REG-01 E11844c

REG
1
Individual Taxation: Part 1
Module
1 Filing Requirements and Filing Status 3
2 Gross Income: Part 1 13
3 Gross Income: Part 2 29
4 Items From Other Entities 43
5 Loss Limitations for Individuals 53

NOTES
R1–2 © Becker Professional Education Corporation. All rights reserved.

1
MODULE
REG 1 1 Filing Requirements and Filing Status
Filing Requirements
and Filing Status REG 1
1 Individual Income Tax Formula
This module begins the discussion of individual income tax. The formula below provides a
summary of the calculation of taxable income and federal income tax liability or refund for
individuals. Ultimately, these items are reported on the individual income tax return, Form 1040.
Gross income
< Adjustments >
Adjusted gross income AGI

< Standard deduction >
Or
< Itemized deductions >
Taxable income before QBI deduction
< QBI deduction >
Taxable income
Regular tax
Federal income tax
< Tax credits > Alternative minimum tax

Self-employment tax Other taxes
(Social Security) Withholding
< Payments >
Tax due Or Refund

Estimated taxes
Excess Social Security tax
Last year overpaid (applied)
© Becker Professional Education Corporation. All rights reserved. Module 1 R1–3

1 Filing Requirements and Filing Status REG 1
2 Taxable Income Formula for Individuals
Taxable income is the base for the individual income tax. The formula below demonstrates the
calculation of taxable income for individual taxpayers.
Wages
Interest
Dividends
State tax refunds
Alimony received*
Business income
Capital gain/loss
Gross income
IRA income
Pension and annuity
Rental income/loss
K-1 flow-through income/loss
Unemployment compensation
Social Security benefits
Other income
Educator expenses
IRA contributions (traditional)
Student loan interest
Health savings account
Deduction Moving expenses**
to arrive < Adjustments > One-half self-employment taxes
at AGI Self-employed health insurance
Self-employed retirement
Interest withdrawal penalty
Alimony paid*
Adjusted gross income
Medical (in excess of 7.5 percent of AGI)
Taxes—state/local (property and either income
or sales, up to $10,000)
< Itemized deductions > Interest expense (Home and Investment)
Charitable contributions (AGI limit varies by type)
Or Casualty/theft loss attributable to federal disaster
Standard deduction (in excess of $100 floor and 10 percent of AGI)
Taxable income before
QBI deduction
< QBI deduction >
Taxable income
*Only for alimony payments pursuant to divorce or separation agreements executed on or before
December 31, 2018.
**Only for members of the armed forces moving pursuant to military order.
R1–4 Module 1 Filing

© Becker Professional Education Requirements
Corporation. and
All rights Filing Status
reserved.
3 Filing Requirements for Individuals
3.1 Who Must File?

The first consideration when thinking about individual taxation is who must file a tax return.
Generally, a taxpayer must file a return if his or her income is equal to or greater than the sum of:
1. the regular standard deduction amount (except for married filing separately), plus
2. the additional standard deduction amount for taxpayers age 65 or older or blind (except for
married persons filing separately).
3.2 When to File

3.2.1 Due Date—April 15
Individual taxpayers must file on or before the 15th day of the fourth month following the close
of the taxpayer's taxable year, which is April 15.
3.2.2 Extension
Automatic Six-Month Extension to October 15: An automatic six-month extension (until
October 15) is available for those taxpayers who are unable to file by the April 15 due
date. The automatic six-month extension is not an extension for the payment of any taxes
owed. Although granted automatically, the six-month extension must be requested by the
taxpayer by filing Form 4868 by April 15.
Payment of Tax: Even with an extension, the due date for payment of taxes remains April 15.
4 Filing Status
4.1 Single (Use the End-of-Year Test)

You are considered unmarried for the whole year if, on the last day of your tax year, you are
either: unmarried or legally separated.
Dec. 31 determines status
4.2 Joint Returns (Use the End-of-Year Test)
In order to file a joint return, the parties must be married at the end of the year, living together
in a legally recognized common law marriage, or married and living apart (but not legally
separated or divorced).
If married during the year, a joint return may be filed, provided the parties are married
at year‑end.
If divorced during the year, a joint return may not be filed.
If one spouse dies during the year, a joint return may be filed.

4.3 Married Filing Separately

A married taxpayer may file a separate return even if only one spouse has income for the year.
In a separate property state, spouses who elect to file using the married filing separately status
must separately report their own income, credits, and deductions on their own individual
income tax returns. In a community property state, most of the income, deductions, credits, etc.,
are split 50/50.
4.4 Qualifying Widow(er) With Dependent Child

Two Years After Spouse's Death: A qualifying widow(er) is a taxpayer who may use the
joint tax return standard deduction and rates for each of two taxable years following the
W year of death of his or her spouse, unless he or she remarries. In the event of a remarriage,
the surviving spouse will file a tax return (joint or separate) with the new spouse.
Principal Residence for Dependent Child: The surviving spouse must pay over half the
cost of maintaining a household where a dependent child lives for the whole taxable year.
The dependent child must be a child (including an adopted child but not a foster child) or
stepchild of the surviving spouse.
4.5 Head of Household Dependent

Head of household status entitles certain taxpayers to pay lower taxes. The lower tax results
from a larger standard deduction and "wider" tax brackets.
To qualify, the following conditions must be met:
H 1. The individual is unmarried, legally separated, or married and has lived apart from his or her
spouse for the last six months of the year as of the close of the taxable year.
2. The individual is not a "qualifying widow(er)."
3. The individual is not a nonresident alien.
4. The individual maintains as his or her home a household that, for more than half the taxable
year, is the principal residence of a qualifying person, including a dependent child, parent, or
relative (as discussed below).
Divorced 4.5.1 A Qualifying Child

mom Child, stepchild, legally adopted child, foster child, brother or sister, or a descendant of one of
these who meets the definition of a dependent under the qualifying children rules.
4.5.2 Father or Mother (Not Required to Live With Taxpayer)

Nursing A dependent parent is not required to live with the taxpayer, provided the taxpayer maintains
home a home that was the principal residence of the parent for the entire year. Maintaining a home
means contributing over half the cost of upkeep. This means rent, mortgage interest, property
taxes, insurance, utility charges, repairs, and food consumed in the home.
4.5.3 Dependent Relatives (Must Live With Taxpayer)

Not Grandparents, brothers, sisters, aunts, uncles, nephews, and nieces (as well as stepparents,
freeloading parents-in-law, sisters-in-law, or brothers-in-law) qualify as relatives. A dependent relative (other
friends than a father or mother) must live with the taxpayer. Note that cousins, foster parents, and
unrelated dependents do not qualify.

Corporation. and
reserved.
4.5.4 Summary of Who Meets Head-of-Household Qualifying Person Requirement
Qualifying Dependent Lives With Taxpayer

Child or descendant Yes Yes H
Parents Yes No
Other relative Yes Yes
Pass Key
In order to avoid confusing the required time period for different filing statuses,
just remember:
W Widow/widower = Must be principal residence for dependent child for whole year.
H Head of household = Must be principal residence for qualifying person for more than half
a year.
5 Dependency Definitions: No exemption after 2017

People, not pets
Certain tax benefits, such as an advantageous filing status or certain tax credits, require either a
qualifying child or qualifying relative. Each category has requirements:
Qualifying Child Or Qualifying Relative

Close relative Support test
Age limit Under a specific amount of (taxable) gross income test
Residency and filing requirements Precludes dependent filing a joint tax return test
Eliminate gross income test Only citizens (residents of US/Canada or Mexico) test
Support test Relative test
Or
Taxpayer lives with individual for whole year test
Taxpayers must obtain a Social Security number for any dependent who has attained the age of
one as of the close of the tax year.

Pass Key
A taxpayer will be entitled to certain tax benefits for anyone whom a taxpayer "CARES" for,
or whom they "SUPORT," even if the dependent:
y was born during the year; or
y died during the year.
5.1 Qualifying Child Option #1 (CARES) easier option to pass

If the parents of a child are entitled to claim the child but do not, no one else may claim the child
unless that taxpayer's AGI is higher than the AGI of the highest parent.
In general, a child is a qualifying child of the taxpayer if the child satisfies the following:
C 1. Close Relative
Under the close relationship test, to be a qualifying child of a taxpayer, the child must be the
taxpayer's son, daughter, stepson, stepdaughter, brother, sister, stepbrother, stepsister, or
a descendant of any of these. An individual legally adopted by the taxpayer, or an individual
who is lawfully placed with the taxpayer for legal adoption by the taxpayer, is treated as
a child of the taxpayer. A foster child who is placed with the taxpayer by an authorized
placement agency or by judgment, decree, or other order of any court of competent
jurisdiction also is treated as the taxpayer's child.
19
A 2. Age Limit
24 + in college
The age limit test varies depending on the benefit. In general, a child must be younger than
the taxpayer, and under age 19 (or age 24 in the case of a full-time student) to be a qualifying
child (although no age limit applies with respect to individuals who are totally and permanently
disabled at any time during the tax year). A "full-time" student is a student who attends an
educational institution for at least part of each of five months during the taxable year. An
"educational institution" is one that maintains full-time faculty and a daytime program.
R 3. Residency and Filing Requirements

Under the residency and filing requirement tests, a child must have the same principal
place of abode as the taxpayer for more than one half of the tax year. The child also must
be a citizen of the United States or a resident of the United States, Canada, or Mexico.
Furthermore, the child cannot file a joint tax return for the year (unless it was filed only for a
refund claim).
E 4. Eliminate Gross Income Test

The gross income test (see SUPORT) does not apply to a qualifying child.
S 5. Support Test
The qualifying child must not have contributed more than half of his or her own support.
Support means the actual expenses incurred by or on behalf of the dependent. Social Security
and state welfare payments are included in the dependent's total support, but only to the
extent that such amounts are actually expended for support purposes. Scholarships received
by a dependent are not included in determining the dependent's support if the dependent
is a full-time student and the son, daughter, stepson, or stepdaughter of the taxpayer. This
exclusion of scholarships from the support test does not extend to siblings or descendants.

Corporation. and
reserved.
5.2 Qualifying Relative Option #2 (SUPORT) harder option to pass

Taxpayers can apply the SUPORT rules to determine whether an individual meets the qualifying
relative rules. In general, an individual is a qualifying relative of the taxpayer if the individual
satisfies the following:
S 1. Support Test
The taxpayer must have supplied more than one half (greater than 50 percent) of the
support of a person in order to claim him or her as a qualifying relative. The same definition
of support as related to a qualifying child applies. Or multiple support
U 2. Under Gross Income Limitation : Taxable
A person may not be claimed as a qualifying relative unless the qualifying relative's gross
income is less than $4,700 (2023). General rule = Exemption amount
Definition of Taxable Income: Only income that is taxable is included for the purpose of
the gross income limitation. Nontaxable is OK
Nontaxable Income = OK
y Social Security (at low income levels)
y Tax-exempt interest income (state and municipal interest income)
y Tax-exempt scholarships
P 3. Precludes Dependent Filing a Joint Return

A taxpayer does not meet the definition of qualifying relative if the taxpayer is a married
dependent who files a joint return, unless there is no tax liability on the couple's joint return
and there would not have been any tax liability on either spouse's tax return if they had filed
separately.
O 4. Only Citizens of the United States or Residents of the United States, Mexico, or Canada
The qualifying relative must be either a citizen of the United States or a resident of the
United States, Mexico, or Canada.
R 5. Relative
Children, grandchildren, parents, grandparents, brothers, sisters, aunts and uncles, nieces and
nephews (as well as stepchildren, stepparents, stepbrothers or stepsisters, in-laws) can meet
the definition of qualifying relative. Children include legally adopted children, foster children,
and stepchildren. Foster parents and cousins are not considered to be relatives.
Or
Remember: A child born at any time during the year will qualify as a relative for qualifying-
child or qualifying-relative purposes. OK if lives with you
Or: - Kissing cousins
T 6. Taxpayer Lives With the Individual (if Non-relative) for the Whole Year - Foster's Beer
A non-relative member of a household (i.e., a person living in the taxpayer's home for the
entire year) may be considered a qualifying relative provided the taxpayer's relationship
with that person does not violate local law. Foster parents and cousins must live with the
taxpayer the entire year because they are not considered to be relatives.

5.3 Multiple Support Agreements : One "supporter" gets full qualification

Where two or more taxpayers together contribute more than 50 percent to the support of
a person but none of them individually contributes more than 50 percent, the contributing
taxpayers, all of whom must be qualifying relatives of (or lived the entire year with) the
individual, may agree among themselves which contributor may claim the individual as a
dependent for tax benefits.
A contributor must have contributed more than 10 percent of the person's support in
addition to meeting the other dependency tests in order to be able to claim him or her
as a dependent.
The joint contributors are required to file a multiple support declaration, Form 2120.
Example 1 Multiple Support Agreement
Facts: Peter, who is single and lives alone in Idaho, has no income of his own and is
supported in full by the following people:
Amount of Support Percent of Total
Tim (an unrelated friend) $2,400 48
Angie (Peter's sister) 2,150 43
Mike (Peter's son) 450 9
$5,000 100%
Required: Under a multiple support agreement, Peter is considered a dependent of which

of the following:
a. No one
b. Tim
c. Angie
d. Mike
Solution: Peter only meets dependency definition requirements for Angie.

Tim Angie Mike
Support test Yes Yes No
Under gross income Yes Yes
Preclude joint filing Yes Yes
Only U.S. citizens Yes Yes
Relative, or No Yes
Taxpayer lived with No N/A

Corporation. and
reserved.
5.4 Children of Divorced Parents

General Rule (Custodial Parents): Generally, the parent who has custody of the child
for the greater part of the year qualifies to use the child as a dependent for tax benefit
purposes (determined by a "time" test, not the divorce decree). It does not matter whether
that parent actually provided more than one-half of the child's support. If the parents have
equal custody during the year, the parent with the higher adjusted gross income will claim
the tax benefits related to the dependent.
Question 1 MCQ-01404
Which of the following is (are) among the requirements to enable a taxpayer to be

classified as a "qualifying widow(er)"?
I. A dependent has lived with the taxpayer for six months.

II. The taxpayer has maintained the cost of the principal residence for six months.
a. I only.
b. II only.
c. Both I and II.
d. Neither I nor II.
Mark and Molly met at a New Year's Eve party held December 31, Year 1. They instantly
bonded, fell madly in love, and were married at 11:38 p.m. that night. Identify Mark's filing
status for Year 1.
a. Single
b. Married filing jointly
c. Head of household
d. Surviving spouse

NOTES
2
MODULE
REG 1 2 Gross Income: Part 1
Gross Income: Part 1 REG 1
1 Gross Income Overview
The first step in determining tax liability is to compute gross income.
1.1 Gross Income Definition

Generally, gross income means all income from whatever source derived, unless specifically excluded.
(For example, if the taxpayer finds $4,000 under a floorboard in his house, cannot find the owner, and
keeps the money, the $4,000 is income regardless of the fact that the taxpayer did not "earn" it.)
1.2 Determination of Amount of Income

For free
Except in the cases of gain derived from dealings in property (discussed below), income is
determined by the amount of cash, property (FMV), or services obtained. In cases of noncash
income, the amount of the income is the fair market value of the property or services received.
Pass Key
Terms
Event Income Basis
Tax = FMV
Taxable = FMV FMV
GAAP = FV
Nontaxable = None NBV
Example 1 Noncash Income
Facts: A taxpayer performs services and receives a car with a fair market value of $3,000
as compensation.
Required: Determine the amount of income for the taxpayer.
Solution: The $3,000 FMV of the property received is income to the taxpayer. Taxable = FMV
1.3 Realization and Recognition

In order to be taxable, the gain must be both realized and recognized.
Realization: Realization requires the accrual or receipt of cash, property, or services, or a = Real world
change in the form or the nature of the investment (a sale or exchange).
Recognition: Recognition means that the realized gain must be included on the tax return
(i.e., there is no provision that permits exclusion or deferral under the Internal Revenue Code). = Records
2 Gross Income: Part 1 REG 1
Illustration 1 Recognition Concept
A taxpayer owns stock for which he paid $100, and the stock goes up in value to $150.
There is no realized gain even though there has been an increase in the taxpayer's wealth.
Gain is realized when the shares are sold for $150 or exchanged for other property worth
$150. If the gain is taxable, it would also be recognized on the tax return.
1.4 Timing of Revenue Recognition

Accrual Method: Under the accrual method, recognition occurs according to the rules of
GAAP (with some exceptions); that is, revenue is taxable when earned.
Cash Method: Under the cash method, recognition occurs in the period the revenue is
actually or constructively received in cash or fair market value (FMV) of property.
2 Specific Items of Income and Exclusions
2.1 Salaries and Wages

Gross income includes many forms of compensation for services.
Money: All money received, credited, or available (constructive receipt).
Property: The fair market value (FMV) of all property is included as gross income.
Bargain Purchases: If an employer sells property to an employee for less than its fair
market value, the difference is income to the employee.
Guaranteed Payments to a Partner: Guaranteed payments are reasonable compensation
paid to a partner for services rendered (or use of capital) without regard to the partner's
income or loss sharing percentage. This earned compensation is also subject to
self‑employment tax.
Taxable Fringe Benefits (Non-statutory): The fair market value of a fringe benefit not
specifically excluded by law is includable in income. For example, an employee's personal
use of a company car is included as wages in an employee's income. Furthermore, the
amount included is subject to employment taxes and income and FICA tax withholdings.
Portion of Life Insurance Premiums: Premiums paid by an employer on a group term life
insurance policy covering his employees are not income to the employees up to the cost on
the first $50,000 of coverage per employee (nondiscriminatory plans only). Premiums above
the first $50,000 of coverage are taxable income to the recipient and normally included in
W-2 wages. (This amount is calculated from an IRS table, and it is not the entire amount of
the premium in excess of the $50,000 coverage.)
2.2 Nontaxable Fringe Benefits

Life insurance
Life Insurance Coverage proceeds are
Employees may exclude from income the value of life insurance premiums the employer tax-free
pays on an employee's behalf for up to $50,000 of group-term life insurance.
R1–14 Module 2 Gross

© Becker Professional Education Corporation. All rightsIncome:
reserved.Part 1
-Deductible by employer
Accident, Medical, and Health Insurance (Employer-Paid)
-Not taxable to employee
Premium payments are excludable from the employee's income when the employer paid
the insurance premiums, but amounts paid to the employee under the policy are includable
in income unless such amounts are:
1. Reimbursement for medical expenses actually incurred by the employee; or
2. Compensation for the permanent loss or loss of use of a member or function of the body.
De Minimis Fringe Benefits
De minimis fringe benefits are so minimal that they are impractical to account for
and may be excluded from income. An example is an employee's personal use of a
company computer.
Meals and Lodging : Not taxable to employee if
The gross income of an employee does not include the value of meals or lodging furnished
to him or her in kind by the employer for the convenience of the employer on the employer's
premises. Additionally, in order to be nontaxable, the lodging must be required as a
condition of employment.
Employer Payment of Employee's Educational Expenses
Up to $5,250 may be excluded from gross income of payments made by the employer on
behalf of an employee's educational expenses and/or student loans. The exclusion applies
to both undergraduate and graduate-level education.
Employee Adoption Assistance Program
For 2023, a taxpayer can exclude from taxable income up to $15,950 of qualified adoption
expenses paid by an employer. The exclusion is phased out for taxpayers with MAGI of
$239,230–$279,230.
Dependent Care Assistance
Employees can exclude from gross income up to $5,000 of benefits paid or reimbursements
by an employer for dependent care expenses. Qualifying dependents include dependent
children under age 13 and a spouse or other dependent physically or mentally incapable
of self-care.
Qualified Tuition Reduction
Employees of educational institutions studying at the undergraduate level who receive
tuition reductions may exclude the tuition reduction from income. Graduate students may
exclude tuition reduction only if they are engaged in teaching or research activities and
only if the tuition reduction is in addition to the pay for the teaching or research. To be
excludable, tuition reductions must be offered on a nondiscriminatory basis.
Qualified Employee Discounts
Employee discounts on employer-provided merchandise and service are excludable as follows:
y Merchandise Discounts
The excludable discount is limited to the employer's gross profit percentage. Any excess
must be reported as income.
y Service Discounts
The excludable discount on services is limited to 20 percent of the fair market value of
the services. Any excess discount must be reported as income.

Employer-Provided Parking
The value of employer-provided parking up to $300 per month (2023) may be excluded.
The exclusion is available even if the parking benefit is taken by the employee in place of
taxable cash compensation.
Transit Passes
The value of employer-provided transit passes up to $300 per month (2023) may be excluded.
Qualified Retirement Plans
y Payments Made by Employer (Nontaxable) At that time
Generally, payments made by an employer to a non‑Roth retirement plan are not
income to the employee at the time of contribution.
y Benefits Received (Taxable) When you retire and withdraw money
The amount contributed to the non‑Roth retirement account that is exempt from tax
(plus any income earned on such amount) is taxable to the employee in the year in
which the amount is distributed to the employee.
Flexible Spending Arrangements (FSAs) = Like a debit card
A flexible spending arrangement stems from a Section 125 employee flexible benefit plan.
The plan allows employees to receive a pretax reimbursement of certain (specified)
incurred expenses.
y Pretax Deposits Into Employee's Account
Employees have the ability to elect to have part of their salary (generally up to $3,050
for 2023) deposited pretax into a flexible spending account designated for them. These
deposits must be done via salary reduction directly by the employer, and the employee
is not taxed on that income. The employee has the option to use the deposited funds to
pay for qualified health care and/or qualified dependent care costs, and submits claims
to the plan administrator for reimbursement.
y Forfeit Funds Not Used Within 2½ Months After Year-End : Use it or lose it by March 15
An employee generally must use the money in an FSA within the plan year. Funds not
used within 2½ months after the year-end are forfeited. However, this grace period only
applies if the employer amended the plan accordingly. Alternatively, the employer may
amend the plan to allow an employee to carry over up to $610 per year (2023) to use in
the following year.
2.3 Interest Income = Report on Schedule B

2.3.1 Taxable Interest Income
The items below represent taxable interest income:
Interest from federal bonds.
Interest from industrial development bonds.
Interest from corporate bonds.
Part of the proceeds from an installment sale is taxable as interest.
Interest paid by the federal or state government for late payment of a tax refund is taxable.
For certain taxpayers and certain bonds, the amortization of a bond premium is an
offset (reduction) to the interest received and a reduction to the bond's basis, and the
amortization of a bond discount is an addition to the interest received and an addition to
the bond's basis.
- Gifts to open up a bank account (FMV)
reserved.Part 1
2.3.2 Tax-Exempt Interest Income (Reportable but Not Taxable)

The following items must be reported on the tax return but are not taxable:
State and Local Government Bonds/Obligations: Interest on state and local bonds/
obligations is tax-exempt. Furthermore, mutual fund dividends for funds invested in tax-free
bonds are also tax-exempt.
Bonds of a U.S. Possession: Interest on the obligation of a possession of the United States,
such as Guam or Puerto Rico, is tax-exempt.
U.S. Series EE Savings Bonds: Interest on U.S. Series EE savings bonds issued after 1989 is
tax-exempt when: Educational Expenses
y it is used to pay for higher education (reduced by tax-free scholarships) of the taxpayer,
spouse, or dependents;
y the taxpayer is over age 24 when bond is issued;
y a married taxpayer files a joint return; and
y the taxpayer meets certain income requirements.
The exclusion of interest from U.S. Series EE savings bonds is phased out when the taxpayer's
modified AGI reaches a certain level (2023).
Filing Status Modified AGI

Robin Hood rule
Single/head of household $91,850–$106,850
Married filing jointly $137,800–$167,800
When a taxpayer uses bonds to pay for a child's education, the bonds must be registered in the
taxpayer's and/or spouse's name. The child can be listed as a beneficiary on the bond, but not as
a co-owner.
2.3.3 Forfeited Interest (Adjustment) (Penalty on Withdrawal From Savings)

Forfeited interest is a penalty for early withdrawal of savings (generally on a time deposit, such
as a certificate of deposit, at a bank). The bank credits the interest to the taxpayer's account and
then, in a separate transaction, removes certain interest as a penalty for withdrawing the funds
before maturity. The interest received is taxable on the taxpayer's income tax return, but the
amount forfeited is also deductible as an adjustment in the year the penalty is incurred. Thus,
the taxpayer only pays tax on the amount of interest actually received. Note, however, that the
amount of forfeited interest is deducted separately and not netted with interest income on the
tax return.
2.4 Dividend Income = Report on Schedule B

2.4.1 Source Determines Taxability
A dividend is defined by the Internal Revenue Code as a distribution of property by a
C corporation out of the company's earnings and profits. The taxability of the dividend is
determined by the amount of the company's earnings and profits:
Corporate earnings and profits → taxable dividend E&P = Retained earnings
No earnings and profits and taxpayer has basis in stock → nontaxable and reduces basis of stock = Return
No earnings and profits and no stock basis → taxable capital gain income of capital

2.4.2 Taxable Dividends = Out of E&P

All dividends that represent distributions of a corporation's earnings and profits (similar to
retained earnings) are includable in gross income.
Taxable Amount (to Recipient Shareholder)
y Cash = Amount received
y Property = Fair market value
2.4.3 Preferential Tax Rate for Qualified Dividends

Qualified dividends are those paid by domestic or certain qualified foreign corporations.
Qualified Dividends Holding Period: To be qualified dividends, the stock must be
held for more than 60 days during the 120-day period that begins 60 days before the
ex‑dividend date (the date on which a purchased share no longer is entitled to any recently
declared dividends).
Nonqualified Dividends:
y Employer stock held by an employee stock ownership plan (ESOP)
y Amounts taken into account as investment income (for purposes of the limitation on
investment expenses)
y Short sale positions
y Certain foreign corporations
y Dividends paid by credit unions, mutual savings banks, building and loan associations,
mutual insurance companies, and farmer's cooperatives.
Qualified dividends are taxed at the same preferential tax rates as long-term capital gains (LTCGs):
2023 Taxable Income

Tax Rate Single Head of Household Married Filing Jointly Married Filing Separately
0% $0–$44,625 $0–$59,750 $0–$89,250 $0–$44,625
15% $44,626–$492,300 $59,751–$523,050 $89,251–$553,850 $44,626–$276,900
20% Over $492,300 Over $523,050 Over $553,850 Over $276,900
2.4.4 Tax-Free Distributions

The following items are excluded from gross income:
Return of Capital = No E&P/reduce your basis
Return of capital exists when a C corporation distributes funds but has no earnings and
profits. The taxpayer will simply reduce (but not below zero) his or her basis in common
stock held.
Stock Split = Nontaxable
When a stock split occurs, the shareholder will allocate the original basis over the total
number of shares held after the split.

reserved.Part 1
Regardless of choice,
Stock Dividend (Unless Cash or Other Property Option/Taxable FMV)
it is taxable
Unless the shareholder has the option to receive cash or other property (which would then
be taxable at the FMV of the dividend), the basis of the shares after distribution depends on
the type of stock received.
y Same stock—original basis is divided by total shares
y Different stock—original basis is allocated based on the relative FMV of the different stock
Life Insurance Dividend = Nontaxable
Dividends caused by ownership of insurance with a mutual company (premium return).
2.4.5 Capital Gain Distribution = No E&P and no basis

Distributions by a corporation that has no earnings and profits, and for which the shareholder
has recovered his or her entire basis, are treated as taxable gross income. Interest income paid
by state on late refund
2.5 State and Local Tax Refunds is taxable
The receipt of a state or local income tax refund in a subsequent year is not taxable if the taxes
paid did not result in a tax benefit in the prior year.
Itemized in prior year = State or local refund is taxable.
Standard deduction used in prior year = State or local refund is nontaxable.
Illustration 2 Nontaxable and Taxable State and Local Tax Refunds
Carlos, a single individual, used the standard deduction on his Year 10 federal individual
income tax return. In Year 11, he received a $150 state income tax refund. The $150 tax refund
is not includable in his Year 11 income because he did not itemize in Year 10 and, therefore, did
not receive a tax benefit from the state income taxes paid. If he had received a tax benefit from
deducting the state taxes when paid in Year 10, a Year 11 (or later) refund of those taxes would
be taxable income for federal income tax purposes when received, regardless of whether or
not the taxpayer itemized deductions in the year the refund was received.
2.6 Payments Pursuant to a Divorce - 2018 and earlier = Income to ex-spouse

- 2019 and after = Not income to ex-spouse
2.6.1 Alimony/Spousal Support Payments
Alimony or spousal support payments made pursuant to a divorce or separation agreement
executed on or before December 31, 2018, are included in gross income by the recipient
and deductible by the payor spouse. For divorce or separation agreements executed after
December 31, 2018, alimony received is not included in gross income, and alimony paid cannot
be deducted. To be deemed alimony under the tax law:
payments must be legally required pursuant to a written divorce (or separation) agreement;
2018 payments must be in cash (or its equivalent);
Pay credit cards
Pay college bills
and payments cannot extend beyond the death of the payee-spouse;
before payments cannot be made to members of the same household;
payments must not be designated as anything other than alimony; and
the spouses may not file a joint tax return.

Pass Key
On the CPA Exam, if a real date is provided (e.g., 2017 or 2018) instead of a generic date
(e.g., Year 1 or Year 2), candidates should use that as a tip-off that there is a date-specific
tax treatment that needs to be considered. The CPA Exam will only use real dates when
it is necessary for the candidate. A clear example of this is a question about alimony in
which the year is indicated so the candidate can correctly decide whether that amount is
includable in income.
Candidates should also apply any assumptions given in a question and assume that the
information provided in the question is material.
2.6.2 Child Support : To ex-spouse receiving the money = Nontaxable

Nontaxable: If any portion of the payments is fixed by the decree or agreement as being
for the support of minor children (or is contingent on the child's status, such as reaching
a certain age), such portion is not deductible by the spouse making payment and is not
includable by the spouse receiving payment.
Payment Applies First to Child Support: If the decree or agreement specifies that
payments are to be made both for alimony and for support, but the payments subsequently
made fall short of fulfilling these obligations, the payments will be allocated first to child
support (until the entire child support obligation is met) and then to alimony.
2.6.3 Property Settlements (Nontaxable) HI D E IT

If a divorce settlement provides for a lump-sum payment or property settlement by a spouse,
that spouse gets no deduction for payments made, and the payments are not includable in the
gross income of the spouse receiving the payment.
2.7 Business Income or Loss (Schedule C)

Net business income or loss from a sole proprietorship is calculated on Schedule C and reported
on Form 1040 as a single item (the specific line item is business income or loss).
2.8 Farm Income (Schedule F)

Profit or loss from farming is calculated on Schedule F and reported on Form 1040 as a single
line item (the specific line item is farm income or loss).
2.9 Gains and Losses on Disposition of Property = Schedule D

Gain or loss on the disposition of property is measured by the difference between the amount realized
and the adjusted basis. Gains and losses are given tax effect (recognized) only when the asset is sold
or disposed by other means. Whether on a cash or accrual method of accounting, taxpayers who
sell stock or securities on an established securities market must recognize gains and losses as of the
trade date, not the settlement date. The basic formula in determining the gain or loss is as follows:
Amount realized
< Adjusted basis of assets sold >
Gain or loss realized
HIDE IT WRAP
reserved.Part 1
2.10 IRA Distributions : Withdrawing money from your IRA account

Distributions for IRAs consist of principal (contributions) and earnings. The tax treatment of a
distribution depends on whether the distribution is from a traditional IRA or a Roth IRA.
Any taxable distributions from IRAs are taxed as ordinary income regardless of the type of
income, such as capital gain, that was earned while the funds were invested.
Deductible
2.10.1 Distributions From Traditional IRAs = 100% ordinary income
Distributions of principal (contributions) are taxable if the taxpayer took a deduction for the
contribution when made.
Distributions of earnings are always taxable, whether or not the taxpayer deducted the
contribution when made.
A distribution from a nondeductible, traditional IRA is allocated between principal
(contributions) and earnings pro rata based on relative amounts in the IRA account at the
time of the distribution. - Principal = Nontaxable
- Earnings = Taxable
Taxpayers are required to start taking required minimum distributions (RMDs) by April 1 of
the year following the year in which the taxpayer reaches age 73.
2.10.2 Distributions From Roth IRAs = Nontaxable

Distributions of principal (contributions) from a Roth IRA are never taxable because
taxpayers are not allowed to deduct contributions to a Roth IRA.
Distributions of earnings from a Roth IRA are only taxable if the distribution is a nonqualified
Roth distribution.
A qualified distribution is a distribution from a Roth IRA that:
1. Is made at least five years after the first day of the year in which the taxpayer made his
or her first contribution to the Roth IRA, and
2. Meets one of the following requirements:
—taxpayer is age 59½ or older;
—taxpayer is disabled;
—taxpayer is a first-time homebuyer (has not owned a home for two years) and uses the
distribution to purchase a home (maximum $10,000); or
—distribution is made to a beneficiary after the taxpayer's death.
Distributions from Roth IRAs are considered to first come from principal (contributions),
then earnings. Withdrawals
Principal
Type of Distribution (Contributions) Earnings
Nondeductible traditional IRA distribution Nontaxable Taxable
Deductible traditional IRA distribution Taxable Taxable
Qualified Roth IRA distribution Nontaxable Nontaxable
Nonqualified Roth IRA distribution Nontaxable Taxable

Example 2 IRA Distribution
Facts: Sally opened an IRA when she was 55 years old and contributed $5,000. Several
years later, when the account had grown to $8,000, she withdrew $6,000 to pay for a
three‑week European vacation.
Required: Determine the amount of Sally's taxable ordinary income from the IRA
distribution under four different assumptions:
Deductible1. Traditional IRA, deduction was taken for the contribution $6,000
Nondeductible2. Traditional IRA, deduction was not taken for the contribution $2,250 = 6,000/8,000 x 3,000
Nonqualified 3. Roth IRA, amount was withdrawn four years after the contribution $1,000 = $6,000 - $5,000
Qualified 4. Roth IRA, amount was withdrawn six years after the contribution = -0-
Solution:
1. $6,000 taxable ordinary income
Traditional IRA and Sally deducted the contribution, so both distribution of
principal (contribution) and earnings are taxable. A distribution of any amount is
100 percent taxable.
Traditional IRA and Sally did not deduct the contribution, so the distribution of
principal (contribution) is not taxable. Distribution of earnings for a traditional IRA
are always taxable. The $8,000 account balance consists of 62.5 percent principal
(5,000 contribution / 8,000 total) and 37.5 percent earnings (3,000 earnings / 8,000
total), so 37.5 percent of the distribution is taxable. $6,000 distribution × 37.5% taxable
portion = $2,250.
The Roth IRA distribution was made before the account had been open for five years,
so it is a nonqualified distribution. Distribution of principal (contribution) is not taxable
but the earnings are taxable. A distribution from a Roth IRA is considered to come
first from principal (contribution), then earnings, so the $6,000 distribution consists of
$5,000 nontaxable principal and $1,000 taxable earnings.
4. $0 taxable ordinary income
The Roth IRA has been open for at least five years and Sally is at least age 59½
(55 years old at contribution + Withdrawal six years later = 61 years old at time of
distribution). The distribution is a qualified Roth distribution and neither the principal
(contribution) nor the earnings are taxed.
Regular tax
2.10.3 Penalty Tax (10 Percent) : Early withdrawal +
10% penalty
Generally, a premature distribution before age 59½ is subject to a 10 percent penalty tax (in
addition to regular income tax) if the individual has not met an exception.

reserved.Part 1
2.10.4 Exception to Penalty Tax (Still Subject to Ordinary Income Tax)

There is no penalty if the premature distribution was used to pay:
H Homebuyer (first time): Distribution used toward the purchase of a first home within 120
days of distribution ($10,000 maximum exclusion)
I Insurance (medical)
Avoid
y Unemployed with 12 consecutive weeks of unemployment compensation
10% penalty
y Self-employed (who are otherwise eligible for unemployment compensation)
but
M Medical expenses in excess of percentage of AGI floor still pay
D Disability (permanent or indefinite, not temporary disability); federally declared disaster regular tax
($22,000 maximum)
E Education: College tuition, books, fees, etc.
A Adoption or birth of child made within one year from the date of birth or adoption ($5,000
maximum exclusion)
D Death or terminal illness
2.11 Annuities
An annuity is a contract between a taxpayer and an insurance company in which the taxpayer
contributes a lump-sum payment (or series of payments) and in return receives regular annuity
payments over time. There are two basic types of annuities: 1) fixed period annuities, in which
payments are received over a fixed period of time; and 2) life annuities, in which payments are
received over the taxpayer's lifetime.
Each annuity payment received by the taxpayer consists of return of investment (contributions),
which are nontaxable, and earnings, which are taxed as ordinary income. How much of each
annuity payment is nontaxable return of investment and how much is taxable earnings depends
on whether the annuity is a fixed period annuity or a life annuity.
2.11.1 Fixed Period Annuity Payments

The annuity exclusion ratio, which is the portion of each annuity payment that is a nontaxable
return of investment, is the original investment divided by the expected value of the annuity. For
a fixed period annuity, the expected value of the annuity is the amount of each payment times
the number of payments.
Example 3 Fixed Period Annuity
Facts: Zoe purchased an annuity for $60,000 that would pay her $750 per month for
120 months (10 years).
Required: Calculate the amount of the taxable portion of each annuity payment received.
Solution:
Expected value of the annuity = $750 monthly annuity payment × 120 months = $90,000
Annuity exclusion ratio = $60,000 original investment / $90,000 expected value = 66.7%
return of capital
Taxable portion of each annuity payment = 100% – 66.7% = 33.3% × $750 monthly payment
= $249.75

2 Gross Income: Part 1 Treat your paid investment as your basis, REG 1
and "depreciate" it over your expected life
2.11.2 Life Annuity Payments (exclude that amount from income each period)
For a life annuity, the number of annuity payments to be received is unknown, so taxpayers must
use IRS life expectancy tables to determine the portion of each annuity payment that is a nontaxable
return of investment. The original investment is divided by the appropriate factor from the IRS
tables. The IRS factor represents the taxpayer's life expectancy at the time he or she starts receiving
the annuity payments. The factor ranges from 360 months for taxpayers age 55 or under to 160
months for taxpayers age 71 or older. The portion of each annuity payment that is a nontaxable
return of investment is the original investment divided by the IRS life expectancy factor.
100% income
If a taxpayer lives longer than the IRS estimated life expectancy, the entire amount of any
additional payments received are taxable. If the taxpayer dies before receiving the expected
number of payments, the remaining unrecovered investment is deducted on the taxpayer's final
income tax return.
Itemized deduction
Example 4 Life Annuity
Facts: John purchased an annuity for $60,000 that would pay him $600 per month for the
rest of his life. John is 64 years old at the annuity start date, so the IRS life expectancy factor
is 260 months.
Required: Calculate the amount of the taxable portion of each annuity payment received.
Solution:
Nontaxable return of capital = $60,000 original investment / 260 months = $230.77
Taxable portion of each monthly annuity payment = $600.00 – $230.77 = $369.23
What if John lived for 270 months? The last ten $600 monthly payments would be fully
Lives longer taxable because he has recovered all of his original investment over the first 260 months.
What if John died after 250 months? The remaining unrecovered investment of $2,307.70
Dies early ($230.77 × 10 months) is deducted on John's final income tax return.
2.12 Rental Income—Passive Activity

Net rental income or loss is calculated on Schedule E and reported as a single line item on Form
1040 (the specific line item is rental real estate, royalties, ...).
2.13 Unemployment Compensation = Taxable

A taxpayer must include in gross income the full amount received for unemployment compensation.
2.14 Social Security Income

Social Security benefits received might be included in income. Taxpayers are classified into five
categories depending on the level of modified adjusted gross income, which is defined as AGI plus
tax-exempt interest plus 50 percent of Social Security benefits. Taxpayers must include in income
the lesser of 50 percent (or 85 percent, depending on income) of Social Security received or 50
percent (or 85 percent, depending on income) of the excess modified AGI over the threshold.
Nontaxable
Low Income = No Social Security benefits are taxable (income equal to or less than $25,000
for single filers or equal to or less than $32,000 for MFJ).
Lower Middle Income = Less than 50 percent of Social Security benefits are taxable.

reserved.Part 1
Middle Income = 50 percent of Social Security benefits are taxable (income over: single
$25,000/MFJ $32,000).
Upper Middle Income = Between 50 percent and 85 percent of Social Security benefits
are taxable.
Upper Income = 85 percent of Social Security benefits are taxable (income over: single
$34,000/MFJ $44,000).
2.14.1 Modified Adjusted Gross Income = MAGI

Modified adjusted gross income (modified AGI), or provisional income, includes the following items:
Any income excluded because of the foreign earned income exclusion.
Any exclusion or deduction claimed for foreign housing.
Any interest income from series EE bonds that was able to be excluded because of qualified
higher education expenses.
Any deduction claimed for student loan interest or qualified tuition and related expenses.
Any employer-paid adoption expense that was excluded.
Any deduction claimed for an annual (non-rollover) contribution to a traditional IRA.
2.15 Taxable Miscellaneous Income

2.15.1 Prizes and Awards = FMV is taxable
The fair market value of prizes and awards is taxable income. An exclusion from income for
certain prizes and awards applies when the winner is selected for the award without entering
into a contest (i.e., without any action on the winner's part) and assigns the award directly to a
governmental unit or charitable organization.
2.15.2 Gambling Winnings and Losses

Winnings: Gambling winnings are included in gross income. Taxable
Losses: Unless the taxpayer is in the trade or business of gambling (which follows specific
reporting rules), gambling losses may only be deducted to the extent of gambling winnings. Not
Gambling losses include the expenses the taxpayer incurred in connection with the netted
gambling activity. Gambling losses are deductible on Schedule A as an itemized deduction.
2.15.3 Damages Awards

To decide whether a damages award is excludable, one must determine what the damages were
paid "in lieu of." Thus, if a damage award is compensation for lost profit, the award is income.
2.15.4 Punitive Damages

Punitive damages are fully taxable as ordinary income if received in a business context or for
loss of personal reputation. Punitive damages received by an individual in a personal injury case
are also taxable except in wrongful death cases where state law has limited wrongful death
awards to punitive damages only.
2.15.5 Cancellation of Debt (COD) Income = Taxable

If a taxpayer borrows money from a commercial lender and the lender later cancels or forgives
part or all of the debt, the canceled debt is generally included in the taxpayer's income. COD
income is not taxable in the following situations:
If:
Debt is discharged through insolvency.
Taxpayer is insolvent when the debt is canceled.

Cancellation of nonrecourse secured loan, including foreclosure on personal residence

(treated as a sale of the forfeited secured property).
Student loans forgiven by lender are not included in borrower's taxable income (2021–2025).
Example 5 COD Income
Facts: Mary owes the bank $80,000 on an unsecured recourse note. She satisfies the
note in full with a payment of $30,000. The bank accepts this payment and forgives the
remaining $50,000 of debt.
Required: Determine Mary's taxable income as a result of the cancellation of debt.
Solution: The debt is unsecured recourse debt and none of the exceptions apply, so Mary
has taxable cancellation of debt income of $50,000.
2.16 Partially Taxable Miscellaneous Items (Scholarships

and Fellowships)
Degree-Seeking Student: Scholarships and fellowship grants are excludable only up to
amounts actually spent on tuition, fees, books, and supplies (not room and board) provided:
y The grant is made to a degree-seeking student;
y No services are to be performed as a condition to receiving the grant; and
y The grant is not made in consideration for past, present, or future services of the grantee.
Non-degree-Seeking Student: Scholarships and fellowships awarded to non-degree-
seeking students are fully taxable at FMV.
Tuition Reductions: Graduate teaching assistants and research assistants who receive
tuition reductions are taxed on the reduction if it is their only compensation, but not if the
reduction is in addition to other taxable compensation.
2.17 Nontaxable Miscellaneous Items

Taxable Life Insurance Proceeds (Nontaxable): The proceeds of a life insurance policy paid
because of the death of the insured are excluded from the gross income of the beneficiary.
Interest y The interest income element on deferred payout arrangements is fully taxable.
income on y If the proceeds are used to pay for long-term care, accelerated death benefits received
installment by an insured who is terminally ill (provided there is certification that the insured is
expected to die within 24 months), is chronically ill, or requires assisted living are
payout not taxable.
y For policies issued after August 17, 2006, if the policy is company-owned (COLI), the
employer beneficiary may exclude from gross income benefits received (no more
than the total amount of premiums and other amounts paid by the policyholder).
Any excess received beyond the amount of premiums and other amounts paid by the
policyholder would be taxable. The gross income inclusion requirement for the COLI is
not applicable, however, if proper notice and consent requirements are met and any of
the following situations apply:
—The insured was a qualified highly compensated officer, director, or employee and a
U.S. citizen or resident.
—Proceeds were paid to a member of the insured's family.

reserved.Part 1
—The beneficiary is a family member or another individual (not the policyholder).

—The beneficiary is a trust for the benefit of the insured's family (or the estate of
the insured). Person
* Gifts and Inheritances (Nontaxable): Gross income does not include property received
from a gift or inheritance; however, any income received from such property (e.g., interest
income, rental income, etc.) after the property is in the hands of the recipient is taxable.
receiving
the gift
Medicare Benefits (Nontaxable): Exclude from gross income basic Medicare benefits
received under the Social Security Act.
Compare Workers' Compensation (Nontaxable): Exclude from gross income compensation received
Unemployment under a workers' compensation act for personal injury or sickness.
compensation
is taxable Personal (Physical) Injury or Illness Award (Nontaxable): Exclude from gross income
damages received as compensation for personal (physical) injury or illness.
Accident Insurance: Premiums Paid by Taxpayer (Nontaxable): Exclude from gross
income all payments received (even with multiple recoveries) if the individual paid all
premiums for the insurance.
Foreign-Earned Income Exclusion: Taxpayers working abroad may exclude from gross
income up to $120,000 (2023) of their foreign-earned income. In order to qualify for the
exclusion, the taxpayer must satisfy one of the following two tests:
1. Bona Fide Residence Test: The taxpayer must have been a bona fide resident of a
foreign country for an entire taxable year.
2. Physical Presence Test: The physical presence test requires that the taxpayer must
have been present in the foreign country for 330 full days out of any 12-consecutive-
month period (which may begin on any day).
Note: The exclusion cannot exceed the taxpayer's foreign earned income reduced by the
taxpayer's foreign housing exclusion ($120,000 foreign earned income exclusion × 16% =
$19,200 maximum). Furthermore, the amount of excluded income and housing is used to
determine the income tax rate for the taxpayer for the year (i.e., although it is not taxed, the
excluded income could cause other income to be taxed at higher rates, as if the excluded
income were taxable).
Clark did not itemize deductions on his Year 8 federal income tax return. In July Year 9,
Clark received a state income tax refund of $900 plus interest of $10, for overpayment of
Year 8 state income tax. What amount of the state tax refund and interest is taxable on
Clark's Year 9 federal income tax return?
a. $0
b. $10
c. $900
d. $910

John and Mary were divorced in 2017. The divorce decree (executed June 30, 2017) provides
that John pay alimony of $10,000 per year, to be reduced by 20 percent on their child's 18th
birthday. During the current year, the $10,000 was paid in the following way: John paid
$7,000 directly to Mary and $3,000 to Spring College for Mary's tuition. What amount of
these payments should be reported as income in Mary's current year income tax return?
a. $5,600
b. $8,000
c. $8,600
d. $10,000
DAC Foundation awarded Kent $75,000 in recognition of lifelong literary achievement. Kent
was not required to render future services as a condition to receive the $75,000. What
condition(s) must have been met for the award to be excluded from Kent's gross income?
I. Kent was selected for the award by DAC without any action on Kent's part.
II. Pursuant to Kent's designation, DAC paid the amount of the award either to a
governmental unit or to a charitable organization.
a. I only.
b. II only.
c. Both I and II.
d. Neither I nor II.
Klein, a master's degree candidate at Blair University, was awarded a $12,000 scholarship
from Blair in Year 8. The scholarship was used to pay Klein's Year 8 university tuition and
fees. Also in Year 8, Klein received $5,000 for teaching two courses at a nearby college.
What amount is includable in Klein's Year 8 gross income?
a. $0
b. $5,000
c. $12,000
d. $17,000

reserved.Part 1
3
MODULE
Gross Income: Part 2 REG 1
1 Business Income or Loss, Schedule C
Net income from self-employment is computed on Schedule C. The net income from the sole
proprietorship is then transferred to Form 1040 as one amount.
Gross business income

< Business expenses > Self-employed
Profit or loss
1.1 Gross Income

Items that normally would be revenue in a trade or business or other self-employed activity
(such as director or consulting fees) are included as part of gross income on Schedule C.
Cash = Amount received (cash basis)
Property = Fair market value
Cancellation of debt
1.2 Expenses = Deductible

Expenses include items that one would expect to find in business, such as:
Cost of goods (inventory is expensed when sold).
Salaries and commissions paid to others. /owner takes "draw" - taxed on net income
State and local business taxes paid.
Office expenses (e.g., supplies, equipment, and rent).
Actual automobile expenses (depreciation expense is limited to only that portion used for
business) or a standard mileage rate (65.5 cents per mile for 2023).
Business meal expenses at 50 percent.
Depreciation of business assets.
Employee benefits.
Legal and professional services.
Bad debts actually written off for an accrual basis taxpayer only (the direct write-off method,
not the allowance method, is used for tax purposes).

Interest expense on business loans (interest expense paid in advance by a cash basis Must be
taxpayer cannot be deducted until the tax year/period to which the interest relates). The incurred
business interest expense deduction is limited to the sum of: and paid
y business interest income;
y 30 percent of adjusted taxable income (ATI); and Only applies if income is $29,000,000 or more
y floor plan financing interest expense.
ATI is taxable business income for the year excluding all interest income and interest
expense. Floor plan financing is debt that is typically used to acquire motor vehicles held for
sale or lease where the debt is secured by the acquired inventory.
Disallowed business interest expense can be carried forward indefinitely. The limitation
does not apply if the taxpayer's average annual gross receipts are $29 million or less (2023)
for the prior three taxable years.
1.3 Nondeductible Expenses (on Schedule C)

Salaries paid to the sole proprietor (considered a withdrawal).
Federal income tax.
Personal portion of:
y Automobile, travel, and meal expenses.
y Interest expense: This may be reported as an itemized deduction if mortgage interest or
investment interest is paid.
Income
y State and local tax expense: Report as an itemized deduction on Schedule A.
y Health insurance of a sole proprietor: Although this is not reported on Schedule C as an
expense, it is reported as an adjustment to arrive at AGI.
Bad debt expense of a cash basis taxpayer (who never reported the income).
Charitable contributions: Report as an itemized deduction on Schedule A.
Entertainment expenses
1.4 Net Business Income or Loss

1.4.1 Net Business Income Is Taxable
There are two federal taxes on net business income:
1. Income tax
Two taxes
2. Self-employment (SE) tax
y An adjustment to income is allowed for one-half of SE tax (Medicare plus Social Security)
paid. This allows the sole proprietor the ability to "deduct" the employer portion of the
SE tax as an adjustment to gross taxable income (of which the net Schedule C amount is
a part).
y All self-employment income is subject to the 2.9 percent Medicare tax.
y Up to $160,200 (2023) is subject to the 12.4 percent Social Security tax (so a total of
15.3 percent on self-employment earnings up to $160,200 in 2023).
y The SE tax is calculated on 92.35 percent of self-employment income.

reserved.Part 2
Example 1 Calculation of Self-Employment Tax
Net earnings
Facts: Tyler earns $20,000 from his consulting business, which he runs as a sole
proprietorship. This was the only income he had in the current year.
Required: Determine Tyler's self-employment tax.
Solution: Tyler's self-employment tax is $2,826 calculated as follows:
$20,000 × 92.35% = $18,470
$18,470 × 15.3% = $2,826
1.4.2 Net Taxable Loss = NOL = Max. loss is limited/carry forward excess NOL and it can
A business with a loss may deduct the loss against other sources of income subject to offset 80% of future
limitations. A combined excess business loss (over $578,000 for married filing jointly and income after
$289,000 for all other taxpayers in 2023) is not allowed and must be carried forward as a net Dec. 31, 2020
operating loss (NOL).
NOLs generated before 2018 can offset 100 percent of a future year’s taxable income, but can
NOL only be carried forward 20 years. NOLs generated after 2017 can be carried forward indefinitely.
2018 NOL carryforwards from post-2017 tax years can offset 100 percent of taxable income in 2019
and 2020. Starting in 2021, any NOL carryforwards from post-2017 tax years can only offset
2019 80 percent of taxable income after deducting any pre-2018 NOL carryforwards.
2020 RM Required when sales
1.5 Uniform Capitalization Rules = Inventory DL exceed limit
Carryback FOH
The uniform capitalization rules apply to all business enterprises that meet the criteria for
5 years implementation (including sole proprietorships, partnerships, and corporations) and provide
and guidelines with respect to capitalizing or expensing certain costs (i.e., taxes paid in connection
with the acquisition of property are capitalized as part of the property's cost). In the first year of
no 80% implementation, they generally cause an increase in the carrying cost of ending inventory and a
limitation decrease in operating expense. This results in an increase to taxable income. Any business that
has average gross receipts of $29 million or less (2023) for the previous three years is exempt
until 2021 from the uniform capitalization rules.
1.5.1 Types of Property
Uniform capitalization rules apply to the following:
Produced for Use: Real or tangible personal property produced by the taxpayer for use in
his or her trade or business (e.g., machine tools for use in the production line of a machine
tool manufacturer).
Produced for Sale: Real or tangible personal property produced by the taxpayer for sale to
his or her customers (i.e., manufacturer's inventory).
Acquired for Resale: Real or tangible personal property acquired by the taxpayer for resale
(i.e., retailer's inventory).

1.5.2 Costs Required to Be Capitalized

Costs required to be capitalized include direct materials, direct labor (e.g., compensation,
vacation pay, and payroll taxes), and applicable indirect costs (i.e., those to which an
allocation must be applied, such as factory overhead). Examples of applicable indirect
costs (capitalizable expenses) include utilities, warehousing costs, repairs, maintenance,
indirect labor (e.g., supervisory), rents, storage, depreciation and amortization, insurance,
pension contributions, engineering and design, repackaging, spoilage and scrap, and
administrative supplies.
1.5.3 Costs Not Required to Be Capitalized = Period expenses = SG&A

Costs not required to be capitalized include selling, advertising, and marketing expenses, certain
general and administrative expenses, research, and officer compensation not attributed to
production services.
1.6 Long-Term Contracts

Special tax rules are required of most taxpayers who operate under long-term contracts
(exceptions exist). A long-term contract is generally defined as a contract that is incomplete at
the end of a tax year in which it was started (i.e., it does not start and finish within the same
tax year) and relates to the manufacture, installation, building, or construction of real or
personal property.
1.6.1 Income Recognition

Percentage-of-Completion Method Required for Tax for Nonexempt Long-Term Contracts
Unless an exemption exists for a taxpayer or a contract, long-term contracts must be
accounted for using the percentage-of-completion method to determine taxable income for
a particular contract. (Note that a taxpayer may use other methods for other contracts if an
exemption exists; thus, contracts are evaluated on a contract-by-contract basis.)
Exemptions
Certain contracts are exempt from the requirements of long-term contract income
recognition for tax purposes and may use other methods (e.g., completed contract method)
to calculate their taxable income under the contract for regular income tax purposes.
These include:
y Small contractors (projects that are expected to last no more than two years and
are performed by a taxpayer who has average annual gross receipts not exceeding
$29 million for the three years that precede the tax year in question).
y Home construction contractors (where at least 80 percent of the total contract costs are
related to the construction or rehabilitation of certain dwelling units, which do not
include hotels, etc., where the majority of the use is on a transient basis).
1.6.2 Cost Allocation Rules

Cost Allocation Rules Required for Tax on Long-Term Construction Contracts
Unless an exemption exists for a taxpayer or a contract, those involved in long-term
contracts must use cost allocation rules to account for their long-term projects. In addition
to all the direct costs associated with a project, other costs that relate to the activities
of the long-term contract (e.g., storage costs, production period interest, pension plan
contributions, etc.) must be allocated to the cost of the long-term project. Essentially, the
uniform capitalization rules discussed previously apply to long-term contracts. Note that
costs associated with marketing, advertising, selling, and research and development are not
subject to such cost allocation (capitalization).

reserved.Part 2
Exemptions
Small contractor and home construction contractors are not required to employ the costs
allocation rules identified above. However, (i) they are required to allocate production
period interest related to the contract to the costs of the project; and (ii) home construction
projects that are not also small constructions projects must use the uniform capitalization
rules (discussed in the above section). Also, interest for the production period need not be
capitalized if the total cost of the project is $1 million or less and the project is estimated to
take less than 12 months to complete.
1.6.3 Production Period Defined

Start Date
For cash basis taxpayers, the starting date of production is generally the date on which
the contractor incurs costs (other than the start-up engineering, design, etc., costs that are
excluded from cost allocation, as discussed above) under the contract. For accrual basis
taxpayers, the starting date is the later of the date for cash basis taxpayers or the date the
taxpayer has incurred at least 5 percent of the total costs initially estimated under the contract.
End Date
The end date of the production period is generally the date on which the work under the
contract is complete (per contract provisions) or on the date the taxpayer has incurred at
least 95 percent of the total costs expected under the contract.
1.6.4 Calculation for Percentage-of-Completion Method Income Recognition

In simple terms, the amount of gross income under the contract that is recognized on the tax
return is the portion of income that relates to the percentage of the contract that has been
completed during the year.
Cost-to-Cost Method (to Determine Percentage)
The percentage is calculated under the cost-to-cost method, which is a ratio of the total
cumulative costs incurred to date at the end of the tax year divided by the total expected
costs to be incurred under the contract. This ratio provides a total "percent-complete"
amount for the contract as of the end of the tax year.
Gross Income Recognition Calculation
To calculate the amount of income that will be recognized under the contract for a given tax
year, multiply the ratio determined using the cost-to-cost method (above) by the total contract
price and subtract the amount of income that was recognized in prior years for the contract.
Cost incurred Work done

= = % earned
Total expected cost Total work

1.6.5 Miscellaneous Effects

Change in Accounting Method : IRS permission required
The method used by a taxpayer for the income recognition on a contract is deemed a
"method of accounting" by the IRS and cannot be changed for the contract without consent
of the IRS. Furthermore, if a taxpayer desires to sever a contract into various contracts or
aggregates several contracts into one larger contract, IRS approval is generally required, and
a statement explaining the changes must be attached to the original tax return for the year.
"Unique" Rules for Personal Property Contracts
In order for the manufacture of personal property to qualify as a long-term contract, not
only must the contract not be completed within the year it was started, but it also must be
for the manufacture of a "unique" item (i.e., an item that is made specifically for a customer
and could not be sold to others, is not generally part of a taxpayer's normal inventory, and
requires significant preproduction costs).
Related Parties
A taxpayer who performs an activity that would normally not be considered a long-term
contract activity (such as engineering or design services) must report income using the
percentage-of-completion method if it is incidental to or necessary to a related party's long-
term contract that must be reported using the percentage-of-completion method.
2 Farming Income: Schedule F
A person (or entity) who engages in the management or operation of a farm with the intent of
earning a profit will report income and expenses (either cash or accrual basis) on Schedule F.
Essentially, income from farming activities is treated the same as income from other
business activities.
2.1 Cash Basis and Accrual Method

Cash Basis
y Most farmers use the cash basis. Cash basis
y Inventories of produce, livestock, etc., are not considered. Expense inventory
y Gross income includes cash and the value of all other items received from the sale of
produce, livestock, etc., that has been raised by the farmer.
y For livestock or other items a farmer may have bought, profit is computed by
subtracting the purchase price (cost) from the sales price.
y Insurance payments from crop damage are treated as income.
y Interest paid on a loan used for the farming business is deductible.

reserved.Part 2
Cash method
Example 2 Farming Deduction
Facts: Bob is a cash basis sole proprietor farmer. During Year 2, Bob spends $2,100 on feed
for the livestock.
Required: Determine how much Bob can deduct in Year 2 related to feed for the livestock.
Solution: Bob may deduct the entire $2,100 on his Year 2 income tax return, because he is
not required to consider inventory.
Accrual Method
y The accrual method is required for certain corporate and partnership farmers as well as Accrual
for all farming tax shelters. Must use
y Inventories must be used and maintained, and they must be taken at the start and end
inventory
of the tax year. The following methods of inventory valuation for farming are accepted
by the IRS:
—Cost.
—Lower of cost or market.
—Farm-price method (inventory is valued at the market price less the disposition costs
and generally must be used for all items inventoried by the farming business, except
for any livestock valued using the unit-livestock-price method).
—Unit-livestock-price method (uses a value for each livestock class at a standard unit
price for animals within the class).
Gross profit equals the value of inventories at year-end plus the proceeds received from the
sales during the year, less the value of inventories at the beginning of the year, less the cost
of inventory purchased during the year.
Accrual method
Example 3 Farming Gross Profit Calculation
Inventory
Facts: Evan has a farming business, and is required to use the accrual method. During Year
3 Evan had net sales of $75,000. Inventory at the beginning of Year 3 was $15,600 including
livestock held for resale. Inventory at the end of the year was $14,200. Inventory purchases
during Year, 3 including livestock, amounted to $60,000.
Required: Determine Evan's farming gross profit.
Solution:
Evan's gross profit for Year 3 is $13,600, calculated as follows:
$75,000 + $14,200 − $15,600 − $60,000 = $13,600
Net Ending Beginning Inventory Sales $75,000
sales inventory inventory purchases Beg. inv. $15,600
Purchases 60,000
COGA $75,600
End. inv. <14,200>
COGS <61,400>
Profit $13,600
2.2 Farm Income Averaging

Taxpayers with a qualifying farming business may be able to average some or all of the current
year's farm income by spreading it out over the past three years. Farm income averaging
provides farmers the opportunity to lower their tax liability during a year in which they earn a
significantly higher income than in the previous three years. An individual is not required to have
been engaged in a farming business in any of the base years in order to make a farm income
averaging election. Schedule J is used for averaging farming income.
Illustration 1 Farm Income Averaging
In the current year, a farmer had a bountiful crop, and the income from his farming business
increased significantly in Year 2 as compared with Year 1. The increased farming income
resulted in the farmer being taxed at a higher rate than in the past three years. The farmer
can elect to average some or all of the current year's income over the past three years.
- Schedule E
3 Rental Income or Loss - Passive activity
3.1 General
Rental activity is reported on Schedule E. Because rental income is usually regarded as passive,
rental income will be discussed in more detail when passive losses are covered. The basic
formula for the determination of net rental income or loss is as follows:
Gross rental income

Prepaid rental income Nonrefundable deposit
Rent cancellation payment
Improvement-in-lieu of rent At FMV
< Rental expenses >
Net rental income Or Net rental loss
3.2 Rental of Residence = Home

Rented Fewer Than 15 Days
If the residence is rented for fewer than 15 days per year, it is treated as a personal
residence. The rental income is excluded from income, and mortgage interest (first or
second home) and real estate taxes are allowed as itemized deductions. Depreciation,
utilities, and repairs are not deductible.

reserved.Part 2
Rented 15 or More Days

If the residence is rented for 15 or more days, and is used for personal purposes for
the greater of (i) more than 14 days or (ii) more than 10 percent of the rental days, it is
treated as a personal/rental residence. Expenses must be prorated between personal
and rental use. However, a different proration method is used for mortgage interest and
property taxes than is used for other property-related expenses (e.g., utilities, insurance,
depreciation, etc.). Rental use expenses are deductible only to the extent of rental income. No rental
3.3 Nonresidence (Rental Property) & Not home loss allowed
For rental property, the taxpayer includes income received from the property in gross income
and deducts all expenses allocated to the rental property on Schedule E of Form 1040. Rental
losses are considered passive and will be deductible only to the extent of passive income. An
exception to this rule allows an active participant in rental activity to deduct up to $25,000 of
rental losses against nonpassive income.
Illustration 2 Vacation Home Rental
Julie rents her vacation home for two months and lives there for one month (during the
other 11 months, Julie lives in the city). Thus, of the three-month period the vacation home
is used, one-third is personal and two-thirds is rental. Assume that Julie's gross rental
income is $6,000, her real estate taxes are $2,400, interest is $3,600, utilities are $4,800,
and related depreciation is $7,200.
These amounts are deductible in the following order:
Rental Personal
(Schedule E) (Schedule A)
Gross rental income $ 6,000 −
Deduct: Taxes $2,400
Interest 3,600
$6,000 × 2/12* (1,000) $5,000—Schedule A
Balance $ 5,000
Deduct: Utilities $4,800 × 2/3** (3,200) $1,600—Not Deductible
$1,800
Deduct: Depreciation $7,200 × 2/3**
$4,800 but limited to*** (1,800) $2,400—Not Deductible
Net income $ 0 Net loss not allowed
* Allocated based on rental period/total annual period.

** Allocated based on rental period/total annual usage.
*** The additional $3,000 ($4,800 − 1,800) is not deductible, but is carried over to
next year and applied against future income from this property.

4 Tax Planning
Understanding the implications of the timing of income and deductions is an effective tool
for maximizing the after-tax wealth of a taxpayer. Using the time value of money principles, a
taxpayer can evaluate the effect of the timing of a tax decision. The two basic tax strategies,
assuming that the taxpayer's tax rate remains constant, are to:
1. Defer taxable income
2. Accelerate tax deductions
However, important tax factors may change from year to year in a dynamic tax environment.
These changes may be a result of a change in tax law or a change in the taxpayer's personal
situation, such as retirement or opening a new business. Therefore, many other factors must be
considered for tax planning. These include:
Type of income
Changing tax rates
Type of entity
Taxpayer's filing status
Postpone income
Example 4 Timing of Income (With Constant Tax Rates)
Facts: Jill Jones owns a small retail business. Jill is a cash-based, calendar-year taxpayer.
She reports her income and expenses related to the business on Schedule C. Jill has the
opportunity to make an unusually large sale in the amount of $100,000 and is trying to
determine the best tax strategy regarding the timing of the sale. She can finalize the sale
and receive payment on either December 31 of the current year or January 1 of next year.
Jill's marginal tax rate is 32 percent in both tax years. (For all examples that follow, assume
an after-tax rate of return on investments of 10 percent for present value analysis. The
present value factor for one year at 10 percent is .909.)
Required: Advise Jill on whether it is optimal for the sale to be made in the current year on
December 31 or next year on January 1.
Solution: If Jill finalizes the sale and receives payment on December 31 of this year, she
will have to report the $100,000 of income on this year's tax return. However, if she waits
to finalize the sale on January 1, then she will have income one year later on next year's
tax return.
(continued)

reserved.Part 2
(continued)
Compare the after-tax effect of Jill's $100,000 sale:

Option A: $100,000 Option B: $100,000
Income This Year Income Next Year
Income $100,000 $100,000
Marginal tax rate × 32% × 32%
Tax on income 32,000 32,000
Discount factor × 1 × 0.909
Present value of tax $ 32,000 = PV of taxes
$ 29,088
Income after tax: paid one year
Before-tax income $100,000 $100,000 from now
Less: Present value of tax (32,000) (29,088)
Income after tax $ 68,000 $ 70,912
Option B to defer the $100,000 income to next year results in $2,912 in additional income
after tax, considering the time value of money since the present value of tax paid one year
later is lower than if the tax is paid in the current year.
Keep more money
Postpone income
Example 5 Timing of Income (With Increasing Tax Rates)
Facts: Using the example above, assume that Jill's marginal tax rate is 32 percent this year
but will increase to 35 percent next year.
Required: Advise Jill on whether it is optimal for the sale to be made in the current year on
December 31 or next year on January 1.
Solution:
Option A: $100,000 Option B: $100,000
Income This Year Income Next Year
Income $100,000 $100,000
Marginal tax rate × 32% × 35% Rate increase
Tax on income 32,000 35,000
Present value of tax savings $ 32,000 = PV of taxes
$ 31,815
Income after tax: paid one year
Before-tax income $100,000 $100,000 from now
Income after tax $ 68,000 $ 68,185
Although Option B is still more attractive, the increase in taxable income is only $185.
A taxpayer must evaluate the specific facts and circumstances in his or her tax situation
to effectively understand the timing effects of taxable income.
Still keep more money

Accelerate tax deductions

Example 6 Timing of Deductions (With Constant Tax Rates)
Facts: Jill is planning to purchase new equipment for her retail business that costs $20,000. Jill
is considering whether to purchase the equipment this year and therefore deduct the cost of
the equipment on this year's tax return or purchase the equipment next year and deduct the
cost of the equipment on next year's tax return. Jill's marginal tax rate is 32 percent.
Required: Determine which year Jill should purchase the equipment to provide the lowest
after-tax cost.
Solution:
Option A: Purchase Option B: Purchase
$20,000 Equipment $20,000 Equipment
This Year Next Year
Tax deduction $20,000 $20,000
Marginal tax rate × 32% × 32%
Tax savings 6,400 6,400
Present value of tax savings $6,400 = PV of tax deduction
$5,818
After-tax cost of equipment: (savings) one year
Before-tax cost $20,000 $20,000 from now
After-tax cost $13,600 $14,182
Option A offers Jill the lowest after-tax cost of the equipment.
Better option,
less expensive

reserved.Part 2
Accelerate tax deduction
Example 7 Timing of Deductions (With Increasing Tax Rates)
Facts: Use the same facts as above, but now assume that Jill expects that her business
income will rise with the use of the new equipment. Therefore, her marginal tax rate will
increase from 32 percent in the current year to 35 percent next year.
Required: Determine which year Jill should purchase the equipment to provide the lowest
after-tax cost.
Solution:
Option A: Purchase Option B: Purchase
$20,000 Equipment $20,000 Equipment
This Year Next Year
Tax deduction $20,000 $20,000
Marginal tax rate × 32% × 35% Tax rate change
Tax savings 6,400 7,000
Discount factor × 1 × .909
Present value of tax savings $ 6,400 $ 6,363 PV of tax deduction
After-tax cost of equipment: (savings) one year
Before-tax cost $20,000 $20,000 from now
Less: present value of tax (6,400) (6,363)
After-tax cost $13,600 $13,637
With an increased tax rate next year, Option A is still more attractive, but only slightly so ($37).
Many factors must be considered in determining the timing of income and deductions
for a taxpayer. In a changing tax environment, the facts and circumstances unique to the
taxpayer must be evaluated. The examples above illustrate the effect of properly timing
income and deductions to increase the after-tax wealth of a taxpayer.
Better option,
less expensive

Which of the following costs is not included in inventory under the Uniform Capitalization
rules for goods manufactured by the taxpayer?
a. Research
b. Warehousing costs
c. Quality control
d. Taxes excluding income taxes
Baker, a sole proprietor CPA, has several clients that do business in Spain. While on a
four‑week vacation in Spain, Baker attended a five-day seminar on Spanish business
practices that cost $700. Baker's round-trip airfare to Spain was $600. While in Spain, Baker
spent an average of $100 per day on accommodations, local travel, and other incidental
expenses, for total expenses of $2,800. What amount of total expense can Baker deduct on
Form 1040 Schedule C, "Profit or Loss From Business," related to this situation?
a. $700
b. $1,200
c. $1,800
d. $4,100
Nare, an accrual-basis taxpayer, owns a building which was rented to Mott under a 10-year
lease expiring August 31, Year 8. On January 2, Year 2, Mott paid $30,000 as consideration
for canceling the lease. On November 1, Year 2, Nare leased the building to Pine under
a five-year lease. Pine paid Nare $10,000 rent for the two months of November and
December, and an additional $5,000 for the last month's rent. What amount of rental
income should Nare report in its Year 2 income tax return?
a. $10,000
b. $15,000
c. $40,000
d. $45,000

reserved.Part 2
4
MODULE
REG 1 4 Items From Other Entities
Items From
Other Entities REG 1
1 Flow-Through Business Entities
For tax purposes, business entities are either separate taxpaying entities or flow-through
entities. A business entity that is a separate taxpaying entity pays tax on the income earned
by the business. In contrast, a flow-through entity reports income on a tax return filed for
informational purposes only. The income flows through to the owners and is taxed at the
individual owner level, regardless of whether or not the amounts are withdrawn by the owner.
Although there are many types of legal entities, the tax system in the United States recognizes
four categories of business entities:
1. Partnership or Limited Liability Company (LLC): Flow-through entity that reports income
K-1 on Form 1065
2. S Corporation: Flow-through entity that reports income on Form 1120S Single member
3. Sole Proprietorship: Flow-through entity that reports income on Form 1040, Schedule C LLC
4. C Corporation: Separate taxpaying entity that reports income on Form 1120
The coverage in this section focuses on flow-through business entities, which must provide an
owner of the entity a Schedule K-1 with the income information to be reported on Form 1040.
Reporting of items from Schedule C is covered earlier in this unit.
1.1 Reporting Partnership/LLC Income and Losses = K-1 Schedule E

A partnership is not a taxpaying entity and files an information return, Form 1065, by March 15
(extension to September 15, if necessary). A limited liability company (LLC) is taxed as a partnership.
The following schedule shows which partnership items will be reported separately on Form 1065
and which will pass through to each individual partner's income tax return as separately stated
items to be treated by each individual according to his or her own circumstances. (Note that the
details of the partnership's ordinary business income and expenses are reported only on Form
1065.) Partnership income and loss is generally allocated per the partnership agreement.
One common separately stated item is guaranteed payments to partners. A partner in a
partnership cannot be an employee of the partnership, so a partnership may give a partner a
guaranteed payment as compensation for services provided to the partnership. Guaranteed
payments are an ordinary business expense to the partnership. A guaranteed payment is also
reported to the partner on his or her Schedule K-1 and included in the partner's ordinary income
on the partner's individual income tax return.

4 Items From Other Entities REG 1
K-1: Each partner gets one

Each partner reports their share of Appears On
net income/loss on their 1040 on Schedule E 1065 K K-1
Business income 
< Business expenses > 
< Guaranteed Payments > Partnership deduction
1. Ordinary business income or loss Loss allowed up to basis   
2. Guaranteed payments to partners To that partner as income   
3. Net rental real estate income or loss E  
4. Interest income B  
5. Dividend income B  
Separately
6. Capital gains and losses D  
reported 7. Net Section 1231 gain (loss)  
items to 8. Charitable contributions A  
each
partner 9.
Section 179 expense deduction  
10. Investment interest expense  
11. Partners' health insurance premiums (included as part of
guaranteed payments)   
Fringe 12. Retirement plan contributions for employees
benefits 
13. Retirement plan contributions for partners  
14. Tax credits (reported by partnership but claimed by partners)  
"Adjustments"
Pass Key
A partner must include on a personal income tax return his or her distributive share of
each separate "pass-through" item.
Guaranteed payments are a business expense that reduce partnership ordinary
business income flowing through to the partners, and are also taxable income to the
partner receiving the payments.
Partnership and S corporation income

- Taxed when business earns and reports the income
- Not when distributed
R1–44 Module 4 Items

© Becker Professional Education Corporation. All From
rights Other Entities
reserved.
Each shareholder gets a K-1

1.2 Reporting S Corporation Income and Losses: K-1 and reports their share of
items on schedule E
An S corporation is also not a taxpaying entity. The S corporation files an information return, Form
1120S, by March 15 (extension to September 15, if necessary). The details of the S corporation's
business income and expenses are reported only on Form 1120S, and the net ordinary business
income and separately stated items are flowed through to the shareholders to be included on their
individual income tax returns. Allocations to shareholders are made on a per-share, per-day basis.
The separately stated items for an S corporation are basically the same as a partnership, with
one exception. Unlike a partner in a partnership, an S corporation shareholder can be an
employee of the corporation, so a corporate shareholder-employee would receive a salary, not a
guaranteed payment. Salary expense
Illustration 1 Allocation on Per-Share, Per-Day Basis
The Duffy Corporation, an S corporation, is owned equally by three shareholders, Rick,

Annie, and Kate. The corporation is on a calendar year basis. On February 1, Year 5,
Kate sold her one-third interest in Duffy Corporation to George. For the year ended
December 31, Year 5, the corporation had non-separately stated ordinary business income
of $120,000. For Year 5, the income of the corporation should be allocated as follows:
Rick ($120,000 × 1/3) $ 40,000
Annie ($120,000 × 1/3) 40,000
1 month Kate (31/365 × $40,000) 3,397
Per share, per day
11 months George (334/365 × $40,000) 36,603
Total $120,000
1.3 Self-Employment Income

1.3.1 Guaranteed Payments for Services
Guaranteed payments to partners or LLC members for services provided to the partnership or
Two taxes LLC are self-employment income to the recipient. Guaranteed payments are therefore subject to
self-employment (Social Security and Medicare) tax in addition to income tax.
A shareholder in an S corporation receives a salary, rather than a guaranteed payment, for Salary
services provided to the corporation. The shareholder is employed by the corporation, not self- expense
employed, so half of the Social Security and Medicare taxes are paid by the corporation and half
are withheld from the shareholder's salary.
1.3.2 Owner's Share of Ordinary Business Income

A partner or LLC member's allocable share of partnership or LLC ordinary business income
is self-employment income subject to self-employment tax if the partner or LLC member
is actively involved in the operations of the business. If the partner or LLC member is not
actively involved, such as a limited partner who is not allowed to participate in managing the
partnership, then the partner or LLC member's allocable share of ordinary business income is
not self-employment income.
A shareholder's allocable share of S corporation ordinary business income is not self‑employment
income, regardless of whether or not the shareholder is actively involved in the operations of the
business. This avoidance of self-employment tax is one reason that a business may choose to
organize as an S corporation rather than a partnership or LLC.

2 Section 199A Qualified Business Income Deduction

for Flow-Through Business Entities
- Sole proprietor/Schedule C
- Partnership
2.1 Section 199A Overview - LLC/LLP
- S corporation
The Tax Cuts and Jobs Act of 2017 enacted Internal Revenue Code Section 199A, which provides
a deduction of up to 20 percent of qualified business income for eligible flow-through entities.
The qualified business income (QBI) deduction (also known as the Section 199A deduction) is
available to all taxpayers other than a regular C corporation. This includes individuals, trusts, and
estates. The deduction is taken "below the line" or from adjusted gross income.
2.2 Definitions
1. Qualified Business Income (QBI): Ordinary business income less ordinary business
deductions earned from a sole proprietorship, S corporation, limited liability company, or
partnership connected to business conducted within the U.S. QBI does not include any
wages earned as an employee or guaranteed payments to partners. Dividends, interest,
and long-term and short-term capital gains and losses are not included. QBI for a business
must be reduced by any adjustments taken to arrive at AGI that relate to that business.
This includes the deductible part of the self-employment (SE) tax, deductions for qualified
contributions to SE retirement plans, and SE health insurance deductions.
2. Qualified Property: Any tangible, depreciable property that is held by the business at the
end of the year and is used at any point during the year in the production of QBI.
3. Qualified Trade or Business (QTB): Any business other than a Specified Service Trade or
Job Business (SSTB).
4. Specified Service Trade or Business (SSTB): An SSTB is a trade or business involving
direct services in the fields of health, law, accounting, actuarial science, performing arts,
consulting, athletics, financial services, brokerage, including investing and investment
management, trading or dealing in securities, partnership interests or commodities, and any
trade in which the principal asset is the reputation or skill of one or more of its employees - Professionals
or owners. Engineering and architectural services are specifically excluded from the - Celebrities
definition of SSTB. - Rock stars
2.3 Calculating the Deduction
The basic deduction:
20% × Qualified business income (QBI) = Exclusion
2.4 Limitations to the Section 199A QBI Deduction

Limitations are applied to the QBI deduction based on the taxable income (before the QBI
deduction) of the taxpayer and whether the business is a qualified trade or business (QTB) or
a specified trade or business (SSTB). SSTBs are only eligible for the deduction if the taxpayer's
taxable income before the QBI deduction is below a certain level. There are three types of
limitations that may apply.

reserved.
2.4.1 Limitations Based on Taxable Income Level

2023
Filing Status Taxable Income Before QBI Deduction
Single and all other $182,100–$232,100 $50,000 phase-out
Married filing jointly $364,200–$464,200 $100,000 phase-out
2.4.2 W-2 Wage and Property Limitation
When applicable, the QBI deduction is limited to the greater of:
1. 50 percent of W-2 wages for the business; or
Test 1
2. 25 percent of W-2 wages for the business plus 2.5 percent of the unadjusted basis
immediately after acquisition (UBIA) of all qualified property. PP&E
The W-2 wage and property limitation does not apply to real estate investment trust (REIT) or
publicly traded partnership (PTP) income.
2.4.3 Overall Taxable Income Limitation to Section 199A QBI Deduction

Once the tentative QBI deduction for each qualifying business is calculated, an overall limitation
based on the taxpayer's taxable income in excess of net capital gain must be considered. For
purposes of the Section 199A overall taxable income limitation, net capital gain includes the
excess of net long‑term capital gain (LTCG) over net short-term capital loss (STCL) and qualified
dividend income. The total Section 199A QBI deduction is the lesser of:
1. Combined QBI deductions for all qualifying businesses; or
Test 2 2. 20% of the taxpayer's taxable income (before the QBI deduction) in excess of net capital gain.
2.5 Three Categories of Taxpayers

To best understand how to apply the limitations based on taxable income and the W-2 wage and
property limitation, taxpayers can be divided into three categories:
Category 1: Taxpayers with taxable income at or below $182,100 (single or head of Full 20% No test 1
household) or $364,200 (MFJ) (2023).
Category 2: Taxpayers with taxable income above $232,100 (single or head of household) or QTB = Limited
$464,200 (MFJ) (2023). SSTB = - 0 -
Category 3: Taxpayers with taxable income between $182,100 and $232,100 (single or head Phase-in
of household) or $364,200 and $464,200 (MFJ) (2023). Category 3 is a very complex calculation of limits
and is beyond the scope of the exam, therefore, the details are not covered in this text.
2.5.1 Category 1 = Below income level

Taxpayers with taxable income at or below $182,100 (single or head of household) or $364,200
(MFJ) (2023):
If QTB  Full 20% QBI deduction

No test 1
If SSTB  Full 20% QBI deduction
Basically, if a taxpayer's taxable income before the QBI deduction is under the applicable
thresholds, neither the restrictive rules for SSTBs nor the W-2 wage and property limit apply.
The taxpayer is eligible for the full deduction (20% × QBI). In this taxable income range, an SSTB
is treated the same as a QTB.

Example 1 QTB With Taxable Income Up to $182,100 Below
Facts: A taxpayer filing as single has the following:

Taxable income before QBI deduction = $50,000
Net capital gains = $5,000
QBI = $40,000
Required: Calculate the Section 199A QBI deduction.
Solution:
Tentative QBI deduction = $40,000 × 20% = $8,000
W-2 wage and property limitation does not apply because taxable income before the QBI
deduction is less than $182,100.
Overall limit = ($50,000 taxable income – $5,000 net capital gains) × 20% = $9,000, so not
limited by overall limit
Section 199A QBI deduction = $8,000
Example 2 SSTB With Taxable Income Up to $182,100 Below

Net capital gains = $15,000
QBI = $40,000
Solution:
Tentative QBI deduction = $40,000 × 20% = $8,000
W-2 wage and property limitation and SSTB exclusion do not apply because taxable income Lesser
before the QBI deduction is less than $182,100. $35,000
Overall limit = ($50,000 taxable income – $15,000 net capital gains) × 20% = $7,000, so
deduction is limited by overall limit

reserved.
2.5.2 Category 2 Above income level

Taxpayers with taxable income above $232,100 (single or head of household) or $464,200
(MFJ) (2023):
If QTB  Full W-2 wage and property limitation applies

If SSTB  No QBI deduction allowed
Example 3 QTB With Taxable Income of $232,100 or More Above

Net capital gains = $0
QBI = $100,000
Taxpayer's share of QTB's W-2 wages = $30,000
Taxpayer's share of QTB's UBIA of qualified property = $80,000
Solution: Because the taxpayer's taxable income of $240,000 is greater than the
maximum amount of $232,100 and the business is a QTB, the full W-2 wage and property
limitation applies.
Tentative QBI deduction = $100,000 QBI × 20% = $20,000
W-2 wage and property limitation:
Lesser Greater of: Lesser
1. $30,000 W-2 wages × 50% = $15,000
2. ($30,000 W-2 wages × 25%) + ($80,000 UBIA of qualified property × 2.5%) = $9,500
W-2 wage and property limitation of $15,000 is less than the tentative QBI deduction
of $20,000, so the QBI deduction is limited to $15,000 by the W-2 wage and
property limitation.
Overall limit = $240,000 taxable income × 20% = $48,000, so not limited by the overall limit

Example 4 SSTB With Taxable Income of $232,100 or More Above

Net capital gains = $0
QBI = $100,000
Taxpayer's share of SSTB's W-2 wages = $30,000
Taxpayer's share of SSTB's UBIA of qualified property = $80,000
Solution: Because the business is an SSTB and the taxpayer's taxable income exceeds
$232,100, the taxpayer is not eligible for the QBI deduction.
Section 199A QBI deduction = $0
2.6 Negative QBI Amount = Net loss on QBI

2.6.1 Negative QBI With Multiple QTBs = Still have net income from QBIs
A taxpayer may have multiple sources of business income that are eligible for the Section 199A
QBI deduction. If one or more of these sources has a loss for the tax year, the losses are
allocated pro rata among the qualifying businesses with positive QBI for purposes of calculating
the QBI deduction. The W-2 wages and UBIA of qualified property of the business with a negative
QBI are ignored, and do not get allocated or carried forward.
Illustration 2 Negative QBI With Multiple QTBs
Business A QBI $100,000 (1/3) - $25,000 = $75,000

Business B QBI $200,000 (2/3) - $50,000 = $150,000
Total positive QBI $300,000
Business C QBI $ (75,000) allocated 1/3 ($25,000) to A and 2/3 ($50,000) to B
Adjusted Business A QBI = $100,000 – $25,000 = $75,000

Adjusted Business B QBI = $200,000 – $50,000 = $150,000

reserved.
2.6.2 Negative Total QBI Amount = Total is a net loss on QBIs

If QBI for the tax year (one source or multiple sources combined) is negative, then the QBI deduction
for that tax year is zero. The combined QBI loss for the tax year is carried forward and treated as a
separate business for the following tax year for purposes of the Section 199A QBI deduction. The
W-2 wages and UBIA of qualified property for any business with a QBI loss does not carry forward.
This carryover rule is for purposes of the Section 199A QBI deduction only and does not affect
the deductibility of the loss for federal income tax purposes.
Illustration 3 Negative Total QBI Amount
Business A QBI $ 100,000

Business B QBI $ 200,000
Business C QBI $(400,000)
Combined QBI loss $(100,000) carried forward to the following year as a separate business
2.7 Aggregation Rules

An individual taxpayer may aggregate QTB (but not any SSTB) businesses if:
1. the same person, or group of persons, owns at least 50% of each business; and
2. the businesses to be aggregated satisfy at least two of the following factors:
y Provide products/services that are the same or customarily offered together
y Share facilities or significant centralized business elements
y Operated in coordination with other businesses in aggregated group
The "same person or group of persons" includes members of the same family (spouse, children,
grandchildren, parents) and owners in the same business entity (shareholders in S corporation,
partners in a partnership).
If the taxpayer elects to aggregate businesses, then QBI, W-2 wages, and UBIA of qualifying
property for all aggregated businesses must be combined for purposes of calculating the W-2
wages and property limitations.
Illustration 4 Aggregation of QTB Businesses
Maria, a single taxpayer, owns 100 percent of QTB businesses X, Y, and Z. The businesses
have W-2 wages but do not have qualified depreciable property. Maria's only other source
of taxable income for the year is a $750,000 salary. She does not have any net capital gains.
Maria's taxable income for the year, before any Section 199A QBI deduction, is $2,400,000.
QBI W-2 Wages
X $1,000,000 $ 500,000
Y 1,000,000 0
Z 2,000 500,000
Total $2,002,000 $1,000,000
(continued)

(continued)
If Maria does not aggregate Businesses X, Y, and Z:

Maria's taxable income is above $232,100 (2023), so the full W-2 wage and property limitation
applies for each QTB. Because the QTBs do not have qualified depreciable property, only the
W-2 wages are taken into account in calculating the W-2 wage and property limitation.
Business X: Tentative QBI deduction = $1,000,000 × 20% = $200,000
W-2 wage limit = $500,000 × 50% = $250,000 (greater than $200,000 so not limited)
Section 199A QBI deduction for X = $200,000
Business Y: Tentative QBI deduction = $1,000,000 × 20% = $200,000
W-2 wage limit = $0 × 50% = $0 (so no QBI deduction is allowed)
Section 199A QBI deduction for Y = $0
Business Z: Tentative QBI deduction = $2,000 × 20% = $400
W-2 wage limit = $500,000 × 50% = $250,000 (greater than $400 so not limited)
Section 199A QBI deduction for Z = $400
Overall limit = $2,400,000 taxable income × 20% = $480,000, so not limited by the overall limit
Total Section 199A QBI deduction = $200,000 + $0 + $400 = $200,400
If Maria aggregates Businesses X, Y, and Z:
Maria's taxable income is above $232,100 (2023), so the full W-2 wage and property
limitation applies. Because the QTBs do not have qualified depreciable property, only the
W-2 wages are taken into account in calculating the W-2 wage and property limitation.
Combined X, Y, and Z Tentative QBI deduction = $2,002,000 × 20% = $ 400,400
Combined X, Y, and Z W-2 wage limit = $1,000,000 × 50% = $500,000 (greater than $400,400 so
not limited)
Overall limit = $2,400,000 taxable income × 20% = $480,000, so not limited by overall limit
Which of the following is both an item that is an allowable tax deduction to the partnership,
reported separately on the individual partner's Schedule K-1, and then included on the
partner's individual tax return?
a. Salaries paid to non-partner employees
b. Advertising expenditures
c. Guaranteed payments paid to partners
d. Depreciation on equipment used in the business

reserved.
5
MODULE
REG 1 5 Loss Limitations for Individuals
Loss Limitations
for Individuals REG 1
1 Overview
There are a number of limitations on the ability of individual taxpayers to deduct various losses.
These include a limitation on the deduction of net capital losses and four limitations on the
deduction of business and rental activity losses:
Tax basis limitation
At-risk limitation
Flow-through entities K-1
- Rental real estate
Passive activity loss (PAL) limitation
Excess business loss limitation - Maximum $ amount allowed is limited
The tax basis and at-risk basis limitations apply to flow-through entities at the entity level, and
limit the ability of owners (partners, LLC members, and S corporation shareholders) to pass
through losses to their individual income tax return for deduction. The PAL and excess business
loss limitations apply at the individual income tax return level.
2 Business Loss Limitations
2.1 Tax Basis Limitation

A taxpayer's tax basis in his or her ownership interest in a flow-through entity is basically
the investment in the ownership interest, adjusted for items such as income, deductions,
distributions, and, in some cases, debt.
A loss can only be flowed through to the owner's individual income tax return and deducted to
the extent of the owner's tax basis. A loss in excess of the owner's tax basis is suspended until
tax basis is reinstated in future years, and is carried forward indefinitely.
Any suspended losses due to insufficient tax basis remaining when the owner disposes of his or
her interest in the flow-through entity are lost.
2.2 At-Risk Basis Limitation

A loss can only be flowed through to the owner's individual income tax return and deducted
to the extent that the owner is "at risk." The amount that a taxpayer is "at risk" represents the
taxpayer's economic risk in the activity. The at-risk amount is typically the same as the owner's
tax basis, but excludes the owner's share of certain debt.
A loss in excess of the owner's at-risk basis is suspended until at-risk basis is reinstated in future
years, and is carried forward indefinitely. Any suspended losses due to insufficient at-risk basis
remaining when the owner disposes of his or her interest in the flow-through entity can be
offset against any gain from selling the interest.

5 Loss Limitations for Individuals REG 1
2.3 Passive Activity Loss (PAL) Limitation

Losses that clear the tax basis and at-risk hurdles are flowed through to the owner's individual
income tax return. However, the ability to deduct the loss may be limited by the passive activity
loss (PAL) limitation and/or the overall excess business loss limitation.
2.3.1 Categories of Income (Loss)

Under the passive activity loss rules, all income and loss items are sorted into three categories,
or "baskets."
1. Active
y Salaries and wages
y Guaranteed payments for services
y Business income or loss from activities in which the taxpayer actively participates
y Other taxable income that does not fall into one of the other two baskets
2. Passive
y Business income or loss from activities in which the taxpayer does not materially
participate
y Rental real estate is automatically considered a passive activity unless an exception
applies
y Income or loss from a limited partnership interest is automatically considered passive
3. Portfolio
y Interest
y Dividends
y Annuities
y Royalties
y Capital gains and losses
2.3.2 Material Participation

A trade or business activity is considered a passive activity if the taxpayer does not materially
participate in the operations of the business. A taxpayer is considered to be a material
participant only if the taxpayer is involved in the operations of the activity on a regular,
continuous, and substantial basis. The most common test for material participation is that the
taxpayer participates in the activity more than 500 hours during the tax year.
2.3.3 Deduction of Passive Activity Loss

A passive activity loss (PAL) can only be offset against passive activity income. A PAL cannot be
offset against active or portfolio income. If an individual taxpayer has multiple passive activity
income and losses for the year, PALs are offset against passive activity income pro rata.
A net PAL for the year is suspended, and carried forward indefinitely to offset future passive
activity income. Any suspended PALs remaining when the owner disposes of the activity can be
offset against active, passive, or portfolio income. Loss allowed
when sold
(nonpassive)
R1–54 Module 5 Loss Limitations

© Becker Professional Education Corporation. All rightsfor Individuals
reserved.
2.3.4 Mom-and-Pop Exception to Passive Activity Loss Limitation

An individual taxpayer may deduct up to $25,000 of net passive activity losses attributable to
rental real estate if the taxpayer: Per year
actively participates in the rental real estate activity; and
PAL
owns at least 10 percent of the rental real estate activity.
exceptions
The $25,000 allowance is reduced by 50 percent of the excess of the taxpayer's AGI (excluding the
rental activity) over $100,000. The allowance is eliminated completely when AGI exceeds $150,000.
2.3.5 Real Estate Professional

If the taxpayer is a real estate professional, rental real estate activities are considered to be
active, rather than passive, and the PAL limitation does not apply. A taxpayer is a real estate
professional if:
more than 50 percent of the taxpayer's personal services during the year are performed in
real estate businesses; and
the taxpayer performs more than 750 hours of services in real estate businesses during
the year.
2.4 Excess Business Loss

Taxpayers are not allowed to deduct an overall "excess business loss" for the year. This
limitation is applied after the passive activity loss limitations.
An excess business loss for the year is the excess of aggregate business deductions for the year over
the sum of aggregate business income for the year plus a threshold amount. For 2023, the threshold
amount is $578,000 (married filing jointly) and $289,000 (all other taxpayers). The combined business
loss for the year in excess of the threshold amount is carried forward as a net operating loss (NOL).
The excess business loss limitation applies to all types of business income, active or passive.
Example 1 Classification of Income
Facts: Michael, a single taxpayer, has a $30,000 tax basis in a limited partnership interest.
Michael's at‑risk amount is $25,000. Michael is a 10 percent investment partner only and
has no management responsibilities in the partnership, M. Green & Sons. Michael does
not materially participate in M. Green & Sons. This year, M. Green & Sons experienced a
$400,000 loss. Michael's share of the partnership loss is $40,000 (10 percent). Michael's
other sources of income for the year include: $75,000 in wages; $6,000 income from a
5 percent investment in Morris & Stubbs (a different partnership in which he does not
materially participate); $3,000 in long-term capital gains; and $12,000 in dividend income.
Required: Classify Michael's income items into the three categories of income: active,
passive, and portfolio.
Solution:
Income Items
Active $75,000 wages
Passive $6,000 income from Morris & Stubbs
Portfolio $12,000 dividend income
Portfolio $3,000 long-term capital gain

Example 2 Loss Limitations
Facts: Same facts as in Example 1.

Required: How much of Michael's $40,000 loss in M. Green & Sons is deductible in the
current year?
Solution: The four factors limiting business losses—tax basis, at-risk basis, passive activity
loss limitation, and excess business loss limitation—must be considered.
Tax Basis: Michael has a $30,000 tax basis in M. Green & Sons. His loss flow-through is
limited to the amount of his tax basis, $30,000. The $10,000 loss in excess of his tax basis
is suspended.
At-Risk: After considering tax basis, Michael must then consider his at-risk basis in
M. Green & Sons, which is $25,000. As a result of the at-risk basis, Michael can only flow
through $25,000 of the $30,000 loss available after considering tax basis. The additional
$5,000 loss in excess of his at-risk basis is suspended.
Passive Activity Loss (PAL) Limitation: Because Michael does not actively participate
in the M. Green & Sons partnership, this investment is a passive activity for him. Passive
losses can only be used to offset passive income. His investment in the Morris & Stubbs
partnership is also a passive activity in which he has $6,000 of passive income. He
can only deduct $6,000 of the passive loss to offset the $6,000 passive income. The
remaining $19,000 of the $25,000 flowed through from M. Green & Sons is suspended
and carried forward to offset future passive income.
Summary Treatment of $40,000 Passive Loss

From M. Green & Sons
Deductible in the current year $ 6,000
Tax basis: Suspended loss carryforward $10,000
At-risk: Suspended loss carryforward $ 5,000
Passive: Suspended loss carryforward $19,000
Excess business loss limitation: No limitation applies, as the deductible loss of $6,000
is well under the threshold amount of $289,000.
Example 3 Use of Losses When Investment Is Sold
Facts: Assume that Michael sells his interest in M. Green & Sons in the following year for a
$20,000 gain.
Required: Determine how the suspended losses due to tax basis, at-risk, and passive
activity loss (PAL) limitations are treated.
No Yes
Solution: The $10,000 suspended loss due to insufficient tax basis is lost. The $5,000 at-risk
suspended loss can be deducted against the $20,000 gain on sale of the partnership interest.
The $19,000 suspended PAL is fully deductible against non-passive income in the year
of disposal. Yes

reserved.
Example 4 Excess Business Loss Limitation
Facts: Assume instead that Michael has a cumulative suspended passive activity loss
(PAL) of $350,000 for M. Green & Sons when he sold the limited partnership interest in
the following year. Also assume that Michael has $20,000 of passive activity income from
Morris & Stubbs, $80,000 in wages, and $400,000 in taxable gambling winnings.
Required: What amount of the $350,000 M. Green & Sons cumulative suspended
passive activity loss is Michael allowed to deduct in the year he disposes of the
partnership interest?
Solution: Michael can deduct $309,000 of the suspended passive activity loss. Cumulative
suspended PALs are treated as nonpassive in the year the taxpayer disposes of the passive
activity, and can therefore be offset against other nonpassive income. However, because
they are business losses, they are still subject to the overall excess business loss limitation,
which applies to both active and passive business activities.
Michael's combined business loss is $330,000 (Morris & Stubbs $20,000 income less
M. Green & Sons $350,000 loss). Michael is single, so his combined business loss deduction
is limited to $289,000. He can use $20,000 of the $350,000 M. Green & Sons loss to offset
the Morris & Stubbs business income and deduct another $289,000 against his other
nonbusiness income, for a total of $309,000. The remaining excess business loss of $41,000
($350,000–$309,000) is carried forward as a net operating loss (NOL).
3 Loss Limitations: Capital Losses
3.1 Net Capital Loss Deduction and Loss Carryover Rules

$3,000 Maximum Deduction: Individual taxpayers realizing a net long-term or short-term
capital loss may only recognize (deduct) a maximum of $3,000 of the loss from other types
of gross income (ordinary income, passive income, or portfolio income). A joint return of
spouses is treated as one person. If the spouses file separately, the loss deduction is limited
to half ($1,500). If the taxpayer has both net short-term capital losses and net long-term
capital losses, the net short-term capital losses are deducted first.
Limitation: Capital losses are limited to taxable income.
Excess Net Capital Loss: Carry forward an unlimited time until exhausted. It maintains its
character as long-term or short-term in future years.
Personal (Nonbusiness) Bad Debt: A personal (nonbusiness) bad debt loss is treated as a
short-term capital loss in the year debt becomes totally worthless.
Worthless Stock and Securities: The cost (or other basis) of worthless stock or securities is
treated as a capital loss, as if they were sold on the last day of the taxable year in which they
became totally worthless.

What is the tax treatment of net losses in excess of the at-risk amount for an activity?
a. Any loss in excess of the at-risk amount is suspended and is deductible in the year
in which the activity is disposed of in full.
b. Any losses in excess of the at-risk amount are suspended and carried forward
without expiration and are deductible against income in future years from that
activity.
c. Any losses in excess of the at-risk amount are deducted currently against income
from other activities; the remaining loss, if any, is carried forward without expiration.
d. Any losses in excess of the at-risk amount are carried back three years against
activities with income and then carried forward for five years.
Which of the following statements regarding an individual's suspended passive activity

losses is correct?
a. $3,000 of suspended losses can be utilized each year against portfolio income.
b. Suspended losses can be carried forward, but not back, until utilized.
c. Suspended losses must be carried back three years and forward five years.
d. A maximum of 50 percent of the suspended losses can be used each year when an
election is made to forgo the carryback period.
In the current year, a taxpayer reports the following items:

Salary $50,000
Ordinary business income from partnership A, in which the taxpayer
materially participates 20,000
Ordinary business loss from partnership B, in which the taxpayer does
not actively participate (40,000)
During the year, the taxpayer disposed of the interest in partnership B (no gain or loss). The
taxpayer had a suspended passive activity loss (PAL) carryover of $10,000 from prior years
for partnership B. What is the taxpayer's adjusted gross income for the current year?
a. $20,000
b. $30,000
c. $60,000
d. $70,000

reserved.
Dietz is a passive investor in three activities that have been profitable in previous years.
The profit and losses for the current year are as follows:
Gain/(Loss)
Activity X $(30,000)
Activity Y (50,000)
Activity Z 20,000
Total $(60,000)
What amount of suspended passive activity loss should Dietz allocate to Activity X?
a. $18,000
b. $20,000
c. $22,500
d. $30,000

NOTES

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REG

1 Filing Requirements and Filing Status 3

2 Gross Income: Part 1 13

3 Gross Income: Part 2 29

4 Items From Other Entities 43

5 Loss Limitations for Individuals 53

R1–2 © Becker Professional Education Corporation. All rights reserved.

1 Individual Income Tax Formula

< Adjustments >

Adjusted gross income AGI

< Itemized deductions >

Taxable income before QBI deduction

< QBI deduction >

< Tax credits > Alternative minimum tax

Tax due Or Refund

© Becker Professional Education Corporation. All rights reserved. Module 1 R1–3

2 Taxable Income Formula for Individuals

< QBI deduction >

R1–4 Module 1 Filing

3 Filing Requirements for Individuals

3.1 Who Must File?

3.2 When to File

4.1 Single (Use the End-of-Year Test)

© Becker Professional Education Corporation. All rights reserved. Module 1 R1–5

4.3 Married Filing Separately

4.4 Qualifying Widow(er) With Dependent Child

4.5 Head of Household Dependent

Divorced 4.5.1 A Qualifying Child

4.5.2 Father or Mother (Not Required to Live With Taxpayer)

4.5.3 Dependent Relatives (Must Live With Taxpayer)

R1–6 Module 1 Filing

4.5.4 Summary of Who Meets Head-of-Household Qualifying Person Requirement

Qualifying Dependent Lives With Taxpayer

5 Dependency Definitions: No exemption after 2017

Qualifying Child Or Qualifying Relative

Age limit Under a specific amount of (taxable) gross income test

Support test Relative test

Taxpayer lives with individual for whole year test

© Becker Professional Education Corporation. All rights reserved. Module 1 R1–7

5.1 Qualifying Child Option #1 (CARES) easier option to pass

R 3. Residency and Filing Requirements

E 4. Eliminate Gross Income Test

R1–8 Module 1 Filing

5.2 Qualifying Relative Option #2 (SUPORT) harder option to pass

P 3. Precludes Dependent Filing a Joint Return

© Becker Professional Education Corporation. All rights reserved. Module 1 R1–9

5.3 Multiple Support Agreements : One "supporter" gets full qualification

Example 1 Multiple Support Agreement

Required: Under a multiple support agreement, Peter is considered a dependent of which

Solution: Peter only meets dependency definition requirements for Angie.

R1–10 Module 1 Filing

5.4 Children of Divorced Parents

Which of the following is (are) among the requirements to enable a taxpayer to be

I. A dependent has lived with the taxpayer for six months.

© Becker Professional Education Corporation. All rights reserved. Module 1 R1–11

Gross Income: Part 1 REG 1

1 Gross Income Overview

The first step in determining tax liability is to compute gross income.

1.1 Gross Income Definition

1.2 Determination of Amount of Income

Example 1 Noncash Income

1.3 Realization and Recognition

Illustration 1 Recognition Concept