Regulation 1

Individual Taxation: Filing Status

I. Filing
A. Requirement for Filing (Who must file?)
1. General Rule
Generally, a taxpayer must file a return if his or her income is equal to
or greater than the sum of:
o The personal exemption, plus
o The regular standard deduction (except for married filing
separately), plus
o The additional standard deduction amount for taxpayers over
age 65 or over or blind (Except for married persons filing
separately).
2. Exceptions
Certain individuals must file income tax returns even if their income is
lower than the general rule requirement.
o Individuals whose net earnings from self-employment are $400
or more must file.
o Individuals who can be claimed as dependents on another
taxpayers return, have unearned income, and gross income of
$1,000 (2014) or more must file.
B. When to File
1. When to File April 15th
2. Extension
Automatic 6-Month Extension October 15: An automatic 6-month
extension (until October 15) is available for those taxpayers who are
unable to file on the April 15 due date by filing ss.
Payment of Tax With either extension, the due date for payment of
taxes remain April 15.
3. Taxpayers Who Are Out of the Country
Taxpayers who are outside of the U.S. on the filing date and have their
principal place of business outside the U.S. or are stationed outside
the U.S. have an automatic 2-month extension to file, but not to pay.
Do not need to file for the extension, but must include documentation
if the extension is taken.
II. Filing Status
A. Single Use the End-of-Year Test
Any taxpayer who does not qualify for one of the other filing classes must use
the single status by default.
o Single at year-end
o Legally separated

B. 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 recognized common law marriage, or married and
living apart (but not legally separated or divorced).
o If one spouse dies during the year, a joint return may be filed.
C. Married Filing Separately

D. Qualifying Widow(er) (Surviving Spouse) With Dependent Child

Two Years after Spouses Death May use the joint tax return standard
deduction and rates (but NOT the exemption for the deceased spouse) for
each of two taxable years following the year of death of his or her spouse,
unless he or she remarries.
Principal Residence for Dependent Child The surviving spouse must
maintain a household that, for the whole taxable year, was the principal
place of abode of a son, stepson, daughter, or stepdaughter.
E. Head of Household
The following conditions must be met:
o The individual is not married, is legally separated, or is married and
has lived apart from his/her spouse for the last 6 months of the year
as of the close of the taxable year.
o The individual is not a qualifying widow(er).
o The individual is not a non-resident alien.
o The individual maintains as his or her home a household that, for
more than half the taxable year, is the principal residence of:
A dependent son or daughter (or descendant)
Father or mother (not required to live with taxpayer)
Dependent relatives (must live with taxpayer).
Pass key: In order to avoid confusing the required time period for different
filing statuses, just remember:
o W Widow = Whole year
o H - Head of household = Half year

Individual Taxation: Exemptions

I. Personal Exemptions
Generally, an individual is entitled to a personal exemption that is indexed
annually for inflation.
For 2015, this amount is $4,000.
A. Persons Claimed as Dependents
Persons eligible to be claimed as dependents on anothers tax return will not
be allowed a personal exemption on their own returns.
B. Married Taxpayers
The exemption for a spouse is always considered to be a personal exemption
(not a dependency exemption), even if the spouse does not work.
Spouse as Personal Exemption on a Separate Return - A married taxpayer
filing separately may claim his or her spouses personal exemption if both of
the following tests are met:
o The taxpayers spouse has no gross income; and
o The taxpayers spouse was not claimed as a dependent of another
taxpayer.
C. Birth or Death During Year
If a person is born or dies during the year, he or she is entitled to either a
personal or a dependency (as appropriate) exemption for the entire year.
Exemptions are not prorated.
D. Phase-Out of Personal Exemptions
The phase-out reduces exemptions by 2% for every $2,500 or portion thereof
($1,250 for MFS) by which AGI exceeds:
Joint/Surviving Spouse
Head of Household
Single
Married Filing Separately

$309,900
$284,050
$258,250
$154,950

II. Dependency Exemptions (Part of Personal Exemptions)

Each taxpayer is entitled to an exemption for each qualifying child (CARES)
and qualifying relative (SUPORT).
The amount of this exemption is $4,000 for 2015. Taxpayers must obtain a
SSN for any dependent who has attained the age of one as of the close of the
tax year.
A. Qualifying Child
If the parents of a child are able to claim the child but do not, no else may
claim the child unless that taxpayers 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:
o Close relative The child must be the taxpayers son, daughter,
stepson, stepdaughter, brother, sister, stepbrother, stepsister, or a
descendant of any of these.

o
o
o

Age limit 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.
Residency and Filing Requirements A child must have the sample
principal place of abode as the taxpayer for more than one half of
the tax year.
Eliminate Gross Income Test (but exemption is required) The gross
income test does not apply to a qualifying child. However, the
child is a qualifying child only if the taxpayer can and does claim an
exemption for the child.
Support Test Changes The support test has been modified to
determine if the child did not contribute more than one-half of his or
her own support. The requirement that the taxpayer (parent) provides
over one-half of the childs support is eliminated.

B. Qualifying Relative
Taxpayers can apply the SUPORT dependency exemption rules to claim a
dependency exemption for a qualifying relative who does not satisfy the
qualifying child requirements.
o Support Test The taxpayer must have supplied more than one-half of
the support of a person in order to claim him or her as a dependent.
Multiple Support Agreements When 2 or more taxpayers
together contribute more than 50% to the support of a person
but none of them individually contributes more than 50%, 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
dependency exemption.
A contributor must have contributed more than 10% of
the persons 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.
o Under Exemption Amount of Taxable Gross Income A person may
not be claimed as a dependent unless the dependents gross income is
less than the exemption amount ($4.000 during the taxable year
2015).
Only income that is taxable is included for the purpose of
determining whether the dependent has earned less than the
exemption amount.
o Precludes Dependent Filing a Joint Return A taxpayer will lose the
exemption for a married dependent who files a joint return unless the
joint return is filed solely for a refund of all taxes paid or withheld for
the taxable year (i.e. the tax is zero).
o Only Citizens of the U.S. or Residents of the U.S., Mexico, or Canada
o Relative
OR
o Taxpayer Lives With the Individual (if Nonrelative) for the Whole
Year
C. Child of Divorced Parents

1. General Rule Custodial Parents

Generally, the parent who has custody of the child for the greater part
of the year takes the exemption (determined by a time test, not the
divorce decree).
If the parents have equal custody during the year, the parent with
the higher AGI will claim the exemption.
2. Exception Custodial Parent Waives Right
A noncustodial divorced or separated parent may claim the exemption
for his or her child if the custodial parent waives the right to the
exemption.
o This is done by the custodial parents signing of a written
declaration that is attached to the noncustodial parents
return.
o Form 8332 is used as the required written declaration.
The custodial parent may revoke the release of claim using the Form
8332 provided (1) notice is given to the noncustodial parent at least
one tax year in advance, and (2) a copy of Form 8322 claiming the
revocation is attached to the custodial parents tax return.

Individual Taxation: Gross Income

I. Gross Income In General
A. Gross Income Defined
B. Computation of Income General Rule
In cases of noncash income, the amount of income is the FMV of the
property or services received.
C. Realization and Recognition
In order to be taxable, the gain must be both realized and recognized.
D. Timing of Revenue Recognition
Accrual Method = Taxable when earned
Cash Method = Taxable in the period the revenue is actually or
constructively received in cash or (FMV) property
E. Characterizations of Income
1. Ordinary
2. Portfolio
3. Passive Only passive losses may offset passive income, and a net passive
loss is not deductible on the tax return (it is suspended and carried forward
until passive income exists to offset it), unless an exception exists and the
requirement for passive treatment is removed.
4. Capital
II. Specific Items of Income and Exclusions
A. Salaries and Wages
Gross income includes many forms of compensation for services.
1. Money
2. Property FMV of all property is included as gross income.
3. Cancellation of Debt
4. Bargain Purchases
If an employer sells property to the employee for less than its FMV,
the difference is income to the employee.
5. 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
partners ratio of income.
Also subject to self-employment tax
6. Taxable Fringe Benefits

The FMV of a fringe benefit not specifically excluded by law is

includable in income.
Also subject to employment taxes and withholding

7. Partially Taxable Fringe Benefits 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.
8. Nontaxable Fringe Benefits
Life insurance proceeds The proceeds of a life insurance policy paid
because of the death of the insured are generally excluded from the
gross income of the beneficiary.
o The interest income element on deferred payout
arrangements is fully taxable.
Accident, Medical, and Health Insurance (employer paid) Premium
payments are excludable from the employees income when the
employer paid the insurance premiums, but amounts paid to the
employee under the policy are includable income unless such amounts
are:
o Reimbursement for medical expenses actually incurred by the
employee;
OR
o Compensation for the permanent loss or loss of use of a
member or function of the body.
De Minimis Fringe Benefits
Meals and Lodging The gross income of an employee does not
include the value of meals and lodging furnished to him or her in kind
by the employer for the convenience of the employer on the
employers premises. Additionally, in order to be nontaxable, the
lodging must be required as a condition of employment.
Employer Payment of Employees Educational Expenses Up to
$5,250 may be excluded from gross income of payments made by
employer on behalf of an employees education expenses. The
exclusion applies to both undergraduate and graduate level education.
Qualified Tuition Reductions Employees of educational institutions
studying at the undergrad 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.
Qualified Employee Discounts Employee discounts on employerprovided merchandise and service are excludable as follows:
o Merchandise Discounts The excludable discount is limited
to the employers gross profit percentage. Any excess must be
reported as income.
o Service Discounts The excludable discount on services is
limited to 20% of the FMV of the services. Any excess discount
must be reported as income.

Employer-Provided Parking The value of employerprovided parking up to $250 per month may be excluded.
o Transit Passes The value of employer-provided transit
passes up to $130 per month may be excluded.
Qualified Pension, Profit-Sharing, and Stock Bonus Plans
o Payments Made by Employer Not income to the employee at
the time of contribution
o Benefits received (taxable) The amount 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 or
made available to the employee.
Flexible Spending Arrangements (FSAs)
o Pretax Deposits into Employees Account Employees have the
ability to elect to have part of their salary (generally up to
$2,550 per year) deposited pretax into a flexible spending
accounting designated for them (must be done via salary
reduction directly by the employer).
o Forfeits Funds Not Used Within 2 Months after Year-End
Funds not used within 2 months after the year-end or not
claimed within a period of time (usually 6 months) are
forfeited. However, this grace period only applies if the
employer amended the plan accordingly.
o

B. Interest Income
1. Taxable Interest Income
Federal bonds
Premiums received for opening a savings account (e.g. prizes and
awards) are included at FMV
Interest paid by the federal or state government for late payment of a
tax refund
2. Tax-Exempt Interest Income (reportable but not taxable)
State and local government bonds/obligation and mutual fund
dividends for funds invested in tax-free bonds
Bonds of a U.S. Possession
Series EE Interest on Series EE Savings bonds is tax-exempt when:
o It is used to pay for higher education (reduced by tax-free
scholarships) of the taxpayer, spouse, or dependents;
o There is taxpayer or joint ownership (spouse);
o The taxpayer is over age 24 when issued; and
o The bonds are acquired after 1989.
Veterans Administration Insurance
3. Unearned Income of a Child under 18 (kiddie tax)
The net unearned income of a dependent child under 18 years of age
(or, a child age 18 to age 24 who does not provide over half of his/her
own support and is a full-time student) is taxed at the parents higher
tax rate.

The childs allowable 2015 standard deduction of $1,050 (or

investment expense, if greater) plus an additional $1,050 (which is
taxed at the childs rate).
2015 Childs Unearned
Income
0 - $1,050
$1,051 - $2,100
$2,101 and over

Tax Rate
0%
Childs
Parents

4. 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 amount forfeited is deductible as an adjustment in the year the
penalty is incurred.
C. Dividend Income
1. Source Determines Taxability
2. Three Categories of Dividends
Taxable Dividends
o Special (Lower) Tax Rate
Qualified Dividends Holding Period 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 of which a purchased share no longer is entitled to
any recently declared dividends).
Tax rates (2015)
15% - Most taxpayers
20% - High income taxpayers
0% - Low income taxpayers (those in the 10% or
15% ordinary income tax bracket)
Tax-Free Distributions The following items are exempt from gross
income:
o Return of capital
o Stock split
o Stock dividend
o Life insurance dividends Dividends caused by ownership of
insurance with a mutual company (premium return)
Capital Gain Distribution
3. Medicare Tax
Starting in 2013, certain unearned income is subject to a new 3.8%
Medicare tax.
The tax is levied on the lesser of (1) the taxpayers net investment
income, or (2) the excess of modified AGI for the tax year over the
threshold amount of $200,000 ($250,000 for married filing jointly, and
$125,000 for married filing separately).
o Modified AGI is a taxpayers AGI adjustment for certain foreign
income exclusions.

D. State and Local Tax Refunds

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.
o Itemized in prior year = State or local refund is taxable (unless a
competing tax law, such as alternative minimum tax, caused the initial
taxes paid to be nondeductible)
o Standard deduction used in prior year = Nontaxable state or local
refund
E. Payments Pursuant to a Divorce
1. Alimony/Spousal Support (income) Payments for the support of a spouse
are income to the spouse receiving the payments and are deductible to arrive
at adjusted gross income (adjustment) by the contributing spouse. To be
deemed alimony under the tax law:
Payments must be legally required pursuant to a written divorce (or
separation) agreement;
Payments must be in cash (or its equivalent);
Payments cannot extend beyond the death of the payee-spouse;
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.
2. Child Support
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 childs 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.
3. Property Settlements (nontaxable)
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.
F. Business Income or Loss, Schedule C or C-EZ
1. Gross Income
2. Expenses
Cost of goods
Salaries and commissions paid to others
State and local business taxes paid
Business meal and entertainment expenses at 50%
Interest expense on business loans (interest expense paid in advance
by a cash basis taxpayer cannot be deducted until the tax year/period
to which the interest relates).
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).

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3. Nondeductible Expenses (for Schedule C)

Salaries paid to the sole proprietor (they are considered a draw).
Federal income tax
Personal portion of:
o Automobile, travel, and vacation expenses
o 100% of country club dues are nondeductible
o Interest expense This may be reported as an itemized
deduction if mortgage interest or investment interest is paid.
o State and local tax expense Report as an itemized deduction
on Schedule A
o Health insurance of a sole proprietor While this is not
reported on Schedule C as an expense, it is reported as an
adjustment to arrive at AGI.
o Bad debt expense of a cash basis taxpayer (who never reported
the income)
o Charitable contributions Report as an itemized deduction on
Schedule A
4. Net Business Income or Loss
There are two taxes on net business income:
o Income tax
o Federal self-employment (S/E) tax
An adjustment to income is allowed for one-half (which
is 7.65% of up to $118,500 of self-employment income
in 2015 plus 1.45% of self-employment income
thereafter, if applicable) of S/E tax (Medicare plus
Social Security) paid.
This allows the sole proprietor the ability to
deduct the employer portion of the S/E tax as
an adjustment to gross taxable income (of which
the net Schedule C amount is a part).
All self-employment income is subject to the 2.9%
Medicare tax, but only up to $118,500 in 2015 is subject
to the 12.4% Social Security tax (i.e., a total of 15.3% on
self-employment earnings up to $118,500 in 2015).
Net taxable loss A business with a loss may deduct the loss against
other sources of income.
o 2-year carryback
o 20-year carryforward
5. Husband and Wife Qualified Joint Venture Election
Certain married persons who operate a business together may elect to
simplify their tax reporting requirements by not filing a partnership
income tax return and instead reporting on their jointly filed personal
income tax return.
The election is made on the jointly-filed Form 1040 by having each
spouse report his/her respective portions of the business activity
(based on ownership interest) separately as a sole proprietor on either
a Schedule C or a Schedule F. Social security and Medicare taxes will
apply to each spouse separately.
6. Uniform Capitalization Rules

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The uniform capitalization rules do not apply to (inventory) property

acquired for resale if the taxpayers average gross receipts for the
preceding three tax years do not exceed $10,000,000 annually.
Capitalized as inventory: DM, DL, FOH
Period expense: Selling, General, Administrative, and R&D

7. Long-Term Contracts
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.
Exemptions Certain contracts are exempt from the requirements
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:
o Small contracts (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 $10 million for
the three years that precede the tax year in question).
o Home construction contracts
o A long-term construction contract that includes land and where
less than 10% of the total contract costs relates to the actual
construction of property on the land
o Services performed by architects, engineers, designers,
construction management advisors, and software
implementation personnel related to the long-term project (i.e.,
those who are contracted by a taxpayer involved in a long-term
contract to perform services but are not generally responsible
for the final product under contract)
o Services performed under warranty and maintenance
agreements related to the long-term contract
For cash basis taxpayers, the starting date of production is generally
the date on which the contract incurs costs.
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% of the total costs initially estimated under the contract.
G. Farming Income
1. General
Schedule F (carries to the face of Form 1040, line 18)
2. Cash Basis and Accrual Method
Cash Basis
o Most farmers use the cash basis.
o Inventories of produce, livestock, etc., are not considered.
o Inventory = Expense (not capitalized)
Accrual Method
o The accrual method is required for certain corporate and
partnership farmers as well as for all farming tax shelters.
o Inventories must be used and maintained.

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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 inventories by the farming business,
except for any livestock valued using the unit-livestockprice 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.

H. Gains and Losses on Disposition of Property

Amount realized
<Adjusted Basis of Assets Sold>
Gain or Loss Realized

I.

IRA Income
1. General Rules (taxable when withdrawn)
Generally, retirement money cannot be withdrawn until the individual
reaches the age of 59 (except in certain situations) or the individual
elects to receive equal periodic distributions over his life.
A taxpayer is required to start withdrawals by the age of 70.
Benefits are not taxable until the taxpayer receives the distribution.
2. Taxation of Distributions (benefits)
Regular Tax
o Ordinary Income (traditional deductible IRA distributions)
When a person retires, the funds will be taxed as ordinary
income when received (regardless of what of income, such as
capital gain, was earned while the funds were invested).
o Roth IRA All qualified benefits received form a Roth IRA are
nontaxable.
o Traditional Nondeductible IRA
Principal = Nontaxable
Accumulated earnings = Taxable
Penalty Tax (10%) - Generally, a premature distribution is subject to a
10% penalty tax if the individual has not met an exception.
Exception to Penalty Tax (still subject to ordinary income tax) There
is no penalty if the premature distribution was used to pay:
o Home buyer (1st time): $10,000 maximum exclusion applies if
the distribution is used toward the purchase of a first home
(within 120 days of the distribution)
o Insurance (medical)
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Unemployed with twelve consecutive weeks of

unemployment compensation
Self-employed (who are otherwise eligible for
unemployment compensation)
o Medical expenses in excess of 10% of AGI
o Disability (permanent or indefinite disability, but not temporary
disability)
o Education: College tuition, books, fees, etc.
o Death
Excess contributions to the plan are subject to a cumulative 6% excise
tax each year until the excess is corrected.

J.

Annuities
The investment amount is divided by a factor representing the number of
months over which the investment will be recovered.
o This factor is based on the age of the annuitant at the start of the
payout period.
If the annuitant lives longer than factor period, then further payments are
fully taxable.
If the annuitant dies before the factor period, the unrecovered portion is a
miscellaneous itemized deduction on the annuitants final income tax return
not subject to the 2% of the AGI floor.

K. Rental Income (passive activity)

Schedule E is used to compute supplemental income and/or loss from:
o Rental real estate
o Royalties
o Partnerships and LLC
o S Corporations
o Estates
o Trusts
1. General
Gross Rental Income
Prepaid Rental Income
Rent Cancellation Payments
Improvement In-Lieu-of Rent
<Rent Expenses>
Net Rental Income/Loss
2. Rental of Vacation Home

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Rented Less than 15 days Treated as a personal residence; Rental

income is excluded from income, and mortgage interest (first or
second home) and real estate taxes are allowed as itemized
deductions.
o Depreciation, utilities, and repairs are not deductible.
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% of the rental days, it is treated as a
personal/rental residence.
o Expenses must be prorated between personal and rental use.
o Rental use expenses are deductible only to the extent of rental
income.

3. Passive Activity Losses (PALs)

Deductibility
o A net passive activity loss may not be deducted against
wages, salaries, and other active income or against portfolio
(interest and dividends) or capital gains income.
o Expenses related to passive activities can de deducted only to
the extent of income from all passive activities.
Nondeductible PALs
o Carry forward without any time limit unused passive activity
losses held in suspension.
Suspended losses are used to offset passive income in
future years.
If still unused, suspended losses become fully tax
deductible in the year the property is disposed of (sold).
If the taxpayer becomes a material participant in the
passive activity (therefore changing from passive to
active), unused passive losses from the activity can be
used to offset the taxpayers active income in the same
activity.

PAL (Disallowed Net Loss) Exceptions An individual may

deduct rental activity losses (although deduction may be
limited) if either of the following two conditions are met:
Mom and Pop Exception
$25,000 and Active Taxpayers may deduct
$25,000 per year of net passive losses
attributable to rental real estate
Phase-out The $25,000 allowance is reduced by
50% of the excess of the taxpayers AGI (without
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consideration of this loss deduction) over

$100,000. This allowance is eliminated
completely when AGI exceeds $150,000.
Real Estate Professional (not passive activity) The
taxpayer can fully deduct losses from the rental
activities against other income if:
More than 50% of the taxpayers personal
services during the year are performed in real
property businesses; and
The taxpayer performs more than 750 hours of
services in real property businesses during the
year.

L. Unemployment Compensation
A taxpayer must include in gross income the full amount received for
unemployment compensation.
M. Social Security Income
Low income No Social Security benefits are taxable (income below: Single
$25,000 / MFJ $32,000)
Upper Income 85% of Social Security benefits are taxable (income over:
Single $34,000 / MFJ $44,000)
Middle Income 50% of Social Security benefits are taxable (income over:
Single $25,000 / MFJ $32,000)
N. Taxable Miscellaneous Income
Prize and Awards The FMV of prizes and awards is taxable income. An
exclusion from income for certain prizes and awards applies where the
winner is selected for the award without entering into a contest and assigns
the award directly to a governmental unit or charitable organization.
Gambling Winnings and Losses Gambling winnings are included in gross
income. Gambling losses may only be deducted to the extent of gambling
winnings.
Business Recoveries If a damage award is compensation for lost profit, the
award is income.
Punitive damages Punitive damages are fully taxable as ordinary income if
received in a business context 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.
O. Partially Taxable Miscellaneous Items Scholarships and Fellowships
Scholarships and fellowship grants are excludable only up to amounts
actually spent on tuition, fees, books, and supplies (not room and board)
provided:
o The grant is made to a degree-seeking student;
o No services are to be performed as a condition to receiving the grant;
and
o The grant is not made in consideration for past, present, or future
services of the grantee.
Scholarships and fellowships awarded to non-degree-seeking students are
fully taxable at FMV.

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P.

Graduate teaching assistant 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.

Nontaxable Miscellaneous items

1. 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.
The interest income element on deferred payout arrangements is fully
taxable.
2. 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.
3. Medicare Benefits (nontaxable) Exclude from gross income basic Medicare
benefits received under the Social Security Act.
4. Workers Compensation (nontaxable) Exclude from gross income
5. Personal (Physical) Injury or Illness Award (nontaxable) Exclude from gross
income
6. 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
7. Foreign-Earned income Exclusion Taxpayers working abroad may exclude
from gross income up to $100,800 (2015) of their foreign-earned income. In
order to qualify for the exclusion, the taxpayer must satisfy one of the
following two tests:
Bona Fide Residence test The taxpayer must have been a bona fide
resident of a foreign country for an entire taxable year.
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).

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Employee Stock Options

I. Employee Stock Options
A. Nonqualified Options
A nonqualified option is taxed when granted if the option has a readily
ascertainable value when granted. Otherwise, the option is taxed when
exercised.
1. Definition of Readily Ascertainable Value
If the option is traded on an established market, it will have a readily
ascertainable value.
Otherwise, it will only have a readily ascertainable value if all of the
following conditions are met:
o The option is transferable.
o The option is exercisable immediately in full when it is granted.
o There are no conditions or restrictions that would have a
significant effect on the value.
o The fair value of the option privilege is readily ascertainable.
2. Employee Taxation Readily Ascertainable Value
If there is a readily ascertainable value, the employee recognizes
ordinary income in that amount in the year granted.
If there is a cost to the employee, then the ordinary income is the
value of the option minus the cost.
The basis of the stock is the exercise price plus any amount previously
taxed on the date of grant.
The holding period begins with the exercise date.
If the employee allows the options to lapse (not exercised), there is a
capital loss based on the value of the options previously taxed.
3. Employee Taxation Without Readily Ascertainable Value
If there is no readily ascertainable value, then the taxable event is the
exercise date, not the grant date.
On the date of exercise, the employee recognizes ordinary income
based on the FMV of the stock purchased less amounts paid (if any)
for the option.
The holding period begins with the exercise date.
If the options lapse, there are no tax consequences.
4. Employer Taxation
An employer may deduct the value of the stock option as a business
expense in the same year that the employee is required to recognize
the option as ordinary income.
B. Qualified Options
1. Incentive Stock Options
Requirements
o An ISO is usually granted to a key employee and is a right to
purchase the stock at a discount.
o The exercise price may not be less than the FMV of the stock
at the date of the grant.

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o
o
o

The employee may not own more than 10% of the combined
voting power of the corporation, parent, or subsidiary as of the
date of the grant.
Once exercised, the stock must be held at least two years after
the grant date and at least on year after the exercise date.
The employee must remain an employee of the corporation
from the date the option is granted until three months (one
year if due to permanent and total disability) before the option
is exercised.

Employee Taxation
o Generally, there is no taxation of the option as compensation.
o Generally, any gain or loss on a subsequent sale of the stock is
capital.
o If the holding period requirements above are not satisfied, any
gain is ordinary up to the amount that the stocks FMV on the
exercise date exceeded the option price.
o An employee may exercise up to $100,00 of ISOs in a year. Any
amount exercised that exceeds this will be treated as a
nonqualifying option.
o The excess of the FMV of the stock on the exercise date less
the purchase price is a preference item for ATM.
Employer Taxation
o An employer does not receive a tax deduction for an ISO
because it is not considered compensation income to the
employee.

2. Employee Stock Purchase Plans

An ESPP may grant options to employees to purchase stock in the
corporation.
Requirements
o An ESPP cannot grant options to any employee who has more
than 5% combined voting power of the corporation, parent, or
subsidiary.
o The option exercise price may not be less than the lesser of
85% of the FMV of the stock when granted or exercised.
o The option cannot be exercised more than 27 months after the
grant date.
o Once exercised, the stock must be held at least two years after
the grant date and at least one year after the exercise date.
o The employee must remain an employee of the corporation
from the date the option is granted until three months before
the option is exercised.
Employee Taxation
o There is no taxation of the options as compensation.
o The basis of the stock is the exercise price plus any amount
paid for the option (if any).
o Any gain or loss on a subsequent sale of the stock is capital.
o If the holding period requirements above are not satisfied, any
gain is ordinary up to the amount that the stocks FMV on the
exercise date exceeded the option price.
o If the option price is less than FMV of the stock on the grant
date, ten ordinary income is recognized as the lesser of the

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difference of the FMV of the stock when sold and the exercise
price, or the difference between the exercise price and the
FMV of the stock on the grant date.
Employer Taxation
o An employer does not receive a tax deduction for an ESPP
because it is not considered compensation income to the
employee.

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