ACCURACY & CONTINUITY ON TAX RETURNS

ACCURACY & CONTINUITY ON TAX RETURNS

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2 Hour(s) - Other Federal Tax

IRS Provider #: UBWMFIRS Course #: UBWMF-T-00207-21-S

NASBA: 116347

CTEC Provider #: 6209CTEC Course #: 6209-CE-0029

The information provided in this publication is for educational purposes only, and does not necessarily reflect all laws, rules, or regulations for the tax year covered. This publication is designed to provide accurate and authoritative information concerning the subject matter covered, but it is sold with the understanding that the publisher is not engaged in rendering legal, accounting or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.

To the extent any advice relating to a Federal tax issue is contained in this communication, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.

COURSE OVERVIEW.............................................................................................................................................................. 9

Course Description ....................................................................................................................................................................... 9

Learning Objectives ...................................................................................................................................................................... 9

ACCURACY & CONTINUITY ON TAX RETURNS .................................................................................................................. 9

Using Schedules and Prior Year Returns ................................................................................................................................... 9

New Client Due Diligence...........................................................................................................................................................10

Importance of Prior Year Return...............................................................................................................................................11

Requirements to Qualify... .........................................................................................................................................................12

Necessity to Amend....................................................................................................................................................................13

Interest, Bonds, and the AFR .....................................................................................................................................................14

A loan by any other name..........................................................................................................................................................15

To 'B' or Not to 'B' (Schedule, that is...) ....................................................................................................................................16

Capital Gains and/or Losses ......................................................................................................................................................16

Rental Property or Vacation Home? .........................................................................................................................................17

Are we Ready for Millennial Dissolution?.................................................................................................................................18

CASE STUDIES..................................................................................................................................................................... 19

Definition of Income...................................................................................................................................................................19

Dependents .................................................................................................................................................................................20

APPENDIX A ....................................................................................................................................................................... 21

Duties and Restrictions ..............................................................................................................................................................21

APPENDIX B........................................................................................................................................................................ 22

Gains and Losses ........................................................................................................................................................................22

APPENDIX C........................................................................................................................................................................ 23

Interest Income...........................................................................................................................................................................23

APPENDIX D ....................................................................................................................................................................... 24

Dividends and Other Corporate Distributions ........................................................................................................................24

APPENDIX E........................................................................................................................................................................ 25

Basis of Property.........................................................................................................................................................................25

APPENDIX F ........................................................................................................................................................................ 31

Reporting Gains and Losses ......................................................................................................................................................31

APPENDIX G ....................................................................................................................................................................... 32

Rental Income and Expenses ....................................................................................................................................................32

APPENDIX H ....................................................................................................................................................................... 34

Retirement Plans, Pensions, and Annuities.............................................................................................................................34

APPENDIX I......................................................................................................................................................................... 35

Duties and Restrictions ..............................................................................................................................................................35

Course Description 9

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COURSE OVERVIEW

COURSE DESCRIPTIONIn Accuracy & Continuity the course content focuses on illustrating the steps necessary to comply with due diligence standards. The tax preparer must not only explore accuracy on a current year return, but review of a prior year return for figures related to carryovers and depreciation should also be performed. In addition, the course content touches on situations that involve interest and dividend income, RMDs, rental income, and short-and long-term capital gains. Finally, the course provides a brief discussion of basis determination and preparer contingency fees.

LEARNING OBJECTIVESReview prior year’s return for accuracy, comparison, and carryovers for current year return.

Recognize items that will affect future returns (e.g., carryovers, depreciation).

Interest Income (taxable and non-taxable) (e.g., Schedule B and 1099-INT).

Dividend Income (e.g., Schedule B and 1099-DIV).

Rental income and expenses (e.g., Schedule E Supplemental Income and Loss).

Required minimum distributions from retirement plans.

Short-term and long-term capital gains and losses (e.g., Schedule D Capital Gains and Losses, Form 1099-B Proceeds from Broker and Barter Exchange Transactions).

Determination of basis of assets (e.g., purchased, gifted, or inherited).

Rules regarding fees, including contingent fees.

ACCURACY & CONTINUITY ON TAX RETURNS

USING SCHEDULES AND PRIOR YEAR RETURNSFleming and Gobriel Buket enter your office with little fanfare but great disdain. "Can you believe this vulgar furniture, Darling?" blurts out Mrs. Buket in her nondescript Eastern European accent, not quite under her breath. "Dreadful, dreadful," comes the reply from her husband. "Sit down gently lest you disturb the molecular beasts harboring within," he instructs in a manner of speech befitting his patrician upbringing. "I do wish Robert would upgrade his surroundings to match his reputation."

Recognizing that these clients have arrived for their appointment to go over their tax return, your staff assistant retrieves the appropriate return from the "Returns Pending" file and approaches the couple. "Mr. and Mrs. Bucket?"

"Oh how vulgar!" pronounces Gobriel with her face assuming a look of astonishment belying the fact that she has endured this indignity countless times in the past.

10 Accuracy & Continuity on Tax Returns

"It's pronounced 'Boo-kay,' darling," corrects Fleming, his lower jaw jutting out for emphasis as his wife vigorously waves a hand fan under her chin, attempting to thwart the approaching palpitations.

"I apologize, Mr. Boo-kay."

"No worries, my dear. And please, call me Flem. This lovely creature attached to my arm is my wife, Gobriel. You may call her Gob." Gobriel snorts and increases the velocity of the fan.

"Nice to meet you, Flem and Gob. Please follow me and I will show you into Robbie's office."

Expecting the couple, you rise from your chair as the staff assistant enters your office, followed by the new clients. As she hands you the return she says, "Robbie, Flem Bucket and his wife Gob are here to go over their return."

"That's BOO-KAY" Flem again corrects, quite assertively this time.

"Sorry," your embarrassed assistant replies, "Flem and Gob Boo-kay."

NEW CLIENT DUE DILIGENCE"Good to see you again," you say, grasping Fleming's hand in a firm shake followed by a gentle clutch of the wilted appendage dangling from his wife's outstretched arm. "Please have a seat. Did you bring in a copy of last year's return?"

"Yes, my dear boy, I believe this is what you need," Fleming says as he hands you a neatly bound set of documents labeled "Tax Returns."

You had asked him to bring in a copy of last year's return because this is the first year you are preparing a return for the couple. As part of your standard due diligence process you know it is a good idea to review the prior year return.

Importance of Prior Year Return 11

When you met with Fleming and Gobriel a couple of weeks ago you went over the tax organizer they had completed for you and asked questions about any information that was missing or seemed inconsistent. While you understand that tax return preparers are not obligated to audit information received from clients and that, generally, preparers may rely in good faith on client-provided information, you also know that you have an obligation to make appropriate inquiries to determine the existence of facts and circumstances meeting the requirements for claiming various items on the return.

Fleming seemed a little annoyed at your persistent follow-up questions, but you remember that the instructor at a recent CPE course you took emphasized that, under Circular 230, you cannot ignore the implications of information that the client furnishes to you or which you otherwise actually know. In fact, you are required to make reasonable inquiries if the information as furnished appears to be incorrect or incomplete.

Once the Bukets understood that you were just complying with professional standards, they were cooperative and provided you with all the information you asked them for. All that is left to do is review the prior year return for accuracy, as well as comparison and carryovers to the current year.

IMPORTANCE OF PRIOR YEAR RETURNOpening the documents Fleming has handed to you, you first note that last year's return was filed as a joint return, the same way you have prepared the current return. You then compare the address and Social Security numbers from the prior return and note that they are the same as what appears on the return you prepared.

Then you recognize a difference. On the prior year's return, the Bukets listed two dependents - one was their granddaughter Rose and the other was for someone named Nicole Andime, a name you don't recognize. On the organizer, the clients completed for you this year they indicated to you that they had no dependents.

"I see you listed Rose as a dependent last year," you observe out loud.

"Yes," Fleming responds. "You see the poor girl was separated from her husband and moved back in with us for a few months. Thankfully they have reunited."

"Her husband is a dreadful man," Gobriel interjects. "He drinks beer directly from the bottle and sometimes wears no shoes. Can you imagine? He is vulgar, just vulgar."

"Now, now, darling, let's not get all worked up," Fleming says as he gently pats his wife's arm. "The boy can't help it. He was raised by wolves."

"Is there a problem, my good fellow?" asks Fleming.

"I don't know," you respond. "Let me explain. In earlier years, the IRS allowed for personal exemptions to be taken by both you and Mrs. Bucket..."

"BOO-KAY!" Fleming interjects.

"Sorry. In addition to the personal exemptions for you and Mrs. Boo-kay," you say with a slightly sarcastic emphasis, "you were entitled to a dependency exemption amount for each qualifying child and qualifying relative. While there isn't an option to claim exemptions anymore due to recent tax reform, there are still benefits to claiming a qualifying child or relative on your return."

"I see. Well, Rose is a mere child indeed and her qualifications are impeccable - she is a Boo-kay, you know," observes Fleming, turning to his wife with a satisfied grin on his face.

"You are so smart, darling!" agrees Gobriel, fluttering her fan.

"Well I suppose I am at that," he replies as the two share a generous chuckle.


REQUIREMENTS TO QUALIFY..."It's not that simple," you say. "A qualifying child can be your child, stepchild, adopted child, or foster child, or even your brother or sister or stepsibling or a descendant of any of these, but there are other criteria that have to be met. For example, they must be under 19 years old, or a student under 24."

Gobriel speaks up, "Our dear Rose is only 23, and she studies art."

"Where does she attend school," you ask.

"Oh, no, darling, she does not commune with the great unwashed masses." Gobriel explains. "She studies at home. Each week her mentor provides a lesson over the television. She has amassed a stupendous portfolio of landscape studies in oil. For a special project she combined her artistic skill with her mathematical studies, didn't she darling," Gobriel says, turning to her husband.

"Indeed," Fleming boasts. "One day we happened upon her working on a masterpiece and noticed that the canvas was filled with numbers - some sort of complex formula I would guess. The girl is brilliant, simply brilliant."

"I see," you reply, taking a moment to reminisce about your childhood love of paint by numbers.

"The problem," you explain, "is that she would have to be a full-time student at an educational organization that maintains a faculty, curriculum, and enrolled body of students."

"Are there any other requirements, my good man?" asks Fleming, rolling his eyes.

"Well, yes. A qualifying child cannot provide over half of his or her own support for the year and she must have lived in your home for over half the year," you say, emphasizing the latter point. "The real problem is that Rose's art studies do not make her a full-time student."

Necessity to Amend 13

"Are you saying that our own grandchild cannot be our dependent? This is an outrage," Fleming stammers indignantly, "I'll call the President!"

"I didn't say she wasn't your dependent. There is another test. If you provided more than half of her support and her gross income for the year was less than the exemption amount, she would be a 'qualifying relative.' Qualifying relatives can be a child, stepchild, or even a foster child, as well as any other descendant, such as a grandchild. This category also includes ancestors, including stepparents, as well as aunts and uncles, nieces and nephews, and in-laws."

"Good grief man, are there any other qualifications?" Fleming asks.

"Yes - Rose must not have filed a joint tax return with her husband for the year and all dependents must be either a U.S. citizen or a resident of the U.S., Canada, or Mexico."

"I'm sure the poor girl did not file a tax return with that vulgar man. The only money either of them has is what we give them," says Gobriel.

"Quite right, dear," says Fleming. "And the girl may have been educated in the finest boarding schools in Paris, but she was born on this side of the pond and is a U.S. citizen."

"Alright, then," you say. "Since Rose is a qualifying relative, it does not matter how old she was or if she was a student. " Now who is this other dependent listed on last year's return, this Nicole Andime?"

"That's 'Awn-dee-mo-nay' my dear boy, of the Beverly Hills 'Awn-dee-mo-nays,'" corrects Gobriel.

NECESSITY TO AMEND"OK, 'Awn-dee-mo-nay.' Who is she?"

"She is the teenage child of dear friends of ours who became embroiled in some unsavory banking business. The pressure was so great they decided to spend some time relaxing at a country club owned by the government. We took Nicole in while they were away," explains Fleming.

"How long did she stay with you?" you inquire.

"The original plan was one to three years, but she ended up being with us for about eight months. Something about 'good behavior,'" says Fleming.

"Yes, she was a model houseguest," agrees Gobriel.

"That's a problem," you explain. "Although non-relatives may be eligible as dependents, they must be a member of your household for the entire year. If she was only with you for eight months, Nicole should not have been claimed as your dependent last year."

"Enough of the technical jargon, dear boy, what is it that you are saying?" pleads Fleming.

"It means that last year's return was filed incorrectly and we'll have to amend. There will be some interest and a penalty."

Fleming turns to his wife with a stricken look on his face. "Dear God, darling, we're fugitives from the law."

Gobriel swoons. "Oh, dear, I look dreadful in stripes. Do you think they'll allow us to have visitors?" She begins fanning herself intensely and slumps in her chair as if she has fainted.


Rolling your eyes, you raise your hands in an effort to calm the couple. "No one is going to jail. The law allows you to amend a return within three years after the date the original return was filed or within two years after the date the tax was paid, whichever is later. We will simply amend your return using Form 1040X and pay the additional tax liability. We may even be able to abate the penalty if we can show reasonable cause, such as good faith reliance on the advice of your tax preparer."

Gobriel seems to come back to life as Fleming comforts her.

INTEREST, BONDS, AND THE AFR"Let's take a look at the rest of last year's return," you continue. Scanning the first page of the prior year's 1040 you notice that the amounts reported as interest and dividends are similar to the amounts reported in those categories this year.

"We need to make sure that we include as income any interest received or credited to you, including interest actually paid from bank accounts and other financial instruments, such as bonds," you instruct. "In most cases, this interest is reported to you on a Form 1099-INT from the payer."

You note that they had purchased some so-called "zero coupon" bonds - corporate bonds for which they paid less than the face amount. "With these bonds the difference between what you paid and the face amount that will be paid back to you at maturity is known as 'original issue discount,' or 'OID,' and represents interest."

You continue: "Part of the OID must be reported each year that you hold such bonds, even though you are cash method taxpayers. The amount of interest included in income is generally the bond's adjusted issue price at the beginning of the year multiplied by its yield to maturity."

"Ooooh we like yield," exclaims Gobriel.

A loan by any other name... 15

"The yield to maturity," you explain, "is simply the discount rate applied to the face amount that results in a present value equal to the amount they paid for the bond. While you will usually receive a 1099-OID with respect to OID bonds purchased directly from the issuer, OID interest may have to be calculated if no Form 1099-OID is received."

You notice that Gobriel has begun to intensely inspect her fingernails, but Fleming seems at least a little interested. "Bonds are something of a hobby of mine," he says proudly.

You go on to explain to them that there are other situations that can affect how interest is reported with respect to bonds. "For example, if you paid an amount in excess of the face amount of the bond, the excess is known as a 'premium.' Bond premiums can be amortized over the life of the bond to reduce the amount of interest income recognized."

You also tell them that interest from municipal bonds is not taxable for federal purposes, but the amount of tax-exempt interest received must be listed on the Form 1040.

"Someone at the club mentioned to me that interest from federal bonds may not be taxable," says Fleming. "He started to explain, but just then I noticed that the bartender had put only two olives in my martini and had to excuse myself to correct that abomination."

"You can exclude the amount of income from the redemption of any 'qualified U.S. savings bond' if you pay qualified higher education expenses during the tax year," you explain. "However, if the aggregate redemption proceeds exceed the qualified higher education expenses paid that year, the excluded interest is limited to the otherwise excludable amount times a fraction that results from dividing the qualified expenses by the redemption proceeds."

You continue, "But not all federal bonds qualify. They must be Series EE bonds issued after 1989 or Series I bonds. Furthermore, the individual who bought the bonds must have been at least 24 years old and must be either the sole owner or a joint owner with his or her spouse. Bonds held in the name of a child or other dependent do not qualify. Finally, the income exclusion phases out at a relatively modest amount of adjusted gross income."

You notice that both clients have now begun to inspect their fingernails.

A LOAN BY ANY OTHER NAME...Turning back to your task, you indicate that they may also have to include "imputed interest," which applies when a loan provides for no interest or for a below-market rate interest. "The imputed interest rules are designed to assure that interest income in at least the amount of the 'applicable federal rate,' or 'AFR,' is taxed to the lender when no interest, or a very low amount of interest, is stated," you explain. This reminds you that the AFR is determined periodically by the Treasury Department and you look up the appropriate amounts on the IRS Web site when needed.

"Does that apply to us?" asks Fleming.

"Not this year," you respond. "You had indicated that the two of you made an interest-free loan to Rose in the amount of $9,000. For imputed interest purposes this is treated as a transfer by the two of you of the loan amount to Rose in exchange for a $9,000 promissory note bearing interest at the AFR. Since the applicable AFR was 5% when the loan was made, you are also deemed to have transferred to Rose the amount needed to pay the interest, which in this case would be $9,000 times 5%, or $450. Rose is then deemed to have paid the $450 of interest back to you, resulting in $450 of imputed interest income."

"But Rose is our granddaughter - can't we treat the interest as a gift?" asks Gobriel.

"Yes," you tell her. "When the forgone interest is in the nature of a gift to the borrower, the loan is deemed to be a 'gift loan.' Fortunately, the below-market loan rules don't apply to gift loans when the outstanding amount of the loan is not more than $10,000, so no imputed interest has to be reported on the loan made to Rose."


TO 'B' OR NOT TO 'B' (SCHEDULE, THAT IS...)Having examined the interest reported on this year's return, you next turn to the issue of dividends. Dividends are corporate distributions of earnings to their shareholders, and the Bukets provided you with several Forms 1099-DIV as well as brokerage statements reflecting the amount of dividends that had been paid to them during the year.

You explained to the Bukets that "qualified" dividends are taxable at capital gains rates and that other dividends are taxable as ordinary income. "Qualified dividends come from domestic corporations and certain qualified foreign corporations, but not passive foreign investment companies."

"Furthermore," you continue, "qualified dividends do not include: (1) dividends paid on stock held for less than 60 days during the 121 day period surrounding the ex-dividend date; (2) dividends that trigger an offsetting obligation to make a payment with respect to positions in substantially similar or related property; (3) any amount that the taxpayer elects to treat as investment income to support an investment interest deduction; (4) dividends paid on deposits by mutual savings banks; or (5) dividends from employee stock ownership plan, or 'ESOP' stocks."

Since the Bukets are reporting over $1,500 in aggregate taxable interest and ordinary dividends, each source of these payments must be listed on Schedule B. You note that, even if the amount were less than $1,500, they would still have to use Schedule B because they are accruing interest from a bond.

You recall recently discussing this issue with a colleague, who explained to you that Schedule B is also required in other circumstances, such as: (1) anytime the taxpayer receives interest from a seller-financed mortgage where the buyer used the property as a personal residence; (2) if the amount of OID interest being reported is less than that shown on a Form 1099-OID; (3) if interest income is being reduced by amortization of a bond premium; or (4) if Series EE or Series I bond interest is being excluded.

CAPITAL GAINS AND/OR LOSSESYour review continues with the short- and long-term capital gains and losses appearing on Schedule D. You had mentioned to Fleming and Gobriel that almost everything they own and use for personal or investment purposes is considered a capital asset, including their home, jewelry, collectibles, real estate, and stocks or bonds. When a capital asset is sold, you explained to them, the difference between the sales price and the basis of the asset is a capital gain or a capital loss. "Basis" was unfamiliar to them, so you explained that it generally means the asset's cost, although if they receive an asset by gift the basis of the donor is carried over and the basis of inherited assets generally depends on the fair market value of the asset when the decedent died.

You went on to explain to them that short-term capital gains are taxed as ordinary income, while long-term capital gains are generally taxed at preferential rates, depending on their nature.

"Oh, yes, I know about this!" Gobriel excitedly exclaims. Turning to her husband she says, "We only have to pay 15% on capital gains, darling."

"Well, sort of," you interject. "Most capital gains are taxed at 15% or even 0%. Since 2018, rates on net capital gains are based on breakpoints versus the taxpayer's marginal bracket. Thus, in the case of an individual with an adjusted net capital gain, to the extent the gain would not result in taxable income exceeding the 15-percent breakpoint, such gain is not taxed. Any adjusted net capital gain which would result in taxable income exceeding the 15-percent breakpoint but not exceeding the 20-percent breakpoint is taxed at 15%. The remaining adjusted net capital gain is taxed at 20%."

You continue, giving them the breakpoints for 2021. The 15-percent breakpoint (maximum zero rate amount) is $80,800 for married filing jointly and surviving spouses, $40,400 for married filing separately, $54,100 for heads of household, and $40,400 for any other individuals. The 20-percent breakpoint (maximum 15-percent rate amount) is $501,600 for married filing jointly and surviving spouses, $250,800 for married filing separately, $473,750 for heads of household, and $445,850 for any other individuals.

Rental Property or Vacation Home? 17

"However, long-term gain from collectibles is taxed at 28%, as is the taxable part of a gain from selling Section 1202 qualified small business stock. Any portion of the gain from real estate equal to the amount of depreciation allowed or allowable is taxed at 25%."

"Now that we've talked about long-term capital gains," you continue, "short-term capital gains are taxed at ordinary income rates."

You note that last year they reported a net capital loss of $10,000. Since capital losses exceeding capital gains can only be claimed up to $3,000, the remainder is carried over to the current year. You glance at the Capital Loss Carryover Worksheet from IRS Publication 550 that Fleming had provided to you at the initial interview.

"Here's something we missed," you observe. "Last year you received a K-1 from a partnership indicating that a Code section 179 deduction flowed through to you."

"Oh no - was that an error as well? Eee-gads dear, we hired a nitwit to prepare our return last year," Fleming says to his wife.

"No, no, not an error," you hastily add, hoping to forestall another drama. "But you could not take the full amount of the deduction because your income was insufficient. It just means that the excess is carried over to this year." Your clients both breathe a sigh of relief.

RENTAL PROPERTY OR VACATION HOME?You next look at Schedule E from the prior year's return and compare it to the information from the current year, noting that the one and only rental property is a house at the shore. "You have only one rental property," you confirm aloud.

"Yes - that is our vacation home, but we simply haven't had the time to use it much lately. Don't tell me that's a problem," pleads Fleming.

"Maybe not," you respond optimistically. "When you own a vacation home and use it for both personal and rental purposes, the deduction of expenses is limited, except for those expenses that are deductible anyway, such as mortgage interest, property taxes and casualty losses."

"But we only used the estate for a few days during the annual regatta. I so love the sea," Fleming explains.

"Unfortunately," you continue, "your use of the home for even one day in the tax year triggers the deduction limits. In that case, the deduction for maintenance, utilities, depreciation, and the like can't exceed the percentage of those total expenses for the year that are 'attributable' to the period of rental. In other words, if it was rented for 50% of the time, you can deduct only 50% of the expenses."

"And that's not all," you continue. "If you rent out your residence, the deductions attributable to rental use are further limited to no more than the gross income derived from rental use for that year, less mortgage interest, taxes, and any deductions that aren't allocable to the use of the home itself, such as management fees. Excess rental expenses may be carried forward to later years."

"But this is not our home, dear boy, it is only a vacation property," says Fleming with a slight tremble in his voice.


You explain that a home is considered to be a residence in any tax year in which the owner's use exceeds the longer of 14 days or 10% of the period of rental use. "Furthermore," you explain if a residence is rented for less than 15 days a year, you can't deduct any of the rental expenses, but you also are not taxed on any of the rental income."

After ascertaining that the Bukets only used the vacation property for 10 days and that it was rented for 90, you explain that 90% of the expense may be deducted and only a minor adjustment is needed.

"Well, other than a couple of minor adjustments and the amended return for last year, I think we're just about done," you announce. "Do you have any questions?"

ARE WE READY FOR MILLENNIAL DISSOLUTION?"Just one," Fleming responds. "Do you have any advice for making our financial advisor stop sending us money?"

Almost afraid to ask, you do anyway: "What do you mean?"

"Our financial man sends us a check every year whether we want it or not. We've tried to send it back, but apparently, it has something to do with the end of the world.

"The end of the world?" you inquire, your interest now peaked.

"Yes. He keeps telling us it is required for the millennial dissolution."

Definition of Income 19

Thinking for a moment and remembering that the return reports income from Fleming's IRA distribution, you hesitatingly inquire: "Uh. . ., could that be 'required minimum distribution'?," hoping against hope that you are right.

"That's it!" explains Gobriel.

You resist the urge to bang your forehead on your desk and instead explain to your clients that a qualified plan or IRA must make certain distributions. "Specifically," you say, distributions must begin by April 1 of the calendar year following the year Fleming turned age 72 for his IRA and age 72 or retired, whichever is later for his qualified plan. Those payments are called required minimum distributions or RMDs and must be made over his life expectancy or that of himself and a designated beneficiary."

"Dear God, man!" Fleming exclaims, "Do you suggest that I am over the age of 72?"

"You indicated on your organizer that you turned 75 last year," you respond.

"Well, if you say so," Fleming says sheepishly. "But why are we discussing my age when the matter of your fee is at hand? How much do we pay you? Do you work on commission? I would gladly agree to pay you a percentage of our refund."

"I'm afraid not," you explain. "As a practitioner authorized to practice before the IRS, I generally cannot charge a contingent fee. There are exceptions for certain services rendered in connection with an audit of your return or a claim for refund filed solely in connection with the determination of statutory interest or penalties assessed, and contingent fees can be charged by practitioners for services connected to judicial proceedings arising under the Internal Revenue Code."

"Instead," you continue, "we can agree on an hourly fee or a flat fee, as long as it is not unconscionable." You pull out a fee sheet from your desk, calculate the fee, and hand your written estimate to your clients.

"We still have some work to do with the adjustments and the amended return for last year, and I'll want to go over the completed returns with you one more time after the adjustments are made, but that is a good estimate of my fee," you say.

Looking at the figures with satisfaction, Fleming replies, "Well, you may not be bred of the highest stock and your office furnishings may be more suited for a trailer home than a professional office, but I must admit you are cheap."

"Don't be so rude, darling!" Gobriel exclaims in horror. Turning to you with an apologetic look she says, "he meant to say 'inexpensive.' Have a good day, dear."

And with that Flem and Gob Buket left your office. You watch as your assistant offers an inaudible farewell to the couple, to which Fleming responds with a harrumph, "its BOO-KAY, dear, BOO-KAY."

CASE STUDIES

DEFINITION OF INCOMEHAM V. COMMISSIONER, TC SUMM. OP. 2012-3 (JANUARY 5, 2012)

FACTS

Like many taxpayers, George Ham invested some of his excess cash in mutual funds. Specifically he invested his money with Janus Capital Group. For the year in question, Janus sent George a 1099-DIV reflecting capital gains distributions, ordinary dividend distributions, and qualified dividend distributions. Normally, a taxpayer would be expected to report these various components of income, but George had a theory.

The way George saw it, the fact that he had purchased his mutual fund shares between "record dates," was significant, and caused a portion of his investment to be properly allocated to accrued dividends. In other words, a portion of his purchase price was really just a reimbursement of the dividends that had been declared, but unpaid, prior to his

20 Case Studies

purchase. Thus, he reasoned, his receipt of this portion of his purchase price was just a nontaxable "return of capital," and therefore not taxable. Neither the IRS nor the Tax Court agreed with this reasoning, and George was ordered to pay the asserted deficiency.

LAW

George's downfall is founded on the basic definition of income for tax purposes. We do not start with a blank slate when analyzing whether an item is properly characterized as income. Quite the contrary, all income cases start with the fundamental premise that gross income includes "all income from whatever source derived" unless specifically excluded by an Internal Revenue Code provision or Treasury Regulation. IRC §61(a); Treas. Reg. §sec. 1.61-1(a). The proper question, therefore, is not "should this be a taxable item," but rather "is there a specific provision excluding this as a taxable item." Much like criminal suspects are presumed innocent until proven guilty, income is presumed taxable unless and until a specific exclusion is identified.

George had an uphill battle to wage, to say the least. The Code, in fact, lists certain types of income as being specifically included, among them dividends. IRC §61(a)(7). Furthermore, the regulations clarify that mutual fund dividends are to be included in income in the year in which they are received. Treas. Reg. §1.852-4(a)(1).

Not all dividends are taxed on the same basis. For example, so-called "qualified dividends" (basically, dividends from domestic corporations) are currently subject to tax at a preferential 15% rate under Code section 1(h). Capital gain dividends distributed from a mutual fund are treated long-term capital gains and must be recognized as income in the taxable year of the shareholder in which they are received. IRC §852(b)(3)(B); Treas. Reg. §1.852-4(b)(1).

ANALYSIS

George had a point. Mutual funds, like corporations, must specify a date certain as to when dividends become payable. Suppose, for example, investor A owned stock worth $100 on which a $10 dividend had just been declared. Since the dividend was declared when A owned the stock, the dividend belongs to A. However, assume that A agrees to sell his stock to B after the dividend is declared, but before it is paid. A will demand not only the $100 value of his stock from B, but also the $10 representing the dividend that is rightfully A's but that will now be delivered to B.

So B will pay A $110. Economically, $100 is for the stock and $10 is merely to reimbursed A for his dividend that will now be diverted to B. If B has to pay the tax on that dividend, he is in essence paying tax on income he never received (after all, he had to "reimburse" A in the form of a higher price for the stock).

The Tax Court clearly understands this, and George's argument has some cache. The problem is that all the cache in the world won't change the law. When it comes to income items, the rule is remarkably simple: they are included in gross income unless specifically excluded by the law. Unfortunately for George, while his reasoning maybe compelling, it finds no home in any statutory or regulatory provision. Nice try, George, but no dice.

DEPENDENTSDAVILA V. COMMISSIONER, TC SUMM. OP. 2012-6 (JANUARY 10, 2012)

FACTS

Ed Davila just wanted to help out his cousin. She was afraid of her estranged husband and needed a safe place to stay. Ed's door was open, and his cousin and her two children moved in with him in May of 2009, staying there until December. Ed cared for the children as if they were his own, and financially supported them throughout the time they remained in his house. Much to Ed's surprise, however, no amount of support would have been enough, and he was denied the dependency exemption.

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LAW

A dependent must be either a qualifying child or qualifying relative. An individual who does not fit into one of these categories simply cannot be claimed as a dependent.

A qualifying child must be a child (biological or adopted) of the taxpayer or descendant of such a child; or a brother, sister, stepbrother, or stepsister of the taxpayer or a descendant thereof. IRC §152(c)(2). The children Ed claimed as dependents were the offspring of his cousin, not Ed. Consequently, those children did not have any of the requisite family relationships necessary to constitute a "qualifying child."

Someone can achieve qualifying relative status in one of two ways. The first way is satisfy one of the specific family relationships enumerated in the statute. The relationships meeting the criteria for qualifying relative status are the taxpayer's: (1) child or a descendant of a child; (2) brother, sister, stepbrother, or stepsister; (3) father or mother, or an ancestor of either; (4) stepfather or stepmother; (5) son or daughter of a brother or sister; (6) uncle or aunt (i.e., brother or sister of the father or mother of the taxpayer); or (7) son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law. IRC §152(d)(2)(A)-(G).

The second route is for the individual to maintain his or her residence with the taxpayer for the entire year and receive more than one-half of his or her support from the taxpayer. IRC §152(d)(2)(H); Treas. Reg. §1.152-1(b).

ANALYSIS

Although Ed may have been a Good Samaritan, he was not a taxpayer with dependents. Unaided by counsel, the record shows that Ed focused on the amount of support he provided to the children. A tax advisor should have been able to tell him that he had good facts, but the wrong argument. The amount of support provided by the taxpayer is only relevant if the taxpayer is trying to qualify the dependent as a qualifying relative. That status applies only to a specifically enumerated list of relationships and those people who live with the taxpayer for the entire year. Cousins (much less children of cousins) are not among the enumerated relationships and it was clear that the children did not live with Ed for the entire year. Close may count in horseshoes, but not in Tax Court. Sorry, Ed.

APPENDIX A

DUTIES AND RESTRICTIONSDILIGENCE AS TO ACCURACY

A practitioner must exercise due diligence in preparing, approving, and filing tax returns and all other documents, as well as any oral statements relating to IRS or Treasury Department matters. The practitioner must use the same diligence in determining the correctness of oral or written statements made to clients with reference to any matter administered by the Internal Revenue Service. A practitioner will be presumed to have exercised due diligence if the practitioner relies on the work product of another person and the practitioner used reasonable care in engaging, supervising, training, and evaluating the person.

Most of the preparer penalties fall under Internal Revenue Code sections 6694 and 6695. Those penalties are summarized below:

IRC section 6694 – Understatement of taxpayer’s liability by tax return preparer:

IRC section 6694(a) – Understatement due to unreasonable positions. The penalty is the greater of $1,000 or 50% of the income derived by the tax return preparer with respect to the return or claim for refund.

IRC section 6694(b) – Understatement due to willful or reckless conduct. The penalty is the greater of $5,000 or 75% of the income derived by the tax return preparer with respect to the return or claim for refund.

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IRC section 6695 – Other assessable penalties for tax return preparer with respect to the preparation of tax returns for other persons. In the case of any failure relating to a return or claim for refund filed in 2022 (generally 2021 tax returns filed in 2022), the penalty amounts under §6695 are:

IRC section 6695(a) – Failure to furnish copy to taxpayer. The penalty is $50 for each failure to comply with IRC §6107 regarding furnishing a copy of a return or claim to a taxpayer. The maximum penalty imposed on any tax return preparer shall not exceed $27,000 in a calendar year.

IRC section 6695(b) – Failure to sign return. The penalty is $50 for each failure to sign a return or claim for refund as required by regulations. The maximum penalty imposed on any tax return preparer shall not exceed $27,000 in a calendar year.

IRC section 6695(c) – Failure to furnish identifying number. The penalty is $50 for each failure to comply with IRC §6109(a)(4) regarding furnishing an identifying number on a return or claim. The maximum penalty imposed on any tax return preparer shall not exceed $27,000 in a calendar year.

IRC section 6695(d) – Failure to retain copy or list. The penalty is $50 for each failure to comply with IRC §6107(b) regarding retaining a copy or list of a return or claim. The maximum penalty imposed on any tax return preparer shall not exceed $27,000 in a return period.

IRC section 6695(e) – Failure to file correct information returns. The penalty is $50 for each failure (per return and item in return) to comply with IRC §6060. The maximum penalty imposed on any tax return preparer shall not exceed $27,000 in a return period.

IRC section 6695(f) – Negotiation of check. The penalty is $545 (per check) for a tax return preparer who endorses or negotiates any check made in respect of taxes imposed by Title 26 which is issued to a taxpayer. There is no limit to the maximum penalty.

IRC section 6695(g) – Failure to be diligent in determining eligibility for earned income credit. The penalty is $545 for each failure to comply with the due diligence requirements imposed in regulations. Any return preparer who fails to comply with due diligence requirements imposed to determine eligibility for, or the amount of, the credit allowable shall pay a penalty of $545 for each failure. There is no limit to the maximum penalty. Those who prepare returns that claim Earned Income Credit (EIC), American Opportunity Tax Credit (AOTC), Child Tax Credit (CTC) (including the Additional Child Tax Credit (ACTC) and the Credit for Other Dependents (ODC)), and Head of Household (HOH) filing status must not only ask all the questions required on Form 8867, Paid Preparer's Due Diligence Checklist, but must also ask additional questions when information seems incorrect, inconsistent or incomplete. In addition, the preparer must verify identity, prepare a computational checklist (Form 8867 or equivalent), and meet a recordkeeping requirement.

APPENDIX B

GAINS AND LOSSESCAPITAL LOSS CARRYOVER

If capital losses are more than capital gains, a taxpayer may claim a capital loss deduction. The allowable capital loss deduction, figured on Schedule D, is the lesser of the following:

$3,000 ($1,500 if taxpayer is married and files a separate return)

The taxpayer's total net loss, as shown on Schedule D

A taxpayer may use his total net loss to reduce income dollar for dollar, up to the $3,000 limit. If the total net loss exceeds the yearly limit on capital loss deductions, carry the unused part over to the next year and treat it as though it had incurred in that next year. If part of the loss is still unused, the taxpayer may carry the unused part over to later years until none of the loss remains. When calculating the amount of any capital loss carryover to the next year, consider the current year's allowable deduction, whether or not the taxpayer has claimed the allowable deduction.

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When a taxpayer carries over a loss, it remains long term or short term. Any long-term capital losses carried over to the next tax year will reduce that year's long-term capital gains before it reduces that year's short-term capital gains. In calculating the capital loss carryover, a taxpayer should use the short-term capital losses first, even if the taxpayer incurred those losses after a long-term capital loss. If a taxpayer has not reached the limit on the capital loss deduction after using the short-term capital losses, use the long-term capital losses until the taxpayer has reached the limit.

Example: Sheila has both long-term capital losses (LTCL) and short-term capital losses (STCL) in 20X1. Her 20X1 net STCL is $5,000 and net LTCL is $10,000. She can only deduct $3,000 in the current year (20X1) and must use her short-term loss first. She carries $2,000 STCL and $10,000 LTCL forward to the next year (20X2).

GAMBLING GAINS AND LOSSES

Another area that is often confusing to taxpayers and practitioners alike involves gains and losses from gambling activity. While it is generally understood that gambling losses are not deductible, this is not always the case. For example, a taxpayer who qualifies as a professional gambler is entitled to deduct all of the non-wagering expenses related to the gambling activity – only the wagering expenses are limited to gambling winnings. Thus, a professional gambler who has broken even or has a net wagering loss will generally still have a deductible loss as a result of other expenditures, such as travel, research, etc. Furthermore, the extent to which wagering outlays can offset gambling winnings is often misunderstood. The problem results from the fact that “net” gambling winnings from a transaction are always included in income, whereas the deduction can be taken only as a Schedule A deduction. This leads to two problems. First, a gain from wagering is determined on a transaction-by-transaction basis. A casual gambler’s gross income from a wagering transaction should be calculated by subtracting only those bets placed to produce the winnings; those bets do not constitute a deduction in calculating adjusted gross income but are used only as a preliminary computation in determining wagering gains.

Code section 165, on the other hand, permits an itemized deduction limited to the amount of gains from wagering. Thus, if a taxpayers places a $50 bet and wins $150 on a horse race in January and then loses $200 playing the lottery later in the year, the taxpayer’s wagering gain is $100 ($150 won at the horse race minus the $50 wager placed to produce that payout). If the taxpayer itemized deductions, he or she is entitled to a Code section 165 deduction of $100 for the lottery losses ($200 of losses limited by the wagering gains of $100). If, however, the taxpayer does not itemize, the $100 wagering gain is included in income without any offset.

APPENDIX C

INTEREST INCOMETAXABLE INTEREST

A taxpayer must generally report taxable interest from Form 1099-INT or Schedule K-1 for partnerships and S corporations. Taxable interest includes income from various sources such as the following:

Bank, savings and loan, or credit union accounts

Money market funds

Certificates of deposit

U.S. treasury bills, notes, and bonds (exempt from all state and local income taxes)

Loans made to others

Gifts more than $10 for opening financial accounts ($20 if the account is more than $5,000)

Interest received on tax refunds

U.S. Savings Bond Interest

Series H and HH - Report semi-annual interest payments in the year received.

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Series I, E, and EE - Interest is credited at maturity. Taxpayers who use the cash method of accounting may elect to defer reporting interest until maturity; those using the accrual method must report interest on U.S. savings bonds each year as it accrues.

Tip: Interest from Series I or EE bonds may be tax-free if used to pay for qualified education expenses the same year. This exclusion is known as the Education Savings Bond Program, and is not available when married filing separately. A taxpayer uses Form 8815 to figure the exclusion and attaches the form to Form 1040.

ORIGINAL ISSUE DISCOUNT (OID)

Original issue discount (OID) is a form of interest. Taxpayers include a portion of the discount as income as it accrues over the term of the debt instrument, even if they do not receive any payments from the issuer. A debt instrument generally has OID when the debtor issues the instrument for a price that is less than its stated redemption price at maturity. OID is the difference between the stated redemption price at maturity and the issue price. The IRS presumes that all debt instruments that do not pay interest before maturity are issued at a discount. Zero-coupon bonds are one example of these instruments.

The OID accrual rules generally do not apply to short-term obligations (those with a fixed maturity date of one year or less from date of issue). The taxpayer may treat the discount as zero if it is less than one-fourth of 1% (.0025) of the stated redemption price at maturity multiplied by the number of full years from the date of original issue to maturity. This small discount is known as "de minimis" OID.

APPENDIX D

DIVIDENDS AND OTHER CORPORATE DISTRIBUTIONSQUALIFIED DIVIDENDS

Qualified dividends are subject to the same 0%, 15%, or 20% maximum tax rate that applies to net capital gains. Qualified dividends are subject to the 20% rate if taxable income exceeds the 20-percent breakpoint. If taxable income exceeds the 15-percent breakpoint but does not exceed the 20-percent breakpoint, qualified dividends are subject to the 15% rate. The tax rate is 0% for qualified dividends if taxable income does not exceed the 15-percent breakpoint.

2021 Capital Gain and Qualified Dividend Breakpoints

Filing Status15-percentBreakpoint

20-percentBreakpoint

Married Individuals Filing Joint Returns and Surviving Spouses $80,800 $501,600

Married Individuals Filing Separate $40,400 $250,800

Heads of Household $54,100 $473,750

Unmarried Individuals (other than Surviving Spouses and Heads of Household) $40,400 $445,850

For dividends to qualify for the maximum tax rate that applies to net capital gains, the following must be true:

The dividends must be paid by a U.S. corporation or a qualified foreign corporation.

The taxpayer must hold the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. (Include the day the stock was disposed, but not the day acquired. The ex-dividend date is the first

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date following the declaration of a dividend on which the buyer of a stock will not receive the next dividend payment. Instead, the seller will get the dividend.)

APPENDIX E

BASIS OF PROPERTYCOST BASIS

Basis is the amount of a taxpayer's investment in a property for tax purposes. A gain or loss is determined by subtracting the adjusted basis from the proceeds of the sale, exchange, or other disposition of property. Basis is used to figure deductions for depreciation, amortization, depletion, and casualty losses. If a taxpayer uses property for business (or investment) purposes and for personal purposes, the taxpayer must properly allocate basis based on the property use. Only the basis allocated to business or investment use of the property is depreciable. The basis of property is usually its cost. The cost is the amount paid in cash, debt obligations, other property, or services. A taxpayer's cost basis also includes (but is not limited to) amounts paid for:

Commissions

Sales tax, freight, installation, and testing

Legal and accounting fees (when they must be capitalized)

Excise taxes, revenue stamps, recording fees, and real estate taxes (if assuming seller's liability)

The original basis in property is adjusted (increased or decreased) by certain events:

Improvements to a property will increase basis

Deductions for depreciation or casualty losses or claiming certain credits will reduce basis

REAL PROPERTY

Real property, also called real estate, is land and generally anything built on, growing on, or attached to the land. Certain fees and other expenses are part of the cost basis in the property. If a taxpayer buys buildings and the land on which the buildings stand for a lump sum, the taxpayer should allocate cost basis among the land and the buildings. The taxpayer should allocate cost basis according to the respective fair market value (FMV) of the land and buildings at the time of purchase. The basis of each asset is calculated by multiplying the lump sum by a fraction. The numerator is the FMV of that asset, and the denominator is the FMV of the whole property at the time of purchase.

TIP: Since land is not depreciable, a taxpayer must allocate a portion of the purchase price to land prior to calculating the depreciation deduction. Improvements that increase the value of a structure apply only to the structure and do not increase the basis of the land.

If a taxpayer buys property and assumes an existing mortgage on the property, the basis includes the amount paid for the property plus the amount to be paid on the mortgage. The basis is adjusted by certain settlement cost as described below:

A taxpayer's basis includes the settlement fees and closing costs paid for buying the property. A fee for buying property is a cost that the taxpayer must pay even if he buys the property with cash. Do not include fees and costs for getting a loan on the property in the basis.

Taxpayers may add the following settlement fees or closing costs to the basis:

Abstract fees (abstract of title fees)

Charges for installing utility services

Legal fees (fees for the title search and preparation of the sales contract and deed)

Recording fees

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Survey fees

Transfer taxes

Owner's title insurance

Any amounts the buyer agrees to pay for the seller, such as back taxes or interest, recording or mortgage fees, cost of improvements or repairs, and sales commissions

Taxpayers may not add the following settlement fees and closing costs to basis:

Casualty insurance premiums

Rent for occupancy of the property before closing

Charges for utilities or other services related to the property before closing

Charges connected with getting a loan, such as points (discount points, loan origination fees), mortgage insurance premiums, loan assumption fees, cost of a credit report, and fees for an appraisal required by a lender

Fees for refinancing a mortgage. If a taxpayer pays points to get a loan (including a mortgage, second mortgage, line of credit, or a home equity loan), the points may not be added to the basis of the related property. Generally, the taxpayer will deduct points over the term of the loan.

Amounts placed in escrow for the future payment of taxes and insurance

Important: The term "points" is used to describe certain charges paid to obtain a home mortgage. Points are prepaid interest, and maybe deductible as home mortgage interest. Special rules apply to points paid on a mortgage to buy a main home. If certain requirements are met, a taxpayer may deduct the points in full for the year in which they are paid. Points paid for refinancing generally can only be deducted over the life of the new mortgage. Points do not increase basis.

Points charged for specific services, such as preparation costs for a mortgage note, appraisal fees, or notary fees, are not interest and cannot be deducted. Points paid by the seller of a home cannot be deducted as interest on the seller's return, but they are a selling expense that will reduce the amount of gain realized. Points paid by the seller may be deducted by the buyer provided the buyer subtracts the amount from the basis, or cost, of the residence. Points you pay on loans secured by your second home can be deducted only over the life of the loan.

ADJUSTED BASIS

Before figuring gain or loss on a sale, exchange, or other disposition of property or figuring allowable depreciation, depletion, or amortization, a taxpayer must usually make certain adjustments (increases and decreases) to the cost of the property. The result is the adjusted basis.

Increase the basis of any property by all items properly added to a capital account. These include (but are not limited to) the following items:

Capital improvements - The costs of improvements having a useful life of more than one year, which increase the value of the property, lengthen its life, or adapt it to a different use. Improvements include the following:

Putting a recreation room in an unfinished basement

Adding another bathroom or bedroom

Building a fence

Installing new plumbing or wiring

Installing a new roof

Paving the driveway


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Assessments for local improvements - Add property assessments for improvements that increase the value of the property assessed to the basis. Do not deduct these assessments as taxes. Examples of assessments are as follows:

Roads

Sidewalks

Water connections

Extending utility service lines to the property

Decrease the basis of any property by all items that represent a return of capital for the period during which the taxpayer held the property. Examples of items that decrease basis include (but are not limited to) the items discussed below:

Non-taxable corporate distributions - Also known as non-dividend distributions. This amount reflects a return of capital and reduces basis.

Casualty and theft losses - Decrease the basis of property by any insurance proceeds or other reimbursement and by any deductible loss not covered by insurance. Increase the basis in the property by the amount spent on repairs that restore the property to its pre-casualty condition.

Depreciation and Section 179 deduction - The basis of a taxpayer's qualifying business property will be decreased by any Section 179 deductions taken and the depreciation deducted, or could have deducted (including any special depreciation allowance), on the taxpayer's returns under the method of depreciation selected.

Easements - Generally, the IRS considers compensation for granting an easement as proceeds from the sale of an interest in real property. Reduce basis of the property by the amount received.

Certain Credits - Basis may be reduced by the amount of credits received for one of the following:

Alternative motor vehicle credit

Alternative fuel vehicle refueling property credit

Residential energy efficient property credit

PROPERTY RECEIVED FOR SERVICES

If a taxpayer receives property for services rendered, its FMV must be included in income. The amount included in income becomes the basis. If the taxpayer performed the services for a price agreed on beforehand, the IRS will accept that price as the FMV of the property if there is no evidence to the contrary. If the property is subject to certain restrictions, the basis in the property is its FMV when it vests substantially. However, this rule does not apply if the taxpayer makes an election to include in income the FMV of the property at the time the transfer of property occurs, less any amount the taxpayer paid for it. Property is substantially vested when it is transferable or when it is not subject to a substantial risk of forfeiture (the taxpayer does not have a good chance of losing it).

BARGAIN PURCHASES

A bargain purchase is a purchase of an item for less than its FMV. If, as compensation for services, a taxpayer buys goods or other property at less than FMV, the difference between the purchase price and the property's FMV must be included in income. The basis in the property is its FMV (the purchase price plus the amount included in income).

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INVOLUNTARY CONVERSIONS

If a taxpayer receives replacement property because of an involuntary conversion, such as a casualty, theft, or condemnation, the basis of the replacement property is calculated by using the basis of the converted property.

Similar or related property - If a taxpayer receives replacement property similar or related in service or use to the converted property, the replacement property's basis is the same as the converted property's basis on the date of the conversion, with the following adjustments:

The basis is decreased by the following:

Any loss recognized on the involuntary conversion

Any money received that the taxpayer does not spend on similar property

The basis is increased by the following:

Any gain recognized on the involuntary conversion

Any cost of acquiring the replacement property

Money or property not similar or related - If a taxpayer receives money or property not similar or related in service or use to the converted property, and he buys replacement property similar or related in service or use to the converted property, the basis of the replacement property will be its cost decreased by the gain not recognized on the conversion.

Example: Bill's dog knocks over a glass of milk destroying his work laptop. His basis in the laptop is $2,000. He receives a $2,500 insurance reimbursement and purchases another laptop for $2,200. Bill recognizes a gain of $500, increasing his basis. He does not spend $300 of the proceeds on the replacement property, reducing his basis. His adjusted basis in the new laptop is $1,900 ($2,200 – $300).

PROPERTY RECEIVED AS A GIFT

To establish the basis of property received as a gift, a taxpayer must know the adjusted basis to the donor (source of gift), its fair market value (FMV) at the time the donor gifted the property, and any gift tax paid on it. The annual gift tax exclusion is $15,000 for 2021. The relationship between the FMV and the donor's basis determines the applicable rule. If a taxpayer receives a gift of property and the donor's adjusted basis determines the basis, the IRS considers the taxpayer's holding period to have started on the same day the donor's holding period started. If the fair market value of the property determines the basis, the holding period starts on the day after the date of the gift.

FMV less than donor's adjusted basis - Basis depends on whether a gain or a loss occurs when the property is disposed of. The following dual basis rules prevent taxpayers from shifting unrealized losses to other taxpayers:

The basis for figuring gain is the same as the donor's adjusted basis.

The basis for figuring loss is its FMV when the taxpayer received the gift.

FMV equal to or greater than donor's adjusted basis - Basis is the donor's adjusted basis at the time the taxpayer received the gift.

If the donor paid gift tax on the transfer, basis increases by the part of the gift tax that is due to the net increase in value of the gift. The net increase in value of the gift is the FMV of the gift minus the donor's adjusted basis. Figure the increase by multiplying the gift tax paid by a fraction.

PROPERTY TRANSFERRED FROM A SPOUSE

The basis and holding period of property transferred to a taxpayer or transferred in trust for the taxpayer's benefit by the taxpayer's spouse is the same as the spouse's adjusted basis. The same rule applies to a transfer by a taxpayer's


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former spouse that is incident to divorce. The taxpayer does not recognize any gain or loss on property transferred to a spouse or former spouse incident to divorce. This is true even if receiving cash or other consideration.

INHERITED PROPERTY

TIP: With the exception of 2010 transfers electing modified carryover basis, a gain on inherited property is always long-term. Basis of an inherited capital asset is generally the FMV of the property on the date of death or an alternate valuation date, if elected by the personal representative. A step-up in basis occurs when the FMV is greater than the decedent's (person who died) basis.

The form of ownership can affect the amount of the step-up:

Qualified Joint Interest - A qualified joint interest is any interest in property held by a husband and wife as tenants by the entirety or tenants with rights of survivorship. One-half of the value of the property receives a step-up in basis to FMV.

Joint tenancy with rights of survivorship (JTWROS) - Joint tenants with rights of survivorship share an equal interest in property. As such, they participate equally in income and deductions. If one owner dies, only the portion included in the decedent's estate receives a step-up in basis. The amount is dependent upon the percentage of total consideration for the property the decedent provided and whether or not a decedent made a gift. Where the capital contribution was 75%, and the decedent did not gift any portion of the property, 75% of the property receives a step-up in basis.

Community Property - In community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), the husband and wife each usually own half of the community property. When either spouse dies, the total value of all community property, even the part belonging to the surviving spouse, can receive a step-up in basis, provided the decedent's share is part of their gross estate.

PROPERTY CHANGED FROM PERSONAL TO BUSINESS OR RENTAL USE

If a taxpayer holds property for personal use and then changes it to business use or uses it to produce rent, the taxpayer may begin to depreciate the property at the time of the change. To do so, calculate the property's basis for depreciation. An example of changing property held for personal use to business or rental use would be renting a former personal residence. The basis for depreciation is the lesser of the following amounts:

The FMV of the property on the date of the change

The adjusted basis on the date of the change

If the taxpayer sells the property at a loss, the FMV on date of conversion (with adjustments) is the cost for purposes of determining basis. If the taxpayer sells the property at a profit, the original basis (with adjustments) is used. This rule prevents a taxpayer from shifting nondeductible losses on personal property to deductible losses on business property.

SECURITIES

The rules explained below apply to most investors. Dealers in securities and day-traders may utilize different methods to account for their transactions.

Stocks or bonds - The basis of purchased stocks or bonds is generally the purchase price and any costs of purchase, such as commissions and recording or transfer fees.

Nontaxable stock dividends or stock splits - In this situation, a shareholder's percentage of ownership does not change. Allocate the total adjusted basis of all shares pro-rata to each share. Reduce the basis of existing

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shares by the amount of basis allocated to the new shares. This rule applies only when the additional stock received is identical to the stock held.

Return of capital - Also known as non-dividend distributions. This amount reflects a return of capital and reduces basis.

Subsequent Transactions - If a person buys and sells securities at various times in varying quantities and cannot adequately identify the shares sold, the basis used is the basis of the securities acquired first. This is the first-in, first-out (FIFO) method. If adequate identification is possible, the taxpayer may elect to report the specific shares sold, regardless of their order of purchase.

FLOW-THROUGH ENTITIES

A taxpayer often does not pay much attention to the basis of a flow-through investment (i.e., S corporation stock or an LLC or partnership interest) until he or she sells the property. At that point, basis is crucial to determine how much gain or loss the taxpayer has to report. Due to the statutory overturning of the Supreme Court’s Home Concrete decision, a taxpayer who uses the wrong basis may be exposed to the 6-year statute of limitation on assessments. Because taxpayers often look to their preparers for guidance with respect to basis, particular care is warranted.

Ordinarily, the IRS must assess a deficiency against a taxpayer within 3 years after the return was due or 3 years after it was filed, whichever is later. The 3-year period is extended to 6 years, however, when a taxpayer omits an amount of gross income in excess of 25% of the amount of gross income stated in the return.

In 1999 Stephen Chandler and Robert Pierce were the sole shareholders of plaintiff Home Oil and Coal Company, Incorporated. Pierce contemplated selling his interest in Home Oil and sought professional financial planning advice in anticipation of the transaction. This financial advice, rendered by several financial planning firms, included proposals to minimize the tax liability generated by the sale of his interest in Home Oil.

Home Concrete & Supply, LLC was formed on April 15, 1999, with its members being Chandler, Pierce, Home Oil, and two trusts established for the benefit of Pierce's children. On May 13, 1999, each of these LLC members initiated short sales of U.S. Treasury Bonds. In the aggregate, the taxpayers received $7,472,405 in short sale proceeds. Four days later, the taxpayers transferred the short sale proceeds and margin cash to Home Concrete as capital contributions. By transferring the short sale proceeds to Home Concrete as capital contributions, the taxpayers created “outside basis” equal to the amount of the proceeds contributed. The next day, May 18, 1999, Home Concrete closed the short sales by purchasing and returning essentially identical Treasury Bonds on the open market at an aggregate purchase price of $7,359,043.

On June 11, 1999, Home Oil transferred substantially all of its business assets to Home Concrete as a capital contribution. Three days later, the taxpayers (except Home Oil) transferred percentages of their respective partnership interests in Home Concrete to Home Oil as capital contributions to Home Oil. On August 31, 1999, Home Concrete sold substantially all of its assets to a third-party purchaser for $10,623,348.

In April 2000, Home Concrete and the taxpayers timely filed their tax returns for the 1999 tax year. Home Concrete made a Code section 754 election to adjust, or “step-up,” its inside basis to equal the taxpayers’ outside bases. Home Concrete then adjusted its inside basis to $10,527,350.53, including the amount of short sale proceeds earlier contributed by the taxpayers. As a result, Home Concrete reported a modest $69,125.08 gain from the sale of its assets.

Home Concrete’s 1999 tax return reported the basic components of the transactions. Its Code section 754 election form gave, for each partnership asset, an itemized accounting of the partnership’s inside basis, the amount of the basis adjustment, and the post-election basis. On its face, Home Concrete’s return also showed a “Sale of U.S. Treasury Bonds” acquired on May 18, 1999 at a cost of $7,359,043, and a sale of those Bonds on May 19, 1999 for $7,472,405.

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The return also reported the resulting gain of $113,362. Similarly, the taxpayers’ individual returns showed that during the year the proceeds of a short sale not closed by the taxpayer in this tax year were received.

Notwithstanding these disclosures, the IRS did not investigate the taxpayers’ transactions until June of 2003. As a result of the investigation, on September 7, 2006, the IRS issued a Final Partnership Administrative Adjustment decreasing to zero the taxpayers’ reported outside bases in Home Concrete and thereby substantially increasing the taxpayers' taxable income. The IRS invoked the extended 6-year statute of limitations arguing that Home Concrete omitted gross income in an amount that exceeded 25% of the amount of gross income stated in its 1999 tax return.

The question before the Supreme Court was whether the 6-year statute applies when the taxpayer overstates the basis in property that was sold, thereby understating the gain that received from its sale. The Supreme Court held that the extended statute of limitations did not apply to an overstatement of basis, hence the IRS could not make the assessment more than 3 years after the return had been filed (or its due date, whichever was later).

The Surface Transportation and Veterans Health Care Choice Act of 2015 effectively overturned this decision by amending Code section Code 6501(e)(1)(B) to now statutorily provide that the 6-year statute of limitations period specifically applies in cases where any overstatement of basis results in a substantial omission of income.

APPENDIX F

REPORTING GAINS AND LOSSESCALCULATING NET GAINS AND LOSSES

Tax rates differ, depending upon the nature of the gain and the type of property involved. Combine gains and losses in each category to arrive at a net gain or loss.

Short-term gains and losses - Sale or trade of investment property held one year or less. Combine the taxpayer's share of short-term capital gain or loss from partnerships, S corporations, fiduciaries, and any short-term capital loss carryover with other short-term capital gains and losses to figure the net short-term capital gain (NSTCG) or net short-term capital loss (NSTCL).

Long-term gains and losses - Sale or trade of investment property held more than one year is a long-term capital gain or loss. Combine the taxpayer's share of long-term capital gain or loss from partnerships, S corporations, and fiduciaries, as well as any long-term capital loss carryover with other long-term capital gains and losses, to figure net long-term capital gain (NLTCG) or net long-term capital loss (NLTCL).

Total net gain or loss - A taxpayer may calculate total net gain or loss by comparing the net short-term capital gain or loss to the net long-term capital gain or loss. If a taxpayer has a:

Net gain and a net loss (NLTCG and NSTCL or NLTCL and NSTCG) - The resulting gain or loss maintains the character of the larger item.

Example: If net short-term losses exceed net long-term gains, the character of the resulting net loss is short-term. If net short-term gains exceed net long-term losses, the resulting net gain is short-term and is taxed at ordinary income tax rates. If net long-term gains exceed net short-term losses, the resulting net gain is long-term and is taxed at the maximum net capital gain tax rates.

Both short and long-term losses (NLTCL and NSTCL) - Each loss maintains its character, either long or short-term.

Both short and long-term gains (NLTCG and NSTCG) - Each gain maintains its character. The maximum net capital gain tax rates apply to the long-term capital gain, while ordinary income tax rates apply to the short-term capital gain.

Since 2018, rates on net capital gains are based on breakpoints versus the taxpayer's marginal bracket. Thus, in the case of an individual with an adjusted net capital gain, to the extent the gain would not result in taxable income exceeding the 15-percent breakpoint, such gain is not taxed. Any adjusted net capital gain which would result in

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taxable income exceeding the 15-percent breakpoint but not exceeding the 20-percent breakpoint is taxed at 15%. The remaining adjusted net capital gain is taxed at 20%.

Under the Tax Cuts and Jobs Act of 2017, starting in 2018, rates on net capital gains are based on breakpoints and are as follows:

2021 Capital Gain Breakpoints

Filing Status15-percentBreakpoint

20-percentBreakpoint

Married Individuals Filing Joint Returns and Surviving Spouses $80,800 $501,600

Married Individuals Filing Separate $40,400 $250,800

Heads of Household $54,100 $473,750

Unmarried Individuals (other than Surviving Spouses and Heads of Household) $40,400 $445,850

IF the net capital gain is from... THEN the maximum capital gain rate is...

Gain on collectibles or qualified small business stock 28%

Un-recaptured Section 1250 gain 25%

Other gain (other than gains on collectibles, small business stock, or un-recaptured §1250):

Taxable income exceeding the 20-percent breakpoint 20%

Taxable income exceeding 15-percent breakpoint but not exceeding 20-percent breakpoint 15%

Taxable income not exceeding the 15-percent breakpoint 0%

APPENDIX G

RENTAL INCOME AND EXPENSESSeveral factors determine the amount of rental income to include on a taxpayer's return. The IRS allows certain expenses as a deduction against gross rental income, resulting in either a gain or loss from rental activities. Report gross rental income and expenses on Schedule E, and transfer the resulting net gain or allowable loss amount to Form 1040.

PERSONAL USE PROPERTY

The IRS treats rental real estate property as a home, if used for personal purposes more than the greater of 14 days or 10% of the total days rented to others.

If the taxpayer does not use the property as a home, report all the rental income and deduct all the rental expenses. Deductible rental expenses can be more than gross rental income.

If the taxpayer uses the property as a home, the rental income and deductions depend on how many days the taxpayer rented the unit at a fair rental price.

If rented fewer than 15 days during the year, do not treat that period as rental activity. Do not include any of the rent as income and do not deduct any of the rental expenses.

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If rented 15 days or more, include all rental income and allocate expenses between rental and personal use. If resulting in a loss, not all expenses may be deductible.

Personal use is use by owners, family members, or anyone for less than fair value.

Any day that the taxpayer rents the unit at a fair rental price is a day of rental use even if used for personal purposes that day.

Any day that the unit is available but not actually rented is not a day of rental use.

RENTAL INCOME

Generally, a taxpayer must include all amounts received as rent in gross income. Rental income is any payment received for the use or occupation of property. In addition to amounts received as normal rent payments, other amounts may be rental income.

Advance rent - Advance rent is any amount received before the period that it covers. Include advance rent as rental income during the year the taxpayer received the income, regardless of the period covered or the method of accounting used.

Security deposits - Do not include a security deposit as income when the taxpayer receives the deposit if the taxpayer is to return the deposit to the tenant at the end of the lease. If the taxpayer keeps part or all of the security deposit during any year because the tenant does not live up to the terms of the lease, include the amount kept as income in that year. If the taxpayer designates an amount called a security deposit as a final payment of rent, treat it as advance rent. Include it as income when received.

Expenses paid by tenant - If a taxpayer's tenant pays any of the taxpayer's expenses, the taxpayer must report the payments as rental income. These payments should be included as income. The taxpayer may deduct certain deductible rental expenses.

Property or services - If a taxpayer receives rent in the form of property or services, instead of money, include the fair market value of the property or services as rental income. If the tenant provides the services at an agreed upon or specified price, that price is generally considered the fair market value.

Rents from personal property - If renting out personal property, such as equipment or vehicles, the method for reporting income and expenses depends upon whether or not the rental activity is a business conducted for profit. In general, if the primary purpose is income or profit and the taxpayer is regularly involved in the rental activity, it is a business. Report income and expenses on Schedule C. If a rental activity is not a business, report rental income as other income on Form 1040 and include any expenses as an adjustment to gross income.

RENTAL EXPENSES

Related expenses - Deductions from rental income include advertising, cleaning and maintenance, utilities, taxes, interest, commissions for the collection of rent, travel, and transportation.

Fire and liability insurance - If the taxpayer pays insurance premiums for more than one year in advance, the part of the premium payment that will apply to a future year is not a deduction until that year. The taxpayer may not deduct the total premium in the year it was paid.

Depreciation - Depreciate rental property when it is ready and available for rent. Depreciation is a method to recover the cost of income producing property through yearly tax deductions. The property type will dictate the period used. The recovery period for residential real property is 27.5 years. The recovery period for non-residential real property is 39 years. Taxpayers may not depreciate the cost of land.

Repairs - A repair keeps property in good operating condition. It does not materially add to the value of the property or substantially prolong its life. Repainting the property inside or out, fixing gutters or floors, fixing leaks, plastering, and replacing broken windows are examples of repairs. If the taxpayer makes repairs as part of an extensive remodeling or restoration of the property, the whole job is considered an improvement. The taxpayer may deduct

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the cost of repairs to the rental property. The taxpayer may not deduct the cost of improvements. Instead, the taxpayer may recover the cost of improvements by taking depreciation.

Improvements - An improvement adds to the value of property, prolongs its useful life, or adapts it to new uses. If the taxpayer makes improvements to the property, the taxpayer must capitalize the cost of the improvement. Examples of improvements include putting a recreation room in an unfinished basement; adding a bathroom or bedroom; building a fence; installing new plumbing, wiring, or cabinets; putting on a new roof; and paving a driveway.

ADDITIONAL CONSIDERATIONS

Local benefit taxes - Generally, a taxpayer may not deduct charges for local benefits that increase the value of the property. Examples of these charges include charges for putting in streets, sidewalks, or water and sewer systems. These charges are non-depreciable capital expenditures, and the taxpayer must add them to the basis of the property.

Vacant rental property - If holding property for rental purposes, ordinary and necessary expenses may be deducted (including depreciation) for managing, conserving, or maintaining the property while the property is vacant. Income loss due to a vacancy is not deductible.

Uncollected rent - Cash basis taxpayers do not deduct uncollected rent because it was never considered as income. Under the accrual method, taxpayers report income when earned. If the taxpayer is unable to collect the rent, he may be able to deduct it as a bad business debt.

Not rented for profit - If the taxpayer rents a property but does not rent the property to make a profit, the taxpayer may deduct rental expenses, but only up to the amount of the rental income. The taxpayer cannot deduct losses nor carry them forward to the next year if rental expenses are more than the rental income for the year.

Property changed to rental use - If a property converts to rental use at any time after the beginning of the tax year, taxpayers divide yearly expenses such as taxes and insurance between rental and personal use. Only the portion of expenses relative to the rental use is deductible. The IRS does not permit deductions for depreciation or insurance during periods of personal use.

Renting part of property - If the taxpayer rents part of the property, the taxpayer must divide certain expenses between the part of the property used for rental purposes and the part of the property used for personal purposes; it would be as though two separate pieces of property existed. The taxpayer need not divide expenses that belong only to the rental part of the property. The taxpayer may deduct depreciation on the part of the house used for rental purposes as well as on the furniture and equipment used for rental purposes.

SELF-RENTAL RULES

In certain situations, a taxpayer must treat income from passive activities as income from nonpassive activities. Specifically, the regulations generally recharacterize as nonpassive the net rental activity income from an item of property if the property is rented for use in a trade or business activity in which the taxpayer materially participates. This is commonly referred to as the “self-rental rule” or “recharacterization rule.” The self-rental rule requires that: (1) property be rented for use in a trade or business and (2) the taxpayer materially participate in the trade or business.

APPENDIX H

RETIREMENT PLANS, PENSIONS, AND ANNUITIESMANDATORY DISTRIBUTIONS

An owner of a tax-deferred retirement plan must take mandatory Required Minimum Distributions (RMD) from his account for each year after a certain age. At the end of 2019, the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) was passed which increased this age to 72. Previously it was age 70.5. The required

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beginning date for mandatory distributions from IRAs (including SEPs and SIMPLE IRAs) is April 1 of the year following the year the taxpayer reaches age 72 (or age 70.5 if turned 70.5 prior to January 1, 2020). The change is also applicable to 401(k), profit-sharing, 403(b), or other defined contribution plans; however, for those plans, the plan could allow participants (other than those who own 5% or more of the company) to base the required beginning date on the year of retirement if working beyond age 72.

Beginning date for your first required minimum distribution (RMD):

IRAs (including SEPs and SIMPLE IRAs) – April 1 of the year following the calendar year in which you:

reach age 70½, if you were born before July 1, 1949.

reach age 72, if you were born after Jun 30, 1949.

401(k), profit-sharing, 403(b), or other defined contribution plan – Generally, April 1 following the later of the calendar year in which you:

reach age 72 (age 70½ if born before July 1, 1949), or

retire (if your plan allows this).

Figure the required minimum distribution for each year by dividing the IRA account balance (as of the close of business on December 31) of the preceding year by the applicable distribution period or life expectancy. The RMD rules prevent people from leaving money in retirement accounts indefinitely. Failure to take RMD can result in a penalty equal to 50% of the required distribution amount. A non-qualified annuity is not subject to age restrictions.

TIP: Another change as part of the SECURE Act is the removal of the age limit for contributing to a traditional IRA. In years prior to 2019, IRA contributions were not allowed unless the taxpayer was younger than age 70.5 at the end of the tax year. The age requirement was eliminated.

ROTH IRA

A Roth IRA is like any other IRA that, except as explained below, is subject to the rules that apply to a traditional IRA. A taxpayer can not deduct contributions to a Roth IRA. If the Roth IRA requirements are satisfied, qualified distributions are tax-free. Roth IRAs never had a contribution age limit, so the elimination of the contribution age limit on traditional IRAs is no longer a difference. Unlike traditional IRAs, a taxpayer can leave amounts in his or her Roth IRA as long as they live. However, the account or annuity must be designated as a Roth IRA when it is set up.

APPENDIX I

DUTIES AND RESTRICTIONSCONTINGENT FEES

A contingent fee is one that is based on whether or not a position taken on a return avoids challenge by the IRS. A practitioner may not charge a contingent fee for services in connection with any matter before the IRS, except:

Services related to an IRS examination or challenge of:

An original tax return

An amended tax return filed within 120 days of a taxpayer receiving a notice of examination

For services rendered in connection with a claim for credit or refund filed solely in connection with the determination of statutory interest or penalties assessed by the IRS

Services connected to a judicial proceeding

In 2014 the U.S. District Court for the District of Columbia called into question the IRS’s ability to police return filing practice. The court in Ridgely v. Lew specifically ruled that a CPA who prepares an original or amended return is not engaged in representation of taxpayers and thus is not engaged in practice subject to Circular 230. Thus, in the court’s

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opinion Circular 230 regulates practitioners only when they are involved in examination or appeals representation. As a result, the court invalidated and permanently enjoined the IRS from prohibiting contingent fee arrangements for refund claims and amended returns. The IRS decided not to appeal that decision.

Even under the pre-Ridgely provisions of Circular 230, a practitioner was permitted to charge a contingent fee for services rendered in connection with the IRS’s examination of, or challenge to an original tax return or an amended return or claim for refund or credit where the amended return or claim for refund or credit was filed within 120 days of the taxpayer receiving a written notice of the examination of, or a written challenge to the original tax return. Furthermore, a practitioner may charge a contingent fee for services rendered in connection with a claim for credit or refund filed solely in connection with the determination of statutory interest or penalties assessed by the IRS, as well as for services rendered in connection with any judicial proceeding arising under the Internal Revenue Code.

Documents

ACCURACY & CONTINUITY ON TAX RETURNS