US Income Tax/Printable version
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Who's who in the tax system[edit | edit source]
Income taxes in the United States are levied by the federal government and by state and local governments. The federal income tax, upon which this text focuses, is collected by the Internal Revenue Service (IRS), part of the Department of the Treasury. The rules for collecting income taxes are set in the Internal Revenue Code (IRC), Title 26 of the United States Code. The IRC is a statute written and regularly revised by Congress. Treasury Regulations are more detailed rules written by the IRS to effectuate the implementation of the IRC. Code provisions, which are statutory, always trump contrary regulatory provisions. Regulations can be of two types: legislative and interpretive. With legislative regulations, Congress says, for example, that depreciation will be an allowable expense "in accordance with regulations to be established by the IRS." It gives the IRS the power to make the rules. Interpretive regulations are those in which the IRS says how it will interpret and apply a given statute.
Disputes over tax rules are generally heard in the United States Tax Court before the tax is paid, or in a United States District Court or United States Court of Federal Claims after the tax is paid. Appeals from the Tax Court go to the United States Court of Appeals for the circuit in which the taxpayer resides, or was domiciled when the tax return in controversy was originally filed. From the Court of Appeals the taxpayer may file a writ of certiorari with the Supreme Court, which may or may not be granted. The IRS also periodically issues Revenue Rulings when taxpayers have questions about how to declare certain transactions. These rulings are only opinions, and are trumped by court rulings or contrary legislation. Revenue Rulings should not be confused with Private Letter Rulings. A Private Letter Ruling is a request by a specific taxpayer to the IRS to rule on the tax consequences of a specific transaction before the action is taken. A Private Letter Ruling is directed only towards the requesting taxpayer, and therefore can not be relied upon by other taxpayers considering the exact action. Private Letter Rulings are released every Friday by the IRS
How tax is calculated[edit | edit source]
The actual computation of tax is a straightforward process that can be performed by hand using IRS worksheets, or by computer using special tax software. The basic steps are as follows:
- The taxpayer computes their gross income, including ordinary gains and losses.
- The taxpayer subtracts capital gains which are taxed separately from other income.
- The taxpayer subtracts business deductions and other above the line deductions to find their adjusted gross income.
- The taxpayer subtracts their personal exemption.
- The taxpayer adds up itemized deductions, and either subtracts that sum or their standard deduction, whichever is greater, to find their taxable income.
- The taxpayer multiplies their taxable income by various percentages to compute their tentative tax liability.
- The taxpayer subtracts tax credits to find their final tax liability.
Accounting[edit | edit source]
Accounting is important to discussions of tax law, because it determines when a receipt becomes taxable income and when a payment becomes deductible. Individuals and corporations generally compute their taxable income on a cash method or an accrual method and it is on this taxable income that the tax liability is based.
The cash method[edit | edit source]
The cash method is primarily used by individuals and small businesses. Under a cash system, generally, transactions count as income in the year of actual receipt, and count as deductions in the year of actual payment. There are some exceptions:
- Some transactions are counted as income before they are actually received because of the doctrine of prior constructive receipt.
- Amortized capital expenditures, deductions on certain business assets, are not deducted immediately.
- Interest is deductible when paid, but prepaid interest is not.
The accrual method[edit | edit source]
The accrual method is primarily used by large businesses which want to keep their income statements and their actual cash flow separate. Goods inventories are generally tracked using the accrual method, so any retail business is likely to use accrual accounting, and many businesses selling goods ancillary to their services may have to use accrual accounting as well.
In addition to the foregoing two methods there are also "Special methods of accounting for certain items of income and expenses" and "Combination (hybrid) methods using elements of two or more of the foregoing." For a non-authoritative but more extensive discussion of all these methods, including when they may and may not be used, and who may and may not use them, see IRS Publication 538, Accounting Periods and Methods. It should be noted that this discussion of the various methods is for the purpose of income taxes and not for the purpose of preparing financial statements in accordance with generally accepted accounting principles (GAAP).
Income[edit | edit source]
An accrual-based taxpayer has income when:
- all events have occurred that fix the right to the income and
- the amount of the income can be determined with reasonable accuracy.
Charles Schwab Corp. v. Commr., 107 T.C. 282 (1996), dealt with this question in the context of securities brokerage, where parties become bound to a transaction on the "trade date" but do not actually perform the transaction until a "settlement date" a few days later. Schwab and the IRS disputed whether the "all events" test was satisfied on the trade date. The court ruled that Schwab had to accrue its income on the trade date, because the execution of the trade was a condition precedent fixing Schwab's right to receive its commission on the settlement date.
Under the claim of right doctrine, a taxpayer has income whenever they receive an amount under a claim of right and without restriction to its use. This means that in some transactions, where an accrual-based taxpayer receives a payment before their right to the payment has been fixed (a "pre-payment"), they recognize income when they actually receive the payment. The main exception to this rule is for security deposits, which are generally not received under a claim of right. Another exception is for non-profit membership organizations such as AAA, which receive prepayments for services: under Section 456, they are allowed to defer their income across the period of liability to perform the services.
Deductions[edit | edit source]
An accrual-based taxpayer has a deduction when:
- all events have occurred that fix the liability for the deduction and
- the amount of the deduction can be determined with reasonable accuracy and
- economic performance has occurred with respect to the liability.
One well-known contest regarding the "all events" test was Mooney Aircraft v. U.S., 420 F.2d 400 (1969). Mooney sold each of its aircraft with a "Mooney Bond" promising to pay the bearer $1,000 when the aircraft was retired from service. Mooney tried to deduct the value of each bond in the year of issue; the IRS argued that the value of a bond could only be deducted when the aircraft was retired. The court sided with the IRS, noting that "the longer the time the less probable it becomes that the liability, though incurred, will ever in fact be paid... the very purpose of the 'all events' test is to make sure that the taxpayer will not deduct expenses that might never occur."
The "economic performance" requirement applies to deductions, but not to income. The rationale of the requirement, which was added in 1984, is that many business liabilities do not require actual payment until a distant point in the future, and many such liabilities can be easily overstated to reduce (or eliminate) tax liability. Under Section 461, economic performance occurs when property or services are provided or used, or when payments are made in the case of workers' compensation and tort claims.
Annual accounting[edit | edit source]
Regardless of whether they use a cash or accrual method, all taxpayers follow a system of annual accounting. Income taxes are always levied on a year-by-year basis, and each year is "compartmentalized" from the previous year and the next year. This means that if a taxpayer loses money in year 1 but has a higher income in year 2, they must still pay taxes on their income in year 2 even if the income is only enough to offset their previous loss. This is a general rule, and like most general rules, it has many exceptions.
Tax benefit doctrine[edit | edit source]
When a taxpayer has an expense, takes a deduction for that expense, but then recovers the expense later, they have income in the year they recover the expense. This principle is known as the tax benefit doctrine. A corollary to the tax benefit doctrine is Section 111, which establishes that recovery of an expense is not income if the taxpayer did not get a tax benefit from the expense.
Income under semblance of unrestricted right[edit | edit source]
What if a taxpayer receives something and believes they have a right to it, but later has to pay it back? In some situations, Section 1341 allows the taxpayer to deduct their previous income when it was received with a "semblance" of an unrestricted right.
Net operating losses[edit | edit source]
Businesses also have an option to "carry back" and "carry over" their net operating losses for the year. Under Section 172, carrybacks are available to the two years preceding the loss year, and carryovers are available to the next twenty years. This allows operating losses to offset income in other years, "flattening" the business's tax liability. Generally, the losses must be applied against income in the earliest year possible (i.e. the earliest year where there is income), but a business can elect to waive its carryback and save losses for carryover only.
The Internal Revenue Code requires three income calculations when determining income tax liability:
- Gross income, the actual income the taxpayer receives.
- Adjusted gross income (AGI), gross income reduced by "above the line" deductions such as trade and business expenses.
- Taxable income, AGI reduced by "below the line" deductions such as personal and profit-seeking expenses.
While taxable income is the only amount that matters when calculating final tax liability, the other two values have great significance in the process as well.
The definition of income[edit | edit source]
Section 61 of the Internal Revenue Code  puts it broadly: "Gross income means all income from whatever source derived." The Code supplies many examples, but provides that the list is not exhaustive. Among its enumerated types of gross income are compensation for services (i.e. wages and salaries), business income, income from dealings in property, interest, rent, royalties, dividends, alimony, annuities, life insurance income, pensions, and a number of other examples.
The simple definition of gross income has led to some questioning of what the word "income" actually means within the text of the statute. The authoritative opinion on this issue is the Supreme Court's decision in Commr. v. Glenshaw Glass Co., 348 U.S. 426 (1955), perhaps the most important case in American tax law. Glenshaw Glass established that income is:
- any undeniable accession to wealth,
- which is clearly realized by the taxpayer,
- over which the taxpayer has complete dominion.
Accession[edit | edit source]
An accession to wealth need not be in the form of money. For instance, if a farmer trades a bushel of tomatoes for an accountant's tax help, the tomatoes are an accession to wealth for the accountant. Such accessions are called receipts in kind—goods or services received in exchange for services. Contrary to popular belief, receipts in kind are considered income, and their value for tax purposes is the fair market value of the goods or services at the time of transfer.
An accession need not be in consideration for anything. "Windfalls," such as prizes and free samples, are accessions to wealth. Even an unanticipated windfall is considered income. For instance, if a taxpayer finds money hidden inside a piano, that money becomes income to them: see Cesarini v. U.S., 428 F.2d 812 (6th Cir. 1970).
Wealth is affected by assets and liabilities. Loans are usually not considered to be income because they are not true accessions to wealth: while they provide a tangible asset to the recipient, they offset this asset with an equivalent liability. But a "loan" that is not offset by an obligation to repay is income to the recipient. Moreover, if a third party pays off a taxpayer's debt, the taxpayer receives income to the extent their debt was reduced. See Old Colony Trust Co. v. Commr., 279 U.S. 716 (1929) (employer paying taxes on employee's behalf).
Realization[edit | edit source]
Realization can be thought of as an administrative rule: it serves to clarify when the taxpayer receives income. The simplest way to conceptualize realization is as the point in time when the taxpayer's property or interests are actually increased.
The Supreme Court used the theory of realization to ban income taxation of stock dividends (splits) in Eisner v. Macomber, 252 U.S. 189 (1920). Because share-for-share stock dividends do not materially affect the assets of the corporation or its shareholders, the Court reasoned that there would be no income to the shareholders in such transactions.
Dominion[edit | edit source]
If a taxpayer sees a $20 bill, but does not pick it up, they have not yet realized any income, because the money is not yet theirs. Once they pick the money up and assert possession of it, the $20 is income to them: they have realized it and assumed dominion and control over it.
Consider a more complicated example: a person signs a long-term lease on a piece of property, then constructs a building on it. They fall behind on their rent and the landlord evicts them. According to Helvering v. Bruun, 309 U.S. 461 (1940), the landlord realizes income amounting to the value of the building in the year of the repossession.
Dominion over wealth is based on practical considerations rather than the considerations of property law. When an accession is legally disputed (or disputable), the claim of right doctrine comes into play. If a taxpayer receives an amount, claims it as theirs, and has no restriction on their disposition of it, that amount is considered income in the year in which they receive it. For instance, if a taxpayer receives a piece of land and someone else disputes its title, the taxpayer will have income so long as they claim that land as their own. Any income gained from illegal activities is also considered to be income whether the taxpayer's title to it is valid or not.
However, the "completeness" of dominion is compromised if the taxpayer recognizes a legal obligation to return the wealth to its previous owner. Security deposits are one example: because they must usually be paid back, they are not considered income until the recipient is legally entitled to keep them. Advance deposits, on the other hand, are income upon receipt, because they are not accompanied by an obligation to repay.
Exceptions to income[edit | edit source]
Employment benefits[edit | edit source]
Some apparent accessions to wealth are not income because the primary purpose of the accession is to benefit the taxpayer's employer. A classic example is U.S. v. Gotcher, 401 F.2d 118 (5th Cir. 1968), in which the taxpayer went on a business trip to Germany, all expenses paid by Volkswagen and the taxpayer's employer (an auto retailer). Examining the facts of the case, the court concluded that the trip primarily benefited Volkswagen, not the taxpayer, and was therefore not income to the taxpayer. But the taxpayer's wife also had her expenses paid to come on the trip, and the court ruled that her half was income, because the benefit of her share of the trip was hers alone and not Volkswagen's.
Besides this primary purpose test, more specific rules covering many types of employment benefits appear in the Internal Revenue Code.
- No additional cost services provided by employers are not income to employees. Standby tickets for airline employees are one example. Allowing employees to fly in otherwise empty seats does not cost an airline any appreciable amount. On the other hand, providing regular "positive space" tickets to airline employees would constitute income to the employees, because the service costs the airline money if it has to deny seats to paying passengers.
- Qualified employee discounts, discounts on goods and services that are offered by the employer to its customers, are not income to employees. The Code imposes a maximum discount of the profit on goods and 20% on services: any greater employee discounts are considered income.
- Working condition fringes, services or property that would be deductible by the employee as a business expense if purchased by the employee, are not income to the employee. Examples include on-the-job training expenses, safety equipment, and travel for purely business purposes.
- De minimis fringes, benefits that are too low in value to be reasonably worth accounting for, are not income to employees. Coffee and donuts in an office are a classic example.
- Meals and lodging provided by employers follow special rules. To be excluded from income, they must be provided on business premises for a "substantial noncompensatory business reason" such as keeping the employee "on call." Note that in the case of lodging, "business premises" does not refer to location: it means that some sort of business activity must be performed at the place of lodging.
Gratuitous transfers[edit | edit source]
Gratuitous transfers, such as gifts and inheritances, are excluded from income by the Code. The standard for determining such a transfer is whether it was made "from a detached and disinterested generosity, out of affection, respect, admiration, charity or like impulses." If a so-called "gift" is made in consideration or anticipation of a benefit, it loses its gratuitous status and can be considered income. See Commr. v. Duberstein, 363 U.S. 278 (1960) (Cadillac given to contact who provided business leads in the past was includible in income despite being declared as a gift).
Transfers of property incidental to divorce are also treated as gifts under Section 1041 of the Code. To qualify, such transfers must either be within one year after the date of the cessation of marriage, or be "related" to the cessation if made beyond the one-year window.
Severance payments, bonuses, honorariums and other "gifts" from employers to employees are almost always considered to be income, although they may be excluded as fringe benefits as described above. Death benefits to survivors of employees have been a more difficult issue and have split the courts as to whether they should be considered as income.
Life insurance[edit | edit source]
Section 101 of the Code excludes life insurance payments from income, including accelerated death benefits for the terminally ill. There are several exceptions to this rule, mainly to cover obvious loopholes. Among them:
- One cannot exclude payment on a life insurance policy that was coupled with an annuity of equal value, because such an arrangement does not shift or distribute any risk.
- Creditors cannot exclude payment on life insurance policies they take out on debtors to secure repayment of their loans.
Scholarships[edit | edit source]
Scholarships are not income in some situations. To be exempt, they must be paid to degree candidates at an educational institution, and they are only exempt to the extent that they compensate for the cost of tuition, fees, books, supplies, and equipment. Payments for teaching, research and other services are always considered income even if they are only paid by reducing the student's tuition.
Loan forgiveness programs receive special treatment under Section 108(f). The discharge of the student's loan debt can be excluded from income, as long as the loan came from the government or an educational institution, contained a provision for forgiveness, and the forgiveness is in exchange for working in "certain professions" or for "any broad class of employers."
Social welfare[edit | edit source]
Sections 85 and 86 of the Code exclude social welfare payments from income. The exclusion applies to TANF, Medicare, disaster relief, replacement housing payments, and assistance to victims of crimes, among many other types of payments. But unemployment compensation is considered to be income.
An exception to the exclusion is Social Security, which follows its own complicated rules because of its dual nature as a welfare program and investment scheme.
Special rules[edit | edit source]
Damage awards[edit | edit source]
The taxation of damages awarded in lawsuits poses complicated policy issues, but the general rules are:
- Punitive damages are always income.
- Compensatory damages may or may not be taxable depending on their nature.
- Damages that compensate for lost income, such as lost profits and back pay, are treated as income.
- Damages that compensate for lost capital, such as property, are not treated as income.
- Damages that arise due to physical injuries are not treated as income unless they are punitive. (This includes compensation to third parties, e.g. for loss of consortium.)
- Damages that compensate for emotional distress are treated as income unless they arise due to a physical injury.
Conduit situations[edit | edit source]
Some taxpayers receive income with the condition that they must pay it to somebody else or for something else. Examples include waitresses who share tips with busboys, political candidates who receive campaign contributions, and funds paying collective expenses for multiple businesses. In most conduit situations such as these, the money "passing through" the taxpayer is not considered income to the taxpayer, but the taxpayer must be able to prove that the income was received with the condition that it be paid to someone else or for something else.
Note that many corporations are taxed on their profits even if those profits are distributed to shareholders as dividends. This is described in further detail in the Tax Liability chapter.
Gains and Losses
The previous chapter in this text discussed the broad concept of income. Income often arises in the trading of property, whether real or personal, tangible or intangible. The income to a taxpayer from disposition of property is called gain or loss. Whether it is gain or loss depends on the adjusted basis of the property and the amount realized by the taxpayer in its disposition.
Gains are income to the taxpayer. Losses may be deductible from income, but not always. If losses are incurred by a corporation, or in an individual's trade or business, they reduce adjusted gross income. Nonbusiness profit-seeking losses, as well as some "casualty losses," are treated as itemized personal deductions.
Determining gain and loss[edit | edit source]
Basis refers to a taxpayer's expenditure in acquiring property. Over time, the basis is "adjusted" to account for improvements, cost recovery, and other factors. When the property is sold, or when another "taxable event" takes place, its adjusted basis is subtracted from the amount realized by the taxpayer. If positive (amount realized exceeds adjusted basis), the amount is a gain. If negative (adjusted basis exceeds amount realized), it is a loss.
For example, a taxpayer might buy a piece of land for $10,000. Its basis thus becomes $10,000. The taxpayer puts a house on the land, at a cost of $40,000. Now, the property's adjusted basis is $50,000: the cost of the land plus the cost of the improvement. If the taxpayer sells the property for $90,000, they realize a gain of $40,000. Conceptually, the other $50,000 does not represent an accession to wealth, because it is wealth the taxpayer already had: they simply shifted its form from cash to property, and did not gain any wealth until they sold the property for more than they paid.
Determining basis[edit | edit source]
When the taxpayer purchases property for cash, basis is easy to determine. Other scenarios pose different problems.
Financing[edit | edit source]
Most real estate transactions, and many purchases of personal property, involve debt financing. When a taxpayer takes out a loan to purchase property, the loan is included in the basis of the property. When the property is transferred, the loan is included in the amount realized if the recipient takes the loan with the property.
In the first example above, the taxpayer could purchase the land with a $10,000 loan. The basis becomes $10,000 after purchase, and adjusts to $50,000 after the house is built. When the taxpayer sells the property for $90,000, their amount realized is $90,000 if the property is sold subject to the loan, but is only $80,000 if the taxpayer remains subject to the loan. The taxpayer therefore recognizes $10,000 in additional gain if the property is sold subject to the loan. In a sense, the taxpayer receives more income if the buyer takes on the liability for the loan, just as they would receive income if the buyer paid off their loan for them.
Property as income[edit | edit source]
In the first example above, the taxpayer might have received their land in exchange for supplying a service to its previous owner. In that case, the basis in the property would become its fair market value—the same amount claimed by the taxpayer as income. Assuming $10,000 was the fair market value, this achieves the same result as if the taxpayer had received a $10,000 payment from the owner and then bought the land for that amount.
Property as an inheritance[edit | edit source]
If our example taxpayer received their land as an inheritance upon the previous owner's death, they would not have to declare it as income, and its basis would be reset to its fair market value as of the date of death of the decedent; i.e, the inheritor receives a stepped-up basis in the assets. There is an alternate valuation date, subject to the rules of IRC §2032, which may be used to value assets. The alternate date is six (6) months to the day following the date of death of the decedent. The generally cited reason for this rule is that death is not an appropriate time to tax a person's heirs for the gains of the deceased, especially considering that they may be liable for a separate estate tax. (The rules concerning inheritances will temporarily change in 2010 to coincide with the temporary repeal of the estate tax.)
Note that while inherited property is essentially "free" for income tax purposes, income in respect of a decedent is not. For instance, if a person contracts to sell some property and then dies, the proceeds from the sale will be paid to that person's heirs and will be fully taxable as income to the heirs.
Property as a gift[edit | edit source]
Gifts by a living person follow a different rule from inheritances. Generally defined as a gratuitous transfer of property, the rule regarding gifts is that the basis in the hands of the donor becomes the basis in the hands of the donee. Effectively, the taxpayer is recognizing the previous owner's gain as well as his own. The reason for this rule is to prevent people from giving property to each other for the sole purpose of resetting its basis and mitigating their gains.
Capital Gains and Losses
Gains and losses from the sale or exchange of capital assets receive separate treatment from "ordinary" gains and losses. Capital gains are taxed before income, at a significantly lower rate than ordinary gains. Capital losses, on the other hand, are only useful to offset capital gains and a small amount of personal income. As a result, tax planners often attempt to maximize capital gains while minimizing capital losses (i.e. reworking them into ordinary losses).
Capital assets[edit | edit source]
In the context of capital gains and losses, the word "capital" has a different meaning than it has in other areas of law. Capital assets are not necessarily those that are "capitalized" by businesses, for instance. The Code does not define "capital assets," but instead states that capital assets are not the following:
- Business inventory (assets bought and sold in the regular course of business).
- Business supplies.
- Accounts .
- Depreciable trade or business assets held for one year or less (including business real estate).
- Copyrights and creative works created by or gifted to the taxpayer.
- Government publications.
- Hedging transactions.
- Commodities derivatives held by brokers.
Any other asset is considered a capital asset.
Calculating capital gains and losses[edit | edit source]
Net capital gain[edit | edit source]
Most capital gains and losses are taxed as net capital gain. Net capital gain is taxed at 15% for taxpayers in the 25% tax bracket or above, and 5% for other taxpayers (unless they are below the minimum tax bracket, in which case they are not taxed).
The Code defines net capital gain as the excess of net long-term capital gain over net short-term capital loss. These two figures are reached by adding up the various long-term and short-term capital gains and losses realized in the taxable year. Gains and losses from assets held for over one year are considered long-term capital gains and losses, while gains and losses from assets held for one year or less are considered short-term capital gains and losses.
The calculation might look like this:
Because there is no excess, there is no net capital gain. The net capital loss is $10,000.
Because there is an excess of net long-term capital gain over net short-term capital loss, the excess $7,500 is taxable at the 5% or 15% rate. Which rate is used depends on which bracket the taxpayer is in.
Net capital losses[edit | edit source]
Net capital losses are used for offsetting.
Individuals can use up to $3,000 of capital losses to offset their income ($1,500 for a married person filing separately). In the above example, the taxpayer would be able to apply $3,000 of his or her net capital loss to reduce his or her taxable income by $3,000, leaving $7,000 in unused net capital loss.
Capital losses can also be carried over. If net long-term capital loss exceeds net short-term capital gain, the excess becomes long-term capital loss in the following year. If net short-term capital loss exceeds net long-term capital gain, the excess becomes short-term capital loss in the following year.
Corporations follow different rules. Their capital losses must first be carried back to each of the three preceding years, if possible. Any capital losses that cannot be applied against capital gains from the three previous years can then be applied against capital gains in the 5 succeeding tax years.
For example, assume that X Corporation has $50,000 in net capital losses in 2005. Their capital gains for the last three years are:
The net capital losses cannot be carried back to 2002 because there is no net capital gain to offset. $23,000 can be used to offset the capital gains in 2003, leaving $27,000. Another $11,000 can be used to offset the capital gains in 2004, leaving $16,000. This $16,000 can be used to offset any net capital gains that arise in the next five years.
Section 1231 assets[edit | edit source]
Many assets held for use in a trade or business receive separate treatment under Section 1231. These assets include those that are:
- sold or exchanged, and
- held for more than one year and
- used for a trade or business and
- depreciable and
- not inventory or intellectual property, OR
- converted (i.e. destroyed/stolen/condemned), and
- used for a trade or business OR
- held for more than one year and
- held in connection with a trade or business or venture for profit.
- used for a trade or business OR
Any gains and losses allowed under Section 1231 are added up. If gains exceed losses, the net gain is treated as long-term capital gain for that year. But if losses exceed gains, the net loss is treated as ordinary loss. This seems to give taxpayers the "best of both worlds" in a sense: they can receive the favorable capital gains rate for 1231 gains, and can treat 1231 losses as ordinary losses directly against their income.
There is one qualification that destroys much of this attractiveness: recapture. Under Section 1231(c), 1231 gains are treated as ordinary income to the extent of net 1231 losses over the past five years. This means that 1231 losses may only provide a temporary advantage: if there are 1231 gains within the next five years, they will be treated as ordinary income to the extent that they offset the prior loss.
Section 1245 recapture[edit | edit source]
The capital gain system is also tempered by Section 1245, which provides for recapture of prior depreciation deductions on personal property. When 1245 property is sold, depreciation is added to the adjusted basis to find the recomputed basis of the property. If the recomputed basis and the amount realized both exceed adjusted basis, the excess is treated as ordinary income, not capital gain. Any amount realized over the recomputed basis can be 1231 gain or capital gain.
For instance, assume a machine is purchased for $100, depreciated by $40 and sold. Its adjusted basis is $60: adding depreciation back in, its recomputed basis is $100, which exceeds adjusted basis. If the machine sells for $65, the amount realized also exceeds adjusted basis, and the $5 gain is treated as ordinary income. If the machine sells for $110, the first $40 gain is treated as ordinary income, and the remaining $10 may be capital gain or 1231 gain.
Section 1245 applies generally to depreciable personal property, but not to real property.
Business pay income taxes on their profit, whether the business is a major corporation or a self-employed individual. This is achieved by deducting trade and business expenses from gross income (which is revenue from a business's perspective) to find adjusted gross income.
Trade and business defined[edit | edit source]
Trade and business deductions are provided by Section 162 of the Internal Revenue Code, but that section does not define the terms "trade" and "business." The current definition is provided by the Supreme Court's ruling in Commr. v. Groetzinger, 480 U.S. 23 (1987):
- To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity. The taxpayer's primary purpose for engaging in the activity must be for income or profit.
The "continuity and regularity" requirement distinguishes trade and business deductions from profit-seeking deductions, which are provided under Section 212. Profit-seeking deductions can be claimed for any activity engaged in for income or profit, whether the taxpayer is actively involved or not. The key difference between the two classes is that profit-seeking deductions are below the line, meaning they are applied against AGI, while trade and business deductions are above the line, meaning they are applied against gross income. Profit-seeking expenses must also be itemized, which is described in more detail later in this text, but practically means that they may not always benefit the taxpayer. Trade and business deductions, on the other hand, always apply against the taxpayer's income, assuming the taxpayer has income to deduct against.
"Ordinary and necessary" defined[edit | edit source]
To be deductible, Section 162(a) requires that trade and business expenses be "ordinary and necessary." Like "trade or business," the phrase "ordinary and necessary" is not defined by the statute. The Supreme Court has also failed to provide a definition for the term.
It is clear that ordinary and necessary business expenses exclude personal expenses and capital expenditures. Some courts have gone further to indicate that strange or arbitrary expenses are also not deductible.
Business assets[edit | edit source]
Capitalization[edit | edit source]
Many expenses in consideration of assets are classified as capital expenditures, and are not deductible as business expenses. Instead, capital expenditures give a basis to the assets purchased, and that basis reduces the amount of income realized when the asset is sold.
Generally, any expenditure that creates or adds value to an asset that will be held for over a year is a capital expenditure. This is not a strict rule: minor assets incidental to a business, such as supplies, materials, furniture and books, may simply be deducted when they are purchased. But all significant assets to be held in the long term must be treated as capital expenditures.
Capital expenditures may also be required for expenses incidental to the acquisition of assets. This was established by the Supreme Court's opinion in INDOPCO v. Commr., 503 U.S. 79 (1992), which held that the legal and consulting fees for a corporate acquisition are considered capital expenditures. The IRS later established so-called "INDOPCO Regulations," which require capitalization of expenditures to acquire, create or enhance an intangible asset, as well as all expenditures incidental to such activity.
Improvements to a property are capital expenditures and affect basis. Repairs to property are normal business expenses which do not affect basis.
Because capitalization affects the basis of the asset in question, classifying an expense as a capital expenditure does not remove all of the tax benefit for that expense: capitalization "shifts" the tax benefit forward in time, so that it will be recognized as part of the gain or loss upon sale of the asset.
Cost recovery[edit | edit source]
Some assets have a limited lifespan: they are known as wasting assets because they lose value over time. Machinery and buildings are examples of wasting assets. Artwork and land, on the other hand, are not wasting assets because their value generally stays constant or goes up over time. Capital expenditures on wasting assets give rise to a type of deduction called cost recovery.
Depreciation[edit | edit source]
Depreciation is the typical form of cost recovery for wasting assets. It provides a system for gradually deducting the cost of the asset over a fixed period. In addition to being a business deduction, depreciation also deducts from the basis of the asset. This means that a fully-depreciated asset has a basis of zero.
Since 1981, the main method of depreciation has been accelerated cost recovery. Property placed into service after 1986 is depreciated by the Modified Accelerated Cost Recovery System (MACRS), while property placed into service between 1981 and 1986 is depreciated by MACRS' predecessor, the Accelerated Cost Recovery System (ACRS).
Under MACRS, each asset is given a recovery period based on its "midpoint life" as determined by the IRS. The recovery periods are 3, 5, 7, 10, 15, and 20 years for various forms of personal property, 27.5 years for residential buildings, and 39 years for nonresidential buildings.
Depreciation always starts and stops at the midpoint of each year. A 10-year asset, for instance, receives half a year's worth of depreciation in the year it is purchased, then depreciates normally until year 11, when it receives another half a year's worth of depreciation (which should equal its remaining basis). This half-year rule is intended to keep taxpayers from benefiting disproportionately if they purchase assets late in the year.
There are two methods for calculating the actual depreciation. The straight line method is mandatory for real property, but can be voluntarily applied to any depreciable asset. Under the straight line method, the same percentage of the asset's basis is deductible each year. So a 10-year asset with a basis of $100,000 would be deductible by $5,000 in the first year, $10,000 each year from year 2 to year 10, and $5,000 in year 11.
Other assets use the declining balance method, which provides higher depreciation in initial years but lower depreciation in later years. 15 and 20-year assets use 150-percent declining balance, while other assets use 200-percent (double) declining balance.
Expensing[edit | edit source]
Section 179 allows a limited amount of machinery and equipment to be "expensed," or deducted immediately. Expensing can be performed in lieu of depreciation, or it can be applied against the basis of an asset and the remainder can then be depreciated normally.
Amortization[edit | edit source]
Section 179 makes a separate cost recovery provision for many intangible assets, including covenants not to compete, franchises, goodwill, government licenses, and trademarks. Such assets are amortizable over 15 years. Other intangibles can be amortized if the taxpayer can prove that they have a limited useful life.
Depletion[edit | edit source]
Depletion is essentially depreciation for natural resources. It applies to mining and lumber operations which are likely to reduce the value of land over time.
Leveraged tax shelters[edit | edit source]
From the mid-1960s to the mid-1980s, many investors took advantage of cost recovery to create leveraged tax shelters, investments that provided a high rate of return by generating high cost recovery deductions that were passed on to investors. The classic tax shelter was a piece of real estate financed through "nonrecourse debt"—a loan secured against the property, such as a mortgage. The investor would put up a tiny portion of the purchase price, and then take cost recovery deductions every year until the property was fully depreciated. Often, they would recover their investment in the form of lower taxes within a few years.
Congress eventually created two rules to block leveraged tax shelters. The at-risk limitation, passed in the Tax Reform Act of 1976, established that the deductible loss of a taxpayer cannot exceed the amount with respect to which the taxpayer is actually "at risk." The limitation applies to all business and investment activities except real estate.
Congress added the passive activity loss limitation in the Tax Reform Act of 1986. Codified at Section 469, the rule states that deductions from passive business activities cannot be used to offset income from other sources. The rule essentially forces taxpayers to separate their "passive" business activities from their personal and "active" business activities, and only apply passive business losses against passive business income.
Excluded business expenses[edit | edit source]
Section 162 renders several types of business expenses non-deductible for "public policy" reasons.
Penalties[edit | edit source]
Fines and penalties for illegal conduct are not deductible under Section 162(f). This rule includes civil and criminal penalties of all kinds, as well as similar private payments such as settlements and restitution.
Influence[edit | edit source]
Lobbying expenses are not deductible under Section 162(e), which bars deductions of expenses to influence legislation, political campaigns, referenda and executive decisions.
Bribery is also not deductible as a business expense. Section 162(c) specifically prohibits businesses from deducting illegal bribes to government officials, although bribes to foreign officials are deductible if they are permitted under the Foreign Corrupt Practices Act.
Golden parachutes[edit | edit source]
Section 280G prohibits deduction of "excess parachute payments," defined as payments to an executive contingent upon a change in ownership or control of a corporation, when such payments exceed three times the executive's average annual compensation over the past five years.
Drug trafficking[edit | edit source]
Section 280E prohibits deduction of business expenses incurred in illegal drug trafficking.
Business vs. personal[edit | edit source]
Some types of business expenses can be construed as having both business and personal purposes. In such cases, their deductibility is often limited.
Home offices[edit | edit source]
Section 280A generally disallows business deductions for home offices, with a number of exceptions. A home office is deductible if it is exclusively used on a regular basis as the taxpayer's principal place of business, or by the taxpayer's clients for meeting or dealing with the taxpayer.
If a home office meets one of these exceptions, its proportion of the total expenses of the home can be deducted as business expenses. For instance, if the office constitutes twenty percent of the house's floor area, then twenty percent of the utility bills and insurance premiums would be deductible.
Travel, meals and entertainment[edit | edit source]
Business travel, including lodging, transportation and meals, is deductible under Section 162(a)(2) when the taxpayer is "away from home." "Home" is considered to mean the taxpayer's principal place of business, so this rule disallows deductions for commuting expenses. If the taxpayer has no such place of business, their "home" is their residence.
Transport, lodging and meals are deductible whenever the taxpayer is spending the night away from home. For trips that do not involve an overnight stay, transportation expenses are deductible so long as they are not commuting expenses between the taxpayer's residence and principal place of business. A doctor, for instance, can deduct the cost of traveling between hospitals and clinics, but cannot deduct the cost of traveling between residence and hospital or residence and clinic. Rev. Rul. 90-23, 1990-1 C.B. 28.
However, there are many restrictions on what employees are allowed to expense and deduct. Most of these restrictions are found in Section 274, which states that the following are nondeductible:
- Tickets purchased above face value (only deductible at face value).
- Skybox tickets (only deductible to an amount equal to the cost of box seats).
- Luxury water travel.
Entertainment expenses not directly related to the taxpayer's trade or business are generally not deductible, as are operating and membership expenses for entertainment facilities, such as sporting and social clubs. But such expenses can be deducted if they are provided as employee compensation or made available to the general public.
Meals and entertainment provided by employers to their employees are only deductible to 50 percent of their cost under Section 274(n). This restriction does not apply if the meal is considered a de minimis fringe, or if it is supplied to transportation workers subject to federal hours limits (e.g. aircrews and long-distance bus drivers).
Vehicles, computers and phones[edit | edit source]
Section 280F deals with vehicles, computers and phones, three types of property that are often provided by businesses to their employees, or used by self-employed individuals for their business. Such items are not depreciable under the usual accelerated system unless more than fifty percent of their use is for business. Use by employees must be for the employer's convenience and required as a condition of employment in order for such use to count as business use. "Profit-seeking" use is also not counted as business use.
Automobiles are subject to additional rules which greatly decelerate their depreciation. However, trucks, vans, ambulances, hearses and all vehicles over 6,000 pounds are not counted as "automobiles" for the purpose of this rule. This means that while a Rolls-Royce must be depreciated over a very long period, a Hummer can be depreciated over a relatively brief period.
Uniforms[edit | edit source]
Business uniforms are only deductible if they are unsuitable for ordinary wear outside the course of business. This leads to some seemingly arbitrary distinctions. The cost of military uniforms, for instance, cannot be deducted when the uniforms can be worn off duty. Fatigues, on the other hand, cannot be worn off duty, and therefore the cost of military fatigues is deductible. By similar logic, a performer can deduct the cost of a unique tuxedo they wear on stage; a lawyer cannot deduct the cost of a suit.
This chapter deals with the deductions that apply to individual taxpayers. The first set of deductions covered are those that are above the line—subtracted from gross income to reach AGI. The other deductions for individuals are below the line—subtracted from AGI to reach taxable income. When calculating below the line deductions, the taxpayer can either use a standard deduction provided by law, or elect to take itemized deductions.
Above the line deductions[edit | edit source]
The main type of above the line deduction is for business and employment expenses, which are discussed in the chapter on Business Deductions. Several other deductions are allowed "above the line" even though they are not business-related. These deductions are listed in Section 62.
Property losses[edit | edit source]
Ordinary losses from the sale of property, as detailed in the chapter on Gains and Losses, are deductible "above the line." This makes them preferable to capital losses, as they can be applied directly against income rather than going through the complicated calculations for capital gains taxation.
Interest[edit | edit source]
Section 163 provides that interest payments are generally deductible. However, interest on "personal" loans, with the exception of home mortgages and student loans, is not deductible.
Interest is generally defined as "rent for borrowed money," so some payments labeled as "interest" may not be considered "interest" for tax purposes. Likewise, some payments are considered to be "interest" despite not being called by that name: "points" and loan origination fees, for instance, are deductible over the term of the loan. Rev. Rul. 69-188, 1969-1 C.B. 54.
"Investment interest," interest for property held for investment (e.g. stocks, bonds, and land) can only be deducted to the extent of net investment income; disallowed investment interest is carried forward and treated as investment interest the following year.
Some interest payments are nondeductible due to the passive activity loss limitation, described in the section on leveraged tax shelters in the previous chapter.
Alimony[edit | edit source]
Educational expenses[edit | edit source]
Educational expenses are deductible if they maintain or improve skills used in a present trade or business, and if they do not qualify an individual for a new trade or business.
This means that the type of education does not determine deductibility: the circumstances of the education do. In Ruehmann v. Commr., T.C. Memo. 1971-157, a student who entered an LLM program after four months of employment as an attorney was allowed to deduct the cost of his degree. But in Wassenaar v. Commr., 72 T.C. 1195 (1979), a student who entered an LLM program immediately after law school was denied a deduction for its cost, on the grounds that he was not employed as an attorney at the time he paid for the classes.
One exception to this rule is when a person takes a job contingent upon completing an educational requirement, as is the case when teachers are hired subject to completing a required degree, or when law school graduates are hired subject to passing the bar exam. In these cases, the cost of their education is not deductible because it is considered a "minimum education requirement" that qualifies the individual for their trade or business.
Student loan interest[edit | edit source]
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Personal exemptions[edit | edit source]
As of 2005, the personal exemption is $3,500 for the taxpayer and each dependent.
Under Section 151(d)(3), personal exemptions "phase out" over a threshold income of $145,950 for single taxpayers and $218,950 for married couples (2005). They fall two percent for each $2,500 or fraction thereof over the threshold, reaching zero at income levels of $268,450 and $341,450 respectively.
A dependent is defined in Section 152 as someone who is reliant on the taxpayer for more than 50% of their support, and either living with or closely related to the taxpayer. Non-resident foreigners cannot be dependents unless they come from a country contiguous with the United States.
Standard deduction[edit | edit source]
Itemized deductions[edit | edit source]
Medical expenses[edit | edit source]
Medical expenses can be deducted to the amount of those expenses which the tax payer has not been reimbursed for and that they exceed 7.5% of the taxpayers adjusted gross income (AGI). (i.e. 100 dollars of unreimbursed expenses for a person with an AGI of 1,000 can be deducted in the amount of 25 [100-1,000*.075]) These deductions are different when calculating Alternative Minimum Tax (AMT) and are subject to phaseout in higher income brackets. See IRS form 1040 Schedule A instructions for more details.
Investment interest[edit | edit source]
Wagering losses[edit | edit source]
Casualty losses[edit | edit source]
Casualty losses include losses due to theft, accident, and other "sudden" incidents. A casualty loss may be the loss of an entire piece of property, or it may be in the form of damage to that property.
Casualty losses do not include:
- Losses compensated for by insurance. But a property owner may claim a casualty loss if their property is covered by insurance but no claim is pursued. Hills v. Commr., 691 F.2d 997 (11th Cir. 1982).
- Property confiscated under color of law.
- Losses due to the owner's gross negligence (e.g. setting a house on fire during a domestic dispute). However, loss due to the owner's ordinary negligence (e.g. dropping a diamond ring down the drain) is deductible as a casualty loss.
- Unrealized declines in property value. See, e.g., Chamales v. Commr., T.C. Memo. 2000-33 (2000) (neighbors of O.J. Simpson not allowed to claim casualty loss for decline in property value due to disorder in neighborhood following Simpson murders).
- Expenses incidental to the loss, such as legal expenses.
Each casualty loss is only deductible to the extent it exceeds $100, and total casualty losses are only deductible to the extent they exceed 10% of AGI.
Casualty loss can never exceed adjusted basis of the property. If casualty loss is taken for damage to property, the adjusted basis of that property is reduced by the amount of the loss.
Profit-seeking expenses[edit | edit source]
Charitable contributions[edit | edit source]
Charitable contributions are deductible under Section 170. The section imposes a limit on deductible contributions of 50 percent of AGI for individuals (less in the case of certain organizations) and 10 percent of taxable income for corporations.
The donor must have a donative intent in order for the contribution to be deductible. The analysis of donative intent is similar to the analysis used in determining whether a payment is a gift: the purpose of the donation must be "detached and disinterested generosity." See Hernandez v. Commr., 490 U.S. 680 (1989) (payments to Church of Scientology for "auditing" sessions were non-deductible quid pro quo exchanges). If a good or service is provided in exchange for the contribution, the contribution is only deductible to the extent it exceeds the fair market value of that good or service. But a de minimis consideration, worth less than 2 percent of the contribution or $50, need not be subtracted from the donation.
When property is donated to a charity, the value of the donation is considered to be the fair market value of the property, not its adjusted basis. Because of this rule, many taxpayers choose to donate appreciated property to charity, rather than sell it and pay taxes on the gain.
Foreign, state and local taxes[edit | edit source]
Many non-federal taxes are deductible under Section 164. The main categories are foreign, state and local income taxes; foreign, state and local real property taxes; and state and local personal property taxes. Other types of taxes, such as sales taxes, are generally not deductible.
Who pays tax, and how much they pay, is dependent on the type of entity paying the tax.
Single taxpayers[edit | edit source]
Families[edit | edit source]
Married taxpayers[edit | edit source]
If a taxpayer is married, they can either file a joint return with their spouse, or file separately.
One commonly-debated point of income tax law is the marriage penalty. Married taxpayers are taxed at different rates than single taxpayers whether they file jointly or separately. The "marriage penalty" is most pronounced when spouses have equal incomes, and becomes less detrimental as the spouses' incomes diverge. When one spouse has much more income than the other, the couple's tax liability is actually lower than it would be if they were both single. For instance, under the Code's rates unadjusted for inflation, a married couple with taxable income of $100,000 would pay $23,529 in taxes. If the couple were unmarried and both had taxable income of $50,000, they would pay $11,127 each, or a total of $22,254. But a single person with taxable income of $100,000 would pay $26,522. As a result, marriage is beneficial, tax-wise, when one spouse works and the other does not; it is often detrimental when both spouses work.
There has been, as of yet, no truly equitable solution posed to the marriage dilemma: every conceivable system would offer marriage bonuses in some cases and marriage penalties in others.
Head of household[edit | edit source]
Under Section 1(b), an unmarried taxpayer with one or more dependents in their household may file taxes as a head of household. Heads of household pay less tax than equivalent single taxpayers, but they pay more tax than an equivalent married couple filing jointly.
Dependents[edit | edit source]
Anyone with income is liable for taxes on that income, even if they are listed as a dependent on someone else's tax return.
Minor children are always taxed independently on their income under Section 73, regardless of whether they are emancipated and regardless of whether they actually receive the income.
If children under 14 have unearned income (e.g. income from returns on investments), their income is taxed at the marginal rates of their parents under Section 1(g). The assumption behind this rule is that parents may be tempted to place assets in their children's names to avoid tax liability.
Alternative minimum tax[edit | edit source]
Corporations[edit | edit source]
Corporate taxes are levied by the schedule in Section 11. Most large corporations and all public corporations are classified as C corporations and are subject to corporate taxes. Smaller private companies can qualify as S corporations, which exempts them from corporate tax liability. However, all corporate distributions to shareholders are taxed regardless of whether the corporation has C or S status. In the case of C corporations, this means that profits passed on to shareholders are taxed twice: once as corporate income, and once as personal income. This double taxation problem is a major issue to investors when deciding how to structure a business.
Partnerships and LLCs[edit | edit source]
Partnerships are not taxed. Instead, their partners pay tax on their proportion of the profits of the entity, regardless of whether those profits are distributed or reinvested. This is known as pass-through or flow-through taxation. Limited liability companies (LLCs) with more than one member usually follow a similar tax structure; single-member LLCs are taxed as an extension of the owner.
The IRS offers check-the-box taxation for such entities, which allows the managers to decide whether to have their LLC taxed as a corporation or partnership by checking boxes on a form. By default, such entities are taxed as partnerships; in some situations, however, it is beneficial to have an entity taxed as a corporation.
Trusts[edit | edit source]
Tax credits are applied at the last stage in the tax computation process. They directly reduce the actual tax paid by the taxpayer. This makes them highly preferable to equivalent deductions.
Personal credits[edit | edit source]
Adoption credit[edit | edit source]
You may be able to take a tax credit for qualifying expenses paid to adopt an eligible child (including a child with special needs). The adoption credit is an amount subtracted from your tax liability. Although the credit generally is allowed for the year following the year in which the expenses are paid, a taxpayer who paid qualifying expenses in the current year for an adoption which became final in the current year, may be eligible to claim the credit on the current year return. The adoption credit is not available for any reimbursed expense. In addition to the credit, certain amounts reimbursed by your employer for qualifying adoption expenses may be excludable from your gross income.
For both the credit or the exclusion, qualifying expenses include reasonable and necessary adoption fees, court costs, attorney fees, traveling expenses (including amounts spent for meals and lodging while away from home), and other expenses directly related to and for which the principal purpose is the legal adoption of an eligible child. An eligible child must be under 18 years old, or be physically or mentally incapable of caring for himself or herself. The adoption credit or exclusion cannot be taken for a child who is not a United States citizen or resident unless the adoption becomes final. An eligible child is also a child with special needs if he or she is a United States citizen or resident and a state determines that the child cannot or should not be returned to his or her parent's home and probably will not be adopted unless assistance is provided. Under certain circumstances, the amount of your qualified adoption expenses may be increased if you adopted an eligible child with special needs.
The credit and exclusion for qualifying adoption expenses are each subject to a dollar limit and an income limit.
Under the dollar limit the amount of your adoption credit or exclusion is limited to the dollar limit for that year for each effort to adopt an eligible child. If you can take both a credit and an exclusion, this dollar amount applies separately to each. For example, if we assume the dollar limit for the year is $10,000 and you paid $9,000 in qualifying adoption expenses for a final adoption, while your employer paid $4,000 of additional qualifying adoption expenses, you may be able to claim a credit of up to $9,000 and also exclude up to $4,000.
The dollar limit for a particular year must be reduced by the amount of qualifying expenses taken into account in previous years for the same adoption effort.
The income limit on the adoption credit or exclusion is based on your modified adjusted gross income (modified AGI). If your modified AGI is below the beginning phase out amount for the year, the income limit will not affect your credit or exclusion. If your modified AGI is more than the beginning phase out amount for the year, your credit or exclusion will be reduced. If your modified AGI is above the maximum phase out amount for the year, your credit or exclusion will be eliminated.
Generally, if you are married, you must file a joint return to take the adoption credit or exclusion. If your filing status is married filing separately, you can take the credit or exclusion only if you meet special requirements.
To take the credit or exclusion, complete Form 8839 , Qualified Adoption Expenses, and attach the form to your Form 1040 or Form 1040A .
Child tax credit[edit | edit source]
Dependent care credit[edit | edit source]
Earned income credit[edit | edit source]
Elderly/disabled credit[edit | edit source]
Mortgage interest credit[edit | edit source]
Business credits[edit | edit source]
Alcohol fuel credit[edit | edit source]
Disabled access credit[edit | edit source]
Employer-provided child care tax credit[edit | edit source]
Employer Social Security credit[edit | edit source]
Empowerment zone credit[edit | edit source]
Enhanced oil recovery credit[edit | edit source]
Native American employment credit[edit | edit source]
Investment credit[edit | edit source]
Low-income housing credit[edit | edit source]
New markets tax credit[edit | edit source]
Orphan drug credit[edit | edit source]
Renewable electricity production credit[edit | edit source]
Research credit[edit | edit source]
Small employer startup costs credit[edit | edit source]
Welfare-to-work credit[edit | edit source]
Work opportunity credit[edit | edit source]