FEDERAL INCOME TAX OUTLINE
A. GENERAL FORMULAS:
1. Gross Income – Certain Deductions = Adjusted Gross Income (AGI)
2. AGI – Personal Exemptions – either Standard or Itemized deduction = Taxable Income
3. Taxable Income X Tax Rate = Tax Liability
4. Tax Liability – Tax Credits = Tax Due (if positive number) or Refund (if negative number)
5. Calculate AMT. If AMT is greater than “tax due,” AMT becomes the amount due.
B. SIX FUNDAMENTAL TAX QUESTIONS:
1. Is it income?
a. Does the particular item fall within the definition of income under §61?
b. Does it fall within any of the statutory exclusions from income?
2. To whom is the income taxable? If a gift has been made, is income shifted to the donee. Consider the following.
a. Was the gift of property or of the income from property?
b. Was the gift of income from services?
c. Did the donor retain excessive controls?
d. If the gift was in trust, is income taxed to the grantor, the beneficiary, or the trust?
3. Is it deductible?
a. Does it qualify as a personal deduction? If so, it must fit within the statutory provisions for interest, charitable contributions, etc.
4. Does a sale of property produce gain or loss?
a. How much was the gain or loss?
1) What was the basis? Are there any adjustments to basis?
2) Was there a realization? If so what was the amount realized?
3) Does the transaction qualify for nonrecognition?
b. Is the asset a capital asset? If so, was there a sale or exchange?
5. Does the alternative minimum (AMT) apply:
a. What is T’s “alternative minimum taxable income?”
b. What is T’s exemption under the AMT?
c. What’s T’s AMT?
d. Is the AMT greater than T’s regular tax.
6. When is the item income or deductible?
a. Does T use the cash method, the accrual method, or the installment method?
b. If the transaction spans several years, should each year be taken separately, or can the entire period be considered?
II. IS IT GROSS INCOME?:
A. COMPENSATION FOR SERVICES:
1. General: cash or property received for services rendered is included in gross income, regardless of the form of such payment.
2. Payment of employee’s income taxes (or any other debts): it is considered additional compensation.
3. Frequent flier miles: aren’t included in income unless the frequent flier miles are turned into cash.
B. INCOME FROM CANCELLATION OF INDEBTEDNESS:
1. General (§108): treated as income unless it falls within several possible exemptions.
2. Exception as to insolvent T: cancellation of debt isn’t taxable if T is insolvent immediately before the cancellation.
a. Insolvency defined: either:
1) Insolvent: liabilities exceed assets.
2) Bankrupcty: T’s debts are discharged in a statutory bankruptcy proceedings.
b. Limitation: exclusion can’t exceed the amount T is insolvent.
c. Definition of assets: includes assets that are exempt from execution under state law (i.e., have to include items like fishing license).
d. Tax benefits: T must reduce certain tax benefits by the amount of the debt cancellation income not recognized which include:
1) Net operating loss carryovers.
2) Disallowed passive loss carryover.
3) Capital loss carryforwards.
4) Note: if these are insufficient to absorb the entire amount of untaxed income, the basis of assets must be reduced in accordance with §1017.
3. Exception for qualified real property business indebtedness: exclude debt cancellation when the debt is secured by real property in trade or business.
a. Acquisition or improvement (debts after 1993): debt must have been incurred in connection with the acquisition or improvement of the real property.
b. Note-basis: basis of all real property owned by T is reduced by the amount of debt cancellation income that was excluded.
c. Limitation: T can’t exclude more than the difference between the debt (before reduction) and the value of the property (reduced by the amount of any other debt to which it is subject).
4. Exception for deductible payments: no income for cancellation of a debt to the extent that payment of the debt would have given rise to a deduction (i.e., like owing money to charitable organization).
5. Cancellation as a gift: creditor’s reduction or cancellation of indebtedness is excluded if it is a gift to the debtor.
a. Note-detached generosity required: unless the creditor and debtor are family, the creditors intent would seldom be “detached generosity” required (i.e., usually just wants to keep debtor in business so he will remain a customer in the future and he can get more $).
6. Student loans: student loans discharged where borrower works for a certain time for certain employers don’t give rise to income.
a. Limitation-lender: lender must be a:
2) Charitable hospital.
3) Educational institution: forgiveness must be pursuant to a program designed to encourage students to serve in occupations or geographic areas with unmet needs.
7. Shareholder debt forgiveness: discharge of a corporate debt by a shareholder:
a. Income of corporation: if a corporation transfers stock in discharge of its debt, it is treated as having satisfied the debt with $ equal to value of the stock.
b. Treatment of shareholder: if shareholder receives stock in exchange for corporate debt, he has gain or loss, unless not recognized section.
c. Contribution to capital: if a shareholder forgives a corporate debt but gets nothing in exchange, the corporation is treated as having satisfied the debt with an amount equal to what shareholder paid for the stock.
8. Reduction in purchase money debt: where for instance, a debt was reduced because of being fraudulently induced, this is treated as a reduction of basis, not a debt cancellation income.
a. Note: debt reduction must come from seller and not third-party lender.
9. Compromise of disputed claim: no in
1) Income levels: $44,000 on joint return and $34,000 on single return.
2. Welfare benefits: excluded from income, even if recipient must work for the government to get payments.
3. Unemployment compensation: is taxable.
H. AWARDS AND SCHOLARSHIPS:
1. Awards and prizes (§74(a)): awards and prizes are taxable to the recipient.
a. Exception-Charitable transfer: a prize isn’t taxable to the recipient if:
1) Achievement: it was received for scientific, educational, or similar achievements and
2) Transfer to charity: recipient orders that it be transferred to charity.
b. Exception-employee achievement awards: isn’t taxable unless it cost the employer more than $400.
2. Scholarships and fellowships (§117): taxable to the recipient except for:
a. Qualified scholarship: amount received as a qualified scholarship is excluded from income if:
1) Tuition: amount can be used only to pay tuition and fees or for required books and supplies.
2) Tax-exempt institution: only degree candidates at tax-exempt educational organizations are entitled to this exclusion.
3) No services: amount received in payment for teaching, research, or other services, required as a condition for the grant, doesn’t qualify.
b. Tuition reduction: tuition reduction plan isn’t taxable income.
1) Limitation-discrimination: plans must not discriminate in favor of highly compensated employees.
2) Limitation-undergraduate: only applies to undergraduate education.
c. Employer provided education assistance plans (§127): employer’s expenditures for educational assistance to employees isn’t included in employee’s gross income.
1) Money limit: educational assistance exclusion is limited to $5,250 per employee.
2) Limitation-graduate assistance: exclusion doesn’t include graduate assistance program classes.
d. Education Accounts (§530): parents can deduct up to $500 per beneficiary per year, but the deduction phases out in an income range starting at $95K and ending at $110K ($150-160K for joint return filed by a married couple).
1) Limits: funds put in the account must be used for higher education tuition and only some room and board.
2) Part-time student: funds can be used for part-time students.
e. Prepaid college tuition plan (§529): allows nondeductible contributions to a tax-exempt fund that pays out in the form of nontaxable prepaid tuition of a designated beneficiary.