EXAM STUDY MATERIALS July 30, 2024 11:26 AM TAX 4001 Exam 2 Questions With Correct Answers It has been suggested that tax policy favors deductions for AGI compared to itemized deductions. Describe two ways in which deductions for AGI are treated more favorably than itemized deductions. - answer✔✔Itemized deductions must exceed the standard deduc tion before taxpayers receive any tax benefit from the deductions (this is equivalent to an overall floor limit). In contrast, business deductions that are deductible for AGI (above the line) reduce taxable income without being subject to an overall floor limit. Also, itemized deductions are subject to many mechanical limitations including ceilings, floors, and phase -outs whereas business deductions are generally not subject to these limits (there are limits on certain specific deductions, but this will be described in greater detail in chapter 9). How is a business activity distinguished from an investment activity? Why is this distinction important for the purpose of calculating federal income taxes? - answer✔✔Both business and investment activities are mo tivated primarily by profit intent, but they can be distinguished by the level of profit -seeking activity. A business activity is commonly described as a sustained, continuous, high level of profit -seeking activity, whereas investment activities don't requ ire a high level of involvement. The distinction can be important for the location of deductions, because business deductions are claimed above the line (for AGI on Schedule C) while investment deductions are generally itemized or from AGI deductions (with the exception of rent and royalty expenses which are deductible for AGI on Schedule E). Describe how a business element is reflected in the requirements to deduct moving expenses and how Congress limited this deduction to substantial moves. - answer✔✔A bu siness element is reflected in both the distance test and time test associated with the move. To satisfy the distance test, the distance from the taxpayer's old residence to the new place of work (business element) must be at least 50 miles more than the d istance from the old residence to the old place of work (business element). The time test for a moving expense deduction requires the taxpayer to be employed full time 39 of the first 52 weeks (or self -employed for 78 of the first 104 weeks) after the move (obviously reflecting a business element). Explain why Congress allows self -employed taxpayers to deduct the cost of health insurance above the line (for AGI) when employees can only itemize this cost as a medical expense. Would a self -employed taxpayer e ver prefer to claim health insurance premiums as an itemized deductions rather than a deduction for AGI? Explain. - answer✔✔This deduction provides a measure of equity between employees and the self -employed. The cost of health insurance is essentially a p ersonal expense. However, employees typically aren't required to pay insurance premiums because their employers pay the premiums for them as a form of compensation. The EXAM STUDY MATERIALS July 30, 2024 11:26 AM employer is allowed to deduct the premium as a compensation expense, and the employee i s allowed to exclude from taxable income the value of the premiums paid on his behalf. Thus, from the employee's perspective, this arrangement has the same effect as if (1) the employer pays the employee cash compensation in the amount of the premium and ( 2) the employee pays the premium and deducts the expense for AGI (completely offsetting the compensation income). In contrast to employees, self -employed taxpayers pay their own health insurance costs, because they don't have an employer to pay these costs for them. Absent a rule to the contrary, self -
employed taxpayers would deduct their medical expenses as itemized deductions subject to strict limitations, because the cost of the health insurance is a personal expense rather than a business expense. To tr eat employees and self -employed taxpayers similarly, Congress allows self -
employed taxpayers to deduct personal health insurance premiums as for AGI rather than itemized deductions. Thus, self -employed taxpayers are able to (1) receive business income and (2) use the business income to pay their health insurance premiums and deduct the premiums as a for AGI deduction (completely offsetting the business income they used to pay the premium). Given the preferential treatment of for AGI deductions relative to i temized deductions, a self -
employed taxpayer should never prefer to claim health insurance premiums as an itemized deduction rather than a deduction for AGI. Explain why Congress allows self -employed taxpayers to deduct the employer portion of their self-employment tax. - answer✔✔To put self -employed individuals on somewhat equal footing with other employers that are allowed to deduct the employer's share of the social security tax. Hence, self -employed taxpayers are allowed to deduct the employer's share o f the self -
employment tax. Using the Internal Revenue Code, describe two deductions for AGI that are not discussed in this chapter. - answer✔✔§62 is the quickest way to identify deductions for AGI, but several can also be identified from the front of form 1040. Examples include the performing artist deduction, deductions of business expenses for state and local officials, reforestation expenses, and remitted jury duty pay. Explain why Congress allows taxpayers to deduct interest forfeited as a penalty on th e premature withdrawal from a certificate of deposit. - answer✔✔The full amount of the interest income is included in gross income, and this deduction reduces the net interest income to the amount actually received by the individual. Describe the mechanica l limitation on the deduction for interest on qualified educational loans. - answer✔✔The maximum deduction for interest expense on qualified education loans is the amount of interest expense paid up to $2,500. However, the deduction is reduced (phased -out) for taxpayers depending on the taxpayer's filing status and modified AGI. Specifically, the deduction for interest on educational loans is subject to proportional phase -out over a range of $15,000 ($30,000 for married filing jointly). The range begins for taxpayers at $65,000 of modified AGI ($130,000 for MFJ) and ends at $80,000 of modified AGI ($160,000 for married filing jointly). Modified AGI for this purpose is AGI before deducting interest expense on the EXAM STUDY MATERIALS July 30, 2024 11:26 AM qualified education loans and before deducting qualified education expenses. Married individuals who file separately are not allowed to deduct this expense under any circumstance. Explain why the medical expense and casualty loss provisions are sometimes referred to as "wherewithal" deductions and how this rationale is reflected in the limits on these deductions. - answer✔✔These deductions are designed to reduce the tax burden on taxpayers whose circumstances have involuntarily reduced their ability to pay. Both deductions are restricted to expenses th at exceed insurance reimbursements and a floor limit based upon AGI. These limits ensure that taxpayers claiming the deduction have exceedingly large involuntary expenditures as measured by their ability to pay. Describe the type of medical expenditures th at qualify for the medical expense deduction. Does the cost of meals consumed while hospitalized qualify for the deduction? Do over -the-counter drugs and medicines qualify for the deduction? - answer✔✔Medical expenses include any payments for the care, pre vention, diagnosis, or cure of injury, disease, or bodily function that are not reimbursed by health insurance. Included are the costs of prescription medicine, insulin, and payments to doctors, dentists, and the like incurred by the taxpayer, taxpayer's s pouse, and dependents. Over -the-counter drugs and medicines do not qualify for the deduction. Besides direct medical expenses, the deduction includes the cost of health insurance (if not already deducted above the line by self -employed taxpayers or if not offset by a premium tax credit under IRC Sec. 36B). Medical expenses also include long -term care services for disabled spouses and dependents to the extent the costs (including meals and lodging) are attributable to medical care. The cost of elective cosme tic surgery and over -the-counter drugs is not deductible. The cost of meals and lodging qualify if incurred at a medical -care facility or hospital and are incident to the care of the patient, but the cost of lodging is limited to $50 per eligible person pe r night. The cost of travel for and essential to medical care, including lodging (still limited to $50 per eligible person per night) is also deductible if the expense is not extravagant and the travel has no significant element of personal pleasure. Under what circumstances can a taxpayer deduct medical expenses paid for a member of his family? Does it matter if the family member reports significant amounts of gross income and cannot be claimed as a dependent? - answer✔✔A taxpayer can deduct medical expens es incurred for members of his family if they are dependents (i.e., either qualified children or qualified relatives). For purposes of deducting medical expenses, a dependent need not meet the gross income test (§213(a)). What types of taxes qualify to be deducted as itemized deductions? Would a vehicle registration fee qualify as a deductible tax? - answer✔✔Taxes qualifying for this deduction include state, local, and foreign income taxes, real estate taxes, and personal property taxes. State and local sales taxes may also be deducted but only in lieu of state and local income taxes. The deduction for sales tax can be based upon either the amount paid or the amount published in the IRS tables (IRS Publication 600). Vehicle registration fees are not deductib le (unless calculated based on the value of the vehicle rather than its weight).
