitionindebtedness.1-87ExampleYou begin building a home using $150,000 of your ownfunds. Prior to completion of construction, you take out amortgage loan of $150,000 and keep the money. The loan istreated as incurred to construct a residence and qualifies fortreatment as acquisition indebtedness.Alternative Minimum TaxFor alternative minimum tax purposes, the term “qualified housing interest”is substituted for “qualified residence interest.” Qualifying housing

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interest is interest on a secured debt that is incurred for the purpose ofacquiring, constructing, or substantially rehabilitating the taxpayer’s residence,or a qualified second residence. The qualified second residencemust be used as a dwelling by the taxpayer or member of the taxpayer’sfamily.If the debt was incurred before July 1982, and secured by the property,then the interest is qualified housing interest and deductible for AMTpurposes without tracing the purpose of incurring the debt.In addition, qualified housing interest also includes the interest on a debtto refinance a prior debt that qualified.ExampleThe taxpayer buys a home for $1.1 million and borrows$880,000 to finance the purchase. After making paymentson the debt for 10 years, the remaining balance on March 3,2002 is $680,000. He refinances and takes out a new mortgageon March 4, 2003 for $1,200,000.a. Assume the fair market value of the house is greater than$1.2 million and the taxpayer used the excess proceeds ofthe new debt for personal expenditures. The amount of acquisitiondebt would be $680,000, the home equity debtwould be $100,000, and the $420,000 would be personaldebt.b. Assume the same facts as in (a) except that $300,000 wasused to substantially improve the house. The amount of acquisitiondebt would be $980,000 ($680,000 + $300,000), thehome equity debt would be $100,000, and $120,000 would bepersonal debt.c. Assume the same facts as in (b) above except the fair marketvalue of the house is $1,000,000. Acquisition debt wouldbe $980,000, home equity debt would be $20,000($1,000,000 - $980,000), and personal debt would be$200,000.1-88PointsPoints that are in the nature of an additional interest charge constitute prepaidinterest. As such, they must be capitalized by a cash-basis taxpayer anddeducted ratably over the term of the loan if incurred in a business transaction,the same as if the taxpayer were on the accrual basis (§461(g)(1)).Points charged for specific services by the lender for the borrower’s accountare not interest. Examples of fees for services not considered interest are:(i) Lender’s appraisal fee,(ii) Preparation costs for the mortgage note or deed of trust,(iii) Settlement fees, and(iv) Notary fees.Points charged for services for getting a Department of Veterans Affairs(VA) or Federal Housing Administration (FHA) loan are not interest.Note: The term “points” is also used to describe loan placement fees that the

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seller may have to pay to the lender to arrange financing for the buyer. Theseller may not deduct these amounts as interest. However, these charges area selling expense that reduces the amount realized.Home Purchase & Improvement ExceptionPoints can be currently deductible if paid on indebtedness incurred inconnection with the purchase or improvement of the taxpayer’s principalresidence, provided the indebtedness is secured by the residence.Note: Points paid to refinance an existing home mortgage are incurred forthe purpose of repaying an existing indebtedness, not to purchase or improvea home. Such points do not qualify.To meet this exception taxpayer must meet all of the following tests:(1) The loan must be secured by taxpayer’s main home (i.e., the onelived in most of the time);(2) Paying points is an established business practice in the area wherethe loan was made;(3) The points paid were not more than the points generally charged inthat area;(4) Taxpayer uses the cash method of accounting;(5) The points were not paid in place of amounts that ordinarily arestated separately on the settlement statement, such as appraisal fees,inspection fees, title fees, attorneys fees, and property taxes;(6) The funds provided by taxpayer at or before closing, plus any pointsthe seller paid, were at least as much as the points charged;(7) The loan proceeds are used to buy or build the taxpayer’s mainhome;1-89(8) The points were computed as a percentage of the principal amountof the mortgage; and(9) The amount is clearly shown on the settlement statement as pointsfor the mortgage.If a taxpayer meets all of these tests, they can choose to either fully deductthe points in the year paid, or deduct them over the life of the loan.RefinancingGenerally, points paid to refinance a mortgage are not deductible infull in the year paid. This is true even if the new mortgage is secured bythe main home.However, if the taxpayer uses part of the refinance mortgage proceedsto improve their main home and they meet the first six tests set forthabove, they can fully deduct the part of the points related to the improvementin the year they paid them with their own funds. The rest ofthe points can be deducted over the life of the loan.Huntsman CaseIn Huntsman, 905 F. 2d 1182 (8th Cir. 1990), the Eighth Circuit heldthat points on an acquisition-related home refinance loan, obtainedthree years after the purchase of the home, could be deducted.Note: In February 1991, the IRS issued an action on decision stating

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that because an inter circuit conflict did not exist it would not appealHuntsman. However, the Service also said it won’t follow the holdingoutside of the Eighth Circuit (which covers Arkansas, Iowa, Minnesota,Missouri, Nebraska and North and South Dakota).Mortgage Interest Statement - R.P. 92-11If a taxpayer paid $600 or more of mortgage interest (including certainpoints) during the year on any one mortgage, they generally will receive aForm 1098, Mortgage Interest Statement, or a similar statement from themortgage holder. A taxpayer will receive the statement if they paid interestto a person (including a financial institution or a cooperative housingcorporation) in the course of that person's trade or business. A governmentalunit is a person for purposes of furnishing the statement.Note: The statement should be received for each year by January 31 of thefollowing year. A copy of this form will also be sent to the IRS. This statementwill show the total interest paid during the year. If a main home waspurchased during the year, it will also show the deductible points paid duringthe year, including seller paid points.Allocation of Interest Expense1-90Generally debt is allocated to the proper category of interest incurred by thetaxpayer by tracing disbursements of the debt proceeds to specific expenditures.The type of property that secures the debt doesn’t matter unless it is ahome mortgage or is tax exempt. Due to the variety of limits imposed on interestdeductions, the IRS has provided special allocation rules to be used todetermine the proper category of interest.All taxpayers other than non-closely held regular (subchapter C) corporationsmust allocate interest. In addition, the interest allocation rules apply forthe purpose of applying limitations for passive losses, investment interest,and personal interest.Under the interest allocation rules, accrued interest is treated as a debt untilit is paid. Compound interest accruing on such debt may be allocated betweenthe original expenditure and the new expenditure on a straight-line basis(i.e., by allocating an equal amount of such interest expense to each dayduring the taxable year). In addition, a taxpayer may treat a year as consistingof twelve 30-day months for purposes of allocating interest on a straight-linebasis.Allocation starts when the taxpayer uses the proceeds and ends when thedebt is repaid or reallocated, whichever is earlier.ExampleOn January 1, the taxpayer borrows $1,000 and uses themoney to buy an investment security. On July 1, the taxpayersells the security for $41,000 and buys shoes with themoney. On December 31, the taxpayer pays $140 of accruedinterest on the $1,000 debt for the entire year.

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1-91Interest expense is allocated to investment expenditures fromJanuary 1 to June 30 and to personal expenditures from July1 to December 31. The taxpayer would therefore have $70 ofinvestment interest expense and $70 of personal interest expense.Interest on a debt may accrue before the taxpayer actually receives the debtproceeds, or before the taxpayer uses the debt proceeds to make an expenditure.During this pre-receipt (or pre-use) period, the debt is allocated to aninvestment expenditure.Debt proceeds that are deposited into a depositor’s account that containsunborrowed funds are treated as being withdrawn first when expenditures aremade.ExampleDavid borrows $1,000 and puts the money in his checkingaccount, which already contains $740, money that David hassaved. The next day, David withdraws $75 cash. The day afterthat, David uses $1,000 from the account to buy a bond.The $75 cash withdrawal would be treated as an expenditureof the debt proceeds.Generally, if the proceeds of two or more loans are deposited into the sameaccount, subsequent expenditures are treated as coming from the borrowedfunds in the order in which they were deposited.Note: A borrower may elect to treat any expenditure made within 15 days afterloan proceeds are deposited into the account as having been made fromthe proceeds of that loan.In an account containing only the proceeds of a debt and the interest earnedon those proceeds, the taxpayer may treat expenditures from the account asbeing made first from the interest earned. Debt proceeds deposited into anaccount are treated as investment property until those funds are expended.Note: The rules for allocation of debt apply separately to each account of thetaxpayer.In general, the re-allocation of expenditures occurs on the date of the expenditurebut the taxpayer may elect:(1) To re-allocate the debt as of the first day of the month in which theexpenditure occurs, orNote: A taxpayer may use the first-day-of-the-month convention only if allother expenditures from the account during the month are similarly treated.1-92(2) To re-allocate the debt as of the day on which the debt proceeds aredeposited in the account if later.Debt proceeds received in cash are treated as if they were used to make personalexpenditures. Debt proceeds are “received in cash” if cash is withdrawnfrom an account containing debt proceeds.Exception: As with debt proceeds deposited into an account, there is a special15-day rule (90 days for residences) that allows a taxpayer to treat any

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cash expenditure he makes within 15 days of receiving the cash as an expendituremade from the debt proceedsIf at any time any portion of a debt is repaid and such debt is allocated tomore than one expenditure, the debt is treated as repaid in the following order:(1) Amounts allocated to personal expenditures.(2) Amounts allocated to investment expenditures and passive activity expenditures.(3) Amounts allocated to passive activity expenditures in connection witha rental real estate activity in which the taxpayer actively participates.(4) Amounts allocated to former passive activity expenditures.(5) Amounts allocated to active trade or business expenditures.ExampleTaxpayer B borrows $100,000 (“Debt A”) on July 12, immediatelydeposits the proceeds in an account, and uses thedebt proceeds to make the following expenditures on the followingdates:August 31 $40,000 passive activity expenditure #1October 5 $20,000 passive activity expenditure #2December 24 $40,000 personal expenditureOn January 19 of the following year, B repays $90,000 ofDebt A (leaving $10,000 of Debt A outstanding). The $40,000of Debt A allocated to the personal expenditure, the $40,000allocated to passive activity expenditure#1, and $10,000 ofthe $20,000, allocated to passive activity expenditure #2 aretreated as repaid.Amounts allocated to two or more expenditures that fall in the same classification(e.g., amounts allocated to different personal expenditures) aretreated as repaid in the order in which the amounts were allocated to suchexpenditures.In the case of borrowings pursuant to a line of credit or similar account thatallows a taxpayer to borrow funds periodically under a single loan agreement:1-93(1) All borrowings on which interest accrues at the same rate are treatedas a single debt; and(2) Borrowings on which interest accrues at different rates are treated asdifferent debts, and such debts are treated as repaid in the order suchdebts are treated as repaid under the loan agreement.ExampleTaxpayer A obtains a line of credit. Interest on any borrowingon the line of credit accrues at the lender’s “prime lendingrate” on the date of the borrowing plus two percentagepoints. The loan documents provide that borrowings on theline of credit are treated as repaid in the order the borrowingswere made. A borrows $30,000 (“Borrowing #1") on theline of credit and immediately uses $20,000 of the debt proceedsto make a personal expenditure (”personal expenditure#1") and $10,000 to make a trade or business expenditure

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(“trade or business expenditure #1"). A subsequentlyborrows another $20,000 (”Borrowing #2") on the line ofcredit and immediately uses $15,000 of the debt proceedsto make a personal expenditure (“personal expenditure #2")and $5,000 to make a trade or business expenditure (”tradeor business expenditure #2"). A then repays $40,000 of theborrowings.If the prime lending rate plus two percentage points was thesame on both the date of Borrowing #1 and the date of Borrowing#2, the borrowings are treated for purposes of thisparagraph as a single debt, and A is treated as having repaid$35,000 of debt allocated to personal expenditure #1 andpersonal expenditure #2, and $5,000 of debt allocated totrade or business expenditure #1.If the prime lending rate plus two percentage points was differenton the date of Borrowing #1 and Borrowing #2, the borrowingsare treated as two debts, and, in accordance with theloan agreement, the $40,000 repaid amount is treated as arepayment of Borrowing #1 and $10,000 of Borrowing #2. Accordingly,A is treated as having repaid $20,000 of debt allocatedto personal expenditure #1, $10,000 of debt allocatedto trade or business expenditure #1, and $10,000 of debt allocatedto personal expenditure #2.With some exceptions, reallocation of debt allocated to an expenditure properlychargeable to capital account with respect to an asset (the “first expenditure”)is reallocated to another expenditure on the earlier of:(1) The date on which proceeds from a disposition of such asset are usedfor another expenditure; or1-94(2) The date on which the character of the first expenditure changes (e.g.,from a passive activity expenditure to an expenditure that is not a passiveactivity expenditure) by reason of a change in the use of the asset with respectto which the first expenditure was capitalized.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the list

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of questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.25. Section 104 covers the tax treatment of personal injury awards. Regardlessof the recovery method, how are damages for personal injuries treated?a. They are included in taxable income.b. They are entitled to installment reporting and treatment.c. They are excluded from gross income.d. They are subjected to the alternative minimum tax.26. Exemptions may be taken for dependents. When is a spouse deemed tobe a dependent?a. if the spouse does not file a return.b. if the spouse is disabled.c. if the taxpayer takes an exemption for the spouse.d. never.1-9527. The term "qualified child" is used for multiple tax purposes including forthe dependency exemption. Four tests are used to determine whether a childis a "qualified child." However, which of the following is disregarded in makingthis determination?a. residency.b. age.c. support.d. joint return prohibition.28. Section 163(h)(1) defines personal interest. Which item is consideredpersonal interest?a. interest incurred on an investment debt.b. interest incurred on debt from a passive activity.c. qualified residence interest.d. interest incurred on a car loan.29. Under §163, there are at least five types of interest expense. Which typeof interest is defined as interest paid or accrued on indebtedness incurred orcontinued to purchase or carry property held for purposes of making aprofit?a. investment interest.b. trade interest.c. qualified residence interest.d. prepaid interest.30. Points are considered a type of interest expense. Under §461(g)(1), whatis a characteristic of points that have features of an additional interest

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charge?a. They are fully deductible when paid on a refinance of a home purchase.b. They constitute personal interest.c. If incurred in a business deal, they are deducted ratably over the loan’sterm.d. They must be capitalized by an accrual-basis taxpayer.

Answers & Explanations25. Section 104 covers the tax treatment of personal injury awards. Regardlessof the recovery method, how are damages for personal injuries treated?a. Incorrect. Personal injury awards are excludable from income under §104.However, awards for lost wages, profits, and interest are includable in income.1-96b. Incorrect. Installment method reporting, under §453, is not available topersonal injury awards under §104.c. Correct. Damages for personal injuries, no matter how recovered, are specificallyexcluded from gross income (§104(a)(2)).d. Incorrect. Damages for personal injuries, under §104, are subject to neitherregular tax nor alternative minimum tax. [Chp. 1]26. Exemptions may be taken for dependents. When is a spouse deemed to bea dependent?a. Incorrect. If separate returns are filed, a taxpayer can take a personal exemptionfor their spouse only if their spouse, among other things, is not filinga return.b. Incorrect. Having a disabled spouse does not entitle a taxpayer to claim adependency exemption. However, a personal exemption may be claimed forthe spouse.c. Incorrect. A taxpayer can take an exemption for a spouse only becausethey are married. The reason for this exemption is what is at question.d. Correct. Personal exemptions are different than dependency exemptions.A spouse is never considered a dependent. [Chp. 1]27. The term "qualified child" is used for multiple tax purposes including forthe dependency exemption. Four tests are used to determine whether achild is a "qualified child." However, which of the following is disregardedin making this determination?a. Incorrect. The child must live with the claimant for more than half of theyear. However, temporary absences due to education, business, vacation,military service, or illness are not counted as absences.b. Incorrect. The potential dependent meets the age test if they are under age

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19 at the close of the calendar year, a full-time student (at least parts of fivemonths during the year) under age 24 at the close of the calendar year, orpermanently and totally disabled.c. Correct. There is no longer a support (unless the child provides more thanhalf of their own support) or gross income test. Instead, the child must havethe same principal place of abode as the claimant for more than half the year.d. Incorrect. An individual cannot be claimed as a qualified child if they areable to file a joint return with another. [Chp. 1]28. Section 163(h)(1) defines personal interest. Which item is considered personalinterest?a. Incorrect. Interest incurred on an investment debt is deductible and is notcovered under the definition of personal interest.1-97b. Incorrect. While the interest incurred on debt arising from a passive activityis nondeductible under §469, it is not covered under the definition of personalinterest.c. Incorrect. Qualified residence interest debt is deductible and is not coveredunder the definition of personal interest.d. Correct. An item that is covered under the definition of personal interest isinterest on car loans. This interest is nondeductible. [Chp. 1]29. Under §163, there are at least five types of interest expense. Which type ofinterest is defined as interest paid or accrued on indebtedness incurred orcontinued to purchase or carry property held for purposes of making aprofit?a. Correct. Investment interest is interest paid or accrued on indebtedness incurredor continued to purchase or carry property held for investment.b. Incorrect. The course material does not define “trade interest.” Businessinterest, however, is interest that can be attributed to a trade or business.c. Incorrect. Qualified residence interest is a type of home mortgage interest.A mortgage is typically held for personal purposes, rather than for purposesof making a profit.d. Incorrect. Prepaid interest is deductible only in the period to which it relatesand must be capitalized and deducted over the period of the loan to theextent it represents the cost of using borrowed funds during such period.[Chp. 1]30. Points are considered a type of interest expense. Under §461(g)(1), what is

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a characteristic of points that have features of an additional interestcharge?a. Incorrect. Points paid to refinance an existing home mortgage are incurredfor the purpose of repaying an existing indebtedness, not to purchase or improvea home. Such points do not qualify for a full deduction.b. Incorrect. Points that are in the nature of an additional interest chargeconstitute prepaid interest.c. Correct. Points that are in the nature of an additional interest charge mustbe deducted ratably over the term of the loan if incurred in a business transaction,the same as if the taxpayer were on the accrual basis.d. Incorrect. Points that are in the nature of an additional interest chargemust be capitalized by a cash-basis taxpayer. [Chp. 1]1-98Education ExpensesEven though the education may lead to a degree, educational expenses are deductibleif the education:(i) Is required by the taxpayer’s employer or the law to keep the taxpayer'ssalary, status, or job (and serves a business purpose of the employer), or(ii) Maintains or improves skills required in the taxpayer’s present work.To be deductible, educational expenses must relate to the taxpayer’s presentwork. Expenses for education that relate to work in the future are not deductible.Education that prepares the taxpayer for a future occupation includes anyeducation that keeps the taxpayer up-to-date for a return to work or that qualifiesthem to reenter a job they had in the past.Note: If the taxpayer has educational expenses during a vacation, temporaryleave, or other temporary absence from their job, educational expenses aredeductible. However, after the absence, they must return to the same kind ofwork and the education must be qualified.Taxpayers cannot deduct expenses for education if the education is part of aprogram of study that qualifies them for a new trade or business. However, if thetaxpayer changes duties but still does the same general work, the new duties arenot considered a new trade or business.ExampleDan is an accountant. His employer requires him to get a lawdegree at his expense. Dan registers at a law school for theregular curriculum that leads to a law degree, even though hedoes not intend to become a lawyer. Because this degree willqualify Dan for a new trade or business, he cannot deduct theexpense.

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ExampleDan is a general practitioner of medicine. He takes a 2-weekcourse to review new developments in several specializedfields of medicine. Dan may deduct the expenses for thecourse because it maintains or improves skills required in hisprofession. The course does not qualify Dan for a new profession.1-99ExampleWhile working in the private practice of psychiatry. Dan entersa program to study and train at an accredited psychoanalyticinstitute. The program will lead to qualifying Dan to practicepsychoanalysis. Dan may deduct his expenses for the studyand training because it maintains or improves skills requiredin his present profession. The psychoanalytic training doesnot qualify Dan for a new profession.Deductible educational expenses include:(i) Tuition, books, supplies, lab fees, and similar items,(ii) Certain transportation and travel costs, and(iii) Other educational expenses, such as costs of correspondence courses, tutoring,formal training, plus research and typing when writing a paper as partof an educational program.Note: Educational expenses do not include personal or capital expenses. Forexample, taxpayers cannot deduct the dollar value of vacation time or annualleave they take to attend classes. This amount is a personal expense.Educational TransportationIf a taxpayer’s educational expenses qualify for deduction, they can claim localtransportation costs of going directly from work to school. If the taxpayeris regularly employed and goes to school on a strictly temporary basis, theycan also deduct the costs of returning from school to home. A temporary basisis irregular or short-term attendance, generally a matter of days or weeks.If the taxpayer goes directly from home to school on a temporary basis, theycan deduct the round-trip costs of transportation in going from their home toschool to home. This is true regardless of the location of the school, the distancetraveled, or whether they attend school on non-work days.Transportation expenses include the actual costs of bus, subway, cab, or otherfares, as well as the costs of using the taxpayer’s car. Parking and tolls arealso included.1-100IS THE EDUCATION NEEDEDTO MEET THE MINIMUMEDUCATIONALREQUIREMENTS OF YOURTRADE OR BUSINESS?IS THE EDUCATION PART OF

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A STUDY PROGRAM THATCAN QUALIFY YOU IN A NEWTRADE OR BUSINESS?IS THE EDUCATIONREQUIRED BY YOUREMPLOYER, OR BY LAW, TOKEEP YOUR PRESENTSALARY STATUS, OR JOB?DOES THE EDUCATIONMAINTAIN OR IMPROVESKILLS REQUIRED IN DOINGYOUR PRESENT WORK?YOUR EDUCATIONEXPENSES ARE NOTDEDUCTIBLEYOUR EDUCATIONEXPENSES AREDEDUCTIBLENoNoNoYesYesNoYesYes

Education Expenses1-101Transportation expenses do not include amounts spent for travel, meals, orlodging while away from home overnight. If the taxpayer uses their car fortransportation to school, they can deduct actual expenses, or use the standardmileage rate to figure the deductible amount.ExampleDan regularly works in Camden, New Jersey, and also attendsschool every night for 3 weeks to take a course thatimproves his job skills. Since Dan is attending school on ashort-term basis, Dan can deduct his daily round-trip transportationexpenses in going between home and school. Thisis true regardless of the distance traveled.Educational TravelTaxpayers may deduct expenses for travel, meals, and lodging if they travelovernight to obtain qualified education and the main purpose of the trip is toattend a work-related course or seminar. However, the taxpayer may not deduct

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expenses for personal activities, such as sightseeing, visiting, or entertaining.ExampleDan works in Newark, New Jersey. He traveled to Chicago totake a deductible one-week course at the request of his employer.While there, he took a sightseeing trip, entertainedsome personal friends, and took a side trip to Pleasantville fora day. Since the trip was mainly for business, he can deducthis round-trip airfare to Chicago, but he cannot deduct histransportation expenses of going to Pleasantville. Only themeals and lodging connected with his educational activitiescan be claimed as educational expenses.ExampleBambi works in Boston and she took a train to a university inMichigan to take a deductible course for work. She took onecourse, which is one-fourth of a full course load of study, andshe spent the rest of the time on personal activities. Her trip ismainly personal because three-fourths of her time is consideredpersonal time. She cannot deduct the cost of the trainticket, but she may deduct one-fourth of the meals and lodgingcosts for the time she attended the university.1-102ExampleDan works in Nashville and recently traveled to California totake a deductible 2-week seminar. While there, he spent anextra 8 weeks on personal activities. These facts indicate thathis main purpose was to take a vacation. He cannot deducthis round-trip airfare or his meals and lodging for the 8weeks. He may only deduct his expenses for meals and lodgingfor the 2 weeks he attended the seminar.The cost of travel that in itself is a form of education is not deductible, eventhough travel may be directly related to the taxpayer’s duties in their work orbusiness.ExampleDan is a French language teacher. While on sabbatical leavegranted for travel, Dan traveled through France to improve hisknowledge of the French language. He choose his itineraryand most of his activities to improve his French languageskills. Dan cannot deduct his travel expenses as educationalexpenses, even though he spent most of his time visitingFrench schools and learning French.Meal ExpensesIf the educational expenses qualify for deduction, the taxpayer may deductthe cost of meals that qualify as travel expenses of education. However, only50% of business-related meals that are not reimbursed by the employer aredeductible.Investment SeminarsSection 274(h)(1) disallows all deductions for conventions, seminars, or similarmeetings unless the expenses relate to a trade or business of the taxpayer.

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As a result, taxpayers may not deduct any expenses for attending a conventionor seminar for investment purposes under §212.Tuition Deduction - §222Tuition deduction extended through 2009. Taxpayers are allowed an abovethe-line deduction for qualified higher education expenses paid by the taxpayerduring a taxable year. Qualified higher education expenses are definedin the same manner as for purposes of the HOPE credit.Dollar limitation and phase out rules exist. The amount of deduction allowedfor taxpayers depends on the taxpayers AGI (§222(b)(2)(B)):1-103AGI does not exceed Eligible education expensesup to$65,000 ($130,000MFJ) $4,000$80,000 ($160,0002008-2009 MFJ) $2,000>$80,000(>$160,000MFJ) $ 0Tuition deduction or education credit allowed. Taxpayers are not eligible toclaim the deduction and a Hope or Lifetime Learning Credit in the sameyear with respect to the same student. A taxpayer may not claim a deductionfor amounts taken into account in determining the amount excludable due toa distribution (i.e., the earnings and contribution portion of a distribution)from a Coverdell ESA or the amount of interest excludable with respect toeducation savings bonds.Taxpayer must now elect Hope/Lifetime if credits would create lower tax.The qualified tuition deduction is unavailable to any taxpayer for any taxableyear beginning in 2008 or 2009 if the taxpayer would, in the absence of thealternative minimum tax, have a lower tax liability for that year if he or sheelected the Hope or Lifetime Learning credit with respect to an eligible individualinstead of the qualified tuition deduction.Classroom Expenses for Teachers - ExpiredDeduction for educator expenses extended through the end of 2009. Educatorswho work at least 900 hours during a school year as a teacher, instructor,counselor, principal, or aide, may deduct up to $250 of qualified out ofpocket expenses for books and classroom supplies in 2009. The deduction isavailable for those in public or private elementary or secondary schools (includingkindergarten). Qualifying expenses include supplies, books, andequipment (§62(a)(2)(D)).Medical Expense Deductions - §213 [Schedule A]

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Taxpayers can deduct only the amount of their medical and dental expenses thatis more than 7.5% of their adjusted gross income. Medical care means amountspaid for the diagnosis, cure, mitigation, treatment, or prevention of disease, andfor treatments affecting any part or function of the body. The medical care expensesmust be primarily to alleviate or prevent a physical or mental defect orillness.1-104Items DeductibleTo the extent a taxpayer is not reimbursed, they may deduct what they paidfor:1. Prescription medicines and drugs, or insulin.2. Medical doctors, dentists, eye doctors, chiropractors, osteopaths, podiatrists,psychiatrists, psychologists, physical therapists, acupuncturists,and psychoanalysts (medical care only).3. Medical examinations, X-ray and laboratory services, insulin treatment,and whirlpool baths which are doctor ordered.4. If a taxpayer pays someone to do both nursing and housework, theymay deduct only the cost of the nursing help.5. Hospital care (including meals and lodging), clinic costs, and lab fees.6. Medical treatment at a center for drug addicts or alcoholics.7. Medical aids such as hearing aid batteries, contact lenses, braces,crutches, wheelchairs, guide dogs, and the cost of maintaining them.8. Costs of a mentally or physically handicapped person at a specialschool, including tuition, meals, and lodging.9. Cost of an individual at a nursing home or home for the aged.10. Amounts paid for an inpatient's treatment at a therapeutic center foralcohol addiction.Items Not DeductibleFollowing medical costs are not deductible:1. The basic cost of Medicare insurance (Medicare A).Comment: If you are sixty-five or over and not entitled to Social Securitybenefits, you may deduct premiums you voluntarily paid for Medicare A coverage.2. Life insurance or income protection policies.3. The 1.45% Medicare (hospital insurance benefits) tax withheld fromyour pay as part of the Social Security tax or the Medicare tax paid as partof social security self-employment tax.4. Nursing care for a healthy baby (except perhaps under §21).5. Illegal operations or drugs.6. Nonprescription medicines or drugs.7. Travel for rest or change which a doctor ordered.8. Funeral, burial, or cremation costs.

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1-105Medical Insurance PremiumsA taxpayer can include in medical expenses insurance premiums they pay forpolicies that cover medical care. Policies can provide payment for:(1) Hospitalization, surgical fees, X-rays, etc.,(2) Prescription drugs,(3) Replacement of lost or damaged contact lenses,(4) Qualified long-term care insurance contracts, or(5) Membership in an association that gives cooperative or so-called freechoice medical service, or group hospitalization and clinical care.Note: Taxpayer cannot deduct insurance premiums paid with pretax dollarsbecause the premiums are not included in box 1 of the Form W-2.If a taxpayer has a policy that provides more than one kind of payment, theycan include the premiums for the medical care part of the policy if the chargefor the medical part is reasonable. The cost of the medical portion must beseparately stated in the insurance contract or given to the taxpayer in a separatestatement.Medicare AIf a taxpayer is covered under Social Security (or if they are a governmentemployee who paid Medicare tax), they are enrolled in Medicare A. Thepayroll tax paid for Medicare A is not a medical expense. If a taxpayer isnot covered under Social Security (or were not a government employeewho paid Medicare tax), they can voluntarily enroll in Medicare A. In thissituation the premiums paid for Medicare A can be included as a medicalexpense on their tax return.Medicare BMedicare B is a supplemental medical insurance. Premiums paid forMedicare B are a medical expense. If a taxpayer applied for it at age 65 orafter they became disabled, they can deduct the monthly premiums theypaid. If a taxpayer was over age 65 or disabled when they first enrolled,check the information received from the Social Security Administrationto find out the premium.Prepaid Insurance PremiumsInsurance premiums a taxpayer pays before they are age 65 for medicalcare after they reach age 65 for themselves, their spouse, or their dependents,are medical care expenses in the year paid if they are:(a) Payable in equal yearly installments, or more often, and1-106(b) Payable for at least 10 years, or until the taxpayer reaches 65 (butnot for less than 5 years).Meals & LodgingA taxpayer can deduct as a medical expense amounts paid for lodging (but

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not meals) while away from home to receive medical care in a hospital or amedical care facility that is related to a hospital. Do not include more than$50 a night for each eligible person. Meals included in the cost of care in ahospital or other institution are deductible.Expenses of TransportationCosts of gas, oil, parking fees, taxi, train, plane and bus fares, ambulance service,and lodging expenses while en-route to the place of medical treatmentare deductible. If a taxpayer uses their own car, they may claim what theyspent for gas and oil to go to and from the place they received the care; orthey may claim 24 cents (in 2009) a mile. Add parking and tolls to theamount a taxpayer claims under either method.Permanent ImprovementsElevators, swimming pools, and other permanent improvements to taxpayer’sproperty (including capital expenditures to accommodate a residence to aphysically handicapped individual) qualify as a medical expense only to theextent the total expense exceeds the amount by which the improvement increasesthe value of the property.ExampleA taxpayer spends $5,000 to put in a central air conditioningsystem after their daughter’s allergist recommends the installationto alleviate an asthmatic condition. If that boosts thevalue of the taxpayer’s home by $4,500, the allowable deductionshrinks to only $500, the amount by which the cost exceedsthe increase in value. A renter could claim the entirecost because the improvement adds nothing to the value ofhis or her property.A written opinion from a competent real estate appraiser detailing how littleor how much the installation raised the value of the property is recommendable.The appraisal fee does not count under the 7.5% of AGI limit for medicalexpenses. Taxpayers may count them with other miscellaneous deductions,such as return preparation fees, which are allowable to the extent theyexceed 2% of AGI.1-107Whether the taxpayer is an owner or a renter, deductible items include theentire cost of detachable equipment - e.g., a window air conditioner that relievesa medical problem. In addition, remember to include as part of themedical deduction amounts spent for such operating and maintenance expensesas electricity, repairs, or a service contract.Comment: Some expenses incurred by a physically handicapped individual toremove structural barriers in their residence in order to accommodate theirphysical condition such as constructing access ramps, widening doorways,and installing special support bars are presumed not to increase value of the

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residence and are deductible in full.Spouses, Dependents & OthersAn individual may deduct the medical expenses of his spouse, his dependentchildren, and any other person who meets the definition of dependent under§152.Reimbursement of ExpensesMedical expenses compensated for by insurance are reduced by the amountso compensated. No reduction is required for amounts received as compensationfor loss of earnings or damages for personal injuries.Long-Term Care ProvisionsA qualified long-term care insurance contract generally is treated as an accidentand health plan. This allows long-term care insurance contracts to receivethe same tax benefits as other health insurance plans.Long-Term Care PaymentsPayments received under such a contract generally are excludable asamounts received for personal injuries or sickness, subject to a per-daylimitation on per diem contracts.The limit on the exclusion for payments made on a per diem or other periodicbasis under a long-term care insurance contract is $280 for 2009(up from $270 in 2008) per day. The limit applies to the total of thesepayments and any accelerated death benefits made on a per diem orother periodic basis under a life insurance contract because the insured ischronically ill.Under this limit, the excludable amount for any period is figured by subtractingany reimbursement received (through insurance or otherwise) forthe cost of qualified long-term care services during the period from thelarger of the following amounts:(1) the cost of qualified long-term care services during the period, and1-108(2) the dollar amount for the period ($280 per day for any period in2009).Long-Term Care PremiumsPremiums for long-term care insurance and long-term care services aretreated as medical expenses for purposes of the itemized deduction formedical expenses and the exclusion for employer-provided health benefits.For 2009, taxpayers can include qualified long-term care premiums, up tothe amounts shown below, as medical expenses on Schedule A (Form1040).Age 40 or under - $320.Age 41 to 50 - $600.Age 51 to 60 - $1,190.Age 61 to 70 - $3,180.

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Age 71 or over - $3,980.This limitation is for each person.Long-term care insurance will not be permitted to be offered under acafeteria plan or to be covered under flexible spending arrangements.IRA Withdrawals for Certain Medical ExpensesThe tax law creates an exception to the 10% penalty tax on early withdrawalsfrom an IRA for medical expenses in excess of 7.5% of adjusted gross income.In addition, the 10% tax does not apply to distributions for medical insurance(without regard to the 7.5% floor) if the individual has received unemploymentcompensation under federal or state law for at least 12 weeks.Charitable Contributions - §170 [Schedule A]In general, a deduction is permitted for charitable contributions, subject to certainlimitations that depend on the type of taxpayer, the property contributed,and the donee organization. The amount of deduction generally equals the fairmarket value of the contributed property on the date of the contribution. Charitabledeductions are provided for income, estate, and gift tax purposes.Since 1987, charitable contributions are deductible only as an itemized deductionon Schedule A. If the taxpayer does not itemize, or cannot itemize, there is nodeduction for charitable contributions.Requirements for DeductibilityTo be deductible charitable contributions must meet the following requirements:1-1091. Contributions must be to or for the use of qualifying organizations;2. Generally, they must be paid within the year, even if the taxpayer is onthe accrual basis;3. They cannot exceed certain statutory limits; and4. They must be itemized deductions for individuals.Comment: A contribution made to an individual is not deductible unless heis acting as an agent for a qualified organization, even though he may be inneed.Qualified OrganizationsA state, a U.S. possession (including Puerto Rico), a political subdivision of astate or possession, the United States, or the District of Columbia is a qualifiedorganization, if the contribution is made only for public purposes. AnIndian tribal government and any of its subdivisions that are recognized by

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the Secretary of the Treasury as performing substantial government functionswill be treated as a state for purposes of the charitable contributions deduction.In addition, a qualified organization is a community chest, corporation, trust,fund, or foundation organized or created in, or under the laws of, the UnitedStates, any state, the District of Columbia, or any possession of the UnitedStates. The organization must be organized and operated only for charitable,religious, educational, scientific, or literary purposes. It may also be for theprevention of cruelty to children or animals.Limitations on ContributionsIf contributions are all to 50% charities, the deduction for contributions islimited to 50% of adjusted gross income before any net operating loss carryback.There is an exception for appreciated capital gain property.Charities that are 50% organizations include:(1) Churches,(2) Tax-exempt educational organizations,(3) Tax-exempt hospitals and certain medical research organizations,(4) Certain organizations holding property for state and local colleges anduniversities,(5) A state, a possession of the U.S., or any political subdivision of any ofthe foregoing, or the U.S. or the District of Columbia, if the contributionis for exclusively public purposes,(6) An organization organized and operated exclusively for charitable, religious,educational, scientific, or literary purposes or for the preventionof cruelty to children or animals or to foster national or international1-110amateur sports competition if it normally gets a substantial part of itssupport from the government or the general public,(7) Limited private foundations, and(8) Certain membership organizations more than one-third of whose supportcomes from the public (§170(b)(1)).Contributions to charities other than 50% charities and contributions for theuse of any charity are limited to 30% of the donor’s adjusted gross incomebefore any net operating loss carrybacks. Additionally, any contribution ofappreciated capital gain property to a 50% charity is subject to the 30% ceilingunless an election is made.Contributions of appreciated capital gain property to 30% charities are deductibleonly up to 20% of adjusted gross income before any net operatingloss carrybacks.Five-year CarryoverIf the 50%, 30% or 20% ceilings limit the contributions, the amount not

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deductible in the year contributed may be carried forward for up to fiveyears and deducted on a future return. The carryover amounts are subjectto the same 50%, 30%, or 20% ceilings the original contributions weresubject to.Contributions of CashGenerally, cash contributions to qualified organizations are deductible. However,there are some exceptions:Benefits ReceivedIf a taxpayer contributes to a charitable organization and also receives abenefit from it, they may deduct only the amount that is more than thevalue of the benefit they received.Examples of charitable contributions which are not deductible because ofbenefits received include:(1) Tuition, even for children attending parochial school, and(2) Payment in connection with an aged person’s admission to a homeoperated by a charity, to the extent allocable to care to be given or theprivilege of being admitted.Note: Some of the expense may be deductible as medical expenses.Benefit PerformancesIf a taxpayer pays more than the fair market value to qualified organizationsfor charity balls, banquets, shows, etc., the amount that is more than1-111the value of the privileges or other benefits received is deductible as acontribution.The presumption here is that the payment is not a gift. The taxpayer mustshow that a clearly identifiable part of the payment is a gift. Only that partof the payment made with the intention of making a gift and for which thetaxpayer received no consideration qualifies as a contribution.Athletic EventsA taxpayer who makes a charitable contribution to or for a college or universityand is thereby entitled to purchase tickets to athletic events is allowedto deduct 80% of the payment as a charitable contribution. However,any amount that is for the tickets themselves is not considered partof the contribution.Raffle Tickets, Bingo, Etc.Amounts paid for raffle tickets, bingo and prizes are not contributions.They are gambling losses, deductible only to the extent of winnings.Dues, Fees, or AssessmentsDues, fees or assessments may be deductible to the extent the amountpaid exceeds benefits received if paid to qualified organizations. Amountspaid to country clubs, lodges, other social organizations, and homeownersassociations are not deductible.Contribution of PropertyThe tax treatment of charitable contributions varies based on the type of

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property given.Clothing & Household GoodsNo deduction is allowed for a charitable contribution of clothing orhousehold items unless the clothing or household item is in good usedcondition or better. Household items include furniture, furnishings, electronics,appliances, linens, and other similar items. Food, paintings, antiques,and other objects of an. jewelry and gems, and collections are excludedfrom the provision.The Treasury Secretary is authorized to deny by regulation a deductionfor any contribution of clothing or a household item that has minimalmonetary value, such as used socks and used undergarments.Note: Tax law does not define "good condition." It is expected that the Secretary,in consultation with affected charities, will exercise assiduously the authorityto disallow a deduction for some items of low value, consistent with1-112the goals of improving tax administration and ensure that donated clothingand households items are of meaningful use to charitable organizations.However, a deduction may be allowed for a charitable contribution of anitem of clothing or a household item not in good used condition or betterif the amount claimed for the item is more than $500 and the taxpayer includeswith the taxpayer's return a qualified appraisal with respect to theproperty.Ordinary Income or Short-Term Capital Gain Type PropertyContributions of property that would have resulted in ordinary income orgenerated short-term capital gain if sold at its fair market value on thedate contributed have a special rule. The amount deductible as a contributionis the fair market value minus the amount that would have beenordinary or short-term capital gain (i.e., adjusted basis).ExampleStock held for five months is donated to a church. The valueof the stock is $1,000 and the amount paid for the stock was$800. The amount deductible would be $800 ($1,000 minus$200) because the $200 of appreciation would have beenshort-term capital gain.ExceptionA corporation other than an “S” corporation is allowed a deduction forthe basis plus one-half of the appreciation of ordinary income property,such as inventory. The property must be for use by the donee tocare for the ill, needy or infants or it must be a qualified research contribution,the deduction can’t exceed twice the basis of the donatedproperty, and other tests must be met.Capital Gain Type PropertyContributions of property that would have resulted in capital gain aregenerally deductible at their fair market value on the date of contribution.

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Nevertheless, contributions of capital gain type property to 50% charitiesare limited to the 30% ceiling for deductible contributions. However, ataxpayer can elect to have the 50% ceiling apply by reducing the amountof the contribution by the capital gain.Note: Contributions of capital gain property to 30% charities are limited tothe 20% ceiling for deductible contributions. There is no election availableto have another ceiling apply.1-113ExceptionsTangible personal property that is unrelated to the donee charity’s exemptfunction (e.g. art to a church that then sells it) is deductible as acontribution only to the extent of the donor’s basis. In addition, capitalgain property (except for publicly traded stock) given to a private foundationthat is not an operating foundation or community foundationand that does not make timely qualifying distributions is deductible asa contribution only to the extent of the donor’s basis.Conservation EasementsA qualified conservation contribution is a contribution of a qualifiedreal property interest to a qualified organization exclusively for conservationpurposes. A qualified real property interest is defined as:(1) the entire interest of the donor other than a qualified mineral interest:(2) a remainder interest: or(3) a restriction (granted in perpetuity) on the use that may be madeof the real property.Qualified organizations include certain governmental units, publiccharities that meet certain public support tests, and certain supportingorganizations. Conservation purposes include:(1) the preservation of land areas for outdoor recreation by. or forthe education of. the general public;(2) the protection of a relatively natural habitat offish, wildlife, orplants, or similar ecosystem:(3) the preservation of open space (including farmland and forestland) where such preservation will yield a significant public benefitand is either for the scenic enjoyment of the general public or pursuantto a clearly delineated Federal. State, or local governmental conservationpolicy: and(4) the preservation of an historically important land area or a certifiedhistoric structure.Qualified conservation contributions of capital gain property are subjectto the same limitations and carryover rules of other charitable contributionsof capital gain property.The 30-percent contribution base limitation on contributions of capitalgain property by individuals does not apply to qualified conservationcontributions. Instead, individuals may deduct the fair market value ofany qualified conservation contribution to an organization described in§170(b)(1)(A) to the extent of the excess of 50 percent of the contribu1-

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114tion base over the amount of all other allowable charitable contributions.These contributions are not taken into account in determiningthe amount of other allowable charitable contributions.Individuals are allowed to carryover any qualified conservation contributionsthat exceed the 50-percent limitation for up to 15 years.Loss Type PropertyProperty contributed to a charity that, if sold, would have created a loss, isdeductible at its fair market value. However, the ideal thing to do whenthis situation exists is to sell the property, recognize the loss on the tax return,and donate the cash to the charity.Vehicle DonationsContemporaneous (30 days) written acknowledgment is required for any"qualified vehicle" donation exceeding $500. If the charity sells the vehiclewithout any significant intervening use or material improvement, theamount of the deduction will be limited to the gross sales price receivedby the charity. Thus, the actual fair market value of the vehicle may bemeaningless.Taxpayers are not entitled to any deduction unless they receive this acknowledgmentfrom the charity containing the donor's name, taxpayeridentification number, and the vehicle's identification number. If thecharity sells the property without significant intervening use the acknowledgmentmust also:(1) certify that the asset was sold in an arm's length transaction betweenunrelated parties;(2) certify the amount of the gross sales proceeds; and(3) include a warning that the donor's deduction is limited to thesales proceeds.Fractional InterestsNo deduction is allowed for a contribution of an undivided portion of ataxpayer's entire interest in tangible personal property unless, immediatelybefore the contribution, all interests in the property are held by:(1) the taxpayer; or(2) the taxpayer and the donee. (Code §170(o)(1)(A))Under (1), if a taxpayer who is the sole owner of an item of tangible personalproperty (e.g., a painting) contributes a portion of his undivided interestin the property to charity (e.g., a museum), he is allowed a charitablededuction if the contribution otherwise qualifies. Under (2), a taxpayerwho owns only a partial undivided interest in property is allowed a1-115charitable contribution for a gift of that interest to charity only if thedonee charity already owned the remaining interest in the property (andthen only to the extent of his partial interest). As a result, a taxpayer who

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donates a portion of his undivided interest in an item of tangible personalproperty to charity gets a charitable deduction for that “initial” gift (assumingit otherwise qualifies). Then, if he later gives any portion of hisremaining undivided interest in that property to the same charity, he getsa charitable deduction for that “additional” contribution.Other Types of ContributionsUnreimbursed out-of-pocket expenses in performing services free for a qualifiedcharity are not deductible. Likewise, travel expenses, including meals,lodging, and transportation while away from home are not deductible as acontribution unless there is no significant element of personal pleasure, recreation,or vacation in the travel.Note: Even if the travel expense test is met, only 50% of the meal expenditurescan be deducted and the deduction is allowed only for meals and lodgingnecessarily incurred while away from home overnight in rendering theservices.For auto expenses, a taxpayer may deduct the actual unreimbursed expensesfor gas and oil or take the standard mileage rate of 14 cents (in 2009) permile. Regardless of whether the standard mileage rate or the actual expensemethod is used, the taxpayer may also deduct parking fees and tolls. Depreciation,insurance, and repairs are not deductible.Charitable Distributions from an IRAFor 2008 and 2009, an IRA owner, age 70½ or over, can directly transfertax free, up to $100,000 per year to an eligible charitable organization.This provides an exclusion from gross income for otherwise taxable IRAdistributions from a traditional or a Roth IRA in the case of qualifiedcharitable distributions. Eligible IRA owners can take advantage of thisprovision, regardless of whether they itemize their deductions.SubstantiationThe kinds of records that must be kept for charitable contributions dependon the amount of the contribution, whether the contribution was cash orproperty, and whether a benefit was derived from the contribution.Cash ContributionsCash contributions include those paid by cash, check, credit card, or payrolldeduction. They also include out-of-pocket expenses when donatingservices.1-116For a contribution made in cash, the records a taxpayer must keep dependon whether the contribution is:(a) Less than $250, or(b) $250 or more.Contributions Less Than $250For each cash contribution that is less than $250, one of the following

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must be kept:(1) A canceled check or a legible and readable account statementthat shows:(a) If payment was by check - the check number, amount, dateposted, and to whom paid,(b) If payment was by electronic funds transfer - the amount, dateposted, and to whom paid,(c) If payment was charged to a credit card - the amount, transactiondate, and to whom paid,(2) A receipt (or a letter or other written communication) from thecharitable organization showing the name of the organization, thedate of the contribution, and the amount of the contribution, or(3) Other reliable written records that include the information describedin (2).Note: Records may be considered reliable if they were made at ornear the time of the contribution, were regularly kept, or if, in thecase of small donations, the taxpayer has buttons, emblems, or othertokens, that are regularly given to persons making small cash contributions.Contributions of $250 or MoreIn addition to the above record keeping requirements, special substantiationrequirements apply in the case of charitable contributions witha value of $250 or more. No charitable deduction is allowed for contributionsof $250 or more unless the taxpayer has written acknowledgmentof the contribution from the donee organization or adequatepayroll records.In figuring whether the contribution is $250 or more, separate contributionsare not combined. However, two checks written on the samedate to the same qualified organization may be considered one contribution(§170(f)(8)).Note: If contributions are made by payroll deduction, the deductionfrom each paycheck is treated as a separate contribution.The acknowledgment must:1-117(1) Be written;(2) Include:(a) The amount of cash contributed,(b) Whether the qualified organization gave the taxpayer anygoods or services (other than token items of little value) as a resultof the contribution, and(c) A description and good faith estimate of the value of any goodsor services described in (b), andNote: If the only benefit received was an intangible religious benefit(such as admission to a religious ceremony) that generally is not soldin a commercial transaction outside the donative context, the acknowledgmentmust say so and does not need to describe or estimatethe value of the benefit.(3) Be received on or before the earlier of:(a) The date the return is filed for the year of the contribution, or

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(b) The due date, including extensions, for filing the return.Payroll Deduction RecordsIf a contribution is made by payroll deduction, an acknowledgmentfrom the qualified organization is not needed. But if an employerdeducted $250 or more from a single paycheck, the taxpayer mustkeep:(a) A pay stub, Form W-2, or other document furnished by theemployer that proves the amount withheld, and(b) A pledge card or other document from the qualified organizationthat states the organization does not provide goods or servicesin return for any contribution made to it by payroll deduction.Noncash ContributionsFor a contribution not made in cash, the records a taxpayer must keepdepend on whether their deduction for the contribution is:(1) Less than $250,(2) At least $250 but not more than $500,(3) Over $500 but not more than $5,000, or(4) Over $5,000.Deductions of Less Than $250If any noncash contribution is made, the taxpayer must get and keep areceipt from the charitable organization showing:(1) The name of the charitable organization,1-118(2) The date and location of the charitable contribution, and(3) A reasonably detailed description of the property.A letter or other written communication from the charitable organizationacknowledging receipt of the contribution and containing the informationin (1), (2), and (3) will serve as a receipt.Note: Taxpayers are not required to have a receipt where it is impracticalto get one (for example, if property is left at a charity’s unattendeddrop site).Additional RecordsTaxpayers must also keep reliable written records for each item ofdonated property. Such written records must include the following:(1) The name and address of the organization to which taxpayercontributed,(2) The date and location of the contribution,(3) A description of the property in detail reasonable under thecircumstances,Note: For a security, keep the name of the issuer, the type of security,and whether it is regularly traded on a stock exchange or in an overthe-counter market.(4) The fair market value of the property at the time of the contributionand how the fair market value was figured,Note: If it was determined by appraisal, keep a signed copy of theappraisal.(5) The cost or other basis of the property if the taxpayer must reduce

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its fair market value by appreciation,(6) The amount claimed as a deduction for the tax year as a resultof the contribution, if the taxpayer contributes less than their entireinterest in the property during the tax year, and(7) The terms of any conditions attached to the gift of property.Deductions of At Least $250 But Not More Than $500If a deduction of at least $250 but not more than $500 for a noncashcharitable contribution is claimed, a taxpayer must get and keep an acknowledgmentof their contribution from the qualified organization.This acknowledgment must contain the information in items (1)through (3) listed under Deductions of Less Than $250, earlier, and thetaxpayer’s written records must include the information listed in thatdiscussion under Additional Records.The acknowledgment must:1-119(1) Be written;(2) Include:(a) A description (but not the value) of any property contributed,(b) Whether the qualified organization gave the taxpayer anygoods or services (other than token items of little value) as a resultof the contribution, and(c) A description and good faith estimate of the value of any goodsor services described in (b); andNote: If the only benefit received was an intangible religious benefit(such as admission to a religious ceremony) that generally is not soldin a commercial transaction outside the donative context, the acknowledgmentmust say so and does not need to describe or estimatethe value of the benefit.(3) Be received on or before the earlier of:(a) The date the return is filed for the year of the contribution, or(b) The due date, including extensions, for filing the return.Deductions Over $500 But Not Over $5,000If a deduction over $500 but not over $5,000 for a noncash charitablecontribution is claimed, the taxpayer must have the acknowledgmentand written records described under Deductions of At Least $250 ButNot More Than $500.In addition, the taxpayer’s records must include:(1) How the taxpayer got the property, for example, by purchase,gift, bequest, inheritance, or exchange;(2) The approximate date the taxpayer got the property or, if created,produced, or manufactured by or for the taxpayer, the approximatedate the property was substantially completed; and(3) The cost or other basis, and any adjustments to the basis, ofproperty held less than 12 months and, if available, the cost or otherbasis of property held 12 months or more.Note: This requirement, however, does not apply to publicly traded securities.

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If a taxpayer is not able to provide information on either the date theygot the property or the cost basis of the property and they have a reasonablecause for not being able to provide this information, attach astatement of explanation to the return.1-120Deductions over $5,000If a deduction of over $5,000 for a charitable contribution of one propertyitem or a group of similar property items is claimed, the taxpayermust have the acknowledgment and the written records described underDeductions Over $500 But Not Over $5,000. In figuring whether thededuction is over $5,000, combine all claimed deductions for similaritems donated to any charitable organization during the year.Generally, if the claimed deduction for an item or group of similaritems of donated property is more than $5,000, other than money andpublicly traded securities, the taxpayer must get a qualified appraisalmade by a qualified appraiser, and must attach an appraisal summary(Section B of Form 8283) to their tax return.Contributions over $75 Made Partly for Goods or ServicesCharities that receive payments made partly as a gift and partly for goodsor services must inform the donor that the charitable deduction is limitedto the excess of the contribution over the value of the goods or serviceswhere the donor makes a payment of more than $75. In addition, thecharity must provide the donor with a good-faith estimate of the value ofthose goods or services.Example #1In a weak moment, Dan contributes $100 to liberal dominatedPublic Television while watching a special on the new lawyers’weasel petting zoo in San Diego. In return he receivestheir number one premium, “Pavarotti Does Country Western,”valued at $40. Public Television would have to informDan that only $60 of his hard-earned Republican dollars aredeductible.Example #2However, if Dan only contributed $35.00 to Public TV and receiveda baseball cap emblazoned with PTV on it, PTV doesnot have to inform Dan of anything, because the donation isless than $75.There is a penalty of $10 per contribution (up to a limit of $5,000 perfundraising event or mailing) for failure to comply with this rule.1-121Deduction for Taxes - §164 [Schedule A]Income TaxesTaxpayers may:1. Deduct state and local income taxes withheld from salary;2. Deduct payments made on taxes for an earlier year in the year theywere withheld or paid; and3. Deduct estimated payments (including any credits for an overpaymentapplied to estimated taxes) made under a scheduled payment plan of a

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state or local government.Note: However, taxpayers must have a reasonable basis for making the estimatedstate tax payments. In other words, if the income does not justify theestimated tax payment the payment is not deductible.Real Property TaxA taxpayer may deduct any real estate taxes for any state, local, or foreigntaxes on real property levied for the general public welfare. Do not deducttaxes charged for local benefits and improvements that increase the value ofthe property.If a taxpayer bought or sold real estate during the tax year, the real estatetaxes must be divided between the buyer and the seller. The buyer and theseller must divide the real estate taxes according to the number of days in thereal property tax year (the period to which the tax imposed relates) that eachowned the property. The seller pays the taxes up to the date of the sale, andthe buyer pays the taxes beginning with the date of the sale.Accrual Method TaxpayersRegulations require accrual method taxpayers to delay property tax deductionsuntil actually paid. This applies to both state and local propertytaxes. Deductions for property taxes can no longer be accrued when thetax lien attaches to the property.Standard Deduction for Real Property TaxesAn individual taxpayer's standard deduction for taxable years beginning in2008 or 2009 is increased by the lesser of:(1) the amount allowable to the taxpayer as a deduction for real estatetaxes described in § 164(a)(1), or(2) $500 ($1,000 in the case of a married individual filing jointly).1-122State & Local Sales TaxEffective for taxable years prior to January 1, 2010, and at the election of thetaxpayer, an itemized deduction may be taken for State and local generalsales taxes in lieu of the itemized deduction for State and local income taxes.Taxpayers can elect to deduct state and local general sales taxes instead ofstate and local income taxes as a deduction on Schedule A. However, taxpayerscannot deduct both.To figure this deduction, taxpayers can use either:(1) their actual expenses, or(2) the optional sales tax tables plus the general sales taxes paid on certainspecified items (see IRS Pub. 600).Note: Taxpayers also may add to the table amount any sales taxes paid on: amotor vehicle, but only up to the amount of tax paid at the general sales taxrate; and an aircraft, boat, home (including mobile or prefabricated), orhome building materials, if the tax rate is the same as the general sales taxrate.

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Actual ExpensesGenerally, taxpayers can deduct the actual state and local general salestaxes (including compensating use taxes) paid if the tax rate was the sameas the general sales tax rate. However, sales taxes on food, clothing, medicalsupplies, and motor vehicles are deductible as a general sales tax evenif the tax rate was less than the general sales tax rate.Sales Tax Deduction for Qualified VehiclesFor purchases on or after February 17, 2009 and before January 1, 2010,the American Recovery & Reinvestment Act provides an above the linededuction for qualified motor vehicle taxes. It expands the definition oftaxes allowed as a deduction to include qualified motor vehicle taxes paidor accrued within the taxable year.Note: A taxpayer who itemizes and makes an election to deduct State and localsales taxes for qualified motor vehicles for the taxable year shall not beallowed the increased standard deduction for qualified motor vehicle taxes.Qualified Taxes: Qualified motor vehicle taxes include any State or localsales or excise tax imposed on the purchase of a qualified motor vehicle.Qualified Motor Vehicle: A qualified motor vehicle means a passengerautomobile, light truck, or motorcycle which has a gross vehicle weightrating of not more than 8,500 pounds, or a motor home acquired for useby the taxpayer after February 17, 2009 and before January 1, 2010, theoriginal use of which commences with the taxpayer.1-123Deduction Limitation: The deduction is limited to the tax on up to$49,500 of the purchase price of a qualified motor vehicle. The deductionis phased out for taxpayers with modified adjusted gross income between$125,000 and $135,000 ($250,000 and $260,000 in the case of a joint return).Comment: While both domestic and foreign vehicles qualify for the deduction,sales taxes paid on a lease agreement are not included.Personal Property TaxTo deduct personal property tax, a state or local tax, the tax must meet thefollowing three tests:(1) The tax must be based only on the value of the personal property;ExampleAssume your state charges a yearly motor vehicle registrationtax of 2% of value plus twenty-five cents per one hundredpounds. You paid $69 based on the value of $3,000 and aweight of 3600 pounds for your car. You may deduct $60 as apersonal property tax, since the tax is based on the value.However, the remaining $9 is based on weight and is not deductible.(2) The tax must be charged on a yearly basis, even if it is collected morethan or less than once a year; and(3) The tax must be charged on personal property.Note: A tax is considered charged on personal property even if it is for theexercise of a privilege. For example, a yearly tax based on value qualifies as apersonal property tax although it is called a registration fee that is for theprivilege of registering motor vehicles or using them on the highways.

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Other Deductible TaxesDeduct taxes if they are ordinary and necessary expenses in the production ofincome. Generally, these taxes must be paid during the tax year.The following are examples of deductible income producing taxes that areordinary and necessary:(1) One-half of the self-employment tax;(2) Taxes attributable to property producing rent or royalty income (generallydeductible on Schedule E, Form 1040);(3) Foreign income taxes a taxpayer pays to a foreign country or U.S. possession;and1-124Note: Location of the deduction is at the discretion of the tax preparer. Thepreparer may choose to deduct the taxes on Schedule A, Form 1040 as anitemized deduction, or claim a credit against U.S. income tax (see Publication514, Foreign Tax Credit for U.S. Citizens and Resident Aliens).(4) Taxes that a taxpayer pays in operating their business, or on theirproperty used in their business (usually deductible on Schedule C orSchedule F, Form 1040).Examples of Non-Deductible TaxesNondeductible federal taxes include:(1) Federal income taxes, including those withheld from pay or paid as estimatedtax payments,(2) Social security or railroad retirement taxes withheld from pay,(3) Social security and other employment taxes paid on the wages of ataxpayer’s employee who performed domestic or other personal services,(4) Federal excise taxes or customs duties, unless they are connected withyour business or income-producing activity, and(5) Federal estate and gift taxes.Note: However, if a taxpayer must include in gross income an amount of incomein respect of a decedent, the tax may be deductible as a miscellaneousdeduction.The following state or local taxes are not deductible:(1) General sales taxes (temporary legislation permits the deductionthrough 2007),(2) Motor vehicle sales tax (see Personal Property Tax, earlier),(3) Inheritance, legacy, succession, or estate taxes,(4) Gift taxes,(5) Per capita or poll taxes, and(6) Cigarette, tobacco, liquor, beer, wine, etc., taxes.Fees and charges such as the following are not deductible:(1) Driver’s licenses, car inspection fees, license plates (see Personal PropertyTax, earlier),

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(2) Dog tags, hunting licenses,(3) Marriage licenses,(4) Tolls for bridges and roads, parking meter deposits (unless businessrelated),(5) Fines (such as for parking or speeding) and collateral deposits,(6) Water bills, sewer, utility and other service charges.(7) Postage (unless business related), etc,1-125(8) State and local taxes on gasoline, diesel, and other motor fuels are notdeductible unless the vehicles are used for business.(9) Taxes for improvements to property are not deductible.Note: These include assessments for streets, sidewalks, water mains, sewerlines, public parking facilities, and similar improvements. A taxpayer shouldincrease the basis of their property by the amount of the assessment.(10) Transfer taxes (or stamp taxes) and other taxes and charges on thesale of a personal home are not deductible.Note: However, if the seller pays them, they are expenses of the sale and reducethe amount realized on the sale. If paid by the buyer, they are includedin the cost basis of the property.(11) Utility taxes charged under state or local law are not deductible if therate differs from that of the general sales tax,(12) A fuel adjustment charge by a municipally owned electric utility companythat is charged to residents is a nondeductible personal expense, and(13) Employment taxes for household workers.Note: A taxpayer may not deduct the social security or other employmenttaxes they pay on the wages of a household worker. However, they may beable to include their share of social security and other employment taxesthey pay as part of medical or childcare expenses.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,

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you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.1-12631. Qualifying work-related educational expenses are deductible. However,under which circumstance is education deemed nonqualifying?a. The taxpayer needs it to keep up with or develop skills needed in thecurrent employment.b. The taxpayer needs it to satisfy minimum educational conditions ofemployment in a current trade.c. The taxpayer needs it in order to maintain a current salary.d. The taxpayer needs it to continue working in a current position, as requiredby law.32. The author lists ten deductible medical items under §213 to the extent thetaxpayer is not reimbursed for such expenses. What is one of these items thattaxpayers may deduct?a. expenses of a funeral, burial, or cremation.b. costs for cosmetic surgery.c. expenses for medical treatment at a drug addiction center.d. over the counter medicines or drugs.33. Under §213, physically handicapped individuals may deduct certain expensesincurred to modify their primary residence. However, which expenseis nondeductible as such a medical expense?a. amounts spent building access ramps and putting in special supportbars.b. amounts spent for operating and maintaining residential accommodations.c. appraisal fees for getting a written, detailed opinion for a home’s increasedvalue.d. the entire cost spent on purchasing detachable equipment.34. According to the author, four requirements must be met for most §170charitable contributions. What is one of these four basic requirements?a. Individual taxpayers cannot itemize contributions.b. Taxpayers must abide by statutory regulations for contribution limits.c. Only taxpayers who use cash basis accounting must make contributionsduring the tax year.d. Taxpayers must make contributions to or for the benefit of individuals.35. Charities often conduct games, events, and activities at which participantstransfer funds. However, which of the following payments to charity is mostlikely deductible outside of the §170 charitable provisions?

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a. payments made for raffle tickets or bingo.b. amounts paid for tickets to athletic events.1-127c. amounts paid for tickets to charity balls, banquets, or shows.d. dues, fees, or assessments.36. The type of property contributed to a charity determines the tax treatmentof the contribution. With regard to charitable contributions of clothingand household items, what is required?a. Paintings and antiques are included in the categorization.b. Used donated clothing or household items must be in good condition.c. A $500 deduction may be claimed for any item not in good used condition.d. Used socks and used undergarments can qualify for a deduction.37. Taxpayers may be able to deduct certain automobile expenses as a charitablecontribution. Which of these expenses may taxpayers deduct whetherthey use the standard mileage rate or the actual expense method?a. depreciation, insurance, and repairs.b. parking fees and tolls.c. the value of transportation services.d. any travel expenses.

Answers & Explanations31. Qualifying work-related educational expenses are deductible. However,under which circumstance is education deemed nonqualifying?a. Incorrect. Education is qualifying education if it maintains or improvesskills needed in the taxpayer’s present work.b. Correct. Even if the education meets all of the requirements, it is notqualifying education if it is needed to meet the minimum educational requirementsof the taxpayer’s present trade or business.c. Incorrect. Education is qualifying education if it is required by the taxpayer’semployer to keep their present salary.d. Incorrect. Education is qualifying education if it is required by the law tokeep their present job. [Chp. 1]32. The author lists ten deductible items under §213 to the extent the taxpayeris not reimbursed for such expenses. What is one of these items that taxpayersmay deduct?a. Incorrect. Funeral, burial, or cremation costs are not deductible under§213.b. Incorrect. Cosmetic surgery not deductible under §213.1-128c. Correct. Under §213, to the extent not reimbursed, taxpayers may deduct

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what they paid for medical treatment at a center for drug addicts or alcoholicsunder §213.d. Incorrect. Nonprescription medicines or drugs are not deductible under§213. [Chp. 1]33. Under §213, physically handicapped individuals may deduct certain expensesincurred to modify their primary residence. However, which expenseis nondeductible as such a medical expense?a. Incorrect. Some expenses incurred by a physically handicapped individualto remove structural barriers in his residence in order to accommodate hisphysical condition such as constructing access ramps, widening doorways, andinstalling special support bars are presumed not to increase value of the residenceand are deductible in full.b. Incorrect. Individuals with physical handicaps should include as part of themedical deduction amounts spent for such operating and maintenance expensesas electricity, repairs, or a service contract.c. Correct. A written opinion from a competent real estate appraiser detailinghow little or how much the installation raised the value of the property isneeded. The appraisal fee does not count under the 7.5% of AGI limit formedical expenses. Taxpayers may count them with other miscellaneous deductions,such as return preparation fees, which are allowable to the extentthey exceed 2% of AGI.d. Incorrect. Whether the taxpayer is an owner or a renter, deductible itemsinclude the entire cost of detachable equipment (e.g., a window air conditionerthat relieves a medical problem). [Chp. 1]34. According to the author, four requirements must be met for most §170charitable contributions. What is one of these four basic requirements?a. Incorrect. A requirement for deductibility of most charitable contributionsis that contributions must be itemized.b. Correct. A requirement for deductibility of charitable contributions is thatcontributions cannot exceed certain statutory limits.c. Incorrect. A requirement for deductibility of charitable contributions isthat contributions generally must be paid within the year, even if the taxpayeris on the accrual basis.d. Incorrect. A requirement for deductibility of charitable contributions isthat contributions must be to or for the use of qualifying organizations. [Chp.1]35. Charities often conduct games, events, and activities at which participants

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transfer funds. However, which of the following payments to charity is mostlikely deductible outside of the §170 charitable provisions?1-129a. Correct. Amounts paid for bingo and raffle tickets are not charitable contributions.They are gambling losses, deductible only to the extent of winningsunder §165.b. Incorrect. A taxpayer who makes a charitable contribution to or for a collegeor university and is thereby entitled to purchase tickets to athletic eventsis allowed to deduct 80% of the payment as a charitable contribution. However,any amount that is for the tickets themselves is not considered part ofthe contribution.c. Incorrect. If the taxpayer pays more than the fair market value to qualifiedorganizations for charity balls, banquets, shows, etc., the amount that is morethan the value of the privileges or other benefits received is deductible as acontribution.d. Incorrect. Dues, fees, or assessments may be deductible to the extent theamount paid exceeds benefits received if paid to qualified organizations.However, amounts paid to country clubs, lodges, other social organizations,and homeowners associations are not deductible. [Chp. 1]36. The type of property contributed to a charity determines the tax treatmentof the contribution. With regard to charitable contributions of clothing andhousehold items, what is required?a. Incorrect. Paintings and antiques are excluded from the provision, as theydo not fall under the category of household items. A qualified appraisalwould most likely be required to deduct the value of these items.b. Correct. The Pension Protection Act of 2006 provides that donated clothingand household items must be in good used condition or better.c. Incorrect. The 2006 Pension Act provides that taxpayers may claim a deductionfor an item that is not in good used condition or better as long as theamount claimed for the item is more than $500 and the taxpayer includes aqualified appraisal of the item.d. Incorrect. Used socks and used undergarments have minimal monetaryvalue and, by regulation, the Secretary is authorized to deny a contribution ofthis sort. [Chp. 1]37. Taxpayers may be able to deduct certain automobile expenses as a charitablecontribution. Which of these expenses may taxpayers deduct whetherthey use the standard mileage rate or the actual expense method?

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a. Incorrect. Depreciation, insurance, and repairs are not deductible underthe standard mileage method.b. Correct. Regardless of whether the standard mileage rate or the actual expensemethod is used, the taxpayer may also deduct parking fees and tolls.c. Incorrect. Unreimbursed out-of-pocket expenses in performing servicesfree for a qualified charity are contributions. The value of services is not deductible.1-130d. Incorrect. Travel expenses are not deductible as a contribution unlessthere is no significant element of personal pleasure, recreation, or vacation inthe travel. [Chp. 1]Casualty & Theft Losses - §165 [Schedule A]A deduction is allowed for all or part of each loss caused by theft or casualty.The taxpayer must itemize deductions on Schedule A, Form 1040 to be able todeduct a casualty loss to nonbusiness property.DefinitionsCasualty - A casualty is the damage, destruction, or loss of property resultingfrom an identifiable event that is sudden, unexpected, or unusual. There is nocasualty loss if the damage is caused by progressive deterioration of propertycaused by termites, moths, drought, disease, or rust.Theft - A theft is the unlawful taking and removing of money or property withthe intent to deprive the owner of it. Lost or mislaid money or property doesnot qualify for the casualty loss deduction.Proof of LossTo take a deduction for a casualty or theft loss a taxpayer must show thatthere was actually a casualty or theft, they were the owner of the propertyand they must be able to support the amount taken as a deduction.1-131Amount of LossThe amount of a casualty or theft loss is generally the lesser of:(1) The decrease in the fair market value of the property as a result of thecasualty or theft, or(2) The taxpayer’s adjusted basis in the property before the casualty ortheft.Taxpayers may use the cost of replacing or repairing property after a casualtyas a measure of the decrease in fair market value if the value of the repairedor replaced property does not exceed the value of the property before thecasualty.Insurance & Other ReimbursementsAny insurance reimbursement must be subtracted from the amount of the

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loss when the deduction is figured. If the reimbursement exceeds the taxpayer’sbasis in the property there will be a casualty gain. If the personalcasualty gains for any tax year exceed the personal casualty loss for that yearall the gains and losses will be treated as capital gains and losses. In thatevent the losses are not subject to the 10% floor.For casualty and theft losses sustained by individuals, and not attributable toa business or a for profit transaction, a loss covered by insurance is taken intoaccount only if the taxpayer files a timely claim.LimitationsNonbusiness casualty and theft losses may be deducted only to the extent thatthe amount of each separate casualty or theft loss exceeds $100, and the totalamount of all losses during the year exceeds 10% of the taxpayer’s adjustedgross income.Nonbusiness casualty and theft losses in excess of this 10% floor are deductedas itemized deductions on schedule A of Form 1040.There are no limitations on casualty or theft losses on property used in atrade or business. If business casualty losses exceed business casualty gainsthey are deductible as ordinary losses on Form 4797.Individual Casualty or Theft Loss DeductionPart A: Loss Arising From a Single Casualty1. Fair market value of property immediately before thecasualty or theft $___________2. Fair market value of property immediately after thecasualty or theft $___________1-1323. Line 1 minus Line 2 (but not less than zero)4 $___________4. Adjusted basis of property destroyed by casualty orlost by theft5 $___________5. Loss - before limitations (lower of Lines 3 or 4) $___________6. Insurance proceeds received by taxpayer6 $___________7. Nonbusiness property limitation $1008. Total of Lines 6 and 7 $___________9. Casualty or theft loss from that property (Line 5minus Line 8) $___________Part B: Total Casualty or Theft Loss for the Year10. Enter amount on Line 9 (if there is more than onecasualty, theft, or disaster loss, combine the amountson Line 9 from the schedules prepared for each casualty) $___________11. Adjusted gross income $___________12. Enter 10% of Line 11 $___________13. Deductible casualty or theft loss for the year (Line 10minus Line 12) $___________Allocation for Mixed Use Property

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When a casualty involves both real and personal property, a taxpayer mustfigure the amount of the loss separately for each type of property, as discussedabove. However, a taxpayer applies a single $100 reduction to the totalloss. Then the taxpayer applies the 10% rule.When property is owned partly for personal use and partly for business or income-producing purposes, the casualty or theft loss deduction must be figuredas though there were two separate casualties or thefts - one affecting thenonbusiness property and the other affecting the business or incomeproducingproperty. The $100 rule and the 10% rule apply only to the casualtyor theft of the nonbusiness property.Standard Deduction for Disaster LossesStarting 2008, a taxpayer can increase his standard deduction by the net disasterlosses suffered from a federally declared disaster.4 The cost of repairing damaged property is evidence of the loss in its value if (i) the repairs arenecessary to restore the property to its former condition, (ii) the amount spent for repairs is notexcessive, (iii) the repairs are restricted to the damage suffered in the casualty, and (iv) the repairsdo not increase the value of the property beyond it former fair market value.5 In the case of property that is converted from personal use in a trade or business or for the productionof income, use fair market value on the date of the conversion if the property’s value onthat date was less than adjusted basis.6 If the loss is insured, a timely insurance claim must be filed with respect to damages to theproperty or the casualty loss will be disallowed (§165(h)(3)(E)).1-133Miscellaneous Deductions - §67 [Schedule A]Certain unreimbursed employee expenses, expenses of producing income, andother qualifying expenses are deducted as miscellaneous itemized deductions onSchedule A (Form 1040). Before 1987, there was no limit on these miscellaneousdeductions.Since 1986, most miscellaneous itemized deductions are subject to a 2% limit.The amount deductible is limited to the total of these miscellaneous deductionsthat is more than 2% of adjusted gross income. The 2% limit is applied after allother deduction limits are considered.Deductions - Subject to 2% LimitThe following deductions are subject to the 2% of AGI limitation:

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(1) Union dues,(2) Safety equipment, small tools, and supplies needed for the taxpayer’sjob,(3) Uniforms required by the taxpayer’s employer, and which the taxpayermay not usually wear away from work,(4) Protective clothing, required in your work, such as hard hats andsafety shoes and glasses,(5) Physical examinations required by the taxpayer’s employer,(6) Dues to professional organizations and chambers of commerce,(7) Subscriptions to professional journals,(8) Fees to employment agencies and other costs to look for a new job inthe taxpayer’s present occupation, even if the taxpayer does not get a newjob,(9) Business use of part of the taxpayer’s home but only if the taxpayeruses that part exclusively and on a regular basis in their work and for theconvenience of their employer,(10) 50% of unreimbursed business related meal and entertainment expenses,(11) Tax counsel and assistance, and(12) Investment counsel fees and investment expenses.Deductions Not Subject To 2% LimitThe following deductions are not subject to 2% of AGI limitation:(1) Moving expenses,(2) Gambling losses but not more than gambling winnings,(3) Federal estate tax attributable to income in respect of a decedent thatis ordinary income,1-134(4) Unreimbursed expenses necessary for a physically or mentally disabledor impaired individual to be able to work,(5) Amortizable bond premium, and(6) Remaining unamortized annuity amounts.Nondeductible ExpensesThe following expenses are not deductible:(1) Political contributions,(2) Personal legal expenses,(3) Lost or misplaced cash or property,(4) Expenses for meals during regular or extra work hours,(5) The cost of entertaining friends,(6) Expenses of going to or from work,(7) Education that the taxpayer needs to meet minimum requirements fortheir job or that will qualify taxpayer for a new occupation,(8)Travel as a form of education,(9) Attending a convention, seminar, or similar meeting unless it is relatedto your employment,(10) Fines and penalties, and(11) Expenses of producing tax-exempt income.

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Moving Expenses - §217Allowable moving expenses are deductible if a taxpayer’s move is closely related,both in time and in place, to the start of work.Taxpayers can generally consider moving expenses incurred within 1 year fromthe date they first reported to work at the new location as closely related in timeto the start of work. It is not necessary that the taxpayer arrange to work beforemoving to a new location, as long as they actually do go to work. If a taxpayerdoes not move within 1 year of the date they begin work, they ordinarily cannotdeduct the expenses unless they can show that circumstances existed that preventedthe move within that time.ExampleYour family moved more than a year after you started work ata new location. You delayed the move for 18 months to allowyour child to complete high school. You can deduct your allowablemoving expenses.1-135Taxpayers can generally consider their move closely related in place to the startof work if the distance from their new home to the new job location is not morethan the distance from their former home to the new job location. A move thatdoes not meet this requirement may qualify if the taxpayer can show that:(1) They are required to live at that home as a condition of their employment,or(2) They will spend less time or money commuting from their new home totheir new job location.Taxpayers must also meet the distance and time tests.Distance TestA taxpayer’s move will meet the distance test if their new main job location isat least 50 miles farther from their former home than their old main job locationwas from their former home. For example, if a taxpayer’s old main joblocation was 3 miles from their former home, their new main job locationmust be at least 53 miles from that former home.The distance between a job location and a taxpayer’s home is the shortest of

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the more commonly traveled routes between them. The distance test considersonly the location of the taxpayer’s former home. It does not take into accountthe location of the taxpayer’s new home.ExampleYou moved to a new home less than 50 miles from your formerhome because you changed main job locations. Your oldmain job location was 3 miles from your former home. Yournew main job location is 60 miles from that home. Becauseyour new main job location is 57 miles farther from your formerhome than the distance from your former home to yourold main job location, you meet the distance test.Time TestTo deduct moving expenses a taxpayer must also meet one of the followingtwo-time tests:(1) The time test for employees, or(2) The time test for self-employed persons.Time Test for EmployeesIf a taxpayer is an employee, they must work full time for at least 39weeks during the first 12 months after they arrive in the general area oftheir new job location. Full-time employment depends on what is usualfor the taxpayer’s type of work in the area.1-136For purposes of this test, the taxpayer:(a) May only count their full-time work as an employee, not any workthey do as a self-employed person,(b) Does not have to work for the same employer for all 39 weeks,(c) Does not have to work 39 weeks in a row, and(d) Must work full-time within the same general commuting area forall 39 weeks.Time Test for Self-employmentIf a taxpayer is self-employed, they must work full time for at least 39weeks during the first 12 months and for a total of at least 78 weeks duringthe first 24 months after they arrive in their new job location. For purposesof this test, the taxpayer:(a) Must count any full-time work they do either as an employee or asa self-employed person,(b) Does not have to work for the same employer or be self-employedin the same trade or business for the 78 weeks, and(c) Must work with in the same general commuting area for all 78weeks.Deductible ExpensesDeductible qualified moving expenses include the reasonable expenses of:(1) Moving taxpayer’s household goods and personal effects (including intransitor foreign-move storage expenses), and

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(2) Traveling (including lodging but not meals) to taxpayer’s new home.Note: Taxpayers can no longer deduct any expenses for meals.Taxpayers can deduct only those expenses that are reasonable for the circumstancesof their move. For example, the cost of traveling from a taxpayer’sformer home to their new one should be by the shortest, most direct routeavailable by conventional transportation. If, during the trip to the new home,taxpayer stops over or makes side trips for sightseeing, the additional expensesfor their stopover or side trips are not deductible as moving expenses.In addition, taxpayers can deduct the cost of packing, crating, and transportingtheir household goods and personal effects and those of the members oftheir household from their former home to their new home. Taxpayers caninclude the cost of storing and insuring household goods and personal effectswithin any period of 30 consecutive days after the day their things are movedfrom the former home and before they are delivered to the new home.Other deductible moving expenses include the cost of:1-137(a) Connecting or disconnecting utilities required because of movinghousehold goods, appliances, or personal effects,(b) Shipping taxpayer’s car and household goods to the new home,(c) Moving taxpayer’s household goods and personal effects from a placeother than the former home, limited to the amount it would have cost tomove them from the former home.Travel ExpensesA taxpayer can deduct the cost of transportation and lodging for themselvesand members of their household while traveling from the formerhome to the new home. This includes expenses for the arrival day.A taxpayer can include any lodging expenses they had in the area of theirformer home within one day after they could no longer live in their formerhome because their furniture had been moved.Note: A taxpayer can deduct expenses for only one trip to their new homefor themselves and members of their household. However, all of membersdo not have to travel together or at the same time.Travel by CarIf a taxpayer uses their car to take themselves, members of their household,or their personal effects to their new home, they can figure their expensesby deducting either:(a) The taxpayer’s actual expenses, such as gas and oil for their car, ifthey keep an accurate record of each expense, or(b) The standard mileage rate of 24 cents (in 2009) per mile.Location of MoveThere are different rules for moving within or to the United States than formoving outside the United States. To deduct allowable expenses for a move

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outside the United States, taxpayer must be a United States citizen or residentalien who moves to the area of a new place of work outside the UnitedStates and its possessions.If a taxpayer’s move is to a location outside the United States and its possessions,they can deduct the cost of:(1) Moving household goods and personal effects from the former hometo the new home,(2) Traveling (including lodging) from the former home to the new home,(3) Moving household goods and personal effects to and from storage,and(4) Storing household goods and personal effects while the taxpayer is atthe new job location.1-138ReportingUse Form 3903, Moving Expenses, to report moving expenses and any reimbursementsor allowances received for a move. Use a separate Form 3903 foreach qualified move. Moving expenses are deducted on line 26 of Form 1040.The amount of moving expenses a taxpayer can deduct is shown on line 5 ofForm 3903.ReimbursementsIf a taxpayer received a reimbursement for their allowable moving expenses,how they report this amount and their expenses depends on whether the reimbursementwas paid under an accountable plan or a nonaccountable plan.If all reimbursements meet the rules for an accountable plan, the taxpayer’semployer should not include any reimbursements of allowable expenses inthe taxpayer’s income in box 1 of the taxpayer’s Form W-2. Instead, the taxpayer’semployer should include the reimbursements in box 13 of the taxpayer’sForm W-2.If a taxpayer’s reimbursements are under a nonaccountable plan, the employerwill combine the amount of any reimbursement paid under the nonaccountableplan with the taxpayer’s wages, salary, or other pay. The employerwill report the total in box 1 of the taxpayer’s Form W-2.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. The

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following questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.1-13938. Taxpayers taking a deduction for §165 casualty or theft losses must showproof of three items. Which proof must be shown to deduct both losses?a. that the loss was a result of the damage, destruction, or loss of theproperty from a sudden, unexpected, or unusual event.b. that the taxpayer owned the property.c. that the taxpayer’s property was stolen.d. when the taxpayer discovered that their property was missing.39. The author lists twelve items subject to the 2% of adjusted gross income(AGI) limitation of §67. Which of the following is such an item?a. the deduction for taxes under §164.b. casualty losses deductible under §165.c. the deduction for amortizable bond premium under §171.d. unreimbursed employee business expenses, including union dues.40. A percentage of business-related meal expenses can be deducted whiletraveling away from home. What percentage of such expenses may a taxpayerdeduct?a. 0%.b. 50%.c. 75%.d. 100%.41. One of two time tests must be met to deduct moving expenses under§217. For purposes of the time test for employees under §217, the taxpayer:a. has to work 39 consecutive weeks.b. has to work for the same employer for all 39 weeks.c. may count any work they do as a self-employed person.d. has to work full-time within the same commuting region for 39 weeks.

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42. Under §217, there are two classifications of expenses that may be deductiblequalified moving expenses. What is one of these classifications?a. meals while moving.b. pre-move house hunting costs.c. residence sale expenses.d. transportation and lodging.1-140

Answers & Explanations38. Taxpayers taking a deduction for §165 casualty or theft losses must showproof of three items. Which proof must be shown to deduct both losses?a. Incorrect. For a casualty loss only, taxpayers should be able to show thatthe loss was a direct result of the casualty, defined as a direct result of thedamage, destruction, or loss of the property resulting from an identifiableevent that is sudden, unexpected, or unusual.b. Correct. For both a casualty loss and a theft loss, taxpayers should be ableto show that the taxpayer was the owner of the property. For a casualty loss,if the taxpayer leased the property from someone else, they should be able toshow that the taxpayer was contractually liable to the owner for the damage.c. Incorrect. For a theft loss only, taxpayers should be able to show that thetaxpayer’s property was stolen.d. Incorrect. For a theft loss only, taxpayers should be able to show when thetaxpayer discovered that their property was missing. [Chp. 1]39. The author lists twelve items subject to the 2% of adjusted gross income(AGI) limitation of §67. Which of the following is such an item?a. Incorrect. Miscellaneous itemized deductions do not include any deductionfor taxes under §164. However, what are included are costs of preparing taxreturns and related expenses.b. Incorrect. Miscellaneous itemized deductions do not include casualtylosses deductible under §165. However, what are included are fees that a taxpayerpays to appraise the amount of a casualty loss or a charitable contributionof property.c. Incorrect. Miscellaneous itemized deductions do not include the deductionfor amortizable bond premium under §171. However, what are included arecertain fees and other expenses in connection with investment income orproperty.d. Correct. Miscellaneous itemized deductions include unreimbursed employeebusiness expenses, including union and professional dues and officeat-home expenses to the extent deductible. [Chp. 1]40. A percentage of business-related meal expenses can be deducted while

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traveling away from home. What percentage of such expenses may a taxpayerdeduct?a. Incorrect. Taxpayers can deduct 0% of nonbusiness-related meal expenses.Such meals are personal and nondeductible.b. Correct. Generally, you can deduct only 50% of your business-related mealexpenses while traveling away from your home for business purposes.1-141c. Incorrect. You can deduct a higher percentage if the meals take place duringor incident to any period subject to the Department of Transportation’s“hours of service” limits. These limits apply to workers who are under certainfederal regulations.d. Incorrect. Previously, this percentage was 100%. However, this percentagehas been gradually reduced by subsequent legislation. [Chp. 1]41. One of two time tests must be met to deduct moving expenses under §217.For purposes of the time test for employees under §217, the taxpayer:a. Incorrect. For purposes of the time test for employees under §217, the taxpayerdoes not have to work 39 weeks in a row.b. Incorrect. For purposes of the time test for employees under §217, the taxpayerdoes not have to work for the same employer for all 39 weeks.c. Incorrect. For purposes of the time test for employees under §217, the taxpayermay only count their full-time work as an employee, not any work theydo as a self-employed person.d. Correct. For purposes of the time test for employees under §217, the taxpayermust work full-time within the same general commuting area for all 39weeks. [Chp. 1]42. Under §217, there are two classifications of expenses that may be deductiblequalified moving expenses. What is one of these classifications?a. Incorrect. Taxpayers can no longer deduct meals while moving.b. Incorrect. Taxpayers can no longer deduct pre-move house hunting costs.c. Incorrect. Taxpayers can no longer deduct residence sale expenses.d. Correct. A taxpayer can deduct the cost of transportation and lodging forthemselves and members of their household while traveling from the formerhome to the new home. This includes expenses for the arrival day. [Chp. 1]1-142

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CreditsA deduction is subtracted either from gross income or from AGI. In either case,the deduction reduces taxable income. A credit, on the other hand, reduces taxon a dollar for dollar basis.Child Care Credit - §21 [Form 2441]Employment related expenses for child or dependent care can qualify for acredit. The credit is 35% of expenses incurred by taxpayers with adjusted grossincome of $15,000 or less. The percentage decreases by 1% for each $2,000 (orfraction thereof) of additional gross income, but not below 20%.AGI in Excess of: Credit Percent:15,000 34%17,000 33%19,000 32%21,000 31%23,000 30%25,000 29%27,000 28%29,000 27%1-14331,000 26%33,000 25%35,000 24%37,000 23%39,000 22%41,000 21%43,000 20%EligibilityA qualifying individual must furnish more than half the cost of maintaining ahousehold for either:(1) A dependent under age 13, or(2) A dependent or spouse who is physically or mentally incapacitated.Employment Related ExpensesExpenses qualifying for the credit include expenses for household servicesand for the care of qualifying individuals that are incurred to enable the taxpayerto be employed.Qualifying Out-of-the-home ExpensesQualifying out-of-the-home expenses include those for a dependent underage 13 and for an older dependent or spouse who is incapacitated aslong as he or she regularly spends at least eight hours each day in the taxpayer’shousehold.Payments to RelativesChildcare payments to relatives are eligible for the credit unless the relative

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is a dependent of the taxpayer or the taxpayer's spouse or are a child(under age 19) of the taxpayer.Allowable AmountThe amount of employment-related expenses that may be used to computethe credit is $3,000 if the expenses are incurred for one qualifying individualand $6,000 if they are incurred for two or more qualifying individuals.Dependent Care Assistance - §129The dollar amount of expenses eligible for the credit is reduced, dollar fordollar, by the aggregate amount excludable from gross income under §129dependent care assistance exclusion.1-144ReportingThe credit is not allowable unless the taxpayer reports the correct name, address,and tax identification number of the care provider. The credit isclaimed by completing and filing Form 2441, Credit for Child and DependentCare Expenses.Earned Income Credit - §32 [Form 1040]The earned income tax credit is a special credit allowable for persons who workand meet certain criteria established by law. The credit reduces the amount oftax owed and may qualify taxpayers for a refund even if they do not owe any tax,or earned enough money to file a return. The credit is intended to offset some ofthe increases in living expenses and social security taxes for taxpayers with limitedincomes.Formerly, the earned income credit was only allowed to lower income workerswith families. Since 1994, §32(a)(1) provides an earned income tax credit amountfor taxpayers:(1) With one qualifying child,(2) Two or more qualifying children, or(3) No children.For a person with one qualifying child, the maximum credit has increased to$3,043 in 2009. If a person has two or more qualifying children, the maximumcredit has increased to $5,028 in 2009.The earned income credit has expanded to include some persons who work, earnunder $16,560, and do not have a qualifying child. The credit could be as muchas $457.

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For 2009 and 2010, the American Recovery & Reinvestment Act increases theEITC credit percentage for families with three or more qualifying children to 45%.ExampleIn 2009, taxpayers with three or more qualifying children mayclaim a credit of 45 percent of earnings up to $12,570, resultingin a maximum credit of $5,656.50.In addition, the Act increases the threshold phase-out amounts for married couplesfiling joint returns to $5,000 (indexed for inflation starting in 2010) abovethe threshold phase-out amounts for singles, surviving spouses, and heads ofhouseholds) for 2009 and 2010.1-145ExampleIn 2009, the maximum credit of $3,043 for one qualifying childis available for those with earnings between $8,950 and$16,420 ($21,420 if married filing jointly).The credit begins to phase down at a rate of 15.98 percent of earnings above$16,420 ($21,420 if married filing jointly). The credit is phased down to $0 at$35,463 of earnings ($40,463 if married filing jointly).Persons with One or More Qualifying ChildrenIn order to take the earned income credit, a person with a child, must:(1) Have a qualifying child who lived with them in the United States formore than half the year (the whole year for an eligible foster child);(2) Have earned income during the year;(3) Have earned income and adjusted gross income less than:(a) $38,583 (in 2009) if they have one qualifying child, or(b) $43,415 (in 2009) if they have more than one qualifying child;(4) Have their return cover a 12-month periodNote: This does not apply if a short period return is filed because of an individual’sdeath.(5) Use a filing status other than married filing separately;(6) Not be a qualifying child of another person;(7) Not have their qualifying child be the qualifying child of another personwhose adjusted gross income is greater;(8) Not claim as a dependent a qualifying child who is married; and(9) Not be filing Form 2555, Foreign Earned Income (or Form 2555-EZ,Foreign Earned Income Exclusion).Note: These forms are filed to exclude from gross income any income earnedin foreign countries, or to deduct or exclude a foreign housing amount. U.S.possessions are not foreign countries.Persons without a Qualifying ChildIn order to take the earned income credit, a person without a qualifying child,must:(1) Have earned income during the year;(2) Have earned income and adjusted gross income less than $16,560 (in

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2009);(3) Have their return cover a 12-month period;1-146Note: This does not apply if a short period return is filed because of an individual’sdeath.(4) Use a filing status other than married filing separately;(5) Not be a qualifying child of another person;(6) Be at least age 25 but under age 65 before the close of their tax year;(7) Not be eligible to be claimed as a dependent on anyone else’s return;(8) Have their main home in the United States for more than half theyear; and(9) Not be filing Form 2555, Foreign Earned Income, or Form 2555-EZ,Foreign Earned Income Exclusion.ComputationFor tax years beginning in 2009, the “maximum amount of the credit” is calculatedby multiplying the “earned income amount” by the “credit percentage”as follows:Type of TaxpayerCreditPercentageEarned IncomeAmountMaximum Amountof the Credit1 child 34 $8,950 $3,0432 or more children 40 $12,750 $5,028No children 7.65 $5,970 $457PhaseoutSection 32(a)(2) provides for the phaseout of the earned income tax credit.The amount of the reduction in the maximum amount of the credit caused bythe phaseout is calculated by multiplying the “phaseout percentage” by theamount by which the taxpayer’s adjusted gross income (or, if greater, earnedincome) exceeds the “threshold phaseout amount.” For tax years beginningin 2009, the “phaseout percentages,” the “threshold phaseout amounts,” andthe “completed phaseout amounts” are as follows:Type of TaxpayerPhaseoutPercentageThresholdPhaseoutAmountCompletedPhaseoutAmount1 child 15.98 $19,540 $38,5832 or more children 21.06 $19,540 $43,415No children 7.65 $10,590 $16,560

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1-147Advance Payment of Earned Income CreditAn eligible individual may elect to receive advance payment of the earned incomecredit from his employer. An employee who believes that he is eligiblefor the credit may claim advance payments by providing the employer with aForm W-5 on which the employee certifies that he expects to be eligible forthe credit, that he doesn’t have a certificate in effect with another employer,and whether or not the employee’s spouse has a certificate in effect. The employerthen is required to add the advance payment to the employee’s paycheck.The advance payment is reflected in the employee’s W-2 form as aseparate item. The amount depends on the employee’s earnings in the payperiod, and is determined from IRS tables included in Circular E whereother payroll withholding tables are.Adoption Credit & Exclusion - §23 & §137A tax credit is allowed for qualified adoption expenses paid or incurred by a taxpayer.Since 2002, the maximum credit is $10,000 (adjusted for inflation) per eligiblechild , including special needs children (§23). The adoption credit is permanentlyallowed against the alternative minimum tax.Note: The $10,000 credit is allowed in the year a special needs adoption isfinalized regardless of whether the taxpayer has qualified adoption expenses.No credit is allowed with respect to the adoption of a special needs child ifthe adoption is not finalized.Qualified adoption expenses are reasonable and necessary adoption fees, courtcosts, attorney’s fees, and other expenses that are:(1) Directly related to, and the principal purpose of which is for, the legaladoption of an eligible child by the taxpayer;(2) Not incurred in violation of State or Federal law, or in carrying out anysurrogate parenting arrangement;(3) Not for the adoption of the child of the taxpayer's spouse; and(4) Not reimbursed (e.g., by an employer).Qualified adoption expenses may be incurred in one or more taxable years, butthe credit may not exceed $10,000 (adjusted for inflation) per adoption. Theadoption credit is phased out ratably for taxpayers with modified adjusted grossincome between $150,000 and $190,000. Modified adjusted gross income is thesum of the taxpayer’s adjusted gross income plus amounts excluded from income

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under §911, §931, and §933 (relating to the exclusion of income of U.S. citizensor residents living abroad; residents of Guam, American Samoa, and the NorthernMariana Islands; and residents of Puerto Rico, respectively).1-148Exclusion from Income for Employer ReimbursementsA maximum $10,000 (adjusted for inflation) exclusion from the gross incomeof an employee is allowed for qualified adoption expenses paid or reimbursedby an employer under an adoption assistance program. The exclusionis also phased out ratably for taxpayers with modified adjusted gross incomebetween $150,000 and $190,000 (§137). These amounts are adjusted annuallyfor inflation.The exclusion does not apply for purposes of payroll taxes. Adoption expensespaid or reimbursed by the employer under an adoption assistanceprogram are not eligible for the adoption credit. A taxpayer may be eligiblefor the adoption credit (with respect to qualified adoption expenses he or sheincurs) and also for the exclusion (with respect to different qualified adoptionexpenses paid or reimbursed by his or her employer).

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.1-14943. Which of the following credits was created by §32 to provide this relief for

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lower income taxpayers?a. Making Work Pay credit.b. child care credit.c. first-time homebuyer credit.d. earned income tax credit.44. The earned income tax credit (EITC) is available to certain income earners.Of the following, who would qualify for the EITC?a. a taxpayer whose income is entirely from interest and dividends.b. an individual whose total disqualified income is over $3,100 in 2009.c. an unmarried individual with no children who is filing as head ofhousehold.d. married individuals filing separately.45. Sections 23 provides an individual credit for qualified adoption expenses.Such expenses must meet four general requirements. For example, suchadoption fees and related expenses:a. must not be incurred in breach of an arrangement for surrogate parentingof a child.b. must be directly or indirectly related to the adoption.c. can be incurred in the process of adopting a spouse’s child.d. can be reimbursed by an employer.

Answers & Explanations43. Which of the following credits was created by §32 to provide this relief forlower income taxpayers?a. Incorrect. The American Recovery and Reinvestment Act of 2009 makesthe Making Work Pay credit available for individuals with earned income.Eligible individuals must be United States citizens, may not be claimed as adependent on another’s return, and may not be an estate or trust.b. Incorrect. Employment related expenses for child or dependent care canqualify for a credit under §21.c. Incorrect. This credit under §36 is allowed for those who purchase a qualifyinghome as a first time homebuyer.d. Correct. The earned income tax credit is a special credit allowable for personswho work and meet certain criteria established by §32. The credit reducesthe amount of tax owed and may qualify taxpayers for a refund even if1-150they do not owe any tax, or earned enough money to file a return. The creditis intended to offset some of the increases in living expenses and social securitytaxes for taxpayers with limited incomes. [Chp. 1]44. The earned income tax credit (EITC) is available to certain income earners.

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Of the following, who would qualify for the EITC?a. Incorrect. Interest and dividend income is disqualified income for EITCpurposes and if a taxpayer's income is entirely derived from such sources,they will not qualify for the EITC.b. Incorrect. Disqualified income equals the sum of taxable and tax-exemptinterest, dividends, net rent and royalty income above zero, capital gains netincome, and net passive income above zero (that is not self-employment income).If an individual’s total disqualified income is over $3,100 in 2009, theEITC will not be available. The total disqualified income must be no morethan this amount in 2009 to be eligible for the EITC.c. Correct. There are three separate EITC credit schedules for taxpayers, andone of them applies to taxpayers with no qualifying children. Thus, taxpayerswithout children may be eligible for the EITC. Also, unmarried individualsfiling as single or as head of household may qualify.d. Incorrect. Generally, married individuals may take the EITC only if theyfile jointly. However, there is an exception. If married individuals are separatedduring at least the last six months of the taxable year, they shall not beconsidered as married, and they could claim the EITC. Thus, married individualsfiling separately will not be eligible for the EITC. [Chp. 1]45. Sections 23 provides an individual credit for qualified adoption expenses.Such expenses must meet four general requirements. For example, suchadoption fees and related expenses:a. Correct. Qualified adoption expenses are reasonable and necessary adoptionfees, court costs, attorney’s fees, and other expenses that are not incurredin violation of state or federal law, or in carrying out any surrogateparenting arrangement.b. Incorrect. Qualified adoption expenses must be directly related to, and theprincipal purpose of which is for, the legal adoption of an eligible child by thetaxpayer.c. Incorrect. Qualified adoption expenses do not include expenses for theadoption of a child of the taxpayer's spouse.d. Incorrect. A taxpayer cannot qualify for the adoption credit if an employerreimburses the adoption expenses. [Chp. 1]1-151Child Tax Credit - §24Credit AmountAn individual may claim a tax credit for each qualifying child under the age of17. In general, in the case of a taxpayer with qualifying children, the amountof the child credit equals the amount of the credit times the number of qualifyingchildren.

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Note: Withholding allowances should be adjusted to take this credit into account.The child tax credit was scheduled to gradually increase to $1,000 over tenyears. However, the Working Family Relief Act of 2004 accelerated thisschedule so that the child tax credit is now $1,000.Qualifying ChildA qualifying child is defined as an individual for whom the taxpayer canclaim a dependency exemption and who is a son or daughter of the taxpayer(or descendent of either), a stepson or stepdaughter of the taxpayeror an eligible foster child of the taxpayer.Note: Since 2005, the term qualifying child is defined under the new uniformdefinition of a "qualifying child" established by the Working Family ReliefTax Act of 2004.Phase outFor taxpayers with modified adjusted gross income (AGI) in excess of certainthresholds, the otherwise allowable child credit is phased out at a rate of $50for each $1,000 of modified AGI (or fraction thereof) in excess of the threshold.For married taxpayers filing joint returns, the threshold is $110,000. For1-152taxpayers filing single or head of household returns, the threshold is $75,000.For married taxpayers filing separate returns, the threshold is $55,000. Thesethresholds are not indexed for inflation.The length of the phase-out range depends on the number of qualifying children.For example, the phase-out range for a single individual with one qualifyingchild is between $75,000 and $85,000 of modified adjusted gross income.The phase-out range for a single individual with two qualifying childrenis between $75,000 and $95,000.Refundable Child Care Credit AmountThe child credit is refundable to the extent of 10% of the taxpayer’s earnedincome in excess of $10,000 for calendar years 2001-2004. The percentagewas increased to 15% for calendar years 2005 and thereafter. The $10,000amount has been indexed for inflation since 2002.Families with three or more children are allowed a refundable credit for theamount by which the taxpayer's social security taxes exceed the taxpayer’searned income credit (the present-law rule), if that amount is greater thanthe refundable credit based on the taxpayer’s earned income in excess of$10,000.For 2009 and 2010, the American Recovery & Reinvestment Act modifiesthe earned income formula for the determination of the refundable childcredit to apply to 15 percent of earned income in excess of $3,000 for taxableyears beginning in 2009 and 2010.AMT & Child Tax Credit

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The refundable child tax credit is not reduced by the amount of the alternativeminimum tax. The child tax credit is allowed to the extent of the fullamount of the individual’s regular income tax and alternative minimum tax.First-Time Homebuyer CreditIn 2008, Congress provided first-time homebuyers with a refundable tax creditequal to the lesser of:(1) $7,500 ($3,750 for a married individual filing separately), or(2) 10% of the purchase price of a principal residence.The credit was allowed for qualifying home purchases on or after April 9, 2008and before July 1, 2009 (without regard to whether there was it binding contractto purchase prior to April 9, 2008). In addition, the credit was recaptured ratablyover fifteen years with no interest charge beginning in the second taxable year afterthe taxable year in which the home was purchased.In 2009, Congress extended the homebuyer credit to qualifying home purchasesbefore December 1, 2009. In addition, it increased the maximum credit amount1-153to $8,000 ($4,000 for a married individual filing separately) and waived the recaptureof the credit for qualifying home purchases after December 31, 2008 andbefore December 1, 2009. This waiver of recapture applies without regard towhether the taxpayer elects to treat the purchase in 2009 as occurring on December31, 2008. If the taxpayer disposes of the home or the home otherwiseceases to be the principal residence of the taxpayer within 36 months from thedate of purchase, the prior law rules for recapture of the credit will apply.First-time homebuyer. A taxpayer is considered a first-time homebuyer if suchindividual had no ownership interest in a principal residence in the United Statesduring the three-year period prior to the purchase of the home to which thecredit applies.Phase out. The credit phases out for individual taxpayers with modified adjustedgross income between $75,000 and $95,000 ($150,000 and $170,000 for joint filers)for the year of purchase.

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Who cannot claim the credit. You cannot claim the credit if any of the followingapplies:(1) your modified adjusted gross income is $95,000 or more ($170,000 ormore if married filing jointly);(2) you are, or were, eligible to claim the District of Columbia first-timehomebuyer credit for any taxable year;(3) your home financing comes from tax-exempt mortgage revenue bonds;(4) you are a nonresident alien;(5) your home is located outside the United States;(6) you sell the home, or it ceases to be your main home, before the end of2008;(7) you acquired your home by gift or inheritance; or(8) you acquired your home from a related person.Related person: A related person includes:(1) your spouse, ancestors (parents, grandparents, etc.), or lineal descendants(children, grandchildren, etc);(2) a corporation in which you directly or indirectly own more than 50% invalue of the outstanding stock of the corporation; or(3) a partnership in which you directly or indirectly own more than 50% ofthe capital interest or profits interests.“Making Work Pay” Tax CreditFor 2009 and 2010, the American Recovery & Reinvestment Act provides eligibleindividuals a refundable income tax credit for two years (taxable years beginningin 2009 and 2010).Credit: The credit is the lesser of:1-154(1) 6.2 percent of an individual's earned income, or(2) $400 ($800 in the case of a joint return).Earned Income: Only individuals with earned income qualify for the MakingWork Pay credit. For these purposes, the earned income definition is the sameas for the earned income tax credit (EITC) with two modifications:1. Earned income for these purposes does not include net earnings from selfemploymentwhich are not taken into account in computing taxable income.Note: However, earnings from self-employment qualify to the extent they aretaken into account in computing taxable income.2. Earned income for these purposes includes combat pay excluded fromgross income under §112.Phaseout: The credit is phased out at a rate of two percent of the eligible individual'smodified adjusted gross income above $75,000 ($150,000 in the case of a

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joint return). For these purposes an eligible individual's modified adjusted grossincome is the eligible individual's adjusted gross income increased by any amountexcluded from gross income as income earned outside the U.S. under §§911, 931,or 933.Eligible Individual: An eligible individual means any individual other than:(1) a nonresident alien;(2) an individual with respect to whom another individual may claim a dependencydeduction for a taxable year beginning in a calendar year in whichthe eligible individual's taxable year begins; and(3) an estate or trust.Credit Reduction: The Making Work Pay credit is reduced by the amount of anypayment received by the taxpayer pursuant to the provisions of the Act providingeconomic recovery payments under the Veterans Administration, Railroad RetirementBoard, and the Social Security Administration and a temporary refundabletax credit for certain government retirees.Identification: Each eligible individual must satisfy identical taxpayer identificationnumber requirements to those applicable to the earned income tax credit.Individuals who do not provide their Social Security number on their tax returnare not eligible for the credit.Claiming the Credit: Taxpayers can receive this benefit either through:(1) a reduction in the amount of income tax that is withheld from their paychecks,or(2) claiming the credit on their tax returns.Hope & Lifetime Learning CreditsIncome limits for credit reduction increased. For 2008, the amount of yourHope or lifetime learning credit is phased out (gradually reduced) if your modi1-155fied adjusted gross income (AGI) is between $48,000 and $58,000 ($96,000 and$116,000 if you file a joint return). You cannot claim an education credit if yourmodified AGI is $58,000 or more ($116,000 or more if you file a joint return).Hope credit. Beginning in 2008, the maximum amount of Hope credit you can

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claim is $1,800 ($3,600 if a student in a Midwestern disaster area) per student.The amount of the credit for each eligible student is the sum of:(1) 100% of the first $1,200 ($2,400 if a student in a Midwestern disasterarea) of qualified education expenses you paid for the eligible student, and(2) 50% of the next $1,200 ($2,400 if a student in a Midwestern disaster area)of qualified education expenses you paid for that student.Students in Midwestern disaster areas. The following rules apply only to studentsattending an eligible educational institution in the Midwestern disaster areasin the states of Arkansas, Illinois, Indiana, Iowa, Missouri, Nebraska, andWisconsin.Hope credit increased. The Hope credit for students in Midwestern disasterareas is 100% of the first $2,400 of qualified education expenses and 50% ofthe next $2,400 of qualified education expenses for a maximum credit of$3,600 per student.Lifetime learning credit increased. The lifetime learning credit rate for studentsin Midwestern disaster areas is 40% of qualified expenses paid, with amaximum credit of $4,000 allowed on your return.Definition of qualified expenses expanded. The definition of qualified educationexpenses for the education credits is expanded for students in Midwesterndisaster areas.“American Opportunity” Education Tax CreditFor 2009 and 2010, the American Recovery & Reinvestment Act modifiesthe Hope credit for taxable years beginning in 2009 or 2010. The modifiedcredit is renamed the “American Opportunity Tax” credit.Allowable credit. The allowable modified credit is up to $2,500 per eligiblestudent per year for qualified tuition and related expenses paid for each ofthe first four years of the student's post-secondary education in a degree orcertificate program. The modified credit rate is 100% on the first $2,000 ofqualified tuition and related expenses, and 25% on the next $2,000 of qualifiedtuition and related expenses.Note: For purposes of the modified credit, the definition of qualified tuitionand related expenses is expanded to include course materials.Four years. Under the Act, the modified credit is available with respect to anindividual student for four years, provided that the student has not completedthe first four years of post-secondary education before the beginningof the fourth taxable year. Thus, the modified credit, in addition to other1-156

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modifications, extends the application of the Hope credit to two more yearsof post-secondary education.Phase out. The modified credit that a taxpayer may otherwise claim is phasedout ratably for taxpayers with modified adjusted gross income between$80,000 and $90,000 ($160,000 and $180,000 for married taxpayers filing ajoint return). The modified credit may be claimed against a taxpayer's alternativeminimum tax liability.Refundable credit. Forty percent of a taxpayer's otherwise allowable modifiedcredit is refundable. However, no portion of the modified credit is refundableif the taxpayer claiming the credit is a child to whom section 1(g)applies for such taxable year (generally, any child under age 18 or any childunder age 24 who is a student providing less than one-half of his or her ownsupport, who has at least one living parent and does not file a joint return).

Ministers & Military - §107ClergyMembers of the clergy must include in income the amounts received from offeringsand fees for marriages, baptisms, funerals, masses, etc., in addition to theirsalary. However, if the offering is made to the religious institution, it is not taxableto the clergy member.Members of religious organizations, who turn over their outside earnings to theorganization, must still include the earnings in their income. However, they maybe entitled to a charitable contribution deduction for the amount paid to the organization.Rental Value of a HomeIf clergy members are provided a home as part of their pay for carrying outtheir duties as an ordained, licensed, or commissioned minister, the rentalvalue of the home and the utility expenses paid for them are not income tothem. However, clergy must include the rental value of the home, and relatedallowances, as earnings from self-employment on Schedule SE (Form 1040)for purpose of the Social Security Self-employment tax.Comment: Expenses of providing a home include rent, house payments, furniturepayments, and utilities. They do not include the cost of food or servants.Similarly housing allowances paid to clergy as part of salary to the extent theyuse it to provide a home or to pay utilities are not taxable.1-157Members of Religious Orders

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A member of a religious order, who has taken a vow of poverty, excludes fromincome the amounts earned for services performed as an agent of the orderthat are renounced and turned over to the order.If the member is directed to take employment outside the order, the employmentwill not constitute the exercise of duties required by the orderunless the services are:(a) The kind that are ordinarily the duties of members of the order, and(b) A part of the duties that is required to be exercised for, or on behalfof, the religious order as its agent.Ordinarily, services will not be considered directed or required by the order ifthe legal relationship of employer and employee exists between the memberand a third party for whom the services are performed. When services are notconsidered to be directed or required by the order, the amounts received forthe services are includable in the member’s gross income. This is true even ifthe member has taken a vow of poverty.ExampleMark Brown is a member of a religious order and has takena vow of poverty. All claims to his earnings are renouncedand belong to the order.Mark is a schoolteacher. He was instructed by the superiorsof the order to get a job with a private tax-exempt school, andas he requested, the school made the salary payments directlyto the order. Because Mark is an employee of theschool, he is performing services as the school’s agent ratherthan as an agent of the order through whom the order performsservices for the school. Therefore, the wages Markearns working for the school are included in his gross income.

Military & VeteransPayments received as a member of a military service generally are taxable exceptfor certain allowances. They are reported as wages. However, veterans’ benefitsgenerally are not taxable.WagesMilitary pay taxable as wages includes:(a) Active duty pay,(b) Reserve training pay,(c) Reenlistment bonus,(d) Armed services academy pay,1-158(e) Amounts received by retired personnel serving as instructors in juniorROTC programs, and(f) Lump-sum payments upon separation or release to inactive duty.Military retirement pay based on age or length of service is taxable and mustbe included on line 16, Form 1040.

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Nontaxable IncomeMilitary benefits not taxable as wages include:(1) Annual round trip for dependent students(2) Burial and death services (internal allowances)(3) Combat zone compensation and benefits(4) Death gratuities(5) Defense counseling(6) Dental care for military dependents(7) Dependent education(8) Disability benefits(9) Educational assistance(10) Emergency assistance(11) Evacuation allowances(12) Family counseling(13) Family separation allowances(14) Forfeited pay(15) Group term life insurance(16) Housing allowances(17) Medical benefits(18) Moving and storage(19) Mustering out payments (payments on discharge)(20) Overseas cost-of-living allowances(21) Premiums for survivor & retirement protection plans(22) Professional education(23) Quarters allowances(24) Subsistence allowances(25) Temporary lodging in conjunction with certain orders(26) Travel for consecutive overseas tours(27) Travel for consecutive overseas tours for dependents(28) Travel in lieu of moving dependents during ship overhaul or inactivation(29) Travel of dependents to a burial site1-159(30) Travel to a designated place in conjunction with reassignment in adependent-restricted status(31) Uniform allowanceVeterans’ BenefitsVeterans’ benefits under any law administered by the Veterans Administrationare not included in gross income. The following amounts paid to veteransor their families are not taxable:(a) Education, training, or subsistence allowances,(b) Disability compensation and pension payments for disabilities(c) Grants for homes designed for wheelchair living(e) Grants for motor vehicles for veterans who lost their sight or the useof their limbs, and(f) Veterans’ pensions paid either to the veterans or to their families.

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Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.46. Parents can take advantage of several child-related credits. Which creditis available to certain taxpayers based on having a qualifying child under age17?a. lifetime learning credit.b. child tax credit.c. Hope credit.d. adoption credit.1-16047. The Making Work Pay tax credit uses the same definition of the earnedincome as the EITC with two modifications. Under these modifications, howis earned income defined under this tax credit?a. amounts received as tips that are excludable from gross income.b. self-employed’s net earnings that are not used to figure taxable income.c. amounts soldiers in active combat receive as extra pay that are excludedfrom gross income under §112.d. income from life insurance and endowment contracts that are excludablefrom gross income.48. The American Opportunity education tax credit is available to qualifiedindividuals for qualified tuition and related expenses. What does this taxcredit include in the definition of qualified tuition and related expenses?a. costs for course materials.b. costs for lodging.c. costs for meals.d. costs for sports.49. Which payments received for military service are taxable as wages?

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a. annual round trip for dependent students.b. armed services academy pay.c. combat zone compensation and benefits.d. mustering out payments (payments on discharge).

Answers & Explanations46. Parents can take advantage of several child-related credits. Which credit isavailable to certain taxpayers based on having a qualifying child under age17?a. Incorrect. The lifetime learning credit is a credit for higher education expensesand was not based on having a qualified child under age 17.b. Correct. The child tax credit, under §24, is a credit provided based on havinga qualified child under age 17. A qualified child is determined under theuniform qualified child definition.c. Incorrect. The Hope credit is for higher educational expenses and is notbased on having a qualified child under age 17.d. Incorrect. The adoption credit is a credit for qualified adoption expensespaid or incurred by a taxpayer and is not based on having a qualified childunder age 17. [Chp. 1]1-16147. The Making Work Pay tax credit uses the same definition of the earned incomeas the EITC with two modifications. Under these modifications, howis earned income defined under this tax credit?a. Incorrect. Tips are not excludable from gross income. They are taxable income.These amounts are included in the definition of earned income underboth credits.b. Incorrect. Under the EITC, earned income includes the amount of an individual’snet self-employment earnings. One of the changes that the MakingWork Pay tax credit makes to the definition of earned income is that selfemployeds’net earnings that are not used to figure taxable income are excludedfrom the definition. However, such earnings used to figure taxable incomeare included in the definition.c. Correct. Amounts soldiers in active combat receive as extra pay may be excludedfrom gross income under §112. Under the EITC, these amountswould not qualify as earned income since they are not includible in gross income.The Making Work Pay tax credit modifies the definition of earned incometo include these amounts.

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d. Incorrect. Income from life insurance and endowment contracts are generallyincludible in gross income. Based on the EITC, earned income excludesany amounts from life insurance and endowment contracts that areexcludable from gross income. No change was made by the Making Work Paytax credit to this portion of the definition. Thus, any of these amounts thatare excludable from gross income are still excluded from earned income underthe Act. [Chp. 1]48. The American Opportunity education tax credit is available to qualifiedindividuals for qualified tuition and related expenses. What does this taxcredit include in the definition of qualified tuition and related expenses?a. Correct. Students can claim the American Opportunity education taxcredit for qualified tuition and related expenses. Under the new Act, costs forcourse materials are included in the definition, which means that lab fees,books, etc. would be considered in determining qualified tuition and relatedexpenses.b. Incorrect. Under the regulations for the new credit, costs for lodging areexcluded from the definition of qualified tuition and related expenses. Thus,these amounts would not be used to figure the allowable credit amount.c. Incorrect. When figuring their qualified tuition and related expenses forthe American Opportunity education, qualified students may still not takemeals into consideration.d. Incorrect. Qualified students may only count expenses of education involvingsports, games, and hobbies if this education is part of the students’ degreeprogram. [Chp. 1]1-16249. Which payments received for military service are taxable as wages?a. Incorrect. Military benefits not taxable as wages include annual round tripfor dependent students.b. Correct. Military pay taxable as wages includes armed services academypay.c. Incorrect. Military benefits not taxable as wages include combat zone compensationand benefits.d. Incorrect. Military benefits not taxable as wages include mustering outpayments (payments on discharge). [Chp. 1]

Learning ObjectivesAfter reading the next chapter, participants will be able to:1. Explain the tax treatment of rental property expenses contrastingtheir impact on landlords and tenants taking into consideration the taxdifferences given to rent, advance payments, and security deposits.2. Analyze the application of the hobby loss rules to a business, determinedeductible health insurance costs, discuss the requirements of the

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home-office deduction, figure self-employment taxes for clients, andname four available business and investment credits.1-1633. Position clients to properly deduct travel and entertainment expensesby:a. Identifying at least nine types of business travel expenses, determininga taxpayer’s tax home, if any, and work locations basedon the IRS’s definition, and clarifying the “away from home” requirementand “sleep and/or rest” rule;b. Listing the key elements of deductible domestic and foreignbusiness travel costs and explaining the Reg. §1.162 deduction ofconvention and meeting expenses;c. Discussing the three §274 entertainment deductibility tests,clarifying the limits on home entertaining, ticket purchases, andmeals and entertainment, and listing eight exceptions to the percentagereduction rule; andd. Listing substantiation requirements associated with businessgifts, employee achievement awards, and sales incentive awards.4. Differentiate accountable and nonaccountable plans identifyingthree requirements for an accountable plan particularly adequately accountingfor travel and other employee business expenses.5. Differentiate local transportation and commuting explaining hownondeductible personal commuting and relates to local business transportationexpenses.6. Apportion automobile expenses between personal and business use,explain the actual cost and standard mileage methods, and define thegas guzzler tax.7. Name twelve types of excluded fringe benefits that can increase employers’deductions and incentive-based compensation of employeesproviding examples of each.8. Apply the cash, accrual, or other methods of accounting, determineavailable accounting periods including their impact on income and expenses,and compare expensing, depreciation, and amortization givingexamples of each.After studying the materials in this chapter, answer the exam questions 50to 112.2-1

CHAPTER 2Expenses, Deductions & Accounting

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Landlord's Rental ExpenseRepairs and certain other expenses of renting property can be deducted fromgross rental income. Rental expenses are normally deducted in the year they arepaid or incurred.If a taxpayer holds property for rental purposes, they may be able to deduct ordinaryand necessary expenses for managing, conserving, or maintaining theproperty while the property is vacant. However, they cannot deduct any loss ofrental income for the period the property is vacant.Note: A taxpayer can deduct their ordinary and necessary expenses for managing,conserving, or maintaining rental property from the time they make itavailable for rent. Likewise, if a taxpayer sells property they held for rentalpurposes, they can deduct the ordinary and necessary expenses for managing,conserving, or maintaining the property until it is sold.

Repairs & ImprovementsA taxpayer can deduct the cost of repairs they make to their rental property. Thecost of improvements is not deductible. Improvements are recovered by takingdepreciation.Note: Taxpayers should separate the costs of repairs and improvements, andkeep accurate records. Taxpayers need to know the cost of improvementswhen they sell or depreciate the property.2-2RepairsA repair keeps a property in good operating condition. It does not materiallyadd to the value of the property or substantially prolong its life. Repaintingproperty inside or out, fixing gutters or floors, fixing leaks, plastering, and replacingbroken windows are examples of repairs.Note: If a taxpayer makes repairs as part of an extensive remodeling or restorationof a property, the whole job is an improvement.ImprovementsAn improvement adds to the value of a property, prolongs its useful life, oradapts it to new uses. Putting a recreation room in an unfinished basement,paneling a den, adding a bathroom or bedroom, putting decorative grillworkon a balcony, putting up a fence, putting in new plumbing or wiring, puttingin new cabinets, putting on a new roof, and paving a driveway are examplesof improvements.Note: If a taxpayer makes an improvement to property before renting it, thecost of the improvement is added to the basis of the property.

Salaries & WagesA taxpayer can deduct reasonable salaries and wages paid to employees. They

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can also deduct bonuses paid to employees if, when added to their regular salariesor wages, the total is not more than reasonable pay.Note: A taxpayer can also deduct reasonable wages paid to their dependentchild if the child is a bona fide employee. However, a taxpayer cannot deductthe cost of meals and lodging for the child.

Rental Payments for Property & EquipmentA taxpayer can deduct the rent they pay for property that is used for rental purposes.If a taxpayer buys a leasehold for rental purposes, they can deduct anequal part of the cost each year over the term of the lease.Rent paid for equipment used for rental purposes can also be deducted. However,in some cases, lease contracts are actually purchase contracts. If so, thesepayments cannot be deducted. The cost of purchased equipment is recoveredthrough depreciation.Insurance PremiumsInsurance premiums paid for rental purposes are deductible. If the premiumsare paid for more than one year in advance, each year the taxpayer can only deductthe part of the premium payment that will apply to that year.2-3Local Benefit Taxes & Service ChargesGenerally, charges for local benefits cannot be deducted if they increase thevalue of the property, such as for putting in streets, sidewalks, or water and sewersystems. These charges are nondepreciable capital expenditures. They must beadded to the basis of the property. Local benefit taxes are deductible if they arefor maintaining, repairing, or paying interest charges for the benefits.A taxpayer can deduct charges paid for services provided for their rental property,such as water, sewer, and trash collection.Travel & Local Transportation ExpensesOrdinary and necessary costs of traveling away from home if the primary purposeof the trip was to collect rental income or to manage, conserve, or maintainrental property are deductible. Local transportation expenses are also deductibleif incurred to collect rental income or to manage, conserve, or maintain rentalproperty.In addition, if a taxpayer uses their personal car, pickup truck, or light van for

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rental activities, they can deduct local transportation expenses using one of twomethods: actual expenses or the standard mileage rate.Tax Return PreparationTaxpayers can deduct, as a rental expense, the part of tax return preparation feespaid to prepare Part I of Schedule E. Taxpayers can also deduct, as a rental expense,any expense paid to resolve a tax underpayment related to their rental activities.Other ExpensesOther expenses a taxpayer can deduct from their gross rental income include:(1) Advertising,(2) Janitor and maid service,(3) Utilities,(4) Fire and liability insurance,(5) Taxes,(6) Interest,(7) Commissions for the collection of rent, and(8) Ordinary & necessary travel and transportation.2-4

Tenant's Rental ExpenseWhen business property is leased, the rent paid can be deducted. Rent is theamount paid for the use of property not owned. In general, rent is deductible asan expense only if the rent is for property that is used in a trade or business. Ifthe taxpayer will receive equity in or title to the property, the rent is not deductible.Note: If a taxpayer rents rather than owns a home and uses part of the homeas their place of business, the rent paid for that part of the home is deductible,if the requirements for business use of a home are met.

Rent Paid in AdvanceIf rent is paid in advance, only the amount that applies to the use of the rentedproperty during the tax year in which payment was made can be deducted. Thebalance of the payment must be deducted over the period to which it applies.ExampleIn May 2009, Dan leased a building for 5 years beginning July1, 2009, and ending June 30, 2010. According to the terms ofthe lease, the rent is $12,000 per year. Dan paid the firstyear's rent ($12,000) on June 2, 2009. On his income tax returnfor calendar year 2009, Dan can deduct only $6,000

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(6/12 x $12,000) for the rent applicable to 2009.ExampleIn January 2009, Dan leased property for 3 years for $6,000 ayear. Dan paid the full $18,000 (3 x $6,000) during the firstyear of the lease. For 2009, Dan can deduct only $6,000, thepart of the rent that applies to 2009. Dan can deduct the balance($12,000) over the remaining 2-year term of the lease at$6,000 for each year.

Lease or PurchaseTo determine if payments are rent, there must first be a determination whetherthe agreement is a lease or a conditional sales contract. If under the agreement,the taxpayer acquired or will acquire title to or equity in the property, theagreement should be treated as a conditional sales contract. Payments made undera conditional sales contract are not deductible as rent expense.2-5Whether the agreement is a lease or a conditional sales contract depends uponthe intent of the parties. Intent is determined based upon the facts and circumstancesexisting at the time the agreement is made.Determining the IntentIn general, an agreement can be considered a conditional sales contractrather than a lease if any of the following is true:1. The agreement applies part of each "rent" payment toward an equity interestthat will be received.2. Title to the property is transferred after making all the required payments.3. The payments are over a short period of time compared to the usefullife of the property and in an amount that is close to the price of theproperty and the taxpayer can continue to use the property for periodsapproximating its useful life for nominal payments even if title does notpass.4. The "rent" paid is much more than the current fair rental value for theproperty.5. There is an option to buy the property at a price that is small comparedto the value of the property at the time the option may be exercised. Thisvalue is determined at the time of the agreement.6. There is an option to buy the property at a price that is small comparedto the total amount required to be paid under the lease.7. The lease designates some part of the "rent" payments as interest, orpart of the "rent" payments are easy to recognize as interest.Taxes on Leased PropertyWhen business property is leased, any taxes that have to be paid to or for the lessor

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can be deducted as additional rent. The timing of this deduction for additionalrent depends on the taxpayer's accounting method.Cash MethodIf a taxpayer uses the cash method of accounting, they can only deduct thetaxes as additional rent for the tax year in which they pay them.Accrual MethodIf a taxpayer uses the accrual method of accounting, they can deduct taxes asadditional rent for the tax year in which they can determine:(1) That they have a liability for taxes on the leased property,(2) How much the liability is, and2-6(3) That economic performance occurred.The liability and amount of taxes are determined by state or local law andalso by the lease agreement. Economic performance occurs as the property isused.ExampleOak Corporation is a calendar year taxpayer that uses theaccrual method of accounting. Oak leases land for use in itsbusiness. Under local law, owners of real property becomeliable (it becomes a lien on the property) for real estatetaxes for the year on January 1 of that year, but do not haveto pay these taxes until June 1 of the next year (18 monthslater). This means that property owners become liable for2009 real estate taxes on January 1, 2009, but do not haveto pay them until June 1, 2010.Under the terms of the lease, Oak becomes liable for the realestate taxes when the tax bills are issued on June 1, 2010.Oak cannot deduct the real estate taxes for 2009 as additionalrent until June 1, 2010. This is when Oak's liability underthe lease becomes fixed.If, according to the terms of the lease, Oak is liable for thereal estate taxes when the owner of the property becomes liablefor them, on January 1, 2009, but does not have to paythem until June 1, 2010, Oak will deduct the lessor's real estatetaxes as additional rent on its 2009 tax return. This is theyear in which Oak's liability under the lease becomes fixed.

Cost of Acquiring a LeaseTaxpayers may either enter into a new lease with the lessor of the property oracquire an existing lease from another lessee. Very often when an existing leaseis acquired from another lessee, in addition to paying the rent on the lease, thetaxpayer must pay the previous lessee a sum of money to acquire that lease.If an existing lease is acquired on property or equipment for use in a business,

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any amount paid to acquire that lease must amortized over the remaining termof the lease.ExampleIf a taxpayer pays $10,000 for an existing lease on a machineand there are 10 years remaining on the lease with no optionto renew, $1,000 can be deducted each year.2-7Option to Renew - 75% RuleThe term of the lease for amortization purposes will include all renewal options,as well as any period for which the lessee and lessor reasonably expectthe lease to be renewed, if less than 75% of the cost is attributable to theterm of the lease remaining on the purchase date. In determining the term ofthe lease remaining on the purchase date, do not include any period forwhich the lease may be renewed, extended, or continued under an option exercisableby the lessee.ExampleDan paid $10,000 to acquire a lease with 20 years remainingon it and two options to renew for 5 years each. Of this cost,$7,000 was paid for the original lease and $3,000 was appliedto the renewal options. Since $7,000 is less than 75% ofthe total cost of the lease of $10,000, Dan must amortize the$10,000 over 30 years, the remaining life of the present leaseplus the periods for renewal.ExampleIf in the above example, the amount applicable to the originallease had been $8,000, then Dan would have been allowedto amortize the entire $10,000 over the 20-year remaining lifeof the original lease because the $8,000 cost of acquiring theoriginal lease was not less than 75% of the total cost of thelease.Cost of a Modification AgreementIf a taxpayer has to pay an additional "rent" amount over part of the lease periodin order to change certain provisions in a lease, these payments must becapitalized and then amortized over the remaining period of the lease. Suchpayments cannot be deducted as additional rent, even if they are described asrent in the agreement.ExampleDan is a calendar year taxpayer and signs a 20-year leaseto rent part of a building starting on January 1. However, beforeDan occupies it, he decides that he really needs lessspace. The lessor agrees to reduce Dan's rent from $7,000to $6,000 per year and to release the excess space from theoriginal lease. In exchange, Dan agrees to pay an additional2-8rent amount of $3,000, payable in 60 monthly installments of

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$50 each.Dan must capitalize the $3,000 and amortize it over the 20-year term of the lease. His amortization deduction each yearwill be $150 ($3,000/20). Dan cannot deduct the $600 actuallypaid during each of the first 5 years as rent.Commissions, Bonuses, & FeesCommissions, bonuses, fees, and other amounts paid to obtain a lease onproperty used in a business are capital costs. These costs must be amortizedover the term of the lease.Loss on Merchandise & FixturesIf merchandise and fixtures bought solely to acquire a lease are sold at a loss,the loss is a cost of acquiring the lease. The loss must be capitalized and thenamortized over the remaining term of the lease.Improved Leased PropertyIf property is leased with a building or other improvement already on it, adepreciation deduction for such building or other improvements is not allowed.Construction Allowances Provided To Lessees - §110Gross income of a lessee does not include amounts received in cash (or treatedas a rent reduction) from a lessor under a short-term lease of retail space for thepurpose of the lessee's construction or improvement of qualified long-term realproperty for use in the lessee's trade or business at such retail space (§110).A short-term lease is a lease (or other agreement for occupancy or use) of retailspace for 15 years or less. The following rules apply in determining whether thelease is for 15 years or less:1. Take into account options to renew when figuring whether the lease is for15 years or less. However, do not take into account any option to renew atfair market value determined at the time of renewal.2. Two or more successive leases that are part of the same transaction (or aseries of related transactions) for the same or substantially similar retailspace are treated as one lease.Retail space is real property leased, occupied, or otherwise used by lessee intheir business of selling tangible personal property or services to the generalpublic.Qualified long-term real property is nonresidential real property that is part of,or otherwise present at, the retail space and that reverts to the landlord when thelease ends.2-9

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Assignment of a LeaseIf a long-term lessee makes permanent improvements to leased land and laterassigns all lease rights to a taxpayer for money, and the taxpayer pays the rentrequired by the lease, the amount the taxpayer pays for the assignment is a capitalinvestment. If the rental value of the unimproved land increased since thelease began, part of the taxpayer's capital investment is for that increase in therental value, and the balance is for the taxpayer's investment in the permanentimprovements.The part that is for the increased rental value of the leased land is a cost of acquiringa lease and can only be amortized over the remaining term of the lease.The part that is for the taxpayer's investment in the building can be depreciated.ExampleIn 2008, Frank leased unimproved land for 99 years and builta warehouse on it. In January 2009, immediately after thebuilding was completed, Frank assigned all his rights in thelease to Dan. Dan paid Frank $100,000 for the assignment,and also agreed to pay the rent for the unimproved land underthe lease. The $100,000 Dan paid Frank is consideredpaid for the warehouse, which Dan can capitalize and depreciate.ExampleAssume that in the above example Frank had leased theproperty, built the warehouse in 1978, and used it in his businessuntil he assigned the lease to Dan in January 2008. Therental value of the unimproved land for the remaining periodof the lease increased $40,000 since the time the lease wasentered into in 1978. Of the $100,000 that Dan paid to Frank,$40,000 is considered to have been paid for the lease. Treatthe balance of $60,000 as having been paid for the warehouse,which Dan must capitalize and depreciate.

Capitalizing Rent ExpensesUnder the uniform capitalization rules, taxpayers must capitalize or include ininventory all costs (direct and indirect) of producing real or tangible personalproperty, or in acquiring tangible or intangible property for resale. Indirect costsinclude amounts incurred for rent of equipment, facilities, or land.2-10ExampleDan rents construction equipment to build a storage facility.The rent Dan paid for the equipment must be capitalized aspart of the cost of the building. Dan recovers his cost byclaiming a deduction for depreciation on the building.

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ExampleDan rents space in a facility to conduct his business of manufacturingtools. The rent Dan paid to occupy the facility mustbe included in the cost of the tools he produces.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.50. Which costs are nondeductible when a taxpayer holds property for rentalpurposes?a. costs for improvements.b. maintenance costs.c. management costs.d. costs of repairs.2-1151. Landlords may deduct employee expenses related to renting property.However, which of the following employee costs are nondeductible by landlords?a. employee bonuses if, when added to their usual salaries or wages, theaggregate is less than reasonable pay.b. reasonable salaries and wages paid to employees who are not relatives.c. reasonable wages paid to a bona fide employee who is also a dependentchild.d. meals and lodging expenses for a bona fide employee who is also a dependentchild.52. Rent paid for business property is deductible under §162. However, underwhich circumstance will an agreement be deemed a conditional sales contract,

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instead of a lease, and thus be nondeductible as rent?a. The agreement does not designate part of the payments as interest.b. The amount paid is a large portion of what the taxpayer would pay totake title to the property.c. The taxpayer has an option to buy the property at its actual price.d. The taxpayer pays much less than the current fair rental value of theproperty.

Answers & Explanations50. Which costs are nondeductible when a taxpayer holds property for rentalpurposes?a. Correct. The cost of improvements is not deductible. Improvements arerecovered by taking depreciation.b. Incorrect. If a taxpayer holds property for rental purposes, they may beable to deduct ordinary and necessary expenses for maintaining the propertywhile the property is vacant.c. Incorrect. If a taxpayer holds property for rental purposes, they may beable to deduct ordinary and necessary expenses for managing the propertywhile the property is vacant.d. Incorrect. A taxpayer can deduct the cost of repairs they make to theirrental property. [Chp. 2]51. Landlords may deduct employee expenses related to renting property.However, which of the following employee costs are nondeductible bylandlords?a. Incorrect. Landlords can deduct bonuses paid to employees if, when addedto their regular salaries or wages, the total is not more than reasonable pay.2-12b. Incorrect. A taxpayer can deduct reasonable salaries and wages paid toemployees.c. Incorrect. A taxpayer can deduct reasonable wages paid to their dependentchild if the child is a bona fide employee.d. Correct. A taxpayer cannot deduct the cost of meals and lodging for a dependentchild. [Chp. 2]52. Rent paid for business property is deductible under §162. However, underwhich circumstance will an agreement be deemed a conditional sale contract,instead of a lease, and thus be nondeductible as rent?a. Incorrect. An agreement may be considered a conditional sales contractrather than a lease if the agreement designates part of the payments as interest,or that part is easy to recognize as interest.b. Correct. An agreement may be considered a conditional sales contract

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rather than a lease if the amount the taxpayer must pay to use the propertyfor a short time is a large part of the amount they would pay to get title to theproperty.c. Incorrect. An agreement may be considered a conditional sales contractrather than a lease if the taxpayer has an option to buy the property at anominal price compared to either the value of the property when they mayexercise the option or the total amount they have to pay under the agreement.d. Incorrect. An agreement may be considered a conditional sales contractrather than a lease if the taxpayer pays much more than the current fair rentalvalue of the property. [Chp. 2]2-13

Health Insurance Costs of Self-Employed Persons- §162(l) [Schedule C]A self-employed person is allowed as a business expense a percentage deductionof the amount paid (during the tax year) for medical care insurance on themselves,their spouse and dependents. For 2003 and thereafter, that percentage is100%. However, no deduction is allowed to the extent the deduction exceeds theindividual's earned income derived from the trade or business.If a self-employed individual is allowed a business deduction for amounts paidfor medical insurance, those amounts are not taken into account in computingthe medical expense deduction.Requirements for EligibilityFor purposes of determining eligibility the following rules apply:1. The taxpayer and their spouse must not be eligible to participate in anysubsidized health plan maintained by their employers.2-142. If the taxpayer has employees, they may not take the deduction unless theyprovide nondiscriminatory health insurance coverage to all employees.3. The taxpayer must have net earnings from self-employment.Amount DeductibleThe amount of medical insurance paid which is deductible as a business expensededuction is equal to a phased-in percentage of the amount paid for medical insuranceand is further limited to the net profit from self-employment.

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PercentageThe percentage deduction for health insurance of self-employed individuals isnow 100% for 2003 and thereafter.

Hobby Loss Rules - §183 [Schedule C]Activities that are "not engaged in for profit" are considered to be hobbies. Taxpayersmust include on their return income from an activity not for profit. Anexample of this type of activity would be a hobby or a farm operated mostly forrecreation and pleasure. Deductions for expenses related to the activity are limited,cannot total more than the income reported, and can be taken only if thetaxpayer itemizes deductions on Schedule A (Form 1040).Note: The limit on not-for-profit losses applies to individuals, partnerships,estates, trusts, and S corporations. It does not apply to corporations otherthan S corporations (§ 183(a); R.R. 77-320; Reg. §1.1831(a)).

Allowable DeductionsInterest, state and local property taxes and other items that are deductible as anitemized deduction are deductible without regard to a profit motive.2-15Limited DeductionsIf an activity is considered a hobby, deductions for depreciation, insurance andother expenses not allowed under the allowable deductions listed above, may bededucted only to the extent gross income exceeds the allowable deductions.Deductions are allowable in the following order and only to the following extent:1. Amounts deductible without regard to whether the activity giving rise tosuch amounts was engaged in for profit are allowable in full (e.g., interestunder §163, real property taxes under §164, etc.).2. Amounts deductible if the activity had been engaged in for profit, but onlyif the deduction does not result in an adjustment to the basis of property.Such deductions are allowed only to the extent the gross income of the activityexceeds the deductions under (1).3. Amounts which result in an adjustment to the basis of property are deductibleonly to the extent that income exceeds the deductions allowed under(1) and (2). Deductions falling within this subdivision include such items asdepreciation, partial losses with respect to property, partially worthless debts,amortization, and amortizable bond premiums.

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ExampleAssume an activity with the following tax items:Gross income $1,000Interest expense 225Property taxes 125Depreciation 500Insurance 200The total deductions for this activity would be as follows:Allowable deductionsInterest expense 225Property taxes 125Total allowable deductions 350Limited deductionsGross income 1,000Total allowable deductions (350)650Depreciation 500Insurance1 2001 Insurance is deductible in full with a portion of the depreciation deductible.2-16700Total limited deduction 650Total deductions 1,000

Profit Motive PresumptionsAn activity is presumed to be engaged in for profit if it shows a profit for anythree or more years out of five consecutive years. A taxpayer who has not engagedin an activity for more than five years can elect on Form 5213 to have thedetermination as to whether this presumption applies not be made before theclose of the fourth tax year.Special Rule for Horse BreedingHorse breeding is presumed to be engaged in for profit if it shows a profit forany two or more years out of seven consecutive years. A taxpayer who has notengaged in an activity for more than seven years can elect on Form 5213 tohave the determination as to whether this presumption applies not be madebefore the close of the sixth tax year.Other FactorsThe three out of five year profit presumption can be rebutted by using all thefacts and circumstances of the activity (Reg. §1.183-2(b)). Among the factors tobe considered are:(1) Whether taxpayer carries on the activity in a businesslike manner (Reg.§1.183-2(b)(1));(2) Whether the time and effort taxpayer puts into the activity indicates intentto make it profitable (Reg. §1.183-2(b)(3));

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(3) Whether taxpayer is depending on income from the activity for their livelihood(Reg. §1.183-2(b)(8));(4) Whether taxpayer's losses from the activity are due to circumstances beyondtheir control or are normal in the start-up phase of taxpayer's type ofbusiness (Reg. §1.183-2(b)(6));(5) Whether taxpayer changes methods of operation in an attempt to improvethe profitability of the activity (Reg. §1.183-2(b)(1));(6) Whether taxpayer, or their advisors, has the knowledge needed to carryon the activity as a successful business (Reg. §1.183-2(b)(2));(7) Whether taxpayer has been successful in making a profit in similar activitiesin the past (Reg. §1.183-2(b)(5));(8) Whether the activity makes a profit in some years, and how much profit itmakes (Reg. §1.183-2(b)(7)); and2-17(9) Whether taxpayer can expect to make a future profit from the appreciationof the assets used in the activity (Reg. §1.183-2(b)(4)).

Self-Employment TaxesSelf-employed individuals are subject to FICA just like employees. The old age,survivors, disability insurance (OASDI) portion of the self-employment tax rateis 12.4% of the earnings from self-employment up to $106,800 in 2009, and thehospital insurance (MHI) portion is 2.9% on all earnings in 2009. The taxpayer isallowed a deduction for AGI of one-half of the self-employment tax.

Home Office Deduction - §280A [Schedule C]A taxpayer's business use of his or her home may give rise to a deduction for thebusiness portion of expenses related to operating the home (e.g., a portion ofrent or depreciation and repairs).Prior to 1976, expenses attributable to the business use of a residence were deductiblewhenever they were ''appropriate and helpful'' to the taxpayer's business.In 1976, Congress adopted §280A, in order to provide a narrower scope for thehome office deduction. These home office rules were designed to prevent the

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perceived abuse of writing off personal expenses as deductible business expense.RequirementsThe basic requirements of the home office deduction are:1. There must be a specific room or area that is set aside for and used exclusivelyon a regular basis as:(a) The principal place of any business, or(b) A place where the taxpayer meets with patients, clients or customersin the normal course of their trade or business, or(c) A separate structure that is used in the taxpayer's trade or businessand is not attached to their house or residence (§280A(c)(1)).2. An employee can take a home office deduction if he or she meets the regularand exclusive use test and the use is for the convenience of the employer.This test is rarely met.Note: The exclusive use requirement does not apply when use of the home isfor day care of children, handicapped or elderly. In addition, the storage ofinventory in home, if the taxpayer is engaged in the business of selling goods,is considered business use provided the home is the only place of that business.In such case, the exclusive use rule also doesn't apply (§280A(c)(2)).2-183. No deduction is allowed unless there is a trade or business involved. Managinginvestments or rental property (unless there are a number of units) isnot considered a trade or business and therefore no home office expense canbe deducted related to such activity.Comment: To the extent that an individual is considered to be conducting atrade or business in the ownership of rental property, the taint of dealerstatus is a problem. A dealer in real estate is precluded from using §1031 exchanges,installment sales, and depreciation (on his "inventory") along withthe prohibition of capital gain benefits. Dealer status may be applied to ataxpayer as a whole or to an individual property.

Deductible ExpensesDeductible expenses are the business portions of:(1) Mortgage interest,(2) Property taxes,Comment: The unused portion of home mortgage interest and propertytaxes should be deducted in the usual places in Schedule A.(3) Depreciation - using 39 year MACRS,(4) Repairs and maintenance to the overall home that help the business usearea,(5) Janitorial services or maid,(6) Utilities,(7) Insurance, and(8) Other expenses directly related to operating the remainder of the home.

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Under IRS rulings, the deductibility of expenses incurred for local transportationbetween a taxpayer's home and a work location also depends on whether thetaxpayer's home office qualifies under §280A(c)(1) as a principal place of business(R.R. 94–47).Employee's Home Leased To EmployerNo deduction is allowed for expenses attributable to the rental by an employeeof all or part of their home to their employer if the employee uses the rentedportion to perform services as an employee of the employer (§280A(c)(6).Residential Phone ServiceSince 1989, individuals may no longer deduct any charge (including taxes) for localphone service for the first phone line provided to any residence (whether ornot their principal residence).2-19AllocationsAllocation of expenses and depreciation or cost recovery is generally based on acomparison of space used for business and personal purposes. This can be on anallocation of rooms or a square footage basis.Room v. Square FootageIn Edward Andrews, TC Memo 1990-391, a taxpayer who used one room ofan eight-room house as a business office could not deduct one eighth of thehousing costs as a business expense. The Tax Court held that a per-room allocationis appropriate only where the rooms are approximately equal. Otherwise,an allocation based on square footage must be used.LimitationsThe deduction limitation for the business use of a home is limited to the grossincome from the business use. Home office deductions may not be claimed ifthey create (or increase) a net loss from a business activity, although such deductionsmay be carried over to subsequent taxable years (§280A(c)(5)).Business deductions for the business use of a home are deducted in this order:(1) The business percentage of the expenses that would otherwise be allowableas deduction, that is, mortgage interest, real estate taxes, and deductiblecasualty losses;(2) The direct expenses for the business in the home, such as expenses for

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supplies and compensation, but not the other expenses of the office in thehome (such as those listed in item (3) below); and(3) The other business expenses for the business use of the home such asmaintenance, utilities, insurance, and depreciation. Deductions that adjustthe basis in the home are taken last.Thus, deductions for the business use of the home will not create a business lossor increase a net loss from the taxpayer's business.Taxpayers are allowed to carry forward any deductions suspended by the grossincomelimit. Deductions carried over continue to be allowable only up to the incomefrom the business from which they arose, whether or not the dwelling unitis used as a residence during the year. This limit also applies to rental activities,as well as trade or business activities.ExampleJoe uses 15% of his home as his principal place of businessfor a landscape service he operates as a sideline to hisregular job. His gross income, expenses, and computationof deductible business use of his home are as follows:2-20Gross income from business 10,500Minus:Business % (15%) of mortgageinterest and real estate taxes 2,000Other business expense (labor,supplies, etc. 7,500 9,500Modified net income 1,000Business use of home expenseMaintenance, utilities,insurance, etc. (15%) 700Depreciation on business portion 9001,600Deduction limited to modified net income 1,000Carryforward to next year (subject to samelimitations) 600The remaining interest and taxes will be deducted on ScheduleA. If Joe were an employee, the same computation of thelimitation would apply. Both portions of taxes and interestwould be deducted on Schedule A, the remaining allowableexpenses would go to line 4, Form 2106, (employee businessexpense).

Expanded Principal Place of Business DefinitionThe ability of taxpayers who work at home to claim deductions for home officeexpenses was enhanced by the TRA '97. The Act expanded the definition of"principal place of business" to include a home office that is used by the taxpayerto conduct administrative or management activities of the business, provided that

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there is no other fixed location where the taxpayer conducts substantial administrativeor management activities of the business.Note: As under pre TRA '97 law, deductions will be allowed for a home officeonly if the office is exclusively used on a regular basis as a place of businessand, in the case of an employee, only if such exclusive use is for the convenienceof the employer.Section 280A specifically provides that a home office qualifies as the ''principalplace of business'' if:(1) The office is used by the taxpayer to conduct administrative or managementactivities of a trade or business, and(2) There is no other fixed location of the trade or business where the taxpayerconducts substantial administrative or management activities of thetrade or business.2-21ExampleDoctor Dan consults with patients at local hospitals and usesa portion of his home exclusively and regularly to conductadministrative or management activities. Dan does not conductany other significant administrative or management functionat another fixed location. Dan qualifies for the home officededuction.Thus, a home office deduction is allowed (subject to the pre TRA '97 law ''convenienceof the employer'' rule governing employees) if a portion of a taxpayer'shome is exclusively and regularly used to conduct administrative or managementactivities for a trade or business of the taxpayer, who does not conduct substantialadministrative or management activities at any other fixed location of thetrade or business, regardless of whether administrative or management activitiesconnected with his trade or business (e.g., billing activities) are performed byothers at other locations. The fact that a taxpayer also carries out administrativeor management activities at sites that are not fixed locations of the business, suchas a car or hotel room, will not affect the taxpayer's ability to claim a home officededuction under the provision. Moreover, if a taxpayer conducts some administrativeor management activities at a fixed location of the business outside thehome, the taxpayer still is eligible to claim a deduction so long as the administrativeor management activities conducted at any fixed location of the business

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outside the home are not substantial (e.g., the taxpayer occasionally does minimalpaperwork at another fixed location of the business). In addition, a taxpayer'seligibility to claim a home office deduction under the provision will notbe affected by the fact that the taxpayer conducts substantial nonadministrativeor nonmanagement business activities at a fixed location of the business outsidethe home (e.g., meeting with, or providing services to, customers, clients, or patientsat a fixed location of the business away from home).If a taxpayer in fact does not perform substantial administrative or managementactivities at any fixed location of the business away from home, then the secondpart of the test will be satisfied, regardless of whether or not the taxpayer optednot to use an office away from home that was available for the conduct of suchactivities. However, in the case of an employee, the question whether an employeechose not to use suitable space made available by the employer for administrativeactivities is relevant to determining whether the pre TRA '97 law''convenience of the employer'' test is satisfied. In cases where a taxpayer's use ofa home office does not satisfy the provision's two-part test, the taxpayer nonethelessmay be able to claim a home office deduction under the pre TRA '97 law''principal place of business'' exception or any other provision of §280A.2-22Note: If a taxpayer's residence is their principal place of business, the taxpayermay deduct daily transportation expenses incurred in going betweenthe residence and another work location. This converts nondeductible commutingexpenses into deductible transportation expenses, which may bemore valuable to the taxpayer than the home office deduction.This expansion opens the home office deduction to millions of business peoplewho work out of their home, such as:(1) Home-based employees who tele-commute to the main office,(2) Doctors who perform their duties in hospitals but need to do their billingsfrom their home office,(3) Salespeople who call at the customer's place of business,(4) Professional speakers who prepare at home but deliver the presentationat hotels and convention centers, and(5) Plumbers and other trades people who perform their duties at job sites

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away from the shop.Many taxpayers who have a second business conducted out of their home may beable to deduct their traveling to and from their "home office" to their main office(previously considered nondeductible commuting mileage) under this expandeddefinition.Office in Home Worksheet1. Home office square footage:a. Office area _________ sq ftb. Storage area _________ sq ftc. Meeting area _________ sq ftd. Other _________ sq ftBusiness square footage _________ sq ft2. Total square footage of house _________ sq ft3. Home office percentage _________ %4. Office expenses:a. Mortgage interest $ _________b. Property taxes $ _________c. Depreciation $ _________d. Repairs $ _________e. Utilities $ _________f. Insurance $ _________g. Trash Removal $ _________2-235. Home office deduction(line 4 times line 3) $__________6. Gross income limit $ _________

Business & Investment CreditsThe Code provides for certain credits against tax with respect to business activitiesand investments. These credits cannot exceed the amount of the tax. All ofthese credits are scheduled to expire, but Congress habitually extends the terminationdates.(1) Testing for rare diseases (§28; §280C(b)),(2) Producing nonconventional fuels (§29),(3) Credit for federal tax on fuels (§34), and(4) General business credit.The credits comprising the general business credit are:(1) Alcohol used as fuel (§40),(2) Research credit (§41; §280C(c)),Note: A taxpayer can claim a tax credit of 20% of the amount of qualified researchexpenses that exceeds the average amount of the research expenses ina base period. The Ticket to Work & Work Incentives Improvement Act

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(HR 1180) extended the research credit through June 30, 2004, and increasedthe credit rate under the alternative incremental credit by one percentagepoint for each step.(3) Low-income housing credit (§42),(4) Rehabilitation credit (§46; §48(g) and (q)(1) & (3)),(5) Energy investment tax credits (§46; §48(l) & (q)(1)),Note: A business energy credit is available for:(a) Solar energy property - 10%, and(b) Geothermal property - 10%.(6) Work opportunity tax credit (§51 & §280(a)), and(7) Welfare-to-work tax credit (§51A).The aggregate of the credits described above cannot exceed the excess of thetaxpayer's net income tax over the greater of (a) 25% times the excess of the netincome tax over $25,000 or (b) the tentative AMT (§38; §39).2-24Business Credit Carryback & Carryforward Rules - §39(a)If in any taxable year the general business credit (the sum of the business creditcarryforwards to the current year plus the current year business credit) exceedstax liability, the excess business credit may be carried back and carried forwarduntil it is exhausted (§39(a)). For credits after December 31, 1997, the carrybackperiod is one year and the carryforward period is 20 years.NOL ComparisonFor a net operating loss (NOL) arising after August 5, 1997, the NOL is generallycarried back two years. Any loss remaining after the two-year carrybackperiod is then carried forward 20 years, starting with the year after the lossyear and then to each succeeding year for 19 more years or until the loss iscompletely used up. Any portion of a net operating loss remaining after the20-year carryover period is nondeductible (§172(b)(1)(A)).However, starting in 2008, the American Recovery & Reinvestment Act providesan eligible small business with an election to increase the present-lawcarryback period for an applicable 2008 NOL from two years to any wholenumber of years elected by the taxpayer that is more than two and less thansix. As a result, qualified businesses have the choice to carryback NOLsthree, four, or five years.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. The

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following questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.2-2553. The author lists three requirements for the health insurance cost deductionfor self-employed individuals. Which of the following rules apply forpurposes of determining eligibility?a. The taxpayer must provide health insurance coverage to key employees.b. The taxpayer must be eligible to take part in a subsidized health plan.c. The taxpayer must have earnings from self-employment.d. The taxpayer’s spouse must not be eligible to take part in a subsidizedhealth plan.54. Under §183, deductions for expenses associated with a not for profitbusiness:a. are allowable for interest, state, and local property taxes.b. are deductible without restriction.c.. cannot total more than the income reported.d. are allowable only if itemized on Schedule C.55. If an individual operates a business out of their home, three requirementsmust be met to allocate a portion of the expenses of the residence to business.What is one of these requirements?a. A specific area is used at least occasionally as a place where the taxpayermeets with patients.b. A portion of a specific room or area is used as the principal place ofbusiness.c. The individual must be self-employed and cannot be an employee.d. A trade or a business must be involved to be allowed a deduction.56. Taxpayers must claim business deductions for the business use of a homein a specific order. Which business deductions must be deducted first?

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a. business expenses for the business use of the home such as maintenance,utilities, insurance, and depreciation.b. business percentage of the costs that would otherwise be claimed as adeduction.c. deductions that adjust the basis in the home.d. direct expenses for the business in the home.

Answers & Explanations53. The author lists three requirements for the health insurance cost deductionfor self-employed individuals. Which of the following rules apply for purposesof determining eligibility?2-26a. Incorrect. For purposes of determining eligibility, if the taxpayer has employees,they may not take the deduction unless they provide nondiscriminatoryhealth insurance coverage to all employees.b. Incorrect. For purposes of determining eligibility, the taxpayer must not beeligible to participate in any subsidized health plan maintained by their employer.c. Incorrect. For purposes of determining eligibility, the taxpayer must havenet earnings from self-employment.d. Correct. For purposes of determining eligibility, the taxpayer’s spousemust not be eligible to participate in any subsidized health plan maintainedby their employer. [Chp. 2]54. Under §183, deductions for expenses associated with a not for profit business:a. Incorrect. Interest, state, and local property taxes and other items that aredeductible as an itemized deduction are deductible without to §183.b. Incorrect. Deductions for expenses related to a not for profit are limitedunder §183.c. Correct. Deductions for expenses related to the activity cannot total morethan the income reported.d. Incorrect. Deductions for expenses related to the activity can be taken onlyif the taxpayer itemizes deductions on Schedule A (Form 1040). [Chp. 2]55. If an individual operates a business out of their home, three requirementsmust be met to allocate a portion of the expenses of the residence to business.What is one of these requirements?a. Incorrect. A requirement that must be met in order for a taxpayer to allocatea portion of expenses of the residence to business is that there must be a

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specific room or area that is used on a regular basis as a place where the taxpayermeets with patients, clients, or customers in the normal course of thetrade or business.b. Incorrect. A requirement that must be met in order for a taxpayer to allocatea portion of expenses of the residence to business is that there must be aspecific room or area that is set aside for and used exclusively as the principalplace of any business.c. Incorrect. An employee can take a home office deduction if he or shemeets the regular and exclusive use test and the use is for the convenience of theemployer.d. Correct. A requirement that must be met in order for a taxpayer to allocatea portion of expenses of the residence to business is that no deduction isallowed unless there is a trade or business involved. [Chp. 2]2-2756. Taxpayers must claim business deductions for the business use of a home ina specific order. Which business deductions must be deducted first?a. Incorrect. The other business expenses for the business use of the homesuch as maintenance, utilities, insurance, and depreciation are deductedthird.b. Correct. The business percentage of the expenses that would otherwise beallowable as deduction, that is, mortgage interest, real estate taxes, and deductiblecasualty losses, are deducted first.c. Incorrect. Deductions that adjust the basis in the home are taken last.d. Incorrect. The direct expenses for the business in the home, such as expensesfor supplies and compensation, but not the other expenses of the officein the home, are deducted second. [Chp. 2]

Travel & EntertainmentTravel away from home, local transportation, and entertainment expensesprobably cause more controversy than any other item on a tax return. This controversycan be over the question of whether a particular expense is deductible,the amount of the allowable deduction, the proof of the deduction, or all ofthese. For this reason it is essential to know which expenses are deductible andwhich are not. In addition, the rules on record-keeping and other requirements

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for proving these expenses are of critical importance.2-28Travel ExpensesA deduction is allowed for ordinary and necessary traveling expenses incurred bya taxpayer while away from home in the conduct of a trade or business.Examples of ordinary and necessary travel expenses include:(1) Meals (but only 50%) and lodging, both enroute and at the destination,(2) Cost of transportation from the place where the taxpayer eats and sleepsto their temporary work assignment,(3) Air, rail, ship, bus, and baggage charges,(4) Telephone and telegraph expenses,(5) Cost of operating and maintaining a car,(6) Cost of transportation by taxi, etc. from the airport or station to the hotel,from the hotel to the airport or station, from one customer or place of workto another,(7) Laundry, cleaning, and clothes pressing costs,(8) Transportation costs for sample and display material, and(9) Reasonable tips to the extent incident to any of the above expenses.Determining a Tax Home - Travel ExpensesTax HomeTo deduct expenses for travel "away from home," the taxpayer must first determinewhere home is. Normally this determination is not a problem. However,for those who travel, keep two homes or places of business, or have nodefinite home, it can be hard to decide where "home" is for tax purposes.Normally, a taxpayer's tax home is:a. The taxpayer's principal place of businessb. If the taxpayer has no principal or regular place of business, their taxhome is their regular place of abode in a real and substantial sense (seediscussion below).c. If the taxpayer fails to fall within the above two categories, they areconsidered an itinerant - i.e., one who has their home wherever they happento be working -and, thus, is never "away from home." As such, thistaxpayer cannot have any deductible travel expenses.Regular Place of Abode in a Real & Substantial SenseThe IRS holds that a taxpayer whose work site constantly changes only has a"regular place of abode in a real substantial sense" if he or she meets two ofthe following three requirements:2-29a. The taxpayer performs a portion of their business in the vicinity of thisclaimed abode and uses such abode (for purposes of their lodging) whileperforming such business there.b. The taxpayer's living expenses incurred at their claimed abode are duplicated

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because their business requires them to be away there from.c. The taxpayer either:(1) Hasn't abandoned the vicinity in which their historical place oflodging and their claimed abode are both located; or(2) Has a member or members of their family (marital or lineal only)currently residing at their claimed abode; or(3) Uses their claimed abode frequently for purposes of their lodging.If the taxpayer meets all three factors, the taxpayer is temporarily away fromhome for travel expense deduction purposes. If the taxpayer meets only twoof the factors, the taxpayer may be temporarily away from home dependingon the facts and circumstances. If the taxpayer meets only one factor, he wasnot temporarily away from home and cannot deduct travel expenses.Two Work LocationsIf a taxpayer works at two or more separate locations, his tax home is wherehis principal employment or business is located.Under R.R. 54-147, the factors considered in determining the principal locationare:(1) Total time ordinarily spent in performing duties in each area(2) Degree of business activity in each area, and(3) Relative significance of the financial return from each areaThe last factor is given substantial weight when services are performed as anemployee.Temporary AssignmentIf a taxpayer engages in temporary work away from their "tax home," their"tax home" does not shift, and they are deemed away from home for the entiretemporary period. As such, all expenses for traveling, meals and lodgingare deductible as travel "away from home."If, however, the change is indefinite (i.e., if its termination cannot be foreseenwithin a fixed and reasonably short period), the "tax home" is consideredto move with the taxpayer and no deduction for travel, meals, and lodgingwill be allowed.Before 1993, the following presumptions applied:a. One year Internal Revenue Service presumption2-30If both the actual and temporary duration of the temporary assignmentwas one year or more, the assignment was considered indefinite andpresumed not to be temporary. If an assignment or job was indefinite,the taxpayer was not considered to be away from their tax home andtravel expenses were not deductible.Note: A series of assignments to the same location, all for short periodsbut which together cover a long period can be considered an indefiniteassignment.

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b. Less than two-year exceptionTaxpayers could overcome the one-year presumption by showing:(1) They realistically expected the job to last less than two years, and(2) They expected to return to their tax home after the job endedSince 1993, the one-year rigid indefinite stay rule applies.Rigid One-Year RuleEffective for amounts paid after 1992, §162(a) provides that a taxpayer isnot temporarily away from home during any period of employment thatexceeds one year. Thus, employment away from home for more than oneyear is indefinite, and no deduction for travel expenses is allowed.This statutory definition of temporary employment does not change therule that facts and circumstances still determine whether employmentaway from home at a single location for less than one year is temporary orindefinite (Conf Rept No. 102-1018 (PL 102-486) p. 430).Example 1 from Pub. 463 (Rev. '94)You are a construction worker. You live and regularly workin Los Angeles. You are a member of a trade union in LosAngeles that helps you get work in the Los Angeles area.Because of a shortage of work, you took a job on a constructionproject in Fresno. Your job was scheduled to endin eight months, and you planned to return to Los Angeles atthat time. Your family continued to live in your home in LosAngeles.While in Fresno, you lived in a trailer you own. You returnedto Los Angeles most weekends and maintained contact withthe local union to see if you could get work in Los Angeles.Because you realistically expected the job in Fresno to lasteight months and expected to return home when it ended,your tax home is in Los Angeles for travel expense deductionpurposes.You can deduct the necessary travel expenses of first gettingto your temporary assignment or job and then returning toyour tax home after the assignment or job ends. Also, you2-31can deduct your reasonable expenses for meals (subject tothe 50% limit) and lodging, even for days off, while you are atthe temporary location.

Away From Home - Travel ExpensesWhile transportation can be deductible whether or not the trip takes the taxpayeraway from home, meals and lodging are deductible only if the taxpayer is"away from home." The IRS has adopted the so-called "sleep or rest" rule as arequirement in determining if the taxpayer is away from their tax home.Sleep & Rest RuleThe sleep or rest rule requires the taxpayer to prove that it is reasonable toneed sleep or rest during release time to meet the demands of their employment.In other words, the taxpayer's duties require them to be away from the

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general area of their tax home for a period which is substantially longer thanan ordinary day's work and, during released time while away, it is reasonablefor the taxpayer to sleep or rest to meet the needs of their employment orbusiness.Substantial PeriodAn employee's absence cannot be considered "overnight" unless the taxpayercould not reasonably be expected to travel home without substantialsleep or rest. The absence need not be for a full twenty-four hour period,or from dusk to dawn, but it must be substantial.A "substantial" period is one that is of such duration that the taxpayercould not reasonably be expected to complete the round trip withoutstopping regular duties for sufficient time to obtain sleep or rest.The "sleep and rest" rule was adopted in United States v. Correll, 389 U.S.299 (1967), which denied an expense deduction to a traveling salesmanfor breakfasts and lunches eaten on the road because he returned homeeach day for dinner. Thus, this rule even covers a taxpayer who conducts aminor or secondary business away from home in the evening. If the taxpayeris able to return to their residence each night they cannot deductdinner meals taken at the place of their secondary business.ExampleYou are a railroad conductor. You leave your home terminalon a regularly scheduled round-trip run between two citiesand return home sixteen hours later.During the run you have six hours off at your turnaround pointwhere you eat two meals and rent a hotel room to get neces2-32sary sleep before starting the return trip. You are consideredto be away from home.ExampleYou are a truck driver. You leave your terminal and returnlater the same day. You get an hour off at your turnaroundpoint to eat. Because you are not off to get necessary sleepand the brief time off is not an adequate rest period, you arenot away from home.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.

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Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.57. The author lists nine examples of deductible travel expenses undertakenfor business. What is included as an example?a. tips paid for services provided.b. expenses for business gifts.c. laundry, cleaning, and clothes pressing costs.d. transportation expenses within the general geographical work area.58. The Service uses a number of factors and requirements to determine ataxpayer's regular place of abode. However, which of the following itemsdoes the Service disregard in making this determination?a. whether part of the taxpayer’s business is performed in the area of theabode.2-33b. duplication of living expenses.c. the taxpayer's business plan.d. the presence of family members at the claimed abode.59. The author identifies two prior law presumptions about an assignment.Under prior law (R.R. 61-95), when was a taxpayer deemed to be engaged intemporary work away from his tax home?a. if an assignment was expected to last for a year or more.b. if both the assignment’s expected and real durations were less than oneyear.c. if living expenses were doubled at the claimed tax home because theirwork required them to be away from that home.d. if the taxpayer’s spouse or children lived at the claimed tax home or thetaxpayer often continued to use that home for lodging.60. Starting in 1993, the treatment of away-from-home travel expenseschanged under §162. What is characteristic of current law for travel expensesmade after 1992?a. All employment away from home at a single location for less than oneyear is temporary.b. Taxpayers can be temporarily away from home during any period ofemployment that exceeds one year.c. Taxpayers’ intentions are indicative of the length of their assignment.d. For employment away from home for more than one year, travel expensedeductions are disallowed.

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Answers & Explanations57. The author lists nine examples of deductible travel expenses undertakenfor business. What is included as an example?a. Incorrect. Only reasonable tips are deductible as they relate to travel.b. Incorrect. Travel expenses do not include business gifts.c. Correct. Deductible travel expenses undertaken for business include laundry,cleaning, and clothes pressing costs.d. Incorrect. Travel expenses must be incurred while a taxpayer is "away fromhome." Transportation within the general geographical work area does notqualify. [Chp. 2]58. The Service uses a number of factors and requirements to determine a taxpayer'sregular place of abode. However, which of the following items doesthe Service disregard in making this determination?2-34a. Incorrect. A requirement of the claimed abode test is that the taxpayerperforms a portion of his business in the vicinity of his claimed abode anduses such abode (for purposes of his lodging) while performing such businessthere.b. Incorrect. A requirement of the claimed abode test is that the taxpayer’sliving expenses incurred at his claimed abode are duplicated because hisbusiness requires him to be away.c. Correct. Any tax home or claimed abode set forth in a taxpayer's businessplan is self-serving and immaterial.d. Incorrect. A factor used in the claimed abode test is whether the taxpayerhas a member or members of his family (marital or lineal only) currently residingat his claimed abode. [Chp. 2]59. The author identifies two prior law presumptions about a work assignment.Under prior law (R.R. 61-95), when was a taxpayer deemed to be engagedin temporary work away from his tax home?a. Incorrect. Under prior law, an assignment or job expected to last for a yearor more was considered indefinite and presumed by the Service not to betemporary. This was referred to as a one-year presumption.b. Correct. Under prior law, if both the anticipated and actual duration wasless than one year and the taxpayer regularly maintained a home near hisusual place of employment, the Service did not question its temporary nature.c. Incorrect. Under prior law, a factor used to determine whether the claimedtax home was the taxpayer’s regular home was whether the taxpayer had living

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expenses at the claimed tax home that were duplicated because theirwork required them to be away from that home.d. Incorrect. Under prior law, a factor used to determine whether theclaimed tax home was the taxpayer’s regular home was whether the taxpayer’sspouse or children lived at the claimed tax home or the taxpayer oftencontinued to use that home for lodging. [Chp. 2]60. Starting in 1993, the treatment of away-from-home travel expenseschanged under §162. What is characteristic of current law for travel expensesmade after 1992?a. Incorrect. This statutory definition of temporary employment does notchange the rule that facts and circumstances still determine whether employmentaway from home at a single location for less than one year is temporaryor indefinite.b. Incorrect. Effective for amounts paid after 1992, §162(a) now provides thata taxpayer is not temporarily away from home during any period of employmentthat exceeds one year.2-35c. Incorrect. Under prior law, taxpayers’ intentions were considered in determiningthe length of an assignment. A rigid time rule has since been establishedthough.d. Correct. Effective for amounts paid after 1992, §162(a) now provides thatno deduction for travel expenses is allowed when employment away fromhome is for more than one year. Under prior law, a taxpayer could overcomethe one-year presumption and continue to deduct travel expenses. [Chp. 2]Business Purpose - Travel ExpenseEven when a taxpayer is determined to be traveling away from their tax home,further distinctions must be made as to the purpose of the trip and the categoriesof expenditures.Categories of ExpenseAll travel expenses must be divided into two categories:(i) Travel costs to and from the destination, and(ii) Expenses incurred while at the destination.Travel CostsIf a trip is undertaken primarily for personal purposes, travel costs arenondeductible personal expenses, and meals and lodging are nondeductibleliving expenses, even though the taxpayer engages in business activitieswhile away from home (Reg. 1.162-2; 262). If the trip is primarily forbusiness, travel expenses are deductible.

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Costs at DestinationExpenses incurred at the destination must always be allocated betweenbusiness and personal pleasure. Thus, even if a trip is primarily personal,expenses incurred while at the destination are deductible if related to taxpayer'strade or business, even though the travel expenses to and from thedestinations might not be deductible (Reg. §1.162-2)All or NothingTravel costs are, therefore, an "all or nothing" proposition depending onthe primary business nature of the trip. On the other hand, the businessrelated portion of costs at the destination is always deductible, even if themajority of expenses were personal.2-36TimeWhether a trip is related primarily to a taxpayer's trade or business, or is essentiallypersonal in nature, depends on the facts and circumstances of eachcase. The most important factor is the amount of time the taxpayer spends onpersonal activities in relation to the length of the trip.51/49 RuleAs a general rule, a trip is primarily for business if bona fide business isconducted on over 50% of the trip days.Foreign Business TravelPersonal PleasureIf a taxpayer travels outside the U.S. primarily for personal pleasure orfor vacation, travel costs to and from the destination are not allowed butbusiness expenses at the destination are allowed.Primarily BusinessIf the trip outside the U.S. is primarily for business (e.g., more than 50%)but there were some nonbusiness activities, not all of the travel cost fromhome to the business destination and back may be deductible by an individual.The cost will have to be allocated between business and nonbusinessactivities. However, there is an exception which provides a full deductionunder these circumstances provided certain conditions are met.Full Deduction ExceptionTo be fully deductible, foreign travel must be primarily for business (e.g.,more than 50%) and meet at least one of the following conditions:(1) The taxpayer is an employee who is not related to his employer;Comment: An employee is related to their employer if the employeeowns, directly or indirectly, more than 10% of the employer.(2) The trip lasts less than eight days (including the return travel day,but excluding the departure day);(3) Less than 25% of the total number of days on the trip is nonbusinessdays;

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(4) Taxpayer had little control over arranging the business trip; and(5) Personal vacation or holiday was not a major consideration in makingthe trip.Limitations - Travel ExpensesThe travel expense area has many special rules, limitations, and requirements:2-37Meals & LodgingMeal and lodging expenses must be incurred while away from home. In addition,the meals must not be lavish or extravagant under the circumstances.Finally, the qualified amounts for meals must be reduced by 50% (i.e., only50% is deductible).Domestic Conventions & MeetingsExpenses for attending domestic conventions and meetings are deductible ifattendance primarily benefits or advances the taxpayer's trade or business. Ifthe agenda of the convention or meeting is so related to the conduct of thetaxpayer's trade or business that attendance was predominantly for a businesspurpose, the primarily business test is met.Factors to determine if the agenda of the convention or meeting is related tothe conduct of the taxpayer's trade or business include:(1) The amount of time devoted to business compared to recreational andsocial activities;(2) If the location is related to the operation of the taxpayer's trade orbusiness;(3) The attitude of the organization sponsoring the convention; and(4) Whether attendance is mandatory.Foreign Conventions & MeetingsNo deduction is allowed for a convention, seminar, similar meeting held outsidethe North American area unless the meeting is directly related to the taxpayer'strade or business, and it is as reasonable for the meeting to be heldoutside as within the North American area.The North American area means the U.S., its possessions (including PuertoRico, Virgin Islands, Guam, and American Samoa), the Trust Territory ofthe Pacific Islands, Canada, and Mexico. Certain Caribbean countries andBermuda are included if the country:(1) Is a "beneficiary country;"(2) Has entered into an agreement with the U.S. for the exchange of taxinformation; and(3) Has no tax laws discriminating against conventions held in the U.S..Factors determining reasonableness are:(1) The purpose of the meeting and the activities taking place at the

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meeting,(2) The purposes and activities of the sponsoring organization or group,(3) The residences of the active members of the sponsoring organization,2-38(4) The places at which other meetings of the sponsoring organization orgroup have been held or will be held, and(5) Such other relevant factors as the taxpayer may present.Cruise Ship ConventionCruise ship conventions have a deduction limited to $2,000 per individual peryear. Married filing jointly taxpayers can deduct $4,000 if each spouse spentat least $2,000 for attending a business related cruise ship convention. In addition,the cruise ship must be registered in U.S. and all ports of call must belocated in the U.S. or its possessions.Two written statements must be attached to a taxpayer's tax return:(1) A taxpayer's statement, signed by the individual attending the meetingand including information with respect to:(i) The total days of the trip (excluding the days of transportation toand from the cruise ship port)(ii) The number of hours of each day of the trip that the individual devotedto scheduled business activity,(iii) The program of the scheduled business activity of the meeting,and(iv) Such other information as may be required by the IRS.(2) A sponsor's statement, signed by an officer of the sponsoring organizationor group, including:(i) A schedule of the business activity of each day of the meeting(ii) The number of hours during which the individual attending themeeting attended such scheduled business activities, and(iii) Such other information as may be required by regulations.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.2-39Short explanations for both correct and incorrect answers are given after the list

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of questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.61. Under Reg. §1.162-2(b)(1), deductible travel costs must be primarily forbusiness. When are domestic travel costs deemed primarily for business?a. If more than half the trip days are spent on business.b. The expenses are incurred at a vacation resort.c. A taxpayer who had control over planning the trip incurs the expenses.d. The travel is related to investigating new or different business opportunities.62. A taxpayer may travel to a foreign country primarily for business purposes.If this taxpayer also engages in some personal activities, how is thetravel cost treated?a. It is disallowed.b. It is subject to the 50% reduction rule.c. It is still allowed in full.d. It has to be allocated between business and personal.63. Domestic and foreign business travel are subject to different rules. However,in which of the following situations would foreign and domestic travelbe fully deductible?a. The travel was entirely for business purposes.b. The travel is 60% for business purposes.c. Travel is primarily for business purposes.d. Travel is 50% for personal purposes.64. There are five circumstances that can avoid the mixed-use allocation rulefor primarily business foreign travel. What is one of these conditions?a. More than half of the days on the trip are business days.b. The employee owns, directly or indirectly, more than 10%.c. The business trip was arranged by someone other than the taxpayer.d. To foreign travel must be to a single foreign destination.65. Convention expenses can be deductible if attendance primarily benefitsthe taxpayer's business. To determine whether it is beneficial, what is comparedwith an individual’s business duties?a. the purposes set forth in its registration with the IRS.b. the purposes that the program or agenda states.c. the purposes provided in the sponsor's statement.2-40d. the purposes stated in the sponsor's tax opinion.

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66. The “North American area” encompasses some Caribbean countries andBermuda. When are costs of attending a convention in such a country deductible?a. if the country is a member of the North Atlantic Treaty Organization.b. if the country maintains diplomatic relations with the United States.c. if the country agrees to exchange tax information with the UnitedStates.d. if the country has been deemed a "friendly" nation by the State Department.67. When a convention is held outside the North American area, a deductionis permitted so long as the meeting directly relates to the business, and holdingsaid meeting outside the area is deemed to be reasonable. Which of thefollowing factors listed below is disregarded when determining this reasonableness?a. The purposes of the sponsor.b. The times at which the lectures are given.c. Where the sponsoring organization’s members live.d. Where other meetings have taken place.68. If a cruise ship convention otherwise qualifies, a taxpayer's statementmust be attached to the tax return. This statement requires detailed informationabout the convention. However, which of the following informationitems can be omitted from the taxpayer’s statement?a. the number of trip days.b. a tally of business hours for each day.c. a convention program.d. the names of other participants.

Answers & Explanations61. Under Reg. §1.162-2(b)(1), deductible travel costs must be primarily forbusiness. When are domestic travel costs deemed primarily for business?a. Correct. As a general rule, a domestic trip is primarily for business if bonafide business is conducted on over 50% of the trip days.b. Incorrect. The Service will consider the location of the site (e.g., vacationresorts). The increasing number of organizations that schedule their conventionsand seminars in resort areas has caused the Service to deny deductionsof alleged business trips that are merely disguised vacations.2-41c. Incorrect. The Service will consider whether the taxpayer had control overplanning the trip. The more control the taxpayer has, the less likely he’d beable to deduct the expenses.d. Incorrect. In order to be deductible currently, the travel must be related toan existing business. Travel costs to investigate new or different business opportunities

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must be capitalized or amortized (except for an initial $5,000)over 180 months under §195. [Chp. 2]62. A taxpayer may travel to a foreign country mainly for business purposes. Ifthis taxpayer also engages in some personal activities, how is the travel costtreated?a. Incorrect. If the trip outside the United States is primarily for business, butthere were some nonbusiness activities, the entire travel cost is not disallowed.b. Incorrect. Travel cost is not subject to the 50% reduction rule. This ruleprimarily applies to meal and entertainment costs.c. Incorrect. If the trip outside the U.S. is primarily for business but therewere some nonbusiness activities, the travel cost is subject to a proration restriction.The travel cost is not allowed in full.d. Correct. When the trip outside the U.S. is primarily for business (e.g.,more than 50%) but there were some nonbusiness activities, not all of thetravel cost from home to the business destination and return is deductible byan individual. The travel cost will have to be allocated between business andnonbusiness activities on a day-to-day basis (Reg. §1.274-4(d)(2)). [Chp. 2]63. Domestic and foreign business travel are subject to different rules. However,in which of the following situations would foreign and domestic travelbe fully deductible?a. Correct. When travel is entirely for business purposes, taxpayers may takea complete deduction for travel expenses (§274(c)).b. Incorrect. While 60% business domestic travel would be would be fully deductible,such a percentage would require proration for foreign businesstravel.c. Incorrect. When foreign travel is primarily for business purposes, some ofthe travel expenses are deductible, but not all of them.d. Incorrect. If the travel is 50% for personal purposes, no travel deductionwould be allowed for business domestic for foreign travel. [Chp. 2]64. There are five circumstances that can avoid the mixed-use allocation rulefor primarily business foreign travel. What is one of these conditions?a. Incorrect. For foreign travel to be fully deductible, more than 75%, not50%, of the total number of days on the trip must be business days.2-42b. Incorrect. For foreign travel to be fully deductible, the taxpayer must be anemployee who is not related to his employer. An employee is related to his employerif the employee owns, directly or indirectly, more than 10%.c. Correct. For foreign travel to be fully deductible, the taxpayer must have

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had little control over arranging the business trip.d. Incorrect. No special exception to the mixed-use allocation rule for foreigntravel is provided for trips to a single foreign destination. [Chp. 2]65. Convention expenses can be deductible if attendance primarily benefits thetaxpayer's business. To determine whether it is beneficial, what is comparedwith an individual’s business duties?a. Incorrect. Sponsors of business conventions are not required to registerwith the IRS.b. Correct. Under R.R. 59-316, the Service compares an individual’s businessand employment duties with the purposes of the meeting as stated in theprogram or agenda. The “primarily for business” test is satisfied when theagenda of the convention or meeting is so related to the conduct of the taxpayer’strade or business that attendance was predominantly for a businesspurpose.c. Incorrect. Most business conventions do not provide a sponsor's statement.However, certain cruise conventions must do so. Thus, the IRS would not beable to make a comparison.d. Incorrect. The sponsor of a business convention does not have to provide alegal or tax opinion as to the deductibility of the convention to either the participantsor the IRS. [Chp. 2]66. The “North American area” encompasses some Caribbean countries andBermuda. When are costs of attending a convention in such a country deductible?a. Incorrect. It is not required the Caribbean country be a member of theNorth Atlantic Treaty Organization in order to be included in the term"North American area."b. Incorrect. Diplomatic relations with the United States are not prerequisiteto being included. However, an agreement for the exchange of tax informationis required.c. Correct. Certain Caribbean countries are included in the definition of theNorth American area if the country has entered into an agreement for theexchange of tax information. However, such country must also be a beneficiarycountry and have no laws discriminating against U.S. conventions.d. Incorrect. There is no "friendly" nation status maintained by the State Departmentfor convention purposes. [Chp. 2]2-4367. When a convention is held outside the North American area, a deductionis permitted so long as the meeting directly relates to the business, and

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holding said meeting outside the area is deemed to be reasonable. Whichof the following factors listed below is disregarded when determining thisreasonableness?a. Incorrect. The purpose of the meeting and the activities taking place at themeeting are important factors in determining the reasonableness of holdingthe meeting outside the North American area.b. Correct. The times at which the lectures are given are immaterial to thedetermination of whether it was reasonable to hold the meeting outside theNorth American area.c. Incorrect. An important determining factor is the residence of the activemembers of the sponsoring organization.d. Incorrect. The places at which other meetings of the sponsoring organizationsor groups have been held or will be held is an important factor in determiningreasonableness. [Chp. 2]68. If a cruise ship convention otherwise qualifies, a taxpayer's statement mustbe attached to the tax return. This statement requires detailed informationabout the convention. However, which of the following information itemscan be omitted from the taxpayer’s statement?a. Incorrect. The total days of the trip (excluding the days of transportation toand from the cruise ship port) is required to be in the taxpayer's statement.b. Incorrect. The taxpayer's statement must set forth the number of hours ofeach day of the trip that the individual devoted to scheduled business activity.c. Incorrect. The program of the scheduled business activity of the meetingmust be included in the taxpayer's statement.d. Correct. The names of other participants are not required in the taxpayer'sstatement. [Chp. 2]2-44Eligible Expenses - EntertainmentDeductible entertainment expenses must be ordinary and necessary for the carryingon of a trade or business (§162). As such, the expenses:(1) Must be incurred for an existing trade or business (compare "start up" expensesunder §195),(2) Must be normal, usual, or customary to the business involved and appropriateand helpful to the business activity when incurred,(3) Must actually be paid or incurred under the taxpayer's accountingmethod, and

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(4) Cannot be lavish or extravagant.In addition, entertainment expenses must comply with the "directly related," "associatedwith," or "statutory exceptions" tests.2-45Test #1 - "Directly Related"Entertainment expenditures will be considered "directly related" if the expenseswere incurred in a clear business setting or the taxpayer can show:(1) The taxpayer had more than a general expectation of deriving incomeor some other specific benefit;(2) The taxpayer did engage in a business meeting, negotiation, discussion,or other bona fide business transaction during the entertainment periodwith the person being entertained; and(3) The main purpose of the combined business and entertainment wasthe transaction of business.Entertainment occurring in a clear business setting is presumed directly relatedto the conduct of a trade or business. Examples of a clear business settingare:(1) A "hospitality room" at a convention where business goodwill is createdthrough the display or discussion of business products,(2) Entertainment that has the main effect of a price rebate in the sale ofproducts, and(3) Entertainment occurring under circumstances where there is nomeaningful personal or social relationship between the taxpayer and thepersons entertained.Test #2 - "Associated With"Entertainment expenses that do not meet the "directly related" test may stillqualify if they meet the following tests:(1) Incurred in the active conduct of trade or business, and(2) Directly precede or follows a substantial and bona fide business discussion.The existence of a substantial business discussion depends on all the factsand circumstances of each case. While it must be shown that the taxpayer ortheir representative actively engaged in a discussion, meeting, negotiation, orother bona fide business transaction to obtain some specific business benefit,it is not necessary to establish that:(1) The meeting was for any specific length of time, provided the businessdiscussion was substantial in relation to the entertainment,(2) More time was devoted to business than entertainment, or(3) Business was discussed during the entertainment period.Entertainment occurring on the same day as the business discussion is automatically

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considered as directly preceding or following the business discussion.However, if they do not occur on the same day, the facts and circumstancesof each case must be considered to see if the rule is met.2-462-47Test #3 - Statutory ExceptionsIf the expenses are one of the following statutory exceptions, a taxpayer doesnot have to meet the "directly related" or "associated with" tests:(1) Food and beverages for employees furnished on the taxpayer's businesspremises;(2) Expenses treated as compensation to an employee subject to withholding;(3) Reimbursed expenses that the employee provides an adequate accountingfor;(4) Recreational, social or similar activity expenses for employees (otherthan highly compensated employees);Note: Expenses under this exception are not subject to the 50% limitation.(5) Expenses directly related to business meetings of a firm's employees,partners, stockholders, agents or directors;Note: However, if the primary purpose of the meeting was social, this exceptiondoesn't apply.(6) Expenses directly related to business meetings or conventions of exemptorganizations;(7) The ordinary and necessary cost of providing entertainment or recreationalfacilities to the general public as a means of advertising or promotinggoodwill in the community;Note: The 50% limitation doesn't apply to this exception.(8) Entertainment sold to customers in a bona fide transaction for adequateand full consideration; andNote: This is a normal business expense not subject to 50% limitation.(9) Expenses includable in the income of a non-employee.Expense for Spouses Of Out Of Town Business GuestsTaxpayers may not deduct the cost of meals or entertainment for theirspouses or the spouses of business customers unless the taxpayer can showthat they had a clear business purpose rather than a personal or social purposefor providing the meal or entertainment.ExampleYou entertain a business customer. The cost is an ordinaryand necessary business expense and is allowed under theentertainment rules. The customer's spouse joins you becauseit is impractical to entertain the customer without the2-48spouse. You may deduct the cost of entertaining the customer'sspouse as an ordinary and necessary business expense.

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Furthermore, if your spouse joins the party becausethe customer's spouse is present, the cost of the entertainmentfor your spouse is also an ordinary and necessary businessexpense.Entertainment FacilitiesNo deduction is allowed for any expense paid or incurred in connection withan entertainment facility (e.g., yacht, lodge, fishing camp, hotel suites, etc.)Home Entertainment ExpensesHome entertainment expenses are deductible to the extent they are an additionalexpense. However, the taxpayer must show a business purpose for theentertaining.Limitations - EntertainmentOnly 50% of business related meals and entertainment expenses are deductible.This reduction also covers related expenses such as taxes and tips relating to ameal. The reduction is applied after determining the amount of allowable deductions.ExceptionsExceptions not subject to 50% reduction include:(1) Expenses treated as compensation,(2) Reimbursed expenses,(3) Recreational expenses for employees,(4) Items available to the public,(5) Entertainment sold to customers,(6) Expenses includable in income of persons, who are not employees,(7) Food or beverage excludable from gross income under the de minimisfringe benefit rules, and(8) A charitable sporting event ticket package.Ticket PurchasesThe deduction for ticket purchases is limited to the face value of the ticket.This amount is also subject to the 50% reduction rule.Charitable Sports Events ExceptionFor charitable sports events, the full amount paid for a ticket includingseating and parking is deductible if:2-49(a) Event was organized for primary purpose of benefiting a taxexemptcharitable organization,(b) 100% of the net proceeds went to the charity, and(c) Volunteers were used for substantially all work performed in carryingout the event.SkyboxesA special deduction limit is place on expenses for luxury "skyboxes" at sportingevents. If a skybox or other private luxury box is leased for more than one

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event, the amount allowable as a deduction is limited to the face value ofnon-luxury box seat tickets. The allowable amount is then reduced by 50% todetermine the amount that can be deducted.One Event RuleIn determining whether a skybox has been rented for more than oneevent, a single game or other performance counts as one event. Therefore,a rental of a skybox for a series of games, such as the World Series,counts as more than one event. In addition, all skyboxes rented in thesame arena, along with any rentals by related parties, are considered inmaking this determination.Related PartiesThe IRS has stated that related parties mean:(a) Family members,(b) Corporations that are members of the same controlled group,(c) A partnership and its principal partners,(d) A corporation and a partnership if the same person owns morethan 50% of the outstanding stock and capital or profits interest, and(e) Parties who have made one or more reciprocal arrangements involvingthe sharing of skyboxes.Food & BeveragesIf expenses for food and beverages are separately stated, these expensesmay be claimed in addition to the amounts allowable for the skybox, subjectto the 50% limit.2-50

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.

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69. Four conditions must be met in order for entertainment to meet the “directlyrelated” test. What is one of these conditions that must be met?a. The taxpayer can prove that the items are associated with active businessperformance.b. The taxpayer performs business during the entertainment period withthe person he or she is entertaining.c. The taxpayer furnishes an employee with goods, services, the use of afacility, or an allowance that might generally constitute entertainment.d. The taxpayer expects that he or she will obtain, at some future time,the benefit of the goodwill of the person he or she is entertaining.70. Reg. §1.274-2(c)(4) provides that certain entertainment expenses are acknowledgedas being directly related to the conduct of a taxpayer’s trade orbusiness. Which of the following would be deemed an apparent business location?a. a hospitality room at a seminar where business services are discussed toestablish goodwill with entertained individuals who have no personal orsocial ties to the taxpayer.b. night clubs, theaters, or sporting events.c. locations where the taxpayer is absent.d. locations where the taxpayer gathers with individuals other than businessassociates at cocktail lounges, country clubs, or vacation resorts.71. To satisfy the associated with test, taxpayers must show that there was asubstantial business discussion. Thus, what must the taxpayer explicitly show?a. A discussion was held for at least one-third the time of the total entertainment.2-51b. Less time was spent on entertainment than on business.c. There was active involvement in a business deal to acquire a particularbusiness gain.d. While the entertainment was occurring, they were discussing business.72. The limitation for meals and entertainment is inapplicable in many cases.However, this limitation is applicable when:a. expenses are treated as compensation to employees.b. costs are excludable from income of nonemployees.c. customers can purchase the entertainment.d. refreshments are treated as de minimis fringe benefits.73. Section 274 places a special limitation on the deduction of expenses forluxury skyboxes at sporting events. What is the deduction limit if a taxpayerleases a skybox for multiple sports events?a. the annual lease value.b. 50% of the cost of tickets for luxury box seats.

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c. the face value of tickets for non-luxury box seats.d. 150% of the cost of tickets for general admission.

Answers & Explanations69. Four conditions must be met in order for entertainment to meet the “directlyrelated” test. What is one of these conditions that must be met?a. Incorrect. The cost of entertainment immediately before or after a substantialand bona fide business discussion (including meetings at a convention)can be deducted if the taxpayer can establish that the items are "associatedwith" the active conduct of their trade or business.b. Correct. Entertainment meets the “directly related” test, if among otherthings, the taxpayer did engage in business during the entertainment periodwith the person being entertained.c. Incorrect. One of the statutory exceptions allows that an employer mayfurnish an employee with goods, services, the use of a facility, or an allowancethat might generally constitute entertainment. These costs are deductibleif the employer uses such items as compensation to the employee andwithholds income tax for this compensation.d. Incorrect. An entertainment expenditure meets the “directly related” test,if among other things, the taxpayer had more than a general expectation of2-52deriving income or some other specific benefit (other than the goodwill ofthe person entertained) at some future time. [Chp. 2]70. Reg. §1.274-2(c)(4) provides that certain entertainment expenses are acknowledgedas being directly related to the conduct of a taxpayer’s trade orbusiness. Which of the following would be deemed an apparent businesslocation?a. Correct. Entertainment occurring in a clear business setting is presumeddirectly related to the conduct of a trade or business. An example of a clearbusiness setting is a "hospitality room" at a convention where business goodwillis created through the display or discussion of business products, and entertainmentoccurring under circumstances where there is no meaningfulpersonal or social relationship between the taxpayer and the persons entertained.b. Incorrect. Circumstances that are presumed to lack a clear business settingare night clubs, theaters, sporting events, or essentially social gatherings suchas cocktail parties.

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c. Incorrect. Circumstances that are presumed to lack a clear business settingare situations where the taxpayer is not present.d. Incorrect. Circumstances that are presumed to lack a clear business settingare where the taxpayer meets with a group that includes persons who aren'tbusiness associates at places such as cocktail lounges, country clubs, golfclubs, athletic clubs, or at vacation resorts. [Chp. 2]71. To satisfy the associated with test, taxpayers must show that there was asubstantial business discussion. Thus, what must the taxpayer explicitlyshow?a. Incorrect. It is unnecessary for the taxpayer to show that the meeting washeld for any specific length of time, so long as the business discussion wassubstantial in relation to the entertainment.b. Incorrect. The taxpayer is not required to show that less time was spent onentertainment than on business.c. Correct. The taxpayer must show that there was active involvement in abusiness deal to acquire a particular business gain. No other requirement isneeded to show that a substantial business transaction occurred.d. Incorrect. One of the three things that are explicitly not required is toshow that, while entertainment was occurring, the taxpayer and guests werediscussing business. [Chp. 2]72. The limitation for meals and entertainment is inapplicable in many cases.However, this limitation is applicable when:a. Incorrect. When expenses are treated as compensation to employees, thecosts are fully deductible.2-53b. Correct. Under §274, expenses that are excludable from the income ofnonemployees are subject to the limitation for entertainment expenses.c. Incorrect. When customers can purchase the entertainment that is provided,under §274, the costs are fully deductible since costs of providing entertainment(or meals, goods and services, or the used of facilities) that areactually sold to the public are deductible.d. Incorrect. When refreshments are treated as de minimis fringe benefitsthat are excluded from income, the limitation for entertainment expensesdoes not apply. [Chp. 2]73. Section 274 places a special limitation on the deduction of expenses forluxury skyboxes at sporting events. What is the deduction limit if a taxpayerleases a skybox for multiple sports events?a. Incorrect. Annual lease value is a concept used to determine the value toan employee of an employer-provided automobile. It is not connected with

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the deduction of skybox seat tickets.b. Incorrect. There is a 50% limitation but it is not applied to the cost of luxurybox seat tickets.c. Correct. If a skybox or other private luxury box is leased for more than oneevent, the amount allowable as a deduction is limited to the face value ofnon-luxury box seat tickets (§274(1)(2)(A)).d. Incorrect. There is no limitation for luxury skyboxes based upon 150% ofgeneral admission tickets. [Chp. 2]SubstantiationTaxpayers must prove their deductions for travel, meals, entertainment, andbusiness gift expenses by either (1) adequate records or (2) sufficient evidencethat will corroborate the taxpayer's own statement. Without such records to substantiatetravel and entertainment expenditures, the taxpayer will suffer a total2-54disallowance of deductions by reason thereof. The taxpayer must therefore makeevery effort to substantiate travel and entertainment expenses.Comment: Some practitioners add language similar to the following to theirtax return enclosure letter - "Additionally, I did not evaluate, review, ormake any judgment regarding the adequacy of your travel, entertainment, orauto documentation. The IRS has established extensive and complicatedrules and regulations regarding the documentation of travel, entertainment,and automobile expenses. I expressly disclaim any opinion as to the adequacyof your travel, entertainment, and auto record keeping."Travel Expense SubstantiationItems needed for travel expense substantiation include:(1) Amount - The amount of each separate expenditure for traveling awayfrom home, such as the cost of transportation or lodging.Comment: The daily cost of breakfast, lunch, and dinner and other incidentaltravel elements may be aggregated if they are set forth in reasonablecategories, such as for meals, oil and gas, taxi fares, etc.(2) Time and Date - The dates of the departure and return home for eachtrip and the number of days spent on business away from home.(3) Place - The destinations or locality of the travel.(4) Purpose - The business reason for the travel or the nature of the businessbenefit derived or expected to be derived as a result of the travel.Entertainment & Meal Expense SubstantiationTo deduct an entertainment or meal expense taxpayer must substantiate eachof the following elements:(1) Amount - The amount of each separate expenditure, except that incidentalitems like cab fares and telephone calls may be aggregated daily ona separate basis.

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(2) Time and Date - The date and time the entertainment took place.Note: If the "associated with" test is used, the time and length of the businessdiscussion should be recorded.(3) Place - The name, address or location, and the type of entertainment,if that information is not apparent from the name.(4) Purpose - The reason for entertaining, or the nature of any businessdiscussion and the benefit expected as a result of entertaining.Note: If the "associated with" test is used, the nature of the business discussionshould be noted.(5) Business Relationship- The occupation or other information relative tothe person or persons entertained, sufficient to establish a business relationshipto the taxpayer.2-55(6) Physical presence - Taxpayer or his employee was present if a businessmeal given for a client.Business Gifts Expense SubstantiationDeductions for business gifts are subject to a special $25 limitation. However,even for these allowable expenses, a taxpayer must substantiate eachof the following elements:(a) Amount - cost of gift to taxpayer,(b) Time - date of gift,(c) Description - description of gift,(d) Purpose - business reason for, or business benefit expected from thegift, and(e) Relationship - name, title, occupation, or other information concerningrecipient of gift sufficient to establish business relationship tothe taxpayer.Substantiation MethodsThere are two basic substantiation methods - adequate records and sufficientlycorroborated statements.Adequate RecordsThe adequate records rule requires taxpayers to maintain:(a) An account book, diary, log, statement of expenses, trip sheets, orsimilar record listing the required elements of each expense and use,and(b) Documentary evidence (where necessary) sufficient to establisheach element of every expenditure or use.Comment: Documentary evidence is required under the "adequate records"rule for the following types of travel and entertainment andlisted property expenditures and uses:(1) Expenditures for lodging (regardless of amount) while travelingaway from home, and(2) Any other "separate expenditure" of $75.00 or more (Reg. §1.274-5(c)(2) (iii)(B).Documentary evidence consists of receipts, canceled checks, paid bills or

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similar evidence that establish the amount, date, place and essential characterof an expenditure or use, or of one or more elements of an expenditureor useAdequate records must be prepared at or near the time of the expenditureor use - i.e., at a time when the taxpayer has full knowledge of the elementsof the expenditure or use.2-56Warning: When there is no documentary evidence for lodging costs, orfor separate expenditures of $75.00 or more, no deduction will be allowed,even if records are otherwise "adequate."Sufficiently Corroborated StatementsWhen a taxpayer fails to comply with the "adequate records" rule, thenthey can still substantiate the required elements by written or oral statements,but only if such statements are supported by sufficient corroboratingevidence.Written evidence is better than oral evidence, and its probative value increasescloser in time to the expenditure or use. However, direct evidenceis required when the element to be substantiated is the description of agift, or amount, time, place, or date of an expenditure or use. Direct evidenceconstitutes:(a) Statements in writing or the oral testimony of witnesses giving detailedinformation about the element, and/or(b) Documentary evidence (i.e., receipts).Exceptional CircumstancesOther evidence may be allowed if because of the inherent nature of thesituation in which an expense is made, the taxpayer cannot get a receipt.If a taxpayer can establish that, by reason of the inherent nature of thesituation:(a) The taxpayer was unable to obtain evidence for an element of theexpense or use that conforms fully to the adequate records requirements,(b) The taxpayer is unable to obtain evidence for an element that conformsfully to the other sufficient evidence requirements, and(c) Taxpayer has presented other evidence for the element that possessesthe highest degree of probative value possible under the circumstances.This other evidence is considered to satisfy the substantiation requirements.Note: Taxpayers may prove an expense by reconstructing their expenses ifthey cannot produce a receipt for reasons beyond their control, such as fire,flood, or other casualty.Retention of RecordsRecords should be retained as long as the income tax return is open toaudit. Thus taxpayers should keep expense records for three years fromthe date of filing the income tax return.2-57

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Employees who give their records and documentation to their employersand are reimbursed for their expenses generally do not have to keep duplicatecopies of this information. However, an employee who turns overtheir records to their employer and is reimbursed for their expendituresshould still keep duplicate copies of that information if they:(a) Claim deductions for expenses in excess of reimbursements,(b) Are certain related stockholder-employees, or(c) Have employers who do not maintain adequate accounting proceduresfor verification of expense accounts.Exceptions to Substantiation RequirementsA limited number of expenses are exempt from the strict substantiationrequirements of §274(d), and may be deducted and substantiated as anyother ordinary business expense, including:(a) Expenses for recreational, social or similar activities primarily forthe benefit of employees (including the expenses of facilities used forsuch purposes),(b) Expenses for food and beverages furnished on the business premisesprimarily for the benefit of employees (including the expenses offacilities used),(c) Expenses for goods, services and facilities furnished to employeesand treated as compensation subject to withholding,(d) Expenses for goods, services, and facilities made available to thegeneral public,(e) Entertainment sold to customers, and(f) Telephone and laundry expenses.

Employee Expense Reimbursement & ReportingIf the taxpayer is an employee and has travel, entertainment, and gift expensesrelated to the employer's business or the taxpayer's work, they may or may not beable to deduct these on their tax return depending on a number of factors.If a taxpayer is not reimbursed for the travel, entertainment, or gift expenses requiredby their job, they must complete the Form 2106 to claim a deduction. Theemployee must itemize deductions to claim these expenses and keep records andsupporting evidence to prove their expenses.If a taxpayer does receive reimbursement or an allowance for such expenses,they must generally include these payments on their tax return, unless they satisfycertain rules (e.g., adequate accounting to the employer under an accountableplan).

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2-58When an Employee Needs to File Form 2106Form 2106 must be used when an employee's business expenses either are:(1) Not reimbursed, or(2) Exceed the reimbursed amount.The Form 2106 is attached to Form 1040 to determine the amount of the unreimbursedemployee business expenses subject to the 2% limitation on miscellaneousitemized deductions.Note: If the reimbursements are included on line 1 of the Form 1040 (fromForm W-2 or Form 1099), the expenses shown on the Form 2106 are claimedas itemized deductions.

Employee Expense Reimbursement & ReportingThe TRA '86 changed the deductibility of business expenses incurred by employees.Since 1987, all unreimbursed employee business expenses are only deductibleas miscellaneous itemized deductions - a "below-the-line" deduction. Miscellaneousitemized deductions are subject to §67 and can only be deducted to the extent(together with all other miscellaneous itemized deductions) they exceed twopercent of adjusted gross income (AGI).However, reimbursed employee business expenses could formerly be claimed asan "above-the-line" deduction exempt from the 2% limit. This was accomplishedby permitting employees who received expense allowances to net expenses andreimbursements without first reducing the expenses by the 2% of AGI limit. Onlyexcess expenses became itemized deductions; excess reimbursement constitutedordinary income.1988 ExampleDan, an industrial wage slave, gets an automobile expensereimbursement from his employer of $.30 per mile. The employerdoes not require Dan to account for mileage. Dan'sbusiness mileage is 10,000 and his actual business autoexpenses are $2,500. Dan's AGI (before any "for AGI" deductions)is $105,000.In 1988 Dan would have included $3,000 (10,000 miles @$.30 per mile) in income and deducted the $2,500 of businessexpenses on Form 2106 as a "for AGI" deduction (not subjectto the 2% AGI floor). The result was Dan had additional taxableincome of $500.Family Support Act of 1988

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Beginning in 1989, the Family Support Act of 1988 severely limited abovethe-line deduction treatment for employee expenses. Under the Act, employ2-59ees who are not required to account for the expense reimbursements receivedmust include these amounts in income. Expenses are then only taken as itemizeddeductions subject to the 2% AGI limit. In addition, employers mustwithhold income taxes on reimbursements without regard to any expensesthat the employee may have.1989 ExampleSame facts as in 1988 example above, except the year is1989. Dan again includes the $3,000 mileage allowance inincome. However, the $2,500 of expenses is now treated as a"below-the-line miscellaneous itemized deduction" becausehe did not adequately report the expenses to his employer.Thus, only $400 ($2,500 minus $105,000 @ 2%) of the$2,500 automobile expenses spent is actually deductible. Theresult is additional taxable income of $2,600.The Family Support Act also gave the IRS authority to impose FICA andFUTA taxes on unaccounted expense reimbursements.1990 & After ExampleSame facts as in 1988 example above, except the year is1990. Dan will not only have income tax to pay on the additional$2,600 but both he and his employer will have FICA(and FUTA for his employer) to pay on the $3,000 "phantom"income. In addition, the $3,000 must be included on Dan's W-2!Remaining Above-The-Line DeductionSince 1989, employees can only claim above-the-line deductions for businessexpenses when the expenses are actually substantiated (under §274(d)) to theperson providing the reimbursement under a reimbursement or other expenseallowance arrangement that qualifies as an "accountable plan."A reimbursement or other expense allowance arrangement is a system orplan that an employer uses to pay, substantiate, and recover the expenses,advances, reimbursements, and amounts charged to the employer for employeebusiness expenses. Arrangements can include per diem and mileageallowances. They can also be a system used to keep track of amounts receivedfrom an employer's agent or a third party (Reg. 1.62-2(c)).Note: If a single payment includes both wages and an expense reimbursement,the amount of the reimbursement must be specifically identified. If anemployee is paid a salary or commission with the understanding that theywill pay their own expenses, there is no reimbursement or allowance ar2-60

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rangement, and they must deduct their expenses using either Form 2106 andSchedule A (Form 1040), or only Schedule A (Form 1040) if not required tofile Form 2106.An employer has different options for reimbursing employees for businessrelatedtravel expenses:(1) Reimburse employees for their actual expenses,(2) Use the standard per diem meal allowance to reimburse meals and incidentalexpenses and reimburse actual lodging expenses,(3) Use the regular federal per diem rate or standard mileage rate,(4) Use the high-low method, or(5) Reimburse under any other method that is acceptable to the IRS.Note: Per diem arrangements using methods other than the regular federalper diem rate, the standard meal allowance, or the high/low method are allowedprovided the per diem allowance is reasonably calculated not to exceedthe amount of the employee's expenses and the employee is required toreturn any portion that relates to miles or days of travel not substantiated(R.P. 2008-59)Reimbursements paid under an accountable plan are not reported as compensation.Reimbursements paid under nonaccountable plans are reported ascompensation.Note: The employer makes the decision whether to reimburse employeesunder an accountable plan or a nonaccountable plan. An employee who receivespayments under a nonaccountable plan cannot convert these amountsto payments under an accountable plan by voluntarily accounting to the employerfor the expenses and voluntarily returning excess reimbursements tothe employer (Reg. §1.62-2(c)(3)).

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.2-61Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,

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you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.74. Section 274(d) detailed substantiation of expenses requires a number ofelements to be proven. However, which of the following items is irrelevant?a. amount.b. time.c. place.d. attire.75. The adequate records substantiation rule requires documentary evidencefor certain kinds of expenses for travel and entertainment. For example,documentary evidence is required for:a. lodging.b. separate expenditures of $25.c. de minimis expenses.d. tips.76. Taxpayers using adequate records substantiation must maintain a diary,trip book or log sheet, and documentary evidence proving the required expenseelements. However, which of the following items fails to qualify as suchdocumentary evidence?a. hand written receipts.b. a canceled check and matching bill.c. paid bills.d. the taxpayer's signed statement.77. The detailed substantiation requirements of §274(d) apply to many sets ofexpenses. However, which type of expense is excluded from these substantiationrequirements?a. entertainment sold to customers.b. travel.c. business gifts.d. entertainment facilities.2-6278. Employees may claim a deduction for unreimbursed expenditures. AfterDecember 31, 1986, how are unreimbursed employee business expenses betreated?a. as above-the-line deductions.b. as excess expenses.c. as miscellaneous itemized deductions.d. as substantiated expenses.

Answers & Explanations74. Section 274(d) detailed substantiation of expenses requires a number of

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elements to be proven. However, which of the following items is irrelevant?a. Incorrect. To satisfy the detailed substantiation requirements, taxpayersmust substantiate the amount of each separate expense for travel, lodging,and meals.b. Incorrect. Section 274 requires that the time and date of travel and entertainmentexpenditures be substantiated.c. Incorrect. The name and address or designation of the place of travel,meal, or entertainment, or place of use of a facility for entertainment must besubstantiated.d. Correct. Attire, whether business, casual, or otherwise, is not an elementthat needs to be proven or shown to satisfy the detailed substantiation requirements.[Chp. 2]75. The adequate records substantiation rule requires documentary evidencefor certain kinds of expenses for travel and entertainment. For example,documentary evidence is required for:a. Correct. Documentary evidence is required under the “adequate records”rule for expenditures for lodging (regardless of amount) while traveling awayfrom home.b. Incorrect. The adequate records rule requires documentary evidence forseparate expenditures of $75 dollars or more. However, prior to10/1/95,documentary evidence was required for separate expenditures of $25 ormore.c. Incorrect. De minimis expenses must not be accounted for using documentaryevidence. It would be impractical to require such evidence for thesesmall expenses.2-63d. Incorrect. Taxpayers are not required to keep detailed records of tips. Taxpayersmay deduct such expenditures on the basis of reasonable estimates(Reg. §1.162-17(d)(2)). [Chp. 2]76. Taxpayers using adequate records substantiation must maintain a diary,trip book or log sheet, and documentary evidence proving the required expenseelements. However, which of the following items fails to qualify assuch documentary evidence?a. Incorrect. Documentary evidence can consists of receipts that establish theamount, date, place, and essential character of an expenditure or use, or ofone or more elements of an expenditure or use (Reg. §1.274-5T(c)(2)(iii)).b. Incorrect. A canceled check or charge slip, together with a bill from the

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payee, ordinarily establishes the amount of expenditure. However, a canceledcheck or charge slip does not by itself support a business expense withoutother evidence to show that it was for a business purpose (Reg. §1.274-5T(c)(2)(iii)).c. Incorrect. Documentary evidence can consists of paid bills that establishthe amount, date, place, and essential character of an expenditure or use.d. Correct. The taxpayer's owned signed statement does not constitute documentaryevidence under the adequate records rule. Such evidence is selfservingand not determinative. [Chp. 2]77. The detailed substantiation requirements of §274(d) apply to many sets ofexpenses. However, which type of expense is excluded from these substantiationrequirements?a. Correct. While the deduction of entertainment sold to customers is subjectto the general requirements of §162, it is not required to meet the detailedsubstantiation requirements of §274(d).b. Incorrect. Expenses for travel away from home are subject to the detailedsubstantiation requirements of §274(d).c. Incorrect. Under §274(d), business related gifts must be substantiated indetail.d. Incorrect. Entertainment and entertainment facilities are subject to the detailedsubstantiation requirements of §274(d). [Chp. 2]78. Employees may claim a deduction for unreimbursed expenditures. AfterDecember 31, 1986, how are unreimbursed employee business expenses betreated?a. Incorrect. Miscellaneous itemized deductions are "below-the-line" deductions.b. Incorrect. Formerly, only excess expenses became itemized deductions; excessreimbursement constituted ordinary income.2-64c. Correct. Since 1987, all unreimbursed employee business expenses are onlydeductible as miscellaneous itemized deductions. Miscellaneous itemized deductionsare subject to §67 and can only be deducted to the extent (togetherwith all other miscellaneous itemized deductions) they exceed two percent ofadjusted gross income (AGI).d. Incorrect. Since 1989, employees can only claim above-the-line deductionsfor business expenses when the expenses are actually substantiated (under§274(d)) to the person providing the reimbursement under a reimbursement

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or other expense allowance arrangement that qualifies as an "accountableplan." [Chp. 2]Accountable PlansTo be an accountable plan, the employer's reimbursement or allowancearrangement must meet all three of the following rules:(a) Expenses must have a business connection (i.e., the employee musthave paid or incurred deductible expenses while performing servicesfor the employer),ExampleDux Inc. provides President Dan with an "advance" of $2,000when it is not anticipated that Dan will incur travel or otherexpenses deductible in the trade or business of being an employee.This "advance" does not meet the business connectionrequirement and is not paid under an accountable plan.2-65(b) Employees must adequately account to the employer (under §162 &§274) for these expenses within a reasonable period of time, andNote: If expenses are reimbursed under an otherwise accountable planbut the employee does not return, within a reasonable period of time,any reimbursement of expenses for which they did not adequately account,then only the amount for which they did adequately account isconsidered as paid under an accountable plan. The remaining expensesare treated as having been reimbursed under a nonaccountable plan(Reg. §1.62-2(c)(2)(ii)).(c) Employees must return any excess reimbursement or allowancewithin a reasonable period of time (§62(a)(2); Reg. §1.62-2(c)).Note: Excess reimbursement means any amount for which the employeedid not adequately account within a reasonable period of time.For example, if an employee received a travel advance and did notspend all the money on business-related expenses, or did not have proofof all expenses, there is excess reimbursement (§62(c); Reg. §1.62-2(f);Reg. §1.62-2(g)).If all these rules are met, the employer does not include any reimbursementsin the employee's income (Box 10, Form W-2). If expenses equalreimbursement, the employee does not complete the Form 2106 sincethere is no deduction for the employee (Reg. §1.62-2(c)(4); Reg.1.3231(e)-3(a)).An employee may be reimbursed under their employer's accountable planfor expenses related to that employer's business, some of which are deductibleas employee business expenses and some of which are not deductible.The reimbursements received for the nondeductible expenses aretreated as paid under a nonaccountable plan.Example from Pub. 463 (Rev '91)Your employer's plan may reimburse you for travel expenseswhile away from home on business, and for meals when youwork late, even though you are not away from home. The partof the arrangement that reimburses you for the nondeductiblemeals when you work late at the office is treated as a secondarrangement. The payments under this arrangement are

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treated as paid under a nonaccountable plan (Reg. §1.62-2(c)(2)).Reasonable Period of TimeThe definition of "reasonable period of time" depends on the facts.However, the regulations create several "safe harbors" by considering itreasonable to:2-66(i) Receive an advance within 30 days of when the employee has anexpense,(ii) Adequately account for expenses within 60 days after they werepaid or incurred, and(iii) Return any excess reimbursement within 120 days after the expensewas paid or incurred (Reg. §1.62-2(g)(1); Reg. §1.62-2(g)(2)(i)).Note: If an employee is given a periodic statement (at least quarterly)that asks them to either return or adequately account for outstandingadvances and the employee complies within 120 days of the statement,the amount is considered adequately accounted for or returned within areasonable period of time (Reg. 1.62-2(g)(2)(ii)).Adequate AccountingEmployees adequately account by giving the employer documentary evidenceof travel and other employee business expenses, along with astatement of expense, an account book, a diary, or a similar record inwhich the employee entered each expense at or near the time they madeit. Documentary evidence includes receipts, canceled checks, and bills(Reg. §1.274-5T(f)(4)).Per Diem Allowance ArrangementsA per diem allowance satisfies the adequate accounting requirementsas to amount if:(a) The employer reasonably limits payments of the travel expensesto those that are ordinary and necessary in the conduct of the trade orbusiness,(b) The allowance is similar in form to and not more than the federalrate,(c) The employee is not related (as defined under the rules applicableto the standard per diem meal allowance) to the employer, and(d) The time, place, and business purpose of the travel are proved(Reg. §1.62-2(c)(1); Reg. §1.62-2(e); Reg. §1.274-5T(g); R.P. 2008-59).Note: A receipt for lodging expenses is not required in order toapply the Federal per diem rate for the locality of travel (R.P.2008-59).If the IRS finds that an employer's travel allowance practices are notbased on reasonably accurate estimates of travel costs, including recognitionof cost differences in different areas, the employee is not con2-67sidered to have accounted to the employer, and the employee may be

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required to prove their expenses (Reg. §1.274-5T(f)(5)(iii)).Federal Per Diem RateThe federal per diem rate can be figured by using any one of threemethods:(1) The regular federal per diem rate (for combined lodging, meals,and incidental expenses),Note: The term "incidental expenses" includes, but is not limitedto, expenses for laundry, cleaning, and pressing clothing, andfees and tips for services, such as for waiters and baggage handlers.The term does not include taxicab fares or the costs oftelegrams or telephone calls (R.P. 2008-59).(2) The meals only (or standard meal) allowance (for meals and incidentalexpenses only), or(3) The high-low method (for combined lodging, meals, and incidentalexpenses or lodging only).The regular federal per diem rate and the standard meal allowanceare often grouped together and called the "standard" system. Thehigh-low method is sometimes referred to as the "simplified" system.Regular Federal Per Diem RateThe regular federal per diem rate is the highest amount that thefederal government will pay to its employees for lodging, meal, andincidental expenses while they are traveling (away from home) in aparticular area. This rate is equal to the sum of the Federal lodgingexpense rate and the Federal meal and incidental expenses(M&IE) rate for the locality of travel.The rates are different for different locations:(i) Continental United States: Federal rates applicable to a particularlocality in the continental United States ("CONUS") arepublished annually by the General Services Administration.(ii) Outside the Continental United States: Rates for a particularnonforeign locality outside the continental United States("OCONUS") (including Alaska, Hawaii, Puerto Rico, theNorthern Mariana Islands, and the possessions of the UnitedStates) are established by the Secretary of Defense and reprintedby various tax services.(iii) Foreign Travel: These rates are published once a month bythe Secretary of State.2-68The rate in effect for the area where the employee stops for sleepor rest must be used. IRS Publication 1542 gives the rates in thecontinental United States.Meals Only (or Standard Meal) AllowanceThe M&IE portion of the regular Federal per diem rate can beused by itself as a per diem allowance solely for meals and incidentalexpenses (Reg. §1.274-5(h)2; Reg. §1.274-5(j)). This is often referredto as the "standard meal allowance" or "meals only per diemallowance." This method replaces the actual cost method.

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Under this method, when a payor pays a per diem allowance solelyfor meal and incidental expenses in lieu of reimbursing actual expensesfor such expenses incurred by an employee for travel awayfrom home, the daily expenses deemed substantiated are anamount equal to the Federal M&IE rate for the locality of travelfor such day.A per diem allowance is treated as paid solely for meal and incidentalexpenses if:(1) The payor pays the employee for actual expenses for lodgingbased on receipts submitted to the payor,(2) The payor provides the lodging in kind,(3) The payor pays the actual expenses for lodging directly to theprovider of the lodging,(4) The payor does not have a reasonable belief that lodging expenseswere or will be incurred by the employee, or(5) The allowance is computed on a basis similar to that used incomputing the employee's wages or other compensation (e.g.,the number of hours worked, miles traveled, or pieces produced)(R.P. 2008-59, Section 4.02).Note: Per diem amounts are deductible without the need to substantiateactual amounts. However, the elements of time, place,and business purpose must still be substantiated.Meal Only Deduction by Employees & Self-EmployedIn lieu of using actual expenses, employees and self-employed individuals,in computing the amount allowable as a deduction for2 Reg. §1.274-5(h) states, "The Commissioner may establish a method under which a taxpayermay elect to use a specified amount or amounts for meals while traveling in lieu of substantiatingthe actual cost of meals. The taxpayer would not be relieved of substantiating the actual cost ofother travel expenses as well as the time, place, and business purpose of the travel."2-69ordinary and necessary meal and incidental expenses paid or incurredfor travel away from home, may use the Federal M&IErate for the locality of travel for each calendar day (or partthereof) they are away from home (R.P. 2008-59).Note: If the taxpayer is not reimbursed for meal expenses, theycan deduct only 50% of the standard meal allowance. This 50%limit is figured on Form 2106 or Schedule C (§274(n); R.P.2008-59).Transportation Workers' Special RateWorkers in the transportation industry can use a special standardmeal allowance. A taxpayer is in the transportation industryonly if their work:(1) Directly involves moving people or goods by airplane,barge, bus, ship, train, or truck, and(2) Regularly requires the taxpayer to travel away from home

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which, during any single trip away from home, usually involvestravel to localities with differing Federal M&IE rates.Eligible workers can claim a $52 a day standard meal allowancefor any locality of travel in CONUS and/or $58 for any locality oftravel in OCONUS. If the special rate is used for any trip, theregular standard meal allowance is not permitted for any othertrips that year (R.P. 2008-59, Sec. 4.04).LimitationsThe standard meal allowance cannot be used to prove theamount of meals while traveling for medical, charitable, or movingpurposes. It can be used when traveling for investment reasonsand to prove meal expenses incurred in connection withqualifying educational expenses while traveling away from home(§162; §212; §274(d); Reg. §1.1625).High-Low MethodIf a payor pays a per diem allowance in lieu of reimbursing actualexpenses for lodging, meal, and incidental expenses incurred by anemployee for travel away from home and the payor uses the highlowsubstantiation method for travel within CONUS, the expensesdeemed substantiated for each day (or part of the day) are equalto a "high" or "low" rate depending on the locality of travel for suchday.2-70Note: The high-low substantiation method may be used in lieuof the regular federal per diem rate, but may not be used in lieuof the meals only (or standard meal) allowance (R.P. 2008-59).This is a simplified method of computing the federal per diem ratefor travel within the continental United States ("CONUS"). Calledthe "high-low method," it eliminates the need to keep a current listof the per diem rate in effect for each city in the continentalUnited States.The combined lodging, meals and incidental expense "high" rate is$256 per day ($198 for lodging only) and $158 per day ($113 forlodging only) for all other locations (R.P. 2008-59, Sec. 5.02). Forpurposes of applying the high-low substantiation method, the FederalM&IE rate is treated as $58 for a high-cost locality and $45for any other locality within CONUS.Note: Under R.P. 2008-59, some areas are treated as high-cost localitieson only a seasonal basis.A payor that uses the high-low substantiation method with respectto an employee must use that method for all amounts paid to thatemployee for travel away from home within CONUS during thecalendar year.Related EmployerA taxpayer cannot use the Federal per diem rate (including the highlowmethod), if they are related to their employer (§267(b)(2); Reg.§1.274-5T(f)(5)(ii); R.P. 2008-59, Sec. 6.07). A taxpayer is related to

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their employer if:(1) The employer is their brother or sister, half-brother or halfsister,spouse, ancestor, or lineal descendent (§267(c)(4)),(2) The employer is a corporation in which the taxpayer owns, directlyor indirectly, more than 10% in value of the outstandingstock (Reg. §1.2745T(f)(5)(ii)), orNote: A taxpayer may be considered to indirectly own stock, ifthey have an interest in a corporation, partnership, estate, ortrust that owns the stock or if a family member or partner ownsthe stock.(3) Certain fiduciary relationships exist between the taxpayer andthe employer involving grantors, trusts, beneficiaries, etc.(§267(b)).2-71Meal Break OutWhen any per diem allowance is paid for combined lodging, meal,and incidental expenses (M&IE), the employer must treat anamount equal to the standard meal allowance for the locality oftravel as an expense for food and beverage (R.P. 2008-59). Thus, thepayor is subject to the 50% limitation on meal and entertainmentexpenses.If the per diem allowance is paid at a rate that is less than the federalper diem rate, the payor may treat 40% of the allowance as theM&IE rate (R.P. 2008-59).Partial Days of TravelProrations are required on the Federal per diem rate and the FederalM&IE rate if the employee travels less than 24 hours of any day:(i) When employees are in a "travel mode" for less than 24 hourson any particular day, the per diem rates must be prorated usingany method that is consistently applied in accordance with reasonablebusiness practice (e.g., 9AM to 5PM may be deemed a fullday); or(ii) The employer may use the Federal travel regulations and proratetotal allowance over 6-hour segments allowing 1/4 of the standardmeal allowance for each segment (R.P. 2008-59).Usage & ConsistencyThe per diem method to be used is determined on an employee-byemployeebasis. However, the employer must be consistent in themethod used for each employee during the calendar year.Unproven or Unspent Per Diem AllowancesAn employer's reimbursement arrangement is considered an accountableplan even if the employee does not return the amount ofan unspent per diem allowance to the employer as long as the employeeproves that they did travel that day. This is an accountableplan because the amount (up to the amount computed under theregular per diem rate or high-low method) of the allowance is consideredproven.

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The employer includes as income in the employee's Form W-2 theunspent or unproven amount of per diem allowance as excess reimbursement.This unspent or unproven amount is considered paid undera nonaccountable plan (R.P. 2008-59).2-72Travel AdvanceIf the employer provides the employee with an expense allowancebefore they actually have the expense, and the allowance is reasonablycalculated not to exceed expected expenses, this is referred to asa travel advance.Under an accountable plan, an employee must adequately accountto their employer for this advance and be required to return any excesswithin a reasonable period of time. If the employee does notadequately account or does not return any excess advance within areasonable period of time, the unaccounted for or unreturnedamount will be treated as having been paid under a nonaccountableplan (Reg. §1.62-2(c)(3)(ii); Reg. §1.62-2(f)(1); Reg. §1.62-2(g)(2)).Reporting Per Diem AllowancesIf an employee is reimbursed by a per diem allowance (daily amount) receivedunder an accountable plan, two facts affect reporting:(a) The federal rate for the area where the employee traveled, and(b) Whether the allowance or the employee's actual expenses weremore than the federal rate.Reimbursement Not More Than Federal RateIf the per diem allowance is less than or equal to the federal rate, the allowancewill not be included in boxes 1, 3, and 5 of the employee'sForm W-2.The employee does not need to report the related expenses or the perdiem allowance on their return if the expenses are equal to or less thanthe allowance. They do not complete Form 2106 or claim any of theexpenses on the Form 1040.Reimbursement More Than Federal RateIf an employee's per diem allowance is more than the federal rate, theemployer is required to include the allowance amount up to the federalrate in box 13 (code L) of the employee's Form W-2. This amount isnot taxable.However, the per diem allowance in excess of the federal rate will beincluded in box 1 (and in boxes 3 and 5 if applicable) of the employee'sForm W-2. The employee must report this part of the allowance as if itwere wage income. The employee is not required to return it to their employer(§3121(x); Reg. §1.62-2(e)(2)).If allowance or advance is higher than the federal rate for the area

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traveled to, the employee does not have to return the difference be2-73tween the two rates for the period the employee can prove businessrelatedtravel expenses. However, the difference will be reported aswages on Form W-2 (Reg. 1.62-2(f)).When the actual expenses are more than the federal rate, the employeeshould complete Form 2106 and deduct those expenses that are morethan the federal rate on Schedule A (Form 1040). The employee mustreport on Form 2106 reimbursements up to the federal rate as shownin box 17 of their Form W-2 and all their expenses (Reg. §1.62-2(c)(2);Reg. §1.62-2(c)(5); Reg. §1.62-2(e)(2); R.P. 2008-59).Reporting & Reimbursement ChartType of Reimbursement orOther Expense Allowance ArrangementEmployerReports onForm W-2EmployeeShows onForm 2106*AccountableActual expense reimbursementAdequate Accounting and excessreturnedNot reportedNot shown, if expenses do notexceed reimbursementActual expense reimbursementAdequate accounting and return ofexcess both required but excess notreturnedExcess reported as wages inBox 1**. Amount adequatelyaccounted for is reported only inBox 13 - it is not reported inBox 1.All expenses (and reimbursementsreported on Form W-2,Box 13) only if some or all ofthe excess expenses areclaimed***. Otherwise, formis not filed.Per diem or mileage allowance (upto federal rate)Adequate accounting and excessreturnedNot reportedAll Expenses and reimbursementsonly if excess expensesare claimed***. Otherwiseform is not filed.Per diem or mileage allowance(exceeds federal rate)

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Adequate accounting up to federalrate only and excess not returnedExcess reported as wages inBox 1**. Amount up to the federalrate is reported only in Box13 - it is not reported in Box 1.All expenses (and reimbursementsequal to the federal rate)only if expenses in excess ofthe federal rate areclaimed***. Otherwise, formis not filed.Nonaccountable Either adequateaccounting or return of excess, orboth, not requiredEntire amount is reported aswages in Box 1**.All expenses***No reimbursement Normal reporting of wages, etc. All expenses**** You may be able to use Form 2106-EZ** Excess is also reported in boxes 3 and 5, if applicable*** Any allowable business expense is carried to line 20 of Schedule A (From 1040) and deductedas a miscellaneous itemized deduction.2-74Nonaccountable PlansA nonaccountable plan is a reimbursement or expense allowance arrangementthat does not meet the three rules listed earlier under AccountablePlans.In addition, the following payments made under an accountable plan willbe treated as being paid under a nonaccountable plan:(1) Excess reimbursements the employee fails to return to the employer(Reg. §1.62-2(c)(2)(ii)), and(2) Reimbursement of nondeductible expenses related to the employer'sbusiness (Reg. §1.62-2(d)(2)).An arrangement that repays the employee for business expenses by reducingtheir wages, salary, or other compensation will be treated as anonaccountable plan because the employee is entitled to receive the fullamount of their compensation regardless of whether they incurred anybusiness expenses (Reg. §1.62-2(d)(3)(i)).Reimbursements from nonaccountable plans produce taxable income forthe employee. All advances and reimbursement from nonaccountableplans must be included on the employee's W-2 in Box 1 (and boxes 3 and5 if applicable).The employee must then complete Form 2106 and itemize their deductionson Schedule A (Form 1040) to deduct expenses for travel, transportation,meals, or entertainment. Meal and entertainment expenses will besubject to the 50% limit and the 2% of adjusted gross income limit whichapplies to most miscellaneous itemized deductions (§62(c); Reg. §1.62-

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2(c)(5)).Example from Pub. 463 (Rev '94)Kim's employer gives her $500 a month ($6,000 total) forher business expenses. Her employer does not require Kimto provide any proof of her expenses, and Kim can keep anyfunds that she does not spend.Kim is being reimbursed under a nonaccountable plan. Heremployer will include the $6,000 on Kim's Form W-2 as if itwere wages. If Kim wants to deduct her business expenses,she must itemize her deductions and complete Form 2106.The 50% limit applies to her meal and entertainment expenses,and the 2% of adjusted gross income limit applies toher total employee business expenses.2-75Example from Pub. 463 (Rev '94)Kevin is paid $2,000 a month by his employer. On days thathe travels away from home on business, his employer designates$50 a day of his salary as paid to reimburse his travelexpenses. Because his employer would pay Kevin hismonthly salary regardless of whether he was traveling awayfrom home, the arrangement is a nonaccountable plan and nopart of the $50 a day designated by his employer is treated aspaid under an accountable plan.Employers must withhold (20% optional withholding method is available)on the advances and/or reimbursements. They are subject to FUTA andFICA (noncompliance penalty is placed on employer).

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.79. In addition to other §62 requirements, to qualify as an accountable planfor employee expense reimbursement and reporting purposes, the employer's

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reimbursement or allowance arrangement must meet three rules. What isone of these rules?a. Employers must receive sufficient accounting of expenses within 180days.b. An estimate of expenses must be provided within a reasonable periodof time.c. Excess reimbursement or allowance must be treated as compensation.d. Expenses must have a business connection.2-7680. Under the accountable plan rules, two conditions require action within aspecifically defined “reasonable period of time.” However, which of the followingcircumstances would demonstrate an unreasonable amount of time?a. The employee receives an advance within 30 days.b. The employee accounts for expenses within 60 days.c. The employee returns any excess within 120 days.d. The employee substantiates expenses within 180 days of a periodicstatement.81. One federal per diem method uses a combined lodging, meals, and incidentalexpense computation. Under this method, what expenses are consideredincidental expenses?a. taxicab fares.b. telegrams.c. telephone calls.d. tips and fees for services.82. The federal per diem rate for travel within the continental United States(CONUS) does away with the need to maintain a current list of each city’sper diem rate and uses a simplified method. What is this simplified method?a. the high-low method.b. the meals only allowance.c. the regular federal per diem rate.d. the nonaccountable method.83. What the employer has to report on Form W-2 depends on the type of reimbursementor other expense allowance arrangement that is in existence.Which type of reimbursement does an employer report on Form W-2?a. actual expenses reimbursed under an accountable plan.b. excess amounts returned to the employer.c. adequately accounted for amounts under a nonaccountable plan.d. per diem or mileage allowance under an accountable plan.84. A nonaccountable plan is a reimbursement or expense allowance arrangementoutside the requirements of §62. Reimbursements from such aplan are:a. taxable income to the employer.

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b. taxable income to the employee.c. are income to the employee and cannot be deducted by the employee.d. are not deductible by an employer.

Answers & Explanations2-7779. In addition to other §62 requirements, to qualify as an accountable plan foremployee expense reimbursement and reporting purposes, the employer'sreimbursement or allowance arrangement must meet three rules. What isone of these rules?a. Incorrect. To qualify as an accountable plan for employee expense reimbursementand reporting purposes, employees must adequately account tothe employer for the expenses within 60 days.b. Incorrect. To qualify as an accountable plan for employee expense reimbursementand reporting purposes, employees must adequately account tothe employer for the expenses within a reasonable period of time.c. Incorrect. To qualify as an accountable plan for employee expense reimbursementand reporting purposes, employees must return any excess reimbursementor allowance within a reasonable period of time.d. Correct. To qualify as an accountable plan for employee expense reimbursementand reporting purposes, expenses must have a business connection(i.e., the employee must have paid or incurred deductible expenses whileperforming services for the employer and the advance must reasonably relateto anticipated business expenses). [Chp. 2]80. Under the accountable plan rules, two conditions require action within aspecifically defined “reasonable period of time.” However, which of thefollowing circumstances would demonstrate an unreasonable amount oftime?a. Incorrect. The IRS considers it reasonable for an employee to receive anadvance within 30 days of when the employee has an expense.b. Incorrect. Adequately accounting for expenses within 60 days after theywere paid or incurred is considered reasonable under the accountable planregulations (Reg. §1.62-2(g).c. Incorrect. The Service considers it reasonable to return any excess reimbursementwithin 120 days after the expense was paid or incurred (Reg.§1.62-2(g)(2)(i)).d. Correct. If an employee were to substantiate expenses within 120 days of aperiodic statement, this would be deemed a reasonable amount of time.

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However, if the substantiation occurred after 120 days, this would be consideredunreasonable. [Chp. 2]81. One federal per diem method uses a combined lodging, meals, and incidentalexpense computation. Under this method, what expenses are consideredincidental expenses?a. Incorrect. "Incidental expenses" do not include taxicab fares.b. Incorrect. "Incidental expenses" do not include the costs of telegrams.c. Incorrect. "Incidental expenses" do not include the costs of telephone calls.2-78d. Correct. "Incidental expenses" include, but are not limited to, fees and tipsfor services, such as for waiters and baggage handlers. [Chp. 2]82. The federal per diem rate for travel within the continental United States(CONUS) does away with the need to maintain a current list of each city’sper diem rate and uses a simplified method. What is this simplifiedmethod?a. Correct. The high-low method is a simplified method of computing thefederal per diem rate for travel within the continental United States(CONUS) because it eliminates the need to keep a current list of the perdiem rate in effect for each city in the CONUS.b. Incorrect. The meals only allowance is often referred to as the standardmeal allowance or meals only per diem allowance. Under this method, whena payor pays a per diem allowance solely for meal and incidental expenses inlieu of reimbursing actual expenses for such expenses incurred by an employeefor travel away from home, the daily expenses deemed substantiated isan amount equal to the federal meal and incidental expenses (M&IE) ratefor the locality of travel for such day.c. Incorrect. The regular federal per diem rate is the highest amount that thefederal government will pay to its employees for lodging, meal, and incidentalexpenses while they are traveling (away from home) in a particular area. Thisrate is equal to the sum of the federal lodging expense rate and the federalmeal and incidental expenses (M&IE) rate for the locality of travel.d. Incorrect. The nonaccountable plan is used to report reimbursements. It isnot a method used to calculate the federal per diem rate for travel. [Chp. 2]83. What the employer has to report on Form W-2 depends on the type of reimbursementor other expense allowance arrangement that is in existence.Under what type of reimbursement arrangement does the employer reporton Form W-2 the normal reporting of wages?a. Incorrect. An actual expense reimbursement under an accountable plan is

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not reported on Form W-2.b. Incorrect. Excess reimbursement amounts returned to the employer withina reasonable period of time are not reported on the Form W-2.c. Correct. Under a nonaccountable plan, the employer reports the entire reimbursementon Form W-2.d. Incorrect. A per diem or mileage allowance under an accountable plan isnot reported on the Form W-2. [Chp. 2]84. A nonaccountable plan is a reimbursement or expense allowance arrangementoutside the requirements of §62. Reimbursements from such a planare:a. Incorrect. Reimbursements of expenses to an employee under a nonaccountableplan not create income for the employer.2-79b. Correct. Reimbursements from nonaccountable plans produce taxable incomefor the employee.c. Incorrect. Reimbursements from nonaccountable plans may be deductibleby the employee. However, the employee must complete Form 2106 anditemize their deductions on Schedule A (Form 1040) subject to the 2% of adjustedgross income limit.d. Incorrect. Reimbursements from a nonaccountable plan would be deductibleby the employer as compensation. [Chp. 2]

Local TransportationTransportation expenses directly attributable to the conduct of the taxpayer'sbusiness are deductible even though they are not away from home overnight.Such expenses include air, train, bus and cab fares and costs of operating autos.Commuting expenses between a taxpayer's residence and their regular businesslocation are not deductible. A taxpayer who works at two or more locations eachday can deduct the cost of getting from one location to the other.Comment: A deduction is allowed when traveling between a home and anotherbusiness location only when the home is the taxpayer's principal placeof business.Transportation to a temporary or minor work assignment beyond the "general

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area of a taxpayer's tax home" may be deducted for the daily round trip transportation.Assignments within Work AreaTransportation expenses between a taxpayer's residence and a regular place ofbusiness are nondeductible commuting expenses (§262). However, transportationexpenses between two specific business sites (in the same or different businesses)are deductible (R.R. 55-109).Old Revenue Ruling 90-23 (Superseded)Early in 1990, the IRS issued R.R. 90-23 providing that transportation expensesbetween a taxpayer's home and a temporary work site (when the taxpayerhad a regular place of business) were deductible business expenses.This rule was retroactive.2-80Note: Prior to 1990, R.R. 55-109 held that transportation expenses between ataxpayer's home and a temporary work site within a metropolitan area, incurredby a taxpayer who ordinarily worked in a particular metropolitan areabut who was not regularly employed at any specific work location, were notdeductible. However, when that taxpayer incurred transportation expensesbetween their home and a temporary work site outside their metropolitanarea, those expenses were deductibleR.R. 90-23 provided that transportation between a residence and temporarywork locations by a taxpayer who had one or more regular places of businesswas deductible, no matter the distance (within or outside of the metropolitanarea). Transportation between a taxpayer's residence and one or more regularplaces of business remained nondeductible.Note: Employee taxpayers deduct daily transportation expenses only as miscellaneousitemized deductions subject to the 2% floor (§67).Temporary Work Site DefinitionUnder R.R. 90-23, a temporary place of business was any location wherethe taxpayer performed services on an irregular basis. However, a taxpayercould be considered as working at a particular location on a regular basiswhether or not they worked at that location every week or on a set schedule.ExampleOnce brilliant tax-attorney, Dan, has an office in NewportBeach. He travels from his beachfront and gold-digger infestedhome to various clients' offices (temporary work locations)to perform tax-planning services. His daily transportationexpenses from home to the temporary work sites are deductible,regardless of the distance traveled. However, transportationexpenses from his home to his Newport Beach officearen't deductible.Caution: If a taxpayer deducts transportation expenses from their home toan asserted temporary job site without proof of a valid business purpose, thedeductions will be denied and penalties imposed.

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Reserve UnitsFormerly, a member of a military reserve unit could deduct transportationexpenses between their home and regular meetings of the reserveunit held outside the metropolitan area where the taxpayer was regularlyemployed. Under R.R. 90-23, these expenses were no longer deductibleon or after January 1, 1990.2-81Revenue Ruling 99-7R.R. 99-7 superseded R.R. 90-23. Under R.R. 99-7, workers may deduct theirdaily transportation expenses if they are traveling between their residencesand a temporary work location outside the metropolitan areas where they liveand normally work.Workers who have one or more regular work locations outside their residencealso may deduct their daily transportation expenses if they are travelingbetween their residences and a temporary work location (inside or outsidetheir metropolitan areas) in the same trade or business. Likewise, workerswhose residence is their principal place of business may deduct their dailytravel expenses if they are traveling between their residences and anotherwork location (regular or temporary; inside or outside the metropolitan area)in the same trade or business.Under R.R. 99-7, a temporary work location is no longer defined as any locationat which the worker performs service on an irregular or short-term basis(see R.R. 90-23). Instead, the IRS regards a work location as temporary ifemployment at the work location is realistically expected to last and actuallydoes last a year or less.If employment at a work location initially is realistically expected to last for ayear or less, but at some later date, the employment is realistically expectedto exceed a year, the IRS will regard the work location as temporary until thedate the worker's realistic expectation changes, but not after that date. Awork location won't be considered temporary if:(1) Employment at a work location is realistically expected to last formore than a year, or(2) There is no realistic expectation that the employment will last for ayear or less. (Reprinted with permission. Copyright 1999. Tax Analysts.)

Automobile DeductionsOperating costs for an automobile, truck, or other vehicle used in a trade orbusiness are deductible to the extent that they represent transportation expensesto carry on the taxpayer's business. Thus, when a taxpayer uses their car in theirbusiness or employment, they can deduct that portion of the cost of operating

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the car.Eligible ExpensesAny expense of operating and maintaining a car used for business purposes suchas gasoline, oil, repairs, insurance, depreciation, interest to purchase the car,taxes, licenses, garage, rent, parking, fees, tolls, etc. are deductible.2-82Apportionment of Personal & Business UseWhen a taxpayer makes both personal and business use of their auto, they mustapportion their expenses between business travel and personal travel, unless thepersonal use is negligible. Thus, total car expenses (except business parking feesand tolls) are deducted in proportion of business to total use. Parking fees andtolls for business uses are deducted in full.There is no definitive rule for making an apportionment between business andpersonal expenses. However, generally accepted methods include:(1) A proration of actual expenses and depreciation based on the percentageof business use to total use; and(2) The standard mileage rate deduction for business miles driven.The taxpayer is free to use whichever method produces the largest deduction,provided the right to the deduction is properly substantiated.ExampleYou are a contractor and use your car in your business. Duringthe year you drove 20,000 miles of which 16,000 mileswere for business purposes. You are entitled to deduct 80%(16,000/20,000) of the total cost of operating your car.

Actual Cost MethodEligible expenses incurred (including depreciation) are totaled together and thenmultiplied by the business-use percentage (see above example) to determine theamount of the deduction. Only the business-use percentage (based on the ratioof business miles to total miles) allowable to business transportation is allowedas a deduction.Depreciation & ExpensingAn amount can be deducted each year that represents a reduction in a car'svalue due to wear and tear. Employees use Form 2106 to figure their depreciationdeduction. All other taxpayers use Form 4562.

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Placed in ServiceA car is placed in service when it is available for use in the taxpayer's workor business, in the production of income, or in a personal activity. However,depreciation can only begin when used in the taxpayer's work, business,or production of income.2-83Half-year ConventionAn automobile is assumed to have been placed in service during themiddle of the tax year for MACRS. As such, depreciation for the firstyear will be based on 1/2 a year.Quarterly Convention ExceptionIf the total of such assets placed in service during the last threemonths of the tax year is more than 40% of all property placed inservice during the entire year, a mid-quarter convention applies.MACRSThe modified cost recovery system (MACRS) is the depreciation systemthat applies to tangible property placed in service after 1986. UnderMACRS, cars are classified as five-year property. However, as a result ofthe half-year convention, the car is actually depreciated over a six-yearperiod.Double Declining Balance MethodTo figure MACRS depreciation, divide one by the recovery period (5years for cars). This basic rate (20% for five-year property) is multipliedby two to get the double declining (200%) balance rate of 40%.Multiply the adjusted basis of the car (determined by reducing the costby the percentage of personal use and any §179 deduction) by this 40%and apply the appropriate convention to figure your depreciation forthe first year. This process is continued for each year of recovery.However, at the point (year four for cars) where straight-line is morebeneficial, a switch is made to straight-line.Depreciation "Caps"For cars placed in service in 2009, the depreciation deduction (includingthe §179 expensing deduction) may not be more than $2,960($10,960 if 50% first year bonus depreciation applies) for the first taxyear of the recovery period, $4,800 for the second year, $2,850 for thethird year, and $1,775 for each later tax year (§280F(a)(2)(A)). Fortrucks and vans placed in service in calendar year 2009, the depreciationcap is $3,060 ($11,060 if bonus depreciation applies) in the firstyear,$4,900 in the second year, $2,950 in the third year, and $1,775 inthe fourth year and thereafter (R.P. 2009-24).Note: Formerly, depreciation limitations for trucks and vans were thesame as for passenger vehicles. However, starting in 2003, the IRS issuedseparate and slightly higher limitations for trucks and vans under§168(k)(4) (R.P. 2003-75).2-84If at the end of the recovery period, any unrecovered basis remains andthe car is still used in business, depreciation is continued. However, in

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determining unrecovered basis, the basis is reduced by the maximumdepreciation allowable - i.e., the IRS always reduces the remaining basisas if the taxpayer had used the car 100% for business.Temporary Increase in Depreciation CapsFor 2008 and 2009, business taxpayers are allowed a 50% bonus depreciationallowance for qualified property (e.g., equipment) placedin service in 2008 or 2009 (§168(k)). As a result, the limitation on theamount of depreciation deductions allowed increases in the first yearby $8,000 for qualified vehicles that taxpayers do not elect out of theincreased first year bonus depreciation.Note: As a result of this provision, luxury autos and other vehicles subjectto the "cap" on depreciation are able to claim an extra $8,000 in theyear the vehicle is placed in service.Expensing LimitSection 179 allows a deduction based on an election to treat a portionor all of the cost of a car as an immediate expense. Generally, the §179deduction allowed for the total cost of qualifying property is limited to$250,000 in 2009. In addition, the §179 deduction is treated as depreciationfor the tax year a car is placed in service. Thus, if a taxpayerplaces a car in service and elects §179 treatment, it will be deemed depreciationand limited to the depreciation cap in the first tax year.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.2-85Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.85. In deciding whether a work site commute was deductible, taxpayers previously

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had to determine whether the work site was temporary using R.R. 90-23. Under this ruling, which work location was considered temporary?a. a swimming pool where a swim instructor taught.b. a school and a professional office of a school teacher.c. a second office in another city.d. a client’s office where bookkeeping services were performed.86. R.R. 99-7 superseded R.R. 90-23. Under R.R. 99-7, how is a temporarywork location defined?a. as a work location where employment is realistically expected to continueand actually does continue for no more than a year.b. as a work location where there is no expectation as to the length ofemployment.c. as any location at which the worker performs service on an irregular basis.d. as any location at which the worker performs service on a short-termbasis.87. Automobile expenses must be apportioned between business travel andpersonal travel. What is an accepted method of apportionment?a. the actual cost method.b. the specific identification method.c. the high low method.d. the annual lease value method.88. Since 1987, tangible business property is depreciated using the modifiedcost recovery system (MACRS). How does this system classify cars?a. as five-year property.b. as seven-year property.c. as ten-year property.d. as fifteen-year property.2-8689. A taxpayer may elect the §179 expensing deduction for a portion or all ofthe cost of an automobile. When the election is made, what must be done?a. reduce the automobile’s basis and then figure the depreciation deduction.b. use the mid-quarter convention.c. increase the basis of their car.d. use the half-year convention.

Answers & Explanations85. In deciding whether a work site commute was deductible, taxpayers previouslyhad to determine whether the work site was temporary using R.R. 90-23. Under this ruling, which work location was considered temporary?a. Incorrect. A swimming pool where a swim instructor taught would nothave been deemed to be a temporary work site since the instructions tookplace on a regular basis.b. Incorrect. Any travel between a school and a professional office wouldhave been nondeductible if the teacher taught at the school on a regular basis

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and worked out of the office on a regular basis.c. Incorrect. If a professional had two regular offices, any travel betweenhome and them would have been nondeductible.d. Correct. A professional who traveled to clients’ offices to perform servicesmay have been able to deduct commuting expenses since the work performedwas on an irregular basis – the standard of R.R. 90-23. [Chp. 2]86. R.R. 99-7 superseded R.R. 90-23. Under R.R. 99-7, how is a temporarywork location defined?a. Correct. The IRS regards a work location as temporary if employment atthe work location is realistically expected to last and actually does last a yearor less.b. Incorrect. A work location won't be considered temporary if employmentat a work location is realistically expected to last for more than a year, orthere is no realistic expectation that the employment will last for a year orless.c. Incorrect. Under R.R. 99-7, a temporary work location is no longer definedas any location at which the worker performs service on an irregular basis.d. Incorrect. Under R.R. 99-7, a temporary work location is no longer definedas any location at which the worker performs service on a short-termbasis. [Chp. 2]2-8787. Automobile expenses must be apportioned between business travel andpersonal travel. What is an accepted method of apportionment?a. Correct. Accepted methods include a proration of actual expenses and depreciationbased on the percentage of business use to total use and the standardmileage rate deduction for business miles driven.b. Incorrect. The specific identification method is used for inventory identification,not for the allocation of automobile use.c. Incorrect. The high low method is a subcategory of travel expense identificationusing recognized seasonal per diems.d. Incorrect. The annual lease value method is not used to apportion businessuse of an automobile between business and personal. The method is used toplace a value on the use of an employer-provided vehicle. [Chp. 2]88. Since 1987, tangible business property is depreciated using the modifiedcost recovery system (MACRS). How does this system classify cars?a. Correct. Under MACRS, cars are classified as five-year property.b. Incorrect. Seven-year property includes office furniture, fixtures, equipment,breeding and work horses, agricultural machinery and equipment, railroadtrucks, single purpose agricultural or horticultural structures and otherproperty with an ADR midpoint of 10 years and less than 16 and property

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not specifically assigned to any other class.c. Incorrect. Ten-year property includes vessels, barges, tugs, assets used forpetroleum refining, manufacture of grain, sugar, and vegetable oils and otherproperty with an ADR midpoint of 16 years or more but less than 20 years.d. Incorrect. Fifteen-year property includes land improvements, assets usedfor electrical generation, pipeline transportation, and cement manufacture,railroad track, nuclear production plants, sewage treatment plants, and otherproperty with an ADR midpoint of 20 years or more but less than 25 years[Chp. 2]89. A taxpayer may elect the §179 expensing deduction for a portion or all ofthe cost of an automobile. When the election is made, what must be done?a. Correct. If a taxpayer elects §179 expensing, they must reduce the basis oftheir car before figuring any depreciation deduction (§280F(d)(1);§1016(a)(2)).b. Incorrect. There is no requirement that, if a taxpayer elects §179 expensing,they must use the mid-quarter convention.c. Incorrect. The amount of the §179 deduction reduces the basis of the car.d. Incorrect. There is no requirement that, if a taxpayer elects §179 expensing,they must use the half-year convention. [Chp. 2]2-88Predominate Business Use RuleThe Tax Reform Act of 1984 created additional limitations on investment taxcredits, depreciation and expensing if a car is not "predominantly used in aqualified business use".Qualified Business UseA qualified business use is any use in trade or business. Qualified businessuse does not include use of property held merely for the production of income(i.e., investment use). However, after the taxpayer has satisfied thepercentage of business requirement, they may combine business and investmentuse to compute any allowable credit or deduction for a tax year.More Than 50% Use TestProperty "used predominantly in a qualified business use" is only met ifthe taxpayer uses their car more than 50% in a qualified business use forthe tax year.2-89LimitationsIf a car is not used more than 50% in a qualified business use in the yearit is placed in service:(1) The depreciation deduction must be figured using the straight-line

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percentages over a five-year recovery period (10% for the 1st and 6thyears and 20% for the 2nd through 5th years);(2) No §179 expensing deduction is allowed; and(3) The investment credit is denied (however, the ITC was repealed effective1986 anyway).RecaptureIf a taxpayer uses their car more than 50% in a qualified business use inthe year it is placed in service but reduces their qualified business use in asubsequent tax year, two things can happen - ITC recapture and excessdepreciation recapture.ITC RecaptureAny reduction of business use will trigger investment tax credit (iforiginally claimed) recapture under Reg. §1.47-1(c) and 1.47-2(e).Thus, if a taxpayer's business use for a later year is less than the percentagefor the year the car was placed in service, but taxpayer istreated as having disposed of part of the car. For example, if his business-use percentage is 80% in the year the car was placed in serviceand in a later year it falls to 60%, the taxpayer is treated as having soldone-fourth of the car. Moreover, if the qualified business use falls to50% or less in any year, the entire car is deemed sold. However, rememberthat the investment tax credit has been repealed since 1986.Excess Depreciation RecaptureIf in a subsequent tax year, the taxpayer fails to use their car more than50% in a qualified business use, then their depreciation for that yearmust be determined using the straight-line percentages over a five-yearperiod. In addition, any "excess depreciation" must be recaptured - i.e.,included in gross income and added to the car's adjusted tax basis.Excess depreciation is the excess, if any, of:(a) The amount of the depreciation deductions allowed (includingany §179 deduction) for the car for tax years in which the car wasused more than 50% in qualified business use, over(b) The amount of the depreciation deductions that would have beenallowable for those years if the car had not been used more than50% in a qualified business use for the year it was placed in service.2-90Leasing RestrictionsThe depreciation and expensing "caps" and the predominant business userules discussed above cannot be escaped by leasing a car (§280F(c)). In orderto equate car owners and lessees, regulations under §280F require the lesseeto include in gross income an "inclusion amount" determined as a percentageof the car's fair market value (on the first day of the lease term) in excess ofstated dollar amounts. This inclusion amount is designed to approximate thelimitations imposed on the owner of a car.

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Standard Mileage MethodThe standard mileage deduction allows a "flat" or standard amount of deductionfor every business mile traveled regardless of actual cost, and therefore only requiressubstantiation of the distance traveled in the pursuit of trade or business.In 2009, the standard mileage rate is 55 cents a mile for all business miles. Theserates are adjusted periodically for inflation (R.P. 2008-27).If a taxpayer chooses to take the standard mileage rate, they cannot deduct actualoperating expenses, such as depreciation, maintenance, and repairs, gasoline(including gasoline taxes), oil, insurance, and vehicle registration fees.Note: However, parking fees and tolls may still be deducted in addition tothe standard mileage rate.LimitationsThe standard mileage rate can only be used by taxpayers who:(1) Do not hire out the vehicle (such as for a taxi), and(2) Do not operate a fleet of cars where five or more cars are used at thesame time (R.P. 2008-27, Sec. 5.06(1)).Formerly, a taxpayer had to own the vehicle and could not lease or rent it.However, final regulations under §274(d) now provide that, effective January1, 1998, taxpayers can figure their deduction for business use of a rentedautomobile by multiplying the number of business miles driven during theyear by a mileage allowance figure (T.D. 8784; REG-122488-97).In addition, taxpayers cannot use the standard mileage rate if they claimed adeduction for the car in an earlier year using:(1) ACRS or MACRS depreciation,(2) A §179 deduction, or(3) Any method of depreciation other than straight-line for the estimateduseful life of the car (R.P. 2008-27).2-91Alternating UseA taxpayer, who owns two cars, using one as an alternative or replacementfor the other, may still utilize the standard mileage rate. When an individualuses more than one car on an alternating basis, they may use the standardmileage rate and combine their mileage when both cars otherwise qualify.The rate is applied to the total business miles that both cars are driven. However,if one of the autos has been fully depreciated, the business mileage ofthe two vehicles is not combined.Switching MethodsAn election to use the standard mileage rate must be made in the first yearthe vehicle is placed in service for business purposes and constitutes an election

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to exclude the vehicle from depreciation under the modified acceleratedcost recovery system (MACRS). In later years, a taxpayer can continue to usethe standard mileage rate or switch to the actual expense method. However,if the taxpayer did not choose the standard mileage rate in the first year, theymay not use it for that car in any subsequent year. (R.P. 2008-27, Sec.5.06(3)).If a taxpayer changes to the actual cost method in a later year, but before thecar is considered fully depreciated, the car must be depreciated on thestraight-line basis.Charitable TransportationTaxpayers may deduct 14 cents for each mile in 2009 they use their vehiclesin work they contribute to a charitable organization, instead of itemizing theexpenses (Treas. Reg. §1.170A-1(g) and R.P. 2008-27). However, no deductionis allowed for charitable travel expenses unless there is no significantelement of personal pleasure, recreation or vacation in the travel (§170(k)).The disallowance applies to payments made directly by the taxpayer of theirown expenses or those of an associated person, to indirect payments such asreimbursement arrangements with the charity, and to reciprocal arrangementsbetween two unrelated taxpayers.Medical TransportationTransportation expenses primarily for medical service are deductible (§213).Taxpayers can list their auto expenses, or deduct 24 cents for each mile in2009. However, medical expenses must exceed 7.5% of AGI to be deductible.2-92

Gas Guzzler TaxThe gas-guzzler tax is an excise tax imposed on the sale by the manufacturer orimporter of any automobile that does not meet statutory standards for fueleconomy. The tax begins at $1,000 for automobile models that do not meet a22.5-miles-per-gallon standard and increases to $7,700 for models with a fueleconomy rating of less than 12.5 miles per gallon (§4064):Miles Per Gallon Tax22.5 & above $021.5 - 22.5 $1,00020.5 - 21.5 $1,30019.5 - 20.5 $1,70018.5 - 19.5 $2,10017.5 - 18.5 $2,60016.5 - 17.5 $3,00015.5 - 16.5 $3,700

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14.5 - 15.5 $4,50013.5 - 14.5 $5,40012.5 - 13.5 $6,40012.5 - 0 $7,700

AutomobilesAn automobile is any four-wheeled vehicle that is:(a) Rated at an unloaded gross vehicle weight of 6,000 pounds or less,(b) Propelled by an engine powered by gasoline or diesel fuel, and(c) Intended for use mainly on public streets, roads, and highways.LimousinesThe tax generally applies to limousines (including stretch limousines) regardlessof their weight.Vehicles Not Subject To TaxFor the gas guzzler tax, the following vehicles are not considered automobiles:1. Vehicles operated exclusively on a rail or rails.2. Vehicles sold for use and used primarily:(a) As ambulances or combination ambulance-hearses,(b) For police or other law enforcement purposes by federal, state, or localgovernments, or(c) For firefighting purposes.2-933. Vehicles treated under 49 USC 32901 (1978) as non-passenger automobiles.This includes limousines manufactured primarily to transport morethan 10 persons.The manufacturer can sell a vehicle described in item (2) tax free only whenthe sale is made directly to a purchaser for the described emergency use andthe manufacturer and purchaser (other than a state or local government) areregistered.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the list

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of questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.90. The Tax Reform Act of 1984 placed limitations on automobile deductions.As a result, what is a consequence of using a vehicle less than 50% in aqualified business use in the year it is placed in service?a. None of its use constitutes “qualified business use.”b. Depreciation must be figured using the 150% declining balancemethod.c. The investment credit is denied.d. The §179 expensing deduction is still allowed.2-9491. The author presents two potential consequences of reducing qualifiedbusiness use in a year after it has already qualified for business use in theyear it is placed in service. What is one such potential outcome?a. recapture of excess depreciation.b. recapture of §179 deduction.c. recapture of the temporary bonus depreciation.d. forced use of the mid-year convention.92. Under the standard mileage method for taking auto expenses, what maybe deducted separately?a. oil.b. parking fees.c. maintenance and repairs.d. license fees.93. When a manufacturer or importer sells an automobile failing to meetU.S. statutory fuel economy standards, the purchaser of the automobile issubject to an excise tax. What is this special tax called?a. auto customs duty.b. a gas guzzler tax.c. a luxury excise tax.d. value added tax.94. The excise tax imposed on the sales of certain automobiles varies dependingon the vehicles’ fuel economy. Automobile models with a fuel economyrating of 23 miles-per-gallon are charged:a. $0 tax.b. $1,000 tax.c. $1,300 tax.d. $1,700 tax.

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95. Under the gas guzzler tax, a special definition of the term “automobile” isuse. As a result, which vehicle is considered such an automobile?a. a limousine.b. a police car.c. a vehicle operated exclusively on a rail or rails.d. an ambulance.2-95

Answers & Explanations90. The Tax Reform Act of 1984 placed limitations on automobile deductions.As a result, what is a consequence of using a vehicle less than 50% in aqualified business use in the year it is placed in service?a. Incorrect. A qualified business use is any use in trade or business. Qualifiedbusiness use does not include use of property held merely for the productionof income (i.e., investment use).b. Incorrect. If a car is not used more than 50% in a qualified business use inthe year it is placed in service, the depreciation deduction must be figured usingthe straight-line percentages over a five-year recovery period.c. Correct. If a car is not used more than 50% in a qualified business use inthe year it is placed in service, the investment credit is denied (however, theITC was repealed effective 1986 anyway).d. Incorrect. If a car is not used more than 50% in a qualified business use inthe year it is placed in service, no §179 expensing deduction is allowed. [Chp.2]91. The author presents two potential consequences of reducing qualifiedbusiness use in a year after it has already qualified for business use in theyear it is placed in service. What is one such potential outcome?a. Correct. One potential outcome is that there could be a recapture of excessdepreciation. This means that any excess depreciation must be includedin gross income and added to the vehicle’s adjusted tax basis for the first yearthe car is used less than 50% for business purposes.b. Incorrect. Recapture of the §179 deduction is not one of the three potentialoutcomes. Thus, this would not happen when a taxpayer reduces hisqualified business use to less than 50% in a subsequent tax year. This deductionis included in the consideration of excess depreciation.c. Incorrect. Recapture of the bonus depreciation is not one of the three potential

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outcomes. Thus, this would not happen when a taxpayer reduces hisqualified business use to less than 50% in a subsequent tax year. This deductionis included in the consideration of excess depreciation.d. Incorrect. One of the potential outcomes of reducing such use is that thetaxpayer would be forced to use straight-line depreciation, not the mid-yearconvention. [Chp. 2]92. Under the standard mileage method for taking auto expenses, what may bededucted separately?a. Incorrect. Expenses for oil may not be deducted separately under the standardmileage method. These expenses are included in a standard mileagerate.2-96b. Correct. Parking fees and tolls are excluded from the standard mileagerate. Thus, these expenses may be deducted separately.c. Incorrect. Maintenance and repairs are included in the standard mileagerate, and thus, they cannot be deducted separately.d. Incorrect. License fees are included in the standard mileage rate, and thusthey may not be deducted separately. [Chp. 2]93. When a manufacturer or importer sells an automobile failing to meet U.S.statutory fuel economy standards, the purchaser of the automobile is subjectto an excise tax. What is this special tax called?a. Incorrect. Customs is a government tax on imports or exports.b. Correct. The gas-guzzler tax is an excise tax imposed on the sale by themanufacturer or importer of any automobile that does not meet statutorystandards for fuel economy.c. Incorrect. Section 4001 imposed an excise tax on automobiles. The luxurytax was imposed on the first retail sale or use (other than use as a demonstrator)of a passenger vehicle with a price exceeding a base amount ($40,000 in2002). The seller of the taxable article paid the luxury tax.d. Incorrect. A value added tax (VAT) is a tax assessed on the amount bywhich merchandise increases in value from the production stage to the finalconsumer. [Chp. 2]94. The excise tax imposed on the sales of certain automobiles varies dependingon the vehicles’ fuel economy. Automobile models with a fuel economyrating of 23 miles-per-gallon are charged:a. Correct. Automobile models with a fuel economy rating of over 22.5 milesper-gallon are charged $0 tax.b. Incorrect. Automobile models with a fuel economy rating of 21.5 to 22.5miles-per-gallon are charged $1,000 tax.

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c. Incorrect. Automobile models with a fuel economy rating of 20.5 to 21.5miles-per-gallon are charged $1,300 tax.d. Incorrect. Automobile models with a fuel economy rating of 19.5 to 20.5miles-per-gallon are charged $1,700 tax. [Chp. 2]95. Under the gas guzzler tax, a special definition of the term “automobile” isuse. As a result, which vehicle is considered such an automobile?a. Correct. The gas guzzler tax generally applies to limousines (includingstretch limousines) regardless of their weight.b. Incorrect. For the gas guzzler tax, vehicles sold for use and used primarilyfor police or other law enforcement purposes by federal, state, or local governmentsare not considered automobiles.c. Incorrect. For the gas guzzler tax, vehicles operated exclusively on a rail orrails are not considered automobiles.2-97d. Incorrect. For the gas guzzler tax, vehicles sold for use and used primarilyas ambulances or combination ambulance-hearses are not considered automobiles.[Chp. 2]

Fringe BenefitsIn addition to compensation, many employers provide fringe benefits to employees.Unless specifically exempted from taxation by law, the employer must includethese fringe benefits in the employee's gross income and withhold incometaxes thereon (§132 and §61).Excluded Fringe BenefitsExcluded fringe benefits are one of the finest tax concepts under the Code.Valuable to the employee these benefits are typically deductible by the employerand not includible income to the employee.Prizes & Awards - §74Employee achievement awards are excluded from gross income. However,tax law limits deductible employee achievement awards to those awards madefor length of service or safety (§274(j)).Group Life Insurance Premiums - §79Premiums paid by an employer for group life insurance providing only forterm coverage are not taxable income to a covered employee if the employee'scoverage does not exceed $50,000. For each $1,000 in coverage inexcess of $50,000, the employee must include the following amounts in gross

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income:Employee's Age Monthly InclusionAt Year End Per $1,000Under 25 5 cents25 - 29 6 cents30 - 34 8 cents35 - 39 9 cents40- -44 10 cents45 - 49 15 cents50 - 54 23 cents55 - 59 43 cents2-9860 - 64 66 cents65 - 69 $1.2770 & over $2.06Personal Injury Payments - §104Gross income does not include insurance payments for permanent loss or useof a member or function of the body or the permanent disfigurement, of thetaxpayer, their spouse, or a dependent.Employer Contributions to Accident and Health Plans - §106 & §105Contributions paid by an employer to accident and health plans for compensationto the employee for personal injuries or sickness are excluded from theemployee's gross income.In addition, employer payments that reimburse employees for medical expensesof the employee, a spouse or dependents are also excluded from income.Partnerships & S Corporations - R.R. 91-26Under R.R. 91-26, accident and health insurance premiums paid for bythe business will be income to S corporation 2% shareholder-employeesand partners. Moreover, the pass-through deduction for such premiumpayments may not be sufficient to offset such income.The ruling holds that when premiums are paid for a partner's serviceswithout regard to partnership income, they are guaranteed payments3 under§707(c). A guaranteed payment is a deduction to the partnership butincome to the partner. Under §162(l), self-employed partners can deductup to 100% (in 2009) of health insurance premiums to determine AGI.However, the §162 deduction cannot exceed the partner's share of thebusiness's earned income. Moreover, it is reduced by any health insurancecredit under §32, and is completely unavailable if the partner is eligiblefor a health plan maintained by their spouse's employer. Finally, the §213deduction must exceed 7.5% of AGI to be deductible.Similar reasoning applies to 2% shareholder-employees of S corporations.Premiums paid are deductible to the corporation under §1372 asfringe benefits4 but income to the shareholder-employee. Shareholderemployeedeductions are subject to the same limitations as the selfemployed

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partner.3 Reported on Form 1065 and Schedule K-1. No W-2 or Form 1099 is required.4 They are deducted as wages and reported on the employee's W-2.2-99Health Insurance & FICA - Announcement 92-16The IRS in Announcement 92-16 has clarified that amounts paid by an Scorporation for accident and health insurance covering a 2% shareholderemployeeare not wages for Social Security and Medicare tax purposes ifthe requirements of §3121(a)(2)(B), which excludes certain paymentsfrom the definition of wages for FICA tax purposes, are met.In R.R. 91-26, the IRS concluded that amounts paid by an S corporationfor accident and health insurance covering a 2% shareholder-employeemust be reported as wages on the employee's Form W-2. However, theIRS says that R.R. 91-26 "does not directly address the treatment of theamounts for such purposes."According to Announcement 92-16, premiums paid for two-percentshareholder-employees may be subject to FICA taxes. The Service explainsthat for Social Security and Medicare taxes, §3121(a)(2)(B) excludesfrom the definition of wages certain amounts paid by an employerto or on behalf of an employee for medical and hospitalization expensesin connection with sickness or accident disability. For the exclusion to apply,the payments must be made under a plan or system for employeesand their dependents generally or for a class of employees and their dependents.If the requirements of §3121(a)(2)(B) are met, the premiumspaid by an S corporation are not wages for Social Security or Medicare taxpurposes, even though the amounts must be included in wages for incometax withholding purposes under R.R. 91-26.If the requirements for the §3121 exclusion are not met, however, thepremiums paid by the S corporation must be included in wages for SocialSecurity and Medicare tax purposes, as well as for income tax withholdingpurposes. In addition, the amounts must be reported in the appropriateboxes on the shareholder-employee's Form W-2.Meals & Lodging - §119An employee can exclude from their gross income the value of any meals orlodging furnished to the taxpayer, their spouse or any of the taxpayer's dependentsby their employer for the convenience of the employer, if:(1) In the case of meals, the meals are furnished on the employer's businesspremises, or(2) In the case of lodging, the employee is required to accept the lodgingon the employer's business premises as a condition of employment.Meals are considered furnished for the convenience of the employer wherethe employee's continued presence on the employer's premises is necessary to

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enable the employee to perform duties properly.2-100Cafeteria Plans - §125A cafeteria plan is a written plan under which participants may chooseamong two or more benefits consisting of cash and qualified benefits withoutresulting in the benefit being included in the employee's gross income. A planoffering a choice only among nontaxable benefits is not a cafeteria plan.A qualified benefit is any benefit that is excluded from income by a specificprovision of the Code except for:(1) Scholarships and fellowships (§117),(2) Educational assistance programs (§127),(3) Employer provided fringe benefits such as a no-additional cost service,working condition fringe, qualified employee discounts, and deminimis fringe (§132), and(4) Qualified transportation provided by the employer.The following benefits can be offered under a cafeteria plan:(1) Coverage under a group-term life insurance plan up to $50,000 (§79),(2) Coverage under an accident or health plan, including disability coverage(§105 & §106)(3) Coverage under a dependent care assistance program (§129),(4) Adoption assistance (§137),(5) Participation in a cash or deferred arrangement that is part of a profitsharing plan (§401(k)),(6) Business provided health savings accounts (§223), and(7) Paid vacation days if the plan precludes any participant from receiving,cash for, in a subsequent plan year, any of such paid vacation daysremaining unused as of the end of the plan year.Note: Elective vacation days provided under the plan are not considered tobe used until all nonelective paid vacation days have been used.Educational Assistance Programs - §127Employer-paid educational expenses are excludable from the gross incomeand wages of an employee if provided under a §127 educational assistanceplan or if the expenses qualify as a working condition fringe benefit under§132.Section 127 provides an exclusion of $5,250 annually for employer-providededucational assistance. The exclusion for employer-provided educational assistanceapplies to both undergraduate and graduate education.In order for the exclusion to apply, certain requirements must be satisfied.The educational assistance must be provided pursuant to a separate writtenplan of the employer. The educational assistance program must not discriminatein favor of highly compensated employees. In addition, not more than2-101

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5% of the amounts paid or incurred by the employer during the year for educationalassistance under a qualified educational assistance plan can be providedfor the class of individuals consisting of more than 5% owners of theemployer (and their spouses and dependents).Dependent Care Assistance - §129The gross income of an employee does not include expenses paid or incurredby an employer for dependent care assistance provided under a qualifiedprogram. The aggregate amount excluded cannot exceed $5,000 or theearned income of the lower earning spouse.Comment: A taxpayer is not allowed both an exclusion from income under§129 and a child and dependent care credit under §21 on the same amount.Childcare expenses are reduced dollar for dollar by the amount of reimbursement.Employees are required to include in income excess amounts (above an exclusionlevel) that an employer provides for dependent care assistance. Dependentcare assistance must be included in the employee's income in theyear in which services are provided, even if the actual payment is made later.No-Additional Cost Services - §132(b)If an employer provides its employees with a service that is offered for sale tocustomers in the ordinary course of its line of business, and the employer incursno substantial additional cost in providing this service, the employee willnot have to include in income the value of the service.In order to qualify as a no-additional-cost benefit, the service available foruse must have otherwise gone unused and the employer must not have foregoneany revenue in providing the service to its employees.Examples of services that qualify as no-additional-cost services include hotelaccommodations, transportation by aircraft, bus, subway or cruise line, telephoneservices and tickets to sporting events.Comment: If these services are generally available only to officers, owners,or highly compensated employees, then the value of the services cannot beexcluded from the income of the officers, owners, or highly compensatedemployees.Qualified Employee Discounts - §132(c)If a taxpayer's employer allows them to buy qualified property or services(defined below) at a discount (a price that is less than the price it is sold forto customers), they will not have to include in income the value of the discountto the extent that:2-102(1) The discount the taxpayer gets on property does not exceed the grossprofit percentage of the price at which the property is being offered for

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sale to customers, or(2) The discount the taxpayer gets the on services does not exceed 20% ofthe price at which the services are offered for sale to customers.Qualified property or services generally means any property (other than realproperty and personal property held for investment) or services offered forsale to customers in the ordinary course of the employer's line of business inwhich you work.Comment: If these discounts are generally available only to officers, owners,or highly compensated employees, the value of the discount cannot be excludedfrom the income of the officers, owners, or highly compensated employees.Working Condition Fringe Benefits - §132(d)A working-condition fringe benefit is any property or service provided to anemployee by an employer to the extent that the cost of such property or servicewould have been deductible by the employee as a business expense.Examples of working-condition fringe benefits include:(1) Business use of employer provided automobiles,(2) Employer-paid subscriptions to business periodicals to employees,(3) Employer expenditures for employees business travel,(4) Parking provided to an employee on or near the employer's businesspremises,(5) Demonstration cars provided to a full time car salesperson if there aresubstantial restrictions on the salesperson's personal use of the car andthe car is available for test drives by customers,(6) On premises gyms and other athletic facilities, and(7) Employees' van pooling transportation provided by the employer.Transportation in Unsafe AreasWorking condition fringes5 are excludable from income under §132.However, the value of employer-provided transportation for commutingpurposes is not excludable.The IRS has issued proposed regulations for transportation furnished dueto unsafe conditions to employees who walk or use public transportation.Under Reg. §1.61-21(k), only $1.50 (per one-way commute) would be in-5 Employer provided property or services for which the employee could have taken a deductionhad he paid for it.2-103cludable in certain rank-and-file employees' income when the transportationis provided due to unsafe conditions.Note: Unsafe conditions exist when a reasonable person would consider itunsafe to walk to or from home or use public transportation during thecommute time. An important factor is the crime history in the subject area.Applied on a trip-by-trip basis, if any particular trip fails to comply withthe regulations, its value is included in the employee's income. The proposedregulations also require an employer to have a written policy statingthe transportation is provided only for avoiding unsafe conditions.The following employees are ineligible:

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(a) Highly compensated employees (§414(q)(1)(C)),(b) Salaried employees, and(c) Employees exempt from the minimum wage and maximum hourprovisions.De Minimis Fringe Benefits - §132(e)A de minimis fringe benefit is any property or service whose value is so smallthat accounting for it is unreasonable or administratively impractical. Anyfringe benefit provided in cash does not qualify because it is not administrativelyimpractical to account for.Examples of de minimis fringe benefits include:(a) Typing of personal letters by a company secretary,(b) Occasional cocktail parties or picnics for employees,(c) Traditional holiday gifts with low fair market value, and(d) Coffee and donuts.Employer Provided AutomobileIf the employer provides a car (or other highway motor vehicle) to an employee,their personal use of the car is a taxable noncash fringe benefit. The employermust determine the actual value of this fringe benefit to include in the employee'sincome. This value may be determined by either of the following methods:(1) The actual value of the employee's personal use of the car, or(2) The actual value of the car as if the employee used it entirely for personalpurposes (100% income inclusion).If the employer includes 100% of the value in the employee's income, they maydeduct the value of their business use of the car. Employees figure the value ofthis business use on Form 2106, Employee Business Expenses.2-104Three methods are available for valuing the availability of employer-provided vehicles- annual lease value method, cents per mile method, and commuting valuemethod.Annual Lease Value MethodUnder the annual lease value method an employee reports the annual leasevalue of the automobile from tables in Reg. §1.61-2T (d) (2) (iii) based onthe automobile's fair market value when it is first made available to the employee.The employee reports only their personal use percentage of the annuallease value in income.Cents Per Mile Method

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Under the cents per mile method the value of the benefits equals the productdetermined by multiplying the total number of miles the employer drove thecar for personal purposes by the optional standard mileage rate. In order touse this method the value of the automobile must be less than $15,000 forcars and $15,200 for trucks or vans placed in service in 2009 (Reg. §1.61-21(e)(1) (iii)(A); R.P. 2009-12).Commuting Value MethodUnder the commuting value method the value of the employee's use of thevehicle for commuting purposes is computed as $1.50 per one way commute.In order to use this method the vehicle must be used in the employer's tradeor business and the employer must have a written policy prohibiting employeeuse of the automobile for personal purposes other than commuting.This rule isn't available if an employee is allowed to, or actually does, makemore than de minimis use of the vehicle for personal reasons other thancommuting. The rule also is unavailable if the employee is a "control" employee- an employee such as a highly compensated employee who controlsthe use or availability of employer-provided cars.Annual Lease Value Table for Automobiles(1) (2)Automobile Fair Annual LeaseMarket Value Value0 - 999 6001,000 - 1,999 8502,000 - 2,999 1,1003,000 - 3,999 1,3504,000 - 4,999 1,6002-1055,000 - 5,999 1,8506,000 - 6,999 2,1007,000 - 7,999 2,3508,000 - 8,999 2,6009,000 - 9,999 2,85010,000 - 10,999 3,10011,000 - 11,999 3,35012,000 - 12,999 3,60013,000 - 13,999 3,85014,000 - 14,999 4,10015,000 - 15,999 4,35016,000 - 16,999 4,60017,000 - 17,999 4,85018,000 - 18,999 5,10019,000 - 19,999 5,35020,000 - 20,999 5,60021,000 - 21,999 5,85022,000 - 22,999 6,10023,000 - 23,999 6,350

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24,000 - 24,999 6,60025,000 - 25,999 6,85026,000 - 27,999 7,25028,000 - 29,999 7,75030,000 - 31,999 8,25032,000 - 33,999 8,75034,000 - 35,999 9,25036,000 - 37,999 9,75038,000 - 39,999 10,25040,000 - 41,999 10,75042,000 - 43,999 11,25044,000 - 45,999 11,75046,000 - 47,999 12,25048,000 - 49,999 12,75050,000 - 51,999 13,25052,000 - 53,999 13,75054,000 - 55,999 14,25056,000 - 57,999 14,75058,000 - 59,999 15,250For automobiles with a fair market value greater than $59,999, Annual LeaseValue = (.25 x fair market value) + $500.2-106ExampleAlpha Corp. provides free to its employee, Tom Smith, a carworth $15,000 on April 30th. During the year Tom drove thecar 75% for business purposes.Annual lease value of $15,000 automobilePer Tables 4,350Personal use Percentage 25%Proration for 8 Months Use 67%Amount to be included in Compensation 729

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course on

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computer), consult the text Index, or review the general Glossary.2-10796. Employees can choose from at least seven qualified benefits under a cafeteriaplan. What is one of these qualified benefits?a. educational assistance programs.b. a profit sharing plan that includes a qualified cash or deferred arrangement.c. qualified employee discounts.d. scholarships and fellowships.97. Under §127, an employee may exclude from gross income for income taxpurposes and from wages for employment tax purposes:a. all or part of the amounts they receive as a scholarship or fellowshipgrant.b. amounts in a qualified tuition program (QTP).c. the cost of higher education for themselves if they itemize deductions.d. no more than $5,250 annually paid by an employer for educational assistance.98. An employer may provide §129 dependent care assistance for employeestax free. Up to what amount may an employer exclude for each employee annually?a. $5,000.b. the amount of the higher earning spouse’s earned income.c. 50% of the total costs.d. There is no statutory limit on the amount.99. Section 132 identifies several fringe benefits such as no-additional-costservices that are excludable from gross income. What is an example of a servicethat qualifies as a no-additional-cost service?a. employer-paid subscriptions to business periodicals to employees.b. on premises gyms and other athletic facilities.c. tickets to sporting events.d. typing of personal letters by a company secretary.100. Which transportation-related fringe must be included in income under§132?a. business use of employer-provided automobiles.b. demonstration cars provided to a full-time car salesperson if there aresubstantial restrictions on personal use and the car is available for testdrives by customers.c. employees' van pooling transportation provided by the employer.d. the value of employer-provided transportation for commuting purposes.2-108

Answers & Explanations

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96. Employees can choose from at least seven qualified benefits under a cafeteriaplan. What is one of these qualified benefits?a. Incorrect. A qualified benefit is any benefit that is excluded from incomeby a specific provision of the Code except for educational assistance programs.b. Correct. Participation in a cash or deferred arrangement that is part of aprofit sharing plan can be offered under a cafeteria plan.c. Incorrect. A qualified benefit is any benefit that is excluded from incomeby a specific provision of the Code except for employer provided fringe benefitssuch as a no-additional cost service, working condition fringe, qualifiedemployee discounts, and de minimis fringe.d. Incorrect. A qualified benefit is any benefit that is excluded from incomeby a specific provision of the Code except for scholarships and fellowships.[Chp. 2]97. Under §127, an employee may exclude from gross income for income taxpurposes and from wages for employment tax purposes:a. Incorrect. Under §117, taxpayers may be able to treat as tax free all or partof the amounts they receive as a scholarship or fellowship grant.b. Incorrect. Section 529 provides tax-exempt status to a QTP under whichpersons may purchase tuition credits or certificates or make contributions toan account.c. Incorrect. The higher education expense deduction allows certain taxpayersto deduct the cost of higher education for themselves, their spouse, or adependent, even if they do not itemize deductions. However, this deductionis not provided under §127.d. Correct. Under §127, an employee may exclude from gross income for incometax purposes and from wages for employment tax purposes up to $5,250annually paid by the employer for educational assistance. [Chp. 2]98. An employer may provide §129 dependent care assistance for employeestax free. Up to what amount may an employer exclude for each employeeannually?a. Correct. The amount that an employer may exclude for each employee annuallyis $5,000 or less. If the individual is married filing separately, theamount that an employer may exclude for each employee annually is $2,500or less.b. Incorrect. The amount that an employer may exclude for each employeeannually is the amount of the lower earning spouse’s earned income or less.2-109c. Incorrect. Fifty percent of dependent care costs could total much greater

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than the §129 deductible limit.d. Incorrect. Section 129 does place a ceiling on excludable reimbursements.Dependent care assistance is often a huge expense, and any amount that theemployer pays beyond the limit is included in the employee’s income onForm W-2. [Chp. 2]99. Section 132 identifies several fringe benefits such as no-additional-cost servicesthat are excludable from gross income. What is an example of a servicethat qualifies as a no-additional-cost service?a. Incorrect. An example of working-condition fringe benefits are employerpaidsubscriptions to business periodicals to employees.b. Incorrect. An example of working-condition fringe benefits are on premisesgyms and other athletic facilities.c. Correct. Examples of services that qualify as no-additional-cost services includehotel accommodations, transportation by aircraft, bus, subway or cruiseline, telephone services and tickets to sporting events.d. Incorrect. An example of de minimis fringe benefits is typing of personalletters by a company secretary. [Chp. 2]100. Which transportation-related fringe must be included in income under§132?a. Incorrect. Working condition fringes such as business use of employerprovidedautomobiles are excludable from income under §132.b. Incorrect. Working condition fringes such as demonstration cars providedto a full-time car salesperson if there are substantial restrictions on the salesperson'spersonal use of the car and the car is available for test drives by customersare excludable from income under §132.c. Incorrect. Working condition fringes such as employees' van pooling transportationprovided by the employer are excludable from income under §132.d. Correct. The value of employer-provided transportation for commutingpurposes is not excludable from income under §132. [Chp. 2]2-110

Methods of Accounting - §446The accounting method implemented determines the period in which a taxpayerrecognizes income and expenses for tax purposes. The cash and accrual methodsare the two most often used methods of accounting.Cash Method

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Under the cash method of accounting all items of income are reported in theyear they are actually or constructively received and expenses are deducted inthe year that they are paid.Constructive ReceiptA taxpayer constructively receives income in the taxable year during which itis credited to their account, set apart for them, or otherwise made availableso that taxpayer may draw upon it.For example: A check received before the end of the tax year is constructivelyreceived in that year even though the check is not cashed or depositedinto the taxpayer's account until the next year.However, income is not constructively received if the taxpayer's control of thereceipt is subject to substantial limitations, restrictions or is contingent on thehappening of some future event. Funds held in escrow pending release of athird party's claim fall within this category.Accrual MethodUnder the accrual method income is reported when it is earned rather thanwhen it is collected and expenses are deducted when they are incurred eventhough they are paid at a later date.2-111Advance PaymentsAdvance payments received without restriction as to disposition for futureuse of property or for future services are generally reported in income in theyear of receipt whether the cash or accrual method of accounting is used.Thus prepaid rent, prepaid interest, and advances for services to be performedlater are generally included in income when received rather thenwhen earned.Accrual Method RequiredThe accrual method must be used where the production, purchase, or sale ofmerchandise is a material income-producing factor. In addition C corporations,partnerships that have a C corporation as a partner and tax shelters arebarred from using the cash method of accounting.Exceptions are allowed for small businesses engaged in farming with grossreceipts of less than $1,000,000, qualified personal service corporations, andentities that meet a $5,000,000 gross receipts test (§448).Comment: A qualified personal service corporation is any corporation, substantiallyall of the activities of which involve the performance of services inthe fields of health, law, engineering, architecture, accounting, actuarial science,performing arts or consulting, and substantially all of the stock ownedby employees performing such services to the corporation.

Other Methods of AccountingA variety of special and special accounting methods exist under the Code.Hybrid Methods

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Combinations of accounting methods are permitted if income is clearly reflectedand such combinations are consistently used. For example, a small retailstore could use an accrual method for sales, purchases, receivables, andpayables and a cash basis for deduction of rent, interest, salaries, and similaritems. However, a cash method of accounting for income cannot be combinedwith an accrual method of accounting for expenses.Long Term Contracts - §460A long-term contract is any contract for the manufacture, building, installation,or construction of property if not completed in the taxable year in whichit is entered into. A manufacturing contract is long term only if the contract isto manufacture (1) a unique item not normally carried in inventory or (2)items that normally require more than 12 months to complete.There are two basic methods of accounting for long-term contracts:(1) The percentage of completion method, or2-112(2) The percentage of completion - capitalized cost method.Percentage of CompletionUnder the percentage of completion method gross income from a longtermcontract is allocated among the accounting periods by comparingcosts allocated to the contract and incurred before the close of the taxyear, with the total expected contract costs and subtracting any gross incomepreviously recognized.Percentage of Completion - Capitalized Cost MethodUnder this method the taxpayer must account for 90% of the long-termcontract items under the percentage of completion method. Only the remaining10% of the contract may be accounted for under the completedcontract method.Look-back RuleIn the tax year that a long-term contract is completed, the taxpayer mustcompare the amount of taxes paid in previous years under the percentagemethod (including the 90%-method used in the percentage of completion-capitalized cost method) with the tax that would have been owed ifactual, rather than anticipated, costs and contract price had been used tocompute gross income. Interest at the overpayment rate compoundeddaily, is owed by or payable to the taxpayer if there is, respectively, an underpaymentor overpayment for any tax year under the look-backmethod.Uniform Capitalization - §263AFor tax years beginning after 1986, additional and more expansive rules than

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those under §471 for the capitalization of direct and indirect costs for propertyproduced or acquired for resale must be used.Comment: These rules are also for most assets constructed by a taxpayer andused in their trade, business, or enterprise.Annual Sales LimitThe capitalization rules do not apply for costs dealing with property purchasedfor resale unless annual sales are over $10 million for the lastthree tax years.Note: Home construction contractors are required to capitalize costs unlessconstruction can be completed within 2 years and the taxpayer's average annualgross for the three prior years is less than $10 million.2-113Artist ExceptionArtists, writers, photographers, and similar "creative types" are exemptedfrom the rules. However, care must be taken because all production costs(i.e., printing, photo plates, films, video tapes) are still under the §263Aprovisions. This exception does not apply to expenses paid or incurred byan employee.Classification of PropertyTwo classes of property are covered under the uniform capitalizationrules:(1) Tangible personal property and real property constructed by thetaxpayer, and(2) Tangible personal property and real property purchased for resaleto customers.CostsManufacturing costs which must be capitalized include the previously requireddirect material and labor and indirect costs but also a much widerrange of indirect costs:Old Law New LawDirect material & cost Capitalize CapitalizeRepairs, maintenance,utilities, rent, indirectlabor, materials, supplies,small tools, equipment Capitalize CapitalizeMarketing, advertisingselling & distribution Expense ExpenseInterest Expense CapitalizeResearch & experiment Expense ExpenseEngineering & design Expense CapitalizeExcess tax depreciation Expense CapitalizePast service costs andpension plans Expense CapitalizeTaxes other than state,local and foreign Optional CapitalizeRework labor, scrapand spoilage Optional Capitalize

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Factory administration andemployee benefits Optional Capitalize2-114Self Constructed AssetsCosts to be capitalized on self constructed assets include direct materialand labor, repair, maintenance, utilities, rent, indirect labor and supervisorywages, indirect material and supplies, small tools, interest, tax depreciation,employee benefits, administration and other support costs.Allocation MethodStandard cost accounting methods may be used for the allocation of§263A and §471 costs. Remember that there is a conformity requirementfor most allocable costs between statement presentation and tax allocationmethods.Manufactured ProductsThe simplified accounting method for production costs may be usedfor manufactured products. The election is made for each separatebusiness in the first tax year that §263A is effective.Costs are to be allocated to inventory or property based on the absorptionratio. The amount of additional §263A costs to be capitalized iscomputed by multiplying the absorption ratio times the amount of§471 costs remaining in the taxpayer's ending §471 inventory balance.InterestSection 263A(f) contains special rules for capitalizing interest with respectto certain property produced by the taxpayer and for determiningthe amount of interest required to be capitalized.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.2-115Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.

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101. The author describes three valuation methods used to determine thevalue of an employer-provided automobile. Under Reg.§1.61-2T(e), for autoswith fair market values (FMV) less than the maximum recovery deductionsallowable for the first five years the auto is placed in service, what valuationmethod should an employer use?a. the annual valuation method.b. the cents per mile method.c. the commuting value method.d. the general method.102. Constructive receipt of income under §451 is a concern for cash basistaxpayers. Under which circumstance would income be reported on the cashmethod in a year other than the current taxable year?a. During the current tax year, the income is only credited to the taxpayer’saccount.b. During the current tax year, the income is only made available so thattaxpayer may draw upon it.c. During the current tax year, the income is set apart for the taxpayer.d. During the current tax year, considerable limitations are placed on receiptof the income.103. The accrual method often must be used. In which of the following circumstancesis the use of this method required under §447?a. An entity meets a $5,000,000 gross receipts test.b. A farming business with gross receipts under $1,000,000.c. Advances are made for services to be performed later.d. The production of merchandise is a material income-producing factor.104. Taxpayers may enter into a contract for purposes of manufacturing,building, installing, or constructing property and the completion of the contractmay occur in a separate taxable year. What does tax parlance call such acontract?a. a long-term contract.b. a manufacturing contract.c. a qualified personal service contract.d. a short period return.2-116105. Under which long-term contract method are costs allocated to the contractand incurred before the end of the tax year compared with the aggregateestimated contract costs to allocate gross income among accounting periods?a. the allocation method.b. the capitalized cost method.c. the cash method.d. the percentage of completion method.106. In 1986, the treatment of certain manufacturing costs under §263A

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changed. Which costs had to be expensed under the old law but now must becapitalized?a. direct material and cost.b. factory administration and employee benefits.c. interest.d. repairs, maintenance, and utilities.

Answers & Explanations101. The author describes three valuation methods used to determine the valueof an employer-provided automobile. Under Reg.§1.61-2T(e), for autoswith fair market values (FMV) less than the maximum recovery deductionsallowable for the first five years the auto is placed in service, what valuationmethod should an employer use?a. Incorrect. Reg. §1.61-2T(d) states that if an employer provides an employeewith an auto, the value of the benefit may be determined using a leasevaluation method. Under this method an employee reports the annual leasevalue of the auto from the tables in Reg. §1.61-2T(d)(2)(iii) based on theauto’s FMV when it is first made available to the employee.b. Correct. For autos with FMVs less than the maximum recovery deductionsallowable for the first five years the auto is placed in service, an employermay determine the value of a vehicle provided to an employee by multiplyingthe standard mileage rate by the total number of personal miles driven by theemployee. The value cannot be determined using this method if the auto’sFMV is more than the maximum recovery deductions allowable in this timeperiod.c. Incorrect. If the auto is provided under the written commuting policystatement exception, the value of the employee’s use of the vehicle for suchcommuting purposes is computed as $1.50 per one-way commute.2-117d. Incorrect. Under Reg.§1.61-2T(b)(4), if none of the special methods areused, the valuation must be determined by reference to the cost to a hypotheticalperson of leasing from a hypothetical third party the same or comparablevehicle on the same or comparable terms in the geographic area inwhich the vehicle is available for use. [Chp. 2]102. Constructive receipt of income under §451 is a concern for cash basis taxpayers.Under which circumstance would income be reported on the cashmethod in a year other than the current taxable year?a. Incorrect. A taxpayer would report income in the current taxable yearwhen the income is credited to their account.

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b. Incorrect. A taxpayer would report income in the current taxable yearwhen the income is made available so that taxpayer may draw upon it.c. Incorrect. A taxpayer would report income in the current taxable yearwhen the income is set apart for them.d. Correct. Income is reported in a year other than the current taxable year ifthe taxpayer's control of the receipt is subject to substantial limitations, restrictions,or is contingent on the happening of some future event. [Chp. 2]103. The accrual method often must be used. In which of the following circumstancesis the use of this method required under §447?a. Incorrect. C corporations, partnerships that have a C corporation as apartner, and tax shelters are barred from using the cash method of accounting.Exceptions are allowed for entities that meet a $5,000,000 gross receiptstest.b. Incorrect. Small businesses engaged in farming with gross receipts of lessthan $1,000,000 and by qualified personal service corporations may use thecash method of accounting.c. Incorrect. Prepaid rent, prepaid interest, and advances for services to beperformed later are generally included in income when received rather thenwhen earned.d. Correct. The accrual method must be used where the production, purchase,or sale of merchandise is a material income-producing factor. [Chp. 2]104. Taxpayers may enter into a contract for purposes of manufacturing, building,installing, or constructing property and the completion of the contractmay occur in a separate taxable year. What does tax parlance call such acontract?a. Correct. A long-term contract is any contract for the manufacture, building,installation, or construction of property if not completed in the taxableyear in which it is entered into.2-118b. Incorrect. A manufacturing contract is long term only if the contract is tomanufacture (1) a unique item not normally carried in inventory or (2) itemsthat normally require more than 12 months to complete.c. Incorrect. Qualified personal service involves the performance of servicesin the fields of health, law, engineering, architecture, accounting, actuarialscience, performing arts, or consulting.d. Incorrect. A short period return is a return for a period of less than twelvemonths and may be filed when the taxpayer, with the approval of the Secretary,changes their annual accounting period. [Chp. 2]

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105. Under which long-term contract method are costs allocated to the contractand incurred before the end of the tax year compared with the aggregateestimated contract costs to allocate gross income among accounting periods?a. Incorrect. The allocation method is not a standard cost accounting methodused for the allocation of §263A and §471 costs.b. Incorrect. Under the capitalized cost method, the taxpayer must accountfor 90% of the long-term contract items under the percentage of completionmethod. The remaining 10% of the contract may be accounted for under thecompleted contract method.c. Incorrect. Under the cash method of accounting, all items of income arereported in the year they are actually or constructively received and expensesare deducted in the year that they are paid.d. Correct. Under the percentage of completion method, gross income froma long-term contract is allocated among the accounting periods by comparingcosts allocated to the contract and incurred before the close of the tax year,with the total expected contract costs and subtracting any gross income previouslyrecognized. [Chp. 2]106. In 1986, the treatment of certain manufacturing costs under §263Achanged. Which costs had to be expensed under the old law but now mustbe capitalized?a. Incorrect. Manufacturing costs which are capitalized under the old andnew laws include the direct material and cost.b. Incorrect. Under the old law factory administration and employee benefitscould be expensed or capitalized. Under the new law these costs also must becapitalized.c. Correct. Interest had to be expensed under the old law but must be capitalizedunder the new law.d. Incorrect. Manufacturing costs which are capitalized under the old andnew laws include repairs, maintenance, and utilities. [Chp. 2]2-119Change in Accounting MethodA change in accounting method is a change in the taxpayer's overall method ofaccounting or a change in the treatment of a material item of income or expense.It covers such changes as from the cash basis to the accrual basis or from one basisof inventory valuation to another. Once a taxpayer has chosen their method

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of accounting they ordinarily may not change it without the permission of the InternalRevenue Service. An application for change must be filed with the IRS onForm 3115 within 180 days after the beginning of the taxable year.Accounting PeriodsTaxable income must be computed on the basis of the taxpayer's taxable year.DefinitionsA calendar year is a period of twelve months ending on December 31.2-120A fiscal year is a period of twelve months ending on the last day of any monthother than December.A 52-53 week year is an annual period which varies from 52 to 53 weeks andends always on the same day of the week and ends:(1) On the date such same day of the week last occurs in a calendarmonth, or(2) On the date such same day of the week falls which is nearest the lastday of a calendar month.A short period return is a return for a period of less than twelve months andmay be filed when the taxpayer with the approval of the Secretary, changestheir annual accounting period. A short period return may also be filed in thetax payer's initial and final year when it is in existence during only part ofwhat would otherwise be their taxable year.Taxable YearsSince the Tax Reform Act of 1986, opportunities for income tax deferral byselecting different tax year-ends for an owner and their business have beenlimited, especially for partnerships, S corporations, and "personal servicecorporations."Note: The latter types of entities may still make a special election to have aSeptember, October or November fiscal year. However, this §444 election, ineffect, requires the entity to agree to give up any tax deferral benefits thatmight result from using the fiscal year.No Books KeptTaxpayer's taxable year is the calendar year if the taxpayer does not keepany books.Comment: Records that are sufficient to reflect income adequately andclearly on the basis of an accounting period will be regarded as the keepingof books.New TaxpayerA new taxpayer must adopt a taxable year on or before the time prescribedby law (not including extensions) for filing the taxpayer's first return.PartnershipUnder §706, partnerships may have only a "permitted" year. Permittedyears of a partnership include:(1) An ownership taxable year-that is:(a) The taxable year of one or more partners having a greater than

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50% aggregate interest in partnership profits and capital;2-121(b) If no group of partners holding more than 50% of the interestshas the same taxable year, of all principal partners (that is, thosewith interests of 5% or more); or(c) If no year results under either of these tests, the calendar year orother year resulting in the least deferral of income to the partners(Temp. Reg. §1.706-1T).(2) A fiscal year with a business purpose-that is:(a) A natural business year that meets the 25%-of-gross-receipts test(R.P. 2002-38);(b) Another year that IRS determines meets a bona fide businesspurpose (R.R. 87-57); or(c) A grandfathered year-that is, a year approved after June 3, 1974that does not result in a deferral of income passthroughs to partnersof three months or less, for which the partnership is able to complythe special notification procedures of R.P. 2002-38.(3) A deferral year permitted under §444 in exchange for the entitylevelpayments on passthroughs deferred for partners - i.e., for newlycreated partnerships, a year resulting in partner's deferral of threemonths or less (generally a September 30, October 31, or November 30year end).S CorporationsUnder §1378, an S corporation may have only a "permitted" year. Permittedyears for an S corporation:(1) A calendar year;(2) An ownership tax-year-that is, a year used by shareholders owning50% or more of the issued and outstanding stock or a year to whichsuch owners are changing (R.P. 2002-38);(3) A fiscal year with a business purpose-that is:(a) A natural business year that meets the 25%-of-gross-receipts test(R.P. 2002-38);(b) Another year that IRS determines meets a bona fide businesspurpose (R.R. 87-57; R.P. 89-15); or(c) A grandfathered year-that is, a year approved after June 30,1974, that does not result in a deferral of income passthroughs toshareholders of three months or less, for which the corporation isable to comply with the special notification procedures of R.P. 2002-38.(4) A deferral year permitted under §444 in exchange for entity-levelpayments on passthroughs deferred for shareholders- that is:2-122(a) For newly created corporations electing S corporation status, ayear resulting in a shareholder deferral of three months or less (generallya September 30, October 31, or November 30 year end); or(b) For other corporations that have not previously made a §444

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election, a year resulting in a deferral period not greater than thelessor of:(i) The previous deferral period, or(ii) Three months.Note: This rule provides no relief to calendar-year corporations.Personal Service CorporationsA personal service corporation must file on a calendar year basis unless itcan establish a business purpose for a different taxable year.Note: A personal service corporation is a corporation whose principal activityis the performance of personal services (e.g., medical, dental, legal, engineering,architecture, accounting, actuarial, consulting, or performing arts)where such services are substantially performed by owner-employees (§441& §448).C CorporationsIt is still possible for a C corporation that is not a personal service corporationto elect a fiscal year (such as a year that ends January 31) and obtainsignificant tax deferral benefits by paying a relatively low base salarythrough December of each year to its employee-owners. Then, in Januaryof the following year, for example, it can pay a large bonus to reduce thecorporation's taxable income for the year of February 1 to January 31.Since the employee-owner would be on a calendar year for tax purposes,the bonuses would not be taxable income to the employee-owner for theyear, since the salary was received in January of the following year.Business Purpose ExceptionPartnerships, S-Corporations and Personal Service Corporations can generallyestablish a business purpose for using a fiscal year if they can showthat gross receipts from sales and services for the last two months of therequested year exceed 25% of the gross receipts for the entire fiscal yearrequested and in each of the three preceding fiscal years.Section 444 ElectionPartnerships, S-Corporations and Personal Service Corporations can electto use a tax year other than a required year if they follow certain proceduresestablished under §444.2-123Partnerships & S CorporationsPartnerships and S corporations may elect an otherwise impermissibleyear if the year results in a deferral of not more than three months' incomeand the entity agrees to make required tax payments. Such paymentsare intended to represent the value of the tax deferral obtainedby the partners and shareholders through the use of a tax year otherthan the required year.Personal Service CorporationsA fiscal year may be elected by a personal service corporation if theyear results in a deferral of not more than three month's income, thecorporation pays the shareholder-employee's salary during the portionof the calendar year after the close of the fiscal year, and the salary forthat period is at least proportionate to the shareholder-employee's salary

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received for such fiscal year.Tiered StructuresA member of a tiered structure cannot make the §444 election unlessall members have the same tax year.

Expensing - §179All or part of the cost of certain qualifying property may be treated as an expenserather than a capital expenditure. Under §179, taxpayers6 can elect to deductall or part of the cost in one year (i.e., expense the item) rather than takingdepreciation deductions spread over several years.Taxpayers must decide for each item of qualifying property whether to deduct,subject to the yearly limit, or capitalize and depreciate its cost. If an election ismade for the deduction, taxpayers can deduct a limited amount of the cost ofqualifying property in the first year the property is placed in service.Placed In ServiceFor §179 expensing, property is considered placed in service in the tax year it isfirst ready and available for its specified use, whether in a trade or business, theproduction of income, a tax-exempt activity, or a personal activity.The determination of whether property is qualifying property, defined later, ismade in the first year the property is placed in service. If property is placed inservice in a tax year and it does not qualify for the §179 deduction, no §179 de-6 Estates and trusts are not eligible to elect the §179 deduction.2-124duction is ever allowed for it, even though it becomes qualifying property in alater tax year.Qualifying PropertyFor property placed in service after December 31, 1990, a §179 deduction may beelected for any tangible §168 property which is §1245 property and which is acquiredby purchase for use in the active conduct of a trade or business. Depreciationcannot be taken to the extent that §179 is elected to expense the cost ofproperty.Note: For property placed in service prior to January 1, 1991, the §179 deductioncould be claimed on depreciable property that was "section 38 property"and that was bought for use in the active conduct of a trade or business. Section

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38 property was substantially similar to those types of property set forthin §1245. However, differences did exist.Purchase RestrictionsThe following property does not qualify for the §179 deduction:(1) Property acquired by one member of a controlled group from anothercomponent member of the same group,(2) Property acquired from another person if the basis in that property isdetermined in whole or in part by reference to the adjusted basis of theproperty in the hands of the person from whom it was acquired, or underthe stepped-up basis rules for property acquired from a decedent, or(3) Property acquired from a related person if the relationship to the relatedperson would result in the disallowance of losses.The rules for disallowance of loss in a transaction between related partiesapply to the §179 deduction with the following modifications:(1) The family of an individual includes only his or her spouse, ancestors,and lineal descendants, and(2) The percentages of ownership in a corporation or partnership arechanged to 50%.Section 1245 PropertySection 1245 property generally includes all depreciable personal property.Buildings and their structural components are not considered §1245 property.Section 1245 property eligible for the §179 election includes:(1) Tangible personal property (except heating or air-conditioning units),Note: Tangible personal property is any tangible property that is not realproperty. Machinery and equipment are examples of tangible personal property.2-125(2) Other tangible property that is:(a) Used as an integral part of manufacturing, production, or extractionor of furnishing transportation, communications, electricity, gas,water, or sewage disposal services,(b) A research facility used in connection with any of the activities in(a) above, or(c) A facility used in connection with any of the activities in (a) abovefor the bulk storage of fungible commodities.(3) Single purpose livestock or horticultural structures,Note: For purposes of determining whether a structure is a single purposeagricultural structure, poultry is considered livestock.(4) Storage facilities that are used in connection with distribution of petroleumor any primary product of petroleum, and(5) Any railroad grading or tunnel bore.The §179 deduction cannot be claimed on the cost of any of the following:(1) Property held only for the production of income,(2) Real property, including buildings and their structural components,(3) Property acquired from certain related groups or persons,(4) Air conditioning or heating units,

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(5) Certain property used predominately outside the United States,(6) Property used predominately to furnish lodging or in connection withthe furnishing of lodging,(7) Property used by foreign persons or entities, and(8) Certain property leased to others (if taxpayer is a noncorporate lessor).Property Used Primarily for LodgingProperty used primarily for lodging is not §1245 property (§50(b)). Thisincludes most property used in the operation of an apartment house andmost other facilities where sleeping accommodations are provided andrented.Note: However, coin-operated vending and washing machines and dryers locatedin apartment houses and other similar facilities are not consideredproperty used primarily for lodging.Property used by a hotel, motel, inn, or similar establishment that primarilyserves transient guests (i.e., where the rental period is normally lessthan 30 days) or property used in nonlodging commercial facilities (suchas a restaurant available to the public as well as tenants) is not consideredproperty used primarily for lodging.2-126Deduction LimitThe §179 deduction cannot be more than the business cost of the qualifyingproperty. In addition, in figuring the §179 deduction, taxpayers must apply thefollowing limits.Maximum Dollar LimitThe total cost a taxpayer can elect to deduct for a tax year cannot exceed$250,000 (in 2009). The maximum applies to each taxpayer and not to eachbusiness operated by a taxpayer. This maximum dollar limit is reduced if yougo over the investment limit in any year.Investment LimitFor each dollar of cost of §179 property placed in service in excess of$800,000 (in 2009) in a tax year, the maximum is reduced (but not belowzero) by one dollar. Any amount disallowed under this rule is lost and maynot be carried over to another tax year (§179(b)(2)).ExampleIn 2009, Danny purchases a machine for $855,000 to beused in his business. Since the cost exceeds $800,000, the$250,000 limitation must be reduced dollar for dollar by theamount that the cost exceeds $800,000. Thus, Danny wouldbe entitled to deduct $195,000 ($250,000 - $55,000) of thecost of the machine in 2009.If the cost of property placed in service in 2009 is $1,050,000 or more, thenno §179 deduction is allowed.Taxable Income LimitThe total cost that can be deducted in each tax year is limited to the taxableincome from the active conduct of any trade or business during the tax year.

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Taxable income is figured as usual but without a deduction for the cost of any§179 property and the deduction for half the self-employment tax. Taxpayerscannot use a §179 deduction to increase or create a net operating loss.ExampleDanny purchases a printer for $8,750. His taxable incomefrom his business activities (determined without regard to thecost of the printer) is $3,700 for the taxable year. Thus,2-127Danny's §179 deduction is limited to $3,700, his taxable incomefor the year.Any cost that is not deductible in one tax year under §179 because of thislimit can be carried to the next tax year and added to the cost of qualifyingproperty placed in service in that tax year.Carryover of Unallowable DeductionIf the cost of §179 property placed in service in 2009 is $1,050,000 or more,§179 deduction cannot be taken and there is no carryover.If the cost of §179 property placed in service in 2009 is less than $1,050,000,the maximum dollar limit is reduced by the amount, if any, by which the costof §179 property placed in service during the tax year exceeds $800,000.If the cost of §179 property placed in service in 2009 is $250,000 or less, themaximum dollar limit is the cost of §179 property placed in service during thetax year.After determining the maximum dollar amount that applies, figure the taxableincome limit. Determine the taxable income limit by figuring the taxableincome from the active conduct of the business without deductions for thecost of §179 property and half the self-employment tax.If this taxable income amount is more than the maximum dollar amount, the§179 deduction is the maximum dollar amount and there is no carryover tothe next tax year.If this taxable income amount is less than the maximum dollar amount, the§179 deduction is the taxable income amount. The carryover is the excess ofthe maximum dollar amount over the §179 deduction. The amount carriedover will be taken into account in determining the taxpayer's §179 deductionnext year.If the taxable income limit is less than the maximum dollar limit, attach astatement to the return showing the computation of the taxable income.Married Taxpayers Filing Separate ReturnsA husband and wife filing separate returns for a tax year are treated as onetaxpayer for the $250,000 maximum (in 2009) and for the $800,000 investmentlimit. Unless they elect otherwise, 50% of the cost of §179 property, beforethe taxable income limit is applied, will be allocated to each.Passenger Automobiles

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For passenger automobiles placed in service in 2009, the total §179 deductionand depreciation deduction cannot exceed $2,960 (R.P. 2009-24).2-128PartnershipsThe §179 limits apply to both the partnership and to each partner. The partnershipdetermines its §179 deduction subject to the limits. It allocates thededuction so determined among its partners. Each partner adds the amountallocated from the partnership to the partner's own deduction and applies thelimit to this total to determine the partner's §179 deduction. The totalamount of each partner's partnership and nonpartnership §179 deductioncannot exceed the maximum dollar limit.The basis of a partnership's §179 property must be reduced by the amount ofthe §179 deduction elected by the partnership. This reduction of basis mustbe made even if a partner cannot deduct all or a part of the §179 deductionallocated to that partner by the partnership because of the limitations.S CorporationsThe rules that apply to a partnership and its partners also apply to an S corporationand its shareholders. The limits apply to an S corporation and toeach shareholder. The corporation allocates the deduction among the shareholders,who then take their §179 deduction subject to the limits.CostThe cost of property for the §179 deduction does not include that part of thebasis of the property determined by reference to the basis of other propertyheld at any time by the person acquiring the property.ExampleWhen a taxpayer buys a new truck to use in business, thecost for the §179 deduction does not include the adjusted basisof the truck the taxpayer trades in on the new vehicle.When property is used for both business and nonbusiness, the §179 deductionmay only be elected if more than 50% of the property's use in the taxyear the property is placed in service is for trade or business purposes. Thecost of the property must be allocated to reflect only the business use of theproperty. Multiplying the cost of the property by the percentage of businessuse does this. Use this adjusted cost to figure the §179 deduction.ElectionAn election must be made to take the §179 deduction. The election is made inthe tax year the property is placed in service. The Form 4562 is used to make the2-129

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election and report the §179 deduction. Taking the deduction on Form 4562filed with the original tax return makes the election.Note: The election cannot be made on an amended tax return filed after thedue date (including extensions).RecordsRecords must be maintained that permit specific identification of each pieceof §179 property and reflect how and from whom the property was acquiredand when it was placed in service. Taxpayers must adhere to their selection of§179 property for which a deduction is claimed in computing their taxable incomefor the tax year the election is made and all later tax years.Revocation of ElectionOnce made, the election can be revoked only with IRS consent. Consent torevoke a §179 election will be granted only in extraordinary circumstances.Requests for consent must be filed with the Commissioner of Internal Revenue,Washington, DC 20224.The request must include the taxpayer's:(i) Name,(ii) Address, and(iii) Taxpayer identification number.The taxpayer or their duly authorized representative must sign it. It must beaccompanied by a statement showing the year and property involved, andmust set forth in detail the reasons for the request.Figuring the DeductionThe maximum §179 deduction is $250,000 (in 2009) of the cost of propertybought for use in a trade or business. The taxpayer decides how much of the costof property they want to deduct under §179. The full $250,000 does not have tobe claimed. Any cost not deducted under §179 can be depreciated.If there is more than one item of property, the deduction can be allocated betweenthe items. If there is only one item of qualifying property and that itemcosts less than $250,000, such as $3,200, the §179 deduction is limited to $3,200.The §179 deduction must be figured before figuring the depreciation deduction.Subtract the amount elected to be deducted from the basis of the qualifyingproperty. This adjusted basis is the amount used to compute the deduction fordepreciation.2-130Recapture of §179 Deductions

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If a taxpayer deducts the cost of property placed in service and the property isnot used more than 50% in a trade or business for any tax year before the end ofthe property's recovery period, they must include in income the benefit receivedfrom the deduction.Note: Any recapture of the §179 deduction is reported on Form 4797, Salesof Business Property.Figure the amount to be included in income by subtracting from the §179 deductionthe depreciation that would have been allowable on the §179 amount forprior tax years and the tax year of recapture.DispositionsIf a taxpayer elects the §179 deduction, the amount deducted is treated asdepreciation for the recapture rules. Thus, any gain recognized on dispositionof the property is treated as ordinary income to the extent of the §179 deductionand depreciation taken.Installment SalesIf a taxpayer makes an installment sale of qualifying property, they must generallyinclude as ordinary income in the year of sale any depreciation recaptureincome to the extent of gain even if no payments are received in the yearof sale.

Depreciation & Cost Recovery - §167 & §168Taxpayers are permitted a deduction for the exhaustion, wear and tear, and obsolescenceof an asset used in a trade or business or for the production of income.The cost of property is recovered by taking deductions for the cost over aset period of years. Property is classified as either real or personal and can beused in business or for personal purposes.The Modified Accelerated Cost Recovery System (MACRS) is required for mostproperty placed in service after 1986. Likewise Accelerated Cost Recovery System(ACRS) was mandatory for property placed in service after 1980 and before1987.Personal PropertyACRS - §168ACRS placed personal tangible recovery property into three recovery periodclasses on the basis of 1981 ADR midpoint class lives (R. P. 83-35).2-131a. 3 year class - included light trucks, automobiles, R&D equipment, racehorses

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over 2 years old and other horses over 12 years old, and otherproperty with an ADR midpoint of 4 years or less.b. 5 year class - included most depreciable equipment, furniture, fixtures,computer equipment and all personal tangible property not included inthe 3 year and 10 year classes.c. 10 year class - included "section 1250 class property" with an ADR classlife of 12.5 years or less.Comment: The term "section 1250 class property" means real property includingelevators and escalators. The 10-year class also includes railroadtank cars, manufactured homes, theme park structures, and road utilizationproperty used in a public utility power plant.Applicable PercentageACRS provided an annual statutory percentage for all classes of tangiblepersonal recovery property. These are the accelerated statutory rates (inpercentage) applicable to personal property placed in service after 1980:If the recovery year is: 3-year 5-year 10-year1. 25% 15% 8%2. 38% 22% 14%3. 37% 21% 12%4. 21% 10%5. 21% 10%6. 10%7-10. 9%Straight-line ElectionTaxpayers may elect to deduct the cost of recovery property on a straightlinebasis over one of the following optional recovery periods:Recovery Period Class Optional Recovery Periods3 year Property 3, 5 or 12 years5 year Property 5, 12 or 25 years10 year Property 10, 25 or 35 yearsMACRSThe general effect of MACRS was to lengthen asset lives. MACRS placespersonal tangible property into 6 recovery classes based on ADR midpointlife (R. P. 83-35).(1) 3-Year Class (200% DB) - includes tractor units for use over the road,special tools used in the manufacturing of motor vehicles, racehorses if 2years old when placed in service, breeding hogs and other personal prop2-132erty with an ADR midpoint of 4 years or less (except autos and lighttrucks).(2) 5-Year Class (200% DB) - includes automobiles, buses, light and heavygeneral purpose trucks, breeding and dairy cattle, trailers and trailermounted containers, computers and peripheral equipment, typewriters,calculators, copiers, R&D property and other personal property with anADR midpoint of more than 4 years and less than 10 years.(3) 7-Year Class (200% DB) - includes office furniture, fixtures, equipment,breeding and work horses, agricultural machinery and equipment,railroad trucks, single purpose agricultural or horticultural structures and

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other property with an ADR midpoint of 10 years and less than 16 andproperty not specifically assigned to any other class.(4) 10-Year Class (200% DB) - includes vessels, barges, tugs, assets usedfor petroleum refining, manufacture of grain, sugar, and vegetable oilsand other property with an ADR midpoint of 16 years or more but lessthan 20 years.(5) 15-Year Class (150%) - includes land improvements, assets used forelectrical generation, pipeline transportation, and cement manufacture,railroad track, nuclear production plants, sewage treatment plants, andother property with an ADR midpoint of 20 years or more but less than25 years.Comment: An allocation to land improvements in the acquisition ofresidential rental and commercial property results in both a shorter depreciablelife (i.e., not the 27.5, 31.5, or 39 years under MACRS) andaccelerated depreciation.(6) 20-Year Class (150% DB) - includes water utilities, municipal sewer,farm buildings, gas distribution facilities and other property with an ADRmidpoint of 25 years or more.Temporary Bonus DepreciationThe Economic Stimulus Package Act of 2008 allows business taxpayers a50% bonus depreciation allowance for qualified property (e.g., equipment)placed in service in 2008 (§168(k)).The amount of the additional allowance is the applicable percentage(50%) of the unadjusted depreciable basis of the qualified property (Reg.§1.168(k)-1(d)(1)). Unadjusted depreciable basis is the adjusted basis ofthe property for determining gain or loss reduced by any §179 amount expensedand any adjustments to basis provided by the Code. RegularMACRS depreciation is computed after reducing the unadjusted depreciablebasis by the bonus depreciation.2-133Note: The new law also raises the first year limit on depreciation for passengerautomobiles by $8,000 if bonus depreciation is claimed for qualifying vehicle.The additional first-year depreciation deduction is allowed for both regulartax and alternative minimum tax purposes for the taxable year inwhich the property is placed in service.Qualifying PropertyIn order for property to qualify for the additional first-year depreciationdeduction it must meet all of the following requirements.First, the property must be property:(1) To which MACRS applies with an applicable recovery period of20 years or less,(2) Water utility property (as defined in section 168(e)(5)),(3) Computer software other than computer software covered bysection 197, or(4) Qualified leasehold improvement property (as defined in section168(k)(3)).

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Second, the original use of the property must commence with the taxpayeron or after January 1, 2008.Third, the taxpayer must purchase the property within the applicabletime period.Finally, the property must be placed in service before January 1, 2009.Coordination with §179The § 179 expense allowance is claimed before the additional depreciationallowance is taken (Reg. §1.168(k)-1(d)).ElectionsMACRS permits a taxpayer to elect straight-line depreciation only overthe MACRS class in which the asset belongs. This election, if made, mustbe made for all property within a recovery class, but can be made for oneclass but not another.In addition, an election may also be made to use the 150% declining balancemethod for property other than 15-year, 20-year, nonresidential realproperty, residential real property.Warning: When this election is made, the alternative minimum tax calculatesthe adjustment for accelerated depreciation using the alternativedepreciation system.2-134MACRS ConventionsGenerally, only a half-year of MACRS depreciation is allowed for personalproperty for the acquisition and disposition year.Mid-quarter Convention ExceptionMACRS substitutes mid-quarter convention for all personal propertyplaced in service during a tax year if more than 40% of the total basisof all personal property placed in service during the year is placed inservice during the last three months. Property placed in service anddisposed of during the same year is not included in the 40% test.The mid-quarter convention treats personal property placed in serviceor disposed of during any quarter as placed in service or disposed of onthe midpoint of that quarter.Quarter Months of Depreciation1st 10.52nd 7.53rd 4.54th 1.5Recapture - §1245Generally gains from the sale of depreciable tangible personal property aretreated as capital gains under §1231 while losses are treated as ordinarylosses. Section 1245 reclassifies gain from the sale of depreciable tangiblepersonal property from capital gain to ordinary income to the extent depreciationor cost recovery deductions were claimed on the asset.The §179 expense election is treated as a MACRS or ACRS deduction forrecapture purposes. Recapture would occur if the expensed property is converted

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to personal use prior to the expiration of its life under MACRS orACRS. A property is converted to personal use if it is not used predominantlyin a trade or business.50% Bonus DepreciationFor 2008 (and 2009 for certain longer lived and transportation property), an additionalfirst-year depreciation deduction is allowed equal to 50% of the adjustedbasis of qualified property placed in service in 2008. The allowance is an additionaldeduction of 50% of the property’s depreciable basis (after any §179 deductionand before figuring your regular depreciation deduction).Note: The additional first-year depreciation deduction is allowed for bothregular tax and alternative minimum tax purposes for the taxable year inwhich the property is placed in service.2-135Qualified property. Property that qualifies for this special depreciation allowanceincludes:(1) tangible property depreciated under the modified accelerated cost recoverysystem (MACRS) with a recovery period of 20 years or less,(2) water utility property,(3) off-the-shelf computer software, or(4) qualified leasehold improvement property.Additional tests. Qualified property must also meet all of the following tests:1. You must have acquired qualified property by purchase after December31, 2007, and before January 1, 2009. If a binding contract to acquire theproperty existed before January 1, 2008, the property does not qualify.2. Qualified property must be placed in service after December 31, 2007, andbefore January 1, 2009 (before January 1, 2010, for certain transportationproperty and certain property with a long production period).3. The original use of the property must begin with you after December 31,2007.Nonqualified property. Property that does not qualify for special depreciation allowanceincludes:(1) property placed in service and disposed of in the same tax year;(2) property converted from business use to personal use in the same tax yearit is acquired,(3) property required to be depreciated under the alternative depreciationsystem (ADS); and

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(4) property included in a class of property for which you elected not to claimthe special depreciation allowance vehicles.Depreciation limits on business vehicles. The total depreciation deduction (includingthe §179 deduction) you can take for a passenger automobile (that is nota truck or a van) you use in your business and first placed in service in 2008 is$2,960 ($10,960 for automobiles for which the special depreciation allowancesapplies). The maximum deduction you can take for a truck or a van you use inyour business and first placed in service in 2008 is $3,160 ($11,160 for trucks orvans for which the special depreciation allowance applies).Note: These limits are reduced if the business use of the vehicle is less than100%.For 2009 (through 2010 for certain longer-lived and transportation property),the American Recovery & Reinvestment Act extends the additional first-yeardepreciation deduction through 2009.Comment: As a result of bonus depreciation and effective January 1, 2009,the regular dollar cap for new vehicles placed in service in 2009 is raised by$8,000.2-136The Act also permits corporations to increase the research credit or minimumtax credit limitation by the bonus depreciation amount with respect tocertain property placed in service in 2009 (2010 in the case of certain longerlivedand transportation property).2-137Tables:Table MACRS-1General Depreciation SystemApplicable Depreciation Method: 200 or 150 PercentDeclining Balance Switching to Straight-lineApplicable Recovery Periods: 3, 5, 7, 10, 15, 20 yearsApplicable Convention: Half-yearIf theRecoveryYear is: And the Recovery Period is:3-year 5-year 7-year 10-year 15-year 20-yearThe Depreciation Rate is:1 33.33 20.00 14.29 10.00 5.00 3.7502 44.45 32.00 24.49 18.00 9.50 7.2193 14.81 19.20 17.49 14.40 8.55 6.6774 7.41 11.52 12.49 11.52 7.70 6.177

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5 11.52 8.93 9.22 6.93 5.7136 5.76 8.92 7.37 6.23 5.2857 8.93 6.55 5.90 4.8888 4.46 6.55 5.90 4.5229 6.56 5.91 4.46210 6.55 5.90 4.46111 3.28 5.91 4.46212 5.90 4.46113 5.91 4.46214 5.90 4.46115 5.91 4.46216 2.95 4.46117 4.46218 4.46119 4.46220 4.46121 2.2312-138Table MACRS-2General Depreciation SystemApplicable Depreciation Method: 200 or 150 PercentDeclining Balance Switching to Straight-lineApplicable Recovery Periods: 3, 5, 7, 10, 15, 20 yearsApplicable Convention: Mid-quarter (property placed in service in first quarter)If theRecoveryYear is: And the Recovery Period is:3-year 5-year 7-year 10-year 15-year 20-yearThe Depreciation Rate is:1 58.33 35.00 25.00 17.50 8.75 6.5632 27.78 26.00 21.43 16.50 9.13 7.0003 12.35 15.60 15.31 13.20 8.21 6.4824 1.54 11.01 10.93 10.56 7.39 5.9965 11.01 8.75 8.45 6.65 5.5466 1.38 8.74 6.76 5.99 5.1307 8.75 6.55 5.90 4.7468 1.09 6.55 5.91 4.4599 6.56 5.90 4.45910 6.55 5.91 4.45911 0.82 5.90 4.45912 5.91 4.46013 5.90 4.45914 5.91 4.46015 5.90 4.45916 0.74 4.460

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17 4.45918 4.46019 4.45920 4.46021 0.5572-139Table MACRS-3General Depreciation SystemApplicable Depreciation Method: 200 or 150 percentDeclining Balance Switching to Straight-lineApplicable Recovery Periods: 3, 5, 7, 10, 15, 20 yearsApplicable Convention: Mid-quarter (property placed in service in second quarter)If theRecoveryYear is: And the Recovery Period is:3-year 5-year 7-year 10-year 15-year 20-yearThe Depreciation Rate is:1 41.67 25.00 17.85 12.50 6.25 4.6882 38.89 30.00 23.47 17.50 9.38 7.1483 14.14 18.00 16.76 14.00 8.44 6.6124 5.30 11.37 11.97 11.20 7.59 6.1165 11.37 8.87 8.96 6.83 5.6586 4.26 8.87 7.17 6.15 5.2337 8.87 6.55 5.91 4.8418 3.33 6.55 5.90 4.4789 6.56 5.91 4.46310 6.55 5.90 4.46311 2.46 5.91 4.46312 5.90 4.46313 5.91 4.46314 5.90 4.46315 5.91 4.46216 2.21 4.46317 4.46218 4.46319 4.46220 4.46321 1.6732-140Table MACRS-4General Depreciation SystemApplicable Depreciation Method: 200 or 150 percentDeclining Balance Switching to Straight-lineApplicable Recovery Periods: 3, 5, 7, 10, 15, 20 years

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Applicable Convention: Mid-quarter (property placed in service in third quarter)If theRecoveryYear is: And the Recovery Period is:3-year 5-year 7-year 10-year 15-year 20-yearThe Depreciation Rate is:1 25.00 15.00 10.71 7.50 3.75 2.8132 50.00 34.00 25.51 18.50 9.63 7.2893 16.67 20.40 18.22 14.80 8.66 6.7424 8.33 12.24 13.02 11.84 7.80 6.2375 11.30 9.30 9.47 7.02 5.7696 7.06 8.85 7.58 6.31 5.3367 8.86 6.55 5.90 4.9368 5.53 6.55 5.90 4.5669 6.56 5.91 4.46010 6.55 5.90 4.46011 4.10 5.91 4.46012 5.90 4.46013 5.91 4.46114 5.90 4.46015 5.91 4.46116 3.69 4.46017 4.46118 4.46019 4.46120 4.46021 2.7882-141Table MACRS-5General Depreciation SystemApplicable Depreciation Method: 200 or 150 PercentDeclining Balance Switching to Straight-lineApplicable Recovery Periods: 3, 5, 7, 10, 15, 20 yearsApplicable Convention: Mid-quarter (property placed in service in fourth quarter)If theRecoveryYear is: And the Recovery Period is:3-year 5-year 7-year 10-year 15-year 20-yearThe Depreciation Rate is:1 8.33 5.00 3.57 2.50 1.25 0.9382 61.11 38.00 27.55 19.50 9.88 7.4303 20.37 22.80 19.68 15.60 8.89 6.8724 10.19 13.68 14.06 12.48 8.00 6.3575 10.94 10.04 9.98 7.20 5.880

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6 9.58 8.73 7.99 6.48 5.4397 8.73 6.55 5.90 5.0318 7.64 6.55 5.90 4.6549 6.56 5.90 4.45810 6.55 5.91 4.45811 5.74 5.90 4.45812 5.91 4.45813 5.90 4.45814 5.91 4.45815 5.90 4.45816 5.17 4.45817 4.45818 4.45919 4.45820 4.45921 3.9012-142Real PropertyACRSACRS established arbitrary depreciation recovery periods and abandonedsalvage value, useful life and new or used considerations.Under ACRS, the recovery periods for real estate are:(1) 15 Year Real Property- §1250 property (real property which is of acharacter subject to its allowance for depreciation) which was placed inservice after 1980 and before March 16, 1984.(2) 18 Year Real Property- §1250 property placed in service after March15, 1984 and before May 9, 1985.(3) 19 Year Real Property- §1250 property placed in service after May 8,1985 and before 1987.Under ACRS, the recovery methods for real estate are:(1) 175% Declining Balance- The accelerated rate for real property (otherthan low income housing) in the 15, 18, or 19 year class was 175% decliningbalance with appropriately timed switches to straight-line to maximizethe deduction. Accelerated cost recovery rates were based on the numberof months the property was in service for the acquisition or dispositionyear. Low income housing in the 15-year class was 200% declining balancemethod.(2) Straight-line Election- Taxpayers could elect to deduct the cost of recoveryproperty using a straight-line method on a property-by-propertybasis over any of the following optional recovery periods:15-year real property - 15, 35, or 45 years18-year real property - 18, 35, or 45 years19-year real property - 19, 35, or 45 yearsThe IRS tables for 15 year, 18 year, and 19 year class real property follow:2-143

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Table ACRS-115-year Real Property except Low-Income Housing(15-Year 175% Declining Balance Full Month Convention)If theRecovery Use the column for the Month in the First YearYear is: The Property is placed in Service1 2 3 4 5 6 7 8 9 10 11 12The Applicable Percentage is:1 12 11 10 9 8 7 6 5 4 3 2 12 10 10 11 11 11 11 11 11 11 11 11 123 9 9 9 9 10 10 10 10 10 10 10 104 8 8 8 8 8 8 9 9 9 9 9 95 7 7 7 7 7 7 8 8 8 8 8 86 6 6 6 6 7 7 7 7 7 7 7 77 6 6 6 6 6 6 6 6 6 6 6 68 6 6 6 6 6 6 5 6 6 6 6 69 6 6 6 6 5 6 5 5 5 6 6 610 5 6 5 6 5 5 5 5 5 6 6 511 5 5 5 5 5 5 5 5 5 5 5 512 5 5 5 5 5 5 5 5 5 5 5 513 5 5 5 5 5 5 5 5 5 5 5 514 5 5 5 5 5 5 5 5 5 5 5 515 5 5 5 5 5 5 5 5 5 5 5 516 - - 1 1 2 2 3 3 4 4 4 52-144Table ACRS-218-Year Real Property (18-Year 175% Declining Balance)(Assuming Mid-Month Convention)Placed in Service after June 22, 1984 and Before May 5, 1985If theRecovery And the Month in the First Recovery YearYear is: The Property is placed in Service is:1 2 3 4 5 6 7 8 9 10 11 12The Applicable Percentage is:1 9 9 8 7 6 5 4 4 3 2 1 0.42 9 9 9 9 9 9 9 9 9 10 10 10.03 8 8 8 8 8 8 8 8 9 9 9 9.04 7 7 7 7 7 8 8 8 8 8 8 8.05 7 7 7 7 7 7 7 7 7 7 7 7.06 6 6 6 6 6 6 6 6 6 6 6 6.07 5 5 5 5 6 6 6 6 6 6 6 6.08 5 5 5 5 5 5 5 5 5 5 5 5.09 5 5 5 5 5 5 5 5 5 5 5 5.010 5 5 5 5 5 5 5 5 5 5 5 5.011 5 5 5 5 5 5 5 5 5 5 5 5.012 5 5 5 5 5 5 5 5 5 5 5 5.0

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13 4 4 4 5 4 4 5 4 4 4 5 5.014 4 4 4 4 4 4 4 4 4 4 4 4.015 4 4 4 4 4 4 4 4 4 4 4 4.016 4 4 4 4 4 4 4 4 4 4 4 4.017 4 4 4 4 4 4 4 4 4 4 4 4.018 4 3 4 4 4 4 4 4 4 4 4 4.019 1 1 1 2 2 2 3 3 3 3 3.62-145Table ACRS-319-Year Real Property (19-Year Declining Balance)(Assuming Mid-Month Convention)Placed in Service after May 8, 1985 and Before 1987If theRecovery And the Month in the First Recovery YearYear is: The Property is Placed in Service is:1 2 3 4 5 6 7 8 9 10 11 12The Applicable Percentage is:1 8.8 8.1 7.3 6.5 5.8 5.0 4.2 3.5 2.7 1.9 1.1 0.42 8.4 8.5 8.5 8.6 8.7 8.8 8.8 8.9 9.0 9.0 9.1 9.23 7.6 7.7 7.7 7.8 7.9 7.9 8.0 8.1 8.1 8.2 8.3 8.34 6.9 7.0 7.0 7.1 7.1 7.2 7.3 7.3 7.4 7.4 7.5 7.65 6.3 6.3 6.4 6.4 6.5 6.5 6.6 6.6 6.7 6.8 6.8 6.96 5.7 5.7 5.8 5.9 5.9 5.9 6.0 6.0 6.1 6.1 6.2 6.27 5.2 5.2 5.3 5.3 5.3 5.4 5.4 5.5 5.5 5.6 5.6 5.68 4.7 4.7 4.8 4.8 4.8 4.9 4.9 5.0 5.0 5.1 5.1 5.19 4.2 4.3 4.3 4.4 4.4 4.5 4.5 4.5 4.5 4.6 4.6 4.710 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.211 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.212 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.213 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.214 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.215 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.216 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.217 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.218 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.219 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.220 0.2 0.5 0.9 1.2 1.6 1.9 2.3 2.6 3.0 3.3 3.7 4.02-146Table ACRS-415-Year Straight-line Method is ElectedFor 15-year real propertyFor which a 15-year period is electedPlaced in Service after 12/31/80 and Before 3/16/80If theRecovery And the Month in the First Recovery YearYear is: the Property is Placed in Service is:

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1 2 3 4 5 6 7 8 9 10 11 12The Applicable Percentage is:1 7 6 6 5 4 4 3 3 2 2 1 12 7 7 7 7 7 7 7 7 7 7 7 73 7 7 7 7 7 7 7 7 7 7 7 74 7 7 7 7 7 7 7 7 7 7 7 75 7 7 7 7 7 7 7 7 7 7 7 76 7 7 7 7 7 7 7 7 7 7 7 77 7 7 7 7 7 7 7 7 7 7 7 78 7 7 7 7 7 7 7 7 7 7 7 79 7 7 7 7 7 7 7 7 7 7 7 710 7 7 7 7 7 7 7 7 7 7 7 711 6 6 6 6 6 6 6 6 6 6 6 612 6 6 6 6 6 6 6 6 6 6 6 613 6 6 6 6 6 6 6 6 6 6 6 614 6 6 6 6 6 6 6 6 6 6 6 615 6 6 6 6 6 6 6 6 6 6 6 616 1 1 2 3 3 4 4 5 5 6 62-147Table ACRS-518-Year Real Property for Which an Optional18-Year Straight-line Method is Elected(Assuming Mid-Month Convention)For Other than Low Income HousingPlaced in Service after 6/22/84 and Before 5/9/85If theRecovery And the Month in the First Recovery YearYear is: the Property is placed in Service is:1 2 3 4 5 7 8 9 10 11 12The Applicable Percentage Is:1 5 5 4 4 3 3 2 2 1 1 0.22 6 6 6 6 6 6 6 6 6 6 6.03 6 6 6 6 6 6 6 6 6 6 6.04 6 6 6 6 6 6 6 6 6 6 6.05 6 6 6 6 6 6 6 6 6 6 6.06 6 6 6 6 6 6 6 6 6 6 6.07 6 6 6 6 6 6 6 6 6 6 6.08 6 6 6 6 6 6 6 6 6 6 6.09 6 6 6 6 6 6 6 6 6 6 6.010 6 6 6 6 6 6 6 6 6 6 6.011 5 5 5 5 5 5 5 5 5 5 5.812 5 5 5 5 5 5 5 5 5 5 5.013 5 5 5 5 5 5 5 5 5 5 5.014 5 5 5 5 5 5 5 5 5 5 5.015 5 5 5 5 5 5 5 5 5 5 5.016 5 5 5 5 5 5 5 5 5 5 5.0

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17 5 5 5 5 5 5 5 5 5 5 5.018 5 5 5 5 5 5 5 5 5 5 5.019 1 1 2 2 3 3 4 4 5 5 5.02-148Table ACRS-619-Year Real Property for Which an Optional19-Year Straight-line Method is Elected(Assuming Mid-Month Convention)Placed in Service after May 8, 1985 and Before 1987If theRecovery And the Month in the First Recovery YearYear is: the Property is Placed in Service is:1 2 3 4 5 6 7 8 9 10 11 12The Applicable Percentage is:1 5.0 4.6 4.2 3.7 3.3 2.9 2.4 2.0 1.5 1.1 0.7 0.22 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.33 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.34 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.35 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.36 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.37 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.38 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.39 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.310 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.311 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.312 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.313 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.314 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.215 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.216 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.217 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.218 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.219 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.2 5.220 0.2 0.6 1.0 1.5 1.9 2.3 2.8 3.2 3.7 4.1 4.5 5.02-149MACRSUnder MACRS real property is 27.5-year class if it is residential rental property.All other depreciable real property (e.g., commercial) was assigned tothe 31.5-year class. On or after May 13, 1993, all other depreciable real propertyis assigned to the 39 year class.The straight-line method must be used for all real property in the 27.5-yearclass, 31.5-year class, and the 39-year class.MACRS uses a half-month convention rules for all real property. Thus, all

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real property placed in service during any month is treated as being placed inservice on the midpoint of each month for purposes of computing theMACRS depreciation deduction.The following tables show the depreciation rate for 27.5 year and 31.5 yearclass real property.Leasehold ImprovementsGenerally, leasehold and retail improvements must be depreciated overthe life of the property using the modified accelerated cost recovery system(MACRS) method and not over the life of the lease (§168(i)(6)).Note: A lessee is no longer allowed to amortize the cost over the remainingterm of the lease. If a lessee does not keep the improvements when the leaseis terminated, their gain or loss is based on their adjusted basis in the improvementsat that time.However, a statutory 15 year straight line recovery period for qualifiedleasehold improvement property placed in service after October 22, 2004and before January 1, 2010 is available.In addition, starting for the first time in 2009, a qualified interior improvementto an over-3-year-old building used for a retail business is depreciableover 15 years straight line method.This 15-year life rule is not elective, but the improvements do not losetheir §1250 real property status, and therefore, the improvements do notqualify for 50% bonus depreciation or the §179 expensing allowance.Qualified Leasehold Improvement PropertyQualified leasehold improvement property placed in service after October22, 2004, and before January 1, 2010, is 15-year property underMACRS. Owners have to use the straight-line method over a 15-yearrecovery period (39 years if the alternative depreciation system (ADS)is elected or otherwise applied).Qualified leasehold improvement property. A qualified leasehold improvementproperty is defined as any improvement to an interior por2-150tion of a building that is nonresidential real property, provided certainrequirements are met. The improvement must be made under or pursuantto a lease either by the lessee (or sublessee), or by the lessor, ofthat portion of the building to be occupied exclusively by the lessee (orsublessee). The improvement must be placed in service more thanthree years after the date the building was first placed in service.Qualified leasehold improvement property does not include any improvementfor which the expenditure is attributable to the enlargementof the building, any elevator, or escalator, any structural componentbenefiting a common area, or the internal structural framework ofthe building.

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Subsequent owner. If a lessor makes an improvement that qualifies asqualified leasehold improvement property, such improvement does notqualify as qualified leasehold improvement property to any subsequentowner of such improvement. An exception to the rule applies in thecase of death and certain transfers of property that qualify for non recognitiontreatment.Qualified Retail Improvement PropertyFor 2009, a qualified interior improvement to an over-3-year-old buildingused for a retail business is depreciable over 15 years straight linemethod.Qualified retail improvement property. The term "qualified retail improvementproperty" means any improvement to an interior portion ofa building which is nonresidential real property if such portion is opento the general public and is used in the retail trade or business of sellingtangible personal property to the general public, and such improvementis placed in service more than 3 years after the date thebuilding was first placed in service.In the case of an improvement made by the owner of such improvement,such improvement is qualified retail improvement property (if atall) only so long as such improvement is held by such owner (thismeans that a new buyer can not separately purchase the building andthe previously inserted improvements, taking 15 year life on the improvements).The term “qualified retail improvements” does not includeany improvement for which the expenditure is attributable to theenlargement of the building, any elevator, or escalator, any structuralcomponent benefiting a common area, or the internal structuralframework of the building. Improvements placed in service beforeJanuary 1, 2009 and after December 31, 2009, do not qualify(§168(e)(8)).2-151Restaurant Improvements - §168Improvements on at least 3 year old building with 50%+ used as restaurant.A statutory 15 year straight line recovery period is allowed for qualifiedrestaurant property placed in service after October 22, 2004 and beforeJanuary 1, 2010. Qualified restaurant property means any §1250property that is an improvement to a building, if such improvement isplaced in service more than three years after the date such building wasfirst placed in service and more than 50% of the building's square footageis devoted to the preparation of, and seating for, on premises consumptionof prepared meals.Comment: The 50% bonus depreciation deduction may not be claimedon any qualified restaurant property (§168(e)(7)(B), as amended by the

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Emergency Economic Act of 2008).A building placed in service after December 31, 2008 and before January1, 2010. The definition of qualified restaurant property has been expandedto include a building placed in service after December 31, 2008,and before January 1, 2010, if more than 50% of the building's squarefootage is devoted to preparation of, and seating for on premises consumptionof, prepared meals. A qualified restaurant building placed inservice in calendar year 2009 is allowed a 15-year straight-line recoveryperiod, whether or not the building is new construction. Surprisingly,there is no binding contract rule that prevents a taxpayer from using the15 year recovery period if the building is acquired pursuant to an existingpre 2009 contract.2-152Table MACRS-6Applicable Depreciation Method: Straight-lineApplicable Recovery Period: 27.5 yearsApplicable Convention: Mid-monthIf theRecovery And the Month in the First Recovery YearYear is: the Property is Placed in Service is:1 2 3 4 5 6The Applicable Percentage is:1 3.485 3.182 2.879 2.576 2.273 1.9702 3.636 3.636 3.636 3.636 3.636 3.6363 3.636 3.636 3.636 3.636 3.636 3.6364 3.636 3.636 3.636 3.636 3.636 3.6365 3.636 3.636 3.636 3.636 3.636 3.6366 3.636 3.636 3.636 3.636 3.636 3.6367 3.636 3.636 3.636 3.636 3.636 3.6368 3.636 3.636 3.636 3.636 3.636 3.6369 3.636 3.636 3.636 3.636 3.636 3.63610 3.637 3.637 3.637 3.637 3.637 3.63711 3.636 3.636 3.636 3.636 3.636 3.63612 3.637 3.637 3.637 3.637 3.637 3.63713 3.636 3.636 3.636 3.636 3.636 3.63614 3.637 3.637 3.637 3.637 3.637 3.63715 3.636 3.636 3.636 3.636 3.636 3.63616 3.637 3.637 3.637 3.637 3.637 3.63717 3.636 3.636 3.636 3.636 3.636 3.63618 3.637 3.637 3.637 3.637 3.637 3.63719 3.636 3.636 3.636 3.636 3.636 3.63620 3.637 3.637 3.637 3.637 3.637 3.63721 3.636 3.636 3.636 3.636 3.636 3.63622 3.637 3.637 3.637 3.637 3.637 3.63723 3.636 3.636 3.636 3.636 3.636 3.63624 3.637 3.637 3.637 3.637 3.637 3.63725 3.636 3.636 3.636 3.636 3.636 3.63626 3.637 3.637 3.637 3.637 3.637 3.63727 3.636 3.636 3.636 3.636 3.636 3.636

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28 1.970 2.273 2.576 2.879 3.182 3.48529 0.000 0.000 0.000 0.000 0.000 0.0002-153Table MACRS-6(Continued)Applicable Depreciation Method: Straight-lineApplicable Recovery Period: 27.5 yearsApplicable Convention: Mid-MonthIf theRecovery And the Month in the First Recovery YearYear is: the Property is Placed in Service is:7 8 9 10 11 12The Applicable Percentage is:1 1.667 1.364 1.061 0.758 0.455 0.1522 3.636 3.636 3.636 3.636 3.636 3.6363 3.636 3.636 3.636 3.636 3.636 3.6364 3.636 3.636 3.636 3.636 3.636 3.6365 3.636 3.636 3.636 3.636 3.636 3.6366 3.636 3.636 3.636 3.636 3.636 3.6367 3.636 3.636 3.636 3.636 3.636 3.6368 3.636 3.636 3.636 3.636 3.636 3.6369 3.636 3.636 3.636 3.636 3.636 3.63610 3.636 3.636 3.636 3.636 3.636 3.63611 3.637 3.637 3.637 3.637 3.637 3.63712 3.636 3.636 3.636 3.636 3.636 3.63613 3.637 3.637 3.637 3.637 3.637 3.63714 3.636 3.636 3.636 3.636 3.636 3.63615 3.637 3.637 3.637 3.637 3.637 3.63716 3.636 3.636 3.636 3.636 3.636 3.63617 3.637 3.637 3.637 3.637 3.637 3.63718 3.636 3.636 3.636 3.636 3.636 3.63619 3.637 3.637 3.637 3.637 3.637 3.63720 3.636 3.636 3.636 3.636 3.636 3.63621 3.637 3.637 3.637 3.637 3.637 3.63722 3.636 3.636 3.636 3.636 3.636 3.63623 3.637 3.637 3.637 3.637 3.637 6.63724 3.636 3.636 3.636 3.636 3.636 3.63625 3.637 3.637 3.637 3.637 3.637 3.63726 3.636 3.636 3.636 3.636 3.636 3.63627 3.637 3.637 3.637 3.637 3.637 3.63728 3.636 3.636 3.636 3.636 3.636 3.63629 0.152 0.455 0.758 1.061 1.364 1.6672-154Table MACRS-731.5 Year - Straight-line - Mid-Month ConventionIf theRecovery And the Month in the First Recovery YearYear is: the Property is Placed in Service is:1 2 3 4 5 6The Applicable Percentage is:1 3.042 2.778 2.513 2.249 1.984 1.7202 3.175 3.175 3.175 3.175 3.175 3.175

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3 3.175 3.175 3.175 3.175 3.175 3.1754 3.175 3.175 3.175 3.175 3.175 3.1755 3.175 3.175 3.175 3.175 3.175 3.1756 3.175 3.175 3.175 3.175 3.175 3.1757 3.175 3.175 3.175 3.175 3.175 3.1758 3.175 3.174 3.175 3.174 3.175 3.1749 3.174 3.175 3.174 3.175 3.174 3.17510 3.175 3.174 3.175 3.174 3.175 3.17411 3.174 3.175 3.174 3.175 3.174 3.17512 3.175 3.174 3.175 3.174 3.175 3.17413 3.174 3.175 3.174 3.175 3.174 3.17514 3.175 3.174 3.175 3.174 3.175 3.17415 3.174 3.175 3.174 3.175 3.174 3.17516 3.175 3.174 3.175 3.174 3.175 3.17417 3.174 3.175 3.174 3.175 3.174 3.17518 3.175 3.174 3.175 3.174 3.175 3.17419 3.174 3.175 3.174 3.175 3.174 3.17520 3.175 3.174 3.175 3.174 3.175 3.17421 3.174 3.175 3.174 3.175 3.174 3.17522 3.175 3.174 3.175 3.174 3.175 3.17423 3.174 3.175 3.174 3.175 3.174 3.17524 3.175 3.174 3.175 3.174 3.175 3.17425 3.174 3.175 3.174 3.175 3.174 3.17526 3.175 3.174 3.175 3.174 3.175 3.17427 3.174 3.175 3.174 3.175 3.174 3.17528 3.175 3.174 3.175 3.174 3.175 3.17429 3.174 3.175 3.174 3.175 3.174 3.17530 3.175 3.174 3.175 3.174 3.175 3.17431 3.174 3.175 3.174 3.175 3.174 3.17532 1.720 1.984 2.249 2.513 2.778 3.04233 0.000 0.000 0.000 0.000 0.000 0.0002-155Table MACRS-7(Continued)31.5 Year - Straight-line - Mid-Month ConventionIf theRecovery And the Month in the First Recovery YearYear is: the Property is Placed in Service is:7 8 9 10 11 12The Applicable Percentage is:1 1.455 1.190 0.926 0.661 0.397 0.1322 3.175 3.175 3.175 3.175 3.175 3.1753 3.175 3.175 3.175 3.175 3.175 3.1754 3.175 3.175 3.175 3.175 3.175 3.1755 3.175 3.175 3.175 3.175 3.175 3.1756 3.175 3.175 3.175 3.175 3.175 3.1757 3.175 3.175 3.175 3.175 3.175 3.1758 3.175 3.175 3.175 3.175 3.175 3.1759 3.174 3.175 3.174 3.175 3.174 3.17510 3.175 3.174 3.175 3.174 3.175 3.17411 3.174 3.175 3.174 3.175 3.174 3.17512 3.175 3.174 3.175 3.174 3.175 3.17413 3.174 3.175 3.174 3.175 3.174 3.17514 3.175 3.174 3.175 3.174 3.175 3.174

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15 3.174 3.175 3.174 3.175 3.174 3.17516 3.175 3.174 3.175 3.174 3.175 3.17417 3.174 3.175 3.174 3.175 3.174 3.17518 3.175 3.174 3.175 3.174 3.175 3.17419 3.174 3.175 3.174 3.175 3.174 3.17520 3.175 3.174 3.175 3.174 3.175 3.17421 3.174 3.175 3.174 3.175 3.174 3.17522 3.175 3.174 3.175 3.174 3.175 3.17423 3.174 3.175 3.174 3.175 3.174 3.17524 3.175 3.174 3.175 3.174 3.175 3.17425 3.174 3.175 3.174 3.175 3.174 3.17526 3.175 3.174 3.175 3.174 3.175 3.17427 3.174 3.175 3.174 3.175 3.174 3.17528 3.175 3.174 3.175 3.174 3.175 3.17429 3.174 3.175 3.174 3.175 3.174 3.17530 3.175 3.174 3.175 3.174 3.175 3.17431 3.174 3.175 3.174 3.175 3.174 3.17532 3.175 3.174 3.175 3.174 3.175 3.17433 0.132 0.397 0.661 0.926 1.190 1.4552-156Recapture - §1250 & §1245There are basically three depreciation recapture provisions: §1245, §1250, and§291. Recapture converts gain that would have been taxed at capital gains ratesinto ordinary income.Section 1245Section 1245 provides that the portion of gain from the disposition of §1245property (including §167 depreciation, §168 cost recovery, §179 expensing,and the old investment credit 50% basis reduction) is recaptured as ordinaryincome. Although §1245 originally applied solely to depreciable personalproperty, nonresidential real estate acquired after 1980 and before 1987 andfor which accelerated depreciation was used is subject to §1245.Full RecaptureAll depreciation taken is subject to §1245 recapture. The method of depreciation(straight-line, ACRS or MACRS) does not matter.Section 1250Recapture under §1250 is less damaging than under §1245. Section 1250 onlyrecaptures the excess of accelerated depreciation actually deducted overstraight-line depreciation. Generally, §1250 property is depreciable realproperty (i.e., buildings and improvements) that is not subject to §1245.Partial RecaptureStraight-line depreciation (except for property held one year or less) isnot recaptured. Thus, §1250 is a partial recapture provision.MACRS Recapture Exception for Real PropertySince residential real property in the 27.5-year class and nonresidential realproperty in the 31.5 or 39 year class is depreciable only under straight-line,

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MACRS real property is not subject to recapture.Alternative Depreciation System - §168(g)Mandatory ApplicationDepreciation must be calculated under the alternative depreciation system inthe case of:(a) Any tangible property that is used predominantly outside the UnitedStates,(b) Any tax-exempt use (of more than 35% of the property) and taxexemptbond financed property,2-157(c) An election to apply the alternative depreciation system to all propertyin a class placed in service during the taxable year, andComment: A property-by-property election can be made in the case of nonresidentialreal property or residential rental property. The election oncemade is irrevocable.(d) The alternative minimum tax to determine the portion of depreciationtreated as a tax preference item.MethodUnder the alternative depreciation system recovery periods are:(a) The ADR midpoint life for property that does not fall into any of theclasses listed below,(b) Five years for qualified technological equipment, automobiles, andlight-duty trucks,(c) Twelve year for personal property with no class life, and(d) Forty years for all residential rental property and all nonresidentialreal property.

AmortizationAmortization is the method of writing off costs that benefit more than one accountingperiod over the benefit period or some period set by the IRS. Thesecosts are usually thought of as intangible but certain tangible property such asleasehold improvements is amortizable.Costs Eligible for AmortizationGenerally the cost or investment must have an ascertainable value and have alimited useful life that can be determined with reasonable assurance or have anamortization life set by the IRS as a time period or a percentage of revenue suchas depletion.Trademarks & Trade Names - §167(r)No amortization or depreciation deduction is allowed for any trademark ortrade name expenses.Methods & Periods for Amortization

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Methods and periods for amortization vary, but generally, useful life must bedemonstrated and used unless otherwise specified.2-158Partnership & Corporate Organization Costs - §709 & §248Organization costs usually include expenditures made in preparation forstarting a business such as legal fees, financial planning for the perspectivebusiness and other costs incurred before business commences. These costsare essentially amortizable over 180 months. Taxpayers have to elect to amortizethem and failure to elect will prevent the write off.Business Start-Up Costs - §195In general, start-up costs must be capitalized subject to an election to amortizesuch costs over a period of 15 years. A start-up cost is any amount paidor incurred in connection with:(a) Investigating the creation of or acquisition or establishment of an activetrade or business,(b) Creating an active trade or business, or(c) Any activity engaged in for profit and for the production of incomebefore the day the active trade or business begins, in anticipation of thatactivity becoming an active trade or business.Depletion - §613Depletion can be taken on exhaustible natural deposits and timber based onits cost or basis times the amount used or exhausted divided by the amountavailable. This is termed cost depletion.Percentage depletion is calculated on a specified percentage of gross incomefrom the property, but can never exceed 50% of taxable income before depletion.Virtually all mineral deposits qualify for percentage depletion. The tables forspecified percentages for the various minerals are included in §613(b) & Reg.§1.613-2(b).Other AssetsOther assets may be amortizable such as:(a) Franchise fees,(b) Customer lists if life can be determined,(c) Bond premiums and discounts,(d) Circulation costs,(e) Commitment fees for loans and closing costs,(f) Covenants not to compete, and(g) Construction period interest.2-159

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. The

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following questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.107. Taxpayers are required to compute their taxable income on the basis oftheir taxable year. What is the taxable year when the taxpayer fails to keepany books?a. the 52-53 week year.b. the calendar year.c. the fiscal year.d. the short period year.108. Personal service corporations may make a §444 election. This electionallows them to use a tax year other than:a. an established business year.b. the traditional calendar year by more than four months.c. a fiscal year.d. the mandatory tax year.109. The author lists five examples of §1245 property qualified for the §179election. Which of the following property is included in the list?a. air conditioning or heating units.b. railroad grading or tunnel bore.c. property used predominately to furnish lodging.d. real property, including buildings and their structural components.2-160110. The mid-quarter depreciation convention must be used if a taxpayerplaces property in service during the last three months of the year and:a. these assets’ total basis is in excess of 40% of the basis of all assets.b. the cost of residential property is included.c. the taxpayer elected out of the half-year convention.d. the cost of property acquired and sold in the same year is included.111. The alternative depreciation system (ADS) must be used for certaintypes of property. When must a taxpayer calculate depreciation using ADS?a. to find depreciation for 25% or more tax-exempt use property.b. to find depreciation of any financed property.

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c. to find depreciation of any intangible property used outside the NorthAmerican area.d. to find the portion of depreciation treated as a tax preference item forthe alternative minimum tax.112. The cost of certain assets must be deducted over the multiple accountingperiods which are deemed to benefit from the asset. What term is used to definethis method of writing off asset costs?a. amortization.b. cost recovery.c. depreciation.d. expensing.

Answers & Explanations107. Taxpayers are required to compute their taxable income on the basis oftheir taxable year. What is the taxable year when the taxpayer fails to keepany books?a. Incorrect. A 52-53 week year is an annual period which varies from 52 to53 weeks and ends always on the same day of the week and ends: On the datesuch same day of the week last occurs in a calendar month, or On the datesuch same day of the week falls which is nearest the last day of a calendarmonth.b. Correct. A taxpayer's taxable year is the calendar year if the taxpayer doesnot keep any books. A calendar year is a period of twelve months ending onDecember 31.c. Incorrect. A fiscal year is a period of twelve months ending on the last dayof any month other than December.2-161d. Incorrect. A short period return is a return for a period of less than twelvemonths and may be filed when the taxpayer with the approval of the Secretary,changes their annual accounting period. [Chp. 2]108. Personal service corporations may make a §444 election. This election allowsthem to use a tax year other than:a. Incorrect. This election does not apply to any personal service corporationthat establishes a business purpose for a different period.b. Incorrect. Even when made, the §444 election only permits at most athree-month variation from the required taxable year.c. Incorrect. Other than pursuant to a §444 election or special business purposeyear, a personal service corporation may not use a fiscal year.d. Correct. Personal service corporations may elect to use a tax year that is

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different from the required tax year under §444. [Chp. 2]109. The author lists five examples of §1245 property qualified for the §179election. Which of the following property is included in the list?a. Incorrect. Section 1245 property eligible for the §179 election includestangible personal property except heating or air-conditioning units.b. Correct. Section 1245 property eligible for the §179 election includes anyrailroad grading or tunnel bore.c. Incorrect. The §179 deduction cannot be claimed on the cost of propertyused predominately to furnish lodging or in connection with the furnishing oflodging.d. Incorrect. The §179 deduction cannot be claimed on the cost of real property,including buildings and their structural components. [Chp. 2]110. The mid-quarter depreciation convention must be used if a taxpayer placesproperty in service during the last three months of the year and:a. Correct. Taxpayers must use a mid-quarter convention in the first and lastyear of the recovery period, instead of a half-year convention, if they placeproperty, including cars, in service during the last 3 months of their tax year,and the total basis of these assets is more than 40% of the total basis of allproperty placed in service during the entire year.b. Incorrect. In determining the total cost of property placed in service duringthe year, residential rental and nonresidential real property is disregarded.c. Incorrect. The half-year convention must be used unless the taxpayer is requiredto use the mid-quarter convention (§168(d)(4)(A)).d. Incorrect. The taxpayer can elect to disregard any property acquired anddisposed of within the same year (§168(d)(3)). [Chp. 2]111. The alternative depreciation system (ADS) must be used for certain typesof property. When must a taxpayer calculate depreciation using ADS?2-162a. Incorrect. Depreciation must be calculated under the alternative depreciationsystem in the case of any tax-exempt use of more than 35% of the property.b. Incorrect. Depreciation must be calculated under the alternative depreciationsystem in the case of tax-exempt bond financed property.c. Incorrect. Depreciation must be calculated under the alternative depreciationsystem in the case of any tangible property that is used predominantlyoutside the United States.d. Correct. Depreciation must be calculated under the alternative depreciationsystem in the case of the alternative minimum tax to determine the portion

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of depreciation treated as a tax preference item. [Chp. 2]112. The cost of certain assets must be deducted over the multiple accountingperiods which are deemed to benefit from the asset. What term is used todefine this method of writing off asset costs?a. Correct. Amortization is the method of writing off costs that benefit morethan one accounting period over the benefit period or some period set by theIRS.b. Incorrect. The cost of property is recovered by taking deductions for thecost over a set period of years using depreciation.c. Incorrect. Depreciation is a decrease in the value of property due to theexhaustion, wear and tear, and obsolescence of an asset used in a trade orbusiness or for the production of income.d. Incorrect. Under §179, taxpayers can elect to deduct all or part of an asset’scost in one year (i.e., expense the item) rather than taking depreciationdeductions spread over several years. [Chp. 2]

Learning ObjectivesAfter reading the next chapter, participants will be able to:1. Distinguish sales of property and easements from exchanges and differentiatecapital gain form ordinary income tax treatment on propertydispositions.2. Outline the key elements of the §121 home sale exclusion explainingits application particularly the three proration safe harbors.2-1633. Demonstrate the importance of the installment method, locate atleast three §453 requirements, and define basic §453 terminology.4. Identify the variables that determine which §1038 rules apply, outlinedistinctions between personal and real property repossessions, anddetermine when a bad debt deduction may be taken on a repossession.5. Explain the tax treatment of a §1033 involuntary conversion by:a. Defining related terminology and the tax consequences of receivinga condemnation award or severance damages;b. Figuring gain or loss from condemnations and directing clientsabout the reporting of involuntary conversion payments; andc. Determining whether clients can postpone gain on condemned,damaged, destroyed, or stolen property and discussing the relatedparty rule.6. Determine the scope of the §465 at-risk rules and their effect onproperty depreciation, and outline the requirements, mechanics, andtypes of §1031 like-kind exchange.7. Compare and contrast qualified deferred compensation plans andnonqualified plans by:a. Identifying the major benefit of the qualified deferred plans and

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explaining the basis of the benefits and contributions enabling theclient to choose plan type and benefit; andb. Explaining the current and deferred advantages and disadvantagesof corporate plans while warning of fiduciary responsibilitiesand prohibited transactions.8. Describe the requirements of the three basic forms of qualified pensionplans permitting clients to compare and contrast such plans.9. Compare defined contribution and defined benefit plans, differentiateamong five types of defined contribution plans, and describe theireffect on retirement benefits.10. Contrast self-employed plans with qualified plans used by otherbusiness types identifying key choice of entity factors, and describe therequirements of IRAs and Roth IRAs.11. Define SEPs and SIMPLEs identifying the mechanics and eligibilityrequirements of each.After studying the materials in this chapter, answer the exam questions113 to 171.3-1

CHAPTER 3Property Transfers & Retirement PlansSales & Exchanges of PropertyA transaction must be a sale or exchange for any gain on it to be taxable or anyloss to be deductible.A sale is a transfer of property for money or for a mortgage, note, or some otherpromise to pay money. An exchange is a transfer of property for other propertyor services1.Sale or LeaseSome agreements that seem to be leases may really be conditional sales contracts.The intention of parties to the agreement can help distinguish between asale and lease.There is no test or group of tests to prove what the parties intended when theymade the agreement. Each agreement should be considered based on its ownfacts and circumstances.Easements

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Granting or selling an easement is usually not a taxable sale of property. Instead,the amount received for the easement is subtracted from the basis of the property.1 A transfer of property to satisfy a debt is a taxable exchange.3-2If only a part of the entire tract of property is permanently affected by the easement,only the basis of that part is reduced by the amount received.If it is impossible or impractical to separate the basis of the part of the propertyon which the easement is granted, the basis of the whole property is reduced bythe amount received.Any amount received that is more than the basis to be reduced is a taxable gain.Capital Gains & LossesA gain from selling or trading stocks, bonds, investment property, or other capitalassets may be taxed or it may be tax free, at least in part. A loss may or maynot be deductible.Capital Assets - §1221Everything is a capital asset except:(1) Property held mainly for sale to customers or property that will physicallybecome a part of the merchandise that is for sale to customers,(2) Accounts or notes receivable acquired in the ordinary course of atrade or business, or for services rendered as an employee, or from thesale of any of the properties described in (1),(3) Depreciable property used in a taxpayer's trade or business (eventhough fully depreciated),(4) Real property used in a taxpayer's trade or business,(5) A copyright, literary, musical, or artistic composition, letter or memorandum,or similar property:(a) Created by a taxpayer's personal efforts,(b) A letter, memorandum, or similar property prepared or producedfor the taxpayer, or(c) Acquired from a person who created the property, or for whom theproperty was prepared, under circumstances entitling a taxpayer to thebasis of the person who created the property, or for whom it was preparedor produced (for example, by gift), and(6) U.S. Government publications that a taxpayer got from the governmentfor free or for less than the normal sales price or that a taxpayer acquiredunder circumstances entitling them to the basis of someone whogot the publications for free or for less than normal sales price, if the taxpayer

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sells, exchanges , or contributes the publication.3-3Capital Gain RatesThe TRA ‘97 initially lowered capital gains rates for individuals and the rateswere lowered again in 2003. As a result, the typical maximum rate on the adjustednet capital gain of an individual is 15%.Note: “Adjusted net capital gain” is the net capital gain determined withoutregard to certain gain for which a higher maximum rate of tax is established.However, a high maximum rate of 28% is provided for:(1) Net long-term capital gain attributable to the sale or exchange of collectibles,and(2) Certain small business stock to the extent the gain is included in income.Likewise, a maximum rate of 25% exists for the long-term capital gain attributableto depreciation from real estate held more than 12 months. In addition,lower rates of 10%, 5%, and even zero apply to the gain for certainlower income individuals.Holding Periods - (§1222 & §1223)Property held more than one year (rather than more than 18 months) is eligiblefor the lower capital gain rates.Note: With long-term capital gains rates available for investments held morethan 12 months, tax-planning strategies that produce capital gains instead ofordinary income will certainly accelerate. Ordinary income can be subject to35% rate (in 2009) while capital gains may only pay 20%.Holding periods are measured by months not days. In addition, the holdingperiod starts one day after the asset is acquired, and ends the day the asset isdisposed.The holding period of property acquired from a decedent starts at the date ofdeath. The holding period for a surviving spouse’s share of community propertythat was acquired during the marriage vests to the survivor at the time ofdecedent’s acquisition. The holding period for the deceased spouse’s share ofthe community property which is inherited by the surviving spouse starts atthe date of the deceased spouse’s death.If the property acquired from a decedent is sold within the short-term capitalgain period, after the decedent’s death the sale is considered long term if:(a) The person who sells the property has a basis determined under §1014(fair market value on date of death or alternative valuation date), or(b) The property is sold or disposed of within one year after the decedent’sdeath.3-4Example

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Tom and Sarah acquired a four-bedroom house in Sunnyvale,California in 1975, which they held as a rental. Their totalcost was $25,000. Tom passed away in November 2007.Sarah sold the rental in April 2008 for $400,000. The holdingperiod for the gain for Sarah’s community property sharewould be 1975; for the part she inherited from Tom, the holdingperiod would start at Tom’s death in November 2007. Hergain would be considered long term for the entire property asnoted above.The holding period for property acquired by gift is determined by its ultimatedisposition. Property held or sold at a gain retains the same basis and holdingperiod as that of the donor. Property sold at a loss that is based on the marketvalue at the time of the gift is considered to acquire the gift’s date for thebeginning of its holding period.ExampleAlex received a gift of 10,000 shares of IBM that his grandfathergave him in November 2008. If the market value of IBMis $100 per share on that date and Alex sells those shares sixmonths later for $110 he will have a gain based on his grandfather’sholding period and basis. If, on the other hand, hesells the stock at $95 per share, he will have a short-termloss, since the value at the date of the gift was $100 pershare.Capital Losses - §1211Capital loss deductions are limited to the lower of:(a) The amount of the loss, or(b) $3,000 ($1,500 for married individuals filing separately).Business PropertySection 1231 “property” is property held in a trade or business that is held formore than one year. Gain from the sale of §1231 property is taxed as follows:(1) Gain in excess of accumulated depreciation is taxed as a capital gain(calculated on Form 4797 and carried over to schedule D),(2) Gain up to the amount of accumulated depreciation is taxed as ordinaryincome under provisions of §1245 and §1250 (reported on Form4797), then3-5(3) Gain equal to “nonrecaptured net 1231 losses” is taxed as ordinary income.Note: Nonrecaptured net 1231 losses are defined as the net §1231 loss forthe 5 most recent preceding tax years which have not had a net section 1231gain in an intervening tax year (§1231(c)(2)).Basis of PropertyIn order to accurately compute the gain or loss on a sale of personal property,its basis must be determined.Cost Basis = Amount paid plus fair market value of any assets transferred

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plus:(1) Sales taxes,(2) Freight,(3) Installation, and(4) Testing charges (§1012).Real estate cost basis includes abstract fees, surveys, title and escrow charges,title insurance, utility installation charges, and seller expenses that a buyerpays. These non-recurring acquisition costs are added to the property basisand depreciated where applicable.Basis AdjustmentsAdditions to basis:(1) Improvements (not repairs),(2) Legal fees-title challenges, and(3) Assessments for improvements (streets, sidewalks, sewers).Basis reductions:(1) Depreciation (MACRS, ACRS)(2) §179 expense deductions (for personal property only)(3) Casualty or theft losses (deductible portion), and(4) Easements (note: if the amount received for an easement is greaterthan the basis, a capital gain must be recognized.)Property Received as a GiftThe donee’s basis is equal to the donor’s basis except when the doneesells the property in a taxable transaction at a later date. If such sale resultsin a loss, the donee’s basis is the lower of the donor’s basis or the fairmarket value of the property on the date of the gift. Basis is increased bya portion of any gift tax paid, depending on whether the gift was receivedbefore or after 1977.3-6ExampleMom gives her daughter a gift of 200 shares of AT&T stockworth $30 a share. The stock cost Mom $50/share. Thedaughter sells the AT&T stock for $25 per share six monthslater. The daughter’s loss is $30 (FMV) - $25 (sales price) x200 shares = $1000. If the daughter had sold the 200 sharesfor $60 per share, her gain would have been $60 (sales price)- $50 (Mom’s basis) x 200 shares = $2000.Property Received by InheritanceThe basis of inherited property is usually the fair market value at the dateof decedent’s death.Changes in Property UsageAfter a change in property usage, the basis for depreciation is the lowerof:(1) Fair market value of property on the date of change, or(2) Cost of property plus additional adjustments, improvements, assessments,etc.

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Basis for gain on sale is the original cost plus or minus basis adjustments.For loss on sale, basis is the depreciable basis.Stocks & BondsThe basis of stocks and bonds is determined by the method of acquisition;i.e. purchase, gift, or inheritance. Four situations require adjustments tothis general rule:1. Stock Dividends & SplitsIn the case of a stock dividend or split, the basis of the old stockmust be adjusted over the total shares.ExampleXYZ Corporation declares a 25% stock dividend. ShareholderA has 100 shares of XYZ Corp. stock with a basis of $10 pershare. After the stock dividend of 25 shares, A must now allocatehis basis of $1,000 over 125 shares or $8 per share.2. Non Taxable DistributionsA receipt of a non-taxable distribution results in a reduction of thebasis of the stock or bond.3. Mutual Funds3-7Sales of mutual fund shares are among the most time-consuming andconfusing areas that tax practitioners encounter. Frequently, thedata needed regarding dividends automatically reinvested and sharesredeemed is unavailable or misplaced. Those distributions that areautomatically reinvested must be added to the basis of the fund.Shares of the fund redeemed reduce the basis. Unless specificallydesignated, shares sold are considered to have been sold from thefirst lot acquired (FIFO). A taxable event occurs when shares aresold, redeemed, or exchanged.Note: To avoid FIFO basis of shares sold taxpayers must designate specificmutual fund shares being sold to the agent-broker for confirmationnotice requirements. Taxpayers can elect to determine the basis by usingone of two averaging methods, but only on a timely basis. (Joseph E.Hall, 92 TC No. 64)4. Wash Sales - §1091Losses on the sale of stock or securities are not deductible if the taxpayeracquires stock or securities that are substantially identicalwithin 30 days before the date of sale and 30 days after the date ofsale (total 61 day time period). The same rule prevails regarding options.ExampleJohn purchases 100 shares of XYZ stock for $10 per shareon June 1, 2007. John sells 100 shares of XYZ stock for $5each on December 30, 2006. John purchases 100 shares ofXYZ stock on January 10, 2008 at $6 each. John’s $500 lossfor 2007 is disallowed because he purchased substantiallyidentical stock within 30 days of the sale. Had John purchasedthe stock on January 31 2008, this loss would havebeen allowed.Tax law requires recognition of gain (but not loss) upon a constructivesale of any appreciated position in stock, a partnership interest,

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or certain debt instruments. A constructive sale occurs when a taxpayerenters into a short sale, an offsetting notional principal contract,or certain other transactions.Note: In effect, this provision eliminates “short-against-the-box” sales,notional principal contracts, and future and forward contracts to deferthe recognition of gain.3-8

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.113. For any property gain to be taxable or loss to be deductible, the propertymust:a. be mortgaged.b. appreciate or depreciate.c. be transferred.d. be sold or exchanged.114. Basis must be figured prior to calculating gain or loss on a sale of property.What is an addition to basis?a. depreciation.b. easements.c. legal fees-title challenges.d. §179 expense deductions.115. According to the author, which of the following property disposition issuesis one of the most time-consuming areas for tax practitioners?a. stocks received as a gift.b. sales of mutual funds.

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c. stock dividends and splits.d. wash sales.3-9116. Under §1091, a taxpayer cannot deduct a loss on a sale of stock or securitywhen, within 30 days of the sale, similar stock or securities are purchased.Which of the following is also subject to the wash sale rule?a. exchanges of stock for stock.b. stock or securities acquired by gift.c. stock or securities acquired by option.d. stock acquired incident to divorce.

Answers & Explanations113. For any property gain to be taxable or loss to be deductible, the propertymust:a. Incorrect. Financing or mortgaging a property is not an event triggeringgain or loss.b. Incorrect. Property appreciation or depreciation does not trigger taxablegain or loss. A taxable disposition as required to make realized gain or lossrecognizable.c. Incorrect. A property transfer does not necessarily trigger taxable gain orloss. For example, when property is transferred by gift no gain or loss is triggered.d. Correct. Property must be sold or exchanged for any gain to be taxable orloss deductible. In short, there must be a taxable disposition under §1001.[Chp. 3]114. Basis must be figured prior to calculating gain or loss on a sale of property.What is an addition to basis?a. Incorrect. Basis reductions include depreciation (MACRS, ACRS).b. Incorrect. Basis reductions include easement transfers. If the amount receivedfor an easement is greater than the basis, a capital gain must be recognized.c. Correct. Additions to basis include: improvements, legal fees-title challenges,and assessments for improvements.d. Incorrect. Basis reductions include §179 expense deductions (for personalproperty only). [Chp. 3]115. According to the author, which of the following property disposition issuesis one of the most time-consuming areas for tax practitioners?a. Incorrect. The general rule for figuring basis of stocks and bonds is basedon the method of acquisition. In this case, the donee’s basis is equal to the3-10donor’s basis. No adjustments are required for these stocks. This is relatively

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clear-cut.b. Correct. Sales of mutual fund shares are among the most time-consumingand confusing areas that tax practitioners encounter. Frequently, the dataneeded regarding dividends automatically reinvested and shares redeemed isunavailable or misplaced.c. Incorrect. Stock dividends and splits require adjustments to the generalrule for determining basis, but these are relatively easy to figure, as shown inthe example in the course material.d. Incorrect. These sales are fairly straightforward. In effect, this provisioneliminates “short-against-the-box” sales, notional principal contracts, and futureand forward contracts to defer the recognition of gain. [Chp. 3]116. Under §1091, a taxpayer cannot deduct a loss on a sale of stock or securitywhen, within 30 days of the sale, similar stock or securities are purchased.Which of the following is also subject to the wash sale rule?a. Incorrect. The §1091 wash sale rule does not apply to stock or securitiesacquired in an exchange of stock for stock.b. Incorrect. The §1091 wash sale rule does not apply to stock or securitiesacquired by gift.c. Correct. The wash sale rule applies to stock acquired by option.d. Incorrect. The §1091 wash sale rule does not apply to stock or securitiesacquired incident to divorce. [Chp. 3]3-11Sale of Personal Residence - §121The rules for gains on the sale of a personal residence under old §121 and §1034were replaced by the TRA ‘97 with a $500,000 exclusion for joint filers ($250,000for single filers), effective generally for sales after May 6, 1997. This exclusioncan be used once every two years.Note: This exclusion does not apply to any gain attributable to depreciationdeductions taken in connection with the rental or business use of the propertyfor periods after May 6, 1997.Under prior law, no gain was recognized on the sale of a principal residence if anew residence at least equal in cost to the sales price of the old residence waspurchased and used by the taxpayer as his or her principal residence within aspecified period of time (§1034). This replacement period generally began two

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years before and ended two years after the date of sale of the old residence. Thebasis of the replacement residence was reduced by the amount of any gain notrecognized on the sale of the old residence by reason of this gain rollover rule.In addition, under prior law, an individual, on a one-time basis, could excludefrom gross income up to $125,000 of gain from the sale or exchange of a principalresidence if the taxpayer:(1) Had attained age 55 before the sale, and(2) Had owned the property and used it as a principal residence for three ormore of the five years preceding the sale (old §121).Two-Year Ownership & Use RequirementsThe new exclusion requires a taxpayer to have owned and used the propertyas his or her principal residence for at least two years during the five-year periodending on the date of the sale or exchange. The exclusion is allowed eachtime a taxpayer who sells or exchanges a principal residence meets the eligibilityrequirements, but no more often than once every two years.Married couples filing a joint return are entitled to a $500,000 exclusionwhere:(1) Either spouse meets the ownership requirement,(2) Both spouses meet the use requirement, and(3) Neither spouse has had a sale in the preceding two years subject to theexclusion.Married couples not sharing a principal residence, but filing a joint return,are each entitled to a $250,000 exclusion. In addition, single taxpayers whomarry a taxpayer who has used the exclusion within two years are allowed a$250,000 exclusion.Note: Once both spouses satisfy the eligibility requirements and two yearshave passed since the last exclusion was allowed to either spouse, a full3-12$500,000 exclusion is available for the next sale or exchange of their principalresidence.Tacking of Prior Holding PeriodIf a taxpayer acquired their residence in a transaction covered by theprior rollover rules, the periods of ownership and use of the prior residencecount in determining ownership and use of the current home.Prorata ExceptionA taxpayer may be entitled to a pro rated exclusion if they fail to meet eithertwo-year requirement because of a change in:(a) Place of employment,(b) Health, or(c) Other unforeseen circumstances.Under this prorata exception, the exclusion is a ratio of:

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(a) The aggregate amount of time the taxpayer owned and used theproperty as his or her principal residence during the five-year period,or, if shorter, the amount of time since the most recent prior sale towhich the exclusion applied, to(b) Two years.ExampleDan and his spouse purchased and occupied a home in LosAngeles. One year later, his employer transfers Dan to Orlandoand the family moves. Dan sells the family home for a$300,000 gain. Since the time Dan and his spouse spent inthe home is only one-half the required two years, the gain eligiblefor exclusion is one-half the exclusion otherwise allowed,or $250,000.Limitations on ExclusionAdditional limitations apply to the exclusion, including:(1) Taxpayers can elect not to have the exclusion apply;(2) Certain periods an individual resides in a nursing home count underthe two-year use requirement;(3) Periods a deceased spouse owned and used the property before deathcount under the two-year requirements;(4) An individual is held to use property as his or her principal residenceduring any period of ownership while the individual’s spouse or formerspouse is granted use of the property under a divorce or separation instrument;and3-13(5) For stock co-ops, the ownership requirement applies to the holding ofsuch stock and the use requirement is applied to the house or apartmentthe taxpayer is entitled to occupy as a stockholder.Reduced Home Sale ExclusionStarting 2009, gain from the sale or exchange of a principal residence allocatedto periods of nonqualified use is not excluded from gross income.The provision is designed to prevent §121 usage on appreciation attributableto periods after 2008 where a residence was a rental property or avacation home before being a principal residence.Computation. The amount of gain allocated to periods of nonqualifieduse is the amount of gain multiplied by a fraction the numerator of whichis the aggregate periods of nonqualified use during the period the propertywas owned by the taxpayer and the denominator of which is the periodthe taxpayer owned the property. Nonqualified use does not includeany use prior to 2009.Note: The provision does not require a market appraisal of the property onJanuary 1, 2009 nor when use is converted to a principal residence but,rather determines the excluded appreciation on a pro rata basis over time.Nonqualified use. A period of nonqualified use means any period (not includingany period before January 1, 2009) during which the property is

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not used by the taxpayer or the taxpayer's spouse or former spouse as aprincipal residence. For purposes of determining periods of nonqualifieduse, the following are not taken into account:(1) any period after the last date the property is used as the principalresidence of the taxpayer or spouse (regardless of use during that period),and(2) any period (not to exceed two years) that the taxpayer is temporarilyabsent by reason of a change in place of employment, health, or, tothe extent provided in regulations, unforeseen circumstances.Post-May 6, 1997 depreciation. If any gain is attributable to post-May 6,1997, depreciation, the exclusion does not apply to that amount of gain,as under present law, and that gain is not taken into account in determiningthe amount of gain allocated to nonqualified use.Surviving Spouse Home Sale ExclusionFor sales after 2007, the maximum exclusion on the sale of a main home byan unmarried surviving spouse is $500,000 if the sale occurs no later than 2years after the date of the other spouse's death. However, this rule appliesonly if the requirements for joint filers relating to ownership and use weremet immediately before the date of such death, and during the 2-year period3-14ending on the date of such death, there was no sale or exchange of a mainhome by either spouse which qualified for the exclusion.Installment Sales - §453An installment sale is a sale of property where a taxpayer receives at least onepayment after the tax year of the sale. In an installment sale the taxpayer reportspart of their gain when they receive each payment. Taxpayers cannot use the installmentmethod to report a loss. In addition, the installment sale rules do notapply to the regular sale of inventory.General RulesThe installment method is available for reporting income from the following:(1) Dispositions of personal property by a person who does not regularlysell or otherwise dispose of personal property on the installment plan,and(2) Disposition of real property that is not held by the taxpayer for sale tocustomers in the ordinary course of the taxpayer’s trade or business.The installment method for reporting dispositions of property applies automaticallyto all deferred payment sales unless the taxpayer elects not to havethe provisions apply with respect to a particular sale. The election is made byreporting an amount realized equal to the selling price on the face of the returnin the year of sale. In addition, the election once made, is irrevocable exceptwith IRS consent.

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The amount of any payment that represents income to the taxpayer is thatportion of the installment payment actually received in the year times thegross profit ratio. The gross profit ratio is the total gain divided by the contractprice.Dealer SalesThe installment method is not available for dealers in personal property withthese exceptions:(1) Dispositions of any property used or produced in the trade or businessof farming, and(2) Dispositions of certain timeshare rights and residential lots; howeverthe dealer must elect to pay interest on the amount of taxes deferred byinstallment reporting.Unstated InterestIf a sale calls for payments in a later year and the sales contract provides forlittle or no interest, unstated interest may have to be figured, even if there isa loss.3-15Related Parties - §453(e)If an installment sale is made to a related party who then makes a seconddisposition within two years of the first disposition and before all paymentsare made on the final disposition, part or all of the amount realized by theseller in the second disposition is treated as being received by the originalseller at the time of the second disposition.ExampleMrs. Smith sells her home to her daughter for $150,000. Thehome cost Mrs. Smith $50,000. Her daughter paid Mrs. Smith$20,000 and gave her a note for $130,000. The daughter immediatelysells the home to a third party for a single paymentof $150,000. There is no gain on the daughter’s sale, but thefamily unit has received the full selling price. Because of theresale rule, Mrs. Smith must recognize the entire gain on saleof the residence regardless of whether or not her daughtermakes payment on the original note.Related persons for this purpose include spouses, brothers and sisters, children,grandchildren, parents, a 50%-owned corporation, and partnerships,trusts, and estates that are related parties to a person under the general corporatestock ownership attribution rules.All payments to be received are considered received in the tax year in whichthe sale occurs in the case of an installment sale of depreciable property betweenrelated persons.Related persons for this purpose include:(1) Sales between a person and a controlled entity,(2) Sales between a taxpayer and a trust which has the taxpayer or his

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spouse as a beneficiary, unless the beneficiary’s interest is a remote contingentinterest, and(3) Sales between an employer and a welfare benefit fund controlled directlyor indirectly by the employer.3-16

Installment SalesHas taxpayer elected out ofthe installment method?Are marketable securitiesbeing sold?Is the property inventory?Is there a payment in yearafter sale?Is the taxpayer a dealer?Is there one payment afterthe year of sale?Is the sales price of theproperty more than$150,000?Installmentmethod isunavailableInstallmentmethodavailableInterest must be paid on deferred tax unless installment obligationsare less than $5 million at year end. If installment note is pledged ascollateral, proceeds are treated as a payment received.NOYESYESYESNONONONONONOYES

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YESYESYES3-17Disposition of Installment Notes - §453BIf an installment obligation is distributed, transmitted, or disposed of otherthan by sale, exchange or satisfaction, gain or loss is recognized, making theentire profit still to be recognized taxable at once.Note: An installment obligation can be in the form of a deed of trust, note,land contract, mortgage, or other evidence of debt.The gain or loss is the difference between the basis of the obligation and itsfair market value at the time of its disposition.Taxable dispositions include:(1) Gift,(2) Assignment to a trust by dissolving partnership, and(3) Transfer by an individual to an irrevocable trust.The following are not taxable dispositions:(1) The transmission of an installment obligation at death, and(2) Distribution in certain tax-free corporate reorganizations, liquidations,and contributions to the capital of a corporation or a partnership.Determining Installment IncomeEach payment on an installment sale usually consists of the following threeparts:(1) Interest income,(2) Return of adjusted basis in the property, and(3) Gain on the propertyIn each year a payment is received, the taxpayer must include the interestpart in income, as well as the part that is their gain on the sale. Taxpayers donot include in income the part that is the return of their basis in the property.Basis is the amount of the taxpayer's investment in the property for tax purposes.Note: If the taxpayer took depreciation deductions on the asset, they mayneed to recapture part of the gain on the sale as ordinary income.If the buyer assumes a mortgage that is more than the taxpayer's installmentsale basis in the property, the selling taxpayer recovers their entire basis. Theselling taxpayer is also relieved of the obligation to repay the amount borrowed.The part of the mortgage greater than the taxpayer's basis is treatedas a payment received in the year of sale.Use Form 6252 to report an installment sale in the year it takes place and toreport payments received in later years. Attach it to the tax return for eachyear3-18Installment Sale Worksheet

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Part I - Gross Profit1. Sales Price $________Less:2. Adjusted basis of property sold $________Less:3. Selling price $________Equals:4. Gross profit $________Part II - Contract Price5. Cash downpayment $________Plus:6. Fair market value of other property received $________Plus7. Face value of purchaser’s note $________Plus8. Excess of assumed mortgage over adjusted basis $________Equals:9. Contract price $________Part III - Gross Profit Percentage10. Divide item 4 by item 9 _____%Part IV - Payments Received in Year of Sale11. Cash downpayment $________Plus:12. Fair market value of other property received $________Plus:13. Principal payments on purchaser’s note $________Plus:14. Excess of assumed mortgage over adjusted basis $________Equals:15. Payments in year of sale $________Part V - Recognized Gain16. Payments received in year of sale (item 15) $________Times:17. Gross profit percentage (item 10) X_______Equals:18. Recognized gain $________3-19Pledge RuleIf a taxpayer uses an installment obligation to secure any debt, the net proceedsfrom the debt may be treated as a payment on the installment obligation.This is known as the pledge rule and it applies if the selling price of theproperty is over $150,000. It does not apply to the following dispositions:(1) Sales of property used or produced in farming,(2) Sales of personal-use property, and(3) Qualifying sales of time-shares and residential lots.

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Escrow AccountIn some cases, the sales agreement or a later agreement may call for thebuyer to establish an irrevocable escrow account from which the remaininginstallment payments (including interest) are to be made. These sales cannotbe reported on the installment method. The buyer's obligation is paid in fullwhen the balance of the purchase price is deposited into the escrow account.Note: If an escrow arrangement imposes a substantial restriction on the taxpayer'sright to receive the sale proceeds, the sale can be reported on the installmentmethod, provided it otherwise qualifies.Depreciation RecaptureIf a taxpayer sells property for which they claimed a depreciation deduction,they must report any depreciation recapture income in the year of sale,whether or not an installment payment was received that year.Like Kind ExchangeIf, in addition to like-kind property, a taxpayer receives an installment obligationin the exchange, the following rules apply:(1) The contract price is reduced by the FMV of the like-kind propertyreceived in the trade,(2) The gross profit is reduced by any gain on the trade that can be postponed,and(3) Like-kind property received in the trade is not considered payment onthe installment obligation.3-20

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.

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117. Current §121 replaced the rules for gains on the sale of a personal residenceunder §§1034 and old 121. Under current §121, who can be entitled toa $500,000 exclusion on the sale of their principal residence?a. a single taxpayer who marries a taxpayer who has used the exclusionwithin two years.b. married couples filing a joint return and using the property as theirprincipal residence for at least one year during a five-year period.c. married couples sharing a principal residence and filing a joint return.d. married couples who have sold a primary residence in the precedingtwo years.118. If a taxpayer fails to meet the home sales exclusion requirement, he maystill be entitled to a prorated exclusion. This exclusion may be available if thefailure to satisfy the requirements was due to:a. an uncooperative spouse.b. being on vacation.c. having an irresponsible tenant.d. an illness.119. Under §453, a portion of any gain must be reported when each installmentsale payment is received. If all other requirements are met under §453,when is the installment method available?a. When the property sold is not inventory.b. The entire purchase price will be received in the year of sale.c. The taxpayer is a dealer.d. There are marketable securities being sold.3-21120. Under §453B, if there is a disposition of an installment sale note, the fairmarket value of the obligation is subtracted from its basis to determine thegain or loss. However, which of the following dispositions is tax free?a. a gift.b. an individual’s transfer to an irrevocable trust.c. a transfer of an installment obligation at death.d. a transfer to a trust by a dissolving partnership.121. Three rules apply when a taxpayer receives an installment obligationalong with like-kind property in a §1031 exchange. What is one of these threerules?a. The taxpayer does not have to report any part of their gain.b. The contract price includes the fair market value of the exchanged likekindproperty.c. Any gain on the exchange that may be deferred reduces gross profit.

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d. The exchanged like-kind property is deemed a payment on the installmentobligation.122. Reg. §1.1038-1 and Reg. §1.1038-2 lay out the rules for repossessions.However, these rules vary depending on:a. whether the buyer willingly relinquished the property to the seller.b. whether the property title was transferred to the buyer.c. the type of property repossessed.d. whether the property was foreclosed on.

Answers & Explanations117. Current §121 replaced the rules for gains on the sale of a personal residenceunder §§1034 and old 121. Under current §121, who can be entitledto a $500,000 exclusion on the sale of their principal residence?a. Incorrect. A single taxpayer who marries a taxpayer who has used the exclusionwithin two years is allowed a $250,000 exclusion.b. Incorrect. Married couples who do not use the property as their principalresidence for at least two years during the five-year period ending on the dateof the sale or exchange do not meet the use requirement and therefore donot qualify for the full $500,000 exclusion.c. Correct. Married couples filing a joint return are entitled to a $500,000 exclusionwhere both spouses meet the use requirement.3-22d. Incorrect. Married couples filing a joint return are entitled to a $500,000exclusion where neither spouse has had a sale in the preceding two years subjectto the exclusion. [Chp. 3]118. If a taxpayer fails to meet the home sales exclusion requirement, he maystill be entitled to a prorated exclusion. This exclusion may be available ifthe failure to satisfy the requirements was due to:a. Incorrect. Having an uncooperative spouse does not entitle a taxpayer tothe exclusion. If one of three allowable reasons caused a taxpayer to fail tomeet the requirements, the exclusion would be allowed. However, this causedoes not fall into any of these categories.b. Incorrect. If a taxpayer goes on vacation for an extended period of time,long enough to fail to meet the use requirement, then the exclusion wouldstill be disallowed.c. Incorrect. If a taxpayer rents out a home and he failed to meet the use requirementfor this reason, he would still be disallowed the exclusion.

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d. Correct. One of the three reasons that may permit a taxpayer to take advantageof the exclusion even though he fails to meet the use and ownershiprequirements is if the failure is due to health reasons. [Chp. 3]119. Under §453, a portion of any gain must be reported when each installmentsale payment is received. If all other requirements are met under §453,when is the installment method available?a. Correct. The installment sale rules do not apply to the regular sale of inventory.b. Incorrect. The installment method is not available if the taxpayer receivesthe entire purchase price in the year of sale.c. Incorrect. The installment method is not available if the taxpayer is adealer. There are a few exceptions.d. Incorrect. The installment method is not available if there are marketablesecurities being sold. [Chp. 3]120. Under §453B, if there is a disposition of an installment sale note, the fairmarket value of the obligation is subtracted from its basis to determine thegain or loss. However, which of the following dispositions is tax free?a. Incorrect. Under §453B, taxable dispositions of installment notes includegifts.b. Incorrect. Under §453B, taxable dispositions of installment notes includetransfers by an individual to an irrevocable trust.c. Correct. Under §453B, the transmission of an installment obligation atdeath, and the distribution in certain tax-free corporate reorganizations, liquidations,and contributions to the capital of a corporation or a partnershipare not taxable dispositions of installment notes.3-23d. Incorrect. Under §453B, taxable dispositions of installment notes includeassignments to a trust by a dissolving partnership. [Chp. 3]121. Three rules apply when a taxpayer receives an installment obligation alongwith like-kind property in a §1031 exchange. What is one of these threerules?a. Incorrect. In a like-kind exchange, a taxpayer does not have to report anypart of their gain if they receive only like-kind property.b. Incorrect. If, in addition to like-kind property, a taxpayer receives an installmentobligation in the exchange, the contract price does not include thefair market value of the like-kind property received in the trade.c. Correct. If, in addition to like-kind property, a taxpayer receives an installmentobligation in the exchange, the gross profit is reduced by any gainon the trade that can be postponed.

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d. Incorrect. If, in addition to like-kind property, a taxpayer receives an installmentobligation in the exchange, like-kind property received in the tradeis not considered payment on the installment obligation. [Chp. 3]122. Reg. §1.1038-1 and Reg. §1.1038-2 lay out the rules for repossessions.However, these rules vary depending on:a. Incorrect. The repossession rules apply whether or not the buyer voluntarilysurrendered the property to the seller.b. Incorrect. The repossession rules apply whether or not title to the propertywas ever transferred to the buyer.c. Correct. The rules for repossession depend on the kind of property repossessed.The rules for repossessions of personal property differ from those forreal property.d. Incorrect. The repossession rules apply whether or not the property wasforeclosed on. [Chp. 3]Repossessions - §1038When, after making an installment sale, a seller repossesses their property fromthe buyer, the seller must figure:(1) Gain (or loss) on the repossession, and(2) Basis in the repossessed property (§1038; Reg. §1.1038-1).3-24The rules for doing this depend on the kind of property repossessed. The rulesfor repossessions of personal property differ from those for real property. Specialrules may also apply if the repossessed property was the seller’s principalresidence before the sale (Reg. §1.1038-1; Reg. §1.1038-2).The repossession rules apply whether or not title to the property was ever transferredto the buyer. Nor does it matter how the property was repossessed,whether foreclosed on or the buyer voluntarily surrendered the property to theseller. However, it is not a repossession if the buyer puts the property up for saleand the seller repurchases it (Reg. §1.1038-1(a)(3)).For the repossession rules to apply, the repossession must at least partially discharge(satisfy) the buyer’s installment obligation to the seller. The dischargedobligation must be secured by the property the seller repossesses. This requirementis met if the property is auctioned off after the seller forecloses and theseller applies the installment obligation to their bid price at the auction (Reg.§1.1038-1(a)(3)).

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The seller reports gain or loss from repossession on the same form used to reportthe original sale. If the seller reported the sale on Form 4797, Form 4797 isused to report the gain or loss on the repossession.Personal PropertyWhen sellers repossess personal property, they may have a gain or a loss onthe repossession. In some cases, they may also end up with a bad debt.To figure gain or loss, subtract the seller’s basis in the installment obligationand any expenses the seller has for the repossession from the fair marketvalue of the property. If the seller receives anything from the buyer in additionto the repossessed property, it is added to the property’s fair marketvalue before making this subtraction (§453B(f)(1)).The way the seller figures their basis in the installment obligation depends onwhether or not they reported the original sale using the installment method.The method the seller used to report the original sale also affects the characterof the gain or loss on the repossession.Non- Installment Method SalesBasis of Installment ObligationFor non-installment method sales, the seller’s basis in the installmentobligation is figured on its full face value or its fair market value at thetime of the original sale, whichever the seller used to figure their gainor loss in the year of sale. From this amount, all principal payments theseller has received on the obligation are subtracted. Any repossessionexpenses are added to the seller’s basis in the obligation. The result isthe seller’s basis in the installment obligation.3-25Note: If only a part of the obligation is discharged by the repossession,basis is figured only on that part.Gain or Loss on RepossessionIf the fair market value of the property repossessed is more than this total,the seller has a gain. Because the gain is gain on the installment obligation,it is all ordinary income. If the fair market value of the repossessedproperty is less than the total of basis plus repossession expenses,the seller has a loss. Because the loss is a loss on the installmentobligation, it is a bad debt loss. How the loss is deducted dependson whether the seller sold business or nonbusiness property in the originalsale (§166(d)(1); §453B(f)(1)).Installment Method SalesBasis of Installment ObligationFor installment method sales, the seller’s basis in the installment obligationis its face value at the time of repossession minus the unreportedprofit - i.e., gain the seller would report as income in the futureif they held the obligation to maturity (§453B(b); Reg. §1.453-1(d)).

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Note: If only a part of the installment obligation is discharged by therepossession, basis is figured only on that part.Gain or Loss on RepossessionThe gain or loss on repossession is the same character as the gain onthe original sale. If the seller had a long-term capital gain on the originalsale, they will have a long-term capital gain or loss on the repossession.If the seller’s original gain was ordinary, their gain or loss on therepossession is also ordinary (§453B(a)).The following worksheet can be used to determine the taxable gain orloss on a repossession of personal property reported on the installmentmethod.Worksheet1. Fair market value of property repossessed $___________2. Selling price $___________3. Minus: Payments made before repossession $___________4. Face value of obligation at time ofrepossession $___________5. Minus: Unrealized profit (amount on line 4times gross profit percentage) $___________3-266. Basis of obligation (amount on line 4 minusamount on line 5) $___________7. Gain or loss on repossession (amount online 1 minus amount on line 6) $___________8. Minus: Repossession costs $___________9. Taxable gain or loss on repossession $___________ExampleYou sold your piano for $1,500 in December 2008 for $300down and $100 a month (plus interest). The payments beganin January 2009. Your gross profit percentage is 40%.You reported the sale on the installment method on your2008 income tax return. After the fourth monthly payment,the buyer defaults on the contract and you are forced toforeclose on the piano. The fair market value of the piano onthe date of repossession is $1,400. The legal costs of foreclosureand the expense of moving the piano back to yourhome total $75. You figure your gain on the repossession asfollows:1) Fair market value of propertyrepossessed $1,4002) Selling price $1,5003) Minus: Payments made beforerepossession $7004) Face value of obligation at timeof repossession $8005) Minus: Unrealized profit (amount online 4 times gross profitpercentage) $3206) Basis of obligation (amount on line4 minus amount on line 5) $480

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7) Gain or loss on repossession (amounton line 1 minus amount on line 6) $9208) Minus: Repossession costs 759) Taxable gain or loss on repossession $845Basis of Repossessed Personal PropertyThe basis of the repossessed personal property is its fair market value atthe time of the repossession (Reg. §1.166-6(c)).3-27The fair market value of repossessed property is a question of fact to beestablished in each case. If the seller bids for the property at a lawful publicauction or judicial sale, its fair market value is presumed to be theprice it sells for, unless there is clear and convincing evidence to the contrary(Reg. §1.166-6).Bad DebtIf the installment obligation is not fully satisfied by the repossession, thesame circumstances that led the seller to repossess the property maymean that the seller cannot collect on the rest of the buyer’s debt to theseller. If the seller cannot collect, they may be able to take a bad debt deductionfor that part of the installment obligation. This rule also appliesto sales not reported under the installment method (§166).Real PropertyThe rules for repossessions of real property allow the seller to keep essentiallythe same adjusted basis in the repossessed property as they had beforethe original sale. The seller can recover this entire adjusted basis when theyresell the property. This, in effect, cancels out the tax treatment the sellerhad on the original sale, and puts them in the same tax position they were inbefore that sale (Reg. §1.1038-1).Thus, the full amount of any payments the seller already received from thebuyer on the original sale must be regarded as income to the seller. The sellerreports, as gain on the repossession, any part of those payments that they didnot yet include in their income, that is, the part that was regarded as a returnof adjusted basis rather than as gross profit (Reg. §1.1038-1(b)(1); Reg.§1.1038-1(c)(1)).ConditionsThe following rules are mandatory and must be used to figure basis in therepossessed real property and gain on the repossession. They applywhether or not the sale was reported on the installment method.However, they apply only if all of the below conditions are met:(1) The repossession must be to protect the seller’s security rights inthe property;(2) The installment obligation satisfied by the repossession must have

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been received in the original sale; and(3) The seller cannot pay any additional consideration to the buyer toget the property back, unless either:(a) The reacquisition and payment of the additional considerationwere provided for in the original contract of sale, or3-28(b) The buyer has defaulted, or default is imminent (Reg. §1.1038-1(a)(1); Reg. §1.1038-1(a)(3)(i)).Note: Additional consideration includes money and other property the sellerpays or transfers to the buyer. For example, additional consideration is presentif the seller reacquired the property subject to an indebtedness thatarose after the original sale (Reg. §1.1038-1(a)(3)(i)).If any of the three conditions is not met, the rules discussed earlier underpersonal property must be used, as if the property repossessed was personalrather than real property (Reg. §1.1038-1(a)(1); Reg. §1.1038-1(a)(3)).Figuring Gain on RepossessionThe seller’s gain on repossession is the difference between:(1) The total payments received, or considered received, on the sale, and(2) The total gain already reported as income (Reg. §1.1038-1(b)(1)(i)).Limit on Taxable GainThere is a limit on the amount of gain that is taxable. Taxable gain is limitedto the gross profit on the original sale, minus the sum of:(a) The gain on the sale seller reported as income before the repossession,and(b) The seller’s repossession costs.This method of figuring taxable gain, in essence, treats all payments theseller received on the sale as income, but limits total taxable gains to thegross profit the seller originally expected on the sale (Reg. §1.1038-1(c)(1)).Repossession CostsRepossession costs include money or property paid for the reacquisitionof the real property. This includes amounts paid to the buyer ofthe property as well as amounts paid to others for such items as courtcosts and legal fees. Repossession costs do not include the fair marketvalue of the buyer’s obligations to the seller that are secured by thereal property (Reg. §1.1038-1(c)(1)(iii); Reg. §1.1038-1(c)(4)).The following worksheet can be used to determine the taxable gain ona repossession of real property reported on the installment method.3-29Worksheet1. Payments received before repossession $___________2. Minus: Gain reported (amount on line 1times gross profit percentage) $___________3. Gain on repossession $___________4. Gross profit on sale $___________

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5. Gain reported (amount on line 2) $___________6. Plus: Repossession costs $___________7. Subtract amount on line 6 from amounton line 4 $___________8. Taxable gain (lesser of amount online 3 or 7) $___________ExampleYou sold a tract of land in January 2008 for $25,000. Youaccepted from the buyer a $5,000 downpayment, plus a$20,000 (9.5%) mortgage secured by the property and payableat the rate of $4,000 annually plus interest. The paymentsbegan on January 1, 2009. Your adjusted basis in theproperty was $19,000 and you reported the transaction asan installment sale. Your selling expenses were $1,000. Youfigured your gross profit as follows:Selling price $25,000Minus:Adjusted basis $19,000Selling expenses $ 1,000 $20,000Gross profit $ 5,000For this sale, the contract price equals the selling price.Therefore, the gross profit percentage is 20%. This is figuredby dividing the gross profit of $5,000 by the contract price of$25,000.In 2008, you included $1,000 in your income (20% of the$5,000 downpayment). In 2009, you reported profit of $800(20% of the $4,000 annual installment). In 2010, the buyerdefaulted and you repossessed the property. You spent $500in legal fees to get your property back. Your gain on the repossessionis figured as follows:Payments received ($5,000 + $4,000) $9,000Minus: Gain previously reported as3-30income ($1,000 + $800) $1,800Gain $7,200Not all of this gain is taxable. The limit on taxable gain is figuredas follows:Gross profit on original sale $5,000Minus:Gain previously reportedas income $1,800Repossession costs $500 $2,300Taxable gain on repossession $2,700Indefinite Selling PriceThe limit on taxable gain does not apply if the selling price is indefiniteand cannot be determined at the time of repossession. For example,a selling price that is stated as a percentage of the profits tobe realized from the buyer’s development of the property is an indefiniteselling price (Reg. §1.1038-1(c)(2)).Character of GainThe taxable gain on repossession is ordinary income or capital gain,the same as the gain on the original sale. However, if the seller did not

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report the sale on the installment method, the gain is ordinary income(Reg. §1.1038-1(d)).Basis of Repossessed Real PropertyThe basis of the repossessed property is determined as of the date of repossessionand is the sum of the seller’s:(1) Adjusted basis in the installment obligation,(2) Repossession costs, and(3) Taxable gain on the repossession (Reg. §1.1038-1(g)(1)).To figure the adjusted basis on the installment obligation at the time ofrepossession, subtract any unreported profit (the gain the seller would reportas income in the future if they held the obligation to maturity) fromits face value at the time of repossession. The face value of the obligationat the time of repossession is the selling price minus the payment received.The following worksheet can be used to determine the basis of real propertyrepossessed.3-31Worksheet1. Face value of obligation at time ofrepossession $___________2. Minus: Unreported profit (amounton line 1 times gross profit percentage) $___________3. Adjusted basis on date of repossession $___________4. Plus:Taxable gain on repossession $___________Repossession costs $___________5. Basis of repossessed real property $___________ExampleAssume the same facts as in the preceding example. Theface value of the installment obligation (the $20,000 note) is$16,000 at the time of repossession because the buyermade a $4,000 payment. The gross profit percentage on theoriginal sale was 20%. Therefore, $3,200 (20% of the$16,000 still due on the note) is unreported profit. You figureyour basis in the repossessed property as follows:Face value of obligation at time ofrepossession $16,000Minus: Unreported profit $3,200Adjusted basis on date of repossession $12,800Plus: Taxable gain on repossession $2,700Repossession costs $500 $3,200Basis of repossessed real property $16,000Holding Period for ResalesIf the seller resells the property they repossessed, the resale may result ina capital gain or a capital loss. To figure whether it is a long-term or ashort-term gain or loss, the holding period includes the period the sellerowned the property before the original sale plus the period after the repossession.

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It does not include the period the buyer owned the property(Reg. §1.1038-1(g)(3)). If the buyer made improvements to the reac3-32quired property, the holding period for these improvements begins on theday after the date of repossession (Reg. §1.1038-1(f)).Bad DebtIf the seller repossesses real property under these rules, they cannot takea bad debt deduction for any part of the buyer’s installment obligation.This is so even if the obligation is not fully satisfied by the repossession.If the seller already took a bad debt deduction before the tax year of repossession,they are considered to have recovered the bad debt when theyrepossessed the property. The amount of the bad debt deduction theseller took in the earlier year must be reported as income in the year ofrepossession. However, if any part of the earlier deduction did not serveto lower the seller’s tax, they do not have to report that part as income.The adjusted basis in the installment obligation is increased by theamount reported as income as a recovery of the bad debt (Reg. §1.1038-1(f)(2),(3); §111).Seller’s Former Home ExceptionIf a taxpayer sells their principal residence and excluded all or part of thegain under §121, then the rule for reporting repossessions of real property isinapplicable provided property is resold within one year from the date of reacquisition(§1038(e)). Under §1038(e), the seller does not have any gain orloss at the time of repossession. The resale of the property is treated as partof the original sale of such property.Repossession on Installment Sale Method - §1038Part IComputation of Gain on Original SaleConsideration Received1. Cash Down $___________2. Existing Encumbrance $___________3. Purchase Money Trust Deed $___________4. FMV of Other Property $___________5. Total Sale Price $___________Less:6. Expense of Sale $(__________)7. Adjusted Sales Price $___________Less:8. Adjusted Basis of Property $(__________)9. Realized Gain $___________Contract Price10. Down Payment (Line 1) $___________3-3311. Purchase Money Trust Deed (Line 3) $___________12. FMV of Other Property (Line 4) $___________13. Excess of Mortgage over Basis (Line 2 less 7 plus 8) $___________

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14. Total contract Price $___________Gross Profit Ratio15. Realized Gain (Line 9) $___________16. Divided by Contract Price (Line 14) $___________ = ________%Summary of Reported GainGross Profit ReportedPercentage Gain17. 20___ Initial Payments in Year of Sale2 $___________ _______% $___________18. 20___ Payments on Principal $___________ _______% $___________19. 20___ Payments on Principal $___________ _______% $___________20. 20___ Payments on Principal $___________ _______% $___________21. 20___ Payments on Principal $___________ _______% $___________22. 20___ Payments on Principal $___________ _______% $___________23. Total Payments Received $___________24. Total Gain Reported $___________Part IIComputation of Repossession Gain under General RuleAmounts Received with Respect to the Sale1. Total Amount Received Directly by Seller $___________2. Amount Received on Sale of Purchaser’s Indebtedness $___________3. Payments Made on Mortgage by Purchaser for Seller’s Benefit $___________4. Other Amounts _______________________ $___________5. Total Amount Received $___________Gain Returned As Income6. Gain Reported as Income (Part I, Line 24) $___________7. Gain Reported on Sale of Notes $___________8. Total Gain Reported $___________9. Gain Before Limitation (Line 5 less 8) $___________Limitation on Gain10. Sales Price (Part I, Line 5) $___________Less:11. Expenses of Sale (Part I, Line 6) $(__________)12. Adjusted Basis of Property (Part I, Line 8) $(__________)13. Net Gain Realized $___________Less:14. Reported Gain (Part II, Line 8) $___________15. Additional amounts Paid or TransferredUpon ReacquisitionsA. Payments to Purchaser or Other Persons $___________B. Payments to Reacquire Purchaser’s Notes $___________C. Assumption by Seller of Purchaser’s IndebtednessWhich Arose After Original Sale $___________2 Line 17 includes (1) cash down payment, (2) payments on principal during the year, (3) fairmarket value of other property, and (4) excess of mortgage over basis.3-34D. Advances by Seller on Indebtedness $___________E. Payments by Seller on Taxes, Insurance, Etc. $___________F. Foreclosure Costs, Legal Fees, Etc. $___________16. Total (Lines 14 through 15F) $___________17. Limitation of Gain3 (Line 12 less 16 - but not less than zero) $___________18. Gain on Repossession - Lesser of (A) or (B) $___________Part IIIDetermination of Basis For Reacquired Property

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1. Original Selling Price (Part I, Line 5) $___________Less:2. Existing Encumbrances (Part I, Line 2) $___________3. Contract Price $___________4. Payments Received (Part i, Line 23) $___________5. Unsatisfied Debt (Line 3 minus Line 4) $___________6. Reduction of Debt of Unreported Gain:A. Profit Ratio (Part I, Line 15) ______%7. Unreported Gain (Line 6A times Line 5) $___________8. Basis of Unsatisfied Debt (Line 5 less 7) $___________Increased By:9. Repossession Gain (Part III, Line 18) $___________10. Payments to Purchaser or Others $___________11. Payments to Reacquire Purchaser’s Notes $___________12. Assumption by Seller of Purchaser’s Indebtedness $___________13. Advances by Seller on Indebtedness $___________14. Payments by Seller on Taxes, Insurance, Etc. $___________15. Foreclosure Costs, Legal Fees, Etc. $___________16. Total (Line 9 through 15) $___________17. Basis of Repossessed Property (Line 8 plus 16) $___________Proof of BasisAdjusted Basis of Property (Part I, Line 8) $___________Add:Selling Expenses (Part I, Line 7) $___________Gain Previously Reported (Part II, Line 8) $___________Gain on Repossession (Part II, Line 18) $___________Additional Amounts Paid or Transferred(Part II, Line 15a - 15F) $___________Total $___________Less:Money and Property Received (Part II, Line 5) $(__________)New Basis $___________3 If Line 17 is a negative amount enter zero. As a result, Line 18 will also be zero.3-35

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,

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you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.123. For non-installment method sales, the seller’s basis in their note must bedetermined on repossession. What is added to the seller’s basis in the note tofigure this basis?a. all principal payments the buyer has paid on the obligation.b. any gain the seller would report as income in the future if they held theobligation to maturity.c. any repossession expenses.d. unreported profit.124. A seller’s basis in the installment obligation also must be determined inthe repossession of a property sold under the installment sales method.Based on §453, how is the seller’s basis figured in such an event?a. subtract principal payments made by the buyer from its full face valueat the time of the original sale.b. subtract the unreported profit from its face value at the time the propertyis repossessed.c. add repossession expenses to its fair market value at the time of theoriginal sale.d. add repossession expenses to the gain the seller would report as incomein the future if they held the obligation to maturity.3-36125. Under §166, if repossessing personal property fails to fully satisfy the obligationand the seller is unable to collect on the remainder amount, whatmay the seller be able to do?a. keep essentially the same adjusted basis in the repossessed property ashe had before the original sale.b. report, as a gain on the repossession, any part that was regarded as areturn of adjusted basis.c. take a bad debt deduction for that portion of the installment obligation.d. take a bad debt deduction for the entire installment obligation.126. When a seller repossesses real property from a buyer, they may recovertheir adjusted basis upon a resale. In such an event, under Reg. §1.1038-1(b)(1), how is the full amount of any payments received from the buyer onthe original sale treated?a. as condemnation proceeds.b. as a gain on the repossession.c. as a loss on the repossession.d. as income to the seller.127. Three conditions must be met to figure basis in the repossessed realproperty and gain on the repossession. What is one of these conditions?

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a. Upon repossession, the installment obligation is satisfied and is receivedin the latest sale.b. Repossessing the property ultimately protects everyone’s security rightsin the property.c. The seller pays any additional consideration that the buyer requires.d. The buyer may not receive any additional consideration from the sellerto get the property back, unless default is about to happen.128. Upon the resale of repossessed real property, a seller may have to reportcapital gain or loss. For these purposes, the combination of the time theseller owned the property prior to the original sale and the time following therepossession becomes?a. the exchange period.b. the identification period.c. the holding period.d. the replacement period.129. A taxpayer may sell her principal residence and exclude all or part of thegain under §121. Thus, the rule for reporting real property repossessions maybe inapplicable provided:a. she has gain at the time of repossession.b. she has loss at the time of repossession.3-37c. the resale is not treated as part of the original sale of the property.d. she resells the property within a year from the date of reacquisition.

Answers & Explanations123. For non-installment method sales, the seller’s basis in their note must bedetermined on repossession. What is added to the seller’s basis in the noteto figure this basis?a. Incorrect. All principal payments the seller has received on the obligationare subtracted from the seller’s basis in the installment obligation.b. Incorrect. The unreported profit is the gain the seller would report as incomein the future if they held the obligation to maturity minus repossessioncosts.c. Correct. Any repossession expenses are added to the seller’s basis in theobligation. The result is the seller’s basis in the installment obligation.d. Incorrect. The seller’s basis in the installment obligation is its face value atthe time of repossession minus the unreported profit. [Chp.3]124. A seller’s basis in the installment obligation also must be determined in therepossession of a property sold under the installment sales method. Based

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on §453, how is the seller’s basis figured in such an event?a. Incorrect. In non-installment method sales, the seller’s basis in the installmentobligation may be figured on its full face value at the time of the originalsale. From this amount, all principal payments the seller has received onthe obligation are subtracted.b. Correct. The seller’s basis in the installment obligation is its face value atthe time of repossession minus the unreported profit.c. Incorrect. The seller’s basis in the installment obligation may be figured onits fair market value at the time of the original sale. Any repossession expensesare added to the seller’s basis in the obligation.d. Incorrect. The seller’s basis in the installment obligation is the gain theseller would report as income in the future if they held the obligation to maturityminus repossession costs. [Chp. 3]125. A seller may repossess personal property from a buyer to satisfy an installmentobligation. Under §166, if repossessing personal property fails to fullysatisfy the obligation and the seller is unable to collect on the remainderamount, what may the seller be able to do?a. Incorrect. The rules for repossessions of real property allow the seller tokeep essentially the same adjusted basis in the repossessed property as hehad before the original sale.3-38b. Incorrect. The full amount of any payments the seller already receivedfrom the buyer on the original sale of real property must be regarded as incometo the seller. The seller reports, as gain on the repossession, any part ofthose payments that he did not yet include in their income, that is, the partthat was regarded as a return of adjusted basis rather than as gross profit.c. Correct. If the seller cannot collect on the rest of the buyer’s debt to theseller, he may be able to take a bad debt deduction for that part of the installmentobligation.d. Incorrect. It is implied that the seller has already collected some of thebuyer’s debt. This portion that has already been collected may not be used totake a bad debt deduction. [Chp. 3]126. When a seller repossesses real property from a buyer, they may recovertheir adjusted basis upon a resale. In such an event, under Reg. §1.1038-1(b)(1), how is the full amount of any payments received from the buyer onthe original sale treated?a. Incorrect. Condemnation proceeds would be under §1033 involuntary conversion

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not a §1038 repossession.b. Incorrect. Since the status quo has been restored with the repossession ofthe property, there is no capital gain on the full amount of the seller’s payments.c. Incorrect. When a seller repossesses personal property, they may have aloss on the repossession. There is no loss on the repossession of real property.d. Correct. The seller can recover the entire adjusted basis when they resellthe real property which, in effect, cancels out the tax treatment the seller hadon the original sale and puts the seller in the same tax position he was in beforethat sale. Thus, the full amount of any payments the seller already receivedfrom the buyer on the original sale is regarded as income to the seller.[Chp. 3]127. Three conditions must be met to figure basis in the repossessed real propertyand gain on the repossession. What is one of these conditions?a. Incorrect. If all other conditions are met, the installment obligation satisfiedby the repossession must have been received in the original sale.b. Incorrect. If all other conditions are met, the repossession must be to protectthe seller’s security rights in the property.c. Incorrect. If all other conditions are met, the seller cannot pay any additionalconsideration to the buyer to get the property back, unless the reacquisitionand payment of the additional consideration were provided for in theoriginal contract of sale.3-39d. Correct. If all other conditions are met, the seller cannot pay any additionalconsideration to the buyer to get the property back, unless the buyerhas defaulted, or default is imminent. [Chp. 3]128. Upon the resale of repossessed real property, a seller may have to reportcapital gain or loss. For these purposes, the combination of the time theseller owned the property prior to the original sale and the time followingthe repossession becomes?a. Incorrect. The term “exchange period” is a §1031 not a §1038 concept. Theexchange period begins on transfer of the relinquished property and ends onthe earlier of: (1) 180 days later or (2) the due date, including extensions, forthe exchangor’s tax return for the year in which the transfer of the relinquishedproperty occurs.

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b. Incorrect. The term “identification period” is a §1031 not a §1038 concept.The identification period starts the day the exchangor transfers the relinquishedproperty and ends 45 days later.c. Correct. If the seller resells the property they repossessed, the resale mayresult in a capital gain or a capital loss. To figure whether it is a long-term ora short-term gain or loss, the holding period includes the period the sellerowned the property before the original sale plus the period after the repossession.It does not include the period the buyer owned the property.d. Incorrect. The term “replacement period” is a §1033 not a §1038 concept.To postpone reporting gain from a condemnation the taxpayer must buy replacementproperty within a specified period of time. This is the “replacementperiod.” [Chp. 3]129. A taxpayer may sell her principal residence and exclude all or part of thegain under §121. Thus, the rule for reporting real property repossessionsmay be inapplicable provided:a. Incorrect. Under §1038(e), the seller does not have any gain at the time ofrepossession.b. Incorrect. Under §1038(e), the seller does not have any loss at the time ofrepossession.c. Incorrect. Under §1038(e), the resale of the property is treated as part ofthe original sale of such property.d. Correct. If a taxpayer sells her principal residence and excluded all or partof the gain under §121, then the rule for reporting repossessions of realproperty is inapplicable provided property is resold within one year from thedate of reacquisition (§1038(e)). [Chp. 3]3-40Involuntary Conversions - §1033An involuntary conversion (exchange) occurs when property is destroyed, stolen,condemned, or disposed of under the threat of condemnation, and other propertyor money is received in payment, such as insurance or a condemnationaward.Gain is not reported if property is involuntarily converted and property that issimilar or related in service or use to it is received. The basis for the new propertyis the same as the basis for the converted property. Thus, the gain on thecurrent transaction is deferred until a taxable sale or exchange occurs.CondemnationsCondemnation is the process by which private property is legally taken, without

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the owner’s consent, for public use. The federal government, a state government,a political subdivision, or a private organization that has the powerto legally take the property may take the property. The owner receives moneyor property in exchange for the taken property. A condemnation is like aforced sale, the owner being the seller and the condemning authority beingthe buyer.ExampleA local government authorized to acquire land for publicparks told Dan that it wished to acquire his property. After thelocal government took action to condemn Dan’s property, hewent to court to keep the property. However, the court decidedin favor of the local government. The government tookDan’s property and paid him an amount fixed by the court.This is a condemnation of private property for public use.Threat of CondemnationA taxpayer is under threat of condemnation if a representative of a governmentbody or a public official authorized to acquire property for publicuse tells the taxpayer that the government body or official has decidedto acquire their property. From this there are reasonable grounds to believethat if the taxpayer does not sell voluntarily, their property will becondemned.A taxpayer is under threat of condemnation if they sell their property tosomeone other than the condemning authority, provided there are reasonablegrounds to believe that their property will be condemned. If thebuyer of this property knows it is under threat of condemnation at thetime of purchase and sells the property to the condemning authority, sucha forced sale will also qualify as a condemnation.3-41Reports of CondemnationA taxpayer is under threat of condemnation if they learn of a decisionto acquire their property for public use through a report in a newspaperor other news media, and this report is confirmed by a representativeof the government body or public official involved.There must be reasonable grounds to believe that necessary steps willbe taken to condemn the property if the taxpayer does not sell voluntarily.If oral statements made by a government representative or publicofficial were relied upon, the IRS may ask the taxpayer to providewritten confirmation of the statements.ExampleDan’s property lies along public utility lines. The utility companyhas the authority to condemn property. They notify Danthat they intend to acquire his property by negotiation or condemnation.Dan’s property is under threat of condemnationwhen he received the notice.

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Property Voluntarily SoldA voluntary sale of property may be treated as a forced sale that qualifiesas a condemnation if the property had a substantial economic relationshipto property that was condemned.A substantial economic relationship exists if together the properties wereone economic unit. It must be shown that a suitable nearby property of alike kind (the same or similar) to the condemned property is not available,and the taxpayer cannot continue to do business as before.This treatment will not apply to the taxpayer if they do not own bothproperties.EasementsIf a taxpayer grants an easement on their property (e.g., a right-of-wayover it) under condemnation or threat of condemnation, they are consideredto have made a forced sale, even though legal title is retained. Althoughgain or loss on the easement is determined in the same way as asale of property, the gain or loss is treated as a gain or loss from a condemnation.3-42ExampleThe Department of Agriculture is authorized to acquire anylands or interest in them for the protection of the historic, cultural,and scenic values of an area. The Department informedDan in writing that condemnation proceedings would bestarted unless he agrees to sell voluntarily a scenic easementover his property. Dan will have made a forced sale when hegives up any use of his property by the sale.Condemnation AwardA condemnation award is the money paid or the value of other propertyreceived for the condemned property. The award is also the amount paidfor the sale of property under threat of condemnation.Amounts Withheld From AwardAmounts withheld from the award to pay the taxpayer’s debts are consideredpaid to the taxpayer. Amounts paid directly to the holder of amortgage or other lien (claim) against the property are part of theaward, even though the debt attaches to the property and is not a personalliability.ExampleThe state condemned Dan’s property for public use. Theaward was set at $200,000. The state paid Dan only$148,000 because it paid $50,000 to his mortgage holder and$2,000 accrued real estate taxes. Dan is considered to havereceived the entire $200,000 as a condemnation award.Net Condemnation AwardA net condemnation award is the total award actually or constructivelyreceived for the condemned property minus expenses of obtaining theaward. If only part of a property was condemned, the award must bereduced by any severance damages and any special assessment levied

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against the part of the property retained.Interest on AwardIf the condemning authority pays interest for its delay in payment ofthe award, it is not part of the condemnation award. The interestshould be reported separately as ordinary income.3-43Payments to RelocatePayments received to relocate and replace housing because the taxpayerhas been displaced from their home, business, or farm as a resultof federal or federally assisted programs are not part of the condemnationaward. They are not included in income. The replacement housingpayments are added to the cost of the taxpayer’s newly acquired property.Severance DamagesSeverance damages are compensation paid if part of a property is condemnedand the value of the part retained is decreased because of thecondemnation.If part of a property is condemned, the part retained may be damaged asa result of the condemnation. For example, severance damages may bereceived if the retained property will be subject to flooding. Severancedamages may also be given if the taxpayer must replace fences, dig newwells or ditches, or plant trees to restore the remaining property to thesame usefulness it had before the condemnation.The contracting parties should agree on the amount of the severancedamages and put that in writing. If this is not done, all the proceeds fromthe condemning authority are considered awarded for the condemnedproperty.ExampleDan transferred part of his property to the state under threatof condemnation. To figure the total award for the condemnedpart, Dan and the condemning authority agree to severancedamages for the part Dan kept. The contract Dan and the authoritysigned showed only the total award. It did not specify afixed sum for severance damages. However, when the condemningauthority paid Dan the award, it gave him closingpapers that clearly showed that part of the award was forseverance damages. Dan may treat this part as severancedamages.A completely new allocation of the total award may not be made after thetransaction is completed. However, taxpayers may show how much of theaward both parties intended for severance damages. The severance damagespart of the award is determined from all the facts and circumstances.3-44Treatment of Severance DamagesExpenses in obtaining the damages must first reduce severance damages.They are then reduced by any special assessment levied againstthe remaining part of the property if the assessment was withheld from

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the award by the condemning authority. The balance is the net severancedamages. The basis of the remaining property is then reduced bythe net severance damages.If the amount of severance damages is based on damage to a specificpart of a property the taxpayer kept, they may reduce only the basis forthat part by the net severance damages.If the net severance damages are more than the basis of the retainedproperty, the taxpayer has a gain. The taxpayer may choose to postponethe gain by purchasing replacement property.If the remaining property is restored to its former use, the cost of restoringit can be treated as the cost of replacement property. Taxpayerscan also make this choice if they spend the severance damages, togetherwith other money received for the condemned property, to acquirenearby property that will allow them to continue their business.Expenses of Obtaining an AwardSubtract the expenses of obtaining a condemnation award, such as legal,engineering, and appraisal fees, from the amount of the total award. Theexpenses of obtaining severance damages must also be subtracted fromthe severance damages paid. If part of the condemnation award is forseverance damages, determine which part of the expenses is for each partof the award. If this cannot be done, a proportionate allocation must bemade.ExampleDan received a condemnation award. One-fourth of it wasstated in the award as severance damages. Dan had legalexpenses in connection with the entire condemnation proceeding.He cannot determine how much of his legal expensesis for each part of the award. Dan must allocate onefourthof his legal expenses to the severance damages andthe other three-fourths to the award for the condemned property.Special Assessment Withheld from AwardWhen part of a property is condemned, the condemnation award must bereduced by the expenses of obtaining the award and by any amount with3-45held because of a special assessment levied against the remaining property.An assessment may be levied if the remaining part of the property isbenefited by the improvement resulting from the condemnation. Examplesof improvements that may cause a special assessment are widening ofa street or installation of a sewer.The assessment must be withheld from the award. The award cannot bereduced by any assessment levied after the award is made, even if the assessmentis levied in the same year the award is made.ExampleTo widen the street in front of Dan’s home, the city acquired25 feet of his land. Dan was awarded $5,000 for this andspent $300 to get the award. Before paying the award, thecity levied a special assessment of $700 for the street improvement

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against Dan’s remaining property. The city thenpaid Dan only $4,300. His net award is $4,000 ($5,000 totalaward minus $300 expenses in obtaining the award and$700 for the special assessment withheld).If the $700 special assessment was not withheld from theaward, and Dan were paid $5,000, his net award would be$4,700 ($5,000 minus $300). The net award is not changed,even if Dan later paid the assessment from the amount received.Severance Damages Included in AwardIf severance damages are included in the award, the severance damagesmust first be reduced by the special assessment withheld. Any balance isused to reduce the condemnation award.ExampleAssume that in the previous example Dan was awarded$4,000 for the condemned property and $1,000 for severancedamages. Dan spent $300 to obtain the severance damages.A special assessment of $800 was withheld from the award.The $1,000 severance damages are reduced to zero by firstsubtracting the $300 expenses and then $700 of the specialassessment. Dan’s award for the condemned property,$4,000, is reduced by the $100 balance of the special assessment,leaving a net condemnation award of $3,900.3-46Gain or Loss from CondemnationsIf net condemnation award is more than the adjusted basis of the condemnedproperty, there is a gain. This gain may be postponed.If the award is less than the taxpayer’s adjusted basis, there is a loss. If theloss is from property held for personal use, it is a nondeductible loss.How to Figure Gain or LossIf property is condemned, gain or loss is determined by comparing the adjustedbasis of the condemned property with the award received minusthe expenses of obtaining it.Part Business or Part RentalIf part of the condemned property was used as the taxpayer’s homeand part as business or rental property, each part must be treated as aseparate property and gain or loss is figured separately for each partbecause gain or loss may be treated differently.Some examples of this type of property are a farm or ranch the taxpayeroperates and lives on, a building in which the taxpayer lives andoperates a grocery, or a building in which the taxpayer lives on the firstfloor and rents out the second floor.Postponement of GainGain on condemned, damaged, destroyed, or stolen property is not reportedif the taxpayer receives property that is similar or related in service or use toit. The basis for the new property is the same as the basis for the old property.Choosing to Postpone Gain

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Gain must be reported if money or unlike property is received as reimbursement.However, taxpayers can choose to postpone reporting thegain if they purchase:(i) Property that is similar or related in service or use to the condemned,damaged, destroyed, or stolen property, or(ii) A controlling interest (at least 80%) in a corporation owning propertythat is similar or related in service or use to the propertywithin a specified replacement period.If the taxpayer is a member of a partnership or a shareholder in a corporationthat owns the condemned, damaged, destroyed, or stolen property,only the partnership or corporation, and not the taxpayer, can choose topostpone reporting the gain.3-47Cost TestTo postpone all the gain, the cost of the replacement property must beequal to or more than the amount realized (reimbursement) for the condemned,damaged, destroyed, or stolen property.Replacement PeriodTo postpone reporting gain from a condemnation the taxpayer must buyreplacement property within a specified period of time. This is the “replacementperiod.”CondemnationThe replacement period for a condemnation begins on the earlier of:(i) The date on which the condemned property was disposed of, or(ii) The date on which the threat of condemnation began.The replacement period ends 2 years after the close of the first tax yearin which any part of the gain on the condemnation is realized.If real property held for use in a trade or business or for investment (notincluding property held primarily for sale) is condemned, the replacementperiod ends 3 years after the close of the first tax year in whichany part of the gain on the condemnation is realized.Replacement Property Acquired Before the CondemnationIf the replacement property is acquired after there is a threat of condemnationbut before the actual condemnation, and the taxpayer stillholds the replacement property at the time of the condemnation, thereplacement property is deemed acquired within the replacement period.Property acquired before there is a threat of condemnation doesnot qualify as replacement property acquired within the replacementperiod.ExampleOn April 3, 2005, city authorities notified Dan that his property

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would be condemned. On June 5, 2005, Dan acquired propertyto replace the property to be condemned. Dan still hadthe new property when the city took possession of his oldproperty on September 5, 2008. Dan made a replacementwithin the required replacement period.ExtensionAn extension of the replacement period may be granted if applicationis made to the District Director. Application should be made before3-48the end of the replacement period and contain all the details about theneed for the extension.An application may be filed within a reasonable time after the replacementperiod ends if reasonable cause can be shown for the delay.An extension of time will be granted if reasonable cause for not makingthe replacement within the regular period is established.Ordinarily, requests for extensions are granted near the end of the replacementperiod or the extended replacement period. Extensions areusually limited to a period of one year or less.The high market value or scarcity of replacement property is not a sufficientreason for granting an extension. If the replacement property isbeing constructed and the replacement or restoration cannot be madewithin the replacement period, extension of the period is normallygranted.Time for assessing a deficiencyIf the taxpayer chooses not to recognize gain from a condemnation,any deficiency for any tax year in which part of the gain is realized maybe assessed at any time before the expiration of 3 years from the datethe District Director is notified that the taxpayer is replacing the condemnedproperty, or intends not to replace, within the required replacementperiod.3-49

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the list

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of questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.130. A federal or federally assisted program may require and pay for a taxpayerto move to another location. Under §1033, how are such relocationpayments treated?a. They are added to the cost of the taxpayer’s new property.b. They are §217 deductible moving expenses.c. They are included in income.d. They are part of the condemnation award.131. When part of a property is condemned and another part of the propertyhas its value decrease due to the condemnation, the taxpayer may receiveseverance damages. In such an event, how are such severance damages initiallyreduced?a. by any special assessment levied against the remaining part of theproperty.b. by costs in getting the damages.c. by the basis of the remaining property.d. by a prorata share of the condemnation award.3-50132. What is arrived at by subtracting from severance damages both the expensesin getting the damages and any assessment levied against the remainderof the property if the condemning authority withheld the assessmentfrom the award?a. interest on the award.b. net condemnation award.c. net severance damages.d. relocation payments.133. Which of the following is characteristic of §1033 treatment, when severancedamages are based on damage to a specific portion of a taxpayer’sproperty?a. Restoration costs cannot be treated as replacement property.b. The severance payments are tax-exempt.c. Any gain cannot be postponed by purchasing replacement property.d. The basis for that portion may be reduced by the net severance damages.134. Expenses of obtaining a condemnation award are subtracted from thetotal award in determining a potential gain or loss. However, which of thefollowing fails to qualify as such an expense?

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a. appraisal fees.b. engineering fees.c. property rental costs.d. legal fees.135. Under which circumstance would the reporting of gain on condemned,damaged, destroyed, or stolen property be unnecessary under §1033?a. A corporation of which the taxpayer is a shareholder owns the property.b. Compensation or property is received from a governmental agency.c. Part of the condemned property was used as the taxpayer’s home andpart as business or rental property.d. Property that is similar or related in service or use to it is received.136. The author lists several transactions whereby taxpayers may postponereporting gain on condemned property. However, which of the followingtransactions would deny taxpayer this postponement option?a. They buy a controlling interest in a corporation owning property that issimilar to the condemned property.b. They buy at least 50% interest in a corporation owning property that issimilar to the condemned property.c. They buy property that is related in use to the condemned property.3-51d. They buy property that is similar in service to the condemned property.

Answers & Explanations130. A federal or federally assisted program may require and pay for a taxpayerto move to another location. Under §1033, how are such relocation paymentstreated?a. Correct. The replacement housing payments are added to the cost of thetaxpayer’s newly acquired property.b. Incorrect. Such relocation payments are not paid by the taxpayer and arenot §217 deductible moving expenses.c. Incorrect. Payments received to relocate and replace housing because thetaxpayer has been displaced from their home, business, or farm as a result offederal or federally assisted programs are not included in income.d. Incorrect. Payments received to relocate and replace housing because thetaxpayer has been displaced from their home, business, or farm as a result offederal or federally assisted programs are not part of the condemnationaward. [Chp. 3]131. When part of a property is condemned and another part of the propertyhas its value decrease due to the condemnation, the taxpayer may receiveseverance damages. In such an event, how are such severance damages initiallyreduced?a. Incorrect. Second, they are reduced by any special assessment levied

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against the remaining part of the property if the assessment was withheldfrom the award by the condemning authority.b. Correct. First, severance damages must be reduced by expenses in obtainingthe damages.c. Incorrect. The basis of the remaining property is reduced by the net severancedamages.d. Incorrect. Severance damages are not reduced by a prorata share of thecondemnation award. Severance and condemnation are calculated separately.[Chp. 3]132. What is arrived at by subtracting from severance damages both the expensesin getting the damages and any assessment levied against the remainderof the property if the condemning authority withheld the assessmentfrom the award?3-52a. Incorrect. If the condemning authority pays interest for its delay in paymentof the award, it is not part of the condemnation award. It is totally separate.b. Incorrect. A net condemnation award is the total award actually or constructivelyreceived for the condemned property minus expenses of obtainingthe award.c. Correct. Net severance damages are figured by subtracting from severancedamages both the expenses in getting the damages and any assessment leviedagainst the remainder of the property if the condemning authority withheldthe assessment from the award.d. Incorrect. Payments received to relocate and replace housing are separatefrom the condemnation award. They are not included in income. [Chp. 3]133. Which of the following is characteristic of §1033 treatment, when severancedamages are based on damage to a specific portion of a taxpayer’sproperty?a. Incorrect. If the remaining property is restored to its former use, the costof restoring it can be treated as the cost of replacement property.b. Incorrect. If the net severance damages are more than the basis of the retainedproperty, the taxpayer has a gain.c. Incorrect. If the net severance damages are more than the basis of the retainedproperty, the taxpayer may choose to postpone the gain by purchasing

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replacement property.d. Correct. If the amount of severance damages is based on damage to a specificpart of a property the taxpayer kept, they may reduce only the basis forthat part by the net severance damages. [Chp. 3]134. Expenses of obtaining a condemnation award are subtracted from the totalaward in determining a potential gain or loss. However, which of the followingfails to qualify as such an expense?a. Incorrect. Appraisal fees may be included in the expenses of obtaining acondemnation award.b. Incorrect. The expenses of obtaining a condemnation award such as engineeringfees are subtracted from the amount of the total award.c. Correct. No costs for renting property during a period of trying to obtain acondemnation award would be considered expenses of obtaining the award.d. Incorrect. Legal fees may be included in the expenses of obtaining a condemnationaward. [Chp. 3]135. Under which circumstance would the reporting of gain on condemned,damaged, destroyed, or stolen property be unnecessary under §1033?a. Incorrect. If the taxpayer is a member of a partnership or a shareholder ina corporation that owns the condemned, damaged, destroyed, or stolen3-53property, only the partnership or corporation, and not the taxpayer, canchoose to postpone reporting the gain.b. Incorrect. Gain must be reported if money or unlike property is received asreimbursement.c. Incorrect. If part of the condemned property was used as the taxpayer’shome and part as business or rental property, each part must be treated as aseparate property and gain or loss is figured separately for each part becausegain or loss may be treated differently.d. Correct. Gain on condemned, damaged, destroyed, or stolen property isnot reported if the taxpayer receives property that is similar or related in serviceor use to it under §1033. The basis for the new property is the same asthe basis for the old property. [Chp. 3]136. The author lists several transactions whereby taxpayers may postpone reportinggain on condemned property. However, which of the followingtransactions would deny taxpayer this postponement option?a. Incorrect. Taxpayers can choose to postpone reporting the gain if they purchase

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a controlling interest in a corporation owning property that is similar tothe condemned, damaged, destroyed, or stolen property.b. Correct. If the taxpayer fails to purchase at least 80% interest in the corporation,they will be unable to choose to postpone reporting the gain.c. Incorrect. Taxpayers can choose to postpone reporting the gain if they purchaseproperty that is related in use to the condemned, damaged, destroyed,or stolen property.d. Incorrect. Taxpayers can choose to postpone reporting the gain if they purchaseproperty that is similar in service to the condemned, damaged, destroyed,or stolen property. [Chp. 3]3-54At Risk Limits for Real EstateThe at-risk rules limit losses from most activities to the loss or amount at risk,whichever is less. The at-risk limits apply to individuals and to certain closelyheld corporations (other than S corporations).The at-risk rules must be appliedbefore the passive activity rules.Amount At RiskA taxpayer is at risk in any activity for:(1) The money and adjusted basis of property contributed to the activity,and(2) Amounts borrowed for use in the activity if the taxpayer:(a) Is personally liable for repayment, or(b) Pledges property (other than property used in the activity) as securityfor the loan.Qualified Nonrecourse FinancingA taxpayer who holds real property is considered at risk with respect toany “qualified nonrecourse financing” which means financing:(a) Which is borrowed by the taxpayer with respect to the activity ofholding real property,(b) From a “qualified person” or from any federal, state, or local governmentor instrumentality, or is guaranteed by any federal, state orlocal government,(c) Where no person is personally liable for repayment, and(d) Is not convertible debt.A “qualified person” is defined as any person who is actively and regularlyengaged in the business of lending money and who is not:(a) Related to the taxpayer (but see the special rule for certain commerciallyreasonable financing from related persons);(b) The person (or not related to the person) from whom the taxpayeracquired the property; or(c) The person (or not related to the person) who receives a fee with

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respect to the taxpayer’s investment in the property.“Qualified persons” would include banks, savings and loans, credit unions,insurance companies or a pension trust. Seller financing and promoterfinancing are not “qualified persons.”A special rule provides that if financing from a related person is commerciallyreasonable and on substantially the same terms as loans involvingan unrelated person, the related person may be considered to be a qualifiedperson. Related persons include family members, fiduciaries, and3-55corporations/partnerships in which the taxpayer or relative has at least a10% interest.If the amount at risk is reduced below zero (e.g.. by distributions to thetaxpayer or by changes in the status of debt from recourse to nonrecourseor from a qualified person to a nonqualified person), the taxpayer recognizescurrent income to the extent of the reduction below zero. However,the amount recaptured is limited to the excess of the losses previously allowed.The amount added to income is treated as a deduction allocable tothe activity in the first succeeding year and allowed if, and to the extent,that the taxpayer’s at risk basis is increased.Section 1031 Like Kind ExchangesSection 1031, by permitting a deferral of the recognition of all or part of the gainor loss realized on the exchange of property, provides an exception from thegeneral rule of §1001 requiring recognition of gain or loss upon the sale or exchangeof real property.Statutory Requirements & DefinitionsAssuming that a property is not within one of the excluded classes set forth inthe §1031, there are essentially only three basic elements for an exchangeunder §1031:(1) The properties must actually be exchanged;(2) Both the property exchanged and the property received must be heldby the same taxpayer for productive business use in the taxpayer’s tradeor business or for investment; and(3) The properties must be of a “like-kind” with one another.Qualified Transaction - Exchanges v. SalesIn order to come within the scope of §1031, there must be a reciprocaltransfer of property, as distinguished from a transfer of property solelyfor money. (Reg. §1.1001-1(d)) In short, there must be an exchange asdistinguished from a sale. The Courts have tended to define a sale ofproperty as a transfer in consideration of a concrete price expressed interms of money; and an exchange as a transfer of property in considerationof the reciprocal transfer of other property, supposedly without theintervention of a significant amount of money. (Estate of C.T. Grant, 36

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BTA 1233 (1937).)Held for Productive Use or investmentTo qualify under §1031, both the property transferred and the propertyreceived in an exchange must be held by the taxpayer either for produc3-56tive use in his trade or business or for investment. A personal residence isnot property held for investment or use in a trade or business and §1031does not apply to it. (R.R. 59-229 and Coupe v. Commissioner, 52 T.C. 394(1969).)Note: The phrase “held for productive use in a trade or business” is not definedby either the Code or the regulations, nor has there been any significantguidance from the Courts concerning this language.Investment PurposeWith regard to property held for “investment” purposes, the regulationsdo state that “unproductive real estate held by one other than adealer for future use or future realization of the increment in value isheld for investment and not primarily for sale.” (Reg. §1.1031(a)-1(b).)Thus, property held for sale in the immediate future is not held for investment.(Regals Realty Co. V. Commissioner. However, property isnot disqualified if it is held for ultimate sale but not in the immediatefuture. (Loughborough Development Corp., 29 B.T.A. 95 (1933).)Statutory Exclusions from §1031Not all property, even when held for productive use in a trade or businessor for investment, qualifies under the nonrecognition provisionsof §1031. Certain types of property are specifically excepted:(1) Stock in trade or other property held primarily for sale,(2) Stocks, bonds or notes,(3) Other securities or evidences of indebtedness or interest,(4) Interests in a partnership,(5) Certificates of trust or beneficiary interests, and(6) Choses in action.Like Kind PropertyIn addition to the requirement relating to the purpose for which theproperty is held, there is a further requirement that the property given upin the exchange must be of a like-kind with the property received.Nature or Quality of PropertyThe term “like-kind” has reference to the nature or character of theproperty and not to its grade or quality, so that one kind or class ofproperty may not, under §1031, be exchanged for property of a differentclass or kind. Accordingly, real property could not be exchangedfor personal property, since each is of a different class or kind. However,the exchange of qualifying personal property for qualifying per3-57sonal property of a similar nature or character will come within thescope of §1031.

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Real v. Personal PropertyReal property is basically land and that which is affixed to the land.Personal property is generally any movable item. Personal propertyshould not be confused with personal use property that is excludedfrom §1031 treatment. Frequently, the distinction between real andpersonal property is not clear. To the extent applicable federal tax law(statute, cases, rulings, etc.) does not carve out exceptions and uniquerules, what constitutes real or personal property is determined by statelaw. (See Aquilino v. U.S., 363 US 509 (1960); Leslie Q. Coupe, 52 TC394 (1969); Commissioner v. Crichton, 122 F.2d 181 (5th Cir. 1941) andR.R. 55-749.) This may create a pitfall, since identical items (e.g., mineralinterests) may constitute real property in one state and personalproperty in another. Under these conditions, a trade of such itemscould not be under §1031 since they would be non-like kind (i.e. realfor personal).

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.137. Under §465, a partner is considered at risk for three items. What is oneof these items?a. amounts borrowed if the lender has an interest in the activity.b. amounts borrowed if the lender is related to a person having an inter3-58est in the activity.c. amounts borrowed that are secured by the partner’s property otherthan property used in the activity.d. amounts protected against loss through guarantees.

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138. Section 465 defines “qualified persons” for purposes of determining atrisklimits. For these purposes, which of the following is a qualified person?a. a person from whom the taxpayer acquired the property.b. a person related to the taxpayer.c. a person who receives a fee due to the taxpayer’s investment in the realproperty.d. a person who actively and regularly engages in the business of lendingmoney.139. According to the author, it is helpful to break down the like-kind exchangeprovisions into three requirements. What is one of these three basicrequirements of §1031?a. One of the properties must be held for investment.b. Personal use must be limited to the property given up.c. The properties exchanged must be like-kind.d. The properties must be similar in use.140. Under §1031, an important distinction is made between real and personalproperty. As a quick rule of thumb, the author suggests that which ofthe following be presumed personal property?a. any item that can be moved.b. any property affixed to land.c. mineral rights.d. personal use property.141. When disposing of property, taxpayers may receive money and/or property.What tax term is used for the total money received plus the fair marketvalue of property, other than money, received?a. the adjusted basis.b. the amount realized.c. the realized gain.d. the contract price.

Answers & Explanations137. Under §465, a partner is considered at risk for three items. What is one ofthese items?3-59a. Incorrect. A partner is generally not considered at risk for amounts borrowedif the lender has an interest in the activity.b. Incorrect. A partner is generally not considered at risk for amounts borrowedif the lender is related to a person having an interest in the activity.c. Correct. A partner is generally considered at risk for amounts borrowed

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that are secured by the partner’s property other than property used in the activity.d. Incorrect. A partner is generally not considered at risk for amounts protectedagainst loss through guarantees. [Chp. 3]138. Section 465 defines “qualified persons” for purposes of determining at-risklimits. For these purposes, which of the following is a qualified person?a. Incorrect. A qualified person is not a person from whom the taxpayer acquiredthe property.b. Incorrect. A qualified person is not a person related to the taxpayer. However,a person related to the taxpayer may be a qualified person if the nonrecoursefinancing is commercially reasonable, and on the same terms as loansinvolving unrelated persons.c. Incorrect. A qualified person is not a person who receives a fee due to thetaxpayer’s investment in the real property.d. Correct. A qualified person actively and regularly engages in the businessof lending money. The most common example is a bank. [Chp. 3]139. According to the author, it is helpful to break down the like-kind exchangeprovisions into three requirements. What is one of these three basic requirementsof §103?a. Incorrect. One of the three basic requirements of exchanging is that theproperty exchanged and the property received must be held for productiveuse in trade or business or for investment.b. Incorrect. A basic requirement of exchanging is that neither the propertyexchanged nor the property received may be held for personal use.c. Correct. One of the three basic requirements of exchanging is that theproperties must be of a “like-kind” with one another. Generally, this meansthat real property must be traded for real property and personal propertymust be traded for personal property.d. Incorrect. There is no "similar in use" requirement or test under §1031.[Chp. 3]140. Under §1031, an important distinction is made between real and personalproperty. As a quick rule of thumb, the author suggests that which of thefollowing be presumed personal property?a. Correct. Personal property is generally any movable item.b. Incorrect. Real property also includes that which is affixed to the land.3-60c. Incorrect. The personal property or real property nature of mineral rightsvaries from state to state depending on which rights are granted.

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d. Incorrect. Personal property should not be confused with personal useproperty that is excluded from §1031 treatment. [Chp. 3]141. When disposing of property, taxpayers may receive money and/or property.What tax term is used for the total money received plus the fair marketvalue of property, other than money, received?a. Incorrect. “Adjusted basis” is simply defined as the cost of the property(including and indebtedness taken subject to or assumed) increased by capitalimprovements, broker’s commissions, attorneys’ fees, appraisal costs, escrowcharges, and other acquisition costs and decreased by allowable depreciation(§1016).b. Correct. The “amount realized” from a transaction is the sum of anymoney received plus the fair market value of property (other than money)received.c. Incorrect. Section 1001 provides that realized gain is the excess of theamount realized from a transaction over the adjusted basis of the propertydisposed of in the same transaction.d. Incorrect. The contract price is the total of all principal payments to be receivedin an installment sale (§162). [Chp. 3]The Concept of “Boot”An exchange under §1031 is only fully tax deferred if the taxpayer exchangesproperty solely for qualifying like kind property. However, the receipt of nonlike-kind property commonly referred to as “boot” will not prevent the partialapplication of §1031 in an exchange which otherwise consists of like-kindproperty. If the taxpayer receives money or other non-like kind property inthe exchange, the taxpayer’s gain is recognized to the extent of the sum of themoney and the fair market value of the other property received.Determining this taxability is a two-step process. First, one must ascertain thetaxpayer’s realized gain. Second, the amount of money and the value of anyother property received by the taxpayer must be calculated to determine recognizedgain.Realized GainSection 1001 provides that realized gain is the excess of the amount realizedfrom a transaction over the adjusted basis of the property disposed ofin the same transaction. The “amount realized” from a transaction is thesum of any money received plus the fair market value of property (otherthan money) received.3-61

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Recognized GainRecognized gain, on the other hand, is the gain that must be reported forincome tax purposes. Without the benefits of §1031, all gains realizedwould have to be recognized.Limitation on Recognition of Gain under §1031Section 1031(b) provides a ceiling as to the amount that can be taxed.This taxable amount cannot exceed the lesser of the boot received or therealized gain (Reg. §1.1031(b)-1(b). As a result, the taxpayer should notbe taxed at anytime greater than if he sold the property outright.The Definition of “Boot”Boot consists of money (including liability assumed or attached to theproperty received in exchange), non-qualifying property, and propertywhich although qualifying by definition is not like kind to the propertygiven in the exchange. Except for money and debt, which are taken at facedollar value, the other categories of boot are taken at fair market value.The Rules of “Boot”To simplify the understanding of “boot,” many practitioners have divided itinto two categories - “property” and “mortgage” boot.Property BootThis property boot is easy to recognize, since we can actually see the nonlike-kind property or cash passing from one party to another in the exchangetransaction. A taxpayer who receives money or nonqualifyingproperty is considered to have received property boot. A taxpayer whopays money or gives nonqualifying property in the exchange is consideredto have given property boot.Mortgage BootMortgage boot consists of liabilities assumed or taken subject to in theexchange. If a taxpayer’s liabilities are assumed or taken subject to, thetaxpayer is considered to have received mortgage boot, even if the“buyer” of the taxpayer’s property refinances the taxpayer’s property aspart of the exchange and uses the proceeds to pay off the taxpayer’smortgage (Earlen T. Barker, 74 TC 555 (1980)). A taxpayer who assumesanother party’s liabilities or takes subject to those liabilities in the exchangeis considered to have given mortgage boot.Note: The terms “property boot” (or “cash boot”) and “mortgage boot” arenot used in the Regulations or Code, although they have been adopted by3-62the Tax Court in at least two cases (Earlen T. Barker, 74 TC 555 (1980) andEstate of Meyer, 58 TC 311 (1972)).Netting “Boot” - The Rules of OffsetWhere boot is not only given but is also received (whether it be in theform of property boot or mortgage boot), then a series of “offset” rulesapply. These rules permit, in certain instances, the netting of boot so thatin determining the total amount of boot that a taxpayer has received, ataxpayer is permitted to subtract certain types of boot that the taxpayergave to one of the other parties.Property Boot Given Offsets Any Boot Received

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Consideration given in the form of cash or other property (propertyboot) is offset against consideration received in the form of such propertyboot or an assumption of liability or a transfer of properties subject-to a liability (mortgage boot). As a result, in determining theamount of boot received by a taxpayer for the purpose of calculatingthe amount of gain to be recognized in an exchange, any property bootgiven up by the taxpayer is subtracted from the mortgage boot orproperty boot received.Mortgage Boot Given Offsets Mortgage Boot ReceivedIn the case of the reciprocal assumption or acquisition of property subject-to liabilities, the regulations clearly provide for netting of liabilitiesin determining the amount of boot received by the taxpayer (Reg.§1.1031(b)-1(c), R.R. 79-44 and Coleman v. Commissioner, 180 F. 2d758 (1950)). Thus, it is only to the extent the taxpayer realizes a net reductionin the indebtedness owed that the taxpayer has in fact receivedmortgage boot.Mortgage Boot Given Does Not Offset Property Boot ReceivedConsideration received in a §1031 transaction in the form of cash orother non-qualified property (property boot) is not offset by the considerationgiven in the form of an assumption of liabilities or a receiptof property subject to a liability (mortgage boot). (Reg. §1.1031(d)-2,example 2(a) and 2(b).)Revenue Ruling 72-456 & CommissionsAs a result of this ruling, brokerage commissions paid in a §1031 exchangeare treated as property boot paid. Consequently, such commissionspaid may be offset against mortgage or property boot received.Thus, R.R. 72-456 provides that otherwise taxable net boot received by3-63the taxpayer may be offset by the taxpayer’s transaction costs, includinghis brokerage commissions.Gain or Loss on BootGain or loss will be recognized on non like-kind property given even if nogain is recognized on like-kind property involved in the exchange. Thetransfer of non-cash boot is treated as a sale (not an exchange) of suchproperty. (Reg. §1.1031(d)-1(e).)Basis on Tax-Deferred ExchangeThe basis of property received in an exchange qualifying under §1031 is thebasis of the property transferred, decreased by the amount of money received(note: mortgage boot received is treated as cash received), and increased byany gain or decreased by any loss (on non like-kind property) recognized inthe exchange. (§1031(d).) This general rule is often referred to as the “substituted”or “carryover” basis rule, because the basis of the original propertycarries over to become the owner’s basis for the new property acquired.

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Observation: Taxpayer’s old basis is essentially reduced by the amount thetaxpayer is “cashed out” in the form of money or mortgage relief received.The old basis is enlarged by the amount of cash put in or the increased indebtednessacquired.Allocation of BasisIf the property received in an exchange consists in part of like-kind propertyand in part of non like-kind property (boot), the total basis of suchproperties must be allocated between the properties (other than money)received. When such non like-kind property is received, basis must befirst allocated to the non like-kind property to the extent of its fair marketvalue. The remainder of the basis is allocated to the like-kind propertiesreceived. (Reg. §1.1031(d)-1(c).)Installment Reporting of BootThe Installment Sales Revision Act of 1980 changed the rules that takelike-kind property into account for installment sale purposes (§453(f)(6)).The existing rules are as follows:(1) The like-kind property received under 1031 is not treated as a paymentin year of disposition (§453(f)(6)(C));(2) The gross profit from the exchange is reduced by the gain not recognized(453(f)(6)(B));(3) The contract price does not include the value of the like-kind property(§453(f)(6)(A)); and3-64(4) The taxpayer’s basis in the property put into the exchange is allocatedfirst to the like-kind property received to the extent of its fairmarket value.Exchanges Between Related PartiesSection 1031(f) requires gain or loss on an exchange between related personsto be recognized if either the property transferred or the propertyreceived is disposed of within two years after the exchange. Any gain orloss4 recognized by a taxpayer because of this rule is deemed to have occurredon the date of the disposition. Thus, the exchangor is not requiredto amend his return for the year of the original exchange. Basis adjustmentsare also made as of the date of disposition.Reporting an ExchangeThe instructions to Schedule D (Form 1040) state that all exchanges mustbe reported. The instructions apply to even fully tax-deferred exchanges.Since 1990, if you exchange property in a like-kind exchange, you mustfile Form 8824, Like-Kind Exchanges, in addition to Schedule D (Form1040) or Form 4797.Types of ExchangesAlthough somewhat of a simplification, in actuality there are only four basictypes of true exchanges:(1) Two-party exchanges,(2) The three-party “Alderson” exchange,

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(3) The three-party “Baird Publishing” exchange, and(4) Delayed exchange or “Starker.”Two-Party ExchangesThe two-party exchange is the simplest but rarest form of exchange. Thisexchange merely involves a transfer of properties between the parties inthe form of a true “barter” transaction. While each party has a similar interestin deferral of the gain on the exchange, the respective tax status ofeach is independent of the other. Thus, one party to the exchange mayqualify under §1031 and the other may not. This could happen, for instance,where one party is acquiring the property in an exchange for purposesof immediate resale.4 Losses would be limited by §267 - see next section.3-65Despite the simplicity of two-party exchanges, they occur very rarely. Notonly must both parties be willing to exchange the properties, but also theproperties must be of approximately the same value and the parties mustbe willing to accept each other’s property. In the real world this rarely occurs.Three-Party “Alderson” ExchangeThe “Alderson” exchange (see Alderson v. Commissioner, 317 F.2d 790(9th Cir. 1963)) involves three parties and two properties and is consummatedin two basic steps, each of which should be accomplished by aseparate escrow. In the first step and escrow, Buyer purchases Parcel Bfrom Seller for cash. In the second step and escrow, Buyer transfers ParcelB to Client in exchange for Parcel A. Functionally, Buyer serves as amiddleman (i.e., accommodator) and Parcel B is transferred twice. Buyerultimately obtains Parcel A and Seller is “cashed out.”3-66When structured properly, Client will have a tax-deferred exchange under§1031, Buyer will have no tax consequences, and Seller will be the onlyparty having a taxable event in the form of a recognized sale. (R.R. 77-297.) Seller realizes gain equal to the excess of the sales price over adjustedbasis and costs of sale (§1001).Buyer’s transfer of Parcel B to Client in exchange for Parcel A is a sale ofParcel B and is potentially taxable to Buyer. Section 1031 will not apply toBuyer since Buyer did not hold Parcel B for a qualified use. (R.R. 77-297and R.R. 75-291.) However, Buyer’s basis in Parcel B is equal to the fairmarket value of Parcel A. The documentation should therefore, placevalues on Parcel A that are consistent with Buyer cost basis in acquiringParcel B. (Amerada Hess Corp. v. Commissioner 517 F.2d 75 (3rd Cir1975) and R.R. 56-100.)Three-Party “Baird Publishing” ExchangeThe “Baird Publishing” type of exchange is very similar to the “Alderson”exchange, except that the exchange step of the transaction occurs before

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the sale step and the middleman (i.e., accommodator) is Seller ratherthan Buyer (J.H. Baird Publishing Co. v. Commissioner, 39 T.C. 608(1962).) As in an “Alderson” exchange, each of the elements must bekept completely separate from the other by using separate escrows, if Sec.1031 status is to be obtained. Under the Baird Publishing type of exchange,Client transfers his property, Parcel A, and receives in exchangeSeller’s property, Parcel B. Seller selling Parcel A to Buyer for cash completesthe second part of the transaction. (See also Mays v. Campbell, 246F. Supp 375 (N.D. Texas 1965).)3-67Delayed ExchangesThe TRA ‘84 expressly authorized delayed exchanges but placed highlyrestrictive time limits on identifying the new property and completing theexchange (§1031(a)(3)). In addition to raising technical compliance issues,the TRA ‘84 failed to resolve many outstanding delayed exchangeissues.45-Day RuleUnder the TRA ‘84, §1031(a)(3) required identification “before theday which is 45 days after the date on which the taxpayer transfers theproperty relinquished in the exchange.” Thus, the taxpayer only had 44full days to identify the property. The Tax Reform Act of 1986 changedthis drafting trap. The TRA ‘86 struck out “before the day” and inserted“on or before the day” to clarify that a full 45-day identificationperiod is now allowed.Method of IdentificationThe legislative history to the TRA ‘84 indicates that the designationrequirement can be satisfied by designating the property to be received“in the contract between the parties.” This presumably meansthe parties to the exchange. In multi-party exchanges where an intermediaryis used to purchase the property desired by the exchangor,the designation requirement should be met if the exchangor designatesthe property to the intermediary.180-Day RuleThe time for completing the exchange under §1031(a)(3) is the earlierof the day which is 180 days following transfer of the property to be relinquishedin the exchange or the due date for the exchangor’s tax returnfor the year of the transfer including extensions. Failure to completethe exchange within this time will cause the replacement propertyto be not of like kind. As a result, dispositions in any year prior to October17 must be completed within 180 days, later dispositions must becompleted by April 15 of the next year, or taxpayer must file for an extensionto prolong the period.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required to

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present review questions intermittently throughout each self-study course. The3-68following questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.142. The existence of boot can create valuation problems in a §1031 exchange.However, two items of boot are taken at face value. What is one ofthese types of boot?a. debt.b. furniture.c. stock.d. vehicles.143. In a §1031 exchange, the computation of a newly acquired property's basisstarts with the original property’s basis. What is this fundamental §1031basis rule often called?a. the “cost” basis rule.b. the modified “cashed out” basis rule.c. the deemed “purchase” basis rule.d. the “substituted” basis rule.144. In a §1031 exchange, an exchangor may receive both like-kind and nonlike-kind property. If this occurs, what happens to the total basis?a. It is allocated using the gross-profit ratio.b. Basis is first allocated to like-kind properties received.c. Basis is first allocated to non-like kind properties received.d. It is allocated in the ratio of the respective fair market values.145. The author identifies four rules for like-kind exchanges for installmentsale purposes. What is one of these rules under §453(f)(6)?a. The value of the like-kind property is included in the contract price.b. The gain not recognized increases the gross profit from the exchange.c. The like-kind property received under §1031 is treated as a payment in

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the year that it is disposed of.d. In such an exchange, the property put in must be allocated first toproperty received to the extent of its fair market value.3-69146. Under §1031, properties must be traded in a reciprocal transaction.Which of the following types of exchange is the most fundamental example ofthat principle?a. an Alderson format exchange.b. a Baird format exchange.c. a delayed exchange.d. a two-party exchange.

Answers & Explanations142. The existence of boot can create valuation problems in a §1031 exchange.However, two items of boot are taken at face value. What is one of thesetypes of boot?a. Correct. Money and debt are taken at face dollar value.b. Incorrect. Furniture and furnishings are taken at fair market value.c. Incorrect. Stocks are taken at fair market value.d. Incorrect. Vehicles are taken at fair market value. [Chp. 3]143. In a §1031 exchange, the computation of a newly acquired property's basisstarts with the original property’s basis. What is this fundamental §1031 basisrule often called?a. Incorrect. The fundamental basis rule of §1031 is not referred to as the"cost" basis rule. The “cost” basis rule is typically reserved for simple and directpurchases of property.b. Incorrect. Taxpayer’s old basis is essentially reduced by the amount he is“cashed out” in the form of money or mortgage relief received. The old basisis enlarged by the amount of cash put in or the increased indebtedness acquired.c. Incorrect. The basis of property acquired in an exchange will never be aslarge as the basis of similar value property that is purchased. However, inmost cases, the exchange will still be advantageous despite the lower depreciationdeduction because of the value of the tax deferral and the appreciationof the property.d. Correct. This general basis rule is often referred to as the “substituted” or“carryover” basis rule, because the basis of the original property carries overto become the owner’s basis for the new property acquired. [Chp. 3]144. In a §1031 exchange, an exchangor may receive both like-kind and nonlike-kind property. If this occurs, what happens to the total basis?

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a. Incorrect. If an exchange is combined with an installment sale, the basis ofthe like-kind property will be determined as if the installment obligation hadbeen satisfied as face and any remaining basis will be used to determine thegross-profit ratio.3-70b. Incorrect. When non like-kind property is received, basis must be first allocatedto the non like-kind property to the extent of its fair market value.c. Correct. If the property received in an exchange consists of like-kind andnon like-kind property, the amount allocated to the non like-kind propertymust be equal to its fair market value as of the date of the exchange.d. Incorrect. When non like-kind property is received, basis is first allocatedto the non-like kind property to the extent of its fair market value. The remainderof the basis is allocated to like-kind property received. [Chp. 3]145. The author identifies four rules for like-kind exchanges for installment salepurposes. What is one of these rules under §453(f)(6)?a. Incorrect. Under §453(f)(6)(A), the contract price does not include thevalue of the like-kind property.b. Incorrect. Under §453(f)(6)(B), the gross profit from the exchange is reducedby the gain not recognized.c. Incorrect. Under §453(f)(6)(C), the like-kind property received under 1031is not treated as a payment in the year of disposition.d. Correct. Under §453(f)(6) the taxpayer’s basis in the property put into theexchange is allocated first to the like-kind property received to the extent ofits fair market value. [Chp. 3]146. Under §1031, properties must be traded in a reciprocal transaction. Whichof the following types of exchange is the most fundamental example of thatprinciple?a. Incorrect. There are several steps to an Alderson exchange, making thistype of exchange more complex than others.b. Incorrect. Under the Baird exchange, there are several steps to complete alike-kind exchange. Thus, this type of exchange is more complex than others.c. Incorrect. Delayed exchanges are often complex due to having to locate anacceptable exchange property. Thus, there are simpler exchanges.d. Correct. Two-party exchanges are the simplest (but rarest) of exchanges.You transfer your property to another in return for their transfer of propertyto you. Children do this a lot with toys. [Chp.3]Final Regulations for Delayed (Deferred) Exchanges

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In 1991, the IRS adopted final regulations for delayed exchanges in TreasuryDecision 8346. Closely following the earlier proposed regulations, the finalprovisions focused on the identification and receipt requirements and finetunedthe applicable safe harbors for actual and constructive receipt of nonqualifyingproperty.3-71

Delayed Exchange FormatEXCHANGORINTERMEDIARYSELLERPARCELBPARCELBPARCELA

$DELAYED EXCHANGE(Now)

BUYER(Now)(Later)

$PARCELACONCURRENTSALE

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LATERACQUISITION3-72Deferred (Delayed) Exchange DefinitionThe regulations define a deferred exchange as an exchange in which ataxpayer transfers property held for productive use in a trade or businessor for investment and later receives property to be held for the same purpose(Reg. §1.1031(a)-3). The transaction must be a transfer of propertyfor property, not for money. Thus, a sale followed by a purchase of likekindproperty will not qualify.Identification RequirementsSection 1031 treatment will not apply if the replacement property is not“identified” before the end of the “identification period” or the identifiedreplacement property is not received before the end of the “exchange period.”Identification & Exchange PeriodsThe identification period starts the day the exchangor transfers the relinquishedproperty and ends 45 days later. The exchange period beginson transfer of the relinquished property and ends on the earlier of:(1) 180 days later, or(2) The due date, including extensions, for the exchangor’s tax returnfor the year in which the transfer of the relinquished property occurs.Time periods are calculated in the traditional manner - don’t count thefirst day, do count the last.Method of IdentificationA replacement property is “identified,” under the regulations, only if itis:(1) Received by the exchangor before the end of the identificationperiod,(2) Identified in a written agreement for the exchange of properties,or(3) Designated as replacement property:(a) In a written document,(b) Signed by the exchangor,(c) Hand delivered, mailed, telecopied, or otherwise sent beforethe end of the identification period,(d) To a person involved in the exchange other than the exchangoror a disqualified person (Reg. §1.1031(a)-3(c)).3-73Property DescriptionThe replacement property must be unambiguously described in thedocument or agreement by a legal description or street address.When the target property is under construction, it will be unambiguously

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identified if the underlying land is properly described and “asmuch detail as is practicable at the time the identification is made isprovided for construction of the improvements.”RevocationThe identification of a property may be revoked provided the followingrequirements are met:(1) Made prior to the end of the identification period,(2) In a written document,(3) Signed by exchangor,(4) “Hand delivered, mailed, telecopied, or otherwise sent” beforethe end of the identification period,(5) To the person to whom the identification was originally sent.Substantial ReceiptThe property received must be substantially the same as property identified.The regulations imply a 75% rule of thumb in an example where2 acres of raw land (worth $250,000) is identified but only 1.5 acres(worth $187,500) are actually received. The 1.5 acres is held to complywith the original identification.Multiple Replacement PropertiesMore than one property can be identified as replacement property.Regardless of the number of relinquished properties, the maximumnumber of replacement properties the exchangor may identify is:(a) Three properties of any fair market value (Reg. §1.1031(a)-1(c)(4)(i)(A)), or(b) Any number of properties as long as the aggregate FMV of allproperties identified as of the end of the identification period doesnot exceed 200% of the aggregate fair market value of all relinquishedproperties as of the date of transfer by the exchangor (Reg.§1.1031(a)-1(c)(4)(i)(B)), or(c) Any number of properties of any value provided that 95% of fairmarket value of all properties identified are received by the end ofthe exchange period (Reg. §1.1031(a)-1(c)(4)(ii)(B)).If the number of properties identified exceeds these requirements, noproperties will be considered identified, provided, however, that any3-74property received prior to the end of the identification period will bedeemed properly identified.Actual & Constructive Receipt RuleSince taxpayers typically are unwilling to rely on a transferee’s unsecuredpromise to transfer the like-kind replacement property, the use of variousguarantee or security arrangements is common in deferred exchanges.Use of these arrangements, however, raises issues concerning actual receipt,constructive receipt, and agency.Four Safe HarborsFor many years, the rules of actual and constructive receipt (§451)have been unclear as applied to §1031 exchanges. To clarify such questions,

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the regulations give four safe harbors that can be used withoutrisk of actual or constructive receipt5:Safe Harbor #1 - SecurityThe obligation of the exchangor’s transferee to complete the delayedexchange can be secured or guaranteed by:(a) A mortgage, deed of trust, or other security interest in property(other than cash or a cash equivalent),(b) A standby letter of credit which satisfies all of the requirementsof Reg. §15A.453-1(b)(3)(iii) and which doesn’t allow thetaxpayer to draw on the letter of credit except on default of thetransferee’s obligation to transfer like-kind replacement property,or(c) A guarantee of a third party (Reg. §1.1031(a)-3(g)(2)).Safe Harbor #2 - Escrow Accounts & TrustsThe obligation of the exchangor’s transferee to complete the delayedexchange may be secured by cash or a cash equivalent if held in aqualified escrow account or a qualified trust.In a “qualified” escrow account or trust, the escrow holder or trusteemust not be the exchangor or a disqualified person6, and the exchangor’srights to receive, pledge, borrow, or otherwise obtain the bene-5 The use of these safe harbors will result in a determination that the taxpayer is not, either directlyor through an intermediary that may be an agent, in actual or constructive receipt ofmoney or other property for purposes of the regulations.6 The proposed regulations used the term “related party,” however, due to potential confusionwith §1031(f), the final regulations adopted the term “disqualified person.”3-75fits of the cash or cash equivalent held in escrow or trust must belimited (Reg. §1.1031(a)-3(g)(3)).Disqualified PersonA person is a “disqualified person” if:(i) The person is an agent of the taxpayer at the time of thetransaction, or(ii) The person and the taxpayer (or the taxpayer’s agent) bear arelationship defined under §267(b) or§707(b) substituting 10%ownership for 50% ownership (Reg. §1.1031(a)-3(k)).Who Is An Agent?A person who has acted as the taxpayer’s employee, attorney, accountant,investment banker or broker, or real estate agent orbroker within the 2-year period ending on the date of the transferof the first of the relinquished properties is treated as an agent ofthe taxpayer at the time of the transaction. However, under thisprovision, the mere performance of services with respect to exchangesintended to qualify under §1031 will not make one anagent of the exchangor.Safe Harbor #3 - Qualified Intermediary

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The exchangor’s use of a “qualified intermediary” who is the exchangor’sagent does not destroy an exchange, provided the exchangor’srights to receive money or other property are limited. Thebenefit of using the qualified intermediary is that the potentialagency attack on the exchange is eliminated.Who Is A Qualified Intermediary?A “qualified intermediary” is a person who is not the exchangor ora disqualified person (see definition above) and who, for a fee, actsto facilitate a delayed exchange by agreeing with the exchangor toan exchange of properties in which the intermediary:(i) Acquires the relinquished property from the exchangor (eitheron its own behalf or as the agent of any party to the transaction),(ii) Transfers the relinquished property,(iii) Acquires the replacement property (either on its own behalfor as the agent of any party to the transaction), and(iv) Transfers the replacement property to the exchangor (Reg.§1.1031(a)-3(g)(4)).3-76Safe Harbor #4 - InterestThe exchangor can receive interest (or a growth factor) in a delayedexchange provided his rights to receive interest and other economicbenefits are limited. The interest (or growth factor) is treated as interestregardless of whether it is paid in cash or in property (Reg.§1.1031(a)-3(g)(5)).Exchanges of Partnership InterestsThe Tax Reform Act of 1984 prohibited the exchange of partnership interests.Thus, §1031(a)(2)(D) provides that §1031(a) does not apply toany exchange of interests in a partnership. The regulations apply this rulewhether the partnership interests exchanged are general or limited or arein the same partnership (Reg. §1.1031(a)-1(a)(1)). However, this provisiondoes not affect the conversion of partnership interests in the samepartnership under R. R. 84-52.Section 1031 Exchange of Property WorksheetPart I - Basis of Property Conveyed1. Cost or other basis of property conveyed $___________2. Less depreciation allowed or allowable $___________3. Adjusted basis of property conveyed (line 1 less line 2) $___________Part II - Realized Gain4. Fair market value of property received $___________5. Cash received $___________6. Fair market value of boot (other than cash) received $___________7. Mortgage balance on property conveyed $___________8. Total consideration received (add lines 4 through 7) $___________Less:9. Adjusted basis of property conveyed (line 3) $___________10. Cash given $___________11. Adjusted basis of boot (other than cash) conveyed $___________

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12. Mortgage on property received $___________13. Exchange expenses $___________14. Total consideration given (add lines 9 through 13) $___________15. Gain realized on exchange (line 8 less line 14) $___________Part III - Recognized GainProperty Boot16. Cash and boot (other than cash) received(add lines 5 and 6) $___________17. Cash and boot (other than cash) conveyed(add lines 10 and 11) $___________18. Exchange expenses (line 13) $___________3-7719. Net cash and boot (other than cash) received(line 16 less lines 17 & 18) $___________Mortgage (Relief) Boot20. Mortgage on property conveyed (line 7) $___________21. Mortgage on property received (line 12) $___________22. Net mortgage relief (line 20 less line 21; if lessthan zero, enter zero) $___________23. Gain recognized (line 19 plus line 22; line 23 cannotexceed line 15; if less than zero, enter zero) $___________Part IV - Basis of New Property24. Adjusted basis of property conveyed (line 3) $___________25. Cash and boot (other than cash) conveyed (line 17) $___________26. Mortgage on property received (line 12) $___________27. Total (add lines 24 through 26) $___________28. Cash and boot (other than cash) received (line 16) $___________29. Mortgage on property conveyed (line 7) $___________30. Total (add lines 28 and 29) $___________31. Line 27 less line 30 $___________32. Gain recognized on exchange (line 23) $___________33. Exchange expenses (line 13) $___________34. Basis of new property (add lines 31 through 33) $___________

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,

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you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.3-78147. In a delayed exchange, a replacement property must be properly identifiedwithin a certain time period. While several identification methods exist,what is a method set forth in Reg. §1.1031(a)-3(c)?a. transmission of a copy of the replacement property designation to a disinterestedthird-party.b. identification in any agreement for the exchange of properties.c. exchangor's receipt of the property before close of the exchange period.d. exchangor's receipt of the property before close of the identificationperiod.148. When five requirements are met, a taxpayer may revoke the identificationof a property in a delayed exchange. What is one such requirement?a. The person who received the initial identification receives the revocation.b. The revocation is made before the end of the exchange period.c. The revocation is agreed to by all parties.d. The revocation is signed by the intermediary.149. While the number of allowable replacement properties is independentof the number of the properties relinquished, there are certain numerical andother detailed restrictions. For example, under Reg. §1.1031(a)-1(c)(4)(i)(B),how many replacement properties may be identified by the exchangor?a. any number providing the total fair market value (FMV) of all propertiesidentified is less than 200% of the total FMV of all relinquishedproperties.b. any number of any value providing the exchangor receives 50% of fairmarket value of all properties identified by the end of the exchange period.c. four properties of any fair market value.d. any number of replacement properties provided they are identified oneat a time.3-79

Answers & Explanations147. In a delayed exchange, a replacement property must be properly identifiedwithin a certain time period. While several identification methods exist,what is a method set forth in Reg. §1.1031(a)-3(c)?a. Incorrect. Under Reg. §1,1031(a)-3(c), a replacement property is “identified”if it is designated as replacement property in a document sent to a personinvolved in the exchange other than the exchangor or a disqualified person.

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b. Incorrect. Under Reg. §1.1031(a)-3(c), a replacement property is “identified”if it is identified in a written agreement for the exchange of properties.c. Incorrect. Proper identification must occur within the identification period.The identification period starts the day the exchangor transfers the relinquishedproperty and ends 45 days later. The exchange period can be up to180 days later.d. Correct. Under Reg. §1.1031(a)-3(c), a replacement property is “identified”if it is received by the exchangor before the end of the identification period.[Chp. 3]148. When five requirements are met, a taxpayer may revoke the identificationof a property in a delayed exchange. What is one such requirement?a. Correct. The identification of a property may be revoked provided it is deliveredto the person to whom the identification was originally sent.b. Incorrect. Any revocation of property identification must be made prior tothe end of the identification period.c. Incorrect. A written agreement is required to revoke the identification of aproperty in a delayed exchange. In addition, the agreement of all parties isnot required.d. Incorrect. The identification of a property may be revoked provided it issigned by the exchangor. [Chp. 3]149. While the number of allowable replacement properties is independent ofthe number of the properties relinquished, there are certain numerical andother detailed restrictions. For example, under Reg. §1.1031(a)-1(c)(4)(i)(B), how many replacement properties may be identified by theexchangor?a. Correct. Regardless of the number of relinquished properties, the maximumnumber of replacement properties the exchangor may identify is anynumber of properties as long as the aggregate FMV of all properties identifiedas of the end of the identification period does not exceed 200% of the3-80aggregate FMV of all relinquished properties as of the date of transfer by theexchangor.b. Incorrect. The maximum number of replacement properties the exchangormay identify is any number of properties of any value provided that 95% ofFMV of all properties identified is received by the end of the exchange period.c. Incorrect. The maximum number of replacement properties the exchangormay identify is three properties of any FMV.

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d. Incorrect. There is no “one at a time” rolling identification provision underthe regulations or Code. [Chp. 3]

Retirement PlansQualified Deferred CompensationQualified deferred compensation plans are the most important form of compensationused to provide retirement and separation from service benefits.Qualified v. Nonqualified PlansA qualified deferred compensation plan is a plan that meets specified requirementsin order to obtain special tax treatment. In general, qualified deferredcompensation plans must satisfy the following requirements:(i) Minimum participation standards under §410,(ii) Nondiscrimination standards (i.e., the plan cannot discriminate in favorof highly compensated employees) under §401(a)(4),(iii) Minimum vesting standards under §411,(iv) Minimum funding standards (particularly, for defined benefit plans)under §412, and(v) Specified limits on benefits and contributions under §415.In addition, reporting and disclosure requirements mandated by the EmployeeRetirement Security Act of 1974 (ERISA) have to be met.3-81

Retirement PlansINDIVIDUALRETIREMENTACCOUNTSSELFEMPLOYEDPLANSCORPORATERETIREMENTPLANSAGI OVER $109,000FULL CONTRIBUTIONNO DEDUCTIONAGI OVER $109,000FULL CONTRIBUTIONFULL DEDUCTIONAGI $89,000 - $109,000FULL CONTRIBUTIONREDUCED DEDUCTIONAGI $89,000 - $109,000

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FULL CONTRIBUTIONFULL DEDUCTIONAGI UNDER $89,000FULL CONTRIBUTIONFULL DEDUCTIONAGI UNDER $89,000FULL CONTRIBUTIONFULL DEDUCTIONNO PENSION PLAN ACTIVE PARTICIPANTMARRIED (2009 Amounts)TYPES OF RETIREMENT PLANKEOGHDEFINED CONTRIBUTIONCORPORATEDEFINED CONTRIBUTIONCORPORATEDEFINED BENEFITKEOGHDEFINED BENEFITMONEY PURCHASEPENSIONDEFINED BENEFITPENSIONANNUITYPLANPROFIT SHARINGPLANFUND PERFORMANCEYEARSRETIREMENT PIPELINENOW RETIREDEFINESCONTRIBUTIONDEFINESBENEFIT3-82Major BenefitFor many employees the retirement plan will be the primary vehicle in theiremployer provided benefit program. These plans are expressly approved bythe Government and are significant wealth building devices. Historically, theemployer considered pension plan benefits a “gift” to the employee. Unfortunately,the current thinking of many employees is that such benefits are a“right.”Current DeductionQualified deferred compensation allows the employer to have a tax deduction

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every time the employer puts money aside for the employee’s retirement.“Funding” the retirement plan through the use of a trust orsimilar arrangement does this.Timing of DeductionsA contribution to a qualified plan is generally deductible in the employer’staxable year when paid. However, §404(a)(6)7 provides that anemployer is deemed to have made a contribution to the plan as of itsyear-end, if the contribution is made on account of such year and is madeby the due date of its tax return including extensions. A special rule isprovided for CODAs.Part of Total CompensationCorporate contributions to a qualified plan are currently deductible as anordinary and necessary business expense. However, keep in mind thatbenefits will be combined with salary to arrive at total compensation thatmust be “reasonable.” In the case of shareholder employees, who arecommon in closely held corporations, this could result in IRS questionswhen substantial benefits are being provided. It should be pointed outthat the reasonableness test must be met even when plan contributionsfall within the maximum limits as set forth in the Code.Compensation BaseAs a general rule, qualified plan benefits or contributions may not be basedon imputed salary or non-qualified deferred compensation arrangements.Therefore, an employee who draws no current salary may not be included inas a participant in a qualified plan. Similarly, shareholder-employees whoelect to reduce their current salaries under non-qualified deferred compensa-7 Section 404(h)(1)(B) provides the same treatment for SEPs.3-83tion contracts may suffer the disadvantages of reduced contribution limits forqualified plan purposes.Salary Reduction AmountsContributions to a money purchase pension plan, however, may be basedon a salary reduction where the reduced amount was used to purchase atax-deferred annuity for the employee of a tax-exempt employer. The IRShas also ruled that the amount of salary reduction under a §401(k) planmay be counted as compensation for purposes of determining benefitsunder a defined benefit plan.For purposes of determining nondiscrimination under §401(a)(4), an employee’scompensation is defined as total compensation included in grossincome. An employer also has the option to include in the definition ofcompensation salary reductions under a §401(k) plan or §125 plan. Aqualified plan may not consider any employee’s salary in excess of$245,000 (in 2009) for purposes of determining contributions, benefits,and deductibility of contributions or nondiscrimination requirements.This limit is indexed to the CPI.Benefit Planning

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Despite the popularity of qualified retirement plans, benefits are rarelyplanned with any logic. To have sufficient income to meet one’s retirementneeds requires some long term planning.In companies where the key employees are also shareholders, retirementplan contributions are normally tied to the fluctuations in company profitsand the desire to “zero out” or equalize the tax rates between the owners andthe company rather than any systematic plan to satisfy pre-determined retirementneeds. In larger companies, little is done to develop benefits basedon what is needed by the retiree. Here most planning focuses on what iscompetitive. While this might appear to be a good approach, there is a defect.Employees can always leave for better pay; retirees cannot leave for betterbenefits.In either event, needs analysis should concentrate on after tax income andexpenses upon retirement adjusted for the new lifestyle of the retiree. An excellenttext for an accountant in the area of planning for retirement needs isthe “Touche Ross Guide to Personal Financial Management” by W. ThomasPorter.The material is good and the chart and calculation sheets are superb. Porterindicates that retirement plans are designed to provide only 35 to 40 percentof one’s retirement income even when properly structured and funded. Theremaining 60 to 65 percent will hardly come from Social Security. Most peo3-84ple do not realize the importance of investment income to their retirementdreams until they are just a few years away from retiring.Pension Protection Act of 2006The Pension Protection Act of 2006 was a sweeping reform of pension fundingrules. The Pension Act identified troubled private pension plans, helpedstabilize them before employers resort to bankruptcy and strengthened thePension Benefit Guarantee Corporation (PBGC).The measure also permanently extended pension and savings tax incentivesthat were part of the Economic Growth and Tax Relief Reconciliation Act of2001 ("EGTRRA"). The Pension Act included:1. An increase in the annual contribution limit for tax-favored IndividualRetirement Accounts (IRAs).Note: The limit is $5,000 in 2009 and is indexed for inflation. Without congressionalaction, that limit was set to return to $2,000 by 2011.2. “Catch-up contributions” that allow people age 50 and over to makeadditional $1,000 contributions to IRAs each year and up to $5,000 contributionseach year to §401(k) plans.3. An increase in the contribution limits on §401(k) plans.

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4. Permanence of a saver’s tax credit aimed at lower income taxpayers.5. Incentives to encourage automatic savings mechanisms by §401(k) plansponsors.Note: It provides legal protections, known as a “safe harbor,” to encouragecompanies sponsoring plans to implement automatic savings mechanisms fordefined contribution plans.6. Increased flexibility and favorable tax treatment to allow individualswith annuity and life insurance contracts with a long-term care insuranceoption to use the cash value of their annuities to pay for long-term careinsurance.7. Direct deposit of tax refunds in to an IRA.8. Rollovers by nonspousal beneficiaries.9. Direct rollovers from retirement plans to Roth IRAs.11. Expanded §401(k) hardship withdrawals.12. Combined defined benefit and §401(k) plans.13. Diversification rights with respect to amounts invested in employersecurities.14. A prohibited transaction exemption under ERISA for investment advice.3-85Corporate PlansAdvantagesFor a small closely held company that can operate in the corporate form,a qualified corporate pension, or profit-sharing plan generally is the bestvehicle for deferring income until retirement. The principal advantagesfall into two categories - current and deferred.CurrentThe current benefits are:(1) The employer corporation obtains a current deduction for theamounts paid or accruable to the qualified plan (§404(a));(2) The employee does not recognize income currently on contributionsmade by his or her employer even though the benefits may benonforfeitable and fully vested (§§402(a) & 403(a)); and(3) Employee benefit trust accumulates tax-free (see §501(a).DeferredAmong the deferred tax advantages are:(1) Lump-sum distributions from a qualified employee benefit planare eligible for favorable five (or in some cases still ten) year incomeaveraging treatment (§402(e)); andNote: The Small Business Job Protection Act of 1996 repealed 5-yearaveraging for tax years beginning after 1999.(2) Certain distributions may be rolled over tax-free into an IRA.DisadvantagesThere are two principal disadvantages of a qualified corporate plan:Employee CostsFor a closely held corporation, it is often the cost to the shareholderemployeeof covering rank and file employees. Generally, the objective

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of qualified retirement plans of closely held companies is to providethe greatest benefit to the controlling shareholders/executives.Comparison with IRAs & KeoghsQualified corporate plans permit substantially larger contributionsthan an IRA. Formerly, corporate plans also exceeded Keogh plans aswell, but effective 1984, such plans are essentially equal in terms ofbenefits.3-86As a result of TEFRA (Tax Equity and Fiscal Responsibility Act of1982) maximum benefits were reduced, the early retirement age wasraised, new rules were enacted for corporate and non-corporate plans,and restrictions were established for “top heavy” plans.Basic ERISA ProvisionsERISA consists of four main sections (Titles):Title I is primarily concerned with all types of retirement and welfarebenefit programs. Health insurance, group insurance, deferred compensationplans, etc. must all be considered from the standpoint of the Departmentof Labor regulations. Reporting and disclosure requirementsare provided for under Title I which requires that detailed plan summariesbe provided to all plan participants and beneficiaries. Similarly, anyplan amendments must also be reported to the participants and beneficiaries.All participants must also receive copies of the plan's financialstatement from the annual report, as well as an annual statement of accruedand vested benefits.Title II covers only qualified retirement plans and tax-deferred annuities,primarily from a federal tax standpoint.Title III involves jurisdiction, administration, enforcement, and the enrollmentof actuaries.Title IV outlines the requirements for plan termination insurance. Becauseof the complexity and length of these provisions (the DOL it seems,feels obligated to equal or exceed the standards of administrative confusionwhich have been so competently laid out by the IRS), we will attemptonly to cursorily cover some of the provisions commonly affecting qualifiedplans.ERISA Reporting RequirementsERISA imposes a large paperwork burden in connection with any qualifiedretirement plan. This burden includes preparing reports that must besent to the IRS, plan participants, plan beneficiaries, the department ofLabor, and the Pension Benefit Guaranty Corporation. When a qualifiedplan is first installed, the IRS approval of the plan is usually sought.In addition, the Department of Labor must receive a plan descriptionwhen the plan is first installed (plus additional reports every time the planis amended). Most plans must file an annual report that includes financial

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statements (certified by a Certified Public Accountant), schedules, an actuarialstatement (certified by an enrolled actuary), and other information.Participants and beneficiaries are required to receive a summaryplan description and a summary annual plan report from the plan.3-87Moreover, participants and beneficiaries are entitled to receive, on request,statements concerning certain benefit information.Fiduciary ResponsibilitiesThe fiduciary responsibilities of plan administration are also detailed byTitle I. A federal prudent man investment rule is imposed on fiduciariesand adequate portfolio diversification is normally required. Any personwho exercises any discretionary control or authority over the managementof a plan, or any authority over the management of the plan’s assets is afiduciary. Therefore, while plan trustees are clearly fiduciaries, other notso-obvious persons may also be so classified by ERISA and, therefore, beliable for losses if they violate their fiduciary duties. The law defines a“party-in-interest” as an administrator, officer, fiduciary, employer, trustee,custodian and legal counsel, as well as certain other parties.Bonding RequirementAll fiduciaries, except certain banks, must be bonded. The amount ofthe bond must not be less than 10% of the amount of funds handled or$1,000, whichever is greater, or generally, not more than $500,000.Plans covering only partners and their spouses, or a sole shareholder,or a sole proprietor and spouse, are not subject to the bonding requirements.Prohibited TransactionsThere are also several prohibited transactions which fiduciaries are forbiddento engage in with party-in-interest. However, the Department ofLabor may grant a specific exemption to any of these prohibited transactionsbased upon disclosure and proof of the benefit to the plan. Theseprohibited transactions are as follows:(1) A sale, exchange, or lease of property between the plan and aparty-in-interest;(2) A loan or other extension of credit between the plan and a partyin-interest;(3) The furnishing of goods, services, or facilities between the plan anda party-in-interest;(4) A transfer of plan assets to a party-in-interest or a transfer that isfor the use and benefit of a party-in-interest; and(5) An acquisition by the plan of employer securities or real estate thatis in violation of ERISA §407(a).3-88Additional RestrictionsThe following actions by plan fiduciaries are also prohibited:(a) Dealing with the assets of the plan for their own account;(b) Receiving any consideration for his own account from any party

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dealing with the plan in connection with a transaction involving planassets; or(c) Acting in any capacity in any transaction involving a plan on behalfof a party, or in representation of a party, whose interests areadverse to the interests of the plan, its participants, or beneficiaries.Fiduciary ExceptionsThere are however, some exceptions to these prohibited transactionsthat do not prevent a fiduciary from doing any of the following:(a) Receiving benefits from the plan as a participant or beneficiaryso long as the benefits so received are consistent with the terms ofthe plan as applied to all other participants and beneficiaries;(b) Receiving reasonable compensation for services to the planunless the fiduciary receives full time pay from the employer or employeeorganization;(c) Receiving reimbursements for expenses actually incurred in thecourse of his duties to the plan; and/or(d) Serving as an officer, employee, agent, etc., of a party-in-interest.LoansAnother important exception to the prohibited transaction rules permitsqualified plans to make loans to plan participants. Any such loansmust be made in accordance with specific provisions in the plan andmust provide for a reasonable interest rate and adequate security.Loans must be made available on a nondiscriminatory basis. That is tosay, they must be made available to all plan participants on a reasonablyequivalent basis.A loan from a qualified plan to a plan participant or beneficiary istreated as a taxable distribution unless:(1) The loan must be repaid within 5 years (except for certain homeloans), and(2) The loan does not exceed the lesser of (a) $50,000, or (b) thegreater of $10,000 or 1/2 of the participant’s accrued benefit underthe plan.The $50,000 limit for qualified plan loans is reduced where the participanthas an outstanding loan balance during the 1-year period ending3-89on the day before the date of any new loan (§72(p)(2)(A)(i)). In addition,except as provided in regulations, a plan loan must be amortizedin substantially level payments, made not less frequently than quarterly,over the term of the loan (§72(p)(2)(C)).Formerly, the above exceptions to the prohibited transaction rules didnot apply to plan loans to owner-employees.Note: For purposes of the prohibited transaction rules, an owneremployeemeans (1) a sole proprietor, (2) a partner who owns morethan 10% of either the capital interest or the profits interest in thepartnership, (3) an employee or officer of a Subchapter S corporationwho owns more than 5% of the outstanding stock of the corporation,and (4) the owner of an IRA.

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However, since 2002, the rules relating to plan loans made to owneremployees (other than the owner of an IRA) were eliminated. Thus,the general statutory exception applies to such transactions.Employer SecuritiesWith the exception of profit sharing and pre-ERISA money purchasepension plans, pension plans may not acquire or hold qualifying employersecurities or real property in the plan in excess of 10% of the fair marketvalue of all of the plan’s assets.Under the 2006 Pension Act, certain defined contribution plans are requiredto provide diversification rights with respect to amounts investedin employer securities.Such a plan is required to permit applicable individuals to direct that theportion of the individual's account held in employer securities be investedm alternative investments. An applicable individual includes:(1) any plan participant; and(2) any beneficiary who has an account under the plan with respect towhich the beneficiary is entitled to exercise the rights of a participant.Thus, participants must be allowed to immediately diversify any employeecontributions or elective contributions invested in employer securities.For employer contributions, participants must be able to diversify out ofemployer stock after they have been in the plan for three years.Excise Penalty TaxWhere a disqualified person participates in a prohibited transaction, aninitial non-deductible excise tax equal to 5% of the amount of the transactionis imposed on such person. An additional tax equal to 100% of thetransaction amount is imposed if the transaction is not corrected within3-90the correction period that is 90 days from the notice of deficiency, plusany extensions.PBGC InsuranceDefined benefit pension plans may be subject to the plan termination insurancerequirements of the Pension Benefit Guarantee Corporation(PBGC). The basic purpose is to guarantee payment of vested plan benefitsat the time of termination of a plan where the plan’s assets are insufficientto pay such benefits.Sixty-Month RequirementThe PBGC guarantees the plan benefits to the extent that a plan hasbeen in existence for 60 months at the time of plan termination. This60-month requirement allows for a phase-in of 20% per year for plansthat have not been in existence for 5 years. The funds to be accumulatedby the PBGC are derived from an annual premium to be paid foreach active participant and retiree. Even fully insured plans are requiredto obtain PBGC coverage.Recovery Against EmployerWhere the PBGC is required to pay benefits to participants, it may recover

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such amounts from the employer up to 30% of the employer’snet worth plus additional sums. Although this contingent employer liabilitymay be covered by special risk insurance, the premiums are substantial.Termination ProceedingsThe PBGC can also be thoroughly involved in the operations of definedbenefit pension plans. For example, the PBGC may institute proceedingsto terminate a plan if it finds that:(1) The plan failed to comply with the minimum funding standards;(2) The plan is unable to pay benefits when they become due;(3) A distribution is made to an owner-employee of $10,000 in a 24month period, unless the payment is made due to the death of theowner-employee if, after the distribution, there are unfunded vested liabilities;or(4) The possible long-term liability of the plan to the PBGC will increaseunreasonably if the plan is not terminated.Plans Exempt from PBGC CoverageSome plans are specifically excluded from the requirement of PBGC insurancecoverage. These plans are as follows:3-91(a) Individual account plans, such as money purchase pension plans,target benefit plans, profit sharing plans, thrift and savings plans, andstock bonus plans;(b) Governmental plans;(c) A church plan which is not volunteered for coverage, does notcover the employees of a non-related trade or business and is not amulti-employer plan in which one or more of the employers are notchurches or a convention or association of churches;(d) Plans established by fraternal societies or other organizations describedin §501(c)(8), (9) or (18) which receive no employer contributionsand cover only members (not employees);(e) A plan that has not, after the date of enactment, provided for employercontributions;(f) Nonqualified deferred compensation plans established for a selectgroup of management or highly compensated employees;(g) A plan outside the United States established for non-residentaliens;(h) A plan that is primarily for a limited group of highly compensatedemployees where the benefits to be paid, or the contributions to be received,are in excess of the limitations of §415;(i) A qualified plan established exclusively for substantial owners;(j) A plan of an international organization that is exempt from tax underthe provisions of the International Organizations Immunity Act;(k) A plan maintained only to comply with worker’s compensation, unemployment

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compensation, or disability insurance laws;(l) A plan established and maintained by a labor organization describedin §501(c)(5) that does not, after the date of enactment, providefor employer contributions;(m) A plan which is a defined benefit plan to the extent that it istreated as an individual account plan under §3(35)B of the Act; or(n) A plan established and maintained by one or more professionalservice employers that has, from the date of enactment, not had morethan 25 active participants. Once one of these plans has more than 25active participants, it will remain covered even if the number of activeparticipants subsequently falls back below 25.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. The3-92following questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.150. The Pension Protection Act of 2006 (PPA) reformed the rules for pensionfunds and helped employers actualize their employees’ retirement plans.What was one item that was included under PPA?a. a decrease in contribution limits on 401(k) plans.b. a safe harbor for plans that contain of automatic savings methods.c. a saver’s tax credit aimed at the elderly.d. catch-up contributions for lower-income workers.151. The author identifies two deferred tax advantages of corporate retirementplans. What is one of these advantages?a. There is a tax-free accumulation of the employee benefit trust.b. The employee may roll over into an IRA certain distributions tax-free.

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c. Amounts paid or accruable to the qualified plan are currently deductiblefor the employer corporation.d. Employer contributions aren’t recognized currently as income.152. The author lists two major disadvantages of qualified corporate plans.What is one of these disadvantages?a. Loans may not be made to plan participants.b. Lump-sum distributions are ineligible for favorable five-year incomeaveraging treatment.c. The expense to the shareholder-employees of paying for taking care ofthe majority of the employees.d. No plan may hold any more than 10% of the fair market value of thetotal assets in qualifying employer real property.153. There are four main sections of the Employment Retirement IncomeSecurity Act (ERISA). Which basic ERISA provision is concerned with onlyqualified retirement plans and tax-deferred annuities, mainly from a federaltax perspective?a. Title I.b. Title II.3-93c. Title III.d. Title IV.154. A fiduciary employs unrestricted control or authority over managementof a qualified deferred compensation plan or of such a plan’s assets. What isa fiduciary permitted to do?a. be involved, in any manner, in any deal that involves another plan onbehalf of a party whose interests are opposing the plan’s interests.b. have authority over the plan’s assets for their own account.c. obtain any payment for his own account from any party involved in theplan in association with a transaction involving plan assets.d. operate as an officer, employee, or agent of a party-in-interest.155. The Pension Benefit Guarantee Corporation (PBGC) guarantees paymentof certain benefits upon a plan’s termination if a plan fails to satisfysuch payment. What plan is included in the requirement of PBGC insurancecoverage?a. a governmental plan.b. a plan established by fraternal societies which receive no employer contributionsand cover only members (not employees).c. a defined nondiscriminatory benefit plan where benefits to be paid areno more than the limitations of §415.d. a qualified plan established exclusively for substantial owners.

Answers & Explanations150. The Pension Protection Act of 2006 (PPA) reformed the rules for pension

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funds and helped employers actualize their employees’ retirement plans.What was one item that was included under PPA?a. Incorrect. The Pension Protection Act of 2006 increased the contributionlimits on 401(k) plans.b. Correct. By offering legal protections, the government is trying to persuadecompanies to apply automatic savings mechanisms for defined contributionplans in order to increase the participation of employees in retirementplans.c. Incorrect. The 2006 Pension Protection Act includes a saver’s tax creditwhich is intended to push lower-income workers to save in qualified retirementaccounts.d. Incorrect. The Pension Protection Act of 2006 includes catch-up contributionsfor those ages 50 and over. Basically, additional annual $1,000 contributionsto IRAs and annual $5,000 contributions to 401(k) plans are allowed.[Chp. 3]3-94151. The author identifies two deferred tax advantages of corporate retirementplans. What is one of these advantages?a. Incorrect. A current benefit of a corporate plan is that employee benefittrust accumulates tax-free.b. Correct. One of the two listed deferred tax advantages of corporate plansis that certain distributions may be rolled over tax-free into an IRA.c. Incorrect. A current benefit of a corporate plan is that the employer corporationobtains a current deduction for the amounts paid or accruable to thequalified plan.d. Incorrect. A current benefit of a corporate plan is that the employee doesnot recognize income currently on contributions made by his or her employereven though the benefits may be nonforfeitable and fully vested. [Chp. 3]152. The author lists two major disadvantages of qualified corporate plans.What is one of these disadvantages?a. Incorrect. One of the exceptions to the prohibited transaction rules allowsfor loans to be made to plan participants. Thus, this is not a disadvantage.b. Incorrect. A deferred tax advantage of a qualified corporate plan is thatlump-sum distributions from a qualified employee benefit plan are eligiblefor favorable five (or in some cases still ten) year income averaging treatment.c. Correct. For a closely held corporation, it is often the cost to the shareholder-employee of covering rank and file employees. Generally, the objectiveof qualified retirement plans of closely held companies is to provide thegreatest benefit to the controlling shareholders/executives.

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d. Incorrect. Most pension plans may not acquire or hold 10% of the fairmarket value of the total assets in qualifying employer real property or securities.However, profit sharing and pre-ERISA money purchase pensionplans may. Thus this is not one of the disadvantages of a qualified corporateplan. [Chp. 3]153. There are four main sections of the Employment Retirement Income SecurityAct (ERISA). Which basic ERISA provision is concerned with onlyqualified retirement plans and tax-deferred annuities, mainly from a federaltax perspective?a. Incorrect. Title I is primarily concerned with all types of retirement andwelfare benefit programs.b. Correct. Title II covers only qualified retirement plans and tax-deferredannuities, primarily from a federal tax standpoint.c. Incorrect. Title III involves jurisdiction, administration, enforcement, andthe enrollment of actuaries.3-95d. Incorrect. Title IV outlines the requirements for plan termination insurance.[Chp. 3]154. A fiduciary employs unrestricted control or authority over management ofa qualified deferred compensation plan or of such a plan’s assets. What is afiduciary permitted to do?a. Incorrect. One of the three listed prohibited actions that plan fiduciariesmay not engage in is acting in any capacity in any transaction involving a planon behalf of a party, or in representation of a party, whose interests are adverseto the interests of the plan, its participants, or beneficiaries.b. Incorrect. One of the three listed prohibited actions that plan fiduciariesmay not engage in is dealing with the assets of the plan for their own account.c. Incorrect. One of the three listed prohibited actions that plan fiduciariesmay not engage in is receiving any consideration for his own account fromany party dealing with the plan in connection with a transaction involvingplan assets.d. Correct. There are four listed exceptions to the prohibited transactions.One of these exceptions allows fiduciaries to operate as an officer, employee,agent, etc., of a party-in-interest. [Chp. 3]155. The Pension Benefit Guarantee Corporation (PBGC) guarantees paymentof certain benefits upon a plan’s termination if a plan fails to satisfy suchpayment. What plan is included in the requirement of PBGC insurance

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coverage?a. Incorrect. Governmental plans are specifically excluded from PBGC insurancecoverage.b. Incorrect. Plans established by fraternal societies or other organizationswhich receive no employer contributions and cover only members (not employees)are specifically excluded from PBGC insurance coverage.c. Correct. Plans that are primarily for a limited group of highly compensatedemployees where the benefits to be paid, or the contributions to be received,are in excess of the limitations of §415 are specifically excluded from PBGCinsurance coverage.d. Incorrect. Qualified plans established exclusively for substantial ownersare specifically excluded from PBGC insurance coverage. [Chp. 3]Basic Requirements of a Qualified Pension PlanThere are three basic forms of qualified plans: pension plans, profit-sharingplans, and stock bonus plans. The qualification requirements for all of these3-96plans are identical, except that certain fundamental differences in the plans requirevariations in the application of some rules.Written PlanThe employer must establish and communicate to its employees a writtenplan (and, usually, a trust), which is valid under state law (Reg. §1.401(a)(2)).CommunicationA plan must actually be reduced to a formal written document and communicatedto employees by the end of the employer’s taxable year, in orderto be qualified for such year. Under ERISA, a summary plan descriptionmust be furnished to participants within 120 days after the plan is establishedor, if later, 90 days after an employee becomes a participant(DOL Reg. §2520.104b-2(a)). The summary plan description must bewritten in such a manner that it will be understood by the average planparticipant and must be sufficiently comprehensive in its description ofthe participant’s rights and obligations under the plan (DOL Reg.§2520.102-2).TrustThe assets of a qualified plan must be held in a valid trust created or organizedin the United States. As an alternative, a custodial account or an annuitycontract issued by an insurance company or a custodial account held by abank (for a plan which uses IRAs) may be used (ERISA §403(b)). Under§401(f), these custodial accounts and annuity contracts will be treated as aqualified trust, and the person holding the assets of the account or contractwill be treated as the trustee thereof.

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RequirementsA trust is a matter of state law. In order to be a valid trust, three requirementsmust be met:(i) The trust must have a corpus (property);(ii) The trust must have a trustee; and(iii) The trust must have a beneficiary.Both the plan and the trust must be written instruments. They may, however,be two separate or one combined instrument.To obtain a deduction for a year, the trust must be established beforeyear end, although the actual contribution is not required until the duedate of filing the employer tax return including extensions (§404(a)(6).Although this contradicts the requirement that a valid trust have a corpus,the IRS has held that if the trust is valid in all respects under local law ex3-97cept for the existence of corpus, and if the contribution is made within theabove prescribed time limits, it will be deemed to have been in existenceon the last day of the year (R.R. 81-114).PermanencyThe plan must be a permanent and continuing program. It must not be atemporary arrangement set up in high tax years as a tax savings scheme tobenefit the employer. Although the employer may reserve the right to terminatethe plan and discontinue further contributions, the abandonment of aplan for any reason other than business necessity can indicate that the planwas not a bona fide program from its inception (Reg. §1.401-1(b)(2)). Thus,if a plan is discontinued after only a short period of years, the IRS may retroactivelydisqualify the plan.Exclusive Benefit of EmployeesThe plan and trust must be for the exclusive benefit of employees and theirbeneficiaries. A qualified plan cannot be a subterfuge for the distribution ofprofits to shareholders. Thus, the plan cannot discriminate in favor of certainhighly compensated employees.Highly Compensated EmployeesUnder §414(q)(1), a “highly compensated employee” is any employeewho:(1) Was a 5% owner (as defined in §416(i)), at any time during theyear or the preceding year, or(2) For the preceding year, had compensation from the employer inexcess of $80,000 (indexed for inflation), and, if the employer electsthis condition, was in the top 20% of employees by compensation forthe preceding year (§414(q)).Reversion of Trust Assets to EmployerThere must ordinarily be no reversion of trust assets and contributions to

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the employer except for actuarial errors or an excess of plan assets upontermination of a defined benefit pension plan.The trust instrument must make it impossible, before the satisfaction ofall liabilities to employees and beneficiaries, for assets to be used for, ordiverted to, purposes other than for the exclusive benefit of employees orbeneficiaries. This provision must be written into the trust instrument(Reg. §1.401-2).3-98Participation & CoverageThe plan must cover a required percentage of employees or cover a nondiscriminatoryclassification of employees. The plan may not discriminate in favorof highly compensated employees.Section 401(a)(3) requires that a plan meet the minimum participation standardsof §410. Section 410 divides these participation standards into two generalcategories:(i) Age and service requirements (that is, the rights of an employer to excludecertain employees on account of age or years of service), and(ii) Coverage requirements, which relate to the portion of the employer’stotal work force that must participate in the plan.Age & ServiceA qualified plan cannot exclude any employee from participation on accountof his age or years of service, except for the exclusion of employeeswho are:(i) Under age 21, or(ii) Have less than one “year of service.”Note: In the case of a plan that provides for 100 percent vesting after nomore than two years of service, it can require a two-year period of service foreligibility to participate.An employee who has satisfied the minimum age and service requirementsof the plan (if any) must actually begin participation (i.e., enter theplan) no later than the earlier of:(i) The first day of the first plan year beginning after he satisfied therequirements; or(ii) Six months after he satisfied the requirements (Reg. §1.410(a)-4(b)).A year of service is a 12-consecutive- month period (referred to as thecomputation period) during which the employee has at least 1,000 “hoursof service.”Hours of service include:(i) Hours for which the employee is paid, or entitled to payment, forthe performance of duties;(ii) Hours for which the employee is paid, or entitled to payment, duringperiods when no duties are performed, such as vacation, illness,

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disability, maternity or paternity leave; andNote: The plan does not have to credit the employee with more than501 hours of service for this category.3-99(iii) Hours for which back pay is awarded or agreed to by the employer.CoverageTo insure that lower paid employees have the benefit of a retirementplan, tax law requires qualified plans to provide coverage for them. This isaccomplished by two sets of requirements. The first set is three tests:(i) A percentage test,(ii) A ratio test, and(iii) An average benefits test.The second set requires a specific minimum number of covered participants.Percentage TestUnder this test, the plan must “benefit” at least 70% of all the employeeswho are not highly compensated employees.Note: This is not the same as the 70% test under pre-TRA ‘86 law. This testis broader, since it requires that 70% of “all nonhighly compensated employees,”rather than “all employees” (which includes both highly and nonhighlycompensated employees).Ratio TestTo satisfy this test, a plan must benefit a percentage of nonhighly compensatedemployees that is at least 70% of the percentage of highlycompensated employees benefiting under the plan.ExampleAn employer has two highly compensated employees and 20nonhighly compensated employees. If the plan covers both ofthe highly compensated employees (100%), it must cover atleast 14 of the nonhighly compensated employees (70% of100% = 70% required coverage). If the plan covers only oneof the highly compensated employees (50%), it must cover atleast seven of the nonhighly compensated employees (70%of 50% = 35% required coverage).Average Benefits TestA plan will meet the average benefits test if:(i) The plan meets a nondiscriminatory classification test (using the§414(q) definition of highly compensated employees); and3-100(ii) The average benefit percentage of nonhighly compensated employees,considered as a group, is at least 70% of the average benefitpercentage of the highly compensated employees, considered as agroup.The classification test is met for a plan year if the classification systemis reasonable and established under objective business criteria thatidentify the employees who benefit under the plan. This classificationmust meet a safe and unsafe harbor range that compares the percentageof nonhighly compensated employees to the percentage of highly

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compensated employees benefiting under the plan.Numerical CoverageThe second set of requirements was added to the Code to eliminatediscrimination in favor of highly compensated employees through theuse of multiple plans. Section 401(a)(26) provides that a trust will notbe qualified unless it benefits the lesser of:(i) 50 employees; or(ii) 40% of “all employees.”Thus, each plan must have a minimum number of employees covered,without regard to any designation of another plan.The additional participation rules of §401(a)(26) only apply to definedbenefit plans. A defined benefit plan does not meet the §401(a)(26)rules unless it benefits the lesser of:(i) 50 employees, or(ii) The greater of:(a) 40% of all employees of the employer, or(b) 2 employees (one employee if there is only one employee).Related EmployersAn employer could attempt to circumvent the coverage requirementsof §410(b) by operating its business through multiple entities. Becauseof this potential abuse, certain related employers are treated as a singleemployer for purposes of the coverage tests. That is, all employees ofeach entity in the group are used in computing the percentage or classificationtests.The related employers that fall into this classification are:(i) Trades or businesses under common control (both parentsubsidiaryand brother-sister forms),(ii) Affiliated service groups, and(iii) Leased employee arrangements.3-101VestingVesting refers to the percentage of accrued benefit to which an employeewould be entitled if they left employment prior to attaining the normal retirementage under the plan. Vesting represents that portion of the employee’sbenefit that is nonforfeitable.Section 401(a)(7) requires a plan to meet the rules under §411, regardingvesting standards. These vesting standards contain three classes of vesting:(i) Full and immediate vesting;(ii) Minimum vesting under §411(a)(2); and(iii) Compliance with §401(a)(4) nondiscrimination requirements.Full & Immediate VestingUnder §411(a), a participant’s normal retirement benefit derived fromemployer contributions must be nonforfeitable upon the attainment ofnormal retirement age, regardless of where the employee happens to fall

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on the plan’s vesting schedule at normal retirement age.Section 411(a)(1) requires that a participant must be fully vested at alltimes in the accrued benefit derived from the employee’s own contributionsto the plan. This requirement applies regardless of whether the employeecontributions are voluntary or mandatory.Section 411(d)(3) requires that a qualified plan provide that accruedbenefits become nonforfeitable for participants who are affected by acomplete or partial termination of, or a discontinuance of contributionsto, a plan.Minimum VestingFor employer contributions, plans have historically had to meet the requirementsof two minimum vesting schedules:1. Five-Year Cliff Vesting. Under this schedule, participants who havecompleted five years of service with the employer must receive a 100%nonforfeitable claim to employer-derived benefits. Thus, the scheduleis as follows:Completed Years of Service Nonforfeitable Percentage1-4 0%5 100%2. Three-to-Seven Year Graded Vesting. This schedule is graded in asimilar fashion to the old five-to-15 year graded schedule, except, ofcourse, that it provides a more rapid rate of vesting. The schedule is:3-102Completed Years of service Nonforfeitable Percentage1-2 0%3 20%4 40%5 60%6 80%7 100%Note: The general rules for counting years of service for vesting aresimilar to those for participation. However, three important differencesexist. First, all years of service after the attainment of age 18 (ratherthan age 21) must be counted. Years of service before age 18 may bedisregarded. Second, contributory plans (those with mandatory employeecontributions) may disregard any years of service in which anemployee failed to make a contribution. Finally, years of service duringwhich the employer did not maintain the plan or a predecessor planmay be disregarded.In the case of matching contributions (as defined in §401(m)(4)(A)),plans had to meet the requirements of two minimum vesting schedules:1. Three-Year Cliff Vesting. Under this schedule, participants whohave completed three years of service with the employer must receive a100% nonforfeitable claim to employer-derived benefits.2. Two-to-Six Year Graded Vesting. This schedule is graded in a similarfashion to the old five-to-15 year graded schedule, except, of course,

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that it provides a more rapid rate of vesting. The schedule is:Completed Years of service Nonforfeitable Percentage2 20%3 40%4 60%5 80%6 100%However, for plan years beginning after December 31, 2006, the expeditedvesting schedule that applied to employer matching contributions was extendedto all employer contributions to defined contribution plans byPension Protection Act of 2006 (§411(a)(2)).As a result, for plan years beginning after 2006, a defined contributionplan (e.g., profit-sharing and §401(k) plans) must vest all employer contributionsaccording to the schedule that, before 2007, applied only toemployer matching contributions. For example, if a defined contributionplan used cliff vesting, accrued benefits derived from all employer contri3-103butions must now vest with the participant after three years of service.Likewise, if a defined contribution plan used graduated vesting, all employercontributions must now vest with the participant at the rate of 20%per year, beginning with the second year of service.Diversification RightsUnder the Pension Protection Act of 2006, in order to satisfy the planqualification requirements of the Code and the vesting requirements ofERISA, certain defined contribution plans are required to provide diversificationrights with respect to amounts invested in employer securities.Nondiscrimination ComplianceEven if a plan adopts one of the statutory vesting schedules, it may stilldiscriminate in favor of highly compensated employees in practice. If theIRS determines either that there has been a “pattern of abuse” under theplan or that there is reason to believe that there will be an accrual ofbenefits or forfeitures tending to discriminate in favor of highly compensatedemployees, it can require a more accelerated vesting schedule under§411(d)(1).Contribution & Benefit LimitsSection 401(a)(16) requires a plan to comply with §415 limitations for contributionsand benefits. These limitations set the maximum amounts that theemployer may provide under the plan. A plan must include provisions to ensurethat these limitations are never exceeded for any participant; otherwise,the entire plan will become disqualified for the year.The limitations imposed on both defined contribution and defined benefit

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plans are based on the participant’s compensation. However, there is amaximum dollar amount of compensation that may be considered. Initiallyset at $200,000, it was decreased by OBRA ‘93 to $150,000. In 2009, it was setto $245,000.Defined Benefit Plans (Annual Benefits Limitation) - §415A defined benefit plan may not provide “annual benefits” in excess of thelesser of:(i) A dollar limit of $160,000 (subject to COLAS) ((§415(b)(1)(A)); or(ii) 100% of the participant’s average annual compensation for thethree consecutive years in which their compensation was the highest(§415(b)(1)(B)).The $160,000 limit is subject to cost of living adjustments. In 2009 planyears, this amount is $195,000.3-104The annual benefit means a benefit payable annually at the participant’ssocial security retirement age in the form of a straight-life annuity, withno ancillary benefits, under a plan to which employees do not contributeand under which the employee makes no rollover contributions.Note: Employee contributions, whether mandatory or voluntary, are consideredto be a separate defined contribution plan to which the limitationsthereon apply.Defined Contribution Plans (Annual Addition Limitation) - §415A defined contribution plan’s “annual additions” to a participant’s accountfor any limitation year may not exceed the lesser of:(i) $49,000 in 2009 (or, if greater, one-fourth of the defined benefitdollar limitation) (§415(c)(1)(A)).; or(ii) 100% of the participant’s compensation (§415(c)(1)(B)).Annual additions include employer contributions, including contributionsmade at the election of the employee (i.e., employee elective deferrals),after-tax employee contributions, and any forfeitures allocated to the employee(§415(c)(2)).Limits on Deductible Contributions - §404To be deductible, a contribution to a qualified plan must be an ordinaryand necessary expense of carrying on a trade, business or other activityengaged in for the production of income. In addition, a contribution maynot be deducted unless it is actually paid into the plan.1. Defined contribution plans: For profit-sharing, stock bonus, simplifiedemployee pension, and money purchase pension plans, deductiblecontributions are limited to 25% of the compensation otherwise paidor accrued during the taxable year to plan beneficiaries(§404(a)(3)(A)).2. Defined benefit plans: An employer is permitted to use either one oftwo methods for determining the minimum deductible annual contributionto a defined benefit pension plan:

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a. The level funding method (§404(a)(1)(A)(ii)), orb. The normal cost method (§404(a)(1)(A)(iii)).Note: However, if the annual contribution necessary to satisfy the minimumfunding standard provided by §412(a) is greater than the amountdetermined under either of the above two, the limit may be increased tothat amount.As to the maximum deductible annual contribution (subject to a specialrule for plans with more than 100 participants), the employer may3-105not deduct an amount that exceeds the full funding limitation determinedunder the minimum funding rules (§412).3. Combination plans: Where any employee is the beneficiary underboth a defined benefit and a defined contribution plan of the employer,deductible contributions are limited to 25% of the compensation otherwisepaid or accrued during the taxable year to plan beneficiaries(§404(a)(9)).Assignment & AlienationSection 401(a)(13) requires qualified plans to provide that the participants’benefits under the plan may not be assigned, alienated or subject to attachment,garnishment, levy, execution or other equitable process.However, several exceptions to this rule exist:1. Any voluntary revocable assignment of an amount that does not exceed10% of any benefit payment, may be made by a participant or beneficiary,as long as the purpose of the assignment is not to defray the costs of planadministration.2. A loan by the plan to the participant or beneficiary that is secured bythe participant’s accrued benefit will not be considered an assignment oralienation, if the loan is exempt from the prohibited transaction tax of§4975 because it meets the requirements under §4975(d)(1).3. The following arrangements are deemed not to be an assignment oralienation:(a) Arrangements for the withholding of federal, state, or local taxesfrom plan benefits;(b) Arrangements for the recovery by the plan of overpayments ofbenefits previously made to a participant;(c) Arrangements for the transfer of benefit rights from the plan toanother plan;(d) Arrangements for the direct deposit of benefit payments to a bank,savings and loan association or credit union, provided that the arrangementdoes not constitute an assignment of benefits; and(e) Arrangements whereby a participant directs the plan to pay anyportion of a benefit to a third party if it is revocable at any time by theparticipant or beneficiary and the third party acknowledges in writingthat he has no enforceable right to the benefit payments.4. The assignment and alienation prohibition does not apply to the creation,

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assignment, or recognition of a right to any benefit payable pursuantto a “qualified domestic relations order” (QDRO).Note: A “domestic relations order” means any judgment, decree, or order(including approval of a property settlement agreement) that relates to the3-106provision of child support, alimony payments, or marital property rights to aspouse, former spouse, child, or other dependent of a participant and whichis made pursuant to a state domestic relation law (including a communityproperty law).Miscellaneous RequirementsForfeitures arising from the non-vested accounts of terminated employeesunder defined benefit plans must be used to reduce employer contributions.Under money purchase or target benefit plans, forfeitures may be reallocatedto the accounts of remaining participants or used to reduce employer contributions.A disability pension and incidental post-retirement and pre-retirement deathbenefits can be provided. However, benefits for sickness, accident, hospitalization,or medical expenses may not be furnished to active plan participants.One of the most important Code requirements is the minimum funding standardwhich must be met by defined benefit, target or assumed benefit andmoney purchase plans. The major purpose of this requirement is for the employerto make adequate funding. An excise tax is imposed on the employerfor failure to meet this standard.When a plan provides for a normal retirement benefit in the form of an annuityfor life, and the employee has been married for the one-year periodending on the annuity starting date, a joint and survivor spousal annuity mustbe provided.Basic Types of Corporate PlansUnder ERISA, qualified corporate retirement plans are one of two basic types:(1) Defined contribution plans, or(2) Defined benefit plans.Although defined benefit plans offer several advantages, defined contributionplans are frequently better to start with and are generally more practical for thesmall corporation.Defined BenefitMechanicsGenerally, a defined benefit plan attempts to specify benefit levels foremployees. Once benefit levels are established, contributions are determinedbased upon actuarial calculations.

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The employer bears the risk of the investment program used by the employeebenefit trust that administers the plan’s assets. If that programcauses the plan assets to fall below the amount actuarially necessary to3-107pay the defined benefits then the employer must make additional contributions.Thus, defined benefit plans are subject to the minimum funding requirementsunder ERISA, whereas those rules have little meaning for definedcontribution plans. In such a plan, income in excess of the forecast levelsbenefits the employer by reducing future contributions (§412(b)(3)).Although contributions may vary based on the investment program, suchplans are a fixed obligation of the corporation and contributions must bemade annually to the plan regardless of the company’s profits.Defined Benefit PensionThe primary form of the defined benefit plan is the defined benefit pensionplan. A defined benefit pension plan must provide for the paymentof definitely determinable benefits to the employees over a period ofyears after retirement. In short, it guarantees a monthly income for a participantat retirement age. Benefits are measured by years of service withthe employer, years of participation in the plan, percent of average compensation,or a combination thereof. In addition, most defined benefitpension plans pay Pension Benefit Guaranty Corporation premiums toinsure that participant’s guaranteed benefits will always be paid at retirement.Defined ContributionMechanicsIn defined contribution plans, an individual account is established foreach employee. The total vested amount of each employee’s account attermination or retirement will be the amount available to provide eachcovered employee with a benefit. The employer defines or fixes the annualcost rather than defining the benefit it wants to have its employees toreceive. Contributions to the employee’s account are based on a formulathat is usually expressed as a percentage of the employee’s salary.DiscretionContributions need not be mandatory as exampled by profit sharing plansthat are in this category. Considerable discretion by the board of directorsis permitted without jeopardizing the qualification of the plan. (Reg.§1.401-1(b)(1)(ii)). The key is that there is no exact benefit. The procedureis not one of defining benefits and then determining the contributionsnecessary to fund it. Benefits are the result of the contributionsmade to the plan and the investment performance (or lack thereof) of theemployee benefits trust that administers the plan’s assets. As a result, the

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3-108participant/employee bears the risk of the investment program and benefitsare directly dependent upon it.Favorable CircumstancesA defined contribution plan can be recommended in the following instances:(1) The principals are relatively young (e.g. - more than 20 years fromretirement) and will have many years to accumulate contributions;(2) There are older employees and the principals do not want to makethe higher contributions necessary to fund a defined benefit plan for afew years;(3) The principals want the plan costs tied to compensation rather thanage, actuarial assumptions or the rise and fall of the stock market; or(4) The business is cyclical and the principals want the flexibility not tomake contributions in bad years.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.156. The three basic types of qualified plans have similar qualification requirements.What is a basic requirement of a qualified pension plan?a. The assets must not be held in a trust.3-109b. The employer must establish a written plan that is valid under federallaw.c. The plan must at least be a temporary arrangement.d. The plan must meet specific age, service, and coverage nondiscriminatoryrequirements.157. Section 401 provides several sets of requirements designed to prevent

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retirement plan coverage discrimination. What is one set of those requirements?a. The plan benefits a percentage of nonhighly compensated employeesthat is at least 50% of the percentage of nonhighly compensated employeesbenefiting under the plan.b. The plan benefits at least 70% of all the employees.c. The plan meets the discrimination classification test.d. The trust will qualify only when it benefits the lesser of 50 employees or40% of all employees.158. For matching contributions, retirement plans must meet minimum vestingschedules. Under the two-to-six year graded vesting schedule, what is aparticipant’s nonforfeitable claim to employer-derived benefits after threeyears of completed service?a. 40%.b. 60%.c. 80%.d. 100%.159. The mechanics for defined benefit and defined contribution retirementplans have many similarities. However, what is a unique aspect of definedbenefit plans?a. An individual account is established for each employee.b. Contributions are based on a formula that is usually expressed as a percentageof the employee’s salary.c. The employer defines or fixes the annual cost.d. The employer must make adequate funding under ERISA.160. The author identifies four circumstances under which defined contributionplans would be auspicious. What is one of these circumstances?a. The principals of a cyclical business want to be able to make contributionsin only good years.b. The principals are relatively old.c. The principals want the plan costs tied to age, actuarial assumptions, orthe rise and fall of the stock market.d. There are younger employees and the principals want to make the3-110higher contributions necessary.

Answers & Explanations156. The three basic types of qualified plans have similar qualification requirements.What is a basic requirement of a qualified pension plan?a. Incorrect. A basic requirement of a qualified pension plan is that the assetsmust be held in a valid trust created or organized in the United States. A

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valid trust must have a trustee.b. Incorrect. A basic requirement of a qualified pension plan is that the employermust establish and communicate to its employees a written plan that isvalid under state law.c. Incorrect. A basic requirement of a qualified pension plan is that the planmust be a permanent and continuing program. It must not be a temporary arrangementset up in high tax years as a tax savings scheme to benefit the employer.d. Correct. A basic requirement of a qualified pension plan is that the planmust cover a required percentage of employees or cover a nondiscriminatoryclassification of employees. The plan may not discriminate in favor of highlycompensated employees. Participation standards include age and service requirementsand coverage requirements. [Chp. 3]157. Section 401 provides several sets of requirements designed to prevent retirementplan coverage discrimination. What is one set of those requirements?a. Incorrect. To insure that lower paid employees have the benefit of a retirementplan, a plan may satisfy the ratio test. However, to satisfy this test, aplan must benefit a percentage of nonhighly compensated employees that isat least 70% of the percentage of highly compensated employees benefitingunder the plan.b. Incorrect. A plan may satisfy the percentage test to avoid discrimination.However, under this test, the plan must “benefit” at least 70% of all the employeeswho are not highly compensated employees.c. Incorrect. To insure that lower paid employees have the benefit of a retirementplan, a plan may satisfy the average benefits test. A plan will meetthe average benefits test if: the plan meets a nondiscriminatory classificationtest; and the average benefit percentage of nonhighly compensated employees,considered as a group, is at least 70% of the average benefit percentageof the highly compensated employees, considered as a group.3-111d. Correct. To insure that lower paid employees have the benefit of a retirementplan, tax law requires that a trust will not be qualified unless it benefitsthe lesser of 50 employees; or 40% of all employees. Thus, each plan musthave a minimum number of employees covered, without regard to any designationof another plan. [Chp. 3]158. For matching contributions, retirement plans must meet minimum vesting

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schedules. Under the two-to-six year graded vesting schedule, what is a participant’snonforfeitable claim to employer-derived benefits after threeyears of completed service?a. Correct. For matching contributions, under the two-to-six year gradedvesting schedule, the nonforfeitable claim to employer-derived benefits after3 years of completed service is 40%.b. Incorrect. For matching contributions, under the two-to-six year gradedvesting schedule, the nonforfeitable claim to employer-derived benefits after4 years of completed service is 60%.c. Incorrect. For matching contributions, under the two-to-six year gradedvesting schedule, the nonforfeitable claim to employer-derived benefits after5 years of completed service is 80%.d. Incorrect. For matching contributions, under the two-to-six year gradedvesting schedule, the nonforfeitable claim to employer-derived benefits after6 years of completed service is 100%. [Chp. 3]159. The mechanics for defined benefit and defined contribution retirementplans have many similarities. However, what is a unique aspect of definedbenefit plans?a. Incorrect. In defined contribution plans, an individual account is establishedfor each employee. No such account is established under a definedbenefit plan.b. Incorrect. Generally, a defined benefit plan attempts to specify benefit levelsfor employees. Once benefit levels are established, contributions are determinedbased upon actuarial calculations.c. Incorrect. In defined benefit plans, the employer defines the benefit itwants to have its employees to receive rather than defining or fixing the annualcost.d. Correct. Defined benefit plans are subject to the minimum funding requirementsunder ERISA, whereas those rules have little meaning for definedcontribution plans. [Chp. 3]160. The author identifies four circumstances under which defined contributionplans would be auspicious. What is one of these circumstances?a. Correct. A defined contribution plan can be recommended if the businessis cyclical and the principals want the flexibility not to make contributions inbad years. This is because the employer can choose to make contributions3-112voluntary, and contributions are determined by a formula, usually expressedas a percentage of the employee’s salary.

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b. Incorrect. A defined contribution plan can be recommended if the principalsare relatively young (e.g. - more than 20 years from retirement) and willhave many years to accumulate contributions. If the principals are relativelyold, they will have few years to accumulate contributions.c. Incorrect. A defined contribution plan can be recommended if the principalswant the plan costs tied to compensation rather than age, actuarial assumptionsor the rise and fall of the stock market.d. Incorrect. A defined contribution plan can be recommended if there areolder employees and the principals do not want to make the higher contributionsnecessary to fund a defined benefit plan for a few years. [Chp. 3]Types of Defined Contribution PlansThere are a variety of defined contribution plans:Profit SharingA profit sharing plan is a defined contribution plan under which the planmay provide, or the employer may determine, annually, how much will becontributed to the plan out of profits or otherwise. As a result profit sharingplans cannot provide determinable benefits. However, distributionscan occur prior to retirement.Requirements for a Qualified Profit Sharing PlanA profit sharing plan is a vehicle through which an employer may sharesome of his profits8 with his employees. We will discuss profit sharingplans of the deferred type only (i.e. payment is to be made to the participantin a future taxable year). Since each participant is creditedwith a share of the allocated profits and the gains or losses thereon, ultimatebenefits are unknown. In this respect, profit sharing plans aresimilar to money purchase pension plans and are generally more suitablewhere the employees (or shareholder-employees) are under age45.8 TRA 86 provides that a contribution to a qualified profit sharing plan does not require that theemployer have current or accumulated earnings or profits.3-113Written PlanThe Code requirements for a qualified profit sharing plan are essentiallythe same as for a qualified pension plan. However, unlike certainpension plans that do not require a trust (i.e. those funded exclusivelywith life insurance and annuity contracts), qualified profitsharing plans usually require a formal written trust agreement andsubstantial and recurring employer contributions.EligibilityThe eligibility requirements for profit sharing plans are generallymore liberal than those of pension plans. A maximum age provision

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is not permissible however; this poses no great cost problem since actuarialfunding is not required.Also, since employer contributions are not required to be made outof current or accumulated profits or earnings, these plans may be establishedby private, non-profit organizations and presumably, by localgovernments as well.Deductible Contribution LimitSince 2002, the maximum annual deduction is 25% of the aggregategross compensation of all plan participants. Contribution and somecredit carry-overs are also permitted.Substantial & Recurrent RuleKeep in mind the “substantial and recurrent” rule. Generally, theIRS will expect a contribution of some sort to be made if there areprofits. However, a contribution need not be made in every planyear. If contributions are not made on a fairly consistent basis, theIRS may claim that the plan has been discontinued and require fullvesting to the participants.Profit vs. Pension PlanA profit sharing plan may be preferable to a pension planbased upon the following considerations:1. When the business is young and substantial earnings arebeing retained;2. When most employees, including owners and keyemployeesare young and have limited past service;3. When business earnings and profits are erratic or generallylow;3-1144. When the incentive element is more important to the planparticipants than a guaranteed pension;5. When the average age of the employees is so high as tomake actuarial contributions prohibitive, but the employerstill wishes to provide some post-retirement assistance;6. When the availability of distributions during employmentis an important factor;7. When a major objective of the employer is to encourageemployee savings through a matching contribution plan;8. Profit sharing plans are not subject to minimum fundingrequirements, plan termination insurance, and actuarial certificationand reports. Profit sharing plans offer reduced administrativeexpenses and governmental regulations.Money Purchase PensionA money purchase plan is a pension plan but, nevertheless, it is categorizedas a defined contribution plan. The employer contributes a fixedamount each year based upon a percentage of each employee’s compensation.The employee’s benefits are the amount of total contributions tothe plan plus (or minus) investments gains (or losses).Profit Sharing & Money Purchase Pension Plans

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Planholder CorporationsS corporationsNon-profit organizationsPartnershipsSole proprietorships (i.e., self-employed)The employer must include employees who have:Reached age 21Completed 2 years of service if 100% vesting is elected or completed1 year of service if a vesting schedule is electedEligibilityRequirementsThe plan must also meet certain coverage and participant requirements.ContributionLimitsProfit Sharing: Maximum deductible amount is 25% of totaleligible participant compensation. Employer contributions arediscretionary and can be based on, but are not limited to profits.Money Purchase: Maximum deductible amount is 25% of totaleligible participant compensation. Employer must contribute apredetermined percentage each year. Contributions are mandatoryregardless of profits.Combination Plans: Combined Money Purchase Pension andProfit Sharing Plans are subject to a single maximum deductiblelimit of 25% of compensation.3-115Annual Additions Maximum: Annual additions to any participant’saccount may not exceed 100% of compensation, or$49,000 (in 2009), if less. Minimum Employer Contributionmay be required if plan primarily benefits key employees.Deadlines ForEstablishment& ContributionsEstablishment: On or before the last day of the employer’sfiscal year, for the year in which the deduction is taken.Funding: On or before the date the employer’s federal incometax return is due, plus extensions.Pension Plans: Must be funded no later than 8½ months afterthe plan year-end, even if the deadline for deduction purposesis later.Filings: Each year there are assets in the plan, a 5500 series taxform should be filed with the IRS no later than the last day ofthe 7th month following the plan year end (except for certain“one participant” plans with $100,000 or less in assets).Earliest (without 10% tax penalty):DeathPermanent disabilityAttainment of age 59½Distribution to pay for deductible medical expensesSeparation from service and age 55Plan termination and age 59½Separation from service and periodic payments based on a lifeexpectancy formula that cannot be modified for at least 5 yearsor until attainment of age 59½, if later

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Payments made to an alternate payee because of a divorce settlementas required by a Qualified Domestic Relations OrderProfit Sharing Plans Only (if plan permits): In-service withdrawaland age 59½. Hardship withdrawal and age 59½Latest (without 50% excise tax penalty):DistributionsApril 1 of the calendar year following the year in which theparticipant reaches age 70½. Special exceptions apply.Tax Treatmenton DistributionTaxed as ordinary income. Distributions from an account containingnon-deductible voluntary contributions must consist ofa non-taxable portion and a taxable portion.Lump-Sum Distributions: For individuals who were age 50 on1/1/86, they can elect 10-year forward averaging under prior taxrates or 5-year averaging under current tax rates and get capitalgains treatment for pre-1974 portion of distribution.Cafeteria Compensation PlanUnder a “cafeteria” or “flexible benefit plan” an employee can selectfrom a package of employer provided benefits, some of which may be taxableand others not taxable. Employer contributions under a written planare normally excluded from the employee’s gross income to the extentthat nontaxable benefits are selected (§125(b)).3-116Thrift PlanThrift plans are a mixed breed of retirement plan. Although they vary inform, in general the employee contributes some percentage of their compensationto the plan; the employer then matches their contribution dollarfor dollar or in some other way spelled out in the plan. Lower employercosts are a factor in the popularity of these plans.Section 401(k) PlansThis is an arrangement whereby an employee will not be taxed currentlyfor amounts contributed by an employer to an employee trust, eventhough the employee could have elected under the plan to receive thecontribution in cash. Section 401(k) has several requirements:(1) It must be a qualified profit-sharing or stock bonus plan;(2) Each employee can elect to receive cash or to have an employercontribution made to the employee trust;(3) Benefits are not distributable to an employee earlier than age 59½,termination of service, death, disability, or hardship;(4) Each employee’s accrued benefit under the plan is fully vested; and(5) There is no discrimination in favor of highly paid employees.Section 401(k) PlansPlanholder CorporationsS corporationPartnershipsSole proprietorships (i.e., self-employed)

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Employees who meet age & service requirements.The employer must include employees who have:Reached age 21Completed 2 years of service if 100% vesting is elected or completed 1year of service if a vesting schedule is electedEligibility RequirementsThe plan must also meet certain coverage and participant requirements.Employees who have completed 1 year of service must beeligible to make salary deferral contributions.ContributionLimitsMaximum Deductible Amount: Maximum deductible amount is25% of total eligible participant compensation. This amount includesemployer basic, employer match and salary deferral. Employercontributions are discretionary and can be based on, but notlimited to, profits.Maximum Salary Deferral Amount: Not to exceed $16,500 (in2009) and is included in the maximum contribution limit. Subjectto a special anti-discrimination test.Non-Deductible Voluntary Contributions are included in themaximum contribution limit. Subject to a special anti3-117discrimination test.Combination Plans: Combined Money Purchase Pension and401(k) Plans are subject to a single maximum deductible limit of25% of compensation.Annual Additions Maximum: Annual additions to any participant’saccount may not exceed 100% of compensation, or $49,000 (in2009), if less. Minimum Employer Contribution may be required ifplan primarily benefits key employees.Deadlines ForEstablishment& ContributionsEstablishment: On or before the last day of the employer’s fiscalyear, for the year in which the deduction is taken.Funding: On or before the date the employer’s federal income taxreturn is due, plus extensions.Filings: Each year there are assets in the plan, a 5500 series taxform should be filed with the IRS no later than the last day of the7th month following the plan year end (except for certain “one participant”plans with $100,000 or less in assets).Earliest (without 10% tax penalty):DeathPermanent disabilityDistribution to pay for deductible medical expensesSeparation from service and age 55Plan termination and age 59½Separation from service and periodic payments based on a life expectancyformula that cannot be modified for at least 5 years oruntil attainment of age 59½, if laterPayments made to an alternate payee because of a divorce settlementas required by a Qualified Domestic Relations OrderIn-service withdrawal and age 59½Hardship withdrawal and age 59½

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Latest (without 50% excise tax penalty):DistributionsApril 1 of the calendar year following the year in which the participantreaches age 70½. Special exceptions apply.Tax Treatmenton DistributionTaxed as ordinary income. Distributions from an account containingnon-deductible voluntary contributions must consist of a nontaxableportion and a taxable portion.Lump-Sum Distributions: For individuals who were age 50 on1/1/86, they can elect 10-year forward averaging under prior taxrates or 5-year averaging under current tax rates and get capitalgains treatment for pre-1974 portion of distribution.Death BenefitsDeath benefits under a qualified plan are permissible only if they are “incidental”(Reg. §1.401-1(b)(1)(i)). Although non-insured death benefits mustalso be incidental, our discussion will be limited to pre-retirement deathbenefits that are provided by life insurance.The specific rules are as follows:3-118Defined Benefit PlansUnder defined benefit plans, if whole life or (preferably) universal life insuranceis purchased, the death benefit is incidental only if one of the followingthree requirements is met:(1) The amount of life insurance does not exceed 100 times the anticipatedmonthly retirement benefit;(2) The death benefit is equal to the reserve (cash value) under thepolicy plus the participant’s share of the auxiliary fund; or(3) Where less than 50% of the total contributions for a participant areused to pay premiums, the total death benefit may consist of the faceamount of insurance plus the participant’s account or share in the auxiliaryfund.Money Purchase Pension & Target Benefit PlansWhere whole life is purchased, the total life insurance premiums must beless than 50% of the total contributions made on behalf of a participant.Alternatively, the 100 to 1 rule may be satisfied.Where pure term or universal life is purchased, the premiums may notexceed 25% of the contributions for a participant. Where whole life andterm are purchased, the term premium plus 50% of the whole life premiummust meet the 25% test.Employee ContributionsSometimes an employer establishes a plan that requires employees to contributeas a condition of participation. Under pension plans, employees maybe required to contribute in order to reduce the employer’s cost. Profit sharing

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thrift plans require employees to contribute in order to receive the benefitof a matching employer contribution.Non-DeductibleIn either case, the employee’s contribution is not deductible. An importantnote is that if employee contributions are required, the plan is stillnot permitted to be discriminatory.Employees may also be permitted to make voluntary contributions to theplan that are, of course, also not deductible.Specific nondiscrimination rules apply to employers making matchingcontributions. These nondiscrimination rules are essentially the same asfor §401(k) plans.3-119Life Insurance in the Qualified PlanCash value life insurance purchased under the auspices of a qualified planhave the dual advantage of provided cash with which to fund the retirementaspect of the plan, and simultaneously providing an additional death benefitover and above the $50,000 limit of group term in the event that the employeedies prior to retirement (although I have had employees who weredead for years and then retired).ReturnAlthough the cash accumulation of a life insurance policy is generally alittle lower than that of an annuity, it will generally surpass most CDs, andcarries no more risk than an annuity. The advantage of having the deathbenefit provided under the same policy that will provide the retirementbenefits may be sufficient inducement for an employer to opt for theslightly lower net yield.Universal LifeIn the event that life insurance policies are used to fund the retirementplan, a universal life product will probably be the most advantageousproduct to use. In addition, universal life insurance would be the productof choice in the profit sharing plan, since the premiums are entirely flexible(i.e., in a year with low profits, you don’t have to worry a great dealabout lapsed policies or forced contributions in excess of profits to keepthe policies in force).CompareAlthough the general requirements for using life insurance to fund thequalified plan have been discussed, it is not enough to merely know aboutthe use of “life insurance.” The policies offered by different companies,although similar in function, can have substantial differences in terms ofmortality cost, current rates, methods of determining current rates, interestbonuses, and guaranteed rates to name a few. You should carefullyconsider several plans of insurance in several different scenarios beforemaking any specific recommendations to your client.Plan Terminations & Corporate LiquidationsA qualified plan must be intended as permanent. If a plan is terminated

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within a few years of its inception for other than a valid business reason, theplan may be subject to retroactive disqualification with the resultant loss ofall corporate deductions. For this reason, if a plan termination is contemplated,a favorable determination should be applied for and received fromthe IRS prior to any such termination. This permanency requirement does3-120not impede the employer’s customarily retained right to unilaterally terminatethe plan or cease contributions. The termination of a plan requires thatall participants be fully vested in their accrued benefits or account balances.ERISA may require specific allocations to be made upon the termination ofa defined benefit plan.10-Year RuleA consequence of the termination of a profit sharing plan because of thecessation of contributions is the immediate and full vesting of the accountbalances. After the plan has been in existence for ten years, it may be discontinuedwithout the necessity of the employer showing a valid businessreason.The complete liquidation of an employer would ordinarily be sufficientgrounds for the termination of the plan and trust, thereby avoiding the taxpenalties.Lump-Sum DistributionsAs long as lump-sum payments are made to plan participants on accountof their separation from service, or upon attainment of at least age 55½,ten-year income averaging will be available. The IRS has ruled that aseparation from service for tax purposes occurs only upon the employee’sdeath, retirement, resignation, or discharge. However, if the corporationis liquidated and the former owners decide to separately conduct theirprofessional practices, a separation from corporate service will have occurred.Asset DispositionsAnother potential way of handling the assets of a qualified plan upon theliquidation of the employer is to terminate the plan but maintain thetrust. Distributions can then be made to the plan participants according tothe terms of the trust.Under ERISA, a qualified lump-sum distribution may be rolled over taxfreeinto an individual IRA if the transfer is made within 60 days of thedate on which the participant receives such distribution.Only that portion of the distribution that represents employer contributionsmay be rolled over. Non-deductible employee contributions are noteligible for the rollover although the earnings on such contributions andany deductible voluntary employee contributions may be rolled over.A major shortcoming of this rollover provision is that ultimately, the distributions

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from the IRA will be fully taxable as ordinary income withoutthe potential but limited benefit of ten-year averaging. If the amounts tobe rolled over are eligible to be rolled over into another qualified corpo3-121rate or Keogh retirement plan however, ten-year averaging may be allowedwith respect to any ultimate lump-sum distributions.IRA LimitationsAlthough an IRA may not receive or invest in a life insurance contract ofany kind whatsoever, this provision should not create any major problemsfor a split funded corporate retirement plan where it is desirable to keepthe life insurance in force. The reason for this is that partial rollovers arepermissible under §402(a)(5) so that employee life insurance policiesneed not be rolled over.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.161. A profit sharing plan is a type of defined contribution plan. What is acharacteristic of a profit sharing plan?a. Total contributions are limited to specific dollar amount.b. Employer contributions are flexible and can be based on profits.c. Employer contributions are mandatory regardless of profits.d. Employer must contribute a predetermined percentage each year.162. Section 401(k) plans must meet five requirements. What is one such requirement?a. Employees may receive benefits at any time.b. Plan benefits that have accrued are fully vested.c. The plan must be a qualified money purchase pension plan.d. Employees must receive benefits in cash.

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3-122163. One condition must be met in order for a death benefit under a qualifiedplan to be allowable. What is this condition?a. It is more than the cash value under the policy.b. It is deemed to be incidental.c. The expected retirement benefit doesn’t exceed 100 times the life insuranceamount.d. The total benefit does not include the face amount of insurance.164. A consideration when incorporating a sole proprietorship is how to dealwith an existing self-employed retirement plan. How does the author suggestthat a self-employed individual deal with such a self-employed plan upon incorporation?a. Take a lump-sum cash distribution, contributed it to an IRA and paythe tax.b. Move any insurance annuity contracts in the plan directly to the newqualified corporate retirement plan.c. Distribute Keogh funds to participants and have them deposit them inthe new corporate retirement plan.d. The plan could be frozen and contributions discontinued.

Answers & Explanations161. A profit sharing plan is a type of defined contribution plan. What is a characteristicof a profit sharing plan?a. Incorrect. The contribution limits of individual retirement accounts (IRAs)are limited to specific dollar amount adjusted annually for inflation. However,the total contributions that can be made to profit sharing plans are notlimited to a specific dollar amount.b. Correct. Employer contributions to profit sharing plans are discretionaryand can be based on, but are not limited to profits.c. Incorrect. Employer contributions to money purchase pension plans aremandatory regardless of profits. Contributions to a profit sharing plans arenot mandatory.d. Incorrect. Employers must contribute a predetermined percentage eachyear to money purchase pension plans. No such requirement is made underprofit sharing plans. [Chp. 3]162. Section 401(k) plans must meet five requirements. What is one such requirement?3-123a. Incorrect. A requirement of a section 401(k) plan is that benefits are notdistributable to an employee earlier than age 59½, termination of service,death, disability, or hardship.b. Correct. A requirement of a section 401(k) plan is that each employee’saccrued benefit under the plan is fully vested.

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c. Incorrect. A requirement of a section 401(k) plan is that it must be a qualifiedprofit-sharing or stock bonus plan.d. Incorrect. A requirement of a section 401(k) plan is that each employeecan elect to receive cash or to have an employer contribution made to theemployee trust. [Chp. 3]163. One condition must be met in order for a death benefit under a qualifiedplan to be allowable. What is this condition?a. Incorrect. A death benefit would be allowable under a defined benefit planif the benefit were equivalent to the cash value under the insurance policyplus the participant’s share of the auxiliary fund.b. Correct. It may be allowable under a qualified plan only if the death benefitis incidental. To be deemed incidental, it must meet one of three requirements.c. Incorrect. A death benefit would be allowable under a defined benefit planif the expected retirement benefit were to exceed 100 times the life insuranceamount.d. Incorrect. A death benefit would be allowable under a defined benefit planif the total benefit were comprised of the face amount of insurance and theparticipant’s account or share in the auxiliary fund. [Chp. 3]164. A consideration when incorporating a sole proprietorship is how to dealwith an existing self-employed retirement plan. How does the author suggestthat a self-employed individual deal with such a self-employed planupon incorporation?a. Incorrect. This would not be beneficial since a self-employed individual oran owner-employee who receives a qualified lump-sum distribution in cash orproperty from her self-employed plan may make a tax-free rollover of all orpart of the property or cash to an IRA or annuity.b. Incorrect. This would not be recommended because nontransferable annuitycontracts which are part of an unincorporated plan and are not held by atrustee may be surrendered back to the insurer in consideration for which theinsurer will issue new policies to the trustee of the qualified corporate plan.c. Incorrect. This would not be beneficial since the assets of the Keogh planmay be transferred by the trustee, to the trustee of a qualified corporate account.3-124d. Correct. Freezing the plan is suggested. All contributions end. Life insuranceor annuity contracts may be placed on a reduced, paid-up basis, but theextended term insurance option for life insurance in as much as immediate

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taxability may result to the self-employed. On a tax-free basis, dividends, interest,and capital appreciation will continue to be shared, and distributionscontinue to be administered by plan provisions and IRC restrictions. This is apopular approach, but it is costly. [Chp. 3]Self-Employed Plans - KeoghAlthough qualified plans for unincorporated businesses are now virtually equalwith corporate plans, there are still sufficient differences to warrant a brief discussionof them separately from all other plans. While the federal tax consequenceswill undoubtedly be a consideration in the decision to incorporate, it isunlikely that the availability of a corporate retirement plan will weigh considerablyas one of the considerations.Contribution TimingCash basis self-employeds are now afforded the advantages of accrual basistaxpayers for purposes of making their contributions to Keogh plans. That is,a contribution may be made any time prior to the due date of the return,rather than by the close of the taxable year. This is undoubtedly of considerablebenefit to those taxpayers who have set-up Keogh profit sharing plans.Prior to this change, it was virtually impossible to determine the allowableamount of the contribution by the close of the tax year since a self-employedindividual does not generally know how much they will earn during a taxableyear until the year is over.However, the Keogh plan itself, as well as any related trust instruments, mustbe established prior to the close of the taxable year for which the first contributionsare to be made.Controlled BusinessWhere an owner-employee controls (either as a sole proprietor or as a morethan 50% partner), one unincorporated business and participates as anowner-employee in the Keogh plan of another unincorporated business,whether or not he or she controls the second business, he or she must establisha plan for the regular employees of the business that they control withbenefits or contributions similar to those which they are receiving. Therefore,if a 10% or less partner participates in a Keogh plan, they do not need to establisha similar plan for the sole proprietorship that they own.3-125If the individual in question controls more than one business, they must treatthe controlled businesses as one for purposes of figuring the maximum contribution

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that they can make for themselves. An owner-employee’s maximumcontribution limits cannot be exceeded even though they participate in morethan one plan. That is to say, participation in two plans does not double theallowable deduction.General LimitationsUnder the provisions of ERISA, all businesses that are under commoncontrol, including incorporated businesses, unincorporated businesses, estatesand trusts, must be aggregated for purposes of the limitations onbenefits, contributions, participation, and vesting. The regulations to§414(b) and (c) state that the percentage to be applied to determine ifthere is common control are 80% in the case of parent-subsidiary controlledgroups and the 80% and more than 50% tests for brother-sistercontrolled groups.As a result of ERISA, corporate and noncorporate employees are generallytaxed alike on their distributions. An owner-employee’s cost basisdoes not include any taxable or non-deductible term cost charges when aKeogh plan has been funded with life insurance.The beneficiary of a deceased self-employed person or owner- employeewill generally be taxed in the same manner as the deceased would havebeen taxed. When life insurance proceeds are paid as a death benefit, theexcess of the proceeds over the policy’s cash value will be tax-free.Effect of IncorporationA partnership or sole proprietorship may have an existing Keogh plan at thetime of incorporation. Since a qualified corporate plan will generally be created,the following alternatives concerning the disposition of the Keogh accountshould be considered:1. The plan may be frozen. All employer and employee contributionssimply stop. Life insurance or annuity contracts may be placed on a reduced,paid-up basis but the extended term insurance option for life insurancein as much as immediate taxability may result to the selfemployed.The assets in the plan or trust will continue to share in dividends,interest and capital appreciation on a tax-free basis. Distributionsto self- employeds and regular employees will continue to be governed bythe plan’s provisions and the IRC restrictions. This approach is frequentlyused although the continued maintenance of the plan or trust typicallyrequires the payment of administrative fees and annual reporting to theIRS.3-1262. The assets in the Keogh trust may be sold and the proceeds used by thetrustee to purchase single premium nontransferable deferred annuities.These annuities can then be distributed tax- free to the participants whowill be taxed only upon the surrender of the annuities or the commencementof payments. In addition, the trustee may continue to hold the annuities.3. The assets of the Keogh plan may be transferred by the trustee, to the

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trustee of a qualified corporate account. The transferred Keogh assetsmust remain segregated from the corporate assets. This will probably increasethe administrative costs somewhat. It is important that any suchtransfer be made only between the trustees or custodians of the two plansinvolved. It may also be possible to arrange for the transfer of a nontransferableannuity or retirement income endowment policy that is not heldby a trustee or custodian (PLR 8332155).4. Nontransferable annuity contracts which are part of an unincorporatedplan and are not held by a trustee may be surrendered back to the insurerin consideration for which the insurer will issue new policies to the trusteeof the qualified corporate plan (R. R. 73-259).5. When the Keogh trust owns life insurance contracts, a sale of the contractsfor their cash values to the trustee of a corporate plan is permissiblesince there is a fair exchange of values (R. R. 73-503). The life insurancecontracts now held by the trustee of the corporate plan are no longer subjectto any of the Keogh plan restrictions.6. A self-employed individual or an owner-employee who receives a qualifiedlump-sum distribution in cash or property from his Keogh plan maymake a tax-free rollover of all or part of the property or cash to an IRAor annuity. The rollover may not be made into an endowment contract,and must be made within the 60-day period.MechanicsUnder a Keogh plan, a self employed9 individual (this term includes a soleproprietor and partners owning 10% or more of an interest in a partnership)is allowed to take a deduction for money he or she sets aside to providefor retirement. Such a plan is also a means of providing retirementsecurity for the employees working for the self-employed individual.Parity with Corporate PlansSince 1983, Keogh plans essentially match the benefits and contributionsprovided by corporate plans under the parity provisions of9 Partners, but not owner/employees of an S corporation are considered self-employed.3-127TEFRA. As a result, self employed individuals who may be disposed toincorporate to secure the greater corporate benefits will need to makea careful cost/benefit analysis before proceeding to incorporate. Since1984, a bank no longer need be trustee.Figuring Retirement Plan Deductions For Self-EmployedWhen figuring the deduction for contributions made to a selfemployedretirement plan, compensation is net earnings from selfemploymentafter subtracting:(i) The deduction allowed for one-half of the self-employment tax,and(ii) The deduction for contributions on behalf of the self-employed

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taxpayer to the plan.This adjustment to net earnings in (ii) above is made indirectly by usinga self-employed person’s rate.Self-Employed RateIf the plan’s contribution rate is a whole number (e.g., 12% ratherthan 12.5%), taxpayers can use the following table to find the ratethat applies to them.Self-Employed Rate TablePlan’s Rate Self-Employed’s Rate1 .0099012 .0196083 .0291264 .0384625 .0476196 .0566047 .0654218 .0740749 .08256910 .09090911 .09909912 .10714313 .11504414 .12280715 .13043516 .13793117 .14529918 .15254219 .1596643-12820 .16666721 .17355422 .18032823 .18699224 .19354825 .200000If the plan’s contribution rate is not a whole number (e.g., 10.5%),the taxpayer must calculate their self-employed rate using the followingworksheetSelf-Employed Rate Worksheet1. Plan contributions rate as a decimal (forexample, 10% would be 0.10) $___________2. Rate in Line 1 plus 1, as a decimal (forexample, 0.10 plus 1 would be 1.10) $___________3. Divide Line 1 by Line 2, this is thetaxpayer's self-employed rate as a decimal $___________

Determining the DeductionOnce the self-employed rate is determined, taxpayers figure their deduction forcontributions on their behalf by completing the following steps:Step 1Enter the self-employed rate from the

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Table or Worksheet above ____________Step 2Enter the amount of net earningsfrom Line 29, Schedule C or Line 36,Schedule F $___________Step 3Enter the deduction for self-employmenttax from Line 25, Form 1040 $___________Step 4Subtract Step 3 from Step 2 and enterthe amount $___________Step 5Multiply Step 4 by Step 1 and enter theamount $___________Step 6Multiply $245,000 (in 2009) by the planContribution rate. Enter the result butnot more than $49,000 (in 2009) $___________Step 73-129Enter the smaller of Step 5 or Step 6.This is the deductible contribution.Enter this amount on Line 27, Form 1040 $___________

Individual Plans - IRA’sThe government wants to encourage everyone to save for retirement. Savings forthis purpose also contributes to the formation of investment capital needed foreconomic growth. For many individuals, including those covered by corporate retirementplans, IRAs play an important role.Deemed IRAIf an eligible retirement plan permits employees to make voluntary employeecontributions to a separate account or annuity that (1) is established underthe plan, and (2) meets the requirements that apply to either traditionalIRAs or Roth IRAs, then the separate account or annuity is deemed a traditionalIRA or a Roth IRA for all purposes of the code (§408).MechanicsAny individual whether or not presently participating in a qualified retirementplan can set up an individual retirement plan (IRA) and take a deductionfrom gross income equal to the lesser of $5,000 (in 2009) or 100% ofcompensation.Individuals age 50 and older may make additional catchup IRA contributions.The maximum contribution limit (before application of adjusted grossincome phase-out limits) for an individual who has celebrated his or her 50thbirthday before the end of the tax year is increased by $500 for 2002 through

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2005, and $1,000 for 2006 and later.Note: One way in which taxation of a lump sum distribution may be postponedis by transferring it within 60 days of receipt of payment into an IRA.This postpones the tax until the funds are withdrawn.Phase-outThe taxpayer and spouse must be nonactive participants to obtain the fullbenefits of an IRA. If either is an active participant in another qualifiedplan, the deduction limitation is phased out proportionately between$89,000 and $109,000 of AGI in 2009. For single and head of householdtaxpayers the phase out is between $55,000 and $65,000 of AGI in 2009.3-130AGIAGI is determined by taking into account §469 passive lossesand §86 taxable Social Security benefits and ignoring any§911 exclusion and IRA deduction.Special Spousal Participation Rule - §219(g)(1)Deductible contributions are permitted for spouses of individuals who arein an employer-sponsored retirement plan. However, the deduction isphased out for taxpayers with AGI between $166,000 and $176,000 (in2009).Individual Retirement AccountsPlanholder Individual taxpayerIndividual taxpayer and non-working spouseEligibilityRequirementsIndividuals under 70½ years old who have earned incomeMaximum Contribution Limit:$5,000 per working individual $10,000 per married couplewith a working & a non-working spouseTax-Deductible Contributions - Who Qualifies:If neither individual nor spouse is covered by an employersponsoredretirement plan, 100% is deductible at any incomelevel.If individual or spouse is covered by an employer-sponsoredplan in 2009:Adjusted GrossIncomeContributionMarried Tax-Deferred DeductibilityBelow $89,000 Yes Full$89,000 -$109,000Yes Partial*Over $109,000 Yes NoSingle Tax-Deferred DeductibilityBelow $55,000 Yes Full$55,000 -$65,000Yes Partial*Over $65,000 Yes NoContribution

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Limits* Subtract $200 of deductibility for each $1,000 of incomeover the floor amount (round to lowest $10); $200 minimum.3-131On or before tax filing deadline, not including extensions(usually April 15 or the next business day if April 15 falls ona holiday or weekend).Penalties:Deadlines ForEstablishment &Contributions$50 penalty for failure to file Form 8606 to report nondeductiblecontributions$100 penalty for overstating the designated amount of nondeductiblecontributionsEarliest (without 10% tax penalty):Death, Permanent disability, Attainment of age 59½: Periodicpayments based on a life expectancy formula that cannotbe modified for at least 5 years or until attainment of age59½, if later. Transfer of assets from a participant’s IRA tospouse’s or former spouse’s IRA in accordance with a divorceor separation document.Latest (without 50% excise tax penalty):DistributionsApril 1 of the calendar year following the year in which theparticipant reaches age 70½Tax Treatmenton DistributionAll distributions from any type of IRA are taxed as ordinaryincome. Remember, however, that if the individual madenondeductible contributions, each distribution consists of anontaxable portion and a taxable portion.Spousal IRAIf a taxpayer files a joint return and their compensation is less than that oftheir spouse, the most that can be contributed for the year to the taxpayer’sIRA is the lesser of:(1) $5,000 in 2009 (or $6,000 in 2009 if taxpayer is 50 or older), or(2) Total compensation includable in the gross income of both taxpayerand their spouse for the year, reduced by:(a) The spouse's IRA contribution for the year to a traditional IRA,and(b) Any contributions for the year to a Roth IRA on behalf of thespouse.This means that the total combined contributions that can be made forthe year to a taxpayer’s IRA and their spouse's IRA can be up to $10,000in 2009, or $11,000 in 2009 if only one spouse is 50 or older, or $12,000 in2009 if both spouses are 50 or older.EligibilityIndividuals can set up and make contributions to a traditional IRA if:(1) They (or, if they file a joint return, their spouse) received taxable

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compensation during the year, and(2) They were not age 70½ by the end of the year.3-132An individual can have a traditional IRA whether or not they are covered byany other retirement plan. However, a taxpayer may not be able to deduct allof their contributions if the taxpayer or their spouse is covered by an employerretirement plan.Contributions & DeductionsAny employer, including a corporation, may establish an IRA plan for thebenefit of some or all of its employees. Contributions may be made by theemployer on an additional compensation basis or on a salary reduction plan.There is no nondiscrimination requirement with respect to the establishment,availability or funding of an IRA plan. However, employee participation inan IRA plan cannot be used as a basis for determining nondiscrimination inany other employer provided plan. Installation and trustee fees paid by theemployer with respect to such plans should be deductible as ordinary andnecessary business expenses. A separate accounting is required for each employee’sinterest in the trust, but commingling of assets is permissible for investmentpurposes.Employer ContributionsAmounts contributed by an employer will be tax-deductible as additionalcompensation and includable in the employee’s income. However, theemployee will be entitled to an offsetting deduction for the contributedamounts. Employer contributions will be subject to FICA and FUTA butnot to federal income tax withholding if the employer reasonably believesthat the employee will be entitled to a deduction for the contributedamounts.Retirement VehiclesAny individual may establish one or more of the types of IRA funding vehiclesas long as the annual contributions limit is not exceeded in the aggregate.The types of funding vehicles available are as follows:(a) A fixed or variable individual retirement annuity may be purchased.The contract must be nontransferable, nonforfeitable and may not bepledged as security for a loan except to the issuing insurance company.An endowment contract must have level premiums and the cash value atmaturity must not be less than the death benefit. In addition, the deathbenefit at some time during the contract must exceed the greater of thecash value or the premiums paid. Whole life insurance may not be usedand, the annuity contract may provide for a waiver of premium, but noother collateral benefits.(b) A written trust or custodial account may be used to fund an individualretirement account. The rules concerning the trustee are generally the3-133

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same as those for a Keogh plan. The only prohibited investment for theaccount is life insurance. Trust assets must not be commingled with otherassets except in a common trust or investment fund.(c) Retirement bonds were available for purchase prior to April 30, 1982and may still be retained by some IRA participants. Since these vehiclesare no longer available there is little point in discussing them.Although the Code does not specifically prohibit an IRA from investing incertain types of property, an investment in collectibles will be regarded as acurrently taxable distribution to the participant.Note: Since 1987, United States minted gold and silver coins after December31, 1986, are not considered to be collectibles.Distribution & Settlement OptionsIn order to encourage participants to set aside funds for their retirement, taxlaw imposes a 10% penalty tax on “pre-mature distributions.” That is, distributionsthat are received by the participant prior to the attainment of age59½. This penalty tax is imposed in addition to the participant’s ordinary incometax liability. However, this penalty does not occur where the distributionis the result of the death, disability or the timely repayment of excesscontributions.Life Annuity ExemptionDistributions made prior to age 59½ are exempted from the penalty tax ifthey are made over a period of years based on the participant’s life expectancy.Payments may also be made in the form of a joint and survivor annuitybased on the participant’s and the spouse’s life expectancy and mustbe substantially equal.The plan must provide for a lump-sum distribution of the participant’sentire interest no later than the required beginning date or for a distributionunder one of the following periods:(a) The participant’s life;(b) The lives of the participant and a designated beneficiary;(c) A period of years not in excess of the participant’s life expectancy;or(d) A period of years not in excess of the life expectancy of the participantand a designated beneficiary.Minimum DistributionsFunds cannot be kept indefinitely in a traditional IRA. Eventually theymust be distributed. However, the requirements for distributing IRA3-134funds differ, depending on whether the taxpayer is the IRA owner or thebeneficiary of a decedent’s IRA.Owners of traditional IRAs must start receiving distributions by Aprilfirst of the year following the year in which they attained age 70½. April1st of the year following the year in which a taxpayer reaches age 70½ is

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referred to as the required beginning date (RBD).Note: The minimum distribution amount for the year the taxpayer attainedage 70½ must be received no later than April 1st of the next year. Thereafter,the required minimum distribution for any year must be made by December31st of that later year.If the minimum required distribution is not made, then an excise taxequal to 50% of the excess of the minimum required distribution over theamount actually distributed will be imposed on the payee.Required Minimum Distribution – Subject to 2009 WaiverThe required minimum distribution for each year is determined by dividingthe IRA account balance as of the close of business on December31st of the preceding year by the applicable distribution period or lifeexpectancy.2009 Waiver of Required Minimum Distribution RulesFor 2009, under the Worker, Retiree, and Employer Recovery Act,no minimum distribution is required for calendar year 2009 from individualretirement plans and employer-provided qualified retirementplans that are defined contribution plans (within the meaningof section 414(i)). Thus any annual minimum distribution for 2009from these plans required under current law, otherwise determinedby dividing the account balance by a distribution period, is not requiredto be made. The next required minimum distribution wouldbe for calendar year 2010. This relief applies to life-time distributionsto employees and IRA owners and after-death distributions tobeneficiaries.Comment: In short, the Act suspends the minimum distribution requirements,both initial and annual required distributions, for definedcontribution arrangements, including IRAs, for calendar year 2009.Thus, plan participants and beneficiaries are allowed, but are not required,to take required minimum distributions for 2009. However, itshould be noted that the required distributions for 2008, or for years after2009, are not waived by the new law.3-135DefinitionsIRA Account BalanceThe IRA account balance is the amount in the IRA at the end ofthe year preceding the year for which the required minimum distributionis being figured. The IRA account balance is adjusted bycertain contributions, distributions, outstanding rollovers, and recharacterizationsof Roth IRA conversions.Designated BeneficiaryThe term “designated beneficiary” is a term of art, and basicallymeans that the beneficiary must be a human being. Thus, an estateis not a “designated beneficiary” nor is a charity or other legal entity.If there is more than one beneficiary, then all of them must behuman beings, or there is no designated beneficiary.Note: There is an exception to this rule if each beneficiary has his or

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her or their own certain separate account.If the beneficiary is a trust, and all of the beneficiaries of the trustare human beings, they will be treated as designated beneficiaries,if certain conditions are met.Date the Designated Beneficiary Is DeterminedGenerally, the designated beneficiary is determined on the lastday of the calendar year following the calendar year of the IRAowner’s death. Any person who was a beneficiary on the date ofthe owner’s death, but is not a beneficiary on the last day of thecalendar year following the calendar year of the owner’s death(because, for example, he or she disclaimed entitlement or receivedhis or her entire benefit), will not be taken into account indetermining the designated beneficiary.Distributions during Owner’s Lifetime & Year of Death after RBDRequired minimum distributions during the owner’s lifetime (and inthe year of death if the owner dies after the required beginning date)are based on a distribution period that generally is determined usingTable III from IRS Publication 590 and set forth below. The distributionperiod (i.e., which table is used) is not affected by the beneficiary’sage unless the sole beneficiary is a spouse who is more than 10years younger than the owner.Table III3-136Uniform LifetimeFor Use by Unmarried Owners and Owners Whose Spouses Are Not MoreThan 10 Years YoungerAge Distribution Period Age Distribution Period70 27.4 93 9.671 26.5 94 9.172 25.6 95 8.673 24.7 96 8.174 23.8 97 7.675 22.9 98 7.176 22.0 99 6.777 21.2 100 6.378 20.3 101 5.979 19.5 102 5.580 18.7 103 5.281 17.9 104 4.982 17.1 105 4.583 16.3 106 4.284 15.5 107 3.985 14.8 108 3.786 14.1 109 3.487 13.4 110 3.188 12.7 111 2.9

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89 12.0 112 2.690 11.4 113 2.491 10.8 114 2.192 10.2 115 and over 1.93-137To figure the required minimum distribution for the current year,divide the account balance at the end of the preceding year by thedistribution period from the table. This is the distribution periodlisted next to the owner’s age (as of the current year) in Table III below,unless the sole beneficiary is the owner’s spouse who is morethan 10 years younger.Sole Beneficiary Spouse Who Is More Than 10 Years YoungerIf the sole beneficiary is owner’s spouse and their spouse is morethan 10 years younger than the owner, use the life expectancy fromTable II (Joint Life and Last Survivor Expectancy) in IRS Publication590.The life expectancy to use is the joint life and last survivor expectancylisted where the row or column containing the owner’s age asof their birthday in the current year intersects with the row or columncontaining their spouse’s age as of his or her birthday in thecurrent year. To figure the required minimum distribution for thecurrent year divide the account balance at the end of the precedingyear by the life expectancy.Distributions after Owner’s DeathBeneficiary Is an IndividualIf the designated beneficiary is an individual, such as the owner’sspouse or child, required minimum distributions for years after theyear of the owner’s death generally are based on the beneficiary’ssingle life expectancy.Note: This rule applies whether or not the death occurred before theowner’s required beginning date.To figure the required minimum distribution for the current year,divide the account balance at the end of the preceding year by theappropriate life expectancy from Table I (Single Life Expectancy)(For Use by Beneficiaries) in IRS Publication 590. Determine theappropriate life expectancy as follows.• Spouse as sole designated beneficiary. Use the life expectancylisted in the table next to the spouse’s age (as of the spouse’sbirthday in the current year). If the owner died before the yearin which he or she reached age 70½, distributions to the spousedo not need to begin until the year in which the owner wouldhave reached age 70½.• Surviving spouse. If the designated beneficiary is the owner’ssurviving spouse, and he or she dies before he or she was re3-138quired to begin receiving distributions, the surviving spouse will

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be treated as if he or she were the owner of the IRA.• Other designated beneficiary. Use the life expectancy listed inthe table next to the beneficiary’s age as of his or her birthday inthe year following the year of the owner’s death, reduced by onefor each year since the year following the owner’s death.A beneficiary who is an individual may be able to elect to take theentire account by the end of the fifth year following the year of theowner’s death. If this election is made, no distribution is requiredfor any year before that fifth year.Multiple Individual BeneficiariesIf as of the end of the year following the year in which the ownerdies there is more than one beneficiary, the beneficiary with theshortest life expectancy will be the designated beneficiary if bothof the following apply:i. All of the beneficiaries are individuals, andii. The account or benefit has not been divided into separateaccounts or shares for each beneficiary.Beneficiary Is Not an IndividualIf the owner’s beneficiary is not an individual (e.g., if the beneficiaryis the owner’s estate), required minimum distributions foryears after the owner’s death depend on whether the death occurredbefore the owner’s required beginning date.a. Death on or after required beginning date. To determine therequired minimum distribution for the current year divide theaccount balance at the end of the preceding year by the appropriatelife expectancy from Table I (Single Life Expectancy) (ForUse by Beneficiaries) in IRS Publication 590. Use the life expectancylisted next to the owner’s age as of his or her birthday inthe year of death, reduced by one for each year since the year ofdeath.b. Death before required beginning date. The entire accountmust be distributed by the end of the fifth year following theyear of the owner’s death. No distribution is required for anyyear before that fifth year.Trust as BeneficiaryA trust cannot be a designated beneficiary even if it is a namedbeneficiary. However, the beneficiaries of a trust will be treated3-139as having been designated as beneficiaries if all of the followingare true:1. The trust is a valid trust under state law, or would be but forthe fact that there is no corpus.2. The trust is irrevocable or will, by its terms, become irrevocableupon the death of the employee.3. The beneficiaries of the trust who are beneficiaries with respectto the trust’s interest in the employee’s benefit are identifiable

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from the trust instrument.4. The IRA trustee, custodian, or issuer has been providedwith either a copy of the trust instrument with the agreementthat if the trust instrument is amended, the administrator willbe provided with a copy of the amendment within a reasonabletime, or all of the following:(a) A list of all of the beneficiaries of the trust (includingcontingent and remaindermen beneficiaries with a descriptionof the conditions on their entitlement),(b) Certification that, to the best of the employee’s knowledge,the list is correct and complete and that the requirementsof (1), (2), and (3) above, are met,(c) An agreement that, if the trust instrument is amended atany time in the future, the employee will, within a reasonabletime, provide to the IRA trustee, custodian, or issuercorrected certifications to the extent that the amendmentchanges any information previously certified, and(d) An agreement to provide a copy of the trust instrumentto the IRA trustee, custodian, or issuer upon demand.If the beneficiary of the trust is another trust and the above requirementsfor both trusts are met, the beneficiaries of the othertrust will be treated as having been designated as beneficiariesfor purposes of determining the distribution period.Inherited IRAsThe beneficiaries of a traditional IRA must include in their gross incomeany distributions they receive. The beneficiaries of a traditional IRA caninclude an estate, dependents, and anyone the owner chooses to receivethe benefits of the IRA after he or she dies.Spouse. If an individual inherits an interest in a traditional IRA fromtheir spouse, they can elect to treat the entire inherited interest as theirown IRA.3-140Beneficiary other than spouse. Formerly, when an individual inherited atraditional IRA from someone other than their spouse, they could nottreat it as their own IRA. They could not roll over any part of it or rollany amount over into it (§408(d)(3)(C)). In addition, they were notpermitted to make any contributions to an inherited traditional IRA(§219(d)(4)).However, the Pension Protection Act of 2006 extended the specialtreatment granted to spousal beneficiaries to nonspouse beneficiaries.For distributions after 2006, nonspouse beneficiaries are allowed toroll over (in a trustee to trustee roll over) to an IRA structured for thatpurpose amounts inherited as a designated beneficiary. Thus, thebenefits of a beneficiary other than a surviving spouse may be transferreddirectly to an IRA.The IRA is treated as an inherited IRA of the nonspouse beneficiary.

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For example, distributions from the inherited IRA are subject to thedistribution rules applicable to beneficiaries. The provision applies toamounts payable to a beneficiary under a qualified retirement plan,governmental §457 plan, or a tax-sheltered annuity.Note: Nonspouse beneficiaries can also apply for waivers of the 60 dayrollover period. In addition, this provision will benefit same-sex couples.Estate Tax DeductionA beneficiary may be able to claim a deduction for estate tax resultingfrom certain distributions from a traditional IRA. The beneficiary candeduct the estate tax paid on any part of a distribution that is incomein respect of a decedent. He or she can take the deduction for the taxyear the income is reported.Charitable Distributions from an IRAFormerly, if an amount withdrawn from a traditional individual retirementarrangement ("IRA") or a Roth IRA was donated to a charitableorganization, the rules relating to the tax treatment of withdrawalsfrom IRAs applied to the amount withdrawn and the charitablecontribution was subject to the normally applicable limitations on deductibilityof such contributions.However, the Pension Protection Act of 2006 now provides an exclusionfrom gross income for otherwise taxable IRA distributions from atraditional or a Roth IRA in the case of qualified charitable distributionsthrough December 31, 2009 (as extended by the Emergency EconomicStabilization Act of 2008). The exclusion may not exceed3-141$100,000 per taxpayer per taxable year. Special rules apply in determiningthe amount of an IRA distribution that is otherwise taxable.The rules regarding taxation of IRA distributions and the deduction ofcharitable contributions continue to apply to distributions from anIRA that are not qualified charitable distributions. Qualified charitabledistributions are taken into account for purposes of the minimumdistribution rules applicable to traditional IRAs to the same extent thedistribution would have been taken into account under such rules hadthe distribution not been directly distributed under the provision.Post-Retirement Tax Treatment of IRA DistributionsThe cost basis of a participant in an IRA account is almost always zero.Therefore, all distributions are fully taxable as ordinary income in the year inwhich they are received. The distribution of an annuity contract to a participantis not taxable when received. Rather, when the annuity payments begin,they will be fully taxable as ordinary income. Furthermore, the transfer of aparticipant’s interest in an IRA plan to their former spouse under a decree ofdivorce or a written instrument incident to such divorce is not a taxable distribution.Thereafter, the IRA will be treated for tax purposes as being

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owned by the former spouse.Income In Respect of a DecedentDistributions to a beneficiary or estate of a deceased individual will generallybe taxed in the same manner as if the participant received them.Life insurance death benefits however, will not lose their tax-exemptcharacter. Any amounts that are taxable to the beneficiary should be regardedas income in respect of a decedent. Therefore, the beneficiary willbe entitled to a deduction from gross income for any federal estate taxesattributable to the inclusion of the IRA in the decedent’s gross estate.Estate Tax ConsequencesThe estate tax consequences are generally nil, since the surviving spouseis usually the beneficiary and is entitled to the unlimited marital deduction.However, there were previously some interesting rules in effectwhich worked to exclude $100,000 of the IRA amount from the gross estateof the decedent. These rules were repealed by TEFRA and, therefore,some estate plans may need reworking to prevent the over-fundingof the “by-pass trust.”Losses on IRA InvestmentsIf a taxpayer has a loss on their traditional IRA investment, they can recognizethe loss on their income tax return, but only when all the amounts3-142in all their traditional IRA accounts have been distributed to them andthe total distributions are less than their unrecovered basis, if any. Basis isthe total amount of the nondeductible contributions in the traditionalIRAs.The loss is claimed as a miscellaneous itemized deduction subject to the2%-of-adjusted-gross-income. A similar rule applies to Roth IRAs. Therule applies separately to each kind of IRA. Thus, to report a loss in aRoth IRA, all the Roth IRAs (but not traditional IRAs) have to be liquidated,and to report a loss in a traditional IRA, all the traditional IRAs(but not Roth IRAs) have to be liquidated.Prohibited TransactionsIf an individual engages in a prohibited transaction with their account, theaccount will become disqualified retroactively to the first day of the calendaryear in which the disqualifying event occurs. Where an employer or a unionhas established a retirement account, and a participant engages in a prohibitedtransaction, such individual’s account will be treated as a separate accountfor disqualification purposes.The examples of prohibited transactions with a traditional IRA include:(a) Borrowing money from it,(b) Selling property to it,(c) Receiving unreasonable compensation for managing it,(d) Using it as security for a loan, and

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(e) Buying property for personal use (present or future) with IRA funds.Effect of DisqualificationIf an IRA is disqualified, the participant is taxed as though they receiveda complete distribution of the fair market value of the assets in the account.Furthermore, all income accrued in the account subsequent tosuch disqualification will be currently taxable to the recipient.PenaltiesFor each prohibited transaction by a sponsoring employer or union, thelaw imposes a tax of 15% of the amount involved. Such tax is to be paidby any disqualified person who engages in the prohibited transaction, withthe exception of a fiduciary acting only in that capacity. If the transactionis not corrected within the correction period, then an additional tax equalto 100% of the amount involved is imposed. However, an account will notbe disqualified where an employer commits the prohibited transaction.This excise tax of 15% or 100% is not imposed on an individual who en3-143gages in a prohibited transaction with respect to their own account. Prohibitedtransactions are defined in §4975.Borrowing on an Annuity ContractIf an owner borrows money against their traditional IRA annuity contract,they must include in their gross income the fair market value of the annuitycontract as of the first day of their tax year. They may also have to pay the10% additional tax on early distributions.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.165. A Keogh plan is a popular type of retirement plan. Which individuals

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can be participants in such a plan?a. sole proprietors.b. employees of an S corporation.c. employees of a C corporation.d. partners owning 10% or less of an interest in partnerships.3-144166. Individual taxpayers and their non-working spouses may establish individualretirement arrangements (IRAs). What are the eligibility requirementsfor IRAs?a. 1 year of service if vesting schedule is elected.b. 2 years of service if 100% vesting is elected.c. underage 70½ years and have earned income.d. sole proprietor or more than 50% partner.167. For purposes of the required minimum distribution rules trusts cannotbe designated beneficiaries of an IRA. However, if four conditions are met,trust beneficiaries will instead be treated the designated. What is one of thesefour conditions?a. Trust beneficiaries can be identified by separate written designation.b. IRA trustee has a copy of the trust, and it is agreed that, if amended,they will be provided with a copy within a reasonable time.c. The trust is revocable during and after the death of the employee.d. The trust has no corpus but is valid trust under federal law.

Answers & Explanations165. A Keogh plan is a popular type of retirement plan. Which individuals canbe participants in such a plan?a. Correct. Under a Keogh plan, a self-employed individual is allowed to takea deduction for money he or she sets aside to provide for retirement. Selfemployedindividuals include sole proprietors.b. Incorrect. Employees of an S corporation are considered self-employed.Thus, these employees may not use a Keogh plan.c. Incorrect. Employees of a C corporation are not considered self-employed.Thus, these employees may not use a Keogh plan.d. Incorrect. Self-employed individuals include partners owning 10% or moreof an interest in a partnership. Thus, these parties could not use a Keoghplan. [Chp. 3]166. Individual taxpayers and their non-working spouses may establish individualretirement arrangements (IRAs). What are the eligibility requirementsfor IRAs?a. Incorrect. Under profit sharing pension plans, money purchase pensionplans, and 401(k) plans, a plan participant who reached age 21 and com3-

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145pleted 1 year of service if a vesting schedule is elected satisfies the eligibilityrequirements.b. Incorrect. Under profit sharing pension plans, money purchase pensionplans, and 401(k) plans, a plan participant who reached age 21 and completed2 years of service if 100% vesting is elected satisfies the eligibility requirements.c. Correct. The eligibility requirements of IRAs are that the individuals areunder 70½ years old who have earned income. Such individuals can establishand make contributions to a traditional IRA. Regardless of whether or notsuch individuals are covered under any other retirement plan, they may havea traditional IRA. Yet, if covered under an employer retirement plan, thecontributions made to the IRA may not be deductible.d. Incorrect. The eligibility requirements of IRAs do not have any stipulationsthat require the plan participant to be a sole proprietor or more than50% partner. [Chp. 3]167. For purposes of the required minimum distribution rules trusts cannot bedesignated beneficiaries of an IRA. However, if four conditions are met,trust beneficiaries will instead be treated the designated. What is one ofthese four conditions?a. Incorrect. The beneficiaries of a trust will be treated as having been designatedas beneficiaries if, among other things, the beneficiaries of the trustwho are beneficiaries with respect to the trust’s interest in the employee’sbenefit are identifiable from the trust instrument.b. Correct. The beneficiaries of a trust will be treated as having been designatedas beneficiaries if, among other things, the IRA trustee, custodian, orissuer has been provided with a copy of the trust instrument with the agreementthat if the trust instrument is amended, the administrator will be providedwith a copy of the amendment within a reasonable time.c. Incorrect. The beneficiaries of a trust will be treated as having been designatedas beneficiaries if, among other things, the trust is irrevocable or will,by its terms, become irrevocable upon the death of the employee.d. Incorrect. The beneficiaries of a trust will be treated as having been designatedas beneficiaries if, among other things, the trust is a valid trust understate law, or would be but for the fact that there is no corpus. [Chp. 3]3-146Tax-Free RolloversGenerally, a rollover is a tax-free distribution of cash or other assets from

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one retirement plan that is contributed to another retirement plan. The taxfreerollover provisions relate to all types of qualified plans, IRAs, annuities,and TSAs.Note: A transfer of funds in a traditional IRA from one trustee directly toanother, either at the taxpayer’s request or at the trustee's request, is not arollover. Since there is no distribution to the taxpayer, the transfer is tax free.Because it is not a rollover, it is not affected by the 1-year waiting period requiredbetween rollovers.Amounts paid or distributed to an individual out of an IRA or annuity arenot currently taxable if:(1) The amount so received is reinvested into another IRA within the 60day period allowed by law; orNote: For distributions made after December 31, 2001, no hardship distributioncan be rolled over into an IRA.(2) The amount received represents the amount in the account or thevalue of the annuity attributable solely to a rollover contribution from aqualified corporate trust or qualified annuity plan and the amount, togetherwith any earnings, is paid into another qualified corporate accountor Keogh plan or trust within the 60 day period.Note: Generally, a rollover is tax free only if a taxpayer makes the rollovercontribution by the 60th day after the day they receive the distribution. Beginningwith distributions after December 31, 2001, the IRS may waive the60-day requirement where it would be against equity or good conscience notto do so.Amounts not rolled over within the 60-day period do not qualify for tax-freerollover treatment. Taxpayers must treat them as a taxable distribution fromeither their IRA or employer’s plan. These amounts are taxable in the yeardistributed, even if the 60-day period expires in the next year. Taxpayers mayalso have to pay a 10% tax on early distributions.3-147Rollover from One IRA to AnotherTaxpayers can withdraw, tax-free, all or part of the assets from one traditionalIRA if they reinvest them within 60 days in the same or anothertraditional IRA. Since this is a rollover, taxpayers cannot deduct theamount that they reinvest in an IRA.Waiting Period between RolloversIf a taxpayer makes a tax-free rollover of any part of a distributionfrom a traditional IRA, they cannot, within a one-year period, make atax-free rollover of any later distribution from that same IRA. In addition,taxpayers cannot make a tax-free rollover of any amount distributed,within the same one-year period, from the IRA into which theymade the tax-free rollover. The one-year period begins on the date thetaxpayer received the IRA distribution, not on the date they rolled itover into an IRA.Partial Rollovers

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If a taxpayer withdraws assets from a traditional IRA, they can rollover part of the withdrawal tax free and keep the rest of it. Theamount kept will generally be taxable (except for the part that is a returnof nondeductible contributions) and may be subject to the 10%tax on premature distributions.Rollovers from Traditional IRAs into Qualified PlansFor distributions after December 31, 2001, taxpayers can roll over tax freea distribution from their IRA into a qualified plan. The part of the distributionthat they can roll over is the part that would otherwise be taxable.Qualified plans may, but are not required to, accept such rolloversRollovers of Distributions from Employer PlansFor distributions after December 31, 2001, taxpayers can roll over boththe taxable and nontaxable part of a distribution from a qualified planinto a traditional IRA. If a taxpayer has both deductible and nondeductiblecontributions in their IRA, they will have to keep track of their basisso they will be able to determine the taxable amount once distributionsfrom the IRA begin.Withholding RequirementIf an eligible rollover distribution is paid directly to a participant, thepayer must withhold 20% of it. This applies even if the participantplans to roll over the distribution to a traditional IRA. This withholdingcan be avoided by a direct rollover.3-148Affected item Result of a payment to you Result of a direct rolloverWithholdingThe payer must withhold 20% of thetaxable part. There is no withholding.Additional taxIf you are under age 59½, a 10% additionaltax may apply to the taxable part(including an amount equal to the taxwithheld) that is not rolled over.There is no 10% additionaltax.When to reportas incomeAny taxable part (including the taxablepart of any amount withheld) not rolledover is income to you in the year paid.Any taxable part is not incometo you until later distributedto you from theIRA.Waiting Period between RolloversTaxpayers can make more than one rollover of employer plan distributionswithin a year. The once-a-year limit on IRA-to-IRA rolloversdoes not apply to these distributions.Conduit IRAsTaxpayers can use a traditional IRA as a holding account (conduit) for

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assets they receive in an eligible rollover distribution from one employer'splan that they later roll over into a new employer's plan. Theconduit IRA must be made up of only those assets and gains and earningson those assets. A conduit IRA will no longer qualify if mixed withregular contributions or funds from other.Keogh RolloversIf a taxpayer is self-employed, they are generally treated as an employeefor rollover purposes. Consequently, if a taxpayer receives aneligible rollover distribution from a Keogh plan (a qualified plan withat least one self-employed participant), the taxpayer can rollover all orpart of the distribution (including a lump-sum distribution) into a traditionalIRA.Direct Rollovers From Retirement Plans to Roth IRAsAmounts that have been distributed from a tax-qualified retirementplan, a tax-sheltered annuity, or a governmental §457 plan may berolled over into a traditional IRA, and then rolled over from the traditionalIRA into a Roth IRA. However, historically, distributions fromsuch plans could not be rolled over directly into a Roth IRA.3-149The Pension Protection Act of 2006 now allows distributions from taxqualifiedretirement plans, tax-sheltered annuities, and governmental§457 plans to be rolled over directly from such plan into a Roth IRA,subject to the rules that apply to rollovers from a traditional IRA intoa Roth IRA.For example, a rollover from a tax-qualified retirement plan into aRoth IRA is includible in gross income (except to the extent it representsa return of after-tax contributions), and the 10% early distributiontax does not apply. Similarly, an individual with AGI of $100,000or more could not roll over amounts from a tax-qualified retirementplan directly into a Roth IRA.Rollovers of §457 Plans into Traditional IRAsPrior to 2002, taxpayers could not roll over tax free an eligible rolloverdistribution from a governmental deferred compensation plan (as definedin §457) to a traditional IRA. Beginning with distributions after December31, 2001, if a taxpayer participates in an eligible deferred compensationplan of a state or local government, they may be able to roll over partof their account tax free into an eligible retirement plan such as a traditionalIRA.The most that a taxpayer can roll over is the amount that would be taxedif the rollover were not an eligible rollover distribution. Taxpayers cannotroll over any part of the distribution that would not be taxable. The rollovermay be either direct or indirect.Rollovers of Traditional IRAs into §457 PlansPrior to 2002, taxpayers could not roll over tax free a distribution from atraditional IRA to a governmental deferred compensation plan. Beginningwith distributions after December 31, 2001, if a taxpayer participates

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in an eligible deferred compensation plan of a state or local government,they may be able to roll over a distribution from their traditional IRAinto a deferred compensation plan of a state or local government. Qualifiedplans may, but are not required to, accept such rollovers.Rollovers of Traditional IRAs into §403(B) PlansPrior to 2002, taxpayers could not roll over tax free a distribution from atraditional IRA into a tax-sheltered annuity. Beginning with distributionsafter December 31, 2001, a taxpayer may be able to roll over distributionstax free from a traditional IRA into a tax-sheltered annuity. They cannotroll over any amount that would not have been taxable. Although a taxshelteredannuity is allowed to accept such a rollover, it is not required todo so.3-150Rollovers from SIMPLE IRAsFor distributions after December 31, 2001, taxpayers may be able to rollover tax free a distribution from their SIMPLE IRA to a qualified plan, atax-sheltered annuity (§403(b) plan), or deferred compensation plan of astate or local government (§457 plan). Previously, tax-free rollovers wereonly allowed to other IRAs.Nonspouse RolloversDistributions from retirement plans or accounts are subject to tax in theyear they are distributed. Prior to the Pension Protection Act of 2006(“PPA”), when a participant died, plan distributions could transfer (or“rollover”) into a surviving spouse’s IRA tax-free (§402(c)(9)). This rolloverscheme was not available to non-spouse beneficiaries.Under §402(c)(11), as created by the PPA, certain tax-qualified plans(e.g., a 401(k)) could offer a direct rollover of a distribution to a nonspousebeneficiary (e.g., a sibling, parent, or a domestic partner). As a result,the rollover amounts are not included in the beneficiary’s income inthe year of the rollover.Starting in 2010, the Worker, Retiree, and Employer Recovery Act permitsrollovers of benefits of nonspouse beneficiaries from qualified plansand similar arrangements. The provision clarifies that the current lawtreatment with respect to a trustee-to-trustee transfer from an inheritedIRA to another inherited IRA continues to apply.Under the provision, rollovers by nonspouse beneficiaries are generallysubject to the same rules as other eligible rollovers.Comment: In short, the Act clarifies that distributions to a nonspouse beneficiary’sinherited IRA are to be considered “eligible rollover distributions,”and plans are thus required to allow these beneficiaries to make these directrollovers. Plans must also provide direct rollover notices in order to maintainplan qualification

Rollover Individual Retirement AccountsPlanholder Recipients of partial or lump-sum distributions from an employersponsored retirement plan within one taxable year. Distributionscannot be a series of periodic payments.

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Recipients of Eligibility total distributions due to:Requirements Separation from service*Attainment of age 59½Termination of plan by employerPermanent disability**Death of employee (if spouse is beneficiary)Qualified Domestic Relations Order3-151*Does not apply to self-employed individuals** Does apply to self-employed individualsRecipients of partial distribution due to:Separation from serviceDeath of employee (if spouse is beneficiary)Permanent disabilityContributionLimitsMaximum Contribution Limit: Up to 100% of the distribution.Employee voluntary non-deductible contributions cannot berolled; earnings on these contributions can. The participant cankeep a portion of the payout and roll over the rest.Deadlines ForEstablishment& ContributionsRollovers must be completed by the 60th day after receipt of thedistribution. Rollovers from an employer-sponsored retirementplan are an irrevocable election.Earliest without 10% tax penalty:DeathPermanent disabilityAttainment of age 59½Periodic payments based on a life expectancy formula that cannotbe modified for at least 5 years or until attainment of age59½, if lateTransfer of assets from a participant’s IRA to spouse’s or formerspouse’s IRA in accordance with a divorce or separationdocument.Latest (without 50% excise tax penalty):DistributionsApril 1 of the calendar year following the year in which the participantreaches age 70 ½Tax Treatmenton DistributionAll distributions from any type of IRA are taxed as ordinaryincome. Remember, however, that if the individual made nondeductiblecontributions, each distribution consists of a nontaxableportion and a taxable portion.Roth IRA - §408AA Roth IRA is a special tax-free nondeductible individual retirement plan forindividuals with AGI of $120,000 (in 2009) or less and married couples withAGI of $176,000 (in 2009) or less. It can be either an account or an annuity.To be a Roth IRA, the account or annuity must be designated as a Roth IRAwhen it is set up. Neither a SEP-IRA nor a SIMPLE IRA can be designated

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as a Roth IRA.Unlike a traditional IRA, contributions to a Roth IRA are not deductible.However, distributions from a Roth IRA are tax free if made more than 5years after a Roth IRA has been established and if the distribution is:(1) Made after age 59½, death, or disability, or3-152(2) For first-time homebuyer expenses (up to $10,000).EligibilityIndividuals can contribute to a Roth IRA if they have taxable compensationand their modified AGI is less than:(a) $176,000 (in 2009) for married filing jointly,(b) $10,000 (in 2009) for married filing separately and taxpayer livedwith their spouse at any time during the year, and(c) $120,000 (in 2009) for single, head of household, qualifyingwidow(er) or married filing separately and taxpayer did not live withtheir spouse at any time during the year.Contributions can be made to a Roth IRA regardless of an individual’sage. Contributions can be made to a Roth IRA for a year at any time duringthe year or by the due date of the individual’s return for that year (notincluding extensions).Contribution LimitationThe contribution limit for Roth IRAs depends on whether contributionsare made only to Roth IRAs or to both traditional IRAs and Roth IRAs.Roth IRAs OnlyIf contributions are made only to Roth IRAs, taxpayer’s contributionlimit generally is the lesser of:(1) $5,000 in 2009 or $6,000 in 2009 if you are 50 or older, or(2) Taxpayer’s taxable compensation.However, if modified AGI is above a certain amount, the contributionlimit may be reduced. Worksheets for determining modified adjustedgross income and this reduction are provided in the IRS Publication590.Roth IRAs & Traditional IRAsIf contributions are made to both Roth IRAs and traditional IRAs establishedfor the taxpayer’s benefit, the contribution limit for RothIRAs generally is the same as the limit would be if contributions weremade only to Roth IRAs, but then reduced by all contributions (otherthan employer contributions under a SEP or SIMPLE IRA plan) forthe year to all IRAs other than Roth IRAs.This means that the contribution limit is the lesser of:(1) $5,000 in 2009 or $6,000 in 2009 if taxpayer is 50 or older minusall contributions (other than employer contributions under a SEP or3-153SIMPLE IRA plan) for the year to all IRAs other than Roth IRAs,or(2) Taxpayer’s taxable compensation minus all contributions (other

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than employer contributions under a SEP or SIMPLE IRA plan) forthe year to all IRAs other than Roth IRAs.However, if modified AGI is above a certain amount, the contributionlimit may be reduced. Worksheets for determining modified adjustedgross income and this reduction are provided in the IRS Publication590.Effect of Modified AGI on Roth IRA ContributionIF you have taxable compensationand your filing status is: AND your modified AGI is: THEN:Less than $166,000You can contribute up to$5,000 in 2009 or $6,000in 2009 if age 50 or older.At least $166,000 but less than$176,000The amount you can contributeis reduced.Married Filing Jointly$176,000 or more You cannot contribute to aRoth IRA.Zero (-0-)You can contribute up to$5,000 in 2009 or $6,000in 2009 if 50 or older.More than zero (-0-) but lessthan $10,000The amount you can contributeis reduced.Married Filing Separatelyand you lived with yourspouse at any time during theyear$10,000 or more You cannot contribute to aRoth IRA.Less than $105,000You can contribute up to$5,000 in 2009 or $6,000in 2009 if age 50 or older.At least $105,000 but less than$120,000The amount you can contributeis reduced.Single, Head of Household,Qualifying Widow(er), orMarried Filing Separatelyand you did not live with yourspouse at any time during theyear$120,000 or more You cannot contribute to aRoth IRA.ConversionsIt is possible to convert amounts from either a traditional, SEP, orSIMPLE IRA into a Roth IRA. Taxpayers may be able to recharacterize

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contributions made to one IRA as having been made directly to a differ3-154ent IRA. In addition, taxpayers can roll amounts over from one RothIRA to another Roth IRA.A conversion from a traditional IRA into a Roth IRA is allowable if, forthe tax year the taxpayer makes a withdrawal from a traditional IRA, bothof the following requirements are met:(1) Taxpayer’s modified AGI is not more than $100,000; and(2) Taxpayer is not a married individual filing a separate return.Amounts can be converted from a traditional IRA to a Roth IRA in anyof the following three ways:1. Rollover. Taxpayer can receive a distribution from a traditional IRAand roll it over (contribute it) to a Roth IRA within 60 days after thedistribution. A rollover from a Roth IRA to an employer retirementplan is not allowed.Note: Taxpayers can withdraw all or part of the assets from a traditionalIRA and reinvest them (within 60 days) in a Roth IRA. If properly (andtimely) rolled over, the 10% additional tax on early distributions willnot apply. Taxpayers must roll over into the Roth IRA the same propertythey received from the traditional IRA.2. Trustee-to-trustee transfer. Taxpayer can direct the trustee of thetraditional IRA to transfer an amount from the traditional IRA to thetrustee of the Roth IRA.3. Same trustee transfer. If the trustee of the traditional IRA alsomaintains the Roth IRA, taxpayer can direct the trustee to transfer anamount from the traditional IRA to the Roth IRA.Note: Conversions made with the same trustee can be made by redesignatingthe traditional IRA as a Roth IRA, rather than opening a newaccount or issuing a new contract.Taxpayers must include in their gross income distributions from a traditionalIRA that they would have to include in income if they had not convertedthem into a Roth IRA.AGI Limit ExceptionThe $100,000 modified AGI limit on conversions of traditional IRAsto Roth IRAs is eliminated for tax years beginning after Dec. 31, 2009.For 2010 conversions, unless a taxpayer elects otherwise, the amountincludible in gross income because of the conversion is included ratablyin 2011 and 2012. Special rules apply if converted amounts are distributedbefore 2012.3-155RecharacterizationsIndividuals may be able to treat a contribution made to one type of IRAas having been made to a different type of IRA. This is called recharacterizingthe contribution.To recharacterize a contribution, the contribution must be transferredfrom the first IRA (the one to which it was made) to the second IRA in a

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trustee-to-trustee transfer. If the transfer is made by the due date (includingextensions) for the tax return for the year during which the contributionwas made, taxpayers can elect to treat the contribution as havingbeen originally made to the second IRA instead of to the first IRA. It willbe treated as having been made to the second IRA on the same date thatit was actually made to the first IRA. Taxpayers must report the recharacterization,and must treat the contribution as having been made to thesecond IRA, instead of the first IRA, on their tax return for the year duringwhich the contribution was made.Note: If a taxpayer files their return timely without making the election, theycan still make the choice by filing an amended return within six months ofthe due date of the return (excluding extensions).ReconversionsTaxpayers cannot convert and reconvert an amount during the same taxableyear, or if later, during the 30-day period following a recharacterization.If a taxpayer reconverts during either of these periods, it will be afailed conversion.Taxation of DistributionsTaxpayers do not include in their gross income qualified distributions ordistributions that are a return of their regular contributions from theirRoth IRA(s). They also do not include distributions from their Roth IRAthat they roll over tax free into another Roth IRA.A qualified distribution is any payment or distribution from a taxpayer’sRoth IRA that meets the following requirements:(1) It is made after the 5 taxable year period beginning with the firsttaxable year for which a contribution was made to a Roth IRA set upfor the taxpayer’s benefit, and(2) The payment or distribution is:(a) Made on or after the date taxpayer reaches age 59½,(b) Made because taxpayer is disabled,(c) Made to a beneficiary or to taxpayer’s estate after taxpayer’sdeath, or3-156(d) One that meets the requirements for first-time homebuyer expenses(up to a $10,000 lifetime limit).Taxpayers must pay a 10% additional tax on early distributions on the taxablepart of any distributions that are not qualified distributions. Worksheetsare provided in IRS Publication 590 to figure the taxable part of adistribution that is not a qualified distribution.No Required Minimum DistributionsTaxpayers are not required to take distributions from their Roth IRAat any age. The minimum distribution rules that apply to traditionalIRAs do not apply to Roth IRAs while the owner is alive. However, afterthe death of a Roth IRA owner, certain of the minimum distribution

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rules that apply to traditional IRAs also apply to Roth IRAs.If a Roth IRA owner dies, the minimum distribution rules that apply totraditional IRAs apply to Roth IRAs as though the Roth IRA ownerdied before his or her required beginning date. The basis of propertydistributed from a Roth IRA is its fair market value (FMV) on thedate of distribution, whether or not the distribution is a qualified distribution.Simplified Employee Pension Plans (SEPs)A simplified employee pension (SEP) is a written arrangement (a plan) that allowsan employer to make deductible contributions for the benefit of participatingemployees. The contributions are made to individual retirement arrangements(IRAs) set up for participants in the plan. Traditional IRAs set up under aSEP plan are referred to as SEP-IRAs (§408(k)).Like an individual IRA, an employee may participate in a SEP even though he isalso a participant in a qualified plan. A simplified employee pension plan is anIRA that meets all of the following requirements:(a) For the calendar year, the employer contributes for each employee whohas attained age 21 and who has performed any service for the employer duringthree of the preceding five years;Note: Any employee who has not earned at least $300 in the current yearmay be excluded; however, most part-time employees will have to be covered.Contributions and deductions are available even if the employee hasattained age 70½ (the normal IRA age limit).(b) Contributions must not discriminate in favor of highly compensated employees;Note: Employees who are members of unions where good faith bargainingon retirement benefits has occurred, as well as nonresident aliens with no incomefrom sources within the United States may be excluded.3-157(c) Employer contributions may be integrated with Social Security basedupon the rules for qualified defined contribution plans; andNote: However, contributions based on a salary reduction arrangement maynot be integrated.(d) Each plan participant must own the IRA account or annuity and employercontributions must not be conditioned upon the retention in such planof any amount so contributed.Note: In other words, 100% immediate vesting and no prohibitions againstwithdrawals from the account;(e) The employer has complete contribution flexibility since the employer isnot required to contribute to the SEP each year regardless of whether or notthere are profits. The amount to be contributed each year may also vary atthe election of the employer so long as the contributions remain nondiscriminatory

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in nature.(f) Employer contributions must be made pursuant to a written instrumentand be based on a definite written allocation formula that specifies:(i) The requirements for an employee to share in an allocation; and(ii) The manner in which the amount allocated is to be computed.The Small Business Job Protection Act of 1996 eliminated salary reduction simplifiedemployee pension plans (SAR-SEPs) in favor of SIMPLE retirementplans. However, SAR-SEPs in effect on 12/31/96 can continue to receive salaryreduction contributions and new employees can make salary reduction contributions.Salary Reduction (SAR-SEP) & Simplified EmployeePension Plans (SEP-IRA)Planholder CorporationsS corporationsNon-profit organizations (SEP only)PartnershipsSole proprietorships (i.e., self-employed)The employer must include employees who have:Reached age 21Worked at least 3 or more of the last 5 preceding yearsAnnual compensation of at least $550 (in 2009)EligibilityRequirementsSEP: All eligible employees must participate in the plan.SAR/SEP: Employer must have 25 or fewer eligible employeesat all times during the preceding year. 50% of all eligibleemployees must participate in the salary reduction provisionof the plan.Contribution SEP Maximum Contribution Limit: Employer contributionsare limited to 25% of each participant’s compensation not to3-158Limits exceed $49,000 in 2009 (overall limit includes employer basicand salary reduction contributions).SAR/SEP Maximum Contribution Limit: Salary reductioncontributions are limited to 25% of each participant’s compensationnot to exceed $16,500 (in 2009). These contributions,reported in Box 16 on the employee’s W-2 Form, aresubject to an anti-discrimination test.Minimum SEP & SAR/SEP Contribution: Minimum employercontribution of 3% may be required if certain highlycompensated or key employees participate.Deadlines ForEstablishment& ContributionsOn or before the employer’s tax filing deadline plus extensions.A SEP may be maintained on a calendar or fiscal yearbasis.Earliest without 10% tax penalty:

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DeathPermanent disabilityAttainment of age 59½Periodic payments based on a life expectancy formula thatcannot be modified for at least 5 years or until attainment ofage 59½, if laterTransfer of assets from a participant’s IRA to spouse’s orformer spouse’s IRA in accordance with a divorce or separationdocument.Latest (without 50% excise tax penalty):DistributionsApril 1 of the calendar year following the year in which theparticipant reaches age 70½Tax Treatmenton DistributionAll distributions from any type of IRA are taxed as ordinaryincome. Remember, however, that if the individual madenondeductible contributions, each distribution consists of anontaxable portion and a taxable portion.Contribution Limits & TaxationThe SEP rules permit an employer to contribute to each participating employee'sSEP-IRA up to 25% of the employee's compensation or $49,000 in2009, whichever is less. These contributions are funded by the employer.An employer who signs a SEP agreement does not have to make any contributionto the SEP-IRAs that are set up. But, if the employer does make contributions,the contributions must be based on a written allocation formulaand must not discriminate in favor of highly compensated employees.The employer's contributions to a SEP-IRA are excluded from the employee’sincome rather than deducted from it. This means that, unless thereare excess contributions, employees do not include any contributions in theirgross income; nor do they deduct any of them.Employees can make contributions to their SEP-IRA independent of employerSEP contributions. They can deduct them the same way as contribu3-159tions to a regular IRA. However, their deduction may be reduced or eliminatedbecause, as a participant in a SEP, they are covered by an employer retirementplan.SIMPLE PlansA savings incentive match plan for employees (SIMPLE plan) is a tax-favoredretirement plan that certain small employers (including self-employed individuals)can set up for the benefit of their employees. Under a SIMPLE plan, employees

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can choose to make salary reduction contributions to the plan ratherthan receiving these amounts as part of their regular pay. In addition, you willcontribute matching or nonelective contributions.A SIMPLE plan can be set up in either of the following ways:(1) Using SIMPLE IRAs (SIMPLE IRA plan), or(2) As part of a §401(k) plan (SIMPLE 401(k) plan).SIMPLE IRA PlanA SIMPLE IRA plan is a retirement plan that uses SIMPLE IRAs for eacheligible employee. Under a SIMPLE IRA plan, a SIMPLE IRA must be setup for each eligible employee.Note: Any employee who received at least $5,000 in compensation duringany 2 years preceding the current calendar year and is reasonably expectedto receive at least $5,000 during the current calendar year is eligible to participate.The term "employee" includes a self-employed individual who receivedearned income.Employers can set up a SIMPLE IRA plan if they meet both the following requirements:(a) They meet the employee limit, and(b) They do not maintain another qualified plan unless the other plan isfor collective bargaining employees.Employee LimitEmployers can set up a SIMPLE IRA plan only if they had 100 or feweremployees who received $5,000 or more in compensation from the employerfor the preceding year. Under this rule, the employer must takeinto account all employees employed at any time during the calendar yearregardless of whether they are eligible to participate. Employees includeself-employed individuals who received earned income and leased employees.Once an employer sets up a SIMPLE IRA plan, they must continueto meet the 100-employee limit each year they maintain the plan.3-160Other Qualified PlanThe SIMPLE IRA plan generally must be the only retirement plan towhich the employer makes contributions, or to which benefits accrue, forservice in any year beginning with the year the SIMPLE IRA plan becomeseffective. However, if the employer maintains a qualified plan forcollective bargaining employees, they are permitted to maintain aSIMPLE IRA plan for other employees.Set upEmployers can use Form 5304-SIMPLE or Form 5305-SIMPLE to set upa SIMPLE IRA plan. Each form is a model savings incentive match planfor employees (SIMPLE) plan document. Which form the employer usesdepends on whether they select a financial institution or their employeesselect the institution that will receive the contributions.Use Form 5304-SIMPLE if the employer allows each plan participant toselect the financial institution for receiving his or her SIMPLE IRA plan

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contributions. Use Form 5305-SIMPLE if the employer requires that allcontributions under the SIMPLE IRA plan be deposited initially at a designatedfinancial institution.The SIMPLE IRA plan is adopted when the employer has completed allappropriate boxes and blanks on the form and they (and the designatedfinancial institution, if any) have signed it. Keep the original form. Do notfile it with the IRS.Contribution LimitsContributions are made up of salary reduction contributions and employercontributions. The employer must make either matching contributionsor nonelective contributions. No other contributions can be made tothe SIMPLE IRA plan. These contributions, which the employer can deduct,must be made timely.Salary Reduction ContributionsThe amount the employee chooses to have the employer contribute toa SIMPLE IRA on his or her behalf cannot be more than $11,500 in2009. These contributions must be expressed as a percentage of theemployee's compensation unless the employer permits the employee toexpress them as a specific dollar amount. The employer cannot placerestrictions on the contribution amount (such as limiting the contributionpercentage), except to comply with the $11,500 (in 2009) limit.Participants who are age 50 or over can make a catch-up contributionto a SIMPLE IRA of up to $2,500 in 2009.3-161Employer Matching ContributionsEmployers are generally required to match each employee's salary reductioncontributions on a dollar-for-dollar basis up to 3% of the employee'scompensation. This requirement does not apply if the employermakes nonelective contributions.Instead of matching contributions, employers can choose to makenonelective contributions of 2% of compensation on behalf of each eligibleemployee who has at least $5,000 (or some lower amount theemployer selects) of compensation for the year. If the employer makesthis choice, they must make nonelective contributions whether or notthe employee chooses to make salary reduction contributions. Only$245,000 in 2009 of the employee's compensation can be taken into accountto figure the contribution limit.Deduction of ContributionsEmployers can deduct SIMPLE IRA contributions in the tax year with orwithin which the calendar year for which contributions were made ends.They can deduct contributions for a particular tax year if they are madefor that tax year and are made by the due date (including extensions) ofthe employer’s federal income tax return for that year.DistributionsDistributions from a SIMPLE IRA are subject to IRA rules and generally

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are includible in income for the year received. Tax-free rollovers can bemade from one SIMPLE IRA into another SIMPLE IRA. However, arollover from a SIMPLE IRA to a non-SIMPLE IRA can be made taxfree only after a 2-year participation in the SIMPLE IRA plan.Early withdrawals generally are subject to a 10% additional tax. However,the additional tax is increased to 25% if funds are withdrawn within 2years of beginning participation.SIMPLE §401(k) PlanEmployers can adopt a SIMPLE plan as part of a 401(k) plan if they meet the100-employee limit. A SIMPLE 401(k) plan is a qualified retirement planand generally must satisfy the rules discussed applicable to such type plans.However, a SIMPLE 401(k) plan is not subject to the nondiscrimination andtop-heavy rules if the plan meets the following conditions:(1) Under the plan, an employee can choose to have the employer makesalary reduction contributions for the year to a trust in an amount expressedas a percentage of the employee's compensation, but not more3-162than $11,500 in 2009 and participants who are age 50 or over can make acatch-up contribution of up to $2,500 in 2009;(2) The employer must make either:(a) Matching contributions up to 3% of compensation for the year, or(b) Nonelective contributions of 2% of compensation on behalf ofeach eligible employee who has at least $5,000 of compensation for theyear;(3) No other contributions can be made to the trust;(4) No contributions are made, and no benefits accrue, for services duringthe year under any other qualified retirement plan of the employer onbehalf of any employee eligible to participate in the SIMPLE §401(k)plan; and(5) The employee's rights to any contributions are nonforfeitable.No more than $245,000 in 2009 of the employee's compensation can be takeninto account in figuring salary reduction contributions, matching contributions,and nonelective contributions.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they may

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help you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.168. A rollover is a tax-free reinvestment from one retirement plan to another.What fails to qualify as a rollover?a. funds in a traditional IRA transferred from one trustee directly to another,at the investor’s request.b. all of the assets from a qualified plan that are withdrawn and reinvestedin a traditional IRA.3-163c. part of the assets from a traditional IRA that are withdrawn and reinvestedin a qualified plan.d. part of the assets from a traditional IRA that are withdrawn and reinvestedwithin 60 days in the same traditional IRA.169. If a distribution from a Roth IRA is made five years after the plan’sformation and one of two conditions is met, the distribution can be tax free.What is one of these two conditions?a. The distribution is for first first-time homebuyer expenses.b. The distribution is made after age 21.c. The distribution is made prior to a disability.d. The distribution is made prior to death.170. Under a simplified employee pension (SEP) IRA, the employer mustcontribute for each employee. However, an employee:a. must have attained age 18 to qualify.b. can still participate if over age 70½ .c. must have earned at least $450 in the tax year to qualify.d. must have performed services for the employer during two of the precedingfour years.171. A savings incentive match plan for employees (SIMPLE) set up as partof 401(k) plan may discriminate if five conditions are met. What is one of thefive conditions?a. The employee has the employer make a salary reduction contributionto an IRA.b. Contributions may be made from any source to a trust.c. Any entitlement that the employee has to contributions must vestgradually.d. Employer’s matching contributions must be up to 3% of compensation

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for the year.

Answers & Explanations168. A rollover is a tax-free reinvestment from one retirement plan to another.What fails to qualify as a rollover?a. Correct. A transfer of funds in a traditional IRA from one trustee directlyto another, either at the taxpayer’s request or at the trustee's request, is not arollover. Since there is no distribution to the taxpayer, the transfer is tax free.b. Incorrect. For distributions after December 31, 2001, taxpayers can rollover both the taxable and nontaxable part of a distribution from a qualifiedplan into a traditional IRA.3-164c. Incorrect. For distributions after December 31, 2001, taxpayers can rollover tax free a distribution from their IRA into a qualified plan. The part ofthe distribution that they can roll over is the part that would otherwise be taxable.Qualified plans may, but are not required to, accept such rollovers.d. Incorrect. Taxpayers can withdraw, tax-free, all or part of the assets fromone traditional IRA if they reinvest them within 60 days in the same or anothertraditional IRA. [Chp. 3]169. If a distribution from a Roth IRA is made five years after the plan’s formationand one of two conditions is met, the distribution can be tax free.What is one of these two conditions?a. Correct. Distributions from a Roth IRA are tax free if made more thanfive years after a Roth IRA has been established and the distribution is madefor first-time homebuyer expenses (up to $10,000).b. Incorrect. Distributions from a Roth IRA are tax free if made more thanfive years after a Roth IRA has been established and the distribution is madeafter age 59½, not age 21.c. Incorrect. Distributions from a Roth IRA are tax free if made more thanfive years after a Roth IRA has been established and the distribution is madeafter disability.d. Incorrect. Distributions from a Roth IRA are tax free if made more thanfive years after a Roth IRA has been established and the distribution is madeafter death. [Chp. 3]170. Under a simplified employee pension (SEP) IRA, the employer must contributefor each employee. However, an employee:a. Incorrect. For the calendar year, the employer contributes for each employeewho has attained age 21, not 18.

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b. Correct. Contributions and deductions are available even if the employeehas attained age 70½ (the normal IRA age limit).c. Incorrect. Employee participants must have earned at least $500 in the taxyear to qualify.d. Incorrect. For the calendar year, the employer contributes for each employeewho has performed any service for the employer during three of thepreceding five years. [Chp. 3]171. A savings incentive match plan for employees (SIMPLE) set up as part of401(k) plan may discriminate if five conditions are met. What is one of thefive conditions?a. Incorrect. While one condition is that the employee may request that theemployer make salary reduction contribution, it must be made to a trust.b. Incorrect. One of the conditions that must be met is that no other contributionscan be made to the trust.3-165c. Incorrect. One of the conditions that must be met is that the employee'srights to any contributions are nonforfeitable.d. Correct. One of the conditions that must be met is that the employer mustmake either matching contributions up to 3% of compensation for the year,or nonelective contributions of 2% of compensation on behalf of each eligibleemployee who has at least $5,000 of compensation for the year. [Chp. 3]

Learning ObjectivesAfter reading the next chapter, participants will be able to:1. Identify the two basic income types and three “buckets” under §469,explain the suspension of disallowed losses including their relationshipto total passive losses, and name six special transfers not deemed to befully taxable dispositions.2. Differentiate the regular and alternative minimum tax computingthe AMT by applying tax preferences and adjustments, define ADS assetlives, and compute, for AMT purposes, taxable income, passiveloss, and ACE.3. Outline the reporting requirements for real estate transactions, independentcontractors, and cash reporting to comply with governmentregulations.4. List four types of accuracy related and unrealistic position penalties,and explain IRS examination return policy and assessment process includingapplicable statute of limitations.After studying the materials in this chapter, answer the exam questions 172to 200.4-1

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CHAPTER 4Losses, AMT & CompliancePassive LossesA taxpayer’s income and losses for each tax year must be categorized into passiveand nonpassive1. Losses from passive trade or business activities in excess of incomefrom passive trade or business activities may not be deducted against otherincome (§469(a)(1)(A)).Prior LawBefore the TRA ‘86, few limitations were placed on the ability of a taxpayer touse deductions from a particular activity to offset income from other activities.Similarly, most tax credits could be used to offset tax attributable to income fromany of the taxpayer’s activities2.1 Nonpassive is further subdivided into portfolio and material participation.2 There were some exceptions to this general rule. For example, deductions for capital losseswere limited to the extent that there were not offsetting capital gains.4-2

Passive Loss Big PicturePASSIVE PORTFOLIOMATERIALPARTICIPATIONEXCESSLOSSESACTIVEREALESTATEOTHERPASSIVE$25,000

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ALLOWANCEOFFSETORFREEDFULLYTAXABLEDISPOSITION4-3Passive Loss RulesThe passive loss rules provide that deductions from passive trade or business activities,to the extent they exceed income from all such passive activities (exclusiveof portfolio income), generally may not be deducted against other income(§469(a)(1)(A)). Similarly, credits from passive activities generally are limited tothe tax attributable to the passive activities3 (§469(a)(1)(A)). Suspended lossesand credits are carried forward and treated as deductions and credits from passiveactivities in the next tax year4 (§469(b)). Suspended losses from an activityare allowed in full when the taxpayer disposes of their entire interest in the activity.However, the ordering of recognized losses is determined under §469(g)(1).Aggregate Definition of Passive Activity LossSection 469(d)(1)(A) defines the term “passive activity loss”as the amount (if any) by which the aggregate losses from allpassive activities for the tax year exceed the aggregate income5

from all passive activities for such year6.ApplicationThe passive loss rule applies to all deductions that are from passive activities,including deductions allowed under §162, §163, §164, and §165.ObservationAs a result, the relationship of a taxpayer to an activity inwhich they do not materially participate is similar to that of ashareholder to a corporation. Losses and expenses borne bythe corporation, and any decline in the value of the corporatestock, do not generate recognition of any loss for shareholdersprior to sale of their stock.3 Thus, if there is no net passive activity income for the year, passive credits will generally not beallowed. However, if the $25,000 allowance for rental real estate is not fully used, passive creditscan sometimes be converted to deductions and used under the allowance.

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4 The carryforward has no time limit.5 Reg. §§1.469-2T(c) and (d) identify the items treated as passive activity gross income and passiveactivity deductions.6 Passive activity credits have a similar aggregate definition (§469(d)(2)).4-4Active LossesSection 469 is a passive loss limitation and does not affect active losses. Ingeneral, active losses may offset any type of income.CreditsThere are limits on credits as well as losses from passive activities. Creditsfrom passive activity are generally limited to the income tax allocable to thenet passive activity income (§469(a)(1)(B)).Calculating Passive LossThe annual computation of passive losses can be summarized as a series of severalbasic steps:(1) Determine all the separate activities of the taxpayer;(2) Categorize all activities as either:(a) Passive,(b) Portfolio, or(c) Material participation;(3) Take the passive activities and net income against loss:(a) First, netting the income of each activity solely against the losses ofthat activity7, then(b) Next, offsetting all net income activities against all net loss activities;and(4) If a loss still exists, it constitutes a passive activity loss and §469 applies.Categories of Income & LossSection 469 annually divides a taxpayer’s income and losses into two basic categories- passive and non-passive. Non-passive is further subdivided into portfolioand material participation. The result is three categories or “buckets” of incomeand loss.PassiveSections 469(c)(1), (c)(2) and (h)(2) define passive items to be any of the following:(1) Any activity that involves the conduct of a trade or business and inwhich the taxpayer does not materially participate;(2) Any rental activity; and7 This first netting will be important for purposes of allocating suspended losses among net passiveloss activities.4-5Mini DefinitionA rental activity is defined as any activity where payments received

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are principally for the use of tangible property(§469(j)(8)). This is true even if the property is rented under anet lease (Conference Report, II-138). However, if substantialservices are rendered or the taxpayer is a dealer with respectto the property (Senate Report, p.720), the activity will not beconsidered a rental activity.(3) Any limited partnership.PortfolioWhile the term “portfolio income” is not used in the Code, the followingitems (which make up “portfolio income”) are deemed to be non-passive under§469(e)(1)(A) and (B):(1) Interest (other than qualified residence interest which is nonpassive(§469(j)(7)),(2) Dividends (net of dividend-received deduction) from:(a) “C” corporations,(b) REITs, REMICs & RICs (Conference Report, II-146, note 3), or(c) Regulated investment companies,(3) Annuities,(4) Royalties (not derived in ordinary course of a trade or business - e.g.,royalties from the licensing of property),(5) Expenses (other than interest) which are clearly and directly allocableto items 1 through 4 (Conference Report H7636),(6) Interest expense properly allocable to items 1 through 4 (ConferenceReport H7636),Note: The Conference Agreement stated that regulations related to appropriateinterest expense allocation be issued prior to 12/31/86. The Service respondedon July 1, 1987 with an intricate set of “tracing” regulations.(7) Gain or loss from the sale of property generating such income or heldfor investment8,(8) Income, gain, or loss which is attributable to an investment of workingcapital9, and8 For purposes of this clause, any interest in a passive activity shall not be treated as propertyheld for investment (§469(e)(1)(A)(ii)).9 Although setting aside such amounts may be necessary to the trade or business, earnings onsuch amounts are investment related and not a part of the business itself.4-6(9) Income10 from a publicly traded partnership (§469(k)).Material ParticipationSection 469(h)(1) defines material participation as an activity in which thetaxpayer is involved:(1) Regularly,(2) Continuously, and(3) Substantially.Self-Charged Interest RegulationsPassive loss rules under §469 prevent passive losses form offsetting active or

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portfolio income. Thus, passive losses cannot offset interest income that isportfolio income. However, passive losses can offset passive income.Passive Deduction - Portfolio IncomeWhen a partner makes a loan to their partnership and the loan proceedsare used in a passive activity, the partnership’s interest deduction is passive.However, the interest received by the partner is portfolio income.Since a portion of the partnership interest deduction is allocated to thelending partner, we now have apples and oranges; the interest deductionis passive, the partner’s interest income is portfolio.RegulationsThe IRS has issued regulations to deal with this situation. Under theregulations, partners are allowed to treat such interest income as passiveso that it can be offset by the partner’s share of the corresponding deduction.Note: Amended returns may be needed if no recharacterization was done onthe original returns.For taxpayer loans to a passthrough entity (i.e., partnership or S corporation),the self-charged interest rules apply if:(a) The borrowing entity has deduction for its tax year for interestcharged by persons that own directly or qualifying indirect interests inthe entity at any time during the taxable year;(b) The taxpayer owns a direct or qualifying indirect interest in theborrowing entity at any time during the entity taxable year and hasgross income for the taxable year from interest charged to the borrowingentity; and10 Net losses and credits from a publicly traded partnership can only be suspended and carriedforward for use against income from that same partnership (Senate Report to RA §87 p. 161).4-74-84-9(c) The taxpayer’s distributive share of self-charged interest deductionsincludes passive activity deductionsThe regulations also give favorable treatment where the partner borrowsfrom their partnership and uses the loan in a passive activity. Here, thepartner’s interest payments are passive deductions, while the interest receivedby the partnership is portfolio income. The regulations reclassifypart of the interest income as passive permitting the partner to use theirpassive interest deduction against their share of the partnership’s interestincome.Note: If an entity has more than one activity, the self-charged interest rulesmust be applied on an activity-by-activity basis.The regulations contain mechanical rules to calculate what interest incomeis passive. However, a partnership or S corporation can elect out of

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these reallocation rules.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.172. One of the three §469 “buckets” of income is portfolio income. Under§469, what is deemed to generate portfolio income?a. royalties received in the ordinary course of a business.b. any activity involving the conduct of a trade or business and in whichthe taxpayer does not materially participate.c. any limited partnership.4-10d. guaranteed payments from a partnership for interest on capital.173. Another of the three §469 “buckets” of income is material participationincome. Under §469, who is deemed to have materially participated in atrade or business activity?a. a partner who is actively involved in operations.b. a taxpayer who is involved in oil or gas working interests.c. a taxpayer who is involved in rental activities.d. a taxpayer who is involved in the activity’s operations on a regular, continuous,and substantial basis throughout the year.174. Section 469 restricts taxpayers from sheltering tax in certain activities.However, under §469, passive losses can still offset:a. active income.b. any portfolio income.c. interest income that is portfolio income.d. passive income.175. There are three categories of income under §469. When income is from

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personal services, wages, or a salary, how is the income classified?a. non-passive material participation.b. non-passive portfolio.c. passive.d. passive portfolio.

Answers & Explanations172. One of the three §469 “buckets” of income is portfolio income. Under§469, what is deemed to generate portfolio income?a. Incorrect. Nonpassive portfolio income includes royalties not received inthe ordinary course of business. Royalties received in the ordinary course ofbusiness would be deemed material participation income.b. Incorrect. Passive items include any activity involving the conduct of atrade or business and in which the taxpayer does not materially participate.c. Incorrect. Passive items include any limited partnership (but not publiclytraded partnerships that are classified as portfolio).d. Correct. Guaranteed payments from a partnership for interest on capital isdeemed to be non-passive portfolio income, whereas guaranteed payments4-11from a partnership for services is deemed to be non-passive material participationincome. [Chp. 4]173. Another of the three §469 “buckets” of income is material participation income.Under §469, who is deemed to have materially participated in atrade or business activity?a. Incorrect. Active participation is not the same as material participation.The rules for active participation are much easier to satisfy than the rules formaterial participation.b. Incorrect. Except for oil and gas working interests, the taxpayer must materiallyparticipate in a trade or business activity to avoid the activity beingsubject to the passive loss limits. Oil and gas interests have very special rulesapplied to them under §469.c. Incorrect. Any involvement in rental activities is presumed to be passive.d. Correct. A taxpayer materially participates if he is involved in the activity’soperations on a regular, continuous, and substantial basis throughout theyear. [Chp. 3]174. Section 469 restricts taxpayers from sheltering tax in certain activities.However, under §469, passive losses can still offset:a. Incorrect. Passive loss rules under §469 prevent passive losses from offsettingactive income.

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b. Incorrect. Section 469 passive loss rules disallow passive losses from offsettingportfolio income.c. Incorrect. Passive losses cannot offset interest income that is portfolio income.d. Correct. Under §469, passive losses can offset passive income. [Chp. 4]175. There are three categories of income under §469. When income is frompersonal services, wages, or a salary, how is the income classified?a. Correct. When income is from personal services or wages or a salary, theincome is classified as a non-passive material participation activity.b. Incorrect. Income from interest, dividends, and annuities is classified asnon-passive portfolio.c. Incorrect. Passive items include income derived from activities consideredpassive under §469.d. Incorrect. There are only three buckets of income and portfolio income isa type of non-passive income. [Chp. 4]4-12Suspension of Disallowed LossesSuspended losses and credits are deemed to be unrealized (i.e., suspended) andonly converted to realized losses and credits when:(1) Passive activity income occurs in future tax years (§469(b)); or(2) Taxpayer disposes of his or her entire interest in a passive activity in afully taxable transaction (§469(g)(1)).Fully Taxable DispositionWhen a taxpayer disposes of their entire interest in a passive activity, the actualeconomic gain or loss on their investment can be finally determined.Thus, under the passive loss rule, upon a fully taxable disposition, any overallloss from the activity realized by the taxpayer is recognized. This result is accomplishedby triggering suspended losses upon disposition.Suspended losses are triggered on a fully taxable disposition, and any overallloss determined is then allowed against income whether passive or active. Afully taxable disposition includes a bona fide and arm’s length sale of theproperty to a third party for a price equal to its value (Senate Report p. 725).Abandonment & WorthlessnessThe scope of a disposition triggering suspended losses under the passiveloss rules includes abandonment, constituting a fully taxable event under§165(a), of the taxpayer’s entire interest in a passive activity (ConferenceReport H7635). Thus, for example, if the taxpayer owns rental propertythat they abandon in a taxable event that would give rise to a deductionunder §165(a), the abandonment constitutes a taxable disposition thattriggers the recognition of suspended losses under the passive loss rule.4-13

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Similarly, to the extent that the event of worthlessness of a security istreated under §165(g) as a sale or exchange of the security, and the eventotherwise represents the disposition of an entire interest in a passive activity,it is treated as a disposition.Related Party TransactionsUnder §469(g)(1)(B), a taxpayer is not treated as having disposed of aninterest in a passive activity, for purposes of triggering suspended losses, ifthey dispose of it in an otherwise fully taxable transaction to a relatedparty (within the meaning of §267(b) or §707(b)(1), including applicableattribution rules). In the event of such a related party transaction, becauseit is not treated as a disposition for purposes of the passive loss rule,suspended losses are not triggered, but rather remain with the taxpayer.Such suspended losses may be offset by income from passive activities ofthe taxpayer.When the entire interest owned by the taxpayer and the interest transferredto the related transferee in the passive activity are transferred to aparty who is not related to the taxpayer in a fully taxable disposition, thento the extent the transfer would otherwise qualify as a disposition triggeringsuspended losses, the taxpayer may deduct the suspended losses attributableto their interest in the passive activity.CreditsA purpose of the passive loss rules is to allow losses only when real economicloss has occurred. Congress believed that credits do not representsuch true economic loss. Credits are creatures of statute. They are not directlyrelated to real gain or loss.DisallowanceAs a result, disallowed credits are not allowable on a fully taxable disposition.In general, credits are only11 allowed when sufficient passiveincome is realized.Increase Basis ElectionHowever, §469(j)(9) provides an election to increase the basis of propertyimmediately before the transfer by an amount equal to the portionof any unused credit that reduced the basis of such property for the taxyear in which the credit arose. The increase in basis cannot exceed theamount of the original basis reduction of the property.11 In some instances they can be added to basis prior to a fully taxable disposition.4-14Entire InterestThe taxpayer must dispose of his entire interest in the activity in order totrigger the recognition of loss (Senate Report p.725). This involves a dispositionof the taxpayer’s interest in all entities (in which he holds an interest)engaged in the activity.

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PartnershipIf a general partnership or S corporation conducts two separate activities,a fully taxable disposition by the entity of all the assets used or created inone activity constitutes a disposition of the partner’s or shareholder’s entireinterest in the activity (Senate Report p.725).Grantor TrustIf a grantor trust conducts two separate activities, and sells all the assetsused or created in one activity, the grantor is considered as disposing ofhis entire interest in that activity (Senate Report p.726).Other TransfersThe following are not deemed to be fully taxable dispositions and are subjectto special rules:Transfer By Reason Of Death - §469(g)(2)Under §469(g)(2), a transfer of a taxpayer’s interest in an activity ondeath allows suspended losses to the decedent12 to the extent they exceedthe amount by which the basis of the interest in the activity is increased atdeath under §101413.Thus, the amount of loss deductible on the decedent’s final income tax returnequals the excess of the sum of the current tax year’s loss and priorpassive activity losses (not previously deducted) over the following difference:(a) Transferee’s adjusted basis as determined under §1014(a), or(b) The decedent’s basis immediately prior to death.Transfer By Gift - §469(j)(6)Section 469(j)(6) provides that a gift of all or a part of the taxpayer’s interestin a passive activity does not trigger suspended losses. However, thestatute does allow suspended losses to be added to the basis of the prop-12 Suspended losses are not available to decedent’s transferee. The losses allowed would be reportedon the final return of the decedent.13 Suspended losses are eliminated to the extent of the basis increase.4-15erty immediately before the gift. If the gift is a partial interest, an allocableportion of any suspended losses is added to the donee’s basis. Suspendedlosses of the donor are eliminated when added to the donee’s basis,and the remainder of the losses continues to be suspended in the donor’shands. The treatment of subsequent deductions from the activity tothe extent of the donee’s interest in it depends on whether the activity ispassive as to the donee.ExampleRalph gifts a duplex that constitutes passive property to hisson. The duplex has an adjusted basis of $65,000, suspendedlosses of $15,000, and a fair market value of$110,000. Ralph can’t deduct the suspended losses but hisson’s basis in the duplex is $80,000.Installment Sale - §469(g)(3)

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Under §469(g)(3), when an activity is disposed of in a transaction inwhich the gain is reported under the installment sale method, the entiresuspended loss attributable to the activity is not triggered all at once. Thelosses are allowed in each year of the installment obligation, in the ratiothat the gain recognized in each year bears to the total gain on sale. Theinstallment gains are reported using the gross profit percentage and thenoffset by the proportionate amount of carryforward losses.Activity No Longer Treated As Passive Activity - §469(f)(1)Circumstances may arise which do not constitute a disposition, but whichterminate the application of the passive loss rules to the taxpayer generally,or to the taxpayer with respect to a particular activity.For example, an individual who previously was passive in relation to atrade or business activity that generates net losses may begin materiallyparticipating in the activity. When a taxpayer’s participation in an activityis material in any year after a year (or years) during which they were not amaterial participant, previously suspended losses remain suspended andcontinue to be treated as passive activity losses.Such previously suspended losses, however, unlike passive activity lossesgenerally, are allowed against income from the activity realized after itceases to be a passive activity with respect to the taxpayer. However, aswith tax-free exchanges of the taxpayer’s entire interest in an activity, thetaxpayer must be able to show that such income is from the same activityin which the taxpayer previously did not materially participate.4-16Closely Held To Nonclosely Held Corporation- §469(f)(2)A similar situation arises when a corporation (such as a closely held corporationor personal service corporation) subject to the passive loss rulesceases to be subject to the passive loss rules because it no longer meetsthe definition of an entity subject to the rules.For example, if a closely held corporation makes a public offering of itsstock and no longer meets the stock ownership criteria for being closelyheld, it ceases to be subject to the passive loss rules. The corporation’sownership has been so broadened that the reason of limiting the corporation’sability to shelter its portfolio income becomes less compelling. Acorporation that is not closely held is less susceptible to treatment as thealter ego of its shareholders, but competing considerations also apply.So as not to encourage tax-motivated transactions involving free transferabilityof losses, the suspended passive losses are not made more broadlyapplicable (i.e., against portfolio income) by the change in ownership, butcontinue to be applicable against all income other than portfolio incomeof the corporation. Deductions arising in years after the year in which thecorporation’s status changes are not subject to limitation under the passiveloss rules.

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Nontaxable TransferAn exchange of the taxpayer’s interest in an activity is a nonrecognitiontransaction, such as an exchange governed by §351, §721, or §1031 inwhich no gain or loss is recognized, does not trigger suspended losses(Senate Report p.726). Following such an exchange, the taxpayer retainsan interest in the activity, and hence has not realized the ultimate economicgain or loss on his investment in it. To the extent the taxpayer doesrecognize gain on the transaction (e.g., boot in an otherwise tax-free exchange),the gain is treated as passive activity income, against which passivelosses may be deducted14.The suspended losses not allowed upon such a nonrecognition transactioncontinue to be treated as passive activity losses of the taxpayer, exceptthat in some circumstances they may be applied against income from theproperty received in the tax-free exchange that is attributable to theoriginal activity15.14 As a result, taxpayers could periodically trade down under §1031 to the extent of their suspendedlosses on their real estate and get the current benefit of their suspended losses on thetraded property.15 This rule does not apply, however, to permit the offset of suspended passive losses against dividendsor other income or gain otherwise treated as portfolio income. In addition, following some4-17Such suspended losses may not be applied against income from the propertythat is attributable to a different activity from the one that the taxpayerexchanged16. Therefore, unless the taxpayer can show that incomeagainst which suspended losses are offset is clearly from the passive activitywhich the taxpayer exchanged for a different form of ownership, nosuch offset is permitted.Ordering of LossesOrdering of the recognized losses is determined under §469(g)(1). In the taxyear the interest is disposed of, the unused losses and any current year lossesfor the activity are allowed to offset income in the following order:(1) Income or gain (including any gain recognized upon disposition) forthe tax year from the passive activity disposed of,(2) Net income or gain for the tax year from all other passive activities,then(3) Any other income or gain.Example from Pub. 925 (Rev.11/87)Ray, whose only other income during the year was his$60,000 salary, had a 5% interest in the B Limited Partnership,which had an adjusted basis of $42,000 at the date ofsale. He had carried over $2,000 of passive activity lossesfrom prior years and then sold his entire interest in the currenttax year to an unrelated person, for $50,000. Ray realizedan $8,000 gain from the sale, but may offset $2,000 of

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that gain with his $2,000 carryover loss. Ray’s $6,000 netgain is computed as follows:Sales Price $50,000Minus: adjusted basis $42,000Gain $8,000Minus: carryover losses allowable 2,000Net gain $6,000Ray will treat the $6,000 net gain as income from a passiveactivity.If Ray sold his interest for $30,000, instead of $50,000, hisdeductible loss would be $5,000, computed as follows:transactions such as a §1031 like-kind exchange, for example, the taxpayer may no longer have aninterest in the original activity. Therefore, there is no special rule permitting suspended lossesfrom the prior interest to be offset by income from the new activity, unless it, too, is a passive activity.16 For example, suspended passive activity losses cannot be applied against portfolio income of apassthrough entity.4-18Sales Price $30,000Minus: adjusted basis 42,000Capital loss $12,000Minus: capital loss limit 3,000Capital loss carryover $9,000Allowable capital loss on sale $3,000Carryover losses allowable 2,000Total current deductible loss $5,000The $5,000 total current deductible loss computed above iscurrently deductible. The $9,000 capital loss carryover is notsubject to the passive activity loss limit. Ray will treat it in thesame manner as any other capital loss carryover.Capital Loss LimitationUpon a fully taxable disposition of a taxpayer’s entire interest in a passiveactivity, the passive loss rules provide that any deductions previously suspendedwith respect to that activity are allowed in full.However, under §469(g)(1)(C), to the extent that any loss recognizedupon such a disposition is a loss from the sale or exchange of a capital asset,it is limited to the amount of gains from the sale or exchange of capitalassets plus $3,000 in the case of individuals (§1211).CarryforwardsDisallowed losses and credits are carried forward in full and treated as passivelosses and credits in the latter tax years. There is no time limit on thecarryforward (§469(b)). The application of a passive loss or credit carryforwardto a later tax year isn’t limited to passive income generated by the particularactivity that gave rise to the loss or credit. They apply to the taxpayer’snet passive income (if they have any) based on the aggregate income and

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losses from all the interests in passive activities owned by the taxpayer.Allocation of Suspended LossesIf any passive losses are not deductible in any given year, the amount of thesuspended losses and credits from each activity is determined on a proratabasis. With respect to each activity, the portion of the loss or credit that issuspended, and carried forward, is determined by the ratio of net losses fromthat activity to the total net losses from all passive activities for the year(§469(j)(4)).Taxpayers AffectedUnder §469(a)(2), the passive loss limit applies to:4-19Noncorporate TaxpayersAll noncorporate taxpayers, including individuals, estates and trusts, are subjectto the passive loss rules (§469(a)(2)(A)). The limitations are imposed atthe taxpayer level. Thus, allocations and distributions from passthrough entitiessuch as partnership and S corporations are limited at the taxpayer level.Regular CorporationsAny “C” corporation in which more than 50% in value of its outstandingstock was owned (directly or indirectly) by five or fewer individuals at anytime during the last half of its taxable year (§469(a)(2)(B)).Personal Service CorporationsAny personal service corporation is subject to the passive loss rules(§469(a)(2)(C)).DefinitionA corporation is a personal service corporation if three conditions aremet:(a) Its principal activity is the performance of personal services;(b) Those personal services are “substantially” performed by “employee-owners”; and(c) Employee-owners, in aggregate, own more than 10% of the stock ofthe corporation.Real Estate ProfessionalsIf a taxpayer qualifies as a real estate professional, rental real estate activitiesin which they materially participated are not passive activities. For this purpose,each interest a taxpayer has in a rental real estate activity is a separateactivity, unless they choose to treat all interests in rental real estate activitiesas one activity.A taxpayer qualifies as a real estate professional for the year if they meetboth of the following requirements:(1) More than half of the personal services they performed in all trades orbusinesses during the tax year were performed in real property trades or

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businesses in which they materially participated; and(2) They performed more than 750 hours of services during the tax year inreal property trades or businesses in which they materially participated.Do not count personal services performed as an employee in real propertytrades or businesses unless taxpayer was a 5% owner of their employer. Ataxpayer was a 5% owner if they owned (or are considered to have owned)4-20more than 5% of their employer's outstanding stock, outstanding votingstock, or capital or profits interest.Note: If a taxpayer files a joint return, do not count their spouse's personalservices to determine whether they met the preceding requirements. However,a spouse's participation in an activity can be counted in determining ifthe taxpayer materially participated.A real property trade or business is a trade or business that does any of thefollowing with real property:(1) Develops or redevelops it,(2) Constructs or reconstructs it,(3) Acquires it,(4) Converts it,(5) Rents or leases it,(6) Operates or manages it, and(7) Brokers it.ActivitiesIn 1989, the IRS issued complicated regulations governing how separate activitieswere to be determined. Although taxpayers could apply the regulations toearlier years, they were mandatory for tax years ending after August 9, 1989.In 1992 the IRS issued simplified proposed regulations, which became final in1994 (TD 8565), to shorten and simplify the rules for identifying activities. Thesefinal regulations are more flexible than the earlier 1989 regulations.Facts & Circumstances TestWhether activities are treated as a single activity depends upon all the relevantfacts and circumstances. A taxpayer can use any reasonable method ofapplying such factors when grouping activities.Relevant FactorsThe following factors are given the greatest weight in determiningwhether activities constitute an appropriate economic unit for the applicationof the passive loss rules:(a) Similarities and differences in types of business,(b) Extent of common control,(c) Extent of common ownership,(d) Geographical location, and4-21

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(e) Interdependencies between the activities17 (Reg. §1.469-4(c)(2)).Note: All of the above factors do not have to be present for a taxpayer totreat more than one activity as a single activityExampleDan has a significant ownership interest in a bakery and amovie theater at a shopping mall in Baltimore and in a bakeryand a movie theater in Philadelphia. Here reasonablemethods of applying the facts and circumstances test may,depending on other relevant facts and circumstances, resultin grouping the movie theaters and bakeries into a single activity,into a movie theater activity and a bakery activity, intoa Baltimore activity and a Philadelphia activity, or into fourseparate activities. (Reg. 1.469-4(c)(3), Example 1)The example in the regulations doesn’t say whether or not theBaltimore bakery and the Philadelphia movie theater could beclaimed as a single activity (or the Philadelphia bakery andthe Baltimore movie theater).ExampleDan is a partner in a business that sells non-food items togrocery stores (Partnership L). Dan also is a partner in apartnership that owns and operates a warehouse (PartnershipQ). The two partnership businesses are located in thesame industrial park and both are under common control.The predominant part of Partnership Q’s business is warehousinggoods for Partnership L, which is also the onlywarehousing business in which Dan is involved. Here Dantreats Partnership L’s wholesale business and PartnershipQ’s warehouse as a single activity under the regs. (Reg.§1.469-4(c)(3), Example 2)The example in the regulations doesn’t say whether Dan mayor must treat the two businesses as a single activity—just thathe does.Rental ActivitiesUnder Reg. §1.469-4(d), a rental activity cannot be grouped with a nonrentaltrade or business activity unless either:17 For example, the extent to which the activities purchase or sell goods between themselves, involveproducts or services that are normally provided together, have the same customers, havethe same employees, or are accounted for with a single set of books and records.4-22(i) The rental activity is insubstantial in relation to the trade or businessactivity, or(ii) The trade or business activity is insubstantial in relation to therental activity.Under Reg. §1.469-4(e), an activity involving the rental of real propertyand an activity involving the rental of personal property (other than personalproperty provided in connection with the real property) cannot betreated as a single activity.Limited Partnership ActivitiesA taxpayer who is a limited partner or “limited entrepreneur18” in certainactivities is not allowed to group that activity with any other activity. Activities

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subject to this rule include:(1) Films,(2) Video tapes,(3) Farming,(4) Oil & gas,(5) Geothermal deposits, and(6) Renting depreciable personal property.However such an activity can be grouped with another activity in the sametype of business if the taxpayer is a limited partner or limited entrepreneurin both.Two activities in the same type of business can also be grouped if the taxpayeris a limited partner or limited entrepreneur in only one of the twoactivities if the facts-and-circumstances test is satisfied (Reg. §1.469-4(f)).Partnership & S Corporation ActivitiesA partnership or S corporation is required to group its activities underthe regulations. Once a partnership or S corporation determines its activities,a partner or shareholder groups those activities with activities conducteddirectly by the partner or shareholder or with activities conductedthrough other partnerships or S corporations under the regulations (Reg.§1.469-4(j)).ConsistencyUnder Reg. §1.469-4(g), once a taxpayer has grouped activities in accordancewith the proposed rules, they are not permitted to regroup them in later taxyears unless:18 A “limited entrepreneur” is defined as a person other than a limited partner who doesn’t activelyparticipate in the management of an activity.4-23(1) The original grouping was clearly inappropriate, or(2) There has been a material change in the facts and circumstances thatmakes the original grouping clearly inappropriate.RegroupingWhen the taxpayer’s grouping fails to “reflect one or more appropriate economicunits” and one of the primary purposes of the taxpayer’s grouping is tocircumvent the passive loss rules, IRS can regroup a taxpayer’s activities(Reg. §1.469-4(h)).ExampleDan, Tom, Harry, Pat, and Mike are doctors who operateseparate medical practices. Dan invested in a tax shelterseveral years ago that generates passive losses and theother doctors intend to invest in real estate that will generatepassive losses. The taxpayers form a partnership to acquireand operate X-ray equipment. In exchange for equipmentcontributed to the partnership, the taxpayers receive limitedpartnership interests. A general partner selected by the taxpayers

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manages the partnership. The taxpayers do not participatein the partnership’s operations. Substantially all of thepartnership’s services are provided to the taxpayers or theirpatients, roughly in proportion to the doctors’ interests in thepartnership. Fees for the partnership’s services are set at alevel that assures the partnership a profit. The taxpayers treatthe partnership’s services as a separate activity from theirmedical practices and offset the income generated by thepartnership against their passive losses. As to each of thetaxpayers, the taxpayer’s own medical practice and the servicesprovided by the partnership constitute an appropriateeconomic unit. Moreover, one of the primary purposes oftreating the medical practices and the partnership’s servicesas separate activities is to circumvent §469. Accordingly, IRSmay require the taxpayers to treat their medical practices andtheir interests in the partnership as a single activity (Reg.§1.469-4(h)).Partial DispositionsUnder the regulations, a taxpayer is allowed to treat the disposition of a substantialpart of an activity as a complete disposition in which suspended lossesare allowed.Under Reg. §1.469-4(k), taxpayers are permitted, for a tax year in which theydispose of a substantial part of an activity, to treat that part of the activity asa separate activity, but only if they can establish:4-24(1) The amount of deductions and credits allocable to that part of the activityfor the tax year under the rules governing the carryover of disalloweddeductions and credits from earlier years, and(2) The amount of gross income and any other deductions and credits allocableto that part of the activity for the tax year.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questions

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and then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.176. Suspended losses are converted to realized losses when an entire interestin a passive activity is sold in a fully taxable transaction. However, if a passiveactivity is sold on the installment sale method what results under§469(g)(3)?a. Suspended losses are not triggered.b. The disposition is deemed to be a fully taxable disposition subject tothe general rule.c. The activity is no longer treated as passive activity.d. Suspended losses from the activity are allowed in years during whichinstallments are made.177. Under which circumstance will an activity that was formerly passive betreated differently under §469(f)(1)?a. Said activity is disposed of in a transaction in which the gain is reportedunder the installment sale method.4-25b. The individual begins to materially participate in said activity.c. The activity becomes a partnership activity.d. When an individual transfers their interest in an activity on death.178. Suspended losses are those losses that that cannot be deducted in thepresent tax year but may be carried forward to the next tax year. Which of thefollowing corresponds to the treatment of suspended losses from a particularactivity?a. They are deductible first against net income or gain from all passive activities.b. They become nonpassive in subsequent years.c. They are carried forward according to the ratio of net loss from that activityto the aggregate net loss from all passive activities for that year.d. They are unusable until the passive interest is sold.179. Under §469, a corporation is a personal service corporation if it meetsthree conditions. What is one of the conditions that must be met?a. Employee-owners possess over 10% of the corporation’s stock.b. No more than six individuals possess over half the value of its outstandingstock.c. The main activity of the corporation is the selling of goods.d. The employee-owners assist in making the goods sold.180. Section 469 is not only concerned with the scope and nature of an activity

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but whether it is to be considered separate from or grouped with other activities.For example, under Reg. §1.469-4(e), which activities are treated asseparate activities?a. activities in different states.b. an activity entailing the rental of real property and an activity entailingthe rental of personal property.c. an activity entailing the rental of real property and an activity entailingthe rental of personal property provided in relation to the real property.d. two activities in the same type of business if the taxpayer is a limitedpartner in only one of the two activities and the facts-and-circumstancestest is satisfied.

Answers & Explanations176. Suspended losses are converted to realized losses when an entire interest ina passive activity is sold in a fully taxable transaction. However, if a passiveactivity is sold on the installment sale method what results under§469(g)(3)?4-26a. Incorrect. An installment sale does trigger suspended losses. However,such losses must be taken ratably over the term of the note.b. Incorrect. Installment sales are not deemed to be fully taxable dispositionsand are subject to special rules.c. Incorrect. Circumstances may arise which do not constitute a disposition,but which terminate the application of the passive loss rules to the taxpayergenerally, or to the taxpayer with respect to a particular activity. However,this example is not one of these circumstances.d. Correct. Under §469(g)(3), when an activity is disposed of in a transactionin which the gain is reported under the installment sale method, the entiresuspended loss attributable to the activity is not triggered all at once. Suchlosses must be taken ratably over the term of the note. [Chp. 4]177. Under which circumstance will an activity that was formerly passive betreated differently under §469(f)(1)?a. Incorrect. When a passive activity is disposed of in a transaction in whichthe gain is reported under the installment sale method, the entire suspendedloss attributable to the activity does not become active under §469(g)(3).b. Correct. An individual who previously was passive in relation to a trade orbusiness activity that generates net losses may begin materially participatingin the activity. While previously suspended losses continue to be treated aspassive activity losses, future losses will be non-passive under §469(f)(1).c. Incorrect. Partnerships are subject to §469 passive loss rules. Thus, thischange of ownership, from an individual to a partnership, would not affectthe treatment of a passive activity.

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d. Incorrect. Under §469(g)(2), a transfer of a taxpayer’s interest in an activityon death allows suspended losses to the decedent to the extent they exceedthe amount by which the basis of the interest in the activity is increasedat death under §1014. [Chp. 4]178. Suspended losses are those losses that that cannot be deducted in the presenttax year but may be carried forward to the next tax year. Which of thefollowing corresponds to the treatment of suspended losses from a particularactivity?a. Incorrect. Suspended losses are deductible first against income or gainfrom passive income and then against net income or gain from all passive activities.b. Incorrect. Suspended losses do not become nonpassive in later years, butare carried forward as passive losses until there is additional passive incomeor a fully taxable disposition.c. Correct. The amount of suspended losses carried forward from a particularactivity is determined by the ratio of the net loss from that activity to the aggregatenet loss from all passive activities for that year.4-27d. Incorrect. Suspended losses are converted to realized losses when passiveactivity income occurs in future tax years or the taxpayer disposes of the entireinterest in a passive activity in a fully taxable transaction. [Chp. 4]179. Under §469, a corporation is a personal service corporation if it meetsthree conditions. What is one of the conditions that must be met?a. Correct. A corporation is a personal service corporation if, among otherthings, employee-owners, in aggregate, own more than 10% of the stock ofthe corporation.b. Incorrect. Under §469(a)(2), the passive loss limit applies to any “C” corporationin which more than 50% in value of its outstanding stock was owned(directly or indirectly) by five or fewer individuals at any time during the lasthalf of its taxable year.c. Incorrect. A corporation is a personal service corporation if, among otherthings, its principal activity is the performance of personal services.d. Incorrect. A corporation is a personal service corporation if, among otherthings, those personal services are “substantially” performed by “employeeowners.”[Chp. 4]180. Section 469 is not only concerned with the scope and nature of an activitybut whether it is to be considered separate from or grouped with other activities.For example, under Reg. §1.469-4(e), which activities are treated as

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separate activities?a. Incorrect. In the example provided in the course material, Dan had a significantownership interest in a bakery and a movie theater in both Baltimoreand Philadelphia. Depending on other relevant facts and circumstances, hecould group the activities into a movie theater activity and a bakery activity,into a Baltimore activity and a Philadelphia activity, or into four separate activities.b. Correct. Under Reg. §1.469-4(e), an activity involving the rental of realproperty and an activity involving the rental of personal property could not betreated as a single activity.c. Incorrect. Under Reg. §1.469-4(e), an activity involving the rental of realproperty and an activity involving the rental of personal property provided inconnection with the real property could be treated as a single activity.d. Incorrect. Two activities in the same type of business can be grouped if thetaxpayer is a limited partner or limited entrepreneur in only one of the twoactivities and if the facts-and-circumstances test is satisfied. [Chp. 4]4-28

Alternative Minimum TaxThe tax laws give special treatment to some kinds of income and allow specialdeductions and credits for some kinds of expenses. Taxpayers who benefit fromthese laws have to pay at least a minimum amount of tax through an additionaltax—the “alternative minimum tax” for individuals and corporations.All taxpayers are subject to the alternative minimum tax (AMT), except partnerships(§701(a)) and S corporations (§1363(a)). Foreign corporations are subjectonly on taxable income which is effectively connected with the conduct of a U.S.trade or business (§882(a)(1)). Exempt organizations taxed on unrelated businessincome as trusts are subject to the AMT on tax preference items that enterinto the computation of unrelated business taxable income (§511(d)(2)).Note: When taxpayers calculate their estimated tax, they must include any alternativeminimum tax they expect to pay.For 2009, the American Recovery & Reinvestment Act provides that the individualAMT exemption amount is:(1) $70,950, in the case of married individuals filing a joint return and survivingspouses;(2) $46,700 in the case of other unmarried individuals; and

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(3) $35,475 in the case of married individuals filing separate returns.For 2009, the Act also allows an individual to offset the entire regular tax liabilityand alternative minimum tax liability by the nonrefundable personal credits.Note: The top rate on capital gains does not create an AMT tax preferenceand the 3% lid on itemized deductions does not apply to the AMT.

ComputationAlternative minimum taxable income is computed as follows:Regular Taxable Income (before NOL deduction)Plus or MinusAMT Adjustments Under §56PlusTax Preferences Under §57Equals4-29Alternative Minimum Taxable Income (AMTI) before AMT NOL deductionLessAMT NOL deduction (limited to 90%)EqualsAlternative Minimum Taxable Income (AMTI)LessExemption AmountEqualsAlternative Minimum Tax BaseMultiplied by 26% or 28% (20% for corporations) EqualsAMT Before AMT Foreign Tax CreditLessAMT Foreign Tax Credit (possibly limited to 90%)EqualsTentative minimum taxLessRegular Tax Liability before Credits minus Regular Foreign Tax CreditEqualsAlternative Minimum Tax (§55(a); §55(b))Exemption Amount - §55(d)In 2009, the exemption amounts for purposes of the alternative minimum taxamount are:(1) Regular Corporations: $40,000, less 25% of the amount by which alternativeminimum taxable income exceeds $150,000, but not less than zero(§55(d)(1)(A); §55(d)(2) and §55 (d)(3)(A)).Controlled Groups: The component members of a controlled group of corporationsare limited to one $40,000 exemption, which unless all of themembers consent to an unequal allocation, is divided equally among themembers. The alternative minimum taxable income of all of the members istaken into account in applying the above 25% of alternative minimum taxableincome reduction, and any resulting reduction of the $40,000 exemptionis divided equally among the members unless all of them consent to an unequalallocation (§1561(a)).(2) Married Filing Jointly & Surviving Spouses: $70,950, less 25% of theamount by which alternative minimum taxable income exceeds $150,000,but not less than zero.

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(3) Married Filing Separately, Estates & Trusts: $35,475, less 25% of theamount by which alternative minimum taxable income exceeds $75,000,but not less than zero.(4) Single & Head of Household: $46,700, less 25% of the amount by whichalternative minimum taxable income exceeds $112,500, but not less thanzero.4-30AMT Exemption PhaseoutIn 2009, the exemption amount is completely phased out if AMT taxableincome exceeds:(a) $310,000, if a regular corporation,(b) $433,800, if married filing a joint return or a qualifying widow orwidower,(c) $299,300, if single or qualify as head of household, or(d) $216,900, if married filing a separate return.Regular Tax Deduction - §55(c)In the calculation of alternative minimum tax, “regular tax” is deducted from“tentative minimum tax.” The regular tax is the regular tax liability that isused for determining the limitation on various nonrefundable credits reducedby the regular (as opposed to the alternative minimum tax) foreign tax creditand without including:(1) The 10-year averaging taxes on lump sum distributions from qualifiedretirement plan; or(2) Any recapture of the low-income housing credit.Tax Preferences & AdjustmentsAny item that is treated differently for alternative tax purposes than it is forregular tax purposes is termed a tax preference (§57) or an adjustment (§56;§55(b)(2)(A)). Adjustments involve a substitution of a special AMT treatmentof an item for the regular tax treatment, while a preference involves theaddition of the difference between the special AMT treatment and the regulartax treatment.Some adjustments can be negative (i.e., they result in alternative minimumtaxable income that is less than taxable income). Tax preferences cannot benegative amounts. Some tax preferences and adjustments only apply to certaintypes of taxpayers.Preferences & Adjustments for All TaxpayersDepreciationDepletionMining CostsPollution Control FacilitiesIncentive Stock OptionsIntangible Drilling CostsLong-term ContractsTax Exempt Interest4-31

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Appreciated Charitable Contribution PropertyFinancial Institutions’ Bad DebtsAlternative Tax Net Operating Loss DeductionAdjusted Basis of Certain PropertyPreferences & Adjustments for Noncorporate Taxpayers OnlyItemized DeductionsState Tax RefundsResearch & Experimental ExpendituresPreferences & Adjustments for Noncorporate Taxpayers & Some CorporationsCirculation ExpendituresFarm LossesPassive LossesPreferences & Adjustments for Corporations OnlyUntaxed Book Income (pre-1990)ACEEarnings & ProfitsBlue Cross/Blue Shield DeductionMerchant Marine Capital Construction FundAdjustments - §56As the AMT formula shows, taxable income is increased by positive adjustmentsand decreased by negative adjustments. Most positive adjustmentsarise because of timing differences between the AMT and the regular tax relatedto deferral of income or acceleration of deductions. When these timingdifferences reverse, negative adjustments are made.There are other adjustments that are based on permanent differences betweenthe AMT and the regular tax. These adjustments are similar to preferencesand are always positive.Itemized DeductionsOnly certain itemized deductions are allowed in the calculation of AMT.Because the AMT calculation begins with taxable income, those itemizeddeductions that are disallowed for AMT purposes must be added back asadjustments.4-32Standard DeductionFor non-itemizers, the standard deduction must be added back to taxableincome to calculate AMT. However it would be rare for a personwho does not itemize to be subject to the AMT.Medical ExpensesFor regular tax purposes, medical expenses are deductible to the extentthey exceed 7.5% of AGI. Medical expenses are deductible for AMTpurposes to the extent that they exceed 10% of the regular tax AGI.The adjustment for medical expense in AMT will be the lesser of

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medical expense claimed in regular tax or 2.5% of AGI.TaxesAll taxes claimed on Schedule A will be an adjustment for AMT. Taxesused to compute AGI such as those on Schedules C, E, or F remaindeductible for AMT.Because no deduction is allowed in AMT for the payment of state orlocal taxes, §56(b)(1)(E) specifically provides that refunds of thosetaxes should not be included in AMTI.InterestInvestment Interest - investment interest is deductible in AMT only tothe extent of investment income. This is the same limit imposed inregular tax without the phase out of a certain base amount. However,because special AMT rules apply to many items of income and deduction,investment income for AMT can be very different from investmentincome in regular tax.Investment interest disallowed in AMT is not carried over to futureyears as it is in regular tax.Mortgage Interest - AMT limits the amount of deductible mortgage interestto qualified housing interest. AMT adopts the restriction limitingqualified residences to one principal and one second home.While regular tax allows a deduction for interest expense in equityloans of less than $100,000, AMT has no similar provision. In AMT,deduction for refinanced debt is now specifically allowed by §56(e), butonly to the extent that the new indebtedness does not exceed the old.Perhaps the biggest difference in the deductibility of mortgage interestin AMT and regular tax is the “grandfather date.” For AMT purposes,debt incurred before July 1, 1982 is considered qualified residence interest.In regular tax, debt incurred prior to October 13, 1987 is grandfathered.4-33Miscellaneous itemized deductions - only those miscellaneous itemizeddeductions that are not subject to the 2% of AGI “floor” for regulartax are allowed for AMT. Miscellaneous itemized deductions allowedfor AMT include gambling losses, moving expenses and impairmentrelated work expenses. Casualty losses and moving expense are deductiblefor AMT purposes under the same rules that apply for regulartax.Personal ExemptionsThe deduction of personal exemptions for AMT purposes is prohibited,retroactive to tax years beginning after 1986 (§56(b)(1)(E)).Taxpayers must enter a positive AMT adjustment for the exemptionamount claimed in computing income tax.DepreciationFor property placed in service after 1986 and property purchased afterJuly 31, 1986 for which an election to use MACRS was made, the AMTadjustment for depreciation will be the difference between regular taxdepreciation and depreciation computed under the Alternative Depreciation

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System (ADS). ADS uses 150% declining balance for personal propertyand straight-line for real property.Property placed in service after 1986 to which the MACRS rules do notapply due to transitional rules, will not be subject to this adjustment. Depreciationfor such property will be subject to the preference calculations.The AMT depreciation adjustment will be the net of both positive andnegative differences for all property.Alternative Depreciation System (ADS)ADS is an optional method in regular tax for most property. UnderADS, depreciation is calculated on a straight-line method over a specifiedrecovery period. The ADS system is modified in AMT for personalproperty to the extent that 150% declining balance is used,switching to straight-line when straight-line results in a larger deduction.ADS Recovery PeriodsGenerally the recovery period for ADS is the midpoint of the class lifein the asset depreciation range as prescribed in §167(m). For some assetsor groups of assets, Congress has specifically modified the life.The following inclusions, exclusions, and default provisions will resultin adjustments for the calculation of AMT.4-345 Years:Automobiles, light duty trucks, over the road tractor units, semiconductormanufacturing equipment, and “qualified technologicalequipment.”Note that for ADS, qualified technological equipment is limited tocomputer or related peripheral equipment, high technology telephonestation equipment installed on customer’s premises and hightechnology medical equipment. Specifically excluded from the fiveyear category is equipment that is an integral part of other noncomputerproperty and typewriters, calculators, adding and accountingmachines, copiers, duplicating equipment, and other similarequipment. These assets are 7-year property.7 Years:No assets have a 7-year ADS life. Assets in the 7-year MACRS classthat have not been specifically assigned an ADS recovery period willrevert to their ADR class life.12 Years:Assets that are not classified in the ADR system.40 Years:Most real property.A comparison of the MACRS life and the life for AMT of those assetsmost frequently encountered is as follows:MACRS AMTAutomobiles 5 5Computers 5 5

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Other Office Equipment 5 6Office Furniture 7 10Rental Buildings:Commercial 39 40Residential 27.5 40Personal Property in Rentals:(Carpets, drapes & appliances) 7 12Unclassified Personal Property 7 12Asset Placed in Service After 1998For property placed in service after 1998, the TRA ‘97 conformed thedepreciable lives used for purposes of the alternative minimum tax tothe depreciable lives used for purposes of the pre TRA ‘97 law regulartax.4-35The most significant alternative minimum tax adjustment of businessesrelates to depreciation. Under prior law, in computing AMTI, depreciationon property placed in service after 1986 was computed by usingthe class lives prescribed by the alternative depreciation system of§168(g) and either:(1) The straight-line method in the case of property subject to thestraight-line method under the regular tax, or(2) The 150% declining balance method in the case of other property.For regular tax purposes, depreciation on tangible personal propertygenerally is computed using shorter recovery periods and more acceleratedmethods than are allowed for alternative minimum tax purposes.For property (including pollution control facilities) placed in serviceafter December 31, 1998, the TRA ‘97 conforms the recovery periods(but not the methods) used for purposes of the alternative minimumtax depreciation adjustment to the recovery periods used for purposesof the regular tax under pre TRA ‘97 law.Mining Exploration and Development CostsMining exploration and development costs, incurred after 1986, that areexpensed (or amortized under §291) for regular tax purposes are requiredto be recovered through ten-year straight-line amortization for purposesof the alternative minimum tax. As with depreciation, the minimum taxtreatment of mining exploration and development costs involves a separatecalculation for all items of income and expense relating to such costs.BasisThe basis of property on which such costs were incurred, and theamount of gain or loss at disposition, likewise may differ for regularand minimum tax purposes, respectively.When a loss is sustained on a mining property (e.g., the mine is abandonedas worthless, giving rise to a loss under §165), the taxpayer ispermitted to deduct, for minimum tax purposes, all mining explorationand development costs relating to that property that have been capitalizedand not yet written off under the minimum tax.Election

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A taxpayer may elect under §59(e) to amortize mining exploration anddevelopment costs over 10 years for regular tax purposes, therebyavoiding the AMT adjustments related to such costs.4-36Long-Term ContractsIn the case of any long-term contract entered into by the taxpayer afterFebruary 28, 1986, use of the completed contract method of accounting(or any other method of accounting that permits deferral of income duringthe contract period) is not permitted for purposes of the minimum tax(§56(a)(3)). Instead, the taxpayer is required to apply the percentage ofcompletion method (determined using the same percentage of completionas used for purposes of the regular tax) in determining minimum taxableincome relating to that contract. The taxable income (from the contract)for AMT purposes less the corresponding amount for regular taxpurposes is the adjustment.Home Construction ContractsFor regular tax purposes, home construction contracts, defined as contractswhere at least 80% of the estimated total costs to be incurredunder the contract are attributable to dwelling units in a building withfour or fewer dwelling units, are exempted from the percentage ofcompletion-capitalized cost method of accounting. For AMT purposes,home construction contracts are exempted only for contracts of smallcontractors. Contracts of small contractors are those that are estimatedto be completed within two years and are entered into by a taxpayerwho has average annual gross receipts for the three tax years precedingthe tax year in which the contract is executed that do not exceed $10million (§460(b)(4)).Pollution Control FacilitiesIn the case of any certified pollution control facility placed in service after1986, the taxpayer is required to use ADS for minimum tax purposes. Thesame procedure used to calculate excess depreciation above is the procedureto calculate the AMT adjustment.Installment SalesFor non-dealer dispositions after 1986, the installment method of reportinggain is allowable in regular tax and AMT.Tax law now bars the use of the installment method by dealers in regulartax for dispositions after 1987 and thereby eliminates the AMT adjustment.Dealers of lots and timeshares who are allowed to report gain onthe installment method for regular tax if they pay the interest on the deferredtax, are not required to adjust AMTI (§56(a)(6)).4-37Circulation ExpendituresAn individual who incurs circulation expenditures is not permitted to expensetheir post-1986 expenditures for minimum tax purposes. Instead, in

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computing alternative minimum taxable income, the taxpayer is requiredto amortize such post-1986 expenditures ratably over a three-year period.However, if the taxpayer realizes a loss with respect to property to whichany such expenditures relate, all such expenditures relating to that propertybut not yet deducted for minimum tax purposes are allowed as aminimum tax deduction.The AMT adjustment may be avoided by electing to amortize circulationexpenditures over a three-year period for regular tax purposes.Incentive Stock OptionsIn the case of a transfer of a share of stock pursuant to the exercise of anincentive stock option (as defined in §422A), the amount by which thefair market value of the share at the time of the exercise exceeds the optionprice (bargain element) is treated as an adjustment. For purposes ofthis rule, the fair market value of a share is determined without regard toany restrictions other than one that by its terms, will never lapse.For minimum tax purposes, the basis of stock acquired through the exerciseof an incentive stock option includes the amount of the adjustment.The time for reporting income from an option is determined under §83.Pursuant to the code section, the excess of fair market value over optionprice is includable when rights in the stock are not subject to substantialrisk of forfeiture and such rights are freely transferable (§56(b)).Credit for Prior Year Minimum Tax & ISOsDecrease in credit for abatement of alternative minimum tax (AMT)related to incentive stock options (ISOs). If you owed AMT for 2007or any prior year due to the AMT adjustment for the exercise of ISOs(Form 6251, line 13, for 2007), the amount of any such tax that you stillowed as of October 3, 2008, has been abated. This means that yourdebt has been forgiven and you no longer owe this tax. However, youmust reduce the amount of your credit for prior year minimum tax.Increase in credit for interest and penalties related to ISO adjustments.If you paid interest and penalties on AMT for 2007 or any prioryear due to the AMT adjustment for the exercise of ISOs, the amountof your prior year minimum tax that is eligible for the credit is increasedfor the first 2 years beginning after 2007 by 50% of the total ofany such interest and penalties you paid before October 3, 2008.4-38Research and Experimental ExpendituresAn individual who incurs research and experimental expenditures describedin §174 is not permitted to expense the expenditures for minimumtax purposes. Instead, in computing alternative minimum taxable income,the taxpayer is required to amortize such post-1986 expenditures over aten-year period. As with certain other items (such as depreciation andmining exploration and development costs), this treatment applies for allminimum tax purposes, rather than as an annual adjustment to regulartaxable income. If the taxpayer abandons a specific project to which any

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such expenditures relate, all such expenditures relating to that propertybut not yet deducted for minimum tax purposes are allowed as a minimumtax deduction.Again, if the taxpayer elects to amortize research and experimentationexpenditures over a ten-year period for regular tax purposes the AMT adjustmentis avoided.Passive Farm LossesAny passive farm loss of an individual or personal service corporation, tothe extent not already denied for minimum tax purposes under the rulesdescribed above, is not allowed in computing alternative minimum taxableincome.DefinitionA passive farm loss is defined as the excess of the taxpayer’s loss forthe taxable year from any tax shelter farming activity. The amount ofthe loss which is otherwise disallowed is reduced, however, by theamount, if any, of the taxpayer’s insolvency, as measured using a standardsimilar to that set forth in §108(d)(3).Tax shelter farm activity - for purposes of this provision, the term “taxshelter farm activity” means (1) a farming syndicate (as defined in§464(c)), and (2) any other activity consisting of farming which is apassive activity (within the meaning of §469(c)).Loss DisallowanceUnder the passive farm loss rule, deductions allocable to a tax shelterfarming activity in excess of gross income allocable to the activity nottruly profitable are disallowed for minimum tax purposes. A separateactivity is defined consistently with §469, with the result that generallyeach farm is treated as a separate activity.The rules for applying the loss disallowance generally are similar tothose for applying the passive loss rule for minimum tax purposes, ex4-39cept that there is no netting between different farming activities. Anexcess farming loss with respect to any farming activity is disallowedeven if there is no netting between different farming activities.The passive farm loss rule is applied, in computing alternative minimumtaxable income, prior to the passive loss rule. Thus, the only passivefarming activities that enter into the passive loss computation (forminimum tax purposes) are those that generate net gain. The gain canthen be offset, for minimum tax purposes under the general passiveloss rule, against passive losses that are not from farming activities.AllocationThe amount of the deductions allocable to a farming activity is determinedafter taking account of all preferences and making all adjustmentsrequired for the determination of alternative minimum taxableincome, other than the preference for excess passive activity losses. Inother words, no deduction which is treated as minimum tax preference,

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or which is redetermined (as with depreciation) for minimum tax purposes,is “double-counted” by also being considered in the determinationof excess farm losses.Same Activity SuspensionTo the extent that a loss from a farming activity is disallowed underthis rule, the amount is treated, for minimum tax purposes, as a farmloss incurred in the same activity in the succeeding taxable year. Thus,it is incurred in the same activity in the succeeding year, to the extentthat the taxpayer otherwise has net income from the farm in such year,or upon an appropriate disposition (i.e., a disposition that would qualifyunder the passive loss rules as triggering the allowance of suspendedlosses from the activity). Congress generally intended thatother aspects of the disposition rules applying with respect to passivelosses apply as well for minimum tax purposes with respect to passivefarming losses.Passive Activity LossesIn computing alternative minimum taxable income, limitations apply tothe use of losses from passive activities of the taxpayer to offset other incomeof the taxpayer. The rule is identical to that applying for regular taxpurposes, under §469, except for three differences:(a) The rule was fully effective in 1987 for minimum tax purposes,whereas it was phased in for regular tax purposes;(b) For minimum tax purposes, the amount of losses that otherwisewould be disallowed for the current taxable year under the limitation is4-40reduced by the amount, if any, of the taxpayer’s insolvency, as measuredusing a standard similar to that set forth in §108(d)(3); and(c) In applying the limitations, minimum tax rules (including the passivefarm loss rule) apply to the measurement and allowability of allrelevant items of income, deduction, and credit.In light of differences between the regular tax and minimum tax treatmentof such items, the amount of suspended losses relating to an activitymay differ for regular and minimum tax purposes, respectively.Note: The $25,000 loss allowed for active participation rental real estate isalso allowed in AMT.The passive rule applying for minimum tax purposes functions is, in effect,like an adjustment to the regular tax rule. Thus, when a taxpayer hasdeductions that are limited under the regular tax passive loss rule, suchregular tax limitations should be disregarded for minimum tax purposes,with the minimum tax limitation being applied instead. Taxable income isfirst reduced, by treating as allowable deductions those that were suspendedunder the regular tax passive loss rule, then adjusted, to reflectminimum tax adjustments and other preferences, and then potentially increasedby applying the minimum tax passive loss rule.

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It is possible for a taxpayer to have a passive loss under one system butnot under the other.ExampleAssume that a taxpayer’s deductions with respect to passiveactivities equaled $80,000 for regular tax purposes and$40,000 for minimum tax purposes. The taxpayer wouldhave regular taxable income of $200,000, a suspendedpassive loss of $30,000 for regular tax purposes, alternativeminimum taxable income of $210,000, and no suspendedpassive loss for minimum tax purposes.Regular MinimumTax TaxTaxable Income 200,000 210,000Gross Income -passive activity 50,000 50,000Deductions (80,000) (40,000)Suspended Losses (30,000) 04-41Business Untaxed Reported Profits (Pre-1990)An additional positive adjustment is included in determining AMTI forthose corporations whose taxable income differs from income used for financialaccounting purposes. For 1987 through 1989, one-half of the excessof pretax adjusted net book income over AMTI was a positive adjustment.Adjusted net book income refers to the net income or loss as shown on thetaxpayer’s applicable financial statements, subject to several adjustments(§56(f)(2)(A) & Reg. §1.56-IT(b)(2)(i)). This business untaxed reportedprofits adjustment was treated as a timing adjustment even if it clearly relatedto a permanent exclusion. Since the business untaxed reported profitsadjustment cannot be negative, AMTI was not reduced where adjustednet book income was less than AMTI.In determining adjusted net book income, the following order of prioritywas used:(1) Financial statements filed with the Securities and Exchange Commission,(2) Certified audited financial statements prepared for nontax purposes,(3) Financial statements that must be filed with any Federal or othergovernmental agency,(4) Financial statements used for credit purposes,(5) Financial statements provided to shareholders,(6) Financial statements used for other substantial nontax purposes,then(7) The corporation’s earnings and profits for the year.After 1989, the use of pretax book income is replaced by a concept basedon adjusted earnings and profits. However, even prior to 1990, corporationshad to use current adjusted earnings and profits in determiningbusiness untaxed reported profits if it did not have any of the statementslisted in 1 through 6 above.

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ACE Adjustment (Post-1989)Effective for tax years beginning after 12/31/89, the business untaxed reportedprofits adjustment is replaced with an adjusted current earnings(ACE) adjustment. The ACE is tax based and can be a negative amount.AMTI is increased by 75% of the excess of ACE over unadjusted AMTI.Or AMTI is reduced by 75% of the excess of unadjusted AMTI overACE. The negative adjustment is limited to the aggregate of the positiveadjustments under ACE for prior years reduced by the previously claimed4-42negative adjustments. Thus, the ordering of the timing differences is crucialbecause any lost negative adjustment is perpetual. Unadjusted AMTIis AMTI without the ACE adjustment of the AMT NOL (§56(g)(1) &(2)).ACE should not be confused with current earnings and profits. Althoughmany items are treated the same, certain items that are deductible incomputing earnings and profits (but are not deductible in calculating taxableincome) generally are not deductible in computing ACE (e.g., Federalincome taxes).The starting point for computing ACE is AMTI, which is defined as regulartaxable income after AMT adjustments (other than the NOL andACE adjustments) and tax preferences (§56(g)(3)). The resulting figure isthen adjusted for the following items in order to determine ACE:1. Depreciation (Repealed by OBRA ‘93): Formerly, the depreciationsystem was calculated using the alternative depreciation system (ADS)in §168(g).2. Exclusion Items: These are income items (net of related expenses)that are included in earnings and profits, but will never be included inregular taxable income of AMTI (except on liquidation or disposal of abusiness). An example would be interest income from tax-exemptbonds. Exclusion expense items do not include fines and penalties, disallowedgolden parachute payments, and the disallowed portion ofmeals and entertainment expenses.3. Disallowed Items: A deduction is not allowed in computing ACE ifit is never deductible in computing earnings and profits. Thus, the dividendsreceived deduction and net operating loss deductions are not allowed.However, since the starting point for ACE is AMTI before theNOL, no adjustment is necessary for NOL. An exception does allowthe 100% dividends received deduction if the payor corporation andrecipient corporation are not members of the same affiliated groupand an 80% deduction when a recipient corporation has at least 20%ownership of the payor corporation (§56(g)(4)(C)(i) & (ii)). The exceptiondoes not cover dividends received from corporations where theownership percentage is less than 20%.4. Miscellaneous Adjustments: The following adjustments, which are

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required for regular earnings and profits purposes, are necessary:(a) Intangible drilling costs,(b) Construction period carrying charges,(c) Circulation expenditures,(d) Mineral exploration and development cost,(e) Organization expenditures,4-43(f) LIFO inventory adjustments,(g) Installment sales, and(i) Long-term contracts (§312(n)(1) through (6)).Other special rules apply to disallowed losses on the exchange of debtpools, acquisition expenses of life insurance companies, depletion, andcertain ownership changes.Adjusted Current Earnings RegulationsThe IRS has issued final regulations (TD 8340) holding that general rulesdefining taxable income also apply to ACE adjustments. The final regulationsprovide that:(i) Discharge of indebtedness income under §108 or any correspondingprovision of prior law (including the Bankruptcy Tax Act of 1980) isexcluded from ACE,(ii) Federal income tax refunds are excluded from ACE,(iii) Appreciated property distributions which trigger multiple E&Padjustments under §312 will have all such adjustments combined to netthe effect of the distribution on ACE,(iv) Distributions of encumbered property or assumptions of liabilityon distributed property which trigger multiple E&P adjustments under§312 will have all such adjustments combined to net the effect of thedistribution on ACE,(v) Lessee improvements excluded under §109 and nonshareholdercapital contributions excluded under §118 are both excluded fromACE,(vi) Dividends paid to employee stock ownership plans have no impacton ACE, and(vii) When the ACE basis in a life insurance contract exceeds theamount of death benefits received or the amount received when thecontract is surrendered, the resulting loss is allowed as a deduction incomputing ACE.The IRS also issued proposed regulations providing guidance on ACE adjustmentsfor LIFO reserves, foreign corporations, and the alternative taxenergy preference deduction.ACE WorksheetAMTI (before adjustment for NOL or ACE) $___________Add:Exclusion incomeTax-exempt interest not included in AMTI $___________

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4-44Key-person insurance proceeds $___________Inside buildup in life insurance policies $___________Others $___________Other adjustmentsDividends received deduction $___________Capitalization of organizational costs $___________Increase in LIFO recapture amount $___________Others $___________Depreciation adjustmentBased on ACE depreciation computation $___________ $___________Deduct:Exclusion expensesOnly if related to exclusion income $___________Dividends received deductionIf from 20% or more owned corporations $___________OthersItems not deductible for E&P $___________ $___________ACE $___________Less: tentative AMTI $(_________)Difference between ACE and AMTI $___________x 75%ACE adjustment (+ or -) $___________Tax Preferences - §57Most tax preference items reflect permanent differences between the regulartax and minimum tax calculations. They generally are positive.DepletionThe excess of the regular tax deduction allowable for percentage depletionover the adjusted basis of the property at the end of the taxable year(determined without regard to the depletion deduction for the taxableyear) is treated as a preference.ExampleA taxpayer who claimed a deduction for percentage depletionin the amount of $50, with respect to property having a basis(disregarding this deduction) of $10, would have a minimumtax preference in the amount of $40.4-45Intangible Drilling CostsExcess intangible drilling costs are treated as a preference to the extentthat they exceed 65% (was 100%) of the taxpayer’s net income from oil,gas, and geothermal properties.Excess Drilling CostsThe amount of excess intangible drilling costs is defined as the amountof the excess, if any, of the taxpayer’s regular tax deduction for suchcosts (deductible under either §263(c) or §291(b)) over the normativededuction, i.e., the amount that would have been allowable if the taxpayerhad amortized the costs over 120 months on a straight-line basisor (if the taxpayer so elects) through cost depletion. Net oil and gas incomeis determined without regard to deductions for excess intangibledrilling costs.

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Intangible drilling costs are all costs including wages, repairs, supplies,etc., incurred in the drilling of wells and preparation of wells for production.The preference does not apply to costs incurred with respectto a nonproductive well (dry hole).Example$1,000 of expenses are incurred on a well that produces$500 in net income. The preference is:Intangible drilling costs 1,000Amortization of IDC ($1,000 / 10 yrs) (100)Excess IDC 90065% of net income 320Preference 580Accelerated DepreciationCertain accelerated ACRS depreciation with respect to property placedin service prior to 1987 is treated as a preference.Real PropertyFor pre-1987 real property, the preference is the excess of accelerateddepreciation over straight-line depreciation. For non-recovery property,the preference is accelerated depreciation over straight-line underCLADR rules. For ACRS property, straight-line is calculated over therecovery period.4-46Personal PropertyFor pre-1987 personal property, depreciation is a preference only if theproperty is considered “leased” personal property. The preference isthe excess of depreciation claimed over straight-line depreciation using5 years for property having a 3-year recovery period and 8 years forproperty with a 5-year recovery period.Private Activity Bond InterestInterest on private activity bonds, reduced by any deduction attributableto it, is a tax preference item. Private activity bonds are bonds issued bystate and local governments to provide financing for purposes other thangovernment operations or facilities. Such bonds might provide financingfor stadiums or housing projects.The taxpayer is allowed a reduction in the AMT preference for costs relatedto the generation of private activity bond interest income.Alternative Tax NOL DeductionFor AMT purposes, figure an NOL for a tax year in generally the same manneras figured for regular tax, with the following exceptions:(i) Make the AMT adjustments to the NOL that were used for regular taxpurposes, and(ii) Reduce the NOL by the tax preference items.Note: The reduction cannot be more than the amount that these items increasedthe NOL.Carrybacks & CarryoversAfter making the above calculations, the amount of the alternative tax

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NOL that a taxpayer can deduct in a carryback or a carryover year cannotexceed 90% of their AMT taxable income for that year, as figured beforethe NOL deduction.Taxpayers can carryback their alternative tax NOL 2 years or carry it forward20 years. This is the same as under the regular NOL rules. However,if a taxpayer elects not to carryback the regular NOL, they cannot carrybackthe alternative tax NOL.If there is no AMT liability in a carryback or carryover year, taxpayers stillmust reduce their net operating loss deduction by 90% of the AMT taxableincome for that year. For this purpose, AMT taxable income is theamount arrived at on line 6, Form 6251. Use Form 6251 to figure the line6 amount even though there is no AMT liability.4-47Alternative Minimum Foreign Tax CreditThe foreign tax credit is the only credit allowed in figuring AMT. The AMTforeign tax credit is figured in the same manner as the regular tax foreign taxcredit except when computing the limit on the credit:(i) AMT taxable income is used instead of taxable income, and(ii) The tax against which the credit is taken is the tentative minimum tax(before the foreign tax credit).The AMT foreign tax credit cannot offset more than 90% of the tentativeminimum tax figured before claiming the foreign tax credit and the net operatingloss deduction.Use a separate Form 1116, Foreign Tax Credit, to figure the amount of foreigntax credit to apply against AMT. Use a separate form for each type ofincome listed at the top of Form 1116. Print “ALT MIN TAX” across the topof each Form 1116 used to figure the credit against AMT. Attach all theforms to the tax return.Foreign Tax Credit Carryback or CarryoverA separate carryover or carryback must be figured for the AMT foreigntax credit. It generally is figured the same way as the regular foreign taxcredit carryover or carryback. The limit that determines the amount ofthe unused foreign tax credit available for carryover or carryback to anotheryear is figured using the rules for the AMT foreign tax credit.Tentative Minimum TaxThe tentative minimum tax is determined by multiplying AMT taxable income,minus the appropriate exemption amount, by 24%. This amount is thetentative minimum tax unless the taxpayer has an AMT foreign tax credit. Ifthe taxpayer has an AMT foreign tax credit, it is subtracted to arrive at thetentative minimum tax.Minimum Tax Credit

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The same income item may be subject to AMT in one year and regular tax in another.The minimum tax credit prevents this double tax. When a taxpayer paysalternative minimum tax, the net minimum tax generally is allowed as a creditagainst the regular tax liability of the taxpayer in subsequent years.If a taxpayer paid AMT in an earlier year, the part of it based on adjustments orpreference items that deferred their tax liability rather than caused a permanentavoidance of the tax can be claimed as a credit against the regular income tax.The Form 8801, Credit for Prior Year Minimum Tax, is used to determine theamount of the credit.4-48Regular Income Tax ReducedThe credit is limited to the regular income tax for the year to which it is carriedminus the following:(i) Credit for child and dependent care,(ii) Credit for the elderly or the disabled,(iii) Mortgage interest credit,(iv) Foreign tax credit,(v) General business credit, and(vi) The tentative minimum tax for the year in which the credit is beingused.Carryforward of CreditThe AMT credit can be carried forward (indefinitely) to reduce the regulartax liability in later years. If a taxpayer does not use all of the credit, the balancemay be carried forward to later tax years. If the net AMT in a later taxyear results in an additional credit, the taxpayer can add that credit to anycarryforward balance from earlier years (see Part II of Form 8801).Other CreditsIf in a prior year, any part of the orphan drug credit or nonconventional fuelscredit was disallowed because it was more than the tentative minimum tax forthe year, a taxpayer can increase their minimum tax credit for this year by theamount disallowed.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. The

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following questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.4-49Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.181. Several components are used in the calculation of the alternative minimumtax (AMT). When figuring AMT, which of the following substitutes anitem used to compute the regular tax?a. a personal exemption.b. a tax preference.c. a tentative minimum tax.d. an adjustment.182. Numerous tax preferences and adjustments apply to taxpayers under thealternative minimum tax (AMT). Which of the following apply to all taxpayerssubject to the AMT?a. circulation expenditures and passive losses.b. itemized deductions and state tax refunds.c. long-term contracts and bad debts of financial institutions.d. Merchant Marine Capital Construction Fund and untaxed book income(pre-1990).183. Certain AMT tax preferences and adjustments apply to specific taxpayers.For example, which of the following apply just to noncorporate taxpayers?a. adjusted basis of certain property and alternative tax net operating lossdeduction.b. earnings & profits and Blue Cross/Blue Shield Deduction.c. farm losses and expenses for research and experiments.d. mining costs and intangible drilling costs.184. Under the AMT, taxpayers may use the Alternative Depreciation System(ADS) to calculate depreciation for most property. Which of the followingassets have a 40-year ADS life?

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a. most real property.b. no assets have a 40-year ADS life.c. qualified technological equipment.d. semi-conductor manufacturing equipment.4-50185. The author presents a comparison of the lives of certain assets under themodified accelerated cost recovery system (MACRS) and the lives of thosesame assets for alternative minimum tax (AMT). For example, what is thelife for AMT of office furniture?a. 5 years.b. 6 years.c. 7 years.d. 10 years.186. A taxpayer, who enters into a long-term contract, must figure alternativeminimum taxable income. In making this calculation, what is required of thetaxpayer?a. They must amortize expenditures ratably over a three-year period.b. They must utilize the percentage of completion method.c. They must recover costs through ten-year straight-line amortization.d. They must use the alternative depreciation system (ADS).187. For purposes of computing alternative minimum taxable income, someitems must be amortized. Which post-1986 items must be amortized over aten-year period?a. incentive stock options.b. installment sales.c. pollution control facilities.d. research and experimental expenditures.188. Passive farm losses are generally disallowed for purposes of calculatingalternative minimum taxable income. However, which of the following passivefarming activities may be allowed in figuring passive losses for minimumtax purposes?a. netted farming activities.b. passive farming activities that produce a net gain.c. passive losses that are not from farming activities.d. tax shelter farm activities.189. The adjusted current earnings (ACE) adjustment replaced the businessuntaxed reported profits adjustment for tax years. To compute ACE, what isthe first step?a. increase alternative minimum taxable income (AMTI) by 75% of excessof ACE over AMTI.b. determine whether ACE alternative minimum taxable income (AMTI)is greater than pre-adjustment AMTI.c. find adjusted current earnings.

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d. find alternative minimum taxable income (AMTI).4-51190. The IRS’s final regulations (TD 8340) provide seven provisions impactingadjusted current earnings (ACE) adjustments. What is one of these provisions?a. ACE is affected by dividends paid to employee stock ownership plans.b. ACE includes federal income tax refunds.c. When multiple earnings & profits adjustments are triggered by appreciatedproperty distributions, each adjustment is treated separately.d. A taxpayer may take as a deduction, in calculating ACE, a loss resultingfrom an ACE basis difference in a life insurance contract.

Answers & Explanations181. Several components are used in the calculation of the alternative minimumtax (AMT). When figuring AMT, which of the following substitutes an itemused to compute the regular tax?a. Incorrect. The deduction of personal exemptions for AMT purposes isprohibited.b. Incorrect. A tax preference involves the addition of the difference betweenthe special AMT treatment and the regular tax treatment.c. Incorrect. The tentative minimum tax is determined by multiplying AMTtaxable income, minus the appropriate exemption amount, by the AMT taxrate. This amount is the tentative minimum tax unless the taxpayer has anAMT foreign tax credit. If the taxpayer has an AMT foreign tax credit, it issubtracted to arrive at the tentative minimum tax.d. Correct. Adjustments involve a substitution of a special AMT treatment ofan item for the regular tax treatment. [Chp. 4]182. Numerous tax preferences and adjustments apply to taxpayers under thealternative minimum tax (AMT). Which of the following apply to all taxpayerssubject to the AMT?a. Incorrect. Circulation expenditures and passive losses are preferences andadjustments for noncorporate taxpayers only.b. Incorrect. Itemized deductions and state tax refunds are preferences andadjustments for noncorporate taxpayers only.c. Correct. Long-term contracts and financial institutions’ bad debts are taxpreferences and adjustments for all taxpayers.d. Incorrect. Merchant Marine Capital Construction Fund and untaxed bookincome (pre-1990) are tax preferences and adjustments for corporations only.[Chp. 4]4-52

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183. Certain AMT tax preferences and adjustments apply to specific taxpayers.For example, which of the following apply just to noncorporate taxpayers?a. Incorrect. Adjusted basis of certain property and alternative tax net operatingloss deduction are tax preferences and adjustments for all taxpayerssubject to the AMT.b. Incorrect. Earnings & profits and Blue Cross/Blue Shield Deduction aretax preferences and adjustments for only corporations.c. Correct. Farm losses and research and experimental expenditures are preferencesand adjustments for noncorporate only taxpayers.d. Incorrect. Mining costs and intangible drilling costs are tax preferencesand adjustments for all taxpayers subject to the AMT. [Chp. 4]184. Under the AMT, taxpayers may use the Alternative Depreciation System(ADS) to calculate depreciation for most property. Which of the followingassets have a 40-year ADS life?a. Correct. Most real property has a 40-year ADS life.b. Incorrect. A 40-year ADS life does exist for certain assets. However, no assetshave a 7-year ADS life. Assets in the 7-year MACRS class that have notbeen specifically assigned an ADS recovery period will revert to their ADRclass life.c. Incorrect. “Qualified technological equipment” has a 5-year ADS life.Note that for ADS, qualified technological equipment is limited to computeror related peripheral equipment, high technology telephone station equipmentinstalled on customer’s premises and high technology medical equipment.d. Incorrect. Semi-conductor manufacturing equipment has a 5-year ADSlife. [Chp. 4]185. The author presents a comparison of the lives of certain assets under themodified accelerated cost recovery system (MACRS) and the lives of thosesame assets for alternative minimum tax (AMT). For example, what is thelife for AMT of office furniture?a. Incorrect. The life for AMT of automobiles and computers is 5 years.b. Incorrect. The life for AMT of office equipment other than computers is 6years.c. Incorrect. No property listed has a life for AMT of 7 years. However, theMACRS life of office furniture is 7 years.d. Correct. The life for AMT of office furniture is 10 years. [Chp. 4]186. A taxpayer, who enters into a long-term contract, must figure alternativeminimum taxable income. In making this calculation, what is required ofthe taxpayer?

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4-53a. Incorrect. In computing alternative minimum taxable income, an individualwho incurs circulation expenditures is required to amortize such post-1986 expenditures ratably over a three-year period.b. Correct. In the case of any long-term contract entered into by the taxpayerafter February 28, 1986, the taxpayer is required to apply the percentage ofcompletion method (determined using the same percentage of completion asused for purposes of the regular tax) in determining minimum taxable incomerelating to that contract.c. Incorrect. Mining exploration and development costs, incurred after 1986,that are expensed (or amortized under §291) for regular tax purposes are requiredto be recovered through ten-year straight-line amortization for purposesof the alternative minimum tax.d. Incorrect. In the case of any certified pollution control facility placed inservice after 1986, the taxpayer is required to use ADS for minimum tax purposes.[Chp. 4]187. For purposes of computing alternative minimum taxable income, someitems must be amortized. Which post-1986 items must be amortized over aten-year period?a. Incorrect. In the case of a transfer of a share of stock pursuant to the exerciseof an incentive stock option (as defined in §422A), the amount by whichthe fair market value of the share at the time of the exercise exceeds the optionprice (bargain element) is treated as an adjustment.b. Incorrect. For non-dealer dispositions after 1986, the installment methodof reporting gain is allowable in regular tax and AMT.c. Incorrect. In the case of any certified pollution control facility placed inservice after 1986, the taxpayer is required to use ADS for minimum tax purposes.d. Correct. In computing alternative minimum taxable income, the taxpayeris required to amortize such post-1986 expenditures over a ten-year period.As with certain other items, this treatment applies for all minimum tax purposes,rather than as an annual adjustment to regular taxable income. [Chp.4]188. Passive farm losses are generally disallowed for purposes of calculating alternativeminimum taxable income. However, which of the following passivefarming activities may be allowed in figuring passive losses for minimumtax purposes?

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a. Incorrect. The rules for applying the loss disallowance generally are similarto those for applying the passive loss rule for minimum tax purposes, exceptthat there is no netting between different farming activities.b. Correct. The only passive farming activities that enter into the passive losscomputation (for minimum tax purposes) are those that generate net gain.4-54c. Incorrect. The gain can then be offset, for minimum tax purposes underthe general passive loss rule, against passive losses that are not from farmingactivities.d. Incorrect. A passive farm loss is defined as the excess of the taxpayer’s lossfor the taxable year from any tax shelter farming activity. The term “tax shelterfarm activity” means (1) a farming syndicate (as defined in §464(c)), and(2) any other activity consisting of farming which is a passive activity (withinthe meaning of §469(c)). [Chp. 4]189. The adjusted current earnings (ACE) adjustment replaced the business untaxedreported profits adjustment for tax years. To compute ACE, what isthe first step?a. Incorrect. The last step in determining the ACE adjustment is to either decreaseAMTI by 75% of excess of ACE over AMTI or to decrease AMTI by75% of excess of AMTI over ACE to the extent of prior increases.b. Incorrect. After the ACE is found, it must be determined whether theACE AMTI is greater than pre-adjustment AMTI.c. Incorrect. After finding the AMTI, the ACE must be found by adjustingAMTI as required.d. Correct. The starting point for computing ACE is AMTI, which is definedas regular taxable income after AMT adjustments (other than the NOL andACE adjustments) and tax preferences. [Chp. 4]190. The IRS’s final regulations (TD 8340) provide seven provisions impactingadjusted current earnings (ACE) adjustments. What is one of these provisions?a. Incorrect. Dividends paid to employee stock ownership plans have no impacton ACE.b. Incorrect. Federal income tax refunds are excluded from ACE.c. Incorrect. The adjustments are combined rather than treated separately inorder to net the effect of the distribution on ACE.d. Correct. When the ACE basis in a life insurance contract exceeds the

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amount received when the contract is surrendered, the resulting loss is allowedas a deduction in computing ACE. [Chp. 4]4-55

ComplianceReporting RequirementsReal Estate Transactions [Form - 1099S]Real estate settlement agents are required to file form 1099-S Proceeds fromReal Estate Sales with the IRS for certain real estate transactions in whichthey are involved. In addition, they must also furnish a written statement totheir customers.Generally, the person responsible for closing the transaction must report onForm 1099-S sales or exchanges of the following types of property:(1) Land (improved or unimproved), including air space,(2) An inherently permanent structure, including any residential, commercial,or industrial building,(3) A condominium unit and its related fixtures and common elements(including land), and4-56(4) Stock in a cooperative housing corporation.Real estate settlement agents responsible for filing information returns aredefined as:(1) Person responsible for closing the transaction, such as a title companyor an attorney,(2) Mortgage lender,(3) Seller’s broker,(4) Buyer’s broker, and(5) Any other person designated in the regulations.Settlement agents designated under the Real Estate Settlement ProceedingsAct (RESPA) are responsible for closing transactions if uniform settlementstatements are used for closing; if they are not used or no settlement agent islisted, then the person who prepares the closing statement or written dispositionof the gross proceeds is responsible for filing. If there is no closingstatement or written description utilized then the transferee’s attorney, ifutilized, must file the required information return. If no attorney is utilizedthen the title or escrow company disbursing the proceeds must file the informationreturn. Finally, the participants in a real estate transaction may designatesomeone as the responsible person with respect to the transaction.The following information is required to be filed between December 31, andFebruary 1 of the year following the transaction:(1) Tax identification numbers of transferor and responsible person,

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(2) General description of real estate involved,(3) Closing date, and(4) Gross proceeds.Non-reportable transactions:(1) Gifts,(2) Mobile home transactions, and(3) Transferors who are corporate or governmental entities.For sales or exchanges after May 6, 1997, the otherwise applicable reportingand information return requirements may not apply to sales of a principalresidence when the total consideration for the sale or exchange is $250,000 orless, or $500,000 or less if the sellers are married. For this exemption to apply,the sellers, who include the persons relinquishing property when thetransaction is an exchange, must give the real estate reporting person writtenassurances in a form acceptable to the IRS.4-57Independent ContractorsAny trade or business who pays an independent contractor, subcontractor, oran individual not treated as an employee $600 or more during the year mustreport this amount on a 1099-MISC.An employee is anyone who performs services that can be controlled by anemployer. The existence of the right to control, not necessarily the exercise ofcontrol is critical. Control includes what shall be done and how it shall bedone.The following factors are considered in determining whether there is an employmentrelationship:(1) The extent of control exercised over the details of the work;(2) Whether or not the person in question is engaged in a distinct occupationor business;(3) Whether the work is usually done under the direction of the employeror by a specialist without supervision;(4) The skill required;(5) Whether the employer or the workman supplies instrumentalities,tools, and place of work;(6) The length of time for which the person is employed;(7) The method of payment;(8) Whether or not the work is part of the regular business of the employer;(9) Whether the parties believe they are creating a relationship of masterand servant; and(10) Whether the principal is or is not in business.Certain individuals are considered statutory employees for FICA, FUTA,and SUI purposes:

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(1) Driver who delivers food, beverages (other than milk), laundry, ordry-cleaning for someone else,(2) A full-time life insurance salesperson,(3) A home worker who works by the guidelines of the person for whomthe work is being done, with materials furnished by and returned to thatperson or to someone that person designates, and(4) A salesperson who works full-time (except sideline sales activities) forone firm getting orders from customers.Note: The orders must be for items for resale or use as supplies in thecustomer’s business. The customers must be retailers, wholesalers, contractors,or operators of hotels, restaurants, or other businesses dealingwith food or lodging.4-58To be considered an employee for FICA, FUTA, and SUI tax purposes, aperson in (1) - (4) (above) must meet all three conditions below:(1) It is understood from a service contract that the person will performthe services;(2) The person does not have an investment in facilities (other thantransportation) used to perform the services; and(3) The services are the kinds that involve a continuing relationship withthe person for whom they are performed.A written contract stating that the individual is an independent contractorwill not be considered valid if the relationship is actually one of an employee/employer. A California Court decision held that “...the mere fact thatboth parties may have mistakenly believed that they were entering into therelationship of principal and independent contractor is not binding.” (MaxGrant v. Director of Benefit Payments (1977), 71 C.A. 3d 647).An employer’s treatment of an individual as an independent contractor maybe upheld for employment tax purposes if:(1) The taxpayer does not treat the individual as an employee;(2) All federal tax returns are filed on a consistent basis; and(3) The taxpayer has a reasonable basis for treating the individual as anon-employee (Sec. 530(a) of the ‘78 Revenue Act).Real estate agents are treated as non-employees if substantially all compensationfor services is directly related to sales rather than number of hoursworked. Such services must be performed under a written contract providingthat they will not be treated as employees for tax purposes (§3508).If the IRS reclassifies an independent contractor as an employee, the employeris subject to the following penalties detailed in §3509:(1) 1.5% of wages paid for income tax withholding (3% if willful),(2) 20% of amount that should have been withheld as employee’s share ofFICA (40% if willful), and(3) Employer’s full share of FICA and FUTA.Cash Reporting [Form 8300]

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A person who receives in his trade or business, more than $10,000 in cash(including foreign currency) in one transaction (or 2 or more related transactions),must file an information return with IRS and furnish the payor with astatement. Reporting is done on Form 8300, Report of Cash Payments Over$10,000 Received in a Trade or Business.The definition of cash under this reporting rule includes certain monetary instrumentsto the extent provided in regulations. In 1991, final regulations4-59were adopted effective for amounts received after February 2, 1992 (TD8373).Under the regulations specified monetary instruments are cash when they arereceived in “designated reporting transactions.” The specified monetary instrumentsare:(1) Cashier’s checks,(2) Bank drafts,(3) Traveler’s checks, and(4) Money orders,having a face amount of not more than $10,000 (Reg. §1.6050I-1(c)(1)(ii)).Such instruments are under the cash reporting rules whether the instrumentsare payable to:(1) Bearer,(2) A named payee, or(3) Left blank.Checks other than cashier’s checks are not included within the definition ofcash. Thus, the term does not include checks drawn on the personal accountof an individual or business checks even if such checks are certified.A designated reporting transaction is a retail sale of:(1) A consumer durable,(2) A collectible, or(3) A travel or entertainment activity (Reg. §1.6050I-1(c)(1)(iii)).A consumer durable is tangible personal property sold for personal consumptionor use that is expected to be useful for at least one year under ordinaryusage and has a sales price of more than $10,000. Thus, for example, a$20,000 automobile is a consumer durable, but a $20,000 factory machine isnot (Reg. §1.6050I-1(c)(2)).A travel or entertainment activity is one or more items of travel or entertainmentrelating to a single trip or event, but only if the total sales price of allitems relating to the trip or event exceeds $10,000 (Reg. §1.6050I-1(c)(4)).Items of travel or entertainment relating to a single trip or event include, for

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example the chartering of an airliner to transport persons to and from asporting event, hotel accommodations related to the event, and admission tothe event itself.In deciding whether the total sales price is more than $10,000, related salesby a single merchant/recipient of items of travel and entertainment relatingto the same trip or event are totaled. However, retail sales of items relatingto a trip or event are not totaled with retail sales of items relating to anothertrip or event.4-60ExceptionsA specified monetary instrument is not cash if the instrument representsthe proceeds of a bank loan. The recipient may rely on a copy of the loandocument or a statement from the bank (Reg. §1.6050I-1 (c)(1)(iv)).Another exception applies to instruments received in payment on a promissorynote or an installment sales contract if:(1) The recipient uses promissory notes or installment sales contractswith the same or substantially similar terms in the ordinary course ofits trade or business related to sales to ultimate consumers, and(2) The total amount of payments received with respect to the sale onor before the 60th day after the date of the sale does not exceed 50%of the purchase price (Reg. §1.6050I-1(c)(1)(v)).A third exception applies to an instrument received pursuant to a paymentplan requiring one or more down payments and the payment of thebalance of the purchase price by the time of the sale if:(1) The recipient uses plans with the same or substantially similarterms in the ordinary course of its trade or business related to sales toultimate consumers, and(2) The instrument is received more than 60 days before the date ofthe sale (Reg. §1.6050I-i(c)(1)(vi)).Recipient’s KnowledgeWhether or not a specified monetary instrument is received in a designatedreporting transaction, the instrument is cash if the recipient knowsthat the instrument is being used in an attempt to avoid the cash reportingU.S. rules (Reg. §1.6050I-1(c)(1)(ii)).Cash Reporting Rules - AttorneysIn U.S. v. Goldberger & Dubin, 67 AFTR 2d 91-1166, the Second Circuithas held that attorneys are not exempt from the cash reporting rules.These rules require any person engaged in a trade or business to reportthe receipt of more than $10,000 in cash in a transaction, or in two ormore related transactions (§6050I(a)). IRS Form 8300 requires detaileddisclosure, including the payor’s name, taxpayer identification number,and nature of the transaction.Attorneys have argued that such disclosure violates the attorney-clientprivilege and the Fifth and Sixth Amendments (self-incrimination andright to counsel).

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The Second Circuit found that when Congress passed §6050I, it did notexempt attorneys despite lobbying for an exemption. The Court held thatCongress deliberately didn’t wish to supply an exclusion and rejected the4-61Sixth Amendment argument, reasoning that §60501 didn’t prevent clientsfrom paying their counsel in a medium other than cash.Note: This argument may have limited application since the RRA ‘89 andproposed regulations treat monetary instruments such as cashier’s checksand money orders as cash.Since a violation of federal law was involved, the attorney-client privilegelaw of New York was held not to apply.Sale of Certain Partnership Interests (Form 8308)Partnerships must include Form 8308 with their partnership return (Form1065) if a sale or exchange of any partnership interests under §751(a) takesplace during the year. Section 751(a) sales and exchanges are defined astransactions where partnership interests are attributable to unrealized receivablesor substantially appreciated inventory.Tax Shelter Registration Number [Form 8271]Anyone claiming or reporting a loss, deduction, credit, or other tax benefit orreporting any income or any tax return from an interest purchased or acquiredin a registration-required tax shelter must file a Form 8271. The formis attached to the tax return on which the loss, deduction, credit, or other taxbenefit is claimed. The registration number is located on schedule K-1 forpartners or shareholders in S Corporations. The penalty for failure to file is$250.Asset Acquisition Statement [Form 8594]Both the buyer and seller of a group of assets constituting a trade or businessmust prepare and attach Form 8594 to their tax return.A group of assets constitutes a trade or business if goodwill could under anycircumstances attach to such assets.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.4-62

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Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.191. Form 1099-S is used to report sales or exchanges of certain transactions.Which transactions must be reported on this form by the individual accountablefor closing the transaction?a. sales or exchanges of a commercial building if the transferors are corporations.b. gift transactions or transfers.c. sales or exchanges of mobile home transactions.d. sales or exchanges of stock in a cooperative housing corporation.192. Independent contractors should not be confused with employees. Whichindividual would most likely be deemed in an employment relationship?a. an individual who does not believe they created a relationship of masterand servant.b. an individual who provides services that the another controls.c. an individual who provides his or her own tools and/or supplies.d. an individual whose work is not part of the regular business of another.193. The author lists four categories of individuals who are considered statutoryemployees for purposes of the Federal Insurance Contribution Act(FICA) tax, the Federal Unemployment Tax Act (FUTA), and State UnemploymentInsurance (SUI). Which of the following is included in this list?a. food delivery drivers.b. individuals who have an investment in facilities used to perform theservices.c. part-time life insurance salespersons.d. full-time factory machinists.194. Section 530(a) of the 1978 Revenue Act provides three conditionswhereby the employment tax treatment of an individual as an independentcontractor by an employer may be upheld. What is one of these conditions?a. The employer often files Form 1099s or W-2s.b. The employer made an honest mistake.c. The employer can show there is a reasonable cause for this tax treatment.d. The employer treats all workers as employees.4-63

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195. Section 3508 provides that employers may treat certain individuals asnon-employees where they pay the individual compensation based on salesrather than number of hours worked. Which of the following workers is coveredunder this provision?a. full-time salespeople who work for one firm getting orders from customers.b. real estate agents.c. statutory employees.d. individuals who work from home under another person’s guidance.196. The regulations (TD 8373) for reporting cash on Form 8300 specify fourmonetary instruments as being subject to cash reporting rules. Which of thefollowing is a specified monetary instrument under these regulations?a. an instrument that represents the proceeds of a bank loan.b. certified business checks.c. money orders.d. personal checks.197. Reg. §1.16050I-1(c)(1)(iii) defines a designated reporting transaction forpurposes of cash reporting on Form 8300. Which of the following is excludedfrom the definition of a designated reporting transaction?a. a sale of a collectible.b. a sale of a factory machine.c. a sale of an automobile.d. total sales of all items relating to a trip.

Answers & Explanations191. Form 1099-S is used to report sales or exchanges of certain transactions.Which transactions must be reported on this form by the individual accountablefor closing the transaction?a. Incorrect. Non-reportable transactions include any transactions where thetransferors are corporate or governmental entities.b. Incorrect. Non-reportable transactions include gift transactions.c. Incorrect. Non-reportable transactions include mobile home transactions.d. Correct. Generally, the person responsible for closing the transaction mustreport on Form 1099-S sales or exchanges of the stock in a cooperative housingcorporation. [Chp. 4]4-64192. Independent contractors should not be confused with employees. Whichindividual would most likely be deemed in an employment relationship?a. Incorrect. If the individual believes that they have created a relationship of

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master and servant, it is likely that it is an employment relationship.b. Correct. An employee is anyone who performs services that can be controlledby an employer. The existence of the right to control, not necessarilythe exercise of control, is critical. Control includes what shall be done andhow it shall be done.c. Incorrect. If the workman supplies instrumentalities, tools, and place ofwork, he is likely to be an independent contractor. If the employer providesthem, the individual is likely an employee.d. Incorrect. If the work is not part of the regular business of the employer,then it is likely the relationship is between a principal and an independentcontractor. [Chp. 4]193. The author lists four categories of individuals who are considered statutoryemployees for purposes of the Federal Insurance Contribution Act (FICA)tax, the Federal Unemployment Tax Act (FUTA), and State UnemploymentInsurance (SUI). Which of the following is included in this list?a. Correct. Drivers who deliver food, beverages (other than milk), laundry, ordry-cleaning for someone else are considered statutory employees for FICA,FUTA, and SUI purposes.b. Incorrect. To be considered an employee for FICA, FUTA, and SUI taxpurposes, a statutory employee must not have an investment in facilities usedto perform the services.c. Incorrect. A full-time life insurance salesperson is considered statutoryemployees for FICA, FUTA, and SUI purposes.d. Incorrect. Full-time factory machinists are not statutory employee butwould be most likely common law employees. [Chp. 4]194. Section 530(a) of the 1978 Revenue Act provides three conditions wherebythe employment tax treatment of an individual as an independent contractorby an employer may be upheld. What is one of these conditions?a. Incorrect. An employer’s treatment of an individual as an independentcontractor may be upheld for employment tax purposes if, among otherthings, all federal tax returns are filed on a consistent basis. The IRS mayconsider past records, but don’t count on it.b. Incorrect. The ’78 Revenue Act does not provide that the treatment will beupheld if it appears as though the employer made a mistake. The IRS willlikely make a point that the employer should have known better, since he isexperienced in distinguishing between independent contractors and employees.4-65c. Correct. An employer’s treatment of an individual as an independent contractormay be upheld for employment tax purposes if, among other things,

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the taxpayer has a reasonable basis for treating the individual as a nonemployee.d. Incorrect. An employer’s treatment of an individual as an independentcontractor may be upheld for employment tax purposes if, among otherthings, the taxpayer does not treat the individual as an employee. [Chp. 4]195. Section 3508 provides that employers may treat certain individuals as nonemployeeswhere they pay the individual compensation based on salesrather than number of hours worked. Which of the following workers iscovered under this provision?a. Incorrect. A salesperson who works full-time (except sideline sales activities)for one firm getting orders from customers is considered a statutoryemployee for FICA, FUTA, and SUI purposes.b. Correct. Real estate agents are treated as non-employees if substantiallyall compensation for services is directly related to sales rather than numberof hours worked. Such services must be performed under a written contractproviding that they will not be treated as employees for tax purposes.c. Incorrect. Statutory employees perform the services under a service contract;do not have an investment in facilities (other than transportation) usedto perform the services; and perform services that involve a continuing relationshipwith the person for whom they are performed.d. Incorrect. A home worker who works by the guidelines of the person forwhom the work is being done, with materials furnished by and returned tothat person or to someone that person designates, is considered a statutoryemployee for FICA, FUTA, and SUI purposes. [Chp. 4]196. The regulations (TD 8373) for reporting cash on Form 8300 specify fourmonetary instruments as being subject to cash reporting rules. Which ofthe following is a specified monetary instrument under these regulations?a. Incorrect. A specified monetary instrument is not cash if the instrumentrepresents the proceeds of a bank loan. The recipient may rely on a copy ofthe loan document or a statement from the bank.b. Incorrect. The specified monetary instruments do not include businesschecks even if such checks are certified.c. Correct. The specified monetary instruments are cashier’s checks, bankdrafts, traveler’s checks, and money orders.d. Incorrect. Checks are not included within the definition of cash. Thus, theterm does not include checks drawn on the personal account of an individual.[Chp. 4]4-66197. Reg. §1.16050I-1(c)(1)(iii) defines a designated reporting transaction forpurposes of cash reporting on Form 8300. Which of the following is excludedfrom the definition of a designated reporting transaction?

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a. Incorrect. A designated reporting transaction is a retail sale of collectibles.b. Correct. The sale of a consumer durable is a covered transaction. A consumerdurable is tangible personal property sold for personal consumption oruse that is expected to be useful for at least one year under ordinary usageand has a sales price of more than $10,000. However, a factory machine is notconsidered a consumer durable under this description.c. Incorrect. A designated reporting transaction is a retail sale of consumerdurables such as automobiles.d. Incorrect. A designated reporting transaction is a retail sale of travel or entertainmentactivity. [Chp. 4]

Accuracy-Related PenaltiesOver the years there has been a proliferation of tax penalties. The RRA ‘89 attemptedto bring order to the penalty area, particularly for the “accuracyrelated”penalties. These include penalties for:(1) Negligence,(2) Substantial understatement of an income tax liability,(3) Substantial valuation overstatements, and(4) Substantial estate & gift tax valuation understatements.4-67Generally, the accuracy-related penalties are set at a common rate of 20% andthe taxpayer defense to their imposition is now largely uniform.NegligenceThe RRA ‘89 made several changes to the negligence penalty:(1) The rate was raised from 5% to 20%,(2) The penalty is imposed only on the portion of the tax underpayment attributedto the negligence19, and(3) The penalty is no longer automatic if a taxpayer fails to account foramounts reported on information returns (e.g., Form 1099 or W-2).Negligence includes any failure to make a reasonable attempt to comply with theprovisions of tax law or to any (careless or intentional) disregard of rules andregulations (§6662(c)).The negligence penalty applies to all taxes, but does not apply when fraud is involved.The penalty can be avoided by a showing of reasonable cause and goodfaith action.Substantial Understatement of Income TaxA substantial understatement of a tax income liability is when the understatement

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exceeds the larger of:(a) 10% of the tax due, or(b) $5,00020

The understatement to which the penalty applies is 10% of the difference betweenthe amount of tax required to be shown on the return and the amountof tax actually reported.The penalty can be avoided in the following circumstances:(a) The taxpayer has substantial authority for such treatment,(b) The relevant facts affecting the treatment were adequately disclosedin the return, or(c) The taxpayer has reasonable cause and acts in good faith.RRA ‘89 changes include:(a) The amount of the penalty is 20% of the amount of the underpaymentattributable to the understatement21,(b) The IRS is directed to publish an expanded list of what constitutessubstantial authority, and19 Under pre-1990 rules, the penalty was imposed on the entire amount of the underpayment.20 The amount is $10,000 for corporations.21 Pre-1990 rate was 25%.4-68(c) The IRS is directed to publish a list of positions that lack substantialauthority.Penalty on Carryover Year ReturnIn Mattingly v. U.S., the Eighth Circuit has held that the §6701 tax-returnpreparerpenalty for aiding and abetting understatement of tax liabilitycan’t be imposed on both the original and the carryover year returns ofthe same taxpayer based on the same understatement.The tax return preparer sold master recording tax shelters to his clients.In preparing their tax returns, he overstated tax credits resulting in an understatementof their tax liability. The return preparer also preparedamended returns to carry over credits that couldn’t be claimed on theoriginal returns. The IRS assessed penalties under §6701 for both theoriginal returns and the amended returns.The District Court had held that separate penalties could be assessed onthe original and amended returns reasoning that amended returns wereseparate from original returns since they claimed credits for different taxperiods.The Eighth Circuit stated that the District Court improperly interpreted§6701 and limited the penalty to the original return year and denied it forcarryover return years.Substantial Valuation OverstatementsThe RRA ‘89 made the following changes to this penalty:

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(a) The penalty is now 20% of the tax that should have been paid had thecorrect valuation or basis been used22,(b) All taxpayers are subject to the penalty23; charitable contributionsautomatically have the 30% penalty rate apply,(c) The penalty applies only when valuation or basis used is 200% ormore of the correct valuation or basis24, and(d) The penalty applies only to the extent that the resulting income taxunderpayment exceeds $5,000 ($10,000 for most corporations).The valuation overstatement penalty can be avoided if the taxpayer can showreasonable cause and good faith. However, if the overvaluation involvescharitable deduction property, two additional facts must be shown:22 For valuation misstatements of 400% or more, the penalty increases to 40%.23 Under pre-1990 rules, only individuals, closely held corporations, or personal service corporationswere covered.24 Pre-1990 rules started at 150%.4-69(a) The claimed value of the property is based on a qualified appraisalmade by a qualified appraiser; and(b) The taxpayer made a good faith investigation of the value of the contributedproperty.Substantial Estate & Gift Tax Valuation UnderstatementsThe penalty is 20% of the transfer tax that would have been due had the correctvaluation been used on Form 706 (estate) or Form 709 (gifts). The penaltyonly applies if the value of the property claimed on the return is 50% orless of the amount determined to be correct. The threshold amount for thepenalty to apply is transfer tax liability in excess of $5,000. Reasonable causeand good faith is a defense.Final RegulationsIn 1991, the IRS issued final regulations for accuracy related penalties, effectivefor returns due after 1989 (T.D. 8381). The final regulations provide rules onlyfor the first three components of the accuracy-related penalty, i.e., the penaltiesfor:(1) Negligence or disregard of rules or regulations,(2) A substantial understatement of income tax, and(3) A substantial (or gross) valuation misstatement.Negligence or Disregard of RulesSection 1.6662-3 of the regulations provides rules for the penalty for negligenceor disregard of rules or regulations. This penalty applies if any portion

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of an underpayment of tax required to be shown on a return for a year is attributableto negligence or disregard of rules or regulations. “Negligence” includesany failure to make a reasonable attempt to comply with the internalrevenue laws or to exercise ordinary and reasonable care in the preparationof a tax return. A taxpayer also is negligent if the taxpayer fails to keep adequatebooks and records or to substantiate items properly.A position with respect to an item is considered to be attributable to negligenceif it is frivolous or if it is not frivolous, but lacks a reasonable basis.Negligence is strongly indicated where a taxpayer:(i) Fails to include income shown on an information return, such as aForm 1099, or(ii) Fails to make a reasonable attempt to ascertain the correctness of adeduction, credit or exclusion which would seem to a reasonable and prudentperson to be “too good to be true” under the circumstances.Negligence also is strongly indicated where the returns of a partner and partnershipor of an S corporation shareholder and S corporation are not consis4-70tent with the treatment on the return of the partnership or S corporation(Reg. §1.6662-3(b)(1)).“Disregard of rules or regulations” includes any careless, reckless or intentionaldisregard of the Code, temporary or final Treasury regulations, revenuerulings, or notices published in the Internal Revenue Bulletin (Reg.§1.6662-3(b)(2)). However, a taxpayer will not be considered to have disregardeda revenue ruling, if the position contrary to the ruling has a realisticpossibility of being sustained on its merits.Substantial Understatement PenaltyThis penalty is not imposed if there is substantial authority for the positionclaimed on the return. “Authority” under the regulations includes private letterrulings and technical advice memoranda issued after October 31, 1976,and general counsel memoranda and actions on decisions issued after March12, 1981 (Reg. §1.6662-4(d)(3)(iii))25.The regulations further provide that an authority ceases to be an authority ifoverruled or modified, implicitly or explicitly, by an authority of the same orhigher source. For example, a private letter ruling will not be considered authorityif revoked or if inconsistent with a subsequent proposed regulation,revenue ruling, or other administrative pronouncement published in the Internal

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Revenue Bulletin.A district court opinion isn’t an authority if overruled by the court of appealsfor that district. However, a Tax Court opinion is not considered overruled ormodified by a court of appeals to which a taxpayer doesn’t have a right of appeal,unless the Tax Court adopts the holding of the court of appeals.In determining whether authority is substantial, an older private letter ruling,technical advice memorandum, general counsel memorandum, or action ondecision generally will be accorded less weight than a more recent one andany such document that is more than ten years old generally will be accordedvery little weight. However, the relevance and persuasiveness of documentsshould be taken into account as well as their age (Reg. §1.6662-4(d)(3)).Adequate DisclosureThe regulations provide for only two methods of disclosure in order for itemsto be treated as though they were properly shown on the return for purposesof the substantial understatement penalty:(1) Disclosure on a Form 8275 attached to the return (or a qualifiedamended return), and25 The final regulations add that the GCMs published in pre-‘55 volumes of the Cumulative Bulletinare also authorities.4-71(2) Disclosure in accordance with the annual revenue procedure thatpermits disclosure on the return itself (or a qualified amended return) forthis purpose (Reg. §1.6662-4(f)).For disregard of rules or regulations, the regulations provide that disclosureis adequate if:(1) Made on a Form 8275, or(2) In the case of a position contrary to regulation, the penalty can beavoided if the position represents a good faith challenge to the validity ofthe regulation.Disclosure of such a position must be made on Form 8275-R, Regulation DisclosureStatement (Reg. §1.6662-3(c)).

Information Reporting Penalty Final RegulationsPenalties are imposed on persons who fail to file required information returns orfurnish required statements to payees. This penalty is generally $50 for each failure.In 1991, final regulations were issued (TD 8386) replacing the temporary regulations.The final regulations apply to information returns and payee statementsthe due date for which (without regard to extensions) is after 1989.The regulations apply to the:(i) §6721 penalty for failure to file correct information returns;

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(ii) §6722 penalty for failure to furnish correct payee statements;(iii) §6723 penalty for failure to comply with other information reporting requirements;and(iv) §6724 reasonable-cause waiver to all the above penalties.Information returns26 are to be filed by February 28. Section 6721 imposes a $50penalty for each failure (up to a maximum of $250,000 per year) to timely file aninformation return or any failure to include all required information.An inconsequential error or omission is not considered a failure to include correctinformation. An inconsequential error is one that does not prevent or hinderIRS from processing the return or from correlating the required informationwith that shown on the payee’s tax return.The penalty is reduced to $15 if the failure is corrected within 30 days of the requireddate, and to $30 if the failure is corrected after 30 days, but before August1 of the year it’s required to be filed. No penalty is imposed when the number of26 These are generally 1099 type forms.4-72errors is small (the greater of 10 or 0.5% of all returns required to be filed) andthey are corrected by August 1.Payee statements27 are to be furnished by January 31. Section 6722 imposes a $50penalty for each failure (up to a maximum of $100,000 per year) to timely furnisha payee statement or to include all information. Under the regulations, if a payeestatement is furnished late and with incorrect or incomplete information, there isonly one $50 penalty.Note: Penalties for failure to furnish timely correct and complete payeestatements may be waived if the filer demonstrates that the failure is due tothe filer’s inability to obtain necessary information from a person on whomthe filer must rely to furnish correct and complete payee statements.Based on §6723, the regulations impose a $50 penalty for every failure to timelyreport:(i) An exchange of a partnership interest by a transferor partner; or(ii) A taxpayer identification number where required.Reasonable cause needed to avoid the §6721, §6722, and §6723 penalties existsunder the regulations when the filer:

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(i) Shows that they acted responsibly both before and after the failure occurred,and(ii) Establishes that either:a. There are significant mitigating factors for the failure, orb. The failure arose from events beyond the filer’s control.Note: If the filer establishes that there are significant mitigating factors for afailure but is unable to establish that the filer acted in a responsible manner,the mitigating factors will not be sufficient for a waiver of the penalty.Reasonable cause in cases of failure to provide a taxpayer identification numbercan be shown by:(i) Solicitation of the TIN at the time the account was opened, or(ii) If the TIN was missing or incorrect, that additional attempts were madeto obtain it.To prove that they acted responsibly, the filer must show:(i) Use of reasonable care in obtaining and handling account information,and(ii) Efforts to avoid and correct the failure, such as:a) Requesting extensions of time to file and attempting to prevent thefailure if it was foreseeable,27 These are statements that must be furnished to partners, S corporation shareholders, beneficiariesof estates and trusts, and recipients of certain payments in the course or a trade or business.4-73b) Removing the cause of the failure once it occurred, andc) Correcting the failure as promptly as possible (Reg. §301.6724-1(d)(1)).Mitigating factors include:(i) The initial filing of this type of return or statement, or(ii) A history of compliance.Events beyond the filer’s control include:(i) The unavailability of the relevant business records, whether as a result of acasualty, a change in the governing law with which, as a practical matter, thefiler cannot timely comply, or the unavoidable absence of a person with thesole responsibility for filing (or furnishing a payee statement);(ii) An undue economic hardship for filing on magnetic media, which mustbe established by a showing that the filer lacks the necessary hardware andwas unable to contract out the filing at other than a prohibitive cost;(iii) The filer’s good faith reliance on erroneous written information furnishedby IRS, provided that the filer furnished all of the relevant facts toIRS in seeking the information relied upon;(iv) The filer’s exercise of reasonable business judgment in selecting andgood faith reliance on an agent who was engaged sufficiently in advance to

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permit timely filing and whom the filer properly monitored; and(v) The failure of a payee or other person to provide the filer correct informationwith respect to the return or payee statement (Reg. §301.6724-1(c)).

Penalty for Unrealistic PositionUnder §6694(a), a person who is an income tax return preparer with respect to agiven return or refund claim is liable for a $250 penalty28 for that return or refundclaim if:(1) Any part of any understatement of liability with respect to any return orclaim for refund is due to a position for which there was not a realistic possibilityof being sustained on its merits,(2) The return preparer knew (or reasonably should have known) of such position,and(3) Such position was not disclosed as provided in §6662(d)(2)(B)(ii) or wasfrivolous.28 A $1,000 penalty is imposed where the understatement is willful.4-74However, the penalty is not imposed where the preparer shows both that there isa reasonable cause for the understatement and that the preparer acted in goodfaith.In 1991, the IRS adopted final regulations for the application of this penalty effectivefor documents prepared and advice given after 1991 (T.D. 8382).Realistic Possibility StandardThe regulations provide that a position is considered to have a realistic possibilityof being sustained on its merits if a reasonable and well-informed analysis bya person knowledgeable in the tax law would lead such a person to conclude thatthe position has approximately a one in three, or greater, likelihood of being sustainedon its merits (realistic possibility standard).The authorities considered in determining whether a position satisfies the realisticpossibility standard are:(1) Applicable provisions of the Internal Revenue Code and other statutoryprovisions;(2) Proposed, temporary and final regulations construing such statutes;(3) Revenue rulings and revenue procedures;

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(4) Tax treaties and regulations thereunder, and Treasury Department andother official explanations of such treaties;(5) Court cases;(6) Congressional intent as reflected in committee reports, joint explanatorystatements of managers included in conference committee reports, and floorstatements made prior to enactment by one of a bill’s managers;(7) General Explanations of tax legislation prepared by the Joint Committeeon Taxation (the Blue Book);(8) Private letter rulings and technical advice memoranda issued after October31, 1976;(9) Actions on decisions and general counsel memoranda issued after March12, 1981 (as well as general counsel memoranda published in pre-1955 volumesof the Cumulative Bulletin); and(10) Internal Revenue Service information or press releases; and notices, announcementsand other administrative pronouncements published by theService in the Internal Revenue Bulletin.Conclusions reached in treatises, legal periodicals, legal opinions or opinionsrendered by tax professionals are not authority.4-75ExampleThe instructions to an item on a tax form published by the InternalRevenue Service are incorrect and are clearly contraryto the regulations. Before the return is prepared, the InternalRevenue Service publishes an announcement acknowledgingthe error and providing the correct instruction. Under thesefacts, a position taken on a return that is consistent with theregulations satisfies the realistic possibility standard. On theother hand, a position taken on a return that is consistent withthe incorrect instructions does not satisfy the realistic possibilitystandard. However, if the preparer relied on the incorrectinstructions and was not aware of the announcement or theregulations, the reasonable cause and good faith exceptionmay apply depending on all facts and circumstances (seeReg. §1.6694-2(d)).

Adequate DisclosureThe penalty will not be imposed on a preparer if the position taken is not frivolous29

and is adequately disclosed. The regulations provide two different sets ofrules for signing and nonsigning preparers.In the case of a signing preparer, disclosure of a position that does not satisfy therealistic possibility standard is adequate only if the disclosure is made on a properlycompleted and filed Form 8275 or 8275-R, as appropriate, or on the returnin accordance with an annual revenue procedure.

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Since the nonsigning preparers ordinarily have no control over a return or refundclaim, the regulations allow nonsigning preparers to make adequate disclosureby advising the taxpayer or another preparer that disclosure is necessary(Reg. §1.6694-2(c)).Note: A “nonsigning preparer” is any preparer who is not a signing preparer.Examples of nonsigning preparers are preparers who provide advice (writtenor oral) to a taxpayer or to a preparer who is not associated with the samefirm as the preparer who provides the advice. Where there are two or moreindividuals in the same firm who could be regarded as nonsigning preparers,it is the individual with overall supervisory responsibility for the advice givenby the firm who is the nonsigning preparer (Reg. §1.6694-1(b))

Form 8275-RThe final regulations add that in the case of a position contrary to regulations,the penalty can be avoided only if the position represents a good faith challengeto the validity of the regulations (Reg. §1.6662-3(c)). New Form 8275-R, Regula-29 A frivolous position is one that is patently improper.4-76tion Disclosure Statement (July 1992), must be used to disclose items or positionson a tax return that are contrary to regulations (Ann. 92-120).

Statute of Limitations for AssessmentsThree Year Assessment PeriodsAll taxes must be assessed within three years after the return was filed or its duedate, if later. For returns that are filed late, the assessment period starts the dayafter the return is actually filed. If an amended return is filed, within 60 days ofthe end of the statutory assessment period the IRS has 60 days from the date ofreceipt which to assess additional taxes.Six Year Assessment PeriodIf there is an omission from gross income which is over 25% of the income reportedon the tax return then the assessment period is extended to six years. Thisdoes not include amounts where adequate information is provided on the returnor attached statements.No Statute Of LimitationsThere is no statute of limitations on assessments when:(a) Taxpayer does not file a return,

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(b) Taxpayer files a fraudulent return with intent to evade taxes, or(c) Taxpayer doesn’t furnish information or a property transfer in a tax-freeexchange.Extension of Statute Of LimitationsBoth parties can agree to extend the statute of limitations prior to the expirationof the assessment period by signing a completed Form 872.

Examination of ReturnsThe IRS may examine a taxpayer’s return for any of various reasons and the examinationmay take place in any one of several ways. After the examination, ifthe IRS proposes any changes to tax, the taxpayer may either agree with thosechanges and pay any additional tax, or may disagree with the changes and appealthe decision.4-77How Returns Are SelectedThe IRS selects returns for examination by several methods. A computer programcalled the Discriminant Function System (DIF) selects most returns. Thismethod scores each return for potential error based upon past experience. IRSpersonnel then screen the returns and select those most likely to have mistakes.The IRS also selects returns by examining claims for credit or refund and bymatching information documents, such as Forms W-2 and 1099, with returns.Arranging the ExaminationMany examinations are handled by mail. However, if the IRS notifies the taxpayerthat the examination is to be conducted through a personal interview, or ifthe taxpayer requests an interview, the taxpayer has the right to ask that the examinationtake place at a reasonable time and place. However, the IRS has thefinal determination on how, when, and where an examination takes place.TransfersGenerally, an individual return is examined in the IRS office nearest the taxpayer’shome. However, not all offices have examination facilities. Businessreturns are examined where the books and records are maintained. If theplace of examination is not convenient, the taxpayer may ask to have the examinationdone in another office or transferred.RepresentationThroughout the examination, the taxpayers may represent themselves, have

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someone else accompany them, or, with proper written authorization, havesomeone represent them in their absence. If a taxpayer wants to consult anattorney, an enrolled agent, a CPA, or any other person permitted to representa taxpayer during an examination, the IRS will stop and reschedule theinterview. However, the IRS will not suspend the interview if the taxpayer isthere because of an administrative summons.RecordingsAn audio recording can generally be made of an interview with an IRS Examinationofficer. The request to record the interview should be made inwriting. The taxpayer must notify the IRS at least 10 days before the meetingand bring recording equipment. The IRS also can record an interview. If theIRS initiates the recording, they will notify the taxpayer 10 days before themeeting, and the taxpayer can get a copy of the recording at their expense.4-78Repeat ExaminationsIRS policy is not to examine an individual’s tax return if the taxpayer has beenexamined for the same issue(s) in either of the two preceding years and the auditresulted in no or a small change in tax.Note: This policy does not apply to business returns or individual returnsthat include a Schedule C (Profit or Loss from Business) or Schedule F(Farm Income and Expenses).If a taxpayer receives a notice of an audit in which the IRS is questioning thesame item(s) as on a previously audited return, they should call the agent whosename appears on the notice and inform him or her that the IRS audited thesame issue(s) in one of the two prior years with little or no change in tax.Changes to ReturnIf the IRS proposes any changes to the taxpayer’s return, they will explain thereasons for the changes. If the taxpayer agrees with the proposed changes, theymay sign an agreement form and pay any additional tax owed. A taxpayer mustpay interest on any additional tax. If the taxpayer pays when they sign theagreement, the interest is generally figured from the due date of the return tothe date the taxes were paid.If the taxpayer does not pay the additional tax when they sign the agreement,they will receive a bill. The interest on the additional tax is generally figuredfrom the due date of the return to the billing date. However, the taxpayer will

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not be billed for more than 30 days additional interest, even if the bill is delayed.Note: If the taxpayer is due a refund, they will be paid interest on the refund.

Appealing Examination FindingsIf the taxpayer does not agree with the examiner’s report, they may meet withthe examiner’s supervisor to discuss the case further. If the taxpayer still does notagree after receiving the examiner’s findings, they have the right to appeal them.The examiner will explain appeal rights and give the taxpayer a copy of Publication5, Appeal Rights and Preparation of Protests for Unagreed Cases, explainingappeal rights in detail.Appeals OfficeA taxpayer can appeal the findings of an examination within the IRS throughthe Appeals Office. The Appeals Office is independent of the examiner andIRS District Director or Service Center Director. Often differences can besettled through this appeals system without expensive and time-consumingcourt trials. If the matter cannot be settled in Appeals, the taxpayer can taketheir case to court.4-79Appeals to the CourtsDepending on whether the taxpayer first pays the disputed tax, the taxpayercan take their case to:(1) The U.S. Tax Court,Note: If the taxpayer did not yet pay the additional tax and disagrees aboutwhether they owe it, a taxpayer must take their case to the Tax Court. TheIRS will mail a formal notice (called a “notice of deficiency”) telling the taxpayerthat they owe additional tax. Thereafter, the taxpayer ordinarily has 90days to file a petition with the Tax Court.(2) The U.S. Court of Federal Claims, or(3) The U.S. District Court.Note: If the taxpayer has already paid the disputed tax in full and filed aclaim for refund for it that the IRS disallowed (or on which the Service didnot take action within 6 months), they may take their case to the U.S. DistrictCourt or U.S. Court of Federal Claims.These courts are entirely independent of the IRS. However, the Appeals Officegenerally reviews a U.S. Tax Court case before the Tax Court hears it.Note: Taxpayers can represent themselves or have someone admitted topractice before the court represent them.Court DecisionsThe IRS must follow Supreme Court decisions. However, the IRS canlose cases in other courts involving taxpayers with the same issue and stillapply their interpretation of the law.Recovering Litigation ExpensesIf the court agrees with the taxpayer on most issues, and finds the IRS’s

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position to be largely unjustified, the taxpayer may be able to recoversome of their litigation expenses from the IRS. However, to do this, thetaxpayer must have used up all administrative procedures within the IRS,including going through the Appeals system.Other RemediesIf the taxpayer believes that tax, penalty, or interest was unjustly charged, theyhave rights that may remedy the situation.Claims for RefundOnce a taxpayer has paid their tax, they have the right to file a claim for acredit or refund if they believe the tax is too much.4-80Cancellation of PenaltiesA taxpayer may ask that certain penalties (but not interest) be canceled(abated) if they can show reasonable cause for the failure that led to the penalty(or can show that they exercised due diligence, if that is the standard forthe penalty).If the taxpayer relied on wrong advice given by IRS employees on the tollfreetelephone system, the IRS will cancel certain penalties that may result,but the taxpayer must show that their reliance on the advice was reasonable.Reduction of InterestIf an IRS error caused a delay in a taxpayer’s case, and this is grossly unfair,they may be entitled to a reduction of the interest that would otherwise bedue. Only delays caused by procedural or mechanical acts that do not involveexercising judgment or discretion qualify.

Review QuestionsUnder NASBA-AICPA self study standards, self study sponsors are required topresent review questions intermittently throughout each self-study course. Thefollowing questions are designed to meet those requirements and increase thebenefit of the materials. However, they do not have to be completed to receiveany credit you may be seeking with regards to the text. Nevertheless, they mayhelp you to prepare for any final exam.Short explanations for both correct and incorrect answers are given after the listof questions. We recommend that you answer each of the following questionsand then compare your answers. For more detailed explanations and reference,

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you may do an electronic search using Ctrl+F (if you are viewing this course oncomputer), consult the text Index, or review the general Glossary.198. TD 8381 provides final regulations for three areas of the accuracyrelatedpenalty. Which area of the penalty is excluded from this regulatorycoverage?a. a substantial (or gross) valuation misstatement.b. a substantial understatement of estate and gift tax valuation.c. a substantial understatement of income tax.d. negligence or disregard of rules or regulations.4-81199. To ascertain whether a taxpayer’s position on a tax return fulfills the realisticpossibility standard, the IRS will consider at least ten authorities.Which of the following qualifies as authority to be considered for these purposes?a. conclusions reached in treatises.b. legal opinions subsequent to March 12, 1981.c. private letter rulings issued subsequent to October 31, 1976.d. tax professionals’ opinions.200. If a taxpayer disagrees with the findings of an IRS examination, he mayappeal the findings. Where must the taxpayer go to appeal the findings if theadditional tax is unpaid?a. the Appeals Office.b. the Tax Court.c. the U.S. Court of Federal Claims.d. the U.S. District Court.

Answers & Explanations198. TD 8381 provides final regulations for three areas of the accuracy-relatedpenalty. Which area of the penalty is excluded from this regulatory coverage?a. Incorrect. The regulations provide for only two methods of disclosure inorder for items to be treated as though they were properly shown on the returnfor purposes of the substantial understatement penalty.b. Correct. The 1991 final regulations provide rules only for the first threecomponents of the accuracy-related penalty. This component remains thesame. The penalty is 20% of the transfer tax that would have been due hadthe correct valuation been used on Form 706 (estate) or Form 709 (gifts).The penalty only applies if the value of the property claimed on the return is50% or less of the amount determined to be correct. The threshold amountfor the penalty to apply is transfer tax liability in excess of $5,000.c. Incorrect. Final regulations are provided for substantial understatements

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of income tax. It provides a loophole for certain taxpayers.d. Incorrect. Section 1.6662-3 of the regulations provides rules for the penaltyfor negligence or disregard of rules or regulations. This penalty applies if anyportion of an underpayment of tax required to be shown on a return for ayear is attributable to negligence or disregard of rules or regulations. [Chp. 4]4-82199. To ascertain whether a taxpayer’s position on a tax return fulfills the realisticpossibility standard, the IRS will consider at least ten authorities. Whichof the following qualifies as authority to be considered for these purposes?a. Incorrect. Conclusions reached in treatises are not authority in determiningwhether a position satisfies the realistic possibility standard.b. Incorrect. Legal opinions are not authority in determining whether a positionsatisfies the realistic possibility standard.c. Correct. Private letter rulings and technical advice memoranda issued afterOctober 31, 1976, are considered authorities in determining whether a positionsatisfies the realistic possibility standard.d. Incorrect. Opinions rendered by tax professionals are not authority in determiningwhether a position satisfies the realistic possibility standard. [Chp.4]200. If a taxpayer disagrees with the findings of an IRS examination, he mayappeal the findings. Where must the taxpayer go to appeal the findings ifthe additional tax is unpaid?a. Incorrect. The courts are entirely independent of the IRS. However, theAppeals Office generally reviews a U.S. Tax Court case before the Tax Courthears it.b. Correct. If the taxpayer did not yet pay the additional tax and disagreesabout whether they owe it, a taxpayer must take their case to the Tax Court.The IRS will mail a formal notice (called a “notice of deficiency”) telling thetaxpayer that they owe additional tax. Thereafter, the taxpayer ordinarily has90 days to file a petition with the Tax Court.c. Incorrect. If the taxpayer has already paid the disputed tax in full and fileda claim for refund for it that the IRS disallowed (or on which the Service didnot take action within 6 months), they may take their case to the U.S. Courtof Federal Claims.d. Incorrect. If the taxpayer has already paid the disputed tax in full and fileda claim for refund for it that the IRS disallowed (or on which the Service didnot take action within 6 months), they may take their case to the U.S. District

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Court. [Chp. 4]4-83sGlossaryAdjusted gross income (AGI): Total income reduced by allowable adjustments,such as for an IRA, student loan interest, alimony and Keogh deductions. TheAGI is important in determining whether various tax benefits are phased out.Alternative minimum tax: A tax triggered when certain tax benefits reduce regularincome tax below a certain threshold.Annuity: An annual payment of money by a company or individual to a personcalled an annuitant.Bankruptcy: Typically, a formal petition filed in Bankruptcy Court under Chapter7, 11 or 13.Capital asset: Property listed in §1221.Community property: Property or income of a married couple, living in a communityproperty state, which is considered to belong equally to each spouse.Deferred compensation: Funds held by an employer or put into an account fordistribution to the employee at a later date. Deferred compensation is normallytaxed when received or upon the removal of certain conditions.Earned income: Income from personal services as compared to income generatedfrom property or other sources. It includes wages, salaries, tips, and selfemploymentearnings.Expensing: A reference to §179 expense deduction.FIFO: An acronym for "first in, first-out."Filing status: Determines the rate at which income is taxed. The five filingstatuses are: single, married filing a joint return, married filing a separate return,head of household, and qualifying widow(er) with dependent child.Foreclosure: A legal procedure upon the fault on a mortgage to invest title in themortgagee.Gross income: Money, goods, services, and property a person receives that mustbe reported on a tax return. Includes unemployment compensation and certainscholarships. It does not include welfare benefits and nontaxable Social Securitybenefits.

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Head of household: Head of household is a federal income tax filing status availableto unmarried taxpayers that can claim a dependent as a "qualifying child" orqualifying relative."Improvement: Expenditure for the correction of the defect in property that extendsits useful life or improves its value. Unlike some repairs, improvementscannot be deducted by the taxpayer.Individual retirement arrangement (IRA): A type of individual retirement arrangementusing a funding arrangement of a trust or a custodial account.4-84Keogh plans: A form of qualified pension or profit-sharing plan for selfemployedindividuals.LIFO: An acronym for "last in, first-out."Like kind exchange: a reciprocal transfer of property without the substantial interjectionof cash.MACRS: An acronym for "Modified Accelerator Cost Recovery System."Net operating loss: A business loss that exceeds current income and may be carriedback against income of prior years or carryforward as a deduction againstfuture income.OCONUS: Acronym for "outside the continental United States."Passive activity: An activity for which the taxpayer does not materially participate.Placed in service: When property is available for use.Qualified child: A qualifying child meets the relationship, age, and residencytests. A person can be claimed as a qualifying child on one tax return only.QDRO: Acronym for “qualified domestic relations order.”Recapture: The forced recovery of depreciation taken as ordinary income.Repossession: The taking back of property by a lender from a borrower or buyer.S corporation: A particular type of corporation established under the Code thatis taxed like but not as a partnership.Standard deduction: Reduces the income subject to tax and varies depending onfiling status, age, blindness, and dependency.Tangible assets: Equipment, buildings and other physical assets which are not intangible.Tax year: The calendar, fiscal, or hybrid year adopted by the taxpayer or requiredby tax law for determining annual income.

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Unemployment compensation: Funds received under federal or state law tocompensate for unemployment. Unemployment compensation is now taxable.Unrelated business taxable income: Non-exempt income of an exempt organization.Vested benefits: Retirement plan benefits owned by the taxpayer.Working condition fringe benefit: A working-condition fringe benefit is anyproperty or service provided to an employee by an employer to the extent thatthe cost of such property or service would have been deductible by the employeeas a business expense.aIndex of Keywords & Phases110-year averaging, 4-30

550% limit, 2-31, 2-47, 2-49, 2-69, 2-71, 2-745-year averaging, 3-85, 3-115, 3-117

Aabandonment, 3-97, 4-12abatement, 4-37accelerated death benefits, 1-107accelerated depreciation, 1-59, 2-132, 2-133, 2-156, 4-45accident and health insurance, 2-98, 2-99accident and health plan, 1-107, 2-98account statement, 1-116accountable plan, 1-138, 2-57, 2-59, 2-60, 2-64, 2-65,2-71, 2-72, 2-74, 2-75accounting methods, 1-21, 2-111, 2-114accounting periods, 2-112accrual method, 1-121, 2-5, 2-6, 2-110, 2-111accrued interest, 1-90accuracy related penalties, 4-69acquired property, 3-43, 3-47acquisition debt, 1-85, 1-87acquisition indebtedness, 1-50, 1-84, 1-85, 1-86, 1-87ACRS, xi, xii, 2-90, 2-130, 2-131, 2-134, 2-142, 2-143, 2-144, 2-145, 2-146, 2-147, 2-148, 2-156, 3-5,4-45action on decision, 1-89, 4-70active participation, 4-40activity not for profit, 2-14actual cost method, 2-68, 2-91additional depreciation, 2-133additional first-year depreciation, 2-133, 2-134, 2-135adequate accounting, 2-47, 2-57, 2-66, 2-73adequate disclosure, 4-75adequate records, 2-53, 2-55, 2-56adjusted basis, 1-34, 1-42, 1-48, 1-49, 1-112, 1-131, 1-132, 2-83, 2-124, 2-128, 2-129, 2-132, 2-134, 2-149, 3-17, 3-18, 3-27, 3-29, 3-30, 3-32, 3-46, 3-54,

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3-60, 3-66, 4-14, 4-15, 4-17, 4-18, 4-44adjusted current earnings, 4-41adjusted gross income, 1-2, 1-14, 1-35, 1-36, 1-57, 1-62, 1-64, 1-65, 1-76, 1-77, 1-83, 1-103, 1-108, 1-109, 1-110, 1-123, 1-131, 1-133, 1-142, 1-145, 1-146, 1-147, 1-153, 1-154, 1-156, 2-58, 2-74, 3-129adjustments to basis, 2-132administrative fees, 3-125administrative summons, 4-77administrator, 3-87, 3-139adoption credit, 1-147, 1-148adoption expenses, 1-147, 1-148ADS, xx, 2-135, 2-149, 4-33, 4-34, 4-36, 4-42advance rent, 1-34affiliated group, 4-42agents, 2-47, 4-55, 4-56, 4-58AGI, xviii, 1-2, 1-6, 1-7, 1-37, 1-64, 1-76, 1-77, 1-78,1-81, 1-102, 1-103, 1-106, 1-133, 1-142, 1-151, 1-155, 2-17, 2-58, 2-59, 2-91, 2-98, 3-129, 3-130, 3-149, 3-151, 3-152, 3-153, 3-154, 4-32, 4-33, 4-83aliens, 3-156alimony, 1-1, 1-2, 1-37, 1-38, 3-106, 4-83alimony paid, 1-38alimony received, 1-1allowed or allowable, 3-76alter ego, 4-16alternative depreciation system, 2-133, 2-135, 2-149,2-156, 2-157, 4-35, 4-42alternative minimum tax, 1-6, 1-13, 1-58, 1-59, 1-62,1-82, 1-83, 1-87, 1-103, 1-147, 1-152, 1-156, 2-133, 2-134, 2-157, 4-28, 4-29, 4-30, 4-34, 4-35, 4-37, 4-38, 4-39, 4-40, 4-47alternative valuation, 3-3amended returns, 1-16, 4-68amortization, 2-7, 2-8, 2-15, 2-157, 4-35amount at risk, 3-54, 3-55amount realized, 1-48, 1-49, 1-88, 1-125, 3-14, 3-15,3-47, 3-60AMT, i, iii, vi, xviii, xix, 1-6, 1-58, 1-59, 1-87, 1-152,2-23, 4-1, 4-28, 4-29, 4-30, 4-31, 4-32, 4-33, 4-34,4-35, 4-36, 4-37, 4-38, 4-40, 4-42, 4-46, 4-47, 4-48

bAMTI, 4-29, 4-32, 4-35, 4-36, 4-41, 4-42, 4-43, 4-44annual addition, 3-104annual lease value method, 2-104annuity, 1-1, 1-76, 1-134, 3-84, 3-96, 3-106, 3-113, 3-119, 3-125, 3-126, 3-129, 3-132, 3-140, 3-141, 3-143, 3-146, 3-148, 3-149, 3-151, 3-157annuity contract, 3-96, 3-113, 3-125, 3-126, 3-132, 3-141, 3-143annuity starting date, 3-106annulment, 1-16Appeals Office, xxi, 4-78, 4-79appraisal fees, 1-88, 3-44appreciated inventory, 4-61Armed Forces, 1-80assessment period, 4-76assessments, 1-111, 1-125, 3-6, 4-76asset depreciation range, 4-33assignment of income, 1-6athletic events, 1-111at-risk rules, 3-54

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attribution, 3-15, 4-13attribution rules, 3-15, 4-13audit, 2-56, 4-78auto expenses, 1-115, 2-58, 2-91averaging, 3-7, 3-120awards, 1-38, 2-97away from home, 1-101, 1-106, 1-115, 2-3, 2-21, 2-27, 2-28, 2-29, 2-30, 2-31, 2-32, 2-35, 2-37, 2-54,2-55, 2-65, 2-67, 2-69, 2-75, 2-79

Bback pay, 3-99backup withholding, 1-51, 1-52, 1-61bad debts, 1-55bankruptcy, 1-46, 1-49, 3-84barter, 1-50, 1-51, 1-52, 3-64barter exchange, 1-51, 1-52base amount, 1-7, 1-34, 4-32basis reduction, 2-156beneficiary country, 2-37bonus depreciation, 2-83, 2-84, 2-132, 2-133, 2-135,2-136, 2-149, 2-151bonuses, 1-13, 1-33, 1-38, 2-2, 2-8, 2-122, 3-119boot, 3-60, 3-61, 3-62, 3-63, 3-76, 3-77, 4-16business connection, 2-64business expenses, 1-77, 2-19, 2-36, 2-58, 2-59, 2-65,2-66, 2-74, 2-79, 3-132business gifts, 1-68, 2-55business interest, 1-82business premises, 2-47, 2-57, 2-99, 2-102business purpose, 1-98, 2-37, 2-47, 2-48, 2-66, 2-68,2-80, 2-81, 2-82, 2-91, 2-106, 2-121, 2-122, 2-128business transportation, 2-82

CC corporation, 2-111, 2-122calendar year, 1-14, 1-79, 1-80, 1-152, 1-154, 2-4, 2-6,2-7, 2-70, 2-71, 2-83, 2-119, 2-120, 2-121, 2-122,2-123, 2-151, 3-115, 3-117, 3-131, 3-134, 3-135, 3-142, 3-151, 3-156, 3-158, 3-159, 3-161California, 1-102, 3-4, 4-58canceled check, 1-116, 2-55, 2-66cancellation of indebtedness, 1-49candidate for a degree, 1-65capital account, 1-93capital appreciation, 3-125capital asset, 1-6, 3-2, 4-18capital contribution, 4-43capital expenditure, 1-106, 2-3, 2-123capital expenses, 1-99capital gain distributions, 1-40, 1-41capital gains, 1-1, 1-2, 1-6, 1-39, 1-40, 1-59, 1-62, 1-131, 2-134, 2-156, 3-3, 3-115, 3-117, 4-1, 4-28capital interest, 1-153, 3-89capital losses, 1-47, 1-62, 4-1capitalization, 2-112carrying charge, 4-42carryovers, 1-47cash boot, 3-61, 3-63cash equivalent, 3-74, 3-75cash method, 1-88, 2-5, 2-110, 2-111cash or deferred arrangement, 2-100cash reporting, 4-59, 4-60

525

casualties, 1-132casualty, 1-7, 1-62, 1-77, 1-130, 1-131, 1-132, 2-19, 2-56, 4-73cents per mile method, 2-104certified historic structure, 1-113

ccertified pollution control facility, 4-36change in accounting method, 2-119charitable contributions, 1-2, 1-108, 1-109, 1-110, 1-111, 1-113, 1-114, 1-115, 1-116, 3-141, 4-68charitable sports event, 2-48charitable travel, 2-91child support, 1-37, 1-38, 3-106child tax credit, 1-2, 1-26, 1-79, 1-151, 1-152children, 1-5, 1-7, 1-8, 1-58, 1-59, 1-61, 1-66, 1-80, 1-107, 1-109, 1-110, 1-144, 1-146, 1-147, 1-151, 1-152, 1-153, 2-17, 3-15church plan, 3-91circulation expenditures, 4-37citizenship, 1-79clean fuel vehicle, 1-76clear business setting, 2-45clergy, 1-156cliff vesting, 3-102closing costs, 2-158closing statement, 4-56clothes, 2-28coins, 3-133collapsible corporation, 1-42collectibles, 3-3, 3-133combat pay, 1-154commissions, 1-13, 1-33, 3-62commodities, 2-125common law, 1-20common stock, 1-43communication, 1-116, 1-118community property, 1-23, 1-75, 3-3, 3-4, 3-106, 4-83commuting expenses, 2-22, 2-79commuting value method, 2-104compensation, 1-13, 1-33, 1-74, 1-75, 1-107, 1-158, 1-159, 2-19, 2-47, 2-48, 2-57, 2-60, 2-68, 2-74, 2-97,2-98, 3-43, 3-80, 3-82, 3-83, 3-91, 3-97, 3-103, 3-104, 3-105, 3-107, 3-108, 3-113, 3-114, 3-115, 3-116, 3-117, 3-127, 3-129, 3-131, 3-132, 3-149, 3-152, 3-153, 3-157, 3-158, 3-158, 3-159, 3-160, 3-161, 3-162, 4-58, 4-83, 4-84completed contract method, 2-112, 4-36computer equipment, 2-131computers, 2-132condemnation, 3-40, 3-41, 3-42, 3-43, 3-44, 3-45, 3-47, 3-48condemnation award, 3-40, 3-42, 3-43, 3-44, 3-45constructive receipt, 3-70, 3-74contingent interest, 3-15contract price, 2-112, 3-14, 3-19, 3-29, 3-63contractors, 2-112, 4-36, 4-57controlled entity, 3-15controlled group, 2-49, 2-124, 3-125, 4-29CONUS, 2-67, 2-69, 2-70convenience of the employer, 2-17, 2-20, 2-21, 2-99conventions, 1-102, 2-37, 2-38, 2-47conversion of partnership, 3-76

526

cooperative apartment, 1-84cooperative housing, 1-89, 4-56corpus, 3-96, 3-139cost basis, 1-119, 1-125, 3-5, 3-66, 3-125, 3-141cost depletion, 2-158, 4-45cost of living, 3-103country clubs, 1-111Coverdell, 1-103credit cards, 1-82credit union, 3-54, 3-105cruise ship, 2-38custodial parent, 1-27custody, 1-60, 1-61

Ddamages, 1-74, 1-107, 1-132, 3-43, 3-44, 3-45day care, 2-17de minimis fringe benefits, 2-103dealer dispositions, 4-36dealers, 1-39, 3-14, 4-36death benefits, 1-69, 3-106, 3-117, 3-141, 4-43debt forgiveness, 1-49debt instrument, 3-7debt instruments, 3-7declining balance method, 2-133, 2-142, 4-35deed of trust, 1-88, 3-17, 3-74deferred annuity, 3-83deferred compensation, 3-80, 3-82, 3-83, 3-86, 3-91,3-149, 3-150deferred exchange, 3-64, 3-66, 3-72, 3-74deferred tax, 3-85, 4-36

ddefined benefit plan, 3-80, 3-83, 3-91, 3-100, 3-103, 3-106, 3-107, 3-108, 3-118, 3-120defined contribution plan, 3-84, 3-89, 3-102, 3-103, 3-104, 3-105, 3-106, 3-107, 3-108, 3-112, 3-114, 3-134, 3-157degree candidate, 1-65delayed exchange, 3-67, 3-70, 3-74, 3-75, 3-76dental expenses, 1-77, 1-103dependency exemption, 1-79, 1-81, 1-151dependency tests, 1-79, 1-80dependent care, 1-2, 1-25, 1-26, 1-79, 1-142, 1-143, 2-100, 2-101, 4-48dependent care credit, 1-26, 1-79, 2-101depreciable property, 1-47, 2-124, 3-15depreciation recapture, 2-130, 2-156, 3-19direct deposit, 3-105direct evidence, 2-56direct rollover, 3-147, 3-148, 3-150disability coverage, 2-100disability insurance, 2-17, 3-91disaster, 1-5, 1-132, 1-155disaster areas, 1-155disaster losses, 1-5, 1-132disease, 1-103, 1-130disqualified person, 3-72, 3-74, 3-75, 3-89, 3-142distance test, 1-135dividend reinvestment plan, 1-39dividends, 1-5, 1-6, 1-39, 1-40, 1-42, 1-61, 1-62, 3-7,3-125, 4-16, 4-42divorce or separation instrument, 1-37, 3-12

527

documentary evidence, 2-56, 2-66domestic conventions, 2-37donations, 1-77, 1-116double taxation, 1-63, 1-75drought, 1-130drugs, 1-104, 1-105dwelling unit, 2-19, 4-36

Eearly retirement, 3-86early withdrawal penalty, 1-62earned income, 1-2, 1-5, 1-6, 1-7, 1-8, 1-21, 1-24, 1-25, 1-26, 1-59, 1-75, 1-79, 1-144, 1-145, 1-146, 1-147, 1-152, 1-154, 2-13, 2-98, 2-101, 3-130, 3-159earned income credit, 1-2, 1-8, 1-21, 1-24, 1-25, 1-26,1-79, 1-144, 1-145, 1-147, 1-152earnings and profits, 1-39, 1-41, 1-42, 3-113, 4-41, 4-42economic performance, 2-6economic recovery payments, 1-154education credits, 1-155education tax credit, 1-2educational expenses, 1-35, 1-63, 1-98, 1-99, 1-101, 1-102, 2-69, 2-100educational savings bonds, 1-64eligible educational institutions, 1-64eligible rollover, 3-147, 3-148, 3-149, 3-150eligible rollover distribution, 3-147, 3-148, 3-149, 3-150eligible student, 1-155emotional distress, 1-74employee achievement award, 2-97employee benefit trust, 3-106employee contributions, 3-89, 3-101, 3-102, 3-104, 3-118, 3-120, 3-125, 3-129employee expenses, 1-133, 2-58employer identification number, 1-52employer-provided educational assistance, 2-100employer-provided vehicle, 2-104enrolled agent, 4-77entertainment expenses, 1-133, 2-27, 2-44, 2-48, 2-54,2-71, 2-74, 4-42entertainment facility, 2-48equitable relief, 1-21, 1-22, 1-23, 1-24ERISA, xv, 3-80, 3-84, 3-86, 3-87, 3-89, 3-96, 3-103,3-106, 3-107, 3-120, 3-125escrow account, 3-19, 3-74estate tax, 1-4, 1-82, 1-121, 1-124, 1-133, 2-6, 3-140,3-141estimated tax, 1-6, 1-14, 1-56, 1-61, 1-121, 1-124, 4-28estimated useful life, 2-90excess contribution, 3-133, 3-158excess depreciation recapture, 2-89excess reimbursement, 2-58, 2-60, 2-65, 2-66, 2-71exchange of partnership interests, 3-76excise tax, 1-1, 1-122, 1-124, 2-92, 3-89, 3-106, 3-115, 3-117, 3-131, 3-134, 3-142, 3-151, 3-158

eexcise taxes, 1-1, 1-124excludable interest, 1-64exclusions, 1-49, 1-63, 1-64, 4-33

528

exclusive benefit of employees, 3-97exemptions, 1-2, 1-25, 1-26, 1-78expense allowance arrangement, 2-59, 2-74expensing deduction, 2-83, 2-89extensions, 1-25, 1-117, 1-119, 2-120, 2-129, 3-48, 3-67, 3-72, 3-82, 3-90, 3-96, 3-115, 3-117, 3-131, 3-152, 3-155, 3-158, 3-161, 4-71, 4-72

Fface value, 1-64, 2-48, 2-49, 3-24, 3-25, 3-30, 3-31failure to file, 3-131, 4-61, 4-71fair market value, 1-33, 1-38, 1-39, 1-46, 1-48, 1-49,1-50, 1-51, 1-68, 1-85, 1-87, 1-108, 1-110, 1-112,1-113, 1-114, 1-118, 1-131, 1-132, 2-8, 2-90, 2-103, 2-104, 2-105, 3-3, 3-5, 3-6, 3-17, 3-24, 3-25,3-26, 3-27, 3-28, 3-33, 3-60, 3-61, 3-63, 3-64, 3-66, 3-73, 3-89, 3-142, 3-143, 3-156, 4-15, 4-37fair rental value, 1-51, 2-5family members, 3-54Family Support Act, ix, 2-58, 2-59farm income, 1-1farming loss, 4-39Federal per diem rate, 2-66, 2-68, 2-70, 2-71fellowships, 1-64, 1-65, 2-100FICA, x, 2-17, 2-59, 2-75, 2-99, 3-132, 4-57, 4-58fiduciary responsibilities, 3-87FIFO, 3-7, 4-83filing status, 1-15, 1-20, 1-21, 1-24, 1-25, 1-26, 1-27,1-29, 1-56, 1-57, 1-64, 1-145, 1-146, 3-153, 4-83,4-84financial accounting, 4-41financial planning, 2-158fines, 4-42fire, 2-56fiscal year, 2-120, 2-121, 2-122, 2-123, 3-115, 3-117,3-158flood, 2-56foreclosure, 1-47, 1-48, 1-49, 3-26foreign earned income, 1-35, 1-75foreign earned income exclusion, 1-35, 1-75foreign income, 1-75foreign tax credit, 1-47, 1-75, 4-30, 4-47foreign taxes, 1-75, 1-121foreign travel, 2-36Form 1040, vi, 1-14, 1-41, 1-50, 1-51, 1-55, 1-56, 1-57, 1-76, 1-108, 1-123, 1-124, 1-130, 1-131, 1-133,1-138, 1-144, 1-156, 1-158, 2-14, 2-58, 2-60, 2-72,2-73, 2-74, 3-64, 3-128, 3-129Form 1040A, 1-57Form 1065, 2-98, 4-61Form 1098, 1-89Form 1099, 1-40, 1-41, 1-42, 1-51, 1-56, 2-58, 2-98,4-55, 4-67, 4-69Form 1099-DIV, 1-40, 1-41, 1-42Form 1099-G, 1-56Form 2106, ix, 2-20, 2-57, 2-58, 2-60, 2-65, 2-69, 2-72, 2-73, 2-74, 2-82, 2-103Form 5305, 3-160Form 706, 4-69Form 709, 4-69Form 8815, 1-64Form 8818, 1-64Form 8824, 3-64

529

Form W-2, 1-105, 1-117, 1-138, 2-58, 2-65, 2-71, 2-72, 2-73, 2-74, 2-99Form W-4, 1-13former passive activity, 1-92forward averaging, 3-115, 3-117foster child, 1-27, 1-29, 1-80, 1-145, 1-151fraud, 4-67fringe benefits, 1-33, 2-97, 2-98, 2-100, 2-102full-time student, 1-5, 1-80fully taxable disposition, 4-12, 4-13, 4-14, 4-18FUTA, 2-59, 2-75, 3-132, 4-57, 4-58

Ggain or loss on repossession, 3-25, 3-26gambling losses, 1-111, 4-33gambling winnings, 1-13, 1-133garnishment, 3-105gas guzzler tax, 2-92general business credit, 1-47, 2-23, 2-24gift tax, 1-1, 1-108, 1-124, 3-5, 4-66gold, 1-69, 2-80, 3-133golden parachute payments, 4-42

fgoodwill, 1-68, 2-45, 2-47, 4-61grandparents, 1-153grantor trust, 4-14grants, 3-41gross estate, 3-141gross income, 1-2, 1-5, 1-14, 1-25, 1-32, 1-33, 1-34, 1-35, 1-46, 1-47, 1-50, 1-61, 1-63, 1-64, 1-65, 1-66,1-68, 1-70, 1-75, 1-76, 1-79, 1-83, 1-115, 1-124, 1-132, 1-142, 1-143, 1-145, 1-147, 1-148, 1-154, 1-157, 1-159, 2-15, 2-19, 2-48, 2-89, 2-90, 2-97, 2-98, 2-99, 2-100, 2-101, 2-112, 2-158, 3-11, 3-13, 3-83, 3-115, 3-129, 3-131, 3-139, 3-140, 3-141, 3-143, 3-149, 3-154, 3-155, 3-158, 4-3, 4-6, 4-24, 4-38, 4-76, 4-83gross profit percentage, 2-102, 3-25, 3-26, 3-29, 3-31,4-15gross profit ratio, 3-14gross vehicle weight, 1-122, 2-92group life insurance, 2-97guaranteed payment, 2-98guarantees, 3-90, 3-107

Hhalf-year convention, 2-83hardship withdrawal, 3-84head of household, 1-1, 1-15, 1-16, 1-21, 1-24, 1-25,1-26, 1-27, 1-28, 1-34, 1-79, 1-152, 3-129, 3-152,4-30, 4-83health insurance, 1-1, 1-107, 2-14, 2-98health insurance credit, 2-98health savings account, 2-100higher education expenses, 1-25, 1-63, 1-64, 1-102highly compensated employees, 2-47, 2-100, 2-101, 2-102, 3-80, 3-91, 3-97, 3-98, 3-99, 3-100, 3-103, 3-156, 3-158hobbies, 2-14holding period, 3-3, 3-4, 3-31home equity debt, 1-87home equity indebtedness, 1-84, 1-85home improvements, 1-86

530

home mortgage interest, 1-2, 1-77, 2-18home office, 2-17, 2-18, 2-20, 2-21, 2-22home office expense, 2-18, 2-20homebuyer credit, 1-152, 1-153housing allowance, 1-156

Iidentifiable event, 1-130identification numbers, 4-56improvements, 1-86, 1-121, 1-125, 2-1, 2-2, 2-8, 2-9,2-132, 2-149, 2-150, 2-156, 3-5, 3-6, 3-31, 3-45, 3-73, 4-43, 4-83incentive stock options, 4-37income averaging, 3-85, 3-120income in respect of a decedent, 1-124, 1-133, 3-140,3-141indefinite assignment, 2-30individual retirement arrangements, 3-156information return, 4-56, 4-58, 4-67, 4-69, 4-71inherited IRA, 3-140, 3-150innocent spouse, 1-21, 1-22, 1-24insolvency, 1-46, 1-49, 4-38, 4-40installment sale basis, 3-17installment sales, 2-18, 4-60insurance premiums, 1-105intangible drilling, 4-45intangible drilling costs, 4-45interest allocation, 1-90interest expense, 1-81, 1-82, 1-83, 1-90, 4-5, 4-32interest income, 1-25, 1-39, 1-55, 1-61, 1-62, 1-69, 1-70, 4-6, 4-9, 4-42, 4-46Internet, 1-3, 1-5intestate succession, 1-66investment company, 1-40investment income, 1-5, 1-8, 1-40, 1-59, 1-60, 1-61, 1-62, 1-63, 1-83, 3-84, 4-32investment interest, 1-7, 1-77, 1-81, 1-83, 1-90, 1-91,4-32investment purpose, 1-102, 3-132investment tax credit, 2-23, 2-88, 2-89involuntary conversion, 3-40IRA, v, xvii, xviii, 1-62, 1-108, 1-115, 3-84, 3-85, 3-89, 3-120, 3-121, 3-126, 3-129, 3-130, 3-131, 3-132, 3-133, 3-134, 3-135, 3-138, 3-139, 3-140, 3-141, 3-142, 3-143, 3-146, 3-147, 3-148, 3-149, 3-150, 3-151, 3-152, 3-153, 3-154, 3-155, 3-156, 3-157, 3-158, 3-159, 3-160, 3-161, 4-83irrevocable trust, 3-17

gitemized deduction recoveries, 1-55itemized deductions, 1-2, 1-7, 1-25, 1-26, 1-55, 1-56,1-57, 1-60, 1-62, 1-65, 1-76, 1-77, 1-78, 1-83, 1-109, 1-131, 1-133, 2-58, 2-59, 2-74, 2-80, 4-28, 4-31, 4-33

Jjewelry, 1-111joint and survivor annuity, 3-133joint returns, 1-8, 1-21, 1-35, 1-144, 1-151

KKeogh plans, 3-85, 3-124, 3-126, 4-84key employees, 3-83, 3-115, 3-117, 3-158

531

kiddie tax, 1-6, 1-59

Lleasehold improvements, 2-157leases, 2-6, 2-8, 3-1, 4-20legal expenses, 1-134, 3-44legal fees, 2-158, 3-28, 3-29legally separated, 1-15, 1-20, 1-21, 1-23, 1-24legislative history, 3-67letter of credit, 3-74life annuity, 3-104life expectancy, 1-70, 3-115, 3-117, 3-131, 3-133, 3-134, 3-137, 3-138, 3-151, 3-158life insurance, 1-27, 1-32, 1-68, 1-107, 3-84, 3-113, 3-117, 3-118, 3-119, 3-121, 3-125, 3-126, 3-132, 3-133, 4-43, 4-44, 4-57LIFO, 4-43, 4-44, 4-84like-kind exchange, 3-64, 4-16like-kind property, 3-19, 3-60, 3-61, 3-63, 3-64, 3-72limitation on itemized deductions, 1-7, 1-78lineal descendent, 2-70listed property, 2-55livestock, 2-125lobbying, 4-60local taxes, 1-77, 1-124, 1-125, 3-105, 4-32local transportation, 1-99, 2-3, 2-18, 2-27lodging, 1-101, 1-102, 1-104, 1-106, 1-115, 1-136, 1-137, 1-158, 2-28, 2-29, 2-31, 2-37, 2-54, 2-55, 2-56, 2-60, 2-66, 2-67, 2-68, 2-69, 2-70, 2-71, 2-99,2-125, 4-57long-term care insurance, 1-105, 1-107, 1-108, 3-84long-term contracts, 2-111low-income housing, 4-30lump sum distribution, 3-129, 4-30

MMACRS, ix, xi, xii, 2-18, 2-83, 2-90, 2-91, 2-130, 2-131, 2-132, 2-133, 2-134, 2-135, 2-137, 2-138, 2-139, 2-140, 2-141, 2-149, 2-152, 2-153, 2-154, 2-155, 2-156, 3-5, 4-33, 4-34, 4-84made available, 1-39, 2-21, 2-57, 2-104, 2-110, 3-88main home, 1-27, 1-28, 1-29, 1-88, 1-89, 1-146, 1-153, 3-13marital deduction, 3-141marital property, 3-106marital status, 1-23married taxpayers, 1-21, 1-24, 1-35, 1-63, 1-151, 1-156material change, 4-23material participation, 4-1, 4-4, 4-6meals and lodging, 1-101, 1-102, 1-104, 1-115, 2-2, 2-29, 2-31, 2-35Medicaid, 1-35medical expenses, 1-2, 1-57, 1-62, 1-105, 1-106, 1-107, 1-108, 1-110, 2-91, 2-98, 3-106, 3-115, 3-117,4-32medical insurance, 1-57, 1-105, 1-108, 2-13, 2-14Medicare, iv, 1-104, 1-105, 2-99mid-quarter convention, 2-83, 2-134mileage allowance, 2-59, 2-73, 2-90military, 1-79, 1-157, 1-158, 2-80minimum vesting, 3-101, 3-102modified adjusted gross income, 1-34, 1-35, 1-36, 1-

532

64, 1-123, 1-147, 1-148, 1-151, 1-152, 1-153, 1-154, 1-155, 1-156, 3-152, 3-153money market funds, 1-39money purchase pension, 3-83, 3-89, 3-91, 3-104, 3-112mortgage boot, 3-61, 3-62, 3-63mortgage revenue bonds, 1-153moving expenses, 1-77, 1-134, 1-135, 1-136, 1-138, 4-33

hmulti-party exchanges, 3-67mutual funds, 1-6, 1-40

Nnegligence, 4-67, 4-69net condemnation award, 3-42, 3-45, 3-46net income, 2-20, 2-23, 4-4, 4-39, 4-41, 4-45net investment income, 1-5, 1-60, 1-61, 1-63, 1-81, 1-83net lease, 4-5net loss, 2-19, 4-4, 4-15, 4-18net operating loss, 1-47, 1-109, 1-110, 2-24, 2-126, 4-42, 4-46, 4-47net proceeds, 2-49, 3-19net worth, 3-90nonaccountable plans, 2-60, 2-74noncustodial parent, 1-27nonrecourse financing, 3-54non-resident aliens, 3-91North American area, 2-37notes, 3-2, 3-56

OOCONUS, 2-67, 2-69, 4-84operating expenses, 2-90options, 1-42, 2-7, 2-8, 2-60, 3-7ordinary and necessary expenses, 1-123, 2-1ordinary dividends, 1-39, 1-41ordinary losses, 1-131, 2-134original basis, 4-13orphan drug credit, 4-48outside earnings, 1-156owner employee, 3-89

Pparking, 1-9, 1-106, 1-115, 1-124, 1-125, 2-48, 2-81,2-82, 2-90passenger vehicles, 2-83passive activity, 1-40, 1-47, 1-59, 1-64, 1-82, 1-84, 1-92, 1-94, 3-54, 4-3, 4-4, 4-5, 4-6, 4-9, 4-12, 4-13,4-14, 4-15, 4-16, 4-17, 4-16, 4-17, 4-18, 4-38, 4-39, 4-40passive activity losses, 1-47, 1-59, 1-64, 4-14, 4-15, 4-16, 4-17, 4-39passive income, 4-6, 4-13, 4-18payments to relatives, 1-143payroll taxes, 1-1, 1-148PBGC, xv, 3-84, 3-90per diem allowance, 2-60, 2-66, 2-68, 2-69, 2-71, 2-72percentage depletion, 2-158, 4-44percentage of completion, 2-111, 2-112, 4-36percentage test, 3-99performing artists, 1-76

533

periodic payment, 3-115, 3-117, 3-150permanent improvements, 1-106, 2-9personal exemptions, 1-62, 1-78, 1-81, 4-33personal interest, 1-82, 1-84, 1-90, 1-91personal pleasure, 1-115, 2-35, 2-36, 2-91personal property, 1-82, 1-113, 1-114, 1-115, 1-123,1-132, 2-102, 2-113, 2-124, 2-131, 2-132, 2-134, 2-150, 2-156, 2-157, 3-5, 3-14, 3-24, 3-25, 3-26, 3-28, 3-56, 3-57, 4-22, 4-33, 4-46personal property tax, 1-123personal service corporation, 2-120, 2-122, 2-123, 4-16, 4-19, 4-38, 4-68personal use, 1-132, 2-82, 2-83, 2-102, 2-103, 2-104,2-134, 2-135, 3-46, 3-57, 3-142physical assets, 4-84placed in service, 2-82, 2-83, 2-84, 2-89, 2-91, 2-104,2-123, 2-124, 2-126, 2-127, 2-128, 2-129, 2-130, 2-131, 2-132, 2-133, 2-134, 2-135, 2-136, 2-138, 2-139, 2-140, 2-141, 2-142, 2-149, 2-150, 2-151, 2-157, 4-33, 4-34, 4-35, 4-36, 4-45plan year, 2-100, 3-98, 3-100, 3-102, 3-103, 3-113, 3-115, 3-117pledge rule, 3-19points, 1-2, 1-39, 1-88, 1-89, 1-93portfolio income, 1-40, 1-83, 4-3, 4-5, 4-6, 4-9, 4-16,4-17preferred stock, 1-39, 1-43premature distribution, 3-147prepaid interest, 1-88, 2-111prepaid rent, 2-111primarily for business, 2-35, 2-36principal place of business, 2-18, 2-19, 2-20, 2-21, 2-22, 2-28, 2-79, 2-81

iprincipal purpose, 1-147principal residence, 1-50, 1-84, 1-88, 1-152, 1-153, 2-18, 3-11, 3-12, 3-13, 3-24, 3-32, 4-56private activity bond, 4-46private foundation, 1-110, 1-113prizes, 1-65, 1-111professional fees, 1-59profit-sharing plans, 3-95prohibited transactions, 3-87, 3-88, 3-142promissory notes, 4-60property boot, 3-61, 3-62property settlement, 3-105property taxes, 1-2, 1-88, 1-121, 2-14, 2-15, 2-18publications, 3-2punitive damages, 1-75

QQDRO, 3-105, 4-84qualified business use, 2-88, 2-89qualified child, 1-28, 1-79qualified deferred compensation, 3-80, 3-82qualified domestic relations order, 3-105, 4-84qualified employee discounts, 2-100qualified farm debt, 1-47, 1-49qualified intermediary, 3-75qualified long-term care insurance, 1-107qualified person, 2-111, 3-54, 3-55qualified relative, 1-79

534

qualified residence interest, 1-84, 1-87, 4-5, 4-32qualified tuition, 1-103, 1-155

Rrailroad retirement benefits, 1-25, 1-35ratio test, 3-99real estate investment trusts, 1-40real estate taxes, 1-121, 2-6, 2-19, 2-20, 3-42real property business debt, 1-47realistic possibility standard, 4-74, 4-75reasonable cause, 3-48, 4-67, 4-68, 4-74, 4-75, 4-80reasonable compensation, 3-88recapture, 1-153, 2-89, 2-130, 2-134, 2-156, 3-17, 4-30, 4-44recharacterization, 3-155, 4-6record-keeping, 2-27recoveries, 1-55, 1-57, 1-58, 1-74refinancing, 1-50, 1-84refundable credit, 1-152refunds, 1-55, 4-32reimbursement of expenses, 2-65reimbursements, 1-55, 1-138, 2-57, 2-58, 2-59, 2-65,2-73, 2-74, 2-75, 3-88REIT, 1-40, 1-41related employer, 3-100related parties, 2-49, 2-124, 3-15related person, 1-153, 2-124, 3-15, 3-54, 3-64relinquished property, 3-72, 3-75remainder interest, 1-113rental activities, 2-3, 2-19rental income, 1-33, 1-51, 2-1, 2-3reorganizations, 3-17replacement period, 3-11, 3-46, 3-47, 3-48replacement property, 3-44, 3-47, 3-48, 3-67, 3-72, 3-73, 3-74, 3-75repossession, 1-47, 1-48, 3-23, 3-24, 3-25, 3-26, 3-27,3-28, 3-29, 3-30, 3-31, 3-32repossession costs, 3-28repossessions of personal property, 3-24repossessions of real property, 3-27, 3-32required minimum distribution, 3-134, 3-135, 3-137,3-138required payment, 2-5required year, 2-122, 2-123research expenses, 2-23residential lots, 3-14, 3-19retirement plans, 3-83, 3-84, 3-85, 3-86, 3-106, 3-129,3-134, 3-149, 3-150, 3-157return of capital, 1-41, 1-42reversionary interest, 1-82rollovers, 3-84, 3-121, 3-135, 3-146, 3-147, 3-148, 3-149, 3-150, 3-161Roth IRA, xviii, 1-115, 3-84, 3-129, 3-131, 3-135, 3-140, 3-142, 3-148, 3-149, 3-151, 3-152, 3-153, 3-154, 3-155, 3-156royalties, 1-1, 1-76, 4-5

jSS corporations, 2-14, 2-98, 2-120, 2-123, 3-54, 3-114,3-157, 4-19, 4-22, 4-28safe harbor, 1-14, 2-65, 3-70, 3-74, 3-84salary reduction, 3-83, 3-132, 3-157, 3-158, 3-159, 3-

535

160, 3-161, 3-162sales tax, 1-122, 1-123, 1-124, 1-125salvage value, 2-142savings bonds, 1-35, 1-63, 1-103scholarships, 1-64, 1-65, 4-83second home, 1-85, 4-32self-charged interest, 4-6, 4-9self-employed persons, 1-135self-employment tax, 1-13, 1-104, 1-123, 2-17, 2-126,2-127, 3-127seller paid points, 1-89selling expenses, 3-29selling price, 3-14, 3-15, 3-19, 3-29, 3-30SEP, xviii, 3-82, 3-151, 3-152, 3-153, 3-156, 3-157, 3-158, 3-158separate liability election, 1-21, 1-22separate maintenance, 1-15, 1-20, 1-32, 1-37separate returns, 1-20, 1-23, 1-24, 1-35, 1-60, 1-80, 1-152, 2-127, 4-28separation from service, 3-80, 3-120service charges, 1-60, 1-124severance damages, 3-42, 3-43, 3-44, 3-45severance pay, 1-33short sale, 1-82, 3-7short-term gain, 3-31SIMPLE, xviii, 3-150, 3-151, 3-152, 3-153, 3-157, 3-159, 3-160, 3-161, 3-162simplified employee pension, 3-104, 3-156, 3-157single taxpayers, 3-11skybox, 2-49sleep or rest rule, 2-31Social Security, i, ii, 1-1, 1-8, 1-34, 1-35, 1-36, 1-64,1-104, 1-105, 1-154, 1-156, 2-99, 3-83, 3-130, 3-157, 4-83Social Security benefits, 1-1, 1-34, 1-35, 1-64, 1-104,3-130, 4-83Social Security tax, 1-104sole proprietorship, 3-124, 3-125sporting events, 2-49, 2-101spousal support, 1-37standard deduction, 1-2, 1-3, 1-4, 1-5, 1-15, 1-21, 1-24, 1-25, 1-26, 1-29, 1-56, 1-57, 1-76, 1-77, 1-121,1-122, 1-132, 4-32standard meal allowance, 2-60, 2-67, 2-68, 2-69, 2-71standard mileage rate, 1-9, 1-101, 1-115, 1-137, 2-3,2-60, 2-82, 2-90, 2-91, 2-104standby letter of credit, 3-74statute of limitations, 1-16, 4-76statutory employees, 4-57statutory exceptions, 2-44, 2-47stepped-up basis, 2-124stock bonus plans, 3-91, 3-95straight line method, 2-149straight-line method, 2-142, 2-149, 4-33, 4-35student loan interest, 4-83student loans, 1-2, 1-47substantial business discussion, 2-45substantial improvement, 1-85, 1-86substantial restriction, 2-102, 3-19substantiation, 1-116, 2-55, 2-56, 2-57, 2-69, 2-70, 2-90substantiation requirements, 1-116, 2-56, 2-57

536

sufficient corroborating evidence, 2-56support test, 1-113suspended losses, 4-4, 4-12, 4-13, 4-14, 4-15, 4-16, 4-17, 4-16, 4-18, 4-23, 4-39, 4-40

Ttangible personal property, 1-114, 2-8, 2-9, 2-124, 2-134, 2-150, 4-35, 4-59tax attributes, 1-47tax benefit rule, 1-57tax credits, 1-2, 1-47, 1-58, 4-1, 4-68tax home, 2-28, 2-29, 2-30, 2-31, 2-35, 2-79tax penalties, 3-120, 4-66tax planning, 1-6, 1-46tax preference items, 4-28, 4-44, 4-46tax preferences, 4-30, 4-42tax refunds, 3-84, 4-43tax returns, 1-15, 1-154, 4-58, 4-68tax shelters, 2-111, 4-68

ktax year, 1-7, 1-8, 1-15, 1-16, 1-20, 1-22, 1-23, 1-24,1-25, 1-27, 1-29, 1-34, 1-51, 1-58, 1-59, 1-61, 1-64, 1-78, 1-79, 1-84, 1-118, 1-121, 1-123, 1-131, 1-146, 2-4, 2-5, 2-13, 2-16, 2-83, 2-84, 2-88, 2-89, 2-110, 2-112, 2-114, 2-120, 2-122, 2-123, 2-126, 2-127, 2-128, 2-129, 2-130, 2-134, 2-135, 3-5, 3-14,3-15, 3-32, 3-47, 3-48, 3-85, 3-97, 3-124, 3-129, 3-140, 3-143, 3-154, 3-161, 4-1, 4-3, 4-6, 4-12, 4-13,4-14, 4-17, 4-18, 4-19, 4-20, 4-22, 4-23, 4-24, 4-33, 4-36, 4-41, 4-46, 4-48taxable event, 3-7, 3-66, 4-12taxable income, 1-2, 1-38, 1-55, 1-57, 1-58, 1-59, 1-60, 1-61, 1-66, 1-142, 1-154, 2-58, 2-59, 2-74, 2-97, 2-122, 2-126, 2-127, 2-129, 2-158, 4-28, 4-29,4-30, 4-31, 4-32, 4-36, 4-38, 4-40, 4-41, 4-42, 4-43, 4-46, 4-47, 4-84taxable year, 1-6, 1-14, 1-28, 1-35, 1-59, 1-84, 1-90,1-102, 1-103, 1-121, 1-122, 1-147, 1-152, 1-153, 1-154, 1-155, 1-156, 2-19, 2-24, 2-110, 2-111, 2-119,2-120, 2-121, 2-122, 2-126, 2-133, 2-134, 2-157, 3-82, 3-96, 3-104, 3-105, 3-112, 3-124, 3-141, 3-150,3-155, 4-6, 4-19, 4-38, 4-39, 4-44tax-exempt income, 1-134tax-exempt interest, 1-35, 1-59tax-free exchanges, 4-15tax-sheltered annuity, 3-140, 3-148, 3-149, 3-150temporary assignment, 2-30tentative minimum tax, 4-30, 4-47, 4-48term life insurance, 1-158, 2-100theft losses, 1-77, 1-131, 3-5threat of condemnation, 3-40, 3-41, 3-42, 3-43, 3-47thrift plan, 3-118ticket purchases, 2-48timeshares, 4-36tips, 1-1, 1-33, 2-28, 2-48, 2-67, 4-83tools, 1-35, 1-133, 2-10, 2-113, 2-114, 2-131, 4-57transportation expenses, 1-101, 2-3, 2-22, 2-79, 2-80,2-81travel advance, 2-65, 2-72travel and transportation, 2-3travel away from home, 2-68, 2-69, 2-70travel expense, 1-102, 1-115, 2-28, 2-29, 2-30, 2-35,

537

2-36, 2-54, 2-60, 2-65, 2-66, 2-68, 2-73, 2-75, 2-81travel expense substantiation, 2-54

Uunderstatement of tax, 1-21, 1-22, 4-68undistributed capital gains, 1-40unemployment compensation, 1-76, 1-108, 3-91, 4-83unforeseen circumstances, 3-12, 3-13uniform capitalization rules, 2-9, 2-113Uniform Gifts to Minors Act, 1-59Uniform Transfers to Minors Act, 1-59universal life insurance, 3-118, 3-119unrealized receivables, 4-61unreasonable compensation, 3-142unrelated business income, 4-28unrelated business taxable income, 4-28unstated interest, 3-14use tax, 1-58, 1-122useful life, 1-86, 2-2, 2-5, 2-142, 2-157, 4-83

Vvacation days, 2-100valuation, 2-119, 4-66, 4-68, 4-69vesting, 3-103Vesting, xvi, 3-101, 3-102

Wwelfare benefits, 4-83working condition fringe, 2-100worthless debts, 2-15worthlessness, 4-13written plan, 2-100, 3-96, 3-115

538