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Income Tax Course

Textbook

2015

Item # D2H124792

Income Tax Course (2015)

Textbook

Product # D2H124792

Income Tax Course (2015)


A Publication of
H&RBlock Services, Inc.
Kansas City, Missouri

Laura Arruda, EA
Daniel Woodard, CPA

This publication was written and produced at


the Client Support Center (CSC).

Disclaimer
The following training was developed by the Client Support Center (CSC) for use by both Companyowned and Franchise-owned offices. Although some aspects of this training may not apply to
employees of a Franchise-owned office, training issues regarding customer service, client experience, tax law, or IRS rules and regulations apply to all Company and Franchise associates. If your
Franchise-office training policies differ from those presented, please bring them to the attention of
your respective Franchisee.

Acknowledgments
This book has been produced with the support of:
Proofreaders: Stephanie Crumpton, Lynne Rice, Jabari Johnson, Kristia Lantz, Nancy
Lowdon, Patricia Potts.
The Editors: Lauren Aspenlieder, Chris Fischer, Connie White, Steve Wilton
Production: Sue Jayaratne, Steve Wilton, Lauren Aspenlieder
The Review Board: Brian Delossantos, Jonathan Meier, Sandra Villanueva, Leslie
Williams, Susan Hammer Cantrell, Rebecca Goodell, Alex Graham, Linda Winfrey, Carlos
Gallastegui, Linda Caton, Christine Grybel, Diane A. Greenberg, Margaret Kropp, Holly
Alspaw, Betty Hughes Balo, Lori J. Cronk

HRB Tax Group, Inc. 2015


Copyright is not claimed in any material secured from official U.S. government sources.

All Rights Reserved

No part of this book may be reproduced or transmitted in any form or by any means, electronic or
mechanical, including photocopying, recording, or by any storage or retrieval system, without
permission in writing from HRB Tax Group, Inc.

Printed in the U.S.A. 2015


The information in this textbook is for general use in teaching an income tax course and is not for the
purpose of rendering legal or other professional services or advice. The information is as timely and
accurate as possible as of the publication date, but because of legislative changes and administrative
interpretations subsequent to that date, caution must be used in the application of any information
contained herein.

REFER A FRIEND
to the

H&R Block
Income Tax Course
  

If you know someone who would make a great Tax Professional,* refer them to the
H&R Block Income Tax Course. Your friend will get the skills to prepare taxes like a
pro. And youll receive $50 when your friend completes the course.
Visit https://www.hrblockreferafriend.com to submit your referrals. You enter your
friends contact information and well send an email to your friend with information
about the Income Tax Course and a link to enroll. Its that easy.
Please note all referrals must be submitted online to be eligible.

To recommend a friend, visit


https://www.hrblockreferafriend.com

*Enrollment in, or completion of, the H&R Block Income Tax Course is neither an offer nor a
guarantee of employment. Additional qualifications may be required. Enrollment restrictions apply. State
restrictions may apply. Additional training may be required in MD and other states. Valid at participating
locations only. Void where prohibited. H&R Block is an equal opportunity employer. This course is not intended for, nor open to any persons who are either currently employed by or seeking employment with any
professional tax preparation company or organization other than H&R Block.
All referrals must be submitted at https://www.hrblockreferafreind.com and must be recorded prior to the
students enrollment date. If a student is referred by multiple referrers, the first recorded referral will be
used to determine eligibility for payment. Limit maximum five referrals paid per person. OBTP# B13696
2015 HRB Tax Group, Inc.

Table of Contents
INTRODUCTION TO TAXATION
Overview..................................................................................................................................................... 1.1
Objectives.................................................................................................................................................... 1.1
Blended Learning....................................................................................................................................... 1.2
Instructor-Led Sessions.......................................................................................................................... 1.2
Homework............................................................................................................................................ 1.2
Self-Study Sessions................................................................................................................................. 1.2
Participant Materials................................................................................................................................. 1.3
Job Aids................................................................................................................................................... 1.3
Participant Materials............................................................................................................................. 1.3
History and Theory of Income Taxes........................................................................................................ 1.4
The Internal Revenue Service............................................................................................................... 1.4
Who May Practice before the IRS?........................................................................................................... 1.5
Limited Practice for Paid Tax Preparers.............................................................................................. 1.6
Circular 230............................................................................................................................................. 1.6
Layout of an Income Tax Return.............................................................................................................. 1.6
E-file......................................................................................................................................................... 1.7
Tax Research.............................................................................................................................................. 1.7
Tax Law Authority................................................................................................................................. 1.7
Primary Authority.............................................................................................................................. 1.7
Secondary Authority .......................................................................................................................... 1.8
Forms and Publications...................................................................................................................... 1.8
Other Tax Information Resources......................................................................................................... 1.8
Tax Terms................................................................................................................................................... 1.9
Wages, Income, and Taxes........................................................................................................................ 1.9
What is Income?....................................................................................................................................... 1.10
Gross Income......................................................................................................................................... 1.10
The Individual Income Tax Forms......................................................................................................... 1.11
Schedules and Forms........................................................................................................................... 1.11
Statements............................................................................................................................................ 1.22
Worksheets............................................................................................................................................ 1.22
State and Local Tax Returns............................................................................................................... 1.22
Rounding................................................................................................................................................... 1.22
Wages........................................................................................................................................................ 1.23
Form W-2 Wage and Tax Statement................................................................................................. 1.23
Specific Form W-2 Box Information.................................................................................................... 1.24
Box a Employees Social Security Number (SSN)....................................................................... 1.24
Box b Employer Identification Number (EIN)............................................................................ 1.24
Box c Employers Name, Address, and ZIP Code........................................................................ 1.24
Box d Control Number.................................................................................................................. 1.24
Box e/f Employees Name, Address, and ZIP Code..................................................................... 1.24
Box 1 Wages, Tips, Other Compensation.................................................................................... 1.27
Box 2 Federal Income Tax Withheld............................................................................................ 1.27
Box 3 Social Security Wages......................................................................................................... 1.27
Box 4 Social Security Tax Withheld............................................................................................. 1.27
Box 5 Medicare Wages and Tips.................................................................................................. 1.27
Box 6 Medicare Tax Withheld...................................................................................................... 1.27
Box 7 Social Security Tips............................................................................................................. 1.27
i

Box 8 Allocated Tips...................................................................................................................... 1.27


Box 9 No Entry in Box 9............................................................................................................... 1.27
Box 10 Dependent Care Benefits.................................................................................................. 1.28
Box 11 Nonqualified Plans............................................................................................................ 1.28
Boxes 12ad....................................................................................................................................... 1.28
Box 13................................................................................................................................................. 1.28
Box 14 Other.................................................................................................................................. 1.28
Boxes 1520....................................................................................................................................... 1.30
Substitute W-2...................................................................................................................................... 1.30
Unemployment...................................................................................................................................... 1.33
Preparing the Form 1040EZ................................................................................................................... 1.33
Heading the Return.............................................................................................................................. 1.33
Taxpayer Identification Numbers.................................................................................................... 1.33
Determining the Income Tax.................................................................................................................. 1.35
Adjusted Gross Income (AGI).............................................................................................................. 1.35
Taxable Income..................................................................................................................................... 1.36
Using the Tax Table................................................................................................................................. 1.36
Third-Party Designee........................................................................................................................... 1.39
Signing the Return................................................................................................................................... 1.39
Chapter Summary.................................................................................................................................... 1.40
Suggested Reading............................................................................................................................... 1.41
FILING REQUIREMENTS
Overview.................................................................................................................................................... 2.1
Objectives................................................................................................................................................... 2.1
Tax Terms................................................................................................................................................... 2.1
Filing Requirements................................................................................................................................... 2.2
Nondependents........................................................................................................................................... 2.2
Filing Status............................................................................................................................................ 2.2
Common-Law Marriages.................................................................................................................... 2.3
Same-Sex Marriages........................................................................................................................... 2.4
Age........................................................................................................................................................... 2.4
Gross Income........................................................................................................................................... 2.5
Standard Deductions.............................................................................................................................. 2.5
Increased Standard Deductions......................................................................................................... 2.7
Blindness............................................................................................................................................. 2.7
Personal Exemption Amount............................................................................................................. 2.7
Dependent Taxpayers............................................................................................................................. 2.9
Certain Children Under Age 19 or Full-Time Student..................................................................... 2.11
Others Who Must File.......................................................................................................................... 2.12
Taxpayer Should File........................................................................................................................... 2.12
Filing Return Penalties........................................................................................................................... 2.13
Filing Status............................................................................................................................................. 2.13
Single..................................................................................................................................................... 2.13
Married Filing Jointly and Married Filing Separately..................................................................... 2.14
Nonresident Alien Spouse................................................................................................................ 2.15
Injured Spouse Allocation........................................................................................................................ 2.15
Request for Innocent Spouse Relief........................................................................................................ 2.16
Chapter Summary.................................................................................................................................... 2.16
Suggested Reading............................................................................................................................... 2.17
ii

DEPENDENT EXEMPTIONS AND SUPPORT


Overview..................................................................................................................................................... 3.1
Objectives.................................................................................................................................................... 3.1
Tax Terms................................................................................................................................................... 3.1
Dependency Exemptions............................................................................................................................ 3.2
Who Is a Dependent?.............................................................................................................................. 3.2
What Is a Qualifying Child?.............................................................................................................. 3.2
What Is a Qualifying Relative?.......................................................................................................... 3.4
Dependent Taxpayer Test...................................................................................................................... 3.7
Joint Return Test.................................................................................................................................... 3.7
Citizen or Resident Test......................................................................................................................... 3.8
Exception for an Adopted Child......................................................................................................... 3.8
Childs Place of Residence.................................................................................................................. 3.8
Determining Support................................................................................................................................. 3.8
Lodging.................................................................................................................................................... 3.9
Education Expenses............................................................................................................................... 3.9
Items Not Included in Support............................................................................................................ 3.10
Health Insurance Benefits................................................................................................................... 3.10
Multiple Support Agreements............................................................................................................. 3.11
Child Tax Credit....................................................................................................................................... 3.11
Income Phaseout................................................................................................................................... 3.11
Interaction With Other Credits........................................................................................................... 3.14
Computing the Child Tax Credit......................................................................................................... 3.14
Dispensing with the Worksheets..................................................................................................... 3.15
Chapter Summary.................................................................................................................................... 3.15
Suggested Reading............................................................................................................................... 3.15
DEPENDENT-RELATED FILING STATUSES
Overview..................................................................................................................................................... 4.1
Objectives.................................................................................................................................................... 4.1
Tax Terms................................................................................................................................................... 4.1
Filing Statuses and Dependents............................................................................................................... 4.2
Head of Household.................................................................................................................................. 4.2
The Cost of Maintaining a Household.............................................................................................. 4.3
Exceptions to the Head of Household Requirements...................................................................... 4.6
Married, But Unmarried For Tax Purposes..................................................................................... 4.7
Qualifying Widow(er)............................................................................................................................. 4.8
Children of Divorced or Separated Parents............................................................................................. 4.9
Temporary Absences Involving Divorced or Separated Parents........................................................ 4.9
Form 8332............................................................................................................................................. 4.12
Tie-Breaker Rules.................................................................................................................................... 4.13
Chapter Summary.................................................................................................................................... 4.15
Suggested Reading............................................................................................................................... 4.15
INTEREST AND DIVIDEND INCOME
Overview..................................................................................................................................................... 5.1
Objectives.................................................................................................................................................... 5.1
Tax Terms................................................................................................................................................... 5.1
Interest........................................................................................................................................................ 5.2
iii

Schedule B............................................................................................................................................... 5.2


Foreign Investments............................................................................................................................... 5.5
Not Attributable to the Taxpayer......................................................................................................... 5.5
Seller-Financed Mortgage...................................................................................................................... 5.6
Tax-Exempt Interest.............................................................................................................................. 5.6
Form 1099-INTInterest Income............................................................................................................ 5.6
Box 1........................................................................................................................................................ 5.6
Box 2........................................................................................................................................................ 5.6
Penalty on Early Withdrawal of Savings Adjustment.................................................................... 5.6
Box 3........................................................................................................................................................ 5.7
Box 4........................................................................................................................................................ 5.7
Box 5........................................................................................................................................................ 5.7
Box 6........................................................................................................................................................ 5.8
Box 7........................................................................................................................................................ 5.8
Box 8........................................................................................................................................................ 5.8
Box 9........................................................................................................................................................ 5.8
Boxes 10 and 11...................................................................................................................................... 5.8
Box 12...................................................................................................................................................... 5.8
United States Treasury Obligations......................................................................................................... 5.8
Other Interest Income.............................................................................................................................. 5.10
Municipal Bond Interest...................................................................................................................... 5.10
Dividends.................................................................................................................................................. 5.10
Form 1099-DIVDividends and Distributions................................................................................. 5.11
Tax Computation for Qualified Dividends and Capital Gain Distributions....................................... 5.13
Chapter Summary.................................................................................................................................... 5.15
Suggested Reading............................................................................................................................... 5.15
BLOCKWORKS PRACTICE 1
Overview..................................................................................................................................................... 6.1
Instructions................................................................................................................................................. 6.1
EARNED INCOME CREDIT
Overview..................................................................................................................................................... 7.1
Objectives.................................................................................................................................................... 7.1
Tax Terms................................................................................................................................................... 7.1
Credits vs. Deductions............................................................................................................................... 7.2
Child Tax Credit......................................................................................................................................... 7.2
Additional Child Tax Credit...................................................................................................................... 7.3
Earned Income Credit................................................................................................................................ 7.6
Qualifying for EIC...................................................................................................................................... 7.6
Taxpayers Without Qualifying Children.............................................................................................. 7.6
Taxpayers With Qualifying Children................................................................................................... 7.6
Rules for Taxpayers With or Without a Qualifying Child.................................................................. 7.6
Understanding the rules............................................................................................................................ 7.7
Being a Dependent................................................................................................................................. 7.7
Living in the U.S.................................................................................................................................... 7.7
Relationship, Age, Residency, and Joint Return................................................................................. 7.7
Relationship......................................................................................................................................... 7.7
Age........................................................................................................................................................ 7.7
iv

Residency............................................................................................................................................. 7.8
Joint Return........................................................................................................................................ 7.8
Tiebreaker Rules A Reminder............................................................................................................ 7.8
Social Security Numbers........................................................................................................................ 7.8
U.S. Citizen or Resident Alien All Year............................................................................................... 7.8
Form 2555 or Form 2555-EZ................................................................................................................. 7.8
MFS Filing Status.................................................................................................................................. 7.9
Investment Income Limitation.............................................................................................................. 7.9
Support.................................................................................................................................................... 7.9
Being a Qualifying Child....................................................................................................................... 7.9
Computing the Earned Income Credit................................................................................................... 7.11
Step 1 All Filers............................................................................................................................. 7.11
Step 2 Investment Income............................................................................................................ 7.11
Step 3 Qualifying Child................................................................................................................. 7.11
Step 4 Filers Without a Qualifying Child.................................................................................... 7.12
Step 5 Earned Income................................................................................................................... 7.12
Step 6 How to Figure the Credit.................................................................................................. 7.12
Earned Income Credit due diligence...................................................................................................... 7.17
Complete and Submit an Eligibility Checklist.................................................................................. 7.17
Computing the Amount of Credit........................................................................................................ 7.17
Complying With the Knowledge Requirement.................................................................................. 7.17
Retaining Records................................................................................................................................. 7.18
Chapter Summary.................................................................................................................................... 7.24
Suggested Reading............................................................................................................................... 7.24
CREDITS
Overview..................................................................................................................................................... 8.1
Objectives.................................................................................................................................................... 8.1
Tax Terms................................................................................................................................................... 8.1
Credits VS. Deductions.............................................................................................................................. 8.2
Child and Dependent Care Credit............................................................................................................ 8.2
Requirements.......................................................................................................................................... 8.2
Qualifying Persons................................................................................................................................. 8.3
Qualified Expenses................................................................................................................................. 8.3
Computing the Credit............................................................................................................................. 8.4
Credit Limitation................................................................................................................................ 8.6
Employer-Provided Benefits.................................................................................................................. 8.6
Credit for the Elderly or the Disabled.................................................................................................... 8.10
Premium Tax Credit................................................................................................................................ 8.13
Eligibility............................................................................................................................................... 8.13
Tax Household...................................................................................................................................... 8.14
Qualified Health Insurance................................................................................................................. 8.14
Monthly Coverage................................................................................................................................. 8.15
State and Federal Marketplaces......................................................................................................... 8.16
Form 1095-A.......................................................................................................................................... 8.16
Form 8962............................................................................................................................................. 8.17
Part 1.................................................................................................................................................. 8.17
Part 2.................................................................................................................................................. 8.19
Part 3.................................................................................................................................................. 8.19
v

Shared Policy Allocation...................................................................................................................... 8.19


Groups Exempt from the Individual Mandate................................................................................... 8.20
Exemptions Available Due to Circumstances................................................................................ 8.20
Chapter Summary.................................................................................................................................... 8.24
Suggested Reading............................................................................................................................... 8.24
EDUCATION CREDITS
Overview..................................................................................................................................................... 9.1
Objectives.................................................................................................................................................... 9.1
Tax Terms................................................................................................................................................... 9.1
Credits VS. Deductions.............................................................................................................................. 9.2
Education Credits....................................................................................................................................... 9.2
American Opportunity Credit................................................................................................................ 9.2
Who Can Claim the AOC................................................................................................................... 9.2
Who Cannot Claim the AOC.............................................................................................................. 9.3
Qualified Education Expenses........................................................................................................... 9.3
Qualifying Academic Periods............................................................................................................. 9.6
Eligible Student...................................................................................................................................... 9.6
Calculating the AOC.............................................................................................................................. 9.7
Income Limitation............................................................................................................................... 9.7
Form 1098-T............................................................................................................................................ 9.7
Claiming the AOC............................................................................................................................... 9.9
Nonrefundable AOC............................................................................................................................. 9.10
Lifetime Learning Credit......................................................................................................................... 9.10
Qualified Expenses............................................................................................................................... 9.10
Claiming the Lifetime Learning Credit.......................................................................................... 9.11
Tuition and Fees Deduction.................................................................................................................... 9.19
Who Is an Eligible Student?................................................................................................................ 9.19
Who May Claim the Deduction?.......................................................................................................... 9.19
Phaseout of Tuition and Fees Deduction............................................................................................ 9.20
Qualified Expenses............................................................................................................................... 9.20
Tuition and Fees Deduction................................................................................................................. 9.21
Who Can Claim a Dependents Expenses?..................................................................................... 9.21
Chapter Summary.................................................................................................................................... 9.24
Suggested Reading............................................................................................................................... 9.24
RETIREMENT
Overview................................................................................................................................................... 10.1
Objectives.................................................................................................................................................. 10.1
Tax Terms................................................................................................................................................. 10.2
Types of Retirement Plans...................................................................................................................... 10.2
Qualified Plans.................................................................................................................................. 10.2
Nonqualified Plans............................................................................................................................ 10.3
Qualified Plans......................................................................................................................................... 10.3
401(k) Plans.......................................................................................................................................... 10.4
Employer-Matching Contributions.................................................................................................. 10.4
403(b) Plans........................................................................................................................................... 10.4
457 Plans............................................................................................................................................... 10.5
Contribution Limits.............................................................................................................................. 10.5
vi

Identifying Contributions to a Deferred-Compensation Plan........................................................... 10.5


IRAs........................................................................................................................................................... 10.7
Compensation........................................................................................................................................ 10.7
Traditional IRAs....................................................................................................................................... 10.8
Different Sets of Rules......................................................................................................................... 10.8
Who Is an Active Participant?............................................................................................................. 10.8
Taxpayers Who Are Not Active Participants..................................................................................... 10.9
Taxpayers Who Are Active Participants............................................................................................ 10.9
Nonparticipating Spouses.................................................................................................................. 10.10
Roth IRAs................................................................................................................................................ 10.11
Simple IRA.............................................................................................................................................. 10.16
Retirement Savings Contribution Credit............................................................................................. 10.17
Qualified Contributions...................................................................................................................... 10.17
Amount of Credit................................................................................................................................ 10.18
Social Security and Equivalent
Railroad Retirement Benefits................................................................................................................ 10.19
Full Retirement Age........................................................................................................................... 10.21
Reporting Social Security and Equivalent Railroad Retirement Benefits.................................... 10.21
Computing Taxable Benefits............................................................................................................. 10.23
Tier 1 Railroad Retirement Benefits................................................................................................. 10.26
Retirement Account Distributions........................................................................................................ 10.26
Taxable Distribution.............................................................................................................................. 10.28
Simplified Method........................................................................................................................... 10.29
General Rule.................................................................................................................................... 10.31
IRA Distributions................................................................................................................................... 10.33
Early Distributions from Qualified Retirement Plans........................................................................ 10.35
Chapter Summary.................................................................................................................................. 10.38
Suggested Reading............................................................................................................................. 10.38
MIDTERM REVIEW
Overview................................................................................................................................................... 11.1
Instructions............................................................................................................................................... 11.1
MIDTERM EXAM
Overview................................................................................................................................................... 12.1
Instructions............................................................................................................................................... 12.1
TAX ESSENTIALS FORM 1040
Overview................................................................................................................................................... 13.1
Objectives.................................................................................................................................................. 13.1
Tax Terms................................................................................................................................................. 13.1
Form 1040................................................................................................................................................. 13.2
Who Must File Form 1040....................................................................................................................... 13.5
Form 1040 Other Income..................................................................................................................... 13.6
Long-Term Disability Income.............................................................................................................. 13.7
Reporting Disability Benefits........................................................................................................... 13.7
Unreported Tips ................................................................................................................................... 13.8
Allocated Tips...................................................................................................................................... 13.11
vii

Employee Treated as an Independent Contractor........................................................................... 13.11


Alimony................................................................................................................................................ 13.13
Bartering............................................................................................................................................. 13.13
Gambling Winnings............................................................................................................................ 13.13
Line 21 Income.................................................................................................................................... 13.14
Hobby vs. Business Activity........................................................................................................... 13.16
Form 1040 Adjustments..................................................................................................................... 13.16
Certain Business Expenses of Reservists, Performing Artists,
and Fee-Basis Government Officials................................................................................................. 13.16
Health Savings Accounts (HSAs)...................................................................................................... 13.16
Eligibility......................................................................................................................................... 13.17
Qualified Medical Expenses........................................................................................................... 13.18
Contribution Limits........................................................................................................................ 13.18
Form 8889........................................................................................................................................ 13.18
Excess Contributions...................................................................................................................... 13.20
Distributions.................................................................................................................................... 13.21
Nonqualified Distributions Penalty............................................................................................... 13.21
Rollovers.......................................................................................................................................... 13.21
Qualified Distributions to HSAs.................................................................................................... 13.21
Penalty on Early Withdrawal of Savings......................................................................................... 13.22
Alimony................................................................................................................................................ 13.22
Payments That Are Not Alimony.................................................................................................. 13.23
Alimony vs. Child Support............................................................................................................. 13.23
Special Rules Regarding Alimony and Separate Maintenance Payments................................ 13.24
Moving Expenses................................................................................................................................ 13.24
Distance Requirement.................................................................................................................... 13.24
Work Time Requirement................................................................................................................ 13.25
Married Couples.............................................................................................................................. 13.25
Closely Related in Time to Start of Work..................................................................................... 13.25
Closely Related in Place to Start of Work.................................................................................... 13.26
Deductible Moving Expenses......................................................................................................... 13.26
Form 3903........................................................................................................................................ 13.27
Student Loan Interest Deduction...................................................................................................... 13.27
Form 1098-E........................................................................................................................................ 13.30
Who Can Claim the Student Loan Interest Deduction................................................................... 13.30
Computing the Student Loan Interest Deduction........................................................................... 13.30
Other Form 1040 Adjustments to Income........................................................................................ 13.34
Personal Exemption Phaseout ............................................................................................................. 13.34
Personal Exemption Phaseout........................................................................................................... 13.34
Form 1040 Credits.................................................................................................................................. 13.35
Adoption Credit................................................................................................................................... 13.35
When to Claim the Credit.............................................................................................................. 13.36
Qualified Expenses......................................................................................................................... 13.36
Eligible Child................................................................................................................................... 13.36
Credit Phaseout............................................................................................................................... 13.39
First-Time Homebuyer Credit........................................................................................................... 13.39
Repayment....................................................................................................................................... 13.39
Residential Energy Efficient Property Credit.................................................................................. 13.42
Nonbusiness Energy Property Credit............................................................................................... 13.42
Foreign Tax Credit............................................................................................................................. 13.43
viii

Mortgage Interest Credit................................................................................................................... 13.43


General Business Credit.................................................................................................................... 13.43
Credit for Prior-Year Minimum Tax................................................................................................. 13.44
Form 1040 Taxes.................................................................................................................................... 13.44
Net Investment Income Tax (NIIT).................................................................................................. 13.44
Types of Income Subject to the 3.8% NIIT................................................................................... 13.44
Additional Medicare Tax.................................................................................................................... 13.45
Household Employment Tax............................................................................................................. 13.45
Excess Social Security or Tier 1 Railroad Retirement Tax............................................................. 13.46
Chapter Summary.................................................................................................................................. 13.46
TAX ESSENTIALS ITEMIZED DEDUCTIONS I
Overview................................................................................................................................................... 14.1
Objectives.................................................................................................................................................. 14.1
Tax Terms................................................................................................................................................. 14.1
Itemizing vs. Standard Deductions........................................................................................................ 14.2
Medical and Dental Expenses................................................................................................................. 14.4
Medicine and Drugs............................................................................................................................. 14.4
Medical Insurance Premiums.............................................................................................................. 14.4
Long-Term Care Insurance.............................................................................................................. 14.5
Ineligible Insurance.......................................................................................................................... 14.5
Medical and Dental Expenses............................................................................................................. 14.5
Stop-Smoking Programs................................................................................................................... 14.6
Weight-Loss Programs and Surgery............................................................................................... 14.6
Cosmetic Surgery.............................................................................................................................. 14.6
Medical Aid Items and Equipment..................................................................................................... 14.6
Capital Expenditures........................................................................................................................... 14.7
Transportation...................................................................................................................................... 14.7
Meals and Lodging............................................................................................................................... 14.8
Special Care.......................................................................................................................................... 14.8
Cafeteria Plans..................................................................................................................................... 14.9
Reimbursement for Medical Expenses............................................................................................... 14.9
Excess Reimbursements....................................................................................................................... 14.9
Determining the Medical and Dental Expense Deduction................................................................... 14.9
Taxes You Paid....................................................................................................................................... 14.10
State and Local Taxes........................................................................................................................ 14.10
Income Taxes................................................................................................................................... 14.10
Sales Taxes...................................................................................................................................... 14.10
Real Estate Taxes............................................................................................................................... 14.14
Personal Property Taxes.................................................................................................................... 14.14
Foreign Taxes...................................................................................................................................... 14.14
Nondeductible Taxes.......................................................................................................................... 14.14
Interest You Paid................................................................................................................................... 14.15
Qualified Home Mortgage Interest................................................................................................... 14.15
Prepaid Interest.................................................................................................................................. 14.17
Points............................................................................................................................................... 14.17
Reporting Home Mortgage Interest on Schedule A......................................................................... 14.19
Qualified Mortgage Insurance Premiums........................................................................................ 14.19
Investment Interest............................................................................................................................ 14.20
ix

Nondeductible Interest....................................................................................................................... 14.20


Charitable Contributions....................................................................................................................... 14.21
Cash Donations................................................................................................................................... 14.22
Volunteer Work................................................................................................................................... 14.23
Contributions of Property.................................................................................................................. 14.24
Chapter Summary.................................................................................................................................. 14.26
Suggested Reading............................................................................................................................. 14.26
TAX ESSENTIALS ITEMIZED DEDUCTIONS II
Overview................................................................................................................................................... 15.1
Objectives.................................................................................................................................................. 15.1
Tax Terms................................................................................................................................................. 15.1
Casualty and Theft Losses...................................................................................................................... 15.2
Proof of Loss.......................................................................................................................................... 15.2
Amount of the Casualty or Theft Loss................................................................................................ 15.3
When to Deduct a Loss........................................................................................................................ 15.4
Net Operating Losses........................................................................................................................... 15.5
Form 4684 Casualties and Thefts........................................................................................................ 15.5
Miscellaneous Deductions........................................................................................................................ 15.7
Expenses Subject to the 2% Limitation.............................................................................................. 15.7
Transportation Expenses................................................................................................................. 15.9
Education Expenses........................................................................................................................... 15.11
Job-Seeking Expenses........................................................................................................................ 15.13
Other Employment-Related Deductions........................................................................................... 15.13
Tax Preparation Fees......................................................................................................................... 15.14
Investment Expenses......................................................................................................................... 15.14
Hobby Expenses.................................................................................................................................. 15.15
Nondeductible Expenses.................................................................................................................... 15.15
Other Miscellaneous Deductions.......................................................................................................... 15.16
Gambling Losses to the Extent of Winnings.................................................................................... 15.16
Itemized Deduction Phaseout............................................................................................................... 15.17
Alternative Minimum Tax..................................................................................................................... 15.17
Credit for Prior-Year Minimum Tax................................................................................................. 15.18
Recovery of a Prior Years Itemized Deduction................................................................................... 15.18
Partially Taxable................................................................................................................................ 15.21
Summary................................................................................................................................................. 15.25
Suggested Reading............................................................................................................................. 15.25
BLOCKWORKS PRACTICE 2
Overview................................................................................................................................................... 16.1
Instructions............................................................................................................................................... 16.1
TAX ESSENTIALS SELF-EMPLOYMENT INCOME
Overview................................................................................................................................................... 17.1
Objectives.................................................................................................................................................. 17.1
Tax Terms................................................................................................................................................. 17.1
The Sole Proprietor.................................................................................................................................. 17.2
Accounting Periods................................................................................................................................... 17.3
Schedule C, The Heading........................................................................................................................ 17.4
x

Schedule C, Part I, Income...................................................................................................................... 17.7


Schedule C, Part III.............................................................................................................................. 17.9
Schedule C, Part II, Expenses............................................................................................................... 17.10
Other Self-Employment-Related Topics............................................................................................... 17.14
Direct Sellers....................................................................................................................................... 17.14
At-Risk Limitation.............................................................................................................................. 17.15
Net Operating Loss............................................................................................................................. 17.15
Self-Employment Tax............................................................................................................................. 17.18
Self-Employed Health Insurance Deduction........................................................................................ 17.19
Home-Office Expenses........................................................................................................................... 17.21
Who Can Deduct Home-Office Expenses?........................................................................................ 17.21
Figuring the Deduction...................................................................................................................... 17.23
Using the Simplified Method............................................................................................................. 17.23
What Expenses Are Deductible under the Actual Expenses Method?.......................................... 17.25
Form 8829............................................................................................................................................... 17.25
Farming Income..................................................................................................................................... 17.27
Course Summary.................................................................................................................................... 17.28
Suggested Reading............................................................................................................................. 17.28
TAX ESSENTIALS DEPRECIATION
Overview................................................................................................................................................... 18.1
Objectives.................................................................................................................................................. 18.1
Tax Terms................................................................................................................................................. 18.2
Depreciation.............................................................................................................................................. 18.2
Depreciable Basis..................................................................................................................................... 18.4
Form 4562 ................................................................................................................................................ 18.5
Amortizing................................................................................................................................................ 18.8
Methods Used to Depreciate Property.................................................................................................... 18.8
MACRS...................................................................................................................................................... 18.8
General Depreciation System (GDS)...................................................................................................... 18.9
Computing the MACRS GDS Depreciation Deduction..................................................................... 18.9
Half-Year, Mid-Quarter, and Mid-Month Conventions...................................................................... 18.11
Half-Year Convention......................................................................................................................... 18.11
Mid-Quarter Convention.................................................................................................................... 18.12
Mid-Month Convention...................................................................................................................... 18.12
MACRS Percentage Tables.................................................................................................................... 18.12
Computing MACRS GDS Depreciation Deduction for Real Property............................................... 18.14
Residential Rental Real Property ................................................................................................. 18.14
Nonresidential Real Property........................................................................................................ 18.16
Reporting MACRS Depreciation on the Tax Forms............................................................................ 18.17
Depreciation Worksheet..................................................................................................................... 18.17
Reporting Depreciation on Form 4562 ............................................................................................ 18.22
Alternative Depreciation System (ADS)............................................................................................... 18.24
Listed Property....................................................................................................................................... 18.25
Restrictions.......................................................................................................................................... 18.25
179 Depreciation Deduction................................................................................................................ 18.26
Other 179 Restrictions..................................................................................................................... 18.33
Special Depreciation Allowance............................................................................................................ 18.34
Mid-Quarter Convention....................................................................................................................... 18.37
xi

Which Assets to Include..................................................................................................................... 18.40


Depreciation Recapture......................................................................................................................... 18.41
Tangible Property Regulations (TPRs)................................................................................................. 18.41
Chapter Summary.................................................................................................................................. 18.42
Suggested Reading............................................................................................................................. 18.42
TAX ESSENTIALS PASSIVE INCOME
Overview................................................................................................................................................... 19.1
Objectives.................................................................................................................................................. 19.1
Tax Terms................................................................................................................................................. 19.1
Passive Income......................................................................................................................................... 19.2
Real Estate Professional...................................................................................................................... 19.2
Trade or Business Activities................................................................................................................ 19.2
Nonpassive Income............................................................................................................................... 19.3
Rental Income and Expenses.................................................................................................................. 19.6
Gross Rent............................................................................................................................................. 19.6
Rental Expenses................................................................................................................................... 19.6
Depreciation.......................................................................................................................................... 19.8
Personal and Rental Use of Property................................................................................................. 19.9
Vacation Homes................................................................................................................................ 19.9
Rental Not for Profit........................................................................................................................... 19.14
Royalties.................................................................................................................................................. 19.14
Depletion................................................................................................................................................. 19.15
Cost Depletion................................................................................................................................. 19.16
Percentage Depletion...................................................................................................................... 19.17
Other Schedule E Income...................................................................................................................... 19.17
Estates and Trusts............................................................................................................................. 19.17
Partnerships........................................................................................................................................ 19.17
Subchapter S Corporations................................................................................................................ 19.18
Passive Loss Rules................................................................................................................................. 19.19
Active-Participation Rental Activities........................................................................................... 19.20
Working Interest in Oil and Gas Properties................................................................................ 19.21
Chapter Summary.................................................................................................................................. 19.21
Suggested Reading............................................................................................................................. 19.21
BLOCKWORKS PRACTICE 3
Overview................................................................................................................................................... 20.1
Instructions............................................................................................................................................... 20.1
TAX ESSENTIALS PENALTIES AND AMENDED RETURNS
Overview................................................................................................................................................... 21.1
Objectives.................................................................................................................................................. 21.1
Tax Terms................................................................................................................................................. 21.1
Other Tax Penalties................................................................................................................................. 21.1
Failure-to-File Penalty......................................................................................................................... 21.2
Failure-to-Pay Penalty......................................................................................................................... 21.2
Combined Penalties.............................................................................................................................. 21.2
Penalty Exceptions............................................................................................................................... 21.3
Failure-to-File.................................................................................................................................... 21.3
xii

Failure-to-Pay.................................................................................................................................... 21.3
Amended Returns..................................................................................................................................... 21.3
Due Date for Filing Form 1040X......................................................................................................... 21.3
Form 1040X........................................................................................................................................... 21.4
Changing Amounts........................................................................................................................... 21.4
Income and Deductions.................................................................................................................... 21.5
Tax Liability...................................................................................................................................... 21.6
Payments........................................................................................................................................... 21.6
Refund or Amount You Owe............................................................................................................ 21.9
Exemptions........................................................................................................................................ 21.9
Presidential Election Campaign Fund............................................................................................ 21.9
Explanation of Changes................................................................................................................... 21.9
Signature......................................................................................................................................... 21.10
Interest on Refunds............................................................................................................................ 21.10
Amended Returns in BlockWorks......................................................................................................... 21.10
Demonstration Information............................................................................................................... 21.11
The Process......................................................................................................................................... 21.19
Household Employment Taxes.............................................................................................................. 21.19
Course Summary.................................................................................................................................... 21.20
Suggested Reading............................................................................................................................. 21.20
Research Question.............................................................................................................................. 21.20
TAX ESSENTIALS TAX PLANNING
Overview................................................................................................................................................... 22.1
Objectives.................................................................................................................................................. 22.1
Tax Terms................................................................................................................................................. 22.1
Pay As You Go.......................................................................................................................................... 22.2
Withholding.............................................................................................................................................. 22.2
Form W-4............................................................................................................................................... 22.3
Page 2 Worksheets............................................................................................................................. 22.10
Supplemental Wages...................................................................................................................... 22.12
Other Withholding Forms.................................................................................................................. 22.12
Pensions........................................................................................................................................... 22.12
Sick Pay........................................................................................................................................... 22.12
Gambling Winnings........................................................................................................................ 22.13
Unemployment Compensation....................................................................................................... 22.13
Social Security Benefits.................................................................................................................. 22.13
Education Tax Planning........................................................................................................................ 22.14
Education Savings Bond Program................................................................................................. 22.14
Coverdell Education Savings Account (ESA)............................................................................... 22.16
Estimated Tax........................................................................................................................................ 22.17
Computation of Estimated Tax......................................................................................................... 22.18
When to Pay Estimated Tax.............................................................................................................. 22.21
Underpayment of Estimated Tax...................................................................................................... 22.22
Completing Form 2210....................................................................................................................... 22.23
Computing the Penalty...................................................................................................................... 22.24
Extensions............................................................................................................................................... 22.27
Automatic Extension.......................................................................................................................... 22.27
Outside the United States................................................................................................................. 22.27
Serving in Combat Zone..................................................................................................................... 22.28
xiii

Direct Deposit of Refund to More than One Account.......................................................................... 22.29


IRAs..................................................................................................................................................... 22.29
TreasuryDirect Account.................................................................................................................. 22.29
U.S. Series I Savings Bonds.............................................................................................................. 22.29
Installment Agreement Request........................................................................................................... 22.30
Payment Methods............................................................................................................................... 22.30
Chapter Summary.................................................................................................................................. 22.32
Suggested Reading............................................................................................................................. 22.32
TAX ESSENTIALS CAPITAL ASSETS
Overview................................................................................................................................................... 23.1
Objectives.................................................................................................................................................. 23.1
Tax Terms................................................................................................................................................. 23.1
Introduction to Property.......................................................................................................................... 23.2
Types of Property.................................................................................................................................. 23.2
Uses of Property.................................................................................................................................... 23.2
Capital Assets........................................................................................................................................... 23.3
Basis.......................................................................................................................................................... 23.4
Holding Period.......................................................................................................................................... 23.5
Gain or Loss.............................................................................................................................................. 23.5
Form 1099-B........................................................................................................................................... 23.12
Capital Gains Tax Rates........................................................................................................................ 23.13
Normal Capital Gains........................................................................................................................ 23.14
28% Gain............................................................................................................................................. 23.14
Taxable Gain or Deductible Loss.......................................................................................................... 23.18
Capital Loss Carryover.......................................................................................................................... 23.21
Form 1099-S............................................................................................................................................ 23.27
Sale of Taxpayers Home....................................................................................................................... 23.27
Chapter Summary.................................................................................................................................. 23.28
Suggested Reading............................................................................................................................. 23.28
ETHICS
Overview................................................................................................................................................... 24.1
Objectives.................................................................................................................................................. 24.1
Tax Terms................................................................................................................................................. 24.1
Due Diligence............................................................................................................................................ 24.2
Accurate and Complete........................................................................................................................ 24.2
Thorough Interview.............................................................................................................................. 24.2
Reasonability Check............................................................................................................................. 24.2
BlockWorks Notes............................................................................................................................. 24.2
Conflict of Interest.................................................................................................................................... 24.3
Exceptions to Conflict of Interest Rules............................................................................................. 24.4
Taxpayer Confidentiality......................................................................................................................... 24.4
Privileged Communications................................................................................................................. 24.5
Privilege Under 7525 Is Narrow.................................................................................................... 24.5
Unenrolled Tax Return Preparers ..................................................................................................... 24.5
Annual Filing Season Program Participants................................................................................. 24.5
PTIN Holders.................................................................................................................................... 24.6
Noncompliance.......................................................................................................................................... 24.6
xiv

Disreputable Conduct.............................................................................................................................. 24.6


Examples of Disreputable Conduct..................................................................................................... 24.7
Sanctions Related to Disreputable Conduct....................................................................................... 24.7
Terminology....................................................................................................................................... 24.8
Chapter Summary.................................................................................................................................... 24.9
Suggested Reading............................................................................................................................... 24.9
STATE-SPECIFIC TRAINING
California.................................................................................................................................................. 25.1
FINAL EXAM REVIEW
Overview................................................................................................................................................... 26.1
Instructions............................................................................................................................................... 26.1
FINAL EXAM
Overview................................................................................................................................................... 27.1
Instructions............................................................................................................................................... 27.1

xv

Introduction to Taxation
OVERVIEW
The hardest thing to understand is the income tax.
Albert Einstein, Physicist
Congratulations on enrolling in the H&R Block Income Tax Course (2015). You are embarking on a
course of study that is challenging and ever-changing. This course will provide a solid foundation on
the subject of taxes, and the preparation of an accurate and complete income tax return.
The course is designed to teach four primary concepts:
Tax theory and law. The course covers federal and state tax law.
Conducting a thorough taxpayer interview.
Offering tax advice and explanations to taxpayers.
Electronic tax preparation through the usage of BlockWorks tax preparation software.
You will understand and develop the ability to explain income taxes in a way that Albert Einstein
could not, undoubtedly because he did not have the benefit of the H&R Block Income Tax Course
(2015)!

OBJECTIVES
This chapter will introduce you to the course schedule, course materials, and information on how to
successfully complete the course. We will then begin an introduction into the exciting field of income
tax! At the conclusion of this chapter, you will know:
Who may practice before the IRS.
The layout of an income tax return.
The role research plays for a Tax Professional.
How to define the various types of income.
How to round cents to the nearest dollar and percentages to two places past the decimal point.
How to interpret the information found on Form W-2, and where it is entered on Form 1040EZ.
How to complete the heading and signature sections of an income tax return.
How to compute Adjusted Gross Income (AGI) and taxable income on Form 1040EZ.
How to determine tax liability using the Tax Tables.

1.1

1.2 H&R Block Income Tax Course (2015)

BLENDED LEARNING
The H&R Block Income Tax Course features a blended-learning approach for participants. It combines instructor-led sessions taught by experienced Tax Professionals with self-study. This innovative
approach provides participants with the best features of classroom instruction and the flexibility and
convenience of self-study.

Instructor-Led Sessions
This course includes 48 hours of instructor-led sessions facilitated by experienced instructors. The
sessions are a combination of tax theory training and software practice. The instructors will show you
how the return is prepared in BlockWorks, giving you adequate exposure to the software before you
actually start using it later in the course.
The instructor-led sessions consist of:
Reviewing and expanding on the tax knowledge you gained from reading the textbook.
Reviewing and explaining the workbook exercises, including the solutions to the hand-prepared
income tax returns.
Software demonstrations and practice in most sessions.
Homework
Prior to arriving for each instructor-led session, you should have:
Read the assigned chapter(s) of the textbook. This includes both federal and state books.
Completed the workbook exercises, including hand-preparing the tax returns.
Written down any questions you have about any of the assignments, including the self-study
chapters.
Homework Tip: Make the effort to familiarize yourself with all forms and schedules. You need to

know where the numbers come from, and where they show up on the return. You should know which
forms and schedules apply to various income documents and tax situations.

This is a challenging course. Do not cheat yourself by trying to get through your reading or workbook
assignments quickly. Make sure you understand the material in each chapter before moving on to the
next chapter. Each chapter builds upon the knowledge you gained from previous chapters.

Self-Study Sessions
This course includes six self-study sessions. The amount of time spent on self-study assignments will
vary by student. You will receive two hours of Qualifying Education (QE) credit for each self-study
session, with the exception of the midterm review, which is one hour of QE. We all have different
learning styles, and as an adult learner, you certainly know what works best for you.
The self-study sessions are comprised of completing the following tasks in the following order:
Reading the assigned chapters of the textbook.
Completing the respective workbook exercises, including hand-preparing income tax returns.
Completing the web-based training (WBT) modules that supplement the textbook and workbook.

Introduction to Taxation 1.3

Your effort with the self-study assignments will directly affect your comprehension of important tax
topics that will be incorporated throughout the course.

PARTICIPANT MATERIALS
You should familiarize yourself now with the materials provided to you in this course. We all have
different ideas of organization. You are encouraged to tab or label the books as you see fit. Your
instructor may have suggestions, or your fellow participants may share their ideas when you attend
an instructor-led session.

Job Aids
Tax Computation Process.
Filing Status.
A Dependent Is
BlockWorks Hot Keys card.

Participant Materials
The following items are available from your instructor:
Important Notice to Potential and Incoming Students of H&R Blocks Income Tax Course.
Computer Usage Agreement.
Course syllabus.
Course schedule.
Textbooksone with federal tax content and one with state tax content, where applicable.
Workbook, including a forms section for preparing tax returns.
WBT access.
The graphic job aids will help visual learners understand fundamental tax concepts. They should
be referred to as often as necessary. The BlockWorks Hot Keys card will be needed once you begin
preparing income tax returns on the computer. You should become very familiar with the hot keys.
You may use your textbook to help you complete any of the exercises in the workbook or the WBTs.
For your convenience, a PDF copy of the textbook is posted in the same location as the WBTs. You
can use the search for keywords by right-clicking in the PDF, scrolling down to Find, typing in the
tax topic you need to find and hitting enter on your keyboard.
Your instructor will be able to address any course-related questions. The focus of this chapter will now
begin your introduction to the field of taxation.

1.4 H&R Block Income Tax Course (2015)

HISTORY AND THEORY OF INCOME TAXES


Taxes are what we pay for civilized society.
Oliver Wendell Holmes, Jr., U.S. Supreme Court Justice
After the U.S. Constitution was ratified in 1788, federal revenues were raised through tariffs and
excise taxes. The Civil War required much more revenue for the federal government than the tariffs
and excise taxes could raise. The income tax was established in 1862 but was repealed in 1872, after
the war.
On February 3, 1913, the states ratified the 16th Amendment to the U.S. Constitution. It reads:
The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived,
without apportionment among the several States, and without regard to any census or enumeration.
The U.S. income tax is considered progressive, because it taxes a larger percentage of income on higher-income taxpayers than on lower-income taxpayers.
Our communities receive public goods and services paid for by the federal government with money
raised through income taxes. Governments use the money collected to pay for items such as public
roadways, schools, and libraries. Tax revenue is also used to pay for services, such as police and fire
protection, subsidized school lunches, and defense funding.

The Internal Revenue Service


The Internal Revenue Service oversees the execution of the Internal Revenue Code, as enacted by
Congress. The IRS administers the Tax Code by collecting income taxes and advocating taxpayer
compliance.
The IRS Mission, according to the IRS website:
Provide Americas taxpayers top quality service by helping them understand and meet their tax responsibilities and enforce the law with integrity and fairness to all.
This mission statement describes our role and the publics expectation about how we should perform
that role.
In the United States, the Congress passes tax laws and requires taxpayers to comply.
The taxpayers role is to understand and meet his or her tax obligations.
The IRS role is to help the large majority of compliant taxpayers with the tax law, while ensuring
that the minority who are unwilling to comply pay their fair share.

Introduction to Taxation 1.5

WHO MAY PRACTICE BEFORE THE IRS?


Practice before the IRS covers all matters related to the following:
Communicating with the IRS for a taxpayer regarding the taxpayers rights, privileges, or liabilities under laws and regulations administered by the IRS.
Representing a taxpayer at conferences, hearings, or meetings with the IRS.
Preparing and filing documents, including tax returns, with the IRS for a taxpayer.
Providing a taxpayer with written advice which has a potential for tax avoidance or evasion.
Furnishing information at the request of the IRS or appearing as a witness for a taxpayer is not practice before the IRS.
Five categories of professionals can practice before the IRS:
1. Attorneys who are members in good standing of the bar of the highest court in a state or the
District of Columbia.
2. Certified Public Accountants (CPAs) are accountants who are qualified and licensed by a state,
possession, territory, commonwealth, or the District of Columbia to practice as CPAs.
3. Enrolled Agents (EAs) are individuals who have enrolled with the IRS and have remained in
active status.
4. Enrolled actuaries are enrolled as actuaries by the Joint Board for the Enrollment of Actuaries.
Actuaries are individuals who assess the financial consequences of risks, and use mathematics,
statistics, and financial theory to analyze and determine the financial impact of uncertain future
events. However, their practice before the IRS is limited to matters related to sections of the
Internal Revenue Code (IRC) within their area of expertise (primarily sections governing employee retirement plans).
5. Enrolled retirement plan agents, like EAs, are individuals who have been approved for active
enrolled retirement plan agent status by the IRS. However, their practice before the IRS is limited to matters related to sections of the IRC within their area of expertise (primarily sections
governing employee retirement plans).

1.6 H&R Block Income Tax Course (2015)

Limited Practice for Paid Tax Preparers


Paid tax preparers do not have all of the privileges to practice before the IRS that are given to
Enrolled Agents, CPAs, and attorneys. A paid tax preparer may represent a taxpayer before revenue
agents, customer service representatives, or similar officers and employees of the IRS, including the
Taxpayer Advocate Service, during an examination, if the paid tax return preparer signed the tax
return or claim for refund that is under examination.
A paid tax return preparer cannot:
Represent a taxpayer before any of these IRS officers: appeals, revenue, counsel, or similar officers
and employees of the IRS.
Provide tax advice other than advice necessary to prepare a return, a claim for refund, or other
document intended to be submitted to the IRS.
mExample: Sam is a paid tax return preparer who prepares and signs Megs tax return every year.
Meg received a CP 2000 Notice (a letter to the taxpayer proposing changes to one of her tax returns.
If Meg wants Sam to help her, he may contact the IRS on her behalf to request a 30-day extension,
prepare a response to the letter, and provide the IRS with more information. If Meg disagrees with
the letter and wants to appeal, she will have to do so through the IRS Office of Appeals where she can
represent herself or seek help from an Enrolled Agent, CPA, or attorney.m

Circular 230
Circular 230 is a publication that covers U.S. Treasury regulations on the rules governing practice before the IRS. These rules require attorneys, those qualified to practice as Certified Public
Accountants, Enrolled Agents, and others persons who prepare tax returns and provide tax advice
to conduct business with high ethical standards that protect the taxpayers. Circular 230 also covers
prohibited conduct and the penalties for noncompliance. You should familiarize yourself with Circular
230.

LAYOUT OF AN INCOME TAX RETURN


Forms 1040EZ, 1040A, and 1040 are the base forms of most individual income tax returns. There are
guidelines to determine which form is appropriate for each taxpayer. In addition, numerous other
forms and schedules are required to support the line entries on these base forms. Tax preparation
software automatically generates the forms, schedules, and worksheets according to the information
the Tax Professional inputs.

Introduction to Taxation 1.7

Tax Professionals should be able to explain the final income tax return to taxpayers. They should be
comfortable with the layout and be able to easily identify the location of the following sections and
how they affect each other:
Income.
Adjustments.
Tax.
Credits
Other Taxes.
Payments.
Refund or Balance Due.

E-file
As of January 1, 2012, any tax return preparer who prepares and files 11 or more Forms 1040, 1040A,
1040EZ, and 1041 during a calendar year, must use IRS e-file (unless the preparer or a particular
return is exempt from the e-file requirement or the return is filed by a preparer with an approved
hardship waiver). Authorized e-file providers are required to:
Manage the e-file process as directed by the IRS.
Protect the privacy of all e-filed documents.
Practice due diligence on behalf of taxpayers in regards to accepted and rejected returns.

TAX RESEARCH
Tax research skills are important to all Tax Professionals. You will not learn everything you need to
know about a tax topic in any one tax course. You will inevitably have questions that have not been
addressed.

Tax Law Authority


There are many tax research resources available. It is important to know which law has precedence,
based on authority. In tax law there are two authorities, primary and secondary.
Primary authority
Primary authority for tax issues consists of:
The Internal Revenue Code.
Regulations issued by the Treasury Department.
Judicial decisions.
Primary authority sources, as listed above in descending order of authority, are the highest authority
in determining the answer to tax-related questions.

1.8 H&R Block Income Tax Course (2015)

Secondary authority
Secondary authority examples are
Commentaries.
Publications.
Tax periodicals.
Common reference materials such as dictionaries and encyclopedias.
Secondary authority sources can help you understand the intent of the law, or provide an interpretation of the law. They are not binding authority.
Although secondary sources are not binding, they can provide what is known as persuasive authority.
For example, the published work of a tax scholar may influence how the IRS executes the law, influences the opinion of a court, or assists in legislation changes.
The IRS website, <www.irs.gov>, is comprehensive and informative. The search function is similar to
most search engines on the Internet. It is not case-sensitive and has advanced search capabilities. It
is to your benefit to familiarize yourself with the content and the navigation of the site.

Primary reasons to use the IRS website:


Researching tax topics.
Information on news and training specific to Tax Professionals.
Obtaining copies of forms, schedules, and publications.
Forms and Publications
The Forms and Publications section of the IRS website provides links to download and print forms,
publications, and schedules. Schedules are found in the Forms section.
The forms and schedules provided in the forms section of your workbook were current as of the date
this course was printed. The IRS does not update all forms and schedules every year. You may see
forms that have a year other than 2014 printed on them.

Other Tax Information Resources

Introduction to Taxation 1.9

Working Tax Professionals have access to other research services and publications. Some require fees,
and others are benefits of membership. H&R Block Tax Professionals receive complimentary research
services provided by the Tax Research Center from The Tax Institute (TTI) at H&R Block. TTI publishes a weekly newsletter called, Tax in the News. At the end of most chapters in this course, you will
see an example of questions that TTI answers for Tax Professionals. These questions and answers will
give you an idea of how tax theory is applied to taxpayer circumstances.
TTI endorses The Tax Book, published by Tax Materials, Inc., as the exclusive in-office tax reference
book. TTI, in partnership with Tax Materials, makes a customized copy of federal and state material
available to each office.
H&R Block Tax Professionals may purchase a copy of these reference materials at their own expense
for the same reduced rate.

TAX TERMS
Look up the definitions of the following terms in the glossary:
Adjusted Gross Income.
Credits.
Earned income.
Exemption.
Federal income tax withheld.
Gross income.
Income.
Medicare Part A.
Social security tax withheld.
Social security wages.
Tax liability.
Taxable income.
Unearned income.

WAGES, INCOME, AND TAXES


A wage is compensation, usually financial, received by workers in exchange for their work. The
Internal Revenue Service (IRS) states that wages received by an employee for performing services for
an employer must be included in gross income (defined later in this chapter).

1.10 H&R Block Income Tax Course (2015)

This chapter focuses on wages as income and how that income is taxed by the federal and most state
governments. You will examine the different tax forms used to report income and taxes to those governments. You will also learn how wages are reported to an employee by an employer. Finally, you
will complete a simple tax return.

WHAT IS INCOME?
Generally speaking, income is financial gain derived from labor (work), capital (money), or a combination of the two. The financial gain derived from labor is generally referred to as wages. Unless specifically exempt or excluded by law, all income is subject to income tax and is reported on a tax return.

Gross Income
Gross income means all world-wide income from whatever source derived, unless specifically excluded
from taxation by law. Gross income includes income realized in any form, whether in money, property,
or services.
See Illustration 1.1 on the next page for some items of income both included and excluded from gross
income.
Illustration 1.1

SOME ITEMS OF INCOME


INCLUDED IN GROSS INCOME*

SPECIFICALLY EXCLUDED FROM


GROSS INCOME**

Compensation for services, including fees, commissions, and certain fringe benefits

Life insurance payments, if paid by reason of


the death of the insured

Net income derived from business

Gifts and inheritances

Gains derived from dealings in property

Interest on state and local bonds

Interest

Compensation for personal injuries

Rents

Qualified clergy housing allowances

Royalties

Federal income tax refunds

Dividends

Qualified scholarships and fellowships

Alimony and separate maintenance payments

Meals or lodging furnished for the convenience


of the employer

Income from life insurance and endowment con- Certain foster care payments
tracts
Pensions

Disaster relief payments

Certain income from the discharge of indebtedness

Certain income from the discharge of indebtedness

Distributive share of partnership gross income


Income in respect of a decedent
Income from an interest in an estate or trust

*Gross income not limited to these items


**Other excluded items are beyond the scope of
this course

Introduction to Taxation 1.11

There are two types of gross income:


Earned income is received for services performed. Some examples are wages, commissions, tips,
and, generally, farming and other business income.
Note: Disability retirement benefits qualify as earned income until the taxpayer reaches minimum
retirement age. Minimum retirement age is the earliest age the taxpayer could have received a pension or annuity if they did not have the disability. Social security disability payments, Social Security
Disability Insurance (SSDI)payments, and military disability pension payments are not considered
earned income.
Unearned income is taxable income that does not meet the definition of earned income. It includes
money received for the investment of money or other property, such as interest, dividends, rents,
and royalties. It also includes pensions, alimony, unemployment compensation, and other income
that is not from performing services.
Note: Social security benefits may be included in taxable income. Benefits are included in the taxable
income (to the extent they are taxable) of the person who has the legal right to receive the benefits.
You will learn more about social security benefits when you read about retirement distributions.
Complete Exercise 1.1 before continuing to read.

THE INDIVIDUAL INCOME TAX FORMS


U.S. citizens and resident aliens are required to file Form 1040EZ, Form 1040A, or Form 1040.
Nonresident aliens who are required to file a U.S. return file Form 1040NR. Residents of Puerto
Rico file Form 1040PR. Completion of Forms 1040NR and 1040PR are not discussed in this course.
For more information, see IRS Publication 519, U.S. Tax Guide for Aliens, or Publication 179, Guia
Contributiva Federal para Patronos Puertorriqueos. Examine the copies of Form 1040EZ, Form
1040A, Form 1040, Form 1040NR, and Form 1040PR, found in Illustrations 1.21.11. Note the similarities and differences. Only the first two pages of Form 1040NR and the first two pages of Form
1040PR are shown. With only 14 lines, Form 1040EZ is the simplest to complete. Form 1040A, popularly referred to as the short form, is getting fairly long, as new items are added almost every
Form 1040, also known as the long form, is the most comprehensive of the three forms. Generally,
additional schedules and forms are required when a taxpayer uses Form 1040A, Form 1040, Form
1040NR, or Form 1040PR.

Schedules and Forms


Schedules and forms are official IRS documents used to report various types of income, deductions,
and credits. Totals determined on each schedule or form are entered on the appropriate line of Form
1040A or Form 1040 or occasionally on another schedule. Schedules and forms are part of the return
and are submitted to the IRS along with Form 1040A, Form 1040, Form 1040NR, and Form 1040PR.

1.12 H&R Block Income Tax Course (2015)


Illustration 1.2

Introduction to Taxation 1.13


Illustration 1.3

1.14 H&R Block Income Tax Course (2015)


Illustration 1.4

Introduction to Taxation 1.15


Illustration 1.5

1.16 H&R Block Income Tax Course (2015)


Illustration 1.6

Introduction to Taxation 1.17


Illustration 1.7

1.18 H&R Block Income Tax Course (2015)


Illustration 1.8

Introduction to Taxation 1.19


Illustration 1.9

1.20 H&R Block Income Tax Course (2015)


Illustration 1.10

Introduction to Taxation 1.21


Illustration 1.11

1.22 H&R Block Income Tax Course (2015)

Statements
Statements may or may not be official IRS forms. They are attached to the return to explain various
types of income, deductions, and credits reported either on a schedule or directly on Forms 1040EZ,
1040A, 1040, 1040NR, or 1040PR.

Worksheets
Worksheets are not sent to the IRS with the return. They are useful in compiling information and are
kept with the taxpayers copy of the return. You will be using various worksheets in many exercises
and review problems during this course.

State and Local Tax Returns


Most states and some cities require residents and individuals who earn income or own property within
their jurisdictions to file state and/or local returns. This course will cover state content as it is applicable to your geographic area.

ROUNDING
The IRS prefers rounding cents to the nearest dollar on all individual income tax returns. This course
adopts this procedure throughout. Rounding increases the accuracy and efficiency of each computation. When rounding cents, (50) fifty cents through ninety-nine cents (99) are rounded up to the
next highest dollar. One cent (1) through forty-nine cents (49) are simply dropped. Unless otherwise
specified, percentages are rounded to two places past the decimal point.
mExample: A total of $23.50 is rounded up to $24; $23.49 is rounded down to $23.m
mExample: The 3.454% rounds to 3.45% (or .0345 as a decimal); 3.456% rounds to 3.46% (or .0346 as
a decimal).m
When rounding income from multiple source documents, Publication 17 says to include cents when
adding the amounts and round off only the total. In this course, we round the amount on each document before entering it into the software.

ax Tip: The instructions in most IRS publications say to round the total,
but when filing electronically, the amounts from each source document
must be rounded. Each Form W-2 is entered into the computer; however, IRS
electronic filing specifications do not allow for the entry of cents.

mExample: Heather received three Forms W-2. The first shows $2,368.43 wages, the second
$5,299.37, and the third $1,022.46. If she adds the amounts together before rounding, her total is
$8,690.26, rounded to $8,690. If she rounds the amount on each document before adding them, her
total is $8,689 [$2,368 + $5,299 + $1,022 = $8,689].m
Complete Exercise 1.2 before continuing to read.

Introduction to Taxation 1.23

WAGES
One type of income familiar to just about everyone is wages. Most taxpayers are employees and must
report their employment income and income tax withholding on their tax returns. Every employee
should receive a Form W-2, Wage and Tax Statement, from their employer by January 31 each year,giving plenty of time to file. This reporting form contains a great deal of information that you need to
understand.
Employee compensation that must be reported on the tax return includes wages, salaries, commissions, bonuses, gifts of more than minimal value received from an employer, tips, back pay, severance
pay, and vacation pay. Certain expense reimbursements for which the employee has not adequately
accounted to the employer are also included in income and entered on Form W-2.
Cash allowances for meals and lodging, and the value of meals and lodging furnished as an employment incentive, are compensation includible in wages. On the other hand, meals and lodging furnished on the employers business premises and for the employers convenience and, in the case of
lodging, as a condition of employment, are not includible in wages.
mExample: Bess Rymon and her coworkers worked late into the evening to fill a rush order for their
employer. Because the workers were missing dinner, the boss sent out for pizza, which he gave to the
workers to eat. The value of the pizza is not taxable to Bess because the meal was consumed on the
employers premises and was provided for the employers convenience.m

FORM W-2 WAGE AND TAX STATEMENT


A Form W-2 is provided to each employee who received payment during the tax year for services performed for an employer. The 2014 standard IRS version of Form W-2 is shown in Illustration 1.12.
Forms W-2 take on many different appearances, but the format and information provided must meet
specific requirements established by the IRS. The complete Form W-2 consists of six copies:
Copy A is sent to the Social Security Administration by the employer along with Form W-3,
Transmittal of Wage and Tax Statements, by February 28 (or March 31, if they are filed electronically).
Copy 1 is sent to the state, city, or local taxing authority, if such authority assesses an income tax.
Copy B is given to the employee to be attached to their federal income tax return. See Illustration
1.12.
Copy C is given to the employee for their records.
Copy 2 is given to the employee to be attached to their state, city, or local income tax return, if
applicable.
Copy D is kept by the employer for their records.
Wages shown on Form W-2 are not reduced by any withholding for taxes, union dues, and other items.
Taxable wages may be reduced, however, by certain elective salary reductions and deferrals, such as
those to a 401(k) plan. You will learn more about these reductions later in the course.
.

1.24 H&R Block Income Tax Course (2015)

The amount of wages and tax withheld, as shown on Form W-2, must be reported on the return. Some
employers may issue two Forms W2, because they operate on a fiscal year or use an accrual accounting system, or because the employee worked in more than one state. If the taxpayer believes a W-2
is incorrect, they should discuss the matter with the employer who issued the document and request
that the employer issue a Form W-2c (corrected).
Employees who change jobs or have more than one job, should receive a Form W-2 from each employer. Also, if a married couple files a joint return and both husband and wife are employed, each should
receive one or more Forms W-2. Regardless of the number of Forms W-2, one total is entered on the
appropriate line of Form 1040EZ, Form 1040A, or Form 1040.

Specific Form W-2 Box Information


Study the Form W-2 shown in Illustration 1.12. The boxes of Form W2 are explained below. We first
concentrate on boxes a through f. Then we will continue, discussing boxes 1 through 20. Illustration
1.12 is a guide to help you see how the information flows from the document to the software screen
and ultimately ends up on the tax form.
Box a Employees Social Security Number (SSN)
Verify the employees social security number. If it is not right, it must be corrected by the taxpayers
employer.
Box b Employer Identification Number (EIN)
Box c Employers Name, Address, and ZIP Code
The employers name, address, and ZIP code are printed here. This information will be entered in the
tax preparation software just as it appears here.
Box d Control Number
This space is for the employers convenience. It may contain an entry, but it has no tax consequence.
Box e/f Employees Name, Address, and ZIP Code
Verify the accuracy of this information, keeping in mind that if the employee moved during the
year, the W-2 may reflect a previous address.
Note: It is important to verify the accuracy of the information in boxes a, e, and fparticularly
if you use it to complete the heading of the tax return. The employer should be notified so they
may correct their records and send the correct social security information to the Social Security
Administration.
If a taxpayer submits Form(s) W-2 in which the taxpayers social security number, name, or address
have been altered, the Tax Professional is responsible for questioning the taxpayer to be sure the SSN,
name, and address reported on the tax return are all correct and documenting how this determination
was made. Then:
If the social security number, name, or address have been altered, check the Yes box below line 11
on the Wage W2 screen in the software.
Inform the taxpayer that the IRS will later send them a notice that the information on the return
does not match the information they have previously received from an employer. The IRS notice
will request additional or updated information.

Introduction to Taxation 1.25


Illustration 1.12

Form W-2

Software Form W-2 Entry screen

1.26 H&R Block Income Tax Course (2015)


Illustration 1.13

Introduction to Taxation 1.27

Box 1 Wages, Tips, Other Compensation


This box represents the taxable amount of wages paid, noncash payments, tips reported, certain reimbursements for business expenses, and other employee compensation. Box 1 does not include amounts
paid into most deferred compensation plans. All box 1 amounts are totaled and then carry to Form
1040EZ, line 1 or Form 1040A, line 7.
Box 2 Federal Income Tax Withheld
Total federal tax withheld is entered on Form 1040EZ, line 7 or Form 1040A, line 40.
Box 3 Social Security Wages
On a single Form W-2, the amount in box 3, combined with any amount in box 7, should not exceed
$117,000 for 2014. If it does, the employer should correct it. Unlike box 1, box 3 includes payments the
employee may have made to deferred compensation plans and therefore may exceed box 1.
Box 4 Social Security Tax Withheld
Most employees are taxed 6.2% on their wages and tips up to $117,000 (for 2014) as their contribution
to the social security system. The tax withheld for this purpose is shown in box 4 for 2014. It should
not exceed $7,254.00 [$117,0006.2%].
Box 5 Medicare Wages and Tips
This box reflects the taxpayers wages and tips subject to the medicare tax. Unlike the amount of
social security wages in box 3, there is no limit on wages for medicare; therefore, this box represents
the total wages from the employer.
Box 6 Medicare Tax Withheld
Employees are taxed 1.45% on all of their wages and tips for medicare. In addition to withholding
medicare tax at 1.45%, the employer must withhold a 0.9% additional medicare tax from wages paid
to employees in excess of $200,000 in a calender year. Box 6 shows the amount withheld for this tax.
This figure has no consequence on the federal return, except for the Additional Child Tax Credit studied later in this course.
Box 7 Social Security Tips
Tips subject to social security tax received by the employee and reported to the employer are entered
in box 7. This amount includes all tips reported by the employee, even if the employees wages were
insufficient to collect the required social security tax on the tips.
Box 8 Allocated Tips
Employees of food or beverage establishments may have a portion of computed tips allocated to them.
These amounts may be taxable, but are not included in boxes 1, 3, 5, or 7.
Box 9 There should be no entry in box 9.

1.28 H&R Block Income Tax Course (2015)

Box 10 Dependent Care Benefits


Some employers help their employees pay for child and dependent care expenses. These (usually) taxfree benefits are entered in box 10. In Chapter 14, you will learn about the child and dependent care
credit and how any box-10 entry figures into the credit computation.
Box 11 Nonqualified Plans
This box is for distributions (payments) from nonqualified retirement plans. A nonqualified plan is a
retirement plan that does not meet certain requirements of the Internal Revenue Code. Any amount
shown in box 11 usually has been included in box 1 and is taxable.
Boxes 12ad
These boxes are used to report a variety of information. The entries in these boxes are accompanied
by letter codes. The codes are described in Illustration 1.14 for your reference, but the ones you see
most often are C, D, E, J, L, and DD.
The employer may enter up to four codes in box 12. A separate Form W-2 should be issued if more
than four codes apply.
Note: Any amounts coded A, B, M, or N will be entered on the dotted line next to Form 1040, line
61, along with the notation UT (uncollected tax), and should be included in the total tax on line 61.
Box 13
The employer will mark each box that applies:
Statutory employee. An employee whose earnings are subject to social security and medicare tax
withholding but not to income tax withholding. A statutory employee may report their income and
related expenses on Schedule C, a form that can only be filed with Form 1040. Certain full-time life
insurance salespersons are the most common examples of statutory employees.
Retirement plan. The employer should mark this box if the employee is an active participant
during any portion of the year in a qualified retirement plan maintained by the employer, such as
a 401(k) plan. If this box is marked, it may limit the amount of traditional individual retirement
arrangement (IRA) contributions the employee may deduct on their return. You will learn about
IRAs later in the course.
Third-party sick pay. This box should be marked if the employee received sick pay from an insurance provider other than the employer. Third-party sick pay may be treated differently from regular wages on the taxpayers state and local tax returns.
Box 14 Other
The employer may use this box to enter any other information they wish the employee to have.
Examples include educational assistance payments, union dues, health insurance premiums, and
charitable contributions. Any entry should be labeled.
Box 14 may also include certain contributions to retirement plans for which there is no applicable code
in box 12, or other deferred compensation or salary reduction plans, such as cafeteria plans.
mExample: Carlos Montana works for a state government and contributes to a 414(h) retirement
plan. There is not a box-12 code for such a plan, so their employer enters their pre-tax contributions
in box 14.m

Introduction to Taxation 1.29


Illustration 1.14

1.30 H&R Block Income Tax Course (2015)

is an entry in box 14 that you do not understand, ask the


TtaxpayerIf ifthere
they know what it represents. It may have a tax consequence
ax Tip:

or it may not, but you will not know unless you find out what it is. Additional
information not shown on Form W-2 can often be found on the stub attached to
it or on the taxpayers paycheck stubs.

Boxes 1520
State and local wage and tax information. These are amounts to be reported on the state and local
income tax returns.
Totals in the state and local tax columns are entered on the appropriate state and local returns and
on Form 1040, Schedule A, if they are included in the taxpayers itemized deductions. You will learn
about itemized deductions later in the course.

Substitute W-2
If an employee is unable to obtain a Form W-2 from an employer, total wages paid and taxes withheld
should nonetheless be determined and reported on the return. A statement, such as the H&R Block
Substitute Statement for Form W-2, should be attached, indicating how the determination was made
and what efforts were made to obtain the W-2. (IRS Form 4852 serves the same purpose as the H&R
Block statement, but the statement has an area to compile pay stub or similar information to arrive
at the totals.)
Study the sample substitute statement in Illustration 1.15. Notice that on the statement, the taxpayer
declares they have informed the IRS they did not receive a Form W-2. This is done by calling a toll-free
number for the taxpayers area of the country. The appropriate number may be found in the instructions for Forms 1040EZ, 1040A, and 1040. The taxpayer should wait until February 15 to make this
call. Also note the Important Notice in the middle of Illustration 1.15. Finally, the taxpayer should
sign this form after photocopies have been made. Only original signatures (not photocopies) should be
sent to the IRS and the Social Security Administration, if necessary. Illustration 1.16 shows an IRS
Form 4852.
a Tax Professional may prepare a return using the taxTpayers Although
paycheck stubs, that return may not be filed electronically without
ax Tip:

a Form W2 or its substitute. The IRS will not accept returns with substitute
W-2s prior to February 15. The electronic return originator must retain copies
of all Forms W2 and signed substitute statements.

Introduction to Taxation 1.31


Illustration 1.15

1.32 H&R Block Income Tax Course (2015)


Illustration 1.16

Introduction to Taxation 1.33

Unemployment
Unemployment compensation generally includes any amounts received under the employment compensation laws of the United States or of a state. If a person received unemployment compensation
during 2014, they should receive Form 1099-G, showing the amount they received. A Form 1099-G is
shown in Illustration 1.17. The amount of unemployment compensation is reported in box 1 and will
go on Form 1040EZ, line 3, or Form 1040A, line 13.
Illustration 1.17

PREPARING THE FORM 1040EZ


Heading the Return
The heading of Form 1040EZ is where the taxpayer enters their personal information and filing information. Taxpayers should always double check the information entered in the heading. For taxpayers
using a professional tax service, the service will enter the correct information and provide an envelope
with the IRS address if the return is not e-filed. Most returns filed by professional tax services are
electronically filed.
Taxpayer Identification Numbers
Most taxpayers have social security numbers, but the IRS can issue an individual taxpayer identification number (ITIN) to taxpayers who are ineligible to get social security numbers. Generally, this
applies to nonresident aliens. Certain tax benefits cannot be claimed by taxpayers without social
security numbers. An ITIN can be obtained by applying to the IRS with Form W-7.

1.34 H&R Block Income Tax Course (2015)

When a tax return is submitted to the IRS with a name or social security number (SSN) that does not
match the information on file with the Social Security Administration (SSA), the return is rejected.
This means the IRS has not accepted it, and it is considered to be unfiled. This often happens, for
example, when a married or divorced person fails to report a name change to the SSA. It is important
that the taxpayer verifies all personal information before filing a tax return. Besides preventing difficulties in processing the tax return, the correct name and SSN helps ensure that the taxpayer receives
all the future social security benefits to which they are entitled.
To head a return being done by hand, clearly print the following (preferably in capital letters, which
tend to be easier to read):
The taxpayers first name, middle initial, last name, and social security number.
The spouses first name, middle initial, last name, and social security number if the couple is filing jointly. (If they are filing separately, they cannot use Form 1040EZ. On the other two forms,
the spouses social security number is entered on this line, but their name is entered on the filing
status line 3.)
The taxpayers street address (including apartment number, if appropriate) or post office box. (If
the taxpayers post office does not deliver mail to their home, enter the post office box rather than
the street address.)
The taxpayers city, town, or post office, followed by the state and five- or nine-digit ZIP code.
The taxpayers Presidential Election Campaign Fund choicetaxpayer(s) should mark the box if
they wish to participate. Marking the box does not change the tax situation; it gives the government permission to transfer $3 of income tax collected from the general tax fund to the campaign
fund. This fund is allocated to presidential candidates based on the amount of money each candidate has received from contributions of individuals.
The taxpayers filing status.
Married taxpayers filing jointly may list their names in either order in the heading of the return.
The name listed first will be the primary taxpayer. Any mention of the taxpayer later in the return
refers to the primary taxpayer. They must be careful, however, to list the social security numbers in
the same order as their names. Married taxpayers should choose the order for entering their names
and social security numbers on their returns and consistently present their names and social security
numbers in that order in order to avoid confusion and delays in processing their returns.
Usually, the first social security number listed in the heading should also be used in the heading on
any other form or document attached to the return. Certain forms, however, require that the social
security number of the taxpayer who earned the income be used in the headings of those forms. Such
forms are identified when they are discussed during the course.
Complete Exercise 1.3 before continuing to read.

Introduction to Taxation 1.35

DETERMINING THE INCOME TAX


There are several methods used to compute a taxpayers tax. Most taxpayers use one of two methods:
the Tax Table or the Tax Computation Worksheet. Other methods used to calculate the tax (instead
of the Tax Table or the Tax Computation Worksheet) are for taxpayers with certain types of income,
such as capital gains, qualifying dividends, or foreign earned income. The following worksheets are
used when these other types of income are included in the tax return:
Qualified Dividends and Capital Gains Tax Worksheet.
Schedule D Tax Worksheet.
Schedule J, Income Averaging for Farmers and Fishermen.
Foreign Earned Income Tax Worksheet.
This chapter covers the Tax Tables and the Tax Computation Worksheet. We will cover the Qualified
Dividends and Capital Gains Tax Worksheet in Chapters 5. Schedule J, Income Averaging for Farmers
and Fishermen and the Schedule D Tax Worksheet are not covered in this course because they must
be filed with Form 1040. The Foreign Earned Income Tax Worksheet is beyond the scope of any beginning or intermediate tax course, but you can learn about it in continuing education courses in the
international tax field.
Before the taxpayer can determine their tax, they must determine their taxable income. The following
sections describe the steps taken to compute taxable income. You may want to look at Illustrations
1.21.7 as you read these sections. Also, the beginning of IRS Publication 17 has a topic, Which
Form Should I Use? that explains which types of income, deductions, credits, and other items may
be reported on each form. Do not worry that you are not familiar with themyou will learn about
most of them before the course is finished. When you begin using the software, you will see that it
automatically determines which base form to use according to the input. However, you will need to
know and understand other forms and schedules because there will be times when you need to select
them based on information the taxpayer shares with you.

Adjusted Gross Income (AGI)


The first step in computing taxable income is to determine the taxpayers adjusted gross income, or
AGI. To compute AGI:
Add up all the income items. The sum of Form 1040EZ, lines 13, is entered on line 4. On Form
1040A, enter the sum of lines 714b on line 15.
Total all income adjustments on Form 1040A, lines 1619. Form 1040EZ does not allow for any
adjustments to income.
Subtract the total adjustments from the total income to arrive at adjusted gross income on Form
1040A, line 21. Because no income adjustments are allowed on Form 1040EZ, line 4 of that form
already reflects adjusted gross income.

1.36 H&R Block Income Tax Course (2015)

Taxable Income
The next step in computing taxable income is to determine the taxpayers allowable standard deduction for their filing status or compute their total itemized deductions.
The standard deduction reduces the amount of income subject to tax and varies based on the taxpayers filing status. The regular standard deduction amounts are shown in the left-hand margin on page
2 of Form 1040A. A complete discussion of the standard deduction is contained in Chapter 2.
The standard deduction is entered on Form 1040A, line 24, and subtracted from the taxpayers AGI.
On Form 1040EZ, the standard deduction and exemption amount (described below) are combined on
line 5.
The final step in computing taxable income is to subtract the taxpayers exemption amount.
An exemption is a dollar amount ($3,950 for 2014) allowed by law as a reduction of income that
would otherwise be taxed. Every taxpayer, except one who may be claimed as a dependent on another
taxpayers return, may claim their own personal exemption. Thus, most tax returns will show one
personal exemption, or two in the case of a married couple filing jointly.
One additional exemption is allowed for each person who qualifies to be claimed as a dependent on
the taxpayers return. Dependent exemptions are discussed in Chapter 3.
The total exemption amount is entered on Form 1040A, line 26. Remember, the standard deduction
and exemption amount are combined on Form 1040EZ, line 5.
mExample: Mark (43) and Linda (42) Ferris file a joint return, shown in Illustration 1.13 on page
1.26, and have no dependents. Their AGI is $41,250, and they use the standard deduction. Their
taxable income is $20,950 [$41,250 AGI $12,400 standard deduction ($3,950 2 2 exemptions) =
$21,250].m
Complete Exercise 1.4 before continuing to read.

USING THE TAX TABLE


The Tax Table is used by taxpayers whose taxable incomes are less than $100,000. The Tax Table is
located in the Appendix of this text on pages A.5A.16. To determine the taxpayers income tax, look
at the column for the appropriate filing status and the line in the table containing the taxpayers taxable income (Form 1040EZ, line 6; Form 1040A, line 27).
The income tax is entered on Form 1040EZ, line 10 or Form 1040A, line 28. Illustration 1.18 shows
the relationship between the Tax Table and Form 1040EZ for Mark and Linda Ferris, from the preceding example.
The Tax Table is the most common way of computing the tax on federal tax returns. However, the
Tax Computation Worksheet (see Illustration 1.19) is required if taxable income is $100,000 or more.
There are also several other methods of computing the tax for taxpayers with special situations. You
will learn how to use the other tax computation methods in future chapters.

Introduction to Taxation 1.37


Illustration 1.18

1.38 H&R Block Income Tax Course (2015)


Illustration 1.19

Introduction to Taxation 1.39

The amount of income tax is reduced by any applicable credits and increased by any additional taxes
to arrive at the total tax. These items will be discussed later in the course.
If the payments are more than the tax, the difference is entered on Form 1040EZ, line 13a; Form
1040A, line 48a. This is the overpayment. A taxpayer who files Form 1040A may choose to have some
or all of their overpayment applied to their next years estimated tax bill. Any applied amount will be
entered on Form 1040A, line 49. Form 1040EZ does not allow an overpayment to be applied to next
years tax. We will discuss estimated taxes later in the course.
Of course, most taxpayers choose to have the full amount of the overpayment refunded to them. They
enter the amount to be refunded on Form 1040EZ, line 13a or Form 1040A, line 48a. The IRS will
mail a check to the taxpayer or make a direct deposit to the taxpayers bank account if so requested.
The bank account information for direct deposit must be entered on lines b, c, and d of the refund line
of the return. If direct deposit is not requested, fill the boxes in lines b and d with Xs or draw lines
through them.
If the tax is more than the payments, the difference is entered on Form 1040EZ, line 14 or Form
1040A, line 50. This is the taxpayers balance duethe amount owed. The balance may be paid by personal check, by money order, through a direct debit from the taxpayers checking or savings account,
or with a major credit card.

Third-Party Designee
Notice the area above the signature section in any of the forms shown in Illustrations 1.2-1.11 beginning on page 1.12. Sometimes the IRS needs additional information to process a tax return. If the
taxpayer wishes to designate the preparer or a third party, such as a friend or family member, as the
person to be contacted by the IRS to obtain the necessary information, he may check the Yes box. If
the paid preparer is designated, the taxpayer should simply enter the word Preparer as the designees name. Otherwise, they must provide the designees name and telephone number along with a
five-digit personal identification number (PIN) selected by the designee.
Complete Exercises 1.5 and 1.6 before continuing to read.

SIGNING THE RETURN


Every taxpayer must sign their own return. A joint return must be signed by both the taxpayer and
the spouse. The date of signing, occupations, and daytime telephone number should be entered in the
appropriate spaces.
If a spouse died before the end of the year, and the surviving spouse files a joint return, the executor
or administrator must sign the return for the deceased spouse. If no one has been appointed executor
or administrator, the surviving spouse can sign the joint return and enter Filing as surviving spouse
in the signature area.

1.40 H&R Block Income Tax Course (2015)

Paid tax return preparers must sign every return they are paid to prepare. The date the return was
prepared should also be entered. The preparer must enter their preparer tax identification number
(PTIN) in the space provided. In addition, the tax preparer must be sure their employers company
name, address, ZIP code, phone number, and employer identification number are entered in the signature section. A self-employed preparer should enter their own name, PTIN, the address, ZIP code,
and phone number where they can be reached all year and should check the self-employed box.
In these early chapters of the course, you will be doing the returns by hand. A few of these may be
done in class; however, the majority of them will need to be completed as homework. For those completed as homework, your instructor will review them and demonstrate how they should be entered
in the software. At the bottom of each return, you will always need to sign the returns, but when you
start doing them in the software, the H&R Block Tax Professional information will be automatically
entered.
Note: If you plan to prepare tax returns for compensation in the upcoming tax season, visit with your
instructor about the process to apply for a PTIN. Your instructor should be able to provide the details
about how and when you should apply.
Complete Exercise 1.7 before continuing to read.

CHAPTER SUMMARY
In this chapter, you learned the information you need to succeed in this course. You also began your
introduction into the field of taxation with information on:
General facts on the history and theory of taxes.
Who may practice before the IRS.
The layout of an income tax return.
The role research plays for a Tax Professional.
That the tax forms for individual taxpayers are Form 1040EZ, Form 1040A, Form 1040, Form
1040NR for nonresident aliens, and Form 1040PR for residents of Puerto Rico.
Form W-2 is used by employers to report wages and various tax withholdings, as well as a variety
of other information, to the IRS, the Social Security Administration, state and local taxing agencies, and the employee.
To arrive at taxable income for a taxpayer who does not itemize deductions, subtract the taxpayers
standard deduction and total exemption amount from their adjusted gross income.
To use the Tax Tables to determine the income tax for most taxpayers with taxable incomes of less
than $100,000.

Introduction to Taxation 1.41

Suggested Reading
For further information on the topics discussed in this chapter, you may wish to read Chapter 1 of
IRS Publication 17.

he Tax Institute Tax in the News Research Question: My client


received a W-2 and a 1099-MISC from her employer. Her year-end bonus
was reported as other income in box 3 of the 1099. What is the proper tax
treatment of the bonus?

nswer: The bonus should be treated as wages, and not as other income or
self-employment income.
Many employers mistakenly report any pay outside of regular salary such as
bonus, commission, or severance pay on form 1099-MISC instead of on Form
W-2. Your client should first ask her employer to rescind the 1099 and issue a
corrected W-2.
If she cannot contact her employer, or the employer wont make the change,
report the correct total wages, including the bonus, on line 7 of Form 1040,
using a substitute W-2 (Form 4852). To pay her share of payroll taxes, complete Form 8919, Uncollected Social Security and Medicare Tax on Wages, and
check box H on the form: I received a Form W-2 and a Form 1099-MISC from
this firm for 2014. The amount on Form 1099-MISC should have been included as wages on Form W-2.
Since your clients regular pay is reported on Form W-2, it is presumed
that her employer is treating her as an employee and not as a contractor.
Therefore, she should not complete Form SS-8 to request a determination of
worker status.

Filing Requirements
OVERVIEW
Not every taxpayer with gross income must file a tax return. Some taxpayers who meet certain
requirements do not have to file a tax return. However, those who do not have a filing requirement
may benefit from filing a tax return in order to get a refund.
This chapter discusses the preliminary information of a tax return. The first step in preparing an
income tax return is to determine if the taxpayer is required to file one in the first place. In this chapter, you will study the filing requirements for federal income tax purposes.

OBJECTIVES
At the conclusion of this chapter, you will be able to:
Determine whether a tax return must be filed based on the taxpayers filing requirements.
Determine the taxpayers standard deduction and personal exemption amount.
Determine whether a taxpayer may use the single, married filing jointly, or married file separate
filing statuses.
Explain the differences between the injured spouse allocation and the innocent spouse relief.

TAX TERMS
Look up the definitions of the following terms in the glossary:
Community income.
Community property.
Dependent.
Gross income.
Joint return.
Married filing jointly (MFJ).
Married filing separately (MFS).
Standard deduction.

2.1

2.2 H&RBlock Income Tax Course (2015)

FILING REQUIREMENTS
Filing requirements differ among the following:
Nondependents.
Dependents.
Certain children under age 19 or full-time students under age 24.
Self-employed individuals.
Aliens.
This chapter focuses on the first three categories. We will also briefly cover the filing requirement for
the self-employed. The filing requirements for aliens are covered in IRS Publication 519, U.S. Tax
Guide for Aliens.

Tfollowing:A thorough client interview begins with questions about the


ax Tip:

Marital status.
Age.
Gross income.

Dependent status.

his important information is a part of every return that is accurate and


complete. This information also helps to determine the taxpayers filing status, standard deduction, and personal exemption amount.

NONDEPENDENTS
The following three factors determine the filing requirement for nondependents:
Filing status.
Age.
Gross income.
See the chart in Illustration 2.1 on page 2.6 for the filing requirement guidelines that apply to nondependents.

Filing Status
For federal income tax purposes, there are five filing statuses:
1. Single.
2. Married filing jointly.
3. Married filing separately.
4. Head of household.
5. Qualifying widow(er).

Filing Requirements 2.3

Specific requirements must be met in order to qualify for each filing status. We will discuss filing statuses 13 later in this chapter. Filing statuses 4 and 5 are a bit more involved and are discussed in
Chapter 4.
The first step in determining a taxpayers filing status is to determine the taxpayers marital status.
Marital status (married or unmarried) is determined on the last day of the tax year. The marital status of a person who died during the year, as well as that of the surviving spouse, is determined as of
the date of death.
mExamples: Bob and Carol were married on December 31, 2014. They are considered married for the
2014 tax year.
Ted and Alices divorce became final on December 31, 2014. They are considered unmarried for the
2014 tax year.
Russell and Dawn have been married for several years. Russell died on March 27, 2014. Russell and
Dawn are considered married for the 2014 tax year.m
If a taxpayer is considered unmarried on the last day of the tax year, then the taxpayer may be eligible
to file as single, head of household, or qualifying widow. If a taxpayer is considered married on the last
day of the tax year, then the taxpayer may file as married filing jointly or married filing separately.
Common-Law Marriages
A taxpayer is considered married if, at the end of the tax year, the taxpayer is in a common-law marriage that is recognized in the state where the couple is residing or was at the time recognized by the
state where the common-law marriage began. Your instructor will inform you about further details
on common-law marriages in your state.
While specific requirements vary by state, a common-law marriage generally must meet four legal
standards:
1. The parties must have the legal capacity to marry.
2. Single parties must have the current intent to marry. That is, they must intend to be married
and must communicate that intent to one another.
3. The couple must live together.
4. The parties must publicly present themselves to others as a married couple.
It is a common misconception that a couple must live together for a set number of years to have a
common-law marriage. In reality, there is no time limit if the four conditions listed above are met.
While some states allow common-law marriages, there is no such thing as a common-law divorce.
If the partners decide to go their separate ways, they must petition the state court for a decree of
divorce just like any other married couple.
is not the job of a Tax Professional to determine whether a relaTtionshipItconstitutes
a common-law marriage. If a couple is in doubt as to
ax Tip:

their legal marital status, they should seek the advice of an attorney.

2.4 H&RBlock Income Tax Course (2015)

Same-Sex Marriages
For federal tax purposes, individuals of the same sex are considered married if they were lawfully
married in a state (or foreign country) whose laws authorize the marriage of two individuals of the
same sex, even if the state (or foreign country) in which they now reside does not recognize same-sex
marriage. For federal tax purposes, the term spouse includes an individual married to a person
of the same sex if the couple is lawfully married under state(or foreign) law. However, individuals
who have entered into a registered domestic partnership, civil union, or other similar relationship
that is not considered a marriage under state (or foreign) law are not considered married for federal
tax purposes. For more details, see Publication 501, Exemptions, Standard Deduction, and Filing
Information.

Age
For general tax purposes, a person is considered to have attained any given age on the first moment
of the last day of that year of his lifethat is to say, the day before his birthday.
mExample: Deanna Shoenburger was born on January 1, 1974. For general tax purposes, she is considered to be age 41 for the 2014 tax year, even though her 41st birthday does not occur until January
1, 2015.m
A taxpayer is considered to have attained the age of 65 on the day before his 65th birthday.
mExample: Jane McGuires 65th birthday is January 1, 2015; for tax purposes, she is considered age
65 for the 2014 tax year.m
The age of a person who dies during the year is determined as of the date of death.
mExample: Shelly Burrows died on September 21, 2014, a month before her 65th birthday. She is age
64 for purposes of her 2014 tax return.m
you may be aware that normal retirement age for social
TsecurityAlthough
purposes is increasing to age 67, the age of 65 retains its signifax Tip:

icance for general tax purposes. You will discover more about the change in
retirement age later, when you learn about social security benefits.

As you will discover throughout this course, some special rules apply to children with regard to age.
For several specific tax purposes, children are considered to have attained a certain age on their
birthday, rather than on the preceding day.
mExample: Jared Peterson, dependent son of Beverly Peterson, was born on January 1, 1998; his
17th birthday is January 1, 2015. When determining whether Beverly may claim the Child Tax
Credit (which you will learn about in Chapter 3), Jared is considered to be 16 years old on December
31, 2014. However, for general tax purposes, Jared is considered to have attained the age of 17 as of
December 31, 2014.m

Filing Requirements 2.5

Gross Income
As discussed in the last chapter, gross income is total worldwide income subject to tax. There are two
aspects to determining gross income:
Who owns the income.
What income should be reported on a tax return.
Ownership of income, in the case of a married couple, is determined by state law. The laws regarding
the ownership of income and property in most states are based on British common law. These states
are called separate property states. In separate property states, income received belongs to the spouse
who earned it or who owns the property that produced the income.
Nine states are community property states. See the chart in Illustration 2.2 for a list of these nine
community property states. With the exception of Wisconsin, the laws of community property states
are based on Spanish civil law. Generally, in community property states, income received for services
performed is considered to belong half to the spouse and half to the other spouse, regardless of which
spouse earned it. The laws regarding the ownership of income from property vary among these states.
Generally, ownership of income needs to be determined only if the couple files separate returns.
When determining if a taxpayer is required to file, generally the nondependent taxpayer would be
required to file an income tax return if their gross income equals or exceeds a gross income threshold
amount. This gross income threshold amount changes based on the taxpayers filing status and age
(see the chart in Illustration 2.1). The gross income threshold amount generally consists of the sum of
the taxpayers standard deduction and personal exemption amount. These two separate items reduce
the taxpayers income subject to income tax on their return. If a taxpayer has gross income less than
the sum of their standard deduction or personal exemption, then it is generally safe to say that their
gross income is reduced to zero and the taxpayer may not be required to file a tax return. The standard deduction and personal exemption amounts will be discussed next in the chapter.
As a general rule, a nondependent taxpayer is required to file a tax
Treturn when
their gross income is equal to or greater than the sum of the
ax Tip:

taxpayers standard deduction and personal exemption amount. However, a


married taxpayer using the married filing separately status must file a return
when their gross income equals or exceeds the personal exemption amount
($3,950 for 2014).

Standard Deductions
The standard deduction reduces the amount of income that is subject to tax. This amount varies,
according to the taxpayers filing status. The following are the regular standard deductions for 2014:
$6,200 Single or married filing separately.
$12,400 Married filing jointly or qualifying widow(er).
$9,100 Head of household.

2.6 H&R Block Income Tax Course (2015)


(2014)
Illustration
Illustration X.X
2.1

GROSS INCOME FILING REQUIREMENTS FOR 2014 (NONDEPENDENTS)


Individuals Who Are:

Are Required to File


Individuals Who Are:
If Gross Income Is:

Single

Married Filing Jointly


Under age 65

$10,150

Both under age 65

$20,300

Age 65 or older

$11,700

One spouse age 65 or older

$21,500

Both age 65 or older

$22,700

Head of Household
Under age 65
Age 65 or older

$13,050 Married Filing Separately


$14,600

Regardless of age

Qualifying Widow(er)
Under age 65

$16,350

Age 65 or older

$17,550

Illustration 2.2

COMMUNITY PROPERTY STATES


Arizona

New Mexico

California

Texas

Idaho

Washington

Louisiana

Wisconsin

Nevada

Are Required to File


If Gross Income Is:

$3,950

Filing Requirements 2.7

Increased Standard Deductions


Taxpayers who are age 65 or older and/or blind are entitled to the following increased standard deduction amounts:
$1,550 (per condition) for singles and heads of households.
$1,200 (per condition) for all married taxpayers and qualifying widow(er)s.
The increased amounts are calculated per the boxes checked on line 23a, Form 1040A (see Illustration
2.3.).
The filing requirement computation for taxpayers age 65 and over includes the extra amount for age,
but the extra amount allowed for blindness is not included in the computation.
Blindness
A taxpayer may claim the additional standard deduction for blindness if they are totally or partly
blind at the close of the tax year. Partly blind means that the person is able to see no better than
20/200 in the better eye with corrective lenses, or the person has a field of vision not more than 20
degrees.
A taxpayer who is partly blind and whose sight will never improve beyond these limits, must obtain
a certified statement from their eye doctor or registered optometrist. The statement must be retained
by the taxpayer with their records; it need not be attached to the return or sent to the IRS.
can be corrected beyond the limits by contact lenses that
Tcan onlyIfbevision
worn briefly because of pain, infection, or ulcers, the higher
ax Tip:

standard deduction for blindness still applies.

Illustration 2.3

Personal Exemption Amount


An exemption is a dollar amount ($3,950 for 2014) allowed by law as a reduction of income that would
otherwise be taxed. The exemption is in addition to the taxpayers standard deduction. Every taxpayer, except those who may be claimed as a dependent on another taxpayers return, may claim his own
personal exemption. Thus, most tax returns will show one personal exemption, or two in the case of
a married couple filing jointly.

2.8 H&RBlock Income Tax Course (2015)

mExample: Matthew (42) and Sue (41) Calendo will file a joint return. Their standard deduction is
$12,400. Their gross income filing requirement is $20,300 [$12,400 + $7,900 personal exemptions =
$20,300].m
mExample: Larry White (66) uses the single filing status. His standard deduction is $7,750 [$6,200 +
$1,550 = $7,750]. His gross income filing requirement is $11,700 [$6,200 + $1,550 + $3,950 personal
exemption = $11,700].m
mExample: Larrys brother, Jeff White (56), is blind and uses the single filing status. His standard
deduction is also $7,750 [$6,200 + $1,550 = $7,750]. His gross income filing requirement is $10,150
[$6,200 + $3,950 personal exemption = $10,150]. Notice that the extra $1,550 standard deduction for
blindness does not count in the computation of his gross income filing requirement.m
One spouse is never the dependent of the other spouse. When the married filing separately status is
used, however, a taxpayer may claim his spouses personal exemption only if the spouse:
Has no gross income.
Is not filing a return.
Is not a dependent of another person.
If the taxpayers spouse is a nonresident alien, the taxpayer may also claim an exemption for their
spouse if the nonresident alien spouse meets the three requirements listed above.
mExample: Ral and Leah Martinez are married. Leah has no income of any kind and does not receive
any other support, but she does not wish to file a joint return with Ral. Ral may claim Leahs
exemption on his married filing separate return.m
In 2012, the Personal Exemption Phaseout (PEP) was reinstated by the American Taxpayer Refund
Act of 2012 (ATRA). This means that the PEP will reduce the taxpayers personal exemption by 2% for
every $2,500 ($1,250 for married filing separately) that exceeds certain AGI thresholds. The exemption deduction begins to phase out when the taxpayers 2014 AGI exceeds the following amounts:
$305,050 Married filing jointly and qualifying widow.
$279,650 Head of household.
$254,200 Single.
$152,525 Married filing separately.
For more information on PEP, see IRS Publication 17, page 36.
is also allowed for each person who qualifies to be
TclaimedAnas exemption
a dependent on a tax return. Dependent exemptions are not to
ax Tip:

be confused with personal exemptions. They will be discussed in Chapter 3.

Filing Requirements 2.9

Dependent Taxpayers
A taxpayer who may be claimed as a dependent on another taxpayers return is considered a dependent taxpayer. A taxpayer becomes a qualifying dependent on another taxpayers return because the
taxpayer meets the qualifying child or qualifying relative tests. These tests are discussed in more
detail in Chapter 4. A taxpayer who may be claimed as a dependent on another taxpayers return may
not, under any circumstances, take their own personal exemption. This is true even if the taxpayer
entitled to claim the dependents exemption chooses not to for any reason.
mExample: Mark and Janice Hall may claim their daughter, Linda (18), as a dependent. Because
Linda holds a part-time job and must file a return, they decide not to claim Linda in the mistaken
belief that she may then take her own exemption on her return. This tactic does not work. The fact
that Linda may be claimed on her parents return precludes her from claiming her own personal
exemption. If Mark and Janice do not claim Lindas exemption, no one will benefit from the $3,950
reduction in taxable income.m
The nondependent filing requirements do not apply to dependent taxpayers. Whether a dependent
taxpayer must file a return depends on the dependent taxpayers unearned income, earned income,
gross income, marital status, age, and whether the dependent taxpayer is blind. See the flowchart in
Illustration 2.4 for details on determining if a dependent taxpayer must file a return. This flowchart
is also available in IRS Publication 17, page 7.
When determining if a dependent taxpayer is required to file, first look at their amount of unearned
income received during the year. If the dependent taxpayers unearned income is greater than $1,000,
then the taxpayer must file. Next look at the dependent taxpayers earned income. If the dependent
taxpayers earned income exceeds a specific threshold amount based on the taxpayers marital status, age, and whether the taxpayer is blind, then the dependent taxpayer is required to file a return.
Next, determine if the dependent taxpayer is married and if their spouse is filing a separate return
and itemizing deductions. If this is true and the dependent taxpayer has at least $5 of gross income,
then the married dependent taxpayer must file a return. Last, determine if the dependent taxpayers
gross income exceeds a specific threshold amount. If the dependent taxpayers gross income exceeds
a specific threshold amount based on the taxpayers marital status, age, and whether the taxpayer is
blind, then the dependent taxpayer is required to file a return.
For dependent taxpayers, the earned income and gross income filing requirement thresholds are
based on the dependents standard deduction. These threshold amounts change based on the dependent taxpayers marital status, age, and whether they are blind.
mExample: Markus Kleen (16) is a dependent on his parents return. He is single, not legally blind,
and his gross income for the year is $1,200 ($800 earned income + $400 unearned income). When
determining if Markus is required to file a return, his unearned income is below the $1,000 threshold amount and his earned income is also below the $6,200 threshold amount. When applying the
gross income threshold, first determine if the maximum threshold amount is the greater of $1,000 or
Markus earned income plus $350. Because Markus earned income is $800, his gross income threshold amount is set at $1,150 [$800 + $350 = $1,150]. Markus is required to file a return because his
gross income of $1,200 is greater than his gross income threshold amount of $1,150.m

2.10 H&RBlock Income Tax Course (2015)


Illustration 2.4

Filing Requirements 2.11

When a married taxpayer wishes to file a married filing separate


Treturn and
their spouse itemizes deductions on their return, the taxpayer
ax Tip:

should itemize deductions on their return because their standard deduction is


reduced to $0.

A dependents standard deduction is generally equal to the greater of the following:


$1,000.
Their earned income plus $350.
A dependent taxpayers standard deduction may not exceed the regular standard deduction for their
filing status, which is $6,200 for the single filing status. Dependent taxpayers are also entitled to
increase their standard deduction by additional amounts ($1,550 if single or $1,200 if married) if they
are age 65 or older and/or if they are legally blind. Review Illustration 2.4 and see how the $1,000
gross income threshold amount increased if the dependent taxpayer age 65 or older or blind.
It is interesting to note that, while blindness is not a factor in determining the gross income filing
requirements for nondependents (as mentioned in the Larry and Jeff White examples earlier on page
2.8), it is a factor in determining the gross income filing requirements for dependents.

Certain Children Under Age 19 or Full-Time Student


If a child is under the age of 19 or a full-time student under the age of 24 at the end of the tax year and
the childs only income is interest and dividends, a parent may be eligible to elect to include the childs
income on the parents return, which in turn releases the child from filing an income tax return.
A parent can make this election if the following items are met:
The child is under the age of 19 or under the age of 24 if a full-time student at the end of the tax
year.
The child had income only from interest and dividends.
The childs gross income was less than $10,000.
The child is required to file a return, unless the parent makes this election.
The child does not file a joint return for the year.
No federal income tax was withheld from the childs current year income, no current year estimated tax payments were made by or for the child, or no previous year overpayments were applied
against the childs current year tax liability.
For more information about a parent claiming their childs interest and dividends income, see IRS
Publication 17, page 206.

2.12 H&RBlock Income Tax Course (2015)

Others Who Must File


There are circumstances under which a return must be filed, even if the taxpayer(s) does not meet the
gross income filing requirements. The most common situations are when an individual:
Owes uncollected social security or medicare tax on tips not reported to the employer or on wages
the taxpayer received from an employer who did not withhold these taxes.
The taxpayer received HSA, Archer MSA, or Medicare Advantage MSA distributions during the
tax year.
Has net profit from self-employment of $400 or more. Self-employment income is generally income
earned by a taxpayer who owns a business and files a Schedule C, Profit or Loss From Business.
Received an advanced premium tax credit (APTC) during the tax year. The taxpayer is required to
file a tax return and attach Form 8962, Premium Tax Credit, even if they did not otherwise have a
filing requirement for the year.
A more detailed list of other situations when a taxpayer must file a 2014 tax return can be found in
IRS Publication 17, page 8.

Taxpayer Should File


Even if a taxpayer is not required to file, they should file a return to get money back or a refund if they
had federal income tax withheld or made estimated tax payments, they qualify for the Earned Income
Tax Credit (EITC), Child Tax Credit (CTC), premium tax credit (PTC), or American Opportunity
Credit (AOC).
Complete Exercise 2.1 before continuing to read.

Affortable Care Act (ACA) may allow qualified taxpayers to


Treceive The
an advance premium tax credit (APTC) by applying for heath insurax Tip:

ance through the Marketplace. The APTC helps taxpayers pay for all or part of
their marketplace health insurance during the tax year. Taxpayers who receive
the APTC will receive a From 1095-A, Health Insurance Marketplace Statement,
showing the total amount of the APTC received. Taxpayers receiving the APTC
are required to file a tax return and attach Form 8962, Premium Tax Credit.
The Form 8962 reconciles any advanced payments of premium tax credit with
the actual premium tax credit the taxpayer is eligible to receive.

Filing Requirements 2.13

FILING RETURN PENALTIES


For taxpayers who are required to file a 2014 return, generally they are required to file their annual
return by April 15, 2015. For a taxpayer who has a tax balance due and fails to file their return by
the due date of their return, they may be subject to a failure to file penalty. The penalty is based on
the tax not paid by the due date (without regard to extensions). The penalty is generally 5% for each
month or part of a month that a return is late, but not more than 25%. If the taxpayers failure to file
is found to be due to fraud, the penalty may increase substantially.
If the taxpayer is not able to file their return by the original due date, the taxpayer may have the
option to file for a six-month extension by filing Form 4868, Application For Automatic Extension of
Time To File U.S. Individual Tax Return, by the regular due date of their return. By filing this form,
the taxpayer would need to file their return by October 15 to avoid the failure to file penalty. However,
the automatic extension to file does not release the taxpayer from paying their tax liability by the
original due date of their return. If the taxpayer fails to pay their tax liability due, the taxpayer will
have to pay a failure-to-pay penalty of 0.5% of the unpaid taxes for each month or part of a month
after the due date that the tax is not paid. This penalty cannot be more than 25% of the unpaid tax.
However, this penalty does not apply during the automatic six-month extension of time to file period
if the taxpayer paid at least 90% of the actual tax liability on or before the due date of the return and
the balance was paid when the return was filed. For more information on these two penalties, see IRS
Publication 17, page 19.

FILING STATUS
The first step in determining filing status is to determine the taxpayers marital status on the last day
of the tax year, as you learned earlier in this chapter. If a taxpayer is married, they may nonetheless
be treated as unmarried for tax purposes if they qualify. You will learn more about this in Chapter 4.

Single
Taxpayers who are unmarried and who do not qualify to use the head of household or qualifying
widow(er) filing status must use the single filing status. For the remainder of this chapter, unless
otherwise stated, you may presume that all unmarried taxpayers are using the single filing status.
The other filing statuses available to unmarried taxpayers will be covered in Chapter 4.

2.14 H&RBlock Income Tax Course (2015)

Married Filing Jointly and Married Filing Separately


Individuals are considered married if they were legally married and not legally separated under a
decree of divorce or separate maintenance as of the last day of the tax year. This provision includes
common-law marriages if such marriages are recognized by the state in which the marriage began or
by the state where the couple resides.
A married couple may choose to file a joint return or separate returns. A joint return often results
in a lower federal tax. If separate returns are filed, the effective tax rates are generally higher and
several deductions and credits are reduced, limited, or not allowed at all. If one spouse files separately, the other must file separately, unless they qualify as unmarried for tax purposes (covered in
Chapter 4). Additionally, if both spouses choose to file married filing separately and one spouse itemizes, the other spouse must either itemize or use the standard deduction of zero ($0).
Whether the couple files jointly or separately, each spouse must report the social security number of
the other spouse in the heading of Form 1040A, Form 1040, or Form 1040EZ. On a joint return, the
spouses name is entered in the heading; on a separate return, the spouses name is entered next to
line 3.
The total income, exemptions, and deductions of both spouses must be included on a joint return, and
they must use the same accounting period. Usually, the spouses can be held liable, together or individually, for the entire tax plus any penalties on a joint return.
The advantages and disadvantages of filing separate returns should
Tbe weighed
carefully. Generally, a married couple who files separately
ax Tip:

will pay higher taxes and be ineligible to claim tax credits that may help to
reduce their income tax liability. You will learn more about this as you progress
through the course.

As you have already learned, a married person who dies during the year is considered married for that
tax year. The surviving spouse is also considered married for that tax year. If the surviving spouse
does not remarry before the end of the year, a joint return or separate returns may be filed.
A surviving spouse who does remarry may file a joint return with the new spouse, or they may file
separate returns. The filing status of the deceased taxpayer in such a case must be married filing
separately.
mExample: Jerry and Betsy were married. Jerry died on January 27, 2014. On December 1, 2014,
Betsy married John. Betsy and John may file a joint return, or they may file separately, whichever
they choose. Jerrys filing status is married filing separately.m
The most common reason married couples choose to file separate returns is that they do not wish to
be liable for each others taxes. Some couples prefer to keep all their financial matters, including tax
returns, separate. Once in a while, separate returns can result in a lower tax, but most couples would
not find the small tax savings worth the effort of filing two returns.

Filing Requirements 2.15

In many states, the filing status on the state return generally must
Tfollow that
on the federal return. If state tax rates are less for the married
ax Tip:

filing separately status in your state, the larger federal tax liability may be
more than offset by a smaller state tax liability.

Nonresident Alien Spouse


A nonresident alien may file a joint return only if they are married to a U.S. citizen or resident alien
at the end of the year and both spouses agree to report their total worldwide income for the entire year
on their joint U.S. return. You will want to do some additional research if you encounter this situation.
IRS Publication 519 would be a good place to start.
Complete Exercise 2.2 before continuing to read.

INJURED SPOUSE ALLOCATION


All income tax refunds are subject to offset against past-due debts. These debts might include pastdue federal income tax, student loans, or child and spousal support payments. When taxpayers file
jointly and only one spouse owes a past-due amount, the other spouse can be considered an injured
spouse.
Form 8379, Injured Spouse Allocation (see Illustrations 2.5 and 2.6), is filed when the injured spouse
wants their share of the refund shown on the return and both of the following apply:
1. The injured spouse is not legally obligated to pay the past-due debt.
2. The injured spouse made or reported tax payments (income tax withholding or estimated tax
payments) or claimed a refundable tax credit.
Note: In community property states, the injured spouse must only meet the first statement.
Form 8379 is filed by itself if the refund has already been offset. If the taxpayer expects that a refund
will be offset, Form 8379 can be filed with a return. A separate Form 8379 must be filed for each tax
year for which injured spouse allocation should be considered. If you think you have a situation where
Form 8379 should be filed, consult with an experienced Tax Professional before filing the return.

2.16 H&RBlock Income Tax Course (2015)

REQUEST FOR INNOCENT SPOUSE RELIEF


As discussed earlier, when taxpayers file a joint return, both spouses are held responsible for the tax,
interest, and any penalties due on a return. Form 8857, Request for Innocent Spouse Relief, can provide three types of relief from joint responsibility:
Innocent spouse relief.
Separation of liability.
Equitable relief.
Innocent spouse relief can be requested after a joint return has been filed and it is discovered that
one spouse has understated the income (or overstated a deduction or credit). For more information,
see IRS Publication 971, Innocent Spouse Relief. Form 8857 is shown in Illustrations 2.72.13. This is
a complex form; if you identify a taxpayer who may qualify for innocent spouse relief, please consult
with an experienced Tax Professional.
Complete Exercise 2.3 before continuing to read.

CHAPTER SUMMARY
In this chapter, you learned that:
Nondependent taxpayers requirements to file a tax return are based on their filing status, age, and
gross income. Most nondependent taxpayers must file a return when their gross income equals or
exceeds the sum of the standard deduction and personal exemption amount, which changes due to
the taxpayers filing status and age.
Dependent taxpayers are taxpayers who may be claimed as a dependent on another taxpayers
return. In turn, the dependent taxpayer is not able to claim their own personal exemption on their
tax return. This is true even if the other taxpayer refrains from claiming the dependency exemption. The dependent taxpayers requirement to file is based on their unearned income, earned
income, gross income, marital status, age, and whether the dependent taxpayer is blind.
Nondependent and dependent taxpayers may be required to file a return due to specific circumstances, regardless of whether their income is less than their filing requirement thresholds. These
circumstances include but are not limited to receipt of self-employment income, unreported tips to
employer, distribuitons from an HSA or MSA, or the receipt of the advanced premium tax credit.
Married taxpayers may choose to file jointly or separately. In most cases, filing jointly is more
beneficial than filing separately. If a taxpayer is considered unmarried at the end of the tax year,
then the taxpayer may file single, head of household, or qualifying widow, assuming the taxpayer
is eligible to claim the filing status.

Filing Requirements 2.17

The IRS provides injured spouse relief for the taxpayer to protect their portion of the refund from
their spouses past-due federal income tax, unpaid student loans, or unpaid child and spousal support payments. The IRS also provides innocent spouse relief to taxpayers who file a joint return
and later learn that their spouse has understated the income (or overstated a deduction or credit)
on the return.

Suggested Reading
For further information on the topics discussed in this chapter, you may wish to read the following
sections in IRS Publication 17:
Chapter 1, Subchapter, Do I Have To File a Return?
Chapter 1, Subtopic Joint Return and Injured Spouse.
Chapter 2, Filing Status.
Can our clients claim
Ttheir son, who is 22 years old and in his third year of incarceration
(of a fivehe Tax Institute Tax in the News Research Question:

year sentence) on their tax return? They say they give him $150 a month for
support. Wouldnt our state (North Carolina) be giving him more support than
that? Also, obviously the son is not living in the home of the taxpayer.
Your clients son is 22 years old and not a full-time student, so it
Ais the qualifying
relative, rather than the qualifying child, tests that must
nswer:

be considered. While incarceration may sometimes be considered a temporary


absence from home (depending on the facts and circumstances), for qualifying
relative purposes, a son or daughter need not live at home, so the absence does
not necessarily prevent the taxpayer from claiming the dependent exemption
for a qualifying relative.
However, the relevant qualifying relative test that could prevent the taxpayer
from doing so in this case is support. Although estimates vary based on region
of the country, the particular facility, and the individuals circumstances, it is
clear that the average cost of incarceration in North Carolina, as in all states,
is several thousand dollars per month at a minimum. Thus, the $150 per month
your clients contribute toward their sons support would not be anywhere near
the qualifying relative requirement to provide more than one-half of his support. Your supposition is correct: it is the state (i.e., a third party) that is providing most of the support.
Because your clients do not provide more than one-half of their sons support,
they cannot claim him for the dependency exemption or any other dependent-related tax benefits.

2.18 H&R Block Income Tax Course (2015)


Illustration 2.5

Filing Requirements 2.19


Illustration 2.6

2.20 H&R Block Income Tax Course (2015)


Illustration 2.7

Filing Requirements 2.21


Illustration 2.8

2.22 H&R Block Income Tax Course (2015)


Illustration 2.9

Filing Requirements 2.23


Illustration 2.10

2.24 H&R Block Income Tax Course (2015)


Illustration 2.11

Filing Requirements 2.25


Illustration 2.12

2.26 H&R Block Income Tax Course (2015)


Illustration 2.13

Dependent Exemptions and Support


OVERVIEW
Taxpayers who have children have an opportunity to qualify for many tax benefits that may reduce
their overall tax liability. Having dependents can affect a taxpayers filing status and tax rate. This
chapter focuses on determining who is a qualifying child (QC) and who might be a qualifying relative
(QR). The chapter ends by beginning to examine how adding a QC or QR impacts the tax return.

OBJECTIVES
At the conclusion of this chapter, you will be able to:
Determine whether an individual is a qualifying child or qualifying relative and who may be
claimed as a dependent of a taxpayer.
Compute the total support to determine if an individual meets the qualifying relative support test.
Determine eligibility for the Child Tax Credit and compute the credit.
Explain how a multiple support agreement works.

TAX TERMS
Look up the definitions of the following terms in the glossary:
Custodial parent.
Dependent.
Eligible foster child.
Full-time student.
Multiple support agreement.
Noncustodial parent.
Permanent and total disability.
Physical custody.
Principal place of abode (principal residence).
Qualifying child (QC).
Qualifying relative (QR).
Support.
3.1

3.2 H&RBlock Income Tax Course (2015)

DEPENDENCY EXEMPTIONS
As you have learned, most taxpayers may reduce their otherwise taxable incomes by $3,950 for each
exemption allowed on their 2014 tax returns. You studied personal exemptions in Chapter 2. Now it
is time to learn about dependency exemptions.
mExample: A taxpayer in the 10% tax bracket saves $395 [$3,950 2 10% = $395] for each allowable
exemption; a taxpayer in the 15% tax bracket saves $593 [$3,950 2 15% = $593] for each exemption.m
The examples above show how the taxpayers tax liability is decreased by reducing his taxable income
using the exemption amount. Keep in mind, however, that the tax savings may be further increased
by other deductions and credits associated with dependency. You will learn more about these tax benefits as you proceed through this course.
One $3,950 exemption is allowed for each dependent on a taxpayers return. An exemption cannot be
divided; it is allowed in full or not at all.
Note: In this chapter, the term dependent is sometimes used to refer to a potential dependent, or a
would-be dependent. In every case, all the necessary requirements must be met to claim the dependency exemption.

Who Is a Dependent?
According to the Tax Code, a dependent is a qualifying child or a qualifying relative for whom all of
the following tests are met:
Dependent taxpayer test.
Joint return test.
Citizen or resident test.
These tests are explained in detail beginning on page 3.7.
mExample: Kimberly is a qualifying child of Martha. Martha cannot be claimed by anyone else as
a dependent. Kimberly is a citizen of the U.S. and is not married. Martha may claim Kimberly as a
dependent on her tax return for 2014.m
What Is a Qualifying Child?
For an individual to be a qualifying child (QC) of a taxpayer, an individual must meet five tests:
Relationship.
Age.
Residency.
Support.
Joint return.
If a child meets the five tests to be the qualifying child of more than one person, a special rule applies
to determine which person can actually treat the child as a qualifying child.

Dependent Exemptions and Support 3.3

Relationship. In order to satisfy the relationship test, an individual must be related to the taxpayer
in one of the following ways:
Son or daughter.
Brother or sister.
Adopted child.
Eligible foster child.
A descendant of any of these (this includes all grandchildren, nieces, and nephews).
Stepsons, stepdaughters, stepbrothers, and stepsisters all satisfy the relationship test. Half-brothers
and half-sisters and their descendants also meet this requirement.
Adopted children satisfy the test even if the adoption is not yet final, provided the child has been
lawfully placed for adoption with the taxpayer.
A foster child must be placed with the taxpayer by an authorized placement agency or by judgment,
decree, or other order of any court of competent jurisdiction.
Age. To meet this test, the child must meet one of the following tests:
Under age 19 at the end of the year and younger than the taxpayer (or the taxpayers spouse, if
filing jointly).
A full-time student under age 24 at the end of the year and younger than the taxpayer (or the taxpayers spouse, if filing jointly).
Permanently and totally disabled at any time during the year, regardless of age.
For an individual to be a qualifying child for a taxpayer filing jointly, the individual must be younger
than the taxpayer or the taxpayers spouse. As stated above, a permanently and totally disabled child
qualifies, regardless of age.
mExample: Tim (23) and his brother, Dave (21), lived together all through 2014. Tim is a full-time
student and is not disabled. Dave may not claim Tim as a qualifying child since Dave is younger than
Tim.m
mExample: Mikes 23-year-old brother, Paul, who is a full-time student and unmarried, lives with
Mike and Mikes spouse. Paul is not disabled. Mike is 21, and his spouse is 24 years old. Because
Mikes brother, Paul, is younger than Mikes spouse and the two of them are filing a joint return, Paul
is Mikes qualifying child.m
Residency. The residency test is satisfied if the individual lived with the taxpayer for more than six
months of the year. An individual who was born or died during the year is considered to have met this
test regardless of how long they lived with the taxpayer, provided they lived with the taxpayer the
entire time they were alive during 2014. There are also exceptions for children who were kidnapped
or temporarily absent from the home. Attending college is an example of a temporary absence. There
are also exceptions for children of divorced or separated parents.

3.4 H&RBlock Income Tax Course (2015)

Support. An individual cannot have provided more than one-half of their own support during the
tax year.
Payments received for the support of a foster child from a child placement agency are considered
support provided by the agency. Similarly, payments received for the support of a foster child from a
state or county are considered support provided by the state or county. A persons own funds are not
support unless they are actually spent for support.
mExample: Dakota, a child actress, has significant income and pays over half of her own support.
Dakota cannot be claimed as a dependent.m
Note: The taxpayer does not have to provide over one-half of the support to satisfy the support test for
a qualifying child. Rather, the qualifying child cannot provide more than one-half of his own support.
This test differs from the support test for a qualifying relative, as you will see in a moment.
Joint return. To meet this test, the child cannot file a joint return for the year unless they file a joint
return merely as a claim for refund.
Special test. Sometimes a child meets the relationship, age, residency, support, and joint return
tests to be a qualifying child of more than one person. Although the child meets the conditions to be
a qualifying child of each person, only one person can actually treat the child as a qualifying child.
To meet this test, you must be the person who can treat the child as a qualifying child. Both of the
sections Children of Divorced or Separated Parents and Tiebreaker Rules, covered later in the next
chapter, will help you understand this test.
What Is a Qualifying Relative?
For an individual to be a qualifying relative of a taxpayer, an individual must satisfy four tests:
Relationship or member of the household.
Gross income.
Support.
Not a qualifying child.
Relationship. The relationship test for a qualifying relative is broader than the test for a qualifying
child. Relationships that satisfy this test:
All relationships included for a qualifying child.
Father, mother, or ancestor of either.
A brother or sister of your father or mother.
In-laws, including brother, sister, son, daughter, father, or mother.
Any individual who lived with the taxpayer the entire year.
Any of these relationships that were established by marriage are not ended by death or divorce.
If you file a joint return, the person can be related to either you or your spouse. For example, your
spouses uncle who receives more than half of his support from you may be claimed as your qualifying
relative, even though he does not live with you. However, if you and your spouse file separate returns,
your spouses uncle can be your qualifying relative only if he lives with you all year.
A person does not meet this test if at any time during the year the relationship between you and that
person violates local law.

Dependent Exemptions and Support 3.5

Gross income. An individual must have a gross income of less than the exemption amount ($3,950
for 2014).
mExample: Tony (28) and Adam (27) are cousins and lived in the same home throughout 2014. Adam
only earned $2,500 in 2014. Tony earned $25,000 in 2014. Adam meets the relationship test for Tony
since Adam lived with Tony the entire year. Assuming that Adam meets the remaining tests, Tony
may be able to claim Adam as a dependent.
Note: Being cousins alone will not meet the relationship test. A cousin, like other non-relatives, must
also live in the home the entire year with the taxpayer in order to meet the relationship test.m
Support. As mentioned earlier, the support test for a qualifying relative is different than for a qualifying child. The taxpayer must provide over one-half of the support for an individual to satisfy the
test to be a qualifying relative.
Remember, a persons own funds are not support unless they are actually spent for support.
In figuring a persons total support, include tax-exempt income, savings, and borrowed amounts used
to support that person. Tax-exempt income includes certain social security benefits, welfare benefits,
nontaxable life insurance proceeds, Armed Forces family allotments, nontaxable pensions, and tax-exempt interest. If a married couple each receive social security benefits that are paid by one check made
out to both of them, half of the total paid is considered to be for the support of each spouse, unless
they can show otherwise.
If a child receives social security benefits and uses them toward their own support, the benefits are
considered as provided by the child.
mExample: John lives with Robert, his father. John provides 30% of Roberts support. John may not
claim Robert as a dependent.m
Not a qualifying child. The individual must not be the qualifying child of the taxpayer or of any
other taxpayer.
mExample: Yolanda lives with her daughter, Elizabeth. Elizabeth is the qualifying child of Yolanda.
Neither Yolanda nor anyone else can claim Elizabeth as their qualifying relative since she meets the
definition of a QC.m
mExample: Recall Tony and Adam from an earlier example. Tony provided more than half of Adams
support. Adam is not permanently and totally disabled. Tony may claim Adam as a dependent
because he meets all four tests for qualifying relative. Adam is too old to be someone elses qualifying
child, and his gross income is less than $3,950.m
mExample: Ron (35) and Sue (35) are married and have two children, Todd (8) and Tracy (6). Neither
child has any income. Stacy (13), Sues child from a previous marriage, came to live with them on
July 4, 2014. Prior to that, Stacy was supported by and lived with her father.
Todd and Tracy are qualifying children of Ron and Sue. Stacy is neither a qualifying child nor a qualifying relative of Ron and Sue. Because she was supported by and lived with her father for more than
six months, she cannot be a qualifying child for Sue (residency test) and is not a qualifying relative of
Ron and Sue (qualifying child test).m

3.6 H&RBlock Income Tax Course (2015)


Illustration 3.1

Dependent Exemptions and Support 3.7

Important: On January 14, 2008, the IRS issued Notice 2008-5. This notice clarifies that an individual is not a qualifying child of any other taxpayer if the individuals parent (or other person with
respect to whom the individual is defined as a qualifying child) is not required by 6012 to file an
income tax return and either:
Does not file an income tax return.
OR
Files an income tax return solely to obtain a refund of withheld income taxes.
mExample: In 2007, Mark and Mindy lived together as an unmarried couple all year. Mindy has a sixyear-old daughter, Marissa, from a previous relationship. Mark is the only member of the household
with income.
In 2007, Mark was able to claim Mindy as a qualifying relative, but not Marissa, since she was the
qualifying child of Mindy. Marissas exemption went unclaimed by anyone because Mindy had no
income.
Notice 2008-05 remedies this situation. Beginning in 2008, Mark (still, with the only household
income) may claim both Mindy and Marissa as qualifying relatives. Mindy will not file an income tax
return, making it possible for Mark to claim them both.m
Complete Exercise 3.1 before continuing to read.

Dependent Taxpayer Test


Any taxpayer who may be claimed by another person on their return may not claim any dependents.
Even if the other person does not claim the taxpayer, the taxpayer still may not claim any dependents.
If a taxpayer has a qualifying child or a qualifying relative, this does not exempt them from this
requirement. Also, if the taxpayer is filing a joint return and their spouse can be claimed on someone
elses return, then the taxpayer and spouse cannot claim any dependents on their joint return.
mExample: Lori (18) and her qualifying child, Cheryl (5 months), lived together with Loris mother,
Brenda (41), for all of 2014. Lori is Brendas qualifying child, and Brenda will claim Lori as a dependent on her tax return. Lori cannot claim herself nor can she claim Cheryl. Brenda may also claim
Cheryl if she meets all the required tests.m
mExample: Amparo (32) and her qualifying child, Miguel (3), lived together for all of 2014. No one can
possibly claim Amparo on their return. Amparo may claim Miguel on her return, assuming the other
tests are met.m

Joint Return Test


Generally, a taxpayer may not claim a married person as a dependent if the married dependent files
a joint return. There is, however, an exception to this rule. In order to claim a married person as a
dependent, the married couple files a joint return merely as a claim for refund.
mExample: Ian (51) lived together with his qualifying child, Robert (21), for all of 2014. In October
2014, Robert married Veronica (21), and both lived with Ian for the remainder of the year. Robert, a
full-time student, did not work in 2014, and Veronica earned only $3,000. Robert and Veronica filed
a joint return to get a refund of $102 withheld from Veronicas wages. Neither Robert nor Veronica
claimed his or her own exemption. Ian may still claim Robert as his dependent.m

3.8 H&RBlock Income Tax Course (2015)

mExample: Ronald (54) and Wendy (52) are married and lived with their qualifying relative, Gwyn
(26), for all of 2014. In November 2014, Gwyn married Tim (27), and both lived with Ronald and
Wendy for the rest of the year. Gwyn earned $2,400, and Tim earned $20,500 in 2014. Ronald and
Wendy may not claim Gwyn as their dependent on their return if Tim and Gwyn file a joint return.m

Citizen or Resident Test


A taxpayer may not claim a person as a dependent unless that person is a U.S. citizen, U.S. resident,
U.S. national, or a resident of Canada or Mexico. A U.S. national is an individual who, although not a
U.S. citizen, owes his allegiance to the United States. U.S. nationals include American Samoans and
Northern Mariana Islanders who chose to become U.S. nationals instead of U.S. citizens.
Exception for an Adopted Child
If the taxpayer is a U.S. citizen and has legally adopted a child who is not a U.S. citizen, U.S. resident,
or U.S. national, the citizenship test is met if the child lived with the taxpayer all year. This exception
also applies if the child was lawfully placed with the taxpayer for legal adoption.
Childs Place of Residence
Generally, a child is a citizen or resident of the country of their parents. If the taxpayer was a U.S.
citizen when the child was born, the child may be a U.S. citizen even if the other parent was a nonresident alien and the child was born in a foreign country.
Complete Exercise 3.2 before continuing to read.

DETERMINING SUPPORT
Items to consider in computing a dependents support include, but are not limited to, the following:
Food.
Lodging (housing).
Clothing.
Grooming and personal care items.
Most medical and dental expenses, including health insurance premiums (however, see Items Not
Included in Support in this chapter).
Most education expenses, including tuition, books, supplies, room and board, and meals consumed
at school (however, see Education Expenses in this chapter).
Child and dependent care (such as day care).
Transportation.
Charitable contributions made on the dependents behalf.
Recreational activities.
Capital items (such as a car, computer, stereo, or television) purchased for the dependents individual use.

Dependent Exemptions and Support 3.9

Support includes those items necessary for a dependents care, as well as luxuries and items used
purely for personal enjoyment.

Lodging
When determining whether the taxpayer provided over half of a dependents support, you must use
the value of the lodging rather than the actual costs. We refer to this as the fair rental value of the
dependents residence. In addition to the fair rental value of the residence as furnished, household
expenses include the actual amounts spent for repairs, utilities, and food consumed in the home.
The total expenses for the household are divided by the number of persons living in the home to arrive
at the lodging cost per occupant.
mExample: Mary Lightfoot owns and maintains a home for herself and her father, Adam, who lived
with her all year. In 2014, she paid $9,000 in mortgage payments, $3,500 for food consumed in the
home, and $1,800 for utilities. A similarly furnished home would rent for $900 per month in her neighborhood without utilities ($10,800 for the year).
Notice that the actual mortgage payments do not count in the support computation.
Fair rental value of lodging

$10,800

Utilities

1,800

Food consumed in home

3,500

Total for year

$16,100

When computing Adams support, Mary will include $8,050 [$16,100 3 2 occupants = $8,050] that she
provided for Adams lodging.m

Education Expenses
Tuition generally is support provided in the year paid. If money is borrowed to pay the tuition, the
tuition is considered to be provided by the person who is responsible for repayment of the loan.
mExample: Sierra received a Stafford loan to help pay her college tuition. She is legally obligated to
repay the loan after she graduates. The loan proceeds are considered amounts Sierra provided toward
her own support.m
mExample: Sierras father took out a home equity loan to help Sierra pay her college tuition. He is
responsible for repayment of the loan. The loan proceeds are considered amounts he provided toward
Sierras support.m
Tax-exempt education benefits, such as those received under the G.I. Bill and federal Pell
grants, are considered to be funds provided by the recipient for his own support. However, see the
Scholarships on the following page.

ax Tip: During the client interview, if there is any question in your mind,
use the support worksheet found on the Qualifying Individual Information
& Tiebreaker screen to determine support.

3.10 H&RBlock Income Tax Course (2015)

Items Not Included in Support


Certain items are not included in support. These include, but are not limited to:
Capital items purchased for general household use, such as furniture and appliances (however, the
availability of these items is taken into account in determining the fair rental value of housing).
Federal, state, and local income taxes paid from the dependents income.
Social security and medicare taxes paid from the dependents wages.
Life insurance premiums.
Funeral expenses.
Survivors and Dependents Educational Assistance payments (used for the support of the child
who receives them).
Certain scholarships.
Scholarships. If the dependent is a full-time student and is the taxpayers son, daughter, stepson,
or stepdaughter, do not include in the support computation any expenses paid with scholarships,
whether taxable or nontaxable.
mExample: Justin is a full-time student at Rutgers University. He received a full scholarship to pay
his college tuition. The remainder of his support was paid by his parents. Because neither the tuition
nor the scholarship is included in the support computation, his parents are considered to have paid
100% of his support.m
mExample: Angelica is a full-time student at Princeton University. She also received a full scholarship to pay her college tuition. The remainder of her support was paid by her aunt. In this case,
Angelicas tuition and the scholarship proceeds are included in the support computation.m

Health Insurance Benefits


Medical and dental expenses paid by a health insurance policy are not included in support, and the
insurance proceeds are not included in income.
mExample: Gerald (69, his birthday is 06/05/1945) is single and lives with his son, Kyle (49), and
Kyles wife, Kim (48). The fair rental value of their home is $18,000. They pay the $1,500 per month
in rent, and the utilities cost another $4,500. The food cost for the family is $7,500. Entertainment
expenses for Kyle and Kim were $6,000.
Geralds income consists of $9,658.80 in social security benefits (his medicare cost was $1,258.80) and
interest income of $450. After paying his medicare, Gerald puts one-half of the remaining social security in savings (at the end of the year, he had $18,500 in his savings account) and spends the other
$4,200 for a golf membership and tickets to sporting events. The interest income is used for personal
grooming items. Kyle and Kim pay Geralds health costs not covered by medicare, which were $3,200
in 2014, and all household expenses.
Gerald will meet all of the requirements to be a qualifying relative if Kyle and Kim provide more
than one-half of his support. Remember, his social security does not count in determining whether
his income is greater than $3,950. Your instructor will lead a discussion around items listed on the
support worksheet in Illustration 3.2.m

Dependent Exemptions and Support 3.11

Multiple Support Agreements


A multiple support agreement may be made when no individual provided more than half of a persons
support, but two or more taxpayers together provided more than half of the persons support. To qualify to participate in a multiple support agreement, a taxpayer must provide over 10% of total support
for the other person. The qualified taxpayers then may decide among themselves which one will claim
the dependency exemption, provided they meet all the other requirements to claim the exemption.
The taxpayer claiming the exemption must complete and file Form 2120, Multiple Support Declaration,
a copy of which is shown in Illustration 3.3. Each taxpayer agreeing not to claim the exemption must
be listed on Form 2120 by name, address, and social security number and must provide a signed statement waiving his right to claim the exemption to the taxpayer claiming the exemption. The taxpayer
claiming the exemption must retain the signed agreements with his records.
Taxpayers who together are supporting a qualifying relative may use any method on which they agree
to decide who will claim the exemption. This includes taking turns or allowing the exemption to be
claimed by the one who will gain the greatest tax advantage. The other dependency requirements
must be met for the current tax year in order for a taxpayer to claim the exemption.
In any situation where one taxpayer cannot prove that they provided over half of the persons support
and all of the qualified taxpayers will not agree on who will be allowed to claim the exemption, no one
is allowed to claim it.

CHILD TAX CREDIT


At this time, it is necessary to introduce you to the concept of tax credits because many of the taxpayers and returns we will be examining will have dependent children on them. The Child Tax Credit is
worth up to $1,000 for each qualifying child. The credit starts out as nonrefundable, but some taxpayers may qualify for the Additional Child Tax Credit, which is refundable. You will study the difference
between refundable and nonrefundable credits later in the course.
In order to qualify for the Child Tax Credit, all of the following must be true:
The taxpayer must have a qualifying child.
The qualifying child must be under the age of 17 at the end of the year.
The qualifying child must be claimed on the taxpayers return.
The qualifying child must be a U.S. citizen, U.S. national, or resident of the United States.
On Form 1040 or 1040A, line 6c, check the box in column 4 for each child who qualifies the taxpayer
for the Child Tax Credit.

Income Phaseout
If the taxpayers income is above a certain level, the allowable Child Tax Credit begins to phase out.
The amount disallowed will be $50 for every $1,000 (or portion of $1,000) by which the taxpayers
modified adjusted gross income exceeds:
$75,000 (single, head of household, or qualifying widow(er)).
$110,000 (married filing jointly).
$55,000 (married filing separately).

3.12 H&R Block Income Tax Course (2015)


Illustration
Illustration X.X
3.2

Dependent Exemptions and Support 3.13


Illustration 3.3

3.14 H&RBlock Income Tax Course (2015)

Modified adjusted gross income is another phrase you will see many times during this course.
Unfortunately, Congress has not yet established a uniform definition, so you must be aware that it
does not mean the same thing for every purpose. Modified AGI (MAGI) always begins with the taxpayers adjusted gross income (AGI), which is then modified for each individual purpose.
Modified AGI, for purposes of the Child Tax Credit, consists of adjusted gross income without regard
to any exclusions for foreign earned income or U.S. possession income. Because we do not cover these
topics in this course, you may assume that, in each situation you encounter, the taxpayers modified
AGI is their adjusted gross income.
mExample: Pat and Geri Dale are filing a joint return and have an adjusted gross income of $124,000
and three qualifying children. Their AGI exceeds $110,000 by $14,000, so their credit is reduced by
$700 [$50 2 14 increments of $1,000 = $700]. Thus, their tentative Child Tax Credit is $2,300 [$3,000
$700 = $2,300]. Their actual credit may be further limited, as explained on the following page.m

Interaction With Other Credits


No portion of the Child Tax Credit may be carried over to future years. In order to maximize the
benefits of each credit, nonrefundable credits must be taken in a specific order. For this reason, other
credits must sometimes be computed first in order to properly apply the Child Tax Credit. The Child
Tax Credit Worksheet is a valuable tool to help you accomplish this.

Computing the Child Tax Credit


The Child Tax Credit may be computed using the IRS Publication 972 worksheet shown in
Illustrations 3.6 and 3.7. Throughout this course, we will use the Child Tax Credit Worksheet, shown
in Illustrations 3.4 and 3.5.
If you wish to check the instructions for the Child Tax Credit placed on line 33 of Form 1040A, you
will find different worksheets. H&R Block has combined the various worksheets into the one shown,
and that is the one we will use in this course.
mExample: Joyce Potter (39) uses the head of household filing status and has three qualifying children. Her adjusted gross income, all from wages, is $87,563. She has no foreign or U.S. possession
income. Her tax before credits, Form 1040A, line 28, is $10,081. She is claiming a $1,200 Child Care
Credit Form 1040A, line 31.
Examine her Child Tax Credit Worksheet in Illustration 3.4 as you read the following explanations of
certain lines.
Line 3. These are the income levels at which the phaseout begins for each filing status.
Line 5. The credit is reduced by $50 for each $1,000 (or portion thereof) by which modified AGI
exceeds the threshold amount. For this reason, the result of line 4 is rounded up to the next $1,000,
multiplied by 5% [$1,000 2 5% = $50], and entered on line 5 [$13,000 2 5% = $650].m

Dependent Exemptions and Support 3.15

Dispensing with the Worksheets


You can skip the worksheet and enter the Child Tax Credit directly on Form 1040A, line 35, if the
taxpayer meets all of the following conditions:
The taxpayer is not excluding any foreign earned income, U.S. possession income, or income from
Puerto Rico.
The taxpayers AGI is not more than the phaseout threshold amount for his filing status.
The taxpayers tax before credits (Form 1040A, line 30) is not less than the number of qualifying
children multiplied by $1,000.
The taxpayer is not claiming any other credits.
If the taxpayer meets all of the above conditions, simply enter $1,000 for each qualifying child on
Form 1040A, line 35. If the taxpayer does not meet these qualifications, the Child Tax Credit must be
calculated using the worksheet.
Complete Exercise 3.3 before continuing to read.

CHAPTER SUMMARY
In this chapter, you learned:
Each dependent a taxpayer may claim generally reduces otherwise taxable income by $3,950 in
2014.
A qualifying child is someone who meets the relationship, residency, age, support, joint return, and
special case tests.
A qualifying relative is someone who is related to the taxpayer (or who lived with the taxpayer for
the entire year), earned less than $3,950 gross income (in 2014), and for whom the taxpayer provided more than half of their support. Also, the potential qualifying relative cannot be the qualifying
child of the taxpayer or of any other taxpayer.
The Child Tax Credit is worth up to $1,000 for each qualifying child. The credit is generally nonrefundable, but certain taxpayers may qualify for the refundable Additional Child Tax Credit.

Suggested Reading
For further information on the topics discussed in this chapter as they relate to 2014 tax returns, you
may wish to read the following chapters in IRS Publication 17:
Chapter 2, Filing Status.
Chapter 3, Personal Exemptions and Dependents.

3.16 H&RBlock Income Tax Course (2015)


Illustration 3.4

Dependent Exemptions and Support 3.17


Illustration 3.5

3.18 H&RBlock Income Tax Course (2015)


Illustration 3.6

Dependent Exemptions and Support 3.19


Illustration 3.7
X.X

3.20 H&RBlock Income Tax Course (2015)

client lives with


This fianc and her two children (ages 7 and 9). She hadMya part-time
job early
he Tax Institute Tax in the News Research Question:

in the year and earned about $4,000; then, she lost the job and has no other
source of income. Her ex-husband stopped paying child support in June. She has
taken her ex-husband to court but so far he has not resumed paying support.
She has never given him a Form 8332 and has no intention of doing so. My client supports the entire household and would like to claim the children as his
dependents. May he claim the dependency exemption and Child Tax Credit for
the children and file using the head of household filing status? His income is out
of EITC range, so could his fianc claim the children for EITC only?
Your client may be able to claim the children as his dependent qualAifying relatives,
but there are several points to be clarified in order for him
nswer:

to do so.

First, verify that the children actually did live with your client the entire tax
year. Since the children are not related to your client, they meet the QR relationship test only if they were members of his household all year. From the facts
youve given, earlier in the year your clients fianc had some income and was
receiving child support, so they could have been living on their own and moved
in with your client when all sources of income stopped.
Second, verify that your client provided more than half of the childrens support
for 2014 by completing the support worksheet for qualifying relatives. While
your client may have started supporting the children at some point during the
year, youve stated that their father paid child support for nearly six months.
Without knowing exactly how much either taxpayer (your client and the childrens father) paid, we dont know which one of them provided more than half of
the childrens support. With some support provided by their mother early in the
year and possible third party support, such as AFDC, it could be that nobody
provided more than half of the childrens support.
Third, in order for your client to claim the children as his qualifying relatives,
they must not be qualifying children of any other taxpayer. The children meet
all tests to be QCs of their mother, so the issue is whether she is considered a
taxpayer. Under Notice 2008-5, an individual is not a taxpayer if she 1) does
not have a return filing requirement, and 2) she does not file a tax return for
any reason other than to claim a refund of all withheld taxes. If your clients
fianc filed a return to claim the children for the EITC, he could not claim them.
Additionally, he would be precluded from claiming them because child-related
benefits cannot be split among taxpayers. Also, even if she claimed only one of
the children for the EITC, she would be considered a taxpayer (because of filing a return for a reason other than getting a refund of withheld taxes) and he
could not claim the other child as his dependent.

Dependent Exemptions and Support 3.21

any one of these tests is not met with respect to the


Achildrene.g., theyIf did
not live with him the entire tax year, or he did not
nswer continues:

provide more than half of their support, or their mother is a taxpayer because
she files a returnthen your client cannot claim them on his tax return.
If all tests are met and he is able to claim them, it would be only for the dependency exemption. He cannot claim the Child Tax Credit or the EITC (even if his
income was within range) because they are not his qualifying children, nor can
he file as head of household. Unrelated individuals who are treated as dependents only because they are members of the taxpayers household all year are
not qualifying individuals for head of household filing purposes.
It may be more beneficial for your clients fianc to claim the children because
she would get the EITC and some part of the refundable Child Tax Credit, all of
which may be a better tax benefit than the dependency exemption would be for
your client.

Dependent-Related Filing Statuses


OVERVIEW
In this chapter, we will discuss how having dependents can affect a taxpayers filing status and tax
rate. Dependents will also qualify many taxpayers for valuable tax credits, which may further reduce
their tax liability or even eliminate it completely. You will learn more about those benefits as you
proceed through this course.

OBJECTIVES
At the conclusion of this chapter, you will be able to:
Determine whether a taxpayer qualifies to file as head of household.
Explain how to determine the cost of maintaining support of a household.
Determine whether a taxpayer qualifies as unmarried for tax purposes.
Determine the correct filing status for any unmarried taxpayer and report it on the tax return.
Determine which parent may claim the dependency exemption for a qualifying child when the
parents are divorced or separated.
Determine which taxpayer will be awarded a qualifying child when more than one taxpayer claims
the child.

TAX TERMS
Look up the definitions of the following terms in the glossary:











Custodial parent.
Dependent.
Fair rental value.
Full-time student.
Multiple support agreement.
Noncustodial parent.
Nonresident alien.
Permanent and total disability.
Physical custody.
Principal place of abode (principal residence).
Qualifying child (QC).
Qualifying relative (QR).
4.1

4.2 H&RBlock Income Tax Course (2015)

FILING STATUSES AND DEPENDENTS


In Chapter 2, you learned there are five filing statuses recognized by the Tax Code:
Single.
Married filing jointly.
Married filing separately.
Head of household.
Qualifying widow(er).
The first three statuses are allowed regardless of whether the taxpayer has a dependent. These statuses were discussed in depth in Chapter 2. The last two statuses require that the taxpayer have at
least one dependent.

Head of Household
Taxpayers may file as head of household if they meet all of the following requirements:
The taxpayer is unmarried or considered unmarried on the last day of the tax year.
The taxpayer paid more than half of the cost of maintaining the household for the year.
The taxpayer maintains a household for either of the following:
A qualifying child or qualifying relative (see exceptions to the head of household requirements
on page 4.6) who lived with the taxpayer for more than half the year and the taxpayer can claim
an exemption for them.
Their mother or father for the entire year and who the taxpayer may claim as an exemption on
their return.
mExample: Herbert (34) is unmarried and pays 100% of the cost of maintaining a household for
Clarice (5). Clarice is Herberts qualifying child. Herbert may file as head of household.m
mExample: Juanita (42) is unmarried and pays 65% of the cost of maintaining a home for her father,
Bernabe (77). Juanita will claim Bernabe on her tax return in 2014. Juanita may file as head of
household.m

Dependent-Related Filing Statuses 4.3

The Cost of Maintaining a Household


In order to file as head of household, a taxpayer must have paid more than half the cost of maintaining
a household for the year. The costs included when making this determination:







Rent.
Mortgage interest.
Real estate taxes.
Insurance on the home.
Property taxes.
Repairs.
Utilities.
Food eaten in the home.

Do not include the costs of the following items:









Clothing.
Education.
Medical treatment.
Vacations.
Life insurance.
Transportation.
Rental value of a home owned by the taxpayer.
Services provided by the taxpayer or other members of the household.

The fair rental value of a home owned by the taxpayer is not included in tallying the cost of maintaining a home. The same is true when that home is owned by one of the taxpayers dependentsfor
example, a parent.
If the total amount paid by the taxpayer is more than the amount others paid, including amounts paid
from government assistance programs, then the taxpayer meets the requirement of paying more than
half the cost of maintaining the household for the year.
When there is doubt as to whether an individual paid more than half the cost of maintaining the
household for the year, use the Worksheet 2-1, Cost of Keeping Up a Home, found in IRS Publication
17, page 23. This worksheet is shown in Illustration 4.1. BlockWorks also provides a Household
Support Worksheet. This worksheet is available on the Filing Status input screen in the software.
This BlockWorks worksheet is shown in Illustration 4.2. After the appropriate lines are filled in and
totaled, divide the amount the individual pays by the total amount of the cost.

4.4 H&R Block Income Tax Course (2015)


Illustration X.X
4.1

Dependent-Related Filing Statuses 4.5


Illustration 4.2
X.X

4.6 H&RBlock Income Tax Course (2015)

the Household Support Worksheet found on the Filing


BStatus screen toUse
determine if a taxpayer has paid more than half the cost of
lockWorks Tip:

keeping up a home for the year, if there are concerns as to whether the taxpayer actually qualifies. This worksheet is very helpful if the clients income level
makes it seem unlikely they could be paying one-half of the cost of maintaining
the household. An example of this worksheet is shown in Illustration 4.2.

mExample: Tim is not sure whether he or his father pays more than one-half the cost of maintaining the household. If Tim pays more than half the cost, he will qualify to file as head of household.
The total costs for maintaining the home were $45,450, and Tim paid $22,950 of the costs. Since
Tim pays 50.5% of the costs [$22,950 Tim paid 3 $45,450 total costs = 0.5050], Tim will file as head
of household.m
Exceptions to the Head of Household Requirements
Married qualifying child. The qualifying child of a taxpayer for head of household purposes cannot
be married unless the taxpayer can claim an exemption for that child.
Nonrelative dependent. A dependent who meets the relationship test because they live in the same
household with the taxpayer for the entire year cannot qualify the taxpayer for head of household
status. To qualify the taxpayer for head of household, the dependent must actually be related to the
taxpayer as indicated in the relationship test for a qualifying relative.
mExample: Lets revisit the cousins, Tony and Adam, from Chapter 3. Adam is Tonys dependent.
However, Tony may not file as head of household unless he has some other qualifying child or another
dependent who is related to him. Although Tony and Adam are cousins, this relationship does not
meet the requirements of the relationship test. Tony must file as single.m
Multiple support agreements. A taxpayer who has a dependent because of a multiple support
agreement cannot file as head of household. Taxpayers who have qualifying relative dependents must
have provided over half of the support for those dependents by themselves.
Nonresident aliens. A taxpayer who is a nonresident alien for any part of the tax year may not file
head of household.

Dependent-Related Filing Statuses 4.7

Married, But Unmarried For Tax Purposes


To be considered unmarried for tax purposes, a married person must be legally separated under a
decree of divorce or separate maintenance or must meet all of the following requirements:
The person must file a separate return from their spouse.
The person must have provided more than half the cost of maintaining their home for the tax year.
The home must have been the principal place of abode of the taxpayer and their dependent son,
daughter, or eligible foster child (qualifying child or qualifying relative) for more than half the tax
year. This includes a child who would be a dependent except that the exemption was awarded to
the noncustodial spouse by (a) a post-1984 divorce or separation agreement or (b) a waiver by the
custodial parent (Form 8332).
The persons spouse must not have lived in the home at any time during the last six months of the
tax year.
This does not include those situations in which the spouse is living away from the home temporarily
(job assignment, military deployment, etc.) as opposed to the couple being estranged from each other.
mExample: Sandy Remington has lived apart from her husband since February 3, 2014. She does not
wish to file a joint return with her husband. They do not have a decree of divorce or separate maintenance or a written separation agreement. She has provided more than half of the cost of the maintenance of the home where she and her son, Mark, have lived all year. Sandy qualifies as unmarried
for tax purposes. Sandy may file as head of household.m
Recall that a persons principal place of abode does not change if an absence from the home is temporary in nature due to special circumstances. Examples include absences due to vacation, business,
hospitalization, education, military service, or short-term incarceration.
mExample: Thelma lived apart from her husband for all of 2014 and does not wish to file a joint return.
She paid the entire cost of maintaining her home in Paducah, Kentucky. She maintains a room in the
home for her dependent daughter, Daphne, who is currently attending college in Los Angeles, where
she shares a dorm room with two other students. Most of Daphnes belongings remain at Thelmas
home. Daphne seldom visits her father and does not keep any of her belongings at his home.
It is clear from the circumstances that Daphnes principal place of abode is Thelmas home. Thus,
Thelma would qualify to be considered unmarried for tax purposes. Thelma may file as head of household.m

4.8 H&RBlock Income Tax Course (2015)

A married taxpayer who does not wish to file a joint return generally will benefit from the rule allowing them to be considered unmarried, if they so qualify. If they do not qualify, they must file a joint
return with their spouse (which often is not an option) or use the married filing separately status. The
disadvantages of the married filing separately status include:
The standard deduction is $0 if the other spouse itemizes.
The effective tax rates are higher.
Many deductions and credits are phased out at lower income levels or disallowed completely.
Complete Exercises 4.1 and 4.2 before continuing to read.

Qualifying Widow(er)
Taxpayers may file as qualifying widow(er) if they meet both of the following requirements:
The taxpayers spouse died in either of the two tax years immediately preceding the current tax
year.
The taxpayer paid over half the cost of maintaining their household, which is the home of their
dependent son, stepson, daughter, or stepdaughter for the entire year.
In the actual year the spouse died, the taxpayer must have been eligible to file married filing jointly
in order to use the qualifying widow(er) status for the next two years afterward. For the next two
years, the taxpayer may file as qualifying widow(er) if they have a dependent son, stepson, daughter,
or stepdaughter. If a taxpayer remarries during any of these years, the taxpayer cannot file as qualifying widow(er).
mExample: Helen and Charles were married for 15 years before Charles unexpectedly passed away
in 2013. Helen has a dependent son, Dennis, who lived with her all year long. In 2013, Helen filed her
tax return as married filing jointly. In 2014 and 2015, Helen may file as qualifying widow (provided
she does not remarry during that time), Dennis remains her dependent for both years, and she pays
over half the cost of maintaining the home.m
mExample: George and Ingrid were married for ten years before Ingrid died in 2012. George has a
dependent daughter, Alice, who lived with him all year long. George remarried in January 2014.
Unfortunately, his marriage did not last, and he was divorced in November of 2014. In 2012, George
filed his tax return as married filing jointly. In 2013, he filed his tax return as qualifying widower.
Now in 2014, George may either file his return as single or head of household. He may no longer use
the qualifying widow(er) status because he remarried in 2014.m
Complete Exercise 4.3 before continuing to read.

Dependent-Related Filing Statuses 4.9

CHILDREN OF DIVORCED OR SEPARATED PARENTS


The rules for qualifying children are handled a bit differently in cases involving divorced or separated
parents. For tax purposes, the custodial parent is the parent with whom the child lived for the greater
number of nights during the year. The other parent is the noncustodial parent. In the case where parents divorce or separate during the year and the child lived with both parents before the separation,
the custodial parent is the one with whom the child lived for the greater number of nights during the
rest of the year.
Note: If the number of nights is equal, the custodial parent is the parent with the higher AGI.
Generally, it is the custodial parent who may claim the qualifying childhence, the dependency
exemptionfor that child.
When dealing with divorced or separated parents, always determine
Tthe custodial
and noncustodial parent. Generally the custodial parent is the
ax Tip:

one with whom the child lived for the greater number of nights during the year.
A child is treated as living with a parent for a night if the child either:
Sleeps at that parents home, whether or not the parent is present.
Is in the company of the parent, when the child does not sleep at a parents
home (for example, vacation).
If the child lived with each parent for an equal number of nights during the
year, the custodial parent is the parent with the higher adjusted gross income
(AGI).

Temporary Absences Involving Divorced or Separated Parents


Generally, a temporary absence from the home due to special circumstances does not constitute a
change in the persons principal place of abode. However, in cases involving divorced or separated
parents, any time the child spends with either parent is not treated as a temporary absence from the
other parent. The number of nights the child spent with either parent during the year is totaled, and
the parent with whom the child spent more nights is, for tax purposes, the custodial parent. This is
true regardless of which parent has legal custody or which claims to maintain the childs permanent
place of abode. The designation of custodial parent is determined by the circumstances each year.
mExample: Tyree and Brenda Butler were divorced in 2008. The divorce decree grants them joint
legal custody of their son, Adam (13). Brenda usually has Adam living with her, but Adam visits
Tyree every weekend and for four weeks in the summer (124 nights in 2013). For 2013, Brenda was
the custodial parent because Adam stayed with his mom for 241 days.
In 2014, Brenda was incarcerated for six months of the year. As a consequence of this unfortunate
event, Tyree became the physical custodian of Adam for over six months of 2014, and Tyree is now
the custodial parent for 2014.m

4.10 H&RBlock Income Tax Course (2015)

The rules for divorced and separated parents apply if all of the following conditions exist:
One or both of the parents provided more than half the childs total support (explained in Chapter
3) for the year.
At the end of the year, the parents of the child are one of the following:
They are divorced or legally separated under a court decree of divorce or separate maintenance.
They are separated under a written separation agreement.
They have lived apart for the last six months of the year, regardless of whether they were ever
married.
The child lived with one or both parents for more than half the year.
These rules also apply even if the parents were never married to each other.
mExample: Butch and Melanie Garrison were divorced in 2005. The divorce decree granted them joint
custody of their son, Brian.
Brian, now age 16, lived with Melanie until June 24. During the tax year, Brian decided that life
would be more fun to live with his father, Butch. Brian went to stay with Butch on June 25 and lived
there the remainder of the year.
Brian stayed with Melanie 175 nights and with Butch 190 nights during the year. Butch is entitled
to claim Brian as a qualifying child because Brian lived with his parents combined for more than half
the year and spent more time with Butch.m
mExample: Suppose that, after Brian moved out of Melanies home, he stayed with his older sister
for three weeks before moving in with Butch. Thus, he stayed with Melanie 175 nights, his sister 21
nights, and Butch 169 nights. Although Brian did not stay with either parent individually for more
than half the year, Melanie is now entitled to claim him as a qualifying child because Brian lived with
his parents combined for more than half the year and he spent the longer amount of time with her.m
Any decree of divorce or separate maintenance or written separation agreement that became effective
after 1984 and prior to 2009 must state the following three facts:
The noncustodial parent can claim the child as a dependent without regard to any conditions, such
as payment of support.
The custodial parent will not claim the child as a dependent for the year.
The years for which the noncustodial, rather than the custodial, parent can claim the child as a
dependent.

Dependent-Related Filing Statuses 4.11


Illustration X.X
4.3
Illustration

4.12 H&RBlock Income Tax Course (2015)

Beginning with 2009 tax returns, divorce decrees or other court documents issued in 2009 and forward do not serve to release the childs exemption to a noncustodial parent. In these cases, Form 8332
must be used. It would be best to secure a Form 8332 any time a custodial parent is sharing benefits
with the noncustodial parent.
Divorced and separated parents. If the noncustodial parent is allowed to take the dependency
exemption for a qualifying child, they are also allowed to claim the Child Tax Credit for that child.
This is true even if their filing status is married filing separately. The custodial parent, in such a case,
may not claim the Child Tax Credit for the child.
Note: The Child Tax Credit is one of the few credits that is allowed to a person using the married filing separately status; however, the phaseout of the credit for married filing separately is substantially
lower than the other filing statuses.

Form 8332
The custodial parent has the option of waiving the right to claim a dependency exemption for a qualifying child, allowing the noncustodial parent to do so. This is usually accomplished by completing
Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent.
Illustration 4.3 shows the current version of Form 8332. Prior to 2009, the agreement also may be
contained in the divorce or separation instrument, making Form 8332 unnecessary when all three
conditions are met.
Form 8332 must be attached to the tax return of the noncustodial parent each year they claim the
dependency exemption. If the waiver is contained in the pre-2009 divorce or separation agreement,
copies of the following pages must be attached in lieu of Form 8332:
On the cover page, they should write the other parents social security number.
The pages containing the information required (see the three bullets on page 4.10).
The signature page showing the date of the agreement and the other parents signature.
The child will be considered the qualifying child of the noncustodial parent if the custodial parent
signs such an agreement.
Stepchildren. For tax purposes, a relationship established by marriage is not terminated by divorce.
So, for example, once a taxpayer marries someone with a child, a stepparent/stepchild relationship is
formed. Even if the couple later divorces, the relationship still exists for tax purposes and is subject
to the rules for divorced or separated parents.
Please note that if a taxpayer attaches Form 8332 to their tax return, the return should either be
mailed or, if the return is efiled, Form 8332 should be attached to Form 8453 and mailed within
three business days after receiving acknowledgment that the IRS has accepted the electronically filed
return.

Dependent-Related Filing Statuses 4.13

TIE-BREAKER RULES
An individual can be the qualifying child of more than one taxpayer. However, only one taxpayer can
claim the individual. Subject to these rules, the taxpayer and the other person may be able to choose
which of the two claims the child as the qualifying child. In a situation where two or more taxpayers
claim an individual, there are a set of tie-breaker rules outlined in the Tax Code to award the qualifying child to a particular taxpayer. The rules:
If only one of the persons is the childs parent, the child is treated as the qualifying child of the
parent.
If the parents do not file a joint return together but both parents claim the child, the IRS will treat
the child as the QC of the parent with whom the child lived for the greater number of nights during
the year. If the child lived with each parent the same amount of time, the IRS will treat the child
as the QC of the parent with the highest AGI for the year.
If no parent can claim the child as a QC, the child is treated as the QC of the person with the
highest AGI for the year.
If a parent can claim the child but no parent does claim the child, the child is treated as the QC of
the person who had the highest AGI for the year, but only if that persons AGI is higher than the
highest AGI of either of the childs parents who could have claimed the child. If the childs parents
file a joint return with each other, this rule can be applied by dividing the parents combined AGI
equally between the two.
mExample: Betty lives with her mother, Stephanie. Stephanies AGI for 2014 is $21,350. Bettys AGI
for 2014 is $32,650. Bettys daughter, Tammi, lives in the same household as Betty and Stephanie.
Tammi is a qualifying child for both Betty and Stephanie. In 2014, Tammis mother, Betty, has the
right to claim Tammi as a qualifying child because the tie-breaker rules state that the parent of the
child has the superior claim to the dependency exemption.m
mExample: In 2014, Paula and David were married and lived with their dependent son, Andrew, from
January 1 until June 30. On July 1, David moved out of the home and filed for divorce. On December
1, their divorce was granted, and Paula was awarded residential custody of Andrew, but the decree
was silent about who could claim the dependency exemption each year.
Prior to the divorce being final, Andrew spent the months of August and October with his father,
David. For the months of September and November, Andrew lived with his grandmother. Andrew
lived with his mother, Paula, the entire months of July and December.
After the separation, in 2014, Andrew spent 62 nights with Paula and 62 nights with David. He also
spent 61 nights with his grandmother. Paulas AGI was $42,000, Davids AGI was $46,500, and the
grandmothers AGI was $58,900. Since Andrew spent an equal amount of time with Paula and David,
David is the custodial parent eligible to claim Andrew as a qualifying child based on the tie-breaker
rules, because he has the higher AGI.m

4.14 H&RBlock Income Tax Course (2015)

mExample: Linda, Jim, and Jane all live with Lindas mother, Betty. Jane is Lindas daughter, and
Linda married Jim when Jane was three years old. Jane is an eligible qualifying dependent for either
Linda or Jim or Betty. Jim and Lindas tax return shows an AGI of $23,000. Bettys tax return shows
an AGIof $21,000. Jim and Linda will not claim Jane on their joint return. Therefore, Betty can claim
Jane, since her AGI of $21,000 is treated as higher than the total AGI of the parents divided equally
between Jim and Linda, as if each individual AGI were $11,500 [$23,000 2 = $11,500].m
mExample: Paula and her son, Trey (5), lived all year with Paulas mother, Carolyn, who paid the
entire cost of keeping up the home. Paulas AGI was $10,000. Carolyns AGI was $25,000. Treys
father, Gary, did not live with Paula or their son at any time during 2014. Under the rules for children of divorced or separated parents or parents who live apart, Trey will be treated as the qualifying
child of Gary, who can claim an exemption and the Child Tax Credit, since Paula signed a Form 8332,
releasing her claim to those benefits. Because of this, Paula cannot claim an exemption or the Child
Tax Credit for Trey.
Treys father cannot claim Trey as a qualifying child for head of household filing status, the credit for
child and dependent care expenses, the exclusion for dependent care benefits, or the Earned Income
Credit. Paula and Carolyn do not have any child care expenses, but Trey is a qualifying child of both
Paula and Carolyn for head of household filing status and the Earned Income Credit because Trey
meets the relationship, age, residency, support, and joint return tests for both Paula and Carolyn.
(Note: You will learn in Chapter 8 that the support test does not apply for the Earned Income Credit.
However, Paula agrees to let Carolyn claim Trey. This means Carolyn can claim Trey for head of
household filing status and the Earned Income Credit, but only if she qualifies for each and if Paula
does not claim Trey as a qualifying child for the Earned Income Credit. (Paula cannot claim head of
household filing status because Carolyn paid the entire cost of keeping up the home.)m
mExample: The facts are the same for Paula, Carolyn, Trey, and Gary as in the example above, except
that Paulas AGI is $25,000 and Carolyns AGI is $21,000. Carolyn cannot claim Trey as a qualifying
child for any purpose because her AGI is not higher than Paulas.m
Complete Exercise 4.4 before continuing to read.

Dependent-Related Filing Statuses 4.15

CHAPTER SUMMARY
In this chapter, you learned:
How to determine whether a taxpayer qualifies to file as head of household.
How to determine who is maintaining the support of a household.
If qualified, a married taxpayer may be considered unmarried for tax purposes.
Unmarried taxpayers may file as qualifying widow(er), head of household, or single. The single
status should be used only if the taxpayer fails to qualify for either of the other two statuses.
In cases of divorced or separated parents, the qualifying child generally may be claimed by the custodial parent. However, the custodial parent may allow the other parent to claim the dependency
exemption if they sign a written agreement waiving their right to claim the exemption.
A multiple-support agreement may be helpful when two or more taxpayers together provide over
half the support of a qualifying relative.

Suggested Reading
For further information on the topics discussed in this chapter as they relate to 2014 tax returns, you
may wish to read the following chapters in IRS Publication 17:
Chapter 2, Filing Status.
Chapter 3, Personal Exemptions and Dependents.
Chapter 34, Child Tax Credit.
client received a
TW-2 and a 1099-MISC from her employer. Her year-endMybonus
was reported
he Tax Institute Tax in the News Research Question:

as other income in box 3 of the 1099. What is the proper tax treatment of the
bonus?
The bonus should be treated as wages and not as other income or
Aself-employment
income.
nswer:

Many employers mistakenly report any pay outside of regular salary, such as
bonus, commission, or severance pay, on Form 1099-MISC instead of on Form
W-2. Your client should first ask her employer to rescind the 1099 and issue a
corrected W-2.
If she cannot contact her employer, or the employer wont make the change,
report the correct total wages, including the bonus, on line 7 of Form 1040,
using a substitute W-2 (Form 4852). To pay her share of payroll taxes, complete
Form 8919, Uncollected Social Security and Medicare Tax on Wages, and check
box H on the form: I received a Form W-2 and a Form 1099-MISC from this
firm for 2014. The amount on Form 1099-MISC should have been included as
wages on Form W-2.
Since your clients regular pay is reported on Form W-2, it is presumed that her
employer is treating her as an employee and not as a contractor. Therefore, she
should not complete Form SS-8 to request a determination of worker status.

Interest and Dividend Income


OVERVIEW
This self-study chapter will show you that wages are not the only source of income for most taxpayers.
Other types of income must be reported on a taxpayers return unless they are specifically excluded by
law. In this chapter, you will study other common types of income. The specific focus will be on interest income and income from qualified dividends and/or capital gain distributions that can be reported
on Schedule B and filed with Form 1040A, but you will also be provided awareness-level knowledge
on items that are required to be reported and filed with Form 1040.

OBJECTIVES
At the conclusion of this chapter, you will be able to:
Recognize several types of interest income and enter them on the tax return appropriately.
Use the Qualified Dividends and Capital Gain Tax Worksheet to compute the tax for taxpayers who
receive qualified dividends and/or capital gain distributions.

TAX TERMS
Look up the definitions of the following terms in the glossary:
Basis.
Capital gain distributions.
Mutual fund.
Nontaxable distributions.
Ordinary dividends.
Ordinary income (loss).
Qualified dividends.
Returns of capital.
Stock dividend.

5.1

5.2 H&R Block Income Tax Course (2015)

INTEREST
Interest is money paid or received for the use of money. Banks often pay interest on money their customers deposit. Governments and corporations pay interest on bonds they issue. Insurance companies
pay interest on money left on deposit. The sources of interest income are vast. Most of the interest
we receive is taxable, but some is not. Illustration 5.2 lists some common types of interest and shows
whether or not the interest is taxable on the federal return.
Generally, interest is taxable in the year received or credited to an account, even if it is not withdrawn. Payers of interest of $10 or more to any one person during the year are generally required
to report such payments to the IRS and furnish the recipient with a Form 1099-INT or an approved
substitute form. If less than $10 interest was received from any payer, that interest is still taxable to
the taxpayer, even though a reporting form is not required from the payer. In some cases, especially
with loans or contracts, the taxpayer must determine the amount of interest received from their own
records (for example, from an amortization schedule).

Schedule B
When the taxpayer receives taxable interest totaling more than $1,500, it must be listed on Schedule
B. Schedule B is shown in Illustration 5.3. Interest totaling $1,500 or less can be entered directly on
Form 1040A, line 8a, or Form 1040EZ, line 2.
If the taxpayer received any interest on foreign investments, even if total taxable interest income is
$1,500 or less, Form 1040 and Schedule B must be used. Schedule B also must be filed if the taxpayer
received any of the following:
Interest not properly attributable to the taxpayer.
Interest on a seller-financed mortgage.
Interest from U.S. Savings Bonds that is being excluded from income (covered later in this course).

lockWorks tip: Without regard to dollar limits, BlockWorks will always


show a Schedule B available for printing. Tax Professionals have the option
to suppress printing the Schedule B when it is not required for a specific tax
return. See Illustration 5.1 below.

Illustration 5.1

Interest and Dividend Income 5.3


Illustration 5.2

Interest Income From:

Paid By:

Taxable:

Savings accounts, certificates


of deposits, checking accounts

Banks, savings and loan associations, credit unions

Yes, as accrued.

Certain short-term corporate


obligations

Banks and similar organizations and corporations

Yes, at maturity.
Yes, generally at maturity
or when cashed, though may
elect as earned.

Series E or EE Bonds, Series


I Bonds

U.S. Treasury

No, if proceeds from qualified


bonds are used to pay qualified higher education expenses.

Series H or HH Bonds

U.S. Treasury

Yes, as accrued.

Treasury Bills

U.S. Treasury

Yes, at maturity.

Treasury Notes/Bonds,
all others

U.S. Treasury

Yes, as accrued.

Municipal bonds

State/local governments

No, but still reportable

Exempt-interest dividends

Mutual funds

No, but still reportable.

Corporate bonds

Corporations, including public


utility companies

Yes, as accrued.

Other bonds and notes

Various

Yes, as accrued.

Personal loans/notes

Borrower

Yes, as received.

Sales contracts

Purchaser

Yes, as accrued.

Insurance dividends left on


deposit

Insurance company

Yes, as accrued.

Overpaid income tax

U.S./state/local government

Yes, year received.

5.4 H&R Block Income Tax Course (2015)


Illustration 5.3
X.X

This is reporting a seller-financed mortgage. This is the


interest Paula received.
This $300 is nominee interest
reported to Paula. Notice that
it is reported, then subtracted.

Note: There are two reasons this Schedule B cannot be filed


with Form 1040A:
The interest Paula received from the seller financed mortgage exceeds $1,500.
The nominee distribution is interest not attributable to
the taxpayer.
Paula Pendletons Schedule B must be filed with Form 1040.

Interest and Dividend Income 5.5

Foreign Investments
Interest on foreign investments is taxed the same as interest received on domestic investments.
Investing in U.S. mutual funds that hold foreign debt instruments does not constitute an interest in
a foreign account for this purpose, nor does an account in a U.S. military financial facility.
When a tax return is filed electronically, Tax Professionals must ask the following questions about
foreign accounts and foreign trusts:
At any time during 2014, did you have any financial interest in or signature authority over a financial account (such as a bank account, securities account, or brokerage account) located in a foreign
country?
Taxpayers who answer yes to this question may have to file FinCEN Form 114, Report of Foreign
Bank and Financial Accounts, and/or Form 8938, Statement of Specified Foreign Financial Assets.
During 2014, did you receive a distribution from or were you the grantor of or transferor to a foreign trust?
Taxpayers who answer yes to this question may have to file Form 3520, Annual Return To Report
Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.
During 2014, did you have ownership or authority over foreign financial assets worth $50,000?
Form 8938, Statement of Specified Value of Foreign Financial Assets, is required to be filed if the
aggregate value of foreign financial assets exceed $50,000 ($100,000 if MFJ) at the end of the year
or exceeds $75,000 ($150,000 MFJ) at any time during the year. The form is required to be attached
to the tax return. Failure to report can result in a penalty of $10,000.
A Tax Professionals due diligence responsibility is to ask the questions and inform taxpayers if and
when any additional forms are required. These forms should not be completed without the assistance
of an experienced Tax Professional.

Not Attributable to the Taxpayer


There are some circumstances when a taxpayer may receive, in their name, interest income (and often
a Form 1099-INT) that does not actually belong to them. One example is nominee interestinterest
that belongs to another person. It is fairly common for a parent to hold a bank account for a minor
child. If the money in the account actually belongs to the child, so does the interest income it produces.
The taxpayer should report nominee interest on Schedule B. Then, write Nominee Distribution, and
subtract the amount of such interest. The total on line 2 should represent only taxable interest. See
Illustration 5.3 for an example that reports a nominee distribution.
Note: If nominee interest totals $10 or more, the taxpayer must issue a Form 1099-INT to the rightful
owner of the income (other than their spouse) by February 28. The IRSs copy of Form 1099-INT is
filed along with transmittal Form 1096.
Other examples of interest not attributable to the taxpayer include certain accrued interest and original issue discounts (OID), which will not be discussed in this course.

5.6 H&R Block Income Tax Course (2015)

Seller-Financed Mortgage
If a taxpayer sells their home to a buyer who uses the home as their residence, and the taxpayer
finances part or all of the mortgage, the taxpayer must report the buyers name, address, and social
security number on Schedule B (or an attachment), along with the amount of interest received each
year. The interest the taxpayer receives is taxable. There is a $50 penalty for failure to report this
information. The taxpayer is also required to provide the buyer with their name, address, and social
security number. See Illustration 5.3 for an example.

Tax-Exempt Interest
Banks, savings and loans, and other payers of interest will report tax-exempt interest on a Form
1099-INT. The taxpayer should report the tax-exempt interest on Form 1040 or Form 1040A, line 8b.
Complete Exercise 5.1 before continuing to read.

FORM 1099-INTINTEREST INCOME


Study Form 1099-INT in Illustration 5.4. You need to understand the following entries at this time.

Box 1
This box includes amounts that are paid or credited to the taxpayers account. It includes such items
as interest on bank deposits, corporate bonds, and notes.
If total taxable interest is more than $1,500, it must be reported on Form 1040 or Form 1040A,
Schedule B. Total taxable interest is reported on Form 1040 or Form 1040A, line 8a, or Form 1040EZ,
line 2.

Box 2
If money in a time savings instrument (such as a certificate of deposit) is withdrawn before maturity, interest may revert to a lower rate and there may also be a period when no interest is paid. The
difference (the amount of interest forfeited) will be reported as an early withdrawal penalty in box 2
on Form 1099-INT or similar statement. It is possible that the penalty could be more than the gross
amount of interest reported in box 1.
Penalty on Early Withdrawal of Savings Adjustment
The interest penalty can be subtracted from total income on Form 1040. Forms 1040A or 1040EZ do
not have this line entry. The interest reported on Form 1099-INT is the amount that was received for
the tax year up to the date of withdrawal.
mExample: In January 2012, Margaret Webber invested $10,000 in a five-year certificate of deposit
with her bank. The CD pays 3% interest annually, but if Margaret were to cash it in prematurely, she
would be charged with a % penalty.

Interest and Dividend Income 5.7

In February 2014, Margaret cashed in the CD. The bank computed her interest income for 2014 to be
$35, but she had to pay a $50 penalty [$10,000 .005 = $50]. She would report $35 in taxable interest, and claim an adjustment to income by subtracting $50 from taxable income on Form 1040 only.m

Box 3
Interest from U.S. Savings Bonds and other Treasury obligations is entered here. Generally, this
income is taxable on the federal return, but nontaxable on state returns. Box 3 amounts are entered
on the federal return in the same manner as box 1 amounts. We will further examine this type of
income later in this chapter.
Illustration 5.4

Box 4
Usually, tax is not withheld from interest payments. However, if the taxpayer has failed to provide the
payer with their social security number or other identifying number, the payer is required to withhold
tax on the interest paid. Any withholding is shown in box 4. Include box 4 amounts in the total entered
on Form 1040A, line 40 or Form 1040EZ, line 7.

Box 5
Any amount shown in this box is the taxpayers share of investment expenses from a real estate mortgage investment conduit (REMIC). REMICs are not covered in this course.

5.8 H&R Block Income Tax Course (2015)

Box 6
Foreign tax paid is any foreign tax withheld from the interest income. The taxpayer may deduct the
tax as an itemized deduction or take a dollar-for-dollar credit, both of which are reported on Form
1040. We will not discuss the details of this topic in this course.

Box 7
Foreign country or U.S. possession is the country or possession to which the foreign tax was paid.

Box 8
This box shows the amount of tax-exempt interest received by the taxpayer. Tax-exempt interest may
be entered directly on Form 1040A, line 8b.

Box 9
This box shows the amount of tax-exempt interest that is subject to the Alternative Minimum Tax.
The Alternative Minimum Tax, or AMT as it is commonly known, is beyond the scope of this discussion. The amount shown in box 9 is included in box 8.

Boxes 10 and 11
Both boxes contain information reported for covered securities, which are not covered in this course.

Box 12
This box shows the CUSIP number of the tax-exempt bond for tax-exempt interest reported in box 8.
If the tax-exempt interest is reported in the aggregate for multiple bonds or accounts, enter various.
If a CUSIP number was not issued for the tax-exempt bond, box 10 will be blank.

UNITED STATES TREASURY OBLIGATIONS


The Department of the Treasury of the United States offers several different types of debt instruments, which accrue and pay interest at various intervals. The most commonly held instruments are
U.S. Savings Bonds.
Series EE bonds have been issued by the Treasury since 1980. Series I bonds have been issued since
1998. Their predecessors, Series E, H, and HH bonds, are no longer issued, but many taxpayers still
hold them. See Illustration 5.5.
Series E and EE bonds accrue interest until they mature. Most taxpayers report Series E and EE bond
interest in the year the bond is cashed or the year of final maturity, whichever is earlier.
A taxpayer may elect to report the interest each year as it is earned. This election is made by attaching a statement to the tax return and does not require IRS permission. Once this election is made, the
taxpayer must include in income the interest from all Series E or EE bonds each year. The taxpayer
may only change back to the other method with IRS permission.

Interest and Dividend Income 5.9


Illustration 5.5

Issued

Reach Maturity
After

Through 11/30/65

40 years

12/1/6506/30/80

30 years

EE

Since 1980

30 years

Through 12/31/79

30 years

HH

Through 08/31/04

20 years

Since 1998

30 years

Series
E

mExample: Baby Janet, born in 2014, received several Series EE bonds for her christening. The bonds
were gifts and were issued in her name.
As odd as it may sound, the best tax-saving strategy may be for her parents to file a 2014 tax return
for Janet, electing to report the interest annually. If the interest is her only income, it will probably
be too little to trigger a tax liability each year. After the election is made, a return will not have to
be filed for each year her income is below the gross income filing requirement. When the bonds are
cashed (or reach final maturity), the prior years taxable interest will not be included in her income.
If, instead, the interest is taxed when the bonds are cashed or reach maturity, Janet may have taxable
incomeenough to require her to pay tax on some or all the interest at her marginal tax rate.m
Through August 31, 2004, mature Series E or EE bonds could be traded in for Series HH bonds. Such
a trade was a nontaxable transaction, meaning the previously accrued interest continued to be tax-deferred until distributed. No new Series HH bonds are being issued after August 31, 2004.
Series HH bonds pay interest directly to the taxpayer twice a year. The taxpayer must report the
interest in income in the year it is received if the taxpayer is a cash-method taxpayer.
Series I bonds are inflation-indexed; that is, they are designed to offer a rate of return over and above
the rate of inflation, as measured by the consumer price index (CPI). Other than the inflation aspect,
these bonds are treated very much as Series EE bonds.
U.S. Savings Bonds that have reached final maturity are no longer yielding interest. Bonds that have
reached final maturity should usually be cashed in as soon as possible.
Treasury bills, notes, and bonds are direct obligations of the U.S. Treasury. T-bills mature in one year
or less and are taxed at maturity. Most other Treasury obligations are taxed as the interest is earned.
See Illustration 5.2 for more information.
By federal law, interest from U.S. Treasury obligations is never subject to state or local income taxes.

5.10 H&R Block Income Tax Course (2015)

OTHER INTEREST INCOME


If the IRS sends a tax refund to a taxpayer who has filed an amended return or if it takes more than
45 days to issue a refund, it will pay interest along with the refund. Such interest is taxable. The same
holds true for interest on late refunds from state and local governments. Generally, the IRSwill send
the taxpayer Form 1099-INT for the year in which the interest is paid.

Municipal Bond Interest


Municipal bonds are generally issued by state and local governments to fund capital improvement
projects. Local governments include counties, cities, school districts, and other administrative divisions of the states that have been granted the authority to issue bonds. The federal government does
not tax municipal bond interest.
Some state and local governments do not tax interest from any municipal bonds. Others tax interest
from municipal bonds issued by state or local governments other than their own. Still others tax interest from all municipal bonds, including their own.
State and local governments will report such tax-exempt interest on Form 1099-INT.
Complete Exercise 5.2 before continuing to read.

DIVIDENDS
Dividends are paid to shareholders (people who own stock) of corporations. They represent the shareholders portion of the corporations profits. In this section, you will learn about the various kinds of
dividends shareholders may receive and their tax treatments.
Note: Certain distributions commonly referred to as dividends are actually interest. Two common
examples are dividends paid by credit unions and exempt-interest dividends paid by mutual funds.
These so-called dividends are properly treated as interestthe former (credit union dividend) is
taxable, and the latter is tax exempt.
Payers of dividends of $10 or more to any one person during the year are required to report such
payments to the IRS and furnish the recipient with a statement of total dividends received for the tax
year. Form 1099-DIV or similar statement of account is used. See Illustration 5.6.
The most common types of distributions are:
Ordinary dividends (including qualified dividends).
Capital gain distributions.
Nontaxable distributions.
Ordinary dividends are the most common type of distribution and are the portion of a corporations
profits paid to the shareholders. While some ordinary dividends are taxed as ordinary income, qual-

Interest and Dividend Income 5.11

ified dividends are treated as long-term capital gains. You will learn why this is important later in
this chapter.
Capital gain distributions are paid by mutual funds, regulated investment companies, and real estate
investment trusts. They represent the shareholders portion of gain from the sale of securities owned
by these investment companies. Capital gain distributions are characterized as long-term regardless
of how long the taxpayer has owned them if they are from a mutual fund or real estate investment
trusts. There are two treatments of capital gain distributions. Both types are taxable for the year
constructively received:
Distributed capital gains are paid in cash to the shareholders or reinvested in additional shares at
the shareholders request.
Undistributed capital gains are retained by the investment company, which pays the tax on them.
These gains are reinvested automatically in additional shares and reported to the taxpayer on
Form 2439 rather than on Form 1099-DIV. An individual who receives Form 2439 may have a
credit which can only be claimed by filing Form 1040.
Nontaxable distributions represent a return of the shareholders capital (original investment), generally made because an excess amount of capital has been accumulated by the corporation. Nontaxable
distributions may be received in cash or reinvested at the shareholders request to acquire additional
shares. The basis of the stock must be reduced by the amount of the distribution. Amounts received
are not taxable until the remaining basis is reduced to zero. It is important to know that returns of
capital are usually not taxable.

Form 1099-DIVDividends and Distributions


Illustration 5.6

5.12 H&R Block Income Tax Course (2015)

Examine the Form 1099-DIV in Illustration 5.6. The entries you will need to understand are:
Box 1a. Ordinary dividends are totaled and entered on Form 1040A, line 9a. If the total is more than
$1,500, the dividends must also be reported in Part II of Schedule B. If the total is $1,500 or less, the
amount is entered directly on Form 1040A, line9a.
Box 1b. Qualified dividends are included in box 1a, but also are shown here because they qualify for
more favorable tax treatment. They are totaled and entered on 1040A, line 9b. We will define qualified
dividends later in this chapter.
Box 2a. Total capital gain distributions are shown here. As mentioned earlier, capital gain distributions represent the shareholders share of capital gains from mutual funds, regulated investment
companies, and real estate investment trusts (REITs). The total gain in box 2a includes any amounts
in boxes 2b2d. Each of these amounts is subject to a different tax treatment and various limitations,
which we will discuss in a moment.
If none of the taxpayers Forms 1099-DIV contain any entries in boxes 2b2d, the taxpayer may report
their capital gain distributions directly on Form 1040A, line 10.
Box 2b. Unrecaptured 1250 gain is a portion of the gain resulting from the sale of certain real estate
used for business purposes. It is taxed at a maximum rate of 25%. A discussion of 1250 gain will not
be held in this course.
Box 2c. Section 1202 gain is gain from the sale of certain small business stock. Some of this gain may
be eligible to be excluded from income. The exclusion will not be discussed in this course.
Box 2d. Gain resulting from the sale of certain collectible items, such as rare coins and works of art,
is taxed at a maximum rate of 28%. We will discuss this category of gain when we discuss capital gain
tax rates.
Box 3. Non-dividend distributions are shown here. These distributions generally are not entered on
the tax return.
Box 4. This is the amount of federal income tax withheld from the taxpayers dividends in the event
the payer has not been provided with the taxpayers identification number. Be sure to include this
amount in the total for Form 1040A, line 40.
Box 5. Usually, this box is empty. If it has an entry, the amount represents the taxpayers share
of expenses paid by a non-publicly offered regulated investment company. The box 5 amounts are
deductible as a miscellaneous itemized deduction on Schedule A. Details of this itemized deduction
are not discussed in this course.
Box 6. Foreign tax paid is the foreign tax withheld from the dividend income. It may be deducted on
Schedule A (if the taxpayer itemizes deductions) or claimed as a foreign tax credit. As mentioned in
the discussion of Form 1099-INT earlier, qualified individuals claim the foreign tax credit by filing
Form 1040.
Box 7. The country or U.S. possession to which the foreign tax was paid.
Boxes 8 and 9. These boxes only apply to corporations that are in partial or complete liquidation;
that is, going out of business. Cash distributions are reported in box 8. The fair market value of items
other than cash distributed as part of a liquidation is reported in box 9. Treatment of liquidation distributions is not discussed in this course.

Interest and Dividend Income 5.13

Many banks and brokerage firms issue their own versions of Forms 1099, sometimes combining multiple reporting forms on one sheet. These substitute statements must contain all the same information,
labeled with box numbers corresponding to the official IRS forms.
These statements include Forms 1099-DIV, 1099-INT, 1099-OID (a form used for reporting interest
from certain bonds), Form 1099-B (not covered in this course), and Form 1099-MISC (a form which
shows miscellaneous income).

TAX COMPUTATION FOR QUALIFIED DIVIDENDS AND CAPITAL


GAIN DISTRIBUTIONS
Qualified dividends (those found on Form 1099-DIV, box 1b) and capital gain distributions (Form
1099-DIV, box 2a) are treated as long-term capital gains, which generally are taxed at lower rates
than ordinary income and short-term capital gains.
Qualified dividends are those received on certain shares of stock held more than 60 days (90 days for
preferred stock). The payer of the dividends should determine if dividends are qualified dividends.
Long-term capital gain treatment is generally reserved for gain from sales or other exchanges of
securities held for more than one year. We will not cover long- and short-term gain and other types
of capital gains in this course. For now, we will concern ourselves only with normal capital gain
distributionsthose shown only in box 2a.
For 2014, the maximum rate of tax on qualified dividends is:
0% on any amount that otherwise would be taxed at a 10% or 15% rate.
15% on any amount that otherwise would be taxed at rates greater than 15% but less than 39.6%.
20% on any amount that otherwise would be taxed at a 39.6% rate.
If a taxpayer has no income eligible for long-term capital gain treatment other than qualified dividends and normal capital gain distributions, the taxpayer may use the Qualified Dividends and
Capital Gain Tax Worksheet to compute their income tax. Taxpayers with other capital gains and
losses must file Schedule D and use the Schedule D tax worksheet. Schedule D must be filed with
Form 1040 and will not be covered in this course.
mExample: Sven and Ingrid Dasen are filing a joint return and are in the 25% federal tax bracket.
Included in their $69,440 taxable income (Form 1040A, line 27) are the dividends and capital gain
distributions shown on the Form 1099-DIV in Illustration 5.6. A portion of page 1 of their Form 1040A
and their Qualified Dividends and Capital Gain Tax Worksheet is shown in Illustration 5.7. Notice
that the reduced capital gains rate saves them $157 in tax (the difference between line 15 and line
14).m
Complete Exercise 5.3 before continuing to read.

5.14 H&R Block Income Tax Course (2015)


Illustration 5.7

Interest and Dividend Income 5.15

CHAPTER SUMMARY
In this chapter, you learned:
Interest income is reported to the taxpayer on Form 1099-INT or a substitute statement.
Dividend income may consist of ordinary dividends, capital gain distributions, or nontaxable
(return of capital) distributions. Dividends are reported to the taxpayer on Form 1099-DIV or a
substitute statement.
Generally, if total taxable interest or ordinary dividend income is $1,500 or less, report the income
directly on the front page of Form 1040 or 1040A (or 1040EZ for interest only). If total taxable
interest or ordinary dividend income is $1,501 or more, use Form 1040 or 1040A, Schedule B.
A taxpayer whose only capital gain income is normal capital gain distributions from mutual
funds, regulated investment companies, etc., may use the Qualified Dividends and Capital Gain
Tax Worksheet to compute their tax.
Qualified dividends and normal capital gain distributions are taxed as long-term capital gains.

Suggested Reading
For further information on the topics discussed in this chapter, you may wish to read the following
sections in IRS Publication 17:
Chapter 7, Interest Income.
Chapter 8, Dividends and Other Distributions.

5.16 H&R Block Income Tax Course (2015)

client, who is a
TU.S. citizen, moved to the U.K. early in 2014 and will beMyliving
and workhe Tax Institute Tax in the News Research Question:

ing there for at least two more years. She has a checking account at a London
branch of a U.S. bank. Although her account balance varies, she has a high
paying job and her pay is directly deposited into this account every other week.
Someone told her that because her money is in an American bank she doesnt
have anything to worry about, but she is concerned that she may have some
type of foreign account reporting requirement. Does she have to file a TD F
90-22.1 or that new Form 8938?
nswer: Your client is correct about not making assumptions about her
reporting responsibility because her account is at an American bank. She
should be aware of the two reporting requirements.

Form TD F 90-22.1 / FinCEN Form 114, Report of Foreign Bank and Financial
Accounts FBAR, is required if a U.S. taxpayer a) has a financial interest in
or a signature authority over at least one foreign financial account and b) the
value of the account(s) is more than $10,000 at any time during the year. For
FBAR purposes, a foreign financial account is any account that is not physically
located in the United States or in one of its possessions or territories. In your
clients case, her checking account maintained in a foreign branch of a U.S. bank
is a foreign financial account. If her checking account balance was more than
$10,000 on any one day during 2014, she must file the FBAR electronically with
FinCEN by June 30, 2015.
Under the Foreign Account Tax Compliance Act FATCA, Form 8938,
Statement of Specified Foreign Financial Assets, is required if a U.S. taxpayer
a) has a specified asset maintained by a foreign financial institution and b) the
value of the asset is over certain thresholds. While a checking account is a specified asset, for this purpose, a foreign branch of a U.S. bank (50 states and D.C.
only) is not considered a foreign financial institution for FATCA purposes. Thus,
given these facts, your client is not required to file Form 8938.
However, if your client decides to transfer her money to a U.K. or other foreign
bank, or opens another account at a foreign financial institution, FATCA may
come into play. For a single U.S. citizen living abroad (assuming your client
meets or will soon meet either the physical presence test or bona fide residence
test), Form 8938 is required if the value of her account is more than $200,000 at
the end of the calendar year or more than $300,000 at any time during the year
but only if the account is maintained in a foreign financial institution.

BlockWorks Practice 1
OVERVIEW
This entire chapter is devoted to the BlockWorks Practice Session 1. This practice session will help
you become familiar with the preparation of taxpayers income tax returns in the BlockWorks software as well as develop your tax interview skills at the tax desk. One of the practice case studies is set
up as a role play to give you the experience of interviewing a client. This will help you start thinking of
ways you will ask questions to conduct a thorough tax interview that results in an accurate tax return.

INSTRUCTIONS
To complete the BlockWorks Practice Session 1, you will first spend one hour completing ITC case
study returns in the BlockWorks software. Your instructor will provide you with guidance as to which
case studies you enter into BlockWorks.
Next, you will spend approximately one hour by yourself completing Case Studies 6.1 and 6.2 in the
BlockWorks software. This case study information can be found on pages W6.1W6.8 in your workbook.
Finally, you will spend the remaining hour of class completing Case Study 6.3 in the BlockWorks
software. To complete Case Study 6.3, you will need to partner with another participant in class. This
case study is set up in your workbook as an interview with a taxpayer at the tax desk. One individual
will play the role of the Tax Professional, and the other individual will play the role of the taxpayer.
Each case study in your workbook is set as two scripts, the Tax Professional and the taxpayer. Use
the script associated with your role to ask or answer questions and complete the case study return
in the BlockWorks software. This case study information can be found on pages W6.9W6.15 in your
workbook.

6.1

Earned Income Credit


OVERVIEW
In this chapter, you will discuss two refundable tax credits for which taxpayers may qualify. The
two credits are the Earned Income Tax Credit (EIC or EITC) and the Additional Child Tax Credit.
The Earned Income Tax Credit can generate tax refunds of a few thousand dollars on very modest
amounts of income. The Additional Child Tax Credit may allow taxpayers with little or no tax liability to receive some of the Child Tax Credit studied in Chapter 3. The chapter ends with a discussion
of the significant responsibilities paid Tax Professionals have regarding Earned Income Credit due
diligence.

OBJECTIVES
At the conclusion of this chapter, you will be able to:
State the difference between refundable and nonrefundable credits.
Determine eligibility for the Additional Child Tax Credit and compute the credit.
Understand the rules regarding taxpayer qualifications for receiving the Earned Income Credit.
Understand the important role of the entire tax interview when preparing returns claiming Earned
Income Credit.
Determine eligibility for the Earned Income Credit and compute the credit.
Comprehend the Earned Income Credit due diligence rules.

TAX TERMS
Look up the definitions of the following terms in the glossary:
Custodial parent.
Dependent.
Eligible foster child.
Full-time student.
Investment income.
Noncustodial parent.
Nonrefundable credit.
Permanent and total disability.

7.1

7.2 H&RBlock Income Tax Course (2015)

Principal place of abode (principal residence).


Qualifying child (QC).
Qualifying relative (QR).
Refundable credit.
Support.

CREDITS VS. DEDUCTIONS


Before we begin a discussion of credits, it is important to understand the difference between credits
and deductions.
While both credits and deductions help taxpayers reduce the amount of tax they must pay, they do so
in different ways. Deductions, such as the standard deduction, lower the tax by reducing the amount
of income that would otherwise be taxable. Lower taxable income results in a lower tax liability.
Unlike deductions, credits do not come into play until after taxable income has been computed and
the tax determined. Then, credits may be used to reduce the tax already determined.
Some credits are nonrefundable, and some are refundable. Nonrefundable means that the combined
amount of these credits cannot reduce the taxpayers tax liability below zero. Refundable credits may
reduce the taxpayers tax liability below zero, and the difference is refunded to the taxpayer.

CHILD TAX CREDIT


Remember, you studied the Child Tax Credit, worth up to $1,000 for each qualifying child, in Chapter
3. In order to qualify for the Child Tax Credit, all of the following must be true:
The taxpayer must have a qualifying child.
The qualifying child must be under the age of 17 at the end of the year.
The qualifying child must be a dependent on the taxpayers return.
The qualifying child must be a U.S. citizen, U.S. national, or resident of the United States.
When a taxpayer has little or no tax liability, they may not receive the entire Child Tax Credit as a
nonrefundable credit. In this case, the Child Tax Credit may be less than the $1,000 per child, since
this credit is nonrefundable. However, if they meet all of the necessary requirements, they may be
able to receive the balance of the credit (any amount not allowed on Form 1040A, line 35) as an
Additional Child Tax Credit, which is a refundable credit.

Earned Income Credit 7.3

ADDITIONAL CHILD TAX CREDIT


A taxpayers nonrefundable credits may be limited by his tax liability. If a taxpayers Child Tax Credit
is limited, they may be eligible to claim the Additional Child Tax Credit. The Additional Child Tax
Credit is a refundable credit, which is available when tax liability limits the Child Tax Credit.
To qualify for the Additional Child Tax Credit, a taxpayer who otherwise qualifies for the Child Tax
Credit must have one of the following:
Earned income exceeding $3,000 for 2014.
Three or more qualifying children.
Any taxpayer with at least one qualifying child may claim a credit of up to 15% of the amount by
which earned income exceeds $3,000. A taxpayer with three or more qualifying children may be able
to claim a higher credit if social security plus medicare tax paid exceeds the Earned Income Tax Credit
(if any). In all cases, the credit is limited to $1,000 per qualifying child and reduced by the nonrefundable portion of the Child Tax Credit.
Earned income. For purposes of the Additional Child Tax Credit, earned income includes both taxable earned income and nontaxable combat pay. When determining the Additional Child Tax Credit,
generally, the more earned income that is taken into account will increase the credit. As you will learn
later in this chapter, more income can either increase or decrease the Earned Income Tax Credit, so
the taxpayer can choose the more advantageous treatment.
The Additional Child Tax Credit is computed using Schedule 8812 (shown in Illustrations 7.1 and 7.2)
and is carried to Form 1040A, line 43. Unless the taxpayer has self-employment income (in which case
a Form 1040 is required), his taxable earned income will be the amount from Form1040A, line 7, plus
any excludible combat pay.
mExample: For 2014, Bill Helget (55) is filing Form 1040A, using the head of household filing status,
and he has five qualifying children under age 17. His earned income and adjusted gross income are
$33,010, and his tax before credits is $21. His employer withheld $2,526 in social security and medicare taxes from his wages. Bill is claiming a $2,942 Earned Income Tax Credit and no nonrefundable
credits other than the Child Tax Credit.
Bill would have been allowed a $5,000 nonrefundable Child Tax Credit, but his tax liability is only
$21. His 2014 earned income exceeds $3,000 by $30,010. Because he has three or more qualifying
children, he may claim an Additional Child Tax Credit for the larger of 15% of that excess [$30,010
2 15% = $4,502] or the amount by which his net social security and medicare tax paid exceeds his
Earned Income Tax Credit, not to exceed his remaining available credit [$5,000 tentative credit $21
nonrefundable credit = $4,979]. Bills social security and medicare tax does not exceed his EIC [$2,526
vs. $2,942]. Illustrations 7.1 and 7.2 show Bills Schedule 8812.m
Complete Exercise 7.1 before continuing to read.

7.4 H&RBlock Income Tax Course (2015)


Illustration 7.1

Earned Income Credit 7.5


Illustration 7.2

7.6 H&RBlock Income Tax Course (2015)

EARNED INCOME CREDIT


The Earned Income Credit, abbreviated EIC, is a valuable credit available to lower-income taxpayers
with earned income. It can be worth as much as $6,143 for 2014, depending upon the taxpayers filing
status, income, and number of qualifying children involved. The EIC is refundable, which allows the
taxpayer to get the credit as part of their refund, even if their tax liability has been reduced to zero.

QUALIFYING FOR EIC


Taxpayers may qualify for the EIC, even if they have no qualifying children, but the rules are slightly
different than for taxpayers with qualifying children. First, we will examine the rules for those without qualifying children. Then, we will look at the rules for those with qualifying children. Finally, we
will discuss additional rules that apply to both.

Taxpayers Without Qualifying Children


To qualify for the credit, taxpayers without qualifying children must:
Be at least 25 years old, but younger than age 65, on January 1, 2015 (if MFJ, either spouse can
meet this requirement).
Not be able to be claimed as a dependent on another taxpayers return.
Not be a qualifying child of another person.
Live in the United States more than half the year.
Have earned income and AGI of less than $14,590 ($20,020 if married filing jointly).

Taxpayers With Qualifying Children


To qualify for the EIC, taxpayers with one or more qualifying children must:
Have a qualifying child who meets the relationship, age, residency, and joint return tests.
Have a qualifying child who is not claimed by more than one person for EIC.
Not be a qualifying child of another person.
Have earned income and AGI less than one of the following:
$38,511 ($43,941 if married filing jointly) with one qualifying child.
$43,756 ($49,186 if married filing jointly) with two qualifying children.
$46,997 ($52,247 if married filing jointly) with three or more qualifying children.

Rules for Taxpayers With or Without a Qualifying Child


To qualify for the credit, all taxpayers must:
Have a valid SSN.
Not use the filing status MFS.
Be a U.S. citizen or resident alien all year.

Earned Income Credit 7.7

Not file a Form 2555 or Form 2555-EZ.


Have investment income of $3,350 or less.
Have earned income.

lockWorks Tip: For EIC purposes, be sure you enter all members of the
household when entering individuals in the Personal Information screen.
You will enter the names, relationships, ages, income, and whether the taxpayer
wishes to claim them or not.

UNDERSTANDING THE RULES


For an in-depth discussion of all the rules, IRS Publication 596, Earned Income Credit, is the best
place to start. A synopsis of these rules also appears in IRS Publication 17 in Chapter 36. What follows
are highlights and important issues to understand for this course.
Whether a taxpayer meets these rules is determined throughout the tax interview performed by the
Tax Professional. Therefore, it is important for the Tax Professional to listen carefully during the
interview to comply with EIC due diligence discussed later in this chapter.

Being a Dependent
If another person may claim the taxpayer (or their spouse if filing a joint return) as a dependent on
their return, the taxpayer cannot take the credit. This is true even if the other person does not actually claim the taxpayer.

Living in the U.S.


The United States consists of any of the 50 states and the District of Columbia. It does not include
Puerto Rico or U.S. possessions, such as the U.S. Virgin Islands and Guam. U.S. military personnel
stationed outside the United States on extended active duty are considered to live in the United States
during that duty period for the purposes of EIC.

Relationship, Age, Residency, and Joint Return


Relationship
The taxpayers qualifying child must be one of the following:
A son, daughter, stepchild, eligible foster child, adopted child, or descendant of any of them.
A brother, sister, half-brother, half-sister, stepbrother, stepsister, or a descendant of any of them.
Age
The taxpayers qualifying child must be one of the following:
Under the age of 19 at the end of 2014 and younger than the taxpayer (or the taxpayers spouse,
if filing jointly).

7.8 H&RBlock Income Tax Course (2015)

A full-time student under the age of 24 at the end of 2014 and younger than the taxpayer (or his
spouse, if filing jointly).
Permanently and totally disabled at any time during 2014, regardless of age.
Residency
The taxpayers qualifying child must have lived with the taxpayer in the United States (defined earlier) for more than half of 2014. The rule for military personnel mentioned previously also applies to
residency.
Joint Return
The taxpayers qualifying child cannot file a joint return, unless merely as a claim for refund.
Married child. If a taxpayers qualifying child is married, the taxpayer must be able to claim a
dependency exemption for that child (unless the divorced parents rules apply).

Tiebreaker RulesA Reminder


If a child is a qualifying child of more than one taxpayer, the taxpayers may decide among themselves,
subject to the tiebreaker rules, which one is to claim the credit along with all the other tax benefits.
(For this purpose, married taxpayers filing a joint return are treated as one taxpayer.) If more than
one taxpayer claims the credit with respect to the same child, the IRS will decide which will receive
the credit, based on the tiebreaker rules described earlier in Chapter 4.
Divorced or separated parents. The waiver of the exemption to the noncustodial parent under the
divorced parents rules does not apply for EIC purposes. Only the custodial parent may claim the EIC
with respect to the child.

Social Security Numbers


To claim the EIC, the tax return must show a valid social security number for the taxpayer, the spouse
(if filing jointly), and all qualifying children.
Note: Some SSNs are issued only to allow taxpayers to receive certain federal benefits. To qualify for
the EIC, a valid SSN is one that allows the holder to work. If the words Not valid for employment
are printed on the social security card, the number is not a valid SSN for EIC purposes, and the taxpayer may not claim the credit.

U.S. Citizen or Resident Alien All Year


Nonresident aliens generally cannot claim the EIC. Resident aliens cannot claim the credit unless
they are authorized to work in the United States. If the taxpayer (or spouse, if married) were a nonresident alien for any part of the year, the taxpayer cannot claim the EIC unless the filing status is
MFJ. The taxpayer can use that filing status only if one spouse is a U.S. citizen or resident alien and
chooses to treat the nonresident spouse as a U.S. resident. If the taxpayer makes this choice, the taxpayer and spouse are taxed on their worldwide income.

Form 2555 or Form 2555-EZ


These forms are filed to exclude income earned in foreign countries from gross income or to deduct or
exclude a foreign housing amount. U.S. possessions are not foreign countries. An in-depth explanation
of these forms is not given in this course.

Earned Income Credit 7.9

MFS Filing Status


If the taxpayer is married, they must file a joint return to claim EIC. Their filing status cannot be
married filing separately. However, if the taxpayer meets the rules for being unmarried for tax purposes, which you learned earlier in Chapter 4, then the taxpayer may file as head of household and
be able to claim the credit.

Investment Income Limitation


In order to prevent persons with substantial assets from receiving the EIC, the credit is denied to
any taxpayer with investment income exceeding $3,350 for 2014. For this purpose, investment income
includes the following:
Taxable and exempt interest.
Taxable dividends.
Net capital gain income (excluding 1231 gains), if greater than zero.
Net nonbusiness rents and royalties, if greater than zero.
Net passive income that is greater than zero and is not self-employment income.
This course only covers investment income that can be reported on Form 1040A, such as that which
you learned about in Chapter 5.

Support
A child who would be a qualifying child for dependency under the uniform definition, except that they
provided more than 50% of their own support, may be a qualifying child for purposes of the EIC.

Being a Qualifying Child


If the taxpayer himself is a qualifying child of another taxpayer, they cannot claim the credit.
mExample: Mark Jones (22), a full-time student, and his son, Jeff (3), lived all year with Marks
father. Mark cannot claim the EIC, even if he otherwise qualifies, because Mark is a qualifying child
of his father. Marks father may or may not be able to claim the credit, depending on his earned
income and AGI, along with all the other qualifications.
Note: Even if his earned income and AGI are less than $14,590 (for 2014), Mark may not even claim
the EIC as a taxpayer without a qualifying child because, as a qualifying child himself, he is prohibited from claiming the credit.m
Complete Exercise 7.2 before continuing to read.

7.10 H&RBlock Income Tax Course (2015)


Illustration 7.3

Earned Income Credit 7.11

COMPUTING THE EARNED INCOME CREDIT


The first step in claiming the EIC for taxpayers who we have determined are eligible is to complete
Schedule EIC for those taxpayers with one or more qualifying children. Taxpayers eligible for the
credit who do not have a qualifying child do not complete this form.
Schedule EIC calls for information about the qualifying child or children. If a taxpayer has more
than three qualifying children, he enters information about only three of them. Bill Helget, from the
example on page 7.3, has five qualifying children. See his Schedule EIC in Illustration 7.3 where only
three children are listed.
mExample: Carol A. Patel files as head of household and qualifies for the EIC for 2014. She has one
qualifying child, her daughter, Dara, born in 2005. Dara lived with Carol all year.
Carol had earned income of $23,246 and investment income of $795, so her AGIis $24,041. Investment
income was discussed in Chapter 5. For now, we will assume she had $307 interest income reported
on Form 1040A, line 8a, and $488 of ordinary dividend income reported on Form 1040A, line 9a. Her
Earned Income Credit is figured using the worksheets shown in Illustrations 7.4 through 7.7. Unlike
Schedule EIC, the worksheets are not filed with her return; they should be kept with her records.m
H&R Block worksheets for determining EIC are customized for H&R Block use. For learning purposes, we will use the IRS Form 1040A instructions to see how Carols EIC was determined. This will help
you understand the flow of information from the worksheet to the forms and schedules.
Step 1 All Filers
Line 1. Determines eligiblity based on income and number of qualifying children.
Line 2. Determines eligibility based on the taxpayer (and spouse if filing a joint return) having a valid
SSN that allows them to work.
Line 3. Determines eligibility based on filing status. Taxpayers whose filing status is married filing
separately are not eligible for EIC.
Line 4. Qualifies taxpayers according to residency status. Nonresident aliens must be married to a
U.S. citizen or resident alien, file a joint return and choose to be treated as a resident alien.
Step 2 Investment Income
Line 1. Computes the taxpayers total investment income.
Line 2. Determines whether the taxpayers investment income exceeds the maximum of $3,350 for
2014.
Step 3 Qualifying Child
Line 1. Determines whether the taxpayer qualifies as a taxpayer with or without a qualifying child.
Line 2. Determines if the taxpayer is filing a joint return or not.
Line 3. For taxpayers who answered yes to line 2, this line qualifies taxpayers according to their ability to be claimed as a qualifying child on another tax return. Taxpayers who are the qualifying child
of another taxpayer who is required to file a tax return cannot claim EIC.

7.12 H&RBlock Income Tax Course (2015)

Step 4 Filers Without a Qualifying Child


Line 1. Determines eligibility according to income and filing status for taxpayers who do not have a
qualifying child. AGI must be less than $14,590 ($20,020 if married filing jointly).
Line 2. Determines eligibility according to age. Taxpayers without a qualifying child must be at least
age 25 but under age 65 at the end of 2014.
Line 3. Determines eligibility according to residency in the United States. Taxpayers whose main
home was not in the U.S. for more than half of 2014 do not qualify for EIC. Members of the military
may qualify under certain circumstances.
Line 4. Determines if the taxpayer without qualifying children is filing a joint return or not.
Line 5. For taxpayers who answered yes to line 4, above, this line qualifies taxpayers according to
their ability to be claimed as a qualifying child on another tax return. Taxpayers who are the qualifying child of another taxpayer who is required to file a tax return cannot claim EIC.
Line 6. Determines eligibility according to the taxpayers dependency status. Taxpayers who can be
claimed as a dependent on another taxpayers tax return cannot claim EIC.
Step 5 Earned Income
Line 1. This line is calculated by adding income from taxable scholarships or fellowships, income from
work performed while in prison, and income from pensions or annuities from nonqualified deferred
compensation plans. The sum total of the above is then subtracted from earned income that was
reported on Form 1040A, line 7. Finally, nontaxable combat pay is taken into consideration, as in
some cases it may increase EIC, and the taxpayer may elect to treat it as taxable.
Line 2. This line takes into consideration the amount from Step 5, line 1, above to make final determination of EIC eligibility.
Step 6 How to Figure the Credit
Part 1. This section determines the EIC based on earned income as calculated in Step 5. Then, AGI
is taken into consideration to see if it differs from earned income. Taxpayers whose earned income
differs from their AGI must go on to Part 2.
Part 2. This section determines EIC based on the taxpayers AGI (see the worksheet for exceptions).
Part 3. The taxpayers EIC is the lesser of the amounts calculated in Parts 1 and 2, above.
Complete Exercise 7.3 before continuing to read.

Earned Income Credit 7.13


Illustration 7.4

7.14 H&RBlock Income Tax Course (2015)


Illustration 7.5

Earned Income Credit 7.15


Illustration 7.6

7.16 H&RBlock Income Tax Course (2015)


Illustration 7.7

Earned Income Credit 7.17

EARNED INCOME CREDIT DUE DILIGENCE


Paid tax preparers must exercise due diligence when preparing tax returns claiming EIC. Treasury
regulations require tax preparers to follow four due diligence requirements. Tax preparers must:
Complete and submit an eligibility checklist.
Compute the amount of credit.
Comply with the knowledge requirement.
Retain records.
If tax preparers fail to follow the due diligence requirements, they are subject to a $500 penalty for
each occurrence.

Complete and Submit an Eligibility Checklist


A tax preparer must complete and submit Form 8867, Paid Preparers EIC Checklist, or a document
equivalent to Form 8867. Also, the completion of the checklist must be based on information provided
by the taxpayer to the tax preparer.
Illustrations 7.87.11 show Form 8867 as it would be prepared for Bill Helget from the example on
page 7.3. When using software, the program will usually gather information that should satisfy the
equivalent of Form 8867. It is important that a tax preparer ask every taxpayer every question on
this list every time.

Computing the Amount of Credit


A tax preparer must keep the EIC worksheet or an equivalent that demonstrates how the EIC was
computed. In this course, we have used the Earned Income Credit Worksheet, which can be found in
Illustrations 7.4 through 7.7. Throughout the course, you will be asked to complete this form for each
taxpayer receiving EIC.

Complying With the Knowledge Requirement


A tax preparer is responsible for knowing the tax law and using that knowledge to ensure that the
correct questions are asked to get all the relevant facts as they apply to each EIC return. Each clients
situation is different. You can ask every client the same question, but you should not expect the same
answer. You must be able to apply a reasonability standard. Ask yourself, Does this situation make
sense?
A tax preparer must not know or have reason to know that any information used by the tax preparer
in determining the taxpayers eligibility for, or the amount of, the EIC is incorrect. Also, a tax preparer
may not ignore the implications of information the taxpayer furnished to, or that is known by, the tax
preparer.

7.18 H&RBlock Income Tax Course (2015)

Lastly, a Tax Professional must make reasonable inquiries and document those inquiries and the
clients answers at the time of the interview.
Important: Software alone cannot meet the knowledge requirement. A Tax Professional must follow
up on information that appears to be incorrect, inconsistent, or incomplete, and software may not ask
all the questions necessary to fully clarify the situation. Tax Professionals must use their best judgment and develop good interviewing techniques to satisfy this requirement.

Retaining Records
Form 8867, Paid Preparers Earned Income Credit Checklist, is used to retain all the information necessary when taxpayers qualify for EIC. Take a few minutes to review this form found in Illustrations
7.87.11. Note that only Part IV in Illustration 7.10 refers directly to the due diligence requirements.
The answers for Parts I, II, and III are compiled from the information the Tax Professional has been
gathering throughout the tax interview.
To comply with the record retention requirement, a Tax Professional must:
Retain Form 8867 and EIC worksheet or equivalents and maintain a record of how and when the
information used to complete these forms was obtained.
Verify the identity of the person giving you the information and maintain a record of who furnished
the information and when you received the information used to determine the credit.
Keep these records for three years from the latest date of the following that apply:
The original due date of the tax return (this does not include any extension of time for filing).
The date the tax return or claim for refund is filed, if you electronically file the return or claim
for refund and sign it as the return preparer.
The date you present the tax return or claim for refund to the taxpayer for signature, if the
return or claim for refund is not filed electronically and you sign it as the return preparer.
If you prepare part of the return or claim for refund and another preparer completes and signs
the return or claim for refund, you must keep the part of the return you were responsible to
complete for three years from the date you submit it to the signing tax return preparer.
When you prepare returns using the H&R Block BlockWorks software, you should always ask enough
questions so that you are certain the taxpayer qualifies. BlockWorks will often prompt you with certain starter questions noted in Illustration 7.12. However, these software EICquestions are only a
starting point. It is the Tax Professionals responsibility to ask appropriate questions beyond the EIC
questions that BlockWorks prompts you to answer, based on the information entered in the software.
In many cases where tax preparers have been fined, the IRS notes, The preparer did not ask sufficient questions, or if they did ask, they did not ask additional questions to show reasonable inquiries,
where appropriate.
Complete Exercise 7.4 before continuing to read.

Earned Income Credit 7.19


Illustration 7.8

7.20 H&RBlock Income Tax Course (2015)


Illustration 7.9

Earned Income Credit 7.21


Illustration 7.10

7.22 H&RBlock Income Tax Course (2015)


Illustration 7.11

Earned Income Credit 7.23


Illustration 7.12

Note: BlockWorks will


populate specific EIC Due
Diligence questions based on
the
taxpayers information
entered into the software.

Select the Add New button


to populate an input box to
answer the EICDue Diligence
questions.

7.24 H&RBlock Income Tax Course (2015)

CHAPTER SUMMARY
In this chapter, you learned:
Credits are valuable to taxpayers because they reduce tax liability dollar for dollar. Nonrefundable
credits may not reduce a taxpayers tax liability below zero. Refundable credits may allow a taxpayer to reduce his liability below zero and receive a refund for the difference.
The Additional Child Tax Credit is refundable and may be available to taxpayers with more than
$3,000 earned income for 2014 or more than three qualifying children for the Child Tax Credit.
The Earned Income Tax Credit is a refundable credit.
Taxpayers with no qualifying children and who are at least 25 years of age and younger than age
65 may qualify for the Earned Income Tax Credit.
The tax interview, performed by the Tax Professional, is an essential tool in determining taxpayer
qualification for the Earned Income Credit and fulfilling the due diligence requirement.
The refundable Earned Income Tax Credit may be worth up to $6,143 to working taxpayers with
earned income and AGI of less than $52,247 for 2014.
The taxpayer may elect to include nontaxable combat pay for EIC purposes.
Paid tax preparers are subject to a $500 penalty (per occurrence) for not exercising due diligence
when preparing tax returns claiming EIC.

Suggested Reading
For further information on the topics discussed in this chapter as they relate to 2014 tax returns, you
may wish to read the following chapters in IRS Publication 17:
Chapter 2, Filing Status.
Chapter 3, Personal Exemptions and Dependents.
Chapter 34, Child Tax Credit.
Chapter 36, Earned Income Credit (EIC).

Earned Income Credit 7.25

client lives with


Ther two sons, a 19-year-old and a 23-year-old. Both wereMyfull-time
students
he Tax Institute Tax in the News Research Question:

in 2014. She will not be able to claim the dependency exemption for the 23-yearold this time because he started a regular job and provided more than half of
his own support. Since there is no support requirement for the EITC, will she
still be able to claim the credit for him, or will the tie-breaker rule prevent her
from doing so, as he is claiming his own exemption?
Yes, your client can still claim the EITC for her older son, assuming
Aher income
is within EITC range and he meets the four tests to be a qualinswer:

fying child for EITC (relationship, age, residency, and joint return). In this type
of situation, the tie-breaker rule is not involved.
When a child is a qualifying child of more than one taxpayer, the tie-breaker
rule of 152(c)(4) serves to prevent taxpayers from splitting child-related tax
benefits. For instance, say that your clients father also lived in the home and
had higher AGI than your client. Your client could agree to let her father claim
child-related tax benefits for the younger son because he would be a qualifying
child of both of them. However, tax benefits for the younger son, such as the
dependency exemption and EITC, could not be split between the two of them,
even if it would be financially advantageous for the family to do so.

The tie-breaker rule with its no split restriction does not come into play in
the case of a non-dependent individual who claims his own exemption and who
is also a qualifying child for EITC purposes. Even though the amounts are the
same, it is important to distinguish a personal exemption under 151(b) from a
dependency exemption under 151(c) and 152. Your clients son is a taxpayer
claiming a personal (not a dependency) exemption. He is not a qualifying child
of more than one taxpayer or, to put it another way, he is not his own qualifying
child and this is not a child-related benefit split!

Credits
OVERVIEW
This self-study chapter will show you that credits are valuable tax savers. In Chapter 3, you learned
about the Child Tax Credit. In Chapter 7, you learned about the Earned Income Tax Credit. In this
chapter, you will learn about other credits that may be claimed on Form 1040A. One common credit
is the Child and Dependent Care Credit. Another credit that is less common, but still important to be
familiar with, is the credit for the elderly and disabled. Lastly, the premium tax credit (PTC) will need
to be considered on every tax return that you prepare. Education credits will be covered in Chapter 9.

OBJECTIVES
At the conclusion of this chapter, you will be able to determine the eligibility and calculations for the:
Child and Dependent Care Credit and compute the credit.
Credit for the elderly or disabled.
Premium tax credit (PTC).

TAX TERMS
Look up the definitions of the following terms in the glossary:
Advance of the premium tax credit (APTC).
Affordable Care Act (ACA).
Benchmark Premium.
Bronze/Silver/Gold/Platinum plans.
Cafeteria plan.
Child and Dependent Care Credit.
Coverage family.
Credits.
Department of Health and Human Services (HHS and DHHS).
Excess advance premium tax credit.
Federal poverty level (FPL).
Limitation on premium tax credit repayment.
8.1

8.2 H&RBlock Income Tax Course (2015)

Marketplace/Exchange.
Net premium tax credit.
Nonrefundable credit.
Open enrollment period.
Qualified health plan.
Refundable credit.
Savers Credit.
Shared responsibility payment.

CREDITS VS. DEDUCTIONS


Before we begin this discussion of credits, it is important to review the difference between credits and
deductions.
While both credits and deductions help taxpayers reduce the amount of tax they must pay, they do so
in different ways. Deductions, such as the standard deduction, lower the tax by reducing the amount
of income that would otherwise be taxable. Lower taxable income results in a lower tax liability.
Unlike deductions, credits do not come into play until after taxable income has been computed and
the tax determined. Then, credits may be used to reduce the tax already determined dollar for dollar.
Some credits are nonrefundable, and some are refundable. Nonrefundable means that the combined
amount of these credits cannot reduce the taxpayers tax liability below zero. Refundable credits may
reduce the taxpayers tax liability below zero, and the difference is refunded to the taxpayer.

CHILD AND DEPENDENT CARE CREDIT


Single parents and two-career couples must find ways to care for their young children while they
work. The Tax Code provides a way for such parents to recoup some of their expenses for child care
through a nonrefundable tax credit. This credit is also available to taxpayers caring for disabled
dependents and spouses.
Study page 1 of Form 2441 in Illustration 8.1 on page 8.8. A taxpayer who incurred and paid expenses
for the care of a qualifying person while they worked or searched for work may be entitled to a tax
credit based on the amount paid during the year for those services.

Requirements
To claim the Child and Dependent Care Credit, the taxpayer must meet the following requirements:
Married taxpayers generally must file a joint return (but see Married taxpayers below).
The care must have been provided so the taxpayer (and the spouse, if married) could work or look
for work.

Credits 8.3

The taxpayer must have some earned income. Taxpayers who are married and are living together
both must have earned income (unless one spouse was a student or disabled, as explained later).
The taxpayer and the person(s) for whom the care was provided must have lived in the same home.
The person who provided the care must not be someone the taxpayer can claim as a dependent.
Services provided by the taxpayers child under age 19 do not qualify, even if the provider is not a
dependent.
Married taxpayers who meet the following requirements may claim the credit even if not filing a
joint return:
The taxpayer paid over half the cost of maintaining a household for the year, which was the principal residence of both the taxpayer and a qualifying person for more than half the tax year.
During the last six months of the tax year, the taxpayers spouse was not a member of the household.

Qualifying Persons
To claim a credit for qualified expenses (defined below), the care must have been provided for one or
more qualifying persons. Qualifying persons include:
A dependent who is a qualifying child and has not reached their 13th birthday when the care was
provided.
Note: For purposes of this credit, the child is considered to have attained the age of 13 on their birthday, not the day before. Generally, the taxpayer must be entitled to claim a dependency exemption for
the child, but an exception applies for children of divorced or separated parents.
The taxpayers dependent of any age who is physically or mentally incapable of self-care and who
has the same principal place of abode as the taxpayer(s) at the time the care is provided.
The taxpayers spouse who is physically or mentally incapable of self-care and who has the same
principal place of abode as the taxpayer at the time the care is provided.
Exception: In cases of divorced or separated parents, the child will be the qualifying child of the
custodial parent for purposes of this credit, even if the noncustodial parent claims the dependency
exemption for the child.

Qualified Expenses
Qualified child or dependent care expenses are those incurred for the primary purpose of assuring the
well-being and protection of a qualifying person while the taxpayer works or looks for work. Expenses
for care provided outside the home for the qualifying child, disabled dependent, or disabled spouse
can be counted, provided the qualifying person regularly spends at least eight hours each day in the
taxpayers home. If the care is provided in a dependent care center (one that cares for more than six
persons for a fee), the center must comply with all relevant state and local laws.
Certain expenses do not qualify for the Child and Dependent Care Credit. The cost of transportation
to and from the child care facility does not qualify, and neither do overnight camp expenses. Also, any
expense allocable to the education of a child in kindergarten or higher does not qualify. The total cost
of schooling below kindergarten qualifies only if the cost of schooling cannot be separated from the
cost of care.

8.4 H&RBlock Income Tax Course (2015)

mExample: June and Henry Stark both work. Their son, Harry, attends first grade at a private school.
After school, the Starks pay to have Harry transported to a child care center where they pick him up
after work. The expenses for the private school and the transportation do not qualify for the Child
Care Credit. The amount they pay the child care center does qualify. If Harry were in an all-day preschool setting where educational activities were part of the child care service, the entire cost would
qualify for the credit.m
Expenses for in-home care of a qualifying child, disabled dependent, or disabled spouse also qualify for
the credit. Qualified expenses for in-home care may include amounts paid for cooking and light housework related to the care of a qualifying individual as well as actual care. Amounts paid for chauffeur
or gardening services do not qualify. Total qualified expenses include gross wages paid for qualified
services, plus the cost of meals and lodging furnished to the employee, plus the employers social security, Medicare, FUTA (federal unemployment), and any other payroll taxes paid on the wages. See the
discussion of Schedule H later for more information about paying employment taxes for household
help. A taxpayer who hires a household worker and pays wages of $1,900 or more during the year to
that worker must pay the employers share of social security and Medicare taxes.
Remember, payments to any of the following do not qualify for the credit:
A person who either the taxpayer or the spouse may claim as a dependent.
The taxpayers child who is under age 19.
An overnight camp.
Complete Exercise 8.1 before continuing to read.

Computing the Credit


The Child and Dependent Care Credit for 2014 is a percentage of the smallest of the following:
The amount of qualified expenses incurred and paid during the year.
$3,000 for one qualifying individual or $6,000 for two or more qualifying individuals.
The taxpayers earned income (defined later) for the year or, for married taxpayers filing jointly,
the earned income for the year of the spouse earning the lesser amount.
The lines on Form 2441 are, for the most part, self-explanatory. Those that require a bit of added
explanation are discussed below.
Line 1. Taxpayers must report the care providers name, address, and identifying number (the social
security number for an individual or the employer identification number for a business). If the care
provider is a tax-exempt organization (a church, for example) and they do not provide a number, enter
Tax-exempt in column (c). Enter the total amount actually paid to each institution or individual in
column (d).
The IRS provides Form W-10 to assist taxpayers in obtaining information from child care providers.
The taxpayer should direct the provider to complete Form W-10 or a similar document to provide the
necessary information to the taxpayer.

Credits 8.5

The IRS can use the information on line 1 to match what the taxpayer paid the care provider with the
amount the care provider reports as income on their tax return. Therefore, all amounts actually paid
to the care provider (by the taxpayer, their employer, or anyone else) during the year must be entered.
Any amounts incurred, but not yet paid, would not be reported on line 1.
If the taxpayer pays social security, Medicare, and other payroll taxes for a child care providers services within their home, those amounts would not be listed on line 1 because they were not actually
paid to the child care provider. These amounts would, however, be entered as part of the total qualified expenses for each qualifying person in column (c), line 2.
mExample: Carol Cruz hired Michelle Garner to come to her home to care for her five-year-old son
while Carol worked. She paid Michelle $2,000 during the year. In addition, Carol paid the federal
government $153 as the employers share of social security and Medicare taxes. Carol should enter
only $2,000 in column (d), line 1, because thats the amount that is income to Michelle, even though
the full $2,153 expense qualifies for the Child and Dependent Care Credit and would be entered in
column (c), line 2.m
Line 2. On this line, enter the name and social security number of each qualifying person for whom
care was provided, as well as the amount incurred and paid during the taxable year for the care of
each person. If there are more than two qualifying persons, attach a statement. The amount on this
line could be more than the amount on line 1, as seen in the Carol Cruz example above. It could also
be less than the amount on line 1, as in the following example.
mExample: Bess and Jim Franklin paid Betty Gessell $1,200 to look after their three-year-old daughter, Margaret. They took Margaret to Bettys home. Of that amount, $1,000 was for expenses incurred
in 2014, and $200 of that amount was for expenses incurred in December 2013 that they paid in
January 2014. The Franklins should enter the full $1,200 on line 1, column (d), and $1,000 on line 2.m
Often, the total of the amount on line 1 and the amount on line 3 (the total of the line 2 amounts) will
be the same, but not always, as illustrated in the examples above. Also, line 3 cannot exceed the maximum amount ($3,000 for one qualifying individual or $6,000 for two or more qualifying individuals).
Another time when the amount on line 3 might not be the same as the total from line 1 is if the taxpayers employer paid any portion of the child care expenses and excluded the amount from income.
In such a case, the taxpayer must complete Part III on the second page of the form. The amount to be
entered on line 3 is determined in that section of the form. We will defer discussion of these benefits
for the moment and return to them in the next section.
Line 4. Enter the primary taxpayers earned income on line 4. The primary taxpayer is the one named
first in the heading on the first page of the tax return.
Earned income includes taxable salaries, wages, tips, strike benefits, other employee compensation,
disability income reported as wages, and net income or loss from self-employment.
Earned income does not include nontaxable employee compensation (like 401(k) contributions), pensions and annuities, social security and railroad retirement benefits, workers compensation, nontaxable scholarships or fellowship grants, nontaxable workfare payments, income of nonresident aliens
that is not derived from a U.S. business, or income received for work while an inmate in a penal
institution.

8.6 H&RBlock Income Tax Course (2015)

Taxpayers have a choice when it comes to nontaxable combat pay. They can elect to treat it as earned
income for the Child and Dependent Care Credit just as they can for the Earned Income Credit. The
credit should be figured both ways to determine which way gives the greater tax benefit.
Line 5. If the taxpayer is filing a joint return, enter the spouses earned income on line 5. Otherwise,
enter the amount from line 4 on line 5.
Student or disabled. If the taxpayer or the spouse was disabled or was a qualified full-time student,
multiply the number of months the taxpayer or spouse met such a condition by $250 ($500 if two or
more qualifying persons are listed on line 2). Add the result to any earned income from other months,
and enter the total on line 4 or 5. Only one spouse may use this adjustment in any given month.
mExample: Wallace and Lena Birch file jointly. Wallace was disabled and incapable of self-care during
2014. He received social security benefits but received no earned income. Lena was a full-time student
through May, and she worked part time through the end of the year, earning $8,000. The remainder
of their income was from investments.
Lena paid a nurse to care for Wallace while she went to school and worked. Wallaces earned income
on line 4 will be $3,000 [$250 2 12 months disabled]. Lenas earned income on line 5 will be $8,000.
Because Wallace used this adjustment every month, Lena may not use it for the months she was a
student; but in this case, it does not matter because she has sufficient earned income.m
Credit Limitation
The taxpayers Child and Dependent Care Credit is limited to their tax liability; any excess is lost.
With certain credits, like the Child Tax Credit or adoption credit, the excess may be refundable.
However, this is not so for the Child and Dependent Care Credit.
Line 10. Taxpayers using Form 1040A will enter the tax liability from Form 1040A, line 28.
mExample: Mary Cubbys tentative Child Care Credit on Form 2441, line 9, is $960. However, her tax
liability on Form 1040A, line 30, is only $693. She will enter $693 on Form 2441, line 10. Her credit
on line 11 will be limited to the lesser of line 9 or line 10.m
Note: If the taxpayer paid qualified expenses in 2014 that were incurred in 2013, they must figure that portion of the credit using Worksheet A, Worksheet for 2013 Expenses Paid in 2014, in
Publication 503, Child and Dependent Care Expenses. Add the amount from the worksheet to the 2013
credit. Such a taxpayer should add the marginal notation CPYE, the name and social security number of the person for whom the expenses were paid, and the amount of the credit based on prior-year
expenses above line 9.

Employer-Provided Benefits
Some employers provide on-site child care for their employees children. Others pay directly for
third-party child care or allow employees to reduce their salaries and save the reduction in accounts
(described below) specifically earmarked to pay for child care expenses. In these cases, the value of
the child care or the amount paid by the employer or from the account is not reported to the employee
as taxable income.

Credits 8.7

Section 125 plans (also called cafeteria plans or flexible spending accounts) are salary reduction
arrangements offered by some employers. These plans allow employees to reduce their salaries by a
certain amount in return for one or more nontaxable benefits. A common example is a flexible spending account (FSA) used to pay child care expenses or medical expenses.
If the employer did not include such amounts in taxable income, the taxpayer must reduce the amount
of expenses eligible for the credit by the amount excluded from income. The amount of child or dependent care benefits (DCB) is shown in box 10 of Form W-2. When a taxpayers W-2 shows dependent
care benefits, they must complete Part III of Form 2441, even if they are not claiming any Child Care
Credit.
Part of the benefits provided by the employer may not be excludible. If the benefits provided by the
employer exceed the smallest of (1) the amount of qualified expenses, (2) the lesser of the taxpayers
or the spouses earned income, or (3) $5,000 ($2,500 MFS), the difference is taxable (see Form 2441,
line 26). Any taxable amount should be added to the taxpayers wages entered on 1040A, line 7, and
the letters DCB written to the left of line 7.
mExample: Becky A. Marshall files as head of household. During 2014, the Tiny Tot Center charged
Becky $2,000 to care for her two-year-old son, Dylan, while she worked. Her employer paid $500 of
the cost of the child care and entered that amount in box 10 of her Form W-2. Becky paid the other
$1,500 herself.
Beckys earned income and adjusted gross income (Form 1040A, line 21) are both $31,600. Her Form
2441 is shown in Illustrations 8.1 and 8.2.m
Most of the entries on Beckys Form 2441 are self-explanatory, but some further explanation may be
helpful. First, consider the order in which the form should be completed. One would logically expect
to complete Part I first, then Part II, and so on, but think again. In this case, because Becky received
employer-provided dependent care benefits, she first completes Part I, then Part III, and then Part II.
Lines 2 and 3. Even though the Tiny Tot Center received $2,000 for caring for Beckys son while she
worked, only $1,500 is entered on line 2, because excluded benefits do not count toward the credit. The
figure on line 3 comes from Part III, line 34, on page 2.
Line 16. This line shows the amount of qualified expenses incurred, the total of line 1, column (d).
Notice that it differs from the amount on line 2, which had to be reduced by the excluded benefits.
Lines 19 and 20. The definition of earned income, for purposes of the exclusion, is similar to that
of the credit. Do not include the dependent care benefits shown on line 12 or any other nontaxable
earned income. However, the taxpayer may elect to include nontaxable combat pay in earned income.
Line 22 asks if any amount on line 12 is from a sole proprietorship or partnership. If so, enter the
amount here. If not, enter zero.
Line 24 is used by those self-employed individuals who file Form 1040 and deduct benefits on
Schedules C, E, or F.
Line 25. Becky is able to exclude from income all of her benefits from her employer. She has no taxable DCB to enter on Form 1040A, line 7.

8.8 H&RBlock Income Tax Course (2015)


Illustration 8.1

Credits 8.9
Illustration 8.2

8.10 H&RBlock Income Tax Course (2015)

To summarize: Employer-provided benefits for dependent care that are shown in box 10 of a taxpayers Form W-2 must always be entered on Form 2441 to determine the excludible amount. If the
taxpayer is claiming the Child and Dependent Care Credit, the excluded benefits reduce the qualified
expenses eligible for the credit. If the total benefits exceed the allowable excludible amount, the balance is entered as taxable income on 1040A, line 7, with the marginal notation DCB.

Complete Exercises 8.2 and 8.3 before continuing to read.

CREDIT FOR THE ELDERLY OR THE DISABLED


This is a seldom-used credit because it has not been indexed for inflation since 1985, and the income
limits are very low. Income includes nontaxable social security over $5,000 or other nontaxable pensions.
Taxpayers might qualify for this credit if either of the following applies:
1. Youre age 65 or older.
2. Youre under age 65, and both of these apply:
You retired on permanent and total disability.
You received taxable disability benefits.
Taxpayers who pass the age or disability test must also fall below the limits set for their filing status
to claim this credit.
TAXPAYERS WHO ARE:

GENERALLY CANNOT TAKE THE CREDIT IF:


Their AGI is:
Or they received:

Single, head of household, or


qualifying widow(er).

$17,500 or more

Married filing jointly and only


one passes the age or disability
test.

$20,000 or more

Married filing jointly and both


pass the age or disability test.

$25,000 or more

$7,500 or more of nontaxable


social security or other nontaxable pensions, annuities, or
disability income.

Married filing separately and


lived apart from spouse for the
entire year.

$12,500 or more

$3,750 or more of nontaxable


social security or other nontaxable pensions, annuities, or
disability income.

$5,000 or more of nontaxable


social security or other nontaxable pensions, annuities, or
disability income.

Credits 8.11
Illustration 8.3

8.12 H&RBlock Income Tax Course (2015)


Illustration 8.4

Credits 8.13

mExample: Agatha Humphrey is 70 years old and received $13,500 from a taxable pension and $1,500
in nontaxable social security income. From this example, you can see how low the income limits are
to receive the small credit. Agathas Schedule R is in Illustrations 8.3 and 8.4. m

lockWorks Tip: The software has been programmed to automatically


generate Schedule R and calculate the credit when the taxpayer meets the
qualifications for the Credit for the Elderly or the Disabled.

PREMIUM TAX CREDIT


On March 23, 2010, the president signed into law the Patient Protection and Affordable Care Act.
There are various tax implications associated with the Affordable Care Act (ACA), most of which pertain to more complicated tax returns. The provision that we will cover in this course is the individual
mandate, which states that, beginning in January 2014, most U.S. citizens and residents are required
to have qualified health insurance coverage, qualify for an exemption, or be subject to the ACA tax
penalty. As it applies to income tax returns, ACA requires all taxpayers to state whether or not they
had qualified health insurance for themselves and their tax household for every month in 2014.
The premium tax credit (PTC) is a credit that helps pay the cost of coverage through the Marketplace.
It is either advanced to the taxpayer or refunded through their income tax return. It is important that
you understand the basics of ACA compliance so that you can conduct a tax interview that correctly
applies the premium tax credit.

Eligibility
Taxpayers are eligible for the PTC if they meet all of the following requirements:
Purchase coverage through the Marketplace.
Are a U.S. citizen or lawfully-admitted resident.
Have household income for their family size that is 100% through 400% of the federal poverty level
(FPL) in states where Medicaid was not expanded. It is effectively 139% through 400% of FPL in
states where Medicaid was expanded. There are three FPL charts: one for the 48 contiguous states
plus the District of Columbia and separate ones for Alaska and Hawaii. If a taxpayer moves during
the year or if spouses live in separate states and more than one chart would apply, the chart listing
the highest amount is used.
Are not eligible for affordable coverage through an employer-sponsored plan. Coverage is considered affordable if it does not exceed 9.5% of household income for self-only coverage. For this purpose, any additional cost for family coverage is not considered.
Are not eligible for coverage through a government program, such as Medicare, Medicaid,
TRICARE, CHIP, etc.

8.14 H&RBlock Income Tax Course (2015)

Do not file a married filing separately tax return. An exception is available to certain victims of
domestic abuse and spousal abandonment.
Cannot be claimed as a dependent by another person.

Tax Household
The individual mandate of ACA requires taxpayers to state, through their tax return, whether they
and everyone in their tax household had qualified health insurance for the tax year. Tax household
includes everyone for whom an exemption is claimed on the tax return and anyone for whom the taxpayer could have claimed an exemption, but did not.
mExample: Miki (34) is a paralegal. She is not married and does not have any children. She shares a
condominium with her brother, Alec (28), who works in construction. Alec is not married and does not
have any children. Miki has one Form W-2 with $48,000 wages and files single using Form 1040-EZ.
Alec also has one Form W-2 with $47,000 wages and files single using Form 1040-EZ. Even though
Miki and Alec share a residence, their tax households consist only of themselves. Mikis tax household
is herself only. Alecs tax household consists of himself only.m
mExample: Manuel (23) works in food service. Manuel and Leticia (25) are the unmarried parents
of Lucas (2). Manuel shared an apartment all year with Lucas and Letitia. Leticia has no income.
Manuel has two Forms W-2 and files head of household claiming both Lucas and Letitia as dependents using Form 1040A. Manuels tax household consists of himself, his son, Lucas, and Lucass
mother, Letitia.m
mExample: Taylor (47) works as a teacher. She is not married and has two children, Francis (20) and
Regina (16). Taylor owns a townhouse where Francis and Regina live. Francis is a full-time student at
the local college and works part-time as a tutor. Regina is a high school student and works part-time
in retail. Neither Francis nor Regina pay more than half of their own support. Taylor files as head of
household claiming Regins as her dependent using Form 1040A. Taylor chooses not to claim Francis,
so that she may claim her own education expenses. Even though Taylor does not claim Francis on her
tax return, she is eligible to do so. Taylors tax household consists of herself and both her children,
Francis and Regina.m
Complete Exercise 8.4 before continuing to read.

Qualified Health Insurance


Taxpayers and people in their tax household usually have qualified health insurance through one of
the following:
Employer-sponsored coverage.
Government program.
Marketplace.
Direct through the individual market.
Qualified health insurance provides minimum essential coverage to its beneficiaries. Coverage
through any of the plans listed above will generally comply with the individual mandate.

Credits 8.15

The following plans do not provide minimum essential coverage:


Stand-alone coverage for vision care, dental care, accident, disability, or workers compensation.
Coverage in the following TRICARE and Medicaid programs:
Optional coverage of family planning
services.

Coverage for medically needy individuals


(also referred to as spend-down).

Optional coverage of tuberculosis-related


services.

Coverage authorized under 1115(a)(2) of


the Social Security Act (Medicaid demonstration projects).

Coverage under pregnancy-only


Medicaid.

Coverage that is solely limited to space


availability in a facility of the uniformed
services for individuals excluded from
TRICARE coverage for care from private
sector providers (also called space available TRICARE coverage).

Coverage limited to treatment of emergency medical conditions.

Coverage for an injury, illness, or disease


incurred or aggravated in the line of duty
for individuals who are not active duty
(also called line of duty TRICARE coverage).

Note: Although the plans listed in the chart above do not provide minimum essential coverage, taxpayers who have any of these coverages will be able to claim an exemption from the ACA penalty
(more information on this, later).

Monthly Coverage
Coverage is determined every month, so it is possible that there are various scenarios.
mExample: Christopher (45) was an employee at a printing company in January 2014 and had coverage through his employer. He was laid off in mid-May. Christopher was eligible to purchase COBRA
coverage, but chose not to purchase it. Christopher was also eligible to purchase coverage through the
Marketplace because he had a qualifying event, but was unaware of the option. Christopher began
working at a grocery store in mid-September and once again had coverage through his employer
effective on October 1.
In this example, Christopher has qualified coverage for eight months (January through May at the
printing company and October through December at the grocery store) and no coverage for four
months (June through September). Christopher may have to pay the ACA tax penalty unless he qualifies for an exemption, to be discussed later.m
mExample: Raquel (29) works at a hotel. She is unmarried and has two children, Anna (3) and Jeremy
(8). In January 2014, Serena did not have health insurance coverage because her employer did not
offer coverage to its employees and she believed she could not get coverage any other way. However,
Raquel made sure that her children had coverage through the Childrens Health Insurance Plan
(CHIP).
When Raquel had her 2013 tax return prepared at H&R Block and was directed to the health care
portal by her Tax Professional, she purchased health insurance through the Marketplace with coverage beginning in March 2014.

8.16 H&RBlock Income Tax Course (2015)

In this example, the tax household consists of Raquel and both of her children. Raquel has qualified
coverage for ten months and no coverage for two months (January through February). The children
had qualified coverage for all 12 months. Raquel may have to pay an ACA tax penalty unless she
qualifies for an exemption, to be discussed later.m
mExample: Warren (57) and Emily (56) Bixby are married and file a joint return. They have four adult
children who do not reside with them. Warren is self-employed and in January 2014 had coverage
he purchased directly from an insurance broker. In March 2014, he learned that he could purchase
lower cost insurance through the Marketplace. His Marketplace plan went into effect beginning May
2014. Emily had employer-sponsored coverage in January 2014. Emily maintained coverage through
her employer all year.
In this example, the tax household consists of Warren and Emily. Each has 12 months of qualified
coverage, but Warren has four months of direct purchase and eight months of Marketplace coverage,
while Emily has 12 months of employer-sponsored coverage.m

State and Federal Marketplaces


Individuals without health insurance coverage or those looking for more affordable coverage may
purchase coverage through a state Marketplace or the federal Marketplace <www.healthcare.gov> if
their state does not operate its own Marketplace. H&R Block offers enrollment services through its
portal <healthcare.hrblock.com>.
Coverage may be purchased during the annual open enrollment period. For coverage in calendar year
2014, the open enrollment period ran from November 15, 2013, through February 15, 2014, to submit
an initial application, plus an extension to April 15 to complete the application, if necessary. For coverage in calendar year 2015, the open enrollment period was November 15, 2014, through February
15, 2015.
Individuals may also purchase coverage outside the open enrollment period during special enrollment
periods, generally 60 days, following certain life events where there was a change in:
Family status (marriage, divorce).
Location.
Citizenship/residency status.
Family size or household income that affects eligibility for the APTC.
Loss of other types of qualifying coverage, such as employer-sponsored coverage.
An insurance plan that is certified by the Marketplace provides minimum essential coverage and
follows established limits on cost-sharing (like deductibles, co-payments, and out-of-pocket maximum
amounts). A qualified health plan will have a certification by each Marketplace in which it is offered.
Plans in the Marketplace are categorized into four typesBronze, Silver, Gold, or Platinumbased
on the percentage the plan pays of the average overall cost of providing coverage to members. The
percentages the plans will spend, on average, are 60% (Bronze), 70% (Silver), 80% (Gold), and 90%
(Platinum).

Form 1095-A
Taxpayers who had coverage through the Marketplace will be sent a Form 1095-A, Health Insurance
Marketplace Statement, regardless of whether they were eligible for the APTC or elected to receive it.

Credits 8.17

The 2014 forms must be issued by January 31, 2015.


All taxpayers who obtained coverage through the Marketplace for themselves, a spouse, or dependents AND received either the APTC or are eligible to claim the PTC on their tax return must have
a Form 1095-A to complete their tax return.

ax Tip: It may be an issue for divorced taxpayers where tax benefits for
dependents are divided between the parents and one parent enrolls the
child in a Marketplace plan, but the other parent claims the childs dependency exemption. This situation requires an allocation of information on the Form
1095-A between the two parents.

Form 1095-A is divided into the following three parts:


Part 1, Recipient Information, reports identification information on the recipient and spouse.
Part 2, Coverage Household, reports information on the individuals covered by the insurance policy
and the dates of coverage.
Part 3, Household Information, reports information required to reconcile the credit. The information is reported for every month of the year. Column A reports the total monthly premium for the
plan without considering any amount that may be paid by the APTC. Column B reports the second
lowest cost silver plan (SLCSP) as determined by the Marketplace. This is the benchmark against
which the taxpayers APTC is calculated. Column C reports the amount of APTC paid, if any. This
information is used to complete Form 8962, Premium Tax Credit.
Using the information from the example above, see Illustration 8.5 for Warren Bixbys Form 1095-A.

Form 8962
Form 8962, Premium Tax Credit, calculates the taxpayers PTC and reconciles it with any APTC
received. Form 8962 must be filed for any taxpayer who received the APTC. Form 8962 may also be
prepared for any taxpayer who is eligible for the PTC but did not receive the APTC. Information from
Form 1095-A is used to complete Form 8962.
Part 1
Part 1 of Form 8962 determines the amount the taxpayers are expected to contribute toward their
own health care insurance premiums.
Line 1. In line 1, family size means the taxpayer; their spouse, if filing a joint return; and the dependents, if any, claimed on the tax return. Compare that to tax household, as previously discussed,
which means the taxpayer; their spouse, if filing a joint return; and all dependents, whether or not
claimed by the taxpayer. Tax family is used to calculate the PTC, while tax household is used to determine if any ACA tax penalty is due.
Lines 2a, 2b, and 3. Household income is the modified AGI of all individuals in the tax family who
are required to file a tax return. Household income does not include the modified AGI for individuals
in the tax family who file a tax return only to claim a refund of withholdings or estimated payments.

8.18 H&R Block Income Tax Course (2015)


Illustration 8.5
X.X

Credits 8.19

Line 4. FPL for family size. As covered earlier, there are three charts.
Line 5. Divide household income by FPL to get the familys household income as a percentage of FPL.
Line 6. If the percentage of FPL is greater than 400%, the client is not eligible for the PTC.
Line 7. Look up the applicable figure in the instructions by the FPL that is calculated in line 5.
Lines 8a and 8b. Multiply household income by the applicable figure to get the familys contribution
amount for their health care insurance, and then divide that amount by 12 to get the amount of their
monthly contribution.
Note: The information above is given to you so that you are aware of how the form is calculated. You
will not have to perform any of the calculations, as the software has been programmed to do so.
Part 2
Part 2 completes the calculation of the PTC and reconciles it with the amount of any APTC the taxpayer received.
Part 3
Part 3 determines the amount, if any, of the APTC the taxpayer owes.
For most taxpayers, the reconciliation process is simple. If the amount of APTC the taxpayer received
exceeds the PTC calculated in Part 1, the taxpayer is required to pay back the excess, up to a limit for
those with income less than 401% of the FPL, through the tax return. If the amount of APTC, if any,
is less than the PTC calculated in Part 1, the taxpayer will receive that amount on their tax return in
the form of a refundable credit.

Shared Policy Allocation


As mentioned earlier, for taxpayers who share a policy with individuals outside their tax family, the
reconciliation process is more complicated and requires information from Form 1095-A to be allocated
between the individuals. Allocation is required for taxpayers who purchased coverage through the
Marketplace and at least one of the following applies to their situation:
An individual in the tax family enrolled someone outside the tax family in qualified coverage.
An individual in the tax family was enrolled in qualified coverage by someone outside the tax family.
The taxpayer got divorced or legally separated in 2014.
The taxpayer is married at the end of the year but filing a separate return.
One policy covers two or more tax families.
Taxpayers who married during the year are also potentially eligible for an alternative calculation
because they may have had both single and family plans in the same year.
mExample: William and Vivienne were married at the beginning of 2014. They have three children
together, and the family of five lived together at the beginning of the year. William and Vivienne
enrolled in Marketplace coverage for themselves and their three children in December 2013. In
April 2014, the couple separated and Vivienne and the youngest children moved out of the home. In

8.20 H&RBlock Income Tax Course (2015)

September, the spouses became legally separated. William will file his tax return as head of household
claiming the oldest child as his dependent, and Vivienne will also file as head of household, claiming
the two younger children. William and Vivienne will need to complete a policy allocation because their
Marketplace plan covered individuals in two tax families.m

Groups Exempt from the Individual Mandate


Membership in one of the following groups exempts taxpayers from the individual mandate:
Health care sharing ministry. A health care sharing ministry is a 501(c)(3) organization continuously in existence since December 31, 1999, whose members share a common set of ethical or
religious beliefs and share medical expenses in accordance with those beliefs and without regard
to the state where the member lives or works.
Federally recognized Indian tribes and individuals who are eligible for health services through the
Indian Health Services.
Certain religious sects that have objections to insurance including Medicare and social security.
Non-resident aliens.
Undocumented immigrants.
How individual members of certain groups obtain their exemption from the individual mandate:
Members of health care sharing ministries, federally recognized Indian tribes, and non-tribal
members eligible for Indian Health Services:

Through the Marketplace or on Form 8965,


which is filed with their tax return.

Members of certain religious sects:

Through the Marketplace.

Nonresident aliens:

By filing Form 1040-NR.

Undocumented immigrants:

Form 8965, which is filed with their tax return.

Note: Certain exemptions require the taxpayer to complete a form and mail it with any required documentation to the Marketplace. If approved, the client will receive an exemption certificate number
that will need to be reported on Form 8965, Health Coverage Exemptions.
Exemptions Available Due to Circumstances
The following circumstances make taxpayers eligible for exemptions from the individual mandate:
Household income is below the filing status threshold. The software is programmed to recognize
when a taxpayer is subject to the penalty but qualifies for this exemption.
U.S. citizen or resident living outside the U.S. To qualify, the taxpayer must have spent 330 full
days outside of the U.S. during a 12-month period or have been a resident of a foreign country or
U.S. territory.
Incarceration. Individuals qualify for this exemption for any month they are in a penal institution
or correctional facility. The exemption is obtained by submitting an application to the Marketplace.
Short coverage gap. Individuals qualify for this exemption if they did not have qualified coverage
for less than three consecutive months. This exemption can only be claimed at the first occurrence
and does not apply when the coverage gap is three or more months.

Credits 8.21

Coverage by May 1. This exemption is available for individuals who had a coverage gap at the
beginning of the year. Individuals qualify for this exemption if they purchased qualified health
coverage that went into effect no later than May 1, 2014.
Coverage is considered unaffordable. If the minimum premium amount (either through employer
sponsored or Marketplace coverage) is more than 8% of household income, the coverage is considered unaffordable, and the individual qualifies for an exemption.
CHIP coverage beginning after the start of the year. An exemption is available to individuals who
applied for and obtained CHIP coverage during the open enrollment period, still leaving a gap at
the beginning of the year.
In addition to the circumstances listed above, exemptions are also granted when the taxpayer experienced any of the following hardships (this list is not all-inclusive):
Cancelled health policy.
Lives in a state that did not expand Medicaid coverage.
Domestic violence.
Homelessness.
Eviction in the past six months or facing eviction or foreclosure.
Shut-off notice from a utility company.
Fire, flood, or other natural or human-caused disaster that caused substantial damage to the taxpayers property.
Bankruptcy in the last six months.
Medical expenses in the last 24 months that resulted in substantial debt.
Unexpected increases in necessary expenses due to caring for an ill, disabled, or aging family
member.
Death of a close family member.
mExample: Michael (25) and Michelle (23) are married. They have two children, Thomas (1) and
Stephanie (2), who live with them all year and who do not provide more than half of their own support. Michael and Michelle file a joint return and have combined wages of $18,856. They have no other
income. The couple is not required to file a tax return, but do so to claim the Earned Income Credit and
Additional Child Tax Credit. Neither Michael nor Michelle had health insurance coverage in 2014, but
both children had coverage through CHIP. Michael and Michelle are subject to the ACA penalty, but
because their income is below their filing status threshold, they qualify for an exemption. Their Form
8965 is in Illustration 8.8 on page 8.23.m

8.22 H&RBlock Income Tax Course (2015)

The example on page 8.21 requires the following screens for Form 8965 in BlockWorks:
Illustration 8.6

Illustration 8.7

Credits 8.23
Illustration 8.8

8.24 H&RBlock Income Tax Course (2015)

CHAPTER SUMMARY
In this chapter, you learned:
Credits are valuable to taxpayers because they reduce tax liability dollar for dollar. Nonrefundable
credits may not reduce a taxpayers tax liability below zero. Refundable credits may reduce the
taxpayers tax liability below zero, and the difference is refunded to the taxpayer.
Taxpayers who pay someone else to care for their child or disabled dependent or spouse while they
work or look for work may be eligible for the Child and Dependent Care Credit. The credit is computed on Form 2441 for taxpayers filing Form 1040 or Form 1040A.
The amount of expenses eligible for the Child and Dependent Care Credit must be reduced by any
employer-provided assistance that qualifies for exclusion from income.
The premium tax credit (PTC) is a credit that helps pay the cost of coverage through the
Marketplace. It is either advanced to the taxpayer, or refunded through their income tax return.
It is important that you understand the basics of ACA compliance so that you can conduct a tax
interview that correctly applies the premium tax credit.

Suggested Reading
For further information on the topics discussed in this chapter, you may wish to read the following
sections of IRS Publication 17:
Chapter 32, Child and Dependent Care Credit.
Chapter 33, Credit for the Elderly or the Disabled.
Chapter 37, Premium Tax Credit.
You might also wish to read sections of:
IRS Publication 503, Child and Dependent Care Expenses.

a single
Tparent who works full-time and pays daycare expenses forMyoneclientof hisis two
chilhe Tax Institute at H&R Block Research Question:

dren. His four-year-old goes to a preschool that costs more than $6,000 a year. His
ten-year-old attends an after-school care program free of charge at a community
center. He can claim both as qualifying children on his tax return. The client does
not have a pre-tax dependent care benefit available at work. Can he use $6,000
to compute the child care credit? Or, is he limited to $3,000 because he has paid
expenses for only one of the children?
may figure credit for child and dependent care expenses
Ausing theYourfullclient
$6,000. Under the regulations (Reg. 1.21-2(a)(1)(ii)), the $6,000
nswer:

applies if there are two or more qualifying individuals with respect to the taxpayer. Under Reg. 1.21-1(b)(1)(i), a qualifying individual includes a taxpayers
dependent (who is a qualifying child) who has not attained age 13. Since your
client has two qualifying children under the age of 13, he is considered to have
two qualifying individuals, and the higher (i.e., $6,000) limit applies.

Education Credits
OVERVIEW
Many clients, or their dependents, take education courses. Whether taxpayers are taking classes
themselves or assisting children who are enrolled in education courses, there may be tax benefits
available to clients with expenses for education. This chapter covers three common tax breaks for
higher education: the American Opportunity Credit, the lifetime learning credit, and the tuition and
fees deduction.

OBJECTIVES
At the conclusion of this chapter, you will be able to:
Determine which expenses are eligible expenses for the American Opportunity Credit, the lifetime
learning credit, and the tuition and fees deduction.
Determine eligibility for the American Opportunity Credit and compute the credit.
Determine eligibility for the lifetime learning credit and compute the credit.
Determine eligibility for the tuition and fees deduction and compute the deduction.
Compare/contrast the three benefits to obtain maximum benefit for the client.

TAX TERMS
Look up the definitions of the following terms in the glossary:
American Opportunity Credit (AOC).
Credits.
Lifetime learning credit.
Nonrefundable credit.
Refundable credit.
Tuition and fees deduction.

9.1

9.2 H&RBlock Income Tax Course (2015)

CREDITS VS. DEDUCTIONS


Recall from previous discussions that both credits and deductions help taxpayers reduce the amount
of tax they must pay, although they do so in different ways. Deductions, such as the standard deduction, lower tax by reducing taxable income. Lower taxable income results in less tax.
Unlike deductions, credits do not come into play until after taxable income has been computed and
the tax determined. Then, credits may be used to directly reduce the tax.
This chapter will focus on two credits and a deduction:
The American Opportunity Credit is a credit that may be partly refundable.
The lifetime learning credit is a nonrefundable credit.
The tuition and fees deduction is taken as an adjustment to income, which means it may reduce
taxable income.
is a helpful rule to think about the tax benefit hierarchy of
TeducationHerebenefits:
ax Tip:

1. Nontaxable benefits (for example, Pell Grants).


2. Refundable credits.
3. Nonrefundable credits.
4. Deductions.

EDUCATION CREDITS
For 2014, there are two education credits: the American Opportunity Credit and the lifetime learning
credit. This chapter will cover qualification and eligibility rules on both.

American Opportunity Credit


The American Opportunity Credit (AOC) was created by the American Recovery and Reinvestment
Act of 2009 (ARRA). The AOC is a modification of the Hope credit and, under current law, is available
only for tax years through 2017. The AOC is a credit of up to $2,500 per eligible student, and up to
40% of the credit may be refundable. Lets take a closer look at the AOC.
Who Can Claim the AOC
Generally, a taxpayer may claim the AOC if they meet all the following requirements:
The taxpayer pays qualified education expenses of higher education.
The qualified education expenses are paid for an eligible student.
The eligible student is the taxpayer, spouse, or dependent for whom the taxpayer actually claims
an exemption.

Education Credits 9.3

Who Cannot Claim the AOC


A taxpayer may not claim the AOC if any of the following are true:
The taxpayers filing status is MFS.
The taxpayer is claimed as a dependent on anyone elses tax return.
The taxpayers modified adjusted gross income (MAGI) is above $90,000 ($180,000 for MFJ).
For the AOC, MAGI equals AGI plus:
Foreign earned income exclusion.
Foreign housing exclusion.
Foreign housing deduction.
Income excluded by bona fide residents of American Samoa.
Income excluded by bona fide residents of Puerto Rico.
Note: The issues in the above list are advanced topics and are not covered in this course. If you have a
client with any of these types of income, please consult an experienced Tax Professional in your office
and/or IRS Publication 970, Tax Benefits for Education.
The taxpayer (or spouse) was a nonresident alien for any part of 2014, and the nonresident alien
did not elect to be treated as a resident alien for tax purposes.
Note: Issues of resident vs. nonresident aliens are beyond the scope of this course. If you have a client
with these issues, please consult an experienced Tax Professional in your office and/or IRS Publication
519, U.S. Tax Guide for Aliens.
The taxpayer claims the lifetime learning credit or the tuition and fees deduction for the same
student in 2014.
Illustration 9.1 on page 9.4 is a very useful guide to who may claim the AOC for 2014.
Dependents. A student who is claimed as a dependent on someone elses return may not claim an
education credit for that tax year on their own return. Any qualified tuition and fees paid on behalf
of a dependent student are treated as paid by the person who claims the dependency exemption. The
expenses may be paid using the taxpayers money, the students money, loans, gifts, inheritances, and
savings.
mExample: Tracy Batts dependent son, Donald (19), is a full-time student at Rowan University. All
of Donalds tuition was paid with his own money and student loan proceeds. Nonetheless, Tracy may
claim the AOC based on all of Donalds qualified expenses.m
If a taxpayer is eligible to claim the student as a dependent but does not do so, only the student may
claim the AOC for their qualifying expenses.
mExample: Tracy Batt (from the preceding example) qualifies to claim Donald as a dependent, but her
taxable income is already zero, so she chooses not to do so. Although Donald may not claim his own
exemption, he may claim the AOC based upon all of his qualified expenses.m
Qualified Education Expenses
Qualified expenses for the AOC are tuition and certain related expenses required for enrollment or
attendance at an eligible educational institution.

9.4 H&RBlock Income Tax Course (2015)


Illustration 9.1

Education Credits 9.5

Eligible educational institution. An eligible educational institution is any college, university,


vocational school, or other postsecondary educational institution eligible to participate in a student
aid program administered by the U.S. Department of Education (USDOE). This includes virtually all
accredited public, nonprofit, and proprietary (privately-owned, profit-making) postsecondary institutions.
Certain related expenses. For purposes of the AOC, expenses for books, supplies, and equipment
needed for a course of study are qualified education expenses, whether or not the materials are purchased from the educational institution.
Expenses involving student activities, sports, games, or hobbies are qualified expenses only if they are
required by the institution as part of a degree program.
Nonqualified expenses. Expenses for meals, room and board, athletic fees, insurance, transportation, and other personal living expenses are not qualified education expenses for the AOC.
mExample: Terri Dougherty is a degree candidate at State University. In addition to her tuition and
required course fees, she purchased her textbooks from an online bookstore not affiliated with the
university. For the AOC, the tuition and course fees and the expense for Terris books are qualified
expenses.m
mExample: Jefferson is a sophomore in Local State Universitys degree program in dentistry. In 2014,
in addition to tuition, Jefferson is required to pay a rental fee to the university for dental equipment
he will use in the program. Because the equipment rental is needed for his course of study, the rental
fee is a qualified education expense for the AOC.m
mExample: In 2014, Krissy enrolled at Private College for her freshman year. In addition to her
tuition, Krissy had to pay a separate student activity fee. The fee is required of all students and is
used solely to fund the student government; none of the fee covers personal expenses for any student.
Although the fee is labeled as a student activity fee, the fee is required for Krissys attendance at
Private College and is a qualified expense for the AOC.m
Reduction of qualified educational expenses. Qualified educational expenses paid with tax-free
funds may not be used to claim the AOC. Qualified expenses must be reduced by any nontaxable:
Scholarships.
Grants.
Veterans or military educational benefits.
Any other nontaxable benefits.

ax Tip: Tax-free funds specifically designated to pay expenses other than


qualified expenses (such as a scholarship specifically designated to pay room
and board) do not reduce qualified educational expenses.

Qualified expenses must also be reduced by excludible amounts withdrawn from the students
Coverdell Education Savings Account (ESA) or qualified tuition plan (QTP).

9.6 H&RBlock Income Tax Course (2015)

ax Tip:If you have a client who has taken distributions from an ESA or
a QTP plan, please partner with an experienced Tax Professional in your
office and refer to IRS Publication 970, Tax Benefits for Education.

Qualifying Academic Periods


The AOC is available for the year in which the qualified expenses are paid. The qualifying education
must begin during that year or within three months following that year. For example, amounts paid
in 2014 for an academic period that begins before April 1, 2015, are eligible expenses for 2014. An
academic period begins on the first day of classes.
Student loans. If the proceeds of a loan are used to pay expenses, the education credit is based on
the amount of the expenses paid (rather than the amount of the loan payments) and are considered
paid in the year the institution was paid, not in the year the loan was repaid. When the loan proceeds
are disbursed directly to the institution, the expenses are considered paid when the students account
is credited. If the actual date is unknown, the expenses are considered paid on the last day the institution would have accepted the payment for that academic period.
Third-party payments. In cases where a third party makes a payment directly to the educational
institution to pay for a students qualified expenses, the student is treated as having paid the expenses.
Expenses refunded. If qualified expenses are refunded by the institution (for example, because the
student withdraws from a class) before the filing of the return for that tax year, the credit is based
on the amount paid after subtracting the refund. However, if the student files their return claiming
a credit for the full amount and later receives a refund, they will have to recapture (pay back) some
of the credit claimed. The recapture is beyond the scope of this course. If you have a client with this
issue, please consult an experienced Tax Professional in your office and/or refer to IRS Publication
970.
mExample: In December 2014, Tiffany Knight paid $2,000 in qualified expenses for the spring 2015
semester. Early in 2015, before filing her 2014 tax return, she withdrew from a foreign language class
and received a tuition refund of $400. Her 2014 AOC will be based on $1,600 of qualified expenses.m

Eligible Student
For 2014, an eligible student for the AOC is a student who meets all of the following conditions:
The student has not claimed an AOC in any four earlier tax years (this includes any tax years in
which the Hope credit was claimed for the student).
The student had not completed the first four years (generally, the freshman, sophomore, junior,
and senior years) of postsecondary education before 2014.
Note:Academic credit awarded solely on the basis of performance on proficiency exams is not taken
into account when determining whether the student has completed the four years of postsecondary
education.
The student was enrolled at least half-time in a program leading to a degree, certificate, or other
recognized academic credential for at least one academic period beginning in 2014.

Education Credits 9.7

Note: The standard for at least half-time is determined by each eligible educational institution. If
the student is not certain if they were at least a half-time student, the institution can tell them.
The student had not been convicted of any federal or state felony for possessing or distributing a
controlled substance as of the end of 2014.
These requirements are outlined in Illustration 9.2 on page 9.8.
Complete Exercises 9.1, 9.2, and 9.3 before continuing to read.

Calculating the AOC


The AOC is available up to $2,500 per eligible student on the tax return. The amount of the AOC is
the sum of:
1. 100% of the first $2,000 of qualified education expenses paid for the eligible student.
2. 25% of the next $2,000 of qualified education expenses paid for the eligible student.
The maximum AOC, which may be claimed for 2014, is $2,500 times the number of eligible students
on the tax return.
Up to 40% of the AOC may be a refundable credit.
Income Limitation
As mentioned on pages 9.29.3, certain levels of MAGI reduce or eliminate the AOC. We covered the
definition of MAGI on pages 9.2 and 9.3. Now, lets take a look at its effect on the AOC.
The AOC is phased out for clients with MAGI between $80,000 and $90,000 ($160,000 and $180,000
MFJ). The AOC is not available to clients with MAGI above $90,000 ($180,000 MFJ).
The credit for taxpayers filing a joint return is computed by multiplying the tentative credit by:
$180,000 Modified AGI
$20,000
For all other filing statuses, multiply the tentative credit by:
$90,000 Modified AGI
$10,000
mExample: Jack and Jill are married and will file a joint 2014 tax return. They have a tentative AOC
of $2,500 and MAGI of $165,000. Their AOC is reduced to $1,875:
$2,500 2 $180,000 $165,000 = $1,875 m
$20,000

Form 1098-T
Generally, an eligible educational institution must send each enrolled student Form 1098-T (or an
acceptable substitute) each year. Form 1098-T contains the information needed to help claim the
AOC. Refer to Form 1098-T in Illustration 9.3 on page 9.11.

9.8 H&RBlock Income Tax Course (2015)


Illustration 9.2

Education Credits 9.9

Following is a brief explanation of each entry on Form 1098-T:


Box 1 shows the total amount of payments received by the institution for the students qualified
expenses. This amount has been reduced by reimbursements or refunds, if any.
Box 2 indicates the net amount of qualified expenses billed to the student.

ax Tip: The amount in boxes 1 and 2 of Form 1098-T may differ from the
amount the client actually paid. Be sure to use the amount paid or deemed
paid in 2014 to calculate the AOC.

The institution may choose to report either payments actually received (box 1) or amounts billed
(box 2) during the year for qualified education expenses.
Box 4 contains any adjustments made for a prior years qualified expenses previously reported on
Form 1098-T. If there is an entry in this box, the taxpayer may need to recapture a prior years education credit. See IRS Publication 970 if you encounter this situation.
Box 5 shows the total of all scholarships or grants received by the institution on behalf of the student. As mentioned earlier, these amounts will reduce the amount of qualified expenses in box 1 for
purposes of the education credit.
Box 6 contains adjustments to scholarships or grants for a prior year. As with box 4, if there is an
entry in this box, the taxpayer may be looking at some credit recapture.
Box 7 will be checked if the amount in box 1 or 2 includes amounts for an academic period beginning
after December 31, 2014, and before April 1, 2015. Because these amounts are eligible for a 2014 education credit, this check box does not change any of the entries on the 2014 tax return.
Box 8 will be checked if the student is considered to be carrying at least one-half the normal full-time
work load for their course of study at the institution. As you know, the student must be at least a halftime student for at least one academic period during the year to qualify for the AOC.
Box 9 will be checked if the student is enrolled in a graduate program. Such a student is probably
not eligible for the AOC. If the student is still in the first four years of post-secondary education, they
can receive the AOC.
Box 10 shows the total amount of reimbursements or refunds of qualified expenses made by an
insurer. As with box 4, these amounts will reduce the amount of qualified expenses for purposes of
the education credit.
Claiming the AOC
The AOC is claimed on Form 8863 (refer to Illustrations 9.4 through 9.6 on pages 9.129.14). Were
going to walk through Form 8863 using this example:
mExample: Mary Williams (745-14-8456) is single and cannot be claimed as a dependent by any other
taxpayer. In 2014, Mary enrolled full-time at a local college (the college is a qualifying educational
institution) to earn a degree in law enforcement. The first year of Marys postsecondary education was
2014. Mary received Form 1098-T (on page 9.11) from the college. Marys expenses meet all of the
qualifications for the AOC. In addition to the expenses reported on Form 1098-T, Mary spent $712 for
needed textbooks, which she purchased through an online book retailer. Marys 2014 AGI (and MAGI)

9.10 H&RBlock Income Tax Course (2015)

is $39,000. Marys Form 1098-T is shown in Illustration 9.3 on page 9.11.


Marys AOC is claimed on Form 8863 (see Illustrations 9.4, 9.5, and 9.6). Mary had no other credits
on her tax return.
Note: Marys total qualified education expenses are $6,312. Subtracting out the $1,000 grant leaves
expenses of $5,312. However, only $4,000 is entered in Form 8863, Part III, line 28. This is because
$4,000 is the maximum amount of qualified education expenses upon which the AOC is based. m

Nonrefundable AOC
We have mentioned several times that up to 40% of the AOC may be available to the taxpayer as a
refundable credit. However, it is extremely important to note that the refundable part of the AOC is
not available to all taxpayers. Taxpayers who do not qualify for the refundable credit:
A taxpayer who is any of the following:
Under age 18 at the end of 2014.
Age 18 at the end of 2014 and earned income was less than one-half of the taxpayers support.
A full-time student over age 18 and under age 24 at the end of 2014 and earned income was less
than one-half of the taxpayers support.
And
Has at least one parent who was alive at the end of 2014.
Is not filing a joint return for 2014.
Complete Exercise 9.4 before continuing to read.

LIFETIME LEARNING CREDIT


The amount of the lifetime learning credit is 20% of the total qualified expenses for all eligible students on the tax return. The maximum amount of expenses allowed per tax return is $10,000; therefore, the maximum annual credit is $2,000 per return, regardless of the number of eligible students.
This is significantly different than the AOC maximum of $2,500 per student. However, the lifetime
learning credit may be claimed for an unlimited number of tax years.

Qualified Expenses
Qualified expenses for the lifetime learning credit include expenses incurred by a student for either of
the following reasons:
The student is enrolled in a course that is part of a degree program for undergraduate or graduate-level courses.
The student took courses to acquire or improve job skills.
There is no requirement that the student attend school on at least a half-time basis. For example, a
Tax Professional may claim the lifetime learning credit for a tax course provided by an eligible educational institution (as defined earlier), even if this is the only class they take. They need not be enrolled

Education Credits 9.11

on a half-time basis or in a degree program.


For purposes of the lifetime learning credit, qualifying expenses generally do not include books. This
is a significant difference from the AOC we covered earlier.
The lifetime learning credit phases out for taxpayers with MAGI between $54,00064,000 ($108,000
128,000 MFJ).
mExample 1: John and Lisa Proctor have modified AGI of $75,000. Their dependent son, Joseph, is a
college freshman at the beginning of the tax year. Joseph does not attend school on at least a half-time
basis. The Proctors paid qualified education expenses totaling $6,000. The lifetime learning credit for
2014 is $1,200 [$6,000 2 20% = $1,200].m
mExample 2: The facts are the same as in Example 1, except the qualified expenses are $12,000. In
this case, the lifetime learning credit would be $2,000 [$10,000 2 20% = $2,000].m
The lifetime learning credit and the AOC may not be claimed for the same student for the same year,
but each credit may be claimed for different students for the same year.
The flowchart in Illustration 9.7 is an excellent reference to help determine who may claim the lifetime learning credit for 2014.
Claiming the Lifetime Learning Credit
The lifetime learning credit is claimed on Form 8863, Part III. As with the AOC, the calculation is
pretty straightforward.
Lets assume Mary Williams (from the example on page 9.9) is in her fifth year of college in 2014. In
this case, Mary will not qualify for the AOC (she has completed her first four years of postsecondary
education), but she will qualify for the lifetime learning credit. Marys completed Form 8863 is presented in Illustrations 9.8, 9.9, and 9.10 on pages 9.16 through 9.18.
Illustration 9.3

9.12 H&RBlock Income Tax Course (2015)


Illustration 9.4

Education Credits 9.13


Illustration 9.5

9.14 H&R Block Income Tax Course (2015)


Illustration 9.6
X.X

Education Credits 9.15


Illustration 9.7

9.16 H&R Block Income Tax Course (2015)


Illustration 9.8
X.X

Education Credits 9.17


Illustration 9.9

9.18 H&R Block Income Tax Course (2015)


Illustration 9.10
X.X

Education Credits 9.19

TUITION AND FEES DEDUCTION


Congress has extended the tuition and fees deduction through 2014. Taxpayers may deduct up to
$4,000 as an adjustment to income for qualified tuition and related expenses. The deduction is a
per-return limit, not a per-student limit. The deduction is figured on Form 8917, Tuition and Fees
Deduction, and claimed on Form 1040A, line 19. See Illustration 9.13 on page 9.22.

Who Is an Eligible Student?


An eligible student is any student who is enrolled in any postsecondary educational institution eligible
to participate in a student aid program administered by the Department of Education. This would
include almost all accredited public, nonprofit, and proprietary (privately-owned, profit-making) postsecondary institutions.
Illustration 9.11

Who May Claim the Deduction?


In order to claim the deduction, the taxpayer must have paid the qualified expenses for themselves, a
spouse, or a dependent who is claimed as an exemption by the taxpayer. If the taxpayer did not pay
the expenses, they cannot claim the deduction. If the dependent paid the expenses and the taxpayer
claims the dependency exemption, no one claims the deduction. The chart in Illustration 9.12 on page
9.21 is a helpful guide to determine who may claim the deduction in the case of a dependent student.

9.20 H&RBlock Income Tax Course (2015)

Phaseout of Tuition and Fees Deduction


The tuition and fees deduction phases out for taxpayers with MAGI between $65,000 ($130,000 MFJ)
and $80,000 ($160,000 MFJ). Unlike some tax benefits, which phase out at a more or less constant
rate, the tuition and fees deduction phases out in steps, as shown above.
mExample: Lets assume Mary Williams (from previous examples) has an AGI of $70,000 and is in her
fifth year of college. In this case, Mary does not qualify for the AOC because she is in her fifth year and
she will not qualify for the lifetime learning credit because her income is too high. Mary qualifies for
the tuition and fees deduction. The first page of her 1040A and her completed Form 8917 is presented
in Illustrations 9.13 and 9.14 on pages 9.22 and 9.23.m

Qualified Expenses
Qualified expenses for the tuition and fees deduction are tuition and certain related expenses required
for enrollment or attendance at an eligible educational institution. Related expenses may include student-activity fees and expenses for course-related books, supplies, and equipment. These are eligible
expenses only if they must be paid to the institution as a condition of enrollment or attendance. Room
and board are not qualified expenses.
mExample: Blake is a sophomore in University Ks degree program in microbiology. This year, in
addition to tuition, he is required to pay a fee to the university for the rental of the lab equipment
he will use in the program. Because the equipment rental fee must be paid to the university, it is a
qualified expense.m
mExample: Stacy attends College J. Her tuition and fees for the year were $3,458. She also purchased
books costing $257 for her classes at the off-campus Wildcat Bookstore. Her qualified expenses for
the tuition and fees deduction would be $3,458 because this expense was not paid to the institution.m
Remember:Expenses used for education credits are not necessarily qualified expenses for the tuition
and fees deduction. Also, any student who uses an education credit cannot use the tuition and fees
deduction even for expenses above those used for the credit.
Complete Exercise 9.5 before continuing to read.

Education Credits 9.21


Illustration 9.12

Tuition and Fees Deduction


Who Can Claim a Dependents Expenses?

9.22 H&R Block Income Tax Course (2015)


Illustration 9.13

Education Credits 9.23


Illustration 9.14

9.24 H&RBlock Income Tax Course (2015)

CHAPTER SUMMARY
In this chapter, you learned:
Which educational expenses are eligible expenses for the tuition and fees deduction, the American
Opportunity Credit (AOC), and the lifetime learning credit.
The tuition and fees deduction of up to $4,000 is available for degree candidates and students
taking college courses to maintain or improve their current job skills. The deduction is figured on
Form 8917 and entered on Form 1040A, line 19.
Taxpayers who pay for higher education may qualify for one or more education tax breaks.
The AOC is available for the 20092017 tax years for degree candidates who have not completed
their first four years of post-secondary education as of the beginning of the tax year.
The lifetime learning credit is available for all years of higher education for degree candidates and
students taking college courses to maintain or improve their current job skills.

Suggested Reading
For further information on the topics discussed in this chapter, you may wish to read the following
sections of IRS Publication 17:
Chapter 19, Education-Related Adjustments.
IRS Publication 970, Tax Benefits for Education, is also an invaluable resource for this topic.

he Tax Institute Tax in the News Research Question: Our clients


have contributed about $5,000 to a Coverdell ESA for their son. They
opened the account when he was a child (when they were still called Education
IRAs!) and have contributed intermittently since then. Unfortunately, their son,
who will soon turn 18, told them he has no intention of continuing his education
after high school. What happens to the money at this point? Can the funds be
rolled over to another kind of savings account for him, such as a Roth IRA?

nswer: Your clients may not roll over the unused ESA funds into any type
of IRA, either for themselves or for their son. There are three possibilities
for the ESA, rather than closing the account and distributing all of the funds.
First, your clients should keep in mind that the ESA can remain intact
until their son turns 30. Although he may be adamant about not going to
college right now, he could change his mind in a few years. Also, education expenses for ESAs include tuition and other costs for qualifying vocational schools, which may be a type of education that interests their son.
Second, the ESA can be rolled over tax-free to an ESA for another family
member who is related to their son in one of several ways, including his
siblings and first cousins.
Finally, as a point of information, the ESA can be rolled over tax-free to a
qualified tuition program (QTP) for their son. Obviously, for this family, a
QTP rollover may not be a good choice.

Education Credits 9.25

nswer continues: If your clients decide to close the account and distribute all of the funds, the earnings portion of the distribution will be taxable
to their son. The distribution will be reported on Form 1099-Q, Payments from
Qualified Education Programs.
For more information, including a list of acceptable relatives for rollover purposes, see Coverdell Education Savings Account (ESA) in IRS Pub. 970, Tax
Benefits for Education, and instructions to Form 1099-Q. Note that we assume
your clients son is not a special needs beneficiary. If he were, the age limitation
does not apply and the funds could remain in the ESA indefinitely.

10

Retirement
OVERVIEW
You have probably read or heard news stories stating that Americans are not saving nearly enough
for retirement. The IRS Tax Code seeks to encourage retirement savings by making a variety of tax
breaks available to taxpayers when they save for retirement. This chapter will cover some of the more
common retirement savings plans available to individual taxpayers.
In retirement planning, generally there are two parts. The first part of retirement is building your
retirement accounts, so that when you retirethe second partyou can strategically withdraw the
funds to live out your retirement. This chapter covers a brief overview of both contributing to and
taking distributions from retirement plans.

OBJECTIVES
At the conclusion of this chapter, you will be able to:
Explain the features of commonly available retirement accounts and the tax benefits of contributing to these accounts.
Determine if a taxpayer is eligible to contribute to a traditional or Roth IRA, and determine the
deductible amount of traditional IRA contributions.
Determine a taxpayers eligibility for the retirement savings contribution credit and calculate the
amount of the credit.
Determine and accurately report the taxable portion of social security or tier 1 railroad retirement
benefits.
Identify and accurately report taxable qualified retirement plan and IRA distributions.
Explain the consequences of an early retirement plan and IRA distributions.

10.1

10.2 H&RBlock Income Tax Course (2015)

TAX TERMS
Look up the definitions of the following terms in the glossary:
401(k) plan.
403(b) plan.
457 plan.
Annuity.
Contribution.
Defined benefit plan.
Defined contribution plan.
Distribution.
Pension.
Rollover.
Roth IRA.
Traditional IRA.

TYPES OF RETIREMENT PLANS


While there are a wide variety of retirement plans, for our purpose, we are going to focus on qualified
plans and nonqualified plans.
Qualified Plans
A qualified plan is a plan that is eligible for favorable tax treatment because it meets the requirements of both the following:
IRC 401(a).
The Employment Retirement Income Security Act of 1974 (ERISA).
A qualified plan is allowed some very advantageous tax treatment:
Employers may deduct the annual allowable contributions that they make for each plan participant.
Contributions and earnings on those contributions are tax-deferred until withdrawn for each participant.
In some cases, taxes may be deferred even further through a transfer into a different type of IRA
account (we will cover IRA accounts later in this chapter).

Retirement 10.3

Nonqualified Plans
As you probably suspect, a nonqualified plan is basically the opposite of a qualified plan. Nonqualified
plans do not meet the requirements of IRC 401(a) and ERISA and do not qualify for favorable tax
treatment. Nonqualified plans are:
Usually designed to meet specialized retirement needs of key executives and other select employees.
Exempt from the discriminatory and top-heavy testing to which qualified plans are subject.
Contributions to a nonqualified plan are usually nondeductible to the employer. Nonqualified plans do
allow employees to defer taxes until retirement; at retirement, distributions from a nonqualified plan
are usually made in the form of an annuity.
Note:You do need to know the basic features of qualified vs. nonqualified plans, but do not get too
wound up in it. We are going to concentrate on contributions to and distributions from qualified plans
or plans that are basically treated as qualified plans.

QUALIFIED PLANS
There are two kinds of qualified plans, defined benefit and defined contribution plans. A defined benefit plan is a retirement plan where the employee receives a predetermined formula-based benefit at
retirement. The most common known type of defined benefit plan is a pension in which the retirement
benefit is calculated by a formula based on number of years worked, age, and their history of earnings
with the employer. Another type of defined benefit plan is an annuity. An annuity is a series of payments under a contract made at regular intervals over a period of more than one year. The taxpayer
can buy the annuity contract alone or with the help of their employer. Annuities are often purchased
from life insurance companies. For these types of retirement accounts, generally the employer and/or
employee makes payments to fund the pension or annuity.
A defined contribution plan (also called a deferred compensation plan) is a retirement plan where the
employee and/or employer make pre-tax contributions into a retirement account where the contributions and earnings grow tax-free until the money is withdrawn. The most commonly known type of
deferred compensation plan is a 401(k). The following are common types of deferred compensation
plans that you may encounter at the tax desk.

10.4 H&RBlock Income Tax Course (2015)

401(k) Plans
A widely available and popular type of qualified deferred compensation plan is the 401(k) plan. 401(k)
plans take their name from IRC 401(k), which governs their existence. As a qualified plan, 401(k)s
offer significant tax advantages:
Employee contributions to the plan are tax-deferred. This means the employee does not pay federal
income tax on the amount of the contributions in the year contributed. Most states also allow contributions to be tax-deferred, although some contributions may be subject to local income tax. Tax
is not paid until the taxpayer receives a distribution, or in other words withdrawal, from the plan.
Earnings on the contributions are also tax-deferred until the taxpayer receives a distribution from
the plan.
Employer-Matching Contributions
The 401(k) plans may also have another potential benefit. The employer may opt to match all or part
of the employees contributions to the account. This may be done by:
Making an additional contribution to the account on behalf of the employee.
Offering a profit-sharing contribution to the plan.
mExample: Teds employer offers their employees a 401(k) plan. The employer offers a matching contribution for each percent the employee contributes, up to 5%, of their annual salary to the plan. If
Ted contributes 10% of his annual salary to the plan, his employer will make matching contributions
equal to 5%. This means Ted is saving 15% of his annual salary for an out-of-pocket expenditure of
only 10%.m

advantage of any employer-matching contribution is a fanTtastic wayTaking


to help build retirement savings. Depending on the taxpayers
ax Tip:

available cash flow, it is always advantageous for the taxpayers to make the
minimum contribution to the retirement plan to receive the employers maximum matching contribution, because the employers matching contribution is
free money.

403(b) Plans
A 403(b) plan is a tax-advantaged retirement savings plan available for employees of the following
types of organizations:
Public education.
Some non-profit.
Cooperative hospital service.
Employee contributions to a 403(b) plan are tax-deferred and so are earnings on the plan.

Retirement 10.5

Note:Technically, 403(b) plans are not qualified plans. However, their main features are identical to
those of qualified plans. For our purpose, we are going to treat 403(b) plans the same as a qualified
plan.

457 Plans
The 457 plans are tax-advantaged, deferred-compensation retirement plans available primarily to
governmental employees. These 457 plans are not qualified plans, but their primary features are
identical to qualified plans. Contributions to the plan, and earnings on those contributions, are tax-deferred until the employee receives distributions from the plan.

Contribution Limits
As wonderful a deal as a deferred-compensation plan is, employees are not allowed to contribute an
unlimited amount to their plan. The IRS does set annual maximum limits on the amount that can
be contributed. These amounts are indexed for inflation and generally rise each year (much as the
allowable amount for the standard deduction generally rises each year).
For 2014, the maximum annual allowable contribution is $17,500. Taxpayers over the age of 50 are
allowed an annual catch up contribution of $5,500.
Note:As mentioned, allowable contributions to plans are generally set as a percentage of an employees salary. Therefore, the maximum amount any one taxpayer can contribute is a function of both the
maximum annual limit and the allowable percentage of salary that may be contributed.
mExample: John Conners annual salary is $100,000. His employer sponsors a 401(k) plan, which
allows each employee to contribute a percentage of their annual salary up to the IRS annual contribution limit. John chooses to contribute the amount of 5% of his annual salary. Therefore, for 2014,
Johns 401(k) contribution is $5,000 [$100,000 2 5% = $5,000].m

Identifying Contributions to a Deferred-Compensation Plan


In order to accurately and completely prepare a tax return, it is essential to know how much the taxpayer contributed to a deferred-compensation plan. Fortunately, the taxpayers Form W-2 generally
contains all the information you need. Recall from Chapter 2 that there are a variety of codes that
can be entered on Form W-2 to communicate a great deal of information. We are interested in box 12
and the codes that identify deferred-compensation plans. Refer to Illustrations 10.1 and 10.2 on the
following page.
mExample: Illustration 10.1 shows John Conners W-2 (from our earlier example). Notice the difference between the amount in box 1 and the amounts in boxes 3 and 5. The $5,000 difference is the
amount John contributed on a tax-deferred basis to his 401(k) plan. The $5,000 401(k) contribution is
reported in box 12 with the code D.m
Complete Exercise 10.1 before continuing to read.

10.6 H&RBlock Income Tax Course (2015)


Illustration 10.1

Illustration 10.2

Retirement 10.7

IRAS
An individual retirement arrangement (IRA) is a personal savings plan that gives taxpayers tax
advantages for saving money for retirement. Two tax advantages of an IRA are that:
Money contributed to the IRA may be fully or partially deductible.
Amounts in the IRA grow tax-free and are not taxed until the money is withdrawn from the IRA
account.
Generally, a qualifying taxpayer has the option to fund two types of IRA accounts, a traditional IRA
and a Roth IRA. Details about both types of IRAs will be discussed later.

Compensation
To qualify to contribute to an IRA, a taxpayer must have earned income, or compensation. For IRA
purposes, compensation includes wages, salaries, tips, commissions, professional fees, bonuses, net
self-employment income, and other amounts the taxpayer receives for providing personal services as
well as alimony payments. If the taxpayers Form W-2 shows any nonqualified plan distribution or
457 plan distribution in box 11, that amount must be subtracted from the taxpayers wages when
determining their compensation for IRA purposes.
Investment income, foreign earned income, or business income where the taxpayer does not actively
participate does not qualify as compensation for IRA contributions. Any foreign earned income or
housing exclusion or deduction the taxpayer is claiming must be subtracted to arrive at total compensation.
For 2014, the maximum allowable contribution to an IRA (traditional or Roth) is the lesser of the
following:
$5,500 ($6,500 if the taxpayer has reached age 50 by the end of the tax year).
100% of the taxpayers compensation.
For this purpose, a taxpayer is considered to have reached age 50 on the day before their birthday.
Thus, a taxpayer born January 1, 1965, is considered to have reached age 50 at the end of 2014.
Please note that the total of all traditional and Roth IRA contributions combined for the year cannot
exceed $5,500 ($6,500 if age 50 or older). So a taxpayer could contribute $5,500 to their traditional
IRA or $5,500 to the Roth IRA, but not $5,500 to both their traditional and Roth IRAs because their
combined IRA contribution would equal $11,000. If the taxpayer wishes to contribute to both their
traditional and Roth IRA, they would have to split the $5,500 maximum contribution limit between
both accounts. For example, a taxpayer could contribute $2,500 to their traditional IRA and $3,000
to their Roth IRA.

10.8 H&R Block Income Tax Course (2015)

TRADITIONAL IRAS
In order to establish and contribute to a traditional IRA, a taxpayer must have taxable compensation
and must not have reached age 70 by the end of the tax year. For this purpose, a taxpayer is considered to have reached age 70 six months after their 70th birthday.
Contributions to traditional IRAs may be deductible from gross income, as an adjustment to income
on Form 1040A, line 17, if the taxpayer qualifies for the deduction. The advantage of a traditional IRA
is that the taxpayer can often deduct amounts set aside for retirement and then watch the fund grow
tax-free while in the IRA account. When the taxpayer reaches age 59, they can withdraw the funds
from the IRA without a penalty. However, the money is generally taxable at that time. The taxpayer
is often in a lower tax bracket due to retirement and will pay less income tax. Money placed in an
IRA should be considered a long-term investment because amounts withdrawn before the taxpayer
reaches age 59 are usually subject to an early withdrawal penalty.

Different Sets of Rules


There are separate sets of rules concerning the deductibility of traditional IRA contributions for each
of three different types of taxpayers:
Taxpayers who are active participants in employer-maintained retirement plans at any time
during the year.
Taxpayers who are not active participants, including joint filers whose spouses are not active participants.
Joint filers who are not active participants, but whose spouses are active participants.

Who Is an Active Participant?


A taxpayer is an active participant in an employer-maintained retirement plan if they participate at
any time during the year in any of the following:
A qualified retirement, profit-sharing, or stock bonus plan (for example, a 401(k) plan).
A qualified annuity plan.
A 403(b) tax-sheltered annuity plan (available to employees of public schools and certain tax-exempt organizations).
A SIMPLE plan.
A government plan (other than a 457 plan).
Certain pension plans funded solely by employee contributions.
A plan established by a self-employed taxpayer (for example, a qualified plan or SEP).
You do not need to become an expert in retirement plan terminology to know if an employee is covered
by an employer-maintained plan. If box 13, the Retirement plan box, on the employees Form W-2 is
marked, the employee is an active participant. If the employee believes the box should not have been
marked, they should obtain a corrected Form W-2 from their employer.

Retirement 10.9

An individual is not treated as an active participant solely because of their coverage under social
security or railroad retirement (tier 1 or tier 2). A person who is receiving retirement benefits from a
former employers plan is not treated as an active participant unless they are covered under a current
employers plan.

Taxpayers Who Are Not Active Participants


IRA contributions made by taxpayers who are not active participants (and whose spouses are not
active participants) are fully deductible up to the maximum allowable contribution amount. A taxpayer who uses the married filing separately status and who did not live with their spouse at any time
during the year is treated as a single taxpayer for this purpose.
If a married couple each have compensation, each spouse may establish an IRA, contribute, and deduct
an amount within the limits. The allowable IRA contribution (and deduction) is computed separately
without regard to any community property laws. An eligible married taxpayer may also establish a
spousal IRA (an IRA for their spouse) even if the spouse has received little or no compensation for the
tax year. A couple making contributions to a spousal IRA must file a joint return.
mExample: Jim (48) and Sally (51) Spencer are filing jointly for 2014. Jim earned $35,000, and Sally
earned $2,500. Jim may contribute up to $5,500 to his IRA for 2014. If Jim contributes the $5,500,
Sallys compensation for IRA purposes is $32,000 [$35,000 + $2,500 $5,500 = $32,000]. The Spencers
may contribute up to $6,500 to Sallys IRA for 2014.m
An IRA may be established and contributed to until the due date (not including extensions) of the
return for the year. That is, a contribution made to an IRA on or before April 15, 2015, may be designated for 2014, and a deduction is allowed on the 2014 return. Therefore, contributing to an IRA is
one of the few actions a taxpayer can take to reduce tax liability after the tax year has ended.
mExample: Lorna Mendiola (39), a single taxpayer who is not an active participant in an employer-maintained retirement plan, computed her taxable income to be $54,689 and her tax to be $9,525.
Because she had only $9,431 withheld from her pay, she would owe the federal government $94.
Lorna did not like the idea of paying additional income tax, so on April 14 she opened a traditional
IRA at her bank and contributed $4,000. She changed her return to show a $4,000 IRA deduction.
Now, her taxable income is reduced to $50,689, and her tax becomes $8,525. Thus, Lorna receives a
refund of $906, and she saved $4,000 for her retirement.m

Taxpayers Who Are Active Participants


When considering taxpayers who are active participants in an employer-maintained retirement plan,
we must be mindful of the distinction between contributing to an IRA and deducting that contribution.
For active participants, the amount that may be contributed to a traditional IRA is the same as it
is for nonparticipants. However, the amount that may be deducted is often limited. The limitation
depends on the taxpayers modified AGI.

10.10 H&R Block Income Tax Course (2015)

Modified AGI (MAGI), for traditional IRA purposes, is determined by adding the following amounts
to regular AGI (without regard to any IRA deductions):
Student loan interest deduction from Form 1040A, line 18 (or Form 1040, line 33).
Tuition and fees deduction from Form 1040A, line 19 (or Form 1040, line 34).
Excludible employer-provided adoption benefits from Form 8839, line 20.
Excludible U.S. Savings Bond interest from Form 8815, line 14.
Domestic production activity deduction from Form 1040, line 35 (beyond the scope of this course).
Certain excludible foreign and U.S. possession income (beyond the scope of this course).
The chart in Illustration 10.3 below summarizes the phaseout ranges for 2014.
Illustration 10.3

2014 TRADITIONAL IRA MODIFIED AGI PHASEOUT RANGES FOR ACTIVE PARTICIPANTS
Filing Status
S, HH, MFS*

Full Deduction
$60,000 or less

Deduction Reduced
$60,00169,999

No Deduction
$70,000 or more

MFJ, QW
MFS**

$96,000 or less

$96,001115,999

$116,000 or more

$19,999

$10,000 or more

*Did not live with spouse at any time during the year
**Lived with spouse at some time during the year

Nonparticipating Spouses
A separate set of deduction limitations applies to married taxpayers who are not active participants
in employer-maintained retirement plans, but who are filing joint returns with spouses who are
active participants in such plans. These taxpayers are referred to as nonparticipating spouses.
For 2014, a nonparticipating spouse is allowed a full deduction for a traditional IRA contribution
if the couples modified AGI is $181,000 or less. If their modified AGI is greater than $181,000 but
less than $191,000, the maximum deduction allowed is reduced. If their modified AGI is $191,000 or
higher, no deduction is allowed.
BlockWorks provides a two-page worksheet, called the IRA Deduction Worksheet Line 32, to help
Tax Professionals compute taxpayers total allowable contributions to their traditional IRAs and to
determine how much of any traditional IRA contributions is deductible. The worksheet is shown in
Illustrations 10.4 and 10.5.

Retirement 10.11

mExample: Henri (39) and Michelle (39) Duval are married and filing a joint return on Form 1040A.
Henri earned $67,700 and is an active participant in an employer-maintained retirement plan.
Michelle earned $32,500 and is not an active participant. The Duvals total income is $100,200. Their
only adjustment to income is a $151 student loan interest deduction, which makes their adjusted
income $100,049. When determining MAGI for the traditional IRA deduction, the $151 student
loan interest deduction is added back. This makes their MAGI equal $100,200 [$100,049 + $151 =
$100,200].
Henri and Michelle would like to contribute $5,500 each to their traditional IRAs for 2014, but they
do not want to contribute more than they can deduct. Because Henri is an active participant in an
employer-maintained retirement plan and the Duvals modified AGI is greater than $95,000, Henris
traditional IRA contribution deduction is limited to $4,350. However, Michelle is able to make the
full $5,500 traditional IRA contribution because she is not an active participant in an employer-maintained retirement plan and the Duvals modified AGI is less than $178,000. The Duvals BlockWorks
IRA Deduction Worksheet Line 32 is shown in Illustrations 10.410.5. The Duvals are excited they
are receiving a $9,850 IRA deduction on their Form 1040A, line 17.m

ROTH IRAS
Roth IRAs are an excellent way to save, not only for retirement, but beyond. Unlike traditional IRAs,
taxpayers can make contributions to their Roth IRA after they reach age 70. Since Roth IRAs do
not have required distributions, the taxpayer could leave contributions in the account as long as they
wish. Unless specific rules prescribe otherwise, the rules that apply to traditional IRAs also apply to
Roth IRAs. For instance:
To make contributions, the taxpayer must receive compensation during the year.
Contributions must be made by the due date of the return, not including extensions.
Contributions for each spouse are limited for 2014 to the lesser of $5,500 ($6,500 for those age 50
and older) or total compensation.
Taxpayers can make contributions for themselves and a nonworking or lower-income spouse, if
they file a joint return.
Allowable Roth IRA contributions must be reduced by any amounts contributed to a traditional IRA,
regardless of whether such contributions were deductible.
Not Deductible. The main difference between a traditional IRA and a Roth IRA is that contributions
to a Roth IRA are not deductible on Form 1040Aqualified distributions, however, are exempt from
tax. This means that the money earned inside the Roth IRA is usually tax-free. Because Roth IRA
contributions are not deductible, these contributions are not reported on the tax return. However, it
is important for the taxpayer to keep records of their Roth IRA contributions.

10.12 H&R Block Income Tax Course (2015)


Illustration 10.4

Retirement 10.13
Illustration 10.5

10.14 H&RBlock Income Tax Course (2015)

The maximum allowable Roth IRA contribution is phased out based on the taxpayers modified
adjusted gross income. This phaseout range applies whether or not the taxpayer or spouse is an
active participant. Participation in an employer-maintained retirement plan has no effect on Roth
IRA contributions, and contributions can be made even after the taxpayer has reached age 70. See
Illustration 10.6 for a table of the 2014 Roth IRA modified AGIphaseout ranges based on the taxpayers filing status.
Illustration 10.6

2014 ROTH IRA MODIFIED AGI PHASEOUT RANGES


Filing Status
S, HH, MFS*

Full Contribution
Less than $114,000

Contribution Reduced
$114,000128,999

No Contribution
$129,000 or more

MFJ, QW
MFS**

Less than $181,000

$181,000190,999

$191,000 or more

$0

$19,999

$10,000 or more

*Did not live with spouse at any time during the year
**Lived with spouse at some time during the year

For Roth IRA purposes, modified AGI is computed in the same manner that it is for traditional IRAs,
except that income resulting from the conversion of a traditional IRA into a Roth IRA is not included.
The BlockWorks 2014 Maximum Roth IRA Contribution Worksheet is used to compute the amount
of Roth IRA contributions a taxpayer (and spouse) may make to their Roth IRA accounts. This worksheet is shown in Illustration 10.7.
For taxpayers whose traditional IRA deduction is reduced because they participate in an employer
retirement plan and their modified AGI exceeds the threshold amount per filing status, the taxpayer may wish to contribute the exact amount of their traditional IRA contribution deduction to their
traditional IRA and contribute the remaining portion to their Roth IRA, assuming their Roth IRA
contribution is not limited due to their MAGI.
mExample: Henri and Michelle Duval (from the preceeding example) still wish to maximize Henris
2014 IRA contribution limit, because the Duvals are very proactive about saving for their retirement.
Because Henris traditional IRA contribution deduction is limited to $4,350, he wants to contribute as
much as he can to his Roth IRA.
Because the Duvals modified AGI is below $181,000, Henri is allowed to contribute $1,150 to his Roth
IRAaccount [$5,500 $4,350 = $1,150]. This way, he maximizes his $5,500 IRA contribution limit.
Henris BlockWorks 2014 Maximum Roth IRA Contribution Worksheet is shown in Illustration 10.7.m

Retirement 10.15
Illustration 10.7

10.16
10.16 H&RBlock
H&R Block Income
Income Tax
Tax Course
Course (2015)
(2015)

Roth IRA Conversion. Taxpayers who have a traditional IRA have the ability to transfer all or part
of the funds from their traditional IRA into a separate Roth IRA account. This transfer is called a
Roth IRA conversion. The taxpayer is required to pay income tax on the transferred amounts in the
year of conversion. The Roth IRA conversion is reported using Form 8606, Nondeductible IRAs. The
traditional IRA funds may be transferred to the Roth IRAusing the following methods:
The taxpayer receives a distribution from their traditional IRA and personally contributes the
money into their Roth IRA. This is called a rollover.
The taxpayer requests the traditional IRAtrustee to transfer the funds directly into their Roth
IRA. This is called a trustee-to-trustee transfer.
The taxpayer reclassifies their traditional IRA account as a Roth IRA, if the account is maintained
by the same trustee.
The taxpayer transfers all or part of their traditional IRAfunds into a new Roth IRA account that
is maintained by the same trustee.
If you are preparing a return for a taxpayer who has made a Roth IRA conversion, additional research
may be required. More information about a Roth IRAconversion can be found in IRS Publication 590,
Individual Retirement Arrangements (IRAs).

SIMPLE IRA
A SIMPLE IRA is a retirement plan generally setup by small employers to allow employees to contribute pre-tax compensation into the plan. Employers are required to either make a matching contribution based on the employees elective deferred compensation or a nonelective contribution that must
be paid to all eligible employees regardless if the employee makes contributions to their account. The
employer receives a deduction on the business return for the contribution they made to the employees
accounts. Unlike a traditional IRA, the employee does not receive a contribution adjustment on their
return, because their contributions are made by their employer on their behalf prior to calculating
and remitting federal and state income tax. The employee taxpayers are then taxed on the SIMPLE
IRA funds when they take distributions from the account. For more information, see IRS Publication
560, Retirement Accounts for Small Businesses.
Complete Exercises 10.2 and 10.3 before continuing to read.

Retirement 10.17

RETIREMENT SAVINGS CONTRIBUTION CREDIT


Qualified lower- and middle-income taxpayers who make retirement plan contributions may be eligible to claim a nonrefundable credit on their tax returns. This Savers Credit, for short, is available in
addition to any allowable deductionwhich makes this one of the very few situations where a double
benefit may be claimed.
A 2014 Savers Credit is not available to taxpayers who were:
Born after January 1, 1997. The year changes each year.
Claimed as a dependent on someone elses 2014 return.
Full-time students during any part of five calendar months in 2014.

Qualified Contributions
Contributions that qualify for the Savers Credit include:
Contributions to traditional and Roth IRAs. (As with the traditional IRA deduction, contributions
for 2014 made in 2014 give rise to a credit for 2014.)
Voluntary salary deferrals to 401(k) plans, 403(b) tax-sheltered annuity plans, governmental
457 plans, SEPs, and SIMPLE plans.
Voluntary employee contributions to qualified retirement plans.
Contributions to 501(c)(18)(D) plans.
While a thorough understanding of the details of each plan type is not necessary at this time, it is
important to be aware of the types of plans that are available.
Generally, when qualified contributions are made by an employee to an employer-maintained plan,
they can be found in box 12 of their Form W-2 denoted by code D, E, F, G, H, or S. You may want to
review the box 12 codes for Form W-2 (Illustration 10.2).
Employers matching contributions do not count toward the credit. Also, mandatory contributions do
not qualify for the credit. Contributions are considered mandatory if they are required as a condition
of employment.
mExample: Michael Oxenbacher (46) voluntarily deferred $1,000 of his salary into his employers
401(k) plan. He also contributed $500 to a traditional IRA and $250 to a Roth IRA. All of these contributions are qualified contributions for the Savers Credit.m

10.18 H&R Block Income Tax Course (2015)

Contributions that qualify for the Savers Credit must be reduced by any distributions from the same
types of plans made in the two tax years prior to the current year until the due date of the current
years return (including extensions). Thus, for 2014, distributions made after December 31, 2011, and
before April 15, 2015, (October 15, 2015, if an automatic six-month extension was requested) reduce
the amount eligible for the credit.
mExample: Suppose that Michael Oxenbacher (from the preceding example) had taken a $600 distribution from his 401(k) plan on January 8, 2014. His $1,750 qualified contributions must be reduced
by the $600 distribution when computing the Savers Credit.m
The following do not reduce the amount eligible for the Savers Credit:
Distributions directly rolled over or transferred from one trustee to another.
Distributions of funds converted from a traditional IRA to a Roth IRA.
Loans from qualified employer plans treated as distributions.
Distributions of excess contributions or deferrals (plus earnings).
Distributions of contributions made during the tax year (plus earnings) and withdrawn before the
due date of the return (including extensions).
Distributions of dividends on stock held by an employee stock ownership plan.
Distributions from a military retirement plan.
mExample: On June 17, 2014, Robert Demler withdrew $1,300 from his traditional IRA. On August
13, 2014, he rolled over the funds into a new traditional IRA. On December 3, 2014, he contributed
$2,000 to the new IRA. Robert is not required to reduce his $2,000 contribution, which qualifies for
the Savers Credit, by the amount he rolled over in 2014. However, if he had kept the money from the
original distribution, he would have been required to reduce his qualified contribution to $700 [$2,000
$1,300 = $700].m

Amount of Credit
The Savers Credit is based on qualified contributions up to $2,000 per taxpayer or $2,000 for each
spouse on a joint return in 2014. The credit rates are 10%, 20%, or 50%, depending upon filing status
and modified AGI. In this case, AGI is modified only for certain excluded foreign and U.S. possession
income. The rates are shown on the following page in Illustration 10.8.

Retirement 10.19
Illustration 10.8

SAVERS CREDIT RATES


Modified Adjusted Gross Income
Married Filing
Head of Household
Jointly

All Others

Credit Rate

Up to $36,000

Up to $27,000

Up to $18,000

50%

$36,00139,000

$27,00129,250

$18,00119,500

20%

$39,00160,000

$29,25145,000

$19,50130,000

10%

Over $60,000

Over $45,000

Over $30,000

0%

The credit is computed on Form 8880, Credit for Qualified Retirement Savings Contributions, shown
in Illustration 10.8. The credit is then entered on Form 1040A, line 34.
mExample: Stephanie Ackerman (35) is a teacher using the head of household filing status. During
2014, she deferred $2,150 of her salary into her employers 403(b) tax-sheltered annuity plan. On
April 13, 2015, she contributed $4,000 to her Roth IRA for 2014. Back in 2012, she had withdrawn
$750 from the Roth IRA when she was having a tough time making ends meet. Stephanies modified
AGI is $33,600, and her Form 1040A, line 28, amount is $1,846. Based on Stephanies modified AGI,
she qualifies for a $200 retirement savings contributions credit (Savers Credit), which is reported on
her From 1040A, line 34. Her completed Form 8880 is shown in Illustration 10.9.m
Complete Exercise 10.4 before continuing to read.

SOCIAL SECURITY AND EQUIVALENT


RAILROAD RETIREMENT BENEFITS
Many taxpayers who are retired or disabled or whose spouses or parents are deceased receive social
security or equivalent tier 1 railroad retirement benefits (RRB). Like many other amounts in tax law
(such as the allowable standard deduction), social security benefit amounts are indexed for inflation,
which generally results in the benefit amount increasing from year to year.

10.20 H&R Block Income Tax Course (2015)


Illustration 10.9

Retirement 10.21

Depending upon each taxpayers situation, up to 85% of a taxpayers social security or equivalent
tier 1 RR benefits may be taxable. Taxpayers with income above a certain threshold will pay tax on
a portion of their benefits.
Note: For purposes of this section, the term social security benefits applies only to payments made
under the Old-Age, Survivors, and Disability Insurance (OASDI) program. OASDI benefits are funded
through the social security payroll tax, are based upon prior earnings, and may be partially taxable.
Social security benefits do not include Supplemental Security Income (SSI). SSI is a federal program
providing income assistance based on financial need for the aged, blind, and disabled. While the Social
Security Administration administers both programs, SSI benefits are not taxable.

Full Retirement Age


For workers born before 1938, full retirement age is age 65. The retirement age is gradually being
increased to age 67 for workers born after 1937. The table in Illustration 10.10 shows how this change
is being phased in. Barring change, the entire process will be complete in 2027.
Illustration 10.10

FULL RETIREMENT AGE


Year of Birth
1937 and earlier

Full Retirement Age


65 years

Year of Birth
19431954

Full Retirement Age


66 years

1938

65 years, 2 months

1955

66 years, 2 months

1939

65 years, 4 months

1956

66 years, 4 months

1940

65 years, 6 months

1957

66 years, 6 months

1941

65 years, 8 months

1958

66 years, 8 months

1942

65 years, 10 months

1959

66 years, 10 months

The full retirement age is 67 years for everyone born in 1960 and later.

Reporting Social Security and Equivalent Railroad Retirement Benefits


Form SSA-1099 is used to notify the taxpayer of total social security benefits received during the year.
This form is shown in Illustration 10.11. Form RRB-1099 is used to notify the taxpayer of tier 1 RRB
received during the year. This form is shown in Illustration 10.12.

10.22 H&R Block Income Tax Course (2015)


Illustration 10.11

Illustration 10.12

Retirement 10.23

Study Form SSA-1099, Social Security Benefit Statement, in Illustration 10.11 and Form RRB-1099 in
Illustration 10.12 as you read through the next section describing the forms. Note: There are minor
differences between the forms. The following references are for the SSA-1099.
Box 1. Recipients name.
Box 2. Recipients social security number.
Box 3. Total amount of benefits paid. This figure may not agree with the actual money the taxpayer
received due to adjustments for items withheld, such as Medicare Part B premiums. All adjustments
are itemized in the box labeled Description of Amount in Box 3 (SSA-1099).
Box 4. Recipients who have not yet reached full retirement age and who earned more than $15,480
in wages and net self-employment income during 2014 may be required to pay some of their benefits
back to the Social Security Administration. Box 4 shows the total amount of benefits repaid, if any.
The earnings limit, above which some benefits may need to be repaid, is $41,400 for taxpayers who
reached full retirement age in 2014. There is no earnings limit for recipients who reached full retirement age before 2014.
Box 5. Net benefits received. This amount is the difference between the figure in box 3 and the figure
in box 4.
Box 6 (Box 10 on RRB-1099). Taxpayers may choose to have federal income tax withheld from their
benefits. The amount of tax withheld is shown here and should be included on Form 1040A, line 40.

Computing Taxable Benefits


The amount of a taxpayers social security or tier 1 RRB subject to federal tax varies from zero to 85%,
depending upon filing status and income. The level of taxability is based on modified AGI (defined
below) increased by one-half of the net benefits received by the taxpayer (and spouse, if MFJ). See
Illustration 10.13 for the taxability ranges.
Illustration 10.13

TAXABLE SOCIAL SECURITY BENEFITS

S, HH, QW

None of Benefits
Taxable
$025,000

Up to 50% of Benefits
Taxable
$25,00134,000

Up to 85% of Benefits
Taxable
$34,001 & over

MFJ

$032,000

$32,00144,000

$44,001 & over

Filing Status

$1 & over
MFS*
* If married filing separately and did not live with spouse at any time during the year, use single.

10.24 H&R Block Income Tax Course (2015)

is a handy rule of thumb to help determine if a portion of social


TsecurityHere
or RRB benefits are taxable: Generally, if 50% of the total benefits
ax Tip:

plus all other income do not exceed $25,000 ($32,000 MFJ, $0 if MFS and the
taxpayers lived together at any point during the year), none of the benefits are
taxable.

Modified adjusted gross income is the sum of the following:


Regular AGI (without taking any social security or RRB tier 1 benefits into account).
Any excluded employer-provided adoption benefits.
Tax-exempt interest (for example, municipal bond interest).
Any interest from qualified U.S. Savings Bonds excluded because the taxpayer has qualified education costs.
Any excluded foreign earned income or housing allowance, or certain U.S. possession income.
Any student loan interest deduction.
Any tuition and fees deduction.
Any domestic production activities deduction.
H&R Block provides a worksheet you will use to determine the taxable amount of social security benefits. The BlockWorks Social Security Taxable Benefits Worksheet is shown in Illustration 10.14. The
worksheet looks intimidating, but dont worryit is very easy to use if you read each line carefully
and follow the instructions.
The taxable amount of the social security or RRB income appears on line 19 of the worksheet.
If line 19 of the worksheet shows that some of the benefits received are taxable, enter the taxable
amount on Form 1040A, line 14b. Also, enter the benefits received (line 1 of the worksheet) on line
14a.
If line 19 of the worksheet shows that none of the benefits received are taxable, enter net benefits
for this income on Form 1040A, line 14a, and enter $0 on line 14b. If the taxpayer is married filing a
separate return and did not live with their spouse at any time during the year, they would also enter
D in the space to the left of line 14a and enter $0 on line 14b.
mExample: Samuel and Carol Walters are filing a joint return. Their Form 1040A, before calculating
taxable social security, shows AGI of $50,000, made up of the following entries:
Line 7 (wages) $40,000.
Line 8a (taxable interest) $10,000.
They also received nontaxable municipal bond interest of $2,000 (Form 1040A, line 8b). Box 5 of Sams
Form SSA-1099 shows $6,000.
On Form 1040A, $6,000 is entered on line 14a, and $5,100 is entered on line 14b. The Walters Social
Security Taxable Benefits Worksheet is shown in Illustration 10.14.m

Retirement 10.25
Illustration 10.14

10.26 H&RBlock Income Tax Course (2015)

Tier 1 Railroad Retirement Benefits


Generally, social security benefits and tier 1 RBB receive the same tax treatment. However, railroad
retirement disability benefits that are payable to individuals who would not be entitled to social security disability benefits, or that are in excess of the social security benefits to which an individual would
be entitled, generally are fully taxable. Similarly, railroad retirement benefits that are payable at an
age earlier than comparable social security benefits, or in an amount greater than the social security
benefits, are generally fully taxable. See IRS Publication 575, Pension and Annuity Income, for more
information. Railroad retirement benefits described in this paragraph are reported to the taxpayer
on Form RRB-1099-R (rather than on Form RRB-1099) and are treated as pension income. Pension
income is discussed in the next section.
Complete Exercise 10.5 before continuing to read.

RETIREMENT ACCOUNT DISTRIBUTIONS


A distribution is when a taxpayer takes money out of a retirement account. Generally, distributions
from pensions, annuities, profit-sharing and retirement plans (including 457 state and local government plans), IRAs, insurance contracts, etc., are reported to the recipient taxpayer on Form 1099-R,
Distribution From Pension, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts,
etc. This form is shown in Illustration 10.15.
Illustration 10.15

Retirement 10.27

Study Form 1099-R in Illustration 10.15 as you read through the next section describing this form.
Box 1. Gross distribution. This is the gross amount the taxpayer received for the year.
Box 2a. Taxable amount. This is generally the taxable portion of the amount received. If there is
no entry in this box, the payer may not have all the facts needed to figure the taxable amount. In that
case, the first box in box 2b, taxable amount not determined, should be checked.
Box 2b. Taxable amount not determined. If the first box is checked, the payer was unable to
determine the taxable amount, and box 2a should be blank, except for an IRA. In that case, the recipient must compute the taxable amount.
Box 2b, Total distribution. If the total distribution box is checked, all the funds in the account
were distributed to close out the account. A lump sum distribution or rollover could trigger a total
distribution of account funds.
Box 3. Capital gain (included in box 2a). If the participant was in the plan prior to 1974, this
portion of the distribution may be eligible for the capital gain election. See the instructions for Form
4972 or IRS Publication 575.
Box 4. Federal income tax withheld. If any federal tax has been withheld, the amount is shown
here. Include this amount on Form 1040A, line 40.
Box 5. Employee contributions or insurance premiums. This box may contain the amount of
the employees after-tax contributions to the plan. If the Form 1099-R is for a pension rather than
a total distribution, the total employee contributions should be shown in box 9b in the first year of
periodic payments. For succeeding years, any amount shown in box 5 will be the amount of employee
contributions recovered tax-free during the year.
Box 6. Net unrealized appreciation in employers securities. Net unrealized appreciation
(NUA) is the untaxed increase in value in employers securities received as part of the distribution.
This amount generally is not taxed until the securities are sold. If you encounter a Form 1099-R with
an entry in box 6, you will need to do some reading about net unrealized appreciation. Here again, the
instructions for Form 4972 will give you a good start.
Box 7. Distribution code(s). As you know, this box contains one or two codes that describe the distribution. Although there may be both a number and a letter entered in box 7, there generally should
be no more than one of each.

10.28 H&R Block Income Tax Course (2015)

With all of the different types of distributions that can be reported on Form 1099-R, the list of codes
has grown quite long. Here is a list of the more common ones along with their meanings for 2014. A
complete list of codes can be found on the back of copy C of Form 1099-R. If you encounter a Form
1099-R with a code you do not understand, you will need to do some research or consult with a more
experienced Tax Professional:
1

Early distribution; no known exception to penalty applies (as far as the payer knows).

Early distribution; exception to penalty applies (for example, conversion to a Roth IRA).

Disability.

Death (includes payments to a beneficiary).

Normal distribution.

May qualify for ten-year averaging and/or capital gain election (as far as the payer knows).

Direct rollover to a qualified retirement plan, tax-sheltered annuity, 457(b) plan, or IRA, or
from a conduit IRA to a qualified plan.

Early distribution from a Roth IRA, no known exception to penalty applies (as far as the
payer knows).

Qualified distribution from a Roth IRA.

Roth IRA distribution due to death or disability or taxpayer has reached age 59, but the
payer does not know if the five-year holding period was met.

Box 8 is used to show the current actuarial value of an annuity contract. This amount may be needed
for Form 4972.
Box 9a is used when the total distribution is made to more than one person. The taxpayers percentage of the total distribution is shown here.
Box 9b shows the amount of the employees total investment in the retirement account. This amount
is used to compute the taxable portion of the distribution.
Boxes 1217. State and local tax information. Any state or local income tax withheld will be
shown in boxes 12 and 15, respectively. Enter these amounts on the appropriate lines of the state
and local tax returns. Also, include them in itemized deductions on line 5 of federal Schedule A, if the
taxpayer itemizes and does not elect instead to deduct state and local general sales taxes. If the state
or local distribution amount is different from the federal amount, the appropriate amounts will be
shown in boxes 14 and 17, respectively.

TAXABLE DISTRIBUTION
Distributions from a qualified retirement account are generally fully or partially taxable because the
retirement account was funded with pre-tax contributions and the earnings grew tax-free while in
the account. Depending on the type of retirement account the taxpayer owns may play a factor into
whether part of or the entire distribution is subject to tax.

Retirement 10.29

A fully taxable distribution is a distribution where the taxpayer did not make after-tax contributions
or is a distribution from which all after-tax amounts have been recovered in previous years.
If the taxpayer made no contribution to the pension plan or annuity (for example, the employer paid
all the costs), or if the taxpayer made only pre-tax contributions to a plan (such as in a 401(k) plan),
the entire distribution amount received during the year is taxable.
Examine line 12 on the first page of Form 1040A. When a distribution from a retirement account,
excluding an IRA, is fully taxable, enter the total amount directly on line 12b and make no entry on
line 12a.
mExample: Harry Murphy (67) receives a fully taxable monthly distribution from his 401(k) of $1,600
($19,200 annually). His Form 1099-R is shown in Illustration 10.15. Harry's fully taxable 401(k) distribution of $19,200 is reported on his Form 1040, line 12b.m
A partially taxable distribution is a distribution where the taxpayer is made after-tax contributions to the retirement account. When the taxpayer receives a distribution from this account, a portion
of the distribution represents a nontaxable return of their after-tax contribution (investment or cost).
Fortunately, most payers will have the required information to compute the taxable amount of the
distribution and report it to the recipient on Form 1099-R, box 2a. For payers who do not know the
amount of after-tax contributions made by the taxpayer, the payer will leave box 2a blank and check
box 2b, taxable amount not determined. In this situation, the taxpayer is required to determine
their taxable amount of the distribution.
When reporting a partially taxable distribution from a retirement account, excluding an IRA, the total
distribution amount received for the year is entered on Form 1040A, line 12a. The taxable amount is
entered on Form 1040A, line 12b.
There are several methods for computing the taxable amount of a partially taxable distribution.
Which one you will use depends mostly on when the payments started. The methods have undergone
considerable changes over the years, but we will concentrate on the most recent rules. The older general rule will be presented later for your awareness.
Simplified Method
The simplified method may be used to compute the taxable portion of a pension or annuity with a
starting date after July 1, 1986, where the taxpayer has after-tax contributions in the plan. The pension or annuity must meet the following three conditions to use the simplified method:
The payments must be from a qualified pension, profit-sharing, or stock bonus plan; a qualified
employee annuity plan; or a tax-sheltered annuity (403(b) plan).
The annuitant (the receiver of the payments) must be under 75 years of age when the payments
begin, or, if 75 or older, there must be fewer than five years of guaranteed payments.
The payments are for either the annuitants life or the joint life of the annuitant and a beneficiary.

10.30 H&RBlock Income Tax Course (2015)

Under the simplified method, the taxpayers excludible amount is determined by using a simple table.
The table included on the Simplified Method Worksheet shows the anticipated number of monthly
payments based on the age of the annuitant(s) for a pension or annuity starting after November 18,
1996. Note, the joint and survivor columns are to be used only for pensions and annuities starting
after December 31, 1997.
The age of the taxpayer is their age on the date the pension payments begin. This is important to note
since often a pension will begin in a year before the taxpayer reaches their full retirement age.
mExample: Thomas Blooms birthday is November 15, 1949. His first pension payment was made
on March 1, 2014. Therefore, the age to use for the table is 64, as he would not reach age 65 until
November 15, 2014.m
The taxpayers after-tax investment, or cost, in the pension or annuity is divided by the appropriate
number from the table to determine the excludible amount of each payment.
For partly taxable pensions and annuities with starting dates after December 31, 1986, part of each
payment received is excludible until the taxpayer has recovered their cost. Once the cost is recovered,
the pension or annuity is fully taxable. If the taxpayer (and their beneficiary, in the case of a joint and
survivor annuity) dies before the cost has been fully recovered, the unrecovered amount is deducted
on the taxpayers (or beneficiarys) final return as a miscellaneous itemized deduction on their Form
1040, Schedule A.
The excludible amount of each payment never changes (until it ceases entirely when the final beneficiary dies or the cost is fully recovered), even though the annuity or pension payments may increase
due to cost-of-living provisions or for other reasons.
mExample: George Castle (69), a single taxpayer, began receiving a pension of $1,500 per month for
life from the Leisure Retirement Funding Pension Fund on March 1, 2014. His Form 1099-R is shown
in Illustration 10.16. Georges after-tax investment in the pension was $74,100. In 2014, he recovered
$3,529 of his investment ($352.86 per month for ten months). Georges Simplified Method Worksheet
is shown in Illustration 10.17. He will report $15,000 on line 16a (12a) and $11,471 on line 12b of his
2014 Form 1040A.m

entering a partially taxable qualified retirement plan


Bor traditional IRAWhen
distribution into BlockWorks, scroll to the bottom of the
lockWorks Tip:

pension input screen in BlockWorks. Here, you will make entries to compute
the taxable amount using the simplified method. Table 1 is used unless the
spouse is a beneficiary of the pension, in which case Table 2 is used and the sum
of both taxpayers ages is entered in the Age at starting date box, such as in
Illustration 10.18.

Retirement 10.31

General Rule
The general rule for calculating the excludible portion of pension and annuity payments may be used
if a taxpayer started receiving payments before November 19, 1996. If the taxpayer started receiving payments on or after that date, the simplified method must be used in most cases. In cases of
purchased annuities and other nonqualified plans, the general rule must be used regardless of the
annuity starting date.
Because the general rule involves using complex actuarial tables, we will not discuss it in this course.
If you encounter a pension or annuity that must be (or is being) recovered using the general rule, you
will need to do some research and partner up with an experienced Tax Professional. IRS Publication
939, General Rule for Pensions and Annuities, is a good place to start.
There was also a death benefit exclusion available for certain beneficiaries of pensions and annuities
in the past. This exclusion was repealed for deaths occurring after August 20, 1996. If you ever need
more information about this exclusion, see IRS Publication 939.
Complete Exercise 10.6 before continuing to read.

Illustration 10.16

10.32 H&R Block Income Tax Course (2015)


Illustration 10.17

Retirement 10.33
Illustration 10.18

IRA DISTRIBUTIONS
Distributions from traditional and Roth IRAs are also shown on Form 1099-R. If a distribution is from
an IRA (or a SEP or a SIMPLE IRA), an appropriate code will be entered in box 7, and the small box
to the right of box 7 will be checked.
Traditional IRAs. Distributions from traditional IRAs are usually reported on Form 1099-R as fully
taxable because the IRA trustee does not know how much, if any, of the taxpayers IRA contributions
were nondeductible. Sometimes, the Taxable amount not determined box is checked. If any nondeductible contributions had been made, the taxpayer must use Form 8606 to compute the taxable
portion of any distributions.
If the IRA distribution is fully taxable, enter the full amount on Form 1040A, line 11b. If the distribution is partly taxable, enter the gross amount on line 11a and the taxable portion on line 11b.
mExample: Mildred Zigler (69), a single taxpayer, withdrew $3,000 from her traditional IRA on
December 11, 2014. She made no contributions to her traditional IRA in 2014. Mildred has an $800
basis in her IRA from a nondeductible contribution she made in 1997 (report on Form 8606, line 2).
According to her IRA trustee statement, her IRA was worth $17,582 at the end of 2014 (report on
Form 8606, line 6). Midreds Form 8606 is shown in Illustration 10.19.
After completing Form 8606, Mildred will enter $3,000 on Form 1040A, line 11a and $2,883 on line
11b. The amount on line 14 of her Form 8606 is her remaining basis, and she will carry it to line 2
(unless the line number changes) of the next Form 8606 she files.m
Roth IRAs. Qualified distributions from Roth IRAs are exempt from tax. A qualified distribution is
one that:
Is taken after the end of the five-year period that began January 1 of the tax year for which the
account was set up.
Is made after the account owner has died, becomes disabled, or reaches age 59 or is used to buy,
build, or rebuild the taxpayers first home.
Part III of Form 8606 (on page 2, which is not shown) is used to determine the taxable amount of any
nonqualified distribution. If you need additional information, see IRS Publication 590.
Complete Exercise 10.7 before continuing to read.

10.34 H&R Block Income Tax Course (2015)


Illustration 10.19

Retirement 10.35

EARLY DISTRIBUTIONS FROM QUALIFIED RETIREMENT PLANS


The Tax Code imposes an additional 10% early withdrawal penalty tax on the taxable portions of most
early distributions from qualified retirement plans and IRAs. An early distribution generally is one
made before the taxpayer has reached age 59 and is denoted by code 1 in box 7 of Form 1099-R. The
10% early withdrawal penalty is only reported on Form 1040. There are, however, several exceptions
to the penalty available. The penalty does not apply to the recovery of cost (investment) or any amount
rolled over in a timely manner. See the IRS Publication 590-A, Contributions to Individual Retirement
Arrangements (IRAs) for a full discussion of IRA rollovers.
mExample: On June 4, 2014, Nahima Meda (33) left her job and took a total distribution from her
401(k) plan. Her Form 1099-R shows a fully taxable distribution of $9,700. She did not roll over any
of the money. The early distribution is also subject to a 10% penalty tax.m
The early distribution penalty is sometimes computed in Part I of Form 5329, shown in Illustration
10.20. There are several exceptions to the penalty. If any of these apply, a code is entered on Form
5329, line 2. The penalty will not apply in the following cases.
Note: Exceptions 01 and 06 do not apply to IRAs. Exception 02 applies to IRAs and to employer
plans, but only if the taxpayer no longer works for that employer. Exceptions 07, 08, and 09 apply
only to IRAs.
01

The distribution was made to an employee who separated from service during or after the
year in which they reached age 55 (age 50 for qualified public safety employees).

02

The distribution is part of a series of substantially equal periodic payments, made at least
annually for the life of the participant (or joint lives of the participant and beneficiary) or
the life expectancy of the participant (or the joint life expectancies of the participant and
beneficiary).

03

The distribution was made due to permanent and total disability.

04

The distribution was made due to the death of the employee.

05

The distribution was made in a year that (and to the extent that) the taxpayers unreimbursed medical expenses exceed 10% (7% if taxpayer or spouse is age 65 or older) of
adjusted gross income (whether the taxpayer itemizes or not).

06

The distribution was made to an alternate payee under a qualified domestic relations order
(usually a separation agreement or divorce decree).

07

The distribution was made from an IRA in a year (and to the extent that) an unemployed
taxpayer paid health insurance premiums.

08

The distribution was made from an IRA to pay qualified higher education expenses for the
taxpayer, spouse, their child, or their grandchild (whether or not the student is the taxpayers dependent).

09

The distribution (up to $10,000 lifetime limit) was made from an IRA to pay qualified firsttime homebuyer expenses.

10

The distribution was made due to an IRS levy of the qualified plan.

11

The distribution was made to a reservist while serving on active duty for at least 180 days.

12

Other. For other exceptions, refer to the instructions for Form 5329. Also, use this code if
more than one exception applies. For additional exceptions applicable to annuities, see IRS
Publication 575 or the instructions for Form 5329.

10.36 H&R
H&RBlock
Block Income Tax Course (2015)

Further explanation on some of the exceptions may be helpful at this point.


Age 55. Observe carefully the wording of exception 01. The recipient must have separated from the
service of their employer before receiving the distribution. They need not have actually reached their
55th birthday prior to the separation, as long as they do so by the end of the year.
Medical expenses. Exception 05 does not require that the money from the distribution itself be used
to pay the medical expensessimply that the taxpayers medical expenses for the year exceed 10% of
AGI (7% if taxpayer or spouse is age 65 or older), even if the taxpayer doesnt itemize. This exception
may apply to all or part of the distribution.
mExample: Alan Trimble is 40 years old and has an AGI of $40,000, including his $5,000 early IRA
distribution. His unreimbursed medical expenses total $4,800. Alan can escape penalty on $800 using
exception 05 [$4,800 ($40,000 2 10% = $4,000) = $800].m
Unemployed taxpayers. To qualify for exception 07, the distribution must be made to a taxpayer
who has received unemployment compensation payments for 12 consecutive weeks. This exception
does not apply to any distribution made more than 60 days after the taxpayer has returned to work.
This exception only applies to IRAs.
Qualified higher education expenses, for the purpose of exception 08, has the same meaning as
for the education credits, plus room and board if the student is enrolled on at least a half-time basis.
The expenses must be paid for the taxpayer, the spouse, or the child or grandchild of the taxpayer or
spouse. The child or grandchild need not be the taxpayers dependent.
mExample: In 2014, Carmen DiGiorgio (43) took $5,000 out of his traditional IRA to pay toward his
sons college tuition. The distribution is fully taxable, but not subject to the 10% penalty. His Form
5329 is shown in Illustration 10.20.m
Qualified first-time homebuying expenses, for the purpose of exception 09, are any costs of
acquiring or constructing a principal residence for a first-time homebuyer. The term first-time homebuyer is misleading; what it really means is someone who has not owned a home during the two-year
period prior to the date of acquisition of the home to which this exception applies.
The distribution must be used to pay qualified expenses within 120 days after the date of distribution. The expenses must be paid for the taxpayer, spouse, their child or their grandchild, or parent or
grandparent.
Five-year period. A Roth IRA distribution (up to $10,000) used to pay first-time homebuying
expenses not only meets the penalty exception but is not subject to taxation at all if it was made after
the end of the five-year period beginning with January 1 of the year for which the first contribution
was made. So, for example, if you first contributed to a Roth IRA for 2009, you could take a qualified
distribution of up to $10,000 to buy your first home any time after 2013and pay no tax or penalty!
The second page of Form 5329 contains a taxpayer signature section. The taxpayer (and paid preparer, if any) needs to sign Form 5329 and complete the address on page 1 only if the form is not attached
to a tax return, but is sent to the IRS by itself. That could happen, for example, if the taxpayer does
not meet the gross income filing requirements but had an early distribution subject to the penalty.

Retirement 10.37
Illustration 10.20
X.X

10.38 H&R
H&RBlock
Block Income Tax Course (2015)

If the only penalty a taxpayer owes is the 10% penalty for an early distribution and their Form 1099R correctly shows code 1, Form 5329 need not be completed if they meet none of the exceptions. Such
taxpayers may enter the 10% penalty directly on Form 1040, line 59, and write No to the left of the
line under the heading Other Taxes, indicating that there is no Form 5329 attached.
Complete Exercise 10.8 before continuing to read.

CHAPTER SUMMARY
In this chapter, you learned how to:
Explain the features of commonly available retirement accounts and the tax benefits of contributing to these retirement accounts.
Determine if a taxpayer is eligible to contribute to a traditional or Roth IRA as well as deductible
amount of traditional IRA contributions.
Determine a taxpayers eligibility for the retirement savings contribution credit and calculate the
amount of the retirement savings contribution credit.
Determine and accurately report the taxable portion of social security or tier 1 railroad retirement
benefits.
Identify and accurately report taxable qualified retirement plan and IRA distributions.
Explain the consequences of early retirement plans and IRA distributions.

Suggested Reading
For further information on the topics discussed in this chapter, you may wish to read the following
sections in IRS Publication 17:
Chapter 10, Retirement Plans, Pensions, and Annuities.
Chapter 11, Social Security and Equivalent Railroad Retirement Benefits.

Retirement 10.39

Our client turned 55


Tin 2014 and took three early distributions from three different
401(k) plans
he Tax Institute Tax in the News Research Question:

during 2014. Two of the 401(k)s are with his two former employers, and one is
with his current employer. Can the age 55 exception apply to all three distributions, or only to the two from the clients previous employers?

nswer: From the facts you have given, all three of the 401(k) distributions
are subject to the 10% early distribution penalty. In order to apply the
72(t)(2)(A)(v) age 55 penalty exception to an early distribution from a retirement plan, two conditions must be met:
1. The distribution must be made to an employee after he or she has separated
from service with the employer maintaining the plan.
2. The separation must occur during or after the calendar year in which the
employee attained age 55.
Unfortunately, many taxpayers do not understand this second condition. They
mistakenly believe that as long as they are either retired or no longer working
for a particular employer, they are free to begin taking distributions from their
former employers plan once they turn 55.
The second condition means that if the separation from service occurs before
the year the employee turned 55whether because of retirement, changing
jobs, a lay-off, etc.the age 55 exception does not apply to that employers plan.
While the distributions from your clients former employers meet the first condition, i.e., they were made after he separated from service, they do not meet
the second condition because he left those companies before the year in which
he turned 55. The distribution from your clients current employers plan clearly
does not qualify for the exception because he has not separated from service for
this employer. Thus, the three distributions are subject to the early withdrawal
penalty unless another exception applies.
Note: It is not clear why your client was able to take a 401(k) distribution from
his current employer. In general, a plan distribution is not permitted unless
an employee has reached age 59, or has left the employer, or is eligible for a
hardship distribution. Plans may allow hardship distributions for certain contingencies, but they are subject to the early distribution penalty.

11

Midterm Review
OVERVIEW
This is a self-study chapter designed to prepare you for the midterm exam. The review consists of:
A game in Compass that focuses on tax theory covering the following:
Correct and most favorable 2014 filing status.
Greatest number of personal and dependent exemptions.
Eligibility to claim the Child Tax Credit.
Determining tax liability according to the tax tables.
Miscellaneous tax topics covered in Chapters 15.
The hand-preparation of two tax returns that include tax topics covered in Chapters 15.
Form 1040EZ.
Form 1040A.

INSTRUCTIONS
During the midterm review, you should use your textbook, along with any notes you took in class.
You are also encouraged to take additional notes, as needed. You may find it helpful to have a copy of
the Tax Season 2015 Desk Card and copies of 2014 Forms 1040EZ and 1040A where they are readily
available for viewing. The Desk Card can be found in the appendix on page A.24. You can see copies
of Forms 1040EZ and 1040A in Chapter 1, beginning on page 1.12.

11.1

12

Midterm Exam
OVERVIEW
This entire session will be devoted to the midterm exam. The midterm will consist of three parts:
Part I Five questions for you to determine a taxpayers:
Correct and most favorable 2014 filing status.
Greatest number of personal and dependent exemptions.
Eligibility to claim the Child Tax Credit.
Tax liability, using the tax tables.
Part II Ten multiple-choice questions, which may cover any material presented in Chapters 15.
Part III Two tax returns, which you must complete by hand. You will then enter specific information into the online exam.

INSTRUCTIONS
To complete the midterm exam, you should do both tax returns by hand before going to the computer.
Your instructor will give you directions about completing the returns. Once you complete the returns
to your satisfaction, go to your computer, enter Compass, and access your midterm exam.
When you access the site, Part I of the exam will appear. Answer those questions, and then you will
see Part II. After entering the answers for both Part I and Part II, Part III will appear. Use the information from the returns you just completed to enter the requested information.
The midterm is open-book, and you may also use any notes you have taken during the class. You may
find it helpful to have a copy of the Tax Season 2015 Desk Card and copies of 2014 Forms 1040EZ
and 1040A where they are readily available for viewing. The Desk Card can be found in the appendix
on page A.24. You can see copies of Forms 1040EZ and 1040A in Chapter 1, beginning on page 1.12.

12.1

13

Form 1040
OVERVIEW
In this course, you will learn about the Form 1040 and when a taxpayer is required file a Form 1040.
This course will also discuss the common items of income, adjustments, credits, and taxes reported
on the Form 1040. It is important to be aware of these common items of income, adjustments, credits,
and taxes reported on the Form 1040 so that, when you encounter them, you may properly prepare a
Form 1040 return for the taxpayer.

OBJECTIVES
At the conclusion of this course, you will be able to:
Identify when a taxpayer is required to file a Form 1040.
Compute adjusted gross income, taxable income, and tax liability on Form 1040.
Identify common types of other income reported on Form 1040.
Identify common income adjustments reported on Form 1040.
Calculate personal exemption phaseout.
Identify common tax credits reported on Form 1040.
Identify additional taxes reported on Form 1040.

TAX TERMS
Look up the definitions of the following terms in the glossary:
Alimony payments.
Child support payments.
Health savings account (HSA).
Necessary (expenses).
Ordinary (expenses).
Adoption credit.
Special needs child.

13.1

13.2 H&RBlock Income Tax Course (2015)

FORM 1040
In this course, you will learn about who must file a Form 1040. Then the course will discuss the common Form 1040 items of income, adjustments, credits, and taxes so that, when you encounter them
at the tax desk, you may properly prepare a Form 1040 return for the taxpayer.
The Form 1040 is often referred to as the long form, because it is the most comprehensive of the
three forms. Its the catch-all form that reports all types of income, all types of income adjustments,
and all types of tax credits. It also computes all forms of tax to which an individual is subject to. This
means that the Form 1040 contains all items of income, income adjustments, tax credits, and tax
reported on both Form 1040EZ and Form 1040A.
Similar to the Form 1040EZ and Form 1040A, the Form 1040 computes the taxpayers income tax
liability by first taking the taxpayers total income less income adjustments to compute the adjusted
gross income (AGI) which is reported on Form 1040, line 37. Looking at Illustration 13.1, the Form
1040, page 1, shows that the taxpayers total income, line 22, is calculated by adding up lines 721.
Then the taxpayers total adjustments shown on line 36, is calculated by adding up the taxpayers
total income adjustments reported on lines 2335.
The next step is to determine the taxpayers taxable income, which is reported on Form 1040, line 43.
Taxable income is computed by taking the taxpayers AGI less their allowable standard deduction per
filing status or total itemized deductions and then subtracting the taxpayers total personal exemption
amount. In Illustration 13.2, the Form 1040, page 2, shows that the taxpayers standard deduction
or total itemized deductions is entered on line 40 and their total exemption amounts are entered on
line 42.
The next step is to calculate the taxpayers income tax based on their taxable income. This tax is
reported on Form 1040, line 44. Generally, the Tax Table is the most common way of computing tax for
taxpayers whose taxable incomes are less than $100,000. However, the Tax Computation Worksheet
is required if taxable income is $100,000 or more. There are also several other methods of computing
the tax for taxpayers with special situations. For example, if a taxpayer has long-term capital gains
reported on Form 1040, line 13, the Qualified Dividends and Capital Gain Tax Worksheet, line 44, is
used to compute their income tax on Form 1040, line 44.
Next, the nonrefundable credits reported on Form 1040, lines 4854, are used to reduce the income
tax computed on line 44. Then, additional taxes reported on Form 1040, lines 5762, are added to
compute the taxpayers total tax. Lastly, the total tax is reduced by federal income tax withheld, estimated tax payments, and refundable credits reported on Form 1040, lines 6473, to determine if the
taxpayer overpaid tax or has a tax balance due.

Tax Essentials Form 1040 13.3


Illustration 13.1

13.4 H&R Block Income Tax Course (2015)


Illustration 13.2

Tax Essentials Form 1040 13.5

WHO MUST FILE FORM 1040


Who is required to file a Form 1040? Generally, this would be a taxpayer who has an item of
income, income adjustment, tax credit, or additional tax not reported on Form 1040EZ or 1040A.
Unfortunately, that answer lacks substance and direction. A better answer would be the following:
A taxpayer must file Form 1040 under certain circumstances, such as:
1. Their taxable income is $100,000 or more.
2. They have certain types of income such as:
Income from self-employment (business, rental, or farm income). These taxpayers may owe
self-employment tax, as well as possibly qualify for the self-employment tax deduction and
health insurance deduction.
Certain unreported tips subject to Social Security and Medicare tax.
Income received as a partner in a partnership, shareholder in an S corporation, or a beneficiary
of an estate or trust.
Dividends on insurance policies if they exceed the total of all net premiums they paid for the
contract.
Distribution from a foreign trust.
Taxable alimony from their ex-spouse.
Taxable refunds, credits, or offsets of state and local income taxes.
Other gains or losses reported on Form 4794.
3. They can exclude certain types of income such as:
Foreign earned income they received as a U.S. citizen or resident alien.
Certain income received from sources in Puerto Rico if they were a bona fide resident of Puerto
Rico.
Certain income received from sources in American Samoa if they were a bona fide resident of
American Samoa for all of 2014.
4. They have certain income adjustments such as:
Deductible health savings account contributions.
Deductible moving expenses incurred during the year.
Penalty on early withdrawal of savings.
Deductible alimony paid to their ex-spouse.

13.6 H&RBlock Income Tax Course (2015)

5. They itemize deductions or claim certain tax credits or adjustments to income, or


6. They owe additional taxes such as:
Household employment taxes reported on Schedule H (Form 1040).
Excise tax on insider stock compensation from an expatriated corporation.
Social Security and Medicare tax on wages earned as an employee which their employer did not
withhold.
Additional Medicare Tax or had Additional Medicare Tax withheld and must file Form 8959.
Net Investment Income Tax and must file Form 8960.
Additional tax on IRAs, other qualified retirement plans, etc., reported on Form 5329.
7. They have an alternative minimum tax adjustment on stock they acquired from the exercise of an
incentive stock option.
8. They had a qualified health savings account funding distribution from their IRA.
9. They are a debtor in a bankruptcy case filed after October 16, 2005.
10. They must repay the first-time homebuyer credit reported on Form 5405.
11. They had foreign financial assets in 2014 and must file Form 8938.
12. They are claiming the following tax credits:
The adoption credit or you received employer-provided adoption benefits. See Form 8839 for
details.
Residential energy credits reported on Form 5695.
General business credits reported on Form 3800.
Minimum tax credit reported on Form 8801.
Note: The list above is not all inclusive and a tax situation may exist that is not listed above which
requires a taxpayer to file a Form 1040. This list is based on information provided on the IRS website,
as well as Form 1040A instructions.

FORM 1040 OTHER INCOME


When preparing a return for a taxpayer, it is important to understand and recognize the more common types of other income reported on Form 1040. These types of income may include alimony, gambling winnings, prizes and awards, jury duty, and hobby income.

Tax Essentials Form 1040 13.7

Long-Term Disability Income


The taxability of long-term disability benefits depends on who paid the disability policy premiums
and whether the disability premiums were paid with pre- or after-tax dollars. Generally, if a taxpayer
retires on disability and the taxpayer paid the premiums with after-tax dollars, then the taxpayers
disability benefits received are tax-free. If a taxpayer retires on disability and the employer or taxpayer paid for the policy with pre-tax dollars, generally, the taxpayer must include in income any
disability benefits received. How the taxable disability benefit is reported on the tax return depends
upon the taxpayers age when the benefit is received:
Until the taxpayer reaches minimum retirement age, the disability pension payments are reported
as wage income (and considered earned income) on Form 1040 and Form 1040A, line 7.
Beginning on the day after the taxpayer reaches minimum retirement age, the disability pension
payments are reported as pension income on Form 1040, line 15a and 15b, or Form 1040A, lines
12a and 12b.
Reporting the disability income as wages can be a little confusing, especially since the taxpayer
receives a Form 1099-R from their employer to report the payments received. Fortunately, disability
pension income is identified with code 3 in Form 1099-R, box 7. Refer to the Form 1099-R example
in Illustration 13.3.
When determining how the taxable disability benefit is reported on
Tthe taxpayers
return, the minimum retirement age for the taxpayer is the
ax Tip:

age at which the taxpayer could have first received a pension or annuity from
the employer if they were not disabled. If the taxpayer does not know if they
have reached the minimum retirement age, please refer the taxpayer to their
employers Human Resources (HR) department (or even better, contact the HR
department while the taxpayer is with you at the tax desk) to find out for certain.

Reporting Disability Benefits


As mentioned earlier, until the taxpayer reaches minimum retirement age, taxable disability pension
payments, reported on Form 1099-R, box 2a, taxable amount, are entered as wage income on Forms
1040 and 1040A, line 7.
Note: Once the taxpayer reaches minimum retirement age, all of their disability pension income for
that year (and subsequent years) is considered and reported as pension income on Form 1040, line
15a and 15b or Form 1040A, lines 12a and 12b. There is no proration in the year the taxpayer reaches
minimum retirement age.

13.8 H&RBlock Income Tax Course (2015)

entering taxable disability benefits in BlockWorks,


Byou will enter theWhen
taxpayers Form 1099-R in the Pension input screen.
lockWorks Tip:

After you have entered the Form 1099-R information into the software and you
have determined that the disability benefit is considered wages, check the box
Disability income is earned income in the Special Treatments section within
the Pension input screen. See Illustration 13.4.

mExample: In 2013, William Turner (45) was injured on the job, and on January 1, 2014, his doctor
made the decision that he was permanently and totally disabled. At that point, William retired early
on long-term disability from his employer, A1 Manufacturers. William is receiving benefits under a
long-term disability plan provided by and premiums paid for by his employer. Williams Form 1099-R
is shown in Illustration 13.3.
Because Williams employer paid the disability premiums and William has not reached the minimum
retirement age, the entire $16,954 of disability benefits is taxable and reported as wages on his Form
1040, line 7. Illustration 13.4 shows a BlockWorks screen shot of Williams Form 1099-R information
entered into the software, and Williams Form 1040, page 1, is shown in Illustration 13.5.m

Unreported Tips
Ideally, a tipped employee reports all of their tip income to their employer, and the employer withholds all the required Social Security and Medicare taxes (as well as the appropriate income taxes)
on those tips. The amount of tips the employee reported is included in box 7 of their Form W-2 and is
also included in boxes 1 and 5. The box 1 amount is reported on the employees tax return.
However, sometimes an employee does not report all of their tips to their employer. Even so, tip
income that was not reported to the employer is still subject to income tax, Social Security tax, and
Medicare tax, and must be reported on the tax return.
An employee is not required to report to the employer tip income of less than $20 from any one job
during a calendar month. Such tips that were not reported are entered directly on the wages line of
the tax return. These tips are not subject to Social Security or Medicare tax, but are subject to income
tax.
Employees who have $20 or more in a month in tips from any one job are required to report their tips
to their employers by the tenth day of the following month. Properly reported tips are treated as being
paid in the month they are reported. For example, tips received in December 2013 and reported to the
employer by January 10, 2014, will be included in the employees W-2 for 2014. Tips not reported to
the employer on a timely basis must be included in income in the year received. So, tips received in
December 2013 and not reported by January 10, 2014, must be included on the employees 2013 tax
return by including the unreported tip amount on Form 1040, line 7. Employees with unreported tips
totaling $20 or more in a calendar month must also complete Form 4137 to calculate the amount of
Social Security and Medicare tax due.

Tax Essentials Form 1040 13.9


X.X
Illustration 13.3

Illustration 13.4

13.10 H&R Block Income Tax Course (2015)


Illustration 13.5

Tax Essentials Form 1040 13.11

mExample: Julienne Markson worked as a server during the first part of 2014. Julienne thought she
had reported all of her tips to her employer, Dons Speedway Grill and Bar. However, when she began
her tax return for 2014, she discovered she had not reported two months of tips. She did not report
$255 of tips for the month of April and $18 of tips for the month of May. January through March,
she had reported $1,021 of tips to her employer. All of Juliennes unreported tips, $273, are subject
to income tax and reported on Form 1040, line 7. Because Juliennes May tips are below $20, she is
only required to pay Social Security and Medicare tax on her $255 of April unreported tips. Juliennes
Form 4137 is shown in Illustration 13.6.m

Allocated Tips
Certain dining establishments, where tipping is customary, must allocate tip income to their directlytipped employees if the employees do not report a specified minimum amount of tips to the employer.
Any amount shown in box 8 is not included in box 1, and taxes have not been withheld from it.
If a taxpayer has an amount shown in the allocated tips box, they must report that amount, in addition to the amount in box 1, as income on their return, unless they have kept sufficient records to
show they did not actually receive some or all of the money. For this reason, it is important for tipped
restaurant employees to keep accurate, timely records of tips received. If a taxpayer is required to
report any allocated tips on their return, they must also file Form 4137 in order to determine the
amount of Social Security and Medicare tax that they must pay.

Employee Treated as an Independent Contractor


Taxpayers who believe they were employees whose employers did not withhold Social Security and
Medicare tax from their wages must use Form 8919, Uncollected Social Security and Medicare Tax
on Wages, to figure and report their share of uncollected Social Security and Medicare taxes. After
calculating the Social Security and Medicare taxes on Form 8919, these taxes are carried to Form
1040, line 58.

Complete Exercise 13.1 before continuing to read.

13.12 H&R Block Income Tax Course (2015)


Illustration 13.6

Tax Essentials Form 1040 13.13

Alimony
Alimony is a payment made to a person pursuant to an agreement or a court decree of divorce or
separation. If a taxpayer is receiving taxable alimony, it is included in income on Form 1040, line 11.

Bartering
Bartering is the trading of one item or service for another. Generally, there is no cash exchanged.
Bartering may take place on an informal basis between individuals and businesses, or it can take
place on a third-party basis through a modern barter exchange company. Taxpayers must include
in their income, at the time received, the fair market value of property or services they receive from
bartering. If they exchange services with another person and both parties have agreed ahead of time
on the value of the services, that value will be accepted as fair market value, unless the value can be
shown to be otherwise.
Generally, income from bartering is reported on Schedule C, Profit or Loss From Business, or Schedule
C-EZ, unless something other than services is exchanged.
mExample: Sam owns an apartment building. In exchange for six months rent-free use of an apartment, an artist gave Sam a work of art she created. Sam must report the fair market value of the art
as rental income on Schedule E, Supplemental Income or Loss, and the artist must report the fair
rental value of the apartment as income on Schedule C or Schedule C-EZ.m

Gambling Winnings
The gross amount of a taxpayers gambling winnings is taxable. This includes amounts won from lotteries, casinos, races, raffles, etc. All winnings are taxable whether or not the winner received a Form
W2G. Gambling winnings, along with several types of other income, are reported on Form 1040, line
21.
Withholding of income tax from certain gambling winnings is required. If a taxpayer had tax withheld
from their winnings, they will receive a Form W-2G, which should be attached to and filed with Form
1040. The tax withheld is included on Form 1040, line 64.
mExample: James Kennedy took a chance one day and bought a $1 scratch-off lottery ticket. It was his
lucky day because he won $100,000! The IRS requires a mandatory 25% withholding on winnings that
exceed $5,000. James received a check for $75,000 and has $25,000 of withholding to report. James
Form W-2G is shown in Illustration 13.7.m
losses may not be netted out of the gross winnings.
TGamblingGambling
losses can only be deducted as an itemized deduction on Form
ax Tip:

1040, Schedule A, and only to the extent of winnings. So, if a taxpayer has gambling losses during the year and no gambling winnings, they are not eligible to
deduct their gambling losses.
t is also important to advise taxpayers who have gambling losses to be certain they maintain full and timely documentation of their wagering amounts,
dates, winnings, and losses. The IRS has been known to audit taxpayers gambling winnings and losses reported on their return. Without proper documentation, the IRS has disallowed gambling losses reported on Schedule A.

13.14 H&RBlock Income Tax Course (2015)


Illustration 13.7

Line 21 Income
In addition to gambling winnings, there are several other types of income that may be reported on
Form 1040, line 21. When one entry is made on line 21, the type and amount of income (for example,
Prize $45 or Jury pay $50) needs to be written directly on Form 1040. When more than one entry
needs to be made on line 21, it is necessary to include a statement showing the required information,
and only the sum of these total amounts is placed directly on line 21. Related expenses generally may
be deducted on Form 1040, Schedule A, which is not covered in this course. Form 1040, line 21, Types
of Income, include the following:
Prizes and awards for which no services were performed. Examples include cash and merchandise won in sweepstakes, in contests, and on game shows. These items may or may not be shown in
box 3 of a Form 1099-MISC, but they are taxable, nonetheless. If a prize or award is compensation
for services performed, as one may receive from an employer, the value should be included in the
wages of the recipient (unless the value of the prize is negligible).
Jury duty pay is taxable. However, if an employee is required to surrender his jury duty pay to his
employer in exchange for his regular pay, the amount surrendered may be deducted as an adjustment to income on Form 1040, line 36. Form 1040 adjustments are discussed later in the course.

Tax Essentials Form 1040 13.15

Canceled debts. If a taxpayer has a debt canceled or forgiven, the amount canceled is usually
taxable income. The taxpayer may receive Form 1099-C, Cancellation of Debt, from the creditor.
If you encounter a taxpayer with canceled debt or foreclosure of property, these are complicated
topics and generally require more research and experience to accurately report on a tax return.
Please partner with a more experienced Tax Professional. For more information about this topic,
see IRS Publication 17.
Reimbursements for items (other than state and local income taxes) deducted in an earlier year,
such as medical expenses, real estate taxes, or general sales taxes.
Alaska Permanent Fund dividends, distributed to residents of Alaska by the state, are taxable
but are not treated as dividends for tax purposes.
Rental of personal property. Income from the rental of personal property, such as equipment, if
the taxpayer is not in the business of regularly renting such property. Not-for-profit rental income
is also reported on Form 1040, line 21.
Taxable distributions from a health savings account (HSA) or an Archer MSA.
Distributions from these accounts may be taxable if (a) they are more than the unreimbursed qualified medical expenses of the account holder or (b) they were not included in a qualified rollover.
The distributions may also be subject to a penalty.
Amounts deemed to be income from an HSA because the taxpayer did not remain an eligible individual during the testing period.
Medical trial income. The compensation received by taxpayers who participate in medical trials
is taxable and generally reported on Form 1040, line 21. In most cases, taxpayers who participate
in such studies will receive a Form 1099-MISC reporting the medical research compensation
received. It is a common misconception that income reported on Form 1099-MISC is automatically
self-employment income reported Schedule C or C-EZ and subject to self-employment tax. However,
in most cases, these taxpayer are not considered to be in the trade or business of participating in
medical research studies and thus their income, while taxable, is not self-employment income.
If the taxpayer is in the trade or business of participating in mediTcal research
studies or trials (in other words, if the taxpayers profession is
ax Tip:

participating in such studies), income received is considered self-employment


income reported on Schedule C or C-EZ and subject to self-employment tax. If
you encounter a taxpayer with such a situation, please partner with an experienced Tax Professional in your office to ensure the income is reported properly.

Hobby income. Gross income from a hobby is taxable. Expenses, to the extent of hobby income,
are deductible as a miscellaneous itemized deduction on Schedule A.

13.16 H&RBlock Income Tax Course (2015)

Hobby vs. Business Activity


It is sometimes difficult to distinguish between an activity engaged in as a business and one engaged
in as a hobby. The determining factor is usually the intent of the taxpayerthat is, is the taxpayer
engaged in an activity with the intent of making a profit? However, the IRS may rule that an activity
is a hobby if it does not make a profit in at least three out of five years.
As discussed earlier, if an activity constitutes a hobby, then income is reported on Form 1040, line 21
and expenses on Form 1040, Schedule A. If an activity constitutes a business, Schedules C or C-EZ
(Schedule F for farming) must be used to report income and expenses.
the determination of hobby vs. business is truly a case-by-case
Tdecision,While
the IRS does publish guidance to help taxpayers determine if they
ax Tip:

carry on a business or a hobby. This IRS guidance can be found in Chapter 1 of


IRS Publication 535, Business Expenses.

FORM 1040 ADJUSTMENTS


When preparing a return for a taxpayer, it is important to understand and recognize the more common types of income adjustments reported on Form 1040. These types of adjustments include certain
business expenses for reservists, performing artists, fee-basis government officials, health savings
account (HSA) deductions, moving expenses, penalty on early withdrawal of savings, alimony payments, and other write-in adjustments to income.

Certain Business Expenses of Reservists, Performing Artists, and Fee-Basis


Government Officials
Armed Forces reservists, government officials who are paid on a fee basis, and performing artists may
be entitled to deduct certain business expenses as an adjustment to income on Form 1040, line 24. A
full discussion of who may claim this adjustment can be found in H&R Blocks Advanced Employee
Business Expense course.

Health Savings Accounts (HSAs)


Health savings accounts (HSAs) are tax-advantaged savings accounts used by eligible taxpayers
to pay current and future medical expenses. From a tax standpoint, HSAs represent the best of all
worlds:
After tax contributions to HSAs are tax deductible (subject to limitations) on Form 1040, line 25.
Employers may allow employees to make pre-tax contributions to their HSAs through their cafeteria (125) plans. These contributions are not deductible on Form 1040, line 25 because the contribution was made pre-taxed.

Tax Essentials Form 1040 13.17

If the employer contributes to the employees HSA, the contributions are tax-free. However, the
employers contribution reduces the total amount an employee can contribute to their HSA. HSA
contributions made through a cafeteria plan are reported on the employees Form W-2, box 12,
code W.
Other parties (such as relatives) may contribute to the taxpayers HSA on their behalf, and the
taxpayer may be eligible to deduct the contributions.
Account funds grow within the account tax-free.
Distributions are exempt from taxation, provided they are used to pay qualified medical expenses.
Eligibility
To qualify to contribute to an HSA, an individual must:
Be in a high-deductible health plan (HDHP).
Not be covered by other health insurance, including Medicare. (Accident, disability, dental, vision,
and long-term care coverage are allowed.)
Not be eligible to be claimed as a dependent on someone elses return.
For HSA purposes, an HDHP is a health insurance plan with a minimum annual deductible of $1,250
for self-only coverage, or $2,500 for family coverage, and maximum annual out-of-pocket expenses not
exceeding $6,350 for self-only coverage, or $12,700 for family coverage (for 2014).
Taxpayers who are eligible for an HSA on the first day of the last month of the tax year are considered eligible for the whole year, provided that they remain eligible during the testing period. For this
purpose, the testing period begins with the last month of the tax year and ends on the last day of the
12th month following that month.
In addition to the deductible and out-of-pocket requirements, an HDHP must not provide any benefits (other than those for preventive care) until the minimum annual deductible is met. Examples of
preventive care include:
Periodic health evaluations, such as an annual physical examination.
Routine prenatal and well-child care.
Screenings for a wide variety of ailments.
Child and adult immunizations.
Tobacco cessation programs.
Obesity weight-loss programs.
Screening services (for cancer and heart and vascular diseases; see IRS Publication 969 for a complete list).

13.18 H&RBlock Income Tax Course (2015)

Qualified Medical Expenses


Qualified medical expenses for HSA purposes are unreimbursed medical expenses that would normally be deductible on Schedule A. However, they do not include insurance premiums, except those for:
Long-term care (LTC) insurance.
Health care continuation coverage (such as coverage under COBRA).
Health care coverage while receiving unemployment compensation.
Medicare or other health care coverage for taxpayers age 65 or older (other than premiums for a
Medicare supplement policy).
The HSA must be established and funded before the qualified expenses are incurred.
Contribution Limits
The maximum annual HSA contribution for 2014 is $3,300 for self-only coverage or $6,550 for family
coverage. This amount must be reduced by any employer contributions made to the employees HSA,
Archer MSA, or any qualified HSA funding distributions.
Taxpayers who have reached age 55 by December 31, 2014, may make an additional catch-up contribution of up to $1,000 for 2014. For example, if the taxpayer has self-only coverage, they can contribute up to $4,300 [$3,300 self-only contribution limit + $1,000 age 55 additional contribution = $4,300].
There are no income limits or phaseout ranges with regard to HSA contributions. Taxpayers who
qualify to make HSA contributions may make them up to the due date of their return. This mean that
a taxpayer has until April 15th, 2015 to make an after-tax contributions to their HSA and deduct the
contribution on their 2014 Form 1040, line 25.
mExample: Betty Sloan (40) is single and self-employed. She purchases her own self-only HDHP
insurance plan. She may, by April 15, 2015, establish an HSA and contribute $3,300 for 2014, and her
entire contribution is deductible on her 2014 Form 1040, line 25.m
Form 8889
Form 8889, shown in Illustrations 13.813.9, is used to compute the taxpayers allowable HSA contribution and deduction, as well as the taxable amount of any HSA distributions. If the taxpayer is filing
a joint return and each spouse has an HSA, each spouse must file a separate Form 8889.
Some of the possibilities regarding HSAs can get a bit complex, especially if a family has more than
one HSA or more than one HDHP. In this course, we will keep it simple. The basic instructions are
summarized below. The IRS also provides in the Form 8889 instructions a flowchart and worksheets
to assist taxpayers with Form 8889.
Line 1. If the taxpayer was covered by a self-only plan and a family plan during the year, check the
box for the plan that was in effect for a longer period. If, at any time, the taxpayer was covered simultaneously by a self-only plan and a family plan, they are treated as having family coverage during
that period.

Tax Essentials Form 1040 13.19


Illustration 13.8

13.20 H&R Block Income Tax Course (2015)


Illustration 13.9

Line 2. HSA contributions for 2014. Do not include employer contributions, pre-tax contributions
made through a cafeteria plan, or amounts rolled over from another HSA or Archer MSA.
Line 3. Enter $3,300 ($6,550 for family coverage) if the taxpayer (a) was under age 55 at the end of
2014 and (b) was enrolled in an HDHP with the same coverage on the first day of every month during
2014. Otherwise, you will need to use the IRS instructions.
Line 4. Enter any contributions to the taxpayers (and/or spouses) Archer MSA. Employer contributions, including pre-tax contributions made through a cafeteria plan, are shown on Form W-2, box 12,
with code R.
Lines 6 and 7 reflect complications into which we shall not delve.
Line 9. Enter any employer contributions to the taxpayers HSA, shown on Forms W-2, box 12, with
code W.
Line 10. Enter any qualified HSA funding distribution. This is a trustee-to-trustee transfer from an
IRA (not a SEP or a SIMPLE IRA).
Line 13. Enter the smaller of line 2 or line 12 here and on Form 1040, line 25. This is the HSA deduction.
Excess Contributions
Taxpayer who make excess contributions (i.e., contribute too much during the year) to their HSA may
be subject to a 6% penalty, plus earnings. This penalty also applies to taxpayers who are ineligible to
contribute to an HSA but do so anyway.
Taxpayers may avoid this 6% penalty by taking a distribution of the excess contribution amount plus
earnings before the due date of the return (including extensions). However, generally the distribution
of earnings is still subject to the 6% penalty.

Tax Essentials Form 1040 13.21

mExample: Kimberly Thiele (67) is a single employee who was enrolled in a self-only HDHP for all of
2014. On February 18, 2014, she established an HSA for 2014 and contributed $3,300. Unfortunately,
Kimberly was also enrolled in Medicare the entire year, making her ineligible to contribute to an HSA.
Assuming Kimberly does not file an extension for her return, she must withdraw the contribution
plus earnings by April 15, 2015, to avoid a 6% excess contribution penalty. However, the earnings are
subject to the 6% penalty.m
Distributions
Distributions may be taken from an HSA at any time to pay for qualified medical expenses:
There are no age requirements.
Funds do not have to remain in the account for any period of time.
There is no risk of forfeiting the money, as there is with a flexible spending arrangement (cafeteria
plan).
There are no required minimum distributions.
HSAdistributions are reported on Form 1099-SA, which is shown in Illustration 13.10. The HSAdistributions reported on Form 1099-SA are then reported in Part IIof Form 8889. Distributions may be
used to pay qualified expenses for the owner, the spouse, and any dependents claimed on the taxpayers current-year return and are not subject to income tax. This is true even if these individuals are
not covered under the HDHP and cannot make current-year contributions to an HSA.
HSAdistributions not used for qualified medical expenses are taxable income to the taxpayer, and
the HSA taxable distributions are determined in Part II of Form 8889. HSA taxable distributions are
then entered on Form 1040, line 21, and labeled HSA.
Nonqualified Distributions Penalty
If HSA funds are used for any other purpose than to pay qualifying medical expenses, they are subject to tax and a 20% penalty. The penalty is waived if the account owner is age 65 or older, becomes
disabled, or dies.
Rollovers
A rollover is a tax-free distribution of assets from one tax-advantaged plan to another. Generally,
the transaction must be completed within 60 days after receipt of the distribution. HSA owners may
make only one rollover contribution to an HSA during any one-year period. However, if the account
owner instructs the trustee to transfer funds directly to the trustee of another HSA, the transfer is
not considered a rollover. There is no limit on the number of these transfers.
Qualified Distributions to HSAs
Taxpayers may be able to make qualified distributions from their health flexible spending arrangement or health reimbursement arrangement to their HSAs. Testing period requirements apply.
Taxpayers can make qualified HSA funding distributions from their individual retirement arrangement. Testing period requirements apply. Although these distributions are not included in income,
nor are they deductible, they do reduce the amount that taxpayers can contribute to their HSA.
Complete Exercise 13.2 before continuing to read.

13.22 H&RBlock Income Tax Course (2015)


Illustration 13.10

Penalty on Early Withdrawal of Savings


A taxpayer will receive a Form 1099-INT when they receive interest on an account from a financial
institution. Recall also that box 2 of Form 1099-INT may show an amount if money in a time-savings
instrument is withdrawn before maturity.
This early withdrawal penalty is deductible as an adjustment to income on Form 1040, line 30. Both
Forms 1099-INT and 1099-OID may show early withdrawal penalties. Total all of these amounts and
enter them on Form 1040, line 30.
Complete Exercise 13.3 before continuing to read.

Alimony
Alimony is a payment made to a person pursuant to an agreement or court decree of divorce or separation. Payment of taxable alimony is deducted by the payer as an adjustment to income on Form
1040, line 31a. The recipients Social Security number is reported on line 31b.
If alimony is deductible by the person who pays it, it is taxable income to the person who receives it
and reported on their Form 1040, line 11. The rules governing whether alimony is deductible by the
payer and taxable to the recipient depend on when the divorce or separation instrument (arrangement) was established or revised. The rules discussed here apply to divorce and separation instruments established after 1984. If you ever need to know the rules for divorce and separation instruments established prior to 1985, see IRS Publication 504, Divorced or Separated Individuals.

Tax Essentials Form 1040 13.23

Deductible alimony or separate maintenance is any payment that is:


Paid in cash (checks and money orders qualify as cash).
Paid under a decree of divorce or separation while the parties are living apart or under a written
separation agreement.
Not specified to be not taxable and not deductible.
To cease upon the death of the recipient.
Payments That Are Not Alimony
Child support, property settlements, voluntary payments not specified in the agreement, and payments not arising from the marital relationship (for example, a bona fide loan from one spouse to the
other spouse) are examples of items that are not alimony. They are not deductible by the payer or
taxable to the recipient.
Alimony vs. Child Support
Payments that are specifically designated in the divorce or separation instrument as child support are
not alimony. Note that amounts not specifically designated as child support will nonetheless be treated as child support if such payments are reduced or eliminated upon the occurrence of a contingency
relating to the child or at a time that is clearly associated with such a contingency.
mExample: Ted Stevens divorce decree states he will pay his ex-wife $400 per month until their son
reaches age 21. Although the divorce decree does not specifically state that the $400 per month is child
support, it will be treated as child support because the payments will cease upon the contingency of
the sons 21st birthday.m
When the divorce decree does not set a specific amount for child support and no child-related contingencies are involved, the entire payment is alimony.
mExample: John and Martha Feinberg are divorced. Martha has custody of the couples two children.
Their divorce decree states only that John will pay Martha $1,200 per month until her death or remarriage. Because the decree does not stipulate a specific amount as child support and no child-related
contingencies are involved, the entire amount is considered alimony.m
When both alimony and child support payments are required to be paid during the year, child support
is always considered to be paid first.
mExample: Bill Drayton is required to make payments of $800 per month until the death or remarriage of his former spouse. The divorce decree designates $600 of this amount as alimony and $200 as
child support. Bill sends only $8,000 in total payments for 2014. Because the first $2,400 paid during
the year [$200 2 12 months] is considered to be child support, Bills alimony deduction is $5,600
[$8,000 $2,400].m

13.24 H&RBlock Income Tax Course (2015)

Special Rules Regarding Alimony and Separate Maintenance Payments


There are a number of situations for which you may wish to do additional research, if necessary, such
as:
Alimony payments that decrease by more than $15,000 during the first three years.
Payments made to third parties for expenses of former spouses.
Treatment of separate maintenance payments in community property states.
You can find more information in IRS Publication 17 or Publication 504 if you encounter any of these
situations.
Complete Exercise 13.4 before continuing to read.

Moving Expenses
Taxpayers who move within one year of starting a new job may be eligible to deduct their moving
expenses as an adjustment to income. The taxpayers moving expense deduction is first reported on
Form 3903, Moving Expenses, before it is reported on Form 1040, line 26.
To claim a deduction for moving expenses, the taxpayer must meet three main requirements:
Distance.
Work time.
Move occurred within one year of the start of work.
Distance Requirement
The distance between the new job location and old residence must be 50 miles farther than the distance between the old job location and old residence. The distance test must be satisfied by all taxpayers other than members of the armed forces who move pursuant to a permanent change of duty
station.
mExample: Danielle Terra, a single taxpayer, works five miles from her residence. She is considering
looking for a new job in another city. In order to deduct moving expenses, her new job location must
be at least 55 miles [50 miles + 5 miles distance between old job and old residence] from her old residence.m
The distance test is measured using the shortest, most commonly-traveled route. A taxpayer who was
not previously employed or who obtains a full-time job after a substantial period of unemployment can
satisfy the distance requirement if the new job location is at least 50 miles from the old residence. The
job location is the place where the taxpayer works most of the time. If the taxpayer has no primary
job location, the job location is the general area where the business activities are centered.

Tax Essentials Form 1040 13.25

Work Time Requirement


An employee must work full-time in the general vicinity of the new job location for at least 39 weeks
during the 12 months following the move. Temporary layoffs because the work is seasonal or because
of strikes and absences due to illness or vacations are counted as work time. For seasonal work to
count, the off-season period must be less than six months, and the employees work contract must
cover the off-season. The 39 weeks requirement does not need to be completed within one tax year.
If the taxpayer expects to meet the work time test, the deduction is claimed for the year the move
occurred. The 39 weeks of full-time work do not have to be consecutive or with the same employer as
long as the jobs are in the same general location and are classified as full-time work.
mExample: Danielle Terra, from the preceding example, took a new job in another city 59 miles from
her old residence. She moved to the new city on November 1, 2014, and began work on November 3.
Danielle must work full-time in the general area of this new city for at least 39 weeks during the period of November 2014 through October 2015. If she expects to meet this requirement, she may deduct
her moving expenses on her 2014 tax return.m
For self-employed persons, they must complete their work time requirement on a full-time basis for
78 weeks during the 24 months immediately following the move. At least 39 of these weeks must be
within the first 12 months of the move. An employee who becomes self-employed before satisfying the
39-week test must meet the 78-week test to claim moving expenses. A self-employed individual who
becomes an employee before satisfying the 78-week test may use the time spent as an employee to
meet the 78-week test.
There are exceptions to meeting the work time test. If a person dies, becomes disabled, or is involuntarily separated from work (for reasons other than willful misconduct), the work time test is waived.
It is also waived if an employer asks the employee to transfer locations before the end of the 39 weeks,
assuming the employee could reasonably have met the 39-week test had the employer not requested
the employee transfer. Military personnel whose move is due to a permanent change of duty station
and taxpayers who return to the United States because of retirement or who are the survivors of a
person who died while living and working outside the United States are not required to meet the work
time requirement.
Married Couples
Moving expenses of a married couple can be claimed if either spouse separately meets the distance
and work time requirements, but their individual distance to work or duration of full-time work cannot be combined to meet the tests to deduct qualified moving expenses.
Closely Related in Time to Start of Work
In addition to the distance and work time requirements, moving expenses must be incurred close to
the commencement of work, and they must be reasonable. In general, only expenses incurred no later
than one year after beginning the new job are deductible. Moving expenses incurred later than one
year are deductible only if the taxpayer can show that circumstances prevented an earlier move.
mExample: Danielle Terra, from the preceding example, started her new job on November 3, 2014,
but decided to commute the 59 miles each day rather than moving right away. If she later decides to
move to the new city, she will have to incur her moving expenses before November 3, 2015, in order
to deduct them.m

13.26 H&RBlock Income Tax Course (2015)

Closely Related in Place to Start of Work


Even if the distance requirement is met, if the distance from the old residence to the new job location
is shorter than the distance from the new residence to the new job location, the move is not considered
as closely related in place to the start of work. In that case, moving expenses are not deductible unless
either of the following are true:
The taxpayer is required to live at the new locality as a condition of employment.
Living at the new place of residence decreases commuting time or expense.
mExample: Suppose this time that Danielle, now living in her old city and working in a new city,
decides to move to a third city before November 3, 2014. The move increases her commute to the new
city from 59 miles to 62 miles. Although the distance and work time requirements have been met,
such a move is not closely related in place to the start of her new job because her commute is now
longer than if she had not moved. The move is not deductible (unless one of the conditions listed above
applies).m
Deductible Moving Expenses
Deductible expenses include the actual cost of moving:
Household goods.
Personal possessions.
Vehicles.
Pets.
This includes expenditures for:
Connecting or disconnecting utilities in order to move appliances, household goods, or personal
effects.
Packing and crating.
Insurance for the transported goods.
In-transit storage and insurance for any 30 consecutive days after the day such goods are moved
from the former residence and before delivery to the new residence.
In addition, the reasonable cost of travel and lodging, but not meals, for all family members during
the actual move may be deducted. This includes expenses for lodging in the old location prior to
departure that are incurred within one day after the furnishings are moved out of the old residence
and lodging expenses incurred on the day of arrival at the new location.
If the taxpayer travels by public transportation, the actual cost may be deducted. If the taxpayer
drives from the old to the new home, they may deduct either the actual cost of gas and oil used
during the trip or the standard mileage rate, 23.5 per mile (generally, whichever is larger).
In either case, the cost of tolls and parking may be added. Depending upon the price of gasoline
and the cars mileage, actual expenses for gas and oil may result in a larger deduction than the
mileage rate for moving.
If a taxpayer later discovers they are ineligible to deduct moving expenses claimed on their income
tax return, they must amend the return or reflect the moving expenses as income in the year the
taxpayer discovers the ineligibility.

Tax Essentials Form 1040 13.27

mExample: Danielle Terra, from the preceding example, started her new job on November 3, 2014,
which is in another city 647 miles from her residence. Danielle used to live 23 miles from her old job.
She moved to the new city on November 7, 2014, and her work will reimburse her $1,500 for moving
expenses. Danielle incurred $1,800 to move her household goods and personal effects and $169 for
gasoline and oil to drive her personal car 647 miles to her new residence. Danielle is allowed a $469
deduction for her move [$1,800 + $169 = $1,969 total moving expense $1,500 reimbursement for
work = $469]. Note that Danielle deducted her actual gasoline and oil expense because it was greater than her standard mileage rate $152.05 [647 miles 2 23.5]. Danielles Form 3903 is shown in
Illustration 13.11.m
Form 3903
Examine the Form 3903 in Illustration 13.11. Line 1 is for entering the expenses of storing and moving household goods and personal items. Enter only those amounts actually paid by the taxpayer
(including any amounts the employer provided) rather than amounts the employer paid directly to
the movers. Line 2 is for travel and lodging expenses of the move. Line 3 is for totaling lines 1 and 2.
If the taxpayers employer paid for part or all of the move and did not include the payment as part of
taxable compensation in box 1 of Form W-2, enter the employer-paid expenses on Form 3903, line 4.
The amount to be entered on line 4 should be shown in box 12 of Form W2, with the code letter P.
Next, compare the amounts on lines 3 and 4. If total expenses on line 3 are more than the employer
provided, subtract line 4 from line 3 and enter the result on line 5. This is the taxpayers deductible
moving expense. Carry it to Form 1040, line 26.
In the event the employer paid more than the move actually cost, making line 4 larger than line 3,
the excess is taxable income to the employee and must be added to the amount on Form 1040, line 7.
If the taxpayers employer included moving expense reimbursement in the taxpayers income (rather
than as a code P item in box 12 of their W-2), the taxpayer may elect to deduct the expenses in the
year of reimbursement, even if they paid the expenses in a different year.
Complete Exercise 13.5 before continuing to read.

Student Loan Interest Deduction


In 2014, a taxpayer may deduct up to $2,500 (per return) of qualified student loan interest paid as an
adjustment to income on Form 1040, line 33 (or Form 1040A, line 18). For the loan interest to qualify
for the deduction, the proceeds of the loan must have been used exclusively to pay qualified higher
education expenses at an eligible educational institution for an eligible student.

13.28 H&R Block Income Tax Course (2015)


Illustration 13.11

Tax Essentials Form 1040 13.29

A qualified student loan is a loan taken out by the taxpayer solely to pay qualified education expenses
that were:
For the taxpayer, the taxpayers spouse, or a person who was the taxpayers dependent when the
taxpayer took out the loan.
Paid or incurred within a reasonable period of time before or after the taxpayer took out the loan.
For education provided during an academic period for an eligible student.
Loans from a related person or a qualified employer plan are not qualified student loans.
The taxpayers dependent may be either a qualifying child or a qualifying relative. Also, for the purposes of the student loan interest deduction, the following exceptions apply to the general rules for
dependents:
An individual may be the taxpayers dependent even if that taxpayer is a dependent of another
taxpayer.
An individual may be the taxpayers dependent even if that individual files a joint return with a
spouse.
An individual may be a taxpayers dependent even if that individual had gross income that was
equal to or more than their exemption amount for the year ($3,950 for 2014).
An eligible student is a student who was enrolled at least half-time in a program leading to a degree,
certificate, or other recognized educational credential.
For the purposes of the student loan interest deduction, qualified education expenses are the total cost
of attending an eligible educational institution, including graduate school. They include amounts paid
for the following:
Tuition and fees.
Room and board.
Books, supplies, and equipment.
Other necessary expenses (such as transportation).
The cost of room and board qualifies only to the extent that it is not more than the greater of the
following:
The allowance for room and board, as determined by the eligible educational institution, that was
included in the cost of attendance for a particular academic period and living arrangement of the
student.
The actual amount charged if the student is residing in housing owned or operated by the eligible
educational institution.
An eligible educational institution is any college, university, vocational school, or other post-secondary educational institution eligible to participate in a student aid program administered by the U.S.
Department of Education. It includes virtually all accredited public, nonprofit, and proprietary (privately-owned, profit-making) post-secondary institutions.

13.30 H&RBlock Income Tax Course (2015)

When determining the student loan interest deduction, the taxpayer is required to reduce their total
qualified education expenses by the amount the tax-free funds are used to pay qualified education
expenses during the time the taxpayer was in school. These tax-free funds include the following:
Employer-provided educational assistance.
Tax-free distribution of earnings from a Coverdell Education Savings Account (ESA).
Tax-free distribution of earnings from a qualified tuition program (QTP).
U.S. savings bond interest that were excluded from income because it is used to pay qualified education expenses.
The tax-free part of scholarships and fellowships.
Veterans educational assistance.
Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational
assistance.

Form 1098-E
Generally, lending institutions that issue student loans will report the student loan interest paid
during the year on Form 1098-E, Student Loan Interest Statement, or a similar statement. These
lending institutions are required to send Form 1098-E, or a similar statement, by January 31 to borrowers who paid student loan interest of $600 or more. A Form 1098-E is shown in Illustration 13.12.

Who Can Claim the Student Loan Interest Deduction


For a taxpayer to claim the student loan interest deduction, the following four requirements must be
met:
The taxpayers filing status is any filing status except married filing separately.
The taxpayer cannot be claimed as a dependent on another taxpayers return.
The taxpayer must be legally obligated to pay interest on a qualified student loan.
The taxpayer paid interest on a qualified student loan.
When determining the amount of deductible interest, the taxpayer is only to deduct the amount of
interest paid during the current tax year. If another taxpayer makes payments on behalf of the taxpayer who is legally obligated to make the interest payments, the taxpayer is treated as receiving the
interest payments from the other taxpayer and, in turn, paying the interest themselves.

Computing the Student Loan Interest Deduction


This deduction is also limited based on the taxpayers modified AGI (MAGI). For this purpose, MAGI
consists of adjusted gross income without regard to any student loan interest deduction. Also, any
tuition and fees deduction must be added back to regular AGI.

Tax Essentials Form 1040 13.31

Married couples filing jointly with modified AGIs greater than $130,000, but less than $160,000, must
reduce the deduction by the following fraction:
Interest Paid* 2 (Modified AGI $130,000)
$30,000
For all other taxpayers (except MFS) with modified AGIs exceeding $65,000, but less than $80,000,
reduce the deduction by the following fraction:
Interest Paid* 2 (Modified AGI $65,000)
$15,000
* Limited to the maximum allowable deduction ($2,500).
The IRS Student Loan Interest Deduction WorksheetLine 18, in Illustration 13.13, will assist you
in computing the allowable deduction. This worksheet is located in IRS Form 1040A instructions on
page 32. For this course, you will also use the BlockWorks Student Loan Interest Deduction Worksheet,
shown in Illustration 13.14.
mExample: Helen D. Jenkins, a single taxpayer, paid $2,850 qualified student loan interest in 2014.
Her Form 1098-E is shown in Illustration 13.12. Her total income for the year is $68,940, and she
is deducting a $1,000 IRA contribution. Helen is not taking the educator expense or tuition and fees
deduction on her return, so Helens modified AGI equals $67,940 [$68,940 $1,000 = $67,940]. Helens
student loan interest deduction will be limited because her modified AGI exceeds $65,000. Helen
is required to reduce her student loan interest deduction by $490 [$2,500 2 ($67,940 $65,000) =
$7,350,000 3 $15,000 = $490]. Helens 2014 student loan interest deduction is $2,010 [$2,500 $490
= $2,010], and she will report her deduction on Form 1040, line 33 (or Form 1040A, line 18). Helens
IRS Student Loan Interest Deduction WorksheetLine 18 is shown in Illustration 13.13, and her
BlockWorks Student Loan Interest Deduction Worksheet is shown in Illustration 13.14.m
Illustration 13.12

13.32 H&RBlock Income Tax Course (2015)


Illustration 13.13

Illustration 13.14

Tax Essentials Form 1040 13.33

When preparing a BlockWorks return for a taxpayer with


Bstudent loan interest
reported on Form 1098-E, you will enter the full
lockWorks Tip:

amount of the taxpayers student loan interest, paid in the current year, on
line 33 of the Form 1040 page 1 input pane, and BlockWorks will calculate a
Student Loan Interest Deduction Worksheet for the taxpayer. A screen shot of
the BlockWorks Form 1040 Pg1 input screen is shown in Illustration 13.15.

Illustration 13.15

Complete Exercise 13.6 before continuing to read.

13.34 H&RBlock Income Tax Course (2015)

Other Form 1040 Adjustments to Income


There are other adjustments to income for which there are no corresponding lines on the Form 1040.
These are write-in adjustments. This means that if you encounter one of these types of adjustments,
you must indicate the adjustment by writing its shorthand identifier on the dotted line to the left of
line 36.
Many of these write-in adjustments are not discussed in this course. However, we will list them in
case you happen to encounter them when reviewing a tax return. These adjustments are:
The deductible contribution to an Archer MSA (Form 8853), identified by the letters MSA.
The repayment of jury duty pay to your employer because your employer paid your salary while
you served jury duty, identified by the phrase Jury Duty Pay.
The deductible expenses related to income reported on line 21 from the rental of personal property
engaged in for profit, identified by the letters PPR.
The deductible amortization and expenses for reforestation, identified by the letters RFST.
The repayment of supplemental unemployment benefits under the Trade Act of 1974, identified by
the phrase Sub-Pay TRA.
The deductible contributions to a 501(c)(18)(D) pension plan, identified by 501(c)(18)(D).
The deductible contributions by certain chaplains to 403(b) plans, identified by 403(b).
The deductible attorney fees and court costs for actions settled or decided involving certain unlawful discrimination claims, but only to the extent of gross income from such actions, identified by
the letters UDC.
The deductible attorney fees and court costs paid by you in connection with an award from the
IRS for information you provided that contributed to the detection of tax law violations, up to the
amount of the award includible in your gross income, identified by the letters WBF.
For more information on these other adjustments to income, see IRSForm 1040 instructions.

PERSONAL EXEMPTION PHASEOUT


Personal Exemption Phaseout
For tax years beginning after 2012, the Personal Exemption Phaseout (PEP) has been reinstated by
the American Taxpayer Refund Act of 2012 (ATRA). This means that the PEP will reduce taxpayers personal exemption by 2% for every $2,500 ($1,250 MFS) that exceeds AGI thresholds per filing
status. The exemption deduction begins to phase out when the taxpayers AGI exceeds the following
amounts:
$305,050 Married filing jointly and qualifying widow(er).
$279,650 Head of household.
$254,200 Single.
$152,525 Married filing separately.
For taxpayers whos AGI exceeds the PEP threshold amount, use the Deductions for Exemptions
Worksheet Line 42 Worksheet (Illustration 13.16) to determine their reduced exemption amount.

Tax Essentials Form 1040 13.35


Illustration 13.16

FORM 1040 CREDITS


When preparing a return for a taxpayer, it is important to understand and recognize the more common types of tax credits reported on Form 1040. These types of tax credits include the Adoption
Credit, First-time Homebuyer Credit, Residential Energy Efficient Property Credit, Nonbusiness
Energy Property Credit, Foreign Tax Credit, Mortgage Interest Credit, General Business Credit, and
Credit for Prior-Year Minimum Tax.

Adoption Credit
In 2014, taxpayers who adopt a child may qualify for a nonrefundable credit for adoption expenses
of up to $13,190 per eligible child. Also, some companies have adoption assistance programs, and
amounts employees receive from their employers for qualified adoption expenses under such programs are generally not taxable up to the same $13,190. How do we know if a taxpayer received
adoption assistance payments from their employer? The amount of adoption assistance is shown on
Form W-2, box 12, with the code letter T.

13.36 H&RBlock Income Tax Course (2015)

If you need more information about the adoption credit and exclusion, you should obtain a copy of IRS
instructions for Form 8839, Qualified Adoption Expenses. You can review the form in Illustrations
13.17 and 13.18.
When to Claim the Credit
If the taxpayer adopts a U.S. citizen or resident, they generally will claim the credit in the year following the year in which they paid the expenses. This is true even if the adoption is never finalized.
However, if the adoption becomes final during or before the year in which the taxpayer paid the
expenses, they will claim the credit in the year the expenses were paid.
mExample: Mike and Judy Wisner paid $4,000 of qualified adoption expenses in 2014. Their adoption
became final on January 20, 2014. They will claim their adoption credit on their 2014 tax return. You
can see their Form 8839 in Illustration 13.17.m
mExample: John and Mary Beyers paid $3,000 of qualified adoption expenses in 2014 and $1,000 of
qualified expenses in 2015. If their adoption became final in 2015, they will claim their adoption credit
based on $4,000 of expenses on their 2015 tax return.
If their adoption is never finalized (assuming the child is a U.S. citizen or resident), their 2014 credit
will be based only on the $3,000 of expenses they paid in 2014. They may also claim a credit on their
2015 return based on the $1,000 of expenses they paid in 2015.m
Child not a U.S. citizen or resident. If the taxpayer adopts a child who is not a U.S. citizen or resident, they may claim the credit (or exclude the employers assistance) only for the year the adoption
becomes final.
mExample: Jim and Sally Williams are adopting a Korean child. They incurred $3,000 of qualified
adoption expenses during 2013 and $1,000 of qualified expenses during 2014. Their adoption became
final on March 3, 2014. They may claim their credit, based on their 2013 and 2014 expenses, on their
2014 tax return. Note, however, that if their adoption had fallen through, they would have no credit.
(A similar couple attempting to adopt a U.S. citizen or resident, whose attempt failed, would claim the
2013 expenses on their 2014 return and the 2014 expenses on their 2015 return.)m
Qualified Expenses
Expenses qualifying for the adoption credit or exclusion are reasonable and necessary expenses for
adoption fees, court costs, attorney fees, travel expenses (including meals and lodging), and other
expenses directly related to, and necessary for, the adoption.
Expenses that do not qualify for the credit or exclusion include those that violate state or federal law,
those associated with surrogate parenting expenses, costs of adopting a spouses child, expenses paid
with funds received from any government program, and amounts allowed as a credit or deduction
under any other federal income tax rule.
Eligible Child
An eligible child for purposes of the adoption credit or exclusion must be under age 18 or physically
or mentally incapable of self-care.
A special needs child is a child who the state has determined should not be returned to the parents
home and who probably will not be adopted unless special assistance is provided to the adopting
family. A special needs child must be a U.S. citizen or resident; a foreign child cannot be treated as a
special needs child.

Tax Essentials Form 1040 13.37


Illustration 13.17

13.38 H&RBlock Income Tax Course (2015)


Illustration 13.18

Tax Essentials Form 1040 13.39

A credit equal to the maximum amount of creditable expenses is allowed for the adoption of each
special needs child, regardless of the actual amount of qualified expenses incurred by the adoptive
parent(s). Thus, a full $13,190 credit is allowed for the adoption of each special needs child that
becomes final in 2014.
mExample: In the process of adopting a special needs child, Lilith Walker paid $1,000 qualified
expenses in 2013 and $800 in 2014. The adoption became final in 2014. Despite the fact that her
qualified expenses total only $1,800, Lilith may claim a $13,190 adoption credit on her 2014 return.m
Credit Phaseout
The amount of the adoption credit begins to phase out when taxpayers MAGI exceeding $197,880 and
is fully phased out when modified AGI reaches $237,880. Modified AGI, for purposes of the adoption
credit, is regular AGI plus certain excludible income from foreign sources and U.S. possessions. The
adoption credit is nonrefundable.

First-Time Homebuyer Credit


There have been various changes to this credit since it was first introduced. The credit expired in
2011. Depending on when the credit was taken, it may or may not have to be repaid.
Repayment
For homes purchased in 2008, the credit is similar to a no-interest loan and must be repaid in 15
equal, annual installments beginning with the 2010 income tax year. If the home ceases to be the
taxpayers main home before the 15-year period is up, they must include all remaining annual installments as additional tax on the return for the tax year the home ceases to be owned by the taxpayer.
This includes situations in which they sell the home or convert it to business or rental property. There
are exceptions for divorce, involuntary conversion, and death.
For homes purchased in 2009 or 2010, the credit does not have to be paid back unless the home ceased
to be the taxpayers main residence within a three-year period following the purchase. Any required
repayment is included in full (i.e., not paid in installments) as an additional tax on the return in the
year the home is no longer the taxpayers main residence.
The credit repayment is computed on the Form 5405, Repayment of the First-Time Homebuyer Credit,
shown in Illustration 13.19. The taxpayer is only required to submit this form to the IRS in the event
there was a disposition or change of use of the home. In this course, we will focus on the repayment
of the credit when there is no disposition or change of use of the home.
mExample: Illustration 13.20 shows the BlockWorks worksheet completed to compute the repayment
for Mary Bateman who purchased her home on May 5, 2008, for $252,750. Mary had not owned a
home prior to this purchase. She claimed the maximum credit available at the time of $7,500. She
began repayment in 2010 and has repaid $2,000.m
Complete Exercise 13.7 before continuing to read.

13.40 H&RBlock Income Tax Course (2015)


Illustration 13.19

Tax Essentials Form 1040 13.41


Illustration 13.20

13.42 H&RBlock Income Tax Course (2015)

Residential Energy Efficient Property Credit


Taxpayers may be able to take a credit of 30% of their costs of qualified solar electric power, solar
water heating property, small wind energy property, geothermal heat pump property, and fuel cell
property. This includes labor costs properly allocable to the on-site preparation, assembly, or original
installation of the property and for piping or wiring to interconnect such property in the home. The
credit amount for costs paid for qualified fuel cell property is limited to $500 for each one-half kilowatt
of capacity of the property.
The credit is calculated on Form 5695, Residential Energy Credits. Part I is used for this credit.
If a home is jointly occupied, each occupant must complete their own Form 5695. Each energy credit
discussed above has different rules for joint occupancy. Therefore, refer to Form 5695 and the instructions that accompany it.

Nonbusiness Energy Property Credit


The Nonbusiness Energy Property Credit applies to improvements such as adding insulation, energyefficient exterior windows and doors, and energy-efficient heating and air conditioning systems. Many
clients believe the credit applies to other energy-efficient appliances, such as washing machines and
dryers. However, it does not.
The credit is calculated on Form 5695, Residential Energy Credits. Part II is used for this credit.
The credit is 10% of the cost of all qualifying improvements, and the maximum credit is $500 for
improvements placed in service in 2014. There is a lifetime limit of $500 for all years after 2005. Of
this $500, only $200 can be for windows; $50 for any advanced main circulating fan; $150 for any
qualified natural gas, propane, or oil furnace or hot water boiler; and $300 for any item of energyefficient building property.
Due to the lifetime limit, if the total of nonbusiness energy property
Tcredits taken
in previous years (after 2005) exceeds $500, the credit cannot
ax Tip:

be taken in 2014.

mExample: In 2014, John Roberts purchased a new gas furnace that cost $1,000, and replaced several
windows for a cost of $3,000. All items were qualifying property installed in his main residence. He
qualifies for a credit of $350 ($200 for the windows and $150 for the furnace).m
To qualify for the credit, the property must be installed in the clients home. A home is where the
taxpayer lived in 2014 and can include a house, houseboat, mobile home, cooperative apartment,
condominium, and a manufactured home that conforms to Federal Manufactured Home Construction
and Safety standards. The home must be located in the United States. The basis of the home must
be reduced for any credit used.
For property placed in service after February 17, 2009, the property must be specifically and primarily
designed to reduce the heat loss or gain of the taxpayers home when installed and must also meet
the prescriptive criteria established by the International Energy Conservation Code (IECC) in effect
on February 17, 2009. However, if the taxpayer purchased property before June 1, 2009, they can still
take the credit if they relied on the manufacturers certification issued before February 18, 2009, that
the property met the standards in effect before February 18, 2009.

Tax Essentials Form 1040 13.43

Foreign Tax Credit


The purpose of Form 1116, Foreign Tax Credit, is to claim a credit for taxes paid or accrued to certain
foreign countries or U.S. possessions. This form is introduced so that you are aware of it. We introduce
the conditions that must be met which allow taxpayers to claim the credit without filing Form 1116.
The election is only available if the taxpayer meets all of the following conditions:
All of the taxpayers foreign-source gross income was passive category income (which includes
most interest and dividends).
Foreign tax paid is less than $300 ($600 MFJ).
All of the income and any foreign taxes paid on it were reported to the taxpayer on a qualified payee
statement. Qualified payee statements include:
Form 1099-DIV.
Form 1099-INT.
Schedule K-1 (Form 1041).
Schedule K-1 (Form 1065).
Schedule K-1 (Form 1065-B).
Schedule K-1 (Form 1120S).
If the election is available, the credit appears on Form 1040, line 48. Otherwise, Form 1116 must be
completed.

Mortgage Interest Credit


This credit is available to taxpayers only if they were issued a qualified Mortgage Credit Certificate
(MCC) by a state or local government unit or agency under a qualified mortgage credit certificate
program. Certificates issued by the Federal Housing Administration, Department of Veterans Affairs,
Farmers Home Administration, and Homestead Staff Exemption Certificates do not qualify for the
credit.
The home must be the main residence of the taxpayer and must also be located in the jurisdiction of
the government unit that issued the certificate. If the interest on the mortgage is paid to a related person, the taxpayer cannot claim the credit. The credit is taken on Form 8396, Mortgage Interest Credit.

General Business Credit


Form 3800, General Business Credit, is filed by taxpayers to claim any of the numerous general business credits. A list of these credits can be found on the Form 3800. Lines 1a through 1zz in Part III
on page 3 detail the numerous credits allowed for the current year and reported on Form 3800, line
32. Then, the line 32 amount is reported on Form 1040, line 53. For those interested in more information, see the instructions for Form 3800 and IRS Publication 334, Tax Guide for Small Business (For
Individuals Who Use Schedule C or C-EZ).

13.44 H&RBlock Income Tax Course (2015)

Credit for Prior-Year Minimum Tax


Form 8801, Credit for Prior-Year Minimum Tax, is used by individuals (also used by estates and
trusts) to figure the current-year nonrefundable credit, if any, for Alternative Minimum Tax (AMT)
a taxpayer incurred in prior tax years; to figure the current-year refundable credit, if any, for any
unused credit carryforward from 2013; and to figure any credit carrying forward to 2015.
The taxpayer should file 2014 Form 8801 if they had:
An AMT liability and adjustments or preferences other than exclusion items.
A carryforward to 2015 (shown on the 2014 Form 8801, line 28).
An unallowed qualified electric vehicle credit.
For those interested in more information, research this credit on the IRS website.

FORM 1040 TAXES


When preparing a return for a taxpayer, it is important to understand and recognize other types of
taxes reported on Form 1040. These types of taxes include the Net Investment Income Tax (NIIT),
Additional Medicare Tax, Household Employment Tax and Excess Social Security or Tier 1 Railroad
Retirement Tax.

Net Investment Income Tax (NIIT)


In 2014, taxpayers with unearned income may be subject to a 3.8% Net Investment Income Tax (NIIT)
if they have net investment income and their modified adjusted gross income (MAGI) exceeds the
following amounts:
Filing Status

MAGI Amount

MFJ and QW

$250,000

S and HOH

200,000

MFS

125,000

Taxpayers with MAGI in excess of the threshold are subject to the 3.8% tax on the lesser of the following:
Net investment income.
The amount of MAGI in excess of the threshold amount.
Taxpayers who are subject to NIIT will first compute the tax on Form 8960 which is then carried to
Form 1040, line 62.
Types of Income Subject to the 3.8% NIIT
Generally, investment income includes, but is not limited to, interest, dividends, annuities, royalties,
passive activity income, and net gains attributed to disposition of property not part of a passive trade
or business.
These net gains include sale of stocks, bonds, mutual funds, investment real estate, sales of passive
interests in partnerships and S corporations, and gains recognized from sales of personal residence in
excess of the $250,000 exclusion ($500,000 MFJ).

Tax Essentials Form 1040 13.45

It is important to note that income from distributions from qualified plans, IRAs, employee annuities,
pensions, profit-sharing, stock bonus plans, and self-employment income are not subject to NIIT.

Additional Medicare Tax


Taxpayer with wages, compensation, or self-employment income that exceeds the following threshold
amounts based on their filing status are subject to 0.9 percent Additional Medicare Tax:
Filing Status

Income Amount

MFJ

$250,000

MFS

$125,000

$200,000

HOH

$200,000

QW w/ dependent child

$200,000

Employers are required to withhold the Additional Medicare Tax from wages paid to an employee
in excess of $200,000 regardless of the employees filing status. Taxpayers who work two jobs or
have self-employment income in addition to W-2 wages may need to adjust estimated tax payments
or request additional income tax withheld on their Form W4, Employees Withholding Allowance
Certificate, to ensure they pay the correct Medicare tax owed and avoid penalties and interest.
Please be aware that Railroad Retirement Tax Act (RRTA) compensation, tips, and noncash fringe
benefits are subject to this tax. Also, there are no special rules for nonresident aliens and U.S. citizens
living abroad.
Taxpayers will first calculate their Additional Medicare Tax liability on Form 8959 which is then
reported on Form 1040, line 62.

Household Employment Tax


A household employee is an individual who performs nonbusiness services in a taxpayers home. Such
services include child care (hence the informal name nanny tax) as well as cleaning, cooking, yard
maintenance, etc. Individuals who employ such employees may report and pay the payroll taxes on
their individual income tax returns. Payroll taxes include social security tax, Medicare tax, and federal unemployment tax.
Taxpayers who employ household workers must pay social security and Medicare tax for most household employees to whom they pay cash wages of $1,900 or more during the year. They must pay
federal unemployment tax for household employees if they pay cash wages totaling $1,000 or more
to all household employees during any calendar quarter of the tax year or the previous tax year. The
taxpayer is not required to withhold income tax but may do so if the employee requests withholding
and the taxpayer agrees.
The above rules generally do not apply to employees under age 18, the taxpayers child under age 21,
the taxpayers spouse, or the taxpayers parent.
Schedule H is used to compute the tax to be entered on Form 1040, line 60a. An employer identification number (EIN) must be obtained by all household employers. It may be obtained by filing Form
SS-4. This is an awareness-level explanation.

13.46 H&RBlock Income Tax Course (2015)

Excess Social Security or Tier 1 Railroad Retirement Tax


If a taxpayer has more than one employer in a calendar year, the taxpayer may have excess Social
Security withheld. Generally, excess withholding will occur when a taxpayers total wages are greater
than $117,000 (for 2014) from all employment for the year. In short, a taxpayer maintains more than
one job during the year, earning over $117,000 in total wages, and they do not inform their employers
of this information. The employers, unaware that their employee will make more than $117,000 in
wages, withholds and remits Social Security tax or Tier 1 Railroad Retirement Tax Act (RRTA) tax
on wages the taxpayer earns. The taxpayer then has Social Security tax or Tier 1 RRTA tax greater
than $7,254 and generally is entitled to claim the excess as a credit against your income tax on Form
1040, line 71.
Most employers must withhold Social Security tax from the taxpayers wages. For railroad employees,
their employer must withhold Tier 1 Railroad Retirement Tax Act (RRTA) tax. Tier 1 RRTA provides
equivalent social security and Medicare benefits.
Joint Returns. If a taxpayer is filing a joint return with their spouse, both the taxpayer and spouse
must figure any excess Social Security tax or Tier 1 RRTA tax separately.
Employers Error. If one employer withheld more than $7,254 in Social Security or Tier 1 RRTA tax,
the taxpayer cannot claim the excess as a credit on Form 1040, line 71. Instead, their employer should
make an adjustment of the excess for the employee. If the employer does not make an adjustment, the
taxpayer may use Form 843, Claim for Refund and Request for Abatement, to claim a refund.
For details, including how to compute the amount of excess credit, refer to Publication 505, Tax
Withholding and Estimated Tax. Also, see the Form 843 Instructions.

CHAPTER SUMMARY
In this chapter, you learned to:
Identify when a taxpayer is required to file a Form 1040.
Compute adjusted gross income, taxable income, and tax liability on Form 1040.
Identify common types of other income reported on Form 1040.
Identify common income adjustments reported on Form 1040.
Calculate personal exemption phaseout.
Identity common tax credits reported on Form 1040.
Identity additional taxes reported on Form 1040.

14

Itemized Deductions I
OVERVIEW
This self-study chapter covers how the Tax Code allows certain personal expenses to be deducted from
gross income. Some of the expenses taxpayers may deduct depend on their adjusted gross income. In
other words, before taxpayers will see any tax benefits from these types of deductions, they will have
to cross a threshold amount. The dollar amount of the threshold is different for every taxpayer, but the
percentages (2%, 7%, and 10%) of AGI are the same. It is not uncommon for a taxpayer to have several thousand dollars of one type of expense, but see no tax benefit from it. Other types of deductions
may be deducted regardless of AGI. This chapter is devoted to a discussion of deductions for medical
expenses, taxes paid, interest paid, and charitable contributions.

OBJECTIVES
At the conclusion of this chapter, you will be able to:
Determine when it is advantageous for a taxpayer to itemize deductions.
Calculate medical and dental expenses and enter them on Schedule A.
Determine deductible taxes and enter them on Schedule A.
Calculate deductible interest expenses and enter them on Schedule A.
Determine deductible charitable contributions and enter them on Schedule A.

TAX TERMS
Look up the definitions of the following terms in the glossary:
Acquisition debt.
General sales tax.
Itemized deductions.
Medicare Part A and Part B.
Personal property tax.
Points.
Prepaid interest.
Qualified charitable organization.
14.1

14.2 H&RBlock Income Tax Course (2015)

ITEMIZING VS. STANDARD DEDUCTIONS


Every taxpayer must decide whether or not to itemize deductions. Generally, taxpayers choose to
deduct the larger of their total itemized deductions or their standard deduction.

ax Tip: Bear in mind that there are two things to consider when deciding
whether to itemize or use the standard deduction. If the itemized deductions do not exceed the standard deduction, one may decide to just use the
standard deduction. First, if using a paid preparer, the cost of itemizing over
the standard deduction may outweigh the tax advantage of itemizing. Second,
returns with a Schedule A are more likely to be audited than a return with the
standard deduction.

When married taxpayers choose to use the married filing separately status and one spouse itemizes
deductions, the standard deduction of the other spouse is $0. Such a taxpayer, while not required to
itemize, benefits from doing sounless the taxpayer has nothing to deduct, which almost never happens. After all, even a small amount of deduction is better than none.
In certain states and under certain circumstances, it may be advantageous for some taxpayers to
itemize deductions on the federal return, even if their federal itemized deductions total less than their
standard deductions. The reason? Itemizing on their federal returns allows them to itemize on their
state returns, thus saving overall tax dollars. Such taxpayers should mark the box on Schedule A, line
30. Your instructor will tell you if this is a consideration in your state.
Schedule A in Illustration 14.1 is completed for taxpayers who itemize deductions. This schedule
contains the following sections:
Medical and Dental Expenses.
Taxes You Paid.
Interest You Paid.
Gifts to Charity.
Casualty and Theft Losses.
Job Expenses and Certain Miscellaneous Deductions.
Other Miscellaneous Deductions.
In this chapter and the next, you will study each section in the order they appear on the Schedule A.
Complete Exercise 14.1 before continuing to read.

Tax Essentials Itemized Deductions I 14.3


Illustration 14.1

14.4 H&RBlock Income Tax Course (2015)

MEDICAL AND DENTAL EXPENSES


Deductible medical expenses include payments made for the diagnosis, cure, mitigation, treatment, or
prevention of disease; for transportation related to medical care; and for insurance covering medical
care for the taxpayer, spouse, and dependents.
Medical expenses are deductible in the year paid regardless of when the services are provided. If
expenses are charged to a credit card, they are considered to be paid on the date charged.
Medical expenses paid by a taxpayer for his spouse are deductible if they were married at the time the
expenses were incurred or at the time the expenses were paid. To be able to deduct medical expenses
paid for a dependent, the individual generally must have been a dependent at the time the expenses
were incurred or at the time they were paid. However, medical expenses paid for an individual who
the taxpayer could claim as a dependent, except that he failed the gross income or joint return test,
are deductible.
A taxpayer may also deduct medical expenses paid by himself for a dependent he is claiming under a
multiple support agreement. The persons who waive the exemption may not deduct medical expenses
paid for the dependent.
If divorced or separated parents who lived apart during the last six months of the year supported
a child together, each parent, whether custodial or noncustodial, is allowed to deduct the medical
expenses actually paid for the child during the year. The deduction may be taken even if the other
parent is allowed to claim the exemption for the child.

Medicine and Drugs


Unreimbursed expenses for prescription drugs and insulin are deductible. Expenses for nonprescription medicines and vitamin and mineral supplements are not deductible. However, certain over-thecounter drugs may be paid for using tax-free dollars. See Cafeteria Plans on page 14.9.

Medical Insurance Premiums


Premiums paid for medical insurance are deductible if they provide for reimbursement for hospitalization, surgical fees, other medical or dental expenses, prescription drugs, or lost or damaged contact
lenses.
The portion of payroll tax allocated to pay for Medicare, Part A, is not deductible. A taxpayer who is
not covered under the social security program and who is not a government employee paying medicare
tax may deduct the premiums voluntarily paid for Medicare, Part A, coverage.
Medicare, Part B, premiums (the premiums paid or withheld from social security benefits for supplemental medicare coverage) are deductible as a medical expense. Medicare, Part D, prescription
premiums are also deductible.

Tax Essentials Itemized Deductions I 14.5

Long-Term Care Insurance


For 2014, premiums paid for qualified long-term care insurance are deductible as a medical expense
up to these amounts:
$370 (age 40 and younger).
$700 (ages 41 through 50).
$1,400 (ages 51 through 60).
$3,720 (ages 61 through 70).
$4,660 (age 71 and older).
A long-term care contract is an insurance contract that provides only coverage for long-term care services. The contract must be guaranteed renewable, have no cash surrender value, and generally must
not cover expenses that would be covered under medicare. Lastly, it must provide that refunds and
dividends under the contract must be used to reduce future premiums or increase future benefits. This
last requirement does not apply to refunds on the death of the insured or surrender or cancellation
of the contract.
Long-term care services are services prescribed by licensed health care practitioners for chronically ill
individuals. These services must be:
Necessary diagnostic, preventative, therapeutic, curing, treating, mitigating, and rehabilitative
services.
Maintenance or personal care services.
Ineligible Insurance
Premiums paid for the following types of insurance policies are not deductible:
Policies covering loss of earnings while injured.
Policies covering loss of life, limb, or sight.
Policies paying a guaranteed amount for each day (or week) for a given period of time while the
taxpayer is hospitalized for sickness or injury. However, if the policy also provides for medical care
and the amounts for each are stated separately, the portion of the premium allocable to medical
care is deductible.
Policies paying for medical care from a portion of automobile insurance premiums.

Medical and Dental Expenses


Deductible medical expenses include most fees paid to medical doctors, dentists, psychologists, psychiatrists, chiropractors, and Christian Science practitioners. Most fees paid for hospital services,
therapy, nursing services, laboratory tests, and payments for acupuncture treatments are deductible.

14.6 H&RBlock Income Tax Course (2015)

Stop-Smoking Programs
The cost of a smoking cessation program is deductible as a medical expense. The deduction may
include the cost of treatment and prescription drugs designed to alleviate the effects of nicotine withdrawal. Costs for nicotine gum and patches not requiring prescriptions are not deductible.
Weight-Loss Programs and Surgery
The government and the health care profession recognize obesity as a disease in and of itself. If a
physician has diagnosed a taxpayer as being obese, the cost of a weight-loss program or weight-loss
surgery is deductible as a medical expense.
A deduction is also allowed in cases where the weight-loss program or surgery is used to treat other
diagnosed diseases, such as arthritis, diabetes, high cholesterol, or hypertension (high blood pressure). However, the cost of such a weight-loss program undertaken for general health purposes or
without a doctors diagnosis of obesity is not deductible. In no case is the cost of diet food deductible.
mExample: Sandy, Roxanne, and Alice joined a well-known national weight-loss program that sells
portion-controlled packaged food to its members. Sandy had been diagnosed as obese by her physician.
Roxannes doctor told her that losing weight would help her lower her high blood pressure. Alice is
not obese and does not suffer from any weight-related health problemsshe just wants to lose a few
pounds.
Both Sandy and Roxanne may deduct the cost of the weight-loss program; Alice may not. None of
them may deduct the cost of the food.
After this attempt at weight loss failed, Sandy had obesity surgery at the recommendation of her
doctor. She may deduct the medical expenses connected with the surgery.m
Cosmetic Surgery
While most legal medical services are deductible, the cost of cosmetic surgery (face lifts and the like)
generally is not. Cosmetic surgery is any procedure directed at improving appearance and does not
meaningfully promote the proper function of the body or prevent illness or disease.
There is an exception to the nondeductibility of expenses for cosmetic surgery. If the surgery or procedure is necessary to correct or improve a deformity arising from a congenital abnormality, an accident
or other trauma, or a disfiguring disease, the cost is deductible.

Medical Aid Items and Equipment


The costs of medical aid items and equipment, such as bandages, blood glucose meters, eyeglasses,
contact lenses, hearing aids, prosthetic devices, crutches, and wheelchairs are deductible. The cost of
related supplies, batteries, cleaning, and maintenance of medical items and equipment is deductible.
The cost of purchasing and maintaining a service animal to assist individuals with any kind of physical disability is deductible. The most common example of a service animal is a seeing-eye dog.
Costs to purchase and maintain TTY/TDD (telecommunications devices for the deaf) equipment,
which allows hearing-impaired persons to communicate by text over the telephone, are deductible.
Costs to purchase Braille books and magazines for the blind are deductible to the extent they exceed
the costs of the same printed materials.

Tax Essentials Itemized Deductions I 14.7

mExample: Steve Henderson, a hearing-impaired individual, purchased a TDD unit for $500. He also
purchased some Braille books for his dependent daughter, who is blind. The books cost $350, but the
same printed books would cost $190. Steven may deduct $660 for these items [$500 + ($350 $190)].m

Capital Expenditures
The cost of special equipment and structural improvements installed in a residence for medical purposes is deductible as a medical expense. If the taxpayer rents the residence, these costs are deductible in full. If the taxpayer owns the residence, the part of the cost that exceeds any increase in the
value of the property is deductible.
mExample: On a doctors advice, a taxpayer who owns his home installs central air conditioning to
alleviate his sons severe allergies. The unit cost $5,000 but increased the value of the home by $5,300.
The cost of installation is not deductible because it did not exceed the increase in property value.m
The cost of operating and maintaining special equipment and structural improvements is deductible
for as long as there is a medical purpose for its use. Therefore, although the cost of the air conditioner
in the example above is not deductible, the increase in utility bills from running the air conditioner
and maintenance costs are deductible as long as the taxpayers son remains his dependent and resides
in his home.
The IRS has ruled that the following capital expenditures undertaken to remove structural barriers
for handicapped individuals will not increase the value of the residence and hence are fully deductible:
Constructing exit or entrance ramps.
Widening hallways and doorways, including entrances and exits to the home.
Installing lifts, but generally not elevators.
Installing railings, support bars, and other modifications in bathrooms.
Lowering counters and cabinets.
Adjusting electrical outlets and fixtures.
Modifying fire alarms, smoke detectors, and other warning systems.
Modifying stairs.
Adding handrails or grab bars, whether or not in bathrooms.
Modifying hardware on doors.
Modifying areas in front of entrance and exit doorways.
Grading of ground to ease access to the residence.

Transportation
Deductible transportation expenses incurred in connection with medical care include fares for buses,
taxis, planes, trains, and ambulance hire. Taxpayers using their own cars for medical transportation
may deduct out-of-pocket expenses for gas and oil. In lieu of actual gas and oil expenses, a standard
mileage rate may be used. For 2014, the rate is 23.5 per mile.

14.8 H&RBlock Income Tax Course (2015)

Regardless of which method is used to calculate medical transportation, add to the deduction any
medically related parking fees and tolls paid. The transportation expenses of a parent who must take
a child to receive medical care or for a nurse who must travel with a patient to get medical care are
deductible. Transportation expenses for regular visits to see a mentally ill dependent are deductible
if the visits are recommended as a part of the treatment.

Meals and Lodging


If a person is in a hospital, nursing home, or similar institution primarily for medical care, the cost of
the meals and lodging the institution provides is a deductible medical expense.
The cost of non-hospital lodging while away from home primarily for medical care provided by a physician in a licensed hospital or in a medical facility that is related to or equivalent to a licensed hospital
is deductible. The deduction is limited to $50 per night per person. Meals are not deductible.
Lodging expenses for a person accompanying the patient are deductible if the patients expenses are
deductible and the patient is unable to travel alone. No deduction is allowed for either the patient or
the companion if the accommodations are lavish or there is a significant element of pleasure involved.
mExample: Janice Rawlins accompanied her ten-year-old dependent daughter, Rachel, to Rochester,
Minnesota, for some medical tests Rachel needed to undergo at the Mayo Clinic. While in Rochester,
Janice and Rachel stayed for three nights at a motel near the clinic while the tests were conducted.
They spent $90 per night for the motel and a total of $130 for meals. Janice may deduct $270 [$90 2
3 nights] for lodging because the mother and daughter have separate $50-per-night limits. Janice may
not deduct the $130 for meals.m

Special Care
Payments for special care necessitated by a physical or mental handicap or disorder are deductible
medical expenses. Such special care includes care furnished by a special school for the physically or
mentally handicapped, advance payments to an institution for lifetime care, treatment and training
of a mentally or physically handicapped dependent, and tutoring provided for an individual who has
severe learning disabilities caused by mental or physical impairments. Alleviating the handicap or
disorder must be the primary reason for obtaining this special care in order for its cost to be deductible.
Wages paid to individuals who provide nursing care, including meals provided and payroll taxes paid
on their behalf, may be deducted as a medical expense. The care need not be provided by a nurse, but
the services must be of a kind generally performed by a nurse. These include caring for the patients
medical condition, administering medications, and assistance with bathing, grooming, and the like.
Certain expenses of handicapped individuals to assist them in their employment are deductible on
line 28 of Schedule A.

Tax Essentials Itemized Deductions I 14.9

Cafeteria Plans
Some employers allow employees to defer some of their earnings before tax into a flexible spending account (FSA). Funds from the FSA may be used to pay medical expenses after they have been
incurred. These plans also may allow employees to pay for their medical or dental insurance with pretax dollars. These plans are often referred to as cafeteria plans (or 125 plans, referring to the section
of the Internal Revenue Code that defines them) because the employee can choose from a menu of
available benefits, usually before taxable wages are computed.
No deduction may be taken for any medical expense that is paid for with pre-tax money. The logic is
simple: You cannot deduct from taxable income something that was never included in the first place.
Non-prescription drugs and medicines, although non-deductible, may qualify for reimbursement
under a 125 plan if they were prescribed by a doctor and used to treat a specifically diagnosed disease
or condition.
mExample: Lisa Curcio had her employer deposit $10 of her salary per week into her 125 plan. Lisa
is under the care of a doctor to treat her arthritis. Her medical expenses for the year include $300 for
four doctor visits and $220 for over-the-counter pain relievers recommended by her doctor. Lisa may
receive reimbursement from her 125 plan to cover the cost of the doctor visits and the pain relievers.
If she did not have the 125 plan, she could deduct the doctor bills but not the cost of the pain relievers.m

Reimbursement for Medical Expenses


Medical expenses that are reimbursed by an insurance plan or paid with pre-tax money from a 125
plan are not deductible. Expenses that are paid directly by insurance are not entered on the return.
Reduce total medical expenses by any reimbursements received (or expected to be received) before
entering the net amount on Schedule A. Any reimbursement received in excess of an actual expense
must be used to reduce other medical expenses.

Excess Reimbursements
If a taxpayer receives reimbursement in excess of medical expenses from an insurance policy for which
he paid the entire premium, the excess reimbursement is not taxable. The section titled, How Do
You Treat Reimbursements? in Chapter 21 of IRS Publication 17 explains the taxability of excess
reimbursements if the employer paid a portion of the insurance premium.

DETERMINING THE MEDICAL AND DENTAL EXPENSE DEDUCTION


To complete the Medical and Dental Expenses section of Schedule A, first enter total deductible medical expenses on line 1. Medical and dental expenses are deductible to the extent they exceed 10%
(7% if either the taxpayer or their spouse is age 65 or older) of the taxpayers adjusted gross income
(AGI). This limit is computed on lines 2 and 3. Enter AGI (Form 1040, line 38) on line 2, multiply this
amount by the respective percentage, and enter the result on line 3. Subtract line 3 from line 1, and
enter the difference on line 4. This is the deductible portion of the taxpayers medical expenses. If line
3 is more than line 1, enter zero on line 4.
Complete Exercises 14.2 and 14.3 before continuing to read.

14.10 H&RBlock Income Tax Course (2015)

TAXES YOU PAID


In general, taxes that fall into the following categories are deductible:
State and local taxes (income or general sales).
Real property taxes (state, local, and foreign).
Personal property taxes (state and local).
Foreign income taxes.
To be deductible, these taxes must be imposed on, and paid by, the taxpayer. Taxes are generally
deducted the year they are paid. Most taxes are deductible only on Schedule A. However, the taxes
incurred in the operation of a business or farm or in producing rental or royalty income must be
deducted from that income. These types of income and related deductions are introduced in later
chapters.

State and Local Taxes


For 2014, taxpayers have the option of deducting either (1) state and local income taxes paid during
the year or (2) state and local general sales taxes paid during the year, but not both.
Income Taxes
Deductible income taxes include all of the following:
State and local income taxes withheld from income (normally shown on Forms W-2 and 1099).
Mandatory employee contributions to the Alaska, New Jersey, or Pennsylvania Unemployment
Compensation Fund; California, New Jersey, or New York Nonoccupational Disability Benefit
Fund; Rhode Island Temporary Disability Benefit Fund; or Washington State Supplemental
Workmens Compensation Fund.
Payments of state and local estimated taxes, including any portion of a prior-year refund the taxpayer chose to have credited to their 2014 state or local income taxes.
Any balances paid on prior years state and local returns.
When considering the amount of state and local income taxes to deduct on Schedule A, be careful to
include only payments made during the tax year, regardless of the year to which the payments apply.
Sales Taxes
Instead of state and local income taxes paid, individual taxpayers may choose to deduct state and
local general sales taxes. Sales taxes paid on items used in a trade or business may not be deducted
on Schedule A, but are included as part of the cost of the items. Such costs generally are deducted as

Tax Essentials Itemized Deductions I 14.11

current expenses or depreciated over a period of time. You learn more about these expenses later in
this course.
A general sales tax is a sales tax imposed on retail sales of a broad range of items at a single rate.
However, sales taxes imposed at different rates may also be fully or partially deductible, as explained
below.
Certain economically depressed areas impose sales taxes at rates lower than the general sales tax
rate. Also, some areas tax food, clothing, medical supplies, or motor vehicles at reduced rates. If
sales tax was imposed at a rate less than the general sales tax rate, the actual amount of tax paid is
deductible.
Sales taxes on items (generally motor vehicles) that are imposed at rates higher than the general sales
tax rate are deductible only up to the amount of tax that would have been imposed on an item of the
same cost taxed at the general rate. For this purpose, motor vehicles include cars, trucks, vans, SUVs,
recreational vehicles, motor homes, motorcycles, and off-road vehicles. Also include any state and local
general sales taxes paid for a leased motor vehicle.
In order to deduct the actual amount of sales tax paid, the taxpayer must keep receipts supporting
his deduction amount. However, many taxpayers do not bother saving all those receipts. Instead,
Schedule A filers may use the amount found in the Optional State and Certain Local Sales Tax Tables
provided in 2014 Instructions for Schedule A (Form 1040). These tables are based on the taxpayers
state of residence, total available income (defined below), and number of personal and dependent
exemptions claimed. The tables are included in the appendix to your text. An excerpt is shown in
Illustration 14.3.
If married taxpayers file separately and both spouses choose to deduct state and local sales taxes
instead of income taxes, both spouses must use the same method to compute their sales tax deductions. Thus, if one spouse uses the optional sales tax tables, the other spouse also must use the tables.
When figuring general sales tax, total available income is adjusted gross income plus any nontaxable
income, including the following:
Tax-exempt interest.
Veterans benefits.
Nontaxable combat pay.
Workers compensation.
Nontaxable unemployment compensation.
Nontaxable portion of social security and railroad retirement benefits.
Nontaxable portions of IRA, pension, or annuity distributions (but not including amounts rolled
over).
Public assistance payments.

14.12 H&RBlock Income Tax Course (2015)


Illustration 14.2

Tax Essentials Itemized Deductions I 14.13


Illustration 14.3

mExample: Russell Kimball lived in Arizona the entire year for 2014. He is single and claims one
exemption. His adjusted gross income is $46,000. In addition, he received $3,820 tax-exempt interest
and $1,850 nontaxable social security benefits. Thus, his total available income is $51,670. His state
sales tax deduction from the Arizona table is $594. See Illustration 14.2.m
In addition to the amount found in the table, taxpayers may add any local general sales taxes plus
the actual amount of state and local sales taxes paid (limited to the general sales tax rate) on certain
specified items. These items include motor vehicles, any aircraft, boats, homes (including mobile and
manufactured homes), and home-building materials.
A worksheet for computing the state and local general sales tax deduction is included in 2014
Instructions for Schedules A and shown in Illustration 14.2. As is our usual practice, round line 5 to
four places instead of the recommended three.
mExample: Russell Kimball, from the preceding example, lived in Scottsdale (Maricopa County) in
2014. The state of Arizona imposes a general sales tax at 6.0137%, and the city of Scottsdale and
Maricopa County imposes an additional 2.35% general sales tax. All items are taxed at the same
general sales tax rate. The only special item he purchased in 2014 was a used boat, costing $4,900,
on which he paid $410 sales tax. Russells state and local general sales tax worksheet is shown in
Illustration 14.2.m
If the taxpayer lived in more than one state during the year, you must prorate the amounts from the
table for each state, based on the number of days lived in each state. Also, prorate any local sales taxes
based on the number of days resided in each locality. See the instructions for Schedule A for more
information if you encounter this situation.
Caution: The decision of whether to deduct state and local general sales taxes instead of state and
local income taxes can get a bit more complex than simply deciding which option gives the greater
Schedule A deduction in the current year. More details will be discussed when we discuss recoveries
in the next chapter.

14.14 H&RBlock Income Tax Course (2015)

Real Estate Taxes


Real estate taxes are state, local, or foreign taxes levied on real property for the general public welfare. They usually do not include local assessments for improvements that increase the value of the
assessed property. However, any portion of a local assessment specifically allocated to repairs, maintenance, or related interest is deductible.
Real estate tax paid into an escrow account (sometimes called an impound account) is deductible in
the year the tax is paid from the account to the taxing authority, as opposed to the year the money is
paid into the account. Usually, the account trustee sends the owner a statement of taxes paid during
the year.
The taxes imposed on real estate sold must be apportioned between the buyer and the seller. The
seller may deduct the taxes from the beginning of the year up to (but not including) the date of sale.
The buyer may deduct the taxes from the date of purchase to the end of the year. This proration is
usually shown on the closing statement.

Personal Property Taxes


A personal property tax is similar to a real estate tax, except that it is imposed on personal property.
Examples of personal property are clothing, jewelry, cameras, and automobiles. The most common
personal property tax is the tax certain states impose annually on the value of automobiles and other
vehicles registered in the state.
To be deductible, personal property tax must be based on the value of the property and imposed on an
annual basis, even if collected more (or less) frequently. A tax meeting these requirements is deductible even if it is labeled as a fee. If only a portion of the fee meets these requirements, that portion is
deductible.
mExample: Your state imposes an annual registration fee on motor vehicles. The fee is equal to $25
plus 2% of the assessed value of the vehicle and $1 for every 100 pounds of the vehicles weight.
Your registration fee for 2014 is $175 [$25 + ($6,000 value 2 2%) + (3,000 pounds 3 100 2 $1) =
$175]. You may deduct $120 of the fee as personal property tax [$6,000 value 2 2% = $120]. The
remaining $55 is not deductible because it is not based on the value of the vehicle.m

Foreign Taxes
You may include on Schedule A, line 8, any income taxes paid to a foreign country or U.S. possession.
These taxes may be claimed either as an itemized deduction or as a credit. A full discussion of the
foreign tax credit, which is generally more favorable than this deduction, can be found in the instructions for Form 1040, line 48.

Nondeductible Taxes
Federal taxes, including the taxpayers federal income taxes, social security and medicare taxes,
excise taxes, customs duties, and gift taxes, are not deductible on Schedule A. State and local taxes
that are not deductible on Schedule A include inheritance taxes, gift taxes, taxes on utilities, gasoline,
tobacco, and alcohol, and taxes that are fines or fees for services.

Tax Essentials Itemized Deductions I 14.15

Federal estate taxes attributable to taxable income received in respect of a decedent may be deductible as a miscellaneous expense. We discuss such deductions later in the next chapter.
Complete Exercise 14.4 before continuing to read.

INTEREST YOU PAID


There are several kinds of loans on which taxpayers may pay interest. Among them are personal
loans, business loans, loans to purchase investments, and home mortgage loans.
Interest paid on personal loans, such as car loans, credit card finance charges, and installment
plans, is not deductible at all. Interest on business loans is deductible from business income on
the appropriate schedule. You will learn how to deduct business-related interest in Tax Essentials,
Self-Employment. Qualified home mortgage interest and investment loan interest are deductible on
Schedule A. Both are described below. For either of these types of interest to be deductible, the taxpayer must be legally liable for repayment of the loan.

Qualified Home Mortgage Interest


Most interest paid on home mortgages is fully deductible, but there are exceptions. It is important
to distinguish qualified home mortgage interest from personal interest because the former is usually
deductible, while personal interest is not deductible.
Home mortgage interest (interest on debt secured by a principal residence or second residence) must
be categorized as interest on acquisition debt or interest on home equity debt. Acquisition debt is debt
incurred to buy, build, or improve the home. Home equity debt is debt incurred for any purpose other
than buying, building, or improving the home and is secured by the taxpayers qualified home.
Interest on acquisition debt is fully deductible as long as the debt does not exceed $1 million ($500,000
MFS) at any time during the tax year. Interest on home equity debt is fully deductible, as long as
the debt does not exceed $100,000 ($50,000 MFS) at any time during the tax year, or the difference
between the fair market value of the home and the remaining acquisition debt, whichever is less.
mExample: In 2008, Mary Mahoney purchased her principal residence for $500,000. In 2012, when
she owed $400,000 on the original mortgage, she borrowed $60,000 secured by the home and used the
proceeds to build a sunroom and install an indoor pool. By 2014, the home was worth $700,000, so
Mary borrowed $130,000 secured by the home and bought a sailboat. On her 2014 return, Mary may
deduct, as qualified home mortgage interest, the interest she pays on:
The $400,000 left on the original mortgage (acquisition debt).
The $60,000 sunroom/pool loan (acquisition debt).
$100,000 of the sailboat debt (home equity debt).
The remaining $30,000 of the sailboat debt generates personal non-deductible interest.m

14.16 H&RBlock Income Tax Course (2015)

mExample: Jack Michaels purchased his home for $80,000. His debt remaining on his original mortgage used to acquire the house is $70,000. The 2011 fair market value of the house is $95,000. Jack
used a home equity line of credit in 2010 to borrow $15,000 to purchase a new car. All of the interest
paid in 2014 on the original mortgage (acquisition debt) and on the $15,000 car loan (home equity
debt) are deductible as qualified home mortgage interest.m
Under the mortgage interest rules, all debt incurred before October 14, 1987, and secured by a main
or second residence is treated as acquisition debt. Such debt is not subject to the $1 million cap, but
it does reduce the $1 million and $100,000 limits if any additional debt is incurred on the residence
after October 13, 1987.
mExample: Mabel Warrens principal residence is worth $3.2 million. In 2014, she had $2 million
outstanding debt on the residence, all incurred prior to October 14, 1987. For 2014, she may deduct in
full the interest she pays on the $2 million debt. If she now borrows any more money, even for a home
improvement, the interest is nondeductible personal interest because she has already surpassed the
$1 million acquisition debt limit and the $100,000 home equity debt limit.m
Recall that the interest paid on home equity debt is deductible up to the lesser of the following:
$100,000.
The difference between the fair market value (FMV) of the home and the remaining acquisition
debt.
Consider the following example.
mExample: Joe Matthews purchased his home in 2008 for $155,000, incurring $147,250 acquisition
debt (his original mortgage). In January 2014, he took out a home equity loan to consolidate his other
debts at a lower interest rate. The lender, the Cash Market, allowed him to borrow up to 110% of
the fair market value of his home. His remaining mortgage principal at the time was $138,600, and
the fair market value of his home was $165,000 [$165,000 2 110% = $181,500 limit]. Joe borrowed
$42,900, the maximum amount allowed [$181,500 limit $138,600 existing mortgage = $42,900].
In 2014, the interest Joe paid on his home equity loan is not fully deductible. Why? Because the home
equity debt limit has been exceeded. The difference between the FMV of the home and the remaining
acquisition debt is $26,400 [$165,000 $138,600 = $26,400], which is less than $100,000. Joe borrowed $42,900; therefore, the interest on $16,500 [$42,900 $26,400 = $16,500] of his home equity
debt is not deductible.m
The computation of such mortgage interest limitations can get rather involved, requiring multiple
worksheets. We do not ask you to complete the worksheets, but it is important to be aware of the
deduction limitations, because these types of home equity loans are rather popular. If you encounter
a similar situation, you may wish to consult IRS Publication 936, Home Mortgage Interest Deduction.

ax tip: In recent years, many mortgage lenders have made special offers
allowing taxpayers to take out home equity loans or lines of credit exceeding the fair market values of their homes. They follow these offers with the
caveat, The interest is usually tax-deductible. Ask your tax advisor. How would
you advise a homeowner in this situation?

Tax Essentials Itemized Deductions I 14.17

Prepaid Interest
Interest paid in advance (for a period extending beyond the current tax year) generally is deductible
in the tax years to which the payments apply. The taxpayer may deduct in each year only the interest
for that year.
Points
Points (also called loan origination fees, maximum loan charges, or loan discounts) are mortgage
interest paid up front, when the mortgage is granted. One point equals 1% of the mortgage loan
amount.
To be deductible as mortgage interest, points must be paid solely for the use of money. Fees paid to
cover services, such as the lenders appraisal fee, notary fees, or the preparation of the mortgage note,
are not deductible.
Because points represent interest paid in advance, they generally must be deducted over the life of the
loan. However, points incurred to finance the purchase or improvement of the taxpayers main home
may qualify to be deducted in full in the year they were paid.
Deducting points in the year paid. Points are fully deductible in the current year if the mortgage
loan was secured by the taxpayers residence and the charging of points is an established business
practice in the area. The deduction may not exceed the number of points usually charged in the area.
Further, funds obtained from the lender cannot be used to pay the points. If the taxpayer is buying the
home, he must provide funds at the time of closing at least equal to the points charged. If any of these
conditions are not met, the points must be deducted over the life of the loan. The flowchart on page
156 of IRS Publication 17 can help you determine whether points are fully deductible in the year paid.
Note that even if a taxpayer qualifies to deduct the full amount of points when paid, a taxpayer who
does not benefit from itemizing deductions for the first year of the mortgage may deduct the points
over the life of the loan.
mExample: Sandy Briggs, a taxpayer filing as head of household, purchased her first home in
November 2014. She paid three points ($3,000) to acquire her 30-year $100,000 mortgage. Her first
mortgage payment was made on January 1, 2015.
For 2014, her itemized deductions, including points paid, totaled only $5,700, far less than her $8,950
standard deduction. Sandy should choose to deduct her points over the life of the mortgage loan.
Because she will have paid a full years worth of mortgage interest and real estate taxes in 2015, she
will be more likely to benefit from itemizing.m
Deducting Points Over the Life of the Loan. Points paid to refinance a home mortgage (often
referred to as a re-fi) or to purchase a second home must be deducted over the life of the loan.
Generally, points deducted over the life of the loan must be amortized using the original issue discount (OID) rules. These rules are rather complex, and we do not cover them in this course. However,
cash-method taxpayers may use a simplified method and deduct the points ratably (equally) over the
life of the loan if all of the following tests are met:

14.18 H&RBlock Income Tax Course (2015)

The loan is secured by a home.


The duration of the loan is not more than 30 years. For loans of more than ten years, the terms
of the loan must be the same as other loans offered in the taxpayers area for the same period or
longer.
Either the loan amount is $250,000 or less, or not more than four points were paid for a loan of 15
years or less (not more than six points for a loan of more than 15 years).
Points paid to refinance a loan are not reportable on Form 1098, unless it is to refinance a construction
loan. Points paid to refinance other loans should be obtained from the refinance statement.
mExample: Sandy Briggs, from the preceding example, may deduct $100 of her points [$3,000 3 360
monthly payments 2 12 payments per year = $100] each year from 2014 through 2043.m
Loan Ends Early. If points are being deducted over the life of a loan and the mortgage is paid off
early, any remaining points can be deducted when the loan is paid off. In cases where the mortgage is
refinanced with a new lender, the remaining points on the original loan are deducted when the loan
is paid off. However, if the mortgage is refinanced with the same lender, the remaining points must
be deducted over the life of the new loan.
mExample: Amanda Probst refinanced her original home mortgage during 2014. The original 30-year
loan, made in July 2006, was for $125,000. Amanda paid 2 points to obtain the loan, a total of
$3,125 [$125,000 2 2.5% = $3,125]. Her first payment was made on September 1, 2006. She has been
deducting the points over the life of the loan at $8.68 per month [$3,125 3 360 monthly payments =
$8.68]. From September 2006 through December 2013. Prior to 2014, she has deducted $764 [$8.68
per month 2 88 = $764]. Amanda made her last payment on the original loan on February 1, 2014.
The re-fi loan is a 15-year, $110,000 loan made on February 20, 2014, with a new lender. Amanda
paid two points to obtain this loan [$110,000 2 2% = $2,200]. The first payment was made on April
1, 2014. She must deduct the points on the re-fi over the life of the loan [$2,200 3 180 monthly payments = $12.22 per month].
Amandas 2014 deduction for points is $2,471 [$3,125 points on original loan $764 deducted prior to
2014 + ($12.22 monthly points on new loan 2 9 months) = $2,471].
Hypothetical: If Amandas original loan had been refinanced with the same lender, the points
remaining from the original loan would have to be deducted over the life of the new loan. Because
Amanda made two payments prior to refinancing the loan, her remaining point balance from the original loan is $2,344 [$3,125 $764 prior to 2014 $8.68 January 2014 $8.68 February 2014 = $2,344].
After Amanda refinanced the loan, she would deduct $13.02 per month for the remaining point balance of the original loan [$2,344 remaining points 180 months = $13.02 per month]. Thus, her 2014
deduction for points would have been $245 [($8.68 2 2) + ($13.02 2 9) + ($12.22 2 9) = $245].
Important: Any deduction for points is in addition to the deduction for the normal monthly interest
payments she made on both loans.m
Seller-Paid Points. Points paid by the seller in connection with a loan to the buyer are usually considered for tax purposes to be paid by the buyer and are deductible by the buyer. The taxpayer must
reduce the basis of the home by the amount of points paid by the seller.

Tax Essentials Itemized Deductions I 14.19


Illustration 14.4

Reporting Home Mortgage Interest on Schedule A


Financial institutions must report, to the borrower and the IRS, mortgage interest of $600 or more
received during the year. Form 1098 (a copy of the standard form is shown in Illustration 4) is used
for this purpose. Box 1 shows the interest received from the payer, exclusive of deductible points. Box
2 shows points received for the purchase of the taxpayers main home, only for the year acquired.
Box 3 shows any refund of interest made because the taxpayer overpaid the amount actually owed.
Entries in this box are fairly rare. If you are interested, you may find more information about taxable
recoveries of previously deducted amounts in Chapter 12 of IRS Publication 17.
Box 5 can show various information, such as the address of the property financed or amounts paid out
of escrow, including real estate taxes and insurance premiums.
On Schedule A, line 10, enter deductible interest and points reported on Form 1098. Keep in mind
that the amounts shown on Form 1098 may or may not be deductible, depending on how they fit the
guidelines discussed earlier.
Deductible home mortgage interest and points paid by the taxpayer not reported to him on Form
1098 are entered on Schedule A, lines 11 and 12, respectively. If the recipient of the interest is an
individual, enter the recipients name, address, and identifying number (usually SSN) on the dotted
lines below line 11.

Qualified Mortgage Insurance Premiums


Taxpayers who were required to purchase mortgage insurance for a mortgage issued after 2006 can
deduct the premiums they paid if the mortgage was secured by their first or second home. The amount
of premiums paid for this insurance can usually be found in box 4 of Form 1098, and it should be
entered on line 13 of Schedule A.

14.20 H&RBlock Income Tax Course (2015)

There is a phaseout range for deducting mortgage insurance premiums. You must use the worksheet
for line 13 of Schedule A (not shown) to figure the deduction for taxpayers whose adjusted gross
income is more than $100,000 ($50,000 if married filing separately). See IRS Publication 936, Home
Mortgage Interest Deduction, for a detailed explanation of mortgage insurance premiums.

Investment Interest
Investment interest is interest paid on money borrowed to buy investment property, such as stocks
and bonds. Investment interest is deductible only to the extent of the taxpayers net investment
income (investment income minus expenses other than interest expense). Any amount disallowed
under this rule may be carried forward to future years.
mExample: Patrick Hamill had net investment income of $900 and investment interest expenses of
$1,000. Patrick is only allowed a current deduction of $900. The remaining $100 is carried forward to
future years and deducted when he has sufficient net investment income to absorb it.m
The deductible interest amount is computed on Form 4952, which we do not cover in this course.
However, if the taxpayer meets all of the following criteria, he may dispense with Form 4952 and
enter his deductible investment interest directly on Schedule A, line 14:
The taxpayers investment interest expenses are not more than his investment income from interest and ordinary dividends (minus qualified dividends).
The taxpayer had no other deductible investment expenses.
The taxpayer has no carryover of investment interest expenses from the previous year.
mExample: Bertha Fieldings only investment income for the year was ordinary (nonqualified) dividends of $500. Her investment interest expense for the year was $200, she incurred no other deductible expenses associated with her dividends, and she had no carryover of investment interest from the
previous year. Bertha should enter $200 on Schedule A, line 14. She does not need to file Form 4952.m
One final note on investment interest: To be deductible, the interest must be incurred to purchase
taxable investments. Therefore, interest on a loan used to purchase municipal bonds, for example, is
not deductible. This is true even if the loan is a home equity loan. Additional information regarding
investment interest can be found in IRS Publication 550, Investment Income and Expenses (including
Capital Gains and Losses).

Nondeductible Interest
Personal interest is not deductible. Personal interest is interest paid on loans for personal purposes, as
opposed to business, investment, passive activity, or home mortgage purposes. Examples of personal
interest are car loan interest, personal loan interest, and credit card finance charges. Also, as mentioned in the section dealing with investment interest, interest on loans used to purchase nontaxable
investments (municipal bonds and life insurance, for example) is not deductible.
Complete Exercise 14.5 before continuing to read.

Tax Essentials Itemized Deductions I 14.21

CHARITABLE CONTRIBUTIONS
The amount of money contributed and the value or cost of property donated to qualified U.S. charities are deductible. Donations must be made voluntarily and without receiving (or the expectation of
receiving) anything of equal or greater value in return.
To be deductible, a charitable contribution must be made to a qualified organization. Qualified organizations generally are nonprofit groups that are charitable, religious, educational, scientific, or literary
in purpose, or that work to prevent cruelty to children or animals. Certain organizations that foster
national or international amateur sports competition also qualify.
Examples of qualified organizations include:
Religious organizations, such as churches, mosques, temples, and synagogues.
Most nonprofit charitable organizations, schools, museums, hospitals, medical research organizations, volunteer fire companies, civil defense organizations, and war veterans groups.
The United States government, governments of U.S. states and possessions and political subdivisions thereof (counties, municipalities, etc.), the District of Columbia, and Native American tribal
governments that perform governmental functions.
Certain nonprofit cemeteries and fraternal organizations.
The chart on page 22 lists some of the most popular charities. Most organizations, other than religious
organizations and governments, must apply to the IRS to become qualified organizations. If you do
not know whether an organization qualifies, you can check with the organization or with the IRS. A
complete list is available online at <www.irs.gov>.
Contributions to fraternal lodge societies (such as Elks, Lions, Masons, and Moose) are deductible if
they are used for qualified charitable purposes. They may not be used for sickness or burial expenses
of its members. Dues paid to fraternal lodge societies are not deductible.
Amounts contributed to a nonprofit cemetery are deductible if the funds are irrevocably dedicated to
the perpetual care of the cemetery as a whole and not for a particular lot or crypt.
To be deductible, contributions must actually be paid in cash or property during the year, regardless
of when pledged. A donation paid by credit card is considered to be paid on the date the charge slip
is written.

14.22 H&RBlock Income Tax Course (2015)


Illustration 14.5

American Cancer Society

POPULAR U.S. CHARITIES


Habitat for Humanity

American Childrens Fund

March of Dimes

American Heart Association

Muscular Dystrophy Association

American Lung Association

National Easter Seal Society

American Red Cross

Planned Parenthood

Boy Scouts and Girl Scouts

Salvation Army

Catholic Charities

Shriners Hospitals

Disabled American Veterans

United Way

Goodwill Industries

YMCA and YWCA

Cash Donations
If the taxpayer contributes cash, the deduction is usually the amount of cash contributed. However,
sometimes amounts that appear at first glance to be charitable contributions do not qualify as deductions. A few examples follow:
Amounts paid to charitable organizations primarily for personal benefit, such as educational or
club activities for the taxpayers child, are not deductible.
Amounts paid to a charitable organization for raffle tickets or to play games of chance, such as
bingo, are not deductible as contributions. (However, they may be deductible as gambling losses,
discussed in Tax Essentials, Itemized Deductions II.)
Contributions made for the benefit of an individual; to Chambers of Commerce and other business,
civic, political, and social clubs or organizations; and to foreign and international organizations
(except certain Canadian, Israeli, and Mexican charitable organizations) are not deductible.
If amounts paid to a qualified organization for merchandise, goods, or services are more than the
fair market value, the amount you pay that is more than the value of the item can be a charitable
contribution. For the excess amount to qualify, there must be an intent to make a charitable contribution.
You cannot deduct a cash contribution, regardless of the amount, unless you keep a record of the
contribution. An example would be a bank record (such as a canceled check, a bank copy of a canceled
check, or a bank statement containing the name of the charity, the date, and the amount) or a written
communication from the charity. The written communication must include the name of the charity,
the date, and the amount of the contribution.
Contributions of $250 or more made at any one time to a qualified charitable organization are deductible only if the taxpayer obtains written substantiation from the donee organization. Canceled checks
do not suffice to document such donations. Written substantiation is required for both cash and
property donations. It must be obtained from the qualified organization by the earlier of the date the
taxpayer files his return or the due date of the return (including extensions).

Tax Essentials Itemized Deductions I 14.23

mExample: Maria Cora donated $300 to the Red Cross on January 4. She must have written substantiation of the contribution from the Red Cross in order to deduct it. However, if Maria had given two
gifts at separate times of $150 each, her canceled checks or other written documentation would suffice
to document the deduction.m
For contributions of more than $75 for which the taxpayer receives goods or services, the donee organization must specify that the contribution is only partly deductible and must furnish the taxpayer
with a good-faith estimate of the value of the goods or services. A detailed discussion of records to keep
can be found in IRS Publication 526, Charitable Contributions.

Volunteer Work
Out-of-pocket expenses incurred in rendering volunteer services to charitable organizations are
deductible. The cost and upkeep of uniforms, equipment, and supplies used when performing services
for a charitable organization are deductible.
The cost of transportation to perform volunteer work is deductible. If the volunteer uses his car, he
may deduct the cost of parking, tolls, gas, and oil. Alternatively, the taxpayer may deduct 14 per mile
for miles driven in 2014, plus parking and tolls. If the taxpayer uses public transportation, that cost
may be deducted. Qualified transportation includes going to and from home to the locations where
volunteer work is performed.
A chosen representative attending a convention of a qualified organization and others whose volunteer work takes them away from home overnight may deduct food, lodging, and other unreimbursed
expenses directly related to the volunteer services. Recent tax law changes have attempted to eliminate deductions for charitable trips that are really disguised vacations. Thus, expenses for volunteer
travel are deductible only if there is no significant element of personal pleasure, recreation, or vacation involved. This does not mean that the volunteer is forbidden to enjoy himself while performing
the volunteer service, but it does mean that volunteer service must be the main motivation for the
trip.
mExample: Lee Martin accompanies a group of Boy Scouts on a camping trip. During the trip, he is
on duty as a supervisor of the scouts in a real and substantive sense most of the time. Lee may deduct
his travel expenses for this excursion. The fact that he enjoys this type of activity does not disqualify
his deduction.m
The value of the volunteers time and work is not deductible.
mExample: Linda Jamison is an attorney. Without charge, she drew up a trust agreement for her
church. The work took her five hours. She normally charges $200 per hour for such work. Linda may
take no charitable deduction because the value of her time is not deductible.m
The cost of transportation to attend meetings of charitable organizations as a member or observer
(rather than to perform volunteer services) is not deductible. The cost of driving one or several people
to an activity is not deductible unless the driving is volunteer service to a charitable organization and
the volunteer would not otherwise attend the activity.

14.24 H&RBlock Income Tax Course (2015)

A taxpayer may deduct up to $50 per school month of the actual amounts spent for the well-being of a
student who is living in his home under a written agreement with a qualified charitable organization.
The student may not be a dependent or relative of the taxpayer and must be a full-time student in the
12th grade or lower at a school in the United States. A school month for purposes of this deduction is
15 days or more in a calendar month during which the student lived with the taxpayer and attended
school. This deduction is used mostly by those who take foreign exchange students into their homes.
However, the costs of a foreign student living in the taxpayers home under a mutual exchange program whereby the taxpayers child lives with a family in a foreign country are not deductible.

Contributions of Property
You cannot take a deduction for clothing or household items you donate after August 17, 2006, unless
the clothing or household items are in good used condition or better.
Generally, the fair market value (FMV) of property at the time it is donated to a charitable organization is deductible. Fair market value is the price at which property would be sold in a transaction
between a willing buyer and a willing seller, both of whom have full knowledge of the relevant facts.
In every case in which the FMV of donated property is less than the cost of the property, the allowable deduction is FMV. A common example is a donation of clothes, home furnishings, or automobiles made to various charitable organizations or thrift shops operated by such organizations. The
FMV of these items is generally less than the cost; therefore, the deduction usually is the FMV.
a taxpayer donates a car worth more than $500 to a qualified orgaTnizationIfafter
December 31, 2004, and the organization sells the car, the taxax tip:

payers deduction is limited to the gross proceeds of the sale or the cars FMV,
whichever is less. However, if the organization improves the car or makes significant use of it before selling it, the taxpayer may deduct the fair market value
at the time of the donation.

Appreciated property. If donated property has appreciated in value (FMV is more than cost), the
allowable deduction is the FMV minus the amount of the value that would have been ordinary income
if the property was sold. In most cases, if the property donated was owned by the donor for personal
or investment purposes, this means that:
If the taxpayer owned the property one year or less, the deduction is the cost of the property.
If the taxpayer owned the property for more than one year, the deduction is the FMV of the
propertythere are some exceptions, so do some research in IRS Publication 526, Charitable
Contributions, if you encounter this type of donation.
mExample: In 2010, Linda Atwell purchased 100 shares of ABC stock for $1,000. In 2014, when
she gave the stock to her synagogue, the stock was worth $2,000. Linda may deduct the full $2,000
because she held the stock for more than one year.m

Tax Essentials Itemized Deductions I 14.25

mExample: In January 2014, Jerry Cloud purchased 100 shares of XYZ stock for $1,000. In November,
when he gave the stock to his church, it was worth $2,000. Jerry may deduct only $1,000 because he
did not own the property more than one year.m
When total property contributions of more than $500 are deducted, Form 8283, Noncash Charitable
Contributions, must be completed. Page 1 is used if the value of the property totals between $501
and $5,000 and is used for certain publicly traded securities of any value over $500. The name and
address of the charitable organization, when and how the property was acquired, and the method used
to value the property must be reported.
If a single item of donated property (or aggregate of similar items) has a value of more than $5,000,
Form 8283, page 2, must be completed. The recipient organization is required to sign this page. The
taxpayer must obtain a written appraisal (except for nonpublicly traded stock of $10,000 or less and
securities for which market quotations are readily available). The appraisal should not generally be
attached to the return. A separate Form 8283, page 2, is required for each different type of property
given and for each separate recipient organization.
For donated art with an aggregate value of $20,000 or more, the donor must attach to his return a
complete copy of the qualified appraisal. The taxpayer must also be able to provide upon IRS request
an 8210-inch color photograph or transparency of any individual objects valued at $20,000 or more.
For purposes of these rules, art includes paintings, sculptures, watercolors, prints, drawings, ceramics, antique furniture, decorative arts, textiles, carpets, silver, rare manuscripts, historical memorabilia, and similar objects.
Note: There is no deduction allowed for a donation of the use of property.
mExample: A taxpayer allows a scout camp to use his property as a parking lot, but retains title to
the land. No deduction is allowed.m
The taxpayer must keep a record of each cash or property contribution he makes. Records of property
donations should include a description of the property, its cost and fair market value, the date of the
contribution, and the name and location of the charity.
There are limitations on deductions for charitable contributions. The majority of contributions by taxpayers are given to qualified charitable organizations. Donations to most of these organizations are
deductible up to 50% of AGI. However, the value of gifts to veterans organizations, fraternal societies,
and nonprofit cemeteries may not exceed 30% of AGI. Gifts of certain types of property may be further
limited. The majority of taxpayers do not approach these limits. If you are interested, you may find
a discussion of these limits and carryover provisions in the section titled Limits on Deductions in
Chapter 24 of IRS Publication 17.
Complete Exercise 14.6 before continuing to read.

14.26 H&RBlock Income Tax Course (2015)

CHAPTER SUMMARY
In this chapter, you learned:
Generally, taxpayers may deduct the larger of their total itemized deductions or their standard
deduction.
Most medical and dental expenses are deductible to the extent they exceed 10% (7% if either the
taxpayer or their spouse is age 65 or older) of the taxpayers adjusted gross income.
Transportation for medical purposes is deductible. In lieu of actual gas and oil expenses, taxpayers
may choose the standard mileage rate, 23.5 for 2014.
A taxpayer may deduct the following taxes:
State and local taxes (income or general sales).
Real property tax.
Personal property tax.
Foreign income taxes.
A taxpayer may deduct interest paid on qualified home mortgages and on money borrowed to buy
investment property. However, personal interest is not deductible.
Cash and property donated to qualified U.S. charities is deductible. A taxpayer must voluntarily
make the donation and not receive anything of equal or greater value in return.

Suggested Reading
For further information on the topics discussed in this chapter, you may wish to read the following in
IRS Publication 17:
Chapter 21, Medical and Dental Expenses.
Chapter 22, Taxes.
Chapter 23, Interest.
Chapter 24, Contributions.

15

Itemized Deductions II
OVERVIEW
The Tax Code allows certain personal expenses to be deducted from gross income. Some of the expenses a taxpayer may deduct depend on the taxpayers adjusted gross income (AGI). In other words,
before a taxpayer will see any tax benefits from these types of deductions, they will have to cross a
threshold amount. The dollar amount of the threshold is different for every taxpayer, but the percentages (2%, 7%, and 10%) of AGI are the same. It is not uncommon for a taxpayer to have several
thousand dollars of one type of expense, but see no tax benefit from it. Other types of deductions may
be deducted regardless of AGI.

OBJECTIVES
At the conclusion of this book, you will be able to:
Identify a casualty or theft loss of personal-use or investment-use property and compute a deductible loss of personal-use property on Form 4684.
Determine if an employee may deduct transportation expenses using the standard mileage rate,
and compute the deduction using Form 2106-EZ.
Determine deductible gambling losses and enter them on Schedule A.
Identify other miscellaneous itemized deductions, and make the appropriate entries on Schedule A.
Explain the Alternative Minimum Tax.
Determine if a recovery (refund) of a previously deducted item is taxable.

TAX TERMS
Look up the definitions of the following terms in the glossary:
Adjusted basis.
Casualty loss.
Itemized deductions.
Qualified charitable organization.
15.1

15.2 H&RBlock Income Tax Course (2015)

CASUALTY AND THEFT LOSSES


A casualty is the complete or partial destruction of property resulting from an identifiable event of a
sudden, unexpected, or unusual nature. It must be due to an external cause, rather than to a defect in
the product itself. A theft is the unlawful taking of property. To claim a casualty or theft loss, the taxpayer must own or be buying the damaged property or be responsible for damages to leased property.
Casualty and theft losses include, but are not limited to:
Damage from a hurricane, tornado, earthquake, tidal wave, volcanic eruption, flood, storm, fire, or
sonic boom.
Damage from an accident, if it was not caused by a willful act or willful negligence on the part of
the taxpayer.
A loss from vandalism or theft.
Damage or loss from a terrorist attack.
Losses that are not deductible include:
Paying for personal injuries or damage to property owned by another person.
Property broken through ordinary use or by wearing out over time.
Loss of trees or other plants caused by a fungus, a disease, insects, worms, or similar pests. (Note:
Sudden destruction of trees or plants caused by an unexpected or unusual infestation of beetles or
other insects may qualify.)
Termite or moth damage.
Accidental loss or disappearance of property if it was not the result of damage from a sudden,
unexpected, unusual, and identifiable event.
Loss caused by a defect in the product.
Loss of market value because the property is near a casualty area.
mExample: The gradual wearing out of a roof is not a casualty. On the other hand, damage to a roof
caused by a severe storm is a casualty.m
mExample: Damage to a car caused by the owner losing control and accidentally running into someone
elses tree is a casualty assuming it was not a willful act or willful negligence. However, the car owner
cannot claim as a casualty any damages he paid for the tree.m

Proof of Loss
In order to deduct a casualty or theft loss, the taxpayer should be able to substantiate:
The nature of the casualty or theft and when it occurred or was discovered.
The loss was the direct result of the casualty or theft.
The taxpayer was the owner of the property or responsible for damages to leased property.
The adjusted basis of the property (usually its cost).
The fair market value of the property before and after the loss.
The amount of insurance or other compensation received or expected to be received.

Tax Essentials Itemized Deductions II 15.3

A casualty or theft loss of property held for personal use is deductible on Schedule A only after completing Form 4684, Casualties and Thefts. The loss must be reduced by:
Any insurance reimbursement the taxpayer receives (or is eligible to receive, even if a claim is not
filed).
$100 per incident.
10% of adjusted gross income after combining all casualties and thefts for the year.
A business casualty loss or theft will not be discussed in this course. Such losses or thefts would be
listed on Section B, Form 4684 (not shown), and then transferred to the appropriate business form.
Unreimbursed losses of investment property, such as notes, bonds, or collectibles held for potential
increase in value, are deductible on Schedule A, but such losses are not reduced by the $100 floor or
10% of AGI. An unreimbursed casualty or theft of notes or bonds is uncommon, because most would
be difficult to cash and would be replaced if stolen or destroyed.

Amount of the Casualty or Theft Loss


Before the amount of a casualty loss can be computed, we must determine the adjusted basis of the
property and the propertys fair market value (FMV) before and after the casualty or theft.
The adjusted basis of property is usually the original cost plus the cost of capital improvements and
the cost of restoring the property after any previous casualty, minus any reimbursement or deduction
of previous casualty losses and depreciation taken (if the property had ever been used for the production of income).
An appraisal fee incurred in ascertaining the amount of loss is deductible as a miscellaneous itemized
deduction subject to the 2%-of-AGI floor, which you will study in this course, and not as part of the
casualty or theft loss.
The cost of cleaning up, repairing, or replacing the property after a casualty is not deductible.
However, it may be used as a measure of the decrease in FMV if:
The repairs are necessary to restore the property to the same condition as before the casualty.
The amount spent for repairs is not excessive.
The repairs only rectify the damage.
The value of the property does not increase beyond the FMV of the property prior to the casualty.
Amounts spent to improve the structure of the property in order to protect against future casualties
are not deductible but may be added to the basis of the property. Expenses incidental to the casualty,
such as moving expenses and rental of temporary quarters, are not part of the casualty loss.
Real property (such as the taxpayers main home, vacation home, or cabin). The amount of casualty
loss is determined for the entire property as a single item. The entire property includes the buildings,
land, landscaping, and other improvements. The loss is the lesser of the adjusted basis of the entire
property or the decrease in FMV of the entire property, minus any insurance reimbursement.
mExample: Pat Land owns a cabin in the mountains. The FMV of the cabin and the land on which it
stands was $95,000 before the uninsured cabin was damaged by a small fire. Its FMV after the fire
was $87,000. The adjusted basis of the property prior to the casualty was $81,000. Pats casualty loss
(before applying the required reductions) is $8,000 [$95,000 $87,000].m

15.4 H&RBlock Income Tax Course (2015)

Personal-type property (such as vehicles, furnishings, jewelry, and sporting equipment). The
amount of casualty loss is determined separately for each item. The amount of the loss is the lesser of
the adjusted basis or the decrease in fair market value of each item of personal property, reduced by
any insurance reimbursement or other recovery.
If multiple assets are destroyed or damaged by the same casualty, the amount of the loss for each
asset is determined as stated, then totaled and reduced by $100. The $100 floor reduces the total loss
from each separate casualty or theft that might occur during the year. The 10%-of-AGI reduction
applies only to the total of all casualty losses incurred during the year. The requirement to reduce
the casualty amount by the $100 floor and 10% of AGI applies to personal-use property but not to
investment property.
Insurance policies can vary greatly and may cover less than (or more than) the entire loss. If the policy
has a deductible clause (the policy holder pays the first specified dollar amount of each covered loss)
or otherwise covers less than the entire loss, only the out-of-pocket expenses are deductible. It does
not matter how much the asset will cost to replace. An insurance reimbursement also may result in a
taxable gain, which we will discuss later in this chapter.
mExample: Kathy Schmitts car was totaled in an accident in 2014. The car was worth $4,000 before
the accident and $300 afterward. Her auto policy had a $250 deductible, so the insurance company
paid her $3,450 [$3,700 loss $250 deductible]. Her deductible loss before limitations is only $250. It
does not matter how much it would cost to buy a replacement car.m

When to Deduct a Loss


In general, a loss is deductible only for the year the casualty occurred or the theft was discovered.
If the taxpayer expects to be reimbursed in a later year, only the part of the casualty only the portion
of the casualty or theft that will not be reimbursed is deductible. If the taxpayer recovers less than
he expected, the difference may be deducted in the year in which no more reimbursement or recovery
can reasonably be expected. If a reimbursement is later received for a casualty or theft previously
deducted, the reimbursement must be included in income for the year in which it is received, to the
extent the deduction reduced the previous years income subject to tax.
Federally declared disaster area. A casualty loss from a disaster that occurred in an area the
President of the United States declares to warrant federal assistance may be deducted either on the
return for the year in which the casualty occurred or on the return for the immediately preceding tax
year. For example, a disaster loss in 2014 may be deducted on either the 2014 or the 2013 tax return.
The purpose of this provision is to allow taxpayers who have been victims of a disaster to receive some
money quickly by filing an amended return for the preceding year, thereby obtaining a refund.
A taxpayer has until the due date of the return for the year of the loss to make this election. The
election to claim the deduction on a prior years return becomes irrevocable 90 days after being made.
The choice should be based on which year the claim will result in the greater reduction of tax and on
how quickly the taxpayer needs the money.
mExample: Brendas car was destroyed by a tornado in September 2014. Due to the severe damage
caused by several tornadoes, her county was declared a disaster area by the president. She may wait
until she files her 2014 return and deduct the loss in the usual way, or she may elect to file an amended 2013 return and deduct it there. She must make the election by April 15, 2015, the due date for
2014 returns.

Tax Essentials Itemized Deductions II 15.5

If she files an amended 2013 return on October 15, 2014, she has 90 days to revoke the election by
filing another amended return and paying back the refund. She may then claim the loss on her 2014,
the due date of the 2014 return (the year in which the disaster area was declared). m

Net Operating Losses


Casualty or theft losses of personal-use property that exceed the taxpayers AGI may possibly be used
to reduce income in prior or future years. If you encounter this situation, you will need to do some
research on the subject of net operating losses. IRS Publication 536, Net Operating Losses (NOLs) for
Individuals, Estates, and Trusts, provides an excellent starting place if you need to learn more about
net operating losses.

FORM 4684 CASUALTIES AND THEFTS


When a person suffers a casualty or theft, in most cases, a loss occurs. In some instances, however,
when insurance or other reimbursement is more than the adjusted basis of the property, the result
can be a gain.
mExample: Suppose that Kathy Schmitt (from the earlier example) had an insurance policy that paid
the replacement cost for her car. She paid $8,500 when she bought the car in 2009, and her insurance
paid $10,000 when the car was totaled. She has a $1,500 gain from the casualty.m
Form 4684, Casualties and Thefts, is used to compute taxable gain or deductible loss from a casualty or theft. Section A is used for personal-use property, and Section B is used for business and
income-producing property. In this book, you will complete only Section A. Study Form 4684, Section
A, in Illustration 15.1.
mExample: Lisa Ogilves car was severely damaged in a hailstorm on September 3, 2014. She was not
insured against such damage. She purchased the car on March 7, 2012, for $11,500. She did not live
in a declared disaster area. Lisa will claim itemized deductions on her return.
Immediately before the storm, the fair market value of the car was $9,750, and after the storm, the
FMV was $6,930. Lisa spent $2,820 to repair the dents and replace the broken glass. Her AGI is
$21,300.
Lisas Form 4684 is shown in Illustration 15.1. The figure on line 6 was computed by subtracting the
cost of restoring the car to its previous condition from its FMV before the storm.m
A separate Section A must be completed for each separate casualty or theft. Each item lost, destroyed,
or damaged in the same casualty or theft is listed separately on line 1. Computations necessary for
each item are done in the appropriate columns A through D.
If more than four items are involved in the same casualty or theft, or if the taxpayer suffers more than
one casualty or theft during the year, some special calculations are necessary. Those are explained in
the IRS instructions for Form 4684.
When Form 4684 is completed correctly, with the line-by-line directions on the form followed carefully, any gain to be reported on Schedule D will appear on Form 4684, line 15. Any deductible loss to be
reported on line 20 of Schedule A will appear on Form 4684, line 18. The rules concerning FMV, basis,
the $100 floor per casualty or theft, and the 10%-of-AGI reduction are all taken into account. (Note:
If any of the losses were in a declared disaster area, you will have to do further research.)

15.6 H&RBlock Income Tax Course (2015)


Illustration 15.1

Tax Essentials Itemized Deductions II 15.7

A special note about Form 4684, line 15, is in order here. If there is a net gain, combine the short-term
gains and losses, and enter the net short-term gain or loss on Schedule D, line 4. Combine the longterm gains and losses, and enter the net long-term gain or loss on Schedule D, line 11.
Further special provisions apply to taxpayers who realize a gain from the destruction of their main
homes or contents in a federally declared disaster area. You can read about this in the IRS instructions for Form 4684 or seek assistance if you encounter a casualty gain situation.
Complete Exercise 15.1 before continuing to read.

MISCELLANEOUS DEDUCTIONS
Miscellaneous itemized deductions generally encompass expenses necessary for the production of
income. Thus, unreimbursed ordinary and necessary employment expenses, gambling losses to the
extent of gambling winnings, hobby losses to the extent of hobby income, tax advice and preparation
fees, investment expenses, and similar expenses are deductible as miscellaneous itemized deductions.
Recall how medical expenses are generally deductible only to the extent they exceed 10%-of-AGI (7.5%
for taxpayers age 65 and over). The total of some miscellaneous itemized deductions is subject to a
similar 2%-of-AGI limitation. Examine lines 21 through 27 of Schedule A, shown in Illustration 15.2,
to see where deductions subject to this limitation are entered.
Next, look carefully at Schedule A, lines 21, 22, and 23. Line 21 is for unreimbursed employee expenses and calls for the attachment of Form 2106 or 2106-EZ in some cases. Line 22 is for tax preparation fees. Line 23 is for other expenses. Other expenses are miscellaneous deductions that are not
employment-related: for example, fees paid for investment advice or the rent paid for a safe deposit
box in which stock certificates are stored.
Form 2106 or 2106-EZ is required to report a number of employee business expenses. These include
transportation, travel, meals, and entertainment expenses, and any reimbursements received from
the employer and not included in box 1 of Form W-2. In this book, you will learn to use Form 2106-EZ
to report only unreimbursed transportation expenses using the standard mileage rate. Other types
of expenses requiring the use of Form 2106 can be studied in the H&R Block Intermediate Vehicle
Expense and Advanced Employee Business Expense courses.
Taxpayers who have unreimbursed employment-related expenses other than those previously listed
need not file Form 2106 or Form 2106-EZ. Simply enter the description of the expense(s) and the
amount(s) on Schedule A on the dotted line to the left of line 21, and enter the total on line 21.

Expenses Subject to the 2% Limitation


The miscellaneous itemized deductions discussed in the remainder of this section are, when totaled,
subject to the 2%-of-AGI limitation. We will not be discussing all miscellaneous deductions available
in this course because sales and home-office expenses and those that require Form 2106 are treated
extensively in the H&R Block intermediate and advanced courses.

15.8 H&RBlock Income Tax Course (2015)


Illustration 15.2

Tax Essentials Itemized Deductions II 15.9

Transportation Expenses
Employees (except statutory employees) who claim a deduction for using an automobile in connection
with their employment must file Form 2106 or Form 2106-EZ. We will focus exclusively on Form
2106-EZ.
People in business for themselves and statutory employees may also claim a deduction for business
transportation. While the rules you will learn in this book generally apply to all taxpayers who have
deductible transportation expenses, independent business persons and statutory employees will claim
their deductions on Schedule C (or Schedule C-EZ). Transportation expenses to care for rental property are deducted from rental income on Schedule E. These forms will be introduced later in this course.
Deductible transportation expenses are those that involve the use of a motor vehicle for business
purposes (other than commuting, discussed below). Outside salespersons and individuals who provide
on-site repair, maintenance, construction, or remodeling services will generally have transportation
expenses, unless the employer provides the vehicle and pays all the expenses. Independent delivery
persons and over-the-road truck drivers will have transportation expenses.
It is possible for many different types of workers to have such expenses occasionally. For example, an
employee who works at the employers place of business and is required to use their car to take deposits to the bank or mail to the post office may have transportation expenses. A taxpayer who works at
two locations for the same employer in one day may deduct the cost of driving from one place to the
other. In addition, taxpayers who work at two separate jobs in the same day may deduct the cost of
driving from one place of employment to the other.
Commuting. It is important to distinguish between deductible business mileage and nondeductible
commuting mileage. A taxpayer cannot deduct transportation expenses for driving from their home
to their regular place of business (a specific building or location) and back home. This is commuting
mileage.
mExample: Carl Anderson, a married taxpayer, is an insurance adjuster. His office is located at his
employers corporate headquarters, five miles from Carls home. Transportation between his home
and the office and back home is a nondeductible commuting expense.m
Driving between work locations. If the taxpayer must drive from the regular location or the first
business location to other business locations, that mileage is deductible. The same is true of running
errands for the employer.
mExample: In the course of his work, Carl (from the preceding example) often drives his own car from
the office to various client-related locations during the workday. He drove 3,340 miles and paid $16 in
tolls while making these visits during 2014. The mileage from the office to client locations and back
to the office produces a deduction. The related tolls are also deductible.m
Temporary work location. An employee who works in a temporary job location for their current
employer may deduct the cost of round-trip transportation from their home to the temporary location,
even if it is within the same general area of the employees regular place of business.
mExample: In addition to the client visits, Carls employer required him to work in one of the companys other offices for two weeks (ten working business days). The other office is 14 miles from his
home. Even though the temporary assignment may be considered to be in the same general area as
his regular place of work, the cost of round-trip transportation between his home and the other office
generates a deductible business expense.m

15.10 H&RBlock Income Tax Course (2015)

Short-term workers. The situation is different if a person has no regular place of work, but rather
works at different locations on a short-term basis in the area where they live. Such a taxpayer may
not deduct the cost of transportation from home to work and return. Such a taxpayer will, however,
generate a deduction if they work at more than one work site during the day.
mExample: Rhonda Wallace is employed as a house painter. Her work takes her to different locations
within the general area in which she lives. Her transportation from her home to her work site and
return each day is a nondeductible commuting expense.
If Rhonda works at two or more locations during the same day, her transportation between work sites
is deductible. However, her commute from home to the first work site and from the last work site back
home is not deductible.m
There are two methods for computing allowable transportation expenses: the regular method (using
the actual expenses incurred) and the optional method (using a standard rate per mile of business
use). In this book, we will discuss the optional method only.
Optional method. To qualify to use the optional method with the standard mileage rate, a taxpayer
must do all of the following:
Own or lease the vehicle.
Not have more than four vehicles in simultaneous business use at any time during the year.
Use the optional method the first year the car or truck is placed in service.
mExample: In 2014, Paula Booth began working for a messenger service that does not reimburse for
mileage. She used her 2011 Honda Civic to make deliveries in the metropolitan area in which she
lives. She also owns a 2006 Chevrolet Cavalier, which she uses for personal purposes. She has not
used either car for business in the past. Paula may use the standard mileage rate for the Honda. If
she decides to use the Chevy for business in a future year, she may use the standard mileage rate for
it too.m
The standard mileage rate is a deductible amount that is computed on Form 2106-EZ, on line 1. For
2014, the rate is 56 per mile.
On line 2, enter parking and tolls paid for employee business purposes. No other actual vehicle
expenses may be added to this amount. Since we will not discuss other expenses, the sum of lines 1
and 2 will be our total expenses.
Any allowable personal property tax paid on an employees vehicle is deductible as usual on Schedule
A. Finance charges (interest) paid on a loan used to finance the vehicle are not deductible by employees. This treatment is slightly different for self-employed taxpayers.
Taxpayer records for substantiation of transportation expenses should be written and kept in a timely
manner as the expenses occur. A record book should contain information showing dates, times, mileage, business purpose, and any other pertinent information.
mExample: Lets go back to Carl Anderson. He started using his car for business purposes on May 1,
2013, claiming the standard mileage rate for that year. He worked at his regular job location 230 days
during 2014. He used his trip odometer to keep track of his business mileage and kept written records.
His records show that the mileage was 3,620 from January 1 through December 31. He received no
reimbursements from his employer. Carl did not know he needed his total mileage for the year, but
he estimates 10,000 miles. His wife also owns a car.

Tax Essentials Itemized Deductions II 15.11

Carls Form 2106-EZ is shown in Illustration 15.3. His business mileage is 3,620 miles [3,340 + (10
days 2 28 miles round trip)]. His commuting mileage is 2,300 miles [10 miles round trip 2 230 days].
His other (personal) mileage was computed by subtracting these two figures from 10,000 miles.m

ax Tip: It is common for the IRS to audit taxpayers with unreimbursed


business expenses. To substantiate the amount of unreimbursed business
expenses reported on Form 2106 or 2106-EZ, the taxpayer should keep a copy
of the employers business expense reimbursement policy as well as documentation that shows the amounts of business expenses reimbursed by the employer.

Education Expenses
The cost of education that maintains or improves the skills required by the taxpayers present job, or
that meets the requirements of the law or the employer for maintaining the taxpayers present salary
or position, is deductible as an employment expense. This is true even if the taxpayer receives a degree
through their course of study.
Expenses are not deductible if the education is required to meet the minimum educational requirements in effect when the taxpayer first obtained the job or if it qualifies them for a new trade or
business.
mExample: Karyn Piccone, a convenience store clerk, took the H&R Block Income Tax Course in 2014
in the hope of becoming a Tax Professional. Because the course would qualify her to work in a new
business, the cost of the course is not deductible.m
In the H&R Block Income Tax Course, you learned about education tax benefits, such as the lifetime
learning credit, the American Opportunity Credit (AOC), and the tuition and fees deduction. As
you will see, with the lifetime learning credit and the tuition and fees deduction, qualified expenses
include amounts paid for tuition and other course-related fees. However, certain expenses that do not
qualify for those tax breaks may be deductible on Schedule A. For example, fees for courses taken
at locations other than qualified institutions (colleges) are deductible. Also the cost of all books and
qualified transportation expenses are deductible.
mExample: Dave Wolfe, an H&R Block Tax Professional, took H&R Blocks Advanced Disposition of
Business Assets course in 2014 to improve his job skills. Daves tuition is deductible.
The classes were held at an H&R Block tax office. Because the tax office is not a qualified institution
for purposes of the lifetime learning credit and the tuition and fees deduction, Dave may not claim
either of those benefits for taking the tax course. He may, however, take a deduction for the course
on Schedule A.m
Remember, the taxpayer may not claim more than one tax benefit for the same expenses. If an
expense qualifies for the American Opportunity Credit, the lifetime learning credit, the tuition and
fees deduction, or a Schedule A deduction, the one that provides the greatest tax benefit is the one
the taxpayer should use. Some of the factors to consider are the income limitations, the taxpayers
marginal tax rate, and whether their deductible expenses exceed the 2%-of-AGI floor.

15.12 H&RBlock Income Tax Course (2015)


Illustration 15.3

Tax Essentials Itemized Deductions II 15.13

Job-Seeking Expenses
Unreimbursed expenses incurred in seeking new employment in the same occupation are deductible.
The same expenses are not deductible if the taxpayer is seeking employment for the first time or
employment in a new occupation. The occupation of a taxpayer, who is unemployed, is the work they
were engaged in during their most recent employment. An individual who has been unemployed for a
long period of time before beginning to look for a job may not deduct their expenses.
mExample: Carol Tashahito was a bank teller. In 2004, she decided to stay at home and raise her
children. In 2014, Carol sought work again as a bank teller. Because of the long period of time between
Carols paid jobs, she cannot deduct her job-seeking expenses.m
Deductible expenses include employment agency fees, the cost of preparing and mailing resumes, and
telephone expenses. Transportation and travel expenses incurred in seeking qualified new employment away from the general area of the present job are also deductible. Qualified job-seeking expenses
are deducted directly on Schedule A, line 21, or on 2106-EZ if transportation or travel expenses are
involved.
It is important to note that qualified job-seeking expenses are deductible even if they do not result in
securing employment.

Other Employment-Related Deductions


The following work-related expenses are listed directly on Schedule A, line 21, unless 2106-EZ is
otherwise used:
Subscriptions to professional or trade publications related to the taxpayers work.
Union dues, initiation fees, and assessments for benefit payments to unemployed union members
are deductible. (However, assessments that provide funds for sickness, accident, or death benefits
are not deductible.)
Dues paid to a professional society by a lawyer, teacher, accountant, doctor, or other professional.
Business liability insurance.
Cost of a physical examination required by an employer. (This may be deducted instead as a medical expense if that is more advantageous.)
Cost of small tools, supplies, and licenses required in the taxpayers employment.
Cost of teaching aids, supplies, and equipment. (Include only amounts in excess of those deducted
as an adjustment to income, discussed in the H&R Block Income Tax Course.)
Cost of safety equipment and protective clothing, such as safety glasses or shoes, hard hats, and
other items to protect the workers physical well-being.
The cost of specialized clothes and uniforms is deductible if such clothing is specifically required by
an employer and is not adaptable to general wear. (Both qualifications must be met.) The cost of
cleaning and maintaining qualified clothing is also deductible. The cost of theatrical costumes and
accessories worn by musicians and other entertainers is deductible if the items are not suitable for
everyday wear.
Tools (or equipment) that are expected to be used in the taxpayers employment for more than one
year must be depreciatedthat is, the cost is deducted over a period of time.

15.14 H&RBlock Income Tax Course (2015)

Tax Preparation Fees


If the taxpayer paid someone to prepare and/or electronically file their income tax return(s), the
fees are deductible. These amounts are entered on Schedule A, line 22. Also, include the cost of tax
preparation software and publications. Bank fees or finance charges paid to financial institutions in
connection with applying for or obtaining refund anticipation loans or checks or similar products are
not deductible.
If the taxpayer is self-employed or owns rental property, the portion of tax preparation fees directly
associated with the business or rental property should be deducted on the appropriate form (Schedules
C, E, or F or Form 4835) and the remainder deducted on Schedule A, line 22.
The fees are deducted in the year paid. Thus, the amount entered on the 2014 return will usually
reflect the preparation of the 2013 return(s).

Investment Expenses
Investment expenses, which are deductible as itemized deductions on Schedule A, line 23, include:
Amounts paid to a broker or similar agent to collect income.
Legal expenses necessary to produce or collect taxable income.*
Appraisal fees to determine the value of property donated to a charity or to establish the amount
of a casualty loss.
Fees paid for investment advice.
Safe-deposit box rental fee if the box is used to keep potentially taxable investment-related papers
and documents, such as stocks or bonds.
Custodial fees in connection with property held for the production of income.
Amounts actually paid for clerical help or renting an office used in taking care of investments (but
no deduction can be claimed for the value of the taxpayers time, other unpaid help, or space in the
taxpayers home).
The taxpayers share of investment expenses of a regulated investment company.
Certain losses on nonfederally insured deposits in an insolvent or bankrupt financial institution.
Deduction for repayment of amounts under a claim of right if $3,000 or less.
* Certain attorney fees and court costs incurred after October 22, 2004, for cases involving unlawful
discrimination may be deducted as an adjustment to income.
Expenses to attend shareholders meetings are usually not deductible. Neither are expenses to produce nontaxable income, such as municipal bond interest.
Note: Casualty and theft losses from property used in performing services as an employee are also
deducted on Schedule A, line 23. These amounts are carried from Form 4684, Section B, and are not
discussed in this course. For more information, see IRS Publication 529, Miscellaneous Deductions.

Tax Essentials Itemized Deductions II 15.15

Hobby Expenses
A hobby, for tax purposes, is an activity not carried on to make a profit.
mExample: George Conway collects stamps for his own enjoyment. Occasionally, he sells a stamp
when he has a duplicate. George has a hobby, not a business.m
Hobby expenses are deductible up to the amount of hobby income reported on the current-year tax
return. The following expenses attributable to hobby income are deductible, in the following order:
1. State and local property taxes and casualty losses (that is, deductions that are allowable as personal itemized deductions) are fully deductible.
2. All other expenses of the hobby, such as craft supplies and sales expenses, may be deducted only to
the extent that gross income from the activity exceeds the deductions described in 1 above.
3. Depreciation may be deducted only to the extent gross income from the activity exceeds the expenses described in 1 and 2 above. (Equipment with a useful life of more than one year that is used to
produce hobby income is a depreciable asset. That is, the cost is divided and a portion is deducted
each year for a number of years, instead of deducting the entire cost in the year of purchase.)
The hobby expenses in items 2 and 3 above may be deducted only as itemized deductions on Schedule
A, line 23. Hobby income is reported on the return as other income on Form 1040, line 21.

Nondeductible Expenses
The IRSspecifically states that certain expenses are not deductible on the Schedule A. Some examples
of nondeductible expenses include:
Funeral expenses.
Repairs and improvements to a personal residence.
The cost of personal-use property (vehicles, furniture, and appliances, for example).
Homeowners or renters insurance.
Nonbusiness license fees (driver, pet, hunting, and fishing, for example).
Fines and penalties (for traffic violations, for example).
Personal legal expenses, except those paid to obtain taxable income.
mExample: Betty Dawson paid her lawyer the following amounts during 2014:
$5,000
650
2,200

Representation during her divorce


Preparation of a new will
Assistance in obtaining alimony

Betty may deduct the $2,200 because she spent it attempting to secure taxable income. The remaining
expenses are not deductible.m
For more information on nondeductible expenses, see IRS Publication 529, Miscellaneous Deductions.

15.16 H&RBlock Income Tax Course (2015)

OTHER MISCELLANEOUS DEDUCTIONS


Two kinds of miscellaneous deductions are available on Schedule A, those subject to the 2%-of-AGI
floor and those not subject to the 2%-of-AGI floor. Lets now look at those miscellaneous itemized
deductions not subject to the 2%-of-AGI floor. Expenses that fall into this category include:
Gambling losses to the extent of winnings included on Form 1040, line 21. Gambling losses include
amounts paid to charitable organizations for lottery and raffle tickets, bingo, and other games of
chance, as well as amounts lost in other forms of gambling.
Impairment-related work expenses for handicapped individuals.
Federal estate tax on income in respect of a decedent.
Unrecovered cost of a decedents pension or annuity.
Repayments of certain types of income more than $3,000 under a claim of right.
Casualty and theft losses from income-producing property from Form 4684, Section B.
Amortizable bond premiums on bonds acquired prior to October 23, 1986.
Miscellaneous itemized deductions not subject to the 2%-of-AGI floor are identified and entered on
Schedule A, line 28. In this course, only gambling losses are discussed. If you encounter any of the
other itemized deductions discussed, you will need to do additional research. A good place to start
would be IRS Publication 529, Miscellaneous Deductions.

Gambling Losses to the Extent of Winnings


The taxpayer is required to report the full amount of their gambling winnings as income on Form
1040, line 21, and the taxpayer can claim their losses (up to the amount of their winnings) as an
itemized deduction on Schedule A. It is ever appropriate to net winnings with losses. Taxpayers who
deduct gambling losses should be advised to keep an accurate diary or similar record of their losses
and winnings. The diary should contain at least the following information:
The date and type of wagering activity.
The name and address or location of the gambling establishment.
The names of other persons present with the taxpayer at the gambling establishment.
The amounts the taxpayer won and lost.
In addition to a diary, the taxpayer should also have other documentation. The taxpayer can generally prove their winnings and losses through Forms W-2G, wagering tickets, canceled checks, credit
records, bank withdrawals, and statements of actual winnings or payment slips provided by the gambling establishment.
The taxpayer would not need to present all of this documentation to the Tax Professional to prove
their deductions, but as a Tax Professional, you should inform the taxpayer that the IRS requires
extensive documentation to substantiate the taxpayers gambling losses.
Complete Exercise 15.2 before continuing to read.

Tax Essentials Itemized Deductions II 15.17

ITEMIZED DEDUCTION PHASEOUT


Under the American Taxpayer Refund Act of 2012 (ATRA), itemized deductions are subject to an overall limit based on the taxpayers adjusted gross income(AGI). For 2014, the phaseout amounts are:
$305,050 Married filing jointly and qualifying widow.
$279,650 Head of household.
$254,200 Single.
$155,525 Married filing separately.
For taxpayers who exceed these thresholds, their itemized deductions are reduced by the lesser of:
3% of the excess of their AGIover their threshold amount.
80% of the amount of their total itemized deductions before considering the overall limit, and
excluding itemized deductions that are not subject to the itemized deduction phaseout.
The itemized deductions that are not subject to the itemized deduction phaseout include the following:
Medical expenses.
Investment interest.
Casualty and theft losses.
Gambling losses.
To calculate the itemized deduction phaseout, the taxpayer would complete the Itemized Deduction
Worksheet Line 29 found in the Schedule A instructions.

ALTERNATIVE MINIMUM TAX


Deductions can add up, and as you will see, certain large deductions can cause the Alternative
Minimum Tax (AMT) to apply to the taxpayer. Therefore, we will briefly discuss the AMT, so you are
aware that large itemized deductions can trigger AMT and you will be able to explain this to your
clients.
The purpose of the AMT is to ensure that taxpayers with higher income levels cannot entirely avoid
income taxes by claiming certain deductions and credits. Taxpayers subject to the AMT must calculate
both the regular tax and the AMT, then pay whichever amount is greater. Form 6251, Alternative
Minimum Tax Individuals, is completed to support any amount reported as AMT on Form 1040, line
45. See Illustrations 15.4 and 15.5.
Taxpayers may be subject to the AMT if their taxable income for regular tax purposes, combined with
certain credits and deductions, is more than:
$82,100 if filing status is married filing jointly (or qualifying widow(er) with dependent child).
$52,800 if filing status is single or head of household.
$41,050 if filing status is married filing separately.

15.18 H&RBlock Income Tax Course (2015)

The following common scenarios may trigger the AMT (this list is not all-inclusive):
A large number of exemptions are claimed on the return.
Itemized deductions with a large deduction for taxes (very common in areas with high state or local
taxes).
Itemized deductions with large deductions for miscellaneous deductions subject to the 2%-of-AGI
limitation (very common on returns claiming large amounts for unreimbursed employee business
expenses).

Credit for Prior-Year Minimum Tax


A credit for a prior years AMT may be claimed against regular tax in future years if the taxpayer
qualifies. Form 8801, Credit for Prior Year Minimum Tax Individuals, Estates, and Trusts, is used
to support this credit when it is claimed on line 53, Form 1040.
The Alternative Minimum Tax is an advanced topic. You will not be required to complete a Form
6251 or 8801 for any exercises, quizzes, or exams.

ax Tip Knowing that a credit might be claimed for having paid AMT in a
prior year is another reason why it is important for new clients to bring in
last years return.

RECOVERY OF A PRIOR YEARS ITEMIZED DEDUCTION


Generally, if a taxpayer recovered all or part of an amount of an item deducted or took a credit for it
in a prior year, all or part of the amount recovered may be taxable income in the year received. The
most common recoveries are refunds, reimbursements, and rebates of itemized deductions.
State and local income taxes, medical expenses, and casualty or theft losses are all examples of itemized deductions that might be deducted in one year and recovered, in part or in full, in a later year.
State income tax refunds are, by far, the most common recovery.
The IRS states that a taxpayer must include a recovery in their income in the year the taxpayer
received the recovery, up to the amount by which the deduction or credit the taxpayer took for the
recovered amount reduced their tax in the earlier year.
If the taxpayer took itemized deductions in the year in which the itemized deduction recovery applies,
the recovery generally is taxable (or partially taxable) based on the amount of the tax the recovery
reduced in the prior year. This makes sense, because the deducted amount, reported on Schedule A,
reduced taxable income for the year deductions were itemized; so when some of the deducted amount
is refunded to the taxpayer, the recovery increases taxable income because it reduced taxable income
in the prior year.
The IRS Recoveries of Itemized Deductions Worksheet, in Illustration 15.7, will assist you in computing the taxability of itemized deduction recoveries. This worksheet is located in IRS Publication 525,
Taxable and Nontaxable Income.

Tax Essentials Itemized Deductions II 15.19


Illustration 15.4

15.20 H&RBlock Income Tax Course (2015)


Illustration 15.5

Tax Essentials Itemized Deductions II 15.21

Partially Taxable
A state income tax refund (or any other itemized deduction that is recovered in a later year) is taxable only to the extent that the deduction reduced taxable income in the earlier year. The taxpayer
may receive a Form 1099-G showing the amount of the state income tax refund. An example of Form
1099-G is shown in Illustration 15.6. However, being a recipient of a 1099-G is not an indication of
whether the refund is taxable. The major clue to when a recovered amount is taxable is whether or
not the taxpayer claimed the expense as an itemized deduction in a prior year, but there are other
circumstances that may apply. For more information on those situations, you may want to read about
recoveries on page 90 of IRS Publication 17.
If the taxpayer did not itemize deductions for the year in which the refund applies, the amount is not
taxable.
To help determine the taxability of state income tax refunds, BlockWorks produces a State and Local
Income Tax Refund Worksheet. This worksheet is shown in Illustration 15.8. This worksheet will only
calculate the portion of 2013 state tax refunds received in 2014. If the taxpayer receives state income
tax refunds for other tax years, the taxpayer should prepare the IRS Recoveries of Itemized Deductions
Worksheet.
In most states, a taxpayer has the option to deduct either:
State and local income tax.
State and local sales tax.
mExample: Omar Kahlil is single. His 2013 federal itemized deductions totaled $6,225, of which he
claimed $1,230 of state income taxes paid in 2013. Omar lives in a state that does not have state or
local sales tax. He filed his tax returns on February 26, 2015, and on March 14, he received his $275
state income tax refund. His Form 1099-G is shown in Illustration 15.6.
The single standard deduction for 2013 was $6,100. By itemizing deductions on his federal return,
Omar reduced his taxable income by $125 [$6,225 $6,100 = $125]. Therefore, only $125 of his $275
state income tax refund is taxable in 2014. Omars BlockWorks State and Local Income Tax Refund
Worksheet is shown in Illustration 15.8.m
Taxable refunds of state and local income taxes from a prior year are entered on Form 1040, line 10.
Taxable recoveries of other prior-year itemized deductions are entered on Form 1040, line 21.
If a taxpayer receives a state tax refund and chooses to deduct state and local income taxes as an itemized deduction in the prior year, then the refund is taxable only to the limit of the excess of the tax the
taxpayer chooses to deduct for the prior year over the tax they did not choose to deduct for that year.
mExample: Irene Cavanaugh filed head of household. Her 2013 federal itemized deductions totaled
$9,400, of which $850 was state income tax. Her available sales tax deduction was $675. She filed her
tax returns on March 1, 2014. On March 22, she received her $700 state income tax refund.
The head of household standard deduction for 2013 was $8,950. By itemizing on her federal return,
Irene reduced her taxable income by $450 [$9,400 $8,950]. Therefore, only $450 of her $700 state
income tax refund is taxable in 2014.
However, Irene could have chosen to deduct her sales tax instead of her state income tax, and her
itemized deductions would have totaled $9,225 [$9,400 $850 + $675 = $9,225], and her state income
tax refund would be nontaxable. Therefore, the maximum refund Irene will include in income is $175
[$850 state income tax $675 state sales tax = $175].m

15.22 H&RBlock Income Tax Course (2015)

When a taxpayer chooses to deduct state and local income taxes as an itemized deduction in the prior
year and then receives a state income tax refund, the taxpayer may end up deferring their federal
income tax to the next year.
Illustration 15.6

mExample: Jeff, who is in the 25% federal tax bracket, had $1,000 state income tax withheld during
2013. He made no other payments. His available sales tax deduction from the Schedule A instructions
is $800. At first glance, it would appear that the state income tax deduction will save him $50 more
in tax than if he claimed the state sales tax deduction [$1,000 $800 = $200 2 25% = $50].
However, after completing his state return, Jeff finds that he will receive a $300 state refund, all or
part of which may be taxable in 2014 if he deducts state income tax in 2013. Thus, if he is again in
the 25% bracket in 2014, the state refund could increase his federal tax by $50. So by Jeff claiming the
state income tax in 2013, he pays $50 less in federal tax in 2013. However, he may end up deferring
the $50 of 2013 federal income tax to 2014. If Jeff uses the state sales tax in 2013, he pays $50 in
federal tax in 2013 and will not have to include his refund in income for 2014.m
Another factor to consider is how your state treats the sales tax deduction. Some states do not allow
taxpayers to include their state and local income taxes as part of the states itemized deduction, but
will allow the taxpayer to include the sales tax deduction in the states itemized deductions.
mExample: Jim had $1,000 state income tax withheld from his pay during 2013. He made no other
payments. His available sales tax deduction from the Schedule A instructions is $850. He is in the
15% federal tax bracket and the 5% state tax bracket.
If he chooses to deduct the state and local income taxes, he would have a savings of $150, all on his
federal return since the income tax paid cannot be used on the state return. If he chooses the $850
general sales tax, he would have a savings of $127.50 [$850 2 15% = $127.50] on his federal return
and $42.50 [$850 2 5% = $42.50] on the state return for a total savings of $170. The savings of $170
is the greater, so he should choose to use the general state and local sales tax on his tax return.m
Your instructor will provide specific information regarding your state. Once again, it is important to
examine all the options.
Complete Exercise 15.3 before continuing to read.

Tax Essentials Itemized Deductions II 15.23


Illustration 15.7

15.24 H&RBlock Income Tax Course (2015)


Illustration 15.8

Tax Essentials Itemized Deductions II 15.25

SUMMARY
In this book, you learned:
Unreimbursed casualty and theft losses on personal-use property are deductible, subject to reductions of $100 per incident and 10% of AGI for all losses during the year. Form 4684 is used to report
casualty and theft losses.
Miscellaneous itemized deductions subject to the 2%-of-AGI limitation include most employee business expenses, fees for financial and tax advice, tax preparation and electronic filing fees, investment expenses, safe-deposit box fees if the box contains items held for investment, and qualified
job-seeking expenses.
Work-related transportation expenses may be deducted using Form 2106 (or 2106-EZ). For 2014,
the standard mileage rate is 56 per mile.
The cost of education that maintains or improves the skills required by the taxpayers present job
or meets the requirements of the law or the employer for maintaining the taxpayers present salary
or position is deductible.
Job-seeking expenses are deductible if they were incurred while attempting to obtain a new job in
the taxpayers current occupation.
Gambling losses to the extent of gambling winnings are deductible.
Higher income taxpayers can be impacted by the Alternative Minimum Tax.
Refunds of amounts previously deducted from taxable income are generally taxable in the year
received.

Suggested Reading
For further information on the topics discussed in this book, you may wish to read the following chapters in IRS Publication 17, plus the other IRS publications listed below:
Chapter 25, Nonbusiness Casualty and Theft Losses.
Chapter 26, Car Expenses and Other Employee Business Expenses.
Chapter 28, Miscellaneous Deductions.
IRS Publication 525, Taxable and Nontaxable Income.
IRSPublication 529, Miscellaneous Deductions.

16

BlockWorks Practice 2
OVERVIEW
This entire chapter is devoted to the BlockWorks Practice Session 2. This practice session will help
you to become familiar with the preparation of taxpayers income tax returns in the BlockWorks software as well as develop your tax interview skills at the tax desk. The practice case studies are set up
as roleplays to give you the experience of interviewing a client. This will help you start thinking of
ways you will ask questions to conduct a thorough tax interview that results in an accurate tax return.

INSTRUCTIONS
To complete the BlockWorks Practice Session 2, you will spend the first hour of class discussing state
chapter material. Your instructor will provide you with guidance as to which state chapters your class
will be discussing.
Next, you will spend one hour completing ITC chapter case study returns in the BlockWorks software. Your instructor will provide you with guidance as to which chapter case studies you enter into
BlockWorks.
Last, you will complete case studies 16.1 and 16.2 in the BlockWorks software. The case study return
information can be found in your workbook starting on page W16.1. The case studies are set up in
your workbook as an interview with a taxpayer at the tax desk. To complete these case studies, you
will need to partner with another participant in class. One individual will play the role of the Tax
Professional, and the other individual will play the role of the taxpayer. Each case study in your workbook is set as two scripts, the Tax Professional and the taxpayer. Use the script associated to your role
to ask or answer questions and complete the case study returns in the BlockWorks software.

16.1

17

Self-Employment Income
OVERVIEW
In this course, you learn how to prepare tax returns for self-employed people. You will use Schedule C,
Profit or Loss From Business, to determine the net profit or loss from a business. Here we concentrate
on the more detailed Schedule C, though the less detailed Schedule C-EZ may be used in some cases.
Schedule C is based on a simple formula: gross receipts (the money taken into a business) minus
expenses equals net profit or loss.
Also, in this course, you learn about Schedule SE, the form used by sole proprietors to compute their
self-employment tax.

OBJECTIVES
At the conclusion of this course, you will be able to:
Determine business income.
Determine business expenses.
Complete Schedule C to determine net business profit or loss and carry the appropriate entries to
Form 1040 and Schedule SE.
Complete Schedule SE to determine the self-employment tax and the corresponding adjustment to
income and enter both the tax and the adjustment on Form 1040.
Identify when self-employment income requires Schedule F.
Explain the tax treatment of a sole proprietors own health insurance premium payments.
Determine if a taxpayer has qualified home-office expenses.

TAX TERMS
The following definitions may be helpful to you as you work through this course:
At-risk rules. Special rules limiting the taxpayers deductible business, partnership, S corporation,
or real estate loss to cash invested plus debt he is legally obligated to pay and the adjusted basis of
any property contributed.
Cost method of inventory valuation. Valuing inventory purchased during the year at cost; that
is, the invoice price less any discounts plus transportation or other costs incurred in acquiring the
merchandise.
17.1

17.2 H&RBlock Income Tax Course (2015)

Cost of goods sold. Beginning inventory plus direct purchases, direct labor costs, and overhead costs
less withdrawals for personal use and ending inventory. Sole proprietors compute their cost of goods
sold in Part III of Schedule C (Form 1040).
FICA. FICA (Federal Insurance Contributions Act) The law that provides for social security and
medicare benefits. This program is financed by payroll taxes imposed equally on the employer and
employee. For 2014, the employer is required to withhold 1.45% from each employees gross wages for
medicare tax and 6.2% of each employees wages up to $117,000 for social security tax.
Hybrid method of accounting. A combination of accounting methods, usually of the cash and
accrual methods.
Independent contractor. A taxpayer who contracts to do work according to his own methods and
who is not subject to control except as to the results of such work. An employee, by contrast, is subject
to the control of the employer as to the methods to be used to obtain the desired results.
Inventory. A list of articles of property. For income tax purposes, inventory refers only to a list of
articles comprising stock in tradearticles held for sale to customers in the regular course of a trade
or business. The cost of goods sold during the year is determined by adding to the inventory at the
beginning of the year the purchases during the year, and subtracting from this sum the inventory at
the close of the year.
Lower of cost or market method of inventory valuation. Inventory valuation considering the
actual cost or the replacement cost of merchandise on the inventory date. The lower value is used,
creating a reduced gross profit for the period in which the decline occurred and an approximately
normal gross profit is realized during the period in which the item is sold.
Partnership. A form of business in which two or more persons join their money and skills in conducting the business as co-owners. Partnerships are treated as a conduit and are not subject to taxation.
Various items of partnership income, expenses, gains, and losses flow through to the individual partners and are reported on their personal income tax returns.
Proprietorship. A business controlled and operated by one person.
Self-employed individuals. Taxpayers who work for themselves. They decide when, how, and
where to work, obtain their own jobs or sales, pay their own expenses, and receive social security and
medicare coverage through payment of self-employment tax.
Statutory Employee. A worker who is treated as an employee for social security and medicare tax
purposes and as self-employed for income tax purposes. The Statutory employee box on such a workers Form W2 should be marked.

THE SOLE PROPRIETOR


Self-employed individuals are their own bosses. They decide when, how, and where to work, obtain
their own jobs or sales, pay their own expenses, and receive social security and medicare coverage
through payment of self-employment tax.
In this course, we discuss in detail the sole proprietorship, which is a business owned by one individual, who files Form 1040 that reports net profit or loss from Schedule C. Schedule C (or C-EZ) is
completed by all sole proprietors, except farmers. Schedule F is used exclusively by farm proprietors.
Farmers have a separate schedule because of their specialized income and expenses. A separate

Tax Essentials Self-Employment Income 17.3

Schedule C (or C-EZ) must be completed for each business. An individual may have more than one
business, or each spouse may have their own business.
If a taxpayer and spouse own and operate a business, even if there is no formal partnership agreement
between them, a partnership exists and Schedule C may not be used. Instead, the partnership must
file Form 1065, U.S. Return of Partnership Income. There are two exceptions to this rule:
If a taxpayer and spouse wholly own an unincorporated business as community property under the
laws of a community property state, the business may be treated as a sole proprietorship.
If the taxpayer and spouse materially participate (see Schedule C, line G, on page 1.5) as the only
members of a jointly owned and operated business and they file a joint return, they can make a
joint election to be taxed as a qualified joint venture. A Schedule C (or C-EZ) must be prepared for
each spouse, reporting their respective amounts of income, loss, and deductions.
A proprietor does not receive a salary, and therefore cannot issue a Form W-2 or withhold and pay
payroll taxes on amounts they withdraw from the business for their own use. This is true even if they
think of certain amounts as wages. Net profit or loss is the correct term to describe the results of
each business activity.
A proprietor who employs their own workers must withhold payroll taxes and remit them to the
taxing agencies as well as prepare Forms W-2 and furnish them to their employees and to the taxing
agencies.
A proprietor files a Form 1040-ES, Estimated Tax, to pay their own estimated income and self-employment (SE) tax liability.

ACCOUNTING PERIODS
When a self-employed taxpayer prepares a statement of income and expenses, generally their income
tax return, they must use their books and records for a specific interval of time called an accounting
period. The annual accounting period for a taxpayers income tax return is called a tax year. The
taxpayer is allowed to use of one of the following tax years when preparing their income tax return.
Calendar tax year.
Fiscal tax year.
Unless the IRS or income tax regulationsrequire a taxpayer to use a specific tax year, the taxpayer
will adopt their tax year by filing their first income tax return using the tax year they desire.
Calendar tax year is an annual accounting period made up of 12 consecutive months beginning
January 1 and ending December 31.
Taxpayers are required to adopt a calendar year if any of the following circumstances apply to the
taxpayer:
The taxpayer does not keep books.
The taxpayer has no annual accounting period.
The present tax year the taxpayer is using does not qualify as a fiscal year.
The taxpayer is required by the IRSor income tax regulations to use a calender year.

17.4 H&RBlock Income Tax Course (2015)

Fiscal tax year is an annual accounting period that consists of either 12 consecutive months ending
on the last day of any month except December or a 5253-week tax year that varies from 52 to 53
weeks, but does not have to end on a last day of a month.
If the taxpayer makes the fiscal tax year election, they are required to maintain their books and
records as well as report their income and expenses based on the fiscal year adopted. For more information on a fiscal tax year, including a 5253-week tax year, see IRSPublication 538, Accounting
Periods and Methods.
Change in tax year. Once a taxpayer has chosen their tax year, generally they are required to
seek IRSapproval before they are allowed to change their tax year. Generally, a taxpayer must file
Form 1128, Application To Adopt, Change, or Retain a Tax Year, along with a user fee to request
IRSapproval to change their tax year. The IRSdoes provide specific exceptions in which a taxpayer
may change their accounting period without filing Form 1128. For more information about these
exceptions available, see the instructions for Form 1128.

SCHEDULE C, THE HEADING


Refer to Schedule C, shown in Illustrations 17.117.2, as we examine Schedule C. The heading
requests information about the business. The following explanations will help you complete this portion of the form.
Principal business or profession is the business or professional activity that provided the principal source of income. Give the general field or activity and type of product sold or produced or client
served. Examples are retail sales of household products and preparation of tax returns for individuals.
Business code is a number taken from the IRS list, reproduced at the end of the textbook.
Business name and address. Use the actual name of the business, or, if there is no business name,
leave line C blank. The business address on line E is the address from which the business is conducted. Enter the street address (including suite or room number), city, state, and ZIP, not a post office
box number. Line E may be left blank if the taxpayer conducted the business from their home and
that address is the address shown on Form 1040.
Employer ID number (EIN). Many self-employed taxpayers are not required to obtain an EIN. A
sole proprietor needs an EIN if they have employees, a qualified retirement plan or are required to file
employment, excise, alcohol, tobacco, or firearms returns, or are a payer of gambling winnings. The
proprietor may obtain an identification number by filing Form SS-4, which is available from the IRS.
Accounting method. The most common methods of accounting are the cash and accrual methods.
Under the accrual method of reporting income, total sales and total charges for services in the tax
year are included in income, even though payment may be received in another tax year. Under the
cash method, only income actually or constructively received during the tax year is included.
Sole proprietors who produce, purchase, or sell merchandise in their businesses generally must use
the accrual method of accounting for their inventories and gross receipts. They may use the cash
method for their operating expenses. This mixed use of accounting methods is called a hybrid method. Qualified taxpayers may choose to use the cash method of accounting for every aspect of their
businesses.

Tax Essentials Self-Employment Income 17.5


Illustration 17.1

17.6 H&RBlock Income Tax Course (2015)


Illustration 17.2

Tax Essentials Self-Employment Income 17.7

Line G. A proprietor materially participates when they are involved in the business in a substantial
way on a regular basis. The answer to this question is important because if the proprietor does not
materially participate, any loss from the business is considered a passive loss and, generally, can only
be deducted currently against passive income. A full discussion of material participation can be found
in IRS Publication 925, Passive Activity and At-Risk Rules.
Line H. Mark this box if the business was started or acquired during the tax year, or if the business
is reopening after a temporary close and no Schedule C (or C-EZ) was filed the previous tax year.
Lines I and J. The boxes on both lines refer to whether the proprietor made any payments related
to the business that would require filing Form 1099.
Complete Exercise 17.1 before continuing to read.

SCHEDULE C, PART I, INCOME


Gross receipts include the gross amount of cash and credit receipts and the fair market value of any
property and services the proprietor receives in exchange for the goods or services they sell. Depending
upon the type of business, the proprietor may receive one or more Forms 1099MISC, reporting some
or all of the income they have made from self-employment. This income should be included as part of
their gross receipts.
mExample: Roberta Stanton delivers newspapers as an independent contractor for the Your City
Daily News. She receives her share of the profits directly from the newspaper, which handles all subscription and billing activities. Robertas Form 1099-MISC is shown in Illustration 17.3. Roberta will
report the income shown in box 7 on line 1 of her Schedule C.m
Roberta will have expenses to deduct from her income, the largest of which probably will be her automobile expenses. We discuss deductible transportation expenses in a later course.
Do not include retail sales taxes imposed on the buyer that are collected by the proprietor and passed
onto state or local taxing authorities. Also, do not include these sales taxes as a tax expense. Certain
taxes may, however, need to be entered on other lines of Schedule C, as you will soon discover.
Keep in mind that if the accrual method is being used for gross receipts, accounts receivable must
be included in income, even if they are not collected by the end of the year.

17.8 H&RBlock Income Tax Course (2015)


Illustration 17.3

Returns and allowances are amounts included in gross receipts that were refunded to customers who returned merchandise for refund or who were given a partial refund because they received
damaged merchandise or for other similar reasons. These amounts are subtracted from gross
receipts.
Cost of goods sold. If the taxpayer produces, purchases, or sells merchandise to produce income for
the business, the taxpayer must complete Part III on page 2 of Schedule C to compute their cost of
goods sold or manufactured.
Gross profit, in Part I, is gross receipts minus returns and allowances and cost of goods sold.
Other income includes income from sales of scrap, interest received on customer accounts receivable,
and other kinds of miscellaneous income received by the trade or business. If the taxpayer is permitted to retain a portion of state or local sales taxes collected, that amount is entered here.
Note: Certain small business taxpayers who produce, purchase, or sell merchandise in their businesses may use the cash method of accounting for every aspect of their businesses, including their inventories. The main advantage to this method is that these businesses do not need to include accounts
receivable in income until they are collected. But even with the new rules, the taxpayer may only
deduct the cost of goods sold. A proprietor cannot stock up on merchandise that remains unsold and
deduct the cost at the end of the year.
In this course, we will use the hybrid method of accounting (accrual for inventory and receipts, cash for
expenses) for all business taxpayers with inventories. If you want more information about using the
cash method for inventories, obtain a copy of IRS Publication 538, Accounting Periods and Methods.

Tax Essentials Self-Employment Income 17.9

Schedule C, Part III


Method(s) used to value closing inventory. The two most common methods of valuing inventory
are cost and lower of cost or market.
The cost method is different, depending on if the proprietor is a merchant or a manufacturer. For
merchants, the cost method usually involves pricing merchandise, at the time of purchase, at the
invoice price less appropriate discounts plus transportation or other charges incurred in acquiring the
goods. To value merchandise on hand at the beginning of the tax year, the cost is the ending inventory
price of the goods from the preceding tax year. For merchandise purchased during the year, the cost
is the invoice price less any discounts plus transportation and other charges (specific cost identification method). For manufacturers who produce merchandise during the year, the cost method is equal
to all the direct and indirect costs associated with the creation of the item. The manufacturer would
include the total cost of raw materials, on hand and purchased during the year, that are used to create
the product, plus the total cost of merchandise in work in process, and the total cost of finished goods
sitting in storage and waiting to be sold.
In using the lower of cost or market method, a comparison is made, at inventory time, of the market
value of each merchandise item and its cost. The lower of the two is used as its inventory valuation.
Taxpayers who use the cash method of accounting must use the cost method to value their inventory.
Beginning inventory is usually the same as the ending inventory from the preceding tax year. Any
difference should be explained. The beginning inventory for a manufacturer includes the total value
of raw materials, work in process, finished goods, and materials and supplies used in manufacturing
the goods. For merchants, the beginning inventory consists of the cost of merchandise held for sale.
Purchases for manufacturers include the cost of raw materials and parts purchased for manufacture into finished products. Purchases for merchants are all merchandise bought for resale. The cost
of purchases is the total amount actually spent; that is, the stated price minus any quantity and
prompt-payment discounts. Note that, if the accrual method is used, purchases are an expense for the
year incurred, even if paid in a later year (e.g., taxpayer purchases merchandise on account).
The cost of merchandise from current-year purchases that is withdrawn for personal or family use is
subtracted from the cost of purchases in Part III, line 36.
Labor costs are usually included in the cost of goods sold only for manufacturing or mining businesses. Merchants usually do not incur labor costs that can properly be charged to cost of goods sold. Labor
costs included here involve the necessary work to make the final product saleable.
Materials and supplies are such things as hardware and chemicals used in the manufacturing
process.
Other costs include amounts spent for containers and packages that are an integral part of the product being manufactured, freight-in for raw materials, supplies used in production, and merchandise
purchased for sale. If an expense incurred is related to both the cost of goods sold and an operating
expense, it should be prorated, and the portion of the expense is properly claimed for each category.
Ending inventory is the inventory on hand at the end of the year. A physical inventory count should
be taken at the end of each accounting period.
Cost of goods sold is the beginning inventory plus purchases and other direct cost of goods minus
the ending inventory.

17.10 H&RBlock Income Tax Course (2015)

Complete Exercise 17.2 before continuing to read.

SCHEDULE C, PART II, EXPENSES


Operating expenses are the ordinary and necessary expenses of conducting a business, trade, or profession. These expenses are deducted on Schedule C, Part II. We will discuss them in the order they
appear on the form.
When self-employed taxpayers are determining deductible operatTing expenses,
they should maintain records to substantiate business use
ax Tip:

of assets that have both business and personal use. Common assets that have
both business and personal use include, but are not limited to, cars and trucks,
computers, and cellular phones.

Advertising. These are expenses to promote the business, including newspaper ads, flyers (including
the cost of distributing them), television and radio promotions, Internet banners, and business cards.
Car and truck expenses. Actual car and truck expenses are deducted on line 9 (except depreciation,
which goes on line 13, and lease payments, which go on line 20a). Alternatively, the standard mileage
rate allowance may be claimed on line 9 if the taxpayer meets certain qualifications. If the taxpayer
used the standard mileage rate for the first year the vehicle was placed into service, either method
may be used in subsequent years. But if the actual expense method was used in the first year, it must
be used for all years that the vehicle remains in service. Part IV on the second page of Schedule C
requests information about the vehicle used in the business.
Commissions and fees. Amounts paid to other individuals or businesses for services and not included on any other line of Schedule C are deducted here. Do not enter wages or benefits paid to the taxpayers employees or any amounts paid to independent contractors or subcontractors who worked for
the taxpayer.
Contract labor. These payments are the compensation paid to independent contractors and subcontractors (non-employees) for services rendered. The proprietor should provide a Form 1099-MISC to
any independent contractor who worked for him and earned $600 or more. The distinction between
an independent contractor and an employee is an important one, because the proprietor is required
to withhold various payroll taxes for an employee. We do not cover all the factors that go into making
this determination in this course, but IRS Publication 15-A provides considerable information on this
topic.
Depletion. The only properties subject to depletion are oil or gas wells, exhaustible natural deposits,
and timber.
Depreciation. Depreciation is the annual deduction allowed to recover the cost or other basis of business property with a useful life of more than one year. If, for example, a proprietor buys a computer
for use in their business, they generally do not deduct its full cost in the year of purchase. Rather,
they deduct a portion of the cost every year for a number of years. The process is called depreciation.
Depreciation is discussed in the Tax Essentials: Depreciation course.

Tax Essentials Self-Employment Income 17.11

Employee benefit programs. Amounts contributed by an employer to employee fringe benefit programs are deductible. Contributions to employee benefit programs include those to education, recreation, health, dependent care, and adoption assistance programs.
Insurance (other than health). Premiums paid to protect the business against losses are deductible as an operating expense. Regardless of whether the cash or accrual method of accounting is used,
advance payments may be deducted only in the year to which they apply. Types of insurance for which
premiums are deductible include fire, theft, flood, merchandise and inventory, credit, workers compensation, business interruption, errors and omissions, disability (for employees), malpractice, and
product liability. Vehicle insurance, if the standard mileage allowance is not claimed, is deducted on
line 9 along with other car and truck expenses.
Mortgage interest (paid to banks, etc.). Use this line to deduct the interest portion of mortgage
payments made to financial institutions on real property used in the business and for which the taxpayer received a Form 1098. However, if the business is located in the taxpayers home, the qualified
business portions of mortgage interest, real estate taxes, rent, and utilities are entered on line 30 after
they are computed on Form 8829, Expenses for Business Use of Your Home.
Other interest. This category includes interest on business indebtedness other than mortgage interest reported on line 16a. Include finance charges on business loans and credit card purchases.
Any interest, including mortgage interest, that is paid in advance must be deducted only in the year
to which it applies.
Legal and professional services. These expenses include attorney, accounting, and other professional fees that are ordinary and necessary to conduct business and expenses for the preparation of
tax forms related to the business.
mExample: Glenn Ippolito opened a new business in 2014. On April 6, 2015, he had H&R Block
prepare his 2014 tax return, which included Schedules C and SE. The fees for those schedules will
be deductible on line 17 of his 2015 Schedule C. The remainder of his tax preparation fees may be
deducted in the usual manner on Schedule A, if he itemizes.m
Office expense. This category includes consumable office supplies such as pads, pens, pencils, order
books, receipt books; supplies for computers, printers, calculators, cash registers, and copy machines;
stamps, express delivery charges, registered or certified mail expenses, and the rental of a postage
meter and post office box; and so on.
Pension and profit-sharing plans. Amounts paid as contributions to pension, profit-sharing, or
annuity plans for employees are deducted here. If the plan includes the sole proprietor, the amount
contributed for the proprietor can be deducted only as an adjustment on Form 1040, line 28.
Rent or lease. Amounts paid are deducted as an operating expense in the tax year for which the
rent is due. Lease payments for assets used in the business are deductible as rent. Enter rent or lease
payments for vehicles, machinery, and equipment on line 20a and all other rent or lease payments,
including that for real property, on line 20b.
Repairs and maintenance. Amounts necessary to maintain business property in an ordinary,
efficient operating condition are deductible. The cost of repairs includes labor, supplies, the annual
portion of the cost of service contracts, and other items incidental to the repair. The cost of repairs
deductible on line 21 do not add value or appreciably prolong the life of the property. The value of
the proprietors labor and the value of unpaid labor of friends and relatives is not deductible. It is
important to distinguish between expenditures for repairs and those for improvements because an
expenditure for an improvement (that is, a capital expenditure) must be added to the basis of the

17.12 H&RBlock Income Tax Course (2015)

property and depreciated. A capital expenditure is incurred to increase the value of the asset, increase
the productivity of the asset, prolong the assets useful life, or adapt it to a different use.
tax years before 2014, the determination of whether an expense
Nwas Ina repair
or an improvement was determined by an analysis of facts
ew:

and circumstances, and sometimes resulted in different interpretations by tax


preparers and the IRS. Consistency in this area is important because an item
classified as a repair can be deducted right away, but an item classified as an
improvement cannot be deducted until the property is sold (though it may be
depreciated.
Beginning in 2014, the IRS issued tangible property regulations (TPRs) to provide framework for how to treat costs incurred to acquire, produce, or improve
tangible property. To comply with the regulations, taxpayers may have to make
certain elections with their tax return or file Form 3115, Application for Change
in Accounting Method.

Supplies. Any supplies not included in Part III that are necessary to the proprietors business are
deductible. The taxpayer can deduct the cost of books, professional instruments, equipment, etc., if
they are normally used in the business and have a useful life of less than one year.
Taxes and licenses. Only those taxes that are directly attributable to the trade or business are
deductible. Such taxes may include:
Real estate and personal property taxes imposed on business assets.
State and local taxes imposed on gross income (as distinguished from net income).
Compensating use taxes that are generally imposed on the use, storage, or consumption of an item
brought in from another taxing jurisdiction.
Payroll taxes (see below).
Federal highway use tax.
Sales taxes imposed on the seller of goods or services. (If the proprietor passes these taxes onto the
buyer, however, these taxes should be included here and in gross receipts on line 1.)
Payroll taxes are the taxes that a business must pay on behalf of its employees. They include social
security tax of 6.2% for wages up to $117,000 (for 2014), medicare tax of 1.45% on all wages, and
FUTA (Federal Unemployment Tax Act) tax ranging from 0.8% to 6.0% on each employees wages up
to $7,000. The employer must also withhold a 0.9% Additional Medicare Tax from wages and compensation paid to employees in excess of the following threshold amounts.
MFJ

$250,000

S/HOH/QW

$200,000

MFS

$125,000

Taxes and other amounts withheld from employees wages are not separately deductible because gross
wages, which include amounts withheld from employees, are deducted under wages on line 26. For
clarity, many taxpayers list the employers portion of payroll taxes in the space provided for other
expenses in Part V on page 2 of Schedule C.
Licenses (such as occupational, chauffeur, or building) and regulatory fees paid annually to state and
local governments in connection with the trade or business are also deducted on this line.

Tax Essentials Self-Employment Income 17.13

Travel, meals, and entertainment. These expenses for a self-employed person are subject to the
same limitations and requirements as those for an employee. Note that generally a 50% limitation
applies to business meals or entertainment expenses. Also, taxpayers who deduct travel, meals, and
entertainment must substantiate these expenses. Records may be maintained in a book of account,
diary, statement of expense, or similar record along with the documentary evidence that supports
each element of the expense. Documentary evidence includes, but is not limited to, such items as
receipts, canceled checks, and invoices marked paid. For more information, see IRSPublication 463,
Travel, Entertainment, Gift, and Car Expenses.
Utilities. This item includes the cost of heat, lights, power, telephone, and Internet access. The taxpayer must allocate between the business-use portion and personal-use portion of such expenses when
separate utility meters are not installed. If the business is located in the taxpayers home, no portion
of the base rate for the first telephone line into the home is deductible. However, if a second line is
added for business purposes, or if extra services, such as call waiting, are added for business reasons,
the business portion of such charges is deductible. Also, long-distance charges incurred for business
purposes are deductible.
Wages. To be deductible, compensation must be an ordinary and necessary expense of carrying on the
business, reasonable in amount, for personal services actually rendered, and actually paid or incurred
during the tax year. Gross salaries, wages, or other compensation paid to relatives (including the proprietors spouse and children) are deductible, provided the above requirements are met.
The cost of meals and lodging furnished to employees is deductible as compensation paid, regardless of
whether the value is taxable to the employees. This is considered a fringe benefit because the employee received this benefit for their performance of services. The value of meals and lodging furnished for
the employers convenience is not included in the employees Form W-2 gross wages. If furnished as
additional employment incentive, the value of meals and lodging is included in the employees Form
W-2 gross wages.
Employment credits. Several credits are available to employers who hire workers from certain
groups or certain areas of high unemployment. If you ever need more information about these credits,
youll find it in IRS Publication 334, Tax Guide for Small Business.
Other expenses. This category covers all ordinary and necessary business expenses not entered on
the other lines of Part II. Examples include bank service charges (such as check-printing fees, night
deposit fees, etc.), bad debts (see below), dues to professional and trade organizations, the cost of business-related publications, and laundry and cleaning expenses for such things as employee uniforms.
All other expenses must be itemized in Part V on the second page of Schedule C and the total from
line 48 entered on line 27a, Part II.
Personal expenses are never deductible as business expenses. If an expense is partly personal and
partly business, only the business portion is deducted on Schedule C. An example of a part-personal,
part-business expense is the fee paid for tax preparation of the previous years return. The portion of
the fee pertaining to the preparation of Schedule C and any other business-related forms would go on
line 17, Schedule C, as mentioned earlier. The balance of the fee would be an itemized deduction on
line 22, Schedule A, and would be subject to the 2%-of-AGI limitation. State and local income taxes on
the net profit from a business are personal expenses and deductible only on Schedule A.
Bad debts are customer accounts receivable and notes receivable determined to be uncollectible. Such
debts are only deductible if the income was previously included in gross income. Cash-method taxpayers ordinarily are not entitled to claim a deduction for business bad debts because sales are not
included in gross income until payment is received.

17.14 H&RBlock Income Tax Course (2015)

mExample 1: David Brooks makes and sells custom skateboards. He sold 12 boards to a sporting
goods store in December 2014 for $700. The terms of the sale specified that the merchandise would be
paid for within 60 days. Because he uses the accrual method of accounting for his inventory and gross
receipts, David included the $700 in his income in 2014.
After the customer failed to pay, David exhausted every legal means attempting to collect the money.
Unfortunately, the customer was now bankrupt. By October 2015, David determined that the debt
was uncollectible. He may deduct $700 for the bad debt on his 2015 return. He may also deduct the
expenses of trying to collect the money.m
mExample 2: Sandra Balderson runs a bookkeeping business. In 2014, she performed $300 worth of
work for a client who left town without paying the bill. Because she uses the cash method of accounting, she did not include the $300 in her income because the client had not yet paid. Thus, even though
her client disappeared without paying, she cannot take a bad debt deduction because the $300 was
never included in income.m
Home-office expenses. If a proprietor uses a portion of their home regularly and exclusively as their
principal place of business or as a place to meet customers, they may deduct the expenses of operating
the home office. Such expenses are calculated on Form 8829, Expenses for Business Use of Your Home,
and entered on line 30, Schedule C.
Fringe benefits. If the proprietor provides their employees extra benefits that help to supplement
the employees salary, the proprietor may be able to include the cost of the fringe benefit provided on
their Schedule C in the category in which the cost falls. Examples of fringe benefits include groupterm life insurance coverage, cafeteria plan, employee use of the business car, tickets to entertainment or sporting events, education assistance, etc. Depending on the type of fringe benefit provided
to the employee, the employer may or may not be required to include these costs of fringe benefits in
the employees wages. For more information on fringe benefits, see IRSPublication 334, Tax Guide for
Small Business, and IRSPublication 15-B, Employers Tax Guide to Fringe Benefits.
Complete Exercise 17.3 before continuing to read.

OTHER SELF-EMPLOYMENT-RELATED TOPICS


While it is important for you to be aware of the topics of direct sellers, at-risk limitation, and net operating loss, these topics will be covered in other intermediate and advanced courses.

Direct Sellers
Direct sellers are individuals who sell consumer products to others on a person-to-person basis other
than at an established retail location. They may sell door to door, through a sales party plan, or by
appointment in customers homes.
Direct sellers and other salespeople often have complex tax situations, to the extent that we cannot
cover them in detail in this course. IRS Publication 334, Tax Guide for Small Business, contains more
information to help you determine which taxpayers qualify as direct sellers and to assist you in the
preparation of their tax returns.

Tax Essentials Self-Employment Income 17.15

At-Risk Limitation
Read Schedule C, line 32. A net loss is allowed as a subtraction from other income and as a net operating loss (discussed shortly) only up to the amount the taxpayer has at risk. At-risk amounts are
the actual cash invested in the business by the taxpayer and the adjusted basis of other property contributed by the taxpayer to the activity. In addition, the taxpayer is at risk for amounts they borrow
for use in the activity if they are personally liable for the repayment or if they have pledged property
(other than property used in the business) as collateral. This limitation prevents a taxpayer who has
borrowed money through a nonrecourse loan (a loan for which the taxpayer is not personally liable
for the repayment) from deducting from income losses greater than the amount actually invested in
the business activity. If the taxpayer has amounts for which they are not at risk in the activity, Form
6198, At-Risk Limitations, must be completed to determine the allowable loss on Schedule C. Form
6198 is not covered in this course.

Net Operating Loss


Net loss from self-employment that exceeds all other income for the year may create a net operating
loss (NOL). An NOL may be carried back and/or forward to reduce the income in other years. This
would reduce the income tax in those years and result in a refund or reduced income tax liability.
An NOL cannot be used to reduce the amount of self-employment tax owed. If a taxpayer appears
to have an NOL, additional research may be required. For more information on NOL, see both IRS
Publication 334, Tax Guide for Small Business, and IRS Publication 536, Net Operating Losses (NOLs)
for Individuals, Estates, and Trusts.
It is important to note that IRShas safe harbor rules, also called hobby loss rules, for determining if a
taxpayer maintains a business for profit or as a hobby. For the taxpayer to meet the IRS safe harbor
rule, their business generally must produce a profit for three of five consecutive years. If the taxpayer
cannot meet this rule, their business is considered a hobby and they are only allowed to deduct business expenses up to the amount of hobby income. When determining if the taxpayers business is for
profit or a hobby, it is the tax preparers responsibility to apply the hobby loss rules. For information
about the IRShobby loss rules, see IRS Publication 535, Business Expenses.

17.16 H&RBlock Income Tax Course (2015)


Illustration 17.4

Tax Essentials Self-Employment Income 17.17


Illustration 17.5

17.18 H&RBlock Income Tax Course (2015)

SELF-EMPLOYMENT TAX
Schedule SE, shown in Illustrations 17.4 and 17.5, is the form used to determine the sole proprietors
social security and medicare taxes. Schedule SE is a two-page form, but we will only be discussing
Section A on page 1 in this course. A flowchart useful for determining which taxpayers must use
Section B is shown just above Section A on the first page of the form. Generally, self-employed taxpayers with net earnings of $400 or more must pay SE tax. Self-employed taxpayers pay SE tax at
the rate of 15.3% on the first $117,000 of self-employment income. Then, the self-employed taxpayer
is subject to the 2.9% medicare tax on wage amounts greater than $117,000. The SE tax computed on
Schedule SE is then reported on Form 1040, line 57. Self-employed taxpayers are allowed to deduct
one-half of their SEtax on Form 1040, line 27. Thus, Schedule SE is unique in that it gives rise to a
tax liability and an adjustment simultaneously. Because the Schedule SEis prepared after the close
of the taxpayers business fiscal year, the self-employed taxpayer may be required to pay estimated
tax payments during the year to avoid an underpayment penalty.
mExample: James S. Dalony has a full-time job at which he earns $30,000. He is also a self-employed
chimney sweep on evenings and weekends. His net self-employment income on his Schedule C (line
31) is $4,216. James is subject to $596 of self-employment tax, but he also receives a one-half self-employment tax deduction of $298. His Schedule SE, page 1, is shown in Illustration 17.4.m
Lines 1a and 1b. Net income or loss from farm operations go on these lines. Farms are not covered
in depth in this course.
Line 2. Net income from self-employment from nonfarm businesses goes here. Net losses also go here
and are enclosed in parentheses. If the taxpayer has more than one business, combine the amounts
from all the taxpayers Schedules C. For example, if a taxpayer had two businesses, one with a net
gain of $10,000 and one with a net loss of $2,000, you would enter $8,000 on line 2. James has just
the one business, so line 2 shows his net profit from line 31, Schedule C.
Line 3. Combine lines 1a, 1b, and 2.
Line 4. Self-employed taxpayers generally pay SE tax at the rate of 15.3% (line 5). Similarly, an
employee and his employer each pay a percentage of the employees gross wages for social security
and medicare taxesthe employee pays 6.2%, and the employer pays 7.65%, for 2014. In an effort to
be more equitable, self-employed taxpayers are allowed to reduce their net income by 7.65% on line
4 before computing their SE tax. The form accomplishes what would otherwise be a two-step process
(multiplying SE income by 7.65% (0.0765), then subtracting the result from SE income) in one step
by instructing us to multiply the SE income on line 3 by 92.35% (0.9235) [100% 7.65% = 92.35%].
If line 4 turns out to be less than $400, the taxpayer is not required to pay SE tax, and they should
not file Schedule SE. As a practical matter, this means there is no need to begin the form if net SE
income is less than $433 [$433 2 .9235 = $399.88]. Of course, any amount of self-employment income
is still entered on line 12 of Form 1040.
Line 5. Follow the appropriate arithmetical directions, depending on the amount shown on line 4.
Jamess amount on line 4 is $117,000 or less, so they multiplied line 4 by 15.3%. The amount on line
5 is carried to line 56, Form 1040.
Line 6. Line 6 is the deduction for the employer-equivalent portion of self-employment tax. It is calculated by multiplying line 5 by 50% (.50). This amount on line 6 is carried to line 27, Form 1040, as
an adjustment to income.

Tax Essentials Self-Employment Income 17.19

Complete Exercise 17.4 before continuing to read.

SELF-EMPLOYED HEALTH INSURANCE DEDUCTION


Sole proprietors may deduct on Schedule C the cost of health insurance benefits for their employees.
However, the cost of such insurance coverage for themselves and their families is not considered a
business expense and may not be deducted on Schedule C. Rather, self-employed taxpayers may be
eligible to deduct amounts they pay for medical insurance for themselves and for their families as
an adjustment to personal income on Form 1040, line 29. In order for the taxpayer to qualify for this
deduction, the following requirements must be met:
The taxpayer may not be eligible for coverage under the medical plan of their employer (assuming
they have a job in addition to their self-employment) or their spouses employer.
The plan must be a qualified health plan meeting the benefit and cost sharing standards established under the Affordable Care Act. The taxpayer may either purchase a plan through the
Marketplace, or they may obtain private coverage that meets these requirements. The policy can
either be in the taxpayers name or in the business name.
The self-employed health insurance deduction may not exceed the net income from the self-employment activity under which the plan was established, minus any amounts on Form 1040, lines 27
and 28, that are attributable to the activity.
Note that if the deduction is limited, any remainder may be deducted on Schedule A if the taxpayer
itemizes. However, any amount deducted on line 29 may not be deducted again on Schedule A.
mExample: Ruth Riddie is self-employed and uses the head of household filing status. Her net income
on Schedule C is $3,000. She does not contribute to a retirement plan. She does hold another, parttime job, but she is not eligible for coverage under her employers medical plan. The deduction for the
employer-equivalent portion of her self-employment tax is $212 [$3,000 92.35% 15.3% 50%].
This calculation has to be completed as if Form 1040, line 29, is zero, since that is the amount we are
determining.
During 2014, Ruth paid $300 per month for qualified health insurance to cover herself and her dependent. Her self-employed health insurance deduction is limited to $2,788: the lesser of her net self-employment income $2,788 [$3,000 $212] or her total health insurance premiums of $3,600 [300 12
months]. The amount of $2,788 is entered on Form 1040, line 29, and Ruth may deduct the remaining
$812 [$3,600 $2,788] as a medical expense on Schedule A if she itemizes deductions.m
Self-employed taxpayers may claim the premium tax credit and
Tthe self-employed
health insurance deduction in the same year. However,
ax Tip:

a circular calculation must first be resolved to arrive at both amounts. Why?


Because the self-employed health insurance deduction affects modified adjusted
gross income, which affects the premium tax credit calculation. This, in turn,
affects the self-employed health insurance deduction (because premiums cannot
be used for both tax benefits). This calculation is beyond the scope of this class,
but IRS Publication 974, Premium Tax Credit, includes a series of worksheets
that can be used to arrive at the optimal amounts and resolve the calculation.

17.20 H&RBlock Income Tax Course (2015)


Illustration 17.6

Tax Essentials Self-Employment Income 17.21

HOME-OFFICE EXPENSES
In this section, we will examine the rules for deducting all home-office expenses for the self-employed.
You must be able to recognize when a taxpayer may be able to deduct such expenses before you can
assist them in deducting such expenses.

Who Can Deduct Home-Office Expenses?


Many taxpayers do part of their work at home, but only certain taxpayers are allowed to deduct part
of the operating expenses of their homes as a business expense. The flowchart in Illustration 17.6
will help you determine if a taxpayer is eligible to deduct home-office expenses. There are several key
points outlined on the following page.
1. Is the office used exclusively for business?
Aside from two exceptions mentioned in the next paragraph, all deductible home offices must be used
exclusively for business. This standard is strict, and the taxpayer should make no personal use of the
office at any time. The office may be an entire room or other separately identifiable space, but the
office area does not need to be marked off by permanent partitions. It is recommended that the office
area is furnished with only office furniture or equipment used in the business. It is better not to have
sofas, easy chairs, or televisions in the office, even though such furniture is common in office buildings.
The following are the two exceptions to the exclusive-use test:
The taxpayer uses part of their home for storage of inventory or product samples.
The taxpayer uses part of their home as a daycare facility.
These two exceptions are discussed in more detail in IRSPublication 587, Business Use of Your Home.
2. Is the office used regularly for business?
This standard is less rigid than the exclusive-use test, and common sense should prevail when interpreting it. Generally, the taxpayer must spend substantial amounts of time working in the office on
a periodic basis to meet the test. Usually, this test is easily met if the taxpayer meets the other tests
as described in Illustration 17.6.
Is the taxpayer an employee?
Employees, as opposed to the self-employed, cannot deduct home-office expenses unless the office is
for the employers convenience.
Is the office for the employers convenience?
Many employees bring work home. Even if the place where this work is done is used regularly and
exclusively for this purpose, it does not qualify for the deduction. Only if such work is for the employers convenience, as opposed to the employees convenience, would it qualify. Usually, this means that
the employer does not provide a place where the employee can perform their required duties.
Does the taxpayer meet clients in the office in the normal course of business?
If the taxpayer meets clients, patients, or customers in their home office in the normal course of business, the office qualifies the taxpayer for a deduction. Notice, if the taxpayer meets this test, their
home office does not need to be their principal place of business.

17.22 H&RBlock Income Tax Course (2015)


Illustration 17.7

Tax Essentials Self-Employment Income 17.23

Is the office in a separate structure?


If the office is located on the taxpayers property but is not physically attached to the taxpayers
residence, the office qualifies for deduction if all other tests are met. Having a separate structure for
a home office eliminates the need to demonstrate that the office is the taxpayers principal place of
business.
Is the office the principal place of business?
Each trade or business in which the taxpayer engages can have a principal place of business.
The definition of principal place of business is similar to the definition of tax homethe place where
the taxpayer earns most of their income or spends most of their income-producing hours. However,
if the taxpayer uses their home office to perform necessary administrative or management activities
(such as billing and recordkeeping), then the home office qualifies as the taxpayers principal place of
business. This applies if there is no other fixed location at which they perform these tasks.

Figuring the Deduction


After the taxpayer has determined that they meet the tests to deduct the business use of the home,
the taxpayer has two methods available for determining the deduction: the simplified method and the
actual expenses method.
The simplified method is an alternative to the calculation, allocation, and substantiation of actual
expenses. The taxpayer is allowed to choose each year which method they wish to figure their business
use of the home deduction.

Using the Simplified Method


Under the simplified method, the taxpayer would determine their business use of the home deduction
by multiplying $5, the prescribed rate, by the area of their home used for qualified business use. The
area used to figure the deduction is limited to 300 square feet (sqft).
Note that if the taxpayer uses the simplified method to figure their deduction for the business use of a
home, their mortgage interest, qualified mortgage insurance premiums, real estate taxes, or casualty
losses, subject to limitations, are treated as personal expenses and deducted on Schedule A, if the taxpayer itemizes deductions. No part of any of these expenses can be deducted as a business expense on
Schedule C. The amount of the deductions under the simplified method is limited to the gross income
from the activity minus all other expenses related to the activity, excluding all expenses relating to
business use of the home.
If the taxpayer uses their home for their trade or business and files Schedule C, they will use the
Simplified Method Worksheet, shown in Illustration 17.7, which can be found in the instructions for
Schedule C.
mExample: On January 1, 2014, Johnny Appleton started a painting business that he runs out of
his home. He uses 240 square feet of his home strictly for his business. For 2014, Johnnys tentative
profit reported on Schedule C, line 29, is $9,000. Under the simplified method, Johnny is allowed to
deduct $1,200 for business use of the home office on Schedule C, line 30. Johnnys Simplified Method
Worksheet is shown in Illustration 17.7.m
When determining the simplified method, special rules apply to taxpayers who have part-year use of
their home office or change the area of their home office during the year. For more information on the
simplified method, see IRSPublication 587, Business Use of Your Home.

17.24 H&RBlock Income Tax Course (2015)


Illustration 17.8

Tax Essentials Self-Employment Income 17.25

What Expenses Are Deductible under the Actual Expenses Method?


Deductible home-office expenses, allowed under the actual expenses method, include depreciation of
the home, rent paid, dwelling insurance, utilities, maintenance, and repairs. Expenses for landscaping, lawn care, and the like are not deductible unless a business purpose can be shown, such as use
as a display to potential clients of a lawn-care business.
The home-office deduction for sole proprietors and statutory employees does include qualified home
mortgage interest, real estate tax, and casualty loss. The business portion of these expenses is allowed
as a home-office expense (even if there is a loss on Schedule C). The personal portion of these expenses
is deductible on Schedule A.
Sole proprietors and statutory employees filing Schedule C compute their home-office deduction on
IRS Form 8829 and carry the deduction to Schedule C, line 30.
On Form 8829, you will be computing a limitation that applies to rent, dwelling insurance, utilities,
maintenance, repairs, and other expenses. These deductions are limited to the gross income from the
activity minus all other expenses related to the activity, including the business portion of qualified
mortgage interest, real estate taxes, and casualty losses that we discussed above. This limitation is
computed on Form 8829, lines 815. A second limitation applies to depreciation. This limitation is
computed on Form 8829, lines 1627. Any expenses that cannot be deducted due to the limitations
may be carried over to future years and deducted when the business or employment creates enough
income to absorb them.

FORM 8829
Form 8829 is the form used by sole proprietors who are not farmers and by statutory employees to
determine their home-office deductions. Illustration 17.6 is a flowchart that will help you understand
the business-use-of home deduction.
mExample: Jason Hoyburg is a self-employed writer who uses one room of his home regularly and
exclusively as his writing studio. His Form 8829 is shown in Illustration 17.8.m
we do not include depreciation in this course, it is importTant thatAlthough
you know that because a portion of the taxpayers home is used for
ax Tip:

business, the depreciation table used for Form 8829 is the table for nonresidential real property, not the table for residential rental real property.

Lines 1 through 3. These lines determine the percentage of business use of the home. All businesses
except daycare businesses enter the line 3 percentage on line 7, as Jason did. If the home were used
for business purposes only part of the year, the business percentage would be prorated in the manner
described in the Form 8829 instructions.
Lines 4 through 7. Generally, a portion of the home must be used regularly and exclusively for business if the taxpayer is to qualify for a home-office deduction.
Note: There is an exception to the exclusive-use test for daycare businesses. The portions of the home
used for daycare must still be used regularly for business purposes to qualify for the deduction, but

17.26 H&RBlock Income Tax Course (2015)

they need not be used exclusively for business. Lines 4 through 7 are for prorating the use of the home
by hours of daycare use.
mExample: Carol Gordon runs a child-care business in her home. For ten hours per day (220 days
during 2014), the kids she watched had the run of the downstairs portion of the house (50% of the
total area of the home). In the evenings and on weekends, of course, she and her family used the entire
home for personal purposes.
Carol can deduct home-office expenses for the downstairs portion of the house, prorated for the hours
of business use. Note that if Carols business were other than day care, she would have no deductible
home-office expense, because she would fail the exclusive-use test.m
Line 8. Enter the amount from Schedule C, line 29. Line 29 represents tentative income from the
business after all other expenses have been subtracted.
Lines 9 through 15. These are for entering various other expenses that are deductible in the proportion they pertain to the home office. The limitation alluded to on line 10 is the million-dollar limitation
on the deductibility of home mortgage acquisition debt. Jasons expenses are shown and are entered
in the indirect column because they pertained to the whole residence.
Columns A and BDirect and Indirect Expenses. Many lines on the form are divided into columns for direct expenses and indirect expenses. Direct expenses are those that are fully chargeable to
the home office. For example, the cost of painting the interior of the home office and the expense for
electricity if the home office is separately metered and billed are direct expenses. Indirect expenses,
on the other hand, are expenses that cover the entire home and must be prorated to determine the
portion attributable to the home office. For example, real estate tax paid on the whole property would
be entered in the indirect expense column because part of the tax is for the business portion of the
home and part is for the personal portion.
Lines 16 through 21. These involve following the line directions. Jason has a total of $3,000 listed on
lines 16 through 21, and 10% is apportioned to his home office. This $300 will become part of Jasons
home-office deduction. Another limitation comes into play at this point. Depreciation can only be
deducted currently to the extent that it does not exceed the income from the business, less all other
expenses, including the operating expenses shown on lines 16 through 21. Therefore, line 27 shows
the maximum depreciation that could be currently deducted for this home office. In Jasons case, the
limit is so high they do not come close, because his depreciation on line 31 is only $256, compared to
the $44,300 limitation. Any depreciation that might be disallowed by the limitation is carried to the
next year.
Lines 22 through 27. Follow the instructions for each line on the form.
Line 28. Casualty losses in excess of the amount on line 9 are multiplied by the business percentage
of those losses (line 7).
Note: The following lines deal with depreciation, which you will study in the next course. For a basic
awareness, depreciation is a deduction allowed for the reasonable wearing out of an asset.
Line 29. The depreciation for the home is taken from Part III of the form. Part III has most of the
same information as the depreciation worksheet; it is just presented in a different format. If this is
the first year for depreciating the home, Form 4562 is also necessary.
Lines 30 through 32. Follow the instructions for each line on the form.

Tax Essentials Self-Employment Income 17.27

Lines 36 through 41. The depreciable basis of property converted from personal use to business use
is the lesser of its adjusted basis (generally, the purchase price plus the cost of improvements) or the
fair market value of the property on the date first used for business.
Lines 42 and 43. Follow the instructions for each line on the form.
Complete Exercises 17.5 and 17.6 before continuing to read.

FARMING INCOME
Determining the profit or loss from a farm is the same formula as that used by a non-farm proprietor:
gross receipts (the money taken into a business) minus expenses equals net profit or loss. However,
because farm returns require the use of some special vocabulary, Schedule F, rather than Schedule C,
is used to calculate the profit or loss of a sole proprietor farmer. Schedule F is shown in Illustrations
17.9 and 17.10.
Farming includes cultivating land; operating dairy farms, fruit farms, nurseries, orchards, poultry
farms, fish farms, plantations, ranches, stock farms, and truck farms; and breeding and raising
fur-bearing animals or laboratory animals. It does not include breeding, raising, or caring for dogs,
cats, or other pets.
While many income and expense items are unique to the business of farming and will require some
explanation, the basic formula is the same as for other businesses: Gross income minus expenses
equals net profit or loss. Schedule F is used to determine the profit or loss from farming.
Schedule F is a two-page form. Part I is used by cash-basis farmers to determine their gross farm
income, and Part II is used by all farmers to report expenses. Part III on the second page is used by
accrual-basis farmers to determine their gross farm income.
Taxpayers who are engaged in a farming business may have the opportunity to calculate the tax on
their farming income by using an averaging method. The taxpayer may be able to average all or some
of their farm income by using tax rates from the three prior years (base years) to calculate the tax on
their farming income. This may give the taxpayer a lower tax rate if their current-year income is high
and their taxable income, which includes income from farming from one or more of the three prior
years, was low. The taxpayer would file Schedule J, Income Averaging for Farmers and Fisherman, to
elect to figure their farming income by averaging and figure their amount of tax. For more information
of income averaging for farmers, see IRSPublication 225, Farmers Tax Guide.

17.28 H&RBlock Income Tax Course (2015)

COURSE SUMMARY
In this course, you learned how to:
Determine business income and expenses.
Complete Schedule C to determine net business profit or loss and carry the appropriate entries to
Form 1040 and Schedule SE.
Complete Schedule SE to determine the self-employment tax and the corresponding adjustment to
income and enter both the tax and the adjustment on Form 1040.
Identify when self-employment income requires Schedule F.
Explain the deduction available to sole proprietors who provide health insurance coverage for their
employees.
Determine if a taxpayer has qualified home-office expenses.

Suggested Reading
For further information on the topics discussed in this course, you may wish to read the following
IRSPublication:
IRS Publication 334, Tax Guide for Small Business.
IRSPublication 463, Travel, Entertainment, Gift, and Car Expenses.
IRSPublication 538, Accounting Periods and Methods.
IRSPublication 587, Business Use of Your Home.
IRS Publication 925, Passive Activity and At-Risk Rules.

Tax Essentials Self-Employment Income 17.29


Illustration 17.9

17.30 H&RBlock Income Tax Course (2015)


Illustration 17.10

Tax Essentials Self-Employment Income 17.31


Illustration 17.11

17.32 H&R Block Income Tax Course (2015)


Illustration 17.12

18

Depreciation
OVERVIEW
Depreciation is an annual deduction that allows the taxpayer to recover the cost or other basis for the
reasonable wearing out of durable assets used in business or held for the production of income. When
an asset, such as a piece of equipment or a building, is purchased for use in business for the production of income, generally the full purchase price is not allowed to be deducted in the year of purchase.
Rather, the taxpayer is allowed to deduct a portion of the propertys cost or other basis over a period
of several years.

OBJECTIVES
At the conclusion of this chapter, you will be able to:
Describe the concept of depreciation.
Describe the two systems of depreciation under the Modified Accelerated Cost Recovery System
(MACRS): General Depreciation System (GDS) and Alternative Depreciation System (ADS) method.
Determine when the mid-month, mid-quarter, and half-year conventions apply and which MACRS
depreciation table applies.
Compute depreciation of business-use property using the MACRS GDS method.
Determine which types of assets are listed property and compute depreciation for listed property
using the MACRS ADS method.
Determine which types of assets qualify for a 179 expense deduction, compute the allowable
deduction, and enter it on the tax return.
Determine which types of assets qualify for a special (bonus) depreciation allowance, compute the
allowable deduction, and enter it on the tax return.
Complete Form 4562, when necessary, and enter the depreciation deduction on the associated tax
forms or schedules.
Determine what events trigger depreciation recapture.

18.1

18.2 H&RBlock Income Tax Course (2015)

TAX TERMS
Look up the definitions of the following terms in the glossary:

















Accelerated Cost Recovery System (ACRS).


Adjusted basis.
Alternative straight-line depreciation system (ADS).
Asset.
Business assets.
Business-use property.
Depreciation.
Disposition.
Estimated (useful) life.
General depreciation system (GDS).
General straight-line depreciation system.
Listed property.
Modified Accelerated Cost Recovery System (MACRS).
Personal property.
Real property.
Section 179 expense deduction.
Straight-line depreciation method.
Unadjusted basis.

DEPRECIATION
Depreciation is a deduction that allows the taxpayer to recover a portion of the cost or other basis of
business property or income-producing property each year because the property is subject to deterioration, wear and tear, and obsolescence.
It is important to understand which assets may be depreciated and which may not. Generally, business-use property with a useful life of more than one year is depreciable.
To be depreciable, the property generally must be owned by the taxpayer, and:
Be used in their business or be income-producing.
Have a determinable useful life.
Be expected to last longer than one year.
Properties that are not depreciable include:
Property placed in service and disposed of in the same year.
Personal-use assets, such as a snowblower used only to clear the family driveway.
Equipment used to build capital improvements. (Generally, the cost of equipment is added to the
basis on the property being improved.)

Tax Essentials Depreciation 18.3

Assets with an unlimited or indeterminable life, such as landeven if used in business.


Intangible assets (e.g., patents, copyrights, trademarks, etc.).
Inventory or stock in trade, such as the cars sold on an auto dealership lot.
mExample: In 2014, Marilyn Cole purchased a refrigerator for use in her floral business. Marilyn
will not deduct the full cost of the refrigerator in the year she purchases it. Rather, she will deduct a
portion of the cost of the refrigerator as an expense against her business income each year for several
years. In 2014, Marilyn also purchased a new freezer for personal use in her home. Marilyn may not
claim a depreciation deduction for her new freezer because it is personal-use property.m
Let us take a moment to explain some terminology as it applies to depreciation. Property can be
divided into two types: real and personal. Real property refers to land and buildings. Personal type
property is all property other than real property. Examples of personal property include automobiles,
furniture, tools, machinery, and livestock. Property is also divided into categories of usage: personal-use, investment-use, business-use, or stock-in-trade (inventory).
is important to understand the difference between personal type
TpropertyItand
personal-use property. Personal type property is one of the two
ax Tip:

classifications of property, real or personal. Sometimes this type of property is


commonly referred to as tangible personal property. Personal-use property is all
property (real or personal type) that is used by the taxpayer for personal purposes. It is important to understand that personal-use property is not depreciable because the taxpayer used the property for non-income producing purposes.
When we refer to personal property in the context of depreciation, we mean
personal type property.

Property owned. Generally, the taxpayer owns the property if they have legal title to the property;
have a legal obligation to pay for the property; are liable for property taxes, maintenance, and operating expenses; and the taxpayer has a risk of loss if the property is damaged, destroyed, or condemned.
With regards to leased property, generally the owner (the lessor) can depreciate property they lease
to someone else (the lessee). Depending on how the lease agreement is executed, the lessee may be
able to depreciate the leased property or lease-hold improvements made to the property. If you are
preparing a return for a taxpayer who leases property, additional research may be required. For more
information about depreciating leased property, see IRSPublication 946, How To Depreciate Property.
Useful life. Depreciable property must have a useful life greater than one year. This means that the
property will eventually wear out, decay, become obsolete, or lose its value over time. If the property
has a useful life of less than one year, the cost of the property may be deducted in the year purchased.
Partial business- and investment-use. Depending on the type of asset, the taxpayer may use the
asset for both business or investment purposes as well as personal-use. Two common assets that fall
into this category include motor vehicles and computers. When determining the depreciation deduction for assets used for business/investment purposes and personal purposes, the taxpayer is only
allowed to deduct depreciation based on business- or investment-use. The taxpayer is not allowed
to deduct depreciation for personal activities. Certain assets that may be used for both personal and
business use are called listed property. Listed property is a special class of property and subject to
separate set of tax rules. Listed property will be discussed in more detail later in the course.

18.4 H&RBlock Income Tax Course (2015)

For a taxpayer to properly calculate the depreciation deduction for their property, the taxpayer must
answer the following questions:




What is the depreciable basis of the property?


What is the depreciation method for the property?
Is the property considered listed property?
Does the property qualify for the special (bonus) depreciation deduction?
Does the property qualify for the 179 depreciation deduction?
Complete Exercise 18.1 before continuing to read.

DEPRECIABLE BASIS
As discussed earlier, the depreciation deduction allows the taxpayer to recover a portion of the cost
or other basis in the business property or income-producing property over several years. The taxpayer starts depreciating the property in the year the property is placed in service. The taxpayer stops
depreciating the property either when the taxpayer has fully recovered their cost or other basis in
the property or when the taxpayer retires the property from service, whichever comes first. With that
said, it is essential for the taxpayer to know the depreciable basis of the property so they can correctly
calculate the propertys depreciation deduction and fully recover their basis.
Cost basis. Depreciable basis is the amount the taxpayer has invested in the property. The cost basis
is generally the cost of the property. The cost basis includes the amount of cash paid, debt obligations
incurred or assumed, and/or the fair market value (FMV) of other property or services provided plus
additional costs incurred in acquiring the property. Additional costs may include sales tax, freight
charges, and installation. Note that if a taxpayer purchased property that has an existing debt obligation and they assume the debt, their basis in the property includes the amount paid plus the debt
obligation assumed.
Other basis. Other basis is the basis for property that is received by a taxpayer through a direct
exchange of the same property (like-kind exchange), through payments for services rendered, received
as a gift or inherited, and is calculated based on the method by which the property was received. If you
are preparing a return for a taxpayer who received property as a gift, inheritance, like-kind exchange,
or for services rendered, additional research is required. For more information about determining the
propertys basis, see IRSPublication 551, Basis of Assets.
Adjusted basis. Once the taxpayer has determined the propertys basis, they may have to increase
or decrease the basis based on events that occurred since the time the property was acquired and the
time the property was placed in service. The taxpayer is required to increase their basis in the property for capital improvements, certain taxes, and legal fees. The taxpayer is required to decrease their
basis in the property for casualty or theft losses, certain credits and deductions received with respect
to the property, and rebates.

Tax Essentials Depreciation 18.5

When determining adjusted basis, the taxpayer must reduce their basis by the greater of the amount
of depreciation allowed or allowable. Depreciation allowed is the amount of depreciation actually
taken. The amount of depreciation allowable is the total amount of depreciation the taxpayer was
entitled to deduct, regardless of how much was actually taken. So, if the taxpayer was entitled to a
depreciation deduction under tax law and did not take the deduction, they are still required to reduce
their basis by the amount of the deduction that could have been deducted.
Repairs vs. improvements. When a taxpayer repairs business property, they are making necessary
maintenance on the property to keep it in good operating condition. Repairs do not materially add
value to the property or substantially prolong its life. The taxpayer is generally allowed to deduct
repair costs in the year incurred. Improvements, on the other hand, are additions or partial replacement of property that adds value and lengthens the life of the property. The taxpayer is required to
add the cost of the improvement to the basis of the property and depreciate the improvements as
separate depreciable property.

FORM 4562
Generally, the taxpayer will use Form 4562 to calculate and report depreciation and amortization
deductions. The taxpayer would attach Form 4562, shown in Illustrations 18.1 and 18.2, to their tax
return in the current tax year when claiming depreciation or amortization on any one of the following
items:
179 depreciation deduction for the current year or carryover from prior years (discussed later in
the course).
Depreciation for property placed in service during the current year.
Depreciation on any vehicle or listed property (regardless of when placed in service).
Vehicle deductions reported on a form other than Form 1040, Schedule C, and Schedule CEZ.
Amortization of costs that begin in the current year.
Depreciation or amortization on any corporate asset reported on a corporate return (other than
Form 1120S).
The taxpayer is required to submit a separate Form 4562 for each business activity reported on their
return. The completion of this form will be discussed in more detail later in the course.

18.6 H&RBlock Income Tax Course (2015)


Illustration 18.1

Tax Essentials Depreciation 18.7


Illustration 18.2

18.8 H&RBlock Income Tax Course (2015)

AMORTIZING
Generally, a taxpayer cannot depreciate new business start-up costs, goodwill, or other intangible
assets such as patents, copyrights, or computer software. Instead, the taxpayer is required to amortize these costs. Amortization is similar to depreciation in that it allows the taxpayer to recover
certain costs over a fixed time period. Generally, the amortization deduction is calculated using the
straight-line method of depreciation. For amortization beginning in the current year, the taxpayer
would complete Part VI of Form 4562 and attach it to their return. If the taxpayer is reporting amortization costs that began before 2014 and they are not required to file Form 4562, the taxpayer would
report the amortization deduction directly on the Other Deductions or Other Expenses line of their
business form or schedule. For more information about amortization, see the H&R Block Intermediate
Depreciation course.

METHODS USED TO DEPRECIATE PROPERTY


The most common method used to depreciate property is the Modified Accelerated Cost Recovery
System (MACRS). This method is generally used to depreciate property placed in service after 1986.
For depreciable property placed in service before 1987, the general method used is the Accelerated
Cost Recovery System (ACRS). In this chapter, we will be focusing on MACRS and will not be discussing ACRS. For more information about ACRS, see IRS Publication 534, Depreciating Property Placed
in Service Before 1987.

MACRS
As noted above, MACRS is the depreciation method generally used for most business and investment
property placed in service after 1986. This system is made up of two depreciation systems: the General
Depreciation System (GDS) and the Alternative Depreciation System (ADS). Both systems provide
different methods and recovery periods to figure depreciation deductions. MACRS provides three
depreciation methods under GDS and one depreciation method under ADS, which are listed below:
The 200% declining balance method (200DB) over a GDS recovery period.
The 150% declining balance method (150DB) over a GDS recovery period.
The straight-line method (S/L) over a GDS recovery period.
The straight-line method (S/L) over an ADS recovery period.
Straight-line method. The straight-line depreciation method is a method of depreciation that takes
the basis of the property less the propertys salvage value or land value divided by the propertys useful life or GDS/ADSrecovery period. The straight-line method allows you to take the same amount of
depreciation each year. This depreciation method is the basis for how the 200% and 150% declining
balance methods are calculated. This is regular MACRS recovery method for residential and nonresidential real property.

Tax Essentials Depreciation 18.9

200% declining balance method. The 200% declining balance method, also called the double declining balance method, is an accelerated depreciation method that is twice the rate of the straight-line
method. This is regular MACRS depreciation method for 3-, 5-, 7-, and 10-year non-farm property.
150% declining balance method. The 150% declining balance method is an accelerated depreciation method that is one and a half times the rate of the straight-line method. This is regular MACRS
depreciation method for farm property, except real property, and most 15- and 20-year property.
Note: Both the 200% and 150% declining balance methods will yield larger depreciation deductions
in the earlier years of the depreciable propertys life compared to the straight-line method, and then
these two methods will convert to the straight-line method in later years.

GENERAL DEPRECIATION SYSTEM (GDS)


Generally, property is depreciated using GDS, unless the taxpayer elects or is required by the IRS to
use ADS. This course will first cover GDS and will then discuss ADS.

Computing the MACRS GDS Depreciation Deduction


To compute the MACRS depreciation deduction for an asset, you need to use two sets of tables:
Table of Asset Class Lives and Recovery Periods (most often needed).
Modified Accelerated Cost Recovery System Percentage Tables.
For GDS, all depreciable personal property and certain depreciable real property (except residential
rental property and nonresidential real property, which you will learn about later in this course) is
classified by the recovery period assigned to it. There are nine property classifications under MACRS
GDS property. Each class covers different types of property:
3-year property.
5-year property.
7-year property.
10-year property.
15-year property.
20-year property.
25-year property.
Residential rental property.
Nonresidential real property.
To determine which GDSclass a particular asset belongs to and its recovery period, you will use the
IRS table in the appendix labeled Table of Asset Class Lives and Recovery Periods. This table is often
referred to as the CLADR (often pronounced as cladder) table. You can find the CLADR table on
pages A18.5A18.14 in the appendix, as well as in IRSPublication 946, How To Depreciate Property.
For a quick reference, Table B-1 of the IRSTable of Asset Class Lives and Recovery Periods is shown
in Illustration 18.3. To help you understand how the table works, lets study the columns in Table B-1
of the IRSTable of Asset Class Lives and Recovery Periods.

18.10 H&RBlock Income Tax Course (2015)


Illustration 18.3

Tax Essentials Depreciation 18.11

Asset class. Notice that to the left of the descriptions of the various kinds of property is a column of
numbers labeled Asset class. You will not use this information for anything, but you may notice that
the assets are listed in roughly numerical order.
Notice that after the descriptions of the various kinds of property are three columns of numbers.
Class life (in years). The first column shows the official IRS class life of the property. It has no practical application for purposes of this course.
Recovery periods (in years). The recovery period for property is the number of years over which
the taxpayer would recover the cost or other basis of the property based on the depreciation system
used, GDSor ADS.
General Depreciation System (GDS). This column provides the GDS class to which the property
belongs and the recovery period over which it will be depreciated.
Alternative Depreciation System (ADS). This column provides the propertys recovery period over
which ADS is computed. Generally, the recovery period for most property is longer under ADS than
under GDS. ADS will be discussed in more detail later in the course.
Complete Exercise 18.2 before continuing to read.

HALF-YEAR, MID-QUARTER, AND MID-MONTH CONVENTIONS


After determining the recovery period for the depreciable property, the next step is to determine
which convention applies. A convention refers to the time period the property was placed in service.
The convention the taxpayer uses determines the number of months for which the taxpayer can claim
depreciation in the year the property is placed in service and in the year the taxpayer disposes of the
property. This affects the amount of depreciation deduction. The taxpayer has three types of conventions available: the half-year convention, the mid-quarter convention, and the mid-month convention.

Half-Year Convention
Generally, the taxpayer would use the half-year convention for depreciable personal type property
placed in service during the year. The half-year convention treats all property placed in service or
disposed of at the midpoint or middle of the year. This means the taxpayer receives one-half year
depreciation deduction for property placed in service or disposed of during the year. The taxpayer
would indicate the half-year convention by entering HY on Form 4562, Part III, column (e).

18.12 H&RBlock Income Tax Course (2015)

Mid-Quarter Convention
Generally, the taxpayer is required to use the mid-quarter convention on all depreciable personal type
property placed in service during the tax year if more than 40% of the basis of all personal type property placed in service during the year occurred in the last three months. This means that if you add
up the total basis of all personal type property placed in service during the year and 40% of the total
basis was placed in service during the last three months, then generally all the personal type property
placed in service during the year must use the mid-quarter convention. When determining the 40%
rule, the propertys basis is first reduced by the 179 depreciation deduction as well as the percentage
time the taxpayer used the property for personal use. Note that the total basis is not reduced by special (or bonus) depreciation claimed during the year.
Under the mid-quarter conventions, the taxpayer treats the property as being placed in service or
disposed of at the midpoint of the quarter. This means the taxpayer receives 1 months of depreciation in the quarter the property was placed in service. The taxpayer would indicate the mid-quarter
convention by entering MQ on Form 4562, Part III, column (e).

Mid-Month Convention
Generally, the taxpayer would use the mid-month convention for nonresidential real property and
residential rental property. Under this convention, the taxpayer treats the property as being placed
in service or disposed of at the midpoint of the month. The taxpayer would indicate the mid-month
convention by entering MM on Form 4562, Part III, column (e).

MACRS PERCENTAGE TABLES


After determining the recovery period and the convention for property, the next step is to determine
the percentage by which you will multiply the depreciable basis of the asset (usually its cost, unadjusted for previous depreciation deductions) to arrive at the current years depreciation. Illustration 18.4
shows MACRS Table A1, the table for the GDS, Half-Year Convention. This table is one of the most
commonly used MACRS GDS tables for personal property. This table, along with other GDS and ADS
percentage tables, is provided in the appendix on pages A18.17A18.41 as well as in IRSPublication
946, How To Depreciate Property.
Looking at Illustration 18.4, you will notice that across the top of the table there are columns labeled
with the recovery periods3-year, 5-year, 7-year, and so on. Find the assets appropriate recovery
period column and then the recovery year in the far left-hand column. For example, if an asset is
placed into service in 2014, then 2014 is recovery year 1, 2015 is year 2, 2016 is year 3, and so on.
Multiply the unadjusted basis of the property by the percentage in the appropriate column on the line
corresponding to the recovery year.

Tax Essentials Depreciation 18.13


Illustration 18.4

mExample: In March 2014, Larry Valentine purchased and placed in service a used desk (asset class
00.11) costing $500 for use exclusively in his business. Under the general depreciation system, desks
have a recovery period of seven years. Therefore, his depreciation deduction for the desk in 2014 was
$71 [$500 2 14.29%, the percentage from the table in Illustration 18.4 for year 1 of 7-year property,
half-year convention]. For 2015, depreciation on the desk is $122 [$500 2 24.49% for year 2 of 7-year
property]; for 2016, it is $87 [$500 2 17.49% for year 3]; and so on.m
mExample: In June 2014, Penny Scott purchased and placed in service a special glass manufacturing tool (asset class 30.21) costing $3,000. This special tool has a three-year recovery period under
MACRS GDS and Penny will use the 3-year column, half-year convention in Illustration 18.4. The
depreciation deduction for each year is computed as follows.
2014

(year 1)

$3,000 2 33.33%

$1,000

2015

(year 2)

3,000 2 44.45%

1,334

2016

(year 3)

3,000 2 14.81%

444

2017

(year 4)

3,000 2

7.41%

222

Total

$3,000

18.14 H&RBlock Income Tax Course (2015)

Notice that it actually takes four tax years to fully depreciate property in the three-year class. This
is because of the half-year convention, meaning that the taxpayer is only granted half the otherwise
allowable depreciation in the year the property is placed in service. So, in the case of three-year property, the taxpayer gets a half year of depreciation, then two full years, then another half year.
To help you determine the correct MACRS GDS and ADS depreciation percentage table to use, the
IRS has provided a MACRS Percentage Table Guide. This guide is shown in Illustration 18.5 and
is also provided in the appendix on page A.15 as well as in IRSPublication 946, How To Depreciate
Property.
Complete Exercise 18.3 before continuing to read.

COMPUTING MACRS GDS DEPRECIATION DEDUCTION FOR REAL


PROPERTY
Real property, as you will recall, consists of land and buildings. The first thing to learn about depreciating real property is that land is not depreciable. That is because depreciation is a deduction allowed
for the wearing out of an asset. Because land does not wear out, it is not depreciable. Buildings, however, are another story. If used for business or the production of income, buildings are depreciable.
The value of land is always subtracted from the value of the property before calculating depreciation.
Residential Rental Real Property
Residential rental real property (such as rental houses and apartment buildings) placed in service
after 1986 is depreciated using a straight-line method over 27 years. You may recall that the
straight-line method means an equal amount of depreciation is claimed each full year the asset is
depreciated.
Illustration 18.6 shows the MACRS GDS Table A-6. This table is used when depreciating residential
rental real property. Notice that the percentages for the year placed in service vary by the month
the property is placed in service. That is because real property under MACRS is required to use the
mid-month convention. The mid-month convention treats the property as being placed in service at
the mid-point of the month during which it was actually placed in service.
mExample: During March 2014, Wanda Trobridge purchased and placed in service a rental house
costing $90,000, which included $10,000 for the land. After subtracting the value of land, her basis
for depreciation is $80,000. Her depreciation deduction for 2014 is $2,303 [$80,000 2 2.879%, the
percentage from the table in Illustration 18.6 under column 3 (March), row #1 (year 1)]. For 2015, her
depreciation deduction will be $2,909 [$80,000 2 3.636%].m

Tax Essentials Depreciation 18.15


Illustration 18.5

18.16 H&R Block Income Tax Course (2015)


Illustration 18.6

Nonresidential Real Property


Nonresidential real property (such as office buildings, factories, and workshops) placed in service on
or after May 13, 1993, is depreciated using the straight-line method over 39 years. Generally, nonresidential real property placed in service after 1986 and before May 13, 1993, is depreciated over
31 years, again using the straight-line method. As with residential rental real property, the first
years percentage depends on the month the property was placed in service because of the mid-month
convention. Illustration 18.7 shows Table A-7a. This MACRS GDS table is used to depreciate nonresidential real property over 39 years using the straight-line method. For nonresidential real property
subject to 31.5 years straight-line, the taxpayer would use the MACRS GDS Table A-7.
mExample: In May 2014, Daniel Corey purchased and placed in service a workshop costing $110,000,
including $20,000 for the land. After subtracting the value of land, his basis for depreciation is
$90,000. His depreciation deduction for 2014 is $1,445 [$90,000 2 1.605%, the percentage from the
table in Illustration 18.7 under column 5 (May), row #1 (year 1)]. For 2015, his depreciation deduction
will be $2,308 [$90,000 2 2.564%].m

Tax Essentials Depreciation 18.17


Illustration 18.7

mExample: In December 2006, Walter Cross placed in service a retail store. Because 2014 is recovery
year 9 for the store, Walter will multiply his unadjusted basis (basis minus land value) by 2.564%.
column 12 (December), row #2-39.m
Complete Exercise 18.4 before continuing to read.

REPORTING MACRS DEPRECIATION ON THE TAX FORMS


When a taxpayer takes a depreciation deduction, entries must generally be made on up to three different forms:
1. The Depreciation Worksheet.
2. Form 4562, Depreciation and Amortization, if required.
3. The appropriate schedule:
Schedule C if the property is used in a non-farm business.
Schedule F if the property is used in the business of farming.
Schedule E if the property is rental real estate or connected therewith.
Schedule A if the property is used for investment or employee business purposes.

Depreciation Worksheet
The Depreciation Worksheet is a useful document to help the taxpayer track depreciation on their
depreciable assets from the time the taxpayer places the asset in service until the time the assets
basis has been fully recovered and/or disposed of. To help taxpayers calculate current-year depreciation, H&RBlock has created a Depreciation Worksheet shown in Illustration 18.8. A blank copy of the
Depreciation Worksheet is provided in the appendix on page A18.3.

18.18 H&RBlock Income Tax Course (2015)

mExample: Britney Kleen opened a womens jewelry store in 2014. She placed the following assets in
service on April 29, 2014:
Store and land (land is valued at $25,000) (39Y)
Glass display case (5Y)*

$200,000
$7,000

Desk (7Y)

$600

Cash register (5Y)

$500

Office chair (7Y)

$350

*Assets used in a retail business to display products of inventory for sale fall under 57.0 Asset class
and have a useful life of five years.
Her 2014 Depreciation Worksheet and Form 4562, page 1, are both shown in Illustrations 18.818.9.
Study Britneys Depreciation Worksheet while you read the following explanations.m
The top portion of the Depreciation Worksheet is used to enter basic information about the asset and
establish the basis for each asset. The lower part is used to make the necessary depreciation computations. Up to eight assets can be listed on each worksheet.
Some of the data on the worksheet includes items you have not read about yet, but do not worryyou
will. For now, let us review those with which you are somewhat familiar.
Manner/date acquired. Most of the assets you will encounter will have been purchased.
Date placed in service. The first date on which this asset was used in business or to produce income.
System and class/life. As we mentioned, MACRS is the predominant system and the one that
Britney is using. For MACRS personal property, enter the recovery period found in the center column
of the CLADR table.
Column A. Enter the cost or other basis, as appropriate. The basis of a purchased item is usually its
cost.
Column B. Sometimes the basis of an asset needs to be adjusted. One example is real estate, because,
as we discussed earlier, land is not depreciable. Thus, the land value must be subtracted before depreciation is computed. Also, certain credits will reduce the depreciable basis of an asset. Enter such
basis adjustments in column B.
Column C. Subtract column B from column A.
Column D. If the asset is used only partially for business or investment purposes, enter the business-use/investment-use percentage here. This may be measured by comparing time, space, or mileage that an asset is used for business or investment to its total use. We will discuss this in more detail
as we go along.
Column E. Multiply the amount in column C by the percentage in column D.
Column F. This column is where the taxpayer would report the 179 depreciation deduction. We will
discuss the 179 deduction later. You may assume that Britney either did not qualify for it or elected
not to take advantage of it.

Tax Essentials Depreciation 18.19


Illustration 18.8

18.20 H&RBlock Income Tax Course (2015)


Illustration 18.9
X.X

Tax Essentials Depreciation 18.21

Column H. This column is where the taxpayer would report special (bonus) depreciation. We will
discuss special (bonus) depreciation later. You may assume that Britney either did not qualify for it
or elected not to take advantage of it.
Columns G and I. These are simple subtractions.
Column J. For most MACRS assets, the recovery period will be the same recovery period found in
the center column of the CLADR table.
Column K. First, enter the method used for depreciating the item in question. For 3-, 5-, 7-, and
10-year personal property, we generally use the 200% declining balance method of depreciation,
which is abbreviated as 200DB on the worksheet. For 15- and 20-year property, enter 150DB,
which stands for 150% declining balance. You will not encounter 25- or 50-year property on individual
returns. For real property, the method used is straight-line and is abbreviated as S/L.
Then, enter the convention used for the depreciation. In the case of personal property, we generally
use the half-year convention, meaning that half the otherwise allowable depreciation is allowed the
year the asset is placed in service. The half-year convention is denoted by the letters HY. In the case
of real property, we use the mid-month convention, meaning the property is considered to be placed
in service at the midpoint of the month it was placed in service. The mid-month convention is abbreviated MM. There is also a mid-quarter convention, abbreviated MQ. The mid-month convention
will be discussed in more detail later in the course.
Column L. One Depreciation Worksheet may not last for the entire depreciable life, because the
document provides space for only three years of depreciation computations. Britneys building, for
example, will require several worksheets to depreciate it over its entire 39-year recovery period. If the
worksheet you are completing is an overflow worksheet (this one is not), you will enter in this column
the total depreciation claimed prior to the first year entered on the new worksheet.
Column M. If the asset was disposed of or withdrawn from service, enter the date of disposition here.
You will learn more about depreciation in the year of disposition later.
Column N. Each depreciation year is divided into three columns. Above the three columns, enter the
calendar year. In the Rec. Year column, enter the assets recovery year. For example, on Britneys
worksheet, 2014 is year 1 of depreciation, so we have entered 1; 2015 is year 2, etc. In the % column,
you will enter the appropriate percentage from the MACRS percentage table. Finally, in the Depr.
column, you will multiply the depreciable amount from column I by the appropriate percentage.
For each year the asset remains depreciable, another column-N entry is completed. Normally, this is
done year by year.
Notice that there is not enough room to fully depreciate all of Britneys assets. For Tax Year 2017,
when this worksheet is full, the data will be transferred to an overflow worksheet. The depreciation
deductions taken prior to 2017 will be totaled and entered in column L of the new worksheet.

18.22 H&RBlock Income Tax Course (2015)

Beneath each row on the bottom of the worksheet is a row labeled AMT. This row is used for alternative minimum tax depreciation, which is often different from that used for regular tax. We will not
delve into that topic in this course.
preparing a BlockWorks return for a taxpayer who
Bhas depreciable When
assets, BlockWorks will produce a simplified version of
lockWorks Tip:

the Depreciation Worksheet previously discussed. A copy of Britney Kleens


BlockWorks Depreciation Worksheet is shown in Illustration 18.10.

Complete Exercise 18.5 before continuing to read.

Reporting Depreciation on Form 4562


As discussed earlier, the taxpayer may be required to complete and file Form 4562, Depreciation and
Amortization, with the tax return. The form is generally required, for example, when a taxpayer takes
a 179 deduction, when depreciated property is first placed in service, or when depreciation on a vehicle is claimed. When required, the form should be completed after the Depreciation Worksheet. Key
information from the worksheet is transferred to the form. Study Britney Kleens Form 4562, shown
in Illustration 18.9, as you read the following information.
For property placed in service during 2014, the taxpayer would report depreciation by completing
Form 4562, Part III. If the taxpayer placed property in service before 2014, they would report depreciation on Form 4562, Part III, line 17.
The heading calls for the taxpayers name, SSN, and a brief description of the business to which the
deduction relates. Part I of the form deals with the 179 expense deduction, which you will learn
about later in this course. Part II includes the special depreciation allowance, which you will also
learn about later in this course.
Part III is used to report the depreciation deduction for assets placed in service during 2014. Notice
how there are lines for the different MACRS classes. On lines 19a19g, all assets in each class placed
in service in 2014 are combined in columns (c) and (g). Column (c) represents the total depreciable
basis from column I of the worksheet, and column (g) is the depreciation deduction from column N.
Columns (d), (e), and (f) show the recovery periods, conventions, and depreciation methods used for
each classification of property.
If a taxpayer has not placed any assets into service in the current tax year and is merely continuing
the depreciation of assets he placed in service in a prior year, Form 4562 generally is not required
(unless the taxpayer has listed property, which you will learn about later). When Form 4562 is not
required, the depreciation amount from the worksheet can be entered directly on the appropriate
business schedule. If Form 4562 is required, the continued depreciation amount of any MACRS assets
placed in service in a prior year would be entered on line 17 of Form 4562.

Tax Essentials Depreciation 18.23


Illustration 18.10

18.24 H&RBlock Income Tax Course (2015)

On lines 19h and 19i, each piece of real property placed in service during 2014 is listed separately.
Britneys building is nonresidential real property; therefore, it is entered on line 19i. Column (b)
shows the month and year the property was placed in service, and column (c) shows the depreciable
basis (exclusive of land value) for the building. The information in columns (d) through (f) is preprinted on the form, except for column (d) in the second row of line 19i.
In Part IV, line 22, is for the total depreciation claimed for 2014. The amount from line 22 is carried
to the appropriate schedule. In Britneys case, the appropriate schedule is Schedule C because she is
a sole proprietor.
Complete Exercise 18.6 before continuing to read.

ALTERNATIVE DEPRECIATION SYSTEM (ADS)


As discussed earlier, MACRS is made up of two depreciation systems, the General Depreciation
System (GDS) and the Alternative Depreciation System (ADS). Under ADS, the taxpayer depreciates
property using the straight-line method over the ADS recovery period. Generally, the recovery period
is longer under ADS than under GDS. The taxpayer may elect to use ADS instead of GDS, but they
are required to use ADS to depreciate the following property:




Listed property with qualified business use of 50% or less.


Tangible property used predominantly outside the U.S. during the year.
Tax-exempt property.
Property financed with tax-exempt bonds.
Farming business property that has been placed in service in the year an election not to apply the
uniform capitalization rules is in effect.
Property imported from a U.S. trade restricted foreign country.
Table A-8, partially shown in Illustration 18.11, is used to compute MACRS ADS under the half-year
convention.
Electing ADS. If the taxpayer elects to use ADS instead of GDS, generally, the election requires that
the taxpayer uses ADS to depreciate all assets in the same property class placed in service during
the year. However, the taxpayer is allowed to make the ADS election for residential rental property
and nonresidential real property on a property-by-property basis. Once the taxpayer has made the
election, it cannot be revoked. To make the election, the taxpayer would complete Form 4562, Part
III, line 20.

Tax Essentials Depreciation 18.25


Illustration 18.11

LISTED PROPERTY
Listed property is property that commonly has both personal and business use. A list of these assets
can be found in IRC 280F(d)(4) and are subject to depreciation restrictions under certain circumstances.
Listed property includes:
Most passenger automobiles weighing 6,000 pounds or less and any other property used for transportation, unless it meets a specific exception.
Property generally used for entertainment, recreation, or amusement, including photographic,
phonographic, communication, and video-recording equipment.
Computers and related peripheral equipment, unless used exclusively at a regular business establishment and owned or leased by the person operating the business.
For tax years beginning after 2009, cellular telephones and similar telecommunication equipment
have been removed from the definition of listed property.

Restrictions
If listed property is used 50% or less for business purposes in the year it is placed in service, the
property does not qualify for the 179 depreciation deduction or special depreciation allowance.
Furthermore, if business use of these assets falls to 50% or less, any bonus depreciation previously
taken is subject to recapture, and the asset must be depreciated using the ADS straight-line method.
When depreciating listed property, check the box in the top section of the Depreciation Worksheet,
noting that the asset is listed property. After completing the worksheet, transfer the appropriate
information to page 2 of Form 4562. From there, the depreciation deduction is carried to line 21 on
page 1 of Form 4562, then to the appropriate schedule.

18.26 H&RBlock Income Tax Course (2015)

mExample: On March 8, 2014, James T. Omar purchased and placed in service a computer costing
$3,500. He uses the computer 40% to keep records for his home repair business and 60% for personal
purposes. James keeps written records of the use of the computer, which is located in his home.
The computer is listed property because it is not used exclusively in a place of business. Thus, it must
be reported on page 2 of Form 4562. Because it is used 50% or less for business, the computer is subject
to the restrictions described earlier, and James must use the ADS straight-line depreciation method.
Illustrations 18.1218.14 show James Form 4562 and Depreciation Worksheet for his computer.m
Notice the following about the forms:
Listed property is reported on the second page of Form 4562, whether or not it is subject to the
restrictions concerning its business-use percentage. Automobiles are always listed property and
will be reported there (unless the taxpayer qualifies to report them directly on another form, such
as Schedule C, as you learned earlier in the course).
Recreational equipment and computers are sometimes listed property and sometimes not. If they
are used exclusively at a regular place of business, including a qualified home office (and in the
case of computers, owned or leased by the operator of the business), they are not listed property.
Otherwise, they are listed property subject to the restrictions. James computer is listed property
because he does not use it exclusively in a place of business. It is subject to the restrictions because
he uses it 50% or less for business.
Be sure to answer the questions about evidence for the business-use percentage on lines 24a and
24b on page 2 of Form 4562.
Complete Exercise 18.7 before continuing to read.

179 DEPRECIATION DEDUCTION


For 2014, a taxpayer generally may elect to expense (deduct) up to $500,000 of the cost of certain property in the year the property is placed in service, instead of recovering that amount under MACRS.
This special depreciation deduction is called the 179 depreciation deduction, and it is named after
IRC 179. Simply put, this special deduction enables taxpayers to deduct the full price, up to $500,000,
of qualifying business property in the year the property was purchased. This enables taxpayers to
take an immediate deduction rather than having to spread out the expense over several years. The
deduction is called the 179 depreciation deduction. Married taxpayers filing separately may elect to
allocate the $500,000 limitation in any manner they choose; each spouse is not limited to a $250,000
deduction. If no allocation is made, each spouse may expense up to $250,000 of eligible property.
For property to be eligible for the 179 depreciation deduction, the taxpayer must purchase the property for use in the taxpayers trade or business. Property acquired through a gift or inheritance does
not qualify. Generally, this includes new or used tangible personal property (usually equipment or
office furniture) purchased and placed in service for use in a trade or business.

Tax Essentials Depreciation 18.27


Illustration 18.12

18.28 H&RBlock Income Tax Course (2015)


Illustration 18.13
X.X

Tax Essentials Depreciation 18.29


Illustration 18.14

18.30 H&RBlock Income Tax Course (2015)

A taxpayer may elect to treat certain qualified real property placed in service during the 2014 tax
year as 179 property. If the election is made, it only includes certain real property that is defined in
the instructions for IRS Form 4562. The maximum 179 expense deduction that may be expensed for
qualified 179 real property is $250,000 of the total cost of all 179 property placed in service in 2014.
This course will not deal with this special election other than to make you aware of the possibility of
making such an election.
mExample: On May 19, 2014, Jim Birmingham purchased a machine for use in his business for
$100,000. He may, if he wishes, claim the 179 depreciation deduction for the whole cost in the year
of purchase, or he may depreciate it using MACRS. He may even split it, expensing part and using
MACRS for the rest if he likes but to do this, he must opt out of the bonus depreciation, which he
could claim in addition to the 179 deduction. Bonus depreciation will be discussed in greater detail
later in this chapter.
Jeff decides to claim the 179 depreciation deduction for the whole cost in the year of purchase. His
Depreciation Worksheet and Form 4562 are shown in Illustrations 18.1518.16.m
Certain depreciable property is not eligible for the 179 depreciation deduction. Such nonqualified
property includes:
Property held for investment.
Real property leased to others.
Real property and furnishings used predominantly to furnish lodging.
Heating and air conditioning units.
Certain property used predominantly outside the United States.
Certain property used by certain tax-exempt, government, and foreign organizations and entities.
A more detailed list of nonqualified 179 depreciation deduction property can be found in IRS
Publication 946, How to Depreciate Property.
If an asset is first used by the taxpayer for any purpose for which depreciation is not allowed (such
as the personal use of a car), the 179 expense deduction will never be available to that taxpayer for
that asset. However, depreciation deductions may be allowed at a later date if the asset is converted
to business use.
mExample: Rosalyn Sanford purchased a computer for personal use in 2011. In 2014, she started
using it for business purposes. She may not claim a 179 expense deduction for the computer, but she
may begin depreciating it using MACRS. However, the computer is still subject to the usual limitations for listed property (discussed earlier).m
The 179 expense deduction may be claimed or revoked on an original return or on an amended return
for any open tax year. If the election is revoked, the taxpayer cannot change their mind again.

Tax Essentials Depreciation 18.31


Illustration 18.15

18.32 H&RBlock Income Tax Course (2015)


Illustration 18.16
X.X

Tax Essentials Depreciation 18.33

Property acquired in any of the following ways may not be expensed under 179:
Property acquired from a person whose relationship to the taxpayer would result in the disallowance of losses under the rules for sales to related taxpayers and 50% owned partnerships. For this
purpose, the family of the taxpayer includes a spouse, ancestors, and lineal descendants only.
Property acquired by one member of a controlled group from another member of that controlled
group.
Property acquired by inheritance or in a transaction in which the basis of the acquired property is
determined with respect to the basis of the property in the hands of the person from whom it was
acquired (a gift, for example).

Other 179 Restrictions


$2,000,000 limitation. If the cost of all property eligible for the deduction during the year exceeds
$2,000,000, the deduction is reduced dollar for dollar by the amount in excess of $2,000,000. Include
in this calculation the cost of any eligible 179 property placed in service during the year by the taxpayers spouse, even if the couple files separately. Thus, if the taxpayer (and spouse) placed $2,500,000
worth of eligible property or more in service in 2014, neither of them could claim a 179 deduction.
Business income limitation. The total cost a taxpayer may deduct each year after they apply the
dollar limit is limited to the taxable income from the active conduct of any trade or business during
the year. Generally, they are considered to actively conduct a trade or business if they meaningfully
participate in the management or operations of the trade or business. The total amount expensed
cannot exceed the taxpayers business income from all trades or businesses.
The business income limitation is calculated by combining income from self-employment, wages,
salaries, tips, and other compensation the taxpayer earned as an employee. Do not subtract any
deductions for self-employment tax, any net operating loss, or any unreimbursed employee business
expenses. On a joint return, combine the amounts for both spouses.
Listed property limitation. The 179 depreciation deduction is not allowed for listed property
used 50% or less in a trade or business. Also, if property for which the expense deduction is taken
is converted to personal use (defined as 50% or less business use) at any time before the end of its
MACRS recovery period, a prorated portion of the amount expensed must be recaptured (added back
into income).
mExample: Amy Wolfman, a sales representative, purchased a car in 2011. She used the car 75% for
business purposes each year until 2014, when she purchased a new car, converting the old one to personal use. Her business use of the old car was only 20% in 2014. Because the car had not reached the
end of its MACRS recovery period, she will have to recapture as ordinary income (pay tax on) part of
the 179 deduction. Depreciation recapture is discussed in more detail later in the course.m
Complete Exercise 18.8 before continuing to read.

18.34 H&RBlock Income Tax Course (2015)

SPECIAL DEPRECIATION ALLOWANCE


The taxpayer is allowed to take a special, also called bonus, depreciation allowance of, generally, 50%
the cost of qualified property placed in service during the tax year. The allowance is only available for
the first year the taxpayer places the qualified property in service. The special depreciation allowance
is taken after the taxpayer applies any 179 depreciation deduction and before they figure regular
depreciation under MACRS for the first year the taxpayer placed the property in service. Please note
that the special depreciation allowance is optional and the taxpayer may choose to not claim the
allowance.
In this course, we will limit our discussion of qualified property to tangible personal property depreciated under MACRS with a recovery period of 20 years or less. It is important to note that for this
property to qualify, it must be purchased after December 31, 2007, and placed in service before
January 1, 2015. The property must also meet the original use test, which generally means the taxpayer purchased the property new and was the first person to use the property.
Special depreciation has been constantly changing for the last few years in an effort to stimulate the
economy. The last change was made in 2010. For the 2010 tax year, special depreciation allows a
depreciation deduction of 100% for certain qualified property acquired after September 8, 2010, and
placed in service prior to January 1, 2012. Generally, the requirements for the 100% allowance are the
same as the requirements for the 50% allowance for qualified property acquired after December 31,
2007, and placed in service before January 1, 2015. While the current, special depreciation allowance
expired at the end of 2014, Congress could decide to extend it for Tax Year 2015.
This course will inform you of many of the changes. However, understanding and implementing
the changes requires a deeper dive into depreciation more than this course discusses. To continue
your study, a good starting point would be the H&R Block Intermediate Depreciation course. If you
encounter situations where you are not confident about how to calculate bonus depreciation, you are
encouraged to turn to a senior Tax Professional for assistance. For those who want to study more, two
good resources are IRSPublication 946, How to Depreciate Property, and the instructions for Form
4562. In all cases for the problems in this course, you will be informed as to whether or not special
depreciation will be used.

Tax Essentials Depreciation 18.35


Illustration 18.17

18.36 H&RBlock Income Tax Course (2015)


Illustration 18.18

Tax Essentials Depreciation 18.37

mExample: On March 6, 2014, Megan Rustaford purchased a new safe for use in her business office.
The safe is seven-year property and cost $3,500. She claimed a 50% special depreciation allowance
[$3,500 2 50% = $1,750], leaving $1,750 to depreciate normally. The normal depreciation deduction
for each year is computed as follows.
2014

(year 1)

$1,750 2 14.29%

$250

2015

(year 2)

1,750 2 24.49%

429

2016

(year 3)

1,750 2 17.49%

306

2017

(year 4)

1,750 2 12.49%

219

2018

(year 5)

1,750 2

8.93%

156

2019

(year 6)

1,750 2

8.92%

156

2020

(year 7)

1,750 2

8.93%

156

2021

(year 8)

1,750 2

4.46%

78

Total

$1,750

Megans 2014 Form 4562, page 1 and Depreciation Worksheet are shown in Illustrations 18.1718.18.m

MID-QUARTER CONVENTION
Recall the three types of conventions discussed earlier in the chapter and the 40% rule for mid-quarter convention. The 40% rule states that the mid-quarter convention generally must be used for all
personal property placed in service during the year if the total depreciable basis of MACRS personal
property placed in service during the final three months of the year exceeds 40% of the total depreciable basis of MACRS personal property placed in service during the entire year. The mid-quarter
convention requires that property be considered placed in service halfway through the quarter in
which it was actually placed in service.
Turn to pages A.17A.19 in the appendix and find the MACRS tables labeled Table A-2, A-3, A-4, and
A-5. These tables are the MACRS GDS Mid-Quarter Convention tables. Notice that there is a table
for each quarter of the year. Once you begin using one of the mid-quarter tables, you will continue to
use the same table for each subsequent year of depreciation.

18.38 H&RBlock Income Tax Course (2015)


Illustration 18.19
X.X

Tax Essentials Depreciation 18.39


Illustration 18.20

18.40 H&RBlock Income Tax Course (2015)

mExample: Emilio Brockman placed the following new business-use assets in service during 2014:
January 17a $3,000 machine (7-year property)
July 7a $1,000 desk (7-year property)
November 10a $5,000 computer (5-year property)
Because the basis of the computer exceeds 40% of the combined basis of the assets placed in service
this year, Emilio is required to use the mid-quarter convention to depreciate all three assets. (There is
a little twist to this equation, but we will look at that in a moment.) Refer to the mid-quarter MACRS
tables in the appendix as you read how each asset is depreciated for 2014.
The machine was placed in service during the first quarter of the year, so we use the First Quarter
Property table. The depreciation percentage for the machine is 25%.
The desk was placed in service during the third quarter of the year, so we use the Third Quarter
Property table. The depreciation percentage for the desk is 10.71%.
The computer was placed in service during the final quarter of the year, so we use the Fourth Quarter
Property table. The depreciation percentage for the computer is 5%.
Illustrations 18.1918.20 shows Emilios Form 4562, page 1, and Depreciation Worksheet for the
assets he placed in service during the year.m

Which Assets to Include


When figuring the depreciable basis of assets for purposes of the mid-quarter convention, reduce all
basis by any 179 deduction. Also, do not include any property placed in service and withdrawn in
the same year, as it is not depreciable. Finally, do not include residential rental or nonresidential real
property.
mExample: Lisa Quinn purchased two new machines, each costing $50,000, for use in her business.
She purchased machine 1 on August 16, 2014, and machine 2 on October 7, 2014. Both machines are
seven-year property. She placed no other assets in service during 2014.
Because the depreciable basis of personal property placed in service in the last quarter exceeds 40%
(in this case, it is 50%) of the depreciable basis of all personal property placed in service during the
year, the mid-quarter convention applies.
However, Lisa could claim a $25,000 179 deduction on machine 2. Now, the depreciable basis of
assets placed in service in the fourth quarter is not more than 40% of the total basis of assets placed
in service during the year [$25,000 for machine 2 3 $75,000 total = 33.33%], so then she would not
be required to use the mid-quarter convention.m
When entering the mid-quarter convention on the forms, use the same procedure you have learned
for personal-type property up to this point. The only difference is that you use the designation MQ to
indicate you are using the mid-quarter convention, rather than the half-year convention.
Complete Exercise 18.9 before continuing to read.

Tax Essentials Depreciation 18.41

DEPRECIATION RECAPTURE
When a taxpayer receives a gain from the sale or disposal of business property that has been depreciated using MACRS, the taxpayer may be required to include all or part of the gain as ordinary
income. This situation is called depreciation recapture. Generally, the taxpayer is subject to depreciation recapture because they were able to take a depreciation deduction that reduced their business
income in prior years. So, when the taxpayer sells the business asset and receives a gain from the sale,
the taxpayer is required to recapture as ordinary income up to the amount of depreciation allowed or
allowable for the property. If a gain remains after the depreciation recapture, the gain is generally
taxed at the taxpayers capital gains tax rate, assuming the gain is long-term.
mExample: Tom Jankins places a piece of equipment in service worth $3,000. Over a couple years, he
claimed accumulated depreciation deductions of $1,500, which in turn reduced his income. He later
sold the equipment for $3,300 and received a $1,800 long-term gain [$3,300 sales prices ($3,000 cost
$1,500 accumulated depreciation) = $1,800]. Because Tom received a gain of $1,800, he is subject to
a depreciation recapture of $1,500, which he is required to include in ordinary income. The remaining
$300 long-term gain is taxed at Toms applicable long-term capital gain tax rate.m
When the taxpayer sells business property, they will report the sale on Form 4797, Sales of Business
Property. The taxpayer will first complete Form 4797, Parts I and II, to calculate the gain or loss
from the sale of the business property. If the taxpayer receives a gain from the sale, the taxpayer will
complete Form 4797, Part III, to calculate the amount of the gain subject to depreciation recapture.
More information on depreciation recapture can be found in IRSPublication 946, How to Depreciate
Property.

TANGIBLE PROPERTY REGULATIONS (TPRS)


The IRS has recently finalized tangible property regulations (TPRs) that govern how taxpayers report
costs they incurred during the year to acquire, produce, repair, maintain, or improve depreciable tangible property. These regulations require that taxpayers adopt several changes in the treatment of
tangible property used in the taxpayers business activity. Taxpayers who file Schedules C, Schedules
E, Schedules F, or an entity-level return, such as an 1120 or 1120S, will be impacted by the finalized
TPRs. Some taxpayers will have to file Form 3115, Application for Change in Accounting Method. This
topic is beyond the scope of this course, but is covered extensively in H&R Block 2015 Tax Update
WBT as well as H&R Block Change in Accounting Method: Form 3115 WBT.

18.42 H&RBlock Income Tax Course (2015)

CHAPTER SUMMARY
In this chapter you learned to:
Describe the concept of depreciation.
Describe the two systems of depreciation under the Modified Accelerated Cost Recovery System
(MACRS): General Depreciation System (GDS) and Alternative Depreciation System (ADS) method.
Determine when the mid-month, mid-quarter, and half-year conventions apply and which MACRS
depreciation table applies.
Compute depreciation of business-use property using the MACRS GDS method.
Determine which types of assets are listed property and compute depreciation for listed property
using the MACRS ADS method.
Determine which types of assets qualify for a 179 expense deduction, compute the allowable
deduction, and enter it on the tax return.
Determine which types of assets qualify for a special (bonus) depreciation allowance, compute the
allowable deduction, and enter it on the tax return.
Complete Form 4562, when necessary, and enter the depreciation deduction on the associated tax
forms or schedules.
Determine what events trigger depreciation recapture.

Suggested Reading
For further information on the topics discussed in this chapter, you may wish to read IRS Publication
946, How to Depreciate Property.

19

Passive Income
OVERVIEW
This chapter is devoted to the study of passive income. This will not be an in-depth study of the topic,
but rather an introduction to various concepts relating to passive income. H&R Block offers a wide
variety of intermediate-level courses, which will be available to you after your first year of tax preparation experience. We highly recommend the Intermediate Rental Income course as the next step in
your learning about passive income.

OBJECTIVES
At the conclusion of this chapter, you will be able to:
Explain how to report rental income and some expenses on Schedule E and how to calculate net
rental income or loss when given the income and expenses.
Share basic knowledge related to the new tangible property regulations (TPRs).
Explain how to report royalty income and expenses on Schedule E and how to calculate net royalty
income or loss when given the income and depletion.
Identify income from partnerships, S corporations, estates, or trusts reported on Schedules K-1.
Identify income and losses as passive, active, or portfolio.
Explain the passive loss rules as they apply to active-participation rental property.

TAX TERMS
Look up the definitions of the following terms in the glossary:
Active income and losses.
Partnership.
Passive income and losses.
Portfolio income and losses.
Rental income.
Royalty.
S corporation.
Trust.
Vacation home.

19.1

19.2 H&RBlock Income Tax Course (2015)

PASSIVE INCOME
Passive income is income derived from a passive activity. There are two types of passive activities.
The first is a trade or business activity in which the taxpayer does not materially participate during
the year. Generally, a taxpayer is not considered to materially participate if they are not involved in
the business operation. The second is rental activities, including the rental of real estate, regardless of
whether a taxpayer materially participates or not. However, if a taxpayer is a real estate professional,
income derived from rental activities is nonpassive.

Real Estate Professional


A taxpayer may qualify as a real estate professional if the following two requirements are met:
More than half of the personal services performed by the taxpayer in all trades or businesses
during the tax year were performed in real property trades or businesses in which the taxpayer
materially participated.
The taxpayer performed more than 750 hours of service during the year in real property trades or
businesses in which the taxpayer materially participated.
For more information on qualifying as a real estate professional, see IRS Publication 527, Residential
Rental Property (Including Rental of Vacation Home), and IRS Publication 925, Passive Activity and
At-Risk Rules.
The precise definition of material participation is an involved proTcess. If you
need to determine whether a taxpayer materially participated
ax Tip:

in an activity, please partner with a Tax Professional experienced in this area.


IRS Publication 925, Passive Activity and At-Risk Rules, is also an excellent
resource to help guide you in this area.

Trade or Business Activities


A trade or business activity is any activity that:
Involves the conduct of a trade or business (that is, deductions would be allowable under IRS Code
162 if other limitations, such as the passive activity rules, did not apply).
Is conducted in anticipation of starting a trade or business.
Involves research or experimental expenditures that are deductible under IRS Code 174 (or that
would be deductible if the taxpayer chose to deduct rather than capitalize them).

Tax Essentials Passive Income 19.3

Nonpassive Income
Nonpassive income is income derived from activities that are not passive. Nonpassive income includes
the following:
Portfolio income. This includes income from interest, dividends, annuities, and royalties not
derived in the ordinary course of business. Gain or loss from the disposition of property that produces these types of income or that is held for investment is also included. Portfolio income does
not include self-charged interest treated as passive activity income.
Personal service income. Salaries, wages, commissions, self-employment income from trade
or business in which the taxpayer materially participates, deferred compensation, taxable social
security and other retirement benefits, and payments from partnerships to partners for personal
services are all included.
Other income. Other income that is not passive activity income includes state and local refunds,
income from intangible property if the taxpayer contributed to the creation of the property, income
or gain from investments of working capital, Alaska Permanent Fund dividends, and income from
a hobby or from gambling.
Note: Portfolio income cannot offset passive activity losses and is entered on the usual forms and
schedules (for example, interest and dividend income on Schedule B).
The IRS may, from time to time, issue regulations to include or exclude specific types of income or
activities from the passive classification. The purpose of this authority is to prevent taxpayer manipulation of the rules that would allow passive losses against nonpassive income disguised as passive.
For more information about the distinction between passive and nonpassive income, see IRS
Publication 925, Passive Activity and At-Risk Rules.
mExample: Edgar Price is the landlord of three single-family homes. All three houses were rented for
most of 2014. Edgar is also a partner in Capital Resources lending corporation. Finally, Edgars family has established a family trust that distributes interest income annually. A copy of Edgars Schedule
E is shown in Illustrations 19.119.2. m
tax years before 2014, the determination of whether an expense
Nwas Ina repair
or an improvement was determined by an analysis of facts
ew:

and circumstances and sometimes resulted in different interpretations by tax


preparers and the IRS. Consistency in this area is important because an item
classified as a repair can be written off right away, but an item classified as an
improvement generally must be depreciated.
Beginning in 2014, the IRS issued tangible property regulations (TPRs) to provide framework for how to treat costs incurred to acquire, produce, or improve
tangible property. To comply with the regulations, taxpayers may have to make
certain elections with their tax return or file Form 3115, Application for Change
in Accounting Method.

Complete Exercise 19.1 before continuing to read.

19.4 H&RBlock Income Tax Course (2015)


Illustration 19.1

Tax Essentials Passive Income 19.5


Illustration 19.2

19.6 H&RBlock Income Tax Course (2015)

RENTAL INCOME AND EXPENSES


Rent is income received for the use of property. Net rental income is determined in the same manner
as net business incomenet rental income equals gross rent received minus related expenses, including depreciation. Generally, rental income and expenses are reported on Schedule E.
Rent is generally considered to be unearned income. This means, among other things, that rental
income does not qualify a taxpayer for the Earned Income Tax Credit, the Additional Child Tax
Credit, or an IRA. For rent to be earned income, services must be provided with the use of the property. Thus, income from a bed and breakfast or motel operated by the property owner is business income
and is reported on Schedules C and SE, rather than on Schedule E.
Rent received for the use of personal-type property (cars, for example) is also Schedules C and SE
income if the rental of the personal property is conducted as a business. If personal property rental is
for profit (but not as a business activity), then:
Rent received is entered on Form 1040, line 21.
Expenses are entered as a write-in entry on line 36 with the marginal notation PPR.
Rent received for the use of farmland is generally passive rental income, not farm income, and reported on Schedule E. However, if the taxpayer materially participates in the farming operations on the
land, then the rent received from the farmland is considered farm income and reported on Schedule
F or Form 4835, Farm Rental Income and Expenses.

Gross Rent
Gross rent must be reported on the return and includes advance payments, late payments, and
current payments received during the year. Rent that is due but not paid is not included in income.
Because unpaid rent is not included in income, no deduction is allowed for uncollectible past-due rent.
Lease cancellation payments received are rental income in the year received. Refundable security
deposits forfeited by the tenant are rental income to the landlord in the year forfeited. Nonrefundable
security deposits are rental income in the year received. Generally, tenant payments made for taxes,
mortgage interest, insurance, or repairs on the rental property are considered rental income. The
value of services rendered or the value of property improvements made by a tenant in exchange for
reduced rent or rent-free property use is also rental income.

Rental Expenses
Maintenance costs and repairs that do not appreciably add to the value or useful life of the property
are deducted as current expenses. Deductible maintenance and repairs include:
Grounds care.
Pest control.
Cleaning of common areas.
Painting.
Wallpapering.

Tax Essentials Passive Income 19.7

Repairing, but generally not replacing, the:


Roof.
Electrical system.
Plumbing.
Heating and air conditioning unit.
The TPRs allow the immediate deduction of routine maintenance under the Routine Maintenance
Safe Harbor. Maintenance for a building is generally routine if the taxpayer expects the activities
to be performed more than once during the ten-year period beginning at the time the building upon
which the routine maintenance is performed is placed in service. Maintenance for property other than
buildings is considered routine only if the taxpayer expects to perform the activities more than once
during the appropriate class life of the particular property.
The TPRs added several tests to make the determination of how to treat repairs easier. In general,
repair expenses are deductible if they are not otherwise required to be capitalized. Repairs keep the
property in good operating condition and do not materially add to the value of the property or substantially prolong its life.
Other expenditures necessary for income production that are deductible from gross rent include:
Real estate taxes.
Management fees.
Mortgage interest, points, and other interest.
Utilities:
Electricity.
Water.
Gas.
Telephone.
Wages paid to a caretaker.
Transportation expenses to look after the property (actual expenses or the standard mileage rate
may be claimed).
Legal expenses incurred for evicting tenants or in an effort to collect rent.
Advertising.
Commissions.
Trash hauling.
Preparation of tax forms related to the property.
The value of the owners labor or the unpaid labor of friends and relatives is not deductible. Prepaid
expenses are deductible in the applicable year.
Insurance premiums are often prepaid for a period of one to three years. Such premiums are prorated and claimed for the number of months of coverage during the year. Generally, unless rental use of
the property began or ended during the year, 12 months of premiums are claimed. The yearly amount
could change if the policy was renewed at a different rate during the year.

19.8 H&RBlock Income Tax Course (2015)

mExample: Harvey Kittleson paid $1,000 for a two-year hazard insurance policy. The insurance covers his rental house from S