See Study Guide

IRS ENROLLED AGENT EXAMINATION
INTRODUCTION AND TIPS
INTRODUCTION AND Q & A's

The Internal Revenue Service Special Enrollment Examination is offered Once each year for individuals
who wish to be enrolled to practice before the Internal Revenue Service (Enrolled Agents). It is comprised
of four parts. Candidates must take all four parts of the examination in the first year. Those who pass at
least one part of the examination in the first year may take the failed parts in the following three years with
these provisions:
Candidates must achieve the minimum retention score on EACH part failed in the first year. The minimum
retention score is 90 percent of the passing score set for the part(s) failed.
Candidates MUST take ALL failed parts of the examination in the second year, all remaining parts the
third year, and all remaining parts the fourth year.
Candidates must achieve a score no less than 90 percent of the passing score for any parts taken in the
second and third years in order to remain eligible to try again. That is to say that if you score below the
minimum retention score on any part taken in the second or third year, you would be required to retake
the examination in its entirety should you wish to continue.
Candidates who do not pass all four parts of the examination by the end of the fourth year must start over
again.
Candidates who pass three of the four parts the first year do NOT have to achieve the minimum retention
score on the part failed. Therefore, they would be required to take only the part failed the following year.
IMPORTANT DATES
Exam Applications available from IRS call 800-829-3676 June 1

Deadline to submit exam applications to IRS July 31
www.dynastyschool.com 1
Questions & Answers

Question: If an individual is unable to retake the examination in a subsequent year, would he/ she
lose credit for examination parts passed?
Answer: Yes, in most cases, since the examination assumes continuity. However, if the candidate
is able to give compelling reasons for a waiver, e.g. serious illness or a death in the family, it could be
granted.
Question: In the above situation, does the candidate still have only four years to complete the
examination successfully or is the candidate allowed additional years?
Answer: The years a candidate misses taking the examination under a waiver will not count
against the four years. Each waiver would extend the period one year. However, there is a six year
[imitation. That is, the candidate must complete the examination successfully within six years if granted
any waiver, including years for which waivers are granted.
Question: May an individual change the district in which he/she takes the examination from year to
year?
Answer: Yes.
Question: Would an individual who passed one or more parts of the examination in the first year and
again failed the parts he/she had to take in the second year be able to carry over first year credit?
Answer: Yes. The candidate would retain credit for any part passed iii the first year for the remaining
three years, provided he/she met the minimum retention score and parts required to be taken conditions
as set forth above.
Question: What if an individual took all four parts of the examination in 1996 and did not pass any of
the four parts?
Answer: The four year requirement does not take effect until the candidate passes at least one part
of the examination.
Question: May an individual take one part of the examination per year for four years?
Answer: No. Candidates must take all four parts the first year, all failed parts the second year, all
remaining failed parts in the third year, and all remaining failed parts in the fourth year.
Question: How many years may an individual take the examination without passing at least one
part?
Answer: There is no limit.
TIPS TO PASS THE EXAM

Because the tax information is enormous, so we have extracted the key points relating to the
examination together with "exercises" to form a four-part WORKBOOK. We recommend you study
the WORKBOOK and the PAST IRS EXAMINATIONS AND QUESTIONS we supplied to you. You
do not need to study all the IRS publications (SEE Package), you should use them as the
indispensable references.
Use the enclosed Special Enrollment Examination (SEE) Study Material Request and Mailing Label
attached to order your IRS publications. (next page)
Study the important Q-Cards (index cards) we prepared for you. These index cards contain the key
information on topics relating to the IRS EA exam.
You are not allowed to bring a calculator into the exam, so practice those computation questions by
hand.
Pay more attentions to the computational questions in Section C first. These questions are worth 3
points each and it is important you finish them first. Answer the TRUE/FALSE questions (Section
A)) last, because they are worth one point each and you have a 50% chance of picking the right
answer.
Many of the questions on Part 4 can be answered using common sense. The IRS likes to ask a few
esoteric questions that will not be familiar to you. Read the questions carefully, if the question
sounds like it makes sense, mark true.
Most of the true questions in Section A are statements right out of the IRS publications, IRC code,
or regulations. Make sure you memorize all those true questions. On the last five year's exams if
you had answered true to every questions on Section A, you would have passed that section of the
exam.
Do NOT attempt to learn every specific details of the tax law. You cannot. We have designed this course
to give you "enough" tax information to pass all four parts of the exam the first time. The passing grade
for last five years exams were between 50% to 58%.
We have prepared you to pass the exam. The rest is on your hands.
GOOD LUCK TO YOUR EXAM & BEST WISHES TO YOUR CARRIER AS AN EA.
Dynasty School
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Special Enrollment Examination (SEE)

Study Material-Request and Mailing Label
You may request the SEE Kit by internet: www.irs.gov/pub/irs-fill/f2587.pdf or you may order, free of
charge, the IRS publications which provide much of the basic information to assist you in the preparation
for the examination. In addition, IRS produces most of the information included in the SEE kit
electronically on “The Federal Tax Products” CD-ROM (Publication 1796).
Electronic or CD-ROM (publication 1796) Version of the 2001 See Kit Study Material (plus the Printed
Copy Version of Items not included on the CD-ROM).
Please send me the printed Version of SEE kit Study Material and CD-ROM ROM Publication 1796.
Please complete the lower portion of this page and mail it to the address listed below. Please print “SEE “
in the lower left front corner of your envelope. (Please do not send this form with your application Form
2587)
Send to: IRS Western Area Distribution Center Rancho Cordova,. CA. 95743-0001
Return label - Fill in your name and address below.
Please expedite shipment of the Special Enrollment Examination Study Material to:
SEE Study Material Pamphlet
Name
Street
City State Zip
IRS ENROLLED AGENT WORK BOOK
PART 1 - INDIVIDUALS
1. PART 1 - INDIVIDUALS
TABLE OF CONTENTS
1. PART 1................................................................................................................ 1-1

INTRODUCTION....................................................................................................... 1-3
PART 1 - THE INCOME TAX RETURN .................................................................... 1-4

1. Filing Requirements ......................................................................................... 1-4
2. Filing Status.................................................................................................... 1-10
3. Personal Exemptions and Dependents .......................................................... 1-14
4. Decedent's Return.......................................................................................... 1-19
5. Estimated Tax ................................................................................................ 1-20
PART 2 – INCOME ................................................................................................. 1-23
6. Accounting...................................................................................................... 1-23
7. Wages, Salaries, and Other Earnings ............................................................ 1-24
8. Tip Income...................................................................................................... 1-29
9. Interest Income............................................................................................... 1-30
10. Dividends and Other Corporate Distributions ................................................. 1-37
11. Rental Income and Expenses......................................................................... 1-41
12. Social Security and Equivalent Railroad Retirement Benefits ........................ 1-49
13. Other Income.................................................................................................. 1-50
PART 3 - GAINS AND LOSSES.............................................................................. 1-55
14. Basis of Property ............................................................................................ 1-55
15. Sales and Trades ........................................................................................... 1-67
16. Reporting Gains and Losses .......................................................................... 1-75
17. Selling Your Home (Pub. 523)........................................................................ 1-91
PART 4 - ADJUSTMENTS, DEDUCTIONS, CREDITS AND TAXES.................... 1-103
18. Individual Retirement Arrangements (IRAs) ................................................. 1-103
19. Moving Expenses ......................................................................................... 1-118
20. Alimony ........................................................................................................ 1-120
PART 5 - STANDARD DEDUCTION AND ITEMIZED DEDUCTIONS.................. 1-123
21. Standard Deduction...................................................................................... 1-123
22. Limit on Itemized Deductions (Pub. 17)........................................................ 1-123
23. Medical and Dental Expenses ...................................................................... 1-124
24. Taxes ........................................................................................................... 1-129
25. Interest Expense .......................................................................................... 1-131
26. Contributions ................................................................................................ 1-133
27. Nonbusiness Casualty and Theft Losses ..................................................... 1-138
28. Travel, Transportation, and Other Employee Business Expense ................. 1-140
29. Employee's Educational Expenses............................................................... 1-152
Dynasty School (www.dynastySchool.com). 1-1

30. Miscellaneous Deductions............................................................................ 1-154

PART 6 - FIGURING YOUR TAXES AND CREDITS............................................ 1-158
31. How To Figure Your Tax .............................................................................. 1-158
32. Tax on Investment Income of Certain Minor Children .................................. 1-160
33. Child and Dependent Care Credit ................................................................ 1-161
34. Credit for the Elderly and Disabled............................................................... 1-164
35. Child Tax Credit............................................................................................ 1-165
36. Education Credits ......................................................................................... 1-166
37. Earned Income Credit (EIC) ......................................................................... 1-169
38. Other Credits ................................................................................................ 1-173

INTRODUCTION
Part 1 of the exam covers individual returns. The exam consists of three sections: “A” is
true or false questions, "B" is multiple choice, and "C" is multiple choice requiring some
computation. The exam follows Form 1040 and Publication 17. For example, the first
questions in each section will start with issues discussed in Part One of Publication 17
and then work through the publication.
MAIN TOPICS
Section A The Income Tax Return

Section B Income
Section C Gains and Losses
Section D Adjustments, Deductions, Credits, and Taxes
STUDY MATERIALS
The official answers are based on the code and regulations. Generally, the publications
reflect the code and regulations and will be sufficient for study purposes.
The following publications will be helpful in preparing for Part 1 of the exam:
Publication 17 Tax Guide For Individuals

Publication 501 Exemptions, Standard Deduction, and Filing Information
Publication 502 Medical and Dental Expenses
Publication 503 Child and Dependent Care Expenses
Publication 504 Divorced or Separated Individuals
Publication 505 Tax Withholding and Estimated Tax
Publication 508 Tax Benefits for Work-Related Education
Publication 523 Selling Your Home
Publication 525 Taxable and Nontaxable Income
Publication 535 Business Expenses
Publication 537 Installment Sales
Publication 544 Sales and Other Dispositions of Assets
Publication 547 Nonbusiness Disasters, Casualties, and Thefts
Publication 550 Investment Income and Expenses
Publication 551 Basis of Assets
Publication 553 Highlights of 20xx Tax Changes
Publication 925 Passive Activity and At-Risk Rules
Publication 926 Employment Taxes for Household Employers

PART 1 - THE INCOME TAX RETURN
1. Filing Requirements
A. General Rules:
If you are a U.S. citizen or resident, whether you must file a federal income tax
return depends upon your gross income, your filing status, your age, and whether
you are a dependent. The filing requirements apply even if you owe no tax.
You may have to pay a penalty if you are required to file a return but fail to. If you
willfully fail to file a return, you may be subject to criminal prosecution.
1. Gross Income - All income received in the form of money, property, and
services that is not exempt from tax.
2. Filing Status - As determined on the last day of the tax year.
3. Age - Considered 65 on the day before one's 65th birthday.
B. Exemption:
The amount you can deduct for each exemption has increased from $2,800 in
2000 to $2,900 in 2001.
* Study Tip * An individual must file if gross income equals or exceeds the sum of
one's exemption amount and standard deduction. These amounts are used to
form the table showing gross income filing requirements.
C. Gross Income Filing Requirements For Most Taxpayers (Table 1 Pub. 501)
Filing Status Age 2001 2000

Gross Income Gross Income
S Under age 65 $7,450 $7,200
Age 65 or older $8,550 $8,300
HH Underage 65 $9,550 $9,250

Age 65 or older $10,650 $10,350
MFJ Both under age 65 $13,400 $12,950

One spouse 65 or $14,300 $13,800
older $15,200 $14,650
Both spouses 65 or
older

MFS* Any age $2,900 $2,800
QW Under age 65 $10,500 $10,150

Age 65 or older $11,400 $11,000
No standard deductible allowed.
D. A self-employed individual is required to file if the gross income, including gross

business income, is at least as much as the filing requirements for the individual's
marital status and age or the net earnings from self-employment is at least $400.
(see Pub. 533)
Note: If you are self-employed in a business that provides services (where

products are not a factor), gross income is gross receipts from that business. If
you are self-employed in a business involving manufacturing, merchandising, or
mining, gross income is total sales from that business minus the cost of goods
sold. To this figure, you add any income from investments and from incidental or
outside operations or sources.
E. A taxpayer is required to file in other situations even if the gross income filing
requirements are not met.
1. The taxpayer owes any special taxes:
a) Social Security and Medicare tax on unreported tips,

b) Uncollected Social Security tax and Medicare tax on reported tips,
c) Uncollected Social Security on group term life insurance,
d) Alternative minimum tax,
e) Tax on an IRA or qualified retirement plan, or
f) Tax from recapture of investment credit, low-income housing credit,
federal mortgage subsidy, or qualified electric vehicle credit.
2. The taxpayer received wages from a church or church related organization

exempt from employer Social Security and Medicare tax.
3. The taxpayer received advanced earned income credit payments from an

employer.
F. The gross income filing requirements is different for dependents.

(See Table 2, Pub. 501: 2000 Filing Requirements for Dependents).
Table 2: 2001 Filing Requirements for Dependents (Pub. 501)
Dependent 2001 Must File If:

Status
Single, under 65, You must file a return if any of the following apply
not blind • Your earned income was more than $4,550
• Your unearned income was more than $750.
• Your gross income was more than the larger of
$750 or Your earned income (upto $4,300) plus
$250.
Single, 65 or • Earned income was more than $5,650 ($6,750 if 65

older or blind or over and blind), or
• Unearned income more than $1,850 ($2,950) if 65
or over and blind), or
• Gross income was more than the total of earned
income (up to $4,300) plus 250 or $750, whichever
is larger, plus $1100 ($2,200 if 65 or over and blind).
Married, under • Gross income at least $5, spouse files MFS and
65, not blind itemizes deductions.
• Your earned income was more than $3,800, or
• Your gross income was more than the larger of
$750 or Your earned income (upto $3,550) plus
$250.
Married, 65 or • Earned income was more than $4,700 ($5,600 if 65

older or blind or over and blind), or
• Unearned income was more than $1,650 ($2,550 if
65 or over and blind), or
• Gross income was more than the total of earned
income (up to $3,550) plus $250 or $750, whichever
is larger, plus $900 ($1,800 if 65 or older and blind).
Exercise 1: Rosa, who turned 14 on December 1, 2001, received interest income

of $700 during 2001. Rosa did not make any estimated tax payments or have any
federal income tax withheld. She had no other income. Rosa is properly claimed
as a dependent by her parents. Rosa is required to file an income tax return for
2001. (True or False)
False. For 2001, a return must be filed by any dependent who is single,
under age 65, and has received unearned income in the amount of
$750 or more.

G. The standard deductions for 2001
The standard deduction for an individual for whom an exemption can be claimed
on another person's tax return is generally limited to the greater of:
1. $750, or
2. The individual's earned income for the year plus $250 (but not more than
the regular standard deduction amount, generally $4,550).
However, if the individual is 65 or older or blind, the standard deduction

may be higher.
See Pub 501: Exemptions: Standard Deduction Charts & Worksheets.
Filing Status 2001 2000

Amount Amount
Single (S) $4,550 $4,400
Married Filing Jointly (MFJ) or $7,600 $7,350
Qualified Widow(er) With
Dependent Child (QW)
Married Filing Separately (MFS) $3,800 $3,675
Head of Household (HH) $6,650 $6,450
* An additional standard deduction is available for the taxpayer and

spouse if age 65 or over or blind. The additional amount for blindness is
part of the standard deduction but is not used for determining gross
income filing requirements. See chart below. (10311g29.gif, pub 17,
ch21.)


Example:
Michael is single. His parents claim an exemption for him on their 2001 tax
return. He has interest income of $780 and wages of $150. He has no itemized
deductions. Michael uses Table to find his standard deduction. He enters $150
(his earned income) on line 1, $400 ($150 plus $250) on line 3, $750 (the larger
of $400 and $750) on line 5, and $4,550 on line 6. The amount of his standard
deduction, on line 7a, is $750 (the smaller of $750 and $4,550).
Due Dates
A. Form 1040:
1. Calendar year taxpayers should have filed by April 15, each year.
2. Fiscal year taxpayers should file by the 15th day of the 4th month after the
close of the tax year.
3 With the automatic 4-month extension obtained by filing Form 4868,

Application for Automatic Extension of Time to File U.S. Individual Income
Tax Return, a calendar year return is due August 15, each year.
Note: The automatic extension of time to file is not an automatic extension of time
to pay.
4 With a second extension obtained by filing Form 2688, Application for

Additional Extension of Time To File US individual Income Tax Return, the
due date for a calendar year return is October 15, each year. The second
extension is for two months and is not automatic. it should be filed early
enough to get IRS approval.
B. A special automatic 2 month extension to file and pay is available:
1. if the taxpayer is living outside of the US and the main place of business
or post of duty is outside of the U.S., or the taxpayer is in the military or
naval services on duty outside of the U.S.
2. By attaching a statement to the return when it is filed.
C. Form 1040NR for Nonresident Aliens:
1. Nonresident aliens with wages subject to U.S. income tax withholding

have the same due dates as residents of the U.S.

2. Nonresident aliens who do not have wages subject to U.S. income tax
withholding must file by June 15, (calendar year) or by the 15th day of the
6th month after the end of the fiscal year.
D. When the due date for doing any act for tax purposes falls on a Saturday,
Sunday, or legal holiday, that act can be done on the next business day.
E. Quarterly estimated payments are due on the 15th day of the 4th, 6th, and 9th
month of the current year and the 15th day of the first month after the end of the
year.
F. An amended return or claim for refund generally must be filed within three (3)
years from the date the original return was filed or within two (2) years from the
date the tax was paid, whichever is later. If the original return was filed before the
due date, without extensions, the return is considered to be filed on the due date.
G. A balance due on an electronically filed return must have been paid by April 15,
to avoid interest and penalties. The payment is submitted with Form 1040-V.
2. Filing Status
A. Single (S) - A taxpayer's filing status is single if that taxpayer is unmarried or
separated from a spouse by a divorce or separate maintenance decree and does
not qualify for another filing status.
B. Married Filing Jointly (MFJ) - The taxpayers may choose this status if they are
married and both agree to file a joint return.
1. Taxpayers are considered married for the whole year if on the last day of
the tax year, they are:
a) Married and living together as husband and wife,

b) Living together in a common law marriage that is recognized in the
state where they now live or in the state where the common law
marriage began,
c) Married and living apart, but not legally separated under a decree
of divorce or separate maintenance, or
d) Separated under an interlocutory (not final) decree of divorce.
2. If a taxpayer's spouse died during the year and that taxpayer did not
remarry, he or she can file a joint return with the deceased spouse. If the
taxpayer did remarry, he or she can file joint with the current spouse, and
the deceased individual would file married filing separately

3. If an individual obtains a court decree of annulment, which holds that no

valid marriage ever existed, that individual must file as single or head of
household, whichever applies. The individual must also amend all prior
years affected by the annulment that are not closed by the statute of
limitations.
4. Both taxpayers may be held jointly and individually responsible for any tax,
interest, or penalty due on a joint return. This applies to divorce situations
for any joint return filed before divorce. A divorce decree stating that one
spouse will be liable for any amounts due on prior returns will not relieve
either spouse of a joint liability.
5. Under certain circumstances, one spouse may not have to pay the tax,
interest, and penalties on a joint return. That spouse must establish that
he/she did not know, and had no reason to know, that there was a
substantial understatement of tax that resulted because the other spouse:
a) Omitted a gross income item, or

b) Claimed a deduction, credit, or property basis in an amount for
which there is no basis in fact or law.
6. For a return to be a valid joint return, both husband and wife must sign the
return.
Exercise 2:
Mr. and Mrs. Jacobs filed their joint 2001 tax return on April 17, 2002. On June 1,
2001, Mr. Jacobs was arrested and charged with embezzling $50,000 cash from
his employer during 2001. Mrs. Jacobs was NOT aware of the embezzlement.
The $50,000 was NOT reported on their 2001 return as filed. Concerning the
understatement of tax, Mrs. Jacobs may NOT be separately liable for ALL
additional tax, penalties, and interest due. (True or False)
True. Where a substantial understatement of tax in a joint return is

attributable to the grossly erroneous items of one spouse, the other
spouse may be an “innocent spouse” and relieved of liability,
including interest and penalties, if the innocent spouse had no
knowledge of (or reason to know of) the substantial
understatement, and, based on all the facts and circumstances, it is
inequitable to hold the innocent spouse liable for the deficiency.
C. Married Filing Separately (MFS) - Taxpayers may choose married filing

separately if they are married on the last day of the tax year.

1. The taxpayer reports only his or her income, exemptions, credits, and
deductions. The taxpayer may claim an exemption for the spouse if that
spouse had no earned income and is not a dependent of another.
2. Limitations if MFS is elected:
a) If one spouse itemizes, the standard deduction for the other spouse
is zero. As such, the other spouse should itemize. There is an
exception to the zero standard deduction rule if the other spouse
meets the qualifications to be considered unmarried.
b) Generally, neither spouse can claim the Child and Dependent Care
Credit.
c) A MFS taxpayer is not eligible for Earned Income Credit.
d) The taxpayer cannot exclude interest from Series EE U.S. Savings

Bonds used for higher education.
e) Unless spouses lived apart the entire year, a MFS taxpayer cannot
take the Credit for the Elderly or Disabled.
f) As MFS, more Social Security benefits may be taxable.
g) The taxpayer's IRA deduction may be phased out faster.
h) The offset against nonpassive income from a rental real estate

activity with active participation is reduced to $12,500 (lived apart
all year) or $0 (lived together at any time during the year).
3. Amending - Taxpayers can amend and change filing status from MFS to
MFJ, but generally cannot change from MFJ to MFS after the due date of
the return.
D. Qualifying Widow(er) With Dependent Child (QW) - Possible status for two
years after the year of the spouse's death. Rules for eligibility:
1. The taxpayer was entitled to file a joint return with the spouse for the year
the spouse died.
2. The taxpayer did not remarry before the end of the tax year.
3. The taxpayer has a child, stepchild, adopted child, or foster child who
qualifies as a dependent for the year.

4. The taxpayer paid more than half of the cost of keeping up a home that is
the main home for the taxpayer and qualifying child for the entire year.
E. Head Of Household (HH) - Applicable if unmarried or considered unmarried on

the last day of the tax year, and the taxpayer paid more than half of the cost of
maintaining a home for oneself and a qualifying person for over one-half of the
tax year.
1. Considered unmarried - The taxpayer must meet all of the following tests:
a) File a separate return,
b) Pay more than half the cost of keeping up a home for the tax year,
c) The spouse did not live in the home during the last six months of
the year, and
d) The home was, for more than half the year, the main home of the
taxpayer's child, stepchild, adopted child, or foster child whom the
taxpayer can claim as a dependent. A waiver of exemption or
decree of divorce allowing the noncustodial parent to claim the
child's exemption does not disallow the HH filing status for the
custodial parent.
2. Qualifying person:
a) The taxpayer's child, grandchild, stepchild, or adopted child. A

single child does not have to be a dependent; a married child must
qualify as a dependent.
b) Other relatives (must be dependent):
Parent Step-father Father-in-law

Grandparent Step- mother Mother-in-law
Brother Step-brother Brother-in-law
Sister Step-sister Sister-in-law
Half brother or sister Son-in-law Daughter-in-law
Foster child if other rules are met.
If related by blood: Nephew, Niece, Uncle, or Aunt.
c) A parent does not have to live with the taxpayer if the taxpayer paid
more than half the cost of maintaining the parent's home for the
entire year. This includes paying more than half the cost of keeping
a parent in a rest home or home for the elderly.
3. Keeping up the home (must pay over half of the cost of upkeep).

a) Costs include: rent, mortgage interest, taxes, insurance on the

home, repairs, utilities, food eaten in the home, or other expenses
related specifically to the home.
b) Costs do not include: clothing, education, medical, vacations, life insurance,

transportation, rental value of home, or the value of taxpayer services.
Exercise 3: Malcolm and Glenda who are legally married lived apart beginning
June 1, 2001. Their one minor child lived with Glenda all of 2001. Glenda worked
all year and provided more than half the cost of keeping up the home for herself
and her minor child Glenda signed Form 8332, Release of Claim to Exemption
for Child of Divorced or Separated Parents, allowing Malcolm to claim the
exemption for their child on his separately filed return. Glenda's proper filing
status is:
A. Single
B. Married filing jointly
C. Married filing separately
D. Head of household
D. Head of household. A divorced or single parent who otherwise qualifies

is entitled to head-of-household filing status even if she is not
entitled to the exemption because of a waiver.
3. Personal Exemptions and Dependents
A. Personal Exemptions - Each taxpayer is entitled to claim one exemption for

himself or herself and if married, one exemption for his or her spouse.
1. If the taxpayer is eligible to be claimed as a dependent on another

person's return, the taxpayer is not allowed his or her own personal
exemption.
2. Special rules apply if MFS. A spouse is never considered a dependent,

however, if the taxpayer's spouse has no gross income and cannot be
claimed as a dependent on another person's return, the taxpayer filing
MFS can claim the personal exemption for the spouse.
B. Dependency Tests - A taxpayer is allowed one exemption for each person he or

she can properly claim as a dependent. A person is a dependent if all five (5) of
the dependency tests are met.

1. Member of Household or Relationship test:
a) Member of Household - The person must live with the taxpayer the
entire year as a member of the household.
(1) Before a legal adoption, a child placed with the taxpayer is

considered the taxpayer's child if placed there by an
authorized agency. If not an authorized agency, the child
must live with the taxpayer the entire year.
(2) A foster child or adult must live with the taxpayer the entire
year (not eligible as dependent if the taxpayer is receiving
foster care payments).
(3) A cousin will qualify if living with the taxpayer the entire year.
(4) An individual temporarily absent due to special

circumstances (education, illness, military, etc.) will still be
considered as a member of the household.
(5) A person who died during the year, but was a member of the
household until death, will meet the test. A person who is
born during the year and lived in the household the rest of
the year will meet the test.
(6) A person does not meet the test if at any time during the
year the relationship between the taxpayer and the other
person violates local law.
b) Relationship test - The person does not have to live with the
taxpayer.
(1) Eligible persons include: child, grandchild, step child, legally

adopted child, brother, sister, step-brother, step-sister, half-
brother, half-sister, parent, grandparent, other direct
ancestor, step parent, aunt, uncle, father-in-law, mother-in-
law, sister-in-law, brother-in-law, son-in-law or daughter-in-
law.
(2) Any of these relationships established by marriage are not

ended by death or divorce.
2. Citizenship test - The person must be a U.S. citizen, resident, national, or

a resident of Canada or Mexico for some part of the calendar year in

which the taxpayer's tax year begins. Children are usually citizens or
residents of the country of their parents.
3. Joint Return test - A dependency exemption is generally not allowed if

the dependent files a joint return with his or her spouse. If the other tests
are met, the taxpayer may take a dependency exemption if:
a) Neither the dependent nor the dependent's spouse are required to

file a return,
b) Neither the dependent nor the spouse would have a tax liability if
they filed separate returns, and
c) They only file a joint return in order to get a refund of tax withheld.
4. Gross Income test - A dependency exemption is not allowed if the

person had gross income equal to or more than his or her exemption
amount. The gross income for 2001 is $2900 (see Pub. 501). The gross
income test does not apply to a child under age 19 or a full-time student
under age 24.
a) Gross income includes all income in the form of money, property,

and services that is not exempt from tax.
b) A full-time student is a person who is enrolled for the number of

hours or courses the school considers to be full-time attendance.
The individual must be a student for some part of each of five (5)
calendar months during the calendar year.
5. Support test - The taxpayer must provide over one-half of the individual’s
total support during the calendar year. Total support includes amounts
spent by that individual. In figuring total support, include tax exempt
income, savings, borrowed funds, and any other amounts actually used for
support.
a) Total support includes amounts spent to provide food, lodging,

clothing, education, medical and dental care, recreation,
transportation, and similar necessities. Expenses not directly
related to one person, such as food costs, must be allocated to all
family members. Lodging means the fair rental value of the room,
apartment, or house in which the person lives.
Exercise 4:
Ms. Clark purchased a color television set for $250 as a birthday present for her
12-year-old son. The television set is placed in his bedroom. For purposes of

whether Ms. Clark is able to claim her son as a dependent, she should include
the cost of the television set in the total support of her son. (True or False)
True. The fair market values of capital items, such as furniture,

appliances, and cars, that are bought for a person during the tax
year may be included in the dependency support computation.
b) Support does not include income taxes, Social Security taxes, and
Medicare taxes paid by the individual; life insurance premiums;
funeral expenses; scholarships for full-time student; or survivor and
dependent educational assistance.
c) If no one individual provides over half of a person's support but two

or more individuals, each of whom would be able to take the
exemption but for the support test, together provide more than half
of the person’s support, a multiple support agreement can be used.
Any one individual who provides more than 10% of the support can
claim the exemption if the other providers consent and sign a
multiple support agreement.
Exercise 5:
For 2001, Mr. and Mrs. Randall filed a joint return. During 2001 they provided
more than 50% support for the following individuals:
• The Randall's single son, age 18, was a full-time student for four months.
He lived with them all year and he earned $3,500 which was spent on his
support.
• The Randall's single daughter, age 25 and a full-time student for twelve
months, lived with them all year. She earned $2,400 which was spent on
her support.
• The Randall's granddaughter, age 3, who lived with them from June to
December.
• Mrs. Randall's mother, age 68, a Canadian citizen living in Canada
received social security benefits of $3800.
• Mrs. Randall's cousin, age 16, lived with them all year and earned $1,200
which was spent on her support.
How many exemptions may Mr. and Mrs. Randall claim on their 2001 tax
return?
A. 7
B. 6
C. 5
D. 4

A. 7. While Mrs. Randall’s cousin fails to satisfy the relative requirement

because she is only a cousin, she qualifies as a dependent
because she was a member of the taxpayer’s household for the
entire year.
Although the son’s earned income ($3,500) was in excess of the
2001 exemption ($2,900), he qualifies because he had not yet
attained the age of 19 before December 31, 2001.
While Mrs. Randall’s mother’s income ($3,800) exceeded the 2001
deduction amount, her full income from Social Security, which is
ordinarily excluded from gross income, is disregarded.
6. An alternate support test is applied for divorced or separated parents.
a) The custodial parent is considered to provide more than one-half of

the child’s total support (it does not matter whether that parent
actually provided more than half) if the following conditions are met:
(1) The parents are divorced or legally separated under a

decree of divorce or separate maintenance, separated under
a written separation agreement, or lived apart at all times for
the last six (6) months of the year;
(2) One or both parents provide over half of the child's total
support for the calendar year; and
(3) One or both parents have custody of the child for more than
half of the year.
b) Custody is usually determined by the terms of the most recent

decree of divorce or separate maintenance. If there is no decree,
then the written separation agreement applies. If neither is
available, then the parent who has physical custody of the child for
the greater part of the year is considered to have custody of the
child.
NOTE: Joint custody seldom works out exactly equal when counting hours per
day that each parent has custody. If exactly even, then neither parent has
custody for "more than one-half of the year."
c) The noncustodial parent will be treated as providing more than half

of the child's support if:
(1) The custodial parent signs a written declaration that he or

she will not claim the exemption for the child and the
noncustodial parent attaches it to his or her return (Form

8332, Release of Claim to Exemption for Child of Divorced or

Separated Parents, is available for this purpose),
(2) A decree or agreement executed after 1984 unconditionally

states that the noncustodial parent can claim the child as a
dependent, or
(3) A decree or agreement executed before 1985 provides that

the noncustodial parent is entitled to the exemption and he
or she provides at least $600 for the child's support during
the year.
d) Support provided by a third party for a divorced or separated parent

is not included as support provided by that parent.
e) If remarried, support provided by the new spouse is included as

support provided by that parent.
f) The amount of support provided by the noncustodial parent is not

reduced by any back child support owed. Any payment of back
child support is not support provided for either the year accrued or
for the year paid.
C. Effective 1997, a Social Security number is required for any dependent

claimed on a tax return. Taxpayers who claim dependents living in
Mexico or Canada must have Social Security numbers for these
dependents.
4. Decedent's Return
A. The same filing requirements that apply to individuals determine if a final return is
required for a decedent.
B. When filing for a decedent, write "DECEASED", the decedent's name, and the
date of death across the top of the tax return.
C. If a personal representative has been assigned, the personal representative must

sign the return. If the return is a joint return with the surviving spouse, the
surviving spouse must also sign the return. With no personal representative or
surviving spouse, the person in charge of the decedent's property must file and
sign as "personal representative".
D. For any filer other than a surviving spouse, Form 1310 must be filed to claim a
refund for a decedent.

Exercise 6: John Smith, whose father died June 15, 2001, is the executor of his
father's estate. John is required to file a final income tax return for his father.
When is this return due if he does NOT file for an extension?
A. October 17, 2001

B. March 15, 2002
C. April 17, 2002
D. June 15, 2002
C. April 17, 2002. The last date for filing an income tax return for a
calendar-year decedent who died in 2001 (absent extensions) is
April 17, 2002.
5. Estimated Tax
A. General Rule - A taxpayer is required to make estimated payments if he or she

expects to owe at least $1000 in tax for year 2001 and after, after subtracting
withholding and credits, and expects withholding and credits to be less than the
smaller of:
1. 90% of the tax to be shown on the current tax year return, or
2. 110% of the tax shown on your previous year tax return. The previous
year return must cover 12 months.
B. Exceptions
There are exceptions to the general rule if you are a farmer or fisherman, and
certain higher income taxpayers. See Publication 505 for more information.
C. No estimated tax payment is required if the taxpayer had no tax liability for the
previous tax year (tax was zero or the taxpayer was not required to file); the
taxpayer was a U.S. citizen or resident for the whole year; and the previous tax
year covered a 12-month period.
D. For most taxpayers, estimated tax payments are due April 15, June 15, and
September 15 of the current year, and January 15 of the next year. Farmers and
fishermen have only one payment due date, January 15 (calendar year filers).
They would then file their return by April 15. Those who file by March 1 and pay
all of the tax owed, do not need to pay estimated tax.
Exercise 8:

All of the following individuals file their income tax returns as single. Which is
required to make estimated tax payments for 2002?
A. Ms. Salinas, who had no tax liability for 2001 expects to owe $1,200 self-
employment tax for 2002 (she has no withholding tax or credits).
B. Mr. Lane, who had a $1,000 tax liability for 2001 expects $1,100 tax
liability for 2002 and withholding of $900.
C. Ms. Givonni who had a $4,000 tax liability for 2001 expects a tax liability of
$4,400 for 2002 with $3,900 withholding.
D. Mr. Charles, who had a 2001 tax liability of $10,000 expects a tax liability
of $19,500 for 2002 with $10,500 withholding.
C. Ms. Givonni, who had a $4,000 tax liability for 2001, expects a tax
liability of $4,400 for 2002 with $3,900 withholding.
Ms. Salinas is not required to make estimated tax payments
because she had no tax liability in 2001;
Mr. Lane is not required to make estimated tax payments because
the difference between his withholding and his tax liability for 2001
is less than $1000;
Mr. Charles is not required to make an estimated tax payments
because the amount withheld for 2002 was at least as great as his
tax liability for 2001.
E. Underpayment Penalty - If the taxpayer did not have enough paid in through
withholding and estimated tax, a penalty can be assessed.
1. General rule:
a) A taxpayer may owe a penalty for the tax year if the total of
withholding and estimated tax payments did not equal at least the
smaller of 90% of the tax year's tax or 100% of the previous tax
year.
b) The penalty is computed on Form 2210. Form 2210 does not have
to be filed unless:
(1) The taxpayer requests a waiver.
(2) The taxpayer uses the annualized income installment

method.
(3) The taxpayer uses the actual withholding for each period.
(4) The taxpayer based any installment on previous year tax information and
filed a joint return in either previous year or this year, but not both.

2. The taxpayer will generally not have a penalty if:
a) Total withholding and estimated tax payments were at least as

much as the previous year's tax and special rules do not apply,
b) The balance due is less than 10% of the total this year's tax and all
estimated payments were timely,
c) This year's tax minus withholding is less than $1000, or
d) The taxpayer did not owe tax for previous year (an individual had
no tax liability if the total tax was zero or the individual was not
required to file).

PART 2 – INCOME
Income Items
Generally Generally
Include does NOT include
Alimony Accident and health insurance proceeds
Bartering income Child support payments
Canceled debt income Gifts and inheritances
Dividends Housing allowance for clergy
Gain on the sale of personal items Interest on state and local government
Gambling winnings obligations
Income from activity not for profit Life insurance proceeds
Interest Meals and lodging provided by
Part of Social Security/Railroad employer
Retirement benefits Military allowances
Pensions and annuities Part of scholarships and fellowship
Recoveries of amounts previously grants
deducted Part of Social Security/Railroad
Rental income Retirement
Royalties Veterans' benefits
Share of estate and trust income Welfare and other public assistance
Share of partnership or S Corp. income benefits
Tips Workers' compensation or similar
Wages, salaries, and other earnings payments for sickness/injury
6. Accounting
A. Cash basis taxpayers report all items of income in the year in which actually or
constructively received.
Income is constructively received when it is credited to one's account or set apart
in a way that makes it available to the taxpayer. Constructive receipt includes the
following:
1. Garnished wages used to pay the taxpayer's debts,

2. Profits from brokerage or other similar accounts when earned,
3. Debts canceled or paid by another,
4. Amounts paid to a third party on the taxpayer's behalf
5. Income received by a taxpayer's agent is considered received in the year
the agent receives it, and
6. A valid check received or made available even if not cashed.
B. Accrual-basis taxpayers report income in the year earned, whether or not actually
received.
If income is received under an agreement to perform services by the end of the

next tax year, the taxpayer can elect to defer an advance payment, but not later
than the year following the year received.
C. Once a method is adopted, IRS permission is usually required to change. A

taxpayer can use a different method for each business.
Exercise 9:
Income was actually or constructively received in 2001 in each of the following
situations except:
A. Earned income of a taxpayer was received by his agent on December 26,

2001, but not received by the taxpayer until January 3, 2002.
B. Taxpayer was informed his check for services rendered was available on
December 29, 2001, but he waited until January 10, 2002, to pick up the
check
C. Taxpayer received a check on December 31, 2001 for services rendered,
but was unable to make the deposit until January 2, 2002.
D. A payment on the sale of real property was made to an escrow account on
December 28, 2001, but the payment was not received by the taxpayer
until January 15, 2002 when the transaction was closed and the buyer
authorized release of the money held in escrow.
D. A payment on the sale of real property was made to an escrow

account on December 28, 2001, but the payment was not received
by the taxpayer until January 15, 2002, when the transaction was
closed and the buyer authorized release of the money held in
escrow. Where a contract of sale is executed subject to conditions
as to title, and the purchase money is placed in escrow, income on
the sale is not taxable until the purchasers have found the title
satisfactory and authorized release of monies held in escrow.
7. Wages, Salaries, and Other Earnings
A. Employee Compensation
Employee compensation generally includes anything received in payment for
services. It includes (but is not limited to) the following:
1. Advance commissions and other amounts for services to be performed in

the future.
2. Back pay awards - Amounts awarded in a settlement or judgment for back

pay, including unpaid life insurance premiums, and unpaid health
insurance premiums.

3. Bonuses and awards paid for outstanding work. If the prize or award is in
the form of goods or services, the fair market value is included in income.
4. Holiday gifts if cash, a gift certificate, or similar item convertible to cash. If

the employer gives a turkey, ham, or other item of nominal value as a
holiday gift, the value is not income.
5. The excess of an allowance or reimbursement over the expense of travel

or other transportation.
6. An advance, allowance, or reimbursement of nondeductible moving

expenses and any amounts received for deductible expenses if under a
nonaccountable plan.
7. If property is purchased from one’s employer for less than fair market
value, the difference between the FMV and amount paid is included in
wages.
8. Severance pay is taxable as wages. When retiring on disability, a lump-

sum payment for accrued annual leave is wages.
9. Sick pay and short term disability. If the taxpayer paid the premiums on an
accident or health insurance policy, the benefits received under the policy
are not taxable.
10. Social Security and Medicare taxes paid for by the employer and not
withheld are treated as additional wages.
11. Stock appreciation rights when exercised. When exercised, the taxpayer
should receive a cash payment equal to the amount by which the FMV of
the stock on the date of exercise has increased over the FMV on the date
the right was granted.
12. Unemployment compensation, which is any amount received under an

unemployment compensation law of the United States or a state, is
taxable but not treated as wages.
a) Supplemental unemployment benefits received from a company-

financed fund are not unemployment compensation but should be
treated as wages.
b) Unemployment benefit payments from a private fund to which the

taxpayer voluntarily contributes is taxable to the extent the total
amount received is more than the total payments. Taxable benefits
are included in gross income on line 21, Form 1040.

c) Benefits to an unemployed union member paid out of union dues

are included as gross income on line 21, Form 1040.
13. Union benefits and dues deducted from an employee's pay are still
included in gross wages.
14. Property received for services is generally included in income at the

property's fair market value. If the taxpayer receives stock or other
property that has certain restrictions that affect its value, the value is not
included in income until it has been substantially vested. Until the property
becomes substantially vested, it is treated as still owned by the person
who made the transfer. Income from such property is included in the year
received, such as dividends on restricted stock. Property is substantially
vested when:
a) It is transferable, or
b) No longer subject to a substantial risk of forfeiture.
B. Fringe Benefits
The value of fringe benefits received from an employer is taxable and must be
included as compensation unless the benefits are specifically excluded by law or
the taxpayer pays fair market value for them.
1. Excludable fringe benefits include:
a) No-additional-cost-service is typically a service offered to

employees which is the same as that offered to customers in the
ordinary course of the line of business in which the employee
works. Generally, the employer will not have any substantial
additional cost. Examples: excess capacity airline ticket or a hotel
room while on duty.
b) Qualified employee discount is a price reduction given to

employees on certain property or services offered to customers in
the ordinary course of the line of business in which the employees
perform services.
c) Working condition fringe is the value of property or services that an

employee could deduct as a trade or business or depreciation
expense if paid for by that employee. This may include the
business use portion of an employer vehicle or total use of a
qualified nonpersonal use vehicle.

d) De minimis fringe is any property or service that has so small a

value that accounting for it would be unreasonable or
administratively impractical. Examples could include the personal
use of the copy machine or coffee and doughnuts furnished to
employees.
e) On premises gym or other athletic facility if substantially all use is

by employees, spouses, or dependent children.
f) Health insurance coverage or payments to employees under a self-

insured medical reimbursement plan.
g) Payments up to $5,000 for qualified dependent care assistance.
h) Benefits elected under a cafeteria plan.
i) Employer contributions to a qualified retirement plan.
j) Meals and lodging if provided at the employer's place of business,

provided for the employer's convenience, and required as a
condition of employment.
k) Qualified transportation fringe up to certain limits.
(1) A qualified transportation fringe is:
(a) Transportation in a commuter highway vehicle

between the employee's home and work place,
(b) A transit pass, or
(c) Qualified parking.
(2) Cash reimbursement under a qualified plan is also

excludable.
(3) The exclusion for transportation (vanpool) and a transit pass

cannot exceed $65 per month. The exclusion for qualified
parking cannot exceed $175 per month.
l) The cost of up to $50,000 group term life insurance coverage. The

cost of insurance in excess of $50,000, reduced by the amount the
employee pays, is included in income. The entire cost is included in
income if the coverage is provided through a qualified trust, such as
a pension plan.
2. Certain exclusions are denied if the employer discriminates in favor of

highly compensated employees or key employees.

C. Disability Income
1. If retired on disability, any amount received for disability through an

accident and health plan paid for by the employer is includable in income.
2. If the employee contributed to the cost of the plan, only the proceeds
attributable to the employer's cost are included in income.
3. If retired on disability, any lump sum payment received for accrued annual
leave is a salary, not a disability payment.
D. Pension and Annuity Contributions
1. Employer contributions to a qualified retirement plan are not income to the

employees when the contribution is made. Employee contributions, such
as through payroll deduction, are included in income.
2. Employer contributions to a non-qualified plan are included in income

when the contribution is made or when the employee has a nonforfeitable
right to the funds, whichever occurs later.
E. Special Rules for Certain Employees

1. Clergy
a) In addition to a salary (W-2 income on line 7, Form 1040, not on
Sch. C), a member of the clergy must also include offerings and
fees received for marriages, baptisms, funerals, masses, or any
other payment for a service provided. These additional payments
will be reported on Schedule C.
b) Do not include in income the rental value of a home provided to the

clergy member. Also exclude a housing allowance paid as part of
salary to the extent the allowance was used to provide a home or
pay utilities for a home. Such amount must be officially designated
by the employer before such payment is made. The amount that
can be excluded cannot exceed the fair rental value of the home
plus the cost of utilities, regardless of how much is designated as a
housing allowance.
c) Both the salary and housing are included for determining self-
employment tax.
d) A properly designated housing allowance provided to retired clergy

is excluded from income and self-employment tax.

Exercise 10: During 2001, Alan, an ordained minister, received a salary of

$10,000, a designated housing allowance of $12,000, and $500 for marriages
performed which he donated to his church. ALL of the housing allowance was
used for mortgage payments including taxes and insurance. Alan itemized
deductions and deducts the mortgage interest and real estate taxes on the home.
What amount must Alan include in gross income on his 2002 income tax return?
A. $10,000
B $10,500
C. $22,000
D. $22,500
B. $10,500. A member of the clergy must include in income any

compensation received in exchange for services rendered. Rental
value of a dwelling house furnished to an ordained minister as part
of compensation is excludable from gross income.
2. A U.S. citizen or resident reports total worldwide income.

If a U.S. citizen is employed by a foreign government, an international
organization, a foreign embassy, or any foreign employer, the taxpayer
must consider any salary as income. (May be eligible for exclusion).
3. A majority of the payments received as a member of the military are

included in taxable income. Exclusions include:
a) Certain allowances, such as subsistence, uniform, and quarters

allowances. Certain payments or services provided, as related to a
spouse or dependent are generally excluded.
b) A member of the U.S. Armed Forces who serves in a combat zone

may exclude certain pay from income. A combat zone is an area so
designated by the President in an executive order.
4. Veterans' benefits under any law, regulation, or administrative practice

that was in effect on September 9, 1986, and administered by the
Department of Veterans Affairs, are not included in gross income.
8. Tip Income
A. A taxpayer must report all tip income as wages. Tips include non-cash items
such as passes, tickets, goods, or services.
B. A daily record or other documentation is needed to prove the amount of tip

income. Records should contain appropriate identifying information for the
taxpayer and the employer. For each workday, the taxpayer will identify cash tips

received directly from customers, credit card tips when received from employer,
amounts paid out to other employees through tip splitting, and identification of
others with whom tips were split.
C. Report tips to the employer by giving the employer a written statement of tips for
each month by the 10th day of the next month. Reporting is required for each
month the taxpayer receives tips of $20 or more while working for that employer.
A total less than $20 per month does not have to be reported to the employer but
is still includable in income.
D. Withholding for income tax, Social Security tax, and Medicare tax is required for
tips reported to the employer. If an employee's pay check is insufficient to cover
the amount required to be withheld, the uncollected amount will be reported on
the W-2, and the employee is required to include that amount on the tax return.
E. Allocated tips is an amount the employee is deemed to have received but did not
report, while employed at a large food and beverage establishment. Allocated
tips are shown on the W-2. They are taxable unless the taxpayer has adequate
records to prove otherwise.
F. All cash, check, or charge card tip income is subject to Social Security and
Medicare tax. Form 4137, Social Security and Medicare Tax on Unreported Tip
Income, will be used to report all tip income and calculate Social Security and
Medicare tax. The amount reported on Form 4137 will include all tips reported to
the employer, all unreported tips, and allocated tips. Social Security and
Medicare tax will be calculated on the amounts for which there was no
withholding.
9. Interest Income
A. General Information
1. Seller-financed mortgage - If a seller finances the sale of a home, the

seller must report the buyer's name, address, and Social Security number
on line 1 of Schedule B (or Schedule 1).
2. Tax-exempt interest must be shown on the return even though not subject
to income tax.
Exercise 11: During the tax year Jeff received tax-exempt interest income of
$200 from municipal bonds. Jeff’s NOT required to report the $200 on his income
tax return. (True or False)

False. Although interest from tax-exempt municipal bonds is generally not

taxable, the amount of interest received must be reported on the
taxpayer’s return.
3. Interest income is portfolio income. Portfolio income cannot be used to

offset passive activity losses.
4. If a child is under age 14, has more than $1,400 of investment income and
is required to file a return, and either parent is alive at the end of the year,
part of that child's investment income may be taxed at the parent's tax
rate. Form 8615 is used for this purpose. Investment income of a child
under age 14 may be reported by the parents on their tax return by filing
Form 8814, Parents' Election to Report Child's Interest and Dividends.
5. A taxpayer must give his or her Social Security number to any entity
required by federal law to make a return, statement, or other document
that relates to that taxpayer. If an account is held jointly with another
person, the Social Security number given should be that of the first person
listed on the account.
6. Interest income is subject to 31% backup withholding if name and Social

Security number are not verified.
7. Report all interest income, whether reported on 1099-INT or not. If

received as a nominee, a subtraction is taken on Schedule B.
8. A taxpayer can exclude any interest credited during the year on frozen
deposits that could not be withdrawn by the end of the year. The Form
1099 amount is reported on Schedule B and the "Frozen Deposit" amount
is then subtracted on Schedule B. The amount that can be excluded is the
interest that is credited on the frozen deposits minus the net amount
withdrawn from these deposits during the year and the amount that could
have been withdrawn as of the end of the year.
Example:
$100 of interest was credited on your frozen deposit during the year. You
withdrew $80 but could not withdraw any more as of the end of the year. Your net
amount withdrawn is $80. You must exclude $20. You must include $80 in your
income for the year.
B. Taxable Interest
1. Includes, but is not limited to, interest received from bank accounts,
interest on loans made to others, certain dividends, gifts for opening an

account, interest on insurance dividends, interest on U.S. obligations,

interest on tax refunds, and installment sale interest.
2. Certain distributions commonly called dividends are actually interest. This

includes amounts from:
a) Cooperative banks,
b) Credit unions,
c) Domestic savings and loan associations,
d) Federal savings and loan associations, and
e) Mutual savings banks.
3. Interest is generally taxable when credited to the taxpayer's account and

available for use.
4. Interest on U.S. obligations, such as U.S. Treasury bills, notes, and bonds,
issued by any agency or instrumentality of the United States, is taxable for
federal income tax purposes but is exempt from all state and local income
tax.
5. U.S. Savings Bonds
a) A cash basis taxpayer will generally report interest on U.S. Savings

Bonds when it is received. An accrual basis taxpayer must report
the interest when it accrues.
b) Series H and Series HH are issued at face value. Interest is paid

twice per year by check or direct deposit. Cash basis taxpayers
must report interest income in the year received.
c) Series F and Series FE are issued at a discount. The difference

between purchase price and face amount payable at maturity is
taxable interest. One can report the increase in redemption value
as interest each year or postpone reporting any interest until the
bond is cashed or matures.
(1) A switch from the postponed reporting to reporting the

interest each year can be done without IRS permission. All
interest accrued and not previously reported is reported in
the year of change.
(2) A switch from yearly reporting to postponed reporting can be

accomplished by filing Form 3115, Application for Change in
Accounting Method. The form is attached to the return timely

filed for the year of change, and permission is considered

automatically granted.
d) If bonds are co-owned, the interest is taxable to the individual

whose funds were used to purchase the bond. This is true even if
another co-owner cashes the bond and receives the Form 1099.
e) If the original purchaser has the bonds reissued in another person's

name, the original purchaser must include in income all interest
earned to date which was not previously reported. This also applies
to transferring a Series E/EE bond to a trust.
f) If transferred due to death, the time to report interest depends on

the accounting and reporting method used by the decedent. If the
accrual method was used, or the cash method with the election to
report interest each year, the interest earned during the year up to
the date of death must be reported on the decedent's final return. If
the cash method and deferred reporting was chosen, the surviving
spouse or personal representative can elect to report all interest
earned up to the date of death on the decedent's final return. If this
election is not made, the income earned up to the date of death is
income in respect of a decedent and not reported on the final
return. The beneficiary, if using the cash method, may elect to
report interest as earned or defer reporting until maturity.
g) No taxable income is recognized on the transfer of Series B/EE for

R/HH unless cash was received in the trade. When the H/HH bond
matures, the taxpayer reports as interest the difference between
the redemption amount and the cost.
h) Interest on Series EE bonds issued after 12/31/89 may be excluded

under the Education Savings Bond Program if redemption proceeds
are used to pay qualified higher education expenses during the
same year. The purchaser must be at least age 24 (or the
taxpayer's spouse if co-owned) and the bond is issued in the
taxpayer's name. The exclusion is not available if filing as MFS.
(1) Eligible expenses are tuition and fees required for the
taxpayer, spouse, or dependent.
(2) All current year’s interest may be excluded if total expenses

exceed proceeds. If proceeds are more, the excludable
amount is based on a fraction. The numerator is the qualified
higher education expenses paid during the year. The
denominator is the total redemption proceeds received.

(3) Form 8815 is used to calculate and report the interest

exclusion and compute modified AGI.
Example:
In April 2001, Mark and Joan, a married couple, cashed qualified Series EE U.S.
Savings Bonds they bought in November 1997. In 2001, they helped pay for
their daughter’s college tuition. They received proceeds of $5,800, representing
principal of $5,000 and interest of $800. They qualified higher education
expenses they paid during 2001 totaled $4,000. They can exclude $552 ($800 x
($4,000 / $5,800)) of interest in 2001.
6. If the taxpayer is receiving life insurance proceeds in installments, part of

each payment is includable as interest income. Divide the amount held by
the insurance company by the number of payments to be received. The
amount of each payment in excess of this result is interest.
a) If payments are to be received over the beneficiaries life, the divisor

is the life expectancy.
b) If a spouse died before October 23, 1986 and the taxpayer is

receiving insurance proceeds in installments, the taxpayer is
eligible to exclude up to $1,000 of interest per year. This is in
addition to the part of the each payment which is excludable as a
recovery of the lump-sum payable at death.
Example:
The lump-sum payable at death is $75,000. The beneficiary elects to receive the
payment in installments over the next ten years. The insurance company agrees
to pay $10,000 for each of these years. The yearly interest is $2,500 ($10,000 -
($75,000 / 10)).
7. Original issue discount (OlD) is a form of interest includable in income

when it accrues whether or not the payments are received. OlD usually
results when a long-term debt instrument is issued for a price that is less
than its stated redemption price at maturity. The amount of OlD is the
difference between the principal amount and the issue price of the
instrument. The taxpayer can disregard the discount and treat it as zero if
it is less than one fourth of one percent (.25%) of the stated redemption
price at maturity.
8. State and local government interest is normally exempt from federal tax.
Example:

The taxpayer bought a ten-year bond with a stated redemption price at maturity
of $1,000, issued at $980 and having OID of $20. One-fourth of 1% of the stated
redemption price of $1,000 ($1,000 x .25%) times 10 (the number of full years
from the date of original issue to maturity equals $25. Because the $20 discount
is less than $25, the taxpayer can disregard reporting OID.
Exercise 12: All of the following are taxable interest income except:
A. Original Issue Discount

B. Dividends received on a credit union account
C. Fair market value of a gift received for opening a savings account
D. Series F Bonds traded for Series HH Bonds and no cash was received.
D. Series E Bonds traded for Series HH Bonds and no cash was received.
Owners of Series E bonds who exchange such bonds for Series H
bonds and elect to defer Series E bond interest for tax purposes
are not required to report such interest until the Series H bonds are
redeemed, disposed of, or mature, whichever comes first.
C. Interest Exclusion
The interest exclusion is limited if your modified adjusted gross income (modified
AGI) is:
• $53,100 to $68,100 for taxpayers filing single or head of household, and
• $79,650 to $109,650 for married taxpayers filing jointly or for a qualifying
widow(er) with dependent child.
You do not qualify for the interest exclusion if your modified AGI is equal to or
more than the upper limit for your filing status.
D. When To Report Interest
1. Cash method taxpayers generally report interest income in the year that it
is actually or constructively received. Interest is constructively received
when it is credited to the taxpayer's account or made available to the
taxpayer.
2. Accrual method taxpayers report interest when it is earned.
Exercise 13: Ms. Smith’s books and records reflect the following for the year
2001:
Salary $35,000
Interest on money market account $1,000
Interest on money from a long-term savings plan $500

where interest cannot be withdrawn until

December 31, 2001, but principal can be
withdrawn at any time (she has principal of $5,000
and accumulated interest of $700)
What is the amount Ms. Smith must include in her gross income for 2000?
A. $35,000
B. $35,500
C. $36,000
D. $36,500
B. $35,500. Salary is included is gross income. Interest credited on a

savings account is taxable to an accrual basis and a cash basis
taxpayer when credited.
E. How to Report Interest Income
1. Part 1 of Schedule B is required if filing Form 1040 and any of the

following apply:
a) Taxable interest is more than $400,
b) Excluding Educational Savings Bond interest,
c) Received interest from a seller financed mortgage,
d) Received Form 1099-INT for tax-exempt interest,
e) Received interest as a nominee,
f) Reporting OlD different than what is shown on Form 1099-OlD, or
g) Electing to reduce bond interest by amortizable bond premiums.
2. The taxpayer will report the full amount of interest received as a nominee
for another individual on Schedule B. The nominee amount is then shown
as a separate item below the subtotal and reduces taxable interest.
3. A withdrawal from a time savings may result in a penalty. The taxpayer

must include in gross income the interest paid or credited to his/her
account without subtracting the penalty. The penalty is deducted on Form
1040, line 28.

10. Dividends and Other Corporate Distributions

A. A taxpayer that receives a dividend distribution as a nominee for another should
issue a Form 1099-DIV to that other person.
B. Dividends from a regulated investment company or real estate investment trust

may be declared in October, November, or December, payable on a certain day
of such month, but not received until January of the following year. Such
dividends are considered received by December 31 and included in income for
the current year.
C. Ordinary dividends are paid out of the earnings and profits of a corporation and
are taxed as ordinary income.
1. Dividends paid on stock held as joint tenants, tenants by the entirety, or

tenants in common should be reported proportionately by each co-owner.
2. Dividends may be used to purchase more stock under a dividend

reinvestment plan.
a) The dividend is included in income if the price paid to purchase the

additional stock is equal to fair market value.
b) If stock is purchased for less than fair market value, the taxpayer
must report as income the fair market value of the stock on the
dividend payment date.
c) If the plan also allows the taxpayer to invest more cash to purchase
additional shares at less than fair market value, the taxpayer must
report the difference between the cash invested and the fair market
value of the stock received.
Exercise 14: E-Z Corporation, which has a dividend re investment plan, paid
dividends of $20 per share during the year. Carlos, who owned 100 shares of E-
Z Corporation prior to the distribution, participated in the plan by using ALL the
dividends to purchase 20 additional shares of stock. He purchased the stock for
$100 per share when the fair market value was $125 per share. How much
dividend income must Carlos report on his income tax return?
A. $2,500
B. $2,000
C. $500
D. $0

A. $2,500. Shareholders who elect to receive shares of greater value than

their dividends under a dividend reinvestment plan receive taxable
distributions to the extent of the fair market value of their shares.
3. Dividends include amounts paid on money market funds and payments on

stock of savings and loan associations. Statements frequently call this
interest but this amount should be reported as dividends.
D. Capital gain distributions are dividends paid by regulated investment companies,

mutual funds, and real estate investment trusts. These distributions should be
reported as long term capital gain regardless of how long the taxpayer owned the
stock.
1. The taxpayer must also include any amounts that the investment company
or mutual fund credited as a capital gain distribution even though not
actually received.
2. The taxpayer can file Form 2439, Notice to Shareholders of Undistributed

long-term Capital Gain, to take a credit for any tax that the investment
company or mutual fund paid for the taxpayer on undistributed capital
gains.
3. The taxpayer would increase the basis in stock by the difference between
the amount of undistributed capital gain that is reported and the amount of
the tax paid by the fund.
Exercise 15: Mr. and Mrs. Cone are investors in a mutual fund which is NOT part
of a qualified retirement plan. For 2001, the fund notified them that it had
a/located an $8,500 capital gain to their account. Of this total, $7,500 was
distributed in 2001. In addition, the fund paid $500 federal tax on their behalf
what is the correct amount of long-term capital gain that the Cones should report
on their 2001 tax return?
A. $9,000
B. $8,500
C. $7,500
D. $0
B. $8,500. Capital gains dividends are reportable as long-term capital

gains, regardless of how long the shareholder may have owned the
stock in the mutual fund.
E. Nontaxable Distributions

1. A return of capital reduces the basis of the taxpayers stock. This is an

amount that is not paid out of the corporation’s earnings and profits (thus
not a dividend) and is not taxed until the basis in stock is fully recovered.
Return of capital distributions in excess of basis are reported as capital
gain. If stock is purchased in different lots at different times, reduce basis
in the earliest purchased stock first. Report on Schedule D for no gain or
loss.
Exercise 16: Larry purchased stock in 1997 for $100. During 1999, he received a
return of capital of $80 on this stock. During 2001, he received another return of
capital of $30. Larry had NO other stock transactions in 2001. What amount
should he report on his 2001 income tax return and what is his basis in the stock
at the end of 2001?
A. $30 capital gain, $100 stock basis

B. $30 dividend income, $100 stock basis
C. $10 capital gain, zero stock basis
D. $10 dividend income, zero stock basis
C. $10 capital gain, zero stock basis. A return of capital on a shareholder’s

stock reduces the basis of the stock. The excess of the return of
capital over the shareholder’s basis is gain from the sale or
exchange of property.
2. A liquidating distribution is received in a partial or complete liquidation of a

corporation. This is a return of capital which is not taxable until stock basis
is recovered. Once basis is zero, further liquidating distributions are
reported as capital gain. The distribution will be allocated to each block of
stock owned. If the total received in liquidation distributions is less than the
basis in stock, a capital loss can be recognized only after the final
distribution.
3. Distributions of stock or stock rights generally are not taxable.

Distributions of stock are referred to as stock dividends. Stock rights or
options are rights to subscribe to the corporation's stock.
a) A distribution of stock or stock rights will be taxable if
(1) Any shareholder has the choice to receive cash or other

property instead of stock or stock rights,
(2) The distribution gives cash or other property to some

shareholders and an increase in the percentage interest in
the corporation's assets or earnings and profits to other
shareholders,

(3) If different classes of stock are offered to common stock

shareholders, or
(4) The distribution is on preferred stock.
b) If the stock dividends or stock rights are taxable, the fair market
value at the time of the distribution is included in income and is the
taxpayer’s basis in the stock or right received. If nontaxable, the
taxpayer's basis in the old stock is divided between the old and the
new.
c) The corporation may establish a plan in which fractional shares are

not issued, but sold and then the cash is distributed. This is
reported as a sale on the shareholder's Schedule D with the gain or
loss being the difference between the cash received and the basis
in fractional shares.
Example:
In 1999 the taxpayer bought one share of common stock for $100. On June 30,
2001, the corporation declared a common stock dividend of 5%. The fair market
value of the stock on June 30, 2001 was $200. The corporation had a plan by
which no fractional shares would be issued. The stock dividend that taxpayer
was entitled to did not amount to a full share, so the corporation sold the
fractional share on the taxpayer’s behalf and paid $10 for the fractional share
stock dividend. The taxpayer will figure gain or loss as follows:
FMV of old stock $200

FMV of stock dividend $10
Total FMV $210
Basis of old stock after dividend $95.24
(($200/$210)x$100)
Basis of dividend ($10/$210)x$100) $4.76
Total Basis $100.00
Cash received $10.00
Basis of stock dividend $4.76
Gain $5.24
F. Other Distributions
1. Exempt interest dividends from regulated investment companies

are not taxable but are reported as exempt interest.

2. Dividends on insurance policies are a return of premiums paid and

are taxable when premiums are fully recovered. Interest on these
dividends is taxable.
3. Dividends on veterans' insurance policies are not taxable and

interest earned on the dividends is not taxable.
4. Patronage dividends are taxable unless:
a) Paid on the purchase of property bought for personal use, or
b) Paid on the purchase of capital assets or depreciable

property bought for use in business. For business
purchases, the basis of the property bought must be
reduced. If already reduced to zero, the excess is taxable.
5. Amounts received from money market funds are taxable as

dividends, not interest.
G. Total dividends of $400 or less, none of which is received as a nominee

can be reported directly on the Form 1040. Capital gain distributions can
also be reported directly on Form 1040. Capital gains are taxed at a
maximum of 28% as opposed to the higher tax rates.
11. Rental Income and Expenses

A. Rental Income
1. Rental income is any payment received for the use or occupancy of
property. Generally, all rent is includable in income in the year received.
Included are advance rent, payments to cancel a lease, expenses paid for
by the tenant, and the fair market value of property or services received. If
the services are provided at an agreed upon or specific price, that price is
the fair market value in the absence of evidence to the contrary
2. A security deposit is not included in income when received if the owner

plans to return it to the tenant at the end of the lease term. If not returned,
it is then included in income. If a security deposit is to be used for the last
month's rent, then it is advance rent reported when received.
Exercise 17: Troy, a cash basis taxpayer, owns an office building. His records
reflect the following for 2001:
• On March 1, 2001, office B was leased for twelve months. A $900 security
deposit was received which will be used as the last month's rent.

• On September 30, 2001, the tenant in office A paid Troy $3,600 to cancel
the lease on March 31, 2001.
• The lease of the tenant in office C expired on December 31, 2001, and the
tenant left improvements valued at $1,400. The improvements were NOT
in lieu of any required rent.
Considering just these three amounts, what amount must Troy include in
rental income on his income tax return for 2001?
A. $5,900
B. $5,000
C. $4,500
D. $1,800
C. $4,500. A cash basis taxpayer must include in gross income for the
year all items of taxable income actually or constructively received
during the year, whether in cash, property or services, However, a
lessor does not realize income upon termination of a lease merely
because he thereby acquires improvements made by the lessee.
Advance rent received upon execution of a lease is includible in
gross income in the year received, whether the taxpayer is on the
cash or the accrual basis.
Exercise 18: Andre, an accrual basis taxpayer, rents a house for $1,000 per
month. The house was rented from January through October when the tenant
moved out and left substantial damages. Andre did NOT refund their $600
security deposit. Andre hired Jerry, a carpenter, to repair the house for $2,400
which included all labor and materials. Jerry completed the work on November
30, 2001. Instead of paying Jerry for the work, Jerry rented the house from Andre
beginning December 1, 2001. They agreed the work would be in exchange for
December 2001 and January 2002 rent. Jerry will begin paying rent of $1,000 per
month on February 1, 2002. Jerry was NOT required to pay a security deposit.
What amount should Andre include in gross rent on his income tax return for
2001?
A. $10,000
B. $10,600
C. $12,400
D. $13,000
D. $13,000. Accrual basis taxpayers report income when it is earned.

Taxpayers who barter property or services are taxed on their fair
market value. Security deposits are income if and when the lessor
becomes entitled to the funds by reason of the lessee’s violation of

the terms of the lease. Advance rent received upon execution of a

lease is includible in gross income in the year received, whether the
taxpayer is on the cash or accrual basis. Andre must include
$10,000 for the ten months that the house was rented to the first
tenant. The $600 security deposit is includible because Andre
became entitled to the funds, due to the damages sustained by the
premises. Although Andre and Jerry have agreed that Jerry’s work
is in exchange for December 2001 and January 2002 rent, the
entire fair market value of Jerry’s work ($2,400) is includible in
Andre’s gross rent for 2001 because it constitutes advance rent.
B. Rental expenses include repairs and other expenses incurred in renting property.
They are deductible in the year paid or incurred, depending on the method of
accounting. From the time made available for rent, expenses for managing,
conserving, or maintaining the property may be deducted, even if vacant for a
time.
1. Repairs keep the property in good operating condition. They do not

materially add to the value of the property or substantially prolong its
useful life. The cost of repairs are currently deductible. Examples include:
repainting inside and outside, fixing gutters or floors, fixing leaks,
plastering, and replacing broken windows.
2. An improvement adds to the value of the property, prolongs its useful life,
or adapts it to new uses. This generally involves replacement with new
items or an addition. Repairs made as part of an extensive remodeling
project should be treated as part of the improvement. The cost of
improvements are depreciable. Examples include: putting on a new
addition or room, putting up a fence, putting in new plumbing or wiring,
putting in new cabinets, putting on a new roof, or paving a driveway.
3. Other expenses include advertising, janitor or maid service, utilities, fire

and liability insurance allocable to the current year, real estate taxes,
mortgage and other interest on loans traced to the rental property,
salaries, wages, commissions, professional fees, and ordinary and
necessary travel and transportation expenses.
4. Charges for local benefits that increase the value of the property, such as
putting in streets, sidewalks, or water and sewer systems, are not
deductible. These are nondepreciable capital expenditures which are
added to the basis of the property.
5. If only part of the property is rented, common expenses have to be

divided. The most common methods for dividing expenses are based on
the number of rooms or based on square footage.

6. Property converted from personal to rental will have expenses allocated

based on the portion of the year attributable to both personal and rental.
The basis for depreciation is the lesser of the FMV or the adjusted basis
on the date of conversion.
7. If the property is not rented for profit, expenses are deductible only to the
extent of income and no excess is carried over. Income is reported on
Form 1040, line 21, expenses are deducted on Schedule A, line 22
subject to the 2% of AGI limitation.
C. Personal Use of Vacation Homes and Other Dwelling Units.
1. A dwelling unit includes a house, apartment, condominium, boat, mobile

home, or similar property. A dwelling unit is not property used solely as a
hotel, motel, inn, or similar establishment if it is regularly available for
occupancy by paying customers and is not used by an owner as a home
during the year.
2. A dwelling unit is used as a home if the taxpayer uses it for personal

purposes more than the greater of 14 days, or 0% of the total number of
days it is rented to others at a fair rental price.
Example:
You rent out a guest bedroom in your home at a fair rental price during the local
college's homecoming, commencement, and football weekends (a total of 27
days). Your sister-in-law stays in the room, rent free, for the last three weeks of
July (21 days). The room is used as a home because you use it for personal use
for 21 days. That is more than the greater of 14 days or 10% of the total days
rented.
3. A day of personal use is any day that a unit is used by:
a) The taxpayer or any other person who has an interest in the

property unless rented as a home to the other owner,
b) A member of the taxpayer's family or a member of the family of any

other person who has an interest in the property unless rented as a
home at fair rental value (family includes only brothers and sisters,
half-brothers and half-sisters, spouses, ancestors, and lineal
descendants),
c) Anyone under an agreement that lets the taxpayer use some other
dwelling unit, or

d) Anyone less than a fair rental price.
4. Any day the taxpayer spends working substantially full-time repairing and
maintaining the property is not counted as a day of personal use, even if
family members use the property for recreational purposes the same day.
5. Do not count as days of personal use the days on which the property was
used as a main home either before or after renting it or offering it for rent
if:
a) The taxpayer rented or tried to rent the property for 12 or more

consecutive months, or
b) Less than 12 months and the period ended because the property
was sold or exchanged.
6. If the dwelling unit is used for both rental and personal, expenses have to
be divided. For this division, any day that the unit is rented at fair rental
value is a day of rental even if the taxpayer personally used it that day,
and a unit is not considered used for rental during the time that it is
available but not actually rented.
7. If the dwelling unit is not used as a home, divide the expenses between
personal use and rental use based on the number of days it was used for
each purpose. Report the rental income and rental expenses on Schedule
F. Within limits, a loss will be allowed.
Exercise 19: Mr. and Mrs. Thomas own a vacation home at the lake. They are
trying to determine their days of personal use for 2001. Which of the following
would be considered personal use days?
A. Mr. and Mrs. Thomas, their daughter and grandchildren spent seven days
in May. Mr. Thomas spent substantially all of his time painting the interior.
Mrs. Thomas and the others spent all of their time on recreation.
B. Mr. and Mrs. Thomas rented the house for four days in September to Mrs.
Thomas’s nephew, Jacob. Jacob paid fair rental price.
C. Mr. and Mrs. Thomas rented a mountain cabin from Lucia for four day's in
October. Lucia rented their lake house for four days also. They each paid
a fair rental price.
D. The Thomas’s son, Seth, rented the lake house for thirty days in
December. He does not have an interest in the property and he used it as
his main home. Seth paid fair rental price.
C. MR. and Mrs. Thomas rented a mountain cabin from Lucia for four
days in October. Lucia rented their lake house for four days also.

They each paid a fair rental price. Lucia’s use of the Thomas house
under a reciprocal arrangement is a personal purpose.
8. If used as a home, reporting depends on number of days rented.
a) If rented fewer than 15 days, report no income. All expenses are

personal so only the interest, taxes, or a casualty or theft loss
would be eligible for deducting on Schedule A.
b) If rented for 15 days or more during the year, all rental income is
included. Expenses will be allocated based on the number of days
used for each purpose. If the rental is a net profit, all expenses will
be deducted. If a net loss, the expenses will be limited. The rental
portion of deductible mortgage interest, real estate taxes, casualty
or theft losses, and certain indirect rental expenses will be fully
deductible. This will be applied against rental income first.
Operating expenses and depreciation will then be deducted, in that
order, to the extent of income remaining. Any amount in excess of
income will be carried forward.
Exercise 20: Francis Snow, who lives in Aspen, Colorado went out of town for
two weeks in February 2001. During this time he rented his townhouse, which is
used as his principal residence, for $2,000. Mr. Snow is NOT required to report
this rental income on his income tax return. (True or False)
True. If a home is rented out for fewer than 15 days during the tax year,
no rental income is includible in gross income, and no business
expenses attributable to rental are deductible.
D. The correct amount of depreciation should be claimed each year. If not taken in
an earlier year, an amendment can be filed. An amount that should have been
taken in an earlier year cannot be taken in the current year, but the basis is still
reduced by what should have been deducted. Land is never depreciable. This
includes the cost of clearing, grading, planting, and landscaping.
1. Modified Accelerated Cost Recovery System (MACRS) applies to all

tangible property placed in service in the tax year. A taxpayer may elect
the Alternate Depreciation System (ADS) instead of using the General
Depreciation System (GDS).
a) MACRS must be used for a dwelling unit used as a home and

changed to rental use in the tax year.
b) MACRS recovery periods: appliances, furniture, and other personal

property with no class life is 7 years under GDS and 12 years under

ADS roads and shrubs are 15 years under GDS and 20 years
under ADS; a residential building is 27.5 years GDS and 40 years
ADS; and commercial real property is 39 years GDS and 40 years
ADS. Improvements and additions will use the class life of the
property to which the addition or improvement was made,
determined as if the property was placed in service at the same
time as the addition or improvement.
c) Basis is the original cost plus improvements. Only the business

percent is depreciable. Original basis may be other than cost if
obtained by inheritance, gift, or exchange.
2. ACRS is for property placed in service after 1980 and before 1987 and old
depreciation rules apply to property placed in service before 1981.
E. Limits On Rental Losses - Rental activities are generally considered passive

activities and the amount of loss allowed is limited.
1. Passive rules do not apply to rental property used as a home during the
year.
2. At-risk rules place a limit on the amount deductible from activities often
described as tax shelters. Real property held prior to 1987 is not subject to
the at-risk rules. Any loss from an activity subject to the at risk rules is
allowed only to the extent of the total amount the taxpayer is at risk, which
is to the extent of cash and the adjusted basis of property contributed to
the activity and certain amounts borrowed for use in the activity.
3. Once past the at-risk limits, the loss is subject to the passive activity rules.
Other income generally cannot be offset with losses from passive
activities, except for other passive income. Rental activities are classified
as passive activities. Form 8582, Passive Activity Loss Limitations, is used
to compute the current year allowed passive loss and any amount to be
carried over.
4. Special rule - A passive loss of up to $25,000 can be taken against

nonpassive income if the loss was incurred in a rental real estate activity
in which the taxpayer actively participated. The allowable amount is
$12,500 if MFS and spouses lived apart for the entire year. If MFS and
spouses lived together at all during the year, no special offset is allowed.
a) Active participation - The taxpayer owns at least 10% of the rental

property and makes management decisions in a significant and
bona fide sense, such as approving new tenants, deciding on rental
terms, and approving expenditures.

b) This offset is reduced by 50% of the amount that modified AGI

exceeds $100,000. Modified AGI does not include taxable Social
Security, IRA or §501(c)(18) deductions, U.S. bond exclusion for
higher education, any passive activity loss, or the deduction for
one-half SE tax.
Exercise 21: Henry and George file a joint income tax return for 2001. During
2001, Henry received wages of $120,000 and taxable Social Security benefits of
$5,000. George actively participated in a rental real estate activity in which she
had a $30,000 loss. They had NO other income during 2001. How much of the
rental loss may they deduct on their 2001 income tax return?
A. $0
B. $12,500
C. $15,000
D. $25,000
C. $15,000. A taxpayer who actively participates in rental real estate

activities may use up to $25,000 of passive activity losses from
such activities as deductions against nonpassive income. The
$25,000 is reduced, but not below zero, by 50 percent of the
amount by which the taxpayer’s adjusted gross income for the year
exceeds $100,000. For this purpose, adjusted gross income is
calculated without regard to taxable social security benefits or any
passive activity loss.
5. A rental activity in which the taxpayer materially participates will not be a

passive activity if it is a real property trade of business. Losses from this
activity will not be limited by the passive loss rules.
a) Material participation in a real property trade or business must be

more than half of the time spent performing all personal services
during the year, and more than 750 hours.
b) A real property trade or business is one that develops, redevelops,

constructs, reconstructs, acquires, converts, rents, operates,
manages, leases, or sells real property.
F. If renting out a building and providing only minimal services, if any, income and
expenses are reported on Schedule E.
G. If services are provided or the rental is not real property, report rental income and
expenses on Schedule C.

12. Social Security and Equivalent Railroad Retirement Benefits

A. Up to 85% of a taxpayer's Social Security or tier 1 Railroad Retirement benefits
may be taxable. The taxable amount is calculated by first comparing income plus
one-half of the benefits to a base amount and then an adjusted base amount.
Filing Status Base Adjusted

Amount Base
Amount
S, HH, and QW(er) $25,000 $32,000
MFS, did not live with spouse at $25,000 $32,000
any time
MFS, did live with spouse $0 $0
MFJ $32,000 $44,000
B. If income is:
1. Less than the base amount, none of the benefits will be taxable.
2. More than the base amount but less than the adjusted base amount, up to
50% of the benefits can be included in taxable income.
3. More than the adjusted base amount, up to 85% of the benefits can be
included in taxable income.
Exercise 22:
Mr. and Mrs. Jones are both over 65 years of age and are filing a joint return.
Their income for the tax year consisted of the following:
Taxable interest $3,000

Social Security payments $25,000
Tax-exempt interest $1,000
Taxable pension $20,000
How much of the Social Security benefits is taxable?

A. $12,500
B. $5,500
C. $2,250
D. $1,500
C. $2,250. The amount of social security benefits that an individual

must include in gross income is the lesser or (1) one-half of the
annual benefits received or (2) one-half of the amount that remains
after subtracting the appropriate base amount from the taxpayer’s
provisional income. Provisional income is the sum of the taxpayer’s
modified adjusted gross income and one-half of his social security
benefits. Modified adjusted gross income is the individuals adjusted

gross income (excluding any social security or tier 1 railroad

benefits) increased by the amount of tax-exempt interest received
during the tax year. The base amount is $32,000 for married
individuals filing a joint return.
C. A special computation is required if a non-deductible IRA contribution was made

during the year.
D. Lump sum benefits received in 1999 for an earlier year will be shown on the 1999
SSA-1099. The full amount can be treated as 1999 benefits or a special election
can be made to determine how much of the benefits allocable to an earlier year
would have been taxable in that year, and then including the amount as taxable
in the current year.
13. Other Income

A. Miscellaneous Taxable Income
1. Alaska oil royalties are reportable as miscellaneous income.
2. Alimony is taxable. Child support is never taxable.
3. Allowances and reimbursements not accounted for under an accountable

plan are taxable as wages.
4. A canceled debt or a debt paid for by another might be debt forgiveness

income reportable on line 21. It is not income if the cancellation of
payment is intended as a gift. Part or all of the canceled amount may be
excluded if the taxpayer is insolvent or in bankruptcy.
5. Court awards and damages may be taxable, depending on what the

settlement is replacing. The following would be ordinary income:
a) Interest on an award,
b) Compensation for lost wages or lost profits,
c) Punitive damages awarded in cases not involving physical injury or

sickness,
d) Amounts received in settlement of a pension right (no taxpayer

contributions),

e) Damages for patent or copyright infringement, breach of contract,

or interference with business operations, or
f) Any recovery under the Age Discrimination in Employment Act.
6. Income of an estate or trust which is not taxed at the entity level.
7. Fees received as a corporate director, executor, notary public, or election

precinct official.
8. Gambling winnings include cash and noncash winnings from lotteries,

raffles, and illegal gambling. The gross amount is reported as income,
expenses are deductible on Schedule A.
9. Illegal income, such as from theft or embezzlement.
10. Jury duty. If the taxpayer is required to turn this amount over to an
employer and receives a regular wage during that time, the amount turned
over can be taken as an adjustment on line 30.
11. Kickbacks, side commissions, or push money.
12. Notes received for services.
13. Prizes and awards.
14. Gain on the sale of personal items.
B. Bartering income is property or services received in exchange for property or

services. Include in taxable income the fair market value of the property or
service received. If the value is agreed upon ahead of time by both parties, that
value will be accepted as the fair market value unless the value can be shown to
be otherwise.
Example:
You are self-employed and a member of a barter club. The club uses "credit
units" as a means of exchange. The club adds credit units to your account for
goods or service you provide to members, which can be used to purchase goods
or services offered by other members of the barter club. The club subtracts
credit units form your account when you receive goods or services from other
members. You must include in income the value of credit units that are added to
your account, even though you may not actually receive goods or services from
other members until a later year.

C. Partnership or S Corporation Income - Each partner/shareholder reports his or

her share of business income, credits, deductions, and tax preference items
passed through on the K- 1.
D. Recoveries of previously deducted items are included in income if a tax benefit

was derived from the deduction.
1. If a recovery and expense occur in the same year, the recovery reduces
the deduction and is not reported as income.
2. A recovery that is for amounts paid in two or more separate years has to
be allocated pro-rata between the years.
3. If no tax benefit was derived from the prior year deduction, the recovery is
not included in income. This can result if credits reduced tax liability to
zero or the taxpayer was subject to AMT.
E. Repayments of an amount included in income because the taxpayer thought he

or she had an unrestricted right to it can be deducted in the year repaid. The type
of deduction depends on the type of income that was reported.
1. If $3,000 or less and reported as wages, unemployment compensation, or

other ordinary income, deduct it on Schedule A line 22 in the year repaid.
If the income was reported as a capital gain, deduct it on Schedule D.
2. Over $3,000, the taxpayer can deduct it on Schedule A or take a credit

against tax for the repayment, whichever method is most advantageous.
The credit is determined by figuring the tax for the prior year with and
without the amount. The difference is the credit claimed on line 60 of Form
1040.
F. Royalties from copyrights, patents, and oil, gas, or mineral properties are taxable
as ordinary income.
G. Income Not Taxed

1. Campaign contributions, unless diverted to personal use.
2. Cash rebates.
3. Employee achievement awards. Up to $400 can be excluded if from

nonqualified plans, and $1,600 from both qualified and nonqualified plans.
4. Energy conservation subsidies.
5. Foster care payments if for less than five individuals.

6. Gifts and inheritances (income produced by such property is taxable).
7. Welfare and other public assistance benefits.
8. Damages or awards for physical injury or sickness.
9. Various payments made due to sickness or injury. These include: worker's

compensation, Federal Employees' Compensation Act payments,
compensatory damages for injury or sickness, benefits received under an
accident or health insurance policy, compensation paid for permanent loss
or use of a part or function of the body, and reimbursement for medical
care.
H. Life insurance proceeds paid due to death are not taxable, unless the policy was
turned over to the taxpayer for a price.
1. If paid in other than regular intervals, include in income only the amount
that is more than that payable at the time of the insured person's death
(interest).
2. If paid in installments, a part of each installment can be excluded. Interest,

the amount in excess of the lump sum payable at death, is included in
income.
3. A surrender of a policy is excluded to the extent of premiums paid.
4. The first $5,000 of payments made by or for an employer because of an

employee's death can be excluded from income of the beneficiaries.
I. Scholarships or fellowships may be excludable, partially taxable, or totally

taxable.
1. Only a candidate for a degree can exclude amounts received as a

qualified scholarship. A qualified scholarship is any amount received that
is for tuition and fees to enroll at or attend an educational organization; or
fees, books, supplies, and equipment required for courses at the
educational institution.
2. Amounts used for room and board do not qualify.
3. All amounts received as payment for services must be included in income

even if the services are a condition of receiving the grant and are required
of all candidates for the degree. This includes the amounts for teaching
and research.

4. Scholarship prizes are not scholarships or fellowships if the taxpayer does

not have to use the prize for educational purposes.
5. A qualified tuition reduction is excluded from income. This is the amount of

reduction in tuition for education furnished to an employee of an
educational institution (or certain other persons) provided certain
requirements are met.
Exercise 23: Kevin is a candidate for a master's degree at a local university.

During 2001, he was granted a fellowship that provided the following:
Tuition $18,000
Books & supplies $2,000
Room and board $14,800
What amount can Kevin exclude from gross income in 2000?

A. $20,000
B. $25,000
C. $29,800
D. $34,800
A. $20,000. A degree candidate at a qualified educational organization

may exclude from gross income amounts of a fellowship grant used
for tuition and course-related fees, books, supplies, and equipment.
Amounts received for room and board are includible in gross
income.

PART 3 - GAINS AND LOSSES

* Study Tip * Basis, realized gain, and recognized gain will be questioned
extensively in Part I, Part II, and Part III of the exam.
14. Basis of Property

This chapter discusses how to figure your basis in property and covers the following
topics.
• Cost basis of property you buy.
• Adjustments to basis after you receive property.
• Basis other than cost.
Basis is the amount of your investment in property for tax purposes. Use the
basis of property to figure the amount of gain or loss on the sale, exchange, or
other disposition of property. Also use it to figure the deduction for depreciation,
amortization, depletion, and casualty losses. You must keep accurate records of
all items that affect the basis of property so you can make these computations.
If you use property for both business and personal purposes, you must allocate
the basis based on the use. Only the basis allocated to the business use of the
property can be depreciated.
Your original basis in property is adjusted (increased or decreased) by certain

events. If you make improvements to the property, increase your basis. If you
take deductions for depreciation or casualty losses, reduce your basis.
Generally, the higher your basis for an asset, the less gain you will have to report
on its sale. The higher your basis in a depreciable asset, the higher your
depreciation deductions.
A. Cost Basis
1. The cost is the amount of cash and debt obligations paid for property as
well as the fair market value of other property or services the taxpayer
provides in obtaining property.
2. Includes additional expenses:
a) Sales tax charged on the purchase,
b) Freight charges to obtain the property,
c) Installation and testing charges,

d) Excise taxes,
e) Legal and accounting fees (when required to be capitalized),
f) Revenue stamps,
g) Recording fees, and
h) Real estate taxes (if assumed for the seller).
3. If purchased on installment with little or no interest, part of the

stated purchase price needs to be allocated to interest. The basis in
the property is the stated purchase price less the amount allocated
as interest.
Exercise 24: If you buy a business or investment property on any time-payment

plan that charges little or no interest; the basis of your property is your stated
purchase price, less the amount considered to be unstated interest. (True or
False)
True. The buyer’s basis in the property does not include the portion of the
payments that is considered to be “interest expense.”
4. Real property is generally defined as land and anything erected on,

growing on, or attached to land.
a) Assumption of a mortgage increases basis.
b) Settlement fees and other costs are included in basis. These

fees need to be allocated between land and improvements
and include the following items:
(1) legal and recording fees,
(2) Abstract fees,
(3) Charges for installing utility services,
(4) Surveys,
(5) Transfer taxes,
(6) Title insurance, and

(7) Any amounts the seller owes that the buyer agrees to
pay.
c) Expenses to obtain a mortgage, such as points, are

generally capitalized and deducted ratably over the term of
the mortgage. Special rules apply to points on a home
mortgage. (Discussed in Section D.)
d) Real estate taxes owed by the seller that the buyer agrees to
pay is part of the cost of the property, not a currently
deductible expense.
Exercise 25:
John bought land with a building on it that he planned to use in his business. His
costs in connection with the purchase were as follows:
Cash down payment $40,000

Mortgage on property $300,000
Survey costs $2,000
Transfer taxes $1,800
Charges for installation of gas lines $3,000
Back taxes owed by seller and paid by John $12,00
What is John’s basis in this property?

A. $348,000
B. $346,800
C. $345,000
D. $343,000
A. $348,000. Basis of property acquired by purchase consists of its

cost (both cash and debt obligations) plus certain fees and
expenditures. These expenditures include survey costs, transfer
taxes, charges for installing utility services, and amounts that the
seller owes that the purchaser agrees to pay.
B. Adjusted basis includes all items properly charged to a capital account.
1. Increases to basis:
a) Capital improvements increase the value of the property, lengthen

the property's useful life, or adapt it to a different use. This includes:
(1) Putting an addition on one's home,

(2) Replacing an entire roof,
(3) Paving the driveway,

(4) Installing central air conditioning, or

(5) Rewiring the home.
b) Assessments for local improvements increase the value of the

property assessed and are not to be deducted as taxes. Typical
assessments include:
(1) Water connections,

(2) Sidewalks, or
(3) Roads.
c) Expenditures to restore property after a casualty loss.
2. Decrease the basis by any item that represents a return of capital or a

deferred gain.
a) Section 179 expense deduction,

b) The exclusion from income of a subsidy for energy conservation
measures or residential energy credit taken,
c) Deduction for clean-fuel vehicle or property or credit for qualified
electric vehicles,
d) Amount received for granting an easement,
e) Casualty and theft loss deductions, any insurance reimbursement,
or recognized losses on other involuntary conversions,
f) Nontaxable corporate distributions,
g) Deferred gain on the sale of a residence, and
h) Depreciation allowable even if not taken.
C. Basis Other Than Cost
1. Fair market value (FMV) is the price at which property would change
hands between a buyer and a seller, neither being required to buy or sell,
and both having reasonable knowledge of all necessary facts.
a) Property received for services is included in income at the FMV of

the property. This also becomes the basis of that property.
Exercise 26:
The basis of property received for services performed is equal to
A. The lower of cost or market price of the property.

B. The cost of the property.
C. The cost of the services provided
D. The fair market value of the properly

D. The fair market value of the property. The basis of property

received for services performed is equal to the fair market value of
the property, less the amount paid, if any, for the property.
b) Bargain purchases result in taxable income which is the difference

between the purchase price and the FMV. The FMV then becomes
the basis.
c) A taxable exchange may result in gain or loss being recognized.

The basis of the property received is generally the FMV at the time
of the exchange.
2. Involuntary Exchange:
a) The basis of property received which is similar or related in service

or use to the property exchanged is the same as the old property's
basis on the date of the exchange.
(1) The carryover basis is decreased by any loss recognized on

the exchange, and any money received that was not spent
on similar property.
(2) The carryover basis is increased by any gain recognized on

the exchange, and the cost of acquiring replacement
property.
b) If money or other property not similar or related in use is received

and the taxpayer buys similar or related property, the basis of the
new property is the cost of the new, decreased by the amount of
gain that is not recognized on the exchange.
Example:
The state condemned your property and paid you $31,000 for it. Your adjusted
basis was $26,000, so there is a realized gain of $5 $00. Yap buy similar
replacement property for $29,000. Your recognized gain is $2,000 ($31,000 -
$29,000), the unspent part of the payment from the state. Gain not recognized is
$3,000. The basis of the new property is $26,000 (cost of $29,000 less gain not
recognized of $3,000).
c) If more than one property is purchased, the basis is allocated

among properties acquired based on their respective costs.
3. A nontaxable exchange is an exchange in which gain is not taxed and any

loss cannot be deducted.

a) The basis of property received is usually the same as the basis of

the property given up.
b) A partially nontaxable exchange is an exchange in which money or

unlike property is received in addition to the like-kind or like-class
property. The basis of the new property is usually the same as the
basis of the property exchanged:
(1) Decreased by any money received and any loss recognized

on the exchange, and
(2) Increased by any additional costs incurred and any gain

recognized on the exchange.
(3) Allocate the basis among properties, other than money,

received in the exchange. The basis of unlike property is its
FMV on the date of the exchange. The remainder is the
basis of the like property.
Exercise 27:
Mr. Brown owned a parcel of real estate having an adjusted basis of $25,000,
that he was holding for investment. Mr. Brown exchanged the real estate for the
assets listed below:
Land to be held for investment, fair market value $30,000

A boat for personal use, fair market value 1,500
Cash 1,000
What is Mr. Brown’s basis in the real estate that he received?
A. $22,500
B. $25,000
C. $29,000
D. $30,000
B. $25,000. If an exchange is only partially tax-free because it involves

an exchange of both like-kind property and “other” property or
money so that gain must be recognized, the basis for the like-kind
property received is the adjusted basis of the property transferred,
minus the sum of the money and the fair market value of any other
property received, plus the amount of the gain that was recognized.
c) If a sale and purchase are, in fact, a single transaction or

dependent on each other, the taxpayer cannot increase the basis of

property for depreciation by selling the old property and buying the
new property from the same dealer. The transaction is treated as
an exchange no matter how it is carried out.
Example:
You are a salesperson and use one of your cars 100% for business. You have
used this car in your sales activities for 2 years and have depreciated it. Your
adjusted basis in the car is $2,600, and its FMV is $3,100.
You are interested in a new car with a listed retail price of $8,695 which usually
sells for $8,000. If you trade your old car and $4,900 for the new one, your basis
for depreciation for the new car would be $7,500 ($4,900 plus $2,600 basis in the
old car). However, you want a higher basis for depreciating the new car, so you
agree to pay the dealer $8,000 for the new car if he will pay you $3,100 for your
old car.
Since the sale and purchase are dependent on each other, you are treated as if
you had exchanged your old car for the new one. Your basis for depreciation is
$7,500.
4. The basis of property received as a gift depends on the donor's adjusted

basis, the FMV on the date given, and any gift tax paid.
a) If the FMV is less than donor's adjusted basis, the donee starts with
the donor's adjusted basis when determining any gain on the sale
or other disposition of the property, and when determining
depreciation. The basis for determining loss on a sale or other
disposition starts with the FMV at the time received. Appropriate
increases and decreases will be made for adjustments attributable
to the period the taxpayer owns the property.
b) If FMV is equal to or greater than donor's adjusted basis, the

donee's basis is the same as the donor’s adjusted basis at the time
of the gift. The basis will be increased by all or part of the gift tax
paid.
(1) If received before 1977, the basis is increased by all of the

gift tax paid but cannot exceed the FMV at the time of the
gift.
(2) If received after 1976, the basis is increased by the part of

the gift tax paid that is due to the net increase in value of the
gift and is figured by multiplying the gift tax by a fraction. The
numerator is the net increase in value of the gift and the
denominator is the amount of the gift.

Exercise 28:
Chester received a gift of stock having an adjusted basis of $11,000 and a fair
market value of $7,200 at the time of the gift. Chester sold the stock for $9,000.
What is the amount of Chester's capital gain or (loss)?
A. $9,000
B. $1,800
C. $0
D. $(2,000)
C. $0. There is no gain or loss. The basis for gain is the adjusted basis
in the hands of the donor ($11,000). The result of subtracting the
basis from the sale price ($9,000 - $11,000) is a negative number.
A gain cannot be less than 0. The basis for loss is the fair market
value at the time of the gift, when the adjusted basis is greater than
the fair market value. The result of subtracting the basis from the
sale price ($9,000 - $7,200) is a positive number. A loss cannot be
larger than 0.
5. A taxpayer's basis in inherited property is usually the FMV on the date of

the decedent's death.
a) If an estate tax return is filed, the basis can be the FMV on the
alternate valuation date if so elected by the executor.
b) If a federal estate tax return does not have to be filed, the basis in
the property is its appraised value at the date of death for state
inheritance or transmission taxes.
c) Inherited property is always considered held long term.
Exercise 29: On July 15, 2001, Jeff received 50 shares of stock as an inheritance
from his father who died April 15, 2001. His father's adjusted basis in the stock
was $50,000. The stock's fair market value on April 15, 2001, was $65,000. On
July 15, 2001, its value was $70,000 and on October 15, 2001, it was $80,000.
The alternate valuation date was NOT elected on the federal estate tax return.
Jeff's basis in the inherited stock is:
A. $50,000
B. $65,000
C. $70,000
D. $80,000

B. $65,000. When an alternate valuation date is not elected, the

income tax basis of property acquired from a decedent is the fair
market value of the property on the date of the decedent’s death.
6. For property converted from personal to business or rental use, the basis
for depreciation is the lesser of the FMV or the adjusted basis on the date
of conversion. The basis for gain is the adjusted basis in the property. The
basis for loss is the smaller of the adjusted basis or the FMV at the time of
the conversion plus or minus required adjustments.
Example:
You sell your house, which you had changed to rental property after using it as
your home. When converted to rental use, it had a FMV of $33,000 and an
adjusted basis of $35,000. The original cost of the house and the adjusted basis
were the same, as there were no increases or decreases to basis since its
purchase.
Your basis for depreciation is $33,000, the lesser of FMV or adjusted basis. You
claimed $3,000 depreciation, figured under the straight line method, while renting
it.
Your adjusted basis at the time of the sale, for figuring gain, is $32,000 ($35,000
original cost - $3,000 depreciation).
Your adjusted basis at the time of the sale, for figuring loss, is $30,000 ($33,000
FMV on conversion - $3,000 depreciation). In this example, FMV must be used
because it was smaller than the adjusted basis at the time the house was
changed to rental use.
If the sales price is between $30,000 and $32,000, you have neither gain nor loss
on the sale.
D. Stocks and Bonds
1. The basis in stocks and bonds is generally the purchase price plus the
costs of purchase. If acquired by other than purchase, the basis will be the
FMV or other party's adjusted basis as determined under the previous
rules. The basis will be adjusted for certain events.
2. Identification of which shares are sold is required, or the basis of shares

sold is the basis of the shares acquired first. Identification can be
accomplished by delivering certificates to a broker and identifying a
specific purchase date or a specific purchase price. If stock is left with the
broker or agent, inform the broker which stock is to be sold and receive
written confirmation.

3. The basis of mutual fluid shares can be determined on a cost basis or an

average basis.
a) Cost basis can be either a specific share identification method or a

first-in first-out (FIFO) method.
b) An average basis method can be used if the shares are acquired at

various times and for various amounts, and the shares are left on
deposit in an account with the custodian or agent. The basis is
figured using either the double-category method or the single-
category method.
c) Unless the requirements for specific share identification are met or

an election is made to use an averaging method, the FIFO method
must be used.
4. Dividend reinvestment plans invest the dividends in additional shares or

fractional shares of stock. The basis is the actual cost of the shares. If
purchased at a discount, the discount is included in income and the basis
is the FMV.
5. For a per share basis of stock received as nontaxable stock dividends, the
taxpayer's adjusted basis of the old stock is divided between the shares of
old stock and the new stock.
a) If the old and new stock are identical, the adjusted basis is divided
by total number of old and new shares.
b) If not identical, the division is in a ratio of the FMV of each lot of

stock to the total FMV of both lots.
c) If the old stock is purchased at various times and prices, the basis
is allocated to each lot based on the dividend attributable to that lot.
Allocation within lots also applies to stock splits.
d) The holding period for the new stock received as a nontaxable

dividend or split is the same as the old stock.
6. For taxable stock dividends, the basis of the new stock is the FMV on the
date of distribution.
Exercise 30: In 1998, Chim purchased 100 shares of preferred stock of Donald
Corporation for $5,000. In 2001, she received a stock dividend of 20 additional
shares of preferred stock in Donald. On the date of the distribution, the preferred

stock had a fair market value of $40 per share. What is Chim's basis in the new
stock she received as a result of the stock dividend?
A. $1,000
B. $833
C. $800
D. $0
C. $800. Dividends on preferred stock are taxable under the dividend

distribution rules. Under these rules, the basis of stock received is
the fair market value of the stock on the date received.
7. Stock rights may be exercised or sold, or may expire.
a) If the rights are taxable, the basis of the right is the FMV at the time
of the distribution.
b) If nontaxable when received, the basis is zero if allowed to expire. If

the right is exercised or sold and if at the time of the distribution:
(1) The rights had a FMV of 15% or more of the FMV of the old
stock, the taxpayer must divide the adjusted basis of the
stock between the stock and the rights based on the FMV of
each.
(2) A FMV of rights less than 15%, the basis is zero.
8. If exercised, the basis of the new stock is its cost plus the basis of the
stock rights exercised.
Exercise 31: Which of the following statements is CORRECT?
A. Stock dividends are distributions made by a corporation of another

corporation's stock
B. In computing basis for new stock received as a result of a nontaxable
dividend, it is immaterial whether the stock received is identical or not to
the old stock
C. If a stock dividend is taxable, the basis of the old stock does NOT change.
D. If you receive nontaxable stock rights and allow them to expire, you have
a loss equal to the fair market value of the rights.
C. If a stock dividend is taxable, the basis of the old stock does NOT
change. The basis of the old stock would be adjusted only if the
distribution were nontaxable; no allocation of the adjusted basis of

the old stock, between the old and new stock, occurs when the
distribution is taxable.
9. If the taxpayer receives investment property in complete or partial

liquidation of a corporation and if gain or loss is recognized when the
property is acquired, the basis in the property is its FMV at the time of the
distribution.
10. If taxable bonds are purchased at a premium and the taxpayer elects to
amortize the premium paid, the basis is reduced by the amount of the
amortized premium deducted each year. Even though no deduction is
allowed for the premium of tax-exempt bonds, each year the premium is
amortized and the basis is reduced.
11. Increase basis in OlD debt instruments by the amount of OlD included in
income. Special rules apply to tax-exempt bonds.
Basis Reference Chart
How Acquired Basis For Gain, Loss And Depreciation

Purchase Usually cost. Includes cash, FMV of other property and
services, sales tax, freight, testing and installation, closing
costs, and indebtedness assumed.
Non-taxable and Basis of property acquired is the same as the basis of the
partially taxable property given up, increased by additional costs and any gain
exchanges recognized, and decreased by money or unlike property
received and any loss recognized.
Gifts Gain or depreciation: Same as donor’s basis, increased (not

over
FMV) by the gift tax allocated to appreciation.
Loss: Lesser of basis for gain or FMV.
Conversion from Gain: Adjusted basis.

personal use to Loss or depreciation: Lesser of adjusted basis or FMV at the
business use date of conversion.
Inherited FMV at date of death or alternate valuation date if elected.
Transfer between Carryover of basis prior to transfer. No gain or loss recognized.

spouses
Replacement Adjusted basis less gain deferred on the sale of the old

residence - on sale of residence. Loss is not recognized.

old
Stocks and Bonds Usually cost. First acquired, first sold.
Stock split: Divide the original basis between the old and new
stock.
Dividend reinvestment: FMV on the dividend payment date.
Reduced by nontaxable distributions.
Mutual Fund Shares Cost, may use average basis if bought at different times and
prices.
Original Issue Cost, increased by OlD included in income.

Discount
15. Sales and Trades

A. A sale is a transfer of property for money or a promise to pay money, and a trade
is a transfer of property for other property or services.
B. A transaction is not a trade when the taxpayer voluntarily sells property for cash
and immediately buys similar property to replace it unless the transactions are
contingent and with the same person.
C. A redemption of stock will receive sale treatment if:
1. The redemption is not essentially equivalent to a dividend,

2. There is a substantially disproportionate redemption of stock,
3. There is a complete redemption of the shareholder's stock, or
4. The redemption is in partial liquidation of a corporation.
D. A redemption or retirement of bonds or notes at their maturity is a reportable sale

or trade.
E. Gain or loss is the difference between the adjusted basis in property and the
amount realized.
1. The adjusted basis of property is the original cost or other original basis
adjusted for certain items. Adjustments include such items as
depreciation, casualty loss, improvements, or special assessments.
2. The amount realized is all money and the FMV of property or services
received. This includes any indebtedness that is paid off as part of the
transaction or that is assumed by the buyer. If the taxpayer trades

property and cash for other property, the amount realized is the FMV of
the property received.
3. Realized gain or loss is the amount realized less the adjusted basis of the
property.
4. Recognized gain or loss is the gain or loss included in determining gross

income.
Exercise 32:
In 2001, Robert sold a building used in his business. His books and records
reflect the following information:
Original cost of building $150,000

Improvements made to building $50,000
Broker’s commissions paid on sale $10,000
Cash received on sale $100,000
Total property taxes paid by Robert $3,000
Portion of property taxes imposed on purchaser $1,000
and reimbursed in a separate payment to Robert
by purchaser under IRC 164(d)
Mortgage assumed by buyer $80,000
Accumulated depreciation $70,000
Fair market value of other property received $20,000
What is the amount of gain Robert must RECOGNIZE from the sale of the
property?
A. $60,000
B. $61,000
C. $70,000
D. $71,000
A. $60,000. The gain from a sale or exchange of property is the

excess of the amount realized from the sale or exchange over the
property’s adjusted basis. The adjusted basis of an asset is
generally its original cost plus the cost of any capital improvements
to the property and less any deprecation or depletion. In computing
the amount realized, the sell does not include any reimbursement
for real property taxes treated under Code Sec. 154(d) as imposed
on the purchaser.
F. An exchange may be nontaxable, partially taxable, or taxed as a sale.

1. Nontaxable Exchange - A taxpayer must postpone paying tax on gain or

deducting a loss until the property received is sold or disposed of.
a) Like-kind Exchange - To be nontaxable, a trade must meet the

following conditions:
(1) Both the old and new property must be held for business or
investment purposes,
(2) The property must not be property held for sale
(3) There must be an exchange of like-kind property. Real

property may be improved or unimproved. Tangible personal
property must be either like-kind or like-class to qualify for
nonrecognition, and
(4) The property must not be stocks, bonds, notes, or other

securities or evidence of indebtedness, including partnership
interests.
Exercise 33:
Which of the following examples of property may qualify for a like-kind
exchange?
A. Inventories
B. Rental house
C. Accounts receivable
D. Raw materials
B. Rental house. Like-kind property includes property held for

productive use in a trade or business or for investment purposes.
(5) The property to be received must be identified on or before

the 45th day after the date of transfer of the property given
up.
(6) The exchange must meet the completed transaction

requirement. The new property must be received on or
before the earliest of the 180th day after the date the
property given up was transferred, or the due date (including
extensions) for the return for the year in which the property
given up was transferred.

Exercise 34: If you transfer property in a deferred like-kind exchange, it will NOT
qualify for nonrecognition if the replacement property is NOT in existence or
being produced at the time you identify the property. (True or False)
False. Property transferred in a deferred exchange will qualify for

nonrecognition even if the replacement property is not in existence
or is being produced at the time that it is identified as the
replacement property.
b) A partially nontaxable exchange occurs when like property and

money or other unlike property is received in exchange for the
property given up.
(1) The taxpayer will be taxed on the gain realized to the extent
of the money and the fair market value of the unlike property
received. An assumption of a liability is treated as cash
received. If both parties transfer a liability with the property,
the one transferring the larger liability will be treated as
receiving cash equal to the amount of the excess over the
liability assumed.
(2) If the taxpayer gives up nonlike-kind property as well as like-

kind property, gain or loss must be recognized on the
nonlike-kind property. The gain or loss is the difference
between the adjusted basis of the nonlike-kind property and
its FMV.
c) Generally, the transfer of property between spouses or a transfer

incident to divorce is not treated as a sale or exchange and no gain
or loss is recognized.
d) An exchange of common stock for common stock or preferred stock

for preferred stock in the same corporation can be completed
without having to recognize gain or loss.
e) An exchange of life insurance policies and annuities can receive

nonrecognition treatment.
Exercise 35:
James transferred an apartment building he held for investment to Ray an
unrelated party, in exchange for an office building. At the time of the exchange,
the apartment building had a fair market value of $90, 000, and an adjusted basis
to James of $70, 000. The apartment building was subject to a liability of $30,000

which Ray assumed for legitimate business purposes. The office building had an
adjusted basis to Ray of $30,000, and a fair market value of $80,000. In addition,
James received $10,000 cash in the exchange. What is James RECOGNIZED
gain on this exchange?
A. $10,000
B. $30,000
C. $40,000
D. $50,000
C. $40,000. If, in an exchange of property for property of like kind,

other (unlike) property or money is received in addition to the like-
kind property, gain is recognized, but only up to the sum of the
money and the fair market value of the other property received. The
amount of any liabilities of the taxpayer assumed by the other party
to an exchange is treated as money received by the taxpayer.
2. Related party transactions.
a) The like-kind exchange nonrecognition rules apply to related

parties. However, if either related party disposes of the like-kind
property within two (2) years after the exchange, the gain or loss on
the exchange must be recognized. Each party would report the gain
or loss on the return for the year in which the later disposition
occurred.
b) Other than a distribution in complete liquidation of a corporation, a

loss on the sale or trade of property is not deductible if the
transaction is directly or indirectly between related parties. Related
parties for this rule are:
(1) Members of one's family - include only brothers, sisters, half-

brothers or sisters, spouse, ancestors, and lineal
descendants.
(2) A corporation in which the taxpayer owns, directly or

indirectly, more than 50% in value of outstanding stock.
(3) A tax-exempt charitable or educational organization

controlled in any manner by the taxpayer or family member.
(4) A trust created by the taxpayer or in which the taxpayer is a

beneficiary.
Exercise 36:

In April 2001, Pamela sold stock with a cost basis of $15,000, to Lisa, her sister,
for $10,000. In September 2001, Lisa sold the same shares of stock to their
cousin, Niki, for $8,000. What is the amount of Pamela’s deductible loss for
2001?
A. $0
B. $2,000
C. $5,000
D. $7,000
A. $0. Pamela may not claim any deductible loss because she sold the
stock to her sister, a related party.
c) If a taxpayer sells or trades at a gain property that was acquired

from a related party, the taxpayer would recognize gain only to the
extent it is more than the loss previously disallowed to the
transferor. This rule applies only if the taxpayer is the original
transferee and acquired the property by purchase or exchange.
G. Capital or Ordinary Gain or Loss.

1. A capital asset is, for the most part, everything the taxpayer owns and
uses for personal purposes, pleasure, or investment. Examples would
include: stocks or bonds, personal residence and household furnishings,
an automobile used for personal purposes or commuting, coin or stamp
collections, gems, or jewelry.
2. Noncapital assets include property held mainly for sale to customers,

depreciable or real property used in a trade or business, accounts or notes
receivable, U.S. Government publications, and any copyright, literary,
musical, or artistic composition, letter or memorandum, or similar property
created by or for the taxpayer.
3. Nonbusiness bad debts arc debts not obtained in the course of operating
a trade or business. To be deductible, the debt must be a genuine and
totally worthless debt, and the taxpayer must have a basis in it.
Nonbusiness bad debts are deducted as short-term capital losses on
Schedule D.
Exercise 37: In 1998, Mr. Baldwin loaned his nephew, Phillip, $6,000 to assist
him while in college. Phillip did not sign a note and no terms for repayment were
established. They both lived in the same state which requires that agreements be
in writing to be legally binding. Phillip did not repay any of the $6,000 and Mr.

Baldwin made no efforts to collect it. Mr. Baldwin can deduct the $6,000 as a
nonbusiness bad debt on his income tax return for 2001. (True or False)
False. In order for a debt to be deductible, it must, among other things, be

a valid and enforceable obligation to pay a fixed or determinable
sum of money. Mr. Baldwin loaned money to a related party,
without benefit of a written note or established payment plan in a
jurisdiction that requires a writing for an agreement to be binding.
No payments have actually been made and no effort has been
made to collect the amount due. Based on these facts, this debt is
not a valid or enforceable obligation, and is, therefore,
nondeductible.
4. Losses on Small Business Stock (§1244 stock) may be deducted as an

ordinary loss up to $50,000 ($100,000 if MFJ), by reporting on Form 4797,
Sales of Business Property. If this stock is a capital asset in the hands of
the taxpayer, gain from the disposition is capital gain.
5. Holding period is used to determine whether gain or loss is reported as

short term or long term.
a) Short-term is property held for one year or less, long-term is more

than one year.
b) The holding period starts on the date after the property is acquired
and ends on the date disposed of For securities traded on an
established market, it starts on the day after the trading date and
ends on the trading date.
c) If property is acquired in an exchange, where the basis of the new

property is determined, in whole or in part, by the basis of the old
property, the holding period for the new property begins on the day
following the date the old property was acquired.
d) The donor's holding period will carry over on gifts.
e) Inherited property is generally treated as held long-term.
f) The holding period of stock received as a nontaxable stock dividend

begins on the same day as the holding period of the old stock.
Exercise 38:
Which of the following statements concerning the holding period of assets is
CORRECT?

A. In the case of stocks and bonds, the holding period begins on the day
after the trading dare.
B. In the case of nontaxable exchanges, the holding period begins 45 days
after the date you transfer the property.
C. In the case of a gift the holding period begins on the date you receive the
gift.
D. in the case of inherited property, there is no holding period.
A. In the case of stocks and bonds, the holding period begins on the
day after the trading day. With respect to a security that is
purchased and sold on a registered security exchange, the holding
period begins on the day after the taxpayer purchases the security.
6. Gain up to $50,000 from the sale of publicly traded securities may receive
tax-free rollover treatment if qualified replacement property is purchased
within 60 days. To qualify:
a) The sale of the publicly-traded securities is after August 9, 1993.
b) The gain is a capital gain.
c) The replacement property is either common stock or a partnership

interest in a specialized small business investment company
(SSBIC).
Exercise 39:
Stan sold the following capital assets on December 1, 2001:
Asset Gain or (Loss) on the

Sale
XYZ stock acquired December 1, 1999 ($14,000)
ABC stock acquired January 13, 2001 15,000
Personal automobile acquired February 2, 2,000
2001
Land held for investment acquired March 8,000
3, 1997
In addition, Stan received a capital gain distribution of $1,000 from the Lucky
Mutual Fund during 2001. What are the respective net short-term capital gains
and the net long-term capital loss that Stan must report on his 2001 Schedule D
(Form 1040)?
Short-term Long-term
A. $17,000 ($3,000)

B. $17,000 ($5,000)
C. $17,000 ($6,000)
D. $18,000 ($6,000)
B. $17,000; ($5,000). Gains and losses resulting from the sale or

exchange of capital assets held for not more than one year are
characterized as short-term. Gains and losses resulting from the
sale or exchange of capital assets help for more than one year are
characterized as long-term (Code Sec. 1222). Capital gain
dividends are taxed as long-term capital gains regardless of how
long the shareholder has owned stock in the fund (Code Sec.
852(b)(3)(B). The ABC stock ($15,000) and the automobile
($2,000) were the only items generating short-term gain, resulting in
a net of $17,000. The XYZ stock ($14,000), the land ($8,000) and
the mutual fund distribution ($1,000) were all long-term assets,
resulting in a net loss of $5,000.
16. Reporting Gains and Losses
Introduction
This section discusses how to report capital gains and losses from sales,
exchanges, and other dispositions of investment property on Schedule D of Form
1040. The discussion includes:
• How to report short-term gains and losses,
• How to report long-term gains and losses,
• How to figure capital loss carryovers,
• How to figure your tax using the maximum tax rates on a net capital gain,
and
• An illustrated example of how to complete Schedule D.
If you sell or otherwise dispose of property used in a trade or business or for the
production of income, see Publication 544, Sales and Other Dispositions of Assets,
before completing Schedule D.
Schedule D
Report capital gains and losses on Schedule D (Form 1040). Enter your sales and
trades of stocks, bonds, etc., and real estate (if not required to be reported on
another form) on line 1 of Part I or line 8 of Part II, as appropriate. Include all these
transactions even if you did not receive a Form 1099-B, Proceeds From Broker and
Barter Exchange Transactions, or Form 1099-S, Proceeds From Real Estate
Transactions (or substitute statement). You can use Schedule D-1 as a continuation
schedule to report more transactions.

Installment sales. You cannot use the installment method to report a gain from the
sale of stock or securities traded on an established securities market. You must
report the entire gain in the year of sale (the year in which the trade date occurs).
Passive activity gains and losses. If you have gains or losses from a passive
activity, you may also have to report them on Form 8582. In some cases, the loss
may be limited under the passive activity rules. Refer to Form 8582 and its separate
instructions for more information about reporting capital gains and losses from a
passive activity.
Form 1099-B transactions. If you sold property, such as stocks, bonds, or certain
commodities, through a broker, you should receive Form 1099-B or equivalent
statement from the broker. Use the Form 1099-B or the equivalent statement to
complete Schedule D.
Report the gross proceeds shown in box 2 of Form 1099-B as the gross sales price
in column (d) of either line 1 or line 8 of Schedule D, whichever applies. However, if
the broker advises you, in box 2 of Form 1099-B, that gross proceeds (gross sales
price) less commissions and option premiums were reported to the IRS, enter that
net sales price in column (d) of either line 1 or line 8 of Schedule D, whichever
applies. If the net amount is entered in column (d), do not include the commissions
and option premiums in column (e).
Form 1099-S transactions. If you sold or traded reportable real estate, you
generally should receive from the real estate reporting person a Form 1099-S
showing the gross proceeds.
"Reportable real estate" is defined as any present or future ownership interest in any
of the following:
• Improved or unimproved land, including air space,

• Inherently permanent structures, including any residential, commercial, or
industrial building,
• A condominium unit and its accessory fixtures and common elements,
including land, and
• Stock in a cooperative housing corporation (as defined in section 216 of the
Internal Revenue Code).
A "real estate reporting person" could include the buyer's attorney, your attorney, the
title or escrow company, a mortgage lender, your broker, the buyer's broker, or the
person acquiring the biggest interest in the property.

Your Form 1099-S will show the gross proceeds from the sale or exchange in box 2.
Follow the instructions for Schedule D to report these transactions and include them
on line 1 or 8 as appropriate.
Reconciling Forms 1099 with Schedule D. Add the following amounts reported to
you for 2001 on Forms 1099-B and 1099-S (or on substitute statements):
Proceeds from transactions involving stocks, bonds, and other securities, and
Gross proceeds from real estate transactions (other than the sale of your main home
if you had no taxable gain) not reported on another form or schedule.
If this total is more than the total of lines 3 and 10 of Schedule D, attach a statement
to your return explaining the difference.
Sale of property bought at various times. If you sell a block of stock or other
property that you bought at various times, report the short-term gain or loss from the
sale on one line in Part I of Schedule D and the long-term gain or loss on one line in
Part II. Write "Various" in column (b) for the "Date acquired."
Sale expenses. Add to your cost or other basis any expense of sale such as
brokers' fees, commissions, state and local transfer taxes, and option premiums.
Enter this adjusted amount in column (e) of either Part I or Part II of Schedule D,
whichever applies, unless you reported the net sales price amount in column (d).
Property held for personal use only, rather than for investment, is a capital asset and
you must report a gain from its sale as a capital gain. However, you cannot deduct a
loss from selling personal use property.
Short-term gains and losses. Capital gain or loss on the sale or trade of
investment property held 1 year or less is a short-term capital gain or loss. You
report it in Part I of Schedule D. If the amount you report in column (f) is a loss, show
it in parentheses.
You combine your share of short-term capital gains or losses from partnerships, S
corporations, and fiduciaries, and any short-term capital loss carryover, with your
other short-term capital gains and losses to figure your net short-term capital gain or
loss on line 7 of Schedule D.
Long-term gains and losses. A capital gain or loss on the sale or trade of property
held more than 1 year is a long-term capital gain or loss. You report it in Part II of
Schedule D. If the amount in column (f) is a loss, show it in parentheses.
You also report the following in Part II of Schedule D:
1. Undistributed long-term capital gains from a regulated investment company

(mutual fund) or real estate investment trust (REIT),

2. Your share of long-term capital gains or losses from partnerships, S corporations,

and fiduciaries,
3. All capital gain distributions from mutual funds and REITs not reported directly on
line 10 of Form 1040A or line 13 of Form 1040, and
4. Long-term capital loss carryovers.
The result after combining these items with your other long-term capital gains and
losses is your net long-term capital gain or loss ( line 16 of Schedule D).
28% rate gain or loss. Enter in column (g) the amount, if any, from column (f) that
is a 28% rate gain or loss. Enter any loss in parentheses.
A 28% rate gain or loss is:
1. Any collectibles gain or loss, or

2. The part of your gain on qualified small business stock that is equal to the section
1202 exclusion.
Capital gain distributions only. You do not have to file Schedule D if all of the
following are true.
The only amounts you would have to report on Schedule D are capital gain
distributions from box 2a of Form 1099-DIV (or substitute statement).
You do not have an amount in box 2b, 2c, 2d, or 2e of any Form 1099-DIV (or
substitute statement).
You do not file Form 4952 or, if you do, the amount on line 4e of that form is not
more than zero.
If all the above statements are true, report your capital gain distributions directly on
line 13 of Form 1040 and check the box on that line. Also, use the Capital Gain Tax
Worksheet in the Form 1040 instructions to figure your tax.
You can report your capital gain distributions on line 10 of Form 1040A, instead of
on Form 1040, if both of the following are true.
1. None of the Forms 1099-DIV (or substitute statements) you received have an
amount in box 2b, 2c, 2d, or 2e.
2. You do not have to file Form 1040 for any other capital gains or any capital
losses.
Total net gain or loss. To figure your total net gain or loss, combine your net short-
term capital gain or loss (line 7) with your net long-term capital gain or loss ( line 16).
Enter the result on line 17, Part III of Schedule D. If your losses are more than your

gains, see Capital Losses, next. If both lines 16 and 17 are gains and line 39 of
Form 1040 is more than zero.
Capital Losses
If your capital losses are more than your capital gains, you can claim a capital loss
deduction. Report the deduction on line 13 of Form 1040, enclosed in parentheses.
Limit on deduction. Your allowable capital loss deduction, figured on Schedule D,

is the lesser of:
1. $3,000 ($1,500 if you are married and file a separate return), or
2. Your total net loss as shown on line 17 of Schedule D.
You can use your total net loss to reduce your income dollar for dollar, up to the
$3,000 limit.
Capital loss carryover. If you have a total net loss on line 17 of Schedule D that is
more than the yearly limit on capital loss deductions, you can carry over the unused
part to the next year and treat it as if you had incurred it in that next year. If part of
the loss is still unused, you can carry it over to later years until it is completely used
up.
When you figure the amount of any capital loss carryover to the next year, you must
take the current year's allowable deduction into account, whether or not you claimed
it.
When you carry over a loss, it remains long term or short term. A long-term capital
loss you carry over to the next tax year will reduce that year's long-term capital gains
before it reduces that year's short-term capital gains.
Figuring your carryover. The amount of your capital loss carryover is the amount
of your total net loss that is more than the lesser of:
1. Your allowable capital loss deduction for the year, or

2. Your taxable income increased by your allowable capital loss deduction for the
year and your deduction for personal exemptions.
If your deductions are more than your gross income for the tax year, use your
negative taxable income in computing the amount in item (2).
Complete the Capital Loss Carryover Worksheet in the Schedule D (Form 1040)
instructions to determine the part of your capital loss that you can carry over to next
year.
Example:
Bob and Gloria sold securities in 2001. The sales resulted in a capital loss of
$7,000. They had no other capital transactions. Their taxable income was

$26,000. On their joint 2001 return, they can deduct $3,000. The unused part of
the loss, $4,000 ($7,000 - $3,000), can be carried over to 2002.
If their capital loss had been $2,000, their capital loss deduction would have been
$2,000. They would have no carryover.
Use short-term losses first. When you figure your capital loss carryover, use your
short-term capital losses first, even if you incurred them after a long-term capital
loss. If you have not reached the limit on the capital loss deduction after using short-
term losses, use the long-term losses until you reach the limit.
Decedent's capital loss. A capital loss sustained by a decedent during his or her
last tax year (or carried over to that year from an earlier year) can be deducted only
on the final income tax return filed for the decedent. The capital loss limits discussed
earlier still apply in this situation. The decedent's estate cannot deduct any of the
loss or carry it over to following years.
Joint and separate returns. If you and your spouse once filed separate returns and
are now filing a joint return, combine your separate capital loss carryovers. However,
if you and your spouse once filed a joint return and are now filing separate returns,
any capital loss carryover from the joint return can be deducted only on the return of
the person who actually had the loss.
Capital Gain Tax Rates

The 31%, 36%, and 39.6% income tax rates for individuals do not apply to a net
capital gain. In most cases, the 15% and 28% rates do not apply either. Instead,
your net capital gain is taxed at a lower capital gain rate.
The term "net capital gain" means the amount by which your net long-term capital
gain for the year is more than your net short-term capital loss.
The capital gains rate may be 8%, 10%, 15%, 20%, 25%, or 28%, or a combination
of those rates, as shown in Table 17-1 (Pub. 17).
Table 17.1 What is Your Capital Tax Rate?

If your net capital gain is from THEN your capital gain rate
is
Collectibles gain 28%
Gain on qualified small business stock 28%
equal to the section 1202 exclusion
Unrecaptureed section 1250 gain 25%
Other gain, 1 and the regular tax rate that 20%
would apply is 27.5% or higher
Other gain, and your regular tax rate is 8% or 10% 2

15%
1:
"Other gain" means any gain that is not collectibles gain, gain on qualified
small business stock, or unrecaptured section 1250 gain.
2:
The rate is 8% only for qualified 5-year gain.
Investment interest deducted.

If you claim a deduction for investment interest, you may have to reduce the amount
of your net capital gain that is eligible for the capital gain tax rates. Reduce it by the
amount of the net capital gain you choose to include in investment income when
figuring the limit on your investment interest deduction. This is done on lines 20-22
of Schedule D. For more information about the limit on investment interest.
Collectibles gain or loss.

This is gain or loss from the sale or trade of a work of art, rug, antique, metal, gem,
stamp, coin, or alcoholic beverage held more than 1 year.
Gain on qualified small business stock.

If you realized a gain from qualified small business stock that you held more than 5
years, you exclude one-half of your gain from income. The taxable part of your gain
equal to your section 1202 exclusion is a 28% rate gain. See Gains on Qualified
Small Business Stock, in chapter 4 of Publication 550.
Unrecaptured section 1250 gain.

Generally, this is any part of your capital gain from selling section 1250 property
(real property) that is due to depreciation (but not more than your net section 1231
gain), reduced by any net loss in the 28% group. Use the worksheet in the Schedule
D instructions to figure your unrecaptured section 1250 gain. For more information
about section 1250 property and section 1231 gain, see chapter 3 of Publication
544.
Using Schedule D.
You apply these rules by using Part IV of Schedule D (Form 1040) to figure your tax.
You will need to use Part IV if both of the following are true.
1. You have a net capital gain. You have a net capital gain if both lines 16
and 17 of Schedule D are gains. (Line 16 is your net long-term capital gain
or loss. Line 17 is your net long-term capital gain or loss combined with
any net short-term capital gain or loss.)
2. Your taxable income on Form 1040, line 39, is more than zero.
See the Comprehensive Example, later, for an example of how to figure your tax on
Schedule D using the capital gain rates.
Using Capital Gain Tax Worksheet.

If you have capital gain distributions but do not have to file Schedule D, figure your
tax using the Capital Gain Tax Worksheet in the Form 1040 instructions. For more
information, see Capital gain distributions only, earlier.
Example:
Emily Jones is single and, in addition to wages from her job, she has income
from some stocks and other securities. For the 2001 tax year, she had the
following capital gains and losses, which she reports on Schedule D. All the
Forms 1099 she received showed net sales prices. Her filled-in Schedule D is
shown in this chapter.
Capital gains and losses — Schedule D. Emily sold stock in two different
companies that she held for less than a year. In June, she sold 100 shares of
Trucking Co. stock that she had bought in February. She had an adjusted basis
of $650 in the stock and sold it for $900, for a gain of $250. In July, she sold 25
shares of Computer Co. stock that she bought in June. She had an adjusted
basis in the stock of $2,500 and she sold it for $2,000, for a loss of $500. She
reports these short-term transactions on line 1 in Part I of Schedule D.
Emily had three other stock sales that she reports as long-term transactions on
line 8 in Part II of Schedule D. In February, she sold 60 shares of Car Co. for
$2,100. She had inherited the Car Co. stock from her father. Its fair market value
at the time of his death was $2,500, which became her basis. Her loss on the
sale is $400. Because she had inherited the stock, her loss is a long-term loss,
regardless of how long she and her father actually held the stock. She enters the
loss in column (f) of line 8.
In June, she sold 500 shares of Furniture Co. stock for $14,000. She had bought
100 of those shares in 1988, for $1,000. She had bought 100 more shares in
1990 for $2,200, and an additional 300 shares in 1992 for $1,500. Her total basis
in the stock is $4,700. She has a $9,300 ($14,000 - $4,700) gain on this sale,
which she enters in column (f) of line 8.
In December, she sold 20 shares of Toy Co. for $4,100. This was qualified small
business stock that she had bought in September 1994. Her basis is $1,100, so
she has a $3,000 gain which she enters in column (f) of line 8. Because she held
the stock more than 5 years, she has a $1,500 section 1202 exclusion. She
enters that amount in column (g) as a 28% rate gain and claims the exclusion on
the line below by entering $1,500 as a loss in column (f).
She received a Form 1099-B (not shown) from her broker for each of these
transactions.

Capital loss carryover from 2001. Emily has a capital loss carryover to 2002 of
$800, of which $300 is short-term capital loss, and $500 is long-term capital loss.
She enters these amounts on lines 6 and 14 of Schedule D.
She kept the completed Capital Loss Carryover Worksheet in her 2001 Schedule
D instructions (not shown), so she could properly report her loss carryover for the
2002 tax year without refiguring it.
Tax computation (Part IV).

Because Emily has gains on both lines 16 and 17 of Schedule D and has taxable
income, she uses Part IV of Schedule D to figure her tax. She had already filled out
her Form 1040 through line 39 and enters the amount from that line, $30,000, on line
19 of Schedule D. After filling out the rest of Part IV, she finds that her tax is $4,484.
This is less than the tax she would have found using the Tax Table, $5,060.
Reconciliation of Forms 1099-B.

Emily makes sure that the total of the amounts reported in column (d) of lines 3 and
10 of Schedule D is not less than the total of the amounts shown on the Forms
1099-B she received from her broker.
Adjustments to Income
The three adjustments to income that you can deduct in figuring your adjusted gross
income, these are:
• Contributions you make to traditional individual retirement arrangements
(IRAs),
• Moving expenses you pay, and
• Alimony you pay.
Other adjustments to income are discussed in other parts of this publication or in

other publications and instructions. They are deductions for:
• Interest paid on student loans — instructions for Form 1040, line 24, or
Form 1040A, line 16,
• Contributions to a medical savings account,
• Self-employment tax,
• Self-employed health insurance,
• Payments to a Keogh retirement plan or self-employed SEP or SIMPLE
plan — Publication 560, Retirement Plans for Small Business,
• Penalty on early withdrawal of savings.
• Amortization of the costs of reforestation — Publication 535, Business
Expenses,
• Contributions to Internal Revenue Code section 501(c)(18) pension plans
— instructions for Form 1040, line 32,
• Expenses from the rental of personal property,
• Expenses of fee-basis officials or certain performing artists,

• Certain required repayments of supplemental unemployment benefits

(sub-pay),
• Foreign housing deduction,
• Jury duty pay given to your employer, and
• Part of the cost of qualified clean-fuel vehicle property — chapter 15 of
Publication 535, Business Expenses.
Example:
On November 2, 2000, John Aubrey purchased 100 shares of Gizmo Inc. for
$5,000. On May 8,2001, Aubrey sold the 100 shares for $20,000. Aubrey will
compute his tax on his $15,000 capital gain by using his ordinary income tax rate
(e.g., 15%. 28%, 31%, 36%, 39.6%). The ordinary income rates apply because
he did not hold the stock more than 12 months.
Example:
Assume the same facts as in previous example, except that Aubrey sold the
shares on December 1, 2001. In this situation, he is entitled to use the new long-
term rate of 20% (or 10% if he is in a 15% tax bracket) because he held the stock
more than 12 months.
A. Schedule D is used to report capital gains and losses.
1. Form 1099-B, Box 2, is reported as the gross sales price. If the broker
advises the taxpayer that the net amount (gross minus commissions) was
reported to the IRS, then the taxpayer reports the net as the sales price.
2. Real estate transactions are reported to the taxpayer on Form 1099-S.
3. Sales expenses are added to the cost or basis of the property.
4. Short-term gains and losses for property held one year or less are
reported in Part I. Include short term gains and losses from partnerships,
S corporations, fiduciaries, and any short-term carryover, with current year
short-term gains and losses to determine the net.
5. Long-term gains and losses for property held more than one year or
eligible inherited property are reported in Part II. Part II also includes: all
capital gain distributions from regulated investment companies and real
estate investment trusts; the taxpayer's share of long-term gains or losses
from partnerships, S corporations, and fiduciaries; and long-term capital
loss carryovers.
6. Total net gain or loss is computed in Part III and combines short term and
long term.

7. Current year deduction for capital losses may be limited. The current year
loss and carryover is combined on a worksheet and the allowable
deduction is carried to Part III, and then to Form 1040.
a) The allowable capital loss deduction for any year is limited to the
lesser of:
(1) $3,000 ($1,500 if MFS), or
(2) The capital loss as shown on Schedule D, line 18.
Exercise 40:
Individuals who have capital losses in excess of capital gains MUST deduct the
excess, up to $3,000 ($1,500 if married filing a separate return), even if they do
NOT have ordinary income to offset it. (True or False).
True. If loss deductions exceed gross income for the tax year, the excess
is taken into account as negative taxable income up to $3,000
($1,500 if married filing a separate return).
b) Loss in excess of the current year allowable deduction is carried

over to later years until completely used up. The carryover will
retain its character as long-term or short-term.
c) When used in a later year, short-term losses are used before long-
term losses.
d) The carryover is figured on a worksheet and is the amount of the

net capital loss that exceeds the lesser of:
(1) The allowable capital loss deduction for the year, or
(2) The taxpayer's taxable income increased by the allowable

capital loss deduction for the year and the deduction for
personal exemptions. If deductions exceed gross income,
use the negative taxable income for this computation.
e) If MFS, the capital loss deduction is limited to $1,500. If the original

loss is determined on a joint return and the taxpayers now file
separate returns, the capital loss carryover can be deducted only
on the return of the person who actually had the loss.
Exercise 41: During 2001, Michael sold the following assets used in his business.

Machinery
Sales price $22,500
Original Cost $20,000
Accumulated depreciation $7,500
Computer Equipment:
Sales Price $17,000
Original cost $14,000
Accumulated depreciation $ 8,000
Michael had a net section 1231 loss in 2001 of $4,000. What is the amount and
character of his gain for 2001?
A. $19,500 ordinary income; $1,500 capital gain

B. $15,500 ordinary income; $1,500 capital gain
C. $8,000 ordinary income; $26,000 capital gain
D. $0 ordinary income; $21,000 capital gain
A. $19,500 ordinary income; $1,500 capital gain. The Section 1231

gain ($21,000) is recharacterized as ordinary income to the extent
of depreciation recaptured ($15,500). The remaining $5,500 portion
is also recharacterized as ordinary income to the extent of
unaccounted for Section 1231 loss over the preceding five years
($4,000).
B. A short sale occurs when the taxpayer agrees to sell property not owned or
property the taxpayer does own but does not wish to sell.
1. The taxpayer generally borrows property to deliver to the buyer.
2. At a later date, the taxpayer buys identical property and delivers it to the
lender to close the sale.
3. Gain or loss is not recognized until the sale is closed. Holding period is
determined by the time the taxpayer holds property delivered to the lender
to close the sale.
C. A wash sale occurs when the taxpayer sells stock or securities at a loss and
within 30 days before or after the sale:
1. Buys substantially identical stock or securities,
2. Acquires such stock or securities in a fully taxable trade, or
3. Acquires a contract or option to buy such stock or securities.

4. A loss on a wash sale is not deductible, but gain is taxable.
D. A commodity futures contract is a standardized, exchange-traded contract for the

sale or purchase of a fixed amount of a commodity at a future date for a fixed
price.
1. A §1256 contract that is acquired and remains open at the end of the tax
year will generally be treated as sold at its fair market value on the last
business day of the year (marked-to-market rules).
2. 60/40 rule - 60% of the gain or loss the taxpayer would have had on the
sale on the last business day will be treated as long-term capital gain or
loss. 40% will be treated as short-term capital gain or loss.
Installment Sales
A. Installment sales are sales in which one or more payments are received after the
close of the tax year. If a sale qualifies as an installment sale, it must be reported
under the installment method unless the taxpayer elects to report the entire gain
in the year of sale. The installment method of reporting can not be used if the
sale resulted in a loss.
1. Payments for the year consist of three components:
a) Interest, which is taxable interest income,
b) Return of basis, which is not taxed, and
c) Gain which may be taxed, postponed, or in some cases, excluded.
2. Form 6252, Installment Sale Income, is used to report the installment sale
and show the computation of gain. If the taxpayer elects not to have the
installment sale rules apply, the entire sale is reported on Schedule D or
Form 4797, Sale of Business Property. Electing out needs to be done on
the tax return for the year of the sale, including extensions.
3. Selling price is the total cost to the buyer. It includes: cash; FMV of any
property the seller receives; liabilities the buyer pays, assumes, or takes
the property subject to; and any selling expenses the buyer pays for the
seller.
4. Installment sale basis is the adjusted basis plus selling expenses and
depreciation recapture income.

5. Gross profit is the selling price, minus the installment sale basis, and any
gain excluded or deferred on the sale of a residence.
6. Contract price is the total amount the buyer will pay the seller, plus the
amount by which any liability assumed by the buyer exceeds the seller's
installment sale basis.
7. Gross profit percentage is the gross profit divided by the contract price.
This percentage will remain constant each year unless the contract is
revised. This percentage represents the portion of each payment that is
reported as gain from the sale.
8. Installment sale income is the payments received during the year (less
interest) multiplied by the gross profit percentage. This is the amount of
the yearly payments included in income.
NOTE: Familiarity with Form 6252, Installment Sale Income, or the following
worksheet will be very helpful when taking the exam. Identify the key terms and
where they fit in the installment sale computations.
A. Gross Profit
1. Selling price of old 1.
2. Adjusted basis of old 2.
3. Selling expenses 3.
4. Income from depreciation recapture 4.
5. Installment sale basis, add lines 2, 3, and 4 5.
6. Gain, line 1 minus line 5 6.
7. Residence excluded and postponed gain 7.
8. Gross profit, line 6 minus 7 8.
B. Contract Price
9. Mortgage and other debts buyer assumed 9.
10. Line 9 minus line 5 (If -0- or less, enter -0-) 10.
11. Line 1 minus line 9 11.
12. Contract price, line 10 plus line 11 12.
C. Gross Profit Percentage and Installment Sale Income

13. Divide line 8 by line 12 (enter as a %) 13.
14. Payments received during year (For year of sale, include line 10)14.
15. Multiply 14 by 13 15.
Exercise 42:

In 2001, Mr. Bradshaw sold property that had an adjusted basis to him of
$19,000. The buyer assumed Bradshaw's existing mortgage of $15,000 and
agreed to pay an additional $10,000 consisting of a cash down payment of
$5,000, and payments of $1,000, plus interest, per year for the next five (5)
years. Mr. Bradshaw paid selling expenses totaling $1,000. What is Bradshaw's
gross profit percentage?
A. 20%
B. 40%
C. 50%
D. 100%
C. 50%. Bradshaw’s gross profit percentage is 50%. It is calculated by

dividing the gross profit ($5,000) by the total contract price
($10,000). The gross profit is determined by subtracting the
adjusted basis ($19,000) and the sale expense($1,000) from the
total amount received ($25,000). The total contract price is
determined by subtracting the mortgage assumed by the buyer
($15,000) from the total amount received ($25,000).
B. Disposition of an installment obligation includes a sale, exchange, cancellation,

bequest, distribution, or transmission of the obligation. Gain or loss will be
reported in full in the year that the obligation is disposed of.
1. The amount of profit on the sale not yet received is the gross profit
percentage times the unpaid balance. The remainder of the unpaid
balance is the basis in the obligation.
2. If the taxpayer sells or exchanges the obligation, or accepts less than face
value in satisfaction of the obligation, gain or loss is the difference
between the basis in the obligation and the amount realized.
3. If disposed of in any other manner, such as by gift or cancellation, the gain

or loss is the difference between the basis in the obligation and its fair
market value at the time of the disposition.
4. If the taxpayer accepts part payment on the unpaid balance and forgives
the rest, it is treated as a sale or exchange. The gain or loss is the
difference between the basis in the obligation and the amount realized on
settlement.
5. If the selling price is reduced but the debt is not forgiven, it is not a
disposition but a renegotiation. The gross profit percentage must be
redetermined and applied to payments after the reduction.

6. If the buyer disposes of the property and the original seller agrees to let
the new buyer assume the original obligation, it is not treated as a
disposition.
7. A transfer due to death is not treated as a disposition unless the obligation

is transferred to the buyer.
Exercise 43:
During 2001, Juan sold a piece of unimproved real estate to Catherine for
$20,000. Juan acquired the property in 1985 for $10,000. During 2000, Juan
received $4,000 cash and Catherine’s note for $16, 000 as the balance of the
sales price, payable in subsequent years. Juan filed his 2001 return using the
installment method to report the sale. During 2002, before Catherine made any
further payment, Juan sold the note for $15,000 in cash to Frank. What is the
amount of the gain or (loss) Juan will show on his 2002 income tax return?
A. ($1,000)
B. $0
C. $7,000
D. $9,000
C. $7,000. The amount Juan will show on his income tax return is a
gain of $7,000. If an installment obligation is sold, the gain or loss is
the difference between the “basis” of the obligation and the “amount
realized” by the holder of the obligation. “Basis” is defined as the
excess of the face amount of the obligation over the income that
would be returnable if it were paid in full. “Amount realized” includes
the cash paid or credit to the account of the seller. The selling price
($20,000) less the down payment received ($4,000) and less the
installments received prior to sale ($0) results in the balance unpaid
($16,000). The balance unpaid ($16,000) less the remaining
income returnable (50% gross profit ratio x balance unpaid
($16,000)) results in the basis of the obligation ($8,000). The
amount realized on the sale of the note ($15,000) less the basis of
the obligation ($8,000) results in the gain to the taxpayer of $7,000.
C. Repossession, after an installment sale, requires a determination of gain or loss

on repossession and a redetermination of the basis in the repossessed property.
1. For personal property, gain or loss is determined by subtracting the basis

in the installment obligation and any expenses of repossession from the
fair market value of the property. The new basis in the property is the fair
market value at the time of repossession.

2. The repossession of real property restores the taxpayer to approximately

the same position as prior to the sale. The basis in the property is the
original basis. The taxpayer reports gain on the sale which is the gross
profit from the original sale, minus the sum of gain previously reported and
the repossession costs.
17. Selling Your Home (Pub. 523)
Important Reminders If you have not deducted all the points you paid
Home sold with to secure a mortgage on your old home, you
may be able to deduct the remaining points in
undeducted points. the year of sale. See Points in Part I of
Publication 936, Home Mortgage Interest
Deduction.
A. Gain or loss from Sale of Residence

Generally, your main home is the one in which you live most of the time.
Gain.
If you have a gain from the sale of your main home, you may be able to exclude
from income up to a limit of $250,000 ($500,000 on a joint return in most cases).
Loss.
You cannot deduct a loss from the sale of your main home.
Worksheets.
Publication 523, Selling Your Home, includes worksheets to help you figure the
adjusted basis of the home you sold, the gain (or loss) on the sale, and the
amount of the gain that you can exclude.
Reporting the sale.

Do not report the sale of your main home on your tax return unless you have a
gain and at least part of it is taxable. Report any taxable gain on Schedule D
(Form 1040).
Main Home
Usually, the home you live in most of the time is your main home and can be a:
• House,
• Houseboat,
• Mobile home,
• Cooperative apartment, or
• Condominium.

To exclude gain under the rules of this chapter, you generally must have owned and
lived in the property as your main home for at least 2 years during the 5-year period
ending on the date of sale.
More than one home.

If you have more than one home, only the sale of your main home qualifies for
postponing or excluding gain. If you have two homes and live in both of them, your main
home is ordinarily the one you live in most of the time.
Example
You own and live in a house in town. You also own a beach house, which you
use in the summer months. The town house is your main home; the beach house
is not.
Example
You own a house, but you live in another house that you rent. The rented home
is your main home.
Property used partly as your home.

If you use only part of the property as your main home, the rules discussed in this
chapter apply only to the gain or loss on the sale of that part of the property. For details,
see Property used partly as your home and partly for business or rental during the year
of sale under Business Use or Rental of Home, later.
Rules for Sales in 2001

Use the rules in this chapter if you sold your main home in 2001.
You may be able to exclude any gain from income up to a limit of $250,000 ($500,000
on a joint return in most cases). If you can exclude all of the gain, you do not need to
report the sale on your tax return.
If you have gain that cannot be excluded, it is taxable. Report it on Schedule D (Form
1040).
The main topics in this chapter are:
• How to figure gain or loss,
• Basis,
• Excluding the gain,
• Ownership and use tests,
• Special situations,
• Reporting the gain, and
• Real estate and transfer taxes.
This chapter includes worksheets you can use to figure your gain (or loss) and your
exclusion. Use Worksheet 1 to figure the adjusted basis of the home you sold. Use

Worksheet 2 to figure the gain (or loss), the exclusion, and the taxable gain (if any) on
the sale. In some situations, you may also need to use Worksheet 3 to figure a reduced
maximum exclusion.
How To Figure Gain or Loss On the Sale

To figure the gain or loss on the sale of your main home, you must know the selling
price, the amount realized, and the adjusted basis.
Selling price
The selling price is the total amount you receive for your home. It includes money, all
notes, mortgages, or other debts assumed by the buyer as part of the sale, and the
fair market value of any other property or any services you receive.
Amount realized
The amount realized is the selling price minus selling expenses.
Selling expenses
• Selling expenses include:
• Commissions,
• Advertising fees,
• Legal fees, and
• Loan charges paid by the seller, such as loan placement fees or "points."
Amount of gain or loss

When you know the amount realized and the home's adjusted basis, you can figure
your gain or loss. If the amount realized is more than the adjusted basis, the
difference is a gain and, except for any part you can exclude, generally is taxable.
To figure your home's adjusted basis, see Basis, later.
Jointly owned home

If you and your spouse sell your jointly owned home and file a joint return, you figure
your gain or loss as one taxpayer.
Separate returns
If you file separate returns, each of you must figure and report your own gain or loss
according to your ownership interest in the home. Your ownership interest is
determined by state law.
Joint owners not married

If you and a joint owner other than your spouse sell your jointly owned home, each
of you must figure and report your own gain or loss according to your ownership
interest in the home. Each of you applies the rules discussed in this chapter on an
individual basis.

Trading homes
If you trade your old home for another home, treat the trade as a sale and a
purchase.
Example. You owned and lived in a home that had an adjusted basis of
$41,000. A real estate dealer accepted your old home as a trade-in and allowed
you $50,000 toward a new house priced at $80,000. You are considered to have
sold your old home for $50,000 and to have had a gain of $9,000 ($50,000 -
$41,000).
If the dealer had allowed you $27,000 and assumed your unpaid mortgage of
$23,000 on your old home, your sales price would still be $50,000 (the $27,000
trade-in allowed plus the $23,000 mortgage assumed).
Foreclosure or repossession
If your home was foreclosed on or repossessed, you have a sale.
Gain On Sale
You will generally exclude all or part of the gain on the sale of your main home under
the new rules. If you sold your home before 1998 different rules could apply. For
more information and the rules that could apply to you, get Publication 523.
Loss on Sale
You cannot deduct a loss on the sale of your home. It is a personal loss.
Basis
You will need to know your basis in your home as a starting point for determining
any gain or loss when you sell it. Your basis in your home is determined by how you
got the home. Your basis is its cost if you bought it or built it. If you got it in some
other way, its basis is either its fair market value when you received it or the
adjusted basis of the person you received it from.
While you owned your home, you may have made adjustments (increases or
decreases) to the basis. This adjusted basis is used to figure gain or loss on the sale
of your home.
Settlement fees or closing costs.

When buying your home, you may have to pay settlement fees or closing costs in
addition to the contract price of the property. You can include in your basis the
settlement fees and closing costs you pay for buying the home. You cannot include
in your basis the fees and costs for getting a mortgage loan. A fee for buying the
home is any fee you would have had to pay even if you paid cash for the home.

Adjusted Basis
Adjusted basis is your basis increased or decreased by certain amounts.
Increases to basis
These include any:
• Improvements that have a useful life of more than 1 year,
• Additions,
• Special assessments for local improvements, and
• Amounts you spent after a casualty to restore damaged property.
Decreases to basis
These include any:
• Gain you postponed from the sale of a previous home before May 7, 1997,
• Deductible casualty losses,
• Insurance payments you received or expect to receive for casualty losses,
• Payments you received for granting an easement or right-of-way,
• Depreciation allowed or allowable if you used your home for business or
rental purposes.
Improvements
These add to the value of your home, prolong its useful life, or adapt it to new uses.
You add the cost of improvements to the basis of your property.
Examples. Putting a recreation room in your unfinished basement, adding

another bathroom or bedroom, putting up a new fence, putting in new plumbing
or wiring, putting on a new roof, or paving your unpaved driveway are
improvements.
Repairs
These maintain your home in good condition but do not add to its value or prolong its
life. You do not add their cost to the basis of your property.
Examples. Repainting your house inside or outside, fixing your gutters or floors,
repairing leaks or plastering, and replacing broken window panes are examples
of repairs.
Recordkeeping
You should keep records to prove your home's adjusted basis. Ordinarily, you must
keep records for 3 years after the due date for filing your return for the tax year in
which you sold your home. But if the basis of your old home affects the basis of your
new one, such as when you sold your old home before May 7, 1997, and postponed
tax on any gain, you should keep those records as long as they are needed for tax
purposes. The records you should keep include:
• Proof of the home's purchase price and purchase expenses,

• Receipts and other records for all improvements, additions, and other
items that affect the home's adjusted basis,
• Any worksheets you used to figure the adjusted basis of the home you
sold, the gain or loss on the sale, the exclusion, and the taxable gain,
• Any Form 2119 that you filed to postpone gain from the sale of a previous
home before May 7, 1997, and
• Any worksheets you used to prepare Form 2119, such as the Adjusted
Basis of Home Sold Worksheet or the Capital Improvements Worksheet
from the Form 2119 instructions.
Excluding The Gain

You may qualify to exclude from your income all or part of any gain from the sale of
your main home. This means that, if you qualify, you will not have to pay tax on the
gain up to the limit described under Maximum Amount of Exclusion, next. To qualify,
you must meet the ownership and use tests described later.
You can choose not to take the exclusion. In that case, you will have to pay tax on
your entire gain, unless you choose to use the rules in chapter 3 of Publication 523.
Maximum Amount of Exclusion

You can exclude the entire gain on the sale of your main home up to:
• $250,000, or
• $500,000 if all of the following are true.
• You are married and file a joint return for the year.
• Either you or your spouse meets the ownership test.
• Both you and your spouse meet the use test.
• During the 2-year period ending on the date of the sale, neither you nor
your spouse excluded gain from the sale of another home (not counting
any sales before May 7, 1997).
More Than One Home Sold During 2-Year Period

You cannot exclude gain on the sale of your home if, during the 2-year period ending
on the date of the sale, you sold another home at a gain and excluded all or part of
that gain. If you cannot exclude the gain, you must include it in your income.
However, if you sold the home due to a change in health or place of employment,
you can still claim an exclusion. The maximum amount you can exclude is reduced.
See Reduced Maximum Exclusion, earlier.
Ownership and Use Tests

To claim the exclusion, you must meet the ownership and use tests. This means that
during the 5-year period ending on the date of the sale, you must have:
1. Owned the home for at least 2 years (the ownership test), and

2. Lived in the home as your main home for at least 2 years (the use test).
Exception. If you owned and lived in the property as your main home for less than 2
years, you can still claim an exclusion in some cases. The maximum amount you can
claim will be reduced. See Reduced Maximum Exclusion, earlier.
Period of ownership and use. The required 2 years of ownership and use during the
5-year period ending on the date of the sale do not have to be continuous.
You meet the tests if you can show that you owned and lived in the property as your
main home for either 24 full months or 730 days (365 × 2) during the 5-year period
ending on the date of sale.
Temporary absence. Short temporary absences for vacations or other seasonal

absences, even if you rent the property during the absences, are counted as periods of
use. See Ownership and use tests met at different times, later.
Example. Professor Paul Beard, who is single, bought and moved into a house
on August 28, 1998. He lived in it as his main home continuously until January 5,
2000, when he went abroad for a 1-year sabbatical leave. During part of the
period of leave, the house was unoccupied, and during the rest of the period, he
rented it. On January 5, 2001, he sold the house at a gain.
Because his leave was not a short temporary absence, he cannot include the
period of leave to meet the 2-year use test. He cannot exclude any part of his
gain, unless he sold the house due to a change in place of employment or health,
as explained under Reduced Maximum Exclusion, earlier. Even if he did sell the
house due to a change in place of employment or health, he cannot exclude the
part of the gain equal to the depreciation he claimed while renting the house. See
Depreciation for business use after May 6, 1997, later.
Ownership and use tests met at different times. You can meet the ownership and
use tests during different 2-year periods. However, you must meet both tests during the
5-year period ending on the date of the sale.
Example. In 1992, Helen Jones lived in a rented apartment. The apartment

building was later changed to a condominium, and she bought her apartment on
December 1, 1998. In 1999, Helen became ill and on April 14 of that year she
moved to her daughter's home. On July 10, 2001, while still living in her
daughter's home, she sold her apartment.
Helen can exclude gain on the sale of her apartment because she met the
ownership and use tests. Her 5-year period is from July 11, 1996, to July 10,
2001, the date she sold the apartment. She owned her apartment from
December 1, 1998, to July 10, 2001 (over 2 years). She lived in the apartment

from July 11, 1996 (the beginning of the 5-year period), to April 14, 1999 (over 2
years).
Cooperative apartment. If you sold stock in a cooperative housing corporation, the

ownership and use tests are met if, during the 5-year period ending on the date of sale,
you:
1. Owned the stock for at least 2 years, and

2. Lived in the house or apartment that the stock entitles you to occupy as your
main home for at least 2 years.
Exception for individuals with a disability. There is an exception to the use test if
during the 5-year period before the sale of your home:
1. You become physically or mentally unable to care for yourself, and

2. You owned and lived in your home as your main home for a total of at least 1
year.
Under this exception, you are considered to live in your home during any time that you
own the home and live in a facility (including a nursing home) that is licensed by a state
or political subdivision to care for persons in your condition.
If you meet this exception to the use test, you still have to meet the 2-out-of-5-year
ownership test to claim the exclusion.
Gain postponed on sale of previous home. For the ownership and use tests, you
may be able to add the time you owned and lived in a previous home to the time you
lived in the home on which you wish to exclude gain. You can do this if you postponed
all or part of the gain on the sale of the previous home because of buying the home on
which you wish to exclude gain.
Previous home destroyed or condemned. For the ownership and use tests, you add
the time you owned and lived in a previous home that was destroyed or condemned to
the time you owned and lived in the home on which you wish to exclude gain. This rule
applies if any part of the basis of the home you sold depended on the basis of the
destroyed or condemned home. Otherwise, you must have owned and lived in the
same home for 2 of the 5 years before the sale to qualify for the exclusion.
Married Persons
If you and your spouse file a joint return for the year of sale, you can exclude gain if
either spouse meets the ownership and use tests. (But see Maximum Amount of
Exclusion, earlier.)

Example 1 - one spouse sells a home. Emily sells her home in June 2001. She
marries Jamie later in the year. She meets the ownership and use tests, but
Jamie does not. She can exclude up to $250,000 of gain on a separate or joint
return for 2001.
Example 2 - each spouse sells a home. The facts are the same as in Example
1 except that Jamie also sells a home. He meets the ownership and use tests on
his home. Emily and Jamie can each exclude up to $250,000 of gain.
Death of spouse before sale. If your spouse died before the date of sale, you are
considered to have owned and lived in the property as your main home during any
period of time when your spouse owned and lived in it as a main home.
Home transferred from spouse. If your home was transferred to you by your spouse
(or former spouse if the transfer was incident to divorce), you are considered to have
owned it during any period of time when your spouse owned it.
Use of home after divorce. You are considered to have used property as your main
home during any period when:
1. You owned it, and
2. Your spouse or former spouse is allowed to live in it under a divorce or
separation instrument.
Business Use or Rental of Home

You may be able to exclude your gain from the sale of a home that you have used
for business or to produce rental income. But you must meet the ownership and use
tests.
Example 1. On May 30, 1995, Amy bought a house. She moved in on that date
and lived in it until May 31, 1997, when she moved out of the house and put it up
for rent. The house was rented from June 1, 1997, to March 31, 1999. Amy
moved back into the house on April 1, 1999, and lived there until she sold it on
January 31, 2001. During the 5-year period ending on the date of the sale
(February 1, 1996 - January 31, 2001), Amy owned and lived in the house for
more than 2 years as shown in the table below.
Five Year
Used as Home Used as Rental
Period
2/1/96 - 5/31/97 16 months
6/1/97 - 3/31/99 22 months
4/1/99 - 1/31/01 22 months
38 months 22 months
Amy can exclude gain up to $250,000. But she cannot exclude the part of the
gain equal to the depreciation she claimed for renting the house, as explained
after Example 2.

Example 2. William owned and used a house as his main home from 1995
through 1998. On January 1, 1999, he moved to another state. He rented his
house from that date until April 30, 2001, when he sold it. During the 5-year
period ending on the date of sale (May 1, 1996 - April 30, 2001), William owned
and lived in the house for 32 months (more than 2 years). He can exclude gain
up to $250,000. However, he cannot exclude the part of the gain equal to the
depreciation he claimed for renting the house, as explained next.
Depreciation for business use after May 6, 1997

If you were entitled to take depreciation deductions because you used your home for
business purposes or as rental property, you cannot exclude the part of your gain
equal to any depreciation allowed or allowable as a deduction for periods after May
6, 1997. If you can show by adequate records or other evidence that the
depreciation deduction allowed was less than the amount allowable, the amount you
cannot exclude is the smaller figure.
Example. Ray sold his main home in 2001 at a $30,000 gain. He meets the
ownership and use tests to exclude the gain from his income. However, he used
part of the home for business in 2000 and claimed $500 depreciation. He can
exclude $29,500 ($30,000 - $500) of his gain. He has a taxable gain of $500.
Property used partly as your home and partly for business or rental during the
year of sale. In the year of sale you may have used part of your property as your
home and part of it for business or to produce income.
Examples are:
• A working farm on which your house is located,
• An apartment building in which you live in one unit and rent out the others,
• A store building with an upstairs apartment in which you live, or
• A home with a room used for business or to produce income.
If you sell the entire property you should consider the transaction as the sale of two
properties. The sale of the part of your property used for business or rental is
reported on Form 4797, Sales of Business Property . For more information, see
Property used partly as your home and partly for business or rental during the year
of sale, under Business Use or Rental of Home, in chapter 2 of Publication 523.
Reporting the Gain

If you have any taxable gain on the sale of your main home, report the entire gain
realized on Schedule D (Form 1040), Capital Gains and Losses, with your return.
Report it on line 1 or line 8 of Schedule D, depending on how long you owned the
home. If you qualify for an exclusion, show it on the line directly below the line on

which you report the gain. Write "Section 121 exclusion" in column (a) of that line
and show the amount of the exclusion in column (f) as a loss (in parentheses).
Tax rate on capital gains.

Your net capital gain is taxed at a tax rate of 10%, 15%, 20%, 25%, or 28%,
depending on your situation.
Installment sale.
Some sales are made under arrangements that provide for part or all of the selling
price to be paid in a later year. These sales are called installment sales. If you
finance the buyer's purchase of your home yourself, instead of having the buyer get
a loan or mortgage from a bank, you may have an installment sale. If the sale
qualifies, you can report the part of the gain you cannot exclude on the installment
basis. Use Form 6252, Installment Sale Income, to report the sale.
Seller-financed mortgage.
If you sell your home and hold a note, mortgage, or other financial agreement, the
payments you receive generally consist of both interest and principal. You must
report the interest you receive as part of each payment separately as interest
income. If the buyer of your home uses the property as a main or second home, you
must also report the name, address, and social security number (SSN) of the buyer
on line 1 of either Schedule B (Form 1040) or Schedule 1 (Form 1040A). The buyer
must give you his or her SSN and you must give the buyer your SSN. Failure to
meet these requirements may result in a $50 penalty for each failure. If you or the
buyer does not have and is not eligible to get an SSN.
Individual taxpayer identification number (ITIN).

If either you or the buyer of your home is a nonresident or resident alien who does
not have and is not eligible to get an SSN, the IRS will issue you (or the buyer) an
ITIN. To apply for an ITIN, file Form W-7 with the IRS.
If you have to include the buyer's SSN on your return and the buyer does not have
and cannot get an SSN, enter the buyer's ITIN. If you have to give an SSN to the
buyer and you do not have and cannot get one, give the buyer your ITIN.
An ITIN is for tax use only. It does not entitle the holder to social security benefits or
change the holder's employment or immigration status under U.S. law.

PART 4 - ADJUSTMENTS, DEDUCTIONS, CREDITS AND TAXES
In this part we discuss three of the adjustments to income that you can deduct in
figuring your adjusted gross income. These sections cover:
• Contributions you make to traditional individual retirement arrangements (IRAs),

• Moving expenses you pay, and
• Alimony you pay
Some other adjustments to income are discussed in other parts of this publication or in
other publications and instructions. They are deductions for:
• Interest paid on student loans -- instructions for Form 1040, line 24, or Form
1040A, line 17,
• Self-employment tax,
• Self-employed health insurance,
• Payments to self-employed SEP, SIMPLE, and qualified plans -- Publication 560,
Retirement Plans for Small Business,
• Penalty on early withdrawal of savings,
• Expenses from the rental of personal property,
18. Individual Retirement Arrangements (IRAs)

An individual retirement arrangement (IRA) is a personal savings plan that offers you
tax advantages to set aside money for your retirement.
We will discusses:
1. The rules for a traditional IRA (those that are not Roth or SIMPLE IRAs), and
2. The Roth IRA, which features nondeductible contributions and tax-free
distributions.
Traditional IRAs
A traditional IRA is any IRA that is not a Roth IRA or a SIMPLE IRA. Two
advantages of a traditional IRA are:
1. You may be able to deduct some or all of your contributions to it, depending on
your circumstances, and,
2. Generally, amounts in your IRA, including earnings and gains, are not taxed until
they are distributed.
Who Can Set Up a Traditional IRA?

You can set up and make contributions to a traditional IRA if:

You (or, if you file a joint return, your spouse) received taxable compensation during
the year, and
You were not age 70 1/2 by the end of the year.
What is compensation? Compensation includes wages, salaries, tips, professional

fees, bonuses, and other amounts you receive for providing personal services. The
IRS treats as compensation any amount properly shown in box 1 (Wages, tips, other
compensation) of Form W-2, Wage and Tax Statement, provided that amount is
reduced by any amount properly shown in box 11 (Nonqualified plans). Scholarship
and fellowship payments are compensation for this purpose only if shown in box 1 of
Form W-2. Compensation also includes commissions and taxable alimony and
separate maintenance payments.
Self-employment income. If you are self-employed (a sole proprietor or a partner),

compensation is the net earnings from your trade or business (provided your
personal services are a material income-producing factor) reduced by the total of:
1. The deduction for contributions made on your behalf to retirement plans, and
2. The deduction allowed for one-half of your self-employment taxes.
Compensation includes earnings from self-employment even if they are not subject
to self-employment tax because of your religious beliefs. See Publication 533, Self-
Employment Tax, for more information.
When and How Can a Traditional IRA Be Set Up?

You can set up a traditional IRA at any time. However, the time for making
contributions for any year is limited. See When Can Contributions Be Made, later.
You can set up different kinds of IRAs with a variety of organizations. You can set up
an IRA at a bank or other financial institution or with a mutual fund or life insurance
company. You can also set up an IRA through your stockbroker. Any IRA must meet
Internal Revenue Code requirements.
Kinds of traditional IRAs. Your traditional IRA can be an individual retirement

account or annuity. It can be part of either a simplified employee pension (SEP) or
an employer or employee association trust account.
How Much Can Be Contributed?

There are limits and other rules that affect the amount that can be contributed and
the amount you can deduct. These limits and other rules are explained below.
Community property laws. Except as discussed later under Spousal IRA limit,
each spouse figures his or her limit separately, using his or her own compensation.
This is the rule even in states with community property laws.

Brokers' commissions. Brokers' commissions paid in connection with your

traditional IRA are subject to the contribution limit.
General limit. The most that can be contributed to your traditional IRA is the smaller
of the following amounts:
1. Your compensation (defined earlier) that you must include in income for the year,
or
2. $2,000 for 2001 ($3,000 for 2002 or $3,500 for 2002 if you are 50 or older).
This is the most that can be contributed regardless of whether the contributions are
to one or more traditional IRAs or whether all or part of the contributions are
nondeductible. (See Nondeductible Contributions, later.)
Example 1. Betty, who is single, earned $24,000 in 2001. Her IRA contributions
for 2001 are limited to $2,000.
Example 2. John, a college student working part time, earned $1,500 in 2001. His
IRA contributions for 2001 are limited to $1,500, the amount of his compensation.
Spousal IRA limit. If you file a joint return and your taxable compensation is less
than that of your spouse, the most that can be contributed for the year to your IRA is
the smaller of the following amounts:
$2,000 for 2001 ($3,000 for 2002 or $3,500 for 2002 if you are 50 or older), or
The total compensation includible in the gross income of both you and your spouse
for the year, reduced by the following two amounts.
1. Your spouse's contribution for the year to a traditional IRA.

2. Any contribution for the year to a Roth IRA on behalf of your spouse.
This means that the total combined contributions that can be made for the year to
your IRA and your spouse's IRA can be as much as $4,000 for 2001 ($6,000 for
2002, or $6,500 for 2002 if only one of you is 50 or older, or $7,000 for 2002 if both
of you are 50 or older).
When Can Contributions Be Made?

As soon as you set up your traditional IRA, contributions can be made to it through
your chosen sponsor (trustee or other administrator). Contributions to a traditional
IRA must be in the form of money (cash, check, or money order). Property cannot be
contributed.
Contributions must be made by due date. Contributions can be made to your

traditional IRA for a year at any time during the year or by the due date for filing your

return for that year, not including extensions. For most people, this means that
contributions for 2001 must be made by April 15, 2002.
Age 70 1/2 rule. Contributions cannot be made to your traditional IRA for the year in
which you reach age 70 1/2 or for any later year.
Designating year for which contribution is made. If an amount is contributed to

your traditional IRA between January 1 and April 15, you should tell the sponsor to
which year (the current year or the previous year) the contribution is for. If you do not
tell the sponsor which year it is for, the sponsor can assume, and report to the IRS,
that the contribution is for the current year (the year the sponsor received it).
Filing before a contribution is made. You can file your return claiming a traditional
IRA contribution before the contribution is actually made. However, the contribution
must be made by the due date of your return, not including extensions.
Contributions not required. You do not have to contribute to your traditional IRA
for every tax year, even if you can.
How Much Can I Deduct?

Generally, you can deduct the lesser of:
y The contributions to your traditional IRA for the year, or

y The general limit (or the spousal IRA limit, if it applies).
However, if you or your spouse was covered by an employer retirement plan, you
may not be able to deduct this amount. See Limit if Covered by Employer Plan, later.
Trustees' fees. Trustees' administrative fees that are billed separately and paid in
connection with your traditional IRA are not deductible as IRA contributions.
However, they may be deductible as a miscellaneous itemized deduction on
Schedule A (Form 1040). See chapter 30.
Brokers' commissions. Brokers' commissions are part of your IRA contribution

and, as such, are deductible subject to the limits.
Full deduction. If neither you nor your spouse was covered for any part of the year
by an employer retirement plan, you can take a deduction for total contributions to
one or more traditional IRAs of up to the lesser of:
1. $2,000 for 2001 ($3,000 for 2002 or $3,500 for 2002 if you are 50 or
older), or
2. 100% of your compensation.

This limit is reduced by any contributions made to a 501(c)(18) plan on your behalf.
Spousal IRA. In the case of a married couple with unequal compensation who file a
joint return, the deduction for contributions to the traditional IRA of the spouse with
less compensation is limited to the lesser of:
1. $2,000 for 2001 ($3,000 for 2002 or $3,500 for 2002 if 50 or older), or
2. The total compensation includible in the gross income of both spouses for the
year reduced by the following two amounts.
The IRA deduction for the year of the spouse with the greater compensation.
Any contributions for the year to a Roth IRA on behalf of the spouse with more
compensation.
This limit is reduced by any contributions to a 501(c)(18) plan on behalf of the
spouse with less compensation.
Note. If you were divorced or legally separated (and did not remarry) before the end
of the year, you cannot deduct any contributions to your spouse's IRA. After a
divorce or legal separation, you can deduct only contributions to your own IRA and
your deductions are subject to the rules for single individuals.
Covered by an employer retirement plan. If you or your spouse was covered by

an employer retirement plan at any time during the year for which contributions were
made, your deduction may be further limited. This is discussed later under Limit If
Covered by Employer Plan. Limits on the amount you can deduct do not affect the
amount that can be contributed. See Nondeductible Contributions, later.
Can I Move Retirement Plan Assets?

Traditional IRA rules permit you to transfer, tax free, assets (money or property) from
other retirement plans (including traditional IRAs) to a traditional IRA. The rules
permit the following kinds of transfers.
y Transfers from one trustee to another.

y Rollovers.
y Transfers incident to a divorce.
Transfers to Roth IRAs. Under certain conditions, you can move assets from a
traditional IRA to a Roth IRA. See Can I Move Amounts Into a Roth IRA? under Roth
IRAs, later.
Trustee-to-Trustee Transfer
A transfer of funds in your traditional IRA from one trustee directly to another, either
at your request or at the trustee's request, is not a rollover. Because there is no
distribution to you, the transfer is tax free. Because it is not a rollover, it is not
affected by the 1-year waiting period required between rollovers, discussed later

under Rollover From One IRA Into Another. For information about direct transfers to
IRAs from retirement plans other than IRAs, see Publication 590.
Rollovers
Generally, a rollover is a tax-free distribution to you of cash or other assets from one
retirement plan that you contribute (roll over) to another retirement plan. The
contribution to the second retirement plan is called a "rollover contribution."
Note. The amount you roll over tax free is generally taxable when the new plan
distributes that amount to you or your beneficiary.
Kinds of rollovers to an IRA. There are two kinds of rollover contributions to a

traditional IRA.
You put amounts you receive from one traditional IRA into the same or another
traditional IRA.
You put amounts you receive from an employer's qualified retirement plan for its
employees into a traditional IRA.
Distributions after December 31, 2001, can be rolled over into a traditional IRA from:
1. A deferred compensation plan of a state or local government (section 457 plan),

or
2. A tax-sheltered annuity (section 403(b).
For more information, see Publication 553, Highlights of 2001 Tax Changes.
Treatment of rollovers. You cannot deduct a rollover contribution, but you must
report the rollover distribution on your tax return as discussed later under Reporting
rollovers from IRAs and under Reporting rollovers from employer plans.
Kinds of rollovers from an IRA. For distributions after December 31, 2001, you
can roll over, tax free, a distribution from your IRA into a qualified plan, including a
deferred compensation plan of a state or local government (section 457 plan) and a
tax-sheltered annuity (section 403(b) plan). The part of the distribution that you can
roll over is the part that would otherwise be taxable (includible in your income).
Qualified plans may, but are not required to, accept such rollovers. Rules applicable
to other rollovers, such as the 60-day time limit, apply.
Time limit for making a rollover contribution. You, generally, must make the
rollover contribution by the 60th day after the day you receive the distribution from
your traditional IRA or your employer's plan.

For distributions made after December 31, 2001, the IRS may waive the 60-day
requirement where the failure to do so would be against equity or good conscience,
such as a casualty, disaster, or other event beyond your reasonable control.
Extension of rollover period. If an amount distributed to you from a traditional IRA or

a qualified employer retirement plan is a frozen deposit at any time during the 60-
day period allowed for a rollover, special rules extend the rollover period. For more
information, get Publication 590.
Rollover From One IRA Into Another

You can withdraw, tax free, all or part of the assets from one traditional IRA if you
reinvest them within 60 days in the same or another traditional IRA. Because this is
a rollover, you cannot deduct the amount that you reinvest in an IRA.
Waiting period between rollovers. If you make a tax-free rollover of any part of a
distribution from a traditional IRA, you cannot, within a 1-year period, make a tax-
free rollover of any later distribution from that same IRA. You also cannot make a
tax-free rollover of any amount distributed, within the same 1-year period, from the
IRA into which you made the tax-free rollover.
The 1-year period begins on the date you receive the IRA distribution, not on the
date you roll it over into an IRA.
Example. If you have two traditional IRAs, IRA-1 and IRA-2, and you make a tax-
free rollover of a distribution from IRA-1 into a new traditional IRA (IRA-3), you
can also make a tax-free rollover of a distribution from IRA-2 into IRA-3 (or into
any other traditional IRA) within 1 year of the distribution from IRA-1. These can
both be tax-free rollovers because you have not received more than one
distribution from either IRA within 1 year. However, you cannot, within the 1-year
period, make a tax-free rollover of any distribution from IRA-3 into another
traditional IRA.
Rollover From Employer's Plan Into an IRA

If you receive an eligible rollover distribution from your (or your deceased spouse's)
employer's qualified pension, profit-sharing or stock bonus plan, annuity plan, or tax-
sheltered annuity plan (403(b) plan), you can roll over all or part of it into a traditional
IRA.
For distributions made after December 31, 2001, if you receive an eligible rollover
distribution from your (or your deceased spouse's) governmental deferred
compensation plan (section 457 plan), you can roll over all or part of it into a
traditional IRA.
Eligible rollover distribution. Generally, an eligible rollover distribution is the

taxable part of any distribution of all or part of the balance to your credit in a qualified
retirement plan.

Maximum rollover. The most that you can roll over is the taxable part of any eligible
rollover distribution (defined earlier). All of the distribution you receive generally will
be taxable unless you have made nondeductible employee contributions to the plan.
When Can I Withdraw or Use IRA Assets?

There are rules limiting use of your IRA assets and distributions from it. Violation of
the rules generally results in additional taxes in the year of violation. See What Acts
Result in Penalties.
Age 59 1/2 rule. Generally, if you are under age 59 1/2, you must pay a 10%
additional tax on the distribution of any assets (money or other property) from your
traditional IRA. Distributions before you are age 59 1/2 are called early distributions.
The 10% additional tax applies to the part of the distribution that you have to include
in gross income. It is in addition to any regular income tax on that amount.
Early distributions tax. The 10% additional tax on distributions made before you
reach age 59 1/2 does not apply to these tax-free withdrawals of your contributions.
However, the distribution of interest or other income must be reported on Form 5329
and, unless the distribution qualifies as an exception to the age 59 1/2 rule, it will be
subject to this tax.
When Must I Withdraw IRA Assets? (Required Distributions)

You cannot keep funds in your traditional IRA indefinitely. Eventually they must be
distributed. If there are no distributions, or if the distributions are not large enough,
you may have to pay a 50% excise tax on the amount not distributed as required.
See Excess Accumulations (Insufficient Distributions), later. The requirements for
distributing IRA funds differ depending on whether you are the IRA owner or the
beneficiary of a decedent's IRA.
Required distributions not eligible for rollover. Amounts that must be distributed
(required distributions) during a particular year are not eligible for rollover treatment.
IRA owners. If you are the owner of a traditional IRA, by April 1 of the year following
the year in which you reach age 70 1/2, you must either:
1. Receive the entire balance in your IRA, or

2. Start receiving periodic distributions from your IRA.
April 1 of the year following the year in which you reach age 70 1/2 is referred to as
the required beginning date.

More information. For more information, including how to figure your minimum
required distribution each year and how to figure your required distribution if you are
a beneficiary of a decedent's IRA, see Publication 590.
Are Distributions Taxable?

In general, distributions from a traditional IRA are taxable in the year you receive
them.
Ordinary income. Distributions from traditional IRAs that you include in income are
taxed as ordinary income.
Distributions Fully or Partly Taxable

Distributions from your traditional IRA may be fully or partly taxable, depending on
whether your IRA includes any nondeductible contributions.
Fully taxable. If only deductible contributions were made to your traditional IRA (or
IRAs, if you have more than one), you have no basis in your IRA. Because you have
no basis in your IRA, any distributions are fully taxable when received. See
Reporting taxable distributions on your return, later.
Partly taxable. If you made nondeductible contributions to any of your traditional

IRAs, you have a cost basis (investment in the contract) equal to the amount of
those contributions. These nondeductible contributions are not taxed when they are
distributed to you. They are a return of your investment in your IRA.
Roth IRAs
Regardless of your age, you may be able to establish and make nondeductible
contributions to a retirement plan called a Roth IRA.
You can make contributions for 2001 by the due date (not including extensions) for
filing your 2001 tax return. This means that most people can make contributions for
2001 by April 15, 2002.
Contributions not reported. You do not have to report Roth IRA contributions on
your return.
What Is a Roth IRA?

A Roth IRA is an individual retirement plan that, except as explained in this chapter,
is subject to the rules that apply to a traditional IRA (defined below). It can be either
an account or an annuity. Individual retirement accounts and annuities are described
in Publication 590.
To be a Roth IRA, the account or annuity must be designated as a Roth IRA when it
is set up. Neither a SEP-IRA nor a SIMPLE IRA can be designated as a Roth IRA.

Unlike a traditional IRA, you cannot deduct contributions to a Roth IRA. But, if you
satisfy the requirements, qualified distributions (discussed later) are tax free.
Contributions can be made to your Roth IRA after you reach age 70 1/2 and you can
leave amounts in your Roth IRA as long as you live.
Traditional IRA. A traditional IRA is any IRA that is not a Roth IRA or SIMPLE IRA.
Can I Contribute to a Roth IRA?

Generally, you can contribute to a Roth IRA if you have taxable compensation
(defined later) and your modified AGI (defined later) is less than:
• $160,000 for married filing jointly,

• $10,000 for married filing separately and you lived with your spouse at any time
during the year, and
• $110,000 for single, head of household, qualifying widow(er) or married filing
separately and you did not live with your spouse at any time during the year.
Is there an age limit for contributions? Contributions can be made to your Roth
IRA regardless of your age.
Can I contribute to a Roth IRA for my spouse? You can contribute to a Roth IRA
for your spouse provided the contributions satisfy the spousal IRA limit (discussed in
How Much Can Be Contributed? under Traditional IRAs) and your modified AGI is
less than:
• $160,000 for married filing jointly,

• $10,000 for married filing separately and you lived with your spouse at any time
during the year, and
• $110,000 for married filing separately and you did not live with your spouse at
any time during the year.
Compensation. Compensation includes wages, salaries, tips, professional fees,

bonuses, and other amounts received for providing personal services. It also
includes commissions, self-employment income, and taxable alimony and separate
maintenance payments.
Modified AGI. Your modified AGI for Roth IRA purposes is your adjusted gross
income (AGI) as shown on your return modified as follows.
1. Subtract any income resulting from the conversion of an IRA (other than a Roth
IRA) to a Roth IRA (conversion income).
2. Add the following deductions and exclusions:
a. Traditional IRA deduction,
b. Student loan interest deduction,

c. Foreign earned income exclusion,

d. Foreign housing exclusion or deduction,
e. Exclusion of qualified savings bond interest shown on Form 8815, and
f. Exclusion of employer-paid adoption expenses shown on Form 8839.
You can use Worksheet 18-2 to figure your modified AGI.
Worksheet 18-2. Modified Adjusted Gross Income for Roth IRA Purposes
Use this worksheet to figure your modified adjusted gross income for Roth IRA
purposes.
1. Enter your adjusted gross income (Form 1040, line 33 or Form 1040A, line 19) 1.
2. Enter any income resulting from the conversion of an IRA (other than a Roth IRA)
to a Roth IRA 2.
3. Subtract line 2 from line 1 3.
4. Enter any traditional IRA deduction (Form 1040, line 23 or Form 1040A, line 16) 4.
5. Enter any student loan interest deduction (Form 1040, line 24 or Form 1040A,
line 17) 5.
6. Enter any foreign earned income exclusion (Form 2555, line 40 or Form 2555-EZ,
line 18) 6.
7. Enter any foreign housing exclusion or deduction (Form 2555, line 34 or 48) 7.
8. Enter any exclusion of bond interest (Form 8815, line 14) 8.
9. Enter any exclusion of employer-paid adoption expenses (Form 8839, line 26) 9.
10 Add the amounts on line 3 through 9. This is your modified adjusted gross 10
. income for Roth IRA purposes .
How Much Can Be Contributed?

The contribution limit for Roth IRAs depends on whether contributions are made only
to Roth IRAs or to both traditional IRAs and Roth IRAs.
Roth IRAs only. If contributions are made only to Roth IRAs, your contribution limit
generally is the lesser of:
• $2,000 for 2001 ($3,000 for 2002 or $3,500 for 2002 if you are 50 or older), or
• Your taxable compensation.
However, If your modified AGI is above a certain amount, your contribution limit may
be reduced, as explained later under Contribution limit reduced.
Roth IRAs and traditional IRAs. If contributions are made to both Roth IRAs and
traditional IRAs established for your benefit, your contribution limit for Roth IRAs
generally is the same as your limit would be if contributions were made only to Roth
IRAs, but then reduced by all contributions (other than employer contributions under
a SEP or SIMPLE IRA plan) for the year to all IRAs other than Roth IRAs.
This means that your contribution limit is the lesser of:

• $2,000 for 2001 ($3,000 for 2002 or $3,500 for 2002 if you are 50 or older) minus
all contributions (other than employer contributions under a SEP or SIMPLE IRA
plan) for the year to all IRAs other than Roth IRAs, or
• Your taxable compensation minus all contributions (other than employer
contributions under a SEP or SIMPLE IRA plan) for the year to all IRAs other
than Roth IRAs.
Contribution limit reduced. If your modified AGI is above a certain amount, your
contribution limit is gradually reduced. Use Table 18-3 to determine if this reduction
applies to you.
Figuring the reduction. If the amount you can contribute to your Roth IRA is
reduced, see Publication 590 for how to figure the reduction.
Table 18-3.Effect of Modified AGI on Roth IRA Contribution

This table shows whether your contribution to a Roth IRA is affected by the amount
of your modified adjusted gross income (modified AGI).
IF you have taxable

AND your modified AGI
compensation and your filing THEN ...
is ...
status is ...
You can contribute up to
$2,000 for 2001 ($3,000 for
Married Filing Jointly Less than $150,000
2002 or $3,500 for 2002 if
age 50 or older).
The amount you can
At least $150,000 but contributed is reduced as
less than $160,000 explained under Contribution
limit reduced.
You cannot contribute to a
$160,000 or more
Roth IRA.
You can contribute up to
Married Filing Separately and
$2,000 for 2001 ($3,000 for
you lived with your spouse at any Zero (-0-)
2002 or $3,500 for 2002 if 50
time during the year
or older).
The amount you can
More than zero (-0-) contribute is reduced as
but less than $10,000 explained under Contribution
limit reduced.
$10,000 or more
Roth IRA.
Single, Head of Household, You can contribute up to
Less than $95,000
Qualifying Widow(er), or $2,000 for 2001 ($3,000 for

Married Filing Separately and 2002 or $3,500 for 2002 if

you did not live with your spouse age 50 or older).
at any time during the year
The amount you can
At least $95,000 but contribute is reduced as
less than $110,000 explained under Contribution
limit reduced.
$110,000 or more
Roth IRA.
When Can I Make Contributions?

You can make contributions to a Roth IRA for a year at any time during the year or
by the due date of your return for that year (not including extensions).
Can I Move Amounts Into a Roth IRA?

You may be able to convert amounts from either a traditional, SEP, or SIMPLE IRA
into a Roth IRA. You may be able to recharacterize contributions made to one IRA
as having been made directly to a different IRA. You can roll amounts over from one
Roth IRA to another Roth IRA.
You can convert a traditional IRA or a SIMPLE IRA to a Roth IRA. The conversion is
treated as a rollover, regardless of the conversion method used. Most of the rules for
rollovers, described under Rollover From One IRA Into Another under Traditional
IRAs, earlier, apply to these rollovers. However, the 1-year waiting period does not
apply.
Conversion methods. You can convert amounts from a traditional IRA to a Roth
IRA in any of the following three ways.
1. Rollover. You can receive a distribution from a traditional IRA and roll it over
(contribute it) to a Roth IRA within 60 days after the distribution.
2. Trustee-to-trustee transfer. You can direct the trustee of the traditional IRA to
transfer an amount from the traditional IRA to the trustee of the Roth IRA.
3. Same trustee transfer. If the trustee of the traditional IRA also maintains the
Roth IRA, you can direct the trustee to transfer an amount from the traditional
IRA to the Roth IRA.
Same trustee. Conversions made with the same trustee can be made by
redesignating the traditional IRA as a Roth IRA, rather than opening a new account
or issuing a new contract.
Converting from any traditional IRA. You can convert amounts from a traditional
IRA into a Roth IRA if, for the tax year you make the withdrawal from the traditional
IRA, both of the following requirements are met.
1. Your modified AGI (explained earlier) is not more than $100,000.

2. You are not a married individual filing a separate return. (See Lived apart from
spouse under Filing status, earlier.)
Required distributions. Amounts that must be distributed from your traditional IRA
for a particular year (including the calendar year in which you reach age 70 1/2)
under the required distribution rules (discussed under Traditional IRAs, earlier)
cannot be converted.
Inherited IRAs. If you inherited a traditional IRA from someone other than your
spouse, you cannot convert it to a Roth IRA.
Income. You must include in your gross income distributions from a traditional IRA
that you would have to include in income if you had not converted them into a Roth
IRA. You do not include in gross income any part of a distribution from a traditional
IRA that is a return of your basis, as discussed earlier under Traditional IRAs.
If you must include any amount in your gross income, you may have to make
estimated tax payments.
Converting from a SIMPLE IRA. Generally, you can convert an amount in your
SIMPLE IRA to a Roth IRA under the same rules explained earlier under Converting
from any traditional IRA.
However, you cannot convert any amount distributed from the SIMPLE IRA during
the 2-year period beginning on the date you first participated in any SIMPLE IRA
plan maintained by your employer.
More information. For more detailed information on conversions, see Publication
590.
Rollover From a Roth IRA

You can withdraw, tax free, all or part of the assets from one Roth IRA if you
contribute them within 60 days to another Roth IRA. Most of the rules for rollovers
explained under Rollover From One IRA Into Another under Traditional IRAs, earlier,
apply to these rollovers.
Are Distributions From My Roth IRA Taxable?

You do not include in your gross income qualified distributions or distributions that
are a return of your regular contributions from your Roth IRA(s). You also do not
include distributions from your Roth IRA that you roll over tax free into another Roth
IRA. You may have to include part of other distributions in your income. See
Ordering rules for distributions, later.
What are qualified distributions? A qualified distribution is any payment or

distribution from your Roth IRA that meets the following requirements.

1. It is made after the 5-taxable-year period beginning with the first taxable year for
which a contribution was made to a Roth IRA set up for your benefit, and
2. The payment or distribution is:
a. Made on or after the date you reach age 59 1/2,
b. Made because you are disabled,
c. Made to a beneficiary or to your estate after your death, or
d. To pay certain qualified first-time homebuyer amounts discussed in
Publication 590.
Additional tax on distributions of conversion contributions within 5-year

period. If, within the 5-year period starting with the year in which you made a
conversion contribution of an amount from a traditional IRA to a Roth IRA, you take
a distribution from a Roth IRA of an amount attributable to the portion of the
conversion contribution that you had to include in income, you generally must pay
the 10% additional tax on early distributions. (See Ordering Rules for Distributions,
later, to determine the amount, if any, of the distribution that is attributable to the
conversion contribution.) The 5-year period is separately determined for each
conversion contribution.
Additional tax on other early distributions. The taxable part of other distributions
from your Roth IRA(s) that are not qualified distributions is subject to the additional
tax on early distributions. See Publication 590 for more information.
Ordering rules for distributions. If you receive a distribution from your Roth IRA
that is not a qualified distribution, part of it may be taxable. There is a set order in
which contributions (including conversion contributions) and earnings are considered
to be distributed from your Roth IRA. Regular contributions are distributed first. See
Publication 590 for more information.
Am I required to take distributions when I reach age 70 1/2? You are not
required to take distributions from your Roth IRA at any age. The minimum
distribution rules that apply to traditional IRAs do not apply to Roth IRAs while the
owner is alive. However, after the death of a Roth IRA owner, certain of the
minimum distribution rules that apply to traditional IRAs also apply to Roth IRAs.
More information. For more detailed information on Roth IRAs, see Publication
590.
Important Changes The most that can be contributed to your traditional

Increased traditional IRA IRA is the smaller of the following amounts:
contribution and • Your compensation that you must include in
deduction limit. income for the year, or
• $3,000 (up from $2,000).
If you are 50 years of age or older, the most that can
be contributed to your traditional IRA is the smaller of
the following amounts:
• Your compensation that you must include in

income for the year, or

• $3,500 (up from $2,000).
For more information, see How Much Can Be

Contributed? under Traditional IRAs.
19. Moving Expenses

A. Requirements For Deductibility
1. Moving expenses must be closely related, both in time and place, to the
start of work at a new job location.
a) Closely related in time occurs if incurred within one year from the
date the taxpayer reported to work. It is not necessary to have the
new job before moving.
b) Closely related in place occurs if the distance from the new home to
the new job location is not more than the distance from the former
home to the new job.
2. Distance Test
a) The move will meet this test if the new main job location is at least
50 miles farther from one's former home than the old job location.
b) If the taxpayer goes to work full-time for the first time, the place of
work must be at least 50 miles from the former home to meet the
test.
c) A move due to change of station in the Armed Forces does not

have to meet this test.
3. Time Test
a) A taxpayer must work full-time for at least 39 weeks during the first
12 months after arriving in the general area of the new job.
b) If self-employed, the taxpayer must work full-time for at least 39

weeks during the first 12 months and a total of at least 78 weeks
during the first 24 months after arriving in the area of the new job
location.

Example. Your family moved more than a year after you started work at a new
location. You delayed the move for 18 months to allow your child to complete
high school. You can deduct your allowable moving expenses.
4. If MFJ, only one person needs to meet the time test. They cannot combine
work of both spouses.
5. You can deduct expenses even if the time test is not met by year's end if
the taxpayer expects to meet the requirement.
B. Deductible expenses are the reasonable expenses of moving household goods

and personal effects and traveling expenses to the new location.
1. The cost of moving household goods includes the cost of packing, crating,
and transporting the goods to the new home. This can also include the
cost of storing and insuring household goods and personal effects within
any period of 30 consecutive days after the day the items are moved from
the former home and before delivery to the new home. Include the cost of
disconnecting and connecting utilities and shipping a car or household pet.
2. Travel expenses for one trip to the new location are allowed. This includes
the expenses within one day of no longer being able to live in the former
home and the day of arriving at the new location. The "one trip" is for each
family member, and family members do not have to travel together. If
traveling by car, the taxpayer can include actual expenses of the vehicle
or 10 cents per mile.
C. Nondeductible expenses include:
1. Meal expenses during house hunting and traveling,
2. Pre-move house hunting if a new job is already obtained,
3. Temporary living expenses,
4. Expenses of selling the old home or buying the new home, or breaking or
getting a lease,
5. Home improvements to help sell the old home,
6. Loss on the sale of the home,
7. Mortgage penalties,
8. Real estate taxes,

9. Car tags, or drivers license,
10. Losses from disposing of club memberships, and
11. Any part of the purchase price of the new residence.
Exercise 50: Susan met all the requirements to deduct moving expenses when
she moved from Arizona to Nevada in 2001. which of the following are deductible
as moving expenses?
A. Pre-move house hunting trips.

B. Meal expenses.
C. Expenses of buying or selling a home.
D. Traveling to her new home.
D. Traveling to her new home. “Moving expenses” include the reasonable

expenses of traveling from the former residence to the new place of
residence.
D. Report on Form 3903, Moving Expenses. Reporting of deductible expenses or

income depends on whether or not the taxpayer received reimbursement and
whether or not the reimbursement was under an accountable plan. Employer
paid expenses or reimbursement should be reported to the taxpayer on Form
4782, Employee Moving Expense Information.
1. Unreimbursed deductible expenses are carried to line 24, Form 1040 as

an adjustment to income.
2. Reimbursement for deductible expenses, under an accountable plan,

should be reported in box 13 of W-2, code P. There is no income to report
and no deduction for the reimbursed expense.
3. Reimbursement from a nonaccountable plan and reimbursement for

nondeductible expenses are included as compensation on the W-2.
Allowable deductions are carried to line 24, Form 1040.
20. Alimony
A. Alimony is a payment to or for a spouse or former spouse under a divorce or
separation instrument. It does not include voluntary payments that are not
required by a divorce or separation instrument. Alimony is deductible by the
payer and is taxable income to the recipient.

B. Divorce or Separation Instrument:
1. A decree of divorce or separate maintenance or a written instrument

incident to that decree,
2. A written separation agreement, or
3. A decree or any type of court order requiring a spouse to make payments

for the support or maintenance of the other spouse, including a temporary
decree, an interlocutory (not final) decree, and a decree of alimony
pendente lite (while awaiting action on the final decree or agreement).
C. Payments to a third parry on behalf of a spouse under the terms of the divorce or
separation instrument may be alimony.
D. If required by decree, some payments on a jointly-owned home qualify.
1. If required to make all mortgage payments, one-half can be deducted as

alimony.
2. If required to pay all taxes and insurance:
a) Property held as tenants in common, one-half of the payment can

be deducted as alimony.
b) Property held as tenants by the entirety or joint tenants (right of

survivorship), none of the payment is alimony.
E. Instruments Executed or Modified after 1984.
1. To be treated as alimony, spouses cannot file a joint return and all of the
following requirements are met:
a) Payments must be in cash, which includes check and money order.

Cash payments to a third parry can qualify. Transfer of services or
property, execution of a debt instrument, or the use of property do
not qualify.
b) The instrument does not designate the payments as NOT alimony.

A written statement signed by both parties can make a designation
of an amount not deductible by the payer and excluded from
income of the recipient.
c) The spouses cannot be members of the same household if

separated under a decree of divorce or separate maintenance.

Exception: If not legally separated under a decree of divorce or

separate maintenance, any payment under a written separation
agreement, support decree, or other court order may qualify as
alimony even if both parties are members of the same household
when payment is made.
d) There is no liability to make payments after the death of the

recipient spouse. If payments must continue, none of the payments
before or after are alimony.
e) The payments are not treated as child support. Child support can
be an amount specifically designated or an amount treated as
specifically designated to the extent the payment is reduced either
on the happening of a contingency relating to the child or at a time
that can be clearly associated with the contingency.
Exercise 51: Which of the following items might be considered as alimony:
A. Child support payments.

B. Non-cash payments.
C. Premiums paid under a divorce or separation agreement for insurance to
the extent that the other spouse owns the policy
D. Payments made for the 12-month period after the death of the recipient
spouse.
C. Premium paid under a divorce or separation agreement for life

insurance to the extent that the other spouse owns the policy.
Alimony consists of any payment is cash received by, or on behalf
of, a spouse under a divorce or separation instrument. It does not
include child support payments or a payment made because of a
liability to make such payment after the payee spouse’s death.
2. Payments are not alimony if the payment is:
a) Designated as child support,

b) A noncash property settlement,
c) A spouse's part of community income,
d) To keep up the payer's property, or
e) Not required by a divorce or separation instrument.
F. If alimony payments decrease or terminate during the first three (3) calendar
years, starting with the first year in which an alimony payment is made, alimony
may be subject to recapture rules.

1. Alimony recaptured is included in income on line 11, crossing out

"received" and writing in "recapture" and the spouse's name and Social
Security number.
2. The spouse originally receiving the alimony would be allowed a deduction

for the recaptured amount. This is reported on line 29, crossing out "paid"
and writing in "recapture", and the spouse's Social Security number.
Exercise 52: If a taxpayer's alimony payments decrease or terminate during the

first three calendar years, the taxpayer may have to recapture part of the alimony
deduction claimed in the earlier years. (True or False)
True. Alimony payments that decrease of terminate during the first three
years may be subject to the recapture rule.
PART 5 - STANDARD DEDUCTION AND ITEMIZED DEDUCTIONS
21. Standard Deduction

A. The standard deduction is a dollar amount by which a taxpayer can reduce
taxable income. If itemized deductions are more, the taxpayer should itemize.
B. A change from the standard deduction to itemizing can be accomplished on an

amended return.
C. For the following, the standard deduction is zero and he/she should itemize:
1. MFS and the taxpayers spouse itemizes,

2. The taxpayer is filing a short tax year, or
3. Non-resident or dual-status alien during the year.
22. Limit on Itemized Deductions (Pub. 17)

A. If your itemized deductions are subject to the limit, the total of all your itemized
deductions is reduced by the smaller of:
1. 3% of the amount by which your AGI exceeds $132,950 ($66,475 if

married filing separately), or
2. 80% of your itemized deductions that are affected by the limit. See Which
Itemized Deductions Are Limited, earlier.

Before you figure the overall limit on itemized deductions, you must first complete
lines 1 through 27 of Schedule A (Form 1040), including any appropriate forms
(such as Form 2106, Form 4684, etc.).
The overall limit on itemized deductions is figured after you have applied any
other limit on the allowance of any itemized deduction. These other limits include
charitable contribution limits, the limit on certain meals and entertainment, and
the 2%-of-adjusted-gross-income limit on certain miscellaneous deductions.
B. All items on Schedule A are affected by the overall limit on itemized deductions
except for medical and dental expenses (after the 7.5% AGI limit), investment
interest expenses, nonbusiness casualty and theft losses, and gambling losses.
C. Itemized Deductions of High-Income Taxpayers Reduced. When AGI Exceeds

Inflation- Adjusted Dollar Amount.
An individual whose adjusted gross income exceeds a threshold amount is

required to reduce the amount of allowable itemized deductions by three percent
of the excess over the threshold amount. No reduction is required, however, in
the case of deduction for medical expenses, investment interest, and casualty,
theft or wagering losses.
23. Medical and Dental Expenses
Important Reminders. From 1999, the amount you can deduct increased
Self-employed health from 45% to 60% of the amount you paid.
insurance deduction.
Stop-smoking You can now include in medical expenses amounts
programs. you pay for a program to stop smoking. If you paid for
a stop-smoking program in 1996, 1997, or 1998, you
may be able to file an amended return on Form 1040X,
Amended U.S. Individual Income Tax Return, to
include in medical expenses the amounts you paid for
that stop-smoking program. However, you cannot
include in medical expenses amounts you pay for
drugs that do not require a prescription, such as
nicotine gum or patches, that are designed to help
stop smoking.
Important Reminder. You may be able to make deductible contributions to a

Medical savings medical savings account (MSA). If you are an
account. employee of a small business (fewer than 50
employees), or self-employed and covered only by a

high deductible health plan, you may be eligible to

have an MSA. You deduct MSA contributions on Form
1040, line 25, not on Schedule A (Form 1040) as a
qualified medical expense. See Publication 969,
Medical Savings Accounts (MSAs), for more
information.
Standard mileage rate The standard mileage rate allowed for out-of-pocket
expenses for your car when you use your car for
medical reasons is now 12 cents a mile.
A. Medical expenses incurred on behalf of oneself are deductible as well as the

expenses for the following:
You can deduct only the amount of your medical and dental expenses that is
more than 7.5% of your adjusted gross income (line 34, Form 1040).
The term "7.5% limit" is used to refer to 7.5% of your adjusted gross income.
Example:
Your adjusted gross income is $20,000, 7.5% of which is $1,500. You paid
medical expenses of $800. You cannot deduct any of your medical expenses
because they are not more than 7.5% of your adjusted gross income.
B. You can include medical expenses you pay for yourself and for the individuals
discussed in this section.
1. Spouse. You can include medical expenses you paid for your spouse. To
claim these expenses, you must have been married either at the time your
spouse received the medical services or at the time you paid the medical
expenses.
Example:
Mary received medical treatment before she married Bill. Bill paid for the
treatment after they married. Bill can include these expenses in figuring his
medical expense deduction even if Bill and Mary file separate returns.
If Mary had paid the expenses before she and Bill married, Bill could not include
Mary's expenses in his separate return. Mary would include the amounts she
paid during the year in her separate return. If they filed a joint return, the medical
expenses both paid during the year would be used to figure their medical
expense deduction.
Example:
This year, John paid medical expenses for his wife Louise, who died last year.

John married Belle this year and they file a joint return. Because John was
married to Louise when she incurred the medical expenses, he can include those
expenses in figuring his medical deduction for this year.
3. Dependent. You can include medical expenses you paid for your dependent. To
claim these expenses, the person must have been your dependent either at the
time the medical services were provided or at the time you paid the expenses. A
person generally qualifies as your dependent for purposes of the medical
expense deduction if:
1. That person lived with you for the entire year as a member of your
household or is related to you,
2. That person was a U.S. citizen or resident, or a resident of Canada or
Mexico, for some part of the calendar year in which your tax year began,
and
3. You provided over half of that person's total support for the calendar year.
You can include the medical expenses of any person who is your dependent
even if you cannot claim an exemption for him or her on your return.
Example:
In 2001 your son was your dependent. In 2002 he no longer qualified as your
dependent. However, you paid $800 in 2002 for medical expenses your son
incurred in 2001 when he was your dependent. You can include the $800 in
figuring your medical expense deduction for 2002. You cannot include this
amount on your 2001 tax return.
3. Adopted child. You can include medical expenses that you paid for a
child before adoption, if the child qualified as your dependent when the medical
services were provided or when the expenses were paid. If you pay back an
adoption agency or other persons for medical expenses they paid under an
agreement with you, you are treated as having paid those expenses provided
you clearly substantiate that the payment is directly attributable to the medical
care of the child. But if you pay back medical expenses incurred and paid before
adoption negotiations began, you cannot include them as medical expenses.
What if you pay medical expenses of a deceased spouse or dependent? If

you paid medical expenses for your deceased spouse or dependent, include
them as medical expenses on your Form 1040 in the year paid, whether they are
paid before or after the decedent's death. The expenses can be included if the
person was your spouse or dependent either at the time the medical services
were provided or at the time you paid the expenses.
C. Deductible medical expenses include, but are not limited to the following items.

1. Medical insurance premiums paid for policies that provide payment for a
majority of medical or dental services and prescription medications. This
includes amounts paid for Medicare B and membership in an association
that gives cooperative or "free-choice" medical services, or group
hospitalization and clinical care.
Exercise 53: During 2001, Norm Ashby paid $1,000 of medical expenses for his
father, Jerome. Norm may NOT claim Jerome as a dependent SOLELY because
Jerome's income exceeds $2,450. Norm may nevertheless include the $1,000 as
a medical expense (itemized deduction) on his tax returns. (True or False)
True. For purposes of the medical expense deduction, the term

“dependent” has the same meaning as it does for determining the
dependency exemptions except that the gross income test does not
apply.
NOTE: Do not include premiums paid by an employer sponsored plan

(cafeteria plan) unless included in income or the portion of health insurance
deducted as an adjustment to income for self-employed individuals.
2. Meals and lodging:
a) Deductible if provided by a hospital or similar institution as a

necessary part of medical care.
b) Lodging not provided by a hospital may be deductible while away

from home if it is essential to the medical care provided by a doctor
in a licensed hospital or equivalent, it is not lavish or extravagant,
and there is no significant element of personal pleasure, recreation,
or vacation with the travel. (Maximum of $50 per night, per person.)
3. Transportation - Can include out of pocket expenses or nine (9) cents a

mile as a standard mileage rate.
4. Impairment related work expenses may be medical or business. As

business, the expense is not reduced by AGI and may reduce SE tax.
5. Capital expenses for equipment or improvements to one's home if the

expense is needed for medical care. The amount eligible as a medical
expense is the excess of the amount spent over the increase in value of
the property. As long as the medical reason for the capital expense
continues to exist, expenses for maintenance and upkeep are also eligible
deductions.

Exercise 54: Billy had bypass heart surgery in February 2001. At the advice of
his doctor, he had an elevator installed in his home so that he would not have to
climb stairs. The costs associated with this capital improvement are as follows:
Cost of elevator installed 6/30/2001 $5,000

Increase in value of home due to elevator $2,500
Cost of decorative lattice work over elevator 6/30/2001 $ 500
Increase in value of home due to lattice work $ 0
Maintenance and repair of elevator 9/30/2001 $ 500
None of the expenses were covered by insurance. How much would qualify as a
deductible medical expense in 2001, BEFORE any limitation?
A. $3,000
B. $2,500
C. $3,500
D. $5,500
A. $3,000. The amount of capital expenditure deductible as medical

expenses is $3,000. Although capital expenditures are generally not
deductible, there can be a medical expense deduction in
connection with a capital expenditure to the extent that the amount
of such expenditure exceeds the amount of the increase in the
value of the property affected.
6. Cost and care of guide dogs or other animals aiding the blind, deaf and
disabled.
7. Part of a life-care fee paid to a retirement home if designated for medical

care.
8. Prescription medicines and insulin.
9. Hospital service fees or medical service fees.
10. Many other expenses for which there is a medical reason.
C. Not includable are expenses for general health, health club dues, household
help, funeral, burial or cremation, illegal operation or treatment, maternity clothes,
nonprescription medicines, cosmetic surgery, diaper service, etc.
D. Total medical expenses are reduced by all reimbursements received from

insurance or other sources prior to inclusion on Schedule A.
E. Total expenses are reduced by 7.5% of adjusted gross income.

Exercise 55:
The Pack Family incurred the following medical expenses during the tax year
2001:
Doctors fees $1,200

Prescription medicine 450
Health club dues (advised by doctor) 2,000
Medical insurance premiums 1,600
Medical insurance reimbursements 500
The Pack's AGI for the tax year was $30,000. What is the amount the Packs
would be able to deduct on their tax return AFTER any limitation?
A. $2,750
B. $2,500
C. $1,000
D. $500
D. $500. The amount deductible is $500. Doctor’s fees, costs of

prescription medicine and the costs of medical insurance premiums
are all deductible. Medical insurance reimbursements must be
offset against the medical expense amounts. Expenses for health
club dues, even though suggested by a physician, are not
deductible since only those expenses incurred primarily for the
prevention or alleviation of a physical or mental defect or illness are
deductible. The amount deductible is the amount of allowable
expenses which exceeds 7.5% of the taxpayer’s AGI.
24. Taxes
A. Tests for Deductibility
1. The tax must be imposed on the taxpayer,
2. The tax must be paid during the tax year.
B. Income Taxes
1. Deductible taxes include state and local income taxes, including estimated
tax payments. Foreign income taxes and contributions to a state disability
fund or state unemployment fund are also deductible.
2. Foreign income tax included as a credit on Form 1116, Foreign Tax Credit,
is not included on Schedule A.

3. Deductions do not include federal income taxes or employee contributions

to private or voluntary disability plans.
C. Real Estate Taxes
1. Include any state, local, or foreign taxes on real property levied for the
general public welfare. They must be based on assessed value and
charged uniformly against all property.
2. Deductible taxes include a tenant-shareholder's portion of real estate tax

paid by the corporation.
Exercise 56:
All of the following taxes are deductible as an itemized deduction except:
A. Foreign income taxes.

B. Personal property taxes.
C. One-half of the self-employment tax.
D. Foreign real estate taxes.
C. One-half of the self-employment tax. A taxpayer may deduct one-

half of his self-employment tax liability for the year as a business
expense in arriving at adjusted gross income; it cannot be taken as
an itemized deduction.
3. Do not include taxes for local benefits, trash and garbage pickup fees,
transfer taxes, rent increases due to higher taxes, or homeowners
association charges.
4. In the year real estate is sold, the taxes must be prorated between the
seller and the buyer. This is prorated according to the number of days in
the tax year each party held the property. The seller is considered to have
paid his/her portion of the real property taxes at the time of the sale, even
though it may not be paid to the taxing authority at that time.
D. Personal property tax is a state or local tax charged on personal property, based
only on the value of that property, and charged on a yearly basis.
E. For itemizing, taxes not considered are trade or business taxes, taxes on rental
or royalty property, occupational taxes, sales tax, excise taxes, fees or charges
such as driver's license or water bills, federal estate and gift taxes, or Social
Security and other employment taxes for household workers. (Some taxes may
be deductible on other schedules).

25. Interest Expense
Important Reminders Personal interest is not deductible. Examples of

Personal interest. personal interest include interest on a loan to
purchase an automobile for personal use and credit
card and installment interest incurred for personal
expenses. But you may be able to deduct interest you
pay on a qualified student loan. For details, see
Publication 970, Tax Benefits for Higher Education.
A. General Rules
1. Personal interest is not deductible.
2. The taxpayer must be legally liable for the debt upon which the interest is
assessed.
3. Interest is deductible in the tax year to which it applies. Amounts paid in

advance are spread over the period to which the interest applies. (An
exception for points later.)
B. Home mortgage interest is any interest paid on a loan secured by the taxpayer's
main home or second home.
1. If the mortgage fits into one of the following categories, all of the interest is
deductible:
a) Mortgages taken out on or before October 13, 1987 (grandfathered

debt).
b) Mortgages taken out after October 13, 1987, to buy, build, or
improve one's home (home acquisition debt), but only if these
mortgages plus grandfathered debt totaled $1 million or less.
c) Mortgages taken out after October 13, 1987, other than to buy,
build, or improve one's home (home equity debt), but only if these
mortgages totaled $100,000 or less.
d) If the taxpayer has more than one home, the interest limits above
apply to the total mortgages on both homes.
Exercise 58:
Janice, a single individual, took out a mortgage on her home in 1989 for
$125,000. In March of 2000, when her home had a fair market value of $150,000,
she took out a home equity loan of $25,000. She used the $25,000 to purchase

tax-exempt bonds. Janice can deduct ALL of the interest on BOTH mortgages.
(True or False)
False. No deduction is allowed for interest on indebtedness incurred to

purchase tax-exempt securities.
2. "Points" are charges paid by a borrower to obtain a home mortgage,

determined as a percentage of the amount borrowed. Points are also
referred to as loan origination fees, maximum loan charges, loan discount,
or discount points. If the payment is for the use of money, it is interest.
a) General rule - Points are not deductible in full in the year paid but
are spread over the term of the mortgage.
b) Special Rule - The taxpayer can deduct the amount of points paid
if the loan is used to buy or improve the main home and is secured
by that home. All of the following tests must be satisfied:
(1) The payment of points must be an established business

practice in the area,
(2) The points paid must not exceed the number of points
generally charged in this area,
(3) The points must be computed as a percentage of the

principal amount of the mortgage, and
(4) If the loan was used to improve the main home, the points
must be paid with funds other than those obtained from the
mortgage lender. If the loan is used to buy the main home,
the taxpayer must have provided funds at the time of closing
other than those obtained from the lender or mortgage
broker at least equal to the points charged.
c) Points paid by the seller are not considered as amounts borrowed

from the lender or mortgage broker. These points are deductible to
the buyer and the basis is reduced.
d) The special rules do not apply to points paid on loans secured by a

second residence.
NOTE: The rule above also applies to a loan origination fee charged for services
for getting a VA or FHA loan to buy one's main home.

3. The remaining balance of points being amortized can be deducted in full if

the mortgage ends early, such as through prepayment, refinancing at
another institution, foreclosure, or sale.
4. Points paid to refinance a mortgage are not deductible in full. The portion
of points attributed to the new loan amount used to improve the main
home may be fully deducted. The remainder of the points are deducted
over the life of the loan.
C. A late payment charge on a mortgage payment or a mortgage prepayment

penalty may be deducted as interest unless charged for a service provided by the
lender.
D. If the taxpayer claimed a mortgage interest credit, the interest deduction is

reduced by the amount of the credit.
E. Closing costs are not deductible as interest or business expenses. These costs
are added to the basis of the property, which will be recovered when sold.
F. Interest other than home mortgage interest must be traced to the use of the
principal.
26. Contributions
Important Reminders You can deduct contributions earmarked for flood relief,
Disaster relief. hurricane relief or other disaster relief to a qualified
organization (defined later under Organizations That
Qualify To Receive Deductible Contributions ).
However, you cannot deduct contributions earmarked
for relief of a particular individual or family.
Written acknowledgment You can claim a deduction for a contribution of $250 or

required. more only if you have a written acknowledgment of
your contribution from the qualified organization or if
you have certain payroll deduction records. For more
information, see Records To Keep.
Payment partly for A qualified organization must give you a written

goods or services. statement if you make a payment that is more than $75
and is partly a contribution and partly for goods or
services. The statement must tell you that you can
deduct only the amount of your payment that is more
than the value of the goods or services you received. It
must also give you a good faith estimate of the value of
those goods or services.

A. Qualified Organizations
1. The United States, any state, the District of Columbia, a U.S. possession,
a political subdivision of a state or U.S. possession, or an Indian tribal
government.
2. A community chest, corporation, trust, fund, or foundation organized or

created in or under the laws of the United States, any state, the District of
Columbia, or any possession of the U.S. It must be organized and
operated only for charitable, religious, educational, scientific or literary
purposes, or for the prevention of cruelty to children or animals.
3. War veterans' organizations.
4. Domestic fraternal societies, orders, and associations operating under a

lodge system when contributions are used solely for charitable, religious,
etc. purposes.
5. Contributions to certain Canadian charities and certain Mexican charities

may be deductible if permitted by the income tax treaty with that country.
Quick Reference Chart of Charitable Contributions
DEDUCTIBLE NONDEDUCTIBLE
Money or property given to: Money or property given to:

• Federal, state, and local • Civic leagues, social and sports
governments, if solely for public clubs, labor unions, and chamber of
purposes. commerce.
• Nonprofit schools and hospitals. • Foreign organizations.
• Public parks and recreation • Groups that are run for personal
facilities. profit.
• Salvation Army, Red Cross, • Groups whose purpose is to lobby
CARE, Goodwill Industries, for law changes.
United Way, Boy Scouts, Girl • Homeowner s associations.
Scouts, Boys and Girls Clubs of • Individuals.
America, etc. • Political groups or candidates for
• War veterans' groups. political office.
• Costs paid for a student living • Cost of raffle, bingo, or lottery
with you, sponsored by a tickets.
qualified organization. • Dues, fees or bills paid to country
• Out-of-pocket expenses when clubs, lodges, fraternal orders, or

you serve a qualified clubs, lodges, fraternal orders, or

organization as a volunteer. similar groups.
• Tuition.
• Value of one's time or services.
• Value of blood given to a blood bank.
B. Deductible contributions generally include contributions of money or property

made to or for the use of a qualified organization.
1. If a benefit is derived by the individual, the individual can deduct only the
amount of the contribution that is more than the value of the benefit
received.
2. If the taxpayer makes a donation to a college or university and receives a

right to purchase tickets for a sporting event, only 80% of the payment is a
contribution. If the donation includes payment for tickets, the payment is
reduced by the price of the tickets first, and then 80% of the remainder is
an eligible contribution.
Example:
You pay $300 a year for membership in an athletic scholarship program
maintained by the university and you receive one season ticket for the stated
purchase price of $120 from the $300 payment, the result is $180. Eighty
percent or $144 is a charitable contribution.
3. The full amount of a contribution is deductible if the taxpayer receives only

token items - bookmarks, calendars, etc.
4. For a payment of $75 or more which is partly a contribution and partly for
goods and services, the qualified organization must give the taxpayer a
written statement. The statement must indicate that only a portion is
deductible and provide a good faith estimate of the value of the goods and
services.
5. Up to $50 per month of expenses for a foreign or American student in the

twelfth or lower grade if the student lives in the taxpayer's home under a
written agreement with a qualified organization (not under a mutual
exchange program). This student cannot be a dependent or relative of the
taxpayer.
6. Unreimbursed out of pocket expenses incurred in giving service to a

qualified organization. The standard mileage allowance for charitable
purposes is 12 cents per mile.

7. Travel expenses necessarily incurred while away from home performing

services for a charitable organization are deductible as long as there is no
significant element of personal pleasure, recreation, or vacation in such
travel.
C. Contributions of property are generally deductible at the FMV of the property at

the time of the contribution.
1. A contribution of partial interest in property is not deductible.
2. A contribution of a future interest in tangible personal property is not

deductible until all of the interest in or rights to the possession and
enjoyment of the property have been relinquished.
3. If the FMV is less than basis, the deduction is limited to FMV.
4. If the FMV is more than basis, the deduction may be reduced.
a) If ordinary income property, for which a sale at FMV on the date of

the contribution would have resulted in ordinary income or in short-
term capital gain, the deduction would be the FMV less the amount
which would be ordinary income or short-term capital gain.
b) If capital gain property (long-term if sold), the deduction is generally

the FMV. The deduction is reduced if the charity's use of the
property is unrelated use or the taxpayer chooses the 50% limit
instead of the 30% limit.
D. Limits on Deductions - A deduction may be limited to 20%, 30%, or 50% AGI

depending on the type of property and the type of organization.
1. The 50% limit applies to gifts to eligible organizations, except for gifts of
capital gain property for which the deduction is figured using FMV without
a reduction for appreciation.
2. The 30% limit applies to gifts for the use of any organization and gifts
(other than capital gain property) to all qualified organizations other than
the 50% limit organizations - veterans' organizations, fraternal societies,
nonprofit cemeteries, and certain private nonoperating foundations.
a) The limit includes expenses for a student living with the taxpayer.
b) Special 30% limit applies to gifts of capital gain property to 50%

limit organizations. The special 30% limit will not apply when the

taxpayer reduces FMV by what would be long-term capital gain if

sold.
3. The 20% limit applies to gifts of capital gain property to all qualified
organizations other than 50% limit organizations.
E. Records and Reporting
1. The taxpayer needs to be able to substantiate cash contributions by

amount, organization, and date.
2. For each cash contribution less than $250, the taxpayer must keep a
canceled check, bank statement, a receipt, or other reliable written
records.
3. For each cash contribution of $250 or more (including separate checks

written on the same day to the same organization), the taxpayer must
have written acknowledgment from the organization.
4. For noncash contributions of less than $250, the taxpayer must have a
receipt or other documents showing the name of the organization, the date
and location of the contribution, and a reasonable description of the
property.
5. For noncash contributions of at least $250 but not more than $500, the
taxpayer needs an acknowledgment from the organization. The
acknowledgment must show the name, date, and description as well as
meeting three tests:
a) It must be written.
b) It must include a description of the property, whether the

organization gave any goods and services, and a description and
good faith estimate of the value of goods and services.
c) The acknowledgment must be received by the filing date or the due

date (including extensions) of the return.
Exercise 59:
Beginning with the 1994 tax year, the written acknowledgment you need from any
charitable organization to claim a deduction for any cash contribution of $250 or
more in a single donation, must include all of the following except:
A. The amount of cash contributed.

B. Whether the organization is a 50% or 30% organization.
C. Whether goods or services were provided to the donor

D. A description and good faith estimate of the value of any goods or

services provided to the donor.
B. Whether the organization is a 50% or 30% organization. A written

acknowledgment of a charitable contribution of at least $250 must
include the amount of the cash contribution, whether the donee
provided any goods or services in consideration of the donation,
and a description and good-faith estimate of the value of any goods
or services provided to the donor, but not whether the organization
is a 50% or 30% organization.
6. Noncash contributions over $500 and not over $5,000 - A receipt is

required as well as records showing all of the previous information. File
Form 8283, Noncash Charitable Contributions, Section A.
7. Noncash contributions over $5,000 - All of the previously mentioned

information as well as an appraisal is needed. File Form 8283, Section B.
27. Nonbusiness Casualty and Theft Losses
A. Loss on deposits occur when a bank, credit union, or other financial institution
becomes insolvent or bankrupt. The taxpayer has a choice of how to deduct such
a loss.
1. Nonbusiness bad debt is deducted as a short-term capital loss on

Schedule D in the year that the actual loss is determined.
2. Casualty loss has no maximum limit but is reduced by a $100 floor amount
and 10% AGI. Deducted on Schedule A.
3. Ordinary loss if not over $20,000 reduced by any state insurance

proceeds. This option is only available on a loss from a qualified financial
institution such as an account not federally insured (FDIC). This is
deducted as a miscellaneous 2% item on Schedule A.
4. A casualty or ordinary loss can be deducted in a year in which the

taxpayer can reasonably estimate how much of the deposits are lost in an
insolvent or bankrupt financial institution.
Exercise 60:

A loss on deposits can occur when a bank, credit union, or other financial
institution becomes insolvent or bankrupt. If you incur such a loss, you may be
able to deduct it as any one of the following except:
A. Short-term capital loss.

B. Long-term capital loss,
C. Casualty loss.
D. Ordinary loss.
B. Long-term capital loss. Individuals may treat a loss on a deposit in an
insolvent financial institution as an ordinary loss, a personal
casualty loss in the year in which the loss can be reasonably
estimated, or a short-term capital loss in the year in which there is
no prospect of recovery.
B. Casualty - The damage, destruction, or loss of property resulting from an

identifiable event that is sudden, unexpected, or unusual.
1. This can also include a government-ordered demolition or relocation of a

home unsafe to use due to a disaster.
2. Nondeductible losses:
a) A loss from a car accident if the taxpayer's willful negligence or

willful act caused the accident.
b) Accidental breakage of glassware or other items under normal

conditions or due to a family pet.
c) Damage caused by: termites or moths, disease, progressive

deterioration, or drought.
C. Theft is the unlawful taking or removing of money or property with the intent to
deprive the owner of it. Theft also includes larceny, robbery, and embezzlement.
D. The loss cannot be more than the smaller of either the decrease in fair market
value due to the casualty, or the adjusted basis in the property before the
casualty, decreased by insurance or other reimbursement.
E. An appraisal fee is not part of a casualty or theft loss, but can be a miscellaneous
deduction subject to 2% AGI.
F. Insurance and Other Reimbursement
1. If covered by insurance, a claim must be filed.

2. Reimbursement must be subtracted in calculating a loss. This includes

insurance that the taxpayer expects to receive. Reimbursement in excess
of basis results in gain which may be taxable or eligible for postponement.
3. Reimbursement may include loan forgiveness, court awards, assistance

from relief agencies, payment from bonding companies, etc. Insurance,
grants, gifts, and other payments are considered reimbursement only if
specifically designated to repair or replace property. Payments for living
expenses are not reimbursement, but the amount for normal living
expenses is taxable income.
4. Disaster relief such as food, medical supplies, and other forms of

assistance received do not reduce the casualty loss unless they are
replacements for lost or destroyed property. These items are not taxable
income.
G. Deduction Limits
1. The loss must be figured separately for each item stolen, damaged, or
destroyed in an event.
2. A single $100 reduction applies to each casualty or theft no matter how

many pieces of property are involved.
3. The total of all casualty and theft losses for the year must be reduced by
10% of the taxpayer's AGI.
H. When Deductible
1. Casualty losses are deducted in the tax year in which the casualty took
place.
2. Theft losses are deductible in the year that the theft is discovered.
3. In a federally declared disaster area, the loss can be claimed on a return

for the year preceding the year in which the loss took place.
28. Travel, Transportation, and Other Employee Business Expense

A. Travel expenses include ordinary and necessary expenses that the taxpayer
incurs while traveling away from home for one's business, profession, or job. An
ordinary expense is one that is common and accepted in the taxpayer's field of

business, trade, or profession. A necessary expense is one that is helpful and

appropriate in one's business.
1. A taxpayer is traveling away from home if the job duties require the
taxpayer to be away from the general area of the tax home substantially
longer than an ordinary day's work and the taxpayer needs to get sleep or
rest to meet the demands of the work while away from home.
2. Tax home is generally the regular place of business or post of duty,

regardless of where the taxpayer maintains a family home. It includes the
entire city or general area in which the business or work is located. If the
taxpayer has more than one regular place of business, the tax home is the
individual's main place of business. If the taxpayer has no regular place of
business, the tax home may be the place where one regularly works. The
tax home of a transient is where he works.
a) The main place of business or work is determined by considering

the total time spent working in each area, the degree of business
activity in each area, and the relative income from each area.
b) If the time, activity, and income do not indicate a main place of

business, the tax home may be the area where the taxpayer lives if
the following conditions are met:
(1) Part of the business is in the area of one's main home and
the taxpayer uses that home for lodging while doing
business there,
(2) The taxpayer has living expenses at a main home that are
duplicated because the business requires the individual to be
away from that home, and
(3) The taxpayer has not left the area in which both the
traditional place of lodging and the main home are located,
the taxpayer has a member or members of his family living
at that main home, or the taxpayer often uses that home for
lodging.
c) If a taxpayer lives in one city (family home) but works in another

city, the city where the taxpayer earns a living is considered the
taxpayer's "tax home." Therefore, the travel expenses between the
residence (family home) and the tax home are not deductible.
However, if the taxpayer is then assigned to work in the area of his
or her family home, he or she may be considered as traveling away
from his or her tax home.

Exercise 61:
Sydney is an outside salesman with a sales territory covering several states. His
employer's main office is in Milwaukee, but Sydney does not go there for
business reasons. Sydney's work assignments are temporary and he has no way
of knowing where his future assignments will be located. He often stays with a
sister in Cleveland or a brother in Chicago over some weekends during the year,
but he does no work in those areas either. He does not pay his sister or brother
for the use of the rooms. Which location is considered Sydney's tax home?
A. Milwaukee
B. Chicago
C. Cleveland
D. Sydney does NOT have a tax home.
D. Sydney does NOT have a tax home. Sydney is a itinerant, since he
has no established residence.
Exercise 62:
Don Cramer is required by his employer to work four months a year in Pittsburgh,
where he maintains a home for his family. He works for the same employer in
Baltimore for the remainder of the year. His salary remains constant ft)r the entire
year. Don rents an apartment in Baltimore and also incurs other living expenses.
Since Don's tax home is Baltimore, he may deduct his share of living expenses
while he is living and working in Pittsburgh.(True or False)
True. Because Mr. Cramer spends most of his working time and earns
most if his salary in Baltimore, it is his tax home. However, when he
returns to Pittsburgh to work, he is away from his tax home and can
deduct his portion of living expenses even though he is staying in
the family home.
3. A temporary assignment or job is one that is expected to end within a fixed and
reasonably short time and does not last more than one year. If away from the tax
home, expenses are deductible.
a) If the assignment or job is indefinite, the taxpayer is not considered away

from home and the travel expenses are not deductible. Employment with
an understanding that the individual will keep the job if work is satisfactory
during a probationary period is an indefinite assignment.
b) An assignment or job expected to last for more than one year is

considered indefinite and presumed not to be temporary.

c) Travel expenses incurred by a taxpayer to go home on days off are

deductible up to the amount it would have cost for meals and lodging if the
taxpayer had stayed in the area of the temporary place of work.
4. Eligible Travel Expenses
a) The cost of airplane, train, or bus fare between one's home and business
destination.
b) The cost of taxi, airport limousines, buses, or other types of transportation

between the airport and the hotel, and between the hotel and work site.
c) Baggage or shipping cost from main job to temporary job.
d) Cost of operating arid maintaining a car when traveling away from home
on business.
e) Lodging if travel is overnight or long enough to require sleep or rest.
f) Meals if away from home overnight or long enough to require sleep or

rest. Allowed the actual cost or a standard amount. (50% limit) The
standard meal allowance covers meals and incidental expenses. The
standard allowance can be used regardless of whether or not reimbursed
and can be used by employees or self-employed individuals.
The standard meal allowance is the federal M&IE rate. For travel in 2001,
the rate is $30 a day for most small localities in the United States. Most
major cities and many other localities in the United States are designated
as high-cost areas, qualifying for higher standard meal allowances.
Locations qualifying for rates of $34, $38, $42, or $46 a day are listed in
Publication 1542. The rate to use when traveling to more than one location
is the rate in effect at the location in which the taxpayer stops for sleep or
rest.
a) Transportation workers can use an average of $32 per day. The average
is available if the travel takes the worker into high and low cost areas.
b) Travel of less than 24 hours at the beginning or end of a trip requires the
standard meal allowance to be prorated by dividing the day into 6 hour
increments.
6. Travel primarily in the U.S. for business is deductible. If the travel is partly
personal, only the business portion is deductible. If primarily personal, travel to
the location is not deductible but directly related business expenses while there
are deductible.

7. Expenses for travel outside of the U.S. are deductible if the trip is entirely
business.
a) Even if some time is spent away from business, the trip can be considered
entirely business if one of the following tests are met:
(1) The taxpayer did not have substantial control over arranging the
trip,
(2) The taxpayer was outside of the U.S. for one week or less,
(3) The taxpayer spent less than 25% of the total time out of the U.S. in
nonbusiness activities, or
(4) The taxpayer can establish that a personal vacation was not a
major consideration.
b) If not meeting any test, expenses are allocated business days to total
days.
B. Entertainment expenses incurred to entertain a client, customer, or employee

may be deductible if the expense meets the ordinary and necessary business
requirements. In addition, it must pass the directly related test or the associated
test.
1. Directly Related Test - The taxpayer must show that the main purpose of
the combined business and entertainment was the active conduct of
business, that business was conducted with the person during the
entertainment period, and there was more than a general expectation of
getting income or some other specific business benefit at some time in the
future.
2. Associated Test - This must show that the entertainment directly precedes
or follows a substantial business discussion. Expenses for spouses are
not deductible unless a clear business purpose can be established.
3. Entertainment includes any activity generally considered to provide

entertainment, amusement, or recreation. Generally, the only
entertainment facility for which a deduction is eligible is a club, which can
include social, athletic, sporting, and country club. Other facilities such as
a yacht, hunting lodge, fishing camp, etc., are not eligible for deduction
unless used for other than entertainment.
4. No deduction is allowed for club dues and membership fees in any club
organized for business, pleasure, recreation, or other social purposes.

C. Limitation on Meals and Entertainment
1. In general, the deduction for business related meals and entertainment is

limited to 50% of the expense. This applies to employees or their
employers and to self-employed persons or their clients depending on
whether the expenses are reimbursed.
2. Exception to the 50% limit is as an employee, the employer reimburses

under an accountable plan and does not treat the reimbursement as
wages.
D. Business gift expenses are deductible up to a $25 value given directly or

indirectly to any one person during the tax year.
1. Incidental costs, such as engraving, packaging, and mailing, are generally

not included in determining the cost of a gift. A related cost is incidental
only if it does not add substantial value.
2. The $25 limit does not apply to an item which is one of a number of
identical items that cost $4 or less and has the business name
permanently imprinted on it; nor does it apply to promotional materials
used on the business premises.
Exercise 63:
During the tax year, Mr. Banks incurred the following unreimbursed business
expenses for which he has adequate proof for the amounts and purpose.
Business meals $2,000
Business entertainment $1,000
Business gifts (10 gifts at $30 each to 10 different people) $300
Based on the above, what is the amount Banks can deduct BEFORE the
percentage of adjusted gross income limitation?
A. $1,625
B. $1,650
C. $1,750
D. $2,650
C. $1,750. The amount Banks can deduct before the percentage

of adjusted gross income limitation is $1,750. The deduction for
business meals and entertainment is limited to 50% of the actual
expense. Business gifts are limited to $25 per donee.
E. Local Transportation Expenses

1. Commuting expenses are costs of taking a bus, trolley, subway, taxi, or

driving a car between a residence and the main or regular place of work.
Commuting expenses are not deductible even if working during the trip.
a) Parking fees paid to park at work are nondeductible commuting

expenses.
b) Using a vehicle in a nonprofit car pool, hauling tools or instruments

to and from work, and advertising on a car does not change
commuting to business use.
2. Deductible expenses are noncommuting business related.
a) Round trip transportation between your office and a client or customer's

place of business is deductible.
b) If an employer requires the taxpayer to attend a training session in another

office in the same city, the travel directly from the taxpayer's home to the
training site and back each day is deductible.
c) The taxpayer's only office is in the home. The taxpayer can deduct the
round trip business related local transportation expenses between the
qualifying home office and the client's or customer’s place of business.
d) The taxpayer has no regular office and no office in home. Transportation

expenses between home and the first business contact and between the
last business contact and home are nondeductible commuting expenses.
Travel between the first and last client is deductible.
e) If the taxpayer has one or more regular places of business, transportation

between home and a temporary location is deductible.
f) With no regular place of business other than the metropolitan area,

transportation outside of that area to a temporary location is deductible.
Transportation to temporary locations within the area is not deductible.
g) Transportation between two places of work in the same day is deductible.
h) Transportation to an Armed Forces reserve meeting is deductible if the

meeting is held on a business day. If on a nonbusiness day, the expense
is generally nondeductible.

3. Car expenses can be deducted using the actual expenses or the standard
mileage rate. Regardless of which method, the taxpayer needs records to show
when business use started, cost or other basis, business miles, and total miles.
a) Actual expenses include depreciation, garage rent, gas, oil, insurance,

lease fees, licenses, parking fees, rental fees, repairs, tires, and tolls.
Other expenses may or may not be deductible. For self-employed
individuals, this also includes interest on a loan to purchase a vehicle.
b) An employer-provided car may be included in taxable compensation,

depending on employer treatment. If the full value is included in
compensation, business-related expenses are deductible.
Depreciation and section 179 deduction.

Decrease the basis of your business property by any section 179 deduction you
take and the depreciation you deducted, or could have deducted, on your tax
returns under the method of depreciation you selected.
For more information about depreciation and the section 179 deduction, see
Publication 946.
Exercise 64:
In March 2001, Jesse traded in a 1997 van for a new 2001 model. He used both
the old van and the new van 75% for business. Jesse has claimed actual
expenses for the business use of the old van since 1997. He did NOT claim a
section 179 deduction of the old OR new van. Jesse paid $12, 800 for the old
van in June 1997. Depreciation claimed on the 1997 van was $7,388, which
included 1/2 year for 2001. Jesse paid $9,800 cash in addition to a trade-in
allowance of $2,200 to acquire the new van. What is Jesse's depreciable basis in
the new van?
A. $11,409
B. $9,562
C. $9,009
D. $9,000
B. $9,562. The basis for figuring depreciation for the new van is (1) the
adjusted basis of the old van ($5,412), determined by subtracting
the depreciation taken ($7,388) from the cost of the old van
($12,800), plus (2) any additional amount paid for the new van,
($9,800) totaling $15,212, minus (3) the excess, if any, of the total
amount of depreciation that would have been allowable before the
trade if the old van had been used 100% or business ($9,850), over
the total amounts actually allowable as depreciation during those
years ($7,388), totaling $2,462. The total depreciation basis for the
new van ($12,750) must be reduced by the mount of personal use
(25%) to determine the depreciation basis for the new van ($9,562).

c) The standard mileage rate can only be used on a car the taxpayer owns.
The rate for 2001 is 34.0 cents per mile for all business miles.
(1) If choosing the standard rate, the taxpayer cannot deduct actual
expenses.
(2) The choice to use the standard mileage rate must be elected the
first year the vehicle is used for business. In later years, the
taxpayer can choose either standard or actual. A choice to use the
standard rate is considered an election not to use MACRS, so
accelerated depreciation and § 179 are not allowed. If the taxpayer
switches to actual expenses in a later year, the remaining useful life
has to be determined and depreciation would be allowed using the
straight line method.
(3) The standard mileage rate is not allowed if the vehicle is used for
hire (such as a taxi) or the taxpayer operates two or more vehicles
at the same time (fleet). The standard rate cannot be used if ACRS,
MACRS or §179 was claimed in a prior year.
Example:
Chris owns a repair shop and an insurance business. He uses his pickup truck
for the repair shop and his car for the insurance business. No one else uses
either the pickup truck or the car for business purposes. Chris can take the
standard mileage rate for the business use of the truck and car.
(4) In addition to the standard mileage rate, the taxpayer can deduct
any business-related parking fees and tolls (if not related to
commuting expenses).
Exercise 65:
In 2001, Dan got a new job which requires him to extensively use his car for
business purposes. Dan is NOT reimbursed for his expenses and he has NOT
claimed any depreciation on his car in the past. Dan's records reflect he incurred
the following expenses for 2001.
Gasoline and oil $3,100

Repairs on auto $850
Business parking and tolls $200
Depreciation $2,200
Insurance $795
Licenses, tags, etc. $100
Total $7,245

Total miles driven: $30,000

Business miles: $24,000
What is the MAXIMUM deduction that Dan is allowed for the business use of his
car? (Giving standard mileage rate is 34.0 cents per mile.)
A. $8,360
B. $7,160
C. $6,850
D. $5,796
A. $8,360. $8,360 is the maximum amount deductible by Dan in 1994.

That is, the standard mileage allowance multiplied by Dan’s total
business miles, 24,000x.29 ($8,160) plus Dan’s business parking
and tolls ($200) equals $8,360.
F. Recordkeeping
1. The taxpayer must be able to substantiate deductions for travel,
entertainment, business gifts, and local transportation. Estimates and
approximations do not qualify as proof of an expense. A record of the
elements of an expense or a business use should be made at or near the
time of the expense or use.
2. Adequate records will show the name and location of the hotel or
restaurant, dates, charges for lodging, meals, or calls, and the number of
people served at a restaurant.
G. Reporting - Self-employed individuals deduct expenses on Schedule C or F.

Employees report the unreimbursed expenses on Form 2106, Employee
Business Expenses and carry the amount to Schedule A, Miscellaneous Itemized
Deductions subject to the 2% AGI limit.
1. Accountable plans are reimbursement or allowance arrangements that

require substantiation to the employer.
a) Accountable plans require the employee to meet all three of the

following rules:
(1) The expenses must have a business connection and be paid

or incurred while performing services for the employer,
(2) The taxpayer must adequately account to the employer for

these expenses within a reasonable period of time, and
(3) The taxpayer must return any excess reimbursement or

allowance within a reasonable period of time.

b) If these rules are met, reimbursement should not be included on the

W-2. If expenses equal reimbursement, no Form 2106 is required.
Exercise 66:
With regard to employer reimbursements under an accountable plan, which of
the following statements is FALSE?
A. The expenses must have been paid or incurred while performing services
as an employee.
B The expenses must be adequately accounted for to the employer within a
reasonable period of time.
C. Any excess reimbursement must be returned within a reasonable period of
time.
D. Any reimbursement paid must be based on a fixed daily amount not to
exceed the Government's per diem rate.
D. Any reimbursement paid must be based on a fixed daily amount not

to exceed the Government’s per dim rate. If a reimbursement
arrangement between an employee and employer meets the
requirements of a business connection, substantiation, and return
of excess payments, then all amounts paid under the arrangement
are treated as paid under an accountable plan.
c) Reimbursement in excess of substantiated amounts or actual

expense, or for nondeductible expenses is considered as under a
nonaccountable plan and is taxable income.
d) Per diem allowance reimbursement may be taxed depending on the

federal rate and the actual expense. The federal rate can be
determined using the regular federal per diem rate, the high-low
method, or the standard meal allowance.
e) If the per diem allowance is less than or equal to the federal rate,
the allowance will not be included in boxes 1, 3, or 5 of Form W-2.
Neither the expense nor the reimbursement needs be reported. If
actual expenses are more than the allowance, Form 2106 can be
completed to deduct the excess expenses. This also applies if the
standard mileage reimbursement is less than or equal to 30 cents.
f) If the per diem allowance is more than the federal rate, the
employer is required to include the allowance amount up to the
federal rate in box 13 (code L) on Form W-2. This amount is not
taxable. The excess will be included on the W-2 and reported as

income. For reimbursement of vehicle use, an excess would occur

if reimbursed more than the standard rate.
2. Adequate accounting is required for all amounts received from an

employer as advances, reimbursements, or allowances.
a) If the employer reimburses for lodging, meals, and incidental

expenses at a fixed amount per day of business travel, the “per
diem allowance” satisfies the adequate accounting if the time,
place, and business purpose is proven and the expense is
reasonably within limits of ordinary and necessary requirements.
b) The federal per diem rate is an amount for lodging, meals, and
incidental expenses while traveling away from home. The rate to be
used is the one applicable to the location where the taxpayer stops
for sleep or rest.
3. Nonaccountable plans are reimbursement or expense allowance

arrangements that do not meet the accountable rules. Nonaccountable
plan amounts are included in wages, and Form 2106 is required to deduct
any expense. Excess amounts paid under an accountable plan and not
returned to the employer are treated as paid under a nonaccountable plan.
H. All reimbursement is reported on Form 2106. This includes amounts received

from an employer or other party which is not included in income. If the employer
reimbursed a single amount to cover meals or entertainment as well as other business
expenses under an accountable plan, reimbursement needs to be allocated. The
following worksheet can be used for allocating reimbursement.
1. Enter the total amount of the reimbursement paid that is not

reported in box 1 of Form W-2
2. Enter the total amount of expenses
3. Of the amount on line 2, enter the part of the total expense for
meals and entertainment
4. Divide line 3 by line 2. (Enter as a decimal, two places)
5. Multiply line 1 by line 4. Enter the result in Column B, line 7 (M&E)
(Form 2106)
6. Subtract line 5 from line 1. Enter the result in Column A, line 7
(other than M&E)(Form 2106)
Example:
Your employer paid an expense allowance of $5,000. It is not clear how much of
the allowance is for deductible meals. Your actual expenses were $2,000 for
meals and $4,500 for automobile use. first divide your meal expenses by your

total expenses ($2,000 ÷ $6,500). The result is 0.31. Multiply your

reimbursement by this decimal ($5,000 x 0.31). The resulting $1,550 is the
amount attributable to meals.
29. Employee's Educational Expenses
A. Qualifying education is deductible even though the education may lead to a

degree.
B. "Qualifying education" is education required by the employer or the law to keep

one's present salary, status, or job, or the education must be to maintain or
improve skills needed in one's present work.
Example:
You are a teacher who has satisfied the minimum requirements for teaching.
Your employer requires you to take an additional college course each year to
keep your teaching job. This is qualifying education even if you eventually
receive a mater's degree and an increase in salary because of this extra
education.
C. Non-qualifying education includes education to meet minimum requirements. The

minimum necessary is generally determined by laws and regulations, the
standards of the profession, or one's employer.
1. Already doing the work does not mean the minimum requirements have
yet been met. Once met, and the minimum requirements change, the rule
does not have to be satisfied again.
2. Requirements for teachers and others employed by educational

organizations are usually set by the state or school district. If no
requirements exist, the teacher will have met the minimum requirements
when he/she becomes a faculty member. If the minimum requirements are
met and the teacher moves to a new state, that teacher is considered to
have met the requirements of the new state. This applies even if the
teacher is required to take some additional education to be certified in the
new state.
3. Education that is part of a program of study that can qualify the individual
for a new trade or business is nondeductible even if the individual is not
planning a job change.

a) Review courses to prepare for the bar exam or CPA exam are
nonqualifying.
b) Teaching and related duties are considered the same general kind
of work. For example, a change from a classroom teacher to a
guidance counselor or a school administrator is not considered a
new business.
Exercise 67:
In regard to education expenses, which of the following statements is
CORRECT?
A. Education expenses are deductible, even though they may be qualifying

an individual for a new trade or business, so long as they improve skills in
a present trade or business.
B. Education expenses are deductible, even though they lead to meeting the
minimum educational requirements for employment.
C. If the minimum educational requirements have been met, then all
additional education expenses are deductible in ALL cases.
D. Education expenses are deductible as long as the minimum educational
requirements have been met, the education is not qualifying for a new
trade or business, and the education is necessary to maintain or improve
skills in the established trade or business.
D. Education expenses are deductible as long as the minimum
educational requirements have been met, the education is not
qualifying for a new trade or business, and the education is
necessary to maintain or improve skills in the established trade or
business. Education expenses are not deductible if they are
required the to meet the minimum educational requirements to
qualify for the taxpayer’s present employment or if the education
qualifies the taxpayer for a new trade or business. In addition, the
education must maintain or improve a skill required of the taxpayer
in his or her employment.
D. Deductible expenses are reported on Form 2106 if the expense includes meals
or travel. Deductible expenses are carried to Schedule A as miscellaneous
itemized deductions subject to 2% AGI.
1. Expenses include tuition, books, supplies, lab fees, and similar items.
2. Transportation and travel costs:
a) Transportation costs of going directly from work to school are

deductible. If regularly employed and going to school on a strictly
temporary basis, the costs of returning from school to home or the
round trip between home and school are also deductible. You can

use actual expense or the standard mileage rate of 30 cents per

mile.
Example:
You regularly work in Camden, New Jersey, and also attend school for 6
consecutive Saturdays, non-work days, to take a course that improves your job
skills. Since you are attending school on a temporary basis, you can deduct your
round-trip transportation expenses in going between home and school. This is
true regardless of the distance traveled.
b) Travel, meals, and lodging are deductible if the taxpayer travels

overnight to obtain qualifying education and the main purpose of
the trip is to attend a work-related course or seminar. Expenses for
any personal activities are not deductible. A seminar or course in
connection with a cruise or convention is limited.
c) The cost of travel that is in itself a form of education is not

deductible even though the travel may be directly related to one's
work or business duties.
E. Self-employed individuals are allowed an educational expense deduction on their

business form and will not be limited by 2% AGI.
30. Miscellaneous Deductions
A. Miscellaneous deductions are divided into those limited to 2% of AGI and those
not limited by AGI. The 2% limitation applies after any other limitations, such as
the 50% reduction in meals.
B. Unreimbursed Employee Business Expenses subject to the 2% AGI limit:
Business liability insurance and malpractice premiums

Damages paid to former employer for breach of employment contract
Depreciation on home computer or cellular telephone *
Dues to Chamber of Commerce if membership helps in your job
Dues to professional societies
Home office or part of home used regularly and exclusively in work
Job search expenses in your present occupation
Laboratory breakage fees
Medical examinations *
Occupational taxes paid
Passport for business trip

Repayment of income aid payments

Research expenses of college professor
Subscriptions to professional journals and trade magazines related to work
Tools and supplies used in work
Union dues and expenses
Work uniforms
* Employer required
C. Other Expenses Subject to 2% Limit
Appraisal fees for a casualty or charitable contributions

Clerical help and office rent in caring for investments
Depreciation on home computers to the extent used for investments
Dividend reinvestment plan service charges
Excess deductions on termination of an estate or trust
Fees to collect interest and dividends
Hobby expenses, but not more than hobby income
Indirect miscellaneous deductions passed through grantor trusts, partnerships,
and S Corporations
Investment fees and expenses
Legal fees related to producing or collecting taxable income, protecting your job,
or getting tax advice
Loss on deposits in an insolvent or bankrupt financial institution
Repayments of income or Social Security benefits
Repayments under a claim of right of $3,000 or less
Safe deposit box rental
Separately billed IRA administrative fees
Tax advice and preparation fees, including fees for electronic filing
Trustee’s fees for your IRA, if separately billed and paid
D. Deductible Expenses Not Subject to the 2% Limit
Amortizable premium on taxable bonds

Federal estate tax on income in respect of a decedent
Gambling losses to the extent of gambling winnings
Impairment-related work expenses of persons with disabilities
Repayments under a claim of right of more than $3,000
Unrecovered investment in a pension
E. Nondeductible Expenses
Adoption expenses Losses on sale of home,

Burial or funeral expenses furniture, personal car, etc.
Campaign expenses Lost or misplaced property
Capital expenses Lunches with co-workers

Check-writing fees Meals while working late

Commuting expenses Personal legal expenses
Disability insurance premiums Personal, living, and family
Expenses to influence general expenses
public on legislation or elections Political contributions
Fees and licenses (auto, marriage) Professional reputation expenses
Fines and penalties Relief fund contributions
Health spa expenses Residential telephone line
Hobby losses Stockholders' meeting (expenses
Home repairs, insurance, and rent to attend)
Illegal bribes and kickbacks Tax-exempt income expenses
Life insurance premiums Voluntary unemployment benefit
fund contributions
Wristwatches
Domestic Employees
A. Defined
1. A domestic employee includes, but is not limited to: cooks, waiters,
waitresses, butlers, housekeepers, maids, cleaning people, gardeners,
and chauffeurs of automobiles for family use.
2. The determination of an employment relationship is based on the element

of control the employer has over the employee.
3. Cash wages include wages paid with check, money orders, etc. It does
not include the value of food, lodging, clothing, and other noncash items.
B. Social Security and Medicare Taxes
1. If a taxpayer pays a household employee cash wages of $1,100 or more

in 1999, all cash wages paid to that employee in 1999 are Social Security
and Medicare wages.!!
2. Social Security and Medicare wages do not include wages paid to: a
spouse, the taxpayer's child under age 21, a parent, or an employee under
age 18 at any time during the year. The exception for an employee under
age 18 at any time during the year does not apply if the household
services is that employees principal occupation.
3. The tax is 6.2% for Social Security and 1.45% for Medicare if the
employee's share is properly withheld from the employee's wage.
Exercise 68:

Beginning in 1999, the wage threshold for Social Security and Medicare taxes for
a household employee is:
A. $1,000 or more in a year.

B. $625 or more in a quarter.
C. $625 or more in a year.
D. $50 or more in a quarter.
A. $1,000 or more in a year. Individuals who employ domestic workers

are required to withhold and pay Social Security and Medicare
taxes for any employee for whom they pay $1,000 or more in a
calendar year.
C. Federal Unemployment Tax (FUTA)
1. The FUTA tax is 6.2% of the employee's FUTA wage.
2. If cash wages paid to household employees totals $1,100 or more in any

calendar quarter of 1998, the first $7,000 paid to each employee in 1998
and 1999 is FUTA wages.!!
3. If the taxpayer pays less than $1,100 cash wages in each calendar quarter
of 1999 but paid household employees $1,000 in any quarter in 1998, the
wages paid in 1999 are FUTA wages.
D. Federal Income Tax Withholding
1. Federal income tax withholding is not required unless the employee asks
the employer to withhold and the employer agrees to do so.
2. Federal income tax withholding is computed on both cash and noncash

wages.
3. If the employer pays the federal income tax without withholding it from the
employee's pay, the amount must be included in income of the employee
and is subject to FICA and FUTA.
E. Tax Payments and Reporting
1. The employer can pay the taxes due on wages paid to domestic workers
using Schedule H filed with his/her Form 1040. An extension to file Form
1040 will also apply to Schedule H.
2. An employer, filing Form 940 and Form 941, MAY include taxes for
household employees on these forms.

3. The household employer is required to have an EIN when filing Forms W-

2 and Schedule H.
Exercise 69:
Mr. and Mrs. Franks, who do not own any businesses, are wage earners who
have household employees. Mr. and Mrs. Franks' employment taxes on the
wages paid to their household employees will be filed and paid with their annual
Form 1040. (True or False)
True. Because the taxpayers are wage earners, and not sole proprietors,
they may report and pay employment taxes for household
employees on their annual Form 1040, Schedule H.
PART 6 - FIGURING YOUR TAXES AND CREDITS
In this part we will explain how to figure your tax and how to figure the tax of certain
children who have more than $1,500 of investment income. They also discuss tax
credits that, unlike deductions are subtracted directly from your tax and reduce your tax,
dollar for dollar.
31. How To Figure Your Tax

After you have figured your income and deductions as explained in Parts One through
Five, your next step is to figure your tax. This chapter discusses:
• The general steps you take to figure your tax,

• An additional tax you may have to pay called the alternative minimum tax, and
• The conditions you must meet if you want the IRS to figure your tax.
Figuring Your Tax

Your income tax is based on your taxable income. After you figure your income tax,
subtract your tax credits and add any other taxes you may owe. The result is your total
tax. Compare your total tax with your total payments to determine whether you are
entitled to a refund or owe additional tax.
This section provides a general outline of how to figure your tax. You can find step-by-
step directions in the instructions for Forms 1040EZ, 1040A, and 1040.
Tax. Most taxpayers use either the Tax Table or the Tax Rate Schedules to figure their
income tax. However, there are special methods if your income includes any of the
following items.
• Capital gains.

• Lump-sum distributions.
• Farm income (see Schedule J (Form 1040), Farm Income Averaging).
• Investment income over $1,500 for children under age 14.
Credits. After you figure your income tax, determine your tax credits. This chapter does
not explain whether you are eligible for these credits. You can find that information in
chapters 33 through 38 and your form instructions. See the following table for credits
you may be able to subtract from your income tax.
Alternative Minimum Tax (AMT)

A. AMT is a minimum tax some taxpayers are required to pay when benefiting from
special tax treatment afforded some types of income, special deductions, or
credits.
B. The tax is based on Alternative Minimum Taxable Income (AMTI) in excess of a

base amount. AMTI is taxable income redetermined by accounting for specific
adjustments and preferences.
Filing Status Base Amount (2001)

MFJ or QW $49,000
S or HH $35,750
MFS $24,500
C. AMTI Adjustments
1. Addition of personal exemptions and the standard deduction or itemized

deductions claimed for state and local taxes, certain interest, most
miscellaneous deductions, and part of medical expenses.
2. Subtraction of any refund of state and local taxes included in income.
3. Accelerated depreciation in excess of straight line.
4. A change in determining income from long-term contracts.
5. The difference between gain and loss on the sate of property reported
using regular tax basis and AMT basis.
6. The excess of fair market value over purchase price for an incentive stock
option.
7. A change in determining income from installment sales.

8. A change in determining a passive activity loss deduction.
Exercise 70:
In regard to the alternative minimum tax for individuals, you may use your
personal exemption in figuring alternative minimum taxable income. (True or
False)
False. The deduction for personal exemptions is not allowed in computing
AMT.
D. AMTI Preferences
1. That part of a deduction for certain depletion that is more than the
adjusted basis of the property.
2. Part of a deduction for certain intangible drilling costs if the deduction is

more than 65% of the net income from oil, gas, and geothermal properties.
3. Tax-exempt interest on certain private activity bonds.
4. Accelerated depreciation on certain property placed in service before

1987.
32. Tax on Investment Income of Certain Minor Children

A. Two special tax rules that apply to certain investment income of a child under
age 14.
1. If the child's interest, dividends, and other investment income total more
than $1,500, part of that income may be taxed at the parent's tax rate instead of
the child's tax rate. (See Tax for Children Under Age 14 Who Have Investment
Income of More Than $1,500, Pub. 17, Chap. 31.)
2. The child's parent may be able to choose to include the child's interest and
dividend income (including capital gain distributions) on the parent's return rather
than file a return for the child. (See Parent's Election To Report Child's Interest
and Dividends, later.)
For these rules, the term "child" includes a legally adopted child and a stepchild.
These rules apply whether or not the child is a dependent.
These rules do not apply if:

1. The child is not required to file a tax return, or

2. Neither of the child's parents were living at the end of the tax year.
33. Child and Dependent Care Credit
Important Reminders
Taxpayer identification You must include on line 2 of Form 2441 or Schedule 2
number needed for each (Form 1040A) the name and taxpayer identification
qualifying person. number (generally the social security number) of each
qualifying person.
You may have to pay If you pay someone to come to your home and care for
employment taxes. your dependent or spouse, you may be a household
employer who has to pay employment taxes. Usually,
you are not a household employer if the person who
cares for your dependent or spouse does so at his or
her home or place of business.
A. Tests which must be met to claim the credit:
1. The care must be for one or more qualifying persons.
2. Taxpayer (and spouse if married) must keep up a home that the taxpayer
lives in with the qualifying person or persons.
3. Taxpayer (and spouse) must have earned income during the year.
4. Taxpayer must pay child and dependent care expenses so he or she (and
spouse) can work or look for work.
5. The taxpayer's filing status is single, head of household, qualifying

widow(er) with dependent child, or married filing jointly. Taxpayer must file
joint if married or an exception applies.
6. Taxpayer must identify the care provider on the tax return.
7. Taxpayer must make payments for child and dependent care to someone
he or she (or spouse) cannot claim as a dependent.

8. Taxpayer excludes less than $2,400 ($4,800 if two qualifying persons

cared for) of dependent care assistance benefits.
B. Qualifying Persons:
1. The taxpayer's dependent who was under age 13 when the care was
provided and for whom the taxpayer can claim an exemption,
2. The taxpayer's spouse who was physically or mentally unable to care for
himself or herself, or
3. The taxpayer's dependent who was physically or mentally unable to care

for himself or herself and for whom the taxpayer can claim an exemption,
or could claim an exemption except the person had $2,750 in 1999 or
more of gross income.
4. Children of divorced parents:
a) The custodial parent can treat a child as a qualifying person even if

that parent cannot claim the child's exemption.
b) The noncustodial parent cannot treat the child as a qualifying

person even if that parent can claim the child's exemption.
C. Keeping up the home includes costs for property taxes, mortgage interest, rent,
utilities, home repairs, insurance on the home, and food eaten in the home. The
taxpayer must pay more than half of the cost of keeping up a home.
D. The earned income test applies to the taxpayer and the spouse if married.
1. Earned income includes wages, salaries, tips, other employee

compensation, and net earnings from self-employment. Earned income is
reduced by a net loss from self-employment.
2. A spouse is treated as having earned income for any month, up to $200

for one qualifying person or $400 for two or more qualifying persons, if he
or she is a full-time student or physically or mentally not capable of self-
care.
E. The work related test means expenses that allow the taxpayer (and spouse) to
work or look for work and are for a qualified person's care. A daily allocation of
expense is required if the taxpayer only works, or looks for work, for part of the
year. Amounts paid while off of work due to illness are not work-related
expenses.

F. Care expenses for the qualifying person includes:
1. Expenses for household services if part of the service is for care.
2. Expenses if the main purpose for the care of the qualifying person is the
person's well-being and protection.
3. Total expense for sending a child to school if the child is not in the first
grade or any higher grade and the amount paid for schooling is incident to
and cannot be separated from the cost of care.
4. Expenses for care outside of the home do not include the cost of sending
a child to an overnight camp (not considered work-related).
5. Employment taxes paid on wages to household workers that provide

qualifying child and dependent care services.
G. If married, the taxpayers must file a joint return unless the spouse did not live in
the taxpayer's home for the last 6 months of the year.
H. Care provider must be identified by name, address, and taxpayer identification

number.
I. In figuring the credit, prepaid expenses are not deductible until the year the care
is provided and employer-provided benefits are not included.
J. Limitation of credit based on AGI. The child credit begins to phase out when
modified adjusted gross income (AGI) reaches $110,000 for joint filers, $55,000
for married filing separately, and $75,000 for singles. The credit is reduced by
$50 for each $1,000, or fraction thereof, of modified AGI above the threshold.
K. Earned Income Limit:
1. The amount of work-related expenses cannot be more than the taxpayer's

earned income for the year if single at the end of the year, or the smaller
of the taxpayer's earned income or the spouse's earned income for the
year if married.
2. If legally separated or married and living apart or if a spouse died during

the year, the taxpayer is not considered married for the earned income
limit.
3. Self-employed's earned income is generally the amount on Schedule SE

line 3 less the deduction for one half of the self-employment tax. If
Schedule SB is not required because income is less than $400, still

include that income. If there is a net loss on self-employment income, the

loss must reduce other earned income.
L. Dollar Limit
1. $2,400 for one qualifying dependent, $4,800 for two or more qualifying
dependents.
2. Employer benefits not included in income will reduce these limits.
M. The credit is determined by a percentage derived from a table. Up to $10,000

AGI, the percentage is 30%. This decreases 1% for each $2,000 increment over
$10,000, to a minimum amount of 20%.
34. Credit for the Elderly and Disabled

A. If you qualify, the law provides a number of credits that can reduce the tax you
owe for a year. One of these credits is the credit for the elderly or the disabled.
The maximum credit available is $1,125. You may be able to take this credit if
you are:
y Age 65 or older, or
y Retired on permanent and total disability.
B. To be eligible for the credit, the taxpayer (U.S. citizen or resident) must be age
65 or older at the end of the tax year, or if under age 65, retired on permanent
and total disability and receiving taxable disability benefits.
B. To Calculate the Credit

1. Start with the initial amount.
S, HH(QW)
65 or older $5,000
Under 65 and retired on disability * $5,000
MFJ
Both 65 or older 7,500
Both under 65, one retired on disability * 5,000
Both under 65, both retired on disability * 7,500
One 65 or over, other under 65 and retired on disability 7,500
One 65 or over, other under 65 and not retired on disability 5,000
MFS, did not live with spouse at all during year 65 or older 3,750
Under 65 and retired on disability * 3,750

* Base amount cannot be more than total taxable disability income

** Base amount is $5,000 plus taxable disability, but not over $7,500
2. Total any nontaxable Social Security or Railroad Retirement benefits and

other nontaxable pension or disability benefits.
3. Determine excess AGI ((AGI - a standard amount) / 2). The standard

amount is: $7,500 if S, HH, QW; $10,000 if MFJ; or $5,000 if MFS and
lived apart the entire year.
4. If the sum of step 2 and step 3 amounts exceed the base amount, no
credit is allowed. If the base amount is more, then the base amount, less
the sum of steps 2 and 3, multiplied by 15% equals the credit.
Exercise 71:
If you are 65 or older and your spouse is UNDER 65 and NOT retired on
permanent and total disability, you are ineligible to claim a Creditor the Elderly or
the Disabled on a jointly filed return. (True or False)
False. Generally, individuals who are married at the close of the tax year
must file a joint return in order to claim the elderly and disabled
credit.
35. Child Tax Credit
Important Reminders The maximum child tax credit for each qualifying child
Child tax credit is increased to $600 for 2001.
increased.
Additional child tax For tax years after 2000, the qualifications for claiming
credit expanded. the additional child tax credit have been expanded to
include qualifying individuals with fewer than three
children. See Additional Child Tax Credit, later, for
more information.
The child tax credit is a credit that can reduce your tax. You may be able to take a
credit on your tax return of up to $600 for each of your qualifying children.
The child tax credit is not the same as the credit for child and dependent care
expenses. For information on the credit for child and dependent care expenses, see
chapter 33.
This chapter gives you information about the child tax credit. It explains:
• Who is a qualifying child.

• How much is the credit.

• How do I claim the credit.
• Why should I check my tax withholding.
If you have no tax. Credits, such as the child tax credit, the adoption credit, or the
credit for child and dependent care expenses, are used to reduce tax. If your tax on
line 42 (Form 1040) or line 26 (Form 1040A) is zero, do not figure the child tax credit
because there is no tax to reduce. However, you may qualify for the additional child
tax credit on line 63 (Form 1040) or line 40 (Form 1040A).
36. Education Credits

The following two tax credits are available to persons who pay higher education
costs.
• The Hope credit.
• The lifetime learning credit.
Hope Credit
You may be able to claim a Hope credit of up to $1,500 for qualified tuition and
related expenses paid for each eligible student.
Eligible student for the Hope credit. For purposes of the Hope credit an eligible
student is a student who meets all of the following requirements.
Did not have expenses that were used to figure a Hope credit in any 2 earlier years.
Had not completed the first 2 years of postsecondary education (generally, the
freshman and sophomore years of college).
Was enrolled at least half-time in a program that leads to a degree, certificate, or

other recognized educational credential, for at least one academic period beginning
in 2001.
Was free of any federal or state felony conviction for possessing or distributing a
controlled substance as of the end of 2001.
Completion of first 2 years. A student who was awarded 2 years of academic

credit for postsecondary work completed before 2001 has completed the first 2 years
of postsecondary education. This student would not be an eligible student for
purposes of the Hope credit.
Any academic credit awarded solely on the basis of the student's performance on
proficiency examinations is disregarded in determining whether the student has
completed 2 years of postsecondary education.

Enrolled at least half-time. A student was enrolled at least half-time if the student
was taking at least half the normal full-time work load for his or her course of study.
The standard for what is half of the normal full-time work load is determined by each
eligible educational institution. However, the standards may not be lower than those
established by the Department of Education under the Higher Education Act of 1965.
Amount of credit. The amount of the Hope credit is the sum of:
1. 100% of the first $1,000 qualified tuition and related expenses you paid for each
eligible student, and
2. 50% of the next $1,000 qualified tuition and related expenses you paid for each
eligible student.
The maximum amount of Hope credit you can claim in 2001 is $1,500 times the
number of eligible students. You can claim the full $1,500 for each eligible student
for whom you paid at least $2,000 of qualified expenses. However, the credit may be
reduced based on your modified adjusted gross income.
Example
Jon and Karen are married and file a joint tax return. For 2001, they claim an
exemption for their dependent daughter on their tax return and their modified
adjusted gross income is $70,000. Their daughter is in her sophomore (second)
year of studies at the local university and Jon and Karen pay qualified tuition and
related expenses of $4,300 in 2001.
Jon and Karen, their daughter, and the local university meet all of the
requirements for the Hope credit. Jon and Karen can claim a $1,500 Hope credit
in 2001. This is 100% of the first $1,000 qualified tuition and related expenses,
plus 50% of the next $1,000.
How to figure the Hope credit. The Hope credit is figured in Parts I and III of Form
8863.
Lifetime Learning Credit

You may be able to claim a lifetime learning credit of up to $1,000 for qualified tuition
and related expenses paid for all students enrolled in eligible educational
institutions.
The lifetime learning credit is different than the Hope credit in the following ways.
1. The lifetime learning credit is not based on the student's work load. It is
allowed for one or more courses.
2. Expenses for graduate-level degree work are eligible.

3. Expenses related to a course of instruction or other education that

involves sports, games, hobbies, or other noncredit courses are eligible if
they are part of a course of instruction to acquire or improve job skills.
4. There is no limit on the number of years for which the lifetime learning
credit can be claimed for each student. It is not limited to students in the
first 2 years of postsecondary education.
5. The amount you can claim as a lifetime learning credit does not vary
(increase) based on the number of students for whom you pay qualified
expenses.
Amount of credit. The amount of the lifetime learning credit is 20% of the first
$5,000 qualified tuition and related expenses you pay for all eligible students. The
maximum amount of lifetime learning credit you can claim for 2001 is $1,000 (20% ×
$5,000). However, that amount may be reduced based on your modified adjusted
gross income. See Does the Amount of Your Income Affect the Amount of Your
Credit, earlier.
Example:
Bruce and Toni are married and file a joint tax return. For 2001, their modified
adjusted gross income is $50,000. Toni is attending the community college (an
eligible educational institution) to earn credits towards an associate's degree in
nursing. She already has a bachelor's degree in history and wants to become a
nurse. In August 2001, Toni paid $4,000 for her fall 2001 semester. Bruce and
Toni can claim an $800 (20% × $4,000) lifetime learning credit on their 2001 joint
tax return.
How to figure the lifetime learning credit. The lifetime learning credit is figured in
Parts II and III of Form 8863.
Income limitation.
The allowable amount of the credits is reduced for taxpayers who have modified
adjusted gross income (AGI) above certain amounts. The phaseout of the credits
begins for most taxpayers when modified AGI reaches $40,000; the credits are
completely phased out when modified AGI reaches $50,000. For joint filers, the
phaseout range is $80,000 to $100,000. Modified AGI is AGI increased by income
earned outside the United States (amounts otherwise excluded from income under
Code Secs. 911, 931, and 933). Income earned in Puerto Rico and U.S.
possessions is considered to be earned abroad. The income ranges for the
phaseout of the credits will be indexed for inflation occurring after the year 2000. The
Hope credit and the lifetime learning credit are not available to married taxpayers
who file separate returns. The credits are available to married individuals (as defined
in Code Sec. 7703) only if a joint return is filed.

Coordination with other provisions. For any tax year, a taxpayer is permitted to
elect only one of the following with respect to one student: (1) the Hope credit, (2)
the lifetime learning credit, or (3) the exclusion for distributions from an education
IRA used to pay higher education costs under Code Sec. 530. In addition, the
amount of qualified higher education expenses, otherwise taken into account in
determining the Series EE U.S. Savings bond exclusion, is reduced by the amount
taken into account in computing the credit.
37. Earned Income Credit (EIC)

A. The credit is based on the taxpayers earned income, adjusted gross income, and
whether or not the taxpayer has a qualifying child.
B. To get the credit, a tax return must be filed even if the taxpayer has no tax liability
or did not earn enough to meet the gross income filing requirements.
C. Taxpayers who work and have one or more qualifying children are eligible for a
higher credit if all requirements are met.
1. The eligibility requirements are as follows:
a) The taxpayer and the qualifying child must live in the same main
home, in the United States, for more than one-half of the year.
b) The taxpayer must have earned income during the year.
c) The taxpayer's earned income and adjusted gross income must

each be less than $32,121 (2001) with qualifying children or
($10,710 if you do not have any qualifying children).
d) The return must cover a 12-month period, except in the case of an

individual's death.
e) The taxpayer's filing status can be any except MFS.
f) The taxpayer cannot be a qualifying child of another person.
g) The taxpayer's qualifying child cannot be the qualifying child of

another person whose adjusted gross income is more than the
taxpayer's.
h) The taxpayer usually must claim as a dependent a qualifying child

who is married.

i) The taxpayer did not file Form 2555 to exclude foreign earned
income or exclude foreign housing.
2. A married taxpayer must file MFJ unless the cost of keeping up the home
test is met and the spouse did not live in the home for the last six months
of the year. (Considered unmarried for tax purposes.)
3. Qualifying child must meet three tests:
a) Relationship Test - The child must be the taxpayer's:
(1) Son, daughter, or adopted child (or a descendent of one's

son, daughter, or adopted child),
(2) Stepson or stepdaughter, or
(3) Eligible foster child - which is any child that lived with the
taxpayer all year for whom the taxpayer cared for as his or
her own.
b) Residency Test - Taxpayer and child must live in the same main
home (located in the U.S.) for more than one-half of the year (whole
year for an eligible foster child). Starting in 1995, military personnel
stationed outside of the U.S. will be treated as maintaining a
residence in the U.S.
c) Age Test - The child must meet one of three rules:
(1) The child must be under age 19 at the end of the year,
(2) The child must be a full-time student under age 24 at the end
of the year, or
(3) The child must be permanently and totally disabled at any

time during the tax year, regardless of age.
4. If the taxpayer is a qualifying child of another person, the taxpayer cannot

claim EIC no matter how many qualifying children he or she may have.
5. If the taxpayer and another person have the same qualifying child, then
the child qualifies only the person with the higher AGI who may or may not
be eligible for EIC.
6. A correct and valid Social Security number is required for each person
listed on the tax return.

D. Taxpayer's without qualifying children may be eligible for a reduced credit, if

his/her earned income and AGI is less than $10,000.
1. Married taxpayers must generally file a joint return.
2. The taxpayer cannot be a qualifying child of another person.
3. The taxpayer must be at least age 25 but under age 65 as of the end of
the year. If MFJ, either spouse can meet the age requirement.
4. The taxpayer must be eligible to claim his/her own exemption.
E. Earned income includes all income received from work, including nontaxable and
deferred amounts.
1. If the taxpayer participates in a cafeteria plan in which the individual

agrees to a salary reduction for receiving a nontaxable benefit, the amount
of the salary reduction is earned income for purposes of EIC.
2. Net earnings from self-employment is included as earned income. The net

earnings is the business gross income less business expenses and one
half of the self-employment tax. This is included even if less than the $400
requirement for Schedule SE. A net loss will reduce other earned income.
a) Statutory employees are generally considered self-

employed, but for purposes of EIC, they are treated as
employees. Include the gross amount received from
employment.
b) Ministers may need to make an adjustment to the amount

carried from Form 1040 line 7 because some of this income
may also be reported on Schedule SE.
3. Community property laws are ignored for determining each

individual taxpayer's earned income.
4. Examples of includable and excludable income for EIC purposes:
INCLUDED NOT INCLUDED

• Wages, salaries, and tips • Interest and dividends
• Union strike benefits • Social Security and Railroad
• Long-term disability benefits Retirement benefits
received prior to minimum • Welfare benefits (including AFDC
retirement age payments)

• Net earnings from self-employment • Pensions and annuities

• Voluntary salary deferrals • Veteran's benefits
• Pay earned in a combat zone • Workers' compensation benefits
• Basic quarters and subsistence • Alimony
allowances and in-kind quarters and • Child support
subsistence for the U.S. military • Unemployment compensation
• The value of meals or lodging (insurance)
provided by an employer for the • Taxable scholarship or fellowship
convenience of the employer grants that were not reported on
• Housing allowance or rental value From W-2
of a parsonage for the clergy • Variable housing allowance for the
• Excludable dependent care benefits military
• Voluntary salary reductions • Disability payments received after
(cafeteria plan) reaching minimum retirement age.
• Anything else of value received
from someone for services
performed even if not taxable.
Exercise 72:
Which of the following items is considered earned income for the earned income
credit?
A. Welfare benefits.
B. Earnings from self-employment.
C. Social Security benefits.
D. Veterans' benefits.
B. Earnings from self-employment. The post-1993 earned income credit is based on
“earned income,” which includes earnings from self-employment.
F. Advanced earned income payments may be received throughout the year if the
taxpayer would be eligible for EIC and files Form W-5 with the employer.
NOTE: Advanced EIC is available only to taxpayers who have at least one
qualifying child.
Exercise 73:
An employee can get ALL of his/her earned income credit from his/her employer
in advance. (True or False)
False. The amount of the earned income credit that may be received as an
advance payment is limited to 60% of the maximum credit available

to an individual with one qualifying child. The advance payment is

not available to an individual who does not have a qualifying child.
38. Other Credits

A. Nonrefundable credits may reduce tax to zero, excess credit is lost.
1. Credit for prior year minimum tax - The credit is the prior year AMT
reduced by the part of the minimum tax generated by exclusion items.
2. Credit for electric vehicles is up to 10% of the cost of a qualified electric

vehicle. The credit is limited to $4,000 for each vehicle placed in service in
2001.
3. Foreign tax credit applies if not claimed as an itemized deduction. Form

1116 can be used to take a credit for taxes paid or accrued to a foreign
country.
4. Adoption credit. You may be able to take a tax credit of up to $5,000 for
qualifying expenses paid to adopt an eligible child. The credit can be as
much as $6,000 if the expenses are for the adoption of a child with special
needs.
If your modified adjusted gross income (AGI) is more than $75,000, your
credit is reduced. If your modified AGI is $115,000 or more, you cannot
claim the credit.
5. Mortgage interest credit applies to a taxpayer who was issued a

mortgage credit certificate (MCC) under a qualified state or local MCC
program.
B. Refundable Credits - The excess after reducing the tax to zero is refunded to
the taxpayer.
1. Credit for excess Social Security tax, Medicare tax, or Railroad Retirement
tax withholding if the taxpayer worked for two or more employers during
the year.
2. Credit from a regulated investment company. A mutual fund may allocate

capital gain distributions, yet not actually make a distribution. If the fund
paid the tax on the capital gain, this tax would be considered paid by the
taxpayer.

3. Credit on diesel-powered highway vehicles available to the first owner of

that qualified vehicle.

PART 2 - SOLE PROPRIETORSHIPS & PARTNERSHIPS
2. PART 2 - SOLE PROPRIETORSHIPS & PARTNERSHIPS

TABLE OF CONTENTS
SECTION A - BUSINESS ORGANIZATIONS .............................................................. 2-4
I. General Information............................................................................................. 2-4
II. Books and Records ............................................................................................. 2-5
III. Accounting Periods ............................................................................................. 2-6
IV. Accounting Methods............................................................................................ 2-9
V. Changing Accounting Methods.......................................................................... 2-11
VI. Business Assets ................................................................................................ 2-12
VII. Basis of Assets.................................................................................................. 2-14
SECTION B - INCOME, LOSS AND EXPENSES ...................................................... 2-20
I. Income .............................................................................................................. 2-20
II. Cost of Goods Sold ........................................................................................... 2-24
III. Business Expenses ........................................................................................... 2-29
IV. Depreciation, Section 179, Amortization & Depletion ........................................ 2-50
SECTION C - SALES, EXCHANGES, AND OTHER TOPICS ................................... 2-64
I. General Information........................................................................................... 2-64
II. Sales and Exchanges........................................................................................ 2-64
III. Gains and Losses.............................................................................................. 2-66
IV. Holding Period................................................................................................... 2-69
V. Reporting Gains and Losses ............................................................................. 2-70
VI. Capital Loss Carryover...................................................................................... 2-73
VII. Installment Sales ............................................................................................... 2-74
VIII. Involuntary Conversions ................................................................................ 2-77
IX. Business Credits ............................................................................................... 2-80
X. Special Rules for Farming ................................................................................. 2-82
XI. Self-Employment Tax ........................................................................................ 2-86
SECTION D - PARTNERSHIPS................................................................................. 2-89
I. General Information........................................................................................... 2-89
II. Form 1065 ......................................................................................................... 2-91
III. Partnership Income ........................................................................................... 2-92
IV. Partner's Income ............................................................................................... 2-94
V. Partner's Dealings with Partnership................................................................... 2-99
VI. Basis of Partner's Interest ............................................................................... 2-104
VII. Basis of Property ............................................................................................. 2-106
VIII. Disposition of a Partner's Interest................................................................. 2-107
2-1
Dynasty School (www.dynastySchool.com)
Dynasty School (www.dynastySchool.com) 2-2

INTRODUCTION
Part II covers sole proprietorships and partnerships. This part of the exam is divided into
three sections. Section A consists of true or false questions, Section B is multiple choice
and Section C is multiple choice that requires some computation. The majority of the
questions on Part II of the exam come directly from Publication 334. Part II of this text
will also follow Publication 334 and other related IRS publications. Each section of this
text will be followed by an exam that consists of questions from prior exams.
MAIN TOPICS
Section A Business Organizations

Section B Income, Loss, and Expenses
Section C Sales, Exchanges, and Basis
Section D Partnerships
STUDY MATERIALS
Most of the questions on the exam are covered in the publications provided by the IRS.
There are a few questions, however, that can only be answered by referring to the code
and regulations.
The following publications will be helpful in preparing for Part II of the exam:
Publication 225 Farmer's Tax Guide

Publication 334 Tax Guide for Small Business
Publication 349 Federal Highway Use Tax on Heavy Vehicles
Publication 463 Travel, Entertainment and Gift Expenses
Publication 534 Depreciation
Publication 538 Accounting Periods and Methods
Publication 541 Tax Information on Partnerships
Publication 544 Sales and Other Dispositions of Assets
Publication 551 Basis of Assets
Publication 946 How to Depreciate Property
2-3
SECTION A - BUSINESS ORGANIZATIONS

I. General Information
A. Sole Proprietorships - A sole proprietorship is the simplest form of doing

business. The business does not exist apart from the owner. Its liabilities are the
personal liabilities of the owner and the ownership interest ends with the
proprietor's death. The income is directly attributable to the owner and is taxed
on Form 1040. Profit or loss is reported on Schedule C or C-EZ (Schedule F for
farmers). A net profit of $400 or more is subject to self-employment tax.
B. Partnership - A partnership is not a taxable entity. The partnership files an

information return using Form 1065. Income or loss is passed through to the
partners on Schedule K-l.
1. The term "partnership" includes a syndicate, group, pool, joint venture, or

similar organization formed to carry on a trade or business and that is not
classified as a trust, estate, or corporation.
2. Each partner shares in the profits and losses according to the partnership
agreement. Any modifications to the original agreement must be agreed to by
all the partners or adopted in any other manner provided by the partnership
agreement. The agreement or the modification may be oral or written.
a) Partners can modify the agreement for a particular tax year after the close
of the tax year but not later than the due date for filing the return. This
filing date excludes extensions.
b) If the partnership agreement or any modification is silent on any matter,

the provisions of local law are treated as part of the agreement.
3. Certain partnerships may choose to be excluded completely or partially from

being treated as a partnership for federal tax purposes if all the partners
agree. This exclusion applies to unincorporated investing or operating
agreement partnerships where there is no active conduct of a trade or
business.
NOTE: A joint undertaking to share expenses is not a partnership. Mere

co-ownership of property that is maintained and leased or rented is not a
partnership. However, if the co-owners provide services to the tenants, a
partnership exists
C. Taxpayer Identification Number - Generally, a person's Social Security number

is his or her taxpayer identification number. However, every partnership,

corporation (including an S corporation) and certain sole proprietorships must

have an employer identification number (EIN).
1. Sole proprietorships must have an EN if they:
a) Pay wages to one or more employees, or
b) Are required to file any pension or excise tax returns, including those for
alcohol, tobacco, or firearms.
NOTE: when a sole proprietorship is required to have an EIN, it is

included on Schedule C along with the Social Security number. If the sole
proprietorship is not required to have an EIN then the Social Security
number is used as the taxpayer identification number and the line for the
EIN is left blank.
2. Change in organization - A new EIN is required for the following changes:
a) A sole proprietorship incorporates,
b) A sole proprietorship takes on partners and operates as a partnership,
c) A partnership incorporates,
d) A partnership is taken over by one of the partners and is operated as a

sole proprietorship, or
e) A corporation changes to a partnership or sole proprietorship. A

corporation that elects to be taxed as an S Corporation does not need to
get a new EIN.
3. Change in ownership - A new EIN is required for the following changes in

ownership:
a) You purchase or inherit an existing business that you will operate as a

sole proprietorship. (You cannot use the same EIN of the former owner
even if that owner is a spouse).
b) You represent an estate that operates a business after the death of the
owner.
c) You terminate a partnership and begin a new one.
II. Books and Records
2-5
A. Adequate records are needed to monitor your business operations, prepare

financial statements, verify income and expenses, and to support items reported
on your tax return.
B. Employment tax records need to specify each employee's name, address, and
Social Security number; cash and non-cash payments; withholding allowance
certificates; amounts and dates paid; and all items withheld. Employment tax
records should be retained for at least 4 years after the date the tax becomes
due or is paid, whichever is later.
C. Asset records are needed to adequately account for depreciation and gain or
loss on a disposition. Records for assets should be retained until the period of
limitations expires for the year in which the property is disposed of in a taxable
transaction.
D. Tax returns should be retained for as long as needed in regard to one of the
preceding paragraphs or until the period of limitations for the return runs out. The
period of limitations is generally 3 years after the date the return is due or 2 years
after the date the tax is paid, whichever is later.
III. Accounting Periods
A. Taxpayers adopt an accounting period when the first income tax return is filed
This is done by filing the first tax return by the due date not including extensions
of time to file.
Entity Tax Year Due Date

Sole Adopts the same tax year as 15th day of the 4th month
Proprietorship the owner, generally a calendar following the end of the tax year
year
Partnership Adopts the same tax year as 15th day of the 4th month
the partners owning 50% or following the end of the tax year
more
C Corporation Fiscal or calendar year 15th day of the 3rd month
following the end of the tax year
S Corporation Calendar year unless there is a 5th day of the 3rd month
valid Section 444 election in following the end of the tax year
effect
B. Calendar Year - A calendar year is a period of twelve consecutive months ending

on December 31.

1 An individual taxpayer that begins a sole proprietorship during the tax year
must use the same tax year he is currently using unless he gets permission to
change to a different year. For most individuals this is a calendar year.
2. An individual must adopt a calendar year if:
a) The taxpayer does not keep adequate records,
b) The taxpayer has no annual accounting period, or
c) The taxpayer's present tax year does not qualify as a fiscal year.
C. Fiscal Year - A fiscal year can be either 12 consecutive months ending on the
last day of any month except December, or a tax year that varies from 52 to 53
weeks. If you elect a 52-53 week year, your tax year will always end on the same
day of the week. The year may end on either:
1. The date on which a specified day of the week last occurs in a particular
month, or
2. The date that day of the week occurs nearest to the last day of a particular
calendar month.
D. Short Tax Year - A short tax year is a tax year which is less than 12 months. This
can occur when the entity is not in existence for the entire tax year or when the
entity changes its accounting period or form of organization. A short tax year is
considered a full tax year. The requirements for filing the short tax year return
and paying the tax are the same as for a full tax year that ended on the same
day.
E. Generally, IRS approval is required for a change in accounting period. Approval

can be obtained by filing Form 1128 and submitting a user fee. This form must be
filed by the 15th day of the second month following the close of the short tax
year.
Example: John, a sole proprietor, filed his return using the calendar year.
For business purposes, he wanted to change to a fiscal year ending June
30. John will have a short tax year for the period January 1 to June 30.
John must file Form 1128 by August 15, the 15th day of the second
calendar month after the close of the short tax year.
Exercise 1: Ally a sole proprietor, must get approval to change his tax
year by filing a current Form 1128 by the 15th day of the 2nd calendar
month after the close of the short tax year and pay the correct user fee, if
any (True or False)
2-7
True. In general, a change in accounting period will be approved

when it is established that there is a substantial business purpose
for making the change.
F. A partnership has limits on the tax year it may use. If all the partners are
individuals, the tax year will generally be a calendar year. However, a partnership
must use what is called a "required year" determined by adapting its tax year to
the partners' tax years as follows:
1. If one or more partners having the same tax year own an interest in
partnership profits and capital of more than 50% (a majority interest), the
partnership must use the tax year of those partners. This is a majority interest
tax year.
2. If there is no majority interest tax year, the partnership must use the tax year
of all its principal partners. A principal partner is one who has a 5% or more
interest in the profits or capital of the partnership.
3. If there is no majority interest tax year or the principal partners do not have
the same tax year, the partnership must generally use a tax year that results
in the least aggregate deferral of income to the partners.
G. Section 444 provides an opportunity for a partnership, S Corporation, or personal

service corporation to have a tax year that is different than the permitted tax year.
1. A partnership may elect a tax year other than a required year (generally a
calendar year) under §444 if:
a) It is not a member of a tiered structure under Reg. §1.444-2T,
b) It has not previously had a §444 election in effect, and
c) It elects a year that meets the deferral period requirement.
2. The deferral period is the number of months between the end of the tax year
it wants to use and the close of the required year. The deferral period must
not be longer than the shorter of:
a) Three months, or
b) The deferral period of the tax year being changed.
Example: A newly formed partnership, owned by calendar year partners,

began operations December 1, 2000. The partnership wants to make a

Section 444 election to adopt a September 30 tax year. The deferral

period for the tax year beginning on December 1, 2000 is 3 months, the
number of months between September 30 and December 31, 2001.!!
3. The election is made by filing Form 8716 by the earlier of:
a) The due date of the return resulting from the Section 444 election, or
b) The 15th day of the sixth month of the tax year for which the election will
be effective.
Exercise 2: Lori, Anne, and Barbara have formed the LAB Partnership.
Each partner's respective ownership interest and fiscal year end is shown
below:
Partner Share and Ownership Fiscal Year End

Lori 40% February 28
Anne 35% July 31
Barbara 25% October 31
Assuming the partnership does NOT make a Section 444 election and does NOT
establish a business reason for a specific tax year, determine what will be the required
tax year of the LAB Partnership.
A. December 31
B. October 31
C. July 31
D. February 28
C. July 31. The correct year is determined using the least

aggregate deferral rule.
IV. Accounting Methods
A. The accounting method is chosen when the entity files its first tax return. If the
entity wants to change its accounting method, it must first get permission from
the IRS.
B. Cash Method - The cash method of accounting may be used by individuals and
most businesses without inventories. This includes sole proprietorships and
partnerships, provided the partnership does not have a C Corporation as a
partner.
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1. Income is reported when actually or constructively received or when made

available without restriction. Property and services received are included in
income at fair market value.
2. Expenses are deducted when actually paid. However, expenses paid in

advance can only be deducted in the year to which they apply. This includes
payments made with a credit card.
3. The cash method cannot be used by the following:
a) Corporations other than S Corporations.
b) Partnerships that have a C Corporation as a partner.
c) Tax shelters.
NOTE: Failure to meet any of the exceptions for limits on the use of the
cash method of accounting will require the taxpayer to change to the
accrual method.
4. Exceptions that allow the use of the cash method:
a) A farming business with $25 million or less in gross receipts,
b) A qualified personal service corporation, or
c) Any entity (except a tax shelter) with average annual gross receipts of $5
million or less.
C. Accrual Method - All income is reported when earned regardless of when

received. Prepaid income for services may be accrued over the period for which
the services are to be performed provided the period does not extend beyond the
next tax year.
1. All expenses are deducted or capitalized when the taxpayer becomes liable
for them regardless of when they are paid.
2. Inventories are necessary to clearly show income when the production,

purchase, or sale of merchandise is an income-producing factor. If inventories
are necessary to clearly reflect income, the accrual method must be used for
sales and purchases.
3. An accrual method taxpayer cannot deduct expenses incurred to a related

cash basis taxpayer until actually paid and included in the related taxpayer's
income.

D. Hybrid Method - The hybrid method is any combination of cash, accrual, or

special method of accounting that clearly reflects income and is consistently
used. Taxpayers may use the accrual method for purchases and sales and the
cash method for all items of income and expenses with the following restrictions:
1. If the cash method is used for figuring income, the cash method must be used
for reporting expenses, and
2. If the accrual method is used for reporting expenses, the accrual method
must be used for figuring income.
NOTE: Different methods of accounting can be used for each

separate and distinct business owned by the same taxpayer provided the
method used clearly reflects the income of each business. Special
methods of accounting are available for certain items of income and
expenses such as installment sales, long-term contracts, and bad debts.
Exercise 3: With regard to accounting methods, all of the following

statements are CORRECT except:
A. You may account for business and personal items under different
accounting methods.
B. You choose your accounting method when you file your first tax
return.
C. You must use the same accounting method from year to year unless
you get consent from the IRS to change your accounting method
D. If you operate several businesses, you must use the same
accounting method for each of the businesses.
D. If you operate several businesses, you must use the same

accounting method for each of the businesses. When a taxpayer
has two or more separate businesses and keeps a complete and
separate set of books and records for each, he may use a different
method of accounting for each business so long as such method
clearly reflects income of that particular enterprise.
V. Changing Accounting Methods
A. A change to a different method of accounting generally requires the permission

of the IRS.
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B. To request a change in accounting method, the taxpayer must file Form 3115,
Application for Change in Accounting Method.
1. For an automatic change, Form 3115 must be filed no later than the due date
including extensions, for filing the income tax return.
2. For a change requiring IRS consent, the application must be filed within the
first 180 days of the tax year for which the change is requested. If the request
requires the consent of the IRS, a $500 user fee must be included with Form
3. Form 3115 is required to be filed regardless of whether consent is required.
C. Consent from the IRS is required in the following situations:
1. Cash to accrual or accrual to cash (unless the change is required),
2. Change in the method or basis used to value inventories, or
3. Change in the method of figuring depreciation (except for changes to the

straight-line method).
Exercise 4: All of the following are considered changes in the method of

accounting requiring the consent of the Internal Revenue Service, except:
A. A change from the cash method to the accrual method or vice versa.
B. A change in the method or basis used to value inventories.
C. A change in the method of figuring depreciation.
D. An adjustment in the useful life of depreciable asset NOT subject to
ACRS or MACRS property.
D. An adjustment in the useful life of depreciable asset NOT

subject to ACRS or MACRS property. An adjustment in the useful
life of a depreciable asset is not considered a change in the method
of accounting requiring consent of the IRS because it is an item that
is traditionally corrected by adjustments in the current and future
years.
VI. Business Assets
A. Capital expenses are not currently deductible but are charged to a capital asset
account. The main types of costs that must be capitalized include expenses of
going into business, the cost of business assets, and the cost of improvements.

1. Going into business generally requires incurring a number of expenses before

the business is operating.
a) Start-up Costs - Start-up costs are those that are paid or incurred prior to
opening the doors for business. These are the costs incurred in setting up
an active trade or business, or investigating the possibility of creating or
acquiring an active trade or business. They include the following:
(1) A survey of potential markets,
(2) An analysis of available facilities, labor, supplies, etc.,
(3) Advertisements for opening the business,
(4) Salaries and wages for training employees and their instructors,
(5) Travel and other necessary expenses for securing prospective

suppliers, distributors, or customers, and
(6) Salaries/fees for executives, consultants, or other professionals.
NOTE: Start up costs do not include deductible interest, taxes, or

R&D costs.
b) Organizational Costs - Organizational costs are those that are incident to

the creation of the partnership (§709) or a corporation (§248).
(1) The cost must be chargeable to a capital account.
(2) The cost must be one that could be amortizable over the life of the
partnership/corporation if the partnership/corporation had a fixed life.
2. If the taxpayer fails to actually go into business, the expenses that have
already been incurred fall into one of two categories:
a) Costs incurred before making a decision to enter a specific business are

personal and nondeductible. They include any cost incurred in the course
of a general search for, or a preliminary investigation of a business or
investment possibility.
b) Costs incurred in connection with an attempt to acquire or begin a specific

business are capital expenditures and are deducted as a capital loss.
B. Property owned by the business and used, directly or indirectly, to earn its
income are business assets. The fill cost of the asset, including freight,
installation, and testing, must be capitalized. If property is produced for use in the
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trade or business, all cost of producing that property should be capitalized under
the uniform capitalization rules.
C. The costs of making improvements to a business asset should be capitalized if

the improvement adds to the value of the asset, appreciably lengthens the time
that the asset can be used, or adapts the asset to a different use.
VII. Basis of Assets

A. Cost basis is the amount the business has invested in the property for tax
purposes.
1. This includes amounts paid for:
a) Sales tax,
b) Freight charges to obtain the property,
c) Installation and testing charges,
d) Excise taxes,
e) Legal and accounting fees,
f) Recording fees and revenue stamps, and
g) Real estate taxes (if assumed for seller).
2. If the buyer of real property pays real estate taxes owed by the seller, these
taxes become part of the buyer's basis.
3. Certain settlement expenses paid on the purchase of real property are

included in basis. This does not include fees and costs of getting a loan.
These fees must be allocated between the land and the buildings, generally
based on the fair market value of each. Settlement expenses do not include
amounts placed in escrow for the future payment of expenses.
4. If an existing mortgage is assumed, basis includes the amount paid for the
purchase plus the amount of the mortgage assumed.
5. For multiple assets purchased for a lump sum amount, the buyer and the
seller may agree to a specific allocation of the purchase price to each asset.
The generally accepted method of allocation is proportionate to, but not in
excess of the fair market value of each asset.

Exercise 5: Matt purchased a high-volume dry cleaning store on January

1, 2001, for $960,000. NO liabilities were assumed. The fair market values
of the assets at the time of the purchase were as follows:
Cash in banks $210,100

US. government securities $100,200
Building and land $312,200
Accounts receivable $100,000
Fixtures and equipment $202,000
Matte will NOT change the name of the cleaners. What is Matt 's basis for
goodwill or going concern value?
A. $0
B. $35,500
C. $91,300
D. $110,560
B. $35,500. Using the residual method, the purchase price is

allocated first to the assets to the extent of their fair market value
(FMV) and any excess is allocated to goodwill and going concern
value. Here, the FMV of the assets ($942,500) is subtracted from
the purchase price ($960,000) for goodwill and going concern value
of $35,500.
B. Uniform Capitalization Rules
1. Uniform capitalization (UNICAP) rules require that certain costs are added to
basis in certain circumstances. UNICAP rules apply in the following situations.
a) The taxpayer produces real property or tangible personal property for use
in a trade or business or an activity engaged in for profit.
b) The taxpayer produces real property or tangible personal property for sale
to customers.
c) The taxpayer acquires property for resale.
2. Direct costs and an allocable portion of indirect cost incurred due to

production or resale activities must be included in basis.
3. The UNICAP rules do not apply to certain property:
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a) Property the taxpayer produces that is not for use in his/her trade,
business, or activity conducted for profit;
b) Costs paid or incurred by an individual or qualified employee-owner of a

corporation who is a writer, photographer, or artist;
c) Property produced under a long-term contract;
d) Research and development expenses allowable as a deduction under

§174; and
e) Costs for personal property acquired for resale if average annual gross
receipts do not exceed $10 million. (The UNICAP rules for inventory and
interest deductions will be discussed later.)
C. Adjusted Basis
1. The basis of property will be increased by:
a) Capital improvements (having a useful life of more than one year),
b) Assessments for local improvements,
c) Rehabilitation expenses reduced by any rehabilitation credit taken,
d) Restoration after a casualty loss,
e) Certain legal fees, and
f) Zoning costs.
2. The basis of property will be decreased by:
a) Energy conservation subsidies,
b) Casualty and theft losses,
c) Certain credits allowed on the property,
d) Deferred gain,
e) Section 179 expense,
f) Certain canceled debt excluded from income,

g) Rebates received from the manufacturer or seller,
h) Depreciation, and
i) Various nontaxable distributions.
3. The taxpayer can elect to deduct or capitalize certain costs:
a) Carrying charges, such as interest and taxes,
b) Research and experimentation costs,
c) Intangible drilling and developmental costs for oil, gas, and geothermal
wells,
d) Exploration costs for new mineral deposits,
e) Mining and development cost for new mineral deposits,
f) The cost or removing architectural and transportation barriers for people

with disabilities and the elderly, and
g) The cost of increasing the circulation of a newspaper or other periodical.
D. Other Basis
1. The fair market value of property received for services is included in income
and then becomes the basis in that property.
2. Property received in a taxable exchange will have a basis equal to the fair
market value of the property at the time of the exchange.
3. Property received in an involuntary exchange, if similar or related in service or

use to the property exchanged, will generally have a basis equal to the old
property's basis with the following adjustments:
a) Decreased by:
(1) Any loss recognized on the exchange, and
(2) Any money received that was not spent on similar property.
b) Increased by:
(1) Any gain recognized on the exchange, and
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(2) Any cost of acquiring replacement property.
4. Property received in a nontaxable or like kind exchange will generally have

the same basis as the old property given up.
5. Property received in a partially nontaxable exchange will generally have the

same basis as the old property given up with the following adjustments:
a) Decreased by:
(1) Any money received, and
(2) Any loss recognized on the exchange.
b) Increased by:
(1) Any additional costs incurred, and
(2) Any gain recognized on the exchange.
c) The basis of unlike property received is its FMV on the date of the
exchange. The remainder of the old property's adjusted basis will be the
basis of the new like property.
d) If the other party assumes the taxpayers liability on the property

transferred, the amount of the liability assumed will be treated as money
transferred to the taxpayer.
Exercise 6: Lou and Casey are independent, unrelated taxi drivers who
decide to swap cabs. The relevant facts are as follows:
Original Owner Lou Casey

Original Cost $12,000 $15,000
Fair Market Value 3,000 5,000
Depreciation Claimed 10,000 12,250
Lou had to pay $2,000 cash and his old cab in order to acquire Casey's
cab. What are Lou and Casey's adjusted bases in their new cabs?
Lou Casey
A. $4,000 $3,000
B. $4,000 $2,750
C. $4,750 $3,000
D. $4, 750 $2,750

B. $4,000; $2,750. Lou and Casey’s adjusted bases in their cabs

before the exchange are $2,000 and $2,750, respectively. After the
exchange, Casey does not recognize any gain even though he
received cash in the exchange. However, Lou’s basis of his new
cab is the adjusted basis of his old cab increased by the amount of
additional cash paid for the new cab. ($2,000 adjusted basis plus
$2,000 cash).
Exercise 7: Reggie owned an asset used in his business that had an

adjusted basis to him of $12,000 and was subject to an outstanding
liability of $2,000. In exchange for the asset Reggie received an asset of
like-kind to be used in his business plus $1,000 in cash. The asset
received had a fair market value of $11,000 at the time of the exchange.
Reggie's liability was assumed by the other party for legitimate business
purposes. what is Reggie's basis in the new asset?
A. $9,000
B. $10,000
C. $11,000
D. $12,000
C. $11,000. If in addition to receiving like-kind property, a

taxpayer also receives money, the amount of recognized gain is the
lesser of the amount of money received or the amount of gain on
the exchange. The amount of money received here is $3,000 (i.e.,
$1,000 cash plus the $2,000 of assumed liabilities) and the amount
of gain on the exchange is $2,000 ($11,000 in property received
plus $1,000 cash plus $2,000 of assumed liabilities minus $12,000
in property transferred). The lesser of these two amounts is $2,000.
The aggregate basis of the like-kind property received is the
adjusted basis of property transferred ($12,000), minus the sum of
the money received ($3,000 - $1,000 cash plus the $2,000
assumed liability), plus the amount of any gain recognized as a
result of the exchange (the aforementioned $2,000). As indicated,
the amount of any liabilities of the taxpayer assumed by the other
party to an exchange is treated as money received by the taxpayer
in the exchange. Thus, $12,000 - $3,000 +$2,000 = $11,000 (Code
Sec. 1031 and Reg. Sec. 1.1031 (d)-2).
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SECTION B - INCOME, LOSS AND EXPENSES

Meal expense deduction In 2002, this deduction increases to 65% of the
subject to "hours of reimbursed meals your employees consume while they
service" limits. are subject to the Department of Transportation's
"hours of service" limits. For more information, see
Meal expenses when subject to "hours of service"
limits. (Pub. 535)
I. Income
A. Business income is the income received when products and services are sold or
delivered. Business income also includes interest, dividends, rents, royalties,
payment for services (including fees, commissions, and fringe benefits), gains
from dealings in property, and the distributive share of partnership income.
1. Property or Service (Barter Income)
a) The fair market value of property or services received as bartering income

is included in business income at the time received.
b) If both parties agree ahead of time on the value for services to be

provided, that value will be accepted as the fair market value unless the
value can be shown to be otherwise.
2. Rental Income - The amount received for the rental of property is included in
gross income.
a) Prepaid Rent - Advance payments received under a lease that does not
put any restriction on the use or enjoyment of the fluids are included in
income in the year received. It does not matter what method of accounting
the taxpayer uses.
b) Lease Bonus - A bonus that is received from a tenant for granting a lease
is an addition to the rent and included in rental income in the year
received.
c) Lease Cancellation Payments - Payments received from a tenant for

canceling a lease are reported in income in the year received.
d) Payments to Third Parties - If a tenant makes payments to someone else

under an agreement to pay the debts of the landlord, the payments are
included in rental income when the tenant makes the payment.

e) Settlement Payments - Payments received by the landlord in settlement of

a tenant's obligation to restore the leased property to its original condition
are income to the extent the settlement payments exceed the leasehold
improvements that were destroyed, removed, or disconnected by the
tenant.
3. Interest Income - Business income includes interest income if the taxpayer is

in the business of lending money. In any business, interest received on notes
receivable that have been accepted in the ordinary course of business is
business income.
a) If the taxpayer is in the business of lending money, any payment received

on a discounted loan usually includes interest and principal.
(1) For a cash basis taxpayer, part of the discount is interest income when
each payment is received.
(2) For an accrual basis taxpayer, the amount of the discount is includable
in income as it accrues over the term of the loan or it is includable as
payments are received if payments are made before they accrue.
b) If a loan becomes uncollectible during the year and the taxpayer uses the
accrual method of accounting, interest that has accrued up to the date the
loan became uncollectible is included in gross income. When accrued
interest is later determined to be uncollectible, a bad debt deduction is
taken.
c) when there is little or no interest charged on an installment sale, unstated

interest is considered to be included in each payment received.
4. Dividends - For most people engaged in a business, dividends are nonbusiness

income. Dividends are business income to securities dealers. Dividends are also
business income to partnerships and corporations that have invested their fluids
in stocks.
5. Canceled Debt
a) General rule - If a debt the taxpayer owes is canceled or forgiven, other than
as a gift or bequest, the canceled amount is included in gross income. This
applies to any debt for which the taxpayer is liable or which attaches to
property the taxpayer holds.
b) Exceptions:
(1) Income is not realized to the extent the payment of the debt would have
given rise to a deduction. Under the accrual method of accounting, the
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canceled debt would be included in income because the expense would

have been deducted when incurred.
(2) If the taxpayer owes a debt on purchased property and the seller reduces
the amount owed, the reduction is treated as a purchase price adjustment
and reduces the basis in the property.
(3) Forgiveness of qualified real property business indebtedness, in the case

of a taxpayer other than a C Corporation, can be excluded by making an
election. The basis of depreciable property is then reduced by the
excluded amount.
(4) Canceled debt is excluded if the cancellation takes place when the
taxpayer is in bankruptcy, or to the extent insolvent, or if the debt is
qualified farm debt.
Exercise 8: Ted, a cash basis taxpayer, owned and operated a business.

He began having difficulty paying his business debts in late 2000. Ted
owed Jeff his computer consultant, $800 for services rendered to his
business and $3,00 for personal services. In 2001, Jeff forgave the entire
debt of $1,100. Ted is NOT bankrupt nor insolvent. What is the amount
Ted will he required to include in income on his tax return for 2001?
A. $0
B. $300
C. $800
D. $1,100
B. $300. A solvent individual taxpayer generally realizes

income to the extent that his debts are forgiven (Code Sec. 108(a)).
On his individual tax return, Ted need only include the forgiveness
of his personal debt of $300. The remaining $800 of debt
constitutes income to Ted’s business.
6. Capital Gains - Gains from the sale or exchange of capital assets are
included in gross income.
7. Franchises, Trademarks, and Trade Names - Amounts received that are

based on productivity, use, or disposition of a franchise, trademark, or trade
name are included as ordinary income.
8. Promissory notes and other evidence of indebtedness are includable in

income at fair market value when they are received, if received as part of the
sales price and the business uses the cash method of accounting.

9. Damages due to patent infringement, breach of contract or fiduciary duty,

antitrust injury, or for punitive reasons is included in gross compensation.
B. Prepaid Income - Prepaid income that is subject to free and unrestricted use is
included in gross income in the year received regardless of the taxpayer's method
of accounting. However, there are some exceptions for accrual accounting.
1. Advanced income received under an agreement for services to be performed

by the end of the next tax year may be postponed until the next year. The
election to postpone reporting does not apply:
a) To income under guarantee or warranty contracts,
b) To prepaid rent or prepaid interest,
c) If the agreement requires any part of the work to be performed

immediately after the close of the following year, or
d) The services are to be performed at any unspecified future date.
2. Advanced income from sales may be reported in the tax year received or
under an alternative method. Under the alternative method, income is
included in the earlier tax year in which:
a) The advanced payments are included in gross receipts under the method
of accounting used for tax purposes, or
b) Any part of the advanced payment is included in income for any financial
reports under the method of accounting used for these reports.
Exercise 9: If an accrual method taxpayer, under an agreement, receives

advanced payments for services to be performed by the end of the next
tax year, the taxpayer can make an election to postpone including the
advanced payments in income until they are earned, but not beyond the
year after the year in which they were received. (True or False)
True. An accrual method taxpayer who, pursuant to an agreement,

receives payment in one tax year for services required to be
performed by him before the end of the next succeeding tax year
may include such payments in gross income as earned through the
performance of the services.
C. Items Not Considered Income - The receipt of money or property is not

considered income in the following cases:
2-23
1. Issuance of stock or income from the sale of treasury stock,
2. Contributions to capital,
3. Loans,
4. Exchange of business property for like property, or
5. Consignments.
II. Cost of Goods Sold
A. Cost of Goods Sold

Taxpayers that make or sell goods are entitled to a deduction on their tax return
for the cost of goods sold. Inventories must be maintained to determine these
costs. When inventories are required to be accounted for, the accrual method of
accounting must be used for purchases and sales.
1. Inventory at the beginning of the year will be identical to the closing inventory
of the year before. Any differences must be explained in a schedule attached
to the return.
2. Inventory is increased by merchandise or raw materials purchased. This is

included at the price paid, so the stated price is reduced by trade discounts
and, depending on the method used, cash discounts. Cash discounts may be
credited to a separate account in which case the stated price is not reduced,
and the credit balance is included in income. Returns and allowances and all
merchandise withdrawn for personal use will also reduce the amount for
merchandise or raw materials purchased.
3. Labor costs are included in cost of goods sold only in a manufacturing or

mining business. In a manufacturing business, labor costs include both the
direct and indirect labor used in fabricating the raw material into the finished
product.
a) Direct labor costs are the wages paid to those employees who spend their
time working directly on the product being manufactured.
b) Indirect labor costs are the wages paid to employees who perform a
general factory function that does not have any immediate or direct
connection with making a salable product but is nonetheless a necessary
part of the manufacturing process.

c) Other labor costs that are not chargeable to the cost of goods sold are
deducted as selling or administration expenses.
4. Materials and supplies used in manufacturing goods.
5. Other costs incurred that are chargeable to the cost of goods sold include:
a) Freight-in, express-in, and cartage-in on raw materials and supplies that

are used in production, and merchandise that is purchased for sale.
b) Overhead expenses such as rent, heat, utilities, depreciation, taxes,

insurance, and maintenance incurred as a direct and necessary expense
of the manufacturing process.
6. Inventory at the end of the year is then subtracted from the total of the costs
included in inventory to arrive at the cost of goods sold.
Exercise 10: A dealer MUST reduce the stated price of articles in

inventory by any TRADE discounts. CASH discounts, on the other hand,
may be shown as either income from cash discounts or as a reduction to
the overall cost of purchases for the year. (True or False)
True. cash discounts representing a fair interest rate may or may

not be subtracted in computing the cost of goods purchased, at the
taxpayer’s election. A trade discount must be treated as a reduction
in the cost of new items in inventory in the year of purchase.
B. Inventories
1. Inventories are necessary to clearly show income when the production,

purchase, or sale of merchandise is an income-producing factor in the
business.
a) The most common inventories are:
(1) Merchandise or stock in trade,
(2) Raw materials,
(3) Work in process,
(4) Finished products, and
(5) Supplies that physically become part of the item intended for sale.
2-25
b) The value of inventories at the beginning and end of each year is required to
determine taxable income. To accomplish this, a method of identifying items
of inventory and a method of valuing these items is required.
c) Inventories include all finished or partly finished goods and the raw materials
and supplies that become part of the merchandise for sale.
d) Merchandise is included in inventory only if the taxpayer has title to it. This
includes goods in transit before the taxpayer actually has physical
possession.
e) Containers are part of inventory if title to them has not passed to the buyer of
the contents. Examples include cases, bottles, drums, and kegs.
f) If merchandise is sold by mail with payment and delivery to happen at the

same time, title passes when payment is made. The merchandise remains in
closing inventory until the buyer pays for it.
2. Cost Identification - There are three methods of identifying items in inventory.
a) Specific identification method - This method is used to identify the cost of

each inventoried item by matching the item with its cost of acquisition. This
includes all allocable costs such as labor and transportation.
b) First-in first-out (FIFO) - This method assumes that the items the taxpayer
purchased or produced first are the first items sold or consumed.
c) Last-in first-out (LIFO) - This method assumes that the items of inventory
purchased or produced last are sold or removed from inventory first. To adopt
the LIFO method, the taxpayer is required to file Form 970, Application To
Use LIFO Inventory Method. The form or statement containing the same
information must be attached to the timely filed return that first uses the LIFO
method.
3. Valuing Inventory - Valuing the items in inventory is a major factor in

determining taxable income. There are two common methods used to value non-
LIFO inventory.
a) Specific Identification Method (cost) - To properly value inventory at cost, all

direct and indirect costs associated with it must be included.
(1) For merchandise on hand at the beginning of the year, cost means the
inventory price of the goods.

(2) For merchandise purchased during the year, cost means the invoice price
less appropriate discounts. Amounts required to be included under the
uniform capitalization rules are also included.
(3) For merchandise produced during the year, cost means all direct and
indirect costs required to be capitalized under the uniform capitalization
rules.
b) Lower of Cost or Market Method - Under this method, the market value of
each item on hand at the inventory date is compared with its cost. The lower
of the two amounts is its value.
(1) Market value under ordinary circumstances means the usual bid price at
the date of the inventory
(2) When goods are offered for sale at prices that are lower than market, the
sales price may be used.
(3) If no market exists, the taxpayer may use whatever evidence of fair market
value exists at the nearest date of inventory.
(4) Unsalable goods that are in inventory arc valued at selling price less direct
costs of disposition regardless of what method is used to value the rest of
the inventory. Unsalable goods may not be valued for less than scrap
value.
4. Uniform Capitalization of Inventory - Taxpayers are required to capitalize direct

costs and the allocable portion of indirect costs that benefit or are incurred
because of production or resale activities.
a) Taxpayers subject to the uniform capitalization rules include:
(1) Taxpayers that produce real property or tangible personal property for use
in a trade or business or in an activity engaged in for profit,
(2) Taxpayers that produce real property or tangible personal property for sale
to customers, and
(3) Taxpayers that acquire property for resale, but not personal property if
average annual gross receipts for the preceding three (3) tax years are not
more than $10 million.
b) Property that is not subject to the uniform capitalization rules include:
(1) Property used for personal or nonbusiness purposes,
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(2) Qualified creative expenses paid or incurred by an individual (other than

as an employee) or a qualified employee-owner of a personal service
corporation in the business of being a writer, photographer, or artist,
(3) Property that is produced under a long-term contract,
(4) Personal property that is purchased for resale if annual gross receipts for
the three (3) prior tax years are $10 million or less, and
(5) Research and experimental costs that are allowed as a current deduction
under §174.
NOTE: The uniform capitalization rules do not apply to personal

property acquired for resale if the retailer's annual gross receipts for the 3
preceding tax years are $10 million or less. This $10 million test is not
available for real property acquired for resale.
c) Direct costs that must be capitalized include:
(1) Direct labor costs incurred for production or resale activities. This labor
cost includes basic, overtime, sick, and vacation pay, plus all payroll
taxes.
(2) Direct labor includes payments to a supplemental unemployment benefit

plan.
(3) Material costs that become an integral part of the asset plus material used
in the ordinary course of business.
d) Indirect costs include all costs other than direct labor and materials. Such
costs may include:
(1) Repair and maintenance of equipment or facilities,
(2) Utilities,
(3) Rent of equipment, facilities, or land,
(4) Indirect labor and associated costs,
(5) Indirect material and supplies,
(6) Tools and equipment not otherwise required to be capitalized,
(7) Certain taxes that are not otherwise treated as part of cost,

(8) Depreciation, amortization, and depletion,
(9) Administrative costs, and
(10) Insurance on equipment and facilities.
NOTE: Producers using the simplified production method qualify for an

exception from UNICAP under the de minimis rule if total indirect costs are
$200,000 or less.
Exercise 11: The uniform capitalization rules apply to all of the following
business related costs except:
A. Direct materials.
B. Indirect materials
C. Direct labor.
D. Research.
D. Research. Research costs are considered currently deductible

expenses and do not need to be capitalized under the uniform
capitalization rules.
III. Business Expenses
A. Employees' Pay
1. Employees' pay consists of salaries, wages, commissions, gifts, and fringe

benefits. Payment can be made in the form of cash or other property.
2. To be deductible, employees' pay must meet all the following tests:
a) Ordinary and Necessary - Salaries, wages, and other payments for

services employees render must be ordinary, necessary, and directly
connected to the taxpayer's trade or business.
b) Reasonable - Reasonable pay is determined by all the relevant facts and

circumstances. This test is based on the circumstances at the time the
taxpayer contracts for the services and not those existing at the time
payment is made.
c) For Services Performed - The taxpayer must be able to prove the

payments were for services actually performed.
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d) Paid or Incurred - The taxpayer must have actually made the payment or
incurred the expense during the year.
(1) Cash-basis taxpayers deduct salaries and wages in the year paid.
(2) Accrual-basis taxpayers deduct salaries and wages when the

obligation is established and economic performance occurs.
(3) A special rule applies to payments made by accrual-method taxpayers

to certain related cash basis taxpayers. The deduction for payments to
related taxpayers is not allowed until the tax year the related taxpayer
includes the payment in income.
3. Bonuses and gifts are deductible if they meet certain tests.
a) Bonuses paid to employees are deductible if they are intended as

additional pay for services and not as gifts. When bonuses are paid, they
must be reasonable in addition to the employee's regular pay.
b) Gifts of nominal value such as turkeys, hams, and other merchandise
distributed to employees at holidays is not taxable as salaries or wages
and remains deductible to the employer. The employer may not deduct
more than $25 per employee per year. Cash, gift certificates, or other
property that is easily converted to cash is taxable as additional wages
regardless of the amount or value.
4. Loans or advances made to employees that are not expected to be repaid are
deducted as wages.
5. Vacation pay is deductible if actually paid even though the employee chooses
not to take a vacation.
a) Cash basis taxpayers deduct vacation pay when payment is made.
b) Accrual basis taxpayers can deduct vacation pay in the year earned by
employees only if it is paid:
(1) By the close of the employer's tax year, or
(2) Within 2-½ months after the close of the tax year if the amount is
vested.
Exercise 12: Mrs. Smith, a calendar year cash basis taxpayer, made
payments of $25,000 as vacation pay to her employees during 2001.
Additional vacation pay of $25,000 was earned by her employees in 2001,

but NOT paid Vacation pay becomes vested on the last day of the year in
which the vacation pay is earned Mrs. Smith may deduct $50,000 of
vacation pay for calendar year 2001. (True or False)
False. A vacation pay deduction is generally limited to the amount

of pay earned during the year to the extent (1) the amount is paid to
employees during the year or (2) the amount is vested as of the last
day of the tax year and is paid to employees within 2.5 months after
the end of the year. If such vacation pay is not paid until after the
expiration of the 2.5-month period, the employer may deduct
vacation pay when paid in its tax year that includes the last day of
the employee’s tax year for which the payment is reported as
income by the employee.
6. Unpaid Salaries
a) If there is a definite, fixed, and unconditional agreement to pay an

employee a certain salary for the year, but payment is deferred until the
following year, the deductibility depends on the method of accounting.
(1) Using the accrual method, the full salary can be deducted when
economic performance has occurred.
(2) Using the cash method, only the amount actually paid each year can
be deducted.
(3) An exception applies for an accrual method taxpayer making payments

to a related party. The salary is deductible for:
(a) The tax year the payment is made, and
(b) The amount is included in income of the person paid.
7. The exclusion amount for employer-provided educational assistance is up to

$5,250. If the employer pays or reimburses educational expenses for an
employee enrolled in a course not required for the job or not otherwise job
related, the full amount of the payment can be deducted as wages.
8. Amounts paid for qualified moving expenses, either reimbursed to employees

or paid on their behalf, can be deducted as a qualified fringe benefit. Qualified
moving expenses include:
a) Moving household goods and personal effects from the old home to the
new home, and
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b) Traveling (including lodging) from the old home to the new home. Meals
are not included.
9. Capital assets transferred to an employee can be treated as wages at the fair

market value of the asset, less any amount the employee pays for the
transfer. The employer will treat the deductible amount as an amount
received in exchange for the asset and will recognize any gain or loss realized
on the transfer.
Exercise 13: Brett transferred an automobile used in his business to Jim,

an employee, as payment for services. The value of the services provided
by Jim was $7,000. At the time of the transfer, the automobile had a fair
market value of $8,000 and an adjusted basis to Brett of $6,000. How
does Brett show this transfer on his 2001 income tax return?
A. Wage expense $8,000; gain on sale $2,000.

B. Wage expense $7,000; gain on sale $1,000.
C. Wage expense $7,000; gain on sale $0.
D. Wage expense $0; gain on sale $2,000.
A. Wage expense $8,000; gain on sale $2,000. An employee who

receives property as compensation for services for an amount less
than the property’s fair market value (FMV) must include in gross
income the difference between the amount paid for the property
and the amount of its FMV at the time of the transfer. A gain results
because the FMV is more than the adjusted basis.
10. A salary paid to an employee-shareholder must meet the same tests for
deductibility as the salary for any other employee.
11. The four tests for deductibility also apply to payments to a relative, including a
minor child.
12. Payments made to an employee's beneficiary because of the employee's

death are deductible if reasonable in relation to past services performed by
the employee.
Exercise 14: Payments made to employees are NORMALLY currently

deductible as business expenses except:
A. Vacation pay paid to an employee even when the employee chooses

not to take a vacation.

B. Wages paid to employees for constructing a new building to be used

in the business.
C. Reasonable salaries paid to employee-shareholders for services
rendered.
D. Payments made to the beneficiary of a deceased employee that is
reasonable in relation to the employee's past services.
B. Wages paid to employees for constructing a new building to be

used in the business. Salaries incurred in connection with the
construction of capital assets are not currently deductible; they
must be recovered through depreciation under the uniform
capitalization rules.
B. Employee benefit programs can include cash or noncash payments for life
insurance, health and accident insurance, retirement plans, dependent care
assistance, or educational assistance.
1. Dependent care assistance expenses can be deductible. This can include

providing the care facility, payments to a third party, or reimbursing the
employees directly. If certain requirements are met, up to $5,000 can be
excluded from an employee's pay for dependent care assistance.
2. Amounts paid to a welfare benefit fund that provides supplemental

unemployment benefits for employees can be deducted.
3. Cafeteria plans, including flexible spending arrangements, are written plans

that allow employees to choose among two or more benefits consisting of
cash and qualified benefits. The plan may not discriminate in favor of highly -
compensated individuals as to eligibility, contributions, or plan benefits. If the
plan is found to be discriminatory, highly-compensated individuals must
include the amounts in income and are subject to withholding.
4. Life insurance premiums paid by the employer are not included in the
employee's W-2 income if it is a group term policy for $50,000 or less of
protection and the employer is not the beneficiary.
5. Health and accident insurance premiums paid by the employer are generally
not included in the employee's income. This benefit may be through a self-
insured plan or an insurance policy. A self-insured plan may not discriminate
in favor of highly-compensated individuals.
6. Meals and lodging furnished to employees are deductible if included as part

of the employee's pay. If the employer reimburses meal and entertainment
costs, only 50% is deductible by the employer. Meals and lodging are not
included in the employee's income if the following tests are met:
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a) Meals and lodging are provided on the employer's business premises,
b) Meals and lodging are provided for the employer's convenience, and
c) In the case of lodging only, the employee must be required to accept the
lodging as a condition of employment.
7. The following employee fringe benefits may be excluded from an employee's

income and can still be deducted as business expenses.
a) A no-additional cost service.
b) A qualified employee discount.
c) A working condition fringe.
d) A de minimis fringe.
e) A qualified transportation fringe, up to $60 per month for combined

commuter highway vehicle transportation and transit passes, and $160
per month for qualified parking for each employee.
f) Certain athletic facilities unless the facility is made available to the general
public through the sale of memberships, renting the facility, or similar
arrangements.
g) Qualified moving expense reimbursement.
C. Qualified retirement plan contributions provided by the employer are generally

excluded from income of employees and deductible by the employer.
Contributions to nonqualified plans are deductible by the employer in the tax year
in which the employee includes the amount in income.
D. Rent Expense
1. Rent is any amount paid for the use of property which the taxpayer does not
own. To be deductible, rent must be reasonable.
a) Rent paid in advance is deductible over the period to which it applies.
b) Lease expenses are deducible as an ordinary expense provided the lease

was not intended as a purchase from the beginning of the lease term. If it
is a lease and not a purchase, the lease payments and any taxes paid on
the leased property are deducted as rent. The cost of acquiring the lease
is amortized over the term of the lease.

2. The cost of acquiring a lease is not rent. Generally, this will arise in
conjunction with acquiring an existing lease from another lessee.
a) If acquiring an existing lease on property or equipment to use in business,

this cost is amortized over the remaining term of the lease. The term of the
lease will include all renewal options if less than 75% of the cost is for the
term of the lease remaining on the purchase date.
b) If an additional amount is paid to change certain provisions of the lease,

this amount is also amortized over the remaining term of the lease.
Exercise 15: In 2000, Bob purchased a lease for an office for 4 years,
beginning January 1, 2001, to use in his tax practice. Of the $21,600 he
paid $5,000 was for the purchase of the existing lease with 4 years
remaining and NO options to renew. The remaining amount was for
monthly lease payments paid in advance. How much can Bob deduct for
2001?
A. $0
B. $1,500
C. $3,800
D. $5,400
D. $5,400. Assuming that Bob is a cash-basis taxpayer,

generally, rental expenses are deductible by a cash-basis taxpayer-
lessee in the tax year in which they are paid. However, the general
rule does not apply to advance rental payments. Advance rental
payments made by a cash-basis taxpayer-lessee are generally
NOT deductible in the tax year in which they are made but must be
allocated over the period of time for which the premises may be
used as a result of such payments.
3. Commissions, bonuses, and fees paid to obtain a lease must be amortized

over the term of the lease.
4. The cost of improvements to leased property are generally depreciated over

the appropriate recovery period under the modified accelerated cost recovery
system. The taxpayer may have a gain or loss if the improvement is not
retained when the lease expires. The gain or loss is based on the adjusted
basis of the improvement at the time the lease expires.
Exercise 16: In 2001, Nancy leased a building for use in her business.
She signed a 6-year lease with an option for an additional 3 years. In
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2001, she made leasehold improvements to the building costing a total of

$8,200. Nancy must:
A. Amortize the improvements over the remaining term of the initial

lease period
B. Amortize the improvements over the remaining term of the initial
lease period plus the option period
C. Depreciate the improvements using the modified cost recovery
system (MACRS).
D. Deduct the cost of improvements as a current expense.
C. Depreciate the improvements using the modified cost recovery

system (MACRS). The cost of improvements made to lease
property by the lessee is recovered under the MACRS rules without
regard to the lease terms.
5. The costs to rent equipment, facilities, or land are considered indirect costs if
the taxpayer is subject to UNICAP.
Exercise 17: You rent space in a facility to conduct your business of

manufacturing precision tools. All of the annual rent that you paid to
occupy the facility can be deducted as a current expense. (True or False)
False. When a cash-basis taxpayer-lessee makes advance rental

payments (i.e., payments that are consideration for the use of the
rented premises in future years), such payments are generally not
deductible in the tax year in which they are made but must be
allocated over the period of time for which the premises will be
used. Although the official answer is False, CCH believes that the
question is misleading because it does not specify that the rental
payments are for periods beyond the present tax year.
E. Travel, Entertainment, and Gift Expenses
1. Travel expenses are ordinary and necessary expenses while traveling away
from home for the taxpayer’s profession or business.
2. Travel is away from home if:
a) The duties require the taxpayer to be away from the general area of his or
her tax home substantially longer than an ordinary day's work, and

b) The taxpayer needs to get sleep or rest to meet the demands of work
while away from home.
3. Generally, a tax home is the main place of business or post of duty regardless
of where the taxpayer maintains the family home. This includes the entire city
or general area in which the business or work is located.
a) If the taxpayer has more than one regular place of business, the tax home
is the main place of business. If the taxpayer has no regular or main place
of business, the tax home may be the place where the taxpayer regularly
lives.
b) If the taxpayer has more than one place of work, the following factors can
be used to determine the main place of business or work:
(1) The total time spent working in each area,
(2) The degree of business activity in each area, and
(3) The relative amount of income from each area.
c) With no main place of business or work, use the following factors to

determine a tax home. If all three factors are satisfied, the tax home is the
home where the taxpayer regularly lives.
(1) Part of the business is in the area of the main home and the taxpayer
uses that home for lodging while doing business there.
(2) The taxpayer has living expenses at the main home that are duplicated
because business requires the taxpayer to be away from that home.
(3) The taxpayer has not left the area in which both the traditional place of
lodging and the main home are located; members of the taxpayers
family live in that home; or the taxpayer often uses that home for
lodging.
d) if only one of the previously listed factors are met, the taxpayer is a
transient and has no tax home from which to determine deductible travel
expenses.
e) If an assignment away from the main place of work is temporary, the tax
home does not change and the travel expenses are deductible. A
temporary assignment in a single location is one that is realistically
expected to last (and does in fact last) for one year or less If the
assignment is indefinite, the tax home has changed.
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4 Deductible travel expenses may include:
a) Air transportation, train, or bus between the tax home and the business
destination,
b) Taxi, commuter bus, or limousine fares between the airport and the hotel
and between the hotel and the work location,
c) Baggage and shipping,
d) Operating and maintaining a car when traveling from home,
e) Lodging,
f) Meals,
g) Cleaning,
h) Telephone, and
i) Tips.
5. The expenses of another individual accompanying the taxpayer is deductible

only if that other individual:
a) Is an employee,
b) Has a bona fide business purpose for the travel, and
c) Would otherwise be allowed to deduct the travel expenses.
6. The standard meal allowance may be used instead of deducting the actual
cost of meals while traveling away from home on business. Publication 1542
lists the allowable per diem rates for most cities within the United States.
a) The standard meal allowance for most areas of the United States is $32
per day.
b) Other locations may qualify for rates of $40 per day.
c) Eligible individuals in the transportation industry may use an average rate

of $36 per day.
7. Actual costs for lodging are allowed. A standard per diem for lodging is
allowed only for purposes of employer reimbursements. A self-employed

taxpayer or an employee cannot use the lodging per diem in lieu of actual
costs.
8. If the business travel is within the United States, all the travel expenses are
deductible if the trip is entirely business related. If the trip was primarily for
business, any expenses related to a nonbusiness side trip would be
nondeductible. Round trip travel costs would still be allowed in full. If the trip
was primarily personal round trip travel costs would be nondeductible.
However, business related expenses would remain deductible.
9. If the business trip was outside the United States and the entire time was
spent on business, all expenses are deductible subject to the applicable meal
and entertainment limitations (50%).
a) If the taxpayer spent 25% or more time on nonbusiness activities, the

transportation expenses may be limited.
b) If travel expenses are limited, the taxpayer must allocate travel expenses
of getting to and from the destination between the business and
nonbusiness activities.
Exercise 18: During October 2001, Dr. Waters, a marine biologist

specializing in sharks, attended a convention in Australia concerning the
feeding and migration habits of sharks. The convention was beneficial to
his business since it was held in an area renowned for its abundance of
sharks. Also, the foremost shark authorities in the world live there. He
spent seven full days attending the convention and three days sightseeing
He incurred expenses of $2,000 for airfare, $1,000 for lodging and $500
for meals. How much may Dr. Waters deduct for the trio on his income tax
return for 2001?
A. $3,250
B. $2,275
C. $1,750
D. $0
B. $2,275. Dr. Water’s deduction is limited because, although he

traveled outside the United States primarily for business purposes,
more than 25% of his time was spent on nonbusiness activities.
Therefore, he may deduct $1,400 (70%) of the air travel costs,
$700 (70%) of his lodging costs and $175 of his meal expenses.
The meal deduction is subject to the 50% limitation, which must be
applied before the deductible amount can be figured. Thus, $500
meal expenses subject to the 50% limit equals $250. 70% of the
$250 is deductible $175.
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10. Meal and entertainment expenses must be directly related to business or

associated with the active conduct of a business. This includes entertaining at
night clubs, theaters, and sporting events.
a) Directly-Related Test:
(1) The main purpose of the combined business and entertainment was
the active conduct of business,
(2) The taxpayer did engage in business with the person during the
entertainment period, and
(3) The taxpayer had more than a general expectation of getting income or
some other specific business benefit at some future time.
b) Associated Test:
(1) The entertainment is associated with the trade or business, and
(2) The entertainment directly precedes or follows a substantial business

discussion.
c) The cost of entertainment for the taxpayer's spouse and the spouse of the
business customer are generally not deductible. Such expense can be
deducted if the taxpayer can show a clear business purpose, rather than
personal or social purpose, for providing the entertainment.
d) Club dues and membership fees are no longer deductible as business

expenses. Dues paid to any club organized for business, pleasure,
recreation, or other social function are not deductible. Nondeductible dues
include dues paid to country clubs, golf and athletic clubs, airline clubs,
hotel clubs, and luncheon clubs.
e) Dues paid to professional associations such as bar or medical

associations, and civic or public service organizations such as Kiwanis,
Lions, Rotary, or other similar organizations remain deductible.
f) Only 50% of business related meal and entertainment expenses are

deductible. This limitation applies to employees, employers, and self-
employed persons or their clients. If a reimbursement is made, the payer
is subject to the 50% limit. Amounts subject to the limit include taxes and
tips related to the business meal, cover charges for admission to a night
club, rent paid for the room to hold the dinner, or the amount paid for

parking at a sports arena. The limit is applied after determining the amount
that would otherwise qualify.
Exercise 19: Ms. Patel, a self-employed attorney is a member of

Executive Club which is a professional businesspersons' club. Ms. Patel
uses the club on a regular basis to entertain clients. Ms. Patel had the
following detailed records to substantiate the expenses of Executive Club
during 2001:
Dues $2,400
Meals directly related to bona fide $2,000
business discussions with clients
Tips $ 400
Transportation to/from meals $ 300
What amount may Ms. Patel deduct on her income tax re turn for 2001?
A. $5,100
B. $2,600
C. $1,700
D. $1,500
D. $1,500. The expenses of a meal include amounts spent on

food and tips relating to the meal. The amount allowable as a
deduction for meal expenses is limited to 50 percent of the
expenses. Transportation expenses to and from a business meal
are 100 percent deductible. No deduction is permitted for club
dues.
11. Business gifts are limited to a deduction of $25 per individual per year.
Spouses are treated as one taxpayer even if they have separate businesses
and a separate connection to the individual. Partnerships and partners are
also treated as one taxpayer.
a) Items that cost $4 or less, have the taxpayer's name permanently

imprinted, and which are one of a number of identical items distributed are
not considered part of the $25 limit.
b) Incidental costs for engraving and gift wrapping are allowed in addition to
the $25.
c) Employee achievement awards are not considered gifts.
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d) Tickets to a theater or sporting event can be treated as a gift or an

entertainment expense if the taxpayer does not accompany the customer.
Exercise 20: Mr. Crowell, a self-employed seafood wholesaler, arranged a

business meeting with his five principal clients during March 2001. The
night the clients arrived in town, Mr. And Mrs. Crowell entertained the
clients and their spouses at their home. The cost of the food and
beverages was $400. As each client left, they were given a cheese and
fruit basket which cost $40 each. The business meeting was held the next
day at Mr. Crowell's office. Assuming NO other similar expenses during
2001, what amount of the above expenses may Mr. Crowell deduct?
A. $0
B. $125
C. $300
D. $325
D. $325. $200 (50 percent) of the meal expense is deductible and

the deduction for gifts to clients is limited to $25 per person. Here,
the Crowells gave each of 5 clients a $40 gift. The Crowells may
deduct $125 of this $200 gift expense.
12. Automobile expenses are allowed within certain limits. Taxpayers have the
option of deducting actual expenses or electing the standard mileage rate.
a) Actual expenses can be deducted to the extent of the business use

percent. Depreciation, including any §179 deduction, is limited depending
on when the car was placed in service.
b) The standard mileage rate is 34.5¢ per business mile for 2001!! The
standard mileage rate is not allowed if:
(1) The taxpayer does not own the car,
(2) The taxpayer uses the car for hire (such as a taxi),
(3) The taxpayer operates two or more cars at the same time, or
(4) The taxpayer claimed a deduction for the car in an earlier year using:
(a) ACRS or MACRS depreciation, or
(b) Section 179 deduction.

13. Reimbursing an employee for the above expenses is generally deductible.

The manner and amount depend on whether it is under an accountable plan
or a nonaccountable plan.
a) Reimbursement under an accountable plan must meet the three

requirements:
(1) The employee's expense must have a business connection,
(2) The employee must adequately account to the employer for the
expenses within a reasonable period of time (60 days), and
(3) The employee must return any excess reimbursement or allowance

within a reasonable period of time (120 days).
b) If the plan rules are met, the expense is deductible as if the business paid
them. If the rules are not met, the reimbursement is under a
nonaccountable plan and reported as income by the employee.
F. Interest paid or accrued on a debt related to a trade or business is deductible.

The taxpayer must be liable for the debt.
1. Allocation rules apply if money borrowed is used partially in a trade or

business and partially for personal or investment purposes or in a passive
activity. Allocation is completed by tracing disbursements to specific uses.
The type of expenditure to which the debt is allocated determines the
limitation, if any, that applies to the interest expense deduction.
2. If any part of a loan allocated to more than one use is repaid, the amount is
treated as repaid in the following order:
a) Amounts allocated to personal use,
b) Amounts allocated to investments and passive activities,
c) Amounts allocated to passive activities in connection with a rental real

estate activity in which the taxpayer actively participates,
d) Amounts allocated to former passive activities, and
e) Amounts allocated to trade or business use and to expenses for certain

low-income housing projects.
3. Deductible interest includes:
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a) Interest amounts paid on amounts borrowed against a life insurance,

endowment, or annuity contract if the loan proceeds were used for
business purposes.
b) Mortgage interest payments on business property. This includes points

paid for the use of the money. This also includes a prepayment penalty
charged by the lender for paying the loan off early.
c) The interest portion of payments on business assets purchased using the

installment method.
4. Nondeductible interest:
a) A cash basis taxpayer does not deduct interest until paid in cash or its
equivalent.
b) Interest that must be capitalized.
c) Commitment fees or standby charges.
d) Interest on an income tax liability on the taxpayer's individual return.
e) Interest related to tax-exempt income.
5. Interest on debt used to finance the production of real or tangible personal

property must generally be capitalized. Interest paid or incurred during the
production period must be capitalized if the property produced is designated
property. Designated property is:
a) Real property,
b) Personal property with a class life of 20 years or more,
c) Personal property with an estimated production period of more than 2

years, or
d) Personal property with an estimated production period of more than one

year if the estimated cost of production is more than $1 million.
Exercise 21: On January 2, 2001, DLW Partnership purchased and

placed in service a machine used for production purposes. The machine
cost $10,000 plus $500 sales tax. DLW financed the entire purchase price.
During 2001, DLW paid total interest of $850 on the note. Concerning the

income tax treatment of the above expenses, which of the following

statements is CORRECT?
A. Under the uniform capitalization rules, the interest AND sales tax
should be included in the basis of the machine.
B. Under the uniform capitalization rules, the interest should be included
in the basis of the machine and the sales tax should be deducted as
a current expense.
C. The interest should be deducted as a current expense and the sale
tax should be included in the basis of the machine.
D. The interest AND sales tax are separately stated items which 'flow-
through" to the partners.
C. The interest should be deducted as a current expense and the

sales tax should be included in the basis of the machine. Generally,
interest expense is currently deductible when paid, but sales tax
incurred in connection with an acquisition of property is added to
the basis of the property.
6. When interest is charged at a rate below the applicable federal rate (below
market loan), the borrower is treated as having received:
a) A loan in exchange for a note that requires the payment of interest at the
applicable federal rate, and
b) An additional payment. The additional payment is treated as a gift,

dividend, contribution to capital, payment of compensation, or other
payment depending on the purpose of the transaction.
G. Insurance premiums are ordinarily deducted in the tax year to which they apply,
even for a cash basis taxpayer.
1. Deductible premiums include:
a) Fire, theft, flood, or other casualty,
b) Merchandise or inventory insurance,
c) Credit insurance to cover losses from unpaid debts,
d) Employees' group hospitalization and medical plans,
e) Employers' liability,
f) Public liability,
2-45
g) Malpractice or professional liability,
h) Workers' compensation,
i) Contributions to state unemployment funds,
j) Business interruption insurance,
k) Car and truck insurance, and
I) Employee performance bonds required by law.
2. Self-employed taxpayers are allowed to deduct 30% of the cost of health

insurance that covers themselves and their dependents. They are not allowed
a deduction if they are eligible to be covered under a plan subsidized by an
employer or a spouse's employer. To be eligible for this deduction, the
taxpayer must be:
a) Self-employed,
b) A general partner of a partnership, or
c) A more than 2% shareholder of an S Corporation.
3. Life insurance premiums paid on policies covering the lives of officers and
employees are deductible if the taxpayer is not the beneficiary under the
contract. The premiums are nondeductible if the taxpayer is, directly or
indirectly, the beneficiary of the policy.
4. Premiums on group term life insurance for an amount up to $50,000 are

deductible. Premiums for the cost over this amount are included in the
employee's income and are deducted as a wage expense.
H. Taxes
1. Taxes paid in the course of an active trade or business are allowed as a

deduction. Deductible taxes include:
a) Real estate taxes,
b) Personal property tax,
c) Employment taxes,
d) Sales tax if included in gross receipts, and

e) Highway use tax.
(1) Vehicles subject to highway use tax include highway motor vehicles
that have a taxable gross weight of 55,000 pounds or more. The tax
period is July 1 through June 30. The tax is incurred when a highway
vehicle is first used on any public highway in the United States. If the
vehicle is first used in July, a full year's tax is due. If the vehicle is first
placed in service in a month after July, tax for a partial year is due.
(2) Trucks traded in during the year do not get credit for a partial year
usage. If the tax has not been paid, the new owner of a used vehicle
will owe the tax for the entire period the vehicle was used, even if the
use was by the first owner prior to the sale or trade in.
(3) Form 2290, Heavy Vehicle Use Tax Return, is used to figure and pay
the tax due on heavy vehicles used on public highways. Form 2290
can also be used to get a suspension of tax liability if a vehicle
otherwise subject to the tax is used on public highways for 5,000 miles
or less (7,500 or less for agricultural vehicles) during the period.
(4) The due date for Form 2290 for the tax on vehicles used in July is
August 31. For newly acquired vehicles, the due date is the last day of
the month after the month the vehicle is first used on public highways.
For example, if it was first used in November the due date is December
31.
Exercise 22: EVERY person in whose name a highway motor vehicle,

having a taxable gross weight of 55,000 pounds or more, is registered at
the time of its first taxable use in any tax period MUST file Form 2290,
Heavy Vehicle Use Tax Return. (True or False)
True. Every person in whose name a highway motor vehicle is

registered at the time of its first taxable use in any tax period must
file Form 2290, Heavy Vehicle Use Tax Return.
I. Other Business Expenses
1. Advertising that relates to the business activity. This can include public
service advertising to keep the business name before the community.
2. Business use of a home used regularly and exclusively for business.
3. Subscriptions to professional, technical, and trade journals.

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4. Education and training of employees or for the taxpayer's own trade or

business education.
5. Environmental cleanup costs to clean up the land and treat groundwater

contaminated by the taxpayer's business waste.
6. Interview expense allowance or reimbursement made to job candidates.
7. Legal and professional fees that are ordinary and necessary to operate the
business. Fees associated with the purchase of assets are part of the cost
bases of those assets.
8. License and regulatory fees paid to state or local governments.
9. Medical expenses necessary for the taxpayer to be able to work.
10. The cost of moving machinery from one city to another or from one part of a
plant to another, plus the cost of installing the machinery at the new location.
11. The cost of outplacement services provided employees.
12. Penalties for the late performance or nonperformance of a contract, but not
for a penalty due to a violation of a law.
13. Repair costs to keep business property in normal and efficient operating
condition.
14. Repayment of an amount included in income because the taxpayer had an

unrestricted right to the income.
15. Material and supplies consumed and used during the tax year.
16. Utilities.
17. A deduction for part of the cost of clean-fuel vehicle property is allowed
against gross income. The vehicle is not required to be used in a trade or
business, but if used in the business, it is an other deduction on the form used
to report the business activity. This is not part of the general business credit.
Exercise 23: Individuals are allowed a limited deduction from gross

income for the cost of qualifying clean fuel vehicle property. Which of the
following is NOT a requirement for the credit?
A. The property must be placed in service AFTER June 30, 1993.

B. The property must be used in a trade or business.

C The amount of the deduction limit is based on the Gross Vehicle
Weight Rating.
D. A taxpayer may deduct the cost of property that modifies an existing
motor vehicle from one that is NOT propelled by a clean-burn mg fuel
into one that is propelled by a clean-burning fuel.
B. The property must be used in a trade or business. The taxpayer

is not required to use the clean-fuel vehicle property in a trade or
business in order to claim the deduction.
J. Nondeductible expenses include:
1. Bribes and kickbacks if they are payments, directly or indirectly, to employees

of the government or payments, directly or indirectly, to a person in violation
to any federal or state law.
2. Charitable contributions are not business expenses. Corporations are allowed

a deduction for charitable contributions.
3. Demolition expenses or losses.
4. Lobbying expenses.
Exercise 24: Dino and Virgil operated a service station for many years as
a partnership. In 2001, they purchased a vacant service station and land
at a better location and moved their business to the new location. As a
result of the move, Dino and Virgil incurred the following related expenses:
Cost of land and building at new location $150,00

0
Cost to move and install the existing machinery, 10,000
equipment, etc., from the old location to new
location
Environmental costs to clean up old location 35,000
contamination
How much of the expenses shown above can Dino and Virgil currently
deduct (not considering depreciation or section 179 applicability) as an
expense on their partnership income tax return?
A. $0
B. $10,000
C. $35,000
D. $45,000
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D. $45,000. Land is a business asset that must be capitalized

(Pub. 334). Environmental clean-up costs are deductible as a
business expense. See Pub. 334. The costs of moving machinery
from one location to a new location is also deductible as a business
expense.
IV. Depreciation, Section 179, Amortization & Depletion
A. Modified Accelerated Cost Recovery System (MACRS) must be used for all
tangible property placed in service after 1986. MACRS consists of two systems
for depreciation, the General Depreciation System (GDS) and the Alternative
Depreciation System (ADS). GDS is generally used.
1. Allowable depreciation is determined under one of three different

conventions. The convention is determined when the asset is placed in
service. The asset's basis, assigned class life, and the convention and
method chosen determine the amount of depreciation allowed.
a) Half-year convention means all property placed in service during the year
is considered to be placed in service during the mid-point of the tax year.
This allows the taxpayer to deduct one-half of a full year's depreciation for
the first year the asset is placed in service. The half-year convention
applies to assets with a class life of 3, 5, 7, 10, 15 and 20 years.
b) Mid-quarter convention applies if more than 40% of the aggregate bases

of all property is placed in service during the last three months of the tax
year. The aggregate basis of all property does not include property placed
in service and disposed of in the same year.
c) Mid-month convention applies only to residential rental property in the

27.5 year class and nonresidential real property in the 39 year class.
Property is treated as if it were placed in service during the mid-point of
the month.
d) Under MACRS, there are five methods that can be used:
(1) 200% declining balance,
(2) 150% declining balance over GDS recovery period,
(3) Straight line over GDS recovery period,
(4) 150% declining balance over ADS recovery period, and

(5) Straight line over ADS recovery period.
Exercise 25: On March 15, 2001, Alexander purchased and placed in

service an apartment building which contained six units. The total cost of
the building was $350,000. All of the units were rented to unrelated third
parties. For MACRS depreciation purposes, which recovery period AND
convention should Alexander use when filing his income tax return for
2001?
A. 27.5 years, half-year convention

B. 27.5 years, mid-month convention
C. 31.5 years, half-year convention
D. 31.5 years, mid-month convention
B. 27.5 years, mid-month convention. MACRS depreciation rules

require that non-residential real property placed in service after
1986 be depreciated over 27.5 years using the mid-month
convention.
2. Some tangible property is not depreciable. Examples include land, leased

property, and costs to demolish a building.
3. Depreciation is allowed or allowable. Allowable depreciation is the amount the

taxpayer is entitled to under the applicable method and convention. If the
taxpayer does not claim depreciation he or she is entitled to, the basis of the
property must still be reduced by the entitled amount. No depreciation
deduction is allowed for property placed in service and disposed of in the
same tax year.
B. Alternate MACRS method is used for tangible property placed in service after
1986 and certain transitional property. The depreciation deduction is computed
using the straight line method with no salvage value over the asset's class life.
Personal property that has no assigned class life has a 12 year recovery period.
All real property is assigned a 40 year life. The same conventions apply as in
regular MACRS.
Exercise 26: Missed depreciation deductions in lax years barred by the

statute of limitations would INCREASE the basis of property. (True or
False)
False. Basis of property is adjusted downward for depreciation

allowable rather than allowed.
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C. Section 179 Deduction.
1. The maximum allowable deduction under §179 is $18,500 and is limited to the
net income from all the taxpayer's active trades or businesses.
2. If the cost of qualifying §179 property exceeds $200,000, the $18,500 limit is
reduced dollar for dollar by the amount that is over $200,000. For purposes of
these limits, married taxpayers filing a separate return are treated as one
taxpayer.
3. The §179 deduction can only be taken on an original return for the year the
qualifying property was placed in service. Any disallowed amount that was the
result of the taxable income limitation can be carried forward to the next
succeeding tax year.
4. If the business use of an asset drops to 50% or less before the end of the
recovery period, the §179 deduction must be recaptured and taxed as
ordinary income on Form 4797.
Exercise 27: Jane Jerrard, who is single, is a fifty-percent partner in AB

Partnership. During 2001, AB placed in service section 179 property
having an adjusted basis to AB of $210,000. The partnership's total
income for the year was $17,500. In addition to being a partner in AB,
Jerrard also operates a business as a sole proprietorship. During 2001,
she placed in service in her business a computer costing $8,000. For
2001, this business had taxable income of $20,000 (before any section
179 deduction). What is the maximum section 179 deduction Jerrard may
claim for 2001?
A. $8,750
B. $11,750
C. $16,750
D. $17,500
B. $11,750. The adjusted basis of the property exceeds the

$20,000 threshold by $10,000, the maximum dollar amount is
$7,500 ($17,500 minus $10,000). Jerrard’s share of the partnership
deduction is $3,750. Jerrad may deduct the full $8,000 for the
computer. Her maximum Section 79 deduction is $11,750 ($3,750
plus $8,000).
D. Amortization

1. Amortization allows a taxpayer to recover certain costs in much the same way
as straight line depreciation.
2. Only specific expenses can be amortized by making an election on Form

4562 and attaching the required statement to the return. The statement
should include total costs, description, date incurred, month business began,
and the number of months in the amortization period (not less than 60).
3. Capitalized cost of certain intangibles (Section 197 intangibles) acquired after

August 10, 1993, must be amortized. The amount of the deduction is the
adjusted basis amortized over 15 years starting with the month acquired.
Exercise 28: The capitalized costs of goodwill or going concern value

acquired after August 10, 1993, must be amortized over a 15-year period
beginning with the month acquired. (True or False)
True. Taxpayers may deduct the ratably amortized capital costs of

specified intangible assets referred to as “section 197 intangibles”
over a 15-year period beginning in the month of acquisition.
4. Section 197 intangibles include:
a) Goodwill,
b) Going concern value,
c) Workforce in place, including its components, terms, and conditions of

employment,
d) Business books and records, operating systems, and any other

information base, including customer lists,
e) A patent, copyright, formula, process, design, pattern, know-how, format,

or similar item,
f) A customer-based intangible,
g) A supplier-based intangible,
h) A license, permit, or other right granted by a government unit or agency,
i) A covenant not to compete entered into in connection with an acquisition

of an interest in a trade or business, and
j) A franchise, trademark, or trade name.

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5. A §197 intangible is treated as depreciable property used in a trade or

business, qualified for §1231 treatment. Recapture is treated as §1245
property.
Exercise 29: A workforce in place, including its composition, terms and

conditions (contractual or otherwise) of employment, is a section 197
intangible asset. (True or False)
True. A workforce in place, including its composition, terms and

conditions (contractual or otherwise) of employment, is a section
197 intangible asset.
6. Start-up cost incurred in setting up a trade or business and organizational

cost incurred for a partnership or corporation (presented in Section A of this
text) are amortizable over 60 months or more.
Exercise 30: Sally opened a cafe on July 1, 2001. Prior to opening the
business, she incurred the following costs:
Consultant for market survey $2,000
Business taxes and license 600
Accounting fees 1,000
Fixtures for the cafe 400
Hiring and training employees 1,200
Advertising for grand opening 500
What amount of amortization may Sally claim, if she elects to use the
shortest period allowed, on her income tax return for 2001?
A. $570
B. $530
C. $470
D. $280
C. $470. Eligible business start-up expenses include the consultant

fees, accountant fees, expenses for hiring and training employees
and advertising expenses. Sally can deduct expenses over a period
of time not less than 60 months and can claim 6 months of
amortization in 2001.
E. Depletion deductions are allowed on oil, gas, geothermal wells, standing timber,
and mineral property. There are two ways of computing depletion.

1. Cost depletion is figured by dividing the adjusted basis of the property by the
total number of recoverable units. This result is then multiplied by the number
of units sold. Cost depletion is used for timber and mineral deposits.
2. Percentage depletion is deducted as a certain percent of the gross income

from the property with the following limitations:
a) It cannot exceed 50% of the taxable income from the property,
b) It's allowed for only certain domestic oil and gas production,
c) It can be used for mine, geothermal, and other natural deposits, and
d) The deduction is the greater of cost depletion or percentage depletion.
F. Business Bad Debts
1. Business bad debts are deductible directly from gross income if they are
closely related to the taxpayer's business activity. They must result from credit
sales to customers or loans to suppliers, clients, employees, or distributors.
2. Accrual method taxpayers can deduct bad debts when they are unable to
collect what is owed to them, provided the amount has been included in
income.
3. Cash method taxpayers generally may not take a bad debt deduction
because they do not report income until payment is received.
4. If the taxpayer guaranteed a business loan and then had to pay it off it may
qualify as a business bad debt, a nonbusiness bad debt, or a nondeductible
gift.
a) If the reason for guaranteeing the loan was closely related to the
taxpayers trade or business, the debt can be treated as a business bad
debt.
b) If the taxpayer entered the guarantee transaction with a profit motive or to

protect an investment, the debt can be treated as a nonbusiness bad debt.
c) If the taxpayer makes the guarantee as a favor to a friend and receives no

consideration in return, the transaction is a gift.
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Exercise 31: In order to protect her investment, Beth, an officer and

principal shareholder of Turbo Corporation, guaranteed payment of a bank
loan Turbo received During 2001, Turbo defaulted on the loan and Beth
made full payment. Beth is entitled to a business bad debt deduction.
(True or False)
False. Since Beth’s guarantee of Turbo Corporation was made to

protect her investment in the business as an officer and principal
shareholder, she may not deduct the amount guaranteed at the
time of default as a business bad debt. To qualify as a business
bad debt, Beth’s dominant motive for making the guarantee must
be proximately related to the guarantor’s trade or business.
5. There are two ways in which to treat amounts that have become uncollectible.
a) Specific charge-off method.
(1) Partially worthless bad debts are limited to the amount charged off the
books. This does not have to be done annually. No part of the bad debt
may be deducted in a year after the year in which the debt becomes
worthless.
(2) Totally worthless bad debts are deducted only in the tax year they
become worthless.
Exercise 32: In 2001, Ms. Azalea had gross income of $80,000, a bad
debt deduction of $7500, and other allowable deductions of $67,000 on
her Schedule C (Form 1040). She uses the accrual method of accounting
and the specific charge-off method for bad debts. During 2001, she
recovered $5,500 of the debt that she had deducted in 2000. How must
Ms. Azalea report the recovery of the bad debt?
A. She must reduce her bad debt deduction for 2000 by $5,500.
B. She must include $5,500 in "other income" on her Schedule C for
2001.
C. She must include $5,500 in nonbusiness "other income" on her Form
1040 for 2001.
D. She must file an amended income tax return for 2000.
B. She must include $5,500 in “other income” on her Schedule C for

2001. Recovery of previously deducted bad debt amounts is
reported as “other income” on Schedule C.
b) Nonaccrual-experience method.

(1) Can be used by qualifying accrual method taxpayers.
(2) Applies only to amounts to be received for the performance of

services. Taxpayers are not required to accrue income they do not
expect to collect.
(3) May not be used for amounts due for which interest or a late payment
penalty is required.
(4) May not be used for amounts owed because the taxpayer is engaged
in the business of lending money, selling goods, or acquiring
receivables or other rights to receive payment from other persons.
Exercise 33: Carolina Partnership, which uses the accrual method of

accounting derives ALL of its income from services. ft does NOT accrue
income that it does NOT expect to receive AND it does NOT charge a late
penalty on past due accounts. Carolina may use the nonaccrual-
experience method of accounting for bad debts. (True or False)
True. Taxpayers who use an accrual method of accounting, derive

all their income from services and do not charge interest or
penalties for late payments may use the nonaccrual-experience
method to report bad debts.
* Study Tip * In past years, the enrolled agents exam has had at least
one question regarding the "nonaccrual experience" method of deducting
bad debts. Although this may be uncommon in real life, the exam may test
the concept.
6. If a bad debt deduction is taken and in a later year all or part of the debt is
recovered, the recovery must be included in income. The recovery may be
excluded to the extent the deduction did not reduce the tax in the year the
bad debt was deducted. A bad debt deduction may add to or produce a net
operating loss.
G. Not-for-Profit Activities
1. An activity that shows a profit in at least 3 of the last 5 years is presumed to

have a profit motive. Activities that consist primarily of breeding, training,
showing, or raising horses are presumed to have a profit motive if they show
a profit in at least 2 of the last 7 years.
2. Factors to consider in determining if an activity is engaged in for profit include

the following:
2-57
a) Whether the taxpayer carries on the activity in a businesslike manner.
b) whether the time and effort put into the activity indicates an intent to make
it profitable.
c) whether the taxpayer depends on the income from the activity for his or
her livelihood.
d) Whether the losses from the activity are due to circumstances beyond his
or her control.
e) Whether the taxpayer changes methods of operation in an attempt to

improve the profitability of the activity.
I) whether the taxpayer, or advisors, have the knowledge needed to carry on

the activity as a successful business.
g) whether the taxpayer was successful in making a profit in a similar activity

in the past.
h) Whether the activity makes a profit in some years, and how much profit it
makes.
i) Whether the taxpayer can expect to make a future profit from the
appreciation of the assets used in the activity.
3. Activities that are not engaged in for profit are limited in their deductions in the
following order:
a) Deductions allowed for personal as well as business activities are allowed

first, such as interest, taxes, and casualty losses.
b) Deductions other than depreciation and amortization are deducted to the

extent of the remaining income.
c) Basis reduction items are allowed to the extent there is any income
remaining after the deductions from 1 and 2 above.
4. Allowable deductions are shown as itemized deduction on Schedule A limited

by 2% of adjusted gross income.
Exercise 34: Spencer operates a fishing yacht during three months of the
year and is not engaged in this activity for profit. He uses the yacht for his

own personal use for one month and leases it to other persons for two
months. For 2001, his income and expenses relating to the yacht were as
follows:
Income $2500
Mortgage interest $1,200
Personal property taxes $ 800
Maintenance and insurance $1,500
Depreciation $1,200
Without regard to the limitation on itemized deductions, what amount is

deductible by Spencer on his 2001 income tax return?
Interest and Maintenance Depreciation

Taxes and
Insurance
A. $1,200 $900 $1,200
B. $1,200 $900 $400
C. $2,000 $900 $400
D. $2,000 $500 $0
D. $2,000; $500; $0. The hobby loss rules apply to an activity not
engaged in for profit, since the law does not use the word “hobby.”
Deductions are allowed, to a certain extent, to individuals and S
corporations according to a 3-tiered ordering rule.
H. Net Operating Losses
1. Net Operating Losses - A net operating loss (NOL) occurs when certain
deductions for the year exceed income.
2. To have an NOL, the loss must be caused by:
a) Deductions from a trade or business,
b) Deductions taken by an employee that are work related, or
c) Deductions taken for casualty or theft losses.
3. An NOL cannot result from the deduction of:
a) Net capital losses,
b) Personal or dependent exemptions,
c) Nonbusiness losses, or
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d) Nonbusiness deductions.
4. Nonbusiness income and deductions must be separated from business

income and deductions.
Business income includes: Business deductions include:

• Ordinary and necessary
• Income from a trade or expenses from a trade or
business business, which includes
• Salary earned as an employee moving expenses
• Gain from the disposition of • Personal casualty and theft
assets used in a trade or losses reportable on Schedule
business A
• Rental income on Schedule E • Deductible employee business
• Income from a general expenses
partnership or S Corporation • State and local income tax on
reportable on Schedule E business profits
• State and local income tax
withheld from W-2 wages
• Section 1244 losses
• Losses from an S corporation
or partnership
• Unrecovered investment in
employee annuity contract
• Interest on business
indebtedness
• Losses on the sale of assets
used in a trade or business
Nonbusiness income includes Nonbusiness expenses include
• Interest and dividends • Alimony paid

• Alimony • Medical expenses after the
• Taxable pensions and AGI limitation
annuities • Charitable contributions
• Income from a limited • IRA, SEP, and Keogh
partnership contributions
• Gambling and/or lottery • Gambling losses
winnings • Standard deduction
• Gains from the sale of property • Tax preparation fee
held for investment • Safe deposit box rental
• Taxable distributions from an

IRA or Keogh • Investment expenses

• IRA custodial fees
5. Determining the NOL
a) Personal and dependent exemptions cannot be claimed.
b) NOL carryover/carryback from other years cannot be deducted.
c) Nonbusiness capital losses are limited to nonbusiness capital gains.
d) Nonbusiness deductions are limited to the total of:
(1) Nonbusiness capital gains that are more than nonbusiness capital
losses, and
(2) Nonbusiness income.
e) Business capital losses are limited to the total of:
(1) Nonbusiness capital gains that are more than the total of nonbusiness
capital losses and excess nonbusiness deductions, and
(2) Business capital gains.
Exercise 35: In 2001, Sherri, who is single, started a leasing business.

Her 2001 income tax return reflected the following income and deductions.
Income
Wages from part-time job $1,225
Interest income $ 425
Net short-term capital gain (business) $2,000
Total income $3,650
Deductions
Net loss from business $5,000
Net long-term capital loss on sale of stock 1,000
Personal exemption 2,450
Standard deduction 3,800
Loss on small business stock 1,000
Total deductions $13,250
Using the above facts, what is the amount of Sherri's net operating
LOSS for 2001?
A. $9,600
2-61
B. $3,350
C. $2,775
D. $2,350
C. $2,775. Sherri’s deductions exceeded her income by $9,600.

The required adjustment reduce Sherri’s net operating loss to
$2,775. $9,600 minus $2,450 (personal exemption) minus $3,375
(standard deduction minus interest income) minus $1,000 (capital
loss on sale of stock).
6. The NOL is carried back 3 years and carried forward for up to 15 years for the
losses in tax years beginning before 8/16/97 and is carried back 2 years and
forward to 20 years thereafter, until used. Any unused portion is lost after the
final carry-forward year.
a) A carryback can be accomplished by either of two methods:
(1) Form 1045, Application for Tentative Refund, can be filed no later than
one year after the close of the NOL year.
(2) Form 1040X is used within 3 years of the due date, including
extensions for filing the tax return for the NOL year.
b) For a carryforward, the NOL is listed as negative income on the "Other

Income" line of Form 1040
c) An irrevocable election to forego the carryback period can be made by

attaching a statement to the tax return for the loss year. This statement
must be filed no later than the due date, including extensions, for filing the
income tax return.
7. Modified taxable income is used only to determine if there is any excess NOL
to be carried to the next tax year. Modified taxable income:
a) Step One - Figure AGI as usual except deduct capital losses only to the
extent of capital gains (no deduction for any part of a net capital loss is
allowed). Do not deduct the NOL carried from the NOL year or any later
tax years. Be sure to deduct any allowable NOL carryovers from years
before the NOL year.
b) Step Two - Take deductions from AGI that are normally allowed. Refigure
deductions and credits that are based on a percentage of AGI using the
modified AGI from step one.

8. Partnerships and S Corporations are not allowed an NOL deduction. The

losses are passed through to the partners or shareholders separately and
deducted on their individual income tax returns.
Exercise 36: All of the following statements about forgoing the net
operating loss (NOL) carryback period are CORRECT except:
A. The election should be made as a written statement attached to the

tax return for the NOL year citing the appropriate Internal Revenue
Code section.
B. Once the election is made, the taxpayer CANNOT later revoke it for
that tax year.
C. A taxpayer may amend a prior year's return to include the election as
long as the election is made before the expiration of the statute of
limitations.
D. A taxpayer who wants to for go the carryback period for more than
one NOL must make a separate election for each NOL year.
C. A taxpayer may amend a prior year’s return to include the

election as long as the election is made before the expiration of the
statute of limitations. An NOL election may be made on an
amended return if the return is filed on or before the due date for
filing returns for the year the election is sought. An election, once
made for any tax year, is irrevocable.
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SECTION C - SALES, EXCHANGES, AND OTHER TOPICS

A. A sale is the transfer of property for money, a mortgage, note, or other promise to
pay money. An exchange is the transfer of property for other property or
services. A transaction must be a sale or exchange for any gain to be taxable or
any loss deductible.
B. The gain is the excess of the amount realized over the adjusted basis of the
property. The loss is the excess of the adjusted basis over the amount realized.
C. Basis is generally the cost of the property if acquired by purchase. Basis may be
different than cost if the property was acquired by gift, inheritance, or in some
way other than by purchase.
D. Adjusted basis is the original cost or other basis plus certain additions such as
improvements or selling expenses; minus certain deductions such as
depreciation, amortization, and casualty losses.
E. The amount realized is the total of all money received plus the fair market value
of all property and services received. The amount realized also includes any
liabilities that were assumed by the buyer and liabilities to which the property
traded is subject (mortgage, real estate taxes, etc.) The amount realized is not
necessarily the same amount that is included in income and subject to tax.
F. The amount recognized is the amount that is included or deducted in determining

gross income for tax purposes. The amount recognized can differ from the
amount realized. An example of this may occur in a like-kind exchange.
G. The fair market value (FMV) is the price at which the property would change
hands between a willing buyer and a willing seller when both have reasonable
knowledge of all the facts and neither is required to sell.
II. Sales and Exchanges
A. Foreclosures and Repossessions
1. A foreclosure or repossession is treated as a sale or exchange from which the

borrower may realize a gain or loss.
2. The transaction is reported the same as other sales with the gain or loss
being the difference between the adjusted basis in the property and the
amount realized.

B. Like-Kind Exchange
1. When an exchange qualifies as '"like-kind" the gain is not taxed and losses
are not deductible. Several requirements must be met before an exchange
will qualify under the like-kind rules.
2. The property exchanged must be business or investment property. Both the

property given up and the property received must be held for business or
investment use. Property held for sale such as inventory or merchandise held
for resale does not qualify.
3. The property must be "like-kind" property.
a) Personal property for similar personal property such as a truck for a van.
b) The exchange of livestock of different sexes will not qualify under the like-
kind rules (heifers for bulls).
c) Real property for real property. Unimproved land for improved land will
qualify as like-kind.
4. Generally stocks, bonds, notes, other securities or evidence of indebtedness

or interest, or the exchange of a partnership interest will not qualify.
5. The exchange may be a deferred exchange in which business or investment

property is transferred, and at a later time, replacement property is received.
A deferred exchange must meet certain requirements.
a) The property to be received in the exchange must be identified within 45

days after the date in which the property exchanged is transferred.
b) The taxpayer then has 180 days from the date the property is relinquished
to take possession of the replacement property.
6. The basis of the property received in a nontaxable exchange is the basis of

the property given up plus any additional cash paid or liabilities assumed.
7. A partially nontaxable exchange is one in which a taxpayer receives unlike

property or money in addition to like property. The basis of property in a
partially nontaxable exchange is the basis of the old property with the
following adjustments:
a) Decreased by money received, any liabilities transferred, and any loss

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b) Increased by any additional costs incurred, money paid, liabilities

assumed, and gain recognized on the exchange.
C. Related Party Exchanges - Exchanges between related parties are nontaxable

provided certain rules are followed. These rules became effective July 10, 1989.
1. Related parties include:
a) Members of a family (spouse, brother, sister, parent, child, etc.), and
b) A corporation in which the taxpayer owns more than a 50% interest, or a

partnership in which the taxpayer owns, directly or indirectly, a more than
50% interest in the capital or profits.
2. If either patty to the exchange disposes of the property within 2 years after the
exchange, the exchange is disqualified from nonrecognition treatment. The
gain or loss, on the original exchange, must be recognized as of the date of
that later disposition.
3. Exceptions to the related party rules include the following:
a) Dispositions due to the death of either related person,
b) Involuntary conversions, and
c) Exchanges or dispositions if it is established to the satisfaction of the IRS

that the main purpose is not the avoidance of federal income tax.
D. Trade-Ins - Property which is traded-in for other property is treated as an

exchange. The transaction is treated as an exchange regardless of how the
parties try to avoid the trade-in rules. An example of a like-kind exchange is the
trade-in of a used vehicle for a new vehicle. The basis of property for
depreciation cannot be increased by selling the old property to a dealer and then
buying new property from the same dealer. If the sale and purchase are
dependent on each other, it will be treated as a trade-in.
E. Foreign Real Property - Transfers of real property located in the United States for
real property that is located outside the United States are not considered like-
kind exchanges. Therefore, if the taxpayer exchanges foreign real property for
property located in the U.S., any gain on the exchange is fully taxable.
III. Gains and Losses

A. If the property sold or exchanged is a capital asset, the owner's gain or loss will
be a capital gain or loss. If the property is not a capital asset, the gain or loss is
an ordinary gain or loss. Taxpayers must distinguish between capital and
ordinary gain and between long and short-term transactions. Capital assets
generally include everything the taxpayer owns except:
1. Property held mainly for sale to customers (inventory) or property that will
physically become part of that property,
2. Accounts or notes receivable that are acquired in the ordinary course of a

trade or business,
3. Depreciable property used in a trade or business, even if fully depreciated,
4. Real property used in a trade or business, or
5. A copyright, a literary, musical or artistic composition, a letter or

memorandum, or some other similar type property.
B. Gain on the sale or exchange of property, that is depreciable property in the

hands of the party who receives it, may be taxed as ordinary income if the
transaction was with a related party.
1. Related parties for this purpose include:
a) A person and the person's controlled entity,
b) A taxpayer and any trust in which the taxpayer is a beneficiary, and
c) An employer and a welfare benefit fund that is controlled directly or

indirectly by the employer.
2. A controlled entity is:
a) A corporation in which more than 50% of the value of all outstanding

stock, or a partnership in which more than 50% of the capital interest or
profits interest, is owned, directly or indirectly, by or for that person.
b) An entity whose relationship with that person is one of the following:
(1) A corporation and partnership if the same persons own more than 50%
in value of outstanding stock and more than 50% of the capital interest
or profits interest.
(2) Two corporations that are members of the same controlled group.
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(3) Two S Corporations, if the same persons own more than 50% in value
of the outstanding stock of each corporation.
(4) Two corporations, one being an S, if the same person owns more than
50% in value of the outstanding stock of each.
3. No deduction is allowed for losses from sales or exchanges between related

parties. However, if the person receiving the property later sells that property
at a gain, the gain is recognized only to the extent that it is more than the loss
not allowed to the related party. For this purpose, in addition to the
relationships just presented, related parties also include:
a) Members of the immediate family, including only brothers and sisters,

husband and wife, ancestors, and lineal descendants.
b) Fiduciaries of two different trusts, and the fiduciary and beneficiary of two
trusts if the same person is the grantor of both.
c) Certain educational or charitable organizations and a person who controls

that organization.
d) A trust fiduciary and a corporation if the more than 50% in value of

outstanding stock is owned by or for the trust or by or for the grantor.
e) The grantor and fiduciary and the fiduciary and beneficiary of any trust.
f) A personal service corporation and any employee-owner.
C. Goodwill is an asset that may or may not exist within a business. The reporting of
its sale depends on the date it was acquired and how it was treated by the
taxpayer. If goodwill was acquired before July 25, 1991 the sale would result in a
capital gain or loss. However, if goodwill was acquired after August 10, 1993 (or
July 25, 1991 if an election was made to apply §197 to such intangibles) the sale
is treated as the sale of §1245 property. If a business with goodwill is sold,
allocation of the selling price to goodwill must be made by the residual method.
Allocate to other assets an amount of the purchase price in proportion to (but not
in excess of) fair market value in the following order:
1. Cash, demand deposits, and similar accounts,
2. CDs, US government securities, other readily marketable stock or securities,

and foreign currency,
3. Noncompete covenant,

4. All other assets except goodwill, and
5. Any remaining purchase price, after the above allocations, is the purchaser's
basis in goodwill or the seller's amount received for the sale of goodwill.
D. Timber held as investment property is treated as a capital asset. Its sale will
result in a capital gain or loss. The sale of timber held primarily for sale to
customers in the ordinary course of business results in ordinary income.
IV. Holding Period
A. Before gains and losses can be determined, the assets must be classified as
long-term or short-term.
1. For assets held one year or less, the gain or loss will be short-term.
2. Assets held more than one year will be treated as long-term gain or loss.
3. In counting for the one year period, start counting on the day following the day
the property was acquired and include the day the property is disposed of.
The same date of each month is the beginning of a new month.
B. The holding period for stock and securities begins the day after the purchase
date. For the sale of securities, the date of disposition is the trade date and not
the settlement date. If payment is received in a later tax year, gain or loss is still
recognized on the trade date.
C. The holding period for inherited property is always long-term regardless of how
long the taxpayer or the person from whom the property was inherited actually
owned the property.
D. For property sold on the installment method, if the property sold was held short-
term, the gain will be reported as short-term gain for the duration of the
agreement. If the property sold was held long-term, the gain will be long-term.
E. When a taxpayer acquires an asset in a nontaxable exchange, the holding period

for the new asset includes the holding period of the old asset.
F. The holding period for property received as a gift includes the donor's holding
period.
G. The holding period for real property begins the day after title to the property is
received.
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H. The holding period for the later sale of repossessed property includes the period
the property was held before the original sale, as well as the period after the
repossession.
V. Reporting Gains and Losses
A. Section 1231 Property - Property used in a trade or business or held for the
production of rents and royalties and held for more than one year is referred to as
§1231 property.
1. In a disposition, first figure the ordinary part of the gain. Any remaining gain is
included in the §1231 computation.
a) Combine all §1231 gains and losses for the year. If the §1231 gains
exceed losses, there will be a net §1231 gain.
b) If §1231 losses equal or exceed §1231 gains, then treat each item as an
ordinary gain or loss.
2. A net §1231 gain is treated as ordinary to the extent the taxpayer has
nonrecaptured net §1231 losses taken in prior years.
3. Nonrecaptured net §1231 losses are those §1231 losses deducted in the
taxpayer's five most recent tax years that have not been applied against any
net §1231 gains in a tax year beginning after 1984.
4. The amount of the taxpayer's net §1231 gain that is not treated as ordinary
income is long-term capital gain.
B. Section 1245 Property - Personal property used in a business, held for more than
one year, subject to an allowance for depreciation, and sold for a gain is §1245
property. Any depreciation, §179 expense deduction, recovery allowance, and
any downward basis adjustment allowed or allowable, is taxed as ordinary
income to the extent of the gain.
Exercise 37: Betty Lou sold a rental condominium she owned for several
years. Her records reveal the following:
Item to be Allocated Total Personal Buildin Land

Property g Rig
hts
Original purchase price $100,0 $15,000 $80,00 $5,000
0 0

0
Total depreciation 67,000 15,000 52000 0
claimed
Excess depreciation 10,000 N/A 10,000 0
claimed
Allocated selling price 150,00 12,000 130,00 8,000
0 0
How much of the gain to be recognized on this transaction will be reported

as section 1245 recapture?
A. $24000
B. $15,000
C. $12,000
D. $10,000
C. $12,000. Section 1245 property and Section 1245 recovery

property are both subject to the Code Sec. 1245 recapture rules.
Section 1245 property is generally depreciable personal property
used in a trade or business. Accordingly, Betty Lou must recapture
the $12,000 gain on the personal property. The residential rental
property and the intangible land rights are specifically excluded
from the definition of Section 1245 recovery property.
C. Section 1250 property includes all real property held long-term, that is or has
been subject to an allowance for depreciation, and is not and has never been
§1245 property.
1. Gain on the sale of business or rental real estate is generally §1250 property
unless the property is nonresidential real property depreciated under ACRS.
Nonresidential real property for which ACRS deductions were taken is
considered §1245 property.
2. Gain on the sale of residential rental property will be treated as ordinary

income to the extent of the excess depreciation under ACRS over straight
line.
3. Ordinary income rules will not apply to residential real property or

nonresidential real property placed in service after December 31, 1986
because MACRS for this property is determined using the straight line
method.
D. If the basis of §1250 property received as a gift or inheritance, or in a tax-free

exchange, is reduced by the depreciation that was either allowed or allowable to
the former owner, a separate statement showing the basis determination must be
attached to the return for the year the property was acquired.
2-71
Exercise 39: Brent received a gift of section 1250 property from his
grandfather. The basis of this property is reduced by the depreciation that
was either allowed or allowable to his grandfather. Therefore, Brent must
attach a separate statement to his return for the year he received the gift
to indicate how his basis in the property was determined. (True or False)
True. All property placed in service after 1986 is depreciated under

the straight-line basis, so there is no excess depreciation to
recover.
E. Section 1244 Stock Loss - A taxpayer that has a loss from the disposition of
"small business stock" can treat the loss as an ordinary loss (rather than a capital
loss). The maximum amount of the loss that can be treated as an ordinary loss
for the tax year is limited to $50,000 ($100,000 for MFJ tax returns). The
determination as to whether the stock qualifies as §1244 stock is made at the
time it is issued. §1244 stock must meet all of the following requirements:
1. At the time the stock is issued, the corporation must be a small business
corporation. For purposes of this section, a corporation will be considered to
be a small business corporation if the aggregate amount of money and other
property received by the corporation in exchange for stock, or as a
contribution to capital (paid-in-surplus), does not exceed $1,000,000.
2. The stock issued by the corporation was for money or other property (other
than stock and securities), and
3. During the period of the 5 most recent tax years ending before the date of the
loss, the corporation derived more than 50 percent of its aggregate gross
receipts from sources other than rents, royalties, dividends, interest,
annuities, and sales or exchanges of stocks or securities.
NOTE: An ordinary loss under §1244 can only be claimed by an

individual to whom the stock was originally issued.
Exercise 40: Ms. Witherby purchased 100 shares of qualifying small

business (Section 1244) stock for $10,000 on January 2, 2001. On July 1,
2001, Ms. Witherby had to make an additional $2,000 contribution to
capital which increased her total basis in the 100 shares to $12,000. On
November 9, 2001, Ms. Witherby sold the 100 shares for $9,000 to an
unrelated party. What is the amount and character of the gain or (loss) Ms.
Witherby may claim on her 2001 income tax return?
Ordinary (Loss) Capital Gain or

(Loss)

A ($12,000) $9,000
B ($3,000) $0
C ($2,500) ($500)
D $0 ($3,000)
C. ($2,500); ($500). If an owner of Section 1244 stock invests

additional capital but is not issued additional shares of stock, the
amount of the additional investment is added to the basis of the
originally issued stock, but this subsequent increase to the basis of
the originally issued stock does not qualify for ordinary loss
treatment. Any resulting loss must then be apportioned between the
qualifying Section 1244 stock and the non-qualifying additional
capital interest (Code Sec.1244). Since the additional capital
interest of $2,000 is one-sixth of the total basis of $12,000, the
$3,000 loss is apportioned as follows: $500 of capital loss (one-
sixth of $3,000) and $2,500 of capital loss (one-sixth of $3,000) and
$2,500 of qualifying ordinary loss.
VI. Capital Loss Carryover
A. Capital gains and losses are netted together regardless of whether they were
held short-term or long-term. The excess of the losses over the gains are allowed
up to $3,000 annually. The remaining losses are carried over until they are used
up. If the taxpayer has a net capital loss, it must be deducted even if there is no
ordinary income to offset the loss.
B. Carryovers retain the original character as Long-Term or short-term. when

figuring how much capital loss to carry over, use short-term losses first, even if
incurred after long-term losses.
C. The method for figuring the amount of capital loss carryover for tax years
beginning after 1986 has changed. The capital loss carryover is the amount of
the capital loss that exceeds the lesser of:
1. The allowable loss deduction for the year, or
2. The taxpayer's taxable income increased by the allowable capital loss

deduction for the year and the deduction for the personal exemptions.
2-73
NOTE: The maximum capital gains tax rate remains at 28%..
Section 1231
Land and depreciable property used in a business, held over one year
Sold at a Gain Sold at a Loss
Section 1245 Section 1250
• Personal property • Residential rental property All losses will be
• Nonresidential real property treated as §1231
• Nonresidential real depreciated using straight line. ordinary losses
property depreciated
using ACRS ACRS
• Depreciation in excess of straight
Treated as ordinary gain line is recaptured as ordinary
up to the amount of income. The remaining gain is §1231
depreciation. The gain
remaining gain is §1231
gain SL or MACRS
No recapture All gain is treated as
capital §1231
VII. Installment Sales
A. Sales that result in a gain and provide for all or part of the selling price to be paid
in a later year are installment sales. Each payment received on an installment
sale consists of three parts:
1. Return of the seller's investment (basis) in the property sold,
2. Gain on the sale, and
3. Interest.
NOTE: If the sale results in a loss, the installment method cannot be

used. A loss on the sale of business assets is deductible only in the year
of the disposition.
B. Recapture of depreciation under §179, §1245, and §1250 is treated as ordinary

income to the extent of the gain. This income is taxed in the year of sale
regardless of when the seller receives payment.

Exercise 41: On December 15, 2001, Miranda, a calendar year taxpayer;

sold two business assets on the installment method for a total of
$300,000. Her section 1245 property accounted for $100,000 of the
selling price and was subject to depreciation recapture of $65,000. Her
section 1250 property sold for the remaining $200,000 and was subject to
a $25,000 depreciation recapture. Miranda received $60,000 as a down
payment in 2001. The remaining payments will be made in subsequent
years. How much TOTAL depreciation recapture will Miranda be required
to report on her 2001 income tax return?
A. $0
B. $18,000
C. $60,000
D. $90,000
D. $90,000. Since any depreciation recapture under Code Secs.

1245 and 1250 is includible in income in the year that the property
is disposed of in an installment sale, Miranda must report $90,000
($65,000 plus $25,000) of depreciation recapture on her return
(Code Sec. 453(I)).
C. A dealer or anyone who regularly sells property on the installment plan may not
use the installment method to report the gain from the sale of real or personal
property. This also applies to real property held for sale to customers in the
ordinary course of a trade or business.
D. The sale of stock or securities traded on an established securities market cannot

be reported using the installment method. The sale must be reported in the year
in which the trade date falls.
E. If an installment obligation from the sale of business or rental property for more
than $150,000 is used as security for any debt, the net proceeds from the debt
are treated as a payment against the installment obligation.
F. Installment method reporting is required unless the taxpayer makes an election

not to use the installment method. If the election is made, the entire gain is
taxable in the year of sale. The election is made by the due date, including
extensions, for the tax year the sale takes place.
G. Income from property sold under the installment method is reported on Form
6252, Installment Sale Income.
1. If the property sold is a capital asset, the capital gain portion is included on
Schedule D.
2-75
2. If the property sold is business property and the property is held long-term,
report the depreciation recapture income in the year of sale up to the amount
of gain on Part II, Form 4797, and the amount of §1231 gain in Part I.
H. The Gross Profit Ratio represents the portion of each payment (excluding the
portion for interest) which is reported as gain from the sale. This ratio is referred
to as the gross profit percentage and remains the same for each payment. All
interest, including unstated interest, is reported on Schedule B.
Gross Profit Percentage = Gross Profit / Contract Price
1. Gross profit is the amount of gain to report under the installment method. It is
figured as the amount realized, less the installment sale basis.
2. Contract price is the total amount the buyer will pay the seller, plus the
amount by which any liability assumed by the buyer exceeds the seller's
installment sale basis.
3. Installment sale basis is the adjusted basis plus the selling expenses and any
ordinary income recapture required to be reported.
4. If taxpayers are able to postpone or exclude all or part of the gain on the
installment sale of their main home, none of that gain is included in the gross
profit for figuring the gross profit percentage.
I. Related Persons - Special rules apply if property is sold to related persons under
the installment method and that person sells or otherwise disposes of the
property within two (2) years of the first sale.
1. The amount the related person realizes as a result of the second disposition
is treated as if it had been received by the person making the first disposition.
2. Gain recognized to the initial seller is based on the gross profit ratio and is
recognized only to the extent the amount realized from the second disposition
exceeds actual payments received under the installment sale.
J. Payments considered to be received include:

1. If the buyer pays or assumes any of the seller's expenses from selling the
property, this amount is treated as a payment in the year of sale.
2. If the buyer assumes or pays off a mortgage:
a) If the mortgage is less than the seller's installment sale basis in the
property, it is not considered a payment and the contract price equals the
selling price minus the mortgage.

b) If the mortgage is more than the installment sale basis, the entire basis is
recovered and the amount in excess of the basis is treated as a payment
in the year of sale. The contract price is the same as the gross profit from
the sale.
K. The single sale of several assets requires determining gain or loss on each
asset. The sale, at a gain, of separate and unrelated assets of the same class
under a single contract is reported as a single transaction. Any assets sold at a
loss cannot be included in the installment sale reporting.
L. Each payment under the installment method contains an interest component. If

interest is less than the applicable federal rate or not stated, the imputed or
unstated interest must be determined. This amount reduces the stated selling
price and the gross profit percentage.
* Study Tip * Installment sales have been consistently tested on prior

exams. You should be familiar with how to compute gain, gross profit
percentage, and contract price.
VIII. Involuntary Conversions
A. An involuntary conversion is the result of a casualty, theft, or condemnation.
1. If business property is completely destroyed, the deductible loss is the

adjusted basis of the property minus any salvage value and any
reimbursement received or expected to be received.
2. If property is partially destroyed, the deductible loss is the lesser of the

decrease in fair market value or the adjusted basis of the property reduced by
any reimbursements.
3. A gain may be postponed if the replacement property is bought within a

specific period.
B. A theft is the unlawful taking of another person's property. To be deducted as a

theft loss, the taxpayer must be able to show a theft occurred under the law of
the state where the theft occurred, when the property was determined to be
missing, and ownership of the property.
1. If the business property is stolen, the deductible loss is the adjusted basis of
the property reduced by any reimbursement received.
2. The theft of inventory is deducted through the cost of goods sold by adjusting
the ending inventory to reflect the theft.
2-77
3. Mislaid or lost property is not a theft.
4. Theft losses are generally deducted only in the year of discovery
C. A casualty is the result of an identifiable event that is sudden and unexpected

such as an act of nature or an accident. Casualty losses are generally deductible
only in the year in which the casualty occurred.
Exercise 42: Baron Landers owned a 3-story building which he built on

leased land in Castroville, California. Baron used two floors (2/3 of the
building) in his business and he lived on the third floor (1/3 of the building).
The building cost $140,000 and he made no improvements or additions to
it. In March 2001, a flood damaged the entire building. The fair market
value of the building was $133,000 immediately before the flood and
$120,000 afterwards. Baron's insurance company reimbursed him $9, 000
for the flood damage. Depreciation on the business part of the building
before the flood totaled $8,400. Baron's adjusted gross income for 2000
was $50,000. what is the amount of Baron's deductible BUSINESS
casualty loss?
A. $0
B. $2,567
C. $2,667
D. $4,000
C. $2,667. In general, the amount deductible as a business

casualty loss is the difference between the fair market value of the
business property immediately before the casualty reduced by the
fair market value of that property immediately after the casualty,
reduced by any insurance received (Code Sec. 165). Accordingly,
($133,000 minus $120,000) minus $9,000 equals $4,000. Since
only two-thirds of Baron’s loss was attributable to business
property, Baron’s deductible business casualty loss is $2,667 (2/3 x
$4,000).
D. Disaster Area losses are losses resulting from a disaster in an area designated
as such by the President of the United States. Such losses may be deducted on
the return for the immediately preceding tax year or on the tax return for the year
of the disaster.
1. An election (irrevocable after 90 days) to deduct the loss in the preceding

year is to be made by the later of:

a) The original due date of the tax return for the year the disaster occurred,
or
b) The due date of the preceding year's return, including extensions.
2. A disaster loss to inventory may be deducted on the preceding year's return

by decreasing opening inventory for the year of the loss so the loss will not
show up in inventory.
Exercise 43: On October 2, 2001, Pamela's freezers in her grocery store

went off due to a tornado causing her to lose $5,000 of frozen foods. Her
insurance company reimbursed her $4,000 on January 7, 2002. Pamela
had a beginning inventory' of $10,000, purchases of $8,000, and an
ending inventory of $3,000. Which of the following is a proper method to
account for this event?
A. Do nothing for 2001, report the $4,000 as additional gross receipts

for 2002.
B. Do nothing to inventory' for 2001, report the $4,000 as additional
gross receipts in 2001.
C. Reduce beginning inventory by $5,000 for 2001 and deduct a $1,000
loss on her 2002 return.
D. Reduce purchases by $5,000 for 2001 and deduct a $1,000 loss on
her 2002 tax return.
B. Do nothing to inventory for 2001, report the $4,000 as additional

gross receipts in 2001. If property is involuntarily converted into
money or other property not similar to the converted property, such
as insurance proceeds, the taxpayer must report the realized
amount as gain in the year the money or other property is received.
E. Condemnation is the legal taking, without the owner's consent, of private property
for public use by a federal, state or local government or political subdivision, for a
reasonable amount of money or property. A condemnation award is money paid
or the value of other property received for the condemned property. This includes
the amount paid for the sale of property under threat or imminence of
condemnation.
1. A gain results if the condemnation award, less expenses of obtaining it, are
more than the adjusted basis in the property. If the property is not replaced
within a specific period or dissimilar property or cash is received, the gain is
taxable. To postpone the entire gain, the cost of the replacement property
2-79
must be equal to or more than the reimbursement for the property. A taxpayer
may choose to postpone reporting the gain if:
a) The taxpayer purchases property similar or related in service or use to the

condemned property, or
b) The taxpayer purchases a controlling interest (at least 80%) in a

corporation that owns similar property.
2. A loss results when the money or other property received is less than the
adjusted basis in the property.
3. The replacement period begins for a casualty or theft on the date the property
was damaged, destroyed, or stolen. For a condemnation or threat of
condemnation, the replacement period begins on the earlier of the date the
condemned property was disposed of or the date on which threat of
condemnation began.
4. The replacement period ends two years after the close of the first tax year in
which any part of the gain from the condemnation, casualty, or theft is
realized. The replacement period ends three years after the end of the first
tax year in which any part of the gain from a condemnation of real property
held for business or investment is realized.
IX. Business Credits
A. General Business Credit
1. The general business credit is limited to the net income tax minus the larger
of:
a) The tentative minimum tax, or
b) 25% of the net regular tax liability that is more than $25,000.
Exercise 44: Your general business credit is limited to your net income tax
minus the larger of 25% of your regular tax liability that is more than
$25,000 or:
A. Your alternative minimum tax.

B. Your tentative minimum tax.
C. Your net income tax.
D. Your taxable income.

B. Your tentative minimum tax. The amount that may be claimed as

the general business credit is limited based on tax liability. The
general business credit may not exceed net income tax minus the
greater of the tentative alternative minimum tax or 25% of net
regular tax liability above $25,000.
2. The general business credit consists of the following credits:
a) Investment credit - The investment credit is the total of:
(1) Reforestation credit,
(2) Rehabilitation credit, and
(3) Business energy credit.
b) Jobs credit - The jobs credit provides an incentive to hire persons from
targeted groups that have a particularly high unemployment rate. This
credit only applies to qualified first year wages. This credit is not available
for an individual that begins work for the employer after December 31,
1999.
c) Alcohol fuel credit - Available only to a person that blends or uses alcohol
as a fuel in a trade or business.
d) Research credit - The credit is equal to 20% of the increase in research

expenses for the year over the base period research expenses. The base
period is the 3 prior tax years.
Exercise 45: Research expenditures related to changing the STYLE of

the product qualify for the research credit. (True or False)
False. Costs incurred for alterations to existing products do not

qualify for the credit.
e) Low-Income Housing credit - The credit is 70% of the qualified basis of

each new low-income building placed in service after 1986. The credit is
taken over a 10-year period.
f) Disabled Access credit - The credit is equal to 50% of the expenses over
$250 but not more than $10,250 incurred to provide access to persons
with disabilities. Thus, the maximum amount of the disabled access credit
for any tax year is $5,000.
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g) Enhanced Oil Recovery credit - The credit is 15% of qualified enhanced oil
recovery costs for the tax year.
g) Renewable Electricity Production credit - The credit is based on electricity

that was sold to an unrelated party and was produced from qualified
energy resources.
i) Credit for Unused Payments into the Trans-Alaska Pipeline Fund.
j) Indian Employment credit - This credit is effective after December, 1993.

Employers are allowed a tax credit of up to $4,000 per qualified Indian
hired after 1993 and before year 2004.
k) Credit for employer's portion of Social Security taxes paid for an

employee's cash tips. This credit applies to amounts paid or incurred after
December 31, 1993.
l) Credit for contributions to certain community development corporations.
m) Empowerment Zone Employment credit - Available for qualified zone

wages paid or incurred during calendar years 1994 - 2004.
B. Rule for Carrybacks and Carryovers - In general, the unused portion of the credit
is carried back 3 years and then forward to the next 15 years. Credits must be
used in the order in which they are earned.
1. Use the credit carryovers from the earliest year first.
2. Next, use the current year's credit.
3. Finally, use the credit carrybacks, from the earliest year first.
X. Special Rules for Farming
A. Estimated Tax Payments - If at least two-thirds of total gross income is from

farming, the taxpayer has two options for filing the income tax return and paying
estimated tax payments.
1. The farmer (or fisherman) may pay only one estimated tax payment by
January 15 and then file the income tax return by April 15.

2. File the income tax return by March 1 and pay all the tax due with the return.
With this option, there are no estimated tax payments due and no penalties
for failure to make estimated tax payments.
3. Gross income from farming includes:
a) Farm income from line 11, Schedule F,
b) Farm rental income from line 7, Form 4835,
c) Gross farm income from pass-through entities reported on Schedule E,

and
d) Gains from the sale of livestock used for draft, breeding, sport, or dairy
purposes reported on Schedule D or Form 4797.
4. Income from farming reported on Schedule F includes amounts received from

cultivating the soil or raising or harvesting agricultural commodities. This
includes income from operating a stock, dairy, poultry, fish and aquaculture
products, bee, fruit, or truck farm, and income from operating a plantation,
ranch, nursery, orchard, or oyster bed.
5. Income reported on the Schedule F does not include gains from the sales of:
a) Farm land or depreciable farm equipment, or
b) Livestock held for draft, breeding, sport, or dairy purposes.
6. Rent received for the use of farm land is generally reported on Form 4835
and Schedule E. If the taxpayer materially participates, the rental income is
reported on Schedule F.
7. Most government program payments are included in income on Schedule F.
8. Farm income does not include wages received as a farm employee. This is
also true for wages received by a farm corporation shareholder.
Exercise 46: Max, a cash basis farmer, operates a cow-calf breeding

operation. The breeder cows are NOT held primarily for sale. In addition to
raising calves on his farm, Max also purchases calves for resale. During
2001, Max had the following acquisitions and dispositions of cattle.
Purchase of 25 calves for resale $2,875

Sale of above 25 calves purchased for resale $5,700
Sale of 40 calves raised by Max $9,200
Sale of 10 breeder cows $6,750
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Original cost of breeder cows $5,500

Accumulated depreciation on breeder cows $2,860
What amount should Max include in gross income on his Schedule F for
2001?
A. $12,025
B. $16,135
C. $18,775
D. $21,650
A. $12,025. Max should include $12,025 ($9,200 + ($5,700 -

$2,875)) in gross income on his Schedule F. Cash basis farmers
must report any gain from the sale of breeder cows on Form 4797
(Code Sec. 1231 (b)(3)).
Exercise 47: Jack and Diane Jarco had the following total gross income in
2001:
Interest and dividend income $43,500

Rental income (Schedule E) $1,500
Farm income (Schedule F) $75,000
Farm rental income (Form 4835) $15,000
Schedule D income (sale of dairy cows) $5,000.
Total gross income $140,000
Which of the following statements BEST describes the Jarco's

ESTIMATED tax responsibilities?
A. They MUST file and pay estimated taxes in quarterly installments in

April, June, September, and January.
B. They can wait until January 17, 2002, to make their first and only
estimated tax payment.
C. They MUST file their return by January 31, 2002, and pay all the tax
that is due in order to avoid an estimated tax penalty.
D. Their adjusted gross income will be too high to take advantage of
ANY special estimated tax filing breaks.
B. They can wait until January 17, 2002, to make their first and only
estimated tax payment. They special rules that apply to farmers
regarding estimated tax liability allow farmers to ignore the first
three installment dates and pay all estimated tax by January 15 (or
the first business day after that date) of the following year and file
their tax return by the regular due date.

B. Drought Sales - Farmers may elect to postpone reporting for one year the gain
from the sale of livestock if the sale was due to drought conditions. This election
applies to all livestock held for sale, draft, breeding, dairy, or sporting purposes.
To qualify for this election, the following conditions must be met:
1. The taxpayer’s principal business must be farming,
2. The farmer must use the cash method of accounting,
3. The farmer must be able to show that under normal business practices, the
sale would not have occurred except for the drought, and
4. The area was designated as eligible for assistance by the federal

government. The livestock does not have to be raised in a drought area.
However, the sale must occur solely because of the drought conditions
affecting grazing, water, or other requirements that made the sale necessary.
C. Crop Insurance and Disaster Payments - An election to postpone reporting these

payments from the tax year the crops were damaged to the following year can be
made if:
I. A statement is attached to the return making the election indicating the crops
were damaged, the cause of the damage, and the total insurance payment
received, and
2. Under normal business practice, the income from the crop would have been
reported in the following year if the damage had not occurred.
D. Farm Expenses
1. The deductibility of farm expenses generally follow the rules previously

discussed.
2. To deduct accelerated depreciation of farm assets under MAC RS, the 150%
declining balance method must be used.
E. Employment Tax Responsibilities
1. Federal income tax must be withheld if the gross cash and noncash wages
paid to a farm employee are more than the dollar value of withholding
allowances for that pay period.
2-85
2. Social Security and Medicare taxes are required to be withheld and deposited
if the farmer has one or more employees who meet either of the following
tests:
a) The employee was paid $150 or more in cash wages during the year, or
b) During the year, $2,500 or more in cash and noncash wages were paid to
all employees.
3. Federal unemployment (FUTA) is required to be paid if cash wages are paid

and either of the following tests are met:
a) Cash wages of $20,000 or more were paid to farm workers in any

calendar quarter during the current or preceding calendar year, or
b) Ten or more farm workers were employed for some part of at least one
day during each of 20 different calendar weeks during the current or
preceding year.
4. Commodity wages (payments in kind) are not considered wages for purposes
of employment tax withholding. However, the value of these noncash wages
is reported in box one of the farm employee's W-2.
XI. Self-Employment Tax
A. Self-employment (SE) tax provides Social Security coverage for self-employed

individuals. A person is self-employed if that individual carries on a business as a
sole proprietor, an independent contractor, a member of a partnership, or
otherwise in business for himself/herself.
1. A trade or business is generally an activity carried on for a livelihood or in

good faith to make a profit.
2. A statutory employee would use a separate Schedule C to report income and

expenses related to the earnings as a statutory employee, however, this net
income is not subject to SE tax.
3. Individuals must pay SE tax if:
a) They had net earnings from self-employment of $400 or more, or
b) They are church employees with income of $108.28 or more.
B. Self-employment Income

1. Resident aliens are subject to the same rules as U.S. citizens. Nonresident
aliens do not pay SE tax.
2. Depreciation recapture or §179 recapture because business use dropped to

50% or less is included in determining SE income.
3. If the taxpayer reduces or stops the business activity, any payments received
for lost income of the business from insurance or other sources are SE
income.
4. Fees received for performing services as a corporate director are SE income.

Income as an employee or officer of the corporation is not SE income.
5. An S Corporation shareholder is not self-employed with respect to the

corporation's taxable income.
6. Newspaper carriers are generally not self-employed. However, if over age 18

and paid the difference between a fixed sales price and the cost of the
newspaper to the carrier, the income is SE income.
7. A distributive share of partnership income or loss and guaranteed payments

from the partnership are treated as SE income.
8. Rent received by a real estate dealer is included in income subject to SE tax.
9. Income paid by an insurance company to a retired insurance agent that is

based on a percentage of commissions received prior to retirement is SE
income.
Exercise 48: All of the following are subject to self-employment tax

except:
A. Troy, a 60% owner in a S Corporation, received $40,000 as his

distributive share of the corporation's taxable income.
B. Lloyd, a real estate dealer, had net rental income of $67,000.
C. Dave, a general partner, received a $20,000 guaranteed payment.
D. Patrick, a corporate director, received $35, 000 for services
performed as a director
A. Troy, a 60% owner in a S corporation, received $40,000 as his

distributive share of the corporation’s taxable income. Although S
corporation shareholders are treated similarly to partners for many
tax purposes, they are not subject to the self-employment tax on
their shares of the S corporation’s ordinary income.
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C. Net self-employment income usually includes all business income less all
business deductions allowed for income tax purposes.
1. If the taxpayer has more than one trade or business, the net earnings from
each business is combined to determine net SE income.
2. A loss in one business will reduce a gain in another business for determining
income subject to self-employment tax.
Exercise 49: If you have more than one trade or business, you must
compute self employment tax for each business separately. (True or
False)
False. For the purposes of computing self-employment tax, net

earnings from self-employment includes the total amounts of
income derived from the operation of any trade or business. The
tax is computed on an aggregate basis from total earnings from
self-employment.
D. The self employment tax rate is 15.3% (12.4% Social Security and 2.9%
Medicare tax).
1. No more than $76,200 (2000) (1999 is $72,600) of combined wages, tips, and
net SE earnings is subject to the 12.4% for Social Security.
2. All wages, tips, and SE earnings are subject to the 2.9% Medicare tax.

SECTION D - PARTNERSHIPS
A. A partnership is an entity of two or more persons who join together to carry on a

trade or business with each person contributing money, property, labor, or skill
and each expecting to share in the profit or loss.
1. Persons may include an individual, a corporation, a trust, an estate, or

another partnership.
2. Partnership includes a syndicate, group, pool, joint venture, or similar

organization that is carrying on a trade or business and is not classified as a
trust, estate, or corporation.
Exercise 50: Two brothers each inherited a 50% ownership interest in a

building from their mother. The building is subject to a lease whereby the
brothers provide NO services to the tenant. The brothers agree to split the
rental income and expenses and share equally in any profits or losses.
which of the following statements is CORRECT?
A. Because the brothers received the property in a distribution from their

mother's estate, they must report the income and expenses
associated with the property on Form 1041.
B. Because the brothers jointly inherited the property, they have a
partnership and must report the property's income and expenses on
Form 1065.
C. Because the brothers have an agreement to share in the profits and
losses they have a partnership and must report the property's income
and expenses on Form 1065.
D. Because the brothers' co-ownership of the property is NOT a trade or
business, they do NOT have a partnership. Each brother must report
his respective share of income and expenses on Schedule E, Form
1040.50
D. Because the brother’s co-ownership of the property is NOT a

trade or business, they do NOT have a partnership. Each brother
must report his respective share of income and expenses on
Schedule E, Form 1040. Selection of the proper schedule for
reporting rental income depends upon whether services are
provided to tenants. In this fact situation, since no services are
provided, Schedule E is the appropriate reporting vehicle.
B. A Limited Liability Company (LLC) is an entity formed under state law by filing
articles of organization.
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1. An LLC may be taxed as a corporation or a partnership. It is classified as a

partnership if it has no more than two of the following characteristics:
a) Centralization of management,
b) Continuity of life,
c) Free transferability of interests, or
d) Limited liability.
2. Converting a partnership into an LLC does not terminate the partnership. The
partnership's tax year does not close, and the LLC continues to use the old
partnership EIN.
C. Family members can be partners.
1. Family members will be recognized as partners only if one of the following

requirements is met.
a) If capital is a material income-producing factor, they acquired their capital

interest in a bona fide transaction, actually own the partnership interest,
and actually control the interest.
b) If capital is not a material income-producing factor, they must have joined

together in good faith to conduct a business. In addition, they must have
agreed that their contributions entitle them to a share in the profits. Some
capital or services must be provided by each partner.
2. Family members include only spouses, ancestors, and lineal descendants, or

any trust for their primary benefit.
Exercise 51: Members of a family can be partners. Members of a family

who must meet
special requirements to be recognized as partners include all of the
following except:
A Trusts for the benefits of lineal descendants.

B Brothers and sisters.
C Spouses.
D Ancestors.

B. Brothers and sisters. The “family” of any individual includes only

a spouse, ancestors, lineal descendants and any trusts for the
primarily benefit of such persons.
3. Capital is a material income-producing factor if a substantial part of the gross

income of the business comes from the use of capital.
4. A capital interest is an interest in partnership assets that is distributable to the

owner of the interest if:
a) He or she withdraws from the partnership, or
b) The partnership liquidates.
5. If a family member receives a gift of a capital interest in which capital is a

material income-producing factor, the donee's distributive share of partnership
income is limited.
a) The partnership income must be reduced by reasonable compensation for

services rendered to the partnership by the donor, and
b) The donee-partner's share of the remaining profits allocated to donated

capital must not be proportionately greater than the donor's share
attributable to the donor's capital.
6. An interest purchased from another family member is considered a gift.
Exercise 52: Mr. Clysdale is a partner in Clysdale and Associates

Partnership. The other two partners are his sister and his 17-year old son,
Gregory. The partnership's income consists mostly of compensation for
services performed by Mr. Clysdale and his sister. Gregory is a high
school student and acquired his one-third interest by gift Gregory is
recognized as a partner in the firm for tax purposes. (True or False)
False. In a family partnership where the material income-producing

factor is not a capital asset, the family member must provide
substantial or vital services to the partnership to be considered a
partner for federal tax purposes.
7. A husband-wife carrying on a business together and sharing in the profits and

losses may be a partnership regardless of whether or not there is a formal
partnership agreement. They should not file a Schedule C in the name of one
spouse as a sole proprietor.
II. Form 1065
2-91
A. A partnership is not a taxable entity but must file an annual information return
using Form 1065, U.S. Partnership Return of Income. The return must be signed
by one of the partners and filed every year of existence even though there is no
partnership income for the year. Form 1065 is due by the 15th day of the 4th
month following the close of the tax year (April 15th for calendar year
partnerships). A partnership is eligible for an automatic 3 month extension by
filing Form 8736.
B. The partner's distributive share of separately reportable partnership items are

shown on Schedules K and K-1, Form 1065. A copy of Schedule K-1 must be
furnished to all partners. Failure to do so will result in a penalty of $50 per
statement per year. A small partnership (10 or fewer partners) may avoid the
penalty by showing reasonable cause and each partner reports his/her share on
an individual return.
C. When a partnership terminates, the tax year ends on the date of termination. If
terminated before the end of the tax year, a short period return is due by the 15th
day of the fourth month following the date of termination. A partnership
terminates when:
1. All of its operations are discontinued and no part of any business, financial
operations, or venture is continued by any of its partners in a partnership or
LLC, or
2. At least 50% of the total interest in partnership capital and profits is sold or
exchanged within a 12-month period, including a sale or exchange to another
partner.
NOTE: The partnership agreement, electing out of partnership

treatment, and tax year are discussed in Section A.
III. Partnership Income
A. Partnership profits are not taxed to the partnership but rather passed through and
taxed to the partners. The partnership computes its income and files its return in
the same manner as individuals. However, a partnership must state certain items
of gain, loss, income, etc. separately and certain deductions are not allowed to
the partnership.
1. Separately stated items include the following:
a) The ordinary income or loss from the trade or business.
b) Net income or loss from rental real estate activities.

c) Net income or loss from other real estate activities.
d) Gains and losses from sales or exchanges of capital assets.
e) Gains and losses from sales or exchanges of §1231 property.
f) Charitable contributions.
g) Dividends for which corporate partners can claim a deduction.
h) Taxes paid or accrued to foreign countries and U.S. possessions.
i) Any §179 expense deduction, which is limited at both the partnership level
and the partner level.
j) Depletion and intangible drilling costs.
k) Distributive shares of any partnership items which, if taken into account

separately by each partner would result in a tax different from the tax if the
item had not been taken into account separately.
2. The partnership makes most choices about how to compute income.
a) Accounting method.
b) Depreciation method.
c) Accounting for specific items, such as depletion, amortization, or

installment sales.
d) Nonrecognition of gain on involuntary conversions of property.
e) Amortization of certain organization fees and business start-up costs.
3. Each partner chooses how to report the partner's share of:
a) Foreign and U.S. possessions taxes,
b) Certain mining exploration expenses, and
c) Income from cancellation of debt.
Exercise 53: The partnership, NOT the partners, makes choices about all
of the following except:
2-93
A. Depreciation methods.
B. Nonrecognition of gain on involuntary conversions of property.
C. Amortization of certain organization fees.
D. Income from discharge of indebtedness.
D. Income from discharge of indebtness. Most elections affecting

the computation of taxable income derived from a partnership must
be made by the partnership. However, the election to reduce the
basis of depreciable property for amounts excluded from gross
income because of discharge of indebtness must be made by each
partner separately.
B. A partnership can choose to amortize certain organizational expenses over a

period of not less than 60 months.
1. Amortizable expenses include those that:
a) Are incident to the creation of the partnership,
b) Are chargeable to the capital account, and
c) Are the type that would be amortized if they were incurred in the creation
of a partnership having a fixed life.
2. Such expenses must be for the creation of the partnership, not for starting or
operating the partnership trade or business.
3. Examples of amortizable expenses include:
a) Legal fees for services incident to the organization of the partnership

(preparing the partnership agreement),
b) Accounting fees for services incident to the organization, and
c) Filing fees.
IV. Partner's Income
A. A partner's distributive share of partnership items is generally determined by the

partnership agreement. If the partnership agreement does not address an
allocation or if the allocation does not have substantial economic effect, the
distributive share will be determined by the partner's interest in the partnership. A
partner's distributive share of certain items of income, gain, loss, deduction, or

credit must be reported on the individual's tax return even though the partnership
does not actually distribute any money to the partner.
B. The character of certain items of income, gain, loss, deduction, or credit included
in a partner's distributive share is determined as if the partner:
1. Realized the item directly from the same source as the partnership, or
2. Incurred the item in the same manner as the partnership.
C. Members of a partnership that carry on an active trade or business must include

their share of the partnership income or loss in net earnings from self-
employment. This includes guaranteed payments made to partners for services
or use of capital if the payments are made without regard to the income of the
partnership.
D. Losses are allowed to the extent of the adjusted basis in the partner's interest in
the partnership. The adjusted basis is figured as of the end of the partnership's
tax year in which the loss occurred, before taking the loss into account. The
excess can be used to reduce any restored basis in the following years. The
basis can never be less than zero.
Exercise 54: Partners Ray, Fay, and Kay of RFK, a calendar year
partnership, share partnership profits and losses in a ratio of 4.3:3,
respectively. All three materially participate in the partnership business.
Each partner's adjusted basis in the partnership as of December 31, 2001,
was as follows:
Ray $10,000
Fay $ 8,000
Kay $12,000
The partnership incurred an operating LOSS of $30,000 in 2001. What is

Ray's, Fay's, and Kay's share of the loss to be reported on their 2001
individual income tax returns?
Ray Fay Kay

A. $6,000 $4,800 $3,600
B. $10,000 $8,000 $9,000
C. $10,000 $8,000 $12,000
D. $12,000 $9,000 $9,000
B. $10,000; $8,000; $9,000. An active partner’s deductible loss

cannot exceed the amount of the adjusted basis of his or her
interest in the partnership at the end of the partnership tax year in
2-95
which the loss occurred (Code Sec. 704(d)). Since the $30,000 loss
is to be shared 4:3:3 ($12,000: $9,000: $9,000), Ray’s and Fay’s
losses are limited to their adjusted bases of $10,000 and $8,000.
However, since Kay’s adjusted basis is $12,000, she can take her
full $9,000 share of the loss.
E. The at-risk rules limit the loss a partner can deduct to the amount the partner is
considered at-risk.
1. The amount of money and the adjusted basis of property contributed to the
activity.
2. The partner's share of net income retained by the partnership.
3. Certain amounts borrowed by the partnership for use in the activity if the
partner is personally liable for repayment or the amounts borrowed are
secured by the partner's property.
Exercise 55: Todd has a 45% interest in a partnership, and he materially

participates in the partnership's business. Todd's adjusted basis in the
partnership was $60,000 at the beginning of 2000. There were no
distributions to Todd during the year. During 2001, the partnership
borrowed $400, 000 for the following reasons:
Purchase equipment needed for business $240,000

Pay balance of existing note in full 160,000
All of the partners are personally liable for all partnership debts. The
partnership incurred a $600,000 loss in 2001. What amount can Todd
claim as a loss from the partnership on his 2001 individual tax return?
A. $60,000
B. $168,000
C. $240,000
D. $270,000
B. $168,000. A general partner’s basis in his partnership interest is

increased by his share of the partnership’s recourse liabilities (Code
Sec. 752 (a)). Todd’s share of the additional partnership liability (45
percent of $240,000=$108,000) plus his original basis of $60,000
gives him an adjusted basis of $168,000. Although Todd’s share of
the partnership loss is 45 percent of $600,000, or $270,000, his
deductible loss is limited to his adjusted basis of $168,000 (Code
Sec. 704(d)).

F. The passive activity rules do not apply to the partnership. They do apply to each
partner's share of loss or credit from the activity.
Exercise 56: The JLC Partnership, which is NOT a rental real estate
partnership, was formed on January 1, 2001, and incurred a $24,000 loss
for the year ending December 31, 2001. The partnership had NO portfolio
income. The three partners share profits and losses equally. Mr. C is a
passive investor in JLC. On January 1, 2001, C contributed $3,000 to the
partnership and an additional $5,000 during 2000. Mr. C had draws
totaling $1,000 during 2001. What is C's deductible loss from JLC for 2001
if he had $4,500 in income from other passive investments?
A. $4,500
B. $6,000
C. $7,000
D. $8,000
A. $4,500. Losses arising from a passive activity generally are

deductible only against income from that or another passive activity
(Code Secs. 469(a) and (d)). Since Mr. C is a passive investor in
JLC, his deductible loss is limited to his $4,500 passive income
from other sources.
G. A partner cannot deduct partnership expenses paid out of personal funds unless
required to do so by the partnership agreement.
H. If a partnership terminates and one of the partners is insolvent and cannot pay
any of the partnership debts, the other partner(s) may have to pay more than his
or her share. As such, that partner can take a bad debt deduction for any part of
the insolvent partner's share of debts that he or she is required to pay.
Exercise 57: Bridget and Brenda formed B & B Partnership in 1999 as

equal partners. They closed the business during 2001 because it was not
profitable. After the partnership closed they had debts to pay. Because
Bridget was insolvent, she paid only part of her share of the partnership's
debts. Brenda was required to pay ALL of the remaining debts during
2001. which of the following statements reflects the correct treatment of
the debts paid by Brenda on her tar return for 2001?
A. She cannot deduct ANY of the debt she paid.

B. She can deduct ONLY her payment of her share of the debt as a bad
debt.
C. She can deduct ALL of the debt she paid as a bad debt
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D. She can deduct ONLY her payment of Bridget's share of debt as a

bad debt
D. She can deduct ONLY her payment of Bridget’s share of debt as

a bad debt. A partner that pays more than her proportionate share
of a partnership debt that becomes uncollectible is permitted to take
a bad debt deduction equal to the amount in excess of that
partner’s share of the debt.
I. If an individual borrows money to purchase an interest in a partnership, the loan

proceeds and interest expense are allocated among all the assets of the
partnership. If the loan proceeds are contributed to capital of the partnership, the
allocation is made based on the assets or by tracing the proceeds to the
partnership's expenditure.
J. Partnership distributions include basically anything distributed from a partnership

and is not taken into account in determining the partner's distributive share of
partnership income or loss. A partnership distribution is treated as a distribution
received on the last day of the partnership's tax year.
1. The partner's adjusted basis in his or her partnership interest is decreased

(but not below zero) by the amount of money and the adjusted basis of
property distributed to the partner.
2. A partner generally recognizes gain on a partnership distribution only to the

extent any money included in the distribution exceeds the adjusted basis of
the partner's interest in the partnership. Any gain recognized is treated as a
sale of a partnership interest on the date of the distribution. If property is
distributed, gain is generally not recognized until that property is disposed of
For distribution rules, a distribution of marketable securities is treated as a
distribution of money.
Exercise 58: The adjusted basis of Eliot's interest in a partnership was

$60,000. He received a nonliquidating distribution of $48,000 cash plus
apiece of equipment with a fair market value and a partnership adjusted
basis of $18,000. Eliot's basis for the equipment is:
A. $18,000
B. $12,000
C. $6,000
D. $0
B. $12,000. The basis of property received in a nonliquidating

distribution from a partnership, while generally the same as the
basis of the property in the hands of the partnership, cannot exceed

the basis of the recipient-partner’s partnership interest, reduced by

the amount of money received by the partner in the same
transaction (Code Sec. 732(a)(2)). Accordingly, Eliot’s partnership
interest is reduced to $12,000 on the receipt of the $48,000
nonliquidating distribution, and although the equipment has a fair
market value and an adjusted basis of $18,000, its basis is limited
to Eliot’s $12,000 basis in his partnership interest.
V. Partner's Dealings with Partnership
A. For certain transactions between a partner and the partnership, the partner is
treated as not being a partner. These transactions include:
1. Performing services for or transferring property to a partnership if:
a) There is a related allocation and distribution to a partner, and
b) The entire transaction, when viewed together, is properly characterized as

occurring between the partnership and a partner not acting in the capacity
of a partner.
2. Transferring money or other property to the partnership if:
a) There is a related transfer of money or other property by the partnership to

the contributing partner or another partner, and
b) The transactions together are properly characterized as a sale or

exchange of property.
B. To determine ownership in partnership capital or profits, the following rules apply.
1. An interest directly or indirectly owned by or for a corporation, partnership,

estate, or trust is considered to be owned proportionately by or for its
shareholders, partners, or beneficiaries.
2. An individual is considered to own the interest that is directly or indirectly

owned by or for the individual's family. Family includes only brothers, sisters,
half-brothers, half-sisters, spouse, ancestors, and lineal descendants.
Exercise 59: Norita is a partner in MNO Partnership. Under which of the

following combinations would she have more than a 50% ownership in the
partnership's capital and profits?
A. Norita 40 percent
Corporation owned entirely by Norita's 60 percent
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husband
B. Norita 40 percent
Norita's mother 10 percent
Norita's niece 50 percent
C. Norita 25 percent
Norita's husband 20 percent
Norita's aunt 55 percent
D. Norita 40 percent
Norita's aunt's trust 60 percent
A. Norita. 40 percent; Corporation owned entirely by Norita’s

husband. 60 percent. Norita is treated as owning the stock owned
by her spouse, children, grandchildren and parents. Here, Norita is
treated as owning her husband’s 60 percent interest, attributing to
her a more than 50 percent ownership in the partnership’s capital
and profits.
3. If a person is considered to own an interest using rule (1), that person (the
constructive owner) is treated as if actually owning that interest when rules (1)
and (2) are applied. However, if a person is considered to own an interest
using rule (2), that person is not treated as actually owning that interest, thus
making another person the constructive owner.
C. Guaranteed payments are those made by a partnership to a partner that are

determined without regard to the partnership's income.
1. Guaranteed payments are reported as ordinary income by the partner and are
generally subject to self-employment tax.
2. If a partner is to receive a minimum payment from the partnership, the

guaranteed payment is the amount by which the minimum payment is more
than the partner's distributive share of the partnership income before taking
into account the guaranteed payment.
3. Premiums for health insurance paid by the partnership on behalf of a partner

for services as a partner are treated as guaranteed payments.
4. If the guaranteed payment creates a loss, the partner still includes the full
amount of payment in income and then reports a proportionate share of the
partnership loss.
Exercise 60: Jay and Ray are partners in JR and Associates. Under the
terms of the partnership agreement, Jay is to receive 25% of all
partnership income or loss plus a guaranteed payment of $60,000 per

year. In 2001, the partnership had $50,000 of ordinary income before any
deduction for Jay's guaranteed payment. what is the amount of income or
loss Jay would report on his 2001 tax return, assuming he materially
participates in partnership activities?
A. $15,000 guaranteed payment, $2,500 loss

B. $57, 500 guaranteed payment
C. $60,000 guaranteed payment
D. $60,000 guaranteed payment, $2,500 loss.
D. $60,000 guaranteed payment, $2,500 loss. Even though a

partnership incurs a loss for a tax year, an active partner who
receives a guaranteed payment must nevertheless take into
account the full amount of such payment (Code Sec. 707(c)). This
inclusion is required even when the partnership loss is caused by
that guaranteed payment to the partner. Furthermore, the partner
must also take into account his distributive share of the partnership
loss. Accordingly, Jay must include his $60,000 guaranteed
payment and 25 percent of the $10,000 loss ($50,000-$60,000) on
his individual return.
D. Sale or Exchange of Property
1. Losses will not be allowed from a sale or exchange of property directly or

indirectly between a partnership and a person whose direct or indirect interest
in the capital or profits of the partnership is more than 50%.
2. This also applies if the sale is between two partnerships in which the same
persons directly or indirectly own more than 50% interest of the capital or
profits of both partnerships.
Exercise 61: Jackie owns a 52% interest in Brown Partnership and a 70%
interest in Black Partnership. In March 2000, Brown sold land having an
adjusted basis to Brown of $170,000 to Black Partnership for $140,000. In
July 2001, Black sold the land to Sharon, an unrelated individual, for
$152,000. what is the amount of gain or (loss) Black Partnership would
recognize in 2001?
A. $0
B. $12,000
C. ($12,000)
D. ($18,000)
A. $0. If a taxpayer purchases property from a related party who

sustained a loss on the transaction but was not allowed a deduction
2-101
for the loss due to the related party rules, any gain realized by the
taxpayer on a subsequent sale of the property is recognized only to
the extent that the gain exceeds the amount of the previously
disallowed loss (Code Sec. 267(d)). In this question, the $30,000
loss in the sale of the property is disallowed since the two
partnerships involved are related parties. The Black Partnership
recognizes no loss when it sells the property for $12,000 more than
it paid for the property, but it also does not recognize any gain since
that $12,000 is less than the $30,000 previously disallowed loss.
3. Gains are treated as ordinary income in a sale or exchange of property

directly or indirectly between a person and a partnership, or between two
partnerships, if both of the following apply:
a) More than 50% of the capital or profits interest in the partnership(s) is

directly of indirectly owned by the same person(s), and
b) The property in the hands of the transferee immediately after the transfer
is not a capital asset.
Exercise 62: Mr. Thomas is the 70% owner of A & T Partnership. On

August 1, 2001, Mr. Thomas bought A & T's computer system for $50,000
for use in his Schedule C business. The system had an adjusted basis to
A & T of $34,000. The accumulated depreciation on the system that was
subject to recapture was $12,000. what is the amount and character of the
gain to be reported by A & T Partnership in 2001?
Capital Gain Ordinary Income

A. $0 $16,000
B. $16,000 $ 0
C. $12,000 $ 4,000
D. $4,000 $12,000
A. $0; $16,000. A taxpayer who realizes a capital gain on the

disposition of certain depreciable property must recapture all or part
of that gain as ordinary income. The amount that must be
recaptured is the lesser of the total of depreciation deductions
allowed or allowable with respect to the property, or the total gain
realized (Code Sec. 1245). Furthermore, capital gain does not
result from the sale or exchange of depreciable property between
“related persons,” defined as a person and any entities controlled
(more than a 50-percent interest) by him. Thus, in the case of a
sale or exchange between related persons, any gain remaining
after recapture of depreciation is also treated as ordinary income

(Code Sec. 1239 and Reg. §1.1245-6(f)). In this example, the

$16,000 difference between the sale price and the computer
system’s adjusted basis is all characterized as ordinary income:
$12,000 pursuant to Code Sec. 1245 and the remainder because
Mr. Thomas and his 70-percent owned partnership are related
persons.
E. Contributions of Property
1. Generally, neither the partner nor the partnership recognize a gain or loss
when property is contributed to a partnership in exchange for a partnership
interest.
2. Gain or loss may be recognized if within a short period of time:
a) Before or after the contribution, other property is distributed to the

contributing partner and the contributed property is kept by the
partnership, or
b) After the contribution, the contributed property is distributed to another

partner.
Exercise 63: During 2001, Scott contributed property having an adjusted

basis to him of $10,000, to the Phillips & Phillips Partnership for a 45%
interest in the partnership. At the time of the contribution, the property had
a fair market value of $20,000 what is the amount and character of Scott’s
gain on this transaction to be reported on his 2001 tax return?
A. $0
B. $4,500 long-term capital gain
C. $10,000 ordinary income
D. $10,000 long-term capital gain
A. $0. Generally, no gain or loss is recognized to either the

partnership or its partners (including the contributing partner) on a
contribution of property to the partnership in exchange for a
partnership interest (Code Sec. 721(a)). Accordingly, Scott’s
property contribution to the partnership in exchange for a 45-
percent interest in the partnership is a nonrecognition transaction.
3. If contributed property is distributed to another partner within 5 years of the

contribution, gain or loss must be recognized by the contributing partner. The
gain or loss is equal to the amount the contributing partner would have
2-103
recognized if the property had been sold for its fair market value when it was
distributed.
4. The partnership's basis for determining depreciation, depletion, and gain or

loss is the same as the partner's adjusted basis of the property when it was
contributed, increased by any gain recognized by the partner at that time.
F. Contribution of Services
1. A partner can acquire an interest in partnership capital or profits as

compensation for services.
2. The fair market value of a capital interest must generally be included in the
partner's gross income in the first tax year in which the partner can transfer
the interest or the interest is not subject to a substantial risk of forfeiture.
3. The receipt of a profit interest in the partnership is not a taxable event for the
partner or the partnership.
VI. Basis of Partner's Interest
Contributed Interest Basis is the amount of money contributed plus the adjusted basis
of any property contributed increased by any gain recognized on
the transfer. Any increase in a partner's individual liability
because of an assumption of partnership liabilities is also treated
as a contribution of money. If the partnership assumes debt on
property contributed, the partner's basis is reduced by the liability
assumed by the other partners.
Purchased Interest Basis is the money paid for the interest.
Inherited Interest Basis is the fair market value of the interest at the date of death
or alternate valuation date increased by the estate or other
successor's share of partnership liabilities and decreased to the
extent such value is attributable to income in respect of a
decedent.
A. Increases to Basis - The partner's beginning basis is increased by the following:
1. Increase in partnership liabilities,
2. Increase in liabilities assumed on partner's property,

3. Tax exempt income,
4. Depletion deductions in excess of basis,
5. Taxable income of partnership, including capital gain, and
6. Additional contributions to capital.
B. Decreases to Basis - The partner's beginning basis is decreased by the following:
1. Decrease in partnership liabilities,
2. Depletion deductions for oil and gas property,
3. Partnership losses including capital losses,
4. Partnership expenses not deducted on return,
5. Withdrawals of cash or property, and
6. Partner's share of any §179 expenses, even if the partner cannot deduct the
entire amount on his or her individual tax return.
Exercise 64: Audra acquired a 50% interest in a partnership by

contributing property that had an adjusted basis of $20,000 and a fair
market value of $50,000. The property was subject to a liability of $44,000,
which the partnership assumed for legitimate business purposes. Which of
the following statements is CORRECT?
A. Audra must include a gain from the sale or exchange of a capital

asset on her individual return, and her basis in her partnership
interest increases.
B. Audra must include a gain on her individual return, and her basis in
her partnership interest is zero.
C. Audra is NOT required to include a gain on her individual return, and
her basis in her partnership interest is zero.
D. Audra is NOT required to include a gain on her individual return, but
the gain increases her basis in her partnership interest.
B. Audra must include a gain on her individual return, and her basis
in her partnership interest is zero. When encumbered property is
contributed to a partnership, a partner recognizes gain to the extent
the partner is deemed to be relieved of a portion of the debt. Audra
has a $42,000 basis upon contribution ($20,000 property basis plus
$22,000, which is half the $44,000 debt). She is also deemed to
2-105
receive a cash distribution of $44,000 (the amount of the debt),

creating a gain of $2,000. This gain does not affect Audra’s basis in
her partnership interest.
C. A partner's share of partnership liabilities depends on whether the liability is

recourse or nonrecourse.
1. A liability is recourse liability to the extent that any partner or related person
has an economic risk of loss for that liability. The partner's share of such
liabilities equals the partner's share of the economic risk of loss.
2. A liability is a nonrecourse liability if no partner or related party has an

economic risk of loss for that liability. A partner's share of such liability
generally is determined by the partner's ratio for sharing partnership profits.
VII. Basis of Property

A. The partner's basis of property, other than money, distributed by a partnership
(other than in liquidation) is the partnership's adjusted basis immediately before
the distribution.
1. The basis of the property received may not be more than the adjusted basis
of the partner's interest reduced by any money received in the same
transaction.
2. The holding period for distributed property to the partner includes the period
the property was held by the partnership.
B. The partner's basis of property received in a complete liquidation of the partner's

interest is equal to the adjusted basis of the partner's interest reduced by any
money received. The basis of the interest is allocated among the assets received
in proportion to the adjusted basis of the assets to the partnership in the following
order:
1. Allocation is first made to unrealized receivables and substantially

appreciated inventory items. The adjusted basis for inventory items and
unrealized receivables will offset the partner's basis dollar for dollar.
2. The balance is allocated to the remaining property distributed in proportion to

their adjusted bases in the hands of the partnership before the distribution.
C. Generally, a partnership may not adjust the basis of its retained property as the
result of a distribution of other property to a partner or a transfer of an interest in

the partnership. However the partnership may choose to make an optional

adjustment to the basis of its property upon the transfer provided the election is
in writing (§754 election).
VIII. Disposition of a Partner's Interest

A. A loss incurred from the abandonment or worthlessness of a partnership interest
is an ordinary loss if:
1. The transaction is not a sale or exchange.
2. The partner has not received an actual or deemed distribution from the
partnership. Even a de minimis actual or deemed distribution makes the loss
a capital loss.
Exercise 65: On December 31, 2001, Kay-Ann's adjusted basis in GEM

Partnership was zero and her share of partnership liabilities was $30,000.
The partnership had no unrealized receivables or substantially appreciated
inventory items. Kay-Ann withdrew from the partnership on December 31,
2001, and was relieved of any partnership liabilities. As a result she had a
$30,000 capital LOSS. (True or False).
False. Relief of partnership liabilities is treated as a distribution of

money to the partner. Consequently, any amount of the relief that
exceeds the partner’s basis in her partnership interest must be
recognized as a capital gain.
B. A sale or exchange of a partner's interest usually results in capital gain or loss.
1. Gain or loss is the difference between the amount realized and the partner's
adjusted basis in his or her partnership interest.
2. If the selling partner is relieved of any partnership liabilities, the amount of

liability relief is included in the amount realized.
3. The sale of a partnership interest at a gain can be reported on the installment

method. The gain is treated as part capital gain and part ordinary income if
the partnership's assets included unrealized receivables and substantially
appreciated inventory items.
Exercise 66: The sale or exchange of a partner's interest in a partnership

usually results in capital gain or loss. Select the CORRECT statement:
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A. Gain or loss is the difference between the amount realized and the
adjusted basis of the partner's interest in the partnership.
B. If the selling partner is relieved of any partnership liabilities, the
selling partner does NOT include the amount of the liability relieved
as part of the amount realized.
C. If the partnership had substantially appreciated inventory items, the
amount realized that is attributable to these items is capital gain or
loss.
D. A loss incurred from the abandonment or worthlessness of a
partnership interest is an ordinary loss only if the transaction was a
sale or exchange.
A. Gain or loss is the difference between the amount realized and

the adjusted basis of the partner’s interest in the partnership.
Generally, a partnership interest is a capital asset, so gain or loss
on the exchange or sale of the interest is capital gain or loss.
C. Ordinary Income - Any amount that would be recaptured if the partnership had
sold its depreciable property at the time the partner sells his interest is treated as
ordinary income. The partner's share of unrealized receivables and substantially
appreciated inventory is also treated as ordinary income.
Exercise 67: Cynthia is a partner in CF Partnership. The adjusted basis of

her partnership interest is $19,000 of which $15, 000 represents her share
of partnership liabilities. Cynthia's share of the partnership's unrealized
receivables is $6,000. The partnership has NO substantially appreciated
inventory items. Cynthia sells her partnership interest for $28,000 cash.
What is the amount and character of her gain?
A. $6, 000 capital gain

B. $6, 000 ordinary income; $18,000 capital gain
C. $18,000 capital gain
D. $18,000 ordinary income; $6,000 capital gain.
B. $6,000 ordinary income; $18,000 capital gain. To the extent that

money received by a partner in exchange for her partnership
interest is attributable to her share of the value of unrealized
receivables, that money is treated as ordinary income (Code Sec.
751). The remainder is treated as income attributable to a capital
asset (Code Sec. 741). Accordingly, after Cynthia is relieved of her
share of partnership liabilities, her partnership basis is $4,000
($19,000 - $15,000) (Code Sec. 752). On the sale of her interest for
$28,000, she has $24,000 above her basis to account for. Since
her share of unrealized receivables is $6,000, she has $6,000 of

ordinary income, and the remaining $18,000 constitutes capital

gain.
D. Liquidation of Partner's Interest
1. Payments made in liquidation of a partner's entire interest in exchange for the

partner's interest in the property are treated as distributions to the partner.
2. Payments to a retiring partner in liquidation of an interest, that are not

considered payments for the interest in partnership property, are treated as
distributed shares of the partnership income or guaranteed payments. These
payments are generally taxed as ordinary income.
Exercise 68: Asya's interest in ATP Partnership has an adjusted basis of

$300,000. In a complete liquidation of her interest; she received the
following:
ATP'S Adjusted Basis Fair Market Value

Cash $140,000 $140,000
Building 160,000 180,000
Compute 40,000 20,000
r
Inventory 60,000 60,000
What is Asya's basis in the building and computer, respectively?

Computer Building
A. $30,000 $120,000
B. $20,000 $80,000
C. $10,000 $90,000
D. $30,000 $135,000
B. $80,000; $20,000. When the basis of property in the hands of a

partner is determined from the basis of his partnership interest, as
is the case with distributions in liquidation of a partner’s entire
interest, the amount of a partner’s basis in his partnership interest
is allocated among the properties received after subtracting the
amount of any cash and inventory items received. The allocation of
the remaining basis to these properties must then be made in
proportion to the partnership’s adjusted bases in such property
(Code Sec. 732). In this case, Asya’s $300,000 partnership interest,
minus $140,000 for the cash and minus the $60,000 in inventory
leaves a remaining basis of $100,000. This $100,000 is then
allocated to the building and computer according to the 4:1 basis
proportion ($160,000: $40,000) of the ATP Partnership in the
building and computer, resulting in a $80,000:$20,000 basis ratio
for Asya.
2-109
E. Deceased Partner
1. The estate of a deceased partner or other successor in interest will report on
its return the decedent's share of partnership items for the partnership year in
which the death occurred.
2. The partnership's tax year does not end when a partner dies unless the
partnership agreement is set up as such. If a partnership terminates with the
death of a partner, the deceased partner's share of the partnership items for
that year would be included on the deceased partner's final return. If the
partner's tax year is different than the partnership's, the decedent's final return
would include both:
a) The share of partnership items for the partnership year ending with the
decedent's death, and
b) The share of the partnership items of any partnership year ending earlier
in the decedent's last year.
Exercise 69: Payments made in liquidation of the interest of a retiring or

deceased partner in exchange for his or her interest in partnership
property are considered a distribution, not a distributive share or
guaranteed payment that could give rise to a deduction (or its equivalent)
for the partnership. (True or False)
True. Payments to a retiring partner are treated as made in

exchange for the partner’s interest in partnership property, not as a
distributive share or guaranteed payment.
NOTE: For purposes of computing the self-employment income for the

deceased partner, include the partner's distributive share of income or loss
from the partnership through the end of the month in which the death
occurred. For this purpose, the partnership's distributive share of the
income or loss is considered to be earned ratably over the partnership's
tax year.

PART 3 - CORPORATIONS, ESTATES, TRUSTS & GIFT TAXES
3. PART 3 - CORPORATIONS, ESTATES, TRUSTS & GIFT TAXES

TABLE OF CONTENTS
SECTION A - CORPORATION .................................................................................. 3-4
I. General Requirements ........................................................................................ 3-4
II. Transfers to a Corporation .................................................................................. 3-5
III. Basis Rules for Stock Received and Property Transferred ................................. 3-8
IV. Dividend Received Deduction ........................................................................... 3-10
V. Extraordinary Dividend ...................................................................................... 3-11
VI. Preoperational Expenses .................................................................................. 3-12
VII. Charitable Contributions .................................................................................... 3-12
VIII. Capital Losses................................................................................................ 3-13
IX. Net Operating Loss ........................................................................................... 3-14
X. Corporate Tax ................................................................................................... 3-15
XI. Corporate Earnings and Profits ......................................................................... 3-17
XII. Distributions....................................................................................................... 3-19
XIII. Liquidations ................................................................................................... 3-22
XIV. Controlled Groups ....................................................................................... 3-24
XV. Constructive Ownership of Stock ...................................................................... 3-25
SECTION B - S CORPORATION............................................................................. 3-27
I. Requirements to Qualify for S Corporation Status............................................. 3-27
II. Electing S Corporation Status ........................................................................... 3-28
III. Separately Stated Items .................................................................................... 3-29
IV. Related Parties for Disallowed Losses .............................................................. 3-30
V. Related Parties for Deducting Business Expenses ........................................... 3-30
VI. S Corporation Taxes ......................................................................................... 3-31
VII. Tax On Excess Net Passive Income ................................................................. 3-31
VIII. Capital Gains Tax........................................................................................... 3-32
IX. Tax On Built-In Gains ........................................................................................ 3-33
X. Stock Basis........................................................................................................ 3-34
XI. Loan Basis......................................................................................................... 3-35
XII. At-Risk Limitations............................................................................................. 3-36
XIII. Distributions.................................................................................................... 3-36
XIV. Terminating S Corporation Status ............................................................... 3-39
XV. Ceasing To Qualify............................................................................................ 3-39
SECTION C - FIDUCIARIES, ESTATES, AND GIFT TAX ....................................... 3-41
I. Major Forms for Reporting ................................................................................ 3-42

II. Definitions.......................................................................................................... 3-44

III. Final Return of Decedent - Form 1040 .............................................................. 3-44
IV. Form 1041, Income Tax Return of an Estate .................................................... 3-48
V. Trusts, Form 1041 ............................................................................................. 3-55
VI. Estate Tax Return ............................................................................................. 3-58
VII. Generation-Skipping Transfer Tax .................................................................... 3-66
VIII. Gift Tax........................................................................................................... 3-66

INTRODUCTION
Part III of the exam covers Corporations, S Corporations, Estates, Trusts, and Gift
Taxes. The exam is divided into three sections with Section A being true or false
questions, Section B is multiple choice questions, and Section C is multiple choice
questions that involve computation.
STUDY MATERIALS
MAIN TOPICS
Section A Corporations
Section B S Corporations
Section C Fiduciaries, Estates, and Gift Tax
Included in the Part III discussion:
Trusts
Basis
Recognized gain
Corporate Liquidations
The following Publications will assist in your preparation for Part III of the exam. There
is no IRS publication which discusses corporate liquidation, so the information in this
text will be the primary source of information, other than the Code and regulations.

Publication 448 Federal Estate and Gift Taxes
Publication 542 Tax Information on Corporations
Publication 559 Survivors, Executors, and Administrators
Publication 589 Tax Information on S Corporations

SECTION A - CORPORATION
I. General Requirements
A. Corporations include associations and unincorporated organizations that have

associates, are organized to carry on a business, divide gains, and have a
majority of the following characteristics:
1. Continuity of life
2. Centralization of management
3. Limited liability
4. Free transferability of interests
B. Corporations also include professional service corporations (PSCs) made up of

doctors, lawyers, CPAs, veterinarians, etc. To be classified as a corporation, the
PSC must be organized and operated as a corporation.
C. Filing Requirements - Corporations must file unless they are specifically exempt,
regardless of their gross income or taxable income. They must continue to file
even if there is no activity and only cash is retained to pay state taxes. A
corporation does not need to file after dissolution even if the charter has not
expired.
D. Due Date - The due date for the corporation's tax return is the 15th day of the
third month following the close of the tax year. For a calendar year corporation,
the due date is March 15.
E. Forms - The taxable corporation files Form 1120, U.S. Corporation Income Tax
Return. Form I 120A is a short form that can be used only if the corporation's
gross receipts and assets do not exceed $500,000 and the corporation is not in
liquidation or a member of a controlled group. An S Corporation files Form
1120S, U.S. Income Tax Return for an S Corporation.
F. Extensions - An automatic six month extension for filing can be obtained by filing
Form 7004, Application for Automatic Extension of Time To File Corporation
Income Tax Return. No further extension of time to file is available. This form can
be used by both the C and S Corporation. The IRS can terminate the extension
to file at any time by mailing a notice of termination to the corporation. If the
return is not filed by the due date, a penalty of 5% per month (not to exceed
25%) will be assessed. If the return is not filed within 60 days of the due date, the
minimum penalty of $100 or the balance due, whichever is less, applies.
Corporations can avoid the penalty by showing reasonable cause.

Exercise 1: Which of the following statements concerning the extension of

time to file a corporate tax return is FALSE?
A. A corporation will receive an automatic 6-month extension of time

for filing by submitting Form 7004.
B. The Internal Revenue Service can terminate the extension to file at
any time by mailing a notice of termination to the corporation.
C. Form 7004 must be filed by the due date of the corporation's
income tax return.
D. An automatic extension of time for filing a corporate income tax
return also extends the time for paying the tax due on the return.
D. An automatic extension of time for filing a corporate income tax

return also extends the time for paying the tax due on the return. In most
cases, a corporation must pay the full amount of the tentative unpaid tax
liability estimated on Form 7004 by the original due date.
G. Prompt Assessment - If a dissolving corporation is filing its final return, the

corporation may wish to wind up affairs without waiting for the statute of
limitations to expire. The corporation would do so by requesting prompt
assessment after filing its final return. This request is made by filing Form 48l0,
Request for Prompt Assessment Under Internal Revenue Code Section 6501(d).
The filing of this form will mean that the IRS must review the return within 18
months of the request.
* Study Tip * Questions on transfers to a corporation have historically been a

major concept on Part III of the EA exam. Look for a substantial number of
questions relating to transfers. Questions in the past require that you know
how to treat such transfers and how basis is determined after the transfer
both for the shareholder and for the corporation.
II. Transfers to a Corporation
A. A corporation is generally formed when a person or persons transfer money or

property to the corporation in exchange for stock. A mandatory provision under
§351 enables a tax-free transfer of property if certain conditions are met.
B. No gain or loss is recognized by the person(s) transferring property if that

person(s) receives only stock of the corporation and immediately after the
transfer, has control (80% or more interest) of the corporation. This enables
owners of unincorporated businesses to change their business entity without
recognizing any gain on the transfer. (IRC §351)

C. Receipt of Other Property - It is possible to receive money and/or other property

in addition to the stock when transferring property to a corporation. This is called
"boot' and could result in the recognition of gain. Liabilities transferred with
property are considered boot. If the liability assumed by the corporation exceeds
the property's adjusted basis, the transferor will recognize gain to the extent of
the excess.
* Study Tip * Recognized vs. Realized Gain - Realized gain involves

economically incurred gains and losses from which recognized gains and
losses are derived. Recognized gain is that much of the realized gain taken
into account for purposes of federal income tax reporting. For example, tax-
free exchanges of like-kind property frequently involve substantial realized
gains, none of which are currently recognized.
Exercise 2: Mr. Carol transferred the title of a condo he owned in Mexico to

his 100% owned accounting corporation in exchange for stock worth $5,000.
Carol used the condo for personal purposes and there was no bona fide
business reason for the transfer. At the time of the transfer, the condo had a
fair market value of $170,000, an adjusted basis of $160,000, and a
mortgage of $165,000 (which was assumed by the corporation). What is the
amount of Mr. Carol's recognized gain?
A. $165,000
B. $10,000
C. $5,000
D. $0
B. $10,000. Without a bona fide purpose, the transfer cannot be

made tax free. The $5,000 worth of stock is a dividend. Because liabilities
assumed by the transferee corporation on the condo ($165,000) exceed
its adjusted basis ($160,000), Carroll recognizes gain to the extent of the
excess ($5,000). Thus, the combined taxable gain is $10,000.
IMPORTANT! Boot, or money, received in an exchange is generally taxable

to the transferor. Re careful to consider the boot in an exchange. If the boot
received is more than the taxpayer's adjusted basis of the property
transferred there may be recognized gain.
D. The gain or loss on a transfer of property to a corporation will be recognized if the

80% ownership rule is not met after the transfer. The property transferred will be
treated as sold at FMV.
* Study Tip * Remember the 80% rule. If there are two or more
shareholders, the rule applies if the new shareholders collectively hold 80%
or more of the outstanding stock of the corporation. (The adjusted basis of

the property transferred in a §351 exchange is increased by any gain

recognized by the transferor.)
E. If the shareholder receives stock in exchange for services, the shareholder will
have taxable compensation. The amount of the compensation will be the
shareholder's basis in the stock.
F. Capital Contributions- Contributions by shareholders to the corporation may be

made in exchange for stock as paid-in capital. Capital contributions are not
taxable to the corporation..
G. Formula to Determine Gain - First determine exactly what the question is asking
for: amount realized, gain realized, or gain recognized.
Step 1:
FMV of stock received
+FMV of other property received including cash received
= Amount realized
Step 2:
Amount realized from Step 1
- Adjusted basis of Property transferred Including cash Paid
= Gain realized
Step 3:
FMV of other property received including cash received
+ Debt relief only to the extent it exceed the adjusted basis of all assets
transferred
= Boot received
Step 4:
Smaller of "Gain realized" from step 2 or "Boot received" from step 3
= Gain Recognized (Taxed)
Exercise 3: In exchange for his old stretch limo that had a fair market value
of $50, 000 and an adjusted basis of $35,000, Jeeves received 100% of the
stock of Wegofast Corporation. The Wegofast stock had a fair market value
at the time of the transaction of $40,000. Jeeves also received a used limo
that had an adjusted basis to Wegofast of $8,000 and a fair market value at
the time of the transaction of $10,000. What is the amount of Jeeves'
recognized gain on this transaction?
A. $0
B. $10,000

C. $13,000
D. $15,000
B. $10,000. The official answer is B. $10,000. However, it is CCH’s

contention that choice A may also be correct. Choice B is correct if it is
assumed that either the limo transferred by Jeeves, or the limo received
by him, was held for personal use and not for productive use in a trade or
business or for investment (that is, the limos are not like-kind property). If
it is assumed that either limo was personal-use property, the usual rules
governing transfers to controlled corporations apply. Thus, while
transferors generally recognize no gain or loss on transfers of property for
stock, transferors recognize gain, but not loss, to the extent of any other
property (money or property other than stock of the controlled corporation)
received in the exchange. The amount of the gain recognized may not
exceed the value of the property received in the exchange. Thus, the
$10,000 value of the limo (other property) is taxable to Jeeves. However, if
it is assumed that both limos were property held for productive use in a
trade or business or for investment, the like-kind exchange rules could
apply. Those rules state that neither gain nor loss is recognized when
property held for productive use in trade or business or for investment is
exchanged for like-kind property. Application of those principles would
create in essence a transfer to a controlled corporation coupled with a like-
kind exchange of limos. In that case, Jeeves would recognize no gain on
the combined transfer.
III. Basis Rules for Stock Received and Property Transferred
A. The basis of stock received by the transferor:
1. In a §351 transfer the basis is the same as the basis of property transferred to
the corporation:
a) DECREASED by:
• The FMV of other property received,
• Money received,
• Liabilities assumed by the corporation, and
• Loss recognized on the exchange.
b) INCREASED by:
• Any amount treated as a dividend, and
• Any gain recognized on the exchange.
2. In a taxable transaction the basis of stock is its FMV.

B. Basis of property received by the corporation
1. The basis of the property transferred into the corporation in an 80% control
transaction as paid-in surplus or as a contribution to capital, is the same as it
was in the hands of the transferor prior to the transfer increased by any gain
Exercise 4: Kim transferred property with an adjusted basis of $16,000 and

a fair market value of $25,000, to Corporation K in exchange for 90% of K's
only class of stock and $3,000 cash. The stock received by Kim had a fair
market value of $22,000 at the time of the exchange. What is Corporation K's
basis in the property received from Kim?
A. $25,000
B. $22,000
C. $19,000
D. $16,000
NOTE: The holding period of property transferred in a §351 transfer includes

the transferor's holding period.
. C. $19,000. The basis of the property received by the controlled

corporation in exchange for its stock is equal to the transferor’s basis in
the property ($16,000), increased by the amount of any gain recognized
by the transferor ($3,000 as a result of the cash distribution). Thus,
corporation K takes the property with a $19,000 basis.
2. The basis of property transferred to a corporation, other than in an 80%

control transaction, is the fair market value of the stock received (if it can be
determined) or the fair market value of the property transferred (if the stock
has no established value).
Exercise 5: Ms. R transferred property with an adjusted basis of $60,000

and a fair market value of $55,000 to Rain Corporation. She received in
exchange 60% of Rain Corporation's only class of stock At the time of the
transfer, the stock Ms. R received had a fair market value of $65,000. What
is Rain Corporation's basis in the property after the exchange?
A. $0
B. $55,000
C. $60,000
D. $65,000
. D. $65,000. Because Ms. R receives only 60 percent of the Rain

stock, she is not in control, and the transfer is not tax free. Accordingly,

the basis of the property received by Rain in exchange for its stock is
equal to the Ms. R’s basis in the property ($60,000), increased by the
amount of any gain recognized by Ms. R $5,000 ($65,000 fair market
value of the stock less $60,000 basis).
SECTION 351 TRANSFER
Assets Transferred Basis to Corporation Basis in Stock

Services Fair market value Transfer of services for
stock
results in taxable
compensation to
shareholder. Basis in stock
is the value of the services
taxed as compensation
Cash Fair market value Amount of cash
Property w/o Liability Adjusted basis of property Adjusted basis of property
received transferred
Property with liability less Adjusted basis of property Adjusted basis of property
than adjusted basis received transferred decreased by
(no gain is recognized by liability assumed by
shareholder on transfer) corporation
Property with liability that is Adjusted basis of property Adjusted basis of property
more than adjusted basis received increased by gain transferred decreased by
recognized by shareholder liability assumed by
(gain recognized is excess corporation and increased
of liability over adjusted by gain recognized
basis of property)
IV. Dividend Received Deduction
A. A corporation is allowed a deduction for a percentage of certain dividends

received. The greater the ownership in the corporation issuing the dividends, the
greater the percentage of dividends eligible for deduction. For domestic (U.S.)
corporations the deduction is:
1. 70% of dividends received or accrued when stock ownership in the paying

corporation is less than 20%,
2. 80% of dividends received or accrued if the ownership in the paying

corporation is 20% or more,

3. 100% of dividends received if the recipient corporation is a small business

investment company, or
4. 100% of dividends received from a member if in the same affiliated group.
B. The dividends received deduction is limited to 70% or 80% of the taxable income
of the corporation. There is an ordering rule if the corporation has both types of
dividends.
C. The taxable income is determined without regard to an NOL deduction or capital

loss carryback. The 80% or 70% taxable income limitation does not apply where
the deduction of dividends received either results in, or increases a net operating
loss.
D. Dividends received in the form of property are included in income at the lesser of
fair market value or adjusted basis to the distributing corporation plus the amount
of gain recognized on the transaction.
Example 1: (From Publication 542). A corporation loses $25,000 from

operations. It receives $100,000 in dividends from a 20%-owned
corporation. Therefore, its taxable income is $75,000 before the deduction for
dividends received. If it claims the full dividend-received deduction of
$80,000 ($100,000 x 80%) and combines it with the operations loss of
$25,000, it will have a net operation loss of $5,000. Therefore, the 80% of
taxable income limit does not apply. The corporation can deduct $80,000.
Example 2: Assume the same facts as in Example 1 except that the

corporation loses $15,000 from operations. Therefore, its taxable income is
$85,000 before the deduction for dividends-received. However, after
claiming the dividends-received deduction of $80,000 ($100,000 x 80%), its
taxable income is $5,000. But because the corporation will not have a net
operating loss after a full dividends-received deduction, its allowable
dividends-received deduction is limited to 80% of its taxable income, or
$68,000 ($85,000 x 80%).
V. Extraordinary Dividend
A. If a corporation receives an extraordinary dividend on a share of stock that was

held two years or less before the dividend announcement date, the corporation's
basis in the stock is reduced, but not below zero, by the non-taxed portion of the
dividend.

B. An extraordinary dividend is any dividend on a share of stock that equals or

exceeds 5% of the corporation's adjusted basis for the stock that is preferred or
10% of the corporation's adjusted basis for other stock.
VI. Preoperational Expenses
A. Start-Up Costs - These expenses are ordinary and necessary expenses of a

business which would be deductible if the business activity had started. The
expenses are not currently deductible however, an election may be made to
amortize the expenses over a period of not less than 60 months. The period
begins with the first month the business becomes active. These expenses may
include surveys of potential markets, advertising for the opening of the business,
and training wages. It does not include interest, taxes, and research and
experimental expenses.
B. Organizational Costs - Expenses directly related to the creation of the business

may not be deductible. These expenses may be amortized over a period of not
less than 60 month. The election must be made when the first return as an active
business is filed. The expenses included in this category would be expense of
temporary directors, organizational meetings of directors, fees paid to a state for
incorporation, and accounting and legal fees incident to the organization.
Exercise 6: An accrual basis corporation’s organizational expenses are

amortizable:
A. Starting with the month the corporation incurred the expenses.

B. Starting with the month the corporation paid the expenses.
C. Starting with the month the corporation actively engages in business.
D. NEVER, they MUST be capitalized and later deducted when the
corporation liquidates.
C. Starting with the month the corporation actively engages in

business. A corporation’s organizational expenditures may be amortized
over any period of at least 60 months that the taxpayer selects, but the
period must begin with the month in which the corporation begins
business.
VII. Charitable Contributions
A. The deduction for charitable contributions is limited to 10% of the corporation's

taxable income.

B. Taxable income is computed without regard to the following:
1. Deduction for the contributions.
2. Deduction for dividends received and paid.
3. Deduction for any NOL or capital loss carryback.
C. Any excess deduction can be carried forward 5 years. There is no allowance for
a carryback of excess charitable contributions. Current year contributions are
deducted before any carryover contributions and an excess contribution cannot
increase an NOL carryover.
Exercise 7: During 2001, XYZ Corporation had the following income and
expenses:
Gross receipts $1,000,000

Salaries $350,000
Contributions to qualified charitable organizations $ 75,000
Operating Expenses $395,000
Dividend income from 20% owned corporation $ 65,000
Dividends received deduction $ 52,000
What is the amount of XYZ's charitable contribution carryover to 2002?
A. $32,000
B. $43,000
C. $51,000
D. $75,000
B. $43,000. The charitable contribution deduction cannot exceed 10

percent of taxable income for the year. For this purpose, taxable income
includes dividend income, but is not affected by charitable deduction or the
dividends received deduction. Thus XYZ has taxable income for the year
of $320,000 ([$1,000,000 gross receipts plus $65,000 dividend income],
minus [$350,000 salaries plus $395,000 operating expenses]). The
charitable contribution deduction for the year is $32,000 ($320,000
multiplied by 10 percent). This leaves $43,000 ($75,000 minus $32,000)
available as a carryover.
VIII. Capital Losses

A. Capital losses are deducted only to the extent of capital gains.
B. Any excess capital losses are carried back three years, then forward five years.
Capital losses cannot be carried back or forward to a year the corporation was a
S Corporation. If two or more capital losses are carried to the same year, the loss
from the earliest year is applied first, either to reduce current gain or as a
deduction. The character of any capital loss carryover becomes a short-term
capital loss carryover.
Exercise 8: McCormick, Inc., a C Corporation, had the following transactions

during 2001:
Long-term gain from sale of land $10,000

Long-term gain from sale of stock $20,000
Long-term loss from sale of securities (40,000)
What is the amount of long-term capital loss that may be taken as a
deduction by McCormick in 2001?
A. $0
B. $10,000
C. $30,000
D. $40, 000
C. $30,000. Capital losses of a corporation may be deducted only

to the extent of its capital gains.
IX. Net Operating Loss
A. A corporate net operating loss (NOL) is figured in the same way as the
corporation's taxable income. The NOL deduction is carried back 3 years and
then forward 15 years before 8/6/97 and back 2, forward 20 on or after 8/16/97.
There are limitations on the deductions allowed for a corporate NOL such as:
B. The NOL is computed without a deduction for an NOL carryback or carryover

from other years.
C. The deduction for the dividends received is not limited to a percentage of the
corporation's taxable income if the corporation has an NOL.
D. The corporation figures how much of its NOL to deduct in the year it is carried to
by subtracting the NOL from the modified taxable income of that carryback or
carryover year. If the NOL is greater than the taxable income of the year it is
carried to, the corporation must modify its taxable income to determine how

much of the NOL is used up in that year and how much is carried over to the next
year. The corporation must figure the deduction for charitable contributions
without considering any NOL carrybacks.
E. The corporation may elect to forego the carryback period and carry the loss
forward. The election is made on a year by year basis.
Exercises 9: During 2001, Pack Corporation reported gross income from

operations of $350,000 and operating expenses of $400,000. Pack
Corporation also received dividend income of $100,000 from Smith Inc., a
domestic corporation, of which Pack is a 20% shareholder. The NOL
carryover from 1999 is $20,000. What is the amount of Pack’s net operating
loss for 2001?
A. $50,000
B. $30,000
C $20,000
D. $10,000
B. $30,000. The dividends received deduction is not affected by

any NOL carryovers. Further, based on the taxable income limitation
discussed in answer #53, above the limitation does not apply here since
there would be a net operating loss of $30,000 (negative $50,000
(operating loss) plus $100,000 (dividend) less $80,000 (the otherwise
available dividends received deduction based on $100,000 multiplied by
80 percent)). Since the limitation is not applicable, Pack Corporation may
deduct the full $80,000, resulting in a current year net operating loss of
$30,000, as computed above. Again, the 1993 NOL carryover is irrelevant.
* Study Tip * Dividend received deductions, capital loss computations, and

NOLs are often 3 point questions for part III of the exam. Practice these
computations until you understand them well!
X. Corporate Tax
A. Corporations are subject to graduated tax rates ranging from 15% to 34% with an
additional 5% tax for corporations with taxable income in excess of $100,000,
then 35% over $10 million. There is an additional 3% surtax for incomes over $15
million.
Taxable Income Tax is Of the amount over

Over But not over

$0 $50,000 15% $0
50,000 75,000 $7,500 +25% 50,000
75,000 100,000 13,750 +34% 75,000
100,000 335,000 22,250 +39% 100,000
335,000 10,000,000 113,900 +34% 335,000
10,000,000 15,000,000 3,400,000 +35% 10,000,000
15,000,000 18,333,333 5,150,000 +33% 15,000,000
18,333,333 35% 0
B. Personal Service Corporations - PSCs are taxed a flat 35% for tax years
beginning on or after 1-1-93. PSCs are professional corporations performing
services in the fields of accounting, health, law, architecture, engineering,
actuarial science, performing arts, or consulting.
C. Alternative Minimum Tax - The corporate AMT is similar to the individual AMT.
The rate for corporations is 20%. The corporation is allowed a $40,000
exemption which is reduced by 25% of the amount by which the alternative
minimum taxable income exceeds $150,000. The tax due is the greater of the
alternative minimum tax or the regular tax.
Exercise 10: Given the following facts, what is the amount of Wood
Corporation's alternative minimum tax?
Taxable income before net operating loss deductions $85,000

Total adjustments to taxable income (2,000)
Total tax preference items $45,000
Regular income tax $17,150
A. $1,250
B. $850
C. $450
D. $0
C. $450. Alternative minimum tax is the excess of tentative

alternative minimum tax over the regular tax liability. In this case, tentative
alternative minimum tax is $17,600, determined by adding taxable income
($85,000) to preference items ($45,000), subtracting total adjustments to
taxable income ($2,000), subtracting the exemption amount ($40,000),
and multiplying by the alternative minimum tax rate of 20 percent. (That is:
$85,000 plus $45,000 equals $130,000 less $2,000 equals 128,000 less
$40,000 equals $88,000 multiplied by 20% equals $17,600.) Because
regular tax liability ($17,150) is less than the tentative alternative minimum
tax ($17,600), the excess ($450) is the alternative minimum tax.

D. Estimated Tax
1. A corporation must make estimated tax payments if it is expected to have a

tax liability of $500 or more.
2. A corporation making estimated tax payments must do so by making

installment payments of its "required annual payment," which equals the
lesser of 100% of the tax shown on the return for the current year or 100% of
the tax shown on the prior year's return. The corporation is not allowed to
base the required annual payment on 100% of the prior year's tax if:
a) The corporation did not file a return for the preceding tax year showing a
tax liability.
b) The preceding year was a tax year of less the 12 months.
c) The corporation is considered a "large corporation" for federal income tax

purposes. A corporation is a large corporation if it had taxable income of
$1,000,000 or more for any of the three immediately preceding years.
XI. Corporate Earnings and Profits
A. The calculation of earnings and profits is necessary to determine the status of

corporate distributions. Earnings and profits differ from retained earnings since
the later is measured on tax basis rather than book basis.
B. The calculation of earnings and profits begins with taxable income and is
adjusted as follows:
1. Subtract the actual federal tax liability
2. Add the full amount of capital losses and charitable contributions incurred
during the year. Adjustments to taxable income must be made to avoid a
double deduction when the carryovers are used.
3. Adjust the insurance deduction for the amount of the premiums in excess of
the cash surrender value.
4. Subtract nondeductible interest expenses and nondeductible contributions.
5. Add tax-exempt interest
6. Add insurance proceeds in excess of the cash surrender value.

7. Add the recovery of debt previously written off but not deducted on the tax
return.
8. Add the difference between the depreciation deducted on the tax return and
the straight line depreciation allowed for earnings and profits.
C. Distributions first reduce current earnings and profits. Any excess reduces
accumulated earnings and profits.
Exercise 11: Vernon Corporation, a calendar-year C Corporation, had

accumulated earnings and profits of $100,000 as of January 1, 2001. Vernon
had a deficit in earnings and profits for 2001 in the amount of ($140,000).
Vernon distributed $35,000 cash to its shareholders on July 1, 2001. Vernon
Corporation’s accumulated earnings and profits as of December 31, 2001 is:
A. $0
B. ($40,000)
C. ($70,000)
D. ($75,000)
C. Negative $70,000. On the distribution date, July 1 (the half-way

point in the calendar year), Vernon had earnings and profits of $30,000
($100,000 accumulated minus $70,000 first half-year deficit in current
earnings and profits). Of the $35,000 distributed, only $30,000 is a
dividend (the amount of earnings and profits). Therefore, only $30,000 is
subtracted from remaining earnings and profits, leaving a balance of $0 on
that date. The corporation’s accumulated earnings and profits as of
December 31, 2001, is a $70,000 deficit (the $70,000 second half-year
deficit in current earnings and profits plus the $0 accumulated balance
resulting from the July 1 distribution).
D. Accumulated Earnings Tax
1. If the corporation allows earnings to accumulate beyond the reasonable

needs of the business, it may be subject to an accumulated earnings tax of
39.6%.
2. An accumulation of $250,000 or less is considered to be within reasonable

limits. This limit is $150,000 for PSCs.
Exercise 12: Blitz, an accrual method C Corporation, had unappropriated

retained earnings of $50,000 as of December 31, 2001. For its 2002 tax year,
Blitz's books and records reflect the following:

Net income per books (after federal income taxes) $125,000

Cash distributions $ 12,500
Federal income tax refund $ 17,000
Based on the above, what is Blitz Corporation's unappropriated retained

earnings as of December 31, 2002?
A. $204,500
B. $192,000
C. $179,500
D. $175,500
C. $179,500. Unappropriated retained earnings equal the opening

balance ($50,000), plus net income ($125,000), plus the tax refund
($17,000), minus the cash distributions ($12,500).
XII. Distributions
A. Distributions from a corporation are taxed according to type. They may be

dividends, stock distributions, or a return of capital.
B. Distributions from corporate earnings and profits are paid to shareholders as

dividends. (This does not apply to S Corporations without prior C Corporation
retained earnings since all earnings pass through to shareholders.) Taxable
distributions (dividends) are first paid from the current earnings of the corporation
and then from accumulated earnings. The profit of the corporation can be paid
out to the shareholders, retained, or accumulated for future use.
1. If the corporation's accumulated earnings is negative at the end of the year,

but was positive at the time the distribution was made, to the extent of the
earnings, the distribution will be a taxable dividend.
2. Dividends of $10 or more are reported on Form 1099-DIV. The 1099-DIV is

due to the shareholders by January 31 and to the IRS by February 28.
C. Nontaxable dividends are distributions that exceed the corporation's accumulated

earnings and profits. Form 5452, Corporate Report of Nondividend Distributions,
must be filed if nontaxable dividends are paid to shareholders. The shareholders
will received a Form 1099-DIV including the amount.
D. Earnings and profits are reduced by any distributions made in cash and by the
adjusted basis of any property distributed, but not below zero. Distributions in

excess of earnings and profits are generally not taxable, but will reduce the basis
in the shareholder's stock. If the distribution exceeds the basis in stock, it is
treated as gain from the sale of property and generally receives capital gain
treatment.
E.
Exercise 13: Dublin, a calendar-year C Corporation, had accumulated

earnings and profits of $32,000 as of January 1, 2001. Dublin had a deficit in
earnings and profits for 2001 of $40,000. On October 1, 2001, Dublin
distributed $15,000 to one of its shareholders, Mr. Murphy. The adjusted
basis of Murphy’s stock before the distribution was $2,000. what is the
amount of Murphy's ordinary dividend income and capital gain as of the date
of the distribution?
Dividend Income Capital Gain

A. $0 $13,000
B. $2,000 $13,000
C. $2,000 $11,000
D. $15,000 $0
C. $2,000 dividend income; $11,000 capital gain. Because the

distribution date is October 1 (three-fourths into the calendar year),
$30,000 of the current year’s earnings and profits deficit ($40,000
multiplied by 3/4) reduces the accumulated earnings and profits as of that
date to $2,000 ($32,000 minus $30,000). A dividend cannot exceed
earnings and profits. Thus, only $2,000 of the distribution is a dividend.
The next $2,000 eliminates Murphy’s basis in his stock, and the remaining
$11,000 is treated as a capital gain.
E. Stock Distributions - Distributions of stock or rights to acquire stock are not

taxable to the shareholder unless:
1. The distributions are made in lieu of money or the shareholder could elect to
receive the cash equivalent,
2. The distribution is disproportionate,
3. The distribution is made on preferred stock,
4. It is a distribution of convertible preferred stock unless it does not result in a

disproportionate distribution, or

5. A distribution of common and preferred stock resulting in the receipt of

preferred stock by some common stock shareholders and common stock by
other common stock shareholders.
F. The distribution of appreciated property is being treated as if it were sold. The

corporation recognizes gain on the excess of the FMV over the adjusted basis of
the property. The character of the gain will be determined by the type of property
distributed. Some of the gain may be ordinary based on the recapture rules.
Exercise 14: Belle Corporation owns as an investment, 10% of the stock of

Gaston Corporation with an adjusted basis of $4,000 and a fair market value
$44,000. Belle uses the Gaston stock to redeem approximately 1%, or
$10,000 par value, of its own outstanding stock from unrelated, noncorporate
shareholders. As a result oft his transaction, Belle must report a gain of:
A. ($15,000)
B. $0
C. $2,000
D. $44,000
C. $40,000. A corporation that distributes property in redemption of

its stock generally recognizes gain, but not loss, if it pays all or part of the
redemption price by transferring property whose fair market value exceeds
its basis to the corporation. Thus, Belle Corporation must recognize the
$40,000 gain inherent in the difference between the value of the Gaston
stock ($44,000) and its basis ($4,000).
G. If property being distributed is subject to a liability which is greater than the

adjusted basis of the property, the fair market value is treated as not less than
the liability assumed or acquired by the shareholder.
Exercise 15: Rally Corporation distributed a sailboat to its sole shareholder,

Ms. H At the time of the distribution, the sailboat had a fair market value of
$175,000 and an adjusted basis to Rally of $150,000. The sailboat was
subject to a loan of $190,000, which Ms. H assumed. What is the amount of
Rally's gain or (loss) on the distribution.?
A. ($15,000)
B. $0
C. $25,000
D. $40,000

D. $40,000. A corporation that makes an in-kind shareholder

distribution of property subject to a liability recognizes gain as if it had sold
the property to the shareholder at an amount not less than the liability.
H. Distributions of stock in satisfaction of debt may is taxable to the recipient. The

fair market value of the stock is considered the payment. If the value of the stock
is less than the debt satisfied, the corporation will recognize debt forgiveness
income.
Exercise 16: Scott Corporation transferred stock with a fair market value of
$20,000 to its creditor in satisfaction of indebtedness of $30,000. The stock's
book value was $15,000. How much income from this transaction should
Scott include' in its 1999 income tax return?
A. $0
B. $5,000
C. $10,000
D. $15,000
C. $10,000. If a corporation issues stock to a creditor in satisfaction

of its indebtedness, the corporation is treated as having satisfied the
indebtedness with an amount of money equal to the fair market value of
the stock. The excess of the debt ($30,000) over the fair market value of
the stock ($20,000) is income to the corporation.
XIII. Liquidations
A. A liquidation is generally accomplished by the corporation redeeming (buying

back) its outstanding stock for cash, property, or a combination of both. This
redemption is treated as if the corporation sold the property for fair market value
to the shareholder for his or her stock. If property is subject to a liability, the FMV
cannot be less than the liability assumed by the shareholder.
B. Distributions to shareholders are considered full payment in exchange for the

stock. They are reported on Schedule D or Form 4797, Sales of Business
Property, if the stock is qualified § 1244 stock.
DEFINITION: §1244 Stock is the stock of a domestic corporation issued after

11/6178 subject to the following requirements. The stock must be original
issue stock issued in exchange for money or property. The issuing
corporation must have must have capitalization of $1 million or less.

Exercise 17: when is a corporation required to file a Form 1099-DIV for a

liquidating distribution?
A. Never, liquidating distributions do NOT require a Form 1099-DIV

B. When the' liquidating distribution equals or exceeds $10 in a
calendar year.
C. When the liquidating distribution equals or exceeds $600 in a
calendar year.
D. Always, liquidating distributions in any amount require the filing of a
Form 1099-DIV
C. When the liquidating distribution equals or exceeds $600 in a

calendar year. When a corporation makes distributions to a shareholder,
in partial or complete liquidation, that exceed $600 in any one calendar
year, the corporation must furnish the shareholder with Form 1099-DIV.
C. Partial Liquidation - a redemption of stock by a non-corporate shareholder is

treated as a sale or exchange of the stock if:
1. The distribution in redemption of the stock is not essentially equivalent to a

dividend (determined at the corporate rather than the shareholder level). A
distribution will not be considered equivalent to a dividend if:
a) The distribution is attributable to the distributing corporation's ceasing to

conduct a qualifying trade or business which was actively conducted
throughout the 5-year period ending on the date of the redemption.
b) Immediately after the distribution, the distributing corporation must be

actively engaged in conducting another trade or business that also had
been carried on for at least five years before the redemption.
2. The distribution is made pursuant to a plan of partial liquidation, or
3. The distribution is made either in the year the plan of partial liquidation is
adopted or in the following year.
D. Partial distributions to a corporate shareholder in redemption of stock (other than

one that is in complete liquidation or is substantially disproportionate) are treated
as dividends to the extent of earnings and profits of the corporation.
E. Basis of Property Received in Liquidation - If gain or loss is recognized, the basis

of the property is the fair market value at the time of the distribution. If gain or
loss is not recognized, the basis is the shareholder's adjusted basis in the stock
given up.

Exercise 18: Select the answer that best describes what happens when
shareholders receive a series of distributions, NOT part of an installment
obligation, covering two or more consecutive tax years in redemption of ALL
of the stock of a corporation pursuant to a plan intended to result in the
complete liquidation of the corporation.
A. The shareholders will be allowed to recover their respective basis in

the stock before recognizing any gains.
B. The shareholders will treat the distributions as dividends to the
extent of the corporation's earnings and profits.
C. The shareholders will recognize a pro- rata portion of the gain in
each of the years that distributions are received
D. NO losses from the transactions will be deductible.
A. The shareholders will be allowed to recover their respective

basis in the stock before recognizing any gains. If a corporation makes a
series of distributions in the course of a complete liquidation, each
shareholder is entitled to recover his entire basis in his shares before
recognizing gain.
XIV. Controlled Groups
A. A controlled group of corporations is limited to one apportionable $50,000

amount and one $25,000 amount in each taxable income bracket below 34%.
The income must be apportioned equally unless there is an apportionment plan
adopted. The statement of consent must be attached to the return of each
corporation. A parent-subsidiary is the only controlled group allowed to file a
consolidated return. The controlled group is allowed one $250,000 accumulated
earnings credit for the group.
B. Parent - Subsidiary: These corporations are connected through stock ownership

with a common parent corporation and:
1. 80% or more of the voting stock or 80% or more of all classes of stock of
each corporation is owned by one or more of the other corporations.
2. The common parent owns 80% or more of voting stock or 80% or more of all
classes of stock of at least one of the other companies.
C. Brother - Sister: These are two or more corporations who are owned by the same
five or fewer persons who own:

1. 80% or more of voting stock or 80% or more of the total value of all classes of
stock of each corporation, and
2. 50% or more of voting stock or 50% or more of the total value of all classes of
stock if taking into consideration the stock owned by these 5 or fewer
shareholders to the extent of identical ownership.
D. Combined Group
1. A group of three or more corporations,
2. Each corporation is a member of a parent-subsidiary or brother-sister group,

and
3. At least one of the corporations is the common parent of a parent-subsidiary

and is also a member of a brother-sister controlled group.
Exercise 19: With regard to a controlled corporate group, all of the following
statements are CORRECT except:
A. The controlled group is allowed only ONE set of graduated income

tax brackets.
B. Controlled groups are allowed ONE $40,000 exemption amount for
alternative minimum tax purposes.
C. The controlled group is allowed a $250,000 accumulated earnings
credit for EACH member.
D. The tax benefits of the graduated rate schedule are to be allocated
equally mount the members of the group unless they all consent to
different apportionment.
C. The controlled group is allowed a $250,000 accumulated

earnings credit for EACH member. A controlled corporate group is
permitted only one $250,000 accumulated earnings credit, shared among
the members.
XV. Constructive Ownership of Stock
A. By Family Members - An individual is considered to own the stock owned either

directly or indirectly by the following family members.
1. Spouse (other than a spouse who is legally separated under a decree of

divorce or separate maintenance), and

2. Children, grandchildren, and parents.
3. For the purpose of the redemption of stock under §302, brothers and sisters
are considered family members.
B. By the Corporation - The corporation is considered to own the stock owned

directly or indirectly by any individual who owns 50% or more of the value of the
stock of the corporation.
C. Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or

trust is treated as being owned proportionately by or for its shareholders,
partners, or beneficiaries.
D. Any individual owning, other than by applying (A), any stock in a corporation, is
treated as owning the stock owned, directly or indirectly, by or for his/her partner.
E. Stock Options - If an individual has an option to acquire stock, that stock should
be considered owned by the individual.
F. Stock constructively owned by a person under paragraph (C), for purposes of

applying paragraphs (A), (B), or (D), is treated as actually owned by that person.
But stock constructively owned by an individual under paragraph (A) or (D) is not
treated as owned by him or her, for again applying either paragraph (A) or (D), to
make another person the constructive owner of that stock.
Exercise 20: Ranger Corporation's only class of stock is owned as follows:

Matthew 40%
Darlene, Matthew's sister 25%
Matthew's and Darlene's father 25%
Matthew's and Darlene's grandfather 10%
What is Matthew's percentage of stock ownership under the attribution rules

for stock redemption?
A. 65%
B. 75%
C 90%
D. 100%
A. 65 percent. An individual is treated as constructively owning

stock owned directly or indirectly by his spouse, children, grandchildren
and parents. Thus, Matthew is treated as owning his shares (40 percent)
and his father’s (25 percent).

* Study Tip *: Attribution and related party rules apply differently in different
situations. Be sure to see exactly what the question is asking for, before you
decide which application applies.
* Study Tip *: Occasionally, the IRS will put what seems to be a uncommon
question on the exam. If the question is unusual, you may not have studied
that area. Concentrate on the questions that are most common. Here is last
year's unusual question for Part III.
Exercise 21: One of the factors that is considered in establishing whether a

foreign corporation’s fixed or determinable annual or periodic income from
US. sources is effectively connected with a US. trade or business is whether
the activities of that trade or business were a material factor in the realization
of the income generated. (True or False).
True. One test for determining when fixed or determinable annual

or periodical income, gains or losses are effectively connected with a U.S.
trade or business is whether the activities are a material factor in the
realization of the income generated.
SECTION B - S CORPORATION
I. Requirements to Qualify for S Corporation Status
A. Domestic Corporation - It must be a corporation that is either organized in the

United States or organized under federal or state law. The term "corporation"
includes a joint-stock company, certain insurance companies, or an association
that has the characteristics of a corporation.
B. One Class of Stock - All outstanding shares of the corporation confer identical
rights to distributions and liquidation proceeds. Stock may have differences in
voting rights and still be considered one class of stock.
C. Number of Shareholders Limited - It must have no more than 75 shareholders.

When counting shareholders, the following rules apply:
1. Count the persons who are considered beneficiaries if the stock is actually
held by a trust. Do not count the trust itself as a shareholder.
2. Count a husband and wife and their estates, as one shareholder, even if they
own stock separately.

3. Otherwise, count everyone who owns any stock, even if the stock is owned
jointly with someone else.
D. It must have as shareholders only individuals, estates (including estates of

individuals in bankruptcy), and certain trusts. Partnerships and corporations
cannot be shareholders in an S Corporation.
E. It must have shareholders who are citizens or residents of the United States.
Nonresident aliens cannot be shareholders. U.S. residents married to alien
spouses who have an ownership interest in the stock through community
property laws will not be eligible shareholders. (§1.1361 - 1(G))
Exercise 22: All of the following would qualify as a shareholder of an S

Corporation except:
A. A resident of the United States

B. An estate of an individual in bankruptcy
C. A trust owned by an individual who is a United States citizen.
D. A partnership.
D. A partnership. Only individuals and specified trusts and estates

may be S corporation shareholders. Other entities, including partnerships
and corporations, are ineligible.
F. The following domestic corporations are ineligible to elect S Corporation status:
1. A member of an affiliated group of corporations.
2. A Domestic International Sales Corporation (DISC) or former DISC.
3. A corporation that takes the Puerto Rico and possessions tax credit for doing
business in a United States possession.
4. A financial institution that is a bank, including mutual savings banks,

cooperative banks, and domestic building and loan associations.
5. An insurance company taxed under Subchapter L of the Internal Revenue

Code.
II. Electing S Corporation Status
A. If the corporation meets the eligibility requirements it must file Form 2553,
Election By Small Business Corporation, to elect S Corporation status.

B. The election requires the consent of all shareholders of record on the date filed. If
filed after the beginning of the tax year for which it is to be effective, the consent
of any shareholder that owned stock on any day during the tax year before the
date of filing Form 2553 is needed.
C. Select a Tax Year - The permitted tax year is the calendar year, or any other
accounting period for which the corporation establishes a substantial business
purpose to the satisfaction of the IRS. In addition, an S Corporation may elect
under §444 to have a tax year other than the permitted tax year.
D. File Form 2553 with the IRS center where the S Corporation will file its income
tax return. The election of S Corporation status is effective for a tax year if Form
2553 is filed at any time during the previous tax year or by the 15th day of the
third month of the tax year to which the election is to apply.
III. Separately Stated Items
A. Items of income, loss, expense, and credit that must be separately stated are
those items that, when separately treated on the shareholder's income tax return
(not as part of a lump sum amount) could affect the shareholder's tax liability.
B. Some items included are:
1. Net income or loss from rental real estate or other rental activities,
2. Portfolio income or loss (interest, dividends, royalty income, capital

gains/losses) and expenses related to portfolio income or loss,
3. Section 1231 net gain or loss, Section 179 expense deduction,
4. Charitable contributions,
5. Health insurance premiums,
6. Credits (low-income housing credit, qualified rehabilitation expenses, etc.),
7. Investment interest expense, and
8. Tax preference and adjustment items needed to figure shareholder's

alternative minimum tax.

IV. Related Parties for Disallowed Losses
A. The family of an individual includes only his or her brothers and sisters (half-
brothers or half-sisters), spouse, children, grandchildren, and parents.
B. Two corporations that are members of the same controlled group of corporations
determined by applying a 50% ownership test.
C. An individual and a corporation if more than 50% of the value of the outstanding
stock is owned by the individual.
D. A trust fiduciary and a corporation if the trust or grantor of the trust owns more
than 50% in value of the outstanding stock of the corporation.
F. The grantor and a fiduciary of any trust, a fiduciary of a trust and a beneficiary of
the trust.
F. Any two S Corporations if the same persons own more than 50% in value of the
outstanding stock of each corporation.
G. An S Corporation and a corporation that is not an S Corporation if the same

persons own more than 50% in value of the outstanding stock of each
corporation.
H. A corporation and a partnership if the same persons own more than 50% in value
of the outstanding stock of the corporation and more than 50% of the capital
interest or profits interest in the partnership.
V. Related Parties for Deducting Business Expenses
A. An accrual method S Corporation must use the cash method for purposes of
deducting business expenses and interest owed to cash method related parties.
For this purpose, related parties also include:
1. An S Corporation and a shareholder who owns, directly or indirectly, any

stock of the S Corporation.
2. An S Corporation and any person who owns, directly or indirectly, any capital
or profits interest of a partnership in which this S Corporation owns, directly or
indirectly, any capital or profits interest. This rule applies to a transaction only
if this transaction is related either to the operations of the partnership or to an
interest in this partnership.

3. Any person related under the related party rules to a person described in (A)
or (B).
B. This rule will apply even if the S Corporation and the related person cease to be
related before the expenses or interest are includible in that person's gross
income.
VI. S Corporation Taxes

A. An S Corporation may be subject to the following taxes:
1. The tax on excess net passive income,
2. The tax on certain capital gains,
3. The tax on built-in gains,
4. The tax from recomputing a prior-year investment credit, or
5. LIFO recapture tax.
B. The corporation (not the shareholder's individually) must pay the tax due in full no
later than the 15th day of the 3rd month after the end of the tax year. If the tax
totals $500 or more, quarterly estimated payments are required. Tax payments
and estimated payments must be deposited with an authorized financial
institution or Federal Reserve Bank and must be accompanied by a federal tax
deposit coupon. Payments are not sent to the IRS.
VII. Tax On Excess Net Passive Income

A. If an S Corporation has pre-S Corporation earnings and profits at the end of a tax
year and its passive investment income is more than 25% of its gross receipts,
the S Corporation may be subject to a tax on excess net passive income. If
passive investment income is more than 25% of gross receipts for 3 consecutive
tax years and the corporations has pre-S Corporation earnings and profits at the
end of each of those years, the corporation's status as an S Corporation will be
terminated.
1. Gross receipts is the total amount an S Corporation receives or accrues

under the method of accounting it uses to figure its taxable income. This
includes the total amount received or accrued from the sale or exchange of
any kind of property (except capital assets and stock or securities), from
services rendered, or from investments. Only the capital gain net income from

the sale or exchange of capital assets and only the gains from the sale or
exchange of stock or securities are included in gross receipts.
2. Passive investment income includes gross receipts from royalties, rents,

dividends, interest, annuities, and sale or exchanges of stock or securities.
Rent does not include payments for use or occupancy if significant services
are also provided. Interest includes tax-exempt interest and unstated interest.
3. Net passive income is passive investment income reduced by deductions

directly connected with the production of passive investment income.
4. Excess net passive income is the amount that has the same ratio to net
passive income as the amount of passive investment income that exceeds
25% of gross receipts has to passive investment income. This cannot be
more than the S Corporation's taxable income for the year.
B. An S Corporation is liable for a tax at a rate of 35% on excess net passive

income.
DEFINITION: Excess net passive income = net passive income x [(passive

investment income - 25% of gross receipts) / passive investment income]
Exercise 23: In the context of the tax on excess net passive income paid by
S Corporations, net passive income does NOT include:
A. Interest and dividends.

B. Annuities.
C. Net operating losses.
D. Sales or exchanges of stock
C. Net operating losses. Net passive income includes the gross

receipts derived from royalties, rents, dividends, interest, annuities, and
the sale or exchange of stock or securities. The term does not include “net
operating losses.”
VIII. Capital Gains Tax
A. An S Corporation that elected S Corporation status before 1987 may be liable for
a capital gains tax if:
1. Its net long-term capital gain exceeds its net short-term capital loss by more
than $25,000,

2. The excess is more than 50% of the corporation's taxable income, and
3. Taxable income is more than $25,000.
B. If the S Corporation is also liable for the tax on excess net passive income it
should figure that tax before figuring the capital gains tax.
IX. Tax On Built-In Gains
A. If an S Corporation has a net recognized built-in gain for any tax year beginning
in the recognition period, a tax is imposed on the income of the S Corporation for
that tax year.
1. The tax generally applies only to a corporation that converted from a regular
corporation to an S Corporation after 1986.
2. The recognition period is the 10-year period beginning with the first day of the
first tax year the corporation was an S Corporation.
B. Net Recognized Built-In Gain
1. The least of the amount that would be taxable income of an S Corporation for
the tax year if only recognized built-in gains and recognized built-in losses
were taken into account,
2. The amount that would be taxable income of the corporation if it were not an
S Corporation, or
3. The amount by which its net unrealized built-in gains is more than its net
recognized built-in gain for all prior tax years in the recognition period (net
unrealized built-in gains limitation).
C. Recognized Built-In Gains - Any gain recognized on the disposition of any asset
during the recognition period, except to the extent the S Corporation shows that:
1. The asset was not held by the S Corporation as of the beginning of its first tax
year as an S Corporation, or
2. The gain is more than the fair market value of the asset at the beginning of
the first tax year minus the adjusted basis of the asset at the beginning of that
year.

D. Recognized Built-In Loss - Any loss recognized when any asset is disposed of
during the recognition period, to the extent the S Corporation shows that:
1. The asset was held by the S Corporation at the beginning of the first tax year
as an S Corporation, and
2. The loss is not more than:
a) The adjusted basis of the asset at the beginning of its first tax year as an
S Corporation, minus
b) The fair market value of the asset at the beginning of that year.
3. Amount of tax is figured by applying the highest corporate rate (35%) to the
net recognized built-in gain for the tax year.
X. Stock Basis
A. The beginning basis of stock is determined by what was transferred to the

corporation in exchange for the stock. If money was transferred for stock, the
amount transferred is the beginning basis of the stock. (See the chart on Section
351 transfer for the basis of stock when property other than money was
transferred for the stock)
B. Increases - The following items increase the shareholder's basis in S Corporation

stock:
1. All income items of the S Corporation, including tax-exempt income, that are
separately stated and passed through to the shareholder,
2. Any non-separately stated income of the S Corporation, and
3. The amount of the deductions for depletion that is more than the basis of the
property being depleted.
C. Decreases - The following items decrease basis:
1. Distributions by the S Corporation that were not included in the shareholder's

income (Example - corporation distributes a vehicle to the shareholder),
2. All loss and deduction items of the S Corporation that are separately stated
and passed through to the shareholder,
3. Any non-separately stated loss of the S Corporation,

4. Any expense of the S Corporation that is not deductible in figuring its income
and not properly chargeable to a capital account (Example - fines, 50% of
meal and entertainment expenses), and
5. The shareholder's deduction for depletion of oil and gas property held by the
S Corporation to the extent it does not exceed the proportionate share of the
adjusted basis of that property allocated to the shareholder.
Exercise 24: All of the following would reduce the basis of a shareholder’s
stock in an S Corporation except:
A A shareholder’s pro rata share of any nonseparately stated loss of

the S Corporation.
B A shareholder’s share of all loss and deduction items of the S
Corporation that are separately stated.
C. A shareholder’s pro rata share of any nondeductible expenses of
the S Corporation that are not properly chargeable to capital
account.
D. A shareholder’s pro rata share of any nonseparately stated income
of the S Corporation.
D. A shareholder’s pro rata share of any nonseparately stated

income of the S corporation. Allocations of income increase a
shareholder’s basis. They do not decrease basis.
XI. Loan Basis
A. If stock basis decreases exceed the amount needed to reduce stock basis to
zero, the excess (excluding a decrease due to distributions) will be used to
reduce the basis of any loans the shareholder made to the corporation.
B. If a shareholder's loan basis is reduced, any increase for a later year requires
that loan basis must be restored before increasing stock basis.
C. Distributions that exceed stock basis are taxed as capital gains and do not
reduce loan basis.
* Study Tip * Basis for an S Corporation fluctuates more than for a C

Corporation. The reason is that the S Corporation is a pass-through entity
transferring the taxation of gains and losses directly to the shareholder. Since
loans to the corporation allow a shareholder additional basis in which losses
can be deducted, the repayment of such loans may result in income to the

shareholder. Untaxed items (for example: tax exempt interest) also adjust the
basis of the shareholders stock.
XII. At-Risk Limitations
A. The deductible loss allow to the shareholder of an S Corporation may be limited

by the at-risk rules.
B. A shareholder is at risk for the following amounts
1. The shareholder's cash contributions and the adjusted basis of property

contributed to the corporation by the shareholder, plus
2. Amounts borrowed for use in the activity either that the shareholder is
personally liable for the repayment of, or for which the shareholder has
pledged property not used in the activity as security.
C. The limitation applies at the shareholder level.
Exercise 25: On January 1, 2001, Mr. Karl purchased 50% of Olive Inc., an
S Corporation, for $75,000. At the end of 2001, Olive Inc. incurred an
ordinary loss of $160,000. How much of the loss can Mr. Karl deduct on his
personal income tax return for 2001?
A. $160,000
B. $80,000
C. $75,000
D. $37,500
C. $75,000. The amount of losses and deductions an S corporation

shareholder can claim is limited to the adjusted basis of the shareholder’s
stock. Thus, Karl can deduct only $75,000 of the loss.
XIII. Distributions
A. S Corporation With No Earnings and Profits (a corporation which has always

been an S Corporation or a prior C Corporation that distributed all retained
earnings) -Distributions would be a treated as a nontaxable return of capital
and/or gain from the sale of property. The type of gain will be determined at the
end of the year after the shareholder has adjusted basis for any increases and
decreases attributable to the current year.

1. Distributions up to the adjusted basis are treated as a nontaxable return of

capital.
2. If the distributions are more than the adjusted basis in the shareholder's stock,
the excess is a gain from the sale or exchange of property. As such, the gain
is generally long- or short-term capital gain.
Exercise 26: Mr. Oliver received a distribution from an S Corporation that

was in excess of the basis of his stock in the corporation. The S Corporation
had NO earnings and profits. Mr. Oliver should treat the distribution in excess
of h is basis as:
A. A return of capital.
B. Previously taxed income.
C. A capital gain.
D. A reduction in the basis of his stock.
C. A capital gain. For S corporations having no accumulated

earnings and profits, distributions are tax-free up to the shareholder’s
basis in the corporation’s stock. Distributions in excess of stock basis are
treated as a capital gain.
B. S Corporation With Earnings and Profits - If an S Corporation has earnings and

profits but has not elected to distribute them first, any distribution it makes will
come from one or more of the following sources in the following order:
1. Treated as coming out of the accumulated adjustments account (AAA). A

distribution out of AAA is applied against and reduces the shareholder's
adjusted basis in the stock. A distribution out of AAA in excess of basis is
treated as gain from the sale or exchange of property. If distributions during
the tax year exceed the AAA at the close of the tax year, the AAA generally is
allocated to each distribution made during the year in proportion to the sizes
of the distributions.
2. If the shareholder has pre-1983 previously taxed income (PTI), the PTI is the
next source of distribution. This is a nontaxable distribution which is applied
against and reduces the shareholder's basis in stock.
3. A distribution is then treated as coming out of the prior C Corporation's

earnings and profits (Retained Earnings). This distribution is treated as a
dividend up to the amount of corporation's earnings and profits. This does not
change the shareholder's stock basis.
4. A distribution is applied against and reduces the shareholder's basis in stock.

5. The distribution is treated as a sale or exchange of property.
Example: Cord, an S Corporation, has accumulated earnings and profits of

$10,000. It distributes $80,000 to its only shareholder, Don. His basis in the
stock is $50,000. Cord has $30,000 in its AAA. The order of distributions and
how they are taxes follow:
Distribution Source Type of Taxable

Distribution Yes/No
$80,000 Form AAA Reduction in No
-30,000 Basis
$50,000 From E&P Dividend Yes
-10,000
$40,000 Remaining Reduction in No
-20,000 Basis Basis
$20,000 Excess of Basis Sale or Yes
-20,000 Exchange of
Property
0
C. If the S Corporation with earnings and profits elects to distribute earnings and
profits first, all shareholders receiving distributions during the year must consent
to the election. The election is binding for that year only. After all earnings and
profits have been distributed, the S Corporation will treat all remaining
distributions under the rules for S Corporations with no earnings and profits.
Exercise 27: In 1999, Lisa acquired 100% of the stock of Computers Inc. for
$25,000 cash. Computers Inc. incurred a loss of $7,800 for 1999. On
January 1, 2000, Computers Inc. properly elected S Corporation status. Its
net income for 2001 was $10,000. A dividend of $2,500 was declared and
paid in 2001. What is Lisa’s basis in Computers Inc. as of December 31,
2001?
A. $35,000
B. $32,500
C. $25,500
D. $25,000
B. $32,500. Lisa’s basis in Computers without taking the dividend

into account was $35,000 ($25,000 purchase price plus $10,000 income).
The $2,500 dividend reduces that basis to $32,500. The $7,800 loss (a C
corporation year) is a built-in loss and does not affect the basis
computation.

NOTE: The IRS exam may call S Corporation distributions, dividends. This
does not necessarily mean that the S Corporation was a prior C Corporation
with retained earnings.
XIV. Terminating S Corporation Status
A. An S election can be revoked for any tax year. It can be revoked only if
shareholders who collectively own more than 50% of the outstanding shares in
the S Corporation's stock consent to the revocation. The consenting
shareholders must own their stock at the time the revocation is made.
B. The revocation would be effective:
1. On the first day of the tax year if the revocation is made by the 15th day of the
3rd month of the same tax year,
2. On the first day of the following tax year if the revocation is made after the
15th day of the third month, or
3. On the date specified if the revocation specifies a date on or after the day the
revocation is made.
C. Terminating an S election means that a corporation generally may not re-elect S

status for a period of 5 years.
XV. Ceasing To Qualify
A. Certain events may cause the S Corporation to cease to qualify.
B. Terminating events include:
1. Having more than 75 shareholders,
2. Transferring stock in the S Corporation to a corporation, a partnership, an

ineligible trust, or a nonresident alien,
3. Creating a second class of stock, or
4. Acquiring a subsidiary, other than certain non-operating subsidiaries.
NOTE: The termination will be effective as of the date the terminating event
took place.

C. Violating the passive income restrictions will terminate the S election if both of
the following conditions occur for three consecutive years:
1. It has pre-S Corporation earnings and profits at the end of each tax year, and
2. Its passive investment income for each tax year is more than 25% of gross
receipts.
NOTE: Termination will become effective on the first day of the tax year that
follows the third consecutive tax year referred to above.
Exercise 28: Which of the following events would cause an S Corporation to

cease to qualify as an S Corporation?
A. A 25% shareholder sells her shares to an individual who wants to

revoke S Corporation status.
B. The corporation is liable for tax on excess net passive investment
income for two consecutive years.
C. A shareholder has zero basis in his stock
D. The S Corporation issues its stock to another corporation.
D. The S corporation issues its stock to another corporation. Only

individuals and specified trusts and estates may be S corporation
shareholders. Other entities, including corporations and partnerships, are
ineligible. Thus, issuing stock to a corporation renders the corporation
ineligible for subchapter S status.

SECTION C - FIDUCIARIES, ESTATES, AND GIFT TAX
RETURNS FOR DECEDENTS

Form Requirements Due Date
SS-4Application for Needed on all returns, As soon as possible after
Employer Identification statements, and other the date of death.
Number documents filed concerning the
estate. Must also give this
number to payers of interest,
dividends, and other income
items. Penalty of $50 for each
failure to supply a number.
56 Notice Concerning Filed by the fiduciary to notify As soon as possible after

Fiduciary Relationship the IRS of the creation, or receiving an employer
termination, of a fiduciary identification number.
relationship under Section 6903.
706 United States Estate Filed if the gross estate is more Due 9 months after the
(and Generation- than $600,000, reduced by the date of death, unless an
Skipping total amount of adjusted taxable extension has been
Transfer) Tax Return gifts made after 1976. Reports granted.
the value of a decedent's estate.
Not an income tax, but a tax on
the transfer of the decedent's
property.
709 U.S. Gift (and Required if a gift was made by The earlier of: the due
Generation-Skipping the decedent prior to death but date (with extensions) for
Transfer) Tax Return before filing. filing the donor's estate
tax return; or April 15 of
the year following the
calendar year when the
gift was made.
1040 U.S. Individual Filed as a final income tax Generally, April 15th of
Income Tax Return return for the year of death. the year after the year of
Includes all income, deductions, death.
and credits up to the date of
death.
1041 U.S. Fiduciary Filed for an estate if its gross The 15th day of the
Income Tax Return income is more than $600 for fourth month after the
the tax year. Reports any end of the estate's tax

income the decedent had a year.

right to receive but did not
receive prior to death. Also
reports earnings on property
after death.
1310 Statement of Required by any person filing a Filed with Form 1040 if
Person return for a decedent and refund is due.
Claiming Refund Due A claiming a refund. Not required
Deceased Taxpayer of surviving spouse filing a joint
return or a court appointed
personal representative.
2758 Application for To request an extension of time Sufficiently early to allow

Extension of Time To to the IRS to consider the
File file an estate return. Generally extension and reply
Certain Excise, Income, up to before the due date of
Information and Other 90 days, can go up to 6 months. Form 1041.
Returns Does not extend the time to
pay.
File the original and one copy.
4768 Application for To request an extension of time Sufficiently early to allow

Extension of Time To to file Form 706. Not more than the IRS to consider the
File 6 months. extension and reply
U.S. Estate (and Two copies required. Can also before the due date of
Generation-Skipping be used to extend time to pay Form 706.
Transfer) Tax Return for up to 10 years, this requires
and/or Pay Estate (and four copies to be filed. See
Generation-Skipping Reasonable cause discussion. *
Transfer) Taxes
4810 Request for A request of prompt assessment After filing the return for
Prompt will limit the time the IRS has for which the prompt
Assessment Under assessing a tax, or for beginning assessment is requested.
Internal court action to collect it, from 3
Revenue Code Section years to 18 months.
6501(d)
I. Major Forms for Reporting
A. Final 1040 - The last 1040 tax return is called the final return. It is filed for the
year of death and includes any income received (by a cash-basis taxpayer) or

accrued (by an accrual basis taxpayer) up to the time of death. Do not confuse
the final return with the 1041 return for a decedents estate.
B. Form 1041, U.S. Fiduciary Income Tax Return
1. The fiduciary of a domestic decedent's estate, trust, or bankruptcy estate

uses Form 1041 to report:
a) The income received by the estate or trust,
b) The income that is either accumulated or held for future distribution or

distributed currently to the beneficiaries, and
c) Any applicable tax liability of the estate or trust.
NOTE: An estate or trust is a separate legal entity (except a grantor type

trust) for federal tax purposes.
2. Form 1041 - Estate - A decedent's estate is created upon the death of an

individual. Form 1041 is used to report income the decedent had a right to
receive, but did not receive prior to death. It also includes the earnings on the
decedent's property after death. For example, wages paid after a taxpayer
died (for a cash-basis taxpayer) or rental income earned by property owned
by the decedent. Form 1041 is required if the gross income of the decedent's
estate is $600 or more.
3. Form 1041 - Trusts - A trust may be created during an individual's life (inter
vivos) or upon his or her death under a will (testamentary). Form 1041 is used
to report income earned by a trust. A trust return must be filed if there is any
taxable income.
4. Beneficiaries pay the tax on income that is passed through to them from Form
1041 for either an estate or trust. Income items are reported to beneficiaries
on Form 1041, Schedule K-l.
C. Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return
is used to report the value of the decedent's estate. The computed tax is not an
income tax but a tax on the transfer of the decedent's property. Form 706 is
required if the gross value of the estate is $625,000 or more. If the decedent
made taxable transfers of gifts during his or her lifetime the $6250,000 filing
requirement is reduced by the amount of the taxable gifts. The estate pays the
tax on the value of the gross estate.
D. Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return
relates closely to Form 706 since a taxpayer is allowed only one $625,000

exemption from estate and gift tax during one's lifetime. However, certain gifts
are not included for purposes of the $625,000 exemption. The donor (the giver of
the gift) is generally responsible for any gift lax on a transfer to a donee (the
recipient of the gift.)
* Study Tip * When someone dies with an estate valued at $625,000 or

more, there are three tax returns that generally apply to the individual. The
final 1040 return is filed with the same due date as if the person were living.
Next, income earned after the date of death is reported on Form 1041. This
form continues to be filed until the assets of the estate are distributed and the
estate is terminated. Third, Form 706 is filed to report the gross value of the
estate and to pay the estate inheritance tax due, if any. Remember, the final
1040 and 1041 report income. Form 706 is used to report and pay the
transfer tax on the decedent's property.
II. Definitions
A. Executor (or Executrix) is named in a decedent's will to administer the estate and
distribute properties as the decedent has directed.
B. Administrator (or Administratrix) is usually appointed by the court if no will exists,

if no executor was named in the will, or if the named executor cannot or will not
serve.
C. Personal Representative is an executor, administrator, or anyone who is in

charge of the decedent's property. The primary duties of a personal
representative are to collect all of the decedent's assets, pay the creditors, and
distribute the remaining assets to the heirs or other beneficiaries. In addition, the
personal representative must file any income tax return and estate tax return
when due and pay the tax determined up to the date of discharge from duties.
D. Fiduciary is any person acting for another person. It applies to persons who have
positions of trust on behalf of others. The term fiduciary includes a trustee of a
trust or the executor, executrix, administrator, administratrix, personal
representative, or a person in possession of property of a decedent's estate.
E. Corpus is the principal of the estate or trust, compared with the earnings of an
estate or trust. The earnings are taxable, the corpus is not taxable.
III. Final Return of Decedent - Form 1040

A. The personal representative must file a final income tax return of the decedent
for the year of death and any returns not filed for preceding years. The filing
requirements are based on age, income, and filing status.
B. Generally, a personal representative is required to file the joint return for the
decedent and the surviving spouse. However, the surviving spouse alone can file
the joint return if no personal representative has been appointed. The income of
the decedent that was includible on his or her return for the year up to the date of
death and the income of the surviving spouse for the entire year must be
included in the final joint return.
C. If the surviving spouse has remarried before the end of the year of death, the
filing status for the decedent is married filing separately.
D. The personal representative must apply for an employer identification number for
the estate. Once the number is received, the personal representative should file
Form 56, Notice Concerning Fiduciary Relationship, with the IRS.
E. Income Included on Final 1040 - The income included depends on if the

decedent was a cash or accrual method taxpayer.
1. Cash method: If the decedent accounted for income only as it was actually or
constructively received, only these same items are accounted for in the final
return. Dividends are constructively received when available for use by the
decedent. If dividends were declared prior to death but not paid until after
death, do not include the dividend as income.
Exercise 29. Mr. Cross, a cash method, calendar year taxpayer; leased his
farm for pasture land each August for one year at $2,000 per year, payable
when the lease was signed. He died on June 30, 2001. Your review of his
records, as personal representative, reflected that as of date of his death, he
had received interest of $8,000. You also found a dividend check which was
undeposited and had been received on June 15, 2001, in the amount of
$650. What is the amount of income to be included on Mr. Cross's final
income tax return?
A. $8,000
B. $8,650
C. $10,000
D. $10,650
B. $8,650. Only the items of income actually or constructive

received by a cash-basis method taxpayer before death are accounted for
on the final return. Mr. Cross must include the interest ($8,000) actually

received and dividends ($650) constructively received, but not the rental
income ($2,000) due in August since that amount was not actually or
constructive received by Mr. Cross as of his date of death.
2. Accrual method: Only the income items accrued before death are to be
included in the final return.
3. If the decedent was a partner, include the distributive share of partnership

income for the partnership's tax year ending within or with the decedent's last
tax year (year ending on date of death). The partnership does not terminate
as long as the decedent's estate or successor continues. The distributive
share of partnership income for the tax year ending after the date of death is
not included. For purposes of self-employment income, a decedent's
distributive share of partnership income or loss through the end of the month
in which death occurred is included.
4. Interest and dividends earned prior to death are included on the final return.
Interest and dividends earned after death should be reported on the estate
income tax return or the beneficiaries tax return. Separate Form 1099s should
be prepared for prior to and after death, with the decedent's social security
number for prior to and the estate employer identification number for after.
F. Exemptions and Deductions- Generally, the rules for exemptions and deductions
allowed to an individual also apply to the decedent's final return.
1. For a non-dependent, the personal exemption can be claimed in full on the

final income tax return.
2. If not itemizing, the lull amount of standard deduction is allowed regardless of

the date of death.
3. Medical expenses paid before death are deductible on the final return.
Medical expenses not deductible on the final return are liabilities of the estate
and are shown on the federal estate tax return. However, if medical expenses
for the decedent are paid out of the estate during the one-year period
beginning with the day after death, the personal representative can elect to
treat all or part of the expenses as paid by the decedent. Amounts incurred in
the final year can be deducted on the final return. A Form 1040X would be
required for amounts incurred in a prior year.
4. A decedent's net operating loss from business operations and any capital
losses sustained during his or her last tax year or any carryover can only be
deducted on the decedent's final return. An unused net operating loss
deduction or capital loss cannot be deducted on the estate's income tax

return. A net operating loss can be carried back to a decedent's prior tax
years.
5. The at-risk limits will continue to apply on any allowable loss on the
decedent's final return.
6. If a passive activity interest is transferred because of the death of a taxpayer,

the accumulated unused passive activity losses may be allowed as a
deduction against the decedent's income in the year of death. Losses are
allowed only to the extent they are greater than the excess of the transferee's
basis of the property over the decedent's adjusted basis in the property
immediately before death.
G. Credits, Other Taxes and Payments
1. A decedent is allowed any credits that applied prior to death. This includes:
a) EIC, even if the return does not include a full 12 months,
b) The Credit for the Elderly or Disabled, if the decedent was eligible, and
c) Unused business tax credits being carried forward. In the final year, the
decedent may take a deduction for any unused business tax credit
amount.
2. Self-employment tax may be owed on self-employment income earned up to

the date of death, if net earnings are $400 or more.
3. The final return may also be subject to alternative minimum tax.
4. Withholding and estimated tax payments are credited the same for a
decedent as would apply had death not occurred.
H. Signing the Final Return - The word "deceased," the deceased's name, and the
date of death should be written across the top of the tax return. If a personal
representative has been assigned, that person must sign the return. If it is a joint
return, the surviving spouse must also sign. If no personal representative has
been assigned, a surviving spouse can sign and write in the signature area
"Filing as surviving spouse." If not a joint return, the person in charge of the
decedent's property must file and sign the return as "personal representative."
I. Due Date - The final return for a decedent who was a calendar year taxpayer is
due on or before April 15 following the year of death regardless of when during
the year the taxpayer died.

Exercise 30: John died on August 18, 2001. All of the following statements
are CORRECT except:
A. John’s death does NOT close the tax year of the partnership in
which he was partners before it normally ends.
B. Medical expenses paid by John before his death are deductible on
his final income tax return if deductions are itemized
C. On John's final return, all income is reported on the accrual method
of accounting regardless of the accounting method that John had
employed
D. Any tax credits that applied to John before his death may be
claimed on his final income tax return.
C. On John’s final return, all income is reported on the accrual

method regardless of the accounting method John had employed. In
computing income for the decedent’s last tax year, only amounts properly
includible under the taxpayer’s method of accounting are included.
IV. Form 1041, Income Tax Return of an Estate
A. An estate is a separate taxable entity, formed on the date of death, and

terminated when all assets are distributed. Any income earned during this period
is subject to income tax and is reported annually on either a calendar year or
fiscal year basis. The tax generally is computed in the same manner and on the
same basis as for individuals. However, there is one major distinction. A trust or
decedent's estate is allowed an income distribution deduction for distributions to
beneficiaries. The computation is made on Schedule B of Form 1041. The
income distribution deduction determines the amount of the distribution that is to
be taxed to the beneficiary.
B. Filing Requirements - Every domestic estate with gross income of $600 or more
during a tax year, or with a beneficiary who is a nonresident alien, must file a
Form 1041. The personal representative has the responsibility of filing a tax
return and a Schedule K-1 for each beneficiary. A Schedule K-1 must also be
given to each beneficiary on or before the date the Form 1041 is filed.
Exercise 31: Mr. Alisamiros, a nonresident alien, is a beneficiary of a

domestic estate. The personal representative of the domestic estate must file
a return even if the gross income was less than $600. (True or False)
True. The personal representative of the domestic estate must file

an income tax return for the estate regardless of income because Mr.
Alisandros is a beneficiary who is a nonresident alien.

C. Tax Liability - The income tax liability of an estate attaches to the assets of the
estate. If the income is distributed or required to be distributed during the current
tax year, it is reportable by each beneficiary on his or her individual income tax
return.
D. Income of the Estate - If the income is not required to be distributed and is not
distributed but is retained by the estate, the tax on the income is payable by the
estate. If the tax is not paid and the income is later distributed, the beneficiary
can be liable for the tax due.
E. Tax Year - The personal representative chooses a fiscal or calendar year and the
method of accounting for the estate when filing the first income tax return.
F. Income to Include - Gross income of an estate consists of all items of income

received or accrued during the tax year. This includes dividends, interest, rents,
royalties, gain from the sale of property, and income from businesses,
partnerships, trusts, and any other sources.
G. Income in Respect of the Decedent (IRD) - All gross income that the decedent
would have received had death not occurred and in a proper manner was not
included on the final return.
1. The character of income an individual receives in respect of the decedent is

the same as it would have been to the decedent if he or she were alive.
2. If an individual transfers a right to income in respect of a decedent, he or she

must include in income the greater of:
a) The amount received for the right, or
b) The fair market value of the right transferred.
3. If the right to income is transferred by gift, the individual must include in

income the fair market value of the right at the time of the gift.
4. Installment obligations that are transferred to the buyer, cause the balance of
the installment obligation to be reported under the rules for the transfer of a
right to income received in respect of a decedent. The amount of income to
be included is the greater of
a) The amount received, or
b) The fair market value of the installment obligation at the time of the
transfer, reduced by the basis of the obligation.

c) If the transferor and the buyer are related, the fair market value cannot be
less than its face value.
5. Any part of a distributive share of partnership income of the estate or other

successor in interest of a deceased partner that is for the period ending with
the date of the decedent's death is income in respect of a decedent. Any
partnership income for the period after the date of death is income of the
estate or other successor in interest.
6. Reporting of series B or BE U.S. Savings Bonds is determined by how the

decedent was reporting the interest.
a) Bonds that were owned by a cash-method individual who had chosen to

report the interest each year are transferred because of death, the
increase in value of the bonds in the year of death up to the date of death
must be reported on the decedent's final return. The transferee reports on
its return only the interest earned after the date of death.
b) If the interest were not reported each year and the deceased had
purchased the bonds entirely with personal funds, then interest earned
before death must be reported in one of the following ways:
(1) The personal representative can elect to report interest up to the date
of death on the decedent's final return. The transferee includes interest
only after the date of death.
(2) If the election is not made, interest earned to the date of death is
income in respect of a decedent and is not included on the final return.
All of the interest earned before and after the decedent's death is
income to the transferee. The transferee may defer reporting until the
bonds are cashed or the date of maturity.
H. Deductions in Respect of the Decedent (DRD) - Items such as business

expenses, income-producing expenses, interest and taxes, for which the
decedent was liable but which are not properly allowable as deductions on the
decedent's final income tax return will be allowed when paid:
1. As a deduction to the estate, or
2. If the estate was not liable, as a deduction to the person who acquired an
interest in the decedent's property because of death.
I. Income that a decedent had a right to receive is included in the decedent's gross
estate and is subject to estate tax. This "income in respect of the decedent" is
also taxed when received by the estate or beneficiary. However, an income tax

deduction is allowed to the person (or estate) receiving the income. This person
(or estate) may qualify to claim the deduction for estate tax if he or she (or
estate) must include in gross income for any tax year an amount of income in
respect of the decedent. For an individual, this would be an itemized deduction
not subject to the 2% AGI limit.
J. Exemptions and Deductions
1. An estate is allowed an exemption deduction of $600 in computing its taxable

income in any year other than the final year. No exemption for dependents is
allowed to an estate.
2. Charitable Contributions - An estate qualifies for a deduction for amounts of

gross income paid or permanently set aside for qualified charitable
organizations. To be deductible, specific provisions for the contribution must
be in the decedent's will. If the contribution is to be paid out of the estate's
gross income, the contribution will be fully deductible. If there is no will, the
contributions will not be deductible even though all beneficiaries agree to
make the gift.
3. Capital Losses - An estate can claim a deduction for a loss that it sustains
upon the sale of property even if the sale is to the personal representative or
other beneficiary. The sale of stock to a personal representative or other
beneficiary does not qualify for the deductible loss treatment.
4. NOLs - An estate can claim a net operating loss, computed as for individuals,
except that distributions to beneficiaries and the deduction for charitable
contributions are not considered. Losses due to casualties or thefts can be
deducted if not claimed on the estate return.
5. Administration Expenses - Administrative expenses can be deducted from the

gross estate in figuring the federal estate tax or from the estate's gross
income in figuring the estate's income tax, but not both. Administrative
expenses allocated to tax-exempt income are not deductible.
6. Depreciation and Depletion - The allowable deductions for depreciation and

depletion that accrue after the decedent's death must be apportioned
between the estate and the beneficiaries depending upon the income of the
estate that is allocable to each.
7. Amounts Distributed to Beneficiaries - An estate is allowed a deduction for the

tax year for any amount that must be distributed currently and for other
amounts that are properly paid or credited or that must be distributed to
beneficiaries out of the estate's income. The deduction is limited to the
distributable net income of the estate.

NOTE: No deduction can be taken for funeral expenses or medical and

dental expenses on the estate's income tax return.
K. Credits, Tax, and Payments - Estates generally are allowed the same tax credits
that are allowed to individuals. The credits are generally allocated between the
estate and the beneficiaries. Estates are not allowed the Credit for the Elderly or
Disabled or EIC.
L. Tax Tables - An estate cannot use the Tax Table that applies to individuals. The
Tax Rate Schedule to use is included with Form 1041 instructions. An estate may
be liable for AMT.
M. The estate’s income tax liability must be paid in full when the return is filed.
Estates with tax years ending 2 or more years after the date of the decedent's
death must pay estimated tax in the same mariner as individuals.
N. Name, Address, Signature, and Due Date - The Form 1041 requires the exact
name and address of the estate, as reported when filing for an EIN and the name
and address of the personal representative. The personal representative must
sign the return.
O. Due Date - The Form 1041 is due by the 15th day of the 4th month after the end
of the tax year (April 15 if a calendar year was chosen).
P. Distributions to Beneficiaries From an Estate - If an individual is the beneficiary of

an estate that must distribute all its income currently, the individual must report
his or her share of the distributable net income whether or not it is actually
received.
1. If an individual is the beneficiary of an estate, and the fiduciary has

discretionary powers to distribute all or a part of the current income, the
individual must report all income that is required to be distributed plus all
other amounts actually paid or credited to him or her, to the extent of his or
her share of distributable net income. For an amount to be currently
distributable income, there must be a specific requirement for current
distribution either under local law or by the terms of the decedent's will. If
there is no such requirement, income is reportable only when distributed.
2. If the currently distributable income is more than the estate's distributable net
income figured without deducting charitable contributions, each beneficiary
must include in gross income a ratable part of the distributable net income.
Exercise 32: Under the terms of the will of Jim Shaw, $9,000 a year is to be
paid to his widow and $6,000 a year is to be paid to his son out of the
estate's income during the period of administration. There are no charitable

contributions. For the year, the estate's distributable net income is $10,000.
How much must the widow include in her gross income?
A. 53,000
B. $5,000
C. $6,000
D. $9,000
C. $6,000. Unless the terms of the will provide otherwise, the widow
includes $6,000, representing her pro rate share (60 percent of $10,000)
in gross income.
3. Current income required to be distributed includes any amount that must be

paid out of income or corpus to the extent the amount is satisfied out of
income for the tax year. An annuity that must be paid in all events would
qualify as income required to be distributed currently to the extent there is
income of the estate not paid, credited, or required to be distributed to other
beneficiaries for the tax year.
4. Any other amounts paid, credited, or required to be distributed to the

beneficiaries for the tax year must also be included in the beneficiary's gross
income. Such an amount is in addition to those amounts that must be
currently distributed. If the sum of the amounts that must be currently
distributed and other amounts paid, credited, or required to be distributed
exceeds distributable net income, then these amounts are included in the
beneficiary's gross income only to the extent that they do not exceed
distributable net income. Other amounts would include:
a) Distributions made at the discretion of the personal representative,
b) Distributions required by the terms of the will upon the happening of a

specific event,
c) Annuities required to be paid in any event, but only out of corpus,
d) Distributions of property in kind, and
e) Distributions required for the support of the decedent's widow, widower, or

other dependent for a limited period, but only out of corpus.
5. If an estate discharges a legal obligation of a beneficiary, that is treated as

income to that beneficiary.
6. An amount distributed to a beneficiary for inclusion in gross income retains

the same character for the beneficiary that it had for the estate.

7. If no charitable contributions are made during the tax year, distributions are
treated as consisting of the same proportion of each class of items entering
into the computation of distributable net income as the total of each class
bears to the total distributable net income.
8. If a charitable contribution is made and the will or local law provides for the
contribution to be paid from a specific source, that provision governs. If no will
or law dictates the charitable contribution deduction must be allocated among
the items entering into the computation of the taxable income of the estate
before allocation of the deductions for distribution to beneficiaries.
Q. Reporting - A taxpayer must include his or her share of the estate income on his
or her income tax return for the tax year in which the last day of the estate tax
year falls.
R. Termination of the Estate - The termination of an estate generally is marked by

the end of the period of administration and by the distribution of the assets to the
beneficiaries under the terms of the will or laws of succession of the state if there
is no will.
1. Unused NOL - An unused net operating loss carryover or capital loss

carryover existing upon termination of the estate is allowed to the
beneficiaries succeeding to the property of the estate.
2. Excess Deductions - If the deductions in an estate's last tax year are more
than gross income for that year the beneficiaries succeeding to the estate's
property can claim such excess on their income tax returns as a
miscellaneous itemized deduction subject to 2% of AGI.
S. Gifts, Insurance, and Inheritances
1. Property received as a gift, bequest, or inheritance is not included in the

individual's income. Income received from such property, whether directly or
through a trust, is includible in the individual's income.
2. The proceeds from a decedent's life insurance policy is not income to the
beneficiary. However, if the proceeds are to be paid in installments, part of
each installment will be taxable income. The part of each installment to
exclude is the amount held by the insurance company (generally, the total
lump sum payable at the insured's death) divided by the number of periods in
which the installments are to be paid (or life expectancy if to be received for
life). Amounts received in excess of the excludable part must be included as
interest income.

T. The basis of property inherited from a decedent is generally the value used for
estate tax purposes. For depreciable property, an individual must generally use
the modified accelerated cost recovery system.
Exercise 33: NO gain is reported on depreciable personal property or real

property that is transferred at a taxpayer's death to his or her estate or
beneficiary (True or False)
True. No gain is reported on the transfer of property from a

decedent to his or her estate or beneficiary because there is no sale or
other taxable disposition of the property.
V. Trusts, Form 1041
A. The term "trust" refers to an arrangement created either by a will (testamentary)

or by an inter vivos (living) declaration by which trustees take title to property for
the purpose of protecting or conserving it for the beneficiaries under the ordinary
rules applied in chancery or probate courts. A trust (except a grantor type trust) is
a separate legal entity for Federal tax purposes.
B. Grantor Trust
1. A "grantor-type trust" is a legal trust under applicable state law that is not
recognized as a separate taxable entity for income tax purposes because the
grantor or other substantial owners have not relinquished complete control
over the trust. If the trust instrument contains certain provisions, then the
person creating the trust (the grantor) is deemed to be the owner of the trust's
assets and the trust is treated as a "grantor type trust." The income of a
grantor trust is taxed to the grantor on his or her individual tax return.
2. The grantor will be treated as the owner of any portion of a trust whose
income may be distributed without the consent of any adverse party or at the
discretion of the grantor or a nonadverse party even thought the trust may be
irrevocable. The income of the trust will not automatically be taxable to the
grantor merely because it may be used for support of a beneficiary (other
than the spouse) whom the grantor is legally obligated to support. (§677)
Exercise 34: Bill, the grantor, set up two irrevocable trusts: Trust A and Trust
B. The income of Trust A is to be accumulated for distribution to Bill's spouse
after Bill's death. The income of Trust B is to be accumulated for Bill's
children, whom Bill is legally obligated to support, and the trustee has the
discretion to use any part of the income for the children's support. Half of the

income was so used in 2001. Based on this information, which of the

following statements is CORRECT?
A. ALL the income from both trusts is taxed to Bill.

B. NONE of the income from either trust is taxed to Bill.
C. NO income from Trust A is taxed to Bill and HALF of the income
from Trust B is taxed to Bill.
D. ALL the income from Trust A and HALF from Trust B is taxed to Bill.
D. ALL the income from Trust A and HALF from Trust B is taxed to
Bill. Income from Trust A is fully includible by the grantor when it is held or
accumulated for future distribution to the grantor or spouse. Income from
Trust B is includible to the extent it is distributed to satisfy a legal
obligation of the grantor to the recipient beneficiary, other than the
grantor’s spouse.
C. Simple Trust - A trust is a simple trust if:
1. The trust requires that all income must be distributed currently,
2. It does not allow amounts to be paid, permanently set aside, or used in the
tax year for charitable purposes, and
3. The trust does not distribute amounts allocated to the corpus of the trust.
D. Complex Trust - A complex trust is any trust that does not qualify as a simple
trust.
* Study Tip * A trust may be a simple trust one year and a complex trust the
next year. For example, a trust that does not distribute all income in the
current year becomes a complex trust because it failed to meet the
conditions of a simple trust.
Exercise 35. A beneficiary of a COMPLEX TRUST must include in his

taxable income the income that is required to be distributed, whether or not it
is actually distributed during the tax year. (True or False)
True. If income of a complex trust is required to be distributed, it is

currently taxable to the beneficiary whether or not it is actually distributed.
E. Taxation of Trusts - A trust computes its gross income in much the same manner
as an individual. Generally, the deductions and credits allowed to individuals are
also allowed to estates and trusts. However, there is one major distinction. A
trust (or a decedent's estate) is allowed an income distribution deduction for
distributions to beneficiaries.

F. Distributable net income (DNI) is the estate's income available for distribution. It
is the taxable income of the estate without considering distributions to
beneficiaries, the exemption, generally capital gains and losses. Tax-exempt
interest which is excluded from taxable income is included in DNI.
Exercise 36: Under the terms of the trust agreement, the income of the Y
Trust is required to be currently distributed to Brad during his life. Capital
gains are allocable to Corpus, and all expenses are charged against corpus.
During the taxable year, the trust had the following items of income and
expenses:
Dividends $35,000
Taxable interest 25,000
Nontaxable interest 10,000
Long-term capital gains 15,000
Commissions and miscellaneous expenses allocable to Corpus 7,000
The trust’s distributable net income is:
A. $53,000
B. $60,000
C. $63,000
D. $70,00
C. $63,000. Taxable income ($68,000) is modified by adding tax-

exempt interest ($10,000) and subtracting capital gains allocable to corpus
($15,000).
G. The income distribution deduction (IDD) allowable to estates and trusts for
amounts paid, credited, or required to be distributed to beneficiaries is limited to
the distributable net income. This limit is also used to determine how much of an
amount paid, credited or required to be distributed to a beneficiary will be
includible in his or her gross income.
H. Character of Distributions - An amount distributed to a beneficiary for inclusion in

gross income retains the same character for the beneficiary that it had for the
estate.
Exercise 37: With regard to a trust, all of the following statements are
CORRECT except..
A. A trust is a separate taxable entity.

B. Generally, the trust is taxed on the income currently distributed and
on the portion it has accumulated

C. If income is required to be distributed currently or is properly

distributed to a beneficiary, the trust is regarded as a conduit with
respect to that income.
D. The income allocated to a beneficiary retains the same character in
his hands as it had in the hands of the trust.
B. Generally, the trust is taxed on the income currently distributed

and on the portion it has accumulated. A trust is allowed a distribution
deduction for amounts required to be distributed currently and any other
amounts properly paid, credit or required to be distributed.
VI. Estate Tax Return
A. Form 706 - The federal estate tax applies to the transfer of property at death. It is
not an income tax, but is a tax on the gross value of the decedent's property
transferred. The estate is responsible for paying any tax due. If not paid by the
estate the beneficiaries may be held liable.
B. The estate tax return is filed by the executor of an estate. The return is due 9
months after the date of death unless an extension has been granted. If the
individual was neither a resident nor a citizen and owned property located within
the United States, the Form 706NA is required.
Filing requirement. The following table lists the filing requirement for the estate
of a decedent dying after 1997. Previously, the amount was $600,000.
Year of Death Filing Requirement 1998 $625,000

1999 $650,000
2000 and 2001 $675,000
2002 and 2003 $700,000
2004 $850,000
2005 $950,000
After 2005 $1,000,000
C. Gross Estate - The gross estate includes the value of all property to the extent of
the decedent's interest in the property at the time of death. It includes property
that was owned by a decedent at the time of death and was transferred at death
by a will or by intestacy laws. It may also include other property interests that the
decedent did not own at death.
1. It does not include property that the decedent owned but could not transfer by
will or by intestacy laws.
2. The gross estate includes, but is not limited to, the following items.

a) Outstanding dividends declared to stockholders of record on or before the

date of death. Those declared after the date of death are not included.
b) Unpaid interest that has accrued on savings certificates from the date of
the last interest payment to the date of death, plus the face amount of the
certificate.
c) U.S. Government bonds or other U.S. Government indebtedness. This

also includes bonds issued by a state government agency and secured by
a pledge of a loan by the federal government.
d) No-fault insurance benefits are included if paid to the estate. Do not

include a "survivor's loss benefit" paid to a survivor.
e) An income tax refund is included in the gross estate. If the refund is based
on a joint return the estate includes a percentage of the refund. The
percentage is derived by determining both spouses tax liability as MFS
and then making an allocation.
f) Medical insurance reimbursements if the decedent had a right to the

amount at death.
g) The value of a surviving spouse's dower or curtesy interest in the

decedent's estate is included.
h) The value of property transferred before death if that person kept

possession or enjoyment of the property or reserved certain rights or
interests in it.
i) The value of property interests transferred that take effect at death, if the
following conditions are met:
(1) The beneficiaries could have possessed or enjoyed the transferred

property through ownership of it, only by surviving the decedent,
(2) The decedent kept a reversionary interest in the property, and
j) The value of the reversionary interest immediately before death was more
than 5% of the value of the entire property.
k) Revocable transfers subject to exercisable powers of the decedent. (If the

decedent, within 3 years of death, transferred a retained interest, a
reversionary interest, or a power relating to above items h, i, or j transfers,
the value of the property is included.)

l) The proceeds of a life insurance policy are included if the decedent made
a completed gift of the policy within 3 years of death. Also included are
proceeds on the decedent's life if:
(1) The proceeds are receivable by the estate,
(2) The proceeds are receivable by another for the benefit of the estate, or
(3) The proceeds are not receivable by or for the benefit of the estate and
the decedent possessed incidents of ownership in the policy. Also
included is the replacement value of a policy of life insurance on the
life of another, owned by the decedent.
m) The amount of gift tax paid by the decedent or the estate on any gift made
by the decedent or the decedent's spouse during the 3 year period ending
on the date of the decedent's death.
n) The value of an annuity or other payment that a beneficiary is due to

receive because he or she survives the decedent. This does not include a
single life policy.
o) The value of the following jointly held property:

(1) One-half of the value of property held jointly with a spouse, and
(2) Entire value of other joint interests except that part of the property that
was acquired by a person other than the decedent for adequate and
full consideration in money or money's worth.
p) The value of property interests over which the decedent had a general
power of appointment are included.
q) Terminable interest property for which a marital deduction was allowed is

also include.
Exercise 38: Ed died on November 1, 2000. The alternate valuation method

was NOT elected. The assets in his estate as of the date of death were as
follows:
Home $300,000
Life insurance (proceeds receivable by the estate) 300,000
Stocks, bonds, & savings 150,000
Jewelry 25,000
Car 15,500
Accrued interest on savings as of November 1, 2000 6,000
Dividend" declared July 1, 2000, NOT paid as of November 1, 2000 1,500

What is the amount of Mr. James' gross estate?
A. $596,500
B. $790,500
C. $796,500
D. $798,000
D. $798,000. All of Ed’s listed items including accrued interest and

dividends declared but unpaid as of his date of death are includible in his
gross estate. A dividend is includible in decedent’s gross estate only if the
decedent dies after the record date of the dividend; the record date is the
date when the shareholder of record becomes entitled to receive the
dividend. This question assumes that the record date was the date the
dividend was declared.
D. Estate Valuation
1. Fair market value on the date of death is generally used to value a decedent's
property for estate tax purposes. Fair market value is the price at which the
property would change hands between a willing buyer and a willing seller, if
neither one is under any compulsion to buy or sell and if both have
reasonable knowledge of all relevant facts. It cannot be determined by a
forced sale or by the sale price in a market other than that in which the item is
most commonly sold to the public.
2. Alternate Valuation Date Method is an election under which the property

included in the decedent's gross estate is valued as of a date 6 months after
the date of death. The executor may elect the alternate valuation method
provided the following requirements are met:
a) A return must be required to be filed.
b) The election applies to all property in the estate.
c) The election must be made on the first estate tax return filed for the estate
and the return must be filed within one year of the due date (including
extensions) for filing the return.
d) The election may be made only if it will decrease the value of the gross
estate and the amount of the estate tax. Once the election is made, it is
irrevocable.
3. If elected, the property is valued according to the following rules:

a) Any property distributed, sold, exchanged, or otherwise disposed of within

6 months after the decedent's death is valued as of the date on which it
was first distributed, sold, exchanged, or otherwise disposed of.
b) Any property not disposed of within 6 months after the decedent's death is
valued as of 6 months after the date of the decedent's death.
c) Any property, interest, or estate that is affected by mere lapse of time is

valued as of the date of the decedent's death. However, this is adjusted
for any difference in value not due to mere lapse of time as of 6 months
after the decedent's death or if earlier, as of the date of its disposition.
(Patents, remainders, reversions)
d) Values of life estates, remainders, and similar interests are figured by

using the ages of the recipients on the date of the decedent's death and
the value of the property on the alternate valuation date.
4. Special Use Valuation can be elected to value qualified real property that is
included in the decedent's estate and is devoted to farming or is used in a
closely held business on the basis of its actual use for these purposes.
Exercise 39: Ms. Rose died on October 15,2000. The assets which
comprised her estate were valued as follows:
10/15/2000 02/15/2001 04/15/2001

House $ 950,000 $ 900,000 $ 800,000
Stocks 1,950,000 1,865,000 1,880,000
Bonds 500,000 500,000 540,000
The executor sold the home on February 28, 2001, for $900,000. The
executor properly elected the alternate valuation date method. What is the
value of Ms. Rose’s estate.
A. $3,220,000
B. $3,320,000
C. $3,265,000
D. $3,400,000
B. $3,320,000. When alternative valuation is elected, the value of

the decedent’s gross estate is determined six months after the decedent’s
death or on earlier disposition. Since the house was sold prior to end of
the six-month period, it’s value for the estate tax purposes was $900,000,
not $800,000.

F. Taxable Estate - The taxable estate is the gross estate minus the following
items:
1. Administrative and funeral expenses.
a) Funeral expenses are a deduction if they are actually paid, are allowable
out of property subject to claims under local law, and satisfy the limitation
for the total amount of expenses allowed. May include the cost of a
tombstone, monument, mausoleum, a burial lot, a reasonable expenditure
for it's future care, and transportation expenses for bringing the body to
the place of burial.
b) Administrative expenses incurred in administering property subject to

claims are deducted including executor commissions, fees of attorneys for
the estate, and miscellaneous expenses such as court costs, accountant's
fees, appraisal fees, and other expenditures necessary for preserving and
distributing the estate. These may also include selling expenses and
interest expenses that accrue after death on federal or state income tax
deficiencies or estate or gift taxes.
2. Claims against the estate, including outstanding obligations to which the

property is subject, if the value of the property is included in the gross estate
and is undiminished by the outstanding indebtedness, are deducted.
3. Casualty and theft losses incurred during the settlement of the estate are
deducted.
4. The marital deduction is a deduction from the gross estate of the value of
property that is included in the gross estate but that passes or has passed to
the surviving spouse. To be eligible, the spouse must survive the decedent
and be married to the decedent at the time of the decedent's death. The
spouse must be a citizen of the United States at the time the estate return is
filed in order to qualify for the marital deduction.
5. Charitable contributions are deducted for the value of property in the

decedent's gross estate that the decedent transferred during life or by will to
or for the use of a qualified organization.
6. A deduction is allowed for amounts payable out of property subject to claims

(generally, the probate assets).
Exercise 40: All of the following would be allowed as deductions from the
Gross Estate in computing the Taxable Estate except:
A. Funeral expenses paid out of the estate.

B. Debts owed by the decedent at the time of death.

C. Income tax on income received after decedent's death.
D. Casualty and theft losses that occur during settlement of the estate.
C. Income tax on income received after decedent’s death. Unpaid income

taxes are deductible if they are on income includible in a decedent’s
income tax return for a period before, but not after, the decedent’s death.
F. Estate Tax Computation - There is one Unified Rate Schedule that applies to
both estate and gift taxes. This schedule is used to determine the tentative tax on
the taxable amount of all gifts whether made by the individual prior to death or
through the estate.
1. The gross estate tax, Your gross estate includes the value of all property in
which you had an interest at the time of death. Your gross estate will also
include:
• Life insurance proceeds payable to your estate or, if you owned the policy,
to your heirs,
• The value of certain annuities payable to your estate or your heirs, and
• The value of certain property you transferred within 3 years before your
death.
2. The net estate tax payable is the gross estate tax reduced by the following
items.
a) The Unified credit. (see Pub. 950)
b) The credit for state death taxes - A credit for any estate, inheritance,
legacy, or succession tax actually paid to any state or the District of
Columbia, on account of any property included in the gross estate of the
decedent. This applies only to taxes that actually were paid and for which
the credit was claimed within 4 years after filing the estate tax return.
c) The credit for gift taxes - No credit is allowed for any gift tax paid on gifts
made after 1976 and only when the gift tax has been paid on the transfer
of non-probate assets and double taxation would result.
d) Credit for tax on prior transfers - The credit is applied against the gross
estate tax for federal estate taxes paid on the transfer of property to the
decedent from a transferor who died within 10 years before or 2 years
after the decedent's death. The property does not have to be identified in
the decedent's estate, nor does it have to exist at the time of death. What
matters is that the transfer was subject to federal estate tax in the estate
of the transferor.

e) Credit for foreign death taxes - The credit is applied against the gross
estate tax for any estate, inheritance, legacy, or succession taxes actually
paid by the decedent's estate to any foreign country, including
possessions or political subdivisions of foreign states and possessions of
the United States.
NOTE: If any amount of taxes claimed as a credit for state death taxes or for
foreign death taxes is refunded, the executor or any person recovering the
taxes must notify the IRS within 30 days. The IRS will redetermine the
federal estate tax.
Exercise 41: Form 706, United States Estate (and Generation-Skipping

Transfer) Tax Return, was filed for the estate of John Doe in 2001. The gross
estate tax was $250,000. Which of the following items CANNOT be credited
against the gross estate tax to determine the net estate tax payable?
A. Credit for marital deduction.

B. Credit for gift taxes.
C. Credit for state and foreign death taxes.
D. Credit for tax on prior transfers.
A. Credit for marital deduction. The marital deduction is not a credit

against the estate, but rather is a deduction from the gross estate in
determining the taxable estate.
G. Assessment period - Generally, no tax may be assessed later than 3 years after
the estate tax return is filed or is due, whichever is later. The period of
assessment is extended to 6 years where there is an understatement of the
value of the estate of 25% or more. The assessment period is 4 years for
recipients of property included in the gross estate.
H. Reasonable Cause For Extending the Due Date of the Form 706
1. Assets needed to pay the tax are located in several jurisdictions and are not
within the executor's immediate control, cannot be readily collected.
2. Most of the estate's assets consist of rights to receive payments in the future.
Cannot borrow against these assets without causing a loss.
3. An estate includes a claim to substantial assets that cannot be collected

without a lawsuit. Cannot determine total estate.
4. Made an effort to convert assets to cash, but would have to borrow at an

interest rate higher than generally available to have enough funds to:

a) Pay the estate tax when due;
b) Provide a reasonable allowance for spouse and dependents while the

estate is being administered; and
c) Satisfy claims against the estate that are due and payable.
VII. Generation-Skipping Transfer Tax
A. This tax applies to all transfers of property, whether or not the transfer is subject
to estate or gift tax, that skips a generation. This is a tax on the value of property
included in the estate that passes to the skip person. The skip person is an
individual who is in a generation two or more generations below the generation of
the decedent.
B. A generation skipping transfer can take place through:
1. A taxable distribution - distributions made from trust accounting income to a

skip person,
2. A taxable termination - the interest in property held in a trust coming to an

end, or
3. A direct skip - transfer of property subject to estate or gift tax.
C. A special $2 million per grandchild exclusion applied to transfers before January

1, 1990.
D. Each individual is entitled to a $1 million lifetime transfer exemption for

generation skipping.
E. The tax is the taxable amount multiplied by a determined rate based on a federal
excise tax rate of 55% and an inclusion ratio.
VIII. Gift Tax
A. The federal gift tax is imposed on the gratuitous transfer of property. The person
making the gift (Donor) must generally pay the tax. If the donor does not pay the
gift tax, the person receiving the gift (Donee) may have to pay the tax. Federal
gift tax applies to all transfers by gift of property, wherever situated, by U.S.
citizens or residents.

B. Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, is
used to report taxable gifts. The form is required for the transfer of all gifts other
than:
1. A transfer that is not more than the annual exclusion,
2. A qualified transfer for educational or medical expenses, or
3. A transfer to your spouse that qualifies for unlimited marital deduction.
C. Due Date - All gift and generation skipping taxes (GST) are computed and filed
on a calendar year basis regardless of the taxpayer's income tax accounting
period. An extension of time to file a gift tax return (up to 6 months) may be
requested from the District Director or Service Center. There is no form provided
for this purpose, but it can be completed with a letter which explains the reason
for the request. An extension to file an income tax return that is a calendar year
automatically extends the time for filing a gift tax return. An extension of time to
pay (up to 6 months) can be obtained from the Service Center where filed. With
no extension, the tax is due when the return is filed.
D. A penalty for failure to pay is one-half percent per month of the unpaid balance,
up to 25%.
E. Gifts in General - The gift tax applies to a transfer of real or personal property.
The property may be tangible or intangible. The gift may be direct, indirect, or
transferred in trust.
1. The tax may apply to transfers made for valuable consideration if the value of
the property transferred is more than the consideration received. (part
sale/part gift)
2. Below market loans may have as a gift the reasonable value of the use of the
money loaned. This provision does not apply to gift loans between individuals
for any day on which the total outstanding amount of the loan between such
individuals is not more than $10,000 unless the loan is directly attributable to
the purchase or carrying of income-producing assets.
3. A consideration that is not reducible to a value in money or money's worth

must be considered as totally gratuitous.
4. The gift tax is not imposed on the receipt of gift property but rather upon the
donor's act of making a completed gift. A gift is completed if the donor has
parted with dominion and control over the transferred property or property
interest, leaving the donor without the power to change its disposition,
whether for the benefit of the donor or for the benefit of others.

5. A promise to make a gift becomes taxable in the year the obligation becomes
binding and not when the discharging payments are made.
Exercise 42: A Form 709, United States Gift (and Generation-Skipping

Transfer) Tax
Return, is required to be filed for
A. A transfer of a present interest that is not more than the annual exclusion
($10,000).
B. A qualified transfer for educational or medical expenses.
C. A transfer of a future interest that is not more than the annual exclusion
($10,000).
D. A transfer to your spouse that qualifies for the unlimited marital deduction.
C. A transfer of a future interest that is not more than the annual

exclusion ($10,000). Since a gift of a future interest is not eligible for the
$10,000 annual exclusion, a gift tax return must be filed, irrespective of the
gift’s value.
F. Special Rules
1. A Power of Appointment is a power to determine who will own or enjoy the

property subject to that power. The exercise or complete release of a general
power of appointment is treated as a gift unless the exercise or release was
for adequate consideration. A power to manage, invest, or control assets or to
allocate receipts and disbursements, when exercised only in a fiduciary
capacity, would not be considered a power of appointment.
2. If a person makes a qualified disclaimer with respect to any interest in

property, the property will be treated as if it had never been transferred to that
person. Accordingly, the disclaimer is not regarded as making a gift to the
person who receives the property because of the qualified disclaimer.
3. Transfers of property or property interests made under the terms of a written

agreement between spouses in settlement of their marital or property rights
are considered to be for adequate consideration in money or money's worth
and therefore, are exempt from gift tax if the spouses get a final decree of
divorce within 2 years after entering into the agreement. A release of support
rights constitutes a consideration in money or money's worth. However, a
transfer in settlement of dower or curtsey inheritance rights is not reducible to
money and results in a gift.

4. A gift generally results when an employee who has an unqualified right to an

annuity elects to receive a lesser amount so that at the employee's death a
survivor annuity will be paid to the employee's designated beneficiary. The gift
is made in the calendar year in which the employee gives up the power to
deprive the beneficiary of the survivor annuity by making the election
irrevocable.
5. The disposition of all or part of a qualifying income interest in any qualified

terminable interest property (QTIP), for which a spouse or spouse's estate
has been allowed a marital deduction, results in a transfer of all interest in the
property and is subject to gift tax.
G. Valuation - The value of a gift is the fair market value of the property on the date
the gift is made. There is no alternative valuation date for federal gift tax. If the
donee pays the gift tax, the value is reduced by the amount the donee pays,
which is viewed as partial consideration paid for the gift. The donor's available
unified credit must also be used to reduce the tax liability of the donee. The fair
market value of annuities, life estates, terms for years, remainders, and
reversions is their present value derived through the use of present value tables.
H. Gift Splitting - A gift made by a person to someone other than a spouse may be
considered as made one-half by each spouse. A lower gift tax rate bracket may
apply and the annual exclusion and unified credit of each spouse would apply.
The requirements follow:
1. Both spouses must consent to gift-splitting.
2. Spouses must be legally married at the time of the gift. If divorced during the
year and neither remarries, may still split gifts.
3. Both spouses must be citizens or residents of the U.S. on the date of the gift.
4. If both consent to gift-splitting, all gifts made during the year that qualify must
be split.
5. If a gift is to be split, both spouses must indicate their consent on the gift tax
return. If only one spouse made the gift and they both consent to split, the
other spouse is not required to file a return if:
a) The total value to any one donee is not more than $20,000, and
b) The property is not a gift of future interest.
6. If the consent is to split gifts of a future interest, both spouses must file gift tax
returns regardless of the value of the gift.

7. The consent to split gifts cannot be made after a gift tax return has been filed
and the due date for filing the return has passed. The consent can be
revoked, but not after April 15 of the year following the year of the gift.
Exercise 43: Which of the following statements regarding gift splitting by

married couples is CORRECT?
A. If only one spouse has made gifts during the year and the spouses
consent to split the gift the other spouse is always required to file a
gift tax return.
B. If both spouses consent to split a gift of future interest, both
spouses must file gift tax returns only if the value of the gift is
greater than $20,000.
C. A consent to split gifts may be made on an amended gift tax return
after the due date of the original return.
D If the spouses are divorced during the year, they still may split a gift
made before the divorce so long as neither marries anyone else
during that year.
D. If the spouses are divorced during the year, they still may split a
gift made before the divorce so long as neither marries anyone else during
that year. Gift-splitting does not apply if a spouse remarries during the tax
year in which the gift is made.
I. Taxable Gifts - Total gifts made during the year, minus the annual exclusion,
minus the charitable deduction, and minus the marital deduction will equal the
taxable gifts. Total gifts do not include a qualified transfer.
J. Annual Exclusion - The first $10,000 of gifts made to any one person during
any calendar year is excluded in determining the total amount of gifts for the
calendar year. This applies to all gifts of a present interest made during the year.
It does not apply to gifts of future interest.
K. Future interests is a legal term that includes reversions, remainders, and other
interests or estates that are to commence in use, possession, or enjoyment at
some future date.
L. Marital Deduction - A taxpayer may deduct from the total amount of gifts made
during the year, the value of gifts made to one's spouse. This amount is
unlimited. To qualify:
1. The spouses must be married at the time of the gift, and
2. The donee spouse must be U.S. citizen. Gifts to noncitizen spouses do not
qualify for the unlimited marital deduction. However, there is a $100,000

(rather than the $10,000) annual exemption. The $100,000 exclusion only
applies to gifts that would qualify for the marital deduction if the donee were a
U.S. citizen. This applies to gifts made after June 29, 1989.
3. The $100,000 annual exclusion for gifts made to a noncitizen spouse applies
regardless of the citizenship of the donor spouse. Gifts to a citizen spouse will
qualify for the marital deduction regardless of the citizenship of the donor
spouse.
M. Gift Tax Computation - The Unified Rate Schedule is used to determine the
amount of tax on taxable gifts. The gift tax on all gifts is then offset by a Unified
Credit. The amount of unified credit a taxpayer may claim for the year may not
exceed the amount of the tax for the calendar year.
Exercise 44: All of the following are deductions allowed in determining the
gift tax except:
A. A gift to the state of Pennsylvania for exclusively public purposes.

B. The value of a gift made to one's spouse who is NOT a United
States citizen.
C. A gift made to one's spouse, a United States citizen, in excess of
$100,000.
D. A gift of a copyrightable work of art to a qualified organization if you
do not transfer the copyright to the charity.
B. The value of a gift made to one’s spouse who is NOT a United

States citizen. Although a marital deduction is available for a gift to a
spouse who is a U.S. citizen, regardless of the spouse who is a U.S.
citizen, regardless of the citizenship or residence of the donor, the marital
deduction is not available for a gift made to a spouse who is not a U.S.
citizen.

PART 4 - ETHICS, RECORDKEEPING, APPEAL PROCEDURES, ETC.
4. PART IV - - ETHICS, RECORDKEEPING, APPEAL PROCEDURES, ETC.

TABLE OF CONTENTS
INTRODUCTION.......................................................................................................... 4-1
SECTION A - RULES FOR PRACTICES, ETHICS, PREPARER RULES, POWER OF

ATTORNEY.................................................................................................................. 4-2
I. Circular 230 ......................................................................................................... 4-2
II. Income Tax Return Preparer Rules................................................................... 4-12
III. Power of Attorney (POA) Rules......................................................................... 4-20
IV. Centralized Authorization File (CAF) System .................................................... 4-25
V. Research Materials ........................................................................................... 4-26
SECTION B - EXAMINATIONS, APPEALS AND COLLECTIONS............................. 4-31

I. Examinations..................................................................................................... 4-31
II. Appeals Conference.......................................................................................... 4-34
III. Appeals to the Court.......................................................................................... 4-36
IV. Claim For Refund .............................................................................................. 4-38
V. The Examination of a Partnership or S Corporation .......................................... 4-39
VI. Enforced Collection ........................................................................................... 4-40
VII. Taxpayer Rights ................................................................................................ 4-47
SECTION C - RECORDS, RETIREMENT PLANS, EXEMPT ORGANIZATIONS,

ELECTRONIC FILING................................................................................................ 4-50
I. Recordkeeping .................................................................................................. 4-50
II. Exempt Organizations ....................................................................................... 4-51
III. Electronic Filing ................................................................................................. 4-54
Dynasty School (www.dynastySchool.com 4-1

INTRODUCTION
Part IV of the exam covers ethics, record keeping procedures, appeal procedures,
practitioner penalty provisions, research materials, examination and collection
procedures, retirement plans and exempt organizations. This part of the exam is divided
into two sections. Section A consists of true and false questions, and Section B consists
of multiple choice questions. Some multiple choice questions require computation, but
the majority are consistent with the format of the first three parts.
STUDY MATERIALS
MAIN TOPICS
Circular 230 Regulations Governing the Practice of Attorneys, Certified Public

Accountants, Enrolled Agents, Enrolled Actuaries, and Appraisers before the Internal
Revenue Service
Publication 216 Conference and Practice Requirements

Publication 552 Recordkeeping for Individuals
Publication 556 Examination of Returns, Appeal Rights, and Claims for Refunds
Publication 557 Tax-Exempt Status for Your Organization
Publication 560 Retirement Plans for the Self-Employed
Publication 575 Pension and Annuity Income (Including Simplified General Rule;)
Publication 586A The Collection Process (Income Tax Accounts)
Publication 590 Individual Retirement Accounts
Publication 594 The Collection Process Employment Accounts)
Publication 908 Tax Information on Bankruptcy
Publication 947 Practice Before the IRS and Power of Attorney
Publication 1345 Handbook for Electronic Filers of Individual Income Tax Returns
Section A Rules for Practice, Ethics, Preparer Rules, Power of Attorney, Courts and
the Legal System, Research Materials
Section B Examinations, Appeals, Collections
Section C Records, Retirement Plans, Exempt Organizations, Electronic Filing

SECTION A - RULES FOR PRACTICES, ETHICS, PREPARER RULES, POWER OF

ATTORNEY
I. Circular 230
A. Rules of Practice
1. A person is practicing before the Internal Revenue Service if he or she:
a) Communicates with the IRS for a taxpayer regarding the taxpayer's rights,
privileges, or liabilities under laws and regulations administered by the
IRS,
b) Represents a taxpayer at conferences, hearings, or meetings with the

IRS, or
c) Prepares and files necessary documents with the IRS for a taxpayer.
2. Who may practice? - Attorneys, certified public accountants, enrolled

agents, or enrolled actuaries. These people may practice as long as they are
not under suspension or disbarment.
a) The Director of Practice may grant enrollment to an applicant who

demonstrates competence in tax matters by written examination.
(1) Attorneys and CPAs are not required to take the examination. If
such individuals want to use the EA designation, prior enrollment or
an examination is required.
(2) Enrollment can be granted to IRS employees or former employees

who have completed 5 years of continuing employment with the
Service. The examination is not required.
b) Temporary recognition may be granted but this does not constitute

enrollment to practice. Temporary enrollment may be withdrawn at any
time by the Director of Practice.
c) Appeal Process if Application Denied - The Director of Practice shall

inform the applicant of the reason. The applicant has 30 days after the
receipt of the notice of denial to file a written appeal.
Exercise 1: The term "Practice Before the Internal Revenue Service"

includes the representation of clients in the United States Tar Court
for cases being handled under the "small tax case procedure".
(True or False)
www.dynastyschool.com 4-2
False. Only communication with the IRS concerning a taxpayer’s

rights, privileges or liabilities are included. “Practice Before the Internal
Revenue Service” doe not include representation before the United
States Tax Court.
3. Enrollment Cycle and Renewal
a) An enrollment cycle is a three year period. Applications for renewal are

required between November 1, (current year), and January 31, (next year),
and every third year thereafter. Those who receive initial enrollment during
the renewal application period shall apply for renewal of enrollment by March
1 of the renewal year.
c) The effective date of renewed enrollment is April 1. The current period of

enrollment is April 1, (current year), through March 31, (current year+3).
NOTE: The current enrollment cycle ends January 31, 2003.

Applications for renewal are required between November 1, 2002,
and January 31, 2003.
Exercise 2: If an enrolled agent has an enrollment date of May 10,

2001, on what date would his/her enrollment card terminate?
A. May 11, 2002

B. February 1, 2004
C. April 1, 2004
D. May 11, 2004
C. April 1, 2004. Renewal dates are April 1, 2004, and every three years
thereafter. Therefore, the enrollment card of an enrolled agent who
was initially enrolled on May 10, 2001, would terminate on April 1,
2004.
(1) Minimum of 72 hours of continuing education must be completed in an

enrollment cycle (three years). This is an average of 24 credits per year.
(2) A minimum of 16 credits must be completed in each year.
(3) An individual who receives initial enrollment during an enrollment cycle

must complete a minimum of 2 credits for each month enrolled. Enrollment
for any part of the month is considered enrollment for the full month.

(4) Qualifying programs may include formal programs (required attendance),

correspondence or individual study programs, serving as an instructor
(including subject preparation time up to 50% of the required credits), or
credit for published articles, books, etc. (not to exceed 25% of the required
credits).
NOTE: You may also complete the requirement by taking (and

passing) all four parts of the EA exam during the three year period
prior to renewal and by completing at least 16 credits of continuing
education during the last year of an enrollment cycle. As you might
expect, few enrolled agents choose this form of meeting the
educational requirements to maintain enrollment.
(5) Waivers can be granted by the Director of Practice for various reasons
including: health, extended active military duty, absence from the U.S., or
other compelling reasons.
(6) Each individual applying for renewal of enrollment shall retain CPE
information for three years. The records shall include the following
information:
(a) The name of the sponsoring organization.
(b) The location of the program.
(c) The title of the program and description of its contents.
(d) The dates attended.
(e) The credit hours claimed.
(f) The name(s) of the instructor(s).
(g) The certificate of completion or a signed statement of the hours of

attendance obtained from the sponsor.
(7) An individual who is ineligible to practice by virtue of disciplinary action is

required to meet the requirements for renewal during the period of
ineligibility (if they want to resume enrollment after the suspension).
4. Limited Practice
a) Individuals may appear on their own behalf, or represent a member of his

or her immediate family.
b) An individual may represent his or her regular full-time individual

employer.
c) A general partner or regular full-time employee may represent the

partnership.
d) Corporations may be represented by bona fide officers or regular full-time

employees.
e) Trusts, receiverships, guardianships, or estates may be represented by

their trustees, receivers, guardians, administrators, executors, or their
regular full time employees.
f) An individual (not under disbarment) who signs a return as having

prepared it for the taxpayer, or prepares the return but is not required to
sign it, may appear without enrollment as the taxpayer's representative
before revenue agents and examining officers of the Examination Division
with proper authorization from the taxpayer.
Exercise 3:
With regard to the categories of individuals who may practice before
the Internal Revenue Service, which of the following statements is
CORRECT?
A. Only enrolled agents, attorneys, or CPAs may represent trusts and

estates before any officer or employee of the IRS.
B. An individual who is NOT an enrolled agent, attorney or CPA, who
signs a return as having prepared it for the taxpayer may, with
proper authorization from the taxpayer, appear as the taxpayer’s
representative, with or without the taxpayer, at an IRS regional
Appeals Office conference with respect to the tax liability of the
taxpayer for the taxable year or period covered by that return.
C Under the limited practice provisions in Treasury Department
Circular No. 230, ONLY general partners may represent a
partnership.
D Under the limited practice provisions in Circular No. 230, an
individual who is under suspension or disbarment from practice
before the IRS may NOT engage in limited practice before the IRS
D. Under the limited practice provisions in Circular 230, an individual

who is under suspension or disbarment from practice before the IRS
may NOT engage in limited practice before the IRS. If an individual is
suspended or disbarred from practice before the IRS, he may not
engage in practice before the IRS on behalf of a client under any

circumstances. In addition, an individual may not knowingly aid another

person to practice before the IRS when that person is suspended or
disbarred from practice before the IRS.
.
NOTE: The prepare who is not enrolled may NOT represent taxpayers
before the Collections Division even if they prepared the tax return
in question.
B. Duties and Restrictions Relating to Practice

1. No enrolled individual shall neglect or refuse promptly to submit records or
information in any matter before the IRS, upon proper and lawful request by a
duly authorized officer or employee of the IRS, unless he believes in good
faith and on reasonable grounds that such record or information is privileged
or the request is of doubtful legality.
2. When the Director of Practice requests information concerning possible

violations of the regulations by other parties, the practitioner must provide it,
and be prepared to testify in disbarment or suspension proceedings.
3. A enrolled practitioner who knows that his or her client has not complied with
the revenue laws, or has made an error in or omission from any return,
document, affidavit, or other required paper, has the responsibility to advise
the client promptly of the noncompliance, error, or omission.
Exercise 4: If an enrolled agent, attorney, or CPA knows that a client

has NOT complied with the revenue laws of the United States with
respect to a matter administered by the IRS, the enrolled agent,
attorney, or CPA is required to:
A. Do nothing until advised by the client to take corrective action.

B. Advise the client of the noncompliance.
C. Immediately notify' the IRS.
D. Advise the client AND notify the IRS
B. Advise the client of the noncompliance. The enrolled agent, CPA or

attorney has the duty to advise the client of the noncompliance.
However, he is not required to notify the IRS.
4. An enrolled practitioner shall exercise due diligence in preparing or filing

returns or documents; in determining the correctness of oral and written
representations made to the IRS; and in determining the correctness of oral
and written representations made to clients with reference to any matter
administered by the IRS.
5. An enrolled practitioner must not unreasonably delay the prompt disposition

of any matter before the IRS.
6. An enrolled practitioner must not knowingly and directly or indirectly do the

following:
a) Employ or accept assistance from any person who is under disbarment or

suspension from practice before the IRS.
b) Accept employment as an associate, correspondent, or subagent, or

share fees with any such person.
c) Accept assistance from any former government employee where

provisions of the regulations would be violated.
Exercise 5:
A practitioner could be suspended from practice before the IRS if the
practitioner employs, accepts assistance from, or shares fees with any
person who is under disbarment or suspension from practice before the
IRS. (True or False)
True. A practitioner may be suspended or disbarred from practicing

before the IRS if he knowingly aids another person to practice before
the IRS when that person is suspended, disbarred or otherwise
ineligible to do so.
7 If the enrolled practitioner, who is a notary public, is employed as counsel,

attorney, or agent in a matter before the IRS, or has material interest in the
matter, he or she must not engage in any notary activities relative to the
matter.
Exercise 6:
Allen is an enrolled agent and a notary public. He is representing Ms.
Scott before the IRS. The revenue agent involved in the case
requests certified copies of the contracts relating to the sale of a
building. Allen can secure copies of the contracts and then certify
them using his notary public stamp. (True or False)
False. An attorney, certified public accountant, or enrolled agent as

well as a notary public is not permitted to certify papers, administer
oaths, or perform any official act with respect to any matter before the
IRS in which he is employed as counsel, attorney or agent.
8. A practitioner may not charge an unconscionable fee for representing a client

in a matter before the IRS. Nor can a practitioner charge a contingent fee for

preparing the original return. A contingent fee includes a fee that is based on
the refund or percentage of taxes saved.
a) Fee Information - M individual eligible to practice before the IRS may

disseminate the following fee information.
(1) Fixed fees for specific routine services.
(2) Hourly rates.
(3) Range of fees for particular services.
(4) Fee charged for an initial consultation.
(5) Availability of written schedule of fees.
b) Those individuals that disseminate fee information shall be bound to

charge the hourly rate, the fixed fee for specific routine services, the range
of fees for particular services, or the fee for an initial consultation
published for a reasonable period of time, but no less than thirty days from
the last publication of such hourly rate or fees.
9. Solicitation
a) No individual eligible to practice before the IRS shall in any way use or
participate in the use of any form of public communication containing a
false, fraudulent, misleading, deceptive, unduly influencing, coercive, or
unfair statement or claim.
b) Enrolled agents may not use the term "certified" or indicate any
employer/employee relationship with the IRS.
c) No enrolled agent shall make, directly or indirectly, an uninvited solicitation

of employment, in matters related to the IRS. This includes in-person
contacts and telephone communications. The restriction does not apply to:
(1) Seeking new business from an existing or former client in a related

matter,
(2) Communications with family members,
(3) Making the availability of professional services known to other

practitioners, so long as the person contacted is not a potential client,
(4) Solicitations by mailing, or
(5) Non-coercive in-person solicitation while acting as an employee,

member, or officer of an exempt organization.
Exercise 7:
Norm, an enrolled agent, wanted to have Malt as a new client. Without
invitation, Norm approached Malt at a local club and explained how
he could assist him with his federal tax matters and would like to
have him as a client. Norm is NOT in violation of the solicitation
regulations set forth in Treasury Department Circular No. 230.
(True or False)
False. An enrolled agent is prohibited from making an uninvited

solicitation of employment to a potential new client in a matter related
to the IRS. However, this restriction does not apply to seeking new
business from an existing or former client in a related matter.
10. Permissible Advertising
a) An individual eligible to practice before the IRS may publish, broadcast, or

use in a dignified manner, the following:
(1) The name, address, telephone number, and office hours of the
practitioner or firm.
(2) The names of individuals associated with the firm.
(3) A factual description of the services offered.
(4) Acceptable credit cards and other credit arrangements.
(5) Foreign language ability.
(6) Membership in pertinent, professional organizations.
(7) Pertinent professional licenses.
(8) A statement that an individual's or firm's practice is limited to certain

areas.
b) Communications may include professional lists, telephone directories,

print media, permissible mailings, radio and television, and any other
method as long as the method chosen does not become untruthful or
misleading. In the case of radio and television, the broadcast shall be pre-
recorded and the practitioner shall retain a recording of the actual audio

transmission. In the case of direct mailing, the practitioner shall retain a

copy of the mailer and a list of all persons to whom the communication
was mailed. Such copies are required to be kept for at least 36 months.
Exercise 8:
An enrolled agent may make the availability of his/her professional
services known to other practitioners, provided the person or firm
contacted is NOT a potential client. (True or False)
True. Although an enrolled agent generally cannot make, either directly

or indirectly, uninvited solicitations of employment in matters related to
the IRS, according to IRS Circular 230, Practice Before the IRS, the
restriction does not apply to making the availability of professional
services known to others practitioners, as long as the person or firm
contacted is not a potential client.
11. An enrolled agent may use the phrase, "enrolled to represent taxpayers
before the IRS" or "enrolled to practice before the IRS”.
12. Enrolled practitioners, who are income tax return preparers, must not endorse
or otherwise negotiate any refund check issued to the taxpayer.
13. A practitioner who provides a tax-shelter opinion analyzing the federal tax
effects of a tax-shelter investment:
a) Must make inquiry as to all relevant facts;
b) Must relate the law to the actual facts;
c) Must ascertain that all material federal tax issues have been considered;
and
d) Provide an opinion whether it is more likely than not that an investor will
prevail on the merits of each material tax issue.
C. Standards for Position Taken, Preparing, and Signing Returns.
1. A practitioner may not sign a return as a preparer if the practitioner

determines that the return contains a position that does not have a realistic
possibility of being sustained on its merits unless the position is not frivolous
and is adequately disclosed to the Service.
2. A practitioner advising a client to take a position on a return, or preparing or

signing a return, must inform the client of the penalties reasonably likely to
apply to the client with respect to the position.
3. A practitioner may rely in good faith without verification upon information

furnished by the client. The practitioner must make reasonable inquiries if the
information appears incorrect.
4. A position is considered to have a realistic possibility of being sustained on its

own merits if a reasonable and well-informed analysis by a person
knowledgeable in the tax law would lead such a person to conclude that the
position has approximately a one-in-three, or greater, likelihood of being
sustained on its merits.
D. An enrolled preparer can be disbarred or suspended for disreputable conduct.

Disreputable conduct includes, but is not limited to the following:
1. Conviction of any criminal offense under the revenue laws of the U.S. or of
any offense involving dishonesty or breach of trust.
2. Participating in or giving false or misleading information to the Department of

Treasury.
3. Prohibited solicitation of employment, as previously covered.
4. Willfully failing to make a federal tax return in violation of revenue laws. This
includes knowingly counseling or suggesting to a client an illegal plan to
evade taxes.
5. Misappropriation of client funds.
6. Directly or indirectly influencing or attempting to influence an action of an IRS

employee through threats, false accusations, offer of special inducement,
gifts, etc.
7. Disbarment or suspension by the State, etc.
8. Knowingly aiding or abetting a suspended, disbarred, or ineligible person to

practice before the IRS.
9. Contemptuous conduct in connection with practice before the IRS.
10. Giving a false opinion knowingly, recklessly, or through gross incompetence.
E. Disciplinary Proceedings
1. Whenever the Director of Practice has reason to believe that an attorney,

certified public accountant, enrolled agent, or enrolled actuary has violated

any provision of the laws or regulations governing practice before the Internal
Revenue Service, the Director of Practice may reprimand such person or
institute a proceeding for disbarment or suspension for such person. The
proceeding begins with a complaint which names the respondent and is filed
with the office of Director of Practice.
2. Failure to answer the allegations within the time prescribed in the complaint
shall constitute an admission of the allegations of the complaint and a waiver
of hearing, and the Administrative Law Judge may make a decision by default
without a hearing or further procedure.
3. The respondent may appear in person or he/she may be represented by

counsel or another representative who need not be enrolled to practice before
the Internal Revenue Service. If either party fails to appear at the hearing, the
Administrative Law Judge may make a decision against the party by default.
Exercise 9:
Marty, an enrolled agent, had been properly notified to appear at a
hearing in regards to a complaint which could result in his
suspension from practice before the Internal Revenue Service. If
Marty fails to appear for the hearing, he shall be deemed to have
waived the right to a hearing and the Administrative Law Judge may
make his decision against Marty by default.(True or False)
True. If the enrolled agent fails to appear at a hearing after receiving

notice, he shall be deemed to have waived his right to a hearing and
the administrative law judge may make his decision against him by
default.
II. Income Tax Return Preparer Rules
A. Reg. §301.7701-15 defines an income tax return preparer as any person who
prepares for compensation, or employs one or more persons to prepare for
compensation, all or a substantial portion of any return or claim for refund.
B. A person shall not be considered an "income tax return preparer" merely

because such person:
1. Furnishes typing, reproducing, or other mechanical assistance,
2. Prepares a return or claim for refund of an employer by whom he is regularly

and continuously employed,
3. Prepares, as a fiduciary, a return or claim for refund for any person, or
4. Preparers a claim for refund for a taxpayer in response to any notice of

deficiency issued to the taxpayer or in response to any waiver of restriction
after an audit of such taxpayer.
Exercise 10:
Which of the following would NOT be an income tax return preparer?
A. Someone who employs one or more persons to prepare for

compensation, other than for the person, all or a substantial portion
of any tax return under subtitle A of the Code.
B. Someone who prepares a substantial portion of a return or claim for
refund under subtitle A of the Code.
C. Someone who prepares an information return for a person or entity
under subtitle A of the Code.
D. Someone who prepares, as a fiduciary, a return or claim for refund
for any person.
D. Someone who prepares, as a fiduciary, a return or claim for refund

for any person. Someone that prepares a return solely in a fiduciary
capacity is not deemed to be an income tax return preparer.
C. In accordance with Reg. §1.6060-1, each person who employs (or engages) one
or more income tax return preparers to prepare any return of tax or claim for
refund, other than for that person, at any time during a return period shall satisfy
the following requirements:
1. Retain a record of the name, taxpayer identification number, and principal

place of work during the return period of each income tax return preparer
employed (or engaged) by the person at any time during the period.
2. Make that record available for inspection upon request by the district director.
3. This record must be retained and kept available for inspection for the 3-year
period following the close of the return period to which that record relates.
4. The person may choose any form of documentation to be used as a record of

the preparers employed during the return period. However, the record must
disclose on its face which individuals were employed (or engaged) as income
tax return preparers during that period.

5. Any individual who, acting as an income tax return preparer, is not employed
by another shall be treated as his or her own employer and shall retain and
make available such records in respect to himself or herself.
6. A partnership shall be treated as the employer of the partners of the

partnership and shall retain and make available a record with respect to the
partners and others employed (or engaged) by the partnership.
D. Reg. §1.6107-1 requires the person who is the income tax return preparer of any
income tax or claim for refund shall furnish a completed copy of the original
return or claim for refund to the taxpayer (or nontaxable entity) not later than the
time the original return or claim for refund is presented for the signature of the
taxpayer (or nontaxable entity).
E. The person who is the income tax return preparer shall:
1. Retain a completed copy of the return or claim for refund, or retain a record,
by list, card file, or otherwise of the name, taxpayer identification number, and
taxable year of the taxpayer (or nontaxable entity) for whom the return or
claim for refund was prepared and the type of return or claim for refund
prepared.
2. Retain a record, by retention of a copy of the return, maintenance of a list or

card file or otherwise, for each return or claim for refund presented to the
taxpayer (or nontaxable entity) of the name of the individual preparer required
to sign the return.
3. Make a copy or record of returns and claims for refund, and a record of the
individuals required to sign, available for inspection upon request by the
district director.
4. The records described here shall be retained and kept available for inspection
for the 3-year period following the close of the return period during which the
return or claim for refund was presented for signature.
F. Internal Revenue Code §6694 provides for tax return preparer penalties for the
understatement of a taxpayer's liability.
1. §6694(a) penalty is imposed for an understatement of liability due to a

position for which there was not a realistic possibility of being sustained on its
own merits.
a) Only one individual associated with a firm is considered the income tax
return preparer. If two or more individuals are associated with a return and
one is the signing preparer, only one of the individuals will be considered
the preparer. This will generally be the individual with the overall
supervisory responsibility. The firm may also be subject to the penalty, as
well as the individual within the firm.
b) A person who is the preparer and knew, or should have known of such a
position, is subject to a penalty of $250 with respect to that return.
c) Exceptions to the penalty can be granted for adequately disclosing a

nonfrivolous position on the return, or if the understatement was due to
reasonable cause and the preparer acted in good faith.
2. §6694(b) penalty is imposed for an understatement of liability that is due to a

willful attempt to understate tax liability, or that is due to reckless or intentional
disregard of rules or regulations.
a) The preparer is subject to a penalty of $1,000 with respect to such a

return.
b) The preparer will have the burden of proof on whether he/she has
negligently or intentionally disregarded a rule or regulation.
c) With respect to non-frivolous positions, the penalties provided under

§6694 (a) and (b) will not be imposed if such position is sufficiently
disclosed on the return or claim for refund.
d) If the imposition of both the unrealistic position penalty, (§6694(a)) and the
willful or reckless conduct penalty (§6694(b)) apply to the same return, the
penalty for willful or reckless conduct is reduced by any amount assessed
and collected against the preparer under §6694(a).
Exercise 11:
Internal Revenue Code §6694(a) provides for a penalty against a
return preparer for understatement of tax liability due to an
unrealistic position. IRC section 6694(b) provides for a penalty if
any part of the understatement is due to willful or reckless conduct.
Both of these penalties may be assessed simultaneously on a given
return but the total amount of the penalties CANNOT exceed the
IRC §6694(b) penalty. (True or False)
True. Although the penalty for willful or reckless conduct is $1,000, that
amount is reduced by any preparer penalty paid under the $250
understatement penalty for unrealistic positions. As a result, the total of
the two penalties cannot exceed $1,000.

Exercise 12:
Bernard is an income tax return preparer. While preparing a 2001
tax return for a client, Bernard determines the client owes a
substantial amount of tax. In order to generate a refund for the
client, Bernard substantially overstates itemized deductions and
expenses claimed on the Schedule C. Bernard is subject to a
penalty of:
A. $1,000
B. $500
C. $250
D. $100
A. $1,000. A $1,000 penalty may be imposed on an income tax

return preparer if any part of an understatement of tax on an income
tax return or refund claim is attributable to a willful attempt by the
preparer in any manner to understate tax liability of another person.
3. Within 30 days after the day on which a notice and demand of either of these
penalties is made, the preparer may:
a) Pay the entire amount assessed and may file a claim for refund of the
amount paid at any time not later than 3 years after the date of payment,
or
b) Pay an amount which is not less than 15% of the entire amount assessed
and immediately file a claim for refund of the entire amount.
G. Other Penalties §1.6695-1:
1. $50 Penalties (per failure)
a) Failure to furnish the taxpayer (including a nontaxable entity such as a

partnership or an S Corporation) with a copy of the return no later than
when the return is presented for signature.
Exercise 13:
Cameron, an income tax return preparer, prepared at different
times during the tax season both Mr. Murphy 's individual income
tax return and his S Corporation's income tax return. Cameron was'
compensated for the preparation of both returns. Cameron is ONLY
required to furnish a copy of his client's original income tax return at
the time the second return is presented for signature. (True or
False)
False. An income tax return preparer must furnish a completed copy of

the original income tax return to the taxpayer no later than when the
original return (the individual return) is presented for the taxpayer’s
signature. It cannot be furnished when the second return (the S
corporation return) is presented for signature.
b) Failure to sign a return. The return must be signed manually (facsimile

stamp is not acceptable) prior to presenting it to the taxpayer for signature.
If more than one preparer is involved in the preparation of a tax return, or
claim for refund , the preparer with primary responsibility for the overall
accuracy of the return is required to sign.
Exercise 14:
Anthony is a partner in AC Partnership. He is responsible for the
overall substantive accuracy of all income tax returns prepared by
the employees. Anthony does NOT collect the necessary
information NOR does he preparer tax returns. Anthony should
NOT sign the returns as a preparer. (True or False)
False. If more than one return preparer is involved in the preparation of

an income tax return, the individual who has the primary responsibility
for the overall substantive accuracy of the return is considered to be
the return preparer who is required to sign the return.
c) Failure to furnish a preparer identification number.
d) Failure to retain a copy or record. The preparer of an income tax return or

claim for refund must either retain a copy of the return or retain a record,
by list, of the taxpayer 1.D. number, the taxable year for the taxpayer (or
nontaxable entity), and the type of return or claim for refund prepared. The
information described should be kept available for a 3-year period
following the close of the return period during which the return or claim for
refund was presented for signature to the taxpayer.
Exercise 15:
Each person who employs (or engages) one or more income tax
return preparers to prepare returns other than for that person must
retain a record, to be kept available for inspection for the 3-year
period folio wing the close of the return period to which the record
relates, of the name, taxpayer identification number, and principal
place of work during the return period (the 12-month period
beginning July 1 of each year) of each income tax return preparer
employed at any time during that period. (True or False)

True. The IRS requires each person who employs a return preparer to
retain for three years a record of the name, taxpayer identification
number, and principal place of work of each employee employed
during any return period.
e) Failure to retain and make available a record of the preparers employed

during the return period, plus $50 for failure to include a required item in
such record, up to a maximum of $25,000.
Exercise 16:
Which one of the following would result in a penalty on the preparer
for failure to sign a tax return?
A. L, a law firm, employs A, an attorney, to prepare tax returns. A

obtains the information from X L's client, and determines X's tax
liability. A signed the tax return instead of his employer.
B. N, an individual, has an arrangement with C, a corporation, to
preparer tax returns for compensation. C does not provide office
space, supplies, etc., N uses forms provided by C which N sends
back to C to be reviewed by E, C's employee, for math and proper
application of tax law. N signed the return instead of C or E.
C. D, who is NOT an enrolled agent, attorney or CPA prepares and
signs income tax returns for compensation.
D. P, prepared income tax re turns for compensation, and signed the
income tax returns with a facsimile signature stamp.
D. P, prepared income tax returns for compensation, and signed

the income tax returns with a facsimile signature stamp. One qualifying
as an income tax return preparer must put his original signature on the
tax return. The signature must be manually applied; a facsimile
signature does not satisfy this requirement. A paid preparer subject to
the signature requirement need not be an enrolled agent attorney or
CPA.
2. A $500 penalty will apply for negotiating or endorsing a check for a taxpayer.
(Exception and special rules apply to preparer-banks.)
Exercise 17:
Which of the following persons would be subject to the penalty for
improperly negotiating a taxpayer's refund check?
A. An income tax return preparer who operates a check cashing

agency that cashes, endorses, or negotiates income tax refund
checks for returns he prepared.
R An income tax return preparer who operates a check cashing

business may cash checks for his clients as part of a second
business.
C. The firm which prepared the tax return is authorized by the
taxpayer to receive an income tax refund, but NOT to endorse or
negotiate the check
D. A business manager prepares income tax returns for clients who
maintain special checking accounts against which the business
manager is authorized to sign certain checks on their behalf The
clients 'federal income tax refunds are mailed to the business
manager, who has the clients endorse the checks and deposits
them in the special accounts.
A. An income tax return preparer who operates a check chasing

agency that cashes, endorses, or negotiates income tax refund checks
for returns he prepared. A return preparer operating a check chasing
agency that cashes the refund check of a taxpayer whose return the
preparer prepared is subject to the penalty for negotiating a taxpayer’s
refund check.
3. Disclosure or use of tax information without formal consent of the taxpayer is

a misdemeanor, and upon conviction thereof, the preparer shall be fined not
more than $1,000 or imprisoned not more than one year or both. Disclosure
of tax information can be made under the following conditions:
a) Quality or peer review,
b) Under the order of any court of record,
c) Disclosure to a duly appointed fiduciary of the taxpayer or his estate, or

the fiduciary's authorized agent, or
d) Disclosures in connection with rendering professional services.
Exercise 18:
Which of the following situations describes a disclosure of tax
information by an income tax preparer which would subject the
preparer to a penalty?
A. Ron dies after furnishing tax return information to his tax return
preparer. Ron's tax return preparer discloses the information to
Jerry, Ron's nephew, who is NOT the fiduciary of Ron's estate.
B. In the course of preparing a return for Duck Company Jan obtained
information indicating the existence of illegal kickbacks. Jan gave
the information to Bill, an auditor in her firm, who was performing a

financial audit of the company Bill confirmed illegal kickbacks were

occurring and brought the information to the attention of Duck
Company officers.
C. Glade informed the proper Federal officials of actions he mistakenly
believed to be illegal.
D. Les, a return preparer, obtained information from Tom while selling
Tom life insurance. The information was identical to tax return
information that had been furnished to him previously Les
discussed this information with Mary, his wife, who was NOT an
employee of any of his businesses.
A. Ron dies after furnishing tax return information to his tax return
preparer. Ron’s tax return preparer discloses the information to Jerry,
Ron’s nephew, who is NOT the fiduciary of Ron’s estate. A return
preparer may not disclose tax return information of a decedent to an
individual that is not a fiduciary of the decedent’s estate.
III. Power of Attorney (POA) Rules
A. A power of attorney (for IRS purposes) is a written authorization which allows

one person to act for another in tax matters. A POA allows one to:
1. Represent a taxpayer before any office of the IRS.
2. Sign a waiver agreeing to a tax adjustment or an offer of waiver of restriction

on assessment or collection of a tax deficiency, or a waiver of notice of
disallowance of claim for credit or refund.
3. Sign a consent to extend the statutory time period for assessment or

collection of a tax.
4. Sign a closing agreement under §7121 of the Internal Revenue Code.
5. Receive, but not endorse or negotiate, a check drawn on the U.S. Treasury.
6. Sign employment tax returns.
B. The representative named under a POA is not permitted to sign a person's

individual income tax return, unless:
1. The signature is permitted under the Code and regulations, and
2. The taxpayer authorizes this in his/her power of attorney.
C. In the case of incapacity or incompetence, the POA can continue if specifically

authorized.
D. A POA is most often required when a taxpayer wants to authorize another

individual to perform at least one of the following actions on his or her behalf:
1. Represent a taxpayer at a conference with the IRS.
2. File a written response to the IRS.
3. Sign a consent or extension.
Exercise 19:
A properly executed Form 2848, Power of Attorney and Declaration
of Representative, is required to allow a representative to perform
all of the following except:
A. Sign a waiver agreeing to an income tax adjustment.

B. Sign a consent to extend the statutory time period for assessment
of tax.
C. Execute closing agreements.
D. To request the disclosure of confidential tax return information.
D. To request the disclosure of confidential tax return information. To

request the disclosure of confidential tax return information, an
individual must make a request under the Freedom of Information Act
(FOIA). The rules under FOIA determine an individual’s entitlement to
confidential return information. Although Form 2848 can be used, it
need not be used for tax return information disclosures.
E. Form 2848, Power of Attorney and Declaration of Representative is used to

appoint a representative.
1. An unenrolled preparer can represent a taxpayer only before revenue agents

and examining officers of the examination division, and only for the period
covered by the return.
2. A document other than Form 2848 can be used if the document contains all of
the information requested on Form 2848. This includes a statement by the
representative referred to as the Declaration of Representative.
3. If the non-IRS power of attorney is missing some information, an attorney-in-

fact can provide the information, provided that the POA filed authorized the
attorney-in-fact to handle federal tax matters.

F. The POA is entered in the Central Authorization File (CAF), which enables IRS
personnel, who do not have a copy of the POA, to verify the authority of the
representative.
G. A POA can be updated or changed by filing a new Form 2848.
1. A new POA revokes a prior POA if it is granted by the taxpayer to another

recognized representative with respect to the same matter.
2. A revocation copy of Form 2848 can be submitted to revoke a POA. A POA

not filed on Form 2848 can be revoked by writing a letter requesting a
revocation.
3. A recognized representative may withdraw from representation in a matter by

filing a statement with the IRS office where the POA is to be revoked.
4. Any representative appointed in a power of attorney may substitute or

delegate authority under the POA to another recognized representative if
substitution or delegation is specifically authorized under the POA. A
substitution or delegation is effected by filing the required information with the
IRS where the power of attorney has been filed. The following items are
required for the substitution or delegation of a recognized representative:
a) Notice of substitution or delegation,
b) Declaration of Representative, and
c) A power of attorney which specifically authorizes the substitution or

delegation.
Exercise 20:
Nancy, who is enrolled to practice before the Internal Revenue
Service, has been appointed in a power of attorney to represent
Lee in a matter before the IRS. Nancy wants to delegate the
authority to another representative. Regarding this substitution of
authority, all of the following statements are CORRECT except:
A. The power of attorney whether it is IRS Form 2848, Power of

Attorney and Declaration of Representative, or a non-IRS power of
attorney must specifically provide that Nancy can substitute her
authority.
B. The new representative must be an individual who is recognized to
practice before the IRS.
C. The new representative must file a written declaration in

accordance with the regulations with the appropriate IRS offices.
D. Nancy need ONLY file a signed statement (notice of substitution or
delegation) with the appropriate IRS offices.
D. Nancy need ONLY file a signed statement (notice of substitution or

delegation) with the appropriate IRS office. A substitution is made by
filing the following items with the IRS: (1) a notice of substitution or
delegation signed by the practitioner who was appointed under the
power of attorney, (2) a declaration of representative made by the new
representative, and (3) a power of attorney that authorizes the
substitution or delegation.
H. Non-IRS powers of attorney. If Form 2848 is not used, a taxpayer can obtain a
power of attorney with a written document which contains the following
information:
1. The taxpayer's name and mailing address,
2. The taxpayer's Social Security number and/or employer ID number,
3. The name and address of the representative,
4. The types of tax involved,
5. The federal tax form number,
6. The specific year(s) or period(s) involved,
7. For estate tax matters, the decedent's date of death,
8. A clear expression of the taxpayer's intention concerning the scope of

authority granted to the representative,
9. The taxpayer's signature and date, and
10. The "Declaration of Representative" statement, made by the taxpayer's

representative , which is contained in Part II of Form 2848 and should read as
follows:
a) I am not currently under suspension or disbarment from practice before

the Internal Revenue Service or other practice of my profession by
another authority,

b) I am aware of the regulations contained in Treasury Department Circular

No. 230 (31 C.F.R., Part 10) concerning the practice of attorneys, certified
public accountant, enrolled agents, enrolled actuaries, and others;
c) I am authorized to represent the taxpayer(s) identified in the power of

attorney; and
d) I am authorized to practice before the Internal Revenue Service as an

individual described in 26 CFR 601.502(a) in my capacity as _______
(attorney, certified public accountant, enrolled agent, etc.).
Exercise 21:
If a representative chooses to use a non-IRS power of attorney form,
all of the following "Declarations of Representative" statements
would be required in order for the power of attorney to be valid
except:
A. A declaration that the representative is NOT currently under

suspension or disbarment from practice before the IRS or other
practice of his or her profession by ANY other authority
B. A declaration that the representative is aware of the regulations
contained in Treasury Department Circular No. 230 concerning the
practice of enrolled agents, attorneys, CPAs, etc.
C. A declaration that the representative is NOT currently under
investigation by the IRS
D. A declaration that the representative is authorized to practice
before the IRS in his or her capacity as an attorney, certified public
accountant, enrolled agent, etc.
C. A declaration that the representative is NOT currently under

investigation by the IRS. The Declaration of Representative is a
statement made by a representative under the penalty of perjury that
he or she is: (1) one of the types of persons authorized to practice
before the IRS; (2) not currently suspended or disbarred from practice
before the IRS; (3) authorized to represent the taxpayer for the matter
specified in the power of attorney; and (4) aware of the regulations
governing practice before the IRS. It is filed with a power of attorney
and its failure to indicate current investigation by the IRS will not
invalidate the power of attorney.
I. POA is not required in the following situations.
1. A POA is not required to authorize the IRS to disclose information concerning

a taxpayer's tax account to an individual or other party. For this purpose use
Form 8821, Tax Information Authorization.
2. A tax matters partner or person [§6231 (a)(7) and §6244] is authorized to

perform various acts on behalf of a partnership or S Corporation. This may
include the power to delegate authority to represent the TMP and to sign
documents in that capacity.
3. A fiduciary (trustee, executor, administrator or receiver) stands in the position

of the taxpayer and, in effect, is recognized as the taxpayer. He or she is not
considered a representative of the taxpayer. Therefore, a power of attorney is
not required. However, a fiduciary should file Form 56, Notice Concerning
Fiduciary Relationship, to notify the IRS of the fiduciary relationship.
4. The Tax Court has its own rules of practice and procedure and its own rules
for admission to practice before it. Accordingly, a power of attorney is not
required to be submitted by an attorney of record in a case which is docketed
in the Tax Court.
IV. Centralized Authorization File (CAF) System
A. Information from both powers of attorney and tax information authorizations is

recorded onto the CAF system. Such information enables IRS personnel who do
not have access to the actual power of attorney or tax information authorization
to determine whether a person is the taxpayer's representative.
B. The issuance of a CAF number does not indicate that a person is either
recognized or authorized to practice before the IRS. Form 8821 is strictly a
disclosure authorization form and cannot be used to name an individual to
represent a taxpayer before the IRS.
Exercise 22:
Form 8821, Tax Information Authorization, can be used when you
want to authorize an individual to represent you before the IRS.
(True or False)
False. Form 8821, Tax Information Authorization, only authorizes an

appointee to receive certain confidential tax information.
C. A tax information authorization or power of attorney which does not include a

CAF number will not be rejected based on the absence of a CAF number.

D. Although a POA or tax information authorization may be on file, the information

cannot be recorded onto the CAF system unless it meets certain criteria:
1. Only matters relating to a specific tax period will be recorded onto the CAF
system. If a specific period is not named, it cannot be entered into the system.
2. The system is limited to accepting three future years. Prior years are
accepted for years under consideration by the IRS.
3. Not more than three representatives appointed under a power of attorney or

designated under a tax information authorization will be recorded onto the
CAF system.
4. The fact that a power of attorney or tax information authorization cannot be

recorded onto the CAF system is not determinative of the (current or future)
validity of the document.
Exercise 23:
With regard to Centralized Authorization File (CAF) numbers, which
of the following statements is CORRECT?
A. The CAF number is entered into the IRS database which allows the
IRS to automatically send copies of notices to the representative.
B. A CAF number indicates that the individual is either recognized or
authorized to practice before the IRS.
C. A CAF number is assigned only to enrolled agents, CPAs and
attorneys.
D. A power of attorney submitted without a CAF number will BE
rejected based on the absence of a CAF number.
A. The CAF number is entered into the IRS database which allows the
IRS to automatically send copies of notices to the representative. The
Centralized Authorization File (CAF) is an automated system designed
to allow IRS personnel to identify representatives and the scope of
their authority.
V. Research Materials
A. The Internal Revenue Code is the law, as passed by Congress, governing

taxation. It is binding on all courts except when held to violate the Constitution.
The judiciary gives great importance to the literal language of the Code, but also
considers the history of a particular Code section, its relationship to other Code
sections, the reports of congressional committees, and Treasury regulations, IRS
revenue rulings, and other IRS pronouncements published in the Internal

Revenue Bulletin.
B. Treasury Regulations provide explanations, definitions, examples, and rules

which explain the language of the Internal Revenue Code. IRS employees are
bound by the regulations, however, the courts are not.
Exercise 24:
All courts except the Tax Court are bound by legislative regulations.
(True or False)
False. Regulations represent the official Treasury interpretation of the

Code. They generally are accorded the force and effect of law as long
as they are reasonable and consistent with the statutory provisions
they interpret. The Tax Court is bound by the legislative regulations to
the same extent that other courts are.
1. Most income tax regulations are issued under the authority of §7805(a).
These regulations are called interpretative regulations. Some other Code
sections specifically authorize regulations to provide the details of the
meaning and rules for that particular code section. Regulations issued under
this authority are called legislative regulations.
2. All regulations are written by the Office of the Chief Counsel, IRS, and
approved by the Secretary of the Treasury.
3. Temporary regulations are issued to provide guidance for the public and IRS
employees until final regulations are issued. Public hearings are not held on
temporary regulations.
NOTE: Temporary regulations issued after November 20, 1988, will

expire within 3 years.
4. Proposed regulations are issued to solicit public written comments and public
hearings are held if written requests are made. Proposed regulations do not
replace temporary regulations unless the proposed regulations specifically
say they replace them.
5. Final regulations are issued after the public comments on proposed

regulations are evaluated, and they supersede the temporary regulations.
Exercise 25:
All of the following statements with respect to classes of regulations
are CORRECT except:

A. All regulations are written by the Office of Chief Counsel, IRS, and
approved by the Secretary of the Treasury.
B. Public hearings are NOT held on temporary regulations.
C. Although IRS employees are bound by the regulations, the courts
are NOT
D. Public hearings are NOT held on proposed regulations.
D. Public hearings are NOT held on proposed regulations. The

purpose of proposed regulations is to give the public an opportunity to
be heard before the regulations are promulgated in their final form.
C. Revenue Rulings and Revenue Procedures
1. Revenue rulings are the published conclusions of the IRS concerning the
application of tax law to a specific set of facts.
2. Revenue procedures are official statements of procedures that either affect

the rights or duties of taxpayers or other members of the public or should be a
matter of public knowledge. Revenue procedures are directive and not
mandatory.
3. The purpose of revenue rulings is to promote a uniform application of the tax

laws, and therefore, IRS employees must follow the rulings as well as the
Treasury Regulations. While taxpayers can rely on the rulings, they can also
appeal adverse return examination decisions based on those rulings to the
Tax Court or other federal courts.
D. The Courts
1. Tax Court
a) A taxpayer may petition the United States Tax Court for a judicial
determination of his or her tax liability within a specified period (generally
90 days) after receiving a notice of deficiency, but before he or she pays
the tax.
b) The Tax Court is authorized by Internal Revenue Code but is entirely

separate from the Internal Revenue Service.
c) The Tax Court has jurisdiction over income, estate and gift taxes, some
excise taxes, and certain declaratory judgments involving taxes.
d) Decisions of the Tax Court are issued as either a regular report or a

memorandum decision. The service's acquiescence or nonacquiescence
in adverse decisions are published in the Internal Revenue Bulletin.
Exercise 26:
The Tax Court has jurisdiction over employment taxes. (True or
False)
False. The Tax Court lacks jurisdiction over employment taxes.

However, it does have jurisdiction over the self-employment tax.
2. District Court and Claims Court
a) A taxpayer may choose to pay a disputed deficiency and then file a claim
for refund. If the claim is denied by the IRS or if no decision is made within
6 months, the taxpayer may petition either the United States Claims Court
or the United States District Court.
b) Cases before the District Court may be tried by jury.
Exercise 27:
Which of the following statements is FALSE?
A. The Tax Court will issue either a regular report or a memorandum

decision depending upon the issues involved and the relative value
of the decision being made.
B. The Commissioner of lnternal Revenue does NOT issue a public
acquiescence or nonacquiescence on District or Claims court
cases.
C. Interpretative regulations are issued under the general authority of
lnternal Revenue Code Section 7805 (a) and legislative regulations
are issued under the authority of specific Internal Revenue Code
section to which they relate.
D. The government prints the regular and memorandum Tax Court
decisions in bound volumes.
D. The government prints the regular and memorandum Tax Court

decisions in bound volumes. Only Tax Court regular decisions are
printed by the government in bound volumes.
3. Appellate Courts
a) Both the taxpayer and the government may appeal decisions of the Tax
Court, District Court, or Claims Court to the Court of Appeals.
b) Decisions of the United States Tax Court and the United States District
Court can be appealed to one of thirteen Courts of Appeals and then to
the United States Supreme Court. Decisions of the United States Claims

Court can be appealed to the United States Court of Appeals for the
Federal Circuit and then to the United States Supreme Court.
4. Supreme Court
a) Decisions of the Court of Appeals and some decisions of other federal

courts may be reviewed by the United States Supreme Court. The
Supreme Court is not obligated to hear all cases so requested.
b) Petition to the Supreme Court to hear a case that is not subject to

obligatory review is by writ of certiorari. The writ is initially requested by
the appealing party and is issued by the Supreme Court to the lower
appellate court, requesting the record of a case for review. The Supreme
Court is said to have denied certiorari when it refuses to issue such a writ.
5. Decisions of the courts other than the Supreme Court are binding on the
Commissioner of Internal Revenue only for the particular taxpayer and for the
years litigated. The Commissioner may decide to acquiesce to an adverse
regular Tax Court decision. Acquiescence generally means that the IRS will
follow the Tax Court decision in cases involving similar facts.
Exercise 28:
Nonacquiescence by the Commissioner of Internal Revenue to an
adverse decision in a regular Tax Court case means the Internal
Revenue Service will NOT accept the decision and will NOT follow
it in cases involving similar facts. (True or False)
True. An acquiescence or nonacquiescence represents the

Commissioner’s official response to a Tax Court decision that is
adverse to the IRS. A nonacquiescence means that the IRS does not
accept the decision and will not follow it in cases involving similar facts.
6. Court Terminology
a) Decision is the court's formal answer to the principal issue in litigation. It

has legal sanction and is enforceable by the authority of the court.
b) Dictum is a court's statement of opinion on a legal point not raised by the

facts of the case. It is not controlling, but may be persuasive to another
court deciding the issue dealt with by the dictum.
c) Memorandum Decision is a report of a Tax Court decision thought to be

of little value as a precedent because the issue has been decided many
times.
d) Acquiescence is notice given by the Commissioner of Internal Revenue

of intent to follow, to the extent indicated in the Cumulative Bulletin, an
adverse Tax Court decision.
SECTION B - EXAMINATIONS, APPEALS AND COLLECTIONS

I. Examinations
A. If the IRS examined the taxpayer's return for the same items in either of the 2
previous years and proposed no change to the tax return, contact the IRS and
they may discontinue the audit. However, if the return was selected for
examination as part of a random sample for TCMP, the examination will
continue.
Exercise 29:
Lamar's income tax returns for 1997 and 1999 were examined by
the IRS. Both examinations covered Schedule C income and
expenses and resulted in NO change in income tax. On September
15, 2001, he received notice that his income tax return for 2000 will
be examined as part of the IRS Taxpayer Compliance
Measurement Program. Lamar should contact the IRS immediately
to exclude his income tax return from examination under the
repetitive audit procedures. (True or False)
False. The IRS may not initiate an examination to harass a

taxpayer. However, the IRS has wide latitude in determining what a
legitimate purpose is for the initiation of an examination. The Taxpayer
Compliance Measurement Program (TCMP) is a random selection
system used to determine a taxpayer’s correct tax liability.
B. The IRS Problem Resolution Office can help to solve administrative or procedural
problems. The taxpayer should first try to resolve the problem by discussing it
with the examiner's supervisor.
C. A tax return is generally examined in the IRS district where the taxpayer lives.
However, if the return can be examined more quickly and conveniently in another
district, such as where the books and records are located, a request can be
made to transfer the examination to that district.
Exercise 30:
Under which of the following conditions can an examination of an
income tax return be transferred to another IRS district?

A. James lives in Maryland and his accountant is located in New York

His records are in Maryland where he works. James wishes a
transfer of h is case from Maryland to New York for the
convenience of his accountant.
B. Donna lives in Kentucky. Her books and her records are in
Kentucky where her business is located. On occasion she works in
Ohio. She wants the examination of her return transferred to Ohio.
C. Herb lives in Washington and travels to California on business 2
months at a time. His records are in New York where his business
is located. Herb wants his case transferred to California to coincide
with a business trip there.
D. Tom lives in New Jersey His books and records are in Delaware
where his business is located and where he works. Tom wishes a
transfer of examination of his return to Delaware. 30
True. The purpose of filing a notice of federal tax lien is to give

notice to the taxpayer’s creditors that the government has a claim
against all the taxpayer’s property. The federal tax lien attaches to all
property and rights to property, whether real or personal, belonging to
the taxpayer at the time the lien arises, as well as to property
subsequently acquired during the period of the lien.
D. If the taxpayer agrees with a proposed change, he or she can sign an

agreement form and pay any additional tax, interest, and penalties due. If the
taxpayer pays when signing the agreement form, interest will be assessed
from the due date of the return to the date of payment. If not paid when
signed, the IRS will send a bill. Interest will be assessed from the due date to
the billing date (not more than 30 days from signing the agreement). If paid
within 10 days of receiving the bill, no additional interest is due. If not paid
within 10 days, interest will be assessed from the due date to the date of
payment.
E. If the taxpayer does not agree with a proposed change, he or she can request
an immediate meeting with the examiner's supervisor. If the taxpayer cannot
reach an agreement with the supervisor, or the examination took place
outside of an IRS office, the taxpayer's case will be sent to the district office
for processing. The taxpayer will then be sent a 30-day letter. The taxpayer
then has 30 days from the date on the letter to accept or appeal the proposed
change.
F. If a taxpayer does not respond to the 30-day letter or reach an agreement

with an appeals officer, the IRS will send the taxpayer a 90-day letter which is
also known as a statutory notice of deficiency. The taxpayer has 90 days (150
days if the taxpayer is outside of the U.S.) from the date of this notice to file a
petition with the Tax Court.
* Study Tip * Study the appeals chart from Publication 556,

Examination of Returns, Appeal Rights and Claims for Refunds.
The chart explains the process of appeals. Time spent memorizing
this process will prove beneficial when taking this part of the exam.
Exercise 31: If a taxpayer does not respond to a 30-day letter OR if

he/she does not reach an agreement with an Appeals Officer,
he/she will receive a statutory notice of deficiency. A statutory
notice of deficiency allows a taxpayer 90 days (150 days if mailed
when the taxpayer is outside the United States) from the date of
this notice to file a petition with the Tax Court. (True or False)
True. The Tax Court’s jurisdiction to redetermine deficiencies by the

IRS depends on the issuance of a notice of deficiency by the IRS and
the filing of a Tax Court petition by the taxpayer. The petition must be
filed within 90 days of the issuance of the notice of deficiency (150
days if mailed when the taxpayer is outside the United States).
G. If the taxpayer thinks he or she may owe additional tax before the examination
ends, he or she can stop the accrual of interest by sending a payment of tax or a
deposit to the IRS. Interest will stop accruing on any part of the amount covered
by this payment or deposit.
1.. A deposit can be returned without filing a claim for refund. A written request
must be submitted to have the submitted amount treated as a deposit.
2. The IRS will treat the amount as a tax payment if:
a) There is no request for it to be treated as a deposit,
b) The money is sent after being notified of a proposed tax liability, and
c) The amount sent is large enough to cover the proposed liability.
3. If a payment is enough to cover a proposed liability, no notice of deficiency

will be sent. If a taxpayer agrees with the examiner's proposed change, a
deposit will be used to pay the tax and no notice of deficiency will be sent. If
no notice of deficiency is sent, the taxpayer will not have the right to take the
case to Tax Court (discussed later).
Exercise 32:
If a taxpayer agrees with the results of an IRS examination that he/she
owes additional tax and signs an agreement form, the taxpayer will
NOT be billed for additional interest for more than 30 days from the

date the agreement was signed if the taxpayer pays the total
amount due within 10 days of the billing date. (True or False)
True. If the taxpayer pays the total amount due within ten days of
the billing date, he will not be billed for additional interest.
II. Appeals Conference
A. A taxpayer may appeal an IRS decision to the regional Appeals Office, the only
level of appeal within the IRS. When requesting an appeals conference, a written
protest or brief written statement may be required.
B. A written statement or protest is not required if:
1. The proposed increase or decrease in tax is not more than $2,500 for any of
the tax periods involved, or
2. The examination was handled by mail or in an IRS office by a tax auditor.
C. A brief written statement is required if the proposed increase or decrease in tax,

including penalties or refund, determined by the examination is more than $2,500
but not more than $10,000.
Exercise 33:
If the proposed increase or decrease in tax resulting from an IRS
examination, conducted at the taxpayer's place of business,
exceeds $2,500 but not more than $10,000, the taxpayer or the
taxpayer's representative must provide a brief written statement
explaining the disputed issues within 30 days of the issuance of the
30-day letter. (True or False)
True. If the proposed adjustments in a field examination case, including

penalties and interest, exceed $2,500 but do not exceed $10,000, the
taxpayer must file a brief written statement of the issues to initiate an
administrative appeal.
D. A written protest of disputed issues is required if the proposed increase or

decrease in tax, including penalties or claimed refund, is more than $10,000. A
written protest needs to be filed within the time limit specified and should contain
the following information:
1. Taxpayer's name and address,
2. A statement that the taxpayer wants to appeal the examination findings to the
Appeals Office,
3. The date and symbols from the letter showing the proposed changes and
findings that the taxpayer disagrees with,
4. The tax periods or years involved,
5. An itemized schedule of the changes with which the taxpayer disagrees,
6. A statement stating the law or other authority on which the taxpayer relied,
and
7. A statement of facts supporting the taxpayer's position on any issue of

disagreement.
a) The taxpayer must sign a declaration that the statement of facts is true
under penalties of perjury.
b) If the protest is submitted by the taxpayer's representative, he or she may

substitute a declaration stating:
(1) That he or she prepared the protest and accompanying documents,

and
(2) Whether he or she knows personally that the statement of facts in the
protest and accompanying documents are true and correct.
Exercise 34:
All of the following statements concerning the procedure for a
written protest submitted by a representative to obtain an Appeals
Office conference are correct except:
A. A written protest is required when the tax due, INCLUDING

penalties, is MORE than $10,000.
B. A written protest MUST contain the tax years involved AND a
statement that the taxpayer wants to appeal to the Appeals Office.
C. A written protest MUST contain a statement of facts for EACH
disputed issue and a statement of law or other authority relied upon
for each issue.
D. A written protest MUST contain a declaration under penalties of
perjury, signed by the taxpayer that the statement of facts is true
and correct.

D. A written protest MUST contain a declaration under penalties of

perjury, signed by the taxpayer that the statement of facts is true and
correct. Although a written protest generally must contain a sworn
statement made by the taxpayer under penalty of perjury declaring that
the statement of facts presented in the protest, and in any
accompanying schedules, are true, correct and complete to the
taxpayer’s best knowledge and belief, a substitute declaration may be
submitted by the taxpayer’s representative stating that the taxpayer
prepared the protest and accompanying documents, and whether the
representative knows personally that the protest and accompanying
documents are true and correct.
III. Appeals to the Court
A. If an agreement is not reached with the Appeals Officer, the IRS will send a
Statutory Notice of Deficiency. A notice of deficiency will not be sent if the
taxpayer remits payment of the same or more than the proposed change. If a
Notice of Deficiency is not received, the taxpayer cannot take the case to Tax
Court.
B. If the taxpayer elects to bypass the IRS's appeal system, the taxpayer may take
his or her case to the United States Tax Court, the United States Claims Court,
or the United States District Court, all of which are independent of the IRS.
C. If the taxpayer elected to bypass the appeals process with the IRS, the Tax Court
may impose a penalty of up to $5,000 if it determines that the taxpayer did not
pursue available administrative remedies.
D. The United States Tax Court can handle disagreements with the IRS over
income tax, estate tax, gift tax, windfall profit tax on crude oil, on certain excise
taxes of private foundations, public charities, qualified pension and other
retirement plans, or real estate investment trusts.
1. The taxpayer must file a petition within 90 days of the date on the Notice of
Deficiency. If not filed on time, the IRS will send a bill and the taxpayer may
not take the case to Tax Court.
2. With the taxpayer's consent, the IRS can withdraw a Notice of Deficiency.
Once withdrawn, both the IRS and the taxpayer are back to the same position
as before the notice was filed. The taxpayer cannot petition the Tax Court
based on this notice.
3. The Tax Court generally hears cases before any tax has been assessed and
paid. However, a case petitioned to the United States Tax Court will normally
be considered for settlement by a regional Appeals Office before the Tax

Court hears the case.
Exercise 35:
Mr. Garcia's individual income tax return was examined and the
IRS issued a statutory notice of deficiency He wishes to contest the
liability by bypassing the IRS's appeals system and taking his case
straight to court. Mr. Garcia should:
A. Contact the IRS Problem Resolution Officer.

B. NOT pay' the lax and petition the US. Tax Court.
C. NOT pay the tax, file a written protest requesting immediate
consideration by the US. Claims Court.
D. PAY the tax, file a claim for refund requesting that the claim be
immediately rejected so he may file a refund suit in District Court
D. PAY the tax, file a claim for refund requesting that the claim be
immediately rejected so he may file a refund suit in District Court. The
official answer is D. However, it is CCH’s contention that choice B is
also correct. A taxpayer has three basic alternatives in contesting an
adverse determination by the IRS or a preliminary or statutory notice of
deficiency: requesting an administrative appeal; not pay the tax and
petition Tax Court; or pay the tax, file a refund claim, and file a refund
suit in a district court or Court of Federal Claims. Therefore, B and D
are both correct.
E. If the amount in the case does not exceed $50,000 ($10,000 for proceedings
commenced prior 7/23/98; including additions and penalties), the taxpayer can
request, and if the Tax Court approves, the case can be handled under "small tax
case procedures". The decision under small tax case procedure is final and
cannot be appealed.
Exercise 36:
With respect to the small case procedure in the Tax Court, all of the
following statements are CORRECT except:
A. Within 90 days of receiving a statutory notice of deficiency, the

taxpayer must pay a filing fee AND file a petition form with the Tax
Court in Washington, DC.
B. The total disputed deficiency (tax and penalties) for ALL tax years
at issue must be $10,000 or less.
C. The decision of the Tax Court CANNOT be appealed to another
court and CANNOT be used as a precedent for any other case or
year.

D. The proceedings are conducted in accordance with such rules of

evidence and procedures as the Tax Court may prescribe.
B. The total disputed deficiency (tax and penalties) for ALL tax
years at issue must be $10,000 or less. The official answer is B.
However, it is CCH’s contention that choice D is ambiguous and
arguably a correct choice, too. The question states that one of the four
choices is an incorrect statement. Choice B is an incorrect statement
because according to Tax Court Rule 171 the $10,000 monetary cap is
tested on a year-by-year basis and not by aggregating all the tax years
before the court. Although choice B is an incorrect statement, choice D
is a confusing and misleading statement and thus arguably an incorrect
statement, too. Trials in a small tax court proceeding are more informal
than regular Tax Court trials, and, unlike regular Tax Court trials, small
tax court proceedings are not bound by the Federal Rules of Evidence.
F. If the taxpayer pays the tax after receiving a Notice of Deficiency and a claim for
credit or refund has been filed, the case can be heard in the U.S. District Court or
the U.S. Claims Court. The taxpayer would file a claim for refund if he/she thinks
the tax is incorrect or excessive. If the claim is rejected or no action is taken
within 6 months, the taxpayer may then file a suit for refund. This must be filed no
later than 2 years after the claim for refund was rejected or after filing Form 2297,
Waiver of Statutory Notification of Claim Disallowance.
Exercise 37:
An income tax case NOT resolved at an appeals conference can
proceed to the United States Tax Court WITHOUT the taxpayer
paying the disputed tax, but generally, the United States District
Court and United States Claims Court hear tax cases ONLY after
the tax is paid and the claim for credit or refund is filed by the
taxpayer and is rejected by the IRS or the IRS has not acted on the
taxpayer's claim within six months from the date of filing the claim
for refund (True or False)
True. The Tax Court has deficiency jurisdiction (disputed tax does
not have to be paid first) whereas the federal district courts and the
Court of Federal Claims have refund jurisdiction (disputed tax must be
paid before an action is brought for a refund).
IV. Claim For Refund
A. A claim for refund, Form 1040X, must be filed for each tax year or period
involved.
B. A claim for refund must be filed within 3 years from the date of filing the original
return, or 2 years from the date the tax was paid, whichever is later.
Example: You made estimated payments of $500 and got an

automatic extension of time to August 15, 2001 to file your 2000
income tax return. You filed your return October 31, 2001, 2 1/2
months after the extension period ended, and paid an additional
$200. Three years later, on October 25, 2004 you file an amended
return and claim a refund of $700. Although filed within 3 years
from the date you filed your original return, the refund is limited to
$200. The estimated tax of $500 was paid before the 3-year plus 4-
month extension period.
C. The credit or refund cannot be more than the part of the tax paid within the 3
years (plus extensions) before filing the claim.
D. If a claim for refund is filed after the 3 year period but within 2 years from the time
the tax is paid, the credit or refund cannot be more than the amount paid within
the immediate 2 years.
E. If the taxpayer is filing a claim for credit or refund based only on contested
income tax, or on estate tax or gift tax issues considered in previously examined
returns, and does not want to appeal within the IRS, he or she should request in
writing that the claim be immediately rejected. A Notice of Claim Disallowance
will then be sent.
F. The taxpayer has 2 years from the date of mailing the Notice of Claim
Disallowance to file a refund suit in the United States District Court having
jurisdiction or in the United States Claims Court.
V. The Examination of a Partnership or S Corporation
A. This will begin with a notification to the Tax Matters Person (TMP).
B. At least 120 days before a final administrative adjustment is mailed to the TMP,
the partners or shareholders will be notified of the examination.
C. Each partner or shareholder has a right to take part in the examination. Any
settlement agreement is binding on all partners or shareholders who take part in
the settlement.

D. Partners or shareholders cannot file a claim for credit or refund on partnership or

corporate items. Instead, they must file an administrative adjustment request.
VI. Enforced Collection
A. Installment payments can be arranged if the taxpayer cannot pay the full amount
of tax liability due. An installment agreement is initiated by the taxpayer filing
Form 9465, Installment Agreement Request. The IRS charges a $43 user fee for
the initial installment agreement.
1. Form 433A or 433F will be completed by individuals and Form 433B will be
completed by businesses to determine monthly income, expenses, and
minimum payment.
2. If the taxpayer is making installment payments, the IRS may file a Notice of
Federal Tax Lien to secure the Government's interest until the final payment
is made.
3. The taxpayer has a right, unless collection is endangered, to a 30-day

notification of the termination, alteration, or modification of an agreement
based on an IRS determination of change in financial condition.
4. The IRS may frequently request current information to determine if there is a

change in the taxpayer's ability to pay.
5. If the taxpayer does not provide financial information when requested, or does
not meet the terms of the agreement, the entire tax becomes due and the IRS
will take enforced collection action.
B. An offer in compromise can be submitted as a practical way to resolve an

outstanding tax liability. Under certain conditions, the IRS will settle unpaid
accounts for less than the full amount of the balance due. This applies to all
taxes arising under the Internal Revenue Code, including any interest, penalty, or
additional amount.
1. By law, the taxpayer has a right to submit an offer in compromise on the tax
bill. The Commissioner of the IRS cannot compromise taxes relating to
alcohol, tobacco and firearms.
2. A compromise may be made on one or both of two grounds:
a) Doubt as to liability, or
b) Doubt as to the ability to make full payment on the amount owed.
3. Submission of an offer in compromise does not automatically suspend

collection of an account. If there is any indication that the filing of the offer is
solely for the purpose of delaying collection of the tax or that delay would
negatively affect collection of the tax, the IRS will continue collection efforts.
C. The IRS can file a Notice of Federal Tax Lien. This is a public notice to creditors
that the Government has a claim against all of the taxpayer's property. This
includes property purchased after the lien has been filed.
1. The notice can be filed once the IRS:
a) Assesses a tax,
b) Sends a notice for demand and payment, and
c) The taxpayer neglects or refuses to pay the tax or otherwise resolve the
tax problem (within 30 days),
Exercise 38:
By filing a Notice of Federal Tax Lien against a taxpayer, the
Government is providing a public notice to the taxpayer's creditors
that the Government has a claim against all of the taxpayer’s
property, INCLUDING property that the taxpayer acquires after the
lien was filed (True or False)
True. The purpose of filing a notice of federal tax lien is to give notice
to the taxpayer’s creditors that the government has a claim against all
the taxpayer’s property. The federal tax lien attaches to all property
and rights to property, whether real or personal, belonging to the
taxpayer at the time the lien arises, as well as to property subsequently
acquired during the period of the lien.
2. Property subject to a tax lien may be released under the following

circumstances:
a) The tax liability is satisfied by payment or adjustment.
b) IRS acceptance of a bond guaranteeing payment.
c) Other property subject to the lien is worth at least twice the amount owed.
d) The IRS receives the value of the Government's lien interest in the
property and the taxpayer is giving up ownership.

e) The IRS determines that the Government's interest in the property is

valueless and the taxpayer is giving up ownership.
f) The property is being sold and there is a dispute as to who is entitled to

the sale proceeds, and the sale proceeds are placed in escrow while the
dispute is being resolved.
3. All fees charged by the state or other jurisdiction for both filing and releasing
the lien will be added to the balance owed by the taxpayer.
4. The taxpayer may appeal the filing of an erroneous lien. A filing is erroneous
under one of the following conditions:
a) The liability was satisfied before the lien was filed.
b) The taxpayer was in bankruptcy and subject to the automatic stay.
c) The examination assessment was improperly made.
d) The statute of limitations for collection expired prior to filing the lien.
Exercise 39:
A Notice of Federal Tax Lien is considered incorrect if the IRS
assessed the tax and filed the lien when the taxpayer was in
bankruptcy under title 11 of the US. Code. (True or False)
True. Although a bankruptcy stay does not prevent tax assessments, a tax
lien generally does not take effect during the pendency of a
bankruptcy.
D. A levy is the taking of property to satisfy a tax liability. Levies can be made on
property in the hands of third parties (employers, banks, etc.) or in the taxpayer's
possession (automobile, real property, etc.). Once served, a levy on salary or
wages continues in effect until it is released or the tax liability is satisfied or
becomes unenforceable due to lapse of time.
1. For taxes assessed after November 5, 1990, and within the statutory period of
limitation for assessment, the tax may be collected by levy or a proceeding in
court, if the levy is made or the court proceeding is begun:
a) Within 10 years after the assessment of the tax, or
b) By the end of any period of collection agreed upon in writing between the
taxpayer and the IRS.
2. Court authorization is not required before levy action is taken unless

Collection personnel must enter into private premises to accomplish their levy
action (actual seizure of property). Generally there are three legal
requirements before levy action can be taken:
a) The tax must be owed,
b) A notice and demand for payment must have been sent to the last know
address of the taxpayer, and
c) If payment is not made, a Final Notice (Notice of Intent to Levy) must be

give to the taxpayer at least 30 days in advance. Such notice may be
given to the taxpayer in person, left at the taxpayer's dwelling or usual
place of business, or sent by certified or registered mail to the taxpayer's
last known address.
3. If collection is endangered, the Service may take immediate collection action.

Jeopardy levies may occur when the Service waives the 10-day Notice and
Demand period and/or Final Notice (Notice of Intent to Levy) 30-day period,
because delay would endanger collection of the tax.
4. If a bank account is levied, the bank is required to hold funds currently on

deposit (up to the amount owed) for 21 days. If arrangements to pay have not
been made, the bank is then required to send the money to the IRS.
5. The IRS must release a levy if:
a) The tax, penalty, and interest for which the levy was made is paid,
b) The statute of limitations expired prior to the levy,
c) The IRS determines the release will help collect the tax,
d) The taxpayer has received approval for a current installment agreement

for the tax on the levy,
e) The IRS determines the levy is creating an economic hardship, or
f) The fair market value of the property exceeds the levy and its release
would not hinder the collection of tax.
6. Property exempt from levy includes:
a) Wearing apparel and school books (furs don't qualify),

b) Fuel, provisions, furniture, and personal effects, not to exceed $1,650 in

value,
c) Books and tools used in a trade or business, not to exceed $ I ,100 in

value,
d) Unemployment benefits,
e) Undelivered mail,
f) Certain annuity and pension benefits,
g) Certain service-connected disability payments,
h) Workmen's compensation,
i) Salary, wages, or other income subject to a prior judgment for court-

ordered child support payments,
j) Certain public assistance payments,
k) Assistance under the Job Training Partnership Act,
l) Principal residence, unless prior written approval of the district director or

assistant district director is secured or jeopardy exists,
m) Deposits to the special Treasury fund made by members of the armed

forces and Public Health Service employees on a permanent duty
assignment outside the U.S. or its possessions, and
n) A minimum weekly exemption for wages, salary, and other income based
on the standard deduction plus the number of allowable personal
exemptions divided by 52. If the taxpayer does not provide a certification
of exemption, the exempt amount will be computed as if the taxpayer were
married filing separately with one exemption.
Exercise 41:
When levies are attached, the IRS has the authority to take
property to satisfy a tax debt. The IRS may levy all of the following
except:
A. Accounts receivables
B. Workmen’s compensation
C. Rental income
D. Commissions
B. Workmen’s compensation. Workmen’s compensation, including any

amount payable for dependents, is property which is exempt from levy.
E. Upon the filing of a bankruptcy petition and during the period the debtor's assets
are under the jurisdiction of the bankruptcy court, all IRS collection efforts against
the debtor and the debtor's property are automatically stayed.
Exercise 42:
Filing a petition in bankruptcy under title 11 of the United States
Code automatically stays assessment and collection of a tax. The
stay remains in effect until the bankruptcy court discharges liability
for the tax or lifts the stay (True or False)
True. Filing a petition in bankruptcy automatically stays the IRS from

collecting tax from the debtor. The stay lasts until the bankruptcy case
is closed or dismissed or the debtor is discharged or denied a
discharge.
F. Seizures and Sales
1. A seizure may not be made on any property if the estimated cost of the
seizure
and sale exceed the fair market value of the property to be seized, at the time of
the seizure. Property cannot be seized or levied on the day the taxpayer attends
a collection interview in response to a summons (unless jeopardy exists).
2. The taxpayer has a right to an administrative review of the seizure action

when the IRS has taken personal property that you own which is necessary
for the maintenance of the taxpayer's business.
3. Once property is seized, the taxpayer will be given a notice of proposed sale.
The sale cannot be earlier than 10 days after giving the taxpayer the notice
(unless the property is perishable).
4. The IRS will determine a "minimum bid price", which is the lowest amount that
will be accepted on the sale.
5. The taxpayer has a right to redeem his property at any time prior to the sale.
Redemption consists of paying the tax due, including interest and penalties,
together with the expenses of seizure.
6. The taxpayer may get real property back within 180 days of the sale by
paying the purchaser the amount paid plus 20% interest.

7. After the sale, proceeds are applied first to the expenses of the levy and sale.
The remaining amount is then applied against the tax bill. If the sale proceeds
are less than the tax bill and the expenses of levy and sale, the taxpayer will
still be liable for the remaining unpaid tax.
Exercise 43:
With respect to the IRS's seizures and sales of personal property to
satisfy a federal tax debt, all of the following statements are
CORRECT except:
A. After the notice of sale has been given to the taxpayer, the IRS
must wait 10 days before conducting the sale unless the property is
perishable and must be sold immediately
B. After the sale, the IRS uses the proceeds first to satisfy the tax
debt.
C. If real estate was sold, the taxpayer; or anyone with an interest in
the property, may redeem it at any time within 180 days after the
sale by paying the purchaser the amount paid for the property plus
a certain percentage of interest.
D. Before the date of sale, the IRS computes a "minimum bid price "
which is the lowest amount the IRS will accept for the sale of that
property to protect the taxpayer's interest in that property.
B. After the sale, the IRS uses the proceeds first to satisfy the tax
debt. The sale proceeds are applied first against the expenses of the
proceedings, next against any federal excise tax imposed directly on
the property, and then against the tax liability for which the levy was
made, including a separate supporting statement containing the basis
for the taxpayer’s explanation.
G. If interest and dividends are not properly reported on the tax return, or if the
taxpayer fails to give the payers a correct taxpayer identification number, the
payer is responsible to withhold tax on such payments.
H. A Trust Fund Recovery Penalty can be assessed against employers who fail to
pay the withheld income tax and the employee's portion of the employment tax.
The amount of the penalty is equal to 100 percent of the tax required to be
collected and paid over. The penalty is computed based on both the withheld
income tax and the employee's (but not the employer's) portion of the
employment tax or collected excise tax. The penalty can apply regardless of
whether the taxpayer is out of business or without assets.
1. The penalty may be assessed against any person responsible for collecting or
paying over income and employment taxes or paying over collected excise
taxes, who willfully fails to do so.
2. The responsible person may be an officer or an employee of a corporation, a

member or employee of a partnership, a corporate director or shareholder, a
volunteer member of a board of trustees of a nonprofit organization or another
person with sufficient control over fluids to direct their disbursement.
Exercise 44:
The trust fund penalty may be imposed against any person who is
responsible for collecting or paying withheld income and
employment taxes AND who willfully fails to collect OR pay them.
(True or False)
True. The trust and fund recovery penalty may be imposed against
any person required to collect, account for, and pay over trust fund
taxes who willfully fails to do so. Trust fund taxes include withheld
income taxes and employment taxes.
VII. Taxpayer Rights
A. A taxpayer has the right to be treated fairly, professionally, promptly, and

courteously by IRS employees. With any change or initial notice from the IRS,
the taxpayer should receive Publication 1, Your Rights as a Taxpayer.
B. The taxpayer has a right to request that the case be transferred to another district
or to another office within a district. Generally, the request will be honored if there
is a valid reason such as a change of address before or during the tax case
resolution.
C. Throughout the examination, the taxpayers may act on their own behalf or have
someone else represent them. If the representative is to meet with the IRS alone,
the representative must have written authorization, power of attorney.
D. Taxpayers who have been unable to resolve their tax problems with another IRS
department, can contact the Problem Resolution Office (PRO) to help resolve
the problem. However, before contacting PRO, the taxpayer should first request
assistance from an employee or manager in an IRS Collection office.
E. If a taxpayer has a significant hardship due to the collection of a tax debt,

additional assistance is available from the IRS by filing Form 911. Application for
Taxpayer Assistance Order (ATAO) to Relieve Hardship. A significant hardship

may occur if the taxpayer cannot maintain necessities such as food, clothing, and
shelter.
F. If the IRS made a mistake or misplaced a taxpayer's check, he/she may file a
claim for reimbursement of the fees, charged by the bank, related to the
erroneous levy.
Exercise 45: All of the following statements with respect to resolving

tax problems involving the collection process are CORRECT
except:
A. You may be entitled to a reimbursement for fees charged by your

bank if the IRS has erroneously levied your account.
B. You should first request assistance from IRS collection employees
or their managers before seeking assistance from the Problem
Resolution Officer.
C. If you suffer a significant hardship because of the collection of the
tax liability, you may request assistance from the IRS on Form 911,
Application for Assistance Order to Relieve Hardship.
D. While you are making installment payments, interest will continue to
accrue only on the tax liability due.
D. While you are making installment payments, interest will

continue to accrue only on the tax liability due. Interest accrues on the
unpaid tax liability as well as on unpaid interest and penalties, too.
Income Tax Appeal Procedure:

SECTION C - RECORDS, RETIREMENT PLANS, EXEMPT ORGANIZATIONS,

ELECTRONIC FILING
I. Recordkeeping
A. The IRS does not require a particular form for keeping records. To verify
deductions, the taxpayer should keep sales slips, invoices, receipts, and
canceled checks or financial statements. To verify income, the taxpayer should
keep Forms W-2, Forms 1099, brokerage statements, or other documents
proving amounts shown on the return.
B. The most often used proof of payment is a canceled check or cash receipt. A
canceled check is no longer sufficient documentation for a charitable
contribution.
C. The taxpayer should keep records that show the basis of property owned. If basis
is determined by reference to other property, such as the deferral of gain on the
sale of a residence, basis information for the old property should be retained.
D. Generally, the taxpayer must keep records for as long as they are important for
federal tax purposes. For most items on a tax return, records should be kept at
least 3 years from the date the return was filed or 2 years from the date the tax
was paid. For unreported income which is more than 25% of the income shown
on the return, the period of limitations does not expire until 6 years after the
return is filed.
Exercise 46:
All of the following statements with respect to effective record keeping
are CORRECT except:
A. Records that support the basis of property should be kept until the
statute of limitations expires for the year that the property was
acquired
B. Records of income should identify its source in order to determine if
it is taxable or nontaxable.
C. If an individual CANNOT provide a canceled check to prove
payment of an expense item, he/she may be able to prove it with
certain financial account statements.
D. Records should show how much of an individual's earnings are
subject to self employment tax.
A. Records that support the basis of property should be kept until

the statute of limitations expires for the year that the property was
acquired. Records regarding the basis of property are relevant and
should be kept for as long as the taxpayer owns the asset. If the
taxpayer exchanges an asset for another asset, for which the basis in
the new asset is determined by the basis in the exchanged asset, the
records regarding the basis of the exchanged asset should also be
maintained as long as the new asset is owned by the taxpayer.
Computerized records.
Many retail stores sell computer software packages that you can use for recordkeeping.
These packages are relatively easy to use and require little knowledge of bookkeeping
and accounting.
If you use a computerized system, you must be able to produce legible records of the
information needed to determine your correct tax liability. In addition to your
computerized records, you must keep proof of payment, receipts, and other documents
to prove the amounts shown on your tax return.
E. With regard to the time period for the preservation of records, any person that is
required by Reg. §31.6001 - 1 to keep records in respect of employment taxes
(whether or not such person incurs the liability for the tax), shall maintain the
records for at least four years after the due date of the tax return to which the
records relate, or the date such tax is paid, whichever is later.
Exercise 47:
Employers are required to keep records on employment taxes
(income tax withholding, Social Security, Medicare, and federal
unemployment tax) for:
A. An indefinite time.
B. The statutory period for assessment of the employees' taxes.
C. At least 4 years after the due date of the return or after the date the
tax is paid, whichever is later.
D. At least 3 years after the due date of the return or 2 years after the
date the tax is paid, whichever is later.
C. At least 4 years after the due date of the return or after the date
the tax is paid, whichever is later. Unemployment tax records must be
retained for at least four years after the tax to which the records relate
is due, or four years after the tax is paid, whichever is later.
II. Exempt Organizations

A. To obtain a determination or ruling for exempt status, most organizations must

file a written application with the key District Director in which the organization's
principal office or business is located.
B. Most organizations will not be treated as tax exempt until their application for
exempt status is filed with the local IRS district, unless they file the application for
exempt status within 15 months from the end of the month in which they were
organized.
Exercise 62: An organization described in IRC Section 5O1(c)(3) must

apply for tax exempt status with its key IRS District Director. If
approved by the IRS, the organization will be recognized as exempt
retroactively to the date it was organized if the application was filed
within 15 months from the end of the month it was organized. (True
or False)
True. To establish its exemption, an organization must file a written

application with the key director for the district in which the principal
place of business or principal office of the organization is located.
There are specific forms depending on the type of organization
applying for the exemption. If filed within the 15-month period, then
retroactive treatment is available.
C. Every organization exempt from federal income tax under §501(a) must file an
annual information return (Form 990 series) except for: (this is a condensed list)
1. Churches, related religious organizations, or exclusively religious activities

(such as mission societies and schools below college level),
2. A stock bonus, pension or profit-sharing trust which qualifies under §401,
3. A state institution the income of which is excluded from gross income under
§115,
4. A §501(c)(l) corporation that is an instrumentality of the U.S. and is exempt

from federal income tax,
5. A black lung benefit trust, or
6. An exempt organization (other than a private foundation) having gross income

that is generally not more than $25,000.
D. Tax-exempt organizations, other than private foundations, must file Form 990,
Return of Organizations Exempt from Income Tax (or the shorter Form 990EZ).
E. All private foundations exempt under §501(c)(3) must file Form 990-PF.
F. The due date for Forms 990, 990-EZ, or 990-PF is the 15th day of the 5th month
after the end of the organizations accounting period.
G. Even though an organization is recognized as tax exempt, it still may be liable for
tax on its unrelated business income. Unrelated business income is income from
a trade or business, regularly carried on, that is not substantially related to the
charitable, educational, or to the purpose constituting the basis for the
organization's exemption. An exempt organization that has $1,000 or more gross
income from an unrelated business must file Form 990-T. Estimated tax
payments must be made quarterly if an organization expects its tax to be $500 or
more.
Exercise 63: With respect to the filing requirements of an exempt

organization (including private foundations), which of the following
statements is CORRECT?
A. A central or parent organization may file Form 990, Return of

Organizations Exempt From Income Tax, for two or more local
organizations that are NOT private foundations. However, this
return is in addition to the central or parent organization's
separate annual return fit must file one.
B. EVERY organization exempt from income tax must file an annual
information return.
C. Forms 990, 990-EZ, and 990-PF are required to be filed by the
15th day of the 3rd month after the end of the organization's
accounting period
D. An exempt organization must have at LEAST $5,000 gross
income from an unrelated business before it is required to file
Form 990-T, Exempt Organization Business Income Tax Return.
A. A central or parent organization may file Form 990, Return of

Organization Exempt From Income Tax, for two or more local
organizations that are NOT private foundations. However, this return is
in addition to the central or parent organization’s separate annual
return if it must file one. A parent or central exempt organization files a
separate return for itself. If it chooses, the organization may also file a
group information return for two or more local organizations, as long as
none of the local organizations are private foundations.
H. Every employer, including an organization exempt from federal income tax, who
pays wages to employees, is responsible for withholding, depositing, paying, and
reporting federal income tax, Social Security taxes and federal unemployment

taxes. Exceptions: Services performed by a minister of a church are not subject

to FICA or FUTA tax.
III. Electronic Filing
A. A firm, organization, or individual that participated in the Electronic Filing

Program is known as an electronic filer.
1. An Electronic Return Originator (ERO), which can be a for-profit or a not-for-

profit organization, deals directly with the taxpayer and is defined as an:
a) "Electronic Return Preparer" who prepares tax returns, including Forms

8453, for taxpayers who intend to have their returns electronically filed; or
b) "Electronic Return Collector" who accepts completed tax returns, including

Forms 8453, from taxpayers who intend to have their returns electronically
filed.
2. A Software Developer is categorized as a firm, organization or individual who

develops software for the purpose of:
a) Formatting returns according to the Service's electronic return

specifications; and/or,
b) Transmitting electronic returns directly to the Service. A software

developer may also sell its software.
3. A Transmitter is a firm, organization, or individual who transmits electronic

returns directly to the IRS Data Communication Subsystem This includes, but
is not limited to:
a) Entities which receive information to be reformatted and sent to IRS, i.e.

third party Transmitters; and
b) Entities which receive reformatted information then speed it up for

forwarding to the IRS (commonly know as providing "Bump-Up" services).
4. A Service Bureau is defined as a firm, organization, or individual who:
a) Receives tax return information on any media from an ERO, formats the
return information, and either forwards the return information to the
Transmitter or sends the return information back to the ERO; and
b) May or may not process Forms 8453 and send them to the appropriate
Service Center.
NOTE: A "Service Bureau" does not send returns directly to the IRS. If
returns are being sent directly to the IRS, the Service Bureau is a
"Transmitter".
B. All organizations or individuals that wish to be considered for participation in the

1996 Electronic filing program as NEW applicants, must submit a completed
Form 8633, Application to Participate in the Electronic Filing program. Applicants
should use the official Form 8633 or an approved substitute. Use of unapproved
forms could delay the acceptance for participation in the electronic filing program.
C. Applicants must file a NEW Form 8633 with fingerprint cards for the appropriate
individuals if:
1. The applicant has never participated in the electronic filing program;
2. The applicant has previously been denied participation in the electronic filing
program;
3. The applicant has been suspended from the electronic filing program.
NOTE: Applicants that are required to submit fingerprints must use an

official fingerprint card from the Internal Revenue Service. A
substitute fingerprint card cannot be used.
D. Applicants in one of the following categories may submit evidence of professional

status in lieu of the fingerprint card:
1. Attorney,
2. Certified Public Accountant (CPA),
3. Enrolled Agent,
4. Banking official who is bonded and has been fingerprinted within the last two
years, and
5. An Officer of a Publicly Owned Corporation.
E. The application period, for new applications, is from August 1 to December 1

each year.

F. The service can suspend, without notice, an Electronic Filer from the electronic
filing program. The suspension of an owner or a Responsible Official is also
grounds for suspension of all entities with whom the individual is associated.
G. An electronic filer shall comply with the advertising and solicitation provision of
the Treasury Department Circular No.230. Any claims concerning faster refunds
by virtue of electronic filing must be consistent with the language in official
service publications. In addition, the Electronic Filer must adhere to all state and
city consumer protection laws.
H. The use of improper methods of advertising may result in immediate suspension

from the electronic filing program. Violations include, but are not limited to:
1. The use of the Services name, "Internal Revenue Service", or "IRS" within a
firm's name; or
2. The use of improper or misleading advertising in relation to the electronic

filing program (including the time frames for refunds and RALs).
I. An electronic filer may only accept returns for electronic filing directly from Drop-
off Collection Point(s) accurately identified on Form 8633, taxpayers, or from
another accepted electronic filer.
J. If an electronic filer charges a fee for the electronic transmission of a tax return,
the fee may not be based on a percentage of the refund amount or on the
amount of taxes. An electronic filer may not charge a separate fee for Direct
Deposit.
K. An electronic filer must ensure that an electronic return is filed on or before the
due date of the return. A tax return is not considered filed until the electronic
portion of the tax return has been acknowledged as accepted for processing and
a completed and signed Form 8453 has been received by the IRS.

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IRS ENROLLED AGENT EXAMINATION

INTRODUCTION AND TIPS

INTRODUCTION AND Q & A's

Exam Applications available from IRS call 800-829-3676 June 1

Questions & Answers

Answer: There is no limit.

TIPS TO PASS THE EXAM

This page intentional blank.

Special Enrollment Examination (SEE)

Return label - Fill in your name and address below.

SEE Study Material Pamphlet

City State Zip

1. PART 1................................................................................................................ 1-1

PART 1 - THE INCOME TAX RETURN .................................................................... 1-4

Dynasty School (www.dynastySchool.com). 1-1

30. Miscellaneous Deductions............................................................................ 1-154

Dynasty School (www.dynastySchool.com). 1-2

 Section A The Income Tax Return

Publication 17 Tax Guide For Individuals

Dynasty School (www.dynastySchool.com). 1-3

PART 1 - THE INCOME TAX RETURN

2. Filing Status - As determined on the last day of the tax year.

3. Age - Considered 65 on the day before one's 65th birthday.

Filing Status Age 2001 2000

HH Underage 65 $9,550 $9,250

MFJ Both under age 65 $13,400 $12,950

Dynasty School (www.dynastySchool.com). 1-4

MFS* Any age $2,900 $2,800

QW Under age 65 $10,500 $10,150

No standard deductible allowed.

D. A self-employed individual is required to file if the gross income, including gross

Note: If you are self-employed in a business that provides services (where

1. The taxpayer owes any special taxes:

a) Social Security and Medicare tax on unreported tips,

2. The taxpayer received wages from a church or church related organization

3. The taxpayer received advanced earned income credit payments from an

F. The gross income filing requirements is different for dependents.

Table 2: 2001 Filing Requirements for Dependents (Pub. 501)

Dependent 2001 Must File If:

Dynasty School (www.dynastySchool.com). 1-5

Single, 65 or • Earned income was more than $5,650 ($6,750 if 65

Married, 65 or • Earned income was more than $4,700 ($5,600 if 65

Exercise 1: Rosa, who turned 14 on December 1, 2001, received interest income

Dynasty School (www.dynastySchool.com). 1-6

G. The standard deductions for 2001

However, if the individual is 65 or older or blind, the standard deduction

See Pub 501: Exemptions: Standard Deduction Charts & Worksheets.

Filing Status 2001 2000

* An additional standard deduction is available for the taxpayer and

Dynasty School (www.dynastySchool.com). 1-7

Dynasty School (www.dynastySchool.com). 1-8

3 With the automatic 4-month extension obtained by filing Form 4868,

4 With a second extension obtained by filing Form 2688, Application for

B. A special automatic 2 month extension to file and pay is available:

2. By attaching a statement to the return when it is filed.

C. Form 1040NR for Nonresident Aliens:

1. Nonresident aliens with wages subject to U.S. income tax withholding

Dynasty School (www.dynastySchool.com). 1-9

a) Married and living together as husband and wife,

Section A The Income Tax Return