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CFP: Income Tax Planning > Chapter 4: Gross Income From Personal & Investment Activities > Flashcards

Chapter 4: Gross Income From Personal & Investment Activities Flashcards

1
Q

Taxable Year

A
  • generally a 12 month period
  • calander year used by most taxpayers
  • fiscal year can be elected if adequate records are maintained
  • 52-53 week year
    • ends on specified day of week of last month of tax year
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2
Q

methods of accounting

cash basis

A
  • recognize income when its received or set aside. (wait until the check is received)
  • recognid deductions when they pay the bill
  • utilized by individuals and some businesses
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3
Q

methods of accounting

accrual basis

A
  • recognize income when it is earned but not yet received
  • most businesses use accrual method
  • businesses with less than 29million a year in the last 3 years dont have to use accrual, can use cash method
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4
Q

methods of accounting

hybrid method

A
  • used when inventory is a material incoem producing factor
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5
Q

Realization vs Recognition

realization

A

occurs when income is received or when a gain on a property trtansaction becomes fixed

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6
Q

realization vs recognition

recognition

A

occurs when the income is reported on the tax return

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7
Q

realized gains

A

all realized gains are recognized, unless an exception applies

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8
Q

recognition of income

follows realization principal from accounting

A

income is recognized (taxed) when realized unless an exception applies

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9
Q

recognition of income

generally, any accretion to wealth is income

A
  • mere appreciation in wealth (economic income) that is not fixed and measurable at a particular point in time is not considered realized income
  • Congress has excluded certain accretions of wealth from the definition of income for tax purposes
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10
Q

recognition of income

income is recognized if received:

A
  • received in cash
  • in kind (property or services)
    • barter services
  • income does not include recovery of capital investment (capital recovery doctrine)
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11
Q

sources of income

Investment Income

A
  • doctrine of the fruit & the tree
    • income taxed to the owner
    • whoever ownd the bond owns the interest income from the bond
    • whoever owns the stock owns the income from the dividends
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12
Q

sources of income

employment income

A
  • doctrine of the fruit & the tree
    • income taxed to earner
    • income may not all be going to the earners pocket, but the earner is getting taxed on it all
  • self-employment income
  • wages
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13
Q

sources of income

income from personal activities

A
  • alimony (pre 2019 divorce)
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14
Q

income tax & community property

income tax & community property

A
  • half of the income earned belongs to each spouse
    • same impact as married filing jointly (MFJ) for income tax
  • married filed separately (MFS)
    • community property income split equally
    • poses a problem if spouses are not cooperating
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15
Q

income from investing activities

income from investment activities

A
  • capital gains
  • interest
    • original issue discount
  • dividend income
  • rental and royalty income
  • annuity distributions
  • income from life insurance and endowment contracts
  • traditional IRA’s
  • income from partnerships, S-Corps, & LLC’s
  • income from Trusts & Estates
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16
Q

income from investment activities

Capital gains exceptions

cap gains tax rate

A
  • collectibles: tax rate of 28% + 3.8%
  • Unrecaptured Section 1250 gain: 25% +3.8%

dont forget to tack on the additional 3.8% Medicare tax imposed by the Affordable Care Act

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17
Q

income from investment activities

effective rate may be more than maximum

cap gains tax rate

A
  • capital gains increase a taxpayers AGI
  • increased AGI may lead to phaseouts
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18
Q

income from investment activities

Original Issue Discount (OID)

A
  • doctrine of constructive receipt
  • taxpayer recognizes imputed interest each year. as interest is recognized:
    • OID is amortized (reduced by the amount recognized)
    • the taxpayers basis increases (by the amo=unt recognized)
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19
Q

income from investment activities

Original Issue Discount (OID) equation

A
  • OID = Maturity value - purchase price
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21
Q

income from investment activities

Original Issue Discount Exceptions

A
  • series E & EE savings bonds
  • or any government bonds that have a maturity less than 1 year
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21
Q

phantom income

A
  • didnt actually receive the cash but have to pay tax on income
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22
Q

income tax issues

income tax issues associated with gifts of debt instruments

A
  • donee and donor report interest income based on # of days the instrument was held, regardless of who receives the payment
  • there may also be gift, estate & generation-skipping transfer tax consequences
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23
Q

income from investment activities

Dividends

A
  • distribution of earnings by corporations
  • taxable to shareholders to extent of earnings
    • if distribution exceeds earnings, its taxed:
      • first as a return of basis
      • then as capital
  • qualified dividends
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24
Q

income from investing activities

qualified dividends

A
  • tax rates
    • follow the capital gains rate table
  • paid by the US corporation or qualified foreign corporation
  • shareholder must meet holding period requirement

dont forget the 3.8% medicar tax imposed by the Affordable Care Act

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25
Q

annuity taxation

annuity

A

is a tax favored investment

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26
Q

annuity taxation

annuity taxation

A
  • for annuity starting dates after 12/31/1986
    • total exlcusion cannot ecveed investment in the contract
    • un-recovered iinvestment is taken as a deduction on the annuitants final income tax return
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27
Q

annuity taxation

exclusion ratio

A

= (investment in the contract/expected return) x distribution received

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28
Q

annuity taxation

annuity taxation

A
  • withdrawls before age 59.5 are also subject to a 10% early distribution penalty
    • exceptions: dealth & disability
  • distributions prior to annuitization are taxed on LIFO basis
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29
Q

income taxation & life insurance

Endowment contracts

A

payout before dealth = taxable income
- if we have a cash basis policy and taking distributions as the decedent, before they die, they are taking the distributions out…this is taxable income

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30
Q

income taxation & life insurance

surrender

A

amount realized - basis = taxable income
- say the cash value (amount realized was 90,000 but they paid 60,000 in premiums) = 30,000 in taxable income theyd want now instead of waiting for say a 500k death benefit when they die

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31
Q

income taxation & life insurance

death benefit (excluded from income) (see exclusions)

if the decedent dies

A
  • ## unless transfer for value rule applies

the death benefit for this beneficiary, the spouse when they receive it, is gonna be excluded from income

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32
Q

income taxation & IRA’s

traditional IRA

A
  • deduction when $ is put in, and taxed when distributed down the road
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33
Q

income taxation & IRA’s

Roth IRA

A
  • no deduction when $ put in, and if you meet the conditions, then the $ comes out tax free
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34
Q

income taxation & IRA’s

Traditional IRA taxation

A
  • generally the $ coming out of a TIRA is ordinary income
  • not all IRA contributions are deductible
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35
Q

income taxation & IRA’s

traditional IRA taxation (exceptions)

A

return of basis
- use exclusion ratio

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36
Q

income taxation & IRA’s

traditional IRA taxation (penalties)

A
  • if you take out distributions too early (early distribution penalty before age of 59.5): its a 10% penalty
  • if you contribute too much (excess contribution penalty): 6% penalty
  • take distrubutions out too late (starty at age 73) (late required distribution): 50% penalty
    • Secure 2.0 Act: tax years after 12/29/22, penalty decreased from 50% to 25% (or 10% if failure corrected timely)
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37
Q

income taxation of business entities

pass-through entities

A
  • partnerships
  • limited liability corporations
  • S-corporations
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38
Q

income taxation of business entities

taxation of pass through entities

A
  • income is taxed to owners based on ownership %
    • depending on the type of business, adjustments may be necessary to calculate the amount of business income subject to tax in the owner’s hands
    • as inome is recognized, owner’s basis increases
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39
Q

5 exceptions to the Transfer-for-Value Rule

A

the death benefit its received income tax free by the beneficiary if the policy is transferred for valuable consideration to:
1. the insured
2. a corporation in which the insured is a shareholder
3. a partnership in which the insured is a partner
4. a partner of the insured
5. a transferee who takes the transferor’s basis

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40
Q

subjecting gross income to taxation: tax year & accounting method

cash receipts & disbursements method

A

cash method
- gross income of a cash method taxpayer is reported in the tax year in whcih cash is received or a benefit is conferred in the form of a cash equivalent

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41
Q

subjecting gross income to taxation: tax year & accounting method

accrual method

A
  • gross income is normally reported when earned rather than when received
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42
Q

subjecting gross income to taxation: tax year & accounting method

hybrid method

A
  • other than the cash or accrual method unless the IRS decides that it does not clearly reflect income
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43
Q

subjecting gross income to taxation

gains normally taxed when realized

A
  • gains from property transactinos are normally taxed when they can be objectively determiend through a sale or exchange
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44
Q

gains normally taxed when realized

realized gain

A

a gain that is objectively determined

45
Q

gains normally taxed when realized

unrealized gain

A
  • those that cannot yet be objectively determined and therefore are not subject to tax until they are objectively determined
46
Q

subjecting gross income to taxation

barter transactions (bartering)

gains normally taxed when realized

A
  • is an exchange of property and or services for other services as opposed to an exchange for cash
  • the value of a good or service received in a barter transaction must be included in gross income
  • the value received can be offset by the cost or other tax basis of goods given up in the transaction
  • when goods or servivces are received by a taxpayer in exchange for services, the services provided by the taxpayer normally have a tax basis of zero
47
Q

types of gross income & exclusions

gains on property are normally taxed upon sale or exchange

A

true

48
Q

gains normally taxed when realized

barter transactions are not reportable for income tax purposes

A

false

49
Q

sources of income

individual taxpayers receive income from: 3 sources of income

A
  1. investments
  2. personal activities
  3. employment & self-employment
50
Q

sources of income

investments generate what type of income

A
  1. dividend income
  2. interest income
  3. gains from the sale of the investments
51
Q

sources of income

investments taxation

A

the taxation of investment income generally follows the Doctrine of the Fruit and the Tree

52
Q

sources of income

personal activities normally generate this type of income

A
  1. receipt of alimony from a former spouse
  2. receipt of prizes and awards
53
Q

sources of income

typically income generated from employment/self-employment

A
  1. wages
  2. salaries
  3. commissions
  4. fringe benefits
  5. other income generated from providing services to an employer
  6. engaging in the conduct of a trade or business generates self-employment income
54
Q

sources of income

investment income

A
  • normally taxable to the owner of the investment
  • the owner of the tree gets taxed on the fruit that the tree produces
55
Q

sources of income

income from personal activities

A
  • gross income generated from personal activities is normally taxable to the recipient
  • it is easier to collect an income tax from the taxpayer who has the cash rather than from the taxpayer who paid the cash
56
Q

sources of income

employment income

A
  • gross income from services provided to an employer or form self employment is normally taxable to the person who performs the services and receives the payment
  • gross income cannot normally be assigned to another person by the person who earns it since it violates the Doctrine of the Fruit & the Tree
57
Q

sources of income

community property

special issues for persons liviing in community property states

A
  • one half of the incime earned by a spouse is deemed to be earned by each spouse and on ehalf of the incie earned from community property is deemed to be the income of each spouse
58
Q

sources of income

section 66 of the IRC provides relief solutions, which are the following:

special issues for persons liviing in community property states

A
  • separated spouse relief
  • innocent spouse relief
  • equitable relief
  • disallowance of community property treatment
59
Q

sources of income

section 66 of the IRC provides relief solutions: what is (separated spouse relief)

special issues for persons liviing in community property states

A
  • for income earned through personal services, community property laws are ignored and each spouse reports his or her own earned income for federal income tax purposes if the married couple lives apart at all times during the year
  • they do not file a joint return with each other, and none of the earned community income is transferred between them during the year
60
Q

sources of income

section 66 of the IRC provides relief solutions: what is (innocent spouse relief)

special issues for persons liviing in community property states

A
  • may be able to exclude that income if the taxpayer does not file a joint return, does not include in gross income an item of community income of the spouse, establishes that the taxpayer did not know of or hae reason to know of that community income, and it is inequitable to inckdue that community income in the taxpayers gross income
61
Q

sources of income

section 66 of the IRC provides relief solutions: what is (equitable relief)

special issues for persons liviing in community property states

A
  • even if the requiremetns for separated spouse relief or innocent spouse relief are not met, the IRS is authorized to allow a taxpayer not to report half of the community income of the taxpayers spouse, if taking into account all of the facts and circumstances, the failure to grant such relief would be “inequitable”
62
Q

sources of income

section 66 of the IRC provides relief solutions: what is (disallowance of community property treatment)

special issues for persons liviing in community property states

A
  • the secratary of the Treasury is given authority in IRC section 66 to disallow benefits of any community property law (splitting of income) to any taxpayer who acts as if they are solely entitled to the community income and who fails to notify their sppouse about the income before the due date (including extensions) for filing a tax return for the year
63
Q

income from investing activities

Capital Gains

investment items Included in Gross Income

A
64
Q

income from investing activities

interest income

investment items included in gross income

A
  • generated by a variety of debt instruments:
    • bank accounts
    • momney market instruments
    • corporate bonds
    • gov agency securities
    • treasury securities
    • municipal bonds
65
Q

income from investing activities

original issue discount bonds (OID)

investments items included in gross income

A

-

66
Q

income from investing activities

gifting of debt instruments

investments items included in gross income

A
67
Q

income from investing activities

dividend income

investments items included in gross income

A
68
Q

income from investment activities

investment income EXCLUDED from Gross Income

investment income items EXCLUDED from gross income

A
  • municipal bond interest
    • some exceptions apply
  • life insurance
    • death benefits
    • accelerated death benefits
  • Roth IRA’s
  • education-related exclusions
    • savings bond interest
    • qualified tuition programs/529 plans
    • coverdell savings accounts
  • Improvement by Tenant to Landlord’s Property
69
Q

income from investing activities

Municipal Bond Interest

investment income items EXCLUDED from gross income

A
  • interest is exempt for regular tax purposes
    • interest may also be excluded from state taxation
    • capital gains are taxable
  • Tax Equivalent Yield
    • TEY = (tax free rate) / (1 - marginal tax rate)
70
Q

income from investing activities

Tax Equivalent Yield (TEY)

investment income items EXCLUDED from Gross Income

A

= (tax free rate) / (1 - marginal tax rate)

71
Q

income from investing activites

Life Insurance Proceeds

investment income items EXCLUDED from Gross Income

A
  • death benefits paid by reason of the death of the insured are exempt from income tax
    • exception: Transfer for Value Rule
  • Distributions from regular in-force policies
    • first, treated as return of basis
    • next, treated as a loan
  • Modified Endowment Contracts
    • FIFO basis: distributions are taxable to extent of the gain
  • Accelerated Death Benefits are excluded from gross income if:
    • terminally ill: death expected in 24 months, or if
    • chronically ill: unable to perform 2 of 6 activities of daily living
72
Q

income from investing activites

Life Insurance Proceeds

investment income items EXCLUDED from Gross Income

A
  • death benefits paid by reason of the death of the insured are exempt from income tax
    • exception: Transfer for Value Rule
  • Distributions from regular in-force policies
    • first, treated as return of basis
    • next, treated as a loan
  • Modified Endowment Contracts
    • FIFO basis: distributions are taxable to extent of the gain
  • Accelerated Death Benefits are excluded from gross income if:
    • terminally ill: death expected in 24 months, or if
    • chronically ill: unable to perform 2 of 6 activities of daily living
73
Q

income from investing activites

Life Insurance Proceeds

investment income items EXCLUDED from Gross Income

A
  • death benefits paid by reason of the death of the insured are exempt from income tax
    • exception: Transfer for Value Rule
  • Distributions from regular in-force policies
    • first, treated as return of basis
    • next, treated as a loan
  • Modified Endowment Contracts
    • FIFO basis: distributions are taxable to extent of the gain
  • Accelerated Death Benefits are excluded from gross income if:
    • terminally ill: death expected in 24 months, or if
    • chronically ill: unable to perform 2 of 6 activities of daily living
74
Q

income from investing activities

Roth IRA’s

investment income items EXCLUDED from Gross Income

A
  • contributions are not deductible
  • distribution is tax free if qualified… must meet 5 year rule AND be made:
    • after 59.5 years of age
    • after death or disability of owner
    • for first time home purchase (up to $10,000)
  • FIFO treatment applies
    • basis distributions are always tax free and penalty free

not always gonna be tax free

75
Q

income from investing activities

education savings exclusions

investment income items EXCLUDED from Gross Income

A
  • savings bonds interest
  • qualified tuition programs/529 plans
  • coverdell savings accounts
76
Q

income from investing activities

educational savings bonds interest income exclusions - to exclude interest from income, qualified savings bonds must meet the following requirements:

investment income items EXCLUDED from Gross Income

A
  • Qualified US Savings Bond:
    • must be EE bonds issued after Dec 31,1989
    • issued in the name of the taxpayer and/or spouse
    • bond owner mus tbe at least 24 years old on date of issue
  • subject to phaseout
77
Q

income from investing activities

529 Plan interest income exclusion

investment income items EXCLUDED from Gross Income

A
  • distributions are tax free if used to cover Qualified education expenses
  • sponsored by states or higher educational institutions
  • can front-load with 5 annual exclusion gifts per donor per beneficiary
    • $17,000 x 5 = $85,000 for 2023 per donor / per donee (for each of the kids)
    • can prepay for up to 5 years worth but you have to live during those 5 years
  • no income phaseouts apply

probably a mutual fund, probably a target date mf

78
Q

income from investing activities

qualified education expense

investment income items EXCLUDED from Gross Income

A
  • must be paid to an eligible institution
  • they include tuition fees paid for the taxpayer, spouse, or dependent, contributions to a qualified tuition program, or contributions to a coverdell educationo savings account.
  • do NOT include expenses from room and board or from courses related to sports, games or hobbies that are not part of the students degree or certificate program
79
Q

income from invest activities

Coverdell Education Savings Accounts

investment income items EXCLUDED from Gross Income

A
  • $2,000 max per year until beneficiary reaches age 18
  • distributions are tax free if used to cover educational expenses, including:
    • qualified elementary/secondary school expenses
    • special needs expenses
    • contributions to 529 plans
  • account must be used or rolled over by the time the beneficiary reaches the age of 30
  • income phaseouts apply
80
Q

income from investing activities

the amount of interest that can be excluded form gross income may be reduced or completely eliminated if the taxpayers “____ ____” exceeds specified amounts

A

modified adjusted gross income (MAGI)
there are phaseout levels

81
Q

529 plans come in two varieties

A

prepaid tuition prgrams & college savings plans

82
Q

income from personal activities

prizes & awards

A
  • if paid directly to charity at request of recipient, excluded from gross income if:
    • the prize was given primarily in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement
    • the recipient must not apply for the award
    • the recipient must not be required to render substantial future services

the general rule is that prizes and awards are included in income unless stated otherwise

83
Q

income from personal activities

employee achievement awards

A

these are excluded from gross income if:
- award is not in excess of $400
- total awards to employee cannot exceed $1,600
- awards must be in the form of tangible personal property

84
Q

income from personal activities

paymetns to former spouses

A

alimonmy pursuant to a decree entered into on or prior to Dec 31, 2018:
- is deducted (above the line) by payor
- taxable to payee

alimony pursuant to a decree entered into after Dec 31, 2018 or a decree substantially modified after that date:
- no deduction by payor
- not taxable to payee

85
Q

income from personal activities

payments to former spouses in terms of child support

A

no deduction is permitted
- its never been deductible by the payor
- never has been includable in the income by the payee

86
Q

income from personal activities

payments to former spouses in terms of property settlement

A

no deduction is permitted

87
Q

income from personal activities

alimony

A
  • payment in cash
  • pursuant to a divorce or separation instrument
    • instrument must not designate the payment as something other than alimony (such as child support or property settlement)
  • parties are not members of the same household (they cannot be living under the same roof)
  • payments do not extend beyond death of payee
  • not between spouses filing jointly
88
Q

income from personal activities

what is NOT Alimony

A
  • elective non-alimony payments
  • child support
    • payments reduced upon a contingency specifically relating to a child will be treated as child support
  • rent-free occupancy of the home
89
Q

income from personal activities

property settlement at divorce

A
  • transfer porperty between divorcing spouses
  • no income tax deduction avaialble
  • treated as a GIFT to a spouse for Income tax purposes (IRC Section 1014)
    • no gain/loss recognized
    • there is carry over basis
90
Q

income from personal activities

special issues with divorce settlements
(Medical Insurance)

A

treated as alimony in entirety if the agreement does not specify what part was for the chidls support

91
Q

income from personal activities

special issues with divorce settlements:
(life insurance)

A
  • payee sposue is owner
    • premium payments made by payor spouse are alimony
  • cash values are not considered to be alimony
  • payee spouse is names as beneficiary
    • premium payments are not alimony
    • death benefit included in payor spouses estate
    • death beneift is tax free to payee spouse
  • abandoned spouse rule:
  • legal fees: if one spouse paid the legal fees for the other, thats deductable could be alimony
    • tax related advice, talk to the attorney, there is no deduction with legal fees associated with divorce*

married filing separately is a pain in the butt of a filing process, but head of household filing status is wonderful

92
Q

income from personal activities

discharge of indebtedness

A
  • it is a beneift, it is income, debt forgiveness is an accretion to wealth
    • to the extent the taxpayer is solvent, must include debt forgiven as income

other exceptions where it will not be included as income and will be tax free:
- certain student loans
- debt forgiven as a gift
- debt discharged as qualified principal residence indebtedness which is discharged before January 1, 2026

93
Q

income from personal activities

Below-market Loans
(a corporation to a shareholder)

A
  • treated as a dividend to shareholder
  • returned to employer as interest income
94
Q

income from personal activities

Below-market Loans
(loan to employee)

A
  • treated as paid compensation for employee
    • subject to employment taxes
  • returned to employer as interest income
    • not deductible by the employee
    • taxable to the employer
95
Q

income from personal activities

below-market rules

A

these rules apply to:
- term or demand loans that are gift loans, or
- tax avoidance loans

96
Q

de minimis exceptions

loan value of 0 <= 10,000

A

$0 if nit used for acquiring income producing assets

97
Q

de mini

10001

A
98
Q

de mini

> 100,000

A
99
Q

income from personal activities

Child support

A
  • child support is not deductible by the person paying it
  • child support is niot taxable to the person receiving it
100
Q

income from personal activities

tax benefit rule: 2 situations

A

seen in 2 situations:
1. state tax refunds
2. medical expenses

101
Q

income from personal activities

tax benefit rule

A
  • taxpayer takes a deduction in one tax year, and
  • recovers (receives a refund) part or all of the expenditure in a later year,
  • the recovered amount should be included in gross income in that later year (to the extent of the tax benefit derived from the deduction)
102
Q

income from personal activities

other personal source income

A
  • gambling winnings
  • fees for:
    • jury duty
    • serving as executor, administrator, or personal represetnatives of an estate (unless you are a professional)
  • income from a hobby
103
Q

personal exclusions

A
  • gifts
  • inheritances
  • scholarships
  • compensation for injuries and sickness (limited)
  • child support and property settlements
  • gain on the sale of personal residences (limited)
  • amounts received under insurance contracts for certain living expenses
  • qualified foster care payments
  • disaster relief payments
104
Q

scholarships

A

income is excluded if:
- candidate for a degree
- at an eligible educational institution
- proceeds are used for qualified tuition and related expenses
- tuition
- fees
- course-related expenses (books, supplies, equipment, NO ROOM + BOARD)
* - room + board is taxable. it cannot be tax free*

105
Q

scholarships
(Qualified tuition reductions)

A
  • excluded from income
  • pell grants
106
Q

compensation for injuries & sickness

inclusion or exclusion of compensation for damages from injuries:

A

insert picture of chart*

107
Q

qualified disaster relief payments

A

received for:
- payment of reasonable and necessary expenses as a result of a qualified disaster
- personal, family, living or funeral expenses
- expenses to repair or rehabilitate a personal residence or its contents

  • promoting general welfare
  • paid by common carrier by reason of the death or personal physical injuries incurred
  • these are “additional standard deductions if you have a “qualified disaster””
108
Q

qualified disaster relief payments
(What are Qualified Disasters)

A
  • terroristic/military action
  • presidentially declared disaster
  • accidents involving common carriers

CFP: Income Tax Planning (9 decks)

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