NOTE: The words and phrases appearing below have been defined to reflect their conventional use in the

field of taxation. Such definitions may, therefore, be incomplete for other purposes. Accelerated Cost Recovery System (ACRS) For tax years after 1980, a rapid write-off of the cost of a capital asset is allowed by this system, which was later renamed Modified Accelerated Cost Recovery System (MACRS). The minimum number of years over which the asset may be depreciated and the applicable percentage of the asset's cost that may be deducted each year depend on the class of the property. Accelerated death benefits Early payouts of life insurance, also called accelerated death benefits or viatical settlements, are excluded from gross income for certain terminally or chronically ill taxpayers. The taxpayer may either collect an early payout from the insurance company or sell or assign the policy to a viatical settlement provider. Accident and health benefits Employee fringe benefits provided by employers through the payment of health and accident insurance premiums, or the establishment of employer-funded medical reimbursement plans. Employers generally are entitled to a deduction for such payments, whereas employees generally exclude the fringe benefits from gross income. Accounting method The method which determines when income and expenses are reported for tax purposes. Major accounting methods include the cash basis, the accrual basis, and the hybrid method. Accounting period The period of time, usually a year, used by a taxpayer for the determination of taxable income and tax liability. Unless a fiscal year is chosen, taxpayers must determine and pay their income tax liability using the calendar year (i.e., January 1 through December 31) as the period of measurement. An example of a fiscal year is July 1 through June 30. A change in accounting periods (e.g., from a calendar year to a fiscal year) generally requires the consent of the IRS. Accrual method A method of accounting that reflects expenses incurred and income earned for any one tax year. In contrast to the cash basis of accounting, expenses do not have to be paid to be deductible, nor does income have to be received to be taxable. Unearned income (e.g., prepaid interest and rent) generally is taxed in the year of receipt, regardless of the method of accounting used by the taxpayer. Adjusted basis

The cost or other basis of property reduced by depreciation allowed or allowable and increased by capital improvements. See Basis. Adjusted gross income A determination peculiar to individual taxpayers used to calculate limitations on the amount of certain expenses which may be deductible, including medical expenses, charitable contributions, personal casualty losses, and certain miscellaneous deductions. Generally, adjusted gross income represents gross income less certain business expenses and expenses attributable to the production of rent or royalty income. Adoption expenses Adoption fees, court costs, attorney fees, and other expenses related to the legal adoption of an eligible child. Alimony payments Payments from one spouse to another, required as a result of a divorce or separation agreement, which meet certain statutory requirements. Alimony and separate maintenance payments are included in the gross income of the recipient and are deducted by the payor. American Opportunity credit A tax credit available for post-secondary education expenses. Amortization The allocation (and charge to expense) of the cost or other basis of an intangible asset over its estimated useful life. Some intangible assets which have an indefinite life are amortizable. Examples of amortizable intangibles include patents, copyrights, and goodwill. Amount realized The amount received by a taxpayer on the sale or exchange of property less the cost incurred to transfer the property. The measure of the amount received is the sum of the cash and the fair market value of any property or services. Determining the amount realized is the starting point for arriving at a realized gain or loss. Annuity A fixed sum payable at specified intervals for a specific period of time or for life. Payments represent a partial return of capital and a return (interest) on the capital investment. An exclusion ratio is generally used to compute the amounts of nontaxable and taxable income. Automobile expenses Automobile expenses are generally deductible only to the extent the automobile is used in business or for the production of income. Personal commuting

expenses are not deductible. The taxpayer may deduct actual expenses (including depreciation and insurance), or the standard ("automatic") mileage rate may be used. Bad debts An ordinary deduction is permitted if a business debt, such as an account receivable, subsequently becomes worthless, providing the income arising from the debt was previously included in taxable income. The deduction is allowed only in the year of worthlessness. A nonbusiness bad debt deduction is allowed as a short-term capital loss when a debt which did not arise in connection with the creditor's trade or business activities becomes worthless. Loans between related parties (family members) generally are classified as nonbusiness debts. Basis The amount assigned to an asset for income tax purposes. For assets acquired by purchase, the basis would be the cost of the asset. Special rules govern the basis of property received as a result of another's death or by gift. Boot Cash or property of a type other than that permitted to be received tax free in a nontaxable exchange. The receipt of boot will cause an otherwise tax-free transfer to become taxable to the extent of the lesser of the fair market value of such boot or the realized gain on the transfer. Business gifts Business gifts are deductible only to the extent that each gift does not exceed $25 per person per year. Exceptions are made for promotional gifts and for certain employee awards. Capital asset All assets are capital assets except those specifically excluded by the tax law. Major categories of noncapital assets include property held for resale in the normal course of business (i.e., inventory), trade accounts and notes receivable, depreciable property, and real estate used in a trade or business. Capital expenditure An expenditure, the amount of which should be added to the basis of the property improved. For income tax purposes, this generally precludes a deduction for the full amount of the expenditure in the year paid or incurred. Any tax deduction has to come in the form of cost recovery or depreciation. Capital gain The gain from the sale or exchange of a capital asset. See Capital asset. Capital loss The loss from the sale or exchange of a capital asset. See Capital asset.

Cash basis A method of accounting under which income is reported when received and expenses are deductible when paid by the taxpayer. Prepaid rent and prepaid interest must be deducted using the accrual method. Casualty loss A casualty is defined as "the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature" (e.g., floods, storms, fires, auto accidents). Individuals may deduct a casualty loss only if the loss is incurred in a trade or business; is incurred in a transaction entered into for profit; or arises from fire, storm, shipwreck, or other casualty or from theft. Personal casualty losses are deductible as itemized deductions subject to a $500 nondeductible floor and only to the extent that the taxpayer's total losses from personal-use property (net of the $500 floor) exceed 10 percent of adjusted gross income. Special rules are provided for the netting of certain casualty gains and losses. Change in accounting method A change in the taxpayer's method of accounting (e.g., from the FIFO to the LIFO inventory method) generally requires prior approval from the IRS. In some instances, the permission for change will not be granted unless the taxpayer agrees to certain adjustments prescribed by the IRS. Change in accounting period A taxpayer must obtain the consent of the IRS before changing his or her tax year. Income for the short period created by the change must be annualized. Charitable contributions Contributions are deductible (subject to various restrictions and ceiling limitations) if made to qualified nonprofit charitable organizations. A cash basis taxpayer is entitled to a deduction in the year of payment. Accrual basis corporations may accrue contributions at year-end if payment is authorized properly prior to the end of the year and payment is made on or before the fifteenth day of the third month following the end of the tax year. Child and dependent care credit This credit is available to individuals who are employed on a full-time basis and maintain a household for a dependent child or disabled spouse or dependent. The amount of the credit is equal to a percentage of the cost of employmentrelated child and dependent care expenses, up to a stated maximum amount. Child support payments Payments for child support do not constitute alimony, and are, therefore, not included in gross income by the recipient or deducted as alimony by the payor.

Child tax credit A direct reduction in tax liability granted for each qualifying child under age 17. The child tax credit is phased out based on the level of modified adjusted gross income. Closely held corporation A corporation, the stock ownership of which is not widely dispersed. Instead, a few shareholders are in control of corporate policy and are in a position to benefit personally from such policy. Community property Community property is all property, other than separate property, owned by a married couple. The income from community property is generally split equally between husband and wife. The classification of property as community property is important in determining the separate taxable income of married taxpayers. Deferred compensation Compensation which will be taxed when received or upon the removal of certain restrictions and not when earned. An example would be contributions by an employer to a qualified pension or profit-sharing plan on behalf of an employee. Such contributions will not be taxed to the employee until the funds are made available or distributed to the employee (e.g., upon retirement). See Qualified pension or profit-sharing plan. Depreciation The write-off for tax purposes of the cost or other basis of a tangible asset over its estimated useful life or recovery period as specified in ACRS or MACRS tables. Direct charge-off method A method of accounting for bad debts whereby a deduction is permitted only when an account becomes partially or completely worthless. See Reserve for bad debts. Earned income Income from personal services as distinguished from income generated by property. Earned income credit The earned income credit is a refundable credit available to qualifying individuals with income below certain levels. Education expenses Employees may deduct education expenses if such items are incurred either (1) to maintain or improve existing job-related skills or (2) to meet the express

requirements of the employer or the requirements imposed by law to retain employment status. Such expenses are not deductible if the education is required to meet the minimum educational requirements for the taxpayer's job or the education qualifies the individual for a new trade or business. Educational Savings Accounts Taxpayers may contribute a specified amount for themselves, a spouse, a child, or a grandchild. The contributions are nondeductible, but earnings may be accumulated and distributed tax free if used to pay post-secondary education expenses. Contributions cannot be made after the beneficiary reaches 18. Entertainment expenses Such expenses are deductible only if they are directly related to or associated with a trade or business. Various restrictions and documentation requirements have been imposed upon the deductibility of entertainment expenses to prevent abuses by taxpayers. Exemptions An exemption is a deduction allowed individual taxpayers in arriving at taxable income. There are two basic types of exemptions, the personal exemption, available for the taxpayer and his or her spouse, and the dependency exemption, available for qualified dependents of the taxpayer. Fair market value The amount at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of the relevant facts. First-in, first-out (FIFO) An accounting method for determining the cost of inventories. Under this method, the cost of inventory on hand is deemed to be the cost of the most recently acquired units. Foreign tax credit or deduction Both individual taxpayers and corporations may claim a foreign tax credit on income earned and subject to tax in a foreign country or U.S. possession. As an alternative to the credit, a deduction may be taken for the foreign taxes paid. Gift A transfer of property for less than adequate consideration. Gifts usually occur in a personal setting (such as between members of the same family). Goodwill The ability of a business to generate income in excess of a normal rate on assets due to superior managerial skills, market position, new product technology, etc. In the purchase of a business, goodwill is the difference between the purchase

price and the value of the net assets. Goodwill is an intangible asset which possesses an indefinite life; however, it is amortized over 15 years for federal income tax purposes. Gross income Income subject to the federal income tax. Gross income does not include income such as interest on municipal bonds. In the case of a manufacturing or merchandising business, gross income means gross profit (i.e., gross sales or gross receipts less cost of goods sold). Head of household An unmarried individual who maintains a household for another and satisfies certain conditions. Such status enables the taxpayer to use income tax rates lower than those applicable to other unmarried individuals but higher than those applicable to surviving spouses and married persons filing a joint return. Hobby loss A nondeductible loss arising from a personal hobby as contrasted with an activity engaged in for profit. Generally, the law provides a presumption that an activity is engaged in for profit if profits are earned during any 3 or more years in a 5-year period. Holding period The period of time property has been held by the taxpayer. The holding period is of significance in determining whether gains or losses from the sale or exchange of capital assets are long-term or short-term. HOPE tax credit A HOPE Scholarship tax credit is available for the first 2 years of post-secondary education expenses. For tax years 2009 and 2010, the Hope Credit has been modified and is referred to as the American Opportunity credit. Installment method A method of accounting enabling a taxpayer to spread the recognition of gain on the sale of property over the payment period. Under this procedure, the seller computes the gross profit percentage from the sale (i.e., the gain divided by the contract price) and applies the percentage to each payment received to arrive at the gain to be recognized. Involuntary conversion The loss or destruction of property through theft, casualty, or condemnation. If the owner reinvests any proceeds within a prescribed period of time in property that is similar or related in service or use, any gain realized on an involuntary conversion can, at the taxpayer's election, be deferred for federal income tax purposes.

Itemized deductions Personal expenditures allowed by the Code as deductions from adjusted gross income. Itemized deductions include certain medical expenses, interest on home mortgages, real and personal property taxes, charitable contributions, personal casualty losses, and other miscellaneous expenses. Life insurance proceeds Generally, life insurance proceeds paid to a beneficiary upon the death of the insured are exempt from federal income tax. An exception exists when a life insurance contract has been transferred for valuable consideration to another individual who assumes ownership rights. In such a case, the proceeds are income to the assignee to the extent that the proceeds exceed the amount paid for the policy (cash surrender value at the time of transfer) plus any subsequent premiums paid. Lifetime learning credit The lifetime learning credit may be used in any tax year the American Opportunity credit is not used for expenses paid for education. Unlike the American Opportunity credit, the lifetime learning credit may be claimed for an unlimited number of tax years. Like-kind exchange An exchange of property held for productive use in a trade or business or for investment (except inventory and stocks and bonds) for property of the same type. Unless different property is received (i.e., "boot"), the exchange will be completely nontaxable. Limited Liability Company (LLC) Business organizations usually treated as partnerships for tax purposes but offering the limited liability of a corporate stockholder to all members. Listed property Listed property includes computer and peripheral equipment, unless used exclusively at a regular business establishment, passenger automobiles, cellular telephones, property used for transportation, and property used for entertainment, recreation, or amusement. The depreciation of listed property is subject to certain limitations. Medical expenses Medical expenses of an individual, spouse, and dependents are allowed as an itemized deduction to the extent that total medical expenses, less insurance reimbursements, exceed limitations based on the taxpayer's AGI. Modified Accelerated Cost Recovery System (MACRS) See Accelerated Cost Recovery System (ACRS).

Moving expenses A deduction in arriving at adjusted gross income is permitted to employees and self-employed individuals providing certain tests are met (e.g., the taxpayer's new job must be at least fifty miles farther from the old residence than the old residence was from the former place of work). Ceiling limitations are placed on indirect expenses (e.g., house-hunting trips and temporary living expenses, and certain disposition and acquisition expenses of personal residences). Necessary Appropriate and helpful in furthering the taxpayer's business or income-producing activity. See Ordinary. Net operating loss To mitigate the effect of the annual accounting period, taxpayers are allowed to use a loss of 1 year as a deduction from income in past or future years. A carryback period of 2 years and a carryforward period of 20 years are allowed. Nonbusiness bad debts A bad debt loss not incurred in connection with a taxpayer's trade or business. Such loss is deductible as a short-term capital loss and will only be allowed in the year the debt becomes entirely worthless. In addition to family loans, many investor losses fall into the classification of nonbusiness bad debts. Nonrecourse debt An obligation on which the endorser is not personally liable. An example of a nonrecourse debt is a mortgage on real estate acquired by a partnership without the assumption of any liability on the mortgage by the partnership or any of the partners. The acquired property generally is pledged as collateral for the loan. Office-in-the-home expenses Employment and business-related expenses attributable to the use of a residence (e.g., den or office) are allowed only if the portion of the residence is used exclusively and on a regular basis as the taxpayer's place of business or as a place of business which is used by patients, clients, or customers. If the expenses are employment related, the use must be for the convenience of the employer as opposed to being merely appropriate and helpful. Ordinary Common and accepted in the general industry or type of activity in which the taxpayer is engaged. It comprises one of the tests for the deductibility of expenses incurred or paid in connection with a trade or business: for the production or collection of income; for the management, conservation, or maintenance of property held for the production of income; or in connection with the determination, collection, or refund of any tax. See Necessary.

Organizational expenses Organizational expenses are associated with the formation of a business prior to the beginning of operation. A corporation may amortize organizational expenses over a period of 180 months. Certain expenses related to starting a company do not qualify for amortization (e.g., expenses connected with issuing or selling stock or other securities). Partnerships Partnerships are conduit entities and are not subject to taxation. Various items of partnership income, expenses, gains, and losses flow through to the partners and are reported on their income tax returns. Passive losses Passive losses are deductible only to the extent of passive income. Unused passive losses carry forward indefinitely (until the activity which generated the losses is disposed of) and can be used by taxpayers to offset passive income in future years. Patents A patent is an intangible asset which may be amortized over its life. The sale of a patent usually results in long-term capital gain treatment. Personal expenses Expenses of an individual incurred for personal reasons which are not deductible unless specifically allowed under the tax law. Personal property Generally, all property other than real estate. It is sometimes designated as "personalty" while real estate is termed "realty." Personal property can also refer to property not used in a taxpayer's trade or business or held for the production or collection of income. When used in this sense, personal property could include both realty (e.g., a personal residence) and personalty (e.g., personal effects such as clothing and furniture). Personal residence The sale of a personal residence may result in the recognition of capital gain (but not loss). Taxpayers may permanently exclude $250,000 ($500,000 if married) of gain on the sale of their personal residence from income providing certain requirements are met. Points Loan origination fees generally deductible as interest by a buyer of property. A seller of property who pays points is required to reduce the selling price, and, therefore, does not receive an interest deduction.

Portfolio income Portfolio income includes dividends, interest, royalties, annuities, and realized gains or losses on the sale of assets producing portfolio income. Prizes and awards The fair market value of a prize or award generally is included in gross income. Qualified pension or profit-sharing plan An employer-sponsored plan that meets certain requirements. If these requirements are met, none of the employer's contributions to the plan will be taxed to the employee until distributed to him or her. The employer will be allowed a deduction in the year the contributions are made. Realized gain or loss The difference between the amount realized upon the sale or other disposition of property and the adjusted basis of such property. Recognized gain or loss The portion of realized gain or loss that is subject to income taxation. See Realized gain or loss. Reserve for bad debts An allowance permitted for estimated uncollectible accounts. Actual write-offs are charged to the reserve, and recoveries of amounts previously written-off are credited to the reserve. This method is not generally allowed for tax purposes. Rollover Transfer of pension funds from one plan or trustee to another. The transfer may be a direct transfer or a rollover distribution. Roth IRAs The Roth IRA allows nondeductible contributions. Although the contributions to a Roth IRA are not deductible, earnings accumulate tax free, and qualified distributions are generally not included in income when received. S corporation A small business corporation whose shareholders have filed an election permitting the corporation to be treated in a manner similar to partnerships for income tax purposes. Of major significance are the facts that S corporations usually avoid the corporate income tax and that corporate losses can be claimed by the shareholders. Scholarships Scholarships are generally taxable income to the recipient except for amounts received for tuition, books, and supplies.

Section 401(k) plan A Section 401(k) plan is a qualified retirement plan which grants employee participants a deferral of income for employer contributions to the plan. The plan allows taxpayers to elect to receive compensation or to have the employer make a contribution to the retirement plan. The plan may be structured as a salary reduction plan. There is a maximum annual dollar limitation, as well as a limitation based on the employee's compensation. Section 1231 assets Section 1231 assets include depreciable assets and real estate used in a trade or business, held for the long-term holding period. Under certain circumstances, the classification also includes timber, coal, domestic iron ore, livestock (held for draft, breeding, dairy, or sporting purposes), and unharvested crops. Self-employment income Self-employment income is the taxpayer's net earnings from self- employment, which includes gross income from a taxpayer's trade or business, less trade or business deductions. Self-employment income also includes the taxpayer's share of income from a partnership trade or business. Self-employment tax The self-employment tax consists of two components: the Social Security portion and the Medicare portion. The Social Security portion of the self-employment tax consists of a tax of 12.4 percent imposed on an individual's net earnings from self-employment, up to a maximum which changes yearly. The Medicare portion of the tax consists of a tax of 2.9 percent imposed on the individual's net earnings from self-employment, with no maximum. In calculating the self-employment tax, a deduction is allowed for one-half of the otherwise applicable self-employment tax. This deduction is calculated by multiplying the taxpayer's self-employment income, before the self-employment tax deduction, by one-half of the total selfemployment tax rate. If a self-employed individual also receives wages subject to FICA, the maximum Social Security tax base on the self- employed earnings is reduced. Separate property Separate property is property, other than community property, acquired by the spouse before marriage or after marriage as a gift or inheritance. SIMPLE plans Retirement plans for small businesses with no more than 100 employees, called the Savings Incentive Match Plan for Employees, or SIMPLE plans. Standard deduction

Taxpayers can deduct the larger of the standard deduction or their itemized deductions in calculating taxable income. An extra standard deduction amount is allowed for elderly and blind taxpayers (see text for amounts). Tax home Since travel expenses of a taxpayer are deductible only if the taxpayer is away from home, the deductibility of such expenses rests upon the definition of "tax home." The IRS position is that the "tax home" is the business location, post, or station of the taxpayer. If the taxpayer is temporarily reassigned to a new post for a period of 1 year or less, the taxpayer's home should be his or her personal residence and the travel expenses should be deductible. Trade or business expenses Deductions for AGl which are attributable to a taxpayer's business or profession. Transportation expenses Transportation expenses for a taxpayer include only the costs of transportation (taxi fares, automobile expenses, etc.) in the course of employment where the taxpayer is not "away from home" in a travel status. Commuting expenses are not deductible. Travel expenses Travel expenses include meals (50 percent deductible), lodging, and transportation expenses while away from home in the pursuit of a trade or business (including that as an employee). Unearned income For tax purposes, unearned income (e.g., rent) is taxable in the year of receipt. In certain cases involving advance payments for goods and services, income may be deferred. Vacation home The Tax Code places restrictions upon taxpayers who rent their residence or vacation home for part of the tax year. The restrictions may result in the limitation of certain expenses related to the vacation home.
2010 Cengage Learning. All Rights Reserved.

Section 1.1 - History and Objectives of the Tax System The US income tax was authorized by the Sixteenth Amendment to the Constitution on March 1, 1913. Prior to its adoption, the US government had levied various income taxes for limited periods of time (Civil War). The finding by the U.S. Supreme Court that the income tax law enacted in 1894 was unconstitutional led to the adoption of the 16th amendment in 1913just in time to assist in U.S. war efforts during WWI. Since this amendment was adopted, the constitutionality of taxing income has not again been before federal courts. Income taxes do more than provide revenue to operate government. Income taxes also serve as a tool of economic and social policy. Tax credits, exemptions, and deductions reward the individual taxpayer for making a particular choice. The choice being rewarded/promoted should positively affect public good. Some tax provisions meet both economic and social goals. If a gain on the sale of a personal residence is excluded from taxable income, it helps a family more easily afford a new home and also ensures that the U.S. has a mobile workforce (employees are not penalized for moving).

Section 1.2 - Reporting and Taxable Entities Under US tax law there are five basic taxable or reporting entities: individuals, corporations, partnerships, estates, and trusts. Taxable income for the individual generally includes wages, salary, self-employment earnings, rent, interest, and dividends. Individual taxpayers file a Form 1040EZ, Form 1040A, or Form 1040. Form 1040-EZs may be filed if the individual taxpayer:
y y y y y y

Is single or married filing a joint return Is not age 65 or older and/or blind Is not claiming any dependents Has taxable income of less than $100,000 Includes in income only wages, salary, unemployment compensation and $1,500 or less taxable interest income Has not received advance earned income credit payments

Form 1040A is generally filed if the individual taxpayer is not self-employed and does not benefit from itemizing his/her deductions. Form 1040, referred to as "the long form", is used by all individual taxpayers who must file a tax return and do not qualify to use the 1040EZ or 1040A. Corporations are subject to income tax and report the tax on a Form 1120-A (short form) or a Form 1120 (long form). A partnership is not a taxable

entity; instead it is a reporting entity. The partnership reports the income or loss on a Form 1065. The partners pay the tax on the income on their individual income tax form. Major Tax Forms and Schedules

Section 1.3 - The Tax Formula for Individuals

Gross income should include all income unless tax law provides for a particular exclusion. Deductions for adjusted gross income include business expenses, alimony payments, moving expenses, and contributions to qualified retirement plans. Adjusted gross income is the basis for limits for some deductions like medical expenses. Itemized deductions include medical expenses, interest expense, charitable contributions, and casualty losses. Note: Taxpayers should itemize deductions only if the total amount exceeds the standard deduction amount. Exemptions are worth $3,650 for 2009. A taxpayers gross tax liability is obtained from a tax table or a tax schedule. Tax credits and prepayments are subtracted from gross tax liability to calculate the net tax due to the government or the refund due the taxpayer. Standard Deduction Table

Section 1.4 - Who Must File You must file a return if you received any amount of advance earned income credit payments from your employer during the year. You also must file if you owe any taxes, such as social security and Medicare tax on tips, alternative minimum tax, tax on an Individual Retirement Arrangement, or tax from recapture of an education credit. A taxpayer otherwise not required to file a return, must do so to receive an income tax refund.

Section 1.5 - Filing Status and Tax Computation Tax law has five different filing statuses: single, married filing jointly, married filing separately, head of household, and qualified widow(er) sometimes called surviving spouse. (See table below). Each filing status has a separate tax schedule. A tax rate schedule is used only if the taxpayers taxable income is over $100,000 or if the taxpayer is using a special method to determine his/her tax liability. Taxpayers who

have taxable income less than $100,000 must use the tax table rather than the schedule.

For 2009, there are six income tax brackets: 10%, 15%, 25%, 28%, 33% and 35%. Even though these brackets are listed on the Income Tax Schedule, they are in effect the tax brackets for taxpayers of all income, even those who use the Tax Table. The American Recovery and Reinvestment Act of 2009 (ARRA) was signed into law on February 17, 2009. The act was passed to help stimulate the economy. The provisions of the new law affect tax years 2009 and 2010. The most significant provision of the ARRA is the "Making Work Pay Credit". The refundable tax credit is for working individuals (up to $400) and for married taxpayers filing joint returns (up to $800). The tax credit is 6.2 percent of earned income up to $6,431 (or $12,903 if married filing jointly) and is phased-out for taxpayers with modified adjusted gross income in excess of $75,000 or $150,000 for married couples filing jointly. Most wage earners benefited with a larger paycheck because of the changes made to the federal income tax withholding tables when the Making Work Pay Credit was added to the law. Selfemployed taxpayers may claim the credit on their tax return. Certain taxpayers received automatic rebates during 2009.

Section 1.6 - Personal and Dependency Exemptions Taxpayers are allowed two types of exemptions: personal (for themselves) and dependency (for their dependents). Almost every taxpayer and spouse is entitled to one personal exemption. An exemption may be claimed for each person other than the taxpayer or spouse who qualifies as a dependent. A dependent is an individual who meets the tests discussed below for either a qualifying child or qualifying relative. In order for a child to be considered a dependent, the following tests must be met: Relationship Test The dependent must be the taxpayers child, stepchild, adopted child or the taxpayers brother or sister, half brother or sister or stepsibling or a descendant of any of these. The child must be younger than the person claiming him or her unless the child is permanently disabled. Domicile Test The child must have the same principal place of abode as the taxpayer for more than six months of the tax year.

Age Test The child must be under age 19 or a full-time college student under the age of 24. A fulltime student is defined as enrolled for at least five months in a tax year. Joint Return Test The child must not file a joint return with his or her spouse. Citizenship Test The dependent must be a United States citizen, a resident of the United States, Canada or Mexico or an alien child adopted and living with a United States citizen. Self-Support Test The taxpayer must provide more than one-half of the childs support. Support includes expenditures for food, lodging, clothes, medical and dental care, and education. In order to qualify as a relative, the following tests must be met: Relationship or Member of Household Test The dependent must be related to the taxpayer or spouse or be a member of the household. The list of relatives includes parents, grandparents, children, grandchildren, siblings, aunts and uncles by blood, nephews and nieces, "in-laws" and adopted children. Any person who lived in the home as a member of the household for the entire year meets the relationship test. Gross Income Test A dependent must receive $3,650 or less in gross income to qualify. Support Test A dependent must receive over half of his/her support from the claiming taxpayer or spouse. Joint Return Test The dependent must not file a tax return with his/her spouse unless it is only to claim a refund of taxes due. Citizenship Test The dependent must be a US citizen, a resident of US, Canada, or Mexico, or an alien child adopted by and living with a US citizen in a foreign country.

Section 1.7 - The Standard Deduction The standard deduction was put into tax law to aid taxpayers with few itemized deductions. Even so, if you may not use the standard deduction you must itemize if 1) you are married and your spouse filing separately itemizes, 2) you are a non-resident alien, or 3) you are an individual filing a short-period return resulting from a change in

accounting period. If a taxpayer has less gross income than his/her standard deduction, he/she has no taxable income.

Taxpayers who are age 65 or older or blind are entitled to an additional standard deduction (2009: $1,400 for unmarried; $1,100 for married taxpayers and surviving spouses). If the taxpayer is both 65 and blind, s/he is entitled to two additional standard amounts. These additional deduction amounts extend to the taxpayers spouse but not to dependents. The total standard deduction for a dependent may not exceed the greatest of $950 or the sum of $300 plus dependents earned income up to the basic standard deduction amount plus any additional standard deduction for old age or blindness. A dependent cannot claim a personal exemption on his or her tax return.

Section 1.8 - A Brief Overview of Capital Gains and Losses When taxpayers sell assets, the resulting transaction creates a gain or a loss. The basic formula for calculating a gain or loss is: Gain (or loss) = Amount realized Adjusted basis Chapter 8 of the text explores gains and losses in more detail. It is more important for this chapter to know the basic definition of capital gains or losses and ordinary gains or losses.

Section 1.9 - Tax and the Internet The Internal Revenue Service has a great site where taxpayers can obtain forms, publications, regulations and view various tax-related articles. The IRS site, www.irs.gov, allows taxpayers to communicate with the IRS via email.

Section 1.10 - Electric Filing (E-Filing) Electronic filing (e-filing) is the process of transmitting federal income tax returns to the IRS Service Center using a computer with a modem or Internet access. Two methods of e-filing exist. The first method is e-filing using a computer and tax preparation software to transmit information to the IRS. The second method is to employ professional tax prepares to send the information.

Complete the following problems on a separate sheet of paper. Check your answers on the Self-Study Problem Solutions page. Problem 1.1 Which of the following is not a goal of the income tax system? a. Raising revenue to operate the government. b. Providing incentives for certain business and economic goals, such as higher employment rates, through business-favorable tax provisions. c. Providing incentives for certain social goals, such as charitable giving, by allowing tax deductions, exclusions, or credits for selected activities. d. All the above are goals of the income tax system.

Problem 1.2 Which is the most appropriate form or schedule for each of the following items. Unless otherwise indicated in the problem, assume the taxpayer is an individual. 1. Bank interest income of $1,600 received by a taxpayer who itemizes deductions 2. Capital gain on the sale of AT&T stock 3. Income from a farm 4. Trust's income 5. An individual partners share of partnership income reported by the partnership 6. Salary of $70,000 for a taxpayer who itemizes deductions 7. Income from a sole proprietorship business 8. Income from rental property 9. Dividends of $2,000 received by a taxpayer who does not itemize deductions 10. Income of a large corporation 11. Partnership's loss 12. Charitable contribution deduction for an individual who itemizes deductions 13. Single individual with no dependents whose only income is $18,000 (all from wages) and who does not itemize deductions

Problem 1.3 Bill is a single taxpayer. In 2009, his salary is $28,500 and he has interest income of $1,500. In addition, he has deductions for adjusted gross income of $2,100 and he has $6,250 of itemized deductions. If Bill claims one exemption for this year, calculate the following amounts: 1. Gross income 2. Adjusted gross income 3. Standard deduction or itemized deduction amount

4. Taxable income

Problem 1.4 Decide whether the following taxpayers are required to file a return for 2009 in each of the following independent situations: 1. Taxpayer (age 45) is single with income of $8,300. 2. Husband (age 67) and wife (age 64) have an income of $18,000 and file a joint return. 3. Taxpayer is a college student with salary from a part-time job of $6,000. She is claimed as a dependent by her parents. 4. Taxpayer has net earnings from self-employment of $4,000. 5. Taxpayers are married with income of $15,900 and file a joint return. They expect a refund of $600 from excess withholding. 6. Taxpayer is a waiter and has unreported tips of $450. 7. Taxpayer is a qualifying widow (age 65) with a dependent son (age 18) and income of $16,800. 8. Taxpayer has income of $4,500 and is single. His age is 45 and he received advanced earned income credit payments.

Problem 1.5 Indicate the filing status (or statuses) in each of the following independent cases, using this legend: A Single B Married, filing a joint return C Married, filing separate returns D Head of household E Qualifying widow(er) 1. 2. 3. 4. The taxpayers are married on December 31 of the tax year. The taxpayer is single, with a dependent child living in her home. The taxpayer is unmarried and is living with his girlfriend. The taxpayer is married and his spouse left midyear and has disappeared. The taxpayer has no dependents. 5. The unmarried taxpayer supports her dependent mother, who lives in her own home. 6. The taxpayers wife died last year. His 15-year-old dependent son lives with him.

Problem 1.6

Indicate in each of the following independent situations the number of exemptions the taxpayer should claim on their 2009 income tax returns. If a test is not mentioned, you should consider that it is met. 1. Abel is 72 years old and married. His wife is 64 and meets the test for blindness. How many exemptions should they claim on a joint return? 2. Betty and Bob are married and have a 4-year-old son. During the year Betty gave birth to a baby girl. How many exemptions should Betty and Bob claim on a joint return? 3. Charlie supports his 26-year-old brother, who is a full-time student. His brothers gross income is $4,500 from a part-time job. How many exemptions should Charlie claim on his return? 4. Donna and her sister support their mother and provide 60 percent of her support. If Donna provides 25 percent of her mothers support and her sister signs a multiple support agreement giving Donna the exemption, how many exemptions should Donna claim on her return? 5. Frank is single and supports his son and his sons wife, both of whom lived with him for the entire year. The son (age 20) and his wife (age 19) file a joint return to get a refund, reporting $2,500 ($2,000 earned by the son) in gross income. Both the son and daughter-in-law are full-time students. They do not live in a community property state. How many exemptions should Frank claim on his return? 6. Gary is single and pays $5,000 towards his 20-year-old daughters college expenses. The remainder of her support is provided by a $9,500 tuition scholarship. The daughter is a full-time student. How many exemptions should Gary claim on his return? 7. Helen is 50 years old and supports her 72-year-old mother, who is blind. How many exemptions should Helen claim on her return?

Problem 1.7 Indicate in each of the following independent situations the amount of the standard deduction the taxpayers should claim on their 2009 income tax returns. 1. Adam is 45 years old, in good health, and single. 2. Bill and Betty are married and file a joint return. Bill is 66 years old, and Betty is 60. 3. Charlie is 70, single, and blind. 4. Debbie qualifies for head of household filing status, is 35 years old, and is in good health. 5. Elizabeth is 9 years old, and her only income is $3,600 of interest on a savings account. She is claimed as a dependent on her parents tax return. 6. Frank and Freida are married with two dependent children. They file a joint return, are in good health, and both of them are under 65 years of age.

Problem 1.8 Erin purchased stock in JKL Corporation several years ago for $8,750. In the current year, she sold the same stock for $12,800. She paid a $200 sales commission to her stock broker. 1. 2. 3. 4. 5. What is Erins amount realized? What is Erins adjusted basis? What is Erins realized gain or loss? What is Erins recognized gain or loss? How is any gain or loss treated for tax purposes?

Problem 1.9 Decide whether the following statements are true or false. 1. The Internet is controlled by the Federal Communications Commission, which is part of the administrative branch of the United States government. 2. Taxpayers can download tax forms and IRS publications from the IRS Internet site. 3. A help function is available to aid users of the IRS site. 4. The TaxCut Internet site is maintained by Practitioner's Publishing Co. for users of its textbooks.

Problem 1.10 Decide whether the following statements are true or false. 1. Compared to paper returns, electronic filings significantly reduces the error rate for tax returns filed 2. Individuals may not use electronic filing for their own personal tax returns, but must engage a tax professional if they wish to e-file. 3. Taxpayers who e-file generally receive faster refunds. 4. Taxpayers who e-file can only request their refund in the form of a check.

2010 Cengage Learning. All Rights Reserved.

Problem 1.1 Answer is d. Answers a, b, and c are goals of the U.S. income tax system.

Problem 1.2 1. Schedule B, Form 1040 2. Schedule D, Form 1040 3. Schedule F, Form 1040 4. Form 1041 5. Schedule K-1, Form 1065 6. Form 1040 7. Schedule C, Form 1040 8. Schedule E, Form 1040 9. Schedule 1, Form 1040A or Schedule B, Form 1040 10. Form 1120 11. Form 1065 12. Schedule A, Form 1040 13. Form 1040EZ

Problem 1.3 1. 2. 3. 4. Gross income = $28,500 + $1,500 = $30,000 Adjusted gross income = $30,000 $2,100 = $27,900 Itemized deductions = $6,250 Taxable income = $27,900 $6,250 $3,650 = $18,000

Problem 1.4 Refer to Figures 1.1, 1.2, and 1.3 in Chapter 1. 1. 2. 3. 4. 5. 6. 7. 8. No No Yes Yes No; However, the taxpayers must file to obtain a refund. Yes; Social Security taxes are due. Yes; See Figure 1.1. Yes

Problem 1.5

1. 2. 3. 4. 5. 6.

B or C D A C D E; The taxpayer is a "qualifying widower."

Problem 1.6 1. 2: Two personal exemptions. 2. 4: Two personal and two dependency exemptions. 3. 1: One personal exemption; the brother fails to meet the gross income test to be a qualifying relative. The fact that the brother is a student is irrelevant since he is older than 24. 4. 2: One personal exemption and one dependency exemption for the mother. 5. 3: One personal and two dependency exemptions. 6. 2: One personal and one dependency exemption since the scholarship is not considered support. 7. 2: One personal and one dependency exemption.

Problem 1.7 1. 2. 3. 4. 5. 6. $5,700 $12,500 = $11,400 + $1,100 $8,500 = $5,700 + $1,400 + $1,400 $8,350 $950 $11,400

Problem 1.8 1. 2. 3. 4. 5. $12,600 = $12,800 - $200 $8,750 $3,850 = $12,800 $200 $8,750 $3,850 = $12,800 $200 $8,750 Because the stock has been held for more than a year, the gain is a long-term capital gain. The long-term capital gain will be taxed at 0 percent for taxpayers in the 10 or 15 percent tax brackets or 15 percent for all other tax brackets.

Problem 1.9 1. False

2. True 3. True 4. False

Problem 1.10 1. 2. 3. 4. True False True False

2010 Cengage Learning. All Rights Reserved.

Discussion
Go to the Discussions Area and answer the following questions. 1. Calculations for Taxable Income (Chapter 1) You often hear the term "for AGI and from AGI" or "above the line and below the line." Discuss what the benefits are for both types of deductions. Which is better? 2. Working Families Tax Act of 2004 (Chapter 1) The Working Families Tax Relief Act of 2004 changed the definition of a qualifying dependent. Why was this changed? What other provisions were included in this Act? How did the provision impact working families? 3. American Recovery and Reinvestment Act of 2009 (ARRA) (Chapter 1) American Recovery and Reinvestment Act of 2009 (ARRA) was signed into law on February 17, 2009. One of the most significant provisions is the "Making Work Pay Credit." What does this mean to working people? What are the tax ramifications of this credit? Why was this particular credit included in the ARRA?