EDSPIRA’S GUIDE TO

U.S. Taxation
By Michael McLaughlin

TABLE OF CONTENTS

Lesson 1: Introduction to U.S. Taxation .....………………………….……...……………..1

Lesson 2: Overview of Federal Tax Law in the U.S. …………………...…………………3

Lesson 3: Gross Income ………………………………………….……………………….…..4

Lesson 4: Business Deductions ……………………………….…………………………….7

Lesson 5: Losses and Loss Limitations …………………….……………………….……13

Lesson 6: Property Transactions ...………………………………………………………...19

Lesson 7: Capital Gains, Losses, and § 1231 .....……..…………………………………24

Lesson 8: Individuals as Taxpayers ...……………………………………………………..28

Lesson 9: Individuals as Employees and Business Owners ………………………….34

Lesson 10: Business Tax Credits …………………………………………………………..40

Lesson 1: Introduction to U.S. Taxation

TAX SYSTEMS TYPES OF TAXES IN THE U.S.

• Taxes are typically calculated as follows: Type Usually taxed at which level(s)?
tax due = tax rate x tax base
• The tax rate is a percentage (e.g., 21%). Income tax Federal, state, local
• The tax base is a figure such as income, wages, sales Sales/use tax State, local
price, or property value.
• Tax rates can be progressive, proportional, or regressive. Excise tax Federal, state, local
Property tax Local
• The tax rate increases as the
Progressive taxpayer’s income increases. FICA tax Federal
• The federal income tax is progressive.
Unemployment tax Federal, state
• The tax rate remains constant (flat) as
Gift tax Federal, state
Proportional the taxpayer’s income increases.
• Some states have a flat income tax. Estate tax Federal, state
• The tax rate increases as the Inheritance tax State
Regressive taxpayer’s income decreases.
• The sales tax is a regressive tax. Severance tax State
Occupancy tax State and local
Note that:
ECONOMIC INCIDENCE OF A TAX • Severance taxes (a tax on the export of natural resources)
and occupancy taxes (a tax on hotel/motel stays) are
popular because the economic incidence of the tax falls
• It is important to understand the economic incidence of a
on people who do not live in (and thus don’t vote in) the
tax.
taxing district.
- The person who pays the tax to the government is
• Self-employed persons pay a “self-employment tax”
not necessarily the person who bears the economic which is their version of the FICA payroll tax.
burden of the tax. • If your home state has a sales tax, but you purchase
something from a state that doesn’t have a sales tax, you
Example owe a “use tax” to your home state.
A landlord is responsible for paying the property taxes for
the building, not the tenant. If the local government
increases property taxes, however, the landlord will most
likely increase the rent at the end of the lease term to TAX PLANNING STRATEGIES
reflect the higher property taxes. Thus, the renter would
indirectly pay the tax even though the landlord is
responsible for paying the tax. You can reduce your tax burden by:
• Avoiding income recognition
• Deferring income recognition until future periods
• Maximizing your tax deductions
THE PURPOSE OF TAXES • Shifting income from high-tax jurisdictions to low-tax
jurisdictions
• The primary purpose of taxes is to generate revenue for • Shifting income from high-tax-bracket years to low-tax-
the government. bracket years
• However, taxes are also used to encourage (or • Shifting income from high-tax-bracket taxpayers to low-
discourage) certain types of: tax-bracket taxpayers
- Economic activity • Changing the character of income and deductions so they
- Industries are more favorable
- Social behavior • Maximizing tax credits

1
Lesson 1: Introduction to U.S. Taxation

THE AICPA’S PRINCIPLES OF GOOD TAX POLICY 1

Principle Description EFFECTIVE TAX ADMINISTRATION

Equity and Similarly situated taxpayers should be taxed • The federal government is very efficient
fairness similarly. when it comes to collecting tax revenue
The tax rules should clearly specify how the - Collection costs (e.g., the IRS) are just
amount of payment is determined, when 0.5% of revenue collected
Certainty • However, there are significant compliance
payment of the tax should occur, and how
payment is made. costs for individuals
- 56% of individuals use a tax preparer
Facilitating a required tax payment at a time or - 33% of individuals use tax software
Convenience of
in a manner that is most likely convenient for
payment
the taxpayer is important.
Costs to collect a tax should be kept to a
Effective tax THE ROLE OF TAX PROFESSIONALS
minimum for both the government and
administration
taxpayers.
Tax professionals assist clients with:
Tax administration must protect taxpayer
Information
information from all forms of unintended and Compliance File the appropriate
security
improper disclosure. documents on-time and
Simple tax laws are necessary so that taxpayers keep the client out of
Simplicity understand the rules and can comply with them trouble with the IRS
correctly and in a cost-efficient manner.
Controversy Help the client deal with tax
Minimizing the effect of the tax law on a authorities if the client is
taxpayer’s decisions as to how to carry out a audited
Neutrality
particular transaction or whether to engage in a
transaction is important. Planning Come up with strategies for
reducing tax liability, and
Economic growth The tax system should not unduly impede or make sure the client has
and efficiency reduce the productive capacity of the economy. cash available to pay taxes
Taxpayers should know that a tax exists and when due
Transparency and
how and when it is imposed upon them and
visibility
others.
Structuring tax laws to minimize noncompliance
Minimum tax gap
is essential.
Accessibility and visibility of information on tax
Accountability to
laws and their development, modification and
taxpayers
purpose are necessary for taxpayers.
Tax systems should have appropriate levels of
Appropriate
predictability, stability and reliability to enable
government
the government to determine the timing and
revenues
amount of tax collections.

1 The first 4 principles are from Adam Smith’s The Wealth of Nations.

2
Lesson 2: Overview of Federal Tax Law in the U.S.

THREE SOURCES OF FEDERAL TAX LAW IN THE U.S. ADMINISTRATIVE

1. Statutory a. Treasury Regulations

2. Administrative • Treasury Regulations ("the Regs") are the official
3. Judicial interpretation of tax law.
• The regs are issued by the Treasury Department.
1. Final Regulations are considered law.
2. Temporary Regulations are also considered law,
but they expire within 3 years of being issued.
STATUTORY
3. Proposed Regulations are not considered law
(the public can comment on them).
a. The U.S. Constitution b. Revenue Rulings
b. Tax treaties • Revenue Rulings are official pronouncements of the
c. The Internal Revenue Code Internal Revenue Service (IRS).
i. The tax code was passed by Congress in • Revenue Rulings do not have the same legal force as
1939. Congress made major revisions to the tax code Treasury Regulations.
in 1954, 1986, and 2017. • A Revenue Ruling describes how the IRS treats a
ii. The tax code is organized by section. For example, specific fact pattern.
§ 401(k) pertains to employer-sponsored retirement • A taxpayer can rely on a Revenue Ruling when filing
plans. their taxes.
c. Revenue Procedures
Revenue Procedures provide instructions to taxpayers.
JUDICIAL d. Letter Rulings
Letter rulings tell a taxpayer how the IRS would treat their
a. Disputes between taxpayers and the IRS can be situation.
resolved in court. e. Notices
b. There are five federal courts that hear tax cases. The IRS issues a Notice when immediate guidance is
c. However, a taxpayer’s case is initially heard in one of needed but the IRS is still working on a long-term solution.
three courts:
i. The U.S. Tax Court Note: Revenue Rulings, Revenue Procedures, and Notices
ii. The U.S. District Court are published each week in the Internal Revenue Bulletin
iii. The U.S. Court of Federal Claims (www.irs.gov/irb).
d. Appeals can be made to two courts:
i. The U.S. Court of Appeals
ii. The U.S. Supreme Court
e. Each tax case sets a legal precedent for future tax
cases.1
1 Decisions in the Small Cases Division of the U.S. Tax Court aren’t
considered legal precedent.

3
Lesson 3: Gross Income
GROSS INCOME

Gross income is important because it is used to calculate TIMING/REALIZATION

taxable income:
gross income – deductions1 = taxable income • Income is not taxed until it is realized.
• Per § 61 of the tax code, “gross income means all income • “Realized” means that some event has occurred to trigger
from whatever source derived.” taxation.
• Gross income includes, but is not limited to:
- Compensation for services Example
- Interest and dividends Let’s say you buy one share of a company’s stock for $50
- Rent and royalties cash. If the value of your share increases to $130, you will not
- Business income be taxed. Even though you have become wealthier, you have
- Gains from disposing of property not “realized” the gain because you haven’t sold the stock. If
- Debt forgiveness (in some cases) you were to sell the stock for $130, you would realize a gain
- Prize winnings of $80
- Illegal income, such as bribes
• Loan proceeds are not gross income.
- If you borrow money, you have to pay it back, so your
net worth is changed. ACCOUNTING METHODS
• Gifts you receive are not gross income.2
1. Cash3
1 Individual taxpayers have two types of deductions: deductions
Income is taxed in the year the income is actually (or
for AGI and deductions from AGI.
2 The taxpayer giving you the gift may incur tax if the value of the constructively) received, regardless of when the taxpayer
gift exceeds a certain threshold. earned the income.
2. Accrual
Income is taxed in the year the income is earned,
regardless of when the taxpayer collects the cash.
CONSTRUCTIVE RECEIPT
3. Hybrid
A taxpayer that sells inventory, but is not required to use
• If income is readily available to you without restrictions the accrual method, could use a hybrid approach. Under
or substantial limitations, then the income is this approach, the taxpayer would use the accrual
constructively received and you can be taxed on it. method for sales and purchases of inventory, but the
- Thus, if you receive your paycheck in December 2021, cash method for everything else.
and you wait until January 2022 to cash the check, the
paycheck will be included in your taxable income for 3 Despite the name “cash method” taxpayers are also taxed on the
2021 (you can’t defer income by turning your back on receipt of things other than cash. For example, if you wash cars
in exchange for chocolate bars, the value of the chocolate bars
it).
constitutes taxable income to you.

GAINS & LOSSES FROM DISPOSAL OF

PREFERRENTIAL TAX TREATMENT FOR CERTAIN INCOME
PROPERTY
• You may incur a gain or loss when you sell or dispose of
property. • Taxpayers (except for C corporations) are taxed at lower
• The gain or loss is calculated as follows: rates on qualified dividends.
amount realized – adjusted basis = realized gain or loss - Qualified dividends are taxed at rates of 0, 15, or 20%.
• Taxpayers (except for C corporations) are taxed at lower
Example rates on capital gains.
If you buy a piece of vacant land for $30,000 and then sell it - Net capital gains are taxed at rates of 0, 15, or 20%.
for $70,000 you will have a realized gain of $40,000.

4
Lesson 3: Gross Income

WHAT IS BASIS?

You’ll hear the word “basis” a lot when discussing taxation, and it’s an important concept.

The adjusted “basis” of property theoretically represents your capital investment in the property. The adjusted basis is
subtracted from the amount realized to prevent double taxation. If you buy land for $30,000 and sell it for $70,000 you
shouldn’t be taxed on $70,000. Even though you’re receiving $70,000, a portion of what you’re receiving ($30,000) is a return of
your investment. You aren’t taxed on the return of capital, only your increase in wealth ($40,000).

You calculate the basis of property as follows:

initial cost + capital additions – depreciation – capital recoveries = adjusted basis

CAPITAL GAINS & LOSSES

• When you sell or dispose of a capital asset, you may realize a 1. Net any long-term capital gains and long-term capital
capital gain or loss. losses together.
• The tax code doesn’t define capital assets, but they are any 2. Net any short-term capital gains and short-term
assets other than: capital losses together.
- Accounts receivable 3. Compare the two amounts you computed in steps one
- Inventory and two.
- § 1231 property (property used in a business and held - If the amounts in steps one and two have opposite
more than one year) signs (one is a gain and one is a loss) net them
- Copyrights, inventions, and formulas together.
• Capital gains or losses are classified as either: - If the amounts in steps one and two have the same
- Short-term (if the asset was held for one year or less) sign (you have a short-term gain and a long-term
• Long-term (if the asset was held for more than one year) gain, or a short-term loss and a long-term loss) do
• There is a multi-step netting process for calculating the tax not net them together.
on capital gains and losses: • Here are the possible scenarios and outcomes:

Situation Outcome Tax consequences

Scenario #1 net LT gain > net ST loss net LT gain 0/15/20% tax rate
Scenario #2 net LT gain < net ST loss net ST loss Deduct up to $3,000; the rest is carried forward to future
tax years
Scenario #3 net ST gain > net LT loss net ST gain Ordinary tax rate
Scenario #4 net ST gain < net LT loss net LT loss Deduct up to $3,000; the rest is carried forward to future tax
years
Scenario #5 net LT gain & net ST gain LT gain & ST gain LT gain taxed at 0/15/20%
ST gain taxed at ordinary tax rate
Scenario #6 net LT loss & net ST loss LT loss & ST loss Deduct up to $3,000 (taken from ST losses first); the rest if
carried forward to future tax years

5
Lesson 3: Gross Income

EXCLUSIONS FROM GROSS INCOME COLLECTIBLES

• Congress has decided to exclude certain items from gross • Collectibles include artwork, antiques, stamps, etc.
income. These include: • Collectibles have a unique tax treatment; they are
- Life insurance proceeds4 taxed at a maximum rate of 28%.
- Interest on state or local municipal bonds5
- Up to $250,000 ($500,000 if married filing joint) of
capital gain on the sale of your principal residence (per
§ 121)
- Certain types of debt forgiveness (bankruptcy6, certain
student loans, etc.)
4 If the person insured chooses to cash out their policy, and the
cash surrender value (the amount they receive) exceeds the
amount of insurance premiums they’ve paid over the years, the
excess amount is taxable.
5 Such interest income may be taxed at the state or local level but
is not taxed at the federal level.
6 This is limited to the amount of the debtor’s insolvency. For
example, if you have $200,000 of assets and $300,000 of debts,
and a lender cancels $125,000 of your debt, only $100,000 of the
debt forgiveness will be excluded from your income because that
is the amount by which you were insolvent.

6
Lesson 4: Business Deductions

THE GENERAL RULE: § 162 TIMING OF DEDUCTIONS

• Expenses related to a trade or business may be tax Cash method

deductible. Taxpayers using the cash method only get a deduction
• To be deductible, the expense must be ordinary and when cash is paid.
necessary. Accrual method
- “Ordinary” means it is a normal or customary
Taxpayers using the accrual method deduct expenses
expense for that type of business.
when two tests are met:
- “Necessary” means a hypothetical, independent
1. The all events test: All the events have occurred to
investor would incur the same expense.
establish a legal liability.
2. The economic performance test: The party obligated
to do something to satisfy the liability does so.
RELATED PARTIES: § 267

There are restrictions on the deductibility of expenses PREPAID EXPENSES

pertaining to related parties.
§ 267 defers the deductibility of an expense
• In some cases, taxpayers (cash-basis or accrual method)
until the related party recognizes income.
can deduct prepaid expenses.
• This is to prevent people from cheating the IRS.
• For the prepaid expense to be deductible, the benefit
• Without § 267, someone could say their spouse is an
being received from the expense must not extend
employee of their business, take a $50,000 deduction for
beyond the earlier of:
wages related to the spouse, but then not give the
- 12 months after the taxpayer first received the
spouse any wages. With § 267, the taxpayer would only
benefit.
get a business deduction for their spouse’s wages if the
- The end of the tax year following the tax year in
spouse recognizes income for the wages.
which the payment was made.
Related parties include:
• Family members (spouse, children, grandchildren, Example
parents, grandparents, siblings) Assume a taxpayer prepays $3,000 for professional liability
• Corporations and shareholders owning more than 50% insurance on October 1, 2020. The insurance policy begins
of the corporation’s stock1 on December 1, 2020 and ends on November 30, 2021. The
• Corporations that are members of the same controlled taxpayer can deduct the full $3,000 in the 2020 tax year.
group This is allowable because (a) the benefit doesn’t extend
beyond 12 months from when it begins (it’s a 12-month
1 This includes indirect ownership. Thus, if your spouse owns policy) and (b) the benefit doesn’t extend beyond the
more than 50% of a corporation’s stock, you are deemed to following tax year (it ends during the 2021 tax year)
own more than 50% of the corporation’s stock and are thus a - This is commonly referred to as “The 12-month Rule.”
related party with respect to the corporation. - The 12-month rule doesn’t apply to prepayments for
services or property for accrual method taxpayers
unless the economic performance test has been met.
- The 12-month rule most commonly applies to prepaid
insurances and dues.

7
Lesson 4: Business Deductions
DISALLOWED DEDUCTIONS LIMITED DEDUCTIONS

You can’t deduct the cost of: • Excessive salaries4, rent, or other expenses
- Political contributions - An expense must be reasonable; excess amounts are not deductible.
- Lobbying expenses2 • Drug trafficking
- Fines and penalties paid to the - The costs of operating an illegal business (e.g., wages, rent) are
government or governmental entities deductible provided the cost is not inherently illegal (a bribe).
- Bribes, kickbacks, and illegal payoffs - When it comes to drug trafficking, however, only cost of goods sold
is deductible.
- Two-thirds of treble damages for
- Thus, a cannabis company cannot deduct the cost of salaries, rent,
antitrust violations
etc.5
- Expenses incurred to generate tax-
• Business interest expense
exempt income - The deduction for business interest expense is limited to:
- Expenses for entertainment, business interest income + 30% of adjusted taxable income
amusement, and recreation3 - “Adjusted taxable income” is taxable income, without accounting
- Expenses the taxpayer cannot for:
substantiate ▪ Business interest income or expense
▪ Deductions for net operating losses
2 You can deduct up to $2,000 of “in-house” ▪ Deductions for qualified business income
lobbying expenditures. These are lobbying ▪ Nonbusiness income, gain, deduction, or loss
costs incurred by the taxpayer, not amounts • Startup costs
paid to a professional lobbyist or other third - These costs include accounting, legal, marketing research, travel,
party.
etc.
3 The cost of business meals, however, was 50%
deductible in 2020 and 100% deductible in - The deductibility depends on:
2021 and 2022. The meal, however, must have ▪ Whether the new business is in a different industry than your
a business purpose and not be extravagant. current business
▪ Whether the acquisition/creation actually takes place

Scenario Tax treatment

RESEARCH & DEVELOPMENT COSTS
You incur costs to investigate Fully deductible.
• R&D costs include the costs to develop a expanding your existing business.
product (materials, salaries) & patent it. You incur costs to investigate acquiring Not deductible.
- They don’t include the costs of routine or starting a business in an industry
testing or market research. different from that of your current
• Taxpayers wishing to deduct R&D costs business. However, you don’t end up
must choose between one of two acquiring/starting the new business.
methods: The first $5,000 of costs are
You incur costs to investigate acquiring
- Expense Method immediately deductible,
or starting a business in an industry
All R&D costs are deducted when different from that of your current although the deduction phases
incurred or paid business, and you do in fact out dollar-for-dollar once the
- Deferral and Amortization Method acquire/start the new business. total startup costs exceed
All R&D costs are capitalized and $50,000. Any startup costs not
expensed over one of two periods: immediately deductible are
1. The 5 years following the time the capitalized and expensed over
product first generates revenue the next 180 months.
2. The 10 years following the time the
first R&D costs are incurred 4 For example, any salary paid to a company executive beyond $1 million is
Once a method is chosen, the taxpayer deemed excessive.
cannot switch without permission of
5 This is because cannabis is illegal at the federal level.
the IRS.

8
Lesson 4: Business Deductions

CHARITABLE CONTRIBUTIONS DEPRECIATION

• Even though donations are not a necessary and ordinary • Taxpayers can deduct the cost of real property7
expense per § 162, businesses are allowed a deduction for (buildings) and some types of personal property
charitable contributions. (equipment, machinery, computers, furniture,
• The amount of the deduction is generally the fair market vehicles, etc.) used in a business. These deductions
value of the property being donated. are called depreciation.
- The deduction is the lesser of the fair market value or - Depreciation deductions are taken over time using
adjusted basis when the donation is: schedules provided by the IRS.
▪ ordinary income property, or - The schedules are part of the “Modified
▪ tangible, personal, capital gain property that the charity Accelerated Cost Recovery System” (MACRS) that
does not end up using in way that is related to its tax- was made part of the tax code in 1986.
exempt purpose. - To depreciate an asset, you must own the asset.
• The deduction can be taken when the property is donated. Also, the asset must be expected to last more than
- Corporations using the accrual method, however, may one year and have a determinable useful life.
take the deduction in the year prior to donating the • Note that there is a difference between personal
property if: property and personal use property.
a. the donation was approved by the corporation’s board - The term “personal property” refers to all business
of directors during that year, and assets other than real property.
b. the donation is made on or before the due date of the - Personal use property is property that is used for
corporation’s tax filing.6 the taxpayer’s enjoyment.
• Limitations - Personal use property is never depreciable.
- For C corporations, the amount of charitable deductions in
a single tax year is limited to 10% of taxable income Example
(excess amounts can be carried forward for the next 5 tax A doctor purchases two couches. She puts Couch #1 in
years). the waiting room of her medical clinic. Couch #1 is
- For other types of taxpayers (not C corporations), the personal property, and the cost of Couch #1 can be
amount of charitable deductions is also limited. deducted through depreciation. The doctor puts Couch
#2, however, in the living room of her home and uses it
6 Assume a corporation’s board of directors approves the donation of
to watch Netflix. Couch #2 is personal use property; its
a company truck to a charity on October 15, 2020. The corporation
could take a tax deduction for the charitable contribution for the cost is not depreciable.
2020 tax year provided it gives the truck to the charity on or before
April 15, 2021. • If an asset is eligible for depreciation, you can only
begin depreciating it once the asset is placed into
service (not when it is purchased).
COST RECOVERY - Thus, a calendar-year taxpayer couldn’t take
depreciation deductions for the 2020 tax year for
Taxpayers may deduct the cost of most assets used for the business equipment they purchased on December
production of income in their business. These deductions may 31, 2020 if the equipment wasn’t placed into
take one of three forms: service until 2021 or thereafter.
1. Depreciation - the recovery of costs related to tangible • Depreciation reduces the basis of the asset.
property. 7 Land, however, can never be depreciated.
2. Amortization - the recovery of costs related to intangible
property.
3. Depletion - the recovery of costs related to natural Continued on next page
resources.

9
Lesson 4: Business Deductions

DEPRECIATION (CONT.) MACRS FOR PERSONAL PROPERTY

Example • Personal property is depreciated over 3, 5, 7, 10, 15, 20, or 25 years,

A company purchases a work truck for $40,000 and depending on the type of property (the IRS has rules about this).
takes $15,000 of depreciation deductions for the • Personal property is depreciated on an accelerated basis, unless
truck over the years. If the company then sells the the taxpayer elects to depreciate the property using the straight-
truck for $32,000 it will realize a $7,000 gain as line method.
follows: • Personal property is depreciated using the half-year convention.
amount realized – adjusted basis =
- This means the taxpayer receives a half-year of depreciation for
realized gain or loss
the year in which the property is placed into service, and a half-
$32,000 – ($40,000 - $15,000) = $7,000
year of depreciation for the year in which the property is
removed from service.
Converting personal use assets to
- Thus, depreciation for 3-year property placed into service during
business use 2020 would take place as follows:
• Total depreciation that can be taken is limited
▪ Half-year of depreciation for 2020
to the lesser of:
▪ Full year of depreciation for 2021
- The asset’s fair market value at the time of
▪ Full year of depreciation for 2022
conversion, or
▪ Half-year of depreciation for 2023
- The asset’s adjusted basis at the time of
- The taxpayer thus receives a half-year of depreciation in the tax
conversion.
year that the property is placed into service, no matter when
• This prevents a taxpayer from getting a
that occurred.
deduction for a decline in value that occurred
during the time period that the asset was used
Mid-quarter convention
• Under the half-year convention, a taxpayer could place an asset
for personal use.
into service during the last month of the tax year and yet receive a
Example full half-year of depreciation.
A taxpayer purchases a truck for $50,000 on • However, there is a rule in place to prevent taxpayers from abusing
January 1, 2021. The taxpayer uses the truck for this and making all their purchases at the end of the year. If a
personal use for three years. On January 1, 2024, taxpayer places more than 40% of their personal property into
the taxpayer starts a construction company and service during the last quarter of the year, then all personal
converts the truck to business use. The fair market property placed into service must follow the mid-quarter
value of the truck on January 1, 2024 is convention.
$28,000. Thus, the taxpayer will not be able to take • The mid-quarter convention treats personal property as it was
more than $28,000 in depreciation deductions place into service during the middle of the quarter when it was
related to the truck. actually placed into service.

Example
Assume that more than 40% of a calendar-year taxpayer’s personal
property was placed into service in December of 2020. Among other
things, the taxpayer purchased a work truck for $60,000 on December
1, 2020. The taxpayer would have to follow the mid-quarter
convention, so the work truck would be treated as if it was placed into
service in the middle of the quarter in which it was placed into service
(in this case, the fourth quarter). Thus, the taxpayer would receive 1.5
months of depreciation for the work truck for the 2020 tax year. Had
the taxpayer instead been able to use the half-year convention, they
would have been able to take 6 months of depreciation for the work
truck for the 2020 tax year.

10
Lesson 4: Business Deductions

MACRS FOR REAL PROPERTY § 179 EXPENSING

Residential rental real property is depreciated using • Taxpayers can make an election per § 179 to deduct the
straight-line over 27 years. acquisition cost of certain types of business property,
• At least 80% of gross rental revenue must come including:
from residential units. Thus, an apartment building - Tangible personal property (e.g., equipment, machinery)
would be considered residential rental real - Qualified improvement property, and certain other
property, but a hotel or motel would not. improvements to nonresidential real property (HVAC
Nonresidential real property is depreciated using systems, alarm/security systems, roofs)
straight-line over 39 years. - Computer software
• Improvements to nonresidential real property • Any amounts deducted per § 179 reduce the asset’s basis.
would normally be depreciated over 39 years as • There is a limit to how much the taxpayer may deduct per §
well. 179 each year.
• There is an exception, however, for qualified - The maximum allowable deduction is further reduced if the
improvement property. amount of § 179 property placed in service during the year
- Qualified improvement property is an exceeds a certain threshold.
improvement to the interior of nonresidential real - Moreover, a § 179 deduction cannot create a net operating
property that does not involve the enlargement loss. Thus, § 179 expensing is limited to the taxpayer’s
or modification of the building (e.g., installing an business income. Any § 179 amount in excess of business
elevator). income can be carried forward to future tax years.
- Qualified improvement property is depreciated
over 15 years.
• Both types of real property are depreciated using a
mid-month convention. PROPERTY USED FOR BOTH BUSINESS & PERSONAL USE
- This means the taxpayer receives a half-month of
depreciation for the month the property was • You can take depreciation on property (e.g., a car) that is
placed into service.
used for both business and personal use. However,
- Thus, if a calendar-year taxpayer places real
limitations apply:
property into service in February of 2020, they
would receive 10.5 months of depreciation for - If the property is not predominantly used for business
that real property for the 2020 tax year. purposes (i.e., business use exceeds 50%), then the
property must be depreciated using the straight-line
method.
- If the property is a passenger automobile, there are annual
BONUS DEPRECIATION caps for how much depreciation can be taken (to reduce
deductions for purchases of luxury cars).
• Until 2022, taxpayers are allowed to deduct 100% of
the cost of qualifying property in the first year the
property is placed into service.
- According to the IRS, this bonus depreciation, ALTERNATIVE DEPRECIATION SYSTEM (ADS)
“generally applies to depreciable business assets
with a recovery period of 20 years or less and This must be used to calculate:
certain other property. Machinery, equipment, • Depreciation for real property (including qualified
computers, appliances and furniture generally improvement property) if the taxpayer opts out of the
qualify.” interest expense limitations
• Bonus depreciation is taken after first accounting • Depreciation allowances as part of E&P for C corporations
for § 179 expensing. • The portion of depreciation treated as an alternative
minimum tax (AMT) adjustment

11
Lesson 4: Business Deductions

AMORTIZATION DEPLETION

• The cost of intangibles is amortized (this is similar to • Taxpayers may also recover the cost of natural resources,
depreciation, but for intangible rather than tangible such as coal, natural gas, oil, timber, etc.)
property) over 15 years. • A taxpayer can choose from two methods to calculate
• Intangibles include: depletion deductions:
- Patents and copyrights
1. cost depletion - this is similar to the units-of-
- Startup costs
production method.
- § 197 intangibles (these are intangibles acquired as
part of an acquisition, including trademarks, 2. percentage depletion - the taxpayer calculates
copyrights, patents, non-compete agreements, and the deduction by multiplying gross income from sales
goodwill) of the natural resource by a statutory percentage from
the tax code.

12
Lesson 5: Losses and Loss Limitations

LOSSES FOR BAD DEBT LOSSES FOR WORTHLESS SECURITIES

• Most taxpayers use the specific charge-off method to Taxpayers realize a loss per § 165(g) when securities
claim loss deductions for bad debt. become completely worthless.
• The tax treatment depends on whether the loss is from
business or nonbusiness bad debt.
• Business bad debt is a loan that is related to the
LOSSES FOR § 1244 SMALL BUSINESS STOCK
taxpayer’s trade or business.
• Nonbusiness bad debt1 is unrelated to the taxpayer’s
trade or business when either: Losses on stock are typically capital losses
- The debt was created, or • However, a taxpayer may treat up to $50,000 ($100,000 if
- The debt became worthless2 married filing joint) of losses from § 1244 small business
Type of bad Deductible when? Tax treatment stock as ordinary losses
debt • To qualify:
- The taxpayer must have received the stock directly
Business Partially or wholly Ordinary loss
worthless from the corporation.
- The corporation must have designated the stock as §
Nonbusiness Wholly worthless Short-term 1244 stock. To do this, the corporation must have had a
capital loss total capitalization of $1 million or less when it issued
the stock.
When dealing with loans to related parties, there is a
question of whether it is a bona fide loan or gift. Example
It is more likely to be treated as a bona fide loan if: A small business is about to issue 100 shares of stock to an
• There is a promissory note. investor. If the company’s capitalization doesn’t exceed $1
• The borrower is charged a reasonable rate of interest. million, the company’s board can designate the stock as §
• The borrower had to provide collateral. 1244 stock. Assume that this happens, and the investor later
• The lender made an effort to collect repayment. sells the stock for a loss of $38,000. The investor would be
• There is evidence that the parties intended for it to be a able to treat the $38,000 loss as an ordinary loss (rather than
bona fide loan.
a capital loss). This is helpful to the investor because the
1 Loans made to friends and family are an example of
maximum net capital loss that can be deducted in a tax year
nonbusiness bad debt. is $3,000. Thus, the investor would be able to recognize the
2 If the borrower becomes bankrupt, for example, the debt might entire $38,000 loss when it occurs, rather than recognizing
become completely worthless . the loss little by little for decades.

NET OPERATING LOSSES

• Taxpayers can carry forward a net operating loss to offset Example

future income. A taxpayer incurs a $250,000 NOL for the 2020 tax year. For
• The amount of deductions a taxpayer can receive in any one the 2021 tax year, the taxpayer has $100,000 of taxable
year from NOLs is capped at 80% of its taxable income (prior income (prior to NOL deduction). The taxpayer may thus
receive an $80,000 NOL deduction for 2021. This reduces the
to considering the NOL).
taxpayer’s taxable income to $20,000 for 2021. The
remaining, unused NOLs ($170,000) can be carried forward
to future tax years.

13
Lesson 5: Losses and Loss Limitations

LOSSES FROM CASUALTIES

AT-RISK LOSS LIMITATIONS (§ 465)

A casualty occurs when a sudden, unexpected, and
unusual event damages property.
- Examples include an earthquake, fire, storm, landslide, or theft. A taxpayer’s losses from an
- Damage stemming from progressive deterioration (e.g., termites) investment are limited to the
doesn’t count. amount the taxpayer actually
• Both businesses and individuals may receive deductions for casualty stands to lose from the
losses.
- When it comes to personal use property, however, significant
investment.
• This rule was created to prevent tax
limitations apply.
shelters from allowing people to tax
• The amount of the casualty loss is reduced by any amount recovered
deductions that exceed the amount they
through insurance.
invested.
- If you a buy a car for $30,000 and it is instantly destroyed by a bolt of
lightning, and your insurance provider then sends you a check for Example
$30,000, you can’t take a casualty loss tax deduction because you You purchase a 25% interest in a partnership
recovered the money through insurance. for $100,000. In addition, you assume
- In some cases, the taxpayer may recover more than the amount they $40,000 of the partnership’s debt. If the
lost. In such a case, the taxpayer would have a casualty gain. partnership were to report a loss of $600,000
Here’s a summary of the casualty loss rules: your share of the loss would be $150,000.
However, the amount of the loss you can
Business/investment deduct is limited to $140,000 (the amount at-
Personal use property
use property risk). You only stand to lose $140,000 (your
Yes. However, casualty initial investment, plus the debt you
Must the casualty losses not from a assumed). Thus, you can’t take more than
loss occur in a federally declared $140,000 in loss deductions.
No.
federally declared disaster area may be
disaster area? netted against casualty • The initial amount at-risk consists of:
gains. - Cash contributed by the taxpayer to the
What is the amount The lesser of: activity
of the casualty loss, -the decline in fair - The adjusted basis of any property
The adjusted basis of contributed by the taxpayer to the
if the property is market value
the property activity
completely -the adjusted basis of
destroyed? the property - Debt the taxpayer has assumed related
to the activity
The lesser of: The lesser of:
What is the amount - Collateral the taxpayer has pledged
-the decline in fair -the decline in fair
of the casualty loss, related to the activity
market value market value
if the property is - The taxpayer’s share of any qualified
-the adjusted basis of -the adjusted basis of
partially destroyed? nonrecourse financing related to the
the property the property
activity
Must the taxpayer • The amount at-risk is also:
first reduce each - Increased by the taxpayer’s share of
No. Yes.
casualty loss by a income or additional capital
$100 floor?
contributions
• Before deducting a casualty loss, individual taxpayers must first reduce - Decreased by the taxpayer’s share of
the loss by 10% of their adjusted gross income (AGI). The remaining losses or withdrawals
casualty loss is a deduction for AGI (an above-the-line deduction).

14
Lesson 5: Losses and Loss Limitations
PASSIVE ACTIVITY LOSS LIMITATIONS (§ 469)

• Similar to the at-risk limitations, the passive activity loss Switching from passive to active
(PAL) limitations were created to prevent the use of tax • If a taxpayer becomes actively involved in an activity that
shelters. was previously passive, any suspended passive losses
• The PAL rules separate a taxpayer’s income into 3 buckets:
remain passive but may be used to offset active income from
1. Active income
that specific activity .
- Salary, wages, or other payments for services rendered
- Profit/loss from a trade or business in which the Which taxpayers are subject to the passive
taxpayer materially participates activity loss limitations?
2. Portfolio income The passive activity loss rules apply to:
- Dividends, interest, annuities, royalties not produced • Individuals, estates, and trusts
from the ordinary course of the taxpayer’s trade or • Personal service corporations
business - This is a C corporation where (a) the principal activity is
- Gains/losses from the disposal of property that
performing personal services and (b) those services are
produces portfolio income or is otherwise held as an
performed by employee-owners,4 and (c) employee-
investment
owners own more than 10% of the fair value of the
3. Passive income
- Income/loss from a trade or business in which the corporation’s outstanding stock on the last day of the
taxpayer materially participates period.
- Most rental activities, whether or not the taxpayer - Personal services include activities in the fields of law,
materially participates3 accounting, consulting, health and veterinary services,
• Passive losses are only deductible to the extent that the architecture, engineering, actuarial science, and the
taxpayer has passive income. performing arts.
• Closely held corporations
Example - This is a C corporation where more than 50% of the value
A taxpayer earned $80,000 this year from her job as a university of the company’s outstanding stock is owned (directly or
professor. The taxpayer is also an investor in a company in
indirectly) by 5 or fewer individuals.
which she does not materially participate. The taxpayer
- Closely held C corporations may use passive losses to
incurred a $30,000 loss this year related to her investment in
that company. The loss is considered a passive loss. Thus, the offset active income, but not portfolio income.
taxpayer cannot use the loss to offset her professor income. • For partnerships and S corporations, passive income or
She can, however, carrying the passive loss forward to offset losses flow through to the partners or shareholders and are
passive income in the future. dealt with at the individual taxpayer level.
• C corporations (aside from personal service and closely held
• A taxpayer may, however, use a passive loss to offset active corporations) are not subject to the passive activity loss
or portfolio income if the taxpayer sells their entire interest limitations.
in the investment for its fair market value to a third party in What constitutes a passive activity?
an arm’s length transaction. • If a taxpayer materially participates in a nonrental trade or
- If this happens, the suspended passive losses related to business, any loss is considered an active loss. If the
that activity are used to offset the gain on the disposition taxpayer does not materially participate, however, any loss is
of that activity. considered a passive loss.
- However, if (a) the suspended losses from that activity • A taxpayer has materially participated if they meet any of the
exceed the gain on the disposition of that activity or (b) the 7 tests listed in Temporary Regulation § 1.469-5T(a) and IRS
disposition of the activity results in a loss, then the excess Publication 925:
loss from that activity offsets other income as follows:
1. First, it offsets net passive activity income (or gains). 4 According to IRS Publication 542, “This requirement is met if more
2. Next, it offsets active or portfolio income (or gains). than 20% of the corporation's compensation cost for its activities of
performing personal services during the testing period is for
personal services performed by employee-owners.”
3 There is an exception for a taxpayer who is a “real estate
professional.” Continued on next page

15
Lesson 5: Losses and Loss Limitations

PASSIVE ACTIVITY LOSS LIMITATIONS (§ 469) (cont.)

You have materially participated if… - Regarding personal service and closely held C
Test #1 You participated in the activity for more than 500 corporations:
hours. a. They are deemed to materially participate if one or
Test 2 Your participation was substantially all the participation more shareholders (who own more than 50% of the
in the activity of all individuals for the tax year, including the corporation’s stock) materially participate in the
participation of individuals who didn’t own any interest in the activity.
activity. b. For closely held C corporations, there are two
Test 3 You participated in the activity for more than 100 hours additional ways to qualify as having materially
during the tax year, and you participated at least as much as participated:
any other individual (including individuals who didn’t own any 1. If the corporation had at least (a) one full-time
interest in the activity) for the year. employee actively managing the activity and (b)
Test 4 The activity is a significant participation activity, and three full-time nonowner employees6 doing work
you participated in all significant participation activities for related to the activity during the entire tax year
more than 500 hours. A significant participation activity is any 2. The corporation’s expenses related to that activity
exceeded the gross income from that activity by at
trade or business activity in which you participated for more
least 15%
than 100 hours during the year and in which you didn’t
materially participate under any of the material participation
How does this relate to rental activities?
• An activity is a rental activity if the business receives
tests, other than this test.
payments for the use of tangible property (real property or
Test 5 You materially participated in the activity (other than by
personal property).
meeting this fifth test) for any 5 (whether or not consecutive) of
• All rental activities are presumed to be passive, unless an
the 10 immediately preceding tax years. exception applies.
Test 6 The activity is a personal service activity in which you • Thus, a rental activity is treated as passive even if the
materially participated for any 3 (whether or not consecutive) taxpayer meets one of the 7 tests for material participation.
preceding tax years. An activity is a personal service activity if it • A rental activity will be treated as a nonrental activity per
involves the performance of personal services in the fields of Temporary Regulation § 1.469-1T(e)(3) if any of the following
health (including veterinary services), law, engineering, are true:
architecture, accounting, actuarial science, performing arts, - The average period of customer use is 7 days or less.7
consulting, or any other trade or business in which capital isn’t - The average period of customer use is 30 days or less and
a material income-producing factor. significant services are provided to customers.
Test 7 Based on all the facts and circumstances, you - Extraordinary services are provided to customers.
participated in the activity on a regular, continuous, and - The rental of the property is incidental to a nonrental
substantial basis during the year.5 activity.
- The taxpayer makes the property available to various
What counts as participation? Any work that is customers for nonexclusive use during defined business
customarily done by an owner in that type of activity. hours.
• Participation by the owner’s spouse counts as participation
of the owner, even if the spouse doesn’t own an interest in
5 You can’t meet Test #7 if you participated in the activity for 100
hours or less during the tax year.
the activity and two of you don’t file a joint return. 6 A nonowner employee is an employee who doesn’t own more
- Note: work done in the owner’s capacity as an investor
than 5% of the corporation’s stock at any point during the tax
(e.g, reviewing financial statements) doesn’t count as year.
participation. 7 This is because businesses with such short-term rentals are
- Limited partners generally aren’t considered to have usually expected to provide significant services to customers;
materially participated, but a limited partner might qualify thus, they really are service businesses, not rental businesses.
for material participation under tests 1, 5, or 6.
Continued on next page

16
Lesson 5: Losses and Loss Limitations

PASSIVE ACTIVITY LOSS LIMITATIONS (§ 469) (cont.)

Two exceptions for rental real estate Relationship between the at-risk and passive
Exception #1: real estate professional activity loss limitations
• A taxpayer qualifies for nonpassive treatment of gains/losses • The at-risk limitations are applied before the passive loss
related to rental real estate if the taxpayer is a real estate limitations.
professional. - Thus, a loss that is now allowed due to the at-risk
• To qualify as a real estate professional, the taxpayer must limitations is suspended due to the at-risk limitations.
meet both of these requirements: - Furthermore, passive losses reduce the taxpayer’s at-risk
1. More than 50% of the personal services the taxpayer basis, even if the passive losses cannot be deducted due to
performed during the tax year must have been performed the passive loss limitations.
in real property trades or businesses in which the Disposing of passive activities
taxpayer materially participates. • When disposing of their entire interest in a passive activity, a
2. The taxpayer performed more than 750 hours of services taxpayer may use suspended passive losses when
in real property trades of businesses in which they calculating the gain or loss on the investment. If this results
materially participated. in a loss, that loss can offset active income or portfolio
- These rules are designed to prevent lawyers, CPAs, etc. income.
who dabble in real estate on the side from qualifying for • However, this general rule doesn’t apply if the disposition
nonpassive treatment. If you work 40 hours a week as a isn’t fully taxable.
CPA, for example, you’d need to show that you work more • This could occur in two different situations:
than 40 hours a week on your real property trades or Situation #1: The disposition occurs because of the
businesses. Furthermore, the time spent on your real taxpayer’s death.
property trades or businesses must be day-to-day - Suspended losses are only allowed (to the deceased
activities related to real estate (collecting rent, doing taxpayer) to the extent that those losses exceed any step-
repairs, etc.) as time spent in the capacity as an investor up in basis. Those losses would then be deductible on the
(reviewing financial statements) doesn’t count toward deceased taxpayer’s final return.
your hours. Also, when it comes to meeting these two - Suspended losses that don’t exceed the step-up in basis
tests, hours worked by a spouse don’t count. are permanently lost.
Exception #2: active participation Situation #2: The disposition occurs because the taxpayer
• A taxpayer can have up to $25,000 of passive losses from makes a gift.
rental real estate offset active income or portfolio income if - Suspended losses are added to the donee’s basis in the
they meet both of these requirements: property
1. The taxpayer owns at least 10% of all interests in the - Thus, neither the donor nor the donee can deduct the
activity during the entire tax year. suspended losses. However, the donee receives two
2. The taxpayer actively participates in the activity. benefits from the higher basis: (a) it will reduce the
- “Active participation” is a lower hurdle to meet than amount of gain (or increase the loss) if they later sell the
material participation. Active participation simply interest, and (b) it could result in higher depreciation
requires that the taxpayer participate in management deductions (if it’s depreciable property).
decisions (approving tenants and expenditures, setting
rental terms).
Passive activity credits
a) The $25,000 allowance is reduced by 50% of the • Tax credits arising from passive activities (passive activity
taxpayer’s adjusted gross income (AGI) over credits) can only offset tax from passive income.
$100,000. • Similar to passive losses, unused passive activity credits can
b) Any passive losses are first netted against other be carried forward.
passive income before they can be applied to active • Unlike passive losses, unused passive activity credits are lost
income or portfolio income. forever if the taxpayer disposes of the passive investment.

17
Lesson 5: Losses and Loss Limitations

“EXCESS BUSINESS LOSS” LIMITATIONS (§ 461)

• This was introduced by the Tax Cuts and Jobs Act of 2017
and applies only to noncorporate taxpayers.
• It limits a taxpayer’s ability to deduct active business losses
against nonbusiness income (e.g., salaries) by disallowing a
deduction for any “excess business loss.”8
• The excess business loss is then carried forward to future tax
years as part of the net operating loss (NOL) carryforward.
• The excess business loss is calculated as follows:
aggregate deductions from trades/businesses
- aggregate income/gains from trades/businesses
- threshold amount
= excess business loss
• The threshold changes each tax year and is indexed to
inflation. For example, the threshold was $518,000 for
married taxpayers and $259,000 for other taxpayers for the
2020 tax year.
• The excess business loss limitation is applied after the § 469
passive loss limitations.

Example
A chemistry professor received a salary of $70,000 from her
university for the 2020 tax year. In addition, she generated
$200,000 of gross income and $500,000 of deductions from a
business she owns and materially participates in during the
2020 tax year. She files her taxes as a single (unmarried)
taxpayer.
$500,000
- $200,000
- $259,000 (the threshold for the 2020 tax year)
= $41,000
The chemistry professor would therefore have an excessive
business loss of $41,000.
The $41,000 can be carried forward as a net operating loss.

8 The excess business loss limitation is applied after the § 469 passive
loss limitations.

18
Lesson 6: Property Transactions

REALIZED GAINS AND LOSSES RECOGNIZED GAINS AND LOSSES

A taxpayer may realize a gain or loss when they • Just because a gain or loss is realized does not mean it
dispose of property. will be recognized.3
For a gain or loss to be realized, there must be an • This is because:
identifiable realization event. - A realized gain or loss might qualify for postponement
• This includes a sale, exchange, or other disposition of the - A realized gain might qualify for tax-free treatment
property. - A realized loss might be disallowed
• It also includes the property becoming worthless or • If a taxpayer has a realized gain, the recognized gain is
destroyed. calculated as follows: recognized gain = realized gain –
deferred gain – tax-free gain
• The realized gain or loss is calculated as follows:
amount realized – adjusted basis = realized gain or loss
• If a taxpayer has a realized loss, the recognized loss is
calculated as follows:
Amount realized recognized loss = realized loss – deferred loss – disallowed loss
The amount realized is the amount of cash and property the
taxpayer receives upon disposing of the property, plus any 3 “Recognized” means the gain or loss will affect the taxpayer’s
debt relief (e.g., if a buyer assumes the seller’s mortgage) gross income.
and minus any selling expenses (a sales commission paid to
a real estate broker, legal fees, etc.) related to the
disposition.
amount realized = cash + FMV of non - cash property ADVANCED ISSUES RELATED TO BASIS
+ debt relief – selling expenses
Adjusted basis • “Basis” represents the taxpayer’s unrecovered
A property’s adjusted basis is its initial basis after making investment in the property.
adjustments for capital additions or recoveries • The initial basis is generally the property’s cost, unless:
adjusted basis = initial basis + capital additions
a. The taxpayer isn’t the one who purchased the
– capital recoveries
property.
• The initial basis is the taxpayer’s cost (or other basis1)
when the property was acquired (it includes liabilities b. The taxpayer acquired the property in a bargain
assumed by the taxpayer). purchase.
• Capital additions are costs that change the efficiency, - In a bargain purchase, basis is the property’s fair
capacity, or useful life of the property. market value.
• Capital recoveries include depreciation, casualties, thefts, - For example, if an employer sells property to an
amortized bond premiums, and nontaxable corporate employee for less than the property’s fair market
distributions.2 value, then (a) the employee’s basis in the property
would be its fair market value and (b) the difference
1 If the property was acquired by gift, for example, there is a between the sale price and the property’s fair
separate process for calculating the initial basis.
market value would be treated as compensation to
2 For example, let’s say you set up a corporation tomorrow and
fund it with $10,000 cash. You instantly change your mind have the employee.
the corporation return the $10,000 cash to you, liquidating the • When a taxpayer purchases shares of the same
corporation. The $10,000 you receive would be a recovery of company at different time periods, and then sells some
capital. Thus, your initial basis in the corporation’s stock would (but not all) of the shares, the taxpayer’s basis in the
be $10,000, but after subtracting the capital recovery your shares sold will be determined using FIFO (first-in, first-
adjusted basis in the stock would be zero.
out) unless the taxpayer provides instructions to the
broker about which shares are to be sold .
Continued on next page

19
Lesson 6: Property Transactions (cont.)
ADVANCED ISSUES RELATED TO BASIS (cont.) DISALLOWED LOSSES

Example • Losses are disallowed for:

Assume a taxpayer bought one share of Amazon in June of 2019 - Personal use assets
for $1,600 and then bought another share of Amazon in June of - Wash sales
2020 for $3,000. If the taxpayer were to then sell one share of - Transactions between related parties
Amazon for $4,000 in December of 2021, the taxpayer’s basis in Situation #1: personal use assets
that share would be $1,600 (the cost of the first share • Taxpayers don’t get a deduction for losses on assets
purchased) and the taxpayer would have a realized gain of intended for personal use; the only exceptions are for
$2,400. If the taxpayer had specifically instructed the broker to casualties and thefts.
sell the share that had been purchased in June of 2020, • Taxpayers may recognize a gain on the sale of
however, then the cost basis would have been $3,000 and the personal use assets, however.
realized gain would have been $1,000.
Example
• When a taxpayer pays a single lump-sum to acquire
You pay $80,000 to acquire a motorhome and travel
multiple assets, the taxpayer must allocate the lump-sum
across the country on vacation. After your vacation is
among the various assets based on their relative fair market
over, you sell the motorhome for $65,000. Even though
values.
the selling price is less than your basis in the asset, you
- If a taxpayer acquires a business, the taxpayer first
don’t get to recognize a loss because the asset was for
allocates basis among the identifiable assets based on
personal use. If you had sold the motorhome for
their relative fair market values, but then allocates any
$95,000, however, you would have recognized a taxable
remaining amount to goodwill (i.e., purchase price – fair
gain ($15,000).
value of identifiable assets = goodwill).
• When a taxpayer receives a nontaxable stock dividend, the Situation #2: wash sales
taxpayer’s pre-dividend basis is allocated to the total shares • Taxpayers don’t get a deduction for losses on the sale
post-dividend (thus, the total cost basis doesn’t change). of stock if they acquired substantially identical stock
• When a taxpayer receives property as a gift, the donor’s within 30 days before or after the date of sale.
basis carries over to the done. - This rule prevents taxpayers from selling a stock
- However, if the fair market value of the property is lower just to book the tax loss and then reacquiring the
than the donor’s basis on the date of the gift, then there is same stock.
a dual basis. This means that: • The disallowed loss from a wash sale is added to the
a. If the donee later sells the property for a gain, the basis of the stock acquired.
property’s basis is the donor’s adjusted basis. - Thus, the disallowed loss is not lost forever; it is
b. If the donee later sells the property for a loss, the postponed.
property’s basis is its fair market value at the time the • The wash sale rules apply only to losses, not to gains.
gift was made.
- The dual basis rules prevent the donee from recognizing a Example
loss for a decline in value that occurred while the donor On December 31, 2020 a taxpayer sells one share of
owned the property. Amazon stock for $3,100; the taxpayer’s basis in that
- The donee’s basis for depreciating the property is the share of stock is $3,300. Then on January 1, 2021 the
same as the donee’s basis for determining gain. taxpayer purchases one share of Amazon stock for
• When a taxpayer receives property through an $3,100. The taxpayer’s sale of stock on December 31
inheritance, the taxpayer’s basis in the property is usually would normally result in a $200 loss, but since the
the fair market value on the date of death. This is called the taxpayer acquired identical stock the next day, the
primary valuation amount. If, however, the fair market value taxpayer would not be able to recognize the $200 loss.
declines following the decedent’s death, the estate However, the disallowed loss would be added to the
administrator may elect for the assets to be valued at their basis of the newly-acquired stock. Thus, the taxpayer’s
fair market value 6 months following the decedent’s death. basis in the new share of Amazon stock would be $3,300
This is called the alternative valuation amount. ($3,100 purchase price + $200 disallowed loss).

Continued on next page

20
Lesson 6: Property Transactions

DISALLOWED LOSSES (cont.)

Situation #3: transactions between related parties Example

• § 267 disallows losses on sales between related parties Charlyn acquires land (held for investment) for $850,000. The
• If the buyer later sells the property to an unrelated third fair market value of the land declines, and Charlyn sells the land
party, the buyer can use the previously disallowed loss to to her son Jerome for $700,000. The $150,000 loss is disallowed
offset any gain (but it can’t create or increase a loss, and any per § 267 because Jerome is a related party. Later that year, the
unused amount is lost forever). Note that only the original fair market value of the land increases and Jerome sells it to an
transferee can utilize the disallowed loss from the transferor unrelated party for $750,000. Jerome has a gain of $50,000 but
he can fully offset the gain with the previously disallowed loss.
The previously disallowed loss ($150,000) exceeds Jerome’s
gain ($50,000), but this does not create a loss. The excess
amount ($100,000) is lost forever.

§ 1031 LIKE-KIND EXCHANGES

§ 1031 allows taxpayers to defer gains or losses Boot

on real property in a like-kind exchange. • If you want to trade your rental property for another rental
• § 1031 is similar to § 351 in that it defers the recognition of property, you'll have a difficult time finding a desirable
gain/loss on an exchange. property that has the same fair market value as your
There are 3 requirements to qualify for tax deferral: property.
1. The properties exchanged must be like-kind property. • Thus, it's okay for one party in the transaction to contribute
2. The form of the transaction must be an exchange. other property (usually cash) to make the transaction work.
3. The properties exchanged must be (a) used in a trade or This other property being transferred is called "boot.“
business or (b) held for investment. • If boot is used, the taxpayer receiving the boot has a
Note: these rules are applied separately to each taxpayer in recognized gain for the lesser of:
the transaction. Thus, it's possible for one party to qualify and 1. the boot received
one party to not qualify in the same transaction. 2. the realized gain
Like-kind property Example
• Like-kind property must be real property (not personal Alyssa owns an apartment building with a basis of $800,000
property) located in the U.S. that is used in a trade or & a fair market value of $2 million. Lauren owns an office
business. Other than that, the rules are pretty flexible. Here building with a basis of $1.4 million & a fair market value of
are some examples: $3 million. Alyssa and Lauren decide to exchange buildings.
a. You can exchange improved land for unimproved land. However…
b. You can exchange a factory for land. The fair market value of Lauren's building is $1 million
c. You can exchange an office building for an apartment higher than that of Alyssa's building. To facilitate the
building. exchange, Alyssa gives Lauren $1 million cash (in addition
d. You can exchange a warehouse used in a business for to Alyssa's building). The cash is not like-kind property and
land held for investment. is thus treated as boot.
Example Lauren's recognized gain is the lesser of:
1. the boot received ($1 million)
Alyssa owns an apartment building with a basis of $800,000 & a
2. the realized gain [$2 million building + $1 million cash -
fair market value of $3 million. Lauren owns an office building
$1.4 million basis = $1.6 million]
with a basis of $1.4 million & a fair market value of $3 million. If
The boot received ($1 million) is less than the realized gain
Alyssa and Lauren can exchange buildings, neither will
($1.6 million), so Lauren has a recognized gain of $1 million.
recognize a gain on the transaction.

Continued on next page

21
Lesson 6: Property Transactions

§ 1031 LIKE-KIND EXCHANGES (cont.)

Use of an Intermediary
• It can be difficult to find someone who wants to swap properties with you.
• For this reason, taxpayers usually complete a § 1031 exchange with an intermediary.
- For example, CWS Capital is a company that specializes in handling § 1031 exchanges.
- Some banks (e.g., Wells Fargo) also offer to serve as an intermediary.
Example Ashley has a rental property in St. Louis with a basis of $100,000 and a fair market value of $500,000. Ashley wants
to get rid of the rental property in St. Louis and obtain a rental property in Texas. If Ashley sells the rental property in St. Louis,
she'll be taxed on a $400,000 gain. To avoid the tax hit, Ashley decides to do a § 1031 exchange. Unfortunately, Ashley doesn't
know anyone in Texas who wants to swap properties. Thus, Ashley hires an intermediary (Wells Fargo) to handle the § 1031
exchange. Ashley then finds someone to buy her rental property in St. Louis. However, Ashley does NOT sell the property to the
buyer. Instead, the buyer pays the money to Wells Fargo. Ashley now tries to find a rental property in Texas that she wants.
1. Ashley has 45 days to identify potential replacement properties
2. Ashley has 180 days to complete the entire transaction
Ashley finds a rental property in Texas that she likes. The property is worth $500,000. Ashley does NOT pay any money to the
seller in Texas. Instead, she has Wells Fargo pay the $500,000. Ashley then takes title to the Texas property from Wells Fargo.
Wells Fargo receives a fee from Ashley for serving as the intermediary. Ashley avoided a tax hit and takes a tax basis of $100,000
in her new property.

§ 1033 INVOLUNTARY CONVERSIONS

• When a taxpayer disposes of property for reasons outside of the taxpayer’s • Special rule for condemnations
control, this is called an involuntary conversion. Examples include complete - When determining whether the replacement
or partial destruction, theft, seizure, sale/exchange under threat of property qualifies for § 1033 gain deferral in
condemnation, etc. a condemnation of business or investment
• Taxpayers may realize a gain or loss on an involuntary conversion. use property, the taxpayer may use the
• The taxpayer may elect to postpone a realized gain if they reinvest the broad rules of § 1031 exchanges in
amount realized if property that is similar or related in service or use to the determining what types of property will
involuntarily converted property. This is determined as follows: qualify as replacement property.
• Time limit
Did the taxpayer use the property or hold it as an investment? - Taxpayers must acquire the replacement
Used the The taxpayer is You would apply Replacement property property within the two years following the
property an owner-user. the functional must have the same end of the tax year in which the gain from
use test. use as the old property. involuntary conversion was realized.
- The time limit is three years if it pertains to a
condemnation of real property used in a
Held as The taxpayer is You would apply Replacement property business or held for investment.
investment an owner- the taxpayer use must be used in a - The time limit is four years if it is a federally
investor. test. similar endeavor as the declared disaster area.
old property. - In all cases, taxpayers can request an
extension if they have reasonable cause.

• The taxpayer use test is more flexible than the functional use test for
determining what types of property will qualify as replacement property.

22
Lesson 6: Property Transactions

§ 121 SALE OF A PRINCIPAL RESIDENCE

• Gains on the sale of personal use assets are typically
recognizable.
• However, taxpayers can exclude up to $250,000 ($500,000 if
married filing joint) of realized gain on the sale of their principal
residence.
• There are two requirements:
- The taxpayer must have owned and used the property as their
personal residence for at least two of the five years preceding
the date of sale.
- The exclusion can only be used once every two years.
• The exclusion can be prorated if the taxpayer failed to meet the
requirements because of :
a. a change in employment or
b. health problems
• If the taxpayer dies, the surviving spouse can count the
decedent’s usage of the property in determining whether the
surviving spouse meets the requirements.

23
Lesson 7: Capital Gains, Losses, and § 1231
CAPITAL ASSETS

HOLDING PERIOD
There are 3 types of assets for tax
purposes: • Property must be held more than one year to qualify for long-term
- Ordinary assets capital gain/loss treatment. The holding period:
- Capital assets - Begins the day after the property was acquired
- § 1231 assets - Ends on the day the property is disposed of
• The tax treatment of gains/losses depends Example
on which asset type you’re dealing with. Sally acquired 10 shares of stock in Pinterest for $700 on January 1,
• For capital assets, individual taxpayers: 2020. On January 1, 2021 Sally sells all 10 shares of her stock for $850.
- Receive preferential tax treatment on Sally’s holding period began on January 2, 2020 and ended on January
capital gains 1, 2021. Thus, Sally did not hold the property more than one year.
- Face limitations on deducting capital Accordingly, she has a $150 short-term capital gain.
losses If Sally had instead sold the stock for $850 on January 3, 2021, she
What is a capital asset? would have recognized a $150 long-term capital gain.
• The tax code doesn’t define capital assets. • Here are some special rules about the holding period in certain
• However, § 1221(a) says that a capital asset situations:
is not: - Gifts: the donor’s holding period is tacked on to the donee’s
- Inventory held for sale to customers in holding period.
the course of a business - Inheritance: the heir’s holding period is always treated as long-
- Receivables from the sale of goods or term.
services in a business - Nontaxable exchange: if the property exchanged is a § 1231 or
- Supplies used in a business capital asset, the holding period of the old asset is tacked on to the
holding period of the new asset.
- Depreciable property or real estate used
- Disallowed loss: if property is acquired in a disallowed loss
in a business
transaction, the holding period of the seller does not carry over to
- Patents,1 copyrights, artistic the buyer.
compositions, formulas or processes
Tax rates
• The taxpayer’s intended use of the asset
• The tax rates on long-term capital gains are based on a taxpayer’s
affects the asset’s classification. For taxable income (excluding the capital gain).
example: • The income thresholds for determining the rates are indexed to
- A truck intended for the taxpayer’s inflation and change each year.
personal use is a capital asset. If the • For the 2020 tax year, the tax rates on long-term capital gains were as
same truck was intended for business follows:
use, however, it would not be a capital Single – Married, filing jointly - Rate
asset. taxable income taxable income
- If the average person owns stock in Less than $40,000 Less than $80,000 0%
Walmart, that stock is a capital asset. But At least $40,000 but At least $80,000 but less 15%
if a securities dealer purchases Walmart less than $441,450 than $496,600
stock with the intention of selling it to At least $441,450 At least $496,600 20%
customers, the securities dealer would
Tax Tax rate for There are 3 exceptions to the capital gain
treat the Walmart stock as inventory.
bracket collectibles tax rates:
• For the most part, capital assets are assets
10% 10% • Collectibles (max rate of 28%)
that are not business-related.
12% 12% - Collectibles include stamps, coins,
22% 22% works of art, antiques, etc.
1 With patents, there is one exception. An
individual who holds a patent may receive long- 24% 24% - The tax rate for collectibles depends
term capital gain treatment if that person 32% 28% on the taxpayer’s tax bracket.
transfers all substantial rights to the patent, per § 35% 28%
Continued on next page
1235. 37% 28%

24
Lesson 7: Capital Gains, Losses, and § 1231

HOLDING PERIOD (cont.) THE NETTING PROCESS

• The taxable portion of gain on qualified • Noncorporate taxpayers receive preferential tax rates for net long-term
small business stock (max rate of 28%). capital gains.
- This pertains to the gain exclusion per § • To calculate net capital gains or losses, taxpayers must use this 4-step
1202. netting procedure:
• § 1250 unrecaptured gain (max rate of 25%) Step 1: organize the gains and losses into 4 groups.
- This pertains to some of the gain that is - Short-term
attributable to past depreciation - Long-term
deductions for depreciable real property. - 28% property
- § 1250 unrecaptured gain
Step 2: Net the gains and losses within each of the 4 groups.
- Net short-term
C CORPORATIONS & CAPITAL GAINS/LOSSES
- Net long-term
- Net 28% property
The tax treatment of capital gains is much - Net § 1250 unrecaptured gain
different for C corporations: Step 3: Combine the net 28% property and net § 1250 unrecaptured
• Net capital gains are taxed at ordinary tax gain.
rates (no preferential treatment). - Take the resulting figure and combine it with the net long-term
• Capital losses can only offset capital gains. category.
Capital losses can never offset ordinary Step 4: Combine the figure from Step 3 with the short-term category.
income. This contrasts with individual - If the result is a short-term capital gain, it is taxed at the ordinary
taxpayers, who can deduct up to $3,000 of rate.
net capital losses against ordinary income - If the result is a long-term capital gain, it is taxed at preferential
annually. rates.
• Net capital losses can be carried back 3 - If the result is a capital loss, the taxpayer may deduct up to $3,000,
years and carried forward 5 years. In both with any excess amount being carried forward to future tax years.2
cases, they must be treated as short-term.
2 Capital loss carryovers are lost forever if the taxpayer dies.

§ 1231 GAINS & LOSSES

• Business assets held for more than one year are treated as § • § 1231 property receives favorable tax treatment in that:
1231 property - Gains are treated as long-term capital gains
§ 1231 property includes: - Losses are treated as ordinary losses.
- Depreciable personal property used in a
The Netting Process Step 3: § 1231 lookback
business (equipment, machines)
Step 1: Net recognized long-term gains and provision
- Real property (depreciable or not) used
losses from casualties of both (a) § 1231 - Any capital gain from the first
in a business (buildings, land)
property and (b) nonpersonal use capital part of step 2 is treated as
- Certain natural resources, livestock, and
assets. ordinary to the extent that §
unharvested crops
- If casualty gains > casualty losses, treat 1231 losses were recognized
- Certain purchased intangible assets
the net gain as § 1231 gain. in the past 5 tax years.
eligible for amortization (goodwill)
- If casualty losses > casualty gains, treat - Thus, prior § 1231 losses are
§ 1231 property does not include:
the casualty losses and gains as ordinary.
- Property held for one year or less recaptured.
Step 2: net the gains and losses within each
- Inventory - § 1231 gain exceeding the
of the 4 groups
- Receivables lookback recapture is a long-
1. Net short-term
- Patents, copyrights, artistic term capital gain.
2. Net long-term
compositions, formulas or processes
3. Net 28% property
4. Net § 1250 unrecaptured gain

25
Lesson 7: Capital Gains, Losses, and § 1231

DEPRECIATION RECAPTURE § 1245 RECAPTURE

• Prior to the § 1231 netting process, • § 1245 requires taxpayers to treat gains as ordinary income if they are
taxpayers must first check whether any § attributable to previous depreciation deductions.
1231 gains should be reclassified as Example
ordinary income per § 1245 or § 1250 In 2020, Samantha purchases equipment for her business at a cost of
depreciation recapture. $80,000. She then takes an $80,000 depreciation deduction for the 2020 tax
- § 1245 and § 1250 recapture apply to year per § 179. In 2021, when Samantha’s basis in the equipment is zero,
individual assets and are not part of she sells it for $95,000. Samantha realizes a $95,000 gain, but $80,000 is
the netting process. attributable to previous depreciation deductions. Thus, $80,000 of the gain
is ordinary income (per § 1245) and the remaining $15,000 is § 1231 gain.
The $15,000 § 1231 gain will then be factored into the § 1231 netting
process.
§ 1250 RECAPTURE • § 1245 property includes:
- Depreciable personal property that is § 1231 property (furniture,
• § 1250 requires taxpayers to treat gains equipment, machines)
as ordinary income if they are - § 197 intangibles that are amortizable (patents, copyrights, goodwill)
attributable to previous excess - Single-purpose agriculture structures (silos), petroleum storage tanks
depreciation. and other tangible real property (but not buildings and their structural
- “Excess” depreciation is depreciation components), certain qualified real property that qualifies for § 179
beyond that of straight-line expensing, baseball and football contracts
depreciation. Example
• § 1250 property includes: Jennifer purchases a work truck for $40,000 and takes $22,000 of
- Depreciable real property (buildings depreciation deductions over the course of several years. The basis of the
and their structural components) truck is now $18,000. If Jennifer then sells the truck for $25,000 she will
- Intangible real property (leaseholds of have a taxable gain of $7,000. This would ordinarily be a capital gain, but
§ 1250 property)
due to § 1245 the $7,000 gain will be taxed as ordinary income.

§ 291 AND ADDITIONAL RECATURE FOR CORPORATIONS

• When it comes to depreciable real property, corporate

Example
taxpayers proceed as follows:
A C corporation purchases an apartment building in 1991
- Step 1: Determine recapture for any excess depreciation
for $95,000 and takes $75,000 of depreciation deductions.
per § 1250.
The basis of the building is now $20,000. If the C
- Step 2: Calculate what the recapture would have been, had
corporation then sells the building for $100,000 it will have
the property been treated as § 1245 property.
depreciation recapture as follows:
- Step 3: Subtract step 1 from step 2. This is the excess §
1245 recapture potential. § 1245 recapture potential $ 75,000
- Step 4: Multiply the § 1245 recapture potential (step 3) by § 1250 recapture amount - $ 0
20%. Excess § 1245 recapture potential $ 75,000
- Step 5: The amount calculated in step 4 is treated as § 291 percentage x 0.20
additional ordinary income.
Ordinary income per § 291 $ 15,000

26
Lesson 7: Capital Gains, Losses, and § 1231

UNRECAPTURED § 1250 GAIN DEPRECIATION RECAPTURE IN

NONTAXABLE TRANSACTIONS
• Real property placed into service since 1986 can only be
depreciated using straight line. • If the transferor’s adjusted basis carries over to the
- Thus, any buildings placed into service since 1986 are transferee in a nontaxable exchange, then depreciation
not subject to § 1250 recapture. recapture potential also carries over to the transferees
• However, previous depreciation that is not recaptured is - Examples of such nontaxable exchanges include:
unrecaptured § 1250 gain. a. § 351 transactions and § 721 transactions
- Noncorporate taxpayers pay a max tax rate of 25% on b. § 368 reorganizations
unrecaptured § 1250 gain. c. § 332 liquidations of subsidiaries
Example - If gain is recognized (due to the receipt of boot), the
Jennifer purchases an apartment building in 1991 for gain is treated as ordinary to the extent of
$95,000 and takes $75,000 of depreciation deductions. a. recapture potential, or
The basis of the building is now $20,000. If Jennifer then b. gain recognized, whichever is lower.
sells the building for $100,000 she will have a § 1250 • In a § 1031 like-kind exchange, recapture potential carries
unrecaptured gain of $75,000 (taxed at no more than 25%) over to the property received.
and a capital gain of $5,000.

DEPRECIATION RECAPTURE WITH GIFTS & ESTATES

• When a gift is made, any recapture potential carries over

from the donor to the done.
• When a person dies, any recapture potential is
completely eliminated.

27
Lesson 8: Individuals as Taxpayers
THE TAX FORMULA
EXAMPLES OF GROSS INCOME
An individual’s federal income tax liability
is calculated as follows: • Compensation for services, • Damages for emotional
Income (broadly defined) salaries, wages, severance distress, discrimination, or
— Exclusions pay, and bonuses harm to one’s reputation
• Tips and gratuities • Punitive damages
Gross income1
• Business income, rent, and
— Deductions for AGI2 royalties 5 A prize/award is excluded from
Adjusted gross income (AGI) • The difference between fair gross income if the recipient
market value and purchase refuses the award or if all 4 of the
— Deductions from AGI3 following conditions are met: (1)
price in a bargain purchase
— Deduction for qualified business income the award was given in
from an employer
recognition of achievement, (2)
Taxable income • Compensation for serving on a the recipient did not take action
× Tax rate jury to enter the contest for the award,
Tax due (before accounting for tax credits4) • Illegal income (e.g., embezzled (3) the recipient need not provide
funds) future services as a condition of
— Tax credits receiving the award, and (4) the
• Dividends and interest
Tax due • Gains from the disposal of recipient transfers the award to a
property nonprofit or qualified
governmental unit. Also, an
1 Gross income includes income “from whatever source • Prizes and awards5 (lottery
employee can exclude up to
derived” unless Congress has provided an exclusion. winnings, awards given by
$400/year of tangible personal
2 Deductions for AGI are also known as “above-the-line employer to employee, etc.) property received in recognition
deductions.” • Gambling winnings of employee achievement.
3 This is the greater of: (a) the standard deduction or (b) • Found property 6 In certain circumstances,
itemized deductions
• Hobby income discharge of indebtedness is not
4 You can calculate the tax due using the tax tables
• Discharge of indebtedness6 treated as gross income.
provided by the IRS.

EXAMPLES OF EXCLUSIONS

• Life insurance proceeds • Social security benefits (a portion may supplies, but not food or housing). A tuition
• Municipal bond interest be taxable12) waiver for a research or teaching assistant,
• Interest on Series EE U.S. government • Unemployment benefits however, is generally taxable because it is
considered compensation for services.
savings bonds if used to pay qualified • Workers’ compensation 9 If Lexi and Charlie get a divorce, and Charlie
higher education expenses • Accident and health insurance proceeds
transfers Microsoft stock with a basis of
• Gifts7 and inheritances from a policy purchased by the taxpayer $25,000 to Lexi per the divorce decree, Lexi is
• Scholarships8 • Compensatory damages received for not taxed upon receipt of the stock. She
• Alimony physical injury or sickness receives a carryover basis ($25,000) in the
• Property settlements per a divorce • Damages for wrongful incarceration § stock.
10 For example, employees are not taxed on the
decree or agreement9 139F
• Child support value of health insurance provided by their
• Gain from the sale of a principal 7 Whether a transfer is a gift is based on the employer.
11 The exclusion also pertains to tuition
residence, subject to limitations per § donor’s intent. A transfer from an employer
to an employee, however, is never a gift. reductions for spouses and children of
121 8 Scholarship income (including athletic employees.
• Fringe benefits provided by employer10 12 If the taxpayer’s income exceeds certain
scholarship income) is excluded from gross
• Tuition reduction for employees11 of a thresholds, as much as 85% of Social Security
income to the extent it is used for qualified
nonprofit educational institution tuition and related expenses (textbooks and retirement benefits may be taxable per § 86.

28
Lesson 8: Individuals as Taxpayers

EXAMPLES OF DEDUCTIONS FOR AGI13 THE STANDARD DEDUCTION

• Ordinary and necessary expenses for a Taxpayers can deduct either:

business per § 162 1. The sum of their itemized deductions, or
• One-half of the self-employment tax paid 2. A standard deduction
• Capital losses (maximum $3,000) • The standard deduction is indexed to inflation and changes each year.
• Contributions to certain types of • The standard deduction is calculated as follows:
retirement plans (IRA, but not Roth) standard deduction = basic standard deduction +
• Contributions to Health Savings Accounts additional standard deduction
(HSAs) • Here are the basic standard deduction amounts for 2020:
• Interest on qualified student loans Filing status Standard deduction for the
2020 tax year
13 Other deductions for AGI are outlined in § 62. Single $12,400
Married, filing separately $12,400
Married, filing jointly $24,800
Surviving spouse $24,800
EXAMPLES OF ITEMIZED DEDUCTIONS Head of household $18,650

• Itemized deductions generally include • Some taxpayers get a limited standard deduction (or no standard
personal expenses and expenses of deduction at all).
income-producing activities that aren’t • Some taxpayers receive one or more additional standard deductions,14
related to a trade or business. Here are as follows:
some examples: If the taxpayer is… Additional standard
State and local income taxes or state and deduction(s)
local sales taxes Blind One
Real estate taxes Over the age of 65 One
Personal property taxes that are ad Blind and over the age of 65 Two
valorem15
• Here are the additional standard deduction amounts for 2020:
Qualified residence interest
Unreimbursed medical expenses exceeding Filing status Additional Standard deduction
7.5% AGI for the 2020 tax year
Charitable contributions Single $1,650
Casualty losses exceeding 10% of AGI Married, filing separately $1,300
Investment interest (limited to the extent of Married, filing jointly $1,300
net investment income) Surviving spouse $1,300
Gambling losses (limited to the extent of Head of household $1,650
gambling winnings)
• Limitations for dependents
Regarding the state and local tax - The standard deduction is limited if the taxpayer is a dependent of
(SALT) deduction: another taxpayer.
• Taxpayers may deduct a maximum of - For the 2020 tax year, a dependent’s basic standard deduction is
$10,000 in state and local taxes. limited to the greater of (a) $1,100 or (b) the dependent’s earned
• This limit doesn’t apply to taxes imposed income plus $350. However, the dependent’s basic standard
on business or investment activity and deduction cannot exceed the basic standard deduction amounts for
property. non-dependent taxpayers.
- The previous limitations apply to the basic standard deduction. A
15 “Ad valorem” means the property taxed is dependent taxpayer may also be eligible an additional standard
calculated based on the value of the property. deduction (if blind, over 65, or both).
Continued on next page 14 A taxpayer may not receive an additional standard deduction for a dependent.

29
Lesson 8: Individuals as Taxpayers
EXAMPLES OF ITEMIZED DEDUCTIONS (cont.)

Regarding the § 213 medical expense deduction: Regarding the qualified residence interest deduction:
• Medical expenses incurred for the taxpayer, the taxpayer’s • Taxpayers can receive a deduction on interest paid or
spouse, and the taxpayer’s dependents are deductible if they accrued for a qualified residence. A qualified residence
exceed the 7.5% AGI floor. includes (a) the taxpayer’s principal residence, which must
• Medical expenses include costs for the diagnosis, cure, meet the requirements for nonrecognition of gain per § 121,
treatment, and prevention of disease (including the cost of and (b) one other residence.
hospital, mental, and dental care), as well as health • Loan origination fees are not deductible.
insurance premiums, prescription drugs, medical • Interest incurred on a home equity loan is not deductible
equipment, and transportation/lodging to receive health unless the money is used to build or improve the taxpayer’s
care away from home. principal residence.
• Cosmetic surgery is not deductible unless medically • A prepayment penalty is considered interest and is thus
necessary (e.g., it addresses the effects of deductible.
deformity/disfigurement or a personal injury). • Points paid by the purchaser are deductible if they are
• Nursing home costs, including the cost of food and lodging, considered prepaid interest and not a service charge.
are deductible if the primary purpose for being in the nursing Regarding the § 170 charitable contribution deduction:
home is to obtain medical care. • Taxpayers may receive a deduction for gifts of property to
• Capital expenditures (e.g., installing an elevator in the qualified organizations.
person’s home) may be deductible if they are deemed • To be a deductible charitable contribution, the taxpayer
medically necessary by a doctor and are primarily used by must establish donative intent and the absence of
the person who needs the medical care. consideration (i.e., the transfer was made due to
Regarding the investment interest deduction: disinterested generosity, and not made to receive something
• The deduction for investment interest is limited to the lesser in exchange).
of: • Donated property is valued at its fair market value at the
- Investment interest paid time the gift was made.
- Net investment income (investment income – investment • Taxpayers may not receive a charitable deduction for the
expenses) following:
• For purposes of calculating net investment income: - The value of services they provide to an organization
- Investment income includes interest, annuities, and - The value of blood donated to a blood bank
royalties not arising from the ordinary course of a trade or - Fees paid to fraternal orders, country clubs, lodges, etc.
business. It does not include passive income. - Fees paid to homeowners’ associations
- Investment expenses include deductible expenses - Lottery, raffle, or bingo tickets
incurred to produce investment income (e.g., property - Gifts made to individuals
taxes on investments). Investment expenses don’t include • There are limits to the amount of the charitable contribution
interest expense, brokerage fees, or investment counseling deduction based on:
fees. - The type of property being contributed
• Any disallowed investment interest can be carried forward to - The type of organization receiving the donation
future tax years. - The taxpayer’s AGI

THE QUALIFIED BUSINESS INCOME (QBI) DEDUCTION

• The QBI deduction is a deduction from AGI, but it is not an itemized deduction. Thus, a taxpayer can take the QBI deduction
whether or not they itemize their deductions.
- The QBI deduction is the lesser of:
a. 20% of QBI, or
b. 20% of modified taxable income

30
Lesson 8: Individuals as Taxpayers
TAX CREDITS VS TAX DEDUCTIONS

Tax credits reduce tax liability dollar-for-dollar, whereas • Thus, one dollar of tax credits is more valuable than one
tax deductions only reduce tax liability by the marginal tax dollar of tax deductions.
rate.
Example
• This is because tax credits reduce the tax due, while tax
A taxpayer faces a marginal tax rate of 24%. A $100 tax
deductions reduce taxable income (the base from which the
tax due is calculated). credit will reduce tax liability by $100. A $100 tax deduction,
however, will reduce tax liability by just $24 ($100 * 24%).

EXAMPLES OF TAX CREDITS

Child tax credit - The American Opportunity credit covers books and course
• Taxpayers can receive a credit of $2,000 per qualifying materials.
child.16 • Both credits phase out when the taxpayer’s income reaches
• A qualifying child must be: certain thresholds.
- Under age 17 • A married taxpayer must file a joint return to receive either
- A U.S. citizen with a social security number credit.
- A dependent of the taxpayer American Opportunity tax credit
• The credit is partially refundable.17 • This credit covers the first $2,000 of expenses and 25% of
Dependent credit the next $2,000 of expenses (for a maximum credit of
• Taxpayers can receive a credit of $500 for each non-child $2,500/year) for the first four years of postsecondary
dependent. education.
• The credit is not refundable and is subject to a phaseout. • This credit is partially refundable.
Credit for child and dependent care expenses • This credit is calculated per student.
• Taxpayers can receive a credit for paying child/dependent • To qualify for this credit, the student must take at least a
care services so they can work outside the home. The care 50% full-time course load in one academic term during the
can be provided in or outside the home. year.
• The credit is for a percentage of the child care costs, with Lifetime learning tax credit
the percentage based on the taxpayer’s AGI (the percentage • This credit can cover 20% of the first $10,000 of expenses.
ranges from 20% to 35%). • This credit is calculated per taxpayer.
- The maximum credit is $6,000. • There is no course load requirement for the student.
- The credit is limited to the taxpayer’s earned income. Premium tax credit
- If the taxpayer is married, the credit is limited to the • Taxpayers with a household income from 100% to 400% of
earned income of the spouse with less earned income. the federal poverty line may receive a tax credit if they
- If the taxpayer is married with a nonworking spouse, the purchase insurance through the Health Insurance
nonworking spouse is deemed to have $250/month in Marketplace created by the Affordable Care Act.
earned income (or $500/month if there are two or more - Eligible taxpayers can receive the credit in advance by
qualifying children/dependents).
having the government send the money directly to the
• To be eligible, the taxpayer must have either:
insurer to reduce their monthly premiums. Alternatively,
- A dependent under age 13, or
the taxpayer may wait until they file their tax return (the
- A dependent or spouse who is physically or mentally
incapacitated and lives with the taxpayer more than 50% credit is refundable).
of the year • Taxpayers must claim the record by filing Form 8962 with
Education tax credits their tax return.
• There are two education tax credits: the American
Opportunity and the Lifetime learning tax credit. Here’s
16 This phases out when AGI exceeds $400,000 (if married filing
jointly) or $200,000 (not married filing jointly).
what they cover: 17 Limited to $1,400 for the 2020 tax year.
- Both credits cover qualified tuition and related expenses.
- Neither credit covers room and board. Continued on next page

31
Lesson 8: Individuals as Taxpayers

EXAMPLES OF TAX CREDITS (cont.) FILING STATUS

Adoption expenses tax credit When filing a tax return, the taxpayer must
• Taxpayers can receive a credit for adoption fees, court choose a filing status.
costs, attorney fees, the cost of a social service review,
• The filing status is used to determine the standard
and transportation costs related to the adoption of an
deduction and the amount of exclusions, deductions,
eligible child.
and credits available for the taxpayer.
• An eligible child is a child that is either:
- Under age 18, or
There are 5 filing statuses:
1. Single - The taxpayer is unmarried or legally
- Physically or mentally incapable of caring for oneself
separated but doesn’t qualify as a head of household.
• A married couple must file a joint return to receive the
2. Married, filing jointly - The taxpayer is married and
credit.
is filing a combined return with their spouse.
• The credit is capped at a certain amount18 and phases
3. Married, filing separately - The taxpayer is married
out when the taxpayer’s AGI exceeds a certain
but has chosen to file a separate tax return.20
threshold.19
4. Surviving spouse (qualifying widow or widower)
Earned income credit
5. Head of household - The taxpayer must meet 3
• Taxpayers with low income may receive a credit for
requirements:
earning income.
- Unmarried at the end of the tax year
• The credit is calculated by multiplying a specified
- Pays more than 50% of the cost of maintaining a
percentage (based on the taxpayer’s AGI) by the
home
taxpayer’s earned income and earnings from self-
- Had one or more qualifying person(s) living with the
employment.
taxpayer in the home for more than 50% of the
• The credit is available to taxpayers who meet either of
year.21 A qualifying person includes a qualifying
these requirements:
child or a qualifying relative.
- Age 25 through 64, and can’t be claimed as a
** There is an exception to the above requirements
dependent on another return
(abandoned spouse).
- Have a qualifying child
• A married taxpayer may file as head of household if:
18 $14,300 for the 2020 tax year. - The taxpayer’s spouse didn’t live in the home for
19 $214,520 for the 2020 tax year. the last 6 months of the year.
- The taxpayer doesn’t file a joint return.
- The taxpayer paid more than 50% of the cost of
maintaining their home for the year.
WHO MUST FILE A TAX RETURN? - The taxpayer’s home was the principal residence
for the taxpayer’s child22 for more than 50% of the
Individuals are generally required to file a tax year, and the child can be claimed by the taxpayer
return if any of the following is true: as a dependent.
• Their gross income exceeds their standard deduction. 20 It is usually best for married couples to file jointly (e.g., they
• They are self-employed and have at least $400 in net
would qualify for a greater exclusion per § 121). In rare cases,
earnings from their business. however, it might make more sense to file separately (e.g., one
• They wish to receive a refund of federal income taxes member of the couple incurred significant medical expenses
withheld. and is trying to maximize the deduction, which is subject to a
• They wish to receive the earned income tax credit. limitation of 10% of AGI).
21 If the qualifying person is the taxpayer’s parent, the parent
need not live in the home for than 50% of the year for the
taxpayer to qualify as head of household.
22 This includes sons/daughters, stepsons/stepdaughters, foster
children, and adopted children.

32
Lesson 8: Individuals as Taxpayers

THE KIDDIE TAX

To prevent parents from shifting unearned income to

children who are in a lower tax bracket, a child’s
unearned income may be taxed at the marginal rate of
the parent.
- Unearned income includes interest, dividends, capital
gains, rent, royalties, income from being the
beneficiary of a trust, etc.
• According to the IRS, the kiddie tax applies when these
conditions are met:
- The child is required to file a tax return.
- The child doesn’t file a joint tax return.
- The child’s unearned income was more than $2,200.
- The child meets one of the following age requirements:
a. Under age 18 at the end of the tax year
b. Age 18 at the end of the tax year, and the child
doesn’t have earned income providing more
than 50% of the child’s support23
c. At least age 18 and under the age of 24, and the
child is a full-time student
- At least one of the child’s parents was alive at the end
of the tax year.
• If the above requirements are met, IRS Form 8615 must
be completed and attached to the child’s tax return.

23 “Support” includes money spent to provide the child with

housing, food, clothes, education, and other necessities.

33
Lesson 9: Individuals as Employees & Business Owners
EMPLOYEE OR SELF-EMPLOYED?

Factor Explanation
• A taxpayer can earn income as an employee or by being self-
6. Continuing A continuing relationship between the
employed.
relationship worker and the person for whom the
- A self-employed taxpayer is called an “independent
services are performed indicates
contractor.”
employee status.
• It can sometimes be difficult for a company to determine 7. Set hours of The establishment of set hours for the
whether a person is an employee or an independent work worker indicates employee status.
contractor. The distinction is important, because 8. Full time If the worker must devote substantially full
employees and independent contractors are taxed required time to the business of the person for
differently. whom services are performed, this
- In 1987, the IRS released a 20-factor test it uses in indicates employee status. An
determining whether someone should be classified as an independent contractor is free to work
employee or an independent contractor.1 when and for whom he or she chooses.
Factor Explanation 9. Doing work on If the work is performed on the premises
1. Instructions If the person for whom the services are employer’s of the person for whom the services are
performed has the right to require premises performed, this indicates employee status,
compliance with instructions, this indicates especially if the work could be done
employee status. elsewhere.
2. Training Worker training (e.g., by requiring attendance 10. Order or If a worker must perform services in the
at training sessions) indicates that the person sequence test order or sequence set by the person for
for whom services are performed wants the whom services are performed, that shows
services performed in a particular manner the worker is not free to follow his or her
(which indicates employee status). own pattern of work and indicates
employee status.
3. Integration Integration of the worker’s services into the 11. Oral or written A requirement that the worker submit
business operations of the person for whom reports regular reports indicates employee status.
services are performed is an indication of 12. Payment by the Payment by the hour, week, or month
employee status. hour, week, or generally points to employment status;
4. Services If the services are required to be performed month payment by the job or a commission
rendered personally, this is an indication that the indicates independent contractor status.
personally person for whom services are performed is 13. Payment of If the person for whom the services are
interested in the methods used to business and/or performed pays expenses, this indicates
accomplish the work (which indicates traveling expenses employee status. An employer, to control
employee status). expenses, generally retains the right to
5. Hiring, If the person for whom services are direct the worker.
supervision, and performed hires, supervises or pays 14. Furnishing The provision of significant tools and
paying assistants assistants, this generally indicates employee tools and materials materials to the worker indicates
status. However, if the worker hires and employee status.
supervises others under a contract pursuant 15. Significant Investment in facilities used by the worker
to which the worker agrees to provide investment indicates independent contractor status.
material and labor and is only responsible for 16. Realization of A worker who can realize a profit or suffer
the result, this indicates independent profit or loss a loss as a result of the services (in
contractor status. addition to profit or loss ordinarily realized
by employees) is generally an independent
contractor.
1 Rev. Rul. 87-41, 1987-1 C.B. 296.
Continued on next page

34
Lesson 9: Individuals as Employees & Business Owners
EMPLOYEE OR SELF-EMPLOYED? (cont.)

Factor Explanation 20. Right to If a worker has the right to terminate the
17. Working for If a worker performs more than de terminate relationship with the person for whom services are
more than one minimis services for multiple firms at the performed at any time he or she wishes without
firm at a time same time, that generally indicates incurring liability, that indicates employee status.
independent contractor status.
• The weight of each factor differs based on the
18. Making If a worker makes his or her services
circumstances. But generally speaking:
service available available to the public on a regular and
- A worker is classified as an employee when the company
to the general consistent basis, that indicates
exercises control over the person’s day-to-day work (what
public independent contractor status.
they do, how they do it, and when they do it).
19. Right to The right to discharge a worker is a factor
- A worker is classified as self-employed when they own an
discharge indicating that the worker is an
independent business in which they offer services to the
employee.
public and may realize a profit or loss.

EXCLUSIONS FOR EMPLOYEES

Qualified fringe benefits,2 such as: - To qualify for the exclusion, the taxpayer must be a bona
• Meals or lodging provided by the employer to the employee fide resident of the foreign country or be present in a
are excluded if the meals or lodging are furnished by the foreign country (or foreign countries) for at least 330 days
employer on the employer’s business premises for the during any 12 consecutive months.5
convenience of the employer. With respect to lodging, the - Any income beyond the excluded amount is taxed at the
employee must be required to accept the lodging as a marginal rate that would apply without the exclusion.
condition of employment for it to be excludible from income
• The use of athletic facilities on the employer’s premises Example
• Qualified tuition reduction plans for employee, spouse, and Jim worked in Saudi Arabia for 348 days in 2020 and earned a
children salary of $150,000. Jim can either (a) include the $150,000 in
• Child and dependent care services provided by the his taxable income and receive a credit for foreign taxes paid
employer (subject to ceiling) or (b) take the foreign earned income exclusion (since he was
• Adoption assistance (subject to ceiling) out of the U.S. at least 330 days during a consecutive 12-
• Health insurance premiums paid by the employer month period). Saudi Arabia doesn’t have an income tax, so
• Premiums on the first $50,000 of group term life insurance Jim didn’t pay any foreign taxes. Thus, it makes sense for Jim
• Frequent flyer miles from a business trip that are credited to to take the foreign earned income exclusion. Jim was out of
a personal account the U.S. 348 of the 366 days for 2020. Thus, the maximum
• Flexible spending plans3 348
amount of foreign earnings he can exclude is: x $107,600 =
• Qualified employee discounts 366
• No-additional-cost-services (allowing Amtrak employees to $102,308. Jim can therefore exclude $102,308 of the $150,000
ride trains for free) he earned in Saudi Arabia from his taxable income in the U.S.
• De minimus fringe benefits (food at a company picnic, For purposes of determining Jim’s marginal tax, however, he
occasional cab fare, etc.) will be treated as if he earned $150,000.
• Qualified transportation fringe benefits (a transit pass or
parking) 2 Qualified fringe benefits are popular because they are deductible by
Foreign earned income employers but excludible from employees’ income.
• A U.S. citizen is taxed on income regardless of where it is 3 With flexible spending plans, the employee accepts less
earned. compensation in exchange for the employer agreeing to pay for
• However, a U.S. citizen working abroad can either: certain costs when they arise. For example, an employee might
agree to accept $1,000 less in salary if the employer pays up to
- Include foreign income in their taxable income and get a
$1,000 of optometry expenses should they arise.
credit for foreign taxes paid, or 4 $107,600 for the 2020 tax year.
- Exclude an indexed amount4 of foreign earnings from 5 If the exclusion period overlaps two years, the exclusion must be
their taxable income. computed on a daily basis.

35
Lesson 9: Individuals as Employees & Business Owners

WORK-RELATED DEDUCTIONS

Automobile expenses to keep their job WORK-RELATED

• Automobile expenses (but not commuting - Help the taxpayer improve or maintain DEDUCTIONS: EMPLOYEES
costs) are deductible. skills in their job VS. SELF-EMPLOYED
• The taxpayer has two options for • Education expenses are not deductible
calculating the automobile deduction: when the expenses: • Work-related expenses
- Use the standard mileage rate provided - Help the taxpayer meet the minimum are only deductible by
by the IRS.6 Multiply this rate by the qualifications for the existing job7 employees if they are
number of miles driven for business - Help the taxpayer qualify for a new reimbursed by the
purposes, and then add the cost of tolls trade of business employer under an
and parking fees. Entertainment and meal expenses accountable plan.
- Calculate the actual operating cost. • Entertainment expenses are never - An accountable plan
This includes the cost of fuel, oil, deductible. requires the employee
repairs, insurance, licenses, and • However, taxpayers may deduct 100% of to (a) substantiate the
depreciation. business-related meals if: expenses with receipts
• The taxpayer may not use the standard - The taxpayer is present at the meal and (b) return any
mileage method if: - Food/drinks are provided to a excess
- The taxpayer has already begun taking current/potential customer reimbursements.
depreciation on that vehicle. - The cost of the meal is reasonable - If an employee receives
- The taxpayer uses 5 or more vehicles for - The cost of food/drinks is presented a reimbursement under
business purposes. separately on the receipt (if the meal a nonaccountable plan,
Travel expenses was combined with entertainment) the reimbursement will
• Taxpayers may deduct the cost of travel, • Business gifts be treated as wages
lodging, and laundry when working away - Taxpayers may deduct $25 per donee and reported on the
from home for a period of time that is (a) per year. employee’s W-2.
longer than an ordinary day of work and - Gifts that cost $4 or less are not
(b) requires the taxpayer to sleep or rest. subjected to the $25 limit.
• Travel expenses are not deductible, Example
Home office expenses
however, if the taxpayer is temporarily Julie pays a $400 work-
• Self-employed taxpayers may deduct the
reassigned for an indefinite period and related expense. She later
cost of having an office in the home if a
doesn’t move to the new location. receives a $400
portion of their home is used exclusively
• Taxpayers may deduct the cost of reimbursement from her
and on a regular basis as (1) their principal
traveling to conventions if it is related to employer under an
place of business or (2) a place of business
their trade or business. If the trip is a mix accountable plan. Julie
used by their customers.
of business and pleasure, but is primarily isn’t required to report
- The home office deduction can be either the expense or the
for business, the taxpayer may need to
calculated based on the square footage reimbursement; the
allocate costs among personal days and
or number of rooms that are used reimbursement income
work days, depending on whether the trip
exclusively for business purposes. was effectively cancelled
is domestic/international along with other
factors. If the trip is primarily for pleasure, - The home office deduction can’t create out by the expense.
no transportation expenses are a loss; unused amounts can be carried
deductible. forward to future tax years.
• Self-employed taxpayers
Education expenses
• Education expenses include the cost of 6 This rate was $0.575 per mile for the 2020 tax (independent
tuition, books, supplies, meals/lodging (if year. contractors) can deduct
the taxpayer has to travel away from
7 There is, however, a separate deduction for work-related expenses
qualified tuition and related expenses (Form as a deduction for AGI.
home), and transportation.
8917) that can be used by taxpayers whose
• Self-employed taxpayers can deduct modified AGI doesn’t exceed a certain
education expenses when the expenses: threshold.
- Are legal requirements for the taxpayer

36
Lesson 9: Individuals as Employees & Business Owners

SELF-EMPLOYMENT TAX QUALIFIED BUSINESS INCOME (QBI)

DEDUCTION
• When you work for an employer, • The Tax Cuts and Jobs Act of 2017 paid to the individual
your wages are subject to a created a deduction for qualified - Guarantee payments made to a
12.4% Social Security tax and a business income (QBI). § 199A allows partner for services provided
2.9% Medicare tax. The an individual to deduct the lesser of: - Income from a business conducted
employer pays half of these taxes - 20% of QBI outside the U.S.
(7.65%) and you pay the other - 20% of modified taxable income8 • The QBI deduction is a deduction
half (7.65%) for a total of 15.3%. QBI includes: from AGI. However, it is not an
• The bad news is that if you’re self- - Ordinary income minus ordinary itemized deduction.
employed, you must pay the deductions from a qualified trade • There are two limitations on the QBI
entire 15.3%. This is called self- or business - The QBI deduction is limited based
employment tax.
- The individual’s share of income on the W-2 wages paid by the
• The good news is that you can
from a partnership and/or S business.
deduct 50% of your self-
employment tax liability as a corporation - The QBI deduction doesn’t
deduction for AGI. QBI doesn’t include: generally apply to income from
• Anyone with at least $400 of net - Dividends “specified services” businesses
earnings from self-employment - Interest (unless allocable to the (accountants, lawyers, dentists,
must file Schedule SE and pay business; e.g., the business makes physicians, consultants, etc.)
self-employment tax . loans)
- Capital gains, capital losses, net § 8 Modified taxable income = taxable income
1231 gain before the QBI deduction – net capital
gain – dividend income.
- Reasonable income the business

CONTRIBUTIONS TO RETIREMENT ACCOUNTS

There are several ways to make contributions to • There is a penalty for withdrawing funds prior to age 59 and
a retirement account a half.
• Contribute to an employer-sponsored retirement account, IRAs
such as a 401(k) plan.9 • An individual can contribute $6,000 annually to an IRA
• Contribute to a self-employment retirement account. ($7,000 if 50 or older).
• Contribute to an individual retirement account (IRA). • There are two types of IRA accounts:
401(k) plans 1. Traditional IRA
• If your employer offers a 401(k) plan, you can get a tax - An individual can make deductible contributions to a
deduction for contributions you make to the plan. traditional IRA if the individual (or their spouse) has
• There are annual limits10 on the amount of contributions earned income.
that can be made. - However, the contributions phase out once the
• Some employers offer a company match individual’s AGI exceeds a certain threshold.
- For example, the company might agree to match 50% of
the first $5,000 in contributions made by an employee. 9 401(k) refers to the section of the tax code that provides this
Thus, if the employee contributes $12,000 to the plan, the benefit: § 401(k).
10 For the 2020 tax year, an employee can contribute up to $19,500
employer would contribute an additional $2,500 ($5,000 x ($26,000 if age 50 or older) to a 401(k) plan.
50%). Contributions made by the employer don’t count
toward the employee’s annual contribution limits.
• Contributions are not taxed until withdrawn. Continued on next page

37
Lesson 9: Individuals as Employees & Business Owners

CONTRIBUTIONS TO RETIREMENT ACCOUNTS (cont.)

1. Traditional IRA (cont.) 401(k) Plans vs. IRAs

- If the individual is not eligible to make deductible Advantages of 401(k) Disadvantages of 401(k)
contributions, the individual can make nondeductible Higher annual contribution Higher administrative fees
contributions to a traditional IRA (there is no income limits than IRA than IRA
limit on nondeductible contributions). While this No income limit for making Limited selection of
doesn’t provide a tax deduction, the account’s earnings contributions investments
accumulate tax-free (although the earnings will be taxed Employer may match Nonworking spouse can’t
when withdrawn). contributions make contributions
- The individual is taxed on withdrawals, with a penalty
for early withdrawal. Rollovers
2. Roth IRA • When employees change jobs, they may convert their 401(k)
- The individual doesn’t receive a tax deduction for from their previous employer to an IRA. The employee
contributions. receives their money from the 401(k) and then transfers the
- However, the account’s earnings accumulate tax-free. funds to the IRA. The employee is not taxed on the money
- Contributions are phased out at higher income levels. withdrawn from the 401(k) provided the funds are deposited
- Withdrawals can be made after 5 years for certain in an IRA within 60 days of receiving the money.
circumstances. Conversions
- Withdrawals in retirement are tax-free (thus, earnings • Individuals may convert a traditional IRA to a Roth IRA.
that accrued are never taxed). • The tax consequences depend on whether the contributions
The IRA contribution limit applies to both traditional and to the traditional IRA were deductible or nondeductible.
Roth IRAs - If the contributions were deductible, then the entire
• Thus, an individual under the age of 50 can contribute amount being converted is included in the individual’s
$6,000 to a traditional IRA or $6,000 to a Roth IRA. gross income upon conversion.
Alternatively, the individual could spread $6,000 between a - If the contributions were nondeductible, the only the
traditional IRA and a Roth IRA (e.g., put $3,500 in a earnings from the traditional IRA are included in the
traditional IRA and $2,500 in a Roth IRA). individual’s gross income upon conversion.

HOBBY LOSSES

• Hobby losses are not deductible.

• An activity is a hobby if it was not entered into for the
purpose of making a profit.
- An activity is presumed to be profit-seeking if it showed
a profit in at least 3 of the past 5 years (at least 2 of the
past 7 years if the activity involves horses).

Continued on next page

38
Lesson 9: Individuals as Employees & Business Owners

HOBBY LOSSES (cont.)

§ 1.183-2(b) lists 9 factors in determining whether an activity is a hobby:

Factor Explanation
1. The manner in which the Was the activity conducted in a businesslike manner? For example, does the taxpayer keep
taxpayer carries on the accurate books and records? Does the taxpayer adopt new techniques and abandon
activity. unprofitable methods?
2. The expertise of the Does the taxpayer prepare for the activity using accepted business, economic, or scientific
taxpayer or his advisors. practices?
3. The time and effort Does the taxpayer devote substantial time and effort to the activity, or employ other persons to
expended by the taxpayer in do so?
carrying on the activity.
4. The expectation that assets Does the taxpayer expect to profit through the appreciation of assets held in the activity, such
used in activity may as land?
appreciate in value.
5. The success of the taxpayer Has the taxpayer engaged in similar activities in the past, and taken them from being
in carrying on other similar or unprofitable to being profitable?
dissimilar activities.
6. The taxpayer's history of Has the taxpayer incurred losses beyond the point which would customarily be needed to
income or losses with respect make the activity profitable, with no explanation for those losses other than that this is a
to the activity. hobby?
7. The amount of occasional Periodically earning a substantial profit suggests the activity is not a hobby. Routinely
profits, if any, which are experiencing large losses, while only occasionally earning a small profit, is indicative of a
earned. hobby.
If the taxpayer has no other source of income, this suggests the activity is not a hobby. But if
8. The financial status of the
the taxpayer has substantial sources of other income, and the taxpayer enjoys recreation from
taxpayer.
the activity, this could be indicative of a hobby.
A profit motivation may be presumed when the activity has no appeal other than seeking a
9. Elements of personal profit. The fact that the taxpayer derives pleasure from the activity, however, does not
pleasure or recreation. necessarily mean the activity is a hobby.

39
Lesson 10: Business Tax Credits
OVERVIEW LOW-INCOME HOUSING TAX CREDIT - § 42

• Business tax credits fall into two • The low-income housing tax credit i. This is because the present
categories: was created by the Tax Reform Act value of 4% annually for 10
1. Credits that are part of the general of 1986 to increase the supply of years is about 30%.
business credit affordable housing. ii. The present value of 9%
2. Credits that aren’t part of the • Taxpayers can receive a credit for annually for 10 years is
general business credit amounts spent to construct or about 70%.
• The distinction matters because special renovate rental housing if they • While taxpayers receive the credit
rules apply to the general business agree to rent the units to low- over a period of 10 years, taxpayers
credit . income tenants at below-market must follow the compliance rules
rates. for at least 15 years.
- Taxpayers receive the credit over The 3 compliance rules are:
GENERAL BUSINESS TAX CREDITS a period of 10 years. 1. Don’t rent to people who
• The annual amount of the credit is earn too much money.
calculated as follows: 2. Don’t charge too much rent.
• This is limited to the taxpayer’s net tax
eligible basis x tax credit percentage 3. Don’t let the property fall
liability1 reduced by the greater of: • The eligible basis consists of the into disrepair.
- The tentative alternative minimum construction costs. The following - If taxpayers violate the
tax (AMT) costs are not part of the eligible compliance rules, the tax credits
- 25% of the taxpayer’s regular tax basis: can be recaptured.
liability over $25,000 - The cost of the land The basic structure of a LIHTC deal
• Any unused portion of the general - Demolition costs - The developer of a project finds
business credit can be carried back one - Landscaping costs an investor (a bank) to put up the
year (tax refund) or carried forward two - Marketing/lease-up costs capital.
years, with the oldest credits used first - Startup costs and syndication - The developer and the bank form
(FIFO method). fees a partnership; 99.9% of the tax
• Here are some examples of tax credits - Costs of a permanent loan (a credits are then allocated to the
that are part of the general business tax loan that remains after bank.
construction is complete) - The developer benefits by
credit:
• The tax credit percentage is either getting financing, while the bank
Low-income housing tax credit 4% or 9%, depending on how the benefits by (a) getting the tax
Historic tax credit project is financed. credits and (b) getting credit for
- Projects financed by tax-exempt complying with the Community
New markets tax credit
bonds have a 4% tax credit Reinvestment Act.3
Renewable energy tax credit percentage. After 15 years have elapsed…
Work opportunity tax credit i. The 4% percentage is a - The investor can pull out (this is
floating rate.2 called the “year 15 exit”).
Research activities tax credit - Projects not financed by tax- - The investor can force the sale of
Disabled access tax credit exempt bonds have a 9% tax the building for its market price.
Tax credit for employer-provided child credit percentage. - The investor can sell the building
care i. The process for receiving a to the developer.
Tax credit for employer-provided family 9% tax credit is competitive. - Rent limitations disappear.
and medical leave There is a limited amount of
funds for 9% projects in each 2 The U.S. Treasury Department
Tax credit for small employer pension
state, with funds being publishes new percentages each
plan startup costs month. Once the taxpayer begins the
allocated to each state
development project, however, the
based on the state’s
1 “Net tax liability” is the taxpayer’s regular tax initial percentage remains locked in for
population.
liability minus certain nonrefundable credits, the next 10 years.
such as the credit for child and dependent - The 4% projects and 9% projects 3 The CRA requires banks to invest in low-
care expenses and the foreign tax credit. are also called 30% and 70% income areas if they accept deposits
projects. from people living in those areas.

40
Lesson 10: Business Tax Credits

THE HISTORIC TAX CREDIT - § 47 NEW MARKETS TAX CREDIT - § 46D

• Taxpayers can receive a credit for up to 20% of The new markets tax credit was created by
qualified rehabilitation expenditures related to Community Renewal Tax Relief Act of 2000 to
a nonresidential or residential certified historic
structure.
increase investment in low-income communities.
- A certified historic structure is either: • Taxpayers can receive a credit of 39% (5% for the first 3 years,
a. Listed on the National Register of then 6% for the next 4 years) if:
Historic Places, or - They make a qualifying equity investment (QEI) in a
b. Located in a registered historic district community development entity (CDE), and
and certified by the Secretary of the - Substantially all (85%) of the QEI is invested (through a loan or
Interior to the Secretary as being of equity) in a qualified active low-income business (QALICB)
historic significance to the district within 12 months.
• To qualify, the qualified rehabilitation • Note: the taxpayer receiving the credit doesn’t give the QEI
expenditures must exceed the greater of: directly to the QALICB.4 Instead, the taxpayer gives the QEI to the
- The adjusted basis of the property (prior to CDE, which in turn makes a qualified low-income community
the rehabilitation expenditures), or investment (QLICI) in a QALICB. It’s set up this way because the
- $5,000
CDE is supposed to have local knowledge about which businesses
Qualified rehabilitation expenditures (QREs)
need the funds.
- QREs include the cost of permanently affixed
items (doors, walls, wiring).
- QREs don’t include the cost of acquiring or Taxpayer QEI CDE QLICI QALICB
enlarging the building, or costs that aren’t
permanently affixed to the building • A qualified CDE is any domestic corporation or partnership if:
(carpeting, landscaping). - The primary mission is serving low-income communities or
• The credit is taken over a 5-year period persons.
beginning with the year the rehabilitated - The entity maintains accountability by giving residents
building is placed into service. The credit representation on a governing board or advisory board.
reduces the basis of the building. - The entity is certified by the U.S. Treasury Department as a
qualified CDE.
• A QLICI can be:
- Any equity investment in, or loan to, a QALICB)
THE HISTORIC TAX CREDIT - § 47 - The purchase of a loan from another CDE
- Financial counseling and other services provided to businesses
There are several tax credits related to or residents of a low-income community
renewable energy: • The tax credit is subject to 100% recapture if:
• The investment tax credit provides a credit for - The CDE ceases to be a qualified CDE.
qualified expenditures related to renewable - The CDE fails to invest substantially all of the funds in a QALICB.
energy (mostly solar) developments.5 - The QEI is redeemed in less than 7 years.
• The production tax credit is a dollar-for-dollar
credit used primarily for wind developments.
4 A QALICB can be a for-profit company or a non-profit.
• The qualifying advanced energy project
credit (§ 48C) provides credits for renewable
energy manufacturing facilities. The credit is
awarded on a competitive basis.
5 The investment tax credit is 26% of the cost of facilities
that began construction in 2020, 22% for those that
began construction in 2021, and 10% starting in 2022
and thereafter.

41
Lesson 10: Business Tax Credits

WORK OPPORTUNITY TAX CREDIT

• The work opportunity tax credit gives employers an - Taxpayers receive the credit by submitting Form 8850 to a
incentive to hire individuals who face obstacles in the state workforce agency within 28 days of the employee’s
workplace. start date.
- The credit is generally calculated as 40% of the first • To qualify, an employee must:
$6,000 in wages paid (per employee) within the first 12 - Complete at least 400 hours of work6
months of the employee commencing work. However, - Be certified by a workforce agency as a member of one of
the amount of wages to which the credit applies and the the following groups:
credit percentage are different for some types of qualified
employees. 6 If the employee does at least 120 hours but less than 400 hours of
work, the credit is 25% (instead of 40%).

Eligible employees Description

The person received cash welfare (Temporary Assistance for Needy Families) for at least 9 of the 18
Welfare recipient
months prior to being hired
• A veteran whose family received food stamps for at least 3 months during the first 15 months of
employment
Qualified veteran • A veteran who was unemployed for at least 4 weeks during the 12 months prior to being hired
• A veteran with a service-related disability who has been released from active duty during the 12
months prior to being hired

Formerly incarcerated A person convicted of a felony who was convicted or released from prison in the 12 months prior to
person being hired, and used food stamps for at least 3 of those months
Designated community A person at least 18 but less than 40 years old who lives in an empowerment zone, enterprise
resident community, renewal community, or rural renewal community
A person 16 or 17 years old who works between May 1 and September 15 and lives in an
Summer youth employee
empowerment zone, enterprise community, renewal community, or rural renewal community
Vocational rehabilitation
A person with a mental or physical disability that creates a barrier to employment
referral
A person at least 18 but less than 40 years old who received food stamps for at least 3 of the 12
Food stamp recipient
months prior to being hired
Supplemental Security
A person who received SSI for any month within 60 days of being hired
Income (SSI) recipient
Long-term family A person whose family received long-term family assistant for at least 18 months prior to being
assistant recipient hired
Long-term unemployed A person who has been unemployed for at least 27 weeks and receives unemployment benefits

42
Lesson 10: Business Tax Credits

RESEARCH ACTIVITIES TAX CREDIT FOREIGN TAX CREDIT

The research activities credit is • The foreign tax credit is not part of the general business tax credit.
the sum of three credits: • It allows taxpayers to receive a credit for foreign taxes paid.
• The incremental research activities • The foreign tax credit is calculated as the lesser of:
credit provides a credit for 20% of a. Foreign taxes paid, or
research expenses in excess of a base Foreign−source taxable income
amount (the base amount is b. x U.S. tax liability (before foreign credit)
Total worlwide taxable income
calculated based on historical levels • Disallowed amounts can be carried back 1 year and forward 10 years.
of research expenses incurred by the
taxpayer).7 Example
• The basic research credit allows C Frugality, a U.S. corporation, reports $1,000,000 of total worldwide taxable
corporations8 an additional 20% income for the 2020 tax year ($600,000 was U.S.-source income and $400,000
credit for research expenses in excess was foreign-source income). Frugality paid $100,000 in foreign taxes.
of a base amount. Frugality’s foreign tax credit would thus be the lesser of $100,000 (actual
• The energy research credit gives foreign taxes paid) or $84,000.9 While it seems unfair that Frugality only
taxpayers a credit for 20% of receives a credit of $84,000 in this example even though it paid $100,000 in
payments made to a tax-exempt foreign income tax, Frugality can carry back the excess $16,000 to the
energy research consortium. previous tax year (to receive a refund) or carry it forward 10 years.
7
Calculated as follows: ($400,000 / $1,000,000) x ($1,000,000 x 21% corporate
If the taxpayer hires an outside firm to
income tax rate for 2020).
conduct the research, however, only 65%
of the research expenses can be used to
calculate the credit.
9
8 Personal service corporations aren’t eligible Calculated as follows: ($400,000 / $1,000,000) x ($1,000,000 x 21% corporate income
for the basic research credit. tax rate for 2020).

43