EA Review Part 1: Individuals PDF

EA Review Part 1: Individuals Enrolled Agent Study Guide May 1, 2024 - February 28, 2025 Testing Cycle Joel Busch, CPA, JD Christy Pinheiro, EA, ABA® Thomas A. Gorczynski, EA, USTCP ...

EA Review Part 1: Individuals Enrolled Agent Study Guide May 1, 2024 - February 28, 2025 Testing Cycle Joel Busch, CPA, JD Christy Pinheiro, EA, ABA® Thomas A. Gorczynski, EA, USTCP  PassKey EA Review 2024-2025 Edition Executive Editor: Joel Busch, CPA, JD Contributors: Joel Busch, CPA, JD Christy Pinheiro, EA, ABA® Thomas A. Gorczynski, EA, USTCP PassKey Learning Systems EA Review Part 1 Individuals; Enrolled Agent Study Guide, May 1, 2024 - February 28, 2025 Testing Cycle ISBN 13: Online Edition First Printing. March 15, 2024. PassKey EA Review® and PassKey Learning Systems® are U.S. Registered Trademarks. The Hock International brand name and the Hock International logo are the property of their respective owners. Cover photography licensed with permission. Cover image photo © Mykhailo Polenok | Dreamstime.com. All Rights Reserved © 2024, PASSKEY ONLINE EDUCATIONAL SERVICES INC. Revised and updated every year, based on updated IRS EA exam specifications. United States laws and regulations are public domain and not subject to copyright. The editorial arrangement, analysis, and professional commentary are subject to this copyright notice. No portion of this book may be copied, retransmitted, reposted, duplicated, or otherwise used without the express written approval of the publisher. Questions for this study guide have been adapted from previous IRS Special Enrollment Examinations and from current IRS publications. The authors have also drafted new questions. All the names used in this book are fictitious, and any resemblance to real people, companies, or events is purely coincidental. Official company website: www.PassKeyOnline.com 2  PassKey EA Review 2024-2025 Edition This study guide is designed for exam candidates who will take their exams in the May 1, 2024, to February 28, 2025, testing cycle. Note: Prometric will NOT TEST on any legislation or court decisions passed after December 31, 2023. For exams taken between May 1, 2024, to February 28, 2025, all references on the examination are to the Internal Revenue Code, forms and publications, as amended through December 31, 2023. Also, unless otherwise stated, all questions relate to the calendar year 2023. Questions that contain the term ‘current tax year’ refer to the calendar year 2023. 3  PassKey EA Review 2024-2025 Edition Table of Contents Essential Tax Law Figures for Individuals..................................................................... 13 Unit 1: Preliminary Work with Taxpayer Data........................................................... 24 Unit 2: Determining Filing Status and Residency....................................................... 54 Unit 3: Dependency Relationships.................................................................................... 82 Unit 4: Taxable and Nontaxable Income........................................................................ 99 Unit 5: Investment Income and Expenses................................................................... 131 Unit 6: Calculating the Basis of Assets.......................................................................... 144 Unit 7: Capital Gains and Losses..................................................................................... 161 Unit 8: Nonrecognition Property Transactions........................................................ 181 Unit 9: Rental and Royalty Income................................................................................ 206 Unit 10: Other Taxable Income....................................................................................... 233 Unit 11: Adjustments to Gross Income......................................................................... 260 Unit 12: Standard Deduction and Itemized Deductions....................................... 276 Unit 13: Individual Tax Credits....................................................................................... 313 Unit 14: The ACA and the Premium Tax Credit........................................................ 347 Unit 15: Additional Taxes and Credits......................................................................... 361 Unit 16: Individual Retirement Accounts................................................................... 379 Unit 17: Foreign Financial Reporting........................................................................... 410 Unit 18: Estate and Gift Taxes for Individuals.......................................................... 429 4  PassKey EA Review 2024-2025 Edition Recent Praise for the PassKey EA Review Series (Real customers, real names, public testimonials) Perfect review book! A. Mietzner This EA review is great! It goes into detail. Explains why. When you do the practice test, it actually details the answer for learning and retaining! Definitely recommend! Fantastic textbooks and video resources. Vino Joseph Philip Comprehensive and accurate video lessons are available online, and testing is also available for each course. I passed all three exams on the first attempt after using Passkey’s resources. Passed on the first attempt! William Collins I passed the first time with the PassKey Part 2 [textbook] for the EA SEE 2 exam. I also used the Part 1 textbook and passed that EA exam on the first try as well. Great resources! I Highly recommend these materials Tosha H. Knelangeon Using only the [PassKey] study guide and the workbook, I passed all three EA exams on my first try. I highly recommend these materials. As long as you put in the time to read and study all the information provided, you should be well-prepared. I passed on the first try. Jake Bavaro I recently passed the first part of the EA exam using just the textbook and a separate practice test workbook. The textbook is very easy to read and understand. Although I have a background in accounting and tax, someone with little or no knowledge of either should be able to grasp all of the various topics covered in the book. I really do believe that it is a superior preparation resource. I passed all three parts the first time taking them. Sheryl Reinecke I passed all three parts the first time. I read each chapter and the review quiz at the end of each chapter. Before taking the real exam, I did the practice exams in the additional workbook. I feel the material adequately prepared me for success in passing the exam. Outstanding Material! E. De La Garza If you are looking to pass the EA exam with minimal expense, I recommend the PassKey system. 5  PassKey EA Review 2024-2025 Edition You can pass. Vishnu Kali Osirion I really rushed studying for this section. These authors make tax law relevant to your day-to-day experiences and understandable. You can pass the exam with just this as a resource. I do recommend purchasing the workbook as well, just for question exposure. The questions in the book and in the workbook are pretty indicative of what’s on the exam. This is a must-buy. Cheers. Absolute Best Purchase Sharlene D. This book was definitely worth the purchase. The layout was great, especially the examples! Reading the book from front to back allowed me to pass [Part 2]. I also recommend purchasing the workbook or subscribing to the material on their website for this section. Excellent explanations! Janet Briggs The best thing about these books is that each answer has a comprehensive explanation about why the answer is correct. I passed all three EA exams on the first attempt. PassKey was the only study aid that I used Stephen J Woodard, CFP, CLU, ChFC The [PassKey] guides were an invaluable resource. They were concise and covered the subject matter succinctly with spot-on end-of-chapter questions that were very similar to what I encountered on the exams. Amazing! Sopio Svanishvilion PassKey helped me pass all three parts of the Enrolled Agent exam. They are a “must-have” if you want to pass your EA exams. I passed all three with Passkey. Swathi B.R. I went through the online membership, read the whole book, solved all the questions, and passed the EA exam on my first attempt. For all three [parts], I referred to Passkey EA Review. Wonderful books. Passed all 3 Parts! Kowani Collins Thank you so much for providing this resource! I have passed all 3 parts of the SEE exam. PassKey allowed me to study on my own time and take the exam with confidence. Thank you for providing such thorough and easy-to-follow resources! 6  PassKey EA Review 2024-2025 Edition Introduction Congratulations on taking the first step toward becoming an enrolled agent, a widely respected professional tax designation. The Internal Revenue Service licenses enrolled agents, known as EAs, after candidates pass a competency exam testing their knowledge of federal tax law. As an enrolled agent, you will have the same representation rights as a CPA, with the ability to represent taxpayers in IRS audits and appeals—an EA’s rights are unlimited before all levels and offices of the IRS. The PassKey study guide series is designed to help you study for the EA exam, which is formally called the IRS Special Enrollment Examination or “SEE.” EA Exam Basics The EA exam consists of three parts, which candidates may schedule separately and take in any order they wish. The computerized exam covers all aspects of federal tax law, with Part 1 testing the taxation of individuals; Part 2 testing the taxation of businesses, and Part 3 testing representation, practice, and procedures. Each part of the EA exam features 100 multiple-choice questions, with no written answers required. The exam will include some experimental questions that are not scored. You will not know which of the questions count toward your score and which do not. Computerized EA Exam Format Part 1: Individual Taxation–100 questions Part 2: Business Taxation–100 questions Part 3: Representation, Practice, and Procedures–100 questions You will have 3.5 hours to complete each part of the exam. The actual seat time is four hours, which allows time for a pre-exam tutorial and a post-exam survey. An on-screen timer counts down the amount of time you have to finish. The testing company Prometric exclusively administers the EA exam at thousands of testing centers across the United States and in certain other countries. You can find valuable information and register online at https://www.prometric.com/IRS. Prometric Testing Center Procedures The testing center is designed to be a secure environment. The following are procedures you will need to follow on test day: 1. Check in about thirty minutes before your appointment time and bring a current, government- issued ID with a photo and signature. If you do not have a valid ID, you will be turned away and will have to pay for a new exam appointment. Refunds will not be issued by Prometric if you forget to bring a proper ID with you. 2. The EA exam is a closed-book test, so you cannot bring any notes or reference materials into the testing room. The center supplies sound-blocking headphones if you want to use them. 3. No food, water, or other beverages are allowed in the testing room. 4. You will be given scratch paper and a pencil to use, which will be collected after the exam. 7  PassKey EA Review 2024-2025 Edition 5. You can use an on-screen calculator during the exam, or Prometric will provide you with a handheld calculator. You cannot bring your own calculator into the examination room. 6. Before entering the testing room, you may be scanned with a metal detector wand. 7. You must sign in and out every time you leave the testing room. 8. You cannot talk or communicate with other test-takers in the exam room. Prometric continuously monitors the testing room via video, physical walk-throughs, and an observation window. Important Note: Violating any of these procedures may result in the disqualification of your exam. In cases of cheating, the IRS says candidates are subject to consequences that include civil and criminal penalties. Break Policy: The Special Enrollment Exam (SEE) now includes one scheduled 15-minute break. You may decline the scheduled break and continue testing. If you choose to take the scheduled break, you will leave the testing room, adhering to all security protocols. You can take additional unscheduled breaks; however, the exam clock will continue to count down during any unscheduled break. Exam-takers who require special accommodations under the Americans with Disabilities Act (ADA) must contact Prometric directly to obtain an accommodation request. The test is administered in English; a language barrier is not considered a disability. Exam Content Each year, using questions based on the prior calendar year’s tax law, the IRS introduces multiple new versions of each part of the EA exam. If you fail a particular part of the exam and need to retake it, do not expect to see identical questions the next time. Prometric’s website includes broad content outlines for each exam part. When you study, make sure you are familiar with the items listed, which are covered in detail in your PassKey guides. Questions from older exams are available on the IRS website for review. Be aware that tax laws change yearly, so be familiar with recent updates. Your PassKey study guides present an overview of all the major areas of federal taxation that enrolled agents typically encounter in their practices and are likely to appear on the exam. Although our guides are designed to be comprehensive, we suggest you also review IRS publications and try to learn as much as possible about tax law in general, so you are well-equipped to take the exam. In addition to this study guide, we highly recommend that all exam candidates read: Publication 17, Your Federal Income Tax (for Part 1 of the exam), and Circular 230, Regulations Governing Practice before the Internal Revenue Service (for Part 3 of the exam) You may download these publications for free from the IRS website. Note: Some exam candidates take Part 3: Representation, Practice, and Procedures first rather than taking the tests in order, since the material in Part 3 is considered less complicated. However, test- takers should know that several questions pertaining to taxation of Individuals (Part 1) and Businesses (Part 2) are often included on the Part 3 exam. 8  PassKey EA Review 2024-2025 Edition Exam Strategy Each multiple-choice question has four answer choices. There are several different question formats. During the exam, you should read each question thoroughly to understand precisely what is being asked. Be particularly careful when the problem uses language such as “not” or “except.” Format One–Direct Question Which of the following entities are required to file Form 709, United States Gift Tax Return? A. An individual B. An estate or trust C. A corporation D. All of the above Format Two–Incomplete Sentence Supplemental wages do not include payments for: A. Accumulated sick leave B. Nondeductible moving expenses C. Vacation pay D. Travel reimbursements paid at the federal government’s per diem rate Format Three–All of the Following Except Five tests must be met for you to claim an exemption for a dependent. Which of the following is not a requirement? A. Citizen or Resident Test B. Member of Household or Relationship Test C. Disability Test D. Joint Return Test If you are unsure of an answer, you may mark it for review and return to it later. Try to eliminate clearly wrong answers from the four possible choices to narrow your odds of selecting the right answer. But be sure to answer every question, even if you have to guess, because all answers left incomplete will be marked as incorrect. Each question is weighted equally. There may also be a limited number of questions that have four choices, with three incorrect statements or facts and only one with a correct statement or fact, which you would select as the right answer. With 3.5 hours allotted for each part of the exam, you have about two minutes per question. Try to answer the questions you are sure about quickly, so you can devote more time to those that include calculations or that you are unsure about. Allocate your time wisely. To familiarize yourself with the computerized testing format, you may take a tutorial on the Prometric website. The tutorial illustrates what the test screens look like. 9  PassKey EA Review 2024-2025 Edition Scoring Methods The EA exam is not graded on a curve. The IRS determines scaled scores by calculating the number of questions answered correctly from the total number of questions in the exam and converting to a scale that ranges from 40 to 130. The IRS has set the scaled passing score at 105, which corresponds to the minimum level of knowledge deemed acceptable for EAs. After you finish your exam and submit your answers, you will exit the testing room, and Prometric will send your results to your email, showing whether you passed or failed. Test results are automatically shared with the IRS, so you do not need to submit them yourself. Test scores are confidential and will be revealed only to you and the IRS. If you pass, your printed results will show a passing designation but not your actual score. The printout also will not indicate which specific questions you answered correctly or incorrectly. If you fail, you will receive diagnostic information to help you know which subject areas to concentrate on when studying to retake the exam: Level 1: Area of weakness where additional study is necessary. Level 2: Might need additional study. Level 3: Clearly demonstrated an understanding of the subject area. These diagnostic indicators correspond to various sections of each part of the exam. If necessary, you may take each part of the exam up to four times during the current testing window. You will need to re-register with Prometric and pay fees each new time you take an exam part. Due to the global pandemic, the IRS extended the two-year carryover period to three years for passing all three parts of the exam. Example: Randall, an EA exam candidate, successfully passed Part 1 on November 15, 2021. Subsequently, he passed Part 2 on February 15, 2022. Randall has until November 15, 2024, to pass the remaining part. Otherwise, he loses credit for Part 1. Randall has until February 15, 2025, to pass all other parts of the examination or he will lose credit for Part 2. Applying for Enrollment Once you have passed all three parts of the EA exam, you can apply to become an enrolled agent. The process includes an IRS review of your tax compliance history. Failure to timely file or pay personal income taxes can be grounds for denial of enrollment. The IRS Return Preparer Office will review the circumstances of each case and make determinations on an individual basis. You may not practice as an EA until the IRS approves your application and issues you an enrollment card, a process that takes up to 60 days or more. Successfully passing the EA exam can launch you into a fulfilling and lucrative new career. The exam requires intense preparation and diligence, but with the help of PassKey’s comprehensive EA Review, you will have the tools you need to learn how to become an enrolled agent. We wish you much success! 10  PassKey EA Review 2024-2025 Edition Ten Steps for the EA Exam STEP 1: Learn Learn more about the enrolled agent designation, and explore the career opportunities that await you after passing your EA exam. In addition to preparing income tax returns for clients, EAs can represent individuals and businesses before the IRS, just as attorneys and CPAs do. A college degree or professional tax background is not required to take the EA exam. Many people who use the PassKey study guides have had no prior experience preparing tax returns, but go on to rewarding new professional careers. STEP 2: Gather Information Gather more information before you launch into your studies. You will find valuable information about the exam itself on the Prometric testing website at www.prometric.com/IRS. Be sure to download the official Candidate Information Bulletin, which takes you step-by-step through the registration and testing process. STEP 3: Obtain a PTIN PTIN stands for “Preparer Tax Identification Number.” Before you can register for your EA exam, you must obtain a PTIN from the IRS. The PTIN sign-up system can be found at www.irs.gov/ptin. You will need to create an account and provide personal information. Foreign-based candidates without a Social Security number are also required to have a PTIN to register to take the exam; they will need to submit additional paperwork with their Form W-12 (PTIN Application and Renewal). STEP 4: Register with Prometric Once you have your PTIN, you may register and schedule your exam on the Prometric website by creating an account to set up your user ID and password. Alternatively, you can schedule an appointment to take the exam by calling 800-306-3926 (toll-free) or 443-751-4193 (toll), Monday through Friday, between 8 a.m. and 9 p.m. (ET); or by submitting IRS Form 2587. STEP 5: Schedule Your Test After creating an account, you can complete the registration process by clicking on “Scheduling.” Your exam appointment must be scheduled within one year from the registration date. You can choose a test site, time, and date that is convenient for you. Prometric has test centers in most major metropolitan areas of the United States, as well as in many other countries. You may schedule your exam through the website or call Prometric directly Monday through Friday (some centers have Saturday testing). The testing fee is nonrefundable. Once you have scheduled, you will receive a confirmation number. Keep it for your records because you will need it to reschedule (which may incur a charge), cancel, or change your appointment. STEP 6: Adopt a Study Plan Focus on one exam part at a time and adopt a study plan that covers each unit of your PassKey guides. The period of time you’ll need to prepare for each exam is truly unique to you, based on how 11  PassKey EA Review 2024-2025 Edition much prior tax preparation experience you have and your current level of tax knowledge, how well you understand and retain the information you read, and how much time you have to study for each test. For those without prior tax experience, a good rule of thumb is to study at least 60 hours for each of the three exam sections. Part 2: Businesses may require additional study preparation, as evidenced by the lower pass rates. One thing is true for all candidates: for each of the tests, start studying well in advance of your scheduled exam date. STEP 7: Get Plenty of Rest and Good Nutrition Get plenty of rest, exercise, and good nutrition before the EA exam. You will want to be at your best on exam day. STEP 8: Test Day Be sure to arrive early at the test site. Prometric advises arriving at least 30 minutes before your scheduled exam time. If you miss your appointment and cannot take the test, you will forfeit your fee and must pay for a new appointment. Remember to bring a government-issued ID with your name, photo, and signature. Your first and last name must exactly match the first and last name you used to register for the exam. STEP 9: During the Exam This is when your hard work finally pays off. Focus and don’t worry if you don’t know the answer to every question, but make sure you use your time well. Give your best answer to every question. All questions left blank will be marked as wrong. STEP 10: Congratulations. You Passed! After celebrating your success, you need to apply for your EA designation by filling out Form 23, Application for Enrollment to Practice Before the Internal Revenue Service. Once your application is approved, you will be issued an enrollment card and you will officially be a brand-new enrolled agent! 12  PassKey EA Review 2024-2025 Edition Essential Tax Law Figures for Individuals Here is a quick summary of some important tax figures for the enrolled agent exam cycle that runs from May 1, 2024, to February 28, 2025. Study Note: The IRS has stated in the most recent version of the official Prometric SEE Candidate Bulletin that candidates should not take into account any legislation or court decisions made after December 31, 2023. Legislation Affecting the 2023 Tax Year: The SECURE Act 2.0 was signed into law on December 29, 2022, as part of the Consolidated Appropriations Act of 2023. The Act included dozens of provisions affecting retirement plans. Most of the provisions in the SECURE Act 2.0 went into effect in 2023. The Corporate Transparency Act (the “CTA”) was enacted by Congress as part of the National Defense Authorization Act. The CTA establishes a beneficial ownership reporting requirement for corporations, limited liability companies, and other similar entities formed or registered to do business in the United States. Starting on January 1, 2024, the CTA will mandate certain types of entities to submit a beneficial ownership information (BOI) report to the Financial Crimes Enforcement Network (FinCEN). Note that according to the testing specifications for the EA exam for this testing window, BOI reports are not included as a testable item on the exam. Individual Income Tax Return Filing Deadline: April 15, 2024.1 Taxpayers residing in Maine or Massachusetts have until April 17, 2024, because of the Patriots’ Day and Emancipation Day holidays in those states. The extended filing deadline is October 15, 2024. FBAR Due Date: The due date for the FBAR (FinCen 114, Report of Foreign Bank and Financial Accounts) coincides with the filing of the federal tax return. An automatic 6-month extension is allowed, typically until October 15.2 FBARs must be timely e-filed separately from federal tax returns, on the FinCEN website. 2023 Tax Rates and Brackets: The individual tax rates for 2023 for U.S. citizens and U.S. residents are: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Nonresident aliens filing Form 1040-NR are taxed at a flat 30% rate on US-sourced income unless a tax treaty specifies a lower rate. 1 Taxpayers are automatically granted a 2-month extension of time to file (to June 15) if the taxpayer lives outside the U.S. and their tax home is outside the U.S. 2 FBAR refers to FinCEN Form 114, Report of Foreign Bank and Financial Accounts, that must be filed with the Financial Crimes Enforcement Network (FinCEN), which is a bureau of the Treasury Department. The FBAR is not filed with the IRS, but the IRS is responsible for FBAR enforcement. 13  PassKey EA Review 2024-2025 Edition 2023 Standard Deduction Amounts (by Filing Status): Single/MFS: $13,850 MFJ or QSS: $27,700 Head of Household: $20,800 Additional Standard Deduction for Age 65 and over and/or blindness ○ MFJ, QSS or MFS: $1,500 ○ Single or HOH: $1,850 2023 Filing Thresholds Based on Filing Status and Gross Income Filing Status Age Filing threshold Single Under 65 $13,850 65 or older $15,700 Married Filing Joint Under 65 (both spouses) $27,700 and Qualifying 65 or older (one spouse) $29,200 Surviving Spouse (QSS) 65 or older (both spouses) $30,700 Married Filing Any age $5 (not a typo) Separate Head of Household Under 65 $20,800 65 or older $22,650 Any filing status The taxpayer had net earnings from self-employment of at least $400.3 Any filing status Church employee income of $108.28 or more. 2023 Retirement Plan Contribution Limits: Roth and traditional IRAs: $6,500 (additional catch-up contribution of $1,000 for taxpayers age 50 or older)4 Qualified Small Employer HRA Limits (QSEHRA): $5,850 Single/ $11,800 family coverage 2023 “Kiddie Tax” Threshold: The “Kiddie Tax” age limit is for those under 18 and certain dependents under 24. The unearned income threshold is $2,500. The kiddie tax only applies to unearned income.5 3 Table source: Publication 501, Filing Requirements for Most Taxpayers. Taxpayers who have gross income under these thresholds may still be required to file a return. This chart is not comprehensive. There are situations where a taxpayer may be required to file a return, even with income below these thresholds, for example, if the taxpayer owes special taxes, or those who received advanced payments of the premium tax credit (APTC). 4 ROTH IRAs: Starting in 2023, SIMPLE and SEP IRAs may now accept Roth contributions. Previously, SIMPLE IRAs and SEP IRAs could only accept pre-tax funds. 5 The kiddie tax is reported on Form 8615, which is attached to the child’s Form 1040. Alternatively, parents can elect to include the child’s unearned income directly on their own return, using Form 8814, if certain requirements are met. 14  PassKey EA Review 2024-2025 Edition 2023 Maximum Compensation Subject to FICA OASDI maximum wage base: $160,2006 Employee and employer portion: 7.65% (6.2% Social Security + 1.45% Medicare) Self-employed 15.30% (12.4% Social Security + 2.9% Medicare) Additional Medicare Tax: 0.9% on earned income exceeding the following thresholds: ○ Married filing jointly: $250,0007 ○ Married filing separately: $125,000 ○ Single, HOH, and QSS: $200,000 2023 Capital Gains and Long-Term Dividends: Short-term capital gains and ordinary dividends are taxed at ordinary income rates. The top rates for qualified dividends and long-term capital gains are as follows: Long-Term Capital Gains & Qualified Dividends Tax Rates for 2023 Filing status 0% rate 15% rate 20% rate Single Up to $44,625 $44,626 – $492,300 $492,301 and over Married filing joint & QSS Up to $89,250 $89,251 – $553,850 $553,851 and over Married filing separately Up to $44,625 $44,626 – $276,900 $276,901 and over Head of household Up to $59,750 $59,751 – $523,050 $523,051 and over Trust & Estates Up to $3,000 $3,001 - $14,650 $14,651 and over Other long-term gains rates Gain on sale of collectibles Maximum 28% Unrecaptured Sec. 1250 gain Maximum 25% 2023 Net Investment Income Tax: A 3.8% tax applies to individuals, estates, and trusts with net investment income above certain threshold amounts. The MAGI thresholds are: Married filing jointly and Qualifying Surviving Spouse: $250,000 Single and HOH: $200,000 Married filing separately: $125,000 Estates and trusts: $14,450 6 “OASDI” is the official name for Social Security in the United States, and the terms are often used interchangeably. The acronym stands for “Old-Age, Survivors, and Disability Insurance.” Church employee income is wages received as an employee of a church or qualified church-controlled organization that has a certificate in effect electing an exemption from employer social security and Medicare taxes. 7 Earned income of spouses is combined towards this Additional Medicare Tax threshold for MFJ returns. Employers must withhold this tax from wages or compensation when they pay employees more than $200,000 in a calendar year, regardless of the employee’s filing status. 15  PassKey EA Review 2024-2025 Edition 2023 Foreign Earned Income Exclusion: $120,000 per person. 2023 Bonus Depreciation and Section 179: Bonus Depreciation ramps down to 80% starting January 1, 2023. In 2023, the maximum Section 179 expense deduction is $1,160,000. This limit is reduced by the amount by which the cost of Section 179 property placed in service during the tax year exceeds $2,890,000. Once qualifying Section 179 assets placed in service during the year exceed $4,050,000, the Section 179 election is no longer available. 8 2023 QBI deduction Limits: The Section 199A limitation phase-in ranges increased and are as follows: Married Filing Joint: $364,200-$464,200 All other filing statuses: $182,100-$232,100 2023 Standard Mileage Rates: Business use: 65.5 cents a mile Medical and moving: 22 cents a mile Charitable: 14 cents a mile 2023 HSA Limits: To qualify to contribute to a health savings account, the taxpayer must have a high- deductible health insurance policy. The plan must also have an annual limit on out-of-pocket expenses (not including premiums).9 HSA contribution limit (employer + employee) Self-only: $3,850 Family: $7,750 HDHP minimum deductibles Self-only: $1,500 Family: $3,000 HDHP maximum out-of-pocket amounts (not including Self-only: $7,500 insurance premiums) Family: $15,000 2023 FSA Limits: Health Care FSA (HCFSA): $3,050 Dependent Care FSA (DCFSA): $5,000 for unmarried filers and couples filing jointly, and $2,500 for MFS filers. 2023 QSEHRA Limits: Maximum payments and reimbursements through the QSEHRA are: $5,850 for an employee only and $11,800 for an employee plus family. 8Section 179 and bonus depreciation are covered more extensively in the PassKey EA Review Part 2, Businesses. 9The IRS also announced an increase to the Excepted Benefit HRA (EBHRA), which is now $1,950. An EBHRA stands for Excepted Benefit HRA. It is a health reimbursement arrangement that pays qualified medical expenses for excepted benefits like dental and vision coverage. This can be offered in addition to group health coverage. An employee can participate in an EBHRA, even if they decline participation in the employer’s group health plan. 16  PassKey EA Review 2024-2025 Edition 2023 Long-Term Care Premiums Maximum Deduction (Per Person): The maximum amount of qualified long-term care premiums includible as medical expenses has increased. The limit on the deduction for premiums is for each person (not per tax return). Long-term care premiums up to the amounts below can be included as medical expenses on Schedule A. Taxpayer’s Age At the End of Tax Year Deductible Limit 40 or less $480 More than 40 but not more than 50 $890 More than 50 but not more than 60 $1,790 More than 60 but not more than 70 $4,770 More than 70 $5,960 2023 Alternative Minimum Tax (AMT) Exemption Amounts: Single or Head of Household: $81,300 Married filing jointly or QSS: $126,500 Married filing separately: $63,250 Estates and Trusts: $28,400 2023 AMT Exemption Beginning Phaseout Range: Single or Head of Household: $578,150 to $ 903,350 Married filing jointly or QSS: $1,156,300 to $ 1,662,300 Married filing separately: $578,150 to $831,150 Estates and Trusts: $94,600 to $208,200 2023 Estate and Trust Exemption Amounts Estates: $60010 Simple trusts: $300 Complex trusts: $100 Qualified disability trusts: $4,700 2023 Estate and Gift Tax Exclusion Amounts Estate and gift tax (highest rate): 40% Combined Estate tax and lifetime gift/GST exemption: $12.92 million ($25.84 million per married couple). Gift tax annual exclusion: $17,000 Annual exclusion for gifts to noncitizen spouse: $175,000 10 For estates and trusts, the exemption amount is not allowed in the entity’s final tax year (the year of dissolution). 17  PassKey EA Review 2024-2025 Edition 2023 Retirement Savings Contributions Credit (Saver’s Credit): This credit11 is between 10% to 50% of eligible contributions to IRAs and qualifying retirement plans up to a maximum credit of $1,000 ($2,000 MFJ). The income limitations are as follows: Credit % MFJ HOH All other filers 50% AGI not more than $43,500 AGI not more than $32,625 AGI not more than $21,750 20% $43,501- $47,500 $32,626 - $35,625 $21,751 - $23,750 10% $47,501 - $73,000 $35,626 - $54,750 $23,751 - $36,500 No Credit more than $73,000 more than $54,750 more than $36,500 11 The IRS uses two different names for this particular credit: the “Saver’s Credit” and the “Retirement Savings Contribution Credit.” However, they are the same credit. 18  PassKey EA Review 2024-2025 Edition 2023 Tax Credit Changes 2023 Earned Income Tax Credit (EITC) Investment income: The investment income limit in 2023 is $11,000. The investment income limitation is now increased and indexed for inflation. Social Security Numbers: Taxpayers with valid Social Security numbers can claim the credit, even if their children do not have SSNs. In this instance, they would get the smaller credit available to taxpayers without qualifying children (the “childless EITC”). In the past, these filers did not qualify for the credit. Special rule for separated spouses. Taxpayers who file married filing separately may qualify for the EITC in limited circumstances (explained later). Children Claimed Maximum AGI (all filing statuses Maximum AGI (MFJ except MFJ) filers only) Zero (“childless EITC”) $17,640 $24,210 One $46,560 $53,120 Two $52,918 $59,478 Three or more $56,838 $63,398 Maximum amount of the EITC in 2023: No qualifying children: $600 (the “childless EITC”) 1 qualifying child: $3,995 2 qualifying children: $6,604 3 or more qualifying children: $7,43012 2023 Child and Dependent Care Credit (CDCTC): The Child and Dependent Care Credit or “Daycare credit” is a percentage ranging between 20% to 35% of up to $3,000 in qualifying expenses (for one dependent) or $6,000 (for two or more dependents). This credit is not refundable in 2023. 2023 Child Tax Credit (CTC): The maximum Child Tax Credit in 2023 is $2,000 per qualifying child. The Additional Child Tax Credit is the refundable component, of which a maximum of $1,600 is refundable in 2023. The CTC phaseout begins at $400,000 (MFJ) and $200,000 for all other filing statuses. 12The IRS cannot issue refunds claiming the Earned Income Tax Credit (EITC) and the Additional Child Tax Credit (ACTC) before mid-February. This is a congressional provision in the Protecting Americans from Tax Hikes (PATH) Act. This time frame applies to the entire refund, not just the portion associated with these credits. 19  PassKey EA Review 2024-2025 Edition 2023 Adoption Credit: $15,950. The AGI phaseout range starts at $239,230 and ends at $279,230 for all filing statuses.13 The exclusion for employer-paid adoption reimbursement is the same. The adoption credit applies per each adopted child. It is non-refundable, but any unused credit can be carried forward for five years. 2023 Credit for Other Dependents/Other Dependent Credit (ODC): The ODC is a tax credit available to taxpayers for dependents who do not qualify for the Child Tax Credit. The maximum credit amount is $500 for each dependent. There is no refundable portion. 2023 Premium Tax Credit: The American Rescue Plan Act temporarily removed the 400% FPL ceiling (commonly called the “subsidy cliff”) and increased the amount of the credit to qualifying households. For 2023, the repayment caps range from $350 to $3,000, depending on the taxpayer’s income and filing status. The ACA subsidy cliff is scheduled to come back in 2026. Energy Efficient Tax Credits: Starting in 2023, the Inflation Reduction Act expands two tax credits focused on energy efficiency. Previously called the Nonbusiness Energy Property Credit, the updated credit is now called the Energy Efficient Home Improvement Credit. This updated credit can provide a maximum annual credit of $1,200 for qualifying property placed in service during the year. Unlike the previous credit with a lifetime limit of $500, this new one has an increased annual limit. Additionally, investments in heat pumps, biomass stoves, and boilers can earn a $2,000 credit. New 2023 Clean Vehicle Credit: The credit for new qualified plug-in electric drive motor vehicles has changed. In 2023, this credit is now known as the Clean Vehicle Credit. The maximum amount of the credit and some of the requirements to claim the credit have changed. The credit is reported on Form 8936 and Schedule 3, line 6f. 13 Unlike most other credits, the adoption credit has the same phaseout range for all filing statuses. 20  PassKey EA Review 2024-2025 Edition 2023 Education-Related Credits and Deductions American Opportunity Credit: The credit is up to $2,500 per student for the first four years of higher education expenses paid. The credit phases out for unmarried taxpayers with MAGIs between $80,000 and $90,000 ($160,000 and $180,000 for MFJ). Lifetime Learning Credit: 20% of tuition paid up to a credit of $2,000 per return. In 2023, the credit phases out for unmarried taxpayers with MAGIs between $80,000 and $90,000 ($160,000 and $180,000 for MFJ). Coverdell Education Savings Accounts (also called an “Education IRA”): The maximum contribution limit is $2,000 per beneficiary in 2023. Contributions must be made in cash, and are not deductible. Section 529 Plans (Qualified Tuition Programs or QTP): The IRS does not specify a specific dollar amount for annual contribution limits to 529 college savings plans, but contributions are considered gifts for tax purposes and are subject to gift tax limits. This means that in 2023, up to $17,000 per beneficiary qualifies for the annual gift tax exclusion. Student loan interest deduction: Student loan interest includes both required and voluntary interest payments. The maximum deduction per return is $2,500, regardless of filing status. The 2023 phaseout limits are: Married filing jointly: $155,000 - $185,000 Single, HOH, QSS $75,000 - $90,000 MFS filers cannot take this deduction. Educational Savings Bond Expense Exclusion: The savings bond education tax exclusion allows taxpayers to exclude interest income upon redeeming eligible savings bonds when the bond owner pays qualified higher education expenses at an eligible institution. This exclusion is subject to the following income limitations in 2023: Married filing jointly: $137,800 – $167,800 Unmarried filers: $91,850 – $106,850 MFS filers cannot take the deduction. Educator Expense deduction: The deduction for educator expenses, also known as the “teacher credit,” is set at $300 for the year 2023. If two teachers are married and file taxes jointly, they can claim a total deduction of $600 ($300 each). 21  PassKey EA Review 2024-2025 Edition Other Essential Tax Law Updates for Individuals in 2023 Insurance premiums for retired public safety officers: Retired public safety officers can receive a tax break on their retirement distributions. They can exclude up to $3,000 of distributions from income from an eligible retirement plan if the funds are used directly for health insurance premiums. Direct File Pilot Program: Direct File is a new IRS tool that provides taxpayers with relatively simple returns to e-file their federal tax return for free. Taxpayer eligibility to participate in the pilot will be limited to 13 states in the initial pilot, but the IRS plans to expand the service in future years. Increase in penalty for failure to file: The penalty for failure of an individual to file a tax return that is more than 60 days late shall not be less than the lesser of (1) $485 or (2) 100% of the tax due on the return. Student Loan Forgiveness: Exclusion from gross income is available for student loan forgiveness after 2020 and before 2026 for most forgiven student loans. In addition, an employer may contribute up to $5,250 annually toward an employee’s student loans, and such payment is excluded from the employee’s income through 2025. The $5,250 cap applies to both the student loan repayment benefit and other educational assistance (e.g., tuition, fees, books) provided by the employer. Required Minimum Distribution Changes: The SECURE Act 2.0 has changed the rules for RMDs. For 2023, the age at which account owners must start taking required minimum distributions goes up from age 72 to age 73. Excess Business Losses: The Inflation Reduction Act extended the provision for excess business losses through 2028. Non-corporate taxpayers, including sole proprietors, are limited in their offset use of overall business losses to offset nonbusiness income. The excess business loss limitation is $578,000 for MFJ, and $289,000 for all other filing statuses in 2023. Personal and Dependency Exemptions: The deduction for all personal exemptions is suspended (reduced to zero) through 2025. For 2023, the gross income limitation 14 for a qualifying relative is $4,700 (also called the “deemed exemption” amount). 2023 “Nanny Tax” on Household Employees: The nanny tax threshold is $2,600 in 2023. A household employer is normally obligated to withhold and pay federal FICA (Social Security and Medicare) taxes for any household employee above this threshold. A household employer is required to pay FUTA taxes if they paid a household employee $1,000 or more in a calendar quarter in the current or prior year. These thresholds are on a per-employee basis. 14A “deemed personal exemption” is used for purposes of determining who is a “qualifying relative” under IRC Sec. 152(d)(1)(B). An exemption amount still applies to Qualified Disability Trusts, which were not subject to an exemption repeal under the Tax Cuts and Jobs Act. 22  PassKey EA Review 2024-2025 Edition 2023 Tax Form Changes Publication 535, Business Expenses, is now historical. The 2022 edition will be the final revision available. The new Form 7206, Self-Employed Health Insurance Deduction, will be used by self-employed individuals to calculate and claim the deduction for health insurance as an above-the-line deduction. Form 1040-X, Amended U.S. Individual Tax Return, now includes the option to select direct deposit of their refund. IRIS Platform for Information Return filings: The Taxpayer First Act required the IRS to develop an Internet portal that allows taxpayers to file Forms 1099 electronically. On January 25, 2023, this new platform, called the Information Returns Intake System (IRIS) went live. Filers must register with the IRS before using IRIS. E-file Mandate for Information Returns: On February 21, 2023, the IRS issued final regulations requiring most businesses to e-file beginning in 2024. This mandate applies to individuals and businesses who submit 10 or more information returns, such as Form 1099, W-2, and 1099-MISC. Failure to e-file, when required, may result in penalties imposed on taxpayers and businesses who file their information returns on paper instead. 2023 Rules for Form 1099-K: The reporting requirement for Form 1099-K, Payment Card and Third- Party Network Transactions, was reduced by the American Rescue Plan of 2021. However, on November 21, 2023, the IRS announced an additional delay in the new 1099-K reporting threshold for third-party settlement organizations (TPSOs). As a result, reporting will not be required unless the taxpayer receives over $20,000 and has more than 200 transactions in 2023. These reporting requirements do not apply to personal transactions such as birthday or holiday gifts, sharing the cost of a car ride or meal, or paying a family member or another for a household bill. 23  PassKey EA Review 2024-2025 Edition Unit 1: Preliminary Work with Taxpayer Data More Reading: Publication 17, Your Federal Income Tax The enrolled agent exam, Part 1, covers a wide range of topics related to preparing tax returns for individual taxpayers. This includes essential knowledge of filing status, requirements, and deadlines; taxable and nontaxable income; deductions, credits, adjustments to income; determining the basis of property; calculating capital gains and losses; reporting rental income; understanding retirement income; and navigating estate and gift taxes. In this section, we will cover the initial steps that tax return preparers must take in order to ensure accuracy when filing taxes for their individual clients. For the current exam cycle, Part 1 of the exam is broken down into the following sections and corresponding number of questions: 1. Preliminary Work with Taxpayer Data – 14 questions 2. Income and Assets – 17 questions 3. Deductions and Credits – 17 questions 4. Taxation – 15 questions 5. Advising the Individual Taxpayer – 11 questions 6. Specialized Returns for Individuals – 12 questions15 We will cover preliminary work with taxpayer data, as well as the importance of a taxpayer’s biographical information in this unit. Use of Prior Year Returns When preparing tax returns for clients, tax professionals are expected to diligently gather and verify all necessary taxpayer information. This includes reviewing prior-year tax returns for accuracy, completeness, and compliance with tax laws. If any errors or omissions are discovered on a prior-year return, the preparer is required by law to inform the taxpayer of the mistake and explain the potential consequences if it is not corrected. However, the preparer is not obligated to fix the error. Utilizing prior-year returns can help identify and prevent major mathematical mistakes and alert the preparer to any issues that may impact the current year’s return. During this review process, the preparer must also consider any items from previous years that may affect the current year’s return, such as: Carryovers, Net operating losses, Tax credit carryovers, of which examples include the prior year AMT tax credit and the adoption credit. Prior-year depreciation and asset basis. 15The current exam specifications are listed in the official Enrolled Agent Special Enrollment Examination Candidate Information Bulletin, which is available for download on the official Prometric website. 24  PassKey EA Review 2024-2025 Edition Taxpayer Biographical Information When filing tax returns, certain biographical information of the client is required. A tax professional must collect this information from each taxpayer to prepare an accurate tax return: Legal name, date of birth, and marital status Residency status and/or citizenship Dependent information The taxpayer’s identification number (SSN, ITIN, or ATIN) In order to prevent fraudulent tax filings, it is important for tax preparers to request identification from taxpayers. Photo IDs are preferred and should include the taxpayer’s name and current address. It is also crucial for tax preparers to verify social security cards, ITIN letters, and other documents to ensure that the correct TINs are used for the taxpayer, their spouse, and any dependents listed on the return. Additionally, taxpayers have the option to request an Identity Protection Personal Identification Number (IP PIN) which must be entered into software for the IRS to accept an electronically filed tax return. This service is now available to anyone, regardless of whether they have been a victim of identity theft or not. The IRS requires all individuals listed on a federal income tax return to have a valid Taxpayer Identification Number (TIN), including the taxpayer, their spouse (if married), and any dependents listed on the return. The types of TINs are: Social Security number (SSN) Individual taxpayer identification number (ITIN) Adoption taxpayer identification number (ATIN)16 Note: The personal and financial information of taxpayers is considered highly sensitive and confidential. It is crucial for tax preparers to understand the importance of protecting this information and to take all necessary precautions to ensure it remains secure. A preparer who wrongfully discloses a taxpayer’s information could face civil and criminal charges. A taxpayer who cannot obtain an SSN must apply for an ITIN in order to file a U.S. tax return. Generally, only U.S. citizens and lawfully admitted noncitizens authorized to work in the United States are eligible for a Social Security number. Nonresident aliens with a U.S. tax liability generally have ITINs, although not always. For example, an ITIN would be required when a U.S. soldier marries a foreign spouse and wishes to file jointly. In order to file a joint return, the couple would need to request an ITIN for the alien spouse. People who do not have lawful status in the United States may obtain an ITIN for tax reporting purposes only. The issuance of an ITIN does not affect an individual’s immigration status or give the taxpayer the right to work in the United States. A taxpayer with an ITIN is not eligible to receive Social Security benefits or the Earned Income Tax Credit. ITINs are for federal tax reporting only and are not intended to serve any other purpose. 16A special form is used for ATIN requests; Form W-7A, Application for Taxpayer Identification Number for Pending U.S. Adoptions. This form is used to apply for an ATIN for a child who is placed in the taxpayer’s home for legal adoption. 25  PassKey EA Review 2024-2025 Edition Example: Umberto is an Italian citizen who has never been to the United States. On January 20, 2023, he inherited a rental property from his deceased aunt, Giuseppina, a green-card holder who was living in the U.S. On his accountant’s advice, Umberto decides to keep the rental property as a passive income source. He hires a management company to receive the rents and manage the property in his absence. Umberto requests an ITIN for tax reporting purposes. He will report his U.S. rental income on Form 1040-NR. He will not be taxed on his worldwide income, only his income from U.S. sources. Example: Kristal is a U.S. citizen living in Norway. In 2023, she met and married Trond, a Norwegian citizen. The couple plans to live in Norway. Trond does not plan to apply for US residency, but Kristal and Trond can make the election to file jointly and treat Trond as a U.S. resident alien by attaching a statement to their joint return. To make this election, Trond must request an ITIN. ITIN Application Process Taxpayers who need an individual taxpayer identification number (ITIN) must fill out Form W-7, also known as the Application for IRS Individual Taxpayer Identification Number. Along with submitting this form, taxpayers must provide documentation that proves their foreign status and verifies their identity.17 There are three ways to apply for an ITIN. Using Form W-7 Using an IRS-authorized Certified Acceptance Agent (CAA) or In-person at a designated IRS Taxpayer Assistance Center A taxpayer can also engage the services of a CAA, or Certified Acceptance Agent,18 to request an ITIN. CAAs can authenticate a passport and/or birth certificate for taxpayers who want to request an ITIN, but do not wish to mail their original documents to the IRS. All ITINs expire unless they are renewed. Example: Adriana, a U.S. citizen with a Social Security number, currently resides in Mexico and is employed by an international manufacturing firm. She recently married Santino, a Mexican citizen, who has a daughter named Lucia from a previous marriage (both Santino and Lucia are Mexican citizens). Adriana and Santino decide to file their taxes jointly as a married couple and claim Lucia as a dependent. To do so, they need to apply for Individual Taxpayer Identification Numbers (ITINs) for Santino and Lucia. Adriana may enlist the help of a Certified Acceptance Agent (CAA) in obtaining these ITINs for her husband and stepdaughter. Note: Typically, the process for obtaining an ITIN involves submitting an application (Form W-7) by mail along with a taxpayer’s initial tax return. This must be done on paper. The Form W-7 cannot be filed electronically. There are limited situations where a foreign person may apply for an ITIN without filing a tax return, such as when claiming tax treaty benefits or providing an ITIN for reporting purposes to a third party, such as a bank or financial institution. A full list of exceptions can be found in the Form W-7 instructions. 17 When a taxpayer applies for an ITIN, the Form W-7 must include original documentation such as: an original passport, birth certificate, or certified copies of these documents from the issuing agency. Notarized copies are no longer accepted. 18 A Certified Acceptance Agent (CAA) is an individual or organization that is authorized by the Internal Revenue Service to assist alien individuals and with obtaining ITINs. The IRS maintains a list of CAAs on its website. 26  PassKey EA Review 2024-2025 Edition Adoption Taxpayer Identification Number (ATIN) ATINs are designed explicitly for adopted children who are not yet eligible for a Social Security number. An ATIN is requested using Form W-7A, Application for Taxpayer Identification Number for Pending U.S. Adoptions. For an adopted child who does not have an SSN, a taxpayer may request an ATIN if: The child is placed in the taxpayer’s home for legal adoption. The adoption is a domestic adoption, or the adoption is a foreign legal adoption, and the child has a permanent resident alien card or certificate of citizenship. The taxpayer cannot obtain the child’s existing SSN, even though he has made a reasonable attempt to obtain it from the birth parents, the placement agency, and other persons. The taxpayer cannot obtain an SSN for other reasons, such as the adoption not yet being final. An ATIN issued for an adoptive child will expire after two years from the date it is issued, although an extension can be requested, using IRS Form 15100, Adoption Taxpayer Identification Number Extension Request. An ATIN cannot be used to obtain the Earned Income Tax Credit, the Child Tax Credit, or the American Opportunity Tax Credit. Special Rules for a Deceased Child If a child is born and dies within the same tax year and is not granted an SSN, the taxpayer may still claim that child as a dependent. Example: On October 9, 2023, Diane had a newborn son. Sadly, he faced health complications and passed away just one week later. The child was issued both a birth certificate and a death certificate, but no Social Security number. When filing her taxes for 2023, Diane can still claim her son as a qualifying child. She will need to submit a paper return in order to do so. Her son will still be considered a “qualifying child” for tax purposes, even though he only lived for a short time. The tax return must be filed on paper with a copy of the birth certificate or a hospital medical record attached. The birth certificate must show that the child was born alive; a stillborn infant does not qualify. The taxpayer should enter the word “DIED” in the space for the dependent’s Social Security number on the tax return. Recordkeeping Requirements for Individuals It is the responsibility of taxpayers, with or without the assistance of a tax preparer, to maintain copies of their tax returns and related records for as long as necessary for the administration of federal tax laws. Typically, it is required that taxpayers retain copies of their tax returns and supporting documentation for at least three years from either the date they were filed or the due date, whichever is later. There are no specific guidelines set by the IRS on how these records should be kept, but individuals are advised to maintain good records for several purposes. These include identifying sources of income, keeping track of expenses for potential deductions, documenting the cost and improvements made to owned property, substantiating items reported on tax returns in case of an audit, and aiding in the accurate preparation of future tax returns. In cases of an IRS audit, it is the responsibility of the taxpayer to provide proof and documentation for their claimed expenses. Even if a tax professional prepares and signs a tax return, the taxpayer is the one ultimately responsible for the accuracy of his 27  PassKey EA Review 2024-2025 Edition or her own return. The IRS allows taxpayers to maintain records in any way that will help determine the correct tax. Electronic records are acceptable as long as a taxpayer can reproduce the records in a legible format. Necessary records that all taxpayers should keep include items related to: Income: Forms W-2, Forms 1099, bank statements, pay stubs, brokerage statements, Schedules K-1. Expenses: Sales slips, invoices, receipts, credit card statements, canceled checks or other proof of payments, written communications from qualified charities, Forms 1098 to support mortgage interest and real estate taxes paid (if the taxes are paid through an impound account). Home purchase and sale: Closing statements, HUD statements, purchase and sales invoices, proof of payment, insurance records, receipts for improvement costs. Investments: Brokerage statements, mutual fund statements, Forms 1099-DIV. Basic Tax Forms for Individuals Form 1040: The Form 1040 is the primary tax form used by U.S. taxpayers to file their annual income tax returns. The Form 1040 includes three numbered schedules: Schedule 1, Additional Income and Adjustments to Income: Schedule 1 is used to report types of income that are not listed directly on the Form 1040, such as taxable alimony, unemployment compensation, and gambling winnings. Schedule 1 also includes adjustments to income, like the student loan interest deduction, the self-employed health insurance deduction, and the deduction for educator expenses. Schedule 2, Additional Taxes: Schedule 2 is used to report additional taxes owed, such as the alternative minimum tax, self-employment tax, or household employment taxes. Schedule 3, Additional Credits and Payments: Schedule 3 has two main sections: nonrefundable credits, and other payments and refundable credits. Form 1040-SR: This form is specifically for use by seniors who are age 65 or older. This form is essentially the same as the standard Form 1040 but is designed to be easier to read with a bigger font. Form 1040-NR: Form 1040-NR is used by nonresident aliens to report their U.S. source income. Form 1040-NR uses Schedules 1, 2, and 3, just like Form 1040. The 1040-NR is never used by U.S. citizens or U.S. residents. The IRS defines an “alien” as any individual who is not a U.S. citizen or U.S. national. A nonresident alien is an alien who has not passed the green card test or the substantial presence test. Form 1040-NR is used by foreign investors, as well as nonresident taxpayers who earn money while in the U.S. Example: Angelo, a Filipino citizen and world-famous boxer, receives permission to enter the U.S. on a special visa in order to participate in a champion boxing match. He earns a substantial income of $900,000 for his appearance, but only stays in the U.S. for six days before returning to his home country. As he is not eligible for a Social Security Number (SSN), Angelo must request an Individual Taxpayer Identification Number (ITIN) to report his U.S. earnings. Without the ITIN, he would face automatic backup withholding on his income. Thankfully, Angelo’s tax accountant requests the ITIN and correctly files his income taxes using Form 1040-NR, which only requires him to report the income he earned while in the United States and not his worldwide income. 28  PassKey EA Review 2024-2025 Edition Example: Ferdinand, a Canadian citizen, travels to the United States on a visitor’s visa. During his visit, he goes to Atlantic City and happens to win $45,000 while playing Baccarat. Since Ferdinand is not a resident alien of the US for tax purposes and does not have an SSN, he falls under the category of nonresident alien. Generally, gambling winnings for nonresident aliens are subject to a flat rate of 30% in taxes, and they are usually unable to claim deductions for gambling losses. However, a beneficial tax treaty exists between the US and Canada. Ferdinand chooses to request an ITIN, so he can file a Form 1040-NR to receive a partial refund of the U.S. taxes withheld from his gambling winnings. Form 1040-X, Amended U.S. Individual Income Tax Return: This form is used to correct errors in a previously filed Form 1040, Form 1040-SR, or 1040-NR. Form 1040-X can now be filed electronically. In 2023, taxpayers electronically filing amended returns may now choose direct deposit to obtain a faster refund. Federal Income Tax Rates An individual’s federal taxable income is taxed at progressive rates in the United States. The IRS groups individuals by ranges of their taxable income level, or brackets, and applies increasing tax rates at each successive level. For tax year 2023, there are seven tax brackets for individuals: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The bottom rate is 10% in 2023. 2023 Federal Income Tax Brackets and Rates Tax rate Single Filers Married Filing Joint & Head of Household Married Filing QSS Separately 10% $0 to $11,000 $0 to $22,000 $0 to $15,700 $0 to $11,000 12% $11,001 to $44,725 $22,001 to $89,450 $15,701 to $59,850 $11,001 to $44,725 22% $44,726 to $95,375 $89,451 to $190,750 $59,851 to $95,350 $44,726 to $95,375 24% $95,376 to $182,100 $190,751 to $364,200 $95,351 to $182,100 $95,376 to $182,100 32% $182,101 to $231,250 $364,201 to $462,500 $182,101 to $231,250 $182,101 to $231,250 35% $231,251 to $578,125 $462,501 to $693,750 $231,251 to $578,100 $231,251 to $346,875 37% $578,126 or more $693,751 or more $578,101 or more $346,876 or more The applicable tax rate for each successive bracket that is applicable to the taxpayer applies only to the additional amounts of taxable income that fall within that particular bracket. Example: Melissa is unmarried, and she earned $32,000 of taxable income in 2023. This means she is in the 12% tax bracket. But that does not mean she will pay 12% on all her income. Instead, she would pay 10% on the first $11,000 plus 12% on the remaining amount. In addition to the regular tax in the United States, there is a “parallel tax” called the alternative minimum tax (AMT). Taxpayers must pay either the regular tax or the AMT, depending on whichever amounts to the greater amount of tax. The AMT is covered in detail later. 29  PassKey EA Review 2024-2025 Edition Tax Return Due Dates and Extensions The normal due date for individual tax returns is April 15. If April 15 falls on a Saturday, Sunday, or legal holiday, the due date is extended until the next business day. The IRS will accept a postmark as proof of a timely filed return. A tax return is considered filed “on time” if the envelope is properly addressed, postmarked, and deposited in the mail by the due date. For example, if a tax return is postmarked on April 15 but does not arrive at an IRS service center until April 30, the IRS must accept the tax return as having been filed on time. This is also called the “mailbox rule.” E-filed tax returns are given an “electronic postmark” to indicate the day they are accepted and transmitted to the IRS. In cases where a tax return is filed close to the deadline, it is highly advisable for a taxpayer to pay for proof of mailing or certified mail. Example: Seraphina is an enrolled agent who specializes in handling tax returns. One of her clients, Watson, is a single father to his 14-year-old daughter, Emily, and provides all financial support for her. On April 15, 2024, Seraphina attempts to electronically file Watson’s 2023 tax return but it is rejected due to someone else already claiming Emily as a dependent. Watson suspects that his estranged ex- wife may have tried to claim their daughter, but he has no way of confirming or contacting her. Upon realizing the issue cannot be resolved electronically, Seraphina advises filing a paper return instead. She prints out the necessary forms for Watson and he signs them with an original ink signature before they are sent via certified mail before the post office closes. The return is considered timely and undergoes regular processing. Approximately eight weeks later, Watson receives his full refund. If a taxpayer cannot file by the due date, the taxpayer may request an extension by filing Form 4868, Application for Automatic Extension of Time to File, which may be filed electronically. The extension must be filed by the original due date. An extension grants an additional six months to file a tax return. Note: Although an extension gives a taxpayer extra time to file a return, it does not extend the time to pay any tax due. Taxpayers must estimate and pay taxes by the original filing deadline. Filing Deadline Exceptions Federal Disaster Areas: Taxpayers in federally declared disaster areas (FEMA disasters) are granted postponements to file and pay their income taxes and to make estimated tax payments. The IRS may also abate interest and any late filing or late payment penalties that apply to taxpayers in these disaster areas. This type of tax relief generally includes: Individuals and businesses located in a disaster area, Those whose tax records are located in a disaster area, and Relief workers who are working in the disaster area. A taxpayer does not have to be physically located in a federally declared disaster area to qualify as an “affected taxpayer.” Taxpayers are also considered “affected” if the records necessary to meet a filing or payment deadline postponed during the relief period are located in a covered disaster area. Therefore, disaster relief also applies to tax preparers (and their clients) who are unable to file returns or make payments on behalf of their clients because of a disaster. 30  PassKey EA Review 2024-2025 Edition Example: Declan owns a 30% interest in a partnership that is located in a federally-declared disaster area. However, Declan himself does not live in the disaster zone. Since he must rely on the information (Schedule K-1) from the partnership to file his individual tax return, he qualifies as an “affected taxpayer” for purposes of receiving filing and payment relief. Declan’s filing and payment deadlines are suspended until the end of the postponement period, just like the affected partnership. June 15 Deadlines (Automatic Two-Month Extension) Three groups of taxpayers are granted an automatic two-month extension to file: Nonresident aliens who do not have wage income subject to U.S. withholding, U.S. citizens or legal U.S. residents who are living outside the United States or Puerto Rico, and their main place of business is outside the U.S. or Puerto Rico, Taxpayers on active military service duty outside the U.S. A citizen or resident alien living abroad must attach a statement to their tax return, explaining which situation qualifies for this special two-month extension. Even if allowed an extension, the taxpayer will have to pay interest on any tax not paid by the regular tax deadline of April 15. December 15 filing extension: For most Americans and U.S. residents living abroad, the six- month extension to October 15 is sufficient. However, a taxpayer who resides outside the United States can request an additional “discretionary” two-month extension of time to file their tax return beyond the regular six-month extension of October 15. For calendar-year taxpayers, the “additional” extension date would be December 15.19 Unless the extension request is denied, the taxpayer will not receive a response from the IRS. Example: Isabella is a U.S. citizen residing and working in Portugal. She has already requested a 6- month extension for filing her tax return using Form 4868. However, she realizes that she may require more time to ensure the accuracy and completeness of her return, as she is still waiting on essential financial documents from a Portuguese bank that has paid her interest during the year. Without these documents, Isabella fears that her income tax return will not be accurate. Luckily, as an expatriate living abroad, she has the option to obtain an additional 2-month extension, giving her until December 15th to file her U.S. tax return. Special Exception for Combat Zones: The deadline for filing a tax return, claim for a refund, and the deadline for payment of tax owed, is automatically extended for any service member, Red Cross personnel, accredited correspondent, or contracted civilian serving in a combat zone. These taxpayers have their tax deadlines suspended from the day they started serving in the combat zone until 180 days after they leave the combat zone. The deadline postponement provision also applies to estate, gift, employment, and excise tax returns. These deadline extensions also apply to the spouses of armed service members serving in combat zones. The extension applies to both spouses whether joint or separate returns are filed. 19 In addition to the normal 6-month extension, taxpayers who are out of the country can request a discretionary 2-month additional extension of time to file their returns (to December 15). See Publication 54 for complete instructions on how to request this extension. 31  PassKey EA Review 2024-2025 Edition Example: Ramon is a U.S. Marine who has served in a combat zone since March 1, so he is entitled to extra time to file and pay his taxes. The 46 days between the date he entered the combat zone and the normal April 15 filing deadline are added to the normal extension period of 180 days, so he has a 226- day extension period after he leaves the combat zone. IRS deadlines for assessment and collection are also suspended during any period that a U.S. service member is in a combat zone. Penalties and Interest The IRS can assess a penalty on individual taxpayers who fail to file, fail to pay, or both. The failure- to-file penalty is greater than the failure-to-pay penalty. If someone is unable to pay all the taxes they owe, they are better off filing on time and paying as much as they can. The IRS will consider payment options for taxpayers. These penalties can be abated if the taxpayer qualifies for an administrative waiver, or can establish that there was a reasonable cause for not paying or filing on time. Common penalties include: Failure-to-file: When a taxpayer does not file their tax return by the return due date (or extended due date, if an extension to file is requested and approved). Failure-to-pay: When a taxpayer does not pay the taxes reported on their return in full by the due date, April 15. An extension to file does not extend the time to pay. Failure to pay properly estimated tax: When a taxpayer does not pay enough taxes due for the year with their quarterly estimated tax payments (or through withholding) when required. Interest on the amount due: In addition to filing penalties, the taxpayer will also be charged interest on the amount due. Failure-to-File Penalty: The penalty for filing Form 1040 late is usually 5% of the unpaid taxes for each month or part of a month that a return is late. The penalty is based on the tax that is not paid by the due date. This penalty will not exceed 25% of a taxpayer’s unpaid taxes. If both the failure-to-file penalty and the failure-to-pay penalty apply in any month, the 5% failure- to-file penalty is reduced by the failure-to-pay penalty. For the tax year 2023 (for returns filed in 2024), the failure-to-file penalty is as follows: 5% of the unpaid balance per month (or part of a month) for a maximum penalty of 25% of the unpaid tax. However, if the failure to file on time is determined to be fraudulent, the penalty is 15% of the unpaid balance per month (or part of a month) for a maximum penalty of 75% of the unpaid tax. For returns filed more than 60 days late, the penalty shall not be less than the lesser of (1) $485 or (2) 100% of the tax due on the return. Example: Lenny does not file his tax return on time, or request an extension, because he believes that he does not owe any income tax this year. When he finally gets around to filing his return, Lenny discovers that he owed $25 in taxes. He files his return on July 30, and pays the amount due, but his return is over 60 days late. He later receives a bill with a late filing penalty of $25, which is 100% of the tax that was due on his return. He will also owe a small late payment penalty of $2, as well as interest on the amount due. 32  PassKey EA Review 2024-2025 Edition Failure-to-Pay Penalty: If a taxpayer does not pay their taxes by the original due date (determined without regards to any extension), the taxpayer could be subject to a failure-to-pay penalty of ½ of 1% (0.5%) of unpaid taxes for each month, or part of a month, after the due date that the taxes are not paid. This penalty can be as much as 25% of the unpaid taxes on the return. The failure-to-pay penalty rate increases to a full 1% per month for any tax that remains unpaid the day after a demand for immediate payment is issued, or ten days after notice of intent to levy certain assets is issued. Note: A taxpayer may request penalty abatement due to “reasonable cause.” Acceptable reasons for abatement include: fire, casualty, natural disaster or other disturbances, inability to obtain records due to a casualty or a disaster, death, serious illness, incapacitation, or unavoidable absence of the taxpayer or a member of the taxpayer’s immediate family. The failure-to-file penalty is reduced by the failure-to-pay penalty if both penalties apply. No penalty will be assessed if the taxpayer is due a refund. If a taxpayer files their return on time, but does not pay on time, then only the 0.5% failure-to-pay penalty will be assessed, which will increase per month until 25% is reached. Example: Ximena does not have all her paperwork ready to file her return on April 15, so she requests an extension. She is not sure if she owes taxes or not, because she is waiting for a copy of a brokerage statement that was lost in the mail. Ximena finally receives her missing documents and files her return on October 1, before the extended deadline. She owes $1,000 in tax, which she pays electronically when she files her return. She does not owe a late filing penalty, because her return was filed on time (on extension). However, she will owe a late payment penalty of approximately $30. She will also owe a small amount of interest on the amount due. Interest on the Amount Due: In addition to penalties, the taxpayer will also be charged interest on the amount due. Generally, interest accrues on any unpaid tax from the due date of the return until the date of payment in full. The interest rate is determined quarterly and is the federal short-term rate plus 3%. Interest compounds daily. Unlike late filing penalties, interest cannot be reduced or abated for reasonable cause. Taxpayers may request abatement of interest by filing Form 843, Claim for Refund and Request for Abatement, or by submitting a request by letter. Interest will only be abated in extremely unusual circumstances, such as in the case of a mathematical error made by the IRS. Example: Nicole died two years ago. She had a filing requirement when she passed away. However, Nicole died without a will, and an executor was not named by the probate court until November 10, 2023. Nicole’s brother, Ezequiel, was named the executor. Ezequiel filed two years of delinquent tax returns on behalf of his deceased sister, and also requested a penalty abatement for filing Nicole’s final tax returns late. The IRS granted the penalty abatement, although the interest on the amount due was not abated and still had to be paid by Nicole’s estate. As the executor, Ezequiel would be responsible for filing and signing all his late sister’s tax returns and making sure her estate pays any assessed tax. Note: These are the penalties that apply to individual taxpayers only. Different penalty amounts apply to business entities, which are covered in detail in Book 2, Businesses. 33  PassKey EA Review 2024-2025 Edition Estimated Taxes for Individuals The federal income tax is a “pay-as-you-go” tax. This means that people need to pay most of their tax during the year, as they earn income. This can be done either through withholding or estimated tax payments. Estimated tax payments can be used to pay income tax, self-employment tax, and alternative minimum tax. For taxpayers who are working as employees and wish to increase (or decrease) their withholding amounts, they must use Form W-4, Employee’s Withholding Certificate. The Form W-4 is not submitted to the IRS. Instead, it is submitted to the taxpayer’s employer. Safe Harbor Rule: Taxpayers can avoid making estimated tax payments by ensuring they have enough tax withheld from their income. A taxpayer must generally make estimated tax payments if: They expect to owe at least $1,000 in tax (after subtracting withholding and tax credits) They expect the total amount of withholding and tax credits to be less than the smaller of: o 100% of the tax liability on their prior-year return o 90% of the tax liability on their current year return Example: Harvey earned $95,000 during 2023 and paid $8,200 in tax, which was enough to cover his tax liability for the year. Although Harvey expects his income to increase in 2024, he will not be assessed a penalty for underpayment of estimated taxes, provided he pays at least $8,200 in estimated tax during the year (100% of the tax liability on his prior year return). Safe Harbor Rule for Higher-Income Taxpayers: If the taxpayer’s adjusted gross income was more than $150,000 ($75,000 if MFS), the taxpayer must pay the smaller of 90% of their expected tax liability for the current year or 110% (instead of the normal 100%) of the tax shown on their prior- year return to avoid an estimated tax penalty. Example: Massimo earned $205,000 in 2023. After applying all his deductions and credits, he had a $30,000 tax liability for the year. In 2024, he expects his income to increase substantially. He estimates that he will earn over $450,000. As long as Massimo pays at least 110% of his tax liability for the prior year (110% × $30,000 = $33,000), he will not owe an estimated tax penalty, regardless of how much he owes when he files his 2024 return. A taxpayer will not face an underpayment penalty if the total tax liability on their return (minus the amounts of tax credits or paid through withholding) is under $1,000. Example: Yvonne is a full-time secretary. She also earns money part-time as a self-employed manicurist. She did not make any estimated payments during the year. However, Yvonne made sure to increase her withholding at her regular job to cover any amounts that she would have to pay on her self-employment earnings. When she files her tax return, she discovers that she still owes $750. She files her return and pays the full amount of tax ($750) on April 15, which is the filing deadline. Although she is responsible for paying the additional tax that she owes, she will not owe an underpayment penalty because her total tax liability, after withholding, is still less than $1,000 for the year. A U.S. citizen or U.S. resident is not required to make any estimated tax payments if they had zero tax liability in the prior year. However, late payment penalties will generally apply if a taxpayer does not pay the taxes they owe by April 15, 2024 (the filing deadline), regardless of whether an extension is filed or not. 34  PassKey EA Review 2024-2025 Edition Example: Edgar, 27 and single, earned $4,700 in wages before he was laid off in the prior year. He did not file a tax return or pay any income tax that year because his income was below the filing requirement. In 2023, he started working as a self-employed rideshare driver. He paid no estimated tax during the year. He files his 2023 return on March 30, 2024, and discovers that he owes $5,000 in tax. Although Edgar owes the full amount of tax, he will not owe an underpayment penalty as long as he pays the full amount due by April 15, 2024, because he had zero tax liability in the prior year. Estimated Tax Due Dates for Most Individuals The year is divided into four payment periods for estimated taxes, each with a specific payment due date. If the due date falls on a Saturday, Sunday, or legal holiday, the due date is the next business day. A taxpayer must complete Form 1040-ES, Estimated Tax for Individuals, to pay estimated tax. If a payment is mailed, the date of the U.S. postmark is considered the date of payment. First Payment Due: April 15 Second Payment Due: June 15 Third Payment Due: September 15 Fourth Payment Due: January 15 (of the following year) To calculate an estimated tax penalty, or to request a waiver of the penalty, taxpayers use Form 2210, Underpayment of Estimated Tax by Individuals, Estates and Trusts. The IRS may waive the underpayment penalty in certain situations, such as when a taxpayer’s income varies throughout the year. For instance, if a taxpayer’s business operates on a seasonal basis or if a person receives a large capital gain towards the end of the year. This is called the “annualized income installment method.” Example: Camila is self-employed as a hairdresser. She usually makes estimated payments throughout the year. Her income doesn’t usually fluctuate much during the year, and she usually makes estimated payments of $500 each quarter. However, at the very end of the year, on December 25, 2023, she receives a large sum from a bridal contract where she was hired to do makeup and hairstyling for a big wedding party. Because of this, she will owe a lot more tax for the year. She plans to increase her final estimated tax payment for the year, but she also wants to avoid an estimated tax penalty. Since a large sum was received by her in December, she can use Form 2210 to report the large variance in her taxable income. By using the annualized income installment method, she can avoid a penalty. Estimated Taxes for Farmers and Fishermen Special rules apply to the payment of estimated tax by qualified farmers and fishermen (those who file on Schedule F). If at least two-thirds of the taxpayer’s gross income in the current year comes from (or in the prior year came from) farming or fishing activities, the following rules apply: March 1 deadline: The taxpayer does not have to pay estimated tax if he files his return and pays all tax owed by the first day of the third month after the end of his tax year (generally, this is March 1). January 15 deadline: If the taxpayer must pay estimated tax, he is required to make only one estimated tax payment (called the “required annual payment”) by the fifteenth day after the end of his tax year (for individuals, this is usually January 15). 35  PassKey EA Review 2024-2025 Edition For this special tax treatment, “qualified farming income” includes gross farming income on Schedule F, gross farming rental income, gains from the sale of livestock, and crop shares for the use of a farmer’s land. This rule also applies to qualified fishermen. Note: If a qualified farmer (or fisherman) files their 2023 Form 1040 by March 1, 2024, and pays all the tax they owe at that time, they do not need to make any estimated tax payments during the year. This rule does not apply to any other type of business activity—it only applies to farmers and fishermen. Example: Naomi’s sole source of income is her organic strawberry farm, and she reports all of her business profits on Schedule F. Since she is a qualified farmer, she is not required to make quarterly estimated tax payments. On February 28, 2024, Naomi filed her 2023 tax return, including a check for the full balance of $9,900. Because she submitted her return and paid the full amount due before March 1, 2024, she will not face any penalties for underpaying estimated taxes, regardless of the amount she owes. Example: Granville is a self-employed owner of a commercial oyster farm. He reports his income and loss on Schedule F. All his income is from farming, so he is not required to pay quarterly estimated taxes. However, his bookkeeper quits at the end of the year, and Granville’s bookkeeping records are incomplete, so he asks his tax accountant to file an extension on his behalf. Granville tells his accountant that he will be unable to file his 2023 tax return by March 1, 2024. Since he cannot comply with the March 1 deadline, and he did not make any estimated payments during the previous year, Granville is required to make a single payment of estimated taxes by January 15, 2024 to avoid an underpayment penalty. Example: Aaron is a farmer who grows hothouse orchids and sells them to florists in his community and online. He makes a tidy profit selling the flowers every year. Aaron also earns a considerable sum as an occasional handyman. In 2023, his net income from farming is $47,000. His net income from his handyman business is $33,000. Since two-thirds of his income is not from farming activities, Aaron is not eligible for the special rule for estimated payments. He is required to pay quarterly estimates throughout the year, just like every other business. Note: This special estimated tax rule also applies to a person’s share of gross income from partnerships, where the majority of the income is derived from farming or fishing. This safe harbor for estimated payments does not apply to C corporations, regardless of the business activity. Backup Withholding There are times an entity is required to withhold certain amounts from a payment and remit the amounts to the IRS. For example, the IRS requires backup withholding if a taxpayer’s name and Social Security number on Form W-9, Request for Taxpayer Identification Number and Certification, does not match its records. The IRS will sometimes require backup withholding if a taxpayer has a delinquent tax debt, or fails to report all their interest, dividends, and other income. Payments that are subject to backup withholding may include: wages, interest, dividends, rents, royalties, and payments to independent contractors. 36  PassKey EA Review 2024-2025 Edition Backup withholding also applies following notification by the IRS, where a taxpayer underreported interest or dividend income on their federal income tax return. To stop backup withholding, the payee must correct any issues that caused it. They may need to give the correct TIN to the payor, resolve the underreported income and pay the amount owed, or file a missing return. The current backup withholding rate in 2023 is 24% for all U.S. citizens and legal U.S. residents. Generally, backup withholding applies only to U.S. citizens, and resident aliens; not to nonresident aliens. However, a nonresident alien may be subject to withholding, as well. Most types of U.S. source i