Regulation 1

Individual Taxation: Filing Status

I. Filing

A. Requirement for Filing (Who must file?)

1. General Rule Generally, a taxpayer must file a return if his or her income is equal to

or greater than the sum of:o The personal exemption, pluso The regular standard deduction (except for married filing

separately), pluso The additional standard deduction amount for taxpayers over

age 65 or over or blind (Except for married persons filing separately).

2. Exceptions Certain individuals must file income tax returns even if their income is

lower than the “general rule” requirement.o Individuals whose net earnings from self-employment are $400

or more must file.o Individuals who can be claimed as dependents on another

taxpayer’s return, have unearned income, and gross income of $1,000 (2014) or more must file.

B. When to File

1. When to File – April 15th

2. Extension Automatic 6-Month Extension – October 15: An automatic 6-month

extension (until October 15) is available for those taxpayers who are unable to file on the April 15 due date by filing ss.

Payment of Tax – With either extension, the due date for payment of taxes remain April 15.

3. Taxpayers Who Are Out of the Country Taxpayers who are outside of the U.S. on the filing date and have

their principal place of business outside the U.S. or are stationed outside the U.S. have an automatic 2-month extension to file, but not to pay.

Do not need to file for the extension, but must include documentation if the extension is taken.

II. Filing Status

A. Single – Use the End-of-Year Test Any taxpayer who does not qualify for one of the other filing classes must use

the single status by default.o Single at year-endo Legally separated

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B. Joint Returns – Use the End-of-Year Test In order to file a joint return, the parties must be married at the end of the

year, living together in a recognized common law marriage, or married and living apart (but not legally separated or divorced).

o If one spouse dies during the year, a joint return may be filed.

C. Married Filing Separately

D. Qualifying Widow(er) (Surviving Spouse) With Dependent Child Two Years after Spouse’s Death – May use the joint tax return standard

deduction and rates (but NOT the exemption for the deceased spouse) for each of two taxable years following the year of death of his or her spouse, unless he or she remarries.

Principal Residence for Dependent Child – The surviving spouse must maintain a household that, for the whole taxable year, was the principal place of abode of a son, stepson, daughter, or stepdaughter.

E. Head of Household The following conditions must be met:

o The individual is not married, is legally separated, or is married and has lived apart from his/her spouse for the last 6 months of the year as of the close of the taxable year.

o The individual is not a “qualifying widow(er).”o The individual is not a non-resident alien.o The individual maintains as his or her home a household that, for

more than half the taxable year, is the principal residence of: A dependent son or daughter (or descendant) Father or mother (not required to live with taxpayer) Dependent relatives (must live with taxpayer).

Pass key : In order to avoid confusing the required time period for different filing statuses, just remember:

o W – Widow = Whole yearo H - Head of household = Half year

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Individual Taxation: Exemptions

I. Personal Exemptions Generally, an individual is entitled to a personal exemption that is indexed

annually for inflation. For 2015, this amount is $4,000.

A. Persons Claimed as Dependents Persons eligible to be claimed as dependents on another’s tax return will not

be allowed a personal exemption on their own returns.

B. Married Taxpayers The exemption for a spouse is always considered to be a personal exemption

(not a dependency exemption), even if the spouse does not work. Spouse as Personal Exemption on a Separate Return - A married taxpayer

filing separately may claim his or her spouse’s personal exemption if both of the following tests are met:

o The taxpayer’s spouse has no gross income; ando The taxpayer’s spouse was not claimed as a dependent of another

taxpayer.

C. Birth or Death During Year If a person is born or dies during the year, he or she is entitled to either a

personal or a dependency (as appropriate) exemption for the entire year. Exemptions are not prorated.

D. Phase-Out of Personal Exemptions The phase-out reduces exemptions by 2% for every $2,500 or portion thereof

($1,250 for MFS) by which AGI exceeds:

Joint/Surviving Spouse $309,900Head of Household $284,050

Single $258,250Married Filing Separately $154,950

II. Dependency Exemptions (Part of Personal Exemptions) Each taxpayer is entitled to an exemption for each qualifying child (CARES)

and qualifying relative (SUPORT). The amount of this exemption is $4,000 for 2015. Taxpayers must obtain a

SSN for any dependent who has attained the age of one as of the close of the tax year.

A. Qualifying Child If the parents of a child are able to claim the child but do not, no else may

claim the child unless that taxpayer’s AGI is higher than the AGI of the highest parent.

In general, a child is a qualifying child of the taxpayer if the child satisfies the following:

o Close relative – The child must be the taxpayer’s son, daughter, stepson, stepdaughter, brother, sister, stepbrother, stepsister, or a descendant of any of these.

o Age limit – A child must be younger than the taxpayer, and under age 19 (or age 24 in the case of a full-time student) to be a qualifying child.

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o Residency and Filing Requirements – A child must have the sample principal place of abode as the taxpayer for more than one half of the tax year.

o Eliminate Gross Income Test (but exemption is required) – The gross income test does not apply to a qualifying child. However, the child is a qualifying child only if the taxpayer can and does claim an exemption for the child.

o Support Test Changes – The support test has been modified to determine if the child did not contribute more than one-half of his or her own support. The requirement that the taxpayer (parent) provides over one-half of the child’s support is eliminated.

B. Qualifying Relative Taxpayers can apply the “SUPORT” dependency exemption rules to claim a

dependency exemption for a qualifying relative who does not satisfy the qualifying child requirements.

o Support Test – The taxpayer must have supplied more than one-half of the support of a person in order to claim him or her as a dependent.

Multiple Support Agreements – When 2 or more taxpayers together contribute more than 50% to the support of a person but none of them individually contributes more than 50%, the contributing taxpayers, all of whom must be qualifying relatives of (or lived the entire year with) the individual, may agree among themselves which contributor may claim the dependency exemption.

A contributor must have contributed more than 10% of the person’s support in addition to meeting the other dependency tests in order to be able to claim him or her as a dependent.

The joint contributors are required to file a multiple support declaration – Form 2120.

o Under Exemption Amount of Taxable Gross Income – A person may not be claimed as a dependent unless the dependent’s gross income is less than the exemption amount ($4.000 during the taxable year 2015).

Only income that is taxable is included for the purpose of determining whether the dependent has earned less than the exemption amount.

o Precludes Dependent Filing a Joint Return – A taxpayer will lose the exemption for a married dependent who files a joint return unless the joint return is filed solely for a refund of all taxes paid or withheld for the taxable year (i.e. the tax is zero).

o Only Citizens of the U.S. or Residents of the U.S., Mexico, or Canadao Relative

ORo Taxpayer Lives With the Individual (if Nonrelative) for the Whole

Year

C. Child of Divorced Parents

1. General Rule – Custodial Parents

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Generally, the parent who has custody of the child for the greater part of the year takes the exemption (determined by a “time” test, not the divorce decree).

If the parents have equal custody during the year, the parent with the higher AGI will claim the exemption.

2. Exception – Custodial Parent Waives Right A noncustodial divorced or separated parent may claim the exemption

for his or her child if the custodial parent waives the right to the exemption.

o This is done by the custodial parent’s signing of a written declaration that is attached to the noncustodial parent’s return.

o Form 8332 is used as the required written declaration. The custodial parent may revoke the release of claim using the Form

8332 provided (1) notice is given to the noncustodial parent at least one tax year in advance, and (2) a copy of Form 8322 claiming the revocation is attached to the custodial parent’s tax return.

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Individual Taxation: Gross Income

I. Gross Income In General

A. Gross Income Defined

B. Computation of Income – General Rule In cases of noncash income, the amount of income is the FMV of the

property or services received.

C. Realization and Recognition In order to be taxable, the gain must be both realized and recognized.

D. Timing of Revenue Recognition Accrual Method = Taxable when earned Cash Method = Taxable in the period the revenue is actually or

constructively received in cash or (FMV) property

E. Characterizations of Income

1. Ordinary

2. Portfolio

3. Passive – Only passive losses may offset passive income, and a net passive loss is not deductible on the tax return (it is suspended and carried forward until passive income exists to offset it), unless an exception exists and the requirement for passive treatment is removed.

4. Capital

II. Specific Items of Income and Exclusions

A. Salaries and Wages Gross income includes many forms of compensation for services.

1. Money

2. Property – FMV of all property is included as gross income.

3. Cancellation of Debt

4. Bargain Purchases If an employer sells property to the employee for less than its FMV,

the difference is income to the employee.

5. Guaranteed Payments to a Partner Guaranteed payments are reasonable compensation paid to a partner

for services rendered (or use of capital) without regard to the partner’s ratio of income.

Also subject to self-employment tax

6. Taxable Fringe Benefits The FMV of a fringe benefit not specifically excluded by law is

includable in income.

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Also subject to employment taxes and withholding

7. Partially Taxable Fringe Benefits – Portion of Life Insurance Premiums Premiums paid by an employer on a group-term life insurance policy

covering his employees are not income to the employees up to the cost on the first $50,000 of coverage per employee (nondiscriminatory plans only).

Premiums above the first $50,000 of coverage are taxable income to the recipient and normally included in W-2 wages.

8. Nontaxable Fringe Benefits Life insurance proceeds – The proceeds of a life insurance policy paid

because of the death of the insured are generally excluded from the gross income of the beneficiary.

o The interest income element on deferred payout arrangements is fully taxable.

Accident, Medical, and Health Insurance (employer paid) – Premium payments are excludable from the employee’s income when the employer paid the insurance premiums, but amounts paid to the employee under the policy are includable income unless such amounts are:

o Reimbursement for medical expenses actually incurred by the employee;OR

o Compensation for the permanent loss or loss of use of a member or function of the body.

De Minimis Fringe Benefits Meals and Lodging – The gross income of an employee does not

include the value of meals and lodging furnished to him or her in kind by the employer for the convenience of the employer on the employer’s premises. Additionally, in order to be nontaxable, the lodging must be required as a condition of employment.

Employer Payment of Employee’s Educational Expenses – Up to $5,250 may be excluded from gross income of payments made by employer on behalf of an employee’s education expenses. The exclusion applies to both undergraduate and graduate level education.

Qualified Tuition Reductions – Employees of educational institutions studying at the undergrad level who receive tuition reductions may exclude the tuition reduction from income. Graduate students may exclude tuition reduction only if they are engaged in teaching or research activities and only if the tuition reduction is in addition to the pay for the teaching or research.

Qualified Employee Discounts – Employee discounts on employer-provided merchandise and service are excludable as follows:

o Merchandise Discounts – The excludable discount is limited to the employer’s gross profit percentage. Any excess must be reported as income.

o Service Discounts – The excludable discount on services is limited to 20% of the FMV of the services. Any excess discount must be reported as income.

o Employer-Provided Parking – The value of employer-provided parking up to $250 per month may be excluded.

o Transit Passes – The value of employer-provided transit passes up to $130 per month may be excluded.

Qualified Pension, Profit-Sharing, and Stock Bonus Plans

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o Payments Made by Employer – Not income to the employee at the time of contribution

o Benefits received (taxable) – The amount that is exempt from tax (plus any income earned on such amount) is taxable to the employee in the year in which the amount is distributed or made available to the employee.

Flexible Spending Arrangements (FSAs)o Pretax Deposits into Employee’s Account – Employees have the

ability to elect to have part of their salary (generally up to $2,550 per year) deposited pretax into a flexible spending accounting designated for them (must be done via salary reduction directly by the employer).

o Forfeits Funds Not Used Within 2 ½ Months after Year-End – Funds not used within 2 ½ months after the year-end or not claimed within a period of time (usually 6 months) are forfeited. However, this grace period only applies if the employer amended the plan accordingly.

B. Interest Income1. Taxable Interest Income

Federal bonds Premiums received for opening a savings account (e.g. prizes and

awards) are included at FMV Interest paid by the federal or state government for late payment of a

tax refund

2. Tax-Exempt Interest Income (reportable but not taxable) State and local government bonds/obligation and mutual fund

dividends for funds invested in tax-free bonds Bonds of a U.S. Possession Series EE – Interest on Series EE Savings bonds is tax-exempt when:

o It is used to pay for higher education (reduced by tax-free scholarships) of the taxpayer, spouse, or dependents;

o There is taxpayer or joint ownership (spouse);o The taxpayer is over age 24 when issued; ando The bonds are acquired after 1989.

Veterans Administration Insurance

3. Unearned Income of a Child under 18 (“kiddie tax”) The net unearned income of a dependent child under 18 years of age

(or, a child age 18 to age 24 who does not provide over half of his/her own support and is a full-time student) is taxed at the parent’s higher tax rate.

The child’s allowable 2015 standard deduction of $1,050 (or investment expense, if greater) plus an additional $1,050 (which is taxed at the child’s rate).

2015 Child’s Unearned Income

Tax Rate

0 - $1,050 0%$1,051 - $2,100 Child’s

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$2,101 and over Parent’s

4. Forfeited Interest (Adjustment) – Penalty on Withdrawal From Savings Forfeited interest is a penalty for early withdrawal of savings

(generally on a time deposit, such as a certificate of deposit, at a bank).

The amount forfeited is deductible as an adjustment in the year the penalty is incurred.

C. Dividend Income

1. Source Determines Taxability

2. Three Categories of Dividends Taxable Dividends

o Special (Lower) Tax Rate Qualified Dividends Holding Period – The stock must be

held for more than 60 days during the 120-day period that begins 60 days before the ex-dividend date (the date of which a purchased share no longer is entitled to any recently declared dividends).

Tax rates (2015) 15% - Most taxpayers 20% - High income taxpayers 0% - Low income taxpayers (those in the 10% or

15% ordinary income tax bracket) Tax-Free Distributions – The following items are exempt from gross

income:o Return of capitalo Stock splito Stock dividendo Life insurance dividends – Dividends caused by ownership of

insurance with a mutual company (premium return) Capital Gain Distribution

3. Medicare Tax Starting in 2013, certain unearned income is subject to a new 3.8%

Medicare tax. The tax is levied on the lesser of (1) the taxpayer’s net investment

income, or (2) the excess of modified AGI for the tax year over the threshold amount of $200,000 ($250,000 for married filing jointly, and $125,000 for married filing separately).

o Modified AGI is a taxpayer’s AGI adjustment for certain foreign income exclusions.

D. State and Local Tax Refunds The receipt of a state or local income tax refund in a subsequent year is not

taxable if the taxes paid did not result in a tax benefit in the prior year.o Itemized in prior year = State or local refund is taxable (unless a

competing tax law, such as alternative minimum tax, caused the initial taxes paid to be nondeductible)

o Standard deduction used in prior year = Nontaxable state or local refund

E. Payments Pursuant to a Divorce

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1. Alimony/Spousal Support (income) – Payments for the support of a spouse are income to the spouse receiving the payments and are deductible to arrive at adjusted gross income (adjustment) by the contributing spouse. To be deemed alimony under the tax law:

Payments must be legally required pursuant to a written divorce (or separation) agreement;

Payments must be in cash (or its equivalent); Payments cannot extend beyond the death of the payee-spouse; Payments cannot be made to members of the same household; Payments must not be designated as anything other than alimony; and The spouses may not file a joint tax return.

2. Child Support Nontaxable – If any portion of the payments is fixed by the decree or

agreement as being for the support of minor children (or is contingent on the child’s status, such as reaching a certain age), such portion is not deductible by the spouse making payment and is not includable by the spouse receiving payment.

3. Property Settlements (nontaxable) If a divorce settlement provides for a lump-sum payment or property

settlement by a spouse, that spouse gets no deduction for payments made, and the payments are not includable in the gross income of the spouse receiving the payment.

F. Business Income or Loss, Schedule C or C-EZ

1. Gross Income

2. Expenses Cost of goods Salaries and commissions paid to others State and local business taxes paid Business meal and entertainment expenses at 50% Interest expense on business loans (interest expense paid in advance

by a cash basis taxpayer cannot be deducted until the tax year/period to which the interest relates).

Bad debts actually written off for an accrual basis taxpayer only (the direct write off method, not the allowance method, is used for tax purposes).

3. Nondeductible Expenses (for Schedule C) Salaries paid to the sole proprietor (they are considered a “draw”). Federal income tax Personal portion of:

o Automobile, travel, and vacation expenseso 100% of country club dues are nondeductibleo Interest expense – This may be reported as an itemized

deduction if mortgage interest or investment interest is paid.o State and local tax expense – Report as an itemized deduction

on Schedule A

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o Health insurance of a sole proprietor – While this is not reported on Schedule C as an expense, it is reported as an adjustment to arrive at AGI.

o Bad debt expense of a cash basis taxpayer (who never reported the income)

o Charitable contributions – Report as an itemized deduction on Schedule A

4. Net Business Income or Loss There are two taxes on net business income:

o Income taxo Federal self-employment (S/E) tax

An adjustment to income is allowed for one-half (which is 7.65% of up to $118,500 of self-employment income in 2015 plus 1.45% of self-employment income thereafter, if applicable) of S/E tax (Medicare plus Social Security) paid.

This allows the sole proprietor the ability to “deduct” the employer portion of the S/E tax as an adjustment to gross taxable income (of which the net Schedule C amount is a part).

All self-employment income is subject to the 2.9% Medicare tax, but only up to $118,500 in 2015 is subject to the 12.4% Social Security tax (i.e., a total of 15.3% on self-employment earnings up to $118,500 in 2015).

Net taxable loss – A business with a loss may deduct the loss against other sources of income.

o 2-year carrybacko 20-year carryforward

5. Husband and Wife Qualified Joint Venture Election Certain married persons who operate a business together may elect to

simplify their tax reporting requirements by not filing a partnership income tax return and instead reporting on their jointly filed personal income tax return.

The election is made on the jointly-filed Form 1040 by having each spouse report his/her respective portions of the business activity (based on ownership interest) separately as a sole proprietor on either a Schedule C or a Schedule F. Social security and Medicare taxes will apply to each spouse separately.

6. Uniform Capitalization Rules The uniform capitalization rules do not apply to (inventory) property

acquired for resale if the taxpayer’s average gross receipts for the preceding three tax years do not exceed $10,000,000 annually.

Capitalized as inventory: DM, DL, FOH Period expense: Selling, General, Administrative, and R&D

7. Long-Term Contracts Percentage-of-Completion Method Required for Tax for Nonexempt

Long-Term Contracts – Unless an exemption exists for a taxpayer or a contract, long-term contracts must be accounted for using the percentage-of-completion method to determine taxable income for a particular contract.

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Exemptions – Certain contracts are exempt from the requirements long-term contract income recognition for tax purposes and may use other methods (E.g., completed contract method) to calculate their taxable income under the contract for regular income tax purposes. These include:

o Small contracts (projects that are expected to last no more than two years and are performed by a taxpayer who has average annual gross receipts not exceeding $10 million for the three years that precede the tax year in question).

o Home construction contractso A long-term construction contract that includes land and where

less than 10% of the total contract costs relates to the actual construction of property on the land

o Services performed by architects, engineers, designers, construction management advisors, and software implementation personnel related to the long-term project (i.e., those who are contracted by a taxpayer involved in a long-term contract to perform services but are not generally responsible for the final product under contract)

o Services performed under warranty and maintenance agreements related to the long-term contract

For cash basis taxpayers, the starting date of production is generally the date on which the contract incurs costs.

For accrual basis taxpayers, the starting date is the later of the date for cash basis taxpayers or the date the taxpayer has incurred at least 5% of the total costs initially estimated under the contract.

G. Farming Income

1. General Schedule F (carries to the face of Form 1040, line 18)

2. Cash Basis and Accrual Method Cash Basis

o Most farmers use the cash basis.o Inventories of produce, livestock, etc., are not considered.o Inventory = Expense (not capitalized)

Accrual Methodo The accrual method is required for certain corporate and

partnership farmers as well as for all farming tax shelters.o Inventories must be used and maintained. o The following methods of inventory valuation for farming are

accepted by the IRS: Cost Lower of cost or market Farm-price method (inventory is valued at the market

price less the disposition costs and generally must be used for all items inventories by the farming business, except for any livestock valued using the unit-livestock-price method).

Unit-livestock-price method (uses a value for each livestock class at a standard unit price for animals within the class).

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o Gross profit equals the value of inventories at year-end plus the proceeds received from the sales during the year, less the value of inventories at the beginning of the year, less the cost of inventory purchased during the year.

H. Gains and Losses on Disposition of Property Amount realized<Adjusted Basis of Assets Sold> Gain or Loss Realized

I. IRA Income

1. General Rules (taxable when withdrawn) Generally, retirement money cannot be withdrawn until the individual

reaches the age of 59½ (except in certain situations) or the individual elects to receive equal periodic distributions over his life.

A taxpayer is required to start withdrawals by the age of 70½. Benefits are not taxable until the taxpayer receives the distribution.

2. Taxation of Distributions (benefits) Regular Tax

o Ordinary Income (traditional deductible IRA distributions) – When a person retires, the funds will be taxed as ordinary income when received (regardless of what of income, such as capital gain, was earned while the funds were invested).

o Roth IRA – All qualified benefits received form a Roth IRA are nontaxable.

o Traditional Nondeductible IRA – Principal = Nontaxable Accumulated earnings = Taxable

Penalty Tax (10%) - Generally, a premature distribution is subject to a 10% penalty tax if the individual has not met an exception.

Exception to Penalty Tax (still subject to ordinary income tax) – There is no penalty if the premature distribution was used to pay:

o Home buyer (1st time): $10,000 maximum exclusion applies if the distribution is used toward the purchase of a first home (within 120 days of the distribution)

o Insurance (medical) Unemployed with twelve consecutive weeks of

unemployment compensation Self-employed (who are otherwise eligible for

unemployment compensation)o Medical expenses in excess of 10% of AGIo Disability (permanent or indefinite disability, but not

temporary disability)o Education: College tuition, books, fees, etc.o Death

Excess contributions to the plan are subject to a cumulative 6% excise tax each year until the excess is corrected.

J. Annuities

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The investment amount is divided by a factor representing the number of months over which the investment will be recovered.

o This factor is based on the age of the annuitant at the start of the payout period.

If the annuitant lives longer than factor period, then further payments are fully taxable.

If the annuitant dies before the factor period, the unrecovered portion is a miscellaneous itemized deduction on the annuitant’s final income tax return not subject to the 2% of the AGI floor.

K. Rental Income (passive activity) Schedule E is used to compute supplemental income and/or loss from:

o Rental real estateo Royaltieso Partnerships and LLCo S Corporationso Estateso Trusts

1. GeneralGross Rental IncomePrepaid Rental IncomeRent Cancellation PaymentsImprovement In-Lieu-of Rent<Rent Expenses>Net Rental Income/Loss

2. Rental of Vacation Home Rented Less than 15 days – Treated as a personal residence; Rental

income is excluded from income, and mortgage interest (first or second home) and real estate taxes are allowed as itemized deductions.

o Depreciation, utilities, and repairs are not deductible. Rented 15 or more days – If the residence is rented for 15 or more

days, and is used for personal purposes for the greater of (i) more than 14 days or (ii) more than 10% of the rental days, it is treated as a personal/rental residence.

o Expenses must be prorated between personal and rental use.o Rental use expenses are deductible only to the extent of rental

income.

3. Passive Activity Losses (PALs)

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Deductibility o A net passive activity loss may not be deducted against

wages, salaries, and other active income or against portfolio (interest and dividends) or capital gains income.

o Expenses related to passive activities can de deducted only to the extent of income from all passive activities.

Nondeductible PALso Carry forward without any time limit unused passive activity

losses held in suspension. Suspended losses are used to offset passive income in

future years. If still unused, suspended losses become fully tax

deductible in the year the property is disposed of (sold). If the taxpayer becomes a material participant in the

passive activity (therefore changing from “passive” to “active”), unused passive losses from the activity can be used to offset the taxpayer’s active income in the same activity.

o PAL (Disallowed Net Loss) Exceptions – An individual may deduct rental activity losses (although deduction may be limited) if either of the following two conditions are met:

Mom and Pop Exception $25,000 and “Active” – Taxpayers may deduct

$25,000 per year of net passive losses attributable to rental real estate

Phase-out – The $25,000 allowance is reduced by 50% of the excess of the taxpayer’s AGI (without consideration of this loss deduction) over $100,000. This allowance is eliminated completely when AGI exceeds $150,000.

Real Estate Professional (not passive activity) – The taxpayer can fully deduct losses from the rental activities against other income if:

More than 50% of the taxpayer’s personal services during the year are performed in real property businesses; and

The taxpayer performs more than 750 hours of services in real property businesses during the year.

L. Unemployment Compensation

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A taxpayer must include in gross income the full amount received for unemployment compensation.

M. Social Security Income Low income – No Social Security benefits are taxable (income below: Single

$25,000 / MFJ $32,000) Upper Income – 85% of Social Security benefits are taxable (income over:

Single $34,000 / MFJ $44,000) Middle Income – 50% of Social Security benefits are taxable (income over:

Single $25,000 / MFJ $32,000)

N. Taxable Miscellaneous Income Prize and Awards – The FMV of prizes and awards is taxable income. An

exclusion from income for certain prizes and awards applies where the winner is selected for the award without entering into a contest and assigns the award directly to a governmental unit or charitable organization.

Gambling Winnings and Losses – Gambling winnings are included in gross income. Gambling losses may only be deducted to the extent of gambling winnings.

Business Recoveries – If a damage award is compensation for lost profit, the award is income.

Punitive damages – Punitive damages are fully taxable as ordinary income if received in a business context for loss of personal reputation. Punitive damages received by an individual in a personal injury case are also taxable except in wrongful death cases where state law has limited wrongful death awards to punitive damages only.

O. Partially Taxable Miscellaneous Items – Scholarships and Fellowships Scholarships and fellowship grants are excludable only up to amounts

actually spent on tuition, fees, books, and supplies (not room and board) provided:

o The grant is made to a degree-seeking student;o No services are to be performed as a condition to receiving the grant;

ando The grant is not made in consideration for past, present, or future

services of the grantee. Scholarships and fellowships awarded to non-degree-seeking students are

fully taxable at FMV. Graduate teaching assistant and research assistants who receive tuition

reductions are taxed on the reduction if it is their only compensation, but not if the reduction is in addition to other taxable compensation.

P. Nontaxable Miscellaneous items

1. Life Insurance Proceeds (nontaxable) – The proceeds of a life insurance policy paid because of the death of the insured are excluded from the gross income of the beneficiary.

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The interest income element on deferred payout arrangements is fully taxable.

2. Gifts and Inheritances (nontaxable) – Gross income does not include property received from a gift or inheritance; however, any income received from such property (e.g., interest income, rental income, etc.) after the property is in the hands of the recipient is taxable.

3. Medicare Benefits (nontaxable) – Exclude from gross income basic Medicare benefits received under the Social Security Act.

4. Workers’ Compensation (nontaxable) – Exclude from gross income

5. Personal (Physical) Injury or Illness Award (nontaxable) – Exclude from gross income

6. Accident Insurance – Premiums Paid by Taxpayer (nontaxable) – Exclude from gross income all payments received (Even with multiple recoveries) if the individual paid all premiums for the insurance

7. Foreign-Earned income Exclusion – Taxpayers working abroad may exclude from gross income up to $100,800 (2015) of their foreign-earned income. In order to qualify for the exclusion, the taxpayer must satisfy one of the following two tests:

Bona Fide Residence test – The taxpayer must have been a bona fide resident of a foreign country for an entire taxable year.

Physical Presence test – The physical presence test requires that the taxpayer must have been present in the foreign country for 330 full days out of any 12 consecutive month period (which may begin on any day).

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Employee Stock Options

I. Employee Stock Options

A. Nonqualified Options A nonqualified option is taxed when granted if the option has a readily

ascertainable value when granted. Otherwise, the option is taxed when exercised.

1. Definition of Readily Ascertainable Value If the option is traded on an established market, it will have a readily

ascertainable value. Otherwise, it will only have a readily ascertainable value if all of the

following conditions are met:o The option is transferable.o The option is exercisable immediately in full when it is granted.o There are no conditions or restrictions that would have a

significant effect on the value.o The fair value of the option privilege is readily ascertainable.

2. Employee Taxation – Readily Ascertainable Value If there is a readily ascertainable value, the employee recognizes

ordinary income in that amount in the year granted. If there is a cost to the employee, then the ordinary income is the

value of the option minus the cost. The basis of the stock is the exercise price plus any amount previously

taxed on the date of grant. The holding period begins with the exercise date. If the employee allows the options to lapse (not exercised), there is a

capital loss based on the value of the options previously taxed.

3. Employee Taxation – Without Readily Ascertainable Value If there is no readily ascertainable value, then the taxable event is the

exercise date, not the grant date. On the date of exercise, the employee recognizes ordinary income

based on the FMV of the stock purchased less amounts paid (if any) for the option.

The holding period begins with the exercise date. If the options lapse, there are no tax consequences.

4. Employer Taxation An employer may deduct the value of the stock option as a business

expense in the same year that the employee is required to recognize the option as ordinary income.

B. Qualified Options

1. Incentive Stock Options Requirements

o An ISO is usually granted to a key employee and is a right to purchase the stock at a discount.

o The exercise price may not be less than the FMV of the stock at the date of the grant.

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o The employee may not own more than 10% of the combined voting power of the corporation, parent, or subsidiary as of the date of the grant.

o Once exercised, the stock must be held at least two years after the grant date and at least on year after the exercise date.

o The employee must remain an employee of the corporation from the date the option is granted until three months (one year if due to permanent and total disability) before the option is exercised.

Employee Taxationo Generally, there is no taxation of the option as compensation. o Generally, any gain or loss on a subsequent sale of the stock is

capital.o If the holding period requirements above are not satisfied, any

gain is ordinary up to the amount that the stock’s FMV on the exercise date exceeded the option price.

o An employee may exercise up to $100,00 of ISOs in a year. Any amount exercised that exceeds this will be treated as a nonqualifying option.

o The excess of the FMV of the stock on the exercise date less the purchase price is a preference item for ATM.

Employer Taxationo An employer does not receive a tax deduction for an ISO

because it is not considered compensation income to the employee.

2. Employee Stock Purchase Plans An ESPP may grant options to employees to purchase stock in the

corporation. Requirements

o An ESPP cannot grant options to any employee who has more than 5% combined voting power of the corporation, parent, or subsidiary.

o The option exercise price may not be less than the lesser of 85% of the FMV of the stock when granted or exercised.

o The option cannot be exercised more than 27 months after the grant date.

o Once exercised, the stock must be held at least two years after the grant date and at least one year after the exercise date.

o The employee must remain an employee of the corporation from the date the option is granted until three months before the option is exercised.

Employee Taxationo There is no taxation of the options as compensation.o The basis of the stock is the exercise price plus any amount

paid for the option (if any).o Any gain or loss on a subsequent sale of the stock is capital.o If the holding period requirements above are not satisfied, any

gain is ordinary up to the amount that the stock’s FMV on the exercise date exceeded the option price.

o If the option price is less than FMV of the stock on the grant date, ten ordinary income is recognized as the lesser of the difference of the FMV of the stock when sold and the exercise

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price, or the difference between the exercise price and the FMV of the stock on the grant date.

Employer Taxationo An employer does not receive a tax deduction for an ESPP

because it is not considered compensation income to the employee.

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