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Top 10 Concerns in Preparation of Form 1040

Tax & Financial Planning ConferenceFort Lauderdale, Florida

December 7, 2012

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by

Alan D. Campbell, Ph.D., CPA, CMA, CFP®Associate Professor of Accounting

Troy UniversityMontgomery, Alabama

andAuthor of the forthcoming book

Tax Savings Prescriptions: How to Keep More Money to Achieve Your Family’s Goals, New York: Morgan James

Publishing, 2013

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Learning Objectives

1. Explain how to report sales of business properties on Form 4797

2. Explain how to report like-kind exchanges on Form 8824

3. Explain how to report installment sales on Form 6252

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Learning Objectives

4. Explain how to report discharge of indebtedness income and exclusions from discharge of indebtedness income, and reduction of tax attributes

5. Explain how to report contributions to IRAs and other retirement plans

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Learning Objectives6. Explain how to report distributions

from IRAs and other retirement plans

7. Explain where to deduct tax preparation fees to realize the greatest tax benefit

8. Explain how to calculate the penalty for underpayment of estimated tax

9. Explain how to report the additional child tax credit

10. Explain how to avoid the penalty for understating the client’s tax liability under Sec. 6694

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Learning Objective 1

Explain how to report sales of business properties on Form 4797

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What to Determine on a Sale of an Asset Used in a Trade or Business

• Amount realized• Gain or loss realized• Gain or loss recognized• Character of gain or loss

recognized

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Amount Realized (Sec. 1001(b))

• Cash received• FMV of property received• Notes received• Debt relief

(Reg. § 1.1001-2)• Real estate taxes imposed

on the seller and paid by the buyer

• Less: Selling expenses• Equals: Amount realized

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Gain or Loss Realized (Sec. 1001(a))

• Amount realized• Less: Adjusted basis

(generally cost plus capital improvements minus accumulated depreciation)

• Equals: Gain or loss realized

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Gain or Loss Recognized (Sec. 1001(c))

• Unless the law provides otherwise, all realized gains and losses are recognized

• Common exceptions– Transfer to a controlled

corporation in exchange for its stock (Sec. 351)

– Like-kind exchange (Sec. 1031)

– Involuntary conversion (Sec. 1033)

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Character of Gain or Loss Recognized

• Ordinary gain (Sec. 64) or loss (Sec. 65)

• Ordinary income from discharge of indebtedness (Sec. 61(a) and Reg. § 1.1001-2(c) Example 8)

• Sec. 1231 gain or loss• Short-term capital gain or

loss (Sec. 1223)• Long-term capital gain or

loss (Sec. 1223)

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Is Operating Rental Property a Trade or Business?

• The courts have generally said yes based on the facts and circumstances– Higgins v. Commissioner, 312

US 212, 41 USTC ¶9233 (USSC, 1941)

– Curphey v. Commissioner, 73 TC 766 (1980)

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Sale of Rental Property

• Many people believe that a sale of rental property results in a capital gain or loss

• But the law generally treats it as an asset used in a business and not a pure capital asset under Sec. 1221

• Thus, gain or loss is usually a Sec. 1231 gain or loss

• If held for less than one year, gain is ordinary gain and loss is ordinary loss

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Treatment of Net Sec. 1231 Losses

• Sec. 1231 gains and Sec. 1231 losses are combined (Sec. 1231(a))

• A net Sec. 1231 loss is an ordinary loss that is fully deductible (Secs. 165 and 1231(a)(2))

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Treatment of Net Sec. 1231 Gains

• A net Sec. 1231 gain is ordinary to the extent of net Sec. 1231 losses recognized in the previous five years that have not previously caused a net Sec. 1231 gain to be treated as an ordinary gain (Sec. 1231(c))

• Any remaining net Sec. 1231 gain is treated as if it were a long-term capital gain (Sec. 1231(a)(1))

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Depreciation Recapture• Any remaining net Sec. 1231 gain on

the sale of depreciable real estate is treated as if it were a long-term capital gain

• It is subject to depreciation recapture at a maximum tax rate of 25 percent (Sec. 1(h)(1)(D))

• Any remaining net capital gain (excess of net long-term capital gain over any net short-term capital loss) is subject to a maximum tax rate of 15 percent through 2012 and 20 percent for 2013 and later unless Congress changes the law (Sec. 1(h)(1)(C))

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Real Estate Held for Resale by a Real Estate Dealer

• Real estate can never be inventory because a taxpayer may not account for it using the lower of cost or market method (Rev. Rul. 69-536, 1969-2 CB 109)

• It can be asset held primarily for sale to customers in the ordinary course of business, which is not a capital asset (Sec. 1221(a)(1))

• Gain or loss on its sale is ordinary gain or ordinary loss and subject to self-employment tax

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Factors Used to Determine Whether the Taxpayer is a Dealer

• Frequency and regularity of sales

• Substantiality of sales• How long the taxpayer

held the property• Nature and extent of the

taxpayer’s business• Purpose for acquiring the

property• Time and effort devoted to

sales

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Sales and Exchanges of Business Properties

• Use Form 4797 to report sales or exchanges of business property other than – Inventory or – Property held primarily for

sale to customers in the ordinary course of business

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Part I

• From a brief look at Part I, one would think that is where one would report all sales of business properties held for more than one year

• But that is NOT true

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What to Report in Part I

• Report sales of land, depreciable personal property, and depreciable real estate if the taxpayer – Held them for more than

one year and – Sold them at a loss

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What to Report in Part II

• Depreciable personal property and depreciable residential real estate the taxpayer– Held for one year or less

and– Sold at a gain or loss

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What to Report in Part III• Depreciable personal property

that the taxpayer– Held for more than one year and– Sold at a gain

• In general, the ordinary income under Sec. 1245 is the lesser of the – Total gain realized or – The accumulated depreciation,

including the Sec. 179 deduction and bonus depreciation

• Any remaining gain is a Sec. 1231 gain

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Learning Objective 2

Explain how to report like-kind exchanges on Form 8824

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Like-Kind Exchanges• The like-kind exchange rules of

Sec. 1031 are exceptions to the general rule of Sec. 1001(c) that all gains and losses realized during the year are recognized

• Applies to real estate exchanged often through qualified intermediaries

• Also applies to exchanges of personal property including a trade-in of a business vehicle for another business vehicle and other similar trades

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Multiple Like-Kind Exchanges• If the taxpayer engaged in more

than one like-kind exchange, file only one Form 8824 and use it as a summary

• Write “Summary” on Line 1• Write the total recognized gains

on Line 23• Write the total basis of like-kind

property received on Line 25

• Attach complete information required on Form 8824 for each exchange

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Basic Information

• Part I of Form 8824 requires you to report basic information about the like-kind exchange to be sure that it qualifies as a like-kind exchange under Sec. 1031

• Describe the like-kind property given up on Line 1

• Describe the like-kind property received on Line 2

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Trade or Business Use Required• Both the property received in the

exchange and the property given in the exchange must be used in a trade or business or held for investment (Sec. 1031(a)(1))

• Personal use assets, such as a taxpayer’s principal residence, are not eligible for a like-kind exchange

• The taxpayer does not care what the other party to the exchange did with the other party’s old property or the property received in the exchange (but see special rule for related parties regarding dispositions)

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Tax Court Allows Home Converted to Principal Residence to Qualify

• In Reesink v. Commissioner, TC Memo 2012-118 (April 23, 2012), the United States Tax Court allowed a couple that obtained a house in a like-kind exchange to treat it as investment property even though the taxpayers moved into the house and used it as a personal residence

• Intent is a question of fact for which the taxpayers bear the burden of proof

• Business or investment intent must be the primary intent

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Taxpayers Had Investment Intent• Taxpayers had advertised the

property for rental and had showed it to potential renters, but were not successful in renting it

• Taxpayers waited about eight months before moving into the property

• The Tax Court ruled that based on the facts and circumstances that the taxpayers had the intent to hold the property for investment at the time of the exchange

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Federal Law Defines Like-Kind Property

• In Chief Counsel Advice (CCA) 201238027 (September 21, 2012), the Office of Chief Counsel concluded that federal law, rather than state law, determines whether properties are of like-kind for purposes of Sec. 1031

• The Office of Chief Counsel ruled that state law was relevant to determine if property is real property or personal property, but that federal law controls

• The determination must be based on all the facts and circumstances

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What Is Like Kind Property for Real Estate?

• For real estate, any real estate in the United States qualifies whether improved (has buildings on it) or unimproved (raw land) (Reg. § 1.1031(a)-1(b))

• Real estate located in the United States is not like kind property to real estate located in a different country(Sec. 1031(h)(1))

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What Is Like-Kind Personal Property?

• To be like-kind property, personal property must be of like class (Reg. § 1.1031(a)-2(a))

• See Rev. Proc. 87-56, 1987-2 CB 674 and Reg. § 1.1031(a)-2(b)(2) for general asset classes

• Properties may differ as to grade and quality

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Not Like-Kind Property

• Livestock of different sexes is not like-kind property (Sec. 1031(e))

• Personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind properties(Sec. 1031(h)(2))

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Ineligible Assets• Inventory• Property held for sale to

customers in the ordinary course of business

• Stocks, bonds and notes• Other securities or evidence

of indebtedness• Partnership interests• Certificates of trust or

beneficial interest• Choses in action (Sec. 1031(a)(2))

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Lines 3 and 4

• Lines 3 and 4 require you to report – The date the taxpayer

originally acquired the property given up in the exchange and

– The date the taxpayer transferred the like-kind property to the other party

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Lines 5 and 6

• On Line 5 you report – The date the like-kind

property received by the taxpayer was identified to the other party

• On Line 6 you report– The date the taxpayer

received the like-kind property from the other party

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Mandatory Nonrecognition

• If the exchange meets the requirements of a like-kind exchange, – Nonrecognition of loss is

mandatory even if boot is received or paid(Secs. 1031(a)(1) and 1031(c))

– Nonrecognition of gain is mandatory except that gain is recognized to the extent of boot received (Secs. 1031(a)(1) and 1031(b))

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Boot• Cash• Fair market value of unlike kind

property• Notes receivable• Net debt relief• Debts incurred can offset boot

from debt relief, but debts incurred may NOT offset other forms of boot (Reg. § 1.1031(b)-1(c))

• See Reg. § 1.1031(d)-2 for detailed examples of the effects of debts incurred and debt relief

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Time Limits• The taxpayer must identify the

property to be received within 45 days of the date the taxpayer gave up the property in the exchange (Sec. 1031(a)(3)(A))

• The taxpayer must complete the exchange within the earlier of – 180 days of the first transfer

or– The due date of the tax

return, including extensions (Sec. 1031(a)(3))

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Related Party Information

• Line 7 requires you to indicate whether the taxpayer made the exchange directly or indirectly with a related party

• If yes, complete Part II• If no, skip Part II and go

to Part III

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Related Parties

• For purposes of Sec. 1031, a related party is a party listed in Sec. 267(b) or Sec. 707(b)(1)

• If the exchange was with a related party, the usual rules of Sec. 1031 apply at the time of the exchange

• File Form 8824 for the year of the exchange and for each of the next two years (Instructions for Form 8824)

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Disposition by Related Party• If the like-kind exchange was

with a related party and within two years of the last transfer of the like-kind exchange – The related party disposes of

the property received or– The taxpayer disposes of the

property received from the related party, then

– The nonrecognition of gain or loss under Sec. 1031 no longer applies and the taxpayer should file an amended return (Sec. 1031(f)(1))

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Exceptions to Two-Year Rule• The disposition occurs because of the

death of the related party or the death of the taxpayer, or

• The disposition was a compulsory or involuntary conversion as defined in Sec. 1033 and the exchange occurred before the threat or imminence of the conversion, or

• The taxpayer proves to the IRS that neither the exchange nor the subsequent disposition within the two-year period had as one of its principal purposes the avoidance of Federal income tax (See Line 11 of Form 8824)

(Sec. 1031(f)(2))

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Relinquishment of Unlike-Kind Property

• The taxpayer must recognize the gain or loss realized on the transfer of unlike-kind property (boot property) as part of the exchange unless another provision applies that allows nonrecognition (Sec. 1001(c))

• Report the FMV of the boot property, its adjusted basis, and the gain or loss recognized on it on Lines 12, 13, and 14, respectively

• Also, report the gain or loss recognized on the appropriate tax form, such as Form 4797

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Amount Realized• On Line 15, report the amount

realized from boot—everything the taxpayer received in the exchange except for the FMV of the like-kind property

• On Like 16, report the FMV of the like-kind property received

• Add Lines 15 and 16 and report the result on Line 17, which is the total amount realized on the exchange (Sec. 1001(b) and Reg. § 1.1001-2(a))

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Gain or Loss Recognized• Gain recognized (Line 23) is lesser of

– Gain realized (Line 19)– Boot received (Line 15)

(Sec. 1031(b))

• The taxpayer must recognize ordinary income due to depreciation recapture before recognizing any Sec. 1231 gain (See Line 21)

• Sec. 1231 gain or capital gain goes on Line 22

• Losses are never recognized on a like-kind exchange (except on boot property) (Secs. 1031(a)(1) and 1031(c))

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Gain or Loss Deferred

• Gain realized (Line 19)• Minus: gain recognized due

to boot received (Line 23)• Equals: gain deferred (Line

24)• If the taxpayer realized a

loss on the exchange, the loss realized (Line 19) equals the loss deferred because losses are never recognized on a like-kind exchange (Line 24)

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Basis of Like Kind Property Received

• Fair market value of new like-kind property received

• Less: gain deferred or plus loss deferred

• Equals: basis of new like-kind property received (Sec. 1031(d))

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How Basis Is Calculated on Form 8824

• Add adjusted basis of like-kind property given up and any amount paid to the other party, including net debts incurred

• Add recognized gain• Subtract boot received• Equals basis of new like-

kind property (Line 25)

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Holding Period• If all gain that was realized is

recognized because of the boot received, then the holding period for the new property begins on the date of the exchange

• If some or all of the gain was deferred or a loss was realized on the exchange, then the holding period of the new property includes the holding period of the old property (Sec. 1223(1))

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Basis of Boot Property Received• The basis of any property that

is not of like kind (boot property) is a cost basis equal to its FMV on the date of the exchange (Sec. 1012)

• Do NOT reduce the basis for any debts the taxpayer assumed on the property or to which the property is subject

• The holding period for any boot property received begins on the date of the exchange

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Learning Objective 3

Explain how to report installment sales on Form 6252

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Installment Sale

• A sale in which at least one payment occurs in the year after the sale and the taxpayer realized a gain (Sec. 453(b)(1))

• Installment method is mandatory for an installment sale of eligible property (Sec. 453(a))

• Taxpayer may elect out of the installment method (Sec. 453(d)(1))

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Loss on Installment Sale

• A taxpayer recognizes any loss realized on an installment sale of business or investment property in the year of the sale or exchange (except for a like-kind exchange) (Sec. 1001(c))

• Do NOT file Form 6252 if the taxpayer realized a loss on an installment sale

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Properties Not Eligible• Inventory

(Sec. 453(b)(2)(B))• Real property held for sale to

customers in the ordinary course of business (Sec. 453(l)(1)(B))

• Securities traded on an established exchange such as the NYSE or NASDAQ (Sec. 453(k))

• Depreciable personal property where all of the gain is due to depreciation recapture (Sec. 453(i))

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Depreciation Recapture• The part of the gain that is

ordinary income due to depreciation recapture is recognized in the year of sale (Sec. 453(i))

• Report ordinary income from depreciation recapture on Form 4797, Part III

• Add to adjusted basis for purposes of calculating the Sec. 1231 gain on Form 6252, Line 12 from Form 4797, Part III (Reg. § 15a.453-1(b)(2)(v))

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Amount Realized and Total Contract Price

• Sales price reported on Form 6252, Line 5

• Subtract debt relief on Form 6252, Line 6

• The total contract price is generally equal to the sales price minus the debt relief and is reported on Form 6252, Line 7 (Reg. § 15a.453-1(b)(2)(iii))

• Debt relief includes debts assumed by the buyer or to which the property is subject

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Debt Relief > Adjusted Basis• If total debt relief exceeds the

adjusted basis of the property as increased by any ordinary income recognized due to depreciation recapture, then

• Excess of total debt relief over adjusted basis adds to the total contract price

• Excess debt relief is also treated as though it were a cash payment in the year of sale

• In such cases, the gross profit percentage will always be 100 percent

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Demand Notes

• Demand notes received are not eligible for gain deferral

• Treat them the same as cash received under the constructive receipt doctrine

• Include as a cash payment in the year of sale (Sec. 453(f)(4))

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Sec. 1231 Gain or Capital Gain Recognized

• Sum of cash payments received on principal, demand notes, and debt relief in excess of adjusted basis

• Multiplied by• Gross profit percentage

(gross profit / total contract price)

• Equals Sec. 1231 gain or capital gain recognized(Sec. 453(c))

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Interest

• Interest is recognized separately as ordinary income

• If rate of interest is not adequate, interest is imputed

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Learning Objective 4

Explain how to report discharge of indebtedness income and exclusions from discharge of indebtedness income, and reduction of tax attributes

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Recourse Debt Discharged on Property Sold or Exchanged

• If a recourse debt discharged in a transfer of property, include debt relief in amount realized on sale of property up to the FMV of the property (Reg. § 1.1001-2(c) Example 8)

• Debt relief in excess of FMV of property is gross income from discharge of indebtedness under Sec. 61(a)(12)

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Nonrecourse Debt Discharged on Property Sold or Exchanged

• If a nonrecourse debt discharged in a transfer of property, include all debt relief in amount realized on sale of property (Reg. § 1.1001-2(c) Example 7)

• In such a case, there is no gross income from discharge of indebtedness under Sec. 61(a)(12)

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Exclusions Under Sec. 108

• Income from discharge of indebtedness under Sec. 61(a)(12) may be eligible for exclusion under Sec. 108

• Debt relief included in the amount realized on the sale of property is NOT eligible for exclusion under Sec. 108

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Available Exclusions

• Debt discharged in bankruptcy (Sec. 108(a)(1)(A))

• Debt discharged while insolvent (to the extent of the insolvency) (Sec. 108(a)(1)(B))

• Debt discharged is qualified farm indebtedness (Sec. 108(a)(1)(C))

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More Exclusions

• Debt discharged is qualified real property business indebtedness for taxpayers except C corporations (Sec. 108(a)(1)(D))

• For debt discharged through 2012, the debt discharged is qualified principal residence indebtedness (Sec. 108(a)(1)(E))

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Where to Report• Report gain or loss on sale of

capital assets on Schedule D• De not report losses on personal

use assets such as a principal residence (Sec. 165(c))

• Report gain or loss on sale of assets used in a trade or business on Form 4797

• Report income from discharge of indebtedness that is not excluded under Sec. 108 as other income on Page 1 of Form 1040

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Exclusions Under Sec. 108 Are Really Deferrals

• Taxpayer must reduce tax attributes for income excluded from gross income under Sec. 108

• Report on Form 982, “Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment)”

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Order of Reduction of Tax Attributes

• Net operating loss for the year and any NOL carryover to the year

• General business credit• Minimum tax credit• Capital loss carryover for the

year and any capital loss carryover to the year

• Basis of property• Any passive activity loss or

credit carryover from the year of the discharge

• Foreign tax credit carryover

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Amount of Reduction

• Reduce credits by one-third of each dollar of the exclusion (Sec. 108(b)(3)(B))

• Reduce other tax attributes dollar for dollar (Sec. 108(b)(3)(A))

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Election to Reduce Basis Only

A taxpayer may elect to reduce the basis of property the taxpayer owns as of the beginning of the next tax year after the year of the discharge only rather than reducing other tax attributes (Sec. 108(b)(5))

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Basis Reduction in Home

Taxpayer must reduce the basis in the principal residence (but not below zero) for any debt discharge excluded from gross income as qualified principal residence indebtedness (Sec. 108(h)(1))

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Learning Objective 5

Explain how to report contributions to IRAs and other retirement plans

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Contributions to IRAs• If taxpayer and spouse were not

covered by a qualified pension plan, they may make deductible IRA contributions up to the annual limit regardless of income (Sec. 219(a))

• If taxpayer and/or spouse is covered by a qualified pension plan, the IRA contribution may be limited (Sec. 219(g))

• The deduction may not exceed earned income included in gross income (Sec. 219(b)(1)(B))

• Taxpayers may make an IRA contribution up to the unextended due date of the tax return and treat it as having been made in the previous tax year

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IRA Contribution Limits for 2012

• $5,000• $6,000 if the taxpayer is

age 50 or older before the end of the tax year ($5,000 + $1,000 catch-up contribution)

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Phaseout for Single Taxpayers

• For 2012, if single or head of household and covered by a qualified pension plan and – Modified AGI is $58,000 or

less, there is no reduction in the deduction

– Modified AGI is $68,000 or more, no deduction is allowed

– Modified AGI is between $58,000 and $68,000, a partial deduction is allowed

(Sec. 219(g))

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Phaseout for Married Taxpayers Filing a Joint Return or Surviving Spouse

• For 2012, if married filing a joint return or a surviving spouse (widow(er) with dependent child) and the taxpayer is covered by a qualified pension plan and – Modified AGI is $92,000 or less,

there is no reduction in the deduction

– Modified AGI is $112,000 or more, no deduction is allowed

– Modified AGI is between $92,000 and $112,000, a partial deduction is allowed

(Sec. 219(g))

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Phaseout for Married Taxpayers Filing a Separate Return

• For 2012, if married filing a separate return and the taxpayer is covered by a qualified pension plan and – Modified AGI is less than

$10,000 a partial deduction is allowed

– Modified AGI is $10,000 or more, no deduction is allowed

(Sec. 219(g))

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Contributions to Other Retirement Plans

• For 2012, the maximum contribution to 401k, 403(b), and 457 plans is $17,000

• If age 50 or older before the end of the tax year, the maximum total contribution to such plans is $22,500 ($17,000 + $5,500 catch-up contribution)

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AGI Limits for 2012 forContributions to Roth IRAs

• Single or head of household: $110,000 to $125,000

• Married filing jointly: $173,000 to $183,000

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Learning Objective 6

Explain how to report distributions from IRAs and other retirement plans

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Distributions from IRAs• Distributions before age

59 ½ result in the 10-percent additional tax unless an exception applies

• The 10-percent additional tax is often called a penalty, but it is not a penalty (Sec. 72(t))

• A taxpayer can have penalties abated for reasonable cause

• To avoid the 10-percent additional tax, the taxpayer must qualify for a specific statutory exception

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Exceptions to 10-Percent Additional Tax for Distributions from IRAs

• Made to designated beneficiary after the employee’s death

• Because employee is disabled• Payments based on life

expectancy that continue for at least 5 years or until the employee is 59 ½, whichever is later

• Distributions made on behalf of taxpayer to the IRS because of a levy

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More Exceptions to 10-Percent Additional Tax for Distributions from IRAs

• Used for qualified higher education expenses

• Used for medical expenses in excess of the 7 ½ percent AGI floor

• Used for first time homebuyer purchase

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Exceptions That Do NOT Apply to IRA Distributions

• The age 55 and separation from service exception does NOT apply to distributions from IRAs (Secs. 72(t)(2)(A)(v) and 72(t)(3)(A))

• The exception for alternate payees under a qualified domestic relations order (QDRO) does NOT apply to distributions from IRAs(Secs. 72(t)(2)(C) and 72(t)(3)(A))

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When Required Minimum Distributions Must Begin

• Required minimum distributions must begin by April 1 following the later of – The end of the tax year in

which the taxpayer attains age 70 ½ or

– The end of the year in which the employee retires unless the taxpayer is an employee who is a five percent owner as defined in Sec. 416 (Sec. 401(a)(9)(C))

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Distributions to Beneficiaries

• Distributions to beneficiaries from tax-deferred traditional IRAs and qualified pension plans after the account holder’s death result in income in respect of a decedent (IRD) under Sec. 691(a)

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Distributions from Roth IRAs

• Tax free if the Roth IRA account has been deemed to have been established for at least five years and

• The taxpayer is at least age 59 ½

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Distributions from Roth IRAs to Beneficiaries

• Distribution is generally tax free

• If the Roth IRA is not deemed to have been established for five years, then the beneficiary can have gross income as income in respect of a decedent (Sec. 691(a))

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Distributions from Other Retirement Plans

• Taxable as ordinary income

• Additional 10-percent tax unless an exception applies

• Exceptions to 10-percent additional tax for– Age 55 and separation

from service applies– Other exceptions apply

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Age 55 and Separation Exception

• The taxpayer must have separated from service after the taxpayer attained age 55

• Separating from service before age 55 and receiving a distribution after age 55 does NOT qualify for the exception (Notice 87-13, 1987-1 CB 432, Q&A 20)

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Learning Objective 7

Explain where to deduct tax preparation fees to realize the greatest tax benefit

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Deducting Tax Preparation Fees• Schedule A provides a line to

deduct tax preparation fees as a miscellaneous itemized deduction (Secs. 212, 62(a), and 67)

• The taxpayer must reduce total miscellaneous itemized deductions by 2 percent of AGI (Sec. 67(a))

• Miscellaneous itemized deductions provide no tax benefit unless – Total miscellaneous itemized

deductions exceed 2 percent of AGI and

– Total itemized deductions exceed the standard deduction

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Deducting Tax Preparation Fees

• Miscellaneous itemized deductions are not allowed at all for AMT purposes (Sec. 56(b)(1)(A)(i))

• Miscellaneous itemized deductions are not allowed in calculating self-employment income and therefore do not reduce the self-employment tax (Sec. 1402(a))

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Tax Preparation Feesfor Business and Farm Income

• Deduct tax preparation fees related to a self-employed individual’s business income and deductions reported on Schedule C and related schedules, including Form 4562, Schedule SE, and depreciation schedule on Schedule C (Sec. 162(a) and 62(a)(1))

• Deduct tax preparation fees related to the income and expenses of a self-employed farmer on Schedule F and related schedules on Schedule F (Sec. 162(a) and 62(a)(1))

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Tax Preparation Fees for Rent and Royalty Income

• Deduct tax preparation fees related to rent and royalty income and deductions reported on Schedule E and related forms and schedules, such as Form 4562 and depreciation schedules on Schedule E (Secs. 162(a) or 212, and 62(a)(4))

• Deduct remaining tax preparation fees on Schedule A as a miscellaneous itemized deduction

(Rev. Rul. 92-29, 1992-1 CB 20)

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Collateral Effects of Deducting Tax Preparation Fees Properly

• Tax preparation fees deducted on Schedules C, E, or F, reduce AGI

• A reduction in AGI can – Reduce the taxable amount of

Social Security benefits (Sec. 86)

– Increase the net itemized deductions subject to an AGI floor such as medical expenses (Sec. 213), casualty and theft losses (Sec. 165), and miscellaneous itemized deductions (Sec. 67)

– Affect the deductible IRA contribution and

– Can affect some tax credits

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Self-Employment Tax

• Tax preparation fees deducted on Schedule C for a self-employed individual or Schedule F for a farmer save – Income tax and – Self-employment tax

(Sec. 1402(a))

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Invoice for Tax Preparation Fees• The invoice for tax preparation

fees should state how much of the fee is deductible on Schedules A, C, E, and F

• Provide to clients for use in preparing next year’s return or in case client uses different tax preparer next year

• If client does not have an invoice for tax preparation fees for the previous year that shows the amount deductible on each schedule, then use a reasonable estimate

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Learning Objective 8

Explain how to calculate the penalty for underpayment of estimated tax

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Exceptions to Penalty for Underpayment of Estimated Tax

• Amount due is less than $1,000 (Sec. 6654(e)(1)) and amount paid in consists of withholding and/or timely estimated payments

• Prior year’s tax exception (Sec. 6654(d)(1)(C))

• When prior year has no tax liability (Sec. 6654(e)(2))

• Annualized method• Special rules for farmers and

fishermen

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Learning Objective 9

Explain how to report the additional child tax credit

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Additional Child Tax Credit

• The child tax credit is a nonrefundable tax credit (Sec. 24(b)(3))

• But the additional child tax credit is a refundable tax credit (Sec. 24(d))

• Report the additional child tax credit on Form 8812

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Who Qualifies?

• The additional child tax credit is for people who got less than the maximum regular child tax credit of $1,000 per qualifying child for 2012 (drops to $500 per eligible child in 2013 unless Congress changes the law)

• A qualifying child must be UNDER age 17 at the end of the tax year and meet other requirements

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Opportunity for Fraud• The additional child tax credit is not a

loophole in the tax law as alleged in a video called “Tax loophole costs billions” posted online by WHTR, Channel 13 in Indianapolishttp://www.wthr.com/story/17798210/tax-loophole-costs-billions

• It is a refundable tax credit passed by Congress and contained in Section 24 of the Internal Revenue Code to help low income families with children

• Because it is a refundable tax credit, fraud on the part of some taxpayers has become a serious problem

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Learning Objective 10

Explain how to avoid the penalty for understating the client’s tax liability under Sec. 6694

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Penalty for Unreasonable Position

• Sec. 6694(a) provides for a preparer penalty of the greater of – $1,000 or– 50 percent of the

income received or to be received for preparing the return

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Penalty for Unreasonable Position

• For an understatement of the client’s tax liability due to an unreasonable position taken on the tax return unless– There is substantial

authority for the position or

– The tax preparer properly disclosed the position on the return

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What Is an Understatement?

• The understatement of the tax liability does NOT have to be significant

• An understatement is ANY understatement of the net tax payable (Sec. 6694(e))

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What Is Substantial Authority?• Internal Revenue Code• Proposed, temporary, or final

Treasury Regulations• Revenue Rulings• Revenue Procedures• Tax treaties• Court cases• Committee reports• The Blue Book• Private letter rulings• Technical advice memoranda (Reg. § 1.6662-4(d)(3)(iii))

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Not Substantial Authority

• Tax treatises• Articles in tax journals• Opinions by tax

professionals• Editorial materials in tax

services such as CCH and RIA

• But these secondary sources are useful in finding substantial authority

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Proper Disclosure

• Proper disclosure is defined in Sec. 6662(d)(2)(B)(iii)(I)

• Must disclose relevant facts in the tax return or in a statement attached to the tax return

• Use Form 8275 or Form 8275-R if the position is contrary to a regulation

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Form 8275

• Provides protection for tax preparer and client

• Be more concerned about avoiding possible penalties than any possible increase in the chance for an audit

• Be sure to discuss Form 8275 with the client

• If client will not allow Form 8275 to be attached, considering withdrawing from the engagement

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Form 8275-R• Use to report positions taken

on the tax return contrary to the Treasury Regulations

• Temporary and Final Regulations generally have the force of law unless they are

• Not within the meaning of the related Code section

• Have been overturned by a court of competent jurisdictio

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Tax Shelters and Reportable Transactions

• Even if disclosed, a position with respect to a tax shelter as defined in Sec. 6662(d)(2)(C)(ii) or reportable transaction to which Sec. 6662A applies is unreasonable unless the tax preparer believes that the position is more likely than not (greater than 50 percent chance) to be sustained on its merits (Sec. 6694(a)(2)(C))

• This is a higher standard because substantial authority is perceived by many to be about a 40 percent chance of success

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Penalty for Willful or Reckless Conduct

• Sec. 6694 provides for a penalty on a tax preparer of the greater of – $5,000 or – 50 percent of the

income received for preparing the return (Sec. 6694(b)(1))

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What Can Result in the Harsher Penalty?

• For either of the following: – The willful attempt to

understate the client’s tax liability or

– A reckless or intentional disregard of rules and regulations (Sec. 6694(b)(2))

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Reduction in Penalty

• The penalty for reckless or willful conduct under Sec. 6694(b) is reduced by any penalty under Sec. 6694(a) for a substantial understatement of the client’s tax liability due to an unreasonable position (Sec. 6694(b)(3))

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Reasonable Cause and Good Faith

• The penalty does not apply if the taxpayer had a reasonable cause for the understatement of the client’s tax liability and the tax preparer acted in good faith (Sec. 6694(a)(3))

• The burden of proof is on the tax preparer

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Summary• Be sure to follow the instructions for

Form 4797 carefully when reporting sales or exchanges of properties used in a trade or business

• Make sure that a like-kind exchange meets all the requirements and report them on Form 8824

• Report the recognized gain on installment sales correctly on Form 6252

• Understand when a discharge of a debt is included in the amount realized on a deemed sale of the property and when it is income from discharge of indebtedness

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Summary• Understand when income

from discharge of indebtedness can be excluded from gross income and the effects on tax attributes

• Report deductions for contributions to IRAs properly, taking into account the limits

• Report distributions from IRAs and other pension plans properly, especially regarding the 10-percent additional tax

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Summary• Report tax preparation fees

applicable to a business, a farm, or rental property on Schedules C, F, and E, respectively

• Calculate the penalty for underpayment of estimated tax correctly using all available exceptions on Form 2210

• Calculate the additional child tax credit correctly

• Document the substantial authority for questionable positions taken on a tax return or disclose the position on Form 8275 or Form 8275-R

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Conclusion

• If you follow the guidance in this presentation, you will– Make fewer mistakes in the

preparation of Form 1040– Save yourself preparer

penalties– Save your clients taxes and

penalties– Have a more productive and

less stressful tax season

• Sharpen your pencils and have a great tax season!