Fundamentals of Taxation for Individuals and Business Entities, with eBook Access Code

GREGORY A. CARNES is the Raburn Eminent Scholar of Accounting at the University of North Alabama. He served as Dean of Sanders College of Business and Technology for 11 years. With a passion for education and taxation, he has dedicated his career to teaching accounting students and guiding them toward successful careers. Specializing in tax, he has taught for over 25 years in CPA review programs and professional tax seminars. In addition to his teaching, he is an accomplished author of tax textbooks and over 30 academic articles. SUZANNE YOUNGBERG joined the faculty at Northern Illinois University as a full-time member in 2000 and is currently teaching in the accounting graduate and undergraduate programs. Prior to NIU, she worked for five years in the tax department of a medium-sized public accounting firm and then maintained her own tax practice for 30 years specializing in Individual and small business compliance and strategic tax planning. Suzanne received her Bachelor of Science in Accountancy from NIU and her Master of Science in Taxation from DePaul University.

• Table of ContentsDEDICATION IIIBRIEF CONTENTS VLEARNING THE BIG PICTURE OF TAX TO BE A VALUEDPROFESSIONAL VIWHAT ARE OUR STORIES? VIIWHAT MAKES OUR APPROACH TO LEARNING TAXDISTINCTIVE? IXASSESSMENT XIIICONNECTING TO THE PROFESSION XVIAN INTERACTIVE, MULTIMEDIA LEARNINGEXPERIENCE XVIIIPREPARING FOR THE CPA EXAM XIXFOR INSTRUCTORS XXACKNOWLEDGMENTS XXITABLE OF CONTENTS XXIIIPart I Introduction to Income Taxation1 The Professional Practice ofTaxation 1-11.1 The Basics of Tax Planning 1-4The IRS: An Uninvited Third Party 1-4The Goal of Tax Planning 1-5Considering Tax Costs and Non-Tax Costs 1-61.2 Individual Income Tax Formula 1-71.3 Tax Compliance vs. Tax Planning 1-15Closed vs. Open Transactions 1-15Marginal Tax Rates, Average Tax Rates, and EffectiveTax Rates 1-16Tax Planning Opportunities 1-201.4 Tax Avoidance vs. Tax Evasion 1-27Tax Evasion 1-27Spotlight on the Law: Is the Tax LawUnconstitutional? 1-28Tax Ethics 1-291.5 Tax Rules vs. GAAP 1-311.6 Goals of Tax Policymakers 1-33Raise Revenue 1-33Social Objectives 1-33Economic Objectives 1-34Equity Objectives 1-35Political Objectives 1-371.7 Other Taxes Paid by Individuals 1-38Other Federal Taxes 1-38State and Local Taxes 1-39Implicit Taxes 1-391.8 Professional Taxation as a Career 1-41The Role of a Tax Professional 1-41Characteristics of Successful TaxProfessionals 1-42Artificial Intelligence in Taxation 1-422 Fundamentals of the FederalIncome Tax System 2-12.1 Taxpayer Activities: Trade or Business, Investment,or Personal Use 2-4Trade or Business 2-4Investment Activities 2-5Personal Activities 2-72.2 Classification of Assets 2-10Ordinary, Section 1231, and Capital 2-10Spotlight on the Law: Classification of an Asset:Sell Now or Later? 2-11Realty vs. Personalty 2-12Holding Period 2-132.3 Basis 2-14What Is Basis? 2-14Recovery of Basis 2-152.4 Foundations of Income 2-17An All-Inclusive Definition of Income 2-18Realization of Income 2-18Income and Basis 2-192.5 Foundations of Deductions 2-21Is an Expenditure Deductible? 2-21Where Are Expenses Deductible? 2-232.6 Introduction to Property Transactions 2-24Gains and Losses from Sales andDispositions 2-24Deferred Gains and Losses 2-27Excluded Gains and Losses 2-32  3 Tax Authority, Research,Compliance Rules, andProfessional Responsibilities 3-13.1 Sources of Tax Authority 3-5Legislative Sources of Tax Authority 3-6Administrative Sources of Tax Authority 3-8Judicial Sources of Tax Authority 3-11Spotlight on the Law: Impact of Filing a Petition Late 3-13Secondary Sources of Tax Authority 3-163.2 Locating and Evaluating Authority 3-17Weighting of Tax Authority 3-17The Research Process 3-183.3 Compliance Responsibilities 3-20Filing Requirements 3-20Taxpayer Penalties 3-223.4 Tax Professional Responsibilities 3-31Circular 230 3-31Statements on Standards for Tax Services (SSTS) 3-343.5 Tax Practice and Procedure 3-36Audit Process 3-37Appeals Process 3-39Other Audit Issues 3-39Signing a Return 3-404 Dependents and Filing Status 4-14.1 Dependents—Introductionand Qualifying Child 4-3General Rules for Dependency 4-4General Rules for Qualifying Child 4-4Tiebreaker Rules 4-7Unmarried Parents 4-8Spotlight on the Law: Can I Claim My Dog as aDependent? 4-104.2 Qualifying Relative and Other DependencyRules 4-11General Rules for Qualifying Relative 4-11Other Dependency Rules 4-134.3 Filing Status—Introduction 4-16General Rules for Married Filing Jointly (MFJ) andSingle 4-17Married Filing Separately (MFS) 4-19Innocent Spouse Relief 4-204.4 Head of Household and Qualifying Widow(er) 4-21General Rules for Head of Household Status 4-21Qualifying Widow(er) 4-254.5 Dependent on Another Returnand Kiddie Tax 4-28Standard Deduction for a Dependent 4-28Kiddie Tax 4-294.6 Filing Requirements 4-32Part II Income5 Framework for IncomeRecognition 5-15.1 All-Inclusive Approach to Income 5-4Determining Income Recognition 5-5Form of Receipt 5-5Treasure Trove Principle 5-6Spotlight on the Law: Great Catch but Beware of theTaxes! 5-75.2 Judicial Doctrines 5-8Constructive Receipt Doctrine 5-9Tax Benefit Rule 5-10Claim of Right Doctrine 5-12Assignment of Income Doctrine 5-135.3 Accounting Methods and Periods—Income 5-14Cash vs. Accrual Method of Accounting 5-14Recovery of Capital 5-16Installment Sales 5-17Income from Community Property 5-22Change in Accounting Method 5-235.4 Business Income for Individuals 5-24Sole Proprietorships and Single Member LLCs 5-24Rental Real Estate 5-26Royalty Income: Investment or Business? 5-27Income from Other Flow-Through Entities:Partnerships, Limited Liability Companies (LLCs),and S Corporations 5-27Advanced Topic—Drilling Down 5-285.5 Qualified Business Income Deduction 5-30Qualified Business Income 5-30Rental Real Estate 5-31Determining the Qualified Business IncomeDeduction (Steps 1–5) 5-31Determining the Qualified Business IncomeDeduction (Steps 6–7) 5-36Determining the Qualified Business IncomeDeduction (Step 8) 5-38Minimum QBI Deduction 5-39Advanced Topics—Drilling Down 5-396 Income from PersonalActivities 6-16.1 Income from Prizes, Awards, and Scholarships 6-6Taxable Prizes and Awards 6-6Exclusion for Awards for Recognition of Civicor Other Achievements 6-7Exclusion for Olympic Medals 6-7Scholarships 6-8and Inheritances 6-15Basis and Holding Period Issues for PropertyReceived as Gift 6-16Basis and Holding Period Issues forInheritances 6-21Basis and Issues for Property Convertedfrom Personal Use 6-22Advanced Topic—Drilling Down 6-246.4 Income from Injuries and Other DamageAwards 6-26Determining the Tax Implications of Damage Awards:Key Questions 6-27Legal Fees and Damage Awards 6-296.5 Income from Death of a Taxpayer 6-31General Rule 6-31Exceptions to the General Rule 6-32Advanced Topic—Drilling Down 6-346.6 Forgiveness of Debt 6-35Love or Generosity 6-36Bankruptcy 6-36Insolvency 6-38Real Property Used in a Trade or Business 6-38Other Debt Forgiveness 6-38Spotlight on the Law: Is Debt Forgiveness AlwaysEquitable? 6-396.7 Other Inclusions and Exclusions 6-40Foster Child Payments 6-41Government Assistance Program Payments(Welfare) 6-41Parsonage 6-41Income in Respect of a Decedent (IRD) 6-42Jury Duty Pay 6-43Unemployment Compensation 6-437 Income from Services 7-17.1 Wages and Tip Income 7-6Wages 7-7Tip Income 7-97.2 Income from Insurance-RelatedFringe Benefits 7-12Discrimination Rules 7-12Employer-Purchased Health, Disability, and Long-Term Care Insurance 7-13Life Insurance Premiums 7-15Insurance Benefits Received 7-177.3 Income from Other Fringe Benefits 7-21Personal Expenses Paid by Employer 7-21Food and Lodging 7-22Working Condition Fringe Benefits 7-23De Minimis Fringe Benefits 7-24No-Additional-Cost Services 7-24Employee Discounts 7-25Nominal Gifts 7-25Safety and Length of ServiceAchievement Awards 7-25Transportation and Parking 7-26Other Fringe Benefits 7-26Cafeteria Plans 7-287.4 Stock Options 7-30Nonqualified Stock Options 7-32Incentive Stock Options 7-32Advanced Topics—Drilling Down 7-357.5 Reimbursement of EmployeeBusiness Expenses 7-37Scenario 1: Accountable Plan 7-37Scenario 2: Nonaccountable Plan 7-377.6 Retirement Plans 7-39Section 401(k) Plans 7-39Pension Plans 7-40Self-Employed Plans 7-41Individual Retirement Accounts 7-41Advanced Topic—Drilling Down 7-487.7 Distribution Rules 7-50Withdrawals from a Traditional IRA 7-50Withdrawals from a Roth IRA 7-52Distributions from Other Qualified Plans 7-52Required Minimum Distributions 7-53Rollovers 7-53Annuities 7-537.8 Social Security Benefits 7-57Spotlight on the Law: Taxation of Social SecurityBenefits 7-597.9 Foreign Earned Income 7-60Part II (Chapters 5–7): Comprehensive TaxReturn Problem 7-72Part III Deductions8 Framework for Deductions 8-18.1 Types of Activities 8-4Trade or Business Activity 8-4Investment/Production of Income Expenses 8-6Personal Expenses 8-78.2 Disallowance of Deductions 8-8Disallowed Expenses 8-8Adequate Substantiation 8-11Benefit of the Taxpayer 8-128.3 Types of Deductions 8-13Spotlight on the Law: Insurance Fraud Payback:Deductible or Not Deductible? 8-158.4 Accounting Methods for Deductions 8-16Prepaid Expenses 8-16Prepaid Interest 8-17All-Events Test and Economic Performance 8-17Payments to a Related Party 8-19Advanced Topic—Drilling Down 8-208.5 Capital Expenditure vs. Repair 8-228.6 Accounting for Inventories 8-24Small Businesses 8-24Large Businesses 8-259 Deductions for AGI,Itemized Deductions,and Additional Deductions 9-19.1 Deductions for AGI 9-5Educator Expenses 9-6Health Savings Account 9-7Moving Expenses 9-850% of Self-Employment Tax 9-8Qualified Plan and IRA Contributions 9-9Self-Employed Health Insurance Deduction 9-9Penalty on Early Withdrawal of Savings 9-10Alimony Paid 9-10Student Loan Interest 9-10Attorney’s Fees for Discrimination Lawsuits 9-11Jury Duty Pay 9-12Cash Charitable Contributions 9-129.2 Itemized Deductions: General Rules 9-14Itemized Deduction vs. Standard Deduction 9-14Phaseout of Itemized Deductions 9-159.3 Medical Expenses 9-17Qualified Medical Expenses 9-17Other Medical Expense Rules 9-18Medical Expense Calculation 9-199.4 Taxes 9-21General Rules 9-21$40,000 Limit 9-22Spotlight on the Law: The Angst of the SALTDeduction Limitation 9-23Sales Taxes 9-24Taxes that Are Not Deductible 9-259.5 Interest 9-26Home Mortgage Interest 9-27Investment Interest Expense 9-29Personal Interest 9-30Other Rules Regarding Interest 9-319.6 Charitable Contributions 9-31Was the Donation Made to a Qualified CharitableOrganization? 9-32Contribution of Services 9-32Contributions of Cash or Property 9-34Is There Appropriate Substantiationof the Donation? 9-36Did the Donor Receive Anything of Valuein Return for the Contribution? 9-36What Limitations Apply to the Amountof the Donation? 9-37Special Rules for Charitable Contributions 9-40Nondeductible Contributions 9-409.7 Casualty Losses 9-42Definition of a Casualty Loss 9-44Casualty Loss Computation 9-44Casualty Gains and Losses 9-45Qualified Disaster-Related Personal CasualtyLosses 9-469.8 Other Itemized Deductions 9-47Deductible Other Expenses 9-47Nondeductible Miscellaneous Expenses 9-48Advanced Topic—Drilling Down 9-489.9 Additional Deductions 9-49Senior Deduction 9-51Personal-Vehicle Loan Interest 9-5210 Business Expenses 10-110.1 Business Expense Requirements 10-4Sole Proprietorship 10-4Employee Business Expenses 10-4New Business Investigation Expenses 10-610.2 Transportation and Travel Expenses 10-8Transportation Mode vs. Travel Mode 10-8Transportation Rules 10-8Travel Expense Rules 10-9Business Travel Mixed with Personal Travel 10-10Travel When Not Away from Home 10-11Other Travel-Related Limits 10-1210.3 Entertainment and Education Expenses 10-14Entertainment 10-14Spotlight on the Law: Meals and Entertainment:Difference in Tax Treatment 10-15Education 10-1610.4 Business Interest 10-1810.5 Bad Debts 10-21Cash Method vs. Accrual Method 10-21Business Bad Debts 10-21Nonbusiness Bad Debts 10-2210.6 Net Operating Losses 10-23Pre-2018 NOLs 10-24NOLs in 2018, 2019, and 2020 10-24Post-2020 NOLs 10-24NOL Computation 10-2510.7 Excess Business Losses 10-2911 Limitations on Business Losses andExpenses 11-111.1 Business Use of a Home 11-4Qualification as a Home Office 11-4Spotlight on the Law: The Home Office Rule 11-5Evaluating Home Office Deductions 11-6Simplified Method for Home Office Deduction 11-911.2 Hobby Losses 11-11Definition of a Hobby 11-11Evaluating the Tax Consequences of Hobbies 11-1311.3 Vacation Homes 11-14Personal Category for a Vacation Home 11-15Rental Category for a Vacation Home 11-16Personal/Rental Category for a Vacation Home 11-1711.4 Basis and At-Risk Limitations 11-23Basis Hurdle 11-23At-Risk Hurdle 11-2411.5 Passive Loss Rules 11-25Tax Consequences of Passive Losses 11-25Material Participation 11-27Limited Partners and Rental Activities 11-29Rental Real Estate 11-30Selling an Activity with Suspended PassiveLosses 11-31Use of Suspended Losses at Death 11-31Passive Credits 11-32Advanced Topic—Drilling Down 11-3311.6 Losses from Partnerships and S Corporations 11-34Part III (Chapters 8–11): ComprehensiveTax Return Problem 11-48Part IV Taxation of Property Transactions12 Taxation of InvestmentIncome 12-112.1 Interest Income 12-4Municipal Interest Income 12-4Series EE and Series I Bonds 12-6Bond Premiums and Discounts 12-7Spotlight on the Law: Is an Interest-Free LoanTreated as a Loan or a Gift? 12-9Advanced Topics—Drilling Down 12-1012.2 Dividend Income 12-14General Rules for Dividends 12-14Qualified Dividend Income 12-15Evaluating the Tax Consequences of DividendDistributions 12-16Stock Dividends 12-18Constructive Dividends 12-2012.3 Capital Gains and Losses 12-22Capital Asset Definition 12-22Netting Capital Gains and Losses 12-23Long-Term Capital Gain Rates 12-27Ordering Rule for Netting Capital Losses 12-29Advanced Topics—Drilling Down 12-3212.4 The 3.8% Net Investment Income Tax 12-37Defining the Net Investment Income Tax 12-38Computing the Net Investment Income Tax 12-3813 Cost Recovery of Property 13-113.1 General MACRS Rules 13-5Personalty (Personal Property) 13-5Realty (Real Property) 13-12Spotlight on the Law: Is It Ever Possible toDepreciate Land? 13-1413.2 Additional Cost Recovery Rules 13-15Bonus Depreciation 13-15Bonus Depreciation for Qualified ProductionProperty 13-17Section 179 Election 13-17Automobile Depreciation 13-21Other Depreciation Systems 13-25Advanced Topics—Drilling Down 13-2513.3 Amortization 13-27Computing Tax Amortization 13-28Defining Amortizable Intangible Assets 13-2813.4 Depletion 13-3014 Taxation of Assets Used in a Tradeor Business 14-114.1 Distinguishing Section 1231 Assets from Ordinaryand Capital Assets 14-4Review of Ordinary and Capital Assets 14-4Section 1231 Assets 14-414.2 Identifying Types of Section 1231 Assets 14-7Spotlight on the Law: Impact of Identifying a BusinessAsset 14-914.3 Netting Section 1231 Gains and Losses 14-1014.4 Section 1245 Depreciation Recapture 14-15Defining Section 1245 Assets 14-16Evaluating Section 1245 DepreciationRecapture 14-1614.5 Section 1250 Depreciation Recapture 14-20Defining Section 1250 Assets 14-21Evaluating Section 1250 DepreciationRecapture 14-22Reporting Sales of Business Assets: Form4797 14-26Advanced Topic—Drilling Down 14-2715 Property Transactions:Nonrecognition of Gains andLosses 15-115.1 Related-Party Losses 15-4Defining Related Party 15-4Evaluating Related-Party Transactions 15-4Advanced Topic—Drilling Down 15-815.2 Wash Sales 15-9Defining a Wash Sale 15-9Evaluating a Wash Sale 15-10Spotlight on the Law: Do Wash Sale Rules Apply to AssetsHeld in an IRA? 15-1515.3 Like-Kind Exchanges 15-15Defining Like-Kind Exchanges 15-15Evaluating Like-Kind Exchanges 15-16Boot 15-19Advanced Topics—Drilling Down 15-2215.4 Involuntary Conversions 15-26Defining an Involuntary Conversion 15-26Evaluating an Involuntary Conversion 15-2815.5 Loss on Sale of Personal Use Assets 15-3215.6 Sale of Principal Residence 15-33Defining a Principal Residence 15-33Evaluating the Sale of a Principal Residence 15-36Advanced Topics—Drilling Down 15-38Part IV (Chapters 12–15): ComprehensiveTax Return Problem 15-52Part V Other Individual Topics16 Personal Tax Credits 16-116.1 Introduction to Personal Tax Credits 16-4Credit vs. Deduction 16-5Nonrefundable vs. Refundable Credits 16-516.2 Child Tax Credit 16-7Refundability 16-8Tax Compliance 16-916.3 Credit for Other Dependents(Family Tax Credit) 16-1016.4 Child and Dependent Care Credit 16-11Defining the Child and Dependent Care Credit 16-12Computing the Child and Dependent Care Credit 16-1416.5 Earned Income Tax Credit (EITC) 16-18Defining a Qualifying Child 16-20Other Rules for the EITC 16-21Computing the Earned Income Tax Credit 16-21Tax Compliance 16-2316.6 Education Credits 16-25General Guidelines for Education Tax Benefits 16-26Trump Accounts 16-27American Opportunity Tax Credit (AOTC) 16-27Spotlight on the Law: Who Can Claim the AmericanOpportunity Tax Credit? 16-29Lifetime Learning Credit (LLC) 16-29Comparison of the AOTC and the LLC 16-31Tax Compliance 16-3216.7 Other Personal Tax Credits 16-33Adoption Credit 16-33Retirement Savings Contributions Credit (Saver’sCredit) 16-35Credit for the Elderly or the Disabled 16-36Energy Credits 16-37Premium Tax Credit 16-38Foreign Tax Credit 16-3817 Alternative Minimum Taxand Other Taxes 17-117.1 Alternative Minimum Tax (AMT) 17-4Formula for Computing the AMT 17-5Adjustments 17-7Preferences 17-9Reconciling Taxable Income and AMT Income 17-10Other AMT Items 17-1117.2 Social Security, Medicare,and Self-Employment Taxes 17-17Independent Contractor vs. Employee 17-18Self-Employment Income 17-18Self-Employment Tax Computation 17-19Social Security and Medicare Taxesfor Employees and Employers 17-22Excess Social Security Tax Credit 17-2217.3 Other Taxes 17-24Nanny Tax 17-24Spotlight on the Law: The Nanny Tax 17-25Additional Medicare Tax 17-26Parts II–V (Chapters 4–17): ComprehensiveTax Return Problem 17-37Part VI CPA Evolution: Core—Tax18 Business Entity Topics: CPA ExamCore—Taxation and Regulation 18-118.1 Corporations: Taxable IncomeComputation and Special Deductions 18-5Corporate Income Tax Formula 18-6Corporate Deductions 18-8Spotlight on Becoming a CPA 18-2018.2 Other Corporate Tax Issues 18-20Capital Gains and Losses 18-20Accounting Methods and Periods 18-21Research and Development Expenses 18-22Reconciliation of Book Income and TaxableIncome 18-23Net Operating Losses 18-26Reconciliation of Retained Earnings 18-28Corporate Alternative Minimum Tax 18-2918.3 Business Tax Credits 18-31Foreign Tax Credit 18-31General Business Credit 18-32Business Investment Credits 18-4018.4 S Corporations 18-42What Is an S Corporation? 18-42S Corporations vs. C Corporations 18-44Eligibility Rules for S Corporations 18-45Election Requirements 18-47Termination of the S Election 18-48Taxation of S Corporation Income 18-50Shareholder’s Basis in S Corporation Stock 18-56Other S Corporation Issues 18-5918.5 Partnerships and Limited LiabilityCompanies 18-63What Is a Partnership? 18-63Taxation of Partnership Income 18-67Partner’s Basis in Partnership Interest 18-7018.6 Tax-Exempt Organizations 18-73Types of Tax-Exempt Organizations 18-73Eligibility to Be Tax-Exempt 18-74Filing Requirements 18-74Unrelated Business Income 18-7418.7 State and Local Taxation 18-76Nexus 18-76Computation of State Taxable Income 18-80Apportionment and Allocation 18-82Part VI (Chapter 18): Comprehensive TaxReturn Problem 18-109APPENDIX A Tax Formula Items A-1APPENDIX B Tax Forms B-1GLOSSARY G-1INDEX I-1