IRS Enrolled Agent Examination Guide PDF

IRS ENROLLED AGENT EXAMINATION INTRODUCTION AND TIPS INTRODUCTION AND Q & A's The Internal Revenue Service Special Enrollment Examination is offered Once each year for individuals who wish to be enrolled to practice before the Internal Revenue Service (Enrolled Agents). It is comprised of four parts. Candidates must take all four parts of the examination in the first year. Those who pass at least one part of the examination in the first year may take the failed parts in the following three years with these provisions: Candidates must achieve the minimum retention score on EACH part failed in the first year. The minimum retention score is 90 percent of the passing score set for the part(s) failed. Candidates MUST take ALL failed parts of the examination in the second year, all remaining parts the third year, and all remaining parts the fourth year. Candidates must achieve a score no less than 90 percent of the passing score for any parts taken in the second and third years in order to remain eligible to try again. That is to say that if you score below the minimum retention score on any part taken in the second or third year, you would be required to retake the examination in its entirety should you wish to continue. Candidates who do not pass all four parts of the examination by the end of the fourth year must start over again. Candidates who pass three of the four parts the first year do NOT have to achieve the minimum retention score on the part failed. Therefore, they would be required to take only the part failed the following year. IMPORTANT DATES Exam Applications available from IRS call 800-829-3676 June 1 Deadline to submit exam applications to IRS July 31 www.dynastyschool.com 1 IRS ENROLLED AGENT EXAMINATION INTRODUCTION AND TIPS Questions & Answers Question: If an individual is unable to retake the examination in a subsequent year, would he/ she lose credit for examination parts passed? Answer: Yes, in most cases, since the examination assumes continuity. However, if the candidate is able to give compelling reasons for a waiver, e.g. serious illness or a death in the family, it could be granted. Question: In the above situation, does the candidate still have only four years to complete the examination successfully or is the candidate allowed additional years? Answer: The years a candidate misses taking the examination under a waiver will not count against the four years. Each waiver would extend the period one year. However, there is a six year [imitation. That is, the candidate must complete the examination successfully within six years if granted any waiver, including years for which waivers are granted. Question: May an individual change the district in which he/she takes the examination from year to year? Answer: Yes. Question: Would an individual who passed one or more parts of the examination in the first year and again failed the parts he/she had to take in the second year be able to carry over first year credit? Answer: Yes. The candidate would retain credit for any part passed iii the first year for the remaining three years, provided he/she met the minimum retention score and parts required to be taken conditions as set forth above. Question: What if an individual took all four parts of the examination in 1996 and did not pass any of the four parts? Answer: The four year requirement does not take effect until the candidate passes at least one part of the examination. Question: May an individual take one part of the examination per year for four years? Answer: No. Candidates must take all four parts the first year, all failed parts the second year, all remaining failed parts in the third year, and all remaining failed parts in the fourth year. Question: How many years may an individual take the examination without passing at least one part? Answer: There is no limit. www.dynastyschool.com 2 IRS ENROLLED AGENT EXAMINATION INTRODUCTION AND TIPS TIPS TO PASS THE EXAM Because the tax information is enormous, so we have extracted the key points relating to the examination together with "exercises" to form a four-part WORKBOOK. We recommend you study the WORKBOOK and the PAST IRS EXAMINATIONS AND QUESTIONS we supplied to you. You do not need to study all the IRS publications (SEE Package), you should use them as the indispensable references. Use the enclosed Special Enrollment Examination (SEE) Study Material Request and Mailing Label attached to order your IRS publications. (next page) Study the important Q-Cards (index cards) we prepared for you. These index cards contain the key information on topics relating to the IRS EA exam. You are not allowed to bring a calculator into the exam, so practice those computation questions by hand. Pay more attentions to the computational questions in Section C first. These questions are worth 3 points each and it is important you finish them first. Answer the TRUE/FALSE questions (Section A)) last, because they are worth one point each and you have a 50% chance of picking the right answer. Many of the questions on Part 4 can be answered using common sense. The IRS likes to ask a few esoteric questions that will not be familiar to you. Read the questions carefully, if the question sounds like it makes sense, mark true. Most of the true questions in Section A are statements right out of the IRS publications, IRC code, or regulations. Make sure you memorize all those true questions. On the last five year's exams if you had answered true to every questions on Section A, you would have passed that section of the exam. Do NOT attempt to learn every specific details of the tax law. You cannot. We have designed this course to give you "enough" tax information to pass all four parts of the exam the first time. The passing grade for last five years exams were between 50% to 58%. We have prepared you to pass the exam. The rest is on your hands. GOOD LUCK TO YOUR EXAM & BEST WISHES TO YOUR CARRIER AS AN EA. Dynasty School d:\inst\tax\tips.doc www.dynastyschool.com 3 IRS ENROLLED AGENT EXAMINATION INTRODUCTION AND TIPS This page intentional blank. www.dynastyschool.com 4 IRS ENROLLED AGENT EXAMINATION INTRODUCTION AND TIPS Special Enrollment Examination (SEE) Study Material-Request and Mailing Label You may request the SEE Kit by internet: www.irs.gov/pub/irs-fill/f2587.pdf or you may order, free of charge, the IRS publications which provide much of the basic information to assist you in the preparation for the examination. In addition, IRS produces most of the information included in the SEE kit electronically on “The Federal Tax Products” CD-ROM (Publication 1796). Electronic or CD-ROM (publication 1796) Version of the 2001 See Kit Study Material (plus the Printed Copy Version of Items not included on the CD-ROM). Please send me the printed Version of SEE kit Study Material and CD-ROM ROM Publication 1796. Please complete the lower portion of this page and mail it to the address listed below. Please print “SEE “ in the lower left front corner of your envelope. (Please do not send this form with your application Form 2587) Send to: IRS Western Area Distribution Center Rancho Cordova,. CA. 95743-0001 Return label - Fill in your name and address below. Please expedite shipment of the Special Enrollment Examination Study Material to: SEE Study Material Pamphlet Name Street City State Zip www.dynastyschool.com 5 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS 1. PART 1 - INDIVIDUALS TABLE OF CONTENTS 1. PART 1................................................................................................................ 1-1 INTRODUCTION....................................................................................................... 1-3 PART 1 - THE INCOME TAX RETURN.................................................................... 1-4 1. Filing Requirements......................................................................................... 1-4 2. Filing Status.................................................................................................... 1-10 3. Personal Exemptions and Dependents.......................................................... 1-14 4. Decedent's Return.......................................................................................... 1-19 5. Estimated Tax................................................................................................ 1-20 PART 2 – INCOME................................................................................................. 1-23 6. Accounting...................................................................................................... 1-23 7. Wages, Salaries, and Other Earnings............................................................ 1-24 8. Tip Income...................................................................................................... 1-29 9. Interest Income............................................................................................... 1-30 10. Dividends and Other Corporate Distributions................................................. 1-37 11. Rental Income and Expenses......................................................................... 1-41 12. Social Security and Equivalent Railroad Retirement Benefits........................ 1-49 13. Other Income.................................................................................................. 1-50 PART 3 - GAINS AND LOSSES.............................................................................. 1-55 14. Basis of Property............................................................................................ 1-55 15. Sales and Trades........................................................................................... 1-67 16. Reporting Gains and Losses.......................................................................... 1-75 17. Selling Your Home (Pub. 523)........................................................................ 1-91 PART 4 - ADJUSTMENTS, DEDUCTIONS, CREDITS AND TAXES.................... 1-103 18. Individual Retirement Arrangements (IRAs)................................................. 1-103 19. Moving Expenses......................................................................................... 1-118 20. Alimony........................................................................................................ 1-120 PART 5 - STANDARD DEDUCTION AND ITEMIZED DEDUCTIONS.................. 1-123 21. Standard Deduction...................................................................................... 1-123 22. Limit on Itemized Deductions (Pub. 17)........................................................ 1-123 23. Medical and Dental Expenses...................................................................... 1-124 24. Taxes........................................................................................................... 1-129 25. Interest Expense.......................................................................................... 1-131 26. Contributions................................................................................................ 1-133 27. Nonbusiness Casualty and Theft Losses..................................................... 1-138 28. Travel, Transportation, and Other Employee Business Expense................. 1-140 29. Employee's Educational Expenses............................................................... 1-152 Dynasty School (www.dynastySchool.com). 1-1 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS 30. Miscellaneous Deductions............................................................................ 1-154 PART 6 - FIGURING YOUR TAXES AND CREDITS............................................ 1-158 31. How To Figure Your Tax.............................................................................. 1-158 32. Tax on Investment Income of Certain Minor Children.................................. 1-160 33. Child and Dependent Care Credit................................................................ 1-161 34. Credit for the Elderly and Disabled............................................................... 1-164 35. Child Tax Credit............................................................................................ 1-165 36. Education Credits......................................................................................... 1-166 37. Earned Income Credit (EIC)......................................................................... 1-169 38. Other Credits................................................................................................ 1-173 Dynasty School (www.dynastySchool.com). 1-2 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS INTRODUCTION Part 1 of the exam covers individual returns. The exam consists of three sections: “A” is true or false questions, "B" is multiple choice, and "C" is multiple choice requiring some computation. The exam follows Form 1040 and Publication 17. For example, the first questions in each section will start with issues discussed in Part One of Publication 17 and then work through the publication. MAIN TOPICS Section A The Income Tax Return Section B Income Section C Gains and Losses Section D Adjustments, Deductions, Credits, and Taxes STUDY MATERIALS The official answers are based on the code and regulations. Generally, the publications reflect the code and regulations and will be sufficient for study purposes. The following publications will be helpful in preparing for Part 1 of the exam: Publication 17 Tax Guide For Individuals Publication 501 Exemptions, Standard Deduction, and Filing Information Publication 502 Medical and Dental Expenses Publication 503 Child and Dependent Care Expenses Publication 504 Divorced or Separated Individuals Publication 505 Tax Withholding and Estimated Tax Publication 508 Tax Benefits for Work-Related Education Publication 523 Selling Your Home Publication 525 Taxable and Nontaxable Income Publication 535 Business Expenses Publication 537 Installment Sales Publication 544 Sales and Other Dispositions of Assets Publication 547 Nonbusiness Disasters, Casualties, and Thefts Publication 550 Investment Income and Expenses Publication 551 Basis of Assets Publication 553 Highlights of 20xx Tax Changes Publication 925 Passive Activity and At-Risk Rules Publication 926 Employment Taxes for Household Employers Dynasty School (www.dynastySchool.com). 1-3 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS PART 1 - THE INCOME TAX RETURN 1. Filing Requirements A. General Rules: If you are a U.S. citizen or resident, whether you must file a federal income tax return depends upon your gross income, your filing status, your age, and whether you are a dependent. The filing requirements apply even if you owe no tax. You may have to pay a penalty if you are required to file a return but fail to. If you willfully fail to file a return, you may be subject to criminal prosecution. 1. Gross Income - All income received in the form of money, property, and services that is not exempt from tax. 2. Filing Status - As determined on the last day of the tax year. 3. Age - Considered 65 on the day before one's 65th birthday. B. Exemption: The amount you can deduct for each exemption has increased from $2,800 in 2000 to $2,900 in 2001. * Study Tip * An individual must file if gross income equals or exceeds the sum of one's exemption amount and standard deduction. These amounts are used to form the table showing gross income filing requirements. C. Gross Income Filing Requirements For Most Taxpayers (Table 1 Pub. 501) Filing Status Age 2001 2000 Gross Income Gross Income S Under age 65 $7,450 $7,200 Age 65 or older $8,550 $8,300 HH Underage 65 $9,550 $9,250 Age 65 or older $10,650 $10,350 MFJ Both under age 65 $13,400 $12,950 One spouse 65 or $14,300 $13,800 older $15,200 $14,650 Both spouses 65 or older Dynasty School (www.dynastySchool.com). 1-4 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS MFS* Any age $2,900 $2,800 QW Under age 65 $10,500 $10,150 Age 65 or older $11,400 $11,000 No standard deductible allowed. D. A self-employed individual is required to file if the gross income, including gross business income, is at least as much as the filing requirements for the individual's marital status and age or the net earnings from self-employment is at least $400. (see Pub. 533) Note: If you are self-employed in a business that provides services (where products are not a factor), gross income is gross receipts from that business. If you are self-employed in a business involving manufacturing, merchandising, or mining, gross income is total sales from that business minus the cost of goods sold. To this figure, you add any income from investments and from incidental or outside operations or sources. E. A taxpayer is required to file in other situations even if the gross income filing requirements are not met. 1. The taxpayer owes any special taxes: a) Social Security and Medicare tax on unreported tips, b) Uncollected Social Security tax and Medicare tax on reported tips, c) Uncollected Social Security on group term life insurance, d) Alternative minimum tax, e) Tax on an IRA or qualified retirement plan, or f) Tax from recapture of investment credit, low-income housing credit, federal mortgage subsidy, or qualified electric vehicle credit. 2. The taxpayer received wages from a church or church related organization exempt from employer Social Security and Medicare tax. 3. The taxpayer received advanced earned income credit payments from an employer. F. The gross income filing requirements is different for dependents. (See Table 2, Pub. 501: 2000 Filing Requirements for Dependents). Table 2: 2001 Filing Requirements for Dependents (Pub. 501) Dependent 2001 Must File If: Dynasty School (www.dynastySchool.com). 1-5 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS Status Single, under 65, You must file a return if any of the following apply not blind Your earned income was more than $4,550 Your unearned income was more than $750. Your gross income was more than the larger of $750 or Your earned income (upto $4,300) plus $250. Single, 65 or Earned income was more than $5,650 ($6,750 if 65 older or blind or over and blind), or Unearned income more than $1,850 ($2,950) if 65 or over and blind), or Gross income was more than the total of earned income (up to $4,300) plus 250 or $750, whichever is larger, plus $1100 ($2,200 if 65 or over and blind). Married, under Gross income at least $5, spouse files MFS and 65, not blind itemizes deductions. Your earned income was more than $3,800, or Your gross income was more than the larger of $750 or Your earned income (upto $3,550) plus $250. Married, 65 or Earned income was more than $4,700 ($5,600 if 65 older or blind or over and blind), or Unearned income was more than $1,650 ($2,550 if 65 or over and blind), or Gross income was more than the total of earned income (up to $3,550) plus $250 or $750, whichever is larger, plus $900 ($1,800 if 65 or older and blind). Exercise 1: Rosa, who turned 14 on December 1, 2001, received interest income of $700 during 2001. Rosa did not make any estimated tax payments or have any federal income tax withheld. She had no other income. Rosa is properly claimed as a dependent by her parents. Rosa is required to file an income tax return for 2001. (True or False) False. For 2001, a return must be filed by any dependent who is single, under age 65, and has received unearned income in the amount of $750 or more. Dynasty School (www.dynastySchool.com). 1-6 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS G. The standard deductions for 2001 The standard deduction for an individual for whom an exemption can be claimed on another person's tax return is generally limited to the greater of: 1. $750, or 2. The individual's earned income for the year plus $250 (but not more than the regular standard deduction amount, generally $4,550). However, if the individual is 65 or older or blind, the standard deduction may be higher. See Pub 501: Exemptions: Standard Deduction Charts & Worksheets. Filing Status 2001 2000 Amount Amount Single (S) $4,550 $4,400 Married Filing Jointly (MFJ) or $7,600 $7,350 Qualified Widow(er) With Dependent Child (QW) Married Filing Separately (MFS) $3,800 $3,675 Head of Household (HH) $6,650 $6,450 * An additional standard deduction is available for the taxpayer and spouse if age 65 or over or blind. The additional amount for blindness is part of the standard deduction but is not used for determining gross income filing requirements. See chart below. (10311g29.gif, pub 17, ch21.) Dynasty School (www.dynastySchool.com). 1-7 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS Dynasty School (www.dynastySchool.com). 1-8 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS Example: Michael is single. His parents claim an exemption for him on their 2001 tax return. He has interest income of $780 and wages of $150. He has no itemized deductions. Michael uses Table to find his standard deduction. He enters $150 (his earned income) on line 1, $400 ($150 plus $250) on line 3, $750 (the larger of $400 and $750) on line 5, and $4,550 on line 6. The amount of his standard deduction, on line 7a, is $750 (the smaller of $750 and $4,550). Due Dates A. Form 1040: 1. Calendar year taxpayers should have filed by April 15, each year. 2. Fiscal year taxpayers should file by the 15th day of the 4th month after the close of the tax year. 3 With the automatic 4-month extension obtained by filing Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return, a calendar year return is due August 15, each year. Note: The automatic extension of time to file is not an automatic extension of time to pay. 4 With a second extension obtained by filing Form 2688, Application for Additional Extension of Time To File US individual Income Tax Return, the due date for a calendar year return is October 15, each year. The second extension is for two months and is not automatic. it should be filed early enough to get IRS approval. B. A special automatic 2 month extension to file and pay is available: 1. if the taxpayer is living outside of the US and the main place of business or post of duty is outside of the U.S., or the taxpayer is in the military or naval services on duty outside of the U.S. 2. By attaching a statement to the return when it is filed. C. Form 1040NR for Nonresident Aliens: 1. Nonresident aliens with wages subject to U.S. income tax withholding have the same due dates as residents of the U.S. Dynasty School (www.dynastySchool.com). 1-9 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS 2. Nonresident aliens who do not have wages subject to U.S. income tax withholding must file by June 15, (calendar year) or by the 15th day of the 6th month after the end of the fiscal year. D. When the due date for doing any act for tax purposes falls on a Saturday, Sunday, or legal holiday, that act can be done on the next business day. E. Quarterly estimated payments are due on the 15th day of the 4th, 6th, and 9th month of the current year and the 15th day of the first month after the end of the year. F. An amended return or claim for refund generally must be filed within three (3) years from the date the original return was filed or within two (2) years from the date the tax was paid, whichever is later. If the original return was filed before the due date, without extensions, the return is considered to be filed on the due date. G. A balance due on an electronically filed return must have been paid by April 15, to avoid interest and penalties. The payment is submitted with Form 1040-V. 2. Filing Status A. Single (S) - A taxpayer's filing status is single if that taxpayer is unmarried or separated from a spouse by a divorce or separate maintenance decree and does not qualify for another filing status. B. Married Filing Jointly (MFJ) - The taxpayers may choose this status if they are married and both agree to file a joint return. 1. Taxpayers are considered married for the whole year if on the last day of the tax year, they are: a) Married and living together as husband and wife, b) Living together in a common law marriage that is recognized in the state where they now live or in the state where the common law marriage began, c) Married and living apart, but not legally separated under a decree of divorce or separate maintenance, or d) Separated under an interlocutory (not final) decree of divorce. 2. If a taxpayer's spouse died during the year and that taxpayer did not remarry, he or she can file a joint return with the deceased spouse. If the taxpayer did remarry, he or she can file joint with the current spouse, and the deceased individual would file married filing separately Dynasty School (www.dynastySchool.com). 1-10 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS 3. If an individual obtains a court decree of annulment, which holds that no valid marriage ever existed, that individual must file as single or head of household, whichever applies. The individual must also amend all prior years affected by the annulment that are not closed by the statute of limitations. 4. Both taxpayers may be held jointly and individually responsible for any tax, interest, or penalty due on a joint return. This applies to divorce situations for any joint return filed before divorce. A divorce decree stating that one spouse will be liable for any amounts due on prior returns will not relieve either spouse of a joint liability. 5. Under certain circumstances, one spouse may not have to pay the tax, interest, and penalties on a joint return. That spouse must establish that he/she did not know, and had no reason to know, that there was a substantial understatement of tax that resulted because the other spouse: a) Omitted a gross income item, or b) Claimed a deduction, credit, or property basis in an amount for which there is no basis in fact or law. 6. For a return to be a valid joint return, both husband and wife must sign the return. Exercise 2: Mr. and Mrs. Jacobs filed their joint 2001 tax return on April 17, 2002. On June 1, 2001, Mr. Jacobs was arrested and charged with embezzling $50,000 cash from his employer during 2001. Mrs. Jacobs was NOT aware of the embezzlement. The $50,000 was NOT reported on their 2001 return as filed. Concerning the understatement of tax, Mrs. Jacobs may NOT be separately liable for ALL additional tax, penalties, and interest due. (True or False) True. Where a substantial understatement of tax in a joint return is attributable to the grossly erroneous items of one spouse, the other spouse may be an “innocent spouse” and relieved of liability, including interest and penalties, if the innocent spouse had no knowledge of (or reason to know of) the substantial understatement, and, based on all the facts and circumstances, it is inequitable to hold the innocent spouse liable for the deficiency. C. Married Filing Separately (MFS) - Taxpayers may choose married filing separately if they are married on the last day of the tax year. Dynasty School (www.dynastySchool.com). 1-11 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS 1. The taxpayer reports only his or her income, exemptions, credits, and deductions. The taxpayer may claim an exemption for the spouse if that spouse had no earned income and is not a dependent of another. 2. Limitations if MFS is elected: a) If one spouse itemizes, the standard deduction for the other spouse is zero. As such, the other spouse should itemize. There is an exception to the zero standard deduction rule if the other spouse meets the qualifications to be considered unmarried. b) Generally, neither spouse can claim the Child and Dependent Care Credit. c) A MFS taxpayer is not eligible for Earned Income Credit. d) The taxpayer cannot exclude interest from Series EE U.S. Savings Bonds used for higher education. e) Unless spouses lived apart the entire year, a MFS taxpayer cannot take the Credit for the Elderly or Disabled. f) As MFS, more Social Security benefits may be taxable. g) The taxpayer's IRA deduction may be phased out faster. h) The offset against nonpassive income from a rental real estate activity with active participation is reduced to $12,500 (lived apart all year) or $0 (lived together at any time during the year). 3. Amending - Taxpayers can amend and change filing status from MFS to MFJ, but generally cannot change from MFJ to MFS after the due date of the return. D. Qualifying Widow(er) With Dependent Child (QW) - Possible status for two years after the year of the spouse's death. Rules for eligibility: 1. The taxpayer was entitled to file a joint return with the spouse for the year the spouse died. 2. The taxpayer did not remarry before the end of the tax year. 3. The taxpayer has a child, stepchild, adopted child, or foster child who qualifies as a dependent for the year. Dynasty School (www.dynastySchool.com). 1-12 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS 4. The taxpayer paid more than half of the cost of keeping up a home that is the main home for the taxpayer and qualifying child for the entire year. E. Head Of Household (HH) - Applicable if unmarried or considered unmarried on the last day of the tax year, and the taxpayer paid more than half of the cost of maintaining a home for oneself and a qualifying person for over one-half of the tax year. 1. Considered unmarried - The taxpayer must meet all of the following tests: a) File a separate return, b) Pay more than half the cost of keeping up a home for the tax year, c) The spouse did not live in the home during the last six months of the year, and d) The home was, for more than half the year, the main home of the taxpayer's child, stepchild, adopted child, or foster child whom the taxpayer can claim as a dependent. A waiver of exemption or decree of divorce allowing the noncustodial parent to claim the child's exemption does not disallow the HH filing status for the custodial parent. 2. Qualifying person: a) The taxpayer's child, grandchild, stepchild, or adopted child. A single child does not have to be a dependent; a married child must qualify as a dependent. b) Other relatives (must be dependent): Parent Step-father Father-in-law Grandparent Step- mother Mother-in-law Brother Step-brother Brother-in-law Sister Step-sister Sister-in-law Half brother or sister Son-in-law Daughter-in-law Foster child if other rules are met. If related by blood: Nephew, Niece, Uncle, or Aunt. c) A parent does not have to live with the taxpayer if the taxpayer paid more than half the cost of maintaining the parent's home for the entire year. This includes paying more than half the cost of keeping a parent in a rest home or home for the elderly. 3. Keeping up the home (must pay over half of the cost of upkeep). Dynasty School (www.dynastySchool.com). 1-13 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS a) Costs include: rent, mortgage interest, taxes, insurance on the home, repairs, utilities, food eaten in the home, or other expenses related specifically to the home. b) Costs do not include: clothing, education, medical, vacations, life insurance, transportation, rental value of home, or the value of taxpayer services. Exercise 3: Malcolm and Glenda who are legally married lived apart beginning June 1, 2001. Their one minor child lived with Glenda all of 2001. Glenda worked all year and provided more than half the cost of keeping up the home for herself and her minor child Glenda signed Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, allowing Malcolm to claim the exemption for their child on his separately filed return. Glenda's proper filing status is: A. Single B. Married filing jointly C. Married filing separately D. Head of household D. Head of household. A divorced or single parent who otherwise qualifies is entitled to head-of-household filing status even if she is not entitled to the exemption because of a waiver. 3. Personal Exemptions and Dependents A. Personal Exemptions - Each taxpayer is entitled to claim one exemption for himself or herself and if married, one exemption for his or her spouse. 1. If the taxpayer is eligible to be claimed as a dependent on another person's return, the taxpayer is not allowed his or her own personal exemption. 2. Special rules apply if MFS. A spouse is never considered a dependent, however, if the taxpayer's spouse has no gross income and cannot be claimed as a dependent on another person's return, the taxpayer filing MFS can claim the personal exemption for the spouse. B. Dependency Tests - A taxpayer is allowed one exemption for each person he or she can properly claim as a dependent. A person is a dependent if all five (5) of the dependency tests are met. Dynasty School (www.dynastySchool.com). 1-14 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS 1. Member of Household or Relationship test: a) Member of Household - The person must live with the taxpayer the entire year as a member of the household. (1) Before a legal adoption, a child placed with the taxpayer is considered the taxpayer's child if placed there by an authorized agency. If not an authorized agency, the child must live with the taxpayer the entire year. (2) A foster child or adult must live with the taxpayer the entire year (not eligible as dependent if the taxpayer is receiving foster care payments). (3) A cousin will qualify if living with the taxpayer the entire year. (4) An individual temporarily absent due to special circumstances (education, illness, military, etc.) will still be considered as a member of the household. (5) A person who died during the year, but was a member of the household until death, will meet the test. A person who is born during the year and lived in the household the rest of the year will meet the test. (6) A person does not meet the test if at any time during the year the relationship between the taxpayer and the other person violates local law. b) Relationship test - The person does not have to live with the taxpayer. (1) Eligible persons include: child, grandchild, step child, legally adopted child, brother, sister, step-brother, step-sister, half- brother, half-sister, parent, grandparent, other direct ancestor, step parent, aunt, uncle, father-in-law, mother-in- law, sister-in-law, brother-in-law, son-in-law or daughter-in- law. (2) Any of these relationships established by marriage are not ended by death or divorce. 2. Citizenship test - The person must be a U.S. citizen, resident, national, or a resident of Canada or Mexico for some part of the calendar year in Dynasty School (www.dynastySchool.com). 1-15 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS which the taxpayer's tax year begins. Children are usually citizens or residents of the country of their parents. 3. Joint Return test - A dependency exemption is generally not allowed if the dependent files a joint return with his or her spouse. If the other tests are met, the taxpayer may take a dependency exemption if: a) Neither the dependent nor the dependent's spouse are required to file a return, b) Neither the dependent nor the spouse would have a tax liability if they filed separate returns, and c) They only file a joint return in order to get a refund of tax withheld. 4. Gross Income test - A dependency exemption is not allowed if the person had gross income equal to or more than his or her exemption amount. The gross income for 2001 is $2900 (see Pub. 501). The gross income test does not apply to a child under age 19 or a full-time student under age 24. a) Gross income includes all income in the form of money, property, and services that is not exempt from tax. b) A full-time student is a person who is enrolled for the number of hours or courses the school considers to be full-time attendance. The individual must be a student for some part of each of five (5) calendar months during the calendar year. 5. Support test - The taxpayer must provide over one-half of the individual’s total support during the calendar year. Total support includes amounts spent by that individual. In figuring total support, include tax exempt income, savings, borrowed funds, and any other amounts actually used for support. a) Total support includes amounts spent to provide food, lodging, clothing, education, medical and dental care, recreation, transportation, and similar necessities. Expenses not directly related to one person, such as food costs, must be allocated to all family members. Lodging means the fair rental value of the room, apartment, or house in which the person lives. Exercise 4: Ms. Clark purchased a color television set for $250 as a birthday present for her 12-year-old son. The television set is placed in his bedroom. For purposes of Dynasty School (www.dynastySchool.com). 1-16 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS whether Ms. Clark is able to claim her son as a dependent, she should include the cost of the television set in the total support of her son. (True or False) True. The fair market values of capital items, such as furniture, appliances, and cars, that are bought for a person during the tax year may be included in the dependency support computation. b) Support does not include income taxes, Social Security taxes, and Medicare taxes paid by the individual; life insurance premiums; funeral expenses; scholarships for full-time student; or survivor and dependent educational assistance. c) If no one individual provides over half of a person's support but two or more individuals, each of whom would be able to take the exemption but for the support test, together provide more than half of the person’s support, a multiple support agreement can be used. Any one individual who provides more than 10% of the support can claim the exemption if the other providers consent and sign a multiple support agreement. Exercise 5: For 2001, Mr. and Mrs. Randall filed a joint return. During 2001 they provided more than 50% support for the following individuals: The Randall's single son, age 18, was a full-time student for four months. He lived with them all year and he earned $3,500 which was spent on his support. The Randall's single daughter, age 25 and a full-time student for twelve months, lived with them all year. She earned $2,400 which was spent on her support. The Randall's granddaughter, age 3, who lived with them from June to December. Mrs. Randall's mother, age 68, a Canadian citizen living in Canada received social security benefits of $3800. Mrs. Randall's cousin, age 16, lived with them all year and earned $1,200 which was spent on her support. How many exemptions may Mr. and Mrs. Randall claim on their 2001 tax return? A. 7 B. 6 C. 5 D. 4 Dynasty School (www.dynastySchool.com). 1-17 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS A. 7. While Mrs. Randall’s cousin fails to satisfy the relative requirement because she is only a cousin, she qualifies as a dependent because she was a member of the taxpayer’s household for the entire year. Although the son’s earned income ($3,500) was in excess of the 2001 exemption ($2,900), he qualifies because he had not yet attained the age of 19 before December 31, 2001. While Mrs. Randall’s mother’s income ($3,800) exceeded the 2001 deduction amount, her full income from Social Security, which is ordinarily excluded from gross income, is disregarded. 6. An alternate support test is applied for divorced or separated parents. a) The custodial parent is considered to provide more than one-half of the child’s total support (it does not matter whether that parent actually provided more than half) if the following conditions are met: (1) The parents are divorced or legally separated under a decree of divorce or separate maintenance, separated under a written separation agreement, or lived apart at all times for the last six (6) months of the year; (2) One or both parents provide over half of the child's total support for the calendar year; and (3) One or both parents have custody of the child for more than half of the year. b) Custody is usually determined by the terms of the most recent decree of divorce or separate maintenance. If there is no decree, then the written separation agreement applies. If neither is available, then the parent who has physical custody of the child for the greater part of the year is considered to have custody of the child. NOTE: Joint custody seldom works out exactly equal when counting hours per day that each parent has custody. If exactly even, then neither parent has custody for "more than one-half of the year." c) The noncustodial parent will be treated as providing more than half of the child's support if: (1) The custodial parent signs a written declaration that he or she will not claim the exemption for the child and the noncustodial parent attaches it to his or her return (Form Dynasty School (www.dynastySchool.com). 1-18 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, is available for this purpose), (2) A decree or agreement executed after 1984 unconditionally states that the noncustodial parent can claim the child as a dependent, or (3) A decree or agreement executed before 1985 provides that the noncustodial parent is entitled to the exemption and he or she provides at least $600 for the child's support during the year. d) Support provided by a third party for a divorced or separated parent is not included as support provided by that parent. e) If remarried, support provided by the new spouse is included as support provided by that parent. f) The amount of support provided by the noncustodial parent is not reduced by any back child support owed. Any payment of back child support is not support provided for either the year accrued or for the year paid. C. Effective 1997, a Social Security number is required for any dependent claimed on a tax return. Taxpayers who claim dependents living in Mexico or Canada must have Social Security numbers for these dependents. 4. Decedent's Return A. The same filing requirements that apply to individuals determine if a final return is required for a decedent. B. When filing for a decedent, write "DECEASED", the decedent's name, and the date of death across the top of the tax return. C. If a personal representative has been assigned, the personal representative must sign the return. If the return is a joint return with the surviving spouse, the surviving spouse must also sign the return. With no personal representative or surviving spouse, the person in charge of the decedent's property must file and sign as "personal representative". D. For any filer other than a surviving spouse, Form 1310 must be filed to claim a refund for a decedent. Dynasty School (www.dynastySchool.com). 1-19 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS Exercise 6: John Smith, whose father died June 15, 2001, is the executor of his father's estate. John is required to file a final income tax return for his father. When is this return due if he does NOT file for an extension? A. October 17, 2001 B. March 15, 2002 C. April 17, 2002 D. June 15, 2002 C. April 17, 2002. The last date for filing an income tax return for a calendar-year decedent who died in 2001 (absent extensions) is April 17, 2002. 5. Estimated Tax A. General Rule - A taxpayer is required to make estimated payments if he or she expects to owe at least $1000 in tax for year 2001 and after, after subtracting withholding and credits, and expects withholding and credits to be less than the smaller of: 1. 90% of the tax to be shown on the current tax year return, or 2. 110% of the tax shown on your previous year tax return. The previous year return must cover 12 months. B. Exceptions There are exceptions to the general rule if you are a farmer or fisherman, and certain higher income taxpayers. See Publication 505 for more information. C. No estimated tax payment is required if the taxpayer had no tax liability for the previous tax year (tax was zero or the taxpayer was not required to file); the taxpayer was a U.S. citizen or resident for the whole year; and the previous tax year covered a 12-month period. D. For most taxpayers, estimated tax payments are due April 15, June 15, and September 15 of the current year, and January 15 of the next year. Farmers and fishermen have only one payment due date, January 15 (calendar year filers). They would then file their return by April 15. Those who file by March 1 and pay all of the tax owed, do not need to pay estimated tax. Exercise 8: Dynasty School (www.dynastySchool.com). 1-20 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS All of the following individuals file their income tax returns as single. Which is required to make estimated tax payments for 2002? A. Ms. Salinas, who had no tax liability for 2001 expects to owe $1,200 self- employment tax for 2002 (she has no withholding tax or credits). B. Mr. Lane, who had a $1,000 tax liability for 2001 expects $1,100 tax liability for 2002 and withholding of $900. C. Ms. Givonni who had a $4,000 tax liability for 2001 expects a tax liability of $4,400 for 2002 with $3,900 withholding. D. Mr. Charles, who had a 2001 tax liability of $10,000 expects a tax liability of $19,500 for 2002 with $10,500 withholding. C. Ms. Givonni, who had a $4,000 tax liability for 2001, expects a tax liability of $4,400 for 2002 with $3,900 withholding. Ms. Salinas is not required to make estimated tax payments because she had no tax liability in 2001; Mr. Lane is not required to make estimated tax payments because the difference between his withholding and his tax liability for 2001 is less than $1000; Mr. Charles is not required to make an estimated tax payments because the amount withheld for 2002 was at least as great as his tax liability for 2001. E. Underpayment Penalty - If the taxpayer did not have enough paid in through withholding and estimated tax, a penalty can be assessed. 1. General rule: a) A taxpayer may owe a penalty for the tax year if the total of withholding and estimated tax payments did not equal at least the smaller of 90% of the tax year's tax or 100% of the previous tax year. b) The penalty is computed on Form 2210. Form 2210 does not have to be filed unless: (1) The taxpayer requests a waiver. (2) The taxpayer uses the annualized income installment method. (3) The taxpayer uses the actual withholding for each period. (4) The taxpayer based any installment on previous year tax information and filed a joint return in either previous year or this year, but not both. Dynasty School (www.dynastySchool.com). 1-21 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS 2. The taxpayer will generally not have a penalty if: a) Total withholding and estimated tax payments were at least as much as the previous year's tax and special rules do not apply, b) The balance due is less than 10% of the total this year's tax and all estimated payments were timely, c) This year's tax minus withholding is less than $1000, or d) The taxpayer did not owe tax for previous year (an individual had no tax liability if the total tax was zero or the individual was not required to file). Dynasty School (www.dynastySchool.com). 1-22 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS PART 2 – INCOME Income Items Generally Generally Include does NOT include Alimony Accident and health insurance proceeds Bartering income Child support payments Canceled debt income Gifts and inheritances Dividends Housing allowance for clergy Gain on the sale of personal items Interest on state and local government Gambling winnings obligations Income from activity not for profit Life insurance proceeds Interest Meals and lodging provided by Part of Social Security/Railroad employer Retirement benefits Military allowances Pensions and annuities Part of scholarships and fellowship Recoveries of amounts previously grants deducted Part of Social Security/Railroad Rental income Retirement Royalties Veterans' benefits Share of estate and trust income Welfare and other public assistance Share of partnership or S Corp. income benefits Tips Workers' compensation or similar Wages, salaries, and other earnings payments for sickness/injury 6. Accounting A. Cash basis taxpayers report all items of income in the year in which actually or constructively received. Income is constructively received when it is credited to one's account or set apart in a way that makes it available to the taxpayer. Constructive receipt includes the following: 1. Garnished wages used to pay the taxpayer's debts, 2. Profits from brokerage or other similar accounts when earned, 3. Debts canceled or paid by another, 4. Amounts paid to a third party on the taxpayer's behalf 5. Income received by a taxpayer's agent is considered received in the year the agent receives it, and 6. A valid check received or made available even if not cashed. B. Accrual-basis taxpayers report income in the year earned, whether or not actually received. If income is received under an agreement to perform services by the end of the Dynasty School (www.dynastySchool.com). 1-23 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS next tax year, the taxpayer can elect to defer an advance payment, but not later than the year following the year received. C. Once a method is adopted, IRS permission is usually required to change. A taxpayer can use a different method for each business. Exercise 9: Income was actually or constructively received in 2001 in each of the following situations except: A. Earned income of a taxpayer was received by his agent on December 26, 2001, but not received by the taxpayer until January 3, 2002. B. Taxpayer was informed his check for services rendered was available on December 29, 2001, but he waited until January 10, 2002, to pick up the check C. Taxpayer received a check on December 31, 2001 for services rendered, but was unable to make the deposit until January 2, 2002. D. A payment on the sale of real property was made to an escrow account on December 28, 2001, but the payment was not received by the taxpayer until January 15, 2002 when the transaction was closed and the buyer authorized release of the money held in escrow. D. A payment on the sale of real property was made to an escrow account on December 28, 2001, but the payment was not received by the taxpayer until January 15, 2002, when the transaction was closed and the buyer authorized release of the money held in escrow. Where a contract of sale is executed subject to conditions as to title, and the purchase money is placed in escrow, income on the sale is not taxable until the purchasers have found the title satisfactory and authorized release of monies held in escrow. 7. Wages, Salaries, and Other Earnings A. Employee Compensation Employee compensation generally includes anything received in payment for services. It includes (but is not limited to) the following: 1. Advance commissions and other amounts for services to be performed in the future. 2. Back pay awards - Amounts awarded in a settlement or judgment for back pay, including unpaid life insurance premiums, and unpaid health insurance premiums. Dynasty School (www.dynastySchool.com). 1-24 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS 3. Bonuses and awards paid for outstanding work. If the prize or award is in the form of goods or services, the fair market value is included in income. 4. Holiday gifts if cash, a gift certificate, or similar item convertible to cash. If the employer gives a turkey, ham, or other item of nominal value as a holiday gift, the value is not income. 5. The excess of an allowance or reimbursement over the expense of travel or other transportation. 6. An advance, allowance, or reimbursement of nondeductible moving expenses and any amounts received for deductible expenses if under a nonaccountable plan. 7. If property is purchased from one’s employer for less than fair market value, the difference between the FMV and amount paid is included in wages. 8. Severance pay is taxable as wages. When retiring on disability, a lump- sum payment for accrued annual leave is wages. 9. Sick pay and short term disability. If the taxpayer paid the premiums on an accident or health insurance policy, the benefits received under the policy are not taxable. 10. Social Security and Medicare taxes paid for by the employer and not withheld are treated as additional wages. 11. Stock appreciation rights when exercised. When exercised, the taxpayer should receive a cash payment equal to the amount by which the FMV of the stock on the date of exercise has increased over the FMV on the date the right was granted. 12. Unemployment compensation, which is any amount received under an unemployment compensation law of the United States or a state, is taxable but not treated as wages. a) Supplemental unemployment benefits received from a company- financed fund are not unemployment compensation but should be treated as wages. b) Unemployment benefit payments from a private fund to which the taxpayer voluntarily contributes is taxable to the extent the total amount received is more than the total payments. Taxable benefits are included in gross income on line 21, Form 1040. Dynasty School (www.dynastySchool.com). 1-25 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS c) Benefits to an unemployed union member paid out of union dues are included as gross income on line 21, Form 1040. 13. Union benefits and dues deducted from an employee's pay are still included in gross wages. 14. Property received for services is generally included in income at the property's fair market value. If the taxpayer receives stock or other property that has certain restrictions that affect its value, the value is not included in income until it has been substantially vested. Until the property becomes substantially vested, it is treated as still owned by the person who made the transfer. Income from such property is included in the year received, such as dividends on restricted stock. Property is substantially vested when: a) It is transferable, or b) No longer subject to a substantial risk of forfeiture. B. Fringe Benefits The value of fringe benefits received from an employer is taxable and must be included as compensation unless the benefits are specifically excluded by law or the taxpayer pays fair market value for them. 1. Excludable fringe benefits include: a) No-additional-cost-service is typically a service offered to employees which is the same as that offered to customers in the ordinary course of the line of business in which the employee works. Generally, the employer will not have any substantial additional cost. Examples: excess capacity airline ticket or a hotel room while on duty. b) Qualified employee discount is a price reduction given to employees on certain property or services offered to customers in the ordinary course of the line of business in which the employees perform services. c) Working condition fringe is the value of property or services that an employee could deduct as a trade or business or depreciation expense if paid for by that employee. This may include the business use portion of an employer vehicle or total use of a qualified nonpersonal use vehicle. Dynasty School (www.dynastySchool.com). 1-26 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS d) De minimis fringe is any property or service that has so small a value that accounting for it would be unreasonable or administratively impractical. Examples could include the personal use of the copy machine or coffee and doughnuts furnished to employees. e) On premises gym or other athletic facility if substantially all use is by employees, spouses, or dependent children. f) Health insurance coverage or payments to employees under a self- insured medical reimbursement plan. g) Payments up to $5,000 for qualified dependent care assistance. h) Benefits elected under a cafeteria plan. i) Employer contributions to a qualified retirement plan. j) Meals and lodging if provided at the employer's place of business, provided for the employer's convenience, and required as a condition of employment. k) Qualified transportation fringe up to certain limits. (1) A qualified transportation fringe is: (a) Transportation in a commuter highway vehicle between the employee's home and work place, (b) A transit pass, or (c) Qualified parking. (2) Cash reimbursement under a qualified plan is also excludable. (3) The exclusion for transportation (vanpool) and a transit pass cannot exceed $65 per month. The exclusion for qualified parking cannot exceed $175 per month. l) The cost of up to $50,000 group term life insurance coverage. The cost of insurance in excess of $50,000, reduced by the amount the employee pays, is included in income. The entire cost is included in income if the coverage is provided through a qualified trust, such as a pension plan. 2. Certain exclusions are denied if the employer discriminates in favor of highly compensated employees or key employees. Dynasty School (www.dynastySchool.com). 1-27 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS C. Disability Income 1. If retired on disability, any amount received for disability through an accident and health plan paid for by the employer is includable in income. 2. If the employee contributed to the cost of the plan, only the proceeds attributable to the employer's cost are included in income. 3. If retired on disability, any lump sum payment received for accrued annual leave is a salary, not a disability payment. D. Pension and Annuity Contributions 1. Employer contributions to a qualified retirement plan are not income to the employees when the contribution is made. Employee contributions, such as through payroll deduction, are included in income. 2. Employer contributions to a non-qualified plan are included in income when the contribution is made or when the employee has a nonforfeitable right to the funds, whichever occurs later. E. Special Rules for Certain Employees 1. Clergy a) In addition to a salary (W-2 income on line 7, Form 1040, not on Sch. C), a member of the clergy must also include offerings and fees received for marriages, baptisms, funerals, masses, or any other payment for a service provided. These additional payments will be reported on Schedule C. b) Do not include in income the rental value of a home provided to the clergy member. Also exclude a housing allowance paid as part of salary to the extent the allowance was used to provide a home or pay utilities for a home. Such amount must be officially designated by the employer before such payment is made. The amount that can be excluded cannot exceed the fair rental value of the home plus the cost of utilities, regardless of how much is designated as a housing allowance. c) Both the salary and housing are included for determining self- employment tax. d) A properly designated housing allowance provided to retired clergy is excluded from income and self-employment tax. Dynasty School (www.dynastySchool.com). 1-28 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS Exercise 10: During 2001, Alan, an ordained minister, received a salary of $10,000, a designated housing allowance of $12,000, and $500 for marriages performed which he donated to his church. ALL of the housing allowance was used for mortgage payments including taxes and insurance. Alan itemized deductions and deducts the mortgage interest and real estate taxes on the home. What amount must Alan include in gross income on his 2002 income tax return? A. $10,000 B $10,500 C. $22,000 D. $22,500 B. $10,500. A member of the clergy must include in income any compensation received in exchange for services rendered. Rental value of a dwelling house furnished to an ordained minister as part of compensation is excludable from gross income. 2. A U.S. citizen or resident reports total worldwide income. If a U.S. citizen is employed by a foreign government, an international organization, a foreign embassy, or any foreign employer, the taxpayer must consider any salary as income. (May be eligible for exclusion). 3. A majority of the payments received as a member of the military are included in taxable income. Exclusions include: a) Certain allowances, such as subsistence, uniform, and quarters allowances. Certain payments or services provided, as related to a spouse or dependent are generally excluded. b) A member of the U.S. Armed Forces who serves in a combat zone may exclude certain pay from income. A combat zone is an area so designated by the President in an executive order. 4. Veterans' benefits under any law, regulation, or administrative practice that was in effect on September 9, 1986, and administered by the Department of Veterans Affairs, are not included in gross income. 8. Tip Income A. A taxpayer must report all tip income as wages. Tips include non-cash items such as passes, tickets, goods, or services. B. A daily record or other documentation is needed to prove the amount of tip income. Records should contain appropriate identifying information for the taxpayer and the employer. For each workday, the taxpayer will identify cash tips Dynasty School (www.dynastySchool.com). 1-29 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS received directly from customers, credit card tips when received from employer, amounts paid out to other employees through tip splitting, and identification of others with whom tips were split. C. Report tips to the employer by giving the employer a written statement of tips for each month by the 10th day of the next month. Reporting is required for each month the taxpayer receives tips of $20 or more while working for that employer. A total less than $20 per month does not have to be reported to the employer but is still includable in income. D. Withholding for income tax, Social Security tax, and Medicare tax is required for tips reported to the employer. If an employee's pay check is insufficient to cover the amount required to be withheld, the uncollected amount will be reported on the W-2, and the employee is required to include that amount on the tax return. E. Allocated tips is an amount the employee is deemed to have received but did not report, while employed at a large food and beverage establishment. Allocated tips are shown on the W-2. They are taxable unless the taxpayer has adequate records to prove otherwise. F. All cash, check, or charge card tip income is subject to Social Security and Medicare tax. Form 4137, Social Security and Medicare Tax on Unreported Tip Income, will be used to report all tip income and calculate Social Security and Medicare tax. The amount reported on Form 4137 will include all tips reported to the employer, all unreported tips, and allocated tips. Social Security and Medicare tax will be calculated on the amounts for which there was no withholding. 9. Interest Income A. General Information 1. Seller-financed mortgage - If a seller finances the sale of a home, the seller must report the buyer's name, address, and Social Security number on line 1 of Schedule B (or Schedule 1). 2. Tax-exempt interest must be shown on the return even though not subject to income tax. Exercise 11: During the tax year Jeff received tax-exempt interest income of $200 from municipal bonds. Jeff’s NOT required to report the $200 on his income tax return. (True or False) Dynasty School (www.dynastySchool.com). 1-30 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS False. Although interest from tax-exempt municipal bonds is generally not taxable, the amount of interest received must be reported on the taxpayer’s return. 3. Interest income is portfolio income. Portfolio income cannot be used to offset passive activity losses. 4. If a child is under age 14, has more than $1,400 of investment income and is required to file a return, and either parent is alive at the end of the year, part of that child's investment income may be taxed at the parent's tax rate. Form 8615 is used for this purpose. Investment income of a child under age 14 may be reported by the parents on their tax return by filing Form 8814, Parents' Election to Report Child's Interest and Dividends. 5. A taxpayer must give his or her Social Security number to any entity required by federal law to make a return, statement, or other document that relates to that taxpayer. If an account is held jointly with another person, the Social Security number given should be that of the first person listed on the account. 6. Interest income is subject to 31% backup withholding if name and Social Security number are not verified. 7. Report all interest income, whether reported on 1099-INT or not. If received as a nominee, a subtraction is taken on Schedule B. 8. A taxpayer can exclude any interest credited during the year on frozen deposits that could not be withdrawn by the end of the year. The Form 1099 amount is reported on Schedule B and the "Frozen Deposit" amount is then subtracted on Schedule B. The amount that can be excluded is the interest that is credited on the frozen deposits minus the net amount withdrawn from these deposits during the year and the amount that could have been withdrawn as of the end of the year. Example: $100 of interest was credited on your frozen deposit during the year. You withdrew $80 but could not withdraw any more as of the end of the year. Your net amount withdrawn is $80. You must exclude $20. You must include $80 in your income for the year. B. Taxable Interest 1. Includes, but is not limited to, interest received from bank accounts, interest on loans made to others, certain dividends, gifts for opening an Dynasty School (www.dynastySchool.com). 1-31 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS account, interest on insurance dividends, interest on U.S. obligations, interest on tax refunds, and installment sale interest. 2. Certain distributions commonly called dividends are actually interest. This includes amounts from: a) Cooperative banks, b) Credit unions, c) Domestic savings and loan associations, d) Federal savings and loan associations, and e) Mutual savings banks. 3. Interest is generally taxable when credited to the taxpayer's account and available for use. 4. Interest on U.S. obligations, such as U.S. Treasury bills, notes, and bonds, issued by any agency or instrumentality of the United States, is taxable for federal income tax purposes but is exempt from all state and local income tax. 5. U.S. Savings Bonds a) A cash basis taxpayer will generally report interest on U.S. Savings Bonds when it is received. An accrual basis taxpayer must report the interest when it accrues. b) Series H and Series HH are issued at face value. Interest is paid twice per year by check or direct deposit. Cash basis taxpayers must report interest income in the year received. c) Series F and Series FE are issued at a discount. The difference between purchase price and face amount payable at maturity is taxable interest. One can report the increase in redemption value as interest each year or postpone reporting any interest until the bond is cashed or matures. (1) A switch from the postponed reporting to reporting the interest each year can be done without IRS permission. All interest accrued and not previously reported is reported in the year of change. (2) A switch from yearly reporting to postponed reporting can be accomplished by filing Form 3115, Application for Change in Accounting Method. The form is attached to the return timely Dynasty School (www.dynastySchool.com). 1-32 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS filed for the year of change, and permission is considered automatically granted. d) If bonds are co-owned, the interest is taxable to the individual whose funds were used to purchase the bond. This is true even if another co-owner cashes the bond and receives the Form 1099. e) If the original purchaser has the bonds reissued in another person's name, the original purchaser must include in income all interest earned to date which was not previously reported. This also applies to transferring a Series E/EE bond to a trust. f) If transferred due to death, the time to report interest depends on the accounting and reporting method used by the decedent. If the accrual method was used, or the cash method with the election to report interest each year, the interest earned during the year up to the date of death must be reported on the decedent's final return. If the cash method and deferred reporting was chosen, the surviving spouse or personal representative can elect to report all interest earned up to the date of death on the decedent's final return. If this election is not made, the income earned up to the date of death is income in respect of a decedent and not reported on the final return. The beneficiary, if using the cash method, may elect to report interest as earned or defer reporting until maturity. g) No taxable income is recognized on the transfer of Series B/EE for R/HH unless cash was received in the trade. When the H/HH bond matures, the taxpayer reports as interest the difference between the redemption amount and the cost. h) Interest on Series EE bonds issued after 12/31/89 may be excluded under the Education Savings Bond Program if redemption proceeds are used to pay qualified higher education expenses during the same year. The purchaser must be at least age 24 (or the taxpayer's spouse if co-owned) and the bond is issued in the taxpayer's name. The exclusion is not available if filing as MFS. (1) Eligible expenses are tuition and fees required for the taxpayer, spouse, or dependent. (2) All current year’s interest may be excluded if total expenses exceed proceeds. If proceeds are more, the excludable amount is based on a fraction. The numerator is the qualified higher education expenses paid during the year. The denominator is the total redemption proceeds received. Dynasty School (www.dynastySchool.com). 1-33 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS (3) Form 8815 is used to calculate and report the interest exclusion and compute modified AGI. Example: In April 2001, Mark and Joan, a married couple, cashed qualified Series EE U.S. Savings Bonds they bought in November 1997. In 2001, they helped pay for their daughter’s college tuition. They received proceeds of $5,800, representing principal of $5,000 and interest of $800. They qualified higher education expenses they paid during 2001 totaled $4,000. They can exclude $552 ($800 x ($4,000 / $5,800)) of interest in 2001. 6. If the taxpayer is receiving life insurance proceeds in installments, part of each payment is includable as interest income. Divide the amount held by the insurance company by the number of payments to be received. The amount of each payment in excess of this result is interest. a) If payments are to be received over the beneficiaries life, the divisor is the life expectancy. b) If a spouse died before October 23, 1986 and the taxpayer is receiving insurance proceeds in installments, the taxpayer is eligible to exclude up to $1,000 of interest per year. This is in addition to the part of the each payment which is excludable as a recovery of the lump-sum payable at death. Example: The lump-sum payable at death is $75,000. The beneficiary elects to receive the payment in installments over the next ten years. The insurance company agrees to pay $10,000 for each of these years. The yearly interest is $2,500 ($10,000 - ($75,000 / 10)). 7. Original issue discount (OlD) is a form of interest includable in income when it accrues whether or not the payments are received. OlD usually results when a long-term debt instrument is issued for a price that is less than its stated redemption price at maturity. The amount of OlD is the difference between the principal amount and the issue price of the instrument. The taxpayer can disregard the discount and treat it as zero if it is less than one fourth of one percent (.25%) of the stated redemption price at maturity. 8. State and local government interest is normally exempt from federal tax. Example: Dynasty School (www.dynastySchool.com). 1-34 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS The taxpayer bought a ten-year bond with a stated redemption price at maturity of $1,000, issued at $980 and having OID of $20. One-fourth of 1% of the stated redemption price of $1,000 ($1,000 x.25%) times 10 (the number of full years from the date of original issue to maturity equals $25. Because the $20 discount is less than $25, the taxpayer can disregard reporting OID. Exercise 12: All of the following are taxable interest income except: A. Original Issue Discount B. Dividends received on a credit union account C. Fair market value of a gift received for opening a savings account D. Series F Bonds traded for Series HH Bonds and no cash was received. D. Series E Bonds traded for Series HH Bonds and no cash was received. Owners of Series E bonds who exchange such bonds for Series H bonds and elect to defer Series E bond interest for tax purposes are not required to report such interest until the Series H bonds are redeemed, disposed of, or mature, whichever comes first. C. Interest Exclusion The interest exclusion is limited if your modified adjusted gross income (modified AGI) is: $53,100 to $68,100 for taxpayers filing single or head of household, and $79,650 to $109,650 for married taxpayers filing jointly or for a qualifying widow(er) with dependent child. You do not qualify for the interest exclusion if your modified AGI is equal to or more than the upper limit for your filing status. D. When To Report Interest 1. Cash method taxpayers generally report interest income in the year that it is actually or constructively received. Interest is constructively received when it is credited to the taxpayer's account or made available to the taxpayer. 2. Accrual method taxpayers report interest when it is earned. Exercise 13: Ms. Smith’s books and records reflect the following for the year 2001: Salary $35,000 Interest on money market account $1,000 Interest on money from a long-term savings plan $500 Dynasty School (www.dynastySchool.com). 1-35 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS where interest cannot be withdrawn until December 31, 2001, but principal can be withdrawn at any time (she has principal of $5,000 and accumulated interest of $700) What is the amount Ms. Smith must include in her gross income for 2000? A. $35,000 B. $35,500 C. $36,000 D. $36,500 B. $35,500. Salary is included is gross income. Interest credited on a savings account is taxable to an accrual basis and a cash basis taxpayer when credited. E. How to Report Interest Income 1. Part 1 of Schedule B is required if filing Form 1040 and any of the following apply: a) Taxable interest is more than $400, b) Excluding Educational Savings Bond interest, c) Received interest from a seller financed mortgage, d) Received Form 1099-INT for tax-exempt interest, e) Received interest as a nominee, f) Reporting OlD different than what is shown on Form 1099-OlD, or g) Electing to reduce bond interest by amortizable bond premiums. 2. The taxpayer will report the full amount of interest received as a nominee for another individual on Schedule B. The nominee amount is then shown as a separate item below the subtotal and reduces taxable interest. 3. A withdrawal from a time savings may result in a penalty. The taxpayer must include in gross income the interest paid or credited to his/her account without subtracting the penalty. The penalty is deducted on Form 1040, line 28. Dynasty School (www.dynastySchool.com). 1-36 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS 10. Dividends and Other Corporate Distributions A. A taxpayer that receives a dividend distribution as a nominee for another should issue a Form 1099-DIV to that other person. B. Dividends from a regulated investment company or real estate investment trust may be declared in October, November, or December, payable on a certain day of such month, but not received until January of the following year. Such dividends are considered received by December 31 and included in income for the current year. C. Ordinary dividends are paid out of the earnings and profits of a corporation and are taxed as ordinary income. 1. Dividends paid on stock held as joint tenants, tenants by the entirety, or tenants in common should be reported proportionately by each co-owner. 2. Dividends may be used to purchase more stock under a dividend reinvestment plan. a) The dividend is included in income if the price paid to purchase the additional stock is equal to fair market value. b) If stock is purchased for less than fair market value, the taxpayer must report as income the fair market value of the stock on the dividend payment date. c) If the plan also allows the taxpayer to invest more cash to purchase additional shares at less than fair market value, the taxpayer must report the difference between the cash invested and the fair market value of the stock received. Exercise 14: E-Z Corporation, which has a dividend re investment plan, paid dividends of $20 per share during the year. Carlos, who owned 100 shares of E- Z Corporation prior to the distribution, participated in the plan by using ALL the dividends to purchase 20 additional shares of stock. He purchased the stock for $100 per share when the fair market value was $125 per share. How much dividend income must Carlos report on his income tax return? A. $2,500 B. $2,000 C. $500 D. $0 Dynasty School (www.dynastySchool.com). 1-37 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS A. $2,500. Shareholders who elect to receive shares of greater value than their dividends under a dividend reinvestment plan receive taxable distributions to the extent of the fair market value of their shares. 3. Dividends include amounts paid on money market funds and payments on stock of savings and loan associations. Statements frequently call this interest but this amount should be reported as dividends. D. Capital gain distributions are dividends paid by regulated investment companies, mutual funds, and real estate investment trusts. These distributions should be reported as long term capital gain regardless of how long the taxpayer owned the stock. 1. The taxpayer must also include any amounts that the investment company or mutual fund credited as a capital gain distribution even though not actually received. 2. The taxpayer can file Form 2439, Notice to Shareholders of Undistributed long-term Capital Gain, to take a credit for any tax that the investment company or mutual fund paid for the taxpayer on undistributed capital gains. 3. The taxpayer would increase the basis in stock by the difference between the amount of undistributed capital gain that is reported and the amount of the tax paid by the fund. Exercise 15: Mr. and Mrs. Cone are investors in a mutual fund which is NOT part of a qualified retirement plan. For 2001, the fund notified them that it had a/located an $8,500 capital gain to their account. Of this total, $7,500 was distributed in 2001. In addition, the fund paid $500 federal tax on their behalf what is the correct amount of long-term capital gain that the Cones should report on their 2001 tax return? A. $9,000 B. $8,500 C. $7,500 D. $0 B. $8,500. Capital gains dividends are reportable as long-term capital gains, regardless of how long the shareholder may have owned the stock in the mutual fund. E. Nontaxable Distributions Dynasty School (www.dynastySchool.com). 1-38 IRS ENROLLED AGENT WORK BOOK PART 1 - INDIVIDUALS 1. A return of capital reduces the basis of the taxpayers stock. This is an amount that is not paid out of the corporation’s earnings and profits (thus not a dividend) and is not taxed until the basis in stock is fully recovered. Return of capital distributions in excess of basis are reported as capital gain. If stock is purchased in different lots at different times, reduce basis in the earliest purchased stock first. Report on Schedule D for no gain or loss. Exercise 16: Larry purchased stock in 1997 for $100. During 1999, he received a return of capital of $80 on this stock. During 2001, he received another return of capital of $30. Larry had NO other stock transactions in 2001. What amount should he report on his 2001 income tax return and what is his basis in the stock at the end of 2001? A. $30 capital gain, $100 stock basis B. $30 dividend income, $100 stock basis C. $10 capital gain, zero stock basis D. $10 dividend income, zero stock basis C. $10 capital gain, zero stock basis. A return of capital on a shareholder’s stock reduces the basis of the stock. The excess of the return of capital over the shareholder’s basis is gain from the sale or exchange of property. 2. A liquidating distribution is received in a partial or complete liquidation of a corporation. This is a return of

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